Sunday, July 31, 2016

The Antrix-Devas self goal

The Antrix-Devas case should be a teachable moment for India's trigger-happy government auditors. 

In brief, Antrix, the commercial arm of Indian Space Research Organization (ISRO), signed a contract in 2005 with Devas Multimedia, a firm promoted by two retired ISRO scientists, whereby Devas acquired a 12 year lease of two ISRO satellites to be operated in the S-band spectrum (which was reserved for defence sector, though India does not possess the technology to use it) to broadcast high speed internet on mobile devices. Devas was to pay $300 million over the contract duration. A CAG report in 2010 found the deal vitiated. In response to the public outcry and media trial, in 2011, an embattled government cancelled the deal saying that the spectrum was necessary for defence purposes. Devas initiated two international arbitration proceedings against the contract cancellation. The International Chamber of Commerce tribunal in Paris imposed a penalty of $855 million, and the UN Commission on International Trade Law at Hague imposed another penalty. The latter ruled that the cancellation constituted "expropriation" and India breached its Bilateral Investment Treaty (BIT) commitments with Mauritius to accord "fair and equitable treatment" to foreign investors. 

The CAG in its report says it is a ‘classic case of public investment at private profit.’ It finds conflicts of interest, disregard for rules and procedures and Cabinet apparently being misled into approving the agreement... When CAG said the Devas-Antrix deal was vitiated, the beleaguered Manmohan Singh government gave in to pressure from the Opposition and baying TV channels to abruptly cancel the contract citing strategic interests... The CAG has been wrong earlier too. In 2005, it faulted the sale of two hotels of Hotel Corporation of India ─ Juhu Centaur and Airport Centaur – to single bidders. It had pointed fingers at Arun Shourie, then minister for disinvestment in the Vajpayee government. The CAG alleged the government had suffered losses because the company that won the bid for Airport Centaur for Rs 83 crore had sold it a few months later to the Sahara Group at a profit of Rs 32 crore. The bidder of Juhu Centaur could not pay the full fee of Rs 153 crore and the hotel was shuttered in 2005. An investigation by the Central Bureau of Investigation was ordered, but in 2008, the investigative agency told the government it could not find any irregularities.

The CAG had also said the treasury had been put to a loss of Rs 10.8 lakh crore by the allocation of coal blocks between 2004 and 2009. In 2015, the Modi government claimed it earned more than that amount by auctioning 20 of the 204 coal blocks whose allocation the Supreme Court had cancelled. The claim is misleading because the money will flow in over 30 years if the mines are worked to rated capacity. These cash flows have to be discounted at an interest rate to arrive at their ‘present value’ (because today’s money will not buy the same amount 30 years later).
In all these cases, the CAG has sought to expand its jurisdiction on performance audit and passed judgement on the merits of public policy actions. This is surprising since the National Audit Office (NAO) of UK, which is the model for India's CAG, has this to say about its remit
We do not comment on the merits of policy but aim to conclude on whether value for money has been secured
Consider the Devas case where the CAG definitively describes it as a "classic case of public investment at private profit". Consider the leap. It has found procedural lapses, may be even conflicts of interest. But, how does it establish malafide? Or more specifically, how does the auditor establish that these lapses are not genuine omissions or those dictated by exigencies of decision making? In any case, isn't this the jurisdiction of vigilance officials and investigators? If the CAG is competent to pronounce guilty, what is left for the departmental proceedings and criminal investigators? Finally, it is surely an extremely sweeping conclusion to describe it as a "classic case" of crony capitalism. 

The CAG is plagued by the same disease that afflicts the Chief Information Commission, the Central Bureau of Investigations, the Chief Vigilance Commission, and most disturbingly the Judiciary. All these regulatory institutions, none of which have to take any decisions on managing a public agency, have been swept into populist grand-standing. In the process, they have compromised professional integrity, eroded their own long-term institutional credibility, and paralyzed public policy decision making. The lack of leadership in these institutions has never been so missing. 

Saturday, July 30, 2016

The coming EM "debt default bulge"?

Bloomberg points to the pace of debt accumulation among emerging economies,
Overall, the external debt of developing economies has tripled in the last 10 years, with the volume growing faster than both gross domestic product and foreign exchange reserves in the last five years
Another article highlights the spectre of non-financial corporate defaults in Asia,
A bulge in Asian defaults is a certainty between now and the end of the decade.
A third article highlights the relative attractiveness of EM, in this case Indian, debt despite their much higher risks,
Glenmark Pharmaceuticals, which sold its first straight dollar bond on Monday. The coupon was 4.5 percent, which translates to a spread of about 325 basis points over Libor, well inside the regulatory limit. The low yield for a company rated two notches below investment grade happened even as the borrower failed to detail its other debts in the prospectus -- "description of material indebtedness," a standard (albeit not mandatory) feature of junk bonds was missing. No worries, the $200 million of notes still received bids equivalent to more than $1.6 billion. With so much cash around, who cares for disclosure, risks or ratings? If it's from India and it pays more than zero, it's good.
All said and done, despite all its risks, given the very low exposure of high-yield Indian corporates to foreign debt, is is tempting to argue that this may be an opportunity to mobilize low-cost capital. But then, in a country with weak general corporate governance standards, high yield corporate offerings are most likely to signal lemons. For a corporate sector already reeling from high levels of leverage, such increased external exposure may tick more negatives than positives.

Friday, July 29, 2016

An FAR sales model

In an earlier post, I had blogged about adopting higher Floor Area Ratio (FAR) and establishing a trading platform and enabling regulatory framework in trading it. 

Since 2004, the Brazilian city of Sao Paulo has been selling Certificate of Additional Construction Potential Bonds (CEPACs) through periodic electronic auctions in the Sao Paulo Stock Exchange (Bovespa). It gives the buyer additional building rights to be used within the notified area. Taking a cue from Sao Paulo, but with several variations, here are the broad contours of a plan for Indian cities. 

To start with, the revised Master Plan with higher and graded FAR should be notified. But property rights should be restricted to the existing FAR. And, construction to realize the higher FAR should be permitted only on purchase of FAR. The FAR would be sold as Transferable Development Right (TDR) through calibrated auctions done on a digital platform.  

Given the vast variation in land prices across a city, it may not be advisable to have a single TDR market for the whole city. Instead, the Master Plan itself should divide the city into TDR zones. This could be done based on a combination of prevailing property prices (guidance value register), economic growth and development synergies, and other parameters that are used in demarcating Business Improvement District (BID) or Tax Increment Financing (TIF) areas. A notified slum or a residential colony could be notified as a zone. The TDR would initially be transferable only within the zone. 

It may also not be prudent to initiate TDR sales across the entire city from the beginning. Instead, it can be operationalized in a few zones identified (and approved by the Council) based on immediate development imperatives (say, a new metro or impending large road widening) or to promote urban renewal (in old town or blighted areas) or to encourage affordable housing (in certain areas close to industrial locations) or to facilitate transit-oriented development (the highest density transit corridors and around major transit stations). 

