Saturday, February 17, 2018

Corporate cash hoards invested in bonds

Rana Foroohar points to a just released Credit Suisse study by Zoltan Pozsar which documented the massive off-shore corporate savings of US S&P 500 firms invested in high yielding corporate bonds. She describes them as being as influential on the bond markets as some of the investment banks. Of the $1 trillion savings of about 150 firms, 80% belong to the largest and most intellectual property rich 10% of firms. 

The savings of the 150 firms shows that IT and pharmaceuticals dominate, with the top 10 names controlling over $600 bn of the off-shore savings, with Apple alone having a trove of over $200 bn!
The next figure shows how the total savings (offshore plus onshore, though 90% are held offshore) of the top 10 have evolved over time in terms of categories of investments.  
Observe the striking coincidence with the global financial crisis, as savings ballooned from just over $100 bn in 2008 to over $700 bn by end-2016. 

Highlighting the relevance of IT companies with their ability to shift profits across borders through IP, Pozsar writes,
Corporations that rely on booking revenues derived from intellectual property (IP) assets in tax havens are more efficient at shielding earnings from the IRS than firms that don’t (IP assets range from the integration of design and hardware into a phone to the formulas of blockbuster drugs). This explains the greater concentration of savings in the first segment. Compared to the first segment, the second segment of the universe is less reliant on IP assets – there ain’t no “killer” apps, brands, codes, designs or formulas in the auto, energy, industrial and medical equipment manufacturing sectors. The strategy to book revenues generated by a portfolio of IP assets in tax havens is not easy to apply in these industries.
The paper has several interesting graphics. There are two graphs which show how the corporate's holdings of US Treasury bond and agency debt as well as corporate bonds, ABS, RMBS etc compare very favourably with those of the largest investment banks.

Friday, February 16, 2018

Holding the mirror on corporate India

Much has been written about how government regulations have shackled private sector growth in India. While it is undoubtedly true that restrictive regulations have constrained private business growth in the aggregate, for a country of India's size this cannot explain the near total absence of world-class companies and brands from India.

Even in the much acclaimed software sector, none of the Indian companies have progressed beyond being outsourced service providers. All this despite enjoying all the textbook requirements for success - cheap supply of skilled manpower, very low taxes, preferential government policies, benefits of exclusive zones or software technology parks, a massive and voracious global market, and the strong tailwinds of recurrent technology disruptions. There are no major commoditised IT solutions nor are these companies at the cutting-edge of work on areas like data science, artificial intelligence, internet of things, cloud computing, blockchains etc.

In terms of research and development (R&D) spending, our IT titans are minnows, with nothing special to show for in the last quarter century of rollicking growth. But the IT sector is no exception in this trend of skimping on R&D.

The recent economic survey holds the mirror on India's very vocal corporate sector and shows how woefully they lag behind others in their share of gross expenditure on R&D.
Several sectors have had multiple opportunities to benefit from protectionist industrial policies. The most classic recent example is of the solar industry. Despite local content restrictions and other forms of protectionism, Indian solar cells industry can supply less than 10% of the annual domestic requirements.

Another example comes from medical devices. The government has showered the industry with several concessions over the years. Nothing of any note has emerged beyond a few copy-cats. The pricing regulations imposed by the National Pharmaceuticals Pricing Authority (NPPA) on diagnostic devices offers yet another opportunity for this industry to generate world leaders in at least some important diagnostic products.

The other example is defence, where the current government has done possibly everything it could have to promote indigenous defence production. The results so far in terms of corporate India seizing the opportunity has been an utter disappointment.

As a comparison, one only needs to look at how Chinese firms have conquered the world in industry after industry by benefiting from their large domestic market and protectionist policies, two factors that Indian companies too enjoy. We can safely assume that even if NPPA holds the line for 10 years (which was for long the case since all these items were strongly regulated for decades), nothing much would have changed in terms of domestic production.

