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Monday, March 18, 2024

Some reforms to GST administration

The mainstream public commentary on GST revolves around the tax rates for various goods and services. This post will look at three other aspects of GST that do not get the attention it deserves. They cover the areas of GST administration (for both tax officials and taxpayers), investigations, and enforcement. 

The GST system consists of four taxpayer-side processes - registrations, returns filings, e-way bills (EWB) generation, and refunds - and its administration by tax officials. These processes generate three distinct databases - GST registrations, GST returns filings, and e-way bills (EWB) generation. Once electronic invoicing picks up, the returns filings database becomes a trove of very granular business transactions. The administration consists of registration of taxpayers, scrutiny of returns, investigations to detect revenue loss and its adjudication (audit, inspection, and vehicle interception), and refunds. 

On the administrative side, the GST Network (GSTN) operates a Back Office portal (BOWEB) that's accessed by tax officials for all administrative activities and taxpayers for all their transactions. This BOWEB provides a standardised process for all GST business processes. The GSTN also provides an MIS of the BOWEB processes and analytics of the transactions in the Business Intelligence and Fraud Analytics (BIFA) portal. 

In the years since its adoption, the GST system has become more automated and access to data has increased. In the last couple of years, the fidelity and reliability of business processes like returns filings have improved with several workflows becoming fully automated. The returns filing and EWB generation processes are moving towards the ideal of a single source of truth. This will only be hastened with the advent of electronic invoicing.

Here are a few thoughts on the next stage of reforms to the GST systems. 

1. Arguably the biggest institutional problem with any tax system is its revenue bias. This manifests in the form of excessive and unreasonable tax demands. This cannot be controlled without strong institutional restraints on such demands. Apart from the formal appellate processes, there should be institutionalised scrutiny and review mechanisms to validate demands before they are raised, especially those above a certain threshold. In a world gripped by the fear of oversight agencies like CBI and CVC, high-pitched demands can be restricted only by directly engaging with the problem. 

I have blogged here about the issue and offered some suggestions to address it.

2. The statutory business processes of the GST system, on both the taxpayer's and the tax administrator's sides, are standardised and run on a single IT system, the BOWEB. This is an essential requirement for a national taxation system. However, this workflow standardisation should be viewed distinctly from value-added aspects like business intelligence generation and decision-support MIS reports. 

In a large country with widely varying contexts and capabilities, there cannot be a one-size-fits-all BI or MIS. It's only natural that each tax unit figures out its unique BI and MIS. The GSTN could of course come up with some default version of data analytics and MIS that tax units could use as a starting point. However, the main objective should be to facilitate innovation in these areas by state units. This requires enabling access to data through web-APIs. 

In this context, it's important to highlight two points. One, it should become part of the policy (in fact data transfer policy itself) to restrict all data access only through APIs and disallow downloads and sharing of information through the likes of file transfers. Only APIs-based access allows for the automation of data processing. Two, it's misplaced to believe that it's sufficient to enable access to loads of tax data that can be downloaded and analysed to generate actionable information. Instead, given weak capabilities and low motivation levels, data analytics must be workflow-automated so that they make available directly actionable information. 

3. Given the extensive workflow automation and digitisation of tax processes, tax administration today is largely a knowledge-based activity. It's about identifying taxpayers whose transactions exhibit a high likelihood of evasion and then undertaking clinical investigations and enforcement of those cases. An essential requirement for this is the quality of data analytics and its interpretation as business intelligence. The objective is to identify taxpayers with a high likelihood of high-value evasion, while also minimising false positives (which can result in the harassment of genuine taxpayers).

This requires developing predictive models of various kinds of evasions that use multiple independent variables. Such models can be developed using the different GST databases, especially that of returns filings. These models will have to be periodically iterated to improve their accuracy in response to adaptive behaviours by taxpayers. 

4. High-quality data analytics require access to data on taxpayer transactions as well as third-party data sources. However, state tax units currently have limited access to the transactional data of taxpayers of other states. Even if they can access case-by-case data on request, there's no way to conduct meaningful automated data analytics. 

For example, a fake outward ITC claim (made on the GST revenue of a sale from another state) cannot be investigated without accessing the transactional data of the other state taxpayer. In such cases, while the purchaser's state loses revenue and has an incentive to investigate, it does not have access to the data required to do so. In contrast, the seller's state, which has the data, has no incentive to investigate. 

For example, the investigations of fake ITC claims most of which involve crisscrossing inter-state transactions are hampered by the data access restrictions. Accessing third-party data sources like NHAI toll gates, Income Tax filings, PAN numbers, corporate registrations and filings (MCA21) etc even in a request mode is difficult, and is impossible in API-mode. 

5. The GST system is currently administered by the tax units of the central and state governments. The taxpayers are more or less equally distributed between the state and central tax units, which exercise considerable concurrent jurisdiction over the taxpayers. This division creates a fundamental incentive mismatch problem that's at the heart of many of the challenges with GST systems reforms. 

For one, with their very limited field presence (compared to the state units), the CBIC units have limited capabilities and incentives to focus systematically on tax evasion and revenue loss. Second, unlike the state tax units which are strongly incentivised to maximise revenues, the internal structure and geographical spread of CBIC units incentivise them to prioritise investigations and enforcement. All this means that the CBIC units tend to be focused on process compliance and raising demands, irrespective of whether they end up realising revenues or not. This also amplifies their revenue bias and results in unreasonable demands. 

6. One of the biggest challenges in GST administration is the presence of fake and non-genuine taxpayers, who exist only to evade taxes through ITC claims. Instead of detecting shell companies after they have been registered through periodic one-off campaigns, the GST administration should shift to detecting likely shell companies at the time of registration application and also constant surveillance of new registrants for unusual activities (disproportionately high ITC claims, EWB generation, low cash-liability ratio etc.). 

In this context, it's useful to keep in mind the trade-off between ease of doing business and economic inefficiencies. An excess of ease of doing business prioritisation, especially given the Indian context, can paradoxically end up lowering the ease of doing business. The pervasiveness of shell companies leads to GST administrators focusing on enforcement actions that also snare the honest taxpayers. 

7. The GSTN provides an unmatched platform for mass flourishing and ecosystem development in two important ways. One, the GSTN's BOWEB can become a platform on which third-party applications can plug in through secure Application Programme Interfaces (APIs). These applications include those developed by state tax units to improve administrative efficiencies - automation of processes like scrutiny and refunds, screening and surveillance of registrations, faceless administration of registration and refunds etc - or by the National Informatics Centre's mobile App used for capturing vehicle interceptions. Or they could also include applications by fintech companies or the RBI's Trade Receivables Discounting System (TREDS) to enable lending to small and medium businesses, and e-commerce platforms to conduct their businesses. This has the potential to catalyse markets, improve economic productivity, and generate large economic multipliers. 

8. The GSTN BOWEB is a source of some of the richest data on economic transactions. This data has immense value in granular macroeconomic surveillance and forecasting sources using trends of high-frequency indicators of consumption across even states and cities. It could plug a big gap in good economic data and spawn a vibrant research ecosystem. On the commercial side, the data could be used by businesses to assess creditworthiness, consumption trends, investment decisions etc. The data sharing can be made secure and with sufficient private protections. 

One of the biggest obstacles to the use of GST data for macroeconomic data is the poor quality of HSN and SAC codes. For a variety of reasons ranging from the multiplicity of goods and services offered by any firm to tax evasion incentives, and the reluctance of the GST administration to be more firm with self-coding by the taxpayer, these codes are not a reliable unique identifier to categorise businesses. This must change if we are to make greater use of the GST data. 

Sunday, March 17, 2024

Weekend reading links

1. Graphic on India's semiconductor chips manufacturing ambitions

On Thursday, the Union Cabinet app­ro­ved Rs 1.26 trillion worth of investments in three semiconductor plants, including one by the Tata group to build India’s first major chip fabrication facility at Dholera in Gujarat. The Cabinet also cleared a separate Tata proposal for a chip assembly and testing plant in Morigaon, Assam, and another by CG Po­wer in Sanand, also in Gujarat. Work on all three is expected to begin within 100 days. The Tata group’s Dholera plant entails an investment of Rs 91,000 crore and will churn out 28-nanometre and above chips — known for high performance and low power consumption — beginning with 50,000 wafter starts per month. It has tied up with the third- largest Taiwanese chip maker, PSMC, for the crucial technology. PSMC might take equity. Tata’s Assam project, for which Rs 27,000 crore is earmarked, will do semiconductor assembly, testing, marking, and packaging (ATMP). Deploying indigenous technology, it will process the wafers manufactured in Dholera, as well as wafers made by other companies, into “make in India” chips. 

