Tuesday, January 29, 2013

Reforms are incremental and probabilistic than binary and definitive?

It frustrates me when people talk about the success or failure of reforms based on their simplified assessments of whether an ideal desired outcome has been achieved or not. Accordingly, education reforms are deemed to have failed unless learning outcomes have improved dramatically. Or structural reforms have failed if fiscal deficit is not eliminated or inflation not brought below 3-4 percent. Or social safety net reforms have failed if they have not succeeded in eliminating leakages. All these betray a cognitive bias that anchors any discussion about reforms into neatly defined solutions in our mental space.  

This world-view of reforms is based on two important assumptions. One, the reforms' outcome matrix is binary - either success or failure. Two, it is possible to achieve success through a complementary set of initiatives that constitute the reforms. I believe both these assumptions are flawed and reveal a failure to appreciate the difficulty of achieving change in complex systems.

Here is an alternative narrative, which can be applied to analyzing many transformations. Consider any reform as consisting of the dynamic interaction of two changes - technical and systemic/behavioural - in an evolutionary mode. The former involves deploying specific inputs, technology, and processes to prepare the ground for alignment of incentives with desired outcomes. I believe that though we cannot ex-ante identify all the ideally required elements of the technical change, it is possible to short-list a broad set of elements. The latter involves the response of interacting stakeholders to these technical changes. In complex social systems, this evolution happens in a highly context-specific, protracted, and non-linear manner, punctuated with multiple equilibrium, and through an iterative process of changes. As they say, two steps forward, one step backward, and another sideward!

A more relevant framework for evaluating the success of any such change maybe incremental and probabilistic than binary and definitive. In particular, I can think of three touchstones for any such reform process. One, do the components of the technical change contain the basic requirements necessary to achieve such transformations? Two, does the first iteration of reforms improve outcomes from business as usual? Three, are the elements of the transformation project cost-effective, compared to other alternatives?

Let me illustrate with the case of education. Consider a program to improve student learning outcomes. A basic requirement to achieve this objective is the presence of an adequate number of schools (to enable access) and teachers, minimum physical infrastructure, reasonably regular attendance of teachers and students, availability of adequate learning materials, a mechanism to measure student-wise learning outcomes embedded in an institutional framework that would optimize incentives of all stakeholders. To this extent, any reform program that seeks to establish schools, appoint teachers, build physical infrastructure, give text-books, nudges and forces teachers and students into attending school, use computers to capture student learning levels data and run a monitoring system (however flawed), is not only an improvement from business as usual but also form essential elements in any effort to improve learning outcomes.

How stakeholders respond to these technical changes has social and political dimensions, which are not readily amenable to the desired trajectory of change. Therefore, for example, if the prevailing political dynamics rule out the adoption of the evidently more cost-effective and incentive compatible arrangement of contract teachers instead of regular teachers, then we should go ahead with the latter, irrespective of the nature of systemic distortions. In fact, the dynamics of systemic/behavioral changes most often push the system into sub-optimal outcomes in such transformations. Fortunately, we can avoid systems remaining entrapped in these sub-optimal outcomes for long if they can embrace an iterative approach to such transformations.

An institutionalized iterative process would provide feedback from the emergent behavioral and systemic failures. This feedback could be used to re-engineer processes so as to re-align incentives and even modify the nature of technical change, wherever required and feasible. The principle behind this iterative process should be that the proposed change would increase the likelihood of movement in the direction of the ultimate objective. I believe that this whole evolutionary process can be best managed through a collaborative process of deep-dive problem solving and experimental research within public systems.

Friday, January 25, 2013

The case for NGDP Targeting examined

As I blogged earlier, Inflation Targeting (IT), which underpinned the monetary policy consensus since the nineties, looks set to be another casualty of the global financial crisis. Nominal Gross Domestic Product (NGDP) targeting has become the most discussed alternative to IT.

As the name suggests, NGDP targeting seeks to fix a trend nominal GDP growth rate as the nominal anchor for setting interest rates and other monetary policy actions. This target is more effective than a pure inflation target at boosting output, especially when the economy is facing the zero-lower bound (ZLB) in interest rate. As Simon Wren-Lewis explains, an NGDP target works by relaxing monetary policy tomorrow in order to raise tomorrow's output and inflation. Assuming rational expectations, this response in turn immediately raises inflation today (since today's inflation depends on expected inflation tomorrow) and therefore reduces real interest rates today, which in turn raises output today and again inflation today. A simple inflation target cannot generate this effect on output today or tomorrow when the economy is facing ZLB.

Further, its supporters claim that by directly targeting the level of output growth, it avoids getting entangled with the intermediate objective of inflation, and focuses on the ultimate objective of stable economic growth. Central Bankers too are loath to give up their hard-won inflation fighting credibility which has helped firmly anchor inflation expectations for nearly two decades. Also, as Scott Sumner points out, it is politically easier to mobilize support since it re-frames the debate around output and avoids the contentious topic of inflation.

At a time when the developed economies are facing deflation and liquidity trap, a generous dose of inflation can be helpful in generating growth. But popular and ideological opposition to the idea of stoking inflation, borne out of a generation of inflation targeting, comes in the way of any attempt to promote growth, even by generating inflation consistent with the defined inflation target. Furthermore, monetary policy, in particular expansionary policy, has come to be intimately associated with inflation. NGDP targeting would replace inflation with output as the nominal anchor.

This distinction is a bit of sophistry, but enough to get political traction for expansionary monetary policy. Fundamentally, the effect of monetary and fiscal policies get distributed between output and price level changes - expansion causes both growth and inflation, while contraction lowers both. In other words, inflation and growth are two sides of the same monetary policy coin, though their relative magnitudes is determined by the nature of supply-side shocks and cannot be influenced directly through monetary policy.

So my concerns with the alleged superiority of NGDP over IT is as follows

1. It may be possible that in general NGDP cycles till now have been more closely correlated with asset inflation cycles than inflation cycles have been with asset prices. But there is limited theoretical basis for claiming that business cycles correlate strongly with asset price cycles, any more so than inflation cycles. Or do we, as before, avoid addressing asset prices, and deal with them through micro- and macro-prudential regulations?

2. Given that an NGDP anchor is the sum of potential output and optimal inflation target, any volatility in potential output is likely to introduce uncertainties into an NGDP targeting framework. If the potential output is itself not stable, then NGDP targeting becomes inconsistent with IT.

3. Further, a reliable assessment of output gap is critical to setting an NGDP anchor. In conditions of zero-lower bound, accuracy of the output gap is less important since even if the central bank over-estimates its magnitude, it can very easily raise rates to correct the situation. But if it under-estimates the gap, there is no possibility of going down in the opposite direction with interest rates. But this does not hold once we are faced with different economic conditions, like an overheating economy facing inflationary pressures.

