## Wednesday, March 25, 2015

### Improving warehousing in India through a grading mechanism

by Smriti Sharma.

A key sub-industry in modern agriculture is warehousing. Storage reduces price fluctuations. Trusted storage permits `dematerialisation', where warehouse receipts are traded or delivered, and is the key link between physical goods and finance. At present, the quantity and quality of warehouses in India are inadequate. This is a key bridge that has to be crossed for the modernisation of agriculture. Trusted mechanisms for warehousing of non-agricultural goods are also an important enabler of the market economy.

Warehouses claim to take in goods and keep them safe. The customer of a warehouse does not know the probability with which the promise will be violated. There are a diverse array of warehouses in India, but customers do not know the failure rate of alternative warehouses. Currently, consumers do not have information to differentiate between one warehouse and the other. Most people make a choice with regard to a warehouse on the basis of word of mouth and local reputation. Sellers of warehousing service withhold privileged information about their warehousing service from the buyers. This leads to a situation of information asymmetry.

Information asymmetry is one of the classic market failures. Market economies seek to establish State capacity that efficiently addresses market failures. As an example, customers of a restaurant do not know whether the kitchen is clean, and this calls for the State to undertake certain interventions which address this problem.

Absent government involvement, users of warehousing services have devised their own solutions to address this problem. National Commodities Derivatives Exchange (NCDEX) operates a remarkable closed-user-group (CUG) that attempts to solve the problem of information asymmetry by creating its own inspection, audit and monitoring mechanism to ensure sanctity of the physical settlement of commodities traded on its exchange. Alongside this, many collateral management companies have come up which offer turn-key services of protection to users.

As is well known in public economics, when faced with market failures, such private solutions are not as nice as having a well structured and efficiently implemented government-based solution.

Warehousing Development Regulatory Authority (WDRA) is mandated by the Warehousing (Development and Regulation) Act, 2007 to regulate warehouses that issue negotiable warehousing receipts (NWRs). Currently, WDRA registered warehouses go through a process of accreditation. This process verifies whether entities who apply to register with WDRA comply with certain registration requirements. This intervention is inadequate in that it does not create a mechanism for watching the performance of a warehouse on an ongoing basis. In and of itself, the WDRA registration has generated limited trust on the part of market participants.

A better intervention, which can be introduced by WDRA, is a mechanism for grading of warehouses, WDRA can provide more granular and complex information pertaining to warehouses and WSPs. This would require establishment of processes through which grades are awarded.

### Experiences with grading in related fields

Is grading the right intervention for this market failure? Some analogies may be instructive:

• Credit rating agencies assign grades to bonds.
• In the real estate sector, grading helps by providing the real estate developers with the incentives to conform to fair trade practices and legal requirements.
• The New York Health Department made it mandatory for the restaurants in its five boroughs to get themselves graded for their sanitary scores. The grades summarising the sanitary scores are then made public. Within 18 months of starting the grading programme, the share of restaurants without a trained food protection supervisor decreased from 13% to 7%. Prior to grading, 11% of the restaurants had inadequate hand washing facilities, which reduced to 5%. Also, a 10% drop was registered in restaurants that had signs of mice infestation.
These areas -- bonds, real estate, restaurants -- have the same market failure as that found in warehouses, i.e. information asymmetry.

### Grading warehouses and warehouse service providers

Warehousing is an amalgam of warehousing infrastructure including warehousing premises, equipment and manpower which is used to deliver a service. For purposes of grading warehouses, warehouses need to be compared to each other, and against some benchmarks that the market may find useful.

A variety of public and private agencies internationally have formulated broad parameters, on the basis of which warehouses are classified and graded. For example, in Tanzania, warehouses are scored on parameters specified by Warehouse Receipts Regulations, 2006 and then graded accordingly. In UK, United Kingdom Warehousing Association issues an advisory for its members that lists broad headings like these, against which standards are set for warehouses.
Real estate consultants like Knight Frank also have their own list of parameters for warehouses. The parameters devised by each of these agencies are customised for the needs of their clientele. There is no single check-list against which WDRA can require warehouses to be graded.

A grade can capture information on the physical attributes of the warehouse (e.g. warehouse building and warehouse site), management of the warehouse (e.g. ownership, technical and managerial staff) and the warehousing processes and activities (e.g. storage and handling of goods, fire security, pest control, use of technology and book-keeping).

There is no fixed recipe for grading. WDRA must allow expertise present in the market to innovate in designing better grading mechanisms, and for grading agencies to discover what information is relevant for the warehousing market. For an analogy, financial regulators have pushed the bond market towards the use of credit rating agencies, while not micro-managing how credit rating agencies analyse a bond.

### Re-imagining the role of accreditation agencies of WDRA

Provisions in the WDR Act allow WDRA to facilitate grading of warehouses by specialised agencies. It would be useful for WDRA to develop such an environment for the warehousing industry.
Rolling this out also presents complexities, which will need to be addressed:

1. Financial regulation in India has encouraged a mindless notion on the part of investors, where the credit rating agency is the only determining factor about whether a bond can be the target for investment or not. A more subtle environment needs to be created, without black-and-white notions. As an example, a steady stream of information emanating from a warehouse, about failures in settlement, is valuable for users without being a black-and-white grade.
2. The business of grading is frought with conflicts of interest. The "issuer-pays" model disincentivises grading agencies to be critical of their clients and award unfavourable ratings. The global experience with rating of bonds has exhibited such problems.
3. The tools of coercion by the State can be applied at various levels, such as forcing warehouses to get graded, or forcing warehouses to always disclose what grade they got, etc. Careful analysis is required to use the minimal coercive power while maximally addressing the market failure.

### Conclusion

There is a market failure -- asymmetric information -- in the field of warehousing, which justifies government intervention. The intervention presently used at WDRA -- requirements applied at registration -- are not addressing the problem. The WDRA Act contains provisions which could be used to bring about a mechanism for grading warehouses. Done right, this could reduce the information asymmetry.

1. First sentence in paragraph three of the article states that “Information asymmetry is one of the classic market failures”. In my opinion the sentence needs some rethinking.

Information asymmetry is not one of the classic market failures. Asymmetric Information may cause significant problems with the efficient functioning of a market (Varian, Ch. 37, Pg. 720). In simple language, when markets do not function efficiently, it is a situation of market failure. In such situations, resource allocation is not Pareto optimal.

Akerlof (1970) Section II (B & C) clearly shows how presence of asymmetric and symmetric can change the market functioning which in turn leads to a situation of market failure. Thus it would be incorrect to say that Information asymmetry is one of the classic market failures. In fact, information asymmetry leads to a market failure.

Hence, the first line in the concluding paragraph of the article may need restructuring.

Reference:

Akerlof, G. A. (1970). The market for" lemons": Quality uncertainty and the market mechanism. The quarterly journal of economics, 488-500.

Varian, H. R., & Repcheck, J. (2010). Intermediate microeconomics: a modern approach (Vol. 8). New York: WW Norton.

2. It was my pleasure to go through an article by Ms.smriti on your blog about grading of Warehouses.
The idea was generated by the Chairman WDRA Sh.Dinesh Rai and now I think it has caught the wings and will in the real sense the WDRA may take a big flight. But ultimately will it serve the purpose of helping the low grad warehouses. I think that amendments in the rules are required to accommodate all warehouses by registering them who so ever applies for by giving a particular grade.It will be then the agreement between the depositors and the warehouse man to decide the terms and conditions.
India can not afford to have such a Act of present WDRA prescribing the high standards of warehouses, as per section 4 of the WDR Act 2007.

DR.N.K.ARORA

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