Friday, May 30, 2014

Improving Business Environment

I have an op-ed in Indian Express today on an agenda for the new government to improve business environment, especially for small businesses (covered in BBC here).

The simple message is that the cutting edge of Indian state, at the districts, should spend more time reviewing parameters that contribute to improving the business environment. Currently, their focus is on wealth re-distribution policies - rural development and implementation of welfare programs.

Instead, district officials, headed by the District Collectors, should focus equally on growth creation. More specifically, they need to focus on attracting entrepreneurs, enabling them to start businesses, and facilitating the linkages that would help these businesses expand and create more jobs. In fact, instead of being reviewed for the generation of unproductive rural employment, they should be held accountable for the creation of productive non-farm jobs in both rural and urban areas. District governments should become the economic growth (and job creation) catalyzing agents.  

Sunday, May 25, 2014

The perils of "unknown unknowns"

Robert Shiller has long advocated the use of structured insurance and hedging instruments to mitigate long-term risks from climate change and natural disasters. He writes in a new Times article,
We need to worry about the potential for greater-than-expected disasters, especially those that concentrate their fury on specific places or circumstances, many of which we cannot now predict. That’s why global warming needs to be addressed by the private institutions of risk management, such as insurance and securitization. They have deep experience in smoothing out disasters’ effects by sharing them among large numbers of people. The people or entities that are hit hardest are helped by those less badly damaged.
But these institutions need ways to deal with such grand-scale issues. Governments should recognize that by giving these businesses a profit incentive to prepare for these unevenly distributed disasters. After all, fire insurance does no good unless you buy it before the house burns down. And you have to diversify your portfolio before the stock market crashes.
And about the prevailing state of the market for hedging against such disasters, he writes,
They tend to focus on relatively short-term risks, and don’t hedge against the increasing cost of disasters over distant future years. Yet if the problems of global warming become more serious, they will very likely be long-lasting, raising some complex, tough-to-quantify issues. Some kinds of crises, like hurricanes, may remain intermittent, but their tendency toward severity may build in a slow, hard-to-predict process and in complex geographical patterns.
I think Prof Shiller himself displays a market cognitive bias here - the assumption that markets can provide the risk mitigation solution for such complex risks. Consider this data snippet,
In the 1960s, 1970s, and 1980s, catastrophe loss costs in the US property casualty insurance industry were about 1% of written premiums. That jumped to approximately 3.5% in the 1990s and in the 2000-2010 period, and doubled to 7.2% from 2010-2013. This was due in large part to catastrophic weather from 2008-2012, including inland wind (tornadoes), hail, and coastal wind (hurricanes), which had become more difficult to predict and model.
I think it is impossible, even for sophisticated insurers and reinsurers, to model such Knightian uncertainties. This is all the more so with assuming long-term risks. Climate trajectories, especially at local levels, are subject to mutations (abrupt changes) which could render previous assumptions completely irrelevant. Once the risk materializes, its holders are left with no options, howsoever much they have hedged for it.

Since the holders of such insurance are citizens, governments would then be forced to step in.  The too-big-to-fail associated with large insurers (who are most likely to be counter-parties to such risks) would anyways make bailouts inevitable. Insurers and reinsurers who have internalized this belief would therefore be less than rigorous with their under-writing standards. This moral hazard at the insurer's end is mirrored at the buyer's end. The availability of insurance whose price is presumably less than the true cost of the risk assumed would encourage people to build on vulnerable areas and so on. The systemic incentive distortions would be considerable.

This is not to suggest that markets have no role to play in mitigating such risks. Far from it. Insurance products can be used to mitigate several risks, especially shorter-term natural disasters. And there is an active market in such products.

But when faced with "unknown unknowns", there are limits to how much smart we (or us collectively, in the form of markets) can be. In some ways, the belief that such uncertainties can be hedged is similar to the classic belief in "free lunch". In fact, the insurance industry itself, in the words of a leading insurance industry think tank Geneva Association, has described such risks as "uninsurable".

