The QE distortion fact of the day

Ewen Cameron Watt of BlackRock summarizes the demand-supply gap created by the scarcity of safe assets caused by quantitative easing (QE). On supply, he estimates,

The G4 supply of “safe assets”, net of debt repurchases, should total negative $300bn this year, we estimate, compared with an annual run rate of $3.5tn before the financial crisis. The result? Abnormally low yields and highly correlated price changes in bond markets, both up and down... 

On demand, his estimates are,

price-insensitive buyers (Life-insurers and foreign exchange reserve funds) have some $40tn of assets under management. Even with a decline in foreign exchange reserves this year, the first in the past 20 years, they require an additional $3.5tn more each year to reinvest the proceeds of their maturing bonds, we estimate. And this is just to stand still!... (pension funds, endowments, and banks increasing 'safe' capital) manages some $20tn of assets... Our best guess for this group’s minimal reinvestment needs is $500bn a year. Together these two groups have reinvestment needs of $4tn of high-quality liquid assets a year. Supply, however, is estimated by us at just $700bn this year. This includes an estimated $1tn of new investment grade corporate bonds and a negative $300bn from governments. This creates a shortage of high-quality, liquid assets of $3.3tn. How is this need supplied?

And about the road ahead, he writes,

Assume the Federal Reserve and Bank of England stop reinvesting the proceeds of maturing issues while the European Central Bank and Bank of Japan press on with QE. The shortage shrinks to roughly $1.7tn, we estimate. It is not until 2017 that equilibrium begins to return. This ends at best in a bigger dose of indigestion than seen recently. At worst, an uptick in the supply of high-quality liquid assets or change in rates expectation sets in motion a vicious circle of selling.

Update 1 (07.06.2015)

Avinash Persaud points to the irony that while the GFC was caused by risky assets, the next one may be caused by a bubble in safe assets. He writes,

Determined to prevent a repetition of the crisis, regulators are forcing the holders of $100tn worth of assets the world over to buy debt from the most creditworthy issuers: companies and sovereigns with pristine credit histories, which comfortably generate enough cash to cover their obligations. After so many banks were sucked down by doubtful debt lurking deep within their portfolios, the impulse to usher them on to firm ground is easy to understand. But corralling a huge amount of capital into a narrow band of the market drives prices to perilous highs. Even if these assets were safe to start with, the enforced concentration is enough to make them risky.

These assets have become so over-valued that their only likely trajectory is downwards, inflicting massive losses all round.

Update 2 (07.06.2015)

Nouriel Roubini points to market illiquidity despite the liquidity flood of QE. He identifies four reasons - illiquidity induced by HFTs who dominate the trades and whose trading periods are concentrated; fixed-income assets are traded over the counter; fixed-income assets are mostly held in open ended funds, where exit is easy, and the combined effect of illiquidity and easy exit can cause sharp price drops; banks role as market makers in fixed income markets is being reduced due to greater regulatory standards like higher capital charges.

Update 3 (13.06.2015)
The FT has two graphics that capture the problem. The first shows the sharp rise in German Bund yields.

The second shows the decline in US Treasuries once QE started.

The holdings of corporate bonds with more than one year maturity held by US primary dealer banks has dropped dramatically from $235 bn in October 2007 to $38 bn in end-April 2015. 

As banks have been vacating the space, asset managers have started to take an increasing share of the market making activity in bond markets (under-writing government securities auctions and buying securities on behalf of clients). The mutual fund bond holdings of the ten biggest asset managers in fixed income group rose from $921 bn on 31.01.2008 to $1.98 trillion on 31.01.2015.

A cautionary note on India's metro rail ambitions

The Government of India have declared support for metro-rail in cities with population greater than 2 million, to be constructed as joint-venture between central and state governments. Accordingly, metro-projects are on the anvil in many cities. In recent months, the government has also been courting Chinese and Japanese investments in metro and high-speed rail networks. 

Metro-rail, elevated or under-ground, is the most expensive mass transit mode. They impose massive upfront expenditures and consequent debt-financing burden, as well as high operating costs. It is therefore vital that the sustainability of each project is rigorously examined before its sanction. A failure to do so would leave local and state governments saddled with white elephants bleeding massive operating subsidies. It will also crowd-out resources from smaller transportation projects that deliver greater bang for the buck. A few considerations are therefore in order.

For a start, we need to eschew the notion of metro projects as an aspirational symbol. Our cities need good urban transit systems, not necessarily good metros. Based on traffic and distances, urban transit modes span a wide spectrum from regular bus services to bus rapid transit, and light rail to metro rail. Each city should identify the appropriate mass transit mode based on its demographics, economic activities, commute patterns, land-use density, and metropolitan configuration.

Second, evidence from across the world, developed and developing, shows that metro-rail projects, even the most efficient and with adequate traffic, are heavily subsidized. Not only do they consume massive public grants for construction, generally raised through taxes or government grants, but also their operation and maintenance (O&M) require large subsidies. In fact, the ticket collection receipts as a percentage of O&M costs, or fare-box recovery ratio, is generally much less than half the operating expenses. Even the highly acclaimed Hong Kong metro received just 28% of its income from fare-box receipts in the 2001-05 period.

Third, apart from demographic considerations, metro rail systems generally need a peak traffic of atleast 40000 passengers per direction per hour (phpdt) to make any commercial sense. Just a handful of our cities would meet this requirement, even two decades from now.

