Some thoughts on energy prices and inflation

Some thoughts about inflation in developed markets. 

Here is some news about UK inflation prospects,

But with Europe’s gas crisis escalating in August, Citi predicted on Monday that inflation would reach 18.6 per cent in January. Continental European gas prices are more than 14 times their average of the past decade. The benchmark European gas price rallied almost 10 per cent on Monday to €278 per megawatt hour ($81 per million British thermal units), the highest closing price on record and taking the rise over August to 45 per cent. Examining the wholesale figures, Citi predicted that the UK’s retail energy price cap — which limits how much households pay for heating and electricity — would be raised to £4,567 in January and then £5,816 in April, compared with the current level of £1,971 a year. It added that the shifts would lead to inflation “entering the stratosphere”. The bank’s projected rate would be higher than the peak of inflation after the second Opec oil shock of 1979 when CPI reached 17.8 per cent, according to estimates from the Office for National Statistics.

An how sharply rising energy prices are feeding into this inflation

Natural gas, which is used to generate electricity and heat, now costs about 10 times more than it did a year ago. Electricity prices, tied to the price of gas, are also several times higher than what used to be considered normal... In Britain, the wholesale price of a megawatt-hour of electricity (enough to supply about 2,000 homes for an hour) hit a record daily average of about 500 pounds, or $590, early this week, roughly five times the level of last August.

And gas prices are tightly linked to electricity prices

Driving the prices is a fear that Europe will run out of gas this winter. Russia has slashed gas flows to Germany and other countries... Nord Stream 1, a key conduit of fuel to Germany, has been flowing at only 20 percent of capacity. These cutbacks are forcing gas providers to buy gas on the spot market at higher and volatile prices than under longer-term Gazprom contracts. In many countries, gas and electric power prices are closely intertwined, a relationship that has added to Europe’s woes. Although there are several ways to generate electricity — such as coal, nuclear, hydroelectric, wind and solar — the price of natural gas is hugely influential in setting electricity prices because gas-burning generators are most often paid to come into service when a power grid like Britain’s needs more electricity... Chris Matson of LCP estimated that in 2021 Britain’s power prices were determined by gas more than 90 percent of the time, even though the fuel only accounted for about 40 percent of total generation... But the pressure to fill gas storage facilities, backed by the government directives, has forced energy companies to buy — and keep buying — expensive gas, driving the price ever higher... But the urge to buy protection for the winter is driving up prices, and is doing some of the economic damage it was intended to prevent, analysts say.

Martin Sandbu placed the out-sized role of energy prices in inflation in perspective and the limits of pure monetary policy actions in containing inflation,

Suppose energy prices account for 10 per cent of the normal price index. (This is just to make the arithmetics easy. The actual share of energy in the US index is 9.2 per cent, and in the eurozone it is 9.5 per cent.) If they double, the rest of the index has to fall almost 9 per cent. If they triple, other prices have to fall 20 per cent in the aggregate. Central banks have a lot of power, but making most prices fall 20 per cent or more in a year or so may be beyond their ability even if they were determined to try. And considering that most of what we do and produce uses energy, this would require the costs of other inputs into production — in particular, profits and wages — to fall even more significantly. In the context of extreme price rises for some goods, to think today’s high year-on-year inflation rates prove that central banks erred 12 to 18 months ago is to say that central banks should have so firmly arrested the recovery and kept economies so long in recession as to bring about abysmal offsetting negative price changes elsewhere.

He links to David Sheppard

Sandbu also points to the confluence of factors,

... the bizarre confluence of bad luck: on top of the war and Putin’s energy extortion, we have had weak wind last year, drought-depleted hydropower reservoirs this year, low water transport levels hindering coal barges in Germany, outages in French nuclear plants and fire damage to US gas liquefaction capacity. It is as if it had all been planned to happen at the same time.

See also this on record drought wave sweeping Europe currently, with almost half the continent affected.

If energy prices have risen so much and are driving up inflation, it's difficult to see how monetary policy can be of much help. The supply constraints are unlikely to be significantly eased by any monetary policy tweaks. The highly inelastic nature of energy demand also means that demand response will be muted, howsoever much the price increases. 

In the circumstances, the best that can possibly be done would be to cushion the price increases with some form of transfers. European governments have spent about $278 bn since September 2021 to support consumers against high energy prices.

Bruegel has a detailed report on six types of energy market interventions - reduction of VAT, retail and wholesale price regulation, transfers to vulnerable groups, mandate to state-owned firms, windfall profits tax, business support. Reduction of VAT and transfers have been the most popular interventions, more or less universally implemented across Europe. 

So what needs to be done in terms of long-term policy to address future energy shocks? Martin Sandbu supplies some of the answers,

Not just in terms of fiscal support, but in terms of managing the consequences of extreme volatility. Encouraging investment may require ample guarantees if prices hit zero more often than expected. An inevitable quid pro quo will be heavier taxation of energy price windfalls. Throw in the need for greater grid investment and co-ordination between countries and the public and private sector in preparing for a shift to a renewables-based energy system, and the contours of an energy system permanently shaped by politics — and the other way round — become clear.

But he stops short of calling for a more nuanced approach towards the energy transition. As I have blogged here, the global clean energy transition has overlooked the practical challenges associated with such shifts. Energy transitions play out over long time periods. It involves winners and losers at multiple levels - individuals, firms, countries, and regions. With consumers unwilling to bear the costs and governments unable to subsidise the transition, it's financially ruinous to compress such transitions to short durations. 

About inflation, BIS's Agustin Carstens has a nice explanation,

I think it’s very important [to note] that the function of inflation is not necessarily that obvious. At the end of the day, the definition of inflation is an overall increase in the price level. That gives the impression that all prices are moving at the same time, at the same pace, and the reality is that that never happens. Usually, when you have a low-inflation regime, what you see mostly is relative price changes [some prices going up and others coming down], and these shape production and consumption decisions. These do not give you particular information about the overall pressures of inflation. But if, at some point, you start seeing that more prices are rising and that those rises tend to be more persistent, that means individual price changes carry more information. That starts a process where firms start revising their prices more often, and feeds back into different loops. Cost gets affected, labour markets start responding. And instead of stabilising, high inflation becomes self-reinforcing...