Apart from all this, I have blogged here, here, here, and here about the failure of the country's startup eco-system to generate innovators and innovations which have had a transformational effect on the country's development or on a pervasive development challenge.

But there is one area where our corporates top - in having among the worst corporate ethics! Consider this,
India was ranked the most unethical of 13 major economies in the 2016 Global Business Ethics Survey, behind even Brazil and China. Last year, Ernst and Young’s Asia-Pacific Fraud survey found that unethical practices are rife in India’s business community with 78 per cent of Indian respondents surveyed saying that bribery and corrupt practices occur widely, while 57 per cent said that senior management would ignore the unethical behaviour of employees to attain revenue targets... Foreign investors and companies complain that Indian businessmen don’t understand the concept of good faith in negotiations. Legal agreements are routinely flouted — often in cahoots with the authorities or the court system. Creative accounting is a commonplace hazard, as is illegal diversion of profits by promoters. The non-performing loan crisis in India’s banks is largely due to bare-faced cheating and fraud by crony capitalists with the connivance of pliant bank executives.
And it appears that questionable corporate ethics has not spared even the start-up entrepreneurs

Wednesday, February 14, 2018

The volatility trade casino

Ananth points to two links that highlights the casino that implied volatility trading has become. 

The market for exchange traded products (ETPs) in equity implied volatility, VIX futures, has exploded spectacularly with handsome returns since the turn of the decade. In the turmoil early last week, short positions which had been built up in the confidence complacency arising from the recent period of extraordinary stability in VIX, despite several signatures of bubbles, unravelled over just a few hours. Sample this
The scale of the returns the trade offered dulled the risks. Buying the largest short volatility ETP — run by Credit Suisse and known by the ticker XIV — at the start of 2015 and holding it to the end of 2017 generated a return of 320 per cent. Holding it from the start of 2015 to after Monday’s eruption, resulted in a total loss of 85 per cent... There are about 40 Vix-linked ETPs, according to Goldman Sachs, and most allow investors to bet on volatility rising... many have become popular, ranking among the most frequently traded exchange products, and rivalling the stocks of companies such as General Electric. 
And the systemic consequences have been, like with commodity futures, less than benign, with futures trading fuelling feedback loops into VIX itself,
“Volatility has become both an input for risk-taking, and something you can trade,” says Christopher Cole of Artemis Capital Management. “Volatility has become a player on the field.” In turn, the behaviour of the ETPs has helped fuel the Vix contracts that form their basis. So much so that it has led to concern that the financial products built to make money from tracking the Vix are now feeding back into the ingredients from which Vix is calculated. Traders say that at the end of Monday, the ETPs that ran into trouble from an initial rise in Vix scrambled to cover positions by buying large amounts of Vix futures, sending the price of the contracts soaring. The Vix, in turn, rose further and the S&P 500 sank.
And how did the markets respond to the unravelling of short positions - by swinging to the other extreme with the biggest ever weekly change into long-positions and the highest level of net long positions as a share of open interest in VIX futures since December 2009! 

Monday, February 12, 2018

The false dawn of blended finance in infrastructure

Blended Finance is the new buzzword in international development. Nancy Lee has a new paper in the CGD website which examines the potential of blended finance to crowd in private capital to finance infrastructure projects in developing countries. It suggests reforms to the private sector windows (PSWs) of multilateral development banks (MDBs) and development finance institutions (DFIs) to achieve this objective. 

