Friday, August 18, 2017

Historical asset prices

Ananth points to the FT Alphaville article that features the new work of Oscar Jorda, Alan Taylor and Co that examines the relative rates of return for equity, housing, bonds, and bills for 16 countries over the 1870-2015 period. Their finding,
Over the long run of nearly 150 years, we find that advanced economy risky assets have performed strongly. The average total real rate of return is approximately 7% per year for equities and 8% for housing. The average total real rate of return for safe assets has been much lower, 2.5% for bonds and 1% for bills. These average rates of return are strikingly consistent over different subsamples, and they hold true whether or not one calculates these averages using GDP-weighted portfolios. Housing returns exceed or match equity returns, but with considerably lower volatility—a challenge to the conventional wisdom of investing in equities for the long-run.
A summary of their finding below shows that while returns on housing and equity have been relatively similar, the former has been much less volatile than the latter.
The relative performances of all assets with respect to bills for the period from 1870 and from 1950 are below.
FT though points to a wrinkle to this assessment, highlighting that contrary to conventional wisdom capital appreciation is a smaller share of wealth effect from housing and a significant share of the returns to housing has come in the form of rental yields, something unavailable to the typical homeowner. This coupled with the cost of mortgage taken to finance the purchase means that the real return to the homeowner from a housing asset would be far lower. 

And in a nod to Thomas Pikketty and Co, the authors find that r, the real rate of return to capital, has consistently exceeded g, the real GDP growth, in the aggregate sample, except during the wars,
A robust finding in this paper is that r ≫ g: globally, and across most countries, the weighted rate of return on capital was twice as high as the growth rate in the past 150 years... In fact the only exceptions to that rule happen in very special periods—the years in or right around wartime. In peacetime, r has always been much greater than g.
They also find that risky rates, a measure of profitability of private investment, have remained more or less constant over the past four decades, whereas risk-free rates have declined over the same period,
Both risky and safe rates of return were relatively high in the pre-WW2 era, with an obvious dip for WW1. The risk premium between risky and safe rates grew large with the Great Depression and through the Bretton Woods era. Safe real rates were especially low in WW2 up to the late 1970s. After spiking in the 1980s, the safe return has gradually declined, yet risky returns have remained relatively close to their historical average level, and the risk premium is approaching post-1980s highs... We find that the real safe rate has been very volatile over the long-run, more so than one might expect, at times even more volatile than real risky returns. 
An equally important finding is the remarkable rise in correlation of cross-country risky asset returns, in particular equity returns, and attendant risk-premiums
Historically safe rates in different countries have been more correlated than risky returns. This has reversed over the past decades, however, as cross-country risky returns have become substantially more correlated. This seems to be mainly driven by a remarkable rise in the cross-country correlations in risk premiums. This increase in global risk comovement may pose new challenges to the risk-bearing capacity of the global financial system, a trend consistent with other macro indicators of risk-sharing.
This is one more datapoint in the growing pile of evidence about the global interconnectedness and systemic risks posed by excessive financial market integration.

Thursday, August 17, 2017

The contrasting trajectories of infrastructure and welfare sectors in development

Consider how roads were built even thirty years back in countries like India. Government officials would make the project reports and work estimates and get the road approved. Once approved, the local officials would procure materials like bitumen, hire workers, and use government owned machinery to lay the road. One group of officials from the department would do the field execution, another group would do the recording and check measurements, and yet another group would conduct quality control checks. Once constructed, another group of officials from the same department would be entrusted the responsibility of maintenance. As can be imagined, the government incurs the full expenditure for the road on its completion. 

Fast forward to now, and the scene has been transformed beyond recognition. Consultants make detailed project reports and estimates. Once approved, the department tenders the work out to contractors, who have the responsibility of construction to specified standards. The department owns no equipment and supplies nothing. It even outsources quality control and project management responsibilities to consultants. The maintenance responsibility is either bundled with the construction contract or outsourced after construction. What's more, the government even amortises its expenditure by making periodic payouts to the contractor on meeting agreed service levels. 

