Sunday, June 29, 2008

Reuters selling information to farmers

Here is a story on Market Light, a pilot scheme under which Reuters sells market information on commodity prices to farmers in Maharashtra. Market information on prices is sent by SMS to the subscribing farmers.

The story so far - economic history of this decade

Here is a parable. The context first. Prosperonia is the largest and most developed economy in Planet Economia. Its currency is the de-facto currency of Economia and the major share of international trade is denominated this currency. It has a financial system that incentivizes debt over savings, which in turn complements its consumers voracious appetite for consumption, which has been magnified by the "wealth effect" arising from a recent boom in its asset markets.

Emergonia is a diverse country with a few large and many smaller states, a recent history of exchange rate crisis, and a culture that incentivizes thrift and savings over consumption. Incidentally, Emergonia produces what the consumers in Prosperonia want and does so at very cheap prices, thereby further fuelling Propseronian consumers desires.

The Emergonian government makes it more favorable for its exporters by keeping currency exchange rates artificially tied at lower than market rates to that of Prosperonia. A massive foreign exchange surplus builds up and in the absence of a mature and developed financial system, the Central Bank of Emergonia invests its burgeoning surpluses in the safer and liquid assets of Prosperonian government.

The result - a massive import boom ensues and Prosperonia builds up a huge and unsutainable current account deficit. Emergonian savings and surpluses end up financing the Prosperonian consumers. Interest rates fall to historic lows and the easily available credit fuels financial market distortions and bubbles. Then the chickens come home to roost and the bubble bursts, tanking the real economy of Prosperonia to a recession. The Prosperonian currency falls against the Emergonian currency, forcing the Emergonian Central Bank to intervene and accumulate even more of the Prosperonian currency, thereby further adding to the bulging forex surplus.

Then the Economian economy experiences a supply side shock and commodity prices rise uncontrolled. Being the premier economy in Economia, and a large proportion of global trade in commodities being denominated in the currency of Prosperonia, the weakness of the Prosperonian currency adds to the upward pressure on the commodity prices. The rising commodity prices in turn drive up inflationary pressures in Emergonia, and this starts adversely affecting their predominantly poor population.

Now, replace Prosperonia with the United States, Emergonia with the emerging economies of Asia, and Economia with our own Earth, and we have covered the major part of the economic history of the world in the first decade of the new millennium!

Update 1
The Economist has this excellent summary of the global economic imbalances that have driven us to the present crisis.

Historical comparison of Arab and European cities

An excellent article by Maarten Bosker, Eltjo Buringh, Jan Luiten van Zanden in VOX highlights the role of vertical socio-political institutions, constraining the power of the state, in contributing towards the rise of European cities and the relative decline of Arab cities.

They find striking differences between the two urban systems. While the European urban systems consisted of smaller and densely populated cities, located closer to the sea or rivers, the Arab cities were larger megapolises and located inland, without access to the best transport facilities.

Drawing from Max Weber, they argue that the European cities were "producer cities", with production and exchange of goods and commercial services with the city’s hinterland and other cities being the main source of economic activity. Such cities have weaker economic and social links with the State and its fortunes were not tied to that of the State.

In contrast, the Arab "consumer cities" were "a centre of government and military protection or occupation, which supplies services – administration, protection – in return for taxes, land rent and non-market transactions". They were intimately linked to the state in which they are embedded, and their fate determined by the ebbs and flows of the State power.

Saturday, June 28, 2008

Is commodity futures speculation driving oil prices?

Back in 1997 the then Malaysian Prime Minister Mahathir Mohammed was scoffed at and virulently denounced when he blamed speculators like hedge funds for being responsible for the East Asian economic crisis. Today the roles have changed and influential voices in the American policy making and academic circles are accusing commodity futures speculators, fleeing the sub-prime mess, of being responsible for the rising oil and commodity prices. They claim that expectations of a higher future price and/or investment in the futures market by institutional investors are pushing up the current price. However, as then, the evidence in favour of speculation as a major contributor to rising commodities prices appears thin.

Economists like Guillermo Calvo argue that the rise in prices cannot be explained solely by the growth in China and India led emerging Asia. They point to the concurrent increase in transaction volumes in the forward markets, and claim that these speculative expectations are determining the current spot prices. Futures market therefore ends up determining the spot prices. Prof Calvo claims that soverign wealth funds and other sovereign investors have been shifting to higher return investments in commodities futures, thereby driving up transactions by a large quantity.

In a controversial paper, Jeffrey Frankel attributed the rising commodity prices to the low interest rates. He argues that high rates increases the supply of storable commodities by increasing the incentive for extraction today rather than tomorrow (extract and sell them, and then invest proceeds at these high interest ratees); by decreasing firms’ desire to carry inventories; and by encouraging speculators to shift out of spot commodity contracts, and into treasury bills. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories and incentivizing inventory build-up and thereby raising commodity prices. So it is argued that the low prevailing interest rates have led to build up in inventories and therefore higher prices.

Paul Krugman, here (Mark Thoma has explanation to the graphs here), here, and here, has been one of the most vocal opponents of the speculation driven oil price hypothesis. For this theory to be correct, Krugman argues, speculators have to indulge in buying up excess supply in the expectation of higher future prices. In other words, somebody has to indulge in hoarding. If this were true, there would have to be a build up of inventories and futures prices have to be atleast higher than spot prices, so as to justify the expectations.

Further, as can be seen from the graph below, oil supplies remain within recent historical ranges, which would mean that current prices reflect fundamental forces rather than speculative excesses.

Further, if the speculative pressure is driving up oil prices, then the long positions ("call option", which speculates that the prices will go up, as opposed to "put options" that seek to profit from prices falling) have to be large in number and rising. But as Alan Reynolds of the Cato Institute writes, "The "net long" position on the New York Mercantile Exchange fell from 113,307 contracts on March 11 to 25,246 by June 10 - so nearly as many traders are now shorting oil as are going long."

In fact, the long positions have dropped sharply since oil crossed $100. Even the exchange-traded US Oil Fund, which tracks the price of West Texas crude, has had a 140% increase in short positions since January 2008, outnumbering long bets by two to one.

But in reality, both there has been no build up in inventories (if anything inventories are at their lowest) and futures market has been characterized by "backwardation" - spot prices ruling over futures. Whenever the futures prices have gone above the spot prices (contango), the difference has been too weak to justify any speculative exuberance.

What makes the speculation story even less credible is the similar trend with other commodities. This USDA data show stocks of wheat and other grains declining in recent years. The trend, as can be seen below (from Mark Thoma), is same with other foodgrain commodities.

Some commentators argue that the hoarding of inventories may be occurring by way of oil producing countries with-holding their reserves from full exploitation. In other words the inventories are being hoarded under the ground. But this explanation comes into conflict with the similar trend in prices of foodgrains which cannot be left under the ground for too long.

It is also possible that hundreds of millions of oil consumers are hoarding small quantities of oil in their car tanks or their basements in expectation of rising prices. The cumulative effect of such multiple hoardings can also be substantial and exert significant price pressures, especially in tight market conditions. But again, this cannot be used to explain rise in the prices of minerals and metals. And in any case, this cannot be interpreted to blame speculation for the high prices.

Evidence from the Indian market too goes against speculation driving up prices. The ban on futures trading in rice, wheat and pulses have had little impact on their prices, which have continued to rise unabated. In contrast, sugar and potatoes which are traded in the futures market, have experienced only very small rise in prices.

Update 1
From Paul Krugman, the spot and futures prices

Update 2
Mark Thoma explains the Krugman model in discrete and continuous time series here and here.

Update 3
NYT has this neat summing up of the more common reasons against the speculation-is-driving-up-prices hypothesis.

Update 4
Big Picture outlines ten fundamental reasons why the oil prices rose in the first instance. He argues that major bull market moves begin on fundamentals, but shift towards the end of its life into a speculative frenzy.

Friday, June 27, 2008

Oil prices and changing incentives

Here is another example of how the high oil prices are changing incentives and living habits. The increased heating and transport costs for the residents of suburban areas is incentivizing people to look to living in the town or city.

Another example of changing lifestyles and incentives is the fact that in March, Americans drove 11 billion fewer miles on public roads than in the same month the previous year, a 4.3 percent decrease — the sharpest one-month drop since the Federal Highway Administration began keeping records in 1942.

