Scaling up Aadhaar-based solutions

Business Standard chronicles the challenges with scaling up biometric validated distribution of rations from the Public Distribution System (PDS) in Andhra Pradesh. A few observations,

1. A transition to a digitally circumscribed validation-cum-distribution mechanism is a paradigm shift, likely to adversely affect several stakeholders. It needs to be done carefully, in a phased manner, slowly onboarding a critical mass of stakeholders. The success of scalability of an idea depends more on its social and political acceptability and internalization that its technological superiority. 

As an example, ten years back third party audits of engineering works were vilified for signaling a lack of trust in public engineering departments. Today, they have become business as usual, with even third party school testing becoming widespread. Ideas take some time to mature. Leadership and public policy can expedite this.  

2. Another reason for phased scale-up is that the supply side, especially in such emerging services, also needs time to develop. It is not just about procuring a few devices, recruiting people and running them. Building operational and managerial capacity is not easy and takes time. A district, leave aside a state, is a very large unit, especially when it involves covering the vast majority of the population. Poorly executed scale-up runs the risk of failures (exclusion errors, harassment of beneficiaries by having to come and go repeatedly etc) which could potentially provide grist to opponents to discredit the intervention.  

3. Public systems are entrapped in low-level equilibriums due to multiple forces interacting in mutually reinforcing and interlocking webs. For example, it is well-known that dealers have accommodated woefully inadequate commissions that make Fair Price Shops (FPS) commercially unviable only because of the ample opportunities for attractive rent-seeking by diverting stocks. This allowed fiscally squeezed governments, led by the respective Finance Ministries, skimp on commissions and condone rent-seeking. Any technological solution that unsettles this equilibrium will generate demands for adequate commissions, which run into budgetary constraints. There are no free lunches!

4. If we did not know it already, it would be useful to keep in mind that technology can only get you so far in addressing state capability problems. As the article itself highlights, several loose ends will still remain. Technology can identify duplicate and fictitious beneficiaries, but may not be able to screen based on eligibility. 

Shopkeepers can put weights in packets of rice and evade detection. They also use pre-packaged rice bags to generate bills, but later use manual weighing machines to deliver the goods to the beneficiaries... Many BPL beneficiaries claim their quota of rice for Rs 1 a kg, but sell it to middlemen for Rs 10 a kg.

5. Finally, for all the undoubted savings from these interventions, some of the numbers on savings being claimed by officials need more forensic analysis. For more, see this. 

The challenge of gentrification

Richard Florida (study here) adds clustering of talent based on the level of occupational creativity (knowledge-based Vs routine) with Michael Porter's theory of tradeable and locally-oriented industrial clusters (to create four distinct industrial-occupational categories), for over 260 metro areas making up three-quarters of US population, and comes up with very interesting findings,

Creative-in-traded employment is a key driver of both innovation and economic growth, according to our analysis. It is positively associated with higher levels of innovation (with a correlation of .61), higher levels of economic output per capita (.53), and higher wages (.6). (As usual, we note that correlation does not equal causation, but simply points to associations between variables). That said, creative occupations are more closely associated with innovation and economic growth (with correlations of .52 to economic output, .52 to patents, and .66 to wages) than traded industries (with correlations of .38 to economic output, .35 to patents, and .25 to wages). Furthermore, creative-in-local jobs are modestly associated with wages (.34) and economic output (.17), but not with innovation. On the other hand, both routine-in-traded and routine-in-local jobs are negatively correlated to wages and innovation, while only routine-in-local jobs are negatively associated with economic output per capita.

Further, creative occupations, tradeable and local, make up just 39% of the workforce, while routine-local occupations make up nearly 45%. The average salary in creative-traded occupations is 31% more than those of creative-local workers, 117% more than toutine-traded workers, and 182% more than routine-local workers. And these trends have been widening over the years.

Pointing to gentrification effects, it finds higher concentration of creative-traded occupations associated with greater inequality, and the same being magnified by housing costs, 

The share of creative-in-traded jobs is positively associated with income inequality (.31)... The share of routine-in-traded jobs (largely in manufacturing), for instance, is negatively associated with inequality (-.20). This divide is magnified by housing costs, which are higher in more knowledge-based metros... All four categories of workers have higher wages in more creative-in-traded metros. But, when we take housing costs into account, we find distinct winners and losers in these more advanced, knowledge-based metros. On the one hand, the two groups of creative workers end up being better off after paying for housing, with positive correlations for both creative-in-traded (.33) and creative-in-local (.36) workers. For both categories, their wages rise enough on average to more than cover the increased costs of housing in these more expensive metros. On the other hand... our analysis found a statistically insignificant correlation for routine workers in traded clusters, and routine workers in local industries are significantly worse off (with a negative correlation of -.43).

And its consequences are stark,

Higher wages in metros with larger creative-in-traded employment create greater incentives for more skilled and advantaged workers to migrate to these metros. As housing costs rise, routine workers—especially those in routine-in-local jobs—are shunted off to less expensive metros which, by definition, have smaller concentrations of higher-paying creative-in-traded jobs. This creates a vicious cycle in which the advantaged become more advantaged over time, while the disadvantaged sink further into poverty.

This challenge is most unlikely to be resolved anytime in the foreseeable future and the problem will keep getting worse. Cities in developing countries like India are witnessing such trends playing out on a much faster scale. Housing within a reasonable distance of the city center in large cities is out of reach for all but those at the top 1% of the income ladder. Government officials, with their quarters, and the small sliver of senior level private employees belong to this category. The booming suburban clusters and towns, into where private economic activity, especially in knowledge-based services, has been displaced, too are soon likely to experience similar gentrification effects, and so on. 

