India's human resource skill deficit fact of the day

A report on India's infrastructure requirements by realty consultant Jones Lang LaSalle for Royal Institution of Chartered Surveyors (RICS) has a glimpse of the formidable challenges facing India's infrastructure sector.

It projects that about 97 million jobs are likely to be created over the 2010-20 period across different sectors in the country. This is estimated to result in the construction of an average of 8.7 billion sq ft of real estate space every year, adding up to a whopping 95 billion sq ft in the ten year period. Its concerns about the deficiency in skilled manpower in construction sector is instructive,

"As of 2011, the supply of professionals in built environment comprises nearly 50 million people, of which only 2 million are professionally qualified (across core and non core professionals). The remaining are mainly unskilled workers. Built environment, comprising construction and real estate related activities... accounts for approximately 17.7% of GDP in 200910.

There is a demand-supply gap in the range of 82-86% in the core professions group comprising civil engineers, architects and planners. To deliver potential real estate space and planned infrastructure, India needs nearly 4 million civil engineers, 396,000 architects and 119,000 planners on an average, over the next decade. However the corresponding average supply available would only be 642,000 civil engineers, 65,000 architects and 18,000 planners.

A sustained period of shortfall in annual supply, coupled with an increasing year on year demand, could result in a cumulative demand of nearly 45 million core professionals, over 2010-20, with a cumulative demand-supply gap of approximately 44 million core professionals over the same period."

The "long" fiscal stimulus - a belated recognition of infrastructure spending?

Prof Tyler Cowen has a strange post. He points to the inadequacy of short-term stimulus spending, however large, to tide over deleveraging balance sheet recessions. He is therefore surprised that

"For all the talk of a 'large stimulus', you don’t hear much about a 'longer stimulus'."

He has this concern about short-term pump priming, whatever its size,

"The problem with a 'too small' stimulus is that you get an initial economic boost, but when the stimulus expires the economy slumps back down, as indeed happened in mid 2011. Ideally a stimulus employs some idle labor, stops it from depreciating, and tides those workers over until they can look for other jobs in fundamentally better economic conditions... If conditions are not improving soon, the ability of the stimulus to 'buy time' for those workers isn’t worth much... We end up having spent a lot of money to postpone our adjustment problems, rather than achieving takeoff. Deleveraging recessions last a long time, as shown by Rogoff and Reinhart. The need for continuing deleveraging implies that even a stimulus twice the size of ARRA won’t turn the tide."

In the circumstances, his suggestion,

"In those cases a well-designed stimulus program should not be so 'timely'. For a given presented expected value sum spent on stimulus, it is better to spread it out across the years. It is better to help a smaller set of workers for five years (or however many years it takes for most of the deleveraging to end), after which they are reemployable, than to temporarily boost a larger number of workers for two years, and then leave them back in the dust because deleveraging is still going on."

Here we go! There appears to be, to put it very charitably, an element of selective amnesia in Tyler's post here. This is effectively an admission of ideological failure (or, is it an error of judgement?) and an advocacy for focusing stimulus spending on creating durable public infrastructure assets atleast now.



In some sense, it is a classic case of the two-handed economist at work, albeit with a time lag in the action of the two hands. The one hand which had considered, debated and opposed the same when the ARRA was being formulated now appears to have changed track and embraced infrastructure spending when the earlier assumptions were proved wrong.



As early as late 2008, when the ARRA was being conceptualized, there was an intense and often acrimonious debate about the nature of the stimulus. Conservatives, who even then opposed any fiscal action, were willing to go only as far as tax cuts. They had opposed it on the grounds that there was no shelf of "shovel ready" infrastructure projects and that such spending takes time before its shows any stimulus effect on the economy. Marginal Revolution itself had directly posted and linked to several such views. In contrast, liberal economists like Paul Krugman, Mark Thoma and Brad DeLong felt that the recession was likely to persist for long and therefore preferred direct spending in infrastructure assets.



From hindsight, even the most conservative of economists would admit that the best course of fiscal policy action in late 2008 would have been to spend money on public infrastructure creation. The ultra-low interest rates, now certain to persist well into 2013 and atleast for a couple of years beyond that, would have provided unbelievably cheap financing for atleast 7-8 years. If in 2006, Congressmen and academics had been offered the prospect of accessing interest free loan for 8-10 years to repair America's battered infrastructure, many of them would have readily grabbed that opportunity. In fact, even the China-bashing Americans would have derived some vicarious pleasure from the realization that China was subsidizing America's infrastructure creation by offering virtually interest free loans!



In fact, Tyler's invocation of Reinhart-Rogoff now to fortify his argument about the pernicious nature of deleveraging recessions, appears to be a case of "what is sauce for the goose (is not) sauce for the gander"! Interestingly, Messers Krugman and Co had then invoked precisely the same duo to base their claim for infrastructure spending based stimulus. They had argued, based on the substantial body of empirical evidence presented by Reinhart-Rogoff about the average lengths of banking crisis induced recessions, that the Great Recession was likely to be a long drawn out one and therefore there was enough time for infrastructure spending to be effective.



The ideal course of action in late 2008 would have been to adopt a two-pronged approach, one which many of the aforementioned liberal/Keynesian economists did advocate, involving long-term stimulus on infrastructure creation and automatic stabilizers like unemployment insurance and food stamps to cushion the worst hit by the recession. Any tax cuts and other stimulus spending would have been an additional bonus.



I am inclined to believe that the impact of such spending on the economy as a whole would have been positive in many dimensions. Apart from the fact that it would have repaired or replaced the country's battered infrastructure, it would also have generated a significant multiplier on the economy on many fronts. It would have brought to work idle resources, encouraged businesses to not postpone investments, spurred market confidence (yes, the "confidence fairy"!) in the long-term health of the country, and so on. Given the fact that these investments were in any case necessary, one would also have to add the opportunity cost benefits of the ultra-low interest rates to calculate the multiplier.



