Lessons from the Thames Water Fiasco

In one more exhibit on the problems with the privatisation of utilities, early this month, Kemble Water Finance, part of the complex financial structure constructed by Macquarie at Thames Water, the largest British water utility serving a quarter of the population and one that provides water to London, announced that it was defaulting on its £400mn bond repayments. This follows its shareholders refusing to make the promised £500mn equity infusion because Ofwat refused to agree to their demands for higher bills and in turn demanded that the shareholders reduce the company’s debt pile. 

The £14.7bn of debt held by the Thames Water utility companies that sit below Kemble should be unaffected by the default. This debt is in the form of a whole-business securitisation, a structure commonly used to borrow against highly regulated assets with predictable cash flows. But it threatens to wipe out the stakes of Thames Water’s nine shareholders, which include the Chinese and Abu Dhabi sovereign wealth funds as well as Canadian and UK pension funds. Further, Kemble’s £400mn bonds are trading at little over 15 per cent of their face value, indicating debt investors too are set for a near-total wipeout. Most importantly, it raises questions about how Thames Water itself will be able to repay the £14.7bn of debt. 

This is the list of Thames Water’s owners.

Underlining the complexity of the financing structure, JP Morgan published this outcome-probabilities chart.

The FT article writes about the origins of Kemble’s troubles

The Kemble debt is a legacy of Thames Water’s 2006 buyout by Macquarie, which has drawn scrutiny for the billions of pounds in dividends the firm siphoned off during its decade-long ownership. Macquarie put in place a so-called “whole-business securitisation”, where the utility’s cash flows service different tiers of debt. Kemble, named after a village in the English countryside near the source of the river Thames, allowed the firm to borrow more money. Kemble relies on dividends from Thames Water to pay interest to its bondholders and lenders. However, new rules introduced by Ofwat last year prevent the payment of dividends from the utility if they put the company’s financial resilience at risk. Ofwat opened an investigation into a £37.5mn dividend paid by Thames Water in October last year, with a ruling expected within weeks.

Then there’s also the inflation-indexed nature of the debt, which forms more than half the utility’s debt. 

The 2022 annual accounts of parent company Kemble Water Holdings show that the weighted average interest on the group’s £7.7bn of “index-linked debt” soared to 8.1 per cent from just 2.5 per cent the previous year… An “inflation risks sensitivity analysis” — which conceded that the RPI-linked debt only acted as a “partial economic hedge” — showed that a 1 per cent increase in the rate of inflation after 31 March 2022 would dent the group’s profit and equity by £911mn.

The original sin of course lies in the 2006-17 ownership of Thames Water by Macquarie. 

When the former prime minister Margaret Thatcher privatised the water monopolies in 1989, she wiped out their debt. Since then, Thames Water’s group borrowings have grown to £18.3bn as the company passed from owner to owner. By 2006, when the Australian asset management firm Macquarie bought Thames Water from the Germany utility group RWE, the water company had £3.4bn in debt. By the time Macquarie sold its final stake in Thames Water in 2017, the company had spent £11bn from customer bills on infrastructure. But far from injecting any new capital in the business — one of the original justifications for privatisation — £2.7bn had been taken out in dividends and £2.2bn in loans, according to research by the Financial Times. Meanwhile, the pension deficit grew from £18mn in 2006 to £380mn in 2017. Thames Water’s debt also increased steeply from £3.4bn in 2007 to £10.8bn at the point of sale.

All this means that in the absence of dividend inflows from Thames Water, Kemble Water Finance is insolvent. With the existing shareholders preferring to take an estimated £5bn loss and cut further losses and not put in any more money, complete equity wipeout and large debt haircuts look inevitable. Any restructuring which does not provide a long-term financing solution for Thames Water, an increasingly difficult prospect, would effectively end up being a return to nationalisation of an asset that was privatised in 1989! A nationalisation should come as no surprise since the latest YouGov polls find that 69% of people believe water companies should be nationalised. 

In this context, Frédéric Blanc-Brude points to the problems with using traditional CAPM models to calculate the fair value of investments. 

At the end of 2022, a group of large pension plans, including funds from Canada, Japan and the UK, discovered that they had lost a large part of the £5bn investment in Thames Water that they had recorded on their books. This Easter, they learnt that they had probably lost all of it. There is only one way for a water utility serving the capital of a G7 country to lose so much value so fast: it was never worth £5bn to begin with.  Yet its owners denied this reality for years. The signs that Thames Water and its parent Kemble Water Finance constituted a high-risk, low-profit business were there all along. The cost of capital in this investment should have been considered quite high (and increasing over the years) and its value much lower… 

Many investors in private assets — and in this case the water sector regulator, Ofwat, too — rely on the “capital asset pricing model” (CAPM) to estimate a cost of capital and the value of the business (and for Ofwat the allowed level of water tariffs)…. Today, CAPM remains the most commonly used framework for estimating the value of private investments like infrastructure companies.  Yet the scientific community has known for more than 30 years that CAPM, while one of the foundations of the field of academic finance, is wrong… The inevitable conclusion from all this is that the reported values of private investments held by institutional investors and their managers today are very likely to diverge significantly from their true market value, and do not represent the level of risk taken or the liquidation value of these assets. This is how investors in Thames Water saw their investment go from £5bn to zero in a few months — they were blindsided by bad models and bad data… 

There is a better way. Applied financial research and data availability about private investments have made significant progress since CAPM was developed in the 1960s. It is time for investors in private companies like Thames Water to take a more scientific view of asset pricing. They need proper measures of risk for the private asset classes to which they now allocate large amounts, and of the value of the assets they hold.

The point that Blanc-Brude makes is very important. The reluctance of the market to use empirical evidence on important decisions like valuation, especially given the stakes involved, is baffling. There’s such a rich repository of data about infrastructure projects from across the world that it must be possible to look at the realised outcomes from projects across different segments of the sector and make informed, evidence-based assumptions of cost of capital, returns on equity etc. Why use theoretical models with limited practical relevance when there’s good historical data available?

A thing that has intrigued me is why alternative investment funds (AIFs), which typically chase high-risk and high-return investment options, find infrastructure as an attractive asset class. Infrastructure is mostly regulated and therefore comes with low but stable returns but for a long tenor. It’s for this reason that traditionally pension funds and insurers, which look at very long investment horizons, find infrastructure an ideal investment option. Its stable returns and long-tenor are high value for them. 

For fund managers in AIFs like private equity, the infrastructure sector’s attractions can therefore come only from the perspective of asset diversification and not returns maximisation. But this is theory. In reality, private equity investors who are now piling into infrastructure feel that they can make high returns from infrastructure. They see Macquarie’s track record of extracting high returns from infrastructure, none more high-profile than Thames Water itself, as evidence. 

But, as I have blogged and written extensively over the years, these returns can come only at the cost of the project itself. It can come only from asset stripping by loading the company with debt, paying out large dividends, skimping investments, not paying employees pension funds, and so on. The shorter cycle of a PE investment compared to the life cycle of an infrastructure asset means that PE investors can strip assets from the project entity. This is especially true in the case of assets that are newly concessioned out or privatised - the first set of PE investors have a strong perverse incentive to squeeze the balance sheet of the project entity, pay themselves handsome dividends, and exit. Even if they don’t exit and get stripped of their equity after a few years, they would have made enough for themselves and their investors. 

