Friday, August 6, 2010

Where's the flaw ...

... in the argument made in this article? Please click on the title to read at least some of an article from the WSJ's Asian edition.

The argument basically is that a project involving a significant amount of capital expenditure whose cost is inflated significantly by corruption and other inefficiencies (in this case of course the author is talking about the mess India is making of preparations for the Commonwealth Games) isn't such a bad thing as the money so misspent has a positive multiplier effect as it is spent and spreads through the economy.

Dangerous and naive in my opinion. Think about it - one could actually reach the conclusion that the greater the inflation of costs by corruption and inefficiencies, the better it is for the economy on a macro level!! If this kind of thinking spreads, with the implicit stamp of some sort of approval that publishing in a leading global financial daily brings, this could become a mantra in large parts of the developing world (who knows - maybe the developed world as well) and we could even see a day where competitive bidding includes a bidding component for bribes vendors etc are willing to pay (this may often already exist but not overtly).

Let's consider that with very few exceptions, those entrusted with the task of deciding how money is spent do so on behalf of certain stakeholders - significantly shareholders of companies, citizens of countries where Government spending is involved and of course creditors. Let's look at the effect on each category:

1) Shareholders of companies - Clearly the viability of projects whose costs have been "inflated" and therefore the returns to project sponsors (ultimately those who have put up the risk capital and their successors i.e. the shareholders of sponsor companies) are adversely affected. Simply put, stock price appreciation and dividends, the two ways in which shareholders earn returns from an investment in companies shares, are both reduced. The principles of equity are even further violated if and when it is the managing shareholders who benefit at the expense of other shareholders. Sadly, this is often the case. Their motivation can no longer be assumed to be aligned with those of other shareholders.

2) Creditors' interests are similarly affected - simply put the risk of default and the ensuing losses rises significantly. Credit issues and defaults also lead over time to reduced credit availability - not good for growth. There's a good reason the recent global financial crisis is also referred to as the credit crunch.

3) In the case of countries, it is sadly the weakest and poorest sections of citizenry that are worst affected. They often don't see any benefits from the project and the money misspent directly bites into resources available for investments that could improve their lot and also investment in infrastructure, education etc (badly needed in the developing world) that if intelligently spent can have huge benefits to those economies.

Also, remember that where costs have been so inflated, the money so gained will often not actually be spent or intelligently invested in the economy and will only fuel asset price bubbles - we now know that bubbles burst and the result isn't pretty!

Apologies if this post sounds a bit simplistic but if the WSJ could publish an article like this then clearly some vary basic points need to be made.

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