Law and Order - The missing reform

Manas Chakravarty has an article in Mint title IBC Ordinance a blow against the Promoter Raj. It talks about new Insolvency and Bankruptcy Code reform.That raises some prospects of execution problems.

I think Modi government faces lot of execution problems because it has not acted to root out corruption. Here is my solution I wrote for Moneylife. Do have a read and leave a comment.

Notes:

World Bank report on Reform in Georgia

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Tax - Analysis of Banking Transaction Tax

Arthakranti, an organisation credited with the proposal for demonetisation, had another proposal in their toolkit - Banking Transaction Tax (BTT). This BTT was part of overall economic reforms including demonetisation, etc. proposed by Arthakranti. 

You readers will know that I was not opposed to the idea of Demonetisation. Demonetisation is like first step of a process. The success of the process depends on how well the rest of the parts are executed. 

But BTT is a different beast all together. The logic of BTT is quite simple, not totally fool-proof but it is not implausible. Yet, India is too big a country to try it out. The case for BTT has to be built from many sides and none of them are in place. 

Few months ago, however, we have got the first step of that process. NIPFP released a report evaluating the arthakranti proposal. I got to know of it through a tweet by Niranjan Rajadhyakshya [ @CafeEconomics ]. I downloaded the report and read it.

The report was a good first step. The analysis was more academic and I thought they tested some arguments for and against demonetisation. NIPFP however stuck to academics as rebuttal for BTT. It was a good first effort but a college kid could have done that. 

I think to analyse BTT you must look at a feedback-looped simulation of the economy or a industry chain at least. The allowance for adjustment of behaviour cannot be tested directly without accounting for feedback loops.  Some parallel thoughts should be given to Flat tax proposals and their impact on tax compliance.

Nevertheless, it is a good read.

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Farmer suicides and loan waivers - can we solve it?

Farmer suicides have brought the problems facing the farmers to the fore. Indebtedness has been highlighted as one of the dominant problems for suicides. As a corollary, governments have taken populist turn towards loan waivers. This is not the first time the farm loans have been waived. But can we do something to make it the last?

I reviewed the research on this topic and summarised them in my paper. I found there are a lot of problems facing agriculture. To put it succinctly, Indian agriculture suffers from: i) poor productivity, ii) falling water levels, iii) expensive credit, iv) a distorted market, v) many intermediaries who increase cost but do not add much value, vi) laws that stifle private investment, vii) controlled prices, viii) poor infrastructure, and ix) inappropriate research. 

These are basically symptoms of two fundamental issues with agriculture. First, farm risk management has gone wrong. Second, there is lack of coordination between various parts of agricultural value-chain. Thus, farmers do not respond to changing prices and market dynamics pro-actively. They also bear higher costs for post-harvest coordination in the value-chain like transportation, packaging, etc. 

Farmers needed to become better at risk management. They should use futures prices at the crop planning stage itself. At harvest stage a mix of contracted sales, and spot sales to can maximise realisations. They also needed more reliable availability of inputs, of credit etc. All this meant we need information – different types and large quantum of information like futures prices, weather forecasts, demand estimations, pesticide usage guidance, seed knowledge, planting knowledge, etc. AND, this information had to be available to farmer when he/she needs it.

But information is only ONE part of the problem. Farmer also needs physical inputs to reach at his remote farm. So, fertilizers should be delivered on time. Farm insurance should approved. Seeds, pesticides should reach the farmer on time. It means the value-chain partners must be available and acting reliably consistently. It meant the value-chain participants need the farming process to be visible.

There is universal agreement about risk associated with dealing with commodities. It means despite much effort many times farmers will fail. The question is then – can they fail safely? 

The corporate world has solved this issue through use of limited liability vehicles. So can we apply that to the farmers? I believe, a limited agricultural bankruptcy mechanism should act like a safety net for farmers. However, we don’t want farmers to hide personal failures within agricultural risks. Hence, we want farmers to separate personal and agricultural assets for this purpose of limiting liability.

I think we can fix these using an information system –an ERP-like solution for agriculture to help assist the farmers. Such system will reduce the coordination costs, improve information availability and increase the scale of operation allowing formal economy to step in and help farmers. With ring-fencing of risks, low cost collaboration, timely information, we can help farmers into a positive spiral of profits-investment-productivity. I sketch out the schematic of such a system called Smart Agriculture Management System (SAMS) in my paper.

This issue is important. Please read the paper, I tried to keep it as short as possible. Please make suggestions for improvement. If you think SAMS will work then do spread the word.

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World War 3 watch 03 - The North Korean challenge

North Korea has suddenly become active. In the past few years, it has acquired missile technology, nuclear technology and is making and weaponizing missiles with nuclear warheads. Now Japan, a nation whose constitution calls for peaceful, non-aggression is developing first strike capabilities.

First, I doubt North Korea got this technology by itself. I suspect China behind the rise of North Korea. It could also be Pakistan at the prodding of China. I include Pakistan because of the noise in US circles for a radical reset with Pakistan. Ignore the reasons cited in that article for some time. It appears that Pakistan, China and Russia are forming closer ties. That is primary reason US may be considering a radical reset. In 2004, China applied for MTCR membership, but its membership was rejected due to concerns that Chinese entities continued to provide sensitive technologies to countries developing ballistic missiles, such as North Korea.

Second, China may be using North Korea as a strategic piece to test US and its intent in the Pacific, particularly closer to China. China may have used the Philippines for this purpose earlier this year. China is sea-locked and is intent on breaking that stranglehold. 

Third, it is possible US knows this. The THAAD deployment cannot be simply for North Korea. South Korea already has enough arsenal to obliterate North Korea two times over. Further, South Korean forces already possess Patriot systems for point defense and Aegis destroyers capable of stopping ballistic missiles. Huffington Post highlights a possible reason why China is wary of THAAD deployment. 

The United States and South Korea have repeatedly asserted that the deployment will be “focused solely on North Korean nuclear and ballistic threats” — not Chinese missiles. The possibility remains, however, for THAAD’s radar to be covertly switched into a longer range mode that feeds into the broader U.S. missile defense — giving Washington earlier notice of Chinese launches.

