By Kalim Siddiqui
Corruption is a considerable challenge for Governments especially in the developing countries. It has become more serious over the last twenty-five years or so with globalisation and deregulation, which have led to an increased reliance on market forces. Under such circumstances, illegally appropriated money could be transferred abroad, also known as money laundering, which means much less is left for reinvestment into local economies. The author discusses the significant effects of corruption in the developing countries and their people. or reinvestment into local economies.
It is clear that a huge amount of capital is leaving the developing countries, especially from Africa, South Asia and Latin America, while the governments of these countries are often asking the IMF and World Bank for [additional] loans. Such foreign loans have to be repaid in foreign currencies, meaning that these countries have to increase their exports. The majority of the developing and poor countries are very often exporters of primary commodities and minerals, which means that any effort to increase the export of such commodities will simply mean increased supplies; however, if demand remains stagnant, then such efforts will lead to glut in the international market and falling export prices, and despite the fact that the quantities of such products have been increased export earnings will fall due to over-supply.
Over the last decade there has been a significant increase in the study of corruption, and indeed recommendations to control it. In 1998, thirty-eight countries were recognised by the OECD Anti-Bribery Convention. In 2007, the World Bank’s attempts against corruption began by launching its ‘Group Engagement on Governance and Anticorruption’ (GEGA) strategy. The US government also launched anti-corruption drives to reduce corruption with enforcement under the Foreign Corrupt Practices Action. These initiatives clearly show that governments and international institutions are concerned about growing corruption and its negative impact on the developing countries.
Corruption threatens to prevent economic development and prevents political stability. The term itself implies the use of public office for private gain. There are also examples from the developing countries of corrupt income running to billions of dollars by their rulers, like Mobutu in Zaire, Marcos in the Philippines, Mubarak in Egypt and Nawaz Sharief in Pakistan (Siddiqui, 2013). However, in recent decades there have been mass movements against government corruption in several developing countries such as Bangladesh, Egypt, India, Indonesia, Pakistan, Tunisia, Congo and the Philippines, which have resulted in governments being toppled; unfortunately, contrary to expectations, such external intervention did not appear to have much effect on corruption in these countries.
The efficiency costs of corruption can be quite severe, as corruption may increase the firms’ marginal tax rates and thus decreases business activity.
I will analyse this issue by defining corruption. Corruption represents a transfer of government money (public money) to another group (government officials and politicians). The efficiency costs of corruption can be quite severe, as corruption may increase the firms’ marginal tax rates and thus decreases business activity. It also increases the marginal cost of public funds by making government projects expensive and economically unviable, thus leading to inefficient outcomes. Transparency International defines corruption as the “misuse of public power for private benefit”. This imposes a serious cost on society, including loss of revenue from taxes and excessively high public expenditure due to its leakage, reduction in investment and growth, delivery of poor quality of services, and loss of confidence in public institutions. The poorer people in society generally suffer the worst due to corruption as it deprives the populace of basic services such as health care and primary education.
Generally, public corruption can be classified as being of two major forms: first, bureaucratic corruption encompasses dishonest practices by government officials in their interactions with the public; second, grand corruption is defined as being where political elites and government officials divert resources in a manner that serves their private interests, such as into offshore accounts. It can be said that businesses and politics are heavily intertwined.
I will also discuss the impact of corruption on the shadow economy. Corruption and the shadow economy are closely linked in developing countries but not so closely in the developed countries. In developed countries, the shadow economy and its relationship with corruption is very different from that in the developing countries. In the former, bribery of government officials, when detected engaging in the shadow economy, is rarely an option and businesses do not have to pay the bribes demanded by government officials. It is highly probable that corrupt officials would be prosecuted, while in latter group, businesses in the shadow economy can reasonably expect to escape without penalty when their illegal activities are detected. In the latter case, government officials typically collude with businesses and taxpayers in exchange for bribes.
