Saturday, November 2, 2019

Thinking through on the Indian Economy's problems

More thinking aloud about the ongoing problems with the Indian economy. 

What to do about the Indian economy? Is the slow-down cyclical or structural? If cyclical, what are the solutions? If structural, what are the reasons? And what are the prescriptions?

Only the naive can claim there are unique answers to any of these questions. What follows is, instead, an attempt to understand the direction of enquiry and perhaps even the broad outlines of some answers.

As a starting point, let's get out of the way what is not disputed. Most people agree on the following.

One, there is an economic slowdown. Two, its immediate manifestation is the declines in consumption across a range of sectors. Three, worsening (and contributing to) it is the clogged credit markets - both the banks and NBFCs, the latter increasingly important for working capital requirements in several sectors, are struggling from NPAs and heightened uncertainties. Four, all signatures of private investment has been trending downwards, and investments in new projects are at a fifteen year low. Capacity utilisation too is very low and declining. Five, the government's ability to prime the pump is limited given the already high fiscal deficits. Six, worsening the problem, tax revenues seem to be declining, further weakening the government's ability to stimulate. Seven, external trade as an engine of growth has long since stalled. Finally, as if all this was not enough, state governments too have been reining in expenditures, as they struggle with rising fiscal deficits.

In other words, C, G, I, and NX are all sputtering. So all the constituents of output growth are struggling simultaneously.

There is of course no agreement on what are the reasons for this state of affairs. Much less on what can be done to pull the economy out of this. This should be no surprise.

Worsening the situation a negative spiral of self-fulfilling prophecies appear to have gripped the economy and its actors. Consumer and business confidence, as captured in RBI surveys, are at very low levels. The confidence fairy has disappeared.

For sure, as the saying goes, we tend to be irrationally exuberant and pessimistic when faced with good and bad times respectively. Even discounting for the doomsday predictions, we can say with reasonable confidence that the economic sentiments are very weak. The problem with such situations is that such negative loops can be self-fulfilling - consumers will cut back purchases, businesses will freeze investments, and each reinforces the other.

The economy can remain entrapped in this grid-lock for a significant time. For a country like India, with weak safety nets, this can be even more damaging in terms of the human suffering and welfare losses. The confidence fairy, therefore, has to be brought back. And this requires action in the immediate.

What can be done in terms of immediate measures to revive growth? As I prefaced, I am not suggesting any specific answers. The typical levers available to revive the economy when faced with an aggregate demand problem are fiscal and monetary policies. Both are constrained, the former due to the limited fiscal space available and latter due to transmission problems from clogged credit markets. As Andy Mukherjee wrote, the "credit and fiscal crises are joined at the hip".

Given the problems faced by banks and NBFCs, it is unrealistic to expect monetary policy on its own to be much effective. In fact, highlighting the gravity of the credit squeeze, Niranjan Rajadhyaksha writes
The Bank of International Settlements provides a very useful data series on what it calls the credit gap, which measures the extent to which the ratio of credit-to-GDP has deviated from the historical trend as calculated by the Hodrik-Prescott filter. The credit gap has been negative for 22 consecutive quarters now, or the credit-GDP ratio has been below trend. Compare this with 55 quarters of a positive credit gap from the three-month period ended December 2000.
Therefore, only the government may have the power to break the doom-loop. This power will have to be exercised, even if it stretches its ability (in terms of the fiscal space). While the 3 per cent FRBM requirement for fiscal deficit is not arbitrary, it is also not a figure cast in stone. So, as a starting point, greater public spending, cannot be avoided.

But there has to be a very high premium associated with this public spending. It will have to acknowledged as being deployed to create the stimulus required to breakout off the grid-lock and also buy the time required to implement the necessary structural reforms. A wasting of the opportunity in terms of not undertaking the deep structural reforms will merely make the economic prospects worse.

Therefore public spending has to be tailored to maximise the boost to consumption and investment. In other words, it should seek to target instruments with the highest fiscal multipliers and target population or consumption groups with the highest marginal propensity to consume.

If fiscal policy will have to do the heavy lifting to provide the thrust, the question arises about the types of fiscal spending. Accordingly, within fiscal policy, capital expenditures, have the highest multiplier. It will have to focus on shovel-ready projects, especially of the public sector units and perhaps city governments. The more promising instrument, in terms of boosting incomes, may well be transfers. However it has to be used carefully and with exit options which can be practically exercised.

