The off-balance sheet debt problem in the US

John Mauldin has a series of US debt crisis. The ticking bomb is the unfunded social security and health care unfunded liabilities, which sits atop the $21.2 trillion federal government debt (105% of GDP) and $ 3.1 trillion (15% of GDP) of state and local government debt. Consider this,

These estimates of when the trust funds run out depend on a slew of assumptions. To estimate revenue, they must know how many workers the US has, their wages, and at what rates those wages will be taxed. To estimate expenses, they mustknow how many retirees will be drawing benefits, the amount of those benefits, and how long the retirees will live to receive them. They also have to assume an inflation rate on which thecost-of-living adjustment is based. A small deviation in any of those can have huge long-term consequences. For what it’s worth, then, Social Security says it has a $13.2 trillion unfunded liability over the next 75 years. That’s the benefits they expect to pay minus the revenue they expect to receive. Medicare projections require even more assumptions: what kind of treatments the program will cover, how much treatment senior citizens will need, and what those treatments will cost. Allthese could vary wildly but the “official” assumptions put Medicare’s 75-year unfunded liability at $37 trillion. It could be vastly more or, if we all get healthier and healthcare costs drop, could be less... 

Larry Kotlikoff estimates the unfunded liabilities to be closer to $210 trillion. That’s a far cry from the $50 trillion official estimate. So, at a minimum, we can probably assume Social Security and Medicare are at least another $50 trillion in debt on top of the $21.2 trillion (and growing) on-budget federal debt. And then you come to the scary part. This doesn’t include civil service or military retirement obligations, or federal backing for some private pensions via the Pension Benefit Guaranty Corporation, or open-ended guarantees like FDIC, Fannie Mae, and on and on... CBO numbers show that by 2041, Social Security, health care, and interest expenditures will consume all federal tax revenue. All of it. Everything else the government does (including defense) will require going into more debt.

The article nicely lays down how these are most likely the best case scenario given the uncertainties associated with making such estimations as well as the headwinds that would have to be overcome.

A few mid-week reading links

1. FT reports of the US decision to suspend Rwanda's access to a preferential trade agreement, African Growth and Opportunity Act (AGOA), in retaliation for that country's decision to restrict the import of used clothes from the US. As a matter of fact, Rwanda's policy on promoting domestic industry follows the much more mercantilist industrial policies adopted by all developed countries during their own growth phases. 

The article also points to the strongly patronising reaction in the UK to Rwanda's decision to promote its tourism potential,

There is a parallel in the harsh reaction Rwanda got when it announced last month it was spending £30m on sponsoring the shirts of Arsenal football club. The Daily Mail, a populist UK tabloid, blustered that what it called a Rwandan dictator was blowing the cash of his impoverished people on a vanity project. Never mind that the sponsorship deal was part of a joined-up strategy to turn Rwanda into a convention and tourism destination. Rwanda has gorillas, a game park with the big five animals, good air links and an impressive new convention centre in Kigali, the well-functioning capital. But, thundered the Mail, it got £62m in British aid and should not be spending its money this way. That message is essentially the same as Washington’s. If we give you any aid or encouragement, we expect to set your policies and your priorities. If you try to lift your country out of poverty, then we will cut you off.

This has resonance with the "evidence-based" belief in international development circles questioning the efficacy that investments in rural roads and rural electrification. 

2. We live in the age of superstar CEOs. Apart from the Wall Street titans, there are the founders of the various technology and other startups who have been endowed with extraordinary abilities and feted by the media and opinion makers. This is despite a very rich body of evidence that disputes this conventional wisdom. So, conditional on the basic entrepreneurial attributes (and smartness, intelligence et al), quite how much of the success of startup CEOs is plain good luck of being at the right place at the right time? I am inclined to think most of it!

FT has this to write about Elon Musk's latest series of outbursts,

The performance has stoked long-simmering questions about whether Tesla has adequate checks and balances to control a chief executive who thrives on shattering convention. One analyst who covers Tesla for a large bank says many observers believe Tesla lacks “grown ups” to rein in Mr Musk’s outbursts, particularly on Twitter, where he goads journalists and promises to “burn” speculators who short the company’s shares. “For a while it was endearing, but he [Mr Musk] has gone full Trump. The pressure, the need for attention — it’s weird, his mental state is deteriorating,” says the analyst, who asked to remain anonymous. An industry executive who knows Mr Musk adds: “If any other CEO on earth exhibited the behaviour he is doing they would be out in an instant.”

As the examples of Travis Kalanick and Mark Zuckerberg shows, much of these reputations vest on plain good fortune.

3. If we are talking of risk appetite and thinking super-big, SoftBank's Masayoshi Son, with his $100 bn Vision Fund, would beat the likes of Elon Musk hands down. Consider this,

SoftBank is shifting the relationship between the tech sector and capital markets. At a time when start-ups are minded to stay private for as long as possible, SoftBank allows its portfolio companies to pursue growth without worrying about burning cash. Some venture capitalists even quip that “SoftBank has replaced the IPO”. Stephen Schwarzman, the billionaire co-founder of private equity firm Blackstone, says Mr Son is redefining technology investing. “No one has ever done that before at this kind of scale,” he says. “It’s unprecedented but it’s meeting a market demand.”

At the least, Son has the $145 bn worth stake in Alibaba from a 2000 investment to show for. More than what can be said about many superstar VC managers from Silicon Valley. 

4. As LIC assumes a controlling stake in IDBI Bank, Bloomberg Quint raises concerns about what it means for LIC's shareholders. Consider this,

LIC currently holds 11 percent in IDBI Bank. Hypothetically, if it were to buy another 40 percent stake to get to 51 percent shareholding, it would cost the insurer Rs 9,600 crore at current market value... India Ratings estimates that IDBI Bank’s total stressed portfolio (including non-fund based faclities) is 35.9 percent of total loans... This means that... in 2018-19, IDBI Bank will need more than the Rs 10,000 crore that it received from the government last fiscal. Even if you take a conservative estimate of Rs 10,000 crore in capital needed, that takes LIC’s immediate capital commitment to IDBI Bank to over Rs 20,000 crore. Is that money well spent by LIC? It’s tough to argue in favor of that given that the bank has reported losses for six consecutive quarters now... Note that no private investor has shown an interest in IDBI Bank even though the government has been wanting to sell equity for over two years now.

