Tuesday, October 16, 2018

The Sears bankruptcy and asset stripping

I have blogged several times in the recent past about asset stripping and corporate conflicts of interest. Sample this, this, this and this

The latest is Sears, the original big retailer, mail-order catalogs to brick-and-mortar chain, which has today filed for bankruptcy under Chapter 11 in the US. 

The company, formed in 1886, and was most recently purchased by hedge fund  owner Edward Lampert in a $11 bn deal in 2005 and merged with Kmart, which he already owned, has since seen its market capitalisation fall from nearly $30 bn to around $40 million. The bankruptcy trigger was a default on a $134 million debt repayment. If liquidated, the company will end up laying-off its 68,000 workers.

The dominant narrative in the post-mortems that will invariably follow will be that of a company which was slow to innovate and which was among those disrupted by the Amazon juggernaut. While these were undoubted contributory factors, a potentially equally important contributor appears to have been the financial engineering asset stripping practices employed by its billionaire owner. Sample this,
He has spun numerous assets off from the retailer into separate companies that his hedge fund invests in. As many of these spinoffs flourished, Sears slid toward insolvency. Over the past five years, the company lost about $5.8 billion; over the past decade, it shut more than 1,000 stores. Many of the 700 stores that remain have frequent clearance sales, empty shelves and handwritten signs... Its total bank and bond debt stood at about $5.6 billion in late September... Sears remains a publicly traded company, but Mr. Lampert exerts an enormous amount of control. He orchestrated a series of deals that generated cash for Sears in the near term, but sold off many of the company’s most valuable assets — creating entities that he also has a stake in. Sears’ shares, which topped $120 as recently as 2007, closed on Friday at 40.7 cents. Sears spun off Lands’ End, the preppy clothing brand, into a separate company, which Mr. Lampert’s hedge fund took a large stake in. The market value of Lands’ End now dwarfs that of Sears. In 2015, Sears sold off stores worth $2.7 billion to a real estate company called Seritage. Mr. Lampert is a big investor in that company as well as its chairman. Seritage is converting many of the best locations into luxury offices, restaurants and apartments. Mr. Lampert is also seeking to buy the Kenmore brand from Sears for $400 million. Even in bankruptcy, Mr. Lampert will have great sway over the company’s fate. His hedge fund owns about 40 percent of the company’s debt, including about $1.1 billion in loans secured by Sears and Kmart properties. As a result, he could force Sears to sell the stores or transfer them to him to repay that debt. “Lampert will make out,” said Mr. Olbrysh, the retired Sears worker. “There is no question about that.”
These practices are perfect examples of asset-tripping. I struggle to understand why this is not criminal misconduct. In any case, given the pervasive nature of such practices, especially in the private market, it is imperative that some very strong prohibitive action be initiated to rein in such stigmatised capitalism before the whole house is brought down by one of such failures. But how can we shape expectations given that the regulators chickened-out when faced with indicting Goldman Sachs for its infamous Abacus engineering.  

In simple terms, as Sears slid down the bankruptcy path, Lampert was busy enriching himself! And one of Lampert's partners in this process and one-time Yale-roommate was one Mr Steven Mnuchin, the current US Treasury Secretary!

Update 1 (17.10.2018)

An FT columnist writes,
Mr Lampert’s commitment to Sears seems genuine.

Monday, October 15, 2018

Thoughts on innovation

John Cassidy credits the Nobel Prizes in Economics to William Nordhaus and Paul Romer as an acknowledgement of market failures (it is deeply disturbing that it required Nobel Prize worthy works for economists to realise this!).

He writes,
Take the development of transistors. Scientific researchers at Bell Labs invented them in the late nineteen-forties, and Western Electric started manufacturing them for commercial use in 1951. The customers who purchased the products that incorporated these early transistors, such as hearing aids and radios, presumably got their money’s worth. But that was only the beginning: once the basic knowledge of how to create a transistor existed, other businesses could use it to make different and better products, a process that Romer likened to creating new recipes. “By now, private firms have developed improved recipes that have brought the cost of a transistor down by a factor of 1 million,” he noted in a 1993 essay. “Yet most of the benefits from those discoveries have been reaped not by the innovating firms, but by the users of the transistors. Just a few years ago, I paid a thousand dollars per million transistors for memory in my computer. Now I pay less than a hundred per million, and yet I have done nothing to deserve or help pay for this windfall.”
Implicit in this line of reasoning is at least the following assumptions

1. It is private firms and markets which drive innovations,

2. therefore innovators deserve the high mark-ups they charge, 

3. innovators also deserve to appropriate all (or at least the major share of) the benefits from an innovation,

4. but innovators cannot appropriate benefits since it is relatively easy to copy innovations and commercialise them,

5. those who follow reap most of the benefits from those discoveries and the innovators reap disproportionately lower benefits, 

6. in the absence of such incentives businesses would not innovate, whereas presented with them they would do so, and 

7. consumers deserve nothing for the lower prices.

It is indeed striking that none of the seven assumptions would hold in many, if not the vast majority, of the cases involving commercial innovations. Marianna Mazzucato has documented it here and here

But the hegemony exercised by this narrative is striking. How about the following alternative narrative?

1. Private firms and markets drive commercial innovations which are built on decades of fundamental research financed largely by governments. Innovations are generally built sequentially on each other.

2. It is therefore only appropriate that the benefits of the commercial innovations that emerge from the foundations of public financed R&D be distributed proportionately and not allowed to be privately appropriated by just the last innovator. 

3. Very few innovations are truly path-breaking in so far as they emerge from first principles - general purpose technology innovations. It would be a mischaracterisation to claim that Facebook or Google or Amazon or Uber or AirBnB would not have emerged without those respective entrepreneurs. In each of these cases, a correct characterisation would be that each of those enterprising entrepreneurs and their respective companies were lucky enough to be at the right place at the right time in the path of technological evolution to be able to seize the breaks that came their way. 

4. Innovators are incentivised by a patent regime which is increasingly skewed in their favour. This allows them a monopoly market power which translates invariably, even in the hands of the best intentioned people, into high mark-ups and even price gouging. 

5. There are considerable entry barriers into copying - not only do you need to copy the innovation itself, it also necessary to copy/develop a business model. In case of knowledge innovations, barriers like network effects can be almost insurmountable. And now with the political capture of the institutions that makes the rules of the game, the entry barriers are institutionally entrenched. 

