News reports claim that the Government of India is actively considering a series of measures to contain the rise in steel prices. This follows futile efforts to get the steel companies to voluntarily rein in prices.
Consider this. Steel prices have gone up by over 60% in the past year, with a 25-30% rise in the last three months. Prices of inputs have gone up rapidly over the past year - iron ore has doubled and coking coal trebled. The Governments itself had contributed its share to the recent price rises, with the National Mineral Development Corporation (NMDC) hiking iron ore prices last October. This hike may be taking its full impact now. The stell companies recently raised steel prices by almost 15% by levying a raw material surcharge of Rs 5000.
It is now becoming increasingly clear that the Cabinet Committee on Prices (CCP) will soon announce a package to contain steel prices. The following measures are being proposed
1. Removing the 5% customs duty on imports of steel, pig iron, mild steel, zinc, ferro alloys, and metcoke.
2. Reduction in excise duty from 14% to 8% on pig iron, sponge iron, iron and steel scrap, granules and powder of pig iron, semi-finished products, pencil ingots, bars and rods, angles, shapes, sections and wires.
3. Elimination of the 14% countervailing duty on TMT bars and structurals.
4. Increase in export duty on iron ore to 15% advalorem rate, from the existing Rs 50-Rs 300 per tonne.
Other measures being considered include reversal of railway freight hike, and suspension of futures trading in iron and steel for six months.
I will stick out my neck and argue that all these measures are going to do precious little to contain steel prices rises. They may at best mildly attentuate the price pressures, and that too only in the short-term. The reasons have been extensively discussed in previous posts here and here.
There is another dimension to these regulatory and fiscal measures to ease supply constraints. It is unlikely, even almost certain, that the producers are not going to pass on the lower excise duties to the consumers. Similarly, the lower customs duties are most likely to be captured by the foreign exporters, who are most likely to hike their prices to offset the lower duties. This happened with edible oil imports from East Asia, and will happen with iron products too. Given the relatively small share of exports compared to domestic demand, the higher export duties will achieve little else other than decreasing the competitiveness of our exporters.
A little understanding of tax incidence will help clarify these aforementioned conclusions. Eco 101 teaches us that for products exhibiting inelastic price elasticity of demand, the incidence of tax burden is more on the consumer. If we draw parallels to the present situation, things become clearer. Steel and other metals, facing tight demand conditions in light of a booming economy and buoyant growth in construction and infrastructure sectors, are therefore price inelastic with respect to demand. All fiscal measures are more likely to help producers partially offset higher costs, than benefit the consumers.
The steep rises in raw material and other input prices across the world and the competition arising from a global market place, has placed considerable cost pressures on producers and manufacturers. In this context, they are more likley to keep all tax cuts, and pass on as little as possible to the consumer. The tax cuts therefore end up as corporate welfare, instead of being a relief for the consumers.
The solution to this conundrum has to come from the market itself. Once the prices cross that level when demand starts getting adversely affected, the producers become forced to pass on a greater share of the fiscal concessions to the consumers. The prices of TMT bars had fallen two weeks back as the high prices had started impacting demand. The problem is that there is no way of estimating this threshold price, so as to time Government fiscal interventions accordingly.
Saturday, April 12, 2008
Friday, April 11, 2008
US importing inflation
The dual coincidence of a falling dollar and rising inflation in emerging economies is putting upward pressure on the prices of American consumption imports from them. Since developing countries now produce nearly half of all American imports, the higher prices contribute a significant share to American inflation. The falling dollar is making imports more expensive, while the rising inflation in the producing countries is incraesing their production costs. The NYT chronicles this change here.
So far the Asian exporters had been taking cuts in their bottomlines, rather than pass on the increasing costs to the American consumers. Now, with no end in sight to the declining dollar, exporters appear to be no longer willing to subsidize the American consumers.
So far the Asian exporters had been taking cuts in their bottomlines, rather than pass on the increasing costs to the American consumers. Now, with no end in sight to the declining dollar, exporters appear to be no longer willing to subsidize the American consumers.
Monday, April 7, 2008
"Many recipes" in development strategy
Harvard Professor Dani Rodrik has written about how our quest for the best solution often leads us astray and prevents us from finding the most optimal solutions to our problems. He has written a deeply insightful article in which he explores the world of second-best, third-best and other alternative approaches to solving the numerous challenges facing global economies.
We need to start our journey of discovering solutions to complex socio-economic problems by acknowledging that these problems act in multiple dimensions with numerous implications, and each problem often has more than a single solution. In fact, all social issues involving interaction among individual economic agents provide fertile ground for numerous emergent situations, with differing permutations and varying probabilities. The development problems facing extremey diverse settings like that in developing societies require multi-pronged responses, which cannot be straitjacketed into any single consistent and overarching logic.
Most of our development schemes adopt the comprehensive and systemic approach to policy formulation and implementation. In an effort to encapsulate and capture the requirements and demands of all areas and different categories of people, we over-standardize a development scheme into a monolithic set of guidelines and thereby curtail the program's effectiveness. Given the diversity and resultant complexity of problems, it is futile to capture all the possible solutions into a single policy framework.
One of the major challenges faced while formulating policies is the need to put in place adequate checks and balances to limit the role of discretion and thereby reduce the probability of the scheme being subverted or exploited by vested interests. This requirement often becomes an alibi for bringing in multiple layers of bureaucracy, which end up losing sight of the very objectives of the scheme.
In order to avoid getting trapped in this bureaucratic gridlock, we need to aim at getting the outcomes right and not be obsessed with the form of the institutions and processes that gets us there. Therefore, we should focus on cultivating all possible institutions and processes, and not just the "best possible", that provide security of property rights, enforce contracts, stimulate entrepreneurship, foster integration in the world economy, maintain macropeconomic stability, manage risk-taking by financial intermediaries, supply social insurance and safety nets, and enhance voice and accountability. The challenge is to get the incentives right within the institutions and the processes so as to achieve the objectives. But this alignment of incentives should be achieved without significantly disrupting the tenuous local political equilibrium.
In fact, once the incentives get aligned towards achieving the desired outcomes, the means too tend to get aligned along the lines of the broader societal interests. Quite often, the outcomes carry within themselves the seeds for institutional reforms which are directed at moving towards the best practice model. Further, for every reform initiative there is an appropriate pace and sequence, which varies widely across different social and economic contexts, without which the reform risks destabilizing the domestic socio-economic and political balance.
China is the best example of how the non-traditional or the best practice model, need not be the only means towards achieving certain desirable economic outcomes. The spectacular story of Chinese economic growth is an excellent example of how economic growth can be achieved by innovative and practical policy decisions without disspiating scarce resources and valuable efforts in dismantling entrenched power structures. In the absence of any strong legal and institutional framework for enforcing contractual obligations, the role of the guanxi type relational contracting in the Chinese and East Asian way of contracting cannot be under estimated. Foreign firms which quickly grasped this reality were able to take advantage of the tremendous potential offered by these markets. Let me illustrate a few other examples of how alternative approaches to the best practice can help solve development problems.
