Thursday, July 30, 2015

London's 'Big Dig'

London's 'Big Dig' is about to start, with contracts to be awarded over the coming weeks. The £4.2 bn super-sewer, being build under the Thames river and one of the most complex infrastructure projects in the world, has several unique contracting features. The construction work on the project being built by Thames Water, London's privately owned water utility, through its special purpose vehicle, Thames Tideway Tunnel, is set to start in 2016 and will take seven years to complete. Apart from its sheer size (it is spread over 42 sites), the project has several technical risks including potential threat to Big Ben's foundations and flooding of the London metro network. 

Given the size and risks involved, a novel off-balance sheet financing arrangement has been worked out. Thames Water will finance a third of the cost, through the SPV's balance sheet, and the remaining two-third of £2.8 bn will come from a consortium of financiers, Bazalgette Consortium, which includes Allianz, Swiss Life Capital, and Dalmore Capital. The consortium will own, finance, and manage the project for 125 years. In order to pay for the project, Ofwat, the water regulator, and the Government have estimated that Thames Water's 15 mn consumers may need to pay a surcharge on their water bills, of upto £80 every year almost in perpetuity. Interestingly, the surcharge will become operational from the date construction begins, and the investors will therefore receive income from the beginning. This, coupled with the high tariffs and the long, almost a perpetuity, contract tenure provide the project's financial risk mitigation. Further, construction risks are mitigated by a few government guarantees, including accidents at project sites, meeting the insurance costs not covered by markets and also any "exceptionally large cost over-run". 

As critics have pointed out, the cost of capital for the consortium is certain to be much higher than would have been the case if it were constructed with public borrowing. Given that construction problems cause mega projects to become "over-budget, over-time, over and over again", whether done with public or private financing, the final cost of the project once construction is completed is most certain to be much higher than its current estimates. Would that result in an increase in the surcharge?

Further, the case for public financing followed by contracting out long-term once the construction risks are off-loaded becomes even stronger given that the government is already assuming constructions risks thereby limiting the project developer's incentives for on-time delivery. If the construction contract is given out as an Engineering Procurement Construction (EPC) contract and once constructed given out on a long-term operation and maintenance concession, the private sector efficiency gains could just as well have been captured, and at a lower cost of capital. 

Tuesday, July 28, 2015

The structural headwinds facing the Indian economy

Massive infrastructure requirements, alarming decline in private infrastructure investments, rapidly growing debt burden of infrastructure companies, rising debt-to-equity ratios for projects, and rising gross non-performing assets of banks. This, captured in the WSJ graphic below, constitutes the perfect storm that the Indian economy tries to weather in its attempt to regain the high economic growth trajectory.
Despite the optimism, the ingredients for the short to medium-term just do not look promising. In fact, even if growth recovers (forget the new series), it is unlikely to be sustained for beyond 2-3 years. Household savings are declining, widening the gap between supply and demand for investment resources. In the absence of massive recapitalization, and that may not be forthcoming, bank lending is unlikely to be anywhere near sufficient to finance high growth rates.  

For sustainable growth, India needs to get the ingredients right. It needs a broad enough platform of skilled labor, productive job creating industries, and consumption demand, none of which are easy to create, leave aside in a short duration. Consider each ingredient. Less than 5% of Indian workers receive some form of skill training, compared to 80% for Japan and 96% for S Korea. This compounded with the woeful school education standards means we have a 17 million strong semi-employable workforce entering the labour market each year. Less than 30% of women are employed, a distant last among any large economy. Supply of skilled labor is already a major constraint faced by businesses.  

Jobs get created and broad-based economic growth sustained by the growth of formal sector small firms into medium sized ones. But India's industrial landscape is characterized by the 'missing middle', a result of firms starting small and informal and remaining so. The ease of doing business should have as much to do with improving the business environment for domestic small and medium enterprises as with large and foreign manufacturers. The former requires that the mundane issues of getting land registered, building plans approved, utility services connected, and accessing credit should become hassle-free. Unfortunately, all these run into issues of state capability. 

Finally, India's consumption story too is characterized by yet another 'missing middle'. Contrary to the popular estimations of the 200-300 m strong middle class, recent domestic and foreign surveys points to a far smaller sized and not very rapidly growing middle-class. Further, rural demand, hitherto supported by the boost from various welfare programs, may no longer be able to provide the demand that supported the high growth rates of 2003-08.   

China's massive investments in infrastructure were complemented with policies that promoted hundreds of thousands of town and village enterprises, rising rural incomes, well educated and skilled workforce and strong female participation in labour markets. India has none of these in place and unfortunately, there are no quick-fixes for any of these deficiencies. They require long-drawn and relentless action at multiple dimensions, especially at the level of state governments. Acknowledging the same would be a good place to start. 

