Thursday, May 31, 2012

Markets and morality

Boston Review has an excellent debate about Michael Sandel's new book. As with all issues involving morality, there can be little agreement on the issues under debate. Prof Sandel's argument is that market motives have the potential to corrupt all participants in a transaction and thereby limit (or crowd-out) the role of morality in them. He therefore advocates that certain things like friendship, wedding toasts, gifts, school admissions, and organs for transplant that should not be commercialized.

Debra Satz makes the important point by arguing that, instead of corruption, the fundamental concern with market is that it is agnostic to fairness in any transaction. She therefore traces the limits to market in its inherent nature to exclude a large proportion of the population from accessing certain goods and services. In terms of economics, this is called inequality. She illustrates this with the example of kidney markets,
Recently the New York Times reported that 60 people were linked in the longest chain of kidney transplants ever constructed. What is the difference between an ordinary market and this trading system in which people barter organs on behalf of loved ones? The morally salient difference is that, in the kidney exchange system, people could not use money to get access to an organ: the standing of rich and poor were thereby equalized. That people respond very differently to kidney chains and kidney markets suggests that there is an egalitarian intuition behind the prohibition on organ trading, not a view about the meaning of body parts.
My own belief is that the debate on which things/services can be transacted in the market and which should be regulated by social norms will never have a conclusion which does not leave a significant minority dissatisfied. If its implications were confined purely to the personal realm, it would have been appropriate to leave the debate to rage on. But in a world where market norms have invaded most of our lives, there is a compelling case to the argument that the application of such norms to certain transactions can have socially destabilizing effects.

Let's take two examples of mainstream debates on inequality and healthcare where the morality goalposts have undergone important changes due to the suffusion of market values. As inequality widens, there is mounting evidence that it has significant distortionary and destabilizing effects on the market's allocative efficiency. But conservatives invoke the principles of free-markets (income distribution is a reflection of inherent merit and hardwork) and oppose any attempt to remedy the situation. The result is an environment where taxation and welfare support are seen as undesirable, despite the co-existence of extreme concentration of wealth with severe deprivation and poverty.

As technological advances and increasing life expectancies drive healthcare costs upwards and fiscally constrained governments are forced to pare down healthcare expenditures, there is an intense debate raging about rationing healthcare. Questions involving what should constitute the basic package of healthcare services, nature of terminal care, subsidizing health coverage for the indigent, and so on, which involve important issues of collective morality, are increasingly being debated and decided based on market principles.     

In both these cases, a market-based system of making decisions, which overlooks the principles of morality and human values, may have contributed to making many of us indifferent to severe deprivation or letting people suffer and even die for lack of access to the best available health care. But do we blame markets for this slip down the morality scales or is it an inevitable accompaniment of development and progress itself?

Wednesday, May 30, 2012

Efficient allocation of road space

Consider this about traffic trends in New Delhi,
According to a 2008 survey, nearly 75 percent of trips in the city are completed on foot, bicycle or public transit, while just 10 percent are by car. The remainder are on motorized two- and three-wheelers... Only 17 out of 1000 Delhi residents own a car... Less than half own any motorized vehicle at all... And despite the fact that they carry only 25 percent of the city’s commuters, cars and two-wheelers (motorcycles and scooters) take up 75 percent of Delhi’s precious road space.
In other words, there is a clear failure with road space allocation. Three-fourth of commuters (those walking, or using bicycle or public transit) use just one-fourth of the city's road space. When such market failures happen, the most obvious way out is to tax the disproportionate road users and make their road use very expensive. The commonest practice is higher vehicle taxes or toll fees. A less deployed form of taxation would be to inordinately lengthen their travel times.

And this is precisely what has happened with private vehicle travel times in New Delhi's experimental 5.8 km BRT corridor which has been opperational since 2008. The crawling traffic in the regular traffic lanes and the long waiting times at traffic lights have made life miserable for car users. But far from being applauded for achieving its objective, the newspapers and opinion makers have lambasted the BRT expriment and pronounced it a failure.

This highlights the complexity associated with addressing traffic issues. Compounding the issue is the small distance of the corridor. It is too small to benefit large enough numbers while seriously inconveniencing the more vocal sections of the population. The only way out is for the Delhi government to stand firm and push through quickly with extending the corridor to cover large enough commute stretches besides providing good quality BRT services. This will hopefully tip the balance in favor of those benefiting and also encourage a significant proportion of car users into using this service.

Tuesday, May 29, 2012

The moral hazard with a Greek exit

With Greece looking certain to default or exit, the critical question is whether it is possible to hold the rest together and maintain stability in Eurozone even after a Greek exit? In this context, John Kay and Gillian Tett point to an existential threat to the single currency union from a Greek exit - the unravelling of the Eurozone's financial integration.

As I have blogged earlier, the build up to the single currency agreement saw a rapid convergence of sovereign risk ratings among the Eurozone economies. Interest rates fell dramatically for the peripheral economies and the bond spreads with German bund dropped. In the firm belief that any Eurozone sovereign debt would be ultimately enjoy collective guarantee of all members, capital moved across borders unhindered. John Kay writes,
When countries joined the single currency, a relatively simple piece of domestic legislation converted contracts in drachmas, pesetas, markkas and Deutschmarks into contracts in euros at a prescribed exchange rate. But you cannot simply reverse that process when countries leave the single currency. You have to prescribe which contracts are now to be fulfilled in drachmas and which remain in euros or converted into Deutschmarks. That determination is politically fraught, technically complex and subject to long legal challenges.
Now that a Euroexit for Greece appears a real possibility, the financial integration process has started reversing. The first indicator of this has been the widening sovereign bond spreads of the peripheral economies (with respect to the German bund) and the near freezing of cross-border inter-bank lending. As speculation about an imminent Greek exit mounts, lenders and investors are looking to cover for cross-border risks. Gillian Tett writes,
Banks are increasingly reordering their European exposure along national lines, in terms of asset-liability matching (ALM), just in case the region splits apart. Thus, if a bank has loans to Spanish borrowers, say, it is trying to cover these with funding from Spain, rather than from Germany. Similarly, when it comes to hedging derivatives and foreign exchange deals, or measuring their risk, Italian counterparties are treated differently from Finnish counterparties, say.
As this trend gathers pace, banks and investors will increasingly seek to match lenders and borrowers within national boundaries. This matching will enable them to cover for the exchange rate and interest rate risks that would surface when Euro-era contracts are forced to be discharged in the respective individual currencies.

This would amount to a virtual repudiation of the process of financial integration that is the objective of the monetary union. Since any Greek exit would put an end to the belief that Euroexit is impossible and would also have laid out the blue-print for any exit, the moral hazard caused by the broken belief would be unleashed.

If this moral hazard gains ground, as it is certain to if Greece exits, it will stretch out the banks across Eurozone. Banks from the core economies, who have large exposure in the peripheral economies, will hasten their deleveraging process. This has the potential to force many of the debt-laden peripheral economies out from the credit markets and send their yields soaring. Wholesale defaults are a strong possibility.