In view of all the aforementioned, the final paragraph to Tyler's post is a sad commentary of the dark age of macroeconomics,

"Oddly, there is not much discussion about the length of fiscal stimulus. But there should be."

PS: I just did not have to energy to mine the numerous links in MR, and Krugman, Thoma and DeLong's blogs that contain the specific material from 2008-09 that I have alluded to in the post. I guess I am lazy! Anyways, interested readers could do so from here and here.

The construction risk transfer through takeout financing

I had blogged earlier about how infrastructure financing can be made more attractive for investors by a two-step financing pattern. This would involve separating the construction activity and its attendant risks from the project life-cycle costs and financing the two separately.



This approach assumes importance in view of the considerable construction risks associated with many infrastructure projects in India, which in turn increases the financing cost and therefore raises doubts about its financial viability. The broad strategy would therefore be to finance the construction with short-term loans, preferably raised by the government (since government is best able to bear the common site-clearance related construction risks) and then swap the loan with long-term bonds once the construction is completed and construction risk has been off-loaded.



In this context, the recent announcement on liberalised takeout financing conditions by the state-owned India Infrastructure Finance Company Ltd (IIFCL) assumes significance. The IIFCL plans to take over projects immediately after their commercial operation date (COD) from the original financiers (mainly banks) and pass on interest rate concessions to project developers. As part of this, a lender financing the infrastructure project can enter into an arrangement with IIFCL for transferring to the latter the outstanding in respect of such financing in its books on a pre-determined basis.



Takeout financing is attractive to banks as it addresses sectoral/group exposure issues and asset-liability mismatch concerns (banks give most of their loans as short-term ones, 3-5 years). Interest rates on the loan taken out by IIFCL is likely to be an estimated 75-200 basis points lower than the original project loan. The project developer would benefit from this reduction in cost of capital. The IIFCL has so far inked takeout financing agreements aggregating about Rs 3,100 crore with a host of banks, including Union Bank of India (Rs 1,020 crore), Central Bank of India (Rs 1,000 crore); Punjab National Bank (Rs 180 crore), and Punjab National Bank (Rs 600 crore).



This intermediation role by the IIFCL will align the incentives of all project parties to commission the project within time and access the take-out loan swap at the much lower cost of capital.

Catch-up growth and global convergence

Citigroup economists Willem H. Buiter and Ebrahim Rahbari, who earlier identified 11 global growth generating (3G) economies for the first half of this century, have another paper investigating the likely future sources of global economic growth between 2010 and 2050.

They use 40 year economic forecasts by Citi economists, historical GDP data for the most recent 10-year period, and available economic research on the drivers of long-term growth, to examine national-level global growth generators. They assume United States as the technology frontier country and draw the distinction between growth at the technology frontier (productivity growth at the frontier) and catch-up or convergence growth (mainly through adoption and importation of best-practice technology and know-how from the frontier countries). Naturally, they foresee most of the global growth to come from the latter source.

Their earlier 3G index aggregates some key growth drivers - gross fixed domestic capital formation; gross domestic saving; a measure of human capital (which aggregates demographic, health and educational achievement indices); a measure of institutional quality; a measure of trade openness; and the initial level of per capita income. Their final analysis and prescription about how a country grows fast

"1. Start poor
2. Start young
3. Open up to trade in goods and services and to foreign direct investment
4. Achieve reasonable political stability (the absence of significant external and internal conflict)
5. Create some semblance of a functioning market economy
6. Boost the domestic saving and investment rates
7. Invest in human capital (educate and train both boys and girls, focusing on pre-school, primary and secondary education and on vocational training)
8. Invest in infrastructure
9. Don’t be unlucky. Avoid war-like neighbours and natural disasters
10. Don’t blow it. Avoid internal conflict and populist assaults on the incentives to work, save and invest; avoid macroeconomic mismanagement, premature capital account
liberalisation and financial regulatory disasters.

Catch-up and convergence will do the rest."

If we examine the Indian economy with respect to these ten attributes/tenets, the picture is indeed encouraging, especially if point 9 is taken care of. Points 1, 2, 4, and 5 are inherent and historical advantages. Points 3 and 6 are true reform achievements. Even point 7 is being addressed. This leaves us with the real concerns - points 8 and 10.

All our immediate (inflation) and long term (growth prospects and convergence growth pace) macroeconomic challenges are closely linked with infrastructure. This is all the more so since infrastructure forms the basic platform that underpins the growth of the modern economy. We need to plan, design, raise resources and execute massively in all infrastructure sectors. And even if we mobilize the resources and show the requisite commitment to conceptualize and create infrastructure, the greater challenge is to ensure that we do not blow it up.

Here I am not worried about macroeconomic mismanagement nor financial market problems nor even corruption or internal conflicts. All these dangers always lurk around the corner and will even explode once a while, but when seen in historic perspective and when analyzing growth prospects over half-century, they are all surmountable, especially for a continental economy like India. A real worry will be with picking up the pieces from the "populist assaults on the incentives to work, save and invest". I will come back and post on this in the days ahead.

China's Local Government Debts

One of the most intriguing questions for Indians marvelling at China's spectacular economic growth is about how its government manages to finance a never-ending shelf of mega infrastructure projects entailing extraordinary investments. For all its governance failures, corruption, resistance to reforms and recent political paralysis, the fundamental problem for a chronically infrastructure deficient India remains paucity of resources to finance its massive infrastructure requirements.

The contrast with a flush-with-funds China is stark. However, as the Times points out in an excellent article chronicling the challenges facing China's increasingly infrastructure investment dominated economic growth push, things may not be as rosy as it appears across our northern borders.

As the Great Recession took hold, the Chinese government stepped in with a mssive $580 bn stimulus package. Local governments across China borrowed heavily from state-owned banks and pumped money into infrastructure. Infrastructure replaced exports as the engine of economic growth.