4. This brings us to the most important flaw with NGDP targeting. A simple NGDP target would reveal little about the distribution of NGDP between real output and inflation. Consider two scenarios. In the first, high inflation caused by a supply-constrained and over-heating economy keeps real output growth low and NGDP below the target. In the second, deflation co-exists with demand-constrained economic conditions and keeps NGDP below the target. The policy prescriptions for the two conditions are different. Expansionary monetary policy would be inflationary in the former while growth stimulating in the second case.

The NGDP level per se would not provide enough information to guide us on the right policy. In fact, in the former case, we can reach the target NGDP level by monetary expansion which would only raise inflation further without creating jobs or boosting real output. But in a deflationary demand-constrained economy, monetary expansion is more likely to increase NGDP by boosting real output, by skirting around the issue of inflation. Since this is exactly the problem facing developed economies today, it is natural that any policy which is likely to promote recovery attract attention.

Fortunately, we now have real world examples of these two conditions being played out simultaneously. Even as many developed economies are struggling with deflationary recessions, India is grappling with a supply-constrained inflationary economic slowdown. In fact, just as NGDP targeting, by skirting around inflation, offers a politically feasible cover for monetary expansion in developed economies, inflation targeting, by focusing directly on persistent high inflation, provides a politically convenient excuse for the Reserve Bank of India (RBI) in not relaxing its monetary tightening.

The contrast between the two conditions is striking and representative of the difficulty of having a uniform policy suitable for all conditions. One practical approach would be to stick with IT, but use nominal GDP as an anchor to help restore growth in economies facing deflationary recessions and the  ZLB in interest rate. In this context, the strategy suggested by Jeffrey Frankel for central banks to shape expectations by introducing a long-run NGDP target and then dynamic short-run targets till growth is restored, without junking the long-run inflation target, looks appropriate.

NGDP Targeting re-frames the Inflation Targeting debate

One of the biggest casualties of the global financial crisis may be the use of Inflation Targeting (IT) as the dominant monetary policy strategy. With IT having failed to avoid the crisis and now not being able to help economies out from the depths of deflation, governments and central banks look set to give IT a honorable burial. As the graphic below shows, prevailing inflation targets provide no guidance for monetary policy for countries seeking help to exit deflation.
Nominal Gross Domestic Product (NGDP) targeting is emerging as one of the strongest alternatives to IT as a monetary policy framework. As the name suggests, it projects the trend growth rate of nominal GDP as the monetary policy anchor. By subsuming inflation within the NGDP target, it avoids getting entangled in the inflation debate.

Scott Sumner has an excellent article where he lays out the defence of NGDP targeting. In making out the case for NGDP, Scott Sumner points to its greater popular and political acceptability, apart from its greater inherent effectiveness. In particular, he points to the difficulty with getting support for policies that explicitly seek out inflation in order to recover from a deep deflationary environment due to the entrenched belief that all inflation is bad. In this context, NGDP targeting provides a nice behavioral psychology sleight of hand by re-framing the debate in terms of raising nominal GDP and job creation instead of generating inflation.

Paradoxically, cognitive biases arising from our aversion to inflation and affinity for output growth, causes us to oppose expansionary policies which cause inflation while supporting those that promote growth, despite both outcomes being two sides of the same monetary policy coin (the effect of expansionary monetary and fiscal policies get distributed between inflation and growth, the relative magnitudes of each being dependent on supply-side factors). This is a classic example of how framing the terms of a debate can increase political acceptability of the same policy instrument. As Scott Sumner writes,
If we stopped talking about inflation targeting and started talking about NGDP targeting, we could greatly simplify the policy debate. Do we want more demand, or not? Most Americans surely think that more demand would be a good thing right now, but very few people want to see more inflation. To the Federal Reserve, these two effects are simply two sides of the same coin. But because the Fed expresses its aims in terms of inflation, its work is understood as a matter of managing inflation, and therefore Fed policies aimed at boosting inflation are politically problematic.
NGDP targeting therefore provides a cover for expansionary monetary policy, which has been stigmatized by its close association with inflation, to play its full role in growth by reducing the focus on inflation. It frames the terms of the debate as between growth and stagnation, not higher and lower inflation.

Thursday, January 24, 2013

The Supreme Court adds a new twist to India's retail liberalization drama!

Srikar points me to this attempt by the Indian Supreme Court to formulate foreign direct investment (FDI) policy. In response to a PIL claiming that the government's retail market liberalization policy violated the fundamental right of small traders, a two judge bench of the Court sought clarification from the government on the safeguards protecting the interests of small traders.
It's been four months since this happened. Have you got any investment which you were contemplating or is this just a political gimmick... Reforms is one part but the same should not close the doors of other traders... What are the checks in place to ensure that there is no obstruction to free trade, especially the small ones. Policy is not sacrosanct, we would also analyse it within the judicial parameters. Our exercise is very constitutional and limited to the constitutional principles... It's possible that a giant retailer might reduce the price of a commodity forcing the small retailers to shut shop. Once there is no competition, the retail giant can monopolise.
Now, this is clearly way beyond the Supreme Court's mandate and a classic example of judicial transgression into the realm of the legislature. What way is the judiciary concerned with the investments received? What evidence is there to show that retail liberalization will "close the doors of other traders"? What is "constitutional" about the promotion of free trade, especially among small traders? What way does the government's policy to liberalize retail trade infringe on the "basic features" of the constitution? What way are the interests of consumers (who gain by lower prices) inferior to that of the traders?

In fact, by raising these issues, the SC has waded into the debate about the dynamics of the free-market, with its inevitable distributional consequences. Since any trade policy measure will have losers and winners, will the judiciary always adjudicate on its distribution of costs and benefits? Is the SC competent, both legally and professionally, to examine such questions? By the same yardstick, it can tomorrow question the government's decision to lower or raise taxes on certain categories of people or regulate some economic activity on grounds of it violating or not promoting certain interests.

Stepping back, I have two observations.

1. This is symptomatic of the difficulty of getting any reform policy through in India. The issue of retail trade liberalization has been dissected in great detail by all and sundry for nearly two years now and, after following the due process, the government of the day has taken a well-considered policy decision which has been approved by the highest body of the country. In any functioning democracy, all debates should have ceased. Instead, we have more uncertainty. Judicial over-reach (sample the large numbers of cases involving land acquisition and environmental clearances that are stuck up in courts) is one of the most important contributors to the environment of uncertainty that characterizes any policy in India.

2. Finally, most importantly, it is amazing that an institution which is so chronically over-burdened and inefficient in the disposal of cases, gets swayed by populist urges and has the time to waste on matters where its locus standi is questionable. In fact, one of the reasons for the large scale pendency of litigation before the SC and other courts is the failure to exercise due diligence in screening cases. When your bandwidth is so severely constrained, it is plain obvious that some form of prioritization is the need of the hour.

Wednesday, January 23, 2013

Is independent central banking over?