Sunday, July 26, 2015

Weekend visualization and links

1. The most popular example of capitalism with Chinese characteristics has been the crawling renminbi peg. Since 2005, the currency has appreciated 30%. As FT reported, while the direction of currency movement was clear, the pace and timing of changes not.
2. As Africa has weaned away in recent years from brutal dictators and internecine civil conflicts, a new scourge threatens to engulf large parts of the continent - extremist Islamism. As the graphic below shows, more than a dozen northern and sub-Saharan African countries are fighting the menace of Jihadism. Such Jihadism in turn forms the ideological breeding ground and recruitment centers for extremist groups like Al-Qaeda and ISIL.
And where do these groups draw their strength,
Although the extremist groups are backed by well-financed elites, they could not survive without popular support. Every one of them taps into well-known local grievances. From Mali and Nigeria to Kenya and Tanzania the story is the same: extremists emerge from and woo Muslim populations on the national periphery who are fed up with decades of neglect, discrimination and mistreatment by their rulers. Jihadists are able to exploit existing religious tensions and latch on to disgruntled Muslim communities. In addition, the conflicts they stir up have created ever bigger populations of refugees, who are either vulnerable to radicalization or likely to cause the sort of resentment that fuels it. Increasingly what drives African extremism is not just opportunity or firepower but ideology. No grand caliphate stretching from Mosul in norther Iraq to Maiduguri in north-eastern Nigeria is likely to emerge. Yet a distinct flavour of poisonous thinking has spread across thousands of miles. Islamism is the continent's new ideology of protest.
3. China has rapidly displaced the US and Europe as the largest investment partner across the developing world. As this NYT article and the interactive graphic shows, China has shown an amazing appetite to invest in some of the most difficult regions of the world, especially in Middle East, Africa, and parts of Latin America, which are largely avoided by western businesses and development finance institutions for both economic and political reasons.
For Beijing, these investments, mainly in the form of loans by state-owned banks, form part of its efforts to "win diplomatic allies, invest its vast wealth, promote its currency and secure much-needed natural resources". In countries which are starved of foreign funding, the Chinese readily offer financing, albeit at steep interest rates, most often in return for securing access to their natural resources and the expertise of their construction and mining companies. Consider this,
China has a lock on close to 90 percent of Ecuador’s oil exports, which mostly goes to paying off its loans... The Chinese money, though, comes with its own conditions. Along with steep interest payments, Ecuador is largely required to use Chinese companies and technologies on the projects... Energy projects and stakes have accounted for two-fifths of China’s $630 billion of overseas investments in the last decade, according to Derek Scissors, an analyst at the American Enterprise Institute... Chinese mining and manufacturing operations, like many American and European companies in previous decades, have been accused of abusing workers overseas. China’s coal-fired power plants and industrial factories are adding to pollution problems in developing nations...Chinese companies are at the center of a worldwide construction boom, mostly financed by Chinese banks. They are building power plants in Serbia, glass and cement factories in Ethiopia, low-income housing in Venezuela and natural gas pipelines in Uzbekistan.
The graphic below captures the $11 bn China has loaned Ecuador, mostly to finance hydro and wind power, transportation, mining, oil drilling, and river water linking. This is broadly representative of the country's investments elsewhere.
4. Stunning map that contrasts the daytime and night time population of New York City.
The daytime map reflects the population that commute to NYC for work, tourism, and other purposes, whereas the night time population captures the actual city residents. As this graphic shows, the hollowing out of the city center during night times is representative of other US cities and a reflection of the countries suburban growth. It drives home the importance of mixed-use urban planning in ensuring the vibrancy of cities. It also serves as a striking reminder to urban planners that estimations of work commuters and tourists are probably as much or more important than that of residents in planning infrastructure facilities for large cities.

5. As the US economic productivity has dipped to below 1% since 2010, Robert Solow's famous quip that "you can see the computer age everywhere but in the productivity statistics" has been much highlighted. WSJ has a nice article on this debate.

However, as a counter-point, Google's Chief Economist Hal Varian has claimed that US doesn't have a productivity problem, but it has a measurement problem. Pointing to the improvements in the quality of life brought about by the digital economy and time-saving apps, he argues that it is very difficult to capture the impact of quality improvements. Critics though claim that such measurement problems have always been there, understating the productivity measurements.

6. Fantastic visualization of the income levels along New York metro lines from this New Yorker project.
Similar maps of Washington and a few other cities by MIT Media Lab are here

Friday, July 24, 2015

Living with debt and what it means for countries like India

It is a sign of the times that the IMF has in the recent past departed from orthodoxy in many areas of macroeconomic management. After accommodating the possibility of capital controls, higher inflation target, and fiscal expansion even when faced with large and growing deficits, the latest mea culpa comes in the form of the possibility of "living with high debt".

At a time when many developed economies face high and growing public debt ratios, a highly contentious debate has been raging about addressing this problem. One side, represented by those advocating fiscal austerity, austerians, have been demanding policies for immediate reduction of debts. The other side, represented by Keynesians, oppose this and argue that growth recovery is the priority and the ultra-low interest rate environment demands more public spending, even if it increases the debt burden.

Now the IMF has waded into the debate, pointing to the possibility of "living with high debt". Its conclusion,
Countries facing imminent risk of a curtailment of market access, or that need to re-establish fiscal space against the risk of contingent liabilities or other shocks, naturally do not have the luxury of living with high debt. For others, the appropriate pace depends on the availability of non- (or less) distortionary sources of tax revenue. And for those countries in the fortunate position of enjoying asset price booms, the message must be that they should seize the opportunity to pay down public debt. In sum, the appropriate response to high levels of public debt depends very much on the extent of available fiscal space and other factors. There is no one-size-fits-all message: be it to pay down the debt to reduce the risk of a funding crisis or to live with the debt, letting the debt ratio decline organically through growth. Countries in the yellow and red zones in terms of fiscal space will not be in a position to “live with the debt.” But nor is it the case that countries with ample space— those firmly in the green zone—should rush to pay down their debt. 
Blessed with the IMF imprimatur, now consider the table below (numbers from here) which aggregates the debt to GDP ratios - dis-aggregated into component household, corporate, and government debts - of some of the larger Asian emerging economies from 2000...
... and from 2014.
It is evident that countries like India, Indonesia, and Philippines not only have low debt-to-GDP ratios, but also those ratios have been stable for more than a decade and even declining in recent years. In particular, household debt-to-GDP ratios for these three countries are among the lowest, and aggregate corporate debt (not that concentrated among the small proportion of the largest corporate groups) far lower than in their fast-growing peer group (during their fast-growing years). 

For these countries, in their search for economic growth leg-room, this is encouraging news. There is large potential for credit absorption among the small and medium enterprises as well as for household consumption (especially in housing and consumer durables). But the challenge is to realize this opportunity by improving credit intermediation mechanisms and getting money across to these categories of borrowers. 

