Emerging market yields and secular stagnation

FT points to an apparent "breakdown in correlation between risk and reward" on emerging market (EM) bond yields. As the graphic below shows, the premium (as reflected in the spread over US Treasury Bonds) required to invest in EM bonds, which was inversely related to EM GDP growth rates before the sub-prime meltdown, has stayed low despite declining growth in these economies.

So, what gives? The conventional explanation, as outlined in the FT article, attributes this to a "search for yields" in an environment where developed markets suffer from ultra-low interest rates, excessive credit supply from quantitative easing, and economic weakness. All of this has made EM's with their relatively higher interest rates and better economic prospects more attractive. The flip side with this being that once the developed economies recover and interest rates rise, the reversal of capital flows will drain EM bonds and restore business as usual with EM bond yields. 

However compelling this argument, certain deeper structural factors may also be at play here. In particular, the secular stagnation hypothesis, being advocated by economists like Larry Summers, may have an echo in the EM bond trends. As Summers explained in a recent interview, secular stagnation refers to the inability in developed economies for "investment to absorb all savings". The attendant consequence is one of a lower trend financially sustainable (in the absence of any bubbles) growth rate for these economies and possibly a lower trend interest rate. 

If this were true, and there are several compelling arguments in favor, then there is a strong likelihood that the EM bond trends go beyond a mere "search for yields" to a "search for investment opportunities". This would in turn seek to permanently narrow down the spreads between EM bond yields and US Treasuries. In that case, the long positions on EM bonds may not turn out as bad as is being portrayed by conventional wisdom today. 

The blame game in Gaza

The violence in Gaza once again spotlights attention on the Israel-Palestine problem. While much of western media have blamed Hamas for inciting the violence by killing three Israeli settlers, John Judis points to deeper underlying policy trends. In particular, this graphic on the sharp increase in construction of housing units in the occupied territories is revealing.

The point about incitement is plain dis-ingenuity, even dishonesty. Since June 2007, Israel has maintained a ruinous and inhuman blockade of the Gaza Strip. The scale of human suffering caused by the blockade makes it a powerful source of incitement. The spurt in settlements, since Netanyahu came to power in 2009, especially in the West Bank, is even more inflammatory in so far as it is a definitive signal that Israel is against any solution involving Palestinian statehood. Given the near impossibility of large-scale relocation of settlers, each housing unit is one more nail in the coffin of the "two-state solution". 

India's urban housing challenge

My latest Governance Agenda column in Pragati explores the policy choices required to meet India's massive affordable urban housing deficit. 

The debate on the real value of the rupee

The real value of the rupee has been a matter of considerable debate. In the last three years, the rupee has suffered two instances of sharp declines. First, from July 2011, for nearly a year, the rupee fell 16%, and then, from May-September 2013, it declined 14%. Both followed periods of elevated inflation, rise in current account deficits, and episodes of (exogenously induced) large capital inflows.

In this context, the real effective exchange rate (REER) is a more reliable basis for assessing the valuation of rupee. It takes into account the trade weighted exchange rate discounted by respective inflation rates, which gives a more accurate measure of the relative competitiveness of an economy with respect to its competitors. Two observations based on data from RBI, BIS and the Bruegel Institute.

1. Despite the persistent high inflation since mid-2009, the REER remains at about the same level today as it was then. In fact, both instances of sharp depreciation followed periods of REER not responding despite inflation remaining elevated for more than a year. Something had to give. Given the high inflation, it is only natural that the volume of goods that can be purchased with the same amount of your currency decline. This was all the more so since among all our major trading partners, India had one of highest inflation rates. The exchange rate had to decline sharply to reflect this.

The first period coincided with the aftermath of the global financial crisis and the flight of capital into emerging economies in search of yield, coupled with a series of seven rate increases at a time when rates were falling elsewhere. The second period coincided with the peak of the third round of quantitative easing in the US and the Eurozone crisis which again triggered another round of capital flight into emerging economies. In both instances, sudden-stops were followed by sharp depreciation.

2. The comparison with its emerging market peers is also important. Compared to most of our competitors, the REER of the rupee remains elevated. Despite the persistent high inflation, the REER of rupee today stands at exactly where it was five years back. Leaving aside China and Brazil, the rupee appears over-valued compared to all other competitors.