In countering the THAAD deployment to South Korea, two existing Chinese missile programs are likely contenders for accelerated development — hypersonic glide vehicles and multiple, independently targetable re-entry vehicles known as MIRVs. 

Fourth, Japan, a nation protected by the US with a full defence presence needs no protection. Yet, Japan last year inducted a pseudo-aircraft carrier, raised constitutional limitations on its armed forces and now is developing first strike capability.

This is a power game between China and US. The strategic pieces used are North Korea, South Korea and Japan. In south China sea, the US did not have a piece in play after Philipines sided with China. These developments do not bode well. But these are the facts.

From the perspective of India and Singapore, China remains a threat. Singapore has conclusively sided with the US and it is the best possible backstop against Chinese domination. India however, has not been decisively in favour of US. It may help to side with the US clearly and unequivocally. At the same time, given the US policy, both Singapore and India need to ramp up their self-defence protocols. Indian missile defence shield is completely inadequate in comparison with what Chinese are capable of. It is time to ramp up the Missile Defences.

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Smart Manufacturing 01 - A Policymaker's guide to Smart Manufacturing by Stephen Ezell

Manufacturing policy intrigues me. The reasons are quite varied. The nations across the world are trying to push manufacturing. I was trying to go through different approaches to manufacturing policy by various nations. I came across this report by Stephen Ezell titled A Policymaker's guide to Smart Manufacturing. I was not quite impressed by the policy recommendations put out in the summary. However, the report is excellent otherwise and a must-read for everyone who loves policy or manufacturing or both.

History of manufacturing

It describes the evolution of the smart manufacturing, rather manufacturing itself. Here are some quotes: [Emphasis and comments mine]

For most of human history, “manufacturing” entailed artisanal fabrication (i.e., individually skilled bronze or iron workers), a paradigm that prevailed through to the Middle Ages (approximately 700 AD), when it gave way to a craft-guild production system [these were the trade body equivalent - RD] that was still specialized in its trade, but now evolved from the individual- to the guild-production level. This system was usurped by the so-called First Industrial Revolution, beginning at the end of the 18th century in Great Britain, which saw the introduction of water- and steam-powered mechanical production facilities (e.g., the cotton gin and textile loom) and the increased use of iron-based products.  

Almost a century later, in the late 19th century, the introduction of electricity-powered mass production based on the division of labor, increased use of steel-based products and machines, and assembly-line concepts (i.e., Henry Ford and mass automobile production) heralded the so-called Second Industrial Revolution.  

A third transformation occurred in the postwar era, when discrete goods manufacturers began to introduce automation technologies (a term coined in 1945 to describe single-purpose machines designed to produce one specific part or conduct one specific process) as well as automated, continuous-flow systems. However, these systems were anything but flexible and, as they matured, the work could often be performed by lower-skilled labor, far from final consumer markets. At the same time, the emergence of science-based industries, including electronics and chemicals, meant that an increasing number of products became more sophisticated. It is important to note, however, that most commentators ignore this third transformation, lumping it together with the transformation at the end of the 1890s. As a result, many refer to today’s transformation as the “fourth industrial revolution” or “Industry 4.0.” (This report will refer to today’s transformation as the fifth wave.) [RD: There was also development of transducer technology that aided automation] 

The fourth transformation occurred in the 1980s and 1990s, when the first digital- electronic systems were developed, empowering ICT-enabled systems (e.g., computer-aided design and manufacturing, robotics, etc.) to further automate manufacturing, adding some flexibility but mostly enabling the better coordination of dispersed supply chains, thereby enabling the global distribution of many kinds of production.  

Emerging today is a fifth wave—an era of “smart manufacturing” that integrates advanced- digital technologies more completely into production systems. These technologies include wireless communication technologies, the Internet of Things, cloud computing, easily (re)programmable robots, machine intelligence, and other next-generation digital technologies to create a direct, real-time interface between the virtual and physical world. 

Here are the sources for the above from the references cited in above article:

• Rebecca Taylor, “Do It in Digital: Virtualization and Tomorrow’s Manufacturing” (presentation, The National Center for Manufacturing Sciences, Ann Arbor, MI, July 2015). 

• Dr. Henning Kagermann, Dr. Wolfgang Wahlster, and Dr. Johannes Helbig, “Recommendations for Implementing the Strategic Initiative INDUSTRIE 4.0” (German Federal Ministry of Research and Education, April 2013), http://www.acatech.de/fileadmin/user_upload/Baumstruktur_nach_Website/Acatech/root/de/Material_f uer_Sonderseiten/Industrie_4.0/Final_report__Industrie_4.0_accessible.pdf. 

• For a description of the history of manufacturing technology waves, see Robert D. Atkinson, The Past and Future of America’s Economy: Long Waves of Innovation That Power Cycles of Growth, (Cheltenham, UK: Edward Elgar, 2005). 

• Stephen J. Ezell, “Industry 4.0 Holds the Key to Modern Manufacturing,” Bridges 42, December 2014, http://ostaustria.org/bridges-magazine/item/8318-stephen-ezell-on-innovation-matters. 

Defining smart manufacturing

There is a lot of confusion as to what kind of manufacturing is being promoted by different governments. One thing, though, is certain. The governments are promoting new manufacturing and not what already exists. This new manufacturing goes by different names across different countries - "advanced manufacturing", "smart manufacturing", industrie 4.0, etc. I use the term "smart manufacturing for this. Stephen also collates the definitions of Advanced Manufacturing or smart manufacturing:

OECD Definition of advanced manufacturing: Advanced manufacturing technology is defined as computer-controlled or micro-electronics-based equipment used in the design, manufacture or handling of a product. 

The President’s Council of Advisors on Science and Technology (PCAST) defines advanced manufacturing as “A family of activities that (a) depend on the use and coordination of information, automation, computation, software, sensing, and networking, and/or (b) make use of cutting edge materials and emerging capabilities enabled by the physical and biological sciences; for example, nanotechnology, chemistry, and biology. It involves both new ways to manufacture existing products, and the manufacture of new products emerging from new advanced technologies.”  

