Sunday, July 31, 2011

Origins of the US public debt

These are tumultuous times on both sides of the Atlantic. Public debt and economic weakness is the common factor in both stories.

The beginning of next week will determine whether the US will have to officially default on its debt commitments. On August 2nd, the $14.294 trillion threshold at which by law America can no longer borrow money, will be reached. In a speech last month Ben Bernanke outlined the consequences of a failure to raise the debt limit. He said,

"Failing to raise the debt limit would require the federal government to delay or renege on payments for obligations already entered into. In particular, even a short suspension of payments on principal or interest on the Treasury’s debt obligations could cause severe disruptions in financial markets and the payments system, induce ratings downgrades of U.S. government debt, create fundamental doubts about the creditworthiness of the United States and damage the special role of the dollar and Treasury securities in global markets in the longer term. Interest rates would likely rise, slowing the recovery and, perversely, worsening the deficit problem by increasing required interest payments on the debt for what might well be a protracted period."

The debt-limit debate has highlighted attention on the origins of the US public debt. Times has an excellent graphic that shows who the US government owes its $14.3 trillion debt and the respective contributions of various Presidents.

In 2001, George Bush inherited a surplus, with projections by the Congressional Budget Office for ever-increasing surpluses. But every year starting in 2002, the budget fell into deficit, and when Bush left office it stood at $1.2 trillion in deficit for 2009. The graphic below shows the damaging effect of Bush tax cuts, all of which if allowed to expire by end-2012 would cut deficits by about half. President Obama’s policies, a fait accompli given the circumstances when he took over, did not add much to deficits.

The Economist has this graphic that shows the evolution of the official debt limit under various US Presidents. The US Congress has acted a total of 91 times since June 1940 to either raise, extend or alter the definition of the debt limit—36 times under Democratic presidents.

See also this Q&A on the US debt ceiling debate.

Update 1 (12/2/2012)

Ezra Klein has this excellent graphical illustration of the origins of America's current debt woes.

Saturday, July 30, 2011

On rights-based development and populist quick-fixes

Pranab Bardhan has a brilliant essay in Boston Review that strikes an immediate chord with development discourse in India. Instead of commenting, let me reproduce portions.

He appreciates the concern among civil society groups and activists at the extreme poverty and vulnerability of the marginalized and their enthusiasm for a rights-based approach (as against the dole-based approach of traditional welfare state). However, he cautions against the prevailing craze for it,

"It (rights-based approach) serves to raise consciousness among the poor and the vulnerable about their entitlements, and remind them that they are not mere supplicants to politicians and bureaucrats. In a weak administrative and institutional context, however, the NGO approach of uncompromising support for citizen’s rights can cause more harm than good. If the structure for implementing some of these rights is weak and corrupt, then the rights are hollow and promoting them breeds cynicism."

In the context of India where courts have joined civil society groups in taking up the cause of the poor and vulnerable, he strikes a much-needed but politically incorrect note of caution,

"India is already littered with hundreds of unenforced or spasmodically enforced court injunctions, some of them on the implementation of rights. This proliferating judicial activism, egged on by the rights-based movement and the media, may end up, for all its good intentions, undermining the credibility and legitimacy of the judiciary itself."

Prof Bardhan hits the nail on its head when identifying the real limitation of civil-society activism driven rights-based approach to development in societies where the ability of governments to deliver is severely constrained. He writes,

"The social activists share with left-wing unions a preoccupation with redistribution, and a lack of concern for generating enough surplus to enable it. There are obvious trade-offs here between incentives for private enterprise and the need for social justice... When real capacity to create wealth is missing, social activism is often reduced to mere populism, which in the long run can be wasteful and counterproductive."

This is the biggest problem with the dominant development policy discourse in India - too much of wealth re-distribution and too little of wealth creation!

Again, in light of the political drama surrounding anti-corruption activists and their populist quick-fixes, Prof Bardhan questions their right to appropriate the mantle of popular legitimacy in democratic societies,

"In the policy arena... such non-party organizations cannot and should not threaten to replace the role of traditional party organizations in a democracy. Voluntary groups, as single-interest advocacy lobbies, lack the mechanism of transactional negotiations and give-and-take among diverse interest groups that large party organizations, representing and encompassing those varied interests, possess.

This kind of give-and-take is particularly important when resolving controversial issues and requires complex trade-offs and balancing of diverse interests. Those who speak for the poor usually underplay the diversity among the poor and sometimes romanticize their traditional way of life. A dam may benefit thousands of small farmers in hitherto parched land, even as it displaces thousands of others; a development project may displace some from their ancestral land but provide jobs and more productive livelihoods for others; and so on. Each such case involves complex trade-offs and demands negotiated compromises and compensations across groups and over time. Such deliberations should take place within a party forum where diverse interests and stakeholders are represented."

Finally, this message for those opposing capitalism on the grounds that capitalist exploits the poor, is extremely relevant,

"Activists who romanticize the pristine life of the poor and the indigenous, and ignore a great deal of misery and stagnation, should keep in mind that the horrors of capitalism fade in comparison with the horrors of pre-capitalism."

Friday, July 29, 2011

The populist assualt on incentives - MFI loan defaults

I had blogged earlier about a study by Citigroup economists Willem H. Buiter and Ebrahim Rahbari where they identified factors that could affect future global economic growth. One of the more interesting factors pointed out was the dangers to growth genereated by "the populist assaults on the incentives to work, save and invest". Here is one such example.

Mint quotes Vijay Mahajan of Basix who claims that, thanks to the state-wide default on Microfinance Institution (MFI) loans by self-help groups (SHGs) in Andhra Pradesh, there could be "92 lakh households in Andhra Pradesh who are appearing on the defaulters list of the National Credit Bureau".

Even assuming an element of exaggeration in the figure, it is an extraordinary situation. As far as I can remember, this is the first truly big example of a full-scale debt default by a large section of population. Unlike the loan waivers, where governments decree to write-off loans, here is an example of borrowers deciding to collectively and unilaterally extinguish their debt obligations, without abrogating their loan contract with the MFIs.

First, there is the legal-technical issue of these defaulters, forming a major share of SHGs and women in Andhra Pradesh, losing their credit-worthiness in a single stroke. How would the banks classify or risk-weight future loans to this massive category of borrowers?

More importantly, the larger message that would have been internalized by these women and their communities is that their contractual obligations to their lenders is no longer sacrosanct. The hitherto entrenched belief among borrowers that their private debt will always have to be re-paid is now shaken (the loan waivers have long since shaken this belief on government debts).

Similarly, lenders, of all kinds (who lend to these people), will now be aware that the credit risk of their borrowers have suddenly spurted. Markets will price it accordingly, with higher rates and stronger conditions, which in turn will adversely affect access and hurt borrowers. Unfortunately, this moral hazard is not limited to just borrowers and lenders. It covers all forms of contracts, and this is an even bigger concern.

As standard economic theories have taught us, a market economy is underpinned by bonds of loyalty and trust which facilitates contracts that form the basis of most market-driven transactions. There are a number of studies which have shown that developing countries have weaker contract obligation and enforcement capital and they are binding constraints on economic growth in these economies. The MFI default would surely have diminished the already limited contract capital available in such societies.

In this context, governments need to ensure that their policy decisions do not distort incentives. In the instant case of MFI loan defaults in Andhra Pradesh, even if the government wanted to punish the MFIs, it would have been appropriate if it was done without distorting incentives.

One approach would have been to, in some form, recover the loans through the regular government SHG institutions, with or without interest. The recovered amounts could then have been returned back to the banks that financed the MFIs. This would have punished the MFIs, who would have been deprived off their profits and would suffer credibility loss, without distorting borrower incentives nor causing loss to the financial institutions that funded the MFIs.

Thursday, July 28, 2011

Globalization and American economy

The impact of globalization has been one of the most controversial topics of debate in macroeconomic policy making for nearly two decades now. However, for most part, the debate has been partisan and driven by ideological considerations (free-marketers Vs protectionists). In this acrimony, important issues about how the dynamics of globalization affects economic output, employment, trade and inequality have not got the deserved attention, atleast among policy makers.