In the notified area, a small proportion, say 5%, of the total original FAR of the zone can be released into the market once every three years. The extent of releases can also be determined based on assessments of population growth or in pursuit of the realization of some pre-defined targeted average per capita floor space over a period of time. The sale can be done through well-publicized auctions conducted on an easily accessible electronic platform following the prevailing capital market regulations. The entire auction process should be outsourced and the bonds traded on the National Stock Exchange.   

In order to curb hoarding and speculation, the validity of a TDR should be restricted to 5 years. The owner would have to utilize the TDR and get the property tax assessment completed within this period. In exceptional cases, where the buyer was unable to develop the property due to delays in municipal and other government building approvals, the City can buy back the TDR at the same price with interest calculated at prevailing rates. In other words, no buyer, under any circumstance would be able to retain an un-utilized right beyond five years.

Further, since all transactions are done on an electronic trading platform, buyers should register with their Aadhaar numbers or corporate PANs (including the Aadhaar numbers of its Directors). Purchases by any individual or entity should be capped at 10% of the total TDR being sold so as to prevent hoarding. The trading platform should incorporate analytics that filter deviations. 

The implementation of this initiative should necessarily follow a strictly iterative approach. The implementation should be closely monitored and assessed, and its elements should be reviewed after a period of three or five years. The City government should enlist a reputed evaluation agency as a partner to study and offer insights about the interventions' successes and failings. 

The expansion of notified zones should be done only after the first round of review. If the system stabilizes, after a few rounds of reviews, it should be possible to merge zones, have auctions with increased periodicity, and so on.

The legal framework necessary for this would not involve any legislative amendments. The City's building regulations should be amended to reflect the distinction between FAR that comes with property rights and that which have to be purchased. The City would also have to register the TDR issuance in each zone with the Securities Exchange Board of India to use their platform to transact the auctions. However, it will have to be examined as to whether the TDR is a "security" under the SEBI Act 1992 or any other relevant legislation.

Such TDRs can be powerful instruments to achieve urban development priorities. For example, TDRs can be sold at a discount to encourage the construction of smaller affordable housing units. It can be sold through a reverse auction on the condition that the developer should sell 25% as affordable housing units. As the affordable housing stock so added increases, it would put downward pressure on property prices.

Further, the phased, market-driven, and potentially self-financing approach to densification and infrastructure augmentation is more likely to address the practical challenges associated with such efforts.

Thursday, July 28, 2016

A vertical development action agenda

Zoning regulations, especially limits on vertical development, impose prohibitive costs on urban development. It can be safely said that housing has become priced out of range for all but the richest 0.5% in the metropolitan cities. A striking manifestation of the problem comes from a nice article by Shanu Athiparambath,
In 1984, the average floor space consumption in Shanghai was 3.6 square meters. By allowing tall buildings, Shanghai raised average floor consumption to 34 square meters by 2010. Cities across the world have raised floor space consumption by allowing tall buildings. In 1910, 16 people lived on a typical floor of 920 square feet in Manhattan. In 2010, four people lived on a typical floor, because floor space consumption had risen four times...
In Mumbai... the average person consumes less floor space than an American prisoner... in 2009, the average floor space consumption in Mumbai was merely 48 square feet... Over half the households have only one room. As early as 1978, a draft of the Department of Justice had accepted that prisons in United States should offer single rooms of at least 80 square feet per man.
It is increasingly evident that affordable housing could be the biggest hurdle to India's urban development aspirations. There are only two approaches to alleviating the constraints - vertical development and unlock vacant public lands. While both would be necessary to address the problem in the long-run, it may be prudent to significantly liberalize vertical development before unlocking vacant government lands so as to realize full value from these last remaining vacant spaces in the largest cities. 

Two fundamental reforms to zoning regulations in Indian cities are essential. One, cities should move away from the present system of single Floor Area Ratios (FAR) across the city to a system of graded FAR. Second, there should be a two-tier FAR arrangement, with certain basic FAR which comes with the property right and the rest to be purchased from the local authority and freely tradeable. In many respects, the still-born Mumbai DP 2034 is a very good example that embraces these principles, though the FAR should have been even higher. These reforms should be complemented with at least four critical policy support initiatives.

1. Cities should then revise their Master Plans based on these principles. Certain areas like the central business district, transit corridors, important transit stations, and newer developments should have much higher FARs. In fact, while the basic FAR can be constant, the sellable FAR can gradually increase with time, based on certain objective considerations.

2. FAR should become an instrument to achieve important urban development objectives. For example, the older and blighted areas of cities, as well as any other strategically valuable areas, should be targeted with very high FAR so as to encourage urban renewal and redevelopment. Similarly, affordable housing developments can even be allowed to purchase the additional FAR at concessional rates. 

3. The local authority should simultaneously invest heavily in upgrading infrastructure so as to increase the carrying capacity of the areas undergoing vertical development. It may be useful to consider ring-fencing such areas and use the proceeds from the sales of FAR in infrastructure improvements there. It can be supplemented with various value-capture techniques to mobilize local area resources to finance such investments.

4. Finally, there should be a trading platform with an enabling regulatory framework to support the trade in FARs. This should capture both the mechanisms for transparent and efficient price discovery and trading of FARs. The Government of India could support the States in the establishment of a platform by preparing model legal and other documents as well as the development of requisite IT applications.

Wednesday, July 27, 2016

Two China graphics for the day

First, from Goldman Sachs, via MR, on the total fiscal deficit, including off-balance sheet items, which touched 15% of GDP!
Second, Ananth points to the spurt in public spending stimulus in the first half of 2016, which rose by 23.5%, even as growth in private fixed investment fell to a record low. 

It is clear that the Chinese government is still reluctant to face the reality and take on the challenge of squeezing out the excesses from credit-fueled growth that has become entrenched over the years. But, like with everything China, however, there are sub-plots. The recent debate on "systemic financial risks" and the increasingly direct role of President Xi Jinping in the country's economic affairs, over the head of the State Council headed by the Prime Minister Li Keqiang, may portend some course corrections. But it is unlikely to be anything like what is necessary. 

Tuesday, July 26, 2016

The challenge with development - the curse of standards

There are very few development challenges that do not come with trade-offs. And on most first-order determinants of development, the trade-offs raise disturbing and difficult questions. This is so even when the change is morally, socially, and economically desirable. But trade-offs invariably mean acceptance of second-best standards. 

Accordingly, the imposition of a rigorous patent regime in a least developed country runs the risk of curtailing local enterprise. In countries without any alternatives, outright bans on market intermediaries like money lenders and agriculture middle-men, howsoever fleecing they are, adversely affects the vast majority. In all these cases of regulatory reforms, the costs of formality often outweigh its benefits, leaving the system as a whole worse off than without the reform. I had blogged earlier about how the high cost of regulation and standards that accompany manufacturing for export markets prices such manufacturers out from India's domestic markets. 

Consider four examples of such trade-offs that India is currently grappling with. The first two involve the pursuit of formulating standards, while the last two involves the problems associated with enforcing laid down standards. 

