Brookings: Experts - Urjit R. Patel

The Gold Effect on Inflation

Urjit R. Patel — Thu, 22 Nov 2012 13:53:00 -0500

The data flow in recent months suggests that despite considerable tightening of monetary policy by the Reserve Bank of India (RBI) over the course of 2010 and 2011, inflation, whilst having declined, has exhibited disquieting stubbornness. India has also been an outlier in relation to most of its comparators in the context of price stability. Evolution of Indian inflation has brought forth several explanations, most with some merit. Among these both monetarist theories and structural explanations have been advanced, as well as internal and external factors. In the former category, a delay or insufficient tightening early in the cycle resulted in generalised inflationary expectations to percolate widely through the economy; in other words, policy makers initially underestimated the risk. In the second category, domestic food price developments catalysed by changes in minimum support prices are drivers. In addition, it has been argued that wage push on account of government funded entitlement schemes in rural areas continues to put upward pressure on prices. Among the external causes, high oil prices since 2008 has been important in policy discourse. Another external variable that has, intermittently, lent itself as a contributor to price pressure at home is high global prices of diverse food cereals.

At its simplest, interest rate changes for controlling inflation works by tempering current investment and consumption by making it more expensive to borrow; in part, growth in aggregate demand is moderated through inducing a change in expected future market interest rates. Usually, the private sector responds to the change in incentives more than the government. Cumulatively, over the cycle, the RBI’s policy rate changes have been prima facie striking, even as the impact on inflation has been gradual and less effective than what policy makers had probably hoped for. The Repo rate was increased in thirteen steps between March 2010 and October 2011 from 4.75 percent to 8.5 percent. Inflation measured by the Wholesale Price Index has remained above the RBI’s comfort zone of 5-5.5 percent for three years now, and persists in the 7-8 percent range. The Consumer Price Index, which analysts claim is important for assessing the trend in inflation expectations has stayed in the range of 9-10 percent since April 2012; that is why the RBI has refrained from further cuts since the fifty basis point reduction in April.

There can be several plausible reasons for the relatively slow price response to an activist monetary policy including, inter alia, a deep fiscal malaise requiring persistent increases in seignorage which is feeding expectations of continuing inflation, “misbehaviour” of monetary policy transmission channels vis-a-vis the real economy, etc. It is noteworthy that seignorage as a ratio to GDP has seen an uptick in India post-2007 compared to immediately prior years in that decade.

There might be an additional explanation. Indians in recent years have benefited from a huge positive boost to their private wealth (and private net worth); this wealth effect originates in the 75 percent increase in global gold prices between October 2009 (roughly US$ 1,000/ounce) and October 2012 (about US$ 1,750/ounce); in Rupee terms the increase is more. Even while keeping aside the rise in volume (that is, inflow) of gold imports in recent years, India’s widely held private stock of gold is disproportionately large; a quick data scan reveals estimates of the stock ranging from a low of 13,000 tonnes to as high as 40,000 tonnes (the latter is probably an exaggeration). As an example, assume that the private stock of gold in India was 17,000 tonnes in 2009; the value of this in October 2012 would work out to about US$ 960 billion (over 50 percent of gross domestic product) compared to around US$ 550 billion three years earlier. The time frame is illustrative, and some other snapshot can be used.

There is little doubt that India is sui generis when it comes to the importance of gold in its citizens’ portfolio of savings instruments and stock of wealth. While gold is not the only global commodity whose price has increased appreciably, gold has characteristics that are distinctive. Households rarely hoard other commodities to pass them from one generation to the next; the exception would be oil owned by Saudi princes. Long after the “Gold Standard” become history, gold held by central banks, national treasuries and multilateral institutions is still counted as a foreign asset in official balance sheets. Physical gold as store of value and as a “guarantee to redeem promises” puts it in a class of its own among physical assets.

While the real value of most financial assets held by Indians has declined (in line with developments elsewhere), house prices have somewhat moderated and business investment has stalled against the background of poor governance, the boost in the value of the stock of gold may have engendered wealth effects that propped up household consumption (at least to some extent) even as policy has increased interest rates across the board. It is not unreasonable that enhanced feeling of well being due to higher wealth can induce a consumer to spend a higher amount from her recurring “normal” income. Of course, it is not that policy induced interest rate hikes have been ineffective for price and real economy developments; the argument is that a coincidental, essentially external, dynamic may have helped to partially offset the effects of monetary tightening. Asset prices have been known to unravel – especially instances when the run up is of the “bubble” variety rather than fundamentals driven, which may be more enduring. Therefore, households’ perception of the permanence or temporariness of the gold price increase (and their increase in wealth) is critical for determining the extent to which their consumption has been impacted on account of this channel.

In conclusion, if gold prices stay elevated or increase going forward, and wealth effects emanating from this externally generated feature are quantitatively important, than monetary policy has that much more work to do to tame inflation.

Authors

Urjit R. Patel

Publication: Business Standard

Image Source: © Ajay Verma / Reuters

Golden Age of Gas

Rahool Panandiker and Urjit R. Patel — Thu, 09 Aug 2012 10:48:00 -0400

The “golden age of gas” is a phrase that may pass into common usage. Unlike the scorned and increasingly illegitimate recent “era of high finance” pioneered in the North Atlantic, this epithet may even have legs — considering that Shell has kicked off plans in the United States for retail distribution of compressed natural gas, or CNG, to the transport sector.

A crucial facet of this development is that cross-border gas trade is growing faster than gas production. The growth trajectory of global gas trade has surpassed the pre-2008-09 rate of over four per cent. Liquefied natural gas has doubled since 2007, to 330 billion cubic metres per annum in 2011; integration is taking place and geographic segmentation is gradually subsiding.

The reasons for the rise in the fuel’s “profile” are well known. First, gas is cleaner than coal and safer than nuclear power; it is widely accepted as a “bridge” towards competitive renewables. Moreover, the lower capital costs and greater flexibility of gas-based power plants afford obvious efficiencies in certain contexts; fertiliser plants with gas as feedstock have a significant cost advantage. Second, it has the potential to be a direct substitute for liquid transport fuels — India is familiar with this. Third, as new technologies make shale and tight gas economical to extract, the geographic spread of new finds means that strong oligopolistic structures will less likely dominate. In other words, apart from coal, natural gas holds out the prospect of a relatively competitive market structure.

Read the full story at Business Standard »

Authors

Rahool Panandiker
Urjit R. Patel

Publication: Business Standard

Image Source: © Eric Gaillard / Reuters

More Elbow Room for India in Gas Contracts

Rahool Panandiker and Urjit R. Patel — Fri, 22 Jun 2012 17:04:00 -0400

The latest foray towards ensuring India’s energy security, the Turkmenistan-Afghanistan-Pakistan-India (TAPI) pipeline, is a welcome move. The signing of the TAPI deal has taken an eternity. That’s not surprising since alignment of the three “Ps” – politics, proximity and pipelines – critical to the gas market, is time-consuming. The TAPI deal helps to partially, but not fully, complete a vital component of the energy jigsaw: secure energy from multiple geographies to diversify supply risk; for India, Qatar represents a disproportionate share at over 80 per cent. TAPI opens up a ten million metric tonnes per annum (MMTPA) gas corridor, although it is at the cost of the pipeline passing through two conflict-ridden countries, one of which is openly hostile to India — supply disruption is within the realm of possibility; given limited capacity for storage (much like electricity), the consequent potential loss to downstream businesses in India can be large. According to the agreement, gas will be available to India from 2018 onwards at an expected landed cost of $13/per million British thermal unit (mmBtu). On a take-or-pay basis, the associated – directly or indirectly guaranteed – contingent liabilities are large.

Despite the TAPI deal, given India’s dire domestic gas supply situation, it is expected that a shortfall of up to 40 to 50 per cent of demand will need to be met by imported liquefied natural gas (LNG). Before the end of the decade, India will be among the largest LNG importers in the world. Concomitantly, significant regasification infrastructure is either being constructed or being planned, with indications that as much as 30 to 35 MMTPA capacity could come on line in the next few years. Much of the incremental capacity is yet to tie up LNG supply linkage, and thus will be hostage to the prevailing spot markets for both volumes and prices.

One can safely assume that a significant part of this capacity would look to long-term contracting to mitigate (price) volatility; the implication is that deals for an additional 90 to 100 million standard cubic metres per day of LNG at a lifetime value of almost $500 to $600 billion should be in the offing over the next few years, and some are already under negotiation.

Developments in the gas sector in recent years underscore the importance of incorporating elbow room in contractual structures. Consider the following, possibly game-changing, sources of uncertainty for India and others, whose effects are still to fully work their way through the international gas market. First, the dynamic in the evolution of shale gas exports to countries outside the North American Free Trade Area that the US Department of Energy will calibrate. Second, supply from emerging shale geographies such as China, Mexico and South America. Third, the amount and cost of deep sea off-shore finds, for example in Australia. Fourth, since demand for gas, like for any other energy source, is a derived demand, it is subject to the vicissitudes of global growth, and key gas consumers (like the euro zone). Fifth, the likelihood of complete replacement of nuclear energy in Japan with alternative fuels. Sixth, industrial customers for gas, including fertiliser plants and power generators, in India will also have to manage marked rupee currency risk in the light of recent sharp fluctuations. Seventh, the changing correlation between oil benchmarks and Asian LNG landed cost.

While the economic rationale of a long-term contract is obvious enough, caution is warranted. In a gas-starved situation, it is easy to overlook the hidden perils that players can be exposed to. The value – and consequently value at risk – of a long-term contract in gas is critically dependent on the specific terms and conditions related to price, volume, flexibility and review mechanisms, as follows:

Contracts can allow for negotiating both specific formulae and scope for indexation (JCC, Henry Hub, oil products, Brent, local hub prices, etc), which would help identify the necessary risk-hedging mechanisms.
The capacity to make well-thought-out estimates of requirements in a supply-starved market may not seem critical, but examples of several European countries that have gone from starved to sated should impress upon us the importance of careful assessments of volume and frequency of requirements.
Flexibility clauses include those that allow for significant range in volume, destination and the rules that govern the consequent value split.
Embedded price reviews can help “reset” the fairness of the contract. Neither the seller nor the buyer is privy to the way the energy world may look in the future, hence flexibility for readjustments triggered by specific events is essential “insurance”.

All four sets of clauses need to be considered together to ensure consistency. A prudent approach to managing risks associated with volatility of “demand” in markets mandates that the terms and conditions of the supply contract adequately compensate for the entailed risks. A long-term contracting strategy, with all its inherent a priori “benefits”, will only deliver overall life-cycle gains when the objective of fuel security is combined with an apposite view of risk hedging.

