Scary Charts - European Edition

Here are three scary charts about Europe. The scariest comes from three BofA economists, via Wonkblog, which carries the output growth projections. Even the optimistic projections look bleak for Italy and France, and positively catastrophic for Spain.



Zero Hedge points to the rapidly declining bank deposits in the PIIGS and Cyprus (which will soon fall sharply). The crisis is certain to leave deep scars in the banking sector of the peripheral economies.

Youth unemployment in Greece and Spain is at shockingly high level, well above 50% and rising. For the Euro-zone as a whole it was 23.8%.

Competition and market failures

Econ 101 teaches us that market competition, by enabling efficient price discovery, results in win-win outcomes for both producers and consumers. Alternatively, in the absence of competitive dynamics, markets fail to take off, leaving both consumers and producers worse off.

In this context, this article from FT about the contrasting fates of US and European telecoms market is instructive. It is considered an efficient practice in utility infrastructure to force the network asset owner to share it with competitors for a prescribed fee, most often determined by the sector regulator. This is thought to lower entry costs in such capital intensive sectors and thereby stimulate competition. Accordingly, the India's Electricity Act of 2003 provides for mandatory "open access" of the distribution and transmission network owned by state-owned entities for a fee to private firms for transmitting and distributing their power. 

The same logic has been applied to unbundling of telecommunication networks. However, even as the European Union aggressively pushed through unbundling in the late nineties, it failed to pass legal challenges in the US. Accordingly, while European network owners were forced to share with their competitors the local loop part of their networks that connect to customers, the US carriers managed to maintain exclusivity and retain entry barriers. If the logic of Econ 101 held, then lower entry barriers and resultant competitive pressures would have boosted the European telecoms market while the absence of the same would have weakened the US market. But the fortunes have been reversed, as the FT writes,

Unbundling has been the single biggest difference between the regulatory environments in the US and Europe over the past decade. The idea was first taken up in the US in the mid-1990s, though the established American carriers managed to block the idea in the courts a decade ago. Their peers in Europe had no such avenue for appeal, forcing them to give new rivals low-cost access to the local loop part of their networks to reach customers. The result: more competition, lower prices and dwindling cash flow. That has been a boon to consumers but, along with the slumping economy, has left network companies badly positioned to finance the next round of network-building.

The contrast with the US could hardly be starker. Over the past five years, the operating cash flow of AT&T and Verizon has risen by a fifth, even as cash flow of the main European players has dwindled. As a result, shares in the two dominant US carriers have risen by more than half since the financial crisis, while their European counterparts have slumped, denting their ability to finance upgrades.

In other words, competition has resulted in market failure. Instead of the "more competition, lower prices, more consumers, more profits, and network expansion", the real-world outcome has been "more competition, lower prices and dwindling cash flow".

The fate of European telecoms market is not an isolated example. Much the same market failures have been a characteristic features of telecoms and airline deregulation in India. In fact, India's telecoms market has evolved in a manner that would have pleased a Chicago economist, but is now facing serious troubles. Instead of the expected win-win outcomes, lower entry barriers and cut-throat competition in both sectors have ended up devastating operators. While consumers have undoubtedly benefited from the lower prices, operators are left without resources to finance expansion and technology upgradation.

This is yet another real-world example of how perfect competition often fails to yield the expected outcomes. In all these markets, once entry barriers get lowered, the size of the market and its long-term potential makes it irresistible for competitors to indulge in price wars. As with winners curse in auctions, such price wars invariably result in a race to the bottom.

The point here is not to convey that competition or deregulation is not desirable, but to caution against any unqualified support for such measures. The dynamics of the market is far too nuanced to be explained away by simplified "invisible-hand" reasoning.

India's labor productivity problem

India's share of population employed in agriculture has fallen sharply from 60% in 2000 to 51% in 2010 and the pace of decline is set to quicken in the coming years. In addition to transitioning those leaving agriculture, there is the need to accommodate the nearly 12 million people who are expected to join the workforce each year. In most historical examples of such growth transitions in developing countries, industries sector has provided the major share of new employment opportunities.

