China, rest of the world, and free-trade

This blog has consistently argued that it is sound economic and, even more, sound politics to satisfactorily compensate the victims of international trade. A couple of weeks back, I had blogged about the need to acknowledge the legitimate concerns of the victims of global trends like trade and globalization. Dani Rodrik makes the same point here in the context of the debate on Trans-Pacific Partnership (TPP). 

The Economist points to a new paper by David Autor, David Dorn, and Gordon Hanson which finds damaging effects on the US labor market from the massive growth of Chinese exports over the past two decades,

China’s emergence as a great economic power has induced an epochal shift in patterns of world trade. Simultaneously, it has challenged much of the received empirical wisdom about how labor markets adjust to trade shocks. Alongside the heralded consumer benefits of expanded trade are substantial adjustment costs and distributional consequences. These impacts are most visible in the local labor markets in which the industries exposed to foreign competition are concentrated. Adjustment in local labor markets is remarkably slow, with wages and labor-force participation rates remaining depressed and unemployment rates remaining elevated for at least a full decade after the China trade shock commences. Exposed workers experience greater job churning and reduced lifetime income. At the national level, employment has fallen in U.S. industries more exposed to import competition, as expected, but offsetting employment gains in other industries have yet to materialize. 

The effects of the Chinese job sucking machine has been in line with the logic of Samuelson-Stolper hypothesis in depressing the wages of less-skilled workers in developed countries. For sure, over time the labor market adjustments will happen, but not before inflicting considerable pain and social instability in localized pockets. The costs have been enormous,

The authors found in a 2013 paper, competition from Chinese imports explains 44% of the decline in employment in manufacturing in America between 1990 and 2007. For any given industry, an increase in Chinese imports of $1,000 per worker per year led to a total reduction in annual income of about $500 per worker in the places where that industry was concentrated. The offsetting rise in government benefits was only $58 per worker. In a paper from 2014... focusing on America’s “employment sag” in the 2000s, the authors calculate that Chinese import competition reduced employment across the American economy as a whole by 2.4m jobs relative to the level it otherwise would have enjoyed.

 For China though, the gains from trade have been remarkable, even unprecedented,

From 1991 to 2013 its share of global exports of manufactured goods rocketed from 2.3% to 18.8%... Average real income rose from 4% of the American level in 1990 to 25% today. Hundreds of millions of Chinese have moved out of poverty thanks to trade.

In this context, though not well documented, it is most likely that the Chinese imports have had a similar immiserating impact on labor markets across developing countries as it had on the US labor market. India's current Chief Economic Advisor Arvind Subramanian has been among those who have described "China’s exchange rate regime as a mercantilist trade policy whose costs are mainly borne by other developing and emerging market countries". Strip China out from the globalization balance sheet and the net effect may even be a slight negative.

It has therefore been one of the most unheralded Chinese foreign policy coups that it has managed to deflect attention from this profound reality and prevent the formation of any coalition of developing countries against its beggar-thy-neighbor trade practices. In some ways, Beijing's checkbook diplomacy has been spectacularly successful.

Update 1 (24.03.2016)
Eduardo Porter urges a more nuanced view on free trade and an acknowledgement of its distributional consequences. 

Weekend reading links

1. The difference a century makes! Tim Taylor has this snapshot of the life of an average American worker from 1915,

Whether or not your abode was a single-family home or a crowded tenement, it probably was heated by a potbelly stove or by a coal furnace in the basement. It wasn’t until the coal shortage during World War I that oil or gas-powered central heating became a popular replacement for the hand-fired coal furnaces and stoves. Your home probably wasn’t yet wired for electricity; less than a third of homes had electric lights rather than gas or kerosene lamps. However, electricity was the byword of new middle-class homes, which sported electric toasters and coffee pots... Telephones could be found in at least a few million homes. However, direct dialing did not exist until the 1920s. If your home had an indoor toilet, the toilet likely was located in a closet or a storage area. It would be a few more years until it was common for toilets, sinks, and bathtubs to share a room... Although some households had running water in 1915, many rural families and city dwellers did not. Less affluent residents still heated a boiler full of water on a coal or wood range, rubbed clothes on a washboard, used a hand ringer, and hung clothes to dry. Homes without gas or electric heat were harder to clean because of soot from the fireplace or wood stove.

