Monday, June 30, 2014

Three development tensions of India

I have an op-ed in Indian Express with Lant Pritchett on three challenges of India's development experience - managing equitable growth, revitalizing a 'flailing' state, and unlocking the potential of states. A longer version is below.

In the euphoria surrounding the election results, it is tempting to avoid facing up to the harsh realities of making development happen. Even for those who characterize the election as “the dawn after the dusk before” in the new light of day India’s development challenges remain essentially the same. These challenges were not overcome by an election, nor can be overcome by doing more of the same, even if effectively, but by doing things differently.

There are, and have been for some time, three central tensions of India’s development experience. The first tension is to sustain a development model which generates rapid economic growth but also creates jobs and produces equitably shared benefits.  The second tension is to deliver effective governance with a “flailing state”. The third tension is to manage national cohesion in a vast and diverse country - where there are as many India’s as there are Indians. None of these three existential tensions of modern India have changed with the electoral results. Let’s examine each.

India needs a dynamic growth strategy, one that goes beyond unproductive dichotomies that pits growth against redistribution, rural against urban, and small against big. The ongoing growth versus redistribution debate, reflected in the recent acrimonious battle between two distinguished pairs of economists, obscures more than it illuminates. This dualism, which pitches one world-view against another ostensibly opposing one, is a gross simplification.

India is far from alone in having gone through this debate. In its initial World Development Reports (WDRs), the World Bank proposed a “two-and-half legged stool” strategy for economic growth – policies for creation of productive labor demand supported by those for development of human capital, and underpinned by a system of “half-a-leg” of a basic safety net. However, with time, the WDRs and global discourse have gravitated towards a single-leg strategy of redistribution, revolving around social transfers, best exemplified by the Latin American Conditional Cash Transfer (CCT) programs.

India, especially over the past decade, has been an enthusiastic adopter of this single-legged stool strategy. The employment guarantee program and food security legislation are totemic illustrations. In this context, it is important to bear in mind that even in Latin America, as in East Asia, the vast majority of people emerged out of poverty not through transfers but through earned incomes from productive jobs created. 
We therefore argue in favor of a development strategy that combines economic growth with productivity. This requires the replacement of the prevailing model of static redistribution of products that revolves around handing out dole with redistribution of productivity that creates the conditions for increased economic growth. This redistribution would equip all Indians, especially the poor, with skills that enhance their productive potential. In other words, India’s development agenda should be framed around economic growth which is underpinned by re-distribution of productivity.

Such redistribution of productivity requires public policies that can enable access to a basic set of essential goods and services for all Indians, irrespective of their economic station. A recent McKinsey report indicates that nearly 650 million Indians are income deprived and need support to access these essential goods and services. This would enable them to develop certain core human resource competencies that are necessary to access opportunities in the modern economy. It will also ensure the ultimate objective of a dignified life for all Indians.

Needless to say, this productivity agenda has to be complemented with the more widely discussed reforms to release infrastructure constraints, deregulation to improve the ease of doing business, removing labor market rigidities, deepening and broadening of the financial markets, and so on. Pro-market and pro-poor need not be contradictory.

Second, the achievement of all development objectives is closely dependent on a state which is effective in the implementation of its core functions. The weak state capability is an obstacle to the achievement of all the ambitions of an “aspirational” India. This weakness is reflected in issues as wide-ranging as the abysmal student learning levels in public schools to the intermittent and poor quality of electricity and water supply and their persistently high distribution losses. It contributes as much to perpetuating the pervasive harassment of citizens approaching the government for statutory services, as to fuelling the large-scale corruption that arises from failure to design and manage contracts with private parties that protect public interest.
This has in recent years resulted in a steady erosion of the commitment of the middle-class to public provision of services. The perception of a weak state and the resultant feeling that governments cannot get the basics done has spawned three trends. One, the belief that government institutions cannot deliver good quality services – education, health care etc – has led people to vote with their feet to private service providers. Two, the belief that public services are so irretrievably damaged have led to the belief that cash or benefits transfers is more effective. Finally, the deep disengagement of those entrusted with the responsibility of delivering these services, not only in their role as providers but also as users, has depleted any incentive to improve performance.     

Restoration of state capability is not easy, given its close interaction with political and civil society dynamics. The commonest causes for degeneration in state capability include politicization of bureaucratic processes, administrative indiscipline, erosion of accountability in the discharge of official responsibilities, weakened supervision and monitoring, and ubiquitous corruption. Any meaningful effort at restoration has to address these failures. The role of state governments is central to success in improving capability of the Indian state.

Finally, on social cohesion, its religious and linguistic dimensions have, rightly so, received much attention. However, a more functionally important dimension revolves around the role of Indian states in its federal structure.