6. There is now a growing pile of evidence that businesses, despite sitting on massive cash surpluses, prefer not to invest in R&D and spend money on share buy backs and the like. 

7. Consumers are also taxpayers who underwrote the overwhelming share of the ultimate cost of bringing these innovations to them.

Wednesday, October 10, 2018

The case of agriculture crop insurance

Consider the challenges faced by a weather index insurance agency. It has to cover for an episode which has a high frequency but is completely uncertain, ensure the data is credible and minimises basis risks (affected farmer not eligible for claim because the index trigger was not hit), and pay out an amount which is commensurate to the damage suffered. It also has to keep the premiums affordable for the poor farmers, ensure that pay outs are done within a reasonable time, and genuine victims are not excluded. And it has to do all this with poor quality of index data and very patchy actuarial data, not to mention very unreliable crop damage models built on the index data.

A viable insurance model assumes reasonable premiums, diversified risk pool, and low frequency of insured episode incidence. But in case of crop insurance for the poor, the actuarial model has to support ultra-low premiums even with the constraints of high (and increasing) frequency of index triggers being hit, highly correlated insured pool (weather is the same over reasonably large areas or regions), and significant enough reimbursements required to make this meaningful enough for the farmers.

If we try doing the math, we will soon realise in no time that self-financed micro-insurance for the poor is an impossible proposition. In fact, it is no surprise that even the most efficient and largest crop-insurance scheme in the developing world enjoy over 80% premium subsidy support. India’s new massive nation-wide crop insurance program, Pradhan Mantri Fasal Bima Yojana (PMFBY), has premium subsidy of a whopping 97%! Even by squeezing out all the efficiency gains from financial engineering and technology, the commercial viability frontier will still remain very distant. In any case, whatever the insurer will pay out has to come from what is remaining after covering their costs – a claim ratio above 100% is not sustainable.

In simple terms, index insurance tries to do both financial engineering and weather modelling to address a complex development challenge. This is a double challenge. One, the actuarial models have to support affordable premiums. Two, the index data model that underpins the premium calculation is robust enough to minimise basis risks and ensure that the development objectives are met. The first suffers historical data deficiencies and the second is an emerging area of research fraught with deep uncertainties. 

In contrast, a direct payment to identified victims does not involve any of the risk mitigation and transaction costs associated with managing an insurance. However, it does involve the challenge of assessing damages and their validation, whereas an index insurance only requires more easily verifiable (though less directly linked to the desired outcome) index triggers. But it eliminates the significant basis risk faced by farmers and ensures that the desired development objectives are realised. Besides, it also captures the true cost of crop damage mitigation in a clean, direct, and efficient manner. 

In light of the above, the most efficient crop risk mitigation strategy would be direct income payments and not heavily subsidised insurance.

If we are engaging on a truly evidence-based policy making mode, the focus of innovation should be on helping governments make accurate assessments of crop damages in quick time. The one area where significant efficiency gains can be realised is from optimising the process of data collection and its validation. And this could be outsourced to a competent agency. But is anyone even talking about this?

Thursday, October 4, 2018

Lessons from the IL&FS case

The post-mortem in the aftermath of the IL&FS crisis has unsurprisingly thrown up several suggestions. The IL&FS model, which assumed both the financing and execution risks, was inherently flawed. The time has come to discard the idea of development/infrastructure finance entity. And so on. 

I will disagree with all such unqualified conclusions. After all Macquarie and their infrastructure funds and asset management model is regarded as one of the most successful infrastructure financing and management models. Successful exclusively infrastructure finance focused institutions and going strong in countries ranging from Brazil to the US and Europe. 

It has to be said that IL&FS went beyond the Macquarie model and ventured into activities undertaken by the likes of Carillion with disastrous consequences.

Shaji Vikraman hits the nail on the head. The real problem is with corporate governance. 
As the government stakeholders and regulators go about trying to work out a resolution plan and contain the damage, they should also take a closer look at what appears to be the weakness in the Indian model of what were seen as professionally managed or run firms without a dominant promoter or diversified shareholding. Over the past year, there has been a serious dent to this model purely because of governance and leadership flaws, subservient boards and integrity issues... In the post reforms period, with delicensing and deregulation and with the state exiting many businesses, successive governments and regulators encouraged the diversified shareholding model and professionally run, board-managed firms. But over a period of time, as the original promoters in some of these listed firms — mostly government-owned banks or investment institutions — started diluting their holdings, with no dominant shareholder, the CEOs of some of these companies acquired a larger-than-life role helped by so-called independent boards meekly acquiescing to the decisions. Rather than the democratisation of wealth which is what was celebrated in the glory days of India’s top software services and other firms including some private banks, this was over the last few years limited to a small club of senior management professionals with little or no relation to the performance of their companies, thus widening the divide.
There is a strong path dependency associated with the trends in areas like private participation in infrastructure finance and management. The first phase was about simple long-term post-construction (with public finance) concessions, especially in countries like Latin America. Then countries like Australia, Canada, and England led with PPPs involving bundling of construction and O&M to initially construction contractors, then construction-cum-O&M consortiums, and finally finance-construction-O&M consortiums. The area of project finance and public bond issuances emerged to support PPPs. Then the likes of Macquarie created exit opportunities for construction contractors and a secondary market for infrastructure assets using privately raised infrastructure funds. Gradually, the private equity players found infrastructure assets a source of stable and reasonably attractive income stream, with ample opportunities for asset-stripping and pass-the-parcel game over the asset's long life-cycle. Now, there is a growing realisation in the developed economies, especially in Europe and the US that private participation is not only not cost-effective but also fraught with problems, and much greater public participation and strict regulation may be necessary in infrastructure projects. The full circle has been completed. 

As we can see, each stage of this evolution created the conditions for the next stage. We, in India, are perhaps just entering the Macquarie-like secondary market stage. We still have to travel the PE journey. The present problems are about NPAs and bankrupt construction contractors. The next phase will see asset-stripped utilities, over-burdened consumers, and bond market defaults. 

The political economy, market dynamics, and herd mentality mean that it will be very difficult for India to learn from the developed economies, short-circuit the journey, and avoid such pain. In fact, just the challenge of meeting the vast infrastructure financing requirements without the public fiscal space required to meet that demand is itself enough to make the reliance on any kind of private capital, even with all its long-term distortions, inevitable. 