The Times reports that spending on so-called fixed-asset investment (infrastructure and real estate projects) is now equal to nearly 70% of the nation’s GDP, a sign of dangerous over-dependence on infrastructure spending. It is a ratio unheard of in modern times for any nation, with the ratio being just 35% for Japan during its 1980s building boom and 20% for US for decades now.



Now this model is becoming unsustainable as local government debts, cleverly hidden from the local government balance sheet through accounting tricks, mount and repayment strains start appearing. The National Audit Office recently released figures showing that the local governments had amassed 10.7 trillion yuan ($1.65 trillion) in debt as of the end of December, amounting to 26.9% of GDP in 2010. Of this debt, local governments are explicitly responsible for repaying 62.6%, have guaranteed 21.8%, and are required to partially repay 15.6%. Worryingly, the report writes that nearly half the debt was accumulated in just two years by way of the loan-powered fiscal stimulus of 2009-10. This debt, mainly owed to state-run banks, poses serious risks for the Chinese financial system.

Most local governments borrow through special investment corporations set up by them and their debt shows up nowhere on its official balance sheet. Such local government financing vehicles (LGFV) were set up to get around rules forbidding them from borrowing directly from banks and raising funds through municipal bonds and also conceal the true extent of local government debts. These LGFVs were set up to finance light rail projects, bridges etc. It is estimated that there are more than 10,000 of these local government financing entities in China.

In fact, the audit office said 46.4% of the debt is held by such intermediary vehicles. Another recent report from the People's Bank of China had said that local government financing vehicles had taken out loans worth up to 30% of total outstanding bank loans or 14 trillion yuan. The collateral for many loans is local land valued at lofty prices that could collapse if China’s real estate bubble burst.

An earlier estimate by the Northwestern University Prof. Victor Shih found that the total local government financing platform debt was around 11.4 trillion yuan ($1.75 trillion) at the end of 2009. His latest estimate of total local governmental debt ranges between 15.4 trillion yuan and 20.1 trillion yuan, or 40% to 50% of China's 2010 GDP. He also estimates that LGFV interest payments are at least 1 trillion yuan a year, and realistically more than 2 trillion yuan.

Another report by Moody's says that the audit office's data fails to account for about 3.5 trillion yuan, or about $540 billion, of loans to local governments. It also estimates that the Chinese banking system's nonperforming loans could reach between 8% and 12% of total loans. This is in stark contrast to the official ratio of non-performing loans of 1.14% at the end of 2010.‬

The biggest concern is a possible rise in inflation, which would force the central bank into raising interest rates. In fact, yesterday the People's Bank raised interest rates for the third time this year in order to cool the sizzling pace of economic growth, estimated to touch 11.9% in the seond quarter. Inflation is up 4.4% for June, the highest rate in more than two years and above the 3% target set by central bank.

In fact, the threat of the whole pack of cards collapsing when faced with higher interest rates is also behind the reluctance of authorities to rein in the bubble. As Prof Shih argues, the only way to cool down the continuously inflating debt bubble and credit flows is by engineering a credit crunch. Unfortunately, this would entail raising interest rates, with all its possible adverse consequences.

There have been rumors that the government is considering write-off about 2-3 trillion ($300-470 bn) in debts owed by local governments to the country's China's top banks. Though this would force losses on banks, local and central governments, it should reduce the risks that cloud the Chinese economy. Fortunately, a banking crisis would not have the sort direct impact on consumers as witnessed in the US since the Chinese citizens save heavily and have limited exposure to mortgages and other financial investments.

The debt build-up also amplified the already frothy real estate market, which was pushed up further by the stimulus spending in 2010 and 2011. A large share of this spending was routed into real-estate related infrastructure. Chinese state-owned banks, on government orders, lent about $3 trillion mostly to giant state-owned enterprises and local governments to fight the effects of the downturn. Though intended at infrastructure, a substantial share of these loans wound up financing real-estate purchases by government agencies.

Further, in the absence of financial alternatives to beat inflation, Chinese savers piled into real estate and drove residential property prices up by half to about 9% of GDP between 2006 and 2010. In that period, real-estate prices in major cities in China roughly doubled.

The continuing paucity of investment avenues coupled with exceptionally high savings rates and the reliance of local governments on land sales for revenue means that property prices could go higher before the bubble bursts. The Standard Chartered estimates that about 50% of China's GDP is linked to the fate of its real-estate market (it affects construction, steel, concrete, power and appliance industries), making a potential bust extremely damaging. A banking crisis would be inevitable.

See also this Times Room for Debate on China's local government debt.

The Great Indian Inflation Challenge

The great Indian inflation debate shows no signs of abating and if the prevailing trends are any indication, it may continue well into the foreseeable future. The RBI recently enacted its 13th continuous repo rate increase in an attempt to bring inflationary pressures under control. But monetary policy may be on its last legs as the negative impact of high interest rates on economic growth already appears to have become predominant.

In the circumstances, it is not surprising that inflation has become a political football. Opposition parties, civil society organizations, and opinion makers in the media cry hoarse at the government's inability to bring down food prices. They blame everything from bad policies to corruption to inefficient bureaucracy to hoarding for the persistence of inflation. Why is the inflation monster becoming so intractable?

Econ 101 teaches us that economies are at their most efficient when they grow at their production possibility frontier, which is a function of the basic resources - manpower, capital, and infrastructure - available in the economy. Any economic growth is under-pinned by these available resources. As economies expand at their natural pace, it accumulates these resources, and a positive virtuous spiral of growth is generated - growth brings in tax revenues, which are funneled into capital investments, which in turn creates the platform for further growth.

However, when the economy experience a sudden growth spurt, wherein the trend rate of growth is suddenly lifted up, the available resources often get depleted quickly and its growth may fail to keep pace with the needs of economic expansion. In simple terms, the economy grows much faster than the supply of resources required to sustain the expansion. More factory capacity is built up than electricity supply can support; manufacturing production exceeds the ability of transportation facilities to move them by road, water and air; cities grow much faster than local governments can provide civic infrastructure facilities and so on. The economy is "over-heating".