There are also limits to the effectiveness of traditional fiscal policy levers like tax cuts. The conventional wisdom around middle-class spending on consumer durables, vehicles, housing etc, leading to a virtuous loop of consumption, investments and economic growth may be on shakier grounds this time. For a start, as discussed earlier, the middle class itself is very small. Second, unlike the early years of the millennium, there may be limited pent-up demand, and also given the limited broadening of the base in the last two decades, the middle-class consumption story may be in its latter stages. Finally, as the RBI survey indicates, consumer confidence is at a six-year low. It is unlikely that a small dose of "income effect" (either by tax cuts or something else), will provide a significant shot at growth revival.

This leads us to the rural consumers and the idea of taking a leaf out of the 2009-11 stimulus which largely involved transfers to them. As demonstrated by that experience, such transfers are fraught with risks and build-up of economic weakness. However, given the high MPC of such types of transfers, they cannot be avoided. 

Some commentators talk about selling public assets to finance the government deficits. The idea of governments exiting certain areas should be welcomed and certain assets should be sold. However, it should also be borne in mind that the performance of the private sector in many areas has been no better. Further, for various strategic and other considerations, government may have to retain ownership in certain sectors.

But more importantly, wanting to privatise does not translate into actual privatisation, for a variety of factors, mostly on the demand-side. While some of the best performing public sector entities, especially on the petroleum and natural gas side, will naturally attract considerable foreign and domestic interest, the same cannot be said about the rest. In these cases, the market interest will be there only if there are windfall gains. In any case, the markets do not have the depth to absorb large volumes of privatisation in quick time. This too will take time.

However, in the meantime, some of the better performing public sector units may have an important role to play in the economic revival. In the absence of fiscal space within governments, these PSUs could expedite or front-load some of their planned and approved investments. This, especially from those in petroleum and gas, power generation and transmission are significant amounts. Similarly, government facilitation can possibly help expedite the planned infrastructure and capital expenditures in the private sector.

But this is hardly the garden variety cyclical weakness. There are too many signatures that the slow-down is structural. So what are these structural problems?

If we peer deep into the structure of the Indian economy, it is difficult to argue against the biggest challenge to long-term economic growth. With V Ananthanageswaran, I have argued in Can India Grow?,
The short story is that India faces acute capital deficiencies on multiple fronts as well as much under-appreciated adverse global structural headwinds which pose serious constraints to the achievement of sustainable high growth rates. High growth can be achieved only as episodes of over-heating followed by years of pain and lower growth from cleaning up the excesses. In the circumstances, the most prudent strategy may be to target a long period of moderate growth by focusing on steady economy-wide physical, human, and institutional capital accumulation and opportunistically riding on emergent global tailwinds.​.​
Among these deficiencies, the demand-side deficiency is acutely self-limiting to growth. The middle class is vanishingly small as a share of population. And national economic growth is supposed to be underpinned by middle-class consumption. It is stunning that there has been such limited acknowledgement among the opinion makers about this problem. 

This blog has written countless times about the "missing middle-class". The Economist had a cover story and briefing on this last year. Worse-still, as Rahul Jacob writes, even this small middle class seems to be shrinking.
... almost three decades after reforms started in 1991, the very notion of a middle class is more of a vague national aspiration than an actuality in India. “The middle class in our minds is actually the upper class," says Rama Bijapurkar, the well-known marketing consultant. Bijapurkar repeats the witticism that the middle class in India is “more sociological than logical." She prefers the term Middle India. That is a better description for people who are merely in the middle of the population in income terms but not at all a middle class. Those with a per capita income between $10 and $20 a day belong to the global middle class, according to a 2015 Pew Research Centre report. This would translate into the top 3% of India’s population.
This fact should be borne in mind whenever we make prescriptions about the Indian economy. It is still a country where the vast majority are very poor.  

Call it the home-market problem or whatever, the real issue is that India's middle-class is surprisingly small, even tiny as a proportion of population compared to its peers. This is perhaps the single biggest structural limitation to the country's sustained economic growth. It is growth constructed on a very narrow base. 

This may have multiple reasons. And it is most likely that all of them are relevant, and it will be impossible to disentangle the exact contributions of each. In any case, one of them is this,
When market forces are left to themselves, farm yields tend to stagnate or even fall. Demand for land increases faster than supply, so landlords lease out land at increasing rents. They also act as money lenders at high rates of interest. (This also adds to their holdings when debts cannot be paid and they seize the land that had been pledged as collateral.) Tenants, facing stiff rents and costly debts, with little or no security of tenure, cannot make the investments, like improving irrigation or buying fertiliser, that would increase yields. The landlords could make the investments, but they make money more easily by exacting higher rents and by usury. Land inequality leads to low long-term growth, which reduces the income of the poor but not of the rich. So, radical land reform is vital.
In fact, for those looking for a practical and actionable road-map for long-term structural reforms, one need not look farther than Joe Studwell's excellent book. How many economists could have written such a book?