Fundamentally, as I blogged here, infrastructure finance 3.0, which PE kind of investors represent, is about separating ownership from the operations and the life cycle of the asset. Ownership gets parcelled into tranches and is transferred from investor to investor. There’s limited skin in the game for these investors in the asset’s long-term prospects. They are concerned only about the asset being a going concern till they are around and can find another investor who too would have similar incentives. 

There are two big losers in such situations. One, creditors to infrastructure assets owned by PE firms (who indulge in such asset stripping) can be left holding a bankrupt entity and are forced to take large haircuts. Two, given the monopoly provider of an essential service nature of such assets, governments cannot allow these assets to fall into liquidation. They will have to step in to facilitate restructuring and find new owners who can operate the asset or take it over and run itself. In either case, taxpayers are on the hook. 

Truth be told, PE investments in infrastructure are mainly aimed at segments like data centres, telecommunications, and natural gas where there are enough opportunities for higher returns. 

Three takeaways from this. One, policymakers should be careful about what they wish when they court private investors like AIF in infrastructure sectors. There’s a strong case for designing bid documents that are explicit about the expectations of investors from such investments. Bid documents should pre-empt asset-stripping possibilities by mandating clear, salient, strict, and public disclosures of relevant information. Two, regulators must be vigilant in monitoring PE (and any other private) investments in infrastructure sectors for the various asset-stripping practices. Three, creditors should have supervisory mechanisms to watch the emerging financials of their borrowers.  

Weekend reading links

1. The Times has an interesting story that points to the problems with phasing out plastics in food packaging.

Plastic works well to slow the decay of vegetables and fruit. That means less produce is tossed into the garbage, where it creates almost 60 percent of landfill methane emissions, according to a 2023 report by the Environmental Protection Agency. A Swiss study in 2021 showed that each rotting cucumber thrown away has the equivalent environmental impact of 93 plastic cucumber wrappers. Food is the most common material in landfills.

Ultimately the problem with such transitions lies in the reluctance of societies as a collective to come around to abandon their food habits.  

Consumers increasingly report that using less plastic and packaging matters to them, but their shopping habits tell a different story. American shoppers bought $4.3 billion worth of bagged salad last year, according to the International Fresh Produce Association. Marketing experiments and independent research both show that price, quality and convenience drive food choices more than environmental concerns... Battle lines seem to be drawn between the never-plastic crowd and shoppers who prefer the ease of fresh salad greens delivered to their door. “The packaging conversation is being held hostage by one side or the other,” said Max Teplitski, chief science officer of the International Fresh Produce Association.

2. Some of the DBT programs make no sense. Sample the DBT to parents to buy textbooks and uniforms for school children in Bihar which was launched in 2017 and wound up in 2022 after failure and criticism. A 2018 survey found that only 18% of students purchased textbooks with the DBT money. 

In the case of Bihar, contextual and operational failings like parents without bank accounts and problems with implementation contributed to the low uptake. But even without these, it's likely that a significant share of parents would not have purchased textbooks. 

3. Story of a failed PPP in healthcare 

In 2002, the Karnataka government set up the Rajiv Gandhi Super Specialty hospital in Raichur and handed over the 73-acre campus with hostel, staff quarters and hospital building to Apollo Hospitals Enterprise Limited to provide specialised treatment for various diseases. The state government drew up an agreement to pay Rs 1 crore per month for revenue expenditure to Apollo. Under the terms of the agreement, the private hospital would have to provide free treatment to below-poverty-line patients in Raichur. A decade later, a state government inspection of the hospital found that it lacked several services that were part of the agreement. Out of 340 beds, only 154 were functional, of which only 58% were occupied by patients in 2010-’11. The below-poverty-line patients admitted covered only 11% of total beds in hospital. In May 2012, the Karnataka government terminated the agreement with Apollo.

4. Quick commerce (q-commerce), the hyper-localised 10 minute grocery delivery model, is surging in India, driven by Blinkit and Instamart. Zomato purchased the struggling Blinkit two years back and has turned it around. Interestingly Instamart is owned by Zomato's food delivery rival Swiggy. Each has a 40% market share. As a Ken story writes, India's q-commerce market can be traced back to Swiggy in August 2020 promising 45 minute grocery delivery, followed by Zepto in April 2021 promising delivery in 10 minutes, and then Blinkit (Grofers then) following suit in December 2021. 

I think it's misleading to revise the priors on scepticism about the long-term potential of q-commerce in India. For all its spectacular growth, Blinkit's revenues in three quarters of 2023-24 have been just Rs 1530 Cr ($185 million). There's some more runway available to absorb the pent-up demand for q-commerce. Like with all else in the ultra-price-sensitive Indian market, this demand too is likely to reach its limits soon. q-commerce priced at sustainable levels is likely to be attractive to only the high-income class, a tiny market segment. 

5. Janan Ganesh has an excellent oped that gives a different explanation for the rise of populism and other societal ills afflicting western countries - the disease of success.

Problems of success are harder to fix because, almost by definition, you wouldn’t want to remove the underlying causes of them... The best explanation for the strange turn in politics over the past decade is too much success, for too long. Few voters in the west can remember the last time that electing a demagogue led to total societal ruin (the 1930s). The result? A willingness to take risks with their vote, as a bank that has forgotten the last crash starts to take risks with its balance sheet. What the economist Hyman Minsky said of financial crises, that stability breeds instability, could be the motto of modern politics too... The most important populist breakthrough, Donald Trump in 2016, happened in a super-rich country, seven years into an economic expansion. The Brexit campaign won most of England’s affluent home counties. 

Populism can’t, or can’t just, be the result of scarcity. It can’t be solved through more and better-distributed wealth. In fact, to the extent that it liberates people to be cavalier with their vote, material comfort might make things worse. Faced with problems of failure — disease, illiteracy, mass unemployment — western elites are supremely capable. When it comes to even apprehending problems of success, less so... Modernity — a world in which most people live in cities, have freedom from clerics and communicate across great distances at low cost — came along about five minutes ago in the history of civilisation. Economic growth was itself an almost unknown phenomenon in the three millennia before 1750. It would be strange if such abrupt and profound change hadn’t had some unintended consequences. The story isn’t phone-induced stress or even low birth rates. The story is that we haven’t experienced much worse.

6. It's ironical that cheap Chinese solar exports are accompanied with weak Chinese solar companies (propped up only by massive subsidies)

Chinese solar-panel makers... account for 80 per cent of global production capacity. But the cost of that victory is now looking too high. China dominates the solar panel sector’s entire supply chain. Prices, which are nearly two-thirds lower than US counterparts, have helped it to win market share. Every year, this price gap widens. There was another 40 per cent price cut in 2023. China’s dominance has come from years of investment. It ploughed over $130bn into the solar industry last year — into production capacity increases. Chinese makers are able to build over 860 gigawatts of solar modules annually. The biggest advantage Chinese companies have is scale. Due to the sheer size of the domestic market — which added a record 217 gigawatts of solar last year — companies invested heavily in larger scale manufacturing and automation. That is paying off today. Another 600 gigawatts of annual capacity is expected to start operations this year. That would be enough to cover the world’s total demand through 2032, according to energy research group Wood Mackenzie...

