The NYT reports that economists are baffled by the ever-widening disparity between the actual cash market prices of foodgrains like corn, soyabeans and wheat, and their prices in the derivatives market. The anomalies are occurring between the price of a bushel of grain in the cash market and the price of that same bushel of grain, as determined by the expiration price of a futures contract traded in Chicago. This gives the illusion of two prices for the same good at the same place and time.
The problem is something like this. Futures contracts are important hedging tools for farmers, grain elevators, commodity processors and anyone with a stake in future grain prices. A futures contract that calls for delivery of wheat in July may trade for more or less for each bushel than today’s cash market price. But as each day goes by, its price should move a bit closer to that day’s cash price. And on expiration day, when the bushels of wheat covered by that futures contract are due for delivery, their price should very nearly match the price in the cash market, allowing for a little market friction or major delivery disruptions like Hurricane Katrina. But on dozens of occasions since early 2006, the futures contracts for corn, wheat and soybeans have expired at a price that was much higher than that day’s cash price for those grains.
The most credible explanation for these anomalies relate to the role of hedge funds, pension funds and index funds, who are distorting futures prices by pouring in so much money without regard to market fundamentals.
Commodity prices world wide have been surging to unprecedented levels. Speculative investors see commodities as a safer and high return investment opportunity and accordingly a bubble has been building up in commodities based derivatives. An irrational exuberance in commodities have also bidded up the prices of these derivative contracts, way beyond even the actual market prices. Many of these speculative investors are holding huge quantities of long positions on these contracts, in anticipation of further rise prices.
As has been well documented by behavioural literature, these holders of long positions are often reluctant to wind down their holdings, even in the face of lower actual market prices. This maintains a disparity in the derivatives market and cash market prices of the same commodity. This disparity may thus be a reflection of the under-developed nature of the arbitrage or carry trade market, which takes advantage of this mis-pricing. My guess is that once this market becomes more liquid and more players get in, the mis-pricings will get arbitraged away and disappear.
Another interesting phenomenon, brought out by the NYT in this article relates to the rising price of rice. This is in direct contrast to the aforementioned two price phenomenon, and is a testimony to the power of globalization in ushering in a global market place.
About the reasons for the steep rice in global rice prices, it writes, "Rising affluence in India and China has increased demand. At the same time, drought and other bad weather have reduced output in Australia and elsewhere. Many rice farmers are turning to more lucrative cash crops, reducing the amount of land devoted to the grain. And urbanization and industrialization have cut into the land devoted to rice cultivation... Until the last few years, the potential for rapid price swings was damped by the tendency of many governments to hold very large rice stockpiles to ensure food security. But those stockpiles were costly to maintain. So governments have been drawing them down as world rice consumption has outstripped production for most of the last decade."
Unlike many other food grains, rice consuming countries are mostly self sufficient, and only 7% of the global rice production is traded across international borders each year. The sharp increase in prices, despite the relatively small quantities traded clearly indicates two things - a tight market, and more importantly, a fairly integrated global market in rice trade.
From the price rises across the world, it is obvious that the domestic rice market has become closely integrated with each other and with the market in global trade. Further, the relatively small quantities traded across borders, combined with small stockpiles, now mean that prices can move quickly in response to supply disruptions. The commodity contract speculators may have exacerbated the problems by artificially boosting the demand.
Interestingly, in both cases, one where the arbitrage market was not fully developed, and another where the market had become closely integrated, the impact has been extreme - lower prices for farmers in the former and higher price for consumers in the later.
Update 1
NYT has an article explaining the drought triggered shift away from water intensive rice to more profitable wine grapes. The six long years of drought has reduced Australian rice production by 98%. Even in normal times, little of the world’s rice is actually exported — more than 90 percent is consumed in the countries where it is grown. In the last quarter-century, rice consumption has outpaced production, with global reserves plunging by half just since 2000. A plant disease is hurting harvests in Vietnam, reducing supply. And economic uncertainty has led producers to hoard rice and speculators and investors to see it as a lucrative or at least safe bet.
Monday, March 31, 2008
Friday, March 28, 2008
Incentives in Elections
The logic in this post is slightly vague at at a few places. Though I am still searching for a few answers, I am convinced there are ways out. But it flags off an important dimension to future electoral reform policies.
It is commonplace in even informed circles to attribute all the ills facing our country to politicians. The middle class see the ubiquitous politician as the embodiment of all that is bad about our political system. They are perceived as corrupt, venal, rapacious in their plunder of the public resources, prevent honest officers from discharging their duties, and so on. My very firm belief is that this may be a very simplified and uncharitable judgement, which overlooks the incentives and disincentives facing a politician.
I shall assume that a politician is a rational economic agent, out to maximize his objectives. Edmund Burke famously said, "The duty of a politician is to win elections". A politician is therefore driven by the ultimate objective of winning over his electorate. This remains true even today and is the fundamental choice facing any politician. To this, we may also add that the politician also faces ample incentives to make money.
I will outline two broad strategies that can be applied to winning elections. There may be variants between Strategy I and Strategy II, but a typical electoral strategy falls somewhere in between the two. Strategy I is the regular stereotype of how a candidate fights elections.
Strategy I : The politician offers inducements or allurements like liquor or cash to win over the voter. Though the typical candidate spends a fortune in such transactions, these inducements are transitory. Even after spending this money, he is not sure of bagging the vote, since his oppponent can pay a little more and outbid him. There is a very real danger of the candidate losing his money and the election too.
Strategy II : In contrast, if the politician fulfills an important felt-need of the village, say a school building or drinking water bore or distribution line, the villagers feel gratified and owe him a debt. This translates into a more enduring and stronger relationship between the politician and the voters in the village. There is a greater probability of them voting for him than if he had resorted to the first strategy. Apart from striking a more durable contract with his voters, the politician benefits in two ways from this strategy.
1. He saves the huge amount he would otherwise have had to spend in buying off his voters.
2. He also pockets his share of commission from the contract awarded to execute the engineering work.
Quite often, this strategy runs into trouble as the executive machinery and administration are not able to deliver on the promise. At other times, the work executed is of very poor quality, and the school building develops leaks after six months. In both cases, the politician gets disrepute and loses his electoral appeal. He is then left with no choice but to return to his original strategy of buying off his electors. Therefore it needs to be kept in mind that the officials and the administration plays a critical role in helping or failing the political representative.
As can be seen, Strategy II is easily more beneficial to the incumbent. He can have the best of both worlds - minimize his expenditure, and increase his chances of victory. But implementing Strategy II requires the support of the bureaucratic and administrative machinery, who are responsible for delivering on the promises made by the politician. This is in turn gives them an incentive for posting capable officials (who are more likely to be reasonably honest) in important positions, thereby reducing cronyism and its attendent corruption.
What are the objections? The major argument against Strategy II is that it always favors the incumbent. Further, since the opposing candidates cannot use this approach, they fall back on Strategy I. Behavioural economists have documented that people tend to forget older gains and be more attracted to the latest gains (since cash and liquor inducements are made just before the voting process). Further, they also acknowledge personal gains more than social or civic gains. This makes the incumbent wary of the inducements offered by his opponents. There is therefore an unstable equilibrium about this arrangement. If the incumbent finds that his opponent gaining ground by resporting to unscrupulous vote buying strategies, he may be forced to defect.
The response to this objection is two-fold. One, if the incumbent is able to fulfill the felt needs of his electorate, then he surely deserves to be re-elected. After all, the whole process of democratic elections is to find out the candidate who can deliver on his promises. If we have a candidate who is able to deliver on his promises, which are in turn reflection of the electoral demands, then where is the need for a replacement? For any opposing candidate to succeed, he has to possess attributes and faith of his electorate that are superior to that possessed by the incumbent.
Two, the opponents should also adopt the same strategy as the incumbent and become rational agents. They should identify the most important felt-need of the village or locality, and make its fullfillment one of their major poll planks. They now benefit from the same advantages as the incumbent - saving the money spent buying voters and rents from contractors. Further, the opponent even gains an advantage over the incumbent, in that he is now promising something which the incumbent failed to deliver. All this will also incentivize candidates, especially in local body elections, to focus on important local issues and needs, thereby making elections more meaningul and issue oriented. And there are no shortage of important felt-needs in every area or village, for all candidates to espouse.
