#88 Economics Matters, Capitalism Works

This newsletter is really a weekly public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?

PS: If you enjoy listening instead of reading, we have this edition available as an audio narration courtesy the good folks at Ad-Auris. If you have any feedback, please send it to us.

India Policy Watch: Pro-market Vs Pro-business

Insights on burning policy issues in India

— Pranay Kotasthane

Indian governments have a rule-making obsession. These myriad rules, regulations, and laws are particularly onerous for running businesses. One anticipated unintended consequence is self-evident: over-regulation incentivises businesses away from the regulated activity into an activity that is far more harmful.

But that’s not all. The other unintended consequence is that overregulation increases rent-seeking opportunities i.e. some businesses cut side-deals with regulatory agents and thrive. Hallward-Driemeier and Pritchett explain this succinctly in their 2015 paper:

“when strict de jure regulations meet weak governmental capabilities for implementation and enforcement … researchers and policy makers should stop thinking about regulations as creating “rules” to be followed, but rather as creating a space in which “deals” of various kinds are possible”.

Kar, Pritchett et al in a 2019 paper find further evidence of the way these deals play out. They reach an interesting conclusion that as regulatory stringency increases, the proportion of firms obtaining clearances, permits, and licenses quicker also increases. In their words:

“..quick deals are often the result of weak implementation via regulatory capture and/or influence or evasion, rather than the result of better regulation or the more speedy completion of regulatory processes. In other words, firms are able to get permits and licences much faster, without due diligence being undertaken for their business activities, by influencing the regulatory bureaucracy and/or their political bosses. As a country’s state capability increases, there is greater ability to counter the pressure for regulatory capture and hence the proportion of such quick deals falls.”

This results in a low-level equilibrium where regulatory capture becomes the de facto norm.

Such deal-making reality is relevant in India today as sector after sector, market concentration is on the rise i.e. a few select firms are able to get clearances, permits, and licenses by cutting side-deals with governments. Unsurprisingly, a lot of media attention is on exposing these special high-level political connections or direct influencing mechanisms.

What’s lost in the din is that while such exposés can shed light on particular instances of government-business dealings, they don’t help reduce levels of corruption. One business tycoon gets replaced by another and the story repeats. As long as higher regulatory burden continues to coexist with low enforcement capacity, side-deals flourish.

The solution then is to decrease the regulatory burden in the short-term and increase enforcement capacity in the long-term. Simplifying rules are pro-market not just pro-business. They negate the advantage that some companies enjoy on account of their special connections with regulatory agents. That’s precisely why simpler tax, policy, and legal environments are pre-conditions for making India’s market more competitive.

Global PolicyWTF: Turkey For Thanksgiving

This section looks at egregious public policies. Policies that make you go: WTF, Did that really happen?

— RSJ

Bad policy ideas never go out of fashion. They spruce themselves a bit, don new clothes and return to wreak havoc all over again. They are remarkably resilient because the public falls for them every time they show up in a new garb. This is why strong institutions matter. Failing which an enlightened populace that appreciates economic reasoning can stand as the last line of defence. We talk a lot about PolicyWTFs here because our modest aim is to evangelise economic reasoning. The root causes of most PolicyWTFs that we target can be traced to two fundamental human failings – good intentions and hubris. In the past few months, we have seen this play out in Turkey in all its glory.

Killing The Messenger

On September 15, Moody’s Investor Service cut Turkey’s sovereign credit rating to B2, about five levels below investment grade. This put Turkey on par with countries like Rwanda and Jamaica.

“Turkey’s external vulnerabilities are increasingly likely to crystallize in a balance-of-payments crisis,” Moody’s wrote in their report.

"Turkey has been muddling through for some time now, but muddling through is not a strategy that can be used forever. At some point they will run out of road," Sarah Carlson, lead sovereign analyst at Moody's Investors Service, told Reuters in an interview.

President Tayyip Erodgan responded by attacking Moody’s and other rating agencies as he has done in the past. The usual bogey of interest rate lobby and currency manipulators was wheeled out to defend his position.

Turkey’s economy is on the rise and not dipping at the moment, but “they are downgrading our ratings again,” Erdogan said in Istanbul on Saturday after the Moody’s announcement. “Do what you want to do, your ratings are of no importance.”

