Why liquidity is no guarantee for 'value' discovery?

John Kay has a delightful piece, where he seeks to upend the conventional wisdom on liquidity, that assets need to be tradeable every milli-second so as to generate volumes. Supporters of this view blame the increased regulation in the aftermath of the global financial crisis for the reduction in liquidity. But Kay argues that neither the savers (who lend) nor businesses (who borrow) need this kind of liquidity,

There is not much trade or liquidity in these (corporate bond) markets because there is not much need for trade or liquidity in these securities. The practitioners were worried that the absence of an active market damaged the process of “price discovery”. But “price discovery” seems to mean something different from “value discovery”, which is an estimate of the expected cash flows that holders will derive from the security over its life. “Price discovery” owes more to other traders’ expectations than fundamentals of valuation. To believe more can be learnt about the credit quality of a bond by stimulating trade in it than from careful evaluation of the circumstances of the issuer requires an unjustified faith in the “wisdom of crowds”. A lesson of the subprime mortgage fiasco is that an active market in securitised products is no substitute for careful assessment of the borrower’s capacity to repay.

And about what is needed, he writes,

Liquidity in financial markets is often equated to the volume of trade. But every financial crisis shows that such liquidity is liable to evaporate when actually required. An assurance that the funding requirements of businesses and households can be met is best achieved by a resilient, well-capitalised banking system and an asset-management sector focused on the long-term needs of both providers and users of capital. A market characterised by large trading volumes on low spreads serves the interests of market practitioners rather than their customers.

It was reported by the US Commodity Futures Trading Commission that this year itself, till September, there had been 35 "flash events" in the market for West Texas Intermediate crude futures. This is more reminder (like this, this, and this) to those who celebrate the power of more liquidity exemplified in trends like high-frequency trading etc. Amen!

Giving cattle to the poorest was the best strategy after all

The Economist points to a recently released evaluation of a large program by the non-profit BRAC in Bangladesh which gave the poorest people a small stipend for food, followed with a cattle asset (a cow or a few goats) coupled with extension services to help them graduate from 'extreme' poverty to 'normal' poverty. It writes, 

We combine data from 21,000 poor and non-poor households in 1309 villages in Bangladesh with the randomized evaluation of a program that provides a large, one-off, transfer of assets and skills to the poorest women. The evidence suggests the poor face imperfections in capital markets that keep them in a low asset-low employment poverty trap where they are only able to engage in low return and seasonal casual wage labor. The transfer of assets and skills allows them to address this misallocation of labor by undertaking more productive capital-intensive work activities, thus increasing total labor supply, earnings, savings and asset holdings. The improved earnings capacity and resource base of the poor allows them to engage in financial intermediation that benefits non-poor households and leads to village-wide increases in savings, saving rates and capital accumulation. Lifting the poor out of the poverty trap therefore sets in place a virtuous cycle that improves the allocation of labor and places the entire village economy on a trajectory out of poverty. 

The paper finds that since agriculture labor is seasonal, the poorest, especially the women, have considerable idle time. So, any asset like cattle immediately gives them an opportunity to utilize their idle time and earn additional income. But such assets require large investments, which may not be forthcoming for the poorest from standard credit sources like microfinance. 

In this context, India's decades-old experience with self-employment programs for rural poor is instructive. Income generation support to poor people by way of providing milch cattle was the centerpiece of India's flagship rural poverty alleviation programs, starting from the earliest IRDP to the more recent SGSRY. Animal husbandry related components formed more than three-quarters of all income generating schemes administered by the District Rural Development Agencies (DRDAs) across the country. 

In fact, the old IRDP documents had exactly the same mechanism logic - more effective utilization of spare time - to justify the disproportionately high spending on milch cattle. The later versions of such self-employment programs, especially those funded with multilateral assistance, in states like Andhra Pradesh even made the distinction between the poor and the poorest of poor to target such assistance. There exists a rich literature on the advantages of cattle rearing for the poorest and evaluations of such programs across different states. But, while cattle formed the major share of aggregate spending, there were regional variations in this focus within the state itself depending on the climate, water availabilty, and social acceptance.  

