Problem with variable pay

Slowdown in profit growth and decline in stock prices might lead to growing employee dissatisfaction under variable pay plans in the quarters ahead

Cafe Economics | Niranjan Rajadhyaksha

It has been estimated that about one-third to half of all American workers have part of their earnings tied to the overall performance of the firms that employ them, through profit sharing, direct ownership or stock options.

This particular tide is rising in India as well. In a recent survey of 540 locally owned, foreign-owned and joint venture companies conducted by consulting firm Hewitt Associates, 95% of the respondents said they had variable pay plans in 2007. The use of stock options, too, is growing, with most large companies listed on the stock exchange giving their employees the option to buy shares at a later date and at a predetermined price.

Tying an individual’s performance to the overall performance of a company seems a good idea. The interests of shareholders and employees are aligned. You really care whether the company prospers or goes down the tube. Some economists have shown that both employee productivity and company growth are higher when employees have a stake in the growth of the firm that employs them. There is some form of incentive compatibility.

But there are several problems as well, though they will tend to remain under the surface when profits are growing rapidly and stock prices are soaring. But I suspect that the coming slowdown in profit growth (which will hurt variable payments to employees) and the decline in stock prices (which will send stock options below their strike price, or under water) will lead to growing employee dissatisfaction in the quarters ahead.

Are company human resource departments ready for this?

There has been a lot of research by economists in recent years about the system of paying workers — either directly through variable pay or indirectly through stock ownership — based on company performance rather than the market price of labour. There is even a name for these arrangements: shared capitalism.

The first big problem in shared capitalism is what is called the free rider problem. Say you are one of the hundreds of employees who will get paid a large chunk of their salary in the form of variable pay. Individually, you have little direct impact on the overall performance of the company: You are a cog in the wheel. There is, thus, an incentive to take it easy in office; you hope the other cogs will work hard enough to help the company meet its goal. You are what economists call a free rider.

This would be less of a problem when the economy is booming. Companies find it relatively easy to meet their sales and profit targets, and so everybody walks away with an impressive stash of money. Free riders are less likely to be abhorred. But the mood could change in a downturn. The ant may ask why the grasshopper is getting the same variable pay deal as it is. There could be tensions in cubicle land.

The other problem is more personal. You have already bet your human capital on one company. Shared capitalism ensures that you are also betting large parts of your financial capital on the same company. It’s a poor diversification of risks—too many eggs have been placed in this one basket.

In a new paper published this month by the National Bureau of Economic Research, an American research outfit, three economists have examined issues of risk and the lack of diversification in shared capitalism. “Since shared capitalism, especially in the form of employee stock ownership and stock options, is an investment, we need to examine it from the critical perspective of risk,” write Joseph R. Blasi of Rutgers University, Douglas L. Kruse of Rutgets University and Harry M. Markowitz of the Rady School of Management in California. (Markowitz is a pioneer of the modern theory of portfolio choice, for which he won the Nobel Prize in economics in 1990.)

They ask whether risk is really “the Achilles heel of employee ownership”. There is little doubt that employees with stock ownership or options have put too much risk in one basket. But Blasi, Kruse and Markowitz show that a lot also depends on each individual’s view of risk and the culture of the companies they work in.

For example, risk-averse employees are less likely to respond to the incentives provided by stock options. Employees who feel they are underpaid are more likely to look at the payments from ownership as wage substitutes rather than added incentives.

And a lot also depends on workplace culture. “In the absence of empowerment, shared capitalism may easily be seen as nothing more than increased income risk, whereas empowerment creates a greater sense that one can affect workplace performance and rewards under shared capitalism.”

In other words: The success or failure of variable pay and stock option schemes depends on the context, both personal and organizational. This is something that Indian companies, too, will have to understand if the current headwinds continue to blow them off their path.

Your comments at welcome at cafeeconomics@livemint.com

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A new portfolio strategy

A sustained rise in the rupee could lead to a change in the way corporate profits are distributed in the country

Cafe Economics | Niranjan Rajadhyaksha

Infosys Technologies will announce its latest quarterly results on Thursday. Its senior managers will also tell us how they expect the company to perform in the coming quarters. The big question they will have to face from journalists and analysts: how will revenues and profits be affected by the relentless rise of the rupee?

