Discounting the bullet train

“It is kind of free,” said Prime Minister Narendra Modi about the Mumbai-Ahmedabad High-Speed Rail project (referred hereafter by its popular name, the bullet train), in its ground-breaking ceremony last week. He was referring to its financing. Japan will provide Rs 88,000 crore (81 per cent) of the Rs 1.1 lakh crore cost as a 50-year loan at an annual interest of 0.1 per cent with a 15-year moratorium.  These exceptionally favourable terms have led to a debate, as have several other features of this venture. Critics say that these parameters yield an unrealistic and overly optimistic internal rate of return for the bullet train.

Internal rate of return is one of the end results of discounted cash flow (DCF) analysis. This takes into account the time value of money for a multi-period project and is based on the reckoning of costs of opportunities forgone in choosing it.

A personal aside: The long-known DCF was introduced in the mid-1960s as part of the development economics curricula in universities. I was among the early students of this concept. I taught it in postgraduate courses and executive-training programmes.  It was quite a novelty in the early 1970s and not very easy to get across. I have continued to use it extensively in my work.

Any undertaking providing benefits in the future involves sacrifice of some alternative use of the funds invested at present. The investment is justified if the sum of the stream of future benefits is greater than the value of present opportunities foregone.  That sum needs to be discounted by an appropriate factor as it materialises not now but later, while the sacrifice is made at present. For investments with limited commercial objectives, such as those of private firms, the factor is the interest earned on own funds or paid for borrowed money. The discounting factor for projects with social benefits is based on weights the society attaches to present and future consumption. A very poor society with low consumption levels will use a high discount rate, while a rich one would use a fairly low one.

On this logic, the negligible rate of interest is the correct discounting factor for both India and Japan. There is little sacrifice involved in India, as Japan funds the project and since the loan is tied to it, investing the money on offer for other purposes is not possible.  For Japan, the cost of funds is extremely low; in fact, not too long ago, Japan had a virtually negative bank rate. It would also create substantial additional demand for Japanese goods and technology in a new market segment.

The logic of using very low, near-zero, rates of discount for projects of long gestation and duration must prevail even when relatively poor societies invest their own meagre resources in creating facilities to provide desirable outcomes.  Large irrigation and infrastructure projects are typical such instances.  Leaving aside controversies on their distributional impact, these activities sometimes take a decade or longer before starting to generate sizeable benefits. Using prevailing interest rates as the discounting factor leads to a gross underestimation of the value the society would normally attach to the these outcomes.  Present values of benefits 20 and 25 years hence at a 10 per cent discount rate are 13 and 8 per cent of their nominal values respectively.

Conventional analysis is thus not quite relevant for investments which could be rightly termed as gifts that keep giving.  We borrow money to own our housing even if the equated monthly installment of repayment is higher than the present rent for equivalent accommodation.

China made enormous investments in power plants, dams and world-class road and rail networks starting in the mid 1970s.  The end result was its spectacular double-digit growth sustained over a long period and global economic dominance three and four decades later.

A relevant but much smaller Indian comparison is with the 1950s and 1960s decisions to establish Indian Institutes of Technology (IIT).  Their feasibility could never have been established even without DCF given since they charged the students pittance as tuition.  Yet one could assert without fear of contradiction that the alumni of these institutions created the image of excellence of Indian technocrats abroad, leading also to substantial homeward remittances earlier and now venture investments.  Arguably, it was also the basis of the information technology revolution placing India in global limelight half a century later.  Although neither of these were planned as results of IITs, they would not have happened in the absence of IITs (disclaimer: the writer is an early alumnus of IIT Bombay).

Friendly gesture: Prime Minister Narendra Modi and his Japanese counterpart Shinzo Abe shake hands at the foundation stone-laying ceremony of the bullet train in Ahmedabad last Thursday. Photo: PTI

Questioning the Bullet train in view of the investment needed in Indian Railways is similar to saying that India needed to invest in primary education rather than in IITs.  The fact is India in either instance needed both the activities.  Much has been written recently, including in this paper, about the direct and indirect benefits of the Bullet train.  We must also remember that this is a classic case of supply creating its own demand.  Shekhar Gupta cites Konkan Railway and the Mumbai-Pune Expressway as examples of this (“Homeopathy as ideology,” Business Standard, September 16, 2017).  The short point is that even the best estimates of future utilisation of such projects are often short of what really happens.

Modi first visited Japan in 2006 as chief minister of Gujarat. He got five minutes with Shinzo Abe, who was the Japanese premier then too. That was a purely formal call, without any agenda.  Modi also managed a ride in the Shinkansen train, including a visit to the driver’s cabin.  He told a bureaucrat accompanying him that he wanted to bring the bullet train to India. It has taken him a decade to do so.  Luckily, he did not attempt to follow DCF analysis in this interim!