Weekend reading links

1. Bypasses, aimed at keeping traffic out of the city centres and thereby prevent traffic congestion, are falling out of favour with British urban planners.

2. More signatures of Japan's demographic challenge - rise in uncontested victories in local government elections. This is striking,

In the most recent nationwide local elections, held in April, 30% of city mayors ran uncontested, up slightly from the previous poll in 2015. A whopping 45% of mayors in towns and villages were elected unopposed. A record number of local-assembly members, elected in each municipality, also won seats with zero votes. In some rural areas there were more assembly seats than candidates... The National Institute of Population and Social Security Research, a government think-tank, reckons about 95% of local municipalities will have fewer residents by 2045. Already, 80% are experiencing declining populations.

3. Is Nigeria, a country of nearly 200 million people, the biggest development disappointment of this decade?

Average incomes have been falling for four years; the IMF thinks they will not rise for at least another six. The latest figures put unemployment at 23%, after growing for 15 consecutive quarters. Inflation is 11%. Some 94m people live on less than $1.90 a day, more than in any other country, and the number is swelling. By 2030 a quarter of very poor people will be Nigerian, predicts the World Data Lab, which counts such things... The debt-to-gdp ratio is 28%. But Nigeria collects so little in tax that interest payments swallow about 60% of federal revenues... most citizens get few benefits from the state. Oxfam, a charity, ranks 157 countries on their commitment to reducing inequality, based on social spending, taxes and labour laws: Nigeria comes last... Nigeria’s electricity firms produce about as much power as the city of Edinburgh.

Very depressing!

4. On privatisation by stealth in India,

The state duopoly which once controlled Indian telephony has been reduced to a 10% share of the market... In 2016 Hindustan Machine Tools, which sold one in seven wrist watches in India at the turn of the century, down from nine in ten in 1990, folded... As recently as 2010 state-owned utilities generated nearly 80% of India’s electricity. Their share has fallen to 56%. These days just 15% of steel is smelted by the government, compared with one-third at the turn of the century... Between 2010 and 2018 the government’s share of banking assets declined from three-quarters to two-thirds.

5. Corporate tax rates - India tops, even if on a selective scale

6. More, from FT, on the asset-stripping and value destruction that goes on in the garb of private equity investing - this time from UK-based Greybull Capital,

Private equity is supposed to function by aligning the interests of all the investors. But in practice, that’s moonshine. The insiders receive hefty fees while having negligible capital at risk; their “upside” coming in the form of an option over the bought-out company’s equity... Perhaps the best analogy for the buyout firm is that of a croupier presiding over a roulette table surrounded by gambling addicts. Whatever the outcome for the players, the croupier makes a steady return. Indeed, if he wants to increase the take, he simply spins the wheel more frequently... The system is set up to guarantee fat fees and payments almost regardless of performance, generally channelled through tax suppressing structures. But the benefits for the wider economy are less appetising. Private equity looks increasingly like an exploitative racket, enabled by well-meaning regulation and misplaced incentives.

7. More generally, Gillian Tett has some striking data on the rise of private capital in the global economy,

Between 2000 and 2018 the number of private equity-backed companies in America rose from less than 2,000 to nearly 8,000. Publicly listed companies in this period, by contrast, fell from 7,000 to about 4,000... What is doubly notable is that the explosion of private activity is not restricted to equities. In the past decade, private debt markets have expanded at a striking clip, totalling more than $600bn today. Private infrastructure and real estate investment is also expanding. Indeed, Willis Towers Watson calculated a couple of years ago that global asset owners have now placed about 14 per cent of their assets in private markets (mostly private equity and real estate), up from virtually nothing a couple of decades ago. They predict this will rise to 20 per cent in 10 years.

As to reasons,

On the one hand, private equity, real estate and debt investments have often offered better returns than public equity in the past decade. And while these sectors used to be run like cottage industries, they are maturing — or at least aping some elements of public markets with slightly better reporting... At the same time, the raison d'être for public markets is faltering. They used to be seen as a more democratic and inclusive form of capitalism (because securities owners had a voice), offering more transparency (since there was more reporting) and liquidity (with more trading). It was also thought that if corporate managers faced the wisdom of (shareholder) crowds, companies would be better run. But the spread of dual class listings, which give a few owners disproportionate power, is undermining the idea of shareholder democracy. Meanwhile, critics argue that the rise of activist investors and quarterly corporate reporting has fostered a more short-term corporate culture.

8. Finally, as President Trump threatens punitive tariffs on Mexico to force it to curb illegal migration with major ramifications, here is a good NYT summary of the President initiated trade-wars. And Trump's obsession with tariffs has a long history. India is among the countries likely to be least affected by trade-wars.

