Thursday, August 24, 2017

PPPs in infrastructure - finance operating assets

Finance 101 teaches us that life-cycle costs of infrastructure projects are optimised by financing them as end-to-end projects, from construction to operation and maintenance (O&M), since it aligns the incentives of the private operator to design and construct in the most efficient manner. Never mind the overwhelming evidence to the contrary. 

This blog has consistently taken the contrary view that the cleanest and most practical approach to leveraging private capital into infrastructure is to channel them into the O&M of commissioned infrastructure assets.

The reasons are simple. One, large infrastructure projects are exposed to very high constructions risks, mostly arising from factors that private operators cannot control. Only governments can control those risks. Two, construction risks induce delays and cost over-runs, which in turn add to the already higher cost of capital that private operators face when compared to governments. Three, post-construction, there are significant uncertainties associated with commissioning - e.g.. traffic realisation in transportation, tariff/user-fee realisation in utility services etc. Four, once constructed and commissioned, the O&M risks are far less, whereas the revenue stream is more predictable. 

In simple terms, the risk allocation and financing terms for construction and commissioning, and O&M are qualitatively different. They demand different types of financing. Accordingly, it is better that construction and commissioning is done by one agency, preferably a government owned but autonomous entity, and a private concessionaire to do the O&M.

An acknowledgement of this comes from two of the most ardent upholders of free-markets and private participation, and that too highlighting the woes facing infrastructure projects on both sides of the Atlantic. 

The FT, which has featured several articles critical of PPPs in recent months, has this to say, in the context of UK's struggle with trying to attract funding to infrastructure projects,
“The big difficulty is in getting investors to take on the risk of major new standalone or bespoke projects”, says Andy Rose, chief executive of the Global Infrastructure Investor Association. “When people talk about a wall of money wanting to invest in infrastructure it is primarily for operating assets.”
And The Economist, in the context of declining infrastructure spending in the US, writes,
Anton Pil of J.P. Morgan points out that most large infrastructure projects in America need at least some federal funding to succeed. Unless the federal government leads the way, there is unlikely to be much new activity... It is easier, it seems, to raise money to invest in infrastructure than to spend it.
Finally, the FT's editorial view on PPPs is very clear,
To insist on the private sector stepping up to finance grand projects with huge construction risks and long-term pay-offs — beyond most investors’ time horizon — is a recipe for failure. There is undoubtedly a role for the private sector in financing smaller projects, those where assets are already in operation or where the future income stream is clear. But the government is the best risk-taker for long-term projects.
How long will it take for governments in countries like India to realise the need to exercise caution in relying on PPPs to stoke infrastructure spending?

Tuesday, August 22, 2017

Mid-week graphics link fest

1. The remarkable rise and stability in the US equity markets since the election of Donald Trump and the daily roller-coaster of uncertainty flies against conventional wisdom. The graphic below captures the Trump stability,

2. Talking about equity markets and widening inequality, John Mauldin points to this stunning graphic from BofA about the number of hours the average worker has to work to buy a notional share of the S&P 500.

3. This graphic, again from Mauldin, is even more stunning - the US has more indices today than there are stocks! ETFs are driving the equity markets, not stocks.  

4. The folks at GMO who forecast the 7-year asset class returns have dismal findings - US equities expected to decline by 4.2% annually and bonds by 1%. The only silver-lining being emerging market equities.

5. One of the major beneficiaries (and an amplifier) of this financialization have been the credit rating agencies, or the nationally recognised statistical rating organisations (NRSRO) in the US. 
The credit rating market is virtually consisting of just three firms!

6. It is well accepted that the Fed has played an important role in propping up the equity markets. This graphic of Fed balance sheet expansion and the rise of equity market from John Authers is pretty striking. 

7. This graphic shows that the Bank of England's lending rates are currently its lowest in its 323 year history! Since its founding in 1694, the BoE had never lowered its lending rate below 2 per cent till January 2009!

8. One of the most unfortunate things about the sub-prime mortgages induced crisis in the US has been the virtual absence of fixing accountability. This graphic shows that even as 324 Main Street mortgage lenders, loan officers, real estate brokers, developers and others have been convicted, US prosecutors have not been able to complete charges against even one Wall Street CEO. This despite over $150 bn having been realised in fines. 

9. I recently blogged about the declining interest in PPPs. The graphic below captures the sharp decline since 2007 in UK's pioneering Private Finance Initiative (PFI) to attract private investors to infrastructure deals. 
The decline should be an eye-opener for those mindlessly continue to hold up the PFI as an exemplar of best practice in PPPs.

Monday, August 21, 2017

Assessing India's economic growth prospects

Ruchir Sharma offers a nice dose of realism about Indian economy, the relationship between economics and politics, government's contribution to growth and more. He makes some interesting points. 

1. Lower growth rates are the new global normal. There is not a single region in the world which is growing faster now than a decade back. Exports, which provided the boost for the last two decades of growth has been stagnant this decade. To that extent, any growth rate above 5 per cent should be good for India. 

2. India has been out-performing its emerging market peer basket by about two percentage points for 2-3 decades, and that out-performance is likely to continue. It helps that the country's GDP per-capita at $2000 is only a fifth or so of the peer basket average, and therefore the boost from low base is significant. 