The benefits of such competitive populism on the society and polity are enormous. The challenge now is to make the politician a rational economic agent and get them to abandon Strategy I and adopt Strategy II! Or in other words, get all candidates to play the same game and not defect! More of this in a later post.
It is commonplace in even informed circles to attribute all the ills facing our country to politicians. The middle class see the ubiquitous politician as the embodiment of all that is bad about our political system. They are perceived as corrupt, venal, rapacious in their plunder of the public resources, prevent honest officers from discharging their duties, and so on. My very firm belief is that this may be a very simplified and uncharitable judgement, which overlooks the incentives and disincentives facing a politician.
I shall assume that a politician is a rational economic agent, out to maximize his objectives. Edmund Burke famously said, "The duty of a politician is to win elections". A politician is therefore driven by the ultimate objective of winning over his electorate. This remains true even today and is the fundamental choice facing any politician. To this, we may also add that the politician also faces ample incentives to make money.
I will outline two broad strategies that can be applied to winning elections. There may be variants between Strategy I and Strategy II, but a typical electoral strategy falls somewhere in between the two. Strategy I is the regular stereotype of how a candidate fights elections.
Strategy I : The politician offers inducements or allurements like liquor or cash to win over the voter. Though the typical candidate spends a fortune in such transactions, these inducements are transitory. Even after spending this money, he is not sure of bagging the vote, since his oppponent can pay a little more and outbid him. There is a very real danger of the candidate losing his money and the election too.
Strategy II : In contrast, if the politician fulfills an important felt-need of the village, say a school building or drinking water bore or distribution line, the villagers feel gratified and owe him a debt. This translates into a more enduring and stronger relationship between the politician and the voters in the village. There is a greater probability of them voting for him than if he had resorted to the first strategy. Apart from striking a more durable contract with his voters, the politician benefits in two ways from this strategy.
1. He saves the huge amount he would otherwise have had to spend in buying off his voters.
2. He also pockets his share of commission from the contract awarded to execute the engineering work.
Quite often, this strategy runs into trouble as the executive machinery and administration are not able to deliver on the promise. At other times, the work executed is of very poor quality, and the school building develops leaks after six months. In both cases, the politician gets disrepute and loses his electoral appeal. He is then left with no choice but to return to his original strategy of buying off his electors. Therefore it needs to be kept in mind that the officials and the administration plays a critical role in helping or failing the political representative.
As can be seen, Strategy II is easily more beneficial to the incumbent. He can have the best of both worlds - minimize his expenditure, and increase his chances of victory. But implementing Strategy II requires the support of the bureaucratic and administrative machinery, who are responsible for delivering on the promises made by the politician. This is in turn gives them an incentive for posting capable officials (who are more likely to be reasonably honest) in important positions, thereby reducing cronyism and its attendent corruption.
What are the objections? The major argument against Strategy II is that it always favors the incumbent. Further, since the opposing candidates cannot use this approach, they fall back on Strategy I. Behavioural economists have documented that people tend to forget older gains and be more attracted to the latest gains (since cash and liquor inducements are made just before the voting process). Further, they also acknowledge personal gains more than social or civic gains. This makes the incumbent wary of the inducements offered by his opponents. There is therefore an unstable equilibrium about this arrangement. If the incumbent finds that his opponent gaining ground by resporting to unscrupulous vote buying strategies, he may be forced to defect.
The response to this objection is two-fold. One, if the incumbent is able to fulfill the felt needs of his electorate, then he surely deserves to be re-elected. After all, the whole process of democratic elections is to find out the candidate who can deliver on his promises. If we have a candidate who is able to deliver on his promises, which are in turn reflection of the electoral demands, then where is the need for a replacement? For any opposing candidate to succeed, he has to possess attributes and faith of his electorate that are superior to that possessed by the incumbent.
Two, the opponents should also adopt the same strategy as the incumbent and become rational agents. They should identify the most important felt-need of the village or locality, and make its fullfillment one of their major poll planks. They now benefit from the same advantages as the incumbent - saving the money spent buying voters and rents from contractors. Further, the opponent even gains an advantage over the incumbent, in that he is now promising something which the incumbent failed to deliver. All this will also incentivize candidates, especially in local body elections, to focus on important local issues and needs, thereby making elections more meaningul and issue oriented. And there are no shortage of important felt-needs in every area or village, for all candidates to espouse.
The benefits of such competitive populism on the society and polity are enormous. The challenge now is to make the politician a rational economic agent and get them to abandon Strategy I and adopt Strategy II! Or in other words, get all candidates to play the same game and not defect! More of this in a later post.
Wednesday, March 26, 2008
Town Planning in our cities
The Town Planning wing in any Municipal Corporation is like the perennial whipping dog, most often rightly so and many times for the not so right reasons. Nearly half the complaints received by the VMC through its 103 complaint redressal system relates to Town Planning. The commonest complaints include illegal and unregulated constructions, road and public space encroachments, hawkers menace, inadequate enforcement of zoning and usage regulations, irregular and unauthorised parking, and even property disputes between private individuals. The one common factor with all these violations is that they are so commonplace, and herein lies the problem.
Vijayawada has an area of 60 sqkm, population of 12-15 lakhs (depending on where you draw the stats from), and 1.75 lakh houses. There are exactly 8 Building Inspectors, or 1 per 7.5 sq km or 1 per 22,000 structures, supervising all the town planning activites on the field. The entire VMC Town Planning Division, including the City Planner and office staff, is only 23. The situation is no different elsewhere. And, this regulatory work is only a small proportion of their regular Town Planning work.
Now, given all these numbers, it does not require any great insight to conclude that it is impossible to enforce the kind of aforementioned complaints with such thin field presence. The major portion of such complaints are commonplace, routine and regular in nature and large in number, and can be controlled (if ever they can be) only by focussed personal inspections and vigilance. The problem is compounded by the exasperatingly tortuous bureaucratic and legal process/hurdles involved in rectifying such deviations or violations.
I will list out a few of the most commonly cited violations of town planning regulations.
1. Every (sic) construction in our cities have deviations. It has almost become the norm to extend cantilever and balconies beyond the permissible setbacks and illegally expand the floor area. Many owners deviate from the plans during construction and add more rooms. A smaller proportion of houses indulge in major deviations like converting a part of the authorised parking area into housing units, or adding an extra floor.
I am convinced that this happens because the house owners try to maximize their floor area by occupying beyond the permissible setbacks. The fantastically huge land values and building lease rents, means that individuals find the financial incentives for deviating too attractive to be given up. This is likley to remain so irrespective of the penalties imposed.
2. Many road side houses encroach into the road margins by either constructing walls or structures. This is a common practice, resorted to by more well off, and can be again traced back to the huge land values. In other areas, where the roads are at a lower level, the house owners construct ramps into the road, thereby encroaching on road space.
3. Most of the shops have no parking and their customers use the road margins for parking. Our policies do nothing to incentivize the shops, but transfers the parking costs to the customers. The same is true with smaller houses, where there is no strict requirement for parking space. The presence of small and fragmented plots, and the presence of multiple tenants in these houses, means that internal street roads get converted as parking lots.
4. With apartment fees being much higher than that for individual houses, many builders find it highly remunerative to take plans for G+2 or G+3 individual house and then illegally convert them into multi-unit house.
5. Most our internal roads have adequate width and support the Master Plan requirements. The problem arises from the presence of encroachments - hawkers, parking, and construction - that reduces the carriage way available for traffic.
6. Lip service is paid regarding enforcement of land use regulations. Commercial activities and shops spring up overnight in every location, without any required permissions, in total disregard for the areas' land use specifications. In fact, houses are constructed with the specific objective of converting some portion into a shop.
Surprisingly, there is a very high degree of tolerance for such activities among citizens. In many cases, it goes beyond tolerance and involves a tacit local accommodation among all the stakeholders. In fact, the overwhelmingly major proportion of town planning complaints come because of personal disputes between parties and rarely out of civic concerns. That very few complaints come due to genuine civic concerns is surprising since none of these activities can be done without the knowledge of the neighbours. This is not to underplay the regulatory duties and responsibilities of Town Planning wing and exonerate their lapses and corruption.