Wednesday, July 22, 2015

Urban development with Chinese characteristics

The latest plan from China, a megalopolis six-times New York, combining Beijing, Tianjin, and Hebei province, called Jing-Jin-Ji, with a population of 130 million,
The new region will link the research facilities and creative culture of Beijing with the economic muscle of the port city of Tianjin and the hinterlands of Hebei Province, forcing areas that have never cooperated to work together...  This month, the Beijing city government announced its part of the plan, vowing to move much of its bureaucracy, as well as factories and hospitals, to the hinterlands in an effort to offset the city’s strict residency limits, easing congestion, and to spread good-paying jobs into less-developed areas...
Jing-Jin-Ji, as the region is called, is meant to help the area catch up to China’s more prosperous economic belts: the Yangtze River Delta around Shanghai and Nanjing in central China, and the Pearl River Delta around Guangzhou and Shenzhen in southern China. But the new supercity is intended to be different in scope and conception. It would be spread over 82,000 square miles, about the size of Kansas, and hold a population larger than a third of the United States. And unlike metro areas that have grown up organically, Jing-Jin-Ji would be a very deliberate creation. Its centerpiece: a huge expansion of high-speed rail to bring the major cities within an hour’s commute of each other.
High-speed rail has a central role in this grand plan, 
Chinese planners used to follow a rule of thumb they learned from the West: All parts of an urban area should be within 60 miles of each other, or the average amount of highway that can be covered in an hour of driving. Beyond that, people cannot effectively commute. High-speed rail, Professor Zhang said, has changed that equation. Chinese trains now easily hit 150 to 185 miles an hour, allowing the urban area to expand. A new line between Beijing and Tianjin cut travel times from three hours to 37 minutes. That train has become so crowded that a second track is being laid. Now, high-speed rail is moving toward smaller cities. One line is opening this year between Beijing and Tangshan. Another is linking Beijing with Zhangjiakou, turning the mountain city into a recreational center for the new urban area... “Speed replaces distance,” Professor Zhang said. “It has radically expanded the scope of what an economic area can be.”
It is no surprise that the two central pillars of this strategy are relocating existing activity clusters (like the administrative center to the Beijing suburb of Tongzhou, and over 1200 polluting businesses outside city centers) to spread growth to newer areas and using high-speed rail to connect population centers within the large region. Both these are logistical interventions, in which Beijing has already demonstrated excellence. And with everything the Chinese do, the sheer scale is staggering. Amidst the recent gloom surrounding China, this may represent a reasonably sound potential economic opportunity for sustaining the country's investment driven growth model. 

Monday, July 20, 2015

Secular stagnation and prospects for a new growth compact

Overcoming secular stagnation (SS) is arguably one of the biggest challenge facing developed economies. The phrase, first propounded by Alvin Hansen in the context of the Great Depression and revived in 2013 by former US Treasury Secretary Lawrence Summers to describe the present times, essentially means “chronic excess of savings over investment” which serves to keep real interest rates low for a prolonged period.

It has been construed that these countries may have entered a phase of lower trend economic growth, a new normal, driven by "persistent shortfalls of demand". The most compelling argument in favor of its demand-side origins come from the fact that even a large asset bubble fuelled economic boom in the last decade was not accompanied by inflationary over-heating.

Supporters of SS hypothesis point to multiple reasons for excessive savings - rising share of incomes going to those with "high savings propensities"; increased uncertainty, greater indebtedness, and expectations of lower returns encourage people to save more; and the burgeoning surpluses of emerging economies and oil exporters which find their way to the safety and liquidity of US Treasuries. On the investment side, they point to the substantial reductions in the relative price of capital goods as well as capital intensity, reflected in the declining share of investment goods in the GDP. This is most evocatively captured in Larry Summers’ example of "WhatsApp, worth $19 bn, with 55 people in a big room with Sony, worth $18 bn, and owning lots of factories and office buildings and the like".

Then there is the challenge posed by demographics. Demographic trends affect both investment and savings. A lower population growth reduces potential output, and limits the scope for investments. An aging population means people save more to fund their retirements. A combination of excess savings, amplified by the accumulating surpluses in emerging economies, and limited investment opportunities keeps interest rates low, even negative in real terms.

Finally, there is the productivity explanation, best captured by Tyler Cowen's best-selling book, The Average is Over - all the low hanging fruits from technological and process innovations have been plucked and large productivity enhancing innovations are very difficult to come by. The combination of all these factors point to the difficulty of operating at full employment and potential output without inflating destabilizing asset bubbles. Critics though dispute the SS hypothesis pointing to the remarkable ongoing economic recovery in the US.

The conventional wisdom on responding to SS has been either monetary accommodation, using unconventional approaches like quantitative easing, or fiscal spending on infrastructure. But the former engenders resource misallocation and ruinous asset bubbles, whereas the latter is constrained by fiscally strapped governments. It is in this context that the international dimension assumes significance.

A striking feature of the SS hypothesis is its "closed economy" assumption. Since the low hanging fruits from technological innovations have been plucked, developed countries, and their firms, face a future of declining gains in productivity. Their companies, exemplified by the cash hordes at two iconic firms Apple and Google, have limited investment opportunities. The income stagnation at all but the highest income levels boosts savings and limits consumption demand. All these trends are confined to developed economies and tend to assume them living in isolation from the rest of the world.

Faced with declining investment opportunities and lower returns to capital, Econ 101 teaches us that the natural response would be to expand trade and other economic linkages. The developed economies have the technologies, businesses, and even capital, all searching for opportunities. It also faces an aging population and therefore diminished supply of labor. In contrast, emerging economies have rising productivity, remunerative investment opportunities, growing consumer demand, and a large pool of labor. The complementarity could not have been any more mutually beneficial. The scope for a new growth compact between the two economic groups could not have been more opportune.

So far, the operations of multi-national corporations has been focused on selling products produced in developed to consumers in developing countries. Imagine the potential of a market for goods and services that are essentially needed for the developing countries. What if the firms from developed countries are able to realize increasing gains in productivity by making products for developing countries? What if there are remunerative investment opportunities in developing countries? As capital flows out from developed economies, their depreciating currencies would boost exports.

Such innovation opportunities and incentives abound – massive savings in infrastructure investments from efficient construction technologies, low cost medical technologies could dampen rising health care costs, on-line instruction technologies can transform education and health care markets, and so on. The "jugaad" innovations that characterize many breakthroughs by Indian firms are an example of such opportunities. 

Developing countries are estimated to invest trillions of dollars in their physical infrastructure over the coming decade. They include investments in electricity, mass-transit, telecommunications, and urban utility systems. The potential for technological innovations to optimize cost-effectiveness in their construction, reduce various forms of operational inefficiencies, and enhance environmental sustainability is enormous.

Consider the potential for transformational change from the recent advances in data science on governance itself. Arguably the most critical governance challenge in developing countries is with translating policies and programs into their desired outcomes during implementation. An important contribution to bridging this implementation deficit can be a right combination of analytics and visualization delivered through a variety of hand-held devices. The cash hordes of the likes of Google could transform governance in developing countries in a mutually beneficial partnership.