This is the global landscape of chip manufacturing

After the slowdown of 2023, says SEMI, 82 fab plants, including new ones and capacity expansion, will be operational during 2022-24 — the majority in 28 nanomet­res. In 2024 alone, 42 fab plants will join the fray, raising concerns about a possible oversupply. Companies including TSMC, Intel, Mic­ron, and Samsung are investing over $500 billion by the year-end in building fabs in their home countries as well as in the US and Europe, where the supply chain is establis­h­ed, instead of looking at newer countries. India’s investment in fab and ATMP tog­ether would account for a mere 3.6 per cent of what the big guns are investing. The country’s subsidy incentive scheme is only 18 per cent of what the US offers ($52 billion). Also, the US and China are locking horns. About 40 per cent of the new plants are being built in the US, of which six will be operatio­nal in 2024. But China is moving faster, with 18 new plants slated to go on stream this year.

2. Office space demand in major Indian cities to top 50 million sq ft. 

Gross leasing of office space stood at 58.2 million square feet across six major cities namely Bengaluru, Chennai, Delhi-NCR, Hyderabad, Mumbai and Pune... In a realistic scenario, the gross leasing of Grade-A office space is estimated at 50-55 million square feet this year across these six cities.

3. Elon Musk and the art of tax evasion in the name of philanthropy.

Since 2020, he has seeded his charity with tax-deductible donations of stock worth more than $7 billion at the time, making it one of the largest in the country. The foundation that houses the money has failed in recent years to give away the bare minimum required by law to justify the tax break, exposing it to the risk of having to pay the government a substantial financial penalty. Mr. Musk has not hired any staff for his foundation, tax filings show. Its billions are handled by a board that consists of himself and two volunteers, one of whom reports putting in so little time that it averages out to six minutes per week. In 2022, the last year for which records are available, they gave away $160 million, which was $234 million less than the law required — the fourth-largest shortfall of any foundation in the country...

A New York Times analysis found that, of the Musk Foundation’s giving in 2021 and 2022 — the latest years for which full data is available — about half of the donations had some link to Mr. Musk, one of his employees or one of his businesses. Among the donations the Musk Foundation has made, there was $55 million to help a major SpaceX customer meet a charitable pledge. There were the millions that went to Cameron County, Texas, after the rocket blew up. And there were donations to two schools closely tied to his businesses: one walled off inside a SpaceX compound, the other located next to a new subdivision for Musk’s employees.

4. China is circumventing sanctions against it by shipping more to Mexico. 

Chinese companies are seeking to circumvent US and EU tariffs in a number of different ways. One of these ways is transshipment, a method that is fully on display in Mexico, which as a member of North American Free Trade Agreement (Nafta) can export goods to the US market at much lower tariffs than China can access. An FT analysis of trade data shows a sharp rise in 20ft containers shipped from China to Mexico in the first three quarters of 2023 compared with the same period a year earlier. The rise came as Mexico overtook China as the biggest exporter of goods to the US last year, and as truck shipments across the border into the US have continued to increase quickly.

Sample this

Figures from Container Trades Statistics, analysed by Xeneta, show the number of 20ft containers shipped from China to Mexico hit 881,000 in the first three quarters of 2023, the most recent period for which data is available, up from 689,000 in the same period of 2022. The rise came as Mexico overtook China as the biggest exporter of goods to the US last year, and as truck shipments across the border into the US have continued to increase quickly.
5. As the WTO stalls and countries are pursuing bilateral deals, this is a good status report on India's bilateral FTA negotiations.
6. Some interesting facts about the dominance of the Magnificient Seven in the US equity markets and the general concentration of market capitalisation.
Today, the top decile of stocks in the US account for more than 75 per cent of total market capitalisation. The only other time we have seen this level of concentration was at the bubble peaks of 2000 and 1929. Worryingly, in both the prior periods, this ratio eventually mean-reverted to 60 per cent. Since 1926, the median ratio of concentration for the US has been 63 per cent. If we look at the top five stocks, at 25 per cent of the S&P 500, this ratio is back to the peak of the Nifty 50 era of the late 1960s. Even the top 10 stocks, constituting 34 per cent of the S&P 500, have never been a bigger part of the market than today. Driven by the Mag Seven, concentration, whichever way you cut it, has never been higher...
Taken together, the Mag Seven stocks, with a market capitalisation of $13 trillion, would be on their own the second-largest stock market in the world, larger than China and more than double the third-largest market, Japan. The single largest stock, Microsoft, at a market capitalisation of over $3 trillion, would on its own be the fifth-largest market in the world (just after India). Today, Microsoft and Apple individually have market capitalisation greater than the UK stock market... Even on the basis of profits, we are in a different world. Taking trailing 12 months profits, the Mag Seven have a total net profit of $361 billion—almost equal to the total profits of corporate Japan and half the profits of all the companies listed in China. Their profits on an absolute basis are more than double the profits of all the companies listed in India ($151 billion: Source DB). Apple alone over the last 12 months, delivered a net profit of $101 billion, 70 per cent of the profitability of all listed Indian corporations (source: DB). Combined, Apple and Microsoft deliver 20 per cent more profit than all the listed companies in India. I don’t think we have ever seen a phenomenon of companies with market capitalisation and profitability equal to large countries before... The US has had an incredible 15 years of both absolute and relative performance, and currently represents 62 per cent of global market capitalisation. It was higher than this in the mid-1960s, when there was no China and emerging markets. This relative performance dominance will reverse at some stage. The US cannot outperform forever...
All other global markets are far more concentrated. Most have a ratio of top 10 stocks over 50 per cent, and many have single stocks at over 25 per cent, compared to 8 per cent for the US. The size and profitability of these platform companies is also due to their network effects, global penetration and the inability of regulators until recently to rein them in. How do you compete against a company spending more than $30 billion a year each in terms of capex and research and design (R&D), as all the global platform stocks do? And how does one compete against Nvidia, which has the software/hardware integration, head start in graphics processing units (GPUs), and has locked much of TSMC’s leading edge Fab capacity?

7. A feature of today's capitalism is the extreme concentration of wealth and therefore power in the hands of a few. This threatens to destroy the social contract. There's a good FT interview of Peter Turchin where he makes this point.

In the modern period, elites have sometimes staved off the worst outcomes. Britain, Turchin argues, suffered decades of instability from the 1830s to the 1860s, but avoided revolution by abolishing food tariffs, widening the suffrage and allowing labour unions. For Turchin, these helped to address the root cause of instability: the fact that real wages had fallen between 1750 and 1800. Wealthy Americans checked their own power between the 1930s and 1960s, accepting income tax rates of more than 90 per cent. But today’s elites — by which Turchin means the richest 10 per cent — are unwilling to follow suit. “We are back to very similar attitudes that were prevalent during the Gilded Age.”

Saving capitalism from capitalists! 

8. Two striking graphics on China. The first is the steep fall in economic data disclosures as the economy worsens.

The second is the surge in Chinese manufacturing surplus during the pandemic that contradicts the conventional wisdom on global decoupling. 
9. FT long read on perhaps the biggest beneficiary yet of the Chip wars, Malaysia. Penang, a state in Northern Malaysia, has become the epicentre of the country's flood of semiconductor chip investments. 
The state attracted RM60.1bn ($12.8bn) in foreign direct investment in 2023, more than the total it received from 2013 to 2020 combined... Malaysia has a 50-year history in the “back end” of the semiconductor manufacturing supply chain: packaging, assembling and testing chips. But it has ambitions to move up to the front end of a $520bn global industry that powers everything from televisions to smartphones and electric vehicles. That includes higher value activities such as wafer fabrication and integrated circuit design.

The region and the country has a history in the industry is well placed to benefit from the diversification away from China,

In 1972, a muddy paddy field in Penang became the first production facility outside the US for Intel. Lured by a new free trade zone and a busy shipping port in the Malacca Strait, Intel, alongside AMD, Renesas (formerly Hitachi), Keysight Technologies (formerly Hewlett-Packard) and several other tech multinationals were the pioneers of what used to be called the “Silicon Valley of the East”. Malaysia became a well-oiled machine in the packaging assembly and testing of chips, until recently considered a fairly low-end, labour intensive but necessary part of the semiconductor manufacturing supply chain. It is already the world’s sixth largest semiconductor exporter and holds 13 per cent of the global semiconductor packaging, assembly and testing market. It is the origin for 20 per cent of US semiconductor imports annually, more than Taiwan, Japan or South Korea. But there hadn’t been much of a catalyst for it to move up the value chain in semiconductors — until now.
Demand for ever more high-powered chips in sectors such as electric vehicles and artificial intelligence means so-called advanced packaging — which connects chips to their circuitboards and protects them from contamination — is regarded as key to improving performance. A previously labour-intensive process now often takes place in highly automated factories. Intel, the world’s largest chipmaker by revenue, is spending $7bn on new facilities in Malaysia, including a “3D” advanced packaging site due to be finished later this year. The cutting-edge technology stacks chips on top of each other to improve performance. It is also building another chip assembly and testing factory in Kulim, which borders Penang... Micron and Germany’s Infineon are also in expansion mode. US-based Micron last year launched its second facility for assembly and testing in Penang, while Infineon, a former subsidiary of German engineering conglomerate Siemens, said it would spend up to $5.4bn to expand over the next five years. It is building the world’s largest production site for the silicon carbide chips widely used by makers of electric vehicles.