The Certitude Of Erdogan

So, what’s gone wrong with policymaking in Turkey? Well, in a single word – hubris. Erdogan cannot imagine being wrong and worse, he thinks the economy can be managed centrally and bent to his will. He has fired central bankers, appointed his son-in-law as the Finance Minister and has made policy moves that would do a tin-pot dictator proud. Things were already bad for Turkey at the start of this year. Then came the pandemic. Alongside these Turkey has been flexing its political and military muscle all around the region. That has won it no friends. From the US, Russia to Saudi Arabia, it has been picking the choicest battles to dig itself further into a hole. The EU integration dream has been smashed beyond recognition.

But Erdogan fancies himself as the leader of the Muslim world and a strong man who will change the destiny of his people. He won’t change course. Admitting a mistake is the biggest sin in his worldview. So now you have a situation where foreign currency funding of over $50 billion has fled Turkey over the past couple of years while the local banks have been mopping up domestic savings in dollar-denominated deposits. These funds are being borrowed by the Turkish Central Bank (CBRT) and sold in the market to defend the Turkish Lira. The CBRT has negative net foreign currency reserves at this moment.

This means Turkish banks are sitting on huge exposure to CBRT which has nothing left in reserves while the government continues to borrow from the state-run banks to fund its ambitious infrastructure programmes. The Turkish Lira has fallen over 30 per cent this year, there’s double-digit inflation and the investors are voting with their feet. A balance of payments crisis is imminent and that’s what Moody’s and other rating agencies have flagged.   

Bonfire Of Economic Reasoning

The problem is you could see this coming for many years because the first casualty of political hubris is economic reasoning. And Turkey has shown a fine disregard to it under Erdogan. Turkey runs a large current account deficit (imports more than its exports) which requires external financing or a capital account surplus to fund. This is usual for an emerging economy with a strong and growing domestic market. Over the years the promise of deeper integration with EU and the relatively large size of its market has meant it has attracted strong foreign capital flow. This led to the expansion of credit that fuelled the consumption boom. The way to manage this is to continue reforms to retain the confidence of foreign capital, invest in infrastructure and human capital to improve the long-term competitiveness of Turkish industry and maintain internal and external harmony to keep the economic engine humming.

Instead, President Erdogan has put his own version of economics at the forefront to bring Turkey to the brink. The list of Erdogan PolicyWTFs is long:

* He loves low-interest rates that allow people to borrow and spend. That makes him popular. But he also has a warped notion that high-interest rates cause high inflation. This is a problem in a country like Turkey that has chronic high inflation and depends on foreign capital. A lower interest reduces the attractiveness of Turkish assets and foreign capital goes elsewhere. This weakens Turkish Lira. This is what has happened in the last two years where a domestic credit boom has been engineered by keeping interest rates artificially low. But the consumption upsurge has meant more imports because Turkish people love buying foreign goods. The weakened Lira means Turkey keeps importing inflation in the form of foreign goods. And the inflation keeps rising, hurting the poor the most.

* Demolishing the independence of central bank has been his singular achievement in the past few years. He has taken the powers to appoint members to CBRT’s rate setting board directly. He has installed a lackey as its Chairman who cut interest rates with little regard to the consequences over the last two years. There is no system of checks and balances left for Turkey to have an independent monetary policy anymore.

* As usual wrong root causes have been identified for the balance of payments crisis. That imports are a problem. One way to solve this is to find energy sources of its own so that fuel imports reduce. That explains its increased belligerence in the eastern Mediterranean region. Nothing good would come out of it except inviting more sanctions and a further flight of capital. Soon there will be a call for import substitution (there are already those calls) and to shun foreign goods. There will be another round of whipping nationalistic fervour to cover the economic mess.

* The three options that can help avert a balance of payments crisis are anathema to President Erdogan. He doesn’t like higher interest rates so that’s not an option. Buying Turkish Lira using domestic foreign exchange reserves is the other. This has been done to its fullest and the reserves are in negative now. The final option is to go to IMF who will dictate terms but that can’t be countenanced by a strong leader.

Turkey is a good lesson in believing intentions and political legitimacy trumps economic rationale. That a strong and popular leader who trusts his instincts can make bold calls for an economy. The economy bends to no one’s will. Except to reason.    

Money Quote: What Has Capitalism Done for the Poorest?

