6. Economics Notes 23

Elaborate Notes

INVESTMENT MODELS

Hybrid Annuity Model (HAM)

The Hybrid Annuity Model (HAM) was introduced in India in January 2015 to rejuvenate the Public-Private Partnership (PPP) model in the highway construction sector, which was facing challenges. It is a synthesis of the two pre-existing models: the Build-Operate-Transfer (BOT) model and the Engineering, Procurement, and Construction (EPC) model.

• Historical Context: Prior to HAM, highway projects were primarily awarded through three models:

  1. BOT (Toll): In this model, the private developer (concessionaire) bears the entire investment cost, builds the road, operates it for a specified concession period, and recoups the investment through toll collection. The primary risk, the ‘traffic risk’ or ‘commercial risk’ (i.e., whether the toll revenue will be sufficient), lies entirely with the private player. This model became unviable for many projects post the 2008 financial crisis due to financing difficulties and inaccurate traffic projections.
  2. BOT (Annuity): Here, the developer builds the road and the National Highways Authority of India (NHAI) pays them a fixed, semi-annual annuity during the concession period. The traffic risk is borne by the government (NHAI). However, this model placed a significant deferred payment burden on the government’s budget, making it fiscally challenging for a large number of projects.
  3. EPC (Engineering, Procurement, and Construction): In this model, the government bears the entire project cost. The private player’s role is limited to being a contractor for engineering and construction work, for which they receive a payment. While this model insulates the private player from financial and traffic risks, it puts the entire financial onus on the government, limiting the number of projects that can be undertaken simultaneously.

• Structure of HAM: HAM was designed to re-allocate risks more equitably.

  • Government’s Contribution (40%): The government (NHAI) commits to providing 40% of the project cost as a lump sum construction support grant. This is typically paid in five equal installments linked to project milestones. This initial infusion of public funds reduces the financial burden on the private developer, making it easier for them to secure financing.
  • Private Developer’s Contribution (60%): The private developer is responsible for arranging the remaining 60% of the project cost through a mix of debt and equity.
  • Revenue and Risk Sharing: Upon project completion, the NHAI takes over the toll collection. The traffic risk is therefore completely borne by the government. The developer receives the remaining 60% of their investment back in the form of fixed, semi-annual annuity payments over the concession period (typically 15 years), along with interest. The developer is also responsible for the operation and maintenance (O&M) of the road, for which they receive a separate payment.

• Benefits of HAM:

  1. Revived Private Interest: By mitigating the key risks for private players (initial financing risk through the 40% grant and traffic risk through government toll collection), HAM successfully attracted private investment back into the highway sector.
  2. Balanced Risk Allocation: It strikes a balance where the government bears the traffic and inflation risk, while the developer bears the construction and O&M risks, aligning risks with the party best suited to manage them. This principle of ‘optimal risk allocation’ was a key recommendation of the Vijay Kelkar Committee (2015) on revitalizing PPPs.
  3. Improved Project Execution: Since the developer has a long-term stake in the project’s maintenance, it incentivizes the use of better quality materials and construction practices.

Swiss Challenge

The Swiss Challenge is a method of procurement, often used for public projects, which combines elements of unsolicited proposals and competitive bidding. It aims to encourage private sector innovation by allowing them to initiate projects.

• Procedural Mechanism:

  1. Unsolicited Proposal: A private entity (the ‘Original Project Proponent’ or OPP) submits a suo motu proposal to the government for an infrastructure project. This proposal is typically detailed, including technical specifications, financial models, and often claims Intellectual Property Rights (IPR).
  2. Government Evaluation: The government assesses the proposal for its technical and financial viability and its alignment with public needs.
  3. Competitive Bidding: If the government finds the proposal attractive, it publishes the core details and invites counter-proposals from other interested parties in an open bidding process. This is the ‘challenge’ phase.
  4. Right of First Refusal: If a counter-proposal (from a ‘challenger’) is found to be superior to the original, the OPP is given the ‘Right of First Refusal’. This means the OPP has the opportunity to match the superior offer. If the OPP matches the offer, it is awarded the project. If it declines, the project is awarded to the challenger.

