Corporate India's wish-list is not India's reform wish-list

Times of India carries a wish-list of reforms for the next government to get "growth and development back on track" from some of the distinguished "thought leaders and captains of industry". I am not sure whether this is a wish-list for 'India' or for 'corporate India'.

It is staggering that improving regular governance and public service delivery, poor quality of school education, skills development, universal health care (aside from the Professor), universal social safety net, and so on do not get even a passing mention. In fact, none of the measures proposed have anything to do with rural development. This a testament to how detached corporate India has become from the vast majority of India. It also explains corporate India's attraction for economic growth, with little concern for its distributional consequences.  

I have no issues with corporate leaders championing their private business interests. But the problem starts when purely partisan lobbying masquerades as promotion of national development. What is in India's national interest goes much beyond what is good for corporate India. And evidently "captains of (Indian) industry" are not exactly the best proponents of "general national interest". 

Industrial Policy is not just about clusters and concessions

A Business Standard article writes,

At the aggregate level, SEZs appear to have made a significant contribution to investment and exports. They have received investment of over Rs 2.39 lakh crore. Exports from SEZs have seen a dramatic jump from Rs 22,840 crore in 2005-06 to Rs 4.76 lakh crore in 2012-13. But a disaggregated analysis is less favourable. Of the 589 formally approved and 389 notified SEZs, only 170 are operational. Further, only two SEZs accounted for nearly 42 per cent of the total SEZ exports in 2011: the Jamnagar refinery and DLF Infosys Mangalore. The share of FDI also remains abysmally small. Not only that, the proposed FDI in newly notified SEZs has been declining. It has declined from Rs 34,509 crore as on 31 December 2009 to Rs 30,964 crore in September 2010 and then further to Rs 26,984.4 crore as on March 31, 2012.

A major share of the growth also is a simple case of displacement of economic activity that would in any case have materialized but was attracted to the SEZs by the concessions provided.

It is lazy thinking to assume that we could easily solve our numerous structural problems - onerous labor market regulations, credit constraints, skilled human resource deficiency, infrastructure bottlenecks, excessive and costly business regulations, and weak contract enforcement - by establishing enclaves of industrial activity and providing concessions to encourage businesses. The New Manufacturing Policy (NMP) too makes the same mistake, little realizing that much the same has been happening since 1965, with limited success.

Most of the efforts of state and central governments at improving business environment has focused on providing fiscal and other concessions, overlooking the other more important challenge of removing structural and regulatory barriers to doing business in India. India's manufacturing will grow not because government will set up a few industrial zones or provide concessions. It will happen when we addresses the aforementioned structural problems and creates economy-wide (and not merely restricted to some clusters) conditions required for achieving global competitiveness. And that goes way beyond cosmetic solutions. 

Some thoughts on a second-best contracting in oil and gas

Kazakhstan's Kashagan oil field can easily lay claim to being the most expensive infrastructure project in the world. Discovered in 2000, the off-shore oil field in the North Caspian Sea is widely considered the largest oil discovery in the past 30 years. It is estimated to hold 35 billion barrels of reserves and 10 billion barrels of recoverable oil, and 1 trillion cubic meters of natural gas.

The field is being developed by North Caspian Operating Company (NCOC), a consortium of state oil firm Kaz Munai Gas, Italy's ENI, US Exxon Mobil, Royal Dutch Shell, and France's Total, each holding 16.81% share, China National Petroleum Corporation (CNPC) with 8.3% and Japan Inpex 7.56%. Though the field is estimated to produce a staggering 8 mbpd by 2014 and 12 mbpd by 2015, it has so far not produced anything despite 13 years of development and nearly $55 bn in investment. This has to be seen against the original investment estimate of $10 bn.

The Kashagan field is a good example of the challenges with off-shore oil and gas exploration. The standard PSCs have royalty payments or taxes predicated either on a return on investment or calibrated cost recovery. Exploration firms are wary of the geological and other technical risks, apart from the various expropriation and other political risks, that can potentially cripple them. Governments become too eager to lay their hands on the massive windfall from the newly discovered reserves.

The fundamental issue with any PSC is how the royalty payments should be structured so as to provide adequate comfort for investors without compromising on the interests of the government. Too liberal an arrangement, especially those that allow developers to scoop windfall gains when oil prices rise, increases expropriation risks. A conservative PSC, with back-loaded cost recovery, increases the risks for investors and thereby discourage exploration.

The exploration firms prefer front-loaded production sharing contracts (PSCs), where they try to recover their investments as quickly as possible. Governments prefer to go the other way, back-loading royalty outflows so that they can start getting their share as soon as production starts. The commercial attractiveness of participating in large fields coupled with incentive distortions within governments (say, corruption) means that incomplete PSCs are inevitable in such environments.

Incomplete PSCs have spawned a series of re-negotiations. International experience, not just in oil and gas, shows that these re-negotiations, done when the project has run into crisis, generally benefit the concessionaire. In the final analysis, the government ends up conceding more than what the concessionaire had demanded before the original contract was signed.

Apart from its strategic value, governments are attracted to oil and gas by the large profits from it. Since the marginal cost of production of oil is often $15-20, and the prevailing market prices are in excess of $100, the business is extremely profitable. Both governments and exploration firms eye this massive differential, or oil rents. Each tries to pursue contracts which protect their interests, mostly at the cost of the other.

It is therefore no surprise that there are not too many successful examples of "fair" sharing of oil rents across the world. The more successful example comes from Australia's resource tax, which tries to reconcile the interests of both government and the exploration firm. It allows firms to make a profit of 10% return on investment before royalty payments being. After this, a progressively increasing tax/royalty kicks-in, so as to capture the windfall that comes from higher oil prices. In fact, the royalty rate is smaller in the initial years and increases with time. Its success also depends on the country's credibility with the investors as well as its strong institutional capacity to monitor investments.

This also means that its replicability to developing country contexts is limited. Country risks, especially high in the oil sector, is not very readily mitigated, if at all. Reliably assessing capital investments, especially in off-shore fields, so as to monitor PSC's is most often beyond the competence of national regulators, especially of the smaller economies.