It is now well acknowledged that most of the dynamism of the Indian economy over the past decade has come from its states. Even as New Delhi slowed down, many progressive states aggressively pushed reforms, invested in infrastructure, and courted private investments. These state economies, many as large as medium-sized countries, did not go through anything like the weakness experienced by the national economy. Astute observers and investors no longer see a “one India”, but prefer to look at the country as “many Indias”. A new government with an ambitious growth target would want the engines of its growth at full throttle.

Indeed the Prime Minister has recently acknowledged that “India’s progress lies in the progress if states”, and affirmed that issues raised by the states will be considered on “priority”. This calls for the central government to step back from dictating to states and let them chart their varying natural growth trajectories. The most sustainable strategy to promote national economic growth is for the central government to facilitate, not micro-manage, state’s unlock their development potential.

The most egregious example of such shepherding is in the role of the Planning Commission. The one-size-fits-all norms and components of all national programs impose stifling and highly inefficient restrictions on states. The annual state plans for each program is made in a routine manner without consideration for the widely varying requirements of states. The result is lack of state ownership and routine, at best, efforts at implementation.

It is time to move beyond this and embrace an approach that allows states enough design and operational flexibility in these programs. The central government should clearly outline the objectives and broad implementation guidelines and leave it to the state governments to prepare detailed plans that meet their requirements. The state Chief Ministers should be encouraged to lead its design and implementation as his or her government’s program. When state governments have the resources and the freedom to address their development problems, it is most likely to generate accountability and effectiveness, both missing from the current paradigm.

Sunday, June 29, 2014

India's banking mess graphic for the day

This graphic below captures the shocking deterioration of bank balance sheets in the past three years. The share of stressed assets has more than doubled alarmingly.
Recapitalizing banks, thereby creating the space for further lending, should be the first priority of the new government. The revival of private investment, especially infrastructure spending, depends critically on this. It is therefore imperative that the forthcoming Union Budget provides the required allocation for recapitalization.  

Friday, June 27, 2014

Japan's Corporate Governance Reforms

Shinzo Abe promises to unleash the third arrow of his Abenomics agenda - structural reforms to enhance competition and innovation. One of the major prongs of this is expected to be corporate governance reforms that would seek to break to distortionary cross-holding relationships between different companies.
The government is also preparing what advisers say will be a world-class corporate governance code that requires multiple independent outside directors, formal protection of whistle-blowers, and other measures that proponents say would have been unthinkable before Mr. Abe came to power a year and a half ago. These corporate governance reforms also seek to put an end to a decades-old tradition: the practice of holding shares in one another to create a web of relationships meant to keep unwanted interference to a minimum. It is not easily visible on the surface, but Japan’s biggest corporations are linked together in a sprawling web of mutual shareholdings that shield company executives from the pressures of the stock market. Coddled in a comfortable old boys’ club, Japanese executives have long gone unpenalized for failed investments, refusing to withdraw from money-losing businesses, hoarding cash and bringing shareholders perennially low returns. Mr. Abe’s government sees the cozy arrangements as out of place these days, especially as the country seeks to win over foreign investors. Mr. Abe’s latest round of measures calls for a reduction in cross-shareholdings to “as low a level as possible.”
In simple terms, Mr Abe is proposing to introduce best-practice corporate governance reforms into a system steeped in deeply traditional Japanese culture. Now this promises to be a defining moment in the country's economic history. The objective of breaking the cozy relationships arising from the web of cross-holdings is to improve corporate governance standards. But it is difficult to say that the reforms would achieve their objective.

The prevailing corporate governance arrangement, for all its distortions, has to be seen in the light of the very deeply traditional cultural norms that steeps Japanese life. Arguably, in any modern society, which is not permeated with the deep sense of respect, deference, and loyalty that underpin personal relationships in Japanese society, such relationships are most certain to engender cronyism and corruption.

But in case of Japan, how are we to say with any degree of certainty that the modern best practice, with its own chequered history of cronyism and corruption, will be more incentive compatible that the current cozy relationships? How are we to say that the reforms would not result in an equilibrium that is more distortionary and sub-optimal? Are there not better ways to hold corporate boards accountable?

