Judicial activism gone too far

Regardless of whatever regulatory and legal reforms India undertakes, it is unlikely to achieve its objectives unless its judiciary shows maturity and exercises restraint. Its propensity to interpret stated law in the broadest terms, far beyond its contextual and literal sense, most often transgressing its functional jurisdiction, has been at the cost of other institutions. The latest institution to fall victim is the Competition Commission of India (CCI),

India’s competition regulator has netted a paltry 0.6% of the total amount of fines that it has imposed on companies as lengthy judicial reviews and overturned orders have rendered the anti-trust watchdog almost toothless. Since its inception in 2009, the Competition Commission of India (CCI) has levied Rs.13,900 crore in penalties on companies for violating rules. The regulator’s success rate in recovering the money is, however, alarmingly dismal at Rs.82.1 crore... Judicial appeals have either delayed or blocked CCI from recovering penalty money, making the regulator appear ineffective... 97% of the penalty (approximately) has been stayed by the courts/appellate authority.

For sure, the CCI cannot absolve itself of its share of the blame for the quality of its orders. But it cannot be so bad that 97% of its orders are not only contested but continue to remain under litigation. Does the Ministry of Finance really want the Reserve Bank of India to be the next victim? 

Weekend Reading Links

1. Larry Summers has a very dismal prognosis for the US and world economy. He has one more reason to be sceptical of any significant rise in the real interest rates,

the increases in demand achieved through low rates in recent years have come from pulling demand forward, resulting in lower levels of demand for the future. For example, lower rates have accelerated purchases of cars and other consumer durables and created apparent increases in wealth as asset prices inflate. In a sense, monetary easing has a narcotic aspect. To maintain a given level of stimulus requires continuing cuts in rates.

And this argument about the possibility of a recession in the US and the weakness of monetary policy in combating it is disturbing,

The experience of the US and others suggests that once a recovery is mature the odds of it ending within two years are about half and of it ending in less than three years over two-thirds... History suggests that when recession comes it is necessary to cut rates more than 300 basis points. I agree with the market that the odds are the Fed will not be able to raise rates 100 basis points a year without threatening to undermine recovery. Even if this were possible, the chances are very high that recession will come before there is room to cut rates enough to offset it. The knowledge that this is the case must surely reduce confidence and inhibit demand.

Central bankers bravely assert that they can always use unconventional tools. But there may be less in the cupboard than they suppose. The efficacy of further quantitative easing in an environment of well-functioning markets and already very low medium-term rates is highly questionable. There are severe limits on how negative rates can become. A central bank forced back to the zero lower bound is not likely to have great credibility if it engages in forward guidance.

2.  The aftermath of the sub-prime crisis has upended many a conventional wisdom. One of them was on interest rates - that zero is the lower limit, below which people will pull out their money and stash it under their mattresses. But, as we have seen with negative rates across Europe, no such thing has happened. While the ECB has cut its main target interest rate to minus 0.3% and the Swiss National Bank is aiming for even minus 1.25%, the total deposits in European banks were 327 bn Euros higher in October 2015 than in June 2014 when the negative rates were introduced. As ECB has reiterated its commitment to go even lower, it remains to be seen how low is too much for savers to start pulling back. For the time being, the conventional wisdom has been replaced by this,

There are a lot of benefits to keeping money in a bank besides the interest you earn. If you keep $10,000 in savings in a bank, and the bank gets robbed, you’re unaffected; the bank is on the hook for the losses. If you keep it in your freezer, theft is your problem. The peace of mind of having your $10,000 in a federally insured bank account and the ability to write a check to make a purchase or wire money to a family member are valuable. More valuable, it seems likely, than the $30 in annual costs that would apply if the Fed put in place the E.C.B.’s new negative 0.3 percent rate.

3. As its own economy slows down and its mills, smelters, and refiners struggle with their excess capacity, Chinese manufacturers have been exporting massive amounts of  steel, aluminium, and oil products, hurting producers across the world. 