Experience from across the world shows that simple gross production royalty-based PSCs, as in the US, are not likely to be effective. The peculiar nature of natural resource ownership (in the US, land owners own the natural resources underneath their land) that has allowed private individuals (and who prefer the simpler signing bonus plus royalty arrangements) to allow prospecting on their lands coupled with the country's strong institutional systems have been critical to the success of this model in the US.

Such PSC's, which transfers to the government a share of the revenues or output, as soon as production starts and without waiting for the investors to recover their costs, are simple to monitor. But this regulatory simplicity comes with sub-optimal risk allocation. They extend the project cost recovery period, thereby amplifying the risks borne by investors.

Oil exporting countries have tended to view the sector from the perspective of revenue maximization whereas importers have sought to incentivize investments in exploration. India belongs to the later category and this should continue to form the basis of its petroleum policy. But, as a second-best alternative, a more sophisticated PSC may be the best bet for countries like India. It should include certain features.

1. The PSC should provide adequate flexibility for investors to recover their investments within a reasonable period of time. The investment recovery schedule should be carefully structured, with annual cash-flow being distributed in some proportion between recovering investments and profits from the first year itself. Here too, the share of "profit oil" can be structured to increase slowly with time. 

2. The contract should seek to cap the upside beyond a reasonable level. This is sound economics and prudent politics. It would discourage the developer from changing production in response to global price signals, and also minimize the prospects of popular backlash if world prices rise high enough to generate windfall gains. An Australia type progressively increasing tax regime enables the government to capture a large share of the upside.

3. Given the limited competition in oil exploration and refining, most governments have sought to keep their respective national oil companies involved in exploration projects, in even those with private developers. While their role has varied widely and government's motivations have been revenue maximization, it has served to keep the private firms honest besides enabling governments retain control over the project. It may therefore be prudent to keep the ONGC involved in these projects.

4. Regulatory regimes in complex markets like oil exploration should not be cast in stone. Regulators should constantly learn from ongoing contracts and refine provisions, prospectively, to optimize the contractual outcomes for both sides. This is especially so since the underlying price signals in markets like that for natural gas are heavily distorted and can change dramatically with policy changes by important governments - imagine the impact on JCC prices due to a liberalized LNG export regime in the US west coast.

The success of such PSCs depend critically on the regulator's capacity to reliably monitor investments. For a country like India, whose bigger concern is incentivizing investments and boosting local production, an arrangement that suitably takes into account the interests of investors may be a more prudent way forward. India, which is a large fuel importer, and is therefore primed to encouraging investments, should strongly consider the establishment of a small highly competent group to help regulators enforce PSCs. In this context, the Brazilian National Petroleum Agency, which has highly competent professionals, remunerated at higher than regular public sector wages, is an example worthy of emulation.

All this is no certainty for a successful oil and gas exploration policy. But, given the complex nature of the issue, it stands a greater chance of success. 

India's structural transformation challenge

There is now strong evidence that countries grow not by producing more of the same goods but by producing more goods of increasing complexity. Prof Ricardo Hausmann describes this in terms of a country's capabilities (or tacit productive knowledge), which are encapsulated in the products it makes. Countries grow when they acquire more capabilities, and upgrade, or move up the product ‘escalator’, from their current products to other, usually more sophisticated products. But this movement, commonly described as structural transformation, is easier between closely related products, or where there exists complementarities in the required capabilities. 

What has been India's performance with the process of structural transformation? Let me highlight the trends using data from World Bank's World Development Indicators and trade data from the CID's Atlas of Economic Complexity.

Among countries with similar percapita GDP, Indian economy has always had a very high level of complexity, as endowed in its export products. In fact, even as late as 2000, India's Economic Complexity Index (ECI) has been similar to that of China.

This has remained so till about 2005. But since then, the two countries have diverged sharply in their respective paths up the escalator, with China pulling away from India.

It's not just that China has pulled away with a dramatic structural transformation of its manufacturing economy, it has also been that India has stagnated, performing slightly worse than countries with similar per capita GDP.

This story is all the more surprising since India's product diversity provides it a very favorable location in the product space, better than any other country, including China. In other words, given its current product space, India is best positioned to jump into more complex products which leverage the existing production complementarities.

But, despite the initial advantages and vast opportunities, India has not been able to capitalize in moving up the manufacturing value chain (or industrial escalator). In fact, its opportunity value has increased in the 1998-2000 period, another pointer to the failure to realize the potential opportunities to move up the value chain. It is also a reflection of the relative stagnation in its manufacturing sector. As a corollary, the decline in China's opportunity value in the same field comes from the fact that it has realized much of the gains from moving up the escalator.

Clearly, the slow pace of structural transformation is a binding constraint on India's economic growth. This is also evident from various other measures of a stagnant manufacturing sector. Manufacturing's share of the GDP has been stagnant at 14-16% for more than three decades, a period which saw the rise of the East Asian economies.

Interestingly, as the graphic above shows, unlike the others, India has traditionally had a disproportionately small manufacturing base. So it is clear that there are deep structural constraints that prevent growth of the country's manufacturing sector, and they have been binding all along our recent history.  

Market competition and student learning outcomes

The latest PISA report is out. The big stories are the expected consolidation at the top by the East Asian countries and the surprising decline of the poster child of school education, Finland.

An equally interesting story is the even bigger decline of another traditional high performer, Sweden. In the 2006-12 period, it has fallen precipitously from 21st to 38th position in Math and 10th to 37th in Reading, both easily being the worst performances in the respective categories. What explains this trend?

Interestingly, over the past two decades, Sweden has undertaken certain fundamental reforms in its education system, most notably the increased involvement of private sector. Private, for-profit schools, Friskolas, were allowed, and parents were given tax-funded vouchers to pay for a school of their choice. The result is that almost a quarter of the country's secondary school students attend voucher-funded private schools, almost twice the global average. A recent report wrote,

Sweden replaced one of the world's most tightly regulated school systems with one of the most deregulated.. . The private schools brought in many practices once found exclusively in the corporate world, such as performance-based bonuses for staff and advertising in Stockholm's subway system, while competition has put teachers under pressure to award higher grades and market their schools.  