Thursday, June 26, 2014

A turn away from PPPs in road sector

This sums up the sad state of India's infrastructure sector woes,
In 2012-13, of the 7,464-km build-operate-transfer (BOT) target, only 1,115.75 km were actually awarded. Similarly, in 2013-14, of the targeted 5,000 km through the public-private partnership(PPP) mode, only 287 km were awarded through three projects, as the bids did not find takers among private-sector players. Another 2,500 km of projects were awarded under the EPC modeFor the 2014-15 financial year, the target was to award 3,000-3,500 km of road projects through the BOT route and another 5,000 km through the engineering, procurement and construction (EPC) route... At present, completion of road projects worth Rs 83,000 Cr are pending. Since 2009, only three projects have been completed, adding only 315 km to the country's existing highway network. This is despite a record 147 projects (a combined value of Rs 1.47 lakh Cr) being awarded under the public-private-partnership (PPP) mode.
Now, in order to kick-start new projects, the new government proposes to set up a transport corporation with a corpus of Rs 1 lakh Cr, with 26% stake of Japanese investors at an assured return of 9%, to finance road projects on an EPC mode. The government in turn proposes to raise its share of the corpus by securitizing its annual toll revenues of Rs 5000 Cr.

This constitutes an important shift in policy by the government. It is an acknowledgement of the difficulties associated with bidding out such road projects on PPP and a resultant shift to public procurement on an EPC mode. Once the construction is completed, the roads would then be entrusted to private partners as long-term O&M concessions.

In other words, the government would bear a major share of the construction risk, and rightly so. These risks are considerable given the land acquisition and environmental clearances associated with such works. Once the road is commissioned, the initial traffic estimates would give a much better idea of the possible toll revenues. It makes possible for potential bidders to give their quotes with much greater certainty, thereby attracting more optimally priced bids and minimizing the likelihood of re-negotiations.

This course of action is exactly what this blog has been consistently advocating, for this and other reasons. While the theoretical case for an DBO/DBFO/BOT PPP contract looks very strong, the risks associated with them are too large to be captured in even the most complete contract. This course-correction is a step in the right direction, though it comes after a series of failures which could have been easily avoided.      

Wednesday, June 25, 2014

India's power sector in ten graphs

The World Bank last week released one of the most well researched reports on India's power sector that I have come across. Here are ten graphics from the richly illustrated report.

1. The graphic below clearly spotlights the Achilles heel of the sector - distribution. Its losses have been mounting alarmingly.

2. The distribution side debt grew the fastest, at a CAGR of 23% in real terms in the 2003-11 period. It also grew from 9% of total electricity sector debt in 2003 to 36% in 2011. Transmission and generation debts grew at a CAGR of 10% and 9% respectively.
3. The cost-revenue gap has almost doubled in 2003-11. In the same period, the average cost rose 7% annually (70% in real terms totally) whereas the average revenues rose 6% (66% in real terms).
4. The main driver of cost has been power purchase costs, which have risen from 56% in 2003 to 74% in 2011. The rise in fuel costs due to imported coal and inefficient power procurement planning (which forces utilities into short-term power purchases) have been behind the rise in power purchase cost.
5. The decomposition of utility losses reveals interesting insights. The losses are decomposed into three buckets - distribution losses beyond an international benchmark of 10%, under-collection of bills, below cost-recovery pricing. In 2003, utilities were charging an average tariff well over cost-recovery and the losses were driven by distribution losses. In 2011, states were in aggregate charging an average billed tariff below cost-recovery. Distribution losses had come down whereas under-pricing losses shot up.
6. Distribution losses dominate in MP, Haryana, Bihar, Jharkhand, Assam, and Tripura. Under-pricing losses dominate for TN, Rajasthan, AP, HP, Punjab, Mizoram. For UP, Karnataka, Maharashtra, and Uttarakhand collection losses matter too.
7. Fortunately, tariffs have been increasing in recent years. In 2012-13, 26 states issued orders raising tariffs. On average states increased tariffs once in two years between 2007-08 and 2012-13.
8. Across the world industrial electricity tariffs are the lowest. However, in most Indian states, industrial tariffs are much higher than both commercial and residential prices.
9. No discussion in Indian power sector is complete without agriculture. While consumption been stable at about 25% since 1991, it formed only 7% of revenues realized in 2011.
10. Apart from agriculture, the other major target of subsidy are domestic consumers, who consume almost a quarter of the electricity sold. A staggering 87% of all electricity consumed by domestic users are subsidized, clearly indicating a very high level of leakage. And this subsidy is large - the tariff subsidy for the 87% is on average Rs 1.5 per kWhr. The cross-subsidy from the remaining 13% is only Rs 0.62 per kWhr. In 2010, 87% of the subsidies were delivered to households above the poverty line. Households below the poverty line either do not have access to supply or consume disproportionately less.

Tuesday, June 24, 2014

Stress Tests in a graphic

One of the differences between the way the US and European authorities responded to the financial crisis was in the rigor of their respective stress tests. The American stress tests credibly signaled the health of financial institutions and thereby stemmed the spread of the panic, whereas that in Europe did little to allay market suspicions and fears.