Multi-lateral agencies and academicians tend to focus more on the institutional and procedural requirements necessary to achieve the desired social and economic goals. They believe that the objectives can be achieved only through institutions that are built on certain universal ideas. Universal ideas like decentralization, deregulation, opening up economies, transparency, stakeholder participation etc need not be seen as sacrosanct and inevitable accompaniments in any institutional reform necessary to achieve development goals. We will explore some examples of such obsession with best practice or standard models, going astray.
The traditional IMF and WB prescriptions view economic open-ness and deregulation as pre-requisites for high economic growth rates. Developing countries are forced into inculcating these ideas into any institutional or policy reform. This arguement misses the critical point that these ideas are only a means towards providing a competitive environment and aligning incentives appropriately. Quite often wholesale and sudden changes, like the "shock therapies" in much of Eastern Europe after the fall of communism, destroys all existing institutions without putting in place any alternative. As the examples of East Asia and China proves, competitive environment, exposure to external market forces, and efficient allocation of resources can be done in more ways than one. All these countries experienced their spectacular growths as closed economies (to both goods and capital), and bureaucratically guided allocation of resources.
Traditional development models stress the need to create strong formal legal institutions, and see informal contract enforcement arrangements as being detrimental to the development agenda. But many academicians refers to the utility of "relational contracting" with all stakeholders, or long-term, personalized relationships built through repeated interactions, in the absence of strong legal enforcement machinery. Such contracting arrangments should be strengthened and developed as a substitute for regular legal systems. In the absence of a strong legal enforcement system, foreign investors in China rely on the "guanxi", or long-term relationships built on trust, which demand immediate payment, screens out unreliablke firms, and re-negotiate when things run into trouble. Dani Rodrik argues in favor of strengthening these relational contracting channels, by iniatiating measures like providing more information about firms, that lowers the information assymetry between them.
Encouraging entreprenuership is one of the most commonly advocated reforms for any developing economy. Lowering entry barriers by reducing licensing and registration requirements is a common prescription for reducing rent seeking and promoting entrepreneurship. But Prof Rodrik argues that "rents may well be a necessary condition for adequate levels of entrepreneurship to emerge in non-traditional economic activities". Most often, free or minimal entry costs, acts as a deterrent to encouraging entrepreneurs. Again the example of many successful East Asian countries, with their heavily regulated business environment and high domestic market prices, provide adequate incentives for entrepreneurs to thrive.
Another example of form taking precedence over susbtance is that of encouraging democracy by forcing down multi-party elections. Many developing countries are socially and ethnically diverse, and in the absence of standard conflict resolution and group bargaining institutions and forums, are often held together by an informal and tenuous consensus or balance of power among the elites or a few groups. A sudden introduction of the elements of multi-party democracy and elections unsettles this unstable equilibrium and brings to the fore the latent differences and long-felt grievances. Civil wars and domestic strife ensues instead of democracy. There are numerous such examples in Africa and East Europe.
Decentralization of authority and decision making powers is a favorite reform theme with multilateral aid agencies. It is argued that decentralization would induce stakeholder participation, improve efficiency of public service delivery, and reduce corrupution. Accordingly funds, functions and functionaries have been decentralized in many countries and many externally assisted and other regular development programs are implemented this way. But there are numerous instances of these powers being delegated to institutions and agencies without the requisite expertise or capacity to administer the delegated powers. The result is increased rent seeking, decreased quality of public services, and wholesale administrative paralysis. Such remedies leave the system worse off than in the first place. While the objectives of decentralization are laudable, the extent to which this reform can be successfully implemented varies widely between and within nations.
Another holy cow with multilateral lending agencies and standard governance theories is transparency. Transparency has emerged as the antidote to cronyism and corruption, and as being vital towards ensuring the effectiveness of governance. This theory fails to acknowledge the reality of the tenuous equilibrium that pervades many societies, where decisions are often made on informal platforms and work flow follows the path of least resistance. Many times, infusion of transparency into such contexts unleashes a cascade of divisive and fissiparous forces that mutates resource draining sub-conflicts that detracts attention form the original objective.
Standardization of procurement and tendering procedures is often a pre-condition for any kind development assistance or soft loans. The objective of having a transparent and fully standardized contracting process is to eliminate rent seeking and ensure quality in the sanctioned works. The standard contracting procedures and documents leaves limited flexibility to accomodate the local needs and requirements. For example, adding or deleting certain components in a work, or changing the specifications of the items to be procured, or adopting slightly informal contracting procedures, are not possible under this arrangement. The rigid procedural requirements overlook the fact that these contracting markets have limited depth and breadth, and often operate through informal mechanisms like sub-contracting and political contracting. Such procedural rigidity contributes significantly towards time over runs and lowering of work quality.
It is observed that local politicians, either directly or indirectly, are most often the major contractors for engineering works and other regular government procurement contracts. Standard models argue that this involvement of political representatives in contracting services and works, breeds corrupt practices and comes in the way of development. It therefore favors eliminating their role in such contracting completely and accordingly puts in place specific controls on this. However, in the real world, these attempt most often end up subverting the whole development agenda and diverting the terms of the debate. The energies get dissipated trying to prevent the involvement of the politician or local vested interest, that the ultimate objective itself remains unachieved.
In many ways, the contracting environment for both engineering works and procurement is very complex and is strongly influenced by local factors (like labor issues, local conflict resolution, tying up of all linkages, rent seeking chains etc) which a local politician is better positioned to combat. Indeed getting the local politician on board is often the best hedge against local uncertainities, including political risks. Instead, we should acknowledge the reality of political representatives involved in contracting, and focus on getting those institutions in place that helps us achieve our objectives. China, with its established arrangement of local party bosses doubling up as entrepreneurs, has achieved precisely the same without unsettling the local political equilibrium.
None of this is to argue that there should not be de-centralization, formal procurement procedures, transparency, legal institutions, deregulation, multi-party elections, and neo-classical growth models. My contention is that all these are ultimately only the means towards certain specific objectives, mainly the effective delivery of governance and public services. Given the compex and often delicately balanced socio-political and economic settings in which these institutions and attributes have to function, it is more appropriate if they are introduced carefully in a phased manner.
We need to start our journey of discovering solutions to complex socio-economic problems by acknowledging that these problems act in multiple dimensions with numerous implications, and each problem often has more than a single solution. In fact, all social issues involving interaction among individual economic agents provide fertile ground for numerous emergent situations, with differing permutations and varying probabilities. The development problems facing extremey diverse settings like that in developing societies require multi-pronged responses, which cannot be straitjacketed into any single consistent and overarching logic.