In countries like India, with fiscally strapped state and local governments and a very tariff sensitive demand-side, the risks associated with operating and maintaining good quality metro systems are considerable. State governments will find it difficult to subsidize metro rail systems for too long. Given the difficult political economy surrounding tariff increases, large volumes are the only insurance to atleast slightly mitigate commercial risks.

This assumes even greater significance since global and Indian experience show that reliable estimation of traffic is a problem with transport projects. This is no less true of our metro projects. In the anxiety to push through projects, governments and promoters make optimistic traffic forecasts – high economic growth rates, planned toll increases, unrealistic diverted traffic from other modes, and large induced traffic. Further, when the economy is on the upswing and financing is readily available, the disciplining forces of credit markets take a back seat. Post-mortems of such projects from across the world, done during their inevitable renegotiations, invariably reveal considerable optimism and froth in traffic and revenue assumptions.

Once traffic volumes fall short, governments are forced to subsidize and operators skimp on maintenance. The latter will pose considerable quality deterioration and safety risks, thereby engendering a downward spiral of lower demand, larger O&M deficits, and even more skimping. Furthermore, as these trends play out, the physical infrastructure of elevated metros, already a blight on urban form, will fall into disuse, dragging down property values in the neighborhood. It could be a very short distance from urban regeneration to urban degeneration. 

Fourth, there is more to metro railway systems than mere mobility improvements. The most successful examples of metros are those which have used it as an instrument to guide urban growth by integrating mobility with land-use. Those cities have used metros to promote transit-oriented development (TOD) by encouraging high-density mixed-use developments surrounding metro stations. They have employed proactive planning in the form of higher floor space index (FSI) in the vicinity of stations to concentrate growth.

Such policies have helped cities like Copenhagen, Stockholm, and Singapore effectively manage the spill-over growth from the main city radially outwards in a planned manner. Instead of one massive urban sprawl, these metropolitan areas are characterized by a central core connected to smaller population centers interspersed with rigidly enforced green belts.  Copenhagen has used the metro to develop a “finger plan” of radial growth of master-planned smaller towns. Singapore’s “Constellation Plan” involved the planned development of eight master-planned towns in the form of a “string of pearls” around the main city. 

Unfortunately all our metros, including Delhi, have overlooked this objective. The new metro-rail projects for Mumbai, Hyderabad, and Bangalore present a rare opportunity to recover lost ground and profoundly shape the city’s growth trajectory through a TOD plan.

Policies like higher FSI and mixed-use zoning around metro stations promote density and transit use. These policies, when supported with investments to improve infrastructure carrying capacity, will encourage consolidation of land and vertical redevelopment. Affordable housing mandates, with more zoning relaxations and transfer of development rights, should be incorporated into these redevelopments. Another requirement for TOD is for the metro corridors to emerge from the metropolitan development plan and the strict enforcement of the region’s master plan. Since all such policies take time to yield results and require painstaking co-ordination among multiple agencies, they are rarely pursued with intent.

Finally, the burden of financing such projects can be cushioned by capturing a share of the increase in property prices generated by the metro through policies like betterment fees, tax increments, and registration cess. Innovative use of zoning regulations – land use conversions and height relaxations – can also be used to capture a share of the increase in property value due to the new infrastructure.

Metro rail projects that incorporate all these considerations, instead of being mere construction projects, can be powerful catalysts for urban transformation and smart growth.

Update 1 (09.08.2015)

This Business Standard article examines the DMRC balance sheet and shows why metro rails are commercially unviable. It has this graphic about the projects currently on in India

China, US, and India - household savings fact of the day

MR points to the difference between the composition of household savings between China and US,

Roughly 50% of Chinese savings – amounting to as much as half of GDP – lie in real estate alone, with 20% in deposits, 11% in stocks, and 12% in bonds. To compare, in the United States, real estate, insurance, and pensions each account for about 20% of total savings, with 7.4% in deposits, 21% in stocks, and 33% in bonds.

If the Chinese savings pattern is skewed and inefficient, see the graphic below on India, where land and gold locks up 71% of the savings. This is most likely an under-estimate given the fact that a significant share of this is unreported or 'black'.

This has engendered a liquid savings deficit in India which has the potential to undermine economic growth. 

The infrastructure financing problem

Where does infrastructure financing money come from? I blogged earlier about how, contrary to conventional wisdom, the overwhelmingly dominant share of infrastructure financing comes from bank loans and the bonds have a marginal role.

But for China, syndicated loans form the lion's share of infrastructure financing. The total annual infrastructure bonds raised have been around $10-12 bn for all emerging markets excluding China.

And about infrastructure debt funds, the amounts raised globally are minuscule compared to the requirement. Just $4.7 bn was raised in  2011, the highest ever raised globally in a year by infrastructure debt funds.

Infrastructure equity funds, which leverage capital from pension funds, while larger, too form a small share of the total infrastructure financing and are concentrated in developed markets, especially the US and Europe. Globally, they formed just above $36 bn in 2013.

Furthermore, structured equity or debt financing - infrastructure equity fund, infrastructure debt funds, or bonds - is rarer still in the construction phase, where bank loans are the most risk-appropriate form of financing. So as India explores various infrastructure financing alternatives, it would do well to keep in mind the reality that bank loans would necessarily have to form the lion's share of infrastructure financing. Alternative sources like structured debt and equity can only contribute marginally. This again underscores the importance of restoring bank balance sheets and their recapitalization.

