Sunday, February 7, 2016

Weekend reading links

1. Tyler Cowen points to the stark contrast in night-time ariel photographs of South and North Koreas to highlight the importance of institutions.
2. The US LNG exports, which just began, have already triggered off speculation of price wars in Europe. Like Saudi Arabia in oil, Gazprom has the potential to become the swing gas producer since it has the largest spare capacity and is also the lowest cost gas producer in the world. In the context of rising US exports and liquefaction terminal construction, the FT reports that Gazprom may be encouraged to increase production to push prices down lower to keep out the shale imports. 

It is only a matter of time before these forces reach the East Asian markets, keeping gas prices there contained. A truly integrated global natural gas market may be only a couple of years away. It is all the more important that India's policy makers keep this in mind while formulating gas pricing policies for the new production sharing contracts. 

3.  A good summary of research on the impact of MGNRES in Livemint. One thing that is clear from recent events is that the program is good politics.

4. In addition to the conventional indicators of economic weakness, consider these trends. Corporate investment intentions hit all-time lows; external commercial borrowings decline; investment commitments by China, Japan, UAE etc fail to materialize; the same Indian corporates who hesitate to invest in India are doing so abroad etc. 
It appears that, at this point in time, India is investment-demand constrained. Public investment should undoubtedly become the engine to revive investment cycle. But, at about 1.72% of GDP for 2015-16 and a high fiscal deficit, there is only so much that is possible with this strategy.

5. Following the 20% import duty on hot-rolled coils imposed in September for 200 days, the Government of India has imposed a minimum import price on different categories of steel products for a period of 6 months. These measures are aimed at protecting a bruised steel industry. It comes even as the industry is floating on excess capacity, and steel makers across the world are fighting sharply falling demand and thereby prices. 

This is certain to invite action against India before the WTO's Dispute Settlement Board and most likely to be untenable. Further, it is not clear whether this is going to improve the prospects of most Indian steel producers whose competitiveness have been seriously hurt by their very large debt-servicing costs, which alone in some cases is more than the import price of Chinese and Russian steel. Finally, the biggest losers will be the country's manufacturing industry, for whom steel is an important intermediate, and the consumers. 

6. The Citylab writes that 2015 was a bumper year for skyscrapers (more than 200 m high), with the highest ever completions. Interestingly, Jakarta had the largest number of skyscrapers completed in 2015, at seven. As a comparison, Mumbai had one.
It is surprising that India, where A-grade commercial real estate has been frothing, does not figure anywhere. Interestingly, while Mumbai has 14 skyscrapers, all but one are residential. This is in stark contrast to global trends, where office and mixed-use dominate and residential is a very small share. Why doesn't India's office space developers go vertical?

7. The Business Standard argues that the Vijay Kelkar report recommendations would go a long way towards reviving PPPs in infrastructure. In particular, this caught attention,
The most path-breaking suggestion is a two-tier framework of dispute resolution with Infrastructure PPP Project Review Committee and Infrastructure PPP Adjudicatory Tribunal. Once a stakeholder files a reference before the tribunal, and it takes cognisance of it, no party or stakeholder would be allowed to approach any court of law, and all courts shall refrain from adjudicating upon any proceedings initiated that are related to the project in question.
The committee has proposed enactment of a law under Article 323B of the Constitution under which Infrastructure PPP Project Review Committee and Infrastructure PPP Adjudicatory Tribunal should be empowered to determine whether there is such a change in the economic foundation or economic viability of a project which requires any intervention amongst options contemplated in that statute. The law will also lay down the guiding principles on the basis of which Infrastructure PPP Project Review Committee and Infrastructure PPP Adjudicatory Tribunal will exercise their functions. In case a substantial question of law is involved, the matter should be directly heard by the tribunal.
I am not that optimistic. There is nothing different here than with all the other Tribunals. In other words, there is nothing that prevents the disgruntled party from approaching the Courts at the drop of a hat and the latter from entertaining their pleas. All such talk of "independent mechanism for speedy redressal of disputes" appears logically and academically great, but have limited real-world basis in India's messy decision-making systems.