Amplifying all this is the impact of growing incomes generated by the booming economy, which changes people's living habits and expenditure patterns. If coincidentally the government is indulging in some direct fiscal spending to boost incomes across the board, then the demand pressures burst open. In such circumstances, where aggregate demand is on the up and the supply infrastructure and other basic resources not keeping pace with the requirements, inflationary pressures are inevitable.

India is experiencing something similar to that described above. A decades long trend annual growth rate of around 5% suddenly gave way to near double-digit rates since the turn of the century. Once the initial slack and spurt of government investments had run its course, the supply constraints started showing up. The supply of capital resources stagnated and failed to keep pace with galloping demand.

Targets in critical infrastructure areas like provision of civic utilities, roads, power generation, port capacity addition, agriculture storage etc were repeatedly missed. A severe shortage of skilled factory and construction manpower and qualified engineering personnel has very badly affected businesses. The high interest rates are only exacerbating this trend by creating constraints on the supply of capital.

The well-intentioned NREGS has had the direct impact of giving thousands of crores of additional cash in the hands of rural poor, besides boosting labour wages across the board. The income effect created by all this has increased disposable incomes and boosted aggregate demand across the economy. The supply-side has badly lagged behind this huge spurt in demand. Inflation was almost inevitable and will persist till these conditions change.

It is clear that while the demand side is robust, the supply side appears constrained. The rise in inflation is therefore more due to cost push factors than demand pull ones. The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The major domestic supply side bottle necks that have been driving prices up include stagnating agricultural production and over-stretched infrastructure, especially power and transport logistics.

Assuming that the lions share of infrastructure investments should have come from governments, it would be reasonable to expect government investments to have increased atleast as spectacularly as the recent spike in GDP growth rates. However, even as gross fixed capital formation as a share of GDP has increased impressively since about 2003, government consumption as a share of GDP has remained stagnant. This is despite the considerable increases in government consumption by way of petroleum and other subsidies in recent years. It can be safely presumed that government capital investments, especially in infrastructure, lags badly and remains woefully inadequate.



On a historic perspective, India's economy has, atleast since about 2003, reached a new and higher growth phase. However, this (involving the near doubling of the average growth rates from about 5% annually to about 10%) has not been accompanied by any commensurate increase in government consumption (the spurt in 2008 can be attributed to the different kinds of stimulus spending).



The choices facing the Indian economy are stark. If it has to rein in inflation in the foreseeable future, capital investments in physical infrastructure and human resources will have to increase exponentially. Or else, faced with chronic supply constraints, inflation will persist, and ultimately growth itself will get compressed. Either are not easily resolved and will take considerable time.

The most plausible scenario appears to be a slip back into an intermediate trend growth trajectory, where moderation of growth stabilizes inflationary pressures. Hopefully, this time, the government gets its act together and channels massive investments into basic physical and human infrastructure, so as to set the stage for recovering back into the current high trend growth stage quickly.

PS: Once the over-heating economy line of reasoning is accepted, the central bank faces no trade-off between inflation targeting and economic growth. The objective then is to do monetary tightening so as to cool down economic growth to a level where the supply-side growth is in sync with the aggregate demand growth. The danger of course is that no-one knows how much tightening or cooling is optimal!

Update 1 (4/7/2011)

Evidence of overheating economy comes from this graphical survey by The Economist. Using inflation, current GDP and employment growth rates over the average of the past decade, credit growth rate, and current account deficits, it finds that India is among those handful of emerging economies which are clearly overheating.

Infrastructure facts - India Vs China

The 1318 km Beijing-Shanghai high-speed rail link, the longest in the world, and constructed within three years at a cost of $33 bn, is just one in the long list of mega infrastructure projects that China has been executing. To just put this in perspective, the total outlay for India's flagship urban development program, the Jawaharlal Nehru National Urban Renewal Mission, covering 64 largest cities in the country, including the metros, and spread over five years (2005-10) was slightly more than $20 bn.

The Bandra-Worli Sea Link (BWSL), built at a cost of Rs 1800 Cr (or ~$400 mn), several years behind schedule and with substantial cost over-runs, was greeted with much national rejoicing as further proof of our arrival as a big economic power. The Hangzhou Bay Bridge, the world's longest cross-sea bridge project, was built at a cost of $16 bn.

The comparison with China is truly humbling. However, this is neither an endorsement of the Chinese model of investment driven economic growth nor of mega-infrastructure projects in general. The contrast is drawn merely to put in perspective the infrastructure investment challenges facing emerging India.

Exploring India's "dynamism-dysfunction" paradox

The NYT has a thought-provoking article that uses the example of Gurgaon to highlight the increasingly obvious paradox with India - "dynamism wrestles with dysfunction"! Its conclusion - dynamism comes from private sector and the dysfunction can be traced to the government.

As the Times article writes with the example of Gurgaon, "economic growth is often the product of a private sector improvising to overcome the inadequacies of the government". In Gurgaon and elsewhere in India, the answer to the country's economic growth paradox that has gained currency is that "growth usually occurs despite the government rather than because of it". It is argued that if governments - central, state, and local - could get their act together, then everything could be so different. Is it as simple as that or does it merit a more nuanced perspective?

It is undoubtedly true that governance remains generally weak and ineffectual across the country. Bureaucracy is stifling, professionalism scarce, political populism rampant, and corruption all pervasive. It is also true that India's private sector, especially in the services, have been remarkable global success stories and have played a major role in placing the country into a robust growth path. Private entrepreneurship has blossomed spectacularly over the past decade despite numerous governance related obstacles.

Therefore, is the problem merely one of a dynamic private sector and a dysfunctional government? Will the problems and deficiencies in public infrastructure service delivery disappear and entrepreneurship bloom if governments become efficient? As always with public policy debates, there are several critical dimensions to the issue that have been brushed under the carpet in our eagerness to find answers and fix blame.