This Bloomberg report captures the scale of the problem,

Net fuel exports surged to an all-time high of 2.22 million metric tons in November, 77 percent above the previous month, customs data showed. Aluminum shipments jumped 37 percent to the second-highest level on record while sales of steel products climbed 6.5 percent, taking annual exports above 100 million tons for the first time... there is almost 700 million tons of excess capacity around the world, with the Asian nation contributing as much as 425 million tons.

4. Ikea is iterating with a new business strategy. In a break from big box, large storefront retailing, the privately held company now proposes to try out three new strategies - pick-up points, smaller stores, and city center stores. Its CEO, Peter Agnefjall describes how it proposes to adopt these changes,

That’s what we’re doing and then it will be trial and error — that’s what an entrepreneurial business is about. You don’t get everything right from the beginning and in some cases it will fail. In some cases this will be a super success, and in some cases it will be something that we can tweak and improve and that’s the way we develop Ikea constantly.

5.  A friend sends this cartoon which captures the essence of the negotiating positions in the climate change meeting at Paris.

6. Talking of climate change, the most striking image of its impact is this.

The website has excellent illustrations of the impact of climate change. 

7. India's National Green Tribunal (NGT) has ordered an interim stay on registration of new diesel vehicles and renewal of registration of those older than 10 years in National Capital Region (NCR). This follows its earlier orders banning the plying of diesel vehicles older than 15 years in NCR, pollution tax on all commercial vehicles entering Delhi, closure of all roadside hot-mix plants in Delhi, and directions to the Delhi government to identify critically polluted areas and issue stay-at-home warnings to elderly and children. In fact, the recent decision of the Delhi government to ban cars with odd and even numbers on alternate days is itself motivated by NGT directions to improve air quality levels in the capital city.

It is another example of how, in the absence of political leadership, judicial activism may be the only way that vexed public policy challenges with strong inertia can be addressed.

8. As the Fed's reversal of monetary accommodation nears, the corporate bond markets appear to have become spooked with borrowing costs for the lowest rated companies spiking sharply. UBS has estimated that $1 trillion worth US corporate bonds and loans below investment grade may be under stress as borrowing costs rise. The ultra-low interest rate environment had driven large volumes of money into high-yield debt in search for yields. 

The clearest evidence of trouble is the decision by asset manager, Third Avenue to stop withdrawals and liquidate its high-yield bond fund, $788 million Third Avenue Focused Credit Fund. This follows the Fund's 27% slump this year which has resulted in investors rushing to redeem their assets. Third Avenue says it has run out of money to "pay redeeming investors without having to dump bonds at fire-sale prices", which would further drag down the Fund's valuation and usher in a death spiral. This is the largest mutual fund failure in the US since the Reserve Primary money market fund shut shop in the immediate aftermath of the Lehman collapse in September 2008, heralding the bursting of the sub-prime mortgage bubble. This from the FT captures the risks,

The Third Avenue fund closure underscores a situation that has raised worries since the financial crisis. Mutual funds have been piling into corporate bond markets in recent years, even as the ability to trade these debts has atrophied as regulation and risk-aversion has spurred investment banks to curtail their market-making activities. That has raised fears over a toxic “liquidity mismatch” in corporate bond markets, a phenomenon that people from Jamie Dimon to Stephen Schwarzman have said could exacerbate or even cause a crisis. The crux is that investors can exit from mutual funds rapidly, which could create a so-called “flighty capital” stampede. However, the funds hold increasingly illiquid securities that are harder to sell... The average yield of the most lowly rated US corporate bonds has rocketed from 10 per cent earlier this year to over 17 per cent this week, and the woes have begun to spread from the energy sector that was the epicentre earlier this year.

The liquidity crunch and the contagion effect on other assets and intermediaries/institutions from forced fire-sales is also a reminder about the systemic importance of asset managers. 

It does not hurt to be corrupt!

