The city is central to India's future

Writing in Indian Express, Pratap Bhanu Mehta reminds us that the city is central to India's future.

We know that urbanisation taking place at a fairly good pace (though not as fast as it would be if the cities worked well). How might the importance of cities bubble through into the political discourse? One element of this could be redistricting: As the mass of people in cities goes up, the number of MPs and MLAs from urban constituencies would go up. I wonder whether India is well placed in terms of the algorithms for redistricting. And, I wonder whether these processes correctly take into account the large numbers of people who live in the urban sprawl that extends for many kilometres outside all cities, outside the old administrative boundaries of the city.

Some key new infrastructure projects are inadequate

From 1997 till 2002, India had a business cycle downturn. In addition, there was considerable uncertainty about the political / regulatory risk that infrastructure projects would involve. As a consequence, many of the projects which were conceived at the time involved very conservative assumptions about traffic growth. The projects of that vintage are now approaching completion, and in many cases, it looks like the traffic today already exceeds capacity. In addition, many of these older projects involved inexperienced teams on the part of both government and the infrastructure vendor. So there are quite a few blunders coming to light as these things come out the front door.

• Here's a story by K. P. Narayana Kumar and Rahul Chandran on the difficulties of the Delhi-Gurgaon expressway, and here's Sunil Jain looking under the hood. Also see this edit in Business Standard.
• Ramesh Ramanathan on the shiny new airport for Bangalore... which won't deliver the goods.
• The new airport for Hyderabad will also be commissioned this year... but the road that links it to the city will immediately choke, and a new elevated road which will solve this is over a year away. See this story by Anjuli Bhargava in Business Standard, and this piece by Sunil Jain there.

It is easy to criticise all involved. But when we look back at the 1997-2002 period, when a lot of these projects were put together, there was genuine skepticism about Indian GDP growth, and fears that traffic growth would be weak (along with unspoken fears about the extent to which politicians would exempt certain classes of traffic from paying user charges). Today, it seems easy to criticise the thought process that went in there, but how many people were buying Nifty at 930 in April 2003?

This same story will be played in reverse also, when optimistic traffic projections made around 2005-2008 will prove to be over-estimates of traffic in the next business cycle downturn.

In thinking about this, it's important to see that the whiplash of GDP growth is a problem of macro policy and not infrastructure policy. India is a third world country where neither fiscal policy nor monetary policy are working to stabilise the business cycle. As a consequence, it is entirely to be expected that there will be a sharp boom-and-bust of GDP growth, such as the recent experience where we went from 3.84% in 2002-03 to 9.62% in 2006-07.

While it is frustrating looking at the blunders underlying shiny new infrastructure that's coming online, in my opinion, an excessive focus on this trickle of old projects that are now coming to fruition would be misplaced. In my opinion, the really important thing is: How quickly and effectively are lessons drawn from these blunders, and fed back into better contracting for the massive scale of infrastructure contracting and construction that is presently underway?

Real estate - an asset class?

Many people are increasingly comfortable treating real estate as `an asset class'. It is argued that land isn't being produced, that as the population grows, demand for real estate only goes up. Astronomical prices of real estate in India encourage holding real estate assets in the hope of obtaining high profits in the future.

This proposition is debatable. There is actually ample land out there. A calculation shows that even if all of India's population had a dwelling of 1000 square feet per family of 4, this requires only 0.76% of India's land area, assuming a low FSI of 1.

In the case of equities, we know that in all countries, a diversified portfolio of equities earns a few percent per year in real terms over long time periods. Some papers show that this is not the case with real estate (!).

If land isn't scarce, then the cost of built-up housing isn't much, it's just the cost of steel and bricks. To think of it as an asset class is as odd as treating (say) a car as a financial asset. The only challenge is one of overcoming government zoning restrictions, and building enough property, so that prices can then crash.

This is part of the story of the US housing market in recent years. Thanks to sound urban policies, there are no real entry barriers to building houses in the US. Zoning rules are sensible, and the policy framework supports easy extension of urban areas into outlying barren land. When houses could be sold for more than the price of cement and steel required to make them, this kicked off a massive supply response. This kicked up GDP growth for a few years. It took a little time, but this killed off the phase of rising prices. For some time now, house prices in the US will be low because of this overhang of supply.

There are legitimate concerns about bank exposures to real estate, since the market is non-transparent and marking to market is difficult. I think it is easy to build a risk management system governing loans against shares or bonds, but I'd worry about loans against houses or cars.

There are strong concerns about foreign capital coming into the real estate sector of a country like India. It is claimed that foreign speculators will drive up prices and thus make housing unaffordable. This needs to be questioned, for foreign capital that goes into development (directly or indirectly) ultimately drives up supply and thus solves the problem (see above link).