Finally, there is the channel of migration. It is no coincidence that Japan, with the most restrictive immigration rules, is the worst affected by secular stagnation, and US, with the least restrictive immigration rules, looks the least affected by secular stagnation. Liberalizing immigration rules could be another important contributor to alleviation of SS, especially in countries facing adverse demographic shifts like Japan and Germany.

We should therefore strive to see the current problems in the developed world as a great opportunity to construct a new paradigm of economic and social co-operation between the developed and developing countries driven by mutually beneficial imperatives.

Sunday, July 19, 2015

Weekend links

1. The AEA has a blog post which highlights the potential benefits from liberalizing labor migration, which far outweigh the benefits from any trade liberalization. This graphic from the famous Michael Clemens paper of 2011 is instructive.
The lion's share of these benefits will accrue to the migrants themselves. However the political economy associated with this would be its biggest impediment.

2. As the credit glut plays itself out, wise words from Scott Minerd of Guggenheim Partners,
This year likely will witness record US stock buybacks; the second biggest year for mergers and acquisitions; the highest percentage of non-investment grade borrowers among new issuers of corporate debt; and a record for covenant-light loan issuance... We are not back in the frothy days of 2007, but we are leaving the realm of smart investment decisions and moving into the “silly season” when investors become convinced that recession is nowhere on the horizon and market downside is limited. It is a world where asset prices continue to appreciate and confidence remains strong, while capital chases a shrinking pool of productive investment opportunities. Similar to the run-up to 2007, rising asset prices and malinvestments today may be sowing the seeds of the next financial crisis.
3. Livemint has a graphic from the IMF's April Financial Stability report which finds that India has the second most stressed banking system in terms of corporate debt at risk (interest coverage ratio below two).
4. Fascinating graphic that captures the advance of democracy
5. Excellent graphic that highlights how the ISIS's recent successes involved maneuvering along the Tigris and Euphrates rivers. This visual guide in the Times captures the rise of ISIS.

Saturday, July 18, 2015

Spain construction boom fact of the day

One of the strongest arguments in favor of private participation in infrastructure is that lender's due diligence will discipline promoters to increase the likelihood of commercial viability. But as we have seen time and time again, financial markets lose their disciplining powers when credit is plentiful and asset markets are booming. 

FT has a nice story of the farcical fate of an airport in Spain,
A Chinese investor bid just €10,000 in an auction to buy the ghost airport of Ciudad RealThe Chinese group, Tzaneen International, was the only bidder for the vast-but-vacant airport built in the thinly populated Castilla-La Mancha region of southern Spain for a reported €1bn. Ciudad Real boasts a 4km runway — long enough to handle an Airbus A380m, the world’s largest passenger jet — and a terminal building designed to accommodate 10m customers a year. Since its completion in 2009 — a year after a decade-long construction boom turned to bust, plunging Spain into its worst recession in recent memory — the airport has been held up as one of the worst excesses of the country’s go-go years. It is seen as a prime example of the reckless ambition that drove local and regional governments to build museums, racetracks, sports arenas and oversized transport hubs up and down the country in the period leading up to the financial crisis... CR Aeropuertos, the operator of the Ciudad Real terminal, went into bankruptcy three years ago.
By any yardstick, Ciudad Real should never had such a large airport,
A provincial capital of just 75,000 inhabitants, Ciudad Real is located in a thinly populated part of Castilla-La Mancha, halfway between Madrid and Cordoba...The city is more than two hours’ drive south of Madrid, the Spanish capital, with little potential for tourism and only negligible commercial activity.  There is no significant industry in the area and the city attracts relatively few visitors, especially from outside the country. According to Spain’s national statistics office, Ciudad Real and the surrounding province typically record only between 1,300 and 5,000 overnight stays by foreign visitors every month. The contrast between the ambition and scale of the airport and the apparent lack of demand for such a terminal in the surrounding region made it an obvious symbol of the folly and excess of Spain’s boom years...The airport was originally named after Don Quixote, the hero of Miguel de Cervantes’s famous novel. The name was quickly changed, but the association with the delusional knight would prove apt: even when it was operational, the airport never handled more than a handful of flights a week.

Friday, July 17, 2015

More reversals in British rail privatization

The FT reports that the British government has decided to change the subsidy transfer mechanism to the country's railway operators. The proposal would mean that £3.9 bn annual subsidies would be transferred directly to the 22 private train operating companies (TOCs), instead of the earlier practice of granting to Network Rail, the state-owned rail infrastructure operator. The TOCs will in turn pay higher access charges to Network Rail. The entity, which controls 2500 stations, tracks, tunnels, and level-crossings, has recently been at the receiving end of widespread criticism about poor management that causes half the commuter trains to arrive late, despite the most expensive ticket prices in Europe.

This constitutes yet another reversal in Britain's tortuous rail privatization process which started in 1994. The re-nationalization of Network Rail came after a failed privatization through unbundling and formation of private infrastructure (Railtrack) and rolling stock operators. Further, before the current arrangement, Railtrack received all its income from rail access charges, and the subsidies were transferred to rail operators. The latest announcement restores status quo ante with respect to subsidy transfer channel.

So why should this be any more efficient than the earlier practice? To answer this, it is necessary to bear in mind that while access charges (a mix of fixed cost, variable usage, and capacity charges) are regulated by the Office of Rail Regulator (ORR), only half the passenger fares are regulated, with off-peak and advance-purchase prices being unregulated. This, especially with higher (and presumably closer to commercial cost recovery) access charges, makes Network Rail a more regulated entity than the TOCs and with lower commercial risks. In contrast, the TOCs face a critical restriction arising from capped passenger tariffs and face the full brunt of traffic risks. It is therefore only more efficient that the subsidy be transferred to the TOCs to make up for loss of profitability from revenue shortfalls, contingent on some service level standards. Further, this would also be more incentive compatible in so far as it would encourage the TOCs to improve passenger service delivery standards.

But on the flip side, with their upside capped, the new subsidy transfer arrangement may not do enough to incentivize Network Rail to improve operational efficiency and safety. Also, the TOCs flexibility with unregulated tariffs leaves open the possibility of abusing the subsidy system. 