Take the latest episode of infrastructure creation. It is true that we are today grappling with NPAs and bankrupt infrastructure promoters, both of which threaten to derail the economy itself. But on the other side of the balance sheet, the economy has added nearly 10 GW of power generation capacity, nearly 100,000 km of highways, 30-40 mt of steel capacity, about 100 mt of cement capacity, country-wide roll-outs of 2G, 3G, and 4G telecommunications within a decade? Would carefully calibrated and gradual policy actions have realised this? Without irrational exuberance, would contractors and developers have taken the plunge, lenders opened the credit taps, and government agencies lowered diligence standards? Maybe this is the creative destruction pathway in infrastructure sector. And such a creative destruction with a generation of infrastructure funds and PE money, even with all attendant costs and pain, is perhaps worth it. 

One of the things policy makers, market participants, and opinion makers can do is to keep this in mind while navigating the course. The more enlightened and perceptive among them do so. Unfortunately, they will be far and few. 

The intellectuals and consultants who peddle the narrative of PPPs and private equity have a vested interest in peddling these narratives. As Upton Sinclair said, "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" This is just the hard reality of development. 

More tangibly, it is critical to focus on corporate governance. The likelihood of malfeasance increases significantly with secondary market asset transfers and private equity ownership. It is hard to believe that we have the requisite state capacity, civic-spirited and vigilant opinion makers, and acceptable enough corporate governance standards to provide sufficient checks and balances against such malfeasance. In fact, our encounters with infrastructure funds, private equity and the likes could degenerate to a level of asset-stripping and debt-loading far worse than in US and UK. 

How do we guard against the different types of value extraction and asset-stripping? How do we guard against leveraging up? How do we guard against value subtracting pass-the-parcel games? How do we guard against equity dilution? They are the second generation issues in infrastructure contracts which are upon us. Unfortunately we are yet to realise their importance. Nor is there any public debate about them.

Ideally there should be detailed project preparation, rigorous value for money analysis on a life-cycle basis, private participation choice based on efficiency gains than financing requirements, unbundling of construction and O&M, public financing of construction through arms-length entities, long-term O&M concessions, safeguards against asset-stripping and leveraging up, strong regulatory oversight, recurrent re-evaluations or flexibility for renegotiations, and so on. Each easier said than done. 

In the circumstances, the prudent objective should be to choose the least bad and distortionary option and structuring from among public procurement and competing variants of private participation depending on the context. This has to be coupled with stringent focus on corporate governance, and safeguards against egregious malfeasance.

Update 1 (13.10.2018)

This and this are good chronicles of IL&FS.

Tuesday, October 2, 2018

The case for investing in roads and railroads - evidence from China

There has been some debate in recent times disputing the value of investing in rural roads and rural electrification. The discussion is summarised here.

This goes contrary to the mainstream literature on the value of transportation infrastructure. It has been held that roads and railways "lowers trade costs, thereby allowing cities to specialise in the production activities for which they have comparative advantages". Further returns from such investments are large in poor countries but are smaller for more developed countries with larger transport networks. 

The research work of Nathaniel Baum-Snow, Vernon Henderson, and others shine light on the impact of the Chinese road and railways building program of recent decades. China undertook a massive highway network construction program, which has seen the freight ton-miles share of roads increase from under 5% in 1990 to well over 30% in 2010. In fact, the country had almost no limited access highways in 1990 and inner-city roads had just two lanes and sometimes not even paved. In the corresponding period about 127 million people are estimated to have migrated into core central cities.
One study examines the effects of road infrastructure within a given radius (450km) of prefecture (or a metropolitan area with one core city and some smaller cities/towns) cities and access to international ports on GDP, population and GDP per capita in Chinese prefectures. They estimate the relative gains or losses to one city that result from a marginal change in its regional highway allocation, relative to other locations. They find two things,
The first is that expanding the regional highway networks drives economic activity towards regionally important ‘primate’ cities (largest city in the region). A 10% expansion in road length (within 450km of a prefecture city) reduces the population in an average non-primate city by an estimated 1.6% and increases the population in an average primate city by 2.5%... Better transport connections facilitate greater centralisation of production activities, shifting activity from hinterlands into regional centres. While primate prefectures are larger than average, many are not among the biggest cities in China. We show that the primacy effects are not due to city size, nor to potentially being a provincial capital or a nodal point in the highway system.