The sudden spurt in activities in Penang has come with all the problems:

Prices of industrial land have gone from about RM50 per square foot in 2022 to as much as RM85 per square foot... Across south-east Asia, Penang’s residential property price growth in the first half of 2023 was second only to the expensive city-state of Singapore... Traffic jams have become a regular feature... The country’s engineering staff shortage has also become more acute. Zafrul, the trade minister, says the electrical and electronics sector alone requires 50,000 engineers, but only 5,000 engineering students graduate each year — and many of them slip across the causeway to Singapore, where they are paid much more. Engineering salaries, especially for starting graduates, are still below most other professional sectors in Malaysia and experts say there is a lack of specialised expertise crucial for moving up to the front end of the supply chain... Malaysia does not have a national champion in semiconductors like Taiwan’s TSMC.

The US crackdown on China has been the trigger for Malaysia,

Since the US began imposing trade restrictions on Chinese technology under the Trump administration, and especially since they were tightened by current US President Joe Biden, Penang started to see a flood of interest from mainland groups like Fengshi, according to InvestPenang’s Loo. Many of these are companies with global suppliers or western customers hedging against further US restrictions, she says. InvestPenang estimates there are now 55 mainland companies in Penang operating in manufacturing, mostly in semiconductors. That compares to just 16 before the American crackdown began. US restrictions do not currently apply to advanced chip packaging services, but Chinese businesses fear potential future curbs, says one Hong Kong-based analyst for a Chinese company, who asked to remain anonymous. Some are de-risking by partnering with Malaysian firms to assemble a portion of their high-end chips, they added.

The most interesting thing is that the wave of chip investments in Malaysia has come without too many incentives and active pursuit by the government. In other words, there has been not too much industrial policy contribution to these investments. 

10. Sajjid Chinoy urges caution on reducing interest rates in India pointing to several conflicts trends and patterns in the economy.

Credit growth has been running at almost 16 per cent for the last year, almost twice as strong as nominal gross domestic product (GDP) growth of 9 per cent -- a multiple last seen in 2007... Uncertainty about neutral rates with the prospect they have increased, negative output gaps, but also forecasted inflation still above target... India’s policymakers are currently confronting several cross currents. Growth has surprised to the upside even as the economy remains below its pre-pandemic path. Core inflation is at multi-year lows, but credit growth is at multi-year highs. Private investment is yet to broaden out but public investment has been strong. GDP growth is strong but GVA growth has slowed.

11. Interesting graphic about the historical trend of GDP.

12. This year's meeting of the Chinese National People's Congress, the country's parliament, and the Chinese People's Political Consultative Conference, the top advisory body, (collectively called the "Two Sessions") set growth rate at an ambitious 5% and resolved to fight the country's high local government debt, property crisis, and persistent disinflation

The ballooning local government debt has been a rising source of major concern. 
Chinese local government debt, including off-balance sheet financing vehicles and shadow credit, was probably equivalent to between 75 and 91 per cent of national GDP in 2022, according to a paper last year by Victor Shih and Jonathan Elkobi of the University of California San Diego. Twelve province-level governments had outstanding bonds alone equivalent to more than 50 per cent of their GDP, they wrote. China says its total central and local government debt is less than 51 per cent of GDP.
The biggest worry is the pace at which indebtedness has grown. 
The deeply indebted province of Guizhou is a totemic example of the problems with debt-based infrastructure development.
Fixed-asset investment was expected to fall this year by 60 per cent for the western province of Guizhou... Guizhou, one of China’s poorest provinces, is now home to nearly half of the world’s 100 highest bridges, including four of the top 10. Yuekai Securities estimates the province’s infrastructure building spree has left it with total debt, including off-balance sheet liabilities, at 137 per cent of its gross domestic product.

13. Finally, an article on the increasing mothballing of conventional car factories as they give way to electric vehicles highlights both the risks of foreign investment in China and more importantly how China is bearing the costs of the green transitions. 

In 2017, Hyundai invested $1.15bn in a new factory in Chongqing, southwestern China, with the goal of reaching an annual output of 300,000 internal combustion engine cars. But six years later, the rapid switch by Chinese consumers to electric vehicles has stalled sales, forcing the carmaker to sell the factory in December for less than a quarter of the investment value... That plant is one of the hundreds of zombie factories that analysts are predicting over the next decade in the Chinese car market, the world’s biggest across sales, production and, since last year, exports. In 2023, China produced 17.7mn internal combustion engine cars, a 37 per cent fall from its prior peak in 2017, according to data from Automobility, a Shanghai consultancy. Bill Russo, the former head of Chrysler in China and founder of Automobility, said the “precipitous decline” of internal combustion engine car sales meant as much as half of the industry’s installed capacity — about 25mn out of 50mn units’ annual capacity — was not being used. While some older factories will be repurposed for plug-in hybrids or pure battery electric vehicles, others will never produce another car, posing a problem for both foreign and Chinese companies.

This has increased the pressure on foreign car makers in China who are now using China as a base for their exports, thereby undercutting their factories elsewhere. 

Until recently, foreign carmakers could only enter the Chinese market as a joint venture with a local partner. Of 16 joint ventures between Chinese and foreign groups, only five had a capacity utilisation rate higher than 50 per cent while eight were below 30 per cent, according to a report by Chinese media outlet Yicai Global. In response to the worsening domestic market situation, Chinese companies have been ramping up exports of cheap petrol-powered cars to Russia, a market that many international carmakers have quit in the wake of that country’s full-scale invasion of Ukraine. Yet analysts question whether those sales deliver meaningful profits to the Chinese groups, for how long they can continue, or if other developing markets can help soak up Chinese non-EV exports. Foreign brands, too, are increasingly trying to export more from their Chinese factories. But, experts say, in doing this companies risk undercutting their own factories in other markets.

Wednesday, March 13, 2024

Some thoughts on digital markets regulation

I have blogged on several occasions on the market abuse problems associated with digital marketplaces. Amazon owns the biggest e-commerce marketplace and is also a seller on it. Facebook and Google provide links to news media content, thereby boosting platform value and traffic, but do not share their revenues with the news publishers. Apple restricts rival app stores on the iPhone and iPad. Apple’s Appstore charges an exorbitant transaction fee for purchases through Apple Pay and also restricts purchases through other payment Apps. All of them erect various kinds of entry barriers to service providers who compete with the platform-owned providers, and also generally try to kill off any kind of nascent competition.

The US Department of Justice’s suit against Google outlines with great clarity how Google has positioned itself across the full value chain of internet advertising and systematically abuses its market dominance.

Every time an internet user opens a webpage with ad space to sell, ad tech tools almost instantly match that website publisher with an advertiser looking to promote its products or services to the website’s individual user. This process typically involves the use of an automated advertising exchange that runs a high-speed auction designed to identify the best match between a publisher selling internet ad space and the advertisers looking to buy it... One industry behemoth, Google, has corrupted legitimate competition in the ad tech industry by engaging in a systematic campaign to seize control of the wide swath of high-tech tools used by publishers, advertisers, and brokers, to facilitate digital advertising. Having inserted itself into all aspects of the digital advertising marketplace, Google has used anticompetitive, exclusionary, and unlawful means to eliminate or severely diminish any threat to its dominance over digital advertising technologies.

Google’s plan has been simple but effective: (1) neutralize or eliminate ad tech competitors, actual or potential, through a series of acquisitions; and (2) wield its dominance across digital advertising markets to force more publishers and advertisers to use its products while disrupting their ability to use competing products effectively... Google, a single company with pervasive conflicts of interest, now controls: (1) the technology used by nearly every major website publisher to offer advertising space for sale; (2) the leading tools used by advertisers to buy that advertising space; and (3) the largest ad exchange that matches publishers with advertisers each time that ad space is sold. Google’s pervasive power over the entire ad tech industry has been questioned by its own digital advertising executives, at least one of whom aptly begged the question: “[I]s there a deeper issue with us owning the platform, the exchange, and a huge network? The analogy would be if Goldman or Citibank owned the NYSE.”