Most of our development schemes adopt the comprehensive and systemic approach to policy formulation and implementation. In an effort to encapsulate and capture the requirements and demands of all areas and different categories of people, we over-standardize a development scheme into a monolithic set of guidelines and thereby curtail the program's effectiveness. Given the diversity and resultant complexity of problems, it is futile to capture all the possible solutions into a single policy framework.
One of the major challenges faced while formulating policies is the need to put in place adequate checks and balances to limit the role of discretion and thereby reduce the probability of the scheme being subverted or exploited by vested interests. This requirement often becomes an alibi for bringing in multiple layers of bureaucracy, which end up losing sight of the very objectives of the scheme.
In order to avoid getting trapped in this bureaucratic gridlock, we need to aim at getting the outcomes right and not be obsessed with the form of the institutions and processes that gets us there. Therefore, we should focus on cultivating all possible institutions and processes, and not just the "best possible", that provide security of property rights, enforce contracts, stimulate entrepreneurship, foster integration in the world economy, maintain macropeconomic stability, manage risk-taking by financial intermediaries, supply social insurance and safety nets, and enhance voice and accountability. The challenge is to get the incentives right within the institutions and the processes so as to achieve the objectives. But this alignment of incentives should be achieved without significantly disrupting the tenuous local political equilibrium.
In fact, once the incentives get aligned towards achieving the desired outcomes, the means too tend to get aligned along the lines of the broader societal interests. Quite often, the outcomes carry within themselves the seeds for institutional reforms which are directed at moving towards the best practice model. Further, for every reform initiative there is an appropriate pace and sequence, which varies widely across different social and economic contexts, without which the reform risks destabilizing the domestic socio-economic and political balance.
China is the best example of how the non-traditional or the best practice model, need not be the only means towards achieving certain desirable economic outcomes. The spectacular story of Chinese economic growth is an excellent example of how economic growth can be achieved by innovative and practical policy decisions without disspiating scarce resources and valuable efforts in dismantling entrenched power structures. In the absence of any strong legal and institutional framework for enforcing contractual obligations, the role of the guanxi type relational contracting in the Chinese and East Asian way of contracting cannot be under estimated. Foreign firms which quickly grasped this reality were able to take advantage of the tremendous potential offered by these markets. Let me illustrate a few other examples of how alternative approaches to the best practice can help solve development problems.
Multi-lateral agencies and academicians tend to focus more on the institutional and procedural requirements necessary to achieve the desired social and economic goals. They believe that the objectives can be achieved only through institutions that are built on certain universal ideas. Universal ideas like decentralization, deregulation, opening up economies, transparency, stakeholder participation etc need not be seen as sacrosanct and inevitable accompaniments in any institutional reform necessary to achieve development goals. We will explore some examples of such obsession with best practice or standard models, going astray.
The traditional IMF and WB prescriptions view economic open-ness and deregulation as pre-requisites for high economic growth rates. Developing countries are forced into inculcating these ideas into any institutional or policy reform. This arguement misses the critical point that these ideas are only a means towards providing a competitive environment and aligning incentives appropriately. Quite often wholesale and sudden changes, like the "shock therapies" in much of Eastern Europe after the fall of communism, destroys all existing institutions without putting in place any alternative. As the examples of East Asia and China proves, competitive environment, exposure to external market forces, and efficient allocation of resources can be done in more ways than one. All these countries experienced their spectacular growths as closed economies (to both goods and capital), and bureaucratically guided allocation of resources.
Traditional development models stress the need to create strong formal legal institutions, and see informal contract enforcement arrangements as being detrimental to the development agenda. But many academicians refers to the utility of "relational contracting" with all stakeholders, or long-term, personalized relationships built through repeated interactions, in the absence of strong legal enforcement machinery. Such contracting arrangments should be strengthened and developed as a substitute for regular legal systems. In the absence of a strong legal enforcement system, foreign investors in China rely on the "guanxi", or long-term relationships built on trust, which demand immediate payment, screens out unreliablke firms, and re-negotiate when things run into trouble. Dani Rodrik argues in favor of strengthening these relational contracting channels, by iniatiating measures like providing more information about firms, that lowers the information assymetry between them.
Encouraging entreprenuership is one of the most commonly advocated reforms for any developing economy. Lowering entry barriers by reducing licensing and registration requirements is a common prescription for reducing rent seeking and promoting entrepreneurship. But Prof Rodrik argues that "rents may well be a necessary condition for adequate levels of entrepreneurship to emerge in non-traditional economic activities". Most often, free or minimal entry costs, acts as a deterrent to encouraging entrepreneurs. Again the example of many successful East Asian countries, with their heavily regulated business environment and high domestic market prices, provide adequate incentives for entrepreneurs to thrive.
Another example of form taking precedence over susbtance is that of encouraging democracy by forcing down multi-party elections. Many developing countries are socially and ethnically diverse, and in the absence of standard conflict resolution and group bargaining institutions and forums, are often held together by an informal and tenuous consensus or balance of power among the elites or a few groups. A sudden introduction of the elements of multi-party democracy and elections unsettles this unstable equilibrium and brings to the fore the latent differences and long-felt grievances. Civil wars and domestic strife ensues instead of democracy. There are numerous such examples in Africa and East Europe.
Decentralization of authority and decision making powers is a favorite reform theme with multilateral aid agencies. It is argued that decentralization would induce stakeholder participation, improve efficiency of public service delivery, and reduce corrupution. Accordingly funds, functions and functionaries have been decentralized in many countries and many externally assisted and other regular development programs are implemented this way. But there are numerous instances of these powers being delegated to institutions and agencies without the requisite expertise or capacity to administer the delegated powers. The result is increased rent seeking, decreased quality of public services, and wholesale administrative paralysis. Such remedies leave the system worse off than in the first place. While the objectives of decentralization are laudable, the extent to which this reform can be successfully implemented varies widely between and within nations.
Another holy cow with multilateral lending agencies and standard governance theories is transparency. Transparency has emerged as the antidote to cronyism and corruption, and as being vital towards ensuring the effectiveness of governance. This theory fails to acknowledge the reality of the tenuous equilibrium that pervades many societies, where decisions are often made on informal platforms and work flow follows the path of least resistance. Many times, infusion of transparency into such contexts unleashes a cascade of divisive and fissiparous forces that mutates resource draining sub-conflicts that detracts attention form the original objective.
