The lessons from the travails of "Fragile Five"

Fragile Five is the new club in town. The central banks of Brazil, India, Turkey, and South Africa have hiked interest rates, some dramatically, either to backstop falling currencies (Turkey and South Africa) or stem rising inflation (India and Brazil). While all of them suffer from weak economic fundamentals (triple whammy of high inflation, fiscal deficit, and current account deficit) and political uncertainty (elections looming this year), a sudden reversal of cross-border capital flows has amplified the problems and triggered off a potential crisis in many developing economies.

International investors, spooked by the Fed's decision early this week to taper its bond-buying program and uncertainty about China's slowing economy, have responded by fleeing equity and bonds markets of emerging economies. They perceive the former as reflective of normalcy returning to the US, with the resultant prospect of higher interest rates in the US, and the later as likely to sharply reduce global demand especially for commodities, thereby adversely impacting many emerging economies. A spiral of self-reinforcing market expectations and resultant contagion have been hammering the emerging economies.

Now, this is a teachable moment about the risks that are likely to arise from the financialization of an integrated world economy and how nation states can prepare to mitigate them. Consider these existential realities.

Political uncertainty and the electoral business cycles are part of the game in democracies and autocracies alike. Institutional weakness and regulatory failures will remain a feature of many of these economies for the foreseeable future. Economic mis-management is not likely to disappear as long as humans run national governments. Similarly, countries, both developing and developed, are always as likely to run deficits, domestic and external, as surpluses.

In the present crisis, notwithstanding the undoubted problems of economic mismanagement and political uncertainty in many economies, the sharp gyrations of global capital flows have exacerbated the problems facing many developing economies. In fact, they have amplified individual national macroeconomic problems and moved them into a potentially global, or atleast emerging markets-wide, economic crisis. This is only the latest example of recurrent sudden-stop induced crises that have become a feature of the global economy in recent decades. Surely, the conditions are not as dire enough to merit this level of divergence in currency valuations,

An economic boom or uncertainty in developed economies drives capital into an emerging economy. It inflates asset market bubbles and distorts incentives that lead to resource mis-allocation in that country. Economic mis-management and other negative accompaniments are never far-away. Investors then realize all these problems and then a sudden-stop ensues, followed immediately by sharp reversal of capital flows. This time is no different.

It is painfully obvious that nation states need to pursue a macroeconomic policy framework that gives them the best change of both preventing such sudden-stop induced crises as well as dealing with them if need arises. A carefully calibrated approach to allowing external capital flows, especially in good times, has to be a central feature of this framework. The IMF has wisely reconsidered its views on managing capital flows advising caution on capital account liberalization.

In the circumstances India needs to be cautious about managing its capital flows liberalization policy. Instead of pursuing any desirable single goal post of "capital flows liberalization", we should adopt a policy of carefully calibrated policy of "capital flows management" with multiple-goals, all aimed at ensuring external macroeconomic stability.

Update 1 (1/2/2014)

Floyd Norris,

Capital controls can make sense when times are good. Countries that have easy access to loans may be better off not taking them.

Informal firms and manufacturing sector

Some research material used for this op-ed.

Excellent IFC report on private sector job creation. I have blogged earlier about India's jobs crisis. The IFC report confirms that micro-enterprises form an overwhelmingly large share of job employment in both manufacturing and services sector in India. However, in developed countries, larger firms contribute the major share of employment.

But the most disconcerting feature of these micro-enterprises is that they remain small and even decline with time. Further, their productivity remains stagnant over the life-cycle, in sharp contrast to that of firms from the US, whose productivity and job creation increases sharply.

This graphic highlights the difference in firm birth and growth dynamics between developing and developed countries. In developed countries, many surviving firms are born small and then grow into bigger firms. In developing countries this is frequently not the case: surviving firms are either born large and do not grow much, or surviving firms in fact decline in size. When the size of 35-year-old firms in India, Mexico, and United States is compared to their size at startup, in India the size declines by a fourth, in Mexico the size doubles, and in the United States it is 10 times larger. These patterns may reflect the fact that small and medium-size firms in low-income economies are faced with constraints

The World Bank Group’s Enterprise Surveys data, which analyzed responses of over 45,000 small and medium enterprises in 106 developing countries shows access to finance, electricity, and informality as the three biggest constraints facing firms.