And the systemic risk consequences posed by LIC's growing exposure to the banking sector,

As part of its investment activities, LIC has been an active investor in public sector banks. This was particularly true in 2015 and 2016, when LIC bought into preferential share issues of a number of government run banks to cover for the shortage of capital. As a result, LIC’s shareholding in these banks has risen. Shareholding data from stock exchanges shows that LIC holds more than 10 percent in at least six government banks. Apart from holding equity in banks, LIC invested in debt securities issued by banks, including additional tier-1 bonds. As such, its connectedness to the banking system is already significant.

5. Livemint has a two past series on traffic congestion in Indian cities that draws on anonymised Uber data from 2016. It shows that Indians have among the longest commute times and this has been worsening in recent years. As a measure of the congestion, commute times almost doubles during the peak times when compared to off-peak hours. 

6. Paul Krugman has this assessment of the consequences of a global trade war. He estimates tariffs to rise buy 32-60 percentage points (he approximates to 40 percentage points), a 70 per cent decline in global trade, and a permanent reduction in world GDP by 2-3 per cent. In simple terms, the world economy would be back to 1950s in terms of trade.

Don't know whether they have been factored into the studies mentioned by Krugman, there are two important collateral damages likely. Consumers in developed economies will be hurt by the imported inflation arising from higher tariffs. And exporters in developing countries would be hit by costlier imports of intermediate goods which would end up increasing the final prices of their finished products.

7. Businessline has a good article that puts India's low tax base in perspective. Contrary to conventional wisdom it does not find tax compliance to be a major problem. Sample this,

The latest Labour Bureau’s Annual Employment-Unemployment Survey in FY16 covered 1.5 lakh households. It found that over 87 per cent of the households earned less than ₹20,000 a month (₹2.4 lakh a year). This included full-time workers, part-time ones, casual workers, as well as the self-employed. This effectively means that only 13 per cent of the 25 crore Indian households (about 3.2 crore households), may be earning enough to pay income tax. If income tax collections are held back by low income levels, corporate tax collections in India seem to be afflicted by the poor scale and low profits reported by the vast majority of businesses. In India, business is dominated by the 6.3 crore unincorporated enterprises that are mostly run from home. Registered companies number just 17 lakh. Of the registered companies, only about 11 lakh are active and about 7 lakh companies filed their I-T returns in FY17. But again, as many as 5.3 lakh of those companies reported an annual income of less than ₹2.5 lakh! The above data also explain why, as the taxman has trained his guns on evaders in the last three years — tracking down non-filers and issuing a flurry of notices — he has mostly netted only small fish. Between FY14 and FY18, India saw the number of I-T return filers expand by 80 per cent from 3.79 crore to 6.84 crore. But the direct tax kitty grew by a far lower 55 per cent. Nearly a fourth of the current return filers fall in the zero-tax bracket.

This was the central message of Can India Grow?

8. Amidst the uncertainties surrounding debates on peak oil, the oil market is going through the latest cycle of investment contraction. Consider this

In the second half of this decade total capital expenditure by the large oil and gas groups is projected to fall by almost 50 per cent to $443.5bn from $875.1bn between 2010-15, according to Norwegian consultancy Rystad Energy. Although partly offset by a fall in oilfield development costs, the drop also coincides with the big groups ploughing more capital into shorter-term projects, which pay off quickly, as well as renewable energy.

This comes even as prices are experiencing downward pressure due to the convergence of renewables and the falling cost of production itself due to technological advances. 

The article points to oil majors preferring renewables and short-cycle shale projects rather than long-gestation conventional projects.

9. Finally, the Times points to the flattening yield curve in the US, a portend for recession. The flattening yield curve sets the stage for its inversion, wherein the long-term rates fall lower than the short-term ones. All but one of the nine recessions since 1955 have been preceded by an inversion of the yield curve.

In normal times, markets expect long terms rates to be higher than short-term ones, a reflection of the inflation expectations over the longer term. However, an inverted curve points to market expectations about weaker economic growth prospects and consequent lower rates.

The next frontier for China - global electricity grid?

FT reports on China's latest global endeavour, the Global Energy Interconnection (GEI) initiative, the equivalent of an internet for electricity.

It is a plan to create a global electricity grid by producing electricity, especially hydro, in China's mountainous hinterland and other low-cost locations around the world, and then transmitting it through underground ultra high voltage (UHV) cable lines as far away as Germany. The country's world leading state owned electricity companies would lead the charge. 

Consider this,

Chinese companies have announced investments of $102bn in building or acquiring power transmission infrastructure across 83 projects in Latin America, Africa, Europe and beyond over the past five years, according to RWR. Adding in loans from Chinese institutions for overseas power grid investments brings the total to $123bn. Throw in all power-related Chinese deals overseas, including investments and loans to power plants as well as grids, and the number almost quadruples. Between 2013 and the end of February 2018, total overseas power transactions announced reached $452bn, up 92 per cent from 2013 levels, according to RWR, which strips out of its calculations deals that are announced only to be subsequently cancelled... The first stage, set to run until 2020, involves investment in domestic grid assets within other countries. The second phase would see the knitting together of some of those grids and that generation capacity...

The state-owned power companies that are hitting the acquisition trail overseas rank as global heavyweights. State Grid is ranked as the world’s second-largest company after Walmart in the 2017 Fortune 500 list. On important issues such as GEI these companies partly co-ordinate their actions through the China Electricity Council, an official body reporting to the State Council, China’s cabinet. The financial firepower at the disposal of these state-backed companies to sweeten bids for assets overseas is underwritten by China’s policy banks, the China Development Bank and the Export-Import Bank of China... China has already demonstrated the UHV technology’s performance at home. The 37,000km of UHV cable that is laid or under construction in China can carry a load of 150GW, equivalent to 2.5 times the maximum electricity load in the UK... Steven Chu, a former US secretary of energy, has called China’s strides in UHV technology a “Sputnik moment” for the US, alluding to the Soviet Union’s 1957 launch of the first earth-orbiting space satellite, which marked a technological leap ahead of the US.