Sometime back I had blogged about why corruption was pervasive, arguing that it pays to be corrupt. A newer version of the decision-tree diagram below (please click to blow-up) captures the expectations and deterrents facing officials when they take bribes

A cursory examination of the extant administrative processes on disciplinary action would reveal that each of the probabilities - p, q, r, a, and b - are far closer to zero than one. Given this, the likelihood of the biggest punishment of a person being caught taking bribes and dismissed from service is (p)(q)(r)(a)(b), an infinitesimally small chance. In any case, the administrative processes make establishing a corrupt practice very difficult. And, even when caught, the current processes leave pretty much the whole share of the rents captured by the official in tact. So, given the stakes involved, if you do not mind the infamy and can manage the inquiry process (not very difficult), it clearly pays to be corrupt!

The probabilities and cost at each stem vary based on how strict the officer concerned with the task is.

Crossing the rubicon in urban air pollution and traffic management

The decision of the state government of Delhi, prompted by a direction on air pollution from the National Green Tribunal, to prohibit private cars and two-wheelers with number plates ending in odd and even numbers on alternate days may well be India's crossing the Rubicon moment in combating urban traffic congestion and air pollution. It is the first time demand constraining policies are proposed to be implemented by an Indian city. 

The measure has predictably not gone down well with opinion makers and vehicle users. The expected responses are out - it will be difficult to enforce, should be after good public transport is put in place, will encourage users to adopt measures to circumvent it, should have been part of a menu of measures, and so on. All logical arguments and with lot of merit. It is for these reasons that the results so far across the world have been mixed, though very successful in some places.

In fact, in an ideal world, this decision should have followed all the aforementioned measures. But in the real world of messy decision making in an Indian city like Delhi, with scarce resources, limited state capability, deficient civic-spiritedness, and lack of long-term political leadership, it would have been impossible to take such a decision if it were to be done only after all these concerns were addressed.

The conventional wisdom on addressing the twin problem of traffic congestion and air pollution in our cities have all been supply-side - widen roads, build fly-overs, expansion of public transit facilities, progressively tightening vehicle emission standards etc. But such supply side measures only take you so far in a context of fast increasing urban population, living standards, and social aspirations. Therefore, demand constraining policies, which seek to limit the numbers of vehicles entering the roads, assume significance. They include both measures to control vehicle usage - congestion pricing, alternate day odd and even numbered vehicle bans, locational bans, car pooling, prohibitive parking charges, etc - and those to limit vehicle ownership - number plate auctions, ceilings on new vehicle registrations etc. I have written about demand constraining policies here. 

All such policies, by their very nature, inconvenience and hurt politically powerful constituencies - vehicle users, businesses, vehicle manufacturers, opinion makers etc. This unpopularity, coupled with its complex nature, would invariably deter political leaders. The same is the case with a vast majority of such wicked problems in public administration. We do not have the luxury to sequence interventions, the omniscience to craft fail-proof implementation plans, and the state capacity to execute implementation plans to perfection. In such circumstances, the only way out is to identify binding constraints, prepare a carefully thought out implementation plan, and then bite the bullet. 

For sure, there will be considerable inconvenience and disruption when this gets implemented from the coming New Year. There will be enforcement problems galore - people will seek to possess two number plates for the same car, paint their plate yellow (to make it appear as a taxi), and even just ignore the ban in confidence that they can bribe their way if caught. But the answer is not to back away from such policies daunted by these challenges, but to implement them by putting in place adequate implementation bandwidth and contingency measures to iterate quickly on addressing the most egregious flaws and transgressions. The entire Delhi administration needs to be alert enough for the next couple of months and be galvanized into responding very quickly to the emergent problems and mitigate them with appropriate changes to the policy and implementation plan. 

Over the coming months, this should be followed up with measures to expand the public transport facilities (more general buses as well as air-conditioned ones), raise parking charges in certain commercial areas, and even try out limiting new vehicle registrations. This could well turn out to be a crossing the Rubicon moment in the fight to make our cities more liveable. If successful, it would turn out to be the smartest among all the proposed Smart City interventions and a strong demonstration of the country's political and societal appetite to run with such contentious and unpopular reforms. 