This graphic nicely captures how these tests restored normalcy to the credit markets.
Once the test results were announced, the TED spread (indicates the perceived risks in lending to banks), CP spread (a similar indicator for business), and the Baa spread (indicating perceptions of corporate risk) all fell precipitously. 

Monday, June 23, 2014

The head start from the "accident of birth"

An excellent video and infographic captures how inequality gets baked into your life  from the accident of birth through massive 6000-hour early childhood learning gap,
By the time they reach 6th grade, middle class kids have likely spent 6,000 more hours learning than kids born into poverty. Learning time is a resource that is unequally distributed, and disadvantaged students suffer the consequences. While middle class children learn to read, create, persist, and problem-solve at home and through after-school and summer experiences, parents stressed by poverty are far less likely to be able to ensure those opportunities for their children.  
Update 1 (13/9/2014)

Nicholas Kristof and Sheryl WuDunn have this nice essay on the benefits of early childhood interventions and good parenting on long-term life outcomes of children.

Sunday, June 22, 2014

Increasing the supply of affordable housing

The problem of affordable housing is a simple demand-supply issue. In cities where new lands available for development are scarce, the only way out are to go vertical or to restrain demand itself. Governments need to aggressively enact policies that address both these dimensions.

Restrictive zoning regulations constrain vertical developments. Several studies have shown that zoning regulations which restrict the Floor Area Ratio (FAR) to very low values are among the largest contributors to keeping property prices elevated. While the role of FAR has received much attention, that of other factors which contribute to inflating prices have received less so.

Liberal taxation policies, on both property and capital gains, coupled with non-transparent property valuation regime, does little to curb demand. In fact, it encourages speculation in property market, which puts upward pressure on prices. Property, especially in rapidly growing cities, becomes a highly profitable asset class for investors.

India has among the lowest property tax rates, whose adverse impacts are exacerbated by widespread outright evasion and under-assessment. Further, property tax regimes make little distinction between small and big houses, nor between sprawling individual homes and vertical housing projects. The large differential between the registration (and therefore taxable) and actual market values of properties makes speculation extremely attractive. The lower capital gains tax rate only adds to the attraction. The combined effect of all these have been that houses have become the most preferred investment asset.

In the circumstances, apart from raising FAR, any meaningful effort by the new government at Delhi, which wants to ensure adequate supply of affordable housing, to deliver on its commitment has to address all these disincentives. Vacant land tax, at a prohibitive enough rate, should be used to discourage people from keeping lands vacant inside the city. Higher property taxes on individual houses, steeply increasing beyond a certain square-foot area, can be used to encourage vertical developments. Similarly, lower building fees for vertical housing, progressively declining with height, can be used to incentivize vertical growth.

The elimination of the wedge between registration and market prices, coupled with much higher (and strictly enforced) capital gains taxes on short-duration owned property transactions could potentially dampen speculative transactions that contribute to upward pressure on property prices and also encourages people to keep them vacant. These policies are increasingly finding favor among policy makers across the world.

Switzerland recently voted to limit second home ownership in areas where they make up more than a fifth of the total stock. London and many other cities are considering the same. Momentum has been gathering in UK on imposing a tax premium on holiday home owners across many parts of the country who have priced out locals from the market. In fact, Larry Summers has argued that trophy-homes are among the biggest contributors to the widening inequality and massive rise in wealth at the top. 

Thursday, June 19, 2014

Inditex and iterative adaptation in fashion retailing

FT has a nice feature on the spectacular success of fashion retail brand Inditex, the world's largest fashion retailer, which retails using its over 6400 Zara shops spread over 88 countries. One area where it outclasses competition is in the speed with which it reacts to fashion trends, using its efficient information feedback mechanisms to swiftly turn sketches into products ready for shipment. It churns out over 30000 individual designs on nearly 900 clothing items every year,
The essence of the Inditex model is to push the moment of production as close as possible to the moment of sale... Many of the items you see in Zara stores today will have been designed back in Arteixo as little as two weeks before... Inditex’s success is based not on speed but on accuracy, on understanding exactly what customers want, week by week, and store by store. Take the new trenchcoat. Once it goes on sale, Mr Ruyman Santos and his colleagues will know almost immediately how it is faring with shoppers around the world. Every day, tens of thousands of customer reactions are fed back to the design teams. Is the sleeve too tight? Are the fringes too long? Does your bottom look big in this? The answers are analysed and swiftly incorporated into new designs, creating a never-ending cycle of iteration and innovation. Even successful designs will never get a second run. You need to evolve, and you must never repeat...
Every Inditex store receives fresh deliveries twice a week – a feat of logistics that helps encourage customers to return to the store as often as possible... Zara customers typically visit the shop four or five times more often than clients of a more traditional fashion store. They sell in small batches and they are producing what they already know will sell. This means, crucially, that Inditex has much lower inventories than its rivals, and less need to discount unsold goods. According to research by Société Générale, the investment bank, only 15-20 per cent of Inditex stock is marked down, as opposed to 45 per cent for a competitor like H&M.
This is a very good example of what Jim Collins calls "empirical creativity", where when faced with uncertainty, firms respond by relying upon "direct observation, practical experimentation, and direct engagement with tangible evidence". This strategy of "experiment, collect evidence, learn, iterate, and adapt" is equally relevant to social policy making as is to business management.