It then constantly faced criticism for this bias towards cattle with arguments about whether it was financially viable enough or not. In any case, the findings of this study come as an evidence-based endorsement of the existing policy priority. But, as I blogged earlier here, it is questionable as to whether a long-drawn and expensive RCT was necessary to draw this policy inference. This would all the more be so since atleast some of these studies are likely to throw up inconclusive findings, thereby raising red-flag on the evidence-based adoption of what is arguably one of the best interventions to assist the poorest among the poor.  

India economy update

More disturbing signals about the Indian economy. The RBI's latest Financial Stability Report points to increased banking sector risks due to deteriorating asset quality and weak corporate performance. Asset quality, in terms of both Gross NPAs and restructured loans has been continuously worsening.

Much the same trend is mirrored in all the important indicators of banking health.

Interestingly, as a share of total sectoral exposure, aviation is the most vulnerable. Encouragingly, with lower fuel prices, sectoral competitiveness and profitability of the aviation sector would, in all likelihood, improve significantly in the years ahead.

An interesting feature of the firm size-wise credit allocation break-up is the dominance of large firms. But the disturbing trends are the share of stressed advances to large and medium scale enterprises, at 21% each. Given that large enterprises make up nearly 35% of all non-food credit, the high share of stressed advances is a matter of systemic concern. The equally high share of stressed advances to medium scale sector is likely to further deter lending to these types of firms, thereby reinforcing the forces that prevent greater credit inflows into a category of firms which are critical to driving job creation.   

The other, upstream, side of the banking sector balance sheet is corporate performance. The major share of the stressed assets, in terms of low interest coverage ratio and high leverage, is in the construction, power, iron and steel sectors. The graphic below highlights the performace of 2711 non-government, non-financial companies.

The Business Standard analysed the balance sheets of the country's top 441 indebted non-financial companies and found that 67 firms, with a total debt of Rs 56,500 bn at end 2014-15, had negative net worth or financially insolvent. This was an increase from 16 companies at the end of 2009-10. The total debt of these 441 companies was Rs 285,000 bn and accounted for 98.1% of the gross debt of 654 listed non-financial corporates. 

The analysis points to a negative feedback loop of falling profitability, rising interest costs, and falling investments, 

Return on capital employed (RoCE) for the indebted in the Business Standard sample declined to a decade-low 7.4 per cent in 2014-15, which was only a few basis points (a basis point is a hundredth of a percentage point) more than their average interest cost of 7.1 per cent. At this rate, many companies may be forced to default on their loans as profits from operations will be insufficient to cover the cost of debt servicing. The firms' interest cost on incremental debt is already trending higher than the underlying return on capital employed. In 2014-15, the cost of incremental debt shot up to 11.8 per cent, nearly 440 bps higher than the underlying return on capital employed. At its peak during the financial year 2004-05, these companies reported a return on capital employed of 18.7 per cent more than twice their average interest cost of 6.9 per cent.

The last financial year was also the first instance in a decade when companies' interest expenses were higher than depreciation. The indebted companies of the sample spent Rs 2.03 lakh crore on interest payments in 2014-15, up from Rs 1.83 lakh crore a year ago. In comparison, their depreciation allowance rose marginally to Rs 2.02 lakh crore from Rs 1.9 lakh crore in 2013-14. Thus, companies spent a greater part of their operating profits on debt servicing rather than capital expenditure and growth. In all, interest payments accounted for 34.2 per cent of the companies' operating profits in average last financial year, up from 16.7 per cent five years ago and 12 per cent a decade ago. This leaves little resources for growth capital.

This is a powerful deterrent to the revival of the investment cycle, essential to the creation of jobs. Worse still, it appears to be taking its toll on the existing jobs, as a recent series in the Indian Express, which also examined the situation in power and roads sectors, wrote, 

A look at the group of 230 leading companies listed on the Bombay Stock Exchange (BSE 500), and have an aggregate market cap of over Rs 55 lakh crore, shows that for the first time in at least four years they witnessed a decline in their aggregate employee strength as it fell by 14,000 in the year ended March 2015. While 105 out of the 230 companies reduced their headcount by an aggregate of 84,688 during the year, 114 companies within the list increased their staff strength by 69,910. For the remaining 11 companies, the numbers remained constant. The aggregate employee strength for these companies came down from 21.56 lakh in the year ended March 2014 to 21.41 lakh in the year ended March 2015... In Financial Year (FY) 2014 the same group of 230 companies added an aggregate of 1.63 lakh employees and in the three year period between FY’11 and FY’14 they added close to 4 lakh employees. However, the numbers fell in FY’15 as companies facing decline in revenue growth and low capacity utilisation resorted to laying off their employees. The biggest drop in number of employees during the year was witnessed by companies in manufacturing, construction and infrastructure, and capital goods, whereas IT and pharma companies saw net addition to their employee strength.