2. Election cycles affect Padma Awards too. The Times of India reports that 30% more awards were given during election years compared to the average of the preceding four years.

3. After nuclear weapons and stealth technologies and precision guided missiles, US military is embracing robotics in its attempt to stay ahead of rivals. "Swarming, unmanned, autonomous vehicles" have become the priority. Like with all previous endeavors, this time too, the field of robotics will benefit immensely from this focus. It is most likely that most of the major advances in robotics related technologies and its civilian applications will have its origins in US military. 

4. Amidst all talk of declining China, its firms appear well-positioned to play a dominant role in the  global telecoms, search, email, social media and e-commerce markets,

(After Samsung and Apple) the next three biggest smartphone makers are all from China: Huawei, Xiaomi and Lenovo... Alibaba has greater reach than Amazon... Ecommerce accounts for about one-tenth of all retail sales in China compared with about 7 per cent in the US. Tencent’s WeChat messaging and calling app has more than 650m active monthly users and is catching up rapidly with Facebook’s WhatsApp, which has just passed the billion-user mark... Google, Apple, Facebook and Amazon, the big four tech companies, may soon be competing more directly with Chinese companies — Baidu, Huawei, Sina and Alibaba, to name a few.

5. In December 2014, Rajasthan passed legislation that mandated functional toilets and minimum educational qualifications (Class X for Zilla Parishad and Panchayat Samiti, Class VIII for Sarpanch, and Class V for Schedule areas) to stand in local body elections. Haryana followed suit for Panchayat elections. The Supreme Court, in another example of kritarchy, upheld the legislations mandating minimum educational qualifications to stand in local government elections. The implications are profound,

The conditions have resulted in the shrinking of the pool of candidates who are eligible to contest. In Haryana, the education requirements—matriculation for the general candidates, Class VIII for women and Scheduled Caste men and Class V for Scheduled Caste women—has disenfranchised 78% of all men, 89.1% of all women and 62.1% and 67.5% of Scheduled Caste men and women, respectively, according to Census 2011 data... Of the 6,207 sarpanch elections across Haryana, 274 were won unopposed and 22 went vacant. It’s more or less the same story in Rajasthan where the January-February 2015 election saw 260 sarpanchs getting elected unopposed, compared to 35 in 2010.

The level of political participation fell across a range of parameters.

6. The day of reckoning for India's start-ups may be soon coming. After nearly $9 bn poured into startups over the past two years, Livemint reports that funding has dried up and firms are hiring investment banks to secure new funds or find buyers. In another manifestation of an impending disruption, FT reports that the investors in the larger ones are getting impatient and are demanding returns on their investments.

In this context, apart from the obviously inflated valuations, it is most likely that all the e-commerce firms may have over-estimated the size of the country's consuming class and their price elasticity of demand. Like with post-liberalization consumer durables market, which initially pointed to decades of China-like very high growth rates, it is likely that the initial growth spurt of e-commerce captured the pent-up demand and the market may now be settling down to more realistic levels of growth.

7. Interesting comparison in Mint about horticulture and foodgrains cultivation. Though its share of cropped area is miniscule, vegetables and fruits have overtaken foodgrains in production.

In terms of irrigated area, 87-90% of fruits and vegetable cultivation is in irrigated areas to just under half for foodgrains.

8. The Masala Bonds were always likely to be exactly that, masala, more garnish than substance. And the reluctance of corporates to go ahead only confirms it. Even with the removal of the with-holding tax and even if the Government of India takes the lead with direct issuances, it is most unlikely to take off. Apart from the well documented historically persistent and pervasive original sin hypothesis (developing countries cannot borrow abroad in their domestic currencies), the global economic uncertainties make it pretty much a non-starter. The comparison with Chinese 'dim-sum' bonds was plain misleading, as would be with most such things Chinese. In any case now, India is more investment demand constrained than capital constrained - decreasing overseas bond issuances (a five year low of $9 bn in 2015 against $19.2 bn in 2014) and ECBs, declining domestic corporate bond yields, lower credit off-take, and falling investment intentions. 