A categorization of these constraints reveals that investment climate - or the legal and regulatory framework and its implementation - is the largest group of constraints. They include informality, tax rates, customs and labor regulation, tax administration, business licensing and permit, courts, access to land, and corruption.

In the context of large numbers of informal firms, one of the biggest concerns for India is the "missing middle" or the disproportionately low number of intermediate sized firms.

Clearly, unlike the US or even Mexico, there is a pronounced deficiency of intermediate sized firms in India. The most likely explanation is that the informal firms which dominate the sector, employ too few workers and very rarely grow out of their informality, while the formal firms are most likely to be large given the various labor market restrictions and credit and other constraints that would work against intermediate sized formal firms. In fact, as the graphic below shows, the number of workers employed by even formal firms remain stationary with time. 

Manufacturing Revival

I have an op-ed on the challenges facing India's manufacturing revival here. In short, the National Manufacturing Policy, with its industrial-cluster focus, will have to be complemented with critical economy-wide structural reforms if we are to change the stagnant trajectory of manufacturing in the country.

Update 1 (25/1/2014)

Excellent article in NYT about the troubles facing American manufacturing. This graphic highlights the deep slump undergone by US manufacturing.

Manufacturing's share of the economy is among the lowest in the US. It is even more depressing for India which at its stage of economic development should have been in the 25-30% range. 

One of India's big comparative advantages in manufacturing is its low wages. In automobile sector, its wages are much smaller than even its other emerging economy competitors. However, this advantage will be significantly eroded when adjusted for productivity. 

Inequality Linkfest

Inequality is the flavor of the season. President Obama recently described inequality as the "defining challenge of our time". Thomas Piketty's Capital in the 21st century, which highlights capitalism's inequality promoting attributes and whose findings bear striking similarities with Marx's epic, has been receiving rave reviews (Economist and Branko Milanovic), rare for an economics book. Two other excellent explorations of inequality are books by Nicholas Carnes and Lane Kenworthy (see essays here and here). In the context of the 50th anniversary of the Great Society Program which sought to eliminate poverty in the US, NYT has two very good articles here and here.

Lane Kenworthy's book is a virtual manifesto for ushering in a social democratic polity and society. He writes in a Foreign Affairs essay about the goal of a Social Democratic America,

Modern social democracy means a commitment to the extensive use of government policy to promote economic security, expand opportunity, and ensure rising living standards for all. But it aims to do so while also safeguarding economic freedom, economic flexibility, and market dynamism, all of which have long been hallmarks of the U.S. economy. The Nordic countries’ experience demonstrates that a government can successfully combine economic flexibility with economic security and foster social justice without stymieing competition. Modern social democracy offers the best of both worlds... Social insurance allows a modern economy to hedge against risks without relying on stifling regulations. 

Nicholas Carnes' White-Collar Government : The Hidden Role of Class in Economic Policy Making, uses hard data to analyze the role of class in policy making and how it contributes to widening inequality. He has two posts in Washington Post.  He summarizes his book,

Lawmakers from different classes bring different perspectives with them: how they think, how they vote, and the kinds of bills they introduce often depend on the classes they came from. The shortage of lawmakers from the working class tilts decisions about the distribution of economic resources, protections, and burdens in favor of the more conservative policies that affluent Americans tend to prefer. Social safety net programs are stingier, business regulations are flimsier, and the tax code is more regressive because working-class Americans are all but absent from our political institutions... 

He brings together a vast array of survey and other data to illuminate these conclusions. On the degree of concentration of power in the hands of the richest, he writes,

If millionaires in the United States formed their own political party, that party would make up just 3 percent of the country, but it would have a majority in the House of Representatives, a filibuster-proof super-majority in the Senate, a 5 to 4 majority on the Supreme Court and a man in the White House. If working-class Americans — people with manual-labor and service-industry jobs — were a political party, that party would have made up more than half of the country since the start of the 20th century, but its legislators (those who last worked in blue-collar jobs before getting into politics) would never have held more than 2 percent of the seats in Congress.

