Saturday, June 29, 2013

The behavioral challenge with reforming harassment corruption

I am now firmly convinced that behavioural psychology plays an important role in all public service environments. Therefore, any effort to reform public systems that revolves around regulation and incentives, and overlooks the cognitive challenges, is most likely to be ineffective or certainly less effective than expected.

Harassment corruption, or those involving delivery of statutory services (birth registration, caste certificates, water and electricity connections, registering FIR in a police station, property tax assessments, issue of driving license etc), is the commonest form of corruption endured by citizens in any developing country. It is a classic monopoly and therefore most of the discussion to address this has revolved around process re-engineering, competition, transparency, and accountability.

An equally important dimension to the problem that has got limited attention is what I call ego depletion due to work over-load. People have a limited quantity of mental resources which they can draw on to exercise self-control and will power, at both individual level and in their inter-personal relationships. Every transaction and decision, of any kind, and its dynamics, uses up mental resources.

Let me illustrate. The service standards for a counter clerk in a customer care center in the US mandate that he/she deal with say, 20 customers an hour. Apart from an exceptional day, they deal with no more than that. This provides them the minimum time required to transact without feeling mentally strained. Similarly, a building inspector or police officer or tax assessment official, has all the time and logistics (eg. transportation facilities to inspect the property or crime site) to diligently follow-up on their mandated responsibilities without excessively depleting their mental resources. It provides them the time and mental space to connect with their client/customer, recover themselves, and then go to the next customer.

Consider the same official in India. On most days a clerk in a customer care center deals with many times more applicants than can be processed in a cognitively optimal manner. A building inspector services several applications each day, which are geographically widely dispersed, without any logistical support or clerical assistance. Additionally, most often he is entrusted with other unrelated responsibilities. To give a sense of the magnitude of the challenge, New York with 3500 eateries has 180 food inspectors, whereas Hyderabad with similar number of formal eateries and many times that many unregistered eateries (push carts, chai shops etc) has just four food inspectors.

Similar spatial, transactional, and functional over-load characterizes all other functionaries, anywhere in India. When people are exposed to the same ego-depletion day-in day-out, without any prospects of improvement even when they move up the ladder, a form of cynical and negative internalization of transactional and inter-personal norms is inevitable.

No amount of process re-engineering, while essential, can mitigate this behavioral challenge. The prevailing socio-political environment militates against either higher user fees or increased budgetary support (both of which can presumably be used to improve logistics or effectively outsource certain services) or hire more officials (which undoubtedly has its share of negatives), which are two possible approaches to start thinking about reforms. Informed opinion makers and mainstream debates sweep them under the carpet. Some others who appear to partially get it prefer to argue with homilies like increasing commitment among public officials.

Friday, June 28, 2013

The slowing escalator - has Africa missed the bus?

Dani Rodrik and Tyler Cowen have written about the bleak prospects of rapid economic growth in developing countries.

The argument goes something like this. Historically, due to its ease of replicability (of new processes and foreign technologies), sustained economic growth has been mostly based on structural transformations, in particular rapid industrialization. But this model faces challenges from three trends. Technological advances, by automating routine work, has made manufacturing much more skill-intensive and therefore less capable of absorbing large quantities of labor. Globalization has internationalized the production supply chain and increased competition among developing countries. Finally, the weak economic prospects of developed economies will make them less receptive to being passive export markets for the industrializing economies. Prof Rodrik concludes,
Manufacturing industries will remain poor countries' "escalator industries", but the escalator will neither move as rapidly, nor go as high. Growth will need to rely to a much greater extent on sustained improvements in human capital, institutions, and governance. And that means that growth will remain slow and difficult at best. 
Tyler Cowen points to efforts by Nike, motivated by rising labor costs in the factories of its traditional East Asian suppliers, to engineer labor out of its production chain using technology and innovation.

Truth to tell, even before all these studies, this fear was occasionally discussed in many forums. The rising labor costs in East Asia, especially China, and the Great Recession have brought this threat to our door-step faster than expected. So has Africa missed the bus? I believe that we need much more compelling evidence before I can agree with Prof Rodrik's pessimism. Few questions need answering.

What is the limit to the automation of factory floor work in the foreseeable future? How soon will the cost of technological innovation fall below Africa's real labor costs? Is it possible for textile manufacturers of Ghana to co-exist with their Chinese counterparts in a global market place? How rapidly will the Chinese move up the escalator, thereby vacating space for more of their own people and those from other developing countries? Which countries will occupy that space?