More posting on central banking. A number of articles in FT in recent days have written about the dramatic shift in the role of central banks, including one obituary of independent central banking.

The most decisive signal of the shift in central banks role and erosion of their autonomy has come from Japan. The new Prime Minister Shinzo Abe has come to power on a platform of promising to do whatever it takes to end the country's "lost decades". In particular, he has targeted the Bank of Japan (BoJ) as not having done enough to exit the deflationary trap and reflate the economy. In fact, he has openly demanded that BoJ raise its nominal inflation target to 2%, failing which he will enact a legislation to incorporate it into the bank's mandate. He has also called for more aggressive intervention to stem the appreciation of Yen against the dollar.

Truth to tell, the BoJ has been far more conservative than its counterparts in Europe and US. Despite the even more painful and protracted nature of the country's economic slump, the BoJ has for long refrained from anything remotely similar to what the Fed has ventured out. With debt-to-GDP ratio of more than 200%, the government has limited fiscal room, thereby making central bank's role critical in any meaningful and large enough attempt to prime recovery. This has given the politicians a rightful cause to demand more aggressive actions by the central bank. Shinzo Abe has only ratcheted it up in a manner that clearly threatens the BoJ's autonomy. And there is a clear danger that he may actually end up going too far with monetary expansion.

In simple terms, Masaaki Shirakawa has failed to display the political nous that is necessary to manage monetary policy, especially when the economic circumstances are extraordinary. In contrast, as Peter Tasker wrote, his compatriots Bernanke, Draghi, and Mervyn King, have factored in the political and social context while managing their monetary policy, thereby pre-empting any political assault on their domain. However, on the flip-side, such pre-emptive action may have had the effect of taking the pressure off governments to act immediately and aggressively, besides pushing monetary policy down a dangerous path and also taking .

Another reason for the erosion of independence of central banks is that their recent actions of extended extraordinary monetary accommodation has strong political overtones. Of greatest concern is its distributional implications. Stephen King points to a recent report (pdf here) by the Bank of England which talks about the inter-generational distributional implications of QE,
by increasing the net present value of pension funds’ future liabilities, it creates problems for those funds already running deficits. That, in turn, means either bigger pension contributions for workers; lower prospective pension benefits; or, in the case of some public sector pensions, tax increases or spending cuts to make the numbers add up. Meanwhile, some of the biggest beneficiaries of QE are those already asset-rich and relatively old who prefer to sit on their windfall gains rather than spend them.
Apart from this, there is also the issue of ultra-low interest rates punishing ordinary people who keep a major share of their savings in fixed income securities, whereas it has boosted the incomes of the richest who use leverage to make massive profits by investing in equities and other asset categories. These are ultimately political decisions and central banks cannot wish them away and go about their work as though they have nothing to do with these consequences.

Monday, January 21, 2013

The poverty of corporate leadership in India?

I happened across a recent interview of Deepak Parekh, Chairman of HDFC, who after the exit of Ratan Tata is being projected as the elder statesman of corporate India. Asked about three key things that the government should focus on in 2013 for the economy to look up, he said,
Three key things I would suggest the government to focus on in 2013 are kickstarting investments, reducing the fiscal and current account deficit and putting big projects on the fast track. We need to reignite the investment cycle. India is desperate for fresh capital; we need to start new projects and raise our capital spending. There is a fear of not getting land, approvals and power for any big investment. This climate must change; investors would come out and invest only in a stable environment.
Second, India needs to reduce its fiscal and current account deficits. The budgetary fiscal deficit target was set at 5.3 percent of the GDP, but we are heading to close somewhere around 5.9 percent, with rating agencies already threatening us with junk status. So the government must ensure that sufficient revenues are generated... besides disinvestment, which may bring in another Rs 30,000 crore — an amount the government has also asked PSUs like RCF, Oil India and NTPC to raise in 2013... Third, and a critical step, would be to fast-track existing projects that have been stuck due to shortage of raw materials or lack of environmental and other clearances. 
While reading the three priorities, I could not but avoid getting the impression that he was talking about the three most important things for corporate India, and not the Indian economy. A straight translation of the three priorities of this corporate leader would come out as - more liberalization, rolling back subsidies, higher infrastructure investments, aggressive disinvestment, lowering interest rates, and expediting land acquisition and environmental clearances.

The poverty, even brazenness, of such an exhortation is stunning, especially from someone who is projected as a highly credible voice from corporate India. There is a difference between acting as a spokesperson of  corporate India and being a senior and important statesman, who claims to contribute positively towards shaping the future of India. Sure, many, but not all, of these reforms are critical for economic growth. But all of them are policies that are much more important for corporate India.

What about policies that are important for the rest of India? I would believe that these are policies that address more fundamental issues of improving governance, state capability, job creation, social safety net, and so on. In no way am I arguing that one set of policies are more important than the other. But the assumption that what is good for corporate India is also good for the rest of India is clearly untenable. We have enough recent evidence that economic growth and business profitability does not automatically translate into jobs.

But there is nothing surprising about Deepak Parekh's advice. What is surprising is how much opinion space these people occupy in discussions about India's future. When was the last time that a corporate leader called for a universal health insurance system or a national social safety net? Who was the last leader from corporate India who had something sensible to talk about improving India's pathetic state capability? It is no good to repeat ad-nauseam about the distortions caused by NREGS and thereby advocate its scrapping without offering suggestions about what can be done to address the critical underlying challenge of providing some form of employment guarantee to the millions affected by India's latest period of jobless high GDP growth.

The views of corporate India and much of the commentary on reforming subsidies and government welfare systems is condescending and see them as undesirable. In fact, subsidy, of any kind, has become a four-letter word for this part of India. I say this because, if we are genuinely talking about reforming subsidies, about increasing its effectiveness without compromising on objectives (dare I say that there is a reasonable consensus that atleast some of the subsidies should stay), we cannot so flippantly talk about reduction of fiscal deficit without also alluding, atleast in brief, about how to achieve that. Only once we start thinking about these issues will we really begin to eschew making such brazenly partisan remarks.

Merely parroting reduction of fiscal deficit or roll back of subsidy in general terms without making even a passing mention of how to do it (of course, nowadays, everyone has the magic pill - cash transfers!) is a reflection or either ignorance or partisanship or political posturing, all of which are undesirable. In one snapshot Deepak Parekh's comment captures the increasing disconnect between one part of India, obsessed with business confidence and India's investment image abroad, and the majority, who form the rest of India and who struggle to eke out subsistence livelihoods and have social and health indicators that would shame even sub-Saharan African countries.

In purely economic and business sense, this is complete short-sightedness, a desire to maximize short-run returns. Corporate India needs to realize that its long-term success has to be built on the prosperity of the vast majority of Indians. Their deprivation is a recipe for political disorder that will seriously undermine macroeconomic stability. The very climate of business confidence and external investment image will be the casualty.