The Chinese push in the development of globally interconnected electricity grid creates the possibility of the country being able to exercise the sort of influence in the electricity sector that US currently does over the internet. This becomes a likelihood at least in Africa, parts of Asia, and Latin America as Chinese loans and power generation, transmission, and distribution companies have made massive investments that give them a dominant stake in the respective markets. 

While there are also significant technical, practical and political barriers to be overcome to realise the vision that Xi Jinping has laid out through the GEI initiative, much less exercise sufficient control over its evolution, its likelihood is not as remote as one would imagine. Therefore the geo-political risks posed by the access to such an essential resource like electricity are very real and significant.

This assumes significance also in the context of China's similar policy in the ports sector.

In the context of Sri Lanka and the Hambantota port, The Times has a nice story about how Chinese investments in the port sector have both created military and strategic concerns as well as engendered indebtedness in the host country. The article highlights the extent of influence that Chinese were able to exert on the Sri Lankan government of Mind Rajapaksa as a quid pro quo for the port deal.

Transformations within governments

New MGI report on achieving success with transformational programs within governments. The report studied 80 cases of transformation projects within governments across 50 countries and came up with five essential ingredients for any successful transformation.

1. Committed leadership 

2. Clear purpose and priorities

3. Cadence and co-ordination in delivery

4. Compelling communication

5. Capability for change

The report claims that embracing these five "disciplines" more than triples the likelihood of success with transformational implemenations. It advocates a combination of the five ingredients with three new age concepts - focusing on citizen experience, design thinking, and agile implementation.

While more or less all such case study examples are more likely an exaggerated illustration of the specific use cases and its channels of impact, and also an advertisement for McKinsey involved transformations (and therefore to be taken with a pinch of salt), the larger message is well taken. 

There is no substitute for passionately committed and decisive leaders who lead from the front, prioritise on a few objective, have a clear but flexible enough plan, have put in place a dedicated team with requisite capabilities, monitor implementation closely and intensely, co-ordinate among all government agencies, and engage deeply with all those affected by the change and communicate with them.

Three new business concentration graphs

Market concentration and its harmful effects on the economy is well documented. But important decision makers (and opinion makers), especially in the US, remain unconvinced by the growing evidence. Or is it a matter of them being captured?

The latest comes in the form of the decision last week by a US Federal Court judge allowing the $85 bn merger of AT&T and Time Warner. The former provides phone, internet, video and data services (or distributes content), while the latter owns television channels across news, entertainment, and sports (produces content), and together they "can count as customers practically every household in America". The Judge ruled against a very weak challenge by the US Justice Department that the combination of a major producer and distributor of content could substantially lessen competition in media industry. The Steven Pearlstein in Washington Post has very nicely described the judgement as a "hatchet job" involving selective and biased evidence by a "judicial scoundrel"!

Be that as it may, here are three latest graphs that highlight the growing market concentration.

David Leonhardt has two graphs on economy-wide business concentration in the US from Business Bureau's Business Dynamics Statistics. The first captures the rising share of businesses with more than 10000 workers and the declining share of those with less than 20 workers.

And companies with more than 10000 workers employ more people than those with less than 50 workers. 

His documentation of the changes in the past quarter century are stunning,

In the late 1980s, small companies were still a lot bigger, combined, than big companies. In 1989, firms with fewer than 50 workers employed about one-third of American workers — accounting for millions more jobs than companies with at least 10,000 employees... The share of Americans working for small companies fell to 27.4 percent in 2014, the most recent year for which data exists, down from 32.4 in 1989. And big companies have grown by almost an identical amount. Today, companies with at least 10,000 workers employ more people than companies with fewer than 50 workers.

The third graphic covers a forthcoming IMF study on business concentration in developed and developing economies using data for publicly listed companies in 74 countries. It captures a measure of market concentration, average mark ups (or how much a company charges for its products compared with how much it costs to produce an additional unit of this product, expressed as a ratio).

The rise since the early nineties in the developed economies is capitalism gone berserk! Markups have increased by 43 percent since the eighties in those countries.

Ananth has a nice post on the irony of how the elites and decision-makers, even at places like the IMF, continue to pay lip-service to the evidence that their own research department comes up with.

The challenge with implementing public policy

You can have the best structured and incentive compatible policies and yet not have much impact on the ground in addressing the underlying problem. And this state of affairs can persist for years, even decades. Not for nothing is state capacity, in the opinion of this blogger, the biggest challenge facing India. 

Crop insurance and foodgrain procurement are two examples of where acute last mile gaps come in the way of realising desired outcomes. In both cases, it is easy enough to announce the best possible design of a crop insurance or crop procurement policy. But those announcements mean nothing when the rubber hits the road. In case of the former, the constraint is the insurance payout, while with the latter it is the actual physical procurement itself. There are no magic pill universally replicable innovations out of these problems.

Indian Express carries a story on the troubles faced by farmers selling off their produce at the public procurement centres at a mandi in Vidisha district of Madhya Pradesh.

Roop had received an SMS eight days ago from the cooperative society with which they are registered, asking him to come to the mandi on Wednesday, but the father and son chose to come a day earlier... Their token number, a chit issued the day they reached, is 234 — there are 233 farmers ahead of them in the queue. No more than 40 trolleys can be weighed in a day, which means the duo will have to spend at least five days before their turn comes... Until last year, trading at the mandi would happen between noon and 4 pm, when farmers would come, post-lunch, with their produce, which would be auctioned in the presence of mandi officials. This year, after chana prices started crashing due to a bumper crop and less demand, the government decided to buy directly from farmers — at Rs 4,500 per quintal — for the Central pool. Selling to the government offers farmers better returns than selling to private traders, which explains the rush... While the Singhs own their tractor-trolleys, many other farmers have hired vehicles to transport their produce to the mandi. “The rent for the first day is calculated according to the weight of the produce (anywhere between Rs 40 and Rs 80 per quintal of produce). From the second day onwards, we have to pay a daily rent for the trolley,” says Roop... The farmers wonder if a dharma-kanta (a weighbridge) would have eased their woes unlike the existing practice of unloading the produce on the floor of the mandi, packing it in bags, weighing each of them and sealing them, the entire process taking nearly 80 minutes for 40 quintals... Six days after they arrived at the mandi, the Singhs managed to sell chana from one of their trolleys. But they were told the chana in the second trolley had impurities. They will now get it cleaned and come back.

