The descent into a Banana Republic?

The quality of debate surrounding the Supreme Court's decision to cancel 122 2G spectrum licenses with the "stroke of a pen" is a reflection of the standards that prevail in public issue discourses in mainstream media in India.

Stripped off all its sensationalism, the 2G spectrum issue essentially boils down to this. The Government of the day, in its wisdom (or lack of it) and well within its rights, put in place (or inherited) a discretionary telecommunications spectrum allotment policy. However, in its implementation (during the 2008 allotments), there were clear discrepancies and irregularities, atleast in case of some of the bidders, that leave no doubts about malafide intent.

So the Supreme Court - three years after the allotments are made, operators have stabilized their full commercial operations, and a web of contractual obligations involving different market stakeholders have emerged - steps in and examines the evidence on corruption in the allotment process and puts a full-stop by cancelling all the spectrum allotments made during that period. What's more, it goes beyond the malafide intent and questions the government's use of a discretionary allotment policy and effectively seeks to "legislate" an "auction-based" allotment process. A nascent mobile telecommunications market-space, the equivalent of a mid-size European country, is decreed to be wiped out in four months.

Now consider this. A newly elected democratic government of Banana Republic, a war torn and military-ruled country in the continent of Timbuktu, decides to encourage foreign investments to boost its economy. It offers attractive concessions like free land, tax holidays, and so on in mineral exploration and manufacturing sector. Investors flock to Banana Republic, enter into sovereign contracts with its government, and start exploration and manufacuting activities. The economy booms, tax revenues increase, and the country starts its recovery from its war-era devastation. There are the inevitable tales of cronyism and corruption in some of the contracts awarded, all of which have aroused some national indignation. Then disaster strikes and the military takes power. Its first act is one of deep populism. It plays on the national resentment at the corruption in contracts signed with foreign investors and cancels all sovereign commitments of the previous government and expropriate the foreign investments. Banana Republic slips into its normal state of turmoil.

Apart from the different exterior trappings (the cancellation was at the "stroke of a pen" in the former, while it was at the "boom of a gun" in the latter), on substantive terms, is there any difference between the two scenarios? In both cases, sovereign policy commitments made by the respective democratically-elected governments of the day (whatever its flaws) and implemented deficiently (as is the case with any implementation in such societies) are, without any of the legal requirements of fairness and justice, cancelled over-night at the arbitrary discretion of a few individuals. In both cases, apart from moral hazard arising from defaulting on sovereign commitments and the long-term economic damage caused, the decision-makers have clearly over-looked the fact that much water has flowed under the bridge subsequent to the "original sin". The decisions extinguished the multiple economic transactions and contractual commitments - many of them without any malafide intent, based on legally valid legislative and executive decisions, and a consequence of the natural flow of economic activity - that have emerged after the original decisions/allotments.

Not for a moment am I holding any brief for those who violated their constitutional responsibilities or who benefited fraudulently. All of them should be brought to book for their criminal liabilities. The political masters, bureaucrats, and the businessmen who colluded to defraud the exchequer should all be throughly investigated, their criminal intent established and punishment imposed. For example, the public servants who took part in the conspiracy should be punished under the prevailing rules, while the businessmen who benefited from it should be punished under the relevant rules and the amounts defrauded quantified and collected from them and their partners. This should be done in a manner that least disrupts the competitive marketplace (and even its critics would admit that the economic outcomes - technology, business models, consumer surplus etc - of India's telecommunications reforms has been one of its economic and policy success stories) that has emerged from the original decisions.

In any case, the sovereign policy commitments of democratically elected governments, however flawed, should always prevail and not be left at the mercy of flippant individual discretion, howsoever mighty, provided the allotment process is in conformity with the broad constitutional principles. This becomes all the more important if subsequent transactions, in good faith and based on the sanctity of a sovereign commitment, have been executed on the original decision. However, law should take its course and severely punish those who displayed any malafide intent, discrepancies, and wilful omissions in the implementation of the allotment process.

The term "banana republic" is characterized by two features - a country operated as a commercial enterprise for private profit and one where the sanctity of long-term policy commitments of any of its governments is of questionable value. On these grounds, does India qualify to be a "banana republic"?