Wednesday, July 15, 2015

Where is India's middle class?

Livemint points to a Pew research work which highlights that while the global middle class (with per capita incomes more than $10 per day) has grown from 7% to 13% of total population in the 2001-11 period, nearly two-thirds continue to remain poor (less than $2 per day) or low-income. 
The income distribution barely shifted at the top half of the income ladder.
In India, while the share of poor declined from 35% to 20%, the middle income hardly changed, inching up from 1.4% to 2.6% in the same period. In fact, among all its major peers whose middle class share is more than 20% of the population, India is easily a disconcerting outlier in its middle-class share. 
This raises several disturbing questions about the country's long-term growth prospects. At 3%, those with middle class incomes and above constitute just 37 million, and is clearly not growing at a satisfactory enough rate to sustain very high economic growth rates. Simply put there aren't enough Indians around who can afford refrigerators and cars, shop at the malls, buy a house in a metropolis, send their children for management education or get treatment at Apollo hospitals, or take-off for annual vacations within the country. Further, since the stock of middle class is growing ever so slowly, the boost from the pent-up demand may be tapering off. Even doubling this estimate, assuming the Pew study is off the mark (which is unlikely given that the recently released Socio-Economic Survey of India points to similar trends), does little to minimize the concern.

Update 1 (01.03.2016)

The Livemint points to this graphic on India's very narrow middle class. The lowest income tax assessee comes in at the 94.2 percentile of income distribution, whereas those paying in the highest income tax bracket make up just 0.5% of the population.

Tuesday, July 14, 2015

Mega-projects and cost over-runs

Excellent analysis by Bent Flyvbjerg (via Project Syndicate) of mega-projects, which, at $6-9 trillion or 8% of global GDP, is described as being ruled by an iron law of mega projects,
Over budget, over time, over and over again.
He finds that nine out of ten megaprojects (more than a billion dollar projects) suffer cost over-runs and under-estimation of costs and over-estimation of benefits are commonplace.
Most often, if not always, mega projects are driven by political economy considerations. Governments and vainglorious leaders see them as aspirational symbols and start the project without the availability of adequate financing. Given the size of these projects and the business they bring, corporate stakeholders - developers, financiers, contractors, etc - play ball with governments to get the project off the ground. The difficulties and real costs surface once construction begins. 

Sunday, July 12, 2015

India real estate market fact of the day

From the Indian Express,
Data collated by the realty research agency Liases Foras, from 2008 till date, show that 88 per cent of the 25.51 lakh residential projects launched across 8 cities have been delayed. 25 per cent of these projects have been delayed by more than 4 years from the promised delivery date. 
A large part of the delay is also due to the low demand. As the real estate boom peaked in the later part of the last decade, projects were initiated with the belief that 'build and they'll come'. Once the market tanked, the delays and inventory accumulation was inevitable.

A very good presentation by Liases Foras has this stunning graphic of how property prices in Greater Mumbai exploded. The average cost of a flat rose by an annual rate of 35% from Rs 27 lakh in 2004 to Rs 191 lakh in 2010.
As a reflection of the extreme form of gentrification, just 1% of the inventory (144 units) in Greater Mumbai costs below Rs 25 lakh and just 6% below Rs 50 lakh! Affordable housing has been relegated to the suburbs. 

China links for the day

As the latest chapter of 'Capitalism with Chinese Characteristics', on financial market management, unfolds, a few snippets from the press coverage during the week. From a redacted chapter of a new World Bank report, via FT, on the Chinese state's conflicting roles as owner, promoter, and regulator of the financial system, 
Instead of promoting the foundations for sound financial development, the state has interfered extensively and directly in allocating resources through administrative and price controls, guarantees, credit guidelines, pervasive ownership of financial institutions and regulatory policies.
The recent stock market crash has seen the Chinese government throwing virtually everything to backstop the fall. David Pilling summarized it brilliantly,
Authorities have tried everything bar passing a law stating that stocks can only go up. With each iteration, their measures have looked more desperate. 
The World Bank report had this graphic which highlights the skewed nature of Chinese economic growth, focused more on capital allocation than productivity improvements,

The same FT report has this about the colossal waste laid out by this capital accumulation binge,
About half of all China's fixed asset investments between 2009 and 2013 - equal to about $6.8 trillion - went into "ineffective" projects, according to government research. 
And this in turn has engendered a Ponzi scheme involving banks, corporates (public and private), and savers (whose exposure to the equity markets has expanded dramatically in recent years),
A consequence of the investment boom is that many state-owned enterprises are lossmaking, while state-owned banks have lent excessively to these companies and to local governments. The authorities are urging them to lend more despite the fact that they will never be repaid in full.
Retail investors have been encouraged into investing in the equity markets, often through highly risky margin loans,  
Margin lending, in which investors borrow money from brokerages to buy stocks, soared from Rmb698bn at the end of October to a peak of Rmb2.7tn on June 18. But an unknown amount of grey-market margin lending also proliferated, funded by shadow banks through complex structures known as “umbrella trusts”... Brokerages and fund companies... encouraged the perception that government policies would drive the market higher. Investment storylines talked about “concept stocks” linked to big themes such as state-owned enterprise reform and Mr Xi’s “New Silk Road” infrastructure blueprint for Asia and Europe.

Saturday, July 11, 2015

Capacity sans cargo - port development in India

The Economic Times reports that the Adani Ports and Special Economic Zone (APSEZ) is in talks with Warburg Pincus to buy out its 31.5% stake in the Gangavaram bulk cargo Port. This comes in the wake of news about advanced stage discussions between APSEZ and Larsen and Toubro (L&T) to takeover the latter's Rs 4000 Cr Kattupalli International Container Terminal near Chennai and the award of the Rs 6000 Cr Vizhinjam container port contract by the Government of Kerala to APSEZ. 