The weak stock performance of Chinese solar cell manufacturers reflects that mismatch. Longi Green Energy Technology, JA Solar Technology and Trina Solar are down more than 50 per cent in the past year. Longi, China’s largest business in the sector which has grown to become the world’s second most valuable solar energy group, trades at 18 times forward earnings. That is less than half the valuation of smaller US peers. Operating margins have halved over the past four years.

7. Big Tech has come to see fines as a legitimate cost of doing business. Worse still, very little of those imposed finally get paid. 

Damien Geradin, an antitrust lawyer who has represented companies in probes against Apple and Google, said fines did not work as deterrents. He said: “A fine is a cost of doing business for Big Tech and the level of profit of these companies is such that no fine will exceed the profit of ignoring the law.”

8. Gillian Tett points to a new paper by Ken Rogoff et al which points to a secular decline in real interest rates over the last seven centuries.

Tett explains the findings

The chart is certainly not smooth. Two big inflection points occurred during the 14th-century Black Death pandemic, and then the European “Trinity” financial crisis of 1557. There were smaller inflections in 1914 and 1981. But what is more striking than these inflections is how rare they are. While long-term rates have often moved in response to recessions, defaults, financial shocks and so on, they almost always revert to trend after a decade or two. As the economist Maurice Obstfeld has pointed out, the result is that they look like mere “blips” from a long-term historical point of view. To put it another way, modernity triggered an inexorable decline in the long-term price of money, and was doing this well before we started to fret about ultra-low rates in the 21st century.

On the reasons, Tett summarises the points made by Rogoff et al and what it means going forward.

The real reason, they say, for falling borrowing costs is not economic shifts, but an issue economists often ignore — the nature of finance. A combination of modern capital markets, risk analysis and innovation around using collateral to back loans has made money more efficient... A key distinction between modern and premodern societies is that innovations ranging from double-entry book keeping to computers have left us believing that we can predict, manage and price future risks, without relying on gods, as our ancestors did... And what does it mean for current rates?... Adopting an eight-century timeframe suggests that the ultra-low rates we saw in the early 21st century were a slightly excessive deviation from the trend. It should thus be no surprise that long-term rates have corrected upwards, particularly given that the short-term neutral rate has probably risen.

9. Nice graphic that shows how after 35 years, the Nikkei has come full circle.

After decades of fighting and failing to create inflation, the Japanese prices have been rising since the spring of 2022. In February this year, the Nikkei 22 finally regained its previous peak and in March the BoJ ended negative interest rates and raised borrowing costs for the first time since 2007.

Inflation in the US - a shift to normalcy?

The US consumer price inflation for March came up at 3.5% year-on-year up from February and slightly higher than the forecast of 3.4%. On the same lines core inflation came up at 3.8%, up from the forecast of 3.7%. Bond yields rose and stocks fell as the likelihood of three rate cuts this year starting from June is now very unlikely.

Traders had also previously seen a July cut as a near certainty, but halved their bets on that timing from about 98 per cent to 50 per cent after Wednesday’s report was released. While the markets still give a very high probability to rate cuts by September, they have not fully priced in a cut until the Fed’s November 6-7 meeting... While Fed chair Jay Powell still believes in a “base case” that shows inflation drifting down towards the central bank’s 2 per cent goal, others on the FOMC are increasingly concerned that price pressures will prove stickier than expected. Chicago Fed president Austan Goolsbee has expressed concern that housing inflation will remain too strong, while Dallas chief Lorie Logan has warned of greater “upside risk” to the outlook.

It's to be noted that CPI inflation in the US fell from its peak of 9.06% in June 2022 to 2.97% in June 2023, a fall of 67% in one year. Since then it rose to 3.7% in September 2023 and has remained tightly range-bound between 3-3.5% for the last six months. 

Some observations:

1. The impressive lowering of inflation by 67% in a year supports the views of the team transitionary who have argued that the spike in inflation was due to the supply shocks induced first by the pandemic and then by the Russian invasion of Ukraine (and the massive US fiscal stimulus) and once the shocks subside inflation would come down. It’s also true that the decisive action by the central bank helped shape expectations and helped in hastening the reduction of inflation.

2. The recent trends in inflation after June 2023 can be construed to resemble a dead cat bounce. Inflation fell rapidly and now looks like stabilising. The tightly range-bound nature of inflation in the last nine months in the 3-3.7% range testifies to this. It might also be a transition path before inflation again starts to decline to a slightly lower level, say 3%. It’s difficult to foretell the trajectory. However, the assumptions behind competing explanations and theories and the resultant monetary policy actions have critical implications for the economy’s future. 

One perspective is to view this as the last mile of the fight to get inflation back to 2%. It can then be argued that the stickiness demands further monetary contraction. The continuing strength of the economy and tightness of the labour market lends credence to the view that the Fed may need to tighten further or at the least wait for the economy to cool further before starting to cut rates. In this perspective, the need of the hour is to either raise rates or wait for the economy to cool before cutting rates. The critical assumption here is the need to get inflation back to 2%.

Another perspective is that the critical assumption itself is wrong and the 2% inflation target, which is a recent invention, is both false precision and unrealistic. If the assumption is wrong, then the policy actions based on it can be very harmful. As I have blogged here, there are compelling reasons to argue that the period of 2% inflation was an aberration and we are now returning to the historic norm of inflation in the 2-4% band. In this view, we are already at the norm and monetary policy should now respond to trends going forward. The worst outcome would be to deploy monetary policy based on the false assumption of the need to get inflation back to 2%. That might end up choking and ushering in a recession due to the limitations of the policymakers (and experts) understanding of the economy. 

There’s no way to know ex-ante who’s right and who’s wrong. I’m both inclined against the first and towards the second. Only time will tell who’s right. 

3. It can also be argued that monetary policy in developed countries never returned to normalcy after the global financial crisis. The GFC induced steep interest rate cuts to prop up the financial markets and the economy. Since early 2009, interest rates remained at zero-bound for over seven years. After a brief rise to 2.5%, it was again brought back to zero-bound as the pandemic struck. It was only in April 2022 that the rate hikes started. 

From April 2008 to July 2022, or over 15 years at a stretch, interest rates in the US have been 2.5% or below, including at the zero bound for over 9 years. But for a brief spike for some months in 2011 and 2018, from November 2008 till March 2021 inflation too has remained in the 0-2% range. The US stock markets boomed. It was a decade and a half of remarkable economic stability and prosperity. Just compare the period with what preceded it. 

The markets and a generation of investors got used to the Goldilocks of low interest rates and low inflation, resulting in a strong economy and labour market and booming equity markets. The myth behind inflation targeting and the 2% inflation target got entrenched during this period. This period also coincided with extraordinary monetary policy measures by the US Fed and other central banks. Quantitative easing, forward guidance, yield control and so on were names given to these policies. Economists and technocrats at central banks started to believe that it was their theories and actions that created this Goldilocks moment in global economic history.

