Month: June 2016

The Sunk Cost of Air India

Air_India_001

There are somethings one never expects a minister to say. Hence, the civil aviation minister Ashok Gajapathi Raju’s recent statement on Air India, came in as a pleasant surprise. The minister told the Press Trust of India: “It is a nice airline. I like Air India but I can’t commit taxpayers’ money for eternity. That is not done.”

This is a huge thing for the civil aviation minister to say. If you take Air India out of the civil aviation ministry (by either shutting it down or selling it off) there isn’t much that remains. Having made this statement, Raju hedged it by saying: “Let’s wish and hope that it (Air India) flies high. I am not against the public sector and I am not for only public sector at all costs. Public sector has a role and private sector has a role. Let them work in competition.”

To be honest, I have also liked Air India, on occasions I have travelled in it, as long as it has taken off on time. The leg space is better than the low cost carriers. The seats are more comfortable and the food is hot. Nevertheless, this is no excuse to keep the airline going.

As I have mentioned in the past, between 2010-2011 and 2015-2016, the airline made total losses of Rs 34,689.7 crore. That is quite a lot of money. Further, the airline also has a debt of Rs 51,367 crore, of which Rs 22,574 crore are outstanding aircraft loans. (As the minister of state for civil aviation Mahesh Sharma told the Parliament in March 2016).

A major part of the debt has helped the airline meet its expenditure, given that it doesn’t earn enough to meet its expenditure. Lenders keep lending to a perennially loss making Air India because ultimately they are lending to the government. And there is no safer lending than lending to the government, at least in theory.

Over and above the debt that airline took on, up until March 2016, the government had already poured Rs 22,280 crore into Air India, to keep it going. A further equity infusion of Rs 1,713 crore has been approved for the current financial year. Hence, a lot of public money is being spent to keep the airline going. What these numbers tell us is that the current government and the ones before it, have been basically in favour of public sector at all costs.

The civil aviation minister Raju further said: “Its (Air India) books are so bad. I don’t think that even if it is offered, anybody would come for it.” What the minister was basically saying is that nobody in their right mind will buy Air India in its current state. But is this good enough a reason to keep the airline going? That seems to be the case, given that there has been absolutely no talk of shutting it down.

Behavioural economists have a term for a situation like this—they call it the sunk cost fallacy. As Daniel Kahneman, the Nobel Prize winning psychologist, writes in Thinking, Fast and Slow: “A rational decision maker is interested only in the future consequences of current investments. Justifying earlier mistakes is not among the…concerns. The decision to invest additional resources in a losing account when better investments are available, is known as sunk-cost fallacy, a costly mistake that is observed in decisions large and small.”

Kahneman gives the hypothetical example of a company that has already spent $50 million on a project. As he writes: “The project is now behind schedule and the forecasts of its ultimate returns are less favourable than at the initial planning stage. An additional investment of $60 million is required to give the project a chance. An alternative proposal is to invest the same amount in a new project that currently looks likely to bring higher returns. What will the company do? All too often a company afflicted by sunk costs…[throws] good money after bad rather than accepting the humiliation of closing the account of a costly failure.”

This escalation of commitment is visible in many areas including war as well. As Richard Thaler writes in Misbehaving—The Making of Behavioural Economics: “Many people believe that the United States continued its futile war in Vietnam because we had invested too much to quit…Every thousand lives lost and every billion dollars spent made it more difficult to declare defeat and move on.”

This escalation of commitment is a major reason which has led to the government keeping   Air India going over the last few years, despite the mounting losses. No minister or the government for that matter, wants to admit defeat and talk about shutting down the airline.

As Kahneman writes in the context of the example we saw above: “Cancelling the project will leave a permanent stain on the executive’s record, and his personal interests are perhaps best served by gambling further with the organisation’s resources in the hope of recouping the original investment—or at least to postpone the day of reckoning.”

