Cracks in the Edifice: Business, Bureaucracy and Courts

Two very interesting, albeit completely different events, both linked through their connection with renewed burst of judicial activism may be the beginning of new trends in India. Seen separately, each of these events seem unlinked and seem too small to make a real difference to the political economy of India. But, on close scrutiny, it is likely that they will alter the way business and administration are likely to be conducted in India. Only time will tell us, if the changes are for the better or for the worse. While, judicial activism is not new, this time it has linked the business of siphoning money and the bureaucracy simultaneously – probably for the first time. 

First, the Supreme Court decision cancelling all the 2G licenses, raises hopes that India will move back towards the liberal state’s (the political institution of the State) central theoretically position: one of neutrality without favouring any group or interest. An extremely optimistic view may be that the Supreme Court decision clearly indicates that cutting corners will not be welcome any more and everybody will have to play by the rules. Lofty intentions, well stated and clearly the need of the hour but, in the real world, such judgements are exceptions rather than the norm and are largely unworkable. Indian business would clearly be the loser if such intentions were implemented and people who are keen in following the rules are allowed to administer. Rajeev Chandrasekhar rejoices the court decision by attempting to day dream the changes the Supreme Court Decision will introduce in a recent article (“SC Judgement shows India ready to battle crony capitalism”, Business Standard¸4/5 February 2012, p.2). Alas! It should probably take at least a few more decades before we reach that stage. There are myriad ways in which public funds have been siphoned off over the last few decades. This is unlikely to stop, since the whole political edifice rests on a continuous cycle of transfer of public resources in a well oiled patronage system – created first by the Mughals and subsequently by the Colonists. Each successive ruling party since independence have succeeded in revolutionised corruption and transfer of public resources to private hands. This transfer of public resources peaked during the period 2004-2008 for the simple reason that the asset bubble had inflated to its maximum possible extent by that time. 2G Spectrum allocation was one manifestation of the problem. The SEZ scam is far larger. The reason why Chandrasekhar may be day dreaming is that the results of the 3G auctions will leave a lasting legacy in the way public resources are transferred in future. Those auctions may have sounded the death knell of free market in India. The cost of allowing a ‘free market’, especially one which transparently welcomes competition is going to be clearly unwelcome. Indian businesses prefer to operate as cartels – cement and steel cartels are the worst kept secret. Cartelisation has reached even the small towns: in AP private educational institutions in the cut-throat coaching market are stated to be the latest group that fix tuition fees and operate as a cartel to keep a lid on the cost of acquiring ‘good’ faculty. In other words, the operation of a ‘free market’ is increasingly becoming an obstacle to Indian businesses, for the simple reason that competition erodes their margins. Moreover, the recent relatively high economic growth rates have increased the cost of quality human resources. Rising global commodity prices connect the dots. Thus, the next phase of auctions, if at all they are auctioned, will invariably witness cartelisation by companies. 

A second important issue that is more dangerous are the recent events in Andhra Pradesh. They are problematic as the events may lead to a change in nature and manner in which the Indian State is administered – probably for the first time in more than 200 years. The Indian bureaucracy, especially at the top, was for two centuries the invisible backbone that administered the country. Their role has increased since the 1970s when the criminalisation of politics gathered steam. By the turn of the century, they had become the pivots around which the country was administered. The beauty of the system was that the more efficient members of the bureaucracy could always play on the dread of elections to keep not only keep a lid on the suicidal tendencies of the politicians in check but also frequently temper attempts to blatantly loot the country. Of course, they were not always successful. But over the years, the higher layers of the bureaucracy have been reasonably efficient in keeping a tight leash on the lower layers of the bureaucracy, while keeping the politicians happy enough so that they are not keen to alter the State structure in a manner that it would unleash the fissiparous tendencies that are smouldering just below the surface. Little wonder that even if there is no real government in place, there is no systemic break down and the system continues to function, albeit with a lot of inconvenience. Difficult to accept this contention? A cursory glance at the background and qualifications of our politicians should suffice: our political leaders are either business leaders who think politics is the best way to protect their money, or an assortment of criminals, faction leaders, swindlers, feudal lords who have captured booths, drop outs, liquor and betting syndicate members, etc. The list is almost never ending and there may be an occasional departure in the list: a mediocre teacher or a lawyer who has adroitly exploited the loop holes in the law. Invariably, most of them have no inkling of idea about governance and frankly, they do not care. The great thing about India is that the system survives for the simple reason that the higher layers of the bureaucracy are the only set of people with a permanent interest (and stake) in making the system chug along, if not function very efficiently. Hence, there are always those who stand up to political pressure to refuse to kow-tow. 

