The commodities super-cycle?

Amidst the gloom surrounding the Great Recession, one of the less discussed stories surrounds the boom in commodity prices in the aftermath of the sub-prime mortgage meltdown. There is a very strong view that the latest spurt in this "commodity super cycle", which has been on the ascendancy for more than a decade now, was triggered off and is being sustained by the ultra-accommodative monetary policy regime followed by the Federal Reserve in the US.

The excellent graphic from Quartz puts the commodity super-cycle theory in perspective. Ruchir Sharma had a very persuasive article in the FT recently. And he argues that the biggest threat to deflating this bubble will come from China's weakening growth prospects. 

China foreign aid fact of the day

In 2009 and 2010 China agreed to lend about $110 to developing countries, $10 bn more than the World Bank in that period... The Chinese Eximbank lent $67.2 bn to sub-Saharan Africa between 2001 and 2010, $12.5 bn more than the $54.7 bn lent by the World Bank. 

(HT : FT) 

Charter Cities project gets a rude wakeup call

So Paul Romer has officially ruled himself out of the first Charter City project in Honduras. Prof Romer had originally joined hands with the government of Honduras to pursue his dream project of establishing a  RED (Region Especial de Dessarrollo) on public private partnership basis to develop a model city. He was appointed a member of the five-member Transparency Commission and made to believe that it would have sweeping powers in ensuring the effective implementation of his new rules-based RED. 

It appears that all that was mere posturing and the Honduras government has been taking the professor and his colleagues for a ride. The Honduras government has entered into an agreement with a private party, without apparently any of the required due diligence, and have even refused to share a copy of the agreement with Prof Romer. 

Now there is nothing surprising about this turn of events. In fact, the Honduras establishment clearly saw the Charter Cities project as a very convenient alibi to push through a public private partnership agenda which had cronyism and corruption written all over it. There is no need of the wisdom of hindsight to have perceived the preferences of the Honduras government. For this would have been the case with the overwhelming majority of governments who volunteered for such projects. One can think of many state governments in India not being averse to accepting an offer from a reputed professor which would provide the fig leaf for them to pursue massive rent-seeking resource theft. 

In fact, one could say that there is an adverse selection problem with government motivations. Given the practically far-fetched nature of the project (and why that is impractical is another debate, partially covered here), governments which would agree to embrace such projects are more likely than not be motivated by desires other than national economic development. The stakes are simply too high and incentives too misaligned for the final outcome to be anything different. 

Consider this parable. A group of robbers pass up the opportunity for their biggest ever heist as a treasure is being moved from one place to another. Furthermore, they also take the trouble of guarding the treasure from being looted and also ensuring that it reaches its final destination. Inconceivable?

India's latest power sector reforms - A recipe for failure?

The Union Government has announced an ambitious plan to restructure the debts of the massively indebted state electricity distribution utilities. As part of the "Financial Restructuring of Discoms" package, worth nearly Rs 2 trillion (~$38 bn), the state governments will immediately take over half the outstanding short-term liabilities upto March 31, 2012 and convert them into state government guaranteed bonds. In the second stage, the the remaining half of the liabilities will be restructured by rescheduling loans and by providing a three year moratorium on the principal repayment.

The electricity utilities will have to enter into a tripartite debt restructuring agreement involving the state and union governments. As part of the deal, they will have to undertake periodic tariff revisions and reduce their aggregate technical and commercial losses. The Union government will reimburse states 25% of the principal they repay if they meet the conditionalities and exceed their loss reduction targets. The plan is voluntary and states will have time till 31st December to embrace the plan.

There are a few immediate concerns. The bonds will not get the statutory liquidity ratio (SLR) status, thereby making them less attractive for banks and other financial institutions. It will also raise the coupon rates for the state governments. Also, state governments will almost certainly breach the Fiscal Responsibility and Budget Management limits and strain an already stretched state fiscal balances. The biggest beneficiaries, apart form the utilities, will be the public sector banks, who face the threat of these loans becoming non performing assets. The RBI data reveals that Indian banks' loans outstanding to the power sector rose to Rs 3.4 trillion as of July 2012, up 17.4% from Rs 2.9 trillion in July 2011.  

On closer analysis, this scheme looks like throwing good money after bad. Such performance based incentives to reimburse loans has been at the center of all the major central government programs in the sector for more than a decade. In fact, in the early part of the last decade, as part of the "big bang" electricity reforms, the debts of the bundled state utilities were similarly restructured. The two rounds of the APDRP reforms have had similar loss reduction and other reform commitments. And even after all these efforts, distribution losses remain at a shockingly high 27% and worse still, it appears to have plateaued.

Further, loss reduction, as I have blogged earlier, is more a political, than technical or enforcement problems. Allowing for the 10% technical losses (itself a high estimate), the remaining are commercial losses, which consists of both theft and fraud, apart from a share of the unaccounted for agriculture consumption. For sure, enforcement will contribute to commercial loss reduction. But it will have to be complemented with political commitment to crack down on those pockets of heavy losses, which are also unfortunately powerful electoral vote banks.