Standardization of procurement and tendering procedures is often a pre-condition for any kind development assistance or soft loans. The objective of having a transparent and fully standardized contracting process is to eliminate rent seeking and ensure quality in the sanctioned works. The standard contracting procedures and documents leaves limited flexibility to accomodate the local needs and requirements. For example, adding or deleting certain components in a work, or changing the specifications of the items to be procured, or adopting slightly informal contracting procedures, are not possible under this arrangement. The rigid procedural requirements overlook the fact that these contracting markets have limited depth and breadth, and often operate through informal mechanisms like sub-contracting and political contracting. Such procedural rigidity contributes significantly towards time over runs and lowering of work quality.
It is observed that local politicians, either directly or indirectly, are most often the major contractors for engineering works and other regular government procurement contracts. Standard models argue that this involvement of political representatives in contracting services and works, breeds corrupt practices and comes in the way of development. It therefore favors eliminating their role in such contracting completely and accordingly puts in place specific controls on this. However, in the real world, these attempt most often end up subverting the whole development agenda and diverting the terms of the debate. The energies get dissipated trying to prevent the involvement of the politician or local vested interest, that the ultimate objective itself remains unachieved.
In many ways, the contracting environment for both engineering works and procurement is very complex and is strongly influenced by local factors (like labor issues, local conflict resolution, tying up of all linkages, rent seeking chains etc) which a local politician is better positioned to combat. Indeed getting the local politician on board is often the best hedge against local uncertainities, including political risks. Instead, we should acknowledge the reality of political representatives involved in contracting, and focus on getting those institutions in place that helps us achieve our objectives. China, with its established arrangement of local party bosses doubling up as entrepreneurs, has achieved precisely the same without unsettling the local political equilibrium.
None of this is to argue that there should not be de-centralization, formal procurement procedures, transparency, legal institutions, deregulation, multi-party elections, and neo-classical growth models. My contention is that all these are ultimately only the means towards certain specific objectives, mainly the effective delivery of governance and public services. Given the compex and often delicately balanced socio-political and economic settings in which these institutions and attributes have to function, it is more appropriate if they are introduced carefully in a phased manner.
Saturday, April 5, 2008
Inflation concerns rise
The inflation story is assuming alarming proportions. Figures for the week ended March 22, reveals that inflation has risen to a three year high of 7%.
Earlier this week, the Government of India announced measures to ease supply side constraints by abolishing import duty on crude form of edible oils, cutting rates on refined edible oils and banning non-basmati rice exports. The Government scrapped import duties on all crude edible oil forms, while cutting duties on refined palm, sunflower, soyabean, coconut oils and hydrogenated vegetable fats to 7.5 per cent. This follows previous measures like ban on futures trading in wheat, rice and pulses, and ban on exports of pulses. These were follwed with the withdrawal of incentives for export of basmati rice.
On a year-on-year basis, the wholesale prices have risen by 27% for iron and steel category, 21% for edible oils, 6% for cereals, 11% for vegetables, 10% for milk, 9% for dairy products, 5% for cement, and 9% for both mineral oil and coal. As can be seen, the major cause for concern comes from iron and steel and edible oils.
The problem faced by the Government is that the recent price rises are not an isolated Indian phenomenon, and cannot be solved by even addressing all our supply side concerns. Global commodity prices - energy, minerals and raw materials, and foodgrains - have been an upward rise for over two years now, and shows no signs of abating. IMFs commodity price index shows that since 2005, food prices are up 65%, metal prices 70%, and petroleum products are up 175.7%. The reasons for the price rises have been well documented here, here, here and here.
Inflation in all our neighbours is much higher than here. Apparently, we are only 79th among high inflation countries. Chinese inflation for February touched 8.7%, an eleven year high. Developed countries too are facing unprecedented inflationary pressures. In an interdependent and integrated global economy, India cannot continue to remain isolated from this global trend.
As has already been written about in previous posts, the Indian growth story is not likely to be affected much by the inflation. The strong demand side pressures will ensure that investments in infrastructure, real estate, inputs to infrastructure sector etc will remain robust. India Inc's order books are already overflowing. The corporate sector has reported a 35 per cent growth in orders in FY07 at Rs 74,568 crore. Order books during the second and fourth quarter of FY08 grew by more than 100 per cent, while the biggest order inflows, in absolute terms, were recorded in the second quarter ended September 30, 2007 at Rs 59,253 crore. The order inflow in the fourth quarter totalled Rs 40,729 crore compared with Rs 19,280 crore in the fourth quarter of FY07, belying slowdown concerns.
The rise in prices has also had little impact on the sales of consumer durables and non-durables. This can be partly explained by the fact that in a nascent and fast growing consumer market like ours, the demand for such products are likely to exhibit inelastic characteristics. The consumer base, especially in the villages and small towns, is expanding very fast, even faster than the supply, and more than off-sets any fall in demand in the older markets due to higher prices. Experts say that consumers have become more value-conscious and less price-sensitive in the mid-priced segment and above, and this segment is also expanding very fast.
The government intervention till date have been focussed on easing supply constraints on food grains. But the major contributor to the 7% inflation has been from non-food primary articles, which have risen 14.6% and basic metals and alloys which have risen 22.9%. In contrast, the food basket has become dearer by only 8.2%. There is precious little the government can do to ease the supply pressures on the non food and metal categories. The high global market prices for these commodities and our dependence on imports means that we have little choice but to live with these higher prices. Further, the relatively small quantities of our imports in relation to the total demand for those commodities, means that the influence of these policies are likely to be only minimal.
Given the cost push, rather than demand pull, nature of the present inflationary pressures, any monetary tinkering is likley to have little impact. Credit growth was at a very reasonable 22% for the last fortnight of February. In fact, they are likely to rebound with adverse consequences on the economic growth. This has been explained in previous posts.
The only hope is for the recession in US to weaken demand for raw materials and other inputs in exporting nations, thereby causing a fall in prices of commodities. The global economy has been growing at a scorching pace over the past decade, stretching the supply side to its seams and resulting in capacity over-utilization. It was only to be expected that such growth cannot be sustained for longer periods, and the supply side bottlenecks develop and inflationary pressures start to emerge. The trend in global commodities prices for the coming quarter will be critical to the propsects of the Indian economy.
The increasingly integrated global economy has severely limited the ability of individual nations to successfully implement domestic policies to contain inflation. In this context, it is a moot point as to whether it is possible to contain inflationary pressures in India, even if the domestic supply side contraints are removed. In an integrated global economy, even with domestic surplus, global demand-supply conditions will determine prices. For example, India has surplus production in iron ore, yet prices have more than doubled in the past year, from $60-70 per tonne in 2007 to $140 per tonne now. This has been a major contributing factor to the rising steel prices too. Domestic policy measures like lowering import duties, are most likely to be offset by the producers in exporting countries raising their prices, thereby capturing the benefits of the lower duties. Regulatory controls and easing supply side restrictions can at best ease inflationary pressures slightly, but cannot contain it when global prices are rising.
