Wednesday, October 29, 2014

Industrial policy in chip design and manufacturing

The Times reports of the latest example of industrial policy from China, promotion of semiconductor chip making industry. It writes,
Last year, the country imported $232 billion of semiconductor products, eclipsing even the amount spent on petroleum. To narrow the gap, Beijing is starting programs to increase investment by the state and to gain expertise from foreign chip companies. Experts say the chip industry is one focus of Chinese espionage efforts... Vice Premier Ma Kai is leading a task force charged with making the country’s chip industry a world leader by 2030. The task force brings together four ministries and is estimated to have $170 billion in government support to spend over five to 10 years.
The rising trend of anti-trust and other investigations against multinationals launched by the Chinese government is being alleged to be part of a strategy that also includes forcing technology firms to lower licensing standards or agree for more liberal technology sharing contracts.

The MGI report, which formed the basis of the Times article, writes about the evolution of the government's semiconductor design and manufacturing policy,
The Chinese government is now putting significant funding and effort behind new policies relating to the development of the semiconductor industry. The government’s previous attempts to build the industry, dating all the way back to the 1990s, had mixed results because funding plans and incentives were focused more on research and academia than on business. Additionally, investments were fragmented—at one point, the government had invested in 130 fabrication sites across more than 15 provinces, none of which was able to capitalize on the scale and scope of its neighbors’ sites, and supporting industries never materialized.
The government, realizing that earlier bureaucrat-led investment initiatives failed to bring the desired results, is now aiming to take a market-based investment approach. In this case, decisions about allocating for-profit investment funds will be managed by professionals but will remain aligned with the government’s policy objectives. Chinese officials have convened a unique task force charged with setting an aggressive growth strategy... Investments will be made by a national investment vehicle (the National Industry Investment Fund) and provincial-level entities. These entities will invest across multiple categories, including project finance and domestic and foreign acquisitions, as well as traditional research and development subsidies and tax credits. 
To avoid the fragmentation issues of the past, the government will focus on creating national champions—a small set of leaders in each critical segment of the semiconductor market (including design, manufacturing, tools, and assembly and test) and a few provinces in which there is the potential to develop industry clusters... The Chinese government has actively pursued consolidation to spur the creation of national champions... The new policy framework specifically encourages consolidation within China’s assembly-and-test market segment.
Semiconductors are only the latest in the long line of industrial policy interventions pursued by the Chinese government. Two things stand out

1. As the example shows, Chinese industrial policy, despite its apparent simplicity is characterized by very smart iterative learning by doing. Each industrial policy intervention has undergone constant revisions based on feedback before they succeeded. All along the primary objective was to develop globally competitive industries. It requires enormous political courage and commitment as well as bureaucratic discipline and competence to acknowledge mistakes, learn from it, and refine policies while not losing sight of the ultimate objective.

2. The magnitude of the resources committed is massive. No country, including in the developed world, can commit such scale of resources to pursue its industrial policy objectives. Even for large countries like India, the resources committed by China for semiconductor industry alone will dwarf their total industrial policy commitment over a longer period. Such scale of support, coupled with strong and disciplined leadership, have generally underpinned Chinese industrial policy interventions. 

Monday, October 27, 2014

Market aggregators - waste management edition

The Times has a story on Rubicon Global, which has emerged as the pioneering market aggregator in the business of private waste management in the US. Rubicon, using its proprietary software, Ceasar, acts as a hub connecting businesses with waste haulers, landfill owners, and trash recyclers. Times writes,
Across the country, millions of companies are creating trash, including food waste, cardboard, plastics and various other materials. These companies hire waste management firms to pick up their trash and truck it to a landfill. Two big national companies, Waste Management and Republic Services, dominate the market, owning fleets of trucks and hundreds of landfills. Thousands of smaller, regional trash haulers fill in the gaps. Rubicon, based in Atlanta, isn’t in the business of hauling waste. It doesn’t own a single truck or landfill. Rather, companies hire it as a kind of waste consultant. It begins by holding an online bidding process for its clients’ waste contracts, fostering competition among waste management businesses and bringing down their prices.
Rubicon also studies its clients’ waste for novel recycling opportunities, connecting businesses with the recyclers who see hidden value in their junk. For a national pizza chain, Rubicon determined that much of its leftover dough could be processed into ethanol. For a regional supermarket, Rubicon discovered that 400,000 old company uniforms could be shredded and resold as a stuffing for pet beds. Insulated containers that carried seafood for one business were repurposed to transport bull semen for another. So beyond saving money for its clients, Rubicon can nudge them toward environmental responsibility by diverting waste from landfills into recycled goods.
Its promoters claim that Rubicon is the "uber of waste". Two observations,

