Graphical summary of the China risk in the global energy transition

This post will provide a graphical summary of China's overwhelming importance in achieving the global energy transition. It covers renewables manufacturing, renewables generation, critical minerals refining, batteries, and electric vehicles. This, this, and this are three reports in recent times by US think tanks examining the Chinese dominance of critical minerals for the energy transition and how to address it. 

Let's start with renewables manufacturing. Graham Allison writes on China's dominance of the solar generation industry

China manufactures 80 per cent of all the solar panels produced globally. And, as the IEA notes, China’s dominance is even more pronounced when one examines the entire supply chain. It produces 85 per cent of the global supply of solar cells, 88 per cent of solar-grade polysilicon, and 97 per cent of the silicon ingots and wafers that form the core of solar cells. China’s rise to dominance in solar has been rapid. In 2005, Europeans led this race, with Germany accounting for a fifth of global solar manufacturing. By 2010, while Europe installed eight out of every 10 solar panels in the world, it produced only one. This year, China will make eight of every 10 solar panels produced worldwide and add five of those to its grid. In 2023 alone, China will install more new solar capacity than the US has deployed since Americans bought their first panels in the early 1970s.

It dominates poly silicon production

Its dominance of the clean energy manufacturing investment has only increased over time

So has the market share of clean energy technology exports

This is a staggering level of dependence,

China for example last year exported 86.6GW of solar panels to Europe, a 112 per cent increase on 2021’s figure, according to InfoLink Consulting. “If we are going to hit our 2030 [climate] targets we need China,” says Jacob Kirkegaard of the Peterson Institute.

The SCMP has a four part series on China's dominance of the electric vehicle supply chain. 

China dominates the EV supply chain as 76 per cent of the world’s production capacity for batteries – they make up 40 per cent of a typical EV’s sticker price – is in the country, with Contemporary Amperex Technology Limited (CATL) and BYD among the world’s top three producers. Fujian-based CATL alone controls a third of the entire global battery market... The country also controls more than two-thirds of the components needed to make them... China is also home to 70 per cent of the global production capacity for cathodes and 85 per cent for anodes, both key battery components, according to the International Energy Agency (IEA). Over half of the world’s lithium, cobalt and graphite processing and refining capacity is located in China... Two-thirds of the 10 million EVs sold worldwide last year were in China, helped by a slew of government policies dating back to 2009 that include subsidies, tax breaks and procurement contracts.

This illustrates the dominance of electric vehicle components and batteries.

And this points to the dominance in the processing of the critical minerals used in EVs

This is a good illustration of China's importance to the EV supply chain

And more on processing capacity

The Times primer captures the entire value chain, right up to final EV production, where China makes 54% of global EVs. 

This is a good summary of the geographical distribution of the entire EV supply chain.

This is a good summary of the different kinds of support the Chinese EV industry has gotten over the years. It has included a ten-year consumer subsidy program that ended in 2022 which reimbursed consumers as much as 60,000 yuan (~$8000), waiver of a 10% levy on smaller EVs till 2025, other tax breaks, manufacturing subsidies, government-funded charging infrastructure (6.36 million chargers, the largest in the world, and 649,000 chargers added in 2022, which is more than 70% of global additions). Several hurdles have been put to disincentivize ICE vehicles - license plate prices in auctions in Shanghai averaged 92,780 yuan last year whereas green license plates can be easily obtained; a tradeable dual-credit system for automobile manufacturers since 2017 that awards points for making clean cars and penalties for those with high fuel consumption, and producers with negative scores may be taken off the market. These were complemented by large purchases by governments at all levels and public transport networks. 

The result is that EVs made a quarter of all car sales last year, compared to one in seven in the US and one in eight in Europe. Including plug-in hybrids, clean-car sales hit 5.67 million in 2022, more than half of all global deliveries and 60% of the world’s 14.1 million new passenger EV sales this year. 

Rana Faroohar points to a German Marshall Fund paper that points to China's dominance of the rare earths market

As the GMF report notes, China controls 61 per cent of global lithium refining, and 70 per cent of the global supply of cobalt for lithium ion batteries comes from mines in the Democratic Republic of Congo, many of which are owned by the Chinese. China controls 100 per cent of the processing of natural graphite used for battery anodes, and 80 per cent of the total rare earth production and processing.

China's dominance of the supply chain for critical minerals is captured in the graphic below

This is a good summary of the drivers of the country's dominance in these markets, 

The factors driving China’s success in this arena are the same ones that have made it the uncontested manufacturing workshop of the world. These include low-cost capital, rapid regulatory approvals, protection from foreign competition, lower labour costs, an unparalleled network of suppliers, and fast-growing domestic demand.

In addition, China also dominates the supply chain for critical minerals used for defence purposes, or "war minerals". They include minerals like gallium, germanium, and indium that are critical for military equipment like lasers, radars, and spy satellites. These minerals have little commercial value and are mined and refined only in very small quantities. Sample this from The Economist

Antimony, known in biblical times as a medicine and cosmetic, is a flame retardant used in cable sheathing and ammunition. Vanadium, recognised for its resistance to fatigue since the 1900s, is blended with aluminium in airframes. Indium, a soft, malleable metal, has been used to coat bearings in aircraft engines since the second world war... Long before cobalt emerged as a battery material, nuclear tests in the 1950s showed that it was resistant to high temperatures. The blue metal was soon added to the alloys that make armour-penetrating munitions. Titanium—as strong as steel but 45% lighter—also emerged as an ideal weapons material. So did tungsten, which has the highest melting point of any metal and is vital for warheads. Tiny amounts of beryllium, blended with copper, produce a brilliant conductor of electricity and heat that resists deformation over time... Gallium goes into the chipsets of communication systems, fibre-optic networks and avionic sensors. Germanium, which is transparent to infrared radiation, is used in night-vision goggles. Rare earths go into high-performance magnets. Very small additions of niobium—as little as 200 grams a tonne—make steel much tougher. The metal is a frequent flyer in modern jet engines.

