Port Concession Models

I had blogged earlier about the new model for production sharing contract (PSC) in petroleum and natural gas exploration and argued that a revenue-sharing model would be easier to administer and, therefore, more acceptable for a risk-averse bureaucracy. In stark contrast, similar revenue sharing arrangements that are being entered into by states in long-term concessions of non-major ports may not only be difficult to administer but also prone to corruption. 

In the case of ports, where tariff setting is the prerogative of the concessionaire, the two conventional licence fee bid parameters are waterfront royalty on the cargo or revenue sharing. The former involves a fixed waterfront levy per tonne of cargo handled, whereas the latter involves payment of the quoted revenue share. In Gujarat and Maharashtra, the license fees are on Rs / MT of cargo handled basis with predetermined escalation at regular interval. On the other hand, states like Orissa, Tamil Nadu, and Andhra Pradesh have revenue share regime. Union territory of Pondicherry also follows the revenue share regime.

The royalty model may be superior since the reliability of government's revenues is much higher and concession management easier. This is because the details of the cargo loaded and unloaded is also monitored by the customs, thereby making waterfront royalty easy to assess. In contrast, accounting records of the operator are complex and can obscure the true revenues of port operations.

Evidence from PPP concessions of non-major ports from across the country reveals that port operators indulge in transfer pricing to shrink their revenues to the benefit of port service providers who are invariably controlled or owned by the promoters. Ports outsource a variety of services - dredging, stevedoring/pilotage, loading and unloading, customs handling, and internal and external transportation. The fees and other payments made by these agencies are under-priced to minimize the operators revenues. It is no surprise that most of the current PPP non-major port operators pay very small amounts as revenue share to state governments.

On the flip side, unlike the revenue sharing model where the commercial risk is distributed between the government and operator, in the waterfront royalty model, the risk sharing with government is limited. Even though the royalty escalates in a pre-determined manner every few years, competitive pressures mean that the developer cannot easily pass on this increased cost.

Weighing the two, it would appear that the waterfront royalty model is a more effective and incentive compatible model. And it is administratively simpler to boot.

Why banks' retreat from asset management is good?

One of the unintended consequences of quantitative easing has been that it has encouraged corporates to approach capital markets to finance their investment (and shares buyback) needs. The tighter banking regulatory requirements have aided this trend.

A second order consequence of both QE and tighter regulations has been that banks have pulled back from playing the role of market makers in fixed income markets, thereby engendering a liquidity problem. Traditionally, banks used to hold a large inventory of bonds on their balance sheets, managed by their "proprietary trading" desks, which they would deploy to provide liquidity for market participants. Now, with tighter lending norms and risk regulation, banks have been reluctant to play this market-making role.

This has had the effect of transferring the liquidity provisioning risk has therefore now fallen on asset managers and investors. This, from an FT article quoting Jim Cielinski, global head of fixed income at Columbia Threadneedle, the fund house, is instructive,

“Liquidity risk is being transferred away from traditional holders and on to asset managers and end investors. There is only one conclusion: the risk is now our responsibility and must be managed.”

In stark contrast to this refreshing confession, Martin Gilbert, the CEO of Aberdeen Asset Management has gone to the extent of demanding that the central banks of the world consider extending emergency liquidity assistance to asset managers if the illiquid markets freeze up. This request for emergency funding assistance comes even as asset managers have stoutly defended attempts to designate them as systemically important institutions. 

One way being suggested to mitigate the liquidity risk is to encourage fund managers to issue closed-end funds which need not be redeemed on demand. This would avoid the runs on assets, especially emerging market debt, which force their fire sales and unleash a spiral of decreasing prices. 

In any case, I would say that the banks' retreat from asset management industry would have a beneficial effect on the fixed income markets in particular and financial markets in general. It would incentivize investors to be more vigilant with their investment decisions and fund managers to exercise greater due-diligence in building up their portfolios. It would also encourage the development of less liquid instruments by asset managers. This surely is a market disciplining trend that we should welcome wholeheartedly. 

Interestingly, this trend comes at a time when asset management service of banks has been increasing in importance, threatening to eclipse the more glamorous investment banking business. This raises the possibility of banks being tempted to peddle in-house asset management products instead of external products so as to maximize their fees. Fund management industry, which has doubled over the past decade to $87 trillion, has become attractive for banks given that it generates a predictable fee stream and is capital-light, especially important when banks are buffeted by higher regulatory capital requirements. 

