Value capture from infrastructure projects

My latest Governance Agenda column in Pragati is on the different options for capturing increase in land valuation arising from infrastructure investments. 

Examining India's long-term economic growth prospects

As India's economic prospects improve, euphoric voices like this about the possibility of double-digit economic growth rates are bound to rise. But such speculation, anchored around the memories of China's spectacularly long period of double digit growth and our own brief interlude with similar growth last decade, overlook the presence of very strong headwinds.

In this context, the work of economists like Dani Rodrik and Arvind Subramanian cautions against such excessive hope and speculation. Three arguments are worth examining. 

1. Apart from favorable domestic conditions, the long period of East Asian economic growth, whose salience is amplified manifold by China's rise, benefited from a happy confluence of benign external conditions. This period of unconditional convergence coincided with favorable geo-political dynamics (the US provided geo-political stability, which also relieved E Asian economies from spending on defense), high-noon of globalization facilitated by sharp fall in tariffs and un-bundling of global manufacturing supply chains, rapid emergence of trade facilitating technologies like containerization and ICT, a receptive consumer market in US and Europe, availability of abundant cheap domestic and global capital, and so on. 

These trends are either considerably attenuated or have run its course. But all narratives of India's high growth prospects are significantly predicated on the continuation of these conditions. Furthermore, there is the strong likelihood of technological disruption of the labor market due to increasing automation and resultant disemployment. While these forces are not likely to immediately bind in any significant manner in countries like India, their potential to disrupt global manufacturing and thereby global labor market, is considerable and deeply uncertain. These are first order headwinds that the Indian economy will have to surmount in its quest for growth comparable to what the East Asian economies sustained for long periods.

2. The second headwind comes from the changes taking place in manufacturing which raises questions about the traditional national economic development path. Manufacturing has traditionally provided the platform for rapid national economic development across history. Countries that have industrialized rapidly have done so by focusing on manufacturing and by moving up the manufacturing escalator - from less sophisticated to more technologically advanced products. Labor productivity in manufacturing has tended to "converge to the frontier"- the smaller the initial incomes, higher the growth in labor productivity (and therefore incomes). This convergence is significant in formal manufacturing, though absent in informal manufacturing. 

This feature of manufacturing sector helps absorb large number of less skilled labor, with prospects of moving up the skill chain on the escalator of industries. But, as Prof Rodrik and others argue, such manufacturing sector growth may be constrained by the weakening of the aforementioned favorable forces. They characterize it as "premature de-industrialization".   

Such de-industrialization, observed in the development trajectories of all advanced countries, appears to be happening much earlier among the emerging economies. In India, manufacturing's share of output has been stagnant at about 14-16% of GDP for nearly four decades and its share of employment peaked at 13% of labor force in 2002 and has since been trending downwards. As the graphic below shows, this feature has been true of even many East Asian economies, including China, who have started de-industrializing earlier than their western counterparts.

As can be seen, India started de-industrializing at a GDP per capita of $2000, in contrast to the $9000-11000 income levels at which manufacturing in western economies started decline. In fact, as the graphic from cross-national panel data below by Arvind Subramanian shows, at any stage in their development, not only are countries devoting less workforce to industries (the downward shift in the curves) but also the point of time at which industrial share of employment peaks is happening earlier (leftward shift in the curves). 

This potentially dampens the prospects for manufacturing led rapid growth for countries like India and Africa. 

3. In all the East Asian economies, the de-industrialization has been accompanied by proportionate growth in the services sector, "making them service economies at substantially lower levels of income". This has led to some commentators pointing to the potential for a new model of services led economic growth. The example of India's successful IT sector has often been cited in support of this, though an a cursory empirical analysis would reveal this as misleading, given its small size and limited relevance to India's overall economic growth. 

Prof Rodrik's argument, brought out also in this article, is that the inherent dynamics of services sector militates against generating similar growth and job creation trends as with manufacturing. The graphic below shows that there are very few examples of simultaneous growth of both productivity and employment.  

The high-productivity sectors, which are typically tradeable, being skill-intensive, cannot absorb much of the not so skilled workers who dominate the 12 million or so people entering India's workforce every year. In fact, as the graphic below from Arvind Subramanian shows, the more productive and therefore rapidly expanding (and mostly tradeable) services are also highly skill-intensive, far more than manufacturing. 

Further, unlike manufacturing, there is limited prospects for natural progression up the skill chain in services sector. While a textile or toy maker can with minimal training migrate into assembling electronic goods, the prospects of a barber or housekeeper moving into business services or banking, even at the lower end of that service, is remote or non-existent. 