She writes
Many were optimistic when the United Nations Sustainable Development Goals were launched in 2015 that the private sector — and domestic resource mobilization — would fund much of the investment needed to achieve these goals — especially as public aid flows stagnate. As 2018 begins, we would do well to reassess these optimistic projections for private finance for development, and ask are the “billions to trillions” materializing?... Many changes will be necessary, but I would highlight two as fundamental: First, greater risk tolerance and lowered expectations for risk-adjusted returns, and second, a major cultural shift to encourage collaboration rather than competition among the MDBs... Current data do not suggest that private investment of sufficient scale will emerge under the status quo, or that poor countries have a real chance to capture a larger share.
The paper suggests several reforms to the environment as well as the structures of PSWs of MDBs and DFIs - off-balance sheet financing of riskiest projects; aligning institutional incentives to doing more stuff like credit guarantees; consolidation and rationalisation of multiple trust funds; collaboration between the PSWs of all institutions to share pipeline, harmonise and pool financial instruments; assuming more leverage and risk; specialise in high-risk greenfield infrastructure etc. 

Unfortunately, none of these reforms are likely to make any significant dent (turn "billions into trillions") on the problem and change the status quo. This naive optimism glosses over fundamental structural factors which strongly militate against the use of foreign private capital to finance infrastructure in developing countries to any meaningful extent.

For a start blended finance is not new in infrastructure. Further, the use of blended finance instruments cannot meaningfully address the deep underlying problems. My guess is that this blog alone has atleast a hundred posts which explore different dimensions of the challenge with making private capital work in infrastructure sector, except a few areas (telecommunications and power, in particular). 

The challenge facing foreign private capital financing of infrastructure in developing countries centre around questionable premises about the use of both foreign and private capital in infrastructure sectors,

1. The total volume of dry powder from all types of sources, including alternative investment funds, available for developing countries (excluding China) is very small. They are minuscule for the low income countries. The report itself says that they received just 1.7% of total private capital flows to developing countries in 2016!

2. While the revenues of most infrastructure projects are in local currency, the repayment or profit repatriation is invariably to a foreign currency (dollar). For countries prone to macroeconomic vulnerabilities, the currency mismatch risk can by itself be a major source of instability. 

3. There are limits to the foreign currency liabilities (of all kinds - debt and equity) that developing countries can assume and the desirability of assuming them. Foreign capital as a share of gross fixed capital formation  (and infrastructure is just one of the destinations) even among the East Asian economies and China during their high-growth years have rarely crossed even 10%. Many African countries are still struggling to recover from the last round of Eurobond issuances. The perils of the original sin and the risks of sudden-stops and capital flights from cross-border capital flows are recurrent and too well documented to be repeated. 

4. Infrastructure projects, especially the large ones and in sectors requiring land acquisition and right of way, invariably get delayed and suffer cost over-runs, often causing escalations which are multiples of original cost, are commonplace. Private parties cannot be expected to bear the associated construction and commissioning risks.

5. Private borrowing is far more expensive when compared to government borrowing. The cumulative costs, as the recent UK NAO report shows, can be very significant. 

6. Even in the developed economies, such infrastructure projects invariably end up in renegotiations within a few years of the concession being granted or project being commissioned. In countries with limited state capacity, weak contract enforcement mechanisms, and poor governance such renegotiations can be very tricky and impose prohibitive ongoing risks for investors.

7. Finally, for all the aforementioned reasons, the returns required to make infrastructure investments attractive enough in developing countries (for both domestic and foreign investors) would be too high for most infrastructure assets to be able to provide. 

While several more challenges can be outlined, historical experience from across the world shows that the aforementioned factors can be insurmountable.  

For sure, developing countries should try to attract foreign private capital to their infrastructure sectors and the reforms suggested by Nancy Lee should be implemented. But these efforts are unlikely to improve things meaningfully and foreign private capital is most certain to remain a marginal contributor to financing infrastructure in developing countries.

In conclusion, the premise of private capital, and foreign one at that, as a major contributor to finance greenfield infrastructure investments in developing countries is doubtful. Developing countries will have to rely on domestic savings and predominantly government revenues to finance such investments. Blending or not, there are no innovations around this stark reality! Turning "billions into trillions" through private foreign capital will remain a dream.