Beyond their varied properties, this group of mighty minerals share certain family traits. The first is that they are rarely, if ever, found in pure form naturally. Rather, they are often a by-product of the refining of other metals. Gallium and germanium compounds, for example, are found in trace amounts in zinc ores. Vanadium occurs in more than 60 different minerals. Producing them is therefore costly, technical, energy-intensive and polluting. And because the global market is small, countries that invested in production early can keep costs low, giving them an impregnable advantage. This explains why the production of war minerals is extremely concentrated. For each of our 13 war minerals, the top three exporters account for more than 60% of global supply. China is the biggest producer, by far, for eight of these minerals; Congo, a troubled mining country, tops the ranking for another two; Brazil, a more reliable trading partner, produces nine-tenths of the world’s niobium, though most of it is sent to China. Many minerals are impossible to replace in the near term, especially for cutting-edge military uses.

The combination of concentrated production, complex refining and critical uses means trading happens under the radar. The volumes are too small, and transacting parties too few, for them to be sold on an exchange. Because there are no spot transactions, prices are not reported. Would-be buyers have to rely on estimates. These vary widely. Vanadium is relatively cheap: around $25 per kilogram. Hafnium might cost you $1,200 for the same amount. All this makes building new supply chains much more difficult.  

On July 4, China announced restrictions on exports of gallium and germanium, that are important in semiconductors, solar panels, and missile systems. This has strategic significance since it highlights the vulnerability of US and other western militaries to such sanctions. In the aftermath of the Cold War, the US has run down its large stocks of strategic minerals and confined its strategic stockpiles to only commodities like oil and gas. 

Such global market-wide dominance by any one country, leave alone by one that's so belligerent and willing to exercise its power as China, should be a matter of serious concern to anyone outside China. 

Update 1 (11.08.2023)

This FT article describes how China came to control the renewables supply chain, focusing on promoting "the whole of supply chain" through a combination of purchases of mines, and the marriage of private sector enterprise and industrial policy in manufacturing and usage.

China is responsible for the production of about 90 per cent of the world’s rare earth elements, at least 80 per cent of all the stages of making solar panels and 60 per cent of wind turbines and electric-car batteries. In some of the materials used in batteries and more niche products, China’s market share is close to 100 per cent... China’s grip on raw materials is “more than it appears”. This is thanks to equity investments in overseas mining operations by Chinese companies such as metals group Huayou Cobalt, carmaker BYD and battery giant CATL. In lithium, for instance, China only has a small share in mining, yet by next year Chinese interests will control more of the resource than the country needs for domestic purposes... 

The country’s overseas metals and mining investments are on track to hit a record this year, according to data published last week by Fudan University in Shanghai. Spending in the first six months of 2023 hit $10bn, more than the total in 2022, and investments this year are likely to surpass the previous annual record of $17bn in 2018... China is the leading producer of at least one stage of the supply chain for 35 of the 54 mineral commodities that are considered critical to the US... China produces a “staggering” 98 per cent of the world’s supply of raw gallium, according to CSIS, despite the product’s US military applications, including in next-generation missile defence and radar systems. In electric-car batteries, for example, China’s share of the raw materials they require is lower than 20 per cent but it holds a 90 per cent share of the market for processed versions of the same materials... The production of graphite, used in the anodes in the heart of a lithium-ion battery, is instructive. While China’s market share of graphite reserves is just over 20 per cent, its market share for graphite processing is nearly 70 per cent... 

More than half of all new wind turbines installed this year will be in China, according to the Global Wind Energy Council, an industry lobby group. In the production of nacelles, which house the turbine’s power generation equipment, China has a market share of 60 per cent. It is currently building more than 60 new nacelle assembly facilities, adding to the 100 already in operation. Further down the turbine supply chain, the GWEC data shows China has more than 70 per cent market share of many crucial components including castings, forgings, slewing bearings, towers and flanges.

This about industrial policy,

Beijing’s cumulative state spending on the EV sector is more than $125bn between 2009 to 2021. Domestic industry was prioritised with heavy-handed local requirements, and from 2016 South Korea’s leading battery makers, LG, SK and Samsung, were cut off from accessing generous subsidies, setting up a boom in CATL and BYD’s battery production. 

This about the inherent advantages that completely distort the playing field for foreign competitors,

The advantages that China now boasts when it comes to manufacturing clean tech products are underpinned by massive economies of scale benefits. Goldman data suggests that China can build an EV factory in about a third of the time it takes in other countries while a battery factory in the US will cost nearly 80 per cent more than in China. Bernstein says the cost of some manufacturing in the US can be three times more than in China. This highlights how China’s rivals must grapple with not only limited access to resources and upfront technology costs, but also labour shortages, wage inflation and higher environmental standards...

Buoyed by massive domestic demand, Chinese manufacturing of polysilicon and its processing results in costs that are two-thirds the price of a European-made product, the IEA says. Chinese wind turbines are half the price of western rivals, according to S&P data. Across these industries, Mazzocco says it is important to credit the role of intense private sector competition. “It is something we miss from the outside: we think it’s just about the subsidies. But in reality, it’s also because [companies] have been able to overcome their competitors within China in an extremely cut-throat environment,” she says. “They are the best of the best at squeezing every cent out of their operations.”

And as if extraction and processing was not enough, China is now seeking to control the trading of clean energy metals. 

China is making a push to dominate the trading of lithium carbonate futures, as it seeks to wrest the financial plumbing linked to metals vital to the clean energy revolution away from the western dollar-based financial system. Last month the Guangzhou Futures Exchange became the fourth global commodities exchange to launch contracts tracking the price of lithium carbonate, a mineral used in the manufacture of electric-vehicle batteries. 