In a recent column Arvind Subramanian and Martin Kessler examined the valuation of rupee with respect to Balassa-Samuelson effect (the positive relationship between PPP prices and GDP percapita) and found the rupee under-valued by 30%. In other words, assuming the relationship to hold, the rupee appears 30% under-valued. However, this theoretical approach over-looks an important structural shift in the Indian economy - the near doubling of the share of tradeable sector from 24% of GDP in 2004 to about 43% in 2012. This would have had the effect of attenuating the rise in aggregate price levels due to non-tradeables, thereby minimizing the Balassa Samuleson effect for the period under consideration.

In the circumstances, for atleast the short to medium-term, further declines in the value of rupee may be both desirable as well as forthcoming.

The premium from zoning regulations

Real estate ownership is no less important to the inequality debate today than it was in the 17th-19th centuries when landed gentry held sway. However, unlike then, the significance lies not so much in the extent of land ownership as its location. Today's aristocrats own real estate, in square yards and not acres, in areas where it commands a massive "location premium".

There is now strong evidence to suggest that restrictive zoning regulations are an important contributor to the "location premium". Such restrictions, mainly in the form of height and setbacks, limit the built-up area, and thereby the number of housing units, that can be constructed in the limited land available in such "desirable" neighborhoods. The scarcity so created raises property valuations and landowner wealth. Property prices in parts of London have risen sharply on the back of purchases by global business oligarchs as investments and not for residential purposes, so much so that it has forced the government to consider imposing higher property taxes on vacant properties.

An excellent recent FT oped, which described the premium as a "ransom" taken from renters and transferred to homeowners, writes,

About 40 per cent of the stated wealth of the UK – more than £3tn – does not exist. It is a terrible illusion. For the US the figure is about 12.5 per cent of total wealth, or $10tn, and growing fast. The “assets” in question are what planning or zoning restrictions have added to house prices. They are the ransom that renters and recent buyers must pay to existing homeowners – whose homes the rules protect – for use of an artificially limited stock of housing. So severe have those restrictions become that the value of the ransom runs into the trillions.

These valuations come from a landmark study by Edward Glaeser and Joseph Gyourko of whether the rise in urban housing prices come from scarcity or restrictions. They compared the prices of the marginal square feet of backyard land attached to a house with the average price of a square feet of land underneath the building. They found a large difference between the two, with the latter being many times the former, reflecting the restrictions on building on the backyard land. Their finding,

In the cities of coastal California, the average price of urban land is 10 times the price of land in a back yard because zoning laws make it impossible to turn one into the other. In Los Angeles, the price of the extra square foot on the garden was $2.60 while the average price of urban land was $30.44. In San Francisco, the back yard land was worth $7.84 per square foot, versus $63.72 on average for the same lot. The ratio of these two figures – as much as 10 to 1 – suggests only 10 per cent of the value of land in expensive cities is due to its natural scarcity. The rest is planning restrictions.

The scarcity in real estate markets induced by zoning regulations bear similarity with the privileged and unfettered access of vehicle owners to public roads at the cost of public transit users. Irrespective of private property rights, both real estate and roads are scarce and have critical public policy implications. Accordingly, many cities have policies that force vehicle owners to internalize the cost of road usage (congestion pricing, tolls, license plate fees etc), thereby also increasing the carriageway supply available for transit users.  

Urban planners need to do something similar with real estate. Like with road carriageway, the total supply of land available in cities is fixed, whereas the demand has been growing unabated. Zoning restrictions mean that the only way to accommodate the influx is to grow outward, resulting in the inefficient sprawl. The efficient alternative is to radically liberalize the zoning regulations and promote densified vertical growth. Lower building fees and property taxes higher up you go coupled with much higher property tax rates on newer large individual houses could incentivize more efficient use of limited land resources. 

More on education vouchers

Liberals, following the arguments of Milton Friedman, claim that school choice through the use of vouchers would improve outcomes. Parents would use the vouchers and vote with their feet, thereby encouraging competition among private and public schools and improving learning outcomes. But do they?

The latest evidence to the contrary comes from Sweden. In the early nineties, Sweden instituted far-reaching reforms by introducing school vouchers, which has paved the way for Sweden having more children going to private for-profit schools today than in any other developed country. However, despite encouraging early signs, evidence from the latest PISA ratings show a steep decline in the performance of Swedish children.