The uncertainty and volatility calls to focus the need to maintain social security mechanisms like Public Distribution System and various welfare schemes. Such systems provide a comfort cushion to insulate the poor from the adverse effects of globalization and emergence of this integrated global economy.
There is a case to be made against this weekly WPI-based inflation scare mongering that has gripped the financial media in India now. In the first place, no major economy publishes weekly inflation figures. Second, a distinction needs to be made between core inflation, which strips out the large fluctuations in specific commodities, and nominal inflation. The former conveys a more accurate reflection of the reality.
Earlier this week, the Government of India announced measures to ease supply side constraints by abolishing import duty on crude form of edible oils, cutting rates on refined edible oils and banning non-basmati rice exports. The Government scrapped import duties on all crude edible oil forms, while cutting duties on refined palm, sunflower, soyabean, coconut oils and hydrogenated vegetable fats to 7.5 per cent. This follows previous measures like ban on futures trading in wheat, rice and pulses, and ban on exports of pulses. These were follwed with the withdrawal of incentives for export of basmati rice.
On a year-on-year basis, the wholesale prices have risen by 27% for iron and steel category, 21% for edible oils, 6% for cereals, 11% for vegetables, 10% for milk, 9% for dairy products, 5% for cement, and 9% for both mineral oil and coal. As can be seen, the major cause for concern comes from iron and steel and edible oils.
The problem faced by the Government is that the recent price rises are not an isolated Indian phenomenon, and cannot be solved by even addressing all our supply side concerns. Global commodity prices - energy, minerals and raw materials, and foodgrains - have been an upward rise for over two years now, and shows no signs of abating. IMFs commodity price index shows that since 2005, food prices are up 65%, metal prices 70%, and petroleum products are up 175.7%. The reasons for the price rises have been well documented here, here, here and here.
Inflation in all our neighbours is much higher than here. Apparently, we are only 79th among high inflation countries. Chinese inflation for February touched 8.7%, an eleven year high. Developed countries too are facing unprecedented inflationary pressures. In an interdependent and integrated global economy, India cannot continue to remain isolated from this global trend.
As has already been written about in previous posts, the Indian growth story is not likely to be affected much by the inflation. The strong demand side pressures will ensure that investments in infrastructure, real estate, inputs to infrastructure sector etc will remain robust. India Inc's order books are already overflowing. The corporate sector has reported a 35 per cent growth in orders in FY07 at Rs 74,568 crore. Order books during the second and fourth quarter of FY08 grew by more than 100 per cent, while the biggest order inflows, in absolute terms, were recorded in the second quarter ended September 30, 2007 at Rs 59,253 crore. The order inflow in the fourth quarter totalled Rs 40,729 crore compared with Rs 19,280 crore in the fourth quarter of FY07, belying slowdown concerns.
The rise in prices has also had little impact on the sales of consumer durables and non-durables. This can be partly explained by the fact that in a nascent and fast growing consumer market like ours, the demand for such products are likely to exhibit inelastic characteristics. The consumer base, especially in the villages and small towns, is expanding very fast, even faster than the supply, and more than off-sets any fall in demand in the older markets due to higher prices. Experts say that consumers have become more value-conscious and less price-sensitive in the mid-priced segment and above, and this segment is also expanding very fast.
The government intervention till date have been focussed on easing supply constraints on food grains. But the major contributor to the 7% inflation has been from non-food primary articles, which have risen 14.6% and basic metals and alloys which have risen 22.9%. In contrast, the food basket has become dearer by only 8.2%. There is precious little the government can do to ease the supply pressures on the non food and metal categories. The high global market prices for these commodities and our dependence on imports means that we have little choice but to live with these higher prices. Further, the relatively small quantities of our imports in relation to the total demand for those commodities, means that the influence of these policies are likely to be only minimal.
Given the cost push, rather than demand pull, nature of the present inflationary pressures, any monetary tinkering is likley to have little impact. Credit growth was at a very reasonable 22% for the last fortnight of February. In fact, they are likely to rebound with adverse consequences on the economic growth. This has been explained in previous posts.
The only hope is for the recession in US to weaken demand for raw materials and other inputs in exporting nations, thereby causing a fall in prices of commodities. The global economy has been growing at a scorching pace over the past decade, stretching the supply side to its seams and resulting in capacity over-utilization. It was only to be expected that such growth cannot be sustained for longer periods, and the supply side bottlenecks develop and inflationary pressures start to emerge. The trend in global commodities prices for the coming quarter will be critical to the propsects of the Indian economy.
The increasingly integrated global economy has severely limited the ability of individual nations to successfully implement domestic policies to contain inflation. In this context, it is a moot point as to whether it is possible to contain inflationary pressures in India, even if the domestic supply side contraints are removed. In an integrated global economy, even with domestic surplus, global demand-supply conditions will determine prices. For example, India has surplus production in iron ore, yet prices have more than doubled in the past year, from $60-70 per tonne in 2007 to $140 per tonne now. This has been a major contributing factor to the rising steel prices too. Domestic policy measures like lowering import duties, are most likely to be offset by the producers in exporting countries raising their prices, thereby capturing the benefits of the lower duties. Regulatory controls and easing supply side restrictions can at best ease inflationary pressures slightly, but cannot contain it when global prices are rising.
The uncertainty and volatility calls to focus the need to maintain social security mechanisms like Public Distribution System and various welfare schemes. Such systems provide a comfort cushion to insulate the poor from the adverse effects of globalization and emergence of this integrated global economy.
There is a case to be made against this weekly WPI-based inflation scare mongering that has gripped the financial media in India now. In the first place, no major economy publishes weekly inflation figures. Second, a distinction needs to be made between core inflation, which strips out the large fluctuations in specific commodities, and nominal inflation. The former conveys a more accurate reflection of the reality.
Friday, April 4, 2008
Surface Railways - the real economic cost
While on a fairly long train journey recently, I glanced through an article about the various urban transport options facing developing countries. From a cost-benefit analysis of surface rail transport and underground railway lines (metro), the article concluded that surface rail was a much cheaper and viable option. Concidentally, the train journey gave me an opportunity to observe some of the more unquantified costs of the presence of surface railway lines, especially in urban areas. I will list out a few of these uncaptured costs.
1. Falling land values. All along the margins of railway tracks, land values remain depressed and turns off high value investments.
2. Sound pollution and other costs discourages many economically productive activites from railway track margins. A buffer of economically unproductive zone in created all along the length of these tracks. However, this is something that technology can surely help mitigate.
3. Unorganised residential slums develop along the margins of these tracks. The margins of rail tracks in all our cities, without exception, is dotted with numerous such slums. The health and other social costs imposed by this development on the residents and the neighbourhood is huge.
4. Railway lines divides the areas on both sides into distinctly separated entities, which are difficult to link with regular transport infrastructure. Unlike roads, which seamlessly gets integrated into the area, railway lines creates sharp disconnects between adjacent areas.
