Weekend reading links

1. Simon Kuper and John Burn-Murdoch explore who among Messi and Ronaldo is the greatest. Couple of graphics stood out. Messi appears to be a greater creator than Ronaldo's poacher.

Messi and Ronaldo tower over the other currently active in terms of their goal scoring abilities.

2. China tech stocks fact of the day

Since the start of the pandemic, China’s 10 largest tech groups have collectively lost $300bn in market value, while their largest US peers have added almost $5tn, according to S&P Capital IQ.

And this

China’s largest tech companies have lost $300bn in market value since start of pandemic while US peers have added $5tn.

3. NYT oped draws the parallels between Silvio Berlusconi and Donald Trump.

4. Overcoming stiff public resistance, Denmark scraps a public holiday to pay for extra defence spending!

5. The less discussed but more important Great Stagnation is that of developing country income catch up with developed countries. Martin Wolf writes,

By the end of 2024, economic activity in these economies is expected to be about 5 per cent below levels projected on the eve of the pandemic.” Worse, in more than one-third of the poorest countries, incomes per head will be below 2019 levels in 2024... The report indicates that, without China, incomes per head of emerging and developing countries have stagnated relative to those in high-income countries since the middle of the last decade. The relative incomes per head of the low-income countries have stagnated for even longer. In brief, the reduction in global inequality seems to have stalled.

This is an extraordinary graphic that shows the steep rise in sovereign spread for C-rated countries by 14.4 percentage points since February 2022. 

Such steep rise in borrowing costs is also driving the low income countries into the lap of China. 

Today, remarkably, bilateral debt owed by low-income countries to the high-income members of the Paris Club has become less than half that owed to non-Paris Club countries, mainly China.

6. Fascinating article on the halo effect, that points to good looking people benefiting from better treatment by others. 

A study published in January in the Journal of Economics and Business found that good-looking banking CEOs take in over $1 million more in total compensation, on average, than their lesser-looking peers. “Good looks pay off,” the authors write. New research from Shanghai Advanced Institute of Finance similarly finds that comely managers of mutual funds lure more investments and enjoy more promotions than their homelier counterparts, even though their funds don’t perform as well. The researchers suggest this performance gap may be because handsome managers approach risk with hubristic levels of confidence... attractive people are less likely to be arrested or convicted, even after controlling for criminal involvement, according to a 2019 study of nationally representative data published in the journal Psychiatry, Psychology and Law... physically attractive people often cultivate self-serving beliefs. A 2014 paper in the journal Organizational Behavior and Human Decision Processes, for example, found that those who saw themselves as good-looking sensed they had more power and higher status than their plainer peers. They were also more likely to attribute growing economic inequality in the U.S. to the hard work and talent of those at the top...

Essentially, lucky people tend to believe that life is fair and fate rewards merit, whereas unlucky people are often more alert to systemic bugs and more supportive of efforts to correct for them. A 2016 study in the Journal of Public Economics, for example, found that people who were randomly assigned hard counting tasks in a lab were more inclined to blame their poor performance on circumstantial factors, such as the clarity of the instructions, and more likely to share tokens in a subsequent game. Those who enjoyed an easier counting task not only ascribed their success to personal effort but also were considerably stingier with the tokens... Andrea Fazio, an economist at Tor Vergata University of Rome, analyzed a nationally representative survey of Germans who rated how much they agreed with statements about money and fairness, such as “Income and wealth should be redistributed towards ordinary people.” The results, which he reported last year in the journal Economics & Human Biology, showed that the respondents who were seen as physically attractive by interviewers were also more likely to say that efforts to redistribute wealth were wrongheaded because everyone gets what they deserve.

7. Valuation concentration in US S&P 500 index

The performance of the S&P 500 index is now the most concentrated it has been since the 1970s. Seven of the biggest constituents — Apple, Microsoft, Google owner Alphabet, Amazon, Nvidia, Tesla and Meta — have ripped higher, gaining between 40 per cent and 180 per cent this year. The remaining 493 companies are, in aggregate, flat. Big tech companies dominate the index to an unprecedented degree. Just five of those seven stocks represent nearly a quarter of the market capitalisation of the entire index. At $2.9tn, Apple alone is worth more than the UK’s top 100 listed companies put together... The chipmaker Nvidia... has gained $640bn in market capitalisation just this year. That is almost as much as the combined market worth of JPMorgan and Bank of America, the two biggest banks in the US.

Apple is worth more than the entire Russell 2000 of smaller US companies.

The article points to two self-reinforcing trends that favour Big Tech

As their market capitalisations grew, they constituted an ever-larger proportion of the S&P 500, which like most stock indices weights its constituents according to their market value. Two wider market trends compounded this. One was an accelerating wave of so-called passive investment, where funds simply seek to replicate the performance of an index by mirroring its composition. This meant that as these stocks went up, so too did their index weights, forcing funds to buy more of them. The other was so-called ESG investment, a style that focuses on environmental, social and governance as well as financial factors. Growing interest in ESG has pushed investment dollars into tech at the expense of carbon-heavy sectors such as oil and gas. Active investors, passive investors, momentum chasers and ESG funds are often all chasing the same targets.

8. Simon Kuper points to the impressive transformation in student recruitments by Oxford and Cambridge,

Pressure from the government helped embarrass Oxford and Cambridge into overhauling admissions... Oxbridge colleges now aim for “contextual admissions”, including the use of algorithms to gauge how much disadvantage candidates have surmounted to reach their academic level. For instance: was your school private or state? What proportion of pupils got free school meals? Did your parents go to university? Admissions tutors compare candidates’ performance in GCSEs — British exams taken aged 16 — to that of their schoolmates. Getting seven As at a school where the average is four counts for more than getting seven at a school that averages 10. The brightest kid at an underprivileged school is probably smarter than the 50th-best Etonian... Oxbridge hosts endless summer schools and open days for underprivileged children... The message to the kids is: “You belong here.” 

It’s working. State schools last year provided a record 72.5 per cent of Cambridge’s British undergraduate admissions. From 2018 to 2022, more than one in seven UK-domiciled Oxford undergraduates came from “socio-economically disadvantaged areas”. Twenty-eight per cent of Oxford students identified as “black and minority ethnic”; slightly more undergraduates now are women than men. Academics told me that less privileged students are more likely to experience social or mental-health problems, but usually get good degrees. These universities haven’t relaxed their standards. On the contrary, by widening the talent pool, they are finding more talent.

9. Alan Beatie argues that the long period of low inflation perhaps had less to do with globalisation than being widely imagined. He points to studies which show that changes in monetary policy, lowers anchored inflation expectations, and reduced uprating of wages in line with prices may have had greater effects. 

For one, the periods don’t quite match. The “hyperglobalisation” period when world trade and global value networks grew most rapidly ran from the late 1990s until shortly before the global financial crisis began in 2008. By that point the fall in inflation in the rich world had largely already happened.

Second, given that goods are much more highly traded than services, you’d have expected rising inflation differentials between the two. In fact, the gap remained constant until after the financial crisis, when services inflation actually fell while goods inflation rose. As a rough sense check of the impact of cheaper imports, those goods subject to low-cost Chinese competition like clothing, shoes and electronics make up quite small parts of the consumer price basket. In the eurozone, apparel and footwear are about 5 per cent of the total, compared with 15 per cent for housing and utilities (and that’s using a narrow measure of housing costs) and 10 per cent for restaurants and hotels.

Nor does the integration of the big middle-income countries automatically push inflation down. It means increases in demand as well as supply. During the global food crisis of 2007-08, one very common story was that wealthier households in countries like China were increasing commodity prices by eating more resource-intensive fare, particularly meat.

Productivism, the new ideology to replace Neo-liberalism?

Dani Rodrik has outlined an alternative to neo-liberalism. It appears focused on developed countries, and in particular the US, is based on productivity enhancement. He calls it productivism and defines it thus, 

This is an approach that prioritizes the dissemination of productive economic opportunities throughout all regions of the economy and segments of the labor force. It differs from what immediately preceded it (“neoliberalism”) in that it gives governments (and civil society) a significant role in achieving that goal. It puts less faith in markets and is suspicious of large corporations. It emphasizes production and investment over finance, and revitalizing local communities over globalization. It also departs from the Keynesian welfare state – the paradigm that “neoliberalism” replaced -- in that it focuses less on redistribution, social transfers, and macroeconomic management and more on creating economic opportunity by working on the supply side of the economy to create good, productive jobs for everyone. And productivism diverges from both of its antecedents by exhibiting greater skepticism towards technocrats and being less instinctively hostile to populism in the economic sphere.