The neo-classical economists assume that corruption takes place due to the government’s excessive control over the economy, which gives their officials the ability to disrupt otherwise efficient markets, and therefore that governmental over-regulation provides the opportunities for officials to take bribes in exchange for allocating rents for those who assist them rather than face delay. Krueger (1974), with regards to rent-seeking, assumed a process of competitive bidding by rent-seekers which resulted in a complete dissipation of the rent. For instance, it can be said that governmental interference in the market could lead to the creation of monopolies, import duties and subsides. However, such a situation allows for rent-seeking opportunities amongst government officials. The creation of economic rents means that the beneficiaries will be willing to pay a price. This also means that government officials must have some degree of incentive to break the law for those who pay them. It seems that the chance of being caught and losing one’s job, or indeed of other legal consequences, is extremely low. As Peter Eigen notes the reasons on why he founded Transparency International: “Corruption – the abuse of entrusted power for private gain – is a roadblock to human development. It distorts competitive markets, leads to the misallocation of resources, and disproportionately burdens the world’s poorest and most vulnerable. … Corruption makes a mockery of rights, breeds cultures of secrecy, deprives the neediest of vital public services, deepens poverty, and undermines hope”. (Eigen, 2008: 19)
Swedish economist Gunnar Myrdal (1968) blamed sociological reasons for corruption. Political leaders in India have a weak sense of loyalty to organised society, and a rather stronger loyalty to family, caste, ethnic and religious groups, which is in sharp contrast to Western countries which encourages corruption and nepotism and which results in a ‘soft state’ with low levels of social discipline. According to Myrdal, corrupt governments officials may, instead of speeding administration up, actually ensure administrative delays in order to attract more bribes.
As more and more money is allocated for mega projects such as the construction of highways, there is greater potential for corruption.
Karl Marx (1978), in his Capital Vol.1, also noted that non-market transfers were most common during the transition from the pre-capitalist mode of production. He described it as ‘primitive accumulation’, namely that the transfer of assets from the pre-capitalist sector to the emerging industrial sector has never been achieved entirely through market exchange. He referred to it as primitive accumulation, through which the conditions of expanded capitalist production are created, and it is this process through which direct subsistence producers in the pre-capitalist economy are separated from their means of production and turned into wage labourers who have nothing to sell other than their labour power. Marx also emphasised that in the 18th and 19th centuries, during the transition from feudalism to capitalism and industrialisation in England, primitive accumulation involved theft, the enclosure of common lands, slavery, colonial plunder and deindustrialisation in the colonies (such as in India in the 19th century) (Siddiqui, 2018a). Britain used political power to engineer unequal exchange and transfer through the appropriate physical mechanisms, as Marx wrote in 1853 in the New York Herald Tribune, when Britain was claiming credit for the launch of the railways in India as a revolutionary development. As Marx (1853) noted: “the misery inflicted by the British on Hindustan [India] is of an essentially different and infinitely more intensive kind than all Hindustan had to suffer before…The profound hypocrisy and inherent barbarism of bourgeois civilisation lies unveiled before our eyes, turning from its home, where it assumes respectable forms, to the colonies, where it goes naked”.
Recent data from the Global Competitiveness Report (GSR) index, Transparency International (TI) and the Business International (BI) index point out that corruption constrains economic development by generating increases in government spending while creating instability and lowering foreign direct investments. As more and more money is allocated for mega projects such as the construction of highways, there is greater potential for corruption. Friedman et al. (2000) found that corruption is associated with unofficial activities that lead to decreasing tax revenue, while in order to hide the illegal money, government officials and politicians invest in the shadow economy, which in turn also leads to a fall in tax revenues.
There seems to be a large set of public consequences to corruption such as the rise in income inequality, lower GDP per capita, undermining the rule of law, lower investment, budget allocation distortions and a decline in the actual delivery of health and education services to the populace; indeed, corruption can distort the functioning of the entire economy. It also leads to market misallocation of resources, which is likely to distort economic efficiency. In open economies, corruption will encourage capital flights and adversely impact on foreign investors and undermine growth prospects. Corruption also contributes to environmental damage, the rise in organised crime and social polarisation.
