Greece graph of the day

Excellent graphic from John Cochrane's blog about the ownership of European government debt.

The graph shows that nearly four-fifths of Greek debt (estimated at 319 billion euros in end-2014) is "foreign official", or owned by other governments. This explains both the absence of market contagion (the European bourses rose on the election results were announced) and the consternation among Eurozone's core area members in the aftermath of the election victory of anti-austerity Syriza party of Alexis Tsipras.

If Tsipras stays the course with his pledge to renegotiate the terms of the country's 240 billion euros bailout package which would force losses on countries like Germany and France, a bitter game of chicken is on the cards. However the country's resolve to stay on in Eurozone and its dire need for loan payments to pay off debts and keep the country running weakens his bargaining position.

In any case, at 174% of GDP in 2014, Greece's debt-to-GDP ratio is surely unsustainable and cannot be stabilized without deep debt write-offs. Bailouts without haircuts are merely kicking can down the road. 

Why a public investments led strategy may not work?

Commentators from both the right and left have converged to the view that the Indian economy needs a large dose of public investment in infrastructure to provide the impetus to regain high economic growth rates. But there are atleast seven reasons to be sceptical of this strategy.

1. A first order reality is that neither the central nor state governments have the fiscal space to prime the pump in any significant manner. Also, unlike the developed economies, interest rates in India are not anywhere near the zero-bound to make capital expenditure borrowings a high-return strategy.

2. Public investments become effective in stimulating the economy only when they can be kick-started without delay. However, given the long time lag between identification of project and the first stone being laid, and the poor track record of in-time completion of public investments, the efficacy of public investments in providing the immediate thrust for regaining high growth rates appears questionable.

3. Even assuming a readily available shelf of "shovel-ready" projects, they can take off only when developers and banks have adequate space on their balance sheets to take on more projects. Given the debt-laden balance sheets of infrastructure firms and the high proportion of distressed assets of banks, the prospect of neither look promising.

4. If the objective is regaining the near double-digit growth rates, then public investments will not be able to achieve that without other critical enablers. Apart from the success of initiatives to improve business environment and stimulate manufacturing, the country can sustain high growth rates only if it is able to sharply increase its savings rate. Further, if the savings rate increases to the 35-40% of GDP range, then the desired level of public investments are in any case most likely to follow.

5. The argument that we only have a flow problem (high fiscal deficits) and no stock problem (lower debt-to-GDP ratio) is misleading. Our debt-to-GDP ratio has been held in the 60-65% range only by the long period of high inflation, which has helped the country inflate away its debt. If the inflation gets anchored at a lower rate, as looks likely, then the stock problem will start to assume significance.

6. The country has struggled hard to restore some macroeconomic stability by reining in revenue expenditure and tight monetary policy. A quick return to high fiscal deficits would certainly erode the hard-won and costly policy credibility. This assumes great significance in a world where massive amounts of capital slosh around and economies are deeply vulnerable to sudden-stops and flow reversals.

7. Finally, all this works on the premiss that we need to do everything possible to regain the high growth rates of the 2003-08 period and emulate China's spectacular three decade long near double-digit growth trajectory. But what if this premiss is itself questionable. Given the prevailing domestic macroeconomic and socio-economic environments and global trends, there are compelling reasons to argue that it may not be possible for India to sustain high growth rates for any long duration.

More on the oil price declines

Daniel Yergin points to two stunning factoids about the recent history of oil prices. First, about the standout winner,

By the end of 2014, oil production in the United States was 80 percent higher than it had been in 2008. The increase of 4.1 million barrels per day was greater than the output of every single OPEC country but Saudi Arabia... This revolution also turned out to be a big boost for the American economy, creating jobs, improving the country’s competitive position and drawing in over a $100 billion of new investment. Only rarely has the global oil market seen production increases on this scale this fast. The last time was in the early 1980s, when new supplies from Mexico, the North Sea and Alaska created an oil surplus that led to a price crash.

Second, the losers,

Over all, the fall in oil prices could mean a $1.5 to $2 trillion transfer from oil-exporting countries to oil-importing countries.