Unfortunately, if events over the past two days are an indications, things may be about to change in Andhra Pradesh. That is beginning of the bad news. In areas related to politics, society and economy, AP’s past is the country’s future. Take politics, since at least 1994, any party that has ruled AP has ruled India. The economy is even better: AP (along with Tamil Nadu and Karnataka) is invariably the home to innovations of various hues: ranging from innovative frauds to innovative business models. In probably the first of its kind event, the higher layers of the bureaucracy are up in arms over the recent Central Bureau of Investigation (CBI) actions that have led to arrests of individuals in business and bureaucracy for impropriety that led to huge losses for the government during their tenure in certain departments. While wrongdoing cannot be condoned, the laws have to be uniformly applied – at least that is the basis on which the principles of justice are built. It is difficult to conjure up reasons as to why politicians can continue to occupy important positions when their role is suspect – after all probity in public life is often thought to be a theoretical prerequisite for elected representatives. It is even amusing to note that a four time MLA was forced to grant permissions by a middle level bureaucrat. 

One can imagine, the problems for governance, if the higher layers of the bureaucracy follows it threats with further action. Any discussion about the scope of the recent actions is not needed, what is worrying is that for the first time, the edifice on which the Indian State has been built has cracked - publicly. A government rules by the legitimacy of what the rule perceive it to be, rather than merely what it is.  Invariably, when the edifice cracks, in the not-too-distant future the floodgates may well be opened for other events. Over the past decades, politicians have systematically undermined the governance structures and this clash could not have come at a worse time for the Indian State. The mere thought of the sheer magnitude of problem, if the politicians and the lower bureaucracy are given a free hand is sufficiently scary, especially since the institutional framework is either non-existent or insufficient to deal with the challenges that India faces. If the edifice does crack, the lasting impact will not be in the realm of politics as people expect but it will be more in the sphere of economy, where circumventing the rules the game is the norm, rather than the exception. Unfortunately, the judiciary has little understanding of the nuances of the way businesses break the rules. That will be the tragedy that we may have to deal with over the next few years.

Collapsing Baltic Dry Index: Inauguration of an Era of Reverse Globalisation

Almost all the asset markets have performed by smartly appreciating during the course of the first three weeks of this years. Ironically, the only two indices that fallen sharply over the past three weeks have been the those related to the US Treasuries and the Baltic Dry Index (BDI). Shipping, like many other transportation indices is an important barometer of the economy. Its important grows manifold when we consider the fact that nearly 90% of the global trade is carried by ships. It is pertinent to note that on an average, the volume of Seaborne trade has grown at 4% a year since 1970. The volume of global sea borne trade by the end of 2008 was 89.79%, while in value terms it was 72.71%. In contrast, the volume of airborne trade was a mere 0.25%. The three important important components of shipping are (a) transportation of oil, (b) Containers, (c) 6 dry commodities transported in bulk. The Barometer for Bulk dry commodities is the Baltic Dry Index issued by the Baltic Exchange based in London. The Exchange has a history of more than 250 years and originally tracked the freight rates between England and its 13 colonies in North America.

The BDI has witnessed a roller coaster ride since 2007. It peaked at above 10,000 in first half of 2008, about six months before the collapse of Lehman Brothers (See Chart Below). It subsequently touched 666 in 2008 and gradually sprang back along with the eternal hope that accompanied unprecedented, probably the first gigantic coordinated, global intervention by Central Bank and Governments since the end of the Second World War.

Source: Bloomberg

A predominant view that has attempted to explain this causation is that the fall was triggered by a rise in global dry-bulk shipping capacity. Dry bulk shipping capacity rose by nearly 10% during the second half of 2011 and is expected to rise another 7% in 2012.There is undoubtedly some merit in the above statistics. However, it is likely that it is only part of the story - especially if we look at it in the context of financialisation. The case of Copper is illustrative: Demand for copper fell in 2011, but the price has gained this year - largely thanks to demand from financial investors.

Another factor that has been missed is, the dawn of a new era that has became more discernible after Japan announced its first trade deficit since 1980 has received less attention than it probably should. Interestingly, the only regulator who probably has not missed its significance is probably the US Federal Reserve: its announcement that US interest rates would stay low till 2014 was announced less a day after Japan’s trade figures were announced. US Fed has politely announced that the US economy is now in the firm grip of a deflation, if not outright economic depression. It is unlikely that US will enter a statistical depression as long as Bernanke is at the helm. Are these simply a confluence of coincidences? Maybe not, if we look at a BDI over a longer period of time – from 2001 (See Chart Below).