I think a very important sign would be, for example, if the percentage of different goods and services that are producing positive changes suddenly starts decreasing. Because then, you start seeing that the overall component of inflation is coming down, and relative price changes are starting to kick in back again... In your CPI, you can have the analysis to sectors. If you see that 90 per cent of the sectors have positive increase in prices, and now it’s 85 per cent and then it’s 70 per cent, and then you get back to normal, I think that starts giving you signals.

Some thoughts about the current inflationary episode

1. The world economy is entering this episode of inflation with reasonably strong economic fundamentals (corporate and household balance sheets, labour market etc) and strong financial markets. This means that there is considerable run way available to absorb the pain of a recession. This can help keep the recession itself short and shallow.

2. The inflationary signals, while now broad-based, is also primarily supply-shocks induced by the back-to-back triggers of pandemic closures and Ukraine invasion. Besides, energy prices have an out-sized role. It's inevitable that these shocks will dissipate as supply recovers. 

The future trajectory of inflation will be critically dependent on whether workers and firms believe that the supply shock will dissipate soon enough without having them to raise wages and prices, thereby triggering a wage-price spiral.

3. In the current inflation episode, the central banks have been behind the curve. But once they realised that inflation was getting baked in, they've responded swiftly, forcefully, and in unison (across developed countries). This means that the intent is being communicated in clear terms. Is this sufficient to convince firms and workers?

Weekend reading links

1. As Work from Home (WFH) becomes a norm, Scott Galloway points to the risks of it contributing to widening of inequality. In particular, sample this correlation between remote workability and median hourly wage. 

Clearly, the low paid workers in general have to go to their work places, while their higher paid colleagues can work from their homes.

2. Do high fee colleges generate proportionately higher earning power for their students?

Three years ago, in an examination that should have received a lot more attention, the center-left think tank Third Way put all available data for all higher education institutions together. It found that at 52 percent of the schools, more than half of the enrollees were not earning more than the typical high school graduate six years after they began their studies. After 10 years, the figure was still 29 percent.

This is the Third Way website. 

3. FT long read on the success of low cost drones in ariel warfare, especially for Ukrainians in their ongoing war with Russia. The article is about Bayraktar TB2, a sleek unmanned aircraft with a 12 m wingspan, costing just about $5 million, which can stay in air for uptown 27 hours, fly at 7600 m, and can carry a heavy enough weapons load. 

It's manufactured by Baykar Technology, a newish Turkish defence firm, which by 2021 became the country's top arms exporter, by selling $664 m worth drones to foreign buyers in nearly 20 countries. The company has become a matter for local pride for Turks and much sought after by small and poor country governments seeking a low-cost option to put down internal conflicts. Incidentally, one of the two brothers who own the company is married to President Erdogan's youngest daughter. Turkey has used the drone extensively in its war on PKK in Kurdistan, with great success. 

In addition to heralding Turkey’s ascendancy in global defence, the TB2 embodies a new phase in the era of drone warfare in which lower-cost technology becomes increasingly accessible to regimes that cannot buy from the world’s more-established arms producers... But their role in the Ukrainian campaign against Russia has been a coup for Baykar. Many of the foreign buyers the company is courting lack sophisticated air forces of their own or are interested in using drones against adversaries without advanced air defences. “Drones allow states that don’t necessarily have the resources to buy advanced fighter jets to have that capability,” says Erik Lin-Greenberg, an expert on emerging military technology at MIT. “A TB2 isn’t going to substitute for a fighter jet. [But] many states view drones as allowing them to leapfrog generations of tech.”

4. News about UK inflation prospects,

But with Europe’s gas crisis escalating in August, Citi predicted on Monday that inflation would reach 18.6 per cent in January. Continental European gas prices are more than 14 times their average of the past decade. The benchmark European gas price rallied almost 10 per cent on Monday to €278 per megawatt hour ($81 per million British thermal units), the highest closing price on record and taking the rise over August to 45 per cent. Examining the wholesale figures, Citi predicted that the UK’s retail energy price cap — which limits how much households pay for heating and electricity — would be raised to £4,567 in January and then £5,816 in April, compared with the current level of £1,971 a year. It added that the shifts would lead to inflation “entering the stratosphere”. The bank’s projected rate would be higher than the peak of inflation after the second Opec oil shock of 1979 when CPI reached 17.8 per cent, according to estimates from the Office for National Statistics.

Energy prices have such an outsized role in today's inflation. This raises questions about the efficacy of monetary policy in containing inflation.

5. Another odd thing about the current economic environment is the persistence of strong retail sales growth with weakening consumer confidence.

Consumer confidence surveys, usually a reliable source of advance warning on which way spending is heading, could not paint a much more dire picture of the outlook as the Federal Reserve scrambles to tame rising prices. The University of Michigan’s index of consumer sentiment hit a record low in June as inflation topped 9 per cent. Even after a slight rally, it still suggests that consumers are more gloomy now than they were during the worst of the Covid-19 pandemic, the global financial crisis or any other moment since the series began in 1952. Other surveys support this trend, with McKinsey finding twice the number of economic pessimists in July as in March. Yet this pessimism is not showing up in the sales story being told by Walmart and its rivals. For all the evidence that high petrol and grocery prices are squeezing those with the tightest budgets, or that pandemic-weary Americans now prize holidays over home goods, the retailers’ figures suggest that spending remains strikingly robust... US retail sales rose more than expected in July, once fuel and car purchases were stripped out. Americans are getting less for their dollars, but they are still spending them. That shopping basket-half-full message has been echoed by executives from Visa and Mastercard to General Motors and Starbucks this earnings season. “Consumer sentiment is all over the map . . . But we have so much excess demand,” observed Tesla’s Elon Musk. Inflation, it seems, has severely affected consumers’ morale but has yet to affect their actual buying behaviour to anything like the same extent.

What's driving this divergence?

The clearest explanation is what John Leer, chief economist of data group Morning Consult, calls an unprecedented divergence between inflation and unemployment. Even as small business optimism scrapes recession-like levels, unemployment remains near record lows. The stimulus payments which helped employers keep staff on also allowed consumers to shore up their savings. US households have twice as much cash to hand as they did at the end of 2019, McKinsey noted.