In any case, whether financed through loans or structured capital, rigorous project preparatory work is critical to the success of any long-term project. These projects will be able to attract private investments only if adequate preparatory work is done and rigorous enough feasibility and commercial viability studies and detailed project reports are available. Its preparation generally takes at the least 18-24 months. It may therefore be appropriate if, atleast to the extent of flagship infrastructure projects, a shelf of works are identified and their due-diligence and documentation initiated immediately, through public finance, and kept investment-ready.

Update 1 (31.05.2015)

The sample of the latest Preqin report is here and it contains this graphic which points to the rising share of infrastructure assets in the portfolios of investors. In 2014, institutional investors had just 4.3% of their assets invested in infrastructure assets, against their target of 5.7%. The report states that 67% of the investors surveyed had plans to increase their infrastructure allocations.

As the FT reports, even a one percentage point increase of allocation can be dramatic. Pension funds, insurers and other big pools of long-term investors seeking investments in assets other than cash, stock, and bonds have $65 trillion in assets. Even a four percentage points allocation is several times the current investments. In fact, of the $296 bn worth unlisted infrastructure assets under management by June 2014, over $100 bn are yet to be committed funds, of which $13 bn is earmarked for Asian markets.

There is a long-term dynamic driving this movement towards long-term infrastructure assets. Stagnant low yields in standard asset classes have forced asset managers to lower their target returns, making infrastructure assets extremely attractive. 

Chequebook justice in US financial markets

Early this week Citicorp, JP Morgan Chase, Barclays, and RBS pleaded guilty to conspiring to manipulated the benchmark price of US dollars and euros exchanged in the forex sport market and agreed to pay fines of more than $2.5 billion. Separately, UBS pleaded guilty of manipulating the LIBOR and other benchmark interest rates and agreed to pay $203 million criminal penalty. This would be the first time that the bank holding companies, and not their subsidiaries or business units, themselves have pleaded guilty.

They used electronic chat room and coded language to manipulate price information, and colluded to manage liquidity (by withholding bids or offers) in these markets at certain critical times so as influence prices. The US Department of Justice Attorney General said,

Today’s historic resolutions are the latest in our ongoing efforts to investigate and prosecute financial crimes, and they serve as a stark reminder that this Department of Justice intends to vigorously prosecute all those who tilt the economic system in their favor; who subvert our marketplaces; and who enrich themselves at the expense of American consumers. The penalty these banks will now pay is fitting considering the long-running and egregious nature of their anti-competitive conduct.  It is commensurate with the pervasive harm done.  And it should deter competitors in the future from chasing profits without regard to fairness, to the law, or to the public welfare... The five parent-level guilty pleas that the department is announcing today communicate loud and clear that we will hold financial institutions accountable for criminal misconduct

Really! All the five firms colluded to manipulate information that affects large financial contracts thereby boosting their profits at the expense of their clients. And instead of being charged with criminal liability and those responsible convicted and sentenced to imprisonment, they are allowed to get away with a small (relative to the size of these banks and their earnings over a long period from such manipulation) penalty.

The Times has described such plea bargaining as "prosecutorial indulgence" and had this to say about the action taken so far on all banks on investigations of forex market rigging,

In all, the banks will pay fines totaling about $9 billion, assessed by the Justice Department as well as state, federal, and foreign regulators. That seems like a sweet deal for a scam that lasted for atleast five years, from the end of 2007 to thee beginning of 2013, during which the banks' revenues from foreign exchange was some $85 bn. 

For a long-time prosecutors have let off financial institutions with deferred prosecution agreements (DPA) or non-prosecution agreements (NPA) which suspends criminal charges in exchange for fines and other concessions. Though in all such cases, it would be axiomatic that some employees be charged, only in a third of such cases were any employees charged and always they were lower-level staff.

Plea bargains, while supposed to come with revocation of certain privileges by the SEC as well as further investigations to fix employee level criminal charges, have increasingly become indistinguishable from DPA or NPA. In this case too, the plea bargains came only after the SEC agreed that there would be no restrictions on their business practices and market activities. Employee level investigations are unlikely to be followed up vigorously by prosecutors. Minus the shame and the small change, it would be business as usual.

This also explains the conundrum about how in the investigations in the aftermath of the financial crisis on interest-rate rigging, ratings manipulation, money laundering, securities fraud, dubious business practices, and excessive speculation, no major banker has yet gone to jail. It clearly appears that they have become "too big to jail".

Update 1 (03.06.2015)

Zero Hedge has a long list of manipulations and rigging penalties paid by JP Morgan in settlements with regulators across the world.

Credit cards and cognitive biases

This is a summary of a series of links from two articles on how credit cards exploit our cognitive biases to make us spend more than what we otherwise would have. First, the Atlantic has a nice article,

Consumers fancy themselves immune to this financial anesthesia. But study after study has documented credit cards’ ability to get people to spend more than they otherwise would, even when cash, credit, and debit were randomly assigned to experimental subjects: Credit cards make people more likely to forget how much they spent on something. They make frugal people spend recklessly. They make people willing to spend a lot more on one-off purchases. And large credit limits promote the illusion that daily purchases are inconsequential. 

A Times article last year on the same topic had this to say,

One of the most well-known studies, published in 2001 and titled “Always Leave Home Without It,” showed that in certain contexts, people were willing to pay up to twice as much for the same item when paying with a credit card instead of cash. This is known as the “credit card premium.” A study in 2008, titled “Monopoly Money,” featured a gift card denominated in dollars. Even though the gift card lost value instantly when people used it, people were still more likely to spend freely with it than they did with cash. And a 2011 study showed that people considering using credit cards tended to focus more heavily on product features when shopping, while cash buyers paid closer attention to costs.