Such uncertainties are best hedged by plain-simple regulations - identification of vulnerable areas, with specific risk probabilities, and rules that limit construction and economic activities. The costs of any disasters that go beyond these (ie one which hit even ex-ante less vulnerable areas) are best covered through some form of direct public payouts (even with its moral hazard) than through the market mechanism.

Some times the transaction costs and incentive distortions associated with risk diversification become too high that it more than offsets the benefits from diversification. And long-term climate risk mitigation may be one such case. 

Thursday, May 22, 2014

Indian economy graph for the day

The slowdown in Indian economy over the past five years or so has been accompanied by a sharp decline in private investment. Fixed capital formation, a good measure of value added through capital investments, in the private sector nosedived by 40% from being 14.26% of GDP in 2007-08 to 8.46% in 2012-13. Reviving this should be central to any attempt at improving the economy.
Public sector GFCF too declined in this period from 8.54% of GDP to 7.80% of GDP. Clearly the massive fiscal splurge in this period went into subsidies and doles rather than financing capital investments. As the combined squeeze of both started to bite, it is no surprise that supply-side inflationary pressures showed up. 

In fact, much of this (and a host of other fundamentals) reflects the problems posed by deep underlying structural issues - infrastructure bottlenecks, rigidities in labor market, tough business environment, accessing credit for small enterprises, and so on. Clearly, a second generation of economic reforms, long overdue, are necessary to alleviate these constraints. Even with aggressive pursuit of reforms, it is going to take time.

As the graph shows, the decline started in 2008, coinciding with the global financial crisis and the resultant recession/slowdown. It has fallen unabated since then. In fact, even the steep rise in investment from 2004-05 was driven by the headwinds from the economic boom during the period which papered over these fundamental problems. 

Monday, May 19, 2014

China's Ponzi Trifecta

As concerns mount about debt overhang in the Chinese economy, FT has a nice blog that points to three ticking time bombs - property developers with meagre cashflow; big cities relying on land sales to repay debts; and some industrial firms facing debt repayment crisis.

Another way to think of them is as the unravelling of a trifecta of massive Ponzi schemes - bubbles financed by leveraging debt in the expectation of never-ending growth - all of which were sustained for long and in such scale through the demand created by the country's spectacular economic growth over the past two decades.

Property developers built up a massive debt-financed portfolio of properties whose valuations kept rising as if there would be no end. Land was purchased at inflated prices and constructions done using cheap and readily available short-term capital, in the firm expectation that the investment could be easily recouped and the debt repaid from sales. But once sales tanked, strains have started to quickly cascade through the system.

City governments borrowed heavily to invest in grandiose infrastructure projects. They relied on land sales revenues to finance these investments. The soaring property prices encouraged them to borrow recklessly and invest in projects. So much so that all major cities rely on revenues from land sales to finance more than half their debts. Again, as property market cool and housing sales decline, demand for land among property developers have been falling sharply. This has in turn squeezed cities off the cash flow required to repay their debts.

Finally, large industrial firms supplied inputs that kept the massive construction boom inflated. Like developers and local governments, in the belief that the investment boom would never end, they too splurged on the massive cheap and easy short-term credit supplied by public sector banks. Since 2009, non-financial corporate debt has more than doubled to 147% of GDP in 2013, far higher than with other major pre-crisis economies of the recent past. Now as demand for their goods tapers off on the back of slowing construction, their reduced cash-flow is threatening to keep not keep up with their debt repayment requirements.

In all three cases, there is a common counter-party to their debts - public sector banks or the shadow banks. Property values are another underlying asset which is leveraged to raised the debts. The argument that the government could ask the creditors to take a hit or roll-over the loans over-looks the second-stage effects of such write-offs on the balance sheets of banks. It would seriously constrain the credit available for capital investments that are necessary to sustain a reasonable rate of economic growth. This is not to even talk of the serious systemic shocks, with unforeseen consequences, that are likely to accompany such credit squeezes.