Most importantly, even if the aforementioned trends take hold, it will take time. Further, in the meantime, even if China's progress up the escalator slows, the space vacated will be large enough to accommodate many others. Will atleast some parts of Africa be ready to step up? If that happens, and we know that dominoes can have unpredictably surprising effects, prospects will be brighter. So there may be much more to the story before we can write its epitaph.

Wednesday, June 26, 2013

On scepticism and serendipity in development

I have not read any works of Albert Hirschman, but this review by Malcom Gladwell of his new biography written by Jeremy Adelman is very interesting. I plan to read Adelman's book at the earliest.

From the review, it is apparent that Hirschman saw development as a highly non-linear process, where tensions created by crises and conflicts have a beneficial role (in addition to its conventional negative consequences), and serendipity and happenstance results in good outcomes. His scepticism of grand narratives and comprehensive plans as the path towards development is similarly obvious. I am sympathetic with this world-view, though not when taken to its extremes of scepticism.

Gladwell highlights Hirschman's embrace of uncertainty and crisis, even failures, as "general principles of action" in the path towards development. He quotes Hirschman,
Creativity always comes as a surprise to us; therefore we can never count on it and we dare not believe in it until it has happened. In other words, we would not consciously engage upon tasks whose success clearly requires that creativity be forthcoming. Hence, the only way in which we can bring our creative resources fully into play is by misjudging the nature of the task, by presenting it to ourselves as more routine, simple, undemanding of genuine creativity than it will turn out to be...
While we are rather willing and even eager and relieved to agree with a historian’s finding that we stumbled into the more shameful events of history, such as war, we are correspondingly unwilling to concede—in fact we find it intolerable to imagine—that our more lofty achievements, such as economic, social or political progress, could have come about by stumbling rather than through careful planning. . . . Language itself conspires toward this sort of asymmetry: we fall into error, but do not usually speak of falling into truth.
On Hirschman's inclination to doubt (be sceptical) things since "it allowed for alternative ways to see the world", Gladwell writes,
But Hirschman would come to recognize that action fuelled by doubt allows for failures to be left behind. Spain (where he went to fight the Civil War) was a tragedy, but it was also, for him, an experiment, and experiments go awry.
Also it prevents the originators and implementers of the initiative to not become captives of their own idea. It provides a healthy detachment which lends objectivity when assessing the initiative. This is of great significance in the development policy space where bad ideas do atleast as much damage as the benefits produced by good ideas.

While Hirschman's point about the positive unintended consequences of bold schemes and plans and the importance of tensions (in development) is understandable, I cannot agree with its exclusionist tone. To say that crises and conflicts can have the seeds of success and development is one thing. But to argue that all such crises and conflicts have beneficial effects may be like saying "all dark clouds have a silver lining". Even more questionable is the argument that creativity arises only from mis-judgements and failures.

Monday, June 24, 2013

When consultants miss the "general equilibrium" effects

I have written earlier about the inadequacy of the standard consulting toolkit in "problem-solving" of social sector issues and suggested an alternative model.

In brief, typical consulting does a very good job of analyzing the situation through a "deep dive problem solving" exercise. But its prescriptions suffer from a linearity bias, in so far as it does not pay adequate attention to the "general equilibrium" effects of stakeholder interaction dynamics (most often, the behavioral changes), which is often considerable in development contexts.

A very good example of this comes from the analysis of energy savings opportunities. A 2009 study by McKinsey & Co showed that the US could save $680 bn over 10 years by improvements to efficiency of its homes, offices, and factories, through strategies like sealing leaky building ducts and upgrading old appliances. But as Brad Plumer writes,
As economists scrutinized those numbers, they realized the picture is more complex. Those engineering studies can’t account for the behavioral changes you might see in response to efficiency improvements... People could, for instance, start adjusting their thermostat if it becomes cheaper to cool the house... One recent study of Mexico, for instance, found that a government program to help people to upgrade their refrigerators with energy-saving models really did curtail electricity use. However, a similar program for air conditioners had the opposite effect — when people got sleeker A/C units, they used them more often, and energy use went up.
Similar unanticipated or unpredictable behavioral responses are commonplace with most large social programs. For example, efforts to improve learning outcomes by assessing outcomes of standardized tests, is likely to be gamed by teachers with time. Similarly, efforts to improve performance among public officials through financial incentives has the potential to be subverted in unpredictable ways. A cash transfer program to replace a food distribution system can fail because people may use the cash for other things or the local prices of food grains may fluctuate in an unpredictable manner or something else, the possibilities of which cannot be incorporated in a context analysis based one-off program design. Unlike the private sector - where designing incentive compatible arrangements is much easier and disciplining mechanisms are more effective - the emergent possibilities with public systems are far too many to be fully anticipated. No amount of theoretical and logical reasoning can anticipate all the emergent possibilities, which arise from cognitively constrained or skewed stakeholders.

