Monday, 15 January 2018

Domestic Resource Cost Analysis: Israel’s contribution to the CBA methodologies

Domestic Resource Cost Analysis
Israel’s contribution to the CBA methodologies
Devendra Narain
(Former head of the Project Appraisal Division,  Planning Commission)

At a time when India and Israel are strengthening their economic and strategic partnership, it would be relevant to pay tribute to Israeli economists for their significant contribution in 1960s which benefited project appraisers of India even without their (Israeli economists’) knowledge and much before the two countries established diplomatic relationship in January, 1992.

The contribution is development of methodology of Domestic Resource Cost (DRC) analysis which enriched methodologies of cost-benefit analysis (CBA) being developed in the Western countries,  India started using this methodology way back in early 1970s when the Project Appraisal Division was set up in the erstwhile Planning Commission to carry out ex-ante as well as concurrent appraisal of major investment decisions by the Central Public-Sector Undertakings and most of the Central Government Departments.

Different methodologies of CBA where developed in the Western economies over a long period of time. The need for CBA arose because of the realisation of the constraints of the conventional financial profitability analysis (CFPA). The private investors are concerned with the costs they incur and the benefits that accrue to them. However, this methodology cannot reflect the total costs and benefits when the state takes  investment decisions for the benefit of the society. The major constraints of the CFPA are as follows:

(a)  When investments are made in un-priced economic activities i.e. for the production of supply of goods or services which are supplied to the consumers free or concessional rates, i.e. public parks, roads and bridges, market prices cannot capture all the costs and benefits.

(b)  In the absence of perfect competition and on account of various tariff and nontariff restrictions on free-trade, market prices fail to reflect the real worth of the scarce resources and full costs and benefits from the point of view of the entire society.

(c) Many elements of cost and benefits which are indirect, secondary, intangible, or external to the particular project, may not enter into commercial profitability analysis of a private entrepreneur. The undertaking implementing the project may not pay directly for some cost  which others have to bear. A classic example of such cost is pollution caused by a factory. (This was the position before anti-pollution measures were made mandatory.)

The complete system of project appraisal including its CBA component (as it exists today) is the product of development over more than a century and half. The different components were developed gradually. It is remarkable that experts from different disciplines – engineering, economics, public finance, public administration, etc. – from different countries of the world worked largely independent of each other to develop the system.

Initially, economics and engineers, particularly in France, US and UK, developed methodologies to deal with the problems they faced. In 1844, while analysing the benefits of a bridge constructed over a river which drastically reduced time to cross the river, Dupuit, a French engineer (Inspector of Bridges), often described as the ‘intellectual father’ of CBA, pointed out that the price mechanism was ill-equipped to indicate the value to the society of the unpriced or inadequately priced activities such as public utilities. He suggested that in such a situation, willingness to pay could be more than what was charged. Without using the term ‘consumer surplus’ he had actually hinted at that. From the early 20th century, the US government started making investment in the development of irrigation facilities, waterways and flood control measures. The US Congress made law to ensure that all costs and benefits, direct and indirect, were identified and quantified. Later, the US Flood Control Act of 1936 enunciated the principle that a project could be considered desirable only if the benefits that might accrue exceeded the estimated cost, direct as well as indirect. The methodologies were subsequently refined by various expert bodies appointed by the US government. In the UK, a number of studies were carried out, especially during the 1960s in the transport sector, to ascertain the real costs and benefits to the waterways and underground railways. In 1967 the British government directed the nationalised industries to adopt cost-benefit analysis.

The emergence of developing countries which adopted the system of planning for achieving the objectives and in which during the era of license and control there was wide dichotomy between the market prices and opportunity costs of goods and services contributed to the development of the methodology from the point of view of developing countries. By the early 1960s, the governments, economists and the aid agencies realised that for achieving these objectives macro and sectoral planning adopted by the developing countries alone was not sufficient. It was necessary to ensure that the scarce resources where invested in the most viable projects. Therefore, there was need for a set of “surrogate” prices to be used for the evaluation of costs and benefits of projects from the point of view of the society.

The result was preparation of comprehensive methodologies for use in the developing countries. The principal methodologies, based on the work done in the Western countries, were:

(a)     UNIDO (United Nations Industrial Development Organisation) Methodology, explained originally in the “Guidelines” (written in 1972 by P. Das Gupta, Amartya Sen and Stephen Marglin) and subsequently explained by Hansen (1978) and John Weiss (1980).

(b)  OECD (Organisation of Economic Co-operation and Development) Methodology (1968), further refined as Little-Mirrlees Methodology (written by I.M.D. Little and J.A. Mirrlees in 1974) and simplified by the World Bank economists (Squire and Tak in 1975 and Colin Bruce in 1976).

Basically, these methodologies deal with the situation when the market prices of traded a/tradable as well as non-traded inputs and outputs are distorted and all objectives need to be expressed in a common numeraire or accounting unit.

However, these methodologies were not enough for Israel, a country that started its journey on the path to economic and military development from scratch with several constraints. Deprived by the nature of the vital natural resources, with little manufacturing capacity and facing violent hostility of the Muslim countries and their friends, it depended heavily on aids, especially from the US and Germany, to import manufactured goods and create domestic manufacturing capacity with imported raw materials. Israel had also to borrow heavily.

The main asset of Israel was its people, most of whom had come from several parts of the world. Led by dynamic and committed political leadership, the Israelis were determined to overcome all the constraints and become a major economic and military power.

The main economic challenge was to save every unit of foreign exchange received and to earn more foreign exchange to build the country and become independent of foreign aid. Faced with the challenge, the Israeli economists developed the methodology of DRC analysis. The analysis helps estimate the total domestic resources spent to earn or save one unit of foreign-exchange which can be compared with the official exchange rate to ensure that the domestic resources are invested in those projects which maximise foreign earning as well as saving. Subsequently, several countries, including India, facing shortage of foreign-exchange, adopted this methodology.

Today, Israel is almost self-sufficient in food production. Though it has to import raw materials for manufacturing and also investment goods, it has become an important exporter of machinery and equipment, chemicals, textiles, software, etc. By making massive investment in research and development, it has made significant progress in the field of science and technology and developed technologies that earn foreign-exchange. The country has made significant progress in the development of software, space technology, renewable energy – it has the worlds largest solar parabolic dish – water conservation, desalination and water recycling, etc.  

Once dependent on Western military support, today with over 150 difference companies, Israel has become a major exporter of defence equipment (ranked sixth largest arms exporter in 2014).

In 2007 Israel stopped taking economic aid of any short and now it has one of the lowest external debts.

Israel is an example to the developing countries how determination, hard work and appropriate technology can transform a poor country into an economic and military power.

January 15, 2017