Consider the problems. Immediately after harvest, with chana prices crashing following a bumper harvest, farmers rush to offload their produce at the procurement centres over a very short time window. The procurement centre, without any weigh bridge or other logistics, has to get the produce graded, packed into gunny bags, and weighed. All this takes up an inordinate time for a single farmer and farmers stand in line for hours days! This wait in turn inflicts heavy tractor rental charges and other opportunity cost on the farmers. And even after waiting for days to get their chance, farmers face the prospect of being turned away and being asked to come back after rectifying some defect or other!

Much the same (difficult last mile gaps) applies to the Soil Health Cards or electronic national agriculture market place (eNAM). Sample this series of actions suggested on eNAM,

The following steps should be taken in a concerted manner: (i) unyielding focus on agri-market reforms starting with basics of assaying, sorting, and grading facilities for primary produce as per nationally recognised and accepted standards; (ii) creating suitable infrastructure at mandi-level (like godowns, cold storages, and driers) to maintain those standards; (iii) bringing uniformity in commissions and fee structures that together do not go beyond, say 2%, of the value of produce; and (iv) evolving a national integrated dispute resolution mechanism to tackle cases where the quality of goods delivered varies from what is shown and bid for on the electronic platform.

Each of the four steps, after putting in place the enabling implementation frameworks, need to be materialised. And that is where state capacity, persistent action, and committed leadership becomes necessary. 

Programs like Fasal Bima Yojana, Bhavantar Bhugtan Yojana, Soil Health Cards (see this and this), and eNAM are examples of reforms where enacting the rules and regulations is the easier part. But when the rubber hits the road, state capacity and other systemic constraints start to bind. There is only so much (mostly tinkering at the margins) that can be done with technology and innovation.

In simple terms, successful implementation of these require committed and stable leadership at the Ministry/Department level for atleast five years, maybe as mission-mode projects, with the mandate being to fix the plumbing challenges and demonstrate success with at least a few models. And they need to be complemented with responsive systems both at the level of the District Collector and the Joint Directors (or equivalent) of Agriculture in the District, in at least some of the districts. And it needs to be done in a phased manner with diligence, practical compromises and improvisation where required. 

And also, a one speed nationwide roll-out of such things may not be possible (state capacity) nor desirable (since it may run into political economy challenges). We need to look at the possibility of doing such stuff as a multi-speed campaign (which would also not concentrate discontent) - get everyone to the starting line with all the enablers (both regulations and requisite documentation), make available a practical implementation plan with the likely constraints and possible solutions around it, let the districts/states run with it at different speeds, and foster healthy (but not high enough stakes) competition among them. 

Many things which can be done relatively easily at the district level may not be possible for the States or Government of India to prescribe. It demands more of a gradual and bottom-up diffusion approach than a top-down, one-speed, universal coverage approach. 

This applies as such to the IBC too. As we go ahead, some or all of the following are likely - the Resolution Professionals (RPs) will be captured, judiciary will intervene indiscriminately, NCLT will be compromised, promoters will create hurdles even after resolution, and so on. We need some concerted systemic effort to be at it for a reasonably long enough period of time to allow some hysteresis to set in. 

A practical agenda for a government is to identify no more than 10 schemes/priorities, structure them as Missions, appoint an appropriate Joint Secretary/Mission Director for each for five years, give them a clear (but practical) road map, equip them with sufficient resources, and let them run with it for 5 years. And monitor them closely for five years at different levels.

Social protection programs and impact on poverty

A recent article in the Economist pointed to success of Ethiopia's social safety net programs. It said that social safety net programs formed 1.5% of GDP in Sub-Saharan Africa. It writes,

Ethiopia’s rural scheme is widely regarded as a success. It has reduced rural poverty and helped the poor buy food during a severe drought in 2016 that might have led to famine.

Now this is deceptive. What do we mean reduced poverty? Does it mean that people's lives have undergone a significant change? I guess all this goes back to the artificial minimalistic thresholds that we have constructed around per capita incomes to define poverty levels. 

The World Bank defines Social Protection (SP) programs as consisting of social insurance (mainly public pension schemes covering old age and disability), social assistance (cash and in-kind transfers and workfare schemes, often targeted to the poor), and labor market programs (training, entrepreneurship support, unemployment benefits).

Martin Ravallion and Co explore the impact of social protection programs on the poorest, the floor level of incomes,

The bulk of the impact of SP in developing countries is due to public pensions, which lift the floor by $0.38 a day. This too is below the mean spending on such pensions, which is $0.67 per day. Social assistance on its own only raised the floor by $0.015 per day on average—merely 8% of the (already low) level of average spending on social assistance. The bulk of the impact of SP on the headcount index (5% points) is also due to contributory pensions. Social assistance on its own reduced the poverty rate by 2% points. Countries that spend more on social protection tend to have a higher floor. The correlation coefficient is 0.751. Mechanically, this relationship reflects both differing levels of SP spending and differing transfer efficiencies. Transfer efficiency in reaching the poorest varies greatly. We see that very few countries attain a value of FTE of unity or more. (Recall that this is the ratio of the gain in the floor due to SP to mean spending.) For the bulk of countries (87% of the sample), the gain to the poorest is less than mean SP spending. FTE tends to be better for social assistance on its own, for which the median value is 0.934, as compared to a median of 0.630 for all SP; 43% of countries have FTE for social assistance greater than unity. In addition to FTE, we measure the efficacy of SP in reaching the poorest 20%, giving our second measure of transfer efficiency, GTE. The two measures are correlated (r = 0.505), but certainly not perfectly; some countries are better than others at reaching the poorest people given their efficacy in reaching the poorest 20%. GTE is positively correlated with spending per capita (r = 0.656), but that is not true for FTE (r = -0.021). As countries spend more on social protection, a larger share of that spending tends to reach the poorest 20% but not the poorest.