The Employees Provident Fund Organization (EPFO), a public sector entity that manages the gratuity and pension of India's central government employees, is apparently considering the enrollment of unorganized sector workers into EPFO. For a start, this is a contradiction in terms since the unorganized sector workers are not in EPFO precisely because they are not part of any formal network. And they prefer to stay informal because the costs of formality are prohibitive. For example, the total salary deductions for an employee with monthly income below Rs 15,000, ones who form the overwhelming share of the informal sector, is about 32%, with EPFO alone claiming 25%. Such massive deductions alone are enough to deter employees. For employees, apart from the costs, there are the compliance requirements and inspections, all of which would leave them commercially unviable. 

In fact, the growing demand for globally harmonized labor standards may have far-reaching effects on the economic growth trajectories of developing countries. Consider the example of domestic and construction workers, two categories who suffer badly from extremely poor working conditions. It is therefore the natural response of well-intentioned people to demand regulation of working conditions and higher standards. Most often, if not always, they advocate state-of-art labor protections for these workers. But in an extremely price-sensitive markets where the margins are very small (the layers of sub-contracting in construction dissipates margins are all levels), the cumulative cost of these protections almost always make them non-starters. In such circumstances, the result of higher standards is almost always regressive - workers forced out of the market, more informality, more harassment, and more corruption. 

The second example is the recently promulgated real estate regulation legislation. It introduces many consumer protection standards, including complete transparency in transactions and escrowing of the amounts collected from buyers. While undoubtedly laudable, they are likely to increase the cost of development for developers, who are most certain to pass on the costs to the buyers, thereby forcing up an already prohibitive real estate market. Its impact on the government's objective of making housing affordable may be less than benign.  

The third example comes from the field of medical education regulation. The Medical Council of India (MCI), responsible for the accreditation of medical colleges across the country, has just denied permissions for the establishment of 83 new medical colleges, expansion of MBBS seats in 47 existing medical colleges, and starting super-specialty courses in 39 medical colleges. The MCI's argument is that these colleges do not have the requisite qualified personnel and physical infrastructure to run such courses or offer more degrees. Who can fault the MCI for adhering to minimum standards? After all who in their right mind would want less than qualified medical doctors roaming around and killing people?

But what if the standards are too high given the context. We need to keep in mind that India is a country with 0.7 doctors per 1000 of population, one-fourth of that in UK. It surely needs a few times more than the 381 existing medical colleges and 63,800 MBBS seats each year, enough to meet just 1% of the demand among aspiring medical students. 

Staying on in the field of medical care, India proudly declaring that it adheres to the World Health Organization (WHO) standards on primary care. It has sanctioned a Primary Health Center (PHC) for each 25000 population and have an Auxiliary Nurse Midwife (ANM) for each 5000 population. But current standards need the heavily over-burdened (just for illustration, in rural areas, just imagine visualizing the distances that need to be covered in field visits to scattered households) ANMs to keep elaborate and state-of-art documentation of each ante-natal case, irrespective of the nature of the case. This forces her to maintain more or less the same standards of monitoring for normal and high-risk ante-natal cases, though the latter with just 10% of all cases contribute 80-85% of all maternal and child morbidity and mortality.  

At some level, there is also a need to question the prevailing standards on even more mundane things like blood pressure and diabetes in a culture where people are used to taking far higher quantities of salt, spice, and oil even in their staple diets when compared to those for whom the standards were originally formulated.  

The final example is that of primary education where it is now well acknowledged that learning outcomes are extremely poor. Here too, the obsession with standards may have done more harm than good. The National Council for Education Research and Training (NCERT), which lays down the grade and subject specific competency standards, in its politically correct wisdom has laid down minimum national learning standards which are comparable to global benchmarks. But for a country with massive antecedent learning gaps and numerous other capacity constraints, such standardize-and-pretend approach does enormous harm.  

I can already hear people mumbling their discontent at this. I understand their concerns. But they need to appreciate that development rarely ever happens in a straight and neat path. These are real world trade-offs that need to be acknowledged and policy design should accommodate them. Most often, this would necessitate decidedly second-best choices and unsatisfactory compromises. Development is always a process of gradual transition where multiple states of being necessarily co-exist, rarely one of abrupt shift from one condition to another. 

So here is my simple smell test. If we stand a far higher chance of saving the lives of a significant number among the 90% of those at risk, but at the cost of, maybe, increasing the risks for 10% of the cases, by revising ante-natal care standards, then so be it. I am willing to accept that trade-off any day. 

Monday, July 25, 2016

Why does Estonia and Poland score so well in PISA?

From the Economist, the correlation between teacher salary and teaching hours, and learning outcomes (as measured by PISA score).
The variation is very interesting. The surprises are Estonia (526) and Poland (521), both of whom achieve close to the scores of PISA leaders (outside the Greater China), South Korea (542) and Japan (540). So the question should be, how do Estonian teachers achieve better PISA outcomes than their counterparts in Holland who are paid five times more, or in Canada, who also work a third more? Is there a cultural dimension to teaching and education in Estonia and Poland, like with Finland, that contributes to their disproportionately superior performance? Or, is it more institutional design and governance improvements that are behind this success?

Staying with education, check out this really cool site. 

Sunday, July 24, 2016

The costs of informality

Ananth has an excellent article that cautions the romanticism of small enterprises. He points to the Annual Survey of Industries 2013-14 report which shows that 72.68% of the 1,85,690 operating factories employ less than 50 workers, makes up 15.62% of all factory employment, utilize only 7.06% of fixed capital, produce 11.18% of gross output, and generates 7.71% of net manufacturing value added. And those with more than 200 employees forms a mere 9.06% of factories, utilize 78.61% of fixed capital, provide 61.44% of employment, produce 71.15% of gross output, and generate 75.78% of net manufacturing value added.

The figures would be even more disturbing if we take into account the respective shares among all economically active 58 million odd enterprises. It is very clear that Indian industry has a massive problem of "smallness". But its origins can be traced back the challenges posed by pervasive informality. The evidence is overwhelming that small enterprises in India start and remain informal, with limited productivity gains throughout its life. See the numerous graphics here and you'll realize that among developing or even the poorest countries, India's level of informality is simply extraordinary. Given this, encouraging more such small enterprises, howsoever much politically appealing, without addressing the root causes of informality may be a medication that worsens the disease.

The debate in India about job creation has become anchored around entrepreneurship. Incentivize innovation and entrepreneurs and jobs will follow. Unfortunately, that is unlikely to happen. Instead, for the vast majority of Indians, like those elsewhere in the world across history, the pathway to a good livelihood would most likely have to come through formal jobs in medium and large enterprises. In other words, we need more numbers of enterprises, which start formal and small, and grow into medium size or bigger, thereby creating large numbers of jobs.

