The regulation Vs subsidy debate and international trade law

Consider the three scenarios.

In the first, the government of Regulationland promulgates a law that prescribes certain domestic content requirement for equipments used in domestic solar power generators. It ensures that the local manufacturers are directly favored over imports under all conditions. It involves no direct subsidy by the government, though the entry barrier erected is an implicit subsidy protection. This is the classic pre-WTO domestic industry protection strategy.

In the second, the government of Subsidyland provides a large direct subsidy to its equipment manufacturers. This enables these manufacturers to beat off competition from their external competitors and imports. Alternatively, it also helps them outbid foreign manufacturers in their own markets. This strategy requires that the government of Subsidyland incur huge subsidy expenditures. China has been following this policy in many sectors, including renewables.

In the third, the government of Tariffland offers to purchase the output from the solar industry - generated solar power - at a (higher) concessional tariff, provided the generator meets certain local equipment sourcing requirement. This indirectly promotes local manufacturers over their external competitors. This approach is a mix of regulation and subsidy, and it reduces the huge upfront subsidy burden on governments. Canada has adopted this strategy under its FIT Program and India under its Jawaharlal Nehru National Solar Mission.

Substantively, in all the three cases, the issue involved is the same. National governments have deployed various strategies to favor their domestic solar equipment manufacturers over their foreign competitors. The objective is to promote domestic industry and prevent them from being swamped by foreign competition. Any international trade law that seeks to promote trade discrimination has to necessarily address the issues raised by all the three strategies in an equitable manner.

Why do countries adopt these different strategies? Individual nations adopt these strategies based on their respective national strengths and weaknesses - fiscal balance, strength of local industry, nature of national renewables program etc. Those unwilling or unable to spend public resources prefer the first, while those with deep pockets prefer the second. The third alternative is deployed by countries with limited fiscal space.

The international trade law provisions that regulate such measures by national governments are covered in the Article III: 4 of Trade Related Investment Measures (TRIMS). This "national treatment" rule prohibits protectionism and discriminatory treatment against imported products and in favour of domestic products. This effectively means that the regulatory restrictions of Regulationland and Tariffland are illegal.

However, and very interestingly, Article III 8 allows for payments of subsidies to domestic producers and consumers. This means that it is permissible for governments to subsidize their manufacturers by offering them direct subsidies or to subsidize consumers by providing power at concessional rates. Accordingly, the action of the government of Subsidyland and that of the Tariffland authorities in providing tariff concessions are permissible. Now there is something clearly amiss with this differential treatment.

The principle of fairness in any law demands that for any particular objective, the law should not be path dependent and should constrain or promote all sides equally. In other words, the mechanics of its implementation should not favor one country over another. In this case, given the specific objective of ensuring that foreign manufacturers of solar equipments are not discriminated against, any law should ensure that none of the three - Regulationland, Subsidyland, and Tariffland - are discriminated against or left less well-off than the others.

This effectively means that the law should equally neutralize the ability of governments to either regulate or subsidize away foreign competition. Regulation and subsidy are two sides of the same coin - a regulation is a negative subsidy (or tax) on the foreign competitor while a fiscal concession to domestic manufacturers are direct positive subsidy to them. In other words, any WTO regulation to restrict trade discrimination can itself be fair only if the degree of restraints imposed on regulation is the same as that imposed on subsidies.

Regulations in the services sector

Econ 101 teaches us that restrictive regulations distort the market and creates conditions for rent-seeking. Such regulations act as entry barriers that stifle competition and confers undue benefits on the existing producers or suppliers or owners at the cost of their prospective competitors and other consumers.

Accordingly, labour market qualification norms in service sector or product standards in manufacturing and agriculture can act to screen out potential competitors. Zoning regulations place restrictions on new residential and commercial developments, thereby keeping real estate prices artificially high. Similarly, excessive and extended copyright protection are an effective legal monopoly, transferring money from consumers to the original developers. In all these cases, apart from keeping out competitors, the regulations help the incumbents earn a premium, an economic rent, at the cost of their consumers.

The FT chronicles restrictions on taxicab permits in Milwaukee, Wisconsin, that promotes rent seeking,

It would cost $150,000, over and above the price of the vehicle itself, to buy from its existing owner one of only 321 cab licences in issue by the city... Licences are so expensive because the limit on competition makes each of Milwaukee’s taxis unusually profitable: their extra earnings are an example of an “economic rent”. These are reflected in the literal rent of up to $1,000 a week that a driver must pay for a fuelled and licensed cab...

The Milwaukee cab licences are together worth $48m – and since 1991 more than half of them have migrated to companies owned by one family: the Sanfelippos. Even at their own more modest price estimate of $80,000 their permits are worth as much as $13m.

The NYT writes about Germany's "dual economy", especially in its service sector,

On one side, we have this very dynamic, innovative, competitive and refreshingly unsubsidized export sector. On the other side, there is a much less glamorous services sector which depends on barriers to entry, subsidies and not developing and reaching out for new activities... This economy is overregulated, intended to insulate insiders from competition and deeply resistant to change... German economy features some of the same flaws... including protected professions and zoning laws that favor existing businesses over new ones...

For example, two years after a promised deregulation of domestic transportation, intercity long-distance bus service is still effectively prohibited in Germany. The decades-old ban shielded the government-owned rail company, Deutsche Bahn... years of training are still required to qualify as a house painter, chimney sweep or bicycle mechanic, to name a few examples... restrictions on advertising and fees limit competition among architects, lawyers and engineers.

In contrast to these strongly regulated service sector markets, India appears like a Chicago economists' dream. Service sector is virtually unregulated, even in the organized economy, and most of these professions have virtually no entry barriers. Ever heard of standardization or courses to become a barber, painter, plumber, or electrician? The only facade of regulation is maybe a vocational skill diploma or a driving license. For sure, it has kept prices down and people move in and out of these occupations without any hinderances. However quality has suffered.

But the market for each of these services has been getting increasingly differentiated. Those equipped with some professional training or certification command a higher premium by signalling their expertise and the assurance of better quality of service delivery. Incidentally, in all these services, market differentiation has followed the emergence of organized service delivery. In other words, as these markets move away from freelance individual-run service delivery towards organized firm-based service delivery, standardization and certification becomes important screening and signalling mechanisms and entry barriers emerge.

The challenge is to find the right mix of standardization. On the one hand, the entry barriers should not be so prohibitive as to stifle competition and constrain job creation. On the other hand, there should be some appropriate level of screening that ensures quality is not significantly compromised. A two-tier market, like in India, in the organized and unorganized sectors respectively, for each of these services, may in someways be a satisfactory compromise.