Standard public policy approaches, including those aimed at education and skilling, are unlikely to make any dent on the problem. Robust social safety nets (eg access to quality healthcare), massive affordable housing programs, re-skilling programs for dis-employed workers especially those engaged in routine-traded sectors, and equal access to inter-generational mobility opportunities (eg. top-quality higher education) have to be essential components of any public policy intervention to mitigate the consequences of this trend. It has to be complemented with far higher levels of taxation at the top of the income ladder to generate the additional resources required to support such policy interventions.

Weekend reading links

1. An ADB study tries to estimate the impact of a slowdown in China on global commodity prices. The impact varies across commodities and there is apprently more to the decline in commodity prices than China.

2. The major argument supporting the wide pay disparity across occupations revolves around a "skill premium" in sectors like finance and law. A Brookings paper by Jonathan Rothwell points to a paper by John Abowd and four others which examined administrative records of millions of Americans from the 1990-2011 period and finds high levels of "rents" or "gratuitous pay" - pay in excess of skills - in these sectors. They find that people working in finance and law earn 26% and 23% more, regardless of skill, whereas those in eating and drinking establishments earn 40% below their skill level. 

What's more, Rothwell finds that the rents have increased dramatically in certain industries in the 1980-2013 period, with that for workers in securities and investment industry rising from 41% to 60%, legal services from 27% to 37%, and hospitals from 21% to 39%, while those in eating and drinking establishments stayed stagnant at about minus 20%.

Rothwell finds that income from financial market investments like hedge funds and large entry barriers (pervasive among lawyers, doctors, and dentists, the three highest represented occupation groups among the top 1 per cent) are far bigger contributors to widening inequality than increasing share of capital income, technology, and superior skills.

3. Illuminating Citi report on the pension fund financing deficit facing the world economy. It estimates that "the total value of unfunded or underfunded government pension liabilities for 20 OECD countries is a staggering $78 trillion, or almost double the $44 trillion publicshed national debt number". The demographic shifts expected across the world are immense.

And the recommendations,

4. Fascinating graphic that captures the dominant revealed preferences of the counties that provide the biggest support base for Donald Trump.

5. The denser the area, less happy people are. But people still prefer to live in denser areas!

It is called the "urban-rural happiness gradient".

6. City Lab points to a fascinating study that captures the sounds (yes!) of localities in a very innovative and stunning visualization. A team of map, social science, data science, and acoustic researchers used public Flickr photos, their geo-location, tagged the photos with sound-related words, categorized the words into six categories (transport, nature, human, music, mechanical, and indoor sounds), and finally mapped the correlation between each category and the emotion it evokes! The maps are available for 12 cities across the world. 

India "missing" middle class fact of the day

This blog holds the view that contrary to perception, the Indian middle class may be far smaller than originally thought, thereby raising doubts about the assumptions held by businesses when they enter the country's market. The latest to hit the growth ceiling are the global fast food majors,

India’s once seemingly insatiable appetite for fast food has hit a wall at McDonald’s, Pizza Hut, KFC and other established global brands, deflating optimism that untapped demand in the 1.2 billion-person market will offset slumping consumption in the West and China. While the overall market for eating out is projected to expand, growth is slowing and less of it is happening at the international chains that were the trailblazers in India... The biggest global fast-food brands had been rolling out outlets at an ever-accelerating rate in Asia’s third-largest economy. Nearly half of Domino’s 1,000 stores in India, for example, were built in the past five years. But the anticipated take off in customers has been weaker than expected.

The tapering off was to be expected and the only uncertainty was how soon. That it has started binding at the initial stages itself is a matter of concern and lends further credence to the argument about the very narrow consumer base.

Update 1 (07.07.2016)

Livemint points to similar trends in e-commerce market,

After pumping more than $9 billion into Indian start-ups since the beginning of 2014, investors started pulling back late last year. For the first time in years, online retail sales in April were at a lower level than December of the preceding year, according to executives at top e-commerce firms... Experts said it is a worrying sign that customers seem to cut back the moment discounts are pulled.

“All of us had hoped that once we create the habit of buying online among consumers, they will keep buying even if discounts are reduced. Factors like a wide product range and convenience of getting products delivered at your doorstep would prove to be compelling, we had thought,” said a Flipkart investor, requesting anonymity, as he isn’t authorized to speak on this topic. “And this is happening with some consumers, but the fact is that a majority of them don’t buy unless you offer steep discounts. It’s true that e-commerce companies are yet to find new ways of growing the market quickly without the help of discounts,” he added.

Picking up the pieces from the latest oil bubble - history repeats itself!

Haven't we seen this before,

From 2004 to 2013, annual capital spending by 18 of the world’s largest oil companies almost quadrupled, from $90bn to $356bn, according to Bloomberg data. The assumptions used to justify that borrowing were fuelled by a textbook example of disruptive technological innovation: the advances in hydraulic fracturing and horizontal drilling that made it possible to produce oil and gas from previously unyielding shales. The success of those techniques added more than 4m barrels a day to US crude production between 2010 and 2015, creating a glut in world markets that has sent prices down 65 per cent since the summer of 2014. The expectations of sustained high prices have vanished: crude for 2020 delivery is $52 a barrel. Oil is now back to where it was in 2004, but most of the debt that was taken on in the boom years is still there.

The extraordinary monetary accommodation by central banks pushed investors in search for yields into oil and gas companies. Now, the signatures of the wreck caused by the boom and bust are seen across the market, 

From 2006 to 2014, the global oil and gas industry’s debts almost tripled, from about $1.1tn to $3tn, according to the Bank for International Settlements. The smaller and midsized companies that led the US shale boom and large state-controlled groups in emerging economies were particularly enthusiastic about taking on additional debt... Since the decline in oil prices began in mid-2014, activity in the Eagle Ford, one of the heartlands of the shale revolution, has slowed sharply. The number of rigs drilling for oil has dropped from a peak of 214 to 37... Since crude prices began to fall in the summer of 2014, investors in oil and gas companies have lost more than $150bn in the value of their bonds, and more than $2tn in the value of their equities, according to FT calculations... The decline in the industry’s cash flows has prompted huge cuts in investment, with about $380bn worth of projects delayed or cancelled according to Wood Mackenzie, the consultancy. 