VC market fact of the day

From the FT on SoftBank's raising of margin loans,

SoftBank has favoured margin loans because even though banks can seize the underlying stock if it falls heavily, they cannot go after any of the borrower’s other assets. This means the loans are not factored into SoftBank’s credit ratings – a concern for the Japanese company, as it already carries junk ratings from Moody’s and S&P.

What does it say about the VC market that the behemoth (the world's second largest VC fund manager struggles to raise $5 bn, when Softbank are planning their second $100 bn fund) is rated junk by the two largest credit rating agencies? Another illustration of a depressing reality - the dynamics of the financial market no longer exercises any disciplining power on the industry and its participants.

Executive compensation and superstar CEOs in public sector

Another one of the entrenched narratives is that performance payment is the way to reform public systems. But, as I have blogged on several occasions, this narrative stands on very flimsy presumptions. 

Adding empirical basis to questioning the narrative, a new paper examines whether CEOs can impact the performance of large and complex public sector organisations. 

It uses the case study of CEOs of English public hospitals under the NHS system, the fifth largest employer in the world with over 1.2 million employees, and where a pool of CEOs keep moving across comparable hospitals. On average these hospitals have 4500 employees, multi-million turnover, and labour costs accounting for 70% of the costs of production. Reforms of the late eighties replaced the administrative model with a highly decentralised managerial approach to hospital management, and hospital boards have autonomy to compensate CEOs accordingly. The authors compare perceived differences in managerial ability, as proxied by their compensation, to actual differences, as they emerge from the analysis of the objective production measures. 

They write,

We study the extent to which CEOs are differentiated in terms of their pay, as well as a wide range of hospital production measures including inputs, intermediate operational outcomes and clinical outcomes. Pay differentials suggest that the market perceives CEOs to be differentiated. However, we find little evidence of CEOs’ impact on hospital production. These results question the effectiveness of leadership changes to improve performance in the public sector...

we... examine whether CEOs have a “style” regardless of the hospital they manage by testing whether there are statistically significant and “portable” CEO fixed effects, i.e. systematic differences in hospital production that are associated with the movement of CEOs across different hospitals. We... “stack” our hospital production variables into distinct sets of input, throughput, output (clinical and financial) and staff job satisfaction measures to take advantage of the fact we have multiple measures of production, and to simplify the exposition of our results while maximizing the number of observations. Our results show little consistent evidence that CEOs are able to generate persistent performance differentials across the organizations they lead. While we find the estimated CEO fixed effects are jointly statistically significant, these CEO fixed effects are essentially period-hospital-specific shocks rather than true CEO effects, since large deviations in one production measure in one hospital are typically not replicated by the same CEO in another hospital... 

hospitals are large complex organizations, in which highly trained (and hard to monitor) individuals run separate but interconnected production processes. Management at the very top of such organizations may find it difficult to engage in coordination and getting a large number of actors, who traditionally have not worked together, to work cooperatively. Put another way, a possible interpretation of our finding is that the organizational inertia of a large hospital is too strong for a single manager – even if this person is the CEO – to be able to impact performance within the short time period in which they are in office, and consistently across organizations. 

And this definitive conclusion is important,

Our results indicate that the CEOs of large public hospitals do not necessarily impact hospital performance, a result that stands in stark contrast with earlier findings relating to the private sector and to smaller public sector organizations... the lack of a CEO effect may also be due, more broadly, to the complexity of hospital production, which transcends the fact that the NHS is publicly owned. From this perspective, our results cast doubts on the effectiveness of a “turnaround CEO” approach–the model in which top managers frequently rotate across hospitals to induce meaningful changes in performance–for large public sector organizations.

There is a related lesson. Market-differentiation, based on executive compensation, the proxy for CEO ability and therefore compensation in the private sector (also the basis of differentiation chosen for study here), is unlikely to be effective in the public sector or with complex systems. In fact, as I have just blogged here, the case for high executive compensations even in the private sector is questionable. 

"Special deals" and capitalism with Chinese characteristics

China satisfies none of the classical requirements for sustained high economic growth rates - it has not clear formal legal protection of private property, there is no independent judiciary for contract enforcement, formal rules and laws for private businesses are opaque, foreign companies have market access blocked for no apparent reason, the ease of starting a business is roughly at the same level as countries like Iraq and Congo, and so on.

If formal institutional arrangements are so weak/poor, how does the economy grow at such rate for so long? 