The fundamental idea is that all economic activities generate externalities, which are not addressed because of co-ordination failures. 

Our core economic problems – poverty, inequality, exclusion, and insecurity – have many roots. But they are reproduced and reinforced on a daily basis in the course of production, as an immediate by-product of firms’ employment, investment, and innovation decisions. In the language of economists, these decisions are rife with externalities for society, i.e., they have consequences that spill over to many people, firms, and other parts of the economy... these externalities are broader and also include what may be called “good jobs” externalities. “Good jobs” are a pathway to the middle class. They pay sufficiently well to allow for a reasonable living standard with some security and savings, are relatively stable and with safe working conditions, and offer some career progression. Firms that generate “good jobs” contribute to the vitality of their communities... Firms’ decisions on how many workers to employ, how much to pay, what kind of technologies to deploy, and how to organize work affect not just the bottom line, but the life chances of prospective employees and their communities. When a company decides to automate its production line or outsource part of its production to another country, society may suffer long-term damage that is not “internalized” by its managers or shareholders.

He points to the re-emergence of a dualism in the economies of developed countries (the original dualism of agriculture and productive manufacturing, and informal and formal, had dissolved over the years in developed countries). Automation, unbundling of supply chains, and globalisation have led to loss of manufacturing jobs, and preference for certain technologies and reduction in labour protections have resulted in winners and losers. Its consequences - poverty, unemployment, blighted areas, social tensions etc - are features of traditional development economics that grappled with issues facing developing countries. 

Rodrik uses a framework that categorises policies based on the stage of the economy (pre-production, production, and post-production) and which segment of the economy is targeted (low, middle, and high productivity). Traditional welfare state targets the pre-production (education and other endowments of workers etc) and post-production (redistributive taxes and social security), and the low productivity segment. The traditional growth strategies target the most productive segments and all three stages (IPR, trade agreements; R&D, export incentives; tax incentives). The former presumes that good jobs will become available to everyone with requisite skills, and the latter presumes that it will support high growth which will pull everyone up. 

But with the current circumstances, neither work well. Bad jobs - low and stagnant pay, poor benefits and protections, high insecurity, limited career progression, sudden layoffs etc - have become the problem. Firms need to be made to internalise the economic and social spillovers of their actions. This calls for policies that target directly production and middle-productivity SME segment - employer linked trainings, customised business incentives and services like for firm's management capacity building, labour friendly innovation and other policies etc. As he says, "we must change what we produce, how we produce it, and who gets a say in these decisions."

In terms of what it means for industrial policy, he writes,

The most effective industrial policies are those that entail close, collaborative interaction between government agencies private firms, whereby firms receive critical public inputs – financial support, skilled workers, or technological assistance – in return for meeting soft and evolving targets on investment and employment. This kind of industrial policy is likely to work much better – whether in promoting local economic development or in directing major national technological efforts – than open-ended subsidies or tax incentives... Advanced and developing nations alike will need a new breed of coordinated policies aimed at the supply and demand sides of labor markets, combining skill training programs with support for firms... Active labor market policies designed to increase skills and employability have to broaden into partnerships with firms explicitly targeting the creation of good jobs. Industrial and regional policies that currently center on tax incentives and investment subsidies have to be replaced by customized business services and amenities to facilitate maximum employment creation. National innovation systems have to be redesigned to orient investments in new technologies in a more employment-friendly direction. Policies tackling climate change, such as the European Green Deal, have to be explicitly linked to programs of job creation in lagging communities. And in recognition that prosperity will have to rely in the future much more on services and on smaller and medium-sized enterprises, the focus of industrial policy will have to be reoriented away from manufactures and “national champions.”

Some thoughts

1. Productivism verges on the microeconomic side - customised policies to actively and directly address problems on the supply and demand sides of the labour market and the productive capacity of the firms. The preference is for bespoke and decentralised action. I don't think there's a problem with the prescription here, and I think developed countries should embrace this and they also have the capabilities to execute them if they go ahead. 

But this kinds of policies become extremely challenging for capacity constrained local governments in developing countries to executive effectively. Imagine implementing management capacity building extension services for SMEs in a typical low capability environment. Apart from the state capability constraint, there's also the supply side constraint on the private sector side. 

2. Even on industrial policies, the preference in productivism is for targeted provisioning of incentives, instead of open-ended subsidies and incentives. Such targeting creates its set of problems, and this also requires high level of state capability. 

3. There may be a case that unlike the developed countries, the developing countries need to engage on both the large "national champion" companies and manufacturing, as well as SMEs. The former is required to create the ecosystems which generate spillovers that are essential for technology diffusion and productivity improvements. 

For example, developing countries need large contract manufacturers in textiles, footwear, electronics etc, as well as large automobile and heavy equipment manufacturers with their respective suppliers and ancillaries. These provide the ecosystem for the emergence of SMEs.

4. I think the simpler macro-policy would be to have the default policy that limits incentives to productive jobs creation. All investment support will have to become conditional on good jobs creation. Simultaneously, certain kinds of investments (eg. robots for routine tasks) will have to be deeply disincentivized. 

5. Finally, I think the time has come to make the distinction between good and bad R&D. The former promotes productivity enhancement while creating jobs (or at least without destroying jobs), whereas the latter is pure efficiency-enhancing and profits maximising automation. For sure, categorisation and identification will create a set of problems. But it's important to address this dimension, and target fiscal and other incentives towards good R&D. Investment subsidies, tax exemptions, and tax deductions on interest expenses (incurred to borrow and invest in R&D) should be limited to the good R&D, or taper outwards from the good R&D. The agenda on automation has to be set by governments and not corporates for their private interests. 

I'm reading Daron Acemoglu and Simon Johnson's latest book, Power and Progress, where they underline the importance of political and social choices in determining the path technologies take in shaping progress and society itself. This is a powerful and very important conclusion

A thousand years of history and contemporary evidence make one thing abundantly clear: there is nothing automatic about new technologies bringing widespread prosperity. Whether they do or not is an economic, social, and political choice.

Private equity impacts across markets

In a short span of time, private equity firms have come to dominate the business landscape in the US. Globally PE firms managed $6.3 trillion in assets in 2021, more than four times what they oversaw in 2007. PE firms are conglomerates, with Blackstone the $1 trillion leader itself owning mortgage lending, infrastructure, television and film studios, entertainment companies, pharmaceuticals, and even the dating app  Bumble.

PE firms have gone from investing in what are traditionally profitable businesses to dull and hitherto considered margin sensitive mass market and bottom of pyramid (BoP) goods and services. Their investments range from mobile homes, prison health care, emergency medicine, ambulances, affordable apartment buildings etc. This is an NYT series on PE investments in infrastructure services. 

This post will examine a few stories on the impacts of private equity investments in different sectors and discuss the value of PE investments in these market segments. 

1. This from the US experience of asset stripping and quality problems with private participation in railways

The railroads have shown great enthusiasm for cutting costs by any means possible — reducing staff by 30 per cent in the past six years, harming the freight system’s reliability while returning nearly $200bn in the past decade to shareholders. From 2019 to 2022, Norfolk Southern reduced its headcount by 23 per cent, returned more than $14bn to shareholders while investing less than $7bn back in its network, and saw its accident rate climb every year — by 25 per cent in total... American freight trains derail tens times as often as their British counterparts, according to the industry’s own data.

2. This article is about the accumulation of mobile home trailer parks by private equity firms which is driving up prices in the only few remaining affordable housing option for the poor in the US. The residents of such parks generally own their houses but have to rent the land their home sits on. The unique nature of the property means that they fall into a regulatory gap between the rights of owners and tenants, a feature that private equity firms have spotted as an opportunity to make money. Further, once a home is placed on a lot, shifting it to another park can be expensive, costing between $5000-10000, thereby making them captive to the park owners. 