Wolfgang Munchau advocates four steps to mitigate this moral hazard. They are a eurozone-wide deposit insurance scheme with an unequivocal guarantee that deposits will be repaid in euros even if the host country leaves the eurozone; a eurozone-funded resolution trust company with the power to force a recapitalisation of the banks – without national veto; a proper eurozone bond to cover a large portion of outstanding and new debt; and a change in the mandate of the European Central Bank to include specific responsibility for financial stability so that it can conduct secondary market operations.

Taken together, they would mean an effective fiscal union. In fact, the issuance of Eurobonds, which would be guaranteed by all the Eurozone members, would be the strongest signal of the commitment of the members to maintain the monetary union. And, given the inevitability of this moral hazard, the only meaningful way to mitigate it would be to backstop losses by a collective guarantee. But this carries its own risks in the sense that it would amount to the ECB playing its last card and its failure will virtually nail the monetary union. 

Monday, May 28, 2012

What can be done to improve learning outcomes?

Addressing the issue of poor student learning outcomes is surely one of the foremost public policy challenges facing governments in many developing countries. However, it is far from settled wisdom as to what should be the best public policy prescriptions to improve learning outcomes.

A Foreign Policy article by Charles Kenny claims that if we want to improve student learning levels, we need to "focus on teachers". And this focus has to come by way of efforts to increase teacher attendance, improve the learning environment (eg. putting computers in the slum), align incentives facing teachers (rewards for student learning outcomes), better equipped teachers, flexible curriculums etc.  He concludes,
All that is left is the willingness to confront the political challenges connected with rewarding teachers for learning outcomes - and ensuring they have the tools to help deliver inside and outside the classroom.
I agree with the role of all these factors to improving learning outcomes. But I am not sure whether they will necessarily result in improved learning outcomes. Consider each of Kenny's suggestions. Though, by themselves, improving teacher attendance is not likely to contribute much to improve learning levels, it is a basic pre-requisite for the success of all other interventions.

But the importance of all the other factors are questionable. Far from being ill-equipped, teachers in many Indian states are over-trained both on content and pedagogy. Even where flexibility is provided in curriculum, as in states like Tamil Nadu, the learning outcomes have not been much better. Aligning incentives by way of performance-based payments is fraught with several imponderables. There is little conclusive evidence that improvements in learning environment by encouraging the use of computers leads to improvements in learning levels. In any case, most of these issues are inter-related with longer term social and economic development issues. So what's the way ahead? 

I believe that this search for new initiatives and strategies reveals an inadequate understanding of the problem and its context. Given the general abysmal condition of public school systems in most developing countries, I feel there may be several low hanging fruits to be plucked from just getting the basics right. For a start, it is possible to dramatically improve teacher attendance with some minimal administrative commitment.

But the most important area that needs focus, more than teachers, are the elements of classroom transaction. It is widely acknowledged that given the differential student learning abilities and their baseline learning levels, some form of remedial instruction has to be central to any meaningful classroom transaction strategy. Its integration into the regular syllabus coverage schedule may not necessarily require much flexibility in curriculum or syllabus. Once a classroom instruction model that revolves around this is ready, the challenge then lies in its scaled up implementation. And it is here that many public systems fail. 

But I believe that this fate can be avoided by closely scripting the classroom transactions required to implement the aforementioned remedial instruction focussed pedagogy. This level of micro-management is necessary in systems with abysmal current learning levels, poor internal motivation, and weak supervisory oversight. This common minimum agenda of the particular classroom instruction model will have to be implemented in a more or less top-down manner. Again, with basic administrative commitment and professional management, it is possible to implement a tightly scripted pedagogy model with some reasonable level of satisfaction.

But to pre-empt the expected criticism, let me caution that this is only the second-best solution to improving learning outcomes. It has the potential to take a poor system to a reasonably good level. But it cannot transform a good system into a very good or a great system. 

Once the public schools system moves from a bad to a satisfactory system, then the transition to a good or very good system would need an alternative strategy. It would have to be underpinned by local motivation and initiative, which would require a more bottom-up and stake-holder focussed strategy. Till then implementing a closely scripted classroom transaction model which revolves around remedial education may be the best way to improve learning outcomes. 

Sunday, May 27, 2012

Two graphics on European bond markets

Two excellent graphics highlight the extent of fear that has gripped the European and global financial markets as a denoument to the Eurozone crisis gets closer. Martin Wolf has a graphic that highlights the widening sovereign bond spreads and the forecasts of output loss following the Eurozone break-up.

The biggest beneficiaries of the crisis have been the safe haven economies. As capital has taken flight from the vulnerable economies, Germany, US and UK have benefited from being able to access capital at ultra-cheap rates. In the case of Germany, it has helped the economy weather the worst of the European crisis and motor along at an impressive pace. For US and UK, it has helped mitigate the impact of weak economic conditions and high public debt and fiscal deficits.


Saturday, May 26, 2012

Bridging our vocational skills gap

Ask any businessman in India about his biggest challenge, and more likely than not he will point to an acute shortage of skilled manpower. Even when they manage to recruit workers, they turn out deficient in the requisite workplace skills and thereby require further training. India needs to address this quickly if it is to sustain its ambitious high growth targets.

There are two fundamental issues here. One, the quality of students being churned out by the institutes and colleges are extremely poor. An overwhelming majority of students, apart those from a few premier institutions, are simply unemployable. Two, there is an acute under-supply of people with skills to work in manufacturing shop floors and in other semi-skilled professions. This is related to the dominant trend of students preferring the four-year professional courses over the shorter vocational skills training courses. So how do we break out of this?  

In this context, the FT has an excellent article that draws attention to the "ability of the German system to match young people’s skills to those required by the labour market" through an apprentice system. It writes,
It emphasises a combination of theoretical training in the classroom and hands-on technical experience on the factory floor... In Germany, apprentice schemes such as this are the norm. About 60 per cent of the country’s school leavers begin an apprenticeship, which lasts up to three and a half years. About 570,000 trainees – or Azubis as they are known in Germany – started a dual programme in 2011.
The roots of Germany’s vocational training stretch back to the Middle Ages and foreigners have often viewed the system as complex, rigid and antiquated. Children are streamed for technical education earlier than in the UK or US, for example, and join one of about 350 prescribed trades that range from baking to floristry and industrial mechanics... German companies also seek to involve local partners, especially local colleges, both to help train the apprentices and to develop the curriculum.
Training is provided on the job and in vocational training schools, combining theory and practice. This model requires close co-operation between companies, vocational schools, local governments, employer associations and trade unions, which develop the curriculum together. Government even subsidize a share of the training costs. The trainee gets paid whilst learning and there is a very high likelihood of obtaining a job at the end of the process. The company benefits by way of cheaper access to the labour market and customizing the trainees for the specific skill-set.

Given the highly skilled nature of workers in many Germany equipment manufacturing firms and the deficiency of people with such skills, German firms have been adopting the dual programme approach even outside the country. Are there lessons for countries like India which are struggling with labour market shortages? Given the large network of industrial and vocational training schools across the country, there is a great opportunity to establish partnerships with local firms to train their prospective employees.

Update 1 (25/1/2013)

NYT has this nice report about the shortage of factory workers in China. It talks about jobs and positions for which skilled workers cannot be found, whereas on the other hand there are talented people with academic degrees, but no skills, who cannot find jobs. It writes,

China’s vocational secondary schools and training programs are unpopular because they are seen as dead-ends, with virtually no chance of moving on to a four-year university. They also suffer from a stigma: they are seen as schools for people from peasant backgrounds, and are seldom chosen by more affluent and better-educated students from towns and cities. Many youths from rural areas who graduate from college... are also hostile to factory jobs... The more educated people are, the less they want to work in a factory.