9. Negative interest rates and record low Baltic dry index portends dismal prospects for the world economy. Sweden's Riksbank cut its key short-term interest rate by 15 basis points to minus 0.5 per cent. Rates for dry bulk carriers, including container ships, have fallen below break-even prices, on the back of large capacity expansion over the past decade, in turn motivated by a 7% increase in global trade in the decade to 2008.  

10. India's banking sector appears to be gripped by a reflexive downward spiral of rising non-performing assets (NPAs), dragging down equity markets. Indian Express reports that the provisioning coverage ratio (total provisions to gross NPAs) of 20 public sector banks fell over the 2011-15 period and are all below the RBI mandated 70 per cent. Indian banks have written off Rs 2.77 trillion over the past ten years, more than half happening in the last three years, and gross NPAs are estimated to jump to Rs 4.26 trillion by March 2016, an increase of 32% over the year. 

Faced with a systemic bad asset problem, regulators face the classic dilemma. Clean up too fast and run the risk of individual bank runs and systemic contagion. Cleaning up too slowly runs the risk of prolonging the misery, even exacerbating it, and encouraging bankers to hide bad assets. 

11. Finally, Ricardo Hausmann makes a compelling case that Venezuela will be the first oil exporting domino to fall and predicts a disorderly sovereign default this year, 

While most other oil exporters used the boom to put some money aside, former president Hugo Chávez, who died in 2013, used it to quadruple the foreign debt. This allowed him to spend as if the average price of a barrel of oil was $197 in 2012, when in fact it was only $111. He also used it to maim the private sector through nationalisations and import controls. With the end of the boom, the country was put in a hopeless situation. The year 2015 was an annus horribilis in Venezuela with a 10 per cent decline in gross domestic product, following a 4 per cent fall in 2014. Inflation reached over 200 per cent. The fiscal deficit ballooned to 20 per cent of GDP, funded mainly by the printing press. In the free market, the bolivar has lost 92 per cent of its value in the past 24 months, with the dollar costing 150 times the official rate: the largest exchange rate differential ever registered...

As bad as these numbers are, 2016 looks dramatically worse. Imports, which had already been compressed by 20 per cent in 2015 to $37bn, would have to fall by over 40 per cent, even if the country stopped servicing its debt. Why? If oil prices remain at January’s average levels, exports in 2016 will be less than $18bn, while servicing the debt will cost over $10bn. This leaves less than $8bn of current income to pay for imports, a fraction of the $37bn imported in 2015. Net reserves are less than $10bn and the country, trading as the riskiest in the world, has no access to financial markets.

The importance of urban leadership

This blog has consistently held that Indian cities lack visionary leadership of the kind that is necessary to shape their long-term development. Municipal Commissioners, with their limited tenures and misaligned incentives, cannot be expected to provide the sort of leadership that a city resident with a five-year tenure and long-term political aspirations can potentially do.

Fernanado Haddad, the mayor of the 20 million Sao Paolo metropolis, is only the latest example of such leadership, challenging the "supremacy of the automobile" to ease congestion and improve commutes,

Drawing inspiration from policies in New York, Bogotá, Paris and other cities, Mr. Haddad has embarked on the construction of hundreds of miles of bicycle lanes and corridors for buses to blaze past slow-moving cars, while expanding sidewalks, lowering speed limits, limiting public parking and occasionally shutting down prominent avenues entirely to cars... surveys show relatively high lvels of support for his policies.

Such paradigm redefining policy mutations are most unlikely to come from bureaucrats. They are most likely to originate from political leadership. But critics point to its pitfalls. And they merit serious consideration. It may be true that three out of five (or four out of five) leaders may turn out to be less than benign, even venal.