Weekend Reading Links

1. Carmen Reinhart estimates seven or eight non-oil commodity price booms since the late eighteenth century. The booms have typically lasted 7-8 years and busts about seven years and peak-to-trough declines of more than 30%.

The current bust is in its fourth year with prices having declined by about 25%.

2. The much-expected decline in bond markets after a sustained bond-cycle may be stemmed by the dynamics generated by demographic forces. Consider this,

The ageing population is transforming savers and risk-taking investors into rentiers — meaning an increasingly large proportion of the economy relies on a stable, regular and predictable income derived from past investments. As baby-boomers become pensioners, this class increasingly favours bond-like instruments and moves their portfolios away from stocks. According to Towers Watson, worldwide pension fund assets under management in the 16 major markets total $36tn — equivalent to nearly half of global gross domestic product. In the seven largest markets, pension asset allocation to bonds (30.6 per cent) was close to that of equities (42.3 per cent), and there is a discernible shift away from other investments towards bonds.

3. John Authers talks about the endowment effect among fund managers and how over-valuing assets contributes to losses,

The endowment effect is by far the most widespread psychological flaw in investors. Based on research of global equity portfolios worth more than $1tn in total, some 25 per cent suffer from the endowment effect... In investment, the endowment effect revolves around fear... and it afflicts successful stockpickers. In a typical example, the manager buys a stock at $20, expecting it to go to $50. It reaches $43 or $44 swiftly, and then stalls. But the manager cannot bear to sell until they have gained their full expected value... The fear of embarrassment, of not getting full value for a good investment, fools talented stock pickers into tying up too much capital in what has become “dead money”, when their skills would be far better put to work finding new stocks to buy... For portfolio managers... the average cost of the endowment effect at about 100 basis points. But for about 10 per cent of portfolio managers, the effect of overvaluing their winners can be far worse, at as high as 2.5 percentage points per year, a terrible disadvantage.

4. Livemint has a nice graphic summary of the evolution of India's human development - education, health, and income - since 1870 using an index constructed by Prof Leandro Prados-de-la-Escosura. The index finds that while the country has narrowed its income gap with the richer countries since the economic liberalization of the early 1990s, the health and education gap continues to widen. The comparison of the trajectories of India and China on the two sub-indices is instructive.

China's impressive health and education performance help laid the foundations for its subsequent economic achievements.

5. Two good data journalism stories in Livemint - in the run-up to Paris, a summary of the climate change problem, and commute patterns in the 53 million plus cities of India. The percentage of people traveling by foot or bicycle in many cities is very high, the single largest commute mode. Ironically, they get the least preference and investments (look at the lack of footpaths and road margin parking that obstructs bicycle users) and their voice rarely heard. This is hardly surprising since they are more likely to be the poorest and most disenfranchised.

6. On the even of the Paris COP, here is a summary of the emission reduction commitments made by the top 15 emitters.

Irrespective of whether a binding commitment emerges or not, and even apart from the fact that these commitments fall short of the two degrees celsius temperature increase target, it may be a prudent step for all concerned to agree to a five-year revision goal.

7. A reminder of the pervasiveness and scale of poverty in rural India comes from this graphic (based on the SECC) of the percentage of households with the monthly income of main bread-earner being less than Rs 5000.

Sustainable long-term growth given such elevated levels of poverty is simply impossible.

8. Container shipping is the latest market to suffer from a race to the bottom (in pricing) driven by excess capacity. So much so that it may be cheaper to rent containers than an equivalent amount of land space!

9. India leads in various measures of corporate fraud in an EIU study for Kroll. The share of companies affected by breaches of regulatory compliances, bribery and corruption, misappropriation of company funds, and theft of intellectual property was the highest in India.

10. Ananth has a very comprehensive list of weekend reading links here. 

More on empowered elected Mayors for Indian cities

I have made the case for empowered and directly elected Mayors for India's largest cities here and here. The graphic captures the priorities of even the most well-intentioned and smartest non-political Municipal Commissioners of Indian cities. The priorities are clearly skewed towards the short-term and very little thinking and effort goes into the city's long-term growth. 

