Weekend reading links

1. Contrary to conventional wisdom, in the long-run smaller companies have outperformed larger ones in generating returns. 

The outsize returns of small companies relative to larger peers was documented in the early 1980s using evidence from the half-century to 1975. The idea found theoretical support. Higher returns compensate investors for taking on the greater risk of backing smaller, younger companies — though that can be minimised in a diversified portfolio... Over the long run, small-cap companies have outperformed larger ones, according to the UBS Global Investment Returns yearbook. Over 43 years in 34 markets, the monthly premium relative to large companies averaged 0.21 per cent. But the premium identified in the 1980s was far bigger. It can disappear — sometimes for years at a time — after periods of strong performance. That pulls down the long-term average.

2. What constitutes physiology of great cricket batting?

A sequence of three movements that produced the longest hits. First, the shoulders and hips pulled away from each other as the batter twisted into a coiled position, like a golfer at the height of a swing. McErlain-Naylor, seated on a Zoom call, demonstrated this well enough to remind me of contrapposto, the idealised stance of ancient Greek statues of discus throwers and warriors: shoulders thrown away from the hips, chest expanded, one leg more tense than the other, the frame taut and strong. Next, the most effective batters flexed their front elbow at the top of the swing and straightened it back out as they brought the bat through their stroke. Finally, they cocked and uncocked their wrists — a final lash of momentum...

James Moore, a psychologist who studies voluntary movement... told me that the brain craves certainty and likes things that flow predictably. “Economy of movement and timing enhance predictability,” he said. “With those who muscle their way through, there are more moving parts, therefore less economy of movement and less predictability.” The best-timed strokes, the most beautiful ones, are those that appear to require nothing beyond a minimal, sweet connection with the ball. “Great art,” he said, “offers no more and no less than the subject matter requires.”

3. The ramp-up in the production of iPhones from India is truly spectacular.

Apple has set a new record by exporting $10 billion worth of iPhones from India during FY24, according to data provided to the government... In terms of consumer products, this constitutes the largest-ever export of a single branded product by any company from India. iPhone exports accounted for 70 per cent of Apple’s total production in FY24. Of the three suppliers, Foxconn exported 60 per cent of its total iPhone output; Pegatron 74 per cent; and Wistron (now the Tatas) 97 per cent. Apple’s total iPhone production by its three suppliers touched $14 billion during the financial year... In FY24, the cumulative export target under the PLI scheme for the three suppliers was $7.2 billion, a target they have exceeded by 39 per cent... In future, as Apple expands capacity in India, it is expected that exports will cross 80 per cent of its total production from India. Apple is the first global value chain lead firm that has made India its home, primarily for labour-intensive manufacturing exports, rather than for the domestic market...

The total exports of mobile phones from India are expected to cross $15 billion in FY24, making Apple by far the largest contributor with nearly two-thirds of the total. The Apple ecosystem has generated nearly 150,000 new direct jobs since the launch of the PLI scheme and approximately 300,000 additional indirect jobs... While the domestic market for Apple products in general and the iPhone in particular is growing fast, the company’s revenue of Rs 49,321 crore for FY23 merely constituted 1.5 per cent of Apple’s global turnover of $383.29 billion. Its FY24, revenue is expected to increase over the previous fiscal by over 30 per cent.

4. Good primers by Shyam Saran and Shankar Acharya on the emerging situation in Myanmar where the military junta is losing control over large parts of the country's territories to the resistance forces of the ethnic minorities and the army mobilised by the opposition National League for Democracy (NLD) led by Aung Sang Suu Kyi's parallel National Unity Government (NUG). The junta has been on the back foot after the civil war broke out following its refusal to recognise the electoral verdict in 2021 won overwhelmingly by the NLD which represents the Burman majority. The junta carried out a military coup and installed itself in power, forcing the resistance from NLD and ethnic minorities. 

5. The national highways monetisation program of the government of India must count as one of the great successes of PPP anywhere in the world. The NHAI has been doing monetisation through TOT bundles and Infrastructure Investment Trusts (InvIT). 

The authority has so far issued 14 bundles of national highways in the TOT mode. This instrument gives highway players the right to collect toll for a specific period by paying the authority upfront cash. The valuation is arrived at through competitive bidding. After having struggled with getting bids considered fair by the authority, NHAI has awarded 10 TOT bundles to raise Rs 42,000 crore since the beginning of the asset monetisation pipeline. In InvIT, the trust which has numerous tax benefits for investors, buys the road from the authority and operates it. It distributes toll earnings in the form of return on units. NHAI has executed three rounds of offers through its InvIT, raising close to Rs 26,000 crore... In FY24, the highway authority had identified 46 national highway stretches, spanning 2,612 km for monetisation through ToTs and InvIT. It finished the financial year, meeting over 90 per cent of its target of Rs 44,000 crore... NHAI had monetised highway assets worth Rs 40,314 crore, through its three models — TOT, InvIT, and toll securitisation — for specific projects, such as the Delhi-Mumbai expressway... The National Highways Authority of India (NHAI) is looking to monetise 33 stretches of national highways during the current financial year (FY25) through its toll operate transfer (TOT) and infrastructure investment trust (InvIT)... Cumulatively, the 33 stretches, spanning 2,741 kilometres (km) earned approximately Rs 5,000 crore revenue in FY24.

6. Harish Damodaran has a brilliant article where he points to some interesting facts about Tamil Nadu, the state with the most diversified economy. This about diversification in agriculture itself.

About 45.3% of TN’s farm GVA comes from the livestock subsector, the highest for any state and way above the 30.2% all-India average. Not surprisingly, TN is home to India’s largest private dairy company (Hatsun Agro Product), broiler enterprise (Suguna Foods), egg processor (SKM Group) and also “egg capital” (Namakkal).