6. Fascinating long read in Nikkei about the tenuous nature of the supply-chain in semiconductor chip industry.

An assessment by BCG suggests there are at least 50 chokepoints in the semiconductor supply chain across design tools, manufacturing, packaging, materials and equipment. These points are defined as areas where 65 per cent or more of a particular item is concentrated in a single country or region. The US dominates chip design tools and at least 23 types of essential equipment, it found. Japan is a leader in the production and critical formulation of critical materials that include wafers as well as photoresists. Europe is the leader in industrial gas...  

There is almost no part of the chipmaking process that does not require deep specialisation and no part of the supply chain that can be simply and quickly duplicated... Chemicals and solvents used in chip plants need to reach the so-called part-per-trillion (PPT) grade — one particle to 1tn drops. Gases need to reach a purity of up to 99.9999 per cent — the so-called 6N — when it comes to cutting-edge chip production. For silicon wafers, the basic substrate materials that chips are fabricated on, all need to be as pure as 9N, or 99.9999999 per cent, an executive with the chip material distributor Wah Lee Industrial told Nikkei.

Fluoroplastics are a critical ingredient, and suppliers are limited.

7. The rise of tangible assets in the valuation of S&P 500 firms (HT: Adam Tooze)

8. Fascinating graphic about the trends in within and across country inequalities over the 1820-2013 period. (HT: Adam Tooze)

It's been between country inequality that has been driving global inequality.

9. Theodore Papageorgiou has a paper in AEA which examines the wage premium of larger cities and finds that the greater number of occupations in these cities is a major contributor. 

Confirming a common observation, there were more occupations available in large cities than in small cities. For instance, the largest cities had more than 450 occupations, whereas small cities had fewer than 200. And in general, the number of occupations increased by 70 as city-size doubled.

Some thoughts on ONDC

The Ken has a long read on the Open Network Digital Commerce (ONDC) initiative of the Government of India which is an open (anyone can join) and inter-operable meta-market for buyers and sellers and third-party Apps. 

The comparator cited for ONDC is Unified Payments Interface (UPI) which since it launch in 2016 has rapidly become the host for two-thirds of India's online merchant payments amounting to six billion monthly transactions. The ONDC's Chief Business Officer Shireesh Joshi is typically bullish, 

“Double e-commerce value in five years, a 100-fold increase in the number of retailers online, and triple the number of people who buy online.” To put that in numbers, 30 million sellers and 300 million shoppers by 2024.

ONDC's supporters think they have taken care of the potential scaling challenges,

Bringing sellers onboard is a lot more effort-intensive. “Buyers know how to buy online. These are sellers who have never sold online. They need to know how to digitise catalogues, maintain inventory online, and use different packaging for every order. They need a lot of training.” And that is the job of the seller aggregators like GoFrugal and eSamudaay... what about customer experience and trust in these platforms’ service standardisation? 

Anup Pai, co-founder of eSamudaay, says these are solved problems in commerce. “Eventually, the net value here is in the movement of food from a local restaurant to a local home. You just need to have somebody who knows the restaurant and its location. So, I’m purely looking at it from a financial perspective. Profitability bana sakthe hain isme, but pura cholesterol mein jaa raha hai (you can make profits in this, but right now it is consumed by cholesterol—overheads),” he says. His solution is to create “10,000 Swiggies” in every district... Pai says a decentralised local digital marketplace model has the scope to create multiple companies valued at $1 million and some $100 million ones across cities...

The way Pai describes eSamudaay is not very different from Shopify, the online marketplace that connects retailers directly to customers. He calls his company “Shopify in a box” since he wants to replicate a Shopify-like marketplace in every district. However, unlike millions of sellers in India, Shopify sellers are digitally savvy. They log into Shopify and can have a digital shopfront within minutes. They don’t need assistance to come online. “In India (especially tier-II cities and beyond), you can’t do digitalisation without a digitising agent. It needs an agent. So, you need to incentivise the agent to be a partner in the seller’s journey,” he says. Pai wants to turn these agents into entrepreneurs who would run the local digital marketplaces. “There are plenty of 45-50-year-olds who have been in business, have connections, and still have the energy to build on the ground. Their aspirations are to take care of their family and not build a unicorn. We’re providing them templated business solutions.”

... 24-year-old Srilakshmi Acharya, who runs the Udupi operations for eSamudaay... the way a Swiggy would, but with eight people—for merchant onboarding, customer support, digital marketing, accounts, operations, and delivery... eSamudaay charges a 15% commission to fulfil an order compared to 25-32% of Swiggy and Zomato... For updating inventory, eSamudaay charges an onboarding fee of Rs 1,500 ($19). It does the hard job of mapping a store’s inventory, after which the store can update it.

What they overlook is the sustainability and unit economics involved in all these interfaces. What if the binding constraint for small sellers is not digital literacy and training, but unit costs? Would the mom-and-pop retailers be willing to pay the price required for eSamudaay to operate a sustainable business? What's required to establish credibility and trust, and change behaviours among these mom-and-pop retailers? Can eSamudaay figure out a scalable model to establish trust and onboard retailers in an ultra-low cost manner, something semi- and unskilled labour market matching platforms have not managed to do for nearly two decades? 

Are small Swiggies commercially viable entities? Can small Swiggies be created as a templatable business solution? If we are looking at creating 10,000 Swiggies, are there that many entrepreneurs and investors (actually we need ten times that many to start with) spread out across the country with the risk appetite, entrepreneurial nous, and diligence required for the purpose?

Sample this snippet about what goes on in the mind of a mom-and-pop retailer

Ajesh Pai (who runs the small shop) says paying a 1% commission to eSamudaay will be worth it if it can bring him more customers. “We don’t even give a free bag. Margins are very important for us.”

One of the comments to the article hits the nail on its head

The comparison with UPI can only go so far. UPI is simple. It has only one SKU – money; only the “order value” and the leading +/- sign change for every transaction. And the settlement rails were prebuilt. Obviously, ONDC is far far more complex. I’m not clear who ONDC’s primary customer is and what problem they solve. The current set of digitally savvy buyers is well served.

The driving force behind technology start-ups is growth. It's believed growth creates the conditions for sustainable business development.

1. At the intensive margin, growth helps acquire customers and transactions and maximise network effects. Apart from adding to the top-line, it also boosts margins in a technology business.  

2. At the extensive margin, growth creates unforeseen emerging business opportunities. An Amazon of 1995 or even 2005 could not have foreseen some its business lines of today. This is especially so in platform businesses. 