Friday, May 25, 2012

End of equity cult or beginning of the equity resurgence?

A recent FT op-ed raises the question whether decades of equity cult is about to end,
Allianz, with a total of about €1.7tn under management, has only 6 per cent of its insurance portfolio in equities, while 90 per cent is in bonds. A decade ago, 20 per cent was in equities. It is far from alone: institutional investors, from pension funds to mutual funds sold directly to the public, have slashed holdings in the past decade. Stocks have not been so far out of favour for half a century. Many declare the “cult of the equity” dead.

With equity financing expensive, many companies are opting to raise debt instead, or to retire equity. As equity markets shrink, so does the sway of the owners of that equity, reducing shareholder control over companies – and challenging accepted concepts of corporate ownership. Further, with equity returns virtually flat for more than a decade, the incentive for investors to take risks by funding smaller, more entrepreneurial companies has declined – eroding a process that has traditionally given managers the flexibility they need to grow. Capitalism with less equity finance would follow a much more conservative model.
As an indicator of the changing trends, the article points to the recent shifts in dividend yields (the amount paid out in dividends per share divided by the share price). For more than half a century, investors have preferred the lower dividend yields, compared to bond yields, in the hope that the longer term returns from equity valuations (capital gains) will more than compensate the lower interest rate returns. And they have not been disappointed. But now that is changing as the graphic below shows.

According to Robert Shiller of Yale University, the dividend yield on US stocks is today 1.97% – above the 1.72% yield on 10-year US Treasury bonds. The article provides more proof of the transformation,
From 1900 to 2010, they beat inflation by 6.3 per cent a year in the US, according to a widely used benchmark maintained by London Business School, compared with only 1.8 per cent for bonds. In the US and the UK, public pension funds had allocations to equities as high as 70 per cent only 10 years ago. They are now down to 40 per cent in the UK, and 52 per cent in the US.
However, this pessimism about equities is questioned by those who point to the apparently cyclical nature of the gap between dividend and bond yields. A recent report by Goldman Sachs claimed that equities are now heavily undervalued and said that given the current valuations, it’s time to say a 'long good bye’ to bonds, and embrace the ‘long good buy’ for equities as they are expected to embark on an upward trend over the next few years.

In fact, seen from its historical perspective, the ex-post equity risk premium of the S&P 500 over the US Treasury has been dismal.    

However, critics point out that the long period of Great Moderation since the early eighties, when inflationary pressures were quelled, have contributed to a long period of stable and low bond yields. They also point to the regulatory reforms, especially sovereign bond holdings, and changes in tax and accounting principles that have all favored bonds. The graphic below shows that government bonds are now more expensive than anytime in history and yields at their lowest.

Therefore, as the FT writes, "The trend cannot continue much longer without yields on bonds turning negative – meaning investors would pay for the privilege of lending to the government."  Therefore, it is argued, it may not be far when bond yields start to revert to historically normal levels, which will in turn trigger off bond sell-offs. This money would then start flowing back into the other big investment opportunity, equities. Does this mean that the apparent lull in equities is merely the beginning of a resurgence of equities?

Thursday, May 24, 2012

The impact of London's congestion pricing - A public policy success

In February 2003, London introduced congestion pricing to control vehicular traffic in its central areas between 7 AM and 6 PM. It is currently £10 or $16.22 and this revenue (it generated $240 mn in 2009) is plowed into the city’s transit system. As the graphics below show, congestion pricing has had a remarkable impact on traffic patterns in the area and should count as a genuine transport policy success story.

The graphic shows that the central parts of the city, filled with blue bubbles, has experienced a significant drop in vehicular traffic. Given the passage of time and the general growth rate in traffic flows, the real drop would be even greater.

This has been accompanied by a remarkable increase in public transit use. Bus ridership has grown 60% over the past decade in London.

The fall in vehicular use has also been accompanied by a spectacular increase in bicycle usage. It is up 110% in London since 2000. As the graphic shows, most of that has been in the central parts of the city.  In the country as a whole, cycling on the road has increased 12% during this period.

Wednesday, May 23, 2012

India's labour market problem in a graphic

An OECD report indicates that close to 70% of employers in India reported recruitment difficulties in 2010.

It is a reflection of both the general skills deficit and jobs market frictions which prevent efficient demand-supply matching. The general skills deficit is itself a combination of the lack of adequate supply and also the unemployable nature of a large proportion of those currently in the labour market.

Tuesday, May 22, 2012

Empowering civil servants in using information

I have an op-ed in Mint today that advocates the use of data visualization techniques to bridge the last mile gap with effective utilization of the rich trove of information within public systems.

Monday, May 21, 2012

Do higher wages reduce supervision costs?

Freakonomics points to the example of Hungarian musician entreprenuer Gabor Varszegi who made millions by providing high-quality service in his photo developing shops in Budapest by hiring workers and paying them wages that were four times the going rate. It quotes Hal Varian on the reason behind this apparently strange wage payments,
There are very few employees per store and monitoring their behavior is very costly.  If there were only a small penalty to being fired, there would be great temptation to slack off. By paying the workers much more than they could get elsewhere, Varszegi makes it very costly for them to be fired — and reduces his monitoring costs significantly.
In other words, higher wages act as a deterrent against shirking and working sub-optimally. Consequently, the need for more rigorous monitoring is less and productivity and retention increases. However, the success of this strategy lies in the threat of being immediately fired if they shirk. Remove this threat and the model collapses.

Public bureaucracies are the best example. Salaries at the lower levels of the permanent bureaucracy in India are very high, several times higher than the going market rate for similar work in the private sector. So, the Varszegi model should have made these workers more productive and reduced supervision costs. But a very strong countervailing force, in the form of (formal and informal) security of tenure or trade union activism, works against and virtually depletes the threat of being fired. The incentives get immediately misaligned.

So can this approach work with the contract employees in the bureaucracy. Thanks to minimum wages, they too get wages that are higher than the prevailing market rates. Theoretically, removing them is easy since the contracts can be easily terminated. And this is the case when the numbers involved are smaller. However, when such contract employees swell in number and have worked for a few years, the moral hazard resurfaces. They form unions and the lines of distinction with the regular employees, atleast to the extent of their labour rights, gets blurred. The threat of being fired gets diminished.  

In other words, the moral hazard arising from being part of the regular public bureaucracy or being part of large enough contract labour force who have been working for sometime nullifies the positive effect of the higher wages. As I blogged earlier, this is yet another example of how the emergent dynamics of human responses, under certain conditions, undermines logically sound incentive systems.  

Saturday, May 19, 2012

Interpreting the US imposition of anti-dumping duties on Chinese solar imports

The United States Commerce Department has finally slapped anti-dumping tariffs of more than 31% on crystalline silicon photovoltaic cells and their modules imported from China. The decision, one of the largest in US history and certain to generate Chinese retaliation, covers one of the fastest growing categories of Chinese imports worth around $3.1 bn last year.

