Monday, July 24, 2017

Limits to progress, economic growth, and capitalism?

FT has more on the challenges facing retail in the US from the e-commerce market,
Credit Suisse estimates that as many as 8,640 stores with 147m square feet of retailing space could close down just this year — surpassing the level of closures after the financial crisis and dotcom bust. The downturn is hitting the largely healthy US labour market — the retail industry has lost an average of 9,000 jobs a month this year, according to the Bureau of Labor Statistics, compared with average monthly job gains of 17,000 last year.
The dramatic flurry of retail stores construction in the US has been a major contributor to this disruption,
PwC estimates that there is about 24 sq ft of retailing floorspace per person in the US, compared with 11 sq ft in Australia — the only other developed country that comes close to the US — and between 2 and 5 sq ft in Europe.
Amazon with less that 10% of US retail sales forms nearly 40% of US retailing valuations, 
The online giant’s shares are now worth $477bn, more than half as much as the rest of the listed US retailing world... Online-only purchases account for just over 10 per cent of all US retail sales, but the share is growing quickly.
And this is true not just of retail, but also in hotel and travel industry,
Priceline and Expedia are now valued at a combined $114bn, almost as much as all the hotels and hospitality groups in the S&P 500, or the airlines.
On labour intensity in retail, this is a stunning statistic,
Goldman Sachs estimates that ecommerce companies only require 0.9 employees per $1m of sales compared with 3.5 for a bricks-and-mortar store, and the sector is on course to lose about 100,000 jobs this year. This may be small compared with the overall retail economy — which employs almost 16m — but it is likely only the beginning of a broad, accelerating trend as even more shopping migrates online.
I have three observations.

1. One of the things that we tend to assume with development and economic growth is that it is always good and brings progress. In the long-run, or the general equilibrium, adjustments are made and losers compensated, it is assumed. However, there is little basis for this assumption. It is a faith-based argument. As Tyler Cowen has written recently, the pain and suffering associated with Industrial Revolution, was far from transient and tolerable. And unlike the 1700s, such adjustments are most likely to be even less acceptable. 

In general, there is nothing to suggest why automation should be accompanied by all the required labour market adjustments. In fact, what if in the future there are less human beings engaged in the work-force? There is no sound basis for the optimism of the techno-optimists. 

In the circumstances, being more cautious with the wholesale adoption of unqualified automation, even if it appears against progress, may not be that bad an idea. Public policy may need to more specifically explore the options to protect and keep meaningfully engaged those most vulnerable to labour market displacement from such trends. If we can exercise restraint on human cloning, we can as well be cautious on the adoption of driverless cars.

2. There is nothing to support the belief that economic growth of this generation and a couple earlier is the natural order of things. It is well-acknowledged that the growth spurt since the late nineteenth-century has not only been unprecedented but also outside the norm for centuries of human existence, and there is therefore nothing to suggest that it should continue. 

In fact, an empirical assessment points to a secular trend of stagnating incomes across the developed world. The Times points to an MGI analysis of 2016 that found 81% of the US, 97% of Italian, 70% of British, and 63% of French populations fall in an income bracket with flat or declining incomes over the last decade.

A world where economic growth is just enough to sustain living standards, while difficult to accept for our generation, should not signal doom. On a historic sweep, even if we are able to sustain the current living standards, with marginal and very gradual increases, it may be a big achievement. The far less desirable, but more likely eventuality (than another century of growth similar to the past century), is a decline in living standards.

3. Finally, this raises more questions about the sustainability of free-market capitalism. What if the inexorable dynamic of the market forces playing themselves out is a world without adequate work to support the billions and results in meaningless lives and pitiable suffering? On a 40-50 year horizon, I see no reason why this scenario is any less less plausible than the widely accepted argument that the "dictatorship of the proletariat" will eventually end up in an centralised and authoritarian system like in the Stalinist Soviet Union.

Update 1 (25.07.2017)

This - India won't allow driverless cars - is good public policy! 

Saturday, July 22, 2017

Is Reliance Jio the biggest product launch ever?

Reliance Jio, the telecommunications service offering of Reliance Industries, has courted controversy with its aggressive launch and pricing strategy. But that controversy aside, the scale of its launch has been truly spectacular. Consider this,
Reliance Jio launched its 4G service commercially on September 5, 2016 offering free data and voice services. It crossed 50 million subscribers in just a matter of 83 days, and 100 million in 170 days, having added an average 6 lakh subscribers per day.
Even when compared to anything the Chinese have done across sectors, this is something truly staggering. And to have done it without the technical and logistical glitches associated with product launches  and project roll-outs in such scale is a massive achievement. To have managed the logistics of customer acquisition and the challenge of the explosive load growth on technology systems is very impressive. 

And, it appears that there is more to come,
JioPhone, a 4G VoLTE feature phone called ‘India ka Smartphone’... is a feature phone, but with a larger screen, access to apps and of course 4G data and 4G VoLTE calls and will effectively cost the customer Rs 0 for the device and Rs 153 per month as monthly tariff... The target is to make 5 million phones available every week. The JioPhone will always have free voice calls. From August 15, the JioPhone will come with free unlimited data. A similar quantity of data on any other operator’s network would cost up to Rs 5000 a month... The phone has been created by Indian engineers for an Indian audience, Mukesh Ambani said, “made in India for Indian users”. The phone will offer an innovative cable link to television to help users view content on a big screen at home. Users will need to buy the Jio Dhan Dhana Dhan package of Rs 309 to get the extra data needed for this. The phone also responds to voice commands, which is unprecedented for a feature phone anywhere in the world.
It begs the question whether the Jio is the most accomplished launch of any technical product or solution by public or private sector across the world?

Thursday, July 20, 2017

The plumbing of third party audits

This study of third party audits of polluting industrial units in Gujarat is highly acclaimed. It claims to provide evidence that independent third-party audits are effective at reducing environmental pollution.

In brief, in response to a High Court directive, certain types of highly polluting industrial units in Gujarat had commissioned and had been filing thrice-a-year third party audit reports since 1996. Instead of being paid by the firms themselves, once the auditor payments were made from a central pool (money raised by researchers) and audits conducted randomly, there was a significant increase in reporting of pollution readings and reduction in actual pollution itself. In order to strengthen their theory of change, the J-PAL researchers also conducted explicitly announced random sample back-check super audits of each auditor and their payments were made contingent on the accuracy of the original audits (compared to the back-check super audits).

Similar third-party audits of polluting industries are being done by some states, either directly or through outsourced management of emission/effluent discharge sensors. In the circumstances, I struggle to understand the likely incremental benefits of an RCT evaluation of third party audits to monitor pollution. Of course, third party audits will reduce pollution. And perceptive environmental protection officials across states are aware of its utility. 

So, did the research provide anything that was valuable for real world life? In the real-world of weak state capacity, effective management of third-party audits itself is a massive task. The back-check super audits make the task even more onerous. Since the back-checks were conducted under the supervision of enthusiastic and committed research associates, were known to the industries, and auditor payments were made contingent on original audits tallying with the super audits, the original audits could not but not have become high stakes and thereby also high quality. The RCT established the efficacy of this particular double-audit design.

