VC market fact of the day

From the FT on SoftBank's raising of margin loans,

SoftBank has favoured margin loans because even though banks can seize the underlying stock if it falls heavily, they cannot go after any of the borrower’s other assets. This means the loans are not factored into SoftBank’s credit ratings – a concern for the Japanese company, as it already carries junk ratings from Moody’s and S&P.

What does it say about the VC market that the behemoth (the world's second largest VC fund manager struggles to raise $5 bn, when Softbank are planning their second $100 bn fund) is rated junk by the two largest credit rating agencies? Another illustration of a depressing reality - the dynamics of the financial market no longer exercises any disciplining power on the industry and its participants.

Executive compensation and superstar CEOs in public sector

Another one of the entrenched narratives is that performance payment is the way to reform public systems. But, as I have blogged on several occasions, this narrative stands on very flimsy presumptions. 

Adding empirical basis to questioning the narrative, a new paper examines whether CEOs can impact the performance of large and complex public sector organisations. 

It uses the case study of CEOs of English public hospitals under the NHS system, the fifth largest employer in the world with over 1.2 million employees, and where a pool of CEOs keep moving across comparable hospitals. On average these hospitals have 4500 employees, multi-million turnover, and labour costs accounting for 70% of the costs of production. Reforms of the late eighties replaced the administrative model with a highly decentralised managerial approach to hospital management, and hospital boards have autonomy to compensate CEOs accordingly. The authors compare perceived differences in managerial ability, as proxied by their compensation, to actual differences, as they emerge from the analysis of the objective production measures. 

They write,

We study the extent to which CEOs are differentiated in terms of their pay, as well as a wide range of hospital production measures including inputs, intermediate operational outcomes and clinical outcomes. Pay differentials suggest that the market perceives CEOs to be differentiated. However, we find little evidence of CEOs’ impact on hospital production. These results question the effectiveness of leadership changes to improve performance in the public sector...

we... examine whether CEOs have a “style” regardless of the hospital they manage by testing whether there are statistically significant and “portable” CEO fixed effects, i.e. systematic differences in hospital production that are associated with the movement of CEOs across different hospitals. We... “stack” our hospital production variables into distinct sets of input, throughput, output (clinical and financial) and staff job satisfaction measures to take advantage of the fact we have multiple measures of production, and to simplify the exposition of our results while maximizing the number of observations. Our results show little consistent evidence that CEOs are able to generate persistent performance differentials across the organizations they lead. While we find the estimated CEO fixed effects are jointly statistically significant, these CEO fixed effects are essentially period-hospital-specific shocks rather than true CEO effects, since large deviations in one production measure in one hospital are typically not replicated by the same CEO in another hospital... 

hospitals are large complex organizations, in which highly trained (and hard to monitor) individuals run separate but interconnected production processes. Management at the very top of such organizations may find it difficult to engage in coordination and getting a large number of actors, who traditionally have not worked together, to work cooperatively. Put another way, a possible interpretation of our finding is that the organizational inertia of a large hospital is too strong for a single manager – even if this person is the CEO – to be able to impact performance within the short time period in which they are in office, and consistently across organizations. 

And this definitive conclusion is important,

Our results indicate that the CEOs of large public hospitals do not necessarily impact hospital performance, a result that stands in stark contrast with earlier findings relating to the private sector and to smaller public sector organizations... the lack of a CEO effect may also be due, more broadly, to the complexity of hospital production, which transcends the fact that the NHS is publicly owned. From this perspective, our results cast doubts on the effectiveness of a “turnaround CEO” approach–the model in which top managers frequently rotate across hospitals to induce meaningful changes in performance–for large public sector organizations.

There is a related lesson. Market-differentiation, based on executive compensation, the proxy for CEO ability and therefore compensation in the private sector (also the basis of differentiation chosen for study here), is unlikely to be effective in the public sector or with complex systems. In fact, as I have just blogged here, the case for high executive compensations even in the private sector is questionable. 

"Special deals" and capitalism with Chinese characteristics

China satisfies none of the classical requirements for sustained high economic growth rates - it has not clear formal legal protection of private property, there is no independent judiciary for contract enforcement, formal rules and laws for private businesses are opaque, foreign companies have market access blocked for no apparent reason, the ease of starting a business is roughly at the same level as countries like Iraq and Congo, and so on.

If formal institutional arrangements are so weak/poor, how does the economy grow at such rate for so long? 

In a new working paper Chong-En Bai, Chang-Tai Hsieh, and Zheng Michael Song write,

The answer, we suggest, lies in the set of informal institutions that emerged in China in the early 1990s. The key feature of these informal institutions is that special deals are readily available to private firms... Chinese private firms succeed, in part, by obtaining a special deal from a local political leader which enables them to either break the formal rules or obtain favorable access to resources. The prevalence of special deals is common in countries with poor formal institutions, and China is no different. The essence of a special deal is that they are only available to some firms, and there is abundant evidence in many settings that the benefits of firms with special deals are out-weighted by the costs borne by firms that are left out.

In the case of China however, there are three reasons why the benefits of special deals may have exceeded the cost. First, Chinese local governments have enormous administrative capacity and use it to provide a “helping hand” to favored firms. This “helping hand” ranges from exemptions to regulations, lobbying the central government for the right to break rules, improving local infrastructure, providing land (and to a lesser extent credit) at below market prices, and blocking entry of other firms that threaten the profits of the favored firms. Some of this help – such as blocking competitors – lowers welfare, but much of it – such as exemptions to inefficient regulations – is probably growth enhancing.

Second, local political leaders have high powered incentives to provide special deals. For example, the largest car company in China is a joint venture between General Motors and the City of Shanghai. Dunne, a long time observer of China’s automobile market, describes Shanghai’s support for General Motors in the following way: “The commercial goal of selling more GM Buicks and Chevrolets in China becomes a political and economic campaign to enhance the power and might of the City of Shanghai. Think of it as Shanghai Inc. with the Mayor as the Chairman and CEO.” Local leaders may support private firms simply out of a sense of duty or because local leaders that show competence in supporting private business are recognized and promoted. The benefits can also be entirely monetary, ranging from tuition payments for their child to (hidden) equity stakes in favored private firms held by family members. Because of the high powered incentives to support private firms, a large and increasing number of Chinese firms benefit from the special deals. So the Chinese system is best described not simply as regime of special deals but one where there is almost “free entry” into special deals.