The article documents how Harmony Communities, a manufactured-home operator with 5000 residents in 33 parks across Western US took over a park in Golden Hills, Colorado and immediately increased rents by 50% and mandated several changes to park rules that entail trailer owners having to alterations to their homes. Residents have little or no control over the changes that happen when a park ownership is transferred. Sometimes they don't even come to know that the park ownership has changed hands. 

Industry leaders are blunt about the business model: According to materials for a “boot camp” for aspiring mobile-home park investors prepared by Mobile Home University, which is run by two of the largest mobile-home park owners in the country, “the fact that tenants can’t afford the $5,000 it costs to move a mobile home keeps revenues stable and makes it easy to raise rents without losing any occupancy.” 

Real Capital Analytics, a market research firm, said in a June 2021 report that institutional investors had accounted for 23 percent of manufactured housing park purchases over the previous two years, up from 13 percent in the two years before that. That has made the investors among the country’s largest landlords. Some 22 million people live in manufactured homes in the United States, according to the Manufactured Housing Institute, a national trade organization. And Fannie Mae said that manufactured housing represents more than 6 percent of the nation’s housing units.

If residents of mobile-home parks can’t keep up with rising rents, or can’t afford to make the often extensive alterations to porches, gardens and awnings that are required under the new management’s rules, they are swiftly replaced. With prices and rents for all kinds of housing soaring in many parts of the country, demand for manufactured housing is climbing. Many young professional families and college students turn to mobile home parks as a final vestige of relatively affordable housing.

Another article in The New Yorker writes

In the past decade, as income inequality has risen, sophisticated investors have turned to mobile-home parks as a growing market. They see the parks as reliable sources of passive income—assets that generate steady returns and require little effort to maintain. Several of the world’s largest investment-services firms, such as the Blackstone Group, Apollo Global Management, and Stockbridge Capital Group, or the funds that they manage, have spent billions of dollars to buy mobile-home communities from independent owners... Some of these firms are eligible for subsidized loans, through the government entities Fannie Mae and Freddie Mac. In 2013, the Carlyle Group, a private-equity firm that’s now worth two hundred and forty-six billion dollars, began buying mobile-home parks, first in Florida and later in California, focussing on areas where technology companies had pushed up the cost of living. In 2016, Brookfield Asset Management, a Toronto-based real-estate investment conglomerate, acquired a hundred and thirty-five communities in thirteen states.

3. This article is about the acquisition of franchises of various kinds by private equity firms. It ends up resulting in higher franchise fees and stringent other requirements that franchisees have to abide by. The article discusses the impact of the purchase of The Little Gym toddler nursery franchise by the PE firm Unleashed Brands.

Private equity has notched decades of high returns for investors by following a well-worn strategy: acquire distressed or undervalued companies or real estate, increase profits and then sell them. Greatest hits include foreclosed homes, highway rest stops and coal mines bought out of bankruptcy.

Franchising has become one of private equity’s targets du jour. According to the research firm FRANdata, the number of franchise brands acquired by private equity firms and other investors rose from 52 in 2019 to 149 in 2021 and was on track to nearly equal that total in 2022... The nation’s franchisees — 237,619, according to FRANdata — like Ms. Cianci, think of themselves as independent small businesses, who have often sunk their life savings into the enterprise. That’s why Little Gym owners are resisting Unleashed’s attempts to squeeze their profits to pad its own...Unlike, say, factory workers, who can be laid off at will, franchisees are supposed to be protected by legal documents that prescribe a certain business model for years at a time... 

Within weeks, long-tenured headquarters employees started leaving. In conversations with franchisees across the country, numerous owners expressed frustration that the support they depended on had evaporated; instead of calling a trusted adviser whenever they wanted, they had to file an online ticket... The company tried to impose a new payroll vendor that caused unending headaches. Certain activities, such as karate, were eliminated as Unleashed acquired businesses with similar programming; the company said it trimmed services with low enrollment to “streamline” the offerings... In the fall of 2021, the company required all franchisees to sign a new agreement allowing Unleashed to automatically debit their bank accounts. Ms. Cianci noticed that it also contained broad language allowing the company to extract any other fees that might be owed, which she believed went beyond her franchise agreement...

In November, Unleashed introduced a revised operations manual that lays out new rules and fees. It specifies the hours the businesses must be open, how quickly they must return customer calls, which architect they must use and what company meetings they must attend. Staff salaries were only supposed to make up 30 percent of revenue. The technology fee can rise to $399 from $119. The national advertising fee can rise to 5 percent of gross sales from 1 percent; part of that will go to a fund that supports other Unleashed properties. New fees appeared, including a $30,000 fee to renew the franchise agreement, and a fee of about $15,000 to relocate the facility. For some owners, the changes seem to mean that they can no longer operate profitably and will have to sell rather than renew... the company continues to try to force everyone to use its call center and point-of-sale system.

4. This about PE firms in the affordable housing market

In the last few years, private equity firms including The Blackstone Group and Starwood Capital have become some of the largest owners of subsidized affordable housing in the United States, acquiring apartment properties with more than 138,000 units backed by the Low-Income Housing Tax Credit and other federal housing programs meant to create affordable housing. Neither private equity firm has created affordable housing. Both Blackstone and Starwood Capital accumulated their portfolios by acquiring interests in existing subsidized affordable properties, raising concern about whether they will maintain the properties as affordable when current subsidies lapse...

Blackstone is by far the largest owner of rental housing in the US, with more than 300,000 units as of July 2022. Starwood Capital is the second largest owner of rental housing in the US, with more than 115,000 units. Blackstone now owns more than 95,000 subsidized affordable units, making it one of the largest owners of affordable rental housing in the United States. Starwood Capital owns more than 43,000 subsidized affordable units, making it one of the top five owners of subsidized affordable housing in the US. These private equity firms have only recently begun acquiring large numbers of subsidized affordable apartments.

This about their profits maximisation intentions, 

Blackstone, which owns most of the affordable properties through its Blackstone Real Estate Income Trust (BREIT) non-traded real estate investment trust, noted in a June 2022 prospectus of its residential and industrial real estate holdings, "Our portfolio’s rents in these high conviction sectors remain below current market rents and have short duration leases, enabling BREIT to increase revenue as leases expire." Blackstone noted in a June marketing presentation that its BREIT investment fund had generated a 30.8% profit over the past year.

5. PE firms' investments in single-family housing took off in the aftermath of the foreclosures that accompanied the Great Recession. 

Load up on foreclosed properties at a discount of 30 to 50 percent and rent them out. Rather than protecting communities and making it easy for homeowners to restructure bad mortgages or repair their credit after succumbing to predatory loans, the government facilitated the transfer of wealth from people to private-equity firms. By 2016, 95 percent of the distressed mortgages on Fannie Mae and Freddie Mac’s books were auctioned off to Wall Street investors without any meaningful stipulations, and private-equity firms had acquired more than 200,000 homes in desirable cities and middle-class suburban neighborhoods, creating a tantalizing new asset class: the single-family-rental home. The companies would make money on rising home values while tenants covered the mortgages...

Wall Street’s latest real estate grab has ballooned to roughly $60 billion, representing hundreds of thousands of properties. In some communities, it has fundamentally altered housing ecosystems in ways we’re only now beginning to understand, fueling a housing recovery without a homeowner recovery... Before 2010, institutional landlords didn’t exist in the single-family-rental market; now there are 25 to 30 of them, according to Amherst Capital, a real estate investment firm. From 2007 to 2011, 4.7 million households lost homes to foreclosure, and a million more to short sale. Private-equity firms developed new ways to secure credit, enabling them to leverage their equity and acquire an astonishing number of homes...

Throughout the country, the firms created special real estate investment trusts, or REITs, to pool funds to buy bundles of foreclosed properties. A REIT enables investors to buy shares of real estate in much the same way that they buy shares of corporate stocks. REITs typically target office buildings, warehouses, multifamily apartment buildings and other centralized properties that are easy to manage. But after the crash, the unprecedented supply of cheap housing in good neighborhoods made corporate single-family home management feasible for the first time. The REITs were funded with money from all over the world. An investment company in Qatar, the Korea Exchange Bank on behalf of the country’s national pension, shell companies in California, the Cayman Islands and the British Virgin Islands — all contributed to Colony American Homes. Columbia University and G.I. Partners (on behalf of the California Public Employee’s Retirement System) invested $25 million and $250 million in the REIT Waypoint Homes. By the middle of 2013, private-equity companies had raised or spent nearly $20 billion on single-family real estate, and more than 100,000 homes were in the hands of institutional investors. Blackstone’s Invitation Homes REIT accounted for half of that spending. 