The definition given by legislation introduced in the 114th Congress proposed a useful formal definition of smart manufacturing as part of the North American Energy Security and Infrastructure Act of 2016 (S. 2012).9 The legislation defines smart manufacturing as: 

“Advanced technologies in information, automation, monitoring, computation, sensing, modeling, and networking that (A) digitally (i) simulate manufacturing production lines; (ii) operate computer-controlled manufacturing equipment; (iii) monitor and communicate production line status; and (iv) manage and optimize energy productivity and cost throughout production; (B) model, simulate, and optimize the energy efficiency of a factory building; (C) monitor and optimize building energy performance; (D) model, simulate, and optimize the design of energy efficient and sustainable products, including the use of digital prototyping and additive manufacturing to enhance product design; (E) connect manufactured products in networks to monitor and optimize the performance of the networks, including automated network operations; and (F) digitally connect the supply chain network. 

How policymakers should view Smart Manufacturing?

Stephen cites Tim Shinbara:

Tim Shinbara, vice president for manufacturing technology at the Association for Manufacturing Technology (AMT), explains that policymakers should envision four levels, or layers, of smart manufacturing. 

At the first layer lie the intelligent machines themselves, the individual production equipment doing the work of forming, cutting, forging, and stamping products that integrate into the Industrial Internet of Things by being equipped with sensors that create information streams. 

At the second level, a “digital thread” consolidates information streams from those individual machines across the factory floor (and indeed across the entire enterprise-wide production system) by linking multiple “process chains” together. This represents a consolidated, ICT-enabled view of each of the individual process chains that constitute an enterprise’s holistic manufacturing production system. 

At the third level lies applying data analytics to this broad “manufacturing intelligence” to optimize processes and to iteratively design intelligent products. 

At the fourth level are smart CEOs, or smart C-suite executives, who are empowered to make optimized, real-time decisions on production levels, production location, production options, etc., based on the corporate intelligence created by the smart manufacturing enterprise. 

There could be the fifth level that protects the consumer’s data and privacy as a part of the structural design of advanced manufacturing itself. Thus it should be easy for the consumer to share her personal information to the manufacturing centre so as to enable better customisation while protecting the data shared by her. One way to do it is through protective laws at a national level. Alternatively, we can use something similar to Asimov's rules for robots for the protection of data in smart manufacturing.

Smart at each step of manufacturing

I get confused when we use a generic word "smart" to everything. Many times it does not clarify what exactly smart means. Using ICT in every step - yes. But what does it mean? Stephen dwells on it and constructs a detailed vision of how the use of ICT can be deployed in manufacturing. The report is full of examples from Xerox and GE to SMEs using these technologies.

He classifies the "smart" discussion into: [some important quotes highlighted for my use-RD]

1. Digitally Enabled Product Design
2. Additive Manufacturing (3D Printing): 
1. Heretofore, most manufacturing processes were subtractive, that is, they started with a block of sheet metal or aluminum and were milled or stamped into desired shapes; in contrast, additive manufacturing is built up layer-by-layer, enabling fundamentally new shapes and even mechanical linkages that simply can’t be achieved through traditional subtractive manufacturing techniques.
3. Digitally Empowered Factory Operations: 
1. Life sciences and ICT hardware manufacturers leverage smart manufacturing technologies to predict problems and cuts costs. Intel uses predictive modeling on data to anticipate failures, prioritize inspections, and cut monitoring costs at its chip-manufacturing plants.
2. Finally, smart manufacturing techniques allow designers to rethink the traditional, location-fixed factory floor, and even to make the “factory floor” itself mobile. For instance, Pfizer is currently developing portable manufacturing platforms, allowing it to efficiently produce vaccines for children in countries where they are needed most.
4. Digitally linked supply chain management:
1. Here the report turns a bit shallow but
5. Smart products beyond the factory:
1. In another instance, in 2013, batteries in two Tesla Model S cars were punctured and caught fire after drivers struck metal objects in the roadway. Tesla realized the chassis on some of its vehicles was too close to the ground, and was able to send an over-the-air software update to all Model S vehicles that raised their suspension under certain conditions, significantly reducing the chances of further punctures.
2. The data stream produced by engines and airplanes also changes the service and support offerings that jet-engine manufacturers can provide. Engines produce tremendous amounts of information. A single Boeing 737 engine produces 20 terabytes of data every hour in flight.81 Therefore, an eight-hour flight from New York to London on an aircraft with two engines can generate 320 terabytes of data.82 GE Aviation Engines tracks the exact conditions—temperature, humidity, altitude, particulates in the air (e.g., dust)—of each mile flown by its engines. Accordingly, when GE puts together its engine maintenance and service bid for airlines such as Emirates, Lufthansa, Southwest, or United its offer is based on knowledge of the historical use and experience of each engine in the contract.

In this part some things may have been missed:

1. Distributed quality control is critical. 
1. One of the reason for keeping the production in-house was control over quality of the product which impacted the brand.
2. With advent of standardized quality control procedures (6-sigma, Kaizen, TPM, etc.) each factory was able to achieve high quality. Yet, adherence to quality remains a significant issue in modern quality. There has been substantial development in this area. Apple uses AI to match the components etc. 
3. It will soon be possible to control the quality remotely.

But what about transfer of jobs and manufacturing to lower cost locations?

Stephen answers this with 

Indeed, smart manufacturing techniques will increasingly enable competitive manufacturing in high-cost environments. For example, professor Suzanne de Treville of the University of Lausanne has developed supply-chain analytics tools that help companies quantify and price the advantages they have in manufacturing locally, making it easier to show that the apparent cost reduction offered by a competitor in a low-wage country might not be as compelling as it seems. By applying quantitative finance tools to demand dynamics, Treville’s freely available Cost-Differential Frontier (CDF) price calculator allows manufacturers to price the increase in exposure to demand volatility that comes from increases in lead time.105 Many companies applying the tool find that the supply- chain mismatch costs arising from increased demand-volatility exposure are frequently greater than the cost reduction offered by an offshore supplier, and that going offshore is often not a bargain. Combining this analysis with quantifying the impact of possible demand peaks also allows companies to rethink cost allocations depending on time sensitivity. In total, the tool helps manufacturers to understand volatility in order to manufacture close to their markets profitably (and without requiring subsidies). In summary, there’s an increasing economic justification in modern manufacturing for co- locating idea generation, design, systems development, production, and supply-chain management.