— Pranay Kotasthane

This month I’m reading the works of Deirdre McCloskey, one of the best living economists. These lines from her book Why Liberalism Works need to be reflected upon by everyone in the public policy space:

“..according to the scientific consensus in economic history, the much-maligned “capitalism” has raised the real income per person of the poorest since 1800 not by 10 percent or 100 percent, but by over 3,000 percent. Cheap food. Big apartments. Literacy. Antibiotics. Airplanes. The Pill. University education. The increase is a factor of thirty. That is, 30 minus the original, miserable, base of 1.0, all divided by the base is 29/1, to be multiplied by 100 to express it per hundred—or a 2,900 percent increase over the base, 3,000 near enough. I will keep saying it, and keep dazzling you with my prowess in arithmetic, until you feel it on your pulse. It is the greatest, yet regularly overlooked, fact about the modern world. Most people by actual questionnaire think that since olden days the real capacity of poor people to buy goods and services has increased maybe 100 percent, at the outside 200 percent, a doubling or a tripling. They’re quite wrong. The increase has been much, much greater. If we appreciate it, the appreciation will transform all our politics. For example, the fact of the Great Enrichment is a crucial element in showing that humane true liberalism of the modern sort I advocate here is good and enriching, in every sense.

The Great Enrichment doesn’t mean, of course, that there’s nothing more to do in helping the poor, especially by ending the numerous, monstrous, and yet politically popular policies that in fact damage them worldwide. But it does mean that it is mischievous to attack, as many political theories do, a “capitalism” that has done more than anything else to help the poor. The Great Enrichment doesn’t mean that little bits of other systems—a soupçon of socialism for worthy public projects, a cup of Christian charity for the poor, a tablespoon of encouragement to worker-owned cooperatives, such as law and accounting firms—are to be scorned. But it does mean that replacing “the system” as a whole would be disastrous for the poor, as it has been shown to be in the USSR after 1917, in Venezuela after 1999, and over and over again in between.”

McCloskey, Deirdre Nansen. Why Liberalism Works . Yale University Press. Kindle Edition.[Emphasis mine]

Matsyanyaaya: Assessing China’s Silicon Rush

Big fish eating small fish = Foreign Policy in action

— Pranay Kotasthane and Rohan Seth

[An edited version of this article appeared first in South China Morning Post on 15th Nov under the headline China’s semiconductor gold rush: A reality check]

The semiconductor industry has become a major front of the US-China tech war. Given that this is a weak link in China’s otherwise impressive technology stack, the US has imposed export controls restricting Chinese semiconductor companies from accessing key equipment, software, and intellectual property.China has been aware of this weak link. Since 2014, the Chinese state has set up two 'Big Funds' to incentivise growth. These funds raise money primarily from government bodies — the finance ministry, state-owned enterprises, local governments — and invest it in upcoming semiconductor companies.The government-led investment has led to a 'crowding-in' of private enterprise. According to recent data, more than 13,000 Chinese enterprises registered as semiconductor companies in the first nine months of this year. That is a significant jump from the nearly 9,000 companies that registered last year. Such is the lure that several new entrants with no prior experience in semiconductors have thrown their hat into the ring. Many come from a range of disparate sectors such as automobiles and seafood.So, does this silicon rush mean that China will become self-sufficient in semiconductors soon? Not quite. China's state-backed funds might well spur private investment, even producing a few champions but such moves are unlikely to result in a self-sufficient Chinese semiconductor industry anytime soon. Here's why.The semiconductor supply chain is a complex one. It can be very roughly split into three main stages: integrated circuit (IC) design, semiconductor manufacturing, and assembly & testing. The returns of investment for China in each of these stages will be different due to their unique limiting constraints.