The Commerce Department was acting on a complaint filed by a domestic solar panel manufacturer, SolarWorld Industries America Inc. The anti-dumpring action covers not only imports of solar cells produced in China and solar modules/panels produced in China from Chinese-made solar cells, but also imports of solar modules/panels produced outside of China from solar cells produced in China.

The 'Agreement on Implementation of Article VI of the General Agreement on Tariffs and Trade 1994' outlines the conditions under which anti-dumping (AD) action can be initiated. It provides for imposition of  AD duties when it is established that exporters are selling their products at less than the "normal value" and the sales of the dumped product is causing material injury to a domestic industry that produces a like product. In other words, to attract AD action, the exporter should be dumping and this should in turn be causing injury.

The aforementioned agreement provides for three methods to calculate a product’s “normal value”. The main one is based on the price in the exporter’s domestic market. Generally, an exporter attracts AD action when the export is priced lower than the price normally charged in its own home market. When this cannot be used, two alternatives are available—the price charged by the exporter in another country, or a calculation based on the combination of the exporter’s production costs, other expenses and normal profit margins.

In the instant case, the Commerce Department calculated the 31% tariff by estimating Chinese manufacturers’ costs and then determining how far below cost the solar panels were being sold in the United States. But since China is designated a non-market economy (where the government plays such a large role in allocating land, credit and other resources that the true costs of any given product may not be apparent), the Department used manufacturing costs in Thailand as a proxy for costs in China. The Chinese are contesting this, arguing that India is a more accurate representative.

Since the Chinese are certain to appeal against this decision, sustaining the case before the WTO's dispute settlement mechanism is going to be widely watched. Of particular interest will be whether the apellate body agrees with the method adopted to establish normal value. If it is upheld by the WTO, it is certain to open the floodgates for similar action by other countries against China. India too will be watching the outcome of the appeal with interest. 

In any case, as I have blogged earlier, the provisions of the WTO’s Article III: 4 of Trade Related Investment Measures (TRIMS) and General Agreement on Tariffs and Trade (GATT) III allows for payments of subsidies to domestic producers and consumers. This exemption given to subsidizing domestic producers mean that the Chinese government's subsidies, direct and indirect, do not infringe the provisions of WTO. It is widely accepted that the Chinese firms benefit from huge subsidies by way of cash grants, raw-materials discounts, preferential loans, tax incentives and cheaper currency. In 2010 alone, Chinese Development Bank gave $30 billion in low-cost loans to top five domestic solar panel manufacturers.

Critics of the AD action argue that the cheap Chinese imports are a massive subsidy transfer to American consumers from the Chinese government. They point to the boom in demand for off-grid roof-top solar panel installations across the US. Further, they argue that Chinese companies often turn to American companies to buy the factory equipment and polysilicon they need to make solar panels. All this, it is claimed, benefits the American economy. And Mathew Kahn makes the important point that the positive externality (in terms of lowering greenhouse gas emissions by increasing the share of solar power) created by cheap solar panel imports means that they should be promoted and not discouraged with dumping.

Friday, May 18, 2012

More on the contribution of RCTs

A recent working paper of a randomized control trial (RCT) in Orissa to test the effectiveness of improved/clean cooking stoves in reducing indoor air pollution and fuel consumption found that the intervention had no impact. The study which tracked 2600 randomly selected households who were provided the improved stove, over a four year period, finds that,
While we find a meaningful reduction in smoke inhalation in the first year, there is no effect over longer time horizons. We find no evidence of improvements in lung functioning or health and there is no change in fuel consumption (and presumably greenhouse gas emissions). The difference between the laboratory and field findings appear to result from households’ revealed low valuation of the stoves. Households failed to use the stoves regularly or appropriately, did not make the necessary investments to maintain them properly, and usage rates ultimately declined further over time. 
Personally, I find nothing surprising about the study. India's social policy space is replete with hundreds of such examples of failed interventions. Logically and theoretically sound interventions, end up with disappointing results when subjected to the real world implementation test. A few days back, I posted about the failed experiment with automatic parking meters in Hyderabad.

There are two issues here. The first is a technical/technological question - Do improved or clean cooking stoves optimize on fuel consumption and reduce indoor air pollution? The second is a sociological/socio-economic question - Assuming a positive answer to the first question, how effective will be the cooking stove in realizing the two objectives when used in the real-world? More specifically, how would users and other stakeholders respond to the new stove?

Most often, when public policy is designed, the first question is scrutinized pretty rigorously while the second is assumed away. But, it is here, in the second question, that these interventions end up failing. Rightly, the working paper highlights this issue
More broadly, this study underscores the need to test environmental and health technologies in real-world settings where behavior may temper impacts, and to test them over a long enough horizon to understand how this behavioral effect evolves over time.
It is not just with technology interventions that these issues rise to the fore. Policies involving regulatory restraints, incentives, restructuring/reframing of the environment, computerization, and so on, in all sectors suffer from these implementation challenges. Stakeholders' response patterns to an intervention cannot be fully anticipated. The emergent dynamics often detracts from the desired outcomes.     

Therefore I believe that more than providing a new methodology to evaluate the impact of interventions, the more important contribution of the randomista movement to development economics may be to draw attention to the importance of human and social dynamics in determining the success of those interventions.

Thursday, May 17, 2012

Designing policy by building a distribution of results

Jim Manzi has an excellent post in The Atlantic where he examines the fundamental problem in social sciences, "How do we know that what we are doing is right?" His illustration of the complexity of drawing causal relationships in social sciences is spot-on,
We can run a clinical trial in Norfolk, Virginia, and conclude with tolerable reliability that "Vaccine X prevents disease Y." We can't conclude that if literacy program X works in Norfolk, then it will work everywhere. The real predictive rule is usually closer to something like "Literacy program X is effective for children in urban areas, and who have the following range of incomes and prior test scores, when the following alternatives are not available in the school district, and the teachers have the following qualifications, and overall economic conditions in the district are within the following range." And by the way, even this predictive rule stops working ten years from now, when different background conditions obtain in the society.
He suggests that the only way to increase the probability of success with such predictive rules that emerge from an RCT is to build as large an array of results of the same phenomenon, both from experimental and non-experimental studies, as possible and then use them to refine the original finding.
What we really need to do is to build a distribution of results of "experiments + model" in predicting the results of future experiments... We can then then compare the accuracy of such a theory this to analogous distributions of predictions made by non-experimental methods (that can vary from sophisticated regression models to newer machine learning techniques to prediction markets to the judgments of experts, and so on) for predicting the results of future experiments... 

Even if I have such a distribution of results for the predictions made by various methods, I can't ever be absolutely certain that this distribution won't suddenly change... But I think this is as close as you can get. What this demands, of course, is a lot of experiments. This is why lowering the cost per test is so critical. Not just as an efficiency measure, but because in practice in enables me to get to much more reliable predictions of the effects of my proposed interventions.
I have no problem with Manzi's suggestion to use a distribution of results to increase the predictive power of any social or public policy intervention. But it has important implications, especially given the time and resources that would have to be expended to acquire such a rich distribution of results for each issue.