Unfortunately, such a two-level audit, which achieves both high stakes and high quality in this manner, while desirable, is too engagement intensive to stand a chance of effective scale up through weak public systems. If instead the research had proved the efficacy of one-level audits, that would have been of at least some practical value (maybe a technical rationale for an interested bureaucrat to push through the reform).

Like with this, I am puzzled by such research endeavours and the attention that it commands in the academic arena. Third party audits or certifications are today common place in monitoring everything from engineering works to the quality of goods procured and services delivered. In countries like India, over the last decade or so, third party quality audits, ostensibly of random samples and carried out unannounced, have come to be embraced for engineering works executed by all departments, big and small, urban and rural. It has undoubtedly contributed to improving the quality of these works, and where done well the benefits are very significant. 

If the authors were interested in showing that how the auditors are paid shape incentives, they need not have taken the trouble since there is a rich body of literature on the problems with ratings shopping by financial institutions. 

The researchers found at least two channels of incentive distortion with the earlier approach. One, an agency problem arising from the auditors being paid by the audited. Two, the auditors being paid significantly less than would have been required to conducted good audits. 

It is difficult to believe that the Gujarat Pollution Control Board (PCB) did not know what was going on. I can think of at least four first-order plumbing reasons why the PCB preferred to go along with the charade than adopt what were obvious (if atleast because they were being done in other sectors) reforms. One, these reports were being generated at the instance of the High Court and being reported to them. As long as the Court was happy, there was no reason nor inherent motivation for the PCB to change the system. Such pro-forma compliance with regulatory requirements is commonplace in bureaucracies. Two, if the government decided to do the audits, there was the question of who would pay for it, not to mention the “headache” of managing this additional administrative responsibility. Three, there are strong vested interests among the polluting industries that prefer the status quo. And regulatory capture, especially in such high stakes sectors (the difference between business as usual and pollution compliance for these firms is in many cases a matter of survival itself), is always imminent. Four, whether we like it or not, pollution control is a marginal concern for most state governments as they chase economic growth and job creation. To this extent, officials posted in such Departments are unlikely to be those with the greatest interest and enthusiasm to pursue painstaking reforms.

The issues of relevance for practitioners with third party audits are more in the plumbing. There at least a few that come to mind immediately. What should be the most cost-effective design of third party audits? What can be done to mitigate the risk of capture of such audits? How can the audits respond to dynamic expectations? And, how can the audits be financed?

In case of an engineering work, the most cost-effective design would focus on the least number of samples with the longest periodicity that would not compromise on deterrence. As regards addressing capture, inspections may not only have to be random but also done by personnel on rotation, and the agencies themselves may have to be shuffled periodically or multiple agencies employed. As to dynamic expectations, it may be necessary to periodically revisit the audit criteria and calibrate for the adaptations. On financing, it may be required for the PCBs to commission and finance the audits and, maybe, recover a part of the cost as a user-fee (or from the fines collected, though it could have perverse incentives) paid into a common pool. 

Ultimately what the practitioner needs is an administratively simple and workable third-party audit design. Or more specifically, he or she would want a tender document that captures these design specifications. The aforesaid research does not provide anything of relevance on this. 

Let me be clear that the purpose of this or an earlier post is not to downplay the importance of field experiments or economics research in such areas. They have undoubted value. Research, even without out a utilitarian dimension, is valuable. At the least, it provides some basis for a government official sitting on the fence to bite the bullet with independent and/or random sampled audits. 

Readers should note that there is nothing Gujarat or even India-specific to the plumbing issues. They are universal to any developing country with weak state capacity. So many of the plumbing features that could have been tested are generalisable. An opportunity has been missed, and more worryingly, we may not even be aware that these are the real challenges. 

These posts are motivated by my strong belief that field research rarely ever start with a felt-need or felt-problem for the primary stakeholder, most often government officials. While there are also practical difficulties, inadequate comprehension of the real plumbing challenges among researchers is the bigger obstacle to engaging directly with the problem. It does appear that, contrary to this, the best plumbers, outside of actual plumbers, are the practitioners themselves. Plumbing knowledge is a lived experience.

Monday, July 17, 2017

Thoughts on urban governance reforms

The issue of direct elections to the post of Mayor is a recurrent theme in Indian politics. A good status report is here

My preference is for directly elected and empowered executive Mayor, with a Council, and assisted by a Commissioner or Secretary, coupled with a few other reforms. 

But the case for a directly elected Mayor is complicated by the likelihood of political stalemate arising from a Mayor and Corporation being from different parties. Hence the argument for an indirectly elected Mayor. But this, in turn, has its flip side. 

The effectiveness of a Mayoral system comes from it throwing up ambitious and incentive aligned Mayors (who see the Mayoral system as a primary for bigger political offices). This is unlikely to emerge from an indirectly elected Mayoral system. As an example, just see this - Kolkata Mayor getting nominated from among the Councillors by the CM (which CM would nominate a powerful person?). In simple terms, an indirectly elected Mayor while addressing the political stalemate problem, weakens the fundamental premise of a Mayoral system - a powerful and incentive aligned Mayor! Only a directly elected Mayor can address that.

We also need to keep in mind that different combinations of Mayoral systems have been tried out in different cities, even in Mumbai. We need to learn from them and be clear as to what is different now that would increase the likelihood that this time will be different. I will suggest at least three things.  

One, a Mayoral-Council cannot by itself be effective without some complementary levers. At the least, assuming a level of delegation of functions under 74th amendment and powers from the State Government, most of the executive powers of the Commissioner should be transferred to the Mayor, and of the Standing Committee to the Council. This should complement further devolution of powers under the 74th amendment. 

Two, there is a need to address the likelihood of political stalemates. One way of partially achieving that, done elsewhere in the West, is to have smaller boroughs (executively administered or through political councils) that have all the daily administrative powers in functional areas like sanitation, management of utility services, tax assessments, building permissions etc. Those Mayors largely deal with broad functional areas like transportation, housing, and economic growth which require city-wide planning and co-ordination. 

Appropriate division of responsibilities between the Mayor/Council and Ward Committees can help mitigate some of the political stalemate risks. The Ward Committees would have all the responsibilities and power over basic municipal functions. Mayor and Council will have policy making and planning powers and control over sectors like housing, transportation, and growth. Financial sanctioning powers will have to be distributed among Corporation, Mayor-in-Council, Mayor, Commissioner/Secretary, and Ward Committee. The Ward Committee will be serviced by an Assistant Commissioner or some such level official and supported by a small Secretariat. The cutting-edge functionaries would be accountable to the Ward Committee. It may be worthwhile re-considering the sizes of current wards or consolidating 4-6 wards under a functional unit like borough (Kolkata has 16 boroughs and 144 wards). 

Three, try this out in a 4-5 second and third tier cities for a five year term and assess what changes need to be made, especially in terms of the functional responsibilities of each level (so as to increase functional efficiency and accountability) as well as capacity requirements for Ward Committees. There should be simultaneous movement towards ring-fencing and corporatisation of at least the utilities. 