A perfect storm looms large. What magic tricks are up the sleeve of the rulers in Beijing to avert this?

China fact of the day

From FT via MR,
In just two years, from 2011 to 2012, China produced more cement than the US did in the entire 20th century, according to historical data from the US Geological Survey and China’s National Bureau of Statistics.
In an indication of just how exposed China’s economy is to a property downturn, Moody’s Analytics estimates that the building, sale and outfitting of apartments accounted for 23 per cent of Chinese gross domestic product last year. That is higher than in the US, Spain or Ireland at the peaks of their housing bubbles.

Sunday, May 18, 2014

Black Money and Campaign Finance in India

It is estimated that political parties spent atleast Rs 300 bn ($5 bn) during the just concluded Indian elections, though only a very small fraction of this would be formally reported. The prohibitive cost of running an election campaign is a major entry barrier to electoral participation. It is a widely known fact, as evidenced by the several large-scale corruption scandals, that candidates view electoral expenditures as a capital investment with rewards to be reaped after assuming power. In the circumstances, it is imperative that any effort at addressing the pervasive corruption start with lowering electoral entry barriers by reforming the process of campaign financing.    

Unfortunately there are no easy solutions. A good summary of possible reforms, though all have compelling deficiencies, is here. For sure, there are some low hanging fruits. For example, it is imperative that all donations be disclosed. As proof of how the current law, which mandates only donations beyond Rs 20000 be disclosed, is being gamed, only 6.2% of Congress funding and 8.7% BJP funding comes from disclosed sources. Placing limits on general campaign spending by political parties is another issue which needs immediate action.

Another approach would be to encourage parties to solicit disclosed small donations and then let them leverage it up with larger corporate and even public funding. In the US, in the aftermath of recent Supreme Court decisions that have dented campaign finance reforms and the growth of back-door financing channels like Political Action Committees (PACs), there have been legislative efforts to introduce greater accountability and transparency into financing political parties. A common feature of all these proposals is the role of parties soliciting small public contributions, $100-150, with federal government matching it few-fold, and a $50 tax credit per voter donor per election cycle. Further, some proposals also link up large corporate donations to being a proportion of small contributions. All these efforts are aimed at both limiting large corporate influence in elections, whose detrimental effects have been well documented, as well as incentivizing candidates to solicit small contributions and thereby increase the likelihood of greater accountability and transparency into electoral campaigns.

A corporate financed election fund, created through tax-deductible contributions, matched with public contributions is another alternative, though its distribution among parties would pose difficulties.  

The difficulty of satisfactorily addressing campaign finance, itself a massive challenge given the problems faced even in countries like the US, may be compounded in India's case from the the fact that solutions lie beyond mere campaign finance reforms. In fact, the most important reforms have to come from addressing the incentives to make money from public office and by limiting the country's massive black economy. The former requires no introduction and its solutions are widely discussed. 

But in a country where black money makes up atleast a quarter of the total economy, any meaningful efforts at reforming campaign finance has to start with addressing the black money economy itself. Apart from criminal activities, a major share of black money is generated from legally permissible economic activities which are under-reported, mainly for evading taxes (eg. business profits) or avoid disclosing investment capital volume and source (eg. land registration), and from manipulation of financial records and accounting (eg. mis-represent and under-disclose income by under-invoicing production or trade - manipulation of sales receipts, expenses, capital employed, closing stock etc). 

Tightening of the norms of corporate accounting and reporting standards and the strict enforcement of existing regulations is critical to eliminating the creation of black money. Simplification of the tax code could help increase the ease of detecting accounting manipulations. Harmonization of reporting standards under different laws could also help tip the cost-benefit ratio in favor of compliance. There are larger regulatory issues of increasing standards of monitoring foreign capital flows, transfer pricing between entities of the same holding company, and so on, as well as enforcement of regulations thereon. 