Within three weeks open interest — a key measure of the size of the market — had risen to more than 20,000 lots and far outstripped activity at rivals London Metal Exchange, Singapore Exchange and the US’s CME Group, which had launched its own version just days earlier. The proliferation of futures contracts on crucial elements of electric-vehicle products such as nickel, copper and lithium carbonate in part reflects the growing importance of the industry, as companies up and down the supply chains seek to hedge against price swings. But the early lead established by Guangzhou has underscored how China is seeking to seize greater control over trading in what it sees as a group of metals critical for the 21st century. By establishing its own trading hubs and benchmarks priced in renminbi, the drive is part of Beijing’s efforts to lessen the commodities market’s reliance on the US dollar...

Even so, China’s drive to convert its dominance over the flow of commodities into global pricing power faces substantial hurdles, including using a currency that cannot be freely traded, and the absence of a global warehousing network for any of China’s five domestic futures exchanges. The LME, which is owned by Hong Kong Exchanges and Clearing, does have a network of warehouses outside of China. It also argues its nickel futures contract — which represents the worst quality piece of metal in the worst part of the world — is more representative of the global market. Its pricing system is based on the value traded on its exchange, supplemented with “regional premiums” to reflect local problems such as distribution.

The economic growth-regulation trade-off

How much regulation is too much? 

Works in Progress has a very good article that highlights the trade-off between regulation and economic growth in the context of developed economies in infrastructure construction. The case in point is environmental and other safeguards-related permissions required for infrastructure projects in developed countries. 

Consider this on the prohibitive costs of environmental and other safeguards documentation required to obtain permissions for large infrastructure projects in the US,

1,961. That’s the number of documents contained within a single planning application for a wind farm off the northeast coast of England – capable of powering around 1.5 million homes. The environmental impact assessment and environmental scoping documents alone totalled 13,275 pages. To put that into context, that’s 144 pages longer than the complete works of Tolstoy combined with Proust’s seven volume opus In Search of Lost Time... EDF Energy had to produce 44,260 pages of environmental documentation for Sizewell C, a new nuclear power station to be built on the same site as two existing nuclear power stations in Suffolk, England.... a Freedom of Information request from New Civil Engineer magazine recently revealed that the UK’s National Highways agency spent £267 million preparing a planning application to build a 23-kilometer road. The planning application, which featured 30,000-plus pages of environmental documentation, was the longest ever prepared... 

It takes, on average, ten years for an electricity transmission project to be completed. But before you get to that point, it can take as long as 13 years just to get approval for the project. For example, Harvard’s Belfer Center cites the case of the 732-mile Transwest Express high-voltage transmission line. It applied for its permit in 2007, but did not receive full approval for construction to begin until 2020. It’ll come online in 2026, 19 years after that first permit application was filed... Using the average environmental page count from a sample of 18 projects (11,756) gives us an average per-project cost of £98 million. And that’s before the projects have put a single spade in the ground and before any spending on environmental mitigations has taken place. Think what could be achieved with even half of that nearly £100 million cost per project.

In stark contrast, sample this from history

France responded to the oil shock of 1973 with the beautiful slogan: ‘In France, we do not have oil, but we have ideas’. Over the next 15 years, the French built 56 nuclear reactors. To this day, France gets more than two thirds of its electricity from nuclear power... consider the construction of Britain’s national electricity grid in the 1920s–1930s. In the space of three years, Britain devised a plan to connect over 100 of the UK’s most efficient power stations into seven local grids across the country, and passed legislation needed to enable the plan and begin work on it. It took five more years for the project to be completed, with 4,000 miles of cables running across 26,000 pylons around the country. A year after the seven local grids were built, a group of impatient and rebellious engineers decided it was easier to ask for forgiveness than permission, and switched on the connections between the seven grid areas themselves to form a single national system. That national system remains to this day. It is hard to imagine projects of similar scale taking place today at similar speeds.

This debate has important relevance in the context of developing countries. In many areas, developing countries tend to adopt state-of-art regulations from their developed counterparts - labour standards, environmental protection, corporate and financial markets regulation, etc. In fact, they are actively encouraged to do so by multilateral lending agencies. But this has consequences that adversely impact their growth. 

Regulation is an incremental cost that gets added to the cost of production. It manifests in the form of additional equipment or building or infrastructure, slack or redundancies, increased construction times, etc on the grounds of safety, pollution abatement, employee welfare and working conditions, community welfare, social inclusiveness etc. This is a simple model of how regulation increases costs, lowers demand, and reduces economic competitiveness. 

Therefore, historically, the scope of these regulations has expanded progressively with the country's development. In fact, the historical trajectories of economic growth of today's developed economies point to a Maslowian hierarchy of values. The values associated with a subsistence economy are very different from that of an aspirational middle-income economy or a rich post-modern economy. 

The early development pathway of all today's developed countries, including that of China recently, have been characterized by large-scale externalisation of costs by all economic agents. The industrial revolution happened in a very loosely regulated world. In fact, it could not have happened with the modern world regulations. 

While gains are privatised, environmental and social costs are externalised on the society. Looser regulations and their enforcement, corruption, crony capitalism, etc are inevitable accompaniments to rapid economic growth from a low baseline. Once countries reach a certain income level and command adequate tax revenues, they venture into the higher levels of the values hierarchy. This is a messy reality of development. Nothing has changed to warrant a revisit of this theory of change.

Many developing countries, or regions there, continue to remain in the pre-industrial stage of economic development. Forget the fourth, they are still to fully realise the benefits of the second industrial revolution. In this debate, the irony of developed countries that have enjoyed lighter regulations during their growth phases now turning around and forcing developing countries to adopt tighter regulations should not be missed. 

Further, the commentators and opinion makers in developing countries, who inhabit the post-modern world, too tend to foist the social and economic values they share with the developed countries on the collective choices of their nations. Politicians and policymakers in developing countries should keep this in mind while making policy decisions on regulations.

The problem with this is that once we accept lower regulation, there is a slippery slope of exploitation by all kinds of economic interests. The markets are not known for restraint and social responsibility. So the challenge is to get regulation right. This has to be borne in mind as policymakers in developing countries adopt progressive regulations. 