However, as the Economic Survey 2012-13 highlights, recent trends in industrial employment creation in India has been cause of concern. Even if industry's share of total employment has been comparable to other large Asian countries at similar stage of their growth, its share of gross value added has remained more or less stagnant over the last decade and is far less than that in other countries.

The main reason for this near stagnant share of industrial sector value addition is the low productivity in the sector. This becomes especially pronounced since construction, where most employment is in the informal sector and involves mostly unskilled and semi-skilled workers, has been the fastest growing segment within industry.

In fact, this low productivity trap extends to informal sector economic activity in general. The value addition by a worker in the informal sector is only a small proportion of that in the formal sector for workers in similarly sized firms. 

PPP with public finance?

The obvious attraction of Public Private Partnerships (PPPs) is that it leverages private capital to provide public goods, thereby relieving public finances of atleast some burden. However, an analysis of India's PPP financing reveals that the "private" capital comes mainly from public sources. A 2008 World Bank note had this assessment of the sources of PPP financing,

In 1995–2007 senior debt accounted for 68 percent of project financing on average. The rest took the form of equity (25 percent), subordinated debt (3 percent), and government grants (4 percent), typically “viability gap” grants provided during construction to PPPs deemed economically desirable but not financially viable. Of the senior debt, about 70 percent was provided by commercial banks, four-fifths of this by public sector banks. The rest of the total debt financing came from institutional lenders (around 23 percent), with 5 percent provided by the International Finance Corporation. Bond markets were used sparingly. The use of subordinated debt also remains limited... In recent years the role of senior debt has grown while the share of equity has declined, leading to rising debt-equity ratios

The biggest concerns are the limited role played by bond markets and foreign capital, the two most desired forms of private capital. Another important concern is that the largest source of funding, forming nearly 50% of the total financing, is public sector banks. To put the problem in its perspective, in 2009 bank credit to infrastructure was Rs 2699 billion while the amount raised by corporate bonds was a mere Rs 5.4 billion. These go against the trend in developed and most other developing countries, where private sources and bond markets are the biggest source of capital. India's PPP financing pattern effectively becomes a case of "backdoor public financing".

These trends persist even today. The share of bank finance extended to infrastructure sector as a share of total bank finance has grown from 2.2% in 2001 to 13.4% in 2011. Most banks have reached or are close to their upper limits on infrastructure lending. Given the long-term nature of these loans, asset-liability mismatches are showing up in the balance sheets of all banks. Further, given the environment of crony capitalism that has enveloped larges swathes of the economy in recent years, especially in rent-thick infrastructure sectors, it may not be a surprise if significant share of the loans from public sectors banks are of questionable nature like this.

While debt-equity ratios have been consistently rising on the back of increased willingness of banks to give commercial loans, there may be some cause for concern with the trend of using the Government of India's viability gap funding as a form of equity,

While the evidence is inconclusive, there are some indications that lenders and developers view grants as substituting for the equity infusion needed during construction. The few projects involving a negative grant—a payment by the PPP to the government—also have a higher ratio of senior debt to equity, suggesting that these payments are being financed by debt borrowed by the PPP project.

Placing the de-worming story in its perspective

De-worming has been the poster child of the randomized control trial (RCT) movement in development economics. Its obvious simplicity and cost-effectiveness, apparently validated by numerous RCTs across Asia and Africa, has been highlighted as proof of what evidence-based development policy making can achieve. No serious discussion on evidence-based policy making is today complete without some mention of de-worming. So much so that crusaders are now out to "deworm the world".

In this context, the latest issue of Lancet (pdf here) has some unsettling truths. An RCT of 72 blocks in Uttar Pradesh in India over a period of 5 years, covering over 5000 children in 1-6 year group, conducted by medical scientists, finds that "regular deworming had little effect on child mortality". The randomization was done at the block level, with 4158 ICDS's anganwadi centers in 36 blocks receiving Albendezole tablets twice a year. 

Though the main objective of the study was to explore the effect of de-worming on child mortality, its findings on other physical health parameters carry relevance in light of claims made by RCTs done by economists. The graphic below shows that on a host of physical - height, weight, BMI, haemoglobin level - and illness prevalence parameters, there is no statistically significant difference between the treatment and control groups of children. Furthermore, this finding comes despite the treatment almost halving the prevalence of worm infection. 