The department's role is to co-ordinate among a group of private providers. Contract management has replaced execution as the primary responsibility of government. Much the same transformation has happened across infrastructure sectors, including the urban sector. 

It cannot be denied that this transformation has had a very significant impact in the ability of governments to develop massive infrastructure projects, improve the quality of service delivery, lower corruption, and become all round more efficient. 

Now take the example of school education. Thirty years back, governments would construct school buildings, hire teachers, and run schools. The department would develop, print and supply text books; stitch and supply uniforms; run mid-day meal kitchens; buy and make available television and computers with operators; procure teaching material for teachers; and provide trainings on curriculum instruction, leadership, motivation and so on. It would also develop testing instruments, hold examinations, hire data entry operators to collect and consolidate data, and so on. 

Fast forward to now, and virtually nothing has changed. The government continues to do all the same set of activities! Much the same applies to health, nutrition, agriculture, and most other welfare sectors. 

In some sense, this also, at least partially, explains the relative stagnation in service delivery quality in welfare sectors.

In a world of twenty years hence, given very weak state capacity, it is highly unlikely that we would have achieved learning and other outcomes without having catalysed markets that offer services across welfare sectors. Therefore, catalysing markets and the emergence of an eco-system of service providers should be one of the primary objectives of public policy in social sectors in developing countries.

This is not an argument in favour of privatisation but one to leverage complementary strengths. The private or non-government sector is likely to be better at doing engagement intensive activities, which weak state capacity is likely to hinder state from being able to deliver effectively. While schooling and primary health care, being public goods, will have to remain mainly public responsibilities, governments should seek opportunities to leverage private sector strengths where possible. 

Tuesday, August 15, 2017

Is the tide turning on PPPs?

It is no hyperbole to claim that the tide on the unqualified embrace of PPPs has turned. The only thing surprising for me is that the likes of FT are leading the charge. Interestingly, the most intense debate on the issue is happening in UK, one of the countries which was at the forefront of the privatisation movement. I have blogged numerous times that PPPs are costlier, invariably run renegotiation risks, and suffer from governance failings, all of which make them extremely controversial.

The latest example of governance failings come from London's £4.2 billion 15 mile long "super sewer" project, which has been accused of profiteering at the expense of tax payers. The project, being developed by Thames Water through a very complicated project structure and with several government guarantees, is an over-flow super-sewer linking the 57 over-flow pipes across London. This sewer will serve as a catchment for sewerage water which prevent overflow into Thames when it rains heavily and the treatment system cannot cope up with the inflows. 
Of the £4.2 bn, £1.4 bn is being provided as equity by Thames Water, with the investments coming from investors through a very complicated company structure,

The FT article writes,
Thames Water paid £157m in dividends to its offshore investors in the year to March 31 2017 and currently carries £11bn of debt... The European Investment Bank has issued a £700m, 35-year loan and the balance is made up of a mix of bank debt and bonds. As of March 31 the investors had paid in £370m in equity and had bought a further £529m of subordinated debt — commonly used to reduce tax liabilities — receiving an interest rate of 8 per cent... the government has agreed to be the backstop for the project, minimising any risk. According to the terms of the contract, if the cost overruns exceed 30 per cent, the government could be forced to step in to provide additional equity to the Bazalgette consortium or the investors will be allowed to discontinue the project and receive compensation... Thames Water’s 15m customers, who will pay for the project through higher water bills — an increase of £12 to £15 a year currently, rising to £20 to £25 by the mid-2020s — paid £33m to Bazalgette last year, which used the money partly to cover the interest payments on the debt... 