This prompted a massive external regrading exercise of the nation-wide standardized tests administered in 2010 and 2011 on over 50000 students of all grades in over 700 schools. The objective was to examine the quality of grades achieved by students in the standardized tests, which, unlike the SAT tests, are graded locally, often at the same school where test takers are enrolled. A study of the results by Bjorn Tyrefors Hinnerich and Jonas Vlachos found,

In Sweden, according to the study by Hinnerich and Vlachos, the scores issued by external evaluators were indeed harsher than those assigned by internal graders. And after accounting for things like a school's location, along with basic student characteristics, it turned out that the external evaluators had downgraded the scores for students at voucher schools much more than for students at government ones. In fact, a sizeable portion of the much-vaunted out-performance of voucher school students could be chalked up to nothing more than easy grading. More surprising still, the voucher school grade inflation is almost as high for math and science (where you'd think an answer is either right or wrong) as it is for Swedish. 

So why did competition fail to generate the desired outcomes?

In Econ 101 we learn that markets work their magic when buyers and sellers are well-informed about what's getting bought and sold, and can therefore transact with one another without fear of getting conned. The apparent failure of the Swedish schooling experiment is a lesson in the inability of markets to solve problems where it's hard to compare the educational "product" that's offered, and the outcomes you can observe are subject to manipulation. It's also a reminder that the cold, hard calculations of markets aren't necessarily suited to the realm of education. Governments don't shut schools because they fail to turn a profit. Private equity firms do. The parents of more than 10000 students learned this difference the hard way last year, whern the Danish private equity group Axcel abruptly announced its exit from the Swedish school market, stating that it could no longer cover the continued losses.  

The value capture problem with greenfield projects

The new government in New Delhi has announced an ambitious urban development program, including the establishment of 100 smart cities to be financed mainly through Public Private Partnerships (PPPs). This may be an appropriate time to step back and examine the challenges with such greenfield investments.

Consider the development of a private township in the sparsely inhabited outskirts of a large city. Once the township develops, the positive externalities from the development drives up property prices in the neighborhood. The property owners in the neighborhood capture most of these externalities and reap windfall gains. In contrast, the township developer, despite being responsible for the value creation, gets little or nothing. Worse still, since he makes most of his sales in the initial stages, the developer captures very little of the massive value creation that comes with the development. In simple terms, he creates value, only to be captured by all others.

Econ 101 teaches us that this is true of most positive externalities. It also tells us that, when faced with such a situation, there will be an under-supply of the activities that create the positive externalities. In the instant case, the developers will be loath to invest in such developments, or in any case unwilling to invest substantial amounts in such projects.

In the circumstances, such socially beneficial projects are most unlikely to emerge from predominantly private investments. Governments are best positioned to undertake such activities. This is all the more so since, unlike the private investors, governments can capture a large share of the value from their investments. And it takes time for the valuations to be realized. Such value capture takes place directly through more property tax revenues, levy of impact fees etc, or indirectly in the form of general tax revenues from the economic activities triggered in the neighborhood. In fact, most often, such revenues are large enough to recover the investments within a very short time.

However, this attractive logic conceals one flaw. Governments do a bad job of project execution as well as capturing value. A purely public procurement based execution is generally badly designed, poorly executed, and badly delayed, thereby raising project costs. Weak or inadequate policy frameworks, exacerbated by lax enforcement, severely limits the value capture from such investments. So what is the way out?

There are no easy answers. Among all flawed models - public procurement, private development, and PPPs - an iterative hybrid appears to be the least distortionary. Front-loaded and progressively declining public investments, strategic partnerships with private developers (not the conventional PPPs), enabling policy frameworks and its rigorous enforcement, and a reasonable sharing of value capture between governments and private partners are some principles that should underpin such endeavors. 

The return of macroprudential regulation

The Global Financial Crisis and the Great Recession have undermined several macroeconomic orthodoxies. The latest trend, in the context of rising property prices and threats of a real estate bubble, is the return to favor of macro-prudential policies to the toolkit of regulators.