Thursday, June 26, 2008

Impact of inflation on the common man

The Businessline presents evidence that even as headline inflation figures have touched a 26 year high of 11.05%, the real impact on the common man may be much smaller. By segregating only those products directly consumed by the common man from the basket of 435 commodities in the WPI, they find that the inflation for the 'aam admi' is only 7.1%. These products have a 26.32% weightage in the WPI index, and their contribution to the overall inflation is only 17%.

Interestingly, the inflation figures are negative for pulses, vegetables and drugs/medicines, and zero or negligible for kerosene and electricity. It is only fruits, edible oils and liquefied petroleum gas that have recorded double-digit rates. These trends are replicated at the retail level too.

It is oil, both petroleum and edible oils, iron and steel, which are the drivers of this runaway inflation. Petro-products, with a combined weightage of 6.99 in the WPI, have caused 16.11 per cent of the overall inflation. The edible oil complex (having a total 6.84 per cent weightage, inclusive of oilseeds and oilcakes) has likewise contributed 14.7 per cent and iron & steel (3.64 per cent weightage) another 10.93 per cent.

There are two observations in this context. One, while we can take some comfort from the fact that the direct impact on the common man may be much smaller, it may not remain so for long. The higher iron & steel, and especially petroleum prices may soon start making their impact felt on the commodities directly consumed by the common man.

Second, it is interesting that the foodgrain inflation in India has remained under control, albeit temporarily, as compared to rest of the world, and especially our neighbours. Is it because the Government has been more aggressive in its intervention with price controls, export bans and controls, and freeing up of imports in selected commodities? Have these measures had the impact of anchoring inflation expectations and containing practices like hoarding which are natural response at such times, and which are also significant contributors towards inflationary pressures?

Wednesday, June 25, 2008

Power of interest groups

It is widely known that small focussed interest groups command disproportionately high influence in the policy making corridors than much larger, but diffused focus groups. The late Mancur Olson had explored the power of small interest groups like cotton-farmers, steel-producers, and labor unions, who have strong incentives to form political lobbies and influence policies in their favor. He concluded that wherever the benefits of a policy are concentrated among a few and costs diffused among the whole (or major share) population, there is likely to be less resistance in the implementation of that policy.

Despite their interests standing in opposition to the interests of the consumers and the economy as a whole, the diffused nature of the opposition ensures that there is little resistance to implementing these policies. Hence as time goes on, and these distributional coalitions accumulate in greater and greater numbers, the nation burdened by them will fall into economic decline.

David Leonhardt draws attention to the power of interest groups in the context of Medicare reforms in the US. Medical equipment makers and pharmaceutical companies are a strong and focussed interest group with entrenched interests. As the article shows, they supply their products to Medicare at prices which are far in excess to the prevailing market rates and are strongly resisting all attempts to make procurement more competitive. The pharma companies and medical equipment makers are a small and focussed coalition, whereas the Medicare consumers are a large population, thereby ensuring that resistance is not built up.

Tuesday, June 24, 2008

Mint op-ed on competitive populism

Here is my Mint op-ed on competitive populism.

Why the Fed should not raise rates now?

What should Ben Bernanke do with the American interest rates? The American economy is facing the twin pressures of the aftermath of the sub-prime mortgage crisis and the rising global commodity and energy prices. Atleast by some estimates, the US economy may already be into a recession, and most macroeconomic parameters are showing clear signs of a downturn. Interest rates are at historic lows, and real rates are in negative territory.

In the circumstances, it appears that the prudent strategy for the Federal Reaserve would be to desist from raising rates in the medium term and focus its attention on reviving the economy and bringing about a soft landing, than targetting inflation.

Here are the four reasons why the Fed should not raise rates

1. The sub-prime mortgage bubble is far from over. The Fed's proactive intervention by way of the Term Auction Facility (TAF) and relaxing credit standards, have had the effect of reassuring the market and squeezing out some of the excesses. It has helped ease the short-term liquidity problems faced by Wall Street and brought valuable time for these financial institutions to reschedule, write down and get their books into some shape. But is estimated that so far, only around a small portion of the bad loans on their balance sheets have been adequately addressed.

Beyond cosmetic tinkering, these measures have done little to address the deeper issue of solvency that bedevils the American financial system. It is estimated that even many of the prime mortgages might come under threat if the housing market continues to drop. The tumbling real estate market has led to many home owners ending up holding debts which outsize the value of their homes. And as the Case Shiller index shows, the fall in home values continue unabated.

Any rate hike now will have a knock-on effect on all these mortgages, raising the cost of servicing the debt. The home owners will find their debt service costs going up, opening up the possibility (even certainty) of more foreclosures. This in turn will adversely affect the mortgage holders and their insurers, leading to further defaults and writedowns. Further, any deepening of the crisis on Wall Street will soon find its way to Main Street. So it is understandable that if Wall Street sneezes, credit dries up and Main Street catches cold.

2. The real economy is precariously perched, facing the possibility of entering a recession (if it has already not entered one!). The "negative wealth effect" from the sub-prime driven credit squeeze and falling home values have led to sharp declines in consumption spending, which was the engine that drove the sustained high growth rates of the nineties and first half of this decade. These problems have now been exacerbated by the rising commodity and energy prices. With the uncertainty and a recession looming large, gross private domestic investment has been falling for successive quarters and the investment climate is not encouraging.

With elections coming up later in the year, the Federal Government has responded with a $145 bn fiscal stimulus to prop up the declining demand and sustain growth. This fiscal stimulus is now underway, and this should be given a chance to play itself out and sustain growth till the excesses in the financial system are wrung out and investment climate improves.

Further, with profits squeezed by a consumer slowdown and soaring commodity and energy prices, companies have been reluctant to hire, thereby driving increase in unemployment rates by its fastest pace in more than two decades. With confidence in the economy dipping at an alarming rate, any further bad news on the unemployment front will be politically suicidal in an election year. The higher rates will only add to the cost pressures being faced by the corporate sector.

In this context, it may be instructive to recall the example of Japan in the later years of the nineties. The Japanese Government reeling under a liquidity trap had resorted to reflating the economy by massive pump priming investments in infrastructure. When the economy was just about looking up in late 1998 after a decade long slump, the Central Bank raised rates thereby killing off the nascent recovery signs. This confined the economy to another 5-6 years of recessionary pain.

3. The US dollar has been on a continuous decline against all the major currencies. But this has helped the American imports and has contributed to a drop in the US current account deficit and addressing external balance distortions. In such uncertain and difficult times as now, a declining dollar will help to maintain growth and employment by raising exports and causing American consumers to shift their spending from imports to domestically produced goods and services.

The low interest rates have had the effect of making investments in US T Bonds unattractive and has led to many Asian Central Banks searching for alternative avenues for investing their growing surpluses. Any rise in the rates now will only increase the yields for US T Bonds and draw in more Asian forex surpluses, thereby putting upward pressure on the dollar.

4. Though inflation is fast emerging as a major problem, it is driven by supply side constraints which are mostly outside the control of the US or any other individual national government. In fact, many analysts are of the view that inflation is being driven mainly by the rising oil prices.

Further, consumer spending and private investment are falling, thereby limiting demand side inflationary pressures. Under such circumstances, monetary policy is likely to have limited effect in containing inflationary expectations. Also, even by historical standards, for an economy standing at the footsteps of a recession, the inflation rate remains fairly benign.

The low rates should continue for some more time so that the financial markets are given adequate time to squeeze out and write down the major portion of the excesses built up during the sub-prime mortgage bubble and the housing market regains some stability. This opportunity should also be used to rectify the external account imbalances and bring down the current account deficit. It will also enable the American consumers to save more and pull up their domestic savings rate from its present negative territory.

Interestingly, the decoupling debate may have a more meaningful resonance in the context of monetary policy now. Even as the China and India led emerging economies may need to raise their interest rates so as to contain runaway inflationary pressures and even cool down their overheating economies, the US may actually need to keep rates low so as to prevent the economy from crashing hard into a deep recession.

Sunday, June 22, 2008

In support of coups!

Paul Collier comes out in support of coups to topple the despotic dictatorships in countries like Burma and Zimbawe, despite all the ill-effects it is likely to have on the nations polity and economy. He contends that a "truly bad government in a developing country is more likely to be replaced by a coup than by an election", and the military dictatorship may even end up improving governance. The military is the only agency powerful enough to over turn the status quo.