Third, a large number of local governments actively support private firms. Moreover, they compete ferociously with other local governments to attract and support their businesses. As described by McGregor (2010) (pg. 175-176), “What is obvious for anyone who travels around the country is how much of the economy is driven by another factor altogether, a kind of Darwinian internal com- petition, that pits localities against each other....each Chinese province, city, county, and village furiously compete to gulp down any economic advantage they can lure their way.” Competition between local governments is crucial in limiting the predatory power of protected firms. A local government can block competitors of favored firms in its locality but has no ability to do so in other cities. Competition also gives firms options when faced with incompetent or predatory local governments.

In other words,

China has “extractive economic institutions”... where political elites extract rents from the rest of society. But our hypothesis is that “extractive economic institutions” in China come with unique “Chinese characteristics” that has made all the difference. First, local political elites extract rents by enabling favored firms to generate more profits in the first place. They can do this because of the enormous administrative capacity of local governments, and the resulting growth of local businesses enables local elites to extract even more rents. Second, local elites get personal benefits from these rents, and thus the local administrative apparatus is laser-focused on supporting favored firms. Third, thousands of local governments compete ferociously to attract and support firms, thus limiting the ability of an individual local government to harm other businesses... 

Our narrative of special deals with Chinese characteristics is closely related to Yasheng Huang’s account of “Capitalism with Chinese Characteristics” and Chenggang Xu’s description of China as “Regionally Decentralized Authoritarianism.” Huang documents the emergence of special deals in China in the early 1990s and argues that such deals are harmful to economic growth. Xu argues that powerful local governments are behind the growth of private firms, but is silent on the key fact that local support for private firms almost always takes the form of special deals. Our hypothesis is that it is precisely the combination of special deals and powerful local governments that underpinned China’s economic success over the last 30 or so years and, at the same time, has created risks for the future. 

And this is important in the context of the ongoing trade confrontation with the US,

Special deals are at the root of the tension between China and its trading partners. Companies based in countries that do not have access to special deals find themselves disadvantaged when they compete with Chinese companies that do. Foreign companies in the Chinese market either have to make their own special deal or, as is the case with a Chinese firm that does not have a special deal, find that their intellectual property and contracts are not well respected. An important and still unresolved question is how the world trading system can accommodate countries based on rules as well as those based on access to special deals.

The note of caution on claims of alpha

All high-level decision-making (as an investor or a sportsperson or an administrator or a CEO) are essentially (well-informed) exercises in human judgement. They are very rarely exercises in logic spinning or theoretical reasoning. 

I have blogged earlier alluding to exercise of good judgement as mark of wisdom and perhaps the most important requirement of decision-making. But such exercises of judgement are inherently inconsistent. For instance, your judgement on the same issue can vary widely depending on a variety of factors, including your state of mind at the decision-making moment. 

We deeply under-estimate this reality and attribute outsized performances (or alphas) to some superior human trait, one which in case of superstars is deemed superior to that of everyone else. This is among one of the most misleading narratives of our times. Instead a more prudent approach may be to look at such performances from a Bayesian perspective.

Tim Harford points to Michael Blastland's recent book, Hidden Half, to highlight the potential role of good luck in explaining what can appear to be alphas. This is important,

... in a competition in which all the leaders are highly skilled, randomness may explain the difference between triumph and failure. Good luck plus skill beats bad luck plus skill any time.

In other words, for any sport or leadership position or market, there is a supply-side of such players or leaders or companies, which is hardly a handful but reasonable sized (in case of businesses, the numbers are likely to be reasonably large). From among them, one emerges a winner in the particular race. And, this is most likely the result of pure good luck. 

This assumes significance when we assess the true worth, as reflected in the executive compensation of Chief Executives and the so-called disruptive genius of internet companies like Facebook or Google or Amazon. It is not incorrect to argue that the confluence of eco-system enabling factors that created the conditions for social media, internet search, double-sided marketplaces like aggregators or e-commerce etc made the emergence of such behemoths inevitable at the turn of the millennium. The present set of winners emerged from among several equally placed competing companies. If there was perhaps one out-sized contributor to the winner's success, it was plain good luck. Much the same logic applies to today's superstar chief executives. 

But once they become successful, these leaders or companies or sportspersons enjoy the benefits of Mathew Effect (see this, this, and this) that is inherent to the dynamic of all the systems where they operate. This Mathew Effect raises insurmountable entry barriers, even on the same cohort of competitors when the next race (for an organisational position or a sporting event or market position).

One of the biggest concerns with present day capitalism is that its dynamic has amplified Mathew Effect, thereby entrenching winners. In fact, such Mathew Effect even conceals the deep deficiencies and incompetence in such winners and perpetuates a very inefficient market. In a broader sense,  there is so much evidence piling up that access to life's opportunities itself is increasingly dependent on the ovarian lottery. 

Two models for promoting vertical development

I have a co-authored paper here with Dr TV Somanathan on optimising urban space through vertical development. To quote the summary,

Arguably the biggest obstacle to the realisation of India's urbanisation goals is the acute shortage of affordable housing. On an economy-wide scale, there is also growing evidence of inflated housing prices contributing to social and macro-economic problems. Since the quantity of land available is fixed, the natural response of cities across the world to this problem has been to raise the Floor Area Ratio (FAR), the ratio of built-up area to the plot size. But restrictive regulations limit vertical development in India - while Singapore and New York allow FSI up to 25 and 15 respectively, Mumbai allows only up to 1.3!

This paper proposes two approaches to raise FAR that combine vertical development with resource raising, and use market forces to determine the level of vertical development. The first is a ‘choose your FAR’ system which dispenses with administratively fixed FAR and replaces it with market-based model where unlimited FAR can be purchased. The second is an FAR trading model where the municipality fixes the permissible additional FAR and periodically auctions them. It combines the two with a series of complementary urban planning reforms.

How can farm incomes be increased?

In the context of the government's professed objective to double farm incomes in five years, it is worth examining what could be potential pathways to realising it. 