And this about the nature of its industrialisation

TN has just a handful of large business houses with annual revenues in excess of Rs 15,000 crore: TVS, Murugappa, MRF, Amalgamations and Apollo Hospitals. Even they are not in the league of Tata, Reliance, Aditya Birla, Adani, Mahindra, JSW, Vedanta, Bharti, Infosys, HCL or Wipro, as far as turnover goes. TN’s economic transformation has been brought about not by so-called Big Capital as much as medium-scale businesses with turnover range from Rs 100 crore to Rs 5,000 crore (some, like Hatsun and Suguna, have graduated to the next Rs 5,000-10,000 crore level). Its industrialisation has also been more spread out and decentralised, via the development of clusters. Some of the clusters – agglomerations of firms specialising in particular industries – are well known: Tirupur for cotton knitwear (the units there clocked exports of Rs 34,350 crore and Rs 27,000 crore of domestic sales in 2022-23); Coimbatore for spinning mills and engineering goods (from castings, textile machinery and auto components to pumpsets and wet grinders); Sivakasi for safety matches, fire crackers and printing; Salem, Erode, Karur and Somanur for powerlooms and home textiles; and Vaniyambadi, Ambur and Ranipet for leather. 

Many cluster towns are hubs for multiple industries. Thus, Karur has powerlooms, bus body builders and even makers of mosquito and fishing nets (one of them, V.K.A. Polymers, is a major exporter of insecticide-treated bed nets). Dindigul has spinning mills and leather tanneries. Namakkal is as famous for layer poultry farms as its large lorry fleet/bulk cargo logistics operators and tapioca-based sago (sabudana) factories. Salem has powerlooms and tapioca starch-cum-sago producers, while Erode is a textile and “turmeric city”. In contrast to them are the more sub-specialised clusters. Chatrapatti, in Virudhunagar district’s Rajapalayam taluka, is “bandage city” not for nothing: It is a manufacturing centre for bandages, gauze pads/rolls/swabs and other surgical cotton products and woven dressings.

Tiruchengode is India’s “borewell rigs capital”. The borewell drilling services contractors of this town near Namakkal take their truck-mounted rigs all over the country to dig up to 1,400 feet. Dhalavaipuram, hardly 10 km from Rajapalayam, specialises in production of nighties and ladies innerwear, just as Natham, next to Dindigul, does in low-priced men’s formal shirts. Most of these clusters have come up in small urban/peri-urban centres, providing employment to people from surrounding villages who may otherwise have migrated to big cities for work. They have, moreover, created diversification options outside of agriculture, reducing the proportion of TN’s workforce dependent on farming.

TN’s early industrialists were mainly Nattukottai Chettiars and Brahmins... Prominent among them were Annamalai Chettiar (the M.A. Chidambaram and Chettinad groups descended from him), A.M.M. Murugappa Chettiar (Murugappa Group), Karumuttu Thiagaraja Chettiar (textile magnate) and Alagappa Chettiar (textiles, insurance, hotels and education). The big Tamil Brahmin-owned houses included TVS, TTK, Amalgamations, Seshasayee, Rane, India Cements, Sanmar, Enfield India, Standard Motors and Shriram. A more recent name is the business software solutions company Zoho Corporation of Sridhar Vembu. The drivers of TN’s more recent decentralised industrialisation have, however, been entrepreneurs from more ordinary peasant stock and provincial mercantile castes...

The promoters of Suguna Foods, CRI Pumps, Elgi Equipment and Lakshmi Machine Works, too, are from Kammavar Naidus. The cluster capitalists of Tirupur, Erode, Salem, Namakkal, Karur and Dindigul are mainly Kongu Vellalar or Gounders... Sivasaki’s fireworks, match and printing industries have been built largely by Nadars. But this belt in southern TN – also covering Virudhunagar, Srivilliputhur, Watrap and Rajapalayam – has produced entrepreneurs from other communities as well: Raju (Ramco Group and Adyar Ananda Bhavan) and Udayar (Pothys). Many from here have also gone on to create successful product brands: Hatsun (‘Arun’ ice-cream and ‘Arokya’ milk), V.V.V. & Sons (‘Idhayam’ sesame oil) and Kaleesuwari Refinery (‘Gold Winner’ sunflower oil)... Christians (MRF, Johnson Lifts and Aachi Masala Foods) and Muslims (Farida Group)... CavinKare’s C.K. Ranganathan, a Mudaliar, was selling ‘Chik’ shampoo (taken from his father Chinni Krishnan’s name) in single-use sachets well before the likes of Hindustan Unilever latched on to the idea.

7. One line of thinking about the impact of high-interest rates on the US economy is that it may be responsible for sustained economic growth.

The jump in benchmark rates from 0% to over 5% is providing Americans with a significant stream of income from their bond investments and savings accounts for the first time in two decades. “The reality is people have more money,” says Kevin Muir, a former derivatives trader at RBC Capital Markets who now writes an investing newsletter called The MacroTourist. These people — and companies — are in turn spending a big enough chunk of that new-found cash, the theory goes, to drive up demand and goose growth.

8. Andrew Haldane has some home truth about inflation forecasting within central banks.

In the early years of inflation targeting in the UK, the then head of forecasting at the Bank of England entered my room clutching a piece of paper. On it were two lines: the inflation forecast produced painstakingly by his team over the preceding weeks, and an alternative inflation projection hand-drawn in pencil by the then governor. Only the latter “forecast” ever saw the light of day... Former central bank governor Mervyn King used to observe that the probability of forecasts proving correct was almost precisely zero. (Ironically, this is one of the few BoE forecasts ever made that turned out to be accurate.)..

Economic models bring rigour to policy. Unfortunately, they also bring mortis. Even models at the frontier are always at least one step behind real-world events: from the global financial crisis (when most were found to take no meaningful account of the financial sector) to the Covid-19 and cost of living crises (when most were found to have no well-developed sectoral supply side). In these instances, models served to unhelpfully blinker policymakers to events playing out before their eyes, but not embedded in their models. This led to them first missing these crises, and then responding too slowly. Those models can also be gamed in ways that impose too few constraints on policy. In my experience, many policymakers produced their economic forecasts by working backwards from their preferred stance. This is an inversion of the way inflation targeting was meant to operate.