8. Are cows and buffaloes substitute goods? The Maharashtra government's ban on cow slaughter appears to have unintended consequences. The prices of cows, even good milch ones, have fallen sharply, just as those of buffaloes have risen. 

Saturday, February 6, 2016

More on monetary policy transmission

Good post from Andy Mukherjee captures the monetary policy transmission problem in India. Despite the 125 basis points repo rate cut, the G-sec and corporate bond yields have actually gone north.
Apart from the structural problems in credit intermediation in India, there are atleast two other factors at play here. One, embattled banks are using the cushion from lowering rates to repair their balance sheets. Two, the corporate debt overhang coupled with weak economic prospects, both rising with time, naturally raises the cost of capital for borrowers.  

Friday, February 5, 2016

Bad loans and bad banks

The Government of India is apparently contemplating the establishment of a 'bad bank' to isolate the distressed assets held by the banking sector. Essentially bad banks are asset management companies which purchase distressed loans at knock-down prices and then revive and sell them to investors.

I had blogged about bad banks and other bank resolution options here and here. At a fundamental level, a bad bank is best captured by the graphic below. Incidentally, this classic model of resolving distressed assets of private banks failed to find traction even in the US during the height of the sub-prime crisis for lack of consensus on what would be an acceptable price discovery mechanism.
There are atleast four models of resolving bad assets. At one end is the 'Swedish model' of complete nationalization, whereby the equity holders are stripped-off their holdings and the assets transferred to one public aggregator "bad bank". This bank can then restructure and manage these assets back to health and dispose them. Alternatively, as Citibank did, each existing bank can create its own "bad bank" and then manage those assets. Another option, commonplace in the US, is to sell/auction off such assets to Asset Reconstruction Companies (ARCs) or even fund managers, with or without partial government guarantees. The least disruptive option is to simply securitize such loans and sell them off, with some sovereign guarantee as is being proposed in case of Italy. A snapshot of all these options is below.
During the Eurozone crisis, bad banks were established across many countries. The three largest - Ireland's NAMA, Sapin's Sareb, and Germany's FMS Wertmanagement - were established as publicly owned entities with 10-15 year life-span, who purchased, largely real estate loans, at haircuts, with the objective of reviving and selling the impaired assets and recovering some value. Their experience has been mixed.

In India, the debate has been whether the distressed assets should be resolved through a publicly owned 'bad bank' or through sales to ARCs. In this context, a few observations.

1. In India's case, the vast majority of assets are held by public sector banks. So any haircuts by the bank are borne by the government itself. This raises the question of whether an aggregator 'bad bank' is the most efficient and incentive compatible way to assume losses.

2. In the US and western Europe, where the vast majority of assets were securitization products, mortgages, real estate, consumer, and student loans. Being financial or functioning assets, at worst, these assets could simply be written off. In contrast, Indian banks' problems stem from commercial loans to real estate and infrastructure project developers, a large proportion of which are non-income generating and at different stages of completion. Here, the completion of these projects is as much important as the bad loans resolution itself. But this would, in most cases, require further capital infusion. In other words, it is important to keep in mind that the resolution of such loans through a bad bank is not a substitute for restructuring distressed projects, as much important for the government as repairing bank balance sheets.

3. The credibility of the process assumes great significance. The markets have to be convinced that the resolution process has been done rigorously enough so that the "good" bank is a healthy enough institution. This would require that all the distressed assets are hived off and those done so are valued fairly.

4. On this, being public institutions, the resolution process runs the risk of being plagued by risk-aversion. The administrators of the process may unwittingly structure the process to maximize the returns for the banks. This corollary effect of this would be increased riskiness of the hived-off asset as well the lower likelihood of its successful resolution. A public sector decision-making process may not be best suited for managing a price discovery process that equates the interests of all sides.