The conventional wisdom on the pathway to increasing farm incomes is two-fold. One, squeeze more out of the farm plot, either by increasing productivity or by crop-diversification. Two, disintermediate the value chain from the farm-gate to the buyers to eliminate the brokers, thereby increasing the value captured by the farmers. 

The first one has been the objective since independence and realisation of significant gains is easier said than done. The challenges to be surmounted are too many to realise significant gains in this regard in the foreseeable future. Interestingly with the second, as the coffee example illustrates, the gains to be had by elimination of brokers may not be as high as being imagined. There are compelling reasons to believe that the narrative of brokers fleecing farmers and capturing a major share of their income as rents is dated. In fact, the average gain to the farmers from such disintermediation is likely to be no more than in single digits. In fact, in terms of value capture, if there are any significant gains, it is likely to come only from the upstream disintermediation (from the wholesale buyers to retailers or processors). But this is much harder and even unrealistic to be thinking of capturing. 

There is another less discussed pathway to increase farm incomes. Consider the current scenario. A large share of the farm produce is wasted in various forms including rotting and rejections due to not meeting the relevant standards. Further, in the absence of adequate storage as well as poorly informed harvesting and post-harvest practices, farmers cannot hold back their produce and are forced into selling it in immediately on harvest when prices are likely at their lowest. 

While I have not come across any study that quantify the aggregate loss to the farmers from this, I am inclined to believe that this is likely to be very significant. In the circumstances, measures that can minimise wastage and increase the local holding capacity of farmers so as to stagger supply release can be an area of engagement to increase farm incomes. In many respects, this may perhaps be the most promising medium-term intervention to increase farm incomes.

Agriculture terms of trade

The FT has a good article on the challenges facing the global coffee producers. At the heart of the problem is the shocking disparity in the terms of trade between the coffee growers and the retailer.

Although the growers’ stories are often used in the marketing of individual coffee brands, consumers are largely oblivious to the current plight of the farmers, assuming that the increased price they are paying for their morning brew is — at least partly — passed on to the producer. But in an everyday £2.50 brew, the coffee itself accounts for about 4 per cent, or around 10p — rent, labour and tax taking a much larger portion of the cost. “The cost of coffee is really marginal [for the retailer],” says Jeffrey Young, chief executive of consultants Allegra Strategies. “Even if your coffee beans go down 30 per cent, the cost of cups and workers has gone up, the rent has probably gone up and everything else has gone up.”

Given that the price share of the coffee bean includes the cost of farmer's labour, inputs, and logistics cost, the farmer's returns net of all costs is minuscule. In fact, just the profit captured by the likes of Starbucks is several multiples of the farmer's returns. 

This also raises the point about the massively skewed terms of trade between primary activities and secondary and tertiary ones, and agriculture producers and consumers in general. Granted the differences in value addition and the nature of economic systems, it is the mind-boggling order of magnitude of difference between the returns to the two kinds of activities that is a matter of great concern. Isn't it a supreme irony that the ingredient which makes coffee what it is, is also the cheapest input, by a long extent, into making a cup of coffee?

Another big takeaway from this illustration relates the idea of increasing farm incomes by disintermediating the value chain from the farm gate to the commercial buyer. While coffee may be an extreme case of upstream value capture, the broader point applies just as well to other crops, and I am inclined to believe that the broker disintermediation gains are likely to be small and not significant enough for smallholder farmers. So the pathway of enhancing farm incomes by disintermediating value chains may be a high-effort but low-return one. More on this in the next couple of days.

A history of China over the past four decades - Yasheng Huang interview

This is just such a brilliant interview of Yasheng Huang, summarising his earlier book. It is about 105 minutes long, but worth all the time. 

It has several insights about China's growth over the past four decades - there is nothing unique about Chinese state capitalism; the competitive market-led entrepreneurship, especially from rural areas (the TVEs), trumps the state-led growth that has been praised by western scholars as an example of capitalism with Chinese characteristics; the comparison between Shanghai's state-led capitalism (Pudong as an illustration of wealth theft from rural areas) and Shenzhen's entrepreneurial capitalism; comparative examples of the two models from regions in China that show how the latter model trumps; how the bureaucrats stifle entrepreneurial growth by favouring state enterprises over private entrepreneurs in channeling credit; how Alibaba struggled in Shanghai and had to go to one of the more entrepreneurial provinces to stabilise its model and make big; the model has survived the crises it has faced only because it could export its way out and because of the opportunity presented by real-estate development led economic boost; the Chinese leaders see innovation and technology as the next growth booster; why Zhao Ziyang and Hu Yaobang are the best Chinese leaders; how Hu Jintao and Weng Jiabao rescued the country from the deep agrarian crisis of the nineties; since the nineties there has been a shift towards state-capitalism and away from entrepreneurial rural capitalism, a trend which has accelerated since Xi Jinping took over; the largest private enterprises of today are those with deep networks not just to the party but also important party officials; why he's called a left-wing intellectual in the US and a right-wing one in China; how the growth of recent years has been brought about by debt-fuelled investments and why it is unsustainable; why India's post-crisis response was more effective than that of China; why it is incorrect to compare India and China and proclaim the superiority of benign autocracies; why countries like China and India need not dress up excessively to attract foreign investors, unlike smaller countries; the importance of state in human resource development and in creating other enabling conditions for capitalism to flourish; why President Trumps's actions on the trade-front demanding China opening up may be good for China in rolling back the march of state-led capitalism; and so on.

On China and India - the role of historical human resource and state capacity

Ananth pointed me to Andrew Batson's post on a Yasheng Huang interview which draws attention to the importance of historic human capital in determining the growth trajectories of India and China. Batson quotes Huang,

If you want to make an apples-to-apples China and India comparison, you need to control for other differences between the two countries. And the basic thing you need to control for is the quality and quantity of human capital. I would argue that unambiguously, China has done a thousand times better than India in terms of human capital development: public health, public education. Historically speaking, in part because of the exam system, China has always had a very strong tradition of literacy, being able to read and write. There is some evidence to suggest that China’s mass literacy in the 17th and 18th centuries was comparable to that in Britain. This is going way back. I do see that as a huge strength.

A lot of the growth differences between India and China and India are really explained by that. So there is a fundamental attribution error that many people have committed. When they look at the differences between China and India they say, one is a democracy and one is an authoritarian system, one has better GDP growth and the other has worse. Little do they know that there are other differences. It’s these other differences that explain the growth difference between China and India. I would say that human capital explains 80% of the differences. Maybe we should take that more seriously.