9.  It's not UK, but Sweden that has the deepest capital markets in Europe. 

At a time when the UK and many other European countries are struggling to attract initial public offerings and suffering from falling trading volumes, Sweden stands out for having, relative to its size, thriving capital markets that are backed by legions of investors and which are even tempting foreign companies to list... Over the past 10 years, 501 companies have listed in Sweden, more than the total number of IPOs in France, Germany, the Netherlands and Spain combined, according to Dealogic data. The UK is top with 765 listings... the Nordic country has been highly successful at encouraging smaller domestic businesses to stay at home, encouraged by the depth of its stock market... Around 90 per cent of listings are valued at less than $1bn... A key driver has been the country’s investment culture.

Consider the preference for equity investment among insurers.

Among larger investors, Swedish pension funds have long owned domestic equities. The country’s four biggest retirement schemes have roughly maintained or increased their holdings of domestic equities in recent years. In the UK, in contrast, domestic equity holdings among pension funds have plunged to about 4 per cent. Meanwhile, Swedish insurance companies have the highest holdings of stocks in the EU.

Swedish households are the most avid retail investors in Europe.

Retail investors are also big buyers of Swedish stocks, helped by a wealth of reforms in recent decades. Compared with the rest of Europe, Swedish households hold among the highest proportion of their investments in listed companies and among the lowest in bank deposit holdings, while financial literacy is greater than in Germany, France or Spain. In 1984, the government introduced Allemansspar, a product enabling ordinary Swedes to invest in stock markets. By 1990 there were already 1.7mn of these accounts, helping drive the launch of domestically focused small and mid-cap funds. Such funds arrived “10-to-20 years before any other country did anything similar, at least in Europe”... Rule changes in the 1990s allowed people to invest 2.5 per cent of the amount they allocate to their pensions into funds of their choice, supported by a public information campaign. And in 2012 the state introduced investment savings accounts called ISKs that allow individuals to invest without needing to report their holdings or worry about capital gains or dividend tax. Instead, the total value of the account is taxed — and in 2024 that was at a level of about 1 per cent... German investors have historically favoured bonds over stocks, making equity raising more challenging.

And Swedish companies are far more likely to be listed than peers. 

And the net result of all this has been positive

Sweden’s system appears to have translated into stock market returns. Its main index has gained 85 per cent over the past decade, while the Euro Stoxx 600 index has risen 49 per cent and London’s FTSE 100 just 17 per cent. That, too, is helping persuade Swedish small and mid-sized companies to stay at home.

10. Chinese State Owned Enterprises (SOEs) are doing better than the broader stock market index among Chinese stocks, mirroring trends in India too.  

11. Good read in Business Standard on the struggles facing the apprentice system in India, where just 1% of work force entrants are apprentices. 

Ability to exercise good judgment is the binding constraint in development

The most important constraint in economic development is not capital, labour or other factors, but the “ability to make development decisions”. This is the point that Albert Hirschman makes in his classic book, Strategy of Economic Development, says Oliver Kim in an excellent essay on one of the truly great economists. 

Rather than endlessly debate which prerequisites for growth a poor country is missing, Hirschman shifts the focus to figuring out how to make the best use of the resources it already has. But, without the guidance of a grand plan, how should policy makers decide how to allocate their attention? The solution Hirschman proposes is unbalanced growth. Instead of trying to solve all problems all at once, policy-makers should push forward in a limited number of sectors, and use the reactions and disequilibria created by those interventions to inform their next move.

Take the example of an industrial district. With limited resources, a policymaker may have to choose between building the actual factories, or laying down the highways and power-plants (what he calls Social Overhead Capital) to supply it. Based on his theory, Hirschman makes the provocative case that infrastructure should sometimes follow, not lead, private investment… Hirschman encourages us to flip the script. Rather than see bottlenecks and shortages as embarrassing signs of failure, policy makers can use these pressure points to identify opportunities where an additional investment might go the farthest. With the road congested, it’s much easier to see it needs to be improved–and far better to upgrade a well-used road than build a highway to nowhere. The policy-maker, once inundated with choices, now has a clear guide on how to act. Even better, pressure points may organically summon other, non-state actors to try and address the now-glaring shortfall. Perhaps an independent power producer will spy a market opportunity, or a private railway may decide to step in and connect the factory to their network.

Hirschman formalizes this insight with his famous notion of backward and forward linkages. Backward linkages are the demand created by a new industry for its inputs, like steel for an auto plant or milk for a cheesemaker. Forward linkages are the reverse—the knock-on effects of a new industry’s outputs on the firms it supplies. Backward linkages, Hirschman goes on to explain, are better at spurring growth than forward ones. Rather than plopping down a steel factory somewhere, with no customers assured, it is far easier to build the auto plant first, sourcing the car parts from other countries as needed, then gradually entice local producers to enter the market. Instead of a Big Push across all industries at once, Hirschman calls for the Targeted Strike–choose the sectors with the most potential to create demand for other inputs, and support those.

Hirschman also argues that the “nonmarket” responses induced by a policy change may be just as important as market ones. If, say, the factories in the industrial zone face a shortage of trained workers, the locals may clamor for new schools. Or if the trucks congest their neighborhood roads, they may pressure their local officials to improve the highway. Politics cannot be separated from economics when thinking about developmental choices. Hirschman’s theory of unbalanced growth is rooted in empiricism, allowing policy makers to test and gauge the reactions of the specific context rather than applying some universal formula. It recognizes that development is naturally a chaotic, messy process, much closer to a “chain of disequilibria” than the result of a master plan. To paraphrase another important development thinker, Hirschman’s unbalanced growth is the modest call to cross the river by feeling the stones, one intervention at a time.

This brilliant. Hirschman makes a very profound observation, one that is genuinely difficult to grasp and also unsettling. It resonates strongly with my instincts as a practitioner of development. 

I’ll frame it slightly differently and in terms of a framework I’ve found useful (see this and this). The development decision that Hirschman alludes to is the “ability to exercise good judgment”. Almost all of doing development is about making non-technical decisions (the technical ones are easier, have limited degrees of freedom, and mostly slot themselves into place). Such decisions are invariably an exercise of judgment by taking into consideration several factors, one of which is the technical aspect (or expert opinion). The most important requirement for the exercise of good judgment is experience or practical knowledge. In the language of quantitative science, it’s about having a rich repository of data points that one can draw on to process a decision. 