The dilemmas faced by Infosys are not unique. It is well known that a host of export industries have been struggling to come to terms with the appreciation of the rupee this year.

A sustained rise in the rupee could lead to a change in the way corporate profits are distributed. And the economics underlying this shift could also give investors useful clues about how to structure their portfolios.

Usually, a strong currency brings down the cost of imports. I recently decided to buy annual subscriptions to two of my favourite foreign magazines, partly because they are now cheaper by more than 10%. Forget magazines. Everything, from crude oil to toothpastes, that lands at Indian ports will be cheaper than before in rupee terms.

Cheaper imports will put downward pressure on local variants. Companies will have to cut their listed prices to compete with imports that suddenly boast of lower prices.

Economists talk about the law of one price—or the fact that prices of goods tend to equalize across national borders. But not everything we buy is hostage to the law of one price. It is hardly likely that the cost of a haircut or a doctor’s consulting fee will drop because of a rise in the rupee’s value against the dollar. These are services that are not traded across national borders.

High transport and transactions costs make the markets for these non-tradable services resolutely domestic. You are hardly likely to catch a flight to New York to get a pedicure because it now costs you less in rupees.

What this means is that the price of tradables will drop but the price of non-tradables will remain steady (or rise) in a country with an appreciating currency. Cheaper iPods, but more pricey music concerts.

This is an axiomatic statement. A nation’s real exchange rate is the ratio of the price of non-tradables to the price of tradables. A drop in the latter is bound to push up the real exchange rate. That could be happening in India, though I have not seen any recent research on how the relative price of non-tradables could be going up.

What should investors make of this? Price pressures in toothpastes and rising prices on hospital fees could mean that profits of companies which make non-tradable goods and services have a better chance of surviving a strong rupee. (Of course, the best companies making stuff that can easily be traded can also deal with the rising rupee by being more productive, innovative and quality-conscious.)

China is already seeing a profit shift from tradables to non-tradables. In a new research report, Goldman Sachs analysts Hong Liang, Yu Song and Eva Yi say this about the appreciation of the Chinese yuan (CNY): “As the CNY appreciates, the prices of upstream products (or tradable goods) tend to decline relatively to the prices of downstream products (or non-tradable goods). In addition, more interestingly, such a shift in relative performance seems to also have taken place in the share of profit distribution between upstream versus downstream industries.”

I would not be surprised if something similar is happening in India as well. If you slice stock market returns over the past few quarters, you’ll see that investors have dumped companies dealing in tradable goods and services.

This is perhaps why automobile, pharmaceuticals, consumer goods and software companies have been relative underperformers.

And now take a look at the stars —retailing, banking, telecom and power, for example. These cannot be easily imported. Hence companies in these sectors are relatively less sensitive to a strong rupee. They are not passive price takers. Investors seem to have figured out how relative prices and profits have shifted (and will perhaps continue to shift) as the rupee strengthens.

If this trend continues—it may not —then it is only a matter of time before the grumbling about India’s de-industrialization becomes audible. Countries with strong currencies have usually seen their manufacturing companies under stress, especially those churning out low-value stuff.

The US went through this phase in the 1980s. So did Japan in the 1990s.

Indian companies, with low wages and low productivity, still have immense scope to control costs and remain competitive despite a strong rupee. But that fact alone will not be enough to silence the inevitable grumbling about how India is losing industrial strength when it should be building it.

One can almost see protectionists emerging out of the woodwork.

Your comments are welcome at cafeeconomics@livemint.com

Disclaimer :- The copyright for the articles published here lies with HT Media Ltd. The blogs are owned and maintained bylivemint.com. You may not copy, reproduce, republish, download, post, broadcast, transmit, make available to the public, or otherwise use livemint.com content in any way except for your own personal, non-commercial use. You also agree not to adapt, alter or create a derivative work from this content without prior written permission of HT Media Ltd. You are however, free to link to this page.

