Accountability deficit in the corporate services industry

In this post, I’ll argue that the global corporate services sectors like management and technical consulting, accounting and auditing, credit rating, and other similar services suffer from a serious market failure, one of accountability deficit. 

A concern that critics highlight about these service providers is that they have managed to somehow or other insulate themselves from the consequences of their actions/advice. When confronted with the consequences of their advice, they have the standard cop-outs - the client did not listen to them, the information that formed the basis of the audit or rating was flawed, and so on. 

Consider the case of audit firms and their effectiveness in deterring fraud.

For decades, investors have lamented how rarely external auditors uncover corporate fraud… The Association of Certified Fraud Examiners’ biennial report on how workplace fraud gets detected has typically shown auditors are the ones uncovering the wrongdoing only 4 per cent of the time… The latest report out a few weeks ago said the number is down to 3 per cent… A survey of investors by the Center for Audit Quality, a trade group for large accounting firms, found that 57 per cent thought the current system “frequently” failed to detect illegal acts… Regulators fear auditors are failing in their role as a last line of defence for investors against corporate shenanigans. 

A 3-4% fraud rate would imply global corporate governance standards that are almost of biblical purity. The rates are farcical. It's similar to the institutionalised small sample audits by superior authorities in government entities that rarely, if at all, uncover any lapses.  

Auditors have their reflexive responses.

Audit firms argue that company executives are responsible for the accuracy of financial statements and that the role of an auditor role is only to provide reasonable assurance — not a guarantee — that a financial statement is free from material misstatement. It is an argument that has prompted the US Securities and Exchange Commission’s chief accountant, Paul Munter, to exclaim to me on more than one occasion that he is fed up hearing from auditors what they do not do… PwC last year promised it would overhaul its fraud detection procedures and probe its clients’ whistleblower programmes more closely, among other reforms to boost audit quality. PwC boss Tim Ryan tried and failed to get all the Big Four firms to make a common pledge on these issues.

The responses get even more disngenuous

Audit industry leaders still talk of an “expectations gap” between what investors want an audit to be and what it really is, as if it is the investors that need to be educated instead of the profession that needs to change.

In response to the obvious problems in the audit industry, the regulators have started acting amidst stiff opposition from the industry. 

In the US, the Public Company Accounting Oversight Board is revamping rules on how auditors must look for and deal with evidence of a client’s non-compliance with laws and regulations (Noclar, in the jargon). The intent is to force auditors to cast a wider net for matters that could have a material effect on a company’s financials, even indirectly by leading to big fines or regulatory action that threatens the business. Audit firms have responded that they cannot be expected to make legal judgments, and that the huge amount of extra work implied by the Noclar proposal as currently drafted probably will not uncover anything significant that current procedures do not already… The latest move is by the International Auditing and Assurance Standards Board, which sets rules that are used as a template by scores of countries around the world. It has proposed strengthening standards on fraud detection to emphasise that auditors must look for financial misstatements that might not be “quantitatively material” but which might be “qualitatively material”, depending on who instigated the fraud and why it was perpetrated.

The FT article has the obvious logical suggestion on how the audit industry ought to have responded to these reforms. 

An alternative response to some of the current proposals would embrace them to strengthen the hand of auditors. They provide new justification to pry open clients’ businesses, push back on hostile finance chiefs and chief executives, and flag more matters of concern to directors, to investors or to the authorities — to follow through on the professional scepticism that is supposed to be at the heart of the auditors’ creed. There is room for agreement, even on the contentious Noclar proposal. Better still for auditors, there is evidence investors are willing to pay for a more robust service. The CAQ survey showed a majority would support auditors charging an additional 20 per cent or more to cover the extra work of rooting out non-compliance. 

We have an interesting problem. As the surveys indicate, investors strongly believe that audit standards are broken and need fixing. They are even willing to pay for any additional work necessary to fix it.When faced with such investor demand, the market should have responded appropriately. Instead, we have auditors pushing back strongly on efforts at any reform. 

In a quasi-cartelised industry like auditing where a handful of firms exercise tight control over the market and are entrenched in a comfortable self-serving equilibrium that also suits their clients, notwithstanding investor interest, reforms to change the equilibrium will naturally face resistance. This is a classic market failure, arising not due to any government intervention or regulation but purely due to the market's inherent inefficiencies and incentive distortions. It’s an example of a case where regulation has a constructive market-making role to play. 

I’m not sure that the auditors will embrace the reform proposals because it would increase their freedom to do more rigorous audits. There’s a trade-off between accountability and freedom. With reforms that confer more freedom (or strengthen their hands) to auditors comes greater accountability. And that’s a problem. 

On similar lines, organisations hire consultants to diagnose problems and offer recommendations. The organisations then decide to implement the recommendations. But when the outcomes don’t follow, the consultants are not held to account. Instead the consultants blame their clients for not executing them properly or for making changes to their recommendations or on confounding factors. Ironically, a consulting firm which advises an organisation on performance management does not hold itself to account for the non-delivery of its consulting objective. 

Here too there’s a market failure. An industry dominated globally by a handful of firms has collectively defined the standards and terms of their service, insulating them from any scrutiny of the consequences of their prescriptions. The incentives of the corporate executives and managers of these firms are most often aligned, for a variety of reasons, to adopt the prescriptions of the external service providers. Even if they want to enforce accountability, clients struggle to overcome the entrenched industry business model. The only way out is to break the stranglehold is through careful regulation that targets the accountability problem.

Given that the vast majority of these corporate services are procured by companies with diffused shareholders and hired executives and managers, market failure also creates a principal-agent problem. How do the investors know that their capital is being deployed and managed effectively when these ubiquitous and critical corporate services suffer from an accountability deficit? Therefore there’s a public goods case for regulation.

The case for industrial and trade policy

The case for free trade has been an article of faith in orthodox economics. It endures despite little evidence from the whole history of national economic growth. But notwithstanding orthodoxy, there has been renewed interest in industrial policy and trade restrictions in recent times. 

Gillian Tett points to a recent IMF report that describes no less than 2500 industrial policy actions globally in 2023 alone, and developing and developed countries racked up 7000 and 6000 industrial policy actions in the 2009-22 period. And industrial policies have spiked in developed countries, spurred by the threat from cheap Chinese imports. 

The IMF report says that “well-designed fiscal policies that support innovation and technology diffusion more broadly, with an emphasis on fundamental research that forms the basis of applied innovation, can lead to higher growth across countries and accelerate the transition to a greener and more digital economy.”

Tett also draws attention to a paper written by IMF economists Reda Cherif and Fuad Hasanov on the return of industrial policy

There is an important difference between policies that try to create growth by shielding domestic companies from foreign competition and those which help those companies compete more effectively on the world stage.  The former “import substitution” strategy was pursued by many developing countries in recent years, including India. It is also the variant favoured by Trump and the one being considered by some European politicians, for instance in the case of Chinese solar panels. But it is this latter approach that has given industrial policy a bad name. On the basis of copious data, Cherif and Hasanov argue that import substitution models undermine growth in the long term since they create excessively coddled, inefficient industries. By contrast, the second variant of industrial policy aims instead to make industries more competitive externally in an export-oriented model, while worrying less about imports. This approach is what drove the east Asian miracle, and is what creates sustained growth, the data suggests. The difference in approach is embodied by the contrasting fortunes of Malaysian automaker Proton car and South Korea’s Hyundai. The former was developed amid import substitution policies, and never soared; the latter flourished on the back of an export-oriented strategy. 

Cherif and Hasanov distinguish true industrial policy from a Technology and Innovation Policy (TIP) and argue that, unlike others, the East Asian economies pursued TIP.