Central Banks should turn to slowing down growth!

The relentless march of inflation continues, and there appears no end in sight! Small and big, rich and poor, developing and developed countries have all been consumed by this rising tide of inflation. Unfortunately, this rise in inflation was to have been expected given the unsustainably high pace of growth in the world economy in the past two decades. The global economy is experiencing a clear supply crunch in commodities, foodgrains and energy, as the growth in demand, especially from the China and India led emerging economies shows no signs of abating. In this context, the only medium term solution is to slowdown growth and thereby demand. The time may have now come for Central Banks across the world to co-ordinate and raise domestic interest rates uniformly, not to combat inflation but to slow down growth.

Inflation figures for the week ended June 7, showed a 13 year high of 11.05% in India. This was expected after the Government had finally bowed to the strains being placed on the fiscal balance by rising oil prices and raised petroleum and diesel prices by an average 10% on June 4. (Petrol, diesel and LPG contributed 94% of the rise.)

The Chinese government followed suit on Friday, raising retail fuel prices by up to 18 per cent and jet fuel by 25 per cent. This rise is certain to drive inflation closer to or even reach double digit. Inflation in China had already breached a 12 year high in February and was 7.7% in April. Even the developed economies of Asia are not spared, as Singapore's inflation touched a 26 year high of 7.5% in April.

Oil prices are increasingly driving the inflation figures and emerging economies of Asia with their high dependence on imported oil are feeling the brunt. Inflation figures are 25% in Vietnam, 26.5% in Sri Lanka, 19.3% in Pakistan, 10.6% in Bangladesh and 10.38% in Indonesia. Global consumer price inflation is expected to jump from 2.4% in February 2007 to 4.3% in June 2008.

The Goldman Sachs index of commodity prices has doubled since early 2007. Nominal prices of oil have increased by 150 per cent over the same period. The upward movement in commodity prices has persisted for 6½ years. It looks as though too much extra demand is pressing on too little ability to increase global supply. The world economy is simply unable to meet this level of sustained demand.

The RBI had raised its key repo rate by 25 basis points to a five year high of 8% in early June. Analysts expect another 25 points hike in repo rate soon, even before its July 29 quarterly review. The market is settled to the expectation that the Central Bank will raise the rates in these small increments. The same is true of other emerging economies and their Central Banks.

But unfortunately, this policy of incremental hike may do little to rein in inflationary expectations. These expectations are too entrenched and may not respond to such cosmetic tinkering. Further, the cost-push nature of inflation means that inflation is driven by global demand supply conditions that are beyond the control of individual nation states. Such monetary policies will only bleed growth, without delivering on the inflation front. A condition of stagnant growth with persistant inflation could be the reality in many countries by mid 2009.

Under the circumstances, given the supply constraints faced by the global economy and the nature of the inflation, it may be appropriate for Central Banks, especially in China and other emerging economies, to turn away from inflation fighting to the more immediate need of slowing down growth.

On the positive side, the US economy is clearly slowing and may even be in a recession. It is now important that the other economies, especially China, follow suit. And we are only talking about slowing down from the breakneck pace of 9-10% to a more reasonable and sustainable 5-7%, atleast for the short term.

It has been observed from central bank policies elsewhere that rising rates in small increments rarely ever yields the desired results. The expectations of small rate hikes gets embedded and gets discounted for by the market, and has little effect beyond its immediate aftermath. While it may be suited to combatting mild inflation, it is surely not appropriate for addressing the present challenge.

In contrast, larger and limited number of rate hikes, over shorter time intervals, may both shake up inflationary expectations and put immediate downward pressure on growth. Two or three rate hikes by 100 basis points may do the trick. But the hikes may have to be done by co-ordination between global Central Banks, so as to have the desired effects. Else, the presciption may turn out exacerbating the crisis!

Update 1
Nouriel Roubini feels that the most effective way to contain inflation is to allow currencies in the emerging economies to appreciate significantly. If the nominal exchange rate is not permitted to appreciate, real appreciation can occur only through an increase in domestic inflation.

Saturday, June 21, 2008

Role of forex market interventions on inflation and US credit squeeze

Martin Wolf feels that the current inflation crisis is part of a larger global picture of credit crunch in the US, soaring commodity prices, and interventionist policies in the foreign exchange markets by the Asian Central Banks to keep their domestic currencies low.

He links up the story,
"Many emerging economies have intervened in currency markets on a huge scale, principally in order to keep export competitiveness up and current account deficits down. Over the seven years to March 2008, global foreign currency reserves jumped by $4,900bn (€3,175bn, £2,505bn), with China’s reserves alone up by $1,500bn. Indeed, as much as 70 per cent of today’s reserves have been accumulated over this period.

Interventionist policies aimed at sustaining export competitiveness expand economies. The results normally include rapid rises in net exports, low interest rates, aimed at curbing the capital inflow, and expansion in the monetary base, despite attempts at sterilisation. The Chinese economy is overheating as a direct result of this trio of effects.

Most of these reserves were accumulated by countries more or less explicitly targeting the US dollar and accumulating US liabilities. The resulting capital flow financed the US trade and current account deficits. But a trade deficit is contractionary: for any given level of domestic demand, it lowers domestic output. Thus, the US needed to expand domestic demand, in order to offset the contractionary effect of the external deficits. Some groups within the economy needed to spend more than their incomes. The most important such group turned out to be households. Thus the growth in US household indebtedness that led to today’s "credit crunch" is a direct result of the global imbalances."

Why carbon trading may not be the way ahead?

The last couple of years have seen a proliferation of projects in India seeking to access the Carbon Emissions Reductions (CERs) provided under the Clean Development Mechanism (CDM) of the Kyoto Protocol. Millions of dollars worth projects have been approved by the Executive Board (EB) of the United Nations Framework for Climate Change (UNFCC), and many more are in the process of getting certified.

Into this climate of euphoria, with a large number of projects already approved and many awaiting sanction, the time may have come to instill a note of caution. The cap-and-trade system may not be the way ahead. In fact, there is a very strong possibility that it could be still-born, replaced by a universal carbon tax. The rising oil prices and its effects on the global economy, only strengthens this view.

The most prominent market-based emissions trading exchange in the world is the European Union Emissions Trading Scheme (EU ETS). The ETS was established in 2005 as part of the emissions reduction target in the Kyoto Protocol, to cap emissions from about 12,000 factories producing electricity, glass, steel, cement, pulp and paper. Under this scheme, companies buy or sell permits based on whether they overshoot or come in beneath their pollution goals.

But the ETS has been mired in problems and controversies since its inception. The NYT has this article by James Kanter that gives a dismal report card on the achievements of the ETS in the last three years.

The European Environment Agency recently reported that despite the EU ETS in operation for over two years, the emissions from factories and plants that trade pollution permits rose 0.4% in 2006 over the previous year, and 0.7% in 2007. During the three years in which they participated in the first phase of the market, carbon emissions in the iron and steel sector in Britain alone rose more than 10% while emissions in the cement industry rose more than 50%.

Some of the participating governments allocated too many trading permits to polluters when the market was created, leading to a near-market failure after the value of the permits fell by half, and called into question the validity of the system. Recent efforts by regulators to tighten the permits given to more polluting industries like electricity producers, oil companies, steel companies and airlines has been met with stiff opposition. Investors are threatening to limit their investments in these sectors and go elsewhere. Poorer countries in the union, led by Hungary, are clamoring to overturn emissions allowances that they say are too stingy and risk undermining their economic growth. If the EU ETS has to succeed, the price of carbon has to rise and the quantity of permits issued has to be reduced.

Cap-and-trade schemes face strong opposition on grounds of economic efficiency and incentive distortions, and an increasing number of influential economists have already thrown in their weight in favor of a universal carbon tax. I have already elaboarted on this ongoing debate here. On the balance, carbon tax appears to be a far superior method to reduce emissions. Unfortunately carbon taxes has not generated any debate or interest in India and other developing countries. We appear to be still caught up with cap-and-trade system and CERs.

There are important lessons to be drawn for the large numbers of projects in developing countries, which employ energy efficient/saving technologies and access CERs under the CDM, from the problems faced by the EU ETS and the debate between cap-and-trade and carbon tax. The CERs are a significant revenue stream in many of these long-life projects in solid waste, non-conventional energy power plants, and transport sectors. These projects will start looking seriously unviable if the CDM market collapses.