The APSEZ had purchased the Dhamra bulk cargo port with a capacity of 100 mt on Odisha coast from L&T and Tata Steel for Rs 5500 Cr in 2014. APSEZ already runs container terminals at Mundra and Hazira, and will soon start operations at Ennore. It had won the tender to operate a container terminal at Ennore with a capacity of 1.4 million twenty foot equivalent units (TEU) at an investment of Rs 1270 Cr by bidding an aggressive revenue share of 37%, the highest in any private port in the country. APSEZ is already India's second biggest container port operator after Mumbai's government owned JNPT. It handled 1.68 mt TEUs in April-December 2014. Vizhinjam will have a proposed capacity of 4.1 mt TEUs and Kattupalli has an available capacity of 1.2 mt. APSEZ's strategy of aggressive expansion through acquisitions has seen it increase the number of terminals and ports operated from just one in 2011 to eight today. The strategic sweep of these acquisitions, coupled with the nature of port sector activities, appears to raise concerns about competition and monopoly. 

The current available annual container capacity on the east coast is about 6 mt TEUs, whereas the actual volume was 2.3 mt in 2013.  This has meant that terminals like Kattupalli has been lying idle for lack of cargo. In fact, inside Andhra Pradesh itself, bulk cargo port capacity worth over 700 mt has been given out on concessions whereas the actual cargo realization is far less than 100 mt. Ennore and Vizhinjam put together will add over 6 mt of container capacity in the next few years. Given this capacity glut, for developers like APSEZ, there are very long term strategic acquisitions, though the possibility of cannibalization of traffic looks real.  

But for governments, such premature concessions looks most certain to turn out as very bad deals. Given the vast uncertainty associated with patterns and pace of development, such long-term mortgages of large extents of land and valuable water-front (there is only so much of deep draft sea-front available!) at today's terms and conditions represents extremely short-sighted policy making. This assumes even greater significance in light of the global business model in container ports. The port operator acts as a landlord, like with the major ports in India, and contracts with others to operate terminals. The resultant competition among terminal operators in the same port mitigates any monopolistic trends. In contrast, Indian terminal operators also generally own the ports.

Private ports in India have hitherto been contracted as entire ports, not terminals. This was understandable given the lack of ports themselves. Now that a number of ports have been contracted, any capacity addition should come from the full realization of the capacity of these ports. Again, as in Andhra Pradesh, while land has been allotted to realize capacity of more than 700 mt, just under 100 mt has been developed. Since developers are obligated to develop their full capacity within a contractually defined period, new capacity addition should come from the development of capacity in the already contracted out port. New port concessions have to be put on hold. Why isn't a PIL on this coming? 

Monday, July 6, 2015

Addressing India's Affordable Housing Challenge

The Ministry of Housing and Poverty Alleviation have estimated a deficit of 18.78 million housing units in 2011, with 95% among the lower income group (LIG) and below. To put this in perspective, the total number of housing units sanctioned in seven years under the flagship JNNURM is 1.44 million, of which less than 0.6 million have been completed and occupied. It is now proposed to bridge this deficit by 2022.

Public housing projects cannot make a dent on such a huge demand. Demand on such scale can be met only through the private markets. Unfortunately, the private market for affordable housing, especially for those at the lower part of the income ladder, is still-born. One of the perverse features of India’s urban housing market is that while 90% of the demand comes from those with annual incomes below Rs 500,000, whereas units for them make up just 10% of the supply.

Two factors contribute to this market failure. One, at prevailing costs, housing is simply unaffordable for the overwhelming majority of people, especially in the Tier I and Tier II cities, leave aside the metropolises. Two, the high costs of doing business in the LIG/EWS segment of the market exacerbate the problems, leaving this market commercially unviable for developers.

Alleviating this market failure requires public policy actions. The first step in bridging the affordability gap and catalyzing a vibrant private market in affordable housing is to enable access to housing mortgages. Public financing of housing in such large scale is simply impossible, leaving house-owner financing as the only alternative. Public support should come in the form of making ownership affordable.

Currently, lower income groups contribute a meagre share of mortgage origination. It is fairly reasonable to argue that this is not going to happen through market forces. Across the world, from Singapore to Mexico’s Infonavit, public policy has had a critical, often direct, role in enabling this access. The design of this arrangement has to be carefully structured as to maintain its credibility. It is fair to argue that access to mortgage market is a sine-qua-non for the achievement of the “housing for all” objective.

Once this access is enabled, the affordability gap can be bridged through a mix of subsidies and lower construction costs. Global experience shows that public subsidy in affordable housing has to come mainly in the form of interest subvention. The design of such interventions have to be carefully structured, so as to not create moral hazard and run the risk of such loans becoming non-performing assets, a reality across the country now, one which is an important factor in banks staying away from such borrowers.

A recent report on affordable housing by the McKinsey Global Institute estimated that construction costs will have to fall by 51% to support such housing demand. It advocates the lowering of construction costs through pre-cast materials, which does so both by directly reducing costs as well as lowering construction times (it is estimated that they reduce construction time by nearly a third, with resultant effects on cost of capital), use of modular construction technologies, and smart procurement approaches. But developers can leverage these benefits optimally if they are large enough.  

Another important contributor to construction costs are the transaction costs associated with dealing with public agencies and the uncertainties arising from time over-runs. It is estimated that developers require 60-100 permits of varying kinds, of which the problems faced in registration of land, its conversion, obtaining building approvals, utility connections, and occupation permits are debilitating. Taxation costs are prohibitive, as state governments have come to see the property market as primarily a revenue generation source. A 2010 McKinsey report estimated that 27% of the end-user cost of housing in Maharashtra came from taxes and levies.  

Finally, all these transactions introduce considerable uncertainty into the process, most often resulting in inordinate time delays in completing the project. It is commonplace for developers to have projects delayed by 24-36 months. The cost of capital almost doubles if a project with a two year construction timeline gets delayed by two years. While some share of the delays are also due to the vagaries of the market, delays in clearances and permits are arguably the dominant causes.

In a business where the developers leverage up heavily, cost of capital is the primary driver of profitability. Since the margins are very narrow in affordable housing, developers have limited cushion for uncertainties. The risks associated with time over-runs, with its cascading effect on cost of capital, are simply too large for developers to bear. 

The combined effect of limited reach of the mortgage market, large affordability gap, and commercially unviable construction costs has left the EWS/LIG housing market still-born. Since these constraints bind together, piecemeal approaches to addressing the problem are unlikely to be effective.