There are some assumptions behind the growth push

1. The higher margin arising from the regulatory arbitrage between the regulated brick-and-mortar business and its largely unregulated internet variant.

2. Once customers are acquired and the business grows into a behemoth, it would wield significant enough market power to be able to raise prices and increase margins.

Both these assumptions are now being tested. The former due to the aggressive anti-trust push back, and the latter due to the drying up of cheap capital and the increasing focus on profitability. 

A few observations in this context:

1. Foremost, the comparison with UPI is misleading given the vastly different nature of the two activities. Consequently the ambitious scaling aspirations of ONDC betrays an ignorance about the size and nature of the India's e-commerce consumers, and underestimates the challenge of establishing credibility and onboarding sellers.

2. The vast majority of retail transactions in India are done by the poor and lower income population. They're extremely price sensitive and the convenience of e-commerce may not be enough to get them to spend a little more on e-commerce transaction fees. The opportunity cost of time for the vast majority of Indians is not high enough for them to avoid shopping physically. 

However, this is not to gloss over the fact that despite being a small rich and middle class as a share of population, they are a large enough market in absolute numbers to support big e-commerce players. But these e-commerce players too should be cognisant of the size of the market and build their business models accordingly.

3. Building businesses involving innovations is not about growth. Instead, it's about getting the offering (product or service) right and figuring out a sustainable business model through a process of experimentation and iterative adaptation. It's about optimising costs and getting the unit economics right. 

4. Finally, and this I think is an important but hardly discussed aspect, an ONDC-like platform could generate two sets of dynamics. One, it eases market frictions, lowers costs, and expands the market. Two, it allows price-sensitive buyers to shop for the cheapest product and cheapest among sellers. 

The latter poses problem. In an already price-sensitive market which is primed to minimise costs and margins, do we need more margin reduction and race to the bottom? We already have examples from the telecoms and airlines market where such race to the bottom has taken the market to the precipice. I have blogged here about how Make for India conflicts with Make in India for the World.

None of these observations should be seen as an argument against ONDC. Indeed ONDC is a great step in the right direction. But its growth and expansion should be more thoughtfully planned with greater understanding of the complex nature of the market and the economic activity, and the broader dynamics of market competition. Most importantly it should eschew the ideological approach followed by growth-at-any-cost startups. 

Its objective should be to create a robust public good and not mimic some canonical startup growth model. The success of ONDC should not be seen in terms of how many tens of millions of retailers and hundreds of millions of customers use it. Instead it should be about how much it would contribute to productivity increase and expansion of the aggregate production possibility frontier by formalising and enhancing the incomes of producers and traders in the informal sector. 

Something like Alibaba's rural Taobao, which would demand entrepreneurship which builds on the platform. Do we have such entrepreneurs?

Update 1 (18.12.2023)

The Ken has an article on the problems with ONDC Apps, highlighting the troubles of Namma Yatri, a ride hailing App in Bangalore developed by Juspay Technologies. 

Weekend reading links

1. The prioritisation of resilience over pure efficiency maximisation may end up boosting the demand for warehouses

The chastening experience of a pandemic during which stocks of everything from face masks to toilet paper ran short has shifted the way a range of businesses operate. Their priorities are now orientated towards building supply-chain resilience rather than pursuing maximum efficiency at all costs. That is creating demand for more local warehouse storage to guard against future shortages. “Every single person we talk to from an occupational perspective is talking about this: pharmaceutical companies, retailers, everyone,” says Preston. His company, Tritax EuroBox, has leased a vast warehouse in the southern Netherlands to food retailer Lidl. The shed is packed full of non-perishable goods that Lidl has no immediate intention of selling. “It’s a resilience package for them, full of pasta, tinned tomatoes, goods that won’t go off. Because when Covid came along, shelves were emptied, they learnt their lesson,” he says.

2. The private equity industry buys out Senator Krysten Sinema who blocked a bipartisan legislative effort to remove the so-called carried interest loophole that allows PE and hedge fund managers to have their investment gains taxed at a lower 20% compared to the marginal income tax rate of 37%. Sinema forced the dropping of the change in the tax provision in return for her support for the Inflation Reduction Act, a wide-ranging climate, health care, and tax bill. 

3. Despite the government's efforts to increase local manufacturing, the share of Indian companies in the smart phone market fell from 21% in 2017 to just 1% in 2021. Indian companies like Lava, Micromax etc have struggled to fight the Chinese competition. 

4. NYT article about the efforts in the US to regulate the container shipping industry 

The ocean carriers have multiplied their shipping rates and imposed a bewildering assortment of fees. The container shipping industry is on track to make $300 billion in profits before taxes and interest, according to Drewry, an industry research firm. The White House has seized on these two realities — soaring prices, and record profits for carriers... Three alliances of shipping companies control 95 percent of routes across the Pacific, according to the International Transport Forum, an intergovernmental body based in Paris. As shipping prices have soared, and as delays have besieged ocean transit, retailing giants like Amazon and Walmart have chartered their own vessels, prompting complaints from smaller importers that they are at an unfair disadvantage.

5. More on the strange recession this time around in the US,

Typically, in recessions, the problem is that businesses don’t want to hire and consumers don’t want to spend. Right now, businesses want to hire, but can’t find the workers to fill open jobs. Consumers want to spend, but can’t find cars to buy or flights to book. Recessions, in other words, are about too much supply and too little demand. What the U.S. economy is facing is the opposite... To most people, of course, this doesn’t feel like a boom. Measures of consumer confidence are at record lows, and Americans overwhelmingly say they are dissatisfied with the economy. That perception is grounded in reality: High inflation is eroding — and in some cases erasing — the benefits of a strong job market for many workers. Hourly earnings, adjusted for inflation, are falling at their fastest pace in decades... 

There is also a subtler consequence: uncertainty. No one knows how long the boom will last, or what the economy will look like on the other side of it, which makes it hard for workers, businesses and governments to adapt... Businesses have now spent two and a half years in a state of constant adjustment. In early 2020, practically overnight, Americans traded restaurant meals for home-baked bread, and gym memberships for socially distanced bike rides. Those shifts caused huge disruptions, in part because businesses were reluctant to make long-term investments to address short-term spikes in demand... Instead, the lingering disruptions of the pandemic, uncertainty over what the post-Covid economy will look like and fears of a recession have made businesses reluctant to make bets on the future. Business investment fell in the most recent quarter. Employers are hiring, but they are leaning heavily on one-time bonuses rather than permanent pay increases.