There's a reason why PE and other investors prefer affordable housing units,

The growth of asset values has outstripped returns on labor for four decades, and a McKinsey report found that a majority of those assets — 68 percent — is real estate. Last year, one in four home sales was to someone who had no intention of living in it. These investors are particularly incentivized to buy the sorts of homes most needed by first-time buyers: Inexpensive properties generate the highest rental-income cash flows.

6. A ProPublica investigation of the multifamily housing market found that PE is now the dominant form of financing among the 35 largest owners of such units, rising from about a third in 2011 to more than  half in 2022. The article has a nice articulation of the problems with PE ownership of housing, compared to traditional landlord ownership. 

Private equity firms often act like a corporate version of a house flipper: They seek deals on apartment buildings, slash costs or hike rents to boost income, then unload the buildings at a higher price... Such firms use economies of scale to more aggressively squeeze profits from their buildings than traditional landlords usually do, tenant advocates say. The firms’ tactics can include sharply increasing rent or fees and neglecting upkeep. Sometimes landlords force out existing tenants and replace them with those who can pay more. The companies’ size allows them to influence market rates and lobby against reforms that could dilute their power. And their goals — quickly hiking a building’s profits so they can sell it at a premium — are often at odds with those of the tenants who need to live in them. In contrast, so-called mom-and-pop landlords usually look for steady streams of rental income over time while their buildings grow in value.

The fundamental problem is the returns expectations that underpin the PE model,

Private equity firms boast about outsize returns, and the most aggressive funds seek a profit of 20% or more on investors’ contribution, minus management fees. That compares to publicly traded real estate investment trusts, which, on average, pay an annual dividend yield of 4.33% and allow investors to hold the value of the trust’s stock.

The report traces the role of Freddie Mac, the largest rental housing financier in the US, in the rise of PE firms in the housing market. It has an explicit mandate of ushering in housing affordability and buys loans from private lenders so that they can make more mortgages.

Large private equity firms accounted for 85% of Freddie Mac’s 20 biggest deals financing apartment complex purchases by a single borrower, according to a ProPublica analysis of data from the industry publication Commercial Mortgage Alert... Large loans to private equity firms, researchers and advocates fear, are helping drive industry concentration and pushing up the cost of renting. The loans typically do not include provisions that increase tenant protections or that keep affordable housing rents low over the long term.

All these examples raise a simple point. Are private equity investments in these boring low-return mass and BoP market segments desirable? 

An important reason for the rapid recent rise of private equity is the decade-plus period of ultra-low interest rates. It has allowed the consolidation of the business model that uses excess leverage to acquire assets and juice up returns. The return to normalcy with interest rates should go some way in reducing the attraction of this model. But that does not mean that we can step back and allow the dynamic to play out.

The problem with PE is its model, which warts and all is one of asset stripping and profit maximisation, and pass the parcel. The commercial incentives in a competitive race to the bottom are badly misaligned with the social objectives. The incentives are in turn dictated by the nature of the financing source itself and their business model. 

The competitive equilibrium does not keep the market honest because we have reached a stage in the  evolution of the market where its collective incentive is to maximise profits to the near exclusion of all else. In the process, the promotion of social well-being and customer welfare fall aside and become market failures. 

Public utilities like mass transit, water, sewerage, electricity, and solid waste management are regulated and low return assets. As I blogged here, there's a case for excluding windfall profit opportunities and explicitly regulating the various kinds of asset stripping. 

In the cases of mobile trailer parks, kindergartens, affordable housing, ambulances, mass market franchises etc, there should be a wider debate on the value add from private equity investments. 

Yes, in these cases, the entry of larger firms and newer business models can add value. But is this particular business model adding value? There's a difference between capturing value from brownfield assets, and creating greenfield assets. Yes, in theory the value capture from the brownfield assets leads in the long-run to creation of greenfield assets. But the theoretical long-run can be very long and we're all dead in the long-run. The empirical evidence points to the taking over-riding the making. 

This is also an occasion to question the blind faith among influential opinion makers in the value of academic research and theoretical evidence in informing shaping the discourse on important public issues of our times. Instead, public debates ought to be informed by practical evidence, common sense, and wisdom. 

The debate on widening inequality is a case in point. The intense academic debate on the issue cannot and should not be allowed to overlook the unambiguous reality of widening inequality and the primary role of asset prices  in contributing to it. Similarly, the debate on the reasons for business concentration should not crowd-out the stark reality of rising business concentration and its corrosive effects on the economy and the polity. On the same lines, the pervasive reality and attendant concern about profiteering and rent seeking by private equity should not be drowned out by the debate on the theoretical merits of private equity in financial intermediation. 

In general, in the context of the increasing pervasiveness of the private equity business model, there should be a wider debate on the role of the market and the business firm. Instead of tip-toeing around fuzzy and feel-good notions of stakeholder capitalism and the likes, it's time to confront the elephant in the room, the largely unrestrained and single-minded firm pursuit of profits maximisation. 

In this context, the Viennese model of social housing, gemeindebauten, is instructive,

Vienna has succeeded in curbing the craving to own. It has done it by driving down the price of land through rezoning and rent control. In general, the beneficiaries of these land-use policies are less the Gemeindebauten (they stopped building from 2004 to 2015 and now only produce some 500 units a year) and more the limited-profit housing associations, the origins of which preceded Red Vienna and have built 3,000 to 5,000 units a year for the last four decades.

Today limited-profit housing accounts for half the city’s social housing. Limited-profit housing associations are restricted to charging rents that reflect costs. Investors — banks, insurance funds — may buy shares of the limited-profit housing associations, generally to help fund initial construction. They are paid a low rate of annual interest on their shares. Any profits beyond that must be reinvested in the construction of new social housing. “It creates a revolving flow of financing for social housing,” said Justin Kadi, a professor in planning and housing at the University of Cambridge. Vienna’s main outlay toward housing is now providing low-cost financing for construction — and the government gets that money back.

The ESG discourse should be expanded to include a B, or responsible pursuit of the corporate bottom-lines (as against the illustrative scorched earth strategies). It should be ESGB. 

This is not to draw some arbitrary thresholds on profits, but proactively put the issue of margins and markups, and profits (and the means of realising them) on the discussion table. There should be simple and clear headline disclosure requirements on these. When the balance has swung to the other extreme on profits maximisation, it's time to proactively introduce a corrective to the discourse. And that may often involve elements which push in the extremes in the other direction. We can afford to be not overly concerned at this shift given the checks and balances in the economy, polity and the society on such issues.

Finally, there is the need to debate the consequences of financialisation, the driving force behind practices and market segments like private equity. Gillian Tett recently pointed to the latest McKinsey report on global wealth creation. It found that the world's stock of paper wealth (the speculative, unrealised price of all its financial assets) has jumped by $160 trillion since 2000. For every dollar of global investment made since 2000, $1.9 of debt has been added, with the leverage rising to $3.4 in the 2020-21 years. The value of global assets (mainly from real estate and equity markets) rising to 470% of global GDP to 600% since 2000. Finance has clearly become an end in itself. Do we need such finance? Should we not restrain it?