This logic applies to the civil aviation minister as well as the government (and not just the current one). No government wants to admit defeat and shutdown the airline. This, in a situation, when the government isn’t exactly flush with money and there are other important sectors, like education, health as well as physical infrastructure, that need more money.

Further, the airline continues to lose money and in a scenario where the Indian Railways is in a mess and needs a lot of money to be revived. If there is only so much money going around, shouldn’t that money be going to the Railways, instead of an airline?

I guess that is a no-brainer. But then no-brainers aren’t always so easy to process.

The column originally appeared in the Vivek Kaul Diary on Equitymaster on June 14, 2016

Why Skill India is as Important as Make in India

 

make in india

Organised retailing is expected to be a big job creator in the days to come. A recent report brought out by National Skill Development Corporation(NSDC) suggests that 5.6 crore people will be working in the sector, by 2022. The earlier estimate was around 1.8 crore.

Estimates made by NSDC suggest that organised retailing employed around 3.86 crore in 2013. This number is expected to increase to 4.51 crore in 2017 and finally to 5.6 crore in 2022.

The question is will this happen? We will get around to answering that later in this column. Essentially, countries escape from being under-developedthree ways: geology, geography and jeans. Jeans is basically a code for low-skilled manufacturing.

As the Economic Survey of 2014-2015 points out: “In recent years West Asia, Botswana and Chile, and further back in time Australia and Canada, exploited their natural resources endowed by geology to improve their standards of living. Some of the island successes (Barbados, Mauritius, and others in the Caribbean) have exploited their geography by developing tourism to achieve high rates of growth.”

On the other hand, the East Asian countries (China, Thailand, Indonesia, Malaysia etc.) got out of being underdeveloped by concentrating on jeans i.e. low skill manufacturing. The initial fillip to economic growth came from these countries relying on low-skilled manufacturing. With time, they diversified into more sophisticated manufacturing.

India has missed the low-skill manufacturing revolution, for sure. Information technology was our great big hope. But the sector needs extremely skilled individuals, and thus has its limitations in creating sustained as well as wide-spread economic growth.

Also, it is worth pointing out here that no country in the world has escaped poverty by using skill-intensive activities as the launching pad for economic growth. One of the major criteria for creating rapid, sustained and wide-spread economic growth is the alignment of the fast growing sector with the comparative advantage of the country.

In the Indian case, this happens to be the availability of labour. As the Economic Survey points out: “To ensure that expansion occurs and the benefits of fast-growing sectors are widely shared across the labour force, there should be a match between the skill requirements of the expanding sector and the skill endowment of the country. For example, in a labour abundant country such as India, the converging sector should be a relatively low-skilled activity so that more individuals can benefit from convergence.”

In other countries which have had abundant labour, low-skill manufacturing has put the labour to work, incomes have gone up and sustained economic growth has been created. Due to various reasons, from focus on public sector enterprises to a surfeit of labour laws leading to firms which do not grow a certain size, India has missed out on the low-skilled manufacturing revolution, which has pulled many East Asian countries out of poverty.

The manufacturing sector as it has developed in India has been highly skill intensive. As Amrit Amirapu and Arvind Subramanian write in a research paper titled Manufacturing or Services? An Indian Illustration of a Development Dilemma: “It turns out that registered manufacturing is indeed a sector that is relatively skilled labour intensive…The share of workers with at least secondary education is substantially higher in registered manufacturing than in agriculture, mining or unregistered manufacturing and also greater than in several of the service subsectors. In some ways, this should not be surprising. High labour productivity in this sector is at least in part a consequence of higher skills in the work force. What it does suggest, however, is that registered manufacturing does not really satisfy requirement number four. The skill intensity of the sector is not quite aligned with India’s comparative advantage.”

Given this, Indian manufacturing the way it is currently structured is not going to solve India’s jobs problem. What India needs are jobs for the low-skilled. The current Modi government has tried to tackle the lack of jobs in India, by launching the Make in India programme.