In simple terms, these impacts are not likely to be assessed with regular problem-solving tools. They require iterative field experiments that can observe outcomes in real-time and try to respond to emergent scenarios using short and tight feedback loops. But they are both expensive and take time. They cannot be part of a "hourly billing" based, "high-intensity" consulting model. Thus the need for a collaborative approach to solving development problems.

Friday, June 21, 2013

The QE exit - A teachable moment

Finally, the much-awaited unwinding of Fed's balance sheet has begun. Ben Bernanke's announcement of the tapering of the quantitative easing program shows that the Fed feels that the US economy is on a sustainable enough recovery path.

He said that the Fed would start tapering its $85 bn monthly pace of asset (treasury securities and mortgage-backed securities) purchases from later this year, and continue until the end of the program sometime in mid-2014 when the US unemployment is estimated to fall to 7 percent. He also said that the pace of tapering will be adjusted depending on the economic outlook. The Fed lowered its unemployment rate forecast for end-2013 from 7.4% to 7.25% and that for end-2014 from 6.7-7% range to 6.5-6.8%, while it raised the 2014 GDP growth expectations to 3.25%.

The Fed's gradual tightening would bring an end to the age of plentiful cheap liquidity, and naturally raise the price of capital, reflected in the interest rates. Institutional investors will look to repatriate a large amount of capital back to the US, both to shore up their margins in anticipation of higher interest rates and in the expectation of recovery improving domestic investment opportunities in the US. Accordingly, the markets worldwide have reacted with broad sell-offs, despite the widespread anticipation of the announcement. Equity markets have fallen sharply and bond yields have risen, in expectation of diminished liquidity support and a reduction in the demand for bonds. The yield on 10 year US Treasuries rose to 2.36%, its highest since March 2012, up sharply from 1.6% at the start of this May.

A few observations on the announcement and its possible implications.

1. The question foremost in everyone's minds will be whether the Fed has timed its exit too early. After all, both the economy and labor market are still weak, and the Fed's decision is premised on the "expectation", and not "certainty", that the economy is firmly on recovery path. But "expectations" are just that! The premature exit from monetary and fiscal accommodation by the Bank of Japan and the Japanese government in the late nineties is thought to have been responsible for prolonging the "lost decade" of deflationary recession in Japan. In the case of the US too, there exists the real possibility that the rates may rise too high and too soon that it will adversely affect the debt-laden governments, businesses, and households.

The US federal, and many state and local governments, are heavily indebted and the recent period of ultra-low rates had served to alleviate their real debt-burden. Since many household mortgages still remain underwater and the rising rates will put upward pressure on mortgage rates, the households with un-repaired  balance sheets will be adversely affected. Finally, businesses will find their cost of investments rising precisely at a time when recovery is likely to be taking hold. A confluence of some of these factors has the potential to nip the green shoots of recovery, just as what happened in Japan.

2. A big danger for the global financial markets will come from the generational shift that will arise in moving from an era of ultra-low rates and abundant liquidity to a more normal period, even one where liquidity may remain strapped for a prolonged period. Gillian Tett makes a very important point about the markets addicted to "cheap money and the carry trade". A generation of traders have seen only cheap and abundant capital and have internalized trading strategies that revolve around them. How will the markets react to the new era of scarcer and more expensive capital?

3. Fueled by the easy money policies of the past five years, the global financial markets have been showing ample signs of froth and bubbles. There is growing consensus that the ultra-low rates had induced several distortions into an already heavily distorted global financial markets. To this extent, the Fed's decision is equivalent to "taking the punch bowl away when the party is on". In other words, the Fed has made a conscious judgement call to puncture the ongoing boom in equity and bond markets, albeit motivated by different considerations.

4. The carefully phrased nature of the announcement on tapering QE is a continuation of the Fed's recently embraced policy of "forward guidance" to steer monetary policy and shape expectations. In simple terms, the fortunes of the US economy, and thereby the world economy itself, is in no small measure being guided by gymnastics with words. Bernanke's communication is obviously intended to cause the least disruption in the financial markets, and reassure investors that there would be a seamless unwinding of the Fed's massively bloated balance sheet. It makes one wonder what role professional communications specialists have had in helping formulate phrase the Fed's "forward guidance" policy? Indeed, every word in the Fed's statements are subjected to the most intense scrutiny to get the best possible interpretation of its intentions.

