6 AM Pacific

The Unfinished Business of Labour Reform

Property rights form the fundamental bedrock of capitalism. In a capitalistic society an individual’s right to own property and dispense with it as he deems fit, must be protected. Only then is the individual encouraged to invest money and effort to add to his property. (Here the term property applies to all assets, not just real estate)

If India is to keep the momentum going on its recent economic growth, it must strengthen the pillars that hold up the edifice of capitalism in the country. Property rights are the most important ones. There are many laws like the rent control act that impact an individual’s right to property. In some cases, the inability of the state to protect its citizens’ property may be construed as something that erodes property rights. I see labour inflexibility in India in the same light. Many will not agree with me on this. I believe that shareholders of a company ‘own’ the company. Not allowing the company to conduct its business as it deems fit, including hiring and firing employees, is in effect constraining the shareholders’ rights to property. More »

Tags: Economics, India

The Worth of a Job

It’s been a long time since my last post. Perhaps too long. Things have been busy at Gridstone Research, the startup I work for and blogging had to take a back seat for a while.

So to make up for it, here’s a meaty subject. Why do people in different professions get paid what they get paid? It’s an interesting subject and I thought I would find some research on it on the internet, but I couldn’t. There’s a lot of data on what people get paid in different professions, but the question we are trying to answer is why.

Let’s first clarify the question at hand. We are not dealing with executive compensation here, although that is quite an interesting (and topical) subject in of itself. We also know that in any profession the higher you sit in the organization chart the more you get paid (generally). What we want to compare here is compensation in different professions - investment banking or software sales or retail bank front office – taking out the effect of position and years of experience. We will ignore stock option related windfalls, which are anyway becoming rare. And for this piece, we assume that we are comparing professions in the same city, so there is no cost of living impact on wages.

After all the assumptions in the last para, you are still left with a significant variation in compensation both at entry level (out of college or business school) or at any time marker after that. The question is why? What makes some jobs worth large amounts of money while others are so-so?

Here’s my hypothesis. If the person in a job can directly impact the company’s profit in a significant, measurable way that job will get paid more than someone in a job that doesn’t.

That sounds almost like a truism. But let’s examine more closely what it means. An example will make it clearer.

Take the job of a Portfolio Manager (PM) at a Mutual Fund. The PM decides which stocks to buy, hold or sell for the Fund. He almost entirely determines how the Mutual Fund performs. If the Fund performs well, its shareholders make higher returns than other comparable funds. The word spreads and more money pours into the Fund swelling the management fee that the Fund Management firm charges. The average mutual fund in the US had assets of $1.05B and expenses of 1.25% in 2005. A 25% increase in assets increases the firm’s fees by over $3 million which should largely drop to the bottom-line. As you can see, the correlation between the PM’s decisions and the business outcomes are very high. Also, and importantly, there are few if any other things that matter. Unlike in a manufacturing company where many people contribute to the value and quality of the product, the PM might depend upon the recommendations of the Fund’s Analysts who research companies, but he makes his own final decisions. Random events or luck play a minor role, especially if these events impact the benchmark as well.

The PM’s job therefore fits our criteria perfectly. He directly impacts the firm’s profits in a significant, measurable way. Not surprisingly, the Portfolio Manager for a Mutual Fund in the US is a highly paid job. Many of them take home over $ 1 million.

Sales people in most industries that sell to businesses tend to get paid more. What predictions can one make about compensation in the Sales profession using my hypothesis? A Sales professional will be paid more when Gross Profit (or Contribution) per Sales professional is higher (significant impact to profit). A salesman for Boeing should therefore be one of the highest paid salesmen in any industry. Also Revenue Producers will be paid more in the Professional Services industries where the Partner or the Banker is the product himself. The client often knows and trusts the Partner or Banker and will give him the deal because of him and not the company he works for (direct impact). Therefore, Management Consultants, Lawyers and Investment Bankers all get paid oodles of cash.

A school teacher’s job is a tough one. They mold young minds. A good teacher can be a glorious thing for a young student. What can be more important than this job to both individuals and society? Yet school teachers are paid very little in almost every country. I have often struggled with this paradox. Why wouldn’t we pay school teachers more and get the best we can for our children?