1. The advances in ICT over the past decade has facilitated the emergence of a distinct class of business service providers, market aggregators, who help consummate all kinds of transactions - buying and selling, erranding, renting, sharing etc. Commentators have christened them brokers in the sharing and renting economy. In the initial phase, these aggregators have been confined to services which could be delivered online through the internet, as evidenced by the success of agencies like Priceline and Expedia in purchase of airline tickets and holiday packages, and iTunes and Spotify in delivering music.

In recent years, it has spread to other parts of the economy, broking retail merchants and deal seekers, vehicle drivers and ride-seekers, errand seekers and chore suppliers, grocery chains and delivery agencies, employers and free-lance workers, and so on. This trend has just started and has a long distance to play out, covering large parts of the economy. All these platforms lower inefficiencies and waste, thereby benefiting both buyers and sellers. Fundamentally they have the potential to lower market inhibiting frictions, thereby easing market transactions and expanding the market.

2. Rubicon aims to help its clients divert 100% of their waste from landfills to recyclers by 2022. Rubicon's ambitions on recycling, motivated by the business opportunity there, is an example of how appropriate alignment of incentives among market aggregators and their clients can help attend to many social and environmental problems. There is window for public policy makers and non-profits to seek out these opportunities and influence the design of these markets in a manner that advances public interest without compromising on their growth.  

Sunday, October 26, 2014

Chinese are coming!

As Anbang Insurance Group, a less known Chinese insurer, purchased the iconic 1232 room New York hotel Waldorf-Astoria for $1.95 bn, the Times writes,
Chinese companies, in particular, have made a splash of late by buying New York real estate. Fosun International bought One Chase Manhattan Plaza, the downtown office building, for $725 million last year. SOHO China and a Brazilian billionaire bought a 40 percent stake in the General Motors Building. And in Brooklyn, Greenland Holding Group bought a 70 percent stake in the 22-acre development now called Pacific Park that had been known as Atlantic Yards.
As Bloomberg writes, this has striking similarity with the wave of Japanese purchases of US real estate in the eighties,
The surge in Chinese real estate investment overseas is reminiscent of the Japanese wave of property purchases in the U.S. and other countries in the 1980s, which included New York’s Rockefeller Center and California’s Pebble Beach golf course. Many Japanese buyers were forced to sell when the US fell into recession. 
And Jamil Anderlini points to the reversal of aggregate capital flows, as China emerges as a net capital exporter, on the back of its $4 trillion war chest of foreign exchange reserves,
Outbound direct investment rose 21.6 per cent in the first nine months compared with last year to $75 bn...  In 2002 Chinese investors spent just $2.7 bn on acquisitions and greenfield projects abroad but by 2013 the total had increased 40-fold to $108 bn... outbound investment could come in at close to $130 bn for 2014.

Friday, October 24, 2014

Is the rupee a one-way bet?

Interesting set of graphics from Research Associates (ht: Barry Ritholtz) on real 10-year expected returns on a variety of asset classes. The one on currencies was of particular interest since unhedged returns on rupee investments (borrow abroad in dollars and invest in short-term rupee bills, and keep rolling them over) topped all other currencies.
India has one of the highest inflation rates among all emerging economies and its inflation trajectory is not expected to subside dramatically. Therefore the prospects of any sharp decline in its high interest rates is not promising. This, coupled with the liquidity trap conditions in developed economies, again likely to persist for some time, points to attractive carry trade potential from borrowing in dollars and investing in rupee assets. This short-term one-way bet and the consequent vulnerability it imposes by way of capital flows and sudden-stops makes capital account management an important macroeconomic challenge for the country.