A band and its business

Radiohead’s experiment also tells us a lot about how trust is the bedrock of the modern market economy

Cafe Economics | Niranjan Rajadhyaksha

Rock music has no place in this column. The proprietor of Café Economics has quaint tastes in music, and is more comfortable listening to Talat Mahmood rather than the Rolling Stones. But this article is an exception to the rule. A rock band named Radiohead has stirred my interest, and of several other economic commentators, because of a daring move. The band has put its new album up on its website, from where fans can download at whatever price they choose.

That’s right: There is no fixed price for the music.

Similar experiments have been tried before, but perhaps never on this scale. Zodiac Grill, the upscale restaurant in Mumbai’s Taj Mahal hotel, did not have a price list at one point of time. Patrons paid what they thought the food was worth. I am told that net revenues did not suffer, since many overpaid.

And then there is the famous experiment recounted in Freakonomics, the wildly popular book by Stephen Dubner and Steven Levitt. Paul Feldman, an economist-turned-bagel delivery entrepreneur in Washington, DC, decided to leave his cash box in the offices where he delivered his bagels. That saved him time. He did not have to wait till his customers paid him and could, hence serve more companies.

There was a note on the cash box that asked customers to leave what they owed Feldman. You would think that he would end up with nothing, as cheapskates (or rational consumers —take your pick) helped themselves to a free bagel. That did not happen. Payments tended to average around 90 cents a bagel, enough to make it a profitable business.

A restaurant in Mumbai, a bagel man in Washington, DC and a rock band in London. Each has tried to shift the power to fix prices to the consumer, assuming that the price will not be zero. Each of them works on an honour system. The seller appeals to the buyer’s sense of honour to pay what he believes to be the true price of a good or service. The rock band’s experiment also tells us a lot about how trust is the bedrock of the modern market economy.

Not every use of the honour system is based on a payment. When you walk out of an international airport, you are allowed to choose whether to walk out of the green or red channel. There are random checks to discourage those who misuse the system, of course. But any such arrangement will not work unless the vast majority of users respect the honour system and do not abuse it.

Coming back to Radiohead. It is too early to say whether its gamble has really paid off. Downloads started on 10 October, so it’ll be many months before the big numbers can be totted up. But one can try to figure out what the rockers are up to. The ease with which music can be downloaded online, often for free, means that the traditional business model in the music industry is cracking. Musicians will no longer depend on CD sales for most of their income.

It is likely that most of the money earned by musicians will come from live concerts and merchandising. To charge premiums on these, it would be useful to have your music playing in as many homes and bars as possible so that your brand has instant recall. Flexible-price downloads help build up a large network of listeners. The larger the network you build, the larger your future income.

Radiohead’s move looks like a stroke of genius.

The new pricing model also throws some light on the nature of value and prices. Ever since the 1870s, most economists have accepted the fact that value is subjective. Each of us has a different sense of how much something is really worth. Some may believe a new Himesh Reshammiya CD is worth Rs5 while there could be others who are willing to put Rs500 on the counter to buy his nasal hits.

No amount of computer modelling and quantitative gimmicks can match the complexity and information-processing prowess of the market.

Radiohead’s great gamble may not work after all. Horror-story writer Stephen King tried something similar a couple of years ago. He started serializing a new book online, chapter-by-chapter. Readers could get the chapters for free, or pay King whatever they wanted to.

The experiment fizzled out. Actually, King had structured the deal in an interesting manner. A reader was downloading a chapter, reading it and then downloading the next chapter. So, the reader had an incentive to pay up. Reading half a novel is no fun. Novels are an indivisible product. Ideally, pricing should have peaked as the novel’s climax approached.

Radiohead’s unusual pricing strategy may or make not succeed. But we should not be surprised if many more such experiments crop up in the years ahead, especially on the Internet. It’s unlikely that you can choose your price for a car or a house, but flexible pricing can come into its own as far as digitized products are concerned.

Your comments are welcome at cafeeconomics@livemint.com

Disclaimer :- The copyright for the articles published here lies with HT Media Ltd. The blogs are owned and maintained bylivemint.com. You may not copy, reproduce, republish, download, post, broadcast, transmit, make available to the public, or otherwise use livemint.com content in any way except for your own personal, non-commercial use. You also agree not to adapt, alter or create a derivative work from this content without prior written permission of HT Media Ltd. You are however, free to link to this page.