5. Apart from risk-aversion, the public sector banks are certain to be hobbled by the decision paralysis syndrome that arises from the risk of post-facto vigilance and audit oversight. In a regime constrained by audit and other oversights, it may not be possible to sell off all assets. It may be necessary to exercise judgment and write-off some assets, or even sell them off at prices far lower than any internal 'off-set' price.  

6. Once decided, this must be done very quickly. Else the possibility of generating moral hazard among banks and other market participants is considerable. This is all the more important given the well-known fact that a not insignificant share of the restructured loans under CDR and 5:25 scheme are not exactly performing assets.

7. But this is most likely to run into the problem of market demand for such assets, given the flood of such assets likely to be released into the market.

8. Finally, it may be necessary to examine the reasons why private ARCs have not made much headway. There may be a need for regulatory enablers like uniform provisioning norms for various kinds of asset restructuring mechanisms.

Given all this, what is the way out for India. The fundamental question that we should be asking is - What is the most effective strategy to resolve the bad loans in bank balance sheets while simultaneously completing the stalled projects which form a major share of these non-performing assets? This requires going much beyond blindly replicating 'bad bank' models elsewhere.

For a start, it would be ncessary to segregate and classify the different categories of loans. Would the under construction infrastructure assets be best resolved by remaining in the respective bank balance sheets and restructured as individual projects, with promoters and lenders taking haircuts, and government infusing capital? Or would they be best resolved by transferring all of them into one entity and then restructuring them? Which of the two approaches would best align incentives and minimize transaction costs, given the constraints of public sector decision-making in India? While there are pros and cons with both approaches, I am inclined to the former.

Given that the broader real estate and infrastructure sector loans form the major share of distressed assets, it may be reasonable to confine this resolution process to them. The other smaller loans can be dealt separately, either written off fully or sold to ARCs. This sectoral focus would enable the asset managers to more effectively manage and resolve them. Further, their  "fair" valuation becomes far less of a challenge with such assets.

All this does again raise the question of recapitalization. Bad assets resolved or not, Indian banks need massive recapitalization, far higher than the drips being administered now. It may be even worthwhile to dedicate a full 0.5% of GDP fiscal deficit relaxation this coming budget exclusively for recapitalization complemented with a focused distressed assets resolution mechanism. 

See these reports from IMF, Bruegel, and McKinsey for more on resolution of distressed assets and bad banks. 

Tuesday, February 2, 2016

The decision paralysis example of the day

As the Non-Performing Assets (NPAs) of India's banks mount and the RBI has allowed them to assume majority equity stakes through the Strategic Debt Restructuring (SDR) mechanism, the role of Asset Reconstruction Companies (ARCs) assumes greater significance. But so far ARCs have made limited headway in the Indian market, with the 15 existing private ARCs having a combined net worth of just Rs 40 bn and have been able to resolve just a third of their acquired assets. 

In this context, this quote in the Indian Express gets to the heart of the challenge,
Public sector banks are scared to sell to private ARCs for fear that the quantum of hair cut can always be questioned by the government’s auditor, vigilance or at worse be probed by the intelligence agencies.
This is very relevant in a bureaucratic environment where every decision is likely to be subjected to post-facto scrutiny, often many years later and completely divorced off its context. Consider the case where an ARC makes windfall gains from one of its assets. A malicious complaint can trigger an enquiry. An auditor, with limited awareness of the context, can attribute presumptive loss and fault the decision by the bank management to take haircuts. An investigating agency with no professional competence to investigate the issue could find fault with the magnitude of the haircut or not having given the asset to a public ARC or managed itself. A humiliating media trial confined to headlines follows.

Construction of such counterfactuals and hindsight with half-knowledge creates a moral hazard which engenders, at best, sub-optimal decision making, and, at worst, decision paralysis. In this environment, vitiated further by deep political acrimony, it is highly unlikely that a large scale program of distressed asset sales from public sector banks to private firms can be pulled off. The systemic constraints, relaxation of which may be beyond administrative and legislative actions, are just too binding. On the issue itself, here is more on what needs to be done to enable the market for ARCs in India.