China has always had something behind its back to have good, solid economic performance. Even in the 16th and 17th centuries they had pretty good performance by the standard of that time. In that sense, I’m not a free market fundamentalist. I see the state as being absolutely critical in building the human capital base. This is what the Chinese did historically, and also what the Chinese did during the Communist period, and also what the Chinese state is doing today. For that I give them an A-plus, I celebrate their achievements.

And this reference by Batson from Dwight Perkins' work on 20th China's functional bureaucracy is also instructive,

China’s capital city had a population of over one million people as early as the Song Dynasty, if not before, and supplying such a city required tens of thousands of merchants, transport workers and the like. Commerce on this scale requires records, and to use records an individual must be able to read at least numbers and some characters.

I am sympathetic to Yasheng Huang's argument. It goes to the point that was made in Can India Grow. India's human resource capacity (health and education) and state capacity are massive challenges, and in its absence there are serious limitations and ceilings to building up other capacities. For example, the quality and speed of execution of something or production of stuff is critically dependent on both these capacities. Government's role in creating the enabling conditions - whether property rights and contract enforcement or law and order - should not be underestimated. Without addressing them, unlocking private capital etc is merely tinkering at the margins. The hope to follow in the footsteps of China will remain just that.

India needs to make human resource development, specifically its quality, a political good. Then, to deliver on that good, meaningful efforts to improve state capacity will likely get initiated.

Declining EM public investments

FT points to an alarming decline in public investments in developing countries. Sample this

The share of national output developing world governments are spending on investment in assets such as schools, hospitals and transport and power infrastructure, net of depreciation of the existing capital stock, has fallen from 3.3 per cent in 1997 to a low of just 0.9 per cent last year, according to data from the IMF.

"Rigidities on wage bills and transfers" coupled with rising public debt-to-GDP ratios have been held responsible for this declining trend in investments.

Even if strip our China, which has experienced a steep decline in net investment, thanks to depreciation from its investment splurge of recent years, the weighted average for the rest of EM work is 3.9 per cent of GDP, lower than the 4.8 per cent of 2010. This is a major cause for concern given the acute need for increasing the rate of capital accumulation in these economies.

Ovarian Lottery and Inequality - UK Edition

From FT, this

As many Oxbridge places go to students from just eight, mostly private, schools as from 2,900 other secondary schools, according to the Sutton Trust, an education charity.

And this,

A report from the Sutton Trust last year showed that almost half of all Oxbridge places go to children at private schools, although only 7 per cent of kids in the UK attend these.

And social mobility in US and UK,

When it comes to issues of social mobility and university, the UK and US are not so far apart: the OECD calculates that while Americans from families with university degrees are 6.8 times more likely to attend college than people from families without a degree, this ratio is only slightly better, at 6.3, in England. In Finland and South Korea, by contrast, it is just over one.

Update (12.06.2019)

From the US in the context of Supreme Court Justice Brett Kavanagh's hiring of the daughter of writer Amy Chua to clerk for him, Ed Luce writes,

On pure arithmetic, the average American’s chances of entering a top university are tiny if they are born into the wrong home. Studies show that an eighth grade (14-year-old) child from a lower income bracket who achieves maths results in the top quarter is less likely to graduate than a kid in the upper income bracket scored in the bottom quarter. This is the reverse of how meritocracy should work. Children from the wealthiest 1 per cent take more Ivy League places than the bottom 60 per cent combined.

Some thoughts on job creation in India

What can be done to enhance productive job creation in the Indian economy, across sectors or within specific targeted sectors (like textiles)? 

The obvious immediate responses are infrastructure bottlenecks, enabling access to credit, and lower taxes. Policy response has been mainly in the form of establishing special economic zones and industrial parks, and offer fiscal concessions and input subsidies. In recent years, there has been a focus on enhancing the ease of doing business. 

While these are all important, and all of them are works in progress, there is little to suggest that these are the binding constraints. Alternatively, conditional on the state of the country's systems, what policy enablers are likely to have the biggest impact on job creation?

Unfortunately, far too little high-quality field research happens in this area. If only some of the numerous development economists who have made successful professional careers for themselves studying poverty in India with limited applied policy relevance had engaged with this issue. If NITI Aayog had to focus on one area of policy engagement it is perhaps this that would be the most relevant. Currently, the only meaningful engagement on this happens with the multilateral organisations, World Bank and ADB. The work of consultants in general is too superfluous to be of sufficient relevance. 

Rana Hasan et al examined the role of labour market regulations in the excessively skewed (towards small firms and too few large firms) firm distribution in India's apparel sector. They use the division of country into states with flexible and inflexible labour market regulations (in relative terms) and find that a much large share of the sector's employment is in larger sized enterprises, both in formal and informal sectors. This holds even while controlling for state of infrastructure and competitiveness of product markets. For formal and informal firms (with more than 10 workers), their firm employment distribution shows.

They also find a greater propensity among firms in state with inflexible labour regulations to hire contract workers.

In another paper Rana Hasan et al use an index of the degree of spatial concentration among plants in an industry and find that industrial agglomeration in India declined substantially in 1998-2013. If true this deprives the country off the benefits of agglomeration in "boosting firm productivity and economic growth due to various positive externalities such as knowledge spillovers, labor market pooling, and input-output linkages across firms in industrial clusters". 

They find that variations in industry policies followed by states (the differential tax incentives, capital subsidy schemes etc) and lower transportation costs (especially when frictions in land and labour markets are significant) have led to "dispersal of manufacturing, with the relatively more advanced among the backward districts experiencing large increases in numbers of firms and employment by 1998". They highlight that states which were intersected by the GQ highways saw much higher decline in industrial concentration than those not connected. They also point to a remarkably low domestic labour mobility,

Based on Bellet al.’s (2015) estimates of internal migration rates in 80 countries over a 5-year interval between 2000 and 2010, India is found to have the lowest migration rate. Similarly, Koneet al. (2017) note that although internal migrants represented 30% of India’s population in 2001, two-thirds were migrants within districts, and more than half were women migrating for marriage. They also note that in comparison to India, internal migration rates across states were nearly four times higher in Brazil and China, and more than nine times higher in the USA in the 5 years ending in 2001, despite the fact that in countries including China, urban–rural wage gaps are considerably lower than in India.