In this context, Michael Spence and Sandile Hlatshwayo have an excellent working paper on the impact of globalization on employment, economic value-added, and value-added per employee across various sectors of the US economy. The deeply empirical paper has several interesting findings.

They divided the economy into two buckets - tradeables and non-tradeables - and examined what happened in them during the high-noon of globalization, the 1990-2008 period. Tradeable sectors' output is traded across national borders and include manufacturing, agriculture, mining, technical services, financial services etc. Non-tradeables include government services, health care, retailing, transportation, construction, restaurants, legal services etc.

Their main findings, based on examination of historical time series data from US BLS and BEA, drawing on aggregate and particular industry level data for employment and value-added, include

"Value added grew across the economy, but almost all of the incremental employment increase of 27.3 million jobs was on the non-tradable side. On the non-tradable side, government and health care are the largest employers and provided the largest increments (an additional 10.4 million jobs) over the past two decades... without fast job creation in the non-tradable sector, the United States would already have faced a major employment challenge."

And about the underlying forces driving these trends and future prospects, they write,

"The trends in value added per employee are consistent with the adverse movements in the distribution of US income over the past twenty years, particularly the subdued income growth in the middle of the income range. The tradable side of the economy is shifting up the value-added chain with lower and middle components of these chains moving abroad, especially to the rapidly growing emerging markets. The latter themselves are moving rapidly up the value-added chains, and higher paying jobs may therefore leave the United States, following the migration pattern of lower-paying ones."

And about the implications of this trend, they point to long-term structural challenges with respect to the quantity and quality of employment opportunities for Americans, especially with respect to income distribution

"... almost all incremental employment has occurred in the non-tradable sector, which has experienced much slower growth in value added per employee. Because that number is highly correlated with income, it goes a long way to explain the stagnation of wages across large segments of the workforce."

More critically, they point to the impact of this trend on the US labor market, which assumes greater significance in view of the prevailing unemployment gloom,

"The expanding labor force was absorbed in the non-tradable sector (roughly 26.7 out of a total of 27.3 million net new jobs), government and health care leading the growth (10.4 million incremental jobs between them). In our view, it is unlikely that this pattern will continue. Chances are good that the pace of employment generation on the nontradable side will slow. Fiscal conditions, the costs of the health-care sector, a resetting of real estate values, and the elimination of excess consumption all point to the potential for a longer-term structural employment problem. Expanding employment in the tradable sector almost certainly has to be part of the solution. Otherwise, the United States will have a longer-term employment problem."

In other words, the authors make the point that while globalization has made goods and services less expensive for Americans (and kept a lid on inflation), it has also diminished employment opportunities for Americans at the lower and middle parts of the value chain, besides leaving open the danger that the higher-paying jobs at the top end of the value chain too may follow lower paying jobs in leaving American shores.

They also claim that the two contrasting trends across the tradeable and non-tradeable sectors - the former growing in terms of income (higher wages and profits) but not jobs and the latter growing in terms of jobs but not income (stagnant wages and benefits) - is a recipe for increasing inequality and social and political polarization.

Their prescription for the American economy is simple - boost the tradeable sector. Without dramatic increases in the size and scope of the tradable sector, the US economy will face an extended period of slow job growth and rising inequality. Arguing against protectionism, they advocate policies that incentivize businesses to invest in the physical and human capital necessary to make American workers more productive, rather than simply outsourcing work overseas.

See also this from Michael Spence and this from Uwe Reinhardt.

Wednesday, July 27, 2011

The "framing effect" and monetary policy

In its quarterly monetary policy review, the Reserve Bank of India (RBI) has raised its benchmark repo rate (the rate at which it lends money to commercial banks) by 50 basis points to 8%, its 11th successive increase since October 2009.

In the accompanying statement, the RBI expressed heightened concerns at inflationary expectations getting unleashed. It argued that inflation was a far bigger concern than any slowdown in economic growth. In simple terms, as the RBI Governor's press statement indicates, the main thrust of the interest rate decision was to "moderate inflation and anchor inflation expectations".

Given this "inflation targeting" based paradigm in central bank communication, the rate hike has expectedly raised concerns about its adverse impact on economic growth. It is argued that the increased cost of borrowing would discourage investments and slow down growth. Further, they also claim that since the inflation is driven by supply-side causes, monetary policy actions will have little impact on the final outcomes. This view is based on the valid assumption of an inflation-growth trade-off.

However, a different, "over-heating economy" paradigm based central bank communication could give a different spin to this interest rate decision. It is common knowledge, and the RBI statement reiterates this, that inflation in India is caused by supply constraints. The growth on the supply-side of the economy is simply unable to keep pace with demand growth. These constraints include infrastructure bottlenecks, slow growth in manufacturing production capacity and agriculture production etc.

In the circumstances, there are only two options - ease supply-side constraints and/or slow down demand growth. Since the former is a medium to long-term challenge, the only alternative is to cool-down the economic growth. In this context, the objective of the RBI's rate hike decision becomes one of deliberately cooling down an over-heating economy. The interest rate hike has the desired contractionary effect on the economy. In this monetary policy communication paradigm, lowering growth, and not inflation, is the direct objective. If this is the objective, then the inflation-growth trade-off loses its relevance, with the balance tipping decisively in one direction.

This debate is a classic case of what behavioural economists call "framing effect". Substantively, both "inflation targeting" and "cooling the overheating economy" based monetary policy decisions amount to the same. However, when framed in terms of the former, concerns about growth come to the fore, forcing governments into criticising the central bank. In contrast, when framed in terms of the latter, where slowing down growth is the explicit objective, the criticism of the central bank is likely to be more muted.

Tuesday, July 26, 2011

The need to regulate consumer finance

One of the most important lessons to be learnt from the sub-prime crisis is the need for better consumer protection in financial markets. In particular, given the shockingly abysmal level of financial literacy among consumers, it was important to provide atleast the most basic level of protection against predatory practices by financial institutions.

In recognition of this imperative, the Dodd-Frank Bill in the US, last year established the Consumer Protection Bureau within the Federal Reserve Board to write and enforce rules protecting consumers of financial products and also increases the authority of state regulators to enforce protections. It would require lenders and sellers of financial products to provide plain-English disclosures, price comparisons with alternative products and clear tripwires before fees are assessed.

This issue assumes much greater relevance in developing countries where financial liberalization of recent years has brought in its wake a proliferation of attractively packaged financial products. The widespread consumer financial illiteracy coupled with skeletal regulation provides fertile ground for predatory lending practices by unscrupulous financiers to unsuspecting borrowers.

A Times article points to the havoc being wreaked by credit card debts, which have also contributed to the extensive economic growth of recent years, in some Latin American countries .

"It has also opened the door to abuses, as credit issuers have used predatory techniques to lure customers, particularly young and less affluent ones, in countries where regulation is scant, annual interest charges can top 220 percent and consumers cannot seek bankruptcy protection, economists and consumer defense groups say... troubling undercurrents in the South American economic boom: indiscriminate lending, lax regulation and ballooning over-indebtedness of large parts of the population, especially those with lower incomes."

And it points to practices that are reminiscent of those of the sterotype of unscrupulous moneylenders, used by certain retailers in Brazil and Chile who peddle consumer durables on credit,

"... among 418,000 clients (of La Polar) in Chile who fell behind on their payments and had their debts repackaged by the retailer La Polar, which raised interest rates and extended loan terms without their knowledge. In early June, it came to light that executives at La Polar had been unilaterally renegotiating clients’ debts for more than six years... The widespread proliferation of credit has been both rapid and relatively recent, developing over the past decade and spurring a consumer revolution across South America. Retail chains like La Polar in Chile and Casas Bahia in Brazil, which sell electronics and housewares, have thrived by offering relatively low-priced goods and extending easy credit terms to entire classes of people who had never had access to it."

While bank-issed credit cards have been regulated, cards issued for in-store use by retailers have enjoyed "light-touch" regulation, thereby setting the stage for a rapidly emerging household indebtedness problem in these countries.