Let’s take a school teacher’s job and evaluate it against the criteria in our hypothesis. A school teacher definitely directly impacts the outcomes for particular students. This impact can be undoubtedly significant. You might decide to become a writer because of a superb English teacher, or totally lose interest in Biology because of lousy one. However, a school teacher in the US typically works for a public (government) school and not for a business. And the outcomes for students discussed above are not exactly measurable outcomes. So a school teacher’s job doesn’t fit the criteria in our hypothesis on a couple of counts. So school teacher salaries will predictably be low, attracting average talent and with lower incentives to excel.

On the other hand, consider the teachers in Delhi’s IIT coaching classes. Their outcomes are very measurable – the students’ JEE rank. The students’ JEE rank drives both the enrollment in the coaching classes and the fees per student. No wonder these teachers can take home as much as Rs. 15 lakhs a year, a salary that an ordinary school teacher in India can only dream of.

I think the hypothesis in general works. But like most things in the complex world of business, it’s hard to make rules stick. There are always eddy currents that produce exceptions. If you find any, let me know.

Tags: Economics

The right time for labour market reform is now

In my first job out of business school with Hindustan Lever, as Area Sales Manager I had a team of over 20 unionized salesmen. I ran a Voluntary Retirement Scheme in my first year and then again in my third year by which time we were down to half the original team size. Yet we introduced new brands in the market, grew our sales and in general did well as a team.

In my third year I took over a small new business of hot beverage vending for Lipton (at that time a division of HLL). The business was small but growing rapidly as we expanded our city coverage. In Sales, Distribution and Service we had about 50 people. Of this the number of direct Hindustan Lever employees was 2. The rest were all outsourced, contract or distributor’s employees.

I then moved to Infosys in the US and over my 11 years there, hired scores of employees onto the company’s US payrolls. I also had to let go of some people for performance or other reasons. At all times, I was acutely aware that I myself was an ‘At Will’ employee. I could be fired with two week’s wages without giving a reason. As long as the reason was not discriminatory (race, sex, religion etc.) I could not bring legal action upon the company.

My experience with the vastly different labour environment in both India and the US has driven home a very important lesson - a business exists to make money for its investors, not to provide employment. And that is, paradoxically, the best way to generate employment.

Let’s take a look at how India’s labour laws distort the business environment and harm employment and employees:

1. It discourages capital investment - particularly in service oriented industries. Investing capital means taking risks. Market risk - the risk that the business may not succeed - is a risk that ‘comes with the territory’. In most countries, investors know that if their business fails in the market, they close down the business, sell off the assets at knocked-down prices, book the loss and take the remaining capital to some other investment opportunity. However, in India, failure, or a downturn, in the market also means that you are still saddled with the payroll costs because you can’t restructure or layoff anybody. You can’t exit the business because employees will lose jobs. That’s something investors don’t have to deal with in most countries. You look at so many rusting factories in every major city in the country where the factory owner has not been able to layoff employees even when the networth of the company has gone down to zero, and you wonder - what a colossal waste of assets. You also wonder -  what do future investors think when they see these rust-buckets? More likely than not it’s - ‘That could be my investment 10 years from now.’

2. It provides no incentive for raising productivity through automation. Look at all the government offices or offices that have unionized staff like banks. To the last one, they opposed computerization. Why? because it could do the job faster and so it would reduce the number of jobs.

Yes it will and that is a good thing. Doing more work with fewer people raises productivity. Productivity raises incomes. The developed world’s prosperity is entirely linked to higher productivity. Also higher productivity creates the surplus (or the profit) that can be invested to create more jobs.

3. If you want to produce a quality product or service it needs carrots AND sticks. With an employee who is not performing, you train, you mentor, you put them on Performance Improvement Plans. But in the end, the employee needs to know that if his performance does not improve he can lose his job. Without this freedom for businesses to manage for performance, it may be possible to compete against companies who are similarly hampered, but it is a clear disadvantage in the global market.

4. It pushes employment generation into the informal sector. In my second stint at Levers I would have loved to hire people directly into the company instead of outsourcing critical functions like Sales. With the Levers brand name as an employer we would have got great talent which would have been better for the company. However, Levers would not do that for a new business that could have failed leaving them with employees they wouldn’t know what to do with. So all of the hiring was done by outsourced contract firms. Did these employees get the PF and benefits they would have got at Levers? I doubt that very much. I don’t think these contract firms even paid any taxes since they were probably classified as Small Scale.