• Indian Context and Concerns:

  • While several states like Andhra Pradesh, Rajasthan, and Karnataka have used this method, it has been viewed with caution at the national level. The Draft PPP Rules, 2011, suggested its use only in “exceptional circumstances,” such as for projects involving proprietary technology or in underserved areas.
  • The Central Vigilance Commission (CVC) has raised significant concerns about the Swiss Challenge method, arguing that it may compromise transparency and create an uneven playing field. The information asymmetry between the OPP (who has had more time to prepare) and the challengers can be substantial.
  • The Vijay Kelkar Committee (2015) strongly discouraged the use of the Swiss Challenge method, warning that without a robust legal and regulatory framework, it could foster crony capitalism and discretionary decision-making, undermining the principles of fair competition.

PUBLIC-PRIVATE PARTNERSHIP (PPP)

Positives of PPP

• Access to Private Sector Finance: PPPs leverage private capital for public infrastructure, alleviating the direct fiscal burden on the government. This is crucial for capital-intensive countries like India, as highlighted in various Economic Surveys.
• Efficiency and Innovation: Private sector participation brings in managerial efficiency, specialized skills, and advanced technology. The focus shifts from merely creating an asset to ensuring its long-term performance and service delivery, a concept known as ‘whole-life costing’.
• Optimal Risk Transfer: A well-structured PPP contract allocates specific risks (e.g., construction, operational, financial) to the party best equipped to manage them. This theoretically leads to a more efficient project outcome. For instance, construction risk is best handled by the private contractor, while legal or political risks are better absorbed by the government.
• Improved Transparency and Governance: The structured nature of PPP contracts, with clear performance metrics and penalties, can potentially lead to greater accountability compared to traditionally executed government projects.

Limitations of PPP Models

• Contractual and Regulatory Challenges: The success of PPPs is heavily dependent on the quality of the concession agreement and the efficiency of the regulatory framework. In India, issues like delays in land acquisition, environmental clearances (‘regulatory cholesterol’), and political interference have stalled many projects.
• Risk of Crony Capitalism: Poorly designed PPPs, especially those with inadequate transparency, can lead to favoritism and corruption. The information asymmetry between the government and private players can result in contracts that disproportionately favor the private entity.
• Dispute Resolution: A significant number of PPPs in India have ended up in prolonged litigation due to disputes over contract terms, revenue sharing, or scope changes. The absence of a swift and effective dispute resolution mechanism has been a major bottleneck.
• Financial Sector Stress: The failure of many PPP projects, particularly in the infrastructure sector post-2010, contributed significantly to the Non-Performing Assets (NPA) crisis in the Indian banking system. This was a key aspect of the ‘Twin Balance Sheet Problem’ identified by former Chief Economic Adviser Arvind Subramanian.
• Cost to Consumers: Since private entities aim to make a profit, PPPs can sometimes lead to higher user charges (e.g., tolls, fees) for essential services, raising concerns about affordability and equity.

VIJAY KELKAR COMMITTEE RECOMMENDATIONS (2015)

The committee, officially titled the “Committee on Revisiting and Revitalising the Public Private Partnership Model of Infrastructure,” was set up to address the challenges plaguing the PPP model in India. Its key recommendations aimed at creating a more mature, stable, and equitable PPP ecosystem.

• Refocus from Fiscal Benefits to Service Delivery: The primary goal of a PPP should be the delivery of high-quality public services, not just as a tool for off-balance-sheet government financing. Performance monitoring should focus on service outcomes for citizens.
• Optimal Risk Allocation: Re-emphasized that contracts must be designed to allocate risks to the party best suited to manage them. The committee cautioned against the government taking on risks it cannot manage, such as commercial or traffic risks, which can lead to significant contingent liabilities.
• Strengthening Institutional Capacity:
  • Proposed the establishment of a national-level institution, 3PI (Public-Private Partnership Projects in India), to function as a center of excellence, support state governments, and develop best practices.
  • Recommended amending the Prevention of Corruption Act, 1988, to distinguish between genuine errors in decision-making and acts of corruption, thereby protecting honest civil servants.
• Robust Dispute Resolution Mechanism:
  • Advocated for an Infrastructure PPP Adjudication Tribunal to be constituted with judicial and technical experts to resolve disputes quickly and efficiently.
  • Suggested developing a culture of contract sanctity and avoiding retrospective policy changes that create uncertainty for investors.
• Revitalizing the Financial Ecosystem: Recommended encouraging banks and financial institutions to issue deep-discount bonds or zero-coupon bonds to raise long-term capital for infrastructure projects.

NATIONAL INCOME

Framework and Circular Flow of Income

The circular flow of income is a macroeconomic model that illustrates the movement of money, goods, and services between different sectors of an economy.