Although they were not hit with severe negative shocks or possessed some intrinsic characteristics for success, their high sustained growth was the outcome of the implementation of an ambitious technology and innovation policy over decades that kept adapting to changing conditions and moving to the next level of sophistication. The state set ambitious goals, managed to adapt fast, and imposed accountability for its support to industries and firms. We argue that first, TIP was based on the state intervention to facilitate the move of domestic firms into sophisticated sectors beyond the existing comparative advantage. Second, export orientation since the onset played a key role in sustaining competitive pressure and pushing firms to innovate. This strategy contrasts with import substitution industrialization strategies, prevalent until the late 1980s among developing economies, that led to inefficiencies, lack of innovation, and persistent dependence on key imported inputs. Finally, the discipline of the market and accountability were enforced in a strict manner… The more a country was willing to leap technologically beyond comparative advantage and the more this technology was produced by domestic firms, the higher the chances were to sustain high growth…

We argue that TIP offers broad concepts of a growth strategy, the modalities (e.g., tools) of which are yet to be defined… In terms of the role of state, TIP is the exact opposite of centralized planning, as it favors more competition and autonomy of the private sector, not less. The role of the state to intervene is to correct market failures where they exist and enforce a strict market discipline. As such, it is the exact opposite of indefinite support for under-performing, under-innovating and rent-seeking firms. We are not arguing that TIP is easy to pursue or that there is a cookbook recipe. For example, how to select sectors or enforce a strict market discipline is still an uncharted territory… TIP is not in opposition to the standard recipe of macro-stability, improving institutions and business environment, or investing in infrastructure and human capital. All these ingredients are necessary, but not necessarily sufficient for high sustained growth. Through the lens of TIP, policymakers can set clearer priorities for their growth strategies, and we argue that higher and more sustained growth is more probable. The Asian Miracles correspond to the most ambitious version of TIP, which led them from low-income to high-income status in a couple of generations. But there is a spectrum of possibilities depending on domestic and external conditions and how ambitious the authorities are and how willing they are to implement TIP.

Cherif and Hasanov have an updated version of their paper here. They argue that industrial policies failed in the past because the “true one was barely tried… among developing economies, very few pursued an export-oriented industrialization policy on a large scale as it was the case in the Asian miracles.” Cherif and Hasanov merely confirm what Joe Studwell has brilliantly illustrated here. 

The pursuit of TIP is hard. Consider the example of India’s automobile industry which is facing the transition from internal combustion engines to greener alternatives. I came across this article by Ajai Srivastava who uses the examples of India and Australia to highlight the points made by Cherif and Hasanov. 

The Indian auto sector took a leap in the early 1980s with a JV between the Indian Maruti Udyog Limited and the Japanese Suzuki Corporation. Japanese technology and India’s expertise in casting, forging, and fabrication enhanced the domestic auto sector’s productivity by 250 per cent over the next 20 years and set it on a high growth path. Subsequently, three government decisions shaped the industry: The imposition of high import tariffs ranging from 70-125 per cent on completely built cars and motorcycles, but a low 7.5-10 per cent tariff on parts and components to allow the import of inputs; not cutting tariffs under the free-trade agreements or FTAs; and allowing up to 100 per cent foreign direct investment through the automatic route. While high import tariffs sheltered firms operating in India from external competition, the presence of many top global firms making cars in India ensured intense internal competition… About 70 per cent of India’s passenger cars are made by companies controlled by foreign firms like Suzuki, Hyundai, Kia, Toyota, Honda, Ford, Skoda, Renault, Nissan, and Mercedes. Key Indian firms are Tata Motors and Mahindra & Mahindra…

Many experts question the rationale of high tariffs. The example of the Australian auto industry, however, suggests an unwelcome outcome of tariff cuts. In 1987, Australia produced 89 per cent of the cars it used, protected by a high 45 per cent import duty. However, as Australia gradually reduced these tariffs, the proportion of locally produced vehicles decreased. Today, with import tariffs at just 5 per cent, Australia imports nearly all of its cars. Major manufacturers like Nissan, Ford, General Motors, Toyota, and Mitsubishi, which once produced vehicles in Australia, have since closed their operations there.

While industrial and trade policy helped India create a strong automobile manufacturing base, it could not make it globally competitive or innovative. This meant an automobile ecosystem primarily serving the local market and that too by foreign manufacturers. There was limited incentive to innovate, expand the technology frontier, become globally competitive, develop domestic brands, and serve export markets. It’s striking that Indian corporates have failed to leverage their massive domestic market to develop globally competitive brands in any major consumption goods and services. 

As the article informs, there’s a danger that India might be committing the same mistake with its policies on electric vehicles. In particular, there’s a strong risk that the domestic EV industry will depend on Chinese components and be captured by foreign manufacturers. I blogged earlier on it here. 

The example of Australia’s auto industry mirrors manufacturing in general across many developed countries, especially the US. The emergence of business models that prioritised outsourcing and services over manufacturing and the attractiveness of cheap imports, coupled with an ideology that scorned industrial policy and trade restrictions, meant that these countries allowed heavily subsidised Chinese exports to destroy their local manufacturing base. 

In this context, here’s my summary of the case for a heterodox industrial and trade policy. 

Certain industries are critical in the evolution of any country’s manufacturing capabilities - textiles, footwear, steel, consumer electronics, automobiles, pharmaceuticals and chemicals, etc. They catalyse manufacturing ecosystems with productivity spillovers that generate good jobs in large numbers. These sectors have backward and forward linkages that allow economies to start with less skilled activities and move up the value chain of skill and productivity. The North East Asian and Chinese economic miracle have been built on these sectors. 

The standard macroeconomic toolkits of stable and predictable policies, enabling business environment, and investments in human capital and infrastructure are insufficient to develop dynamic and competitive manufacturing ecosystems. Instead, the realisation of these beneficial effects from manufacturing depends also on the industry structure and the nature of the demand. 

So for example, a textile or electronics industry dominated by small and medium firms and manufacturing for a lower middle-income country's domestic market is unlikely to harvest the full gains from manufacturing. They are unlikely to generate the market discipline, competition, and ecosystem required to increase productivity and move up the value chain. They are similarly unlikely to have the incentives to innovate and invest in new technologies and push the frontier by moving up the value chain. Scale and export competition are critical. 

Scale can be achieved either by a large multinational company or being a contract manufacturer for large global brands. The East Asian economies generally took the latter route in their initial years. It also meant that the firms had to maintain high competitiveness in productivity and quality. This created a solid foundation for the growth of the manufacturing sector in the region. They also benefited from favourable geopolitics, trade liberalisation, and globalisation. 

Trade liberalisation and globalisation led to global value chains (GVCs) that integrated businesses and industries across borders. These value chains expanded in breadth and depth, resulting in greater economic integration of whole economies into the GVC with all its beneficial effects. 

In stark contrast, India struggled to create globally competitive manufacturing ecosystems at scale in any of these sectors and failed to integrate with GVCs. For a long time neither could India produce multinational companies nor attract large contract manufacturing firms. The resultant lack of competitiveness and scale meant that India’s manufacturing base was largely aimed at making for India. The domestic companies could not compete with foreign competitors in wide swathes of the economy. The premium and higher segments were captured by foreign brands, leaving the low-margin lower market segments to the local manufacturers. 