By deploying opaque rules that benefit itself and harm rivals, Google has wielded its power across the ad tech industry to dictate how digital advertising is sold, and the very terms on which its rivals can compete. Google abuses its monopoly power to disadvantage website publishers and advertisers who dare to use competing ad tech products in a search for higher quality, or lower cost, matches. Google uses its dominion over digital advertising technology to funnel more transactions to its own ad tech products where it extracts inflated fees to line its own pockets at the expense of the advertisers and publishers it purportedly serves…

The harm is clear: website creators earn less, and advertisers pay more, than they would in a market where unfettered competitive pressure could discipline prices and lead to more innovative ad tech tools that would ultimately result in higher quality and lower cost transactions for market participants. And this conduct hurts all of us because, as publishers make less money from advertisements, fewer publishers are able to offer internet content without subscriptions, paywalls, or alternative forms of monetization. One troubling, but revealing, statistic demonstrates the point: on average, Google keeps at least thirty cents—and sometimes far more—of each advertising dollar flowing from advertisers to website publishers through Google’s ad tech tools. Google’s own internal documents concede that Google would earn far less in a competitive market.

This problem is not unique to digital technologies. Instead, it’s a common problem with all platforms or platform marketplaces. They are as old as markets and most markets are platforms. Shops, malls, roads, railways, utilities etc are all platforms. Even a school or college, clinic or hospital is also a platform. Imagine a highway monopolist dominating the markets for toll-gate operations, highway rest areas, vehicle manufacturing, ride-sharing, and so on.

All these are universally used markets, enjoy monopoly features, and benefit from network effects (more users result in greater value from its use). Besides, most often they are privately owned, thereby have monopolistic exploitation incentives. They are classic market failures. Therefore the case for their regulation. 

As illustrations, consider the following. Walmart charges exorbitant fees from retail brands to display their wares on its shelves. A railway or road concessionaire charges high fees for railway lines or vehicles to use the infrastructure. A utility company charges high wheeling tariffs on electricity providers using its infrastructure. And so on. And to top it off, all these monopolists also have their proprietary products and services that can potentially get preferential treatment to use the market platform.

The fundamental issue here is that of the near monopoly or disproportionate market power that many platforms command. These platforms become gatekeepers to market access. It becomes a problem when the platform is privately owned and the platform owner starts to charge exorbitant platform access fees. This is considered a market failure. Therefore, given this pervasive problem with all privately owned platforms, such markets are regulated. 

In the initial stages of the emergence of any innovation, it’s natural for the first movers to be incentivised with a high premium in their returns. For practical reasons, the regulations too take time to emerge. All the aforementioned historical platform markets too followed this trajectory of development. We know of the market abuse problems associated with railroad monopolies which made billionaires out of their owners in the US. We also know about the fierce opposition from entrenched monopolists to regulating these markets. 

The evolution of internet-based platforms too is following the same path. Given their practices, profit margins, and piles of cash surpluses, it’s clear that the monopolists have been allowed to enjoy an extended period of unregulated over-exploitation. In any case, it’s hard to argue that e-commerce or social media or payment platforms are not mature enough and therefore need more innovation runway before they are regulated. They should have been regulated yesterday. 

The elite capture of the intelligentsia and academia has meant that the commentary and thinking on this issue have been muted or confined to tinkering at the margins. The political capture of the rule-making process has been critical to perpetuating the unregulated over-exploitation of these markets. It’s a testament to the failure of the progressive movement that they have been co-opted by the Big Tech and Wall Street interests. 

In the US, the courts are still beholden to the consumer welfare test for digital market regulation and thereby tend to overlook the market abuse and anti-competitive practices that Big Tech firms indulge in. In this context, the EU’s ongoing actions against the technology firms deserve to be strongly supported. The centrepiece of the EU’s anti-trust pursuit is the European Union's Digital Markets Act. 

Its full implementation has opened the possibility of widespread anti-competitive actions by the EU. A major objective of the Act is to prevent large tech companies from abusing their market dominance to crush competition and build monopolies. The DMA Rules which came into effect in March 2022 had given time to the large systemic companies (defined appropriately as "gatekeepers") two years till March 7, 2024, for compliance. 

The FT has a long read on the impact of the DMA Rules

There is little evidence yet to suggest that the law is having the desired effect. Industry groups representing travel apps such as Airbnb and Booking.com, and entertainment apps like Spotify and Deezer, complain the tech companies are focused on the letter of the law rather than the spirit of it, and it is having no meaningful impact on their businesses. Judging by the record stock market highs enjoyed by some of these companies, Wall Street doesn’t believe it will have much practical effect on profits or the level of competition either — particularly as the tech industry hurtles into the AI age, resetting the competitive dynamics in some of the core tech markets... The big companies have been adept in the past at redesigning their services to sidestep regulations, making it very difficult for under-resourced government agencies to keep up, this investor says. The law does grant European regulators extraordinary powers of enforcement, including fines of up to 20 per cent of total worldwide annual turnover for repeat infringements, or — as a “last resort option”, forced structural changes such as the break-up of businesses...

A gatekeeper is defined by the law as a platform with an annual turnover of more than €7.5bn, a market cap above €75bn and active monthly users in the EU of 45mn. The commission has singled out 22 “core platform services” offered by the six, ranging from Google’s search engine and Meta’s Facebook and Instagram services to Apple’s App Store. The law forbids the tech companies giving favourable treatment to their in-house services at the expense of third parties — a practice known as self-preferencing — and obliges them to open up their platforms to more alternative services, presenting users with more choices. It also challenges their power to share data between their own services — between Facebook and WhatsApp, for example — without their users’ consent, and seeks to make it easier to switch by making it simpler for users to export their data. “The gatekeeper theory of industry domination is profound,” says Megan Gray, formerly a US Federal Trade Commission lawyer and general counsel at search company DuckDuckGo. At least in theory, it gives the regulators a powerful weapon, she says. On paper, the law could have a direct impact on the profitability of some important tech services, says Gallant. “The DMA poses some risk to Apple’s App Store commissions, which is the biggest part of their services business,” he says.

But the market participants feel that the technology companies will figure out ways to subvert the DMA Rules.

According to Gray, the entrenched nature of the dominant platforms, and in particular the tight linkages between their services that have turned them into powerful digital “ecosystems”, will make it hard to pick them apart by attacking individual products or services. The most drastic effects of the new regulations are also likely to be blunted by the manner in which the tech companies have said they will adapt their services to comply with the DMA... Tech companies are also implementing changes in ways that allow them to hold on to their competitive advantage. This year, Apple published a highly detailed set of technical changes that in effect open the way for rival app stores on the iPhone and iPad, while also allowing developers to stop using its payments service. But it also said that anyone choosing to take advantage of these new arrangements would have to pay a new fee of €0.50 cent for every app downloaded over 1 million installations — something that would hit companies that have large numbers of free app users on mobile platforms, making them less likely to take advantage of the new freedom to launch an app store of their own...

“Spotify, like so many other developers, now faces an untenable situation,” it said following Apple’s announcement. “Under the new terms, if we stay in the App Store and want to offer our own in-app payment, we will pay a 17 per cent commission and a €0.50 cent core technology fee per install and year. This equates for us to being the same or worse as under the old rules.” The changes were designed to give developers like Spotify choice, Apple said. “Every developer can choose to stay on the same terms in place today,” it said, “and under the new terms, more than 99 per cent of developers would pay the same or less to Apple.” The tech companies have also limited most of their technical changes to users in the EU, rather than extending them worldwide — limiting the likelihood of their wider adoption, and creating obstacles for developers.

In India, a Digital Competition Bill is under preparation. A news report says, 

The proposed Digital Competition Bill is expected to put a self-reporting obligation on online entities to declare their dealings are fair and transparent, not restrictive towards third-party applications, according to sources in the know. The digital entities that qualify as gatekeeper platforms or systemically important digital intermediaries (SIDIs) would have to provide this declaration to the Competition Commission of India (CCI), according to the proposed Bill. The CCI will have the power to levy a fine of up to 1 per cent of the global turnover of the online entity in case it fails to make this declaration, sources said. 

Such online firms would have six months to submit this declaration from the time they cross the threshold set for SIDIs, it is learnt. These thresholds, according to sources, are based on the India and global turnover of online platforms, their gross merchandise value in India, average global market capitalisation, and the number of end users. As part of the self-reporting obligation, SIDIs would have to declare that they are not inter-mixing or cross-mixing personal data of end users without their consent and have kept anti-steering provisions, which stop users from going out to other platforms, in check. 

On the issue of digital market regulation, Rana Faroohar writes about the divergence between how consumers and regulators view dynamic pricing in physical and digital markets. 

