The growing worries for pension funds

The growing deficit pile between the assets and liabilities of pension funds, especially in developed economies, should count as one of the least discussed public policy challenges. The problem is masked by the classic time-inconsistency issue - it is not my problem since my successors have to deal with it. But the day of the reckoning may be approaching faster than expected, thanks to quantitative easing. 

FT has an excellent read on the troubles facing pension funds. The unavoidable headwind comes from demographics... 

... which has been compounded by the secular decline in bond yields

Both these have had the effect of widening the gap between the assets and liabilities of pension funds.

It can, therefore, be said that pension funds face the triple whammy of declining birth rates, increasing life expectancies, and historic low bond yields. While little can be done about the first two, the third has been a largely self-inflicted phenomenon. They have been among the worst affected by the extended monetary accommodation in developed economies and its attendant distortions. Apart from these, lower rates contribute to higher valuations on equities, which in turn limits the expected future returns from the equity portfolios of pension funds. 

The latest to experience turbulence from these forces is the world's largest pension fund, Japan's Government Pension Investment Fund (GPIF), which announced a whopping $52 bn quarterly investment loss in the second quarter of 2016. 

A few decades back, employers replaced defined benefit (DB) plans with defined contribution (DC) ones. The consultancy Willis Towers Watson estimates that the latter accounts for 48% of the $35.4 trillion in pensions in 19 developed countries today. While the DC plans shifts the risk away from employers, it merely transfers it to the employees, and through them the governments. Consider the scale of the savings challenge, 

Many savers started contributing when it seemed reasonable to expect strong returns over their lifetimes. A popular metric was that savers who put away 8 per cent of their income every year for 40 years would be able build up an income of 75 per cent of their final earnings by the time they retired... this approach would have worked with real returns, above inflation, of 5.5 per cent per year. This is roughly what a US-based portfolio of 60 per cent stocks and 40 per cent bonds has achieved since 1951. But if future returns drop by only two percentage points, to 3.5 per cent, savers will need to put aside almost 15 per cent of their income. With bonds and stocks now historically expensive, 3.5 per cent is if anything optimistic... If someone today invested $100,000 in a balanced portfolio of stocks and bonds, they could expect a return of $21,800 over the next two decades after costs. Ten years ago, that same investor might have expected to make $60,000, and three decades ago $150,000... At the end of 2013, the median 401(k) plan held by US households near retirement had a balance of $104,000, according to the National Institute on Retirement Security. Following the typical actuarial recommendation of withdrawing no more than 4 per cent a year, this would provide an annual income of about $4,000.

The actuary, Mercer, estimates that UK's largest 350 listed companies face a pensions funding deficit of £149bn, as their assets, £721bn, far outstrip their liabilities, £870bn. The situation is no different in the US where a doubling (105% increase) of pension fund assets has accompanied a near quadrupling (278% rise) of liabilities, according to actuarial group Ryan ALM. Mercer estimates unfunded pension liabilities among the US S&P 1500 companies to be $562 bn by end-July, up by $160 bn in just seven months!

There are two issues that come to mind. The first concerns how long can the unfunded liabilities widen? Now with rates having fallen sharply to close to the zero lower bound since the Great Recession and not likely to rise much in the foreseeable future, the unfunded liabilities are only likely to widen further. As the article shows, some of them are already facing the crisis on not being able to even finance their current liabilities.

Second, the pensions deficit raises a fundamental question about how much of such social safety nets can be self-financing. Pensions have a very short-history of about a hundred years. Till now, favorable demographics (in terms of rising workforce participation), and long period of post-War economic boom (which kept open a pipeline of attractive investment opportunities), coupled with the transition from DB to DC plans, may have given the impression that pension schemes can be self-financing, at the most require only cross-subsidy. But now, with all these conditions having reversed, the ability of pension schemes, even the DC ones, to meet their objectives is becoming questionable. 

The nuanced case for policies to improve productivity

The conventional wisdom on productivity is tied up with capital formation. As businesses make capital investments, it increases worker productivity. 

I have three problems with this line of reasoning, especially for developing countries grappling with the challenge of providing jobs for the new workforce entrants as well as those moving out of agriculture. For these countries, productivity improvement is just a means to achieve increased incomes for their workers as well as to create new jobs. But it can be so that while headline productivity numbers improve, increases in worker incomes may be disproportionately lower. 

To start with, productivity enhancements can come from investments in either physical technologies or human skills or both. Improvements in physical infrastructure - plant and machinery, information and communication technologies etc - increases the productivity even with minimal incremental human capital formation. A semi-automation of factory floor in a low technology manufacturing also increases output considerably without much worker capacity augmentation. Returns from such investments are disproportionately likely to be captured by the owners of physical capital. 