He also uses empirical data to debunk the two standard explanations for this class stratification in the ruling elite - Americans want (voters, of all classes, exhibit a particular preference for legislators from a particular class) and need (people of particular classes have the attributes necessary to rule) it that way. He uses data on roll-call voting in the 106th through 110th Congress (1999-2008) and found,

Like ordinary Americans, legislators who worked primarily in white-collar jobs before getting elected to Congress — especially profit-oriented jobs in the private sector — tend to vote with business interests far more often than legislators who worked primarily in blue-collar jobs... I found similar patterns when I examined other measures of how lawmakers behave: voting scores computed by the AFL-CIO, DW-NOMINATE scores (the vote-based ideology measures often used by legislative scholars), data on the kinds of bills lawmakers introduce, surveys of lawmakers’ personal views about economic issues, and aggregate-level data on the economic policies that state and city legislatures enact. At every level of government, in every time period and in every stage of the legislative process, the shortage of lawmakers from the working class tilts economic policy in favor of the conservative outcomes that more affluent Americans prefer... Likewise, across states and cities, when working-class Americans are absent from our legislatures, tax policies are more favorable to businesses, social safety net programs are stingier, protections for workers are weaker, and economic inequality is significantly worse.

One of Thomas Piketty's central arguments is that the equitable growth pattern of the era of Great Moderation (for a variety of favorable factors including high population and productivity growth, and far-reaching life-style influencing technological progress) may have been an exception to the norm of iniquitous economic growth that characterized both the pre-war and Victorian eras as well as after 1980. The latest version of the Piketty-Saez graph underlines this point.

Piketty analyzes the ratio of the economy's capital to output ratio from 1700 to WWI for W Europe and finds that it hovered around 700%. The wars and depression dragged the wealth level down and the Great Moderation kept it low for sometime, only for the original trends to return in the past three decades.

Once the changes in the underlying variables are a given, the trends in the ratio fits in with standard economic theory. In steady state, the ratio of wealth (capital stock) and income (GDP) would converge to that of savings rate and economic growth. Once the economic growth rate (due to lower labor supply and productivity growth and decline in technological progress) falls (a new normal growth rate which is lower than the Great Moderation era rate), ratio of wealth as a share of GDP will rise and with it capital's share of national income (which is the rate of return on capital multiplied by the total stock of wealth as a share of GDP).

The challenge with immigration policies

From the comments section of an article by John Kay in the context of the recent proposal by UK government to limit immigration,

I've lived in a part of London, not a fashionable part but to me a wonderful part, where there used to be a huge diversity of small businesses and workshops. We even had several small farms providing fresh produce of all kinds including poultry, dairy and meat. We used to have our local dairy, bakeries, woodshops, foundries, printers, brickfields, artistic businesses of various kinds and small manufacturers making components and glass ware. It used to be great walking around and seeing what was being done and made. There used to be no unemployment in our district.

Since the 80's these small businesses have increasingly sold out because the land on which they were working became so valuable and goods from abroad so cheap that one by one the businesses folded. Now you can get very little locally and many if not most people shop in malls, out of town supermarkets and online. You cannot buy locally baked bread anymore or fresh eggs or locally sourced veg, fruit and meat as you could just a decade ago.

As developers took over a higher and higher proportion of our land they built smaller and smaller housing units in dense, soulless housing estates which had none of the quality of the Victorian housing which used to dominate. In fact most of our iconic historical buildings have vanished to be replaced by high rise flats. It is heart breaking to see this happening.

As the businesses and open land vanished more and more immigrants from all over the world came into our borough because it was their first port of call on arriving here. I have nothing against them because they are people, just like us natives. They too have to deal with the massive development and loss of character and choice which we used to have. It is not their fault that our borough has been ruined and now depends on ever less eco friendly consumption through the usual supermarkets and other outlet stores. But I do wish we had the businesses back instead of the wave of immigration. Local businesses are green and allow the ordinary person to have a living within distance of their home and it cuts down on costs and disadvantages of goods coming a long way.