Efforts at choking off the creation of black money itself has to be complemented with introducing greater transparency and vigilance into the largest channels of black money circulation. Real estate and gold are two of the biggest platforms for money laundering. In real estate, the steep difference, often a few multiples, between the official land/property registration price and the actual market transaction value is arguably the biggest channel for circulation of black money. The sales of gold, which is a major source of hoarding black money, upto Rs 2 lakh pass off without coming under the tax scanner. In both cases, the loopholes should be closed - land registration values should be the same as market value and all gold transactions should be tax accounted. Finally, cash transactions should be limited so that all transactions are incentivized to be inter-mediated through the financial system.

Update 1 (23/08/2014)

Here is an excellent collection of 40 graphs from Vox on campaign finance challenges in the US.   

Saturday, May 17, 2014

The political and social consequences of widening inequality

Much of the mainstream debates on inequality tend to get entangled with less important technical details. Critics of Thomas Piketty have sought to reduce the debate surrounding his book to a question of why the rate of growth of capital should always be greater than the rate of economic growth. A few have pointed to the apparent contradiction in the obvious socially beneficial effect of the emergence of 50 more Bill Gates despite its contributing to further widening of income inequality. Some others argue that the relevant metric should not be within-country inequality, but the that within the global population taken as a single unit (which has apparently declined). Still others argue that the income gap between those at the top 0.001 percentile and those at the 1st percentile is much higher and has grown faster than that between those at the top 10 percentile and the top 50th percentile, which in turn has outstripped that between those at the top 50th percentile and the 90th percentile.

I am less interested in the outcome of this technical debate. I am not even interested in the far less contentious argument about the economic desirability of some level of income inequality in promoting economic growth. My concern with widening inequality arise from two sources, both related to its role in eroding the social contract that underpins modern democracies. 

1. It has been a dominant characteristic of all historical human societies that political power has followed economic power. The financiers of the political process call the tune in setting the public policy agenda. There is ample evidence that politicians' preferences more accurately reflect the views of their financiers than of their constituents. For example, those holding the reins of economic power determine, to their advantage, decisions on taxation (whom to tax and by how much) and public spending (what to spend, where, and how much), the two levers of managing the modern social contract. This trend is most likely to become amplified as the scale of wealth concentration among the top 1 percent (or 0.1%) begets even more concentration of political power.    

Conservatives point to the remarkable progress achieved over the past half-century in the quality of life, even for the poorest (especially in the developed countries), as a response to the critics of widening inequality. Ironically, this progress in assuring a dignified human life to the vast majority may have had the effect of papering over the aforementioned less benign political economy consequences of widening inequality.    

2. Two, widening inequality is increasingly coming in the way of the central tenet of modern social contract - equality of access to opportunities. The result is the biblical Mathew Effect - "the rich remain rich and the poor remain poor" - which severely limits social mobility. For example, it is increasingly the case that access to high-income livelihoods is determined by being able to study in a top university, which in turn is disproportionately related to the family's economic profile.

Wednesday, May 14, 2014

Road Safety - Choice Architecture in Sweden

Sweden has the lowest road accident rates in the world, just 2.7 deaths per 1000,000 people last year. And it has been declining since the country adopted the Vision Zero goal to eliminate road accidents.