This issue is all the more dangerous for countries like India with a history of extremities of political populism. Credit-driven financial growth has the potential to be the most dangerous form of populism. Unlike conventional electoral populism, involving handing out doles to the electorate which bankrupts the state, credit-driven populism could first bankrupt the households and then the state (in the process of bailing out the banks and the households). This danger is amplified in countries which are in the nascent stages of their financial market growth, where the major share of financial institutions are government owned and financial illiteracy is the norm.

Consider a scenario where the central bank liberalizes (or is forced into) lending regulations on consumer financing (both credit cards and for EMI-based purchases). Predatory lending is never far away and even state-owned banks too enter the fray with several easy-credit schemes. A consumer debt-bubble gets inflated in which a large number of people, especially from the lower middle-class, become exposed. Come elections and the demands start for some form of loan waiver by an electorate socialized into feeling nothing unethical about such demands. It only requires one unscrupulous political party, and there is no dearth of them, to promise write-offs on all consumer debt owed to PSU banks, to force everyone else to follow suit.

That this is not a far-fetched scenario is borne out by the numerous precedents in our history. Loan waivers have been a common feature of our political landscape for decades now. The recent state supported forced write-offs of MFI loans in Andhra Pradesh is a reminder of the vast possibilities of such a trend.

Further, apart from the political populism associated with write-offs, there are factors which strongly encourage such credit growth. For a start, such credit growth drives economic growth. Businesses make profits, consumers are happy borrowing and spending at apparently easy terms and without any hassles, policy makers are satisfied with business investments that create jobs, and bankers are thrilled at the rapid growth of their business (and lending excesses are inevitable). Most importantly, politicians benefit by keeping all these stakeholders satisfied. So where is the incentive to take away the punch-bowl?

It is in this context that more prudent regulation of the sector assumes significance. Such regulation is required to align the incentives of all stakeholders into driving the overall objectives of consumer credit flow. As the experience of Chile and Brazil shows, with increasing financial liberalization, it is only a matter of time before such practices start showing up.

Monday, July 25, 2011

Issues from urbanization trends in India

The latest figures released from India’s Census 2011 shows that for the first time ever India added more people to cities than rural areas. Cities and towns added 91 million people to 90.4 million by villages in the 2001-11 period. The decadal population growth rate for urban India was 31.8%, while for rural India it fell to 12.2%.

It also found that 31.2% of the total population lives in urban centres compared with 27.8% in 2001 and 25.5% in 1991, with South Indian states leading the urban charge. Cumulatively, of the 1.21 billion population, 833 million live in rural India while the remaining 377 million reside in urban India.

The number of towns in the country rose 53.74% to 7,935 between the last two census. However, this conceals an interesting division - the number of statutory towns (notified as a municipality or corporation) rose by 242 to 4,041, while census towns (officially gram panchayats, but have large populations) almost trebled to 3,894. The emergence of such small and informal census towns, especially in states like Kerala (where urban population share nearly doubled in the last decade), is a cause for concern.

As Mint reports, the residents of these census towns benefit from all government benefits that go to rural areas and also lower property taxes and other permit fees. The tax revenues foregone aside, more worryingly, these areas are currently being administered (or not administered) by gram panchayats with limited expertise in managing governance and infrastructure service delivery for larger population centers. This administrative deficit is likely to have adverse long-term consequences for these cities, especially since they are experiencing rapid pace of expansion and development.

These census towns, which are in the early stages of their development, do not have the infrastructure nor the governance capabilities to absorb the sudden influx of migrants from neighbouring villages. Adhoc and chaotic growth in residential settlements and commercial establishments and deficient or absent civic infrastructure are inevitable. The unplanned layouts which emerge from such growth resemble squatter settlements, and leave little scope for future growth and severely constrains the subsequent establishment of standard civic infrastructure facilities.

This failure to plan urban development is a classic case of policy paralysis that characterizes much of policy making in India. In most of these cases, political considerations take precedence over objective requirements. The local panchayats in most cases oppose merger into the neighbouring city or notification as a municipality. Panchayat members risk losing power and play up local resident's fears over higher taxes. Finally, when the merger or notification comes, it is too late. The city's broad topographical layout is already in place, leaving little room for any planned expansion.

On the positive side, in a reflection of the growing political prominence of cities, the number of urban Lok Sabha seats increased from around 70 to at least 100. This growing political influence of urban India will help correct the skewed nature of governance bandwidth in the country. However, since nearly 70% of Indians continue to live in rural areas, the compulsions of electoral politics dictates that rural issues will get priority over urban ones.

Sunday, July 24, 2011

Tax and subsidy way to healthy eating?

Mark Bittman bites the bullet and advocates taxing unhealthy food like soda, French fries, doughnuts and hyperprocessed snacks, and subsidizing fruits and vegetables.

He suggests that sweetened drinks could be taxed at 2 cents per ounce, so a six-pack of Pepsi would cost $1.44 more than it does now. An equivalent tax on fries might be 50 cents per serving; a quarter extra for a doughnut. He argues that "taxes would reduce consumption of unhealthful foods and generate billions of dollars annually. That money could be used to subsidize the purchase of staple foods like seasonal greens, vegetables, whole grains, dried legumes and fruit."

Such taxes are justifiable despite arguments that it will unfairly target poor people who pay a higher percentage of their income for food. Such critics overlook the long-term health effects of these foods and the much higher medical and other costs imposed on low-income people. Such criticism can be mitigated by subsidies on high-quality, fresh and healthy foods.

Though no American city today has taxes that are explicitly aimed at reducing consumption, many have proposals to tax soda or all sugar-sweetened beverages. Research by the Rudd Center for Food Policy and Obesity at Yale have found that such soda taxes become significant at the equivalent of about a penny an ounce. Further, it is also suggested that these taxes should be in the form of excise taxes on inputs, so that the taxes will be incorporated into the shelf price of the drink, thereby nudging consumers on their purchasing decisions.

There is also an excellent graphic that points to how economic incentives, signalled through prices of cigarettes, have contributed to a dramatic drop in smoking among Americans since the eighties.

Remarkably, more than half of all Americans who once smoked have quit and smoking rates are about half of what they were in the 1960s.

Saturday, July 23, 2011

Greece's selective default

After prolonged foot-dragging, the inevitable has happened. The Eurozone leaders approved the second bailout of Greece, one that bears clear signatures of a partial default. The €109 bn ($157 bn) bail-out of Greece will force private bondholders to take losses on their bonds through debt swaps, roll-overs and buy-backs. In return, the Eurozone economies collectively guarantee the repayment of Greece's debt principal.

Instead of significant "haircuts", bond holders will now have to accept smaller losses and agree for maturity extensions at lower interest rates. Private bondholders will be required over the next three years to swap or roll over debts for new 15-30 year bonds. Whatever its form, this will ensure that Greece becomes the first western developed world country to default in more than 60 years.

This bailout deal comes after consistent opposition among the main economies, especially Germany, against any form of selective or partial debt default by any Eurozone economy. In the circumstances, the preferred policy was to continuously keep rescheduling Greek debts by swapping it with longer-term bonds in the hope that austerity measures would restore growth and ease the debt burden. It was also argued that this would prevent a run on Greek debt and ensure that Greece and other PIIGS economies were not elbowed out of the nobd markets. However, these measures had failed to reassure the bond markets, especially in light of recent fears of a similar crisis in Italy.

In an attempt to limit contagion effects, the debt deal also contained provisions to enable the European rescue fund, the €440 bn European Financial Stability Facility (EFSF), to assist countries like Spain and Italy that have so far not received any assistance. All three bail-out countries – Ireland, Portugal and Greece – will see rates cut to about 3.5%, or about 100-200 basis points, and will not have to repay the loans for up to 30 years. The EFSF will now be able to buy government bonds (or alternatively lend to these economies) on the secondary market (presumably at a discount rate, compared to the high rates that each of the peripheral economies would have to pay) and to help recapitalize banks, moves long resisted by Germany.