They also find that existing land market regulations and general fragmentation of land holdings deter the assembling of large land tracts necessary for industrial agglomerations to form.

Their headline explanation for the decline in agglomeration and consequent dispersion,

reductions in trade costs alongside limited labor mobility and policy-induced scarcity of land should, in theory, have led to the dispersion of industry... inefficient land management policies and improved transport infrastructure may be driving the trend toward de- agglomeration... the hypothesis implies that forces of congestion are preventing a more efficient level of agglomeration from taking place, and there may thus be a role for policy to reverse this trend by reducing inefficiencies in land markets and encouraging greater labor mobility... our hypothesis (is) that congestion costs related to land and labor market frictions are disrupting the forces of agglomeration, at the potential cost of future economic growth.

In another paper the same set of authors examined the effect of place-based industrial development policies in India by evaluating the impact of a nation-wide program initiated in 1994 that aimed to promote industrial development in underdeveloped areas. The program classified districts based on their level of industrial backwardness and provided five year tax exemption to qualified manufacturers in backward districts. They found that the program was only marginally successful - only the better-off backward districts benefited, and that too to the extent of light manufacturing industries. Compounding matters, it displaced industries from the more backward districts and those marginally better than the treated districts.

The authors raise the intriguing policy takeaway that industrialisation is perhaps best achieved by targeting the movement of industries to areas where manufacturing has a comparative advantage than trying to move them to disadvantaged regions.

Finally, there is the linkages between formal and informal manufacturing firms. The work of Ejaz Ghani et al show significant horizontal and vertical linkages between formal and informal firms,

Informal firms are an important supplier of inputs to formal firms. Employment and output have increased in the formal sector in those states in India that also have a greater presence of informal firms. Conversely, unorganized employment and output are greater in states that have a greater presence of organized buyers of inputs. But there are two important asymmetries in the relationship between the organized and unorganized sectors. First, the unorganized sector is much more dependent on and responsive to organized sector presence than vice versa. Second, unorganized sector productivity is dependent on and responsive to organized sector productivity and presence but the reverse is not true.

Ejaz Ghani writes, 

A 10% increase in employment and output in the informal sector is associated with an increase in employment in the formal sector by 16% and increase in output by 12.6%. As formal enterprises become more productive, they demand better inputs from informal enterprises, and strengthen the forward spillovers. The backward spillovers are also strong, as informal enterprises purchasing from formal enterprises induce greater output in the formal enterprises. Although the productivity of the informal sector is more important for the formal sector, than vice versa, the two sectors act more like friends, and family members supporting each other. These linkages mean more than just buying inputs and selling outputs. They generate huge spillovers by working together.

Much of the manufacturing sector’s employment growth has come in the form of informal establishments in the tradable sector. The exceptional increase of employment in the informal tradable sector in India exceeded 10 million jobs, equivalent to the entire net growth of the manufacturing sector. This rise in the informal tradable employment coincided with a strong decline in the non-tradable sector. The concentration of informality in the tradable sector suggests that the growth in traded industries is not due to plants achieving larger economies of scale and shipping goods at a distance, as might have initially been imagined, but an important role played by the informal sector. Informal firms in the tradable sector provide an opportunity to leapfrog the development process, by connecting to global value chains, resulting in greater opportunities for domestic suppliers, increased exports, and higher productivity.

A few thoughts

1. India's firm size distribution is excessively small, even compared to other developing countries. Also, complementarily, the number of really large firms are also excessively small. We have a "small is bad" problem. What is driving the small-ness? Is labour regulations responsible for discouraging businesses from "placing too many workers under one roof"? Is there anything else driving or contributing significantly to this trend?

2. Large manufacturing firms create their own value chains which support several formal and productive SMEs. But India has too few such large firms. This in turn limits the conditions required for productive SMEs to flourish. And conversely, too many less large formal firms mean their value chains are more likely to consist of smaller, less productive, and even informal SMEs. Therefore, the case for encouraging the development of a few very large domestic manufacturing units and also attracting a few large global manufacturers. 

3. There is a trade-off between agglomeration economies and equitable growth. The former leads to spatial concentration of firms within an industry whereas the latter demands geographical dispersion. In case of India, the latter seems to have become the dominant force. This is a cautionary note against the standard policy of dispersing industrial investments across the country (and within a state itself) based on considerations of regional equity. 

More on the "Xi Jinping turn"

I had blogged earlier why Xi Jinping's tenure may be a turning point in China's stability and prosperity. The fundamental premise is that his centralisation has closed down (completely or at least partially) all the traditional safety valves that allowed a calibrated play of differing opinions and ideas, competition among different vested interests within the party, circulation of power and so on, all so important and inevitable in a massive country with a multi-level governance system.

Reading this and this, there is another danger associated with such centralisation. It shuts down any circulation of honest feedback as followers compete to follow the diktats of Xi. Sample this,

For the last three years even China’s state-run banks have been trying to extricate themselves from spending more on the initiative. Yet despite these problems, the initiative expands to new countries and continents. Why this is happening is clear enough—no other foreign policy program is associated personally with Xi like this one is. Xi’s apotheosis to permanent leadership at the 19th Party Congress this spring meant that his signature foreign-policy initiative also had to be elevated—and so it was, written directly into the constitution of the Chinese Communist Party. Now to attack the Belt and Road Initiative is to attack the legitimacy of the party itself. The Belt and Road Initiative is evidence that the party’s once responsive policymaking system is breaking down. The rest of the world must recognize that BRI persists only because it is the favored brainchild of an authoritarian leader living in an echo chamber.

... and this,

Effective statesmanship is difficult when statesmen cannot get an accurate read of how things are playing out on the ground... The trade war is another symptom of the Party's inner crisis. The most spectacular thing about the trade war is how surprised the Party was that it happened at all. Zhongnanhai was caught flat footed by a conflict whose contours were clear months before the first shots were fired. They have needlessly bumbled and stumbled since, handing gifts to their rivals in Washington that need not have been given. The trade war ads placed in the Des Moines Register back in September are the perfect example. The advertisements targeted a President known for personalizing even tepid attacks on his program, were oblivious to a media landscape that had long defined election interference as the most explosive issue in American politics, and were published just after the administration's China skeptics were signalling they had finally devised a strategy to counter rising Chinese influence. Everything about these advertisements betray terrible judgement. This was obvious before they were published. Anyone who understood just an inkling about American political culture would have known how foolish it was to go ahead with that ad campaign. It still happened.