See also this.

6. FT long read on the changing face of private equity investing. From being small mercenary takeover specialists in the 1970s to early nineties, PE firms today manage nearly $10 trillion in assets. Their new area of focus is private debt,

Firms that once bludgeoned opponents now nurture complex business relationships with their competitors. Private equity has become just a fraction of their overall assets under management, with credit investing businesses now managing hundreds of billions of dollars, including providing loans for leveraged buyouts... With private equity deals now accounting for over 25 per cent of global M&A activity — a record market share — the collective power of the leading groups is starting to attract the attention of regulators... 

The modern day private equity buyout traces to Michael Milken’s Drexel Burnham Lambert, the investment bank that popularised the “junk bond”. Drexel financed small teams of dealmakers targeting corporate giants such as Disney, Texaco and then RJR Nabisco, the signature LBO of the go-go 1980s. Milken, and many of Drexel’s clients, were considered aggressive outsiders, unafraid to gatecrash Wall Street... By the 2008 crisis, private equity had become part of the financial mainstream as it pulled off a string of ever-larger takeovers. These so-called “club deals” hinted at the willingness of some firms to co-operate out of self-interest...

Investment banks, hamstrung by new regulations like the 2010 Dodd Frank Act, were curtailed from holding risky assets such as low-rated debts, which has limited their ability to finance many deals. As a result, corporations and private equity buyers have had to seek new ways of issuing debt. Blackstone, Apollo, KKR and Carlyle stepped into the void. They bought billions of non-performing loans from banks in the US and Europe, betting that the portfolios would stabilise. As markets recovered, they shifted to originating new loans, underwriting midsized private equity takeovers that banks would not finance. It set off private equity’s march into new businesses such as lending, insurance-related investments, real estate and infrastructure, which were far from their original speciality in buyouts... These private financings have continued as interest rates rise — just as many investment banks have been refusing to make new lending commitments until loans from deals struck earlier in the year have been sold on.

Another trend is the rise of sales from one PE firm to another, or "GP-led secondary transactions",

The fastest way for buyout firms to deploy their nearly $2tn in “dry powder,” or funds they have raised that have yet to be invested, is to buy companies directly from other private equity firms. A record 442 of such deals worth $62bn were struck last year, according to Refinitiv. These deals can close in less than three months, say bankers, versus as long as nine months to acquire a public company. They can also be expedient: sellers sometimes look to quickly lock in gains and show strong returns as they raise their next fund, notes one private equity firm executive... There has also been a surge in so-called “GP-led secondary transactions,” where one private equity firm sells a large stake in an existing investment to another firm at a higher valuation. 

7. The pandemic induced surge in demand for goods is tapering off,

Consumer goods retailers and ecommerce companies who profited amid lockdowns and mistakenly expected the good times to continue rolling have been hard hit. Big box retailers Target and Walmart, which won last year by scooping up inventory and paying extra for air freight, are now having to slash prices and cancel orders to clear excess stock. Ecommerce companies such as UK fast fashion site Asos are similarly coming down to earth, as it becomes clear that pandemic-related online buying marked a one-time jump rather than a permanent shift to faster growth. Overall US online prices for goods fell in July for the first time since May 2020, with price drops recorded in 14 of 18 categories tracked by Adobe. Electronics, the largest ecommerce category, saw a 9.3 per cent year-on-year decline, as the bulge driven by home office upgrades begins to recede.

But the demand in services shows no signs of abating,

Now it is the service providers who are struggling to keep up. After two grim years marred by closures and limited demand, their sales are climbing. Walt Disney reported record revenue in its theme parks division, hotel chain Marriott bragged of “outstanding” results and both American and United Airlines returned to profit for the first time since the start of the pandemic.

8. Unintended consequences of private equity in housing

Right to Buy was a remarkable success in that it led to the sale of more than 2mn homes and resulted in an immediate transfer of wealth. But one of its direct, longer-term consequences has been that, rather than increasing home ownership, it contributed to the rapid growth of an under-regulated and precarious private rented sector. In 1979, more than a third of people in England lived in council housing built, owned and administered by local government. Now, more than 40 per cent of the council homes bought under Right to Buy have been sold on to private landlords, who rent them out at three or four times the price of an equivalent property in the social housing sector. The result is that, in many parts of the country, private renting is unaffordable for those on lower and even middle incomes, excluding people from the market and leading to a continuous cycle of eviction.

9. From FT about couple of graphics about the shipping industry. Interesting that the global LNG capacity has been more or less stagnant over the past five years.

Container freight rates have rocketed

10. Don't know the source of these numbers, Arun Maira quotes about India's labour market growth,

The gap between where our economy is and where it needs to be is increasing. Between 1980 and 1990, every one per cent of GDP growth generated roughly two lakh new jobs; between 1990 to 2000, it decreased to one lakh jobs for every per cent growth; and from 2000 to 2010, it fell to half a lakh only.

But it's most likely in some similar range. 

11. Satyajit Das points to the private markets being the faultline for the next financial crisis. Investors have poured $9.8 trillion into unlisted equity, private debt, and seed and venture capital. The illiquidity, opacity, and diffusion of risks have led to valuation bubbles. Consider this recent example,

After being valued in 2021 at $46bn, a 2022 $800mn funding round valued Klarna at $6.7bn (an 85 per cent fall). As the disappointing initial public offerings of Uber and WeWork highlight, the case is not isolated.

Das points to the faultlines, 

First, as private investments are inherently illiquid, investors cannot cauterise losses easily. Monetisation, largely reliant on initial public offerings and trade sales, is now difficult, especially at previously anticipated prices... Second, the lack of market prices means opaque valuations, which frequently misstate investment or fund values... Third, private equity originally focused on long holding period investments purchased with substantial borrowings in traditional industries that offered undervalued shares, strong cash flows, low operating risk and the potential for business improvements. Today, many of these elements, other than leverage, are frequently absent... Fourth, for non-profitable or cash-flow-negative enterprises, availability of follow-on funding necessary for operations is presumed... Finally, private markets exhibit complicated layers of risk... Today, investments are frequently held through tiers of funds, some with borrowings from banks or private providers. Securitisation of private equity loans and non-bank credit display familiar opacity and exacerbate leverage in the system. Falls in asset value anywhere can create instability elsewhere within the financial system.