Since many of these projects are in the Government sector,undertaken by Urban Local Bodies (ULBs) and other government agencies, it is important that Governments exercise more stringent evaluation criteria before approving these projects. Otherwise, the same governments may end up having to bail out these failed projects.

The problems faced by the EU ETS also underlines the importance of harmonization of policies across countries for any carbon reduction scheme to succeed. Carbon reduction policies are typical examples of policies producing positive externalities. The marginal social benefits accruing to the world from individual nations following such policies is much more than the marginal private benefit accruing to the particular nation. There are strong incentives for individual nations to defect and free-ride, thereby imposing unacceptably high costs on those following these policies.

Friday, June 20, 2008

What my daughter teaches me about economics?

My two year old daughter drives me and my wife into exasperation and even anger with her tantrums. Though I must admit that without the tantrums, I would have been even more exasperated and unhappy!

Trying to reason out and analyse her tantrums, I am convinced that there is a major incentive problem with the way parents treat children, especially infants. Instead of taking cue and incentivizing them to follow our lead, parents try to force themselves upon their children, who in turn resist with tantrums. I am also convinced that children are the most ideal of economic agents, in that they exhibit great versatility in responding to incentives.

My wife carefully covers my daughter with a sheet when she gets ready to sleep, so that she does not feel cold. My daughter, who like me does not like using a sheet, promptly wriggles out and throws off the sheet. Only to snuggle back under the sheet, again like me, as she gets drowsy and cold. I have watched this sequence of events being played out every day. My wife still persists with the routine.

I suppose it is true with all mothers that they are bent on feeding their children as much as the child can possibly ingest. It is therefore nothing unusual for my wife to force down the rice porridge or chappati down a vociferously resisting daughter. I have tried explaining to her that the little one is resisting because she is just not hungry enough. Or may be she had enough with the sticky porridge and wants a change. Why not wait for her to get hungry and ask for food, and serve her different food items each day, and possibly repeat it with some periodicity?

Even a trivial thing like getting her to sleep or dissuading her from wandering out, can be reduced to one of incentives and disincentives. A Wee-willie-winkie or the bogo demon, who can frighten away my daughter is another example of incentives at work. Similarly, with a packet of popcorn or lolli-pop or crayons(yes, these are her favorites!).

It is not just incentives that children teach us. Consider this example. Parents in their anxiety to get their children to read and write as early as possible, forces the English alphabet and numerals on the resisting child. Instead, why not inculcate in the child the interest and inquisitiveness (and children are very curious and inquisitive indeed) to learn the alphabet and numeral. This produces interesting results.

Again exasperated with my daughter's initial stubborn refusal to learn the language of her world, we experimented with arousing her curiosity for the written word with some interesting children's play material. Now, as soon as I get back back everyday evening my daughter runs to me with her latest picture book acquisition, demanding that I explain it or tell the story.

What do we learn from this? Initially our misguided and ill-directed efforts at teaching our daughter was not yielding result, as the child was just not interested. Have we not seen this before in Eco 101? It is a classic case of the over enthusiastic parent's efforts crowding out any pretence of effort by the child. Now fast forward a few years, with the child is going to school and being given homework everyday. If the over zealous parent, instead of gently guiding the child starts sitting with the child and effectively shepharding the child through her regular homework, we have a major problem. The parental effort will obviously crowd out the child's initiative and interest, leaving her with little incentive to do her homework herself.

Children are extremely impressionable and responsive and hence a fertile ground for incentives and disincentives to play out. It is therefore necessary to inculcate the appropriate incentive and disincentive calculus in children from a very early age, so that it remains a strong foundation that underpins their character.

(PS: I have recently completed reading one of Steve Landsburg's older books, Fair Play, and this post has been inspired by that book)

Thursday, June 19, 2008

China's place in the world economy

The following three graphs about global cement production (drawn from Paul Krugman's blog) is self-explanantory, and is a fairly accurate representation of China's importance in the world economy.

Wage insurance to combat inequality?

Some days back, I had posted on the ongoing debate about whether trade is contributing towards widening inequality in the US and the role of Stolper-Samuelson theorem in explaining this. Now Dani Rodrik has claimed that the fall in wages of unskilled workers in the US is not due to any Stolper-Samuelson permanent wage compression, and makes a case for wage insurance to cushion the affected workers.

The general version of the Stolper-Samuelson theorem states that at least one factor of production must experience a decline in real income from trade as long as trade causes the relative price of some domestically produced good to fall. This is understandable, since the loss incurred by way of lower prices have to be borne by someone (either labour or capital).

As to who will bear the loss, it is logical that the most abundant factor in the good (experiencing fall in price) should bear the greater burden of the loss. It has therefore been argued by proponents of the "trade-is-causing-inequality" theory that the lower prices have led to a Stolper-Samuelson permanent wage compression on American unskilled workers. It has been claimed that this has in turn more than offset the benefits that have accrued to American consumers by way of cheaper imports from China(Christian Borda and John Romalis).

Rodrik quotes from a recent paper by Raphael Auer and Andreas Fischer, who argue that the fall in prices of some goods produced in the US have come more from increases in Total Factor Productivity (TFP) and not so much from fall in returns to unskilled labour. So there is the possibility that the Stolper-Samuelson reduction in wages of American workers has been covered by the TFP increases due to import competition.

Dani Rodrik writes, "The mechanical link between prices and factor costs--which I appealed to above in the proof of the generalized S-S theorem-breaks down whenever there is productivity change. After all, if TFP increases, employers can afford to pay unchanged wages even if the prices they face decline."

Rodrik suggests that this TFP improvement comes about from an industry restructuring, causing the exit of the least efficient firms and attendant lay-offs. This appears to imply that "the main threat to workers is not a Stolper-Samuelson type permanent compression in wages, but the more temporary (and limited) wage losses incurred by displaced workers." This, he claims, is the kind of problem that wage insurance is ideally suited for.

Wednesday, June 18, 2008

After $4 gallon oil, here comes $1 pound bananas!

Dan Koppel has this excellent NYT op-ed, tracing the growth of the Cavendish variety of banana as the primary staple fruit in America (and elsewhere) and the recent rise in banana prices, which touched $1 a pound.

The major reasons for this rise are the rising cost of oil, reduced supply caused by floods in Ecuador, the world’s biggest banana exporter, and the spread of a virulent strain of the fungal Panama disease.

Resource Curse and under-development

Orissa has been witness to vociferous and often violent protests in the recent months over the proposed setting up of a $12 bn steel plant by the South Korean Steel giant, POSCO. The investment, if it goes through, would easily be the largest FDI in Indian manufacturing.

It is alleged that the Steel Plant would result in displacement of large numbers of tribal communities. Opponents point to the examples of Jharkahand and Uttaranchal, which despite being rich in mineral resources, have not enjoyed the proportionate benefits of their resource ownership and continue to remain poor and deprived. The left-wing extremists too have taken up the cause of these tribals and are threatening to launch a violent agitation against the mining project.

Economists have a term to describe this phenomenon - "resource curse". It refers to the condition wherein natural resource rich regions not only do not get the benefits from the resources they own, but also suffers from violent conflicts, extreme poverty and under-development. Orissa may only be the latest example in the long line of resource rich countries or regions experiencing such conditions. The large numbers of resource-rich African countries are the commonest examples of nations afflicted by this "resource curse".

The latest edition of the State of India's Environment, "Rich Lands Poor People, is sustainable mining possible?", brought out annually by Centre for Science and Environment (CSE), says, "India’s richest lands — with minerals, forests, wildlife, water sources — are home to its poorest people. Mining in India has, contrary to government’s claims, done little for the development of the mineral-bearing regions of the country."

The report observes that of the 50 top mineral producing districts, 34 fell under the 150 most backwards districts. It concludes that the vast majority of the wealthiest districts in terms of natural resources were the poorest and the most under-developed districts. The report said that "the wealth of mining does not go back to the mining areas. Mining takes minerals, degrades land, water and forests, and does not provide local employment."

The report also observes, "Between 1950 and 1991, mining displaced about 2.6 million people — not even 25 per cent of these displaced have been rehabilitated. For every 1% that mining contributes to India’s GDP, it displaces 3-4 times more people than all the development projects put together."