The capital conundrum

The government needs to back RBI’s moves with a tighter fiscal policy to cool demand in the economy

Cafe Economics | Niranjan Rajadhyaksha

How should India respond to the flood of capital gushing into its economy?

The Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) have, for better or worse, stepped knee-deep into the flood water and tried to control its flow. And have courted controversy in the bargain.

RBI has done either of two things, depending on the circumstances. It has tried to buy up the dollars and pump more money into the domestic economy. Or it has let the rupee appreciate. The first policy weakens it in the fight against inflation and the second could hurt export competitiveness. Sebi has tried to turn away one category of investors in the stock market—hedge funds and other shadowy investment pools that invest indirectly through offshore derivatives. This has shaken the stock market.

It is time the government, too, got into the act in a meaningful way—by slashing the fiscal deficit.

First: how big is the flood?

The finance minister says the inflows are “copious”, an adjective that has gained wide currency over the past 10 days. The International Monetary Fund (IMF) says in its new World Economic Outlook that the amount of private capital cumulatively flowing into India since 2002 is equal to 18.3% of its GDP, far more than the 6.9% in 1988-90 (in the run-up to the crisis of 1991) and the 3.2% in 1994 (the first big burst of foreign institutional investors activity in India).

How does this compare with other countries? It’s middling. Many in Europe’s north are dealing with capital inflows that are three to five times larger than ours, for every unit of GDP. In Asia, Vietnam has been getting cumulative inflows of 38.5% of its GDP. In that sense, India is by no way being soaked in foreign capital.

Between 1990 and 1996, Korea received cumulative capital flows equal to 18.9% of its GDP in the last year of that period. That did not protect it from the wave of capital outflows that wrecked East Asia and South-East Asia in 1997. The others affected were in deeper water: Indonesia (26.3%), Malaysia (79.1%) and Thailand (88.8%, between 1988 and 1996).

Any way you look at it, India does not seem to have had threateningly large capital inflows in the past five years. But this does not mean that Indian policymakers are mistaken in their flurry of discussion and policy. IMF has identified 109 episodes of “large net private capital inflows” since 1987; of these, 87 were completed by 2006. IMF says that “one-third of the completed episodes ended with a sudden stop or a currency crisis, suggesting that abrupt endings are not a rare phenomenon.”

Two further issues need to be looked into. First, what is the nature of these private capital flows? Are they predominantly long-term foreign direct investment or are they short-term speculative capital that can be withdrawn by hitting the enter key on a laptop in the Bahamas?

It is quite well-known that India has been more popular with portfolio investors than with corporate investors in the past decade or so, though the balance between the two is less skewed than before.

The other troublesome question is the state of the economy’s fundamentals. India needs to worry about two things: its current account deficit and its fiscal deficit.

The former puts India at greater risk of a sudden reversal of capital than those countries that have large trade and current account surpluses. “The consequences of large capital inflows are of particular concern to countries with substantial current account deficits...” says IMF.

Then there is the fiscal deficit. Capital inflows usually stoke up economic growth but put the overall economy to the risk of overheating—thus creating the conditions for eventual loss of investor confidence and capital outflows. The textbook way to deal with such a situation is either to run a tight monetary policy and/or a tight fiscal policy. RBI has been doing the first, as a result of which we have seen some deceleration in bank credit and consumer demand.

The government needs to back this with a tighter fiscal policy to cool final demand in the economy. The finance ministry is busy making self-congratulatory statements about how it will meet its fiscal targets this year and will eventually bring the revenue deficit down to zero by 2009.

But surely the government can do better. The bipartisan deal to bring India government finances back on track through the Fiscal Responsibility and Budget Management Act was hammered out at a time when economic growth and tax collections were sluggish. The subsequent economic boom has led to huge increases in tax collections, which ideally should have been used to slash the fiscal deficit, something that the Clinton administration did in the 1990s in the US. The Mumbai sisters have a huge battle on their hands. Isn’t it time the big brother in New Delhi entered the fray?