State Capability in India

My book, State Capability in India, co-authored with Dr T V Somanathan is finally published by Oxford University Press.It has a foreword by Robert Zoellick, former World Bank President and US Commerce Secretary.  

This and this are the publisher pages. It can be bought on Amazon here (India) and here (global).

This is the description

The deficiencies in the capability of the state to design and implement effective policies are arguably the biggest development challenge facing developing countries like India. This book seeks to assess state capability in India, identify weaknesses in policy design and programme implementation, and their causes, and propose some measures to remedy them. Importantly, it does so while recognizing political economy constraints and focusing predominantly on the administrative contributors. To this extent, the book's suggestions are practical enough for adoption by stakeholders at different levels.

It describes the institutional design, constitutional provisions, the organizational structure, and the personnel of the Indian state. It covers a wide spectrum of aspects impacting state capability, ranging from ideological narratives and systemic constraints to procedural and personnel management issues to the behaviours and attitudes of individual bureaucrats. It offers a new analytical framework to think about effectiveness of state on the policy-making process. It also offers a nuanced perspective and suggestions on many of the popular themes in public administration - size of the state, generalist and specialist debates, lateral entry, digital monitoring systems in governance, outsourcing and private participation, use of consultants, risk aversion in bureaucracies, performance-based incentives, programme evaluations, and so on.

Finally, being participants and observers in the bureaucratic system, the authors describe reality without always seeking to locate it in the framework of existing academic literature, thereby offering fresh insights and enriching the discourse on state capability.

I enjoyed writing the book and also learning from my co-author. Readers of this blog would know that state capability is a favourite topic and, in my opinion, its weakness is the most important long-term challenge to development. Hope the readers find something useful from it.

A graphical summary of market concentration and its consequences

Matt Stoller points to a striking graphic from Sparkline Capital about the progressive market concentration in defence contracting market in the US.

From the end of the Cold War to the early 2000s, the number of prime contractors shrank from over 100 to 5, from a diverse set of actors to Boeing, Raytheon, Lockheed Martin, General Dynamics, and Northrop Grumman.

This about the change in US contracting rules,

Policymakers in the Clinton administration also fostered contractor price gouging, especially on contracts where there was only one bidder, or ‘sole source’ contracts. A key way to do that was to eliminate contracting rules when buying things that were determined to be ‘commercial items.’ Originally meaning that contracting rules didn’t apply to things like pencils or off-the-shelf computers that are regularly sold to private citizens, Congress changed the meaning of ‘commercial items’ in the mid-1990s to mean anything, like military transports or sophisticated weapons system that are anything but commercial... For example, the C-130 transport - which has never been sold to a private commercial party - is considered a ‘commercial item.’ And its price, which should come down as technology and manufacturing know-how improves, has skyrocketed, from one model selling at $37.5 million in 1994 to a slightly bigger version going for $200 million apiece today...

TransDigm is a more blatant example. Transdigm is a company that bought up sole source providers of spare parts and raised prices; in one case they overcharged DoD as much as 4,451% on certain items. Indeed, according to the Pentagon’s inspector general, current regulations “enable sole-source providers and manufacturers of spare parts to avoid providing uncertified cost data, (which, if you want to get technical, is a much weaker and less reliable version of the certified cost data that contractors were routinely required to submit prior to the Clinton Administration’s embrace of defense contractors). Numerous government reports have repeatedly shown that the Pentagon pays too much for spare parts. For example, IGs found that companies charged DoD $71 for a pin that should have cost less than a nickel and $80 for a drainpipe segment that should have cost $1.41.

Sparkline Capital has a great read on the rise and consequences of monopoly capitalism. This from the airline industry, where by 2016 the big four airlines had an 80% market share.

This table captures the market shares of technology monopolies

This shows the market share in highly concentrated product markets

In general, David Autor and Co have shown that the market share in the US of the top four firms (superstar firms) in 676 industries increased by around 50% over the 1980-2012 period.

The spike in M&A activity since 1980s has been a major driver of this increasing market concentration.

The superstar firms can exercise market power and therefore are much more profitable 

... and rely less on labour

Given their heavy use of automation, the labor efficiency of Big Tech is even more extreme. Apple only has 0.37 employees per $1 million revenue. Using this logic, Scott Galloway estimates that Google and Facebook’s disruption of the advertising industry led to around 199,000 job losses.

Expectedly, US corporate profit margins have risen sharply since the nineties

Historically, profits were reliably mean-reverting around 6% of GDP (blue). However, starting in the late-1990s, they seemingly underwent a paradigm shift (red). While they still gyrate with the business cycle, itappears to be around a significantly higher mean.

And this has been also associated with a decline in the share of income going to labour - both have been mirror images since 1997 or so.

Explaining this trend, Jose Azar et al examined over 8000 geographic-occupational labour markets in the US and found,

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 17% decline in posted wages, suggesting that concentration increases labor market power.

And all through this period, anti-trust activity has been declining

Mergers are almost never blocked and companies are rarely fined for antitrust violations. The decline of antitrust enforcement has proceeded through both Democratic and Republican administrations.

On a theoretical note, this early finding by Larry Summers and Brad De Long is spot on,

“An industry with high fixed costs and near-zero variable costs has another important characteristic: it tends to monopoly. The rule of thumb in high technology has been that the market leader makes a fortune, the first runner-up breaks even, and everyone else goes bankrupt rapidly. … [C]ompetition in already established markets with high fixed and low variable costs is nearly impossible to sustain.”

This is in addition to the conventional network effects.

The most disturbing factor is the political capture that invariably follows such business concentration. This, more than the business concentration by itself, is the corrosive aspect.

Revising the paradigm on anti-trust in the United States

I have blogged here about the new era in anti-trust activity within the US government. The new paradigm calls on regulators to look beyond the test of just immediate consumer welfare to cover anti-competitive practices which creates the structural conditions for market concentration and consequent abuse. 