Why do such resource rich regions appear to suffer from such extreme poverty and deprivation? Here are a few possible reasons

1. Mining belongs to that category of industries, in which the consumers benefit more than the producers. Invariably, the consumers live very far away from the production centers.
2. Mining causes significant environmental damages and pollution, which are rarely addressed fully. This in turn excerbates the health and environmental problems in the area. It is estimated that the mining of major minerals in India generated about 1.84 billion tonne of waste in 2006, most of which has not been disposed off properly.
3. Such areas are generally situated in inhospitable terrain and areas, thereby accentuating accessibility and development problems. As the report points out, "If India’s forests, mineral-bearing areas, regions of tribal habitation and watersheds are all mapped together, they will overlay one another on almost the same areas." The forest cover for the top 50 mineral bearing districts was one-third higher than natural average.
4. Mining is labor intensive and therefore mining cities have to support a large proportion of unskilled and semi-skilled population, who invariably are poor and have limited purchasing power.
5. In the absence of a critical mass of consumer base, mining areas cannot support many of the modern businesses, especially in the services sector. Good quality hospitals, schools and civic infrastructure requires a minimum number of consumers who are willing to pay for the delivery of these services.

It does not help that many of these areas are also originally some of the poorest districts, and thereby requiring consciously pro-active government policies. In conclusion, despite the presence of valuable natural resources, these areas have substantial legacy costs, which draws the region into a vicious cycle from where escape becomes a difficult challenge.

Tuesday, June 17, 2008

Chavez's Bolivarian revolution

Celeberated writer Jon Lee Anderson has this excellent account of Hugo Chavez and Bolivarian ambitions in the New Yorker magazine.

Rising oil prices and air travel

With oil price rise showing no signs of letting up, and fuel accounting for over 40% of a carrier's costs, airlines have been responding by optimizing and minimizing their fuel consumption. In a few cases, this has involved cutting down on non-stop long haul flights.

The long hauls are going because they burn fuel simply to carry enough fuel to make the long runs. Short haul flights too are facing pressure, since the 37- and 50-seat regional jets bleed more fuel.

Friday, June 13, 2008

"Panglossian" world financial system

Paul Krugman had compared the modern day investment manager, who sees only the silver lining in every dark cloud and ignores risk from rational considerations, to Voltaire's hero Pangloss.

Daniel Cohen feels that this Panglossian investment manager "realises that the downside is limited to being fired, but the upside is limitless. This asymmetry between profits and losses encourages audacity. Once a certain risk threshold is breached, the investment manager who places bets with other people’s money ignores danger. From a social point of view, the problem stems from the divergence of incentives. Even though the intermediary knows that he may suffer a severe personal loss, it will never be proportional to the losses inflicted on investors".

Rating Municipal debt

Good news for the US Municipal Bond market - Moody's finally announces its decision to rate municipal bonds on the same scale it uses for corporate debt. It would be a significant change for the tradition-bound municipal bond market and could help to lower borrowing costs for some local governments during tougher economic times. It could also lead to less demand for bond insurance at a time when several big guarantors are faltering. (More on this here)

When are the rating agencies in India going to follow suit? If in the US, a uniform rating scale will help sustain a faltering Munis market, in India the same could break open its still-born Municipal debt market.

Thursday, June 12, 2008

Bernanke faces the ultimate test

Whatever decision Ben Bernanake takes over interest rates over the next couple of weeks and its consequences, may end up ultimately being the final verdict on his regime as Fed Chairman. For far too long, the Fed had put inflation fighting on the back-burner and has been fighting to stave off a recession. But now, inflation is becoming too real and immediate to ignore any longer, while growth is hanging precariously on the back of a temporary fiscal stimulus and the cheap interest rates.

The European Central Bank (ECB), faced with rising inflaiton, has already announced its intent to raise rates hikes and many others have already done so. According to the IMF's International Financial Statistics, global consumer price inflation is now running at an annual pace of nearly 5½ percent, compared with less than 4 percent in recent years. The acceleration in global commodity and energy prices shows no signs of easing off.

If the rates are hiked now and a process is initiated that will somehow help US avoid both inflation and recession, or a stagflation, then Greenspan will be forgotten and Bernanke will emerge out of the shadow of his predecessor and as a hero. If on the other hand, the hike in rates end up choking any remaining signs of growth, then Bernanke will be vilified and the Fed's reputation in the markets will take a hit.

The other remote possibility of keeping rates unchanged, may not be an option, especially given the rising oil prices and falling dollar. In the circumstances, the best that Bernanke can pray for, would be for a soft landing - one that would squeeze out the sub-prime and related financial market distortions and credit excesses, without stfling growth.

The cheap money policy (negative real interest rates) has contributed to many distortions in the global economy too. The cheap money policy, coupled with recessionary fears, have placed continuous downward pressure on the US Dollar, forcing it down to historic lows. With the major part of international trade in commodities, and especially oil, being priced in dollars, a depreciating dollar has had the effect of magnifying the rapidly rising commodity prices. Further, the cheap rates and the declining dollar was driving institutional investors into the emerging economy equity and debt markets, increasing their foreign exchange surpluses and their domestic money supply, thereby adding to the high commodity price driven inflationary pressures. In a way, the Federal Reserve was exporting inflation into the world economy!

As Tim Duy argues (from Mark Thoma), any hike in rates now could also have adverse consequences, especially with the housing mortgage crisis still on the balance. He writes, "Furthermore, higher rates threaten to intensify and lengthen the housing downturn; a 30-year conventional mortgage is already at 6.25%. Note also the Fed would be raising rates into what many believe will be the second wave of mortgage problems, the Alt-A and option adjustable mortgages that reset beginning in 2009. If the Fed starts raising rates meaningfully at this point, anticipate the yield curve to invert early next year, signaling a recession in 2010."

It will be interesting to see how the markets react to any US rate hike. The trade-off would be whether the markets perceive the rate hikes would contain inflation without choking growth, or not.

Wednesday, June 11, 2008

Domestic Vs International trade

Many trade economists and policy makers have tended to draw conclusions or form hypothesis about international trade by drawing parallels with domestic trade. They tend to see international and domestic trade in the same analytical framework, with the same rules of the game.

Recently Tyler Cowen, in an article defending globalization, had argued that while acceptance of domestic trade is built into the system, trade with foreigners evokes, often passionate, opposition.

Now, what is so different between domestic and international trade, that they evoke such contrasting feelings? Dani Rodrik thinks it has to do with the "embeddedness" of markets. He feels that "domestic trade takes place within thoroughly embedded markets; there are clear rules and they apply to all transactions equally. International trade, on the other hand, is conducted in only weakly embedded markets; the rules either do not exist or apply unevenly."

The concept of emebeddedness arises from his contention that "markets need to be embedded in a larger set of man-made rules and governance structures. Markets need regulation, stabilization, and legitimation because they are not self-regulating, self-stabilizing, or self-legitimizing. The success of modern capitalism is due as much to the institutions that govern markets - political democracy above all - as it is to the power of markets themselves."

This lack or deficiency of institutions that govern markets, or embedded markets, means that international trade is often driven by regulatory arbitrage opportunities - variations in quality, labour, environment, patent, and other standards.

Dani's analysis is from the perspective of the developed economies, whereas let me speculate on the view from the side of the developing economies.

1. The operative condition is not so much the quality of embedded institutions, as the issue of uniformity or homogenity in the "rules of the game". In many developing markets too, opposition to international trade arises from the absence of a "level playing field" - larger and well supported MNCs swamping domestic manufacturers, heavily subsidized farm products driving out local farmers, competition and government procurement policies that weigh in favour of larger firms, unregulated financial markets that spawn dubious practices etc. Yes, these are also perceived as "regulatory arbitrage" - depends on which side of the fence you are in!

2. The logical next step in this analysis would appear to be that we need to harmonize the rules of the game, so as to increase the domestic acceptability of globalization and international trade. While this may increase the acceptability in the developed countries (though I suspect, it will not, given the previous point), it will only increase the suspicion and resistance in the developing economies. We have seen this story enacted before!

It is impossible to bridge these contrasting views easily or soon. Till then, international trade and globalization will have to be driven by more uniform sharing of trade benefits, both between and within countries, and by having adequate enough social safety nets that can cushion those hardest hit by trade and globalization. In the meantime, we can progressively strive towards increasing the "embeddedness".