Since interventions vary widely in complexity, there is a need to define some standards for collecting the distribution of results. Certain interventions like the impact of deworming or default savings accounts may not need the exhaustive collection of examples to draw fairly reliable predictions or conclusions. But certain others, like a particular type of classroom instruction model or a specific performance incentive to teachers, may need results from a wide diversity of field conditions, to establish their robustness. However, for a number of interventions, we may never be able to draw reliable enough predictive inferences even from a large distribution of results.

The collection of a number of results of all types from varied social and political environments will help tease out policy design elements that illuminate both successes and failures. Any policy tailored based on this collection of results will stand a greater likelihood of success. 

I believe that the development of an analytical framework to triage interventions and thereby more effectively use experimental and non-experimental data to design social policy interventions should be the next most important area of research in the years ahead.

Wednesday, May 16, 2012

Jaime Dimon and "regulatory capture"

Amidst all the discussion surrounding JP Morgan Chase's bet on corporate debt derivatives going terribly wrong, this from Eliot Spitzer, highlights the severe structural problems in Wall Street. The presence of JP Morgan Chairman Jamie Dimon - who lobbied aggressively to redefine the meaning of hedging under the Volcker Rule that was proposed to curb proprietary trading by deposit taking commercial institutions (banks) - on the board of the New York Federal Reserve should constitute as one of the most egregious and shameful examples of "regulatory capture",
Jamie Dimon sits on the board of the New York Federal Reserve Bank - the very organization that is supposed to oversee his bank’s financial practices, the organization that is supposed to issue all sorts of regulations that control what his bank can do, the very organization he has been lobbying to relax the rules about the bets he wants to make...
The Fed conflict is so obvious that it defies any possible rationalization or explanation. For a decade, the New York Fed has failed to pick up on any of the significant Wall Street threats:  excess leverage, subprime fraud, dangerous concentration in “too big to fail” entities.  Maybe the reason is that the board is controlled by the very voices that have been at the root of the failure. There has been not the slightest voice of protest from the board—yet it is a public organization!
By any yardstick of propriety, leave alone decency, Jamie Dimon and all others similarly placed should recuse themselves from the NY FRB Board. See this, this, this, this, this, and this about how JP Morgan's corporate debt derivatives bet went wrong. See also this on why the New York Fed is rife with conflicts of interest and incentive distortions.

Update 1 (7/7/2012)

The scandal that erupted in the aftermath of revealations that Barclays rigged its interest rate estimates used to calculate LIBOR once again spotlights attention at the rotten core of global banking. 

The London Interbank Offer Rate (LIBOR), which is a measure of the rate at which banks borrow money in the money markets, is released each day by the British Bankers’ Association (BBA), covering 10 currencies and 15 different maturities. The Libor rate is used to set rates for some $800 trillion in global financial transactions from derivatives to consumer lending. More than $10 trillion in loans to businesses and consumers have interest rates based on Libor, with the borrowers paying more or less depending on where Libor is on a particular day. Many derivative contracts are also based on it. The BBA collects the rates at which each bank says it could have borrowed money that day without putting up any security for the loan. The highest and lowest responses are thrown out, and the rest are averaged to produce a number. There is no need for any bank to show that it actually borrowed at the rate it claims.
Barclays rigged the LIBOR by manipulating its estimates to suit its interests. During the financial crisis, it low balled its estimate of borrowing rates so as to reassure everyone of its creditworthiness. At other times, when its trading positions called for lower rates, it lowballed its estimates even if it reduced the interest income received by the bank. The FT was scathing in its verdict,
The bankers involved have betrayed an important public trust – that of keeping an accurate public record of the key market rates that are used to value contracts worth trillions of dollars. They did this to make money and to conceal from the wider world their true cost of borrowing. This was market-rigging on a grand scale. It is hard to think of anything more damning – or more corrosive of the reputation of capitalism.
The always incisive Simon Johnson points to Dennis Kelleher of Better Markets, who has a devastating critique of the major banks that have been colluding to rig the LIBOR,
The Libor interest rate is based on a survey of banks like Barclays.  Those banks know what that the information they provide in that survey sets the Libor rate, which is then used to set the rate for those $800 trillion-plus transactions. What Barclays settled - and what the other banks are being investigated and sued for - is knowingly and intentionally providing false information that they knew would result in a false Libor rate being set. This is not some isolated sales practice or trading strategy. The allegations are of a massive conspiracy involving 20 or so of the biggest banks in the world manipulating one of the most important rates in the world. So this isn't about Libor - this is about Lie-More.

That seems to be the business model for the big global finance houses.  They like to call themselves "banks," but they aren't banks in any traditional sense. They are global behemoths that are not just too-big-to-fail, but also too-big-to-regulate and too-big-to-manage. Take JP Morgan Chase for example. It has a $2.35 trillion balance sheet, more than 270,000 employees worldwide, thousands of legal entities, 554 subsidiaries and, as proved by the recent trading losses in London, a CEO, CFO and management team that has no idea what is going on in their own bank.

Tuesday, May 15, 2012

Limits of technology in public policy interventions

We consistently underestimate the last mile gaps that are pervasive in society. Despite several ubiquitous examples of failures, we mistakenly continue to believe that technology fixes or regulatory diktats will help address social policy issues.   

Sample the fate of the parking ticket vending machines installed at a few locations in Hyderabad city,
The much-talked about parking meters installed in the State capital to automate the disbursement of parking tickets is proving to be futile as the vehicle-owners are not evincing any interest in utilising the facility... But due to the lack of public participation... (the company) which maintains the machines, is now forced to employ contract workers to issue the tickets... a motorist has to go and take the parking token. But none of them prefer to do it... Motorists are used to paying money and obtaining the tickets and so they are reluctant to walk down to the parking meters.
It is obvious that the opportunity cost of walking across to the parking meter, dropping the coins and generating a parking ticket is too high. There are two elements to this cost. One is the deeply internalized behavioural inertia against this additional exercise, especially when motorists are so used to getting tickets from parking attendants.

Two is the minimal cost associated with not generating the parking ticket. Without strict supervision, motorists would simply drive off without making the payment. However, if supervisors are appointed and monitoring is made rigorous, then (given the numbers required to supervise even small stretches) the cost becomes prohibitive and defeats the purpose of installing such devices. We could as well have a more efficiently run outsourced parking attendants (equipped with electronic billing machines) based system. And there is always the danger that the supervisors will themselves start collecting illegal parking rents.

Lowering the opportunity cost would involve inculcating a sense of civic responsibility among motorists and also increasing the cost of non-compliance (by prohibitive fines or vehicle tow-aways). But both these solutions run into problems when examined from the lens of real-world implementation. The first takes a long-period of continuous use of such parking meters, apart from issues related to general socio-economic development. The second poses significant enforcement challenges and compliance costs.

So, at this stage of the country's development, except for a few locations (where civic responsiveness is likely to be higher), the traditional attendants based parking regulation appear the more realistic proposition.The availability of cheap labour only serves to increase its attractiveness.

Monday, May 14, 2012

Eurozone - fiscal irresponsibility was not the problem

The Eurozone crisis is far from a simple story of fiscally irresponsible governments running up huge debts that they are now struggling to repay.