To summarise
  1. Directly elected Mayor and nominated Mayor-in-Council (from among elected Councillors) for a term of five years
  2. Executive power with Mayor 
  3. Commissioner to be Secretary to the Corporation
  4. Delegation of all basic municipal functional responsibilities to Ward Committees - a Secretariat to administer basic functional activities
  5. Mayor and Council's responsibilities to be confined to transportation, housing, and economic growth, and planning and policy support on other functional areas. 
  6. Delegation of financial powers among different levels

Tuesday, July 11, 2017

Policing is hard - a bit of humility would be great!

I really cannot understand the purpose of this oped. Abhijit Banerjee points to the increased use of breathalysers (tools) and introduction of higher fines (laws) as essential in the fight against drunken driving. This, he says, has to be complemented with a strategy of vehicle checks at randomly decided locations using dedicated teams of police drawn from the reserves.  

But there is nothing new about this "strategy" that Banerjee claims to have figured out with an RCT. In fact, it is exactly this "strategy" that police superintendents and commissioners resort to for short periods when something (usually a high-profile accident or a court directive) precipitates greater vigilance on drunken driving. And some of the more enterprising police leaders with interest in traffic issues too adopt randomised checking locations strategy. The problem is that these things cannot go beyond short periods. Coincidentally, they are also exactly the same "strategies" than new entrants and popularity seeking police leaders embrace. 

Take the issue of random locations. While, from the outside, allocating random locations may appear an algorithmic exercise, it is far from that when operationalised in scale. A combination of closing ranks by powerful and entrenched interests and systems with very weak institutional capacity at field (read police station) levels mean that such strategies are easily sabotaged, unless there is a strong enough leader micro-managing the process. As an example, random third party quality checks of engineering works under construction, now passe, has become completely captured in many jurisdictions. As to reserves, their deputation beyond a few days, is by definition, impossible. In a heavily under-staffed police force overburdened with crowd and VIP events management responsibilities (bandobasth), reserves, are that only in name. 

In fact, the optimism with even with the first two may be misplaced. The challenge, as Esther Duflo pointed out in other contexts, is with the plumbing. We need to understand the evidentiary standard for a legal offence of drunken driving. For example, in order to limit discretionary excesses, the law (regulations issued on the central Act in different states) mandate that breathalyser tests have to be carried out in the presence of a police personnel above a certain rank. And over-burdened policy administrations have too few personnel of such rank to spare for any traffic responsibilities, much less for night-time drunken driving patrols. But delegating this responsibility raises its set of problems.

Actually, I can unpack several plumbing layers which can make the challenge even more daunting. But this is sufficient for our purpose. 

The article itself is drawn from this research paper which conducted RCTs covering 162 police stations in Rajasthan covering five management interventions - limitations of arbitrary transfers, rotation of duty assignments and days off, increased community involvement, on-duty training, and "decoy" visits by field officers posing as citizens. It found the first three "which would have reduced middle managers' autonomy, were poorly implemented and ineffective", while the last two had "robust impacts". Based on these findings, the researchers found "very large outcomes" from an intervention that linked "good performance" on sobriety tests without relying on middle managers to  the "promise of a transfer from the reserve barracks to a desirable police station posting".

The paper's headline finding is plain misleading, maybe even dangerously populist,
The experimental results in this paper show that it is possible to affect the behavior of the police in a relatively short period of time, using a simple and affordable set of interventions.
If only it were possible to easily replicate a sanitised pilot! So what do the authors conclude,
It is striking that two of the three most clearly successful interventions had never been advocated by the many police Reform Commissions or in the discussions we had with the police top brass despite the motivation for reform and support of the top administration. In contrast, the interventions that failed to work were all carefully selected by the police leadership, partly based on the recommendations of various Police Reform Commissions, who among them combine a huge amount of experience and expertise. These senior police officers also did not lack human capital, being selected through an extraordinarily competitive set of exams. Yet they had clearly substantially underappreciated the difficulty of implementing these interventions even with their full backing, suggesting that they did not fully realize the nature of the informal authority enjoyed by the station chiefs.
And this,
We see the relatively poor performance of police force interventions as evidence against the view that the managers know how to translate the general principles of management into solutions that are relevant for their organization. The managers in this case were the elite of the Indian police, with decades of experience and who were motivated enough, among other things, to engage with us to launch this reform program. They had a clear and articulated understanding of the principles that motivated the interventions and they were recognized as outstanding leaders. However, none of that could guarantee that they would automatically hone in on all the right interventions. And while they clearly shared the view that incentives, as a general principle, are important, they could not see a way to introduce them within the political and administrative constraints, until we intervened as pseudo-consultants. What do outsiders, with less institutional knowledge and experience, provide in these situations...
Really! This is staggering hubris, even if borne out of ignorance.

Let us examine the six (five plus one) "strategies" that the researchers have explored. "On-duty trainings" are a staple of any administrative system. The problem is just that the trainings do not get translated into meaningful enough learning or internalisation, even when done on the right set of issues and by outsider consultants. "Decoy" visits by field officers is more a figment of juvenile imaginations from stories of kings visiting their kingdom in disguise to obtain citizens' feedback than an institutional solution. In fact, if at all police leaders want better feedback, instead of hiring decoys, they should hire the services of third party agencies (and manage it well) or randomly solicit telephone feedback through call centres from people who have just interfaced with the police system.

Good police superintendents and commissioners (is actually true of managers at any level) do not require fancy "decoys" to quickly figure out more or less what is going wrong and who among their officers can be trusted. The practical difficulty of identifying and managing the activities of decoys is immense. Instead of trying to improve the effectiveness of their institutionalised intelligence wings, sending out "decoys" is exactly what populists and band-aiders would suggest. Finally, the researchers would not even be able to imagine the ways in which such "decoys" can end up creating an even bigger problem for the police force.

Take the case of the last intervention, linking transfers to good performance. Again plumbing is the challenge, which the researchers have unsurprisingly glossed over. 

For a start, drunken driving enforcement would hardly figure among the top-ten priorities of the mainstream police force, leave aside of the reserve force. And their (reservists) main bandobasth activities are not amenable to quantitative assessments of individual policemen. Second, how sustainable is a policy that explicitly seek to reward some policemen with transfers to "desirable" places (for whatever "good performance") and penalise some others (the natural corollary) by drafting them to reserves? 

Third the moment we start linking incentives to quantitative performance indicators in detecting drunken driving, it is only time before we get into targets and slip down an undesirable slope. Four what is the sustainability of an administrative process where there is no involvement of middle-managers? Ultimately managers at some level have to be managing this institutionally. Even assuming that level exists outside the "middle-managers", are we any less likely to have concerns with them? And is it even practical to think about such administrative stuff without the involvement of middle managers? Finally, it is far from true that "evaluation generated evidence and information is not typically available to the police leadership". "Evidence", of a far more sweeping breadth and with more than the requisite credibility and rigour, in large measure, is available, to police leaders who keep their eyes and ears open. No amount of careful evidence generation can get you beyond a few baby steps in your endeavour to effectively manage large systems. 