Moreover, corruption is also associated with a larger shadow economy in the developing countries. The shadow economy, which is hidden from the revenue officials’ corruption, often takes place in order to pay for activities so that the business in the shadow economy is not comparably detected by government authorities. Under such circumstances, the shadow economy and corruption are likely to reinforce each other, as corruption is needed to expand the shadow economy’s activities, while at the same time the underground economy requires bribes to expand and flourish. Under such deals, businesses save on tax payments and government officials get bribes. However, such practices lead to a fall in tax revenues due to the expansion of the shadow economy, after which governments have to resort to overseas borrowing to finance mega projects. Mega projects provide also considerable opportunities for corrupt politicians and government officials to take large amounts in bribes, but in the long term such policies have an adverse impact on the poorer in society, as they are often forced to accept austerity measures so that foreign debts can be repaid.
The shadow economy, which is hidden from the revenue officials’ corruption, often takes place in order to pay for activities so that the business in the shadow economy is not comparably detected by government authorities.
Dreher and Schneider (2010) have analysed a cross-section of ninety-eight countries over the period 1999-2002 in order to find the relationship between corruption and the size of the shadow economy. Their results show that corruption and the shadow economy are complementary in the developing countries; they also found that there is no such relationship in the developed countries. In the developing countries, taxpayers collude with government revenue officials so that officials under-report taxpayers’ tax liabilities in exchange for bribes.
Another study by Olken and Barron (2010) analysed the widespread corruption in the transport sector (i.e., truck drivers) in the Aceh province, in Indonesia. The study found that truck drivers have to bribe police officers on their routes to and from Aceh. The truck drivers have to pay each time they are stopped at a police checkpoint or weigh station. “Over the 200 trips, they observed more than 6,000 illegal payments. Usually each payment was small – averaging US$0.50-US$1, sometimes in cash and sometimes in kind… In total, the illegal payments represented 13% of the marginal cost of the trip. By comparison, the salary of the truck driver was only 10% of the marginal cost of the trip.” (Olken and Barron, 2010:7) Another study by Fisman and Wei (2004) considered business tax evasion in Hong Kong’s exports and Chinese imports of the same product. The study differentiated three different aspects of tax evasion: underreporting of unit value, underreporting of taxable quantities and mislabeling of higher-taxed products as lower-taxed products. The study found that at least 40% tax evasion took place, meaning huge loss of public exchequer.
The mismanagement and rampant corruption in the government’s welfare programme, meaning that in reality the targeted group (i.e., poorer people) will have received much less than is actually declared. Olken (2006) studied an anti-poverty programme which was launched by the Indonesian Government to improve the living conditions of the poorer sections of society. This programme targeted the distribution of subsidised rice to the poorer households of Indonesia. He surveyed a few villages and compared his results with government data. His estimation employed the welfare losses due to corruption from “missing rice” which were large enough to offset the potential welfare gain from the redistributive intent of the programme. The intended programme, that is, in the absence of corruption, would have been very cost effective and would have transferred money from the government to the poor; but, due to corruption, it had the opposite effect. In a case study of deforestation by Burgess et al. (2011), the rampant bribes allowed more logging than the government officially targeted, due to reasons relating to the water-shed and biodiversity protection. The government officials’ corrupt practices led to increased illegal logging and hence a greater loss to the ecosystem and local environment.
India’s economic boom since 2005, also known as the ‘growth miracle’, certainly produced high growth rates (Siddiqui, 2018b) but also led to very high levels of corruption. A recent report by Transparency International (2018) ranked India 81st in its global index, down few places from ten years ago. Bribes and misallocation of resources lowers investment and economic growth. Developing countries businesses, such as in India, Pakistan, Brazil, China, and South Africa, skim off top/extract, what are called “rents”, while the country is building its infrastructure or developing its export sector. In fast-growing economies, expansion of infrastructure and other investments boosting projects are very tempting in terms of the opportunities for corruption they present, which is due to the existence of poor institutions and lack of transparency, which encourages ‘mega corruption’.
Under such circumstances, the suggestions made by the advanced economies and the international financial agencies could be deliberately misleading, with the intention of trapping these poorer countries in such a way as to benefit their own businesses and financial interests. For example, John Perkins’ (2016) book Confession of an Economic Hit Man, notes that the US government and corporations bribed the leaders of developing countries through providing them with huge loans, knowing that these countries will not be able to make their repayments. According to Perkins, these loans were recycled into their private accounts in US banks, who also become clients of MNCs (multinational corporations) such as Bechtel, Halliburton, and Boeing.