Many of the outcomes were completely predictable. Private participation and deregulation was accompanied by the inevitable problems of deteriorating quality. The Schools Inspectorate has found high-profile cases of private operators focusing merely on getting students to pass-grade instead of improving quality, stocking up on temporary teachers without required qualifications, and schools without adequate facilities. And the inexorable logic of choice,

As the best students flock to certain schools, standards suffer at the schools they leave behind. 

For the researchers and education "experts", who spend millions of dollars with sanitized micro-experiments of all kinds to assess the effectiveness of school-vouchers and private participation in education, the results from Sweden should be of much greater interest. In particular, Sweden's experience has much to enlighten about the debate about school vouchers. Furthermore, it is also a very good test case for the scaled version of the school voucher system, private participation, and deregulation. Since it has been on for nearly two decades, its general equilibrium effects are a more reliable barometer of such complex reforms.

Correlation is not causation. But neither is experimental research the gold-standard for determining causation. My only brief here is that we need to tread with extreme caution with such profound school reforms. Any aggressive push for private participation in schooling, especially in countries with weak state capability, is most certain to fall far short of expectations.

The PISA test assesses math, reading, and science competencies of more than half a million 15-16 year-olds in 65 countries/regions representing 28 million children of that age group. It is widely acknowledged as a touchstone for schooling excellence, including conceptual understanding, in all major countries of the world, except India!

Ireland's non-recovery?

Ireland, which received a $92.9 bn bailout in return for a very strong dose of austerity, apparently has become the first crisis-hit European country to regain market access. Its fiscal deficit has shrunk from 30% of GDP in 2010 to 7.5% for 2013. But the cost, as this NYT article highlights, may have been prohibitive, 

The government cut 30 billion euros in spending, or nearly 20% of gross domestic product, one of the largest austerity programs anywhere. New taxes were introduced. Salaries for public employees were cut by around 20%, and reductions in unemployment and welfare benefits followed. The bill to bail out Ireland’s banks has amounted to nearly €10,000 per Irish citizen... As the austerity measures have played out, the number of people in need has jumped. Homelessness is up nearly 20% since 2010. A study by Growing Up in Ireland tracking 11,000 families with young children found 67% could not afford basic necessities, and were behind on utility bills, rent and the mortgage.

Consumer spending has been flat. Through the end of the third quarter this year, 18.5% of homeowners had missed a mortgage payment and 12.5% were three months or more behind on their repayments, according to the central bank. Half of all loans to small- and medium-size business are also in arrears. More than 200,000 of Ireland’s population of 4.6 million have emigrated since 2008. Youth unemployment is 28%. Over 60% of job seekers have been out of work for a year or more. And 20% of children now live in households where neither parent works, the highest rate in the European Union.

Ireland's 10 year sovereign bond yields may have plummeted from 14.5% to 3.5%. But in the absence of any economic growth and the sharp cut in public spending, I am not sure how the country can recover fully without prolonged period of slow growth. Even as the economy has been contracting, public debt to GDP has ballooned to over 120%. It will rise further, unless growth picks up smartly in the near-term.

At the same time, unemployment rate has risen to 13% and labor force participation rate has fallen from 64% in 2009 to 60%.

One area where the savage austerity has been successful is in the country regaining its labor competitiveness vis-a-vis Germany. But ironically, the depressed wages are most likely to keep the aggregate demand muted for some time to come, thereby discouraging private investments and in turn further constraining growth.

Update 1 (1/10/2014)

Fintan O'Toole writes about the illusion of recovery from austerity policies, "an unreal image of slimmed-down perfection".

Two more graphs on QE

This striking graphic points to relative equity market performances of regular goods and luxury goods retailers. The sharp divergence in the aftermath of the inception of QE may constitute the largest wealth transfer in history.

Central banks have virtually taken over the bond market. At $1.6 trillion in 2013, central bank purchases account for more than half of all bond market transactions. It is no surprise that taper will have a large impact on the bond market.

Capital markets development in emerging economies

Deepening and broadening of capital markets, in particular debt markets, have been at the top of the agenda for developing countries for many years now. But global experience does not appear promising, a throwback to the original sin hypothesis.

As can be seen, non-financial businesses form a very small share of total national debt. More prominently, government debt takes up nearly half the share of debt in both India and Brazil, thereby lending credence to the crowding-out hypothesis. 
India's non-financial debt market has been growing in recent years, though government dominates the market.

The depth of global financial markets varies widely between developed and developing countries. It is in the range of 400-500% in developed economies, whereas it is in the range of 100-250% in emerging economies. However, in these emerging economies, the share of non-financial corporate debt and securitized loans is minuscule. For example in India, of the 42% of non-financial debt, just 4.8% (or 2% of GDP) is held as long-term bonds. It is no different in China, where while non-financial debt forms 96% of GDP, just 4.1% is held as long-term bonds. In fact, even in Latin America where most countries undertook big-bang capital market liberalizing reforms and put in place state of art regulation, non-financial bonds were just 2% of  GDP.

Globally, the rapid growth in financial stock since 2000 has been led by growth in equity markets, public debt securities, and financial institution bonds. The share of non-financial corporate bonds is relatively small and concentrated mostly in US and Europe.

Clearly, as the graphic shows, there is enormous potential for financial markets deepening across developing countries.

Indian corporates remain overwhelmingly dependent on banks and internal resources for capital mobilization. The share of corporate funding that came from internal resources remain elevated
at 30.8% in 2010-11, just down from 35.8% in 2000-01. In fact, new equity has fallen from 17.2% to 13.8% in the same period. More interestingly, the share of corporate bonds has hardly moved from 3.5% to 3.9%, a far lower than the 17% in China.

Despite the wave of financial market liberalization and the resultant surge in capital mobilization, domestic and foreign, private debt securities markets have remained relatively small. This is stark contrast to the rapid growth in equity markets and bank deposits.

In fact, globally too capital markets have remained elusive everywhere except the US. Globally, equity and bank loans have dwarfed long-term bonds as sources of infrastructure finance.

This trend is evident across Asia, Europe, Middle East, Africa, and Latin America. Only in US and Canada, do capital markets assume a significant share.