Choice architecture has been the underlying theme behind its Vision Zero interventions,
In a departure from most American traffic safety approaches... Swedish authorities have generally dismissed the effects of education or enforcement on pedestrian safety... “Design around the human as we are,” said Claes Tingvall, the director of traffic safety at the Swedish Transport Administration and a godfather of the Vision Zero plan.... The result has been a sort of social contract between state and citizen: If residents follow the most basic traffic laws, engineers can design roads to guard against all fatalities.
One example is nudging to lower speed,
Potted vegetation is a traffic tool, placed on local roads to slow down drivers on straightaways... About 20 years ago, a now-defunct program allowed some homeowners to decide where speed bumps would be installed. The result: a hump every 20 meters in some neighborhoods, and some very slow trips home.
And nudging to reduce drunken driving,
In Sweden, nearly all school buses and government vehicles include built-in Breathalyzers, which prevent a car from starting if a driver is not sober. About one-third of Swedish taxis have also added the technology.
I think this approach, which designs mitigation measures conditional on the general human behavior, should be the way forward on many civic and social issues like energy and water conservation, littering, road safety etc. This assumes even greater significance in many less developed countries where the scale of these civic and social problems are much greater and likelihood of success with either enforcement or awareness creation minimal. 

Monday, May 12, 2014

Consumption affluence Vs human development services deprivation

Sometime back I had written about the changing middle class consumption profile - "as economies develop and incomes grow beyond subsistence requirements, a new set of necessities—education, healthcare, housing, and energy—are taking an increasing share of people’s incomes". But the rising cost of these human development services was creating a new type of deprivation among them.

Now the Times has an excellent graphic that captures why people are enjoying "consumption affluence", fuelled largely by technological progress and cheap imports, while feeling deprived on these new non-tradeable service necessities, which largely determines the human development trajectory.
Unfortunately, inadequate access to these services, which are critical to future life outcomes, hurts the poor - and even the middle class in developing countries - very badly. And the widening inequality is only amplifying these effects.  

Shanghai - Then and Now!

What difference can 26 years make? MR points to these stunning visuals that capture the spectacular transformation that accompanied the development of Shanghai's Pudong financial district over the 1987-2013 period.

In 1987...
... and in 2013!
Yes, it is the same place!

Saturday, May 10, 2014

More on the urban housing challenge

New York's new mayor Bill De Blasio has announced an ambitious housing program (full plan pdf here). It commits $8.2 bn public funds to leverage $41.1 bn in total funding, public and private, over a 10 year period to develop 200000 affordable units - 80,000 new ones and rehabilitate 120,000 old ones.

The public funds would be used to encourage new construction of affordable units, incentivize landlords to rehabilitate buildings which fall under rent-control, and discourage landlords from keeping houses under-occupied. The previous Bloomberg administration had spent $5.2 bn of public funds and leveraged more than three times that from private sources to preserve or build 165,000 affordable housing units over the 12 year period.

The Plan revolves on two factors. One, it embraces a vision for a denser New York, by allowing the possibility of increased floor area ratio (FAR) for new housing projects, thereby encouraging more vertical constructions. Two, it takes a leaf out of cities like Boston and Denver and promotes "inclusive zoning" which mandates developers to include affordable housing in rezoned areas. In other words, developers who benefit from upzoning will have to set aside a small share of their development for affordable housing units. It is hoped that together these reforms would encourage private developers to build more affordable housing units.

The Plan contains several other reforms like lower building setbacks, relaxation on parking requirements for affordable housing units, tax incentives to discourage people from keeping lands vacant or buildings underoccupied, and transferable development rights (TDRs) to owners of underbuilt lands to sell their excess buildable area. However, even this ambitious agenda dwarfs the problem,
In documenting the depth of the problem, the plan notes that the city has about 980,000 households who earn less than $42,000 a year (50% of metropolitan “area median income”) for a family of four—including more than half of its renters—and about 360,000 of them spend more than half their income on rent. It says there are about 425,000 apartments that rent for $1,050 or less (about 40% in public housing), what these households could afford without spending more than 30% of their income on rent. That’s a shortfall of more than 550,000 units. In short, the de Blasio plan would build about 16,000 apartments for this income group—more than twice as many as Bloomberg did, but not quite 3 percent of what it implies are needed.
Further, even as the actually realized benefits from such developments may be marginal, they are more likely to generate other unintended distortions. The previous administration of Mike Bloomberg had encouraged massive rezoning cum redevelopment programs in several dilapidated and neglected neighbourhoods of the city. But one of its unintended consequences was the gentrification of those areas, leading to the increase in rental values in the area. This in turn has had the effect of making New York housing among the most expensive in US and un-affordable for all but a handful of the population.