Some exposures faced by buyers in India can be better managed if an India-oriented LNG price “marker” evolves. Thus far, India has been a passive price taker, specifically, at the high end of LNG prices contracted by Korea and Japan, countries that pay a hefty reliability premium but that are easily able to absorb the elevated cost on account of energy-efficient industrial processes and structures. In this context, it is instructive that China is a preferred customer — on a weighted average basis, it pays a lower price for imported gas compared to practically all other buyers in Asia.

In conclusion, a capacity to delve into the details of the contract structure, simulate different scenarios, draw insights from potential outcomes and hedge the relevant risks associated with long-term contracts has the potential to engender either a gas bonanza or a gas problem. The devil is in the details.

Authors

Rahool Panandiker
Urjit R. Patel

Publication: Business Standard

Image Source: Rupak De Chowdhuri / Reuters

Regaining Fiscal Credibility in India

Vijay L. Kelkar and Urjit R. Patel — Wed, 15 Feb 2012 10:37:00 -0500

Editor's Note: An abridged version of this commentary was published as an op-ed in Mint on February 13, 2012.

The challenge of reining in large fiscal deficits has re-emerged in diverse parts of the world. In India doubts over sustaining a high growth performance have morphed to reservations on broad stability issues. There are two macroeconomic drivers that have changed the state of affairs. First was a sharp depreciation of the Indian rupee towards the end of last year to the extent of it being the worst performing currency among emerging market peers, despite hikes in policy rates. Notwithstanding official foreign exchange reserves of $293 billion, India’s external position is no longer felt to be impregnable; for example, the ratio of short term debt on a residual maturity basis to reserves has more than doubled since 2006/07 to 40 percent in 2010/11. The second factor is that the stream of poor, mainly self inflicted, trends for the expected budget outturn in 2011/12 have turned into an avalanche for the government’s fiscal balance (after correctly accounting for off-budget items). Most components of the budget have gone awry, viz., lower than projected tax revenues, negligible privatization receipts, and subsidies reaching stratospheric levels, especially those related to energy. At present, India’s fiscal position, as measured by such common indicators as the general government budget deficit and the general government gross debt (as shares of GDP) puts it in the same camp as recognized fiscally stretched economies. India has had a run of four years of general government deficit of about 10 percent of GDP, of which the central government’s share is two-thirds. Against this background, it is difficult to reject claims that recent growth performance has been propped up by unsustainable aggregate demand policies.

For the most part, the disquiet over India’s fiscal stance stems not so much from impending external debt service problems as doubts over maneuverability. To start with, a virtual exhaustion of fiscal “insurance cover” to counter cyclically deal with prospective shocks emanating as backwash from serious crisis elsewhere like the euro zone, or, Iran, not to mention the task of recapitalizing government-owned banks as non-performing assets rise. The fiscal situation also severely circumscribes exchange rate management by the Reserve Bank of India as an instrument of strategic commercial policy. Even more worrisome, and a source of considerable uncertainty for the nation’s public finance, is the impending expansion of entitlements, both explicitly for food and implicitly for petroleum products. Furthermore, there has been an excessive reliance on monetary policy in the absence of the requisite fiscal retrenchment in the fight against inflation.

It is important to observe that the adverse evolution in the central government’s fiscal balances in recent times has not wholly been on account of the operation of automatic stabilizers during a cyclical slowdown. On the contrary, the central government’s revenues have been buoyant – the gross tax-GDP ratio increased from 9.7 percent in 2004/05 to 12.6 percent in 2007/08 – on the back of an almost 9 percent average annual real growth rate. The profligacy of the central government has its primary driver in populist spending policies initiated in early 2008 by the ruling coalition leading up to national elections in May 2009; three stimulus packages (including a reduction in indirect tax rates) starting in late 2008 to counter the global recessionary headwinds only accentuated matters.

The challenge of addressing the parlous fiscal situation was squarely faced by the 13th Finance Commission (TFC). Quantitative signposts for general government consolidation were recommended. The TFC called for general government deficits to shrink by 4 percentage points of GDP between 2009/10 and 2014/15 and for public debt to fall from 79 to 68 percent of GDP. The TFC also sought to impart integrity to the budgetary process of the central government by drawing attention to off-budget liabilities that had been accumulated since 2005/06.

It is natural at this juncture to examine the broad possibilities to obtain the quantum of consolidation envisaged by the TFC. On the revenue side, the decline in indirect taxes on account of excise duty reduction in 2008/09 presents a natural point for efforts to reverse the trend. In addition, removing exemptions on the direct tax side will add to the revenue kitty without upward tinkering of tax rates. Even more importantly, implementing a comprehensive Goods and Service Tax (GST), which encompasses the petroleum sector, should not be delayed. Rationalization of coal prices in tandem with its inclusion in GST is desirable, viz., mitigating distortion between hydrocarbon fuels and although coal has a share of one-half in commercial primary energy consumption its share in revenue is negligible at 0.1 percent of GDP.

The expenditure side, where the government’s credibility is at its lowest, presents the toughest challenge. India has painted itself in a corner in this regard. Analogous to old-age and health related commitments in mature economies, the implementation of schemes for the poor in India (inter alia comprising of sector subsidies) have been mangled into unconditional, uncapped and open-ended entitlements. In political economy terms, all non-merit subsidies are considered part of social spending, hence a holy cow. A widening of the food security net combined with the inability to adjust petroleum product prices has engendered a backdrop to India’s fiscal challenge that almost seems overwhelming, especially since the large number of stakeholders who benefit from the schemes are perceived, rightly or wrongly, to vote against political dispensations that seek to downsize outlays.

One form of expenditure growth mitigation could be a phased expansion in entitlement coverage so that the impact on the budget is spread over several years. Over time, Aadhar – under implementation by the Unique Identification Authority of India – through better targeting should help to plug leakages and assist expenditure control. However in the near term, on balance, given the constraints on the expenditure side, viz., interest payments, defense and education, disproportionate adjustment on the fiscal balance is likely to come from revenue enhancements.

The difficult path of consolidation is further challenged along other dimensions. Growth is faltering, and even as headline inflation finally shows sign of declining, an important caveat is in order. Energy prices, comprising petroleum and power, have not yet been adjusted to the requisite levels by some distance, with concomitant pass through implications. Core inflation is still above the comfort zone and, therefore, the down cycle in interest rate reduction could be delayed. There has been procrastination in reorienting growth drivers towards eliciting supply and productivity responses in key sectors, and away from government sponsored aggregate demand. Lastly, investing in macroeconomic management credibility means that the Indian government cannot postpone matters; easy options have been exhausted for some time.

Authors

Vijay L. Kelkar
Urjit R. Patel

Publication: Mint

Image Source: © Rupak De Chowdhuri / Reuters

Dynamics of Inflation "Herding": Decoding India's Inflationary Process

Gangadhar Darbha and Urjit R. Patel — Tue, 24 Jan 2012 14:22:00 -0500

Compared to immediately preceding years, that is, its own recent history, India’s inflation became unhinged (thereby reversing creditable performance) from as far back as 2006. In the last two years, among its major comparators India has the highest rate of consumer inflation; it is also volatile in relation to its peers in Asia and the BRICs. This paper puts forward an empirical framework to analyze the time series and cross-sectional dynamics of inflation in India using a large panel of disaggregated sector prices for the time period 1994-95 to 2010-11. It has been motivated in no small part to official pronouncements seemingly unencumbered by methodological rigor. There are several grounds for distrust by citizens regarding policy makers in this context. Firstly, officials have attributed the upswing in prices (measured by all indices) to food supply constraints, and therefore claim they are powerless to do anything about it. Secondly, they resort to hand wringing and public communication that essentially amounts to “we are staring the problem down” as the common refrain for an inordinately long time; in tandem, rolling “(mental) spreadsheet forecasts”—that have been optimistic by some distance—were, and still are, put out at regular intervals to give succor and hope to the public. Thirdly, a spate of recent statements seems to suggest that the medium-term objective of around three percent inflation articulated by inter alia the Reserve Bank of India (RBI)3 is being given a quite burial.

The operational methodology introduced in the paper facilitates a rigorous exploration of issues that have been, at best, loosely posed in policy debates such as diffusion or comovement of inflation across sectors, role of common and idiosyncratic factors in explaining variation, persistence, importance of food and energy price changes to the overall inflation process, and contrast the recent experience with the past. It is found that the current period of high inflation is more cross-sectionally diffused, and driven by increasingly persistent common factors in non-food and non-energy sectors compared to that in the 1990s; this is likely to make it more difficult for anti-inflationary policy to gain traction this time round compared to the past.

The paper has also introduced a novel measure of inflation, viz., Pure Inflation Gauges (PIGs) in the Indian context by decomposing price movements into those on account of: (i) aggregate shocks that have equiproportional effects on all sector prices; (ii) aggregated relative price effects; and (iii) sector-specific and idiosyncratic shocks. While aggregate Wholesale Price Index (WPI) inflation by the end of 2008-09 had declined to about 1 percent (from about 8 percent in 2007-08), PIGs were running at around 3 percent; in contrast to the headline inflation, the most recent trough for PIGs was 2005-06 and not 2008-09. The decline in (and the level of) headline inflation in 2008-09 may have conveyed to the authorities that they had less need of (or more time for) tightening than was the case looking at inflation measures corrected for sectoral and idiosyncratic shocks. If PIGs, in conjunction with our other findings, for example, on persistence had been used as a measure of underlying (pure) inflationary pressures, the monetary authorities may not have been sanguine regarding the timeliness of initiating anti-inflationary policies.

Downloads

Download the paper

Authors

Gangadhar Darbha
Urjit R. Patel

Image Source: Kim

Public Finance and the Energy Sector in India

Urjit R. Patel — Tue, 27 Dec 2011 00:00:00 -0500

Herbert Stein’s “Law” is expressed as: “If something cannot go on forever, it will stop.” From a public finance perspective, India’s energy sector challenges now encompass its federal structure in an almost “symmetric” manner. The petroleum sector has become a fiscal morass for the central government, and the electricity sector in many states is equally problematic. But, unlike Delhi, states neither have recourse to RBI’s printing press for rupees nor can they “impound” the central bank’s foreign currency reserves.