This captures the essence of the immigration problem as seen by those affected. No amount of sermonizing about the aggregate benefits of immigration, confirmed by rigorous research, can clear this impression. It is therefore only natural that political leaders, the vast majority of whom realize its possible net beneficial effects, reflect the concerns of their affected electorate.

Even when their overall effect is beneficial, real people, and large numbers, lose heavily in the process of globalization and liberalization. It is only prudent that any efforts to promote them should therefore necessarily be accompanied by policies that directly seek to cushion those adversely affected.

Instead of the interminable debates and research about the effects of immigration, we should be more concerned about the design of policies that can attenuate the adverse impacts of these trends. What should be the nature of policies that cushion the victims? What should be the extent of social safety protection policies? What should be done to reintegrate those affected back into the mainstream? How should such policies be financed? How much should the winners of these trends compensate the losers?

The same logic applies not only to population groups within countries but also changes in multilateral regimes that often hurt countries as a whole.

The "procurement" problem with social enterprise solutions

Use market dynamics to solve social problems is the new buzz phrase in development. Newly minted development professionals, backed by small grants from donors seeking diversification of their lending portfolios, enthusiastically venture out from schools on social enterprise pursuits in Africa and elsewhere. Even the business schools have been swept by this trend. The nature of this approach chimes well with the prevailing academic ideology of evidence-based field-experiment driven search for development solutions.

But the one thing that the growing list of such projects reaffirms is that social problems are fiendishly intractable and not amenable to any one strategy. It is therefore no surprise to find young and incredibly smart entrepreneurs, who put their heart and soul into designing what they think are perfect low-cost solutions for critical social problems, apparently far superior to anything in the market, face repeated road-blocks with their projects.

Times has an article which describes the frustration faced by a non-profit firm, D-Rev, in its efforts in India to promote (in public hospitals) the use of a more efficient and sturdy photo-therapy equipment used to treat infant jaundice. Its business model is typical of social enterprise firms - leverage their knowledge-capital to design medical equipments suited to the conditions of developing countries and then license it to for-profit distributors. So, what gave,

"We thought if you design a good product, it will scale on its own... That works in efficient markets, but most developing communities don’t have efficient markets"... D-Rev’s... designers and engineers came up with an inexpensive light therapy system, called Brilliance, that was rugged enough to roll smoothly across dusty, rural hospital floors, and able to cope with erratic power supplies. But... D-Rev’s commercial distributor in India... found that cronyism or corruption sometimes led hospitals to select higher-cost, lower-quality products... Hospital systems still sometimes chose higher-price systems because of bribery or cronyism, or because they didn’t understand Brilliance’s technical innovations... Seven years after its founding — and a decade into the rise of “social entrepreneurism”— D-Rev and its peers have found that the marriage of nonprofit motives to for-profit markets can be rocky.  

It was amazingly naive for D-Rev to have expected its new device to be procured by government hospitals. Even in the most ideal procurement environment, D-Rev's new device would have stood no chance of even getting to the starting line. Public procurement of all kinds requires certain universal pre-qualification requirements - experience (device has been used by a critical threshold of users for a period of time, say 2-3 years) and financial turn-over (the firm has done business beyond a critical financial threshold for a period of time). D-Rev, or for that matter any social entrepreneur promoting a new device or idea, would fail both tests. I have blogged earlier about the first mover disadvantage with public procurements here, here, and here. Furthermore, for equipments there are also technical specification requirements, which are always bench-marked based on that of the most widely available devices in the market.

As for corruption, it arguably would have played a part in the procurement, but would have been by way of preferential treatment to a particular provider among notionally pre-qualified competitors. Regarding "technical brilliance" claimed by D-Rev, where is the credible market (or other) test? It baffles me that we go around in circles with this problem. Such initiatives can succeed (ie scaled-up) only under one of the following four conditions.

