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Tuesday, August 28, 2012

Welcome Ila Patnaik to the Internet

Ila Patnaik now has a blog, an RSS feed and a twitter feed. The blog will also email out updates to you. Her stock of materials is on her home page on the web.

Tuesday, August 21, 2012

The widget illusion

The Economist runs a discussion forum titled The Economist By Invitation. In this, they recently setup a discussion about an opinion piece by Dani Rodrik about the future of manufacturing-led growth in emerging markets. I wrote a response there which is reproduced here.

The role of manufactures

I agree with a small element of Dani Rodrik's argument, but mostly for different reasons. Rodrik says:

Except for a handful of small countries that benefited from natural-resource bonanzas, all of the successful economies of the last six decades owe their growth to rapid industrialization.

I have seen this kind of thinking among some policy makers in India also: that industrialisation is somehow special and good when compared with services. I would question this proposition, that I term `the widget illusion'. What matters to a country is having sophisticated firms that have a high marginal product of labour. We should not care whether this happens in services or in manufacturing. If anything, the opportunity to do it is perhaps better in services.

India is a good example of a country which embarked on its catchup by connecting into globalisation late: from 1991 onwards. It was probably the last country in the world to shed autarkic policies. This has given a remarkable growth acceleration. Sustained growth of 7 per cent is pretty good by world standards. These achievements have been significantly driven by services production in India within global supply chains (whether within production facilities owned by global MNCs who are operating in India, or contracted-out by global MNCs to Indian firms). If your null hypothesis was that industrialisation is essential to growth, then you would not have predicted what happened in India, where manufacturing was hobbled by an array of policy mistakes.

This illustrates the limitations of manufacturing-focused thinking, which seems a bit out of date in today's world economy where most output is services. Agriculture and manufacturing have wilted away in the consumption of the global representative agent: to succeed in the world economy today requires prime attention upon services.

Rodrik says:

Consider India, which demonstrates the limitations of relying on services rather than industry in the early stages of development. The country has developed remarkable strengths in IT services, such as software and call centers. But the bulk of the Indian labor force lacks the skills and education to be absorbed into such sectors. In East Asia, unskilled workers were put to work in urban factories, making several times what they earned in the countryside. In India, they remain on the land or move to petty services where their productivity is not much higher.

As Rodrik points out, there are important gaps between the skills of the great unwashed masses in India versus China, where elementary technical training reached a larger mass of humans. In addition, China did better on core economic policy choices about (a) Removing protectionism; (b) Removing barriers to FDI; (c) Building hard infrastructure; (d) Labour law and (e) Rationalising taxation.

What policy advice would flow from this? India should not have have made these six mistakes in economic policy (low training for the masses, protectionism, barriers to FDI, weak investments into infrastructure, labour law and mistakes in tax policy). At the same time, this does not recommend a bias in favour of manufacturing. It is hard to discern a meaningful choice about emphasising services versus manufacturing in Indian economic policy. Participation in all global production is good. Governments should remove all barriers that inhibit global integration whether in goods or in services - e.g. the six mistakes in Indian policy sketched above.

A paragraph earlier, Rodrik says:

To be sure, some modern service activities are capable of productivity convergence as well. But most high-productivity services require a wide array of skills and institutional capabilities that developing economies accumulate only gradually. A poor country can easily compete with Sweden in a wide range of manufactures; but it takes many decades, if not centuries, to catch up with Sweden's institutions.

I would point out the contradiction: "A poor country can easily compete with Sweden in .. manufactures" but earlier it was asserted that the gaps in Indian skills inhibited India's ability to compete with Sweden in manufactures.

Doing things that push skills and institutional capabilities

I would go further to say that it is good to go after fields which require a wide array of skills and institutional capabilities.

I am reminded of Ricardo Hausmann's `Good Cholesterol' argument about financial globalisation as opposed to mere FDI. When a poor country operates in an institutional vacuum, foreign investors are uncomfortable, and the only thing that can happen is FDI. To obtain financial flows, the country has to build institutions: laws, regulators, property rights, and so on. This is a good thing! A country that gets to FDI and gets stuck there should ponder what is going wrong. In similar fashion, no country aspires to have low-wage production; every country wants to understand the secret sauce through which a part of the labour force can earn high wages by world standards.

As a country rises out of poverty, it is essential to build up skills and institutional capabilities. If policy makers hinder services and/or favour manufacturing, there is a greater chance of being stuck in low skills and low institutional capabilities. I am not proposing industrial policy in favour of services. I am only proposing the absence of industrial policy; we should avoid a `widget illusion' and foster more global integration without trying to push towards one industry or another.