The second concerns the capital investment focused definition of productivity. What about productivity that is driven by increases in human capital formation – education, skill acquisition, etc? The less developed countries are characterized by poor levels of primary school learning outcomes, abysmal rate of employability among professional graduates, very low penetration of skill trainings, and limited use of apprentice system. Or the use of better management tools by the millions of small enterprises that dot the economic landscape of countries like India. Given their massive antecedent lags, there is a huge potential for large productivity gains from improvements in any of them. In fact, in terms of bang for the buck, investments in these areas are likely to be far superior in resource-constrained countries. Alternatively, the returns from every unit invested in human capital formation far exceed that invested in physical capital formation. 

It is, of course, true that co-ordination problems and externalities come in the way of the practical realization of gains from human capital investments. Why should the private sector invest in human capital formation if it cannot appropriate the full benefits from such investments? How can public financed skill training and apprentice promotion schemes be closely integrated with industry requirements? But these are matters of getting the enabling policy and implementation design right than policy design failings.  

My last problem with capital investment focused productivity improvement strategy comes from its adverse impact on jobs. There is a very rich body of evidence that robots and automation have been destroying or displacing jobs. It has even been estimated that a majority of today's jobs are at risk of being replaced by automation.  

Productivity enhancement which comes at the expense of jobs imposes prohibitive welfare costs. This is more so for developing countries, where social safety nets are grossly inadequate. Here, the rate of job destruction far exceeds that of job creation. 

Public policy in developing countries seeks an unqualified increase in productivity improvement through increases in physical capital formation. This is reflected in the large subsidies and fiscal concessions provided to encourage capital investments. In fact, industrial policy in these countries is largely about fiscal concessions. In contrast, initiatives that enhance human capital investment is largely forgotten and, therefore, marginalized. Public support for physical capital investments are orders of magnitude more than that for human capital investments. This should constitute arguably the least discussed and among the most important resource misallocation problems in the context of poor human capacity constrained developing economies.

The policy implication of this argument is that the unambiguous focus on productivity improvements through physical capital formation need to be more nuanced. We need to acknowledge that, while very important, it may not be an unalloyed good. For poor developing countries with weak human resource development, the pursuit of productivity enhancement should involve encouraging both human and physical capital formation.

The problem with unfettered free trade

An unequivocal acceptance of free trade has been a central theme of mainstream macroeconomics for decades. It is argued that factor markets adjust over time to generate superior outcomes. Among all the tenets of the Washington Consensus, this alone continues largely intact. 

But in recent years, as the dynamics unleashed by the emergence of China has played itself out, some influential voices, including those from the right, have started questioning the conventional wisdom. In fact, David Autor, David Dorn, and Gordon Hanson have even claimed that import growth from China caused 2.4 million jobs in the US over a dozen years. 

At a conceptual level, for the world as a whole, there is no doubt that free trade leads to better outcomes. But there are at least two problems with this line of reasoning. 

1. The world is politically organized as countries and regions. The world as a whole matters little in political terms, and is largely an academic construct. When seen in terms of individual countries or even more so among regions, there is very little evidence to suggest that free trade leads to superior outcomes - increased output and more jobs - even in the aggregate. Labor market adjustments take time and a large share of those displaced end up with inferior jobs and lower lifetime incomes. And there is nothing to suggest that comparative advantage in certain sectors offsets the loss in output and jobs due to lower competitiveness in other tradeables.

2. Then there is the fairness argument. Even the most ardent free traders accept its adverse distributional consequences. But they rationalize this by saying that governments can enact policies to mitigate this by facilitating labor market adjustments (re-trainings and re-skilling etc) and through transfers by appropriating from the winners and giving to the losers. But here too, there is scarce evidence of such hopes materializing. In fact, given the reality of the political economy in developed or developing countries, especially in the present times, the winners are far more likely to resist and prevail over any attempts to appropriate a share of their gains. To paraphrase Machiavelli, the greed of the influential few is most certain to overcome the requirements of the powerless many! In other words, not only is there little evidence of re-training and transfers, political economy militates against its realization. 

Given this, all arguments for unfettered free trade are essentially faith-based arguments. This assumes significance since India is in the process of negotiating free-trade agreements with many countries. Yes, we need to embrace free trade. But we should be aware of its consequences and negotiate hard to obtain adequate safeguards for those sectors most likely to be vulnerable to trade-induced disruptions. This has to be complemented with a re-skilling programs and robust enough social safety net that rehabilitates and cushions the losers. 