India's woeful deficiencies in education and skill development would certainly come in the way of it being able to reap the benefits from tradeable services in any significant manner. It would require atleast more than a decade of intensive focus on education and skill development for the country to realize more substantial benefits from tradeable services. And even then, like with manufacturing, there are significant uncertainties over the possible disruption to parts of the services sector, especially at its labor-intensive lower end, from technological advances.    

The less productive non-tradeable services face self-limiting constraints - labor absorbing services are less productive and therefore slow growing, whereas the fast growing and more productive services experience higher relative wage growth with resultant limits on job creation. As Dani Rodrik writes, "services sectors that have the best productivity performance typically shed labor; labor absorbing sectors typically have worst productivity performance". It is therefore difficult to envision non-tradeable services as being the predominant channel for productive employment creation and rapid economic growth.

To conclude, global political, economic, and technological environment is undergoing important shifts. The traditional get-rich-quick route of escalator industries looks increasingly out of bound. And the prospect of services becoming the new rapid growth sustaining platform does not appear promising. In the circumstances, India and others will have to navigate against the combination of all three headwinds in their quest to attain high economic growth rates. 

In case of India, its preparedness - poor quality of human resources and pervasive weakness in state capability - constrain the country's ability to overcome these headwinds. The shackles imposed by restrictive regulations exacerbate our weaknesses, further limiting the ability to achieve high growth rates and sustain it for prolonged periods. With business as usual, given its massive size, even with all these internal weaknesses and headwinds, the country may grow rapidly in short bursts (as happened for a few years in last decade) interspersed with longer moderate growth periods. 

Sustaining very high growth rates for long periods like East Asia would require large-scale and long-drawn reforms in numerous areas coupled with concerted efforts to improve human resource capacity and state capability. Even if the reforms are initiated with vigour, it is unlikely to result in any dramatic gains in the short or medium-term. This, rather than cognitive biases, should form the basis for any examination or speculation on the country's long-term growth prospects.  

India transportation fact of the day

From FT

Indian truckers, it turns out, spend a quarter of their journey times waiting at checkpoints, state frontiers (there are 650 border posts) and city entrances, and another 15 per cent at toll plazas. In all, they spend only 40 per cent of the time driving, often in herds to comply with urban time restrictions. For the rest, the truck is not moving. They cover just 250km-300km a day on average, compared with 800km in the US.

And more,

At present the cost of logistics for Indian manufacturers is often more than the entire wage bill – more than double, in the case of textiles – and far higher as a percentage of sales than for international competitors. Halving the delays caused by roadblocks and other stoppages would cut freight times by 20-30 per cent and logistics costs 30-40 per cent, says the World Bank.

The transformation of public policies

Subir Gokarn draws attention to the violation of Tinbergen's "one instrument for one objective" rule in public policy issues in India. Specifically, he points to the transformation of Minimum Support Price (MSP) from being an instrument to encourage foodgrain procurement to being also an instrument to sustain farm incomes. The other example presented is that of labor-friendly labor regulations, which while seeking to both job creation and unemployment insurance, have imposed prohibitive costs on businesses.

There are several other examples. The NREGA which began as an employment insurance program, got transformed into being also a job creation cum job entitlement program. Housing programs intended at providing shelter (rental or otherwise) for poor people, changes into home ownership program. More generally, the recruitment of teachers and other public workers, aimed at delivering specific public services, gradually become an end in itself, with attendant distortions, due to the creation of a constituency of voters who captures the bureaucracy.

Gokarn's point is well taken. But the challenge here is not so much the issue of violating the Tinbergen rule as one of managing the political economy. These examples are illustrative of the complex political economy that surrounds public policy decisions. While any policy generally begins as an instrument to address one objective, it difficult to keep it that way. As implementation proceeds, the emergent dynamics pushes policy makers to embrace other objectives, even when they conflict with the original objective. Further, most often, the new objective crowds-out the original one, thereby distorting the program's focus and making it dysfunctional. This is one of the biggest challenges in the management of public policy.  

Japan's remarkable resilience

In lamenting Japan's struggles with deflationary stagnation, we overlook the dramatic demographic shifts the country has undergone in the past two decades.

Its working age (15-64 ages) population dropped sharply from about 87 million in 1998 to about 77 million in 2013. This 12% drop in its primary factor of production over just 15 years is remarkable, considering its strong downward pressure on economic output.