Discretionary public policy - the case of 2G spectrum allocations

This post will be provocative. I have a simplified interpretation of India's controversial 2G telecoms spectrum allocation process.

The fundamental issue is that the government of the day decided to allocate the spectrum without any competitive price discovery process, and subsequent events (spectrum resales by a few purchasers) point to the allotment having been made at a steep discount thereby causing huge losses to the public exchequer. In simple terms, the spectrum was sold cheap, and private spectrum purchasers benefitted at the expense of the tax payers.

Critics of the allotment process claim that if the spectrum was auctioned off, as happened with the subsequent 3G auctions, the government would have raised huge amounts. The bidders would have paid close to the actual cost of the spectrum. There would have been no corruption. So what gives?

Here is a thought experiment. I can imagine two forces that were generated by the low spectrum prices.

1. The substantial discounts enabled the telecom operators to keep their initial fixed investments low. They now had resources to spend on technology and more importantly, aggressive expansion. Furthermore, it gave all players the initial cushion to establish the market, without having to over-charge. Such over-pricing is a characteristic feature of any nascent market, as the first generation of firms try to establish themselves. It generally takes time before the market stabilizes and the firms start responding to market competition signals.

2. It cannot be denied that the lower spectrum prices dramatically reduced entry barriers and contributed towards creating an intensely competitive marketplace. The threshold cost to enter the market was lowered. In simple terms, the government subsidized the private operators significantly.

As the private operators got established, the market stabilized, customer base exploded, these two aforementioned factors interacted to generate fierce competition. This competition benefited the customers and the market itself.

Consider the counterfactual. Assume the spectrum was allocated by auctions. It is most certain (especially given the information asymmetry in a new market) that the process would have been affected by "winner's curse", whereby bidders would have quoted a premium on the fair market value. The successful operators would have entered the market with strained balance sheets and limited inclination to be aggressive in their investments and pricing. Instead of spectacular explosion, the market would have grown in fits and starts. Most certainly the government would have had to intervene subsequently to prop up the market with various types of fiscal concessions.

The central point I want to make is that the discounted allocations provided the operators with the required cushion to be aggressive and innovative in a nascent market. This in turn helped lay the foundation for a very competitive and vibrant telecoms market in India. The aforementioned dynamics is true of any emerging market. China is the best and most recent exemplar of the wastage, excesses, and corruption that lubricates such emerging markets.

In any typical emerging market, governments provide considerable fiscal support, directly and indirectly. In its absence, the only way in which a market can emerge is if large foreign competitors, with deep-pockets and a commitment to take sustained losses for some time, enter the market.

Much of this support is not planned and is a response to problems posed by emergent difficulties in the growth process of the particular sector. In fact, there is considerable corruption (sanitized through lobbying which conceals an equally nauseating underbelly of quid-pro-quos) involved in these policy decisions. It would be interesting if we could compare the fiscal support given to sunrise sectors like IT and biotechnology with that given to the mobile telecom sector.

The critical governance question here should be about the extent of malafide discretion involved in the allotment process. The acrimonious post-mortem has revealed that the government, or influential people within the government, played an important role in picking winners and enriching themselves at the cost of the public exchequer. It is this market failure that should be the cause for the greatest concern.

This also raises another question. If auctions would have led the market into a low-level equilibrium and discretionary allotments spawned massive corruption, what is the alternative? What process of allotment would have given the participants with the required cushion and allowed the market to develop fast without causing incentive distortions that spawn corruption? I am not sure there is any such process.

This brings us back to the inevitability, even desirability, of discretionary public policy, espcially in incubating new markets. In the circumstances, the focus should be on minimizing corruption in the discretionary public policy making space.

Internet penetration graph for the day

India may be the leader in the software industry among emerging economies. However, in the use of the platform that delivers this software, internet, it lags badly behind as this graphic illustrates.



And, as FT writes, despite the low base, it is the slowest growing market among the BRICS,

India, however, may have a decent number of people online (around 100m) but that’s only 8 per cent of the population. India’s online users growth rate is 13 per cent, which sounds fast until compared to the other three – China and Brazil are at 18 per cent and Russia is 14 per cent.