This trend, especially in those sectors which traditionally contribute to large job creation, does not portend well. 

The one-way renminbi bet?

It is now well-acknowledged that the fortunes of the world economy for the year ahead are more intimately tied to developments in China than elsewhere, including the US. Arguably one of the most keenly watched China-related news is that about its currency. In this context, Christopher Balding argues that the renminbi may be a one-way bet,

The market knows the RMB is going in one direction and they like those odds. Even if a hedge fund just shorts the CNY/CNH overnight with a not insignificant leverage and sells at trading open, recently, they would be making solid money... Chinese investors, retail and institutional, know that quality investment options in China are limited and are very interested in moving money elsewhere... If investors believe that the RMB is going lower, they will move more money out of China... the more the PBOC moves the RMB down, I see the pressure build on the RMB for additional weakening and additional pressure for rapid and violent movement. I see the incremental downward movement as adding incrementally to the probability of a sudden dislocation.

Given this strong incentive to short renminbi, the People's Bank of China's (PBoC) management of the currency over 2016 would be a test of its ability to play against global financial market participants. In this contest, it is likely that we end up seeing a few bouts of volatility in the value of renminbi, with its adverse consequences on the global financial markets as well as the competitiveness of other emerging market exporters.

But Beijing may have few other options left. As Balding writes, given the estimated 20-40% overvaluation of renminbi, any abrupt floatation would result in a sharp depreciation, with attendant adverse financial market consequences. It is, therefore, appropriate that on 11th December, the People's Bank of China (PBoC) announced that the currency would be denominated against a basket of currencies and not just the dollar. But this is also confirmation that Beijing prefers devaluation. Given the rising dollar and depreciating currencies elsewhere, this move would allow the renminbi to decline hopefully gradually against the dollar, thereby increasing China's export competitiveness without destabilizing other EM economies.

The fallacy of "decoupling" from EM asset class

Neelkanth Mishra cautions against reading too much about the Indian economy from the stock market gyrations. I agree completely. 

He also argues that stock markets react to global economic weakness, in particular, problems in emerging markets (EM), the category to which India gets bundled,

The market capitalisation of the top 100 stocks (BSE100) has fallen by 5 per cent in the last 12 months, whereas for the next 400 stocks (let’s call them the Next400), the aggregate market capitalisation has increased by 9 per cent... The larger stocks are more pressured by FII selling as they have higher FII ownership, and they also have much higher fundamental linkages to global trends. The Next400 stocks are dominated by sectors like consumer discretionary and non-banking finance companies that are less exposed to global trends, and better reflect the improvement in the Indian economy. They are also less owned by FIIs... 

Indices regularly shed weaker companies and add stronger ones: Over the next few years, as the Indian economy continues to outperform global trends, it is likely that they may become more representative of the economy. Similarly, it is likely that India becomes an “asset class” by itself, that is, given its idiosyncratic economy, global savings may choose India-focused funds rather than investing in India through EM or Asia funds.

This conclusion is baffling and as misleading as the Sensex is of the economy. For a start, the share of the Next 400 in the total market capitalization is most likely to be disproportionately small. More importantly, the hope of India decoupling from the EM asset class and acquiring its distinct identity among international asset managers and other financial institutions goes against a voluminous body of research on cross-border capital flows which clearly indicates that it does not discriminate based on fundamentals. It may, therefore, be unrealistic to assume that India can, based on a few years of growth, emerge as an asset class distinct from the broader EM category.   

At a more broader level, such reasoning presumes that it is possible to have a significant share of the domestic economy, one that drives economic growth, largely insulated from the rest of the world. This overlooks the fundamental economy-wide structural imbalances and limitations, arising from the very narrow corporate and industrial bases, in a landscape dominated by small and informal enterprises. It would require more than economic growth to address these problems. 