Three observations

1. All rapid sectoral growth episodes will, more likely than not, end up in tears. Industry analysts, especially the cheerleaders of US shale boom, who gloated over the spectacular technological breakthroughs generally suffer from cognitive biases which nudged them into overlooking historical evidence and flashing warning signals. Who will hold up the mirror to infuse a dose of realism among all stakeholders during such booms?

2. No matter how rigorous regulatory restrictions are, euphoric times will always be accompanied by over-optimistic investments and reckless lending, and are almost always backed by governments. Financial markets simply lose their disciplining powers as the "irrational exuberance" takes hold. Someone has to "take away the punchbowl when the party gets going".

3. Commodity exploration lenders should eschew mark-to-market valuation of the borrowers commodity reserves, and resultant borrowing limits. In good times, when prices balloon, it encourages excessive lending, whereas during troughs, it engenders liquidity squeezes and insolvencies. A more prudent strategy may be to value them at a ten-year rolling average or a long-term trend price.  

The great Chinese "cash out"?

The Governor of the People's Bank of China (PBoC) has expressed concern about the rising Chinese corporate indebtedness, now at 160% of GDP. Corporate weakness has been rising alarmingly in recent months,

Data from the 1,627 domestically listed companies, or 58 per cent of the total, that have reported their 2015 earnings show a clear deterioration in fortunes. Average operating revenues per share fell to their lowest level so far this decade, sliding to Rmb5.4 from Rmb6.55 in 2014... In addition, just over one-fifth of listed Chinese companies reported negative cash flows during 2015 and about one-third owed at least three times as much in debts as they owned in assets.

The Governor's statement follows a week after the little known and reclusive Chinese private insurer with deep political connections, Anbang Insurance, made audacious $13 bn and $6.5 bn all-cash offers to purchase Starwood Hotels & Resorts and Strategic Hotels & Resorts. This takes the total volume of Anbang's foreign purchases to $32 bn in the last 18 months. 

Such aggressive deal-making, most often through all-cash transactions, have taken overseas spending by Chinese investors to $102 bn, just shy of the $106 bn record for all of last year. Data from the 54 overseas deals last year show that may of these transactions are "highly leveraged". This has also stretched Chinese banks, whose NPAs have risen to 1.3 trillion renminbi, itself most likely a heavy underestimate. 

Anbang's rise is symptomatic of rising corporate indebtedness and foreign deal making. For a firm which has never published an audited financial statement, does not divulge its owners or even executives, and does not disclose the business cases for its various investments, Anbang has been wildly successful in raising cash for such transactions. The all-cash offers are a way around the disclosure requirements and may reflect either lack of desirable level of assets or reluctance to disclose asset ownership. It also allows these firms to move at amazing speed in taking decisions and closing deals. 

The FT has this story which argues that the foreign deal making is motivated by a desire by the country's high net worth individuals to move away from renminbi-based assets and diversify their income sources into foreign currency denominated cash flows, 

A broader concern about China Inc’s acquisition spree stems from questions about why it is happening. Is it being driven by strength, or is it a reflection of the waning vigour of heavily indebted corporations in a slowing domestic market? To a significant degree, analysts say, the exodus of Chinese investment capital is in fact a “quest for cash flow”... the ample cheap credit available under Beijing’s loose monetary policies allows companies with good banking relationships to spend heavily overseas as a way to diversify away from their dwindling earnings at home.

But hedging against a slump in renminbi may not be the full story. Such purchases are also motivated by the emergence of the global Chinese consumer and strategic thinking,

Many of their investments are linked to the emergence of the global Chinese consumer. In residential real estate, Shanghai-based Greenland Group bought a majority stake in the Atlantic Yards development in Brooklyn, promising to help sell units to wealthy Chinese immigrants and investors. Part of the project has been renamed Pacific Park. Dalian Wanda, owned by China’s richest man, Wang Jianlin, has similar plans for its projects in Madrid, Australia’s Gold Coast, Chicago and Beverly Hills in Los Angeles.

In other cases, the motivation is to acquire foreign technology. China’s leaders have long said that they want national champions to move up the value chain, especially in basic commodity industries suffering from overcapacity, which has cut profit margins to the bone. Many of these deals are too small to grab headlines. In 2014, state-owned China National Building Materials acquired Avancis, a German manufacturer of advanced materials used in solar panels. This year’s $43bn bid by ChemChina, a large state-owned enterprise, for Syngenta, the Swiss agribusiness, was driven mainly by the Swiss company’s biotechnology and agrochemcial prowess.

Fund management fact of the day

More confirmation of the case against stock-picking from a global S&P Dow Jones study which analyzed the after-fee performance of 25000 active funds and,

... found that 100 per cent of actively managed equity funds sold in the Netherlands have failed to beat their benchmark over the past five years. Ninety-five per cent of funds sold in Switzerland and 88 per cent of those on offer in Denmark also underperformed... Overall in Europe, four out of five active equity funds failed to beat their benchmark over the past five years, rising to 86 per cent over the past decade... Within that sample, 98.9 per cent of US equity funds underperformed over the past 10 years, 97 per cent of emerging market funds and 97.8 per cent of global equity funds... On a one-year basis it is still possible to outperform, but it is very difficult on a consistent basis over the long run.