In the Communist Party of China there is a disconnect between the people who have the power to shape events on the ground and the people who understand how things actually stand on the ground. This disconnect has many sources: the obvious one, which I focus on in the column, is the deification of Xi Jinping. General Secretary Xi's rise to godhood means that criticism of his policies (especially the policies upgraded to the label "Xi Jinping Thought") is equated with betrayal of the Party itself. Xi's great anti-corruption campaign is another likely culprit. Anti-corruption means no flamboyant expenses; no flamboyant expenses means fewer government salaried academics, think tankers, and officials traveling to places like the United States. Anti-corruption also means fear. Hundreds of thousands of officials have been jailed or sacked. In an environment where everyone's job is on the line, there is little incentive to be the bold truth teller in the room. To succeed in today's Party, you keep your head down.

And this is the real danger for outsiders, 

I do not mind if the Party leadership miscalculates on the economic front; the more reasons they give western firms to get out of China, the better shape we are in. My worries lie in the military domain. The People's Liberation Army has been ruthlessly gutted by Xi's campaigns. Were Secretary Xi to overestimate the capabilities of the armed forces under his command, which PLA leader is in a position to talk him back to reality? Things did not turn out well for the last general who tried to tell hard truths to the Party's 'core leader.' May the next general to attempt this feat secure a happier fate than he.

This assumes great significance given the very successful approach of "crossing the river by feeling the stones", one where calibrated dissonance and feedback was important, and where experimentation and deviation from the national norm was tolerated, and underpinned the country's remarkable stability and progress over the past four decades. 

Weekend reading links

1. MR points to this article by Samo Burja about the remarkable stability and prosperity of Botswana despite several extenuating circumstances and contrary to the orthodox theories on international development. It attributes the country's success to "well-executed succession between presidents".

2. A very informative Livemint primer on the impact of demonetisation. This coupled with the return of 99% of the currency under circulation points to little having changed on the cash front. See also this. And this graphic from JP Koning is instructive. 

On the digital payments too, very little sustained impact appears visible,

3. This article points to the rise and rise of groupthink and elite consensus that censors dissenting views in international conference circuits. 

You can understand why provocative outsiders are not always welcome. Inviting them in might risk someone rudely pointing out that Mr Griffin just paid $238m for the most expensive apartment in the US, that Mr Schwartz ran Bear Stearns before its collapse or that Mr Dalio reportedly took home $2bn last year. Gadflies can be exasperating individuals, too, and unwilling to engage constructively with the people they criticise: the Milken Institute’s CEO revealed that there had been a dismaying increase in the number of people refusing to share panels with people holding different views.

4. On the context of the debate on inflation targeting, Scott Sumner reiterates the case for NGDP targeting in stabilising economies faced with demand and supply shocks.  

5. Finally a Bates Medal for macroeconomics to Emi Nakamura. This from Noah Smith and this from  Kevin Bryan. 

As Noah Smith points out while her work has supported the New Keynesian school shown that "even very small amounts of... price stickiness can generate large recessions, and make the economy very sensitive to changes in monetary policy", she has also questioned the efficacy of standard monetary policy responses. She has shown "that interest rate cuts tend to boost expectations of future growth without raising expected inflation much",  questioned the assumption that "inflation causes as much harm to the economy as unemployment", and the assumption that "a central bank always has the ability to fight recessions by lowering interest rates" including questioning the efficacy of policies like forward guidance. In contrast, her work points to fiscal policy being a more promising lever to respond in such situations. 

6. Fascinating graphic of the direct relationship between economic output and the daily calories that come from animals and their products.

And like with most things, China is the driver of the growth in global meat production.

Between 1961 and 2013 the average Chinese person went from eating 4kg of meat a year to 62kg. Half of the world’s pork is eaten in the country.

Interestingly, Indians eat just 4 kg meat a year today! However, its milk production has risen from 20 mt in 1970 to 174 mt in 2018. 

7. Andy Mukherjee highlights the biggest problem with Indian capitalism, the behaviours of its capitalists and the corporate governance culture it breeds. Finance, or more specifically investors and lenders, have been a critical pillar to disciplining and making capitalism efficient. This unfortunately, for a variety of reasons, is deficient in Indian capitalism,

Almost every large business failure in India today involves providers of outside capital — and their agents — giving insiders a free pass to maintain control using other people’s money, destroying value in the process... consider the problems brewing in India’s mutual funds industry, which lent money to media mogul Subhash Chandra against his shareholding in Zee Entertainment Enterprises Ltd... When Chandra’s leveraged bets on infrastructure ran into liquidity problems, the mutual funds agreed not to sell the Zee shares they held as collateral. The fund managers now have the chutzpah to tell investors that the net asset value for their maturing plans isn’t available in full — and won’t be until Chandra can find a buyer for Zee. Even more shockingly, the bilateral loans to Chandra, masquerading as bonds, are still rated A. Relationship lending is to be expected in a state-dominated banking system prone to rigging by crony capitalists. But relationship-based fund management? That shows the extent to which even the private sector is compromised. Business “promoters,” as they’re known in Indian law, have used a mix of personality cult and proximity to political power to terrorize the ultimate providers of outside capital.

8. Livemint again points to some proxy indicators of economic growth associated with the current and previous governments.

9. In the context of the latest impasse on the US-China trade talks, Ananth points to this brilliant tweet by Chris Balding characterising the Chinese diplomatic playbook,

1. A lot of the Chinese negotiation tactics are classic Chinese negotiation strategies. 1. Changing the terms of the agreement in major ways after they have been agreed to at the last minute. That's practically SOP

2. Urging people to continue to talking without specifying what the substance or issue that requires resolution and even not acknowledging that the issue is a problem

3. Backhandedly complementing or apologizing. We regret that you're an A$$ monkey that leads to this problem. For that we apologize. Classic Chinese.

4. Insisting that the only change that needs to happen is on the other side of the table. This benefits all man kind and the benefits are there and we urge you to change to help realize that objective.