Cooray and Schneider (2017) analysed the relationship between corruption and public debt in 106 countries, where their results suggested that corruption leads to an increase in public debt. There are a number of other scholars who also found corruption could be damaging to the economy; it reduces growth, discourages foreign investment and undermines productivity growth and innovation. There are several scholarly works demonstrating how corruption inhibits economic development. As Wei argues, “There are several channels through which corruption hinders economic development. They include reduced domestic investment, reduced foreign direct investment, overblown government expenditure, distorted composition of government expenditure…” (Wei, 1999: 25)
Higher levels of corruption could result in higher rates of inflation and increase the size of the shadow economy. The experiences in many developing countries of the past two decades show that higher inflation also raises foreign debt stock and interest payment on debts, which means the country has to export more in order to service its debts (Siddiqui, 2018c). Under such situations, it is more likely that, despite the increase in the expenditure on education and health by the public sector, in reality due to corruption such investment does not reach its populace. Moreover, to maximise rent-seeking, politicians and government officials could be more inclined towards launching large-scale capital projects that are, in all likelihood, at inflated prices so that they can receive more and/or larger bribes. If a government accepts foreign loans to finance its developmental mega projects such as the construction of highways, ports and bridges, then foreign debt levels will of course increase sharply (Siddiqui, 2017a). Corruption not only increases public debt and expenditure, but in many instances can also change the composition of such public expenditure away from vital sectors such as health and education. Therefore, the more corrupt a government is the larger the proportion of money that will go to pay bribes, which can in turn reduce the total amount of tax revenues, hence requiring more borrowing and dependency on foreign lenders. Under such circumstances, this can lead to a vicious cycle of corruption and borrowing.
The effects of corruption can vary widely in developing countries. Most researchers have suggested that there are some common factors responsible for corruption that are different from those in the developed economies. At the same time, the diverse economic performance of the developing countries also suggests that not all developing countries face the same types of corruption. Developing countries can be categorised into two groups in this regard: one group whose per capita growth rates are higher than the developed economies and have built stronger institutions and rule of law. This group has generally also experienced a rapid transformation of their economies, and a lower rate of unemployment and poverty; and the second group who have experienced lower average growth rates (below OECD average) and high levels of unemployment with poor public institutions. This latter group is, consequently, generally falling behind in relative terms and has high incidences of corruption, mismanagement of the economy and political instability.
Since the early 1990s after the debt crisis, international institutions such as the IMF and World Bank introduced the Structural Adjustment Programme (SAP) in several developing countries (Siddiqui, 2017b). During the post-debt crisis, neoliberal reform programmes also included trade and capital liberalisation, which encouraged huge amounts of capital flight from the developing countries (Girdner and Siddiqui, 2008). The elites and corrupt officials found new opportunities to invest their illegally appropriated money abroad. In such cases, non-market asset transfers are very different from the primitive accumulation that led to the emergence of capitalism. The recent trends are instead simply predatory expropriations that bring economic and political instability, increased inequality and deepening economic crises in some developing countries.
The overwhelming reliance on one commodity for a large proportion of a country’s export revenues distorts the associated economy (Siddiqui, 2015). This is known as the ‘Dutch Disease’. Such development encourages corruption in developing economies, as witnessed in recent years in Nigeria and Indonesia; despite the sharp increase in oil revenues, foreign debts and corruption has risen sharply. Commenting on rampant corruptions in Nigeria, Hackett (2016:5) argues that: “These types of transactions really reflect post-colonial Nigeria, where relationship of moral, political and economic insecurity have evolved, suggesting that it is in navigating these insecurities that assess to the resources of the state may be granted… two ways of thinking of corruption with one being the abuse of the wider good by narrow interests, and the other being that whatever abuses the public good and undermines public faith in the integrity of rules, system and institutions is corrupting; perhaps examples of abuse in this case are a lack of effective governance, law and order, issues and questions around legitimacy of the government.” According to Hacketts (2016), the discovery of oil and the process of extraction have contributed to a significant rise of corruption, as it is known that oil and corruption go together and which is clearly visible in the fact of Nigeria’s oil income creating extraordinary opportunities for corruption. Therefore, it seems that a developing country such as Nigeria, with poorly developed public institutions and high inequality, huge oil and mineral dependency breeds and encourages corruption. Corruption is a clear sign that something has gone wrong in the management of the state.