Just as the higher oil prices engendered a shale oil and gas boom that boosted the US economy, the declining prices threatens to damage the economy. Times reports that drilling firms are decommissioning rigs and laying off workers and companies that leased equipment have fallen behind in their payments,

Since the Permian Basin rig count peaked at around 570 last September, it has fallen below 490, and local oil executives say the count will probably go down to as low as 300 by April unless prices rebound... Unlike traditional oil wells, which cannot be turned on and off so easily, shale production can be cut back quickly, and so the field’s output should slow considerably by the end of the year.

And Jim Hamilton, the foremost authority on the economics of oil markets, had this to write about the demand-supply dynamics,

Field production increased worldwide by only 2.3 mb/d between 2005 and 2013. That compares with a predicted increase of 8.7 mb/d from extrapolating the pre-2005 trends in consumption growth for developed and emerging economies, and that’s without even taking account of the dramatic acceleration in demand from the emerging economies... According to the 2014 IMF World Economic Outlook database, world real income increased by 27.7% between 2005 and 2013. If we assume an income elasticity of 0.7, for which Csereklyei, Rubio, and Stern provide abundant empirical support, we would have expected that in the face of a stable price of oil, production should have increased by 19.4%. The actual increase in field production of crude oil was only 3.1%, consistent with a shortfall of 12 mb/d.

Apart from demand-supply dynamics, Jeffrey Frankel points to how real interest rates may be affecting real commodity prices. He identifies four channels whereby high real rates reduce the price of storable commodities - increases incentive for extraction today rather than tomorrow; lowers desire to carry inventories; encourages money to shift out of commodity contracts into treasury bills; and strengthens domestic currency, thereby reducing the price of internationally traded commodities in domestic terms.

He feels that the fourth channel has had an important role to play in the recent decline in oil prices. Since most oil contracts are dollar denominated and since the dollar has appreciated against all other currencies, it is only natural that it has weighed on the decline in dollar price of oil. The graphic below is illuminating.

US interest in "India" visualized

NYT has this superb tool that searches its archives dating from 1860s and visualizes language usage in its news coverage throughout its history. The graphic below shows the sharp increase in news articles covering India since the turn of the century, with a pronounced spike last year.

To the extent that New York Times news coverage is a reflection of US interest, the graphic points to heightened interest in India.

Talking about visualization, this article by Seth Stephens-Davidowitz on preferences about sex among males and females revealed from analyzing Google search database makes fascinating reading. 

Unintended consequences of development - bednets edition

Scholars supporting Randomized Control Trials (RCTs) have long advocated the use of bed-nets to keep out mosquitoes as a cost-effective way to fight malaria. They have invoked meta-studies on the use of bed-nets and its effectiveness in different environments to claim sufficient external validity to scale up the intervention.

In this context, the New York Times has an interesting story about the unexpected use to which anti-malaria bed-nets are being put in parts of Africa. It writes,

Nets... are widely considered a magic bullet against malaria — one of the cheapest and most effective ways to stop a disease that kills at least half a million Africans each year. But Mr. Ndefi and countless others are not using their mosquito nets as global health experts have intended. Nobody in his hut, including his seven children, sleeps under a net at night. Instead, Mr. Ndefi has taken his family’s supply of anti-malaria nets and sewn them together into a gigantic sieve that he uses to drag the bottom of the swamp ponds, sweeping up all sorts of life: baby catfish, banded tilapia, tiny mouthbrooders, orange fish eggs, water bugs and the occasional green frog... 

Across Africa, from the mud flats of Nigeria to the coral reefs off Mozambique, mosquito-net fishing is a growing problem, an unintended consequence of one of the biggest and most celebrated public health campaigns in recent years. The nets have helped save millions of lives, but scientists worry about the collateral damage: Africa’s fish. Part of the concern is the scale. Mosquito nets are now a billion-dollar industry, with hundreds of millions of insecticide-treated nets passed out in recent years, and many more on their way. They arrive by the truckload in poor, waterside communities where people have been trying to scrape by with substandard fishing gear for as long as anyone can remember. All of a sudden, there are light, soft, surprisingly strong nets — for free. Many people said it would be foolish not to use them for fishing...