Does this mean that the quest for development of long-term bond markets is not a very realistic one? If so, where does the capital for financing infrastructure projects come from?

More on auditing infrastructure projects

Mint reports that India's Comptroller and Auditor General (CAG) has found the Government of India's Civil Aviation Ministry guilty of favoring the private concessionaire modernizing Mumbai airport with "undue benefits" amounting to atleast Rs 5887 Cr (~ $1 bn). The airport modernization project, initiated in 2006, is being executed by Mumbai International Airport Ltd (MIAL), a consortium led by GVK Power and Infrastructure Ltd (GVKPIL).

The latest cost of the project, originally estimated to be commissioned in 2010 at a cost of Rs 5826 Cr, is Rs 11647 Cr and the last completion deadline was for end-2013. The Government, through the Airport Authority of India (AAI) has 26% of equity in MIAL. A few observations from the report.

1. The report finds fault with the MIAL promoters' refusal to raise their equity investments despite the AAI offering their willingness to pare down debt and raise equity. It writes, "It appears that government of India, acting through AAI, was ready to infuse more equity ... the private party was not willing to take risk which is not acceptable." 

This is a surprising observation. Undoubtedly, raising equity would have lowered the cost of capital and the project riskiness, both of which would benefit the government. However, altering the original project capital structure would affect profitability of the original investments. Raising equity, as in this case, would lower the returns on equity investors. Why should MIAL or any other private investor agree to this, even if the government stakeholder is volunteering with more capital? 

2. Another observation by the CAG about the implications of the doubling of project cost on the capital structure is more pertinent. It writes, "It was also noticed that the debt of MIAL has not altered even as the project cost nearly doubled. This indicates that the finance risk for the project was not appropriately transferred to the concessionaire." Most of the increased project cost was passed on to the passengers in the form of higher Development Fees (DF). 

However, it may not be as simple as that. Though it is not clear as to how the upfront investment capital for the cost over-run was raised, it was most probably done through debt issued against the DF cash flow. If that is the case, and even if this debt did not reside with MIAL and is held by another SPV, then it may not be that bad. Then the question of how the cash-flow waterfall (which lays out the charge of various financiers on the net profits) is structured then assumes significance. 

3. The CAG report also finds fault with the Aviation Ministry for not imposing liquidated damages for the construction delays and allowing extension till 2013. Now, almost all big projects, done as PPP or otherwise, suffer delays. Most of these delays are due to context-specific factors that are beyond those of any one actor. Liquidated damages are imposed under exceptional circumstances when the cause of delay is obvious. It is of course possible that the poor governance within the Ministry, a very real possibility, contributed to mis-aligning the incentives of the developer.

While such omissions are not to be condoned, an indiscriminate application of this principle (that all delays should be penalized with liquidated damages), without regard for the extenuating project circumstances (and there are many of them), can be a death knell for many projects. Fear of being hauled up by the auditors is already causing project engineers to not take decisions on even genuine requests for time extension and cost escalation, thereby causing further delays. Policy paralysis is never far away.  

4. The CAG attributes a presumptive loss of Rs 5887 Cr for 11 acres of additional land, over and above that contractually agreed, transferred to MIAL. The basis of this is the estimation that the earning potential of 196.1 acres of land over a 60-year lease period is Rs 104,897.81 Cr. Such presumptive loss estimations are hazardous. In the instant case, as the AAI pointed out in its reply, such estimations may not be reliable in view of the fact that a significant share of the land is filled with encroachments, some including wholesale slums. 

5. The CAG also point out that the creation of eight subsidiaries by MIAL, without permission of AAI, and the outsourcing of its activities on revenue sharing arrangements would be detrimental to AAI's interest. This assumes great significance since MIAL has to share 38.7% of its revenues with AAI and the outsourcing of work will create conflict of interest concerns involving transfer pricing (paying higher prices to the subsidiary and thereby transferring profits) and profit dilution. 

German Manufacturing Lessons

Germany recently recorded the largest monthly trade surplus by any country ever, of €20 billion this September. NYT has two stories that nicely illustrate the reasons behind Germany's success with retaining and growing manufacturing jobs in the country, even as the rest of the developed world struggles with the same challenge. 

The first is a story about Faber Castell, the world's largest maker of pencils, pens, crayons, markers, and other drawing and writing supplies. It writes,

Faber-Castell illustrates how midsize companies — which account for about 60 percent of the country’s jobs — are able to stay competitive in the global marketplace. It has focused on design and engineering, developed a knack for turning everyday products into luxury goods, and stuck to a conviction that it still makes sense to keep some production in Germany.... In contrast to many American companies, like Apple, that have outsourced nearly all production to Asia, Faber-Castell and many other German companies make a point of keeping a critical mass of manufacturing in Germany. They see it as central to preserving the link between design, engineering and the factory floor...

While the basic design of a pencil has not changed much in 400 years, Faber-Castell has managed to find ways to be unique. For example, in the late 1990s, it developed a triangular pencil with raised dots that make it easier to hold. That proved popular. Innovations include the use of water-based coatings to make pencils more environmentally friendly, as well as nontoxic to compulsive pencil chewers...

Even boxes of the highest-quality Faber-Castell colored pencils and artists’ markers can easily cost hundreds of dollars. It is this focus on the premium end of the market that has enabled German companies to survive in markets flooded by low-cost Asian alternatives. Mercedes and Audi cars are good examples of this, but German companies have also achieved similar success with more mundane products like Rösle kitchen implements, Steiff stuffed animals and Falke socks. 

The other story is about the famous German apprentice system which has kept the supply of skilled manpower flowing to meet the demand from manufacturing firms, besides easing labor market problems that have bedeviled other developed economies. About Germany's 1.8 million apprentices, it writes,

In Germany, apprentices divide their time between classroom training in a public vocational school and practical training at a company or small firm. Some 330 types of apprenticeships are accredited by the government in Berlin, including such jobs as hairdresser, roofer and automobile electronics specialist. About 60 percent of German high school students go through some kind of apprenticeship program, which leads to a formal certificate in the chosen skill and often a permanent job at the company where the young person trained.

