Price Controls and Subsidies Distort Markets: Sugar Edition

From today’s Star (excerpts):

Sugar woes

PETALING JAYA: There is an acute shortage of sugar in the country.

Consumers and traders in several states have voiced their frustration in getting supply of the essential commodity, describing the shortage as the “worst so far”.

A check at several grocery shops here revealed that no sugar had been on sale for over a week…

…Fomca secretary-general Muhd Sha’ani Abdullah said it had received complaints in various areas including Kuantan, Muar, Klang and Temerloh since a month ago.

He said the problem was not due to retailers hoarding sugar but the smuggling of the item to other countries, especially Thailand.

Federation of Sundry Goods Merchants president Lean Hing Chuan said the shortage nationwide was caused by manufacturers halving production, adding that its members started noticing the slowdown in April.

“Factories might be slowing down their production to keep their costs down until subsidies for sugar are withdrawn,” Lean said.

It’s hard to describe in words, so here’s the classical theory (Econ 101)in graphical form (I’m learning how to use Paint!):

The vertical axis represents price, while the horizontal axis  represents volume. The “A” (blue) line represents the supply schedule i.e. the volume that producers are willing to supply at any given price. As the price goes up, producers are willing to produce and supply more of a good to the market. The “D” (red) line represents the amount that consumers are willing to buy at any given price. As price goes up, people are less willing to consume a particular good, or equivalently, less people are able to afford a particular good. In either case, demand falls as price rises. P1 represents the prevailing equilibrium price at which demand exactly meets supply, and volume of X1 is transacted between producers and consumers.

So far so good – this is a fairly common sense view of what happens in the market for any “normal” good. The underlying assumptions are of course that there are many producers who are able to instantaneously adjust production according to price and demand, there are no barriers to market entry for either producers or consumers, the market and the price are visible and accessible to all, and there are no transactions costs. You can drop any or all of these assumptions without necessarily detracting from the insights gained from the subsequent analysis.

So what happens when the government provides a production subsidy? Since a subsidy reduces the cost of production, the entire supply schedule shifts to the right and down:

The supply schedule “A” drops to “B”, and a new equilibrium price is established at P2 where a volume of X2 is supplied. In the case of sugar, a production subsidy effectively means greater production, a lower market price, and greater consumption relative to the original market equilibrium. As costs of production are lower, more firms are able to enter the market, and marginal firms (those who would otherwise have gone bust because they are inefficient) are able to survive.

So while we have greater production, it is at the cost of misallocation of resources because of the embedded inefficiency of production that is covered by the subsidy. This can actually be calculated by the area of the triangle between the intersections of the price and volume lines, and the demand curve. That area represents a net loss to social welfare, as the money could have been used for more productive uses, or to reduce government spending and thus the tax burden. To put it in more understandable layman terms, the amount of subsidy required per unit of output will almost always exceed the drop in price achieved.

There are also negative externalities involved which are not covered by the market price or production costs, as excess consumption of sugar leads to health costs through a higher incidence of diabetes and obesity.

What happens when price controls are added to the mix? You get a really, really bad distortion of market price, demand and production:

Let’s say the government puts the price ceiling at P3, which is lower than either the original market price P1, or the subsidy induced price of P2. The retail market price will always converge to P3 – given the demand and supply curves as drawn, the price can never drop below P3, as it is uneconomical for producers to increase supply large enough for the market price to fall lower than that. So at P3, demand zooms to P4 as more and more people can afford to buy sugar, with the concomitant increase in the cost of negative externalities to society in the shape of increasing health costs.

But also at P3, the aforementioned marginal producers are out of the business as even with the subsidy previously given, their cost of production is so much higher. Other producers who could have survived even at the original equilibrium market price are also out of the business, again because their costs now exceeds potential revenues. So we have a contraction in supply to X3 – which means that there will be a permanent excess of demand and a permanent shortfall in supply. The bigger the difference between the equilibrium price (subsidy-supported or original), the bigger the shortfall will be. And the controlled price of sugar in Malaysia is a full third lower than the market price currently prevailing in our neighbours.

The only way for the government to ensure that demand meets supply at price control level P3 is to provide a subsidy that drops the supply curve to the point where the demand schedule meets P3. This is not the equivalent of a price subsidy equal to the difference between P1 and P3, which is what most people think is sufficient, but rather the difference between P4 and P3 which is an order of magnitude higher. Assuming a 45 degree angle for the supply curve, that’s equivalent to double the subsidy level from P1 and P3.

If you add intertemporal lags to changing production output (i.e. assuming a short-term inelastic supply curve), then the level of subsidy would be that much greater, as the slope of the supply curve would be steeper. A subsidy that is less than that provides an incentive for producers to hawk their produce outside the country, as they can gain more revenue for a given supply.

So what you get with production subsidies is an expansion in both supply and consumption, but at the cost of inefficient use of resources and lower productivity. What you get with price controls is much worse, with the spectre of permanently decreasing production and a constant shortfall relative to demand. And as time goes on, the situation deteriorates, as consumers feel “entitled” and as more and more producers quit the industry.

That’s the narrative that’s playing out here in Malaysia today, not just in sugar, but in rice, vegetables, and all the other items that the government cares to cap prices on in the name of consumer protection.