Further, the question is, will the services sector, of which organised retailing is a part, be able to generate enough jobs. Estimates suggest that nearly one million individuals are entering the workforce every year. And this is expected to continue for a while.

Does the services sector have the potential to put low-skilled Indians to work? As Amirapu and Subramanian point out: “Services in aggregate are no less skill-intensive: on average, 78% of workers in the service sector have at least a primary education (77% in registered manufacturing), and 48% have at least a secondary education (43% in registered manufacturing). Furthermore, a large number of service subsectors – including 1) Banking and Insurance, 2) Real Estate and Business Services, 3) Public Administration, 4) Education, and 5) Health and Social Services – have significantly higher educational attainment (90% or more of workers have at least primary education) than registered manufacturing. What this implies is that many service subsectors (precisely the high productivity, high growth subsectors, for the most part), have a limited capacity to make use of India’s most abundant resource, unskilled labour.”

The NSDC report on organised retailing also talks about lack of skill in the organised retailing sector. Hence, if the services sector in general and the organised retailing sector in particular, have to create jobs in India, the skill-set of Indian labour needs to improve in the years to come.

As the Economic Survey points out: “Sustaining a skill-intensive pattern on the other hand would require a greater focus on education (and skills development) so that the pattern of development that has been evolving over time does not run into shortages. The cost of this skill intensive model is that one or two generations of those who are currently unskilled will be left behind without the opportunities to advance. But emphasising skills will at least ensure that future generations can take advantage of lost opportunities.”

Further, if a skill-intensive pattern of development has to be followed, what it means is that the Skill India programme is as important as the Make in India programme. As the Economic Survey points out: “What the analysis suggests is that while Make in India, which has occupied all the prominence, is an important goal, the Prime Minister’s other goal of “Skilling India” is no less important and perhaps deserves as much attention. Make in India.”

Disclosure: The basic idea for this column came after reading Akhilesh Tilotia’s research note Forecasts of fewer jobs dull demographic sheen. Tilotia works for Kotak Institutional Equities and is also the author of The Making of India.

The column originally appeared in the Vivek Kaul Diary on June 13, 2016

Interest rates are also about savers, not just about borrowers

ARTS RAJAN

One of the points that I have made in the past is that interest rates are not just about borrowers; they are also about savers.

Raghuram Rajan, the governor of the Reserve Bank of India(RBI) explained this beautifully in a recent interview to NDTV. At a talk somewhere, one gentleman got up and told the governor that he should bring down the interest rates to 4%.

A point that most people fail to understand is that an RBI governor can decide only on the repo rate. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

The RBI governor does not decide on the interest rate that a bank charges on its loans. Neither does he decide the interest rate a bank pays on its deposits for that matter. That is a decision individual banks make.

Hence, Rajan cutting the repo rate is not enough. Banks need to pass on the cut to the end consumers. Since January 2015, Rajan has cut the repo rate by 150 basis points. Banks have passed on around half of that cut to the end consumers due to various reasons. The public sector banks have been accumulating a huge amount of bad loans and this has limited their ability to cut interest rates on their loans.

Rajan asked this gentleman that the rate of inflation was still 5.5% and if he brought down the interest rate to 4%, would he still deposit his money at the bank? The gentleman said no. So he was not willing to deposit his money at a low interest rate, but wanted banks to lower their lending rates.

To this Rajan said: “say a bank pays 6% on deposits and lends at 4%, who is going to make up for the difference”. “The idea is that somebody is going to pick up the tab. We are used to somebody picking up the tab. Who is going to pick up this tab?”

The point here is very simple. A bank can only lend at a rate of interest which is higher than the rate at which it borrows. Further, it needs to offer a certain rate of interest on its deposits, so that people deposit money with it and do not invest it in other avenues which offer a higher rate of return. Currently, the rate of interest offered on small savings schemes are significantly higher than those of fixed deposits.