Conventional wisdom has been that such asset bubbles could be regulated through conventional interest rate policies. Monetary tightening would take care of asset bubbles. But in reality monetary tightening has been off the table as an option for a variety of reasons. One, central bankers have always been averse to taking the punch bowl away when the party is on. Two, the prevailing economic weakness, especially in many developed economies,necessitated a prolonged period of monetary accommodation to boost aggregate demand. Finally, the effect of monetary policy changes go beyond real estate markets, with potentially adverse impact on the real economy. Just ask Sweden.

In the circumstances, and especially with the extended period of ultra-low interest rates, it was only natural that real estate bubbles inflate. Faced with these realities, it was only inevitable that macro-prudential policies make a come back as a preferred instrument to regulate real estate markets. However, there exists considerable uncertainty about the consequences of such policies. In particular, given construction sector's close linkage with several other real economy sectors, any adverse impact on it would most likely reverberate across the economy.

There are several macro-prudential instruments available to both rein in housing credit growth and dampen prices. One, a much stricter affordability test to ascertain the borrower's repayment ability. Two, virtual mortgage borrowing limits can be imposed either through Loan-to-value (LTV) or Loan-to-income (LTI) or Debt-to-income (DTI) ratios. Three, counter-cyclical buffers, as mandated by Basel III would force institutions to gradually raise their capital buffers as credit market conditions become imbalanced. Four, bank capital requirements on mortgages can be raised, though it would increase the cost of lending for banks. Finally, higher risk weights for mortgage lending can curb housing credit growth.

Sweden has been trying both higher capital requirements and risk weights to tame real estate prices. Norway has been gradually lowering LTV ratios, raising capital requirements, and even introduced a 1% counter-cyclical buffer. New Zealand has tightened LTV ratios. Bank of England too has embraced it, mandating only 15% of a lender's mortgages should be at an LTI ratio of more than 4.5. However, evidence from Canada, which has been implementing it, has not been encouraging. Singapore, by sharply tightening LTV ratios from 90% in 2009 to 40% in 2013, has managed to stabilize its property market.

An IMF study of macro-prudential and capital flows management (CFM) policies from 46 countries in the 2000-13 period (353 cases of policy tightening and 129 of loosening) has found that the former has been effective in stabilizing housing markets especially in Asia. In fact, even CFM policies have been found useful in damping property prices in Asian markets where they have been used intensively. It finds that macro-prudential policies have reduced credit growth by 2.6 percentage points annually.

A BIS paper that examined nine non-interest rate macro-prudential policies on housing prices and housing credit growth in 57 countries over three decades finds,

We find that changes in the maximum debt-service-to-income (DSTI) ratio have the largest and most robust effects on housing credit, with a typical tightening action lowering the real growth rate by 4 to 7 percentage points over the subsequent four quarters. None of the policies consistently affects house prices with the exception of housing-related tax increases, which slow real house price appreciation by 2 to 3 percentage points... 

However, their negative results are equally instructive,

One such finding is that instruments affecting the supply of credit generally by increasing the cost of providing housing loans (reserve and liquidity requirements and limits on credit growth) have little or no detectable effect on the housing market. Nor do risk-weighting and provisioning requirements, which target the supply of housing credit... Measures aimed at controlling credit supply are therefore likely to be ineffective... Of the two policies targeted at the demand side of the market, the evidence indicates that reductions in the maximum LTV ratio do less to slow credit growth than lowering the maximum DSTI ratio does. This may be because during housing booms, rising prices increase the amount that can be borrowed, partially or wholly offsetting any tightening of the LTV ratio.

Higher taxes are certain to tread on economically uncertain and politically difficult territory. However, in the light of evidence that real estate ownership has been a major contributor to the widening inequality, economists like Larry Summers and Adam Posen have advocated higher property taxes, especially on large homes and those keeping them vacant, and therefore presumably as an investment.

In any case, these econometric findings have limited generalizable external validity and it would also be strongly influenced by other macroeconomic conditions. As Andrew Haldane remarked, "macro-prudential policy is roughly where monetary policy was in the forties", a very much evolving field. The lack of proper understanding of its transmission mechanisms and effects only means that we have to be prepared for cautious experimentation. This insight alone should be invaluable for regulators as they seek to stabilize financial markets.