The high growth period of 2003-11 were built on release of pent-up demand, massive public investments in infrastructure, and large transfers through welfare programs. As the present problem highlights, that growth did not lead to any significant broadening of the middle-class. It appears to have largely increased incomes through temporary transfers from the government, especially to rural citizens. The attendant consumption boost and investments supported the high economic growth rates. Once the transfer spigots dried up, rural incomes tanked, and household savings fell by more than six percentage points, it took the wind out of economic growth. Exogenous factors and shocks merely exacerbated the problems.

In light of above, the debate on whether the slowdown is cyclical or structural misses the point. The current slowdown has both cyclical and structural features. Further, as discussed earlier, all the major engines of growth appear to be sputtering. 

This brings us to the point about specific structural reforms. The list is long. A listing of many of them are here, here, and here. The approaches to be adopted too are outlined in there.

In this context, one note of caution will be to refrain from using the sledgehammer. Like with everything else in nature, change too has to take its time. Too quick a change will do more harm than good. And unlike physical systems, we are dealing with social systems inhabited by people. And human suffering should be minimised.

Take the example of the credit market reforms. Logically, the RBI's slew of actions on recognition and resolution of banking sector problems - SMA, AQR, PCA framework, February 12 circular etc - cannot be faulted. For sure, they have undoubtedly laid the foundations for a better financial intermediation. But the question is at what cost and whether it could have been phased out more gradually? Perhaps not. But we cannot ignore the costs of such actions. This is a good analysis of the sledgehammer that RBI delivered.

In any case, I am inclined to the belief that using the sledgehammer is just as inappropriate as is ignoring the problem altogether. Both are easy responses for policy makers at the helm of affairs. Making change happen in a more thoughtful and calibrated manner is very challenging.  

Such sledgehammers are most often counter-productive. In the case of China, it is now widely acknowledged that the crackdown on corruption and off-balance sheet financing entities has had the effect of squeezing spending and investments. 

Another example is the idea of transitioning the economy from informality to formality. This, as overwhelming evidence from elsewhere suggests, cannot happen directly. The share of the formal sector increases not by shrinking the informal sector, but by having the formal sector grow faster and gradually displacing the latter. 

Weekend reading links

1. Ananth points to this article on the floatation of Virgin Galactic, the loss-making $2.3 bn valued space tourism company for the immensely rich. Some of the comments are delicious,
And while 3 bn persons need fresh water and healthy food we all wish you a nice flight...
I'm sure the Vision Fund will invest in this...

New 'beyound meat'!
2. FT has an article on China's strategic investments in metals. This about the Chinese state-owned Citic Metals in Ivanhoe Mines in Democratic Republic of Congo,
Chinese companies already own some of the richest deposits of copper and cobalt in the DRC and beyond, metals that are critical to the switch away from fossil fuels to renewable energy. They have invested at least $8bn in Congolese mining assets since 2012, with miner China Molybdenum buying the Tenke copper and cobalt mine from Freeport-McMoran for $2.65bn in 2016... China has long coveted the idea of having a large mining company to rival western groups such as BHP, Anglo American and Rio Tinto, which they see as controlling the world’s best deposits.
3. Is Mark Zuckerberg the epitome of everything that is wrong with Big Tech? It is hard to not come away from watching his Congressional deposition on Libra without feeling concerned about the competence of Facebook's leadership.