Sunday, February 11, 2018

Global bond market fact of the day

There are currently about 25,000 bonds on the global market, issued by both governments and corporations. According to Kirk’s data, the average yield of these bonds is a paltry 1.9%. Back in 2000, the average bond yielded significantly higher at 6%. Average current duration is seven years, quite risky considering the low yield. If rates rose at all over that time, which is highly likely – both the Federal Reserve and the European Central Bank are indicating so – you would lose money.

Thursday, February 8, 2018

The challenge with health insurance model to universal health coverage

In the context of PPPs and the recently unveiled health insurance program in India, Karthik asks the questions (in the comments here),
If the decision of public vs. insurance model of health care is a matter of comparison between the capacity to run public hospitals vs. capacity to regulate private players... are we stuck in a trap where we don't have either of these capacities? In this context, which capacity is easier to build from the current state?
It is a good opportunity to clarify my own thoughts. I naively started out as a strong believer in the insurance model to deliver universal health coverage - see this and this. I no longer subscribe to this view. 

Here is the challenge. Any insurance model is inherently suited to address secondary and especially tertiary care. It cannot be tailored to the effective delivery of non-curative preventive and primary care, especially given the public health challenges that we face. And the cost-effectiveness of insurance by its very nature depends on the ability to limit incidence of the insured events. But the incidence of secondary and tertiary treatment episodes depends on the strength of preventive and primary care. In other words, you need to build the insurance system on a very good preventive and primary care system so that disease incidence itself is minimised. But our preventive and primary care is broken. Worse still, we have a situation where the insured are the poor who are also those with the weakest preventive and primary care and therefore the population category with the highest likelihood of incidence of the insured events. In the circumstances, the insurer faces the maximum disease incidence likelihoods. 

In fact, there is an even greater practical problem with the focus on insurance approach. It takes the attention and resources away from the more important and difficult task of fixing the broken preventive and primary care system. This is not amenable to electorally popular announcements or administrative actions like empanelling insurers, Third Party Administrators (TPAs), and hospitals. It demands persistent and painstaking work which is diffuse and beyond the abilities of systems with weak state capacity. We fall into an even worse equilibrium.

Finally, there is the impossible fiscal challenge. I have written with Lant Pritchett about the problem of doubly-universal coverage - population coverage and conditions coverage - which is an inevitable slippery slope with insurance models. The move from the limited RSBY to Ayushman Bharat is only the latest example. Andhra Pradesh's Aarogyasri Program started with a token amount for just child heart surgeries and in less than a decade (by 2014-15) came to progressively cover nearly 1100 conditions and over Rs 5000 Cr for the combined state. The only reason it did not reach Rs 10,000 Cr was because the supply-side to deliver secondary and tertiary care could grow only so fast. 

It is a only a matter of time before the fiscal limits start to bind as supply expands inexorably to meet the latent demand. The squeeze on preventive and primary care was more or less proportionate to the ballooning of the insurance costs. Even a very very modest health insurance scheme that can reasonably address the secondary and tertiary care needs would easily cost 3-4% of the GDP (if not much more), a tripling or quadrupling of current expenditures. This is a clearly unrealistic expectation for a country grappling with a 11-12% tax-to-GDP ratio. 

So here is the verdict on the insurance model from one of the most authoritative sources, N Srikant, the most outstanding CEO of Aarogyasri who tried to salvage the bloated and expensive corporate give-away that Aarogyasri had become,
We found that adding an additional layer of insurance intermediary between the trust and hospitals reduced the benefit cost ratio under the scheme by 12.2 % (p-value = 0.06). Every addition of 100 beds under the scheme increases the scheme payments by US$ 0.75 million (p-value < 0.001). The gap in claim denial ratio between insurance and trust modes narrowed down from 2.84 % in government hospitals to 0.41 % in private hospitals (p-value < 0.001)... The scheme is a classic case of Roemer's principle in operation. Introduction of insurance intermediary has the twin effects of reduction in benefit payments to beneficiaries, and chocking fund flow to government hospitals. The idea of engaging insurance intermediary should be abandoned.
There is no country in the world which has developed an effective universal health coverage by focusing predominantly on secondary and tertiary coverage based insurance. 