The Greeks describe this synthesis as phronesis, or practical wisdom. In practice, as the history of development shows, given the political economy, organisational bargaining, and distorted incentives, such judgments many times go astray. 

It gets more complicated. It’s not one decision, but a series of continuing, even interminable, decisions. In other words, a country’s development trajectory is determined by a continuing series of judgments. This applies to industrial policy and promotion of industrial growth, macroeconomic policy and inflation targeting, and programs to improve student learning outcomes or skills, increase nutrition levels and health care outcomes, improve agricultural productivity, and so on. 

Institutional structures that facilitate information flows and create the right incentives are perhaps essential to create the conditions for good judgments to emerge. But enlightened and wise leadership often papers over institutional failings, at least for some time. A combination of both is ideal. 

This judgment is made at both tactical and strategic levels. At the former, it’s about an immediate response to an emerging issue or situation, whereas at the latter, it’s about keeping in mind long-term considerations. In the latter, sometimes an exercise of judgment can be about “losing the battle to win the war”, “shooting in a different direction to the target”, “embracing the enemy and building coalitions”, and so on. 

Travelling the development journey can be like driving a car at night or in dense fog. It’s like what EL Doctorow said in another context, “It's like driving a car at night. You never see further than your headlights, but you can make the whole trip that way.” Add that you are driving at night on a road with several forks and must make the right decisions to reach your destination. The metaphor is apt for the development journey. 

Every example of successful development journeys in recent times from Singapore under Lee Kuan Yew to China under Deng Xiaoping to South Korea under Park Chung-hee and their respective successors, has been about “driving a car at night on roads with several forks and turns” or “crossing the river by feeling the stones”. These journeys have been about the right political and institutional incentives and wise leadership combining to create the conditions for the exercise of a series of good judgments that in turn facilitated “good development decisions”. 

Such judgments can sometimes go wrong. It’s common in national development journeys to have bad judgments (or misjudgments), even phases of several bad judgments. The more complex the context, the greater the likelihood of mistakes. Most commonly, bad policies and bad leadership often stray into the path and can derail the journey. 

The challenge is not to avoid these mistakes, for they are inevitable. But to have institutional incentives that allow mistakes to get quickly detected, deliberated, and rectified. This means institutional acceptance of failures and the space for deliberation within the policy-making and implementation systems. Strong institutional systems can help countries that have gone astray recover lost ground and get back.

There are strong parallels here with the private sector. Amazon did not plan to get where it stands today when Jeff Bezos started in 1995. No company plans its life beyond a handful of years. Yes, they’ll have strategic plans and all, but in terms of operation or execution, their time horizons are limited. But they have systems (and also incentives) to respond to emerging developments in the market. This response involves an exercise of judgment. 

The best companies are those that respond swiftly and effectively to external stimuli. They also have the conditions that allow experimentation, tolerate failures, quickly cut losses and kill failing ideas. These decisions are also about the exercise of judgment. 

To this extent, private sector growth is also constrained by “decision-making ability”. However, the conditions under which the judgment has to be exercised are far less complex than in government. In some ways, in general, the difference is like that between driving in dense fog and clear conditions, or roads with more and few forks. Most importantly, there’s the disciplining force of the markets that aligns incentives and channels the leadership towards making the right decisions. This important institutional incentive does not exist in governments, except in the theory that there’s a marketplace for votes that aligns with the incentives of politicians. 

This explanation is just as relevant for national development trajectories as it is for the implementation of individual policies and programs. As I have blogged here, there are no perfect policies or programs. Their success is mostly about their implementation. And implementation, to be effective, must be necessarily iterative, involving a series of decisions that are essentially exercises of judgments. 

All this does not mean there’s no space for technical and professional expertise. On the contrary, good judgments are built on the foundations of which expertise is an important ingredient. It’s only that they go much beyond technical and professional expertise. It’s most critically dependent on the experiential knowledge accumulated over a long time of practice. It’s this important distinction that experts and commentators who engage with policy from the outside struggle to grasp. For most, it’s an unknown unknown. 

In conclusion, I’ll slightly modify Hirschman and argue that the binding constraint in economic development is the “ability to exercise good judgment”!

Lessons from the Thames Water Fiasco

In one more exhibit on the problems with the privatisation of utilities, early this month, Kemble Water Finance, part of the complex financial structure constructed by Macquarie at Thames Water, the largest British water utility serving a quarter of the population and one that provides water to London, announced that it was defaulting on its £400mn bond repayments. This follows its shareholders refusing to make the promised £500mn equity infusion because Ofwat refused to agree to their demands for higher bills and in turn demanded that the shareholders reduce the company’s debt pile. 

The £14.7bn of debt held by the Thames Water utility companies that sit below Kemble should be unaffected by the default. This debt is in the form of a whole-business securitisation, a structure commonly used to borrow against highly regulated assets with predictable cash flows. But it threatens to wipe out the stakes of Thames Water’s nine shareholders, which include the Chinese and Abu Dhabi sovereign wealth funds as well as Canadian and UK pension funds. Further, Kemble’s £400mn bonds are trading at little over 15 per cent of their face value, indicating debt investors too are set for a near-total wipeout. Most importantly, it raises questions about how Thames Water itself will be able to repay the £14.7bn of debt. 

This is the list of Thames Water’s owners.

Underlining the complexity of the financing structure, JP Morgan published this outcome-probabilities chart.

The FT article writes about the origins of Kemble’s troubles

The Kemble debt is a legacy of Thames Water’s 2006 buyout by Macquarie, which has drawn scrutiny for the billions of pounds in dividends the firm siphoned off during its decade-long ownership. Macquarie put in place a so-called “whole-business securitisation”, where the utility’s cash flows service different tiers of debt. Kemble, named after a village in the English countryside near the source of the river Thames, allowed the firm to borrow more money. Kemble relies on dividends from Thames Water to pay interest to its bondholders and lenders. However, new rules introduced by Ofwat last year prevent the payment of dividends from the utility if they put the company’s financial resilience at risk. Ofwat opened an investigation into a £37.5mn dividend paid by Thames Water in October last year, with a ruling expected within weeks.