The costs of formality in land titling

I have blogged earlier about the high, often prohibitive, costs associated with formality in manufacturing, labor market, and real estate. In simple terms, in the absence of any reduction in complementary costs, formality introduces layers of compliance costs which the demand side in these markets cannot support. All sides to transactions in these sectors, therefore, prefer to keep them informal.

The MR folks point to a paper by Sebastian Galiani and Ernesto Schargrodsky, who studied a natural experiment involving allocation of land titles to very poor families in the suburbs of Buenos Aires, and found similar costs associated with formal land titling,

Although previous studies on this experiment have found important effects of titling on investment, household structure, educational achievement, and child health, in this article we document that a large fraction of households that went through a situation at which formalization was challenged (death, divorce, sale/purchase), ended up being de-regularized. The legal costs of remaining formal seem too high relative to the value of these parcels and the income of their inhabitants... The cost of processing the inheritance of an asset valued at US$ 11,700 is about US$ 2,300... When property rights are transferred to very poor people, preserving legal tenure will likely entail onerous expenses in the form of attorney and public notary fees, and courts costs. In addition, these charges are higher in relative terms in very unequal societies where the gap between the poor and the relatively well-off is wider.

These low-level informality equilibriums are rarely ever broken with regulatory changes. They require economy-wide changes whose benefits by way of lowering the cost of transactions offsets the increased cost associated with going formal. 

India banking sector - a long road ahead

Livemint has this assessment of the Strategic Debt Restructuring (SDR) scheme initiated by the Reserve Bank of India (RBI) last year to address the issue of bad bank loans,

In the 14 months since it has been introduced, banks have invoked the provisions of SDR in at least 21 cases... they have converted debt to equity in only four cases... Of these, they have closed out only two. Difficulties in finding buyers, disagreement over valuations and even the choice of merchant bankers used in the SDR process seem to be impeding closure... some of the probable buyers that came on board eventually exited due to creditors’ concerns around their genuineness and source of funding, among others... In most of these deals, the banks are required to take a serious haircut, which is something that they are not interested in.

The SDR entailed converting debt to equity, taking over management, and finding a buyer in 18 months, failing which the asset became classified as a Non-Performing Asset (NPA) with all requisite provisioning requirements. As if acknowledging its failure, in June, the RBI introduced another scheme, the Scheme for Sustainable Structuring of Stressed Assets (S4A), which allowed banks to convert up to 50% of debt into equity without the need to find buyers immediately.

This problem does not have any immediate and easy solutions. Given the size of the NPAs, Rs 6.3 trillion as of end-June, and more likely to be much higher, there are at least two binding constraints on both supply and demand sides. On the supply-side, as mentioned, the banks are clearly unwilling for various reasons, the vigilance enquiry concerns being primary, to take anything close to the reasonable haircuts required to make such assets attractive to buyers. Given the persistent global economic weakness and related uncertainties, as well as the risks associated with restructuring such assets, it is not surprising that investors demand very high haircuts. In any case, the valuations of many of these assets are far below their liabilities. On the demand-side, the market is too narrow, in fact by orders of magnitude, to absorb these assets. Apart from the finances, the human resource and corporate capital available to manage and restore the health of bad assets too is acutely scarce. And neither of these can be addressed soon.

Apart from this, there are several other operational challenges - incentive compatibility problems with Asset Reconstruction Companies (ARCs) and the Security Receipts (SRs) issuance processes; continuing linkages between banks and the assets sold to ARCs; practical difficulties associated with consolidation of fragmented debt; and problems with taking over management control and bankruptcy resolution. Complicating matters, the considerable risk of corrupt practices in transactions, engendered by the poor corporate governance standards and lack of market competition, forces the RBI into more tougher regulations, which in turn limits the sale prospects further.

In the circumstances, the best that can be done is a mix of different options. One, continue the ARC and leveraged buyout fund routes. Two, encourage purchases by private (infrastructure funds) and public (like NIIF, IIFCL etc) funds which could either securitize some assets or establish SPVs and manage these assets till they become profitable. Three, strategic acquisitions of some of the infrastructure assets, especially in power, by the better governed public sector units. Four, strategic auction of certain other assets, especially in steel and metals, to reputed private buyers. In at least some of these cases, provisions like back-ended clawback of some share of windfall gains by potential buyers may ease the resistance and apprehensions associated with such sales. 

In order to facilitate this process, to start with, it would be useful to classify the NPA loans into different categories based on the nature of loans and the types of buyers who are likely to be interested. For example, retail loans like mortgages, credit card, and other small enterprise and personal loans can be classified into one category, which can be sold off in plain vanilla auctions. The infrastructure loans can be classified into completed cash-flow generating projects (strategic sales), incomplete public goods (strategic acquisitions with public leverage), and incomplete private projects like steel plants (restructured disposal). It may also be useful to make available to potential investors the portfolio of such assets so as kindle the interest of the biggest global asset managers and pension and insurance funds. Or even bundle similar assets so as to make them attractive to buyers with deep pockets and patient capital. 