But, given the institutional checks and balances, in the long run, we are likely to be none the worse off. In fact, the positive deviants alone may be enough to unsettle the bad equilibrium our cities are currently entrapped in. In any case, when this is the norm in pretty much all major developing countries, with equally corrupt and short-sighted political eco-system, and many of their cities have done far better than ours, it is not clear why we should be different.

Weekend reading links

1. Tyler Cowen points to the stark contrast in night-time ariel photographs of South and North Koreas to highlight the importance of institutions.

2. The US LNG exports, which just began, have already triggered off speculation of price wars in Europe. Like Saudi Arabia in oil, Gazprom has the potential to become the swing gas producer since it has the largest spare capacity and is also the lowest cost gas producer in the world. In the context of rising US exports and liquefaction terminal construction, the FT reports that Gazprom may be encouraged to increase production to push prices down lower to keep out the shale imports. 

It is only a matter of time before these forces reach the East Asian markets, keeping gas prices there contained. A truly integrated global natural gas market may be only a couple of years away. It is all the more important that India's policy makers keep this in mind while formulating gas pricing policies for the new production sharing contracts. 

3.  A good summary of research on the impact of MGNRES in Livemint. One thing that is clear from recent events is that the program is good politics.

4. In addition to the conventional indicators of economic weakness, consider these trends. Corporate investment intentions hit all-time lows; external commercial borrowings decline; investment commitments by China, Japan, UAE etc fail to materialize; the same Indian corporates who hesitate to invest in India are doing so abroad etc. 

It appears that, at this point in time, India is investment-demand constrained. Public investment should undoubtedly become the engine to revive investment cycle. But, at about 1.72% of GDP for 2015-16 and a high fiscal deficit, there is only so much that is possible with this strategy.

5. Following the 20% import duty on hot-rolled coils imposed in September for 200 days, the Government of India has imposed a minimum import price on different categories of steel products for a period of 6 months. These measures are aimed at protecting a bruised steel industry. It comes even as the industry is floating on excess capacity, and steel makers across the world are fighting sharply falling demand and thereby prices. 

This is certain to invite action against India before the WTO's Dispute Settlement Board and most likely to be untenable. Further, it is not clear whether this is going to improve the prospects of most Indian steel producers whose competitiveness have been seriously hurt by their very large debt-servicing costs, which alone in some cases is more than the import price of Chinese and Russian steel. Finally, the biggest losers will be the country's manufacturing industry, for whom steel is an important intermediate, and the consumers. 

6. The Citylab writes that 2015 was a bumper year for skyscrapers (more than 200 m high), with the highest ever completions. Interestingly, Jakarta had the largest number of skyscrapers completed in 2015, at seven. As a comparison, Mumbai had one.

It is surprising that India, where A-grade commercial real estate has been frothing, does not figure anywhere. Interestingly, while Mumbai has 14 skyscrapers, all but one are residential. This is in stark contrast to global trends, where office and mixed-use dominate and residential is a very small share. Why doesn't India's office space developers go vertical?

7. The Business Standard argues that the Vijay Kelkar report recommendations would go a long way towards reviving PPPs in infrastructure. In particular, this caught attention,

The most path-breaking suggestion is a two-tier framework of dispute resolution with Infrastructure PPP Project Review Committee and Infrastructure PPP Adjudicatory Tribunal. Once a stakeholder files a reference before the tribunal, and it takes cognisance of it, no party or stakeholder would be allowed to approach any court of law, and all courts shall refrain from adjudicating upon any proceedings initiated that are related to the project in question.

The committee has proposed enactment of a law under Article 323B of the Constitution under which Infrastructure PPP Project Review Committee and Infrastructure PPP Adjudicatory Tribunal should be empowered to determine whether there is such a change in the economic foundation or economic viability of a project which requires any intervention amongst options contemplated in that statute. The law will also lay down the guiding principles on the basis of which Infrastructure PPP Project Review Committee and Infrastructure PPP Adjudicatory Tribunal will exercise their functions. In case a substantial question of law is involved, the matter should be directly heard by the tribunal.