The people don't use the mosquito nets for mosquitoes. They use them to fish... But the unsparing mesh, with holes smaller than mosquitoes, traps much more life than traditional fishing nets do. Scientists say that could imperil already stressed fish populations, a critical food source for millions of the world’s poorest people... Many of these insecticide-treated nets are dragged through the same lakes and rivers people drink from, raising concerns about toxins.

None of this is to down-play the undoubted utility of bed-nets in combating malaria. In fact, this was well-known to health experts for long and did not need to be established by spending millions of dollars on expensive and time-consuming field experiments. The more substantive benefit of RCTs and related research on bed-nets (and others like de-worming) may have been not so much on establishing its benefits but in drawing billions of dollars from philanthropic foundations and non-profits into financing bed-net campaigns. The RCTs have provided the objective basis for donors searching for cheap and high-impact development interventions, of which there are very few, to funnel their resources.

But the example from Africa illustrates the complex challenges associated with all such interventions. The unintended consequences of development interventions, and there are always some with any intervention, are revealed only when it is scaled up and over time. No amount of field studies, regression controls, and validation can help us prepare for such "unknown unknowns" of development. So before we advocate the use of bednets or deworming or toilets or multi-grade teaching to the level or safe water storage or mobile phone-based reminders or something else as superior to their competing alternatives, we would be well-advised to pause and be cautioned about its unintended consequences. 

Airline industry fact of the day

From the Times,

The total backlog of unfilled orders for Boeing and Airbus stands at more than 12,000 aircraft, valued at close to $2 trillion and enough to keep their assembly lines humming for more than eight years.

But Boeing and Airbus, which each control nearly half the market for planes with more than 100 seats, are struggling to keep their order pipelines flowing as falling oil prices makes it increasingly profitable for airlines to continue with their fuel-guzzling older planes and defer replacements. 

Finance Commission and optimal currency areas

The Thirteenth Finance Commission's recommendations may have set the cat amongst the pigeons by sharply hiking the states share of the central taxes by ten percentage points from 32% to 42%. Coming on the back of the scrapping of the Planning Commission, this effectively means the end of many centrally sponsored schemes (CSS).

This is an undoubtedly welcome move in so far as it paves the way for more effective utilization of development spending. The increased transfers and cut backs in CSS will endow states with the resources and flexibility to design and implement state-specific sectoral programs. However, while the curtailment of the one-size-fits-all CSS programs is to be welcomed, a sharp and substantial erosion of the central government's fiscal space may be a matter of concern. In particular, the extent to which it will limit the central government's fiscal space for macroeconomic stabilization.

Consider the impact of the global financial crisis and the resultant recession. In the 2008-10 period, the central government indulged in additional fiscal spending, which helped mitigate the adverse effects of the global economic weakness and stabilize the Indian economy. This allowed state governments to tide over the crisis with their balance sheets in tact. In fact, even as the central government today faces a 4.1% fiscal deficit, the state governments have a consolidated fiscal surplus, and just three face deficits. It is a different matter that the resources could have been better spent on productive infrastructure creation than on populist subsidies.

Given that many Indian states are atleast as large as Eurozone countries, the responses of the respective governments to the great recession are instructive. In contrast to the central government in India, the European Commission has advocated sharp spending cuts and refrained from additional fiscal transfers to the worst affected peripheral economies. As the credit markets froze, peripheral economies struggled to raise resources, some even lost market access, and the human and economic costs of the absence of fiscal transfers has been substantial.

This is in keeping with the literature on Optimal Currency Areas (OCAs). A strong fiscal authority is an important ingredient in the success of any OCA. Apart from its role in macroeconomic stabilization when members (states in India or countries in Eurozone) have varying business cycles,   such fiscal transfers help stabilize the economy in times of more uniform economic weakness when members may lose market access or may struggle to raise resources for demand management policies. In fact, the availability of this fiscal cushion is critical to effective fiscal federalism. 

Make for India Vs Make in India

The debate triggered by the remarks of the Governor of Reserve Bank of India, Raghuram Rajan, on the central government's high-profile "Make in India" campaign missed an important insight about the strategy that should be adopted to encourage manufacturing. The Governor had cautioned about excessive focus of the campaign on both manufacturing and external markets and suggested "Make for India". So, how are 'Make in India' and 'Make for India' different?