On the demand side, the incentives favoring deviations are substantial. This becomes especially so, in light of the rocketing land and rental values, which place a premium on utilizing every available vacant land and every possible floor space. A typical appartment can increase the floor space in each unit by a quarter, simply by extending the balcony projections to 4-6 ft beyond the pillars. The builder saves a significant amount by evading the building fees for this excess floor space, and pases on some share of this benefit to the buyer. The Town Planning Building Inspector, too gains his regular share of rent, for turning a blind eye to this deviation. Every individual stakeholder benefits in this arrangement, though the society collectively suffers the consequence.
All the aforementioned activities, that take place in violation of town planning regulations are classic examples of negative externalities. I have already written about them in previous posts. The incentives for such activities are very high because of the massive stakes and benefits gained by indulging in them. Such unauthorised activities take place because the individuals benefit substantially at a very small cost of being detected and punished, and share only a very small portion of the social costs inflicted by their actions.
These things cannot, repeat cannot, be physically policed without the presence of large field supervision. And I am not sure such supervision is the most desirable option, because it has other more debilitating dimensions and is not sustainable. For example, it is likely to increase the avenues for corruption. As long as demand side inclinations to deviate remains very strong, no amount of regulatory interventions can help.
We have a problem where practically everyone (and this is true) violates building rules, and many of these rules no longer have the sanctity. This is the surest indicator that there is something amiss with the rules. There is therefore a strong case in favor of simplifying and liberalizing these rules, so as to focus only on the important objectives of building regulation. Preventing negative externalities would be a good touchstone for filtering building rules - parking, inconveniencing neighbours, easier land use conversions etc. The more long term and sustainable way of addressing such deviations is to create a climate of civic intolerance for such violations and deviations. More on these in a later post.
But like the low voter turnouts in elections, such problems suffer from the "tragedy of commons". Every citizen thinks his neighbour will take the initiative and make the complaint and he can enjoy the free ride!
Vijayawada has an area of 60 sqkm, population of 12-15 lakhs (depending on where you draw the stats from), and 1.75 lakh houses. There are exactly 8 Building Inspectors, or 1 per 7.5 sq km or 1 per 22,000 structures, supervising all the town planning activites on the field. The entire VMC Town Planning Division, including the City Planner and office staff, is only 23. The situation is no different elsewhere. And, this regulatory work is only a small proportion of their regular Town Planning work.
Now, given all these numbers, it does not require any great insight to conclude that it is impossible to enforce the kind of aforementioned complaints with such thin field presence. The major portion of such complaints are commonplace, routine and regular in nature and large in number, and can be controlled (if ever they can be) only by focussed personal inspections and vigilance. The problem is compounded by the exasperatingly tortuous bureaucratic and legal process/hurdles involved in rectifying such deviations or violations.
I will list out a few of the most commonly cited violations of town planning regulations.
1. Every (sic) construction in our cities have deviations. It has almost become the norm to extend cantilever and balconies beyond the permissible setbacks and illegally expand the floor area. Many owners deviate from the plans during construction and add more rooms. A smaller proportion of houses indulge in major deviations like converting a part of the authorised parking area into housing units, or adding an extra floor.
I am convinced that this happens because the house owners try to maximize their floor area by occupying beyond the permissible setbacks. The fantastically huge land values and building lease rents, means that individuals find the financial incentives for deviating too attractive to be given up. This is likley to remain so irrespective of the penalties imposed.
2. Many road side houses encroach into the road margins by either constructing walls or structures. This is a common practice, resorted to by more well off, and can be again traced back to the huge land values. In other areas, where the roads are at a lower level, the house owners construct ramps into the road, thereby encroaching on road space.
3. Most of the shops have no parking and their customers use the road margins for parking. Our policies do nothing to incentivize the shops, but transfers the parking costs to the customers. The same is true with smaller houses, where there is no strict requirement for parking space. The presence of small and fragmented plots, and the presence of multiple tenants in these houses, means that internal street roads get converted as parking lots.
4. With apartment fees being much higher than that for individual houses, many builders find it highly remunerative to take plans for G+2 or G+3 individual house and then illegally convert them into multi-unit house.
5. Most our internal roads have adequate width and support the Master Plan requirements. The problem arises from the presence of encroachments - hawkers, parking, and construction - that reduces the carriage way available for traffic.
6. Lip service is paid regarding enforcement of land use regulations. Commercial activities and shops spring up overnight in every location, without any required permissions, in total disregard for the areas' land use specifications. In fact, houses are constructed with the specific objective of converting some portion into a shop.
Surprisingly, there is a very high degree of tolerance for such activities among citizens. In many cases, it goes beyond tolerance and involves a tacit local accommodation among all the stakeholders. In fact, the overwhelmingly major proportion of town planning complaints come because of personal disputes between parties and rarely out of civic concerns. That very few complaints come due to genuine civic concerns is surprising since none of these activities can be done without the knowledge of the neighbours. This is not to underplay the regulatory duties and responsibilities of Town Planning wing and exonerate their lapses and corruption.
On the demand side, the incentives favoring deviations are substantial. This becomes especially so, in light of the rocketing land and rental values, which place a premium on utilizing every available vacant land and every possible floor space. A typical appartment can increase the floor space in each unit by a quarter, simply by extending the balcony projections to 4-6 ft beyond the pillars. The builder saves a significant amount by evading the building fees for this excess floor space, and pases on some share of this benefit to the buyer. The Town Planning Building Inspector, too gains his regular share of rent, for turning a blind eye to this deviation. Every individual stakeholder benefits in this arrangement, though the society collectively suffers the consequence.
All the aforementioned activities, that take place in violation of town planning regulations are classic examples of negative externalities. I have already written about them in previous posts. The incentives for such activities are very high because of the massive stakes and benefits gained by indulging in them. Such unauthorised activities take place because the individuals benefit substantially at a very small cost of being detected and punished, and share only a very small portion of the social costs inflicted by their actions.
These things cannot, repeat cannot, be physically policed without the presence of large field supervision. And I am not sure such supervision is the most desirable option, because it has other more debilitating dimensions and is not sustainable. For example, it is likely to increase the avenues for corruption. As long as demand side inclinations to deviate remains very strong, no amount of regulatory interventions can help.
We have a problem where practically everyone (and this is true) violates building rules, and many of these rules no longer have the sanctity. This is the surest indicator that there is something amiss with the rules. There is therefore a strong case in favor of simplifying and liberalizing these rules, so as to focus only on the important objectives of building regulation. Preventing negative externalities would be a good touchstone for filtering building rules - parking, inconveniencing neighbours, easier land use conversions etc. The more long term and sustainable way of addressing such deviations is to create a climate of civic intolerance for such violations and deviations. More on these in a later post.
But like the low voter turnouts in elections, such problems suffer from the "tragedy of commons". Every citizen thinks his neighbour will take the initiative and make the complaint and he can enjoy the free ride!
Tuesday, March 25, 2008
Higher Education trends
Harvard University has finally taken the plunge, and it was only to be expected. In an industry/activity, where the quality of students is the primary determinant of success, it was not surprising that the University announced significant expansion of its aid coverage for undergraduate students. It is a belated acknowledgement of the fact that any University, even Harvard, is only as good as its students. And fortunately, economic background do not determine the quality of students! But the consequences of this shift are likely to be more profound.
Harvard's decision has led to a number of other richer Universities following suit in increasing aid and substituting grant for loans. The Universities claim that these efforts are aimed at making higher education more affordable and also clear the damaging perception that the elite Universities are going out of reach for all but the richest. But the real motivation may be the growing realization that high tution fees and other college costs are driving away many middle and even upper-middle class students from the elite Universities, in turn depleting the quality of these schools.
Harvard currently provides a free undergraduate education to students from families earning up to $60,000 a year. Under its new plan, families earning between $120,000 and $180,000 a year would pay only 10 percent of their incomes for tuition and fees on an education that is currently priced at more than $45,000 a year. More than 90 percent of American families would be eligible for this aid. More than half of all Harvard undergraduates will now have some form of scholarship. It would cut costs by a third to 50 percent for many students and make the real costs of attending Harvard comparable to those at major state universities. In fact, a Harvard degree will now be cheaper than degrees from many leading public universities.