A WTO study on informality quantifies the magnitude of certain costs,
Countries with larger informal economies experience lower export diversifi cation – an increase in the incidence of informality by 10 percentage points is equivalent to a reduction in export diversifi cation of 10 per cent... countries analysed in this study lose up to 2 percentage points of average economic growth due to their informal labour markets... countries with above-average sized informal economies are more than three times as likely to incur the adverse effects of a crisis as those with lower rates of informality... Countries with above average sized informal economies are almost twice as likely to experience extreme economic events, compared to countries with less informal employment.
In the specific area of trade, the paper makes the distinction between de jure and de facto trade openness. The former is a measure of implementation of trade reforms which immediately results in labor and other market readjustments, while the latter represents the actual flow of goods and services from and into the country. The paper says that "de jure trade reforms may be expected to require some time before they achieve de facto trade openness."
Empirical analysis carried out for the purpose of this study shows that more open economies tend to have a lower incidence of informal employment. By contrast, trade reforms, such as cuts in tariff rates, tend to be associated with higher informal employment. Likewise, larger inflows of FDI tends to be associated with higher informal employment. These findings may suggest that even if trade and investment reforms hold the promise of more and better jobs in the long run, such reforms tend to be associated with negative labour market developments in the short run. ƒDecent work policies can help to improve this trade-off between the short and long-term effects of trade reforms. Evidence in this chapter suggests that the incidence of informal employment is lower in countries that enjoy: a) better enforcement of the rule of law, including core labour standards, b) well-designed social protection and labour regulations, notably appropriately set minimum wages; and c) more transparent business regulations and a more supportive environment for sustainable enterprise creation.
The paper tries to quantify the effect of various policies and regulation on informality.
It is unsurprising that economic development is the biggest contributor to reducing informality. The surprises are that business regulation and subsidies and transfers (read, universal social safety net) do not appear to have the expected impact. Interestingly, decentralized wage bargaining is the second largest contributor to reduction of informality. 

Land title reform story of the day

Land title across large parts of developing world are a serious constraint on economic development. So, if this is indeed true, then it should count as one hell of an achievement,
Rwanda, for example, rolled out a programme over three years, whereby local surveyors worked with land owners and their neighbours to demarcate and register 10.3m parcels of land. By the time the scheme was completed in 2013, 81% of plots had been issued with titles, at relatively low cost; investment and women’s access to land have both improved.
This is bigger than anything that any Indian State has achieved with similar projects over a far longer period of time. 

Thursday, July 21, 2016

Global energy market fact of the day

The most stunning anecdote about how the shale dynamics have upended the global energy market comes from this reversal of hydrocarbon trade,
Two cargoes of US liquefied natural gas from Cheniere Energy’s Sabine Pass plant in Louisiana have been delivered to Kuwait and Dubai in recent months to meet the rapidly growing demand for energy. 
And more on how the US shale exports have been transforming the global hydrocarbons market,
The Sabine Pass plant shipped its first cargo in February, and has already sent LNG to seven countries: Argentina, Chile, Brazil, India and Portugal, as well as Dubai and Kuwait... Those additional supplies are depressing prices, making LNG a more attractive fuel for power generation, and low-cost floating regasification plants have made it easier for countries to become importers. Kuwait’s LNG imports tripled from 1m tonnes in 2012 to 3.04m tonnes last year, according to the Middle East Economic Survey. Egypt and Jordan became LNG importers for the first time last year. Qatar is the world’s largest LNG exporter, but over the next few years it is set to be toppled by Australia and rivalled by the US. The International Energy Agency has forecast that by 2040 gas demand in the Middle East will almost double, so the region could become an increasingly important market for US LNG.
As regards oil, US continues to import about 1.6 million barrels a day from the Middle East, down from 2.4 mbd in 2003-04.

I think an even bigger transformation will be when more liquefaction terminals on the US east coast come on-line. It could lead to the emergence of a single global market in natural gas

Tuesday, July 19, 2016

The nuanced case for financial liberalization

Financial market development is most often conflated with financial liberalization in debates on economic development. Financial deregulation had therefore become a central pillar of the Washington Consensus world view. Capital account liberalization was advocated as an unqualified requirement for developing countries. 

Since the Global Financial Crisis, the IMF has been at the forefront of questioning several prevailing orthodoxies. The latest comes this working paper by Sami Ben Naceur and RuiXin Zhang which draws the distinction between various dimensions of financial development and points to certain less than benign effects of financial liberalization, especially its effect on income distribution. Specifically, going beyond the conventional focus on financial deepening, they focus on four other dimensions of financial sector development - access, efficiency, stability, and liberalization. They find, 
The results suggest that most financial development dimensions can help reduce income inequality and poverty. However, external financial liberalization tends to have the opposite effect on the global average. In addition, our evidence suggests that banking sector development has a stronger positive effect on income distribution than stock market development. 
They have interesting prescriptions for policy making, including giving priority to banking sector development over capital markets and caution with capital account liberalization,
Observing the benefits of financial development on both economic growth and income distribution, policymakers need to steer the development of the financial system in a progrowth and pro-poor direction. Financial reform policies aimed at expanding financial access and depth, as well as enhancing financial efficiency and stability, should all be encouraged. These policies may include relaxing credit and interest controls, and improving banking and securities market supervision. However, given that external financial liberalization aggravates poverty, capital account liberalization should proceed in a carefully designed and well-sequenced fashion in a stable macroeconomic environment to avoid offsetting the poverty-reducing gains with the development of other dimensions of the financial sector. It is also important to develop an effective regulatory system for financial institutions and to enhance financial infrastructure (credit information, and collateral and insolvency regimes) in order to limit risk taking of banks. Given that the development of financial institutions has a greater impact than the development of the stock market, policymakers may give priority to banking sector improvement when considering poverty and income inequality alleviation. 
This is very sound advice to countries like India which has very narrow traditional banking market and where commentators have tended to prioritize capital market development and external liberalization. Reflecting the very low financial market depth, compared to our even our peers leave aside more developed economies, banking sector assets as a share of GDP is among the lowest in India. Worse still, it has been stagnating for the past decade, including in the high-growth years in the middle of last decade. 
There is only so much you can intermediate with such a narrow traditional banking sector. This goes back to another structural deficiency in our savings balance sheet - over 70% of household savings are held in illiquid property and gold, far higher than elsewhere. These are plumbing issues that need to be addressed before we navigate into the deeper end of the financial development pool.

Monday, July 18, 2016

National cuisines and economic strength

Atlantic has an interesting article that charts the "hierarchy of tastes" or social acceptance trajectories of different national cuisines in the United States. In particular, why does the French and Japanese cuisine get admitted to high-ed, white-tablecloth establishments while the Chinese and Indian recipes are relegated to lower-status eateries as "ethnic" food?
Consider the cases of steak frites and carne asada. They both involve cooking a fairly high-quality cut of meat over high heat, and they’re both dishes whose origins are foreign to America. But they’re often listed on American menus at vastly different prices. Why? “The shortest answer would be cultural prestige, some notion of an evaluation of another culture's reputation,” says Krishnendu Ray, an associate professor of food studies at New York University. In a book published earlier this year, The Ethnic Restaurateur, Ray expands on this idea, sketching the tiers of what he calls a “global hierarchy of taste.” This hierarchy, which privileges paninis over tortas, is almost completely shaped by a simple rule: The more capital or military power a nation wields and the richer its emigrants are, the more likely its cuisine will command high menu prices.
Ray consolidated the average price of a meal at a Zagat-listed restaurant in New York and came up with this graphic, which appears to neatly tie up with the hypothesis about relative economic strength of the country. 
Interestingly, Indian cuisine has been falling down the "hierarchy of taste" since 1986!

More realpolitik for India's foreign policy

The US drone strike that killed Mullah Akhtar Muhammad Mansour, the Taliban leader, a few months back, while driving across Pakistan's Baluchistan Province, may have interesting consequences. A few observations.