And about South Carolina's experiment with trying to embrace the apprenticeship system to alleviate shortage of skilled workers,

Still, the close cooperation between employers and the state educational system is unusual, and despite initial skepticism on both sides, apprenticeship opportunities are rapidly expanding both for high-school age students and for older workers. Apprenticeship Carolina started in 2007 with 777 students at 90 companies. It now has 4,500 students at more than 600 companies in the state, with the typical apprentice in his or her late 20s. Mr. Neese’s goal is to have 2,000 companies by 2020... it links the state’s technical college system with private companies to help create specialized programs. 

Replication of the German business culture outside the country may remain a distant possibility, though the adoption of the apprentice model may be a more realistic project. In fact, for countries like India, with ambitious manufacturing sector goals, such apprentice systems may be the only practical way to assure the supply of medium-skilled manpower required by manufacturing firms. 

A "re-negotiations policy" for road projects?

I have blogged extensively on the moral hazard that have been unleashed with the widespread trend of re-negotiations that have gripped the infrastructure sector. Private infrastructure developers have internalized the norm that they can bid aggressively and irresponsibly, as many have done, with the assurance that they can always go back to re-negotiate the terms. India's pernicious culture of crony capitalism encourages the trend.

In this context, the Roads Ministry has proposed to break the gridlock with stalled National Highway Authority of India (NHAI) road projects by restructuring them. There are currently 48 road project developers who are renegotiating the restructuring of premium payments with the NHAI. However, instead of re-negotiating on a project-by-project basis, newspapers report that the Roads Ministry has effectively proposed a blanket policy (I am not aware of the details though) for restructuring premium payments owed by developers. It proposes that the premium payments of developers whose projects are stressed, mainly due to traffic shortfalls, be restructured in accordance with a general policy. The Mint reports on the crux of the Ministry's restructuring policy,

In principle, the roads ministry’s recommended restructuring involves back-ending the agreements with developers to reduce their payments to the government in the initial years of the contract—a move that could help them complete the projects. The ministry and its arm, NHAI, are worried that if projects are stuck on account of financing troubles, developers could start walking out of projects—resulting in a delay in building required infrastructure and losses on account of unpaid premiums. These projects will also have to be re-bid.

It immediately raises the question about why the same internal restructuring of its cash-flows cannot be done by the developers themselves. It needs to be borne in mind that most road developers have a portfolio of projects, with varying levels of profitability, which would facilitate the process of such re-balancing. In fact, the very objective of firms specializing in infrastructure and accumulating a portfolio of projects with a diverse risk-profile and cash-flow patterns, is to leverage their overall balance sheet and mitigate their individual project risks. GMR and the like have clearly internalized the norm that they will view each project as a stand-alone entity, and transfer commercial risks on to the government through the process of re-negotiations.

In simple terms, the Ministry is effectively proposing a re-negotiations policy for all road projects. It is a virtual fait accompli that developers will internalize this policy into their bids, thereby distorting the process of efficient price discovery in the forthcoming tenders. The tendering process would then become just a transit point in the process of arriving at the final contract conditions.

I have been thinking for sometime that, given the inevitability of re-negotiations with many infrastructure projects, it may be an efficient second-best approach, to transparently outline the principles that would define any process of re-negotiations. But we should be careful that it does not become codified into some policy, which would take away from the process of competitive bids that allot these projects. Re-negotiations should be done on a project-by-project basis, and not through a routine application of rules to qualify projects and renegotiate their terms.

Further, in order to discourage any moral hazard, the process has to be accompanied with prohibitive enough haircuts on equity holders. Promoters who bid irresponsibly or with other, less than transparent, considerations have to pay with their capital, and that too a prohibitive enough amount. It will be interesting to see what the Rangarajan Committee, entrusted with formulating a restructuring policy, comes out with. 

NGDP targeting and escaping the ZLB

Much of the innovations in monetary policy in the aftermath of the Great Recession have been driven by the compulsions of monetary accommodation when the interest rates are at the zero-lower bound (ZLB). It started with direct credit injection through unlimited liquidity auction windows, lowering collateral requirements and so on. Then, the quantitative easing policies sought to leverage the central bank's balance sheet by purchasing securities, private and government, undertaking maturity transformations in government securities etc, thereby "rebalance portfolios" to lower real interest rates. Finally, central banks are now, through forward guidance, seeking to shape market expectations through credibly committing to remain accommodative over a long-time horizon so as to restore normalcy in the economy.

The net result of all these policies is that we have had five years of ultra-cheap money and sustained recovery does not appear to be any closer. More worryingly, these policies have induced several distortions in the financial markets. Furthermore, any exit from the accommodation, before recovery has taken firm hold, threatens to destroy both the gains so far as well as trigger off a contagion across the emerging markets.

Amidst all this, the ZLB continues to bind, and looks set to do so for the foreseeable future. This, by itself is severely limiting on the effectiveness of monetary policy, and demands an exploration for new monetary policy frameworks. In this context, a new paper by economists at the US Federal Reserve Board argue that a revised monetary policy framework, like NGDP targeting, may be effective at overcoming the ZLB constraint. It has raised commentaries here and here in Free Exchange.

The paper explores various scenarios of monetary policy over the medium-term and finds that interest rates are not likely to rise beyond 4%, even by 2019. The likelihood of the US economy tipping to the next cycle of recession by then is very strong, thereby leaving the Fed with limited space to cut rates and adopt an accommodative stance with its monetary policy. In other words, the problem of ZLB is here to stay with us, ironically as a result of the global success with taming the high inflation trend. This raises the issue of how to design a monetary policy framework that can be responsive even when faced with the ZLB.

This has the potential to be very relevant for monetary policy debates in the coming years. Nominal interest rates remain low and will continue to be so for the foreseeable future. Further, deflationary pressures remain strong on both sides of the Atlantic. Even with economic recovery taking hold and interest rates rising, there is the strong likelihood that many developed economies will move into the next recessionary trough with far lower rates than would be enough to sustain the necessary monetary accommodation to recover from the recession. Inflation Targeting is likely to be a blunt instrument. An NGDP target is more likely to generate the thrust required to restore economic growth.  