Both sectors, from a fiscal perspective, are partly off-balance sheet vis-à-vis government accounts. Much like social claims in the EU, energy entitlements in India can impinge on broader fiscal stability. The quasi-fiscal hole due to non-remunerative pricing in the electricity and petroleum sectors each account for about 1% of GDP (see table).

Internationally, retail prices of kerosene, diesel and petrol are usually in the same ballpark; in India, the prices are, respectively, roughly in the ratio 1:5:7. The concomitant distortions in fuel use are becoming more severe. More than kerosene, diesel consumption has reached a level where the refined product has to be imported because of the skewed consumption pattern; diesel is now being substituted for furnace oil—the price of which is market linked—as an industrial fuel.

Bond markets, and even credit rating agencies, eventually take off-balance sheet liabilities, current and prospective, into account. The implications of several years of under recoveries are far reaching. First, government debt management issues; the stock of oil bonds issued by the government in lieu of cash is R1.4 trillion, and outstanding borrowing of oil marketing companies (OMCs) is around R1 trillion. Second, the extant process by which subsidy is provided imparts ambiguity in the central government’s budgetary accounts, which in turn catalyses needless uncertainty in the financial markets. Only a hypothetical amount of R30 billion is included in budget estimates under the central government’s 2002 scheme. Third, the much touted energy security as a strategic objective is undercut. Upstream PSUs are, due to burden sharing, “relieved” of (potentially) investible resources to the tune of 0.6% of GDP. Regarding private sector investors, price caps that are way out of line with prevailing international prices, for example, in the case of natural gas undermines long-term sector economics. Moreover, the pervasive discretionary backdrop is demoralising for all exploration and production stakeholders.

Given the scope of the burden on account of the petroleum sector, the financial sector is often caught off balance in the short run; abrupt requirements for stopgap liquidity and bridge loans transpire under these circumstances. Oil bonds do not have SLR status, so banks don’t have to buy them, or accept them as collateral; OMCs may need explicit government guarantees to access further credit (much like Air India). Of course, the Centre can have RBI print rupees on its behalf, which can be used by OMCs to buy dollars to import crude. Or, as in 2008 (before the crisis), RBI directly gives dollars in exchange for oil bonds (outright purchase or collateralised repo), so as not to destabilise markets. Hence, Stein’s Law may be kept in abeyance for some time.

Turning to the power sector, whilst shortages continue, state government-owned distribution companies (discoms) are curtailing supply in many parts, at the same time as merchant power generators can deliver more electricity (Stein’s Law has kicked in). The primary driver of the financial morass that states find themselves in is the gap between the average cost of supply (ACS) and average revenue realisation (ARR) of 73 paisa/unit, up from 27 paisa/unit in 2005-06 (lower panel of table). Aggregate technical and commercial (ATC) losses continue to be high as curtailment efforts lose traction, with about 27% of electricity generated not being paid for; the cross subsidy in favour of agriculture and household consumption continues to incentivise theft. Tariff revisions have been infrequent and inadequate, much like in the case of petroleum products; it is rather silly to expect regulators to be independent when the sector is dominated by state governments.

Many state governments are only partially releasing budgeted subsidies, down from 94% in 2006-07 to about 55% currently. Not surprisingly, the private sector is feeling skittish; for instance, IPPs reliant on merchant transactions face problems as market prices remain soft and elevated cost of imported fuel is absorbed. A sector workout (akin to 2001) seems imminent, while power sector bonds estimated at R130 billion, which are liabilities of state governments, remain to be liquidated from the previous bailout! It has been extensively documented that lenders to the power sector are nervous. Regulatory forbearance, viz, maturity elongation of loans could temporarily window dress NPAs and mitigate the Centre’s bill for recapitalising its banks. Given the systemic nature of the power sector, how long can central government entities be ring-fenced? Can NTPC really cut supply to a Congress-ruled state, or to any other state that will have assembly elections soon? Coal India Ltd is already claiming payment defaults. Open-ended unconditional subsidised consumption of energy is the “road to fiscal perdition”.

Authors

Urjit R. Patel

Publication: The Financial Express

India's Budget: Deft Political Management (and Some Luck) Needed for Fiscal Consolidation

Urjit R. Patel — Mon, 07 Mar 2011 09:26:00 -0500

There are two perspectives that can be justified from the Union Budget of India for 2011/12 delivered in parliament on February 28. First, it was largely an agnostic event and did not make major headway for key reforms (i.e., opening up new sectors for foreign direct investment). Simultaneously, the government maintained restraint by eschewing additional (populist) schemes to gratify sections of the population, considering that there are a few state elections due this year. The stress has been on existing programmes.

Second, for the first time since 2007/08, India’s finance minister may just have convinced investors that the country is making a serious attempt to put its fiscal house in order in a bid to restore macroeconomic stability; the fiscal deficit of the central government is budgeted to decline from 5.1 percent of GDP in 2010/11 to 4.6 percent of GDP in 2011/12. This has been overdue against the backdrop of three successive years of virtually double-digit consumer inflation; strong persistence strongly suggests that this has not been due to food and energy, much as government macroeconomic managers dissemble on the subject. In addition, the emphasis in the budget to pass outstanding economic legislation will be more effective than any major efforts on innovative issues.

Both inflation and interest rates are influenced by expectations. Therefore, the proximate goal of bringing down government-induced aggregate demand in the budget proposals (to moderate inflation expectations and reverse the extant upward pressure on market interest rates) will be well served for driving private investment in the medium term.

A potentially decisive break of substituting indirect (highly distortionary) subsidies for cash transfers in lieu of kerosene, cooking gas (LPG) and fertiliser subsidies is probably the most far-reaching announcement in decades for delivering targeted benefits to the poor. But in these key expenditure categories there are non-trivial risks in the projections made in the budget, in particular the compression of one-half percent of GDP in subsidies envisaged in 2011/12:

The elevated oil prices, if they persist, will need to be passed through to the final consumer to achieve the fiscal targets, although the budget estimate for 2011/12 shows a decrease from the level for the current year. Without adjustment in retail fuel prices, a one percent of GDP fiscal hole is a distinct possibility. Either the finance minister will have to be lucky so that oil prices moderate soon or his recalcitrant colleagues will have to support him in revising prices of all liquid hydrocarbon fuels.
An increase in the food subsidy on account of imminent right-to-food legislation does not seem to have been budgeted for. If the universal scheme is not postponed to 2012/13, food subsidy expenditure will increase by an estimated Rs.100-150 billion in the coming year.
Inflation indexation of the rural employment guarantee payments can add as much as Rs. 100 billion to overall expenditure.

It is noteworthy that during the transition to cash transfers, overall expenditure need not (automatically) decline (and may actually increase). There is compelling, albeit indirect, evidence: the rural income support scheme – a form of dole – that has now been in operation for several years has not led to a reduction in myriad subsidy payments made in the name of the poor in India. It is also pertinent to note that cash transfers per se need not translate into better targeting. The supporting administrative “ecosystem” needs to fall into place (information technology-centric work on this is taking place). Expenditure overrun in entitlements may have to be met by savings elsewhere. The much respected and experienced Indian finance minister will have to actively manage the expenditure compression; it cannot be left on autopilot.

On the tax side of the budget, although revenues slated to increase by 18.5 percent next year may come across as optimistic, the much-delayed removal of tax breaks for the information technology & IT-enabled service providers, and a minimum alternate tax on special economic zones, has justifiable upside potential for enhancing the government’s revenues.

The government’s (and the Reserve Bank of India’s) concern on financing the external current account deficit has forced the finance minister’s hand into liberalising capital inflows, namely, allowing foreign retail investors directly into Indian mutual funds, raising limit for foreign funds in infrastructure debt to US$ 25 billion, and raising the overall cap for foreign institutional investment in corporate debt to US$ 40 billion. Analysts would put these in the category of “fair weather” capital, hence prone to dry up if global risk aversion were to come back into vogue. However, if the requisite legislations are passed to allow higher foreign investment in insurance companies in India and lift voting rights of foreign investors in Indian banks, then more stable and durable inward investment can be expected.

If investment does not respond positively to the finance minister’s “invitation” of a larger “financial space” for the private sector, then growth next year will be considerably lower than the 9 percent (a best-case scenario) that has been assumed by the government. Interest rates have already hardened and are unlikely to reverse quickly, which will impact private corporate investment. Furthermore, in the coming year, the fiscal multiplier will work in reverse as fiscal consolidation is pursued. The fiscal deficit outcome for 2010/11 at 5.1 percent of GDP comprised 1.3 percent of GDP in (non-tax) one-time telecommunications spectrum auction proceeds and 0.3 percent of GDP in disinvestment in government-sponsored enterprises (GSEs). If these are excluded, the fiscal deficit is 6.7 percent of GDP. Now, the 2011/12 budget projects a deficit of 4.6 percent of GDP, which contains 0.4 percent of GDP in GSE disinvestment. In essence, the planned deficit reduction is from 6.7 percent of GDP to 5 percent of GDP – 1.7 percent of GDP in one year – which is unprecedented since the crisis-driven consolidation in 1991/92. A modest fiscal multiplier of 0.5 means that the implied reduction in GDP growth due to aggregate demand compression is about 0.9 of a percentage point. Therefore, because of this and other reasons, overall growth in 2011/12 will be lower than the 8.6 percent achieved in 2010/11 unless private and inward foreign investment in India spikes up considerably on account of, say, greater confidence in the government’s ability to manage affairs, including recent governance challenges at the highest levels which have roiled the country. A potential upside to the “growth calculus” is strong global growth helping to further accelerate the already impressive Indian export earnings rebound in 2010/11.

The table below provides a quick summary of the evolution of some important macroeconomic variables.

Authors

Urjit R. Patel

Image Source: © B Mathur / Reuters

Assessing the Investment Exuberance in India’s Power Sector

Urjit R. Patel — Thu, 03 Feb 2011 14:07:00 -0500

Recognition of the power sector’s central role in hindering India’s competitive cost advantage hardly needs elaboration; industrial power tariffs in India are probably the highest amongst its major emerging market peers. In an increasingly globalised and open trade environment, this is a significant disadvantage in sectors with a major power cost component. A faltering in India’s industrial growth momentum has implications for debt servicing capacities of large, bulk consumers, further aggravating sector financials.

There is an emerging dichotomy regarding prospects of the sector. There seems to be an assessment by important and diverse stakeholders that there is a revival underway in India’s power sector. Actual and planned investment and financing decisions based on hard data and anecdotal evidence seems to corroborate this. The fiscal year 2009/10 witnessed capacity addition, much of it thermal, of 9.6 GW, the highest ever in a single year. In contrast, the “exuberance” of investment is somewhat confounding when we examine recent official “macro” commentary on the Indian power sector.