Our second striking result is that highways’ facilitation of easier access to international ports promotes growth in GDP, population and GDP per capita for all prefectures. A 10% reduction in travel time to an international port results in a 1.6% increase in GDP, a 1% increase in population and a 0.5% increase in GDP per capita. This suggests that better access to international markets has had a high return in China, where the policy environment has emphasised export-driven investments and growth.
Another paper describes the state of infrastructure and cities in China and how infrastructure affected the development of its cities. At an aggregate level, as a description of the trends from China, the authors see three trends over the 1990-2010 period
First, we see a large increase in GDP. Second, we see a huge migration of people from the countryside to the major cities. Third, we see a dramatic decentralization of manufacturing (away from the urban core to the suburbs). That the decentralization of manufacturing GDP is so much larger than of total GDP suggests a countervailing centralization of services.
Examining city development in terms of population and economic activity, they find,
Our analysis suggests that transportation infrastructure networks had profound and long-lasting impacts on urban form in China. Both radial highways and ring roads promoted substantial population decentralization out of central cities. On the other hand, radial railroads and ring roads both promoted the decentralization of industrial production and its workforce... Each radial highway displaces about 4 percent of central city population to surrounding regions and ring roads displace about an additional 20 percent, with stronger effects in the richer coastal and central regions. Each radial railroad reduces central city industrial GDP by about 20 percent, with ring roads displacing an additional 50 percent. Similar estimates for the locations of manufacturing jobs and residential location of manufacturing workers is evidence that radial highways decentralize service sector activity, radial railroads decentralize industrial activity and ring roads decentralize both... However, radial railroads did not influence the allocation of population between central cities and suburban regions... we find no effect of radial highways on the location of industrial production.
These trends are representative of the mainstream literature on the trajectory of urban development,
Economists have recognized that denser cities provide richer information environments, which in turn improve productivity and increase innovation. However, central city environments have much higher land and somewhat higher labor costs than suburban and hinterland locations. As a result, in developed market economies, central cities typically specialize in business and financial services which benefit sufficiently from richer information environments to justify these higher factor costs. Standardized manufacturing is typically found on the lower cost urban periphery and in small cities and towns. The situation in developing countries more resembles the U.S. in the early 20th century when industry was concentrated in central cities, as in Chinese cities circa 1990. Manufacturing facilities in developing countries often start in central cities, perhaps in part because of localized externalities in learning and adaptation of technologies from abroad. However, as transferred technologies mature, central cities become expensive locations for standardized manufacturing; in a version of the product cycle, industrial firms decentralize to find lower land and labor costs.
A third paper examines the effects of construction national highways on the economic geography of China,
We investigate the effects of the recently constructed Chinese national highway system on local economic outcomes. On average, roads that improve access to local markets have small or negative effects on prefecture economic activity and population. However, these averages mask a distinct pattern of winners and losers. With better regional highways, economic output and population increase in regional primates at the expense of hinterland prefectures. Highways also affect patterns of specialization. With better regional highways, regional primates specialize more in manufacturing and services, while peripheral areas lose manufacturing but gain in agriculture. Better access to international ports promotes greater population, GDP, and private sector wages on average, effects that are probably larger in hinterland than primate prefectures. An important policy implication is that investing in local transport infrastructure to promote growth of hinterland prefectures has the opposite effect, causing them to specialize more in agriculture and lose economic activity... our findings suggest Chinese highways do allow regions to specialize and pursue their comparative advantages. In particular, prefectures where land is abundant, i.e., hinterland prefectures, become more specialized in agriculture, while more centrally located prefectures specialize in manufactured goods for regional consumption.
The Chinese experience carries relevance for India as it tries to draw policy inferences from its own transportation projects. For a start, the limited growth of railway networks in India, even in the upgradation of existing lines, may have had some effect in constraining the geographic diffusion of manufacturing. How much of this is responsible for India's failure to increase manufacturing's share of output?

If the same Chinese trends hold for India, the effects of the national highways would have been to centralise manufacturing activity in major regional cities to the exclusion of the smaller cities and towns. This coupled with the rural roads programs would have facilitated population shifts towards the major regional cities, though given the housing affordability and internal city transport constraints, the population shifts likely revolves around the suburbs of these cities. Further, in the absence of adequate investments in agriculture - irrigation, storage, etc - the rural areas are unlikely to have realised the gains similar to those experienced by such areas in China. 

Monday, October 1, 2018

The cash transfers non-debate

Two working papers on cash transfers released in recent weeks provides more fodder to critics and supporters alike.

First Chris Blattman tweeted,
Can cash grants lift the poor out of poverty? How I've started to change my mind.
His latest research, with Nathan Fiala and Sebastian Martinez found,
In 2008, Uganda granted hundreds of small groups $400/person to help members start individual skilled trades. Four years on, an experimental evaluation found grants raised earnings by 38%. We return after 9 years to find these start-up grants acted more as a kick-start than a lift out of poverty. Grantees’ investment leveled off; controls eventually increased their incomes through business and casual labor; and so both groups converged in employment, earnings, and consumption. Grants had lasting impacts on assets, skilled work, and possibly child health, but had little effect on mortality, fertility, health or education.
Just a couple of days later, Craig McIntosh and Andrew Zeitlin compared the relative efficacies of cash transfers and an in-kind regular government program in Rwanda and found the following,
In Rwanda, an IPA research team rigorously evaluated the impact of unconditional cash transfers, compared to an integrated nutrition and WASH program, on the following main outcomes: household dietary diversity, child and maternal anemia, child growth (height-for-age, weight-for-age, mid-upper arm circumference), value of household wealth, and household consumption. After approximately one year, the nutrition and WASH program had a positive impact on savings, a secondary outcome, but did not impact any main outcomes. An equivalent amount of cash (a cost to USAID of $142 per household with $114 being transferred) allowed households to pay down debt and boosted productive and consumption asset investment, but had no impact on child health indicators. A much larger cash transfer—of more than $500 per household—had a wide range of benefits: it not only increased consumption, house values, savings, and assets, but improved household dietary diversity and height-for-age, and decreased child mortality.
Dylan Matthews has two excellent articles analysing each of the papers, here and here

In the context of the Ugandan program, this, by the World Bank economist and longtime sceptic of cash transfers Berk Ozler, struck me as being profoundly misleading,
Özler also raised the issue of spillovers. The point of the program was to get more people into skilled trades, like tailoring. But that doesn’t just affect the people getting the skills; it affects the other tailors already working in the area. “Creating 10 to 15 tailors at once in a parish of 10,000 people, it’s got to affect existing tailors,” he said. “Maybe some went out of business.” It’s hard to know whether the program is cost-effective without knowing what happened to those other tailors. If the program just made some people successful tailors at the expense of others, that’s not really a huge gain.
I struggle to understand what's all this fuss about. For a start, the scenario of 10-15 tailors in a population of 10,000 is just rhetoric. (Btw, this was exactly the case with the in-kind self-employment asset-transfer programs  that the likes of World Bank have financed for decades).

More substantively, every intervention that seeks to achieve significant improvements in human condition (assuming that moving out of extreme poverty is a significant improvement) over a short period (say, 3-5 years) requires significant external support. And such support invariably creates externalities, good and bad, beneficiaries and losers. The most likely immediate impact is on aggregate demand and price level, and an upward shock at that. But the village or parish is an open system, and such interventions set in motion dynamics that accommodates those shocks. The role of public policy should be to minimise the shock and to expedite the adjustment.

Any opening up to international trade has the immediate impact of benefiting some and impoverishing others. A large mall opening in a small town has the definite effect of shutting down or at the least significantly hurting small shop owners. Or a productivity enhancing farm mechanisation ends up lowering the demand for landless labour. The redevelopment of a blighted urban locality populated by low income residents causes gentrification and makes the area unaffordable for them. But do we apply the Ozlerian test to evaluate any of these? 

Readers of the blog will know that I am no fan of cash transfers. In fact, if anything, I am sceptical of cash transfers in many areas and in many countries, including India. But like horses for courses, they have a role where appropriate. 