5. One cannot but not notice the relative lack of any sophisticated economic models in the Fed's decision, though doubtless some monetary policy model has informed the forecasts and the predicted trajectories. However we cannot say anything with any reasonable degree of certainty about how things will pan out in the foreseeable future. This is one of the more important teachable moments in macroeconomic policy making that we have seen since the bursting of the sub-prime mortgage bubble. By all the same arguments, the Fed could have delayed the exit by another six more months, announcing this only towards the later part of this year. To that extent, one can say that the timing, sequencing, and pacing of the exit is an informed judgement call by the FOMC.

6. Its impact on India is likely to be atleast mildly disruptive in the short-run. India's problems are exacerbated by the fact that it suffers a very high and rising current account deficit. The inevitable sell-offs in equity markets and capital flight will increase the downward pressure on the rupee. The RBI will be forced into keeping rates high, so as to discourage the foreign capital from fleeing, even if inflationary pressures appear to be subsiding. To this extent, there will be an important shift in monetary policy, which hitherto had been guided only by the trajectory of inflation. Now monetary policy will have to accommodate the need to both lower inflation as well as maintain stability in the exchange rate market.

Thursday, June 20, 2013

Structuring PPPs in Infrastructure

I have a column in today's Indian Express, co-authored with Dr TV Somanathan, on structuring Public Private Partnerships after off-loading construction risks.

Update 1 (6/10/2014)

Subir Gokarn feels exactly the same,
In the early stages of the process, PPP needs to be a combination of public funding and private execution. It is only at a later stage - the last two steps on the capital ladder - that private funding becomes viable. Proximity to the beginning of the revenue stream for the project - the predictability and stability that I alluded to earlier - is the determinant for effective entry of private financing into the process. Just as the entities associated with the each successive step of a capital ladder make their money by selling their stakes to the entities specialising in the next step, public funding of infrastructure can, at an appropriate time, sell stakes in projects to private entities, using the money thus made to finance new infrastructure projects. And so on. To give the concept clarity, PPP should perhaps be re-labelled FPTP - First Public, Then Private.

Wednesday, June 19, 2013

Insider Trading in Infosys?

The volume of Infosys shares traded in NSE on Friday, May 31, 2013, at 2.312 million, was twice the daily average for the year. On the same day, volumes in Infosys call options too surged and its share gained 3%, even as the broader Nifty itself fell 2.3% and technology scrips experienced a downward correction. By itself nothing unusual, except that the next day, June 1, 2013, a special board meeting was convened to announce the return of NR Narayana Murthy as the company's Chairman.

By any definition, one cannot but be convinced that this is enough prima facie suspicion of "insider trading" to warrant a full-fledged investigation by regulators and public debate by media and opinion makers. Based on all publicly available information, instead of rising, the share valuation of Infosys should have, given its recent travails, trailed those of its peers, all of whom experienced downsides on that day. It is clear that certain players had private information about a "positive" development the next day or so, which drove the surge in volumes and price. Given the secrecy surrounding the issue, it is perfectly logical to presume that only a select handful of top executives of Infosys, apart from Mr Murthy, knew this. Atleast one of them, possibly many of them, have benefited from the transactions done on May 31.

It is surprising that this has received so little attention in the media. None of the vocal television channels, some of whom are self-appointed conscience keepers of the nation, and who cry hoarse with indignation at corruption and injustice, real or perceived, have even discussed this, leave alone pursue it. But it should not come as a surprise given the kid-glove treatment of sections of corporate India, especially those involving certain individuals, by mainstream media and opinion makers. But we have lost a great opportunity to shine light and improve regulatory oversight on "insider trading", which given India's corporate culture and its pervasiveness even in more regulated markets, is certainly considerable.

It is good that this has caught the attention of the market regulator SEBI. It does not need much insight to argue that if the investigation is taken to its logical climax, some corporate reputations will bite the dust. It is also certain that efforts are already afoot to influence the investigations and limit any damage. If nothing comes out, and that seems most likely, the media cannot escape its share of complicity in losing yet another opportunity to improve corporate governance in Indian boardrooms.

Tuesday, June 18, 2013

A note of caution on harmonization of policies

In a recent FT op-ed, Google Executive Chairman Eric Schmidt suggests that corporate tax reforms, aimed at resolving the ongoing controversy about firms evading taxes by exploiting the variations among different national tax jurisdictions, should occupy the agenda of a multi-lateral forum like the G-8. This suggestion is in line with the belief that in a closely integrated world, the rules of the game governing such trans-national issues should be formulated in multi-lateral forums. While the importance of a trans-national consensus on such issues cannot be denied, this should not be taken to mean a one-size-fits-all harmonization of policies.