1. In a tinpot country, a large donor could make a difference. If the donor finances the use of the device or process across the country at a scale reasonably large enough to credibly establish its effectiveness, then it becomes possible for an enlightened government to legitimately procure the same equipment in scale across the rest of the country.

2. The social entrepreneur could convince a few or one large private service provider (say, a large hospital group in case of medical equipments) to use their equipment and thereby establish its reliability and effectiveness. Once it becomes established that the device is cheaper and more effective than its competitors, the private market will immediately embrace it. It is then only a matter of time before public sector takes to it. In the process, the social entrepreneur would be able to acquire enough financial turnover and experience to meet public procurement requirements.

3. A "smart" alternative is to play the same rules of the game as the incumbent competitors and strike a deal with a corrupt government. If the equipment is as good as is being claimed and it gets to be used by a large enough sample of users, then it will invariably generate demand elsewhere. In addition to the reputational goodwill, like with the private market based entry, the social entrepreneur will acquire enough  financial turnover and experience to meet the financial and technical qualification norms to formally compete in public procurement.

4. An extremely enlightened official or leader, at a very high-level, could become personally convinced about the effectiveness of this device. Then they would personally assume the risk (of indictment from a future enquiry or audit holding them responsible in case the device fails) and award the contract to the social entrepreneur on a nomination basis.

I think the last two paths are not in the interests of the social entrepreneur, for a number of reasons. Both are unsustainble and it will be only a matter of time, especially when governments or officials change, before the contract starts unraveling. Disgruntled incumbent suppliers, with strong connections, too are certain to play their role in this process. The first and especially the second provide the best strategies for social entrepreneurs (and their donors) to promote the adoption of innovations. In the second strategy, it will require constant engagement with progressive private managers to get them to bite the bullet. The donors too will have to stay engaged with the process for a long-time before the idea's commercial opportunities starts to look up.  

Yes, you could turn around and argue that innovations happen through a tortuous process of discovery, where failure is the norm and successful examples are very rare. Venture capital (VC) works on that principle and has been behind much of the advances in the field of Information Technology (IT). The social entrepreneurs are merely following this trend.

But I strongly feel that this premise is misguided assessment. IT and the role of VCs is a superficially attractive but mis-leading similarity. The equipments which are being pursued by social entrepreneurs are much more complex, especially in its functional versatility. Even if the technical challenge is overcome, that of ensuring its reliability in the exceptionally demanding usage environment is very difficult.

In fact, I cannot recollect any example of a spectacularly successful low-cost device to address social problems that has emerged from such social enterprise endeavors (and whose use has been scaled up, and is not just a demonstration example to showcase before donor agencies). Where are the reliable and scaled-up low-cost incubators, sonograms, prosthetic devices, sewer cleaning machines, biometric attendance devices, water purifiers, classroom instruction tablets, healthy and environment friendly cooking stoves, solar lamps, energy efficient motors, and so on that could have been created by social entrepreneurs?

Doubtless there are isolated pockets of small-scale implementation examples in all these cases. In fact, in countries like India, every state would have atleast one example implemented in a few schools or hospitals or villages by a committed group of individuals working for a non-government organization. But scaled-up versions impersonally embraced by governments, virtually nothing! In any case, leave aside social entrepreneurs, even regular entrepreneurs face often insurmountable problems breaking open markets in developing countries.

Maybe, such innovations are more likely to emerge from established firms with deeper pockets, pursuing the same product market for a sustained period of time, rather than from inexperienced but smart, idealistic, and well-intentioned social entrepreneurs pursuing the same idea for a limited time on shoe-string budgets.  

Breaking up large corporations - Israel takes the lead

At a time when big corporations are being perceived as a threat to market stability as well as contributing to widening inequality, and there have been increasing public support for breaking them up, the Israeli Knesset has voted to do exactly that.