As the credit card markets deepen in emerging economies, these findings should serve as an important note of caution for governments. The standard response involving financial literacy and regulatory interventions are unlikely to make a dent to the problem. A more effective strategy would be through nudges which counteract these cognitive biases. 

Broken windows theory and public policy

From Vera T Velde, a fascinating list of experimental findings that validate the 'broken windows' hypothesis - some evidence of law/norm violation will encourage people to break others. For example,

Bikes are parked in a row next to a fence with a conspicuous "no graffiti" sign, and flyers are attached to each bicycle such that they must be removed to use the bike. If no graffiti is on the fence, 33% of subjects will litter their flyers. If graffiti is on the fence, 69% will. This was so surprising that a news station paid the researchers to replicate the study while they watched from rented rooms looking down on the area. The finding replicated very closely, and now the Netherlands requires immediate removal of graffiti. 

This reinforces the importance of choice architecture - framing of the environment in which human beings engage or transact - in designing public policies that can induce behavioural change. For example, consider the case of littering and cleanliness. Since the best choice architecture of keeping the place clean is tautological, a next best alternative is to keep exceptionally clean certain important locations within each city or neighborhood - say, the public transit station, park, an important pedestrian shopping area etc - and then use them to as cognitive reminders. This coupled with aggressive awareness campaigns can be a powerful strategy in the more effective implementation of campaigns like the Clean India program.

The shifting Chinese foreign investments strategy

Much of the "Chinese investments" in Latin America and Africa have come as infrastructure (mostly transportation) project lending secured against long-term commodity supply contracts. Finalized during the long-period of commodities super-cycle, these projects were considered mutually beneficial contracts for both sides. Now that commodity prices have been falling, there is growing concern in China, best exemplified by the case of Venezuela where China has lend more than $50 bn against oil supply contracts, about the returns from these investments. 

As FT reports, it has prompted a re-assessment of this strategy,   

International rail contracts are a political priority for Beijing, which sees exports as a solution to China’s burdensome overcapacity in steel, rail, construction and engineering services as the economy slows. Chinese-built rail projects have been proposed for Thailand, Indonesia and central Asia. A rail programme fits Beijing’s preference for government-to-government infrastructure deals that can be allocated to state-owned companies, which remain wary of complex Latin American tax and labour laws. China engineered a merger in its two state-owned rail companies late last year to prevent them from undercutting each other in international tenders.

In simple terms, through government-to-government contracting, the Chinese engineering firms will build massive rail projects quickly using Chinese money (and also, mostly Chinese workers) borrowed by the host government. For the host country, it is a form of 'plug-and-play' infrastructure investment, having to merely show the site (and make repayments, of course), and have the project delivered in quick time, a contrast to the long-delayed and poor quality infrastructure projects that have been commonplace in the country's history. For China, if the previous strategy was about accessing secure supplies of raw materials to feed the insatiable appetite of its economy, the current one is to clean up the dregs of this orgy make up for fast declining domestic demand. It is about finding an outlet for the massive excess capacity that has been built up in steel, cement, and capital equipment (BTG, renewable generation equipment, high speed rail, etc). 

When countries court foreign investment, they primarily look for foreign businesses to come and establish manufacturing facilities, transfer technology, introduce best practices, create jobs, and bring in foreign equity capital. Does Chinese investment qualify as foreign investment on any of these parameters?  Not if the Chinese have their way.

But there is an undeniable opportunity for other countries if they can leverage the Chinese compulsions to their benefit. One way would be to facilitate the process of making it easier for Chinese firms to compete for domestic construction contracts. Given that the larger Chinese construction firms are world-class in their speed and quality of execution and does it cheaper than anyone else, its benefits are immense. Another option would be to let the Chinese over-capacity subsidize your economy, by importing cheap steel and equipments. But this would run afoul of local producers. The third option of Chinese lending to domestic corporates, which may be the least preferred, may also be the most forthcoming.

In any case, the host governments would have to drive a hard bargain to make such investment partnerships mutually beneficial. Else, the Chinese would leave you with plenty of trophy projects of limited utility, large debts, and bruised local industry.

Weekend Visualizations

1. From Zero Hedge, only 22 countries have escaped British invasion.

2. Times has this graphic which captures the massive decline in heart disease related death rate.

3. FT has this snapshot of iPhone's component eco-system.

4. And finally, the rapidly rising share of exports in Chinese steel production. Does this portend similar trends in other sectors - cement, solar panels, BTG equipment, railway carriages etc - with attendant effect on global prices.

5. City Lab points to a fantastic transit visualization tool, TRAVIC, which maps transportation flows data from 249 cities across the world. The one below is Manhattan, New York.

6. Times has this interactive graphic on executive compensation in the US. The average executive compensation at the top 200 US firms topped $22.6 million in 2014, the highest ever.

Update 1 (31.05.2015)

1. This interactive feature helps you compare your assessment of how family income affects children's college chances with the actual data. This helps us compare our perception and the reality of where we stand with respect to others across the world in incomes.

2. This interactive feature tells you what 2000 calories looks like in terms of restaurant menus and this tells us about the different healthy eating menus.