Both are anchored around the East Asian manufacturing-led rapid economic growth strategy. The success of the East Asian model depended on both domestic and external demand. Proactive government policies encouraged manufacturers who produced export quality goods for both domestic consumption and exports. In all these cases, the domestic demand was supported by a wide enough consumer base for good quality products and the domestic market in turn provided the platform for manufacturers to develop and refine those products to world-class standards.

In contrast, manufacturers in India may struggle with domestic demand. The headline numbers that proclaim large declines in those living 'below the poverty line' (BPL) does not mean that the new entrants into the 'above the poverty line' (APL) are ready for middle-class consumption. In fact, as a MGI report from last year shows, atleast 56% of the country's population do not have the resources for their basic needs. Further, nearly 95% of the households make less than Rs 1.5 lakh a year.

It is fair to argue that these consumers are likely to be deeply price sensitive and less concerned about quality beyond some basic considerations and durability. Only a tiny sliver of the market is likely to be demanding on quality. A manufacturer making automobiles, clothing, or consumer durables is therefore encouraged to keep costs down, thereby discounting for quality. Margins are also minimal in this side of the market, thereby limiting their ability to expand or move up the quality escalator. Needless to say, none of these products can be exported. Export quality manufacturers are constrained by the limited domestic market base to refine their products through a "learning by doing" approach.

In the circumstances, India's manufacturers have two choices - 'Make for India' or 'Make in India' for export markets. As illustrated, they are qualitatively different choices. The former leaves them entrapped in a low-level equilibrium, exit from which is very difficult. Its market dynamics makes it difficult for these manufacturers to re-orient their production to also meet export markets. Further, manufacturers in this end of the market face stiff competition from cheap imports from competitors in China and elsewhere who have moved up the quality chain and can therefore produce the same quality at far competitive prices. Therefore any campaign to 'make in India' by 'making for India' is unlikely to achieve intended results, atleast in the medium-run.

The latter choice - 'make in India' for external markets - requires technological and professional expertise, which only a handful possess, and an enabling infrastructure and policy environment, which is sorely deficient. Here, India has sought to emulate the latest entrants into the "flying geese" model like China and Vietnam where public policy encouraged greater external-market focus through the establishment of export-only Special Economic Zones. But in order to make an impact, this strategy requires massive investments on infrastructure in these zones and its surrounding areas as well as equipping public systems there with much greater state capability. Further, it also assumes the presence of a receptive external market. The reliability of these assumptions are, at best, questionable. 

Interest rate cuts and lazy banking

The RBI's surprise 25 basis points repo rate cut early this week has been greeted with widespread enthusiasm by India's corporates. With banks expected to lower the rates in response to the central bank's rate cuts, the  belief is that this marks the start of an easy credit cycle. I am not sure whether the rate cuts would readily translate into lower cost of capital for borrowers in the short-term, for atleast two reasons.

1. The more substantial economy-wide impact of the rate cut will be felt when the overwhelming majority of corporate borrowers, the small and medium enterprises, have access to cheaper credit. This is unlikely to happen anytime soon given the circumstances. Hobbled by distressed assets and declining capital adequacy ratios, banks are likely to be averse to assuming riskier loans, leave aside providing them at cheaper rates.

2. There is a strong likelihood that the banks may find the rate cuts as an opportunity to atleast partially ease the burdens from their distressed balance sheets. The temptation to only marginally lower lending rates while proportionately lowering deposit rates would be high given the proclivity for lazy banking among the country's banks. A recent Business Standard article gave an indication of the dominance of risk-free margin (spread between 10 year G-secs and deposit rate) on the banking sector's pre-tax profits.

Update 1 (16/03/2015)

Despite two rate cuts by the RBI, none of the major banks have lowered lending rates, preferring to use it to shore up their distressed balance sheets. 

The challenge with transactional reforms

In about a month, the government in Delhi would be presenting its first full budget. In the seven months, it has had some notable achievements. It has restored macro-economic stability through fiscal prudence - decontrolled diesel price, limited LPG subsidy through introduction of cash transfer, and restrained the increase in Minimum Support Price (MSP) - and by allowing the central bank to pursue an inflation targeting monetary policy. Favorable external factors have doubtless helped.