The importance of human capital investment and the account of its delivery

From a Policy Note made for the Government of India in 1955 by Milton Friedman (HT: Sanjaya Baru)

In any economy, the major source of productive power is not machinery, equipment, buildings and other physical capital; it is the productive capacity of the human beings who compose the society. Yet what we call investment refers only to expenditures on physical capital; expenditures that improve the productive capacity of human beings are generally left entirely out of account. In the United States, for example, only about one-fifth of the total income is return to physical capital, four-fifths to human capital. By this writer's estimate similarly, only about one fifth of the annual rate of growth in the United States can be attributed to the direct effects of investment in the usual sense; four-fifths must be attributed to the growth in the productivity of human beings. Annual expenditures on improving the quality and quantity of human resources are at least as large as and perhaps much larger than investment as usually defined. Destroy the physical plant of the United States and leave the skills of the people and it would take but a few years to restore the initial position. Destroy the skills and leave the plant and the level of output would sink irretrievably. The cathedrals of medieval Europe, the pyramids of Egypt, the monuments of the Moghul empire in India are all testimony to the possibility of a high rate of investment in physical capital without a growth in the standard of living of the masses of the people. These considerations are especially important for India, precisely because its frontier is the frontier of technical knowledge and skill.

This is not to deny in any way the desirability of investment in physical capital. It is certainly highly important and is to some measure an indispensable concomitant of the development of human capital. But it is not the whole or even the most important part of the story. The danger is that concentration on it may lead to policies that increase physical investment at the expense of investment in human capital; and even within the area of physical investment, may lead to increases in the kind of physical investment that we can measure at the expense of kinds that we cannot measure. We must be aware lest we become the victims of our statistical creations.

This is brilliant writing. Clear and elegant articulation of one of the most important overlooked realities of macroeconomic policy making globally.  

And it's perhaps even more relevant as a policy brief for India today than it was then. 

Investments in human capital suffer from problems at least three levels, thereby making it less attractive for all stakeholders concerned. All of them have to do with the qualitative and long-drawn nature of investments in human capital.

On the political side, while the physical components of investments in human capacity are a political good, the same cannot be said about the quality of the service delivered. So for, example, have we come across villagers complaining that the quality of instruction in their schools is poor? Or that the doctor does not ask enough or relevant questions or spend enough time to do the right diagnosis and provide the correct treatment?

On the bureaucratic side, while the physical components of buildings, equipment, personnel, and other inputs are measured using the standard accounting system, the same cannot be done for quality of service delivery on education, skilling, health care, sanitation, nutrition etc. Even when they focus on quality, it becomes confined to the accounting of quality, which in all these cases suffers from several limitations. So both the politician and the bureaucrat gloss over the quality side and focus on the inputs. 

The citizen (or customer of the public service) struggles for various reasons to go beyond the physical components. In most cases, there are no easily comprehensible measures of the quality that are quantifiable, connected to some practical desirable benchmarks, and credibly measured. In these circumstances, the citizen's expectations are left anchored around inputs. Compounding matters, there are some distracting measures of perceived quality that generate perverse incentives - perception of English fluency, excess use of diagnostics and medications, doing IT skilling courses etc.

It's for this reason that I'm increasingly convinced that any meaningful reform efforts in sectors that are human engagement intensive, and involve quality or behaviour change necessarily require systemic efforts. The traditional accounting based implementation has to be complemented by the building of a narrative around the account. Without this, all accounting efforts, using the best of technologies and most intense monitoring will merely be a band-aid on the gangrene. 

The importance of experience

I just completed Bent Flyvbjerg's How Big Things Get Done. He talks about the importance in project planning of experimentation and experience, captured in the Latin word experiri. 

This about the importance of experience in successful project execution (and a lot else) 

But as the scientist and philosopher Michael Polanyi showed, much of the most valuable knowledge we can possess and use isn’t like that; it is “tacit knowledge.” We feel tacit knowledge. And when we try to put it into words, the words never fully capture it. As Polanyi wrote, “We can know more than we can tell... Highly experienced project leaders like Frank Gehry and Pete Docter overflow with tacit knowledge about the many facets of the big projects they oversee. It improves their judgment profoundly. Often, they will feel that something is wrong or that there is a better way without quite being able to say why. As a large research literature shows, the intuitions of such experts are, under the right conditions, highly reliable. They can even be astonishingly accurate.. This is “skilled intuition,” not garden-variety gut feelings, which are unreliable. It is a powerful tool available only to genuine experts—that is, people with long experience working in their domain of expertise...

When Aristotle discussed the nature of wisdom more than 2,300 years ago, he didn’t scorn the knowledge we get from classrooms and textbooks. It is essential, he said. But practical wisdom, the wisdom that enables a person to see what’s right to do and get it done, requires more than explicit knowledge; it requires knowledge that can be gained only through long experience—a view supported by Michael Polanyi and a great deal of psychological research 2,300 years later. As previously mentioned, that practical wisdom is what Aristotle called “phronesis.” He held it in higher regard than any other virtue, “for the possession of the single virtue of phronesis will carry with it the possession of them all [i.e., all the relevant virtues],” as he emphasized.

He describes the importance of experience in the success of several important large projects.

Experience is what elevates the best project leaders—people like Frank Gehry and Pete Docter—above the rest. And in both planning and delivery, there is no better asset for a big project than an experienced leader with an experienced team. How does experience make people better at their jobs? Ask someone that question, and you’ll likely hear that with experience people know more. That’s true as far as it goes... When a highly experienced project leader uses a highly iterative planning process—what I earlier called “Pixar planning”—good things happen... the process of building the Disney Concert Hall taught Gehry a host of lessons that he used in building the Guggenheim Bilbao and has used in projects ever since. Who has power, and who doesn’t? What are the interests and agendas at work? How can you bring on board those you need and keep them there? How do you maintain control of your design? These questions are as important as aesthetics and engineering to the success of a project. And the answers can’t be learned in a classroom or read in a textbook because they are not simple facts that can be put fully into words. They need to be learned as you learn to ride a bike: try, fail, try again. That was what Gehry did and Utzon didn’t. One had built experience, the other had not.

The importance of experience arises from its role in people's ability to exercise good judgement. It's about phronesis, the ability to exercise good practical judgement, the highest intellectual virtue as per Aristotle. 

A simple theory of knowledge processing I have found useful is that it has three parts - learnt knowledge, lived life, and lived career. The first is the theoretical and the second and third are experiential knowledge. The Aristotlean phronesis emerges from an interaction of the theoretical and experiential knowledge. You need a combination of the three to process knowledge, understand the world, and make good judgements. 

The importance of practical wisdom increases with the complexity of the issue being examined. And there are few more complex issues in the world than policy making and implementation on development and economic growth. As I blogged here, decision making in development contexts is invariably about the exercise of judgement. Good judgement is the difference between success and failure. 

From this aforementioned perspective, international development discourse has a fundamental problem. It elevates theoretical knowledge as superior and discounts experiential knowledge. It also elevates the knowledge of the sayers and discounts that of the doers. I have blogged about the sayer-doer dissonance in development,

The sayers are informed by their knowledge of the why and what ought to be done, the concepts and theoretical frameworks of the issue. The doers are informed by their judgement of what is possible and doable given the circumstances. Each side understand their role and acknowledge it. The sayers draw on their concepts and analytical frameworks to supply the inputs which the doers can apply in their decision making. The doers screen the inputs from the sayers by drawing on countless insights and data points from their practical experience, and thereby exercise good judgement in their decisions. 

The sayers acknowledge the limitations and narrowness of their knowledge, the absence of insights and data points gathered from the experience of a lived life. This gives them an epistemic humility... The acknowledgement of role distinction comes from their respective expertises and perspectives. The sayer's expertise is largely theoretical. The doer's is experiential, the lived experience of doing things. The sayer has the comfort and luxury of working in sanitised environments - contemplating, theorising, designing and experimenting. The doer has to respond to the issue in real-time and based on a multitude of emerging contexts and scenarios. It's accepted that the doers will apply their judgement to the outputs of sayers and tailor their responses accordingly. It's therefore also accepted that these responses will sometimes incorporate the inputs from the sayers, sometimes modify them, and sometimes reject them. It's considered the normal course of things in their respective areas. Flawed judgements by the doers are assumed to be part of the deal.

The development experts and the discourse framed by them offer no such leeway to its practitioners. Instead, the entire debate tends to get side-tracked into one between experts and generalists, where the latter are considered of inferior quality and expected to take the advice offered by experts and implement them unconditionally. This view gets reinforced by the dominant narrative about the inefficiencies and incompetence of governments, politicians and bureaucrats.