3. Great visualization of how buses bunch together even if there is a slight delay in one service.

4. This graphic shows how long it take to travel from 28 European cities to any point in the continent.

The challenge with "bolder" labor market reforms

Labor market reforms run into several challenges. The OECD Economic Survey of India advocates "bolder" labor market reforms. It writes,

Bolder reforms would further promote quality employment and reduce income inequality. Work on OECD countries suggests that reducing labor market dualism by narrowing the gap between the protection of permanent and temporary jobs lowers income inequality by reducing both wage dispersion and unemployment. In India, the large unorganized and informal sectors, which leave many workers with low income and virtually no social protection, contribute to labor market segmentation. Reforming labor regulations should aim at providing a minimum floor of pay and social and labor protection conditions for all workers irrespective of the status, size and activity of the firm. This would require introducing a comprehensive labor law which would consolidate and simplify existing regulations. In turn, this would reduce uncertainty surrounding regulations as well as compliance costs for manufacturing companies. Barriers to formal employment should also be reduced, in particular by abolishing the most restrictive provisions of the Industrial Dispute Act that require prior government permission for employment termination and exit decisions. At the same time, the new law should consider providing better training and assistance in job search. 

While the argument is appealing, I am not sure whether it will stand the test of scrutiny, even on simple logic, leave alone political economy considerations.

Currently, starting and remaining small and informal enables firms to keep costs down (by paying lower wages and avoiding social protections and certain taxes) as well as escape regulatory requirements. In a country where more than 90% of business enterprises are small and informal, any reform involving minimum pay and social protections, as suggested by the OECD, would be a massive, even impractical, exercise of public intervention. This cannot be done by consolidation and simplification of existing regulations but would require direct executive fiat, whose enforcement poses its set of challenges and distortions.

So here is the fundamental challenge with labor market reforms. On the one hand, the vast majority of businesses in the informal sector barely manage to make ends meet even after paying far lower than minimum wages and offering no social protections. On the other, any formal regulation, even in the most liberalized form, cannot not insist on a reasonable minimum wage and social protections . 

The only way to reconcile this dilemma is to acknowledge the reality that a major part of the market will have to remain outside formal minimum wage and social protections, thereby accepting the informal sector. In short, "bold" reforms involving state of art labor regulations and elimination of the informal sector may be a difficult balancing act. This leaves us with the next best reforms like consolidation and simplification of existing regulations.  

The alternative, as this blog has long advocated, is to provide certain basic universal social protections - and the recently launched triptych of programs on life and accident insurance, and pensions is a step in that direction - and use its cushion to roll-back the dual-price market in labor wages. The public subsidy inherent in such programs can potentially provide the cushion, atleast to some employers, to support employer-employee financed health insurance and pensions. 

However, for this to make any meaningful dent, the public subsidy accruing to these programs will have to be of a much higher magnitude. But it is clear that currently the country does not have the fiscal space to support a large enough universal social safety net. 

The changing priorities of corporations

John Kay makes an insightful point,

The good corporation — like the good smartphone or the good school — can be identified by what it achieves. It pays workers a living wage; it does not engage in aggressive tax avoidance. It develops the skills and capabilities of its employees and does not bewilder customers with complex tariff structures. It earns profits, reinvests some and pays a dividend to shareholders. Its executives spend more time walking around offices and shop floors than sitting in the meeting rooms of investment banks. The good corporation contributes relevant expertise to the formation of policy but does not engage in lobbying on a scale that corrupts political decision-making.

The political and social legitimacy of the market economy, and of the corporations through which it functions, cannot simply be asserted — as it has been in the market-fundamentalist rhetoric that has dominated economic policy for the past three decades. Its legitimacy has to be earned by the behaviour of the leading economic institutions. That social contract has too often been broken in recent years. And drawing attention to that breach, and the measures needed to regain trust, is an agenda that is not hostile but rather friendly to the long-term interests of the business community.

There may be a point about social internalization here. Each of those priorities indicated above - tax avoidance, confusing customers with complex tariff structures, gambling with financial products, lobbying that verges on corrupt deal-making, and so on - would have been considered outright illegal two or three decades back. Today, they are all accepted as integral to a business enterprise. In fact, the interpretation of tax non-compliance by drawing the distinction between tax evasion and tax avoidance is itself a recent phenomenon. 

I am not very optimistic about whether we can do much to realign our social moral compass. But merely being aware of this insight when taking decisions or positions on various issues can itself help us take a more balanced view of such issues. 

The challenge with making stuff happen

Stuff happens (in people's lives and in a society at large) when a number of things aggregate. Very often, we have limited idea of what are all those things, leave aside how much of each ingredient is required and in what sequence, to get the stuff to happen. In other words, we know little about the "stuff-happening" function! And worse still, this function varies across contexts.

I say it in the context of this Times story highlighting a failed attempt to provide healthy-food choices to residents of a poor Bronx neighborhood. Though the New York city government's tax incentive program helped establish a healthy-food supermarket, it had little effect on the diets of neighborhood residents. People continued their earlier unhealthy food consumption. The article also points to latest research, which show that people's preferences, more than access, determine their eating habits.

Our results indicate that policies aimed at improving access to healthy foods in underserved areas will leave most of the socioeconomic disparities in nutritional consumption intact.

A significant number of opinion-makers are likely to take away the message that the US federal government's program to improve healthy food habits by incentivizing grocery stores to locate to places with high obesity rates which they had hitherto avoided, may be money down the drain. 

On similar lines, social researchers who swear by evidence-based policy design have found that school buildings and textbooks have limited effect on learning outcomes, whereas deworming or provision of information to parents on returns to education have large effects. They decry the wasteful spending on these items and favor using the scarce resources on the cheaper alternatives like deworming or providing information. And there are several other similar evidence-based inferences. 