One approach which has the potential to be effective is the capitation model followed in countries like Thailand. But this in turn too requires a strong primary health care system. 

So back to Karthik's questions. The insurance model is simply unsustainable BIG TIME for a country like India. In fact, it is perhaps the worst scenario. So we are left with no option but focus on preventive and primary care and improve public facilities. Even with the weak state capacity, this is just the only long-term way forward. This is my theoretical assessment. 

But since the insurance genie is out of the bottle and given its powerful electoral attractions, some form of insurance cannot be avoided. In fact, in Andhra Pradesh, it is widely believed that Aarogyasri was one of the main reasons for Mr Y S Rajasekhara Reddy retaining power in the 2009 elections. In the circumstances, faced with electoral battles, no government can be faulted for thinking along these lines. So a prudent compromise may be to have an insurance model which covers a basic package of catastrophic illnesses. It should be complemented with some of the following 

1. This insurance should be operated by a Trust with its dedicated TPAs and not insurers. 

2. A high quality IT system that can manage the logistics of screening, pre-authorisation, treatment, payments, and follow-up, which was a feature of Aarogyasri, should be replicated. It should be accompanied by analytics and vigilance to monitor the problem of over-diagnosis and over-treatment. 

3. The public hospitals and government doctors should be incentivized, even with positive discrimination, to attract patients, so that the insurance program does not end up being a give-away to private hospitals.  

4. The rates should be fixed on very objective considerations, free from political interference, and through transparent process of price discovery involving strategic purchasing at an appropriate administrative level. Maybe this should vary across States. 

5. There should be a mechanism to limit the creeping expansion of conditions coverage. An institutionalised arrangement like the National Institute for Health and Care Excellence (NICE) in the UK should be in control of such decisions. 

6. It is useful to demand some limited co-payment or small premium from all but the poorest. 

7. Finally, the expenditure on this insurance cannot come at the expense of primary and preventive care as well as investments in public secondary and tertiary facilities.

If it is decided to purchase from insurers (instead of using the Trust model), there is perhaps some logic in moving away from the current one-premium-for-all model to one which uses different premia for different age-groups, albeit the same for all members in an age-group irrespective of pre-existing medical conditions (community-rating).

All easier said than done! And even if done there is nothing to stop them being changed or reversed. Therefore, the best that can be done for bureaucrats to try incorporate these elements to the extent possible to the insurance program design.

Tuesday, February 6, 2018

PPPs and Value for Money?

In the aftermath of the collapse of Carillion and the NAO report, FT has been leading the sceptical scrutiny on PPPs. I am extracting a few snippets which convey the story.

The headline takeaways on value for money from PFI,
A National Audit Office report last month found schools built using the PFI are 40 per cent more expensive and hospitals cost 60 per cent more than the public sector alternative.
Investors strip assets and leave the companies indebted,
In 1989, the water industry in England and Wales was privatised with no net debt. Yet almost three decades on, it has built up borrowings of £42bn. All but three of the 10 English water companies have been taken off the stock market by private equity investors — many backed by foreign sovereign wealth funds and pension schemes. In the meantime, all the industry’s post-tax profits have been carried off in the form of dividends. Shareholders’ funds have barely budged since 1989.