FT reports that the US Federal Trade Commission (FTC) has filed a lawsuit to stop Meta from buying Within, a small start-up which creates experiences for virtual reality (VR). Its biggest hit, Supernatural is a fitness app that's one of the most popular on Meta's VR marketplace. FTC's argument is that halting the deal was necessary to prevent Meta from quashing a competitive threat in a potentially large market. With this, FTC is testing for the first time its new theory of harm which deals with structural conditions. 

Part of Khan’s antitrust thesis argues that regulators have previously dropped the ball by waiting until companies became multibillion-dollar players before becoming concerned about takeovers or mergers. Technology companies have proven themselves to be adept at spotting cheap newcomers and making offers that almost cannot be refused... The FTC argued in its court filing that Within, while a minnow today, exists in a new market that may become a major new platform, following the same trajectory as the smartphone. Others note the potential for fitness games to be a “killer” app, the term given to breakthrough uses that spur widespread adoption of a new technology platform. The FTC argued a company that had found early success, such as Within, should remain independent, because doing so would force Meta to build its own fitness products, increasing competition in the marketplace. Instead, acquiring the company would remove Within as a competitor and discourage others from entering the VR fitness space, the FTC said, noting that Meta had already acquired seven similar companies in the metaverse industry.

The NYT writes about how this suit seeks to upend the prevailing anti-trust paradigm,

At the heart of the F.T.C.’s lawsuit is the idea that regulators can apply antitrust law without waiting for a market to mature to the point where it is clear which companies hold the most power. The F.T.C. said such early action was justified because Meta’s deal would probably eliminate competition in the young virtual-reality market. Since the late 1970s, most federal challenges to mergers have been in large, well-established markets and aim to prevent already clear monopolies. Regulators have mostly rubber-stamped the purchases of start-ups by tech giants, such as Google’s 2006 deal to buy YouTube and Facebook’s 2012 acquisition of Instagram, because those markets were still emerging. As a result, Ms. Khan faces an uphill climb. Regulators have been reluctant to try to stop corporate mergers by relying on the theory that competition and consumers will be harmed in the future.

As the FT article reports, the industry and its lobbyists have sought to paint this as regulatory over-reach and have warned that this could have a chilling effect. 

Should it become more difficult for big companies to acquire promising start-ups, they argue, it would deprive early-stage investors of one of their primary means of cashing in on their support.

This is an important moment in the new-found anti-trust activism. It could set precedents. 

However, it may be very difficult to establish the likelihood of harm before a court of law. It's required to convince the judge on the promise of VR and in particular Supernatural, and that Meta's acquisition would, in the net, be damaging to market development.

What makes Khan’s move groundbreaking, said one antitrust academic, was the degree to which the decision may well hinge on a judge’s assessment of VR. Its prospects of commercial success are by no means certain, with adoption still lagging far behind that of traditional video games.

Then there is the risk that any policy maker faces while making decisions - is this the right time to take the decision?

But leading experts in antitrust law said the FTC’s lawsuit was “high risk”, and questioned whether Within will genuinely provide a huge boost to Meta’s dominance at the expense of consumers... A loss might undermine the FTC’s newly zealous approach, and give credence to claims that Khan’s impartiality on tech is compromised because of her prior academic work about the monopoly power of Big Tech.

But Ms Khan's response may be in terms of how the suit could shift the reference frame and the set of possibilities on anti-trust debates,

For Ms. Khan, winning the lawsuit may be less of a priority than showing it’s possible to file against a tech deal while it is still early. She has said regulators were too cautious in the past about intervening in mergers for fear of harming innovation, allowing a wave of deals between tech giants and start-ups that eventually cemented their dominance.

The paradigm set by the originalist interpretation of the US Constitution by conservatives like Robert Bork is now under serious attack for the first time in over forty years. Given the massive stakes involved and the enormously powerful interests behind them, it's unlikely to give way quickly. The struggle between the Borkian thesis and its emerging anti-thesis led by the triumvirate of trust-busters in the Biden administration is most likely to be long-drawn. 

Update 1 (27.08.2022)

FT long read on how the US trust busters are training funds on private equity firms and their buyout deals. The PE industry has risen spectacularly over the last three decades to hold nearly $10 trillion in assets under management, which are mostly management control of Main Street businesses. In 2021, PE did $1.2 trillion worth deals, and in 2022 till date PE deals formed 25% of all transactions.

The FTC and DoJ argue that the traditional application of antitrust laws — focusing on single, bilateral acquisitions — misses buyout groups’ anti-competitive behaviour as their portfolios involve multiple acquisitions that relate to each other in ways that are not immediately apparent... Bill Baer, former head of the DoJ’s antitrust division under Barack Obama, says that the approach of Khan and Kanter recognises “that private equity is a special kind of buyer in the M&A context and that some . . . firms have a record of buying assets or companies and then diminishing their competitive significance.” This marks a departure from competition policy in recent decades, where “the general view was: if it’s a private equity deal it would not get the same attention as a deal that [impacts the structure of a market],” says Rule. Among the agencies’ main concerns are private equity’s roll-up strategy and its buy, strip and flip model, whereby undervalued companies are acquired, restructured and sold off shortly thereafter... 

Both the FTC and DoJ have sounded the alarm on buyout groups acquiring assets that companies have been ordered to divest to complete another tie-up... The agencies are also scrutinising “interlocking directorates”, where private equity executives sit on boards of competing companies, which Kanter has said could violate existing antitrust legislation. And they are considering broadening disclosures in pre-merger notification forms, including on private equity’s involvement, and overhauling merger guidelines with tougher measures against unlawful deals and a stronger focus on buyout groups... The DoJ is investigating ways to challenge private equity on monopoly grounds, a violation of section two of the 1890 Sherman Antitrust Act, which could entail criminal charges. “In addition to examining whether a single acquisition violates the law, certain industry roll-ups have the potential to constitute attempted monopolisation as well when examined as a whole,” says Kanter, adding: “Antitrust enforcement must evolve to keep pace with market realities.”

This is an important point

But Kanter and Khan have already made it clear they are not afraid to lose in court. If parties “know that we’re not going to be afraid to take on a tough fight against well-resourced opponents,” he said earlier this year, “they’re going to think twice”.

See this McKinsey Report on PE industry. 