In this context, I cannot but not resist quoting Richard Bernstein’s comparison of the Fed Chairman to a Maytag Repairman,  

The Maytag Repairman was a fictional washing machine mechanic who was lonely because no one ever needed to repair a reliable Maytag appliance. Instead of tools, he carried a book of crossword puzzles and cards to play solitaire to combat his boredom. For many years, the US Federal Reserve played the role of the Maytag Repairman with respect to inflation. With the expansion of globalisation and the resulting secular disinflation, there wasn’t much for it to do to fight inflation. Rather, it could generously ease monetary policy during periods of financial market volatility without much concern that its efforts to save investors might spur inflation.

These claims overlook the contributions of peak globalisation, the spectacular long period of growth of China (and to a very limited extent India), the rise of renewable technologies, the spectacular advances in information technology (and the rise of Big Tech), the skill-biased nature of technologies, demographic shifts and global savings glut, geo-political stability, and the extraordinary period of ultra-low interest rates (which drove to the booms in venture capital and private equity models). The world economy experienced an extraordinary confluence of favourable conditions. 

It was clear that these tailwinds could not be sustained. Many of them have tapered off and headwinds have arisen starting with the pandemic and now there’s the possibility of a long period of deep geopolitical uncertainties. We are returning to the historical normalcy in the world economy and politics.

It’s therefore reasonable to argue that the Goldilocks period is in the rear-view mirror and inflation will be higher than the 2% target. And the US economy is currently in that range. It will be in the normal inflation territory of 2-4%. Even a cursory look at this graphic will show that US inflation has been above 2% for most of the post-war era. The sub-2% inflation rate has been the exception, not the norm. Monetary policy must respond now based on the emerging inflation trends in the world where normalcy has been restored. 

In fact, the IMF itself, as early as 2010, when Olivier Blanchard was the Chief Economist, endorsed a higher inflation target. 

A four percent target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. This benefit would come at minimal cost, because four percent inflation does not harm an economy significantly.

This does not mean that the Fed start cutting rates (since given the new inflation band, the rates are evidently high). Since economic policy is strongly influenced by expectations, it’s also important to consider how the consumers, investors, and markets will react to policy changes given their immediate priors (which continue to be strongly anchored to the Goldilocks world). More importantly, monetary policy has become captive to the financial markets and Wall Street interests. It’s not easy for any Federal Reserve to break out of this capture. 

It will take some time before the expectations get adjusted to the new norm and central bankers can free themselves from their masters, and policies can get made based purely on the new normal world. Policy-making must tread carefully in the interregnum. And we are not sure how long it’ll last. 

Even if this perspective is wrong, it’s useful for influential policymakers and commentators to consider, introspect, and then make a decision of whether to accept or not. The unknown unknown is the biggest danger. 

4. This new world will also mean that valuations in the equity markets will have to be revised downwards. It will upend the business models in areas like private equity. In fact, many parts of financial markets which had become excessively dependent on the ultra-low interest rate environment will face their reckoning when faced with the regime shift in interest rates. 

Given how much the economy has become entangled with the fortunes of the financial markets, especially in the US, the revision in valuations will pose a great risk for the economy. More than the economy, this is the most important soft-landing event to look out for in the next couple of years. Will the financial markets be able to adjust to the new normal of interest rates with its attendant downward valuation revisions without too many convulsions? It’s a question on which fortunes of trillions of dollars are riding. 

5. In the last four years, many reputed economists like Larry Summers have consistently got everything wrong on inflation and economic growth. One would imagine that they would have learnt some humility. It’s clear from his cheeky remarks quoted in the FT article linked above that the next Fed move might be to raise the rate (instead of any rate cut) that he’s only digging in his heels on his views on inflation. 

This is one more reason to argue that the view of people with expertise in non-scientific fields (economics and social sciences) should be taken with caution by policymakers. They are captives of their long-held ideologies and theories, and it takes great courage to step back and break out of the captivity. Rare are those, especially among economists. Angus Deaton is an exception.

Inflation is a wicked problem and you need humility to not be beholden to any grand theory to explain emerging trends. Economists, especially those who have built their reputations defending the orthodoxy, are not well-placed to explain these trends. 

6. Finally, putting all the above together, as an explanation of inflation over the last four-odd years, it’s reasonable to argue that the constraints from the consecutive supply shocks spiked prices and once normalcy returned inflation got back to its normal levels (not the pre-pandemic lows). The pandemic and the war provided the much-needed disruption to break out of the long period of low inflation which led to inflationary expectations getting anchored at unrealistically low levels. 

Inflation is now back to the range where it has been for most of the post-war era. But given the expectations and the need to gradually reshape them, policymakers must tread cautiously for this and next year to stabilise the new inflation and interest rate regime. Regime shifts are periods of high uncertainty. 

Palliative care in Kerala - a case study for development

Johanna Deeksha has an excellent story in Scroll.in that chronicles Kerala’s success with palliative care (caring for those living with serious or terminal illnesses like cancer, cardiovascular and chronic respiratory diseases, kidney failure, paralysis, dementia etc.).

The state leads by a large margin when it comes to providing such care to its citizens – while in India, just about 2% of the patient population has access to palliative care, in Kerala, almost 60% of the patient population has access to palliative care… Kerala provides this care through a network of almost 1,700 palliative care centres across its 14 districts, said Kumar. While some of these centres have in-patient services, most provide home-care services – that is, they serve as a hub comprising some medical professionals and volunteers from the area, who visit homes of residents in the region to treat them. Of these, 1,100 are government centres, and between 400 and 450 are run by NGOs. Between 80 and 90 are run by political parties, which Kumar explained is a phenomenon only seen in Kerala. Kozhikode has the largest number of palliative care centres, and is where the state’s model of palliative care has its roots.

It’s interesting that the palliative care success of the state can be traced back to the efforts of a couple of individuals who worked tirelessly to create awareness and mainstream the issue.

As a young medical student in Kozhikode, Dr Rajagopal MR heard screams from his next-door neighbour, who was afflicted with a terminal illness and suffered from intense pain. Rajagopal recounted that this experience led him to start thinking about the importance of pain management… In order to give focused attention to the problem, in 1993, he and his former student Dr Suresh Kumar established the Pain and Palliative Care Society, in Kozhikode – Rajagopal served as its chairman and Kumar as its secretary. Rajagopal recounted that he was deeply influenced by a lecture he attended around this time, by Gilly Burn, a British nurse who was travelling around India and introducing the medical fraternity to the idea of palliative care. He also attended a training programme of about 10 weeks in the United Kingdom, after which he returned to dedicate himself to the society’s work… Initially, the society functioned out of a 12-foot-by-12-foot room with a verandah, at the Government Medical College, where patients could consult doctors on palliative care and pain management. While the society offered home care services from its inception, it was only in 1995 that a formal home care team was established. Also in 1993, Rajagopal established Pallium India, which had broader aims, including of spreading awareness and training about palliative care.

The palliative care system in Kerala is firmly grounded in the community.