April 2010 Trade: Rational Expectations Versus Conditional Expectations

In my post last month on March trade, I said I thought that exports would slow down and return to the mean of what my models were predicting. A more normative explanation would be that the March numbers represented a catching up on production and clearing of accumulated finished inventory post-CNY. Either would do in explaining the April numbers (annual and monthly log changes, seasonally adjusted):

Not so good, but given the rationale I’ve thought up of (ex-post facto), not all too surprising either. It’s interesting to contrast this with the prevailing consensus view prior to the data release (38% growth in exports, 30% growth in imports), and analysts’ reactions afterwards. On a side note, I continue to be surprised that people think electrical and electronics exports are driving export growth (RM millions, seasonally adjusted):

Only half of the research houses expected April export growth to register below 30%, and none were even close in forecasting imports. I have to admit that I hesitated before writing that mean reversion line in last month’s post, simply because the consensus was running the other way and there’s also a very human tendency to extrapolate the future based on recent events.

Which brings us to the title of this post. The concept of rational expectations has taken a beating over the last couple of years, with the wide recognition that economic agents don’t always behave consistently or rationally. That applies to professional forecasters as much as it does market players. One of the problems with a non-model based approach is that there is a tendency for agents to display what’s called conditional expectations instead. This is actually also often used as a proxy for rational expectations, since with the former all you need is a knowledge of past events – “we expect this to happen because this happened” – which makes plugging data into models considerably easier (in fact, proving conditional expectations is all that’s required to prove weak form efficient markets).

Rational expectations of course, implies a more forward-looking view of events. But looking at the consensus view, more than a few were guilty of taking the March numbers and expecting that pace of growth to continue. You can see the same effect in research houses’ forecasts of trade and other variables during the recovery last year (leading up to the fourth quarter, they were highly pessimistic), and now the pendulum has gone too far the other way. For that matter, it’s highly unusual to find market forecasters who are willing to be publicly contrarian at any point in time, and you generally find forecasts tending to extrapolate off recent market trends. I’m as guilty of that as anyone is – it’s really hard to run against the herd.

There’s an excellent article in the The Economist last week along the same lines, though with respect to professional investors, not forecasters (I’m quoting in full, because free access to The Economist is time limited):

Who's the patsy? Even sophisticated investors have just been chasing returns

SMALL investors are often portrayed as the “dumb money” in markets, doomed to buy just before a crash and fatally drawn into buying fashionable sectors like technology funds in the late 1990s. But are wealthy and institutional investors really any better?

A new study* by researchers at the European School of Management and Technology examines how investors allocated money to hedge funds from 1994 to 2004. This process ought to be highly sophisticated. After all, hedge-fund investors tend to fall into three categories: rich individuals, who usually take advice from private banks; institutions, such as pension funds and endowments, which often employ investment consultants; and funds of funds, which market themselves on their expertise.

Hedge-fund selection is an extremely complex business. At the industry’s peak in 2007 there were almost 10,000 funds operating in a myriad of different styles. Potential clients need to examine the background of the managers, the level of safeguards (independent valuers, for example) and the likely return characteristics of each fund’s investment approach.

However, when the academics examined why investors ploughed money into different types of hedge fund, one reason stood out: recent performance. Funds that had performed well in the previous three quarters attracted significantly more money. Each 1% of extra performance attracted around $9m of new assets.

Such a return-chasing approach might be justified if investors were rightly anticipating that a short-term improvement in the returns of a particular hedge fund indicated a long-term shift in favour of its style. But the study finds that “there are no significant differences in subsequent performance between those styles favoured by investors and those less favoured.”

What explains this selection failure? It may be that hedge-fund styles are so opaque that investors are forced to rely simply on recent returns. But it may also be that investors are more careless about choosing hedge funds than they should be. Some professional investors put money with feeder funds linked to Bernie Madoff, for example, even though statistical analysis suggested his performance record was implausibly smooth.

Some of this faulty decision-making may also reflect the underlying rationale of hedge-fund investments. Take pension funds. For decades they used their bargaining power to force down the fees they paid to conventional, active fund managers. So it seems rather odd that they should have signed up for hedge funds which charge annual management fees of 2% plus 20% of any returns.

James Montier of GMO, an asset-management firm, argues that pension schemes have been pushed into the hedge-fund world by weak past (and likely future) returns from traditional asset classes. If valuations return to the mean, a benchmark portfolio split 60/40 between equities and government bonds will return just 4.5% annually over the next seven years. That is not enough to pay for pension promises, so funds decided to follow the example of Yale University, whose endowment diversified into hedge funds and private equity in the 1980s.

Alas, like the supposedly dumb small investor, the pension funds ended up chasing past performance. The flood of money into private equity caused more competition in the world of buy-outs, with the result that deals were done at higher valuations. Those higher valuations have duly led to lower returns.

Another rationale for the move into alternative assets (as hedge funds and private equity are known) is that returns are uncorrelated with those on other assets. But Mr Montier points out that the correlation of returns from different hedge-fund styles (which invest in a wide range of assets, from corporate bonds through to equities) has risen from around 0.3 in 1993 to 0.8 in 2009. Given that 1 would represent perfect correlation, that implies most hedge-fund styles are rising and falling in near-unison. As Mr Montier remarks: “It would appear as if all the hedge funds are doing exactly the same thing—riding momentum or selling volatility.”