The "drugs test" for financial products

Steve Levitt points to this paper by Glen Weyl and Eric Posner who aadvocate that all financial instruments should be rigorusly screened for their social utility before they can be traded. They claim that enhanced discolusre and the use of exchanges and clearinghouses, which form the centerpiece of most financial regulation proposals, will not achieve the objective of stabilizing financial markets. They write,

"We argue that disclosure rules do not address the real problem, which is that financial firms invest enormous resources to develop financial products that facilitate gambling and regulatory arbitrage, both of which are socially wasteful activities. We propose that when investors invent new financial products, they be forbidden to market them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if and only if they satisfy a test for social utility. The test centers around a simple market analysis: is the product likely to be used more often for hedging or speculation? Other factors may be addressed if the answer is ambiguous."

The challenge with this proposal would be the definition of social utility. There is a thin line between gambling and hedging, especially with complex derivative instruments. I am not sure whether it is possible to draw any clear distinction between the two. In the circumstances, there is likely to be litigation and lobbying, which will generate incentive distortions that will benefit lawyers, lobbyists, and unscrupulous regulators.

However, a test to verify the exploitation of regulatory arbitrage stands a good chance of success and may also be socially and systemically desirable. After all, any regulation is put in place to address market failures. If market players are allowed to skirt around those regulations, it does not bode well for the stability and health of that market.

Another touchstone could be an examination of the possible conflicts of interest. This should determine who can buy and sell these products. As the events of the past few years show, regulators failed to control even basic, first-level conflicts of interests. Financial institutions like Goldman were peddling derivative products to unsuspecting clients, even as they themselves were shorting the underlying assets. Is it possible to have a code of conduct underlying the transactions for each product?

Market failure in the US Banking sector

NYT has an excellent graphic that illustrates the enormity of the huge concentration of market power in the US banking industry. Of the more than 8000 banks in the US, the top 3 have 44% of market share while the top 20 take 92%.



The Times article is spot on its assessment of the US banking sector in the aftermath of the sub-prime mortgage crisis,

Failure is as important to healthy capitalism as success. The nation’s handful of huge banks, however, are spared the indignity of failure... It’s extremely likely that all of the nation’s largest banks would have collapsed over the past three years without enormous help from the Federal Reserve. In any normally functioning market, they would have subsequently had trouble making huge profits. Instead, they’ve gotten bigger and richer.

In this context, more often than not, regulatory expansion will favor the existing entrenched big firms. In fact, even the current credit squeeze, by hurting the smaller firms disproportionately and also subsidizing the bigger firms, will only amplify the market power of the latter. This is a classic market failure, with potentially catastrophic systemic risk consequences (the TBTF moral hazard), crying out for policy intervention. The only way out of this systemic risk gridlock is to break-up the larger firms and disaggregate the concentration of market power and thereby risk.

In light of both the obvious danger of systemic risk caused by a few large firms and the fresh memory of the banking sector trends in the aftermath of the sub-prime crisis, one can only assume that policy makers are being deliberately obtuse if they can't get round to pulling the plug on the banking behemoths.

The Kingfisher bailout request - saving capitalism from capitalists!

In the past four years, bailouts have been at the center stage in many developed economies. Financial institutions, companies, and even countries have been bailed out in the aftermath of the bursting of the sub-prime mortgage bubble.

It should therefore come as no surprise that the B-word should find favor among struggling Indian companies. Sample this request from Kingfisher Airlines

"Facing serious financial turbulence, Kingfisher Airlines has sought government help for a bailout... The seriousness of the crisis was underlined by the urgent request Kingfisher owner Vijay Mallya made to finance minister Pranab Mukherjee and civil aviation minister Vayalar Ravi to help Kingfisher in infusion of funds through banks at low interest rates, besides other concessions in line with what Air India was getting."

And there are indications that this may be just the beginning. It is certain that all the other similarly struggling airlines will express their solidarity with Kingfisher and come forward with their own bailout requests. In fact, request for government help has already started,

"India’s private airlines have asked the government to cut taxes on jet fuel and force state-controlled Air India​ Ltd to raise fares, as losses mounted at private carriers that control at least 83% of the local passenger market. The airline firms have lost Rs. 3,500 crore in the six months ended September, more than the Rs. 2,900 crore they had lost in the last fiscal, according to an airline lobby group."

And what has been the government's preliminary response to this request,

"Union civil aviation minister Vayalar Ravi on Friday said he would talk to finance minister Pranab Mukherjee​ to get financially-troubled Kingfisher Airlines​ assistance from banks. The minister is also talking to state governments to reduce sales tax on aviation fuel."

The government does not need to be defensive on this. It is a great opportunity for the embattled government to atleast begin the process of its redemption. The sheer audacity and hypocrisy of the request is staggering. Kingfisher, the flag-bearer of hedonistic capitalism in India, wants equivalent treatment with a public sector entity. It wants the dregs of its orgy to be cleaned up with tax payer money. In simple terms, it is a request for socialization of private losses.

The fundamental tenet of Capitalism 101 is that market competition creates and destroys companies. In this case, a badly mismanaged Kingfisher and some other larger airlines, are reaping the sins of their earlier excesses (see this earlier blog post). Capitalism 101 tells us that when faced with such circumstances in a competitive market, we should let the market dynamics prevail. This would mean letting Kingfisher go bankrupt. Its equity holders and promoters should lose their shirts to repay the company's liabilities.

The details of the bankruptcy proceedings and resultant restructuring will vary and are debatable. There are real dangers of crony capitalism rearing its head. If the government intervenes to assist Kingfisher, there is the possibility of sweetheart debt restructuring deals, wherein portions of its debt owed to public sector banks will be foisted on them as equity without forcing the existing shareholders to take losses. In fact, there are already signs of something unpleasant brewing,

"A group of 13 lenders, including State Bank of India​ and ICICI Bank Ltd, bought a 23.21% stake in Kingfisher Airlines in April this year. SBI picked up a 5.67% stake and ICICI Bank 5.3%. The airline converted Rs. 750 crore of its total debt of Rs. 7,000 crore into equity at a 61.6% premium over its share price in what many considered a sweetheart deal. It allotted shares to lenders on 31 March at Rs. 64.48 apiece."

Kingfisher shares closed at Rs 19.65 on Friday, less than one-third the price at which the banks purchased their stakes. It was clear in April (when the stakes were purchased) that Kingfisher was on terminal decline. So why were the share purchased at such a premium? It would also be worth investigating the share transactions of the original promoters and largest equity holders in the aftermath of these deals and in recent months. It could turn out to be an excellent case study for corporate governance (or malfeasance) standards in India.

However, a note of caution is that the government should not be tempted into taking it over and merging with Air India. This would be letting the promoters of Kingfisher get away too lightly. It would be unfair on Air India. It will also generate long-term moral hazard concerns. More than anything else, it would reek of crony capitalism.

Fortunately, Kingfisher is neither too-big-to-fail nor does its bankruptcy pose any systemic risk within the industry or the financial markets. There were enough indications of this coming for some time now. It is widely known that the company is neck-deep in troubles and owes money to banks, oil companies, other airlines, DGCA, and the government (by way of taxes).