A popular movement against the sharp spurt in concentration of wealth, spearheaded by the newspaper Haaretz among others, has now culminated in the decision to break-up the country's massive pyramids - an interlocking ownership pattern whereby an individual or family which owns a public company controls several other companies. As the Times writes,

Public shareholders often lost out as the tycoons used them to subsidize their collection of businesses. The tycoons could put down little money but control vast swathes of the Israeli economy. These pyramids also used their size to crowd out competitors and take on excessive debt by lending among their companies. The Israeli economy was viewed by some to be uncompetitive because the concentration of businesses arguably drove up prices and decreased competition. In the small Israeli economy, the pyramids were behemoths that some termed too big to fail... In other words, with a single bill and a few big changes in its corporate law, Israel is looking to overhaul its economy and hopefully reduce income inequality.

The decision follows the recommendations of a ten member committee of government regulators, the concentration committee, which examined the adverse effects of pyramids on the economy. Apart from recommending the breakup of pyramids, the committee also advocated the prohibition of significant cross-holdings between financial and non-financial groups. This would ensure that financial institutions will not bring down entire firms when they collapse. Interestingly, the conservative government has supported the proposal. 

Football writing of the week!

From Simon Kuper in FT, high class sports journalism,

Maradona offered the spectacle of the footballer’s struggle with the inner man. Messi offers only a perfectly professional genius, as if Claude Monet had signed a contract to produce masterpieces twice a week and then actually did.

And how Rupert Murdoch and Silvio Berlusconi revolutionized football,

Before the 1990s, few matches were televised. A European fan might have seen Pelé play perhaps 10 times in his career, whether on TV or in the stadium. Then Rupert Murdoch and Silvio Berlusconi built TV channels on football. Suddenly the game had to become more entertaining. Stars were now TV content, and so they needed protection. Football’s authorities cracked down on fouls, banning the tackle from behind. Today, Lionel Messi gets a free kick almost whenever he is touched. TV made big clubs richer. A very few rich clubs came to monopolise the best players.

Thoughts on Payments and Wholesale Banks

The RBI appointed Nachiket Mor Committee has recommended interesting reforms to promote financial inclusion. As it reports, more than 90% of small business have no access to formal institutions, while over 60% of Indians have no bank accounts. Two important reforms suggested are the establishment of a Payments Bank, to serve as a small savings platform, and a Wholesale Bank, to make larger consumption and investment loans. The former will not be allowed to assume any credit risk, while the later shall accept deposits of only more than Rs 5 Cr. Here are a few observations,

1. Since the Payment Banks will have to invest their proceeds in approved SLR securities, there is the strong likelihood that they'll become captive financiers for the government. Instead of aligning incentives so as to discourage the government's capital "crowding-out" tendencies, these institutions may actually end up furthering the distorted incentives.

2. The Committee also suggests that scheduled commercial banks (SCBs) too could establish Payments Bank. There is the possibility that the SCBs could focus their financial inclusion activities to mere provision of a savings channel, thereby lowering the focus on the provision of other benefits from access to full-service institutions - loans, insurance products etc.

3. Fundamentally, if the recommendations are acted upon, it will seek to dis-aggregate the banking system - a savings bank (payment bank), a lending bank (wholesale bank), and the existing regular banks. Even if it has functional benefits, by way of furthering financial inclusion, does it raise the transaction costs?

Consider this. Today the same bank does both deposit-taking and loan-making, thereby have negligible internal intermediation costs between the two activities. According to the recommendations, one set of banks will exclusively take smaller deposits, while another will exclusively make large consumption and investment loans, thereby adding a layer of intermediation cost between the now two distinct entities. In other words, if this is true, then the benefits of dis-aggregation has to outweigh the Coasean benefits (for both the bank as well as its customers) from a full-service bank. I am not sure.

4. Finally, what about the existing institutions like the regional rural banks and grameen banks set up to further financial inclusion? The Committee appears to have fallen victim to the illusion of creating new institutions instead of getting the existing ones working. With minimal reforms, effective management, and robust oversight, these existing institutions could well serve the same purpose, and at much lower cost.

When does corporate malfeasance become a crime?