It is all reminiscent of the “search for yield” in the past decade, which saw investors ignore risk as they piled into structured products linked to subprime mortgages. This chase for higher returns may not prove quite so disastrous. But it is more likely to reward hedge-fund managers than their clients.

 

*“Style Investing: Evidence from Hedge Fund Investors”, by Guillermo Baquero and Marno Verbeek.

Bottom line: forecasts are fun to do and read about, but always take them with a bag of salt, especially if you have money riding on the outcome.

On to next month’s forecast (salt not included):

Seasonally adjusted model

Point forecast:RM53,536m, Range forecast:RM60,224m-46,847

Seasonal difference model

Point forecast:RM50,892m, Range forecast:RM58,051m-43,734m

Note that both models are predicting exports to continue to contract marginally, given the fall in April imports. I’d make allowance for inventory build-up in prior months, so look for approximately flat to slightly positive m-o-m growth for May exports.

Technical Notes:

Preliminary April 2010 External Trade Report from the MATRADE

Women: There’s No Progress Without Them

I’m late in commenting on this article – it’s been sitting tagged in my Google Reader for over a week now, but I’ve only just gotten round to posting on it (excerpts, emphasis added):

Women in workforce augur well for the economy

KUALA LUMPUR: The 2010 Asia-Pacific Human Development Report (AHDR) estimates that if women's employment rates were raised to 70%, countries like Malaysia, India and Indonesia would enjoy an increase in GDP between two and four per cent.

Such employment rate of women are only seen in the developed nations and the lack of women's participation in the workforce across Asia-Pacific costs the region an estimated US$89 billion every year...

Countries in the region that have done the most to tap women's talents and capacities have traveled farthest on many aspect of human development. Countries that tolerate deep inequalities fall short of equal citizenship and face social instability and economic loss...

Despite laws guaranteeing equal pay for work, the pay gap between men and women in Asia Pacific ranges between 54 per cent and 90 per cent.

In terms of economic power, a total of 67 per cent of East Asian women participate in the labour force, above the global average of 53 per cent, but South Asian women fall far behind, at only 36 per cent.

A majority of women in the region also, up to 85 per cent in South Asia, are in 'vulnerable' employment, such in the informal economy or low-end self-employment, far above the global average of 53 per cent.

More than 65 per cent of female employment in South Asia and more that 40 per cent in East Asia is in agriculture.

Yet, women in the Asia Pacific region head only seven per cent of farms, compared to 20 per cent in most other regions of the world.

Globally, Asia has the largest number of micro credit borrowers and highest percentage of poor women borrowers.

In Asia 98 per cent of micro credit borrowers in 2006 were women, compared with 66 per cent in Africa and 62 per cent in Latin America.

Meanwhile, the flow of women into business in Asia-Pacific is steady, up to 35 per cent of small or medium enterprises in the region are headed by women.

I’ve pointed out more than once that the female labour force participation rate in Malaysia is remarkably poor (here and here for instance). Note the last sentence I blocked out above – the global average is 53% and the East Asian average is 67%. Malaysia stands at just about 47%, worse than the global average and way below the regional norm. Wonder why Malaysia isn’t a high income economy and hasn’t been able to keep up with the Tiger economies? You’ve just found one big reason.

To be fair, this is largely a generational thing as the participation rate for females in the 25-34 age group is already very close to the East Asian average at 65%. The real big gap is in the older cohorts, with participation rates falling to under a quarter for females aged over 55 (compared to 60% for men). So this isn’t something that can be easily remedied through exhorting women to enter the work force – there’s a skill and experience gap that is probably to big to overcome.

On the flip side, we can look forward in 10-20 years to a much greater contribution from working Malaysian women towards economic growth and development in the future, as the population turns over and we get better average participation rates. That and the bulge of youngsters entering the work force in the next couple of decades is why I think demographic transition will be the main driver in transforming Malaysia into a high income economy - not new development models, or government incentives and subsidies, or lack thereof.

Crime Rates Are Down, But It Isn’t All Due To Policy

Cutting subsidies isn’t the only thing the Government has been working on. One of the National Key Result Areas (NKRAs) that the administration of Dato’ Sri Najib has committed to is reducing street crime, and it seems that the fairly innovative approach (*cough*) of putting more policemen on the beat, and in identified crime hotspots is bearing fruit (excerpt):

Najib’s fight against crime showing good results

The hurdle was to get a large number of “men in blue” in a relatively short time, given the fact that recruitment and months of training was needed before a policeman could start duty.

Chief Secretary to the Government Tan Sri Sidek Hassan said Najib, who wanted to try new things using existing and available resources had suggested that desk-bound police personnel be reassigned to go to the ground and their place in offices be taken over by civilians.

The result: an additional 7,402 police personnel including officers on the ground today to fight crime. The move has seen some impressive results.

Home Minister Datuk Seri Hishammuddin Hussein recently revealed that the street crime index and the total crime index had fallen by 39% and 15% respectively in the first quarter of the year – well beyond the 20% and 5% target set for the end of the year.