5. Railway tracks are generally lined by an unhygenic strip of land on both sides of the track, which become a breeding ground for many health hazards.
6. Surface Railway lines do not have the same potential for leveraging commercial spaces development as underground lines. The entire area on top of a metro station can be developed commercially, while surface railway stations are constrained by lack of space for similar exploitation.
In other words, surface railway lines produce a huge amount of unquantified negative externalities, which impose a prohibitively high cost. In contrast, underground railway lines, while undoubtedly expensive to lay, are free from all these negative externalities and help us make optimum use of our land resources. It is as though a railway track comes along with a package of negative externalities - pollution, slums, health and social problems, falling land values etc.
My contention is not to abandon all surface railway lines, but to include the opportunity cost of surface railways in making choices between alternate modes of railway transport.
1. Falling land values. All along the margins of railway tracks, land values remain depressed and turns off high value investments.
2. Sound pollution and other costs discourages many economically productive activites from railway track margins. A buffer of economically unproductive zone in created all along the length of these tracks. However, this is something that technology can surely help mitigate.
3. Unorganised residential slums develop along the margins of these tracks. The margins of rail tracks in all our cities, without exception, is dotted with numerous such slums. The health and other social costs imposed by this development on the residents and the neighbourhood is huge.
4. Railway lines divides the areas on both sides into distinctly separated entities, which are difficult to link with regular transport infrastructure. Unlike roads, which seamlessly gets integrated into the area, railway lines creates sharp disconnects between adjacent areas.
5. Railway tracks are generally lined by an unhygenic strip of land on both sides of the track, which become a breeding ground for many health hazards.
6. Surface Railway lines do not have the same potential for leveraging commercial spaces development as underground lines. The entire area on top of a metro station can be developed commercially, while surface railway stations are constrained by lack of space for similar exploitation.
In other words, surface railway lines produce a huge amount of unquantified negative externalities, which impose a prohibitively high cost. In contrast, underground railway lines, while undoubtedly expensive to lay, are free from all these negative externalities and help us make optimum use of our land resources. It is as though a railway track comes along with a package of negative externalities - pollution, slums, health and social problems, falling land values etc.
My contention is not to abandon all surface railway lines, but to include the opportunity cost of surface railways in making choices between alternate modes of railway transport.
Thursday, April 3, 2008
Regulating Wall Street
The nineties and this decade were years of financial deregulation that sought to liberate financial institutions and their instruments from the shackles of regulators. The free hand given to financial regulators and the resultant wave of financial innovation saw the emergence of a number of exotic financial instruments with an alphabet soup of names and off-balance sheet entities that sought to purchase and sell risk.
The whole objective of all this financial engineering was the diversification of risk as wide and deep as possible, and increasing the liquidity available by a continous chain of onward lending through securitization of debt. In the process risk got disseminated into unknown terrain, where it became impossible to even locate, leave alone price risk. The versatile financial creatures called Structured Investment Vehicles (SIVs) even emerged as a convenient alibi for hiding risks.
The massive deregulation saw the proliferation of unhealthy practices like abusive loans by independent mortgage brokers; risky and opaque transactions by financial institutions; credit-rating decisions that turned out to be wildly optimistic; and the underwriting of loans by mortgage brokers that were often based on fraudulent or inaccurate information.
The wave of deregulation climaxed with the bursting of the bubble in sub-prime mortgage backed securities. A series of other asset backed securities followed suit - Collateralized Debt (and Loan) Obligations, and Credit Default Swaps. Wall Street Banks, hedge funds, and insurers all ran into crisis as margin calls induced forced sell offs to cover losses.
Now there have been growing calls for tightening supervision of the risk-management practices of Wall Street investment banks and perhaps requiring them to keep higher cash reserves as a cushion against unexpected trading losses. This school of thought demands the same tight regulation that banks had for decades to be extended to Wall Street firms. There have been calls for setting up a regulator to re-examine capital reserves, risk-management practices and consumer protection without regard to whether companies were commercial banks, investment banks or nonbank mortgage lenders.
The actions of the Fed in recent weeks, in its capacity as lender of last resort, may have unleashed powerful moral hazard factors. The Fed had offered a $30 billion credit line to JPMorgan Chase to help it take over failing Bear Stearns, and also announced the opening up of its "discount window" - an emergency loan program that had been reserved strictly for commercial bank - lending to big investment banks. The later is an effective acknowledgement of the blurring of lines between Wall Street banks and commercial banks.
Commercial banks submit to greater regulation, partly in exchange for the privilege of being able to borrow from the Fed’s discount window. But with the throwing open of the "discount window", Wall Street firms were getting the same protection without subjecting themselves to additional scrutiny. As Roger Lowenstein writes in the Times, "Since the bank runs of the 1930s, federal protection of retail depositor institutions has been a hallmark of American capitalism. The Federal Reserve, in a sweeping extension, has now extended the privilege to gilt-edged investment firms."
The opponents have the usual explanations - higher cash reserves will dry up the liquidity available for lending, trading and underwriting new securities; tighter regulation will inhibit financial innovation, and so on. As the events of recent months have amply demonstrated, this is something akin to arguing for more of the deregulated environment that was instrumental in promoting moral hazard, greed, recklessness, all of which inflicted so much damage.
Paul Krugman has this excellent reminder of what lessons we should have, but did not, learnt from the Great Depression. He feels that Wall Street chafed at regulations that limited risk, but also limited potential profits and created a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.
He writes, "For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.
As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned."
The whole objective of all this financial engineering was the diversification of risk as wide and deep as possible, and increasing the liquidity available by a continous chain of onward lending through securitization of debt. In the process risk got disseminated into unknown terrain, where it became impossible to even locate, leave alone price risk. The versatile financial creatures called Structured Investment Vehicles (SIVs) even emerged as a convenient alibi for hiding risks.
The massive deregulation saw the proliferation of unhealthy practices like abusive loans by independent mortgage brokers; risky and opaque transactions by financial institutions; credit-rating decisions that turned out to be wildly optimistic; and the underwriting of loans by mortgage brokers that were often based on fraudulent or inaccurate information.
The wave of deregulation climaxed with the bursting of the bubble in sub-prime mortgage backed securities. A series of other asset backed securities followed suit - Collateralized Debt (and Loan) Obligations, and Credit Default Swaps. Wall Street Banks, hedge funds, and insurers all ran into crisis as margin calls induced forced sell offs to cover losses.
Now there have been growing calls for tightening supervision of the risk-management practices of Wall Street investment banks and perhaps requiring them to keep higher cash reserves as a cushion against unexpected trading losses. This school of thought demands the same tight regulation that banks had for decades to be extended to Wall Street firms. There have been calls for setting up a regulator to re-examine capital reserves, risk-management practices and consumer protection without regard to whether companies were commercial banks, investment banks or nonbank mortgage lenders.