Furthermore, the authors compare the physical health parameters between infected and non-infected students within the control group ICDS centers and report similar findings. In fact, for all worm categories, there is no statistically significant difference in health outcomes between the infected and non-infected child populations. 

The main case of the supporters of de-worming is that it prevents students from falling sick frequently and thereby increase their school attendance days. But this study questions the presumption that it contributes to significant health improvements or reduce other disease incidence. Even where worm infection has been halved, it appears to not have contributed to any increase in general physical well-being and lowering of other disease incidence. If this true, how does it square up with the claims of the de-wormers that school attendance increased because of improving child health outcomes and resultant lowering of disease incidence? 

The authors of the study qualify their findings to "lightly infected" areas, which are more likely in rural areas. But this leads us to what is a "high infection" rate? The "de-worming crusaders" themselves report incidence rates at 16% for Delhi slums and 14% for Andhra Pradesh. But this is just half the incidence rate of the "lightly infected" areas in the present study. Other studies of Kathmandu and Assam, two areas one would suspect of being "high incidence", too point to worm infection rates of 10-25%. If this infection range can be generalized across most of developing Asia, then the findings of the present study becomes immediately relevant. 

Now, it is possible for the supporters of de-worming to quibble about the small details of any study and dig their heels in. But what cannot be denied is that contrary to anything they claim, there is no unqualified (or so obviously clear) case for universal and prioritized adoption of de-worming on the highfalutin grounds that it is the most cost-effective intervention to improve student attendance. 

Further, as I have already blogged here, the definition of what constitutes "cost-effectiveness" is certainly flawed. A more appropriate frame of reference for judging "cost-effectiveness" would be the "implementation bandwidth" of public systems. Supporters of de-worming overlook the fact that the limited "implementation bandwidth" of any public system would invariably result in this intervention squeezing the implementation space for all other programs.

None of this is to decry or oppose the idea of de-worming. This is only an attempt to temper the claims around de-worming and locate it in its true perspective. It is a note of caution to the prevailing trend of squeezing the last ounce of "academic juice" from a fairly commonplace intervention. In that sense, this post is deliberately written to be similarly provocative, though in the opposite direction, as the "de-worming crusaders".  

Promotion of air-connectivity to remote areas

India's civil aviation ministry is considering two proposals - a direct subsidy and a market-based seat-credit trading mechanism among airlines - to boost air connectivity to less-developed markets and remote areas of the country.

The current Route Dispersal Guidelines of the Civil Aviation Ministry mandates all scheduled operators to deploy atleast 10% of their trunk-route capacity on flights to less well-served areas, or so-called category II routes (like northeast, J&K, Andaman, Lakshadweep), and 50% of trunk-route capacity on Category III routes (smaller towns like Coimbatore).

Under the seat-credit trading mechanism, all airlines would be allotted a minimum number of mandatory remote areas connection requirements. Airlines could meet their connectivity deficit by purchasing seat-credits from other airlines who have already met their requirements. Livemint writes,

Under the ministry’s proposed seat-credit mechanism, small air taxi operators can fly to a particular small city destination and earn seat credit that can be sold to a scheduled airline such as Jet Airways or SpiceJet. The bigger carriers will be able to use such credits to meet their requirement of having to connect such remote areas without having to lose money on such operations.

It is reasoned that the seat-credit trading would incentivize small regional air-taxi operators with smaller airplanes to service the small town airports, leaving the more established operators with their regular sized aircrafts to service the bigger towns. The operators themselves or the government would have to establish an exchange which would facilitate efficient price-discovery and trading of seat-credits.

An alternative to the seat-credit trading mechanism is a proposal to encourage regular airlines service the 80 Category-III towns by offering them a subsidy and a monopoly over the route for 2-3 years. The routes could be auctioned off to the airline that would bid for it at the least subsidy. The subsidy would be paid from an Essential Air Services Fund, mobilized from a combination of budgetary grant and a cess on the major route tickets.