The overwhelming lesson for long-term retail investors in equity markets is to choose the low-cost index-tracking funds which have grown six-fold over the past decade to $2.9 trillion,

The average equity fund manager is unable to deliver outperformance from stock selection or market timing. This means a typical investor would be almost 1.44 per cent better off per annum by switching to a UK equity tracker. A small group of star fund managers are able to generate superior performance, but they extract the whole of this outperformance for themselves via fees, leaving nothing for investors. All but the most sophisticated investors should invest in index funds.

Amen!

The high rural-urban wage gap in India

Kaivan Munshi and Mark Rosenzweig examined the low rate of rural-to-urban migration in India and find rural insurance markets as responsible for keeping adult males in villages. They point to the significantly slower growth of urbanization in India compared to countries like China, Indonesia, and Nigeria. In fact, India's urbanization rate is about 15% lower than countries with similar GDP per capita.

Focusing on workers with less than primary education (who are likely to perform similar menial tasks in both rural and urban areas) to avoid confounding effects of returns to education, they find,

The wage gap for India, at over 45%, is actually much higher than the corresponding gap for the other two countries, which is about 10%. One reason why urban wages are higher than rural wages is because the cost of living is higher in urban areas. When we account for these differences in the cost of living, the Indian wage gap declines to 27%. Although the Chinese and Indonesian data do not allow us to make the same adjustment, the nominal wage gap in these countries serves as an upper bound for the real wage gap because urban prices will always be higher than rural prices. It follows that the real wage gap in India is at least 16 percentage points larger than it is in China and Indonesia. There is evidently some friction that prevents rural Indian workers from taking advantage of more remunerative job opportunities in the city

The authors attribute the friction to informal rural insurance networks which draw strength from social capital and threats of social sanctions in tightly knit rural communities, 

The explanation that we propose for India’s low mobility is based on a combination of well-functioning rural insurance networks and the absence of formal insurance, which includes government safety nets and private credit. When an insurance network is active, households that receive a positive income shock provide a transfer (in cash or kind) to one or more households in the network that receive a negative shock. This smooths the consumption of each household over time, making risk-averse households better off. In rural India, informal insurance networks are organized along caste lines...  Frequent social interactions and close ties within the caste, which consists of thousands of households clustered in widely dispersed villages, support very connected and exceptionally extensive insurance networks.

An undoubted role for social insurance in mobility frictions apart, there are at least a few confounding factors and (not water-tight) assumptions that come in the way of identifying causal mechanisms. For example, the higher income families, independent of caste, are more likely to be socially aspirational and, therefore, more likely to migrate, irrespective of the strength of caste links or the marginal utility of attendant social insurance. 

There are potentially other compelling hypotheses about such frictions. Fundamentally, it may not be unreasonable to argue that there are social/behavioural and economic factors that contribute to the friction. Apart from the loss of social insurance, the former may include a high level of social inertia, by itself - people just prefer to stay in the comfort zones of their community. There may be differences in the nature and conditions of similarly placed jobs in rural and urban areas (rural jobs of the same kind may be less demanding and, therefore, less productive) and in the general quality of life for those with similar incomes. The latter may include the lack of affordable housing, loss of welfare benefits, and so on. It is most likely that all these factors interact in a complex manner, with wide variations in their dynamics based on the socio-economic contexts, to generate the frictions that retard migration to urban areas. 

We need to examine interventions that can potentially relax these factors. For example, better transportation networks may lower the social inertia and encourage migration. Similarly, a portable social insurance mechanism (through Aadhaar) may lower the economic cost of migration. In any case, policies to bridge the high rural-urban wage gap documented in the paper can be very powerful income growth-boosters. 

Growth on steroids - the case of infrastructure sector

This blog has long questioned the fetish with emulating China and growing at 8-10% rates. Such growth is possible only through excesses, as was the hallmark of the 2003-08 growth episode - aggressive bidding by infrastructure contractors, reckless lending by banks, and lax contracting standards by the government. We are now picking up the pieces.

Livemint has this graphic which shows that bank loans outstanding to infrastructure and metals rocketed from 29.8% to about 47% in six years from 2005. 

And bank loans outstanding to infrastructure sector as a share of total non-food credit nearly doubled from 7.9% to about 14.5% in the same period.   

Such spectacular growth is akin to a sprinter on steroids, bad for health and simply unsustainable. It becomes all the more so when the economy does not have a broad enough base, in terms of various kinds of inputs, to support such growth spurts. And cleaning up takes years of slow growth and bitter suffering.

Unfortunately, neither businesses nor banks nor policy makers appear to learn from such experiences. The latest example of such excessive optimism may be in the solar power sector, where promoters have been bidding down tariffs hyper-aggressively. The steep fall in solar tariffs looks most likely another bout of irrational exuberance. This time too may be no different! 

Weekend Reading Links

1. The investment revival cycle for the Indian economy may be years, not quarters, away.

2. Gentrification is a massive problem in cities across the world, especially in developing economies, where housing is already unaffordable to all but those at the very top of the income ladder. NYT supports Mayor Bill de Blasio's affordable housing plan in New York which aims to build or preserve 200,000 affordable apartments. It is part of a proposal to rezone 15 large areas across the city so as to allow developers to put up taller buildings in return for mandatory affordable housing mandates. Cities in countries like India have to necessarily build in and ensure compliance with similar mandates in urban renewal projects.