Unfortunately, the ongoing debate on cash transfers is stuck in an unproductive equilibrium around quantitative indicators between critics and supporters. There are several meta studies, all of which distil quantitative research findings. Missing from the debate is the more sophisticated empirical studies (which goes beyond mere quantitative indicators) that look at issues of when (both context and use case) are cash transfers more likely to be effective based on considerations on state capacity, local market conditions or maturity, individual's agency, hold of vested interests, cultural and behavioural norms, and so on. Time for someone to distil all these together and write a paper, even a book. That would really be sophisticated and smart thinking about development and some practical guidance for policy makers.

A Poor Economics for cash transfers? Or is there something like, sophisticated enough, that already out there?

Saturday, September 29, 2018

Weekend reading links

1. As global supply chains show stirrings of calibrating in response to the US tariffs on China, it is a reasonable proposition that India stand to gain. But not by much if we examine China's competitors in some of the largest affected sectors.
2. Another FT report points to how China has swiftly moved up the value chain to dominate the medium-level technology areas.
The country today has a 32% share of the global medium high-tech industries. Its share of the global capital goods market has risen from 5% to 20% in the 2007-16 period.

3. Another article draws attention to the pensions crisis staring at developed economies in this age of low interest rates. The graphic below show the grossly inadequate savings of working age population and those close to retirement.
4. Nice article on the growing trend of "pass-the-parcel" deal making (or secondary deals) in private equity space, where one PE firm sells stake to another. Last year the industry did a record 576 such deals. The trend has been associated with successive owners paying themselves large dividends, leveraging up, skimping on investments and maintenance, piling up unpaid pension obligations, and passing on to the next firm when they have squeezed out all the juice they can. In industry lingo, the existing owners "sweat" the asset as much as they can before passing it on. And the game goes on.

This story of Simmons Bedding in the US is emblematic,
In the US, mattress maker Simmons Bedding, which was bought and sold by private equity owners seven times in 20 years, filed for Chapter 11 bankruptcy protection in 2009 and more than 25 per cent of the workforce was laid off. Still, its former owners, which included Thomas H Lee Partners, made a profit of $750m through special dividends, according to a New York Times investigation.
Given the vast volumes of dry powder accumulated by PE firms in recent times, $1.7 trillion and growing, industry watchers expect secondary transactions to rise in the immediate future.

5. Renewable energy facts for the week,
Last year, China added 50 gigawatts of solar power capacity, according to the International Energy Agency — more than it added for coal, gas and nuclear power capacity put together, and equivalent to the combined solar capacity of France and Germany. India, the world’s fastest-growing major economy, added around 9.5GW of solar. The country is on course to hit 28GW by the end of 2018 — six times what it had installed three years ago. Wind is growing less quickly, but from a higher base. Last year, China added 15.6GW of wind capacity — an increase of 10 per cent.
By the end of 2017, the price of solar panels have fallen by more than 80% since 2009, and wind turbines by half. However, recent decision by China to cut incentives for solar power have had the effect of weakening domestic demand for panels forcing manufacturers to dump panels at lower prices abroad, in turn eliciting anti-dumping duties in US, EU, and India.

6. Funny how signatures of Marxian analysis making a comeback is everywhere. The latest is Leonid Bershidsky declaring the gig-economy workers as the modern proletariat. He examines a recent ILO report which surveyed 3500 workers in 75 countries employed on web-based gig-economy jobs found in digital labour platforms,
the average worker on five such platforms earned $4.43 per hour—or just $3.31 an hour if one takes into account all the unpaid time, about 20 minutes per hour, spent looking for orders, researching clients, taking qualification tests and writing reviews. Even that is relatively generous: Another study published last year estimated that “Turkers,” as workers on the Amazon platform are known, made a median hourly wage of $2. Almost two-thirds of US “Turkers,” according to the ILO study, made less than the federal minimum wage of $7.25 an hour, and only 7% of Germans on the Clickworker platform made the statutory minimum wage of 8.84 euros ($10.40) an hour. This would perhaps be marginally tolerable if “crowdworkers” only logged on to supplement income from other jobs. But 32% of those surveyed by the ILO earned their primary income from the platforms. These mostly educated people spend many hours filling out questionnaires for academic researchers, transcribing audio, even moderating content for social networks, which means watching violent videos or reading hate-filled posts all day. This is not the nicest work, and some of it can even have a lasting psychological impact, yet the “crowdworkers” live in a world without the basic worker protections guaranteed even to holders of most menial real-world jobs. Not only do they earn less than the minimum wage, they are not protected against non-payment. No one owes them an explanation when their work is rejected or when they fail a test or receive an unfavourable rating.
7. As IL&FS totters at the precipice and strains show up at others like Dewan Housing Finance, it should serve as a wake up call for financial market regulation. It has rattled the financial markets, and spooked the fixed income securities market and shadow financial sector. The 11,400 odd Non Banking Financial Companies (NBFCs) market with a combined loan book of INR 22.1 trillion ($304 bn) is expected to undergo a major churn with several smaller companies winding down. Several debt and hybrid mutual funds have significant exposure to IL&FS's debt securities and a liquidity crisis threatens the market if funds redemption pressures mount. 

There should be greater scrutiny of at least two market participants. One, rating agencies, a culprit in every major financial market crisis in recent times across the world, did not fail to show up this time too. Sample this
On credit quality, IL&FS group’s debt securities looked good till a month and a half ago. The rating rationale for IL&FS Financial Services Ltd was reaffirmed A1+ (top most rating—highest probability of repayment). However, as on 17 September, IL&FS Financial Services was downgraded to D... One must question why the A1+ rating was reaffirmed in August 2018.
The failings of credit rating agencies cannot condone the mindless acceptance of such ratings by fund managers despite the several signatures of concern associated with IL&FS and its business model

The second one is state-owned Life Insurance Corporation (LIC). It owns a quarter of the failing entity and runs the risk of of being forced to pour money in order to prevent a contagion and systemic collapse. The worrying thing is that LIC, in view of its role as the state-directed buyer of last resort of capital market instruments, may actually be sitting on more such potential duds. 

There should also be a deeper scrutiny of the transactions undertaken by IL&FS over the years and their adherence to corporate governance standards. Andy Mukherjee has an excellent starting point here. Ravi Parthasarathy's $3.65 m (INR 25 Cr) take home salary last year is only the latest example of sordid ethics in corporate India.