Successive governments in India missed the opportunities to use industrial and trade policies like adjusting tariffs to move up the value chain, subsidies and concessions linked to export performance, joint ventures, technology transfers, local content requirements etc. Indian private sector failed to seize the opportunities to create world-class companies and brands and emulate their counterparts in East Asia. Their failure to invest in technology upgradation and innovation, manifest in their low R&D expenditures, must count as a singular failure of corporate India. 

It can perhaps also be argued that India may not have had the economic bargaining power in the early years of liberalisation to pursue such policies. Besides, unlike the East Asian economies, the global economic orthodoxy and institutions like the IMF have generally had greater influence on India’s macroeconomic policies. 

A marked shift in recent years has been the willingness to break out of the orthodoxy and exhibit greater commitment and diligence to pursue heterodox industrial and trade policies. It has certainly helped that the Indian economy is now larger and a major contributor to global economic growth, thereby dramatically increasing its bargaining power. Finally, the global concerns with excessive economic reliance on China and the escalating Cold War between the US and China have been tailwinds that favour the Indian economy.

This willingness to shun orthodoxy also owes to the economic and national security threat posed by Chinese imports and its dominance of sectors and critical manufacturing inputs. The tense border situation with China supplements the increasingly evident security risks posed by that country’s beggar-thy-neighbour economic policies. The refusal to join the Regional Comprehensive Economic Partnership (RCEP) and stiff restrictions on Chinese imports and capital inflows must be viewed from this perspective. 

However, given China’s current dominance in important industrial sectors, it would be foolish and impractical for any country to abruptly and significantly cut itself off from China in the short term. Any policy to reduce reliance on the Chinese economy can only be nuanced, gradual and calibrated. It’s like sailing on two boats or pursuing two conflicting goals. 

In the short term, it’s prudent to continue trade with China and benefit from the several advantages of such engagement. However, the evolution of such trade must be continually observed and policies tweaked to steer its course away. It would involve prohibitions on certain strategic sectors, imposing barriers on certain imports and continually adjusting them, encouraging the development of domestic capabilities, and diversifying away from China. Its success or failure cannot be evaluated based on short-term trends in imports from China. 

It will entail significant costs by hurting local firms and the economy. This must be seen as the cost of national security against China. Economic interest groups and commentators who wail at the so-called protectionist policies aimed primarily against China would do well to keep this perspective in mind. 

It’s undeniable that the cheap Chinese imports are great on a purely short-term cost-benefit assessment. In areas like renewables and new technologies, the Chinese subsidies have done more to mainstream innovation and technology and reduce costs. But they have come at the cost of the destruction of domestic industries across the world and created a very risky dependence on China across manufacturing sectors. This trend cannot be allowed to continue. 

But India’s biggest challenge will be its ability and discipline to pursue well-calibrated and dynamic industrial and trade policies of the export-promoting kind that the East Asian economies did. Can it ensure that these policies prioritise export competition over import substitution? How do we ensure that such policies do not get captured by private interest groups that prevent the changes and adaptation required to move up the value chain? Specifically, can it ensure that the protection of domestic producers does not become an end in itself? 

India’s private sector and mainstream commentators will by and large stoutly oppose such policies. Opinion makers will describe such policies as protectionist and retrograde. The central government ministries have disparate interests and would be far less committed to a national security narrative. More importantly, they will struggle to internalise that perspective required for the single-minded pursuit of such policies. Finally, there’s also the deficiency of the state capability needed to pursue such dynamic policies effectively.  

Weekend reading links

1. Less discussed achievements of Abenomics, on corporate governance and capital market reforms that are major contributors to the country's economic resilience and equity market rebound.

“Reforms, new policy ideas, and civil society participation arrived in a heady rush (with Abe),” says Jamie Allen, who recently stepped down as secretary general of the Asian Corporate Governance Association (ACGA), a non-profit membership organisation driving effective corporate governance practices throughout Asia. He lists the Japan Stewardship Code of February 2014 (it has undergone two revisions since, in 2017 and in 2020); the Ito Review, in August 2014, which put return on equity (RoE) and corporate competitiveness on the map; the Corporate Governance Code of June 2015; a new third system of board governance, the Audit and Supervisory Committee Company, in 2015; the growth of sustainability reporting, strongly encouraged by the Financial Services Agency and the Ministry of Economy, Trade and Industry (METI); the emergence of new director-training institutes; an official set of Guidelines for Investor and Company Engagement in June 2018; new METI guidelines on group governance in June 2019. “Part of (Abe’s) government’s genius was to link CG reform not to risk reduction — as in most markets where governance is a corrective to excessive corporate risk taking — but to the long-term growth of companies and the revitalization of the underperforming Japanese economy,” avers Jamie...

Japan Inc was cash-heavy and that the financial indicators for Japanese companies trailed their European and United States counterparts. Years of poor capital allocation led to low RoE and low price to book (P/B)... The challenge was to link governance and financial performance, which the Tokyo Stock Exchange did through its focus on capital allocation... In March 2023, the exchange asked companies with a P/B ratio below 1 to disclose specific policies and initiatives to lift their value above it. While there may have been other financial indicators for companies to focus on, like return on capital equity or return on capital employed, the exchange narrowed in on P/B, which is now the prominent indicator. Since then, companies have begun focusing on capital efficiency. They have begun buybacks, mergers, spinoffs, unwinding crossholdings, and disposal of treasury stocks. All these are standard tools for any well-managed company but were shunned by Japanese enterprises.

As can be seen,  these are not the kind of big bang ones that commentators harp on. Instead, they are the plumbing of corporate governance and equity market regulation. These less noticed reforms are the kinds of reforms that countries need.

2. India's trade story in numbers over the last two decades

The total merchandise exports figures went up from $63.84 billion in 2003-04 to $314.40 billion in 2013-14 (a rise of $250.62 billion), and now stand at $437.06 billion (a rise of $122.65 billion). So, while the merchandise exports grew almost four-fold during 2004-14, they grew by a little over a third during 2014-24. The services exports, however, grew from $46 billion in 2003-04 to $167 billion in 2013-14 (a rise of $123 billion) and to $340 billion in 2023-24 (a rise of $173 billion from 2013-14). Thus the rise in exports of services is more than the rise in the exports of merchandise in the past ten years... the share of petroleum products (Chapter 27) in our exports basket has stagnated around 20 per cent in the past ten years. The share of gem and jewellery (Chapter 71) exports (7.7 per cent) have halved during the past 20 years. The share of pharmaceuticals (Chapter 30) has doubled in 20 years but still is only around 5 per cent. The shares of chemicals (Chapters 28 and 29) at 5.2 per cent and farm, marine etc. products (Chapters 1 to 24) at 11.01 per cent have stagnated in 20 years. The share of cotton including yarn, fabrics etc. (Chapter 50) at 5.4 per cent has gone up from 3.9 per cent two decades back. The share of highly labour intensive readymade garments (Chapters 62 and 63) has gone down from 8 per cent to 3 per cent in 20 years. The success story is that of engineering products exports (Chapters 72 to 89) whose share in our total exports went up from 18.78 per cent in 2003-04 to 21.33 per cent in 2013-14, and now stands at 29.01 per cent. The share of other products has halved at 13.06 per cent in the past 20 years. From these figures, it is clear that engineering and petroleum products account for almost half of our exports.