Surge pricing is something that anyone who takes a ride share on a regular basis has become used to. Try calling an Uber or Lyft on a rainy day during the dinner hour or around the school pick-up or drop-off time and you’ll be paying more than your usual rate — sometimes a lot more.  Yet when consumers are confronted with common online business models like “dynamic pricing” in the bricks-and-mortar world, they may revolt… Platform technology firms developed or perfected techniques like dynamic pricing, real-time auctions, data tracking, preferential advertising and all the other tricks of surveillance capitalism. But the behaviour we take for granted online somehow becomes more problematic when these methods are deployed in the real world. People are outraged about the price of burgers or their rent surging but don’t think twice when it happens to the cost of their commute — particularly when they are booking it on an app…

I’d love to see the FTC, for example, use its rulemaking power to stipulate a “thou shalt not discriminate” statue that makes it illegal to charge people different prices for different goods, no matter how and where they are buying them. What’s illegal in the physical world should also be illegal in the online world. This would put the onus on companies to prove that they are not causing harm, rather than forcing regulators to create a distinct and more complex system for a particular industry. Online or offline, all businesses should be playing by the same rules.

I have blogged earlier about the unfair regulatory arbitrage that digital market firms exploit to their advantage. There’s no reason why such regulatory arbitrage should be allowed to continue in mature marketplaces. 

Big Tech will respond to digital market regulation with denial, tinkering, obfuscation, and brazenness. Unless dealt with firmness, they will keep figuring out ways to limit conceding ground by getting around regulation. Fines are too small in relative terms and are already internalised as a cost of doing business. Aggressive enforcement will have to become the norm. This will require often exorbitant or disproportionate fines, even at the risk of judicial reversals. It will also require the “nuclear option” of even breaking up firms. The norms can be upended and new norms established only through such aggressive actions. When the pendulum has swung too far to one side, there’s a need for disproportionate force from the other side. 

However such actions will require political will and popular support to force these changes in a meaningful manner on the entrenched technology firms.

For references on earlier posts, here is a compilation. I have compared the likes of Amazon to "a large vehicle manufacturer having the power to both prohibit someone from using the road and also make competing vehicle manufacturers unattractive (say, because of inadequate servicing options) for users". I have blogged earlier here(beginning of anti-trust actions in the US and Europe), here (Google and anti-trust challenge), here (anti-trust challenge in the US), here (market monopolisation), and here (Amazon's market abuse of startups) on the problems with market concentration and the need for regulation. This points to what Google founders themselves thought about data monetisation and digital advertising. I have blogged herehere, and here on the problems with regulatory arbitrage and here on the market service quality problems due to limited and poor regulation. And we are not even talking about the several other distortions arising from such market concentration, especially the valuation bubbles in the financial markets - see this and this. Finally, this is a summary examining the dynamics of digital markets and how it offer a different perspective on these markets, and this is a summary of how the big technology companies have become digital gatekeepers to large and critical markets.

Monday, March 11, 2024

Some thoughts on India's automobile green transition path

I have blogged on the need for developing countries like India to be prudent with the green transition. For these countries, unlike their advanced counterparts, poverty eradication competes with climate change as an existential challenge. For a large share of the populations of these countries, the daily and immediate challenge of subsistence far overrides the more distant and diffuse challenge of climate change.

It’s easy for academicians, commentators and opinion-makers to demand a rapid green transition with ambitious decarbonisation goals. They advocate coal-based electricity generation to be phased out with renewable generation, and internal combustion engines (ICE) to be phased out with electric vehicles. And they all advocate both these transitions to happen rapidly. 

But all such transitions impose prohibitive costs and there’s very little understanding of who and how these costs will be borne across different sectors. It’s important to recognise these realities and design policies accordingly. 

Consider the current policy in India that pushes aggressively for the adoption of electric vehicles (EVs) among four-wheelers. 

Amidst the frenzied commentary and euphoria around electric vehicles and batteries, we overlook chastening emerging developments in the global EV markets. Outside of China, in the developed markets EV sales growth has been stuttering. 

The Times has an article that provides a good summary of the plans of the big automobile manufacturers in the US.

In the last six months, sales of electric vehicles have slowed, and American car buyers looking to cut their fuel bill and tailpipe emissions have been flocking to hybrids. Now Toyota’s sales are booming, and the company is reporting huge profits... Toyota has introduced just two fully electric models in the United States so far, betting that its gas-electric hybrids and plug-in hybrid vehicles, which it has become known for, would remain popular and were sufficient to address climate change for now... Toyota has plans to significantly increase hybrid production and sales. A hybrid version of its Tacoma pickup is rolling out. A redesigned Camry sedan, due this spring, will be available only as a hybrid... 

Mercedes-Benz, which had been hoping to phase out internal combustion models by 2030, said last month that it had pushed that goal back by at least five years. Ford has lowered production targets for electric vehicles and is slowing construction on plants that are supposed to produce batteries for electric vehicles. G.M., which had stopped selling hybrids in the United States to focus on electric vehicles, has delayed the introduction of a few battery-powered models. It is also now planning to reintroduce hybrid and plug-in hybrid models, which dealers had pushed for.

The article discusses the challenges faced by EVs.

Electric vehicles have so far failed to win over many car buyers because they are generally more expensive than combustion or hybrid models even after taking into account government incentives. The challenges of charging electric vehicles, worries about range and their performance in cold weather have also caused some people to hesitate. Hybrids don’t face many of those issues. Some hybrids cost only a few hundred dollars more than similar gasoline cars — a premium that owners can quickly recoup in fuel savings. In addition, regular hybrids never have to be plugged in. 

Plug-in hybrid models, some of which can travel on just electricity for more than 40 miles and have a gasoline engine for longer trips, have much smaller batteries than electric vehicles and can be recharged relatively quickly. But these vehicles, which make up a small part of the market, may not be as beneficial financially or environmentally when driven long distances on just gasoline.

A recent Livemint article had this table on the taxes levied on various categories of four-wheelers in India. 

Hybrid vehicles are taxed at the highest GST rate of 28%, the same as ICE vehicles. They are also taxed with a cess of 1-7 percentage points depending on the car type. In contrast, EVs attract a preferential GST rate of 5% with no additional cess. 

The article points to the case for hybrid four-wheeler vehicles over EVs.

Pro-hybrid companies have argued that hybrid vehicles emit significantly lower emissions than combustion engine vehicles but continue to be taxed at nearly the same rate… These companies have further argued that even under best case scenario, electric cars will account for around 30% of new car sales by 2030, leaving a substantial portion of the market to combustion engines. In such a situation, tax cuts on hybrid vehicles could see higher adoption of hybrids in the non-electric car market, especially in the case of larger vehicles. Using the Maruti Suzuki Grand Vitara as an example again, the strong hybrid version boasts a fuel efficiency that is over 33% better than its mild hybrid variant. It’s claimed fuel economy is as much as 50% better than comparable rivals with conventional powertrains.

It’s clear that public policy in India has made the decisive choice in leapfrogging from ICE to EVs in four-wheelers. There’s no space for hybrids and plug-in hybrids in the government’s policy priorities. 

Given that meaningful reductions in emissions are an immediate necessity, is the direct shift from ICE to EVs the most practical strategy for India? Is the direct transition even possible given the local demand conditions? What’s the opportunity cost of overlooking the phased transition from ICE to EVs through full hybrids and plug-in hybrids? Have we examined the strategic considerations involved in the choice made, especially important given the global dependence on China for battery inputs and batteries themselves? What could be an alternative EV strategy for India? 

A few thoughts in this context:

1. I’m not sure whether the Indian market can support the demand for anything more than a few lakh EVs for the foreseeable future. The domestic production in 2022 was 49,800 out of 3.8 million four-wheelers and is currently about 7000-8000 per month. Imports are anyways more expensive. Even at the most optimistic growth forecasts, four-wheeler EVs are unlikely to take up more than 10% of the market share this decade. Therefore a policy that directly targets EVs while also discouraging hybrids runs the risk of foregoing the considerable immediate carbon emissions reductions possible from the far more affordable and competitive hybrids. 

2. Then there’s the question of whether the urban Indian four-wheeler market needs EVs. Given the short urban commute requirements, hybrids and plug-in hybrids more than serve the purpose. When less is enough why do more, and that too at a prohibitive cost?

3. Given the universal trend of EVs co-existing with different kinds of hybrids and the near certainty of ICE vehicles retaining a major share of the market for four-wheelers, India will not only not miss out on any global trend but would, in fact, be going with the global norm. 

4. Unlike EVs, hybrids of both kinds require smaller batteries. The battery chemistry too is less daunting. This means far less dependence on China for batteries and its inputs, with all the strategic and national security benefits. It also means a much greater likelihood of Indian battery manufacturers being able to acquire a foothold in the global battery value chain. 