8. The US enjoys its "exorbitant privilege" in being able to run up deficits in perpetuity and fund it at lower cost than others. While that situation is likely to continue well into the future, some recent trends should a matter of some concern.
Dollar's share of global foreign exchange reserves slid from 66% to 62% since 2014, and that too at a time when the dollar has strengthened by 4.52%.

9. Finally, Bhanuj Kappal has an excellent story in Mint about the problems facing the 30,000 resettled illegal slum residents of Mumbai's Mahul Prakalpgrast Samiti (MMRDA Colony). The colony situated in the outskirts amidst polluting chemical and other industrial factories has become a toxic "human dumping ground".

This is so representative of similar slum rehabilitation programs across Indian cities. Relocate residents far away from their livelihoods (after all large vacant tracts are likely to be available only in the suburbs), poor quality of housing construction by government agencies, colonies with any basic community facilities (schools, hospitals etc) and limited transport connectivity. 

Thursday, September 27, 2018

The out-sized importance of basic management practices

There is perhaps no branch of development economics research which has a richer systematic body of rigorous evidence than the new empirical economics of management.

Rafaella Sadun, Nicholas Bloom, and John Van Reenan examined the management practices of over 12000 firms across 34 countries and found that firms with superior core management practices are "more profitable, grow faster, and are less likely to die", these practices accounts for "a large fraction of performance differences across firms and countries", and they are "incredibly hard to copy". They rated companies on their use of 18 practices in four areas - operations management (flow of information across and within functions), performance monitoring, target setting, and talent management. They write,
In MBA programs, students are taught that companies can’t expect to compete on the basis of internal managerial competencies because they’re just too easy to copy. Operational effectiveness—doing the same thing as other companies but doing it exceptionally well—is not a path to sustainable advantage in the competitive universe. To stay ahead, the thinking goes, a company must stake out a distinctive strategic position—doing something different than its rivals. This is what the C-suite should focus on, leaving middle and lower-level managers to handle the nuts and bolts of managing the organization and executing plans... but our research shows that simple managerial competence is more important—and less imitable... There are vast differences in how well companies execute basic tasks like setting targets and grooming talent, and those differences matter: Firms with strong managerial processes perform significantly better on high-level metrics such as productivity, profitability, growth, and longevity. In addition, the differences in the quality of those processes—and in performance—persist over time, suggesting that competent management is not easy to replicate... if a firm can’t get the operational basics right, it doesn’t matter how brilliant its strategy is. On the other hand, if firms have sound fundamental management practices, they can build on them, developing more-sophisticated capabilities—such as data analytics, evidence-based decision making, and cross-functional communication—that are essential to success in uncertain, volatile industries. Achieving managerial competence takes effort, though: It requires sizable investments in people and processes throughout good times and bad. These investments, we argue, represent a major barrier to imitation... According to our estimates, the costs involved in improving management practices are as high as those associated with capital investments such as buildings and equipment...
Data has led us to two main findings: First, achieving operational excellence is still a massive challenge for many organizations. Even well-informed and well-structured companies often struggle with it. This is true across countries and industries—and in spite of the fact that many of the managerial processes we studied are well known. The dispersion of management scores across firms was wide. Big differences across countries were evident, but a major fraction of the variation (approximately 60%) was actually within countries. The discrepancies were substantial even within rich countries like the United States... These differences show up within companies, too... variations in management practices inside firms across their plants accounted for about one-third of total variations across all plant locations... Even the biggest and most successful firms typically fail to implement best practices throughout the whole organization. Some parts of it are effectively managed, but other parts struggle.

Our second major finding was that the large, persistent gaps in basic managerial practices we documented were associated with large, persistent differences in firm performance... our data shows that better-managed firms are more profitable, grow faster, and are less likely to die. Indeed, moving a firm from the worst 10% to the best 10% of management practices is associated with a $15 million increase in profits, 25% faster annual growth, and 75% higher productivity. Better-managed firms also spend 10 times as much on R&D and increase their patenting by a factor of 10 as well—which suggests that they’re not sacrificing innovation to efficiency. They also attract more talented employees and foster better worker well-being. These patterns were evident in all countries and industries.
They attribute the failure to adopt these simple management practices to false (or excessively optimistic) perceptions about their own operational efficiency, insufficiently democratic/collaborative governance structure, poor employee skill levels, and organisational politics and culture.

Going forward, as developing countries seek to increase their productivity, I am inclined to believe that improvements in management practices may be at least as important as technological advances.

This applies as much to management of businesses as to administration in government. The weak capacity of public systems is well acknowledged. Its contributors include chronic resource scarcity, politicisation and corruption, and apathy and complacency. But a less noticed fact is deficient management or administrative capacity at the leadership levels. 

Like with private businesses, certain basic management practices can be high value in weak state capacity and resource constrained public systems. Foremost are prioritisation, identifying and nurturing competent and committed sub-ordinates, work delegation, fixing accountability, and systems for the diligent follow-up on the prioritised issues. One could add a few other practices like time management. These are, on the face of it, simple administrative practices, but they are very scarce. 

While there is no empirical evidence to validate, there are several anecdotal examples that attests to its importance and scarcity. For example, it is common place that offices which had been floundering for long occasionally become abruptly functional and energised when certain new officers take charge. In most such cases, the change can be traced back to some of the aforementioned practices and culture introduced by the particular new official. 

This carries relevance for those designing training programs for government managers. It may generate more bang for the buck and strengthen state capacity if these trainings focus on basic administrative practices that have the potential to significantly impact efficiency than on say, substantive content. 

Monday, September 24, 2018

Hedge Funds and Currency Volatility

Gillian Tett points to this JP Morgan Chase research that appears to point to hedge funds being a major contributor to currency market volatility.