A comparison of the cyclically adjusted PE ratios (real price divided by average of real EPS over the past ten years), CAPE, reveals that Indian equity market is among the most volatile and remunerative. 
Finally, a comparison of real 10-year expected returns indicate that among all asset categories, emerging market assets occupy the top three places - equity, local debt, and currency 
The importance of this graphic comes from the attendant capital flows related vulnerabilities that emerging markets face from cross-border capital as they search for yield in an environment of ultra-low interest rates.

Friday, October 17, 2014

Last mile gaps - financial inclusion and toilet usage

Last mile gaps are pervasive with many social policy issues. Two flagship programs of the government are most certain to be only the latest to realize that supply-side strategies are unlikely to address this challenge to any degree of satisfaction.

1. Jan Dhan Yojana aims to increase financial inclusion, thereby enabling access for the vast majority of unbanked Indians to formal financial institutions.

2. Total Sanitation Campaign aims to address India's shameful open-defecation problem by provision of heavily subsidized toilets to those without toilet facilities.

In both cases, formidable last mile gaps come in the way of access to bank accounts translating into actual usage and new toilet owners using their toilets. Such gaps can be overcome only through massive social mobilization involving painstaking and long-drawn campaigns that resist the temptation for targets-driven quick wins and band-aid solutions. Does the Indian state have the capability to successfully manage such efforts?

Saturday, October 11, 2014

India's growing corporate external borrowings risk

In a speech early this week, the RBI Deputy Governor, HR Khan, had this to say about the rising share of unhedged foreign exchange exposure of Indian corporate,
In India, there is emerging anecdotal evidence of reduced propensity to hedge foreign exchange exposures arising out of a sense of complacency. The unhedged exposures in respect of External Commercial Borrowings (ECBs)/ Foreign Currency Convertible Bonds (FCCBs) lead to large scale currency mismatches in view of the bulk amount borrowed by domestic corporates for longer tenors with limited or no natural hedges. Further, the increasing use of bond route for overseas borrowings exposes the domestic borrowers to greater roll-over risk. As per indicative data available with the Bank, the hedge ratio for ECBs/FCCBs declined sharply from about 34 per cent in FY 2013-14 to 24 per cent during April-August, 2014 with very low ratio of about 15 per cent in July-August 2014. Large scale currency mismatches could pose serious threat to the financial stability in case exchange rate encounters sudden depreciation pressure.
Hedging or not, the fundamental reality has been the sharp increase in ECBs in recent years. ECB as a share of external debt has doubled since 2007. As I have blogged earlier, the government has consistently, in response to rising external imbalances, relaxed the ECB norms.
Similarly, short-term debt too has risen sharply in recent years. The portfolio of international bonds of all maturities, mostly raised by corporates and financial institutions, has risen dramatically since 2008. 
The decline in hedging has been attributed to the growing belief that the rupee value is likely to stabilize at Rs 60-62. Recent stability in rupee despite continuing turmoil in many other emerging market currencies, prospects of economic recovery, declining commodity prices (and consequent downward pressure on current account deficit), and a perception that RBI would aggressively defend the currency are thought to underpin this belief.

However, these optimists overlook India's persistent high inflation, easily the highest among all major emerging economies. This is unlikely to decline to the levels in other emerging economies anytime in the near future. The consequent depreciation of real exchange rate is not only inevitable, but also desirable. Further, as the US Fed exits quantitative easing and given the relative strength of US economy in comparison to the economic weakness in Europe, the recent trend of strengthening US dollar is likely to persist for the near future, thereby adding more downward pressure on the rupee.

If these trends play out, as they look likely to, then a depreciating rupee will leave the unhedged corporate borrowers in serious trouble. Once the US economic recovery takes firmer hold and interest rates start rising, coupled with a depreciating rupee, a backlash by way of capital flight, in whatever scale, is a real possibility. It would leave the Indian economy, especially its banking sector, exposed to problems similar to that experienced by countries like Thailand and Indonesia in the late nineties and Spain and Portugal just recently, albeit on a smaller scale.

It is therefore important that the RBI and government make corporates to periodically share the details of their external exposures. This will enable, as Paul Tucker recently pointed out, banks to deploy more prudent macro-prudential norms in their lending to corporates with larger unhedged external exposures.

Postscript : Nice article in Business Standard highlights the risk.