Further, holders of short-term obligations would be able to swap their notes for debt with longer maturities and backed by high-rated bonds. It is expected that 90% of all Greek bonds will be exchanged. The terms of the aid package from Europe to Greece would be eased, with maturities lengthened to 15 years from 7.5 years, at very low 3.5% interest rate. Most encouragingly, the deal also includes a commitment from Europe’s leaders to support Greece until it is able to return to the financial markets – a potentially unlimited guarantee that could see European taxpayers fund Greece for years.

As the FT reports, bondholders will be given four options – three forms of debt exchange and one rollover plan – with different durations and interest rates. The first exchange plan and the rollover would flip existing paper into new 30-year bonds at par value and with interest rates beginning at 4% and rising in 0.5 percentage point increments during the first 10 years to 5.5%.

The other two exchange plans – one for 15 years and the other for 30 – would pay higher coupons of 5.9-6.8% as compensation for taking an upfront 20% "haircut" on the value of the bond. All plans would be backed by an obligation on Greece to reinvest a portion of receipts from the rolled-over or exchanged financing in European AAA bonds, which would act as collateral against default. These bondholder programmes, limited to Greece only, amount to a 21% reduction in the net present value of their current bondholdings, and amount to a selective default.

Though voluntary, it is estimated that upto 90% bond holders will participate. Most major investors and financial institutions have welcomed the plan. Accordingly, private bondholders are expected to contribute €54 bn from mid-2011 to mid-2014 and a total of €135 bn during the period to 2020. On top of all this, an additional €12.6 bn is expected to come in commitments from bond owners to sell their holdings at a reduced price as part of a bond buy-back programme.

The financial institutions that own Greek bonds would effectively contribute 54 billion euros through 2014, largely by accepting reduced interest payments, and will stretch their maturities to as long as 30 years. The plan does not immediately reduce the total Greek debt is 350 billion euros ($496 billion) which form nearly 150% of GDP by much. Greece will benefit by way of reduced interest burden, extended loan maturities, discounted rates for Greek bond repurchases by EFSF, and even some haircuts on debt principals. The benefits are conservatively estimated to shave off atleast €26 bn off the country’s €350 bn debt pile by 2014. Further, the maturity profile of Greek debts will increase from six to eleven years.

The selective default is also an admission of the failure of the fiscal austerity policies. Over the 12 months ending in March, the Greek economy shrank by 5.5%, while unemployment, at 12.2% when the country was first bailed out, rose to 15%. More importantly, it is the first step in acknowledging that the solution to Eurozone problems lies in a fiscal union. The bailout virtually involves fiscal transfers from the better off economies to the beleaguered ones. Further, the EFSF, with its explicit financial stabilization mandate, becomes an effective European Monetary Fund.

Friday, July 22, 2011

Catch-up growth and global convergence

Citigroup economists Willem H. Buiter and Ebrahim Rahbari, who earlier identified 11 global growth generating (3G) economies for the first half of this century, have another paper investigating the likely future sources of global economic growth between 2010 and 2050.

They use 40 year economic forecasts by Citi economists, historical GDP data for the most recent 10-year period, and available economic research on the drivers of long-term growth, to examine national-level global growth generators. They assume United States as the technology frontier country and draw the distinction between growth at the technology frontier (productivity growth at the frontier) and catch-up or convergence growth (mainly through adoption and importation of best-practice technology and know-how from the frontier countries). Naturally, they foresee most of the global growth to come from the latter source.

Their earlier 3G index aggregates some key growth drivers - gross fixed domestic capital formation; gross domestic saving; a measure of human capital (which aggregates demographic, health and educational achievement indices); a measure of institutional quality; a measure of trade openness; and the initial level of per capita income. Their final analysis and prescription about how a country grows fast

"1. Start poor
2. Start young
3. Open up to trade in goods and services and to foreign direct investment
4. Achieve reasonable political stability (the absence of significant external and internal conflict)
5. Create some semblance of a functioning market economy
6. Boost the domestic saving and investment rates
7. Invest in human capital (educate and train both boys and girls, focusing on pre-school, primary and secondary education and on vocational training)
8. Invest in infrastructure
9. Don’t be unlucky. Avoid war-like neighbours and natural disasters
10. Don’t blow it. Avoid internal conflict and populist assaults on the incentives to work, save and invest; avoid macroeconomic mismanagement, premature capital account
liberalisation and financial regulatory disasters.

Catch-up and convergence will do the rest."

If we examine the Indian economy with respect to these ten attributes/tenets, the picture is indeed encouraging, especially if point 9 is taken care of. Points 1, 2, 4, and 5 are inherent and historical advantages. Points 3 and 6 are true reform achievements. Even point 7 is being addressed. This leaves us with the real concerns - points 8 and 10.

All our immediate (inflation) and long term (growth prospects and convergence growth pace) macroeconomic challenges are closely linked with infrastructure. This is all the more so since infrastructure forms the basic platform that underpins the growth of the modern economy. We need to plan, design, raise resources and execute massively in all infrastructure sectors. And even if we mobilize the resources and show the requisite commitment to conceptualize and create infrastructure, the greater challenge is to ensure that we do not blow it up.

Here I am not worried about macroeconomic mismanagement nor financial market problems nor even corruption or internal conflicts. All these dangers always lurk around the corner and will even explode once a while, but when seen in historic perspective and when analyzing growth prospects over half-century, they are all surmountable, especially for a continental economy like India. A real worry will be with picking up the pieces from the "populist assaults on the incentives to work, save and invest". I will come back and post on this in the days ahead.

Thursday, July 21, 2011

The impossibility of regulating street vendors

The Times reports that many American cities are grappling with the issues raised by an increase in food trucks vending relatively inexpensive and convenient food in its streets.

Opponents of food trucks argue that such food trucks clog streets, eat into scarce parking spaces, pollute the area, annoy neighbours, and cannibalize the earnings of existing restuarants. Therefore, several US cities - Seattle, Chicago, and Raleigh - have sought to regulate food trucks with more restrictions - notifying areas where they could park, types of food they could sell, distance from restuarants etc. Such restrictions are expected to regulate the food truck business without causing much harm to existing business, raising opposition from neighbours, and by minimizing negative civic externalities.

This example is an excellent illustration of the difference between societies like India and the US in using regulations to control such types of activities in our cities. The city councils in the US obviously take for granted that these restrictions are enforceable and the minority of deviants could be forced to toe the line by strict enforcement. In contrast, in Indian cities, practical considerations, as discussed here, makes enforcement a near impossibility.

For a start, most city spaces and corners are already occupied either by squatting hawkers or cart-based vendors. Despite grappling with the problem for several years now and having passed numerous legislations, no Indian city has even remotely succeeded in addressing the problem of regulating street vendors. In simple terms, the challenge is in choosing between depriving tens of thousands (as in the case of any decently large city) off their livelihoods and in the process bringing order and discipline into urban life or leaving cities as stages for vibrant small-scale entrepreneurial activity with all its attendant disorderliness problems.

There are two issues here. Is there enough space to accommodate the demand? And assuming there is enough space, is enforcement of regulations possible? The first question is easily answered. No! The rapid pace of urbanization in recent years has ensured that there is no corner of any city which has been left free from being encroached. The informal market (controlled by local musclemen) in accessing such spaces and the magnitude of its rents is a reflection of their huge demand.

Any rationing would perforce leave massive numbers of people without their livelihoods. This is apart from sucking the government into a highly corrupt and inefficient allotment process, which the informal second-best market is currently administering with reasonable fairness and efficiency. The possible incentive distortions with such an arrangement are unimaginable and hugely counterproductive.

About the second issue of enforcement, as already discussed, it is a non-starter. When deviations and violations are the norm than the exception, enforcement becomes simply impossible. Enforcement works when deviations are at the margins. Strong enforcement signals can get the recalcitrant few at the margins to fall in line. It fails when the majority are deviants or violators.

Given the scarcity and demand for space, actual enforcement would involve uprooting large numbers of street vendors from each area in order to limit, regulate and discipline the hawking activity. Apart from the political impossibility of getting such policies through municipal councils, there is the practical issue of finding out alternative livelihoods for them.