The authors of the Reform Commission reports, in contrast to academic researchers, are life-long plumbers, who, with varying degrees of success (or failures), have grappled with the plumbing challenges of policing in the real world. They were spot on with the three recommendations, which, however you look at police reforms, cannot but not be a part of any end-stage that Rajasthan Police would hope to achieve with police reforms. In fact, they are essential plumbing necessities in any administrative system, all of which can be very logically established (not being done here because of lack of space). In contrast, the three researchers' solutions, as discussed above, suffer from serious practical deficiencies. The Reform Commissions refrained from such band-aid recommendations because they were responsible and honest (apart from not being ignorant) to not do so.

Instead of suggesting solutions that help improve institutions and systems that are at the cutting-edge of policing activities, the researchers end up recommending piece-meal and unsustainable solutions. The objective, for example, should have been to improve policing outcomes by enhancing accountability of middle managers and enhancing the quality of intelligence from institutional channels, instead of hiring decoys and dispensing with middle managers.

This example is teachable in many respects. Abhijit Banerjee acknowledges the importance of  the so called inputs and regulations - breathalysers and prohibitive enough punishment as critical deterrents. But he also points to the role of complementary factors (strategy) to the success. 

It is in the same vein that we should see other input and regulation prescriptions in cases of education, health care, nutrition, state capacity and so on. Everywhere inputs and regulations are critical requirements to even get to the starting point. While they are necessary, they are not sufficient. Complementary levers of implementation as essential.

I have written about this many times earlier and let me repeat it. Performance incentives that involve large enough financial rewards or transfers are unlikely to work in scale in weak public systems like in India. After all where does it work in even developed systems? For a start, several plumbing challenges, mostly related to weak state capacity and the socio-political environment, increases the likelihood of an even more inefficient general equilibrium. Second, quantifying outcomes in a credible manner is deeply problematic, and collecting and managing it even more so, in most contexts. Third, financial incentives most likely end up becoming entitlements, thereby worsening the problem of already high lower level government salaries. Finally, transfers are among the highest stake administrative actions, and when done in environments where rank ordered "good performance" cannot be credibly and indisputably established is a recipe for controversies.

Let me state this and I would be happy to be refuted by practitioners from the police bureaucracy. There are no innovations, either great ideas or process re-engineering or even management theories, that can dramatically improve policing outcomes in conditions of acute systemic and leadership weaknesses. Wherever police systems work well, it is more likely a combination of functional administrative capacity and good leadership. The intensity of the latter can even temporarily mask deficiencies in the former. It is for this reason that we keep hearing stories of poorly run administrations suddenly becoming efficient with the arrival of a good Police Commissioner.

In economists' speak, the production function for good policing outcomes is largely these two. Innovations most often can work at the margins to improve administrative capacity and free up leadership energies for productive use elsewhere. But in really weak systems, as we have here, leadership is necessary to both generate short-term good outcomes and build long-term institutional capacity.

That this paper got through a peer-review is a reflection of how badly disconnected the real world of experimental economics is despite at least some economists' claims to being superior plumbers. These are thoughtful economists who swear by the general equilibrium. But that, in turn, requires deep plumbing knowledge. Not exactly their forte, despite claims to the contrary. 

Monday, July 10, 2017

India labour market graphic of the day

In the absence of reliable data, India's labour market assessments are mostly speculative exercises. In that context, a new MGI report tries to tease out some inferences. This assessment of the changes in the labour market for the 2011-15 period drawn from the annual survey of the Labour Bureau is instructive.
The report points to three broad areas of job creation - public investments in infrastructure; advances in automation and its impact on IT and BPO sectors; and independent work and micro-entrepreneurship driven by the new digital ecosystems. 

Sunday, July 9, 2017

Mobile phones manufacturing and industrial policy

FT has this graphic that shows the composition of mobile phones manufacturers in India, the world's second biggest smart phone market.
Four of the top five smart phone sellers today are Chinese, an inversion of the market position till recently. The good thing with the "Make in India" push has been this,
The proportion of locally assembled phones jumped from 30 per cent in 2014 to 80 per cent by early 2016, estimates Bipin Sapra, a partner at Ernst & Young.
Smart industrial policy has helped,
Over the past 18 months, the government has rolled out supplementary import duties to incentivise the domestic manufacturing of components — focusing initially on simple parts with low investment requirements. February’s budget extended this policy to printed circuit boards, a key component that lies at the heart of every smartphone... The new measures are also convincing foreign groups to deepen their manufacturing work in India, says Manu Kumar Jain, country head for Chinese smartphone maker Xiaomi... Today, more than 95 per cent of Xiaomi phones sold in India are made at local facilities run for it by the Taiwanese contract manufacturer Foxconn, helping it to achieve Indian smartphone sales second only to Samsung during the final quarter of 2016.
But the concern,
For many phones in India, Nitin Kunkolienker, vice-president of the industry lobby group MAIT says, “local value addition is not more than 2 or 3 per cent”, with some producers putting together Chinese kits imported in near-complete form. “It’s just screwdriver technology,” he says.
The only surprising thing is that it is the FT, which is implicitly endorsing more industrial policy,
But this growth was driven... largely by a “differential duty” structure that pushed up the cost of imports relative to domestically assembled phones. This has now been superseded by India’s landmark, all-encompassing goods and services tax that came into force at midnight last Friday. From now on, according to policy announced so far, an effective tax of 12 per cent will apply to imported and locally assembled phones alike. The government calmed fears in the small hours of Saturday morning, announcing a 10 per cent duty on imported phones that will maintain the fiscal incentive to produce onshore... But by maintaining — and strengthening — a differential duty regime on imported products, the government can push foreign groups to do more of their manufacturing in India, while eroding the advantages that they enjoy over local brands from their huge international operations, argues Shubhajit Sen, marketing head for Micromax.

Friday, July 7, 2017

Examining agriculture in India

Very good analysis of India's agriculture system by Ram Kaundinya. I have always struggled with a outlining a satisfactory enough pathway to agricultural sector reforms. Here is only the latest attempt. 

As a context, about 130-140 m farmers cultivate around 175 m hectares of land, of which over 60% is unirrigated and rely on erratic monsoons. Mechanization is limited and with perhaps not much (though not non-trivial) potential given the small and fragmented holdings. Farming is therefore not very productive and largely subsistence. A vast and entrenched intermediary network coupled with lack of storage infrastructure means that most of farm production is sold immediately at farm gate at lower prices in a post-harvest buyers market. Cropping patterns have been shifting, with riskier and more infrastructure dependent horticulture crop production recently exceeding food grains. 

Given the aforementioned context, I see two major market failures. 

1. Price signals are distorted by information and access barriers as well as intermediation layers. This means that the fundamental requirement for price transmission and resultant supply-demand balance is vitiated. The result is price gouging when crop fails and price collapses after good harvest. Given the role of global factors, price shocks, both positive and negative, are increasingly common.

2. Markets do not offer affordable instruments to hedge against the two biggest risks - weather-related events and price-shocks - which are both much higher than for most other major livelihoods. Such hedges are costly, inaccessible, and under-supplied. 