I am not that optimistic. There is nothing different here than with all the other Tribunals. In other words, there is nothing that prevents the disgruntled party from approaching the Courts at the drop of a hat and the latter from entertaining their pleas. All such talk of "independent mechanism for speedy redressal of disputes" appears logically and academically great, but have limited real-world basis in India's messy decision-making systems.

8. Are cows and buffaloes substitute goods? The Maharashtra government's ban on cow slaughter appears to have unintended consequences. The prices of cows, even good milch ones, have fallen sharply, just as those of buffaloes have risen. 

More on monetary policy transmission

Good post from Andy Mukherjee captures the monetary policy transmission problem in India. Despite the 125 basis points repo rate cut, the G-sec and corporate bond yields have actually gone north.

Apart from the structural problems in credit intermediation in India, there are atleast two other factors at play here. One, embattled banks are using the cushion from lowering rates to repair their balance sheets. Two, the corporate debt overhang coupled with weak economic prospects, both rising with time, naturally raises the cost of capital for borrowers.  

Bad loans and bad banks

The Government of India is apparently contemplating the establishment of a 'bad bank' to isolate the distressed assets held by the banking sector. Essentially bad banks are asset management companies which purchase distressed loans at knock-down prices and then revive and sell them to investors.

I had blogged about bad banks and other bank resolution options here and here. At a fundamental level, a bad bank is best captured by the graphic below. Incidentally, this classic model of resolving distressed assets of private banks failed to find traction even in the US during the height of the sub-prime crisis for lack of consensus on what would be an acceptable price discovery mechanism.

There are atleast four models of resolving bad assets. At one end is the 'Swedish model' of complete nationalization, whereby the equity holders are stripped-off their holdings and the assets transferred to one public aggregator "bad bank". This bank can then restructure and manage these assets back to health and dispose them. Alternatively, as Citibank did, each existing bank can create its own "bad bank" and then manage those assets. Another option, commonplace in the US, is to sell/auction off such assets to Asset Reconstruction Companies (ARCs) or even fund managers, with or without partial government guarantees. The least disruptive option is to simply securitize such loans and sell them off, with some sovereign guarantee as is being proposed in case of Italy. A snapshot of all these options is below.

During the Eurozone crisis, bad banks were established across many countries. The three largest - Ireland's NAMA, Sapin's Sareb, and Germany's FMS Wertmanagement - were established as publicly owned entities with 10-15 year life-span, who purchased, largely real estate loans, at haircuts, with the objective of reviving and selling the impaired assets and recovering some value. Their experience has been mixed.

In India, the debate has been whether the distressed assets should be resolved through a publicly owned 'bad bank' or through sales to ARCs. In this context, a few observations.

1. In India's case, the vast majority of assets are held by public sector banks. So any haircuts by the bank are borne by the government itself. This raises the question of whether an aggregator 'bad bank' is the most efficient and incentive compatible way to assume losses.

2. In the US and western Europe, where the vast majority of assets were securitization products, mortgages, real estate, consumer, and student loans. Being financial or functioning assets, at worst, these assets could simply be written off. In contrast, Indian banks' problems stem from commercial loans to real estate and infrastructure project developers, a large proportion of which are non-income generating and at different stages of completion. Here, the completion of these projects is as much important as the bad loans resolution itself. But this would, in most cases, require further capital infusion. In other words, it is important to keep in mind that the resolution of such loans through a bad bank is not a substitute for restructuring distressed projects, as much important for the government as repairing bank balance sheets.

3. The credibility of the process assumes great significance. The markets have to be convinced that the resolution process has been done rigorously enough so that the "good" bank is a healthy enough institution. This would require that all the distressed assets are hived off and those done so are valued fairly.

4. On this, being public institutions, the resolution process runs the risk of being plagued by risk-aversion. The administrators of the process may unwittingly structure the process to maximize the returns for the banks. This corollary effect of this would be increased riskiness of the hived-off asset as well the lower likelihood of its successful resolution. A public sector decision-making process may not be best suited for managing a price discovery process that equates the interests of all sides.