• Two-Sector Model (Households and Firms): This is the simplest model.

  • Households own the factors of production (land, labor, capital, entrepreneurship). They supply these factor services to firms.
  • Firms use these factors to produce goods and services. In return, they make factor payments (rent, wages, interest, profit) to the households. This is the income of the households.
  • Households spend this income on goods and services produced by the firms, which constitutes the consumption expenditure. This flow of payments completes the circle.
  • The income generated through this process is Productive Income, as it corresponds to the production of goods and services.

• Three-Sector Model (Households, Firms, Government): This model introduces the government, which affects the flow through taxes, spending, and transfer payments.

• Four-Sector Model (Households, Firms, Government, External Sector): This is an open economy model that includes transactions with the rest of the world (exports and imports).

• Transfer Payments vs. Factor Payments:

  • Factor Payments are payments made in exchange for productive services (e.g., wages for labor). They are included in the calculation of national income.
  • Transfer Payments are unilateral payments made without any corresponding good or service being provided in return (e.g., old-age pensions, unemployment benefits, scholarships). These are not included in national income as they do not represent any current production. However, pensions for retired employees are considered deferred wages for past services and are included in national income.

Economic Systems

• Market Economy (Capitalism): Characterized by private ownership of means of production and decisions driven by supply and demand in the market. The theoretical foundation was laid by Adam Smith in his work “The Wealth of Nations” (1776), where he introduced the concept of the ‘invisible hand’ guiding the market. In its purest form (laissez-faire), government intervention is minimal.
• Command Economy (Socialism/Communism): Characterized by state ownership of the means of production. Central planning authorities make all key decisions about production and distribution. The intellectual roots lie in the works of Karl Marx.
• Mixed Economy: A blend of both market and command systems. Most modern economies are mixed. The government plays a role in regulation, providing public goods, and redistributing income, while private enterprise drives most economic activity. The theories of John Maynard Keynes, advocating for government intervention to manage economic downturns, provided a strong rationale for the mixed economy model.

Sectors of the Economy

1. Household Sector: Comprises all individuals and households who are the primary consumers of goods and services and the owners of factors of production.
2. Private Sector (Firms): Includes all private enterprises, from small proprietorships to large corporations, that undertake production.
3. Government Sector: Encompasses all government activities, including administration, defense, and public sector undertakings (PSUs) that engage in production.
4. External Sector: Represents the economic transactions of the domestic economy with the rest of the world, including exports, imports, and international capital flows.

Important Concepts under National Income

• Domestic/Economic Territory: This is a crucial concept for calculating GDP. It is the geographical territory administered by a government within which persons, goods, and capital circulate freely. Importantly, it includes:

  • Ships and aircraft owned and operated by normal residents between two or more countries.
  • Fishing vessels, oil and natural gas rigs operated by residents in international waters.
  • Embassies, consulates, and military establishments of the country located abroad.
  • It excludes foreign embassies, consulates, etc., located within the country’s geographical boundaries.

• Types of Goods:

  • Intermediate Goods: Goods used as raw materials or inputs for the production of other goods. Their value is not included in the final GDP calculation to avoid the problem of double counting. For example, the tires purchased by a car manufacturer are intermediate goods.
  • Final Goods: Goods that are meant for final consumption or for investment. They are not subject to further stages of production or resale.
    • Consumption Goods: Purchased by households for final consumption. They can be durable (e.g., cars, refrigerators) or non-durable (e.g., food, fuel). Services (e.g., healthcare, education) are also a form of consumption good.
    • Capital Goods: These are durable goods used in the production of other goods and services but are not consumed in the process (e.g., machinery, factory buildings). Investment in capital goods is a key driver of economic growth.