In fact, a Kingfisher bankruptcy will have several positive externalities. For a start, this outcome would be an acid test for India's bankruptcy laws. It would send out a strong signal to corporate India that private losses have to remain private and will not be borne by tax payers. The resultant disincentivization of bailout moral hazard will strengthen the institutional foundations of India's emerging capitalism. Furthermore, it will provide a much-needed boost to the beleaguered government in New Delhi. It will be a rare triple win for the government - political populism converging with sound economics and equally sound public policy.

An important dimension to this development is the role of the Director General of Civil Aviation (DGCA). What was the aviation regulatory authority doing when Kingfisher was merrily running up its Rs 7000 Cr debt? Why did it not pull the plug early? Should it not have raised the alarms much early than the belated attempts now? What powers should it be vested to ensure that such failures do not recur? Answers to these and the public policy response to the post-mortems will be a test of the government and corporate India's commitment to uphold high standards in corporate governance.

In conclusion, the Government of India is faced with the dilemma of saving capitalism from capitalists. Unfortunately, when faced with this dilemma governments have traditionally failed the test. Will this time be different?

Postscript - The fear of failure and the possibility of losing your equity through a bankruptcy is the "invisible hand" that disciplines risk-taking in any market. If this deterrent is removed, excessive risk-taking and other undesirable business practices - whose catastrophic effects have been made amply clear by the events across the world over the past few years - will be left with no institutional restraints.

Update 1 (17/11/2011)

After so many days, finally one piece of meaningful analysis of the KF crisis from Businessline.

Kingfisher's interest costs as a proportion of sales were as high as 22 per cent in the latest September quarter, compared to 6.9 per cent for Jet Airways and a negligible 1.2 per cent for low cost carrier SpiceJet. Costs other than interest payouts and fuel also seem to have had a role in Kingfisher's poor performance.

The airlines' cost per available seat kilometre (CASK), a key metric used to assess how competitive an airline is, was Rs 4.31 in the September quarter. This was much higher than the Rs 3.31 reported by Jet Airways. Of this number, Kingfisher incurred as much as Rs 2.46/SKM on costs other than fuel, 45 per cent higher than the Rs 1.69 for Jet Airways.

Incidentally, fuel cost, which is often painted as the biggest villain of the piece accounted for 54 per cent of sales for Kingfisher, compared with the 48 per cent for Jet Airways and 63 per cent for SpiceJet.

How we got here and what is the way forward with bank reforms

Andrew Haldane, Executive Director at the Bank of England, is one of the leading and credible voices championing financial regulation reforms so as to prevent a recurrence of events that led to the sub-prime mortgage meltdown. His most recent speech, the Wincott Annual Memorial Lecture, is an excellent chronicle of banking industry and summarizes his reform proposals.

He describes the source of a governance fault-line in banking sector,

"Ownership and control rights are exercised by shareholders. But for banks, equity is a vanishingly small fraction of their balance sheet. Worse still, equity-holders often have risk-taking incentives out of line with the interests of other bank stakeholders, much less society. This fault-line lies at the heart of the imbalance between privatised returns and socialised risks. Only in banking do control rights and incentive wrongs combine so uncomfortably."

He traces the evolution of the banking sector since the nineteenth century - unlimited liability moved to extended liability and finally to limited liability. Given limited liability, bank managements realized the benefits of excessive risk taking - the downside losses were capped, while the upside gains were all theirs. This meant that volatility with high upside gains increased the returns on equity. Similarly, higher leverage too enabled equity holders to amplify their returns on equity.

With equity holders having increasingly limited skin in the game, the other possible restraint on excessive risk taking, arising from debt holders (who could either have demanded higher returns on their investments or even denied their funds), too started breaking down. The disciplining role that debt holders had exercised on banks started failing for various reasons, the most prominent being the realization that governments will step in and bail out failing banks.

A measure of the too-big-to-fail (TBTF) subsidy of UK and global banks, based on different models, rose dramatically in the build-up to the sub-prime crisis. For the global banks, the TBTF subsidy is worth at least hundreds of billions of dollars per year. This subsidy is also a measure of the risk mispricing by bank debtors, and by implication also the extent of dilution in debtor discipline.



Finally, there is the executive compensation system that rewards short-term equity market gains over more sustainable value addition. Return on equity (ROE), with quarterly periodicity, has become the guiding post on evaluating manager performance and shareholder returns. Haldane describes how the shorter-term investors in bank equities gained from volatility,

"Institutional investors in equities are typically structurally long. They gain and lose symmetrically as returns rise and fall. Many shorter-term investors face no such restrictions. If their timing is right, they can win on both the upswings (when long) and the downswings (when short). For them, the road to riches is a bumpy one – and the bigger the bumps the better. As in Merton’s model, all volatility is good volatility. Perhaps reflecting that, there is evidence of the balance of shareholding having become increasingly short-term over recent years... Average holding periods for US and UK banks fell from around 3 years in 1998 to around 3 months by 2008. Banking became, quite literally, quarterly capitalism. Today, the average bank is owned by an investor with a time-horizon considerably less than a year...

What we have, then, is a set of mutually-reinforcing risk incentives. Investors shorten their horizons. They set ROE targets for management to boost their short-term stake. These targets in turn encourage short-term risk-taking behaviour. That benefits the short-term investor at the expense of the long-term, generating incentives to shorten further horizons. And so the myopia loop continues."

Increased volatility, high leverage, and distorted basis for calculating management compensation and return on shareholder investments favors the short-term investor and the management over all others. All this coupled with the basic "governance fault-line" meant that incentives became badly mis-aligned all round.

He captures the results of all this in a few stunning figures. In the 1880s, total UK bank assets were equal to 5% of GDP. At the bubble peak they were 500%. The assets of the UK’s three biggest banks at the start of the 20th century were 7% of GDP. By the end of it they were 75%, and by 2007 it was 200%. Leverage climbed from 3-4 times in the 19th century to 30 times in the bubble. And return on equity went from modest single figures to 30% at the peak. As to executive compensation among the CEOs of the seven largest US banks, in 1989 it averaged $2.8 million, or almost 100 times the median household income. By 2007, it had risen ten-fold to $26 m, over 500 times the median US household income. Most astonishingly, temporary support for the global banking system during the crisis peaked at around a quarter of global GDP.

Haldane suggests four financial market regulation proposals

1. Higher equity capital. He writes about its benefits

"It would put more skin in the game for equity-holders, thereby reducing their incentives to extract option value. It would reduce leverage directly, thereby reducing banks’ capacity to risk-up. And it would increase banks’ capacity to absorb loss, thereby reducing the probability of official intervention."

He favors much higher capital reserve ratios than that being considered under the Basel III norms. More radically, he favors equalizing the scaales between equity and debt, thereby forcing debt holders to have much greater skin in the game and encourage them to play their traditional disciplining role.