The political indignation in UK forced Prime Minister David Cameron to push in the direction of a global consensus on corporate tax rates. Some of the reforms being suggested, most notably disclosure requirements like country-by-country reporting of revenues and profits, are undoubtedly desirable. But the danger remains that it is only a short step from here for someone to suggest harmonization of corporate tax rates. I believe that this would be undesirable.

The Great Recession has unsettled the conventional wisdom in several areas. The four largest economic entities - US, Europe, Japan, and China - have been pursuing domestic economic policies that not only go against economic orthodoxy but also may be adversely affecting other countries. Consider the following four sets of macroeconomic policies.

1. In an age of global production chains, multinational corporations have sought to limit their tax liabilities by exploiting the vast variations in tax rules across the world. For some time now, concerns about high profile firms like Google and Apple avoiding taxes through complex webs of cross-national ownership holdings and revenue transfers have been brewing. Fundamentally, they seek to transfer income from a higher tax country to lower tax ones through complex accounting transactions.

Recently Apple, despite sitting on $145 bn cash reserves, two-thirds located outside the US, decided to take a $17 bn loan to buy back some of its own shares, clearly to avoid paying taxes in the US. A US Congressional investigation has found that in the 2009-11 period, Apple Inc paid only $5.3 bn in taxes instead of the $21 bn it would have had to pay at 35% corporate tax rate. At a time when governments, especially in the developed world, are fiscally constrained and economies are weak, this massive revenue loss has become a matter for serious concern.

Ireland has been at the center of this controversy, thanks to its very low corporate tax rate of 12.5%. All the major corporates have "letterbox subsidiaries" in Ireland or other low-tax jurisdictions, whose utility is exclusively to avoid taxes. Critics argue that such low tax rates are beggar-thy-neighbor and recently, as part of the Irish bailout package, the European Union aggressively pushed for raising Ireland's corporate tax rate. But it cannot be denied that the low corporate tax rate played a not insignificant role in Ireland's emergence as a poster child of successful globalization.

2. The US Federal Reserve has been pursuing extraordinary monetary accommodation through its quantitative easing policies in its attempt to restore economic growth. The balance sheet of the Fed has surged nearly four times since late-2008 to over $3.3 trillion, unleashing a massive volume of credit. Apart from generating domestic asset bubbles and other distortions arising from resource mis-allocation, the ultra-low interest rates and liquidity glut has increased the vulnerability of developing countries.

The sharp spurts of capital inflows have affected exchange rate stability and imported inflationary pressures, thereby increasing the macroeconomic challenges faced by many developing economies. In addition, as Morgan Stanley's Ruchir Sharma, among others, have argued, the easy money has fueled a commodity bubble. This has adversely affected the current account of countries like India. The same set of expansionary monetary policies are at the center of European efforts at economic recovery. The European Central Bank's quantitative easing has only served to amplify the Fed's actions.

3. In Japan, in an effort to pull the economy out of a prolonged deflationary slump, the government of Shinzo Abe has embarked on a policy of aggressive monetary expansion and currency devaluation. The Bank of Japan (BoJ) has expanded credit supply through both large quantitative easing and by communicating a higher inflation target. In recent months, the Japanese Yen has depreciated by nearly a fifth of its value, thereby artificially boosting Japanese economic competitiveness. In fact, the sudden and sharp devaluation of the yen, coupled with its explicit pursuit by the Japanese government, has aroused fears of global currency wars. The Yen has depreciated significantly against all the emerging market economies.

4. The spectacular economic growth of China has in no small measure been driven by external markets. Chinese exporters and infrastructure firms have benefited enormously in their conquest of overseas markets from several implicit subsidies. These subsidies include cheap land and labor, low cost unlimited capital, cheap inputs like electricity and water, and fiscal incentives. To this long list we must also add the benefits of the dollar-renminbi peg. It is undeniable that all these give Chinese exporters an unfair advantage against firms, especially from other competing developing countries, in the global export markets.

All these have been the result of policies explicitly aimed at supporting Chinese businesses in export competition. These policies have been critical to their external competitiveness and helped Chinese firms establish a firm foothold in all markets. The massive scale of such support and the unique nature of the Chinese political economy means that these policies are not replicable elsewhere.

In all the four cases, the respective policies are being driven in pursuit of perceived core national economic interests. The five governments see these policies as critical to either economic recovery or fundamental to their economic growth model. Given the level of political support for such policies and central role it plays in the nation's growth model or macroeconomic policies, it is difficult to believe that they can be taken off the table. Further, the relative size of these economies, except Ireland, mean that these policies have deep impact on the global economy.