This feature of international development discourse is interesting since there is a clear distinction between the sayers and doers in all other fields. The sports coach, management guru, research team of fund management house, and election campaign manager acknowledge their advisory role and leave the execution to the phronesis of the sportsperson, chief executive, fund manager, and politician respectively.

Update 1 

This is a great illustration of the difference between knowledge and experience.

Consultants and conflicts of interest - the PwC Australia edition

PwC has been headline story in Australian newspapers over the last few days. It has emerged that a senior PwC official leading a team advising the Finance Ministry leaked out confidential information about an Australian government's tax policy change to curb cross-border tax avoidance to the company's multinational clients thereby allowing them to pre-empt move and limit their tax outgo. See also this, this, and this. 

In 2015, Peter Collins, PwC Australia's international tax chief, leaked in breach of confidentiality agreements secret information about the Multinational Anti-Avoidance Law which was set to come into effect in January 2016 covering multinationals operating in Australia with global revenues above $1 billion. The information was disseminated internally in an email to around 50 people, including employees in other countries, with a view to helping PwC clients. 

A newspaper report outlined the sequence of events in great detail, 

By October 2014, the tranche of emails released by the Tax Practitioners Board shows that this confidential information was seeping through PwC. “Because it was provided to us on a confidential basis I ask that you don’t circulate it beyond us or discuss it outside PwC – it would really put PwC Australia and me in a real bind,” one PwC executive said, with name redacted. A frenzy of activity on both sides of the 2015 budget worked out avoidance plans and which companies to target with what the government had dubbed the “Google tax” - reflecting the role the tech sector giants had among the so-called “dirty thirty”, the worst transgressors on tax avoidance. “Controversy treasure trove if we can land a few of these,” Collins noted in August 2015...

An email from January 6, 2016 reported just how successful PwC’s tax partners had been in attracting 14 clients with the firm’s plans to combat the new tax laws, including customers who had not previously worked with the firm. Millions in revenue had already been generated from the work, “heavily helped by the accuracy of the intelligence that Peter Collins was able to supply”, the redacted email said. Collins was named Tax Institute’s corporate adviser of the year just months later, but his work had been too successful. The Australian Tax Office (ATO) had become alarmed at just how quickly these companies managed to come up with structures expertly designed to evade the new laws...

By the start of 2017, the tax office was ready to turn its attention to the peddlers of these schemes: The big four consulting firms, PwC, KPMG, EY and Deloitte. Most of the big firms complied as expected. One did not – as the ATO told Senate estimates this week. “It appeared our investigation was being frustrated through false Legal Professional Privilege (LPP) claims. We had to issue further notices to obtain information that was clearly not subject to LPP, such as internal PwC emails,” tax commissioner Chris Jordan told estimates this week. Due to these obstacles, it took the tax office far longer than expected to get the information it needed, but it was worth the wait.

Shockingly, even as it became clear to the Tax Office that Collins was leaking confidential information, it still took time to formally expose him. The investigations evolved in slow-motion with the different organs of the government taking their own time to respond. 

By late 2017, the tax office had emails that indicated Collins had shared confidential Treasury information with PwC partners, and they had hatched plans to profit from it... secrecy obligations prevented the department from sharing any of this information with Treasury, the treasurer, or any other department... Meanwhile, Collins was still attending Treasury briefings, signing another confidentiality agreement in February 2018... The tax office soon contacted the AFP, but fresh problems cropped up. The feds had the criminal investigative powers but the ATO had the information and, once again, couldn’t share much of it. The AFP has said there was insufficient information in the material provided by the ATO at the time to support a formal referral...

The matter was referred to the TPB in July 2020, and the tax body commenced investigations into Collins and PwC in 2021. The TPB’s board would finally determine there were breaches in October 2022 – four years after evidence of wrongdoing was discovered by the tax office and eight years after PwC’s first known transgression. Amazingly, no one outside the ATO, TPB or PwC was aware of the scandal at this stage. Collins was allowed to quietly leave PwC that month. The firm has not said if he is receiving the customary pension of as much as $140,000 a year. Things took a turn, however, in January this year, when Collins was finally named. 

Even after he was exposed, PwC's response was nonchalant,

But the only penalty imposed was PwC being ordered to carry out additional training on conflict of interest and Collins being banned as a tax practitioner for two years... PwC, while apologetic, played down the seriousness of the offence. “We acknowledge the TPB found that a partner of the firm did not comply with confidentiality agreements in relation to a consultation process with Treasury, which occurred in 2014,” a PwC spokesman said at the time. Privately, PwC told journalists – but more importantly, Finance – that the information was shared with a small group of people within the firm and the investigation did not find that any client arrangements or structures were impacted in connection with this matter... When PwC Australia boss Tom Seymour described the issue as a “perception problem”, politicians went ballistic... Labor senator Deborah O’Neill, through dogged questioning in Senate estimates in March, yielded the 143-page document which finally laid bare just how brazenly PwC partners had leveraged the confidential information for commercial gain. Seymour later confirmed he was a recipient of the damning emails. He stepped down as CEO and is leaving the firm in September. 

Some observations:

1. It's imperative that criminal charges be laid on Collins and all others who breached confidentiality and leaked information and those culpable be arrested. Penalties and other financial settlements, and quiet exits of those directly culpable will do little to deter future such behaviours by both individuals and the companies. This should be complemented with a ban of at least five years from any kind of contracts with any public agency. This ban should cover all the business lines of PwC given that in this case it's evident that the consulting part leaked information to the tax practice. 

Such punishments are required to break the comfortable equilibrium wherein the consultants have come to expect and internalise into their pricing the penalties and short and limited bans as the financial cost of such unethical and illegal practices. This equilibrium can be broken only with pattern breaking and prohibitive punishments. Such punishments should become the new norm with consultants. Only such actions will inform individuals that these are irregularities amounting to moral turpitude and will immediately invite termination and criminal liability. 

The corporates too should take the cue and exercise their corporate responsibility by avoiding the consultant. The consulting industry associations should realise the seriousness of the problem, and take strong enough action that signals the shift from the previous comfortable equilibrium. 

Underlining this point is the fact that despite all the mounting evidence of clear leakages, and despite even the Tax Practitioner's Board, the industry watchdog, banning Collins from tax practice for two years, PwC has not formally fired anyone. All the partners who have left have been "stood down". In the absence of information to the contrary, given the several examples from consulting and finance, it's likely that even those who have been stood down have been done so with generous severance packages. 

2. Stunningly, PwC is still refusing to reveal the names of the 50 or so senior employees who received the emails from Collins and the clients who benefited from this information. This requires a completely independent investigation by an agency appointed by the regulator or the government (and certainly not by PwC). For a start, given the seriously sensitive nature of the information that was sent in these emails, did these partners report its contents to the company's risk or internal control units, or atleast their managers? If they did not, and especially if none did, it's compelling enough to argue that such information transfers across the company are common enough.

Then there's the issue of what happened on the information leaked. What did each recipient do with the information? Their mails and subsequent actions will have to be scrutinised, including that of those  contacted within the company. It's important that this case be used to identify all the failures in internal controls to monitor and prevent such illegal practices. It's also important to also identify and document the internal mechanism of such practices, which are most certainly prevalent in other consultants and in other countries. 

This can be used to formulate guidelines that explicitly call out the possibility of such practices and pre-empt them with specific monitorable actions and with prohibitive punishments. These guidelines should become part of all consulting contracts. I have discussed them in an earlier post here. 

When illegal and unethical practices have become the norm, and are not being acted on because of the difficulties with documenting them to the legally mandated standards, it's required to explicitly identify them and formulate safeguards and measures to prevent them. That's the requirement now. 

3. This raises an important question that I had alluded to in an earlier post about why such core policy design activities were given to consultants. As an oped in SMH wrote,

Why on earth was PwC – a substantial contributor to the global problem of cross-border tax minimisation – involved in designing Australia’s response to that very problem? Anyone could see this was going to be a problem.

It’s impossible to police such work and very difficult to establish any wrongdoing. And, as this case, demonstrates, even if something comes out it would take an inordinately long time by when the damage would have been done. In all such engagements, the confidentiality clauses exist only in name. Having consultants manage sensitive policy design should therefore be strictly prohibited.