Transforming the real estate sector requires a sustained push in terms of financial capital in development, professional management teams that will build millions of square feet instead of thousands of square feet, and a big jump in the FSI. Once these initiatives are in place, real estate prices will drop, households and businesses will find space to be much more affordable, and it will not look so good as an asset class.

Some of these pieces are now coming together. A new breed of firms are now accessing public markets to obtain capital on a scale that was previously unimaginable, and bringing modern professional organisations to bear on the task of rapidly building properties. Foreign capital and foreign firms are increasingly coming into this area, though much slower than would be the case thanks to capital controls.

The CMIE executive summary for this sector shows a growth in total assets from Rs.22,156 crore in 2004-05 to Rs.53,522 crore in 2006-07. The market capitalisation of listed firms on NSE in this sector is Rs.3,13,981 crore, and the P/E of 37.3 will attract entry. Of the 80 firms in this sector, CMIE finds that 54 have adequate liquidity to make it into the price index for this sector. These are all still small numbers compared with the size of India, but it looks like serious firms are finally coming together, that might ultimately be able to pull off a massive supply response.

In this context, I was intruiged by this story by Raghavendra Kamath in Business Standard, describing incremental supply of ~ 15 million square feet in Bombay in a year. That sounds nice, it represents the kind of dent that is required on the part of supply to make a serious difference to prices.

Wrong call by RBI

I wrote an article in Business Standard today titled Wrong call by RBI on the subject of exchange rate pegging, interest rate differentials and the recent monetary policy (non) announcement by RBI.

In recent quarters, roughly 10-15% of GDP has come in by way of net capital flows. The true capital flows into the country are larger than this, owing to capital flows that are implemented over the current account. Hence, it's reasonable to think that RBI will be forced to add $100 billion to reserves (which is less than 10% of GDP) if the present policy framework continues. My rough calculations (in the article) suggest that this involves gifting Rs.20,000 crore to the private sector. This is money that is being paid for by the common man, since the fiscal costs of sterilisation are being placed on the exchequer. This seems like an inappropriate thing to do.

My main point is that there's a huge arbitrage opportunity out there. Hence, a tonne of money will come in. Hence, monetary policy distortions will build up with a pegged exchange rate. Hence, RBI will be forced to either break the peg, or lower rates, or both.

• Why can countries like the UK or Israel hold rates while the US has cut rates? They don't run pegged exchange rates, and are hence blessed with a central bank that can think about what is right for them.
• Isn't inflation a concern, justifying high interest rates? Whether inflation is too high or too low, we are powerless to use monetary policy to deal with it once we have pegged the exchange rate.
• Doesn't this arbitrage fizzle out once RBI permits an INR appreciation and/or cuts rates? Yes, it does, but note that the long-INR + long-bond position gets an exit bonus when RBI does move. If RBI does nothing, there is a one way bet. But the profits to the position are accentuated to the extent that the INR appreciates and/or interest rates go down.
• Shouldn't we focus on the rate at which corporations can borrow and lend, rather than interest rates on government bonds, when discussing the interest rate differential? Yes, the true size of the arbitrage opportunity is the difference between the borrowing rates abroad for USD-denominated borrowing by an Indian firm against the returns available by deploying that money in India. That differential happens to be bigger than 5.3 percentage points - so this actually strengthens my case. However, from the viewpoint of monetary policy, what RBI can control is only the policy rate; it doesn't control credit spreads. Hence, the discussion is couched in terms of the policy rate.
• Isn't the Indian business cycle different from that in the US, meriting a different stance of monetary policy when compared with the US? Even if it is, once we peg the exchange rate, we have given away the ability to do monetary policy based on domestic considerations.
• Why do you say that the interest rate differential needs to be no worse than 2 percentage points? Where is that number `2' coming from? India has been rapidly opening up to the world; openness is higher than ever before. And, we're right now running a tight INR/USD pegged rate with the price moving between Rs.39 and Rs.40. With high openness (by historical standards) and low currency flexibility (by historical standards), the interest rate differential must be low (by historical standards). Look at the graph, and the number of 2 suggests itself. If India were fully open, then running a pegged rate would require an interest rate differential of zero.
• Is it wise for India to peg the exchange rate? No, it isn't, but now that we are running a pegged exchange rate regime, we have to deal with the consequences. It seems nice to peg the rate when focusing on the interests of exporters. But in the process, the larger interests of the economy get hurt.