5. One of the important motivators for EV adoption in India is also the Chinese strategy of plunging headlong into EVs across market segments. Like with most other areas, the Chinese policies to encourage EV adoption are extremely wasteful and motivated by larger macroeconomic imperatives of the regime in Beijing to find new drivers of economic growth to replace weakening engines of growth. India would do well to avoid being sucked into following what China is doing. 

6. On the EV side, instead of four-wheelers, India’s public policy should instead aggressively double down on two and three-wheelers. It’s far more likely that EVs will become the dominant part of these markets shortly. It’s more realistic to expect public policy to expedite that transition. Further, acquiring expertise in two and three-wheeler EVs will provide the manufacturing base and technology expertise to move more credibly into the affordable four-wheeler EV market.

7. On a prudent note too it makes sense for India to adopt a cautious wait-and-watch policy with EVs. The EV market is a rapidly changing landscape due to battery and car technology evolution. Then there’s the geo-political uncertainty of sourcing critical minerals for EV batteries. From all evidence, it appears that we are some time away from the arrival of the truly affordable EV that the Indian market requires. 

Therefore, instead of expending scarce public finance and policy efforts on four-wheeler EVs, India should prioritise two- and three-wheeler EVs and hybrid variants of four-wheelers while also keeping its eye open to engage opportunistically on four-wheeler EVs. This would help the country acquire strong domestic manufacturing capabilities in EVs and batteries, apart from achieving significant immediate reductions in carbon emissions. It would be both sound environmental policy and sound economics. 

8. Finally, the focus on EVs should not blind us to alternative transition fuels like natural gas. After all, one of the most successful examples of carbon emission reduction in the transportation sector in the country has been the adoption of CNG in public transport buses in the National Capital Region of Delhi. 

Much the same logic of phasing transitions applies to the shift from thermal to renewable power generation. Instead of trying to abandon fossil-fuel power altogether, public policy should incentivise existing thermal plants to enhance their energy efficiencies and lower emissions by improving operations and retrofitting. Policy should also encourage the use of natural gas in the transition period. 

Sunday, March 10, 2024

Weekend reading links

1. One of the less discussed but genuine successes of India's Insolvency and Bankruptcy Code (IBC) is the resolution of stressed power generation assets

“Stressed assets” — coal generators that were unable to pay their debts to lenders — became a $23 billion drag on the financial sector, but the list of plants has been whittled from 34 in 2018 to four after alternative utilities, led by state-owned NTPC Ltd., stepped in as buyers of last resort and creditors took haircuts on their investments.

This about the comparative economics between coal and solar

In 2017, a new solar or wind generator was still marginally more costly than a new coal plant. Nowadays, it’s drastically cheaper. The average Indian solar generator in 2024 needs about $30.76 per megawatt hour to break even and wind is at $39.91/MWh, according to BloombergNEF, compared to $50.53/MWh for new coal and an average tariff at NTPC, the largest coal generator, of about $59/MWh in the 2023 fiscal year.

The article writes about the return of private investments into coal plants and the slowdown in the growth of renewable investments. 

In this context, it's instructive that the major coal power investors are also the ones with the biggest renewables generation ambitions. This presents conflicting incentives. 

2. Taylor Swift's East Asia tour is confined to just two places - Singapore and Japan - leading to Swifties from across the region being forced to travel to these countries. This has in turn boosted economic activity in these countries. This about Singapore.

In contrast, during the next leg of her tour in Europe, Swift is traipsing across major and minor cities throughout the continent, hitting four European cities in May, and another six in June, including smaller U.K. cities such as Liverpool and Cardiff. Many of the more than 300,000 tickets sold in Singapore have gone to overseas fans who will fly in, and hotels and restaurants haven’t been shy. The city’s iconic five-star hotel, the Marina Bay Sands, is offering “The Wildest Dreams Package," which comes with a three-night stay, four VIP tickets and a round-trip limousine ride from the airport. The cost: nearly $40,000. More than 90% of guests buying the exclusive packages are coming from abroad, according to the hotel. Travel booking website Agoda said that searches for accommodation in Singapore spiked 160 times over usual levels after ticket sales began last summer... Nomura Bank estimates that the combined effect of six Coldplay concerts in January and six Taylor Swift concerts in March could contribute $300 million to Singapore’s tourism revenues in the first quarter. Bookings for tours and Singapore attractions have surged, according to travel booker Trip.com. “With the trade recovery yet to take off fully, Singapore is busy making ‘concert economics’ its new growth driver," said HSBC in a note.

3. The taxation structure on ICE, hybrid, and electric cars.

4. Some facts about capex in India from a Livemint long read. One point has been the declining private sector capex and the much lower public sector capex compared to the pre-reform era.

The entire reform period has seen a secular decline in public sector capex to around 6-8% of GDP, from levels of well above 10-11% of GDP in the 1980s. As an aside, what is also alarming is the steep decline in private sector capex since the global financial crisis of 2008. Importantly, the private sector never really recovered from that crisis and its after-effects.

Within public sector capex too, the share of public sector units has declined, with budgetary capex replacing PSU capex in recent years.

Add in PSE capital spends to the mix (from their own resources), as compiled by budget documents, and overall central government capex rises to over ₹14.5 trillion. But seen in the context of overall GDP, the sharp bump in absolute terms looks less impressive—even in the context of the last decade or so. Combined central government capex (main government plus PSEs) is budgeted at around 4.4% of GDP for 2024-25—that’s still lower than the level 10 years ago.

This about highways and railway spending.

In 2021-22, it budgeted a spend of ₹1.22 trillion on such projects, of which, over half was to be funded by itself (largely through borrowing). Since 2022-23, however, all of NHAI’s funding was done directly through the government budget. It was not allowed to borrow any funds directly from the market, the aim being to keep the body’s borrowing on a tight leash. For 2024-25, as much as 15% of the main central government capex, or ₹1.68 trillion, is allocated toward funding NHAI... As of 2019-20, the central government budget contributed less than half of railways capex for the year ( ₹1.46 trillion). This ratio started to creep up. As of 2024-25, almost all the capex for the railways ( ₹2.52 trillion) will come directly from the central government budget, with just ₹10,000 crore earmarked to be raised by the railways directly from the bond market or its internal resources. In this sense, at least a significant part of the increase in capex is a shifting of funds—bringing them ‘on-budget’—rather than extra spending.

5. FT has a long read on the spectacular but suspicious rise of Temu, the Chinese e-commerce platform that retails cheap clothes, toys, footwear, kitchen items etc. It has undergone the fastest retail expansion in history spreading from China to 49 countries after less than two years in operation.  Temu's parent company, PDD Holdings, owns Pinduoduo, the sister App which dominates the Chinese market. PDD is a retail e-commerce giant and is known for its aggressive marketing and discounting. 

When it still published such numbers, PDD reported more than 870mn active users in the country supplied by over 13mn merchants who, it claimed, together generated a third of all parcel traffic in the country, tens of billions of packages a year. After just nine years in business, PDD is now bearing down on the world’s biggest ecommerce group Alibaba, both in terms of retail scale and stock market capitalisation. Worth $162bn, it regularly trades places with the older retail giant as the most valuable Chinese company listed on a US stock exchange.

The article points to the surprisingly limited asset base, low cash flow, low manpower etc., despite the firm's market impact and compared to competitors.

Why do balance sheet metrics move at a different pace to revenues? How does a $200bn company own less than $150mn worth of hard assets?... It operates like eBay and Amazon’s third party marketplace, connecting buyers with sellers to take a cut of each transaction and charging merchants to advertise on its platform. In its most recent quarter those revenues almost doubled versus the previous year, to $9.4bn, prompting Alibaba founder Jack Ma to exhort his former company to “change and reform” in response. PDD reported $2.5bn of cash flow, even as it appears to throw very large sums at the expansion of Temu. It has achieved this with a headcount that upends all assumptions about ecommerce logistics: it started last year with 12,992 employees, an order of magnitude less than Alibaba and a small fraction of Amazon’s 1.5mn staff. PDD’s physical footprint is also minuscule, a striking contrast with Amazon, JD.com and Alibaba, where control of logistics was long seen as a competitive advantage; a way to ensure speed, capacity and satisfactory service. Where Alibaba spends $5bn a year on property and equipment, including the upkeep of 1,100 warehouses, PDD owns just $146mn of hard assets — mainly office equipment and IT hardware and software... 