I do not agree with the conclusion. I think manufacturing can remain more distributed than before. I don't see why Auto servicing centres cannot assemble the entire cars while maintaining quality controls. 

Comparative policy analysis

Stephen thereafter compares the policies used by different nations to develop smart manufacturing. Here is the comparative snapshot:

He has described the policies in short. But these policies still remain too generic. The idea is to spend the money and hope for the best. Most of these countries, though, do have a basic idea of what can be achieved.

Comments on policies

First, there is no focus on what kind of talent will be required for the Smart Manufacturing initiatives. 

There is also no comprehension as to what effects it will have on jobs. 

In this aspect Germany seems to be doing better. Firstly, it has developed some use cases which hopefully means that German entrepreneurs and manufacturers get some exposure of what is possible with new tech. Secondly, it means the adoption of basic level of Smart Manufacturing will be more widespread than other countries estimate.

Singapore has done well in this area too. Singapore government has engaged with different industry sectors to identify the skill requirements of these sectors and their future.

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Demonetisation - Why did it NOT affect GDP at all?

India released its GDP growth number for Q3 of the Financial Year 2017 (April 2016-Mar 2017) and it clocked in at 7%. This performance was particularly noteworthy (pardon the pun) because 86% of notes in circulation were withdrawn on November 8. The problem eased only by mid-January. Thus, two out of three months in the quarter, India faced a massive disruption. Anecdotally, during the period since November 8, most of the country was busy depositing cash, swapping notes etc. Consumption activity was reduced, there was stalling of transportation services (trucks) etc. Experts commented that Indian GDP growth would reduce - by 1.5-3% from ~7.5%. In effect, markets were expecting GDP to clock in at 6.1%. Notwithstanding that, Indian GDP came in at a strong 7%. Economists were spooked and people have started blaming the CSO for the quality of data.

Naturally, today's papers are filled with sceptical articles.

Mint Manas Chakravarty concludes that this is not entirely because of base effects. In fact, some sectors have had base effect advantages but others do not. Overall, the trend in activity seems to be smooth.

Another Mint article indicates a possibility that Strategic timing of demonetization and fiscal stimulus seems to have helped in retaining growth despite demonetisation. Here the author suggests few reasons. First, the informal sector mainly affected by demonetization is not appropriately captured in GDP statistics. It also attributes the muted impact to strategic timing after the festive season demand has played out. The Third reason could be that the government has been using some sort of a counter-cyclical fiscal policy to stimulate investment activity. Government Final Consumption Expenditure (GFCE) grew at a massive 19.9% in year-on-year terms in the previous quarter.

The Economic Times questions the credibility of the data. In another article ET cities various analysts /economists who find the data incredulous. Interestingly, ET also has an article that says Fiscal deficit for first 3 quarters has surpassed the annual target. This sort of corroborates with the Mint's suspicion of fiscal stimulus.

Financial Express article states that, some analysts believe that some said use of old notes for consumption might have contributed to the rise. It also highlights some discrepancies —

the difference between the supply and demand side of GDP — turned negative after a gap of four quarters (-Rs 6,767 crore) in the December quarter, compared with Rs 45,378 crore in the second quarter and Rs 30,645 crore in the first quarter. In the last quarter of 2015-16, discrepancies touched a massive Rs 1,43,210 crore, causing a flutter then and raising doubts about the credibility of the country’s data collection mechanism. When private final consumption expenditure, gross fixed capital formation, government final consumption expenditure, change in stocks, valuables, and net exports exceed the overall GDP (based on the supply side data), discrepancies turn negative.

So what happened? Was the pain felt during the demonetization unreal? Actually, no. The answer to the positive surprise in the GDP figures is in the details.

First, the informal economy is severely under-represented in the GDP numbers. Naturally, it does not count the upside nor the downside. Thus, GDP number remains disconnected from their reality. However, this may not fully explain the upside surprise.

The main reason why data surprised because of the way it is designed. Nothing wrong with the calculations but these are design flaws. Here is a table showing the components used to determine the growth in individual sectors.

GDP Advanced Estimates - Indicators used for estimating GDP

If you notice, the indicators are not sensitive to the demonetization effect. At least not so quickly. The effect of using these indicators is that you will get a smoothened GDP series when compared to changes on the ground. Most of these indicators were positively affected by demonetization. For example,

1. More taxes (municipal, sales and excise, etc) were paid so as to use the existing cash. 
2. Many smaller firms were used to push money into bank accounts by showing that as cash sales (taxed at 35% v/s penalty rate of 50%). 
3. Agricultural sowing/production was not affected because of the timing of the move.
4. The number of train bookings had gone up during the demonetization period. There could be a similar increase in freight bookings too.

All in all, I do not think it is any calculation or manipulation effect. The high GDP number is result of design of the indicator itself which leads to smoothened output. Naturally, we may see a dampening effect in subsequent quarters are the true distortion gets dissipated.

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Black Money - Shell Company game

Since demonetization, everyone wanted to know how the black money will be uncovered. The uncovering of black money is like a game of chess. It is boring to watch but very interesting if you follow it. The government, it seems, has made another move. Shell Companies are under the scanner in the next step against Black Money. Mint first broke the news in this article titled "Govt. plans crackdown on shell companies". The mainstream media is not focussed much on this development. Economic Times put it up recently titled Centre may shut down 7 lakh shell companies in war on black cash. Yet, it represents a significant move.

There are, by one estimate about 600,000 to 700,000 shell companies in India. It was not easy to identify these. Here is what Mint reported:

After monitoring a small sample of these shell companies, it has been found that Rs1,238 crore has been deposited in the accounts of such entities in the November-December period. 

Further, 49 shell companies and other proprietorship concerns have been identified wherein it was found that 559 beneficiaries laundered money amounting to Rs3,900 crore with the help of 54 professionals including chartered accountants. 

The Serious Fraud Investigation Office (SFIO) has filed for criminal prosecution of these entities and initiated the process for winding them up.