The cost for the University with a $35 bn and rapidly growing endowment, thanks to the generous tax exemptions on their investments, is a miniscule $120 million, up from $ 98 million earlier. The Harvard management Company (HMC), which manages the University's endowment, made nearly $ 7 billion from its investment income in 2006-07, a 23% rate of return. (Former PIMCO ED, Mohamed A. El-Erian, heads the AMC)
In this context, it is important to highlight the most important development in US higher education since the early 1990s - spectacularly growing university endowments. Since then, universities have hired sophisticated money managers and moved their portfolios into hedge funds, private equities and other high-performing investments, resulting in skyrocketing endowments. This development has coincided with the decline in subsidies to public universities. The result has been the emergence of a sharp division among university endowments - fewer than 400 of the roughly 4,500 colleges and universities in the United States had even $100 million in endowments in 2007.
The market for higher education has certain unique characteristics, which set it apart from the regular forces of supply and demand. The quality of a school is dependent on the quality of its students and to a lesser extent on its instructors. It is therefore important for any University to widen its recruitment base, so as to be able to reach out to all the best and the brightest students. This in turn demands that entry barriers for such students are eliminated or atleast lowered. One of the more commonest ways of doing this is to incentivize them by offering fantastic aid packages, which competitors cannot match. Only Universities with deep pockets can play this game and succeed.
What are the likely consequences? In the short run, it is likely to make it more affordable for even the middle class students to access the elite Universities. But the more long run distortions possible are
1. Those high achieving students from less well-off backgrounds and therefore unable to afford the expensive elite universities, would have gone to the other colleges. But the generous aid packages attract them to the elite schools, thereby depleting the quality pool for the not so rich colleges. The already wide gap between the elite and the rest widens.
2. The tuition discounting to the middle and upper middle class in smaller universities could end up shifting financial aid from low-income students to wealthier, thereby making pricing seem even more arbitrary and creating pressures to raise full tuition to pay for all the assistance.
3. This will open up pressures on the universities to expand aid coverage to include even the wealthy high achieving students, thereby reducing the amount of aid available for the poorer. Aid will become an instrument for buying off the merit students, a practice openly flaunted by the numerous IIT and other professional courses training institutes in India.
4. Reduce the economic diversity of the student intake, thereby reducing the quality of the school. Donald E. Heller, director of the Center for the Study of Higher Education at Pennsylvania State University, says that "if Harvard’s new aid program encouraged more middle- and upper-middle-income students to apply, then the number of slots for low-income applicants in an entering class will probably decline."
5. In all likelihood, this trend will hasten the process of attracting the superstar instructors. Do not be surprised if the remuneration for the other critical determinant - superstar professors - too rockets up at a much larger rate in the coming years. Superstar professors are being courted by Universities by offering better pay and benefits and tenurial positions.
6. A distribution similar to private and public schools is likely to emerge in college education, with the best schools attracting the best students and the others left with the remaining. A self-reinforcing spiral of widening quality gap between the elites and the rest is set in motion. The increasing quality of students improves the quality of the elite universities, while the depleting quality of students lowers the quality of the rest.
7. A distinctly two-tier higher education system will emerge, with a set of elite universities having massive endowments, thriving and attracting the best, leaving but the crumbs for the rest.
The same trend is observed in India among training institutes for entrance examinations to the various professional courses like Engineering, IIT, Medicine, IAS, MBA etc. This trend can be gauged by the same names dominating the field every year. The well established reputation and the deep pockets of the major training institutes ensures that most of the good students join them, thereby imposing forbiddingly high entry barriers on new entrants. These institutions compete to woo the best students, even offering them financial incentives over and beyond full fee expemptions, thereby effectively buying them over. Simulataneously, they raise the fees on the remaining students, and rake in more profits.
Harvard's decision has led to a number of other richer Universities following suit in increasing aid and substituting grant for loans. The Universities claim that these efforts are aimed at making higher education more affordable and also clear the damaging perception that the elite Universities are going out of reach for all but the richest. But the real motivation may be the growing realization that high tution fees and other college costs are driving away many middle and even upper-middle class students from the elite Universities, in turn depleting the quality of these schools.
Harvard currently provides a free undergraduate education to students from families earning up to $60,000 a year. Under its new plan, families earning between $120,000 and $180,000 a year would pay only 10 percent of their incomes for tuition and fees on an education that is currently priced at more than $45,000 a year. More than 90 percent of American families would be eligible for this aid. More than half of all Harvard undergraduates will now have some form of scholarship. It would cut costs by a third to 50 percent for many students and make the real costs of attending Harvard comparable to those at major state universities. In fact, a Harvard degree will now be cheaper than degrees from many leading public universities.
The cost for the University with a $35 bn and rapidly growing endowment, thanks to the generous tax exemptions on their investments, is a miniscule $120 million, up from $ 98 million earlier. The Harvard management Company (HMC), which manages the University's endowment, made nearly $ 7 billion from its investment income in 2006-07, a 23% rate of return. (Former PIMCO ED, Mohamed A. El-Erian, heads the AMC)
In this context, it is important to highlight the most important development in US higher education since the early 1990s - spectacularly growing university endowments. Since then, universities have hired sophisticated money managers and moved their portfolios into hedge funds, private equities and other high-performing investments, resulting in skyrocketing endowments. This development has coincided with the decline in subsidies to public universities. The result has been the emergence of a sharp division among university endowments - fewer than 400 of the roughly 4,500 colleges and universities in the United States had even $100 million in endowments in 2007.
The market for higher education has certain unique characteristics, which set it apart from the regular forces of supply and demand. The quality of a school is dependent on the quality of its students and to a lesser extent on its instructors. It is therefore important for any University to widen its recruitment base, so as to be able to reach out to all the best and the brightest students. This in turn demands that entry barriers for such students are eliminated or atleast lowered. One of the more commonest ways of doing this is to incentivize them by offering fantastic aid packages, which competitors cannot match. Only Universities with deep pockets can play this game and succeed.
What are the likely consequences? In the short run, it is likely to make it more affordable for even the middle class students to access the elite Universities. But the more long run distortions possible are
1. Those high achieving students from less well-off backgrounds and therefore unable to afford the expensive elite universities, would have gone to the other colleges. But the generous aid packages attract them to the elite schools, thereby depleting the quality pool for the not so rich colleges. The already wide gap between the elite and the rest widens.
2. The tuition discounting to the middle and upper middle class in smaller universities could end up shifting financial aid from low-income students to wealthier, thereby making pricing seem even more arbitrary and creating pressures to raise full tuition to pay for all the assistance.
3. This will open up pressures on the universities to expand aid coverage to include even the wealthy high achieving students, thereby reducing the amount of aid available for the poorer. Aid will become an instrument for buying off the merit students, a practice openly flaunted by the numerous IIT and other professional courses training institutes in India.
4. Reduce the economic diversity of the student intake, thereby reducing the quality of the school. Donald E. Heller, director of the Center for the Study of Higher Education at Pennsylvania State University, says that "if Harvard’s new aid program encouraged more middle- and upper-middle-income students to apply, then the number of slots for low-income applicants in an entering class will probably decline."
5. In all likelihood, this trend will hasten the process of attracting the superstar instructors. Do not be surprised if the remuneration for the other critical determinant - superstar professors - too rockets up at a much larger rate in the coming years. Superstar professors are being courted by Universities by offering better pay and benefits and tenurial positions.
6. A distribution similar to private and public schools is likely to emerge in college education, with the best schools attracting the best students and the others left with the remaining. A self-reinforcing spiral of widening quality gap between the elites and the rest is set in motion. The increasing quality of students improves the quality of the elite universities, while the depleting quality of students lowers the quality of the rest.
7. A distinctly two-tier higher education system will emerge, with a set of elite universities having massive endowments, thriving and attracting the best, leaving but the crumbs for the rest.
The same trend is observed in India among training institutes for entrance examinations to the various professional courses like Engineering, IIT, Medicine, IAS, MBA etc. This trend can be gauged by the same names dominating the field every year. The well established reputation and the deep pockets of the major training institutes ensures that most of the good students join them, thereby imposing forbiddingly high entry barriers on new entrants. These institutions compete to woo the best students, even offering them financial incentives over and beyond full fee expemptions, thereby effectively buying them over. Simulataneously, they raise the fees on the remaining students, and rake in more profits.