These aspects should also inform global policy formulation on such issues. The energy transition debate where developing countries are being asked to sharply cut their carbon footprints at a very early stage in their economic growth is a case in point. Steep cuts and rapid changes by developing countries will erode their global competitiveness, besides also raising questions of affordability and market demand (see this and this). It's also an existential issue for people in many developing countries - poverty will get you before climate change can. I'll write about this in the coming days.

Examining more myths on energy transitions

Happy New Year!

I'll kick off the new year with a post questioning some principles of one of the most powerful enduring narratives, on energy transition. In an earlier post, I had shown using an economic model how economic transitions impose costs, whose allocation is always a problem. 

Consider these claims. There are trillions of private dollars waiting for opportunities in developing countries, especially in infrastructure sectors. There are hundreds of billions available for investment in green energy projects. There are tens of billions waiting to invest in businesses that help the poor. 

There are powerful proponents and supporters of these narratives that it's almost impossible to make a contrarian voice heard. These supporters are very rarely the capital providers themselves, but consultants, think-tanks, boosters, commentators, do-gooders, lobbyists, retired investors, philanthropists, and so on. 

For practitioners who engage from the other side of attracting these trillions and billions (like governments,  and green energy and impact entrepreneurs) and who have experienced the repeated frustrations from such engagements, nothing could be farther from the truth. I feel the same would apply to fund managers and investors who taken in by the hype trawl the market only to find little of substance. These are all pure ideological tropes at best, self-serving market making advocacy at worst. 

I have blogged on multiple occasions and written a long paper here questioning these narratives. The essence is this. The amount of foreign private capital available for infrastructure, green energy, and development in general for developing countries is much much smaller than is claimed. The risk appetite and returns expectations of the trillions of investment capital sloshing around is very different from that available (or even possible) in/from developing countries like India. After all, even theoretically these are different asset categories. Besides there are fundamental mismatches - foreign capital investment and local currency revenues.

For sure the regulatory environment can be improved and government policies can be made more predictable. And the envelope of investible projects can be expanded with support from development finance institutions. But these are all tinkering at the margins compared to the requirements. A continental economy like India can make large strides on its energy transition predominantly only with domestic capital, which includes significant concessional capital from its government. And it also requires demand-side acceptance of some of the costs associated with these transitions - see this for a model for economic transitions. 

A recent oped in Business Standard was effusive on the foreign capital supply-side of the climate financing problem, 

Climate financing for investment is a largely solved problem: The highway to near-infinite resourcing from foreign capital has been established in the form of ESG investment. This involves pensioners and insurance customers in DMs who get a sub-market rate of return for their investments in return for funding the Indian energy transition. Global ESG investment has reshaped the facts on the ground in investment finance in Mumbai.

The confidence - "largely solved problem", "near-infinite resourcing from foreign capital" etc - is mind-boggling. Such articulation does tremendous dis-service to the cause itself. It reinforces the already strong narrative of private and foreign capital being the solution to many complex development problems. It misleads the highest level decision-makers and forces policy makers into expending their efforts chasing chimeras. 

The oped then lays the blame for the lack of availability of demand side on the easiest target, governments.

The ESG world is quite able to support the Indian energy transition, subject to the limitations of present and future Indian financial regulation, capital controls, tax policy and rule of law. It is now hard to find financial closure for fossil fuel energy businesses in Mumbai. It is easy to find financial closure, at concessional rates, for economically sound clean energy businesses. 

The climate financing glass is thus half full for the Indian energy transition. On the one hand, infinite capital is available from the global financial system for sound projects. But on the other hand, there are limitations in the Indian electricity sector that limit what is possible. Our foundational problem is that we have an electricity sector that operates through state control instead of one which operates through the price system.

This is illustrative of a typical problem with armchair prescriptions. Such prescriptions are made on the assumption that there is a clean slate and governments have the agency to do whatever is technically right. 

Consider the problems with the above. India is what India is. Its financial market regulation, for sure, could and will improve. Its bond markets will deepen. Taxes will come down. But it's not at all clear that all this deregulation and lower taxation will lead to significant increases in capital inflows.   

On reforms to the electricity sector as a whole, it's easy enough to advocate cost-recovery pricing. In a country which is poorer than conventional wisdom appreciates, and where meaningful pricing reform on the farm power side is years away, the accounting reality is that aggregate cost recovery tariff schedule, even with cross-subsidisation, will require significant increases in tariff for the lowest category of consumers and large increases for middling consumers. Would our political economy, the shaping of which is a responsibility of the same commentators, allow any government to survive an electoral cycle after having raised tariffs as proposed? As Jean Claude Juncker famously said, we'll know what to do, but the problem is to win elections after having done that.

I have yet to see an oped by any esteemed commentator illustrating how less in purchasing power terms our higher category electricity consumers pay compared to similarly placed consumers in developed countries. Or a research work documenting the extent of farm power subsidy captured by undeserving large farmers, or a campaign exhorting governments to end free power subsidies to those large farmers. Most importantly, apart from articles blaming governments, I have not seen any oped or sustained efforts which seek to marshal hard facts to mobilise public awareness campaigns that creates the political space to undertake reforms.  

Take the example of privatisation of power sector assets, as a source to finance one-time expenditures. For a start, these are heavily regulated assets, whose upside potential is tightly capped. Further, almost all public sector generation and distribution companies have significant volumes of unregulated debt on their balance sheets. Besides, many also carry on their balance sheets debts raised on behalf of their state government to finance subsidies, debts which cannot be assumed by fiscally constrained governments. Finally, the political economy related uncertainties associated with the distribution sector also means that private investors will hedge and heavily discount any power sector asset purchased from the government. If all the liabilities are netted off and discounts applied, the likely returns from even the most competitive privatisation of power sector assets will be small, even negative. One should ask officials in any state where governments have seriously explored these options about the nature of these challenges. 