Rajan also said that it takes some time for depositors to get used to the fact that inflation has actually come down over the last few years. “The real interest rate they [i.e. depositors] are getting now is much higher than the real interest rate they were getting earlier,” Rajan said.

The real interest rate is essentially the nominal interest rate offered by a bank on its fixed deposit subtracted by the prevailing rate of inflation. “When inflation was 9% they [i.e. depositors] were getting 9%. This meant earning nothing in real terms and losing everything in inflation,” Rajan explained. “Today they are getting 7% on their deposits and inflation is 5.5%. They are earning 1.5%. It is a real difference,” he added.

This is something that will take time to sink in because money illusion is at work. What is money illusion? As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes: “[Money illusion] involves a confusion between ‘”nominal” changes in money and “real” changes that reflect inflation…Accounting for inflation requires the application of a little arithmetic, which…is often an annoyance and downright impossible for many people…Most people we know routinely fail to consider the effects of inflation in their finance decision making.”

So, the point is that even though people are earning a better real rate of interest they don’t realise it. What they see is that nominal rate of interest has fallen and given this they are not happy with banks offering a lower rate of interest on their fixed deposits.

As Rajan said in the NDTV interview: “Depositors are already complaining that they are not getting enough. That is why banks are reluctant to cut [deposit] rates.” And unless banks can cut deposit rates there is no way they can cut lending rates, irrespective of what the RBI chooses to do with the repo rate.

This is how bank interest rates work. As Rajan asked: “For somebody to say that I have a God given right to get a loan at low interest rate but I won’t deposit at that rate, where is the money going to come from them?” This basically means that banks lend money they essentially get as deposits. And without deposits there is going to be no lending.

“One of the most difficult things in economics to understand is general equilibrium. You do one thing it has other effects as well,” Rajan said. If interest rate on lending is cut where is the money going to come for savings, Rajan asked.

This is something that people who keep demanding lower interest rate at a drop of a hat don’t seem to understand. There are two sides to bank interest rates. The interest rate banks charge on their loans and the interest rate they pay on their deposits. And if interest rates on deposits can’t fall beyond a point, then the interest rate on loans can’t fall as well.

This is a basic point that people don’t seem to understand. And it’s not rocket science.

The column was originally published in the Vivek Kaul Diary on June 10, 2016

India’s Agriculture Crisis is Set to Become Worse

agriculture

The gross domestic product(GDP) data for 2015-2016 was declared sometime back. As per this data, agriculture (actually agriculture, forestry and fishing), made up for around 14.1% of the GDP, during the course of the financial year. The trouble is that close to 50% of the population continues to depend on agriculture for a living.

This basically means that agriculture formed around one seventh of the Indian economy during the last financial year. At the same time around half of the population is dependent on it. The point being that it employs many people than it actually should. Hence, there is a huge disguised unemployment in the rural areas.

Disguised unemployment essentially means that there are way too many people trying to make a living out of agriculture. On the face of it they seem employed. Nevertheless, their employment is not wholly productive, given that agricultural production does not suffer, even if some of these employed people stop working

There are many more people than the sector requires and this leads to lower incomes for those who work in agriculture. The broader point is that if the average incomes need to go up, people need to be moved away from agriculture. But a new analysis suggests that this will not happen at the pace it was earlier expected to be.

Akhilesh Tilotia of Kotak Institutional Equities makes this point in a recent research note titled Forecasts of fewer jobs dull demographic sheen. Tilotia is also the author of The Making of India. He reviewed a “set of 24 industry reports commissioned by the National Skills Development Council (NSDC) and compare them with similar reports that NSDC had put together around the end of the last decade.”

The earlier reports had put the size of the Indian workforce at 65.4 crore by 2022. The number is now a lot lower at 57.5 crore. As far as number of people employed in agriculture in 2022 is concerned, the earlier estimates put the number at 11.4 crore or 18% of the workforce. As per new estimates the number of people who are expected to be working in agriculture in 2022, stands at 21.6 crore or around 38% of the workforce.

