Sunday, December 21, 2014

China's role in Latin America

Eduardo Porter has a story examining China's role in Latin America's recent economic prosperity. The benign side first,
In 2010, Chinese lending to Latin America roughly equaled that of the World Bank, the Inter-American Development Bank and the United States Ex-Im Bank combined. 
And the less benign side,
Not only did China’s cheap labor out-compete Latin American industry and draw the lion’s share of global manufacturing investment, but its appetite for Latin America’s minerals, oil and agricultural products also raised the value of currencies around the region, making their manufactured goods even less competitive. Manufacturing’s share in Latin America’s economic output has declined steadily for more than a decade, ever since China inserted itself aggressively into the global economy by entering the World Trade Organization. At the same time, the share of raw materials in Latin America’s exports, which had fallen to a low of 27 percent in the late 1990s, from about 52 percent in the early 1980s, surged back to more than 50 percent on the eve of the global financial crisis.

Saturday, December 20, 2014

Value subtraction in India's public schools

In a new paper, Lant Pritchett and Yamini Aiyar finds that public schools in India subtract value when compared to private schools. Public schools cost more than twice private schools, and that too to deliver a far inferior learning outcomes output. Their estimate of what it would take public schools, at their existing efficacy in producing learning, to achieve the learning results of the private sector - 2.78% of GDP (or Rs 232,000 Cr or $ 50 bn)!

The graphic below captures this massive value subtraction.
Any serious effort at attaining and sustaining high economic growth rates has to involve fixing woeful school education system. 

Monday, December 15, 2014

India's disappointing economic growth recovery

The latest IIP figures on the Indian economy makes dismal reading. It fell 4.2%, its worst performance in three years, on the back of weak manufacturing performance. This was despite the festival season and a favorable base-effect. So, despite all the "animal spirits" released in recent months, what's going on?

Madan Sabnavis of CARE Ratings captures symptoms of the malaise,
Growth in consumer durable goods for instance was 2.6% and 2.0% in 2011-12 and 2012-13 respectively, and then declined by 12.2% in 2013-14 and further by 12.6% in the first half of 2014-15. Clearly, households are not spending on non-food items. The reason is not hard to guess. Food inflation has eroded the spending power, as Consumer Price Index (CPI) inflation has been high averaging 10.2% in 2012-13, 9.5% in 2013-14 and 7.4% in 2014-15... industry has cut back on investment. This is mainly due to surplus capacity with the average capacity utilization rate coming down from 77.7% in first quarter if 2011-12 to 70.2% in the June quarter if 2014-15. Quite clearly, low consumer demand translates into lower demand for intermediate, basic and capital goods. Add to that the surplus capacity in a high interest rate environment and investment is bound to be curtailed.
For an economy where consumption makes up nearly 60% of the output and therefore critical to do the heavy lifting, this weakness is very damaging. As Mr Sabnavis identifies rightly, the prolonged period of inflation is the major culprit, having significantly eroded purchasing power among the workforce. To get a sense of the wealth erosion - the 9% average inflation over the 2008-14 period, exactly halved our purchasing power. It is reasonable to assume that incomes would have grown by far less to compensate for the loss. The steep negative impact on aggregate demand is understandable. The importance of RBI's stance on inflation has to be seen against this backdrop.

In the circumstances, as I have blogged earlier, there are two important parts to restoring economic growth - revival of credit growth and investment. Non-food credit growth, currently languishing at less than 10% has to return to atleast 15-20% levels. More importantly, infrastructure credit growth has fallen precipitously from its heady 35-40% growth rates in 2010-12 to less than 15% in 2013-14. Excluding power sector, itself weak, the infrastructure lending performance is poorer still. There are two important requirements to meet this target.

One, any rise in credit growth is contingent on the ability of banks to meet the demand. Here the weak balance sheets of the public sector banks, who supply over 80% of the bank credit, is a major constraint on lending, even if investment demand picks up. Large scale recapitalization is arguably the most urgent macroeconomic policy requirement and it is unlikely to materialize by merely divesting bank share holding. In fact, even if most of the Rs 18 lakh Cr worth projects currently stuck up in various tangles are disentangled, a very small proportion of them are likely to find the capital to start work.

Two, in the absence of investment demand - due to debt-laden corporate balance sheets, weak infrastructure investments, and the anemic consumer demand - the government becomes the engine to trigger investment revival. Unfortunately, it does not have the fiscal space to finance infrastructure investments. This is reflected in the marginal budget allocations made for even flagship projects of the government, with unrealistic hopes being thrust on private sector and public private partnerships.