More details on the reduction in crime are available here. I’m not intending here to belittle this achievement, but I have to ask: How much of this reduction is due to the changes in deployment of police personnel, and how much is due to the fact that the economy has improved?

I stumbled upon this unpublished working paper last year and have been meaning to post on it for quite a while (abstract, emphasis mine):

Crime and economic conditions in Malaysia: An ARDL Bounds Testing Approach

Economists recognized that economic conditions have an impact on crime activities. In this study we employed the Autoregressive Distributed Lag (ARDL) bounds testing procedure to analyze the impact of economic conditions on various categories of criminal activities in Malaysia for the period 1973-2003. Real gross national product was used as proxy for economic conditions in Malaysia. Our results indicate that murder, armed robbery, rape, assault, daylight burglary and motorcycle theft exhibit long-run relationships with economic conditions, and the causal effect in all cases runs from economic conditions to crime rates and not vice versa. In the long-run, strong economic performances have a positive impact on murder, rape, assault, daylight burglary and motorcycle theft, while on the other hand, economic conditions have negative impact on armed robbery.

Causality has a very specific meaning in econometrics, so don’t take this to mean that poor economic conditions literally “cause” crime in the dictionary sense of the word. Nevertheless, you can construct a fairly common sense rationale for why crime goes up when the economy goes down – higher unemployment and reduced income in economic downturns means that individuals on the margin have an incentive to resort to crime, and the opposite happens when the economy turns northward.

Juxtapose this reasoning against the drop in crime that has been registered for the first quarter of 2010 relative to last year. Since 1Q 2009 was the bottom of the recession and we’ve seen considerable improvement in economic activity since then, it shouldn’t be all too surprising to find crime rates dropping in the past year.

The trick is to disentangle the various influences on crime rates, from the change in deployment (possible), to the change in economic conditions (definite), to changes in income and wealth inequality (no relationship apparently), to the growth in the supply of potential criminals via population growth (I’d argue for this one). As a modelling approach, I’d treat the latter three as explanatory variables, while the change of deployment would be represented by a dummy variable (i.e. as a potential structural break), either within a Vector Error Correction Model (VECM) or an ARDL framework.

Since I don’t have the time series on crime rates or their breakdown, this is all sheer conjecture on my part, but I would say the structural break would test as significant, but so would economic growth and population growth. But that’s just a guess.

On the other hand, I don’t see why there’s any particular reason to ascribe all the credit to changes in crime rates to government policy or police deployment – just as there is no reason to assign them all the blame when things go wrong.

Technical Notes:

1. Habibullah, M.S. and Baharom, A.H. (2008): “Crime and economic conditions in Malaysia: An ARDL Bounds Testing Approach”. Unpublished.
2. Baharom, A.H. and Habibullah, M.S. (2008): “Crime and Income Inequality: The Case of Malaysia”. Unpublished.

And some further reading on crime economics from the same source:

1. Baharom, A.H. and Habibullah, M.S. (2008): “Is crime cointegrated with income and unemployment?: A panel data analysis on selected European countries”. Unpublished.
2. Habibullah, M.S. and Law, Siong-Hook (2008): “Property crime and macroeconomic variables in Malaysia: Some empirical evidence from a vector error-correction model”. Unpublished.
3. Puah, Chin-Hong, Voon, Sze-Ling and Entebang, Harry (2008): “Factors stimulating corporate crime in Malaysia”. Unpublished.

Idris Jala Is Turning Into A Politician

…and now says his comments on bankruptcy were “taken out of context”. Where have we heard that before? Not to knock what he’s done – I doubt anybody from any of the mainstream political parties would have taken the bull by the horns as he has, or achieved so much, so fast, with so little.

But when you’re speaking to a national audience, there will always be someone with the knowledge and credibility to poke holes in any argument, especially an indicator that is as closely followed as government borrowing.

Case in point, this article in the Malaysian Reserve (H/T Jebat Must Die). Although I have to disagree with the article writer Senator Datuk Akbar Ali on one crucial point – US fiscal deficits have actually been fairly mild over the last decade (not including the mother of all stimulus packages pushed through last year). My vote for worst managed economy in the world still goes to Zimbabwe (with Iceland coming a distant second).

Were Ministers Briefed On The Subsidy Rationalisation Proposals?

Or are they just dim? Or did I completely misunderstand the specific proposals for education?

Don’t cut subsidies for students, says deputy minister

The Government has been urged to continue with subsidies under the Higher Education Ministry’s education programmes for students from poor families.

Deputy Higher Education Minister Datuk Saifuddin Abdullah said the ministry provided education subsidies which most parents relied on to send their children for higher studies.

He said many students would not be able to pursue higher studies if the facility was to be withdrawn.

“Many parents in the rural areas whose children study at public institutions of higher learning rely on government aid and loans,” he told reporters after closing a Moh Desa Perwira programme at the National Defence University in Kampung Bangau Parit near here yesterday.

He said the loans provided by the National Higher Education Fund Corporation had helped ease the parents’ burden.

“As such, it would not be right for the Government to reduce or withdraw the education subsidy.”

Principle 2 of the Subsidy Rationalisation Plan says:

Education is a human capital investment and subsidy should continue but we must reduce wastage / abuse.