Just consider this. Amidst all the recent scandals of crony capitalism, the mainstream debates have conveniently overlooked the fact that its responsibility cannot be confined to government and politicians alone. Corporate India, including some of its leading names, played its murky, equally abhorrent, part in these scandals. In a more just world, many of these "captains" should have been languishing in jails. In fact, it could be logically argued that the politicians and officials were only responding to the actions of corporate groups, who realized the massive fortunes to be had by subverting the rules of the game or the prevailing policy frameworks.

It requires no great insight to argue that corporate India should have done the same level of soul-searching and introspection that it was demanding politicians do. Disappointingly, there has been little talk about this. I cannot remember any major corporate leader talking about the need to shine the torch lights within corporate India itself.

I am not surprised since many of modern India's corporate fortunes are built either on the graft-greased props of the earlier license permit raj or the current crony capitalism. Crony capitalism may deliver short term windfalls, but is not sustainable. Similarly, image boosting reform gymnastics cannot make India better than it really is. Corporate India would do well to realize.

Sunday, January 20, 2013

Lessons from Dreamliner's troubles

The blame game for Dreamliner's latest fiasco has started. Outsourcing is the culprit. Has outsourcing gone too far? Predictably, the political machinery that opposes outsourcing see this as the latest evidence of the evils of outsourcing.

The latest trouble to hit Boeing's ambitious Dreamliner 787 project was the ignition and sparking of its Li-ion batteries in two accidents in Boston and Tokyo. The Li-ion batteries, which can be charged quickly, without loss of power, and can pack in a higher energy density (energy per unit weight) and therefore help reduce weight, has always been vulnerable to overheating and igniting. There have been a number of cases of planes catching fire due to problems related with Li-ion batteries. Even with multiple firewalls to ensure that the problem is contained even if the battery ignites, airline firms have not been able to completely reduce the danger. But recent technical advances have made fires, even when the battery fails, an extreme rarity. The plane has been grounded by US, India, and others.

In recent years, riding the global outsourcing wave, Boeing has embraced outsourcing with great gusto. It has transformed itself from being a primary manufacturer to a systems integrator who outsources 80% of its production requirements.

Its components and parts are manufactured across the globe, in four continents.

In any case, amidst all the populist rhetoric, we are likely to gloss over critical questions. The debate raises two questions.

1. Like all other such ideas, outsourcing works effectively under certain conditions. The most important requirement is rigorous enough contracting principles and its management. If you can't do that effectively, don't outsource. Or develop strong capability before you move aggressively into contracting. Did Boeing rush headlong into outsourcing contracts, even before it had built adequate company-wide contract management capabilities?

2. Again, as with all other ideas, there is an extent to which we can pursue it. In technologically sophisticated industries like aviation, there may be a case for keeping the overall design and certain core manufacturing activities within the firm. Although, it may be straining credulity to believe that Li-ion batteries may one such core activity. But managing the thin-line between outsourcing and keeping activities within the firm is not easy. Did Boeing slip up here? Or does complex modern manufacturing make these decisions impossible to make with any degree of certainty?

Either ways, one cannot but help feel that Boeing failed to effectively manage its outsourcing processes. The fact that Boeing's problems are with Li-ion batteries which have a history of catching fires in other electronic equipment's  lends further credence to the belief that Boeing and its suppliers got it wrong. I am inclined to believe that it is a failure of outsourcing as Boeing did, rather than of outsourcing itself.

Update 1 (30/1/2013)

James Surowiecki has this nice article in New Yorker that examines Boeing's troubles. He writes

Boeing didn’t outsource just the manufacturing of parts; it turned over the design, the engineering, and the manufacture of entire sections of the plane to some fifty “strategic partners.” Boeing itself ended up building less than forty per cent of the plane... it was a huge headache for the engineers. In a fascinating study of the process, two U.C.L.A. researchers, Christopher Tang and Joshua Zimmerman, show how challenging it was for Boeing to work with fifty different partners. The more complex a supply chain, the more chances there are for something to go wrong, and Boeing had far less control than it would have if more of the operation had been in-house. Delays became endemic, and, instead of costing less, the project went billions over budget... And the missed deadlines created other issues. Determined to get the Dreamliners to customers quickly, Boeing built many of them while still waiting for the F.A.A. to certify the plane to fly; then it had to go back and retrofit the planes in line with the F.A.A.’s requirements.

Thursday, January 17, 2013

Subsidy reforms can wait, put the Aadhaar infrastructure in place!

India's economic weakness has rightly focused attention on its strained public finances. However, it may be misguided to address this problem as a subsidy-rollback, price-increase, expenditure reduction reform.

Just because 60% of rations supplied through Fair Price Shops does not reach the intended beneficiaries, neither does the Public Distribution System (PDS) become any less important nor we can wish away the reality that cheap rations are a life support for a significant proportion of Indians. In the circumstances, merely junking PDS, without putting in place a more effective alternative mechanism, is both bad politics and economics, besides being plain unjust.

It is bad politics because it is certain to vote the party out of power (remember, the new political darling of upper-middle class India has tried none of these innovations on subsidies in his state!). It's bad economics because of its adverse secondary effects - in the development of capable human resources and in laying the platform for sustainable economic growth. And unfairness... well, let's leave it at that!

Most media experts, commentators and academics shooting off their mouth (or pens) on subsidy reforms betray a limited knowledge of the complex political economy surrounding subsidies and over-estimate the effectiveness of technological quick-fixes. We need to come down from our all-knowing high-pedestal and acknowledge that there are no easy solutions, at least those that can be offered over an op-ed piece or television sound-bite, to reforming many of the larger subsidies. It is not vested interests alone that has sustained many of these subsidies (but not all), but the fact that there is a compelling logic to provision of those subsidies, though not the way they are being delivered.

At least at some level, the Government of India have realized the tactical importance of keeping food grains out of the first phase of Aadhaar-transfer based cash transfer scheme. The regime-altering cash transfer is taking place only with kerosene and LPG. In both, the market itself is heavily regulated, and the potential for any adverse effects of a shift on the beneficiaries are limited. In the remaining services, the only change is with Aadhaar-based validation.

However, detached from what is actually being implemented, the mainstream discussions on the issue give the impression of a government plunging headlong into a massive paradigm redefining cash transfer program for all subsidies, including food grains. It contributes nothing to improving the current implementation program. This is a reflection of the poverty of serious discussions on most public issues.

We wildly underestimate the difficulty of implementing such programs in the field, especially in such continental scale. There are hundreds of small, but critical, obstacles to be overcome, before any such arrangement stabilizes. It will easily take atleast a couple of years. Ideally, the first phase of Aadhaar-based cash transfers should have been limited to only ongoing accounts-based cash transfers (scholarships, pensions, JSY, and NREGS) and for validating the disbursal of in-kind transfers (like PDS). It should focus on resolving the implementational problems with Aadhaar enrollment, porting of user-department data, use of Point-of-Sale terminals, data communication, cash transfer process, budget releases, and so on. In fact, in the first phase, if we get just the Aadhaar validation and cash-transfer infrastructure and mechanisms right, without substantively changing any subsidy, that by itself would be a great achievement.