The researchers would point to the need for such prioritization given the scarce resources available. But they overlook the damage done by the headline grabbing takeways - pare down public support for the program to encourage healthy-food grocery stores to set up shop in disadvantaged areas or scale back funding for providing textbooks or building schools and focus on deworming and providing information. Needless to say, these micro-evidence based inferences fly against more historical macro-evidence. 

Just as access is a necessary, but not always sufficient, condition for ensuring healthy eating, no society has ever achieved acceptable learning outcomes across it without having good physical school infrastructure and textbooks for children. Attempts to change the food preferences of poor people are more likely to succeed when they have ready access to places where they can buy such food. Similarly, learning outcomes are more likely to improve when children have textbooks and are taught in a school with reasonable physical infrastructure.

While the process of making stuff happen is generally always iterative, we should not lose sight of the insight that stuff happens when several ingredients, often diffuse and spread over time, come together. Unfortunately, such findings are not amenable to headline grabbing evidence-based research. See also how this research popularized by this article flounders when faced with arguments here. 

The power of economic geographies visualized

The Growth Economics Blog points to a paper by Roy Elis and Stephen Haber which claims that "economic and political institutions depend, to some extent, on the natural level of transactions supported by the hinterland surrounding the core area of different economies". One dimension of transactions levels they identify is the transportation catchment - higher levels of transactions are associated with lower transportation costs and areas with plain topography or waterways benefit.

In this context, they point to the examples of New York and Mexico City, represented by the following maps, about how far you could get from the center of each city using 40 megajoules of energy.

As can be seen, the hinterland for New York at a 40 megajoules energy budget is 93,300 sqkm against 13,320 sq km for Mexico City. While the authors make their inference in the context of agricultural economy, the seven times difference in the economic geography (or hinterland size) would translate into much higher economic activity in any economy.

The concerns with India's proposed financial code

I have five concerns with the proposals outlined in India's Financial Sector Legislative Reforms Commission (FSLRC) report.

1. Are such far-reaching reforms needed? – The FSLRC proposes certain far-reaching reforms, with atleast two fundamental shifts in the regulatory paradigm – the shift from rules based to principles based regulation; and the assumption that financial markets are inherently efficient and regulation is required to address market failures and not necessary to enable market development. Further, its specific proposals on realigning the regulatory architecture are equally transformational – shift from multiple to single capital and money markets regulator, and the judicial review of RBI’s regulatory actions. There is no evidence whatsoever, from India or elsewhere, to warrant such a radical departure – either by way of the superiority of the new paradigm or the relative inferiority of the prevailing system – on something like financial market regulation on which there is little global consensus on what is the best approach.

2. Judicial review of RBI’s regulatory actions - The RBI’s banking sector regulatory decisions would come for appeal before the Financial Sector Appellate Tribunal. In fact, this judicial over-sight is not just confined to issues like the magnitude of penalties, but also on policy decisions (involving exercise of judgment) like whether to ban a particular financial instrument or the magnitude of leverage caps on trading positions. Such decisions are invariably deeply judgemental in nature, based on a very comprehensive appreciation of trends and the theory and model being used to make the assessment. Further, most such invariably decisions have a compelling enough counter-point, again based on a different judgement arrived at through a different theory and model. In the circumstances, defending the decision before a court of law can become very tricky. It will encourage banking regulators to play safe – delay decision-making on throwing sand into the wheels of a booming asset market till the bubble bursts. It will also embolden financial market participants and their lobbyists to question, for example policy decisions that address systemic safety. This goes against the practice elsewhere, including in the US, where such decisions can only be reviewed (on grounds of legality and adherence to due process of law) and not appealed on merits. 

As the Governor of RBI has argued against the move saying that the regulator would “simply not have the capability, experience, or information to make, and where precise evidence may be lacking… a lot of regulatory action stems from the regulator exercising sound judgment based on years of experience. In doing so, it fills in the gaps in laws, contracts, and even regulations”. In this context, it is worth remembering that India’s recent experience with the Securities Appellate Tribunal (SAT) and its judgements on SEBI decisions has not been encouraging. 

3. Separation of capital flows regulation - One proposal in the Union Budget 2015-16 involves amending Section 6 of FEMA to provide that controls on capital flows as equity will be exercised by the government, in consultation with the RBI. This assumes that cross-border capital flows market can be segmented neatly into equity and debt components. In fact, equity flows are subject to much the same global financial linkages induced volatility as debt flows. Also, such separation of responsibilities and the resultant regulatory arbitrage opportunities may engender systemic distortions in equity and debt inflows. 

It therefore goes against the argument that capital flows management measures have to be undertaken in a comprehensive manner. Further, it increases the moral hazard for governments to keep open the equity market gates in good times and to that extent restrict the RBI’s ability to impose counter-cyclical macro-prudential measures to effectively manage the overall current account balance.

4. Creation of a super-regulator - Creation of a super-regulator UFRA that would subsume SEBI (securities trading), IRDA (insurance), PFRDA (pensions), FMC (commodities trading), and the RBI’s bond trading regulation activities. This is being done on grounds of synergies from such consolidation. This raises the question as to the need to fix institutions that are atleast not broken. India’s experience with financial market regulation has been far better than that elsewhere in the world. Its regulators, led by the central bank, have adopted a heterodox mixture of macro-prudential measures to limit asset and credit bubbles, keep a leash on the shadow banking system, and manage capital flows, with far greater success than in most other economies, developed and emerging. 