From the specific proposals:

• Remove subsidies for foreign students
• Re-target subsidies for poor families

What on earth is the Deputy Minister talking about? Nowhere is the Government  contemplating cutting support for poor students.

Update:

It’s even worse than I thought – apparently ministers aren’t even talking to their deputies.

Subsidy Rationalisation Lab Open Day

I attended the Open Day this morning on invitation from PEMANDU (or rather my company got invited and I was one of the truckload that got picked to go).

You can find Dato’ Sri Idris Jala’s presentation on the PEMANDU website (warning: pdf link).

Now we know where this RM74 billion figure being bandied about comes from. It includes not just officially designated subsidies, but also Petronas’ spending on the gas subsidy (which isn’t carried on the government accounts), as well as spending on education, healthcare and social services, which aren’t necessarily subsidies as the term is commonly used.

The rest of my thoughts on the subject:

1. I think for the most part the rationalisation plan is sensible – in the political sense, though not necessarily in the economic sense. Spreading the pain over 3-5 years means less citizen anger, and gives the government time to formulate and implement a better social welfare policy – I’m not sure the mitigation proposals contained in the rationalisation plan go far enough to ensure that the subsidies that remain or newly introduced will offset the impact on the poor and lower income groups.
2. There was a lot of general support for getting rid of consumer subsidies, especially on sugar (the stats on obesity and diabetes in the open day exhibition were truly frightening) where there were a few proposals from the floor in favour of immediate abolishment rather than phased in over 3-5 years. In this case, I think we have to take the next logical step – if sugar consumption has negative social welfare impact, then removing subsidies only partly compensates for the social costs (treatment of diabetics, healthcare for the obese and overweight). That means there’s actually a strong argument for taxing sugar as well as removing the subsidy on it.
3. And if you buy that argument, then it goes ten-fold for petrol and other use of carbon fuels, because the environmental and social impact is so much greater. If you consume too much sugar, the costs are largely borne yourself, and partly on society through higher healthcare costs. Pollution from carbon fuel burning affects the air we all breathe, not just ourselves. That health costs are less visible, but no less powerful – check the incidence of asthma and bronchitis, not to mention lost work days from illness resulting from pollution (check this post for the basis of my argument).
4. On the time span for rationalisation, I’m in favour of a shorter rather than a longer period. BNM apparently ran some simulations and came up with a figure of 4% in 2011-12, and back to 3% from 2013-2015 if all the proposals were implemented. To me the problem with a longer period is that you risk unanchoring inflationary expectations – i.e. people will start expecting higher inflation as a matter of course, and that means continuously higher wage demands which feed into higher inflation.  There was one proposal from the floor for the period to be shortened to 24 months – I think that strikes the right balance between spreading the pain and getting it over with as fast as possible. Five years is a long time, especially in politics, and there’s no guarantee that the political will for getting rid of subsidies will last that long. Understand that I’m not arguing against cost of living adjustments to existing wage levels – but rather a self-perpetuating cycle of price increases, which would necessitate a monetary policy response. As it is, I’m already thinking that OPR might go back to 3.5% next year, and even higher in 2012, just to mitigate higher nominal demand.
5. There was also a lot of talk on education, although I think even the panel discussion missed some basic points. Dato’ Sri Idris mentioned that Malaysia ranks 7th in the world in spending on education per capita. If that’s the case, then the declining standards in maths and science in Malaysia suggests that money isn’t being used as effectively as it should, nor does it explain why tertiary enrollment (<30%) is so low compared to high-income economies (>60%). That’s a qualitative and quantitative issue that has to be addressed.
6. Apart from a remark by Tan Sri Azman Mokhtar and an observation by YB Tony Pua that the fall in global oil prices meant that there is effectively no subsidy on petrol, there was little to no discussion on what to do if market prices fell below government mandated prices during the rationalisation phase – shall we go to market prices directly? Or some form of adjustment mechanism? Details here would be welcome.
7. I’m still against the idea of providing substantive support to smallholders and small-scale fishermen. They are not productive, and no amount of technology or incentives are going to make them so. Better to provide living support (just give them cash), until the pace of development overtakes them. I know that sounds callous, but our food and agricultural production will never improve if we only look to perpetuating an existing moribund market structure that cannot survive without government support, instead of rationalising land use and capital into units that can be competitive and productive. This is of course more a political issue rather than an economic one, which is why I doubt there will be much change here.
8. The panel discussion very nearly turned into an IPP-bashing session, and here’s hoping that there will be some movement in the direction of renegotiating the contracts.
9. YB Tony also brought up the issue of toll highways, again. Check out his blog for details.

Is Ability In English Important?

You betcha. The debate on English education in Malaysian schools has from my perspective largely been conducted on the basis of “he said, she said”, with very little in the way of compelling research to back up either of the two opposing positions. While I’m firmly in the “English is important” camp (it’s certainly helped boost my career), I’ve never been comfortable without the backing of solid data. So I was quite happy to see this in my RSS feed yesterday (excerpts):

English skills raise wages for some, not all, in India

It is widely believed that there are sizable economic returns to English-language skills in India. Due to India’s British colonial past, English remains an official language of the federal government, and is still used in government and education. Moreover, due to the rapid expansion of international trade and outsourcing in recent decades, English has become even more important. Despite this, there are surprisingly no estimates of the wage returns to English skills in India. The impediment appears to have been the lack of a microdata containing measures of both earnings and English ability. In our study (Azam et al. 2010), we quantify the English premium using data from the newly available 2005 India Human Development Survey (IHDS)...