The additional fiscal space come from either increased tax revenues and squeezing expenditures elsewhere. But both direct and indirect tax collections have been disappointing - 5.8% growth in indirect taxes against the budget estimates of 25% and 7.09% growth in direct taxes against the budget estimates of 15.31% in the April-September half year. This is not surprising given weak demand, low corporate investment appetite, and anemic economy. Cutting welfare spending is politically contentious and better targeting through Aadhaar will take time. Thanks to the one-step forward, half-step backward reforms, the windfall from the more than 40% drop in oil price appears unlikely to be fully reaped. Most of the measures to improve revenues and optimize expenditures are diffuse and long-drawn and unlikely to yield similar windfall.

All this highlights the adverse headwinds that the Indian economy has to navigate before it can start growing at 6-7%, leave alone the heady 8-9% rates. And I am not even talking about these long-term trends. In the circumstances, the journey towards regaining a 6-7% growth rate looks likely to be painstaking and long-drawn. Talking up the economy can only take you so far, and there are no magic reform pills available in the government's armor.

Update 1 (20/12/2014)

In its mid-term economic policy review, the Finance Ministry too comes to the same conclusion - public spending has to do the heavy lifting for reviving the economy. It points to corporate's median debt-to-equity ratio of 70%, one of the highest in the world, and posits a "balance sheet syndrome with Indian characteristics". The report's argument that household balance sheets are alright overlooks the harm done by the "income erosion effect" from persistent high inflation.

It identifies fiscal space by highlighting that the country has a debt flow (high fiscal deficit) problem and not a debt stock (reasonable and declining public debt to GDP ratio) problem. Though it finds "growing ground for hope", I am not sure. 

Sunday, December 14, 2014

China manufacturing facts of the day

From Forbes, on China's claim to be the factory of the world,
In 2011, for example, it manufactured 90% of all the personal computers produced globally that year, as well as 80% of the air conditioners, 74% of the solar cells, and 70% of the mobile phones.
From Nicholas Lardy, on the changing nature of Chinese economy and how private firms are its growth engines,
State firms now account for only one-fifth of manufacturing output, compared to four-fifths when reform began. They account for only one-tenth of investment in manufacturing. State firms in all sectors account for only one-tenth of urban employment and only one-tenth of China’s exports... According to data released by the People’s Bank of China, private firms received 52 per cent of all credit flowing to firms from 2010–2012, while the share of state firms was only 32 per cent.

Friday, December 12, 2014

Labor market reforms - deregulation or lower taxation?

I have briefly observed that instead of wading into the controversial hire-and-fire reforms, the next round of labor market reforms should involve addressing the dual price market in labor wages.

The fundamental problem is that Indian manufacturing firms start and remain small and informal. This engenders an inefficient equilibrium of low productivity, low wages, deficient social protections, limited investments, and stunted growth. What is required to break out of this equilibrium?

The likes of Arvind Panagariya argue that the restrictive hire and fire policies encourage firms to start small and informal and remain so. There is another possibility, as highlighted by Manish Sabharwal, that the high rate of labor taxation, payable by both employers and employees (upto 45% of wages are deducted for pensions and insurance for those with smaller incomes, whereas just over 5% of wages are deducted from those with higher wages), encourages much the same as above. It is certain that both - restrictive labor regulations and high rate of labor taxation - contribute to keeping firms small and informal. What is not certain is which is a greater constraint facing firms.

In this context, I have argued in detail that restrictive regulations may not be as binding a constraint as prohibitive taxation rates are. Consider this story. If you are the typical entrepreneur starting a textile unit, you are more likely  to start small and not be able to afford higher salaries. However, at such salaries, you are also unlikely to be able to attract workers, especially given the prohibitively high payroll deductions. So the firm prefers to either start informal or contract labor. Once it starts informal, it gets entrapped in a low-level equilibrium, exiting from which is constrained by several factors, including informality itself as well as restrictive labor regulations.

A more prudent strategy involving labor market reforms would revolve around lowering mandatory payroll deductions and replacing it with publicly funded social protection that is programmed for a gradual phase out. 

Thursday, December 11, 2014

Observations on the declining oil price

Much of the current decline in oil price can be explained by recent demand-supply dynamics. Supply has risen sharply due to shale and tar sands oil production coming on line, return of Libyan and Iranian production, and new discoveries in Africa and elsewhere. On the other hand, demand has been constrained primarily by global economic weakness, and less so by increased fuel consumption efficiency.