The backbone for Aadhaar-based cash transfer scheme has to be fully laid before we start pumping more complex cash transfers. Serious opinion makers should spend their energies analyzing these challenges and facilitating the process of stabilization, instead of putting the cart before the horse and talking about paradigm redefining subsidy reforms.

Truth to tell, the government has done itself and the program no favor by being strategically obtuse about the political positioning of the program. By projecting it as one of its main electoral planks, even before the delivery infrastructure is fully in place, it has negated whatever tactical nous it displayed by keeping the more complex subsidy transfers out of the first phase. It now runs the risk of discrediting a conceptually very good program, both ideologically and politically, even before it has had a fair chance at demonstrating its benefits.

Tuesday, January 15, 2013

Return of the "real" economic anchors in monetary policy

As a recent Mint op-ed pointed out, the Friedmanite consensus on monetary policy may be another casualty of the global financial crisis. In his famous 1968 lecture at the American Economic Association, Milton Friedman had debunked the effectiveness of the Keynesian Phillips Curve relationship between inflation and unemployment. He questioned the belief that monetary policy could be used to stabilize the business cycle and lower unemployment arguing that it would only stoke inflation without any corresponding gains in reduction of unemployment rate. Agents (laborers bargaining for wage rise) would quickly factor in this expectation and thereby drive up inflationary pressures.

It also meant that governments and central banks could no longer target real variables to stabilize the output. Only a nominal anchor could achieve this purpose. Since then monetary policy has sought to  target a nominal anchor - initially money supply level, then exchange rate, and finally either price level or some measure of inflation. Inflation targeting was borne out of the last set of trends and have been underpinned by the New Keynesian theories about "sticky" prices. For nearly two decades, nominal inflation targeting has been the name of the game in monetary policy. 

However, in December, the FOMC announced a landmark decision to keep interest rates low till unemployment falls below 6.5%, so long as its inflation forecast remains below 2.5%. This effectively brings back "real" anchors back into monetary policy making. Fed Governor Ben Bernanke has argued that numerical thresholds for low rates would help “support household and business confidence and spending” and that this would make monetary policy “more transparent and predictable” to the public. 

But it is in Japan that nominal anchors are making the biggest splash. The new Shinzo Abe government looks set to make nominal anchors the basis of its macroeconomic policy making. After calling on the central bank to revise upwards its long-held inflation target to 2%, it has moved on to target other indicators. A recent Telegraph article wrote,
Mr Abe's Liberal Democrats have already lambasted the central bank, threatening a new bank law unless it adopts radical measures to pull Japan out of deflation – including a growth target of 3% for nominal GDP, implying massive monetary stimulus. He has set an implicit exchange range target of 90 yen to the dollar, instructing the Bank of Japan to drive down the yen with mass purchases of foreign bonds along lines pioneered by the Swiss.
The new Bank of England (BoE) Governor, Mark Carney recently suggested abandoning the nominal inflation targeting policy in favor of nominal GDP (NGDP) targeting. He said, "adopting a nominal GDP-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting". He argues that such a regime shift may be useful in times as now when the interest rate is touching zero-bound. Robin Harding wrote in the FT recently about NGDP,
The Fed’s new 6.5 per cent unemployment condition is a way to tell everybody that rates will stay low until the economy gets better. The nominal GDP target is a more drastic version of the same thing. In essence it combines growth and inflation into one number. Targeting this not only puts more weight on growth, it means promising to make up for low inflation now with more in the future – another way of saying the central bank will keep interest rates low.
In other words, inflation, nominal GDP, and even exchange rate have all become "real" economic anchors for a government looking to throw the kitchen sink in a desperate attempt to recover from its current deep slump. At a time when the economy is stuck in a protracted deflationary trap, interest rates are at zero bound, and excess capacity is widespread, nominal anchors may not be a bad strategy to shape expectations and get the economy's animal spirits active.

But in any case, it decisively marks the end of the Friedmanite consensus on nominal anchors in monetary policy making.

Performance-based payments to doctors

Just as achievement of student learning outcomes has become the holy grail of education, alignment of incentives among doctors, patients, and insurers is arguably the most challenging problem in healthcare.  In particular, how do we ensure that doctors deliver the most cost-effective treatments - most effective treatment at the lowest cost?

In an interesting experiment, New York city public hospitals have initiated a project to reward doctors for their performance based on a set of parameters related to better patient outcomes, instead of the prevailing volumes or procedures-based remuneration of doctors. Doctors attached to hospitals are generally remunerated based on the income they generate for the hospital. The latter has been found responsible for generating several incentive distortions, primarily in promoting over-treatment.

The New York public hospitals, the largest public health system in the US with 11 large public hospitals and more than a million emergency room visits a year, proposes to link doctors pay increases to performance on bench-marked indicators. The Times, which runs the story, writes,
Under the proposal, bonuses of up to $59 million over the next three years would be distributed to about 3,300 doctors, and would be given to physicians as a group at each hospital, rather than as individuals, so that even the worst doctor would benefit. They would amount to up to 2.5 percent of salaries, which range from about $140,000 for entry-level primary-care physicians to $400,000 for experienced specialists... The public hospital system has come up with 13 performance indicators. Among them are how well patients say their doctors communicate with them, how many patients with heart failure and pneumonia are readmitted within 30 days, how quickly emergency room patients go from triage to beds, whether doctors get to the operating room on time and how quickly patients are discharged. 
However much I am enthused by such initiatives, I am not too optimistic about its success. Already the union of doctors have disputed the set of parameters being used for bench-marking. The selection of parameters will be critical. What constitutes patient outcomes will vary, often widely, based on the category of medical conditions being treated. It will also vary based on the nature of patients, and their expectations. Arriving at a set of parameters that accurately reflect all these and other variations and will be more or less universally accepted may be easier said than done.

Sunday, January 13, 2013

Is QE turning into "stealth nationalization"?

I am surprised this has not generated the level of discussion it merits. The Telegraph (via FT) reports of the new Shinzo Abe government's plan to lift the Japanese economy out of its long-slump,
Premier Shenzo Abe is to spend up to one trillion yen (£7.1bn) buying plant in the electronics, equipment, and carbon fibre industries to force the pace of investment... The plan to buy plant involves leasing back the assets to firms in trouble. Analysts say it is a means of funnelling industrial aid, a move sure to raise the hackles of global rivals. It may violate World Trade Organisation rules on subsidies.
As FT writes, this is a "stealth nationalization" of the economy. And it argues that this is a logical culmination of quantitative easing itself,

Whether it’s QE or government-debt funded stimulus, the two amount to the same thing. Both offer support to industries, companies and banks which might otherwise collapse. QE is simply a more generic funnel. Stimulus, on the other hand, involves strategic government choices with respect to which industries, companies and banks to invest in and support. Take this trend along its natural course, however, and you only get to one result. The nationalisation of almost everything.