The actions of the Fed in recent weeks, in its capacity as lender of last resort, may have unleashed powerful moral hazard factors. The Fed had offered a $30 billion credit line to JPMorgan Chase to help it take over failing Bear Stearns, and also announced the opening up of its "discount window" - an emergency loan program that had been reserved strictly for commercial bank - lending to big investment banks. The later is an effective acknowledgement of the blurring of lines between Wall Street banks and commercial banks.
Commercial banks submit to greater regulation, partly in exchange for the privilege of being able to borrow from the Fed’s discount window. But with the throwing open of the "discount window", Wall Street firms were getting the same protection without subjecting themselves to additional scrutiny. As Roger Lowenstein writes in the Times, "Since the bank runs of the 1930s, federal protection of retail depositor institutions has been a hallmark of American capitalism. The Federal Reserve, in a sweeping extension, has now extended the privilege to gilt-edged investment firms."
The opponents have the usual explanations - higher cash reserves will dry up the liquidity available for lending, trading and underwriting new securities; tighter regulation will inhibit financial innovation, and so on. As the events of recent months have amply demonstrated, this is something akin to arguing for more of the deregulated environment that was instrumental in promoting moral hazard, greed, recklessness, all of which inflicted so much damage.
Paul Krugman has this excellent reminder of what lessons we should have, but did not, learnt from the Great Depression. He feels that Wall Street chafed at regulations that limited risk, but also limited potential profits and created a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.
He writes, "For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.
As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned."
Tuesday, April 1, 2008
Entry Barriers in Infrastructure contracting
Two observations about the urban infrastructure contracting market in India.
1. The VMC had called tenders for outsourcing the Operation and Maintenance (O&M) of its entire sewerage network. After a long drawn out National Competitive Bidding process, one of India's leading sewerage contractors emerged as the successful bidder. It had quoted Rs 10.8 Cr in its financial bid. But after negotiations they lowered the bid value to Rs 3.9 Cr, without altering any of the contract conditions. The actual cost incurred by the VMC in doing this work is Rs 1.6 Cr!
2. There are only a handful of qualified contractors and suppliers for major water, sewerage, solid waste, and urban tranpsort contracts. Therefore, in the context of the massive boom in such works and the consequent spurt in demand for these services and equipments, sub-contracting of work has become a common practice. In many cases, the involvement of the primary contractors, who are invariably a major infrastructure company, are confined to merely pocketing a commission from the sub-contractor.
These two observations give a fair assessment of the Indian market for urban infrastructure services. Despite the rapidly increasing policy focus on investments in urban infrastructure, the market for these services remain under developed and in its incipient stages. At a time when it is estimated that over $200 bn will be invested in urban infrastructure over the next five years, it is therefore imperative that there be rapid development of the market for urban infrastructure contracting and the proliferation of such contractors. This post will focus on the second problem.
This nascent market in urban infrastructure contracting is populated by a very few major contractors, with many of them not meeting all the basic requirements of professionalism and expertise. But unfortunately, instead of encouraging the development of this market by encouraging more competition, government regulations may actually be stifling its development. Very high entry barriers have constrained competition and prevented the expansion of the numbers of contractors beyond the limited pool of those presently eligible.
Government agencies have to follow a process of tendering for sourcing any service, contracting any work, or procuring any material. The entire bid process, with all the steps involved and the specifications and requirements, are outlined in detail in numerous Government Orders. The typical bidder pre-qualification norms for any Government tender are
1. Financial qualification for similar category of work - generally 50% of the Estimated Contract Value (ECV) over any one of the previous three years
2. Technical qualification for similar category of work - generally 50% of the contract volume over any one of the previous three years
3. Financial eligibility of the contractor, quantified in terms of the total turnover to be a minimum amount.
In an emerging market for urban infrastructure services, there are very few contractors who meet these stiff requirements. A virtually closed group of few contractors alone become eligible and corner all the contracts.
As already mentioned, the major contractor bids and then sub-contracts it out to a sub-contractor, who though capable of doing the work, fails to meet the financial and technical requirements. The primary contractor charges anywhere between 2-5% of the ECV as his profit. This is effectively an unearned increment, or a backdoor subsidy, arising from the rigid government regulations. In a few other cases, the ineligible sub-contractor seeks out big primary contractors and enters into joint venture with them. This will help them gain valuable experience, which can be used for future works. But the profit margins demanded by the primary contractors for such arrangement are higher and goes upto 10% of ECV.
This seller's market has boosted the margins available and the major contractors are no longer satisfied with the regular 15-25% profits. This partially explains why our publicly listed infrastructure majors are the hottest scrips in the equity markets and private equity majors are chasing them.
The differences in contracting procedures across states, and even departments in the same state, is another cause of major market distortions. For example, while some states like Rajasthan follow the World Bank norms and do not place any limits on the tender premiums, others like Andhra Pradesh impose a 5% limit. While some states like Tamil Nadu permit taking into account private sector experience for financial and technical qualifications, others like Andhra Pradesh insist on Government sector experience. Some states allow for only manual earth excavation work, while others permit machine excavation. Some departments provide for additional contractors profit margin in the Estimated Contract Value (ECV), while others disallow the same. These distortions in a seller's market ensures that contractors gravitate towards where the profit margins are the maximum.
All this ensures that the market for urban infrastructure contracting does not expand to keep pace with the rapidly growing demand. As Eco 101 teaches us, a market with the same limited suppliers and fast growing demand, and inhibited by high barriers for entry, will give rise to monopoly pricing and economic inefficiency.
I have tried to list out a few other problems being increasingly felt in procuring services and materials
1. There are no standard model contracts or concession agreements for outsourcing civic services. So, every city invariably ends up re-inventing the wheel and preparing their own RFQ and RFP documents. Very often, such agreements are prepared by the bidder(s) and i many cases, accepted in full, by the Government agency. As can be expected, such agreements fail to fully take into account the interests of the Government and thereby produce incomplete contracts.
2. The pre-qualification norms in many states do not take into account the experience of works done in private sector. Thus we have ridiculous situations where some of the biggest real estate developers in the country do not qualify to bid for much smaller housing projects of the Government.
3. Many services like use of energy saving devices in streetlighting, Supervisory Control and Data Accquisition (SCADA) in water supply and sewerage, intelligent transport systems etc involve procuring sophisticated equipments and devices whose specifications and rates are not available in the SSR. Given the huge value of such contracts and the absence of standards, it becomes difficult to scrutinize the tenders and finalize their procurement.