More lessons from the iPhone story

Apple has undoubtedly been the most enigmatic company of its times, a touchstone for technical excellence and commercial nous. The Economist has an excellent graphic on the iPhone 4, which shows who makes what inside the iPhone, and how much the various bits cost.



There are three observations from the graphic. One, Apple has ceased to be a manufacturer. It does not make iPhone itself - it neither manufactures the components nor assembles them into a finished product. The components come from a variety of suppliers and the assembly is done by Foxconn, a Taiwanese firm, at its plant in Shenzhen, China. This leaves Apple free to concentrate on "designing elegant, easy-to-use combinations of hardware, software and services".

Second, Samsung, which is Apple's closest competitor in the smartphones market, is also its largest supplier, accounting for 26% of the component cost of an iPhone. As The Economist writes, Samsung provides some of iPhone's most important components - the flash memory that holds the phone's apps, music and operating software; the working memory, or DRAM; and the applications processor that makes the whole thing work. This gives an insight into Samsung's own business model - "acting as a supplier of components for others gives it the scale to produce its own products more cheaply".

Third, the last two years have seen a dramatic shake-up in the global smartphones market, comparable to anything elsewhere in history. Apple's increase in market share from 13% to 19.1% pales in comparison to Samsung's spectacular rise from just 5.6% to 16.2% and Nokia's precipituous decline from 37.3% to 15.7%.

Update 1 (23/1/2012)

Even though Chinese workers contribute only about 1 percent of the value of the iPod, the export of a finished iPod to the United States directly contributes about $150 to our bilateral trade deficit with the Chinese.

Hal Varian

Winner's curse and market failures in resource allotments

One of the most controversial areas of public policy in recent years has been that involving allotment of public resources to private interests. As the role of the private participation in the economy expands, many hitherto public assets - land, mines, telecom spectrum, municipal infrastructure, etc - are increasingly being operated by private participants.

In light of the numerous resource allocation scandals in recent months, a debate has been generated about what is the most effective strategy to allot public resources. Though competitive allocation of resources appear to be the best strategy for such allotments, there are very valid enough reasons to be sceptical. Critics point to the need for governments to be flexible and retain discretion in such allotments in the larger public interest. Let us examine both sides and see how the balance sheet squares up.

Conventional wisdom would have it that competitive markets always result in efficient allocation of scarce resources. However, real world experience reveals that competition also has the potential to generate market failures that create inefficient outcomes. In particular, all sides in the bargain are vulnerable to the winner's curse - over-paying for your purchases. This happens irrespective of whether the allotments are done in a transparent and competitive manner or by discretionary allotments. So what is the most efficient method to allot public resources to private interests?

The most famous recent example of winner's curse is the 3G spectrum auctions in Europe at the turn of the century. Telecom operators who bid fantastic sums to claim 3G licenses soon realized the folly of their excessive commitments. It had a devastating impact on their balance sheets and adversely affected the sector itself. Subsequently, the subject has generated considerable research and analysis and many prescriptions have been offered on efficient auction designs (see Paul Klemperer here).

However, nothing seems to have been learnt from the European debacle by both policy makers and the industry itself. Though it is a little early to tell, there is enough evidence to suggest that most of the telecom operators in India over-bid during last year's 3G spectrum auctions. The poor latest quarterly results of these operators are an indicator of the strains imposed by their excessive bids.

All these represent classic market failures. It is astonishing that professionally competent managers who run these telecom operators could not have learnt the bitter lessons from the European auctions. Equally baffling is the failure of financial institutions that supported the respective bidders to exercise the required due diligence that would have exposed the risks inherent in such irrationally exuberant bidding. Policy makers too should take the blame for failing to take into account the inevitability of winner's curse in such auctions and their inability to design the auction so as to mitigate these risks.

However, one of the critical, albeit less-discussed, reasons for such exuberance in bidding could be attributed to the moral hazard arising from the increasing trend of contract re-negotiations. The number of recent precedents of governments permitting such re-negotiations on very specious and flimsy grounds, after the completion of a competitive price discovery process, has considerably eroded the sanctity of contracts. Bidders realize this and rationalize that they could bid on the higher side and mitigate any risk of winner's curse by lobbying to re-negotiate away the unpalatable terms and conditions. And when all bidders play the game on the same assumptions, then winner's curse becomes superfluous.