Public services contracting woes in UK

Even as Britain grapples the legacy of its Thatcherite privatizations, the National Audit Office (NAO) has an excellent report that questions the way public services are contracted out in UK. The report was commissioned by the government in the aftermath of several scandals of mis-reporting, over-billing, and fraud.

Two of the largest outsourcing contractors, Serco and G4S have been found guilty of over-charging and fraud (by way of billing dead individuals) in their contracts for electronic tagging of offenders. Another, Atos entrusted with the responsibility of testing whether disability living allowance claimants are entitled to a government benefit, was found to have denied benefits to large numbers of people with terminal cancer and other serious illness.

The NAO report looks at the market for outsourcing public services, valued at £93.5bn last year, by examining four largest public contractors in UK. It raises concern at the concentration of public contracting in a few large firms and also at whether the money is being well-spent and desired outcomes are being delivered. 

In particular, the report examines three questions - whether public contracting market is sufficiently competitive; whether contractors profits reflect a fair return; and whether contractors are delivering services to the desired standards. It writes, 

First, it raises questions about the way public service markets operate. This includes the need for scrutiny over whether public service contracts are sufficiently competitive and whether the rise of a few major contractors is in the public interest. Secondly, it highlights the issue of whether contractors’ profits reflect a fair return. Understanding contractors’ profits is important to ensure that their interests are aligned properly with that of the taxpayer. But transparency over rewards that contractors make is at present limited.

Thirdly, the report asks how we know that contractors are delivering services to the high standards expected. In particular, government needs to ensure that large companies with sprawling structures are not paying ‘lip-service’ to control and that they have the right culture and control environment across their group. This requires transparency over contractors’ performance and the use of contractual entitlement to information, audit and inspection. This should be backed up by the threat of financial penalties and being barred from future competitions if things are found to be wrong.

The FT has this to say about the state of many outsourcing contracts,

Recent research by the Institute for Government think-tank has raised questions about the capacity of civil servants to ensure this money is well spent. “Gaming” of contracts is far too common, with departments too rarely checking whether providers are hitting the targets but missing the point... Competition is often non-existent...

Contracts, meanwhile, are too long and inflexible. Providers offer big discounts in return for guaranteed income over a longer period - and ministers and officials are often tempted by this deal, knowing they are unlikely to be there five years later. Policy, demand for services and technology all change frequently, however. Nine-year tagging contracts looked good value when they were signed in 2005 but not once the price of tagging technology plummeted. Taxpayers are still paying the price of 25-year public finance initiative deals to build and maintain hospitals and other essential infrastructure.  

An FT editorial hits the nail on its head in its assessment of what is wrong with public sector outsourcing in UK,

First, there is too little competition. Ministers must do more to allow smaller providers to grow. Second, Whitehall needs to be smarter about how it bargains over contracts, especially those where quality of service is as important as price. Ministers often sign up for deals merely on the grounds that they save money. They also need to be more savvy about monitoring subsequent performance. Third, more transparency is needed. Taxpayers need to see in much greater detail how these companies make profits and who their suppliers are... the pace of outsourcing has far outstripped Whitehall's ability to manage it properly. 

In fact, following the outbreak of the scandal, the government has put on hold a wave of contracts, worth an estimated  £500m a year, to outsource management of prisons and lowering of recidivism among prisoners. Outsourcing prisoner probation work had become almost a fad following some boutique experiments on lowering recidivism through social impact funding based business model.

There is nothing surprising about UK's experience with public contracting. In a matter of two decades, public services contracting has grown from virtually nothing to nearly £100 bn a year market. Public systems, especially those at the cutting edge, barely have the capacity to manage complex contracts. This problem gets amplified when they are dealing with large contractors with the capability to 'game' the contracts. 

This assumes great significance for countries like India where too public services contracting has grown rapidly without public systems being equipped with the capacity to manage these contracts. A classic example of an activity which runs the risk of losing credibility is independent third party quality control contracts entrusted to monitor the quality of engineering works. It is commonplace to today find many routine services contracts like that for cleaning and sanitation in public institutions like hospitals having degenerated into being indistinguishable from their previous publicly managed avatars.

Update 1 (10/1/2014)
The UK Civil Aviation Authority (CAA) has proposed cutting the user charges collected by the operators of the three private airports at Heathrow, Gatwick, and Stanstead in real terms over the next five years. While Heathrow had proposed that the user charges should increase by inflation plus 4.2 percentage points over the next five years, the CAA has awarded an increase of inflation minus 9.8 percentage points. The operator claims that the CAA award would cut its return on investment from 5.6% to 5.35%. Apart from this, the CAA has also imposed a more rigorous monitoring framework. The operators have criticized the decision. 

Securitizing electricity revenues

The Times reports of the first ever securitization of solar electricity payments,

Standard&Poor’s has given its preliminary blessing to the first offering of this kind, rating a set of notes intended to raise $54.4 million for the fast-growing installation company SolarCity... it gave a rating of BBB+, a low investment-grade designation, to the notes. SolarCity plans to sell the bonds, which are secured by a bundle of residential and commercial power contracts, privately this month... Many of the power contracts are with individual residences and businesses, which have increasingly turned to leasing solar systems to avoid the upfront costs. Under those terms, SolarCity pays for installing and maintaining the system in return for monthly payments for the electricity generated. The deal will help finance the rapid expansion of SolarCity, which has become a leading installer of solar systems in the United States... It has signed up more than 82,000 customers so far...

Theoretically contracts backed by tariff payments by consumers should be attractive given that people will continue to use electricity and bill default rates are very low. However the lack of standardization of contracts and the lack of any performance history increases the risks associated. The prevailing market conditions have undoubtedly played a role in the issuance,

The bonds are expected to have a yield of around 4.8 percent, which, in a time of low interest rates, is a relatively high rate that compensates investors for buying such an untested security. The offering is also relatively small and will be sold only to select institutional investors.

As solar and other renewables sector expands, developers are already facing financing constraints. In the circumstances, they have to rely on such innovative approaches to mobilize the resources required to finance their investments. But such investments are not likely to be readily forthcoming in normal times. Further, there is the associated danger that the promoters, many with only a handful years of existence, may disappear leaving investors saddled with massive loans. Finally, there is the ever-present danger associated with securitization when it goes beyond its first stage into transactions that are far removed from the original contract.     