2. Equity-like liabilities

He favors the use of financial instruments which explicitly combine the incentive features of debt and equity, the so-called contingent convertible securities or CoCos. They are debt in good times, but convert to equity in bad, and combines the benefits of unlimited liability without its practical drawbacks.

However, such instruments should be time-consistent (they should kick-in without discretion and expectations of its kicking in should not distort market incentives).
He suggests that the bank management should have no discretion on when and how conversion takes place. Further, conversion needs to take place well ahead of bankruptcy, thereby avoiding the deadweight costs of default which, for too-big-to-fail institutions, are likely to be too large to be tolerable by the authorities.

As a trigger for the conversion, Haldane prefers market-based measures of capital adequacy, like even equity prices. This would be better that regulatory ratios which can be tweaked to suit requirements. Such triggers would expedite pre-emptive recapitalisation of failing institutions and contain the spread of risks.

3. Control rights

Haldane prefers a ownership and control rights model that is a right mixture of the two extremes of a public limited company (rights vested in a small minority and voting rights assigned according to portfolio weights – an equity dictatorship) and the mutually-owned co-operative (rights spread over a wide set of liability-holders, with voting rights unrelated to portfolio weights – a liability democracy). Voting rights could be extended across a wider set of liability stakeholders, with rights allocated on the basis of their deposits, thereby ensuring that governance and control are distributed across the balance sheet - a wealth-weighted democracy.

4. Performance and compensation

he advocates moving over from a system of evaluating performance based on ROE to one based on return on assets (ROA). This covers the whole balance sheet and, because it is not flattered by leverage, does a better job of adjusting for risk. He writes that if the CEOs of the seven largest US banks had in 1989 agreed to index their salaries not to ROE, but to ROA, by 2007, their compensation would not have grown tenfold but would have risen from $2.8 million to $3.4 million. Rather than rising to 500 times median US household income, it would have fallen to around 68 times.

The need to regulate consumer finance

One of the most important lessons to be learnt from the sub-prime crisis is the need for better consumer protection in financial markets. In particular, given the shockingly abysmal level of financial literacy among consumers, it was important to provide atleast the most basic level of protection against predatory practices by financial institutions.

In recognition of this imperative, the Dodd-Frank Bill in the US, last year established the Consumer Protection Bureau within the Federal Reserve Board to write and enforce rules protecting consumers of financial products and also increases the authority of state regulators to enforce protections. It would require lenders and sellers of financial products to provide plain-English disclosures, price comparisons with alternative products and clear tripwires before fees are assessed.

This issue assumes much greater relevance in developing countries where financial liberalization of recent years has brought in its wake a proliferation of attractively packaged financial products. The widespread consumer financial illiteracy coupled with skeletal regulation provides fertile ground for predatory lending practices by unscrupulous financiers to unsuspecting borrowers.

A Times article points to the havoc being wreaked by credit card debts, which have also contributed to the extensive economic growth of recent years, in some Latin American countries .

"It has also opened the door to abuses, as credit issuers have used predatory techniques to lure customers, particularly young and less affluent ones, in countries where regulation is scant, annual interest charges can top 220 percent and consumers cannot seek bankruptcy protection, economists and consumer defense groups say... troubling undercurrents in the South American economic boom: indiscriminate lending, lax regulation and ballooning over-indebtedness of large parts of the population, especially those with lower incomes."

And it points to practices that are reminiscent of those of the sterotype of unscrupulous moneylenders, used by certain retailers in Brazil and Chile who peddle consumer durables on credit,

"... among 418,000 clients (of La Polar) in Chile who fell behind on their payments and had their debts repackaged by the retailer La Polar, which raised interest rates and extended loan terms without their knowledge. In early June, it came to light that executives at La Polar had been unilaterally renegotiating clients’ debts for more than six years... The widespread proliferation of credit has been both rapid and relatively recent, developing over the past decade and spurring a consumer revolution across South America. Retail chains like La Polar in Chile and Casas Bahia in Brazil, which sell electronics and housewares, have thrived by offering relatively low-priced goods and extending easy credit terms to entire classes of people who had never had access to it."

While bank-issed credit cards have been regulated, cards issued for in-store use by retailers have enjoyed "light-touch" regulation, thereby setting the stage for a rapidly emerging household indebtedness problem in these countries.

This issue is all the more dangerous for countries like India with a history of extremities of political populism. Credit-driven financial growth has the potential to be the most dangerous form of populism. Unlike conventional electoral populism, involving handing out doles to the electorate which bankrupts the state, credit-driven populism could first bankrupt the households and then the state (in the process of bailing out the banks and the households). This danger is amplified in countries which are in the nascent stages of their financial market growth, where the major share of financial institutions are government owned and financial illiteracy is the norm.

Consider a scenario where the central bank liberalizes (or is forced into) lending regulations on consumer financing (both credit cards and for EMI-based purchases). Predatory lending is never far away and even state-owned banks too enter the fray with several easy-credit schemes. A consumer debt-bubble gets inflated in which a large number of people, especially from the lower middle-class, become exposed. Come elections and the demands start for some form of loan waiver by an electorate socialized into feeling nothing unethical about such demands. It only requires one unscrupulous political party, and there is no dearth of them, to promise write-offs on all consumer debt owed to PSU banks, to force everyone else to follow suit.

That this is not a far-fetched scenario is borne out by the numerous precedents in our history. Loan waivers have been a common feature of our political landscape for decades now. The recent state supported forced write-offs of MFI loans in Andhra Pradesh is a reminder of the vast possibilities of such a trend.

Further, apart from the political populism associated with write-offs, there are factors which strongly encourage such credit growth. For a start, such credit growth drives economic growth. Businesses make profits, consumers are happy borrowing and spending at apparently easy terms and without any hassles, policy makers are satisfied with business investments that create jobs, and bankers are thrilled at the rapid growth of their business (and lending excesses are inevitable). Most importantly, politicians benefit by keeping all these stakeholders satisfied. So where is the incentive to take away the punch-bowl?

It is in this context that more prudent regulation of the sector assumes significance. Such regulation is required to align the incentives of all stakeholders into driving the overall objectives of consumer credit flow. As the experience of Chile and Brazil shows, with increasing financial liberalization, it is only a matter of time before such practices start showing up.

Moral Hazard in Power Sector

I have blogged earlier here and here about how the possibility of contract renegotiations on competitively bid tender conditions has generated a moral hazard among infrastructure developers. Secure in the belief that the re-negotiation window is always open, they bid aggressively to win the bid.

The latest evidence of this moral hazard comes from Reliance's Coastal Andhra Power Ltd. (CAPL) stopping work at its Krishnapatnam Ultra Mega Power Project due to increase in the cost of its Indonesian coal. The developer claims that the new Indonesian Coal Price Regulation would push up the coal price and therefore cost of generation, imperil its cash flow and its ability to repay lenders.

As the Businessline writes, this development is surprising since the UMPP PPAs exclude fuel from the force majeure provisions, being specifically mentioned under Clause (a) of Article 12.4 of the PPA that lists out the 'Force Majeure Exclusions'. Further, even the 'Non-natural Force Majeure events' specified in the PPA does not include actions by a foreign government.