Tuesday, June 10, 2008

Trade and inequality debates

It has long been argued that international trade is a Pareto improvement and benefits both partners. The Ricardian theory of comparative advantage states that the most efficient and mutually beneficial arrangement for each country is to produce those goods in which they have a comparative advantage and then trade in those with other countries. While it may indeed be true that trade benefits both partners in the long-run and as a whole, it may have adverse distributional effects within any country.

There is an intense debate raging on in the United States over the sharply widening inequality and the role of trade in promoting this. It has been argued that trade has intensified wage inequality in the US. One of the foremost trade theorists, Paul Krugman, suddenly changed track from his long-held position that trade has very limited influence on inequality, and now claims that trade may be a much larger influence on inequality in developed countries. He based this claim on two factors - the rise of China, and the growing fragmentation of production.

The steep rise in share of imports from China led developing world, 6% of GDP for US, where wages are only a fraction of the developed world, 3% of US wages in China, has put sharp downward pressure on American wages. This has been exacerbated by the proliferation of a new category of labour-intensive industries through the fragmentation of production process and outsourcing of services, facilitated and encouraged by globalization, advances in communications technology and the increasing trade between nations.

Paul Krugman also feels that, "it's hard to avoid the conclusion that growing U.S. trade with third world countries (that pay their workers low wages) reduces the real wages of many and perhaps most workers in this country".

He argues that unlike trade between high-income countries, which produces broadly shared gains in productivity and wages, "trade between countries at very different levels of economic development tends to create large classes of losers as well as winners". He writes, "Workers with less formal education either see their jobs shipped overseas or find their wages driven down by the ripple effect as other workers with similar qualifications crowd into their industries and look for employment to replace the jobs they lost to foreign competition. And lower prices at Wal-Mart aren’t sufficient compensation."

James Surowiecki waded into this debate by suggesting that the "benefits of free trade with China, at least when it comes to shopping, are concentrated overwhelmingly among average Americans". While conceding that job losses and wage declines have affected middle and low income Americans badly, he argued that the same category, as consumers, were the biggest beneficiaries of the cheap Chinese import of manufactured goods.

Given that these imports consist mainly of products commonly consumed by lower and middle-income Americans and make up a large share of their consumption budgets, trade with China benefits them disproportionately more than the richer consumers. He quotes a study by University of Chicago economists Christian Broda and John Romalis which indicates that between 1999 and 2005, the inflation rate for lower-income Americans was almost seven points lower than it was for the wealthiest Americans, due mainly to trade with China.

Mark Thoma however takes a different view and feels that given the stagnant wages, rise in inequality, loss of health care and retirement benefits, and decreased job security, low and middle-income Americans may not feel that the benefits of globalization has not been proportionately shared.

He writes, "We need to find a way to distribute the gains (and the pains) of globalization so they are shared more equally, to increase opportunity so that everyone has the chance to reach their full potential, and we need to reverse the declines in economic security, retirement benefits, and health care coverage that have occurred for middle and lower income households over recent decades."

Some others have cited the Stolper-Samuelson theorem to explain the rising wage inequality in the US and other developed countries. This theorem states that "a rise in the relative price of a good will lead to a rise in the return to that factor which is used most intensively in the production of the good, and conversely, to a fall in the return to the other factor". Alternatively, trade lowers the real wage of the scarce factor of production, while protection from trade raises it.

Therefore, an increase in the relative price of American exports to cheaper Asian imports, will lead to higher returns for capital (which is more intensively deployed in US exports) and lower returns for the other factor, labour. To quote Wikipedia, "Unskilled workers producing traded goods in a high-skill country will be worse off as international trade increases, because, relative to the world market in the good they produce, an unskilled first world production-line worker is a less abundant factor of production than capital."

It is therefore claimed that if the removal of barriers to trade causes the price of exported goods to increase (relative to imports), and if the exported goods use skilled labor intensively, then the price of skilled labor (the wage) will go up, and that of unskilled labor will go down.

But this may only be part of the story, since the other side of Stolper-Samuelson theorem reveals that in the Asian economies, the opposite effect dominates when export prices rise. Since their exports are more labour intensive, the returns to labour rises while the returns for capital falls.

The whole debate ultimately boils down to identifying which of the two effects - work migration and downward wage pressure on American workers, and cheaper produce for American consumers - pre-dominate. While Surowiecki argues in favor of the later, Mark Thoma and Krugman feels that the former pre-dominates.

As Tim Worstall points out, the importance of trade lies in the undeniable fact that while relative poverty is increasing in the rich countries, it is at the same time abolishing absolute poverty in the poor ones.

There are also convincing studies to indicate that changing economic environment and technology may play critical roles in determining wage inequality. Dani Rodrik calls attention to the work of Robert Feenstra and Gordon Hanson, who show that global "production sharing" has the same effect as skill-based technological change in shifting demand away from low-skilled activities, while raising the relative demand and wages of the higher skilled. Lawrence Katz and Claudia Godin have made out a brilliant case that the rising inequality in the US can be accounted for by rising educational wage differential.

Sunday, June 8, 2008

Carbon footprint in food

Ezra Klein draws attention to a study by Christopher Weber and Scott Matthews of the Carnegie Mellon University, which breaks down the carbon footprint contribution to a typical American food basket. Some interesting findings of the study are

1. 83 percent of emissions came from the growth and production of the food itself. Only 11 percent came from transportation, and even then, only 4 percent came from the transportation between grower and seller (which is the part that eating local helps cut). This means that the food shipped from far off may be better for the environment than food transported within the country -- ocean travel is much more efficient than trucking.

2. The average American household burns through about 8.1 metric tons of greenhouse gases as a result of food consumption. By contrast, if your house has a car that gets 25 mpg and you drive 12,000 miles a year (US average), that produces 4.4 metric tons of greenhouse gases. Therefore, switching to a totally local diet is equivalent to driving about 1000 miles less per year.

3. Red meat and dairy are responsible for nearly half of all greenhouse gas emissions from food for an average U.S. household. Replacing red meat and dairy with chicken, fish, or eggs for one day per week reduces emissions equal to 760 miles per year of driving. And switching to vegetables one day per week cuts the equivalent of driving 1160 miles per year.

Matching beneficiaries with benefits

Some time back, I had written a Mint op-ed about how the NGO world could benefit from the services of institutions like credit rating agencies, which can help funnel the massive amounts of philanthropic contributions, especially from the smaller contributors, to the most deserving causes. As a corollary to this, it is another major challenge to match deserving beneficiaries to the available philanthropic assistance.

Now Georgia Levenson Keohane, draws attention through a Slate column, about the role of SingleStop USA, a poverty fighting startup, which seeks to "connect the working poor in New York with government funds and services intended for them". After connecting beneficiaries to specific eligible assitance, SingleStop also helps them through the entire application process, helps them obtain the benefits and even give guidance on how to optimally use the assitance.

It has been estimated that nationally more than $65 bn in social welfare assistance goes unclaimed for, that 25 percent of the working poor receive no benefits at all, despite their eligibility, and that only 7 percent of these families access all four of the major supports (tax credits, Medicaid, food stamps, and child care subsidies). It gets support from philanthropists and some well known foundations.

Keohane describes SingleStop's operating model thus, "With a Turbo Tax-like software and legal and financial counseling, it helps people tap into public benefits (tax credits, food stamps, child care subsidies, and health insurance) that they're eligible for but aren't using." After matching them with the eligible assistance, SingleStop also after clients determine what they're eligible for, counselors walk them through the application process, help obtain the benefits, and then provide specific guidance about them.

Keohane goes on, "In 15 minutes, the organization's software tools calculate a family's eligibility for a host of benefits—public assistance (TANF and other welfare-to-work initiatives), food stamps, Medicaid, housing and child care subsidies, health care, school lunch programs, heating assistance, Social Security disability, and tax credits. SingleStop counselors then provide families with tailored legal and financial advice—how to stave off eviction with new rent money or vouchers, how to consolidate debt and begin to pay it off, how to open a savings or IDA account."

Since 2001, a New York City pilot version of the program has connected 70,000 low-income residents to hundreds of millions of government dollars. According to a McKinsey & Co. study of the New York pilot, the average family in a SingleStop program recouped $1,800 in tax credits and $5,000 in benefits that they weren't previously receiving.