Against the backdrop of a revival in investment in the sector and the concomitant larger context of concerns about the possibility of credit stress, the development of power markets, and open access and third party sales are assuming increased importance.

The recent paper by Saugata Bhattacharya and Urjit R. Patel, “Does the Exuberance in the Indian Power Sector Have Legs?”, presented at the Federalism and Reform in Asia Conference in New Delhi, focuses on two issues which are likely to have a profound impact on the nature and speed of development of the power sector. The first issue is the fiscal implications of the changing financials of the distribution segment of the electricity sector. The second issue is the evolving conditions of commercial orientation of the sector. The first concern is self evident. The second follows from the increasing participation of private developers of generation plants, the rapidly growing exposure of domestic and foreign debt financiers in the projects and the critical role of distribution utilities in generating cash flows for successful enabling of power purchase agreement (PPA)-tied debt servicing for borrowers. To aid this exercise, a summary measure – Index of Revenue Orientation (IRO) – which had earlier been conceptualised and constructed by the authors to capture critical (commercial) aspects of the sector is updated.

The mid-decade improvement in the performance of the power sector has not been transformative. While there is widespread differences between states (and, indeed, between utilities), the unsettling aspect of recent performance of state-level power utilities is the speed of deterioration in the sector’s overall financials, with losses in 2008/09 exceeding Rs. 526 billion, that is doubling over the course of just a couple of years. After a period of relative tranquillity, as a percent of GDP, financial losses are back to 2002/03 levels.

Although the recent increase in the losses of state utilities have not yet overrun GDP growth to the extent of the situation in the late 1990s and early 2000s, and hence might be containable from a fiscal perspective at least in the short term (which is still a matter of disquiet given the desirability of fiscal consolidation), the implications for servicing the debt required for funding additional capacity is potentially of considerable concern if the recent trajectory of sector performance continues.

The increasing gap between the Average Cost of Supply and Average Revenue Realisation of electricity, specifically pertaining to the industrial segment, is probably the most important driver of the deteriorating losses. This gap is mainly due to the sharply increased cost of procured power outpacing the (relatively modest) increase in revenues as reduction in Aggregate Technical and Commercial losses has lost traction in recent years. It is becoming increasingly evident that not only is the power sector less homogenous than it used to be less than a decade ago, it has become more heterogeneous in 2008/09. What had initially begun to appear as a “separating” equilibrium in 2005/06, with some state governments (as owners) managing a financial turnaround and sustaining (cash) profits for several years has unfortunately not sustained for many states.

Is there any indication that the course of increasing losses can be reversed quickly? Not that we can see. What is worrying about the deterioration and its concentrated origins is that the utilities of the relevant states were considered, even until very recently, to be some of the better ones in operational terms. The continuing losses reported in 2009/10 and projected for 2010/11 can only suggest that the deterioration has spread to other states as well.

Since financial sector exposure to the sector has grown robustly in recent years, there is the possibility of a wider challenge if the health of the cash-generating segment has been misread by private investors and lenders. Given recent global experience of coping with the aftermath of miscalculated risk and leverage it may not be as unlikely as one would prima facie think. When private entities, including financial backers/banks, involved in a sector are deemed too systemically significant (too big, too complex, too interconnected) or too politically connected to fail, bailouts (even of irrationally exuberant sectors) take place. Are we at yet another threshold of private gains but losses socialised? Time will tell!

Authors

Urjit R. Patel

Does the Exuberance in the Indian Power Sector Have Legs?

Saugata Bhattacharya and Urjit R. Patel — Thu, 03 Feb 2011 13:56:00 -0500

Abstract—

The increasing losses of state electricity utilities are again starting to affect the evolving contours of federalism in India. The power sector has an important role, not just due to the high levels of government subventions to the sector, but increasingly due to the implications for debt servicing capacities, following the massive expansion in power sector projects that are currently under implementation. The paper, inter alia, uses a framework developed earlier by the authors for decoding and evaluating the “commercial orientation” of distribution utilities, for the purpose of assessing the potential of these losses worsening. The increasing gap between the Average Cost of Supply and Average Revenue Realisation of electricity, specifically pertaining to the industrial segment, is probably the most important driver of the deteriorating losses. This gap is mainly due to the sharply increased cost of procured power outpacing the (relatively modest) increase in revenues as reduction in Aggregate Technical and Commercial losses has lost traction in recent years. The mid-decade improvement in sector performance has not been transformative. In the context of the extant upsurge in investment in the sector, it is pertinent to query whether risk and leverage has been miscalculated—a case of irrational exuberance and sub prime funding?

Read the full paper »

Downloads

Download the Full Paper

Authors

Saugata Bhattacharya
Urjit R. Patel

Liability Legislation for Indian Nuclear Energy Business is Enacted

Urjit R. Patel — Wed, 01 Sep 2010 10:42:00 -0400

Both Houses of India’s Parliament have passed the Civil Liability for Nuclear Damage (CLND) bill, which establishes and allocates liability on diverse stakeholders participating in the nuclear power industry. Previously, I observed that key contentious issues had to be resolved in order to move forward with the bill, including a stronger compensation regime; broadening the “actors” beyond operators of the facility who would be liable for compensation; and extending the statute of limitations.

After intense debates, backroom negotiations between the two main political parties and important redrafting, the following five points are noteworthy:

The overall maximum amount of liability in respect to each nuclear incident is assessed at Special Drawing Rights 300 million (21 billion rupees), except where the government changes the maximum amount through a notification.
The operator of a nuclear plant of 10 MW and above is liable for compensation up to 15 billion rupees.
The central government is liable for damage in respect of a nuclear incident where the liability exceeds the amount of liability of an operator.
The period over which victims can claim damages for injuries is 20 years.
Even if an operator does not have a contractual right for recourse vis-à-vis a supplier, the CLND bill provides for recourse to compensation if the nuclear incident has occurred due to a supplier’s actions. In other words, supplier’s liability is part of the legislation.

In the run up to the voting on the CLND bill, a fair amount of discussion focused on the fifth point above. There was strong representation from the industry that supplier’s liability will make India an outlier in the nuclear power sector, and consequently Indian operators will find it difficult to source equipment and service vendors from abroad and domestically. Several observations are pertinent in this context.

First, even if the supplier’s liability clause (# 17b in the bill) were not included, the operator through an apposite contract could hold a supplier liable. Regardless of the lack of precedent, good housekeeping on the part of the operators to protect their investors’ interests should include channelizing some liability to vendors; after all, this is generally the case in the energy sector. (It is instructive that in South Korea there is right of recourse to suppliers unless excluded by contract.)

Second, it is important to conceptually assess the industry position against supplier’s liability. The primary reason why the subject of liability is important in the nuclear business is the potential for a large negative externality, regardless of the cause, if matters go awry—a ceiling on damages is needed precisely because they can be astronomical. Therefore, liability clauses that impart responsibility on a stakeholder who is best placed to assume a specific risk is optimal. In this sense, the CLPD bill distinguishes between a broad operational risk and a (relatively) narrow supplier-related risk. To further underscore this point, it is noteworthy that an operator does not bear risk on account of natural disasters, act of war, terrorism etc.—past experience suggests that in these instances it is usually left to the government to bell the cat!

Lastly, the world is on the verge of a nuclear energy renaissance, hence suppliers’ order books will witness robust growth, and thus it may be beneficial to “sharpen” incentives against cutting corners by suppliers (regardless of how small the possibility is due to adverse reputation effects). In fact, inclusion of supplier’s liability is a model that other countries may emulate in due course as it is not without merit, irrespective of industry clamour against it in the Indian context.

Authors

Urjit R. Patel

Image Source: © Babu Babu / Reuters

Crucial Deadline for Nuclear Energy Business in India

Urjit R. Patel — Tue, 17 Aug 2010 11:59:00 -0400

Introduction

Over the last two years, India has signed bilateral nuclear power agreements with several countries, including the U.S., France, Russia, Kazakhstan and Canada. On July 30, a prerequisite for U.S. nuclear fuel suppliers to conduct business with India was concluded with the two countries signing an agreement on the reprocessing of American nuclear spent fuel by India, marking the final steps toward implementation of the landmark 2008 civil nuclear deal. These latest arrangements and procedures will enable reprocessing by India of the U.S.-obligated nuclear material at a new national reprocessing facility to be established by India and dedicated to the reprocessing of safeguarded nuclear material under International Atomic Energy Agency (IAEA) safeguards.

Efforts by foreign companies to enter the Indian market will not be successful in the absence of a Civil Liability for Nuclear Damage (CLND) legislation, which is necessary for investors who are unwilling to accept unquantified risks of nuclear energy without some limitation on their liability. Specifically for the U.S., progress toward two nuclear reactor park sites designated by India for U.S. technology in the states of Andhra Pradesh and Gujarat has been held up in the absence of a CLND Act. Both the U.S. and India would like to have the legislation in place prior to President Obama’s visit to India in November.

It is noteworthy that the legacy of cooperation and deals between state-controlled enterprises in Russia and India is bearing fruit. The much-delayed 1,000 MW first unit of Kudankulam nuclear generating station in Tamil Nadu, being built with Russian collaboration, will be active by December. The plant will be made operational irrespective of whether the proposed nuclear liability legislation is enacted. The second unit of the Kudankulam power plant is envisaged to come on stream within six months of commissioning the first unit by June 2011. Russia does not seem overly anxious about the passage of the liability bill before its companies conduct business in India.

Background

Given the legacy of the present energy profile, growing energy demand in emerging markets, broad availability and the evolution of prices, fossil fuels will continue to comprise a significant part of the global energy mix until 2030, even for developed blocs like Europe and the US. India will be no different (see Table 1 for India’s electricity projections by fuel). The single largest fossil fuel in the energy mix is coal at 40 percent of India’s energy consumption and is the most abundant and domestically available primary energy resource other than thorium and solar insolation.

Table 1: Generation Capacities and Load Factors, 2031/32

Source	Capacity (GW)
Coal	270
Natural Gas	70
o/w Coal bed methane	28
In-situ Coal gas	22
Nuclear	63
Hydro	150
IGCC pet coke	3
Wind – onshore	32
Wind – off-shore	1
Biomass gasification	1
Biomass combustion	50
Solar	10
Total	700

Note: 1 GW is equal to 1,000 MW.
Source: Report of the Expert Committee on Integrated Energy Policy, 2006.