In other words, when the tender was called and agreement negotiated, it was clearly known to all parties that the fuel risk was solely vested with the developer. CAPL had bid aggressively in the tariff-based competitive bidding process, quoting a levelised tariff of Rs 2.33 per unit. Reliance Power has won three UMPPs so far. It is therefore, on every measure of reasonableness and contractual obligations, unacceptable for CAPL to stop work citing fuel price risks. Given precedents elsewhere by the same firm and others, this is the predictable path towards a request for re-negotiations on the terms of the contract.

It reflects a lack of professionalism, even questionable intent, on the part of the developer to have entered into the PPA without having hedged for fuel price risks. In the circumstances, the government should issue notice and get the developer to comply with its contractual commitments failing which the PPA should be terminated and the firm black-listed. It is the least that can be done to mitigate the moral hazard that has been unlreashed by frequent requests for re-negotiations.

Most importantly, the final outcome from the CAPL example could well determine the fate of tariff-based competitive bidding in India. The critical parameter in all the Case I bids are the tariffs discovered in the competitive bidding process. All bidders offer their quotes based on clearly known assumptions, of which fuel price risk being borne by bidder is the most fundamental. It is outright dishonest for any successful bidder to backtrack from the project citing fuel price increases.

Therefore, if the CERC buckles on this, it will inevitably open the floodgates for similar requests and destroy the market for tariff-based competitive bidding in the country.

Update 1 (28/7/2011)

Another example of contract renegotiations is the decision by Reliance Power Transmission's Talcher-II Transmission Company to issue the force majeure notice to electricity distribution utilities in Andhra Pradesh, Karnataka, Kerala, Tamil Nadu and Orissa. The Businessline reports that the company has cited unforeseen delays in clearances for a key transmission link being executed by it as one of the reasons for serving the notice. It has not started work on the Talcher-II transmission system that was to evacuate electricity from generation stations in the eastern region to mainly the southern States. The link was to be up by October 2012.

Overcoming the moral hazard from contract renegotiations

I had blogged earlier about the increasing trend of contract renegotiations in infrastructure concessions and the moral hazard generated by it. Such re-negotiations generate inefficiencies in multiple dimensions.

Assured of the possibility of re-negotiations, bidders offer excessive bids to win the tender. This often screens out the best developers or operators who lose out to those with the political muscle to wring out favorable terms during re-negotiations. More importantly, it results in considerable cost escalation, as the re-negotiated terms are certain to be in favor of the bidder. In simple terms, re-negotiations fritter away the efficiency and cost-effectiveness gains that come from a competitive bidding process.

This assumes significance in view of the decision of National Highways Authority of India (NHAI) to focus more on BOT Toll contracts instead of annuity concessions. BOT Toll concessions carries the risk of over/under-estimation of traffic, which in turn often opens up contract re-negotiations. Experience from such re-negotiations show that they are neither transparent nor conclusive. The controversy surrounding the re-negotiations of the Delhi-Noida Toll Bridge is a case in point.

In this context, a recent report on infrastructure public private partnerships (PPP) in the US advocates the use of present value of revenues (PVR) contracts as a means to mitigate the risk of contract renegotiations. Such renegotiations are common in infrastructure contracts which are financed with service fees, like tolls and user charges. The demand (or traffic) risk associated with such contracts is generally borne by the bidders, who cite the shortfalls to re-negotiatee contracts.

It is in this context that flexible-term contracts like PVR contracts assume relevance. In a PVR contract, the regulator sets the discount rate and the user-fee schedule, and bidders bid the present value of the user fee revenue they desire. The firm that makes the lowest bid wins and the contract term lasts until the winning firm collects the user fee revenue it demanded in its bid.

If the demand is lower than expected, the concession period is longer, and vice-versa. The resultant elimination of demand-side risks reduces the risk-premiums demanded by the concessionaires and would attract investors at lower interest rates. The UK was the first to use such variable term contracts, for the Queen Elizabeth II Bridge over the Thames River and the Second Severn bridges on the Severn estuary. Both contracts will continue till the toll collections pay off the debt issued to finance the bridges and are predicted to do so several years before the maximum franchise period.

Chile used a PVR auction to contract out the improvement of the Santiago-Valparaíso-Viña del Mar highway in 1998. It has since adopted PVR auctions as the standard to auction highway PPPs.

The report points to two other important advantages with PVR. One, it provides for a natural fair compensation payable, if the government decides to terminate the contract early. It can buy out the franchise by paying the difference between the winning bid and the discounted value of collected toll revenue at the point of repurchase (minus a simple estimate of savings in maintenance and operations expenditures due to early termination).

Second, unlike fixed term contracts, variable term contracts are especially useful in urban highways, where ex-ante fixation of tolls carries considerable risks - either too high (which causes under-utilization and reduces revenues) or too low (which results in over-use and congestion, generates a windfall for the concessionaire, and distorts his incentive to make investments in improvements). In a PVR contract, the regulator could set the toll rate efficiently to alleviate congestion (by raising or lowering it), without causing any harm to the concessionaire.

Apart from highways, port infrastructure, water reservoirs, and airport landing fields are natural candidates for a PVR. However, the real world risk with PVR contracts is the possibility that regulators will be forced into keeping user fees or toll rates low for political considerations (to not alientate the voters). This would generate sub-optimal outcomes, with the concessionaire having a longer than optimal concession period.

Why governments are important in a market economy?

Wish I had written this! Dani Rodrik has a superb explanation of the role of governments in the successful functioning of modern markets.

"Modern markets need an infrastructure of transport, logistics, and communication, much of it the result of public investments. They need systems of contract enforcement and property-rights protection. They need regulations to ensure that consumers make informed decisions, externalities are internalized, and market power is not abused. They need central banks and fiscal institutions to avert financial panics and moderate business cycles. They need social protections and safety nets to legitimize distributional outcomes.

Well-functioning markets are always embedded within broader mechanisms of collective governance. That is why the world’s wealthier economies, those with the most productive market systems, also have large public sectors."

Once we recognize this, a few things naturally follow

1. Markets require basic physical infrastructure and rule of law to be effective. Regulation is necessary to correct market failures. In other words, Governments underpin markets.

2. This, as Prof Rodrik writes, also raises the issue of who makes the rules that govern this system and then administer them. Democracy and politics inevitably follow.

3. Development of good quality infrastructure and establishment of effective administrative and governance systems do not come cheap. People need to pay taxes in return for enjoying these services. And given the low tax base, especially in countries like India, those at the top of the income ladder need to pay more.

4. Ironically, and contrary to conventional wisdom, the rich and well-off benefit disproportionately from government and its activities than the poor. They use the physical infrastructure directly and derive much greater benefits from its use than the poor. Similarly, contractual regulations and rule of law undepin much of the transactions made by the rich. In fact, in countries like India, the transactions carried out by the poor are mostly done outside the formal government institutional channels.