3. Empirical analysis of state elections shows that even in the past decade, anti-incumbency has been the dominant trend in Indian politics, even when states deliver impressive economic performance. Anti-incumbency has only marginally declined from 65% to 58% in the past decade.

4. The findings of the World Values Survey over the past 2-3 decades show that among the major countries India shows the highest increase in public preference for authoritarian leaders (as against one more answerable to the Parliament and favours more democracy). 

5. Economic growth in recent years has been driven by consumption than investment, as reflected in the buoyant performance of consumer stocks as against the poor performance of manufacturing and infrastructure sector stocks. To the extent that the former is less dependent on government policies than the latter, the government role in contributing to the high growth rate is marginal. 

6. The arrival of a new leader in emerging economies is associated with elevated stock market performance for 2-3 years, with an out-performance of 20-30%. Over the past three years, Indian stocks have out-performed emerging market peers by 10-15%. 

7. The quality of private sector companies, in terms of having consistently delivered 15% or more earnings growth on a steady basis for more than five years, driving equity markets in India is the best in the world. This is encouraging sign both for the sustainability of the bull market as well as for future growth. 

He writes,
The path has been one of incrementalism for a very long period of time and that is the path that we should expect over the next few years and therefore... to pay attention to politics in India is, from an economic perspective, is really a waste of time... this is a country... that consistently disappoints both the optimist and the pessimist. And so, that realism is what we need. You can always be an optimist and always say that this is going to happen. But for me, that is a money losing strategy and that is one thing which is also, we have not appreciated that if you look at what has happened over the last three years, had you bet on the government to deliver, look at it from a pure stock market perspective, you would have been a loser... the evidence suggests that there is really no connection between politics and economics in this country. On the other hand, it is this sentiment of nationalism and you see this, you see this across social media, you see it across television channels, it is this sentiment towards nationalism and stride at hyper-nationalism at times, it is this sentiment which is what is buoying Modi and the current administration... 
if you look at what has worked in the stock market over the last three years, you will find that there is nothing to do with the government or politics. The best performing sector since May 2014 has been the consumer staples sector. This reflects the fact that what is really driving the Indian economy over the last three years has been consumption. As we know from instances across the world, that the government really doesn't have much of an impact on consumption as much it has on investment. Investment is what the government can really drive by creating the investment environment for investment to pick up or pushing that. Instead if you look at investment related stocks in India, those have done quite poorly on a relative basis especially over the last three years.
And this is interesting and I agree,
So, my simple point being here that the connection between politics and economics in this country is rather limited and the stock market's behaviour over the last three years since this government came to power has only reinforced that notion. If you look at both the internals of the market, in terms of what has done well and also the overall market, neither the pessimists nor the optimists on the Modi government would have made any money based on a political view. So, in this country if you want to do well you have tune out the politics and be an internal exile as far as politics is concerned because that only interferes with sort of making money in this nation.
But, in favour of the government, it has to be argued that the counter-factual is impossible to have. To its credit, the government has not done any harm, and has largely been pursuing stable fiscal and macroeconomic policies. This is more than can be said of governments, not just in India previously, but also globally in emerging markets. 

It is here that I disagree with Ruchir, 
There are countries like China, Korea, Taiwan which have been able to grow at 10 percent plus. But my point has always been that to expect big bang reforms in India, to expect that some major big bang reforms will take place in India has always been a bad bet because that never happens. Our culture is one of incrementalism. We do things in incremental steps and I think that is what should be the operating assumption.
I do not think that there are big-bang reforms in India's context. When we talk of big-bang reforms, we think of one-off decisions like deregulation, privatisation, promulgation of new laws, and so on.  Take a decision and you are done. The sort of stuff like privatisation of banks and public sector units, while necessary, on their own, are unlikely to unlock massive growth energies.

The real reforms in India's context, as we laid out in our book, Can India Grow?, are more in the nature of steady and focused accumulation of human, physical and institutional capital, whose base is astonishingly low for an economy of India's size. Deficiencies in these are the binding constraints to sustainable high growth rates. No amount of big-bang can make up for them. For sure, there are some big-bang stuff there, as we outlined, but those are not the stuff the markets associate with big-bang reforms. They are in the nature of pulling complementary levers and persistent follow-up for long periods to address deep-rooted problems.

They would include reorientation of school education single mindedly towards learning outcomes; restructuring of UGC, MCI etc; facilitating the development of financial savings  instruments and enabling access to them, so as increase the savings rate; transition to outcomes-based financing in health care, away from line-items health funding; policies to provide tenure stability and address politicisation of officials postings; across the board standardisation, e-procurements, and third party quality audits; reforms to address decision paralysis and so on. Not the sexy stuff like repeal of Section 25N of Industrial Disputes Act 1947 or the privatisation of Air India or Indian Railways!

Friday, August 18, 2017

Historical asset prices

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

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

Thursday, August 17, 2017

The contrasting trajectories of infrastructure and welfare sectors in development

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

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

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

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

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

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

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

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

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

Tuesday, August 15, 2017

Is the tide turning on PPPs?

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

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

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

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

Monday, August 14, 2017

The GIS mapping challenge in power distribution

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

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

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

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

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

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

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