There is another side to the debate. Economies in transition, especially in a closely integrated world, face an interesting dilemma. On the one hand, they have to compete with others to attract investments and engender business confidence. This competition exists among nations and within them between regions. Governments therefore have to accommodate the requirements of this competitive environment and tailor policies that encourage investors. This often demands discretion-based decisions that appear to favor or provide preferential treatment to certain private groups or firms.

Consider this. A state government faces stiff competition from other states to provide additional incentives to lure say, an IT company, to prefer the state over competitors to set up its new development center. Apart from standard infrastructure sops (like assured quality of power, good connectivity etc), such incentives typically include fiscal concessions, exclusive infrastructure, and additional land. Over the past few years, states have wooed such investors with huge land allotments, far in excess of the specific investment requirements.

Arriving at the right type and degree of incentives is at best of times a very difficult exercise. There is a fundamental information asymmetry in this process. The private firm has clear information of what are the respective offers of individual states and can make its decision based on them. However, the state governments work in an environment of information asymmetry. Unaware of the promises and intentions of their competitors, a state government is forced into marking up its offer on the higher side so as to pre-empt its competitors. The private firm is fully aware of this game and contributes more than its fair share to exacerbating the information asymmetry and trying to bargain the best possible deal from its interlocutor states. The net result is that the successful government invariably ends up with a winner's curse by offering excessive concessions.

Since the environment in which these decisions have to be taken is bedevilled with information asymmetry, it is no surprise that preferential offers made to attract individual investments are mostly controversial and involve some form of corruption.

More worryingly, this challenge has to be managed by public institutions and a civil society that are rarely strong enough to exercise the vigilance required for ensuring fairness in such decisions. Most often, the public institutions are captured by the private firm and the terms of the bargain severely compromised against public interest.

The civil society and its opinion makers mistake the trees for the woods by falling prey to the attraction of a public media trial of a few scapegoats. The public debate gets circumscribed and rarely tries to address the problem with systemic solutions.

Given the prevalance of winner's curse with both strategies, how do we address the problem of public resource allotments? In an ideal world, the benevolent and wise ruler would negotiate with the best interests of his citizens at heart and commit just enough concessions to tip the investment in their favor. But as discussed, the real world is rife with information asymmetry, moral hazard, and winner's curse. Besides there are real-people (read officials and politicians) prone to colluding with unscrupulous investors and a public who are either powerless or distracted by media trials and the lure of instant justice.

Allotments of public resources by way of both competitive bidding and discretionary approaches face the problem of winner's curse. In the former, the private firms end up over-paying and ultimately ending up defaulting or atleast compromising on its commitments. In case of the latter, public resources get allotted on the cheap to private interests.

So the issue boils down to which approach is likely to work best, given these circumstances? Alternatively, which risk - winner's curse for bidders or governments - is less difficult to mitigate? Here, I am inclined to hold that ensuring transparency in the process of allotments of public resources on a discretionary mode, even through empowered committees of eminent people (who are the eminent people and how honest are they), is an almost impossible task in most developing countries, including India. Institutional mechanisms to minimize corruption is difficult to implement for a variety of reasons.

However, markets are versatile enough to mitigate the adverse consequences of winner's curse. After all, the fundamental ideological issue here is over whether the individual wisdom and knowledge of government (and a few of its officials) is superior to the collective wisdom of the market in both ensuring most efficient price discovery and in mitigating the effects of possible incentive distortions like winner's curse. This debate has been settled for some time now.

However, if markets are to determine the allotment process, it is important to structure its institutional design details by taking into account the specific issues related to the sector and lessons from failures across the world. Besides trying to resolve any winner's curse, the design should also address the other sector-specific problems that come in the way of success with such allotments. This not only ensures transparency and efficiency, it can also mitigate the consequences of the market failures that result from various incentive distortions.

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.

The amazing pace of mobile phone penetration

Two graphics that puts the pace at which mobile phone usage has expanded in perpective. First, mobile phones have been adopted more than five times as fast as fixed line telephone services, which took 100 years to reach 80% of country populations.