Weekend Reading Links

1. India needs more of this type of market makers and peer-to-peer lending platforms which can credibly signal the credit-worthiness of borrowers by using non-conventional sources and strategies of credit assessments,

The financial tech startups are trying to evaluate credit risk using a wide variety of consumer data including the digital footprint of customers arising out of social networks, ecommerce, mobile usage and geo-location. For example, IndiaLends claims to capture alternative information points such as bank statement, utility data, social data and customer interaction with the website... Startups like IndiaLends do not lend money of their own. Using their technology platform, they connect consumers with banks and financial institutions which results in better rates for the borrowers and a reduction in overall default rates... where they differentiate... from the bank is in scientifically matching the right borrower profile with the most relevant lender and hence reducing inefficiencies that lead to lower loan approvals, higher interest rates and sub-optimal loan amounts.

2. The most obvious indicator of state capability weakness is the gross inadequacy of personnel in many critical public agencies. As against a global average of one policeman per 450 people, India's has one for 709 people, with the numbers being 1298 and 1282 for Bihar and UP respectively. 

The problem here is that any discussion on increasing personnel strength gets conflated with the mistaken belief that the government is already too big and needs to be pruned down.

3. Ian Bremmer points to this map of the world would could well represent the beliefs of ISIS

4. Economic Times has a story on the increasing use of robots among India's car manufacturers,

Robots have begun to take over an array of functions from humans at car plants in India. Volkswagen India has 123 robots at its Pune plant while Hyundai Motor India, the subsidiary of the Korean carmaker, has 400 robots at its factory in Chennai... The Ford Sanand plant actually has 453 robots in the shop floor, with up to 90 per cent of the work automated... The entire body shop, most of the paint shop and parts of the final assembly line in these plants are now automated. Robots are performing functions ranging from welding to foundry operations to laser applications.

But robots are not likely to displace humans any time in the foreseeable future,

Still, despite the many benefits, companies will not be in a hurry to replace labour simply because robots are costly. A robot does the work of three technical workers, but it typically costs between $3,00,000 and $4,00,000. In other words, automation is 10 times more expensive than manual labour

5. Business Standard has an article on the findings of the Ashok Misra Committee which examined India's unregulated professional course entrance examinations coaching industry. The report proposes the establishment of a regulator for the coaching industry. The report highlights the scale of the industry,

According to an a 2013 survey by Associated Chambers of Commerce and Industry of India (Assocham), titled "Business of Private Coaching Centres in India", the size of the private coaching sector was $23.7 billion, or Rs 1.41 lakh crore. The survey also predicted that by 2015, it would grow to $40 billion, or Rs 2.39 lakh crore. The survey had collected data from 5,000 students and parents across 10 cities. It revealed that 87 per cent of primary and 95 per cent of high school students in the major cities took private tutoring. This industry grew by 35 per cent in the previous six years.

6. Global corporate bond offerings have crossed $2 trillion for the fourth consecutive year on the back of continuing monetary accommodation and signals that the ECB may be willing to continue and expand the ongoing QE.

7. Roula Khalaf has a nice summary of the differences between Isis and Al Qaeda. This is interesting,

The Sahwa movement comprised a group of Iraqi tribesmen that collaborated with the US a decade ago to root out the Iraqi branch of al-Qaeda. That branch took its revenge: it eventually became the Islamic State of Iraq and the Levant, better known as Isis... Isis seems obsessed with al-Qaeda, from which it split in 2013 following disagreements over the goals of jihad in Syria. Since then Isis has distinguished itself from its parent through its savagery (there is no limit to the violence it is willing to inflict) and its move to create a caliphate in parts of Iraq and Syria. 

8. Nice article in NYT on how Isis sustains itself - "they fight in the morning and they tax in the afternoon". The article describes how Isis is running the legitimate revenue collection operations of a regular government,

The better known of the Islamic State’s revenue sources — smuggling oil, plundering bank vaults, looting antiquities, ransoming kidnapped foreigners and drumming up donations from wealthy supporters in the Persian Gulf — have all helped make the group arguably the world’s richest militant organization. But as Western and Middle Eastern officials have gained a better understanding of the Islamic State’s finances over the past year, a broad consensus has emerged that its biggest source of cash appears to be the people it rules, and the businesses it controls...