1. The "violation" of Pakistan's airspace and the Pakistanis being unaware of the strikes may signal more strains in an already tenuous relationship. That Mullah Mansour was close to Pakistani military and intelligence establishment lends further credence to that view.

2. This victory for the Americans may be short-lived since Sirajuddin Haqqani, who is expected to succeed Mansour, is close to the Pakistani ISI and is a more hardline opponent of the peace process. 

3. For India, the US policy towards Pakistan is a teachable moment in realpolitik. The US are actively engaging with Pakistan, even willing to provide them military assistance, despite their soldiers suffering at the hands of terrorists supported by Pakistan. They see no problem with the apparent contradiction and neither do continuously complain about Pakistan's duplicity. They realize that the Pakistan army and intelligence apparatus are largely outside the control of the country's elected government. But engaging with the government at least leaves them with the best possible lever to influence the trajectory of developments in the country. Further, the weapons supply also helps them exercise some influence over the all-powerful Pak military establishment.

India needs to emulate the US foreign policy calculus in its dealings with both China and Pakistan, especially the latter. In contrast to the Americans' (public) nonchalance with the recurrent stream of Pakistani-supported Taliban attacks on its soldiers in Afghanistan, India makes a very public remonstration and suspends talks after every attack. I am not sure whether this even contributes to keeping Pakistan on the backfoot at international platforms. Playing to the domestic audience, maybe, but this trend has predated the rabble-rousing 24X7 media channels.

There is nothing inherently odd about juggling contradictions - deepening engagement even as we stave off the insurgents. The US foreign policy revolves around a marriage of Wilsonian idealism and George Keenan's realpolitik, although it sometimes throws up ugly contradictions. In dealing with nations, India's national interests dictates that we imbibe a dose of realpolitik. 

Sunday, July 17, 2016

China debt fact of the day

From a Bloomberg article on China's fascination with high speed rail, whose network has grown to nearly 12000 miles in just under a decade,
In May, state-owned China Railway Corporation, the operator of China's rail network, reported that its debt had grown 10.4 percent in the past year and now exceeded $600 billion; in 2014, roughly two-thirds of that debt was related to high-speed rail construction. That’s more than the total public debt of Greece. The company runs only one profitable line -- the massively traveled Beijing-Shanghai corridor.
That is a staggering number. The debt of just China Railway Corporation is 30% of India's GDP!

Update 1 (15.08.2016)

IMF's Article IV consultation had this to say about China's ballooning debt pile outside the banking system,
International Monetary Fund staff said that 19 trillion yuan ($2.9 trillion) of Chinese “shadow” credit products are high-risk compared with corporate loans and highlighted the danger that defaults could lead to liquidity shocks. The investment products are structured by the likes of trust and securities companies and based on equities or on debt -- typically loans -- that isn’t traded... The “high-risk” products offer yields of 11 percent to 14 percent, compared with 6 percent on loans and 3 percent to 4 percent on bonds, the commentary said. The lowest-quality of these products are based on “nonstandard credit assets,” typically loans.
These products are mainly issued by banks and attract retail investors with their high returns. Such products grew nearly 50% last year to 40 trillion renminbi ($ 6 trillion). The FT writes,
Shadow banking emerged as a force five years ago, ranging from interbank transactions through to wealth management products. By recording the products off-balance sheet, or by classifying them as “investments” rather than loans, banks are able to report higher capital adequacy ratios and set aside smaller provisions against bad loans.
The Times describes these wealth management products,
China’s wealth management products are neither stocks nor bonds nor mutual funds. A typical wealth management product offers a fixed rate of return over a set period. Many Chinese investors treat them like bank savings deposits because many are sold by state-controlled banks that give the funds the appearance of government backing. But unlike bank deposits, they are uninsured. They are also typically structured so that the banks are not responsible if the investments fail. Among the biggest issuers of wealth management products are hundreds of banks and other financial institutions in poor, inland provinces. These banks are under intense pressure from provincial political bosses to keep lending and help sustain big employers like state-owned enterprises, at a time when the entire country’s economy is slowing. To raise money for large-scale lending, banks have ramped up issuance. They sold 187,000 separate wealth management products by the end of last year, up 56 percent from a year earlier, according to official statistics.

Corporate subsidy fact of the day

FT has this article on the struggle to increase minimum wages in the US,
Walmart’s founding family, worth a net worth $130bn according to Forbes, has been a target in the debate over inequality, which has gained traction in this presidential election year. It has also highlighted the extraordinary wealth of one family while many of its staff struggle to make ends meet. Nita Fischer, a single mother, says she was coerced into leaving her Walmart job paying $10.14 an hour when she was pregnant and to reapply after three months. She said she is earning $9 an hour and is reliant on the US government to pay her $294 a month in food stamps — which are spent at Walmart.
Such transfers must constitute one of the largest corporate subsidies in the history of the world!

In this context, I have blogged earlier that, contrary to conventional wisdom, even including all the direct welfare subsidies, the rich benefit disproportionately more from government spending than the poor. In fact, even leaving aside the things that people like Mariana Mazuccato talk about, a very large proportion of corporate fortunes are directly built on the foundations of tax payer financed systems. And this is true for countries across the world - developed and developing, democratic and autocratic, capitalist and socialist, eastern and western. 

Saturday, July 16, 2016

Weekend reading links

1. Following Paris, Brussels, Dhaka, Orlando, and Istanbul, the French Riviera town of Nice was the latest to suffer in the growing list of terror attacks. In the context of the terror attack by an unsophisticated attacker who crudely rammed a plain truck through a crowd of holiday revelers, killing 84 people, the NYT has an excellent article which highlights the challenge posed,
And yet this act, whatever its particulars, represents the culmination of long-building trends, in which terror tactics become more rudimentary and the targets more random. It is forcing a recognition that security and intelligence measures, long the core of Western thinking, are of limited utility and can never provide total safety from an individual who decides to kill. This is shifting pressure onto more abstract and unproven counterterrorism methods that do not promise to halt violence but merely ameliorate underlying political or social drivers. And it is straining the politics of Western countries, where leaders have spent the past 15 years describing terrorism as a war that could be won. The populations targeted by terrorism are confronting a difficult new reality, in which the danger can be managed or policed but perhaps never entirely overcome...
In 2008, Pakistani militants killed 166 people in Mumbai, India, attacking what experts call “soft” targets: places such as hotels and train stations that are populated but, because of their seeming randomness, rarely defended. At security conferences in Western capitals, officials and analysts began to worry about whether they could prevent a “Mumbai-style attack” in their own countries. Then came the rise of “lone wolf” attackers who acted on their own, without training from or often even contact with the terrorist groups they claimed to serve. Attacks are planned within the minds of individuals whose intentions remain hidden until the shooting begins.