Although hydrocarbon-based power is likely to remain the mainstay for India’s power sector at a construction cost in the median range of $1.4 – 2.5 million per MW, the potential size of India’s nuclear business is huge. In two decades, India hopes to more than double the share of nuclear power in its electricity portfolio from 4.2 percent at present to 9 percent, a 14-fold increase in installed capacity to 63 GW over the next two decades.

India’s Nuclear Energy Strategy

Nuclear energy theoretically offers India long-term energy security. Achieving this goal is crucially dependent on India implementing its long-standing strategy of nuclear fuel recycle as compared to the preponderant once-through fuel cycle. This entails the realization of the multi-stage development process to tap into India’s vast thorium resource – about a quarter of known global reserves.

Continuing support to the three-stage development of India’s nuclear potential is essential. India is extracting uranium from extremely low grade ores, often as low as 0.1 percent, compared to ores with up to 12-14 percent uranium in certain geographies elsewhere; this makes Indian nuclear fuel 2-3 times costlier than international supplies. The substantial thorium reserves can be used but only if it can be converted to fissile material. In this context, a three-stage nuclear power program has underpinned India’s objectives in the sector:

Establishing pressurised heavy water reactors (PHWRs) in the first stage – which has now reached maturity – since these reactors are efficient users of natural uranium for yielding plutonium fuel. Capacity addition supplemented by electricity generation through light water reactors (LWRs), initially through imports of technology from Russia but with the long-term objective of indigenization.
Fast breeder reactors (FBRs) in the second stage based on plutonium yield from the first stage. The FBRs will also recycle spent uranium from PHWRs to breed more plutonium fuel for electricity generation. FBR technology is critical to developing stage two of India’s nuclear power program, otherwise it will find it difficult to go beyond 10,000 MW installed capacity based on domestic uranium resources. Deployment of FBR technology would enable indigenous uranium resources to support a much larger nuclear power program by 2020 and more importantly thorium used as blanket material in FBRs will produce uranium 233.
The third stage deploys reactors based on the uranium 233-thorium 232 cycle. The “resource multiplier” for power generation of the three-stage strategy is summarized in Table 2.

Table 2: Approximate potential available from nuclear energy in India

	Amount (tonnes)	Electricity (MW)
Uranium:	61,000
in PWHR		10,000
in FBR		500,000
Thorium:	225,000
in Breeders		Very large

Against this background, the 2008 civilian nuclear agreement with the U.S. has catalysed for India autonomy and choice along three dimensions:

Access to secure long-term uranium supplies from abroad to close the gap between capacity factor and availability factor of existing PHWRs.
Add PHWR capacity through imports of up to 40 GW.
Harness external innovation in both equipment and fuel that would allow India to use its ample indigenous supply of thorium.

The Legislative Challenge

In the current monsoon session of India’s Parliament, an important piece of legislation essential for foreign investment and commerce into India’s energy sector will be discussed by the Parliamentary Standing Committee on Science and Technology and then voted upon by both houses of India’s Parliament. It is unclear whether all this will be accomplished in the month-long session, which ends on August 27. The CNLD bill – which will become an act after it is passed by Parliament – has been caught in a controversy with several opposition political parties demanding its redrafting.

Key contentious issues for resolution at the Parliamentary committee stage include: enhancing ceiling on damages – the Supreme Court’s judgement on the Bhopal gas calamity has triggered a demand for a stronger compensation regime in industrial accident cases; broadening the “actors” beyond operators of the facility who would be liable for compensation; extending the statute of limitations; and whether a separate dispensation for liability should be given to Indian nuclear energy operators, which would in effect bias the sector somewhat against foreign investment.

The current draft of the CNLD bill stipulates in clause six the maximum financial liability of the operator of a nuclear power plant at five billion rupees. If the damage is assessed to be more than this, the additional money has to be provided for by the government up to Special Drawing Rights 300 million (21 billion rupees) in congruence with the 1997 Convention on Supplementary Compensation for nuclear damage, developed under the auspices of the IAEA. This amount is felt to be inadequate in India partly because of the recent paltry damages awarded in the Union Carbide case; for example, the Price Anderson Act 1957 in the U.S. established a no fault insurance-type system in which the first $10 billion is nuclear industry-funded, and any claims above the $10 billion would be covered by the federal government.

There is the prospect that outstanding matters before the Parliamentary Committee could be resolved, albeit not exactly, along the following lines:

A doubling of the operator compensation cap to 10 billion rupees could be recommended.
Since the full effects of cancer caused due to exposure to radiation could take 10-15 years to be known, the Parliamentary Committee is also likely to suggest extending the period of victims claiming damages in clause eighteen of the bill from the current 10 years from the time of a nuclear incident to more than 15 years.
From the perspective of expanding the scope, even as it is contemplated that clauses may be inserted to cover eventualities like accidents during transport of nuclear materials or in their handling at domestic and even foreign ports, it is unclear whether pressure from proponents to insert a supplier liability clause will be successful.

In conclusion, while the deadline is tight relative to the process that still has to be traversed before the CLND bill is legislated, it is possible for hard work and compromise over the next two weeks to bear fruit and further unlock business opportunities in the Indian nuclear power sector.

Authors

Urjit R. Patel

Indian Fiscal Rules: Framework and Critical Review of Outcomes and Design

Urjit R. Patel — Mon, 26 Jul 2010 11:25:00 -0400

The challenge of reining in large fiscal deficits has re-emerged in India and elsewhere. Since the mid-2000s, India’s federal and state governments have conducted their budgetary affairs against the background of fiscal responsibility legislations (FRLs). The fiscal rule for India’s central government was enshrined in the Fiscal Responsibility and Budget Management Act (FRBMA), which was legislated in 2003 (and amended in 2004) and whose targets were effective from fiscal year 2004/05 up to 2008/09. A recent National Bureau of Economic Research working paper, “Fiscal Rules in India: Are They Effective?” by Willem H. Buiter and Urjit R. Patel, critically explores the outcomes of the FRBMA over the period of its operation using an eclectic but comprehensive metric comprising of quantitative targets, qualitative strictures, transparency, integrity, and overall financial performance over the business cycle. The paper deploys a formal solvency arithmetic framework to guide, direct and discipline the discussion.

The paper also reviews FRLs and concomitant outcomes at the state government level. Furthermore, the recommendations of the 13th Finance Commission (FC) regarding a prospective roadmap for fiscal consolidation are examined against the background of both the Indian experience and outcomes of similar fiscal rules in the European Union (Stability and Growth Pact) and in the U.S. (Gramm-Rudman-Hollings Act).

India has a long-standing “preference” for running large fiscal deficits compared to not only its peer group of emerging economies, but also globally. Over the last three decades, India has found it impossible to sustain, for an appreciable time, an overall public sector financial deficit of less than 8 percent of GDP. It has also been extremely rare for the general government fiscal deficit to be lower than 6 percent of GDP.

There were two key “hard” features of the FRBMA: (1) a restriction that by 2008/09 the overall central government financial deficit be not more than 3 percent of GDP; (2) the “golden rule” restraint that the revenue or current budget should be in balance or surplus by 2008/09.

The “outcomes” section of the paper clearly shows that the central government has missed both the fiscal and revenue deficit targets by some margin. Its fiscal deficit for the terminal year, 2008/09, was 6 percent of GDP, excluding estimated off-budget expenditure (settled by IOUs or simply ignored) of about 2 percent of GDP. After 2004/05, not only has there been no fiscal correction once off-budget items are included, but indicators mostly deteriorated. Taking into account off-budget expenditure, it is amply clear that the FRBMA “transition” annual targets towards a 3 percent of GDP fiscal deficit and balance on the revenue account by 2008/09 were exceeded before the onset of the 2008 Great Recession. Moreover, the FRBMA’s clauses were insufficient to prevent the finance minister from excluding (unpaid) dues on account of subsidies in calculating the fiscal and revenue deficits; the provision for off-budget bonds was inadequate to cover the expenditure overrun (or deliberately shown to be low); for example, estimates by market analysts suggest that excess expenditure was about 1.9 percent of GDP in 2007/08.

The adverse evolution in the center’s fiscal balances was not on account of the operation of automatic stabilizers during a cyclical slowdown; on the contrary, the Indian government’s revenues have been buoyant. The gross tax-GDP ratio increased from 9.7 percent in 2004/05 to 12.6 percent in 2007/08 on the back of an almost 9 percent average annual real growth rate. The recent profligacy of the central government has its primary driver in populist spending policies by the ruling coalition leading up to national elections in May 2009. Three stimulus packages, including a reduction in indirect taxes, starting in late 2008 to counter global recessionary headwinds only helped matters along in the same direction. Much of the slippage on the expenditure side can be attributed to large and increasing energy, food and fertilizer subsidies; funding loss-making public sector units; expanding a rural income support scheme (started in 2005); increasing salaries and pensions of civil servants (implemented in 2008), and a huge agricultural loan waiver scheme announced in early 2008 but not budgeted for!

It is instructive that central government liabilities have declined even with an annual average central government fiscal deficit over the five years at 4.8 percent of GDP (including off budget bonds). The driver for this happy state of affairs is India’s unprecedented growth performance in recent years – annual average nominal GDP growth of 15 percent during the 5 years of the FRBMA’s operation – in comparison to the government’s cost of borrowing. This is also the case from a wider perspective: between 2002/03 and 2007/08, overall public sector debt ratios in India declined substantially. The net public debt level is relatively low at about 56 percent of GDP and is largely domestically held, primarily in the banking system, much of which is state controlled.

Fiscal consolidation by state governments (in aggregate) in recent years has been commendable. Between 2003/04 and 2007/08, their fiscal deficit declined markedly from 4.4 percent to 1.5 percent of GDP. The main explanation being that enhanced budget revenues were not offset by discretionary action on the expenditure side. During 2008/09, the fiscal performance deteriorated somewhat with the deficit at 2.6 percent of GDP, but still below the mandated 3 percent ceiling. This was due to the economic slowdown and the accompanying moderation in the pace of revenue growth. However, the revenue deficit in most states was within the target of zero balance in 2008/09. The management of states of their fiscal affairs over both a period of high growth and the subsequent slowdown exhibits successful conduct of “discretionary countercyclical” policy within the rules. Therefore, the recent deterioration in India’s national fiscal situation cannot be blamed on state governments. The evidence suggests that in recent years the fiscal space “vacated” by the states has been usurped by the central government. Nevertheless, caution is warranted: recent fiscal restraint by state governments does not necessarily imply continuation of rectitude in the future.