On secular stagnation and the quest to lower real interest rates

Larry Summers' speech at the IMF conference, where he hints at the possibility of a long-period of post-1991 Japan-style stagnant economic growth in US and Europe, has generated great interest.

Briefly, the economy is stuck at the zero lower bound, where the equilibrium real interest rate is negative. Conventional policies become ineffectual. More worryingly, this may not be an aberration, but the new normal. In fact, but for a series of equity and asset market bubbles, this should have started binding since atleast the early nineties. In this period, despite fairly loose monetary policy and a steep rise in household borrowings, there have been very few signatures of aggregate demand overheating. Inflation has remained consistently low. Summers conjectures that the short-term real interest rate consistent with full employment has fallen to negative territory, and therefore the economy needs the financial excess from bubbles to sustain full employment. He invokes Alvin Hansen to describe this as a "secular stagnation" - permanent as against cyclical. He leaves us with a summary of the problem,

It is not over until it is over…We may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back, below their potential.

Paul Krugman attributes this stagnation to declining investment and widening output gap caused by a mix of lower population growth and slower pace of innovation. Miles Kimball points to the negative feedback from the declining share of population working (the labor force is estimated to grow by 0.5% annually in the 2012-22 period, half the rate in previous decade). Whatever the case, Krugman advocates that in such circumstances prudence is folly and spending is virtuous and the way out is to either introduce negative rates for deposits or raise inflation, by whatever means, and keep it there.

The diagnosis of a secular stagnation comes out as being plausible. In fact economists like Robert Gordon and Tyler Cowen have been arguing that the low hanging fruits from technological innovations having been plucked, we may now be in a period of technological stagnation. The related decline in productivity (output per worker in business sector rose by 3.6% per year in the 1997-2003 period, whereas it declined to just 1.6% in the 2003-12 period) when coupled with the declining population growth lends strong credence to a secular stagnation hypothesis. These are important long-term trends whose effects are certain to be profound.

Given the secular stagnation hypothesis, I am not sure whether the policy goal should be to attain the Great Moderation era "full employment" by seeking to lower the real interest rate. That would require continuing for an indefinite period the regime of quantitative easing and further monetary accommodation, as Krugman suggests, or deepening financial de-regulation, as Summers (may) be alluding to. Both are fraught with serious dangers of resource mis-allocation, incentive distortions, and structural problems (widening inequality and workers dropping out of the labor force).

There appears to be a distinct reluctance to accept the reality of a secular stagnation. Fundamentally, a sustainable pre-crisis trend recovery can happen only through the aggregate demand channel. But the aforementioned long-term structural trends are certain to keep aggregate demand muted. Therefore, instead of asking how to restore growth and employment back to pre-crisis levels, a more relevant exploration would be that of managing the economy given this new reality of a lower potential output. And that surely is not about seeking to lower real interest rates.

Update 1 (12/22/2013)
Lawrence Summers on secular stagnation as the new normal in developed economies. He argues that the US economy has been facing inadequate demand (as evidenced by low inflation and limited signs of over-heating even when growth was high) for some time now, and that this was the new normal. Further, under such conditions, the economy can get close to full employment only when supported by asset bubbles and unsustainable borrowing, as was the case in the nineties and first half of last decade. See also Paul Krugman here.

Update 2 (1/9/2014)

In order to avoid secular stagnation, and given the "new normal" of low interest rate regimes, Larry Summers argues in favor of large scale investments in infrastructure to help raise demand. Willem Buiter too feels the same, as also FT Alphaville. See also John Cassidy's summary on the secular stagnation debate here.

Update 3 (29/7/2014)

Larry Summers explains secular stagnation,

The question that this account leaves open so far is why, if there is a tendency for savings to exceed investment, why can’t lower but still reasonable interest rates balance things out? Here I think there are a number of answers both on the savings side and on the investment side. On the savings side, there’s a tendency towards increased saving because of greater wealth inequality and a rising share of profits increased the share of income going to those with high savings propensities; because increased uncertainty and greater indebtedness encouraged savings to repair balance sheets; because an expectation of lower returns leads to people or pension funds needing to put aside more money to prepare for their retirement or to send their kids to college or whatever their savings target is. All of that tends to lead to an excess of savings.

On the investment side, you have a tendency for substantial reductions in the price of capital goods, particularly those associated with information technology. You have a change in the capital requirements for starting a business. Contrast WhatsApp, worth $19 billion, with 55 people in a big room with Sony, worth $18 [billion], and owning lots of factories and office buildings and the like. Or think about Google and Apple, major leaders in scale on the stock market, but with vast cash hordes. That operates to reduce investment.

Update 4 (26/11/2014)

In 1938, following the persistent slowdown after Great Depression, Alvin Hansen described secular stagnation as "sick recoveries which die in their infancy and depressions which feed on themselves and leave a hard and seemingly immovable core of unemployment.” 

SS is a period of depressed growth due to a combination of weak demand and excess savings, coupled with slowing technological progress, which limits productive investment opportunities and makes conventional monetary policy blunt. An Economist article suggests another reason for the prolonged stagnation - demographics.

The primary channel through which demographics affects growth is by lowering potential output, which is dependent on both population growth and productivity. Now with both population growth and productivity stagnant or even declining, potential output has nowhere to go but down. Population patterns affect both investment and savings. The Economist writes,

Firms need a given capital stock per worker—equipment, structures, land and intellectual property—in order to produce a unit of output. If output growth is hampered by lack of workers, firms will need less capital. Ageing populations also mean that more people are saving heavily in order to fund their retirement, depressing consumption... businesses are buying less machinery because they have fewer workers to operate it and fewer technological breakthroughs to exploit.

Another possible contributor to SS is the rising inequality and stagnant wages. This assumes significance since the richer people are more likely to save and less likely to spend than those less well off. This would dampen consumption and therefore growth.

Its signatures are everywhere - cash hoarding by businesses, declining long-term bond yields, lowest net investment (gross investment minus depreciation) as a share of capital stock, slowing potential output growth, and so on. 