Then there’s also the inflation-indexed nature of the debt, which forms more than half the utility’s debt. 

The 2022 annual accounts of parent company Kemble Water Holdings show that the weighted average interest on the group’s £7.7bn of “index-linked debt” soared to 8.1 per cent from just 2.5 per cent the previous year… An “inflation risks sensitivity analysis” — which conceded that the RPI-linked debt only acted as a “partial economic hedge” — showed that a 1 per cent increase in the rate of inflation after 31 March 2022 would dent the group’s profit and equity by £911mn.

The original sin of course lies in the 2006-17 ownership of Thames Water by Macquarie. 

When the former prime minister Margaret Thatcher privatised the water monopolies in 1989, she wiped out their debt. Since then, Thames Water’s group borrowings have grown to £18.3bn as the company passed from owner to owner. By 2006, when the Australian asset management firm Macquarie bought Thames Water from the Germany utility group RWE, the water company had £3.4bn in debt. By the time Macquarie sold its final stake in Thames Water in 2017, the company had spent £11bn from customer bills on infrastructure. But far from injecting any new capital in the business — one of the original justifications for privatisation — £2.7bn had been taken out in dividends and £2.2bn in loans, according to research by the Financial Times. Meanwhile, the pension deficit grew from £18mn in 2006 to £380mn in 2017. Thames Water’s debt also increased steeply from £3.4bn in 2007 to £10.8bn at the point of sale.

All this means that in the absence of dividend inflows from Thames Water, Kemble Water Finance is insolvent. With the existing shareholders preferring to take an estimated £5bn loss and cut further losses and not put in any more money, complete equity wipeout and large debt haircuts look inevitable. Any restructuring which does not provide a long-term financing solution for Thames Water, an increasingly difficult prospect, would effectively end up being a return to nationalisation of an asset that was privatised in 1989! A nationalisation should come as no surprise since the latest YouGov polls find that 69% of people believe water companies should be nationalised. 

In this context, Frédéric Blanc-Brude points to the problems with using traditional CAPM models to calculate the fair value of investments. 

At the end of 2022, a group of large pension plans, including funds from Canada, Japan and the UK, discovered that they had lost a large part of the £5bn investment in Thames Water that they had recorded on their books. This Easter, they learnt that they had probably lost all of it. There is only one way for a water utility serving the capital of a G7 country to lose so much value so fast: it was never worth £5bn to begin with.  Yet its owners denied this reality for years. The signs that Thames Water and its parent Kemble Water Finance constituted a high-risk, low-profit business were there all along. The cost of capital in this investment should have been considered quite high (and increasing over the years) and its value much lower… 

Many investors in private assets — and in this case the water sector regulator, Ofwat, too — rely on the “capital asset pricing model” (CAPM) to estimate a cost of capital and the value of the business (and for Ofwat the allowed level of water tariffs)…. Today, CAPM remains the most commonly used framework for estimating the value of private investments like infrastructure companies.  Yet the scientific community has known for more than 30 years that CAPM, while one of the foundations of the field of academic finance, is wrong… The inevitable conclusion from all this is that the reported values of private investments held by institutional investors and their managers today are very likely to diverge significantly from their true market value, and do not represent the level of risk taken or the liquidation value of these assets. This is how investors in Thames Water saw their investment go from £5bn to zero in a few months — they were blindsided by bad models and bad data… 

There is a better way. Applied financial research and data availability about private investments have made significant progress since CAPM was developed in the 1960s. It is time for investors in private companies like Thames Water to take a more scientific view of asset pricing. They need proper measures of risk for the private asset classes to which they now allocate large amounts, and of the value of the assets they hold.

The point that Blanc-Brude makes is very important. The reluctance of the market to use empirical evidence on important decisions like valuation, especially given the stakes involved, is baffling. There’s such a rich repository of data about infrastructure projects from across the world that it must be possible to look at the realised outcomes from projects across different segments of the sector and make informed, evidence-based assumptions of cost of capital, returns on equity etc. Why use theoretical models with limited practical relevance when there’s good historical data available?

A thing that has intrigued me is why alternative investment funds (AIFs), which typically chase high-risk and high-return investment options, find infrastructure as an attractive asset class. Infrastructure is mostly regulated and therefore comes with low but stable returns but for a long tenor. It’s for this reason that traditionally pension funds and insurers, which look at very long investment horizons, find infrastructure an ideal investment option. Its stable returns and long-tenor are high value for them. 

For fund managers in AIFs like private equity, the infrastructure sector’s attractions can therefore come only from the perspective of asset diversification and not returns maximisation. But this is theory. In reality, private equity investors who are now piling into infrastructure feel that they can make high returns from infrastructure. They see Macquarie’s track record of extracting high returns from infrastructure, none more high-profile than Thames Water itself, as evidence. 

But, as I have blogged and written extensively over the years, these returns can come only at the cost of the project itself. It can come only from asset stripping by loading the company with debt, paying out large dividends, skimping investments, not paying employees pension funds, and so on. The shorter cycle of a PE investment compared to the life cycle of an infrastructure asset means that PE investors can strip assets from the project entity. This is especially true in the case of assets that are newly concessioned out or privatised - the first set of PE investors have a strong perverse incentive to squeeze the balance sheet of the project entity, pay themselves handsome dividends, and exit. Even if they don’t exit and get stripped of their equity after a few years, they would have made enough for themselves and their investors. 

Fundamentally, as I blogged here, infrastructure finance 3.0, which PE kind of investors represent, is about separating ownership from the operations and the life cycle of the asset. Ownership gets parcelled into tranches and is transferred from investor to investor. There’s limited skin in the game for these investors in the asset’s long-term prospects. They are concerned only about the asset being a going concern till they are around and can find another investor who too would have similar incentives. 

There are two big losers in such situations. One, creditors to infrastructure assets owned by PE firms (who indulge in such asset stripping) can be left holding a bankrupt entity and are forced to take large haircuts. Two, given the monopoly provider of an essential service nature of such assets, governments cannot allow these assets to fall into liquidation. They will have to step in to facilitate restructuring and find new owners who can operate the asset or take it over and run itself. In either case, taxpayers are on the hook. 