It is no different in India where the large numbers of State and Central Government welfare programs - especially in health care, education, skill development, and rural credit - are inaccessible to the most deserving, both due to lack of awareness and also the complexity involved in the application procedure. The SingleStop model is an excellent example of how the huge challenge of rectifying the gaps and inefficiencies in the welfare assitance delivery channels can be addressed. It can be emulated to match beneficiaries with both Government welfare and philanthropic assistance.

It is not "embedded inflation"

This blog has consistently argued here and here that the RBI has a limited role to play in the current inflation scenario. The global rise in commodity prices and the resultant cost-push nature of inflation means that monetary policy levers become irrelevant.

Yes, oil is kicking on to $140 and maybe beyond, but RBI can do little to either lower oil price or to keep people from consuming oil. The major driver of inflation has been commodity and foodgrain prices, which are not sticky and adjust quickly to supply side signals. In contrast, the cost of final goods like consumer durables, services, and wages have not shown any alarming rises.

In this context, this blogpost by Paul Krugman makes interesting reading. He makes the distinction between those products and services whose prices fluctuate in response to market signals and those which are stickier and whose prices are set at fairly longer intervals. He defines inflation arising form the later as embedded inflation, since there is the possibility of a competitive price setting spiral among producers, that causes inflationary expectations to get embedded into the system. Such inflations can be addressed with Central Bank intervention.

But in case of the former, as we have in India today, the only option for Government is to mitigate the hardships faced by the poorest by strengthening the social safety nets. Such times are a strong reminder of the continuing need for a vibrant and strong food security and targetted social security policy. And direct cash tranfers are an excellent way to efficiently target the beneficiaries.

Update 1
Pauyl Krugman has this explanation of the importance of core inflation - in measuring "inflation inertia".

Friday, June 6, 2008

"First mover disadvantage" in infrastructure finance

One of the biggest challenges facing the infrastructure debt market in India (and many developing countries) is the problem of the "first mover disadvantage" faced by the borrower. This refers to the high risk that in an emerging market, the initial borrowers will be saddled with a deal (cost of capital) that would look unfavorable or even bad, a few years henceforth when the market would have matured fully. I will briefly elaborate the problem below.

In an essentially virgin debt financing market in a particular sector, the lender is faced with numerous risks, many which are not fully understood. There is a huge information asymmetry problem and lenders are apprehensive of adverse selection. This gets exacerbated when government agencies, with their reputation for inefficiency and legacy costs, are involved. There are risks associated with the sector, company, and the project being financed. The fact that very few agencies in the sector have been credit rated, only compounds the problem.

Given the risks inherent in the sector, the credit rating agencies too tend play safe and discount for the general sectoral risks while rating the borrower or the project. The credit rating is therefore never a true reflection of the financial and organizational strength of the specific borrower or the particular project. The lenders hedge for all the risks and pass them on to the borrower as higher capital cost.

With the markets not appreciating the inherent strengths of the company and its projects, even a very credit worthy borrower faces a difficult situation. The onus is on him in effectively signaling to the market his credit worthiness and inherent financial strength, and thereby differentiating himself from the others in the sector. In other words, the borrower needs to differentiate himself from the numerous 'lemons'.

Further, the borrower has exposure to local banks who are willing to lend at much lower rates, albeit for a shorter tenor. The local banks tend to have good working relationships with such borrowers, and have a much better understanding of the borrowing organization. By lending at the lowest possible rates, these commercial banks "crowd out" other more long-term and structured sources of debt and thereby delays the development of alternative debt markets.

But the borrower's biggest concern arises from a fear that he may be left holding a debt, which while reasonable now, may look like a very bad deal after a few years when the sectoral debt market has matured. It is natural that when the sectoral risks have been fully understood, some debt financed projects are successfully implemented and regular repayment is established, and credit rating is a more accurate reflection of the strengths of the organization, the cost of capital will fall significantly.

This coupled with the long-term trend towards lower rates (given the high base rates in many emerging economies), it is inevitable that the cost of capital for the first few projects may look very expensive a few years down the line. In a Government organizational context, such apprehensions makes managers and officials wary of taking innovative financing decisions.

This is the dilemma facing many borrowers in urban infrastructure and power distribution and transmission sector financing markets in India. A recent study of the 63 JNNURM cities by the Water and Sanitation Program (WSP) found that the major demand for debt is coming from those ULBs that are strapped for finances and have weak balance sheets. In contrast, the stronger and richer ULBs are trying to fund their investments from internal revenues, reluctant as they are to venture into the debt market. The major deterrents for these stronger ULBs being the higher cost of capital relative to the cheaper local financing options available and the tortuous process of accessing the debt market.

Similarly, the power transmission and distribution companies have access to assured and easily available loans from traditional financiers like Rural Electrification Corporation (REC) and the Power Finance Corporation (PFC), apart from local commercial banks with which they have their regular banking relationships. Despite the fact that these loans come at very high rates, the ease of accessing them endears such sources to these borrowers. These readily accessible sources have had the effect of "crowding out" the formal long term debt market. The result is that there are no Government sector transmission or distribution companies that have accessed the debt market. In fact, I could not come across even a single distribution company which had got itself credit rated, with a fully disclosed rating.

Let me sum up the story. The lenders are wary of the risks associated with these emerging sectors, and hence charge higher returns on these investments, which forces up the cost of capital. Credit rating agencies refuse to rate borrowers on a stand-alone basis and circumscribe the borrowers within the sectoral risk matrix, thereby making lenders warier still. The borrowers, exposed as they are to inefficient, but readily accessible, alternative sources, balk at the higher cost of capital and refuse to venture into the debt market! We therefore have a classic chicken-and-egg situation!

I have dwelt earlier here and here about how the urban infrastructure financing market was stuck in a stalemated debate between credit rating agencies, financial markets/institutions and the Urban Local Bodies (ULBs). The same is happening in the downstream of power sector too, and the economically inefficient loans from REC and PFC crowds out the emergence of any structured long term debt market.

How do we get out of this chicken and egg riddle? For a start, financial institutions will need to exhibit enterprise by assuming more risks and finance a few credit worthy organizations and projects. Such delayed gratification will invariably benefit the lenders in the long run, as it opens up the way for tapping the massive market in infrastructure finance. The enterprising lenders also benefit from the first mover advantage in these emerging markets.

The Government should consider providing risk mitigation support by way of credit enhancement facilities or even gap funding for these initial borrowers. The borrowers can be reassured of the "first mover disadvantage" by structuring the facility of swapping and/or a floating rate provision for the original debt. All these steps would reassure borrowers and encourage them to actively explore the debt markets.

Once we have runs on the board, with a few project successes to show for, it becomes easier for others to enter the market. As the uncertainties and apprehensions become cleared, and risks more clearly understood, the cost of capital will come down, especially for the more credit worthy projects and organizations. Only then will the risk arising from "first mover disadvantage" will be mitigated.

Wednesday, June 4, 2008

Role of NGOs in the development process

It has been some time since the Non Government Organizations (NGOs) have joined the public and private sectors as partners in the development process. More than a million NGOs operate in India, covering all the development sectors. But unfortunately, their impact, measured in terms of final outcomes, have been marginal and disproportionately lower than expectations. Only a handful of NGOs, and that too in a few sectors, have made an impact and significantly influenced the course of development process.

Unlike a few years back, when there was an acute scarcity of development funds, today we have an abundance of resources. But the problem remains one of spending the available resources, and spending them effectively and within the designated time. Getting the biggest bang for the development buck is the challenge! This is where Government institutions and systems fail miserably, and where the non-profit sector is uniquely positioned to assist.

The reasons for the government failings are numerous and is not the concern of this post. I will try to identify a few ways in which NGOs can increase their influence on the development process. So here is a laundry list of prescriptions for how NGOs can improve their performance. (some of them are inter-related)

1. Too many NGOs, especially the smaller ones, are involved in themselves running small schools, clinics, anganwadi centers, watershed projects, Self Help Groups (SHGs), child labour schools etc. Many of these NGOs are in turn funded by large aid agencies and foundations. While most of these institutions are undoubtedly run well, they are a small drop in the vast ocean of such activities. It is common place to find 20 to 30 good primary (even secondary and high) schools run by NGOs in each district, as against a few thousands of Government run schools.