Such attacks predate the Islamic State, though the group emphasizes them, disseminating propaganda that provides tactical guidance and ideological justification available to anyone with an internet connection. The use of a truck in Nice was new only in the specifics and in the degree to which it has forced a realization increasingly difficult to ignore: In the world of lone wolves and Mumbai-style attacks, more barricades and metal detectors and monitoring programs can improve security, but can’t guarantee it absolutely.
2.  In the context of the failed military coup in Turkey, MR points to this paper by Jonathan Powell and Clayton Thyne which clearly indicates that while coups are far less frequent today, they are much more likely to succeed,
3. The third big global story is the rise of right-wing populism that underpinned the Brexit vote and the rise of Donald Trump in the US. Dani Rodrik draws the distinction between globalization 'shocks' from immigration and trade and foreign investments. He argues that the former sets the stage for the emergence of right-wing parties (much of Europe) and the latter of left-wing ones (Latin America).

He also makes the case for the left to embrace an alternative to unfettered free market capitalism and hyper-globalization,
Consider just a few examples: Anat Admati and Simon Johnson have advocated radical banking reforms; Thomas Piketty and Tony Atkinson have proposed a rich menu of policies to deal with inequality at the national level; Mariana Mazzucato and Ha-Joon Chang have written insightfully on how to deploy the public sector to foster inclusive innovation;Joseph Stiglitz and José Antonio Ocampo have proposed global reforms; Brad DeLong, Jeffrey Sachs, and Lawrence Summers (the very same!) have argued for long-term public investment in infrastructure and the green economy. There are enough elements here for building a programmatic economic response from the left.
A crucial difference between the right and the left is that the right thrives on deepening divisions in society – “us” versus “them” – while the left, when successful, overcomes these cleavages through reforms that bridge them. Hence the paradox that earlier waves of reforms from the left – Keynesianism, social democracy, the welfare state – both saved capitalism from itself and effectively rendered themselves superfluous. Absent such a response again, the field will be left wide open for populists and far-right groups, who will lead the world – as they always have – to deeper division and more frequent conflict.
4. In a reflection of the rise of "alternative" investment class in a world of ultra-low yields, Brookfield, the Toronto-based asset manager which has $250 bn under management, has raised a $14 bn fund to invest in infrastructure. It would be the largest single commitment to a sector. Brookfield, which bought the owner of London's Canary Wharf, allocates 60% of its investments to developed and the rest to emerging markets, and follows a counter-cyclical investment strategy of buying in distressed periods. It has as partners some of the world's largest SWF's like Singapore's GIC and Qatar Investment Authority and has been acquiring assets in Latin America, including a 2013 acquisition of an integrated system of railroads, ports and inland terminals in Brazil and is investing $7bn to expand the port and terminals.

5. Finally, to Ireland, which claims to have increased its GDP by 26% in 2015. On the back of corporate tax inversions and other forms of corporate re-engineering, Irish exports rose 34%, imports 22%, and investment by 27%. For example, when AerCap, the world's biggest aircraft leasing company, moved its fleet to Ireland, the country gained 35 billion euros in output, without any real economic impact. But even with its super-low taxation rate, corporates have not been satisfied - corporates based in Ireland made $100 bn in profits in 2012, of which, instead of paying $12.5 bn in taxes, they actually paid just $4 bn!

Alphaville puts the Irish growth story in perspective.

Thursday, July 14, 2016

Status note on the Rupee

Is the Rupee over-valued? I have tried to capture the relative real effective exchange rate (REER) trends of Indian Rupee against those of its emerging market peers.
The graphic (data from Breugel) presents the REER of 14 major emerging economies, including two of India's neighbours, since 2007. As on September 2008, with the base year of 2007, the Indian currency was the weakest in the sample. Fast forward to March 2016, and the rupee has appreciated more than all but four currencies, rising steadily by 16% since January 2007. It was largely stable during the peak of the crisis, but declined in mid-2013 as the taper tantrum played out. However, since the September 2013 trough, the rupee has steadily appreciated by more than a fifth, making its real appreciation significant.
Apart from China, among its peers, only Bangladesh, Vietnam, and Pakistan have had greater currency appreciation since 2007. Since the taper tantrum trough, only Bangladesh and Pakistan currencies have appreciated more. The Bangladeshi Taka has appreciated by nearly 54% and Vietnamese Dong by nearly 44% since January 2007. Interestingly, but for the 2009-10 blip, Bangladesh and Vietnam have been growing steadily upwards of 5-6% for some time now. Pakistan, growing at 3-4%, clearly has a currency over-valuation problem. 

Since September 2013, India's central bank has waged a very firm battle against inflation and has been largely successful in anchoring inflationary expectations. In the process, it has not only managed to provide macroeconomic stability but also enhanced the perception among investors. The problems elsewhere coupled with the country's relatively strong economic growth has only added to the positive animal spirits. In this "country world of the blind", the Rupee has naturally held strong against its counterparts in East Asia and elsewhere.

In other words, this strength of Rupee is a natural consequence of good macroeconomic policies, relatively high growth, boosted by the Central Bank's credibility, and amplified by economic weakness elsewhere. The RBI could not have engineered such persistent currency strength through open market operations in such choppy times. But its corollary has been erosion in trade competitiveness relative to its competitors, several of whom have benefited from significant depreciation.

It also underscores the point that a simultaneous pursuit of macroeconomic stability, high growth and depreciating currency may not have been possible in such times. In fact, may not be possible during most times in a closely inter-connected global economy.

Wednesday, July 13, 2016

Reflex internationalism and revealed prejudices

In the context of the widespread populist resentment at globalization, Larry Summers makes the point about the need to circumscribe the urge to harmonize everything globally (reflex internationalism) so that governments have the flexibility to respond to their citizens' first order problems, 
If Italy’s banking system is badly undercapitalised and the country’s democratically elected government wants to use taxpayer money to recapitalise it, why should some international agreement prevent it from doing so? Why should not countries that think that genetically modified crops are dangerous get to shield people from them? Why should the international community seek to prevent countries that wish to limit capital inflows from doing so? The issue in all these cases is not the merits. It is the principle that intrusions into sovereignty exact a high cost.
What is needed is a responsible nationalism — an approach where it is understood that countries are expected to pursue their citizens’ economic welfare as a primary objective but where their ability to harm the interests of citizens elsewhere is circumscribed. International agreements would be judged not by how much is harmonised or by how many barriers are torn down but whether citizens are empowered.
This is all great. But only till he goes on to suggest areas for future international co-operation,
This does not mean less scope for international co-operation. It may mean more. For example, tax burdens on workers around the world are a trillion dollars or more greater than they would be if we had a proper system of international co-ordination that identified capital income and prevented a race to the bottom in its taxation. Taxes are only the most obvious area where races to the bottom interfere with the achievement of national objectives. Others include labour and financial regulation and environmental standards. Reflex internationalism needs to give way to responsible nationalism or else we will only see more distressing referendums and populist demagogues contending for high office.
Now this is really odd and reveals latent prejudices. Why should any country accept some global best practice financial regulation? Why should a developing country forego its major source of competitiveness by incorporating several layers of labor protections and resultant costs, with also the attendant risk of driving even more workforce informal? Why should the present and future generation of developing countries be denied the competitiveness arbitrage benefit that has been a major driver of economic growth in all previous examples of transition from developing to developed status? Why should they risk their "citizen's economic welfare" and disempower their citizens by embracing some idealistic notion of internationalism? What way is a country's inclination to arbitrage its "stage of development" advantages (like lower labour and environmental costs) any more abhorrent or any less acceptable than the imposition of capital controls or bans on genetically modified foods? 