However, this is not to overlook the near certain improvements to efficiency and reduction in further bleeding from privatisations. But these are all in the future, and cannot make up for the legacy burdens. 

Commentators should acknowledge (as markets do) that developing countries like India, no matter what kinds of regulatory facilitators are put in place, are a different asset category from developed markets. It's fundamentally wrong to believe that even a significant proportion of the large volumes of private and public capital chasing infrastructure and green energy projects will flow into these markets. It's just as wrong to assume that the regulatory and political economy constraints that deter these investors can be addressed or alleviated significantly in quick enough time. 

The first requirement to create conditions for meaningful efforts at energy transition (or anything else) is to acknowledge the real extent of the problem/issue. Then, it's required to usher stability and predictability in policies, expand the envelope of investible projects, create enablers for effective intermediation of domestic risk capital into these projects, and of course create conditions to attract whatever foreign capital is available. All this has to be coupled with serious reforms on the power sector side in loss reduction, utilities performance improvements, and tariff increases. This will require a mix of regulatory oversight, state capability and governance improvements, and private participation where appropriate and possible. None of these are anywhere near close to being "solved problems". 

A model of economic transitions

I'll argue that any forced transitions to formality or higher labour or environmental standards is a supply shock induced demand compression, which invariably lowers the output. In general, any economic transition increases costs which if not supported by associated increases in demand, will necessarily lower output.  

I have blogged earlier in the context of formalisation of the economy that formality introduces layers of production costs which increases the market prices, which in turn reduces market demand. At the higher price, only a smaller number of customers can afford the good or service. The cost structure of the formal market can be met by only a small proportion of the total demand. The market settles down to a lower equilibrium output. 

In fact, it can create perverse incentives. In case of goods and services which are essential (or which have inelastic demand), the reduced affordable formal supply has to invariably result in substitution with lower cost informal supply. If formality is tightly enforced (as in case of certain goods and services), the informal market supply becomes an illegal (or harmful) market supply. 

Supporters will point out that increased formality will raise wages, productivity, profits, and quality which in turn will benefit workers, firms, and consumers in a virtuous loop. But this simplified belief assumes away the considerable adjustment requirements on all sides, which in the real world takes an inordinate time, and in many cases never materialises. It's for these reasons that such transitions have historically taken time, as with the developed countries of today. This ain't an area for leapfrogging. 

The supply will be constrained at both the intensive and extensive margins. At the intensive margin, the informal workers will not be able to acquire the skills required and the informal businesses will not be able to put up the capital for the increased production costs. At the extensive margin, supply of both new sets of workers and businesses will not expand as required. And, in any case, demand cannot expand enough in quick time to create a market which can absorb the higher production costs. 

This dynamic is just as true of labour or environmental or any other set of standards, which can all be seen as dimensions or aspects of formality. Each of these standards adds a layer of production and supply cost to the industry. And these costs must be passed through in the form of higher costs. 

In fact, we can extend this logic to economic growth itself. Economic output can grow sustainably only if the demand side can grow at the same pace as the expansion in supply. While it's possible for the supply to expand rapidly (say, with foreign capital), it cannot do much in the short-run to increase demand. In other words, sustained high economic growth requires the growth to be broad-based enough as to support growth in demand. 

The exception, which China and East Asian economies benefited from, is if the increased demand can come from an external market. In this case, the local economy can benefit with more investments and jobs, and greater productivity and higher incomes, without the proportionate expansion in demand. This positive supply shock will, in course of time, create the foundations for sustained broad-based economic growth. But this opportunity appears to have shrunk considerably. 

In the circumstances, any action plans for economic transitions, like that involving informality or renewables, should acknowledge its limitations and financial costs.

Weekend reading links

1. Peter Thiel is Exhibit A on several things which are bad with our world. Foremost, he represents one of the totemic examples of elite capture of political power. He's also an exemplar for human cognitive failing in terms of expecting expertise and success in one field to be sufficient to make them successful in another field, especially on public issues. 

And he's backed by libertarian ideologues like Tyler Cowen at Marginal Revolution blog and George Mason University's Mercatus Centre, who has serious conflicts of interests involving Thiel, considers him one of the foremost public intellectuals alive. Sample this fawning introduction,

It’s been my view for years now that Peter Thiel is one of the greatest and most important public intellectuals of our entire time. Throughout the course of history, he will be recognized as such... Peter himself doesn’t need an introduction; he has a best-selling book. His role in PayPal, Facebook, Palantir, many other companies, is well known. Peter is a dynamo. There is no one like Peter.

2. India's Nifty stock index has comfortably outperformed its peers, including developed markets, in dollar returns over the last decade. 

In the 10 years to mid-October this year, Nifty returns stand at 124% against 54.5% for the Dax and 33.8% for China’s Shanghai Composite Index. The UK’s FTSE and Hang Seng generated negative returns of 8.4% and 12.8%, respectively... The Nifty outperformed its peers despite the Indian currency being the worst performer against the dollar in the 10-year period. The rupee depreciated 60% versus the dollar, against the euro’s 23% depreciation and the pound’s 27% decline. The yuan was pegged at 6-7 to a dollar while the Hong Kong dollar moved in a narrow 7.75 -7.87 during the period.

3. The recoveries from the IBC process have been declining

However, it's still superior to the other recovery mechanisms.

For the four years until 2020-21, the recovery from IBC averaged 43.5 per cent, compared to 26.4 per cent for ARCs, 4.5 per cent for debt recovery tribunals and 4.8 per cent for Lok Adalats... By March 2022, the IBC recovery rate had declined compared to previous years. The time taken for resolution had increased to 700 days, as against the envisaged time of 330 days.