Similarly, in Mozambique too the recent discovery of natural gas and the availability of Tuna fish on its long coast, attracted investors and bankers. Corruption has also risen sharply and new found wealth is seen as a ‘resource curse’. For instance, Mozambique’s former finance minister Mr. Chang, along with other ruling party leaders have been accused of stealing over US$ 2bn of hidden loans and bribery scandals. The Frelimo party has governed the country since its independence in 1975 and created a system of loyalty and patronage. In recent years, the country has witnessed new commodities to export, which certainly has created huge opportunities for corruptions for ruling elites. As Cotterill (2019:7) notes: “The origins of the scandal point to the opportunities for corruption that were created when a poor country discovered gas in 2009… [also] Mozambique has one of Africa’s longest coastlines – and plentiful tuna. But it also has security forces that are politicised, opaque and welded to Frelimo patronage by the legacy of the country’s long, post-independence civil conflict… and everyone will want to have his/her share of the deal while in office, because once out of the office it will be difficult.”
Global Financial Integrity has estimated that between 1950 and 2010, nearly US$ 462 billion (adjusted at current prices) has been lost due to tax evasion, corruption, drug trafficking and criminal activity in India.
India is regarded as one of the most corrupt countries in the world. In India, black money has become all pervasive, affecting the day-to-day life of the common man. Black money is that on which income tax is not paid and whose sources are not revealed. Black money as a percentage of national income in India was between 3-7% of GDP in the 1960s, but this has risen sharply since the early 1990s due to the adoption of neoliberalism, i.e., deregulation, privatisation, trade liberalisation and a more open economy. It was estimated that the black economy had increased to 40% by 2000, and is currently estimated to be nearly 50% of the GDP. This has resulted in huge losses of tax revenues, fiscal crisis and a significant rise in public debts as investment gets diverted to, or siphoned, abroad (Siddiqui, 1996). Global Financial Integrity has estimated that between 1950 and 2010, nearly US$ 462 billion (adjusted at current prices) has been lost due to tax evasion, corruption, drug trafficking and criminal activity in India. Mega corruption often involves high government officials and ministers who often also implicates MNCs and large domestic firms, in which both parties gain substantial benefits and the common people are ultimate losers. These mega projects are nexuses of large-value contracts and difficult to prove.
This neoliberal model of development is leading to further concentration of wealth into fewer hands and the culture of Western lifestyle and consumerism is fast spreading among the elites in India. According to Forbes, the number of billionaires in India has doubled within a decade to 52, and their combined net wealth has reached US$ 286 billion or a quarter of the country’s GDP. Any attempt to chasten the wealthy could inevitably cause instability and economic slowdown. If an elected government on the premise of introducing changes to status quo that favour the less well off, the wealthy and powerful merely send their capital overseas and thereby cause the market to crash, giving an impression of instability and chaos, thus causing capital flight and a downturn in investment and growth.
Moreover, foreign intervention to safeguard the interests of their big corporations also destabilises the economy and institutions of the developing countries. A number of studies have confirmed that the US has used forcible covert action against a series of elected governments in the developing countries since the 1950s to secure US global interests: Iran (1953), Guatemala (1954), Indonesia (1955), Congo (1961), Brazil (1964), Chile (1973), Nicaragua (1980s) (Siddiqui, 1990). David Harvey in his book (2003) The New Imperialism has argued that MNCs make decisions not in terms of what is best for the host countries but rather in terms of what is best for them. They organise the production and marketing of their products with little regard to the host country’s interests, where their main aim is purely to maximise profits and accumulation. According to Harvey (2003), the coup in Iran in 1953 was organised by the US intelligence agency, the CIA, to remove the elected government of Mohammed Mossadegh in order to secure US oil companies’ interests in the country. (Also see Siddiqui, 1990)
The need of MNCs to enhance their profitability drives them to seek new markets, and corruption is seen as an important and necessary method of securing the associated contracts. For instance, clear interference was seen in the host country politics in the case of ITT, a giant US firm who, with CIA collaboration, engineered the overthrow of the elected government of Salvador Allende in Chile in 1973, as he wanted to nationalise copper mines and telephone companies, which threatened US corporate interests. The ITT then bribed the government, which resulted in a military coup and eventually the assassination of President Allende. On the basis of the associated evidence, historian Peter Winn (2004) has found signs of US complicity in the coup of 1973. He argued that US covert support was crucial to engineering the coup, the assassination of Allende, and the consolidation of power by the Pinochet regime following the takeover.