4. This is important since the main business of consultants comes from their corporate advisory services. The government advisory is a small share of the total revenues. Public sector consulting provides consultants with access to extremely sensitive and commercially high value information. It's therefore highly valued, and explains why consultants go the extra-length to offer free consulting services to the government. Apart from specific knowledge about the policy proposal, it also helps them understand the government processes and the people involved.

Given everything we know about the reality of corporate ethics and governance globally, we are kidding ourselves if we believe that a company whose main business is corporate advisory (in the same areas where they help governments make laws) will not use privileged information for its private benefit. 

Consultants had the potential to advise private clients how to win grants while the consultants’ own staff were part of the apparatus approving them. Ken McAlpine, who was a policy adviser and a chief of staff in Victoria’s Brumby government, tweeted this week how widespread the practice is. “They all do it. PwC, EY, KPMG and Deloitte. They design and administer programs for government and they also help private sector clients chase government grants. They’ve been doing it for years,” tweeted McAlpine, who now works as a lobbyist. “The pressure to share this information must be intense.”

5. Such practices by consultants are now commonplace with numerous examples that have surfaced in recent months from the US, Germany, the UK, South Africa, etc. It's most certainly happening and widely prevalent across consultants working with governments in India. It's only a matter of time before some of them surface as scandals that have caused massive losses to the government. It's therefore essential that the model contract document for hiring consultants be amended to incorporate these safeguards. This post has some useful suggestions in this regard. 

Update 1 (06.07.2023)

It has now come to light that PwC tipped off Google on Australian law changes,

PwC tipped off Google on the timing of a controversial Australian tax law, based on inside information gleaned by one of the accounting firm’s partners, it has been revealed. The tech company is the first to be named as a recipient of confidential information in a scandal that has engulfed PwC Australia and led to the firing of eight partners. A PwC partner who acted as an adviser to the Australian government passed information about upcoming laws to colleagues, who used it to tout for business on the US West Coast, according to internal emails unearthed in an investigation by Australian lawmakers. A Google employee received an email from a PwC partner in August 2015 that said Canberra would be pressing ahead with a tax clampdown on multinationals the following year, despite pressure to delay the new legislation... A January 2016 email celebrated $2.5mn in new business in North America, which one partner wrote had been “heavily helped by the accuracy of the intelligence that Peter Collins was able to supply”. The Australian tax partners had worked “extensively” with other PwC firms around the world, including in the US, Netherlands and Singapore, the email said.

Weekend reading links

1. China's solar capacity addition is back and at a scorching pace.

The country installed almost three times the volume of solar capacity between January and the end of April than in the same period in 2022, and is on track to add more panels this year than the entire total in the US... The nation could install 154 gigawatts of solar capacity this year, BloombergNEF said on Monday, raising its China forecast from a previous total of 129 gigawatts. The US had a cumulative total of 144 gigawatts installed at the start of 2022, according to BNEF data... The rise in China’s deployments means the world is on track to have a total of 5,300 gigawatts of capacity by 2030 — about the volume of solar that is required in scenarios under which global net zero targets are met.

2. Green Hydrogen is the buzz word. It's estimated that 500 million tonnes of Hydrogen would be needed by 2050 or 10% of the energy mix. The total financing requirement for this would be a staggering $20 trillion by 2050. 

For an idea of the size of this capital project, however, it is worth dividing hydrogen capex three ways; the cost of renewable electricity needed to make the gas, expenditure on electrolysers used to split water into oxygen and hydrogen and, lastly, the infrastructure — pipelines, ships and storage sites — required to take the hydrogen where it is needed. Generating this amount of hydrogen will need almost 25,000TWh of renewable electricity a year, about 100 times the UK’s current electricity demand. On the assumption that solar panels and wind turbines are placed in sunny and blustery areas, we would need 10TW of infrastructure, Lex calculates. At an average cost of $800 per kW, the investment required would be about $8tn. The second bucket is the electrolysers. Today, inflation has pushed up the price to about $1,500 per kW but it could be as low as $250 per kW by 2050. Using a midpoint of $875 per kW implies a capex requirement of $7tn to achieve the desired goal. When it comes to infrastructure, the expenditure needed for transport and storage depends on the specific technology. The cheapest option involves pushing hydrogen through repurposed gas pipelines and using repurposed storage sites. Supply chains involving shipping hydrogen transformed into ammonia will be more expensive. Overall, capex may hover at about $5tn.... 

A simple way of calculating the average cost of hydrogen is to divide the capex by how much hydrogen the kit it buys might produce over its 20-year lifespan. By that reckoning, the average cost for the hydrogen would work out at about $62 per MWh... Assuming that natural gas will stabilise at a more reasonable $50 per MWh, that would suggest every unit of hydrogen needs a $12 per MWh subsidy on average. Multiplying that for the whole of the hydrogen produced, we are looking at about $4tn in subsidies... A look at Platt’s hydrogen price wall, which shows the cost of hydrogen produced in different regions, suggests that, while some projects manage to come in at $50-$100 per MWh, the cheapest hydrogen in Europe today costs more than $150 per MWh without transport and storage. European natural gas meanwhile is below $32 per MWh. This means that a serious subsidy push is needed if hydrogen is going to reach the scale required to break even with existing energy sources.

The Americans are supporting Green H2 development by direct tax credit of around $3 per kg for a period of 10 years, whereas the Europeans are mandating green hydrogen in energy mix mandatory (42% of the hydrogen used in industry to be renewable by 2030).

3. Adani Transmission facts of the day,

Adani Transmission, which went from being a fledgling to India’s largest private utility in seven years, has grown its asset portfolio 3.6 times to 19,779 circuit kilometers (ckm) across 33 projects. Of these, 13 projects are currently underway, but many face delays or cost overruns, including the largest one: the Warora-Kurnool Transmission line that runs through three large southern Indian states. Others have been beset by adverse weather, pandemic-era disruptions or legal wrangles — common issues in infrastructural projects in India which makes the Adani group the rare private company that has been scaling up aggressively in this space. With India planning to add more than 27,000 ckm of transmission lines by 2025, the company’s continued expansion will be crucial for the national goal.

The Adani story is important for another reason. It's now clear that India need the likes of Adani who have both the ultra-high risk appetite and the massive scaling ambitions required to support its very large infrastructure addition requirements. 

Apart from its long gestation and scarce long-term finance, infrastructure execution is full of messy problems arising from its entanglement with the local political economy. Even the most sanitised contracting cannot avoid the rent-seeking at various levels that extend through the life-cycle of the project. Given the messy realities of infrastructure execution, I've argued here that scale growth in infrastructure requires greasing with rents. This requires a third attribute, the capability and corporate culture to navigate the bureaucracy and polity. And Adani is the rare company which appear to meet all three requirements. 

The problem is with having the scaling ambition and also having the capabilities to realise it. This works at the level of the country and the company. Does India have the capabilities to grow at sustained high rates with its existing capabilities? Does Adani itself have the capabilities to support its spectacular growth ambitions? In Can India Grow, we've argued against the former. On Adani, there's little to suggest its track record for such scale execution. 

From its track record, the Adani Group appears to be one that has ultra-high risk appetite, sky-high ambitions, and excellent political economy navigation skills. But its capabilities are nowhere even remotely close to realise its ambitions. 

There's no precedent of starting out from nothing to own a third of India's airport capacity in 3-4 years. In any of the several other verticals it operates in, the Group has had little or no experience. There are hard limits to such inorganic growth. Infrastructure execution is not like IT with their network effects and exponential growth. 

For a start, there's finance. The Group has followed a virtual Ponzi financing model, whereby it bids aggressively for a project, secures it, raises debt by leveraging the new contract, uses this money to bid more, and so on. And simultaneously start execution. Ultimately, it has to keep generating revenues from the projects it has secured to be able to repay its burgeoning debt pile. In so far as its cash flow challenges, this is like a trapeze artist on the thinnest trapeze. 

This trapeze art works so long as either the rate of new project/contract acquisitions and associated debt mobilisation exceeds the repayment obligations and investment requirements, or the rate of project revenues and debt mobilisation exceeds the repayments and investments. The problem is that infrastructure execution is filled with uncertainties and time and cost over-runs are common, which in turn necessitate renegotiations, which in turn demand invoking political economy connections. 