In most of these cases, they are well run because of the immense personal effort and attention put in by a few dedicated individuals, and not the result of any radical systemic or institutional innovation. Given all the aforementioned are scarce commodities, it therefore becomes difficult to replicate and scale up. In fact, it would be more appropriate and efficient if these valuable human personnel are utilized on a larger canvas, rather than being confined to a few schools. In other words, we have an inefficient utilization of scarce, committed human resources.

Apart from being examples of well run development institutions, they have limited utility. Of course there are significant learnings from these examples, and many Government programs and policies have indeed drawn important lessons from them. But such examples are too many in number to draw any more meaningful inferences, but are too small to make any significant dent on the problem at a macro level.

2. NGOs need to complement and supplement the efforts of the Government in all their activities. But too many NGOs start running operations parallel to the Government and in competition with it, most often even without the knowledge of the local district administration. The perception that Government machinery is corrupt and inefficient may be the predominant reason for NGOs hesitating to associate with the local administration. But this fails to acknowledge the reality that there are severe limitations to their independent role, and the reality of Government role cannot be wished away.

NGOs need to be partners in assisting the local administration in achieving development goals. Instead of remaining stuck with pilots and small demonstration examples, NGOs need to be actively involved in the implementation of on going Government welfare programs. The local administration can leverage the strengths of these NGOs in effectively implementing major programs like the SSA, NREG, SHGs etc.

3. NGOs are more likely to have the expertise and knowledge to conceptualize school curriculums; affordable and appropriate construction designs for housing; rural transport systems; low-cost irrigation structures; identifying and adopting indigenous technologies after appropriate modifications and so on. NGOs can become an invaluable location for Government departments and agencies to source such expertise. NGOs can specialize in a specific sector, and become best practices resource banks for that sector. Such best practices need not be confined to technologies or materials, and should involve processes and work practices.

4. One of the biggest problems facing our field level development administration is the virtual absence of any comprehensive program for training functionaries working at the cutting edge. NGOs can play a vital role in preparing training material. They can also directly assist in the training of teachers, ANMs, community health workers, anganwadi workers, agriculture assistants, veternary assistants, community activists helping SHGs etc.

If one major NGO or corporate group can fully adopt the training requirements of primary school teachers in a district (say), that can make more meaningful difference than running a hundred schools. And all this will cost much less.

5. Government agencies are severely handicapped by the absence of adequate systematic process support. This deficiency manifests in the poor progress and quality of implementation of works and programs. NGOs and corporate groups can give a qualitative filip to the implementation of Government programs by helping put in place independent third party quality controls, independent program monitoring systems (software etc), carrying out impact evaluation studies.

Therefore it would be invaluable if NGOs assist local administration in such process support for programs like NREGS, SSA, PMGSY, NRHM/NUHM, welfare pensions and the numerous state government welfare programs.

6. NGOs and corporate groups can help Government agencies implement internal process improvements. For example, Urban Local Bodies (ULBs) in India are grossly inefficient and do not have any established and standardized accounting systems. NGOs and corporate groups can assist in the development and implementation of financial accounting softwares for double-entry accounting or revenue collection in ULBs.

In fact, this is an ideal example of how corporate welfare and development objectives can be reconciled. While the corporate group can make its money out of selling such software, albeit at a lower profit, the ULBs benefit by way of having access to a single stop software solution to their problems. Similar internal software support useful for Government offices include work-flow automation, file management systems, bill management/tracking systems, citizen grievance redressal softwares etc. While there have been too many local experiments in such systems, most of them have been unprofessional and have suffered from lack of standardization. Such software support increases the efficiency of government services and helps in containing corruption.

7. Another area where NGOs can be of great value is in helping adopt low cost solutions and technologies to many development problems. In recent years, construction technolgies and processes have undergone a massive revolution and we are constructing hundred storey buildings and grand civil engineering marvels. But on the other side, we are yet to have reliable, low-cost, pre-cast housing technolgies or models that can be replicated in a mass scale.

The Government of Andhra Pradesh is building 2.5 million houses for rural poor in three years and the Government of India is proposing to build another 10 million housing units to providing housing for poor. These are massively ambitious construction challenges and cannot be implemented along the conventional lines, and will require substantial pre-cast inputs so as to ensure their completion in time and with good quality.

Low cost irrigation solutions, electrification of remote and interior villages are examples of areas where non-profit sector can contribute in making a meaningful difference.

8. One of the most fertile areas for non-profit sector intervention is in awareness creation or Information Edication Campaigns (IEC). It has been well documented through numerous studies that one of the most important reasons for the poor implementation of various government programs is lack of adequate awareness among the stakeholders. Development also involves bringing about changes in the attitudes behaviour and perceptions of the stakeholders on many social issues.

Regular government programs and agencies do not attach much importance to this critical dimension, that is vital towards sustaining the change. Non-profit sector and NGOs have greater expertise in conceptualizing, preparing campaign materials and even running such IECs. In fact, effectively communicating social and other public interest messages would require borrowing techniques and processes from corporate communication strategies. Further, professsional communication strategies are important for effectively communicating critical reform issues to stakeholders.

9. Finally, Public Private Partnerships (PPP) are a more sustainable and mutually beneficial strategy for NGOs and private charitable foundations to become involved as active partners in the development process. There is enormous potential for mutually beneficial PPPs in agriculture (extension services, storage, and marketing facilities), micro-finance, vocational skill trainings, health care, education, sanitation and public health etc.

The PPPs, when suffused with a reasonable public service dimension, can deliver basic services of good quality at affordable cost to the poor. It is surely the way of the future and is also the most effective way to bring in the private sector into being active partners in the development process.

Tuesday, June 3, 2008

High popcorn prices in cinemas

Regular working lunch at the recently opened Rajiv Gandhi International Airport in Hyderabad costs an exorbitant Rs 300 per plate! (didn't check out other prices, but am sure the mark up would be substantial) The airport operator has sought to maximize his concession revenues by selling rights to only one restaurant concessionaire in each of the four floors. The monopoly pricing power confers on the concessionaire the freedom to charge these high premiums.

The 35 km commute distance between the airport and the city center, and the uncertainties associated with traffic congestion means that passengers invariably arrive a little earlier and spend more time at the airport. This, coupled with the fact that passengers leave their workplaces or homes a good three to four hours before the scheduled flight departure, means they are more likely to have skipped their lunches. The irregular airline schedules only increases the amount of time the passenger spends in the airport. The restaurant concessionaire now has a captive market in the airport, with passengers having to spend more time than they otherwise would have. (The only danger is whether the concessionaire may have priced himself out of the market!)

Restaurants in airports is only one of many examples of such primary-secondary product linkage markets. In the airline market itself, food sales in the low-cost carriers are another example of such markets. Recent studies from Stanford and the University of California, Santa Cruz seem to suggest that high prices charged in cinema theatres for concession items like popcorn, candy and ice cream (secondary products) help keep cinema ticket (primary product) prices low. This makes it possible for more people, like the price-sensitive ones, to view cinemas. While the cinema exhibition hall owners have to share ticket prices with distributors, they keep the entire profits from sales of secondary products.

Comparing concession purchases in weeks with low and high movie attendance for a chain of movie theaters in Spain, Wesley Hartmann, associate professor of marketing at the Graduate School of Business, and Ricard Gil, assistant professor in economics at University of California, Santa Cruz, proved that pricing concessions on the high side in relation to admission tickets makes sense. The fact that concession sales were proportionately higher during low-attendance periods suggested the presence of "die-hard" moviegoers willing to see any kind of film, good or bad-and willing to purchase high-priced popcorn to boot.

Gil says, "If you want to bring more consumers into the market, you need to keep ticket prices lower to attract them. And theaters wisely make up the margin by transferring it to the person willing to buy the $5 popcorn bucket." They also found that moviegoers who purchase their tickets over the internet tend to buy more concession items than those who purchase them at the door, by phone, at kiosks, or at ATMs.

The study found that people who come to the movies in groups tend to buy more popcorn, soda, and candy. As Hartmann says, if this is true then "it may be that theaters will want to run more family- or adolescent-oriented movies to attract a more concession-buying crowd ".

The study provides strong support for adopting similar strategy in all business ventures that involve a primary and many secondary products. It is also a vindication of the captive market hypothesis, with its contention that getting consumers to the party is the important thing. Once they are there, unlike the cliched horse, getting the consumers to buy is easier! Getting them there in the first place is the challenge!