Patients spent the greatest amount of time with their family, neighbours and community. “The only way to provide proper care would be to train people in the community to intervene and become caregivers,” Suresh Kumar said. “It seemed like such a simple idea but took us so long to figure that out.” To address this problem, in 1998, Rajagopal and Kumar, with support from several NGOs, set up a community-based and volunteer-driven palliative care programme in Kerala, known as the Neighbourhood Network for Palliative Care, centred on the idea that palliative care is not merely a medical problem, but also a societal one. “That is why only in Kerala, the palliative care programme is the responsibility of the local government bodies – panchayats, municipalities and corporations,” Kumar said. The project was the first of its kind in India, and its approach came to be known as the “Kerala model”.

Five years later, in 2003, Rajagopal and Kumar set up the Institute of Palliative Medicine, adjacent to the medical college – the institute was to serve as a centre for treatment, training, research and outreach. The institute is now a partner to the World Health Organisation, in which role it supports the WHO in carrying out activities related to palliative care in India. The state’s community-centred system of palliative care received a fillip after the government made it the basis of its Palliative Care Policy, released in 2008. The policy stated that palliative care was an integral part of healthcare, and that not just the state health department, but even local government bodies should participate in setting up palliative care services. Kerala was the first state to have such a policy – Maharashtra followed in 2012, and Karnataka in 2016. By 2013, every panchayat in Kerala had a care centre unit. Most of these centres are home care centres, providing doctors, nurses and caregivers at home to families in need. Today, all district and taluk hospitals have palliative care centres where patients can receive treatment – but, Kumar explained, home care centres are more efficacious since most patients, especially those with terminal diseases, and those who are bedridden or otherwise have limited mobility, cannot travel back and forth to treatment centres.

The article has several stories of active involvement by the local community and public-spirited individuals in the sustenance of the state’s palliative care system. 

In many instances, individuals who need palliative care do not have caregivers who can take them to a hospital or provide care at home. In such situations, the local government body ensures that a neighbour or some member of the locality that the patient lives in is given the training needed to become a caregiver. “Do neighbours really volunteer to take care of someone who isn’t related to them?” I asked Nambath, “Why? How would it benefit them?” He responded, “In Kerala, we are a very close-knit society. There is no floating population. People often live in the same area for decades and they all already know each other. So, they step up to help each other.”

At the Community Palliative Care Centre’s office in Malaparamba, volunteers said that they were rarely short of funds. “We always have enough,” Nambath said. “People are always contributing.” He added, “When we told people in the locality that we needed another vehicle so we could visit more houses, immediately the funds poured in, and someone would always enquire if we bought the vehicle and if it had made our jobs easier for us.”

The emergence of palliative care in Kerala provides several learnings for other areas of social development. 

For a start, human engagement interventions must be grounded in the community and develop local ownership and accountability if they are to succeed. This applies to improving student learning outcomes, mental health improvements, sanitation and hygiene, sensitivity to children with special needs, welfare of disabled people etc., just as much or more as it applies to palliative care. 

Second, the service delivery system has to collectively embrace an account of its mission, one that goes beyond being a mere job responsibility. There must be a civic-spirited and moral imperative associated with this account. This is critical and difficult to achieve from a top-down government mandate (top-down mandates can only supplement the critical local action). 

Third, government engagement and funding must be complemented by volunteerism and local philanthropy, for it is such acts that contribute to ownership and accountability. Public policy must acknowledge the importance of such actions and must proactively create (and encourage its creation) the space for them. 

Fourth, the internalisation of an account generally emerges through long-drawn social mobilisation, which in turn comes from a gradual collective realisation of the issue as a problem or felt need. Societies and polities with strong social capital will find it easier to embrace such accounts, whereas those with weak social capital will struggle even with strong top-down promotion. It underlines the need for a strong social fabric in social development. 

Fifth, all such efforts to internalise accounts require a combination of social mobilisation and government support. The former without the latter runs into the problems of sustainability and especially scalability. The latter without the former is unlikely to get internalised and will, at best, meander. 

Sixth, both social mobilisation and top-down engagement require passionate champions to nurture and grow the movement for several years. The top-down bureaucratic change is not likely to come from the typical politician or bureaucrat but from passionate insiders with a strong personal stake in the cause. The system (both in the society and the bureaucracy) must provide the space and openings for the emergence of such champions and encourage them. They are worth their weight in gold. 

Finally, this example highlights a couple of very important high-level points on engaging with such issues. One, there are binding limitations to the effective adoption of externally grafted public policy ideas (and interventions) that lack serious local ownership. The latter is an essential requirement. Two, it’s perhaps wrong to engage with such issues with the framework and objective of their scalability, especially in their early stages. There’s something about the imperatives, techniques, and methods of scalability that conflicts with that of internalisation and adoption. 

Ironically, such ideas and interventions are more likely to scale when we think less of scale and focus on building community ownership and accountability. Long-drawn actions gradually gather enough moss to tip over and scale. As Lenin said, for years and decades nothing happens, and then in days years and decades happen!

Weekend reading links

1. Interesting analysis of foundation-owned companies.

Denmark’s weight loss drugmaker Novo Nordisk is the best known example. Support from a foundation holding 77 per cent of its voting rights allowed it to invest in the then-unfashionable area of obesity research in the 1990s. It is now Europe’s most valuable company, having made its owner the world’s biggest charitable foundation. Foundation-owned firms’ financial results are comparable to those of their other corporate peers, according to research by Steen Thomsen of the Center for Corporate Governance at Copenhagen Business School. They are particularly prevalent in Denmark — think Maersk and Carlsberg. Elsewhere, examples include Sweden’s Wallenberg empire, India’s Tata conglomerate, the UK’s Associated British Foods, Switzerland’s Rolex and California’s Patagonia. The latter — created in 2022 — is a rare US example, as unfavourable 1969 tax rules were only lifted in 2018

2. From Noahpinion, this post about zoning in Japan - zoning law is national, but cities have the flexibility to adapt it within limits; there are only 12 clearly defined zoning areas from low-rise residential to only industrial areas; almost all areas allow mixed-use, but some with use restrictions; no restriction on the nature of residential property etc.

3. Conflicts of interest in the legal services industry

Some US firms, most notably Kirkland & Ellis (the dominant legal adviser to the private equity industry), have allowed partners to invest hundreds of millions of their own dollars in the funds managed by the buyout groups they advise. Critics point out that having a personal financial interest in a certain outcome from an investment you have advised on could compromise your legal duty to give impartial advice. Accountants in the US and UK are barred by professional rules from investing in audit clients for just this reason.

4. Rana Faroohar rightly calls out China's recent decision to take the US to the WTO challenging its Inflation Reduction Act.

All I can think is: seriously? Is there anyone blind to the hypocrisy of China challenging tax credits that support US clean energy producers for breaking WTO rules, when its entire economic model benefits from a double standard in which everyone seems to accept its own wildly discriminatory policies? China’s economy is, after all, built on plans that lay out decades-long subsidies and protectionist ringfencing for the most strategic industries, including but not limited to clean energy, telecommunications and artificial intelligence. This massive problem hides in plain sight. 