Then there is the manpower capabilities. This includes capable sub-contractors at scale, good internal managers, and excellent senior project leadership capabilities. All these are extremely scarce. It's almost impossible to acquire the managerial and execution capabilities at the scale required from the Indian labour market. Talent of such quality at this scale just does not exist.

In the absence of all these, the Adani Group's growth was bound to hit the ceiling. It is all fine as long as they were merely acquiring contracts. However, once the repayments rose enough to demand project revenues too, the strains were inevitable. 

4. On the central bank forecasting

Most of the Federal Reserve’s rate-setters failed to foresee that inflation would ever rise, and then overestimated the speed of its decline. Economists at the BoE and the European Central Bank underestimated the scale and persistence of inflation. Across the world, poor forecasts have contributed to central bankers failing to do their main job: maintaining price stability. The failure to spot inflation has not only left central bankers risking financial instability by having to raise rates far faster than usual but threatened the credibility of institutions that rely on trust to steer the economy towards sustainable growth.

5. Some snippets about foreign banks in India,

HSBC India has 12 per cent share in the foreign exchange business, 9 per cent in exports, and close to 20 per cent of foreign direct investment has been done through this bank... More than 30 per cent multinational companies in India — over 1,000 — bank with Citi. It manages 8 per cent of India’s trade flows and 5 per cent of domestic electronic payments flows... HSBC India... is into multinational banking in a big way (45 per cent of the multinational companies in India bank with it) besides emerging and large Indian corporations.

Foreign banks have avoided the low margin mass-market services and have preferred sticking to the high-margin niche market services. 

6. Semiconductor chips manufacturing is an extremely specialised and perhaps the most capital intensive of all manufacturing. It's most unlikely that India will make a breakthrough and get a foothold on this market. The Chinese have struggled. Besides the amount being offered as PLI incentives are tiny for the kind of investments required for smaller size chip manufacturing. It's therefore no surprise that the Vedanta-Foxconn deal has unravelled, and it's perhaps good that it has unravelled quickly. All the others showing interest are doing so only to knock-off the incentives, and it's great that the government has seen through the game. None of the three dominant global chip makers - Intel, Samsung, and TSMC - have shown any interest. 

If there's an area in the semiconductor value chain that India should be pursuing aggressively, it should be in chip design where it already has some strength.

7. In the context of semiconductor chips manufacturing, FT has a long read on how small chips can get. The critical driver of how small chips can get is chip lithography, where Dutch company ASML is a monopoly. Its extreme ultraviolet (EUV) photolithography machines "print" transistors almost as small as "the diameter of a human chromosome on to sheets of silicon to make a semiconductor". 

It is now ASML that is seen as keeping Moore’s Law alive, helping manufacture chips the size of a fingernail that can hold about 50bn transistors. “What’s driven Moore’s Law? It’s basically lithography,” says Jamie Mills O’Brien, an investment manager at Abrdn, a top 50 investor in ASML.

But the limits are now clearly evident and imminent,

The latest 3-nanometre chips being mass produced for this year’s iPhones will be followed by what some see as an even bigger leap forward to 2nm by 2025. “But once you get to 1.5nm, maybe 1nm, Moore’s Law is 100 per cent dead,” says Ben Bajarin, a technology analyst at Silicon Valley-based Creative Strategies. “There’s just no way.” Chip engineers have defied forecasts of an end to Moore’s Law for years. But the number of transistors that can be packed on to a silicon die is starting to run into the fundamental limits of physics. Some fear manufacturing defects are rising as a result; development costs already have. “The economics of the law are gone,” says Bajarin.

To give a sense of the technology involved

ASML produces machines capable of vaporising tiny droplets of molten tin up to 50,000 times a second, creating a 13.5nm wavelength of light. This EUV light is then bounced off a series of mirrors inside a vacuum chamber, narrowed and focused until it hits a silicon wafer... The company’s high numerical aperture (NA) machine is the latest output of its huge research and development investment, which rose 30 per cent to €3.3bn in 2022. High-NA essentially expands the numerical aperture — or range of angles — over which the light can be bent and emitted, allowing it to create smaller transistor patterns on a wafer. ASML has just five customers for its existing EUV machines — TSMC in Taiwan, Samsung and SK Hynix in South Korea, and Intel and Micron in the US. All of them have ordered the latest model.

The company is also a monopoly in Deep UV (DUV) machines used to make larger chips used in cars and electric equipment.

8. Vivek Kaul makes some important points about the current state of the Indian economy,

First, a large section of the population is still struggling financially... Second, there has been a marginal turnaround when it comes to investment in the economy, but the question is if this can be sustained without a more equitable growth in consumption... Third, more people have gone back to agriculture over the last few years and that is not a good trend... “the agricultural sector witnessed a return of 36 million workers between 2017–18 and 2021–22”. This has led to a scenario where “the absolute count of workers in agriculture stood higher in 2021–22 than in 2011–12.” This is perhaps an impact of the gradual destruction of the informal sector, which has always been a major job creator... Fourth, micro, small and medium enterprises, which are usually major job creators, have been struggling for a while now... Fifth, there are not enough jobs for India’s youth.

9. In the context of mobile phone manufacturing and the PLI scheme, Andy Mukherjee raises questions on the value addition potential in India.

On each phone assembled locally, the government pays the likes of Foxconn and Wistron Corp., another Taiwanese contract manufacturer for Apple Inc., up to 6% of the invoice price... The emerging consensus in policy-advisory circles is that in a decade the nation will go on to capture about 20% of the final price of a device. That’s optimistic, considering that China garnered $6.5 on the first iPhone in 2009. It took the People’s Republic nearly a decade to raise its take to $104, or 10% of the final price of iPhone X, economist Yuqing Xing has estimated.

On this, Raghuram Rajan et al write,

For the Apple iPhone 12 Max, industry estimates are that Foxconn’s value added from final assembly and testing is about 4 percent of the manufacturing costs, which in turn are about 1/3rd of the value of the mobile phone. As India goes further into sub-assemblies, the value added in India will increase. But so long as India does not make the component parts themselves (such as the memory, the processor, the lens, the display, and the battery), the manufacturing value added in India will be small. Indeed, a key question is whether the 6 percent subsidy India pays on the finished mobile phone, coupled with state subsidies, actually outweighs the value added in India.

10. Finally, private equity investments may be posing national security concerns in the US vis-a-vis China as Chinese state-backed sovereign funds are investors in PE funds floated by US PE firms. Chinese state funds State Administration of Foreign Assets (SAFE) and China Investment Corporation (CIC) with $1 trillion and $1.35 trillion in assets have a quarter of their funds invested in alternatives, mainly through western buyout funds.

Private equity executives insist there is no risk to national security in having money from Chinese state entities in their funds because the way they are structured typically does not give such investors board seats or voting rights. Indeed, some see it as a risk-free way to attract Chinese capital without giving up any actual corporate influence. However, the close relationship between private equity and the Chinese state has become increasingly at odds with the shifting political mood in western capitals, where governments have become much more vigilant about the potential for Chinese influence over strategic industries. In the case of private equity, this is aggravated by a wider lack of transparency...

The investments by Chinese state-based funds are starting to attract political scrutiny because they have created ties between Beijing and western economies that could be nearly impossible to unpick. “It is deeply concerning that Chinese state investors effectively own such large swaths of our economy and infrastructure, through their investments in private equity funds and other investment vehicles,” says Alicia Kearns, a Conservative MP who chairs the influential foreign affairs select committee in the UK. “The private nature of these funds means it is impossible to know the true extent of this phenomenon.”... The fallout from the global financial crisis helped the Chinese sovereign wealth funds build closer ties with private equity firms, many of which were struggling to raise money from more traditional sources of capital... the large sums being channelled through private equity funds could make it much harder for the US government to consider using sanctions as a policy tool against Beijing in the event of heightened tensions between the two countries. “The more China is integrated financially and economically, this will act as a deterrent to introducing sanctions or mean it’s very difficult to implement them,” she says.

This indirect mode of Chinese capital inflows into the US skirts the rigorous scrutiny of direct investment under the Trump-era Committee on Foreign Investment in the US (CIFIUS) legislation.