Truth be told, PE investments in infrastructure are mainly aimed at segments like data centres, telecommunications, and natural gas where there are enough opportunities for higher returns. 

Three takeaways from this. One, policymakers should be careful about what they wish when they court private investors like AIF in infrastructure sectors. There’s a strong case for designing bid documents that are explicit about the expectations of investors from such investments. Bid documents should pre-empt asset-stripping possibilities by mandating clear, salient, strict, and public disclosures of relevant information. Two, regulators must be vigilant in monitoring PE (and any other private) investments in infrastructure sectors for the various asset-stripping practices. Three, creditors should have supervisory mechanisms to watch the emerging financials of their borrowers.  

Weekend reading links

1. The Times has an interesting story that points to the problems with phasing out plastics in food packaging.

Plastic works well to slow the decay of vegetables and fruit. That means less produce is tossed into the garbage, where it creates almost 60 percent of landfill methane emissions, according to a 2023 report by the Environmental Protection Agency. A Swiss study in 2021 showed that each rotting cucumber thrown away has the equivalent environmental impact of 93 plastic cucumber wrappers. Food is the most common material in landfills.

Ultimately the problem with such transitions lies in the reluctance of societies as a collective to come around to abandon their food habits.  

Consumers increasingly report that using less plastic and packaging matters to them, but their shopping habits tell a different story. American shoppers bought $4.3 billion worth of bagged salad last year, according to the International Fresh Produce Association. Marketing experiments and independent research both show that price, quality and convenience drive food choices more than environmental concerns... Battle lines seem to be drawn between the never-plastic crowd and shoppers who prefer the ease of fresh salad greens delivered to their door. “The packaging conversation is being held hostage by one side or the other,” said Max Teplitski, chief science officer of the International Fresh Produce Association.

2. Some of the DBT programs make no sense. Sample the DBT to parents to buy textbooks and uniforms for school children in Bihar which was launched in 2017 and wound up in 2022 after failure and criticism. A 2018 survey found that only 18% of students purchased textbooks with the DBT money. 

In the case of Bihar, contextual and operational failings like parents without bank accounts and problems with implementation contributed to the low uptake. But even without these, it's likely that a significant share of parents would not have purchased textbooks. 

3. Story of a failed PPP in healthcare 

In 2002, the Karnataka government set up the Rajiv Gandhi Super Specialty hospital in Raichur and handed over the 73-acre campus with hostel, staff quarters and hospital building to Apollo Hospitals Enterprise Limited to provide specialised treatment for various diseases. The state government drew up an agreement to pay Rs 1 crore per month for revenue expenditure to Apollo. Under the terms of the agreement, the private hospital would have to provide free treatment to below-poverty-line patients in Raichur. A decade later, a state government inspection of the hospital found that it lacked several services that were part of the agreement. Out of 340 beds, only 154 were functional, of which only 58% were occupied by patients in 2010-’11. The below-poverty-line patients admitted covered only 11% of total beds in hospital. In May 2012, the Karnataka government terminated the agreement with Apollo.

4. Quick commerce (q-commerce), the hyper-localised 10 minute grocery delivery model, is surging in India, driven by Blinkit and Instamart. Zomato purchased the struggling Blinkit two years back and has turned it around. Interestingly Instamart is owned by Zomato's food delivery rival Swiggy. Each has a 40% market share. As a Ken story writes, India's q-commerce market can be traced back to Swiggy in August 2020 promising 45 minute grocery delivery, followed by Zepto in April 2021 promising delivery in 10 minutes, and then Blinkit (Grofers then) following suit in December 2021. 

I think it's misleading to revise the priors on scepticism about the long-term potential of q-commerce in India. For all its spectacular growth, Blinkit's revenues in three quarters of 2023-24 have been just Rs 1530 Cr ($185 million). There's some more runway available to absorb the pent-up demand for q-commerce. Like with all else in the ultra-price-sensitive Indian market, this demand too is likely to reach its limits soon. q-commerce priced at sustainable levels is likely to be attractive to only the high-income class, a tiny market segment. 

5. Janan Ganesh has an excellent oped that gives a different explanation for the rise of populism and other societal ills afflicting western countries - the disease of success.

Problems of success are harder to fix because, almost by definition, you wouldn’t want to remove the underlying causes of them... The best explanation for the strange turn in politics over the past decade is too much success, for too long. Few voters in the west can remember the last time that electing a demagogue led to total societal ruin (the 1930s). The result? A willingness to take risks with their vote, as a bank that has forgotten the last crash starts to take risks with its balance sheet. What the economist Hyman Minsky said of financial crises, that stability breeds instability, could be the motto of modern politics too... The most important populist breakthrough, Donald Trump in 2016, happened in a super-rich country, seven years into an economic expansion. The Brexit campaign won most of England’s affluent home counties. 

Populism can’t, or can’t just, be the result of scarcity. It can’t be solved through more and better-distributed wealth. In fact, to the extent that it liberates people to be cavalier with their vote, material comfort might make things worse. Faced with problems of failure — disease, illiteracy, mass unemployment — western elites are supremely capable. When it comes to even apprehending problems of success, less so... Modernity — a world in which most people live in cities, have freedom from clerics and communicate across great distances at low cost — came along about five minutes ago in the history of civilisation. Economic growth was itself an almost unknown phenomenon in the three millennia before 1750. It would be strange if such abrupt and profound change hadn’t had some unintended consequences. The story isn’t phone-induced stress or even low birth rates. The story is that we haven’t experienced much worse.

6. It's ironical that cheap Chinese solar exports are accompanied with weak Chinese solar companies (propped up only by massive subsidies)

Chinese solar-panel makers... account for 80 per cent of global production capacity. But the cost of that victory is now looking too high. China dominates the solar panel sector’s entire supply chain. Prices, which are nearly two-thirds lower than US counterparts, have helped it to win market share. Every year, this price gap widens. There was another 40 per cent price cut in 2023. China’s dominance has come from years of investment. It ploughed over $130bn into the solar industry last year — into production capacity increases. Chinese makers are able to build over 860 gigawatts of solar modules annually. The biggest advantage Chinese companies have is scale. Due to the sheer size of the domestic market — which added a record 217 gigawatts of solar last year — companies invested heavily in larger scale manufacturing and automation. That is paying off today. Another 600 gigawatts of annual capacity is expected to start operations this year. That would be enough to cover the world’s total demand through 2032, according to energy research group Wood Mackenzie...