The word “protectionism” tends to only come up when the US or Europe attempt to impose tariffs or subsidies to protect their own industries. This is true even when it’s for good strategic reasons such as the need to deal with climate change or create a just transition to the green economy for workers. And yet, when it comes from China, protectionism is understood to be the status quo. The rest of the world seems to simply accept that this is the starting point of China’s state capitalism; we sigh and wring our hands, all while hoping against hope that something in this picture will change... The entire nature of China’s political economy goes against the free trade assumptions of the WTO, not to mention the Washington Consensus... China’s new manufacturing stimulus plan, which is about to flood the world with even more cheap stuff, will only continue to expose the cracks in the current trade system. The true picture — that the WTO’s rules are often a straitjacket for everyone but China — is becoming ever clearer.

Faroohar's perspective is something which is missed by her colleague in FT Martin Sandbu who writes.

China has been willing to put in place the green tech subsidies and other government support that the west has until recently shied away from. What, precisely, is not to like about the resulting flood of cheap clean energy exports? Would it be better to reduce the flood to a trickle, so we have less of the kit it takes to decarbonise? Or to have a flood of expensive rather than cheap green tech supplies, to make decarbonisation costlier? The intellectual short-circuit that offends me is to simultaneously complain that it is too hard or expensive to decarbonise and that the tech to do so is too cheap and abundant. You can’t have this both ways. And the way to take it should, of course, be to celebrate cheapness.

It's striking that commentators like Sandbu are so blinkered on the cheap chinese solar imports as to be blind to the protectionism that China indulges in and the role of such imports in destroying manufacturing and jobs in the importing countries. 

5. Gillian Tett points to price-shrouding by companies as an example of market failure.

First, business competition does not always deliver true efficiency; markets can fail. Second, this market failure arises because consumers are not the all-knowing rational agents that they appear in economic models. They have cognitive biases that lead them to make poor choices and leave them ill-equipped to make judgments about inflation. And third, digitisation alone does not magically fix these competition problems. Yes, it can create more price transparency in some arenas, such as airline tickets. But the internet sometimes creates so much information overload that it can also lead to shrouding, particularly when consumers are busy or poorly educated. Indeed, the image — or illusion — of online transparency can actually make obfuscation worse... efficiency and efficacy would rise for the public and private sectors alike if there were anti-shrouding policies. These could include measures to impose standardised labelling for products and support price comparison websites, consumer advisory services and so on.

6. The phenomenon called K-pop

In its survey of the state of the global music industry in 2023, the International Federation of the Phonographic Industry (IFPI) reported that six of the world’s top 20 best-selling artists last year were South Korean. K-pop commanded all top three positions in the roster of the year’s best-selling albums. K-pop concerts collectively drew audiences in the millions. When other countries now think about lab-culturing an exportable, enchanting music monster, K-pop is the only genotype worth emulating.

7. India is, atleast till now, not gaining from the diversification away from China.

India’s share of global foreign direct investment (FDI) inflows fell from 3.5 per cent in the first nine months of 2022 to 2.19 per cent in the same period in 2023, according to OECD data. The sharp drop of 54 per cent is much steeper than the overall global FDI inflow decline of 26 per cent in the first nine months. FDI inflows to China have fallen dramatically from a share of 12.5 per cent in the first nine months of 2022 to only 1.7 per cent in the same period in 2023. It is not India but countries like the US, Canada, Mexico, Brazil, Poland, and Germany which gained the most from China’s loss by seeing their global share rise.

8.  Global supply of equities have been shrinking.

The number of listed companies in the US has fallen from more than 7,000 to fewer than 4,000 since 2000, according to Wilshire, the index provider. A similar trend has unfolded in Europe and the UK. Smaller companies hoping to raise funds but wary of the financial and regulatory burdens associated with being public are still turning to private markets or venture capitalists, according to strategists.

9. Interesting entrant in the race to secure control over minerals critical for the green transition, the Gulf countries!

Gulf nations, hungry to diversify their economies beyond fossil fuels, are redirecting petrodollars to secure copper, nickel and other minerals used in power transmission lines, electric cars and renewable power. Beyond the UAE, chief among them is Saudi Arabia which wants mining to contribute $75bn to its economy by 2035, up from $17bn. Oman has started construction of what could be the world’s largest green steel plant that plans to use iron ore from Cameroon, while the Qatar Investment Authority, the gas-rich state’s sovereign wealth fund, is now Glencore’s second-biggest shareholder... With Gulf nations raking in $400bn of fossil fuel revenues annually, but facing a future where hydrocarbons will be phased out, expanding into mining is a logical step... For resource-rich nations in Africa, Asia and Latin America, the entrance of these middle powers into the critical minerals battleground is a welcome alternative to decades of exploitative arrangements underpinned by either western colonialism or Chinese debt... These nations believe that selling to Gulf states can help sidestep tension between the US and China over their copper, iron ore and lithium — resources the two powers need to electrify their economies...

But Gulf investment also comes with risk, industry insiders warn. Sovereign wealth can bring opacity and complexity when what mining projects and local communities desperately need is more accountability and transparency. Despite this, Washington has welcomed the Gulf’s expanding role in mining for helping to break Beijing’s monopoly over processing critical minerals. The US has been actively brokering Saudi, Emirati and Qatari investment in riskier jurisdictions, such as the Democratic Republic of Congo, where western companies struggle to enter, in order to keep China out, according to executives from mining companies and trading houses, as well as a senior US government official. For international mining groups also seeking to navigate US-China tensions over natural resources, the Middle East offers a neutral venue for minerals processing, capital and corporate headquarters.

Their investment strategy mirrors that of China

Saudi Arabia aims to secure copper, iron ore, lithium and nickel from overseas for processing domestically through Manara Minerals, a joint venture established last year between state mining group Ma’aden and the Public Investment Fund. In return for minority investments into established operations run by blue-chip companies such as BHP and Rio Tinto, it aims to receive metals supply — a model Japanese trading houses have successfully deployed for decades... The emirate of Dubai, a key precious metals trading hub, already has a large foothold in Africa’s ports and logistics network, the fortunes of which are closely tied to commodities. Dubai government-owned DP World has won port concessions in DRC and most recently Tanzania’s Dar es Salaam, a crucial shipping juncture for copper from Zimbabwe and Zambia... Much like the Chinese, the Gulf states are promising resource-rich nations an investment package centred around mining; Zambia expects the UAE to invest in agriculture, tourism and energy.

The development - climate change mitigation conflict - case of Guyana

I have written on multiple occasions arguing that developing countries have to navigate a development trajectory that has to constantly reconcile the often conflicting imperatives of promoting economic growth and limiting climate change. 

Gaiutra Bahadur in the NYT has an excellent long read on how Guyana is forced to confront this challenge.