Estimates from Table 1 suggest that for men, hourly wages are on average 34% higher for workers who speak fluent English and 13% higher for workers who speak a little English relative to workers who speak no English. These effects are not only statistically significantly different from zero, but also economically meaningful. For example, the return to being fluent is as large as the return to completing secondary school, and half as large as the return to completing an undergraduate degree. For women, the average return is 22% for fluent English and 10% for a little English...

A striking finding is that older workers earn high returns to English regardless of their educational attainment while younger workers earn high returns only when they are highly educated. For example, older men without an undergraduate degree receive a 53% wage premium for being fluent in English, compared to 28% for older men with an undergraduate degree. In contrast, younger men without a degree receive a 13% wage premium for being fluent in English, compared to 40% for younger men with a degree. Among younger men, the returns to English are increasing in educational attainment. Furthermore, we find that English skills do not raise wages at all for younger men who have not completed their secondary school education...

Quantifying the returns to English-language skills in India is of interest for several reasons. First and foremost, a deeper understanding of the returns to learning English will help individuals and policymakers in India make decisions about how much to invest in English skills... But the amount to invest is the subject of active debate. In India, as well as many other developing countries, there are those who favour promoting the local language as a way to make primary schooling more accessible and to strengthen national identity. At the same time there are those who argue that learning English leads to economic prosperity given the role of English in the global economy and many Indians are willing to spend extra money on schools and tutors to gain English proficiency. Given that English skills are costly to acquire – it takes time, effort, and often money, to learn English – choosing the optimal amount to invest in English-language skills involves comparing expected costs to expected benefits. This study provides the first estimates of these expected benefits.

‘Nuff said.

Subsidies? How About Raising Petrol Taxes Instead?

One of the key aspects of the NEM, and a vital part of regularising government finance, is reducing and eventually phasing out entirely subsidies, particularly on food and fuel. Some of the figures bandied about, not least by the Prime Minister, are a little too much in la-la land, but the gist of it is clear – the cost of subsidies are too high, they’re not benefiting the target groups as much as they should, and they’re creating perverse economic incentives.

There’s a nice piece on the subject of petrol subsidies in yesterday’s The Star (excerpt):

Malaysians consume more fuel

As Malaysia practises a blanket subsidy on fuel, data made available to the Performance Management and Delivery Unit (Pemandu) subsidy rationalisation lab showed that 71% of fuel subsidy was enjoyed by the middle to high-income level groups.

Some 28% of those enjoying fuel subsidy earn more than RM5,000 per month, while 43% earned between RM2,500 and RM5,000.

Abuse of liquid petroleum gas (LPG), or cooking gas, has also contributed to an inflated subsidy bill. Some RM1.71bil was spent on subsidising LPG, to which only RM397mil or 30% are used by households.

In addition, there’s the rather telling datum that fuel consumption rose 8% in 2008, despite pump prices doubling in that year.

What are the actual subsidy numbers? Officially, based on MOF’s functional classification of expenditure, the government spent RM18.6 billion on subsidies in 2009 and RM35.2 billion in 2008. The historical data is illuminating (RM billions, inflation adjusted; 2000=100):

Subsidies started climbing in the wake of the 2000 recession, and haven’t stopped since. The killer blow was the climb in commodity prices and the concurrent upswing in food prices in 2008 (remember the rice “shortage”?).

Of course the official figure isn’t the whole story – there’s the hidden gas subsidy at Petronas which ends up as reduced government income from petroleum royalties and corporate taxes; the difference in pricing between what TNB charges against what it has to pay the IPPs; controlled prices on basic food items; as well as whether development spending as a whole can be considered as subsidies, as implied by the PM’s figures. I don’t think any of these are on the table for abolishment just yet.

In any case, the cabinet is meeting tomorrow to discuss the issue, and there will be an open day at KLCC on Thursday to gain public feedback.

The key problem in my view is that the subsidies are directed at consumer prices, rather than targeted at a particular group. This is easier to administer, but from the numbers in the article quoted above, it’s fairly obvious that the actual benefits accrue to everybody, rich and poor alike, corporations as well as individuals. That’s a rather inefficient and expensive way to handle welfare transfers – it’s actually highly regressive i.e. those that benefit the most need it the least.

But getting rid of subsidies isn’t the whole answer, as you still have the negative welfare impact on the poor and lower income groups from higher food and fuel prices. They’d still need some form of support to replace the expenditure lost through higher outlays. Royal Professor Ungku Aziz has suggested a debit card scheme for the hard-core poor, with a monthly token of RM300 for basic food items. Or you can follow some Western practices like food stamps, or outright cash giveaways. Whichever the route we end up following, there’s going to be a call on Government finances and there’s going to have to be some form of administrative framework to manage the scheme i.e. the Government’s going to get bigger.

Now, from the financial perspective funding a social safety net can be derived from savings gained from the abolishment of subsidies. I don’t think that’s going to be a big issue, unless the scheme itself becomes too complex, or the government goes overboard in terms of benefits. You could also argue for an income tax cut, but that would be pretty regressive too as the tax base is so narrow. Alternatively, the reduction in subsidies could be predicated on a lower GST, if and when that comes into play.