Weekend reading links

1. Global semiconductor industry facts of the day,

What makes the U.S. effort unique is the enormous one-time sum—roughly $77 billion in subsidies and tax credits—earmarked to boost American manufacturing of the ubiquitous tech component... China has prepared investments of more than $150 billion through 2030, according to one estimate. South Korea, with an aggressive array of incentives, aims to encourage roughly $260 billion in chip investments over the next five years. The European Union is pursuing more than $40 billion in public and private semiconductor investments. Japan is spending about $6 billion to double its domestic chip revenue by the end of the decade. Taiwan has around 150 government-sponsored projects for chip production over the past decade, with its leader pushing for more localized manufacturing of semiconductor equipment. Singapore landed a $5 billion chip factory earlier this year from United Microelectronics Corp...

Annual chip-industry revenues are expected to hit $1.35 trillion by 2030, more than doubling from $553 billion in 2021, according to International Business Strategies Inc., a chip consulting firm... About three-quarters of chip-making capacity is located in China, Taiwan, South Korea and Japan, according to the Semiconductor Industry Association, an industry trade group. The U.S. represents 13%... The semiconductor industry is already on a historic spending spree. It approved some $153 billion in capital expenditures in 2021—about 50% more than before the pandemic started and double the levels from five years earlier... The U.S. was expected to capture about 13% of global semiconductor capital investments through 2026, according to Gartner projections from July, with Asia forecast to account for more than three-quarters of the total spending.

2. Central Banks have acted in unison to slay inflation.

3. Thomas Edsall points to some stunning facts about the economic composition of the two political parties in the US

In 2018, according to ProximityOne, a website that analyzes the demographics of congressional districts, Democratic members of Congress represented 74 of the 100 most affluent districts, including 24 of the top 25. Conversely, Republican members of Congress represented 54 of the 100 districts with the lowest household income. The median household income in districts represented by Democrats was $66,829, which is $10,324 more than the median for districts represented by Republicans, at $56,505. The 2018 data stands in contrast to the income pattern a half-century ago. In 1973, Republicans held 63 of the 100 highest-income districts and Democrats held 73 of the 100 lowest-income districts.

He also points to this observation by Princeton political scientist Nolan McCarty,

Democrats are mostly the party of the master’s degree — modestly advantaged economically but not exactly elite. On the flip side, the Republicans are the party of the associate degree (a two-year college degree), less educated than the Democrats but not exactly the proletariat.

This from NYU Law Professor Richard Pildes

Since the New Deal in the United States and WWII in Western Europe, the base of the dominant parties of the left was less affluent, less highly educated voters; the dominant parties of the right drew their primary support from higher income, more highly educated voters... Democratic candidates received twenty-two points less support from voters in the top ten percent of the income bracket than from those in the bottom ninety percent. By 2012, that gap had dropped to only an eight-point difference and in 2016, voters in the top ten percent had become eight points more likely to vote for Democratic candidates. Similarly, in the 1940s, those with university degrees in the United States were twenty points less likely to vote for Democrats, while in 2000 there was no difference and by 2016, they were thirteen points more likely to vote for Democrats.

4. More on the problems at Byju's here. More one sees it (several articles in The Ken), Byjus appears similar to the infrastructure contractor who specialises in striking deals, cutting-corners, and massaging accounts, masquerading as a tech startup. It's also pertinent that nearly two-thirds of its revenues come from hardware, and looks likely to increase given its recent focus on physical tuition centres.   

5. Rahul Jacob writes that the US Stimulus programs were also a large Marshall Plan for Indian exporters. He argues that the country's spectacular export performance in 2021-22 was driven by US demand.

India’s strong export performance in 2021 benefitted from a once-in-a-century surge in US demand, a black swan outlier of the happy kind... merchandise exports to the US from India grew 43% in fiscal 2021-22. Our nominal exports of jewellery and leather products to the rest of the world actually declined in 2021, compared with the mostly pre-pandemic yea r of 2019. Exports of these products to the US, by contrast, surged by 50% and 20% respectively. In other words, the huge US stimulus packages in 2020 and 2021 turned out to be a Marshall Plan to revive Indian labour-intensive exporters, albeit unintentionally.

It'll be hard to replicate 2021-22, as we are already finding out. A reversion to the mean is most likely. 

6. Interesting graphic in an FT article shows the disproportionately high share of fuel imports in the India's import basket

The country's inflation is the second highest, after Thailand, among major Asian economies. More worrying is the similar position in terms of external balance.

7. FT has a report on immigration trends in UK which has a graphic highlighting the positive role played by immigration in keeping its population younger than most of Europe.

8. The year 2021 may well have been "peak-VC". From an FT report

Sample this stunning statistic,

According to Coatue, one of a new band of “crossover” investors that moved from the public markets into the VC world, $1.4tn found its way into promising growth companies globally last year, half of it in the form of venture capital and half through IPOs. That single-year surge, it calculated, was nearly $1tn more than the average of $425bn a year raised over the previous decade.

The age of FOMO is on the rearview mirror.

9. Jared Dillian on the strange nature of the current "recession"

Activity has contracted, as measured by the official gross domestic product calculations put out by the Commerce Department, but it doesn’t feel like a recession. The economy has added 2.74 million jobs this year through June. This earnings season has shown that many consumer-facing companies such as Starbucks Corp. and Uber Technologies Inc. are enjoying pricing power, and travel companies are experiencing booming demand, with Marriott International Inc. saying hotel occupancy has nearly returned to pre-pandemic levels. If you have taken a flight within the US recently, you have probably noticed that the plane is completely full and the airports are mobbed. Overall, members of the benchmark S&P 500 Index are on track to post record profits for the second quarter.

10. Shuli Ren has a very informative essay on the Chinese conglomerates, jituan, and their convoluted holding structures to raise capital. This opacity is becoming the Achilles heel as corporate defaults mount. 

The article points to the Korean chaebols which the Chinese are trying to imitate. The likes of Samsung have perfected the art of controlling massive businesses with small shareholding through multi-layered shareholding structures. 

The difference in case of China being the role of public finance, government ownership of some of these conglomerates, and their role as instruments of Chinese geo-political ambitions. Ren points to the example of Tsinghua Unigroup, "a Samsung wanna-be" and leading the Chinese semiconductor ambitions.

This seven layered structure which allowed Unigroup to both exercise control over the flash-memory chip maker YMTC and also mobilise large volumes of debt, has also proved its failing by reducing accountability and transparency.