4. As European countries grapple with high energy prices every country has some market intervention in place to cushion people. Martin Sandbu examines the most incentive compatible approach in this regard. He points to the need to retain the price signal incentive that can reduce gas consumption, and therefore prefers means-tested cash compensation. He writes about the likely German approach,

It seems an amount of gas — in general, 80 per cent of consumption — will be subsidised so as to cost no more than €120/MWh. A particularly nice feature of the German proposal is that you get to keep the whole rebate that secures the guaranteed price even if you manage to bring consumption down to less than 80 per cent (the full allocation). In theory, you could come out in profit if you reduced your energy use enough as explained here. The market incentive to economise never disappears... The German reference to past consumption is far from ideal, for example, because it favours those who could afford to be profligate with their energy use — a flat allowance based on household characteristics rather than past behaviour would be better.

See this explainer by Sebastian Dullien. 

5. Bank of Japan is the undisputed leader in pioneering new frontiers in monetary policy. The latest example is its unrelenting pursuit of monetary accommodation which was initiated in 2013 by Haruhiko Kuroda and Shinzo Abe. This is despite rising inflation, the Yen plunging to a 32-year low against the dollar, and reversals across the world. And the BoJ's policy has broad consensus within the country and unstinting support from the government of Fumio Kishida. 

There is an important nuance to BoJ's policy,

Japan wants good inflation — the kind created by lively consumer demand. But it has gotten bad inflation — the kind created by a strong dollar and supply shortfalls related to the pandemic and the war in Ukraine — and that is why the bank should stay the course... In Japan, however, there is broad agreement that — at least for now — a rate rise would do more harm than good. The Japanese economy, the world’s third largest, has barely returned to its prepandemic levels, and wages have stagnated despite a labor market so tight that unemployment remained below 3 percent during the pandemic’s worst months... While inflation pressures in the United States have been broadly distributed, in Japan they have primarily hit essentials like food and energy, for which demand is satisfied largely through imports. Inflation in Japan (excluding volatile fresh food prices) has reached 3 percent, the government reported on Friday, the highest since 1991, excluding a brief spike related to a 2014 tax increase. But stripped of food and energy, Japanese prices in September were just 1.8 percent higher over the last year. In the United States, that number was 6.6 percent...

Perhaps the largest contributor, however, is a public grown used to stable prices. Producer prices — a measure of inflation for companies’ goods and services — have climbed nearly 10 percent over the last year. But Japanese companies, unlike their American counterparts, have been reluctant to pass on those additional costs to consumers. That means much of the current inflation pressure is coming from the strong dollar and supply issues affecting imports — factors outside Japan and therefore outside the Bank of Japan’s control. Under those circumstances, bank officials “know full well that driving up interest rates is not going to attenuate those price pressures — it’s just going to push up business costs,” said Bill Mitchell, a professor of economics at the University of Newcastle in Australia.

Weekend reading links

1. Adam Tooze has a good post on the troubles facing the Chinese economy. He links to an article by Matthew Klein.

Homebuilders sold an average of 156mn sq m a month of residential floor space from April to June 2021. This year in the same period, Chinese developers have sold just 106mn sq m a month. The plunge in demand has flowed through to new building, with the amount of “residential floor space started” in April-June 2022 down by nearly half compared to last year. The pace of homebuilding has not been this slow since 2009... According to China’s ministry of finance, local government revenues from land sales so far this year were 31 per cent lower than in the first six months of 2021... Chinese consumer spending in the first half of 2022 was barely higher than in the first half of 2021 after accounting for inflation, and is now running more than 10 per cent below the pre-pandemic trend. Chinese oil refiners have been processing 10 per cent less crude oil since April compared with last spring thanks to the plunge in petrol demand. Electricity consumption, which had been expanding by about 7 per cent a year before the pandemic, is now growing just 2 per cent... In dollar terms, spending on imports has been flat since the end of last year. Factor in rising prices, and China’s real import demand is down about 8 per cent since the lockdowns began, according to estimates from the Netherlands Bureau for Economic Policy Analysis.

At a time when the global economy is grappling with supply constraints and rising inflation, lower demand from China is very helpful.

Chinese debt to GDP ratio has doubled since 2013, with the biggest contributor being the local government financing vehicles, who in turn leverage real estate to raise debt. 

2. Energy market risk diversification illustration

Berlin Brandenburg airport, newly opened after decades of delays, depends heavily for its kerosene jet fuel on the nearby Russian-owned Schwedt oil refinery. Authorities have been warning that a complete German embargo on Russian oil will threaten the airport’s operations. By contrast Berlin’s former airport, Tegel, was more resilient even during the cold war: a diversification rule meant aeroplane fuel arrived by a variety of means including truck and train.

3. Rana Faroohar points to inequality being a contributor to US consumption spending not declining as much as expected,

To the extent that the wealthy in the US are not yet cutting back on spending, they may be an important and under-explored factor driving the inflation felt by all. The top two-fifths of income distribution in the US accounts for 60 per cent of consumer spending, while the bottom two-fifths accounts for a mere 22 per cent, according to 2020 BLS statistics... The American Enterprise Institute, a right-leaning think-tank, estimated in February that the wealth effect of both asset gains and cash extraction from the refinancing of property (which hasn’t corrected yet, like stocks) represented $900bn, with a consumption impact that started last year and will continue through 2022... when the top quintile of Americans as a whole enjoy 80 per cent of the wealth effect from rising stock and home values (the AEI’s estimate), I suspect it starts to have a real impact on inflation, and on the overall structure of our economy, which over the course of the past 30 years of real falling interest rates has become highly financialised.

4. Businessweek points to the rise in college tuition fees in the US

5. The FT has a graphic that shows how European countries are reducing their reliance on Russian natural gas. 

By weaponising natural gas, Vladimir Putin is under-cutting Russia's strategic leverage over Europe for short-term gains. 

6. Ruchir Sharma draws attention to the counter-intuitive point of whether the world can produce robots "fast enough to save the world economy from labour shortages". 