The broad outlines of a health care system for India

Lancet last week released a comprehensive study of India's health care system which reinforces the belief that it needs serious repair. Its headline findings,

We make the case not only for more resources but for a radically new architecture for India's health-care system. India needs to adopt an integrated national health-care system built around a strong public primary care system with a clearly articulated supportive role for the private and indigenous sectors. This system must address acute as well as chronic health-care needs, offer choice of care that is rational, accessible, and of good quality, support cashless service at point of delivery, and ensure accountability through governance by a robust regulatory framework. In the process, several major challenges will need to be confronted, most notably the very low levels of public expenditure; the poor regulation, rapid commercialisation of and corruption in health care; and the fragmentation of governance of health care. Most importantly, assuring universal health coverage will require the explicit acknowledgment, by government and civil society, of health care as a public good on par with education. Only a radical restructuring of the health-care system that promotes health equity and eliminates impoverishment due to out-of-pocket expenditures will assure health for all Indians by 2022.

The conventional wisdom is that health insurance is the holy grail in health care. I have written here about why this is a fiscally unsustainable slippery slope that could potentially ruin even that small part of the country's health care system that functions. In this context, here is a set of possible prescriptions about translating this vision into action.

1. India's healthcare priority should be to dramatically improve preventive and primary care standards. Its facilities should be strengthened with more personnel, increased capacity building, and rigorous monitoring, all complemented with greater demand-side pressures. The primary health center (PHC) and its subcenters should be trained to act as a single-stop for all preventive and primary care services, and a gatekeeper for all referral services. While this is notionally their mandate even today, its compliance remains weak and these institutions have been reduced to being maternal and child health centers. All the existing national programs, including the village public health activities, should be closely integrated into the PHC and brought under the control of its medical officer. These facilities should be provided resources to equip themselves with all the basic infrastructure and equipments and maintain them in a clean and hospitable manner. Wherever the medical officer is not appointed, a senior staff nurse should be entrusted the supervisory responsibility.

2. The PHC would act as a nodal agency co-ordinating all preventive and primary care activities - maternal and child health interventions, basic OP services, normal deliveries, administration of national programs, and coordination of village public health activities. This functional profile demands the services of a public health manager, more than a trained medical practitioner, much less one trained rigorously for more than five years. A three-year course with a curriculum designed to accordingly may be one way to also overcome the acute shortage of MBBS doctors that leaves a large proportion of PHCs without any doctor. 

3. Given that less than fully qualified (LTFQ) providers, commonly called quacks, are the point of first contact in nearly 80% of cases in rural areas, no meaningful reform is complete without integrating them into the mainstream. Their capacity building should involve continuous trainings and a gradually phased pathway to formality. One approach may be to offer a very basic preventive and primary care-focused course curriculum as a certificate in primary care, to be acquired over a 4-6 month duration of distance learning. The entire coursework can be provided on-line and through mobile phone apps, with the final examinations too conducted online under strict monitoring. Once they acquire the certification, these providers can be empanelled and used for various preventive and primary care services offered by the government in return for a fee.

4. The secondary care institutions like the 30-100-bed community health centers (CHCs) should be strengthened with all basic facilities and kept very clean. Currently, they are the weakest part of India's health care system. These hospitals should contain round-the-clock doctors and be equipped to handle basic surgeries including C-section deliveries. Wherever resources are extremely scarce, staff from two CHCs can be temporarily redeployed to run at least one full-fledged CHC. A mobile team of anesthetists can be made available if required.

5. All tertiary care admissions, except in cases of emergencies, should happen only through the primary care center and preferably the first referral unit in the CHC. While this may be difficult to enforce, a variety of different approaches may have to be adopted to gradually internalize this approach among all the public and private stakeholders.

6. It may be difficult to put the insurance genie back in the bottle. The next best option is to consolidate all the public insurance schemes offered to different categories of people under one umbrella, with a basic insurance plan and different types of top-ups, including those which provide premium care. Like in the continental Europe, the basic plan should be community-rated, cover a very basic set of high-incidence catastrophic medical conditions and no more, and have the same premium across insurers within a region. Private insurers should also offer this basic plan and at the same terms. They would be allowed to differentiate based on the top-ups and the quality of their services. 