(Your comments are welcome at cafeeconomics@livemint.com)

Disclaimer :- The copyright for the articles published here lies with HT Media Ltd. The blogs are owned and maintained by livemint.com.

You may not copy, reproduce, republish, download, post, broadcast, transmit, make available to the public, or otherwise use livemint.com content in any way except for your own personal, non-commercial use. You also agree not to adapt, alter or create a derivative work from this content without prior written permission of HT Media Ltd. You are however, free to link to this page.

Look ma, no cash

Indian companies can use stock swaps for future global buys. But what about family control?

Cafe Economics | Niranjan Rajadhyaksha

The global acquisition bandwagon has stalled, ever since the international credit market stumbled into a crisis in August—a crisis that could worsen in the months ahead as estimates of loan losses mount. So, we now have nothing to match the headline-grabbing deals of early 2007: Tata Steel and Corus, Hindalco and Novelis, Suzlon Energy and Repower.

That’s not surprising. In July, Café Economics had asked whether it was time to end the leveraged buyout (LBO) revelry. “The entire LBO party has been fuelled by cheap money, because interest rates have been very low in recent years thanks to central banks across the world. In other words, LBOs have been an arbitrage between the credit markets and the market for corporate assets. You borrow from one to buy in another. The ground is now shifting below the feet of the party-goers, as borrowing costs in the credit markets have started inching up.”

The lack of easy money to fund overseas takeovers has had its expected effect. But this does not mean that Indian companies will have to stay away from global acquisitions till the loan party comes to life again.

Perhaps it is time to use another type of acquisition strategy—stock swaps, where an acquiring company uses its own shares as currency to take control of a target company. Each shareholder in the target is offered a certain amount of shares in the acquiring company in exchange for his original shares.

Here’s why this could work.

The past few months have seen a very significant shift in global valuations, as investors have come to believe that Asia is decoupling from the US. Emerging market stocks now attract better valuations than stocks in the rich countries, for perhaps the first time ever. A recent report in The Economic Times shows that the market valuation of ICICI Bank is now at par with that of Lehman Brothers, a Wall Street investment bank. State Bank of India has a higher value than Singapore’s DBS. In a few years, it is likely that many Indian companies will have market values that are more than their global competitors.

More generally, the MSCI index for emerging market stocks has a trailing price-earnings multiple that is 12% higher than that for developed markets. And this could widen. The Economist says that CLSA strategist Christopher Woods expects the forward price-earnings multiple of shares in emerging Asia to “peak at twice America’s”. Though the two sets of figures are not strictly comparable, you can get the general idea. Investors seem to be ready to pay far more for every dollar of profits in emerging markets, compared with what they will pay for American profits.

And given the fact that economic growth in our part of the world is most likely going to be far quicker than that in the US, Japan and Europe, it is not unrealistic to expect emerging market companies to play catch up with their rich-world peers. China has already caught up, though this is also because of its irrationally exuberant stock market. Petro China was briefly valued at a trillion dollars, making it the world’s most valuable company. And Industrial & Commercial Bank of China (ICBC) has a market value more than that of Bank of America.

It’s all about the price of acquisition currency. LBOs and cash deals had a good run over the past few years because of the low price of global credit. Stock swaps could be the next big thing because of the high price of emerging market shares. Companies that have higher valuations need to offer fewer of their shares in exchange during an acquisition. You get more for less.

But there is a problem. Business families control many emerging market groups. A stock swap will dilute their control, as the investor base widens. To the extent that control matters, business families in Asia (including India) have little incentive to go in for this variety of acquisitions.

Mittal Steel had used a combination of cash and stock offers to buy Arcelor in 2006. One reason this was possible is that the Mittal family owned 88% of Mittal Steel before the Arcelor acquisition. Their holding in ArcelorMittal, the new merged entity, is down to 49.4%, enough to maintain control.

There are undoubtedly many Indian companies where the controlling family owns a large chunk of the share capital—DLF, Wipro and TCS, for example. Then there are the cases such as ICICI Bank and HDFC, where ownership is widely distributed and the top management does not come from a “family”. But a majority of Indian companies do not fall into either of these categories, and will find it difficult to do large stock-swap mergers without putting management control under threat.