Labour shortfalls are at historic highs in advanced economies, including the UK and US. There are now 11.2mn openings for 5.6mn job hunters in the US, the widest gap since the 1950s... The working-age population is shrinking in nearly 40 nations, including most of the major economic powers, up from just two in the early 1980s... underlying demographic trends foretell continuing shortages. Among the hardest hit nations are China, Japan, Germany and South Korea — all are expected to see the working age population drop by at least 400,000 a year through to 2030. Not coincidentally, these countries already host high concentrations of robots, and are rolling out more. Japan’s manufacturers deploy nearly 400 robots per 10,000 workers, up from 300 just four years ago. China, in its top-down way, is heavily subsidising robot makers, aiming to boost their output by 20 per cent a year through 2030. Even at that pace, Bernstein analysts predict, robots cannot fill all the holes in the labour force, which China expects will shrink by 35mn workers in the next three years.

7. Queen Elizabeth's passing away takes away a constant anchor for the last seven decades. This graphic is striking.

8. When we talk in general about inflation, so much is lost in the translation. FT has a superb graphic which looks at how the consumer price inflation in UK in July 2022 varied for different population categories compared to the national CPI average of 8.8%.

9. On the reemergence of unions among US companies, albeit in a different form,

The upstart union, Starbucks Workers United, is one of a new breed of organised labour that has emerged in the US in recent months. The movement has traditionally been dominated by large, sector-specific unions such as the United Auto Workers, the Service Employees International Union and the Teamsters, which have maximised their scale and reach to fight for better conditions for workers. Instead, the Starbucks employees have taken a different approach — forming smaller groups led by workers on a store by store basis, in the hope that it will build to a broader movement. The strategy has attracted a younger, more politically engaged type of worker, and has helped unions gain a foothold not just in the coffee giant, but also in Amazon, Chipotle and others following a similar path...

Since baristas in Buffalo, New York, founded Starbucks Workers United last December, some 233 other locations have followed suit. Workers at Amazon, Chipotle, and Trader Joe’s have all cited the union’s speedy rollout as the inspiration behind their own drives. But none of the new Starbucks unions have successfully completed what labour scholars say is the most important step on the path to unionisation: negotiating a collective bargaining agreement, the legally binding contract that unions rely upon to improve conditions for its members.

10. Mahesh Vyas points to interesting trends in India's labour market - increasingly ageing and less educated workforce.

Estimates from CMIE’s Consumer Pyramids Household Survey (CPHS) suggest that in 2016-17, 17 per cent of the labour force was of the 15-24-year age. By 2021-22, this proportion had dropped to 13 per cent... In 2016-17, a quarter of the total employment in India was of people below the age of 30. This fell to 21 per cent by 2019-20 and then to 18 per cent by 2021-22. The proportion of the workforce in their thirties has also fallen from 25 per cent in 2016-17 to 21 per cent in 2021-22. As a result, what is left in the workforce is mostly people in their forties and fifties. In 2016-17, 42 per cent of the workforce was in their forties and fifties; by 2019-20, this had risen to 51 per cent... 

A related problem is that the educational qualification of the workforce is deteriorating. The share of graduates and post-graduates increased from 12.5 per cent in 2016-17 to 13.4 per cent by 2017-18. Then it fell to 13.2 per cent in 2018-19 and then to 11.8 per cent in 2019-20. It recovered but only partially to 12.2 per cent... India’s workforce comprises mostly people whose maximum educational qualification is of secondary education (those who cleared their 10th – 12th examinations). They accounted for 28 per cent of the workforce in 2016-17 and in 2021-22, their share went up to 38 per cent. There is a similar increase in people whose maximum education was between 6th and 9th standards. Their share went up from 18 per cent in 2016-17 to 29 per cent in 2021-22.

11. Finally The Ken has a good story on the struggles with the Ayushman Bharat Digital Mission (ABDM), the giant project to introduce electronic health records in India - “unified health system for every citizen and the central verifier of all truths in healthcare”. The article says that the project is being implemented at a cost of $200 million. 

I don't think it's a good idea to plunge into such an ambitious project at such scale. This requires very carefully phased out and gradual progress up the electronic medical records value chain. It'll probably require at least decade to even have the rudiments of an effective EMR system in place. And it'll cost several multiples of the $200 m, besides serious engagement on its adoption down the public health referral chain.

Some thoughts on energy prices and inflation

Some thoughts about inflation in developed markets. 

Here is some news about UK inflation prospects,

But with Europe’s gas crisis escalating in August, Citi predicted on Monday that inflation would reach 18.6 per cent in January. Continental European gas prices are more than 14 times their average of the past decade. The benchmark European gas price rallied almost 10 per cent on Monday to €278 per megawatt hour ($81 per million British thermal units), the highest closing price on record and taking the rise over August to 45 per cent. Examining the wholesale figures, Citi predicted that the UK’s retail energy price cap — which limits how much households pay for heating and electricity — would be raised to £4,567 in January and then £5,816 in April, compared with the current level of £1,971 a year. It added that the shifts would lead to inflation “entering the stratosphere”. The bank’s projected rate would be higher than the peak of inflation after the second Opec oil shock of 1979 when CPI reached 17.8 per cent, according to estimates from the Office for National Statistics.

An how sharply rising energy prices are feeding into this inflation

Natural gas, which is used to generate electricity and heat, now costs about 10 times more than it did a year ago. Electricity prices, tied to the price of gas, are also several times higher than what used to be considered normal... In Britain, the wholesale price of a megawatt-hour of electricity (enough to supply about 2,000 homes for an hour) hit a record daily average of about 500 pounds, or $590, early this week, roughly five times the level of last August.