As the graphic below shows, public debt as a percentage of GDP has remained remarkably stable for most countries since the mid-nineties. In fact, it even declined for countries like Italy, Spain, and Ireland - all currently accused of being among those most fiscally irresponsible. Even Greece did not suffer anything like the spectacular explosion in public debt that has currently become conventional wsidom. Now, once the crisis exploded and economies tanked, the sovereign debt ratios have risen steeply and have become dangerously high for many of them.

In fact, apart from Ireland, none of these economies accumulated debt much higher than the prevailing average debt levels for developed economies.

Even government expenditure as a percentage of GDP has remained more or less stable. The graphic below does not have the signatures of the classic fiscal irresponsibility induced financial crisis and economic recession. It exploded in Ireland. But in Greece, Spain, and UK, while it did increase, but not at a rate that merited a financial crisis and recession of this magnitude.

So are households responsible? While household consumption did rise in Ireland and Greece, it was remarkably stable elsewhere. These are not the usual indicators of a crisis of this magnitude.

Clearly closer scrutiny is required. More than government and household balance sheets, those of non-financial corporations and financial institutions in the peripheral economies today look unsustainable.

The massive inflow of cheap capital in the aftermath of the currency union led to unsustainable resource misallocation and bubbles. Construction activity and real estate markets in many countries boomed. Ireland, Iceland, and Spain, were the three worst affected by this misallocation problem. In fact in Spain, financial institutions have accumulated 323 billion euros ($418 billion) in real estate assets, of which 175 billion euros was labeled “problematic” by the Bank of Spain last year. Notice that construction activity declined throughout this period in Germany.  

Corporates across manyof these peripheral economies binged on these inflows. As the graphic below shows, corporate borrowings boomed, especially in countries like Spain. Again Germany stands out in its restraint. As the Times recently wrote, the Spanish debt crisis is built on corporate borrowing, and its nonfinancial private sector debt at 134% of GDP is higher than any major economy in the world with the exception of Ireland.

There are two immediate crises that need to be addressed. The most important is the banking crisis, which directly impinges on institutions in the center and the periphery. The core economy banks remain heavily heavily exposed to the peripheral economy banks. As the saying goes, it becomes your problem if someone has borrowed a million dollars as against a few hundred dollars. If recent events are any indication, Spain looks set to go down the Ireland route and nationalize its banking system so as to avert a full-fledged banking crisis.

A series of reform measures have been announced by Spain, where three-fifths of Spanish banks’ €310bn property lending exposure is “problematic”. Increased provisioning for bad loans, including the possibility of a "bad bank" (like was done in Ireland in 2009) to house these "problematic" loans, so as to restore market confidence and ease the credit markets, are among the reforms. Then there are the larger Eurozone reforms required - ECB to become a lender of last resort, the creation of a European Deposit Insurance and Resolution Fund. One immediate policy change could be to permit the euro zone’s new bailout fund, the European Financial Stability Facility, to lend directly to struggling banks rather than solely to national governments.

Then there is the challenge to prop up economic activity. The private sector is hobbled with the double whammy of badly bruised balance sheets and badly frozen credit markets. Households too are in no position to step in with the big-bang required to boost aggregate demand. In the circumstances, there is no alternative to some form of government spending and significant external support. In a recent FT op-ed Nouriel Roubini suggested "monetary easing by the ECB, a weaker euro, fiscal stimulus in the core, less front-loaded austerity in the periphery, more international firewalls and debt mutualisation".

But unfortunately, austerity remains the preferred medicine. A starving man is now being deprived off his only remaining source of food. And all this, even at the cost of pushing him to death, is to drive home the message of prudence and eliminate any moral hazard of him becoming lazier still. 

Saturday, May 12, 2012

Income concentration in India

Just 1.25% of India's income tax assessees, or 406,000 people, with annual earnings above Rs 2 million paid Rs 932 bn or 63% of total personal income tax collections in 2011-12! Our total tax-payer base is 32.5 million.

Which is the most elite school in the world?

Just under half of France’s 40 largest companies are run by graduates of just two schools: ENA, the national school of administration, and the École Polytechnique, which trains the country’s top engineers. Together the schools produce only about 600 graduates a year. There are fewer than 6,000 ENA graduates alive today, compared with at least 160,000 Oxford alumni.
(HT: Times)

Thursday, May 10, 2012

Some lessons from the sub-prime crisis responses

There are very few counterfactuals in social sciences. The closest to such a counterfactual are the contrasting responses of US and Europe to resolving their respective financial market crises. Though in recent months, Europe has taken steps to emulate the US, the initial responses across both sides of the Atlantic bear a striking contrast.

In the US, at the first signs of the sub-prime crisis bursting, the Treasury and the Federal Reserve aggressively intervened to contain the damage. The Treasury came forward with its Troubled Assets Relief Program (TARP) to directly assist the beleaguered banks and other financial institutions with equity injections. The Federal Reserve expanded its balance sheet many times and initiated quantitative easing programs to emerge as the lender, insurer, and buyer of last resort for the financial markets.

However, across the Atlantic, driven both by lack of similar political resolve and strong ideological predilections, the Eurozone governments and the European Central Bank refrained from aggressive intervention. They let events take their own course in the hope that markets would soon resolve the issue. Credit markets froze, driving up sovereign debt yields and nearly shutting off the peripheral economies. Banks, saddled with massive sovereign debt exposures, stumbled to the brink. The ECB refused to lend either to the banks or the battered sovereigns. It stepped in finally only when the situation had worsened considerably.

The contrasting fortunes of both economies, atleast their respective financial sectors, is a clear verdict on the policy courses followed on both sides of the Atlantic. Europe stares at a potential Japan like financial dystopia, whereas American financial institutions have recovered smartly and are back to doing all those things that caused the sub-prime crisis! However, there are a few quick learnings from the situations across both sides,

1. The loudest message from the two different courses of action is that markets do not repair themselves and when faced with such deep financial market crises, governments and central banks have to step in with aggressive policies.This becomes all the more important as the complexity of our banking systems increase and the too-big-to-fail syndrome become entrenched.

2. Related to this is the central and disproportionate importance that financial markets have come to assume in determing the economic fortunes of a country. Despite the fact that the financial sector occupies a far less share of both the economy and the working population, its good health is critical to the fortunes of any modern economy.

3. Similar to the stark contrast between the US and European responses is the difference between the responses by the US Government and the Fed to the condition of over-leveraged financial institutions and debt-ridden individual households. The latter received nothing like the unlimited and cheap liquidity injections, debt rescheduling at very favorable terms, and sweeping credit guarantees offered to the financial institutions. Household foreclosures, even when it happened in a massive scale, became a source of concern only when it threatened to affect an exposed financial institution.

In other words, the disciplining elements of the free-markets are reserved for individual households and small business firms, while the financial sector behemoths, the much trumpeted success stories of deregulated free-market capitalism, face no such constraints. The negative externalities created by financial institutions do not get internalized.

4. All this highlights the increasingly sharp cleavage between the real economy and the financial markets. Are the gains of the financial markets, especially their outsized wins, coming at the expense of the real economy? Is there a recession or even a depression lurking at the end of a sustained period of financial market boom? The financial markets, especially in their current avatar, appear to have become too big a systemic risk to be left as it is.