Though both these are interesting proposals, it may not be possible to make definitive judgements in favor of either given the complex nature of airline markets in extremely price-sensitive countries like India. However, I am inclined to the latter for the following reasons

1. A direct subsidy suffers from much less information asymmetry. The reverse auction will help transparently and efficiently (atleast better than anything else) identify the amount of subsidy. Once this is done, it is much more easier to administer than the seat-credit trading mechanism. Further, such a subsidy support is likely to help establish the market and also facilitate the integration of these markets to the mainstream. A seats-credit sharing would merely exacerbate the existing market stratification of these areas.

Typically, some risk insurance or viability gap financing is necessary to break open any such market and only governments can finance this. In other words, given the inevitability of such a subsidy support, a reverse auction based direct subsidy may be the least distortionary and most cost-effective subsidy transfer design.

2. The seat-credits model does little to address consumer welfare. Relative to the larger airlines, the smaller air-taxi operators (unless some large players emerge) will have neither the incentive nor the capability to pass on the benefits of an expanding market by way of lower ticket prices. Given the risks involved, it is difficult to imagine airlines operating exclusively on these routes ever acquiring the balance-sheet cushion to lower prices in any meaningful (read market-creating) manner.

3. Lower prices can contribute to sharply increasing volumes, which in turn enables operators to benefit from economies of scale. In the absence of lower prices, these price-sensitive markets are likely to remain stuck up in a low-volume equilibrium. The fact that the seat-credit trading mechanism physically divides the market into two parts, with different operators and their business models, makes a low-level equilibrium a strong likelihood.

4. Finally, there is the Achilles Heel of all trading mechanisms - the initial allocation of mandatory remote-areas connections requirements to each airline. In the absence of a satisfactory process to discover an efficient initial allocation, airlines are more likely to get away with smaller quotas that would be easily met by purchasing from the existing air taxi operators. An efficient initial allocation would have to based on an estimate of the traffic growth in these nascent markets, a highly unreliable exercise at most times. There is also the danger that the seat-credits would end up subsidizing the air taxi operator's traffic expansion that would have happened anyways in the business as usual conditions. As with all such discretionary decisions, corruption can never be far away.

The African Bond Bubble?

The FT reports of a number of sub-Saharan African countries rushing to raise foreign currency denominated debt. In September 2012, in a heavily overs-subscribed offering, Zambia raised $750 million as 10 year dollar denominated debt at an yield of 5.625%, lower than Spain sovereign bond yield at that time. Rwanda and Angola have announced plans to raise $350 m and $1 billion respectively, and Nigeria and Ghana too are expected to enter the market.

Unlike Latin America and Asia, Africa has had very few foreign currency denominated bond offerings. Currently, only 13 out of 54 African countries have issued foreign currency denominated debt. Multi-lateral and bilateral financing have formed more than three-quarters of external debts in Africa.


The current interest in emerging market debt has to be seen in light of the global liquidity glut engendered by the ultra-low interest rates in developed economies. With debt market yields hugging the bottom, investors have been looking at exotic markets in search of yields. Even the emerging market bond yields have been falling. Zambia was able to raise debt at such low rates despite its offering being rated "junk" (B+) by S&P.

Predictably, the number of African countries trying to raise foreign currency denominated sovereign debt has led to concerns about its repayment and the "original sin" of a Latin American style potential future debt crisis. The low rates does not tell anything about the risks posed by exchange rate volatility and the country's balance of payments (BoP) position. A depreciating currency would increase the effective repayment rates, while a weak BoP position would strain the repayment capacity.

Zambia, for example, is heavily reliant on Copper, which forms 80% of its export basket. Any volatility in exchange rates will therefore have dramatic effects on its real debt burden. Its currency has depreciated by over 40% against the US dollar since January 2008. Others are similarly exposed, with small variations, to commodity prices and therefore forex market volatility could potentially affect debt sustainability.

Given the widespread governance problems in all these countries, it is important that these debts are for clearly defined objectives. For example, debt raised to finance critical infrastructure investments are more likely to be effectively utilized and compensate the debt cost. In this context, multilateral loans for infrastructure projects can be dovetailed with foreign currency debt. The presence of the multi-lateral lender would not only increase expenditure side discipline, but also serve as a credit enhancement and contribute to lowering of the cost of debt.