Stripped off its moral dimensions, on a utilitarian calculus, the quest for harmonization in standards trades-off with the struggle to retain competitiveness. Such harmonization, by limiting the legitimate sphere of action of national governments not only circumscribes genuine national interest but also undermines democracy itself. I have blogged herehere, and here refuting the conventional wisdom on harmonization of international trade policies. 

It is ironical that this comes from Summers, an ardent advocate of accommodatory monetary policy in the US. Now that the shoe is on the other feet, how would he view Raghuram Rajan's argument in favor of global monetary policy co-ordination, one which would invariably demand restraints on the extraordinary monetary accommodation that Summers and Co have staunchly supported?

Tuesday, July 12, 2016

The resource mis-allocation problem during credit booms

FT chronicles the success of Jon Gray, the head of Blackstone's real estate business, which has made the private equity firm the largest real estate owner in the world,
Blackstone owns more offices in the US and India than anyone else. It is also the largest residential landlord in the US, with a portfolio of 50,000 rental homes that it would like to take public by next year... When Mr Gray joined Blackstone in 1992 straight from college, the young firm had only $1bn under management; today it has about $335bn. He is responsible for the greatest part of that pile of money, entrusted to find profitable opportunities for the $100bn he has received from investors. Mr Gray’s business has made as much money as all of KKR, a rival in private equity, in the past three years. And he can boast of 17 per cent annualised net gains over 25 years, according to public filings from Blackstone... (In India) has since (2011) invested a total of $1.2bn. Some of purchases came from developers who were forced to sell, either because of regulatory pressure or as a way to raise badly needed cash. Acquisitions included a partially completed Goldman Sachs project in Bangalore. Today Blackstone is the largest owner of office parks in the country, often bought at bargain prices, with a market value of $4.2bn.
Buoyed by cheap debt, PE firms in general have been very large investors in real estate,
Blackstone and the other alternative investment groups have been among the biggest beneficiaries of the US Federal Reserve’s quantitative easing policies. Low borrowing costs, combined with depressed asset prices, were a godsend for these companies, whose lifeblood is debt. The Fed’s policies may not have led to a robust economy, but they were the major reason asset prices in financial markets — including property — recovered so quickly.
This is a clear example of the resource misallocation towards low productivity growth and high pledgeability sectors (like construction and real estate) that happens when credit is plentiful. I have blogged about this earlier. In this context, Claudio Borio and the folks at BIS examined a sample of 21 countries over the period from 1969 and have these findings,
First, credit booms tend to undermine productivity growth as they occur. For a typical credit boom, a loss of just over a quarter of a percentage point per year is a kind of lower bound. Second, a large part of this, slightly less than two thirds, reflects the shift of labour to lower productivity growth sectors – this is the only statistically significant component. Think, for instance, of shifts into a temporarily bloated construction sector. The remainder is the impact on productivity that is common across sectors, such as the shared component of aggregate capital accumulation and of total factor productivity (TFP). Third, the subsequent impact of labour reallocations that occur during a boom is much larger if a crisis follows. The average loss per year in the five years after a crisis is more than twice that during a boom, around half a percentage point per year. Put differently, the reallocations cast a long shadow. Taking the 10-year episode as a whole, the cumulative impact amounts to a loss of some 4 percentage points. 
This is a clear market failure and one which requires regulatory action. It is also a strong reminder of the need to have robust macro-prudential norms and even some form of capital controls during credit booms that can prevent such resource misallocations. 

Monday, July 11, 2016

The inequality debate summarized

There is considerable evidence that the two biggest contributors to widening inequality are the rising housing prices in cities and low capital gains tax rates.

A Demand Institute study documents the distribution of housing wealth and its increases in the US since 2000 among various income quintiles.   
As Mathew Rognlie has shown, housing has been the driving force behind the returns to capital induced inequality story. 

The other major contributor has been the low capital gains tax rate, a result of tax rate decreases in 1994 and 2004 in the US. Since they hold the major share of financial assets, most of the benefits have been concentrated among the richest 1%, even 0.1%.
This is a universal script, across developed and developing countries. The battle against inequality, at a policy level, will be won or lost in these two terrains. Capital gains has to be taxed at a much higher rate and cities have to go vertical.

Sunday, July 10, 2016

The march of negative rates continues

Sovereign bonds continue their slide down deeper into negative territory. Switzerland is at the forefront of the lurch towards negative rates. It has become the first country where even bonds out to 50 years have turned negative!
The Swiss 10 year bonds reached minus 0.616%. This follows news that the global sovereign bonds trading in the negative territory rose by $1.3 trillion to $11.7 trillion in June 2016.
And, foretelling more dismal economic prospects, the yields on Treasuries across major developed economies have been on continuous decline. The 10 year US Treasury bond fell to 1.385 per cent. In fact, this was a record low for the 10 year bond in a history spanning more than 225 years since 1790! The 30 year bond too touched its record low of 2.226 per cent.
Unfortunately, as the WSJ has described, large parts of the world economy may be gripped by a "doom loop". While these rates are eating into the banks' profitability and threatening their survival, a reversal could leave debt laden households, corporates, and sovereigns vulnerable!
There may be no satisfactory denouement for this. The idea of buying time with low rates so as to provide the space for deleveraging, the basis for the ultra-accommodatory monetary policies across developed economies, appears to have reached a dead-end. And we are not even talking other more deep-rooted structural features like secular stagnation. 

More "crossing the river by feeling the stones"

FT points to one more example of reform with Chinese characteristics in agriculture sector. This time it is with contract farming in Xiaogang village. Incidentally, it is the same place where the experiment on decollectivization by way of breaking up commune land and allotting them to individuals was initiated successfully before its nationwide scale up.

Even today Chinese law does not recognize rural land ownership. All lands are owned by the village collective and are contracted to households with 30-year farming rights for an average 6-10 mu (1-1.5 acres) of land. There are also large swaths of reclaimed "wasteland" belonging to enormous state farms. Since 2008, Beijing has legalized the transfer of this right, or "renting". Accordingly, nearly half the land in places like Anhui province is "rented".

These trends have led some farmers in Xiaogang to experiment with "renting" in land, hiring labor, and effectively doing contract farming. But such experiments have to be carried out discreetly without attracting the glare of Beijing. Further, in the absence of property rights, they suffer from significant risks arising from land owners demanding their lands back and the 30 year rights expiring.

It helps that such examples coincide with a period of massive urban migration, especially by the youth who have left their old parents to till the lands. Increasing swaths of rural areas are left with such people who are too old to work. The country therefore needs to transition into a new trajectory of agricultural development, one which is more capital intensive. 

President Xi Jinping, recently visited Xiaogang, like Deng did decades back to bless the decollectivization experiment, and endorsed the transfer of rural lands to create modern state farms.

Friday, July 8, 2016

Brexit Done, The Italian Job Awaits?