Political opportunism (rational at the individual, partisan level) in India as elsewhere calls for the postponement of expenditure cuts or tax increases and the prompt spending of revenue windfalls. There is always the chance that the political cost of painful fiscal retrenchment will be borne by the opposition, when its turn in office comes around. The main difficulty thrown up by our analysis of outcomes under the FRBMA and other FRLs remains the design of a fiscal rule to incentivize the government not to give in to a procyclical bias, which behaviourally and in practice is especially pertinent for policy during upswings.

It is not surprising that given the fiscal situation in India, there has been a flurry of activity. Both the 13^th Finance Commission’s report and the central government’s 2010/11 budget have laid out a road map to cut the fiscal deficit and public debt over the next five years. Drawing lessons from the central government’s conduct in recent years, the FC’s report has, to its credit, made constructive suggestions for changes in the areas of transparency, limited in-built flexibility, and enhancing the integrity of fiscal policy in the design of future legally-binding rules. Although the “golden rule”, a balanced revenue budget, has been maintained as an objective in the latest proposals, the important change in emphasis is the dominance of gross public debt-GDP ceilings over the next five years. It is noteworthy that the FC spurned the opportunity to demonstrate innovation in the urgent and difficult task of designing and implementing a time consistent fiscal rule for the sovereign (in a democracy which shows a sustained proclivity for running high fiscal deficits without public opprobrium). In this context, we draw the paper to a close by outlining a basic incentive compatible framework for state and central governments to hold each other accountable over agreed pre-determined targets.

See related National Bureau of Economic Research working paper, “Fiscal Rules in India: Are They Effective?” by Willem H. Buiter and Urjit R. Patel.

Authors

Urjit R. Patel

Decarbonization Strategies: How Much, How, Where and Who Pays for a Rise of 2 Degrees Celsius?

Urjit R. Patel — Tue, 23 Mar 2010 11:26:00 -0400

Introduction

At a panel discussion at the London School of Economics (LSE) in early October, I said in my concluding remarks that while I was not optimistic about the likelihood of a robust global climate deal at Copenhagen, “there seemed to be a strong consensus in world capitals for a weak agreement.” Well, I was more or less right. We ended up with something rather ineffectual: a less than unanimous declaratory announcement (of feeble aims), although they call it an accord; and, in any case, it is neither a treaty nor even a binding commitment underpinned in law. In fact, domestic politics and the recession have probably put paid to hopes for a precise emissions quota-focused treaty in the near term. At any rate, a legally binding multilateral document is hardly sufficient: emission outcomes even under the formally binding Kyoto Protocol with a built-in enforcement mechanism are widely perceived to have been inadequate.

An address of this sort has the advantage that it is not entirely out of place to share expansive thoughts, which is, of course, another way of saying that I can take some liberty or that this is a work in progress and therefore bits of the paper are, “cognitively speaking”, unsettled. Nonetheless, I shall be forgiven since I was a guest.

Regardless of what has transpired in Copenhagen, the sheer scope and longevity of the challenge of climate change will be impacted by and impinge on four factors:

Coordination among nations: Without further engagement, the amount of global abatement realized, due to the free rider problem, will almost certainly be undersupplied relative to the magnitude of the global “public bad” threat (if the scientists are right, and the balance of probabilities warrant action commensurate with the “precautionary principle”).
Technology transformations: Highly capital intensive ones, in part because of more demanding “target & regulate” national policies.
Instruments for pricing carbon: These may change, for instance, from cap and trade (CAT) to a carbon emission tax (CET). Also, there are likely to be multiple prices; as it is, there is a spread between EUissued tradable allowances and Clean Development Mechanism (CDM)-generated offset permits; and, if CETs are imposed, then (international) harmonization will inevitably be a long drawn affair.
Institutions and capacities, both domestic and multilateral: New ones may have to be created and existing ones will have to be strengthened for funding, facilitating transfers, monitoring, implementing, etc.

The paper has been motivated primarily to outline and delve into what is entailed—along key dimensions—in bringing about emissions reduction for climate stabilization. In some way, this tack, inter alia, may help to implicitly explain why it has been so difficult to agree on sharing responsibilities and confront other challenges. The plan of the paper is as follows. In the next section, I briefly review the desired quantum and possible timeline for global carbon abatement for minimizing the likelihood of irreversible climate change. The subsequent two sections explore promising approaches in the transport and power sectors that are likely to be at the crux for halving energy-related emissions by 2050. Also in these sections, the indispensable technologies are described and the obstacles in the way of routine commercialization are explained. I analyze the “well-to-wheel” strategy for curtailing use of liquid hydrocarbon fuels and associated discharge in the transport sector in the context of rising incomes driving increasing aspiration for personal transport in the coming decades. The role of decarbonizing the electricity sector is underscored, and the chasm that has to be crossed in reaching emission targets in this area is critically drawn to attention. Next, I evaluate the relative merits of worldwide carbon policy mechanisms that are crucial for incentivizing a low-carbon outcome. Specifically, we look at how best to dynamically price emissions through markets-based instruments. A case is made for establishing explicit rules rather than unfettered discretion for policy makers. In the absence of other credible instruments for helping developing countries with costs of mitigation, suggestions are made for widening the scope of the CDM, as also strengthening its integrity. Following on, the subsequent section assesses the scope for financial help for developing countries from the rich nations towards mitigation. The final section has conclusions.

Downloads

Download

Authors

Urjit R. Patel

India and a Carbon Deal

Urjit R. Patel — Mon, 02 Nov 2009 13:29:00 -0500

There is an emerging consensus among governments that aggressive climate change mitigation would be desirable, though they remain bitterly divided about how the associated burden should be shared. The Government of India has made a commitment not to allow the country's per capita emissions to rise above per capita emissions in the advanced countries (ACs). Developing Countries (DCs), more generally, have concomitantly demanded that every person on earth should have the same emissions rights over the atmospheric global commons.

In a paper recently published by the University of Oxford's Smith School of Enterprise and the Environment, Vijay Joshi and I argue that an attractive criterion for burden sharing could involve emissions permit allocation to each developing country to prevent the estimated welfare loss it would suffer from undertaking (costly) climate mitigation (in other words, a "no harm" principle for DCs). We are strongly attracted to this norm as a reasonable compromise between fairness to DCs and acceptability to ACs. We argue that India should reconsider its stance and negotiate to join a mitigation treaty, say in 2020, if it can negotiate a fair deal on the above basis.

The paper brings to notice that over 40 percent of Indians do not have access to electricity, and coal will continue to be the dominant fuel for power generation in India (and, indeed, elsewhere). However, carbon capture and sequestration (CCS), is expensive and will almost double the cost of electricity from coal-fired stations, which consumers in poor countries will simply not be able to pay. In this regard, sale of permits by India would help to fund the installation of clean coal technology to existing and new coal-fired power plants, and India would be compensated for the cost of cutting future emissions for several decades.

We observe that any questioning of India's effort toward curtailing emissions would need to recognise, inter alia, the contribution to "net carbon taxes" of present (and past), often heavy, taxation of energy. A very rough and ready proxy calculation indicates that the net taxation (after deducting subsidies) on petroleum entails an "emissions tax" of about $49/tonne of carbon dioxide emitted from this source in 2007. On the other hand, emissions from coal are (implicitly) "taxed" at around one dollar per tonne, and for the energy sector as whole, emissions (on average) are "taxed" at about $6/tonne.

We conclude that it is in India's interest to help reach a new settlement if it is fair and rich countries agree to significant emissions cuts of their own. India's co-operation could prompt China and the U.S. to follow suit and win "first-mover advantage" in carbon permit allocations. An additional benefit could include a seat on the U.N. Security Council.

Authors

Urjit R. Patel

Infrastructure in India: The Economics of Transition from Public to Private Provision

Saugata Bhattacharya and Urjit R. Patel — Tue, 27 Oct 2009 00:00:00 -0400

This paper was originally published in the Journal of Comparative Economics.

Abstract

Indian infrastructure is in a state of flux. The provisioning of infrastructure services in India is steadily moving away from the realm of government to that of private sector. The critical issue has been getting economic structures right; in those sectors where there has been a recognition (and systemic implementation) of the principles of appropriate market structures, competition, and measured regulatory oversight, development has been rapid. The outcomes have varied by sector, with Indian telecom providing services that are globally cost-effective and electricity remaining a nightmare for consumers and a major bottleneck for India’s continuing growth. While a few ports have significantly increased their efficiency, the ports sector overall remains behind international benchmarks. The initial remarkable spurt in the National Highways Development Project enabled (and probably to an extent, fuelled) growth, and brought in some of India’s most innovative policy responses, but there has been a slowdown in momentum in expanding the programme. In recent years, there has simply not been the requisite (political) commitment to ownership of the innovation and motivation that is needed to sustain the pace of reform in key infrastructure sectors.

Downloads

Download

Authors

Saugata Bhattacharya
Urjit R. Patel

Publication: Journal of Comparative Economics

The Challenges of Emissions Trading

Urjit R. Patel — Fri, 16 Nov 2007 12:00:00 -0500

There are two principles for reducing greenhouse gas (GHG) emissions efficiently. First, abatement should occur up to the point where the costs of going any further would outweigh the extra benefits. Second, a common price signal across countries and sectors ensures the most cost-effective reductions.

On efficiency grounds, a global price of carbon is unexceptionable. The benefits and costs of action should be thought of in terms of the expected impacts on wellbeing over time, appropriately discounted. At a simple level, the price of carbon is determined at the point where the downward sloping marginal benefit from emission reduction (“demand”) curve intersects the (upward sloping) marginal cost of reducing emissions curve (the familiar scissors of economics 101!). The price signal (tax) should trend upwards over time as the social cost of carbon is likely to increase as concentrations rise towards the long-term stabilisation goal (it is not an easy tax to implement).

Although science informs us that the ‘social cost’ of emitting a tonne of GHGs is independent of where in the world it is emitted, there are obviously significant differences in marginal abatement cots across locations due to differences in rates of output and emissions growth, as well as differences in the structure of economies and energy sectors. If the carbon price across countries is not broadly similar, there will be unexploited opportunities to abate an extra tonne of GHG more cheaply in one country compared with another. Current estimates of the social cost of carbon are much higher than the marginal abatement cost today. The academic literature provides a range of estimates of the social cost of carbon, from $0/tonne to over $400/tonne. The mean value of estimates in recent surveys has values around $30/tonne, and there are studies with a lower figure.