The real economic effect of all these policies are no different from traditional protectionism. Protectionists erect tariff barriers to external competition. Ireland's low corporate tax rate clearly under-cuts its partners in the competition to attract investments. The expansionary central banks are, in one stroke, effectively exporting inflation, raising global capital market volatility, and manipulating their currencies. And China is directly subsidizing away competition. All these policies hurt other economies as much as it benefits the country pursuing it.

The movement to harmonize global trade policies was a result of efforts to contain protectionism. By the same logic, in the current circumstances, demands for harmonization of corporate tax rates or exchange rate policies or co-ordination of monetary policies or restrictions on national subsidies cannot be seen as far-fetched. Eric Schmidt may or may not have had tax rate harmonization in his mind, but this issue is certain to be attractive for Congressional leaders in the US and elsewhere at a time when they are perceived as victims of low corporate tax rates in certain economies. But this would be a gross simplification of the complex forces that drive the world economy.

As the costs imposed by the Eurozone's experiment of monetary union without fiscal integration has shown, we need to be cautious about the benefits of excessive harmonization. Apart from the obvious differences in their economic profile and level of development, national economies will always be exposed to asymmetric economic and other shocks. What may be good for one country at a point in time may be the antidote for another at that time. In the circumstances, instead of being boxed into straitjacketed one-size-fits-all policy choices, nation states will require the freedom to pursue policies that are suitable for them at any point in time.

It is also a reminder that there is no orthodox policy toolkit that can help economies successfully navigate these environments. In these conditions, India needs to adopt a heterodox approach towards macroeconomic policy management. Industrial policy, capital controls, and the like have an important role to play in macroeconomic management. In fact, in light of recent events, even the traditional upholders of economic orthodoxy, the Bretton Woods twins, have advocated heterodox policies like fiscal expansion, higher inflation target, capital controls, and industrial policy. In the circumstances, harmonization of macroeconomic policies, while logically appealing, may not be the most appropriate response to the challenges we face.

Monday, June 17, 2013

Crony capitalism and Indian banks

A rising share of non-performing assets (NPA) of Indian banks, in particular the public sector ones, has become a cause for concern in recent months. Unfortunately, the search for explanations have been limited to standard reasons like poor governance in public sector banks and priority sector lending needs arising from populist political compulsions. But while these factors have undoubtedly played a part, I am inclined to believe that this time around crony capitalism may have a bigger contributory role. In fact, India's public sector banks may have become the most important channel feeding illegitimate business-politics linkages.

Before, further analysis, consider these figures. The operating margin of public sector banks for the first quarter of 2013 and for the fiscal 2012-13 rose 0.52% and 5% respectively. In stark contrast, for the private banks, the profits rose 25.41% and 25.65% respectively. In 2012-13, the NPAs of the 38 listed banks, private and public, grew by 51% from Rs 61000 Cr to Rs 92500 Cr, with that of private banks growing by 35% and of public banks by 52%. As this Livemint article indicates, the NPAs of Indian banks at 3.2% is the highest among all Asian economies. 
Graphic by Naveen Kumar Saini/Mint
Further, if the Rs 2.2 trillion corporate debt that has so far been restructured through the debt recast cell and an estimated equal amount that has been restructured through bilateral deals between banks and borrowers is taken into account, 11% of all loans are under stress. The rating agency ICRA has estimated that once the RBI's revised norms on bad asset classification comes into force by June 2015, the NPAs will rise to 5.5-6.5%. 

The last decade saw a boom in construction and infrastructure investments. In the absence of a deep and liquid long-term debt market, a major share of the financing for these projects came from banks. Since the public sector banks dwarf the private ones, it was natural that the major share of these loans come from them. Today, we have a situation where most banks, public and private, are heavily exposed to sectors like power, mining, and roads, close to or exceeding their regulatory limits - 20% of capital funds to a single borrower and 50% to a single borrower group. In fact, a major portion of the debt in private domestic financing that has come as public private partnerships (PPPs) have been from public sector banks. In other words, a major part of PPPs have been just backdoor public financing.  

For sure, many of these projects have suffered from delays in regulatory approvals and inertia in decision making within the government bureaucracy. But from hindsight, as recent events have shown, many of these projects were also conceived on shaky foundations themselves. Contracts were awarded without competitive bidding and as part of rent-seeking transactions, firms bid aggressively at commercially unviable terms, bidders did not have sufficient professional expertise, and so on. 