How do you characterize a debt-laden promoter who manages to get public sector banks to lend more money even as he was defaulting on his existing commitments? What if those loans were made against collateral whose valuations were allegedly manipulated and inflated? What if the promoter now tries to sell his mortgaged business assets before his unsuspecting creditors get around to seize them? What if the unscrupulous promoter then tries to surreptitiously funnel the proceeds away to an international tax haven? What if the promoter is a leading member of the country's corporate elite and a honorable political leader? 

Sub-national jurisdictions as engines of development

From a very good op-ed in NYT about how well functioning cities (in this case Lagos) could show the way for failing states,

Nigeria, of all places, may be pointing the way to a strategy by which fragile states might begin to succeed: Devolve more power to cities from their corrupt and overcentralized national governments. At least in democracies, the cities have promise because their elected politicians face pressure to deliver specific services to their constituents. In the central governments, which are more remote, there is too much power and wealth to be grabbed by dysfunctional politicians and their cronies, and too little direct accountability...

The turnaround in Lagos can be traced to 1999, when Nigeria returned to democracy and the city began holding regular elections. For the first time since independence, Lagos was able to re-elect its own leaders, or turn them out of office. And while national elections became a mud fight between elites to control the state’s enormous oil wealth, local contests forced candidates to show pragmatism and competence. Citizens in densely populated cities find it easier to organize themselves. And in an ethnically and religiously diverse metropolis like Lagos, politicians could not afford to pit ethnic and religious groups against one another, a problem that has long bedeviled Nigeria. Simple geography also helped the city administration. The powerful and wealthy classes are more likely to insist on better governance when their own neighborhoods are affected.

And unlike national politicians, local leaders know that the better they perform, the more money their city nets. The better its roads, schools and business environment, the more likely companies will pay taxes, and individuals will buy goods and services, which also contribute to the tax base. At the national level, by contrast, the great majority of the central government’s income has little to do with government’s performance, since about 75 percent of the national budget comes from the $50 billion a year that Nigeria collects in oil revenue.

Whether Lagos is a model or not, the central point about encouraging cities as the locus of development is hard to disagree. For many strife-torn African countries, where the capacity of the central government is very weak, smaller sub-national governments are far more likely to be effective. Among sub-national governments, city governments are best positioned to push the boundaries on economic growth. Therefore, devolution of power to city governments should be top of the agenda in political reforms for these countries. In large countries like India too, the major source of dynamism is already from well governed states rather than the central government.

The challenge is to get national governments to devolve power to these local governments. Multi-lateral agencies and international diplomacy should spend as much capital pushing for such reforms as they do with democratization and the like. That will be good politics as well as sound economics.

Asset markets in 2013

Barry Ritholtz draws attention to this graphic from Economist.

Both charts are good manifestations of the changed economic order. The rapid growth of last ten years has been on the back of spectacular performance by the emerging markets, which in turn drove commodity prices to record levels. 

Notice the absence of any prominent emerging market in the list of equity market toppers. However, the performance of the first four countries - Argentina, Greece, Ireland, and Pakistan - is clearly at a remove from their economic fundamentals. Further, the strong performance of many developed economy equity markets, despite their persistent economic weakness, is more a reflection of the uncertainty facing the world economy coupled with the liquidity glut than their own economic fundamentals. The second graphic shows that commodities have been the worst performing asset class, along with emerging market equities.  

Is the market-registration price wedge a good second-best policy?

It is widely believed that the difference between market value and (government notified) registration rates (basic or guidance value) in India are a major contributor to the creation of black money and its amplification. Across the country, sales transactions are generally recorded at the registration rates, which are much lower than the actual transaction rates. A lower officially recorded transaction price helps buyers and sellers minimize their outflow on stamp duty and capital gains tax.  

But on the positive side, it is also believed that the wedge works to the advantage of mortgage lenders since it leaves them with an asset whose actual valuation is much higher than its declared collateral value. Given the impressive growth of mortgage market in the country, it will be interesting to explore the contribution of the price-wedge to the development of this market. 