The comparison with Scottish Water, which was not privatised and remained public, is instructive,
Yet unlike the English utilities, it remains relatively unleveraged. Its borrowings of £3.8bn represent just 48 per cent of the value of its regulated assets, as against the 65-80 per cent that is prevalent in England. Meanwhile, the average bill from Scottish Water was £357 last year — 10 per cent lower than the English average of £395.
And in terms of benefits to consumers, in UK 
A study by Greenwich university claims that refinancing utility debt and equity with government bonds and scrapping dividends could save £2.3bn a year. That is equivalent to a saving of almost £100 off the average £400 water bill.
... and elsewhere in Europe,
A study of French water services in 2004 found that the price of privately-delivered water was 16.6 per cent higher than in places where municipalities delivered the service.
And from the other big example of privatisation, railways,
The cost of running the UK’s railways is 40 per cent higher than it is in the rest of Europe, according to a 2011 government report by Sir Roy McNulty, the former boss of UK aviation group Short Brothers who has long experience in transport regulation... Since privatisation, the bill has mainly been shared between the taxpayer and the passenger. The contribution from the state has almost doubled from £2.3bn in 1996 to £4.2bn in real terms in 2016-17, despite a conscious decision in recent years to push more of the cost on to users’ shoulders. Ticket prices have risen: they are now 25 per cent higher in real terms than in 1995 and 30 per cent higher than in France, Holland, Sweden and Switzerland. The latest average rise in fares of 3.4 per cent, announced on New Year’s Day, was greeted with outrage. 

Like with water, operational efficiency gains and attendant cost reduction have remained elusive, and asset stripping has proceeded apace,
Despite the vastly expanded usage, the network’s costs have not obviously come down relative to its income. According to the 2011 report, unit costs per passenger kilometre were roughly 20p in 2010, much the same as they were in 1996... Critics argue that train operators are able to make returns, and pay themselves dividends, despite contributing very little in the way of risk capital. While operating margins of 3 per cent are not high, the train companies paid nearly all the £868m operating profits between 2012-13 and 2015/16 as dividends — £634m in the four year period.

A sense of the complexity of such outsourcing and private participation,
“The train you catch is owned by a bank, leased to a private company, which has a franchise from the Department for Transport to run it on this track owned by Network Rail, all regulated by another office, and all paid for by taxpayers or passengers,” says John Stittle, a professor of accounting at Essex university. “The complexity is expensive.” 
Finally, on the public mood,
An October poll conducted by the UK’s far-from-socialist Legatum Institute showed 83 per cent of respondents favoured the nationalisation of water. For energy, the figure was only slightly lower, at 77 per cent.
But who will listen, since the regulators have been captured and the liberals are blindly anti-state and pro-market,
Ofwat, for instance, has been criticised for its focus on investors rather than customers. While the watchdog sets aside two days a year to give presentations to the City of London, there is no forum for it to meet customers.
With regulatory capture and renegotiations, the original spirit of privatisation has been cast aside in railways too,
As with other privatised monopolies, competition was supposed to ensure lower prices and sharper services. But in recent years this has faded, raising questions over the legitimacy of the franchising system. A third of train operating companies now hold their franchises by so-called “direct awards” from government, rather than auction. Successive governments, out of an apparent desire to keep the private sector onside, have been reluctant to wield their powers against poorly performing franchises. Only one train operator has ever been stripped of its contract — Connex for poor performance in south-east England in 2001 and 2003. Three more have walked away after overbidding for contracts, with minimum penalties. Last month, the government allowed Virgin Rail and Stagecoach to terminate their East Coast line franchise three years early, saving them the need to write a £2bn cheque to the government under previously agreed revenue growth forecasts. Yet with only a handful of operators bidding for franchises, the duo may end up operating the line again — on more profitable terms.
This verdict of rail privatisation contrasted with public ownership comparator is striking,
There is a growing consensus among both executives and industry experts as well as the public that Britain’s unique attempt to create competition on Britain’s rail network has not delivered. While it has led to more services, and encouraged more users to pay higher prices, it has not unleashed the productivity improvement necessary both to upgrade the network and stabilise the network’s finances. Over the same period, for instance, London’s state-owned metro network, Transport for London, has grown just as quickly and delivered much more state-of-the-art investment. 
No wonder the likes of Corbyn and Trump look attractive!