Interestingly, the chart clearly indicates that the BDI is back to 2001 levels (Close on 25th January 2012: 784), despite the fact that the volume of global merchandise has not risen dramatically since 2007. The chart below clearly illustrates the rise in the Volume of Merchandise over the decades, but it is clear that since 2007 the velocity of growth has slowed down remarkably. This despite the fact that the growth seems to be high in 2010. That rise may largely because of inventory re-stocking (companies seem to be getting used to the operating with razor thin inventories).

It is likely that it will revist the 666 level and hopefully it stays above that level.

Understanding freight rates is not an easy task. Theory states that price is always dependent on Demand and Supply, since demand has fallen last year (WTO points out that world trade likely declined by 5% in 2011),  what has been missed is the fact that is likely that Global Seaborne trade may be in the process of topping and may. That indicates that the breakneck speed of globalisation itself may be tempered over the next few years. If the BDI is an indicator and if my understanding of economic history (as well as my intuition) is right then a process of reverse globalisation may have already begun. A trend change that includes, High unemployment, declining incomes and wages across the developed world is well under way. If one includes factors like employee productivity and geopolitical tension, policy uncertainty and other risks in the emerging markets, capital and big business is likely to be rethinking their whole global business model based on a globally dispersed production supply chain. Instead it is likely to be one based on production within broadly defined economic geographies. It is unlikely that Japanese companies are likely to produce in India to supply US market: global finance and economy have become too complicated and no technology products or risk models can factor something like the timing of extremists among the US Republicans or in the Iranian government triggering another round of conflict. If the recent trend of increasingl investment in US rail roads is an indication, production for the local areas may be the beginning of a new trend.

The only asset class that is likely to benefit in this deflationary era: US Treasury bonds (at least till 2013-14) - I have been saying that for quite some time on this blog. After all, US will not default since it can simply print more US Dollars. The added benefit is that bonds of all hues, especially US Treasury are under-owned by individuals. Still doubtful of deflation in the USA? Don't look at Bloomberg headlines, instead look at the consumption of Petroleum and Electricity in USA.This fall in Petroleum usage and electricity output in the USA seems to have been missed by most of the observers. It is often an advance indicator of economic slowdown. Electricity output has been remarkably flat over the past year and has started falling quite drastically over the past three weeks.

Welcome to the New Era. If we survive this deflation unscathed, we will have great bedtime stories for our grandkids when we are more or less senile.

Do You Have A Dime to Spare

The remarkable feature of the current Eurozone crisis is the near total absence of any understanding of the nature of the present crisis. This sad state invariably worsens the crisis due to the circularity of global finance. Historically, that has been the nature of Europe. Remember the 1920s and 1930s! Till the downgrade of France (on Saturday) by S&P, the magic wand that would save the world from the perfect financial storm was thought to be the EFSF. The downgrade has shown that there is an urgent need for EU countries to conjure up new temporary solutions - like ECB lending more than US$600 billion to banks and they in turn depositing money with the ECB or buying Bonds of debt stricken companies. 

A recent article by Bloomberg provided a graphical overview of what we may expect due to uncertainties of debt rollover. The illustration is reproduced below:

The recent round of downgrades clearly indicates that this is not going to be the last. Most of the countries need to rollover more than 10% of their outstanding debt in 2012. 

An interesting facet has been pointed out by a fund manager: rising cost of capital is likely to bankrupt a  number of countries - an issue we have highlighted in the past in our postings is the bankruptcy of all the countries which are facing bond market pressures. A country or company borrowing at 24% is more likely to be insolvent than solvent. Portugal is definitely in the list of insolvent countries as their borrowing costs have hovered around 12% for more than a year. In the next two years, Italy and Spain are likely to follow suit.

Two years ago we were told that a 110 billion Euro bailout for Greece would be suffice. We were one of the few sceptics. Two years ago throwing two trillion Euros would have solved the crisis, now the tab is probably close to about 5 trillion.