It doesn’t report the size, location or number of the warehouses it rents. Those logistics, like PDD’s servers and customer service call centres, are mostly outsourced, ephemeral and unenumerated. The opacity extends inside the business. Staff use pseudonyms and know little about other teams. The structure is flat, with a small group of decision makers directing the “grassroots”, young people chosen for their poverty or debt obligations which motivate them to work long hours... Over 2020 and 2021, PDD reported selling $2bn worth of merchandise without disclosing any stocks of inventory on its balance sheet, or the costs of those goods sold, two standard retail accounting items. Then it stopped selling mystery merchandise as abruptly as it started... Research and development spending that year rose only slightly to $1.5bn in total, similar in scale to eBay rather than Alibaba’s $8bn annual spend on product development... In the blow-out recent quarter, marketing services grew at roughly the same pace they have since the middle of 2021, about 40 per cent year-on-year. But over the same period, transaction fee revenues grew at more than three times the rate of marketing services. Based on the transaction fee rate PDD reported in 2021, that would suggest an improbable level of activity, making the PDD ecosystem twice the size of Alibaba and on a par with the $2.2tn annual output of the Italian economy. Instead, PDD must be charging its merchants a lot more.

This is the most stunning point, Temu's rise is not being felt by its competitors

PDD’s impact is hard to detect in their numbers. In the battle of online flea markets, Alibaba’s Taobao reported improving take rates and growing merchant numbers last month that hardly indicate obliteration by Pinduoduo. Alibaba’s executives have not addressed their upstart rival by name on any of their earnings calls. Outside China, both eBay and US discount chain Five Below said last year they hadn’t seen any impact on their business from Temu. Amazon didn’t mention it when reporting results last month... If PDD’s numbers are indeed to be believed, then a shrewd executive team directing pseudonymous underlings has created one of the most successful businesses the world has ever seen. But it is not clear how the several thousand staff who run PDD deal with the risks in administering hundreds of millions of transactions, and tens of millions of suppliers delivering tens of billions of parcels...
Investors searching for further detail were unlikely to find it at the most recent earnings call, when Chen took a total of six questions from three analysts and made pronouncements that resembled state political sloganeering. “We are dedicated to generating value through innovations, which forms the foundation of our high-quality development,” he said, echoing a key tenet of his country’s latest five-year plan. They would also draw a blank attempting to direct questions to a chief financial officer. PDD doesn’t have one. Instead it is on its fourth “vice-president of finance” since the 2018 initial public offering, if a period when founder Huang added the job to his duties is counted. It seems that while profits are good, investors are willing to tolerate such opacity. On Wall Street, 53 out of 56 analysts recommend their clients buy, and not one suggests they sell... Unlike other large US-listed Chinese companies, PDD — which is nominally headquartered in Dublin — hasn’t courted the investors who might know it best with a secondary Hong Kong listing. The structure for foreign ownership of Chinese assets remains untested, with “heightened operational and legal risks”, according to the head of the Securities and Exchange Commission. Holders of PDD stock own shares in a Cayman Islands company that has unpublished contractual agreements said to entitle it to the profits of the Chinese operating companies.

On the face of it, it's hard not to come away with the feeling that we might be witnessing the biggest Ponzi scheme of the digital age! 

6. The pushback against low-cost and short-haul flights in Europe on environmental grounds throws up several difficult public policy challenges. From an FT long read.

Last week Spain followed France in unveiling a limited ban on short-haul flights. The Netherlands, Denmark and France have pushed ahead with plans for higher taxes on flying, while the Dutch government previously tried to impose a hard cap to lower the number of flights at Schiphol... But policymakers also need to acknowledge the public popularity of cheap flying and confront the lack of viable alternatives... Aviation supports close to 5mn jobs in the EU and contributes €300bn, or 2.1 per cent, to European GDP, according to European Commission figures. But it is also responsible for around 4 per cent of EU carbon emissions. It is one of the fastest-growing sources of pollution and faces a huge technological challenge to decarbonise... European airlines and airports laid out a detailed plan in 2021 to reach net zero by 2050. Most of that will be achieved through a switch to so-called sustainable aviation fuels or SAFs, which are made from feedstocks other than fossil fuels and, from production to combustion, emit less carbon.

There's the challenge of tightening regulations and forcing the internalisation of negative externalities to create a level playing field for alternative transport options like high-speed rail.

Airlines in Europe say they are already subject to the toughest environmental rules in the world courtesy of a carbon tax imposed on intra-European flights and a requirement that 6 per cent of fuel on every flight is sustainable by 2030... The industry says the rising cost of the EU’s emissions regime will drive ticket prices higher and deter some people from flying. Pricing travellers out contributes around 15 per cent of the net carbon emissions reduction within the industry’s net zero road map. But it is not enough for environmental groups, which want the clampdown on cheap flights to go much further. T&E has called for higher carbon prices, a tax on aviation fuel and for value added tax to be added on airline tickets. Currently, airlines pay no duty on their fuel while tickets are exempt from VAT and airports and aircraft makers often receive state subsidy, T&E says. That gives flying a cost advantage; a Greenpeace study comparing ticket prices on more than 100 routes between major European cities last summer found that trains were on average twice as expensive as flights. Paul Morozzo, a transport campaigner at Greenpeace, says flying “only looks like a bargain because airlines are not forced to pay for the devastating cost of their pollution”. “The failure of governments to properly tax the aviation sector for the fuel it uses and the pollution it causes has created an uneven playing field.”

But even with the regulations and higher prices, and its several advantages, rail transport faces daunting challenges to emerging as a competitive alternative. Connectivity infrastructure need large investments.

Cost is not the only issue preventing more rail travel. A much bigger problem is that the network simply does not provide the connectivity that travellers demand. A Eurobarometer survey published in 2020 found that while the main obstacle to greener forms of travel was cost, 40 per cent of respondents also cited speed. Even allowing time for travelling to and passing through airports, flights are almost always quicker than trains at present... Part of its efforts are to put more concerted focus — and investment — into the so-called TEN-T network — a trans-European spider web of roads and rail lines intended to link the continent’s major hubs. It forms the backbone of the EU’s land transport policy. The commission’s overarching but non-binding target is to double high speed rail traffic by 2030 and triple it by 2050, ensuring that passenger trains running on the TEN-T network travel at a minimum speed of 160km/h. The Green Deal climate law, which commits the bloc to reaching net zero emissions by 2050, stipulates that greenhouse gas emissions from transport must be cut by 90 per cent. But compared to the vast expansion of airline routes in recent decades, land-based connections have been painfully slow to open up, despite Brussels’ efforts to stimulate growth... Transport also consumes the biggest share of the EU’s €723bn Recovery and Resilience Facility, while rail accounts for the majority of projects within the €25.8bn provided for transport by the EU’s Connecting Europe Facility. But new rail infrastructure is expensive, often subject to delays and takes a long time to pay back the capital absorbed in construction, making it less attractive to private finance and difficult for states to justify when public finances are stretched.

Besides railways are largely state-owned monopolies, which in turn creates its set of problems.

While aviation is a highly competitive marketplace with frequent price wars, rail remains dominated by state-run monopoly operators whose domestic priorities often trump efforts to improve international connectivity... Whatever Brussels proposes in terms of international connections often butts up against national concerns, according to Bas Eickhout, a Dutch Green MEP. “No matter what, all the national decisions always go to improving the domestic train system,” he says. “So if the Dutch need to decide: ‘am I going to improve Amsterdam-Berlin or Amsterdam-Utrecht?’ they [will] decide it’s going to be Amsterdam-Utrecht.” Because such thinking is replicated across the EU, he adds, “of course we are having difficulties in having a credible alternative for short-haul flights.”

Finally, there's the complex political economy of the energy transitions.

Politicians increasingly fear voters will punish those pushing for climate-related policies such phasing out gas boilers in favour of heat pumps or curtailing the use of combustion-engine cars. Even efforts to complete existing legislation have slowed; a revision to the energy taxation directive that would have reduced exemptions for jet fuel has stalled, for instance, and will not be agreed before the end of the commission’s mandate. Brussels is also hesitant about forcing costly decarbonisation rules on industry amid concerns for the bloc’s competitiveness... The Dutch government in November bowed to pressure from airlines, the EU and the US government — all of whom warned of a hit to competition — and paused plans to lower the number of flights at Schiphol. The future of the airport is now part of coalition negotiations following national elections.