This is compounded by the farmer's incapacity and cultural and psychological reluctance to respond swiftly to emergent information signals. And exacerbated by backward looking and reactive policy responses (the bigger increase in the Minimum Support Price for pulses and lower for cotton). 

So what can public policy do? Some very general thoughts. The minimum would be to increase public investments in research and infrastructure - higher yielding varieties, irrigation facilities on an outcomes (irrigation potential actually realised) focused approach, storage facilities etc - and ease regulatory barriers - effective implementation of the APMC Act etc. Others would involve catalysis of markets in affordable access to upstream and downstream linkages, mechanisation (custom hiring centers etc), information flows, provision of credit, and so on. All these would require persistent and long-drawn work, not exactly the sort of activities a weak state is good at. 

The more difficult ones involve de-risking agricultural activity and addressing the issue of property rights. There are no satisfactory answers in either case and the risk of moral hazard, with the former, is significant. We should strive to develop crop insurance as the primary risk-mitigation tool (away from an MSP) over a 10-15 year period. But in the short-run, some form of price support, including for some horticulture crops, may be unavoidable. On the latter, an even more difficult challenge, we should seek to clean/update land records and develop a practical regime for ownership and tenancy rights.

Tuesday, July 4, 2017

Premature de-industrialisation - Ethiopian edition

Consider this. Ethiopia may perhaps be the only economy which has grown at 11% a year since 2005. It has often been held up as a poster child of the new face of Africa, attracting big-brand FDI into its manufacturing sector, especially textiles and shoes. And its several advantages make it best placed for sustaining this growth.

It is one of the poorest countries, even in Africa, and therefore naturally with a very high catch-up potential. Its relative political stability, stronger bureaucracy, and very low wages make it a very attractive investment destination in Africa as well as provide an opportunity to increase its industrial base. And  manufacturing's share of GDP is lowest among all sub-Saharan African countries, with the average being 10.6%. 
But surprisingly, despite the very low base and wages, relatively favourable conditions, and the sustained very high economic growth rates, manufacturing value add has continued to decline steeply
In fact, during the decade when the economy grew at 10% annually, the manufacturing's share of GDP fell from over 6% in 2005 to 4.1% in 2015, well below the peak of 7.8% in 1997!

Monday, July 3, 2017

Some thoughts on promotion of entrepreneurship

Here is the challenge with entrepreneurship. India has too many of the wrong type of subsistence entrepreneurs, micro-entrepreneurs in the informal sector, and too little of the right kind of job creating entrepreneurs, small entrepreneurs in the formal sector.

Ejaz Ghani et al define entrepreneurship as presence of formal establishments which are less than 3 years old, measured in terms of number of such establishments per 1000 workers in formal sector. Evidence shows that jobs get created when firms which start small and formal, grow into medium sized ones. Accordingly, areas (both at state and sub-state region levels) with high levels of new enterprises have been found to generate higher employment growth. Further, as Andrei Shleifer and Rafael La Porta have argued “informal firms stay permanently informal, they hire informal workers for cash, buy their inputs for cash, and sell their products for cash, they are extremely unproductive, and they are unlikely to benefit much from becoming formal”.

This means that the primary objective should be to promote the establishment of formal small enterprises, instead of trying to move informal firms to formality. 

In India, the two most consistent factors that predict overall formal entrepreneurship, in both manufacturing and services, are local education levels and the quality of local physical infrastructure. These relationships have been found much stronger in India than in the US. Liberalized labour regulations and household banking quality in the districts concerned are also important predictors. Further, in manufacturing, agglomeration economies (Chinitz effect) in the district arising from supportive incumbent industrial structures for input and output markets (common labour needs or have customer-supplier relationships with the city's incumbent businesses) too contribute to new entrepreneurship

Despite these correlations, even in case of developed economies, identification of policy levers that drive entrepreneurship and incubation of new enterprises has proven elusive. The mainstream discussion on entrepreneurship focus on three types of policies – trainings, clusters, and deregulations. However, there is little evidence that entrepreneurship trainings work or economic clusters materially increase the level of overall entrepreneurship within a city. In fact, there is no example of validated successes with entrepreneurship training anywhere in the world, developed or developing. Though deregulation has not been found to increase entrepreneurship, it is likely that excessive regulation may prevent the growth of firms.

So, what are the policy responses available? A first order takeaway may be to eschew policies that seek to create entrepreneurs or directly promote entrepreneurship. Also avoid too much focus on trying to roll back informal sector. 

Instead focus on creation of conditions for enterprise entry and growth. These conditions can be divided into two broad categories – physical and enabling. 

The former involves improvements in infrastructure, access to credit and skilled labour at competitive terms etc. Unfortunately, there is limited progress possible in the short-run and only so much that can be done even in the medium-term. 

This leaves us with the latter as the focus of all policy action. They involve broadly business development and enabling regulatory environment. Numerous studies have shown that productivity can be improved by 25-35% by merely introducing simple management practices like monitoring, setting targets, personnel incentives, inventory management etc. Such business development services should become quasi-public goods, to be subsidized by governments. This should be complemented with regulatory enablers. Deregulation, limiting interface with government, extensive use of IT work-flow automation, and so on are some possible steps in this direction.

Sunday, July 2, 2017

The life-cycle benefits of early childhood education programs

The latest evidence in favour of the benefits of early childhood education programs come from Jorge Luis Garcia, James Heckman, Duncan Ermini Leaf, and Maria Jose Prados. In a new paper that combines experimental and non-experimental data from the US in a very large cohort of ages from zero to mid-thirties, they estimate the life-cycle benefits of early childhood education programs using an approach that goes beyond current narrowly focused analyses, 

Our estimates of the internal rate of return (benefit/cost ratio) range from 8.0% to 18.3% (1.52 to 17.40)... Our baseline estimate of the internal rate of return (benefit/cost ratio) is 13.7% (7.3).
The graphic below shows the net present value of the life-cycle cost-benefit gains over control, in terms of increases in own labour income (from 21 to retirement), incomes of parents, gains from reduced crimes, improvements in QALYs, and so on.   

Wednesday, June 28, 2017

Revisiting the debate on PPPs

The Economist has this critique of the calls for re-nationalisation of public services in UK. In contrast, Nina Shapiro has this to say in Naked Capitalism on public private partnerships (PPPs),
... the greater efficiency of private enterprise and the consequent cost savings of public-private partnerships. Yet, studies of their use in infrastructure investment provide little support for this presumed cost saving, and, as the critics of these partnerships argue, there is little reason to believe that they would save money. Governments can finance investment at a lower cost than private companies can, and, unlike the investments of governments, those of private concerns must earn a profit. Their capital costs for the same investment will be higher than that of the government’s, and the government must cover all of these in its payments to them. And since private enterprises can fail, and some of those partnered by governments have failed, bail out money has to be factored in as well. The government... cannot allow the disruption of essential services (such as air traffic control), and thus must bail out the firms providing them.
Private enterprises may be more efficient than governments, but for a public-private partnership to save taxpayer money, the efficiency of the private firm has to be high enough to offset the higher capital costs of its investment, as well as the cost of enforcing its contract and risk of its failure. And, here, we must remember that the cost savings of private firms can come at the expense of employees and suppliers – governments generally pay more – and at the cost of the services provided as well... Costs can be reduced in ways other than through productivity increases. Their reduction may have more to do with the reduction of services or incomes than with efficiency gains, and the profit that drives the economizing of private firms is not received by the people that actually fulfill the government contracts either...