Amazingly, for the last two years, in a last gasp attempt to revive the economy, the Japanese Central Bank has been priming the equity markets by purchasing exchange traded funds (ETFs), so much so that it is now "en route to becoming a majority holder in the country's primary equity ETF". 

This transformation of monetary policy has been stunning. A simple credit infusion program by opening a liquidity injection window, shifted gears to different versions of quantitative easing by initially purchasing government securities and then private bonds with increasing dilution of credit standards. The credit expansionary interventions moved into a different plane by then purchasing ETFs in the equity markets and is now echoing nationalization by proposing to directly take stakes in private firms.  

With governments reluctant or paralyzed from taking the strong steps required to reverse the course and preferring to take the easy route by passing on the buck to central banks, there will be increasing pressure on them to incessantly keep printing money so long as inflationary pressures remain invisible. If the economy does not recover with conventional QE, as looks increasingly likely in most parts of developed world, then the pressure on central banks to indulge in, apparently "costless", Japanese style "nationalization" will rise. Is the Fed and ECB going to follow the Bank of Japan?

Saturday, January 12, 2013

Negative Externalities of Central Bank Actions

The fundamental macroeconomic challenge facing large parts of the world economy today is how to manage a sustainable recovery from the depths of the global financial market crises and the Great Recession. Any such recovery has to be a twin recovery - repairing financial market balance sheets and restoring growth and lowering unemployment rates in the real economy.

In his Stamp Memorial Lecture (pdf here) at the LSE, Mervyn King, the Governor of Bank of England, had this to say about the challenge with using expansionary policies to mitigate the economic impact of financial market crises,
Misperceptions mean that unsustainable levels of spending, and associated levels of debt, can build up over many years. When those misperceptions are eventually corrected, they lead to sudden large changes in asset values, a synchronised de-leveraging of balance sheets, a large downward correction to spending and output, and defaults. Keynesian policies to smooth the path of adjustment by supporting aggregate demand can help in the short run, but their effectiveness is limited by the fact that a significant adjustment to spending – from consumption to investment – is required.
While undoubtedly, there is the hope that low interest rates will provide the time and conditions for all agents to repair their balance sheets and for recovery to take hold, it also runs the risk of aggravating the problem. Gangrene cannot be treated with a sustained high dose of steroids. Fundamental adjustments, with short to medium-term pain, may be necessary to sustainably address this problem. There are two related risks

1. There is the risk that the monetary accommodation may not be able to solve the fundamental problems that caused the crisis and it may only be delaying the inevitable adjustments. If that is the case, then it also carries the risk that by kicking the can down the road, we may be actually aggravating the crisis by making the necessary adjustments larger than would have been the case if it were done now. By the time the inevitable amputation happens, the gangrene infected patient would also have undergone untold suffering. 

2. The other risk is more political. It cannot be denied that central banks across the world have come to assume the center-stage in national economic policy making. But unfortunately their rise has mirrored the reluctance of governments to bite the bullet when faced with severe economic and financial crises. In fact, the aggressive monetary accommodation may have contributed to this trend. As Martin Feldstein wrote recently in the context of the US, "By keeping the long-term interest rate low, the Fed has removed pressure on the president and Congress to deal with deficits". Much the same motivations are evident elsewhere as governments sit back paralyzed goading central banks to cover for their own inaction.

There is the danger that ultra-low rates will come in the way of decisions that are necessary to wring out the excesses built-up during the boom times. For example, the assumption that all major asset categories will recover close to its pre-crisis valuations and thereby eliminate the balance sheet problems of financial institutions is questionable. In the circumstances, central banks provide the alibi for governments to abdicate on their fundamental responsibilities.

Wednesday, January 9, 2013

The junk bond bubble

The extraordinary monetary accommodation by central banks across developed economies has been criticized for laying the seeds for another round of resource mis-allocation in the financial markets. It has been blamed for inflating speculative bubble in commodities markets. The latest signal of market distortions comes from junk bond yields which have fallen to its lowest rate ever, declining below the 6% mark.

This has forced the FT to question the wisdom of even calling them "junk" bonds. It writes,
To put this in perspective, junk yields peaked at almost 23 per cent during the financial crisis and have traded at a median of 8.2 per cent over the last decade. Current junk yields are closer to investment grade bonds’ 10-year median of 4.7 per cent... The yield on the 10-year Treasury... remains below 2 per cent. Investment grade bonds yield 2.8 per cent, on average. Top-rated 10-year municipal bonds are paying 1.8 per cent. All three are near historic lows. So bond investors fleeing the craziness of junk bonds will not find much sanity elsewhere, and junk, at least, tends to be less vulnerable than other bonds to losses when rates rise.
The ultra-low interest rates have driven down returns on all but the high risk securities. Investors in fixed income securities have responded by driving up the prices on these high risk junk bonds. According to The Bank of America Merrill Lynch High-Yield Master II Index, junk yields have fallen to 5.975% from 8.24% at the beginning of 2012 on the back of a 15.58% increase in their values this year. Junk bond issuance too has been rising in recent years. A record $79 billion in high-yield corporate bonds were sold in the United States in the third quarter. 

As yields fell, prices climbed, from 98.1 cents on the dollar at the start of 2012 to 104.75 now, near the all-time high of 104.99 recorded in January 2004, and above the key call-constrained 103% level that once served as a reliable upper boundary. Corporates too have been using the low rates to raise capital for retiring off their older, higher interest rate capital. Junk bonds have been on a rising path over the past four years, increasing by 4.4%, 15.2%, and 57.5% respectively in 2009, 2010, and 211 respectively. 

However, fortunately, there is a limit to how much junk bonds may rise. They can be redeemed early, from halfway through their life and starting at par plus half of the coupon. With average coupon of 8%, the redemption price comes to about $104, lower than the current pricing of $105. 

But for now, investors and financial institutions are piling on the risk as they see junk bonds as the only fixed income instrument offering attractive enough returns. Its immediate beneficiaries are the weaker companies, whose debt generally would have had to be priced at high premiums, who now are able to raise capital at much lower rates. 

Amidst all this, it cannot be denied that riskier bonds cannot become any less risky just because the market thinks that the cost of carrying it can be lower. 

Tuesday, January 8, 2013

India's Jobs Crisis

Amidst all talk of the need for second generation of reforms in India, we should not overlook the fundamental reality that the sustainability of India's economic growth, indeed its democratic polity itself, would depend on how it is able to manage the transition from agriculture to manufacturing and services for the majority of the 60% of population currently working in the former. This boils down to job creation, especially in manufacturing. And it is here that the alarm bells are ringing the loudest.