Another global corporation, BAE systems, is the UK’s largest weapons manufacturer. The company offered bribes to win weapons contracts with Saudi Arabia. The company has exported weapons to Saudi Arabia for an extended period; however, in order to get these deals in the first place, BAE resorted to bribery. The arms deal is known as al-Yamamah, which involved aircraft and other military equipment. BAE admitted to false accounting and making misleading statements in relation to corruption, and agreed to pay out almost £300 million in penalties when it finally admitted guilt over its worldwide conduct, in simultaneous settlement deals with the Serious Fraud Office in the UK and the Department of Justice in the US. By this time, BAE had sold £43 billion worth of military hardware through al-Yamamah to Saudi Arabia. In 2006, Tony Blair, the then UK Prime Minister, terminated the investigation, arguing its continuation would damage Britain’s national security. BAE accepted that secret shell offshore companies had been opened to allow for covert payments into a Saudi intermediary’s Swiss account. It was said that Prince Bandar was “anonymously but unmistakably the recipient of $2 billion in ‘corrupt bribes’ from BAE”. (Leigh and Evans, 2010)
Another example of MNCs negligence and corruption took place in India. In December 1984, 45 tons of the dangerous gas methyl isocyanate leaked from the Union Carbide Corporation (US company) and more than 3,000 people died from its effects in Bhopal, Madhya Pradesh State, India. At the time, it was called the worst industrial accident in history; some further 50,000 people were treated over the first few days after the accident, suffering terrible side-effects that included blindness, and kidney and liver failure. Due to corruption, the culprits are still at large and hardly any lessons were learnt as to how to improve the legal system and create greater accountability in India.
The Panama papers leaked in 2016 show how Mossack Fonseca’s clients were able to launder money, dodge sanctions and avoid tax. This would seem to be a direct breach of international regulations designed to prevent money laundering and tax evasion. Moreover, this allowed for the brazen tax avoidance and evasion practices that powerful interest groups employ, even without ostensibly breaching legal frameworks, and certainly to the disregard of taxation rules. It is an important new source of both evidence and initiative for greater reflection on the principles of tax morality on a global scale, underpinned by rising inequality and low transparency in developing countries. The leaked documents also revealed that the offshore firm was not only a place for the rich to avoid taxes, but also showed how shell companies could be used to hide such criminal activity.
The IMF and World Bank have been doling out loans, slapping the harshest conditions on the developing countries and have been using the ruling elites of the borrowing countries to make such conditions ‘palatable’ for the people of these countries. Neoliberalism has virtually legalised corruption due to its deregulation and capital liberalisation policies. In recent years, corporate houses in India have developed a major way in which to finance political parties in an overt manner, as has been exposed by the Indian media. This has resulted in the unfettered behaviour of corporate businesses, which are now out to rein in people’s resistance to such activities.
There is an urgent need to gain greater control over corruption, and strict control over the transfer of illegally expropriated money.
In conclusion, since the 1950s the intervention in the poorer countries by the rich countries (namely the US) has undermined local institutions and, under such circumstances, corruption has flourished. The current economic model, with its implicit faith in the market forces which have been imposed by international financial agencies with the full support of the rich countries, has encouraged corruption. (Siddiqui, 2012)
There is an urgent need to gain greater control over corruption, and strict control over the transfer of illegally expropriated money. Of course, such measures will not be popular among the global financial capital and the IMF and World Bank. The domestic institutions and state have to play a greater role rather than largely leaving the situation to the market forces. There should be greater transparency and accountability to prevent public resources from being misused. It seems that governments also have to increase taxation on the rich, and the increased revenue should be spent on education and health, which are the most important factors for the development and prosperity of a nation.