It is therefore no surprise that the current interventions that provide subsidies to developers and purchasers have had minimal impact. The Rajiv Awas Yojana (RAY) and the Affordable Housing Partnership (AHP) provide infrastructure capital grants to developers while the Rajiv Rin Yojana (RRY) and the Credit Risk Guarantee Fund Scheme (CRGFS) provide interest subvention subsidy to EWS/LIG house purchasers and credit guarantee to financiers of such units respectively. The limited uptake of these programs shows that response has not been encouraging.

Mortgage interest subsidy ought to take the largest share of public spending on affordable housing. But this requires the enablement of a mortgage market. Even with generous subsidies, catalyzing the mortgage market will require a host of enabling policies that mitigate the risk for lenders – a national credit registry (aadhaar-enabled) and/or psychometric tests to assess credit history, simplified mortgage foreclosure regulations, credit guarantees to banks on EWS/LIG mortgages etc. There may even be the need for a dedicated platform for channeling mortgage credit or an institution for mortgage re-finance.

Needless to say, any meaningful effort to create a vibrant mortgage market has to address the fundamental issue of lack of transparent market valuation of properties, distorted by the differential between the notified registration value and the actual market price. A bouquet of policies to lower stamp and registration duties, dispense with formal notification of registration values, limit circulation of black money in real estate transactions, create a database of property transactions and prices, stricter monitoring of housing finance transactions, and so on, would be necessary to address this problem.

All this has to be complemented with policies to lower construction costs through newer building technologies and processes, lower taxes, and considerably simplified approvals process. The entire process from land procurement to construction and occupation, for all housing projects, can be work-flow automated and its progress monitored on-line so as to minimize the harassment and delays in obtaining these permits. Since the vast majority of these projects are in municipal or urban development authority areas, the Urban Development Ministry in each state can be the nodal agency entrusted with the responsibility of monitoring and ensuring timely clearances. Developers can be encouraged to register into this by making such registration mandatory for loans, availing various benefits under government housing programs and so on. 

Policies like higher FSI for affordable housing schemes, transit-oriented development, and inclusive zoning, by increasing the depth and breadth of supply, too would contribute towards lowering housing costs.  Calibrated releases of the large hoardings of vacant lands in city centers with various public agencies and their densified development too can help put a downward pressure on property prices.

A mix of all of these coupled with the standard recipes - public housing projects, slum re-development, affordable housing mandates – may be necessary to make a significant dent on arguably our biggest urban development challenge. 

Sunday, July 5, 2015

China as development financier of emerging economies

A Beyondbrics column has this listing of China's global development finance dry powder.
This is nearly double the $200 bn capital that the World Bank can call on. This is apart from the hundreds of billions of dollars that China has already invested or loaned to African and Latin American economies. It is easily more than that available with infrastructure debt funds and the like, thereby positioning the country as the most important contributor to global development finance. 

Managing financial market turbulence by "feeling the stones"

The Shanghai and Shenzhen stock market indices have fallen 30% over the past three weeks, as deleveraging margin traders have wiped out $2.8 trillion in market capitalization, on the face of fears about the massive liabilities of financial institutions and corporates. 

In order to reassure and stabilize the markets, Chinese authorities have announced a slew of extraordinary measures. Even more dramatically, the government enlisted industry associations to announce voluntary commitments to stabilize the markets. 

The measures announced the government include relaxation of collateral rules on margin loans to prevent forced liquidation when collateral ratio declined below a certain threshold and extension of margin loan tenures; allowing real estate as an acceptable collateral for margin traders; permitting brokerages to securitize margin loans; crackdown on short-sellers and market manipulators; lowering transaction fees on stock trades by a third; and suspension of the approved initial public offerings (IPOs) of 28 companies (estimated to have realized $645 bn). Some like the suspension of IPOs were done earlier in 2012-14 for 15 months to boost the flagging market.   

The voluntary measures include a pledge by 25 fund managers to help stabilize the market; announcement by the Securities Association of China that brokers would not sell stocks as long as the Shanghai Composite Index remained below 4500 and buy back their own shares; decision by the Asset Management Association of China that asset managers would buy units in their own funds, roll out new products and hold on to shares for at least a year; and a voluntary contribution of $19 bn by 21 of the country's largest brokerages to the establishment of a market stabilization fund. Some of the measures like allowing real estate, non-listed shares, and "other assets" as collateral for margin traders and establishment of a fund to stabilize the stock markets are clear acts of desperation.

In a country where retail investors drive the equity markets, the negative wealth effect from the plunge in equity prices can be substantial. This assumes even greater significance in the backdrop of the government efforts to address one of the biggest structural distortions in the Chinese economy - the very low level of private consumption expenditures. Further, corporates and public sector entities too with their massive debt loads, are critically dependent on a booming equity market to raise capital and defray their debts. 

All these measures strike out against orthodoxy and are exceptional even by Chinese standards. Apart from being remarkable examples of a co-ordination success, the voluntary commitments by industry associations are also a testament to the enormous influence wielded by the government in the functioning of financial markets.

The secret of capitalism with Chinese characteristics has been the effectiveness of the Chinese state to translate its policy intent into reasonably successful outcomes. But, put together, the efforts to stabilize financial markets and manage an orderly deleveraging are likely to be severest test of the Deng's policy of "crossing the river by feeling the stones". The danger today is that the Chinese economy has grown too big and too complex that certain parts of the river are so deep that you cannot feel the stones. Managing a financial market crisis is far more complex than managing the calibrated deregulation of various real economy sectors, liberalization of the political system, and opening up of the financial markets. Not only are there too many parts to the crisis, with completely unknown  and unpredictable interacting reaction functions.  

It looks very likely that China may have entered the deeper parts of the river, where feeling the stones is no longer an option. It may have no choice but to swim against the currents and prevail.

Update 1 (11.07.2015)
More desperate measures with the China Securities Regulatory Commission banning investors with share holdings of more than 5% in a company from selling shares, announcement that the China Securities Finance Corporation, a government-backed fund which among other things also does margin financing for investors, would provide "abundant liquidity" to steady the market and would be effectively the conduit for the central bank to inject funds into the securities market, and directions to state-owned enterprises to buy-back their shares.