Thames Water has a complicated offshore holding structure and so does Bazalgette, which is owned by Bazelgette Holdings Ltd, which in turn is owned by Bazelgette Ventures Ltd, which is owned by a holding company, Bazelgette Equity Ltd... Meanwhile, Bazalgette paid £2.2m in directors’ salaries in the year to March. Andy Mitchell, chief executive, saw his base salary almost double in the past year to £425,000. He also received a bonus of 66 per cent of his salary, or £281,000, taking his total package to £729,000. These rewards were made even though the management of the project has been outsourced to Amey OWR for system integration and Ch2MHill, which is project managing the three construction consortiums. All the management of the tunnel is doing is co-ordinating some contractors... The tunnel has also provided rich pickings for dozens of law firms, including Linklaters, Herbert Smith Freehills, Ashurst and Norton Rose Fulbright. UBS — which also advised on the sale of High-Speed One, Eurostar, Royal Mail and the Green Investment bank — was an adviser on the project, and the chief financial officer of Tideway was formerly a UBS employee.

Monday, August 14, 2017

The GIS mapping challenge in power distribution

This post is slightly technical and may interest those engaged in power distribution sector. A feature of distribution loss reduction programs across India over the past fifteen years has been the focus on GIS mapping of 11 KV distribution feeders emanating from sub-stations. This is also a major part of the government's latest distribution loss reduction thrust as well as an important priority under the UDAY distribution sector reform agenda. 

Interestingly despite tens of thousands of crores of rupees having been spent on GIS mapping by distribution companies, we do not yet have even a single 11 KV feeder anywhere in the country GIS mapped in a manner that it serves as decision-support. The last part is important since many discoms will claim to have GIS mapped their networks without delivering any reasonable functional utility. This should count as arguably one of the biggest technology scandals in any sector. And, what's more, I shall hazard the claim that we are unlikely to succeed any time in the foreseeable future with such GIS mapping. Here is why. 

A 11 KV distribution feeder is a network with a 11 KV spine that culminates in several distribution transformers from each of which further lines feed into several household connections. This network is a very dynamic system, especially in urban areas, with new connections being added and old ones disconnected, connection categories being changed, and transformers being split or upgraded. Further the distribution network itself undergoes constant changes due to strengthening works, road widenings, large property developments, and several other practical exigencies. 

In this context, any GIS map is reliable only if we have a system to capture these changes and update the network map in real time. This can be done only if the entire work-flow of the distribution company - approval of works, connection changes etc - is automated and captured in one application. Further, the work and completion plans of all network related works and connection changes should  respectively emerge from and be captured and integrated into the base GIS map. 

Even the best distribution companies in India especially those with significant rural areas, despite powerpoint presentations and tall claims, are still some distance away from being able to achieve this.

None of this is to deny the undoubted importance and urgency of distribution feeder mapping - identifying all the consumers under a feeder and each one of its distribution transformers. This is an essential starting point for any meaningful energy audit, critical for the reduction of distribution losses. But this is best done as a simple and diligent exercise of physical mapping of all connections under each feeder. Unfortunately, there are no technology shortcuts to this basic requirement.

This should also count as a teachable example of the limits of using technology in improving public systems. If ever there was the need for a negative screen for an "innovation", GIS mapping of electricity distribution network is the one!

Friday, August 11, 2017

Comments on lateral entry

One of the concerns expressed about the proposal we made on lateral entry into the IAS is that the entry conditions are too stringent as to make it unattractive to the best among prospective candidates. Instead, it is suggested, that lateral entry should include contract tenures for five years or so.

As a preface, it is useful to draw the distinction between lateral entry into the bureaucracy and appointments of technocrats into ministerial positions. All the standout successes belong to the latter category. We should also make the distinction from contract appointments for five year tenures to specific posts. I have argued in favour of such appointments and have covered them in an earlier article here.

This proposal is for an institutionalised system of lateral entry into the bureaucracy. It therefore stands to reason that it has to follow the bureaucratic rules of the game of a parliamentary democracy. A proposal to cherry-pick the bureaucratic features of a Presidential system (the federal bureaucracy in the US) and incorporate them into a Parliamentary system only reveals a profound lack of understanding of different political systems.