Update 1 (19.02.2023)

One key point is that Inditex, whose brands include Zara and Pull & Bear, has always kept its supply lines local and nimble. “If you have the fabric, you can send this fabric to a factory in Galicia or in Morocco, then you could have in two weeks the garment coming back to the logistics platform and being sold,” says Pablo Isa who just stepped down as Inditex's chief executive. The company’s capacity to produce sought-after garments on a very quick turnround became a template that other high-street retailers have since tried to imitate. Inditex produces about half of its clothing close to home in factories near its headquarters in the town of Arteixo in Galicia, north west Spain, as well as in Portugal and Morocco. One of Isla’s most significant improvements to this process was to shepherd the development of technology that turned a largely bricks and mortar operation into a hybrid retailer, using its global network of 6,400 stores as display windows and mini distribution hubs for people buying garments on their smartphones. The move was successful, and by 2021, a quarter of Inditex’s sales came from online purchases... Inditex operates a very flat dispersed management structure, giving country managers the power to make decisions quickly.

Monday, June 16, 2014

On urban sprawls and transport-led growth

This article is in praise of projects initiated by the local government agencies of Bangalore which have "led to several localities in the suburbs opening up and witnessing significant growth". It captures an important dimension of our urban development paradigm. I could not disagree more. 

Here is the script that gets played around across Indian cities. Local governments build connecting roads that open up suburbs for development. Even as the quiescent Master Plan remains just that, the dynamics of unrestrained markets take over. Speculators and realtors get into business. Layouts, with minimal and makeshift infrastructure, gets plotted and sold out. Constructions spring up in fits and starts, and then explodes after some time. A chronically infrastructure deficient patchwork settlement sprawl develops.

Policy makers think this is desirable. After all, when there are few land parcels available for development within the city, such projects unlock more areas for development. It increases land values, which makes land owners happy, and speculators and brokers happier. Realtors benefit from building activity. It leads to increases in housing stock and commercial activity. It is populist. And it appears a fiscally inexpensive solution to accommodating the massive influx of migrants joining the city. All this appears a "free lunch"! So what's wrong?

The result of several iterations of this process is the unplanned sprawl that envelopes all our cities. Such greenfield projects are a great opportunity to plan and enforce a set of progressive zoning regulations (higher FAR, especially), unencumbered by legacy infrastructure constraints. A rigorously enforced Master Plan should encourage the growth of densified transportation-centered developments in these areas, in concentrated blocks rather than as an endless continuum sprawl. The transport infrastructure laid should be used to leverage such development.

Instead of being instruments to plan and facilitate the long-term development of the city, projects like metros are seen as instruments to promote the expansion of the city as a sprawl. What we need is not geographically massive cities but more compact and governable cities. Such geographical jurisdictions merely serve to amplify the governance deficit that so egregiously plague municipal governments.  

Saturday, June 14, 2014

In praise of tolerance

Michael Bloomberg was fantastic at this year's Harvard commencement. These views carry great relevance across the world,
If you want the freedom to worship as you wish, to speak as you wish, and to marry whom you wish, you must tolerate my freedom to do so - or not do so - too. What I do may offend you. You may find my actions immoral or unjust. But attempting to restrict my freedoms in ways that you would not restrict your own leads only to injustice... 
There is an idea floating around college campuses - including here at Harvard - that scholars should be funded only if their work conforms to a particular view of justice. There’s a word for that idea: censorship. And it is just a modern day form of McCarthyism... Isn’t the purpose of a university to stir discussion, not silence it?... In politics - as it is on too many college campuses - people don't listen to facts that run counter to their ideology. They fear them.

Friday, June 13, 2014

Construction risks and Thames Tideway

I have blogged many times about the challenges posed by construction risks with complex infrastructure projects. London has two of the most complex of such projects - the Crossrail, under execution, and the Thames Tideway (or "super sewer"), being planned. Like with all such mega-projects, both have been at the center of controversies over its economic benefits, financing sources, ownership structure, and so on.