Update 2 (18.07.2015)

The scale of public bank lending to CSF was staggering,
The big state-owned banks have lent a combined Rmb1.3tn ($209bn) in recent weeks to the China Securities Finance Corp, for lending on to brokerages to finance their investment in shares and to purchase mutual funds directly... The CSF was established in 2011 to lend to securities brokerages to support margin lending to stock investors. Amid the tumble in equities, however, the government has deployed CSF as a conduit for injecting rescue funds into the stock market...Caijing, a well-known Chinese financial magazine, reported on Friday that the country's sixth-largest lender by assets, China Merchants Bank, provided the largest single loan, at Rmb186bn.

Saturday, July 4, 2015

Low level equilibrium in airline industry

Livemint has a story on Air Asia's turbulent first year of operation. In a sector where six airlines each disappeared in the first five years after open-skies in 1992 and since 2009, the immediate prospects look gloomy despite the boost to profitability from low fuel price (it declined by 24% between September 2014 and January 2015, or a 12% reduction in costs since fuel represents almost half the operational cost),
India’s airlines alone have lost more than USD10 billion combined since FY2009. Airline debt stands at around USD11.3 billion, rising to close to USD14 billion if liabilities to vendors are included. At an industry level airline debt is now equivalent to more than 100% of airline revenue. In FY 2015 traffic increased and losses declined but this was largely a function of lower fuel prices. 

Prohibitive operational costs, arising from higher taxes on Aviation Turbine Fuel (ATF) and high airport access charges, cut-throat competition which has bid down ticket prices to rock bottom, strongly price sensitive customer base, and heavy regulation are cited as contributors to the woes of airline industry. But for Indigo, all other carriers have been bleeding money for a long time and there is nothing to suggest any change in fortunes. No full-service carrier has made money on a sustained basis in the Indian market since the open-skies policy era began.

While all the aforementioned are important, there is a strong possibility that India'a airline industry may be entrapped in a low-level equilibrium from where exit may not be very easy. India is unique in that it is possibly the only large airline market without a significant full-service market. Low cost carriers make up nearly three-quarters of the domestic traffic, and a significant part of the full-service market is some version of the low-cost carrier model. This has had the effect of low-balling the reference price for low cost carrier tickets, further eroding their margin for profitability. In price-sensitive markets, since prices are very sticky upwards, recovering lost-ground from price-wars has proved very difficult. The willingness of public sector banks to keep supporting sinking promoters removed a critical backstop against the commercially destructive competition to the bottom. 

The absence of a strong full service market is also explained by the overwhelming dominance of the point-to-point service business model. Since regional markets are not large enough and are fragmented, no single full service carrier has the market power to operate a hub-and-spokes model, essential to the sustainability of a full-service model. Air India, the one full service carrier with the potential to leverage its size and international traffic to develop a hub-and-spokes model with regional hubs, has failed to do so due to its own inefficiencies and lethargy. 

Ironically, the rapid expansion of market share by Indigo, expected to rise from 36.4% in end-March 2015 to 45-50% in the next two years, can potentially help the industry break-out of the low-level equilibrium. It could help the industry regain some pricing power and increase profitability. However, it runs the risk of monopolistic dynamics that could adversely affect the long-term health of the market.

Update 1 (06.07.2015)

The IPO filing information of Indigo throws up a few interesting features. One, despite the lower fuel prices, its fuel cost as a percentage of the revenue for the last three quarters of 2014 was 48.4% against 31.3% for Jet Airways. Two, its maintenance costs at 3.1% of total expenses was just one-fifth of Jet Airways. 

Thursday, July 2, 2015

Grexit or haircuts

A country can reduce a very high debt burden by one or all of the three means - sustained GDP growth, persistent inflation, or write-downs. So how does Greece fare?

Far from growing, the Greek  economy has contracted sharply and sustained growth appears a chimera. Given its structural weakness and lack of competitiveness against other Eurozone members, economic growth prospects for the foreseeable future are not promising. In light of this, the debt to GDP ratio, currently at nearly 175%, cannot be expected come down to reasonable levels, even if the country accumulates no more debt or gradually pays down its debt. The lack of competitiveness also means that the strategy of export-to-growth too may be difficult without very sharp devaluation, which would in turn require Grexit. Inflating its way out is a very remote prospect as long as the country stays in Eurozone. In any case, Grexit and devaluation carries considerable contractionary risks for a country deeply dependent on natural resource imports. High inflation would only compound the problems.

It should be borne in mind that the recent balancing of fiscal deficit and current account deficits, driven by forced contraction of public spending and imports, are most certain to be temporary. Government spending has contracted 31% from Q1 2008 to Q1 2015 on the back of sharp pension cuts and 25% retrenchment of public employment. It is a testament to the severity of the contraction (and the weakness in private sector growth) that despite this, government spending as a share of GDP rose from 48% to nearly 60% in the same period. On the external account, imports contracted 38% between Q3 2008 and Q1 2015, whereas exports rose just 4% in the period, whereas current account deficit shrunk from minus 14.6% for 2008 to plus 0.6% for 2014. Clearly, apart from devastating the economy, these figures does little to support any belief in private sector led economic growth and export-led growth. For a country which has been historically running up internal and external deficits, there is little to suggest that this time (post-Grexit) will be different. 

The magnitude of the contraction in Greek economy in the 2008-2013 period has been staggering. It contracted by 24% in the period. If we assume a trend growth of 3% (the 2001-07 average growth was 4.11%), then the economy is 40% below its potential output. These are truly frightening numbers, comparable only to the Great Depression in the US.
This leaves write-downs as the only possibility to pare down debt. A comprehensive debt restructuring with significant haircuts is essential for any realistic plan to restore economic growth. Since the counterparties to these debts include German and French banks, its political acceptability will be in question. 

The troika bailouts of 2010 and 2012 involved no haircuts and the fresh loans only rolled over the existing debt, thereby kicking the can down the road. The ECB quantitative easing announced in July 2012 helped temporarily ease borrowing costs and buy time. Any new bailout has to perforce involve haircuts to not become a repeat of the previous two instances. Further, delaying the decision only weakens the Greek economy, prolongs human suffering, and increases the magnitude of the haircuts. Worse still it could have deeply destabilising effects on the political system.

So the country is now faced with the prospect of exiting the Euro and navigating a very turbulent "deep blue sea" or hoping that its Eurozone creditors agree to take haircuts. This Anil Kashyap note is an excellent primer.