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Prelims Pointers

• Hybrid Annuity Model (HAM): A mix of BOT (Build-Operate-Transfer) and EPC (Engineering, Procurement, and Construction) models.
• HAM Financial Structure: Government pays 40% of the project cost during construction; the remaining 60% is paid as an annuity after completion.
• Risk in HAM: Traffic/commercial risk is borne by the government (NHAI). Construction and maintenance risk is borne by the private developer.
• Swiss Challenge: A procurement method where a private player submits an unsolicited proposal, which is then opened to challenge from other bidders.
• Right of First Refusal: A key feature of the Swiss Challenge, allowing the original proponent to match the best counter-offer.
• Vijay Kelkar Committee (2015): Reviewed the PPP model in India. It discouraged the use of the Swiss Challenge method.
• Transfer Payments: Unilateral payments with no corresponding service. Examples: old-age pensions, unemployment benefits, scholarships.
• National Income Exclusion: Transfer payments are not included in the calculation of National Income (like GDP).
• Personal Income Inclusion: Transfer payments are included in the calculation of Personal Income.
• Pension Distinction: Retirement pensions for employees are considered deferred wages and are included in National Income.
• Domestic Territory: Includes embassies, consulates, and military bases of a country located abroad. It excludes foreign embassies located within the country.
• Double Counting: The problem of counting the value of intermediate goods in GDP. It is avoided by only counting the value of final goods.
• Final Goods: Consist of Consumption Goods and Capital Goods.
• Capital Goods: Produced man-made goods that are used as inputs for further production without getting transformed (e.g., machinery).

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Mains Insights

Investment Models: A Critical Analysis

• Cause-Effect (HAM): The failure of BOT (Toll) due to excessive private risk and the fiscal unsustainability of BOT (Annuity) led to the genesis of HAM. HAM’s success in reviving the highway sector demonstrates that an optimal and balanced risk-sharing framework is critical for the success of PPPs. However, a potential long-term risk is the accumulation of significant annuity payment obligations (contingent liabilities) on the government’s budget.
• Debate (Swiss Challenge): The core debate is Innovation vs. Transparency.
  • Proponents argue that it encourages the private sector to bring unique, innovative, and efficient solutions to the table, which may not emerge from standard government tenders.
  • Critics (like the CVC and Kelkar Committee) argue that it creates information asymmetry, giving an undue advantage to the original proponent. This can stifle fair competition and potentially lead to crony capitalism, where projects are awarded based on influence rather than merit. A robust, transparent, and legally sound framework is a prerequisite for its ethical implementation.

Public-Private Partnership (PPP): The Indian Paradox

• Paradox of High Potential, High Failure: India has one of the largest PPP programs in the world, yet it is plagued by stalled projects, litigation, and financial stress. This points to deeper institutional and governance failures rather than a flaw in the PPP concept itself.
• PPP and the Twin Balance Sheet Problem: Many PPP failures in the post-2008 era directly contributed to the Twin Balance Sheet problem (stressed corporate balance sheets and NPA-laden public sector bank balance sheets). Over-leveraged private companies that took on excessive risk in PPP projects defaulted on loans, crippling the banking sector’s ability to lend further and thus slowing down the entire investment cycle.
• The Way Forward (Kelkar Committee as a Guide): The recommendations of the Vijay Kelkar Committee provide a comprehensive roadmap. The focus must shift from a purely transactional approach to a partnership-based one. Key reforms needed are:
  1. Institutional Strengthening: Establishing an independent regulator and a center of excellence like the proposed 3PI.
  2. Sanctity of Contracts: The government must ensure policy stability and honor contractual obligations to build investor confidence.
  3. Dispute Resolution: Creating specialized tribunals like the proposed Infrastructure PPP Adjudication Tribunal is essential to prevent projects from being mired in courts for years.

National Income: Beyond the Numbers

• GDP as an Indicator - Strengths and Weaknesses:
  • Strength: GDP is a comprehensive measure of a country’s economic production and a widely accepted indicator of economic health and growth.
  • Weaknesses: GS Paper III (Economy) & IV (Ethics). GDP is often criticized for being a poor measure of overall welfare.
    • It ignores the distribution of income; a high GDP can mask severe inequality.
    • It does not account for the negative externalities of production, such as environmental pollution and resource depletion.
    • It excludes non-market transactions (e.g., care work done by homemakers) and the informal economy, which are significant in countries like India.
    • It treats all expenditure as positive; for example, spending on rebuilding after a natural disaster increases GDP.
• Policy Implications: An over-reliance on GDP as the sole policy target can lead to skewed development priorities. This has led to the development of alternative metrics like the Human Development Index (HDI), which includes health and education, and the concept of Gross National Happiness (GNH). For Mains answers, it is crucial to present a balanced view, acknowledging GDP’s utility while highlighting the need to supplement it with broader indicators of human and environmental well-being.
• Data Credibility: Recent debates in India regarding changes in the methodology of GDP calculation (e.g., shift to GVA at basic prices, new base year, use of MCA-21 database) have raised questions about data credibility. For a stable policy environment and robust investor confidence, the transparency and integrity of national income statistics are paramount.