Ironically, it is the politics surrounding an empowered Mayor (how powerful that individual would be against the local legislators and members of Parliament, even the Chief Minister in the case of the metropolitan cities) that comes in the way of such a reform. This may prove insurmountable.

A compromise would be to have directly elected Mayors to head metropolitan development authorities, with a few critical responsibilities which involve co-ordination among many local governments and departments. They could include affordable housing, economic growth and job creation, and transportation planning. 

Quantitative easing, share buybacks, and secular stagnation

Martin Wolf lays out the reasons for the persistent low-interest rate environment. He attributes this to the "savings glut", arising not just from emerging market foreign exchange surpluses but also from the rising pile of retained surpluses of corporates from developed economies. These surpluses have been financing fiscal deficits in Japan and accumulation of foreign assets in the case of Germany. The first graphic points to the rising corporate gross savings.

However, the rising savings have been accompanied by declining corporate investment, a reminder of the secular stagnation argument.

These trends have led to accumulation of corporate retained earnings.

A significant portion of this is being used to buyback shares and return money to investors. In fact, corporates, especially in the US, have sought to leverage the ultra-low rate environment to finance the share buybacks. So much so that stock buybacks have overtaken aggregate dividends as the main form of corporate payout. These low rates and the resultant high equity risk premium make it prudent for businesses to replace costly equity financing with cheaper debt. The largest US corporates have been leading this market distorting trend. Apart from being an important contributor to fuelling the equity market boom, the resultant reduction in equity base has further inflated corporate surpluses. 

The BIS has documented that in the 2009-14 period, US non-financial corporates repurchased $2.1 trillion in shares and raised $1.8 trillion in net bond financing. 

Clearly, the extended period of quantitative easing and resultant ultra-low interest rates have served to amplify the effects of secular stagnation. 

An agenda for distribution sector reforms

I blogged earlier on my skepticism with power sector reforms. My concerns arise from deep-rooted fundamental problems that afflict the sector and not the details of the financial restructuring plan. 

On the face of it, the distribution side of power ought to be technically the simplest to manage. Power flows without any transactional engagement by the discom. The purely operational transactions done by the discom are secondary and just three - repair and restore supply when interrupted, replace non-working meters, and do periodic operation and maintenance (O&M). And then there are the management issues of releasing new services, spot-billing, and theft detection and disconnection. The discoms do none of these to any reasonable degree of satisfaction. State capability and political economy constraints bind big-time. And even if we get this right, we run into the twin challenges of free farm power and low tariffs. 

The limited technology adoption, archaic processes, low level of professional competence among field-level engineers (a reflection of our workforce employability crisis), limited large and credible enough local service providers (spot-billing, transformer and other equipment servicing, O&M contracting of services etc), unionization, corruption etc are first order problems. They are amplified many times over by weak state capability, sensitive electoral politics, and inherently complex nature of the problem, all of which make technology adoption, howsoever beneficial, a very difficult challenge.

I have blogged earlier here, here, and here on this and am being deliberately provocative in arguing that technology solutions like GIS, SCADA (maybe DA, but surely not SC), DTR (transformer) metering etc are not going to happen in even our best discoms (power point presentations in conferences and seminars apart!) anytime for the foreseeable future. In a difficult and constraining environment, a strategy that focuses on these first-best solutions is certain to crowd-out the effective implementation of even feasible second-best solutions. It would detract from the effectiveness of supervision and make the best the enemy of the good!

So what is the way out? Understand the problem, acknowledge it, and then start work on it. As a first-order and non-negotiable requirement, discoms need to measure and audit its energy distribution and bill and collect from services, the equivalent of plain good governance in the distribution side. But this requires real-time metering of feeders, consumer mapping under each feeder (and keeping track of the dynamic downstream LV network), and then rigorous monitoring and enforcement. And the same with billing services, replacing non-working meters, and collecting dues. Simple as it appears, given the environment, this is a super-difficult challenge and unlikely to happen in quick time. Without arguing for a sequential approach to reform, this is an essential pre-requisite for any other reform. 

Technology can be useful here, but not as top-down GIS/SCADA/AMR solutions, as is currently being advocated. The best strategy is to make available the full spectrum of technology and re-engineering options available in the market and let discoms adopt what they can sustain and suit them best. Different categories of technology interventions in energy audits should be implemented across and within discoms and technology solutions should be allowed iterate and evolve. Given the size of the country, the three orders of the interventions (multiple discoms, multiple areas within a discom, and different technologies) should, if done in a focused manner, over a period of time, throw up technologies that emerge as successes and can diffuse into scale.