For a start, I am not willing to buy the argument that the lateral entry as proposed will not be able to attract the best and brightest. For example, the likely candidates could include at least some of the following, and they are likely to be a fairly significant number
  1. Private sector professionals who have made their money and experience a mid-career urge to serve the country
  2. People with passion and commitment who chose a career with non-government agencies and have risen to leadership positions there
  3. Government employees who have excelled in their careers and have exhibited leadership skills for greater responsibilities.
Second, it is very unlikely that lateral entrants, barring rare exceptions, can come straight from outside the government into positions of Secretary to Government of India and the like and succeed to any reasonable degree. The learning gap will be very steep and not easily bridged in a short time. 

Most lateral entrants would need exposure to not just field conditions, but also understand the dynamics of decision-making - negotiations with diverse stakeholders, trade-offs associated with a political system, engagement with states, co-ordination with other departments, navigating the bureaucracy, extracting work in public systems, being effective in systems with scarce resources and weak capacity, and so on. In this, there is no substitute for a few years of field experience. This is also the biggest differentiator between the IAS and the rest, including from the other civil services.  

Third, the proposal is to recruit bureaucrats and not Ministers. Their role is to plan and execute. Professional competence is just one of the desirable attributes. An arguably more important attribute is the ability to administer and navigate a formidable decision-making labyrinth to get stuff done. Experience can be invaluable in this regard. 

Four, an arrangement where some outsiders are able to cherry-pick their posts and be governed by a different set of administrative rules governing their postings, leaving the regular bureaucrats to be satisfied with the remaining posts, is not just untenable but also plain unfair. It would distort the cadre management within the IAS.

Five, high-profile lateral entrants are unlikely to be willing to rough it out to gain this experience. It is unlikely that they would be able to sub-ordinate themselves to their Ministers and play by the rules of a bureaucracy. They are better off being Ministers themselves.    

Six, I am inclined to believe that these criticisms are unlikely to disappear even with a five year contract. For there will still remain the uncertainty associated with postings and tenures. After all, even in the most optimistic scenarios, the tenure of a Secretary would be less than three years. Would the best lateral entrants be willing for a bargain which could run the risk of glamorous and unglamorous, and with uncertain tenures to boot?

Finally, the belief that outsiders, in general, can parachute in for a few years and make a significant enough dent on the complex development challenges of India betrays a very high degree of naivety. Lateral entry into the IAS has to be introduced without doing more harm than good in a complex political and administrative system. There are rarely any simplistic solutions to such complex development challenges.

Wednesday, August 9, 2017

A case for institutionalised lateral entry into the IAS

An evolution of my earlier view on lateral entry. I have a co-authored article here with Dr D Subbarao advocating an institutionalised system of lateral entry into the Indian Administrative Service (IAS).

Monday, August 7, 2017

The failings of post-modern capitalism

Consider this narrative. A combination of economies of scale, first-mover advantages and network effects have privileged a handful of firms across industries. The superstar firms lobby hard to capture the government and set the rules of the game through regulation and occupational licensing, as well as seek innovative approaches to erect entry barriers to competitors. They attract the smartest talent and compensate them with exorbitant salaries, which often border on the vulgar, far far higher than those affordable for their also-ran competitors, thereby engendering an ever widening skills inequality. They raise capital at the cheapest terms while also crowding out capital to the remaining majority. Finally, and most disturbingly, they also exercise market power egregiously to accumulate massive surpluses, which in turn finds its way back not as increased investments and more jobs but returns to shareholders in the form of share buy-backs at inflated prices. The result is heavily amplified market concentration and declined competition. Finance and technology sectors dominate this trend. 

As much as we sing paeans about these innovative and disrupting companies, this picture of post-modern capitalism is far from the orthodoxy associated with free market capitalism.  