In a new working paper Chong-En Bai, Chang-Tai Hsieh, and Zheng Michael Song write,

The answer, we suggest, lies in the set of informal institutions that emerged in China in the early 1990s. The key feature of these informal institutions is that special deals are readily available to private firms... Chinese private firms succeed, in part, by obtaining a special deal from a local political leader which enables them to either break the formal rules or obtain favorable access to resources. The prevalence of special deals is common in countries with poor formal institutions, and China is no different. The essence of a special deal is that they are only available to some firms, and there is abundant evidence in many settings that the benefits of firms with special deals are out-weighted by the costs borne by firms that are left out.

In the case of China however, there are three reasons why the benefits of special deals may have exceeded the cost. First, Chinese local governments have enormous administrative capacity and use it to provide a “helping hand” to favored firms. This “helping hand” ranges from exemptions to regulations, lobbying the central government for the right to break rules, improving local infrastructure, providing land (and to a lesser extent credit) at below market prices, and blocking entry of other firms that threaten the profits of the favored firms. Some of this help – such as blocking competitors – lowers welfare, but much of it – such as exemptions to inefficient regulations – is probably growth enhancing.

Second, local political leaders have high powered incentives to provide special deals. For example, the largest car company in China is a joint venture between General Motors and the City of Shanghai. Dunne, a long time observer of China’s automobile market, describes Shanghai’s support for General Motors in the following way: “The commercial goal of selling more GM Buicks and Chevrolets in China becomes a political and economic campaign to enhance the power and might of the City of Shanghai. Think of it as Shanghai Inc. with the Mayor as the Chairman and CEO.” Local leaders may support private firms simply out of a sense of duty or because local leaders that show competence in supporting private business are recognized and promoted. The benefits can also be entirely monetary, ranging from tuition payments for their child to (hidden) equity stakes in favored private firms held by family members. Because of the high powered incentives to support private firms, a large and increasing number of Chinese firms benefit from the special deals. So the Chinese system is best described not simply as regime of special deals but one where there is almost “free entry” into special deals.

Third, a large number of local governments actively support private firms. Moreover, they compete ferociously with other local governments to attract and support their businesses. As described by McGregor (2010) (pg. 175-176), “What is obvious for anyone who travels around the country is how much of the economy is driven by another factor altogether, a kind of Darwinian internal com- petition, that pits localities against each other....each Chinese province, city, county, and village furiously compete to gulp down any economic advantage they can lure their way.” Competition between local governments is crucial in limiting the predatory power of protected firms. A local government can block competitors of favored firms in its locality but has no ability to do so in other cities. Competition also gives firms options when faced with incompetent or predatory local governments.

In other words,

China has “extractive economic institutions”... where political elites extract rents from the rest of society. But our hypothesis is that “extractive economic institutions” in China come with unique “Chinese characteristics” that has made all the difference. First, local political elites extract rents by enabling favored firms to generate more profits in the first place. They can do this because of the enormous administrative capacity of local governments, and the resulting growth of local businesses enables local elites to extract even more rents. Second, local elites get personal benefits from these rents, and thus the local administrative apparatus is laser-focused on supporting favored firms. Third, thousands of local governments compete ferociously to attract and support firms, thus limiting the ability of an individual local government to harm other businesses... 

Our narrative of special deals with Chinese characteristics is closely related to Yasheng Huang’s account of “Capitalism with Chinese Characteristics” and Chenggang Xu’s description of China as “Regionally Decentralized Authoritarianism.” Huang documents the emergence of special deals in China in the early 1990s and argues that such deals are harmful to economic growth. Xu argues that powerful local governments are behind the growth of private firms, but is silent on the key fact that local support for private firms almost always takes the form of special deals. Our hypothesis is that it is precisely the combination of special deals and powerful local governments that underpinned China’s economic success over the last 30 or so years and, at the same time, has created risks for the future. 

And this is important in the context of the ongoing trade confrontation with the US,

Special deals are at the root of the tension between China and its trading partners. Companies based in countries that do not have access to special deals find themselves disadvantaged when they compete with Chinese companies that do. Foreign companies in the Chinese market either have to make their own special deal or, as is the case with a Chinese firm that does not have a special deal, find that their intellectual property and contracts are not well respected. An important and still unresolved question is how the world trading system can accommodate countries based on rules as well as those based on access to special deals.

The note of caution on claims of alpha

All high-level decision-making (as an investor or a sportsperson or an administrator or a CEO) are essentially (well-informed) exercises in human judgement. They are very rarely exercises in logic spinning or theoretical reasoning. 

I have blogged earlier alluding to exercise of good judgement as mark of wisdom and perhaps the most important requirement of decision-making. But such exercises of judgement are inherently inconsistent. For instance, your judgement on the same issue can vary widely depending on a variety of factors, including your state of mind at the decision-making moment. 

We deeply under-estimate this reality and attribute outsized performances (or alphas) to some superior human trait, one which in case of superstars is deemed superior to that of everyone else. This is among one of the most misleading narratives of our times. Instead a more prudent approach may be to look at such performances from a Bayesian perspective.