Weekend Reading Links

1. David Evans in the World Bank blog has an awesome compilation of the papers presented at the Northeastern Universities Development Consortium Conference.

2. FT has a nice article which explores the valuation problem in mature start-ups arising from a new category of private shares with guaranteed returns. The insurance against downside distorts the valuation since the investors are now less concerned about the valuation and only interested in the pre-determined guaranteed returns,

Many of the investments in the more mature start-ups are structured: in effect giving investors guaranteed returns and a degree of protection against any losses.Financial experts refer to these headline valuations as “marketing numbers”, highlighting that they are a function of image as much as anything else: the greater the degree of guaranteed return a company is prepared to give, the higher the hypothetical value that investors place on the company... Even some of the best-regarded tech companies have used these methods. At Uber, a major investor received a guaranteed 25 per cent return during an early investment round. Investors also received significant protections during Airbnb’s $10bn round last year.

Square, the most prominent of the current generation of start-ups to have so far opted for a public listing, is typical of this trend. In its most recent private fundraising investors paid $15.46 per share, generating headlines about a $6bn valuation. Those who bought in were guaranteed a 20 per cent share price bump in an IPO. Their compensation, if Square fails to hit this: extra shares to make up the difference, potentially diluting the value for earlier investors and many employees.These new investors may have paid a higher price for their shares, giving them less upside if the company does well. But they also have a degree of insurance unavailable to other investors if the company falls short of expectations.

These multi-share class structures, along with the lack of a liquid market for private shares, have made it almost impossible to calculate an accurate valuation for many start-ups. Even investment professionals whose job it is to assess the value of private shares in their portfolios admit that they cannot do this with 100 per cent certainty. In a private company, unlike in public markets, each class of share commands a different price because of the protections that come with it. In Square’s case, the headline valuation figure of $6bn assumes wrongly that all shares could command the highest share price.

This trend to guarantee returns has been driven by founders desire to join the unicorn club, which enables them to raise more cash, recruit employees and raise their profile.

3. Much the same is happening in India, with late stage VCs putting in tough riders to guarantee their investments and startups accommodating those demands in order to attract the capital required to both sustain operations as well as expand their market shares. Such conditions, commonly described as 'liquidation preference' (LP), ensure that the investor takes back "its entire capital or the amount due to it in proportion of its shareholding in the firm, whichever is higher". As valuations froth, the LP multiples demanded has been rising. The immediate losers from such deals are the start-up founders, whose shares come only after the late and early stage investors recover their investments. 

4. John Reed, the former Chairman of Citigroup, comes out in favor of restoring Glass-Steagall and dispensing with the universal banking model. Apart from the questionable claims on financial benefits from a single entity, he also points to the unstable cultural balancing in bringing all activities under one roof,

As is now clear, traditional banking attracts one kind of talent, which is entirely different from the kinds drawn towards investment banking and trading. Traditional bankers tend to be extroverts, sociable people who are focused on longer term relationships. They are, in many important respects, risk averse. Investment bankers and their traders are more short termist. They are comfortable with, and many even seek out, risk and are more focused on immediate reward. In addition, investment banking organisations tend to organise and focus on products rather than customers. This creates fundamental differences in values.

5. NYT on the ubiquity of Samsung in South Korea,

In South Korea virtually all of your wants and needs can be met by Samsung, the most dominant conglomerate. You can be born in the renowned Samsung Medical Center, attend a prestigious Samsung-owned university, live in Samsung housing complexes — even buy life insurance from a Samsung subsidiary and go for vacation to the Samsung-owned Everland amusement park. It is possible to use virtually only Samsung electronic devices in daily life. And, if you ace the widely taken GSAT — Global Samsung Aptitude Test — you can land a prized job at one of its subsidiaries. No wonder that Samsung is so large that it is responsible for a fifth of South Korea’s exports and about 17 percent of the annual gross domestic product.