Before oil, outsiders mostly came to Guyana for eco-tourism, lured by rainforests that cover 87 percent of its land. In 2009, the effort to combat global warming turned this into a new kind of currency when Guyana sold carbon credits totaling $250 million, essentially promising to keep that carbon stored in trees… Six years later, Exxon Mobil discovered a bounty of oil under Guyana’s coastal waters. Soon the company and its consortium partners, Hess and the Chinese National Offshore Oil Corporation, began drilling with uncommon speed… The find is projected to become Exxon Mobil’s biggest revenue source by decade’s end. The deal that made it possible — and which gave Exxon Mobil the bulk of the proceeds — has been a point of public outcry and even a lawsuit, with a seeming consensus that Guyana got the short end of the stick. But the deal has nonetheless generated $3.5 billion so far for the country, more money than it has ever seen, significantly more than it gained from conserving trees. It’s enough to chart a new destiny.

The government has decided to pursue that destiny by investing even further in fossil fuels. Most of the oil windfall available in its treasury is going to construct roads and other infrastructure, most notably a 152-mile pipeline to carry ashore natural gas, released while extracting oil from Exxon Mobil’s fields, to generate electricity. The pipeline will… carry the gas to a proposed power plant and to a second plant that will use the byproducts to potentially produce cooking gas and fertilizer. With a price tag of more than $2 billion, it’s the most expensive public infrastructure project in the country’s history… The country has already been transformed. Next to its famously elegant but decaying colonial architecture, new houses, hotels, malls, gyms and offices of concrete and glass crop up constantly. Trucks carrying quartz sand for all this construction judder along the highways. While nearly half of Guyanese still live below the poverty line, the country is bustling with possibility, and newcomers arrive from around the world.

And all the trappings of modernity and capitalist growth, with their good and bad, have been quick to arrive.

Oil has created a Guyana with pumpkin spice lattes. The first Starbucks store appeared outside the capital last year; it was such a big deal that the president and the American ambassador attended the opening. People still “lime” — hang out — with local Carib beer and boomboxes on the storied sea wall, but those with the cash can now go for karaoke and fancy cocktails at a new Hard Rock Cafe… Hyperinflation has made fish, vegetables and other staples costlier, and many Guyanese feel priced out of pleasures in their own country. A new rooftop restaurant, described to me as “pizza for Guyana’s 1 percent” by its consultant chef from Brooklyn, set off a backlash on social media for serving a cut of beef that costs $335, as much as a security guard in the capital earns in a month.

This aspirational consumerist playground is grafted onto a ragged infrastructure. Lexus S.U.V.s cruise new highways but must still gingerly wade through knee-deep floods in Georgetown when it rains, thanks to bad drainage. Electricity, the subject of much teeth-sucking and dark humor, is expensive and erratic. It’s also dirty, powered by heavy fuel, a tarlike residue from refining oil. In 2023, 96 blackouts halted activity across the country for an average of one hour each. A growing number of air-conditioners taxing aging generators are partly to blame… The country’s larger companies — makers of El Dorado rum, timber producers — generate their own electricity outside the power grid. Small companies, however, don’t have that option… The government’s investment in a natural gas pipeline and power plant offers the prospect of steady and affordable power. The gas, a byproduct of Exxon Mobil’s drilling, tends not to be commercialized and is often flared off as waste, emitting greenhouse gases in the process.

All this is happening even as Guyana appears to be Ground Zero in the fight against climate change.

At the same time, climate change laps at Guyana’s shores; much of (capital) Georgetown is projectedto be underwater by 2030. 

Countries like Guyana are forced to assume the responsibility of tackling a crisis that they did nothing to create, and that too by foregoing a rare opportunity to follow the same economic growth strategy that all others who developed before them zealously pursued.

Countries like Guyana are caught in a perfect storm where the consequences for extracting fossil fuels collide with the incentives to do so. Unlike wealthy countries, they aren’t responsible for most of the carbon emissions that now threaten the planet… the Biden administration approved drilling in the Alaska wilderness just last year, and the United States is producing more oil than ever in its history. A country like Guyana, with an emerging economy, has even more reason to jump at temptation…

How can wealthy countries be held to account for their promises to move away from fossil fuels? Can the institutions of a fragile democracy keep large corporations in check? And what kind of future is Guyana promising its citizens as it places bets on commodities that much of the world is vowing to make obsolete?

Amidst all this, we are not even talking about the political economy challenges and historical legacies that countries like Guyana have to confront when exposed to such resource windfalls.

The potential for the petroleum boom to implode is in plain sight next door, where Venezuela — which has recently resurrected old claims to much of Guyana’s territory — is a mess of corruption, authoritarian rule and economic volatility. For centuries, foreign powers set the terms for this sliver of South America on the Atlantic Ocean. The British, who first took possession in 1796, treated the colony as a vast sugar factory. They trafficked enslaved Africans to labor on the plantations and then, after abolition, found a brutally effective substitute by contracting indentured servants, mainly from India… Fifty-seven years ago, the country shook off its imperial shackles, but genuine democracy took more time. On the eve of independence, foreign meddling installed a leader who swiftly became a dictator. Tensions between citizens of African and Indian descent, encouraged under colonialism, turned violent at independence and set off a bitter contest for governing supremacy that continues to this day. Indigenous groups have been courted by both sides in this political and ethnic rivalry. 

It wasn’t until the early 1990s that Guyana held its first free and fair elections. The moment was full of possibility. The institutions of democracy, such as an independent judiciary, began to emerge. And the legislature passed a series of robust environmental laws. Now that Exxon Mobil has arrived to extract a new resource, some supporters of democracy and the environment see those protections as endangered. They criticize the fossil-fuel giant, with global revenue 10 times the size of Guyana’s gross domestic product, as a new kind of colonizer and have sued their government to press it to enforce its laws and regulations.

The article vividly brings out the challenges faced by developing countries as they grapple with the often conflicting goals of development and climate change mitigation. 

Consider the context. 

Notwithstanding the several political economy challenges and less-than-promising historical precedents, Guyana has the rare generational opportunity to leapfrog into a higher development trajectory. If it misses this bus, there’s an even chance that the country will remain stuck or at best marginally improve on its current stage of development. Further, in any case, if Guyana is to reach the status of even a middle-income country in a reasonable time, even with the least carbon intensity growth, its aggregate emissions will inevitably rise several-fold. 

In relative terms, countries like Guyana have done next to nothing to create the environmental disaster that threatens humanity. The gains from its mitigation efforts, even if it forego oil drilling, would pale into insignificance when compared with the gains from comparable mitigation efforts in developed countries and the opportunity cost of national economic development. Imagine consumers in developed countries giving up on SUVs or steep cuts in private air charter flights.

I’m reminded of Larry Summers’ famous internal World Bank memo where he made the theoretically sound argument that polluting industries should be relocated to developing countries given their lower marginal cost of negative externalities. Summers should now be asked why he’s not performing an encore to reverse his argument on emission reductions by highlighting the much higher marginal welfare loss per unit of emission reduction for developing economies. 

All this means that advanced countries must keep reducing their emissions much faster than developing countries are increasing their carbon footprints. In fact, given the climate change realities imposed by the accumulated stock and flow of emissions share of developed countries, the sustainable boundaries of growth and income-level status for developing countries are today dictated by the pace of emission reductions by developed countries. 