Mandating tariff revisions, based on cost of service, too is not easy to enforce. Currently, most of the larger utilities provide for tariff revisions in their annual tariff filings before the state regulatory commissions. However, even when they are agreed to, the state governments quickly step in to subsidize the incremental tariffs, especially on residential consumers. Further, though the subsidy has to be a budgetary transfer, the state government force the utilities, through creative accounting practices, to raise debt to cover for the higher burden.

In the circumstances, any meaningful attempt to wipe the slate clean and initiate genuine reforms in the finances of state utilities has to go beyond loss reduction and tariff revision mandates. There are atleast two areas which require immediate attention.

One, the most urgent challenge is the problem of free agriculture supply. Agriculture is critical because it not only contributes to the commercial losses, but also a large proportion of the free power subsidy burden gets transferred to the balance sheets of the utilities. In fact, agriculture is one big black hole in energy audits into which all undesirable and unaccounted for supply units are lumped. A more reliable audit could reveal even higher losses in many utilities. Therefore agriculture supply has to be metered and audited. Incentives have to be introduced to optimize and ration consumption and improve feeder level energy audits within utilities. It will also make rural supply sufficiently remunerative for utilities to focus on improving supply quality and reducing losses.

Second, there has to be a mechanism to take the burden of costly power purchases - mostly peak-time and summer spot market purchases - off the utilities books. Whether they are passed through to consumers, atleast certain categories, is a matter of important detail. Borrowings to finance such purchases have come to  form an increasingly large share of the accumulated debts on utilities' balance sheets. Both these measures will not be easy and will risk strong political opposition. But without addressing these two issues, especially the former, it is certain that the state utilities will require another round of debt restructuring in a decade.  

Outsourcing urban water sector services

This blog has consistently argued that outright privatization, especially in certain sectors like urban infrastructure, stands very remote chance of success in countries like India. Instead, a more realistic route to bring private participation in urban infrastructure services is to un-bundle and outsource specific service categories.

In particular, though water and sewerage has been the subject of several explorations at private participation, there have been very few successes. Conventional wisdom has it that the biggest impediment is the low prevailing water tariff and the political difficulty of achieving cost recovery by commercial pricing.

In this context, a nice study from CRISIL questions conventional wisdom and suggests a model for private participation in urban water sector. It examined nine water utilities and finds that a lifeline supply of water (80 lpcd or 12 kl per household per month) can be delivered with reasonable commercial tariffs, which are much smaller than the monthly electricity bill though higher than the current water rates, while ensuring operations and maintenance (O&M) cost recovery. The graphics below tell the story.

The critical element in the model suggested is the assumption that the capital expenditure be made by the urban local body, while the O&M will be outsourced to a private agency and cost recovery achieved through commercial pricing. This itself is a significant achievement given that only 7 of the 65 cities covered by the flagship urban renewal program currently achieve O&M cost recovery. Such concessions stand the best chance of success in highly sensitive sectors like water. But there are a few concerns

1. The study uses the O&M expenditure currently being incurred by the utilities. This can be a misleading indicator since this is most often far lower than that required to manage the network optimally. The shoe-string reactive O&M, borne out of the utilities' budgetary constraints, most often ends up increasing maintenance costs and contributing to service quality problems. If the higher O&M costs are taken into account, then the commercial tariff for cost recovery could be much higher.

2. In the circumstances, it may be required to keep the tariffs for the urban poor as low as possible and achieve cost recovery through an appropriately designed Increasing Block Tariff (IBT) structure that charges higher rates on the bigger consumers.

3. The most important element will be in the details of the concession structuring. Factors like the baseline supply standards, obligations of the service provider, extent and scope of services outsourced, and so on need careful attention since they are typically the elements that derail such concession agreements.   

The dangers of more monetary accommodation

Over the past few days, monetary authorities on both sides of the Atlantic have announced further extraordinary monetary accommodation policies. 

In Europe, the ECB finally bowed to pressure and announced  an ambitious program, dubbed "outright monetary transactions”, to purchase an unlimited amount of eurozone sovereign debt with maturities of between one and three years. The ECB's bond buying program, though conditional on governments signing up to a European Financial Stability Facility or European Stability Mechanism programme for fiscal and structural reforms, comes despite strong opposition by the German Bundesbank. Further, the ECB would not be treated as a preferred creditor in the event of default, thereby signalling to investors that the ECB purchases will not subordinate their own holdings of peripheral country bonds. This is part of ECB's determined effort to do "whatever it takes" to save the Euro. 

In the United States, spurred into action by the persistent dismal unemployment figures, the Federal Reserve announced its third round of quantitative easing program, QE3. It has decided to inject an extra $40bn into the economy each month through purchases of mortgage-backed securities for an unlimited time till the labour market improves. The FOMC reported, 

The Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative... the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

As the FT reports, this marks a significant strategic shift in the Fed's policy stance. It has now, for the first time tied policy to developments in the economy – and promised not to shift policy until it succeeds.