3.  Tamal Bandopadhyay has a very good column taking stock of the Insolvency and Bankruptcy Code.

A November 2023 report of rater Crisil Ltd pointed out that the recovery rates (as a percentage of admitted claims) have fallen from 43 per cent to 32 per cent between March 2019 and September 2023 even as the average resolution time has more than doubled, from 324 to 653 days. Realisation by financial creditors, as a percentage of liquidation value, has also dropped from 194 per cent to 168.5 per cent during this period... Since the IBC’s inception, 6,815 cases have been admitted to the NCLT, and 2,827 of these cases, that’s 41 per cent, are still undergoing the resolution process. The average resolution time has been rising and is now at a three-year high. Till December 2023, of the 6,815 cases, 891 had been resolved (against financial creditors’ claims of Rs 9.09 trillion, the realisation is Rs 3.1 trillion); 2,376 ended in liquidation (1,789 received no resolution plans and 587 got at best a couple of plans); and 721 in voluntary liquidation.

There are two problems that are not easily addressed. One, corporate India's innate instincts of using vexatious litigation to delay and subvert the process. Two, more importantly, the judiciary's willingness to foist themselves on these cases and leave them unheard for months (as the Videocon-Vedanta case pending in Supreme Court for more than two years shows). 

4. Have long run neutral interest rates in the US gone higher?

The neutral rate, sometimes called “r*" or “r-star," can’t be directly observed, only inferred... Every quarter, Fed officials project the longer-run interest rate, which is, in effect, their estimate of neutral. Their median estimate declined from 4.25% in 2012 to 2.5% in 2019. After subtracting inflation of 2%, that yielded a real neutral rate of 0.5%... if inflation resumes its decline, questions about neutral would drive how much the Fed ultimately cuts rates. The Fed wants to “normalize policy, but ‘normalize’ to where?" said David Mericle, chief U.S. economist at Goldman Sachs. “They are not going to stay in the 5s, but normalization is not going to take them all the way to 2.5%. Where in the 3s or 4s they feel comfortable stopping is still up in the air." There are several factors cited for why neutral may be rising: soaring government deficits and strong investment driven by the green-energy transition and an artificial-intelligence-fueled frenzy for electricity-intensive data centers. Higher productivity from AI could also lift long-run growth and the neutral rate. Dallas Fed President Lorie Logan warned in a recent speech that interest rates may not be as restrictive as believed because of a higher neutral rate. “Failing to recognize a sustained move up in the neutral rate could lead to over-accommodative monetary policy," she said... Interest-rate futures suggest the fed-funds rate will stabilize around 4% in coming years.

5. Interesting that the growth of GST collections have lagged behind the growth rates of nominal GDP and Income Tax.

The corporate tax cuts have not only not revived private investments but has also led to a reduction in corporate tax revenues as a share of GDP.

The tax cut failed to achieve its goals, as private investments have not taken off and the government has been forced to pump in massive amounts through capital expenditure to support the economy. At the same time, the immediate result of the tax cut is visible in collections, which is expected to be 3.2% of GDP in 2024-25, significantly less than the average mop-up a decade before the decision. As such, the government’s coffers are being filled more by personal tax collections than by corporate tax, raising questions about whether it is indeed pro-corporate.

6. FT has an article that points to the steep decline in water desalination costs on the back of cheap solar power.

Older, thermal plants, which used heat to turn salt water into steam, delivered potable water at more than $3 per cubic metre. Since then, reverse osmosis technology — in which water is pushed through a membrane to remove salt, minerals and impurities — has taken over. Plants cost less to build — perhaps $400mn to purify 500,000 cubic metres per day, says Christopher Gasson of GWI. Including installation, a return on capital and operating costs, that translates to $0.30 per cubic metre of water. Newer plants also need less energy — 2.6KWh per cubic metre — and are increasingly powered by cheap solar plants. The cheapest plant in the world gets energy at $0.025/KWh, or $0.07 per cubic metre. Put that together and it explains how the Hassyan project in Dubai has promised desalinated water at just $0.37 per cubic metre. For reference, drinking water in London is priced at £1 per cubic metre. At this sort of level, desalination becomes more affordable for dry, coastal areas, not just in the Middle East but also in Egypt, Algeria and Morocco, which are all building new plants... the market for new plants is expected to grow by perhaps 8 per cent a year from now to 2030... early movers in the desalination sphere, including Saudi Arabia’s ACWA power, Spain’s Acciona and France’s Veolia, have a clear advantage in a competitive race.

7. Rana Farrohar points to the dysfunctional nature of the US home insurance market.

A couple of months ago, my insurance company decided to raise the price of the yearly insurance premiums on our Brooklyn home by 51 per cent over three years, after more than doubling the estimated cost to rebuild should it burn to the ground or be washed away in a hurricane. While neither outcome seems likely for a limestone townhouse that sits on a hill more than a mile and a half away from the nearest flood zone, our insurer came up with an estimate that was more than double what the house would go for on the open market, making coverage both excessive and unaffordable... No one was willing to sell us a premium for the market value of our home and simultaneously prepared to write us a cheque for that value in case of total loss. We had two choices. Take out a policy with a handful of luxury insurers that would only sell us far greater coverage than we wanted for much more than we could afford. Or go with a budget policy offering roughly a third of what it would cost to buy a similar home in the case of a total loss — with the money only paid out if we chose to rebuild on site... we have any number of friends with similar homes who are paying wildly different prices for insurance. When I asked our broker how it was possible, or even legal, for a neighbour with the same insurer and the exact same house three doors away to pay a bit more than half our new quote, she told us that their premiums would very likely be raised next... 

How could there be so few options, so little transparency and such tolerance of inflation and inefficiency in a market as big as New York? Why was my home, which has never been seriously damaged by weather, being risk-assessed like something in a hurricane flood zone that is more than a mile and a half away? Why is the insurance industry so bad at pricing risk in a more precise way around the city, and indeed, much of the rest of the country?

Talk about free markets and their magic! This is a great example of how markets on their own fail to work, thereby necessitating regulation and government intervention to make them work effectively.  

8. China economy imbalance facts of the week.

China’s investment to gross domestic product ratio, at more than 40 per cent last year, is one of the highest in the world, according to the IMF, while private consumption to GDP was about 39 per cent in 2023 compared to about 68 per cent in the US. With the property slowdown, more of this investment is pouring into manufacturing rather than household consumption, stimulating oversupply, western critics say. “China is responsible for one-third of global production but one-tenth of global demand, so there’s a clear mismatch,” US secretary of state Antony Blinken said in Beijing last week... China’s high national savings rates, which, at more than 47 per cent of GDP in 2022, are double the world average.

“The solution has always been a massive increase in investment,” Pettis says. But, he adds, with signs of over-investment now “everywhere”, from the property sector to overbuilt infrastructure, and debt to GDP at about 300 per cent, “you can see that investment can no longer be the solution”... Greater consumption would also necessarily mean reducing the role of manufacturing or investment in the economy. This could be done by unwinding China’s intricate system of subsidies to producers, which includes government infrastructure investment, access to cheap labour, land and other credit, says Pettis. But if that was done in a big bang fashion, the share of household consumption to GDP would increase while overall GDP would contract as manufacturers suffered. This was obviously not a politically preferable option for Xi. “They are locked into this system,” Pettis says.

9. Michael Pettis has a nice summary of the economic imbalance problem.

China’s structurally-high domestic saving rate is the result of a decades-long development strategy in which income is effectively transferred from households to subsidise the supply side of the economy — the production of goods and services. As a result of these transfers, growth in household income has long lagged behind productivity growth, leaving Chinese households unable to consume much of what they produce. Some of these subsidies are explicit but most are in the form of implicit and hidden transfers. These include directed credit, an undervalued currency, labour restrictions, weak social safety nets, and overinvestment in transportation infrastructure. These various policies automatically force up Chinese savings. By effectively exporting excess savings through the subsidy of the production of goods and services, China is able to externalise the resulting demand deficiency...