It has also initiated reforms aimed at improving the ease of doing business, including amendments to the Land Acquisition Act and liberalization of labor markets. It has also accelerated long-delayed reforms like harmonization of indirect taxes and liberalized foreign equity participation in many sectors - insurance, defence, and railways. Encouraging has been its intent on collaborating with state governments and reforming governance standards in public sector banks.

But the expected rapid return to high-growth rates has not materialized. As the economy shows little signs of regaining the momentum of 2003-08, the government's exuberant supporters appear to be losing patience and no day passes without pressure mounting on the government to do more. So what is missing?

Commentators point to the vaguely phrased "second-generation reforms" as the solution. Whatever its constituents, these reforms are unlikely to be big-bang and generate immediate results. Two reasons stand out. One, by nature, most of them are diffuse, incremental, and long-drawn. Two, most of them have to be implemented by state governments.

The first generation of reforms were about changes like elimination of licensing and easing of entry barriers, opening markets and lowering tariffs, and repealing restrictive and distortionary regulations. For most part, these reforms involved one-off regulatory decisions, whose effects were immediately felt. Such reforms were, unsurprisingly, the low-hanging fruits that yielded immediate results. For lack of a better word, let us describe them as decisional reforms. In fact, many of the reforms implemented by this government are, in some sense, the remainders from the first phase of reforms.

In contrast, the second generation of reforms are less about one-off decisions and more about transactional improvements. Consider getting an electricity connection or procuring a property. The former requires the applicant to apply; an estimate to be made; payment to be remitted; tenders called, work contracted, and work executed; and supply to be connected. The latter needs inquiring with multiple agencies to verify the reliability of land title and encumbrances, getting the property registered and mutated, and obtaining land-conversion certificate (if agriculture land). The human interfaces and legacy problems in these transactions cannot be avoided by computerization or automation, or even standardization. Much the same could be said about improving school education, delivering universal health care, and reducing skills-deficit among workforce.

All of them require transactional interventions, often recurring, whose effectiveness is intimately dependent on the quality of human interface. The systemic legacy problems - poor state of records, woefully inadequate infrastructure, untrained and over-burdened personnel etc - are profound and not easily addressed. They are not amenable to one-off decisions and require continuous engagement between the applicants and public systems. It is here that the much-debated state capability problems surface. Even with state-of-art governance frameworks and incentive compatible policies, you still need public officials to transact and translate them into actual outcomes.

Whatever the hype surrounding these reforms, those expecting immediate and big-bang results are likely to remain disappointed. Unfortunately, by raising the expectations through high-profile slogans and media campaigns, the government may be limiting the political space available for it to pursue these reforms. 

India's corporate weakness graph of the day

The weaknesses in corporate balance sheets is one of the three headwinds the Indian economy has to navigate in its quest for higher growth rates.

A reflection of this weakness comes from the graphic (from a very interesting article on India's banking sector by Harsh Vardhan) below highlighting the deteriorating ratings profile of bond issuances from 2009 to 2013. 

The three ratings agencies account for 95% of all bond issuance and the shift towards riskier issuance is evident. 

India's new paradigm in financing infrastructure and attracting investments

India's Twelfth Five Year Plan estimates a trillion dollars investments in infrastructure. But a trifecta of problems threaten to pour cold water on these ambitions.

One, governments, both at the center and in states, are fiscally strapped and are likely to remain so even after recovery takes firm hold. Two, debt-laden infrastructure firms, especially in power and transport, have little or no space within their balance sheets to take on newer projects. In any case, despite all the hype around PPPs, many of these projects are hugely risky and are not amenable to such financing. Third, banks, especially the public sector ones who make up nearly 80% of the lending, are struggling with double-digit impaired assets and are touching their sectoral exposure limits. Even with the most aggressive reforms, the situation is unlikely to change in the foreseeable future. 

Faced with this perfect storm, governments appear to believe that the way out is by collaborating with foreign governments. More specifically, in partnerships with East Asian governments, whose large investible foreign exchange reserves are currently invested in low-yielding US Treasury bonds. In the face of global economic weakness and ultra-low interest rates in developed economies, these countries have limited investment options. In their search for yield, the sovereign wealth funds and external lending agencies of countries like China, Japan, and Singapore have been scouting higher-return long-term investment opportunities across the world. The size of India's economy and its relative strength makes the country an attractive investment destination. 