This argument should not be seen as one supporting street hawkers. It is merely outlining the challenges that need to be overcome if we are to regulate street vendors in developing countries. Unfortunately, it is a challenge which does not appear to have been satisfactory addressed anywhere.

Wednesday, July 20, 2011

The solar power convergence

One of the most talked about points in power sector is when the cost of solar power converges with conventional carbon power. At current pricing levels, solar photo-voltaic generators still cannot compete with thermal and other traditional generators. However, the dramatic reduction in solar panel prices in recent years has ensured that the convergence is not far away.

The graphic below shows that PV panel manufacturing costs have come down, from $60 a watt in the mid-1970's to $1.50 today, declining about 18% for every doubling of production. People often point to a "Moore's Law" in solar - meaning that for every cumulative doubling of manufacturing capacity, costs fall 20%.

A staggering ramp-up in installations around the world have driven an even greater increase in solar manufacturing. Underlining the speed with which solar panels can be manufactured and installed, in 2010, 17 GW of capacity was manufactured, shipped and installed, the equivalent of 17 nuclear plants in one year! GTM Research predicts we'll have 50 gigawatts of module global production capacity by end-2011.

The commercial convergence is more likely to happen earlier with distributed solar generation in rural and remote areas for lighting, agriculture pump sets etc. Even in cities, technologies other than flat-panel PVs, like concentrating parabolic troughs and multiple reflecting mirrors offer great potential to both generate electricity and heat for boiling water in large single-point installations like hotels, hospitals, airports etc.

Stephen Lacey has excellent pricing curves of solar with respect to peaking natural gas, nuclear, and thermal. He shows that solar PV panels will become competitive against even new coal plants in the next 6-8 years.

Tuesday, July 19, 2011

Moral Hazard in Power Sector

I have blogged earlier here and here about how the possibility of contract renegotiations on competitively bid tender conditions has generated a moral hazard among infrastructure developers. Secure in the belief that the re-negotiation window is always open, they bid aggressively to win the bid.

The latest evidence of this moral hazard comes from Reliance's Coastal Andhra Power Ltd. (CAPL) stopping work at its Krishnapatnam Ultra Mega Power Project due to increase in the cost of its Indonesian coal. The developer claims that the new Indonesian Coal Price Regulation would push up the coal price and therefore cost of generation, imperil its cash flow and its ability to repay lenders.

As the Businessline writes, this development is surprising since the UMPP PPAs exclude fuel from the force majeure provisions, being specifically mentioned under Clause (a) of Article 12.4 of the PPA that lists out the 'Force Majeure Exclusions'. Further, even the 'Non-natural Force Majeure events' specified in the PPA does not include actions by a foreign government.

In other words, when the tender was called and agreement negotiated, it was clearly known to all parties that the fuel risk was solely vested with the developer. CAPL had bid aggressively in the tariff-based competitive bidding process, quoting a levelised tariff of Rs 2.33 per unit. Reliance Power has won three UMPPs so far. It is therefore, on every measure of reasonableness and contractual obligations, unacceptable for CAPL to stop work citing fuel price risks. Given precedents elsewhere by the same firm and others, this is the predictable path towards a request for re-negotiations on the terms of the contract.

It reflects a lack of professionalism, even questionable intent, on the part of the developer to have entered into the PPA without having hedged for fuel price risks. In the circumstances, the government should issue notice and get the developer to comply with its contractual commitments failing which the PPA should be terminated and the firm black-listed. It is the least that can be done to mitigate the moral hazard that has been unlreashed by frequent requests for re-negotiations.

Most importantly, the final outcome from the CAPL example could well determine the fate of tariff-based competitive bidding in India. The critical parameter in all the Case I bids are the tariffs discovered in the competitive bidding process. All bidders offer their quotes based on clearly known assumptions, of which fuel price risk being borne by bidder is the most fundamental. It is outright dishonest for any successful bidder to backtrack from the project citing fuel price increases.

Therefore, if the CERC buckles on this, it will inevitably open the floodgates for similar requests and destroy the market for tariff-based competitive bidding in the country.

Update 1 (28/7/2011)

Another example of contract renegotiations is the decision by Reliance Power Transmission's Talcher-II Transmission Company to issue the force majeure notice to electricity distribution utilities in Andhra Pradesh, Karnataka, Kerala, Tamil Nadu and Orissa. The Businessline reports that the company has cited unforeseen delays in clearances for a key transmission link being executed by it as one of the reasons for serving the notice. It has not started work on the Talcher-II transmission system that was to evacuate electricity from generation stations in the eastern region to mainly the southern States. The link was to be up by October 2012.

Monday, July 18, 2011

The counterfactual problem in public policy

Heads I win, tails you lose! This aphorism could well describe the debate on many intractable public policy issues, those where conclusive answers are difficult to come by. Supporters claim that it would have been worse without the intervention. Critics denounce the intervention as a failure since the problem persists. The challenge with all such issues is the difficulty of establishing the counterfactual. Let me illustrate this dilemma with three examples.

The most famous counterfactual problem of our times is the debate on the impact of expansionary policies implemented in the US in the aftermath of the Great Recession. Conservatives point to the persistent high unemployment rates and weak economic conditions, despite the extraordinary fiscal (more than $ 1 trillion) and monetary expansion (zero bound rates and $2.3 trillion QE), as conclusive proof of the failure of expansionary policies.

They reinforce their argument by pointing to the failure of the now infamous recovery projection, estimating future unemployment rates with and without a stimulus plan, made in January 2009 by Christina Romer and Jared Bernstein, then part of President Barack Obama's team. Their way-off-the-mark estimates suggested that unemployment would approach 9% without a stimulus, but would never exceed 8% with the plan.

In May 2011, using the latest figures available from the BLS, the unemployment rate reached 9.1%. In contrast to the Romer and Bernstein projections which estimated that the unemployment rate would be around 8.1% for May without a recovery plan, or 6.8% with a stimulus plan, the actual rate was 9.1%. The actual unemployment rate has been consistently above Romer and Bernstein’s worse case scenario for the economy – and by a considerable margin. Critics of the stimulus invoke this as proof of its complete failure. After all, though a massive and unprecedented monetary and stimulus was enacted, it appears to have had no impact in terms of improving the economic conditions.

Supporters of the stimulus in turn point to other statistics to put forward their claims about how the stimulus created employment, supported the poorest, propped up aggregate demand, and helped local governments. They argue that in the absence of the stimulus measures, the counterfactual, the economy would have plunged into a full-blown depression.

Further, economists like Paul Krugman have consistently held that the actually enacted stimulus policies have been severely deficient and have been advocating much larger doses of expansion to mitigate the high unemployment rate. In the absence of the required magnitude of expansion, they claim, it is unfair and incorrect to blame the expansionary policies for the economy languishing.

Such counterfactual problems are pervasive in economic policy making. This is especially so given the impossibility of localizing and quantifying the impact of specific policy interventions. In the circumstances, if the intervention fails to yield the desired result, critics will denounce it as a failure. Supporters will find that establishing the counterfactual, the scenario in the absence of the stimulus, is fraught with insurmountable difficulties.

Another example of such analysis is the debate about the benefits of metro-rail in New Delhi. Critics argue that despite the massive investments in the Metro, the Delhi traffic remains as bad as ever, even worse. This argument is made on the assumption that the Delhi Metro was set up with the objective of lowering traffic congestion in the city. Now that the final outcome shows no signs of traffic improvement, they argue, the Metro project has failed.

Supporters naturally point that without the Metro Delhi would been uninhabitable. They argue that the Metro has taken 1.7 million people out of the roads, and thereby ensuring that those many people stay out of city roads. They argue that the success of the Metro is a function of how many people it is able to attract and how fast its network expands. The persistent congestion is only a reflection of the fact that the Delhi traffic has been growing at a pace faster than even the growth in the Delhi Metro traffic.