China’s structurally-high domestic saving rate is the result of a decades-long development strategy in which income is effectively transferred from households to subsidise the supply side of the economy — the production of goods and services. As a result of these transfers, growth in household income has long lagged behind productivity growth, leaving Chinese households unable to consume much of what they produce. Some of these subsidies are explicit but most are in the form of implicit and hidden transfers. These include directed credit, an undervalued currency, labour restrictions, weak social safety nets, and overinvestment in transportation infrastructure. These various policies automatically force up Chinese savings. By effectively exporting excess savings through the subsidy of the production of goods and services, China is able to externalise the resulting demand deficiency.

10. The economic imbalance is also creating foreign policy tensions, and increasingly with other developing countries over cheap Chinese imports flooding their markets and destroying local industries. 

Brazil’s industry ministry has launched a number of investigations into the alleged dumping of industrial products by China as Latin America’s largest economy reels from a wave of cheap imported goods. At the request of industry bodies, the ministry has in the past six months opened at least half a dozen probes on products ranging from metal sheets and pre-painted steel to chemicals and tyres... In addition to Brazil, China’s steel exports to Vietnam, Thailand, Malaysia and Indonesia have risen sharply in recent months... In Thailand, the government has accused Chinese companies of evading anti-dumping duties, while industry groups have warned of big losses from cheaper steel in the market. Vietnam’s government has launched investigations into dumping of wind towers and some steel products from China after complaints from the local industries. In August last year Mexico imposed tariffs of 5-25 per cent on imports of hundreds of goods from countries with which it does not have a free trade agreement, with China being one of the countries most affected.

11. A less discussed but one of the most remarkable achievements of energy policy, foreign policy (and the European Project), and infrastructure mobilisation was the success of Germany and Europe in replacing Russian natural gas imports in the aftermath of the Ukraine invasion. Germany took the lead in establishing LNG import terminals, Floating Storage Regasification Units (FSRU). 

Wilhelmshaven was the first floating storage regasification unit (FSRU) to come online during the crisis but many more are in the works. Since Russia started cutting pipeline supplies to Europe in 2021, at least 17 liquefied natural gas (LNG) terminals have been planned or are under construction. LNG received by these FSRUs have helped replace all but 10 per cent of the gas supplies that previously came to the EU from Russia via pipelines, helping to reduce gas prices from record highs of over €300 per megawatt hour in August 2022 to near pre-crisis levels of around €30 per megawatt hour today. The energy crisis that Europeans feared two winters ago has not come to pass, thanks to a combination of unprecedented energy policy interventions, cuts in demand and good luck... The bloc is reliant on imports, either through pipelines or LNG shipments, for nearly 90 per cent of its supplies. Before the war, flows through four main pipelines from Russia accounted for around 40 per cent of the EU’s total supplies.

The higher prices being paid in Europe led LNG traders to prioritise deliveries to customers there over those in Asia, says Tom Marzec-Manser, head of gas analytics at ICIS. “Market signals were fundamental in allocating resources where it was needed.”

12. Hybrids cars are growing faster than EVs, whose growth has declined globally.

According to S&P Global, the penetration of all categories of hybrids has gone up from 9 per cent globally to 11 per cent in 2023 and is neck-and-neck with electric cars, though the latter are marginally ahead at 12 per cent, compared to 10 per cent in 2022. In the United States, hybrid sales in 2023 were 1.4 million and overtook electric cars, which sold 1.2 million. Globally, sales of plug-in hybrids grew faster, going up by 43 per cent in 2023, compared to a 28 per cent increase for electric cars.

Plug-in hybrids have two engines and the electric part has a much larger battery than in the regular hybrids. As the name suggests, plug-in hybrids require to be plugged into an electric socket to charge their battery. A regular hybrid gets its battery (smaller than in plug-ins) charged by the gasoline engine – the two complement each other -- and regenerative braking. Plug-in hybrids in China grew by 85 per cent in 2023, while electric vehicles grew by 70 per cent. In India, the popular hybrids, such as Toyota Hyryder and Maruti Suzuki’s Grand Vitara, do not require to be plugged in. The global trend towards hybrids is now visible in India, where they are being seen as an essential bridge to EV land... Electric cars attract a goods and services tax (GST) rate of 5 per cent. Hybrid cars attract 28 per cent GST, but the cess takes the total tax incidence to 43 per cent, unless it is a small car. ICE cars attract the same GST, but the cess takes the total to up to 50 per cent, varying according to the size of the body and engine.

This is an interesting cautionary tale from Norway about the promised emission benefits from EVs.

A study by Goehring & Rozencwajg, a natural resource investor, says despite the noise on Norway’s successful model for electrification of cars, the country forks out $4 billion on electric vehicle subsidies annually, as much as it does for building highways and maintaining public infrastructure, which has a big financial impact. Goehring & Rozencwajg also points out that despite all the action on the electric front in Norway — 20 per cent of all vehicles on the country’s roads and 80 per cent of new vehicles are electric — gasoline demand has gone down by only 4 per cent. That is because Norwegians are reluctant to give up their ICE cars even after they have bought an electric. Two-thirds of car owners in Norway have at least one ICE vehicle, and they continue to use it.

This effect is likely to be more pronounced in India.

13. Shyam Saran has a good oped on the ongoing situation in Gaza, which is clearly a genocide and a humanitarian disaster happening with the full knowledge of the UN and the international community and with so limited restraints on Israel. As Saran writes, the political survival of Netanyahu depends on the continuation and escalation of the situation in the region. 

The drivers of inflation in the US

One of the big macroeconomic debates after the pandemic has been on the trajectory of inflation. The team persistent, led by Larry Summers and Co., worried that the persistence of the extraordinary monetary and fiscal policies, long after the pandemic subsided, may have unleased inflationary forces that cannot be brought down without a recession. The team transitory, led by Joseph Stiglitz and Co., argued that the inflationary episode was due to negative supply shocks from the pandemic and the Ukraine war and would recede once the shocks subside. 

As with everything in economics, it’s difficult to establish who’s turned out right conclusively. There are arguments in favour of both. The Economist has a good summary here that also points to a study by researchers at Allianz.

They conclude that the Fed played a vital role. About 20% of the disinflation, in their analysis, can be chalked up to the power of monetary tightening in restraining demand. They attribute another 25% to anchored inflation expectations, or the belief that the Fed would not let inflation spiral out of control—a belief crucially reinforced by its tough tightening. The final 55%, they find, owes to the healing of supply chains.

I’m inclined to agree with the Allianz conclusion. Even if the surge in inflation was completely driven by supply shocks, given the massive accompanying fiscal and monetary stimuluses, I don’t think inflation would have subsided on its own. In fact, it can be argued that inflation could have been lower if the monetary authorities acted earlier than they did. 

The latest World Economic Outlook has some useful pointers about the sources of inflation across advanced countries in the 2020-24 period. Martin Wolf has the same graphics that disaggregate the drivers of inflation in the US and the Eurozone.

This disaggregates inflation drivers in the UK.

It’s clear that at least from early 2021 till about the end of 2022, all the advanced countries were deeply impacted by the supply shocks and the pass-through effects. These effects were more pronounced in Europe given its direct dependence on Russia for its energy needs. But the one standout feature is the rapid recession of the supply shocks and pass-through effects once the episodes themselves (the pandemic and the war) subsided. The difference though is that in the US a labour market tightness emerged to sustain inflation. The WEO writes,

The rapid fading of pass-through from past relative price movements––in particular from energy price shocks––has played a larger role in the euro area and the United Kingdom than in the United States in reducing core inflation. In the United States, labor market tightness and, more broadly, strong macroeconomic conditions, which partly reflect the effects of earlier fiscal stimulus as well as strong private consumption, are the main source of remaining upward pressure on underlying inflation. In the United Kingdom, labor market tightness predating the pandemic may partly explain why inflation has been higher than in the US or euro area following the onset of the pandemic. 