3. The release of Robert Gordon's book has coincided with a surge in literature that appears to validate the hypothesis of a productivity slowdown. Opponents of the view argue that the measured annual labor productivity growth of 1.3% since 2005, compared to 2.8% in preceding 10 years, is due to mismeasurement of the consumer surplus due to social media and advances in information and communications technology. Chad Syverson refutes this argument,

I conduct four disparate analyses, each of which offers empirical challenges to this “mismeasurement hypothesis.” First, the productivity slowdown has occurred in dozens of countries, and its size is unrelated to measures of the countries’ consumption or production intensities of information and communication technologies (ICTs, the type of goods most often cited as sources of mismeasurement). Second, estimates from the existing research literature of the surplus created by internet-linked digital technologies fall far short of the $2.7 trillion or more of “missing output” resulting from the productivity growth slowdown. The largest—by some distance—is less than one-third of the purportedly mismeasured GDP. Third, if measurement problems were to account for even a modest share of this missing output, the properly measured output and productivity growth rates of industries that produce and service ICTs would have to have been multiples of their measured growth in the data. Fourth, while measured gross domestic income has been on average higher than measured gross domestic product since 2004—perhaps indicating workers are being paid to make products that are given away for free or at highly discounted prices—this trend actually began before the productivity slowdown and moreover reflects unusually high capital income rather than labor income (i.e., profits are unusually high). In combination, these complementary facets of evidence suggest that the reasonable prima facie case for the mismeasurement hypothesis faces real hurdles when confronted with the data.

4. Guess, which is the most protectionist country in the world, in terms of implementation of discriminatory trade measures in the 2008-15 period.

5. Greg Ip has a nice article that makes out the cases that higher capital ratios and greater certainty in the resolution process (through 'living wills') have considerably reduced the TBTF risks and the need to break up large banks.

6. China is exploring the resolution of bad assets on its bank balance sheets through various strategies. Something India should keep a close eye on.

7. Martin Wolf points to a presentation by Andrew Haldane on the effect of technology in the financial services sector. In particular, despite introduction of advanced technologies, the unit cost of financial inermediation has remained more or less stationary.

Globally banks still generate 40% of their revenues, or $1.7 trillion, from making payments. This is likely to be disrupted by the emergence of 'block-chain' technologies involving distributed ledgers which allow for real-time settlements. This, coupled with peer-to-peer services rasies existential questions for traditional banking services.

8. Block-chain technology, which is a sort of peer-to-peer system of running a currency, "is presented as a piece of innovation on a par with the introduction of limited liability for corporations, or private property rights, or the internet itself". Its ledger/database is distributed and can be downloaded, and are protected by clever cryptography.

9. Container shipping capacity which has doubled since 2000 may have reached "peak capacity". The current largest ship, the Mediterranean Shipping Company's Oscar class introduced in 2015 is 395 m long, 59 m wide, and carries 19,224 TEUs of containers. 

It is now felt that any gains in shipping from capacity expansion would be offset by the prohibitive costs of port logistics - handling, dredging, and congestion arising from handling such large loads of multiple ships simultaneously.

More of 'whatever it takes' and advance warning signs flashing

Mario Draghi continues to do "whatever it takes" to revive the Eurozone economies with a far more aggressive set of measures than expected. The latest being a cut in ECB's deposit rate by 10 basis points to minus 40 basis points, main refinance rate by 5 basis points to 0 percent, increase in monthly QE from 60 bn to 80 bn euros, and an expansion of range of assets purchased in QE from government debt, covered bonds, and small bundles of loans repackaged into asset-backed securities to cover corporate bonds.

Most importantly, the ECB will also henceforth provide liquidity through its targeted longer-term refinancing operations (TLTROs) at minus 0.4%, in effect paying banks to borrow money. The FT writes,

The ECB will hold four auctions — one each quarter from June 2016 to March 2017. Banks can bid for cash of the value of as much as 30 per cent of their loan book. At most, they pay nothing on the four-year loans, which they will not have to pay back until 2020 at the earliest. But if the banks lend more, then the ECB will pay them up to 0.4 per cent interest on the lenders’ loans with the central bank. Paying private banks to lend is novel, even for a generation of monetary policymakers used to rolling out shock-and-awe measures. Yet earlier designs of the TLTRO were touted as game-changers and in the end proved much less effective than ECB hoped. In a region drained of confidence, businesses and households might not want to borrow. Or banks could use the funds to invest in financial markets instead of expanding their loan books, pumping up asset prices but leaving the eurozone economy flat.

In other words, the success, if at all, of these measures, especially the new liquidity window, would critically depend on overcoming the banks reluctance to pass on the negative rates to their retail customers for fear of losing them. In its absence, these measures are unlikely to boost demand and investment and only likely to further erode bank's profitability. Further, it engenders several distortions in the bond and equity markets. The distortions will mount longer the rates stay below zero without igniting any revival in demand and investment.  

This latest decision deepens the uncertainty facing the global financial markets. There are atleast certain advance warning indicators of an impending crisis in the financial markets that may be flashing red. A recent BIS paper draws attention to the rising rates of high yield bond markets in advanced economies. The widening has been particularly sharp for US high-yield debt, reflecting the exposures to shale oil firms and fears of defaults,

Since mid-2014, the US high-yield spread more than doubled, reaching levels comparable to the peaks observed during the European debt crisis in 2011... One interpretation of recent events is that the high-yield rout is an isolated development, driven by US oil industry weakness; another is that this is a "canary in the coal mine" moment signalling broader fragilities. Recent experience, supported by academic research, suggests that sharp increases in credit spreads are a leading indicator of recessions. This is the case even when wider spreads initially reflect sector-specific strains: high-yield credit spreads started to rise in the technology sector at the beginning of 2000, just before the burst of the tech bubble, while financial sector high-yield spreads rose in 2007, before the Great Financial Crisis. Spreads of other risky securities in these episodes only started to widen when the broader economy turned down. More recently, while spreads have widened dramatically since the second quarter of 2015 in the energy sector, other credit spreads, including those on emerging market corporate debt, have crept up much more gradually. 