The Bank researchers used JP Morgan's database of 400 m institutional investor transactions to isolate 120,000 spot and forward forex trades conducted just before and after the unexpected 2015 Swiss central bank decision to abandon its floor for the Swiss franc, the 2016 Brexit vote outcome, and Donald Trump's US election victory. She writes,
In normal times, JPMorgan cuts an average of $500m in trades each day with hedge funds that involve the Mexican peso and dollar, and some $2.8bn of sterling-dollar trades and $900m for the Swiss franc and euro. Trades with other banks and asset manages are similar in size. But just after the Swiss bank, Brexit and Trump shocks, daily trading volumes by hedge funds more than tripled. Bank trading volumes also rose sharply after the Swiss and Brexit events (but not after the Trump victory). This might imply that it was the hedge funds that pushed the currencies around. Not entirely so. Most funds did buy francs after the Swiss bank announcement. But they bought and sold sterling after Brexit, trading on opposing sides on a massive scale. So too after the Trump shock, although there were more hedge fund dollar sales. This is striking. But what is more important is that the volume of trades cut by pension funds, insurance companies, public investment groups and corporate treasury departments did not rise at all after the shocks. These groups only started to shift risk much later, long after prices had been reset... this pattern has important implications. Traditionally, banks were the main providers of liquidity in foreign exchange markets. But since 2008, they have reduced this role because of post-crisis regulatory reforms. Regulators had hoped that other long-term holdings of capital would start to fill that gap, supplying badly needed liquidity that could stabilise markets when a crunch hit. But the data suggest this is not happening. Most institutions are sitting on their hands in a crisis instead... the unpalatable truth is that it is they (hedge funds) who often keep markets trading in a crunch.
Talk about efficient financial markets, the belief that markets take care of themselves, and that market regulation should be minimal!

General Vs particular in policy making

Apurva Bamezai and MR Sharan have an excellent follow-up to Jean Dreze's brilliant articulation of the limitations of economists to offer good policy advice.

They draw attention to the limitations of quantitative techniques in studying particular effects (in specific localities or on specific categories of population), as opposed to general (or aggregate and average) effects, which are important to understand distributional consequences. Similarly, it is not much useful to study mechanisms of impact. They argue that centralised policy making privileges evidence on average or general effects. They write,
Insofar as we have centralised policymaking and an over-burdened policy apparatus, the ‘general’ will be privileged over the ‘particular’ and development economists will continue to generate the kind of evidence that influences policy. However, this does not preclude the need for much greater State engagement with a wider set of researchers, cutting across disciplines in social sciences. This is particularly true for researching impact of policies on poor, vulnerable, and marginalised groups. Furthermore, policy design affects different groups differently and it is imperative that the State listens more (thereby also diversifying its evidence base) to citizens, civil society groups, social movements, and NGOs. Plugging gaps in policy design and implementation cannot be just a product of technocratic thinking and economic efficiency, especially in a democracy.
Agree. But there is more to this than these limitations. 

There is a fundamental difference between policy making and policy implementation. While policy is made in the aggregate or at the general level, successful policy implementation (in a diverse country) demands attention to the specific context and its particular details. This, in turn, demands that policy be made by according adequate flexibility in implementation. In simple terms, since implementation has to be tailored to fit the context, policy has to be offer the greatest flexibility consistent with an acceptable degree of control over the implementation and the realisation of objectives. 

But the point about implementation flexibility raises the practical issue of state capacity. Customisation to meet contextual requirements, howsoever marginal, demands significant quality of engagement by officials at that level. Further, it also requires credible enough monitoring metrics and system for officials at various higher levels. Unfortunately, all these are difficult to realise in the short-run, maybe even the medium-term of a particular implementation. In its absence, tinkering with implementation design is more likely to leave us worse off than with an one-size-fits-all implementation.

This is the Catch 22 situation that policy makers face. 

Sunday, September 23, 2018

A graphical look at the post-Lehman world economic trends

AnanthJohn Authers, and JP Morgan have nice summaries of the post-Lehman events and trends. 

The defining feature of the post-Lehman decade has been the zero-bound interest rates, which is still in the negative territory in a few cases.
The central banks embarked on an extraordinary expansion of their balance sheet, buying up more than $10 trillion in bonds. And it remains at historic highs
The ultra-low rates penalised savers, benefited borrowers and corporates, boosted asset prices, and increased the top 1 percent's share of global wealth by 10 percentage points.
One of the most important consequences of the extraordinary monetary accommodation has been a surge in global debt burden. Global debt has surged from $84 trillion at the turn of the century to $173 trillion at the time of the 2008 crisis, and $250 trillion today.
Non-financial corporations (77% of GDP in 2008 to 90% today), governments, and China have been the biggest offenders. Consider this,
China is now saddled with almost $40 trillion of debt, compared with less than $30 trillion for all other emerging markets combined. In 2008, the group had $16 trillion of debt, while China only carried $7 trillion. 
Excluding financial corporations, it was $169 trillion in H1 2017
Non-financial corporate bonds outstanding have increased 2.7 times over the past decade to $11.7 trillion.
Governments too have been the big offenders,
The US government has been leading from the front,
The $15.3 trillion U.S. Treasury market, the world’s biggest bond market... has tripled in size since August 2008. For context, in the prior 10-year period, it grew by “only” $1.5 trillion, even amid the beginning of the Iraq War. The totality of U.S. federal debt now makes up more than 100 percent of America’s gross domestic product. 
Student loans have exploded in the US,
The issuance of leveraged, covenant-lite loans and junk bonds by US non-financial corporates has doubled.
Even as wages have remained stagnant, corporate profits have surged,
Irrespective of Dodd-Frank legislation and creation of resolution mechanisms for systematic winding down of failed institutions, markets seem to still believe in the too-big-to-fail (TBTF) subsidy. As a reflection, the difference between the interest rate differential in the borrowings of the parent financial institution and its banking unit has remained stable. Clearly the markets believe that in case of a systemic crisis, the parent units will get bailed out along with the banking units.
The remarkable growth of Chinese banks to top the global banking table adds more to the ever growing concerns about the next crisis being made in China.
A rare encouraging feature has been the reversal of financial globalisation and step fall in global cross-border flows.
Global bonds held by non-bank investors as a percentage of their total holdings of equities/bonds/M2 has risen sharply post-Lehman, reflecting risk reduction, regulatory changes, and demographic shifts.
As to real GDP growth, the US economy may appear to have rebound the most.
But once controlled for working age population, Japan has been the undoubted best performer since the crisis in terms of real output per working age person...
... and in terms of employment creation.

Wednesday, September 19, 2018

The misleading narratives of our time

Narratives define our lives. Even when they are completely divorced off reality or any evidence, they exercise vice like grip on our imagination. In fact, all of us, howsoever smart, are captives of narratives.  