The WEO also points to the normalisation/depletion of the excess savings accumulated during the pandemic. 

As the WEO writes, the massive fiscal stimulus especially by way of direct transfers coupled with the booming stock markets, and associated strong private consumption has been an important factor in keeping the labour market tight and inflation elevated in the US. While the supply shocks have long receded, the lagged effects of this stimulus still linger. 

But there have been two additional factors stimulating the economy and consumption in the US - the strong equity and housing markets and associated wealth effects, and the investment boom (including government stimulus) in green technologies, semiconductor chip manufacturing, and AI. The investment boom is in its early phase and will play out over at least this decade, if not longer. There will be associated productivity improvements. 

All this means that it’s unlikely that the US inflation will fall back to 2% anytime soon. In fact, as I have blogged earlier, the return to normalcy in inflation might not mean a return to the pre-pandemic 2% rate but a slightly higher band, perhaps 2.5%-3.5%. There has been a regime shift in inflation. If this is true, the US economy is far closer to its new normal inflation regime than the Fed imagines.

Corporate profits, subway tunnelling techniques, and affordable housing

1.  A new working paper by Michael Smolyansky shows that low-interest rates and corporate tax rate cuts explain a major share of corporate profitability.  

From 1989 to 2019, the S&P 500 index grew at an impressive real rate of 5.5 percent per year, excluding dividends. The rate of U.S. real GDP growth over the same period was 2.5 percent. What accounts for this enormous discrepancy? And is it sustainable? I argue that it is not. To reach this conclusion, I consider 60 years of data on the earnings and stock price performance of S&P 500 nonfinancial firms, from 1962 to 2022. My central finding is that the 30-year period prior to the pandemic was exceptional. During these years, both interest rates and corporate tax rates declined substantially. This had the mechanical effect of significantly boosting corporate profit growth. Specifically, I find that the reduction in interest and corporate tax rates was responsible for over 40 percent of the growth in real corporate profits from 1989 to 2019. Moreover, the decline in risk-free rates over this period explains the entirety of the expansion in price-to-earnings (P/E) multiples. Together, these two factors therefore account for the majority of this period’s exceptional stock market performance... The overall conclusion, then, is that—with the expected slowdown in corporate profit growth and no offsetting expansion in P/E multiples—real longer-run stock returns in the future are likely to be no higher than about 2 percent, the rate of GDP growth.

He compares the real EBIT (earnings before interest and tax expenses) growth for the 1962-89 and 1989-2019 periods - 2.2% and 2.4%. He shows that interest and tax expenses as a share of EBIT declined from 54% in 1989 to 27% by 2019, pointing to an ever-declining share of profits being paid out to debt holders and tax authorities. 

Now both interest rates and corporate tax rates have bottomed out - the 10-year Treasury yields have fallen from 7.9% to 1.9% over 1989-2019 and the effective tax rate for S&P 500 companies fell from 34% to 15%. In fact, both rates are now likely to rise. This means that corporate profits can at best only grow at the same rate as EBIT. 

This also means that companies benefited from policy changes and good luck, and enjoyed higher profits not attributable to their efforts.

This blog has been long-time sceptic of the economic orthodoxy and conventional wisdom that low corporate tax rates will spur investment. In The Rise of Finance, we point to evidence that contradicts this. 

The latest example is from India, where corporate investments have struggled to materialize despite significant corporate tax cuts and a favourable economic environment. In fact, not only have corporate tax cuts not revived private investments but it has also led to a reduction in corporate tax revenues as a share of GDP.

2. Fascinating account by Brian Potter in the latest edition of Works in Progress about the shift from the cheaper but more disruptive cut and cover technique to the much more expensive tunnel boring techniques in the construction of metro railway systems. 

This about how the Brunel shield technique was used to tunnel under the Thames in 1825. 

Soft-ground TBMs evolved from unmechanized tunnel shields, large hollow structures that supported the sides of the tunnel while it was being excavated. The tunnel shield was invented by Marc Brunel (father of ​Isambard Kingdom Brunel) in 1806 for tunneling under the Neva River in Russia, and was first used to tunnel under the Thames in 1825. Brunel’s shield consisted of a 21-foot-tall grid of iron frames, divided into 12 separate frames, each one consisting of three compartments stacked on top of one another. Within each compartment, the face of the tunnel would be supported by a series of boards called poling boards. A worker would remove a single board, dig away the soil behind it to a depth of around nine inches, and then replace the board and move on to the next one. After all boards had been dug out, the frame would advance forward with large mechanical jacks, and the process would repeat. Behind the shield, brick lining would be installed around the sides of the tunnel to form its structure. With Brunel’s shield, tunneling under the Thames proceeded at about eight feet per week on average...

The tunnel shield prevented the sides of the tunnel from collapsing while it was bored, but they still required some method to prevent the face of the tunnel from collapsing, and to prevent water from intruding when tunneling below the water table. By the late nineteenth century, the standard method was to use compressed air. By pressurizing the tunnel to several times atmospheric pressure, water would be kept out. Compressed air remained in use well into the twentieth century, and is still sometimes used today, but it has been largely supplanted by slurry machines and earth pressure balance machines, which respectively use a bentonite slurry and the excavated material itself to support the face of the tunnel. Today, earth pressure balance machines are the most common type of TBM for tunneling through soil.

Then there’s the top-down and bottom-up approaches in the cut-and-cover method

Cut and cover also uses different methods for building the tunnel structure itself. In the conventional method, known as bottom-up, the trench is fully excavated and the tunnel structure is built up starting from the bottom. With the top-down method, by contrast, the tunnel is excavated only partway down, and then the roof of the tunnel is built using the existing soil as a vertical support. Once the roof is in place, the rest of the tunnel is then excavated below it. With top-down construction, the surface can be completely restored after the roof has been built; with bottom-up, the top of the excavation will often be covered with temporary decking to allow use of the surface while tunnel construction is taking place.

This about the respective speeds and economics of different tunneling technologies

Brunel’s non-mechanized shield tunneled under the Thames at the glacial pace of eight feet per week. By the early 1900s, Price mechanized shields were achieving excavation rates of nearly 200 feet per week. And by the 1970s, TBMs were achieving rates of 1,400 feet per week in soft ground, and 1,900 feet per week in rock... As TBMs got faster, they also got cheaper, and became increasingly competitive with cut and cover. When a TBM was used to bore some of the tunnels on the Bay Area Rapid Transit (BART) project in the 1960s, its costs were just 40 percent higher on average than the cut and cover sections, a far cry from the eight-times cost difference on the New York Subway... Depending on the nature of the project and how disruptive surface construction would be, TBMs in some cases began to be cheaper than cut and cover...

TBMs have high fixed costs (in the form of the time, effort, and expense to buy the machine and get it set up) but low operational costs: once they are up and running, the marginal cost of additional excavation is low. TBMs are thus often particularly economical on large tunneling projects where the fixed costs of the machine can be thinly spread. ​When Madrid built 60 miles of underground tunnel when constructing its metro in the late 1990s and early 2000s, it achieved a famously low cost ​of €42 million per kilometer (about $73 million per kilometer in 2023 dollars) using TBMs. And the recent extension of the L11 line in Madrid, which adds another 4.3 miles to the metro system, likewise found that excavation with TBMs would be cheaper than cut and cover.