Monday, March 24, 2008
Inflation and growth concerns in India
Two sets of recently released figures on the economy - the Index of Industrial Production (IIP) and inflation - have set off an interesting debate about the direction of our monetary policy. The RBI has become caught between the never ending debate about making a trade-off between inflation and growth.
Recently released CSO data on the IIP indicates that industrial growth decelerated in January 2008 to 5.3%, compared to 11.6% for January 2007. The biggest hit was taken by the two critical engines of industrial and consequently economic growth - consumer durables and capital goods. While the former fell 3.1% ( a rise of 5.3% in Jan 2007), the later rose a mere 2.1% (16.3% in Jan 2007) for the month of January 2008. However, Fast Moving Consumer Goods (FMCG, consumer non durables), exhibited a 10.1% growth in January, compared to 9.1% last year. Food products, beverages, tobacco etc showed double digit growth. The growth rate of the core infrastructure industries group - crude petroleum, petroelum refinery products, coal, cement, electricity and steel - which has a 26.7% weightage in the overall IIP fell from 4.2%in January, compared to to 8.3% in January 2007.
Wholesale Price Index (WPI) had already begun to breach the self-imposed year-on-year 5% tolerance level in the third week of February and continues to rise. WPI based inflation rate breached the critical 5% mark to close at 5.11% for the week eneded March 1, 2008, the highest in over nine months. It further rose to 5.92% when the latest figures were relased for the week ended March 8, 2008, to reach teh highest figuresince May 7, 2007. The prices for cereals increased 6.28%, for milk 9.71%, vegetables 9.79%, dairy products 9.31%, cement 5.13%, iron and steel 20.87%, and edible oils 17.52%.
There are many reasons to doubt that the drop in capital goods is not part of any long term trend. For a start, statistically 2006-07 was an year of extraordinary industrial growth, with the final quarter growth being 12.5%. Sustaining this was not realistic and maybe not even desirable, given the strains it would place on an already stretched out economy. Investments in the main consumers of capital goods like infrastructure have been growing and shows no signs of slackening. The order books of the main capital goods manufacturers remain buoyant and their sales numbers have shown robust growth. In fact, the key listed capital goods companies grew by about 33 per cent in the last quarter of 2007, in comparison to the same period last year.
The already committed investments in these sectors may be enough to sustain the present capital goods growth trends in the near future. The projected expenditures in these non tradeable services like ports, airports, highways, power, urban infrastructure, telecommunications etc is massive, are by themselves capable of sustaining very high growth rates. The Government's own flagship programs like the Golden Quadrilateral and other National Highway projects, PMGSY, JNNURM, and the programs to promote PPP in core infrastructure, should provide more than adequate demand side stimulus to sustain high rates of growth for sectors like capital goods. The demand for both residential and commercial real estate is both massive and ever growing, and has not shown any signs of slackening. The critical inputs to infrastructure sector like steel and cement, after a blip in January, exhibited robust growth in February.
The construction sector, which encompasses all these infrastructure investments, exhibited one of the lowest sectoral ICORs in the Tenth Plan period at a very low 1.2. It has also been shown that construction sector generates one of the highest employment rates for every rupee investment. All this will ensure that the economic multiplier will be significant from these committed and projected investments. So any talk of a major slowdown may be not based on any logical foundations.
The recent budget cut CENVAT on all goods from 16% to 14%, excise duties on automobiles from 16% to 12%, excise duties on drugs and diagnostic equipments, and some packaged food items from 16% to 8%. These rates were cut with the objective of lowering prices and thereby spurring consumption and boosting industrial and business activity. The consumer durables sector, especially two-wheelers and automobiles, is expected to be one of the largest beneficiaries of this. The Sixth Pay Commission is expected to put nearly Rs 350 bn in the hands of consumers, thereby providing a major filip to manufacturing demand. These are all strong stimulus measures that are expected to keep aggregate demand high, and thereby keep the corporate investment climate healthy.
The Government have responded to the rising food and commodity prices by piecemeal and stop-gap measures like price controls, freeing imports, banning exports (on edible oils), lowering customs duties (on rice and edible oils), imposing export duties (on steel), and prohibiting futures trading (on food grains). These efforts are based on the wishful but futile assumption that it is possible to insulate the Indian economy from the global trend of rising food and commodity prices. This attempt at importing deflation by freeing up the external sector has severe limitations, given the small quantities involved in such trade and the high prices prevalent in the global markets.
The rising global commodity prices, both food and non-food, has pushed up import prices. Addressing this inflation with monetary policy levers may not only not yield results, but may backfire badly, especially at a time when growth itself is slowing down. That the inflation is not driven by demand side pressures is also clear from the fact that growth in money with the public has declined form a very permissible 17% to an even less 14% in Febraury, 2008. The RBI figures show that money supply which has been growing at 22.2% annually, is slowing down to an estimated 21.2%. It is clear that while the demand side is robust, the supply side appears constrained. The rise in inflation is therefore more due to cost push factors than demand pull ones.
The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The major domestic supply side bottle necks that have been driving prices up include stagnating agricultural production, declining private capital investments in manufacturing, and over-stretched infrastructure, especially power and transport logistics.
The domestic supply side factors that are driving inflation need to addressed through some immediate policy interventions. Infrastructure bottlenecks are an immediate priority that will continue to strangle any economic growth. It is impossible for India to grow at double digit growth rates, by maintaining low inflation, without massive investments in its creaking infrastructure. Agriculture investments, both physical and those aimed at improving productivity, have been declining and this is manifested in the stagnating production, thereby forcing imports. This needs to be addressed immediately on the highest priority, especially given the large share of population dependent on agriculture.
The external sector has also been a significant determinant on price increases. Since 2004, import prices of oil have soared from $34 to $110, palm oil from $471 to $1177, and Thailand rice from $225 per tonne to $510 per tonne. Our import basket has taken an enormous hit, and naturally inflationary pressures have been building up. Commodity prices worldwide - food grains, cash crops, energy and metals - have been growing at an alarming rate. Over the six years to February 2008, the Goldman Sachs broad commodity index jumped by 288 per cent, the energy price index by 358 per cent, the non-energy index by 178 per cent, the industrial metals index by 263 per cent and the agricultural index by 220 per cent.
The external factors are beyond our or anybody's control, and cannot be helped beyond a certain extent. The stronger rupee will help in ensuring cheaper imports and controlling inflationary pressures. The major hope will be that the US recession and resultant drop in consumption will set in motion a chain of events that will bring down global aggregate demand. The reduced US demand will immediately translate into a lower demand for manufacture imports from East Asia and China, and hence demand for many primary commodities and metals.
All this will also reduce the demand for oil and other energy supplies. Economic growth in the merging economies too will drop, though not sharply, thereby further reducing domestic demand in these markets. All this is likely to result in lower commodity prices, which will benefit large domestic market and commodity import dependent economies like India and China.
There have been calls from many quarters to tighten monetary policy in the light of the rising inflation. This may be a wrong prescription for many reasons. Any monetary tightening now will only generate expectations that would force both inflation up and push medium term growth down. Interest rates are critical for Indian industry, especially the massive small scale and unorganised sector, who depend solely on bank debt to finance a major share of even their working capital requirements.
What should the Government do at such times? Such times are a strong reminder of the continuing need to maintain a robust and effective Public Distribution System (PDS), which would help insulate atleast the poorest of the poor from global economic volatility. It is also a reiteration of the importance of food security, and the need to make investments in agriculture with the objective of increasing productivity and thereby expanding production. There is very little Governments can do to control the rising commodity and energy prices, apart from cosmetic exercises that play to the galleries, but will achieve precious little. Aggressive promotion of investments in infrastructure will be important for easing the constraints faced in a sector vital for promotion of overall economic growth.
These times also highlight the immense complexity involved in aggressively intenventionist market controlling approaches like price controls and duty hikes. Therefore, in such circumstances, if the Government decides to assist a category of consumers with some subsidy, it is more appropriate that such subsidies be transferred as direct cash transfers than by meddling with the price mechanism. Such measures are better able to co-ordinate with the market and deliver the full bang for the buck. Besides, it will also prevent market distortions that have consequences that often go much beyond the duration of the crisis itself.
What should the RBI do to ward off inflationary pressures? It appears that the RBI's dilemma can be resolved if not by easing the monetary policy, but atleast by holding on to it, so as to address growth concerns. Any tightening of monetary policy would have serious implications at a time when the investment climate is not at the pink of health. Further, in a cost push inflation scenario, any monetary tightening will be ineffective.