Now the takeaways in English. We need to make the distinction between poverty alleviation (allows people to have three meals a day compared to two) and poverty eradication (allows people to have meat twice a week, or a more dignified human existence). SP programs in almost all the developing countries help address the former. It will keep people meaningfully above the biological poverty line. It does little, on their own, to help the poorest transition to any meaningfully higher income level. This is just stating the obvious - social safety nets are for poverty alleviation, and not elimination.

If this is the case, then how appropriate is to use indicators like increase in savings or increase in aggregate consumption to measure the impact of social assistance programs like cash transfers? A more relevant measure of impact would be just the change in food consumption - having enough to eat three meals against the typical one or two, or eating meat once a week, or something like those.

This is a bit like the debate about the role of women self-help group movement. It is often confused as an instrument of economic empowerment, when its more relevant utility may be as a tool of social empowerment. 

Some PE myths busted

Fascinating article by Daniel Rasmussen that tests some of the claims made about the superior nature of private equity (PE) investments.

PE firms claim that their investments "accelerate growth and more efficient operations due to superior capital structure and PE managers ability to make long-term investment decisions that public companies cannot make". On this, an examination of 390 deals in the US, accounting for over $700 bn in enterprise value representing the majority of the largest deals ever done, for the financials of the portfolio companies reveals,

In 54 percent of the transactions we examined, revenue growth slowed. In 45 percent, margins contracted. And in 55 percent, capex spending as a percentage of sales declined. Most private equity firms are cutting long-term investments, not increasing them, resulting in slower growth, not faster growth... In 70 percent of cases, PE firms are leveraging up the businesses they buy. PE firms typically double the amount of debt on the balance sheet, from 2.5x ebitda to 5x ebitda—the biggest financial change apparent from our study... As an industry, PE firms take control of businesses to increase debt and redirect spending from capital expenditures and other forms of investment toward paying down that debt. As a result, or in tandem, the growth of the business slows. That is a simple, structural change, not a grand shift in strategy or a change that really requires any expertise in management.

The addiction to debt is the Achilles Heel of PE,

There is a big difference—bigger than most realize—between what private equity used to do (buy companies at 6–8x ebitda with a reasonable 3–4x ebitda of debt) and what private equity does today (buy companies at 10–11x ebitda with a dangerous 6–7x unadjusted ebitda of debt). Debt is a double-edged sword. It can provide great benefits if used judiciously, but if regularly applied in large dollops, it can create massive problems... The real reason PE firms want control of the companies they buy is not because of superior strategic insight but because they want to significantly increase debt levels. And while debt magnifies positive returns and enhances the returns of good decision-making, it can also cut the other way, exacerbating negative returns and punishing bad decisions.

 On returns,

From 1990 to 2010, private equity returned 14.4 percent per year, compared to 8.1 percent per year for the S&P 500 index. This 6.3 percent outperformance was net of private equity’s “2 and 20” fee structure, meaning that the gross return of private equity over this period was more like 20 percent per year... since 2010, private equity has, on average, underperformed the public equity market. Cambridge Associates’ U.S. private equity index has lagged the Russell 2000 by 1 percent and the S&P 500 by 1.5 percent per year over the past five years...

The Canadian Pension Plan Investment Board (CPPIB) and the Abu Dhabi Investment Authority (ADIA) did a bottom-up analysis of 3,492 private equity transactions from 1993 to 2014 to understand these dynamics. They found that private equity deals are different on two key quantitative dimensions from public equity investments. First, PE firms buy companies that are significantly smaller than broader public benchmarks. The median market capitalization of a company in the S&P 500 is $41 billion. The median market capitalization of a small-cap company in the Russell 2000 is $2 billion. But the median enterprise value of PE deals is only $250 million. Only about fifteen private equity investments have ever been larger than the maximum market capitalization of the small-cap index. Second, PE deals are significantly more levered than the typical public equity. The CPPIB and ADIA found that the average ratio of net debt to enterprise value at inception has been approximately 65 percent. The typical Russell 2000 small-cap company is levered at about 16 percent while the median large-cap company in the S&P 500 is levered at about 18 percent.

These two factors have been basically constant since the early 1980s. Changes in deal size and deal leverage levels do not explain why performance relative to public equity markets dropped off after 2010. And differences in size and leverage explain only about 50 percent of private equity’s historical outperformance of public equity markets. The factor that has changed is valuation. Private equity firms have historically bought companies at much lower valuations than the broader public markets. Here we see a significant shift from before the financial crisis to after. Since the crisis, the flood of money into private equity has driven up purchase prices significantly, eliminating the formerly large gap between private and public market valuations... 

Private equity is price sensitive because of the use of debt. Higher prices require more debt, leading to higher interest costs and higher risk of bankruptcy... The first approach is to look at PE deals and compare returns to purchase price. One PE firm did just such an analysis and found that over 50 percent of deals done at valuations of more than 10x ebitda lost money and that the aggregate multiple of money was barely over 1.0x (i.e., for every dollar invested, only slightly more than one dollar was returned to investors). The second is to compare the average purchase multiple in a given year to the returns of the funds from that vintage year. There is a –69 percent correlation between purchase price and vintage year return, a strong inverse relationship... The third is to look at PE-backed companies that IPO. My firm, Verdad, looked at every company taken public in the United States and Canada by a top-100 PE firm since the financial crisis, a data set of 195 IPOs with an aggregate ebitda of $66 billion and an aggregate market capitalization of $728 billion... According to our research, the cheaper IPOs dramatically outperformed the Russell 2000, the moderately priced IPOs matched the Russell 2000’s return, and the expensive IPOs underperformed.

In the context of the criticism of short-termism associated with public equity markets and the resultant long-term flexibility that private equity provides, this punchline is delightful,

And it is of course ironic that the same PE firms making these arguments—Blackstone, KKR, Apollo—have themselves gone public.

How much low can this get?