Such criticisms are commonplace with infrastructure investments. They most often fail to produce tangible and immediate impact, and leaves all stakeholders unsatisfied. When the power deficit is a few gigawatts, the commissioning of a few hundred megawatts of power generation capacity has limited impact on the load-shedding situation. Similar situation arises with even major new water and sewerage treatment capacity expansion, since the requirements are massive. The problem is most acute with transportation, since traffic always appears to worsen. In the absence of any salient impact, municipal councils have no incentive to sanction scarce resources in such sectors.

Finally, the left-wing critics of economic liberalization in India point to the persisting high poverty rates and social deprivation and blame it on the neo-liberal policies of the past two decades. They argue that these policies have exacerbated social tensions, widened economic inequality, dismantled social and economic protections and therefore weakened the nation economically.

This too is a classic counterfactual problem. There are two issues here. One, serious commentators question the nature and extent of liberalization undertaken by successive governments, claiming that they have been too little and limited in scope and piecemeal and stop-start. In the absence of, leave alone the full breadth and scope, atleast even some reasonably acceptable level of liberalization, they argue, how can we blame liberalization for the current state of affairs?

Second, they argue that in the absence of this limited economic liberalization, the economy would have been in doldrums. They point to the undoubted macroeconomic gains of recent years as proof of this. How do we know what would have the state of affairs in the absence of the liberalization policies? See Ananth's excellent take on the critics of economic liberalization, including on other dimensions.

In all three cases - stimulus measures in the US, Metro railways in New Delhi, and economic liberalization in India - there is a classic cognitive bias at work, availability bias. People observe salient outcomes - the poor state of the economy, despite the stimulus spending; poor state of Delhi traffic, despite the Metro; and the persistent high poverty levels, despite economic liberalization - and conclude that these interventions failed to achieve the outcome. However, the reality clearly (albeit less so clearly in case of stimulus) points to all having had considerable effect in mitigating the respective problems, though the exact magnitude of their impacts is difficult to quantify.

Then there is another issue here. In all three cases, the opponents frame the debate by equating the particular intervention with the text-book case of the underlying concept. Accordingly, for example, they define the stimulus as was implemented in the US was the classic Keynesian stimulus, and therefore its apparent failure to get the economy out of the recession is conclusive evidence of the failing of the underlying Keynesian concept itself.

Similarly, critics' definition of the success of metro rail as measured by the resultant reduction in congestion rate, means that an actual increase in congestion is taken as proof of its failure. For neo-liberal critics, Manmohanomics is the embodiment of economic liberalization and since it did not "eliminate poverty", as promised, it has failed!

Sunday, July 17, 2011

The dynamism-dysfunction paradox

I have an article in this month's Pragati that examines the challenges facing Indian cities. It advocates that more than improvements in municipal governance, the need of the hour is massive public investments in civic infrastructure coupled with efforts that seek to increase willingness to pay among users of civic services. It also argues that even with enabling policy frameworks, private sector can be only marginal player in the process of city building, atleast at this stage.

See a contrarian take by Harsh Gupta here.

Saturday, July 16, 2011

The call for austerity - cure worsens the disease?

Carmen Reinhart and Ken Rogoff, the foremost historians of macroeconomic crises, have an excellent article in Bloomberg, where they express concern at the high debt overhang among developed economies.

Their magisterial examination of the history of financial crises and the relationship between growth and public liabilities found that when the debt-to-GDP ratio exceeds 90% in case of developed economies, it starts having adverse impact on long-term growth and macroeconomic stability. And this level has either been already breached or is fast approaching in most developed economies.

They cast doubt on the arguement of advocates of fiscal expansion, who claim that the ultra-low interest rates justify another round of stimulus despite the high public debt ratios. They argue that market interest rates can change dramatically in a few months with disastrous cascading consequences, whereas debt reduction takes years. Further, as the Japan example shows, high debt overhang, even without high interest rates, can hinder growth.

Though this analysis cannot be faulted, the implied solution - reining in debt with austerity and tax increases - is fraught with even bigger dangers. As I blogged earlier this week, expansionary fiscal consolidation holds limited promise. It contracts private domestic demand and the GDP. This should not come as a surprise since private consumption and business investment, which form the predominant source of growth in the absence of government spending, remains abysmally weak and shows no signs of revival. The only other remaining source of growth, external trade, too holds little promise and in any case cannot provide the thrust for recovering from such a bad crisis in case of large economies. See this and this.

Without private sector consumption and investment recovering, any contraction in government spending will only push the economy further down the recessionary path. The knock-on effect on the revenues side of the fiscal balance will be disastrous.

As has been well documented with the impact of the Great Recession on the US government deficit, the biggest concern during a recession is the reduction in government revenues and the resultant widening of fiscal deficits and debt-to-GDP ratios. In other words, the prescription turns out worsening the disease!

Paul Krugman has this concise response to the two most frequent arguments that deficits will drive up interest rates - government borrowing crowding out private borrowers and driving up rates, and fears of government's solvency frightening off investors and increasing the cost of borrowing.

Update 1 (17/7/2011)

The two big concerns for conservatives who advocate fiscal contraction are fears of high borrowing costs (bond-vigilantes) and high-inflation. These two concerns go against all standard macroeconomic models of economies stuck in slowdowns with interest rates at the zero-bound. Moreoever, they have been proved as wildly misplaced both from experience till date and from all available long-term forecasts.

In fact, quite to the contrary, all evidence points to a period of persistent low interest rates and low inflation (so much so that some economists, including the IMF, have called for raising the inflation target). This points to deflation, accompanied by Japan-style deep recession, as the greater danger now.

As to why the fiscal contraction story continues to grip the imagination of opinion makers, Paul Krugman points to Robert Kutter. They argue that this line of reasoning supports the interests of creditors, with significant exposure in bonds, loans, and cash. Mike Konczal calls it as "wealth and income defense". These rentiers have an interest in keeping inflation down and they positively benefit from a deflationary environment. Unfortunately, these run exactly opposite to the interests of workers and others.

Update 2 (3/9/2011)

Excellent op-ed in the Times which points out how Argentina, faced with similar high unemployment rate and a sovereign default, rebounded not with austerity but with massive fiscal expansion. For a start, the government intervened to keep the value of its currency low. It then increased taxes to finance a New Deal-like public works binge, increasing government spending to 25% GDP from 14% in 2003. It also strengthened its social safety net - the Universal Child Allowance, started in 2009 with support from both the ruling party and the opposition, gives 1.9 million low-income families a monthly stipend of about $42 per child, which helps increase consumption.

The Washington Post writes that a downturn in Europe deepened by choking off government revenues and increasing the demand for public services, could put struggling countries such as Spain and Italy at risk of missing the very deficit-reduction targets that budget cuts and other austerity measures were meant to achieve.

Friday, July 15, 2011

The coming coal crunch

It is now becoming increasingly apparent that fuel scarcity is arguably the biggest constraint facing Indian power sector. The situation is alarming in case of thermal power plants, where a large number of plants are scheduled to become operational over the coming 3-4 years.

The Coal Ministry has forecast coal shortfall to be 104-121 mt by end-2012 and 200 MT by 2016-17. This comes on the back of Planning Commission deciding to reduce the 11th Plan (2007-12) annual production estimates from 680 mt to 630 mt (486 mt from CIL, 81 from captive mines, and rest imports). However, this revised coal production target too appears difficult to achieve, with more realistic estimate being 592 mt.

The capacity addition expected based on coal linkage provided by Coal India Limited (CIL) itself is about 40 GW in the 2011-14 period. Assuming an 85% plant load factor (PLF), this would require about 200 mtpa of additional coal, whereas the incremental coal availability, assuming an 8% production growth, would be just around 73 mpta, leaving a whopping deficit or an average PLF of 40% for these new plants.

This leaves generators of all kinds with no option but to blend large quantities of imported coal. The inevitable cost escalation will adversely affect their profitability. Since NTPC has the largest exposure to CIL, it is naturally among those most likely to be affected by the coming deficits.