None of these are simple and are certain to throw up challenges and uncertainties. It is, therefore, essential that the restructuring embraces at least three principles. One, it will be necessary to let enabling regulations emerge as the process unfolds. Two, there will have to be a high level of tolerance for omissions and oversights (which are likely to become egregious with the benefit of hindsight) and failures. Finally, avoid the attractions of quick-fix solutions and prepare for the long haul. A mix of restructuring and restoration by economic growth, played out over a period of time, may be the most prudent strategy. 

The excesses of QE - Japan Edition

There are public sector companies and then there are public sector companies. In the former, as in the erstwhile Communist and Socialist countries, governments physically established and owned businesses. The latter is a neat twist to ownership, where private sector establishes companies, float them in the capital market, and then government becomes the majority share-holder in those companies! Thanks to the never-ending adaptations of quantitative easing, Japan has become the progenitor of this new economic model!

The Bank of Japan (BoJ) had embarked on a massive quantitative easing program, including purchases of Exchange Traded Funds (ETFs). As of June 2016, the Bank of Japan (BoJ) owned 60% of the country's ETF market and is now a top-five owner of stocks in 81 out of the 225 companies that make up the Nikkei Stock Index. Last month, it increased the annual ETF purchase target to 6 trillion yen. It is now estimated that the ETF purchases will make the BoJ the largest shareholder in 55 of the 225 Nikkei stocks and top 10 holder in 99% of its companies by December 2017!

The BoJ's ETF purchases are rapidly depleting the free-float of shares (or those available for trading). As the free-float is expected to rise above 50% in many companies, market liquidity will be squeezed with increased volatility.

The apparent logic of all this is that ETF purchases will boost economic activity, enhance risk appetite, and thereby raise inflation above two per cent. There is a hollow ring to this, given the disproportionately low returns from years of expansionary fiscal and monetary policies. Instead of such hugely risky experiments, Japan, as I blogged earlier, should get down to more fundamental labor market reforms on migration and women workers to address its massive demographic challenge. 

Limits to rapid growth - Higher Education Edition

A recent ASSOCHAM study found out that just 7% of the pass-outs from business schools in India, excluding the top 20 schools, are employable and are able to get a job immediately after completing their course, 

India has at least 5,500 B-schools in operation now, but including unapproved institutes could take that number much higher... Low education quality coupled with the economic slowdown, from 2014 to 2016, campus recruitments have gone down by a whopping 45 per cent. There are more seats than the takers in the B-schools... In the last five years, the number of B-school seats has tripled. In 2015-16, these schools offered a total of 5,20,000 seats in MBA courses, compared to 3,60,000 in 2011-12. Lack of quality control and infrastructure, low-paying jobs through campus placement and poor faculty are the major reasons for India’s unfolding B-school disaster...

While on an average each student spent nearly Rs 3 to Rs 5 lakh on a two-year MBA programme, their current monthly salary is a measly Rs 8,000 to Rs 10,000... Of the 15 lakh engineering graduates India produces every year, 20-30% of them do not find jobs and many other get jobs well below their technical qualification. There is clearly a rush towards engineering, that which is engineered largely by parents and the society... There is a large mismatch in the aspirations of graduating engineers and their job readiness. 97% engineers aspire for a job in IT and core engineering. However, only 18.43% employable in IT; 7.49% in core engineering, adds the paper.

This is a teachable moment. The tripling of business school seats, like with similar explosion in engineering colleges in the 2006-11 period, came with a prohibitive cost in terms of quality. The provision of good quality professional education requires competent faculty, adequate infrastructure, and good students. And finally, there should be enough jobs going around to absorb those passing out. These are not achieved easily at the speed and scale expected, given our antecedent human and physical capital quality deficiencies. And in any case, colleges take time to develop good quality and establish credibility. They cannot be manufactured on a production line in a routine manner.

This is equally true of the spurt in IITs, IIMs, AIIMS, and other institutions of national excellence. After failing to build on the success of these brands by gradually increasing their numbers over the years, there has been a swing to the other extreme in recent years in terms of sanctioning of a slew of such institutions. It is only to be expected that the supply-side in terms of quality of faculty and students fail to keep up with the growth in such institutions.