4. Bloomberg points to the likely source of the next round of financial market crisis - CLOs. Sample this,
CLOs own about 54% of all leveraged loans outstanding... An alarming number of leveraged loans—29% by some estimates—are rated B- by S&P Global Ratings or B3 by Moody’s Investors Service. For both ratings companies, that’s just one rung above CCC, the very lowest tier before default.
5. How many times will this repeat? The latest episode of African debt defaults appear on the horizon. High fiscal deficits, fraud and deception, and the increased share of non-concessional commercial debt have all been contributors. Sample the signatures of troubles in frontier market debt,
Almost half of frontier market countries are either at high risk of falling into debt distress or are already distressed, the IMF has said, up from zero as recently as 2014. The warning comes as issuance of hard currency frontier market debt is set to hit a record high this year, with $38bn set to be raised, according to the IMF... Mozambique is already in default after it borrowed more than $2bn, much of it concealed from the IMF and donors, ostensibly to finance a tuna fishing fleet and maritime security projects, only for much of the money to be diverted to kickbacks for bankers and government officials, according to US prosecutors. The Republic of the Congo, Africa’s third-largest oil producer, Zimbabwe, The Gambia and Grenada are also on a list of nine states the IMF classes as being “in debt distress”. A further 24 countries, including Ethiopia, Ghana, Zambia, Haiti, Laos and Tajikistan are deemed to be at “high” risk of following suit, by far the highest level since comparable records began in 2010... The outstanding stock of such debt has already tripled to $200bn over the past five years with the median issuer now labouring under a debt pile equivalent to 7 per cent of gross domestic product and close to half its gross reserves, compared with 3 per cent and 20 per cent respectively in 2014. In terms of debt to GDP, the median frontier issuer now has a ratio of about 55 per cent, a rise of almost 20 percentage points since 2013.
Despite the growing risks frontier market yields have fallen from 8.2 per cent in November 2018 to 6.2 per cent as investors search for yields.

But with global monetary accommodation most likely in its final phase, this graphic on debt redemption (or roll-over) schedules looks ominous.

6. FT on the changing face of American capital markets. The abundance of private capital has led to an almost having of listed companies in the US.
7. In the context of the RCT focused Nobel Prize, some very good articles - Sanjay G Reddy, Ingrid Harvold Kvangraven, TCA Srinivasa Raghavan, Jean Dreze, and this one unravels the actual story behind the claims made here

Friday, November 1, 2019

Behavioural failings of public administrators

I have a co-authored paper with Dr TV Somanathan on behavioural failings of public administrators here on the Prime Minister's Economic Advisory Council website.

It has two parts. The first part covers thirteen commandments to "become better officers", and the second covers twenty insights to "become better policy makers".

Thursday, October 31, 2019

The "Phantom" FDI

The IMF's WEO talks about "phantom investments" or FDI which seeks to benefit from tax avoidance. It writes,
In practice, FDI is defined as cross-border financial investments between firms belonging to the same multinational group, and much of it is phantom in nature—investments that pass through empty corporate shells. These shells, also called special purpose entities, have no real business activities. Rather, they carry out holding activities, conduct intrafirm financing, or manage intangible assets—often to minimize multinationals’ global tax bill. Such financial and tax engineering blurs traditional FDI statistics and makes it difficult to understand genuine economic integration... Globally, phantom investments amount to an astonishing $15 trillion, or the combined annual GDP of economic powerhouses China and Germany... In less than a decade, phantom FDI has climbed from about 30 percent to almost 40 percent of global FDI...

Today, a multinational company can use financial engineering to shift large sums of money across the globe, easily relocate highly profitable intangible assets, or sell digital services from tax havens without having a physical presence. These phenomena can hugely impact traditional macroeconomic statistics—for example, inflating GDP and FDI figures in tax havens. Prominent cases include Irish GDP growth of 26 percent in 2015, following some multinationals’ relocation of intellectual property rights to Ireland, and Luxembourg’s status as one of the world’s largest FDI hosts.

Sample this,
According to official statistics, Luxembourg, a country of 600,000 people, hosts as much foreign direct investment (FDI) as the United States and much more than China. Luxembourg’s $4 trillion in FDI comes out to $6.6 million a person... Interestingly, a few well-known tax havens host the vast majority of the world’s phantom FDI. Luxembourg and the Netherlands host nearly half. And when you add Hong Kong SAR, the British Virgin Islands, Bermuda, Singapore, the Cayman Islands, Switzerland, Ireland, and Mauritius to the list, these 10 economies host more than 85 percent of all phantom investments.
This from the FT.
This should be a matter of concern to countries like India, which aggressively court foreign investments and tweak policies to encourage FDI. Already, only a tiny share of FDI is coming to job creating or export-generating manufacturing activities. What monitoring mechanisms do we have to assess the extent of FDI being driven by profit shifting and other financial arbitrage considerations?