This trend is most egregious with technology based firms, where the popular perception endures of start-ups in garages creating entire markets or disrupting entrenched incumbents. Instead the reality has been of a small group of massive firms, which benefited from being at the right place at the right time to take advantage of a nascent industry with dominant network effects and regulatory arbitrage potential. 

Consider the evidence. The Economist points to the work of Germán Gutiérrez and Thomas Philippon of New York University, who write, 
The US business sector has under-invested relative to Tobin’s Q since the early 2000s. We argue that declining competition is partly responsible for this phenomenon. We use a combination of natural experiments and instrumental variables to establish a causal relationship between competition and investment. Within manufacturing, we use Chinese imports as a natural experiment to test the main prediction of competition-based models of investment and innovation, namely that competition forces industry leaders to invest (innovate) more. We establish external validity beyond the manufacturing sector by showing that excess entry in the 1990s, which is orthogonal to demand shocks in the 2000’s, predicts higher industry investment given Q. Finally, we provide some evidence that the increase in concentration can be explained by increasing regulations and, to a lesser extent, stronger winner-takes-all effects in some industries.
The Economist elaborates on the investment slowdown,
Messrs Gutiérrez and Philippon benchmark investment against “Tobin’s Q”, the ratio of a firm’s market value to its book value. A high Q signals that an industry is earning a lot from its assets, which, all else being equal, suggests it should invest more. The authors show that America’s investment has fallen most substantially, relative to Q, in concentrated industries. In these sectors, investment has also fallen more than in Europe. To explore the issue further, the authors draw a distinction between “laggards” and “leaders”, defined as firms comprising the top third and bottom third, respectively, of an industry’s market value. Laggards, they reason, are more likely to wither in the face of competition, so their investment might be expected to fall. Leaders, though, should be up for a fight if rivals challenge them; their investment should rise. They find it is leaders, not laggards, who are responsible for the bulk of the investment slowdown, suggesting a lack of competition.
And its contribution to the declining labour share of profits relative to capital and widening inequality, 
Recent research by David Autor of MIT and four co-authors finds that “superstar” firms pay out less of their profits in wages. As these firms have grown in importance, labour’s overall share of GDP has fallen. Other research suggests that these firms nonetheless pay more, in gross terms, than ordinary firms, so their rise has directly contributed to inequality.
Rana Faroohar has this to say about its impact on the labour market and labour share of the income,
Finance takes 25 per cent of all corporate profits while creating only 4 per cent of jobs, since it sits at the centre of the dealmaking hourglass, charging whatever rent it likes. Meanwhile, wealth and power continue to flow into the technology sector more than any other — half of all American businesses that generate profits of 25 per cent or more are tech companies. Yet the tech titans of today — Facebook, Google, Amazon — create far fewer jobs than not only the big industrial groups of the past, like General Motors or General Electric, but also less than the previous generation of tech companies such as IBM or Microsoft. What’s more, it is not just the top sectors that control the majority of corporate wealth, but the top companies themselves. The most profitable 10 per cent of US businesses are eight times more profitable than the average company. In the 1990s, that multiple was just three. Workers in those super profitable businesses are paid extremely well, but their competitors cannot offer the same packages. Indeed, research from the Bonn-based Institute of Labor Economics shows that the differences in individual workers’ pay since the 1970s is associated with pay differences between — not within — companies. Another piece of research, from the Centre for Economic Performance, shows that this pay differential between top-tier companies and everyone else is responsible for the vast majority of inequality in the US.
Finally, Gillian Tett points to Thomas Philippon and Ariell Reshef who have shown how closely linked pay has been to deregulation of the sector.
However one slices the data, the case for more employee power and use of collective bargaining, direct regulatory action on anti-competitive practices, and enhanced role for public policy to address the failings of excessive competition has never been so clear. Just as the welfare state saved capitalism from the onslaught of socialism in the immediate post-war aftermath, these policies may be needed now to save capitalism from capitalists.