The super-sewer project is a £4.2 bn project involving a 16 mile (25 km) long tunnel, mostly running about 30-70 m under Thames River, intended to provide storage and conveyance of 39 mt of combined raw sewage and rain water discharge that currently flow untreated into Thames. The 7.2 m diameter tunnel will collect combined sewer overflows from 34 discharge points and convey it to a treatment facility before its release. Its construction is expected to start in 2016 and be completed by 2023. 
London's 20000 mile sewerage network, mostly constructed in 1860s by Sir Joseph Bazalgette following a series of cholera outbreaks, is managed by Thames Water, owned by a consortium led by Macquarie. The super-sewer will be the largest addition to the network since. The entire cost of construction is proposed to be ultimately collected by progressively raising the sewerage tariffs on Thames Water's existing 14 million customers. 

The standard approach to building such massive and complex utilities projects has been through public procurement. However, since this project would have to be integrated with the Thames Water's ongoing contract, it was proposed to keep them closely involved. Therefore Thames Water was entrusted with its execution.  

Since it had limited construction experience, Thames Water has proposed an innovative financing plan. Instead of balance sheet financing, Thames Water proposes to set up a company that will own the tunnel and receive a license from the water regulator, Ofwat. Thames Water will contribute £1.4 bn towards the cost of the project while the rest is being sought from pension, insurance, and sovereign funds. The company will be responsible for overseeing procurement and raising bank debt. As aforementioned, the investors will be repaid by the incremental tariffs collected from existing customers. 

Construction risks are considerable with such projects. Apart from engineering risks associated with drilling under the river, there are the always present time and cost over-run risks. Already the cost of the project has risen from £1.7 bn in 2004 to £4.2 bn today. And this estimate is most likely to be revised upwards when the contract is finally bid out, and repeatedly revised during construction phase due to unexpected contingencies. 

The risks associated with a complicated construction phase and its seven year duration are being sought to be mitigated through a couple of ways. One, the investors will receive earnings from the beginning, even as construction starts. Their payment will be made from an 11 percent increase in customer bills - upto £80 a year - over the rest of the decade. Two, though details are not clear, the investors are sought to be compensated with a 12-13% IRR. Three, the UK government will act as a backstop or insurer to the project, bearing the brunt of any exceptional cost overruns or incidents during the construction. 

This financing pattern naturally raises several questions. One, since Thames Water is only a procurer of construction contracts, it has limited incentive to undertake the most efficient design to keep the price and life-cycle costs down. Two, the massive construction risks, even with the government backstop, would obviously raise the cost of capital, as demanded by private creditors. Three, the near certainty of cost overruns means that the construction cost will be higher and most likely to vest on the government. 

In addition to all these risks, there are doubts about whether the project is necessary at all. Its economic benefits are estimated at £3 bn. However, a recent estimated by the same engineer who recommended its construction in a 2005 report, has put it at just £180 m. Two observations on the project

1. A more practical approach to risk mitigation in such projects would be to do a scenario analysis. Different scenarios, based on a few construction/engineering risk materialization, can be modeled. This is a more realistic strategy to assessing the spectrum of risks associated with such complex projects. It would help all stakeholders to better prepare for the materialization of those risks.  

2. The major reason for private financing of infrastructure projects, despite its higher cost of capital, is that it enables incentive compatibility between the construction and O&M contractors and thereby allows for minimizing life-cycle costs. The proposed financing pattern and structuring of the project does not appear to achieve this objective. It effectively uses private finance to construct the project and then transfer its operation to the incumbent private provider. This results in not only a higher cost of capital but also does not align the incentives of the construction contractor with that of the O&M contractor. A more prudent approach in the circumstances would have been to use public procurement and then transfer it to the O&M contractor, Thames Water. 

Wednesday, June 11, 2014

A twin agenda for urban transformation

I have an oped here in Indian Express today on an urban agenda for the new government. Long-term sustainable growth focused political leadership and focus on urban planning and its enforcement is essential to any urban transformation. 

Tuesday, June 10, 2014

Metro railways and failure of urban planning in India

I have written earlier about the abysmal state of urban planning in India. A recent survey by Bangalore-based non-profit Janagraha too highlight the same. A classic example of this failure is the lack of planning surrounding the construction of metro rail projects in many cities. 

Consider this. Urban Economics 101 teaches us that cities are characterized by density. It generates knowledge, financial, and logistical network externalities; efficient markets for both buyers and sellers; and economies of scale in the provision of public infrastructure. But high density requires the infrastructure to support it - primarily the carrying capacity of roads and transit, water and sewerage. It is the mandate of urban planners to facilitate this process of densification.  