Public-private partnerships conflate public and private interests, and in conflicts between them, the private interests win out... Private interests dominate the affairs of nations, and public-private partnerships not only reflect the influence of these interests, they also increase it. Government is run more like a business. Investments become “assets”, and citizens “customers”, officials are elected (and appointed) because of their success in business, and services decided by profitability. And since the profitability of a service depends on the relation between benefits and costs, values have to be placed on benefits to the public. The worth of these, in monetary terms, has to be determined, and this requires valuing such invaluable products as clean air and water, healthy and cultured lives.
If we were to do an evidence-based assessment of PPPs in developed countries in recent times, there is now a rich body of examples that illustrate many of the concerns raised in the above three paragraphs.

Only recently I blogged about the increasingly negative experience of water sector privatisation in UK. In the latest comes news that Ofwat, the water regulator, has found Thames Water, the country's largest water company, guilty of "unacceptable failure" to control water leakages resulting in a fine of £8.55 m. This comes on top of the company being fined £20 m by Ofwat for releasing 1.4 bn litres of sewage water between 2012 and 2014 into London's main water supply source. This comes even as the company paid out £100 m in dividends in the year to March 2017. An FT report writes,
Thames Water investors include pension and sovereign wealth funds, such as the Abu Dhabi Investment Authority and the China Investment Corporation, and since May — when Australian infrastructure bank Macquarie sold its final stake in Thames Water for £1.35bn — the Canadian pension fund Omers and the Kuwait Investment Authority. In the decade between 2006-16, Macquarie paid itself and fellow investors £1.6bn in dividends, while Thames Water was loaded with £10.6bn of debt, ran up a £260m pension deficit and paid no UK corporation tax, according to research by the Financial Times. At the same time it has in effect forced the Treasury and taxpayers to contribute to the cost of London’s new super-sewer or Thames Tideway tunnel, which started construction last year.
This comes in the backdrop of new rounds of privatisations in these countries. In the US, President Trump has initiated a proposal to privatise air-traffic controllers in the US, currently with the Federal Aviation Authority (FAA). Prisons privatisation is being widened, with the latest being the 20 year £1.5 bn contract bagged by Serco to run the largest prison in Australia, the Grafton Correctional Centre in New South Wales from 2020. 

The case for prison privatisation runs against a growing body of global experience that caution against it. In 2015, Serco was stripped off running the Mt Eden prison in Auckland, the largest prison in New Zealand, on allegations of ill-treatment and allowing "organised fight clubs" between inmates. In the UK, both Serco and G4S, the two largest prison operators globally, were found guilty of overcharging the government for electronic tagging of offenders.  

In a famous paper, Oliver Hart, Andrei Shleifer, and Robert Vishny examined the trade-off in delivering public services between improving service quality and cost reduction. Examining specifically the case of prisons, they wrote,
If contracts are incomplete, the private provider has a stronger incentive to engage in both quality improvement and cost reduction than a government employee. However, the private contractor's incentive to engage in cost reduction is typically too strong because he ignores the adverse effect on non-contractible quality... We have examined the conditions that determine the relative efficiency of in-house provision versus outside contracting of government services. Our theoretical arguments suggest that the case for in-house provision is generally stronger when non- contractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant, and when corruption in government procurement is a severe problem. In contrast, the case for privatization is stronger when quality- reducing cost reductions can be controlled through contract or competition, when quality innovations are important, and when patronage and powerful unions are a severe problem inside the government...

We concluded that the case for in-house provision is very strong in such services as the conduct of foreign policy and maintenance of police and armed forces, but can also be made reasonably persuasively for prisons. In contrast, the case for pri- vatization is strong in such activities as garbage collection and weapons production, but can also be made reasonably persuasively for schools. In some other services, such as provision of health care, an analysis of the efficiency of alternative arrange- ments is a great deal more complicated. 
Eduardo Porter has the best summary of the incentive mis-alignment in the case of prisons,
Private prison operators who bid for government contracts by offering the lowest cost per inmate will most likely focus on cutting costs rather than tightening security. 
Alex Tabarrok has this critique of the Hart et al paper. His primary arguments being that cost reduction can come not just from cutting something but also from quality improvements themselves, and weak incentives (as with public bureaucracies) do not encourage improving quality. Both these arguments appear far less compelling when seen in light of experience. In developed economies, the cost reduction gains from incremental quality improvements, even in the long-run, is likely to be marginal. And, nor do stronger incentives, when coupled with incomplete contracts (on non-contractible quality) and far larger cost-reduction opportunities (by lay-offs and skimping on investments), necessarily encourage improving quality in all its dimensions.

Another less appreciated problem with such contracts that differentiate them from any other competitively procured services comes from the nature of these services. These are essential public services and it is very difficult to cancel a contract, force losses and bankruptcy of the provider, and transfer the same to another operator without unacceptable levels of disruption. The operators know this leverage and position themselves to extract the maximum leverage from this reality. In fact, even the technical challenge associated with shifting operators is non-trivial. The monopolistic dimension to such contracts come more from these considerations than the pure monopoly arguments of Econ 101.

So does this mean we should step away from PPPs? Far from it! My assessment of PPPs hinge on "the efficiency of the private firm has to be high enough to offset the higher capital costs of its investment, as well as the cost of enforcing its contract and risk of its failure". As I have written earlier, while there is scope for PPPs, they have to be chosen for the right reasons - efficiency improvements and not fiscal considerations, and for O&M and not construction-cum-management.

But I see at least three dimensions to this challenge - which sector is amenable to private service delivery, state capacity, and the nature of the private investor. Let's examine each.

The identification of activities appropriate for privatisation has to revolve around Hart and Co's analysis of private contractors incentive to ignore non-contractible quality. In case of activities like prisons and air traffic controllers, there are either too many dimensions of quality or externalities generated that, their capture in a contract poses prohibitive transaction costs and detracts from the provider's operational control. But without their inclusion, the private operators will doubtless be incentivised to skimp on investments or ignore those dimensions so as to reduce costs.

I am inclined to argue that the costs-benefits assessment makes many current PPPs less favourable in developed countries. In these countries, state capacity is strong and local governments  are reasonably capable of managing large utility systems - after all UK is the only country with a fully private water and sewerage utility. The efficiency gains from private transfers is likely to be small enough to off-set the countervailing costs. At best management contracts may be the more prudent option for these countries.

For example, in case of the air-traffic control privatisation, of which Serco is incidentally one of the big operators, there may be reasons to question the rationale. US air-traffic controllers, though with an excellent safety record, have often been blamed for persisting with antiquated technologies and not shifting to the satellite GPS-based NextGen system. Lack of adequate funding and slow-moving bureaucracy have been blamed for this, though the persistence with old technologies for this long period has to be attributed more to the former than the latter. In that case, and especially since FAA is even today funded with passenger fees (by way of a taxes on tickets) and recent safety record has been excellent, it is not clear where private providers will be able to find the resources and have the incentive to make significant investments in air-traffic control systems. In the circumstances, lay-offs will be inevitable and efficiency gains questionable. And, if experience elsewhere and across sectors is a marker, then price increases for travellers is also inevitable. After all, now while the passenger fees is collected as a tax on tickets, once privatised, it will be levied as a user fee by private negotiations with Airlines. 