For the backdrop to this, see the recent credit policy statement, in particular their call for capital controls:

95. In the context of a more open capital account and the size of inflows currently, public policy preference for a hierarchy of capital flows with a priority for more stable components could necessitate a more holistic approach, combining sectoral regulations with broader measures to enhance the quality of flows and make the source of flows transparent. In this context, it is critical for public policy to effectively, demonstrably and convincingly indicate commitment to managing capital flows consistent with macro fundamentals through appropriate and decisive policy actions.

And, in an interview, Y. V. Reddy said:

The US rate cut is a relevant input for monetary policy, but domestic issues predominate. Moreover, when you talk of an interest rate differential, which is the currency where you measure the difference. Since maximum carry trade was in the Japanese Yen the argument has to be in respect of Japanese Yen where there has been no change in rates. For us, domestic policy considerations dominate. In the US they are facing a slowdown but we are only seeing moderation from 8% to 8.5%. US is pumping liquidity into the markets, we are absorbing liquidity. For leading institutions in the US, profitability is under question, here banking profitability is good. We can have a convergence of a solution only when there is a convergence of the problem. I will be surprised if there is a uni-directional movement in policy rates across all countries.

If you go back and look at history, there have been occasions when we had a huge interest rate differential and we had outflows instead of inflows. US rate changes are an important but not a determining factor. It is also exchange rate expectations, view on fundamentals and there are several other factors operating. On one hand, we have to give weightage to that rate of interest that offers an optimum balance between savings and investment.

On the other hand, there is the interest rate differential. For which should you give more weight? At this point, I would repeat domestic considerations have to dominate to maintain a balance between savings and investment in India.

Finally, see these materials by Ila Patnaik: link, link and link. Update: Ila offers a big picture on the difficulties that motivate RBI reform.

Watching markets work - Was Microsoft's offer to buy Yahoo value-destroying for Microsoft shareholders?

A few days ago, I had written about Microsoft's bid for Yahoo, suggesting that this wasn't such a bright idea for shareholders of Microsoft. Maybe it was better for the board of directors of Microsoft to block such empire-building and just pay out the cash to shareholders. The graph above of intra-day stock prices over the last few days (taken from Yahoo finance; click here for the latest data) shows a striking story. (Click on the graph above to see it more clearly). The Microsoft stock price dropped by ~ 10% in response to the takeover bid while the Yahoo stock price went up by ~ 55%.

Broad books on Indian economics

My suggestions for the three good broad books on Indian economics:

1. India: The Emerging Giant by Arvind Panagariya, Oxford, 2008.
2. The Oxford Companion to Economics in India, edited by Kaushik Basu, Oxford, 2007.
3. Documenting reforms: Case studies from India, edited by S. Narayan, Macmillan and Observer Research Foundation, 2006.

See my India bookshelf.

Mulling over Microsoft's bid for Yahoo

A lot of people are dazzled when Microsoft is ready to put down $44.6 billion to buy Yahoo. In New York Times, Joe Nocera has written an article A giant bid that shows how tired the giant is that offers an unusually clear-headed interpretation.

In modern thinking, a good financial system is one where investment is based on prospects, not cashflows.

Firms with cashflow but not prospects

Some firms - like Microsoft - are producing a lot of cash, and don't have good prospects. Such firms should be paying out dividends. CEOs and managers derive private benefits from size, and always have a bias in favour of more investment. The critical task of the board of directors, in such companies, is to say to the management team: "Please don't try to use your shareholders money on projects that aren't exciting. Just pay it out to the shareholders, who will buy securities of companies with good prospects." Good corporate governance is about forcing firms with below-median prospects to pay out high dividend rates and not allow their managers to use shareholder's money suboptimally.
I'm puzzled about how the board of directors of Microsoft sees this. Could this purchase be value-destroying, because a Yahoo that's managed by Microsoft might actually be worth less? E.g. many people who like Yahoo finance and yahoo messenger today, owing to their clean software foundations, might stop using them if they are turned into Microsoft-style products. Might it be better for shareholders of Microsoft if they were paid $44.6 billion in a dividend, and then they (i.e. the shareholders) choose how to do their own diversification - which could include buying shares of Yahoo?

Firms with prospects but not cashflow

When a firm has poor cashflow (or lacks tangible assets) but has high NPV projects, a good financial system is one which is able to process information, make forecasts, understand the good projects in the hands of this firm, and get debt and equity capital to this firm.

In a bad financial system, investment follows cashflow or tangible assets, dividend payout ratios are stable across time and across firms. A good financial system is one which breaks this link; investment is also found in firms with bad cashflows (or firms that lack tangible assets), dividend payout ratios are unstable through time and dividend payout ratios are non-uniform across firms.

I have the privilege of serving on the board of directors of one company where the projects aren't good. I have tried hard to persuade the board of directors to pay out bigger dividends. It is hard.