Back to square one - financial market regulation?

The bitter lessons of the sub-prime crisis appears to be slowly receding away from memory and the unhealthy practices that inflated the sub-prime bubble era are returning back with vengeance. Now that the markets are back to normal, atleast in appearances, the urge to return to the boom days is proving irresistible.

The latest evidence comes from the US Federal Reserve’s recent decision to allow major banks to increase their dividends and to buy back shares. The decision comes in the aftermath of the Fed's Comprehensive Capital Analysis and Review (CCAR), a cross-institution study of the capital plans of the 19 largest US bank holding companies.

In an excellent post, Simon Johnson has strongly contested this decision and the validity of the CCAR to reliably assess the strength of banks

"The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged... Bank executives and other key personnel are paid on a "return on equity" basis, so this increases their upside — that is, what they will make as long as the economy and their sector does well... Any individual bank will want to keep its equity levels low, because its executives and owners are not worried about system-wide spillover costs, such as what happens to other banks when one bank fails."

The failure risk for big banks is mitigated by the blanket insurance provided by the too-big-to-fail problem - governments cannot allow such institutions to sink for fear of a financial market meltdown. The bank executives, creditors, and even shareholders, all suffer from the moral hazard problem arising from this.

In a letter to the Financial Times, Anat R Admati and her colleague financial academics, had this to say about dividend payouts and share buybacks,

"A dollar paid out to shareholders through either dividends or share repurchases is a dollar that would not be accessible to creditors in a situation of financial distress. For this reason, and to prevent the shifting of value from debt holders to equity holders, debt covenants typically restrict dividend payments when leverage is high... taxpayers should be concerned when banks pay dividends and remain thinly capitalized, because, as we have seen, taxpayers are the ones who are likely to end up covering the banks' liabilities in a crisis... retaining earnings is generally viewed as the least costly way to raise funds and build capital, as it avoids the transactions costs associated with new equity issuance."

This debate revolves around one of the most fundamental problems in modern financial markets - who will bear the cost of addressing the systemic risks (with its massive negative externalities) that are generated by certain actions of banks, what should be that cost, and in what form should it be levied?

The sub-prime crisis has drawn attention to the dangerous consequences of excessive risk-taking and leverage, and the systemic risk created by too-interconnected to fail big financial institutions (the TBTF problem). The tax payers had to bear the burden of the massive amounts required to bailout financial institutions in the aftermath of the bursting of the mortgage bubble. It is therefore universally accepted that these financial institutions have to internalize the cost of addressing the systemic risks generated by their actions.

It is widely acknowledged that adequate equity capital and reasonably high enough counter-cyclical risk weighted capital reserves are necessary to meaningfully resolve these problems. The global banking regulators recently announced the Basel 3 regulations in an effort to mitigate the systemic risks that arise in the financial markets. However, a large number of influential financial economists have argued that the capital reserves required to address such risks are much higher than what is proposed under the Basel 3.

In an excellent NYT article Gretchen Morgenson points to a few other instances of attempted regulatory dilution as the Dodd-Frank Law becomes operational. These measures are being pushed by taking the cover of getting the securitization, derivatives and the mortgage market moving again and to buoy falling home and other asset prices.

One of the biggest achievements of the new legislation was to route all derivative trades through clearing houses and exchanges. However, now bankers are calling for exempting currency swaps from Dodd-Frank citing a provision that permits the Treasury secretary to exempt foreign-exchange swaps from the regulation. Foreign exchange swap trades are in the range of about $4 trillion a day, and trading in foreign-exchange contracts generated revenue of $9 billion in 2010 in the top five US banks, more than was produced by any other type of derivative.

Critics say that the only the only reason this market did not seize up like others during the meltdown was that the Fed lent huge amounts — $5.4 trillion — to foreign central banks through so-called swap lines during the fall of 2008. However, the Treasury Secretary Tim Geithner looks inclined to providing the exemption.

There are details of interpretation of specific provisions in the Dodd Frank law that could determine whether the relevance or otherwise of the regulation. One concerns how regulators define a 'qualified residential mortgage'. Morgenson writes,

"Issuers of asset-backed securities that are made up of such loans needn’t keep any credit risk of those securities. But sellers of loan pools that don’t consist of qualified mortgages are required to retain some of the risk in them. This provision was meant to eliminate the perverse incentives of the mortgage boom, when packagers of loan pools were encouraged to fill said pools with toxic waste because they had little or no liability for the deals once they were sold.

What constitutes a qualified mortgage has become a battleground issue because of the risk-retention rules under Dodd-Frank. Qualified mortgages should be of higher quality, based upon a borrower’s income, ability to pay and other attributes to be decided by financial regulators... Among the questions to be considered is how much of a down payment should be required in a qualified loan, and whether mortgage insurance can be used to protect against the increased risks in loans that have smaller down payments.

The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured. But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans.Lengthy litigation between the parties is under way but has by no means concluded.

Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington."

She also points to the battle to re-open trade on covered bonds - pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets, while the issuing bank retains the credit risk. The problem with this is that since the investors who bought the covered bonds would have first call on the banks' assets (over that of the FDIC), this would wind up bestowing a new form of government backing (FDIC's deposit insurance) to the major banks issuing the bonds.

And confirmation that things are indeed getting back to normal comes from the graphic below of financial sector (it accounts for less than 10% of the value added in the economy) profits, which have regained its pre-crisis share and is back to more than 30% of all domestic US profits



Felix Salmon should have the last word,

"Banks are still extracting enormous rents from the economy, and profits which should be flowing to productive industries are instead being captured by financial intermediaries. We’re back near boom-era levels of profitability now, and no one seems to worry that the flipside of higher returns is higher risk. Any dreams of seeing a smaller financial sector have now officially been dashed. And the big rebound in corporate profits since the crisis turns out to be largely a function of the one sector which we didn’t want to recover to its former size."

The impossibility of policing "insider information"

The investigations surrounding the Galleon hedge fund insider-trading scandal has provided an opportunity to observe the backroom activities that often underpin the actions of financial market traders and analysts.

In particular, of interest to readers in India, have been the revelations (transcript here and podcast here) that the former Chairman of McKinsey, Mr Rajat Gupta, was constantly passing on critical insider information to Galleon founder Mr Raj Rajaratnam, about investment decisions of firms on whose Mr Gupta was serving. The SEC, as part of its largest insider trading investigations, have found evidence that Mr Gupta passed on information to Mr Rajaratnam immediately after Goldman Sachs board meetings he attended and Mr Rajratnam in turn made investments based on that information.

The investigations have thrown up several examples of such practices. Mr Anil Kumar, a McKinsey director, put his own reputation at risk, and passed insider information about Goldman's clients, in return for $2.6 m. Mr Rajiv Goel, an Intel Manager, has testified that he passed on advance information about the semiconductor group’s earnings to Mr Rajaratnam. There are surely more skeletons that will come tumbling down as the trial progresses.