However, even if governments become more efficient and outcome focused, there are certain other critical pre-requisites for any government action to deliver results. Efficiency improvements and planning can only create the platform for effective public service delivery. It cannot be a substitute for the massive capital investments required to actually deliver public services. Further, a substantial share of such resources, for setting up the infrastructure and more importantly for its operation and maintenance, have to come from its users. Governments will have to bear the subsidy burden for the poor.

Let me illustrate both these issues with reference to the Times article.

1. Development requires massive financial investments. Development spending in India resembles a trickle-down drip, whereas the need of the hour is a large-sized pipe. The Times article writes about Gurgaon's deficiencies,

"Gurgaon... does not have: a functioning citywide sewer or drainage system; reliable electricity or water; and public sidewalks, adequate parking, decent roads or any citywide system of public transportation. Garbage is still regularly tossed in empty lots by the side of the road.

With its shiny buildings and galloping economy, Gurgaon is often portrayed as a symbol of a rising 'new' India, yet it also represents a riddle at the heart of India’s rapid growth: how can a new city become an international economic engine without basic public services? How can a huge country flirt with double-digit growth despite widespread corruption, inefficiency and governmental dysfunction?"

Addressing all these deficiencies require huge investments, running into thousands of crores. Each major city would require a few thousands of crores. After they are put in place, issues of governance assume importance. Governance improvements with deficient infrastructure is equivalent to running a complex software on a low-end and out-dated computer. However, unfortunately the trends in this direction have been far from encouraging.

In recent years, an impression has gained ground that government investments in infrastructure services could be substituted with private investments in the name of public private partnerships (PPP). All it requires is for governments to either contribute land as its equity or agree to pay an annuity to the developer to deliver the service, and private investors will que up. Governments at all levels across the country have been chasing PPP investors in the past few years to partner with governments in delivering civic and public infrastructure services. As can be seen, except in a few inherently private investment friendly sectors, the results have been dismal everywhere.

This outcome is to be expected. In its broad historical sweep, no major country in the world, including both developed and now emerging economies, have developed their public infrastructure except through massive direct public investments. Nowhere in the world have private investors replaced governments as the major or even a significant provider of services in sectors like urban civic infrastructure, mass transit, roads and bridges etc. These investments have been and continues to be the preserve of governments.

There is no secret for this. Investments in these sectors are capital intensive and require high user charges or tariffs to be sustainable (some like public transit run into problems even with high tariffs). The user charges and tariffs in India are too small that it is inconceivable that any government could permit raising them by the many times required to recover these user charges. The other alternative of governments subsidizing private service delivery would require massive annuity type payments, which are again beyond the resources of most local and state governments.

This gridlock is unfortunate because atleast some Indian cities have fairly robust and professional governance systems in place. There are a few cities which even have excellent City Development Plans, professionally prepared, which could not be operationalized for lack of resources. In fact, urban governance has improved considerably in many cities across the country in the past few years. But the hardware is missing.

2. Where do these massive investments have to come from? If these services are to be sustainable, there is no denying that users have to bear a considerable share of the cost, much more than what they are paying today, of accessing these services. Sample this from the Times,

"To compensate for electricity blackouts, Gurgaon’s companies and real estate developers operate massive diesel generators capable of powering small towns. No water? Drill private borewells. No public transportation? Companies employ hundreds of private buses and taxis. Worried about crime? Gurgaon has almost four times as many private security guards as police officers."

Herein lies another paradox - people are individually paying exorbitant rates to access services from private providers but collectively unwilling to agree to pay for the same from government agencies. The politics of taxes and tariffs is a major stumbling block to any increases in them. There is also the fact that only a small proportion of the population are actually paying for these high-priced private provision of civic services. (The anecdotal examples of poor people accessing drinking water from informal bore and tanker operators etc is a misleading generalization)

The misconception that privatization is the alternative for government service delivery and government service delivery is inherently inefficient has merely amplified this collective reluctance to pay for services. Why pay the government for a service, when its delivery is unreliable and quality questionable?

It is ingrained into the public discourse that government providers are inefficient and expensive, whereas private service providers can deliver the same service with much greater quality and cheaper. This misconception persists despite the fact that private service delivery costs much higher. Critics counter this argument by claiming the people are willing to pay higher user fees or prices if they are assured of reliability and quality. While theoretically unexceptionable, as I have argued here, this stumbles when faced with real world implementation.

The rich live in near complete isolation. They have their reliable and world-class utility services - water, sewerage, electricity, telephone etc - delivered by private service providers. They hire private security guards to maintain law and order in their gated communities. These self-contained communities have their own parks, gyms and other recreational facilities. They have all the exclusive global brand retail outlets and shopping malls to satisfy their desire for conspicuous consumption. Though they still have to endure the traffic congestions and bad roads, they can afford to do it from the luxury of their chauffeur driven limousines. (It is surprisingly less discussed in all debates about public transit systems about how the rich have no incentive in establishing it) And when they want to get away from even these, they have access to world-class airports and luxurious resorts.

In other words, the rich and upper middle-class are increasingly finding diminishing incentive in improving public infrastructure. And unfortunately, they are among the only category of users who can afford to pay the high prices required to establish and deliver world class civic services. If they abdicate, the ability of local governments to finance and sustain such services become even more tenuous.

None of this is to absolve governments and its machinery off blame for the dysfunctionality of our governance systems. It is just that the society and its government need to face up to the reality that world class public service delivery requires massive investments in infrastructure and a willingness by citizens (and wherever they cannot, by governments) to pay much higher than what they are paying now in the form of tariffs and taxes. Simplified explanations that attribute the dysfunction-dynamism paradox to the standard private-public sector stereotypes are merely brushing issues under the carpet.