This is true not just of higher education, but any sector. There are limits to how quickly any sector can grow in a country with a very narrow base in industry, human resource, agriculture, financial capital, state capacity, and so on. India needs economy-wide human and physical capital accumulation for a long period of time to build up the platform necessary for sustainable growth. Without this foundation, high growth can only happen in short episodes of over-heating followed by cleaning up balance sheets, as is happening now. 

Japan Housing Fact of the Day!

This is a truly stunning graphic! Especially, that of the Minato ward of Tokyo.

As are these statistics,

In 2014 there were 142,417 housing starts in the city of Tokyo (population 13.3m, no empty land), more than the 83,657 housing permits issued in the state of California (population 38.7m), or the 137,010 houses started in the entire country of England (population 54.3m)... Japan has experienced the same “return to the city” wave as other nations. In Minato ward — a desirable 20 sq km slice of central Tokyo — the population is up 66 per cent over the past 20 years, from 145,000 to 241,000, an increase of about 100,000 residents. In the 121 sq km of San Francisco, the population grew by about the same number over 20 years, from 746,000 to 865,000 — a rise of 16 per cent. Yet whereas the price of a home in San Francisco and London has increased 231 per cent and 441 per cent respectively, Minato ward has absorbed its population boom with price rises of just 45 per cent, much of which came after the Bank of Japan launched its big monetary stimulus in 2013.

In the aftermath of the property bubble of 1990s, Japan, which has a single set of nation-wide development control norms, ushered in a new set of dramatically liberal development rules as part of the Urban Renaissance Law of 2002. It made rezoning and vertical redevelopment simpler. The result - increased demand was offset by increased supply, muting price increases. Tokyo has the highest Floor Area Ratio among all major global cities, and dwarfs Indian cities.

External Debt and EM crises

The last decade-and-half, despite the turmoil in global financial markets, has been a period of remarkable stability for emerging market (EM) economies. 

A decomposition of contributors to the significant decline in the frequency of EM crises during the past 15 years - the unconditional probability of a country experiencing a crisis declined from 12.2% in 1987-99 to 6.2% in 2000-14 - found this.

Evidently, reduction of external debt exposures has been the major contributor - the average ratio of external debt to annual exports declined from 236% in 1987-99 to 123% in 2000-14. The findings,

The estimates suggest that the decline in the observed probability of crisis is primarily due to sharply reduced external debt stocks (estimated to have reduced the average crisis probability by 3.6 percentage points), a substantially higher reserve coverage (-0.6 pp), stronger real GDP growth (-0.3 pp), and improved current account balances (-0.2 pp).

Market failure in higher education

Rana Faroohar points to the market failure in the most competitive higher education market. She draws attention to the strong parallels between the student debt crisis and the sub-prime crisis,  

Many of the same factors are in play: a cost bubble (the price of college has increased by over 1100 per cent in the past three decades); vulnerable borrowers paying above-market rates (student loan prices, fixed by the government, have not fallen despite near zero real interest rates); corruption (scandals involving Pell Grants, subsidies for low-income students, have been rife); conflicts of interest between educators and regulators (which are predictably understaffed and underfunded); and a victim-blaming mentality when it all goes wrong. While too many students sign up for useless degrees in things like sports marketing, it is also true that they are aggressively pushed into it by both non-profit and for-profit institutions that spend an increasing amount of their revenue on marketing to students. Apollo, parent company of the for-profit University of Phoenix, which went public in 1994, at one point had a marketing budget larger than Apple’s. Colleges, too, often invest in luxury facilities to attract richer (full-fee paying) students, or, in the case of the for-profit sector, take big profits (margins typically run above 30 per cent). Students are regularly over-promised financial aid in complex deals that then change year on year, just like the subprime mortgages that blew up in 2008.

This has strong echoes with the higher education market in countries like India. The case of engineering and management degree courses are illustrative. Despite the perception of regulatory micromanagement by institutions like the University Grants Commission (UGC) and the All India Council for Technical Education (AICTE), there has been an explosive growth of seats and colleges in the private sector in recent years. Swayed by aggressive and alluring advertisements, parents have been willing to spend large amounts to admit their children. But several surveys have shown that the quality of students passing out of these colleges are so poor as to be largely unemployable and the vast majority of these professionally qualified students are either unemployed or are working in occupations which do not require such skills.

The higher education markets in US and India are excellent case studies of market and regulatory failures. The former represents the failure of markets to intermediate the desired outcomes, except in a very small set of elite institutions with long pedigrees, in a largely unregulated environment. In contrast, the latter is an example of the problems with largely mis-directed and highly intrusive regulation, whose flaws get compounded by pervasive corruption and its very weak enforcement. The two cases while reinforcing the point about market failures in higher education, also highlights the importance of getting regulation right. 