And gas prices are tightly linked to electricity prices

Driving the prices is a fear that Europe will run out of gas this winter. Russia has slashed gas flows to Germany and other countries... Nord Stream 1, a key conduit of fuel to Germany, has been flowing at only 20 percent of capacity. These cutbacks are forcing gas providers to buy gas on the spot market at higher and volatile prices than under longer-term Gazprom contracts. In many countries, gas and electric power prices are closely intertwined, a relationship that has added to Europe’s woes. Although there are several ways to generate electricity — such as coal, nuclear, hydroelectric, wind and solar — the price of natural gas is hugely influential in setting electricity prices because gas-burning generators are most often paid to come into service when a power grid like Britain’s needs more electricity... Chris Matson of LCP estimated that in 2021 Britain’s power prices were determined by gas more than 90 percent of the time, even though the fuel only accounted for about 40 percent of total generation... But the pressure to fill gas storage facilities, backed by the government directives, has forced energy companies to buy — and keep buying — expensive gas, driving the price ever higher... But the urge to buy protection for the winter is driving up prices, and is doing some of the economic damage it was intended to prevent, analysts say.

Martin Sandbu placed the out-sized role of energy prices in inflation in perspective and the limits of pure monetary policy actions in containing inflation,

Suppose energy prices account for 10 per cent of the normal price index. (This is just to make the arithmetics easy. The actual share of energy in the US index is 9.2 per cent, and in the eurozone it is 9.5 per cent.) If they double, the rest of the index has to fall almost 9 per cent. If they triple, other prices have to fall 20 per cent in the aggregate. Central banks have a lot of power, but making most prices fall 20 per cent or more in a year or so may be beyond their ability even if they were determined to try. And considering that most of what we do and produce uses energy, this would require the costs of other inputs into production — in particular, profits and wages — to fall even more significantly. In the context of extreme price rises for some goods, to think today’s high year-on-year inflation rates prove that central banks erred 12 to 18 months ago is to say that central banks should have so firmly arrested the recovery and kept economies so long in recession as to bring about abysmal offsetting negative price changes elsewhere.

He links to David Sheppard

Sandbu also points to the confluence of factors,

... the bizarre confluence of bad luck: on top of the war and Putin’s energy extortion, we have had weak wind last year, drought-depleted hydropower reservoirs this year, low water transport levels hindering coal barges in Germany, outages in French nuclear plants and fire damage to US gas liquefaction capacity. It is as if it had all been planned to happen at the same time.

See also this on record drought wave sweeping Europe currently, with almost half the continent affected.

If energy prices have risen so much and are driving up inflation, it's difficult to see how monetary policy can be of much help. The supply constraints are unlikely to be significantly eased by any monetary policy tweaks. The highly inelastic nature of energy demand also means that demand response will be muted, howsoever much the price increases. 

In the circumstances, the best that can possibly be done would be to cushion the price increases with some form of transfers. European governments have spent about $278 bn since September 2021 to support consumers against high energy prices.

Bruegel has a detailed report on six types of energy market interventions - reduction of VAT, retail and wholesale price regulation, transfers to vulnerable groups, mandate to state-owned firms, windfall profits tax, business support. Reduction of VAT and transfers have been the most popular interventions, more or less universally implemented across Europe. 

So what needs to be done in terms of long-term policy to address future energy shocks? Martin Sandbu supplies some of the answers,

Not just in terms of fiscal support, but in terms of managing the consequences of extreme volatility. Encouraging investment may require ample guarantees if prices hit zero more often than expected. An inevitable quid pro quo will be heavier taxation of energy price windfalls. Throw in the need for greater grid investment and co-ordination between countries and the public and private sector in preparing for a shift to a renewables-based energy system, and the contours of an energy system permanently shaped by politics — and the other way round — become clear.

But he stops short of calling for a more nuanced approach towards the energy transition. As I have blogged here, the global clean energy transition has overlooked the practical challenges associated with such shifts. Energy transitions play out over long time periods. It involves winners and losers at multiple levels - individuals, firms, countries, and regions. With consumers unwilling to bear the costs and governments unable to subsidise the transition, it's financially ruinous to compress such transitions to short durations. 

About inflation, BIS's Agustin Carstens has a nice explanation,

I think it’s very important [to note] that the function of inflation is not necessarily that obvious. At the end of the day, the definition of inflation is an overall increase in the price level. That gives the impression that all prices are moving at the same time, at the same pace, and the reality is that that never happens. Usually, when you have a low-inflation regime, what you see mostly is relative price changes [some prices going up and others coming down], and these shape production and consumption decisions. These do not give you particular information about the overall pressures of inflation. But if, at some point, you start seeing that more prices are rising and that those rises tend to be more persistent, that means individual price changes carry more information. That starts a process where firms start revising their prices more often, and feeds back into different loops. Cost gets affected, labour markets start responding. And instead of stabilising, high inflation becomes self-reinforcing...

I think a very important sign would be, for example, if the percentage of different goods and services that are producing positive changes suddenly starts decreasing. Because then, you start seeing that the overall component of inflation is coming down, and relative price changes are starting to kick in back again... In your CPI, you can have the analysis to sectors. If you see that 90 per cent of the sectors have positive increase in prices, and now it’s 85 per cent and then it’s 70 per cent, and then you get back to normal, I think that starts giving you signals.

Some thoughts about the current inflationary episode

1. The world economy is entering this episode of inflation with reasonably strong economic fundamentals (corporate and household balance sheets, labour market etc) and strong financial markets. This means that there is considerable run way available to absorb the pain of a recession. This can help keep the recession itself short and shallow.

2. The inflationary signals, while now broad-based, is also primarily supply-shocks induced by the back-to-back triggers of pandemic closures and Ukraine invasion. Besides, energy prices have an out-sized role. It's inevitable that these shocks will dissipate as supply recovers. 

The future trajectory of inflation will be critically dependent on whether workers and firms believe that the supply shock will dissipate soon enough without having them to raise wages and prices, thereby triggering a wage-price spiral.

3. In the current inflation episode, the central banks have been behind the curve. But once they realised that inflation was getting baked in, they've responded swiftly, forcefully, and in unison (across developed countries). This means that the intent is being communicated in clear terms. Is this sufficient to convince firms and workers?