Assessing China and BRI

Grand carefully orchestrated plans and conspiracy theories are the staple of both hindsight analysis and real-time debates. Accordingly, the austerity imposed on Greece was part of a grand German plan, or the trade-related actions by US on China are part of a comprehensive plan, or the BRI is a grand 

In this context, Yanis Varoufakis's words of wisdom is pertinent,

When a large-scale crisis hits, it is tempting to attribute it to a conspiracy between the powerful. Images spring to mind of smoke-filled rooms with cunning men (and the occasional woman) plotting how to profit at the expense of the common good and the weak. These images are, however, delusions. If our sharply diminished circumstances can be blamed on a conspiracy, then it is one whose members do not even know that they are part of it. That which feels to many like a conspiracy of the powerful is simply the emergent property of any network of super black boxes.

In recent months, there have been alarming news about the trends associated with Chinese lending to developing countries as part of the Belt and Road Initiative (BRI). Commentators have been quick to characterise it as part of a new wave of Chinese colonialism, debt-trap diplomacy, and hard development philosophy. 

But a new study by Mark Akpaninyie questions the argument of a grand national strategy by Beijing and instead claims that it is largely the consequence of profit-seeking actions by Chinese companies,

Little evidence actually suggests that Beijing coordinates a unified strategy to lure the developing world into unsustainable debt. Instead of a state-led strategy, Chinese firms — motivated by profit and abetted by a toxic combination of bureaucratic disorganization, incompetence, and negligence at the state level — have exploited poor nations, which are dependent on cheap, and sometimes bad, loans. These companies, knowingly or unknowingly, persuade countries to pursue projects where benefits to the firms far outpace the benefits of the host nation. Asymmetric information or deception may even misrepresent the feasibility or sustainability of pursued projects. What is worse, governments sign onto nonconcessional loans that accrue high interest rates or carry onerous terms that disadvantage already vulnerable countries. This practice does not trap recipient countries into taking on unsustainable debt. Instead, it allows Chinese companies to profit from often crooked deals building much-needed infrastructure in some of the world’s poorest countries, exploiting the undersupply of financing and these countries’ appetite for infrastructure projects.

One could replace country with business enterprises and the effects would be same. As the history of cross-border capital flows teach us, credit can flow into even the most indebted nations breaking down all semblance of discipline. In fact, this debt-fuelled investment strategy has been exactly what these same firms and their creditors have been following in China itself over the past two decades. 

Andrew Batson is spot on,

The broader point here is that looking at the Belt and Road through the lens of “grand strategy” or “geopolitics” ... is quite misleading... The Belt and Road is really the expansion of a specific part of China’s domestic political economy to the rest of the world. That is the nexus between state-owned contractors and state-owned banks, which formed in the domestic infrastructure building spree construction that began after the 2008 global financial crisis (and has not yet ended).

This assessment of BRI should not be taken to mean we can be complacent about other things that China does, some of which are most likely part of a conscious strategy. It's just that we need to assess trends on their merits and not be led purely by conspiracy theories and our availability biases or preconceived notions.

Update 1 (10.05.2019)

MR points to Tanner Greer's analysis of a study by Lee Jones and Zeng Jinhan. They write,

China’s massive ‘Belt and Road Initiative’ (BRI) – designed to build infrastructure and coordinate policymaking across Eurasia and eastern Africa – is widely seen as a clearly-defined, top-down ‘grand strategy’, reflecting Beijing’s growing ambition to reshape, or even dominate, regional and international order. This article argues that this view is mistaken. Foregrounding transformations in the Chinese party-state that shape China’s foreign policy-making, it shows that, rather than being a coherent, geopolitically-driven grand strategy, BRI is an extremely loose, indeterminate scheme, driven primarily by competing domestic interests, particularly state capitalist interests, whose struggle for power and resources are already shaping BRI’s design and implementation. This will generate outcomes that often diverge from top leaders’ intentions and may even undermine key foreign policy goals.

In other words,

BRI projects are not centrally directed. Instead, lower state bodies like provincial and regional governments have been tasked with developing their own BRI projects. The officials in charge of these projects have no incentive to approve financially sound investments: by the time any given project materializes, they will have been transferred elsewhere. BRI projects are shaped first and foremost by the political incentives their planners face in China: There is no better way to signal one’s loyalty to Xi than by laboring for his favored foreign-policy initiative... BRI projects are chosen through a decentralized project-management system and then funded through concessional loans offered primarily by PRC policy banks. This is a recipe for cost escalation and corruption... In democracies this way of doing things is simply not sustainable, and in most BRI countries it is only so long before an angry opposition eager to pin their opponents with malfeasance comes to power, armed with the evidence of misplaced or exploitative projects... the failures of the BRI seem to factor back to a few central points: first, that project selection is mostly driven by the priorities of folks working in SOEs, provincial governments, and a plethora of different policy banks. The central government in Beijing has difficulty directing their efforts. Secondly, that these people do not have a good understanding of the countries in which they are investing, and face little incentive to gain this understanding. This leads to the sort of corruption and 'predatory' funding that has given BRI its poisonous reputation in countries long exposed to it.

And this confluence of economic interests is critical,

China rode out the crisis only through a US$586 billion stimulus package, mostly involving local government borrowing to finance infrastructure projects. By the early 2010s, the stimulus was spent and many local governments were virtually bankrupt. Overcapacity exceeded 30% in the iron, steel, glass, cement, aluminium and power generation industries. Many SOEs faced a major profitability crisis, with returns on domestic infrastructure turning negative. Meanwhile, Chinese banks faced their own over-accumulation crisis, with US$3 trillion in foreign exchange reserves and dwindling domestic lending prospects. For these interests, OBOR represented an opportunity to internationalise their domestic surplus capacity. Unsurprisingly, these politico-economic actors lobbied furiously to influence the translation of Xi’s slogans into concrete policy, in order to grab part of the spoils.

Thoughts on system transformation

Some thoughts in the context of the WDR 2004 and systems transformation. 

In physics, the second law of thermodynamics states that the entropy of a system always increases. Any system perturbation sets in motion a dynamic whose transmission trajectory and consequence is unpredictable. This is so even for physical systems where particles are not self-acting.