7. The government, jointly with the private insurance agencies, should negotiate the annual price schedules of care providers and diagnostic services on a regional basis. This price schedule would be applicable for all government and private insurance and for any other contracting of services (like with CGHS). It would be a matter of debate as to whether the fee schedule should become the price standard for all categories of consumers as would be the case in a completely regulated market. 

8. The public tertiary care facilities should be strengthened with more facilities, greater cleanliness and responsiveness, and better management. Since such institutions are only a handful in each state, the state governments should take it up as a mission to bring them up to the standards of the best private hospital in the region. Patients under public insurance or being subsidized for their health care should be discouraged from visiting tertiary care facilities for simple secondary care treatments. Apart from providing affordable and accessible care for the poor, strong public tertiary care facilities are essential to keep private providers honest. 

9. In an environment where government hospitals are badly managed and discourage even those who cannot afford private hospitals, allowing insured citizens to choose their hospital is certain to further enfeeble public facilities. In the circumstances, there may be only two options. One, public insurance schemes can mandate that patients go to private facilities only in case the same treatment is not available at the public facility and on referral by the tertiary care facility (or on pre-authorization by the TPA). Two, the personnel delivering the care in the public facility should be incentivized with a share of the payments. It is not clear as to which of the two alternatives may work and a light-touch mix of both may be necessary. 

10. Finally, districts should be allowed to innovate to implement the components of this plan. The Government of India should offer a menu of interventions to improve health care service delivery - electronic medical records of all medical transactions in public facilities, strengthening of the rogi kalyan samitis at the PHC level, initiatives to make public facilities more attractive for patients, integration of the LTFQ care providers, rating of private providers and so on. The district may commit to the implementation of a clearly defined action plan consisting of some of these interventions and corresponding outcomes and enter into a 3-5 year MoU with the state National Health Mission Society. In return, the district should be encouraged with an incremental share of the NHM allocations. This strategy should not be forced upon all districts. In fact, only a handful of self-selected districts in each state should experiment with it, and based on their learnings, the strategy should be gradually expanded to cover others. Apart from closely monitoring and refining the programs, the state and central governments should encourage competition among those districts in the achievement of their action plans.

Now, it would be impossible to implement all these components in a one-size-fits-all mode across the country on a mission mode. It is just too complex. For sure, many of these reforms would struggle to pass the test of political acceptability and seriously strain the administrative bandwidth for effective implementation. Greater program flexibility would certainly lead to failures and scams. Dfferent parts of the country, even parts of the state, will progress at different pace in implementation. But given the enormity of the challenge, this may be the only way to initiate a process which could, potentially, over a long time frame, atleast stand a reasonable chance of getting us to the destination. 

Weekend Reading Links

1. Quietly, Barack Obama, the reluctant foreign policy President, has made it a landmark year for US foreign policy,

In reality, the climate change accord brings to an end a year of landmark breakthroughs in international diplomacy by the Obama administration. As well as the climate agreement, this year has brought a diplomatic pact on Iran’s nuclear programme, a major trade accord in the form of the Trans-Pacific Partnership and the reopening of US diplomatic relations with Cuba. All four of these achievements have been many years in the making.

2. Livemint has the latest dismal news on the Indian banks stressed assets problem which comes from Nomura Research,

The banking industry is sitting on around Rs.5-6 trillion of stressed assets. The brokerage further says that the loss resulting from default on these assets could be as much as Rs.1.7 trillion. Put another way, these Rs.6 trillion of assets are as high as three-fourths of the current stock of stressed assets (declared non-performing assets, or NPA, plus restructured assets) in the system.

Clearly, for metals and infrastructure, two of the drivers of investment cycle, there is no light at the end of the tunnel.

3. Livemint captures the declining share of corporate profits as a share of economic output.

In this context, Jahangir Aziz makes the point that even the mid-2000s rise in corporate profits were driven by exports rather than increased domestic demand,

In the golden years of 2003-08, when growth in India averaged almost 9 per cent, much of it was driven by corporate investment, which tripled from 6 per cent of the GDP to 18 per cent. Who consumed most of the goods produced by the increased investment? Not residents, as domestic consumption fell from 61 per cent of the GDP to 58 per cent. Instead, much of the newly created capacity was absorbed by foreigners, with exports surging from 15 per cent of the GDP to 24 per cent. With foreign demand accounting for more than 50 per cent of India’s manufacturing in the pre-crisis year, the relentless decline in exports since 2011 has, more than anything else, driven the weak industrial growth and languishing corporate investment.