Gurgaon's fundamental problem is that it requires massive investments in civic infrastructure. Possibly tens of billions of dollars. The city has grown far too fast for its cash-strapped local government (India is possibly the only major country where local governments do not get any share of the larger central and state taxes) to sustain any meaningful investments. It is of course important that the urban governance systems have to be competent and efficient enough to professionally plan and execute these investments and then effectively maintain them. But the finances for the hardware has to come first.

No major Indian city is presently capable of executing projects on a scale that cities like Gurgaon need nor have the financial resources to do so. I am also not sure whether the supply side has the expertise and capability to deliver on them even if the financial bottlenecks are overcome. After all, for all talk of government lethargy, the actual execution is done by private contractors.

Efficiency Vs Cost trade-off in infrastructure

Conventional wisdom would have it that governments are not only very inefficient but also expensive in delivering public services. It is also widely believed that private sector is not only more efficient but can also deliver the same service more cheaply. In other words, in contrast with the private sector, government service delivery offers the worst of both worlds - inefficient and expensive. How does this conception square up with reality?

The cost-efficiency curves for a typical market for public service delivery in developing countries would look something like in the graph below.



Atleast for the short term (given the same investments), the cost of delivering a service at the same efficiency is much higher in the private sector than the public sector. See this, this and this (there are many more other reasons). This raises the issue of whether people are willing to pay the higher prices required to access these basic public services.

However, certain markets are more amenable for private contracting. The curves for such markets would look like this



In these markets, to achieve efficiency beyond certain point, Ee, the private sector is easily more cost-effective than the government. In such cases, beyond a basic minimum level of efficiency, Ee, the private sector can achieve the same efficiency as government, Eg, at far less cost than government (P1-P2).

In conclusion, public provision of services may be more cost-effective in most public infrastructure services. However, if the private sector is made to deliver the same services, at greater efficiency, that would have to come with a cost. In the absence of willingness of users to pay the higher price, governments may have to bear the higher cost of these services by subsidizing service delivery.

But in certain infrastructure services like airports, ports, power generation, and telecoms, which are single location services, involve considerable professional expertise in their management, and where cost recovery is possible (due to the economic profile of its users), it may be prudent to rely on private providers. They can deliver such services in a more cost-effective manner than government service providers.

PS: The graphs are intuitive representation and not based on any data.

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.

Beijing's Transport Plans!

China has lined up ambitious plans to address Beijing's worsening traffic problems.

280,000 new parking spaces; 1,000 share-a-bike stations; 348 miles of new subway tracks; 125 miles of new downtown streets; 23 miles of tunnels; 9 new transportation hubs; 3 congestion zones; and 1 cure-all, "the use of modern technology".

The sheer scale of that is staggering. To put it in perspective, it is more that what is planned in all Indian cities put together!

Is the pendulum swinging on outsourcing civic services?

Conventional wisdom on the delivery of civic services holds that service quality can be improved only if urban local bodies (ULBs) outsource or contract out or even privatize their services. In-house service delivery is perceived as fundamentally inefficient and inherently poor in quality. Accordingly, in recent years, there has been a clearly pronounced trend towards outsourcing civic utility services - water, sewerage, solid waste management, IT operations, customer care centers, etc - in many Indian cities.

In this context, Stephen Goldsmith, the deputy mayor of New York, and an one-time Republican Party star for privatizing government services when he was mayor of Indianapolis, has triggered off a debate on the merits of privatization of civic services with this very interesting op-ed column,

"Usually, when government officials talk about spending less money, they talk about outsourcing services to the private sector. And in many cases, that can be very effective. But union leaders often argue that it would be more cost-effective to give the work to city employees - and sometimes, they are right...

Mayor Bloomberg requested that I review all information technology, or IT, contracting. After conducting a thorough review, I have concluded that much of the solution lies not in more outsourcing to the private sector, but rather in employing city workers to perform more of our IT work. So in the weeks and months ahead, we will decisively shift more work from consultants outside government to our talented public employees. This will save taxpayers millions of dollars a year."

As part of this review, the Bloomberg administration has sought to consolidate the city's 40 separate data server rooms into a handful of centralized data centers. This project, expected to yield taxpayer savings of atleast $100 mn over the next five years, is being executed using public employees,

"To build our new data center, instead of hiring an outside vendor for project management and quality assurance as we would have done in the past, we insourced the work to the Department of Information Technology and Telecommunications' project management team... Using the know-how of city staff to oversee these projects will save an additional $25 million over and above the $100 million we will save from having fewer server rooms and other efficiencies. That center where the mayor stood was built in record time, from start to finish in only six months."

He also wrote about other successes with in-sourcing,

"Our Business Express tool - which helps businesses get permits faster - and our expanded 311 online program are both now led by insourced city employees, not consultants. The Finance Department is hiring 45 city employees to replace outside consultants, almost entirely in its technology department. That will save millions more."

And about the way forward,

"At the same time as we intelligently insource, we need to tighten our oversight over outside contractors. Competent and honest vendors respond best when they are well-managed by able city officials. We are proposing, therefore, to expand a high-level city vendor management office - and in the process, reduce the cost of outside projects and test whether certain projects are even necessary.

And we are going to start challenging all components of technology contracts, and ensure that the city does not pay a markup to a consultant for work we could just as well do internally. We must also focus on subcontractors - companies hired by our own vendors to help them complete their assignments... Insourcing the management of projects and important decisions about scope and cost will allow us to save taxpayer dollars, enhance service delivery and ensure that IT vendor resources throughout the city are delivering on time and on-budget for New Yorkers."

Predictably, this has re-ignited the debate about the merits of in-house service delivery and outsourcing of municipal services. Here are a few observations

1. As Mildred Warner writes, "Contracting out only saves money if there are technological innovations or economies of scale that come from moving functions out." It therefore becomes critical to objectively and accurately assess the costs and benefits of any such initiative. However, as we have seen with the numerous examples of high-profile failures with mergers and acquisitions with big private firms, such decisions are difficult to make.