Indian shell companies fall into a few categories below (not exhaustive):

1. Companies held by Benami-owners (example owned by driver/servants of politicians)
2. Dormant shell companies  (companies that have not filed any returns, primarily because they do not have any business activity either by design or by lapse of time)
3. Aged shell companies (these are marginal companies not filing returns regularly but having some assets and liabilities)
4. Foreign registered shell companies

Few ways Money is laundered using shell companies

1. Government Contracts are given to Companies held by Benami-owners. [Municipal Corporations tend to like this mechanism]
2. Backdating the Infusion of cash and transactions in dormant shell companies. [Individual money launderers, developers, construction industry participants prefer this]
3. Hiding a high-value asset in aged shell company which has otherwise minimal net worth. [Always a chartered accountant is involved in such deals]
4. Purchase of aged shell company with accumulated losses in combination with point no. 3 above. It delivers double advantage - tax savings and subsequent long-term capital gains (tax-free). [This is also a chartered accountant money laundering technique]
5. Globally registered shell companies do business with India using the P-note route.  [This is sophisticated routes the big fish are here]
6. Alternatively, they interact with legitimate businesses owned by relatives of politically-connected persons at a discount or loss. [Central and State bureaucrats use this modus operandi]

And there are more.

In this context three essential elements need to be tackled. First, the ownership of these companies should be made clearer. Second, the banking channels should be tightened. Finally, P-note route should be closed.

Further Reading - The Global Shell company problem

The shell companies are also on the radar across the world. 

To understand one aspect of the shell company game you can see this post How shell companies launder dirty money? This is the American description of the problem. 

These companies are fronts for money laundering, illegal trade and smuggling. Jo Becker, back in 2010, detailed the mechanism of using shell companies by Iranian arms smugglers in his New York Times article. It is worth a read. 

Huffington post has a great compilation of different aspects of shell companies.

Reuters' investigation Shell Games is a must read.  Read this line from the report:

At a single address in this sleepy city of 60,000 people, more than 2,000 companies are registered. The building, 2710 Thomes Avenue, isn't a shimmering skyscraper filled with A-list corporations. It's a 1,700-square-foot brick house with a manicured lawn, a few blocks from the State Capitol.

Global Witness has taken up a campaign to end anonymity of the shell companies. More on Global Witness' war on anonymous companies is here.

World Bank has released a report on links between corrupt and shell companies in its report titled "The Puppet Masters: How the Corrupt Use Legal Structures to Hide Stolen Assets and What to Do About It". Needless to say it is a fascinating read.

This problem affects Indians through the p-note route.

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RBI minutes of meeting - Was RBI unanimous in its monetary policy?

The Reserve Bank of India released the minutes of the third meeting of the Monetary Policy Committee (MPC). In that meeting two important decisions were made. Firstly, the rates were left unchanged and second the stance was changed to "neutral" from "accommodative". While the first was in the deliberation set of the market, the second truly spooked the market. Markets were not expecting a change of policy stance. There was speculation about if the decision was, in fact, unanimous or not.

Well, the minutes do not give us that clarity. Indian mentality is to deliberate and discuss the differences and then once consensus is reached, the decision is "unanimous". The deliberations and differences are left out of the public statement. 

The statement includes this explanation as such:

3] According to Section 45ZL of the amended Reserve Bank of India Act, 1934, the Reserve Bank shall publish, on the fourteenth day after every meeting of the Monetary Policy Committee, the minutes of the proceedings of the meeting which shall include the following, namely:–

(a) the resolution adopted at the meeting of the Monetary Policy Committee;

(b) the vote of each member of the Monetary Policy Committee, ascribed to such member, on resolutions adopted in the said meeting; and

(c) the statement of each member of the Monetary Policy Committee under sub-section (11) of section 45ZI on the resolution adopted in the said meeting.

In effect, the minutes of MPC are nothing but public statement or press release for the MPC and is duly sanitised. It does not state of any differences between the MPC members. Nevertheless, the committee seems to have been unanimous on both the aspects of the decision. The committee has made some important statements: [formatting changes for improved readability are mine]

On Inflation 

It is important to note three significant upside risks that impart some uncertainty to the baseline inflation path – 

• the hardening profile of international crude prices; 

• volatility in the exchange rate on account of global financial market developments, which could impart upside pressures to domestic inflation; and 

• the fuller effects of the house rent allowances under the 7th Central Pay Commission (CPC) award which have not been factored in the baseline inflation path.  

The focus of the Union budget on growth revival without compromising on fiscal prudence should bode well for limiting upside risks to inflation. 

On GVA growth 

GVA growth for 2016-17 is projected at 6.9 per cent with risks evenly balanced around it. Growth is expected to recover sharply in 2017-18 on account of several factors. 

First, discretionary consumer demand held back by demonetisation is expected to bounce back beginning in the closing months of 2016-17. 

Second, economic activity in cash-intensive sectors such as retail trade, hotels and restaurants, and transportation, as well as in the unorganised sector, is expected to be rapidly restored. 

Third, demonetisation-induced ease in bank funding conditions has led to a sharp improvement in transmission of past policy rate reductions into marginal cost-based lending rates (MCLRs), and in turn, to lending rates for healthy borrowers, which should spur a pick-up in both consumption and investment demand. 

Fourth, the emphasis in the Union Budget for 2017-18 on stepping up capital expenditure, and boosting the rural economy and affordable housing should contribute to growth. 

The Committee inflation and growth expectations are mapped as follows:

The forecasts do lend legitimacy to the neutral stance. The statement includes emphasis on "caliberated approach" to achieve the 4% target. Urjit Patel clarified that neutral stance implies that rates can move any direction. Thus, in effect turns out to be quite benign policy.

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Tax as a destabilising force - Border Adjustment Tax

John Mauldin, a prolific commentator, is well connected to the Republican establishment. He has recently concluded a three-part series titled Tax Reform: The Good, the Bad, and the Ugly on the coming tax reform in the US. The parts can be found here - first, second and third. It is a must read. 

The US is trying to simplify tax structures. This, by itself, is nothing new. All the countries have been trying since time immemorial to simplify tax codes. Surprisingly, they keep getting more complicated. I do not think "simplify" means what you think it means. But this time, it does seem simpler. Let us not jump the gun, it is still early days. Let the bureaucrats have a go at it and it will come out as complicated as it has ever been. Nevertheless, the intent seems to be right.

The disturbing part is the way BAT or Border Adjustment Tax is supposed to work. John paints a pretty grim picture and rightly so of the adverse consequences of ill-thought out Border adjustment tax. Mauldin and his friend Charles Gave, both seem to suggest that this move will disturb the present equilibrium. Other republicans do not think so. But there is merit in Mauldin-Gave arguments.