Now consider the example of a human system where agents are clearly self-acting. A social system is a tenuously balanced one with countless and overlapping relationships involving human beings with a wide variety of preferences. This balance has emerged organically through repeat interactions. Further, this is no balance in the static sense, but a dynamic one. It is impossible to predict the outcome of any perturbation (a reform) to this system, beyond its immediate aftermath. Even when well-intentioned and planned, the emergent unintended consequences can be several and often very damaging.

The only response in such a situation is to get the minimum viable product (MVP) out and engage actively with the system, especially in the initial period, to respond quickly to emergent trends and iteratively improve the intervention's design accordingly.

This assumes relevance because it goes against the conventional wisdom on planning a program end-to-end. If we accept the aforesaid reality, then it becomes impossible to plan the details of execution beyond the MVP.

In fact, the only thing that can be planned is to be ready with enabling requirements at different levels to respond quickly and effectively to emergent situations. And given the importance of iterative adaptation, mechanisms to collect data and make available granular-enough actionable information (or feedback) relevant to each level of the bureaucratic system becomes central.

Here is an illustrative plan for a reform idea in terms of the four principal-agent relationships. One, engage continuously to keep ripening the conditions so that the change being sought can be a political good. Two, design an incentive compatible compact between the government and organisational providers (its own departments and non-government providers). Three, design an MVP implementation plan that is sufficiently flexible to allow for local adaptation and has a feedback monitoring system that enables iterative refinement of the plan. Four, create enabling conditions that make frontline service providers accountable to the end-users.

Apart from the second relationship, all others are likely to be dynamic, especially in the initial periods of a program implementation. The first and last would require ongoing political engagement and community mobilisation respectively, with the need for opportunistic engagement being critical in the former. The third would be the realm of iterative adaptation of the implementation plan.

Prudence dictates that the level of flexibility and iteration be calibrated to be consistent with the state's capacity to be able to respond effectively and engage as required.

Programs like the GST or IBC or Ayshman Bharat or Rythu Bandhu scheme or RERA in India are all good examples of reforms which could benefit from such an approach to implementation. 

Inflation dynamics in India

Interesting ongoing debate on inflation dynamics in India. Mainstream discussion points to two structural factors. One the MPC and Inflation Targeting framework; and second the reforms on the agriculture side.

The argument on MPC/IT framework is perhaps not a very compelling one, given the fairly strong body of global research which questions the efficacy of IT framework, especially for developing countries. See this, this, this, and this, all by IMF. In fact, on the inflation count, I would be more inclined to argue that the credit should go to the Government in having exercised restraint on the fiscal front (especially when compared to the previous regime).

This brings us to the argument that supply-side factors on agriculture have been responsible for the disinflation of recent years. Sample this,

“We believe the key driver of the collapse in vegetable prices has likely been the deregulation of markets. Vegetables inflation declined sharply in 2014 and 2015 and has stayed low since then. The timing of the sharp drop in vegetables inflation coincides with the delisting of vegetables from the Agriculture and Product Marketing Committee (APMC) Act in 14 states.” (Prachi Mishra)

I doubt the impact of this transmission channel for several practical reasons. The APMC Act implementation has been very tardy. This is understandable given that its implementation is not just a legislative enactment but creation of a whole set of enabling market facilitation infrastructure and systems, as well as the political economy challenges with breaking the stranglehold of brokers and mandis. These will take time, even long time, to make any meaningful impact. It is also factually borne out that intra-mandi trades, even in the states where APMC implementation has progressed reasonably well, have been negligible. Even the volumes on e-NAM have been very small, and a significant proportion are effectively off-line business-as-usual transactions whose data have been digitised.

The most charitable thing that can be said about monetary policy lowering inflation is perhaps of its classic indirect effect,

“People seem to overlook that this structural decline in inflation may have something to do with the inflation-targeting credibility that central banks and the RBI have earned the hard way. A change in central bank objective, i.e., it will not hike until and unless inflation has become entrenched, could well erode this credibility, un-anchor inflation, and start an inflation spiral. Would India like to risk this?” (Jahangir Aziz)

But this is too general and applicable to any country or context. It is difficult to believe that a 2-3 year old IT regime could have firmed up expectations so strongly. In fact, this is more likely due to the fairly long history of RBI being a relatively independent and credible institution, rather than any recent institutional shifts or personalities. And herein lies the need for governments to exercise restraint on how much it interferes with the central bank's actions.

For now, the only thing we can be sure is that food price inflation has been declining. And core-inflation though running over 4% has been stable.

So it may be reasonable to argue that we are experiencing low inflation because of a confluence of happenstance factors (oil prices, global economic cycle etc) and low aggregate demand in general, coupled with the government’s restraint on fiscal slippage (especially, the restraint on MSP etc).

In the context of the low food prices, this collateral damage from the war on inflation is interesting,

“We don’t see inflation because we are focused on urban households. The continued food disinflation… has resulted in the terms-of-trade that farmers face to sink to their lowest in over 35 years.” (Jahangir Aziz)

This is borne out by the recent work of Ashok Gulati etc, which show that Producer Price Index faced by Indian farmers has been the most adverse among large economies in recent years. Some commentators have pointed to structural factors like the transition to an “age of surplus” from one of production deficits. In any case, farmgate prices have been falling. The issue of general distress facing the farm sector in India therefore appears unsurprising. 

This takes us to the classic conundrum. Low food prices hurt farmers. And high food prices hurt the urban consumers. The latter being more vocal, their concerns are more likely to influence the considerations of the technical experts in the RBI. Amplifying this would be the theoretical models which would have it that higher food prices feed into inflation and impact macroeconomic stability.

We know that in any democracy, the considerations of both constituencies have to be taken into account. The latter (producers) especially so given that they form the majority of the country’s population and that of the poor. But monetary policy experts generally do not take this into consideration in their rate-setting decisions. The IT framework only exacerbates this skewed decision-making calculus.

Not to speak of the questionable value of interest rate policy when faced with cost-push inflation arising from the numerous (and recurrently surfacing) supply side constraints in the food market. 

Would the defenders of RBI's sole pursuit of inflation ignoring the government's repeated calls to take economic growth into account, acknowledge this failing of their model? Does this also raises questions about the orthodoxy on monetary policy in India?