See also this article by Donald Kohn, currently a member of UK's macro-prudential regulator, Financial Policy Committee, on how the US Financial Stability Oversight Council (FSOC) can be strengthened as a macro-prudential regulator. 

India's infrastructure grid-lock

I have blogged many times about the gridlock that faces Indian infrastructure sector. Here is the story re-told.

The largest infrastructure firms have limited free cash or space in their balance sheets to take up newer projects. Worse still, they are heavily indebted. Their problems have been exacerbated by their own aggressive bids and the anemic economy. On the other side, their major source of financing, commercial banks, have reached, even breached, their sectoral exposure limits. A large share of these loans have either been restructured or have turned sour. In the absence of large scale recapitalization, they too have limited space on their balance sheets for further lending. In fact, these banks need an estimated $100 bn worth fresh capital by 2018. In other words, both developers and lenders have reached their thresholds. 

One way out is to get foreign capital. But foreign investments in most infrastructure projects suffer from currency mismatch problems - revenues in rupee, debt repayments in foreign currency. In a world of capital-floods and sudden-stops, this is most likely to leave the country badly exposed. The other way out is through government financing. But the fiscally strained central and state governments are in no position to generate the resources required to make any dent on the problem. 

A more sustainable but long-drawn solution is to broaden capital markets and create a market in securitization that would take the project debts and loans off the balance sheets of the developers and banks respectively. This would have to be complemented with strong regulation of the concession contracts so that the service delivery standards are not compromised when original promoters exit the projects. 

Doubtless, there are other problems that have derailed the sector - land acquisition, environmental clearances, policy paralysis, and so on. But, to the extent that financing is arguably the most basic requirement, there are no easy answers to reviving infrastructure investments. For the immediate, there is no alternative to large-scale bank recapitalization in today's Union Budget. 

The rise of central banks as sovereign financiers

Among the many distortions that have accompanied the extended period of quantitative easing across developed economies has been the rise to prominence of central banks as the predominant financiers of public debts. In the US, the Fed purchased 71% of all Treasuries issued in 2013.

Since the beginning of its latest QE program in April 2013, Bank of Japan has been purchasing about 70% of all government securities. Japanese bond yields have declined continuously despite upward tick in inflation. 

In UK, the Bank of England's share of UK public debt has ballooned to over 25%, up from negligible levels in 2008. 

In all these cases, the story is the same. Governments issue securities either to finance investments or to bend the yield curve. In the absence of adequate market demand, central banks print money, buy the securities, and thereby lend to governments. Central bank interventions keep interest rates low, thereby both discouraging  fiscal prudence and encouraging easy money-based asset market speculation.  

This cannot go on forever. When the circle gets broken and interest rates inevitably rise, governments will be stuck with massive debt loads and unsustainably high financing costs. 

Soccer rules the world!

Vox points to this map highlighting the most popular sport in each country.

Apart from the sub-continent (cricket), China (table tennis), US (football), and Canada (Ice hockey), soccer pretty much dominates the playgrounds across the world.

"Optimism bias" in a graphic

Excessively optimistic traffic forecasts are a feature of road concessions across the world. An S&P study of 32 these projects across the world found that actual traffic was less than forecast in all but four of them. The average actual traffic volumes were only 73% of the forecast volume.

A CRISIL study of 15 NHAI projects shows that traffic growth in passenger car units (PCUs) was just 3-4% in 2011-12 and 2-3% in 2012-13, as against 7-8% in the 2006-11 period. This slowdown is due to the slowdown in commercial vehicles traffic, which account for over three-fourths of total traffic. In another analysis of 6 NHAI projects, it found that base traffic was 20-40% lower compared with NHAI estimates and average project returns 8-14% compared with the 22-26% based on NHAI traffic and cost estimates. This meant that 5 out of the 6 projects had average debt service coverage ratio (DSCR) of less than one in the first five years of the operation, thereby making debt restructuring inevitable. Re-negotiations invariably follow.

It is for this reason (and also cost over-run due to construction delays) that governments in UK, Australia etc include an "optimism bias" into their calculations while evaluating infrastructure project bids. The "bias" is the difference between the bid parameter and the average of its actually realized valuation from all previous projects. It is also the reason why EPC contracts, bundled with medium-term operation and maintenance activities, are gaining favor over BOT PPPs.