It also a timely reminder about the need to keep a low interest rate cushion when the economy is doing well, so that it gives the Government a sufficient enough interest rate buffer that it can exercise and increase rates when inflation rears its head. In fact, we should have lowered the interest rates late last December itself, in anticipation of such a reality, given the storm clouds that were then gathering around the US economy.
For the foreseeable future ahead, Indian economy will have inflationary pressures stoked up due to factors that are cost-push than demand-pull. Inflation is more likely to arise out of the economy's inability to provide the critical inputs necessary to sustain the fast pace of growth. In such circumstances, monetary policy will be more critical in lowering the cost of capital and encouraging growth, and will have only a minimal role in controlling inflation.
In the final analysis, a 7-7.5% GDP growth rate is by any yardstick a very good deal, especially at a time of such tumult in the global economy. Given the fact that the robust 9% plus growth of the past few years, was taking its toll on an over-stretched economy and supply side constraints were becoming increasingly evident, a relative cooling off should even be welcomed.
Given all our supply side constraints and infrastructure bottlenecks, sustaining a 9% growth without stoking off inflation was an impossibility. A slowdown in growth to 7-7.5% should suit us, in so far as it would help prevent over-heating and consequent build up of inflationary pressures, all of which have the potential of squeezing medium-term growth itself.
Recently released CSO data on the IIP indicates that industrial growth decelerated in January 2008 to 5.3%, compared to 11.6% for January 2007. The biggest hit was taken by the two critical engines of industrial and consequently economic growth - consumer durables and capital goods. While the former fell 3.1% ( a rise of 5.3% in Jan 2007), the later rose a mere 2.1% (16.3% in Jan 2007) for the month of January 2008. However, Fast Moving Consumer Goods (FMCG, consumer non durables), exhibited a 10.1% growth in January, compared to 9.1% last year. Food products, beverages, tobacco etc showed double digit growth. The growth rate of the core infrastructure industries group - crude petroleum, petroelum refinery products, coal, cement, electricity and steel - which has a 26.7% weightage in the overall IIP fell from 4.2%in January, compared to to 8.3% in January 2007.
Wholesale Price Index (WPI) had already begun to breach the self-imposed year-on-year 5% tolerance level in the third week of February and continues to rise. WPI based inflation rate breached the critical 5% mark to close at 5.11% for the week eneded March 1, 2008, the highest in over nine months. It further rose to 5.92% when the latest figures were relased for the week ended March 8, 2008, to reach teh highest figuresince May 7, 2007. The prices for cereals increased 6.28%, for milk 9.71%, vegetables 9.79%, dairy products 9.31%, cement 5.13%, iron and steel 20.87%, and edible oils 17.52%.
There are many reasons to doubt that the drop in capital goods is not part of any long term trend. For a start, statistically 2006-07 was an year of extraordinary industrial growth, with the final quarter growth being 12.5%. Sustaining this was not realistic and maybe not even desirable, given the strains it would place on an already stretched out economy. Investments in the main consumers of capital goods like infrastructure have been growing and shows no signs of slackening. The order books of the main capital goods manufacturers remain buoyant and their sales numbers have shown robust growth. In fact, the key listed capital goods companies grew by about 33 per cent in the last quarter of 2007, in comparison to the same period last year.
The already committed investments in these sectors may be enough to sustain the present capital goods growth trends in the near future. The projected expenditures in these non tradeable services like ports, airports, highways, power, urban infrastructure, telecommunications etc is massive, are by themselves capable of sustaining very high growth rates. The Government's own flagship programs like the Golden Quadrilateral and other National Highway projects, PMGSY, JNNURM, and the programs to promote PPP in core infrastructure, should provide more than adequate demand side stimulus to sustain high rates of growth for sectors like capital goods. The demand for both residential and commercial real estate is both massive and ever growing, and has not shown any signs of slackening. The critical inputs to infrastructure sector like steel and cement, after a blip in January, exhibited robust growth in February.
The construction sector, which encompasses all these infrastructure investments, exhibited one of the lowest sectoral ICORs in the Tenth Plan period at a very low 1.2. It has also been shown that construction sector generates one of the highest employment rates for every rupee investment. All this will ensure that the economic multiplier will be significant from these committed and projected investments. So any talk of a major slowdown may be not based on any logical foundations.
The recent budget cut CENVAT on all goods from 16% to 14%, excise duties on automobiles from 16% to 12%, excise duties on drugs and diagnostic equipments, and some packaged food items from 16% to 8%. These rates were cut with the objective of lowering prices and thereby spurring consumption and boosting industrial and business activity. The consumer durables sector, especially two-wheelers and automobiles, is expected to be one of the largest beneficiaries of this. The Sixth Pay Commission is expected to put nearly Rs 350 bn in the hands of consumers, thereby providing a major filip to manufacturing demand. These are all strong stimulus measures that are expected to keep aggregate demand high, and thereby keep the corporate investment climate healthy.
The Government have responded to the rising food and commodity prices by piecemeal and stop-gap measures like price controls, freeing imports, banning exports (on edible oils), lowering customs duties (on rice and edible oils), imposing export duties (on steel), and prohibiting futures trading (on food grains). These efforts are based on the wishful but futile assumption that it is possible to insulate the Indian economy from the global trend of rising food and commodity prices. This attempt at importing deflation by freeing up the external sector has severe limitations, given the small quantities involved in such trade and the high prices prevalent in the global markets.
The rising global commodity prices, both food and non-food, has pushed up import prices. Addressing this inflation with monetary policy levers may not only not yield results, but may backfire badly, especially at a time when growth itself is slowing down. That the inflation is not driven by demand side pressures is also clear from the fact that growth in money with the public has declined form a very permissible 17% to an even less 14% in Febraury, 2008. The RBI figures show that money supply which has been growing at 22.2% annually, is slowing down to an estimated 21.2%. It is clear that while the demand side is robust, the supply side appears constrained. The rise in inflation is therefore more due to cost push factors than demand pull ones.
The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The major domestic supply side bottle necks that have been driving prices up include stagnating agricultural production, declining private capital investments in manufacturing, and over-stretched infrastructure, especially power and transport logistics.
The domestic supply side factors that are driving inflation need to addressed through some immediate policy interventions. Infrastructure bottlenecks are an immediate priority that will continue to strangle any economic growth. It is impossible for India to grow at double digit growth rates, by maintaining low inflation, without massive investments in its creaking infrastructure. Agriculture investments, both physical and those aimed at improving productivity, have been declining and this is manifested in the stagnating production, thereby forcing imports. This needs to be addressed immediately on the highest priority, especially given the large share of population dependent on agriculture.
The external sector has also been a significant determinant on price increases. Since 2004, import prices of oil have soared from $34 to $110, palm oil from $471 to $1177, and Thailand rice from $225 per tonne to $510 per tonne. Our import basket has taken an enormous hit, and naturally inflationary pressures have been building up. Commodity prices worldwide - food grains, cash crops, energy and metals - have been growing at an alarming rate. Over the six years to February 2008, the Goldman Sachs broad commodity index jumped by 288 per cent, the energy price index by 358 per cent, the non-energy index by 178 per cent, the industrial metals index by 263 per cent and the agricultural index by 220 per cent.
The external factors are beyond our or anybody's control, and cannot be helped beyond a certain extent. The stronger rupee will help in ensuring cheaper imports and controlling inflationary pressures. The major hope will be that the US recession and resultant drop in consumption will set in motion a chain of events that will bring down global aggregate demand. The reduced US demand will immediately translate into a lower demand for manufacture imports from East Asia and China, and hence demand for many primary commodities and metals.
All this will also reduce the demand for oil and other energy supplies. Economic growth in the merging economies too will drop, though not sharply, thereby further reducing domestic demand in these markets. All this is likely to result in lower commodity prices, which will benefit large domestic market and commodity import dependent economies like India and China.
There have been calls from many quarters to tighten monetary policy in the light of the rising inflation. This may be a wrong prescription for many reasons. Any monetary tightening now will only generate expectations that would force both inflation up and push medium term growth down. Interest rates are critical for Indian industry, especially the massive small scale and unorganised sector, who depend solely on bank debt to finance a major share of even their working capital requirements.