It is inevitable that insider information on business dealings will be shared during socializing within a closed friendship network of financial market executives. Such information transfers can be either part of party gossip or deliberate leakages. It is inconceivable that atleast some of this information will not be used by some members of the group to make beneficial financial investments (directly or indirectly, through their partners). Since most of these executives are also investors in these markets, the incentive to profit from such opportunities are often irresistible.

In this context, Luigi Zingales points to a working paper by Andrea Frazzini, Christopher J. Malloy, and Lauren Cohen who find that college friendship ties generate a considerable premium. They find that portfolio managers place larger bets on firms that have directors who are their college mates, earning an excess 8% annual return. He writes,

"A benign interpretation of these results is that college mates know each other better; thus, a portfolio manager has an advantage in judging the quality of the CEO better if they spent time with him or her in college. But this benign interpretation is difficult to reconcile with the finding that these positive returns are concentrated around corporate news announcements."

In simple terms, it is almost impossible to police insider information sharing within small friendship networks and investment transactions based thereon. Criminalizing such information disclosure and moral suasion to encourage executives to keep such information confidential, while partially effective, have their limits. In fact, I would be surprised if insider trading were not rampant within corporate circles. The incentives are simply too attractive for atleast a substantial numbers of actors to forego. Only those with the strongest moral character can be relied upon to constantly resist the allurements from such information sharing.

Much the same conflicts of interest entangle government officials. They come from the same stock and faced with similar incentives are likely to react no differently. Consider this. Mr Babu Ram is the official who heads the Industries Development Corporation of Briberonia. The Government of Briberonia decides to set up an ambitious Special Economic Zone (SEZ) in about 100 Acres, about 25 km away from Metropolis, its capital city. Mr Babu Ram also heads the Committee that is to soon finalize the SEZ proposal.

Mr Realtor Ram is one of Mr Babu Ram's closest friends. During one of the regular family dinners, Mr Babu Ram mentions about the SEZ proposal. Mr Realtor Ram realizes the significance of this in terms of its potential impact on land values around the proposed SEZ location. He suggests that they buy a few acres at the prevailing cheap rates in anticipation of prices rising manifold once the SEZ is developed in a few years. Accordingly, Mr Babu Ram and his friends make considerable investments in the area.

One of the distinguishing features of the real estate bubbles in many Indian cities is the close nexus between politicians, bureaucrats, and real estate developers. Property developers have made rampant use of insider information to purchase massive extents of land adjacent to upcoming (and unannounced) mega industrial and infrastructure projects.

There is a slippery slope with such information disclosures and consequent actions. Such information is often used to dispossess poor people off their lands at very cheap prices and leave them laborers on their own lands. Further, once the regulators (the officials and politicians) have themselves invested in lands surrounding a project area, they develop a stake in the project itself, which often ends up distorting the government decisions on the project itself.

Such conflicts of interest are not confined to land issues. There is the likelihood that officials administering tenders on huge infrastructure and IT projects share confidential information (again, deliberately or as party gossip) on either the tender details or rival bidders within a friendship network. This could in turn unfairly favor some bidders, often in return for some benefits for the officials. A college friendship network involving an official and a potential bidder is amongst the commonest channel for such insider information transfers.

Just as in the financial markets, the service rules of government officials specifically prohibit such information disclosures. However, like in the financial markets, this has not prevented officials from working closely with private business interests and striking mutually beneficial relationships that have caused loss to the public exchequer.

In any case, I am inclined to the belief that, contrary to the optimism of Luigi Zingales that only a small proportion of traders are rotten apples, such unethical practices are more widespread in both corporate and government circles than we would like to believe. And as simple Econ 101 would teach us, higher the stakes, greater the incentives, and greater the possibility of prevalence of such trends.

Revamping urban housing policies

A McKinsey Report (summary here) in 2010 estimated that 25 million urban households cannot afford housing, and estimates the demand to rise to 38 million by 2030. The Government of India have estimated an additional housing requirement of 26.53 million during the 11th Five Year Plan (2007-12).

Bridging this deficit is one of the biggest challenges facing urban administrators and infrastructure specialists in the country. Further, in view of the growing importance of urban growth (urban areas contributed 58% of GDP in 2008 itself), this is critical to sustaining our economic growth itself.

State governments across the country have adopted several policy variations to address this. The commonest strategy has been direct construction of housing units, either on vacant lands or on existing slums (by in-situ development). State governments have dovetailed funds from various Central Government schemes and bank loans to develop large numbers of housing units.

Another increasingly important approach has been to develop slums on public-private-partnerships (PPPs). The most popular form is one where developers are permitted to commercially develop a portion of government land allotted to them in return for constructing a defined number of dwelling units for the poor in the remaining land.

Other strategies include earmarking a portion of a layout or built-up area being developed for urban poor. The private developers would then sell these houses to the targeted category at prevailing market rates. It is hoped that this would both open up scarce urban land for housing and also cross-subsidize weaker section housing. As part of efforts to acheive the goal of "Affordable Housing for All", the National Urban Housing and Habitat Policy, 2007 (NUH&HP) mandates the reservation of "10-15 percent land in new public/ private housing projects or 20-25 percent of FAR (whichever is greater) for EWS/ LIG housing through appropriate legal stipulations and special initiatives".

The Andhra Pradesh Government has become only the latest state to notify guidelines making it mandatory to reserve 20% of developed land in all urban housing projects to the economically weaker sections (EWS) and Lower Income Groups (LIGs). This is in addition to 15% of built-up area being reserved for EWS and LIG in housing projects.

For the layouts, the maximum plot size for EWS is to be 35 sq.mts and 55 sq.mts for LIG. The plots are to be disposed to registered weaker section societies or to public agencies at prevailing market rates as per the Registration Department. Such societies should develop them as group housing schemes and not plotted development. The policy also provides for complete exemption on stamp duty, non-agriculture conversion charges, and development charges for one time registration of EWS/LIG and 50% of development charges and other fees for LIG plots.

I am afraid that such policies, while populist and logically appealing at first view, do not pass muster on rigorous analysis. For a start, they are cosmetic exercises and will do little to address the urban housing problem. Even if all the several formidable implementation problems are overlooked, the houses that can be built under this will be minuscule in comparison to the requirements, especially in the larger cities.

The fundamental objective of all these interventions should be to ensure that it increases the supply of urban housing stock with the least possible market distortions. However, such policies will not only fail to meet its objective, but will also generates market inefficiencies that can create other problems.

There are two categories of consumers who face massive urban housing shortages. The economically weaker sections, consisting mainly of migrant labor, exert the largest demand on the market. The lower-income and middle-income groups too form large shares of the demand for urban housing.

In fact, such strategies overlook the multiplicity of categories within urban poor themselves. At one end are those, primarily the LIG, who can possibly afford to buy these houses with a bank loan. At the other end of the spectrum are the largest numbers, especially the poorest, who cannot afford these houses and will be reliant on heavily subsidized housing.