Global financial intermediation in one graphic

Andrew Haldane says that "interest rates are now lower than at any time in the past 5000 years". The graphic below is truly stunning.

And on a more immediate, quarter century basis, the 10-year global real interest rates have dipped spectacularly since the mid-nineties.

Haldane attributes this trend in interest rates to excess savings in the East, deficient investment in the West, worsening demographic trends, and rising inequality. 

The coming rush of capital inflows - this time will be no different

As investors scramble for yield in a negative rate environment in developed economies, emerging markets (EMs) are becoming the natural attraction. Institutional investors like BlackRock, the world's largest fund manager with $4.6 trillion in assets under management, who are struggling to give back the required 7-8% annual returns for US public pension funds, have become cheerleaders for EMs. The IMF estimates EM growth to increase every year for the next five years, even as developed economies stagnate.

This is a sudden reversal of fortunes for EMs. Consider this,

Until this year, nobody would have taken seriously the idea that emerging markets could make up the shortfall in economic growth. EM stocks spent much of 2015 in free fall, losing more than a third of their value from a peak in April to a trough in January 2016. Economic growth in these countries has been a serial disappointment. As the IMF figures show, aggregate GDP growth in emerging markets has fallen every year since 2010, while the developed world has spent the past three years in post-crisis recovery.

So, what's changed, and that too in such quick time? Nothing fundamentally,

Ruchir Sharma, head of EM equities and chief global strategist at Morgan Stanley Investment Management... says investors in emerging markets are less concerned about whether these economies are growing more quickly than those in the developed world. Rather what excites them is whether the differential between GDP growth in the two is actually increasing. “EM has been growing faster than DM for the past five years and yet EM has underperformed because the differential has been collapsing. This year the differential has stopped collapsing. It has stabilised"... 

He dismisses any suggestion that this heralds a return to the glory days of the 2000s, when emerging markets consistently outperformed those in the developed world by a wide margin and foreign capital flooded in. In 2007 — the peak of the boom for emerging markets — there were 60 economies in the world that were growing annually at a pace of more than 7 per cent, Mr Sharma notes. “Today, that number is down to eight or nine countries,” he says... During those boom years, China was the powerful driver of growth, sucking in exports from other emerging markets, especially commodity producers, to sustain a frantic pace of investment and urbanisation. This model has run its course and today... the effort required to make China’s economy “pop” each time is getting bigger and bigger. Before the global financial crisis, says Mr Sharma, China needed one dollar of credit to deliver one dollar of growth. Now the ratio is six to one. "They are finding it impossible to grow without increasing quantities of debt,” he says. “It is the kiss of debt.

This is a critical inflection point for EMs. In the months ahead, capital inflows into EMs as an investment destination will increase. The better performing ones like India are likely to get more inflows. Foreign capital borrowings will appear very cheap for their non-financial corporates. The stability of rupee is also likely to encourage these borrowers to go unhedged. As the tide rises, the domestic cheerleaders of foreign capital inflows are likely to up the ante, demanding further deregulation by removing withholding tax etc. Will the new Central Bank Governor resist the temptation and run the risk of being accused of hindering growth by depriving the country of ultra-cheap foreign capital? 

For an economy of its size, India has disproportionately lower exposure to global financial markets. That may be about to change. And for sure, it will bring benefits in its wake in the form of access to cheaper capital. But, the costs can be prohibitive. The risks are especially so given the small size and limited depth and breadth of the country's financial intermediation, the fragility of its regulatory institutions, the very poor general corporate governance standards, and a deeply populist political economy. And, the first exposure to such critical transitions will generally always leave excesses in its wake. 

It requires rare courage to cut through the illusions of being the "next big thing" and understand the dynamics of such capital inflows. As I've blogged earlier, such capital flows are dictated by the attraction or otherwise of EMs as a collective asset class. Among them, capital would show a greater preference for those which are more attractive at that point in time. So, given its current economic prospects, India is likely to be a beneficiary. But very little of these flows are motivated by long-term bets. Once the tide turns, as it must, sudden stops and flows reversals follow. Nothing, including sound macroeconomic fundamentals, can cushion against such reversals. Those swimming naked, with unhedged bets and excessive exposures, as there will be many corporates including from India, will get shown up. But by then, it would have been too late.

As recent IMF research has shown, capital controls are far more effective in managing inflows than outflows. There is little that can be done to limit the vulnerabilities from EM capital flow reversals after gorging massive volumes of foreign capital. Therefore, the central bank should exercise the greatest caution before any relaxation of restrictions on capital inflows, influenced by the availability of cheap global capital. 