Tim Harford points to Michael Blastland's recent book, Hidden Half, to highlight the potential role of good luck in explaining what can appear to be alphas. This is important,

... in a competition in which all the leaders are highly skilled, randomness may explain the difference between triumph and failure. Good luck plus skill beats bad luck plus skill any time.

In other words, for any sport or leadership position or market, there is a supply-side of such players or leaders or companies, which is hardly a handful but reasonable sized (in case of businesses, the numbers are likely to be reasonably large). From among them, one emerges a winner in the particular race. And, this is most likely the result of pure good luck. 

This assumes significance when we assess the true worth, as reflected in the executive compensation of Chief Executives and the so-called disruptive genius of internet companies like Facebook or Google or Amazon. It is not incorrect to argue that the confluence of eco-system enabling factors that created the conditions for social media, internet search, double-sided marketplaces like aggregators or e-commerce etc made the emergence of such behemoths inevitable at the turn of the millennium. The present set of winners emerged from among several equally placed competing companies. If there was perhaps one out-sized contributor to the winner's success, it was plain good luck. Much the same logic applies to today's superstar chief executives. 

But once they become successful, these leaders or companies or sportspersons enjoy the benefits of Mathew Effect (see this, this, and this) that is inherent to the dynamic of all the systems where they operate. This Mathew Effect raises insurmountable entry barriers, even on the same cohort of competitors when the next race (for an organisational position or a sporting event or market position).

One of the biggest concerns with present day capitalism is that its dynamic has amplified Mathew Effect, thereby entrenching winners. In fact, such Mathew Effect even conceals the deep deficiencies and incompetence in such winners and perpetuates a very inefficient market. In a broader sense,  there is so much evidence piling up that access to life's opportunities itself is increasingly dependent on the ovarian lottery. 

Two models for promoting vertical development

I have a co-authored paper here with Dr TV Somanathan on optimising urban space through vertical development. To quote the summary,

Arguably the biggest obstacle to the realisation of India's urbanisation goals is the acute shortage of affordable housing. On an economy-wide scale, there is also growing evidence of inflated housing prices contributing to social and macro-economic problems. Since the quantity of land available is fixed, the natural response of cities across the world to this problem has been to raise the Floor Area Ratio (FAR), the ratio of built-up area to the plot size. But restrictive regulations limit vertical development in India - while Singapore and New York allow FSI up to 25 and 15 respectively, Mumbai allows only up to 1.3!

This paper proposes two approaches to raise FAR that combine vertical development with resource raising, and use market forces to determine the level of vertical development. The first is a ‘choose your FAR’ system which dispenses with administratively fixed FAR and replaces it with market-based model where unlimited FAR can be purchased. The second is an FAR trading model where the municipality fixes the permissible additional FAR and periodically auctions them. It combines the two with a series of complementary urban planning reforms.

How can farm incomes be increased?

In the context of the government's professed objective to double farm incomes in five years, it is worth examining what could be potential pathways to realising it. 

The conventional wisdom on the pathway to increasing farm incomes is two-fold. One, squeeze more out of the farm plot, either by increasing productivity or by crop-diversification. Two, disintermediate the value chain from the farm-gate to the buyers to eliminate the brokers, thereby increasing the value captured by the farmers. 

The first one has been the objective since independence and realisation of significant gains is easier said than done. The challenges to be surmounted are too many to realise significant gains in this regard in the foreseeable future. Interestingly with the second, as the coffee example illustrates, the gains to be had by elimination of brokers may not be as high as being imagined. There are compelling reasons to believe that the narrative of brokers fleecing farmers and capturing a major share of their income as rents is dated. In fact, the average gain to the farmers from such disintermediation is likely to be no more than in single digits. In fact, in terms of value capture, if there are any significant gains, it is likely to come only from the upstream disintermediation (from the wholesale buyers to retailers or processors). But this is much harder and even unrealistic to be thinking of capturing. 

There is another less discussed pathway to increase farm incomes. Consider the current scenario. A large share of the farm produce is wasted in various forms including rotting and rejections due to not meeting the relevant standards. Further, in the absence of adequate storage as well as poorly informed harvesting and post-harvest practices, farmers cannot hold back their produce and are forced into selling it in immediately on harvest when prices are likely at their lowest. 

While I have not come across any study that quantify the aggregate loss to the farmers from this, I am inclined to believe that this is likely to be very significant. In the circumstances, measures that can minimise wastage and increase the local holding capacity of farmers so as to stagger supply release can be an area of engagement to increase farm incomes. In many respects, this may perhaps be the most promising medium-term intervention to increase farm incomes.