The most alarming signal is this graphic taken from a CRISIL report which shows that job creation slowed down even as growth rate increased. In the five years from 1999-00 the economy grew at 6% and created a net 92.7 million wage and self-employment jobs, whereas in the next five years from 2004-05 the net job creation declined to just 2.2 million even as the economy grew at an average rate of 8.6%. The biggest problem was the decline in the numbers joining the self-employed category by 25.5 million in the later period. The report finds that the majority of this fall in self-employed jobs was in agriculture. The role of NREGA in this shift is undeniable.

Even within the regular jobs, job creation fell dramatically in that engine of formal economic growth, urban areas. The number of urban regular jobs created fell sharply from 13.7 million in the 1999-2005 period to just 5.5 million in the 2004-10 period.

The biggest concern was the performance of the creating sectors like manufacturing, which were supposed to create the jobs required to help the country make the transition from a predominantly primary to a secondary and tertiary sectors. In many of these sectors, even as sectoral growth rate rose, the employment growth rate actually declined.

The report also contains another graphic that highlights how employment intensity, or the number of people employed for every Rs 100000 of real output, has been falling. It has been falling steadily in all sectors except construction. In fact, for the economy as a whole, it has fallen from 1.71 in 1999-2000 to 1.05 in 2009-10. While on the one hand, it is a reflection of productivity improvements, it also underscores the magnitude of the job creation challenge, even when growth is robust.

In this context, Livemint draws attention to a Planning Commission report which points to an alarming decline in employment elasticity in recent years. The Mint report writes,
The Planning Commission says that employment elasticity has come down “from 0.44 in the first half of the decade 1999–2000 to 2004–05, to as low as 0.01 during the second half of the decade 2004–05 to 2009–10.” An employment elasticity of 0.01 implies that with every 1 percentage point growth in GDP, employment increases by just one basis point. (One basis point is one-hundredth of a percentage point.) It’s as good as saying that the extraordinary growth during those years didn’t lead to any employment growth at all. What is worse is that employment elasticity of growth was much higher during the pre-reform period. The 10th Plan document has a table that shows employment elasticity for the economy as a whole was 0.68 during the period 1983 to 1987-88; this fell to 0.52 if we consider the period 1983 to 1993-94, implying a slowing down during the later years; and it went down to a mere 0.16 during 1993-94 to 1999-2000, which led to much worrying about jobless growth at that time. But employment elasticity during 2004-05 to 2009-10 is even lower than during the late 1990s. The bang we used to get for the buck is now an almost inaudible whisper.
Historical growth trajectories of countries show that as the economy grows and diversifies, the non-formal sector would shrink. But in India's case, exactly the opposite appears to be happening,
The total net increase in employment between 2004-05 and 2009-10 was 2.72 million. But the increase in informal employment during the period was 4.62 million. That means not only were the new jobs all created in the informal sector, but there was some shrinkage in formal sector employment as well, with jobs shifting to the informal sector. Indeed, in the decade 1999-2000 to 2009-10, formal sector jobs shrunk by two million and the entire job growth was in the informal sector. Nearly 93% of the workforce in 2009–10 was in informal employment, compared with 91% in 1999–2000. Not only are jobs hard to get, their quality too has worsened. 
Construction sector, where employment is predominantly non-formal
Many of the new jobs in the informal sector were in the construction industry. Between 2004-05 and 2009-10, there was a reduction of 14 million jobs in agriculture and five million in manufacturing. Most of the persons displaced found jobs in construction, where employment went up by 18 million. And since most of the construction industry is in the informal sector, the trend explains the growing share of informal employment.
It is a no-brainer to realize that job creation is India's biggest challenge in the years ahead. It is at the same time a massive economic, social, and political problem. Failure here will have consequences for the social and political order in the country.

Update 1 (24/1/2013)

Mint reports of an alternative explanation for the fall in jobs created during the 2004-09 period. It points to research which shows that the main reason for this decline was an improvement in the rural economy, which led many women to quit agricultural work. It writes,

Of the 59.5 million jobs created during the first half of the previous decade, nearly a third was in agriculture, at a time when the sector was in distress and agricultural growth was near-zero. Most of the new farm jobs in that period went to “self-employed females”. The majority of such workers were “unpaid”, which means they worked mostly for their relatives or husbands, without compensation. The rise in such low-quality jobs was a reflection of rural stagnation. As the rural economy improved in the second half of the decade and wages shot up, especially for males, women quit distress jobs. The fact that these women could afford not to work even in the drought year of 2009 suggests a rapid reversal of rural fortunes in the last decade. Thus, despite an increase in 22.3 million jobs in the non-agricultural sector, the overall increase in employment in 2004-09 appears poor because of the withdrawal of 21.1 million agricultural workers. The spread of education is also partly responsible for the declining LPR (the sum of employment and unemployment rates): most young males and nearly a third of women missing from the workforce chose to study rather than work. 
Update 2 (1/12/2013)
Mint has an excellent series on structural changes in India's labor market, based on the latest NSSO survey findings. This graphic has the changes in sectoral composition of jobs in India.
This graphic shows the changes in urban wages over the 2004-05 to 2011-12 period...
... and this in the rural areas...
... and this the female labour force participation trends. In the period, female labor force participation rate has declined by seven percentage points to 22.5%, one of the lowest in the world.


Sunday, January 6, 2013

Mr Bernanke, put back that wall!

The quantitative easing and unconventional monetary accommodation policies followed by central banks in developed countries has undoubtedly shifted monetary policy into a largely unknown terrain. Though supporters assure that central banks have adequate instruments at their disposal to roll back when need arises, given the sheer size of expansion of central bank balance sheets and the massive quantities of liquidity being created, the concerns are well-founded.

The conventional wisdom on the issue of central bank independence has revolved around governments trying to keep a leash over their activities to maintain their freedom to indulge in seignorage (or printing money) to finance public spending. In this context, Alan Blinder points to an alternative reason why central bank independence may be in danger - the increased co-ordination between monetary and fiscal policy authorities. He says,
The question is whether there has been too much coordination between monetary and fiscal policy, not too little; whether the close cooperation between central banks and Treasuries has compromised central bank independence; and whether, therefore, this close cooperation should end promptly. If I may paraphrase Ronald Reagan, it’s: Mr. Bernanke, put back that wall.
He argues that the recent crisis forced central banks and governments across much of developed world to co-ordinate very closely to stabilize the financial markets and also to prevent economies from slipping deeper into recession. Central banks on both sides of the Atlantic deployed all the monetary policy instruments at their disposal in this endeavor. In fact, popular and large sections of professional opinion has been socialized into believing that central banks, more than even governments, hold the dominant policy cards for stimulating economic growth.