6. FT has this dismal assessment of the impact of QE exit on emerging markets,

By some estimates, $7tn of QE dollars have flowed into emerging markets since the Fed began buying bonds in 2008. Now, a year after the Fed brought QE to an end, companies in emerging markets from Brazil to China are finding it increasingly hard to repay their debts. The excess capacity these companies created became apparent just as China’s slowing economy triggered a collapse in global commodity prices, hurting companies across the emerging world and sending Brazil’s economy into deep recession. Some experts say QE policies by the Fed and other central banks have left a legacy of oversupply from which it will take years to recover.

The article also describes how the search for yields resulted in leveraged 'carry trade' from developed to EM economies. The BIS estimates an amount of $9 trillion flowed into the EM economies as bank loans and bonds in the 2009-14 period. As I have blogged earlier, it also found evidence of cash-rich EM firms using this route to speculate with 'carry trade' rather than for investment purposes.  

This has had the effect of driving up EM private sector debt, raising concerns about its repayment once the interest rates in developed economies start to rise.

The disturbing thing about this debt build-up is that it comes at a time when the EM economies are themselves slowing down sharply and consumer demand has been tanking. Apart from declining asset prices, the massive over-capacity in many of these economies mean that the ability of local borrowers to repay their debts once the capital flows tide reverses, as it can in very quick time, is seriously suspect. 

7. The FT has a graphic of the 10 most polluted cities in the world, with India contributing 6 and Pakistan 3.

In fact, the latest Global Burden of Disease report estimates that ambient air pollution was responsible for 586,788 premature deaths in India in 2013, up from 365,592 in 1990.

8. FT reports that peer-to-peer (P2P) lending platforms like Lending Club, Funding Circle, and Prosper have the potential to disrupt the banking sector in a Uber-style revolution. They offer higher yields to lenders, and faster, cheaper, and more convenient loans to borrowers of different categories - consumers, students, small businesses etc. Investors globally have raised more than $80 bn over the past two years for direct lending funds. Though, P2P lenders make up just 1.1% of all unsecured consumer loans in the US, PwC expects annual P2P lending in the country to soar from $5.5 bn in 2014 to $150 bn in 2025. As the article writes, their business model,

P2P lenders say their algorithmic credit scoring technology is as good as the banks. But because they do not need to hold regulatory capital or liquid assets, operate expensive physical branches or deal with costly legacy IT systems, they are more efficient than banks... the “frictional cost” for their companies in making a loan is equal to about 2 per cent, against about 5—7 per cent for a typical bank... As a result, P2P lenders can offer investors a higher yield than banks do to depositors. 

The P2P market has attracted insurers and asset managers who have launched direct lending arms, lending especially to small and mid-sized companies.

Four observations on this trend. One, as banking sector regulations tighten, such platforms could crowd-in the riskier categories of borrowers. Two, the very nature of such lending makes it difficult for the emergence of large lenders. Given that the major source of P2P financing are high-net worth individuals and also given the limits to how much you can lend through impersonal and algorithmic due-diligence, there may be an inherent self-limiting factor to the sizes of such enterprises. Three, this may be a welcome trend shift in the global banking sector in so far as it promotes greater systemic risk diversification. Four, however, the entry of financial institutions like insurers and asset managers makes greater regulation, atleast of their P2P lending arms, essential. Or this could end up being yet another of the "dark corners" of financial markets. 

9. This FT graphic is a very good illustration of the state of the Chinese economy. All the leading indicators of economic growth are falling.

10. In the recently concluded local government elections in Kerala, a corporate social responsibility initiative group won the Panchayat elections in Kizhakkambalam of Ernakulam district in Kerala state. Candidates of Twenty20 Kizhakkambalam, a CSR initiative of the local Anna-Kitex group, a Rs 15 bn garment and aluminium company, won 17 of the 19 wards and 2 out of 3 block panchayat seats. The village, with an area of 32 sq km, 8000 households and population of 23000 is predominantly agricultural and has a literacy rate of 94.74%. The 'party' campaigned on a platform of "improving facilities for drinking water, housing, food, toilet, electricity, healthcare, education and employment besides reviving agriculture in the village".

11. Finally, a reminder of the global downturn comes from this,

The price of iron ore in Qingdao, the widely accepted benchmark for Chinese metal consumption, is down 76 per cent from its 2011 peak... The Baltic Dry index, a measure of the cost of shipping commodities around the world, subsided this week to its lowest ever. It has now dropped 95.5 per cent from its peak set in 2008, shortly before the financial crisis.