3.  As I have blogged on numerous occasions, arguably the biggest challenge to urban growth is housing affordability in the larger cities. Given the limited extent of vacant lands remaining, there’s no alternative to radical changes to urban planning rules to create the conditions that allow for incentives and market forces to increase the supply of housing from brownfield properties. 

Ben Hopkinton and Sam Dumitriu have a series of posts on increasing housing supply in London where prices have risen sharply and the average floor space has declined. In the first post they propose upzoning in the brownfield locations around transit stations. They point to Paris, Madrid, and Milan having areas twice as dense as the densest parts of London and some of the best-connected parts of London being built at extremely low densities. They propose permissions for additional floors on the older properties (pre-1919 ones), and adoption of New Zealand’s 2020 plan of automatic approval for six floors in properties that are within walking distance of city centres, commercial hubs, and transit stops. 

In the second post, they propose building on some of London’s several Golf courses, those that are well-connected or centrally located. They point to some very interesting facts about Golf courses.

If all of London’s golf courses were a borough, they would be its 15th largest – roughly the size of Brent… London’s 95 golf courses (excluding driving ranges and courses with fewer than 9 holes) take almost as much land as all other sporting activities combined. There are also a further 74 golf courses just outside London too. More of London is dedicated to golf than to football, despite the fact that many times more Londoners play football than play golf on a regular basis. A large proportion of London’s golf courses are publicly-owned. In fact, if London’s publicly owned golf courses were a borough, they would be larger than Hammersmith and Fulham. Yet councils get little in return as they lease them to golf clubs on the cheap. For instance, one golf course pays just £13,500 in rent to Enfield council for 39 hectares. That’s £3,000 less than it costs to rent a one bed flat in Enfield.

The third post proposes the rezoning of industrial sites and localities that are well connected. The last post proposes policies to encourage the renewal of older areas, specifically old public housing estates. 

The ideas raised in the four posts are universal and applicable to cities worldwide. Affordable housing policies must work on similar urban planning reforms to create the conditions for increasing housing supply. 

Weekend reading links

1. Two long reads in NYT about Novo Nordisk and its wonder drugs Ozempic and Wegovy. The first is about the transformation it has brought about to the Danish town of Kalundborg, a town of under 17000 people, and where the company makes nearly all the semaglutide, the active ingredient for its wildly popular diabetes and obesity treatment drugs. It now plans to invest $8.6 bn to expand its facilities there, adding 1250 employees to its existing 4500 workforce. 

Kalundborg knows the benefits and risks of pinning the town’s fortunes to one company. A shipyard briefly dominated the town’s economy early last century, but was decimated during the Great Depression. In the 1960s, Kalundborg thrived as the manufacturing site for Carmen Curlers, which pioneered electric hot hair curlers, causing a sensation in the United States. Then the company was sold to the American firm Clairol, fashions changed, thousands were laid off and the plant eventually closed in 1990... Educational opportunities are already undergoing a transformative change. For years, high school graduates left town to continue their education, and Novo Nordisk struggled to retain scientists and other employees with advanced training. Now, three universities offer courses in biotechnology and related subjects in town, with more institutions arriving soon. The Novo Nordisk Foundation also finances the Helix Lab, where graduate students complete their master’s thesis working with local companies, including Novo Nordisk... Recently, Kalundborg has been able to sell plots of land it had previously been struggling to shift to private developers. And there is talk of opening an international school to teach children in English to accommodate the drugmaker’s increasingly international work force.

The impact on the Danish economy has been no less significant.

Novo Nordisk is already reshaping Denmark’s economy. The country’s economy grew 1.9 percent last year, among the fastest in Europe and all thanks to the pharmaceutical industry, led by Novo Nordisk. Without it, the economy would have stagnated. Nearly all of Novo Nordisk’s revenue is earned overseas, more than half in the United States alone... The company is the largest corporate taxpayer in Denmark. Last year it paid about 15 percent of the country’s entire corporate tax intake, more than other big Danish companies like the brewer Carlsberg, the toy company Lego and the shipping firm Maersk... (But) Novo Nordisk’s employees represent just 1 percent of the Danish work force — though it did account for 20 percent of the jobs added last year. Some of the corporate taxes that Novo Nordisk pays return to the communities where the company operates. Gladsaxe, the municipality on the edge of Copenhagen that includes Bagsvaerd, the home of Novo Nordisk’s headquarters, is investing in day care centers and new sports facilities, and is building a light rail transit system with other regions outside the capital.

The company's spectacular growth (the 100 year-old company's revenue grew by over 30% in 2023 to $33 bn, and its market value exceeded $555 bn) has created challenges for itself. 

For most of its 100 years Novo Nordisk has been focused on the steady business of treating diabetes, one of the world’s most prevalent chronic diseases. Even today, it produces half the world’s insulin. But the development of Ozempic and Wegovy has led to a bigger and bolder ambition to “defeat serious chronic diseases.” That includes treating, and even preventing, obesity, which is linked to other health issues like heart and kidney diseases. By pursuing a much larger target than diabetes, the company expects to unlock the door to a multibillion-dollar market with nearly a billion potential patients. In the United States alone, more than 40 percent of adults are obese...

But in all the tumult, there is something executives are trying to hold on to: the company’s longstanding values, codified in the “Novo Nordisk Way.” Those principles, which include having a “patient-centered business approach,” have helped earn the company a good reputation at home, where it’s considered a place where people are proud to work. But these guideposts are facing pressure as tens of thousands of new employees are hired, lawmakers denounce the drugmaker for its high prices and counterfeit versions of its products make people sick... The heart of the growth is semaglutide, Novo Nordisk’s synthetic version of a hormone known as glucagon-like peptide 1, or GLP-1, which helps the body regulate blood sugar levels. The patent developed by the company also proved remarkably effective for weight loss. It causes people to feel fuller when they eat and reduces cravings...

Ozempic, the brand name for semaglutide, a weekly injection for Type 2 diabetes patients, has been around for more than six years. But in the last couple of years, there was an explosion in popularity, helped along by heavy advertising, social media videos and intrigue over celebrity use... As Ozempic began to take off, Novo Nordisk pushed ahead with Wegovy, which is semaglutide marketed specifically for weight loss... Novo Nordisk leads the pack in obesity treatment, but it now has strong competition from Eli Lilly, which sells a similar drug under the brand names Mounjaro, for diabetes, and Zepbound, for weight loss. Other pharmaceutical companies are clambering to catch up.

2.  How do rich and poor countries reduce their debt?

Interesting that poor countries have relied more on inflation and economic growth to pare their debt, and rely less on generating primary surpluses. 

3. The evolving story of the market expectations on US interest rate cuts.

At the end of last year, futures markets had priced in six interest rate cuts for the US in 2024. As stubborn inflation data kept coming in over the first quarter, traders began to slowly align with the US Federal Reserve’s forecast for just three. But, over the past two weeks, those still expecting several cuts this year have started to look like stubborn contrarians. A third above-expectation reading for US consumer price index inflation in March was the final straw. Traders repriced to between one and two rate cuts this year — although zero is an increasingly popular punt too. 

4. Ruchir Sharma writes that the strong performance of the US economy, perhaps a third of the growth in 2023, can be attributed to the overhang of the large fiscal and monetary stimulus. The US continued stimulating its economy long after the recession of 2020 got over. Apart from sustaining growth, the over-stimulation may also explain idiosyncrasies in different markets.