Since the contract agreement of standard PPAs, especially the tariff-based bids, excludes fuel supply from force majeure provisions, the entire cost escalation may have to be borne by the generator. Much the same would be the fate of private IPPs who won bids under Case I bids, whose tariffs are already determined. The profitability of merchant power plants, seen no long ago as an extremely profitable business opportunity, too will come under severe strain.

A significant number of generators who won Case I bids in recent years do not have firm coal tie-up for a major share of their coal and rely on spot purchases. This exposes them to severe risks on coal availability and coal pricing. Merchant power plants without coal tie-ups are even more vulnerable, being exposed to both fuel and price volatility.

Further, though the CIL issued Letter of Assurances to generators, many of them have not been converted into firm contractual Fuel Supply Agreements (FSAs). This means that while supplies of coal to these plants are on for now, in the absence of a firm FSA, CIL is not bound to maintain a minimum supply round the year. This has shaken up investors who face the risk of developers defaulting on their debt repayment commitments.

In light of all these developments, it is not surprising that, as the Businessline reports, investor interest in private generation is petering out. In any case, this reduction in investor interest was inevitable since the surge in power sector lending of recent years had left many banks with portfolios excessively exposed to the power sector. In order to re-align themselves to their regulatory commitments, they were already paring down lending to power sector.

All these problems comes even as CIL grapples with its failure to increase production capacity (it produces 80% of the country's coal production). Ading to the woes, the Ministry of Environment and Forests' (MoEF) refusal to accord clearances has left an estimated 203 blocks with combined reserves of 600 mtpa and potential generation capacity of 130 GW in limbo. The MoEF in 2009 had categorised these 203 coal blocks as "no go" mining zone. The Coal Ministry has been demanding permission to mine at least 90% of these 203 blocks to meet the ever widening demand-supply gap of the dry fuel.

None of these include the big risk posed by the worsening finances of State Electricity Boards, whose accumulated losses have crossed Rs 55000 Cr. These losses are certain to rise further when distribution losses are 25-30% and more than 20% of electricity is given free to farmers. Saddled with such huge debts, discoms are not likely to venture into spot market purchases, except when faced with an electoral season. This will add to the woes of an already volatile and deficient spot market.

In recent weeks, the government has also started cracking down on developers who though allocated coal blocks had not started developing them. A panel set up by the Coal Ministry has recommended issuing warnings to 29 coal and three lignite blocks allocatees, apart from the cancellation of 14 coal blocks and one lignite block to six PSUs, including NTPC and three private firms for failing to develop the mines.

Update 1 (26/1/2012)

The Economist writes,

"By the year to March 2017 domestic coal production will meet only 73% of demand, leaving a gap of some 230m tonnes, almost five times the level of 2012. Include other industries that use coal, such as steel, and some analysts calculate that India’s total imports by 2017 could reach some 300m tonnes. That is on a par with the current exports of Australia, or those of Indonesia, South Africa and Canada combined."

Thursday, July 14, 2011

Debt Contagion Fears - Is Italy next?

Here is a grapical representation of European national debts, with countries sized in proportion to their respective sovereign debts.

Notice that, excluding Greece, Eurozone's third largest economy, Italy, has the highest debt-to-GDP ration among these economies. And as expected, exacerbated by domestic political uncertainty, markets appear to be forming expectations about Italy following Greece, Ireland, Portugal and Spain into the troubled periphery of Eurozone, thereby completing the complement of PIIGS.

Admittedly, Italy's banks never speculated in a property bubble and are sound, its budget deficit at 4.6% of GDP looks low when compared to the sinners, and unlike other PIIGS Italian own more than half the country's debt. But as interest rates rise and with economy not likely to get back into high growth path anytime soon, it does not require much for the markets to tip the balance against Italy. And the indications look ominious.

As this Bloomberg ticker shows, the cost of insuring Italian sovereign debt against default have zoomed to its highest ever.

Italy is the largest issuer of government bonds among Eurozone economies and its 10-year Bond yields shot up alarmingly, again to its highest in recent history. And if rates exceed 6%, Italy will start experiencing the same repayment and new debt raising problems as others.

A contagion spread to Italy would make Greece and Portugal look like boy-scouts. As the Timess reports, European banks have total claims and potential exposures of 998.7 billion euros to Italy, more than six times the 162.4 billion euro exposure they have to Greece. European banks have 774 billion euros of exposure to Spain and 534 billion euros of exposure to Ireland. American banks are also more exposed to Italy than to any other euro zone country, to the tune of 269 billion euros. American banks’ next biggest exposure is to Spain, with total claims estimated at 179 billion euros.

Update 1 (28/9/2011)

List of "Who Gets Smashed If Italy Goes Bust".

Tuesday, July 12, 2011

The contraction with "expansionary fiscal consolidation"!

The big macroeconomic debate of our times is over whether economies facing the Great Recession should indulge in more fiscal and monetary expansion or should embrace fiscal austerity and monetary contraction.

Advocates of more stimulus point to dismal economic conditions - aggregate demand slump, lack of business confidence, idle capacity, depressed business investments, high unemployment rates etc - and argue that the economy would remain in a deep recession in the absence of expansionary policies. The zero-bound in interest rates, they say, only exacerbates the problems.

The Austerians point to the huge build up of public debts across most developed economies and demand immediate steps to bring them down to sustainable levels. They also see dangers of an inflationary spiral and even asset bubbles unleashed by the extended expansionary monetary policy. They also fret at bond-vigilantes driving up interest rates.

In recent months, they have pointed to the work of Alberto Alesina and Silvia Ardagna (pdf here, earlier version here) who examined episodes of all large fiscal policy stances, both stimuli and adjustments, in OECD countries from 1970-2007. They found,

"Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions."

This has repeatedly been invoked to justify "expansionary fiscal contraction" or "expansionary austerity", where fiscal consolidation will result in increased growth. It is argued that fiscal consolidation by way of spending cuts or tax increases today will, by reducing the expectations of the need for a larger and disruptive fiscal adjustment later, raise household and business expectations about their future incomes and thereby stuimulate private consumption and business investments.

They also argue that if current fiscal policy can influence agents' expectations about interest rates by signalling to them about the government's resolve, by way of fiscal stabilization, to rein in public debt, "they can ask for a lower premium on government bonds". Further, aggregate demand components sensitive to real interest rates too get a boost if such credible expectations about fiscal stabilization and lower future interest rates are conveyed. They forecast a possible consumption/investment boom if such expectations can be credibly conveyed. This study has also been used to justify the preference of tax cuts over government spending if stimulus is deployed.

A recent paper by IMF economists Jaime Guajardo, Daniel Leigh, and Andrea Pescatori have examined the dataset used by Alesina and Ardagna and find that their findings may have been compromised by the bias within the examples used. The IMF economists drew a distinction between fiscal consolidations motivated by a desire to reduce budget deficit and those responding to prospective economic conditions. They focussed on the impact of short-term fiscal consolidation arising out of only the former and found

"Using this new dataset, our estimates suggest fiscal consolidation has contractionary effects on private domestic demand and GDP. By contrast, estimates based on conventional measures of the fiscal policy stance used in the literature support the expansionary fiscal contractions hypothesis but appear to be biased toward overstating expansionary effects...

Based on the fiscal actions thus identified, our baseline specification implies that a 1 percent of GDP fiscal consolidation reduces real private consumption by 0.75 percent within two years, while real GDP declines by 0.62 percent... Our main finding that fiscal consolidation is contractionary holds up in cases where one would most expect fiscal consolidation to raise private domestic demand. In particular, even large spending-based fiscal retrenchments are contractionary, as are fiscal consolidations occurring in economies with a high perceived sovereign default risk."

As Paul Krugman writes, the Alesina and Ardagna findings are muddled by reverse causation - they mistake the rise in revenues and/or fall in expenditures that generally follows fiscal consolidation (since safety-net spending falls or government prunes down expenditures) to claim that economic expansion follows all spending cuts and/or tax increases.

Monday, July 11, 2011

The rural-urban divide in governance

Where do India's political and administrative energies get spent? What is the ratio of distribution between rural and urban Indias?