In India, with 7 per cent growth, GDP doubles every decade. As a thumb-rule, I feel that a comprehensive transformation of skills and institutions is required across each doubling of GDP, which is roughly each decade for India. A country that is stuck in low-skill manufacturing will find it difficult to achieve the reinvention of this `soft infrastructure' of the mind. If policy makers tried to push a country towards doing low end grunge work, it would be harder to obtain these repeated transformations of institutions and the furniture of the mind, which would lead to growth decelerations.

As an example, in the article New wave of deft robots is changing global industry, John Markoff says:

Foxconn has not disclosed how many workers will be displaced or when. But its chairman, Terry Gou, has publicly endorsed a growing use of robots. Speaking of his more than one million employees worldwide, he said in January, according to the official Xinhua news agency: ``As human beings are also animals, to manage one million animals gives me a headache.''

The project of economic development requires sophisticated interactions between firms and workers. The laws, human rights and management practices that are required when dealing with humans are different from those required when running a firm with `one million animals'. I would hence argue that it is limiting for a country to focus on the political, legal and institutional requirements to produce a la Foxconn. It is better to confront the complexities of high skill, high wage production, and to build the environment for this to happen: in the political and legal system, in management practices of firms, and in the power structure embedded in a conversation between two citizens who are co-workers within a firm. Services production is a valuable learning ground where the complex management practices that involve high skill humans can be learned.

The new world of manufacturing

Rodrik correctly points out that manufacturing has become more sophisticated in recent years. This has some fascinating dimensions:

  • The rapid improvements in capabilities and declining costs of robots.
  • The rise of open source design coupled with 3-d printers. If a 3-d printer in the US fabricates a part close to its usage in an assembly line, while the labour-intensive design work ("services") that controls the 3-d printer is done in India, does this entail manufacturing or services work in India?
  • The world economy is likely to be in a low interest rate environment for a long time, which will encourage capital intensity worldwide (robots, 3-d printers), thus blunting the value of low wages.

Momentous changes are afoot, which challenge our traditional notions of manufacturing versus services. To some extent, we are even seeing some manufacturing go back to the US.

Things that might `go wrong'

Finally, Rodrik talks about reduced willingness in the West to tolerate unfair tactics like the Chinese exchange rate regime. I would generally consider this to be a good thing, both for developing countries and for the world. In any case, the Asian `Bretton Woods II' episode seems to be subsiding. As an example of the disenchantment with exchange rate distortions: From 2004 to 2007, India debated exchange rate rigidity, and walked away from it. The links between undistorted exchange rates and growth have not been adequately emphasised in the discourse. A developing country builds up inferior skills and institutional capabilities by exporting under a subsidised exchange rate: it is better to force firms to confront the market price and achieve the productivity required to participate in globalisation when facing an undistorted price vector.

He worries about a rise in protectionism in the West, but we have to admit that the 2008-2012 experience has been pretty good in this regard: by and large the West has not succumbed into protectionism. In 2008, all of us worried about Smoot-Hawley. Today, things seem to be be going well.


In summary, I would argue that we should avoid a `widget illusion'. There is nothing special about manufacturing or industrialisation: as long as people in India get high wage jobs, this is good. Getting there requries deep integration into the world economy, which includes policy battlefronts such as:

  • Openness to the Internet
  • Use of English
  • Inbound and outbound FDI
  • The array of cross-border financial services that are the enablers of complex globalised production of both goods and services
  • Globalisation-compatible tax policy on both trade and finance
  • The absence of either protectionism or mercantalism
  • Fostering high quality human skills, and
  • Infrastructure.

To the extent that globalised production of goods and services happens in areas which involve high skills and complex institutional development, this is a bonus, since any high growth country needs a rapid pace of reinvention of laws and institutions.

Most of this is the old orthodoxy. Policy makers worldwide are generally focused on these issues, as they should be. From the 1960s onwards, dirigisme has generally subsided, with the twilight of policies like fixed exchange rates, industrial policy, capital controls, protectionism, etc. These key lessons remain intact in the 21st century.

Sunday, August 19, 2012

Interesting readings

Ila Patnaik in the Indian Express on the role of the Ministry of Finance in India's growth. Pratap Bhanu Mehta in the Indian Express on India's cabinet reshuffle. Anil Padmanabhan in the Mint about how things have changed at MoF after Chidambaram got back.

Bibek Debroy on a major problem that afflicts India today: Human capital obsolescence. Now that I'm safely past that age, I know the right answer for leadership positions: the right age is 40.

Theodore Dalrymple in the Wall Street Journal likes India's Olympian detachment from the Olympics.

Trampling on the individual in India: Jayalalithaa vs. India Today. Also see Gopu Mohan in the Indian Express who shines the light on the systematic use of litigation.

Russell Green in Mint on the problems of priority sector lending.

Pramit Bhattacharya in Mint on Kaushik Basu's tenure as CEA.

Mythili Bhusnurmath in the Economic Times on the difficulties of bank solvency that India now faces. The article refers to this RBI report on restructuring of bad debt.