Wednesday, October 30, 2019

More on the balance sheet of privatisation - Chilean edition

From the ProMarket Blog on utility services in Chile, the country which is often hailed as a pioneer in privatisation of infrastructure services,
The median wage is 400,000 CLP (Chilean pesos). That means that half of all workers are making $550 or less every month, and the replacement rate for pensions is only 31 percent. In 2019, the price of electric power increased by 19 percent, despite huge decreases in electric generation costs. Part of the explanation is that the private electric companies have a monopoly position and a law-mandated profit of 10 percent. The same thing happens with water monopoly companies. The biggest of them, Aguas Andinas, had a profit margin of 19 percent in 2013.

Finally, a public transport fare increase was the last straw. On October 6, the cost of a rush-hour subway ride grew from 800CLP to 830 (from $1.10 to $1.14). Those 4 cents were too much, considering that the average worker is spending as much as 30 percent of his income on transportation. Plus, the fares were already high compared with 47 cents for a metro ticket in Buenos Aires or 45 cents in Lima, the other capitals in Chile’s “neighborhood.”
This is illustration of inequality and market concentration is stunning,
The concentration of wealth is also similar to African countries, with the richest 1 percent of the population capturing 30.5 percent of the total income (and the 543 wealthiest households receiving 10.1 percent of that). In 2012, economist Ramon Lopez calculated that the five richest men in Chile, according to Forbes (including President PiƱera), have the same income as the lowest-earning 5 million Chileans.. The beer, tobacco, and domestic air travel markets are each dominated by a single company (with 87 percent, 95 percent, and 74 percent market shares, respectively). And these are just three examples among many; according to the pro-free-market think tank Horizontal, Chileans spend 40 percent of their income in markets without any real competition.

Tuesday, October 29, 2019

SMEs and job creation in India

Ananth and me have an oped in Livemint which summarises our joint work published by Carnegie on  promotion of small, formal firms started by educated entrepreneurs to create productive jobs.

The summary stylised facts,
One, although micro businesses dominate most countries’ economies, India’s economy has an excessive proportion of less productive, informal micro businesses. Two, employment in India is concentrated in these micro businesses, whereas in developed countries, it is concentrated in formal small and medium-sized firms. Three, productive jobs are created by firms that start out as formal. Four, new and young firms create more jobs than older, established firms. Five, growing and efficient firms are founded and run by educated entrepreneurs. Six, with age, Indian firms typically stagnate or decline in employment. Seven, India has a deficit of productive, job-creating entrepreneurs, and an excess of informal entrepreneurs focused on survival.
The full paper is here. An extract here. A review here

Monday, October 28, 2019

Higher taxes could encourage racism and anti-semitism???

If there is an annual award for the "Tweet of the Year", then this by Lawrence Summers should make it to the list. In a series of tweets, Summers throws aside all pretensions and declares his allegiance. Sample this,
Forcing the wealthy to spend could boomerang. If the wealth tax had been in place a century ago, we would have had more anti-semitism from Henry Ford and a smaller Ford Foundation today.
And this,
Very few of the problems today involve personal contributions of the wealthy. They instead involve corporate contributions or large groups: e.g., the NRA, the insurance industry, sugar producers...
See the responses on the tweet thread itself. Even an apologetic Paul Krugman cannot take it.

And this,
Wealth inequality is a highly problematic basis for judging a society. Consider a country that put in place super effective social insurance against retirement, disability & health expenses. Middle class people would run their “standby assets” down & wealth inequality would go up
In fact do read the whole tweet thread. It is an exercise in mendacity.

The whole tweet storm is triggered by what appears to have been a very good event at PIIE where Summers had a panel discussion with Emmanuel Saez. 

The larger point that Saez-Zucman make about the need for higher taxes and redistribution to lower inequality is being detracted from by the quibbling over the implementation challenges of a specific set of proposals (never mind the numerous acceptable variations possible, even if the specific set was not feasible). Incidentally, the same Summers was at the forefront of the attack on Thomas Piketty when his book which highlighted the point about widening inequality and how the dynamic of today's capitalism contributes to it. Then the quibble was about how r > g would not always hold or that r was greater largely due to higher real estate prices.

The point about implementation difficulties is one of the main arguments against progressive measures like wealth tax, higher income taxes, breaking up tech companies, and taxing multinationals. This is unsurprising since implementation of most radical changes will ex-ante always appear challenging. But in this case, it is a bit rich coming as it does from ideologues who have played a major role in entrenching the narrative around far more difficult implementation endeavours like valuation of start-ups or executive compensation, both of which have engendered egregious excesses and perverse incentives. 

With nomenklatura like Larry Summers representing them, the Liberals should not be surprised by the rise of the likes of Donald Trump!