Thursday, October 9, 2014

India's Economic Challenge in Two Graphs

As the Indian economy continues on its uncertain recovery path, it is worth looking back at where things went wrong. The following two graphs are instructive.

The first graphic tells us that investment and credit growth have fallen precipitously since the Great Recession struck. The decline in gross fixed investment has been alarming, falling sharply from 33% in 2007 to just above 27% estimated for 2014. In the 2008-14 period, credit growth has nearly halved from its peak in 2008.
The twin effect of this decline on the economic growth becomes evident from the second graphic. Consumption and fixed investment, two bulwarks of growth for much of last decade, have tanked dramatically. Investors have virtually gone missing over the past two years. Inventories, a good proxy for business confidence, has shown negative or no growth since 2010.
In simple terms, consumers have to spend more and businesses have to invest more, thereby generating the virtuous circle which can sustain a high growth trajectory. In the face of formidable headwinds - high interest rates, high inflation, deficient infrastructure, weak global cues, and bruised bank balance sheets - the prospects for either looks bleak. 

Wednesday, October 8, 2014

Inequality fact of the day

From Guardian, on a recent Oxfam report,
The richest 85 people across the globe share a combined wealth of £1tn, as much as the poorest 3.5 billion of the world's population... The wealth of the 1% richest people in the world amounts to $110 tn (£60.88 tn), or 65 times as much as the poorest half of the world... Winnie Byanyima, the Oxfam executive director who will attend the Davos meetings, said: "It is staggering that in the 21st Century, half of the world's population – that's three and a half billion people – own no more than a tiny elite whose numbers could all fit comfortably on a double-decker bus."
As the report writes, such staggering inequality invariably translates into political capture.

The politics of widening inequality

Most of the discussions surrounding the global debate on widening inequality has focused on its fairness and its implications on the prospects for future economic growth. A more immediate and pernicious concern is how it affects politics, governments, and the nature of public policies.

Whether we like it or not, any economic policy decision involving regulation, investment, contracting, recruitment, and incentives is essentially a political decision. They generally benefit one group or other, often at the cost of another. Such decisions are invariably influenced by the predilections of those holding the reins of power. And as the graphic below, from a Washington Post article, shows, political activity increases with income levels, for every metric of political engagement.
This is most certain to reinforce the already strong economic influence wielded by those at higher income levels, thereby translating economic power into political influence. As the Post article writes,
Our representative democracy is not as representative as it could be. Relative to other income groups, the wealthy are over-represented in the political process simply because they're more likely to participate in it. This means that political debates - and political outcomes - are much more reflective of the interests of a wealthy minority than they are of the middling majority.
This is increasingly true of most countries today, including India. This dynamic which is disruptive of democracy itself is the most disturbing part of the widening of inequality.

Update 1 (5/11/2014)

Der Speigel has this excellent essay on how widening inequality and other trends have eroded the inclusive nature of capitalism in western democracies.

In this context, one illustration of the channel through which financial power begets political decision-making influence comes from this famous study of how the stocks of certain financial institutions (with which Tim Geithner had some form of connections) rose in the immediate aftermath of Geithner's elevation as Treasury Secretary. The value of connections is universal, playing an important role in translating economic power into political influence in countries across the world. 

Monday, October 6, 2014

Bank's are no different from other borrowers

Simon Johnson has an excellent article in Project Syndicate where he points to the improper framing of the debate on bank capital requirements. Supporters of higher capital requirements argue that it is necessary to align incentives and ensure that the bankers have their skin in the game, thereby reining in irresponsible lending. Critics claim that higher capital reserves take away from the amount of capital available for lending, thereby adversely affecting the bank's profitability and limiting lending volumes.

Fundamentally, as Simon Johnson argues, the supporters view capital reserves as a liability whereas the critics view it as an asset. When viewed in this frame of reference, the issue gains much needed clarity.

Consider this. When you visit a bank to borrow money to finance your business, the first level of due-diligence for the banker is to examine the share of owner's equity in the total investment. In a balance sheet, this equity is treated as a liability, or what is owed to shareholders. As a rule of thumb, even the most aggressive banker will demand that the owner put in atleast a fifth of the investment as equity. You will find scarce a business owner who complains that this restriction is adversely affecting his business.