There has been no bigger catalyst to densification in our cities in recent years than the construction of many corridors of metro railway lines. In fact, the full benefits of metro rail projects, with capacity to handle 50000-80000 passengers per hour per direction, can be captured only by having very dense corridors. However, this requires co-ordinated action to augment water and sewerage distribution networks as well as incentivize further construction in these areas. Given the scarce vacant lands in these corridors, the only possible way to increase built-up space is by going vertical. This would in turn require planned increases in Floor Area Ratios (FAR) in parts of these corridors.  

But metro rail projects across India are being executed in isolation, not as part of a larger urban planning initiative. This constitutes a massively inefficient deployment of scarce public resources. It is also a lost opportunity for urban transformation.

For example, in the absence of further densification, the biggest beneficiaries of the first phase of the Mumbai metro, the 11.4 km Versova-Andheri-Ghatkopar (VAG) link, are the property owners in the corridor. In fact, the rail line constitutes a massive transfer to them from the future property buyers as well as renters, in addition to the construction subsidy.

The Mumbai Municipal Corporation would do well to improve other civic infrastructure in these areas and raise the FAR to facilitate new construction to leverage the full benefits of the new metro line. It would incentivize redevelopment and new additions to residential and commercial stock, thereby stabilizing property prices and preventing the emergence of sprawls. Much the same is required from urban planners in other cities where metros are under construction. 

Monday, June 9, 2014

Is taxation the binding constraint?

For the new government in Delhi seeking to kickstart the economy, the forthcoming budget will be a litmus test. Lowering corporate tax rate is at the top of the wish list for corporate India. But is taxation a binding constraint on private investment?

The graphics below compare several taxation related parameters for India with that of other countries, and the trends in each parameter for India, China, Brazil, Indonesia, and Mexico. 

1. Number of taxes - For countries with similar level of economic development (measured by GDP percapita), Indian firms do not face too many taxes, though when compared to China, Brazil, and Mexico, they pay more numbers of taxes. However, there has been a declining trend in recent years.
2. Taxes paid on procuring goods and services as a percentage of firm revenues - India has among the lowest tax expenditures on purchases of business inputs. Further, it has been declining steadily.

3. Labor tax and contributions as percentage of business profits - Is lower than all its major competitors, except Indonesia. Further, among similarly placed countries, its labor tax contributions are only slightly above the average. 
4. Other taxes payable as percentage of business profits - Includes property taxes and other smaller taxes levied by local governments etc, over and above the corporate tax. Though it is just about the average paid by firms in other countries with similar percapita GDP, it is higher than that paid by other competitors. 
5.Taxes on profits as a percentage of commercial profits - Is about the same rate as that paid by its competitors (except China), though it is higher than for countries with similar per capita GDP. 
6. Effective corporate tax rates - Is about the same as in other developing countries, in fact among the lowest for MNCs. The effective tax rate estimate of 30% for 2014-15 is just fiction. 
Obviously, left to themselves, businesses would like to pay no taxes. But the more relevant question is whether business activity is being seriously constrained by high taxes, especially in comparison to our competitors. Maybe there is a case for rationalization of tax administration, so as to make it easier to file and pay taxes, and also bring down the multiplicity of taxes. But there is nothing here that to suggest that taxation is a binding constraint to private investment. 

Sunday, June 8, 2014

The "endowment bias" with stock selling decisions

John Authers points to the risk aversion bias arising from the endowment effect that distorts traders selling decisions. He writes that the "effects of poor selling decisions outweigh good buying ideas",
Inalytics, a London-based investment research group, broke down the effects of all 45,000 trades made by a group of pension funds between December 2003 and September 2006. Buying decisions on average improve returns compared to the relevant benchmark index by 0.47 percentage points – suggesting their stockpicking added a little value for clients, at least before fees. But the selling decisions added up to a negative impact of 0.94 percentage points, exactly double the positive impact of the buying decisions.
Evidently, selling decisions pose a dilemma. In good times, there is the risk of selling too soon without capturing the full upside gains. In bad times, there is the risk of staying invested too long as to further increase the losses. In other words, the dilemma is between managing the risks of maximizing the upside when the markets are rising and capping the losses when markets are tanking. The greater danger arises from holding on to losing stocks for too long in the hope that it will rebound. Therefore a good trader must "ditch the emotional baggage that makes selling harder than buying", and one way to do this is to limit the endowment bias by down-playing (or even masking) the purchase price.