For the record, the QE1 in 2008-09 involved purchases of $600 bn in mortgage backed securities and agency debt, $1.25 trillion of agency MBS, $200 bn in agency debt, and $300 bn in Treasuries.  The QE 2, from November 2010 to July 2011, involved purchases of $600 bn in similar securities. The most recent Operation Twist in September 2011 involved a swap of $400 bn of Treasuries to achieve maturity transformation and lower long-term rates.

The underlying premise behind both these actions in the US and Europe is the belief that liquidity injections will somehow help address the underlying problems and help the respective economies back on recovery path. In other words, this view sees the current problems as mainly liquidity problems, which can be tided over by an extended period of monetary accommodation.  

Unfortunately, this view may be deceptively misleading and could lead us down the path of even more pain. The best that can be said in favor of this policy is that monetary accommodation will help buy the time required to address the fundamental structural and fiscal problems. Though extraordinary monetary accommodation has been going on for nearly 5 years now, governments have done precious little to address the fundamental problems in the real economy. Nor is any inclination on their part to do anything different. And all along, things may have steadily gotten worse.

Europe's problems, certainly that of Greece, cannot be addressed by merely buying time and hoping that the denominator in the debt-to-GDP calculus improves with time. Fiscal austerity has already deepened it to a level from where all the possible options may have been shut off. In case of the US, while financial institutions' balance sheets have been repaired, very little has been done to address the balance sheet problems of the households. Further, no amount of central bank aggression will address the real problem of persistent unemployment rate and output gap, as well as the longer term debt problem arising from health insurance expenditures.  

And associated with any cheap money policy is the resource mis-allocation dangers, both domestically and globally.  Ruchir Sharma summed it up nicely,

The Fed can print all the money it wants - but it cannot dictate where it will go. The frst two rounds of quantitative easing fuelled a commodity bubble, increased income inequality and set a bad example for the rest of the world. During the 16 months of round one, up to March 2010, the CRB commodity price index rose 36 per cent, while food prices rose 20 per cent and oil prices surged 59 per cent. During round two, in the eight months up to June last year, the CRB rose 10%, with food up 15%, while oil prices rose a further 30%... Now, there is a tight link between stocks and commodities, with prices rising and falling in lockstep. This link neuters monetary policy makers, because rising commodity prices negate the stimulative impact of looser credit... a third round of quantitative easing... could be more counterproductive than the first two, since oil and food prices are now dangerously close to levels that have acted as a tipping poing for the global economy in the past.

Financial market distortions caused the sub-prime crisis and if conditions of extended accommodation persist for too long another bubble may get inflated somewhere in the wide markets. More worryingly for the developing countries, in a world awash with liquidity in search for returns, their economies offer attractions for speculators looking for quick bucks. This is all the more so given the diminishing investment options in the developed economies. Such capital flows, as we already know from several recent experiences, can have damaging consequences. In the circumstances, from the perspective of developing economies, is some form of capital controls desirable?

Climate change and traffic congestion

What's common between addressing climate change and traffic congestion? Disincentivizing private vehicle usage will help mitigate carbon emissions and control traffic congestion. As the graphic below shows, transportation is a large contributor to global carbon emissions.

Happily for environmentalists, the sheer immediacy of the problem of traffic congestion, makes it an issue demanding urgent attention for policy makers. In simple terms, climate change advocates stand a greater chance of succeeding in their fight against carbon emissions by joining hands with urban transport managers in addressing traffic congestion.

Any effort to reduce carbon emissions has to involve aggressive action by US, China, and India. Given the magnitude of the problem - deteriorating traffic and air quality - it is therefore unsurprising that in recent weeks all three have initiated policies aimed at restricting vehicle usage and/or reducing the carbon footprint from vehicular emissions.

Following Shanghai and Beijing, Guangzhou, the third largest Chinese city, has embraced license plate auctions and lotteries to restrict the growth of vehicles. It is estimated to halve the number of new vehicles entering the market. Even the usually lethargic Indian government has been spurred into action and is contemplating urban transport tax to discourage vehicle ownership and congestion pricing to disincentivize vehicle use. In the US, President Obama recently announced stricter energy efficiency standards which are expected to nearly double the average fuel economy of cars and light trucks to about 54.5 miles a gallon by 2025.

However, as the Times points out in a recent article, a more effective way to address this challenge may be by simply taxing carbon fuels. This blog has consistently argued in favor of carbon tax as the preferred strategy to achieve carbon abatement, based on considerations of both economic efficiency and practical implementation challenges. This graphic from the Times article highlights the potential gains from a carbon tax in the US.

Nevertheless, as this McKinsey report shows, improvements in emission standards is one of the cheapest carbon abatement options.

But with the issue of discouraging vehicle use, we need to realize that we can make a meaningful dent only by simultaneously deploying all the three policy options available - making vehicle ownership costly (vehicle tax, license plate auctions etc), internalizing the social costs of vehicle usage (carbon tax, congestion pricing, high parking fees etc), and encouraging the use of public transport. In countries like the US, among these options, carbon tax, despite its certain political opposition, is likely to be the least distortionary and most effective way to address both traffic congestion and climate change.