Further, there are no best-practice examples from anywhere in the world. A large variety of practices are the norm. Therefore, the most prudent strategy would be to introduce reforms in a gradual manner as has been happening – crossing the river by feeling the stones. In any case, there is little evidence either way to argue that unified regulatory institutions are superior to fragmented architecture. The example of countries with unified regulators like the UK - where the Bank of England, through the Financial Policy Committee (FPC) and the Prudential Regulatory Authority (PRA), is the sole regulator - is not encouraging enough to merit a whole-hearted switch to a single regulator regime. 

5. Separation of inter-bank bond market regulation - Another example comes from the shift in responsibility for regulating the interbank bond market (repo and reverse repo securities) from RBI to SEBI (this has been recently shelved, though it is not clear whether it is a temporary retreat). This assumes significance since these securities are the primary monetary policy transmission lever for the central bank. The RBI Governor himself opposed this move, “Is the regulation of bond trading more synergistic with the regulation of other debt products such as bank loans and with the operation of monetary policy (which requires bond trading) than with other forms of trading? Once again, I am not sure we have a compelling answer in the FSLRC report. My personal view is that moving the regulation of bond trading at this time would severely hamper the development of the government bond market, including the process of making bonds more liquid across the spectrum, a process which the RBI is engaged in.”

Weekend visualization

1. In a British election where Labor got routed and Conservatives swept across the country, the old coal mining belts remained steadfastly Red.

2. Brilliant superimposition of different global cities onto the map of Netherlands brilliantly captures the power of population density.

3. This map (via @MaxCRoser) depicts the global scientific collaboration linkages as represented by the geographical locations of collaborating scientific researchers.

Finally, Upshot has this collection of its 250 most-read articles, including interactive graphics. 

The four globalization trilemmas

Michael Bordo and Harold James have a paper where they explain the challenges of globalization, especially that arising from cross-border capital flows, facing countries in terms of four distinct policy constraints or trilemmas. They write,

The analysis of a policy trilemma was developed first as a diagnosis of exchange rate problems (the incompatibility of free capital flows with monetary policy autonomy and a fixed exchange rate regime); but the approach can be extended. The second trilemma we describe is the incompatibility between financial stability, capital mobility and fixed exchange rates. The third example extends the analysis to politics, and looks at the strains in reconciling democratic politics with monetary autonomy and capital movements. Finally we examine the security aspect and look at the interactions of democracy with capital flows and international order. The trilemmas in short depict the way that domestic monetary, financial, economic and political systems are interconnected with the international. They can be described as the impossible policy choices at the heart of globalization. Frequently, the trilemmas conjure up countervailing anti-globalization tendencies and trends.

Countries trade-off among these choices as they pursue their macroeconomic policies. Consider the case of India. It has adopted a regime of floating exchange rates, partial capital controls, and monetary policy autonomy, as its strategy to achieve financial market stability. As regards the political dimension, it is currently grappling with the tension between democratic politics and monetary autonomy of the central bank. The recent Union Budget even usurped some of the Central Bank's powers in managing cross-border capital flows. 

The last trilemma is the newest and assumes great significance in view of the challenges thrown up by the Global Financial Crisis. It is amply clear that global financial market stability requires close co-ordination among atleast all the major economies. The quantitative easing policies pursued in US, Europe, and Japan, motivated by domestic economic considerations, have generated large-scale negative externalities, especially by way of enhanced cross-border capital flows volatility, with considerable destabilizing effects. Developing countries, which faced the brunt of these effects, have expressed their concern at the absence of international co-ordination in the management of effects of such domestic policies. However, the achievement of such co-ordination to mitigate the externalities arising from cross-border flows would require trade-offs between democratic politics, both within countries and among nation states. 

This squares up with another framing of this conundrum outlined a few years back by Dani Rodrik. He argued that full democracy, national sovereignty and global economic integration may be incompatible. The major fault lines on this include the adverse impact of international trade on certain sections of the population. Faced with the pressure from their constituents, democratic governments have generally preferred to hold back on full economic integration.

The importance of neighborhoods in children's life outcomes

An excellent example of data journalism in the Times that highlight the works of Raj Chetty, Lawrence Katz and Nathaniel Hendren on how neighborhoods - schools, community, neighbors, local amenities, economic opportunities, and social norms - influence life outcomes. Briefly their two studies from the US show that not only do neighborhoods attract those who succeed (or fail), they also nurture success (or failure).

The first study tracked the life outcomes of the children in 4600 families in five large US cities in 1994-98 who won the Moving to Opportunity housing experiment (families living in public housing could enter a lottery in which the winners were offered a voucher to mover to better neighborhoods) lottery. The authors used the natural random selection experiment to track the outcomes of the move on younger and older children (the earlier studies clubbed both and found negligible effects). They also compared outcomes of those who won Section 8 subsidized housing vouchers which did not require moving to better parts of the city. The Times summarizes,

The children who moved when young enjoyed much greater economic success than similarly aged children who had not won the lottery. And the children who moved when they were older experienced no gains or perhaps worse outcomes, probably the result of a disruptive move, paired with few benefits from spending only a short time in a better neighborhood... those who moved as a result of winning this voucher before their teens went on to earn 31% more than those who did not win the lottery. They are also more likely to attend college. Other families were awarded Section 8 housing vouchers, which subsidize renting a housing or apartment. But because they did not require the winners to move to better parts of the city, people typically moved to neighborhoods that were better but perhaps by only half as much. As a result, the eventual income gains to the pre-teen children who won this lottery were about half as large... 