In summary, the current labour laws in India distort the business environment to where it reduces employment generation by discouraging investment, reduces income growth by discouraging productivity increases, reduces quality by taking away the freedom to manage for performance and pushes employment generation into the informal sector.

Whenever I bring this up with people in industry in India, I am given many reasons why this is not a problem. Someone says ‘Only 20% of my workforce is unionized, I just work around them’. Another one will say ‘If you really want to fire an employee for performance, it can be done.’ But most of all the reason I get is ‘But the economy is doing so well why do we need to think about redundancies and labour flexibility?’ On the contrary, it is because the economy is doing so well that this is the right time for labour reform.

I believe this is the most important reform that government must now address. However, this is also the most difficult. Dismantling industrial licensing was like a walk in the park compared to this. With the government dependent upon the CPI(M) to stay in power makes it almost impossible to do major reforms. But major one-shot reforms aren’t the right answer anyway. There should be a 10 year road map on labour reform. But starting now. Let’s begin the discussion.

Tags: Economics, India

Street Power

The recent fiasco in France holds many lessons for democracies everywhere.

France has this strange combination of a thriving corporate industry and high unemployment especially amongst youth. The culprits here are France’s rigid labour laws which make it almost impossible to dismiss or layoff employees. Companies therefore prefer not to hire. If they have to, they use temporary workers. Since older employees can’t be fired easily, unemployment hits the youth. Much of the unemployment is among the children of immigrants which ultimately was the cause of rioting in France a few months ago. People with no jobs are more likely to riot - they have time on their hands and nothing to lose.

The government in France, with the best of intentions, decided to fix some of these problems to regenerate employment amongst youth. But they could not suddenly change labour laws across the working population. If layoffs were permitted across the board, sure, growing companies would start hiring young people, but there would also be a lot of older workers laid off and out of jobs. So the government decided to make it easier to fire only young workers in the first two years after they join.

Big mistake. Within days, massive student and youth protests were organized across the country. Colleges shut down because all the students were in the streets protesting against what they were calling a law unfairly targeting young people! The government first said it was willing to negotiate the time period - make it 18 months instead of 2 years. In the end, Jacques Chirac just withdrew the bill, in effect dashing the Presidential hopes of his trusted luitenant Dominique de Villepin who was the author of the bill. So were all students against the new bill? No. Last week they were interviewing a law student from the Sorbonne on BBC. The student was being asked about the law and the protests. She was against the protests and for the law. She didn’t like the fact that the colleges had been shut for the past 4 weeks and who knows what would happen to her final exams. But more importantly, she thought that the new bill would generate employment for the youth! She also said that none of the economics and law students of her university were in the protest marches.

I think the new bill would have worked. Not that the French government didn’t deserve the shellacking it got. They have nobody to blame but themselves for making France into an insular, inflexible place to do business. But really, this bill didn’t have a chance. Why? For two reasons:

1. The rationale for the new law is not easy to explain. It is not obvious that making it easier to fire young workers will result in higher employment among the same workers. I can imagine myself trying to explain that to a 3rd year medieval history student. Even if I knew French, I don’t think I could. On the other hand, the opposition can easily spin it the other way portraying it as an evil law designed to protect older workers or even designed to keep immigrant youth from keeping good jobs. Here I don’t just mean the Opposition in Parliament. Every change has opposition to it simply because someone is going to get hurt by the change.

2. The opposition to the law had Street Power. The people who were in favour of the new law like the Sorbonne law student and her friends, did not.

Cut to India. Labour flexibility, for decades, has been the one reform that no politician wants to touch. It is hard to believe that if you are the owner or manager of a company, your company can make losses, go bust and lose its entire net worth, but you can’t restructure your workforce. Capital treads softly where labour is inflexible. There was a time when there was talk of an Exit Policy for sick companies. A very unfortunate choice of name, if you ask me. The opposition (trade unions) quickly positioned the Exit in Exit Policy to be the exit of employees. ‘Hire and fire’ was another colorful phrase they used. The government had to bury the whole thing.