Wednesday, May 9, 2012

The great lending reversal

Historical stereotypes show that the rich owed a great share of their incomes to leverage. They invested borrowed money in remunerative enterprises and leveraged it to raise their incomes. In contrast, the middle-class and poor were seen as debt-averse and relying on debt only when forced into it. However, as this IMF study indicates, the roles, atleast in terms of the debt-aversion of the non-rich, appear to have changed. Sample this evidence from the US,
In 1983, the top 5 percent had 80 cents of debt for every dollar of income, while the remaining 95 percent had 60 cents for every dollar. By 2007, after decades in which an increasing share of income flowed to the top, the situation had reversed. The top 5 percent had 65 cents of debt for every dollar of income, while the remaining 95 percent had $1.40 in debt for every dollar.

The authors use cross-country data and develop models that try to simulate changes in income distribution and household debt to GDP ratios and its impact on the economy. Their DGSE model, where workers income shares decline at the expense of investors, show,
Loans to workers from domestic and foreign investors support aggregate demand and result in current account deficits. Financial liberalization helps workers smooth consumption, but at the cost of higher household debt and larger current account deficits. In emerging markets, workers cannot borrow from investors, who instead deploy their surplus funds abroad, leading to current account surpluses instead of deficits.  
In other words, the only way to sustain high levels of consumption and national aggregate demand growth in the face of stagnant incomes was for poor and middle-class households to borrow. And its result is widening inequality and eventual debt-default which brings down the whole economic edifice. 

They therefore argue that the only sustainable way to reduce this is to address the critical issue of stagnant incomes. It is now well-established that markets do not generate efficient outcomes with income distribution. The prevailing balance of power in the economic structure and its hand-maiden political establishment, are too skewed to generate the desired level of income distribution.

To address the immediate challenge of debt-reduction among households, an "orderly debt reduction" wherein the process takes a few years may be the most appropriate method. In the medium to long-run, given the skewed distribution of incomes between labour and capital, this market failure will have to be addressed through an institutionalized mechanism that restores some element of collective bargaining. 

India's ratings plateau?

The S&P recently put India on the watchlist for a ratings revision downwards from its current investment grade. Without debating the merits of the downgrade, there is a troubling trend from this, especially when comparing our ratings trend to that of other emerging economies.

The graphic below, a composite measure of the ratings of all the three major rating agencies, shows that India moved up to investment grade rating in January 2007. However, unlike all its other partners, in a fairly accurate reflection of the political paralysis that has gripped the country, it has remained there for the past more than five years.

Tuesday, May 8, 2012

Why Able Abel has to be taxed?

Karl Smith points to this morality tale by Bryan Kaplan,
Suppose there are ten people on a desert island. One, named Able Abel, is extremely able.  With a hard day’s work, Able can produce enough to feed all ten people on the island.  Eight islanders are marginally able.  With a hard day’s work, each can produce enough to feed one person.  The last person, Hapless Harry, is extremely unable.  Harry can’t produce any food at all.

1. Do the bottom nine have a right to tax Abel’s surplus to support Harry?
2. Suppose Abel only produces enough food to support himself, and relaxes the rest of the day.  Do the bottom nine have a right to force Abel to work more to support Harry?
3. Do the bottom nine have a right to tax Abel’s surplus to raise everyone‘s standard of living above subsistence?
4. Suppose Abel only produces enough food to support himself, and relaxes the rest of the day.  Do the bottom nine have a right to force Abel to work more to raise everyone‘s standard of living above subsistence?
How would most people answer these questions?  It’s hard to say.  It’s easy to feel sorry for the bottom nine.  But #1 and #3 arguably turn Abel into a slave.  And #2 and #4 clearly turn Abel into a slave.  I suspect that plenty of non-libertarians would share these libertarian moral intuitions.  At minimum, many would be conflicted.
The tale and the conclusions drawn lie at the heart of libertarian opposition to taxation and government intervention. But in the real world, the tale does not end as Kaplan envisions, but goes on. And here is a possible (among many) sequel.
Able Abel knows that he can produce more (of say, dates) and sell it to others and use the money realized to increase the quality of his leisure. He has heard of the neighbouring village island, Fishland, where he can pursue his dream hobby, fishing. So he strikes a deal with his other inhabitants. He offers to transfer a share of his extra production, if they help him with laying a road to transport his produce from the far-off fields to their village. 

Accordingly, the eight marginally able people sell one-fourth of their time to help Able Abel lay the road. However, taking pity on Harry, they also demand that he be provided subsistence feed by Able Abel, who readily agrees. Within three months the road is completed and simultaneously Able Abel has stored enough food for a week to cover his fishing expedition. 

He travels to Fishland and starts fishing. Now the people of Fishland find the dates which Abel eats irresistible and they offer him a deal. If Abel supplies them with ten bags of dates, they will in turn provide him accommodation for his fishing expeditions and also five buckets of fish, which he can take back and sell to his desert island villagers. Abel takes back fish samples to his village. As anticipated, his villagers like the fish and immediately agrees to buy it. 

But again the transportation problem crops up. Abel needs help to lay the road so as to transport dates and fish. Now it is a much longer road and needs help from the people of Fishland too. They all agree to contribute a share of their work in return for a share of Abel's earnings - dates for the people of Fishland and fishes for those from his village, including for Harry. And so the story goes on.
As can be seen, the fundamental issue here is not taxation or other transfers. Able Abel can pursue his economic activity only with help from his co-inhabitants. In the barter-world, this help comes in the form of work-sharing in return for a share of Abel's production. In the modern world, instead of the in-kind transfer, a share of his production or revenues is appropriated, in the form of taxation, to meet the cost of the infrastructure required to carry out that activity.

This help or support required to sustain an economic activity can be in many forms - maintenance of law and order to protect against thieves; mechanism to enforce contractual obligations; infrastructure to transport and store goods, and so on. It is unviable for individual economic agents to establish these support mechanisms. Someone has to co-ordinate the demands of all those needing these support systems and collect the cost required to establish and maintain them. The government steps in to provide them in return for a share in their incomes, in the form of taxation.

As I have blogged earlier, the abler, and consequently those more likely to be rich and well-off, generally benefit greater from these support systems. It is therefore only appropriate that they bear a greater share of the cost required to establish and maintain these systems.

Just as the eight villagers sympathized with Harry and demanded that Abel provide him with a share of Abel's produce in return for their labour to construct the road, there are certain underlying currents of morality in any society. Once social agreement on them break-down, Harry would not be able to rely on society to provide for him. Thankfully, societies today collectively agree on certain minimum moral principles, whose fulfillment they seek to achieve by setting apart a share of the proceeds from the taxation revenues. In simple terms, their willingness to contribute to the establishment of the support systems (which help people like Able Abel disproportionately) is conditional on the fulfillment of these moral obligations. 

To paraphrase Adam Smith, the villagers of the desert island and Harry get a share of Able Abel's produce not because of charity or some moral code or government expropriation, but because his own self-interest encourages Abel to strike the deal.   

Monday, May 7, 2012

Power sector - back to square one?

A report by consulting firm Avendus Securities estimates that, in the absence of any reforms, the cumulative losses of all distribution utilities in India, as a percentage of the nominal GDP, are likely to reach 1.2% by March 2014. This slippage turns the clock back to the pre-reforms era electricity sector, since between 1999-2002 the losses of state electricity boards (SEBs), as a percentage of the nominal GDP, had surged high to 1.2-1.5%. Then the SEBs were bailed out, and the Electricity Act 2003 and Tariff Policy were formulated.