Two news stories over the week gave good illustrations of how far down the slope that the mainstream discourse and the establishment elites have slipped.

The first is an excellent story in FT about the latest in line from Wall Street's stable of financial market innovations. This one is manufactured default. In simple terms - buy default insurance on a company for a specific form of default, sell that company a loan which it "defaults", pocket the default insurance even as the loan keeps getting serviced in normal course. The graphic below nicely captures the transaction.

The description,

It is the debt equivalent of a controlled explosion: offering a company favourable financing, such as low interest loans, to convince it to intentionally default in a way that will trigger payouts on CDS contracts, but without bringing down the whole company. By doing this GSO pushed its trading edge on rivals to the limits of what many saw as legal.

The protagonist being Blackstone Group's GSO Hedge Fund, and the market being that for the very controversial Credit Default Swaps (CDS). And for once, Goldman Sachs was at the receiving end of chicanery that they have been used to dispensing, ending up owning the CDS which GSO had purchased. 

There are two observations. One, the surprising thing here was what a friend described as the break down of the "honour code" among the Wall Street majors. Goldman complained in public about manufactured defaults. Clearly, even by Goldman's standards this was a new low!

Two, this was not the work of a rogue trader. This was led by a Senior Managing Director, who apparently sat on  Blackstone's European Investment Committee. Clearly this was a part of Blackstone's (or GSO's) formal business plan. 

The second concerns this article on the happenings at London's Evening Standard tabloid whose editor is the former British Chancellor of Exchequer George Osborne (HT: Ananth). The ubiquitous London daily may be the first to almost formally breakdown the barrier between news and advertisements and package advertisements as news. Here is the summary,

London’s Evening Standard newspaper, edited by the former chancellor George Osborne, has agreed a £3 million deal with six leading commercial companies, including Google and Uber, promising them “money-can’t-buy” positive news and “favourable” comment coverage... The project, called London 2020, is being directed by Osborne. It effectively sweeps away the conventional ethical divide between news and advertising inside the Standard – and is set to include “favourable” news coverage of the firms involved, with readers unable to differentiate between "news" that is paid-for and other commercially-branded content... The London Evening Standard has a circulation of close to 900,000 and distributes more copies within a two-mile radius of Westminster than the Times does across the UK nationally. Many London commuters, who pick up their free copy of the Standard at underground and rail stations, will be unaware that they will be reading paid-for news coverage that is part of a wider commercial deal.

There is another important dimension to this story - the conflicts of interest associated with George Osborne. He also hold a £650,000 a year part time job (a day a week) with BlackRock, which holds a £500 m stake in Uber, one of the six groups.

Clearly, if these are true, Osborne is pioneering the standards for a new low in the formal news media industry. 

It also draws attention to the relevance of career politicians, as against those successful elites who foray into politics occasionally. Are we better served by corrupt career politicians who may have sufficient administrative capabilities? Or are we better off with fleeting professionals (and in the net maybe equally corrupt in a more sophisticated way) whose administrative capabilities are questionable (assuming that it does require some experience of government processes to be able to control government bureaucracies and get stuff done)? After all how can we reconcile President Obama who would have been confronted with very hard decisions on Wall Street firms and regulations governing them with Citizen Obama who is hobnobbing with them in the most egregious manner? Or Governor Ben Bernanke and Economist Ben Bernanke?

Now consider this. Both Blackstone and its executives, and George Osborne form part of the liberal elite establishment on both sides of the Atlantic. Their actions and the venality inherent in them are clear enough. Despite these they remain the most respectable icons of the establishment. 

I struggle to understand why Trump's actions are any more morally repugnant than these? I can understand the indignation that comes out when Trump uses public office to aggrandise himself. But I cannot understand when such egregious fraud and venality by the icons of the liberal establishment, which by the way is pervasive, gets nary a mention. FT has to be complimented for covering the GSO story. If this is the case, why should we at all be surprised by Trump or Brexit?

Predictive policing to deter crime

From the Economist Technology Quarterly,

Crime does not occur randomly across cities; it tends to cluster. In Seattle, for instance, police found that half of the city’s crime over a 14-year period occurred on less than 5% of the city’s streets. The red squares in Foothill district cluster around streets near junctions to main roads—the better to burgle and run while homeowners are at work—as well as around businesses with car parks (lots of inventory, empty at night) and railway stations. Burglars who hit one house on a quiet street often return the next day to hit another, hence the red squares.

The reference is to PredPol, a leading crime prediction software, which is used in Foothill and other districts across the LAPD, and each red square represents 2.3 hectare.  

Such algorithmic applications have two use cases - one to monitor the policeman's performance by measuring arrests and other specific actions, and second to deter crime by increasing surveillance and patrolling in high-risk areas. 

It may be the second use case that carries greater relevance for police districts in developing countries. Instead of focusing on punitive actions and personnel performance management, supervisory officials could focus attention on whether resources are being deployed in line with the diagnosis generated by the algorithms so as to deter crime. While the counter-factual of crime prevented is not easy to comprehend or communicate, this is a more sustainable and appropriate approach to using such applications, especially in the early stages.

I am reminded of the story of the Municipal Commissioner who used a similar approach to get the public health staff to keep the city clean. Sanitation in cities is critically dependent on night-sweeping of main roads and early morning garbage lifting, and cleaning of roads and open drains. It is therefore a practice for good Municipal Commissioners to make early dawn surprise rounds of the city streets. Though the Commissioner rarely ventures out of his car during the couple of hours of morning rounds, the likelihood of a surprise round by the Commissioner (or his/her easily recognisable car) has a powerful effect in keeping the public health workers on their toes.

Some of the more enterprising Commissioners, instead of waking up early in the morning, would send out just their vehicles with instructions to the driver to randomly cover a few streets! The galvanising effect was just as same! The same could apply to Police Commissioners making surprise night patrols. Anecdotally at least, in weak capacity systems, one could argue that Commissioners (Municipal and Police) who make shirking and non-compliance costly are among the most effective officers.

Signalling and deterrence are powerful forces in disciplining weak capacity systems and keeping order.

Credit market access for low income countries, but at what cost?