In line with "second-best" models approach, it would appear that the price-wedge, despite all its distortions, may have had important unintended consequences. It may have provided property lenders the additional collateral cushion required to expand their lending activity. In other words, the premium may have incentivized financiers to readily lend against properties. It may also have served as a buffer against declines in property prices, thereby acting as a form of default-risk insurance, for the entire financial system.   

The "assault on Incentives" in Delhi

I have blogged earlier (here, here, and here) that the most retrograde and debilitating policies are those that dramatically distort incentives. These "assault on incentives" are more pernicious than common manifestations of governance failures like corruption, wasteful subsidies, and poor quality service delivery.

The policies on free water, power, and so on being implemented or under consideration in Delhi are good examples of "assault on incentives". Nobody needs any reminder about the political challenge with reforming free farm power and raising electricity tariffs. Given the resonance between such policies and the entrenched culture of political populism, it was only a matter of time before such things generated a cascade of demand from elsewhere for free and lower priced utility services. See this, this, and this.

Now, I am not against providing free water. Appropriately structured free supply can be both good politics and economic efficiency enhancing, especially in systems with intermittent supply. For example, in South Africa, Durban municipality initiated a program in 1998 to provide a basic minimum water supply, amounting to 40 lpcd (litres per capita per day) for a family of five (or 6 kilolitres per month per family). This was subsequently implemented in many other municipalities across the country.

But the Delhi experiment has atleast two important differences. One, instead of an assured universal minimum free of cost, consumers who use more than the free quota of 20 kl have to pay a (higher) full price (based on an increasing block tariff pricing model) for the entire consumption. Two, whereas the South African model assures a basic minimum supply free of cost, the Delhi model assures the global standard of supply free.

The former will certainly distort incentives by making 20 kl a high-stakes target, and there encourage manipulated clustering of consumption around that target. The later ensures that the scheme will benefit the non-poor much more than the poor. In fact, even though there are benchmarks of 140-170 lpcd, the median Indian city resident can rarely access this quantity of water.

While the aggregate supply (upstream treatment) may be high, the actual supply (downstream distribution) is far less, due to atleast three factors. One, the distribution loss by way of leakages etc is atleast 30-50% of the supply in most Indian cities, including Delhi. Two, the consumption pattern is heavily skewed towards the large consumers for a variety of factors. Three, the typical slum resident, who has supply for 1-2 hours, at very low pressures (a head of 3-5 m), can collect much less than half the aggregate supply. In the circumstances, the full benefit of the 700 litres free supply accrues only to the not-so-poor.

Personnel deployment and procurement reforms

My latest Governance Agenda column on reforming transfers of officials and public procurement, the two biggest contributors to governance failures, is available here. 

Re-negotiations and the "bid premium"

Aggressive bidding by developers has been one of the features of private participation in India's infrastructure projects in recent years. All but a few of these projects end up in re-negotiations. Such re-negotiations, which post-facto accounts the unhedged risks in the original bid, invariably lead to much favorable terms for the developer, most often at the cost of the tax payer or user. Further, the inherently non-transparent manner of re-negotiations, engenders a culture of crony capitalism that favors politically connected firms and vitiates the contract environment. Most worryingly, all this generates a moral hazard that erodes the sanctity of the tender process and makes developers bid aggressively safe in the assurance that they can change the rules of the game during the re-negotiations.

So how do we curb aggressive bids? How about a "bid premium" for each bid that would normalize each bid? This "bid premium", unique for each developer, could be calculated based on the  developer's prior history of re-negotiations. The difference between the original and re-negotiated bids is a measure of the mis-pricing of risks (a sector premium) and the degree of aggression in the bid (a bid premium).

The former can be adjusted by discounting for the same difference for all the projects that have been bid out in the sector. The excess difference, that remains after subtracting the sector premium, belongs to the firm and is a measure of the firm's aggressive bidding. Each project would have a bid premium. Some weighted average of the bid premiums of all projects undertaken by the same promoter in that sector can be used to calculate his project bid premium. This bid premium can then be added to his present bid so as to discount his current bid for any aggressive practice when evaluating the bids. 

Happy New Year!