Saturday, June 7, 2014

This time is no different with Africa's bond issuances

There is nothing that convinces me that "this time is different" with the current spate of African sovereign bond issuances. FT highlights the scale of the trend,
African countries raised a record of more than $11bn in hard-currency sovereign bonds last year, up from $6bn in 2012 and just $1bn in 2000, according to industry estimates.
Kenya is the latest, initiating roadshows to raise $2 bn in sovereign bonds. Apart from the standard "resource curse" challenges of poor governance, corruption, and inefficiency, which by themselves are matters of very serious concern, there are three other worries,

1. All these countries have a medium-term trend of depreciating currencies. This has been despite the commodities boom and is most likely to gather pace as the commodities cycle reverses. The travails of Zambia, where Copper accounts for 60% of its exports, is just a portend of what is likely to come. The real debt burden (and effective cost of borrowing) would increase dramatically with depreciating currencies. In simple terms, these countries may have borrowed at the peak of the commodities cycle, when their currencies are the strongest (they could have been), and the potential down the line is for increasing effective borrowing rates.  

2. A significant share of these loans are to finance infrastructure investments, especially transportation facilities. In all such cases, the revenues are invariably in local currency while the repayments are dollar-denominated, thereby raising a currency mismatch on the country's balance sheet. This highlights the challenge with all external financing of infrastructure - developing countries suffer from inadequate domestic capital to finance capital investment spending, therefore necessitating external capital, which in turn carries the risk of currency mis-matches and attendant problems.  

3. All the recent successes with raising capital are most certain to have been done with less than rigorous due-diligence. In recent years, the euphoria surrounding African resurgence on the back of high commodity prices and oil discoveries, has been complemented by a world awash with cheap capital and investors chasing higher yields. In such euphoric times, finance loses its disciplining powers. A famous example of this was Zambia's 2012 $750 million 10 year Eurobond issuance at 5.625%, cheaper than even Spain's sovereign debt at that time. In some ways, once the African bond bubble bursts, it will add to the long list of collateral damages from quantitative easing policies. 

Friday, June 6, 2014

To liberalize capital account or not

Barry Eichengreen and Andrew Rose have this to say about capital controls,
The lesson here is that countries anticipating having to resort to controls for purposes related to macroeconomic or macro-prudential management should hesitate before dismantling their control apparatus. Having done so and moved all the way to capital account convertibility, it can be difficult and costly to go back.
In an op-ed in February I had made the same argument,
Markets overreact when countries respond to signs of currency trouble by reintroducing capital controls. It makes the original decision on liberalisation all the more critical. It is no surprise that China, which had strong capital controls all along, has been the only country to escape all the currency crises of the past decade and a half. All this should be reason enough for India to pause on its pursuit of full capital account liberalization.
In other words, capital account liberalization is a fairly irreversible process. The argument therefore should not be about imposition of capital controls, because its re-erection is a bit like using sand bags to fill the breach left by dismantling parts of a concrete flood barrier. The right question would on whether to liberalize capital account or not. India's policy makers should examine on a case-by-case basis the consequences of any proposed capital account liberalization measure, especially during times of economic distress, given the inevitable cycles of large capital inflows and sudden stops and the lack of credible institutional mechanisms that can mitigate its adverse effects.  

Update 1 (10/6/2014)

The progressive relaxation of rules surrounding ECB borrowings, in response to pressure from corporates to access cheap foreign credit that became available when capital was rushing into emerging markets in 2010-13, has been one of the largest breaches that have opened up in India's capital convertibility framework. For example, while previously ECB under both Automatic and Approval routes were permissible only for financing capital investments, it has now been permitted for "general corporate purposes", which appears to include both "working capital" and "repayment of INR loans". Similarly ECB rules have been relaxed for borrowings by infrastructure firms, raising the concern of currency mismatches. The most far-reaching relaxation though was in June 2012 when the RBI relaxed ECB norms to allow manufacturing and infrastructure firms to borrow externally to repay their rupee loans.  

Sunday, June 1, 2014

Plain simple good governance is the low hanging fruit

Much of the debate in India talks about policy reforms and innovations to restore the country's economic vibrancy. I think this both misses the perspective and also betrays an ignorance of how stuff gets done.

What we need to prioritize is on plain simple good governance - get the basics right. An example of this is the Project Monitoring Group (PMG) set up within the Cabinet Secretariat to expedite clearances for large projects. What it does is good old rigorous monitoring (beware : much of current fad of online monitoring is just the creation of an online work-flow and portal, with little of actual monitoring). The bang for the buck is immense - $90 bn worth investments being expedited. And all this with little innovation or reform. Much the same could be done for improving business environment and a host of other things which only require logistical activities - construction, clearances etc. Heck, this is what bureaucracies are supposed to do!
This is not to say that reforms are not required. Far from it. In fact, these $90 bn worth investments will soon run into problems in the absence of complementary conditions - credit an land availability, electricity supply, skilled manpower, export/import linkages etc. This would require reforms like restructuring/recapitalizing banks, deepening debt markets and so on. But there are too many low-hanging fruits that are lying un-plucked, even as we cry hoarse on difficult (politically and administratively) reforms.