The ghost of Abraham's letter by N. Sundaresha Subramanian in the Business Standard.

Amol Sharma and Megha Bahree in the Wall Street Journal about Mukesh Ambani's 4G plans. In it: "On one page there was a complex mathematical calculation of how fast each cell tower could carry data."

Odd SDP data for Maharashtra, by Dilasha Seth in the Business Standard. Also see.

The man who saved capitalism by Stephen Moore in the Wall Street Journal.

Monday, August 06, 2012

White label ATMs

by Harsh Vardhan.

On 20 June, RBI issued guidelines that permitted White Label ATMs (WLA) to be operated in India. These guidelines could make a very significant change in the banking business - one that would go a long way in improving penetration of banking. This was a move that was long overdue. We can now look forward to very rapid expansion of the ATM networks along with many new services being offered at them.

ATMs arrived in the US in the late 1970s and in India somewhere in the 1990s, when some foreign banks set up a few in Mumbai and other metros. It was not until the late 1990's and early 2000's that ATMs became an important channel and there was a rapid growth. This growth can be attributed to the new generation private banks who used ATM's cleverly to expand the reach of their (then) limited branch networks to attract customers. These banks realized that it will take them a long time to match the branch reach of public sector banks, and hence adopted a model where a branch surrounded by a slew of ATM's became the means of attracting customer. The proposition to the customer was - "Open an account in the branch which may be far away from your home or place of work but transact on an ATM which is very close to you". A new generation of customers, more amenable to the use of this channel also helped. Slowly, most of the new generation banks managed to transfer a sizeable part (in some cases over 80%) of basic transactions -- cash withdrawal, balance enquiry, etc. -- to ATMs. The cost advantage was compelling. Doing transactions on ATM's can be 50% to 80% cheaper than using branches. We also saw some small "value added services" emerge at the ATM, such as bill payments.

Despite the rapid growth of the ATM network, their density is still low compared to other countries. India has ~ 77 ATMs per million population which is much lower than even countries like Thailand and Malaysia which have ~200 ATMs per million and significantly lower than the US which has over 1200 ATMs per million people. Clearly, ATM density will have to grow which means a large number of ATM's will have to be rolled out. For this to happen, appropriate incentives have to come into play in this field.

How do ATMs work?

It is important to first understand the mechanics of ATMs, to fully appreciate the roles played by different entities and how the new regulations change these roles and thus the incentives.

ATMs are essentially electronic contact points between a bank and its customers. The jargon of the field involves three kinds of entities:

  • Issuing banks - those that issue ATM cards (or debit and credit cards) to their customers
  • Acquiring banks that operate ATMs and dispense cash (similar process also is followed in case of the so called Point of Sales (PoS) terminals that are used at merchant establishments for payments)
  • Payment associations (also called Network Providers) - the intermediaries that facilitate the flow of information (payment instructions) and funds between issuing and acquiring banks

The process flow of cash dispensation by ATMs (which is 95% of what they do) works like this:

  1. A customer approaches an ATM and inserts his card.
  2. The ATM "reads" his card and passes the information to the bank which has set up the ATM. This bank is conventionally called the "acquiring" bank.
  3. Computers of the acquiring bank read the information and determine if the customer is its own or of some other bank.
  4. In case of its own customers the bank invokes his account, checks if there is enough money, and if the password is correct, sends instruction to the ATM to dispense cash. Such transactions, where the acquiring bank and the card issuing bank is the same, are called "On Us" transactions.
  5. Sometimes the customer has a card issued by another bank ("the issuing bank"). The acquiring bank (i.e. the one which setup the ATM) sends a message to Visa, MasterCard or "NFS" the National Financial Switch (a system set up by National Payment Corporation of India) depending on the arrangements between the acquiring banks, the issuing bank and these entities. These entities are called "Payment Associations" and they perform the role of connecting card issuing banks with the acquiring banks
  6. Upon receiving the information from the payment association, the issuing bank checks up the availability of a balance in the bank account, and sends the payment instruction to the ATM which dispenses cash. In this situation the acquiring bank is making the cash payment to the customer on behalf of the issuing bank. Such transactions are usually referred to as "Off Us" transactions
  7. The payment associations keep records of all "Off Us" transactions. At the end of each day, they do clearing and settlement of funds whereby all banks pay or receive funds depending on the net Off Us transactions made through their customers and possibly their ATMs.
  8. The issuing bank pays some fees to the acquiring bank and to the network providers for every transaction that their customers carry out on ATMs (i.e. for all "off us" transactions). These fees are a revenue for the acquiring banks which spends money in building and running the ATM network.

It is useful to think that there are 2 distinct flows in this process: a flow of information (or instructions), and a flow of money. Information flow takes place on communication lines between the entities involved and funds flow is mediated by the payment association through its own clearing and settlement processes. The two flows are linked but distinct.