Realizing this, a few state governments and the central government have been aggressively wooing these governments. The successful summit meetings of the Indian Prime Minister with counterparts from Japan and China have provided a fillip to these explorations. Investments in infrastructure and manufacturing, both public and private, are being pursued on the back of bilateral agreements between governments. Such investments come essentially in two forms - long tenor concessional loans to finance infrastructure projects and financing of large industrial parks through joint ventures between public and private entities of the two countries. 

An MoU between the governments of India and Japan commits Japanese capital to the development of a 1500 km dedicated freight corridor between Delhi and Mumbai. Similar partnerships are being explored with Japan to finance a 534 km high-speed rail link between Ahmedabad and Mumbai at a cost of Rs 54000 Cr and with China for a 1700 km Chennai-Delhi link that would cut travel time from 28 hours to just six. MoUs have also been signed with the Chinese government to dovetail funding from China Development Bank for two large industrial Special Economic Zones (SEZs) in Maharashtra and Gujarat. The Indian and US Governments have signed an MoU to develop three smart cities at Ajmer, Allahabad, and Visakhapatnam. The government of Andhra Pradesh have signed an MoU with the Singapore government to develop the nucleus of the recently formed state's new capital city near Vijayawada. Similar MoU is being planned with Japanese government to develop the Vizag Chennai industrial corridor and facilitate Japanese companies to invest there.  

Such government-to-government partnerships have the potential to herald a new paradigm in attracting investments. However, they come with several cautions. 

1. Whatever the spin given, such investments in infrastructure are essentially public borrowings to be repaid over a long duration by government entities at different levels. Therefore, given the limited fiscal space, we need to be cautious not only about the scale of debts assumed but also about its public utility. In particular, instead of frittering away scarce money on grandiose aspirational projects with disproportionately low socio-economic utility, we need to channel it to financing projects which carry the greatest bang for the buck. This assumes greater significance since the counterpart governments are more likely to be interested in precisely such grandiose projects - like high-speed rail or metros - which offer the potential of highly attractive returns for their contractor and supplier firms. 

2. Another concern arises from the procurement conditions attached with such lending and investments. For example, lenders invariably insist that the contract be awarded to and procurements made from their firms. This raises concerns about whether public resources are being spent in the most cost-effective manner and on the most efficient technologies and appropriate systems. Even with the potential for joint ventures, Indian firms are likely to lose out to the larger and better endowed counterparts from these countries. Further, as experience of similar partnerships for real-estate based developments between state governments like Andhra Pradesh and Kerala with Middle Eastern governments have shown, the potential for cronyism and corruption are never far away.   

3. The Chinese, in particular, see development of SEZs in partnership with Indian agencies - MIDC in Maharashtra and DMIC in Gujarat - as excellent platforms for facilitating Chinese companies to invest in India without the general hassles associated with investing in the country. It could help orderly flow of production factors from China to India and an enabling regulatory framework that are required to support such investments. 

But given that Chinese imports are already out-competing Indian manufacturing, once these units become operational, the additional incentives that come with SEZs are unlikely to go down well with Indian manufacturers. In any case, there are enough doubts about the wisdom of encouraging manufacturing growth through the SEZ route. 

4. There are also concerns about the dynamics associated with Chinese investments which are certain to generate controversies and disputes. Howard French has written about the controversies surrounding Chinese investments in Africa on the displacement of local labor by Chinese migrants, racially clouded interactions with locals, and crowding out of local entrepreneurs and businesses. The visa problems faced by Chinese boiler-turbine-generator makers for Indian power plants and spying charges against Chinese telecoms equipment makers are cases in point.   

5. Finally, there are all the other risks and limitations associated with such capital inflows. Since these loans are foreign currency denominated and unhedged and the investments generate rupee cash flow, they leave the Indian government counter-parties exposed to foreign exchange risks. There is also a limit to such investments - a handful of iconic infrastructure projects and SEZs that are likely to materialize through this route can at best scratch the surface of requirements.