In contrast, in developing countries state capacity is extremely weak. Public service delivery is, in most cases, of very poor quality - leakages, contamination, interruptions, unreliable, poor safety and so on. Most egregiously, public systems are over-staffed and with limited accountability to deliver on outcomes. The scope for efficiency improvements from private operation and management can be very high, though it often comes at a steep and unaffordable price for consumers. But this has to be traded-off with the state's weak capacity to manage even simple contracts, with the attendant risk of having lopsided contracts or its management which ends up causing private benefit at public cost. 

Finally, as to the capital, the failings with private equity investments in public services in the US are well-documented. Unlike a specialised private provider, a PE firm has less incentive to protect its industry reputation, an important ingredient to aligning incentives to ensuring quality and limiting skimping. To that extent, President Trump's proposal which mandates that the private entity should be a non-profit appears a good decision.

In other words, any decision on privatisation should preferably be done on efficiency considerations, and an examination of, among other things, the type of activity, state capacity, and nature of the capital. Unfortunately, this is easier said than done, and demands both vast experience (of actual implementation, and not mere theoretical knowledge) and exercise of very sound judgement. 

Monday, June 26, 2017

Notes on the GST roll-out

Two articles about India's impending Goods and Services Tax (GST) caught my attention.

1. Livemint explores the potential impact of GST on the country's massive informal sector. It points to the likely shift in activity from the informal to formal firms in sectors with high share of informality. 
It alludes to possible adverse impact on informal livelihoods, even as they are recovering from the effects of demonetisation. It writes, 
Many of the firms operating in this part of the economy make profits largely due to tax evasion and non-compliance with regulatory norms, which allows them to offer products at comparatively lower prices. However, in the GST-era, it will be a struggle for survival for such firms because they will be faced with taxes, lower margins and a sharp spike in the cost of compliance. Some firms in the unorganized sector may go under, while others could find their profits curtailed. To be sure, in some instances the two sets of companies cater to different customers, but there is always some overlap. And it is not just the manufacturers in the informal economy who will suffer but also the smaller dealers and wholesalers... The move to the new tax regime has the potential to cause immense disruption to the shadow economy that is the source of livelihood for many, although it is nobody’s case that firms that survive by flouting regulations and evade taxes continue to do so.
This theory of change of informality shrinking in any significant manner in response to GST goes contrary to historically observed trajectories of informality across countries. I have blogged on several occasions, in the context of the demonetisation, about the futility of trying to shrink the informal economy. See this, this, this, and this

Andrei Shleifer and Rafael La Porta have the most authoritative work on this,
Informality declines, although very slowly, with development. This is not to say that we oppose the structural policies such as simplification of registration or equalizing labor tax burdens across formal and informal sectors... These policies surely have desirable effects, but our reading of the evidence is that it is modernization, rather than structural policies, that shrinks informality... although avoidance of taxes and regulations is an important reason for informality, informal firms are too unproductive to thrive in the formal sector. Lowering registration costs neither brings many informal firms into the formal sector, nor unleashes economic growth... the informal economy is largely disconnected from the formal economy. Informal firms rarely transition to formality, and continue their existence, often for decades, without much growth or improvement... as countries grow and develop, the informal economy eventually shrinks and disappears. The formal economy comes to dominate economic life.
In simple terms, the policy focus should be on growing the formal sector than shrinking or nudging the informal sector. 

2. The GST will have a five-member National Anti-Profiteering Authority (NAPA) to look into cases of profiteering by firms not passing lower taxes to consumers, including power to deregister violating firms. Firstpost has a nice article which writes, 
Many other countries had... just one rate of GST across all goods and services. This naturally makes it easier to calculate the cost of inputs and taxes on them, set-offs, etc. Instead, what do we have in India? Multiple slabs with even the same product sometimes falling in different slabs. Not all the inputs going into a television set will be taxed at a same rate, the manufacturer will have to deal with multiple rates. The only person who will have a field day is the tax official and the worthies on the NAPA. Even in Malaysia, the anti-profiteering mechanism didn’t work too well and led to a large number of disputes and enormous litigation. Later the rules were eased and given up altogether after a year. The government then limited itself to appealing to businesses not to increase prices.
The point about easing regulations in response to emergent situations is instructive. It resonates with the adoption of minimum viable product approach in such complex roll-outs. Starting out with strict regulation is a strong signal of intent and can be valuable in shaping expectations and disciplining potential errant behaviours. The challenge though will be the ability to respond swiftly to the emerging scenarios. 

Unfortunately, it is here that Indian bureaucracy's decision paralysis is likely to hurt. Easing regulations will most certainly invite populist backlash with critics presenting it as favouring those profiteering. No logical analysis of the costs and benefits can take place in likely high-pitch media-mediated debates on such issues. Therefore, when faced with the choice of what is the right thing to do and the most politically correct thing to do, governments are most likely to incline to the latter. This deprives the government off one of the important levers to manage complex initiatives like  the GST. 

Saturday, June 24, 2017

Weekend visualisations - urban edition!

Very good video that explains the historical reasons for the high density urban cores in European cities as against the low density cores and sprawls in American cities. Despite its skyscrapers, the urban sprawl makes New York only half as dense as Paris! 
And this is a fascinating article on jobs accessibility maps, developed by the University of Minnesota's Accessibility Observatory, which chart how far you can travel on a transportation network in different times of the day from different locations in a city and the numbers of jobs within that travel zone. The map is constructed with three different datasets - public transit maps and timings, OpenStreetMap data on pedestrian routes and walking times, and census data on job counts in areas. 

The map below captures the change in accessibility to jobs, during the 7-9 AM peak morning commute window, between 2010 and 2013. The dark green areas have access to 100% more jobs in 2013 than 2010. The yellow arrow points to a region where bus frequency was significantly increased along a particular line. The red arrow highlights a corridor with a new BRT line, with major improvements to job access right around a single station.
This is an extremely powerful tool for decision-support on planning public transit routes and urban transport infrastructure. Unfortunately, for cities in developing countries, the challenge is with the availability of good underlying data. In this case, very few cities have information about area-wise jobs data or its changes. 

But the emergence of innovative business models that incentivise private entities to collect such data does not look a very unrealistic prospect. 

Friday, June 23, 2017

The "bucketing" problem in financial markets

In recent weeks rating agencies have come for stinging rebukes from India to China and Russia. Livemint has this story examining whether rating agencies are biased against India and developing countries. 