A study by Furman Center for Real Estate and Urban Policy found that in 2011 only 38% of New York renters live in market rate apartments. The income cap to qualify for a rent stabilized apartment in $200000 per year, and several studies have found that the majority of those enjoying its benefits are those with higher incomes.

The scale of affordable urban housing challenge in developing countries like India is amplified many times over. It essentially boils down to building millions of additional housing units across different income categories. This requires both land and, in case of the lower income group, public resources. In land scarce cities, where unregulated and inefficient sprawls have become the norm, the only way to accommodate the massive demand for additional housing is to go vertical. This requires dramatic relaxation of zoning regulations, and has to be complemented with development of sufficient infrastructural carrying capacity. Further, given the rising construction costs, affordable housing for the foot soldiers of urban growth, the low income migrants, would require large public subsidies. Both infrastructure and housing requires massive investments.

Scarce land and scarcer public resources are hard binding constraints. In the absence of steps that do not alleviate them, no amount of innovation and PPPs can help address India's urban housing problems. In the larger cities, given the practical difficulties associated, PPPs involving up-front LIG housing mandates, as in New York, would contribute only marginally to increasing the LIG housing stock.

There are no innovative solutions to everything. In fact the solutions to some of the biggest social problems are well known, but require surmounting formidable political, social, and fiscal barriers. Urban housing is no different. 

Thursday, May 8, 2014

The importance of urban leaders

In a recent article I have argued that India needs to reform its urban governance and place cities under the control of directly elected Mayors replacing the current control exercised by career bureaucrats.

In this context, a Times article points to the rise of a group of activist Mayors across American cities who are setting the agenda not just on economic growth but also on social issues. As Thomas Edsall writes,
A wave of newly elected mayors from New York to Seattle has taken office committed to deploying the power of city government and aggressive wage and tax policies to attack inequality and revive social and economic mobility... Urban chief executives are raising minimum wages; requiring contractors to hire inner-city residents and to increase pay on municipal projects; backing local union organizing efforts; initiating or expanding pre-K schooling; extending public transit into poor neighborhoods; and requiring police to videotape contacts with citizens...
They are, in short, enacting at the municipal level many of the major policy changes that progressives have found themselves unable to enact at the federal and state levels... The political impetus behind this ideological development is the fact that American cities are on the cutting edge of the current demographic transformation of the United States into a majority-minority nation... Urban America is now on a reconnaissance mission for progressive politics. 
No Indian Municipal Commissioner could have had such an agenda on economic growth and job creation, strategic planning for long-term development, or on enhancing social welfare. Their agenda, even among the best of them, is generally confined to grandiose infrastructure projects (read fly-overs, ring roads etc) or operational concerns like improving sanitation or collecting taxes. With the prevailing distribution of powers, mayors would be too powerless to operationalize this agenda even if they had one.

Urban reforms that replace Municipal Commissioners with directly elected Mayors can potentially usher in a paradigm shift in urban governance. As the recent success of Arvind Kejriwal and the AAP in Delhi shows, urban politics is fertile ground for issues-based politics and the emergence of responsive leaders. This is likely to encouragee political parties to put forward strong candidates and also for successful people from other careers to enter politics. Currently powerful local leaders tend to prefer the state assembly or the Parliament over the post of Mayor. A Nandan Nilekani can be transformational as the Mayor of Bangalore than as a Parliamentarian.

India deserves its versions of Mike Bloomberg, Enrique Penalosa, Ken Livingston and the like, to lay the foundations for dynamic and world-class cities. 

Monday, May 5, 2014