One of the main objectives of international development agenda has been to enable greater access to private capital for low income countries. Though the headline objective has been achieved, the unintended consequences appear to be not very benign. The IMF's latest Fiscal Monitor has some very interesting snippets on this.

Diversifying away from multilateral and bilateral aid, low income countries have been able to increase their access to non-concessional private sources. Market access has been realised...

... and non-concessional lending takes up the dominant share of borrowings in some of the largest low-income countries.

But this trend has coincided with interest expenditures touching the highs prior to the debt-forgiveness initiatives of the early noughties...

... and indebtedness is slowly climbing back to the pre-debt relief times.

All this has squeezed public investment, thereby imperilling future growth.

This could not have been any different. These low-income countries struggle with weak state capacity, very low and stagnant domestic tax revenues, pervasive macroeconomic instability, and very corrupt governments. They have very limited capacity to absorb commercial capital and generate the necessary returns (in terms of economic output growth) to be able to service the high cost debt. The infamous $850 m Tuna Bonds issued by Mozambique ostensibly to promote fishing is only the most egregious example.

It is only a matter of time before we will have the need for another round of debt reduction initiative. The only difference being that this time it would involve private creditors and not governments, and why should the former play ball in the name of development? And unlike Argentina, these small and far less powerful countries would be at the mercy of distressed asset vultures like Elliot Capital Management. Heck, when even Greece could not get any meaningful debt reductions, how could we expect Congo or Zimbabwe to swing something better?

Talk about operation successful, but patient dead!

Anti-trust action in labour markets?

The case for anti-trust action is evident for most people except the American regulators and regulated entities.  

The latest evidence comes from Eric Posner, Glen Weyl, and Suresh Naidu, who demonstrate labour market concentration and monopsony power exercised by corporations over workers in several labour markets in the US. They argue that it lowers economic growth, raises prices, disadvantages workers, and widens inequality. Here is Cass Sunstein on their work,

Their central argument is that in the United States, many labor markets are not competitive. Employers have a ton of market power. They use it to suppress wages, often harming low-income workers in particular... Posner and his co-authors estimate that the economic power of employers is reducing overall output and employment by a whopping 13 percent — and labor’s share of national output by 22 percent. Their driving idea is “monopsony,” which arises when corporations have market power in their purchases of goods and services, including labor. As a result, employers may be able to drive down wages and benefits and to provide poor (and unsafe) working conditions.

Posner and colleagues show that anti-trust regulators generally ignore labour market power while evaluating mergers and confine themselves only to product market power, even though the latter invariably leads to the former. In fact they find that increased business concentration and attendant firm power leads to a compression of labour share of national income by upto a fifth. They write,

Employment, we calculate, is 5 to 18 percent less than it would be in a competitive market... Given the way our economy works historically, labor’s share of economic output should be about 74 percent if labor markets were perfectly competitive. Because of employers’ power to drive down wages, labor’s share of economic output falls to somewhere between 51 and 64 percent. This transfer significantly increases income inequality.

To put this into more concrete terms, consider the market for nurses. The median wage for a nurse is about $68,000. Given what we know about the labor market power of medical institutions, the true competitive wage for a nurse would be at least $90,000, possibly as much as $200,000. However, because most areas have few hospitals, they can suppress nurses’ wages without worrying that nurses will move to a rival hospital. Some nurses will drop out of the labor market entirely, but the hospital still earns a greater profit by shrinking its operation and cutting wages dramatically.

For the labor market as a whole, the median annual compensation is $30,500. If markets were competitive, we estimate that this amount could rise to $41,000, and possibly to as much as $92,000. If labor market power reduces employment and wages, then it must also reduce government’s revenue from taxes... Our calculations suggest that revenue declines by 20 to 58 percent as a result of labor market power.

In sum, growing labor market power may well be a significant explanation of the host of maladies that have beset wealthy countries, notably the United States, in the past few decades: declining growth rates, falling labor share of corporate earnings, rising inequality, falling employment of prime-age men, and persistent and growing government fiscal deficits... Many conservative economists blame high taxes for these problems. But inordinately high taxes cannot explain these trends, because tax rates have been cut several times during this period. Nor can globalization and automation. Globalization and automation can help explain why inequality has increased but not why economic growth rates have stagnated: On the contrary, globalization and automation should have increased economic growth (by expanding markets and by reducing the cost of production), not reduced it.

They argue that a labor market is confined to a few sq km area, in so far as people are reluctant to go beyond that in search of jobs. And in most localities business concentration means that some businesses have come to exercise significant labour market power. Non-compete clauses which prevent workers who leave a job from working for a competitor, cover nearly a quarter of all workers. 

Adding to their work, Jose Azar, Ioana Marinescu, and Marshall Steinbaum, write about labour market concentration,

Using data from the leading employment website CareerBuilder.com, we calculate labor market concentration for over 8,000 geographic-occupational labor markets in the US. Based on the DOJ-FTC horizontal merger guidelines, the average market is highly concentrated. Using a panel IV regression, we show that going from the 25th percentile to the 75th percentile in concentration is associated with a 15-25% decline in posted wages, suggesting that concentration increases labor market power.

The problem is so evident that even the Economist has argued in favour of greater bargaining power to workers, or more and stronger unionisation!

Weekend reading links

1. Economist has a nice article that shines light on the rising entry barriers faced by start-ups in the digital economy from incumbent platform companies, especially Amazon, Facebook, and Google. He said,

Venture capitalists... now talk of a “kill-zone” around the giants. Once a young firm enters, it can be extremely difficult to survive. Tech giants try to squash startups by copying them, or they pay to scoop them up early to eliminate a threat... Venture capitalists are wary of backing startups in online search, social media, mobile and e-commerce. It has become harder for startups to secure a first financing round...