5. Apart from risk-aversion, the public sector banks are certain to be hobbled by the decision paralysis syndrome that arises from the risk of post-facto vigilance and audit oversight. In a regime constrained by audit and other oversights, it may not be possible to sell off all assets. It may be necessary to exercise judgment and write-off some assets, or even sell them off at prices far lower than any internal 'off-set' price.  

6. Once decided, this must be done very quickly. Else the possibility of generating moral hazard among banks and other market participants is considerable. This is all the more important given the well-known fact that a not insignificant share of the restructured loans under CDR and 5:25 scheme are not exactly performing assets.

7. But this is most likely to run into the problem of market demand for such assets, given the flood of such assets likely to be released into the market.

8. Finally, it may be necessary to examine the reasons why private ARCs have not made much headway. There may be a need for regulatory enablers like uniform provisioning norms for various kinds of asset restructuring mechanisms.

Given all this, what is the way out for India. The fundamental question that we should be asking is - What is the most effective strategy to resolve the bad loans in bank balance sheets while simultaneously completing the stalled projects which form a major share of these non-performing assets? This requires going much beyond blindly replicating 'bad bank' models elsewhere.

For a start, it would be ncessary to segregate and classify the different categories of loans. Would the under construction infrastructure assets be best resolved by remaining in the respective bank balance sheets and restructured as individual projects, with promoters and lenders taking haircuts, and government infusing capital? Or would they be best resolved by transferring all of them into one entity and then restructuring them? Which of the two approaches would best align incentives and minimize transaction costs, given the constraints of public sector decision-making in India? While there are pros and cons with both approaches, I am inclined to the former.

Given that the broader real estate and infrastructure sector loans form the major share of distressed assets, it may be reasonable to confine this resolution process to them. The other smaller loans can be dealt separately, either written off fully or sold to ARCs. This sectoral focus would enable the asset managers to more effectively manage and resolve them. Further, their  "fair" valuation becomes far less of a challenge with such assets.

All this does again raise the question of recapitalization. Bad assets resolved or not, Indian banks need massive recapitalization, far higher than the drips being administered now. It may be even worthwhile to dedicate a full 0.5% of GDP fiscal deficit relaxation this coming budget exclusively for recapitalization complemented with a focused distressed assets resolution mechanism. 

See these reports from IMF, Bruegel, and McKinsey for more on resolution of distressed assets and bad banks. 

The decision paralysis example of the day

As the Non-Performing Assets (NPAs) of India's banks mount and the RBI has allowed them to assume majority equity stakes through the Strategic Debt Restructuring (SDR) mechanism, the role of Asset Reconstruction Companies (ARCs) assumes greater significance. But so far ARCs have made limited headway in the Indian market, with the 15 existing private ARCs having a combined net worth of just Rs 40 bn and have been able to resolve just a third of their acquired assets. 

In this context, this quote in the Indian Express gets to the heart of the challenge,

Public sector banks are scared to sell to private ARCs for fear that the quantum of hair cut can always be questioned by the government’s auditor, vigilance or at worse be probed by the intelligence agencies.

This is very relevant in a bureaucratic environment where every decision is likely to be subjected to post-facto scrutiny, often many years later and completely divorced off its context. Consider the case where an ARC makes windfall gains from one of its assets. A malicious complaint can trigger an enquiry. An auditor, with limited awareness of the context, can attribute presumptive loss and fault the decision by the bank management to take haircuts. An investigating agency with no professional competence to investigate the issue could find fault with the magnitude of the haircut or not having given the asset to a public ARC or managed itself. A humiliating media trial confined to headlines follows.

Construction of such counterfactuals and hindsight with half-knowledge creates a moral hazard which engenders, at best, sub-optimal decision making, and, at worst, decision paralysis. In this environment, vitiated further by deep political acrimony, it is highly unlikely that a large scale program of distressed asset sales from public sector banks to private firms can be pulled off. The systemic constraints, relaxation of which may be beyond administrative and legislative actions, are just too binding. On the issue itself, here is more on what needs to be done to enable the market for ARCs in India.