7. Don't know how you can revive economic growth through a radical austerity programme that crushes both consumption and investment as Javier Milei is doing in Argentina

Milei is trying to push through a radical, high-risk programme of austerity to heal Argentina’s stricken economy. A political outsider, he is facing stiff opposition from Congress, unions, social movements and protected industries. In response, he has doubled down on confrontation, insulting anyone who opposes him and refusing to negotiate. For the time being, Milei’s popularity is holding up — giving him some space to direct public disquiet towards the politicians and vested interests he blames for the country’s economic woes. But if that popular support falters, he will have little institutional backing for his controversial agenda. Some political observers are already wondering privately whether his presidency will last its full four-year term...
Milei only entered politics just over two years ago and his La Libertad Avanza party holds less than 15 per cent of seats in Argentina’s Congress. He quickly ran into trouble when he tried to pass ambitious legislation to overhaul the heavily regulated economy. The president tabled about 1,000 reforms aimed at deregulating the labour market, promoting competition and raising some taxes to balance the budget. About a third of the measures were contained in an emergency decree, which faces a wave of legal challenges on the grounds it may be unconstitutional. The remainder were in a huge “omnibus bill” intended to sweep away 40 years of regulation.

None of his major measures have passed the Congress. In response to the opposition, Milei has doubled down with confrontation, often carried out in social media platforms. 

People who deal with the government say the president is now more dependent than ever on a small inner circle of true believers and his army of social media followers, to whom he devotes more than two hours a day online. His closest advisers include his sister Karina, who used to sell specially decorated cakes on Instagram and is now the presidential chief of staff, and Santiago Caputo, a 38-year-old political consultant and social media guru whose father is a cousin of Luis Caputo, the former Wall Street trader now serving as finance minister... Some question Milei’s economic results too. Eduardo Levy Yeyati, an economist and professor at Torcuato di Tella university in Buenos Aires, believes the much-vaunted fiscal surplus in January benefited from accounting tricks such as shuffling government payments around.

8. Martin Wolf points to China's extraordinary savings, at 28% of the total global savings in 2023 it's only slightly less than the combined US and EU share of 33%. 

This is a good summary of the problems facing Chinese policymakers

If demand is to match potential supply in such an economy, domestic investment, plus the current account surplus, must match the desired savings. If they do not, the adjustment will work through weak economic activity — that is, a recession or even a depression. This is “secular stagnation”. With savings as high as China’s that is hard to avoid. Doing so required a huge current account surplus prior to the 2008 global financial crisis and, subsequently, China’s debt-fuelled property boom. The latter is now apparently over. So what next? A natural course would be for the investment rate to fall significantly. It is highly implausible that the economically profitable rate of investment can remain over 40 per cent of GDP in an economy whose potential rate of growth has, at the very least, halved over the past 15 years. That makes no sense. The property boom masked this reality. Now it is here. If the savings rate remains where it is and the investment rate duly falls, the “solution” will then be a rise in the current account surplus as savings flow abroad. Official data do not yet show this. But there are doubts about this. Brad Setser of the Council on Foreign Relations argues that the surplus may be double what the official data show, at 4 per cent of GDP... 

A current account surplus of 4 per cent of GDP does not look large by China’s past standards. But, since 2007, when China’s current account surplus peaked at 10 per cent of GDP, its share of the world economy (at market prices, which is what matters here) has jumped from 6 to 17 per cent. So, from the point of view of the rest of the world, a Chinese surplus of 4 per cent of GDP is far bigger than one of 10 per cent in 2007. Who is going to run the offsetting deficits? Who, in particular, will run them when the concomitant rise in exports will be driven by investment in competitive manufactures, such as electric vehicles? The answer is not creditworthy high-income countries: they will view these as “beggar-my-neighbour” policies. The same will surely be true for big emerging economies, such as India. If China wants the mercantilist solution to excess savings it will have to fund smaller emerging and developing countries. It can pretend these are loans. But much of the money will be grants, after the fact. If it ends up funding renewable energy there, that could be good for the world. But, from China’s perspective, it would be a costly gift... Given China’s size, stage of development and excessive savings, an essential part of any strategy for macroeconomic stability must be a jump in private and public consumption as shares of GDP. Moreover, given the financial difficulties of local government, this will also mean a bigger role for central government spending.

The automobile sector is rapidly emerging as an important source of investments and surpluses.  


But in a world fearful of Chinese intentions, these surpluses are simply unsustainable. Contrary to the media commentaries, China it seems is much more dependent on the world economy for its survival in the current form than acknowledged.  

9. Cocoa prices have surged to touch historic highs

Prices of beans have surged to all-time highs, with cocoa futures in New York more than doubling from the same period last year. On Tuesday cocoa futures in London traded at a record high of £5,827 per tonne. On the same day last year, they traded at £1,968. Prices are rising in part because supply is stretched. Poor weather in Ivory Coast and Ghana, which together produce around two-thirds of the world’s cocoa beans, has affected crop yields. El Niño, the sea temperature phenomenon which occurs every three to five years, returned last year, first bringing unseasonal heavy rainfall to the region and then dry heat. The result is a global crop 11 per cent smaller than last year’s season, according to forecasts published by the International Cocoa Organization on Thursday. Analysts are warning that chocolate makers and brands will pass along higher costs to consumers... Years of vast cocoa output, especially in neighbouring Ivory Coast which produces nearly half of the global supply, have kept prices low generally. That might be good news for Western consumers, but here it has meant that cash-strapped farmers have not been able to invest in their cocoa plantations. Most have not planted new trees since the early 2000s, and can ill-afford to use fertiliser or pesticides. As trees age, they become less productive and more vulnerable to disease and adverse weather events.
10. Finally an excellent long FT Alphaville post on the private equity industry, specifically how its long-term returns compare with the market. The main challenge is with benchmarking PE industry returns. But now the wealth of evidence points to nothing superior about PE returns.
One of the first broadsides against private equity was Steven Kaplan and Antoinette Schoar’s Private Equity Performance: Returns, Persistence and Capital Flows. Published by the Journal of Finance in 2005 it sensationally argued that returns were roughly similar to that of public equities after adjusting for the eye-watering fees. In 2012, Kaplan and colleagues Robert Harris and Tim Jenkinson... published a new paper that estimated returns had exceeded public markets for “a long period of time” and by a healthy margin — more than 3 per cent per year on average... In 2013 Andrew Ang, Bingxu Chen, William Goetzmann and Ludovic Phalippou caused a stir by arguing that “private equity is, to a first approximation, a levered investment in small and mid-cap equities”. Then in 2020 Phalippou, a professor of financial economics at Oxford’s Saïd Business School... published an incendiary paper... calculating that the only people to do well out of it (on average) are the private equity tycoons themselves.

There are at least two factors that raise questions about the industry's future. One the industry is today a behemoth with $5 trillion in assets under management and $2.9 trillion in dry powder it's struggling to deploy. With size comes intense competition and limited opportunities in a relative sense. Two, the industry was boosted by declining and low-interest rates over the last four decades, which are now bygone. 

Four decades of falling interest rates helped increase corporate earnings and swell equity market valuations. Indeed, a Federal Reserve paper published last year estimated that lower interest expenses and tax rates explain almost half of all growth in US corporate profits between 1989 and 2019. At the same time, valuations of those earnings streams have increased because of lower discount rates used to calculate their worth. Despite private equity insisting that they improve companies, Bain’s latest report on the industry estimates that “nearly all the value creation” in private equity-owned companies between 2012 and 2022 actually came from revenue growth and multiple expansion. “Margin expansion barely registers,” the consultancy noted drily... Kaplan and Schoar’s 2005 paper highlighted nearly two decades ago that there was “substantial persistence” in the performance of private equity funds... However, more recent studies indicate that the persistence of private equity fund performance is weakening, and since 2000 there is “little evidence” of it, according to a 2020 paper by Harris, Jenkinson, Kaplan and Ruediger Stucke.

The institutional LPs like pension and sovereign wealth funds with very large funds to deploy and have been deterred by the high fees charged by PE firms are now seeking to invest through their own internal teams or co-invest with the PE funds. 

Co-investments (and in some cases direct investments) have become far more prevalent in recent years, as Canadian, Australian and European pension plans have followed the path first taken by a few sovereign wealth funds... While CEM Benchmarking estimates that internally managed private equity portfolios on average do slightly worse than the industry as a whole, the cost saving “far outweighs any difference in top line return”.

Finally, the article questions the low volatility of PE funds, and the so-called illiquidity premium they generate. 

Because private companies don’t trade like stocks on an exchange, private equity funds only do modest quarterly valuations and firmer annual ones. These can often be more art than science. That means that there’s a lot of scope for smoothing out returns, making them look both better and gentler than those derived from stock markets. Perhaps they don’t go up as much in a rally but they often stay steady in a bear market — a welcome cushion for institutional investors, even if it is just an artifice of accounting rules. This doesn’t get talked about too loudly. A lot of investors in private equity prefer to justify their large and growing allocations with a reference to a mythical creature called the illiquidity premium, a fairy that apparently sprinkles private markets with its magical return-enhancing dust.

See also this about the fake smoothness of private markets.