4. Many services like hiring a professsional communication strategist or a consultant to manage a Project Management Unit (PMU), cannot be fitted into the traditional unit rate procurement process. These are all human resource dependent services, which are extremely expensive. Government procurement guidelines do not account for the high premium commanded by quality HR personnel. There are serious audit related limitations on such procurements.
5. Contracts do not factor in the volatility in prices. Steel prices rose from Rs 34,502 per tonne for the 16 mm steel in December 2007 to Rs 39,390 per tonne in February 2008, to Rs 56,000 per tonne in second week of March 2008. Cement and Bitumin prices have also been showing siognificant volatility. Contractors, who bid for a long construction period contract, ends up bearing the entire price risk. The price escalation provisions introduced by a few states like Andhra Pradesh (price escalation based on the WPI) and Tamil Nadu (price escalation once a quarter, to be decided by a Committee) are at best feeble efforts at reflecting the market prices. It is necessary for contracts to accurately reflect the market rates, especially in times of high market volatility, at least for the mandated construction period.
1. The VMC had called tenders for outsourcing the Operation and Maintenance (O&M) of its entire sewerage network. After a long drawn out National Competitive Bidding process, one of India's leading sewerage contractors emerged as the successful bidder. It had quoted Rs 10.8 Cr in its financial bid. But after negotiations they lowered the bid value to Rs 3.9 Cr, without altering any of the contract conditions. The actual cost incurred by the VMC in doing this work is Rs 1.6 Cr!
2. There are only a handful of qualified contractors and suppliers for major water, sewerage, solid waste, and urban tranpsort contracts. Therefore, in the context of the massive boom in such works and the consequent spurt in demand for these services and equipments, sub-contracting of work has become a common practice. In many cases, the involvement of the primary contractors, who are invariably a major infrastructure company, are confined to merely pocketing a commission from the sub-contractor.
These two observations give a fair assessment of the Indian market for urban infrastructure services. Despite the rapidly increasing policy focus on investments in urban infrastructure, the market for these services remain under developed and in its incipient stages. At a time when it is estimated that over $200 bn will be invested in urban infrastructure over the next five years, it is therefore imperative that there be rapid development of the market for urban infrastructure contracting and the proliferation of such contractors. This post will focus on the second problem.
This nascent market in urban infrastructure contracting is populated by a very few major contractors, with many of them not meeting all the basic requirements of professionalism and expertise. But unfortunately, instead of encouraging the development of this market by encouraging more competition, government regulations may actually be stifling its development. Very high entry barriers have constrained competition and prevented the expansion of the numbers of contractors beyond the limited pool of those presently eligible.
Government agencies have to follow a process of tendering for sourcing any service, contracting any work, or procuring any material. The entire bid process, with all the steps involved and the specifications and requirements, are outlined in detail in numerous Government Orders. The typical bidder pre-qualification norms for any Government tender are
1. Financial qualification for similar category of work - generally 50% of the Estimated Contract Value (ECV) over any one of the previous three years
2. Technical qualification for similar category of work - generally 50% of the contract volume over any one of the previous three years
3. Financial eligibility of the contractor, quantified in terms of the total turnover to be a minimum amount.
In an emerging market for urban infrastructure services, there are very few contractors who meet these stiff requirements. A virtually closed group of few contractors alone become eligible and corner all the contracts.
As already mentioned, the major contractor bids and then sub-contracts it out to a sub-contractor, who though capable of doing the work, fails to meet the financial and technical requirements. The primary contractor charges anywhere between 2-5% of the ECV as his profit. This is effectively an unearned increment, or a backdoor subsidy, arising from the rigid government regulations. In a few other cases, the ineligible sub-contractor seeks out big primary contractors and enters into joint venture with them. This will help them gain valuable experience, which can be used for future works. But the profit margins demanded by the primary contractors for such arrangement are higher and goes upto 10% of ECV.
This seller's market has boosted the margins available and the major contractors are no longer satisfied with the regular 15-25% profits. This partially explains why our publicly listed infrastructure majors are the hottest scrips in the equity markets and private equity majors are chasing them.
The differences in contracting procedures across states, and even departments in the same state, is another cause of major market distortions. For example, while some states like Rajasthan follow the World Bank norms and do not place any limits on the tender premiums, others like Andhra Pradesh impose a 5% limit. While some states like Tamil Nadu permit taking into account private sector experience for financial and technical qualifications, others like Andhra Pradesh insist on Government sector experience. Some states allow for only manual earth excavation work, while others permit machine excavation. Some departments provide for additional contractors profit margin in the Estimated Contract Value (ECV), while others disallow the same. These distortions in a seller's market ensures that contractors gravitate towards where the profit margins are the maximum.
All this ensures that the market for urban infrastructure contracting does not expand to keep pace with the rapidly growing demand. As Eco 101 teaches us, a market with the same limited suppliers and fast growing demand, and inhibited by high barriers for entry, will give rise to monopoly pricing and economic inefficiency.
I have tried to list out a few other problems being increasingly felt in procuring services and materials
1. There are no standard model contracts or concession agreements for outsourcing civic services. So, every city invariably ends up re-inventing the wheel and preparing their own RFQ and RFP documents. Very often, such agreements are prepared by the bidder(s) and i many cases, accepted in full, by the Government agency. As can be expected, such agreements fail to fully take into account the interests of the Government and thereby produce incomplete contracts.
2. The pre-qualification norms in many states do not take into account the experience of works done in private sector. Thus we have ridiculous situations where some of the biggest real estate developers in the country do not qualify to bid for much smaller housing projects of the Government.
3. Many services like use of energy saving devices in streetlighting, Supervisory Control and Data Accquisition (SCADA) in water supply and sewerage, intelligent transport systems etc involve procuring sophisticated equipments and devices whose specifications and rates are not available in the SSR. Given the huge value of such contracts and the absence of standards, it becomes difficult to scrutinize the tenders and finalize their procurement.
4. Many services like hiring a professsional communication strategist or a consultant to manage a Project Management Unit (PMU), cannot be fitted into the traditional unit rate procurement process. These are all human resource dependent services, which are extremely expensive. Government procurement guidelines do not account for the high premium commanded by quality HR personnel. There are serious audit related limitations on such procurements.
5. Contracts do not factor in the volatility in prices. Steel prices rose from Rs 34,502 per tonne for the 16 mm steel in December 2007 to Rs 39,390 per tonne in February 2008, to Rs 56,000 per tonne in second week of March 2008. Cement and Bitumin prices have also been showing siognificant volatility. Contractors, who bid for a long construction period contract, ends up bearing the entire price risk. The price escalation provisions introduced by a few states like Andhra Pradesh (price escalation based on the WPI) and Tamil Nadu (price escalation once a quarter, to be decided by a Committee) are at best feeble efforts at reflecting the market prices. It is necessary for contracts to accurately reflect the market rates, especially in times of high market volatility, at least for the mandated construction period.
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