And then I read the US intelligence’s ‘Global Trends, Paradox of Progress’ report. That is another bleak report. What is disturbing is that the world seems to be in a precarious balance at present and 5 years out. Some situations in next 5 years as highlighted by the report:

Now the timing of BAT by Trump has become exceptionally crucial. At times in history you get amplified impact because historically small acts happened at unstable times. Here we are faced with a big act at unstable point. In effect, we are beholden to Trump's good sense, pragmatism and sense of leadership.

Interesting times these.

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Why is the current easy-monetary policy ineffective?

Ben Inker, head of GMO's Asset Allocation team had a great article this quarter.

It has been the extended period of time in which extremely low interest rates, quantitative easing, and other expansionary monetary policies have failed to either push real economic activity materially higher or cause in ation to rise. The establishment macroeconomic theory says one or the other or both should have happened by now. It seems to us that there are two basic possibilities for why the theory was wrong. 

The first is a secular stagnation explanation of the type proposed by Larry Summers and others. 

The second possibility for why extraordinarily easy monetary policy has not had the expected effects on the economy and prices is an even simpler one: Monetary policy simply isn’t that powerful. is line of argument (which Jeremy Grantham has written about a fair bit over the years) suggests that the reason why monetary policy hasn’t had the expected impact on the real economy is that monetary policy’s connection to the real economy is fairly tenuous.

In this context, there are some important aspects.

First, monetary policy and economy are connected to each other by feedback loops. By now, every market participant knows that if there is any inflation up-tick the monetary policy will be tightened. This information prods the participants in asset classes where the inflation impact will be low. A look at inflation basket will tell us which are these sectors where price runs will not affect inflation. Exotic assets are in fashion for this reason. Art, diamonds, high-end real estate (trophy), luxury items etc all form part of this group.

Second, why does the low-cost debt not push investment for improving productivity for general items that form part of the inflation basket? The answer is there is no demand. When the market concludes that there is a substantial demand to justify the investment then the investments will come. There is no demand because there is excess capacity, predominantly in China for manufactured goods. This is the reason monetary policy is not effective. 

Monetary policy is effective when there is underlying demand is strong. Without demand monetary policy is just an enabling environment for nothing in particular.  That the monetary policy is not working is itself a data point. It is telling us that the masses do not have the purchasing power to fuel a demand pick-up. There are two reasons.

Most of these masses derive their incomes from the products that make up the inflation basket. If inflation remains subdued, their incomes remain subdued. The low-interest rate has reduced the cost of capital meaning it is cheaper to deploy robots instead of people. So in fact machines are replacing some jobs. These two factors currently suppress the purchasing power. To compensate, people want to build higher threshold of income-level before they start consuming normally. So, the general population is busy buttressing their purchasing power. 

The second reason is that the pre-crisis demand was inflated by debt. The low-cost debt created a hyper-demand which may never return. At the same time, the debts from the past consumption binge have come due. So the indebted families are busy working their debts off. If all the debts of the bottom 50% of the population were simply forgiven, it would have been cheaper than QE. But it would have immediately buttressed the purchasing power of the masses. 

It is a complicated explanation, but it cannot be simplified any more. When feedback systems are interacting, you will get complexity.

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Should democracies reclaim power over production of money?

Ann Pettifor writes a blog post drawing on her new book "The Production of Money: How to Break the Power of Bankers" saying as much. At the outset I must say that I love to read her articles and posts and I have tremendous respect for her.

Her diagnosis is that our present predicament is the following: (emphasis mine)

It is my view that current economic disorder is largely caused by the invisibility, the lack of transparency, and the intangibility of the international financial system – the cause of recurring global economic failure. The fact that the system cannot be seen or understood, that it is opaque to society, means that it cannot be changed or transformed by society. Widespread ignorance of the workings of the great public good that is our monetary system has made society vulnerable. Ignorance enables those financial interests that have wrested control of the system away from democracies, to continue to undermine the security of society. 

If democracies are to once again subordinate the finance sector to the role of servant to the real economy, it is vital that the public gains greater understanding of the monetary system – which I believe to be a great public good. That is the ambition of my modest book, The Production of Money.

This book indeed will be interesting. At present, I am only commenting about this post. I am with her up to this point.  Understanding the monetary and banking system is indeed important. But then she cites an example of the system:

The reality of life under a model that elevates the global over the domestic economy was starkly exposed recently by the fate of a small tea room based in Highcliffe Castle, Dorset. The tea-room had been owned and run by a local, Sean Kearney, for 17 years. It was put out to tender by the council. The company that won the tender was a global behemoth – the $14bn Aramark corporation, that owns prisons and canteens worldwide and is headquartered in Philadelphia. 

This ‘storm in a tearoom’ as The Times dubbed it, was a classic example of how today’s economic model fails the people of Britain. It pits the minnow of a locally-owned tea room against a globally powerful and financially mobile shark. This is not free market competition. This is grossly unfair, economic slaughter of a viable business. As a result Sean Kearney may well now become one of those ‘left behind’ by British government policies.

I am not sure I understand this. There are too many confusing ideas at play. Are we against a buyout of small companies by big ones? Are we against a buyout of local companies by foreign companies? Are councils beholden to grant tenders to local individuals? 

Then she says:

Depressingly, our politicians – on both sides of the House – learn nothing from this. Despite all the nationalist rhetoric, we know that the dominant economic model that led to the populist uprising for Brexit has not been seriously challenged by the Conservative party, or any of our politicians. The government will continue to stand aside as footloose, mobile capital uses its absolute advantage to swallow up the enterprising minnows of the economy, and to wreak havoc on society’s social, economic, and political goals.

This example is very casually stated - it does not buttress the case of the book. In fact, governments that intervene in such deals are frowned upon by commentators like Ann Pettifor. Such protectionist interventions are limited to companies where strategic interests are involved. (Ports, dams, critical road or intellectual property etc.) What is surprising are the steps suggested to control the capital are even more onerous.

Capital control over both inflows and outflows, is, and will always be a vital tool for doing so. In other words, if we really want to ‘take back control’ we will have to bring offshore capital back onshore. That is the only way to restore order to the domestic economy, but also to the global economy. 