The broad measure of money supply known as M2, which includes cash held in money market accounts and bank deposits, as well as other forms of savings, is still well above its pre-pandemic trend. In Europe and the UK, where monetary stimulus was less aggressive, M2 has fallen back below trend. This liquidity hangover has countered Fed interest rate hikes and helps explain the current behaviour of asset prices. Corporate earnings are up, on strong GDP growth, but prices for stocks — not to mention bitcoin, gold and much else — have been rising even faster. This odd combination — higher stock valuations despite higher rates — has not happened in any period of Fed tightening going back to the late 1950s. A similar levitation act is visible in the US housing market; despite higher mortgages rates, prices have risen steadily and faster than in other developed nations. Since 2020, the total net worth of US households has risen by nearly $40tn to $157tn, driven by home and stock prices. For the better off, this “wealth effect” is a happy turn. More Americans plan to vacation abroad this summer than at any time since records begin in the 1960s. For the less well off, who summer locally, do not own a home and tend to be younger, these conditions are less felicitous.

He feels that with both consumer and asset prices elevated and money supply still high, there's limited room for the Fed to cut rates immediately.  

5. In another shot at anti-competitive practices, the US FTC has voted to ban non-compete agreements by employers that restrict employees freedom to change jobs. 

The FTC said approximately 30mn workers are subject to such contracts, which prohibit employees from working for a competitor or setting up a competing business for a period of time or within a geographical area after they leave a job. “Non-compete clauses keep wages low, suppress new ideas, and rob the American economy of dynamism, including from the more than 8,500 new start-ups that would be created a year once non-competes are banned,” said Lina Khan, FTC chair. Non-competes constituted “unfair methods of competition”, she added. The FTC estimated the new rule will raise an average worker’s earnings by $524 a year... The US Chamber of Commerce announced it would sue the regulator, arguing the agency lacked constitutional and statutory authority to enact the rule, calling it a “blatant power grab” that “sets a dangerous precedent for government micromanagement of business”.

The non-compete clauses cover a vast variety of jobs that include TV news producers, hairdressers, corporate executives, and computer engineers. Non-compete clauses covering senior executives are not covered by this order. This decision is certain to be challenged in courts, with the US Chamber of Commerce vowing to sue the FTC. The Times writes.

Workers in finance and professional services are the most likely to have noncompete contracts, at a rate of nearly 20 percent. Studies have shown that noncompetes suppress wages because switching jobs is the most efficient way workers can increase how much they make.

6. FT has a long read that discusses the discontent in South Africa at the legacy of Nelson Mandela. The crux of the argument is that while Mandela's leadership gave the black majority political freedom, his compromises with the white minority ended up depriving them of economic freedom. 

ANC was too timid from the outset in pursuing a more progressive economic agenda. Instead, Mandela’s government adopted the neoliberal orthodoxy of the times... Enacting a self-imposed structural adjustment of the sort favoured by the Washington consensus, it reduced tariffs, cut fiscal deficits and ran a hawkish monetary policy that persists to this day. “We wanted to outdo the neoliberals,” says Msimang, adding that a desire to prove a Black government could govern responsibly led the ANC mistakenly to “out World Bank the World Bank”. One result of that shock therapy, say some economists, was to expose the previously protected manufacturing base to outside competition too quickly, nearly halving manufacturing as a share of output from 21 per cent to 12 per cent in the 20 years after the ANC took power. When the commodity supercycle ended and the global financial crisis hit in 2008, growth rates plummeted with an inevitable knock-on effect on living standards...

The re-evaluation of Mandela’s legacy from across South Africa’s political spectrum has been accompanied by a revival of appreciation for Winnie, who was put in solitary confinement, tortured and sent to a remote internal exile by the apartheid authorities. “She bore the brunt of the apartheid regime’s attacks on Black people,” says Jonny Steinberg, author of Winnie & Nelson, a book that re-examines their dual legacy. “She said, ‘I was physically engaged with the enemy because my body was being battered while you [Nelson] were wrapped in a cocoon.’ Her story was that he negotiated away his people’s future because he was no longer truly a Black person, he’d been turned into somebody else inside prison, whereas she was the embodiment of people’s suffering.”... Winnie’s death in 2018 sparked a resurgence in her reputation and her adoption as an icon by Malema, leader of the EFF. In her defiance and refusal to compromise with her oppressors, many younger Black South Africans have come to regard her as a metaphor for the path not taken.

7. The latest industry to suffer from China's capacity glut is car manufacturing. 

China has more than 100 factories with the capacity to build close to 40 million internal combustion engine cars a year. That is roughly twice as many as people in China want to buy, and sales of these cars are dropping fast as electric vehicles become more popular. Last month, for the first time, sales of battery-electric and plug-in gasoline-electric hybrid cars together surpassed those of gasoline-powered cars in China’s 35 largest cities. Dozens of gasoline-powered vehicle factories are barely running or have already been mothballed... Automakers with factories close to China’s coast are exporting gasoline-powered cars. But many of the endangered factories are in cities deep inside the country, like Chongqing, where high transport costs to the coast make it too expensive to export... Sales of gasoline-powered cars plummeted to 17.7 million last year from 28.3 million in 2017... That drop is equivalent to the entire European Union car market last year, or all of the United States’ annual car and light truck production...

The longstanding benchmark is that car factories should run at 80 percent of capacity, or more, to be efficient and make money. But with new electric car factories opening and few older factories closing, capacity utilization across the entire industry fell to 65 percent in the first three months of this year from 75 percent last year and 80 percent or more before the Covid-19 pandemic, according to China’s National Bureau of Statistics. Without a big burst of exports last year, the industry would have operated even further below full capacity. Chinese manufacturers, many of them partly or entirely owned by city governments, have been reluctant to reduce output and cut jobs... 

The country’s auto industry is near the start of an E.V. transition that is expected to last years and eventually claim many of those factories. How China manages that long change will influence its future economic growth, since the auto sector is so big and could transform its workforce. The stakes are great for the rest of the world, too. China, the world’s largest car market, became the largest exporter last year, having passed Japan and Germany. China’s auto sales abroad are exploding. Three-quarters of China’s exported cars are gasoline-powered models that the domestic market no longer needs... Those exports threaten to flatten producers elsewhere. At the same time, China’s electric vehicle companies are still investing heavily in new factories... Electric car sales in China are still growing. But the pace of growth has halved since last summer, as consumer spending has faltered in China because of a housing market crisis... China also has overcapacity in electric vehicle manufacturing, although less than for gasoline-powered cars. Price cutting for electric vehicles is common... Almost all of China’s electric cars are assembled at newly built factories, which qualify for subsidies from municipal governments and state-directed banks. It’s cheaper for automakers to build new factories than to convert existing ones. The result has been enormous overcapacity... Assembling electric vehicles requires considerably fewer workers than making gasoline-powered cars, because E.V.s have much fewer components. 

8. From the EC on China's trade distorting subsidies

The European Commission published an updated report, 711 pages long, on state-induced distortions in the Chinese economy. The trade complaint, broadly, is that China follows a nefarious playbook whereby it has attracted foreign investment, required joint ventures and acquired key technologies, granted massive subsidies for domestic suppliers while also slowly erecting barriers or closing the market for foreign groups, and then dumped excess supply on foreign markets. According to research from the Kiel Institute for the World Economy, a German think-tank, BYD has been a chief beneficiary of EV-related subsidies with direct government subsidies to the company of up to €3.4bn from 2018 to 2022. Across the Chinese green-tech industries, the research points to other channels of government support including preferential access to critical raw materials, forced technology transfers, strategic use of public procurement as well as the favourable treatment of domestic companies by local officials.