Japan - QE cannot overcome demographics

The future is Japan! This is the nightmare that central bankers across developed economies are willing to do "whatever it takes" to avoid. The country's long period of economic weakness, when compared to its own long period of very high growth that set the stage for the region's growth itself, is the metric that has been anchored in the minds of opinion makers. It is also the justification for the Bank of Japan's extraordinary quantitative easing (QE) policies which has already seen the BoJ emerge as the single largest owner of Government bonds as well as the equity market.

But while output has been stagnant, the other indicators have been surprisingly healthy. Unemployment rate is easily among the lowest of any major economy and has fallen sharply since 2010. 

More interestingly, the country's GDP per capita has been growing no less slower than any others, including the US. In fact, it has had the fastest increase in real GDP per working age adult since the Great Recession. And this, despite the country's declining labor force participation rate. Clearly, despite its worsening demographics, Japan has been able to squeeze more out of its workforce. 

The answers to demographic problems lie outside QE - liberalize migration and encourage more female participation. If there are less people going around each successive year, it is only natural that there will be less people buying consumer durables, taking out mortgages, studying or getting treated, even generally shopping. Investment has to decline, or at least not rise much. Deflation is inevitable and there is nothing that quantitative easing can do to avert this. It is a stage which other countries too will also reach. 

This begs the question why the country should have QE? How can QE enhance output when the malaise is not so much declining per capita incomes, but declining numbers of consumers? How can QE overcome an accounting problem? In the circumstances, how can QE stoke inflation? Even assuming it can, is this such an extraordinarily bad situation, a deep crisis, that requires an extraordinary solution like QE? 

Instead of hankering after a bygone growth age, or even seeking to inflate, Japan should be happy that its economy is not as unhealthy as thought and its per capita income is among the fastest rising in developed world. It sure needs reforms, if only to even sustain the current growth trajectory. But QE and its variants are not those reforms. 

A labor market reform agenda

There is a three-way stalemate with labor market reforms in India. The government is committed to the achievement of the following

1. Expand the coverage (both benefits and target group) of social and other protections for labor and increase the level of existing protections. 

2. Lower the cost of doing business by reducing various regulatory compliance costs - compliance filings, maintenance of documents and registers, periodic renewals and licensing, recurring payments.

3. Limit discretionary transactions in the interface with the government so as to reduce harassment corruption. 

But public provision of social protections runs into the fiscal constraint very quickly. In the case of the private sector, it increases the employee cost to the company. This, in turn, runs counter to the second objective, thereby necessitating direct trade-offs. Similar trade-offs, albeit of a lower degree, arise between the first and third objectives since greater protections (basic facilities at the workplace, freedom to exercise basic rights, decent wages and other benefits, safeguards against exploitation and abrupt retrenchments etc) invariably demand more interfaces. But in a deeply corrupt system, more interfaces merely exacerbate the harassment. So what gives?

The fiscally cheap and politically easy challenge is the third one. Modern IT systems - involving integrated work-flow automation and Aadhaar linkage, complemented with high quality data analytics - have the potential to dramatically reduce harassment corruption. But the quality of implementation most often detracts from the achievement of the desired objective. And the vast entrenched vested interests committed to its failure are powerful. But, to the extent that harassment corruption can be crippling on new and smaller firms, its mitigation can be a big nod for firms to start formal. 

It also lays down the platform for effectively balancing the first two objectives. Apart from reducing harassment corruption, with its attendant costs, work-flow automation also lowers compliance costs significantly. A combination of lower compliance and harassment costs eases the burden on firms from a gradual increase in labor protections. But even these, on their own, would only offer marginal attraction for firms. In this mileu, targeted and structured public support for labor protections, also made possible by the IT systems, has the potential to dramatically increase the attractions of formality. 

For example, the insurance and pension deductions and contributions for all new employees of a firm (with a small negative list to exclude the largest firms) earning below a certain income could be subsidized for a period of ten years, with a progressively declining phase-out schedule. Assuming a maximum support of 15% of salary and for employees with monthly income below Rs 20,000, and a steady state of 1 million workers, the net annual outflow would be just Rs 36 billion. 

Even assuming a steady state of five times as many workers, it would be far lower than the generous subsidies given to capital. Once the costs of formality are lowered and benefits raised, it may even no longer be necessary to be so generous with the public support. But even if the political economy makes a benefits reduction difficult, the overall economic and social benefits would far outweigh the financial costs.

India's impossible trilemma

In an earlier post, I had argued that "the simultaneous pursuit of macroeconomic stability (or low inflation), high growth, and depreciating currency" may not be possible for any country in a closely integrated global economy. I'll call this the impossible trilemma that commentators in India advocate. A failure to appreciate this also leads them to be critical of the RBI's reluctance to lower interest rates.