This basically means that nearly 10.2 crore more Indians will be dependent on agriculture as a mode of living, than was expected earlier. Further, by 2022, agriculture is expected to form around one-ninth of the GDP or the overall economic size of the country.

The automobile sector which was earlier expected to employ 4.8 crore individuals is now expected to employ only around 1.5 crore individuals. The same goes for the food processing sector, which was earlier expected to employ around 1.8 crore individuals, but is now expected to employ only 40 lakh individuals. On the other hand, the numbers for organised retail have gone up dramatically from 1.8 crore individuals earlier, to 5.6 crore individuals, as per the latest estimates.

Long story short, enough jobs will not be created to move people out of agriculture into other sectors where they can make a living.

In fact, as the Economic Survey of 2014-2015 points out: “The data on longer-term employment trends are difficult to interpret because of the bewildering multiplicity of data sources, methodology and coverage. One tentative conclusion is that there has probably been a decline in long run employment growth in the 2000s relative to the 1990s and probably also a decline in the employment elasticity of growth: that is, a given amount of growth leads to fewer jobs created than in the past. Given the fact that labour force growth (roughly 2.2-2.3 percent) exceeds employment growth (roughly about 1½ percent), the challenge of creating opportunities will remain significant.”

As the Survey further points out: “Regardless of which data source is used, it seems clear that employment growth is lagging behind growth in the labour force. For example, according to the Census, between 2001 and 2011, labour force growth was 2.23 percent (male and female combined). This is lower than most estimates of employment growth in this decade of closer to 1.4 percent. Creating more rapid employment opportunities is clearly a major policy challenge.”

One reason why enough jobs are not being created is because of what economists call falling labour intensity. Economic growth now generates fewer jobs in the non-farm sector (industry including manufacturing, construction, mining and utilities plus services sector) than it used to earlier. For every 1% increase in the gross domestic product, the non-agricultural employment went up by 0.52%, between 1999-2000 and 2004-2005. This fell to 0.38% between 2004-2005 and 2011-2012. (Source: D.Joshi and V.Mahambare, HIRE & LOWER–Slowdown compounds India’s job-creation challenge, Crisil Research, January 2014)

Hence, economic growth does not translate into the same number of jobs as it used to in the past. This basically means that economic growth is less labour intensive. This has happened primarily because of two reasons. First, the economic growth now is driven by less labour intensive sectors like business and financial services as well as information technology and information technology enabled services. These sectors require only one or two people to produce Rs 10 lakh of real value added Gross Domestic Product or economic output. This basically means that faster growth in these sectors does not necessarily translate into jobs. (Source: D.Joshi and V.Mahambare, HIRE & LOWER–Slowdown compounds India’s job-creation challenge, Crisil Research, January 2014).

This is clearly a big problem which does not have easy answers. Further, people dependent on agriculture are low on skill-sets that are needed for jobs in other sectors. It also needs to be pointed out here that moving people from agriculture into other areas is not so easy.

In fact, other countries which have grown at a very fast pace in the past, have experienced the same phenomenon. TN Ninan makes the point in The Turn of the Tortoise. Take the case of Thailand. Agriculture still constitutes close to 40% of its workforce. Or China, which has become the factory of the world. Around 35 per cent of the workforce is still engaged in agriculture, even though it produces just 10 per cent of the Chinese economic output.

The column originally appeared in the Vivek Kaul Diary on June 9, 2016

The Trouble with Economic Forecasting is…

PricingSometime in May last year, I wrote a column for a digital publication, in which I said that the Modi government’s luck on the oil front would run out in 2015-2016. As is wont in such cases, I was more than a little vague about exactly when would the Modi government’s luck on the oil front run out.

I was just trying to follow an old forecasting rule: “forecast a number or forecast a date, but never both”. So, I sort of forecast a date. Honestly, I was wrong about it. The Narendra Modi government’s luck on the oil front continued through 2015.