However, there’s a hidden aspect particular to petrol and gas that isn’t being addressed – pollution and the concomitant need for healthcare (need I say that the services offered by public hospitals and clinics are also highly subsidised?), known in the economic terminology as negative externalities. Abolishing subsidies on these items would go a long way toward matching supply and demand, but the market price does not address their true economic costs. These become another form of hidden subsidy – increased healthcare costs, pollution cleanup costs, infrastructure delivery costs and more, that are borne not by the users of petroleum products but by everyone.

So I’m firmly of the belief that we ought to tax petrol and gas, not just lift subsidies. That achieves three things – one is to impose the true costs of using petrol and gas on users; secondly, it reduces fuel consumption, the impact on the environment, and encourages conservation; and third the proceeds can be used to help offset the costs of both the social safety net as well as the ancillary costs of the negative externalities arising from the use of petroleum products. It also helps that a Pigovian tax and transfer mechanism of this form will also be far more efficient in terms of raising social welfare and rebalancing incomes. There’s also the secondary effect of increasing pressure to raise pay packets – which is the direction we want to head in anyway.

I’m not blind to the difficulties here. There’s an obvious corollary that the government’s social welfare capabilities needs to be beefed up (it’s awful right now) in terms of manpower, organisation, data collection and funding – which increases the opportunities for waste, mismanagement and corruption. There’s also going to be an outcry from the middle classes, as they have the most to lose (no increase in benefits, but with all the cost).

This isn’t a vote winning proposition, but it is the right and economically correct thing to do.

For Further Reading (from Prof N. Gregory Mankiw):

1. The Pigou Club Manifesto
2. Alternatives to the Pigou Club
3. Smart Taxes: An Open Invitation to Join the Pigou Club (pdf link)

April 2010 CPI: Tightening The Screws

April’s consumer price report shows the overall price level has been flat for the fourth month running, while the core price level (ex-food, ex-transport) is barely budging (log annual and monthly changes; 2000=100):

On the surface, that’s not a particularly good sign – if in fact the economy was growing, you would expect prices to be rising as the economy returns closer to full capacity. There’s a couple of reasons why there hasn’t been much movement, and the big one is the appreciation of the MYR (trade-weighted nominal index; 2000=100):

 

The MYR is up 7.1% in log terms for the year measured by the trade-weighted index, and is up against the currencies of every one of Malaysia’s major trade partners (my definition: >1% share in exports or imports). The big shifts are against the Euro (19.8%) and the GBP (15.1%), but we’re also up against Japan (8.3%), Australia (7.7%) and China (5.4%). Against our regional peers, the MYR hasn’t moved as much, which explains why food prices especially have held steady, as opposed to actually falling.

The other rather (marginally) less important reason is that there actually isn’t much momentum in terms of domestic demand in the economy, notwithstanding the 10.1% GDP growth in 1Q 2010. What we’re seeing over the last few months has really been a trade-driven recovery predicated on a commodity price upswing, which obviously isn’t having much impact on taking up the slack left by the recession much less the existing spare factory capacity which we already had pre-crisis. That in turn means that there’s very little pricing power that can be leveraged to improve business margins, hence the subdued inflation outlook this year.

The problem for the Malaysian consumer going forward is that I think the MYR uptrend has run its course for now – the MYR has risen nearly 8% in log terms in the space of 9 months, which is pretty abnormal even for a highly volatile international forex market. If BNM’s normalisation of interest rates continues pulling in portfolio capital, then I’d start to consider MYR to be overvalued again, much like it was at the end of 2007. The long term structural story for MYR is still intact, but I’m looking for a breather so that the fundamentals can catch up with market prices.

On that basis I’m still looking for higher inflation in the second half and a consolidating exchange rate, but we’re likely to average under 2% CPI growth for the year.

On a side note, subdued inflation and a stronger Ringgit both mean that BNM’s tightening shift is being magnified i.e. monetary policy is tightening faster than implied by the two 25bp hikes already made. My view remains that BNM should’ve let held fast at the last MPC meeting, with the next hike in July. If they do hike one more time in July, I think that will be it for the year.

OPR Trajectory Subject To Prevailing Conditions

The Governor is keeping her options open:

Zeti: Further hikes in OPR will depend on economic performance

Governor Tan Sri Dr Zeti Akhtar Aziz said the normalisation process for the overnight policy rate (OPR) was a “dynamic one” and depended on how the economy performed.

“The process of normalisation is a dynamic one, if there's a slowdown in the economy then we'll pause but if there's growth then we'll continue,” she told reporters on Wednesday.

The next Monetary Policy Committee meeting is scheduled for July, which means at best they’ll be deciding on the level of the OPR based on April and May economic numbers.

I’d originally thought that BNM would stand pat in May and raise in July, as 1Q 2010 numbers were good, but not so good as to justify a rapid tightening in policy. Certainly the developments of the last couple of weeks stemming from the dramatic fallout from the bailout of Greece, where there’s been a reassessment of Europe’s chances of a sustained recovery, argue for some caution.