In contrast, when it comes to banker's themselves, it appears to be a case of what is sauce for the goose is not sauce for the gander. Banks borrow from depositors. It is therefore only natural that depositors should demand a similar share of owner's equity from their bank borrowers as lenders to other businesses do. The capital base is the cushion that lenders (in this case, depositors) demand from banks. In other words, it is the explicit restriction that lenders place on the bank's leverage. But banker's, oblivious to this and unlike all other business borrowers, feel that this restriction is detrimental to their business prospects. Somewhere in time, bankers have come to forget that depositors are their lenders, and lenders demand capital/equity stake from owners.

In fact, as the Global Capital Index database shows, very few banks have a capital reserve ratio of even 5%. In other words, banks have been borrowing from their lenders (or depositors) by putting forward less than 5% as equity. And now when someone calls out on this egregious anomaly, bankers turn around and cry foul. Clearly, the critics are being disingenuous.

Update 1 (5/11/2014)

A good primer on bank capital ratio is here

Sunday, October 5, 2014

Corporate tax avoidance fact of the day

The Times has a nice article on the issue of tax avoidance by corporates using strategies to shift profits (through higher royalties to the intellectual property owning entity) to jurisdictions where taxes are lowest and costs to those where they are highest (subsidiaries in high tax areas, where interest is deductible, to borrow from those in low tax areas, where interest is not taxable). It writes,
According to a report from Kimberly Clausing of Reed College, the top five countries for American affiliates, measured by jobs, are Britain, Canada, Mexico, China and Germany. Measured by reported profit they are the Netherlands, Luxembourg, Ireland, Canada and Bermuda... In 2010, according to the International Monetary Fund, Barbados, Bermuda and the British Virgin Islands received more foreign direct investment combined than Germany or Japan. The British Virgin Islands was the second-largest investor in China, after Hong Kong. These fictions are possible because most of the money flows through shell corporations that employ nobody and produce nothing. 
And this graphic nicely captures corporate tax trends,

In the same article, Larry Summers points to the problems likely to arise due to weak enforceability of corporate and income tax rules in a globalized world where businesses and rich people can easily move around their activities to minimize their tax outflow,
Consider a superstar banker, an enormously valuable pharmaceutical patent, a terrific entertainer, an assembly line worker and a teacher. Of all those things, which is the least mobile? A tax system that can’t reach the mobile is a tax system that is going to burden working people.
For an Indian government seeking a proactive international role, there may be no more appropriate issue to assume a global leadership role than co-ordinating a global effort to limit corporate tax avoidance strategies.

Update 1 (15.11.2014)

Times has a nice story about US MNCs using European tax havens to minimize their tax outflow by cutting preferential tax deals with those countries. It writes,
Luxembourg had inward foreign direct investment of $2.4 trillion in 2012, exceeding the combined intake of Germany and France, the eurozone’s two largest economies... To put that in perspective, Luxembourg has a population of just over 500,000 people. Germany and France have a combined population of 146 million people. About 91 percent of the foreign direct investment coming into Luxembourg is through special-purpose entities... Ireland has become particularly popular as a way station for managing taxes. A United States Senate report last year found that from 2009 to 2012, Apple transferred “$74 billion in worldwide sales income away from the United States to Ireland where Apple has negotiated a tax rate of less than 2 percent.” Another Senate report found that Microsoft transferred “rights to the intellectual property developed by American engineers” to a small Dublin office with less than 400 employees, then reported an annual profit of $4.3 billion, which was taxed at 7.2 percent.
Update 2 (20/12/2014)
From Newsweek,
Google pays as little as 2.4 percent tax on its offshore earnings, compared with the official 35 percent tax rate on American profits and the 21 percent rate in Britain, its second largest market. Google’s worldwide pretax profits grew 72 percent from 2009 to 2013, but profits booked offshore grew more than five times faster, from $7.7 billion to $38.9 billion.
In early December, the British government sought to clamp down on corporate tax avoidance by offering companies a choice between a 25 percent tax on “profits generated by multinationals from economic activity here” and a 21 percent tax on profits kept in the country. 