Broad agreement on a common global emissions target will necessitate requisite and predictable subsidies to developing countries (for on-the-ground diffusion of carbon emission abatement technology). Advances in technology will have to be viewed as global public goods; furthermore, the intellectual property right regime may have to be relaxed as part of a multi-pronged strategy (as in the case of anti-AIDS drugs). The incremental costs of low-carbon investments in developing countries will be substantial, estimated in the range of $20-30 billion/year. Supporting reduction in costs of low GHG emitting technologies (such as fuel cells, for example) is critical and estimates suggest that the Global Environment Facility (GEF) would require a ten-fold increase in funding to accomplish this (since inception in 1991, the GEF has provided $6.2 billion in grants).

It may prove difficult to use taxes to evolve a common price signal in the absence of political commitment to move towards a harmonised carbon tax across countries. A common price signal can also be delivered through tradable quotas. To the extent that a tradable quota scheme embraces different countries and sectors, it may be an effective way of delivering a consistent price signal, though this requires agreement on the mechanics of the scheme, not least appropriate initial distribution of quotas. Equally important are monitoring, reporting and verification (MRV) rules to ensure that a tonne of carbon emitted or reduced in one factory is equal to a tonne of carbon emitted or reduced in another factory.

Emissions’ trading is not new to environmental policy, for example, trading in emissions has been used successfully since 1995 (under the US Acid Programme) to reduce sulphur dioxide and nitrous oxide emissions that cause acid rain. The biggest plans for new emissions trading market are in the US through the Regional Greenhouse Gas Initiative from 2009, and California’s plans for using a cap-and-trade scheme from 2008 to reduce emissions by 25 percent by 2020. The voluntary market for carbon reductions is also growing (Chicago Climate Exchange is an example).

The Kyoto Protocol (KP) binds participating developed countries to legally binding commitments to reduce their overall emissions of a basket of six GHGs by at least 5 per cent below 1990 levels over the first commitment period 2008-2012. In effect, an overall national quantity ceiling or quota has emerged for each signatory. The KP, very importantly, but less heralded, has established the institutional basis for monitoring, reporting and verifying emissions to build up a registry of ‘emissions inventory”; it is too early to assess with confidence the accuracy and effectiveness of the system on this dimension (accurately measuring emissions is neither inexpensive nor easy).

The EU’s Emissions Trading Scheme (ETS) launched in January 2005 is the first international emissions trading scheme covering about 40 percent of EU emissions, with the permit market over the three-year period worth around $115 billion (2 billion allowances/year with the average allowance price of $19). The EU states decide through their National Allocation Plans (NAPs) the allotment of emissions allowances within their country. In the ETS, allocation decisions were based on projections of business-as-usual (BAU) emissions that were overestimated, with the result that it was hardly effective for curbing emissions; the total EU allocation turned out to be just 1 percent below the BAU scenario! In contrast, earlier successful emissions trading schemes such as the US Sulphur Dioxide trading programme, had allocation levels at around 50 percent below baseline emissions. In mature economies where the composition of sectors/industry is relatively stable, allocations are easier to make than in (developing) countries where the industry structure is more dynamic and less settled; there is a distinct possibility that allocations can turn out to be entry barriers (license-permit raj) for new firms.

Apart from naming and shaming non-compliant parties, the KP suffers from the usual and challenging time inconsistency problems of legally binding rules that have little by way of tangible sticks and carrots to elicit behaviour congruent to the objectives underpinning the initiative. However, while enforceability at the international level may be impossible, national governments can enforce tougher standards in the manner analogous to that is deployed for ubiquitous and long-standing pollution benchmarks that are in place in practically all countries.

Authors

Urjit R. Patel

Publication: Business Standard

The Subprime Mortage Crisis and Central Banks: a Rock and a Hard Place

Urjit R. Patel — Sun, 11 Nov 2007 12:00:00 -0500

The recent turbulence originating in the US sub-prime market led to rumours (and fear) as far away as Europe of collapse of intermediaries with concomitant concerns for the banking system. It led to comments and actions by relevant authorities, including politicians, that added to the uncertainty amongst the general public and market participants, which was most starkly observed in the context of UK’s fifth largest mortgage lender, Northern Rock (NR). An examination of the sources of confusion goes to the heart of two much-debated issues: (i) the separation of powers with respect to monetary control and financial supervision; and (ii) the practical limits to central bank independence. Briefly, proponents of separation argue that close connection with banks (a form of moral hazard) leads to bad monetary policy, while those arguing for a combined role say that the central bank should be concerned with the health of the banking system (from the perspective of preserving the efficacy of a monetary policy transmission channel).

The purpose of the article is not to apportion blame for the problems emanating from the NR matter, but rather to draw some lessons from an institutional point of view. The two aspects that pricked our interest are (a) the time lag between the financial sector supervisor (Financial Services Authority (FSA)) sharing its concerns with both the Treasury and the Bank of England (BoE) that NR “was systemically significant in the market conditions prevalent at the time”, and the media leak from the Treasury assuring liquidity support from the BoE (and a subsequent announcement that effectively guaranteed all deposits); and (b) the perception among stakeholders that there was a lack of clarity among UK’s financial decision makers, who are respected for professional sophistication and prompt action.

As India assimilates international best practices in the financial sector, the subject matter is important. Two sources of moral hazard – ownership and investment banker to the Government of India – that impact on the conduct of monetary policy have already been addressed in India. The RBI has divested its stake in financial intermediaries, and a government debt office at the Ministry of Finance will raise resources to finance the fiscal deficit; both changes are unexceptionable. However, an examination of recent events in the UK may lead to a re-evaluation of the debate for further changes in the institutional design related to the conduct of monetary policy, banking supervision, and the role of the government.

A plausible explanation of the manner is which the NR crisis was handled is that the FSA and the BoE did not see eye to eye. The Chairman of the FSA in his memorandum to the Treasury Committee admitted that he had a “slightly different” view from the BoE regarding the balance to be struck between preventing moral hazard and action to halt a crisis. Could it be that the BoE did not have faith in FSA’s analysis and assessment about the prospects of systemic risk if NR were to go belly up? Would BoE have come to a different conclusion if it had an informal feel about what was actually happening in the credit market and not just the formal information from the FSA?

Obviously the one critical dimension is coordination for effective action. There is something to be said in favour of a hierarchical structure as it can help to obviate delay on account of having to reach a consensus with counterparts at a coordination forum (in the UK, the Tripartite Coordination Committee comprises of the FSA, the BoE and the Treasury). In the present context, analogy with medicine is instructive. A radiologist (a fully qualified doctor, in his own right) takes x-rays and gives the specialist the films with a report; given the hierarchy in the medical field, the radiologist would not hold anything back and there is no question of the specialist being required to coordinate with the radiologist on the treatment for the patient. A recognised notion of primus inter pares keeps the wheels moving smoothly.

Conceptually, an important aspect of who is responsible for banking supervision is determined by who bells the cat. If rescues are primarily by the central bank (through, inter alia, lender of last resort/liquidity facility) then the central bank is a natural candidate for supervision accountability. If a rescue is financed on an explicit government fiscal basis, or, even deposit insurance then there is a good case for a separate government agency for supervision (in the UK, the latter model is in place). We occasionally forget that bailouts usually entail some form of taxation. Even the central-bank financed rescue – involving some form of liquidity injection – is taxation of the general public through seignorage (or inflation tax) and as such it is part of the government’s budget identity deployed by public finance economists to ascertain sustainability of the fiscal stance. Once the government is brought into the picture (given the fiscal dimension), then its views are paramount. Some would argue (sniff) that the system the current UK Prime Minister put in place when he was Chancellor has been undermined by the politics of wooing Middle England.

Monetary policy (and inflation targeting) is only one aspect of public policy so when other dimensions emerge, overriding the narrow mandate of a central bank can be rationalised. Some of the positions (“corner solutions”) parlayed in the Indian context about responsibility and mandates are not as clear cut as they are made out to be; nuance and subtlety is bread and butter of macroeconomic management, and can be ignored by stakeholders only at their peril. Economists feel smug about their insight regarding the merits of an independent (and narrow) central bank. Actually it is politicians who are smart; it helps to have a central bank (designated as independent) that can be blamed for taking away the punch bowl just when the party is getting started, but it can also overrule the central bank and be seen on the side of depositors, who also happen to be voters.

Authors

Urjit R. Patel

Publication: Business Standard

Global Climate Change: A Stern Warning

Urjit R. Patel — Fri, 26 Oct 2007 12:00:00 -0400

In a previous article, BS 16 October 2007, I had commented that the proximate reason why reaching consensus on the scale, speed and durability of global warming has been painstakingly slow is the inherent uncertainty of the subject. Having said this, there is not only no dispute over pertinent facts, there is now also convergence from diverse sources over projections about the future (regarding climate science, the Intergovernmental Panel on Climate Change (IPCC) has been the key non-partisan multinational forum). The associated estimates of the costs, including on human capital (comprising adverse consequences for agriculture, forestry, water cycles, mortality from vector-borne diseases, coastal zones, and heat stress), are provided in Stern Review: The Economics of Climate Change (SR, hereafter), which is a magisterial state-of-the-knowledge primer on facts, risk assessments, challenges and policies for confronting global warming.

At the outset, here are some facts. (i) Accurate and widespread temperatures are available for only the last 150 years, thus a large component of temperature records are rebuilt from “proxy” sources such as tree rings, ice cores, lake sediments etc.; (ii) the earth has warmed by 0.7^oC since 1900, of which the last three decades account for 0.6^oC, resulting in the global mean temperature elevated to what is probably at or near the warmest level reached in the current interglacial period (i.e., between ice ages); (iii) the ten warmest years on record have occurred since 1990; and (iv) Earth’s natural capacity to remove greenhouse gases (GHGs) from the atmosphere is considerably less than current emissions (only about a fifth).

The scope of the challenge can be gauged when it is appreciated that every type of modern economic activity contributes to GHG emissions. Power, including emissions from petroleum refineries, accounts for one-fourth of all global GHGs. Changes in land use, mainly driven by deforestation in countries like Brazil and Indonesia, account for 18% of GHGs. Transport, industry and agriculture account for 14% each of GHG emissions (it may be surprising to see agriculture in the list which is mainly on account of fertiliser use and livestock).

Declines in both carbon intensity of energy and energy intensity of output have slowed growth in global emissions of GHGs, but total emissions have still risen because of income and population growth. In the recent past, income growth/head has tended to raise global emissions by 1.9%/year whereas reductions in global carbon and energy intensity have tended to reduce them by the same quantum; however, since world population has grown by 1.4%/year, aggregate emissions have gone up. CO₂ emissions/head have been strongly correlated with GDP/head across time and countries, which is not entirely surprising when we consider, for instance, how personal transport evolves: as a family becomes wealthier, the scooter gives way to the compact car, in turn followed by the mid-sized car, which is overtaken by the sedan, and, eventually, the SUV.