It has never been easy to make it as a startup. Now the army of fearsome technology giants is larger, and operates in a wider range of areas, including online search, social media, digital advertising, virtual reality, messaging and communications, smartphones and home speakers, cloud computing, smart software, e-commerce and more. This makes it challenging for startups to find space to break through and avoid being stamped on. Today’s giants are “much more ruthless and introspective. They will eat their own children to live another day,” according to Matt Ocko, a venture capitalist with Data Collective. And they are constantly scanning the horizon for incipient threats. Startups used to be able to have several years’ head start working on something novel without the giants noticing, says Aaron Levie of Box, a cloud and file-sharing service that has avoided the kill-zone (it has a market value of around $3.8bn). But today startups can only get a six- to 12-month lead before incumbents quickly catch up, he says.

As I have written on countless occasions, it is perplexing that these companies do not face anything close to the level of anti-trust focus they ought to.

3. Dani Rodrik places the China-US trade spat in perspective,

China plays the globalization game by... the strategy is to open the window but place a screen on it. They get the fresh air (foreign investment and technology) while keeping out the harmful elements (volatile capital flows and disruptive imports). In fact, China’s practices are not much different from what all advanced countries have done historically when they were catching up with others. One of the main US complaints against China is that the Chinese systematically violate intellectual property rights in order to steal technological secrets. But in the nineteenth century, the US was in the same position in relation to the technological leader of the time, Britain, as China is today vis-à-vis the US. And the US had as much regard for British industrialists’ trade secrets as China has today for American intellectual property rights. The fledgling textile mills of New England were desperate for technology and did their best to steal British designs and smuggle in skilled British craftsmen. The US did have patent laws, but they protected only US citizens. As one historian of US business has put it, the Americans “were pirates, too.”

3. Deepak Nayyar makes a compelling argument in favour of bringing back development banks, calling for the establishment of a National Development Bank for India,

Between 2000 and 2010, the outstanding loans of development banks as a percentage of gross domestic product dropped from 7.4% to 0.8% in India, but rose from 6.4% to 9.7% in Brazil and 6.2% to 11.2% in China, and declined from 8.6% to 6.8% in Korea, while this proportion rose from 8.5% to 15.9% in Germany and from 3% to 7.2% in Japan.

I agree.

4. A J-PAL analysis of ten evaluations of the use of weather index insurance (payouts based on rainfall) has this graphic on the insurance uptake and price.

Clearly large premium discounts are necessary to achieve significant uptake. In fact, an uptake of over 50% necessities discounts in the range of 70%. Given that the bottom half will consist predominantly of very poor farmers, the target for publicly subsidised crop insurance programs, it raises questions about the efficacy of index insurance. 

In the circumstances, an alternative proposal suggested by one of the NITI Aayog members, Ramesh Chand, is to avoid the transaction costs associated with an insurance and make pre-defined direct compensation payments to farmers who suffer crop damage from deficient rainfall. Sometimes we complicate public policy.

5. John Mauldin's weekly newsletter carries this graphic which highlights the financing challenge facing the burgeoning US government debt.

Foreign central banks stopped net purchases of US government debt five years back. In the circumstances, the only way for the US government to finance its rising deficits is higher interest rates to attract investors. And the consequences of that can be very painful.

6. NYT has a good story on the impact of fiscal austerity on public services in UK. The impact of such cuts are felt the most by local governments.

In the eight years since London began sharply curtailing support for local governments, the borough of Knowsley, a bedroom community of Liverpool, has seen its budget cut roughly in half. Liverpool itself has suffered a nearly two-thirds cut in funding from the national government — its largest source of discretionary revenue. Communities in much of Britain have seen similar losses.

The aggregate impact on welfare spending too has been very significant,

By 2020, reductions already set in motion will produce cuts to British social welfare programs exceeding $36 billion a year compared with a decade earlier, or more than $900 annually for every working-age person in the country, according to a report from the Center for Regional Economic and Social Research at Sheffield Hallam University. In Liverpool, the losses will reach $1,200 a year per working-age person, the study says... Local governments have suffered a roughly one-fifth plunge in revenue since 2010, after adding taxes they collect, according to the Institute for Fiscal Studies in London. Nationally, spending on police forces has dropped 17 percent since 2010, while the number of police officers has dropped 14 percent, according to an analysis by the Institute for Government. Spending on road maintenance has shrunk more than one-fourth, while support for libraries has fallen nearly a third. The national court system has eliminated nearly a third of its staff. Spending on prisons has plunged more than a fifth, with violent assaults on prison guards more than doubling. The number of elderly people receiving government-furnished care that enables them to remain in their homes has fallen by roughly a quarter... Virtually every public agency now struggles to do more with less while attending to additional problems once handled by some other outfit whose budget is also in tatters.

This is a fairly accurate description of how Britain got to this pass,

London bankers concocted a financial crisis, multiplying their wealth through reckless gambling; then London politicians used budget deficits as an excuse to cut spending on the poor while handing tax cuts to corporations. Robin Hood, reversed.

Conservative commentator Scott Sumner examines the aggregate UK government spending data and blames these problems not on austerity but on "progressivism" and its growing list of new "unmet needs". I think his focus on the aggregates is deceptive in so far as it glosses over the reality of local governments as offering the most basic services that citizens are concerned with and the fact that local government allocations have shrunk significantly in recent years.

Simplicity and effectiveness

Morgan Housel has this absolutely fascinating video on investing, one that is as much relevant to several other things in life itself. (HT: Ananth)

This slide may appear funny, but is profound.

People just instinctively prefer complexity. They have a problem with appreciating something which is simple. Patiently doing simple things is just not sexy enough!

In development, governments chase innovation even when there is no evidence of any innovation having made a significant dent on any of the persistent development challenges - poor learning outcomes, traffic congestion, poor property tax collection, poor primary care and public health conditions, malnourishment, social evils, leakages in government programs, poor attendance etc. Maybe self-help groups and micro-finance on small savings and women's empowerment. Nudges. What else? 

Instead simply doing basic stuff like good governance, or collecting and using routine data to monitor effectively, or ensuring compliance with procedures, or diligently monitoring performance and acting on them, or making inspections, or simple prioritisation of responsibilities, and so on, all of which are most likely to have effects which outstrip those of any innovation by orders of magnitude are considered unsexy.  

Maybe investing and development need a movement to go back to simplicity. A "Back too Basics" campaign?

Do watch the full presentation for it has several other very important insights. The transcript is here.