China's prospects in IC design

The first stage — IC design — is skill-heavy and asset-light. Coming up with newer chip architectures and integrating them requires a large number of high-skilled engineers familiar with specialised software. There were nearly 138,000 design startups in China as of September 2020, most of them getting registered after the first government-backed fund was announced in 2014. Though there are fears of talent shortage, government-backed massive investment means that such shortage can be tackled by poaching talent from Taiwan at higher wages. The fortune of design shops is on the rise.And yet, these design shops are not destined for success. One critical bottleneck remains in the US control: software. IC design is intricate and requires extensive use of automated design software collectively known as Electronic Design Automation (EDA). EDA requires massive R&D investment and in-depth knowledge of chip fabrication. As a result, this market has rapidly consolidated over the years. Currently, there are three dominant global players, two of which are US-owned while the third is based in the US. Exploiting this asymmetry, the US banned the sale of US-origin EDA software to HiSilicon, Huawei's IC design unit. With China having no EDA firm at the cutting edge and the US taking a hardline approach on IP piracy, developing self-sufficiency in EDA tools will require considerable time.The second bottleneck is processors for high-end mobile phones. ARM Holdings is the dominant firm here with over 90 per cent market share. ARM was recently bought by NVIDIA, making it directly subject to American export restriction laws that are being used to target Huawei. To overcome this dependence, Chinese companies such as Alibaba have thrown their weight behind a rival open-source architecture known as RISC-V. Though impressive development has taken place on this front, RISC-V still has many years of catching up to do before it can displace ARM’s core general purpose processors in mobile phones and tablets.

China's prospects in chip fabrication

Physically translating IC design onto silicon is a capital-intensive process requiring regular and massive capital infusion. For example, TSMC, the world's leading chip manufacturer estimates that its next-generation chip fabrication plant will cost $19.5 billion.China’s Big Chip Funds will help pool in the significant investment for building new fabrication plants. Despite this, two challenges will constrain China's hand in the catch-up game.One, China's starting point remains a handicap. Even Semiconductor Manufacturing International Corporation (SMIC), China's national champion in this space, can commercially produce 14-nanometer chips as of now. This is a couple of generations behind the industry leader's (TSMC) 5-nanometer capability. This number is indicative of the transistor size; the smaller this number, the more transistors can be packed in the same area leading to higher device performance. Even with enough capital investment, it might take the better part of a decade for China to catch up with TSMC. And by the time that happens, the cutting edge would likely have moved on to a more advanced process. Until then, companies such as Huawei have no local option for manufacturing their high-end chips.Two, a fast follower approach is challenging to execute with ongoing US sanctions. For instance, the US has been applying pressure on ASML, the world's only producer of a technology required to manufacture high-end chips. Applied Materials and Lam Research, two other US companies which supply critical manufacturing equipment to SMIC also face US export curbs. Without access to this equipment, SMIC will not be able to produce advanced chips.

China's prospects in assembly & testing

Finally, the back-end, commonly referred to as Outsourced Semiconductor Assembly & Test (OSAT), is a labour-intensive sector with lower profit margins.OSAT has already moved to countries that have a comparative advantage in the availability and cost of labour. The capital investment is still significant, but not as high as the manufacturing process. These characteristics make OSAT a low hanging fruit for China's Big Fund investments. Although Taiwan remains the leader in the space by a significant margin, China's market share has been growing steadily. Jiangsu Changjiang Electronics Technology Co. (JCET), backed by a Big Fund, now has over 15% market share in the global market. As the state lays out an increasing number of incentives, it is the OSAT segment that is most likely to benefit from them as compared to the other stages.China faces an additional geopolitical challenge in chip fabrication and assembly. Just a handful of Japanese companies dominate the global market in silicon wafers, photoresists, and essential packaging chemicals. These companies are well-regarded for their high-quality production capabilities and their products are not easily replaceable even by a manufacturing heavyweight such as China. In a changed world where strategic concerns are guiding technology flows, China’s chip ambitions can be foiled not just by the US but also by Japan and Taiwan.Based on this survey of China's strengths and weaknesses in different stages of the semiconductor supply chain, judging Big Funds' success by the number of registering companies doesn't provide an accurate picture. Throwing money at the problem is not a solution that can work for all sectors. The spectacular failures of Fujian Jianhua Integrated Circuit Company (a memory chip maker) and Wuhan based HSMC (a chip manufacturer) have amply demonstrated that China's push to be self-reliant will require a lot more than massive public investment. Crucially, China's own arrogant international conduct that has resulted in significant geopolitical barriers for its fledgeling semiconductor industry. To adapt William Gibson's oft-repeated quote, the future of semiconductors in China is here — it's just not very evenly distributed.

HomeWork

Reading and listening recommendations on public policy matters

* [Article]: ‘An imbalance of payments leaves Turkey with hard choices’: John Lubbock in the Ahval on where Turkey’s economy stands today

* [Paper]: Cooperative arrangements in the technology domain to balance China’s power seem to be gaining traction.

That’s all for the week from us.

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