It is no surprise that in recent years there have been a large number of cases of reverse contracting - bringing previously privatized services back in house - from cities across the world. A study for the International City Managers Association (ICMA) by Mildred Warner and Amir Hefetz finds that the reasons for reverse contracting are problems with service quality (61%), lack of cost savings (52%), improvements in public delivery (34%), problems with monitoring (17%) and political support to bring the work back in house (17%). As can be seen, the "reversals reflect problems with service quality and lack of cost savings in contracted services" instead of the usual suspect of political opposition.

2. There is a fundamental incentive challenge - private firms have incentives to reduce quality to enhance profits and governments have the incentive to reduce costs. This means that the city managers have to effectively police and re-align the incentives of the contractors. At the same time, they have to bear in mind the need to ensure that life-cycle costs of delivering the service is optimized.

However, this requires that the city managers have the requisite professional competence and integrity to effectively carry out this responsibility. Unfortunately, there are very few cities which have the required numbers of professionally competent (upto speed with the latest technologies and processes) and honest managers.

3. It is no surprise that there are massive delays in all types of projects being executed in our cities. Monitoring and supervision, even of internally executed projects, have never been a strength of public systems. It is therefore unreasonable to expect municipal governments to do an effective job of external contract management, especially those involving complex and difficult to quantify outcomes.

Monitoring the adherence with service levels involves rigorous data collection and supervisory over-sight which is often beyond the competence of public officials and their bureaucratic systems. As can be expected, project management is one of the weakest areas of urban governance.

4. The most critical determinant of the success of any contracting agreement is the ability to monitor with reasonable degree of accuracy the achievement of outcomes. However, it is difficult to quantify the outcomes, leave alone the quality, of many civic services. Sometimes, it is difficult to even define and monitor certain outcomes. Performance-based contracts, which are successfully implemented across the private sector, is therefore difficult to structure for civic service delivery.

Further, even when it is possible to quantify outcomes and their quality, the process of data collection is a source of concern. It is either gamed by the contractor, in collusion with the supervising public officials, or its reliability suspect due to the sheer inefficiencies within public bureaucracies.

5. Compounding the problem is the absence of adequate competition and depth in the market for service providers. In the US itself, for most local government services the average number of alternative providers is less than two. Only one third of the 67 most common local government services have two or more alternative providers in the market. Reflecting the virtual absence of choice, fully 75% of contracts are given to the incumbent without re-bidding. The situation is far worse in developing countries like India. In other words, "all privatization does is substitute a private monopoly for a public one".

6. Cronyism and corruption is rampant in all our urban local governments. However it is not the exclusive preserve of our local bodies. Chicago's parking meter privatization is the most high-profile example of incompetence, short-sightedness, and corruption that characterises contracting of civic services.

Contracting out civic services, especially in the larger cities, require a highly professional bid process management. It should be free from external interference and decisions should be taken on purely professional and objective considerations. It is difficult to replicate such environments in most Indian cities.

The net result is a completely compromised bid process, in which extraneous considerations prevail over professional qualifications. The willingness of most service providers to play this game only makes the process even murkier. The result is a badly designed/structured contract (often done to favor certain parties) awarded to a contractor with neither the expertise nor the intent to execute the project effectively. Failure, criticism and controversy is therefore inevitable.

None of this is to oppose outsourcing and privatization and advocate in-house civic service delivery. As Nicole Gelinas writes, "Privatization of government services can be a tool for competent governments but it's not a cure for incompetence... privatization doesn't obviate the need for government competence and honesty, as well as for the democratic checks and balances that encourage these traits". Governments should decide to use outsourcing and privatization based on the specific project and the local market conditions and not on ideological considerations. Elliott Scalar has this standard for making privatization decisions,

"Three factors drive the decision: the number of interactions required between the service supplier and the purchasing organization; the ability of the purchasing organization to judge the quality of the product; and the nature of control over the physical assets and people involved in delivering the goods. The general rule of thumb is that when the number of interactions is high, quality is not easily determined and control over assets is required, you should keep the function in-house. If the reverse is true, you can outsource."

John Donahue prescribes this standard,

"Tasks that are well-defined, easy to monitor and available from competitive suppliers — call them 'commodity tasks' — are prime candidates for privatization. Tasks that are complex and mutable, lack clear benchmarks or are immune from competition — 'custom tasks' — should be kept in-house."

All this ultimately boils down to the original Coasean theory about firms and transaction costs - firms exist because the transaction costs associated with doing ancillary activities externally are simply too large. In this case, certain services, instead of being outsourced, are more effective if done internally within the civic utility.

The final word should go to an excellent meta-study of privatization across the world of water distribution and garbage collection by Germà Bel, Xavier Fageda, and Mildred E. Warner, which finds,

"Privatization of local government services is assumed to deliver cost savings but empirical evidence for this from around the world is mixed. We conduct a meta-regression analysis of all econometric studies examining privatization for water distribution and solid waste collection services and find no systematic support for lower costs with private production. Differences in study results are explained by differences in time-period of the analyses, service characteristics, and policy environment. We do not find a genuine empirical effect of cost savings resulting from private production. The results suggest that to ensure cost savings, more attention be given to the cost characteristics of the service, the transaction costs involved, and the policy environment stimulating competition, rather than to the debate over public versus private delivery of these services."

Plan for a Renewable Future

Policy Innovations contributor Roy Morrison weighs in on alternative global warming solutions and related policies to finance them. He calls for a 20-year plan to transition to renewable resources:

The popular wisdom is that a global emissions reduction agreement through cap and trade or taxation is humanity's last best hope before the consequences of melting ice and methane hydrates make irrelevant further human efforts to stop global warming. If that's true, we are in grave danger indeed. We should instead focus on a workable global investment and jobs plan to build the global renewable resource infrastructure that can sustain global prosperity while slashing global greenhouse gas emissions.