(Isis) has set up a predatory and violent bureaucracy that wrings every last American dollar, Iraqi dinar and Syrian pound it can from those who live under its control or pass through its territory. Interviews... describe the group as exacting tolls and traffic tickets; rent for government buildings; utility bills for water and electricity; taxes on income, crops and cattle; and fines for smoking or wearing the wrong clothes. The earnings from these practices that mimic a traditional state total tens of millions of dollars a month, approaching $1 billion a year, according to some estimates by American and European officials. And that is a revenue stream that has so far proved largely impervious to sanctions and air raids... 

In Raqqa, the Syrian city that is now the de facto capital of the Islamic State, a department called Diwan al-Khadamat, or the Office of Services, sends officials through the city markets to collect a cleaning tax — 2,500 to 5,000 Syrian pounds, or about $7 to $14, per month depending on the size of the shop. Residents go to collection points to pay their monthly electricity and water bills, 800 Syrian pounds, or roughly $2.50 for electricity and 400 pounds, about $1.20, for water. Another Islamic State department, the Diwan al-Rikaz, or the Office of Resources, oversees oil production and smuggling, the looting of antiquities and a long list of other businesses now controlled by the militants. It operates water-bottling and soft-drink plants, textile and furniture workshops, and mobile phone companies, as well as tile, cement and chemical factories, skimming revenues from all of them...

The group has taken over the collection of car-registration fees, and made students pay for textbooks. It has even fined people for driving with broken taillights, a practice that is nearly unheard-of on the unruly roads of the Middle East. Fines are also included in the punishments meted out for breaking the strict living rules imposed by the Islamic State. 

In this context, the prevailing strategy to contain them, involving targeting their oil production and smuggling operations is unlikely to yield results,

Ultimately, though, many officials and experts said the Islamic State would probably be able to cover its costs even without oil revenue, and that so long as it controls large stretches of Iraq and Syria, including major cities, bankrupting the group would take a lot more than blowing up oil tankers. “These are all going to be little pinpricks into Islamic State financing unless you can take their revenue bases away from them, and that means the territory they control,” said Seth Jones, a terrorism expert at the RAND Corporation... the old strategy for stopping the flow of money to terrorist groups like Al Qaeda, which was largely based on cutting them off from donors in the Persian Gulf upon which they depend, does not apply to the Islamic State. 

9. The $160 bn reverse takeover of US-based Pfizer (maker of Viagra) by the Dublin-based Allergan (maker of Botox), an investment company trading pharmaceuticals businesses, is classic tax-inversion. It enables Pfizer to use its accumulated overseas profits without incurring US tax liability, thereby saving atleast $21 bn in future tax liabilities. It also joins Burger King and Liberty Global as brands which have fled overseas to avoid tax payments.

Apart from tax inversion, as John Gapper writes, it also highlights a new trend in pharmaceuticals industry,

Pharmaceuticals companies used to be research enterprises that discovered and developed drugs. Then they became marketing giants, skilled at selling as many blockbuster pills as possible. Lately, they have turned into mergers and acquisitions machines, buying and selling medicines invented by others. It is hard to view their evolution as progress... Instead of taking their chances by investing in drug discovery themselves, some wait until a smaller biopharmaceutical enterprise has done so and then try to buy the rights. It is less risky and uncertain for investors but it also tends to be extremely expensive. AbbVie, for example, paid $21bn for Pharmacyclics this year, largely to acquire a single blood cancer treatment.

In this case, Pfizer is buying up Botox!

10. Finally, the ECB has extended QE, but not by as much as anticipated. Apart from extending its 60 billion Euro a month bond buying program for another six months till March 2017 or "beyond" and purchase municipal bond in addition to government bonds, it has also lowered the deposit rate to minus 0.3 per cent.

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.