Most worryingly, it also finds that to bridge the widened net gap, the DISCOMs of key states need to raise tariffs at a CAGR of 13–58% in 2012-13 to 2013-14. But the average realized rate (ARR) per unit rose at a CAGR of 1.9-7.0% in 2007-12 period. Even assuming an ARR growth by a CAGR of 11%, it will take nine years for the DISCOMs to achieve profit after tax (PAT) breakeven. But an 11% annual increase in power costs wouldhave a davastating impact on all economic activity. In fact, the report estimates that an 11% annual increase in tariffs may dent industry profits by up to 2.5%.

The net gap, or the difference between revenue per unit purchased and cost per unit purchased, rose up to Rs 2.6/kwh in key states.

States like Rajasthan, UP, TN, Andhra Pradesh, and Madhya Pradesh would have to significantly raise tariffs if they are to recover from their present situation. 


It also finds that, as of December 2011, banks, PFC, and REC had outstanding loans of  Rs 5,031 bn to the power sector. Out of this, 50% of the loans to the work in progress (WIP) generators and 90% to DISCOMs are likely to be at risk. This would amount to Rs 1,627 bn, or 32% of the banks, PFC, and REC's exposure to the power sector.

The major contributors to this return to pre-reforms era weaknesses are multiple failures in cost recovery (read, stagnant tariffs), significantly lowering distribution losses, reforming the provision of free power to agriculture, and meeting capacity addition targets. The sole bright spot has been the doubling of the share of private generators in installed capacity from 10% to 20% over the March 2002 to February 2012 period. Furthermore, 62% of the current capacity addition projects are being executed by private companies.

The report recommends three next stage of power sector reforms - allowing pass through of imported coal costs, tariff increases by DISCOMs, and expedited approvals for captive mining coal blocks. Recent examples of changes in Indonesian mining law and additional taxes imposed on miners in Australia has led to a rise in costs and made many PPAs economically unviable.
likely to restore the economic viability of private investments into such projects.

This is all the more troubling given the massive quantity of WIP generation capacityaffected by this. Out of the coal-based WIP capacity of 95000 MW, 31% being executed by state and central generators are to be sold on a cost-plus basis to DISCOMs, while of the remaining 69% executed by private companies, 59% (includes both PPAs and merchant plants) does not have cost pass-through. 

Another major concern is with the slow pace of regulatory approvals for coal blocks allotted as captive mines. An estimated thermal capacity of 45000 MW was approved in 2006-10 with fuel linkages to undeveloped captive coal reserves. However, the Ministry of Environment's refusal to accord regulatory clearances have held up their development. The report estimates captive mines to support upto 41000 MW of capacity addition when they are fully exploited.

In the absence of tariff increases, the debt-laden and fiscally strained DISCOMs are averse to purchasing power from traders and exchanges. Instead, they prefer to suppress demand with massive load -shedding. This in turn keeps the demand down and keeps merchant generators from operating at their full capacity. Faster regulatory approvals for captive mines will reduce the reliance on imported coal.

In this context, the Planning Commission appointed Shunglu Commission has made several recommendations to reform the distribution utilities. It has suggested the establishment of an SPV to buyout the distressed debts of banks to DISCOMs, with about 76% of its share capital to be owned by the RBI and the rest by PFC and REC. The loan repayment would be rescheduled after the states and their DISCOMs agree to certain pre-conditions on tariff increases, operational parameters, interest rates, repayment period etc. The RBI would then provide a line of credit to the SPV for buying the debt from the respective banks. This report also advocates that in an event of the DISCOMs defaulting on their ARR filings, the SERCs would have the power for suo-moto tariff revision. Further, in case the DISCOMs default, the state governments would have to repay the loans.

Sunday, May 6, 2012

What ails Eurozone?

This from Ezra Klein is instructive, 
After it joined the euro area in 2001, Greece went from paying about 7 percent interest on a 10-year bond to a bit more than 3 percent because investors assumed that its debt was backed by Germany and the European Central Bank. This encouraged profligacy in Athens.
When the European economic and monetary union (EMU) became operational from 1 January 1999, all the peripheral eurozone economies experienced windfall gains from the sharp reduction in bond yields and resultant cost of borrowing. Over a four year-period, beginning 1995, the bond yields more than halved and converged around 4% across most of the eurozone economies (see graphics on France, Spain, Portugal, Greece, Italy, Ireland, Belgium).

Governments and, especially, corporates piled up debt, especially by way of borrowings from banks in the core area economies, as they splurged on this sudden access to cheaper capital, triggering off resource mis-allocation and asset bubbles. The boom also led to rise in wages and input prices, with the resultant decline in relative economic competitiveness. Therefore, deleveraging and restoration of external competitiveness is critical to a sustainable resolution of Eurozone's problems.

Update 1 (7/5/2012)

Paul  Krugman has this excellent analysis of how Germany managed its successful reforms last decade. As he writes, Germany benefited hugely from an export boom, driven by a combination of inflation in its periphery and rise in trade competitiveness vis-a-vis its Eruozone partners.

Update 2 (10/5/2012)

Spain is a classic example of a country brought to its knees by reckless private external borrowing. Even today, the government debt as a percentage of the total economic output for Spain is a relatively low ratio of 70 percent, compared with 165 percent for Greece and 120 percent for Italy. But, according to a recent report by McKinsey on global debt, Spain’s nonfinancial private sector debt is 134 percent of gross domestic product, higher than any major economy in the world with the exception of Ireland, where the figures are skewed by the outsize presence of foreign multinationals. Factoring in bank, household and government obligations, the total figure rises to 363 percent of GDP, trailing only Japan at 512 percent and Britain at 507 percent.

Corporates borrowed heavily to invest and to diversify by buying large equity stakes in companies in Spain and elsewhere. Massive public investments in infrastructure helped boost the demand for private supply. The Times writes about a "relentless private sector downsizing in Spain — by individuals weighed down by mortgages and corporations tethered to their boom-time loans — that threatens to make the Spanish economic collapse semipermanent as opposed to cyclical".

Update 3 (23/6/2012)

Jay Shambaugh argues that Euro area is bedevilled by three crises - of banking, sovereign debt, and growth. He writes,
The euro area faces three interlocking crises that together challenge the viability of the currency union. There is a banking crisis – where banks are undercapitalized and have faced liquidity problems. There is a sovereign debt crisis – where a number of countries have faced rising bond yields and challenges funding themselves. Lastly, there is a growth crisis – with both a low overall level of growth in the euro area and an unequal distribution across countries. Crucially, these crises connect to one another. Bailouts of banks have contributed to the sovereign debt problems, but banks are also at risk due to their holdings of sovereign bonds that may face default. Weak growth contributes to the potential insolvency of the sovereigns, but also, the austerity inspired by the debt crisis is constraining growth. Finally, a weakened banking sector holds back growth while a weak economy undermines the banks.

Update 4 (9/7/2012)

Nice article in the Times chronicles how in Spain the regional governments, the regional cajas, and property developers formed a system of trading favors during the boom years. Now that the party is over, the central government is forced to pick up the cost of the revlery.