But its now resurfacing. You hear snatches of statements made by the PM and FM about the need for labour flexibility. Although they’ve picked a better name this time, I don’t like the government’s odds of passing any substantive legislation on this matter. Why? because of the same reasons that the French government failed.

How do you explain the rationale of labour flexibility to Mr. Godbole who is a teller in a bank? Mr. Godbole, we plan to make it easier to fire people such as yourself because this will encourage capital investment which will generate more jobs. I can just see Mr. Godbole’s eyes glazing over. Before he gets angry. Even Mr. Godbole can understand that making it easier to fire him is not good for his pension. Self interest is a great motivator. When it comes down to Godbole’s job security vs. more employment in the country, Godbole knows which side of his toast is buttered. And finally, Godbole is part of a union. He has Street Power. His union can call a strike, do a dharna and if it comes down to it, burn a few buses. The stakes are very high. And a burning bus is an arresting sight on TV.

The challenge of sound economic policy making is that often doing the right thing benefits a silent majority, but hurts a vocal minority. In some cases the vocal minority can make their voice heard. In others they can take their campaign funding elsewhere. You need money to run elections. You need votes to win them.

I do think that one of the most important reforms that the Indian economy can benefit from is bringing labour flexibility. This is the best time to do it when economic growth is strong. But I won’t be holding my breath waiting for it. Not while the govenment depends upon the support of CPI(M).

Tags: Economics

Indian Real Estate Funds

The world of business is fascinating. There are parts of it that are science - you can predict outcomes based upon the conditions and a set of rules. Or you know that you could if you knew enough about the rules and could measure all the conditions. And there are parts of it that aren’t science. Or if they are, they are more of a ’social science’. I find joy in both CAPM and Leadership theory. Both make sense to me.

But then, I have another category - Things That Don’t Make Sense To Me. Over time I have generally found that most things in the TTDMSTM category don’t make sense to me only because I haven’t found the answer to my question, or haven’t found the right person to ask. But sometimes they just don’t make sense. The Indian Real Estate Funds question is one I have put to many people and haven’t yet found a satisfactory answer. So if anyone out there has a good answer I’ll be eager to hear from them. Here it is:

In the US there is a vehicle called REIT, which is essentially a publicly listed company that invests in real estate. Management fees are low and they are available to the public to invest in (both facts are linked in a way).

In India in the last few years real estate funds have been mushrooming like rabbits. Every company that has an asset management side of the house, and many that don’t, either has a real estate fund or is starting one. Which is not surprising, since the thesis that real estate is a good investment in a booming economy with crowded cities is reasonable. However, all these funds are structured so that they make a lot of money for the fund managers at the expense of the investors. Most of them have the economics of a Venture Fund - 2% Management Fees; 20% Carry. (20% Carry means that the Fund managers will keep 20% of the returns of the Fund over a certain hurdle rate of return).

There is a big difference between the risks in a Venture Fund and a Real Estate Fund. VC thumb rules say that a third of a VC’s investments go bust, a third are chart-busters with the remaining third somewhere in between. This is a high-risk business. It is also a business where the expertise of the fund managers in attracting and backing good ventures hugely determines the success of the fund.

Investing in real estate is not like that at all. The risk on individual properties is much more contained. Also, the level of expertise is not that high. A local real estate broker will know far more about a property than an MBA who manages the fund. I am not saying that the quality of management, the reputation of the firm and so on doesn’t add value, but 20% carry for just diversifying one’s real estate holdings sounds like a ‘get rich’ scheme - for the Fund managers.

As you may have guessed, I have so far not bought into any Indian real estate fund. If they come up with a REIT like instrument that is publicly traded, regulated and has low mutual fund like fees, I will gladly invest in that. Or if someone can explain what justifies the fees. If it is simply supply and demand for such funds, that’s not a good enough reason. I’ll wait.

Before you get influenced by this post, let me tell you about another TTDMSTM of mine - GOOG (Google). For a long time, my wife was on my case to buy GOOG. I didn’t. My reason - its P/E didn’t make sense to me. Where were they going to get that kind of growth from? Recently, when GOOG dropped over 20% from its high of $475, I told my wife that I felt vindicated about not buying GOOG. She sneered "I told you to buy it at $180!"

Tags: Economics, India