In this context, I had blogged earlier pointing to this article by Nandini Vijayaraghavan which gets to the heart of the problem with any ratings approach - it buckets the target populations, and does ratings based on assessments across and within buckets, 
The impediment to the rating agencies upgrading India’s sovereign ratings lies in their methodologies. The sovereign rating methodology factors economic strength, institutional strength, fiscal performance, and susceptibility to event risk to assign ratings. The rating agencies categorise countries into buckets based on their size (GDP), growth, volatility of growth and per capita income, among other factors. The emphasis on per capita income is because countries with higher per capita incomes are better equipped to withstand cyclical volatility and are endowed with higher debt servicing ability. India’s low per capita income has resulted in its sovereign rating being lower than countries with higher deficits and indebtedness and lower growth prospects.
For example, in India till recently, rating agencies would not let even highly prudent, historically well managed, and resource rich sub-state entities, like say a state distribution company or a municipality, pierce the ratings accorded to their respective state governments. This deterred the best run and most credit-worthy urban local bodies and distribution utilities from accessing bond markets, with their higher cost of capital (due to the lower forced ratings), and preferred banks instead. This bears at least some part of the blame for the still-born municipal bond markets in India.

But rating agencies are not the only financial market agents to use the bucketing approach. Such bucketing produces distortions all round financial markets with profound impacts. Consider the interest surrounding MSCI's decision to include mainland Chinese equities, known as A-shares, in its benchmark emerging market equity index. This means that the $1.6 trillions of global funds that track the index will now have to buy into mainland Chinese stock market. 

Incidentally, despite mainland China being the second biggest global equity market, MSCI has limited the exposure of A-shares to just 0.73% of the index. It has clarified that any increase in weight will be dependent on corporate governance reforms in the mainland's equity markets, which had been subjected to very heavy regulatory intervention last year in response to downward volatility.  However, this small percentage is deceptive since the actual exposure of the index to Chinese companies, through those like Alibaba and Tencent floated elsewhere, is 25.3%. 

The MSCI is only the largest and most high-profile of indices that bucket emerging markets and force the bundling of these countries as asset categories. This is no small contributor to the observation that cross-border capital flows does not discriminate among emerging market economies and treat them all as a single asset class. Accordingly, even countries with strong economic fundamentals cannot escape the tyranny of asset buckets when sudden stops leads to capital flow reversals. 

In the context of the MSCI decision and the intense lobbying surrounding it, John Authers writes about the large power wielded by such indices,
Indices are not impartial or abstract constructs; they are an expression of someone’s opinion, and this should not be forgotten. And perhaps most importantly, there is something ungainly in the way such power has been outsourced to MSCI, a relatively small for-profit organisation based in New York. Such a momentous matter as the terms of trade in which capital flows between China and the rest of the world might seem more naturally to belong to democratic or governmental institutions. Either that, or this should be an issue for the market to decide, without intervention by governments, or heavy guidance from MSCI. As it is, the big multilateral organisations do not seem to be providing the leadership provided... something is not right with the way capital markets have come to operate when a small company like MSCI can tell the world’s most populous country what to do.
Indices, like rating agencies, distort the global equity markets in different ways. These distortions are best captured by the rise of passive exchange traded funds (ETFs), which form an increasingly large share of all equity assets. ETFs, which were introduced 25 years back, now track more than $3 trillion worth assets and are dominant share of the market in countries like Japan. 

For a start, such index tracking funds contribute to a Mathew Effect, making larger company scrips which are likely to be part of many indices, rise even more. Authers explains with the example of Amazon, 
But how much of the positive performance for Amazon is down to the momentum created for it by indexers? As investors switch to passive, or to the numerous different factor funds which currently hold a lot of Amazon, so the stock appreciates. The problem is that most stocks, including Amazon, are now judged as a series of factors with a series of properties, rather than as companies. Mark Lapolla of Sixth Man Research expressed this well, saying that the initial reaction to the Amazon purchase was not to be trusted and that

“there is a higher order context in play that is a critical point of understanding for fund managers. Namely, it is taking place at a time when passive and quantitative investors account for 60 per cent of equity assets under management and are estimated to drive about 90 per cent of daily trading volumes.”
On this basis, he says that Amazon
“is no longer a dynamic business, but a complex, inconstant security ‘type’ that proliferates data points used to predict the direction of its stock. In this new paradigm, cost basis and expected return have no meaning; the direction of price is all that matters.”
Finally, after looking through the latest holdings statements, he makes the devastating point that of late Amazon has been sold by the biggest active investors, whose stakes have ended up with big passive players:
— It will take some time for this acquisition to prove out and, in the meantime, unless the positive, fundamental buzz turns negative, AMZN will continue trading as quantitative “type” and not a business.
— A final note of interest: As of the Q1 13Fs, the largest, active investors have been selling their Amazon holdings to passive investors, quants, and the national banks of Norway and Switzerland.
More generally, index tracking funds, as Authers writes elsewhere, contribute to the inflation of bubbles and amplification of market volatility,
According to George Cooper, a fund manager and author of The Origin of Financial Crises, “the big beef” involved in tracking an index is that “you mech­anically lend most to the biggest borrowers, and buy the most overinflated stocks”. He draws an analogy with road safety: “Imagine a motorway where cars all benchmark their speed to everyone else. Then imagine what happens if everyone is trying to be a little faster than everyone else. They end up crashing.”

Paul Woolley, head of the London School of Economics’ Centre for the Study of Capital Market Dysfunctionality, suggests that market benchmarks inflate bubbles and should be abandoned altogether, in favour of comparing fund managers to rises or falls in gross domestic product... Most bond indices are weighted according to how much debt a company or country has issued. This means that the more indebted an issuer becomes, the bigger share it will take in the index, and the more of its debt passive funds will be required to buy. This is why many funds were led to load up on Argentine debt before its default crisis... 
But there are also concerns about the use of indexing in equities. Most indices are weighted according to market capitalisation. That means the more a company’s price grows, the more index-trackers will be required to buy of it, open­ing them up to accusations that they help to inflate bubbles. A second charge is that indexing at­tacks market efficiency. The more money passively tracking indices, the less devoted to seeking out underpriced stocks. If all money were managed passively, markets would cease to function.
In fact, it gets even worse,
Not only are the indexers powerful, but that power is concentrated in a few hands. Consolidation has left three big companies — S&P Dow Jones, FTSE Russell and MSCI — jointly providing the benchmarks for 73 per cent of US mut­ual fund assets, worth some $9.4tn. In bonds, the indices overseen by Barclays are dominant. Its bond aggregates (formerly known as the Lehman Aggregates) account for more than half of all ETF assets held in fixed income.
At one level, bucketing is a lazy approach to assessing and pricing risk. Instead of developing country-specific metrics and surveillance systems to keep track of them, rating agencies and indices initially preferred to take the easy way out by bucketing and reducing the monitoring data points. But once established, vested interests and market inertia have taken over and now come in the way of any change.

In the context of rating agencies, there is some evidence that Credit Default Swaps may be a better measures of credit-worthiness of the entity. Yang Liu and Bruce Morely used panel data from the main EU countries, US and Japan and found, 
The results indicate there is little evidence to show any relationship between the credit ratings and the sovereign CDS spreads,and the main drivers of sovereign CDS spreads are macroeconomic fundamentals which reflect the ‘health’ of the economy.