Moving a Mountain: Re-skilling Macaulay’s Products

An interesting trend that seems to gain greater momentum by the day is the increasing felt-need of people from all walks of Indian society to invest in education. A field visit to even the remote areas seems to attest to this trend. Interestingly, English-convent education is the preferred medium of education. A visit to small towns and a cursory glance at the advertising billboards seems to underscore the attempt by educational institutions to gain the attention of passersby who may at some point be a consumer of their services. Amongst the parents, there is a fond hope that, once their child completes their education, they will gain “good” employment, which in turn comes with its own social and economic mobility. This is a welcome long-term development, but comes often ends us with considerable risks to a household. The risks arise not because of the households, but because of the fact that mediocrity is the norm in the Indian Education system. Over the years, either the education system has emerged the single most important destination to people who suffer from either intellectual poverty or have no hope for any gainful employment in the sector. The last three decades has witnessed the emergence of the educational system as the refuge for incredibly stupid people in important positions. Even the most meaningful governmental measures are circumvented. UGC guidelines recommend modifications in the syllabus every five years, with the hope that new developments may be incorporated. Ingenious methods are founds. A few chapters are deleted every few years and an occasional chapter added. After a few years, the deleted chapters are usually brought back and the new ones deleted.

On the other hand, completely unaware of the internal working of the system Parents, continue to invest large sums in the hope that their child will succeed. In order to achieve their aim parents, especially those with higher incomes send their children to distant places – like people from rural areas of Kurnool district sending their kids to places like Vijayawada. Families invest substantial amounts of money for years before their efforts reach fruition. Financial Constraints convince a rural household to take the next best option: send their children to English medium schools in the vicinity of their village – usually more expensive. The interesting aspect of contemporary Andhra Pradesh is the extent to which families are willing to sacrifice their immediate needs for unknown future benefits that may accrue from educating their children. This, growing expenditure has a number of potentially negative repercussions for the families over the long-term (apart from an immediate pressure on the financial health of households).

The above problems need to be understood in the context of the nature of our demographics. It has been pointed out that India's labour force is growing at 2.5 percent per year, the ability to generate employment leads to the absorption of only 2.3 percent in a year – where about 7 million people join the pool of workforce annually (on a national scale). Demographically, about 65 percent of the country’s labour is in the age group 15-29 years, make employment generation as a central concern of policy makers. McKinsey points out, India has an estimated 14 million young professionals-twice that of the US-and topped up this number by 2.5 million new graduates every year, only 10 to 20 per cent of these would ultimately get hired by MNCs.

The picture below is a small advertisement of a college in Koilakuntla, a small town in Kurnool District of Andhra Pradesh. A poster essentially personifies the problems with the education system in contemporary Andhra Pradesh. It is an advertisement of a distance education study centre that claims “even if one fails in intermediate (10+2 classes) they can get a degree”. Interestingly, a unique selling proposition of the college is its ability to impart training in various disciplines including English. 

The highlighted areas in the above image draw immediate attention to the nature of the problem that contemporary Indian Education system faces. These educational institutions predominantly churn out unemployable, low skilled students are likely to emerge as a problems that aggravate the problems of households, especially the rural poor who spend a large proportion of their earnings on such education. At best such graduates will only gain low paying jobs that will not allow them to earn sufficient amounts to repay large debts incurred by their families while leaving the hope for any future socio-economic advancement a mere mirage.

A remarkable feature of rural society in Andhra Pradesh, especially over the last decade, is its willingness to assume large sums of high cost debts in order to meet the educational requirements. While debt are incurred in the present and have to be serviced for years, the employability of the students seems to indicate that there is little possibility of households repaying these based on the earnings from the skills learnt in college years. Students need to invest substantial amounts in acquiring new skills – often from educational institutes like those in the above photo.

The response of the government to this problem is insufficient. In right earnest, it has offered to invest large amounts in imparting skills. The National Skill Development Council, which hopes to re-skill about 500 million people over the next two decades.  Mercer Consulting has estimated that only about 20 percent of those graduating have the skills required by Industry. It has been pointed out that only 25 percent of about 450,000 annual engineering graduates in India are directly employable by technology companies. It has invited the participation of the private sector in the hope that reach of the private sector will help quickly re-orient the poorly skilled graduate. This is well intentioned but unfortunately a part of the problem. Private sector efficiency in India is often overly hyped, under-performing segment. The case of AP is illustrative: there are thousands of private engineering colleges and schools which do not have the basic amenities yet, have licences to operate almost unregulated and not answerable even to those who consume their services.