Second, monetary relationships must be carefully managed – by public, not private authority. Loans must primarily be deployed for productive employment and income-generating activity. Speculation leads to capital gains that can rise exponentially. But speculation can also lead to catastrophic losses. Loans for rent-seeking and speculation, gambling or betting, must be made inadmissible. 

Third, money lent must not be burdened by high, unpayable real rates of interest. Rates of interest for loans across the spectrum of lending – short- and long-term, in real terms, safe and risky – must, again, be managed by public, not private authority if they are to be sustainable and repayable, and if debt is not going to lead to systemic failure. Keynes explained how that could be done with his Liquidity Preference Theory, still profoundly relevant for policy-makers, & largely ignored by the economics profession.

This takes the pendulum in the other direction. I have a problem with this approach.

Removing the power of creating money from Banks 

It is a bad idea. The function of banks in a properly governed system is to create money where there is a potential for creating value. This distributed money creation helps create money at the point where it is most useful. And the same time if it is not useful a money incurs a cost that is interesting and expense on the bank's balance sheet. The core principles of this process have been undermined in the recent years. But that does not mean the principle is bad. 

Dr Pettifor suggests that a public body needs to take charge of this function. In fact, governments or public agencies are absolutely the worst agency to create money. If you imagine a bureaucratic agency like central bank to take it over then you will end up with delays. Further such bureaucratic institutions are open to regulatory capture by the same banks.

The alternative is the political system. Political systems are best geared to determine "policy direction" and not operations. Thus, without expertise, if you let politicians determine the money creations you will have a worse system than what you have.

The problem with the present system is not that it has failed. But it is that it does not fail enough. The regulatory mechanisms are mollycoddling the banking industry. Because of regulatory interventions, banks do not fear the losses from risk-taking. In my book, Subverting Capitalism & Democracy I call this failure of attribution. Regulation should make these losses more directly attributable to the banks. So no bailouts. Increase capital buffers - Anat Admati recommends 30%. There should also be an unlimited liability to shareholders to the extent of losses caused by their firm. 

The "bad" debt and capital issue

Dr Pettifor is right when she says that interest rates cannot be ridiculously high. Credit-card industry is a prime example. It is in a dire need for regulatory oversight. The Elizabeth Warren's initiative to reduce the credit-card agreement to readable short form is commendable.

She is also right to the extent that loans should not be made for non-productive uses. In effect, she implies we need to differentiate good debt from bad debt. This is absolutely critical and I have said so before. Productive debt creates an asset of higher value than the debt itself.

The question we need to ask is why banks were ready to lend for non-productive activities. The answer lies in the export-led growth model pursued by developing countries - first Japan, then South East Asia and then finally China. To hold their exchange rates low they created dollar reserves sending large amounts of capital into the US. The US has benefitted enormously from this available capital. It pushed the risk curve lower thereby sending funds (venture capital) into high-risk ventures. Without the return-lowering effect of this capital Google, Yahoo, Facebook none of this would be possible.

Another side of the problem, the expert central banks have kept interest rates too low for too long. This low-interest rate regime has caused some damage resulting in mal-investment. It has also pushed capital as an alternative to labour leading to lower quality employment.

In recent years the tide has turned. The new capital was generated by consumption overseas. This capital does not want to return to the US - because of taxes and other reasons. But more importantly, this capital does not want to finance bad investment (debt or equity). If you really think it through most of the low-hanging "productive" opportunities are in developing countries. In effect, what the capital is saying is that - on a post-tax level the capital cannot create a positive, real return in the US. If such returns were possible this capital would have flown back to the US.

The real problem

Dr Pettifor's line that "you need to cut out the bankers from the production of money" may be paraphrased for marketing reasons but it is not a solution. However simple we want life to be, the reality is it is quite complex. The solution to the 2008 financial crisis is fixing the various failed incentives structures created by public systems. The solution is not the let public systems go berserk in other areas. The solution is to reorient the incentives - one by one. It is not a glamorous solution but it is the only thing that will work.

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Unmanufacturing Revolution - Is it the future?

Today I came across an article about Apple wanting to sell refurbished iPhones in India. The author, Tim Culpan, goes on to state that India could disassemble the iPhone for Apple. In this, there could be much more value. I agree.

Unmanufacturing is organised processing of manufactured products to their basic salvageable state. It is not new. India is a leader in Ship-breaking. There is no reason to believe we can do far better in unmanufacturing for electronic goods too. For quite some time we have focussed on manufacturing jobs and manufacturing contributing to the GDP. There could be substantial value in this activity too. 

Electronic waste processing is just one aspect of the work. As companies focus more on sustainability and recycling, we should be able to process all products - automobiles (cars, ships, aeroplanes), electronic goods (computers, phones etc.) durables (washing machines and etc.) to demolition (processing of buildings etc.).

This is not waste processing - which is a different and also lucrative business. This is about high-value items being disassembled to recycle the critical parts such as precious metals etc.

Done at a large enough scale, in a proper systematic manner, it can open up huge opportunities for employment.

  

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Is India still rising?

I came across this superb talk by David Mulford, former US Ambassador to India given in October 2016. Some positive highlights (I paraphrase):

1. India is a genuine democracy unlike China or such other countries. The data is more dependable and governance is more transparent, unlike non-democratic countries.
2. India has leapfrogged the fixed line telecom revolution by going to mobile directly.
3. India is also likely to leapfrog the credit card system.
4. India had the best monsoon 1954 this year.
5. The way to look at India is not to compare it with China, Singapore and others but to think of India as 19th Century America with robber barons. 
6. India has a service-oriented economy but Modi is pushing for manufacturing. Many of these projects particularly in defence and technology will materialise sooner.
7. By the enhanced transfer of funds to State Modi is trying to create competition between States for growth. Young people are joining the state politics and the political climate is likely to see a drastic change. India constitution is explicit as to the division of powers between State and Center and that helps the political leadership in the states to set correct goals.
8. Religious stability is high in India. Despite having about 250 million Muslims, Indian Islam seems to be softer and therefore radicalisation is much lower.
9. Cooperation between US and India increased after the 26/11 attacks (hotel attacks as he calls them). FBI teams from US helped Mumbai police. Some cooperation as to how to coordinate intelligence between local-central agencies is being shared.
10. India's Nuclear disaster liability law is not correctly worded which has prevented capital from coming into the country for nuclear power. The liability currently is on the suppliers and not the operators.