What should the Government do at such times? Such times are a strong reminder of the continuing need to maintain a robust and effective Public Distribution System (PDS), which would help insulate atleast the poorest of the poor from global economic volatility. It is also a reiteration of the importance of food security, and the need to make investments in agriculture with the objective of increasing productivity and thereby expanding production. There is very little Governments can do to control the rising commodity and energy prices, apart from cosmetic exercises that play to the galleries, but will achieve precious little. Aggressive promotion of investments in infrastructure will be important for easing the constraints faced in a sector vital for promotion of overall economic growth.
These times also highlight the immense complexity involved in aggressively intenventionist market controlling approaches like price controls and duty hikes. Therefore, in such circumstances, if the Government decides to assist a category of consumers with some subsidy, it is more appropriate that such subsidies be transferred as direct cash transfers than by meddling with the price mechanism. Such measures are better able to co-ordinate with the market and deliver the full bang for the buck. Besides, it will also prevent market distortions that have consequences that often go much beyond the duration of the crisis itself.
What should the RBI do to ward off inflationary pressures? It appears that the RBI's dilemma can be resolved if not by easing the monetary policy, but atleast by holding on to it, so as to address growth concerns. Any tightening of monetary policy would have serious implications at a time when the investment climate is not at the pink of health. Further, in a cost push inflation scenario, any monetary tightening will be ineffective.
It also a timely reminder about the need to keep a low interest rate cushion when the economy is doing well, so that it gives the Government a sufficient enough interest rate buffer that it can exercise and increase rates when inflation rears its head. In fact, we should have lowered the interest rates late last December itself, in anticipation of such a reality, given the storm clouds that were then gathering around the US economy.
For the foreseeable future ahead, Indian economy will have inflationary pressures stoked up due to factors that are cost-push than demand-pull. Inflation is more likely to arise out of the economy's inability to provide the critical inputs necessary to sustain the fast pace of growth. In such circumstances, monetary policy will be more critical in lowering the cost of capital and encouraging growth, and will have only a minimal role in controlling inflation.
In the final analysis, a 7-7.5% GDP growth rate is by any yardstick a very good deal, especially at a time of such tumult in the global economy. Given the fact that the robust 9% plus growth of the past few years, was taking its toll on an over-stretched economy and supply side constraints were becoming increasingly evident, a relative cooling off should even be welcomed.
Given all our supply side constraints and infrastructure bottlenecks, sustaining a 9% growth without stoking off inflation was an impossibility. A slowdown in growth to 7-7.5% should suit us, in so far as it would help prevent over-heating and consequent build up of inflationary pressures, all of which have the potential of squeezing medium-term growth itself.
Sunday, March 23, 2008
Economics of ethanol as a biofuel
By enacting the Energy Independence and Security Act of 2007, the US Government legislated into force a whole new economy in biofuels, whose consequences are bound to be felt for decades to come.
As David Rotman writes in the Technology Review, "the energy bill prescribes a minimum amount of biofuel that gasoline suppliers must use in their products each year through 2022. The new mandates, which significantly expand the Renewable Fuels Standard of 2005, would more than double the 2007 market for corn-derived ethanol, to 15 billion gallons, by 2015. At the same time, the bill ensures the creation of a new market for cellulosic biofuels made from such sources as prairie grass, wood chips, and agricultural waste. The standards call for the production of 500 million gallons of cellulosic biofuel by 2012, one billion gallons by 2013, and 16 billion gallons by 2022."
Economists are worried about the distortions such mandates will create in the agriculture and energy markets. Producing 15 billion gallons of conventional ethanol will require farmers to grow far more corn than they now do. And even with the increased harvest, biofuel production will consume around 45 percent of the U.S. corn crop, compared with 22 percent in 2007. Because corn is the primary feed for livestock in this country, that means higher prices for everything from beef to milk and eggs. High corn prices could also make it harder to switch to cellulosic biofuels, because farmers will be reluctant to grow alternative crops. Since it became apparent that the biofuel standards would become law, the price of corn has risen 20 percent, to around $5.00 a bushel.
Professor Wallace Tyner of Purdue University studued the economics of corn, ethano and oil, and finds that biofuels struggle to compete with oil on cost, in part because of extreme sensitivity to the commodity price of corn. In the absence of government subsidies or mandates, according to his model, no ethanol is produced until oil reaches $60 a barrel. But with oil at that price, ethanol is profitable only as long as corn stays around $2.00 a bushel, which limits production of the biofuel to around a half-billion gallons a year. As oil prices increase, so does ethanol production. But production levels continue to be limited by the price of corn, which rises along with both the demand for ethanol and the price of oil (farmers use a lot of gasoline). Even when oil reaches $100 a barrel, ethanol production will reach only about 10 billion gallons a year if there are no subsidies; and even then, ethanol is profitable only if corn prices stay below $4.15 a bushel. If oil hits $120 a barrel, ethanol production will, left to market forces, reach 12.7 billion gallons--still more than two billion short of the federal mandate.
Tyner claims that setting the ethanol market at 15 billion gallons will mean an "implicit tax" on gasoline consumers, who will have to pay to sustain the high level of biofuel production. When oil costs $100 a barrel, the consumer will pay a relatively innocuous "tax" of 42 cents per gallon of ethanol used (the additional price at the pump will usually be only a few pennies for blends that are 10 percent ethanol). But at lower oil prices, the additional cost of ethanol will be far more noticeable. If oil falls to $40 a barrel, the implicit tax for ethanol will be $1.05 a gallon--or $15.77 billion for all the nation's gasoline users.
Update 1
Here is an article about how the ethanol craze may be driving up food prices.
As David Rotman writes in the Technology Review, "the energy bill prescribes a minimum amount of biofuel that gasoline suppliers must use in their products each year through 2022. The new mandates, which significantly expand the Renewable Fuels Standard of 2005, would more than double the 2007 market for corn-derived ethanol, to 15 billion gallons, by 2015. At the same time, the bill ensures the creation of a new market for cellulosic biofuels made from such sources as prairie grass, wood chips, and agricultural waste. The standards call for the production of 500 million gallons of cellulosic biofuel by 2012, one billion gallons by 2013, and 16 billion gallons by 2022."
Economists are worried about the distortions such mandates will create in the agriculture and energy markets. Producing 15 billion gallons of conventional ethanol will require farmers to grow far more corn than they now do. And even with the increased harvest, biofuel production will consume around 45 percent of the U.S. corn crop, compared with 22 percent in 2007. Because corn is the primary feed for livestock in this country, that means higher prices for everything from beef to milk and eggs. High corn prices could also make it harder to switch to cellulosic biofuels, because farmers will be reluctant to grow alternative crops. Since it became apparent that the biofuel standards would become law, the price of corn has risen 20 percent, to around $5.00 a bushel.
Professor Wallace Tyner of Purdue University studued the economics of corn, ethano and oil, and finds that biofuels struggle to compete with oil on cost, in part because of extreme sensitivity to the commodity price of corn. In the absence of government subsidies or mandates, according to his model, no ethanol is produced until oil reaches $60 a barrel. But with oil at that price, ethanol is profitable only as long as corn stays around $2.00 a bushel, which limits production of the biofuel to around a half-billion gallons a year. As oil prices increase, so does ethanol production. But production levels continue to be limited by the price of corn, which rises along with both the demand for ethanol and the price of oil (farmers use a lot of gasoline). Even when oil reaches $100 a barrel, ethanol production will reach only about 10 billion gallons a year if there are no subsidies; and even then, ethanol is profitable only if corn prices stay below $4.15 a bushel. If oil hits $120 a barrel, ethanol production will, left to market forces, reach 12.7 billion gallons--still more than two billion short of the federal mandate.
Tyner claims that setting the ethanol market at 15 billion gallons will mean an "implicit tax" on gasoline consumers, who will have to pay to sustain the high level of biofuel production. When oil costs $100 a barrel, the consumer will pay a relatively innocuous "tax" of 42 cents per gallon of ethanol used (the additional price at the pump will usually be only a few pennies for blends that are 10 percent ethanol). But at lower oil prices, the additional cost of ethanol will be far more noticeable. If oil falls to $40 a barrel, the implicit tax for ethanol will be $1.05 a gallon--or $15.77 billion for all the nation's gasoline users.