The weak stock performance of Chinese solar cell manufacturers reflects that mismatch. Longi Green Energy Technology, JA Solar Technology and Trina Solar are down more than 50 per cent in the past year. Longi, China’s largest business in the sector which has grown to become the world’s second most valuable solar energy group, trades at 18 times forward earnings. That is less than half the valuation of smaller US peers. Operating margins have halved over the past four years.

7. Big Tech has come to see fines as a legitimate cost of doing business. Worse still, very little of those imposed finally get paid. 

Damien Geradin, an antitrust lawyer who has represented companies in probes against Apple and Google, said fines did not work as deterrents. He said: “A fine is a cost of doing business for Big Tech and the level of profit of these companies is such that no fine will exceed the profit of ignoring the law.”

8. Gillian Tett points to a new paper by Ken Rogoff et al which points to a secular decline in real interest rates over the last seven centuries.

Tett explains the findings

The chart is certainly not smooth. Two big inflection points occurred during the 14th-century Black Death pandemic, and then the European “Trinity” financial crisis of 1557. There were smaller inflections in 1914 and 1981. But what is more striking than these inflections is how rare they are. While long-term rates have often moved in response to recessions, defaults, financial shocks and so on, they almost always revert to trend after a decade or two. As the economist Maurice Obstfeld has pointed out, the result is that they look like mere “blips” from a long-term historical point of view. To put it another way, modernity triggered an inexorable decline in the long-term price of money, and was doing this well before we started to fret about ultra-low rates in the 21st century.

On the reasons, Tett summarises the points made by Rogoff et al and what it means going forward.

The real reason, they say, for falling borrowing costs is not economic shifts, but an issue economists often ignore — the nature of finance. A combination of modern capital markets, risk analysis and innovation around using collateral to back loans has made money more efficient... A key distinction between modern and premodern societies is that innovations ranging from double-entry book keeping to computers have left us believing that we can predict, manage and price future risks, without relying on gods, as our ancestors did... And what does it mean for current rates?... Adopting an eight-century timeframe suggests that the ultra-low rates we saw in the early 21st century were a slightly excessive deviation from the trend. It should thus be no surprise that long-term rates have corrected upwards, particularly given that the short-term neutral rate has probably risen.

9. Nice graphic that shows how after 35 years, the Nikkei has come full circle.

After decades of fighting and failing to create inflation, the Japanese prices have been rising since the spring of 2022. In February this year, the Nikkei 22 finally regained its previous peak and in March the BoJ ended negative interest rates and raised borrowing costs for the first time since 2007.

Inflation in the US - a shift to normalcy?

The US consumer price inflation for March came up at 3.5% year-on-year up from February and slightly higher than the forecast of 3.4%. On the same lines core inflation came up at 3.8%, up from the forecast of 3.7%. Bond yields rose and stocks fell as the likelihood of three rate cuts this year starting from June is now very unlikely.

Traders had also previously seen a July cut as a near certainty, but halved their bets on that timing from about 98 per cent to 50 per cent after Wednesday’s report was released. While the markets still give a very high probability to rate cuts by September, they have not fully priced in a cut until the Fed’s November 6-7 meeting... While Fed chair Jay Powell still believes in a “base case” that shows inflation drifting down towards the central bank’s 2 per cent goal, others on the FOMC are increasingly concerned that price pressures will prove stickier than expected. Chicago Fed president Austan Goolsbee has expressed concern that housing inflation will remain too strong, while Dallas chief Lorie Logan has warned of greater “upside risk” to the outlook.

It's to be noted that CPI inflation in the US fell from its peak of 9.06% in June 2022 to 2.97% in June 2023, a fall of 67% in one year. Since then it rose to 3.7% in September 2023 and has remained tightly range-bound between 3-3.5% for the last six months. 

Some observations:

1. The impressive lowering of inflation by 67% in a year supports the views of the team transitionary who have argued that the spike in inflation was due to the supply shocks induced first by the pandemic and then by the Russian invasion of Ukraine (and the massive US fiscal stimulus) and once the shocks subside inflation would come down. It’s also true that the decisive action by the central bank helped shape expectations and helped in hastening the reduction of inflation.

2. The recent trends in inflation after June 2023 can be construed to resemble a dead cat bounce. Inflation fell rapidly and now looks like stabilising. The tightly range-bound nature of inflation in the last nine months in the 3-3.7% range testifies to this. It might also be a transition path before inflation again starts to decline to a slightly lower level, say 3%. It’s difficult to foretell the trajectory. However, the assumptions behind competing explanations and theories and the resultant monetary policy actions have critical implications for the economy’s future. 

One perspective is to view this as the last mile of the fight to get inflation back to 2%. It can then be argued that the stickiness demands further monetary contraction. The continuing strength of the economy and tightness of the labour market lends credence to the view that the Fed may need to tighten further or at the least wait for the economy to cool further before starting to cut rates. In this perspective, the need of the hour is to either raise rates or wait for the economy to cool before cutting rates. The critical assumption here is the need to get inflation back to 2%.

Another perspective is that the critical assumption itself is wrong and the 2% inflation target, which is a recent invention, is both false precision and unrealistic. If the assumption is wrong, then the policy actions based on it can be very harmful. As I have blogged here, there are compelling reasons to argue that the period of 2% inflation was an aberration and we are now returning to the historic norm of inflation in the 2-4% band. In this view, we are already at the norm and monetary policy should now respond to trends going forward. The worst outcome would be to deploy monetary policy based on the false assumption of the need to get inflation back to 2%. That might end up choking and ushering in a recession due to the limitations of the policymakers (and experts) understanding of the economy. 

There’s no way to know ex-ante who’s right and who’s wrong. I’m both inclined against the first and towards the second. Only time will tell who’s right. 