It is a must watch.

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Demonetisation: Penalty of equal amount on cash transactions greater than Rs. 300,000!

After the budget, Finance Secretary spoke to TV channels and clarified that Government will be imposing 100% penalty for accepting cash greater than Rs 300,000/- per transaction. The penalty will be levied on the receiver. Mint has an article reporting this.

Immediately a few thoughts came to mind:

1. This move is trying to choke the points through which black money becomes white in large sums but few transactions. Example, purchase of luxury cars, watches, exotic items like liquors etc. Such businesses have no reason to be in cash except to serve the black economy fellows.
2. There are still points where we have black money exchange is based on small sums but large transactions. This is excluded. Most of these transactions may be legitimate cash transactions in the white economy and it would be impossible to differentiate between legitimate and black money transaction in this space. An example could be payments made to the large contract labour force.
3. Now imagine normal businesses such as eateries which collect most of sales through cash transactions. These eateries cannot make payments above Rs. 300,000/- to their vendors using cash. It means they necessarily deposit the cash into the bank and then push it through the electronic pathways.
4. Allowing such businesses to work is humane. But it also serves another advantage. If the government wants to move to a less-cash economy, these businesses will suck out the cash from the system gradually.
5. At the same time, the black money holders use this mechanism to launder money. The modus operandi is simple, open a saloon or service shop. This shop does not sell any product with upstream or downstream purchases required. It simply sells services. Imagine a wellness spa. This spa has a large number of fictitious customers who make payments of Rs. 2000 or so per transactions. The spa employs few employees - for argument sake - one masseuse. This fellow does more than 100 massages (!!) per day to launder 200,000/- per day. You can tweak the numbers based on your fancy. The owners get the share of profits based on the equations you use. Now comparing the employee productivity with legitimate massage centres can expose these easily.
6. So now the government is isolating the black economy from the white economy. I assume the white economy will get all sorts of benefits while the black economy will get penalties. Going by honest-friendly orientation.

The government has made an interesting move. Small move big impact seems to be the new motto. The next steps to demonetization seem to be in the works. In the budget, we also got some glimpses of the benefits. V. Aanatha Nageswaran has a super post on that.

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World War 3 watch 02 - Gorbachev thinks World is heading for war

Former President of Soviet Union Mikhail Gorbachev has written a piece in Time Magazine titled "It All Looks as if the World Is Preparing for War".

The article, however, is sparse on details. He based the possibility of war on some statements that go like this:

the militarization of politics and the new arms race. 

More troops, tanks and armoured personnel carriers are being brought to Europe. NATO and Russian forces and weapons that used to be deployed at a distance are now placed closer to each other, as if to shoot point-blank. 

While state budgets are struggling to fund people’s essential social needs, military spending is growing. Money is easily found for sophisticated weapons whose destructive power is comparable to that of the weapons of mass destruction; for submarines whose single salvo is capable of devastating half a continent; for missile defense systems that undermine strategic stability. 

Politicians and military leaders sound increasingly belligerent and defense doctrines more dangerous. Commentators and TV personalities are joining the bellicose chorus. It all looks as if the world is preparing for war.

I do not doubt the ability of that man to sense the war is around. Each of the statement made above is quite loaded. But it can be argued it is nothing new.

But is he right?

A fire is caused only when certain conditions - the presence of fuel or inflammable material (base), spark (trigger) and oxygen (enabler) are present. Take away one and there cannot be fire. Similarly, war too only happens when certain conditions are met. We get a sense of war from a few things. 

First, there must be a technical capability to wage a war. The capability comes from technology. War tech is not about technology itself but how much of it is deployed. It is not easy to manufacture and deploy it quickly. So there is necessarily a lead time where powers of the world deploy advanced weapon systems. 

The second element is people to fight the war. Large unemployed mass of youth means there are people. If people feel wronged then such population may be volatile. 

Third, there should be mutual hostilities. Absent the hostilities, no amount of tech and people can enter into the war. Thus, say around 2001 there were no hostilities between countries. So when 9/11 happened it was a bit of a surprise and it was not a national act. Today, we have certain hostilities emerging. US middle class feels wronged by China. China feels wronged by the US intervention in the South China Sea. The western world has been targetted by the ISIS and its affiliates. ISIS believes US is to blame for all its ills.

Fourth, there should be a trigger. The trigger is the last and essentially the most dangerous bit of the whole deal. If the peoples of the world have made up their mind to go to war they will find a trigger. It cannot be avoided. Thus the doctrine of peace should rest on disabling the first three. Obama fought ISIS with capability attrition doctrine.

Are we there?

In a sense, we are at the threshold of major war. But the tech is not yet in place. Hostilities are rising, people factor is primed. Technical capability exists but lead time is not enough. The fellow who will get ready first will look for the trigger. 

Russia, it seems, is not inclined to wage a war against anyone. It may go to assist Turkey and Syria and stuff but that is more operation than a war. Russia is tough when it is in trouble. But I doubt it will want to engage with the US.

In the present scenario, ISIS will not have the technical capability to wage conventional war. It can wage unconventional war. It is already waging this war. The counter strategy for such attacks is not well-evolved. The most development of these strategies was done by Israel. But Israel is small and homogenous and thus the strategies are simpler. At a large scale, we still do not have well-evolved strategy.

China has the technology to wage a conventional war with the US. But it is short of numbers. It needs more weapons. It is possible that China is developing them secretly. It is possible for China to do it. It is the only capable power which can threaten the US. 

It is also possible that Chinese augment the ISIS capabilities with superior tech. In fact, that would be the most efficient way for China to attack the US. China does the tech and manufacturing and ISIS does the fighting. The problem is ISIS does not have the people scale to engage in conventional war. 

Let us be careful

The conditions are fast approaching the break-point. The political leaders have the duty to step back from this brink. Looking at the political rhetoric and the media discussion, it does not seem likely. Brinksmanship is the new game in town, apparently. Let us hope sense prevails. War benefits no one.

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