About the Author
Dr. Kalim Siddiqui is an economist, specialising in International Political Economy, Development Economics, Economic Policy and International Economics. He is senior lecturer at the Department of Accounting, Finance and Economics, University of Huddersfield, UK. He has taught economics since 1989 at various universities in Norway and UK.
Kalim is member of a number of international economic bodies including: Association for Heterodox Economics; International Initiative for Promotion of Political Economy (IIPPE) and The World Association of Political Economy (WAPE). He has spoken at several conferences in Denmark, Germany, Norway, Sweden, Portugal, Poland, Turkey, China, India, Pakistan, USA and UK.
References
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As CEO and founder of 2ndBase Inc, Cape Town-based André de Wet helps companies grow and launch their businesses internationally.
Uber: Pressure to Perform
By John Colley
News that Uber’s 2018 third quarter losses have widened to $1.1 Bn with slowing sales growth, are signs of a much more difficult future for ride hailing. The concept of low cost, easily summonsed, responsive taxi services provided by part time car owner drivers is attractive to drivers, customers, governments, investors and even economists alike. Or is it? The reality is starting to appear much more doubtful and suggests interested parties are going to be significantly less happy.
Uber CEO Dara Khosrowshahi has the almost impossible task of steering the privately held firm towards profitability, whilst at the same time maintaining user growth. Rarely has a business consistently managed to lose so much money for so long. The promised 2019 Initial Public Placing (IPO) means the current performance has to significantly improve and begin to offer the prospect of profits if new investors are to be attracted. Current investors are keen to take profits sooner rather than later and have concerns that stock markets are becoming increasingly volatile which may delay the IPO for a protracted period. Investors may also have other concerns as the ride hailing business model may not be capable of profit delivery. User growth is slowing and losses will top $8Bn over the last two years.
Uber’s Model
The business model relies on a responsive cheap service summonsed by an app. The intention is to create network effects so that the more drivers the greater the benefit to customers through increased responsiveness. The more customers then drivers gain through more fares and less time waiting for a fare. The theory suggests, and indeed investors hope, that this is a ‘winner takes all’ market. To ‘pump prime’ this model Uber offers incentives to both drivers and customers to attract them from other taxi companies and forms of transport. The weakness in the model is that the app has no proprietary software and so can easily be copied. There are also low switching costs for both drivers, many of whom also work for other taxi businesses, and customers who may have more than one taxi hailing app. There is also a problem with the proposed sustainable aspects of the ride hailing model in allowing ride sharing and avoiding the need for car ownership by customers.
Good For The Environment?
Firstly recent research (reported in the Economist 3rd November, 2018) finds that half of all Uber trips directly displace journeys by public transport or walking. In effect half the journeys are creating pollution, congestion and road accidents. Taxi hailing scarcely benefits the shared economy as it is actively displacing shared public transport. Uber may claim to be encouraging use of hybrid and electric vehicles but the proportion of trips by sustainable transport looks disappointingly small. Cities such as New York or London which has 40,000 Uber drivers are considering restricting new taxi driver licences. Worse still the average Uber driver travels 2.8 miles additionally for each paid mile. The number of taxi drivers in London has doubled in 4 years to 120,000 in 2017 and rising. Sooner or later governments will have to start restricting these services.
Stakeholder Benefits?
How about the drivers who are receiving additional income? The problem is that they have been lured into this business with highly subsidised incentives from Uber. However these are are now being withdrawn. Uber drivers are striking in a number of cities due to wage cuts in an attempt to make the firm profitable and in preparation for the looming public offering of the shares. In 2017 Uber lost $4.5Bn; in 2018 it is likely they will lose between $3 and $4Bn. This is unlikely to encourage new investors when the investment banks promoting the sale of the shares are attempting to justify a $120Bn price tag.
Not only will wages have to decrease but prices will have to increase. This is happening quietly in many markets. There has also been the offer of subscriptions to avoid surge pricing. The problem now is that there is competition running similar models in most cities. Higher prices will simply push customers to other ride hailing competitors. Low switching costs can work for and against a business like Uber. Incentives attract customers and drivers rapidly with meteoric growth, whilst both can move rapidly elsewhere if conditions appear more attractive. From zero Uber attracted over 40,000 drivers in London in 4 years. Similarly over that period they created 3.5 Mn customers on the basis of Uber’s own figures. Easy come, easy go! The model is easily replicated therefore anyone willing to invest significant money in attracting drivers and customers is likely to experience transitory success. To make matters worse the battleground is each city so a competitor only needs to select a few cities to take on Uber.