But it looks very unlikely that the developed countries will even remotely closely adhere to their part of the bargain. As the recent trends with fossil fuel exploration and production in Europe and the US show, even as developing countries are forced into assuming their climate change responsibilities, the developed economies continue to pursue business as usual where economic incentives prevail or where the political economy constraint is very strong. Besides, they have been unwilling collectively as economies or societies to make the hard choices that can make a meaningful dent in climate change mitigation. 

Will Western policymakers enact policies to make their consumers give up high carbon footprint wants (as against needs)? Would advanced economy societies be able to mobilise and create new norms that reduce consumption of items with high carbon emissions, even at the cost of popular conveniences and lifestyles? Would the political economy in developed economies allow the subordination of corporate financial incentives to climate change mitigation? Would advanced country governments be able to meet even their current meagre commitments, much less multiply them, to support developing countries in climate change adaptation? 

If we read the tea leaves today and even with an optimistic assessment of the future trends in these countries, I’m not hopeful of any of these happening in any significant enough manner for the foreseeable future. Unless there are persisting shocks (like Covid 19) which make everyone face up to reality. 

In these circumstances, it’s wishful thinking to hope that Guyana and other developing countries where a large the major share of people are struggling with subsistence challenges will be able to somehow magically surmount domestic opposition, pass over their development opportunities in the name of climate change mitigation, and assume disproportionately greater economic costs than the developed countries.

Does an all equity long-term protfolio trump all else?

I have blogged here and here about the strong likelihood of a general trend of secular decline and stagnation of interest rates. This raises questions about the investment strategies of pension funds, which had taken a big hit from the long period of ultra-low interest rates. 

A recent FT article points to multiple interesting links on the issue. A paper by academics from US universities looked at how a typical couple starting to save at 25 can hit three critical targets - amassing as much money as possible for retirement at 65, providing financial security through retirement, and leaving a bequest for the next generation. Their finding:

We challenge two central tenets of lifecycle investing: (i) investors should diversify across stocks and bonds and (ii) the young should hold more stocks than the old. An even mix of 50% domestic stocks and 50% international stocks held throughout one’s lifetime vastly outperforms age-based, stock-bond strategies in building wealth, supporting retirement consumption, preserving capital, and generating bequests. These findings are based on a lifecycle model that features dynamic processes for labor earnings, Social Security benefits, and mortality and captures the salient time-series and cross-sectional properties of long-horizon asset class returns. Given the sheer magnitude of US retirement savings, we estimate that Americans could realize trillions of dollars in welfare gains by adopting the all-equity strategy.

The graphics below capture the monthly real returns (geometric mean return and standard deviation of return) for domestic stocks, international stocks, bonds, and bills for some countries. 

The FT article elaborates on the study findings, especially the counter-intuitive risk-return calculus. 

The study assumes that the hypothetical couple saves 10 per cent of gross income, and then starts off draining 4 per cent of those funds a year at retirement. If the money runs out, they rely on social security, which is based on the US model, as is longevity. On average, parking entirely in stocks produces some 30 per cent more wealth at retirement than stocks and bonds combined. To get the same cash pile at retirement, someone blending into bonds would need to save 40 per cent more than an all-stocks saver. That is striking, but not so surprising — stocks have beaten bonds, and bills, everywhere since 1900, as UBS’s recent long-term markets study noted. But the really odd bit concerns the chance of so-called ruin, or running out of funds in retirement. A portfolio that bulks up in bonds as we get older comes with a 17 per cent chance of ruin. For domestic equities, the risk is about the same. But a half-and-half strategy of domestic and international stocks produces an 8 per cent chance of ruin.

The UBS long-term returns report mentioned above has some very interesting snippets. The UBS database, constructed by Elroy Dimson, Paul Marsh, and Mike Staunton (DMS for short), covers stocks, bonds, bills, inflation, and currencies for 35 economies (124-year histories for 23 of them, and over 50 years for the remaining 12). It’s complemented by 12 to 48-year histories for another 55 countries. The Indian database is since 1953, or 71 years. The report has several graphics capturing the evolution of equity market shares across countries, returns on various asset categories etc. 

The report shows that in the long-run since 1900, equities have outperformed bonds and bills in every country. However, since the 1980s, bonds have been providing equity-like returns. It highlights that the majority of long-run asset returns are earned during easing cycles, a stage where central banks stand today. 

The report documents the geographical shares of equity markets. Compared to continental Europe (Amsterdam in 1608 and London in 1698), trading in marketable securities began in New York only in 1792. However, the US emerged as the biggest equity market at the turn of 1900 and took off in the 1920s. It’s interesting that in the second half of the eighties, the market capitalisation of Japanese equities surpassed the US, only for a very quick return to the norm by the end of the nineties. At its peak, start-1989, Japan accounted for 40% of global index, compared to 29% for the US. Today though the shares are 6% and 60.5% respectively.

The report notes an interesting paradox - the relative underperformance of high GDP growth markets compared to the lower-growth US market. The most striking illustration of this is China compared to the US.

As an endnote from the excellent UBS report, this is a striking snippet that captures how many of the salient aspects of today’s lives are such a recent phenomenon in the long-view of things.

At the start of 1900 – the start date of our global returns database – virtually no one had driven a car, made a phone call, used an electric light, heard recorded music, or seen a movie; no one had flown in an aircraft, listened to the radio, watched TV, used a computer, sent an e-mail, or used a smartphone. There were no x-rays, body scans, DNA tests or transplants, and no one had taken an antibiotic; many died young as a result. Mankind has enjoyed a wave of transformative innovation dating from the Industrial Revolution, continuing through the Golden Age of Invention in the late 19th century, through to today’s information revolution. This has given rise to entire new industries: electricity and power generation, automobiles, telecommunications, aerospace, airlines, pharmaceuticals and biotechnology, oil, gas and alternative energy, computers, information technology, and media and entertainment…

Markets at the beginning of the 20th century were dominated by railroads, which accounted for 63% of US stock market value and almost 50% in the UK. 124 years later, railroads have declined almost to the point of stock-market extinction, representing less than 1% of the US market and close to zero in the UK. Of the US firms listed in 1900, some 80% of their value was in industries that are small or extinct today; the UK figure is 65%. Besides railroads, other industries that have declined precipitously are textiles, iron, coal and steel. These industries still exist but have largely moved to lower-cost locations in the emerging world. Yet similarities between 1900 and 2024 are also apparent. The banking and insurance industries continue to be important. Similarly, such industries as food, beverages (including alcohol), tobacco, and utilities were present in 1900 and continue to be represented today… within industrials, the 1900 list of companies includes the world’s then-largest candle maker and largest manufacturer of matches.

The report strikes a cautionary note on writing off traditional industries and their substitution with new and emerging technologies.

For example, we noted above that, in stock-market terms, railroads have been the ultimate declining industry in the US in the period since 1900. Yet, over the last 124 years, railroad stocks have beaten the US market, and outperformed both trucking stocks and airlines since these industries emerged in the 1920s and 1930s. Indeed, the research in the 2015 Yearbook indicated that, if anything, investors may have placed too high an initial value on new technologies, overvaluing the new and undervaluing the old.

The report is very good and has several interesting graphics. Unfortunately restrictions on reproduction without “explicit written permission” prevent me from posting more of the graphics.