Update 1
Here is an article about how the ethanol craze may be driving up food prices.
Saturday, March 22, 2008
Another bubble in the making
The sub-prime mortgage crisis and the resultant loosening of monetary policy, so as to ease the credit squeeze, may actually end up blowing a new bubble. Commodities trading is the new boom sector. In an ironic twist to the tale, the leaner, lighter, and knowledge and internet-based economy is being now propped up by the clunky and mundane commodities economy of copper, wheat, and oil. The recent small drop in commodity prices, is seen as only a temporary blip, since the factors repsonsible for the higher prices continue to be active.
A NYT article describes the commodities market thus,"The heart of commodities markets is the so-called cash market, a “professionals only” setting where producers sell boatloads of iron ore, tanker ships full of oil and silos full of wheat for immediate use. Wrapped around that core are the commodities futures markets. Here, hedgers and speculators trade various versions of a derivative called a futures contract, which calls for the delivery of a specific quantity of a commodity at a fixed price on a particular date."
"Futures contracts trade both on regulated exchanges and in the immensely larger but less regulated over-the-counter market, where banks and brokers privately negotiate futures contracts with hedgers and speculators around the world. The prices at which all these contracts trade indicate the potential strength of demand and supply for commodities still in the ground or in the fields. That makes them important to everyone who produces, buys and uses those goods — wheat farmers, baking companies, grocery shoppers, oil companies, electric utilities and homeowners. Prices here can also influence the values of the increasingly popular exchange-traded funds, or E.T.F.’s, that focus on commodity investments."
Investors perceive that commodities like oil and gold offer a safe hedge against inflation. They are seen as one of the few remaining sources of double-digit gains that have fast been disappearing from the markets for stocks, bonds and real estate. Small investors are plunging in, too, using dozens of new retail commodity funds to participate in markets that by one measure have jumped almost 20 percent in the last six months and doubled in six years.
As NYT reports, "the biggest speculators and lenders in the commodities markets are some of the same giant hedge funds, commercial banks and brokerage houses that are caught in the stormy weather of the equity, housing and credit markets. As in those markets, an evaporation of credit could force some large investors — especially hedge funds speculating with lots of borrowed money — to sell off their holdings, creating price swings that could affect a host of marketplace prices and wipe out small investors in just a few moments of trading."
Margin calls and volatility can be managed as long as the prices of commodities continue to rise, as they are now. Credit will continue to flow uninterrupted, further raising the prices of commodities based financial instruments. But commodity prices can record daily percentage changes that dwarf typical movements in stocks, thereby adding considerable volatility to the market. And when the time of reckoning comes, as it should, the same sub-prime mortgage backed securities story will get enacted.
Wall Street and the global financial markets need to face up to the reality that there is a deep solvency problem. There are whole classes of asset backed securities, traded and re-traded many times over, insured and reinsured, which are now valued at a fraction of the original value of the asset. In some cases, the original asset itself has been liquidated or has spiralled into oblivion. The repayment of these liabilities can be postponed for some days or months. They can even be transferred or shifted to some others. All this financial engineering will only be at great cost to the long term health of the financial system, as it will release moral hazard and information asymmetry problems aplenty into the system.
The bottomline is that somebody has to bear these liabilities. The sooner we realise it the better. The breathing time that the Fed is giving by its rates cuts, liquidity injections and the extraordinary relaxations in credit standards has to be utilized effectively to wring out these losses in a slow and phased out manner.
Instead it would appear that the financial and mathematics wizards and Nobel laureates occupying the backrooms of the Wall Street firms and hedge funds, are using this breather to spin out new asset categories that would seek to shift or transfer away (or even conceal) their liabilites and risks to other unsuspecting investors and lenders (of which there appears to be plentiful in supply, even after the very recent, bitter lessons of the sub-prime mess). The game will go on and the agony will be postponed for a few more days or months.
The technology stocks led equity market boom (remember Dow 36,000!) of the nineties and the real estate market bubble of this decade generated huge Ponzi schemes, with deferred judgement days, that spread wealth around a wide base of consumers and investors. A whole generation of investors have grown up used to double digit returns, that has been the distinctive mark of the last two decades of financial market innovations and booms. It is no surprise that this era is now coming to an end. It had to end, for those boom era returns were built on fickle foundations and thereby not sustainable.
One of the most eternal and profound lessons from the financial market is simple - that which goes up has to come down, and that which goes up furthest has to go down the deepest! Investors will be all the more wiser to pay heed to this basic lesson.
A NYT article describes the commodities market thus,"The heart of commodities markets is the so-called cash market, a “professionals only” setting where producers sell boatloads of iron ore, tanker ships full of oil and silos full of wheat for immediate use. Wrapped around that core are the commodities futures markets. Here, hedgers and speculators trade various versions of a derivative called a futures contract, which calls for the delivery of a specific quantity of a commodity at a fixed price on a particular date."
"Futures contracts trade both on regulated exchanges and in the immensely larger but less regulated over-the-counter market, where banks and brokers privately negotiate futures contracts with hedgers and speculators around the world. The prices at which all these contracts trade indicate the potential strength of demand and supply for commodities still in the ground or in the fields. That makes them important to everyone who produces, buys and uses those goods — wheat farmers, baking companies, grocery shoppers, oil companies, electric utilities and homeowners. Prices here can also influence the values of the increasingly popular exchange-traded funds, or E.T.F.’s, that focus on commodity investments."
Investors perceive that commodities like oil and gold offer a safe hedge against inflation. They are seen as one of the few remaining sources of double-digit gains that have fast been disappearing from the markets for stocks, bonds and real estate. Small investors are plunging in, too, using dozens of new retail commodity funds to participate in markets that by one measure have jumped almost 20 percent in the last six months and doubled in six years.
As NYT reports, "the biggest speculators and lenders in the commodities markets are some of the same giant hedge funds, commercial banks and brokerage houses that are caught in the stormy weather of the equity, housing and credit markets. As in those markets, an evaporation of credit could force some large investors — especially hedge funds speculating with lots of borrowed money — to sell off their holdings, creating price swings that could affect a host of marketplace prices and wipe out small investors in just a few moments of trading."
Margin calls and volatility can be managed as long as the prices of commodities continue to rise, as they are now. Credit will continue to flow uninterrupted, further raising the prices of commodities based financial instruments. But commodity prices can record daily percentage changes that dwarf typical movements in stocks, thereby adding considerable volatility to the market. And when the time of reckoning comes, as it should, the same sub-prime mortgage backed securities story will get enacted.
Wall Street and the global financial markets need to face up to the reality that there is a deep solvency problem. There are whole classes of asset backed securities, traded and re-traded many times over, insured and reinsured, which are now valued at a fraction of the original value of the asset. In some cases, the original asset itself has been liquidated or has spiralled into oblivion. The repayment of these liabilities can be postponed for some days or months. They can even be transferred or shifted to some others. All this financial engineering will only be at great cost to the long term health of the financial system, as it will release moral hazard and information asymmetry problems aplenty into the system.
The bottomline is that somebody has to bear these liabilities. The sooner we realise it the better. The breathing time that the Fed is giving by its rates cuts, liquidity injections and the extraordinary relaxations in credit standards has to be utilized effectively to wring out these losses in a slow and phased out manner.
Instead it would appear that the financial and mathematics wizards and Nobel laureates occupying the backrooms of the Wall Street firms and hedge funds, are using this breather to spin out new asset categories that would seek to shift or transfer away (or even conceal) their liabilites and risks to other unsuspecting investors and lenders (of which there appears to be plentiful in supply, even after the very recent, bitter lessons of the sub-prime mess). The game will go on and the agony will be postponed for a few more days or months.
The technology stocks led equity market boom (remember Dow 36,000!) of the nineties and the real estate market bubble of this decade generated huge Ponzi schemes, with deferred judgement days, that spread wealth around a wide base of consumers and investors. A whole generation of investors have grown up used to double digit returns, that has been the distinctive mark of the last two decades of financial market innovations and booms. It is no surprise that this era is now coming to an end. It had to end, for those boom era returns were built on fickle foundations and thereby not sustainable.
One of the most eternal and profound lessons from the financial market is simple - that which goes up has to come down, and that which goes up furthest has to go down the deepest! Investors will be all the more wiser to pay heed to this basic lesson.
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