Here are three less discussed observations on the decline in oil price.

1. There is little to doubt why this time is different with the oil price cycle. History teaches us that oil price spikes are associated with a sharp rise in investments in wells and refineries. These investments take time to come on line, by which time the business cycle reverses, causing a supply glut and declining prices. Since their investment option value is exercised, new producers keep producing so as to cover their variable costs. But falling price in turn boosts consumption and economic output, as well as discourage investments in production capacity (which any ways take time to become operational). The combined effect of increasing demand and stagnant production (and prospects) is a return to rising prices.

All the standard signatures of this dynamics are present in the current cycle. The China-led emerging market boom and pre-recession spike in oil price triggered an investment binge. It made shale and tar sands attractive sources. Businesses invested in sweet crude refining capacity in the US. The Great Recession struck and Chinese economy started showing weakness. Oil price falls by nearly 40% in less than six months. Consumers benefit and it is likely to be a net gain for the world economy as a whole. This sets the stage for increased demand and rising prices...

2. Much has been made out of the dramatic increase in shale oil production in the US and its salutary effect on US manufacturing and the economy. Now that the momentum has turned, the sustainability of the shale oil exploration induced economic growth has become questionable. Apart from the commercial viability of shale oil at these prices (which is highly contentious and very difficult to estimate), new drilling projects and other investments are being scaled back or cancelled. The cumulative impact on US economy could be substantial, even if off-set by the consumer wealth effect and decreased production cost for non-oil businesses.

3. Finally, the falling oil prices present opportunities for emerging economies like India and Indonesia in both lowering current account deficits (CAD) and rolling back their massive energy subsidies. However, in India's case, there are formidable challenges to seizing these opportunities.

Though India has already taken the first step by recently decontrolling diesel price, on top of the earlier decontrol of petrol price, there are doubts about its resolve to hold steady when prices recover. For example, the gains from the decontrol have been offset by the subsequent hike in excise duty on petrol and diesel and the decision to not pass it on to the consumers and let it be borne by the national oil companies. Further, instead of slowly lowering the subsidy by not reducing prices on the face of decline in global price, the government has preferred to pass on the down-side gains to the consumers.

Similarly, hopes of lower CAD may be misplaced. The decline in oil import bill could be more than offset by increased gold (consequent to easing of the import controls) and other imports (as the economic growth picks up). Indeed, the CAD is already showing signs of widening.

Tuesday, December 9, 2014

India's affordable housing challenge - a graphical summary

I have written earlier about the near impossibility of achieving the government's affordable housing mandate. The following graphics reinforce the point.

The country has one of the highest price-to-rent ratio among all its emerging Asian peers, thereby constraining demand. This points to over-valued property prices, a fact reflected here.
This is complemented by low rental yields, the gross annual rental income expressed as a share of property purchase price. Rental yields, a measure of the landlord's return on investment, have been stagnant at 2.5-3% for a long time.
The combination of these two factors severely distorts the country's property markets. The former prices a large share of the population out of the market. The low rental yields, over and above acute land scarcity and high building costs, come as a disincentive to creation of housing stock other than for living in, and encourages land owners to hoard land rather than build on it. The combined effect of both is to severely constrain demand and supply respectively.

This effect is even more pernicious given the nature of demand and supply in India. The country's affordable urban housing demand stood at 25 million in 2010, of which 16.6 m was in slums. Nearly 90% of the demand comes from households with incomes below Rs 5,00,000.
The real estate consultancy Jones Lang LaSalle estimates that 60% of the demand would come from households with annual incomes below Rs 5,00,000, whereas units for them constitute just 10% of the total supply. Interestingly, those with incomes greater than Rs 7,00,000 form just 20% of the demand, whereas a whopping 70% of the units in the market caters to them. In other words, 90% of the housing units in the market cater to the demands of just 40% of the population, those with incomes above Rs 5,00,000.
A 2010 MGI report highlighted the housing unaffordability problem for those below the Rs 5,00,000 income barrier. The graphic below shows the affordability gap for Tier 2 cities in 2010. The affordability gap is massive among those at the bottom two categories...
... who make up the majority of the population. In 2005, they formed nearly 95% of the total population. Even in 2015, the share of population with household income below Rs 2,00,000 is estimated to be 78%.  
In the circumstances, meeting the affordable housing challenge appears a distant dream.