The speed of its adoption remains unprecedented.



(HT: William Jack and Tavneet Suri)

Research Proposal on Telecommunication

Introduction
In this research proposal paper, I will present the following four topics: a summary of the competitive landscape of the telecommunications industry; competition: is more or less necessary in the industry; how competition has influenced my business and life; and what leaders should consider when selecting partners from these competitors.

Competitive Landscape Summary
The competitive landscape of the telecommunications industry has become a major race down the information superhighway. With technological advancements creating new and better ways to communicate, competition in the telecommunications industry seems to have become more than just local and long distance services; these services now include voice, data, Internet access, cable TV, and multimedia. Because of this expansion, competition has become a major challenge (Bonocore 4). The emergence of so many providers makes competition possible, but it may not be the fierce competition of firms offering identical services as in long-distance telephony. Each of these technologies is distinctly different, with advantages and disadvantages. Even if there are many providers that could serve a given residence, there may only be one that can provide what that customer wants (Peha). There are too many companies to determine which ones will come out on top, but Bonocore feels that these six companies have a chance, they are: AT&T, MCI WorldCom, SBC Communications, Verizon Communications, Deutsche Telekom, and British Telecommunications (24 - 30).
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Competition: More or Less
Since the AT&T divestiture in 1984, competition has finally been realized in the telecommunications industry. Long distance services became the first open market for competition; local service has now become the most recent area for competition. In 1999, the Federal Communications Commission (FCC) granted NYNEX, one of the Baby Bells, access to long distance; this opened the doors for the other Baby Bells to enter as well (Verizon). But before this access was granted in 1996 to competitive local exchange carriers (CLECs) who entered the local service market and grew in number (Telecommunications Act of 1996). With all these companies in the market place, is more or less competition necessary in the industry? This answer has two parts for me; with more competition it could possibly lead to confusion for the customer. Excessive competition could possibly lead to many companies going out of business, with the end result possibly being one company dominating the market again. So, what I think needs to happen would be a level playing field of either several companies who would offer all of these communication technologies or several different companies that offer only a few of the different services available. With all of the different procedures and rules that go with all of these new services, I do not think that one company could handle all of them efficiently and keep up with quality and commitment to customer service.

Competition Influence
My experience with competition in the telecommunications industry has been quite interesting. Considering I work for one of the major telecommunications companies on the east coast, Verizon, I have felt the brunt of competition take its toll on the company. I watched many companies enter local service by using Verizon’s facilities and also saw customers change from one provider to the next many times over. The FCC and the Pennsylvania Public Utilities Commission (PUC) would not allow Verizon to enter the long distance market until after they proved themselves by completing a checklist of thirteen items to demonstrate commitment in the competitive market in local service before they could enter the long distance market (Bonocore 82). Once Verizon entered the long distance market, I changed my long distance carrier and now have Verizon for all my telephone communication needs.

Leaders Selecting Partners
These are some of the considerations telecommunications leaders should have when selecting partners from the competitors in the telecommunications industry, they are:
· Data - Know the companies infrastructure; how and why they use it
· Basic connectivity – what the company uses for Internet access
· Understand the companies’ WAN integration; call center integration, and contractual reconciliation/resolution (Gable).
· Determination of the best suitable company with the leaders company
· Customer-managed network

Summary
The competitive landscape in the telecommunications industry has changed from one source to hundreds of sources since 1984. The industry went from a monopoly of AT&T to several hundred long distance and local service providers. The future of competition in the telecommunications industry is not company dependent anymore; Bonocore stated, “The real winners in the future will be those businesses that don’t get stuck in traffic at the usual bottlenecks, but are able to break away and make customer-managed their next – and final – destination” (111). Telecommunications businesses and leaders, it seems, will have to change their way of thinking due to the amount of competition, the growth of technology, and customers demands in order to survive and prosper. Telecommunications competition could be bad if there are not enough or too many companies in the industry. With all of the acquisitions and mergers taking place, the leaders in telecommunications industry will need to determine exactly how their business vision will fit in the changing market place before choosing to merge or acquire a business. The bottom line is that competition in the telecommunications industry has just begun, so the future will be the true determination of the businesses that survive.

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