Calculations indicate that direct warming effect from a doubling of carbon dioxide concentrations (known as climate sensitivity) would lead to an average surface warming of 1^oC. But this is not all, the full warming effect of past emissions is yet to be realised; climate models project that the world is committed to a further warming of 0.5^o- 1^oC over several decades due to past emissions only. By comparing predictions of different climate models, the IPCC Third Assessment Report (IPCC TAR) concluded that the likely range of climate sensitivity is 1.5^o- 4.5^oC. Using this range, if GHG levels could be stabilised at current levels, global mean temperatures would eventually rise to around 1^o - 3^oC above pre-industrial (meaning on average up to 2^oC more than today); therefore, stabilising GHGs at current levels, is unlikely to save us from serious adverse implications. Even more disturbing, some recent studies have shown up to a 20% chance that climate sensitivity could be greater than 5^oC. Temperatures may already be at the limit of human tolerance (peak temperatures in the Indo-Gangetic Plain presently exceed 45^oC). In cities heat waves will become increasingly hazardous with the urban heat island effect leading to extreme temperatures and more dangerous air pollution episodes. There is also a (rare) silver lining; for example, in northern latitudes global warming may lead to fewer cold-related deaths.

The effect of climate change will be most acutely felt through changes in the distribution of water around the world, and its seasonal and annual variability. Impacts, however, are likely to be uneven. The water cycle will be intensified with drought and floods becoming more severe in many parts, e.g., the Mediterranean, parts of Southern Africa and South America are likely to experience further deceases in water availability; on the other hand, South Asia, parts of Northern Europe and Russia are likely to experience increase in water availability (runoff).

Developing countries are especially vulnerable to climate change on account of geography, low incomes (which undermines adaptive capacity), and greater reliance on climate-sensitive sectors such as agriculture. Climate scenarios reveal that the most serious impacts are likely to be in Africa, the Middle East, India and South East Asia (“tropical geography has a substantial negative impact on output density and output per capita compared to temperate regions”). By the middle of the century, 150-200 million people may become permanently displaced due to rising sea levels by flooding from coastal storm surges (again, South and East Asia will be most vulnerable). In SR’s baseline climate scenario for estimating the economic costs of global warming, the mean cost to India and S. E. Asia is around 6% of regional GDP in the long run, compared with a global average of 2.6% of GDP. We can ill afford to be smug, the SR cogently observes: “India’s economy and social infrastructure are finely tuned to the remarkable stability of the monsoon, with the result that fluctuations in the strength of the monsoon both year-to-year and within a single season can lead to significant flooding or drought, with significant repercussions for the economy”.

Authors

Urjit R. Patel

Publication: Business Standard

The Heat Is On

Urjit R. Patel — Tue, 16 Oct 2007 12:00:00 -0400

Climate is a classic public good, non-excludable and non-rival; in other words, those who don’t pay for it cannot be excluded from enjoying its benefits, and one person’s enjoyment of the climate does not diminish the capacity of others to enjoy it too. Conversely, if one person damages (or improves) it, he does it for everyone (including future generations) and himself; in addition, the full cost is never borne by the individual responsible for the damage so there is no economic incentive to preserve the atmosphere. We continue to depreciate environmental capital – call it “E-capital” – without provisioning for it. It helps to think of “E-capital” as interacting with all other inputs of production in a Leontief structure, which in plain language means that we need a minimum irreducible amount of it for practically everything that we do (it cannot be substituted). The quantum of greenhouse gases released in the atmosphere each year, of which carbon dioxide is the most prevalent, are much higher than what nature can absorb (ocean and land are natural “sinks”), hence the problem. The greenhouse effect is a natural process that keeps the Earth’s surface around 30^oC warmer than it would be otherwise; without this effect all the infrared radiation would escape to outer space and the Earth would be too cold to support life.

While the effects of climate change are negative global externalities in the sense that the damage from emissions is broadly the same irrespective of where they are emitted, impacts are likely to be felt unevenly around the world. The most omprehensive treatment of the risks, challenges and policy instruments that are central to the task of confronting global warming is provided in Stern Review: The Economics of Climate Change (SR, hereafter). The proximate value of SR is its potential to coalesce the (national and global) policy debate, in other words, get stakeholders to at least read from the same page; in fact, it has already made admirable strides in this direction in a few short months. Yes, it is possible that the increase in global mean surface temperature over the last three decades is part of natural variability (cycle) which may correct itself (as opposed to a trend), even as we continue to have a ball with our SUVs and temperature-controlled football stadiums. The cerebral former President of Czechoslovakia, Vaclav Havel, in a recent article likened human beings interface with the environment as borrowing from the future: “ . . . the Euro-American world has been running up a debt, and now other parts of the world are following its example . . . Maybe we should start considering our sojourn on Earth as loan”. (The “excess” analogy is striking with monetary overhang of recent years primarily fuelled by the US Federal Reserve Bank under the not-so-iconic-anymore Alan Greenspan.) It may be no exaggeration to assert that global warming may be the (longest and) most painful hangover that the world is waking up to. The intertemporal nature – essentially, inheritance from the past and endowment to the future – of aspects related to the environment is not new. In his commentary on the Bhagavad-Gita, Gandhiji wrote: "In burning wood [from forests] in this age, we misuse the capital of our forefathers . . . " (emphasis added).

The methodology deployed by climate scientists is a primary reason why reaching consensus has been painstakingly slow. Models that can replicate past developments and trends is the primary tool that scientists use to assess the power of diverse models (which, in turn, are grounded in researchers hypotheses); the methodology, almost by definition, entails a combination of past observations, some estimated relationships and many assumptions. The balance of climate science evidence that has accumulated suggests clearly (at least in the mind of scientists) that while natural factors such as changes in solar intensity and volcanic eruptions can explain much of the trend in global temperatures in the 19^th century, rising levels of greenhouse gases provide the only plausible explanation for the observed trend for at least the past fifty years.

The link between greenhouse gases (GHGs) and climate change comes about from rising atmospheric GHGs changing the energy balance, in turn leading to rising atmospheric and ocean temperatures comprising of local and global feedbacks, for example, changes in clouds, water content of the atmosphere and the amount of sunlight reflected by sea ice. In Integrated Assessment Models (IAMs), the workhorses for cost estimates of global warming, the causality runs from economic activity to emissions to atmospheric concentrations to global climate to regional weather to market and non-market impacts comprising adverse consequences for agriculture, forestry, water cycles, coastal zones, ecosystems as well as mortality from vector-borne diseases, heat stress and cold stress. The SR recognises that the entire subject area is fraught with uncertainty, and hence deploys tools that allow outcomes to vary statistically with the odds calibrated to the latest scientific quantitative evidence on particular risks. Cost estimates of global warming based on IAMs, underscore the need for a modelling approach based on probabilities (deploying Monte Carlo simulation), which means that a scenario is run many times (as many as 1000 times), each time choosing a set of uncertain parameters randomly from pre-determined ranges of possible values. In this way, a probability distribution of results is engendered rather than just a single point estimate. It yields a probability distribution of future income under climate change, where climate-driven damage and the cost of adapting to climate change are subtracted from a baseline GDP growth projection.

Global warming is an outcome of the "mother" of all market failures or, to put it another way, on account of the biggest free lunch in history (interestingly, CO₂ had not been identified as a pollutant until about twenty years ago). Targeting reduction of the stock of GHGs is an efficient way to control the risk of catastrophic change in the long term; it is efficient because it focuses on the source of the externality directly. The challenge to fix the problem requires international coordination (at the least, understanding) on a commensurate scale. Therefore, the flurry of recent meetings and conferences in Vienna, Washington, and Sydney on global warming have been exceptionally important on the subject of “grazing” the global commons and then rehabilitating it; the term grazing is apposite because starting from the industrial age, we continue to depreciate the atmospheric environment endowed to us.

Subsequent instalments will, inter alia, summarise and review the scope of the challenge, the facts, the costs of addressing the problem, extant state of international cooperation, and the economic opportunities for emissions reduction. The next piece is titled, "A Stern warning".

Authors

Urjit R. Patel

Publication: Business Standard

Global Agenda Forum

Tue, 20 Feb 2007 10:00:00 -0500

Event Information

February 20, 2007
10:00 AM - 5:00 PM EST

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

As the forces of globalization gain strength and speed, the challenges and opportunities presented to policymakers, corporate heads and civil society leaders have grown more complex. The Brookings Global Agenda Forum, hosted for the first time on February 20, 2007, spotlighted the top international challenges for the year and offered in-depth, exclusive analysis.

As part of the forum, Brookings Global released the 2007 Top 10 Global Economic Challenges report, which ranks the most pressing global economic issues as viewed by Brookings experts and offers policy recommendations.

View the Global Agenda Forum program
Read the bios of forum participants
Read the 2007 Top 10 Global Economic Challenges report

Brookings: Experts - Urjit R. Patel

The Gold Effect on Inflation

Authors

Golden Age of Gas

Authors

More Elbow Room for India in Gas Contracts

Authors

Regaining Fiscal Credibility in India

Authors

Dynamics of Inflation "Herding": Decoding India's Inflationary Process

Downloads

Authors

Public Finance and the Energy Sector in India

Authors

India's Budget: Deft Political Management (and Some Luck) Needed for Fiscal Consolidation

Authors

Assessing the Investment Exuberance in India’s Power Sector

Authors

Does the Exuberance in the Indian Power Sector Have Legs?

Downloads

Authors

Liability Legislation for Indian Nuclear Energy Business is Enacted

Authors

Crucial Deadline for Nuclear Energy Business in India

Authors

Indian Fiscal Rules: Framework and Critical Review of Outcomes and Design

Authors

Decarbonization Strategies: How Much, How, Where and Who Pays for a Rise of 2 Degrees Celsius?

Downloads

Authors

India and a Carbon Deal

Authors

Infrastructure in India: The Economics of Transition from Public to Private Provision

Downloads

Authors

The Challenges of Emissions Trading

Authors

The Subprime Mortage Crisis and Central Banks: a Rock and a Hard Place

Authors

Global Climate Change: A Stern Warning

Authors

The Heat Is On

Authors

Global Agenda Forum

Event Information

Transcript

Event Materials