This goes back to my argument that tries to make the distrinction between making in India for exports and for local market, with the trade-off being one between quality and price. Given the anemic global economy and the 12th straight month of decline in exports, the case for orienting make in India for the domestic market appear compelling.

4. Bhupesh Bhandari makes the case for industrial policy to encourage mobile handset makers to print their circuit boards in India, so that a value addition of eight to nine per cent takes place here. Currently manufacturers import everything as semi knock down (SKD) kits and then assemble them here, creating a value addition of no more than one to two per cent. Instead, he advocates imposing a countervailing duty of 12% on imports of PCBs so as to encourage phone makers to import the components as completely knock-down (CKD) kits and then print the circuits in India. This would be first step in designing and fabricating chips in India, which together make up nearly 40% of the phone cost.

This may be a good example of actually picking winners by guiding the development of a market. The duty could potentially set the industry in the path of an escalator from printing the circuit board, to designing the chip, to finally manufacturing it.

5. Whatever spin you try to give to the US health care market, one cannot but come away with convinced that it is the best example that free markets do not work in health and regulated prices are necessary. The Times points to a new study which examined US insurance data for the 2007-11 period and found,

First, health care spending per privately insured beneficiary varies by a factor of three across the 306 Hospital Referral Regions (HRRs) in the US. Moreover, the correlation between total spending per privately insured beneficiary and total spending per Medicare beneficiary across HRRs is only 0.14. Second, variation in providers’ transaction prices across HRRs is the primary driver of spending variation for the privately insured, whereas variation in the quantity of care provided across HRRs is the primary driver of Medicare spending variation. Consequently, extrapolating lessons on health spending from Medicare to the privately insured must be done with caution. Third, we document large dispersion in overall inpatient hospital prices and in prices for seven relatively homogenous procedures. For example, hospital prices for lower-limb MRIs vary by a factor of twelve across the nation and, on average, two-fold within HRRs. Finally, hospital prices are positively associated with indicators of hospital market power. Even after conditioning on many demand and cost factors, hospital prices in monopoly markets are 15.3 percent higher than those in markets with four or more hospitals.

6. The Lancet has an article calling for an integrated national health care system for India built around a strong public primary care system supported by private and indigenous providers. Livemint has a graphical summary of the report, from which two stands out. One, the personnel deficiency, especially of paramedical staff is staggering.

In a country with very high out-of-pocket spending, health care costs have been rising across the board. 

7. In a week the Fed finally took the plunge and reversed monetary accommodation by raising the Federal funds rate by 25 basis points, Larry Summers points to the work of Luckaz Rachel and Thomas Smith, who find that a 450 basis points decline in the global neutral real interest rate over the past 25 years. Summers points to the authors finding that factors other than slowing global growth being responsible for more than 75 per cent of the decline in real rates,

They note that since the global saving and investment rate has not changed much even as real rates have fallen sharply, there must have been major changes in both the supply of saving and demand for investment. They present thoughtful calculations assigning roles to rising inequalityand growing reserve accumulation on the saving side and lower priced capital goodsand slower labour force growth on the investment side. They also note the importance of rising risk premiums associated in part with an increase financial frictions.

This from Mervyn King and David Low captures the declining real rates

 8. At a time when politics is increasingly characterized by extreme caution bordering on paralysis, parochialism and short-sightedness, Angela Merkel's embrace of the Syrian refugees has rightfully earned her FT's acclaim as the Person of the year. I feel this assessment is spot on,

Her response to the refugee crisis has shaken Europe profoundly. Germany will never be the same again. For better or for worse, the cautious Ms Merkel is boldly transforming a continent. Even if she fails, she has left an indelible mark.

To put that in perspective, by end-November the country received 965,000 refugees, more than five times the figure last year. Who cares whether she succeeds or fails, this is the stuff of great leadership. This profile by George Packer is a classic.