At a theoretical level, sociologists like Richard Sennett (in The Culture of New Capitalism) have pointed out to the growing ‘spectre of uselessness’ in an era when skills of employees often become redundant very quickly. The present programmes are conceived in such a manner that they often encourage skilling programmes which are required in distant cities – thereby encouraging migration to urban areas. That in turn adds to the pressures on policy makers as our cities are not equipped to supporting such huge population movements. Delivering basic amenities to these rapidly growing cities consumes most of the time and resources of the institution of the State, therefore forcing the government to reduce spending on other areas. The best areas where such government spending can be reduced without the strains of funding squeeze popping up instantly: Education, health and other welfare measures. This completes the vicious downward spiral for any society. The disastrous impact of this is always felt in the long-term, often spaced out over decades. Twenty years of slashing spending on education completes the cycle that has led to the ascendency of mediocrity in the education system. Dismantling this could be more difficult because special interests now form a powerful block. Since, Indian businesses thrive on siphoning public funds, these institutes will invariably corner any new funds.

The chart below provides an overview of the urban populations over the next few decades. A 2010 study by McKinsey Global Institute points out that by 2030, Indian cities are expected to generate 70 percent of the new jobs created, thereby accentuating the growing magnetism of cities, especially amongst the youth. This phenomenal urban expansion will lead to nearly 590 million people residing in cities by 2030 (an increase from 290 million 2001 and 340 million in 2008) – or about 40 percent of India’s population. In order to place this growth in historical perspective, it is imperative to point out that it took an estimated four decades for the urban population to reach 230 million. India is expected to have 6 megacities with a population of more than 10 million, 13 cities with a population of more than 4 million and 68 cities with a population of more than 1 million while at least 331 cities will have a population of less than 1 million. 

It is pertinent to note that haphazard growth poses major social as well as economic risks -something which is ignored. Pity the policy makers for the simple reason that problems in the present are sufficiently overwhelming, let alone future possible headaches.

New Approach Needed

There is an important need for a new approach. This need also arises (in my personal view) in mistaken notions and biases that we have in the present. We often believe that the future skill requirements will be exactly like the requirements in the most recent past. Unfortunately, the economy is more dynamic – especially when we need to factor in the technological change. There is, therefore, an urgent need for Indian re-skilling programmes to conceptualise and encourage programmes that impact skills based on regional requirements in the economy and society. That customised knowledge is completely lacking in the present. To illustrate this with an example: Indian economy is predominantly agrarian in nature. Yet, very few of the re-skilling courses in vogue currently, attempt to train human resources in agriculture and water related issues. Courses that would be extremely useful are those related to soil and water quality testing.

Paradox of Governance in India

A unique aspect of the present crisis has been that at every stage it has created, reinforced and then busted a series of false, exaggerated hopes and expectations. The next two years will literally be the end of an era in the way governance systems work in India. These hopes, claims and expectations were created and nurtured for over thirty years and we have now reached a terminal point where what preceded these claims, hopes and expectations are likely to be ‘lost in transmission’ from societal collective memory. Take for instance the institutional collective memory that policy makers of yesteryears had of the economic conditions in the 1960s and to the events leading up to the 1991 crisis has been mostly lost or will be lost due to demographic changes. This is particularly relevant for the western countries. In the case of India, where we are relatively lucky, because there remain some remnants of the older generation amongst the policy makers, the structural changes in the economy mean that their memory has only limited application. Even that limited application is often constrained due to the nature of our political society and the exigencies of governance and democratic politics.    

Theoretically, a natural corollary of the process of liberalisation and structural change inaugurated in 1991 should have culminated in the economy and the society to become less dependent on the government largesse. In reality, the process seems to have been the reverse, where a complex relationship of dependence on the government seems to have increased rather than decreased. Interestingly, this increase becomes progressively greater at the higher levels of the economic pyramid. Hence, while we have witnessed industrialisation and the growth of a dynamic service sector dependent/oriented economy, unlike most of the industrial societies, there are no processes to distribute risks. Therefore, the risk is transmitted back to the government and then repackaged and passed on back to the people. Such a blatant system has served to automatically restrict the development of institutional mechanisms that facilitate the transmission of risks to those who claim that they are willing to assume them in the first place: there is a complete lack of trust in any other institution except those that are owned and manned by the government. An excellent example is that of deposits in the banking system: people prefer to deposit their money with the public sector banks due to the perception that their money is safe. Thus, the dependence on the government is not simply economic, but one that is socially ingrained and it runs deep. Despite the inefficiencies that may exist in the practical working of the governance structures, they carry a remarkable ability to convince people. It is probably one reason why even those who blatantly break the law seek government intervention to slime their way out of their problems. Little wonder that the best insurance that smart business houses (especially the more leveraged ones) prefer is be appointed as directors of the Reserve Bank of India.

This symbiotic relationship is here to stay and the longer the crisis drags on, the more entrenched it becomes. That indeed is the paradox of India’s governance.