Sunday, January 31, 2016

Weekend reading links

1. Despite concerns about its decline, Apple dominates the global smart phone market,
Among leading smartphone manufacturers, Apple takes 60 percent of the sector's revenue on just 20 percent of the sector's unit sales (or about 14 percent of the world's overall smartphone market). Samsung, on the other hand, snares 26 percent of the sector's revenue, on 43 percent of the sector's unit sales.
2. The WSJ captures the increasing weakness among emerging market economies as reflected in the successive downward revisions of their growth projections by the IMF.
3. For all talk of China's debt stricken corporates, India's corporate debt servicing problem is worse than that of Chinese firms, and has remained at that level for more than three years.
4. An OECD policy note finds that financial expansion fuels greater income inequality, and advocates the use of macro-prudential instruments to prevent credit over-expansion and eliminating the tax bias against equity (interest payments are deductible from income tax payable, whereas dividends are not). It also "supports measures to reduce explicit and implicit subsidies to too-big-to-fail financial institutions through break-ups, structural separation, capital surcharges or credible resolution plans". Underlining the skewed nature of its effect, a 10% of GDP expansion of financial sector credit has a positive effect on incomes of only the top decile of households.
5. Thomas Piketty's book elevated the problem of widening inequality to the center of public policy debates across the world. However, the consensus on its contributors, leave aside how to mitigate it, elides us. Skill-biased technological change, automation of middle-class jobs, greater financialization, weakening unions, greater returns to capital complemented with stagnating labor incomes etc have been blamed. In this context, Mathew Rognlie (paper here) has this compelling graphic which spotlights attention on the role of housing prices as contributing to the inequality wedge.
As the graphic shows, Rognlie argues that "recent trends in both capital wealth and income are driven almost entirely by housing". It does not depreciate whereas modern technology investments depreciate rapidly. He, therefore, advocates liberalization of zoning and building regulations to lower property prices. Irrespective of whether it is the leading contributor to widening inequality or not, its can be safely presumed that greater deregulation of the property market has so many beneficial effects. 

6. The latest NSSO data draws attention to India's chronic under-employment problem. Though there were 62 million graduates and post-graduates in 2011-12, formal unemployment rate was less than 5%, since a large share of them are employed in occupations which clearly do not need such educational qualifications. Livemint has the followin graphic about the occupation patterns of Indians.
Underlining this, just 35.4% of graduates and above have regular salary paying jobs.
7. There are very few large low-hanging fruits with public sector reforms in India. One exception may be Indian Railways and the potential benefits and savings from a series of cumulative operational reforms. Rationalization of trains and routes, increasing speed by reducing stoppages, radically improving its IT systems, outsourcing services, more efficiency manpower deployment, and so on have massive potential for unlocking value. This is apart from more macro and policy-oriented reforms like private participation, PPPs in the development of railway stations, high-speed rail etc. 

The challenge is with the political economy of these reforms. One strategy may be to undertake a devolution of far greater powers to the eighteen zones, especially operational powers, leaving the Railway Board with minimal co-ordination responsibilities. Letting zones develop as cost-centers and fostering competition among them in both commercials and service delivery quality is more likely to create the conditions required to overcome the political economy obstacles. Allowing a few mutant General Managers to change the rules of their game is a more likely strategy for change. 

Oil industry - this time is no different!

Commodities markets are prone to the classic boom and bust cycle - economy booms/demand increases, prices rise, capacity expands, production soars, excess supply/economy weakens, prices fall, capacity expansion halts, and so on. The US shale market is the latest to fall victim. Shale oil production in the US soared on the back of rising global oil demand (China effect), rapid technological developments (hydraulic fracturing and horizontal drilling), and cheap capital. The FT writes,
Companies have achieved remarkable gains in productivity by optimising production techniques and drilling only in the “sweet spots” that generate the most. They have also been driving down the prices they pay their suppliers and contractors. Jim Burkhard of IHS, the research group, says the cost of drilling and completing a typical shale well fell 35-40 per cent last year...