QE in 12 graphs from MGI

The MGI have a excellent report on the effects of the quantitative easing programs across the world. Here is a graphical summary.

1. An extraordinarily long period of ultra-low interest rates was pursued so as to help recover from the Great Recession and enable financial institutions, businesses, and households to repair their debt-laden balance sheets.

2. The low interest rates were complemented with aggressive balance sheet expansion by all the major central banks in developed economies.

3. Apart from purchases of government securities, the US Fed and ECB intervened aggressively in credit markets, purchasing private assets like mortgage backed securities and commercial paper, and opened unlimited liquidity facilities to keep banks from being credit squeezed.

4. This extended period of monetary accommodation has had large-scale distributive consequences. Corporate borrowers and banks have been the biggest beneficiaries, whereas pension funds and households have been the losers. Non-financial firms in US, UK, and eurozone have saved an estimated $710 in 2007-12 on their debt service costs.

5. The bond markets have been the biggest beneficiaries.

6. Interestingly, its impact on equity markets, despite the recent surge, has been mixed.

8. The biggest beneficiaries though have been governments. By the end of 2012, governments have collectively benefited $1.4 trillion in reduced interest costs over the 2007 rate. To that extent, it has provided the fiscally constrained governments in these countries with the resources to finance their stimulus programs.

9. As the central banks start deleveraging, the biggest concern will be about its impact on the real economy, especially when economic activity remains weak and most countries are yet to recover fully their lost output and employment. The MGI report estimates that a 100 basis points increase in rates will increase household debt payments in US and UK by 7% and 19% respectively. In fact, households across US and Europe have lost a combined $630 bn as the lower interest on fixed income savings have more than outweighed the lower cost of borrowing.

10. Emerging economies too have not been spared. The Fed's balance sheet expansion has coincided with surge in capital inflows into emerging economies. In the Q2 2009 to Q4 2012, $700 bn of portfolio capital flowed into emerging market debt. In fact, in 2009-12 Mexico experienced seven times bond inflows as 2005-08, and Turkey five times.


11. So when the Fed unwinds its balance sheet, it is natural to expect a reversal in flows. And we have already had a sneak preview of that possibility, with its adverse economy-wide consequences.

12. The adverse external account of many emerging economies makes them vulnerable to the risks associated with the exit from the quantitative easing programs.

More discussion on the report in FT and Economist. 

India's Household Debt Graph of the Day

Even as government and corporate indebtedness has been mounting, the one silver-lining for the Indian economy comes from its low and declining household debt, which is the lowest among all major economies.

Second generation issues in infrastructure

I have this op-ed with Dr TV Somanathan on the second generation issues in infrastructure. 

Measuring global inequality

Late on this insightful paper on global inequality by Branko Milanovic. This graph of change in real incomes among people at various percentiles of global income distribution in the 1988-2008 period has received considerable attention.



About the winners and losers from this period, he writes,

The top 1% has seen its real income rise by more than 60% over those two decades. The largest increases however were registered around the median: 80% real increase at the median itself and some 70% around it. It is there, between the 50th and 60th percentile of the global income distribution that we find some 200 million Chinese, 90 million Indians, and about 30 million people each from Indonesia, Brazil and Egypt. These two groups—the global top 1% and the middle classes of the emerging market economies— are indeed the main winners of globalization...

But the biggest loser (other than the very poorest 5%), or at least the “non-winner,” of globalization were those between the 75th and 90th percentile of the global income distribution whose real income gains were essentially nil. These people, who may be called a global upper-middle class, include many from former Communist countries and Latin America, as well as those citizens of rich countries whose incomes stagnated.

The paper has a very interesting representation of the progress made by some emerging economies...

In 1988, a person with a median income in China was richer than only 10% of world population. Twenty years later, a person at that same position within Chinese income distribution, was richer than more than one- half of world population. Thus, he or she leapfrogged over more than 40% of people in the world. For India, the improvement was more modest, but still remarkable. A person with a median income went from being at the 10th percentile globally to the 27th. A person at the same income position in Indonesia went from the 25th to 39th global percentile. A person with the median income in Brazil gained as well. She went from being around the 40th percentile of the global income distribution to about the 66th percentile. Meanwhile, the position of large European countries and the United States remained about the same, with median income recipients there in the 80s and 90s of global percentiles.

.... and the losers in Africa, Latin America, and East Europe,

So who lost between 1988 and 2008? Mostly people in Africa, some in Latin America and post-Communist countries. The average Kenyan went down from the 22nd to the 12th percentile globally, the average Nigerian from the 16th to 13th percentile. A different way to see this is to look at how far behind the global median was an average African in 1988 and twenty years later. In 1988, an African with the median income of the continent had an income equal to two-thirds of the global median. In 2008, that proportion had declined to less than one-half. The position of a median-income person in post-Communist countries slid from around the 75th global percentile to the 73rd. The relative declines of Africa, and Eastern Europe and the former Soviet Union confirm the failure of these two parts of the world to adjust well to globalization, at least up to the early years of the 21st century. 

Another interesting insight is the increased contribution of location or citizenship on people's income determination. He writes,

More than fifty percent of one’s income depends on the average income of the country where a person lives or was born (the two things being, for 97% of world population, the same). This gives the importance of the location element today. There are of course other factors that matter for one’s income, from gender and parental education which are, from an individual point of view externally given circumstances, to factors like own education, effort and luck that are not. They all influence our income level. But the remarkable thing is that a very large chunk of our income will be determined by only one variable, citizenship, that we, generally, acquire at birth. It is almost the same as saying, that if I know nothing about any given individual in the world, I can, with a reasonably good confidence, predict her income just from the knowledge of her citizenship... Around 1870, class explained more than 2/3 of global inequality. And now? The proportions have exactly flipped: more than 2/3 of total inequality is due to location.  

Finally, the paper also captures the differences in economic positions of people from different countries. It divides the population of all countries into groups of 5% or ventiles and maps their position in the global income distribution.

Update 1 (2/1/2014)
The International Business Times has this nice graphic of the changes in global inequality.