So how will Indian companies that have an acquisition opportunity respond—by going in for a stock-swap acquisition or preferring to maintain tight control? It’s an interesting choice.

Your comments are welcome at cafeeconomics@livemint.com

Retirement saving myths

The standard portfolio model is flawed because it ignores human capital, according to economist Joseph Stiglitz

Cafe Economics | Niranjan Rajadhyaksha

Most of the financial advice we get is hopelessly inadequate and simplistic—if not outright wrong.

Last week, I heard Joseph Stiglitz launch a typically blunt and brilliant attack on some of the sacred cows of the financial advisory business. The economics professor at Columbia University in the US and winner of the 2001 Nobel Prize in economics is popularly known as a trenchant critic of some aspects of globalization, though his academic work spans a wide range of economic issues, including financial ones.

“Long-term financial planning is a very complex task. Individuals cannot judge what they need to do and so they fall prey to wrong advice. This gives rise to fashionable rules of thumb,” said Stiglitz in a presentation at the Second European Colloquia organized by Pioneer Investments in Vienna at the end of November. (Disclosure: I was in Vienna as a guest of Pioneer Investments.)

The most common rule of thumb is that an individual should invest heavily in equities at a young age and then gradually move into bonds as the age of retirement nears. A popular and pseudo-scientific way of defining this rule is as follows: subtract your age from the number 100, and you get your ideal exposure to equities. For example, a 30-year-old should have 70% of his long-term savings in equities (100-30) while a 50-year-old should bring it down to 50%.

Neat, huh? But also wrong, said Stiglitz.

Most financial advice—and the economics that underlies it—is flawed. It assumes that an individual has only two types of capital: relatively safe fixed-income bonds and equities that are more risky but which also give more returns. The question is how long-term savings should be distributed between the two as we age.

“The standard portfolio model ignores other forms of individual capital,” said Stiglitz. One important form of this is human capital, which is usually calculated as the present value of all the future earnings an individual will earn over his working life.

Most of our value as economic animals resides in our ability to earn over our working lives—our human capital. According to some estimates, nearly 80% of an individual’s capital is human capital. This form of capital and its risk profile should ideally be considered while designing a good financial plan for retirement.

Human capital is usually more risky at a young age, points out Stiglitz. You are just starting off on your career and the future is uncertain. As you age and get settled into your chosen profession, the uncertainty about your ability to earn starts declining. Human capital gets less risky as you age.

Seen from this perspective, most financial plans are built on shaky foundations. A 25-year-old setting out down a fresh career path faces huge amounts of risk in his overall portfolio (financial and human), because his future earnings are uncertain. Ideally, his financial portfolio should have low risk to balance out the high risk in his human capital. He should be buying more bonds than he is usually advised to do. But the cookie-cutter financial advice that he gets is to put most of his savings into equities—and increase his overall risk.

The big question is whether human capital resembles a safe bond or risky equity. In a separate presentation, Stephen P. Zeldes, a professor of finance and economics at Columbia University, asked: “Is labour income stock-like or bond-like?” He suggested there are no easy answers here. Without disagreeing with Stiglitz, Zeldes said labour income has both characteristics, depending on the circumstances.

All this makes financial planning a complicated process. Besides, other factors such as which industry one is working in, the nature of one’s family responsibilities and home ownership also need to be thrown into the consideration. In a country such as India, for example, where a large part of the population is self-employed, labour income would tend to be risky.

Perhaps we are wrong in blindly assuming that we should cut our exposure to equities as we age. In fact, a well-settled professional with stable earnings perhaps has more reason to invest in equities than, say, a young entrepreneur in a technology start-up.

These are nuances that are often ignored, even in our grander debates on how pension fund money should be used in India.

One challenge before those involved in designing social security systems is how to balance freedom of choice and good guidance. Choice is important because an individual knows about his retirement needs than outsiders. But, as Stiglitz pointed out, individuals make rational decisions by learning from past experiences—their own and of others. That’s not possible for retirement planning. A person who realizes at 60 that he has not saved enough for his retirement cannot say: “I’ll do better next time.”

There is no second chance.

Your comments are welcome at cafeeconomics@livemint.com