This was accompanied by a 35% appreciation of the currency, with attendant consequences on a heavily export-dependent economy. If we take both this into account, instead of being concerned, we ought to be surprised at the economy's resilience.

Clearly, the Japanese have been successful in squeezing more out of its remaining factors of production. Further, successive Japanese governments should be complimented for having avoided the public suffering that accompanies such prolonged slowdowns. In fact, as Krugman has written, Japan's real GDP per working age adult has risen faster than others since the Great Recession.  

One possible way out of this is to liberalize immigration rules and nudge the country into being more open to migrants. This could be the fourth arrow of Abenomics. But that looks some time away since we are still awaiting the third.

Update 1 (23/03/2015)

Adair Turner argues that Japan's quantitative easing program is effectively monetizing away the country's massive public debt burden, apart from sustaining the country's debt financed public spending programs,

Japanese government debt now stands at more than 230% of GDP, and at about 140% even after deducting holdings by various government-related entities, such as the social-security fund...  For Japan to pay down its net debt even to 80% of GDP by 2030, it would have to turn a 6%-of-GDP primary budget deficit (before interest payments on existing debt) in 2014 into a 5.6%-of-GDP surplus by 2020, and maintain that surplus throughout the 2020s. If this was attempted, Japan would be condemned to sustained deflation and recession... 

Instead of being repaid, the government's debt is being bought by the BOJ, whose purchases of ¥80 trillion per year now exceed the government's new debt issues of about ¥50 trillion. Total debt, net of BOJ holdings, is therefore falling slowly. Indeed, if current trends persist, the debt held neither by the BOJ nor other government-related entities could be down to 65% of GDP by 2017. And because the government owns the BOJ, which returns the interest it receives on government bonds to the government, it is only the declining net figure that represents a real liability for future Japanese taxpayers...

That reality is not yet openly admitted. The official doctrine is that the BOJ eventually will sell back all of the government bonds that it has acquired. But it need not do so. Indeed, the BOJ could maintain its current level of government-debt holdings indefinitely, making new purchases as existing bonds mature. And if the money created – in the form of commercial bank reserves at the BOJ – ever threatened to support excessive credit growth and inflation, the BOJ could offset that danger by imposing reserve requirements on the banks.

The undesirable and hypocritical quest for harmonization

I am generally always in agreement with Simon Johnson. But his argument in a recent article urging the US to use its trade policy to fight foreign exchange market interventions deserves to be refuted.

He advocates that the US should insist on making participation in the ongoing Trans-Pacific Partnership (TPP) contingent on refraining from currency market intervention. He claims that such intervention is "an unfair way to gain a trading advantage, with excessive negative effects on trading partners" and that "some Asian countries have overstepped the boundaries of reasonable behaviour", with "associated adverse effects on sectors and communities in the US". In simple terms, currency market intervention imposes adverse negative externalities on other countries.

I do not contradict this allegation. Currency market manipulation undoubtedly has a beggar-thy-neighbour dimension. But so do most other macroeconomic policies. Almost any industrial policy, including those supporting defense industries, where the US is the undisputed leader, would unfairly disadvantage similar industries elsewhere. Similarly, national trade policy interventions, even those  not infringing WTO regulations, invariably involve decisions that favor one group over another, whose effects are felt within and across countries.

Further, it is not as though the "currency manipulators" are trying to weaken their currencies. It can be safely argued that in today's world no country can have the fire-power required to "manipulate" their currencies downward in any significant manner, leave alone consistently. At best, they can only try to prevent their currencies appreciating further, so as to arrest the erosion of their existing competitive advantage. And here too, there are significant limitations. The BoJ's attempt to hold down the rising yen in recent months is a case in point.

In fact, there are more pernicious forms of economic policy manipulations, which attract much less attention. The recent debate on tax avoidance highlights how differential taxation policies can harm other countries. The extraordinary quantitative easing policies followed by US, Japan, and European countries have generated massive capital flows, and has been the biggest contributor to global macroeconomic instability.

If the East Asian economies are being accused of "manipulating" their currencies to retain trade competitiveness, then by the same yardstick the central banks in US, Europe, and Japan would have to be accused on "manipulating" their monetary policy to restore economic growth. What is sauce for goose is also sauce for gander.  