The plan will draw upon existing and emergent renewable energy technologies. These technologies range from the now-familiar wind turbines, photovoltaic solar arrays, hydropower dams, and geothermal plants, to new solar concentrators and medium-temperature geothermal systems running organic Rankine cycle generators. These will be combined with electric and renewable-fueled hybrid vehicles using their lithium batteries for energy storage. Renewable systems are characterized by rapidly improving energy conversion efficiency and declining cost.

We should understand that the problem is not that we do not have sufficient renewable resources. This is a plan that will create millions and millions of new jobs and global markets for our products and at the same time free us from the fossil fuel curse and its economic, ecological, and security threats.

The plan for a renewable future is based not on imposing taxes on the unwilling or forcing everyone to eat celery. It's time to stop focusing our efforts on raising costs for polluters who are politically powerful and will fight us every step of the way. We can do without the higher taxes or complex cap and trade schemes that will further enrich Wall Street sharks and may not even work.

It's absolutely clear that markets with sharply fluctuating asset prices, whether for carbon credits or Renewable Energy Credits (RECs), do not provide sufficiently stable long-term cash flows to convince bankers and investors to risk trillions of dollars financing a sustainable future.

For example, I'm working on building solar farms in New Jersey. New Jersey, admirably, sets high regulatory alternative compliance payments (ACP) for energy suppliers that do not purchase solar RECs (SRECs) from solar developers. But since the actual price for those SRECs is determined by a bid-and-ask market with fluctuating prices, there is no working futures market for buying and selling large quantities of SRECs. Why stock up on SRECs now when prices could plunge, as they have for RECs around the country and for carbon in Europe?

Without a long-term SREC contract in hand, financiers will not invest hundreds of millions of dollars in solar farms. We are scrambling to negotiate deeply discounted long-term deals with electricity suppliers and designing our own innovative financial structures to get the financing to build our solar farms.

What works much better is the feed-in-tariff (FIT) used by Germany and now by Ontario. The Ontario Power Authority offers 20-year fixed price contracts, at different price levels, for various renewables, with the goal of ultimately eliminating the province's reliance on coal. You can take an approved design and a 20-year OPA contract to the bank.

If it's true that renewable resources can do the job, then why not put America on the path to its own 20-year plan? As renewable resources and a continental-scale renewable smart grid are phased in, fossil fuel resources will be phased out gradually. The oil and coal can be left in the ground, or sometimes used for chemical feedstock in accord with an industrial ecology of zero waste and zero pollution.

As we increase renewable resource use by a small percentage each year, natural gas can serve as the transition fuel. We don't even need to build the next generation of coal and nuclear plants and gas-guzzling automobiles. If it's politically necessary, we can pay the coal companies for mineral rights, much as we have paid farmers not to plant corn. And, of course, we could stretch the time frame out for 40 years to 2050. But why do that? The risks are too high to drag our feet, while the benefits of implementing a 20-year plan are enormous.

In 20 years, by 2030, fossil fuel power can be an artifact of a bygone era. Gasoline-powered engines would become a once-a-year treat at the county fair demolition derby. The daily news would be not about military deployments, but about surprising new trends in building an ecological civilization.

There's no reason to wait. Renewable resource construction is already moving ahead. It just needs a little more systematic push. Mechanisms we can rely on include:

Feed-in-Tariffs: We set goals for phasing in renewables and phasing out fossil fuels and nukes. We offer long-term contracts at prices sufficient to support investment given current capital costs and energy market prices. Most renewables have zero fuel cost, but high capital costs. Periodically, the price level of new FIT contracts are adjusted to keep up with changes in capital costs and market income as more renewables are phased in and the need for subsidies decreases. The FIT should be applicable to storage and efficiency projects as well as generation.

Continental-Scale Renewable Smart Grids: We transform the current regional power grid system into one capable of operating efficiently on a continental scale using High Voltage Direct Current (HVDC) power lines and smart controls. Such continental systems will be designed to optimize the balance between distributed local resources and system resources. Developing efficient and cheap local devices such as fuel cells, heat pumps, photovoltaics, batteries, flywheels, and capacitors means a potential major reduction in large scale "system" generation and storage resources needed to move large amounts of power over long distances.

Self-Equilibrating Systems: The system can be designed to operate in a substantially self-equilibrating and highly secure manner using cybernetic feedback loops. By equipping end-use devices and distributed generation with the ability to sense and respond to fluctuations in local voltage and frequency, the system can be substantially self-controlling, capable of operating in a regional fashion in the event of system disruption, and largely immune from cyber attack from malware and viruses since there will be few control signals to sabotage such as the current Automatic Generation Control (AGC) signals.

Clean Development: Development aid must be provided in sufficient quantities for poor and developing nations to make the transition. In countries without a national power grid, regional renewable resources with local storage and smart control can do the job. The approach must be global or it will fail. Global problems will require global solutions and cannot be accomplished upon the backs of the poor for the benefit of the rich.

This is a plan with winners and few losers. We build massive new non-polluting industries, and create millions of good-paying high-technology manufacturing, installation, computer control, and service jobs. In addition to transforming the economy, we free ourselves from the oil curse, the resource wars, and balance of payments nightmares. Cash will flow in from our customers instead of out to the sheikhs and oil barons. And we will lessen the threat from nations that wish to enrich uranium for "peaceful" purposes under the Non-Proliferation Treaty (NPT).

Today we face resolute opposition to anything more than marginal changes in emissions from such political and economic heavyweights as the global coal, oil, auto, and electric industries, and from major energy exporting and importing nations such as OPEC, Russia, China, and even the United States.

It's time to stop trying to plow a granite field. We can instead focus our efforts on an investment and job strategy that will build the renewable infrastructure and the powerful new industries that will be the basis not only for the prevention of climate catastrophe, but also for the development of prosperous and sustainable ecological future.

[PHOTO CREDIT: Photovoltaik, by Bernd Sieker (CC).]