Nevertheless, things have started to heat up in the recent past. Since February 12, 2016, the price of the Indian basket of crude oil has gone up by around 75%. As on May June 2, 2016, the price of the Indian basket for crude oil was at $46.83 per barrel.

This isn’t a column on trying to defend, what was a largely wrong forecast. What I want to explore in this column is the basic point about forecasting being a very difficult thing to do. While it’s always easy to explain things in retrospect, it is very difficult to predict how things will play out. And it is even more difficult to predict when things will play out, the way you expect them to play out.

Let’s take the basic forecast of oil prices going up. I was right about the point that when oil prices start to go up, the luck on which the good fortunes of the Modi government are built will start to run out. I will not explain it again here, given that I have explained it, often enough in the past, and perhaps might do it again, in the days to come.

Nevertheless, I got the timing wrong, despite making a very open ended forecast. There are two basic points to making a forecast—one is you expect the trend to continue—the other is you do not expect the trend to continue.

I expected that the trend of lower oil prices would not continue. While I have been right about that, but I have been wrong about the timing.

But what about forecasts, where economists and analysts, expect a trend to continue. Take the case of what economist Arvind Panagariya wrote in India—The Emerging Giant, a book that was published in 2008: “India has been growing at an average annual rate exceeding 6 percent since the late 1980s. During the four years spanning 2003-2004 and 2006-2007, its growth rate reached 8.6 percent—a level close to that experienced by the East Asian miracle economies of the Republic of Korea and Taiwan during their peak years. As the book goes to press, fears that the economy is overheating can be heard loudly, but virtually no one is predicting a significant slowdown in the growth rate in the forthcoming years.”

Panagariya, like most economists, did not see the financial crisis, coming. He also, like most economists, thought the current trend would continue. But that did not turn out to be the case. Also, most economists find it easier to say what other economists are saying. This is because if and when they are wrong, then they are wrong in a majority.

And it is safe to be wrong when everyone else is wrong. Nevertheless, if one economist forecasts something which goes against the trend and is wrong about it, then only he has to bear the consequences of being wrong. Life is easy, when everyone is wrong, and hence it makes sense to go with the herd.

Let’s take another example here of the economist Milton Friedman and the prediction he made when the price of oil started to go up in the early 1970s.

In January 1974, the Organisation of Petroleum Exporting Countries(OPEC) raised the price of oil to $11.65 per barrel. This was after OPEC’s economic commission had determined that the price of oil should be $17 per barrel.

It was around then that the economist Milton Friedman wrote in a col­umn in the Newsweek magazine where he predicted that “the Arabs … could not for long keep the price of crude at $10 a bar­rel.” For this prediction, Friedman was awarded the Booby Prize by the Association for the Promotion of Humour in International Affairs
The price of oil was quoting at more than $18 a barrel by the end of 1979. And by early 1981, it had risen four-fold and was quoting at nearly $40 a barrel. Friedman had been proven wrong for a long period of time.

In 1986, finally the price of oil was quoting again at $10 a bar­rel. And Friedman wrote a “I told you so” column in an issue of the Newsweek magazine which appeared on March 10, 1986. The column was titled “Right at Last, an Expert’s Dream.” This, of course, was in jest. As Friedman confessed, “Timing, as well as direction, is important…I had expected the price of oil to come down far sooner.”
Now does that mean that it makes sense to go against the herd? I wish I could say that. Over the last few years, a huge number of gold bugs have been coming out of the woodwork and predicting that gold prices will rise again. While, gold has done reasonably well in the recent past, a sustained rally in the yellow metal hasn’t been seen as yet.

So, next time you hear an analyst or an economist, make a forecast, with great confidence, it might be worth remembering that old saying in economics: “economists have predicted nine out of the last five recessions”.

The column was originally published on June 7, 2016