This is dangerous either way. If all these fail and the economy falls into a long-drawn recessionary trap, it will seriously erode the functional credibility of central banks themselves. This will have very adverse long-term consequences. After all, a large part of the effectiveness of monetary policy actions stems from rational expectations about the central banks' inflation targeting commitment.

And if the policies succeed and the economy recovers, then the central bank will be pushed even more into the center-stage of the larger economic policy making domain. Such an expanded role invariably comes with more political compulsions that may often conflict with its primary responsibility of maintaining price stability. For example, it may constrain central banks from leaning against the wind and pursuing counter-cyclical policies.

Furthermore, it could also aggravate the current disconcerting trend of national governments passing the buck on to central banks and refraining from taking the hard long-term structural reforms required for sustainable long-term growth.

In the circumstances, a careful re-examination of the role of central bank may be necessary for the long-term institutional health of central banks themselves as well as the effectiveness of larger economic policy making itself.

Wednesday, January 2, 2013

The "other" internal and external validity problems with RCTs

Randomized Control Trials (RCTs) have been described as the "gold-standard" in estimating causal relationships in development. At the heart of the matter is that randomization helps us create a counter-factual group (the control group), without any observable or un-observable bias (from the treatment group), that any final variation in outcomes is due to the treatment itself. The findings of RCTs have been acclaimed as having revolutionized development research, especially in illuminating what works best in addressing specific development problems.

I am not sure. Consider two possibilities. The first, a "pseudo-placebo" effect, arises from the fact that most RCTs are not double-blind. The treatment target knows that he/she is receiving the particular intervention, and that alone many be enough to modify the individual behaviors or the environment in a manner that enhances outcomes. In other words, the treatment effect may be overstated. As a recent study found"the expectation of receiving the treatment can cause people to modify their behaviors in a way that produces a significant "average treatment effect" even if the actual intervention is not particularly effective".   

The second, the "scale-up effect", arises from the fact that the outcomes of a small pilot implementation does not always gets replicated when the intervention is scaled up. This is especially true of social policy interventions in developing countries with pervasive micro-governance failures and very weak delivery systems. I blogged earlier about "the concentrated effort and scrutiny of the research team, the unwitting greater over-sight by the official bureaucracy, and the assured expectation, among its audience, that it would be only a temporary diversion, contributes to increasing the effectiveness of implementation". This means that "there is the strong possibility that we will end up implementing a program or intervention that is qualitatively different from that conceived experimentally". 

Taken together, both these add several layers of complication. The former doubts the internal validity, and thereby the causal mechanisms of the outcome. The later questions the external validity of the finding, in terms of its replicability. It raises doubts about wisdom of drawing the conclusion that once we know what is the best strategy, in terms of policy design and implementation, then the big development problem can be resolved. 

Both these, different from the conventional measures of internal and external validity, are not easily addressed, if addressed at all. The nature of the interventions, the need for human stakeholders to calibrate actions in response to a treatment, makes them not amenable to double-blind trials. And, the gap between pilots and scale-up is a function of state capability, which has no easy or short-term answers. 

In other words, after all the statistical gymnastics, we are not any significantly nearer to the development holy grail than when we started. The fundamental challenge of what works in a scaled-up intervention still remain unresolved. 

Tuesday, January 1, 2013

Moral Hazard and Time Inconsistency in NHAI Projects

I have blogged earlier here, here, and here, about the moral hazard concerns unleashed by contract re-negotiations and how the power sector in India has been badly affected by it. Now comes news that some of the aggressive bidders for road projects bid out by the National Highways Authority of India (NHAI) may be thinking of pulling out of their contracts.

The Times of India has a report on GMR which had won the 555 km Kishangarh-Udaipur-Ahmedabad by quoting Rs 636 Cr in annual premium payable to the NHAI. This meant that instead of receiving annuity payments from the government, GMR would assume the traffic risks and make annuity payments to the government. In a public auction in 2011, GMR had offered to pay NHAI Rs 636 Cr every year for 26 years, to win the four-lane to six-lane conversion project estimated at Rs 5387 Cr tender. GVK Power was the next highest bidder at Rs 516 Cr. It writes,
This particular case and the trend of several top highway builders struggling to tie up funds for their projects are signals of tough times ahead. Though GMR has cited delay in getting environmental clearance for the project to start its expansion as the main reason to walk out of the project, highway ministry sources called this an indication of early "course correction" to "aggressive bidding" that happened during the last financial year. There were around a dozen projects where almost all bidders quoted high premium (upfront revenue to NHAI that increases by 5% annually) and doubts were raised whether this would be sustainable. At present, about 35 projects are awaiting financial closure... GMR's move could have been because of many other reasons including the project's financial viability considering  the high premium offered.
Now, it is quite possible that GMR have a genuine reason for seeking a termination of the contract. But it is also clear that such aggressive bidding, where concessionaires assume all sorts of market risks and also provide handsome premiums, was not exactly fundamentals-driven. Atleast some of the bidders were clearly aware of the risks they were taking and also knew how to mitigate them, legally or through the backdoor. Some others saw benefits from adding one more project to their project portfolio, especially in leveraging their balance sheets.

Site clearance problems and environmental clearance delays are inevitable parts of any such project in India. They should not form the reason for bidders to renege on their contracts. Most of these contracts would already contain cost-escalation and other provisions that would largely insulate the contractors from such risks. If they do not, then future contracts should incorporate these provisions.

But allowing such contracts to be terminated, especially for non-regulatory reasons, is certain to unleash moral hazard concerns and vitiate the bidding environment for the upcoming tenders. It will entrench expectations within contractors about the inviolability of contractual obligations and encourage similar aggressive bidding in the forthcoming bids.

Further, this will also aggravate the time-inconsistency problems that contractors face when bidding for such long-gestation infrastructure projects. Ex-ante, the contractors will bid aggressively without much regard for market risks so as to win the bid. Some of them presumably realize that they could re-negotiate and wrest a more favorable deal from the government agency. But ex-post, after all due-diligence and covering for risks, they will decide to pursue only those contracts with large margins and low risk. In other words, this practice will also allow contractors to cherry-pick on their public projects portfolio.

All this negates the very purpose of open competitive tendering, which seeks to address precisely such problems.

Update 1 (14/1/2013)

After GMR walked out of the Kishanpur Project, GVK has decided to terminate its 12 January 2012 BOT contract for four-laning of the Shivpuri-Dewas section of the NH 3 in Madhya Pradesh. The two to four-lane conversion of 332.46 k of the Delhi-Agra NH had a concession period of 30 years and construction period of 2.5 years at an estimated cost of Rs 3300 Cr. It invoked the Clause 34.8 of the concession agreement, citing delays in site handing over and environmental clearances. However, aggressive bidding where the contractor over-committed annuity payments to the government may be the real reason for the pull-out.