China steel fact of the day

From a fascinating Bloomberg story on China's steel sector problems,

The country’s leaders have vowed to reduce excess industrial capacity and labor in state enterprises even as they battle the slowest economic growth in a quarter of a century. China will eliminate up to 150 million metric tons of steel-making capacity in the next five years, the State Council said after a Jan. 22 meeting.

To put this in perspective, India's total steel production in 2014-15 was 91.46 mt!

The worrying world of negative interest rates

Negative interest rates may have broken new ground with relaxing the perceived technical constraint with the zero-bound. The ECB and central banks in Switzerland, Denmark, Sweden, and Japan have embraced negative interest rate policy (NIRP). It is estimated that globally there are now $7.7 trillion worth negative yield bonds outstanding. But the sheer scale and the likelihood of its persistence raise several uncertainties and pose troubling questions.

The ultimate objective of negative interest rates is to get savers to spend and business to respond by investing. But negative interest rates have so far largely been confined to long-term bond and money markets and on deposits parked with the central banks.

They have not been passed on to businesses and retail customers. This, as a new BIS report says on negative rates currently in place in Sweden, Denmark, Switzerland, Eurozone, and Japan, raises questions about its effectiveness in stoking demand,

The experience so far suggests that modestly negative policy rates are transmitted through to money market rates in much the same way as positive rates are. It also appears that they are transmitted to longer-maturity and higher-risk rates, although this assessment is clouded by the impact of complementary monetary policy measures. By contrast, so far retail deposit rates have remained insulated, partly by design. And, at least in Switzerland, negative rates have actually raised, rather than lowered, mortgage rates... there is great uncertainty about the behaviour of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period. It is unknown whether the transmission mechanisms will continue to operate as in the past and not be subject to "tipping points".

Banks have so far been reluctant to pass on the negative rates to deposits for fear that it will encourage depositors to exit and retain their money as cash. This also takes negative rate lending off the table. Banks have been betting on the view that the negative rates period will soon pass and appear to be holding out in expectation. But if, as it seems likely, the negative rate period endures for a long enough period, it will start seriously undermining the business models of not just banks but also insurers, both of whom rely on higher long-term returns. 

Another BIS report has raised concerns about the effect on persistence of negative rates on bank's viability as financial intermediaries,

Uncertainty about banks' earnings prospects have been heightened by the expectation that negative policy rates and exceptionally low interest rates out the yield curve may prevail for longer than originally anticipated. Interest margins have been squeezed, given banks' reluctance to pass negative rates on to depositors. Banks seem to have coped with the operational challenges so far, but this offers limited comfort if rates move lower and stay negative for a prolonged period.

Further, an increasing share of sovereign debt in Japan and Europe have been pushed into the negative territory, more than 60% in Japan. In Europe, this shrinks the pool of sovereign securities eligible for purchases under the ECB's asset purchase program, which prohibits their purchases. This narrowing of the scope of ECB's program naturally reduces its effectiveness, thereby forcing banks to pass on negative rates to depositors. If this starts encouraging depositors to convert to cash, fears about the viability of banking business models could start becoming real. 

Recently Japan followed Switzerland to issue 10 year bonds at negative rates. In other words, investors were paying to hold the debt of the most indebted major economy. Large regular investors like pension funds and banks stayed away and left market participants worried about unforeseen risks,  

The buying appears to have been almost entirely dealers and speculators looking to hold the paper for a brief time or covering short sales accumulated in expectation of the yield dropping into negative territory. Traders expect much of it to be flipped directly back to Japan’s central bank in a few weeks as part of a bond-buying programme, also designed to stimulate the economy... As well as forcing wholesale adjustments to the structure of many investment products, analysts at Nomura have warned that the JGB market could now be prone to regular phases “where fair prices are no longer obvious”... Another motive behind the dealers’ buying appears to be a straightforward play on the BoJ’s upcoming “rinban” bond purchases and the opportunity to sell to the central bank at a profit.

In fact, these are signs of a 'carry trade' developing within 10 year bonds, in anticipation of volatility. If the yields go further down, speculators could pocket gains from the increases in the price of their bond holdings, and so on. But how far it can go down? And for how long can it persist? Nobody knows with any degree of comfort. This is clearly a Knightian world.

Update 1 (21.03.2016)
Gavyn Davies has concerns about the negative rates on bank profitability given the difficulty of lowering deposit rates below zero.

Update 2 (18.04.2016)
Excellent primer on negative rates here and the IMF on the beneficial effects of negative rates.

Update 3 (10.06.2016)
Concerned at losing profitability due to negative interest rates, at least some German and Japanese banks are apparently considering keeping their excess cash in safe deposit boxes inside underground vaults instead of paying to keep them with the central banks! However, this would incur various storage costs (rent, security etc) and insurance fees. It therefore would mean that one physical limit to how much low the rates can get would be the total storage costs.

The march of the "market perception" fairy

Amid all the discussion surrounding the build-up to India's recent Union Budget, the big struggle was between those advocating staying the course with fiscal consolidation and those arguing for deviating to revive the investment cycle by raising public spending. 

The former argued that any deviation from the pre-defined fiscal consolidation path would raise questions about the government's commitment to reforms and alarm the financial markets. Foreign investors will hesitate and private investments will not be forthcoming. The latter opposed this view arguing that given the strained corporate and banking sector balance sheets, public spending was the only economic engine with the firepower necessary to trigger investment revival. The small fiscal cost would be more than offset by the potential gains from revival of growth.  

The government stayed the course with fiscal consolidation and markets have been expectedly euphoric. It is now reasonable to presume that the market reaction could have been extremely adverse if the government choose to abandon fiscal consolidation. So the fiscal hawks won this round. And have been winning for sometime now. But these may be Pyrrhic victories and not be in the best interests of the country.  