The WSJ highlights the bad debt problem in Italy as being potentially more dangerous than even Brexit in the immediate future. Brexit, with its attendant uncertainties about the trajectory of interest rates, appears to have exacerbated the problem,
In Italy, 17% of banks’ loans are sour. That is nearly 10 times the level in the U.S., where, even at the worst of the 2008-09 financial crisis, it was only 5%. Among publicly traded banks in the eurozone, Italian lenders account for nearly half of total bad loans.
This comes even as banks across Europe have been battered by post-Brexit fears that interest rates will remain lower for the foreseeable future,
Europe’s banks were already retrenching before the U.K. vote, and markets appear fearful many don’t have thick enough capital buffers. Even before the vote, shares were valued at levels that signaled distress. Since June 23, an index of European banks has dropped 17%, bringing total losses from the beginning of the year to 30%.
The problems of Italian banks have strong echoes with the situation in India, both in terms of the institutional environments and scale of the problem,
The profitability of Italian banks has long been among the worst in Europe, weighed down by bloated staffs and too many branches, leaving the banks with little extra capital to cover loans that go bad. Today’s low interest rates have hit Italian banks especially hard because of their heavy focus on plain-vanilla lending activities, with relatively little in fee-generating activities such as asset management and investment banking. When the financial crisis of late 2008 hit, Italian banks tended to roll over loans whose borrowers weren’t repaying on time, hoping an economic upswing would take care of the problem, say Italian bank executives... The result is that impaired loans at Italian banks now exceed €360 billion—quadruple the 2008 level—and they continue to rise. Banks’ attempts to unload some of the bad loans have largely flopped, with the banks and potential investors far apart on valuations. 
Banks have written down nonperforming loans to about 44% of their face value, but investors believe the true value is closer to 20% or 25%—implying an additional €40 billion in write-downs. One reason for the low valuations is the enormous difficulty in unwinding a bad loan in Italy. Italy’s sclerotic courts take eight years, on average, to clear insolvency procedures. A quarter of cases take 12 years. Moreover, in many cases, the loan collateral is the family home of the owner of the business, or it is tied up in the business itself. “There is a desperate need to make collateral liquid,” said Andrea Mignanelli, chief executive of Cerved Credit Management Group. “Right now, it gets stuck in auctions and judicial procedures that make cashing the loan very hard.”
While the Italians appear to have done more than India, it has hardly had an impact,
The Italian government has put forth a series of solutions since last fall, but with little success so far. The proposals include incentives to encourage the creation of a nonperforming-loan market, shorter bankruptcy procedures and new rules to push Italy’s 400-odd cooperative banks to merge.
Fortunately, India does not have the problem of complying with a harmonized cross-national banking regulations like the Italians have to, which compounds the problems and raises political hackles,
The Italian government has sought EU permission to inject €40 billion into its banks to stabilize the system. To do so would require bending an anti-bailout rule the bloc adopted in 2014 to force troubled banks’ stakeholders—shareholders, bondholders and some of their depositors as well—to pay a financial price before the country’s taxpayers must... Rome has criticized the EU’s new banking regime and doesn’t want to use “bail-in” rules that prescribe the order in which stakeholders must bear losses for winding down an ailing bank, in part because of the peculiarities of the Italian banking system. About €187 billion of bank bonds are in the hands of retail investors, whose holdings would be wiped out by a bank resolution under the new rules. Last year, more than 100,000 investors in four small Italian banks that were wound up saw their investments wiped out. Some lost their life savings. The controversy exploded in December after Italian news media reported that a retiree committed suicide after losing €110,000 in savings invested in one of the banks. Such problems carry little truck in Brussels.
The political implications of going ahead with the "bail-in" regulations may be catastrophic. The pain and suffering on depositors and retail investors would immediately resonate across the political spectrum, lending further credence and support for Beppe Grillo and the Five Star Movement's anti-EU rhetoric. A Quitaly coming on the steps of a Brexit can tip the balance towards gradual fragmentation of the Union. 

The more prudent way out would be to let the Italian government capitalize the banks, if need be by taking stakes, with strict conditions about structural reforms to the banking sector, including on diversification of their income sources. This would require relaxation of the extant EU regulations. 

This highlights the folly of globally harmonized regulations and the mindless intransigence with conformity to those regulations even when faced with extraordinary situations. Like Italy and the EU banking regulations, India has the problem of its Fiscal Responsibility and Budget Management Act. Just as EU should give a one-time relaxation to Italy to infuse capital, India should ease FRBM for two years and use the proceeds to finance only bank recapitalization.

Despite the moral hazard associated with them, given the exceptional circumstances, such one-time relaxations with strict conditions and timelines, may be a more prudent and efficient strategy to stave off a long period of suffering and political turmoil, and far bigger bailouts with greater incentive distortions. Among all the less than satisfactory solutions available, this may be the least bad one.

Update 1 (11.07.2016)
Nice article in the FT which examines the challenge faced by Italian banks. It points to a Goldman Sachs assessment of 38 billion euro gross capital gap. Unlike other European banks which restructured in the aftermath of the crisis and hived off their non-performing assets, Italy choose to kick the can down the road.

Wednesday, July 6, 2016

The collective debt monetization solution?

John Mauldin's latest newsletter draws attention to the common problem of ballooning debt across developed and developing world and has this to say,
If I had come on to this stage four years ago and told you, my friends, that we were going to have 40% of the world’s governmental debt at negative interest rates, $10 trillion on central bank balance sheets, and $10 trillion worth of dollar-denominated emerging-market debt, and that global GDP growth would average only 2%, unemployment would be below 5%, and interest rates would be negative in much of the world and less than 50 basis points in the US, you would have laughed me out of the room. You would have all hit the unsubscribe button. Today’s world was unthinkable a mere four to five years ago.
He describes the Fed's quantitative easing policy as akin to St George fighting to slay the Dragon of Deflation, 
They have manipulated the system and set the wrong price of money. They have created a world where savers are penalized, companies are paid to buy their competition rather than compete, and only the participants on Wall Street are rewarded with appreciation of their assets. My Austrian and monetarist economics school friends, who predicted inflation from all the QE that we saw, have actually seen inflation – it has just been in asset prices that benefited Wall Street and not Main Street.
His denouement, a controlled simultaneous collective monetization and devaluation,
Could we, the major developed countries of the world, all monetize our debts together... We need to do it in a coordinated fashion so that no one major country gets an advantage in terms of currency valuation. It’s a controlled currency war... Central banks and their governments have painted themselves into the mother of all corners, and they are going to paint themselves into more corners because their belief system and their presuppositions are fundamentally wrong. I think they will continue to make the system worse until they have to do something drastic. At that point the only thing they will be able to do collectively is rationalize the debt. One country cannot do that without every country doing it, too. One country doing it alone creates a massive dislocation and a preference for its own currency, which devalues its currency. Without a collective devaluation, we will have currency wars that make the ’30s look like a spring picnic.
It may have sounded unthinkable even a few months back, but central banks now own an increasing share of national debt. This means that a simultaneous collective debt monetization, one which leaves everyone relatively at the same position with respect to the others, is logically possible, notwithstanding the massive moral hazard it would engender. However, the collective action problem is likely to come in the way of its execution, unless the crisis is simultaneously so severe among all major economies that force them into biting the bullet on this course of action. But some of the large economies like Germany do not have a large debt problem and would have no reason to agree to such solutions.