US crude production rose from 5.1m barrels a day at the start of 2009 to 9.7m b/d in April last year, a surge that has few parallels in the industry’s history... The small and medium-sized companies that led the shale revolution raised $113bn from selling shares and $241bn from selling bonds during 2007-15, according to Dealogic... Low rates drove investment in marginal US shale projects “that are uncompetitive at lower prices and now need to be unwound”...

The boom years left the US oil industry deep in debt. The 60 leading US independent oil and gas companies have total net debt of $206bn, from about $100bn at the end of 2006. As of September, about a dozen had debts that were more than 20 times their earnings before interest, tax, depreciation and amortisation... Almost a third of the 155 US oil and gas companies covered by Standard & Poor’s are rated B-minus or below, meaning they are at high risk of default...

Private capital funds raised $57bn last year to invest in energy, according to Preqin, an alternative assets research service, and most of that money is still looking for a home... Bankruptcies, a cash squeeze and poor returns on investment mean companies will continue to cut their capital spending. The number of rigs drilling oil wells in the US has dropped 68 per cent from the peak in October 2014 to 510 this week, and it is likely to fall further... The US oil and gas industry has lost 86,000 jobs over the past year, about 16 per cent of its workforce, and many of those people will never return. When the industry does want to expand again, it will need to offer attractive wages and training, which will raise costs.
This is all predictable history, exactly the same storyboard as earlier episodes. There is nothing which warrants a belief that this time will be different with the rebound. The most compelling arguments in favor of a long period of low oil prices are secular stagnation in developed economies, the continuing decline of Chinese demand, and the full return of Iran and Iraq. All first is only a marginal contributor to the decline in demand, the second vastly over-played, and the third marginal and one-off. So the question is not whether oil prices will stay long for a long period or not, but when, over the next 1-3 years, will it start its rebound. 

Thursday, January 28, 2016

Cushioning the victims of global trends

There are atleast three drivers of displacement of people from the labor market - technology, free trade and globalization, and immigration. All three also have the effect of depressing wages, widening inequality, and fostering social and political discontent. 

But conventional wisdom and orthodoxy advocate unambiguous support for such policies. Their arguments are based on the view that the aggregate effect of these forces are a net positive. While this may be so, it cannot be denied that all of them creates losers in addition to winners. In the circumstances, it is facile, even disingenuous, to argue in favor of free-trade without complementary policies that compensate the losers or at the least mitigate their suffering. A generous and robust social safety net is one of the primary requirements to cushion the losers against these trends and proceed ahead with them. 

It is in this context that Steve Rattner makes the moral and political case for compensating the losers of globalization. While the US loses manufacturing jobs, its consumers benefit by way of cheaper imports and greater disposable incomes. 
A similar challenge is faced by European countries as they grapple with hordes of immigrants fleeing the civil war in the Middle East. The spectre of immigrants displacing locals, especially in lower skilled jobs, looms large.
Much the same applies to embrace of technology. In all these cases, the concerns of those likely losers cannot be simply brushed aside on ideological and humanitarian (to refugees) grounds. Unfortunately, as Martin Wolf writes, the politics of the elites on both sides of the spectrum miss this 
The projects of the rightwing elite have long been low marginal tax rates, liberal immigration, globalisation, curbs on costly “entitlement programmes”, deregulated labour markets and maximisation of shareholder value. The projects of the leftwing elite have been liberal immigration (again), multiculturalism, secularism, diversity, choice on abortion, and racial and gender equality. 
I am inclined to the opinion that the political leaders have been ill-served by thought leaders and opinion makers in addressing such challenges. The latter have let their ideological predilections cloud their judgements. Instead, a prudent appraisal of the outcomes of these trends would have led to the advocacy of a more nuanced approach towards them. In its absence, the ideological space has been occupied by extremist political ideologues who peddle protectionist, anti-immigrat, and neo-Luddite policies, all of which corrode the country's social and political fabric.