Clearly, many of these loans were disbursed without the basic due diligence. Given the stakes involved and the environment in which these were approved (the large-scale instances of egregious corruption that have been exposed in the same decision making systems), it is not a stretch to imagine that the same negative factors influenced these loan decisions. The State Bank of India (SBI) alone has nearly Rs 3200 Cr worth exposure to Kingfisher, whose business model and corporate governance was questionable from the beginning. Similarly, for the past four years, the same bank has exceeded the credit exposure limit to a single borrower, Reliance Industries Ltd. The Finance Ministry cannot absolve itself off responsibility for these problems.  

In the circumstances, the recent outspoken comments by senior officials on governance standards in public sector banks is surprising. It is well-known that the government exercises considerable influence, if not complete control, both formally and informally, on all public banks. Apart from the appointments of all officials and boards of banks, the government is represented on their boards by senior officials of the Finance Ministry. It is inconceivable that large loans could have been extended, especially those which are now under stress and have undergone restructuring, without the tacit approval of the Government. Nothing would have prevented the government nominees from putting their foot down on the build up of such bad assets and excessive exposures. 

A CAG audit of the public sector banks could easily expose another large scam, and incriminate the Finance Ministry itself, apart from the bank regulators. Large banks have become a facade for governments to extend patronage to big business groups and deepen the unhealthy relationship that has developed in recent years between big business and politics.

It is indeed surprising why this issue has not received anything remotely close to the attention it deserves, either in public debates or academic research. Elsewhere too, especially in the East Asian economies in late nineties, state-owned banks played a critical role in cementing crony capitalism. Much the same appears to be playing out in India too. Reforming this has to go beyond debt restructuring and regulatory oversight, to far-reaching changes in the manner of control exercised by the Finance Ministry itself.   

Friday, June 14, 2013

More on Australia's "Dutch Disease"

I've blogged earlier, here and here, about the skewed growth of the Australian economy, pointing to the resource mis-allocation caused by the strong performance of the commodities sector. Riding on the back of China's insatiable appetite for minerals, the Australian economy has surged ahead during the first decade of the millennium.

Here are two excellent graphics that capture the essence of Australia's version of the "Dutch Disease". The first graphic shows that the increased price of its major exports - coal and iron ore - has been the dominant contributor to its economic growth in the 2000s.

Tsy - ToT contribution to income growth
The second graphic shows the sharp rise in investments in mining sector. Mining, which forms just 10% of the GDP, has sucked up nearly 70% of the capital expenditure in the economy.
ScreenHunter_34 Jun. 13 04.59

Sunday, June 9, 2013

It's the politics, stupid!

The IMF recently admitted (pdf of report here) that they mis-handled the bailout of Greece, in particular the 110 Euros first rescue package, claiming that growth assumptions were too optimistic and debt restructuring should have taken place earlier, in early 2011. Predictably, this has provoked a strong reaction from the Europeans, who have strongly defended the bailouts. Critics of IMF have pounced on it as further proof, if any was still needed, of its long history of mishandling sovereign debt crises and failure to learn from its mistakes.

Now, I believe that both IMF and the EC are right, albeit for different reasons. From a purely economic perspective, the IMF's argument that Greece did not meet medium-term debt sustainability was plain obvious and that debt restructuring was inordinately delayed cannot be faulted. But the EC's delayed rescue and its management of the rescue package as a compromise may be a reflection of the deeply political nature of such decisions. In fact, even history may bear out the European leaders in positive light if its long-term implications turn out as desired.

For those who followed the intense debates in Europe about bailing out the peripheral economies, it is plain evident that decision makers needed to pull off a very delicate balancing. On the one hand, Greece had lost market access and was on the verge of a sovereign default, even exit from the eurozone, thereby posing a serious danger that the European project would collapse. This imperative to rescue Greece, was matched by the equally compelling opposing argument that Greece's problems were essentially its own creation and a bailout would generate a dangerous moral hazard spill-over to others, besides being legally questionable under the European integration treaties.

In an ideal world, without moral hazard and other market failures, the debts of Greece and its financial institutions should have been restructured much earlier. The delay obviously worsened the situation and made the rescue costlier, both financially and in human suffering. Further, in the absence of medium-term debt sustainability, any bailout would be tantamount to throwing good money down the drain.

But the Europeans (and rational economists too) would see that as the psychological deterrent cost, which presumably others have internalized, of minimizing the moral hazard. Further, it may also have been the political cost required to convince both parties to accept the terms of bailout - for Greek politicians and its citizens to accept the harsh austerity that came with the rescue (Greece's failure to comply with its structural reform commitments agreed in mid-2010 is proof of this), and for Germany and other creditors, political support to use their taxpayers money to help Greece. These costs may have had to be incurred to mitigate the ever-present bias towards a repeat of the events that led to the crisis.