More importantly, this will adversely affect the general housing market itself and conflict with the primary objective of making housing affordable for the non-poor. From the perspective of the private developer, earmarked development will effectively reduce the amount of land available for full realization of commercial opportunities.

The developers would naturally pass on this additional cost (by way of incomes foregone, the opportunity cost) to purchasers through higher prices. In other words, the buyers of the original housing units (who are not always the economically well-off) end up paying higher prices. And this too without the LIG and EWS necessarily getting houses at a low price (even if they get at low price, the government pays a very high subsidy).

In other words, the earmarking serves as a tax on home buyers. The middle-income group (MIG), themselves a large customer group and the engine that drives urban economic growth, will be the worst affected by this. Similar attempts to get developers part with a share of their housing, say by offering a share of developed space for social housing in return for additional FAR also translates into higher prices for buyers of the original units.

In any case, the extent of land that is likely to be made available through such interventions is too small to impose such a large cost on the general market itself. Finally, there is also the administrative nightmare of enforcing such programs. The wide variations in land values, itself non-transparent, complicates matters. Who are the LIG and EWS? How do we monitor the allocation process? Even if state governments agree to provide the subsidy, how will the price discovery happen and what will be subsidy? How do we ensure that these housing units are not captured by middlemen who in turn will rent it out to beneficiaries?

At a more fundamental level, the massive demand can be met only with a mix of policies that increase the supply of vacant lands and encouragess vertical growth. Since most cities have already run out of their stock of vacant and un-allocated government lands, it is important to tap the massive extents of un-utilized lands available with various government departments.

Another source for unlocking land is to re-develop the squatter settlements on government lands, both notified and un-notified slums, with multi-storied housing units. It is here that we run into the highly regressive regulatory restrictions on built-up area that can be developed in any land.

There are regulatory and infrastructural limits on vertical growth in our cities. Indian cities have amongst the lowest Floor Area Ratios (FAR), ranging from 1-3. In contrast, FSI in most Asian cities varies from 5 to 15 and in many Western cities goes up to even 25. However, such vertical expansion would also require investments in the appropriate enabling utility infrastructure.

Restrictive Floor Area Ratios (FAR) are the single biggest impediment to unlocking the potential of urban housing market in India. Among all the bigger economies, India has the lowest FAR, which restricts the amount of built-up area that can be constructed on a land. The commonplace manifestation of this is the absence of high-rise buildings in our cities. I have blogged earlier about the need for Indian cities to go vertical and infrastructure facilities to be planned to accommdate vertical growth.

As a recent World Bank paper points out, all these policies are a legacy of an era when the objective was to discourage urban migration and distribute growth to smaller cities and villages.

There are also other stifling policy restrictions. The McKinsey report found that state and central governments impose a total tax of 27% on housing. This is in addition to the several regulatory conditions that are also de-facto taxes that increase the real cost of urban housing.

Sharing network infrastructure - way forward for telecommunications?

South East Asian countries like Hong Kong and South Korea are leaders in the provision of ultra-high speed (in the range of giga bit) broadband services, and that too offered at exceptionally cheap rates. In fact, South Korea has a plan to connect every home in the country to the Internet at one gigabit per second by the end of 2012. This is in stark contrast to elsewhere even in developed economies, where broad band services are limited to a few megabits and exorbitantly expensive.

In the US, the fastest service of Verizon, the leading provider of fiber-to-the-home service, is only 50 megabits a second and it costs $144.99 a month. In contrast, Hong Kong Broadband Network offers one gigabit per second service for less than $26 a month, and it operates profitably. Similarly, a pilot gigabit project initiated by the South Korean government with 1,500 households in five South Korean cities costs 30,000 won a month, or less than $27, for a connection.

Broadband service providers in Hong Kong and South Korea undoubtedly enjoy the benefits of high population density of these countries. They also have a critical mass of consumers for these services.

A NYT article argues that in the United States, "costs would come down if several companies shared the financial burden of putting fiber into the ground and then competed on the basis of services built on top of the shared assets. That would bring multiple competitors into the picture, pushing down prices." Most broadband markets in the US have one dominant cable and phone company each.

Another reason for the lack of interest in ultra-broadband services in the US is the absence of services that require such high speeds. Uncompressed, broadcast-quality HD video, for example, uses 23 megabits a second. High speed services include those requiring two-way video-feeds like those used for tele-medicine and other services requiring video-conferencing, require software applications and service providers, apart from customers.

I am not upto speed with the latest regulatory provisions in telecom sector in India. However, the same approach could be adopted in India too where several telecom operators have already laid vast fibre optic backbone networks. In fact, fibre optic networks are today available across the length and breadth of the country, even in rural interiors. In many places, these are adequate to deliver even utlra-broadband services.

With appropriate regulatory changes, similar to the open access arrangements in electricity, telecom service providers can share their networks. The electricity distribution and transmission utilities are obliged to permit anyone to transfer electricity using their networks for payment of a fee.

In the absence of such regulatory enablers, telecom companies would be get locked up in an expensive and inefficient battle to lay competing network lines. This would crowd-out investments in content development and prevent the realization of the full potential of broadband-based service delivery. This is all the more unfortunate since unlike South Korea and other smaller developed countries, distances and problems posed by it are stumbling blocks to India's development. Education, health care, employment skills development and many other areas could be transformed if the infrastructure and softare platform to deliver broadband-based services is available.

Local Carbon Taxes Are an Innovative Band-Aid

I must say, I'm pretty proud of the county where I grew up: Montgomery County, Maryland. It just passed the first county-level carbon tax in America. It also increased the energy consumption levy on homeowners and businesses by 85 percent. This comes as only mildly surprising for an area that has long been a fairly progressive suburb of Washington, D.C.

Combined these two new sources of revenue should generate $15 million and $112 million respectively. The sad news is that the money is needed to bridge a budget deficit, and the taxes will sunset in two years. The carbon tax applies to all sources generating more than 1 million tons of CO2 in a given year, charging them $5 per ton. Ironically, only one facility makes the cut: the Dickerson Generating Plant, a coal power station. Some of the money is set to be reinvested in an energy efficiency program for local homeowners.

The tragedy here is that local legislation has become necessary in the fight against climate change precisely because of the failure to pass national and international laws. This failure produces the sort of regulatory patchwork many large businesses say they hope to avoid in their operations across multiple districts. Of course, many of those same large corporations have also lobbied against any action whatsoever.

So while I applaud the first-movers in Maryland, let's hope they also hop the Metro to Washington to put some pressure on Congress to pass a clean energy bill this year so that the Obama administration can negotiate in better faith this winter in Mexico. Meanwhile, China is set to impose a carbon tax on its industries starting in 2012.

[PHOTO CREDIT: Power lines in Dickerson, Md. by Andrew Bossi (CC).]