The new guidelines

Historically, RBI regulations prevented non bank players from competing in this space. Regulations allowed only commercial banks to own and operate ATMs. This means that each ATM, in the view of the regulator, belonged to the acquiring bank. And no entity other than a commercial bank could do the acquiring part of this process.

Building and running ATMs is more of an IT/telecom business and many banks were not keen to create these capabilities. A significant amount of outsourcing was done by banks, whereby the maintenance and in many cases even the rollout of ATM's was done by independent companies for banks. But regulations dictated that all the crucial aspects of running the ATM network remained squarely with banks. Even the locations of ATMs - which banks needed to inform the RBI - were pegged to a bank. The new guidelines effectively open up most of the acquiring part of the process to non bank independent players. They clearly recognize that the information and the funds flow are distinct and while there may be some logic in keeping the funds flow within the ambit of commercial banks, the information flows can be performed by non banking entities. The new guidelines make some profound changes, including allowing:

  • Independent white label ATM providers to set up and operate ATM networks (without being a bank); these companies can apply for and get approvals for the locations of ATMs - the locations will be assigned to these companies and not to banks
  • Independent ATM networks to connect directly with network providers such as Visa Mastercard, and NFS - thus allowing them to pass on the payment instructions emanating from the ATM without having to go through the acquiring bank, While the cash settlement will continue to be via the acquiring banks (called sponsor banks under the new guidelines), an independent ATM operator can do such settlement through multiple sponsor banks
  • Allowing companies to tie up with multiple banks as acquiring (sponsor) banks; this will meant that even if the arrangement between a particular bank and an ATM operator is discontinued, the operator can tie up with another bank and continue to operate ATMs
  • ATM operators the freedom to offer value added services

Effectively, these changes imply that running the ATM network has now been recognized as an independent activity, but at the same time seeing that it is a business that needs the support by banks for activities such as managing cash and for settlement. Thus the RBI has taken significant part of running ATM networks out of the ambit of commercial banking.

Why is this a good idea? Building out the ATM network is not a core activity for banks. For banks, an ATM is a transaction point for customers. Setting up and running a large number of ATMs is an activity that adds little to the profitability and performance of banks but does add a significant amount of operational burden. This is the reason why many Indian banks started outsourcing ATM rollout and management once they reached a critical mass on ATMs. This is not the business of banking. At first blush, it is an IT or telecom business. But at a deeper level, it is closer to the retail business, with issues like location, branding, efficiency, multiple services, etc.

For independent white label operators, building out a large ATM network and squeezing operational efficiencies out of it would be the core business. They are expected to focus on much faster rollout of network, strategically thinking about locations, squeezing efficiencies in the management of the network, adding value added services, etc. An analog would be the case of money-changing business - what is popularly known as "Exchange Bureaus". For a long time only banks were allowed to run these and so we saw very few outlets even at airports and so on. This business was opened up for private independent players about a decade or so ago, which resulted in a dramatic increase in the number of outlets as well as the quality of their service. There are several classes of players that are likely to enter this business. Large established international players (eg Star, Pulse, NYCE from the US) should be interested as they would see India as a major growth market. Local players currently providing oursourcing services for ATM rollout and management would be another class of players that are likely to enter. ATM manufacturers (eg NCR, Diebold) also could look at this as an extension of their business. Other firms in related business such as telcos that provide the network connectivity could also consider entry. Each of these different classes of players have their own strengths and weaknesses. Time will tell which is the ideal business model. The competitive dynamics between these various kinds of players will give customers in India better ATM services in all respects: more locations, better locations, more services, and superior customer experience.

Many aspects of the white label ATM business will only become clear as the story unfolds. The most critical is the long term sustainable economics of the business which will determine the capital that is deployed into the business. While the RBI guidelines prescribe overall restrictions on the fees charged by the ATM operator to the bank, they stay away from prescribing the exact charges, which is the right approach. At first, there will be a bit of a competitive frenzy; some players will set some charges to very low or very high levels. It will be some time before stable pricing structures and levels emerge. The guidelines are not absolutely clear if these companies can develop independent brands for their networks (such as Most and Cirrus in the US). Such branding will be a crucial part of making white label ATM an independent business. My interpretation is that independent branding is not explicitly prohibited but it is not explicitly permitted either and clarity on this count would be very useful. Overall these guidelines are a move in the right direction. There is a lot in the payment space that is currently tied to commercial banking due to regulatory reasons. The evolution of technology and consumer behavior suggests that many aspects of payment business need not remain confined to banking and in fact taking them out could unleash innovation that would drive significant efficiency gain and consumer value. We can hope that the deregulation of ATMs is the first of several similar steps that the RBI takes to allow the emergence of a payments industry in India, distinct from the business of banking.