Consider some of the enduring narratives of our times. 

People on welfare prefer to stay on and not search for work, thereby necessitating tight restrictions on welfare amounts and duration. Market dynamics ensures efficient allocation of returns on economic activity between labour and capital. Higher minimum wages lead to businesses hiring less or relocating or even closing down. 

Higher taxes discourage people from working and businesses from investing. Higher taxes force businesses to relocate. Capital gains taxes should be lower than income taxes so as to avoid double taxation. Soaring wage compensation is just desserts for superstar executives, attracting whom is essential to compete in the market. 

Large companies are also the biggest job creators. The vibrancy of economic activity is dependent on the economy's large companies. Industrial policy is about providing input subsidies and fiscal concessions - this is what attracts businesses. Foreign direct investment leads to technology transfers, is associated with manufacturing activity, results in large job creation, and is therefore critical to economic growth of developing countries.   

The main role of financial markets is to intermediate capital for economic activities. Financial markets facilitate efficient allocation of resources between savers and borrowers. Capital markets are the most efficient part of the financial markets. Boring banking is inefficient and lazy, even perhaps an example of rent-seeking. Stock markets can be made more efficient by financial engineering and high frequency trading. Stock prices are a fair reflection of life-cycle valuation of the business. Sophisticated financial engineering is productivity enhancing and creates value. Hedge funds and private equity firms contribute to more efficient financial intermediation. What is good for Wall Street is good for Main Street!

Public private partnerships (PPPs) are the most efficient and cost-effective approach to managing infrastructure projects. Private sector delivers more value for money with managing infrastructure projects than the public sector comparators. Infrastructure funds and private equity investments bring in high quality management practices to improve the efficiency of large and long-term infrastructure projects.   

Business competitiveness is about containing costs, especially worker wages, almost to the exclusion of all else, including retaining workers or externalising internal costs. Higher business profitability and surpluses are good for the economy since companies will re-invest them to create more growth and jobs. Higher interest rates discourage businesses from investing. Government regulation of any kind is bad, unless there is a clear market failure and the costs-benefits balance from that regulation is favourable. Mergers and acquisitions help businesses leverage economies of scale and scope to increase competitiveness and maximise profits. Maximising shareholder value should be the objective of businesses.

Digital economy companies are unlocking more value than the externalities they create. The business structure in industries with network effects have to be oligopolistic - therefore the inevitability of behemoth superstar monopolies like Facebook, Google, Amazon etc. The superstar technology companies are the touchstone for innovation. They are led and populated by nerds who have created fantastic products and services on their own.

It is markets, and not governments, who lead on innovation and cutting edge technologies. Most of the great new technologies have   been the outcome of private entrepreneurship and initiative. Most the global research and development (R&D) work takes place in private companies and R&D spending comes from the private sector. The leading companies in their areas, especially in technology and pharmaceutical sectors, invest heavily in R&D so as to stay ahead of the market. The prevailing intellectual property (IP) rights protections are necessary to promote investments in R&D. Innovative technologies from the private sector are the result of IP protections.

Finally governments are invariably inefficient, corrupt, and unproductive. Government officials are slothful, inept, apathetic, and unimaginative. Governments, in general, are sand on the wheels of market enterprise. Governments should be involved only in areas where markets cannot work or till markets become mature enough. Governments need to step aside to let markets unlock value and realise the full potential. 

Where is the evidence for the unqualified embrace of any of these narratives?

Some of these narratives do not stand even a cursory test of empirical scrutiny. Most of them stand on weak ground when faced with empirical evidence. In some cases, the evidence is too confusing to form any definitive opinion. In some other cases, like with executive compensation, the response function may well be a reverse U-shaped curve - higher compensation upto a certain level is good, but it starts becoming counter-productive beyond a certain level. We know about the famous Laffer curve in taxation, though we have no evidence about its actual shape for different contexts - when the rising curve turns around.  

Never mind all these bitter realities, these narratives form the basis for modern capitalist economies. Ideologies are formulated, opinions are formed, policies are made, and behaviours are shaped based on these narratives. These narratives exercise a form of hegemony over the society's collective consciousness.

Accomplished economists speak with great certitude about each of these without anything remotely close to the standard of evidence required to do so, one which they themselves aggressively promote and accuse governments and others of not adhering to. Ideologues and opinion makers confidently follow suit. Newspapers quote all of them and peddle them as definitive. Policies get made. Narratives get entrenched. These become conventional wisdom.

This blog itself has posts, scattered across, on most of these narratives, outlining the evidence to the contrary. The incisive Ha-Joon Chang has outlined several of these with illustrations here

US-China trade facts of the day

As the trade-war intensifies, highlighting the complex trade-offs involved, the Times writes,
The Dartmouth economist Douglas Irwin estimated 140,000 American workers make steel, while 6.5 million workers make products that include steel.
The Obama administration imposed tariffs on Chinese car and light-truck tire makers in 2009-12, and 2015 onwards for five years. The result,
Imports of Chinese tires for sale to American consumers fell to 12.3 million in 2017 from 43 million in 2009, according to Modern Tire Dealer, a trade magazine.
On Chinese FDI into the US,
Amid rising tensions, Chinese direct investment in the United States declined to $2 billion during the first half of 2018 from $45.6 billion in 2016, according to Rhodium Group, a consultancy.
But here is China's problem
China doesn’t import nearly enough from the United States to target $200 billion in American goods — let alone the additional $267 billion in Chinese goods that Mr. Trump has threatened to target... Chinese officials “are generally confused,” said Raúl Hinojosa-Ojeda, a trade specialist at the University of California, Los Angeles.. “They don’t know what to do,” he added. “They worry that the tit-for-tat model is playing into Trump’s hands.”... But China’s leaders feel they can’t back down. They have presented the trade war as part of a broader effort by the United States to contain China’s rise. The Chinese public could see any effort to soothe tensions as capitulation.
And this is even more disturbing for China,
The tariffs may be here to stay. Mr. Trump is suffering from weak approval ratings and could lose influence in congressional elections in November. But while Democrats have opposed most of his agenda, many have supported his attacks on trade with China. Even if Mr. Trump leaves office in two years, there is little guarantee that his China trade policies will be changed.