The McKinsey Global Institute (pdf here) estimates that cities will provide the overwhelming share of economic growth (70%), new jobs (70%), and tax revenues (85%) by 2030. It may be therefore appropriate to illustrate this with the following Venn Diagram.

However, the prevailing political and therefore administrative paradigm in India suffers from an excessive rural-focus. Villages are the central focus of our attention. Another Venn Diagram represents the distribution of our administrative bandwidth.

The commonest justification for this rural focus is that India lives in its villages (nearly 70% of the population lives there) and rural growth should be the priority. However, there is growing evidence, here and here, that urbanization and urban growth are among the most potent rural economic growth and poverty reduction strategies.

Saturday, July 9, 2011

The dynamics of the "Apple Economy"

One of the most intriguing and controversial dimensions of the globalization debate has been about the distribution of jobs and incomes in any industry between the host country and foreigners and among different categories of workforce in each.

In this context Greg Linden, Jason Dedrick and Kenneth L. Kraemer, who studied how the quintessentially American iPod has created jobs and profits around the world, have several interesting findings. Chrystia Freedland has a nice analysis of its findings here. The authors show that in 2006, the iPod employed nearly twice as many people outside the United States as it did in the country where it was invented — 13,920 in the United States, and 27,250 abroad. Of the foreign jobs, fewer than half, 12,270, are in China, and 4,750 are in the Philippines.

As regards salaries of these workers, the study shows that though most iPod jobs are external, the major share of total iPod salaries are in the US - the 13,920 American workers earned nearly $750 million, to less than $320 mn for the 27,250 non-American Apple employees. More stunningly, while more than half the US jobs, 7,789, went into low-skill retail and other non-professional workers (office support, freight, distribution etc) who earned just $220 mn, the 6101 engineers and professionals took home $525 mn.

This finding goes against the conventional simplified arguments against globalization that it causes job losses and reduces earnings for host country workers. The iPod economy is far more nuanced than such explanations. Since Apple is able to leverage the cheaper cost of production outside, its profitability increases. However, this profit is not widely shared. Since it keeps most of its R&D inside the US, its small number of higher skill workers reap a windfall. The same eludes the other non-professional workers in the US. Similarly, though workers in China and elsewhere gain jobs, their relative financial gains are marginal.

The biggest winners from globalization are the companies themselves, Apple in this case, and its scarce high-skill employees. It cannot also be denied that, despite their low financial value-added, workers in many emerging economies gain significantly. The big losers in the iPod economy appear to be the similarly skilled American workers who are outbid by the lower wage workers of emerging economies.

This forms further confirmation of the Samuelson-Stolper theorem which states that "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". In other words, labor intensive imports from developing countries exercises a depressing effect on the real wages of less-skilled workers (who are relatively less abundant in developed economies).

Friday, July 8, 2011

China's Local Government Debts

One of the most intriguing questions for Indians marvelling at China's spectacular economic growth is about how its government manages to finance a never-ending shelf of mega infrastructure projects entailing extraordinary investments. For all its governance failures, corruption, resistance to reforms and recent political paralysis, the fundamental problem for a chronically infrastructure deficient India remains paucity of resources to finance its massive infrastructure requirements.

The contrast with a flush-with-funds China is stark. However, as the Times points out in an excellent article chronicling the challenges facing China's increasingly infrastructure investment dominated economic growth push, things may not be as rosy as it appears across our northern borders.

As the Great Recession took hold, the Chinese government stepped in with a mssive $580 bn stimulus package. Local governments across China borrowed heavily from state-owned banks and pumped money into infrastructure. Infrastructure replaced exports as the engine of economic growth.

The Times reports that spending on so-called fixed-asset investment (infrastructure and real estate projects) is now equal to nearly 70% of the nation’s GDP, a sign of dangerous over-dependence on infrastructure spending. It is a ratio unheard of in modern times for any nation, with the ratio being just 35% for Japan during its 1980s building boom and 20% for US for decades now.

Now this model is becoming unsustainable as local government debts, cleverly hidden from the local government balance sheet through accounting tricks, mount and repayment strains start appearing. The National Audit Office recently released figures showing that the local governments had amassed 10.7 trillion yuan ($1.65 trillion) in debt as of the end of December, amounting to 26.9% of GDP in 2010. Of this debt, local governments are explicitly responsible for repaying 62.6%, have guaranteed 21.8%, and are required to partially repay 15.6%. Worryingly, the report writes that nearly half the debt was accumulated in just two years by way of the loan-powered fiscal stimulus of 2009-10. This debt, mainly owed to state-run banks, poses serious risks for the Chinese financial system.

Most local governments borrow through special investment corporations set up by them and their debt shows up nowhere on its official balance sheet. Such local government financing vehicles (LGFV) were set up to get around rules forbidding them from borrowing directly from banks and raising funds through municipal bonds and also conceal the true extent of local government debts. These LGFVs were set up to finance light rail projects, bridges etc. It is estimated that there are more than 10,000 of these local government financing entities in China.

In fact, the audit office said 46.4% of the debt is held by such intermediary vehicles. Another recent report from the People's Bank of China had said that local government financing vehicles had taken out loans worth up to 30% of total outstanding bank loans or 14 trillion yuan. The collateral for many loans is local land valued at lofty prices that could collapse if China’s real estate bubble burst.

An earlier estimate by the Northwestern University Prof. Victor Shih found that the total local government financing platform debt was around 11.4 trillion yuan ($1.75 trillion) at the end of 2009. His latest estimate of total local governmental debt ranges between 15.4 trillion yuan and 20.1 trillion yuan, or 40% to 50% of China's 2010 GDP. He also estimates that LGFV interest payments are at least 1 trillion yuan a year, and realistically more than 2 trillion yuan.

Another report by Moody's says that the audit office's data fails to account for about 3.5 trillion yuan, or about $540 billion, of loans to local governments. It also estimates that the Chinese banking system's nonperforming loans could reach between 8% and 12% of total loans. This is in stark contrast to the official ratio of non-performing loans of 1.14% at the end of 2010.‬

The biggest concern is a possible rise in inflation, which would force the central bank into raising interest rates. In fact, yesterday the People's Bank raised interest rates for the third time this year in order to cool the sizzling pace of economic growth, estimated to touch 11.9% in the seond quarter. Inflation is up 4.4% for June, the highest rate in more than two years and above the 3% target set by central bank.

In fact, the threat of the whole pack of cards collapsing when faced with higher interest rates is also behind the reluctance of authorities to rein in the bubble. As Prof Shih argues, the only way to cool down the continuously inflating debt bubble and credit flows is by engineering a credit crunch. Unfortunately, this would entail raising interest rates, with all its possible adverse consequences.

There have been rumors that the government is considering write-off about 2-3 trillion ($300-470 bn) in debts owed by local governments to the country's China's top banks. Though this would force losses on banks, local and central governments, it should reduce the risks that cloud the Chinese economy. Fortunately, a banking crisis would not have the sort direct impact on consumers as witnessed in the US since the Chinese citizens save heavily and have limited exposure to mortgages and other financial investments.

The debt build-up also amplified the already frothy real estate market, which was pushed up further by the stimulus spending in 2010 and 2011. A large share of this spending was routed into real-estate related infrastructure. Chinese state-owned banks, on government orders, lent about $3 trillion mostly to giant state-owned enterprises and local governments to fight the effects of the downturn. Though intended at infrastructure, a substantial share of these loans wound up financing real-estate purchases by government agencies.

Further, in the absence of financial alternatives to beat inflation, Chinese savers piled into real estate and drove residential property prices up by half to about 9% of GDP between 2006 and 2010. In that period, real-estate prices in major cities in China roughly doubled.

The continuing paucity of investment avenues coupled with exceptionally high savings rates and the reliance of local governments on land sales for revenue means that property prices could go higher before the bubble bursts. The Standard Chartered estimates that about 50% of China's GDP is linked to the fate of its real-estate market (it affects construction, steel, concrete, power and appliance industries), making a potential bust extremely damaging. A banking crisis would be inevitable.

See also this Times Room for Debate on China's local government debt.