This episode is illustrative of the shift that has taken place in India's economy policy narrative in recent years. I have written about it earlier here. Courting and satisfying the "market perception" fairy has become the guiding principle of economic policy making. Apart from fiscal consolidation, this fairy likes lower taxes, deregulation, reduction in subsidies, and PPPs in infrastructure. The followers claim that any policy initiative that goes contrary to these, howsoever objective and prudent, and expedient for the circumstances, runs the risk of antagonizing the fairy and bodes ill for the economy. 

It is a reflection of the extent of ideological capture and resultant social internalization of the elites representing corporate India that their idea of reform equates with only such policies. Any thing to the contrary is "socialist" and all else, including in areas as important and health and education, are of marginal value and therefore best consigned to footnotes.

Unfortunately, this capture of the policy making narrative is as much corrosive and distortionary as the pre-nineties socialist orientation of the Indian economy. It is as much disturbing a capture of policy making by crony capitalists and corporates, as was the case in the bygone socialist era with the neta-babu nexus. The Budget tussle is only another reminder that capitalism needs to be saved from capitalists.

Weekend reading links

1. From The Economist on India's e-commerce marketplace,

In the next 15 years India will see more people come online than any other country. Last year e-commerce sales were about $16 billion; by 2020, according to Morgan Stanley, a bank, the online retail market could be more than seven times larger. Such sales are expected to grow faster in India than in any other market. This has attracted a flood of investment in e-commerce firms, the impact of which may go far beyond just displacing offline retail.

I am not sure of this simple linear extrapolation of the market size, prompted by China's 600% expansion in the 2010-14 period. The underlying assumptions about the size of the Indian middle class and the ability of squeezing large incremental value once customers are captured are largely questionable. And the price sensitive nature of the majority of customer base means that phasing out the discounts may lead to large attritions. 

2. Fascinating long forms in FT on 'land grabs' across Ethiopia, Indonesia (where deforestation loses 100,000 soccer pitches of dense rainforest each year), and Myanmar. The Myanmar essay is about a 4000-acre special economic zone with 'deep sea port' facilities being built involving mainly Chinese firms at Kyaukphyu, which is being touted as a 'mini-Singapore', potentially providing a trade corridor between China, Africa, and the Middle East. Kyaukphyu is also the origin of a nearly 800 km twin gas and oil pipelines, each a meter wide, landing in China's Yunnan province and a gas terminal off its coast.

The gas pipeline project started operations in 2013 and oil pipeline in 2015. Its geo-strategic importance for China is immense,

Kyaukphyu links the Middle Kingdom to seaways towards south Asia, Africa, the Gulf and beyond. It cuts the long and sometimes perilous journey round the Strait of Malacca, which has long been a piracy hotspot. It also reduces China’s reliance on this crucial channel, to which the US Navy has access through its Southeast Asian regional allies.

The project has aroused resentment in the area among locals who were forced to give up their land without any transparent and fair compensation and rehabilitation process. As one of the workers said, 

I work as a casual labourer on my own land. I am doing it just to survive... I can only eat when I work now. I have to wish that someone will ask me to come and work for them. When I had my own land, I didn’t have to feel that way.

3. An investigation by the Competition Commission of India (CCI) finds that the five biggest tyre manufacturers, who  control 83% of the market, were guilty of cartelization in the 2011-12 to 2013-14 period. Business Standard points to the CCI report,

Despite a significant decline in input costs, particularly in 2012-13 and 2013-14, prices were kept higher, which could not have been possible without an agreement among these companies. The presence of conducive conditions in the market facilitated a cartel among the companies... Despite slack tyre demand in in 2012-13 and 2013-14, the companies were able to significantly enhance operating margins, a strong indication of coordinated action... The increase and decrease by similar magnitude during 2011-12 to 2013-14 indicated tyre prices moved in tandem.

Such anti-competitive practices are pervasive in India's corporate sector and rarely get the attention that they deserve. 

4. The Dutch Institute which monitors international trade has reported an alarming 13.8% decline in global trade value in 2015 on the back of a 40% decline in oil prices and 14% in that of other commodities, coupled with weakness in China. 

A few interesting trends. One, even as the dollar value of international trade has declined, its volumes have remained on the upward trend. Second, in fact since 2005, growth in international trade volumes have remained ahead of industrial production (or value added in mining, manufacturing, and utilities). Third, the decoupling in value terms between industrial production and world trade. 

The big disturbing trend, evident since mid-2014, has been the declining value of international trade, even as industrual value addition has been rising. 

5. Livemint reports that India has emerged as the world's largest PE and VC investment destination, attracting $22.4 bn in 2015, the highest ever, and a 47% increase over 2014. 

A vast majority of these investments are focused in ecommerce, real estate, and IT sector. Unlike the rest of the world, investments in distressed assets is a very small proportion of the investments in India and venture capital investments have tended to dominate. Given the perilous state of the banking sector and the large pool of leveraged buyout (LBO) dry powder available with PE firms, as well as the limited depth of India's financial markets to absorb and restructure large volumes of stressed assets, it may be a good idea to encourage PE investments in asset resolution. 

Such PE funds would bargain hard, force large haircuts, and would naturally raise concerns about asset stripping and windfall gains. The absence of adequate regulatory oversight and systemic weaknesses amplify those concerns. But given their expertise in structuring and managing leveraged buyouts of stressed assets across the world, it is surely an experiment well worth the cost.

6. Finally, Edward Luce,

Nations, it seems, suffer from similar disorders to humans — what happens in their formative years shapes their character for evermore. Just as India sees foreign investors as potential colonisers, and Britain confuses Brussels with the papacy, so the US is enchained to its original sin of slavery. Half a millennium after the first Africans were shipped across the Atlantic, the US still has one foot in its past.