In effect Uber is simply offering low prices and high wages in a highly commoditised market together with substantial advertising. All funded by the shareholders. It could be argued that anyone doing this in commoditised markets will attract significant trade, and indeed lose it once prices are increased. The model may do little more than pass wealth from investors to drivers and customers.
The subscription service to avoid surge pricing is aimed at increasing switching costs. This is intended to avoid the haemorrhage of customers who when faced with surge pricing go to a competitor, possibly never to return. The idea of surge pricing is to equate supply and demand at times when demand exceeds supply such as large events. The surge pricing translates to higher driver wages which is intended to incentivise increased supply. Hence the model is the darling of economists. However if competitors do not adopt a similar approach then customers either pay the premium and grumble, or they exit to a competitor.
Investors
Investors have contributed $22Bn to Uber, a significant element is Saudi Arabian money via the Japanese SoftBank. Much of it has been used to subsidise driver wages and customer fares to kick start network effects. How many customers and drivers will stay? What is Uber really worth? Ironically SoftBank is also bank rolling competitors such as Lyft, Ola, Didi Chuxing and Grab. Clearly they have been trying to resolve some of the wars of attrition which are destroying shareholder funds by distributing to drivers and customers worldwide in the form of incentives. Uber has pulled out of China in favour of Didi Chuxing, and South East Asia in favour of Grab, they have also exited Russia. However the war still goes on in India in which Ola and Uber share the market roughly equally. Large amounts of money on both sides are being ‘invested’ in a war of attrition. At some stage a truce will need to occur.
Diversification
As growth in the taxi hailing business diminishes then to justify the bankers valuation Uber has to find more early stage investments such as food delivery, shared electric bikes and scooters, and autonomous vehicles. These could justify raising money and distract attention from the inability of the taxi ride hailing business to be profitable. One has the impression this is not going to end well for investors.
Autonomous Vehicles
Uber’s development of autonomous vehicles is a major diversification as Uber may know about providing taxi services but little about making and controlling cars. Several car manufacturers plus Google are developing similar technology. Why does Uber need to compete here rather than form a partnership? It will be a number of years before the driver no longer has to supervise the technology and only at that point does it become viable. In effect then Uber will be replacing cheap drivers who loan their vehicles with dedicated expensive vehicles which will need financing. It is really not clear how this will play out as an industry or whether Uber will be a prime beneficiary from autonomous vehicles.
UberEats
Home delivery of takeaway food appears to be the next attritional battle approaching the investors. This requires three way network effects all of which may need some initial incentives. Takeaway food outlets want to be listed on the website to provide more trade, customers need to be attracted to visit the website wanting responsive and reasonably priced delivery, and delivery people are required wanting plenty of work and remuneration. In the U.K. UberEats has around 10% of this market with Just Eat having 80%. Uber may need to ‘invest’ substantially to win this war. Indeed it may be more economical for them to buy Just Eat which is listed and in the FTSE100 so far from being a bargain. It is reported that Uber are negotiating to buy the loss making Deliveroo for in excess of $2Bn. Deliveroo has around 10% also of the U.K. market and again has a model which is far from proven. It could well be another model which does not work when profits have to be made.
The IPO is being brought forward apparently due to increasing market turbulence. However the longer the IPO is deferred the more progress on loss reduction will be expected and that is looking difficult. In effect we are seeing more ‘development opportunities’ becoming the focus of investment to obscure the reality that the taxi hailing model may never make money. Indeed the taxi industry has always been low margin and that situation looks likely to continue.
Uber has historically been highly secretive with its data, releasing little to the public. An IPO will bring an end to this approach as substantial data has to be released. At least we will then know the true position of Uber.
When profits are necessary the reality of ride sharing is far less attractive to the various stakeholders than originally envisaged. Driver incentives are ending and customer fares are increasing. Network effects with low switching costs may not be the recipe for success many hoped. Disappointment is only set to intensify once the model needs to make money in a highly competitive industry traditionally known for low margins and little profit.
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