3. It can also be argued that monetary policy in developed countries never returned to normalcy after the global financial crisis. The GFC induced steep interest rate cuts to prop up the financial markets and the economy. Since early 2009, interest rates remained at zero-bound for over seven years. After a brief rise to 2.5%, it was again brought back to zero-bound as the pandemic struck. It was only in April 2022 that the rate hikes started. 

From April 2008 to July 2022, or over 15 years at a stretch, interest rates in the US have been 2.5% or below, including at the zero bound for over 9 years. But for a brief spike for some months in 2011 and 2018, from November 2008 till March 2021 inflation too has remained in the 0-2% range. The US stock markets boomed. It was a decade and a half of remarkable economic stability and prosperity. Just compare the period with what preceded it. 

The markets and a generation of investors got used to the Goldilocks of low interest rates and low inflation, resulting in a strong economy and labour market and booming equity markets. The myth behind inflation targeting and the 2% inflation target got entrenched during this period. This period also coincided with extraordinary monetary policy measures by the US Fed and other central banks. Quantitative easing, forward guidance, yield control and so on were names given to these policies. Economists and technocrats at central banks started to believe that it was their theories and actions that created this Goldilocks moment in global economic history.

In this context, I cannot but not resist quoting Richard Bernstein’s comparison of the Fed Chairman to a Maytag Repairman,  

The Maytag Repairman was a fictional washing machine mechanic who was lonely because no one ever needed to repair a reliable Maytag appliance. Instead of tools, he carried a book of crossword puzzles and cards to play solitaire to combat his boredom. For many years, the US Federal Reserve played the role of the Maytag Repairman with respect to inflation. With the expansion of globalisation and the resulting secular disinflation, there wasn’t much for it to do to fight inflation. Rather, it could generously ease monetary policy during periods of financial market volatility without much concern that its efforts to save investors might spur inflation.

These claims overlook the contributions of peak globalisation, the spectacular long period of growth of China (and to a very limited extent India), the rise of renewable technologies, the spectacular advances in information technology (and the rise of Big Tech), the skill-biased nature of technologies, demographic shifts and global savings glut, geo-political stability, and the extraordinary period of ultra-low interest rates (which drove to the booms in venture capital and private equity models). The world economy experienced an extraordinary confluence of favourable conditions. 

It was clear that these tailwinds could not be sustained. Many of them have tapered off and headwinds have arisen starting with the pandemic and now there’s the possibility of a long period of deep geopolitical uncertainties. We are returning to the historical normalcy in the world economy and politics.

It’s therefore reasonable to argue that the Goldilocks period is in the rear-view mirror and inflation will be higher than the 2% target. And the US economy is currently in that range. It will be in the normal inflation territory of 2-4%. Even a cursory look at this graphic will show that US inflation has been above 2% for most of the post-war era. The sub-2% inflation rate has been the exception, not the norm. Monetary policy must respond now based on the emerging inflation trends in the world where normalcy has been restored. 

In fact, the IMF itself, as early as 2010, when Olivier Blanchard was the Chief Economist, endorsed a higher inflation target. 

A four percent target would ease the constraints on monetary policy arising from the zero bound on interest rates, with the result that economic downturns would be less severe. This benefit would come at minimal cost, because four percent inflation does not harm an economy significantly.

This does not mean that the Fed start cutting rates (since given the new inflation band, the rates are evidently high). Since economic policy is strongly influenced by expectations, it’s also important to consider how the consumers, investors, and markets will react to policy changes given their immediate priors (which continue to be strongly anchored to the Goldilocks world). More importantly, monetary policy has become captive to the financial markets and Wall Street interests. It’s not easy for any Federal Reserve to break out of this capture. 

It will take some time before the expectations get adjusted to the new norm and central bankers can free themselves from their masters, and policies can get made based purely on the new normal world. Policy-making must tread carefully in the interregnum. And we are not sure how long it’ll last. 

Even if this perspective is wrong, it’s useful for influential policymakers and commentators to consider, introspect, and then make a decision of whether to accept or not. The unknown unknown is the biggest danger. 

4. This new world will also mean that valuations in the equity markets will have to be revised downwards. It will upend the business models in areas like private equity. In fact, many parts of financial markets which had become excessively dependent on the ultra-low interest rate environment will face their reckoning when faced with the regime shift in interest rates. 

Given how much the economy has become entangled with the fortunes of the financial markets, especially in the US, the revision in valuations will pose a great risk for the economy. More than the economy, this is the most important soft-landing event to look out for in the next couple of years. Will the financial markets be able to adjust to the new normal of interest rates with its attendant downward valuation revisions without too many convulsions? It’s a question on which fortunes of trillions of dollars are riding. 

5. In the last four years, many reputed economists like Larry Summers have consistently got everything wrong on inflation and economic growth. One would imagine that they would have learnt some humility. It’s clear from his cheeky remarks quoted in the FT article linked above that the next Fed move might be to raise the rate (instead of any rate cut) that he’s only digging in his heels on his views on inflation. 

This is one more reason to argue that the view of people with expertise in non-scientific fields (economics and social sciences) should be taken with caution by policymakers. They are captives of their long-held ideologies and theories, and it takes great courage to step back and break out of the captivity. Rare are those, especially among economists. Angus Deaton is an exception.

Inflation is a wicked problem and you need humility to not be beholden to any grand theory to explain emerging trends. Economists, especially those who have built their reputations defending the orthodoxy, are not well-placed to explain these trends. 

6. Finally, putting all the above together, as an explanation of inflation over the last four-odd years, it’s reasonable to argue that the constraints from the consecutive supply shocks spiked prices and once normalcy returned inflation got back to its normal levels (not the pre-pandemic lows). The pandemic and the war provided the much-needed disruption to break out of the long period of low inflation which led to inflationary expectations getting anchored at unrealistically low levels. 

Inflation is now back to the range where it has been for most of the post-war era. But given the expectations and the need to gradually reshape them, policymakers must tread cautiously for this and next year to stabilise the new inflation and interest rate regime. Regime shifts are periods of high uncertainty.