Making a crisis count - disciplining the markets

One of the most disturbing consequences of the Global Financial Crisis may well be its impact on distorting financial market incentives. It cannot be denied that the post-crisis bailouts and the unabated growth of Too-Big-To-Fail (TBTF) institutions, coupled with the persistent fragility of the global financial markets have entrenched the growing belief among the most influential market participants about a public bailout insurance. 

MR points to the Bailout Barometer estimate of the Richmond Fed which shows that the share of private financial liabilities which appear to have explicit or implicit (based on past government actions and statements) government protection has grown to 61% as of December 31, 2014. 

This 'financial safety net' constitutes the most credible 'smell test' of the systemic weakness of modern financial markets. It seriously erodes the market's disciplining powers and sows the seends for the next crisis. In light of the entrenched social beliefs, governments would need to go the extra mile to shake this settled wisdom. In fact, regulators have to establish a credibility of TBTF equivalent to the inflation-fighting credibility of central bankers. 

Irrespective of whatever regulatory and systemic changes , such credibility comes only with decisive action to that effect during a crisis. But when faced with a crisis, financial market regulators and their political masters have hitherto preferred to elevate short-term considerations of preventing contagion over long-term incentive compatibility concerns. This stands in contrast to central bankers who have resisted the urge to reflate, even at the cost of significantly damping a growth cycle, when faced with inflationary pressures. Financial market regulators need to exhibit similar resolve and independence during a financial crisis to be able to reverse the trend of rising financial safety net and thereby create a healthier and more efficient financial market. 

This assumes significance for India as it grapples with its bad loans problem. It is a great opportunity to definitively dispel the growing bailout moral hazard and let the markets punish greedy promoters and reckless lenders, even if it means a delay in the revival of the investment cycle. 

The manufacturing challenge - what is Bangladesh doing right?

It is well known that premature de-industrialization is a major obstacle to job creation and economic growth for the next generation of industrializers hoping to emulate the path of China and other East Asian economies. 

This UBS report for the World Economic Forum has two graphics that capture the contrasting trajectories of manufacturing sector growth among developing countries. The first graphic looks at the trend in manufacturing's share of output after the demographic inflexion, when the share of workforce exceeds 60%, for the early industrializing emerging economies. The trajectories show distinct upward trend.

The second graphic captures the trajectories for the late (say, post-nineties) industrializers. 

In all these economies, the trend before and after the demographic inflexion has been stagnation or decline. It is remarkable that apart from Turkey, where it is marginally higher, the share of manufacturing in all these countries is today lower than at the time of their inflexions. 

The demographic inflexion years for the various economies - India: 1996; China: 1981; Korea: 1977; Thailand: 1984; Indonesia: 1991; Brazil: 1990; South Africa: 1995; Mexico: 1997; Turkey: 1992; Malaysia: 1993; Vietnam: 1998; Bangladesh: 2003; Egypt: 2002. 

From this, the two standout economies, which have managed to buck the secular trend on premature deindustrialization have been Vietnam and Bangladesh. Coincidentally, Rahul Jacob has this article in Business Standard which may have some clues on what they are doing right compared to countries like India. Bangladesh continues to impress and puzzle.

The CEZs will be no different

Preferential treatment industrial enclaves like Export Processing Zones (EPZs) and Special Economic Zones (SEZs) have been a staple of industrial and export promotion policy in India for decades. The Business Standard has an unflattering assessment of their legacy,

A CAG report in 2014 sampled 152 SEZs and found under-performance on targets in exports (ranging from 46 per cent to 93 per cent), employment (ranging from 65 per cent to 96 per cent) and investment (ranging from 24 per cent to 75 per cent). In case of exports, the CAG reported that there is a shortfall of almost 75 per cent in actual exports (Rs 100,579 crore) vis-a-vis projected figures (Rs 395,547 crore) in 84 developers/units in nine states between 2006-07 and 2012-13. Land appeared to be the most crucial and attractive component of the SEZ Act. Of 45,635.63 hectares notified for SEZ purposes, operations commenced in only 28,488 ha (62 per cent). Around half of the land allotted remained idle despite approval in 2006. The CAG observed that SEZs in India took tax concessions worth Rs 83,104 crore between 2006-07 and 2012-13. Further, a ministry of finance study estimated the loss from tax holidays granted to SEZs between 2004 and 2010 at Rs 175,487 crore.

The latest repackaging of clusters comes in the form of the proposal to create mega Coastal Economic Zones (CEZs) to promote industrial export growth. But the paper's prescriptions to improve effectiveness and increase the output of CEZs is unlikely to make much difference. This is because, fundamentally, SEZs and similar enclaves in India are marketed (by governments) and perceived (by businesses) as fiscal concession zones instead of reform zones which can be scaled across the zone borders. And such fiscal concessions can impact, and that too marginally, only already planned investment decisions, most often inducing them to shift to these zones. Rarely do businesses make new investment decisions because an SEZs has come up. 

In fact, there is a rich body of research surrounding such clusters which find that their success depends primarily on unique geographical and other locational advantages rather than conscious policy decisions. Accordingly, policy making to promote industrial clusters in developed economies, with its logic of economies of scale in backward and forward linkages and informational spillovers, may be another classic example of logical consistency conflicting with real world evidence. 

In his recent book, Other People's Money, John Kay highlights the difficulty of replicating economic clusters by examining the growth of the three main models of start-up/SME financing – the Silicon Valley VC-based financing, mainly focused on IT and technology services; the local bank finance based German Mittlestands; and the Israeli relationships based electronics SMEs. Each, he says, is the result of “particularities of history, culture, and environment which are probably irreproducible elsewhere”. This, coupled with Ronald Coase and Ning Wang's excellent refutation of the top-down Chinese SEZs growth narrative, hold compelling arguments against pitching industrial policy around cluster-based investments and growth. It is difficult not to agree.