But those who were teens when their families won the lottery - the typical child was 15 - saw few years in their better neighborhoods and also had to deal with the disruption of moving. A result is that their incomes were 13-15% lower...the net present value of the extra earnings that will eventually accrue to a child who moved at age 8 is $99000, meaning that for a family with two children, the program yields $198,000 in extra earnings. 

The second study uses earnings records to effectively track the careers and neighborhoods of 5 million people over 17 years. It reinforces the MTO experiment,

The earlier a family moved to a good neighborhood, the better thee children's long-run outcomes. The effects are symmetric, too, with each extra year in a worse neighborhood leading to worse long-run outcomes. Most important, they find that ech extra year of childhood exposure yields roughly the same change in longer-run outcomes, but that beyond age 23, further exposure has no effect. That is, what matters is not just the quality of your neighborhood, but also the number of childhood years that you are exposed to it. 

This graphic is a cognitively striking description of the study.

Here is the interactive graphic that shows how much extra money a county causes children in families (at different income levels) to make when compared to children in poor families nationwide.

The challenge here is the difficulty of designing public policies that enable such mixing. As Thomas Schelling has shown, experiments with forced de-segregation face formidable challenges, and the headwinds are even more adverse in societies like India. I have blogged about it here, here, and here.

Update 1 (10.05.2015)

Mathew Martin has this to say about the findings,

Chetty and Hendren's dataset includes only families that voluntarily chose to move under the status quo. The fact that they chose to move suggest that they had something to gain from the move, such as, for example, relatives or a lucrative job opportunity--things that would benefit the kids. Take those away, and it's not clear that moving actually does benefit kids. I mean, surely, there exists someone who is better off living in Hamilton county than Warren.

Restructuring stalled infrastructure projects

The massive numbers of stalled infrastructure projects constrain India's economic growth on multiple fronts. Apart from preventing downstream economic activity (even sunk investments), it acts as a huge drag on the balance sheets of infrastructure firms and lending institutions. The Economic Survey has an analysis of such projects. Here is a graphical illustration of the magnitude of the problem.

The decline in new investments coincided with sharply rising volumes of stalled projects since 2009.

A high-level Project Monitoring Group (PMG), established mid-2013, was entrusted the responsibility of de-clogging 437 major stalled projects (342 with investments above Rs 1000 Cr) worth Rs 21 lakh Cr (or Rs 21 trillion). The sector-wise projects break up reveals that power, steel, and petroleum and natural gas make up Rs 17 trillion of these projects.

The Department-wise break-up indicates that Environment and Coal Ministries made up 60% of the projects.

In late-2014, the Planning Commission presented to the Prime Minister that an additional Rs 5.7 trillion would be required to complete 738 central government funded infrastructure projects on which already Rs 5.6 trillion has been expended. It also said that 83% of these projects were delayed, resulting in cost over-run of Rs 1.89 trillion. Interestingly, 274 out of the 289 railway projects were delayed, mainly due to financial constraints.

The delays with railway projects are surprising since many of them involves gauge conversion or additional lines, which have limited land acquisition requirements. Financing problems and equally importantly, implementation inefficiencies and contractor delays, are likely reasons for the delays.

In March 2015, the Ministry of Statistics and Program Implementation placed details of these 738 projects being monitored before the Parliament. It stated that 315 of these projects had passed their implementation deadline. Road Transport and power formed nearly half these projects and railway projects formed eight of the ten most delayed projects.

As to the major reasons for the delays, an HSBC study of the top 100 largest stalled projects in the CMIE records found that site acquisition make up a third.

In contrast, another analysis of stalled projects, based on data for 804 such projects provided by the Ministry of Finance, appears to contradict the claim that land acquisition problems are holding back projects. The MoF data informs that just 8% of the projects are stalled due to land acquisition problems and 39% are due to unfavorable market conditions. Interestingly, the reasons for delays in about a third of the stalled projects is unclear.

There are significant variations across sources about the reasons for delays. It is clearly not as simple as the conventional wisdom that land procurement and environmental clearances have derailed many of these projects. My own belief is that a large numbers of these projects were initiated without rigorous due diligence and at a time when credit was easily available. Therefore, commercially unviability may be the under-stated real contributor to delays in the majority of cases.

Even assuming expedited clearances and site procurement, itself no mean task, given the delays that have already happened, those projects too would undergo cost-escalation. In the circumstances, there are only two solutions - restructuring or scrapping. The former assumes that the project can be salvaged by changing its terms.

Such changes in terms can potentially come in three forms. In purely private projects - steel, telecoms, petroleum, manufacturing, real estate etc - the developers should find the present market conditions commercially viable enough even with the increased investments required. In infrastructure projects - power, roads, railways, mass transit etc - the governments should finance the cost-escalation either by agreeing to pass-through some of the costs (through higher tariffs or tolls) or provide budgetary support for the increased expenditure. Finally, in certain cases, especially roads where traffic forecasts were optimistic, it may be possible to restructure the project merely by increasing the project tenure and without any additional financial burden.

This assessment in turn critically depends on the sunk investments made in those projects. In projects where significant investments have already been made, restructuring becomes more likely, whereas those where investments made are marginal, developers may prefer to wait out or scrap the project.

It may be necessary to carry out detailed analysis along these lines before we embark on any restructuring of projects. If the developers of purely private projects find them commercially unviable given the prevailing market conditions and government is in no position to bear the fiscal burden, then the possibility of restructuring diminishes dramatically. In that case, all talk of restructuring stalled projects is barking up the wrong tree. In that case, scrapping becomes the only alternative.