Finally, the bailout happening despite Greece not being on a medium-term debt sustainability path was not surprising, since the decision to bailout Greece was a purely political one. It is inconceivable that the European decision makers were unaware of Greece's perilous finances and therefore the inevitability of further bailouts. In fact, the multiple drips of bailouts, instead of single shot of big-bang rescue, may itself have been part of the calculus of managing the aforementioned psychological and political costs.

In view of the aforementioned reasoning, analysts are off the mark in suggesting that the IMF's latest admission would form the template for future rescues. It would not, because all such decisions are more political than technical, and the former invariably trumps the latter. And being unaware of that betrays a naive understanding of politics and international relations that govern such decisions. In this context, it is surprising that IMF's ex-post evaluation of its role does acknowledge the political dimension of the joint decision made with EC and the ECB. To that extent, the current acrimony could have been easily avoided.

Friday, June 7, 2013

Nudging to lower deaths by over-medication

Over-medication, both deliberate and by accident, claims a large number of lives across the world. In this context, Times argues that packaging of commonly used "suicide pills" like Tylenol in small blister packs of 16-25, instead of bottles of 50-100, can reduce such deaths. It writes,
In September 1998, Britain changed the packaging for paracetamol, the active ingredient in Tylenol, to require blister packs for packages of 16 pills when sold over the counter in places like convenience stores, and for packages of 32 pills in pharmacies. The result: a study by Oxford University researchers showed that over the subsequent 11 or so years, suicide deaths from Tylenol overdoses declined by 43 percent, and a similar decline was found in accidental deaths from medication poisonings. In addition, there was a 61 percent reduction in liver transplants attributed to Tylenol toxicities.

Thursday, June 6, 2013

The importance of "reserve requirements"

One of the central pillars of bank regulation is capital and reserve requirements. The Basel III regulation advocates larger capital adequacy, higher quality of capital, and more liquidity requirements, though critics argue that they are too small to be effective in cushioning banks against financial crises.

Traditionally, micro-prudential regulation of banks has sought to align their incentives against excessive risk taking and also reduce vulnerability to bank runs using minimum equity capital standards and reserve requirements respectively. However, while the former, however inadequate its magnitude, remains an important instrument of banking regulation, the latter appears to have become marginal in many developed countries.

Reserve requirements consist of both cash and liquid government securities, the former being reflected in cash reserve requirements and the latter in liquidity ratios. In the US and many developed countries, on grounds that they adversely affect bank profitability, both these are no longer important levers of bank regulation. Banks have lobbied strongly, arguing that such requirement adversely affect their profitability, and have managed to convince regulators to rely on publicly provided instruments like deposit insurance as hedge against bank runs. However, in developing countries, they remain critical tools for the bank regulators to cushion the system against bank runs.

In the context of the global financial crisis and the policy measures undertaken to mitigate the credit squeeze, bank reserve requirements assume great significance. A minimum bank reserve requirement, with a counter-cyclically adjusting split between cash and securities, would have enabled bank regulators considerable flexibility in managing the crisis. The important point here is that the reserves would include both cash and government securities, and their respective shares would be dynamic.

In good times, a higher share of cash would serve to throw sand on the wheels of a galloping financial market. Further, by keeping the share of government securities low, it would also ensure that governments do not convert the reserve requirement as a backdoor to support public borrowing. This is a very valid concern, since the RBI in India effectively uses the statutory liquidity ratio (SLR) to force banks to buy government debt. A single reserve requirement, with cyclically adjusting shares of cash and securities, would help eliminate this discretionary risk. The higher share of cash would also be useful in a crisis - it provides a more reliable (than capital ratios) signal against default risk besides also providing a high enough base which can be lowered to increase liquidity in the system.

In contrast, in times of liquidity squeeze, a higher share of securities would have freed up more liquidity and also made banks increase their share of securities holdings, which in turn would have contributed to increasing the price and lowering the yields of these securities. In other words, these actions would have had the same effect as the quantitative easing programs of central banks. In India, the presence of SLR and cash reserve ratio (CRR) have enabled the RBI to indirectly carry out quantitative easing to ease liquidity squeeze in recent years.

Furthermore, as Jeremy Siegel and Charles Calomiris have written, an increased use of reserve requirements would provide the US Fed with a very effective tool to manage a calibrated exit from the extraordinary balance sheet expansion of the last five years.

Along with other prudential regulations, Charles Calomiris has suggested a 20% cash reserve requirement for banks. Though the magnitude will be a matter of debate, the case for using reserve requirements in banking regulation is compelling.