Saturday, October 4, 2014

The challenge with market-driven supply of affordable housing

The Union Housing and Urban Poverty Alleviation Ministry has estimated urban housing shortage for the Twelfth Plan period (2012-17) at 18.78 m, of which 96% will be in the EWS/LIG categories. As I have already blogged here, here, and here, none of the strategies currently being pursued to encourage market-based supply of these units are likely to bear fruit.

The Government of India has been implementing various programs - JNNURM, RAY, Affordable Housing in Partnership (AHP), Rajiv Rin Yojana (RRY), Credit Risk Guarantee Fund Scheme (CRGFS) etc - to increase EWS/LIG housing stock by public construction or market-based supply through various kinds of incentives.

Under the AHP scheme, the GoI would provide a subsidy of Rs 75000 per unit for both housing and internal infrastructure for units with carpet area below 40 sqm (430 sq ft) in projects with atleast 250 dwelling units. The RRY scheme mandates a 5 per cent interest subsidy for loans upto Rs 5 lakh for EWS/LIG applicants for units below 40 sqm. The CRGFS provides for credit guarantee, to an extent of 85-90%, for loans upto Rs 5 lakhs and units below 40 sqm, thereby enabling lending without collateral.

The government mandates units below 60 sqm as affordable housing, and people with annual incomes below Rs 1 lakh as EWS and Rs 1-2 lakh as LIG. All the aforementioned incentives are confined to houses with carpet area below 40 sqm. In simple terms, only people with incomes below Rs 2 lakh, purchasing houses below 40 sqm, and at a cost of less than Rs 5 lakh, can avail of these incentives and benefits.

I am inclined to believe that this eligibility criteria leaves us with a very small sub-set, approximating a null set. Consider this. Why would someone with annual income of Rs 2 lakh want to pay a mortgage of Rs 5500 a month to purchase a 430 sqft house for about Rs 5 lakh when he can get a 800 sq ft house on rent for less than half the mortgage amount? All the more so since their income is most likely to go up and they would want a house larger than 430 sq ft as children grow up. Similarly, it may be a stretch to expect a person with an annual income of less than Rs 1 lakh to be able to afford a monthly mortgage payment of about Rs 1500 to acquire a 250 sqft house. The differential with rental housing applies here too. Further, including all the subsidies and incentives, a 250 sq ft house cannot come any cheaper than Rs 3 lakh in even the suburbs of any Indian city. Finally, it is also important to realize that the overwhelming majority of affordable housing requirement would be for those with incomes far below Rs 1 lakh.        

None of the schemes outline the pricing strategy for the houses for EWS/LIG except vague assertions of "no-profit-no-loss basis" and "open and transparent process". No state has anything like a satisfactory price fixation mechanism. This should come as no surprise since the large variability in land (especially) and construction costs make it is very difficult to have an administered price for privately developed housing units.

Even assuming we surmount the challenge of fixing a price, that of identifying the beneficiaries will remain. It may be unreasonable to assume that the government can allot a relatively valuable asset like an urban housing unit in a transparent and fair manner, given the massive and exploding demand for such housing and the limited supply that is likely to materialize from the market-based incentives.

The mandates driven policies (reserving a share of units in any development for EWS/LIG housing) too are not likely to be any more effective in increasing supply. Such policies have been operation in many Indian states for years, with negligible addition to the stock. The land premium in the price of EWS/LIG units in such areas makes them prohibitively expensive and even an unlikely EWS/LIG purchaser is most likely to dispose off his unit at the earliest opportunity. It is no surprise that the only places where mandates have generated some stock, they are being sold as studio-suites.

Finally, these policies adopt a very restrictive definition of affordable housing. Though I have not been able to get supporting data, there are many reasons to believe that the price-to-rent and price-to-income ratios for housing are likely to be very high, even for those in the middle-class category, as to make home ownership unaffordable and unattractive.

In view of all the above, it is reasonable to argue that while we should persist with incentives and mandates, any realistic dent on meeting the EWS/LIG demand may have to come predominantly from public housing projects. A pure public procurement driven model may not be appropriate given the associated inefficiencies. Therefore, the government may have to cough up a much larger share of the construction cost as well as provide land, while the construction and maintenance of such projects should be entrusted to private agencies through incentive-compatible contracts.