Their argument is logically attractive. Lower rates will encourage investments, induce job creation, boost consumption, and therefore put in place a positive growth spiral. Lower rates will also trigger exchange rate depreciation, boost exports, and feed more growth forces. So what is wrong with this assessment?

The logic applies only if businesses are well positioned to respond to lower rates with investments. What if the businesses are stuck with excess capacity, indebtedness, and far less demand than expected? It is, therefore, no surprise that corporate credit off-take is contracting, especially to the small and medium enterprises, pointing to deeper factors that go beyond mere high-interest rates. And what if banks, with battered balance sheets, are unwilling, even unable, to assume more risks? And the global trade conditions lend little credence to the belief that India's external trade will take off with a lower rate and a depreciating currency.

More fundamentally, what if the conditions required to achieve the ambitious high growth rates are simply not there? What if the industrial base, corporate sector, human and financial capital formation, depth of financial intermediation, and state capacity are too limited and narrow to sustain high growth for long periods? Most importantly, what if the consumer base too is far smaller than expected?

I feel that the most important belief that should be dispelled is that we can grow fast and long with a combination of low rates, higher inflation, and macroeconomic stability. The belief comes from a failure (or difficulty) to realize (imagine) the limitations of our capital accumulation (primary products, credit, labor, capital goods, and state capacity) stock as well as flows. Push any of these buttons too hard and too long and excesses will become evident in just 2-3 years. Opinion makers are deceived by extrapolating the limited world that they see around us as representative of India and making growth assumptions based on them. Unfortunately, this is a tiny sliver of the vast and largely still very poor country. I wish there were some great interactive graphics that could explain this nuance to those advocating high growth strategies.

In the circumstances, the only way to realize such high growth is through episodes of over-heating that India had in the 2003-08 period. Corporates made reckless bets and aggressive bids, especially in the infrastructure sector, banks provided credit with limited due diligence, markets and government egged on. This was also complemented with a generous boost in public spending by way of welfare schemes, which cranked up rural demand. Once the party got over, everyone was left picking up the pieces and still haven't recovered from it. 

There is only one way out of this. Steady and gradual human and physical capital accumulation, as well as the development of strong state capacity. Building rapid and sustained growth in a balanced manner on our current foundations does not look a promising endeavour.  

The "other" Branko Milanovic graph

Much has been written about this graph on cumulative real income growth between 1988 and 2008 at various percentiles of the global income distribution.

Milanovic has an article in Vox which tries to interpret this graphic to explain the recent social and political turmoil in US and Europe. Nine out of ten people at around the global median income (45th to 65th percentile) are from Asian countries and seven out of ten people at around point B (70-85th percentile) are from lower half of income distribution of the developed economies.

The contrast between the unambiguous success of people at point A and the relative failure of people at point B allows us to look at the effects of globalisation more broadly. Not only can we see them more clearly when thus juxtaposed, but it enables us to ask whether the two points are in some sense related: is the absence of growth among lower middle classes of the rich world the ‘cost’ paid for the high income gains of the national middle classes in Asia? It is unlikely that one can provide a definitive answer to that question, since establishing causality between such complex phenomena that are also affected by a host of other variables is very difficult and perhaps impossible. However, the temporal coincidence of the two developments and the plausible narratives linking them, whether made by economists or by politicians, make the correlation in many people’s mind appear real.

The symmetry in the graph (between A and B) leads us to think about this conclusion. But this graph only measures income growth percentages among percentiles and the symmetry is therefore deceptive. Instead, imagine if we have another graph that measures the absolute real income gains across percentiles. Consider this possibility (it is completely fictitious and off the hat, but most plausible).

Now this graph would go against the earlier narrative and present another symmetry - between the top 5% in developed economies and their own lower half of income distribution. Given their very low baseline incomes, the absolute gains at various percentiles of income in the developing countries would be smaller, even when compared with low percentage percapita increases at each percentile of income in developed countries. 

This would anchor the debate around a different locus - the structural causes for concentration of income at the top. It would take us back to the narrative about widening inequality due to institutionalized forces - loss of bargaining power for labor, institutional and regulatory capture, skill-biased technical change, excessive financialization, and so on, that are in play across developed economies. After all, while corporate profits and returns to capital have risen sharply in these countries over the past quarter century, and even labor productivity has risen, labor incomes have largely remained stagnant.

The framing of such debates are critical, especially in a world where information and analysis is both plentiful and cheap. It is therefore important that public intellectuals make efforts to present all sides of the debate. Intellectuals need to be cognizant of their culpability in fueling populist anger. In my opinion, Professor Milanovic should not have had his percentage graphic out without the other one.