Sharp falls in commodity prices also augur badly for sustained trade growth, since that has been the main driver for Malaysia’s export performance since at least 2006. And 1Q 2010 GDP growth had mixed numbers on a quarter to quarter basis.

But the rest of the region is still being pulled along by the China’s economic dynamo (Singapore has just revised 1Q 2010 GDP 2% higher – pdf link), and prospects in the US and Japan appear to be brighter.

On that basis, I think BNM will add another 25bp to the OPR in July as I originally thought, even if I think the pace of tightening is a little too quick for my taste.

ADB Thinks Emerging Asia Should Think About Capital Controls

Seems we're getting an outbreak of sanity here, especially after the IMF's change of heart (excerpt of press release):

Emerging Asia Should Be Ready to Act on Potentially Destabilizing Capital Inflows - ADB Report

The report said recent surges in capital inflows have been driven by portfolio equity flows as investors take advantage of widening earnings potential between emerging Asian and mature markets.

The use of capital controls may be appropriate in circumstances where capital inflows are transitory and are adding undue pressure on exchange rates and where effectiveness of macroeconomic policy measures to counter the inflows and the exchange rate movements is uncertain.

"Managing capital flows requires a wide array of policy measures; sound macroeconomic management, a flexible exchange rate regime, a resilient financial system and sometimes the use of temporary and targeted capital controls," Mr. Madhur said.

How and why do capital flows cause problems? There are a number of dimensions to this question, and most of the answers are bad.

First, on an overall basis, there’s little evidence that an open capital account, where portfolio capital is allowed to freely move into or out of a country, has any beneficial effect on economic growth or development (as opposed to capital market growth and development). In fact the opposite effect is more prevalent – liberalisation of the capital account in developing countries has a distressing tendency to turn into a full-fledged currency/financial crisis.

There may be an argument that inflows of foreign capital can lower the cost of capital, and thus increase real investment, but I find this line of thought unpersuasive. As I pointed out once, investment in the stock market is not investment in an economic sense, and does not contribute to a nation’s stock of real wealth – unless shares and bonds are bought at source via the primary market i.e. IPOs or auctions.

More to the point, the real problem with foreign portfolio inflows is twofold – they can just as easily leave as they come in; and they have a destabilising impact on nominal (but not real) valuations. The first problem is well-known, and complicates everything in macro-economic management, from volatility in exchange rates, money supply, and market interest rates, to the increased financial fragility of the financial system through cheap short-term foreign funding recycled through the banking system into long-term illiquid assets such as loans. This is exactly the problem that underlay the vulnerability of Malaysia and other East Asian economies in the run-up to the 1997-98 crisis.

The valuation issue essentially arises from this – nominal asset prices on the capital markets are determined by demand and supply of those assets. There’s nothing here to relate these prices to the underlying intrinsic value of any asset. If an asset was already correctly priced, then incoming money flows would inflate the price of that asset beyond its fundamentals – you have an asset price bubble.

The problem is further complicated by portfolio asset allocation, where foreign fund managers follow certain allocation rules – they generally go for highly liquid stocks and bonds (the better to sell in case of trouble), which in our case would be KLCI component stocks, and MGS or AAA corporate bonds. That means that incoming hot money flows tend to overinflate prices of highly liquid assets, and disproportionately reduce them when they leave. So what you get is much higher volatility in highly visible capital market securities.

The problem is much worse if capital inflows stick around for too long, and get recycled through the banking system. Since capital inflows in the presence of a flexible exchange rate cause an appreciation of the currency, that makes foreign funding cheaper for domestic companies. This is even more apposite since BNM is ahead of the curve in raising official interest rates. Foreign money inflows also have the impact of increasing the money supply and reducing market interest rates, potentially opening the door for inflation.

But the flip side is also true – a sudden outflow of portfolio funds will cause the exchange rate to depreciate, which while it won’t affect your funding cost would certainly affect the principal you have to pay back (not to mention creating a constricted monetary environment just when you need it the least). That in essence was Thailand’s and Indonesia’s bugbear in 1997-98, as their private companies had borrowed in USD but had their income streams in Baht and Rupiah. The downfall of the US dollar pegs in those countries caused a massive private debt crisis, to go along with recession and the loss of international purchasing power.

In short, portfolio capital flows tend to exacerbate changes in the business cycle, which has obvious costs in terms of misallocation of real investment.

So are capital controls the answer?

Only an imperfect one, as in it’s really hard to make them truly effective – where there’s profit to be made, there’s bound to be someone willing to take a risk on both sides of the border (China and its “A” shares are a good example). On the other hand, there is evidence to suggest that capital controls on portfolio capital flows does not harm foreign direct investment at all, so that is a positive.

Second is the issue of whether the capital controls imposed are transitory or permanent – the former can make your policymakers look wishy-washy (low credibility), while the latter would hamper development of the domestic capital markets. You have to pick your poison here.

Third, there’s little precedent for designing effective capital controls in the floating exchange rate era. We have very few case studies of effective implementation of capital controls in the last 40 years, and ironically Malaysia’s two flirtations with capital controls (1993-94, 1998-2005) are among the better known and most studied. Chile in the 1990s is another good example, targeting very specifically short term capital flows. The IMF is now advocating more research into policy design in this area, so we might have some hypotheses to test out soon.