Or how about the negative externalities imposed by America's high fiscal deficit in a world where the US dollar enjoys the exorbitant privilege? It encourages (or atleast contributes to) other countries (say, China) to consume less and run up large surpluses; make them to park their savings in low yield US assets; amplify the risks arising from cross-border capital flows, and so on. More disconcertingly, irrespective of its economic fundamentals, it privileges America to print money and borrow very cheap, more than any other country, and at the cost of the savers in other countries.

One could go on about other such perceived "policy manipulations". After all, as we have seen, the negative externalities arising from many policies naturally lead to accusations of "manipulation". But the response to such policies in the form of a selective quest for harmonization betrays both naivety and hypocrisy.

In a world of such vast social and economic disparities, economies move forward in widely varying trajectories. It is therefore inevitable that they follow different, often conflicting, policies on the same issue. Most often, especially with external market policies, these policies generate undesirable negative externalities. This has been case all along the modern era of the nation state. In fact, these policies have underpinned the successful growth trajectory of all of today's developed economies.

In the circumstances, a selective quest for harmonization of policies in a manner that suits the requirements of a few is not only undesirable but also hypocritical. The adverse consequences of the European monetary union, which deprived peripheral economies the traditional option of restoring competitiveness by devaluing their currencies, is fresh in memory. Heterodoxy in policies and not harmonization has been the norm in all of history. Therefore, instead of seeking harmonization, economies should try to adjust their policies to mitigate the negative externalities arising from policies of others, as was being done for centuries. 

Industrial policy in chip design and manufacturing

The Times reports of the latest example of industrial policy from China, promotion of semiconductor chip making industry. It writes,

Last year, the country imported $232 billion of semiconductor products, eclipsing even the amount spent on petroleum. To narrow the gap, Beijing is starting programs to increase investment by the state and to gain expertise from foreign chip companies. Experts say the chip industry is one focus of Chinese espionage efforts... Vice Premier Ma Kai is leading a task force charged with making the country’s chip industry a world leader by 2030. The task force brings together four ministries and is estimated to have $170 billion in government support to spend over five to 10 years.

The rising trend of anti-trust and other investigations against multinationals launched by the Chinese government is being alleged to be part of a strategy that also includes forcing technology firms to lower licensing standards or agree for more liberal technology sharing contracts.

The MGI report, which formed the basis of the Times article, writes about the evolution of the government's semiconductor design and manufacturing policy,

The Chinese government is now putting significant funding and effort behind new policies relating to the development of the semiconductor industry. The government’s previous attempts to build the industry, dating all the way back to the 1990s, had mixed results because funding plans and incentives were focused more on research and academia than on business. Additionally, investments were fragmented—at one point, the government had invested in 130 fabrication sites across more than 15 provinces, none of which was able to capitalize on the scale and scope of its neighbors’ sites, and supporting industries never materialized.

The government, realizing that earlier bureaucrat-led investment initiatives failed to bring the desired results, is now aiming to take a market-based investment approach. In this case, decisions about allocating for-profit investment funds will be managed by professionals but will remain aligned with the government’s policy objectives. Chinese officials have convened a unique task force charged with setting an aggressive growth strategy... Investments will be made by a national investment vehicle (the National Industry Investment Fund) and provincial-level entities. These entities will invest across multiple categories, including project finance and domestic and foreign acquisitions, as well as traditional research and development subsidies and tax credits. 

To avoid the fragmentation issues of the past, the government will focus on creating national champions—a small set of leaders in each critical segment of the semiconductor market (including design, manufacturing, tools, and assembly and test) and a few provinces in which there is the potential to develop industry clusters... The Chinese government has actively pursued consolidation to spur the creation of national champions... The new policy framework specifically encourages consolidation within China’s assembly-and-test market segment.

Semiconductors are only the latest in the long line of industrial policy interventions pursued by the Chinese government. Two things stand out

1. As the example shows, Chinese industrial policy, despite its apparent simplicity is characterized by very smart iterative learning by doing. Each industrial policy intervention has undergone constant revisions based on feedback before they succeeded. All along the primary objective was to develop globally competitive industries. It requires enormous political courage and commitment as well as bureaucratic discipline and competence to acknowledge mistakes, learn from it, and refine policies while not losing sight of the ultimate objective.

2. The magnitude of the resources committed is massive. No country, including in the developed world, can commit such scale of resources to pursue its industrial policy objectives. Even for large countries like India, the resources committed by China for semiconductor industry alone will dwarf their total industrial policy commitment over a longer period. Such scale of support, coupled with strong and disciplined leadership, have generally underpinned Chinese industrial policy interventions.