Brazil

Use your coconut: Of investment gaps and how to fill them (conclusion)

The Philippines has been trying to crack open the investment nut by lifting its competitiveness for such a long time but has not been getting very far. Here’s why.

Continuing on from the first part where we looked at the country’s investment gap of over half a trillion pesos a year, we now turn to the problem of how to fill it and bring unemployment down. The imperative to boost competitiveness is based on the notion that low social returns on investment are due to a lack of opportunities to invest due to poor governance, inadequate infrastructure, and bad local finance.

Government failures caused by macro risks like poor fiscal, monetary and financial policies along with micro-risks including corruption, high taxes and weak property rights lead to a lack of incentives for investing in new ideas. These failures block the supply of innovation and investment. While this forms conceivably part of the problem, it does not necessarily explain the entire puzzle.

A missing piece is the demand not forthcoming from entrepreneurs for existing technology and capital even when it is available due to market failures. Dani Rodrik and Ricardo Hausmann talk about how this comes about when there are significant hidden costs associated with information and coordination. I will try to explain these failures using the coconut analogy.

Imagine that several decades after Robinson Crusoe left the island of Despair, a number of coconut plantations were established. The owners of these plantations were competing for a shrinking share of the coconut trade that existed between several islands in the vicinity. To improve their earnings, they each could find different ways of using the coconut. The process of discovering what types of products could be made comes with a cost caused by free-riders.

The evidence shows that low income countries actually develop first by diversifying their exports. The degree of specialization follows a U-shaped curve with income (diversifying more until reaching about the same level of income as Ireland before specializing). They do this by imitating technology already developed in rich countries. Instead of competing by creating new technology, they find cheaper ways of using existing modes of production in diverse sectors.

This process of “self-discovery” as Rodrik termed it often comes at a cost to the first-mover within a country, a cost which imitators do not incur. This creates a market failure because no one is willing to invest in this process since the information generated by it (“which goods can be produced more cheaply at home”) usually cannot be protected by patents.

This random process of discovery is why such countries as Pakistan and Bangladesh with similar levels of development and competitiveness produce very different products (the former produces soccer balls while the other produces hats). Korea and Taiwan also offer the same lesson (one produces microwave ovens and hardly any bicycles unlike the other). For the entrepreneurs who first ventured into these markets and were protected from the free-riding copycats, huge profits were on offer.

Bailey Klinger and Daniel Lederman have shown that their measure of export diversification, the frequency a country introduces new products into its export mix, is directly related to the height of entry barriers. This is a stunning result since it goes against the prevailing consensus on efficient and well-functioning markets.

Rather than the Global Competitiveness Index cited in the first part of this piece, which is based on subjective surveys, Klinger and Lederman used the World Bank’s Doing Business indicators for measuring barriers to entry which are based on objective measures like the number of days for starting and closing a business. They found that the higher the cost, the greater the returns to innovation from self-discovery.

The barriers in effect performed the role of greenhouses, protecting fragile innovative start-ups from the harsh winds of the free market. This counter-intuitive conclusion robustly supported by the evidence is consistent with the market failure argument. It violates the prevailing theory that increased specialization for poor countries and lowering costs of doing business is the way they should attract investments.

This is also borne out by the development experience of Japan which used “administrative guidance” to encourage many players within emerging industries to consolidate into oligopolies, Korea which offered loan guarantees as a way to subsidize the discovery costs of large diversified business conglomerates, India with its licensing raj which allowed a few pioneering software companies to gain economies of scale without the fear of new entrants, and Brazil which sponsored competitions for innovation with significant exclusive licenses going to the winner.

Klinger and Lederman state that this does not imply that there are no negative effects due to protection. What their study shows is that the positive effects swamp them. This means that rather than justifying protectionism, what it does is build a case for state support for emerging industries. I will have more to say regarding this in a moment.

Moving on to the second form of market failure which is due to coordination costs, picture the island once again. To transport various coconut products to other parts of the area, investments in seafaring ships and the training of sailors are necessary. These complementary investments are needed for an expansion of production to occur. Unfortunately, no one is willing to coordinate with the other inhabitants who live near the shore who could profit from such activities, so nothing happens.

Taiwan’s experience with the orchid industry is illustrative. When the world price of sugar declined, the state figured that shifting farm production to this high end product would prove beneficial. This required coordinated investments in things like greenhouses and storage facilities which the state encouraged and subsidized. The same type of intervention was performed by Fundacion Chile a partly state-owned enterprise which gave rise to a new salmon exporting sector.

The faltering seaweed industry located mostly in the Autonomous Region of Muslim Mindanao and the nascent industry of coco juice seem to be suffering a combination of the market failure problems discussed above. Our electronics industry which is highly specialized in “screwdriver” assembly operations as South Korea once was could be expanded likewise to incorporate more value adding steps in the manufacturing process.

The usual ways by which governments address these market failures is by offering subsidies to defray the costs of “self-discovery” (by sponsoring contests which award a prize to the best solutions for example), financing high risk ventures at the pre-commercialization phase and coordinating complementary investments in specific areas such as research and development, infrastructure and general training.

Think of it this way: instead of borrowing from foreign governments to pay their suppliers to develop our infrastructure (think broadband and high-speed rail) we should be licensing their technologies and awarding these to local firms which can prove they can use it cost effectively to build what we need. This should also apply to contracts awarded to private firms partnered with foreign companies. They should be conditioned on meeting certain local content requirements. Defense contracts should increasingly source local producers as well.

The Department of Transportation and Communication is already on the right track by seeking to borrow to pay for the build while privatizing the operations and maintenance of certain projects like light railways. In time we could be exporting some of these products and services if we create local expertise. South Korea did this with its ship building industry in the 1970s with Hyundai Heavy Industries becoming the world’s leading exporter within a decade. It did this even as global demand for ships declined.

Where will the government get the money to do all this? From itself, by using the savings remitted by overseas Filipinos and stored with the central bank in the form of foreign currency reserves–an unorthodox view that even the “humbled” former dean of the UP Economics School holds! If the government were to set aside a third of the currency surplus flowing in each year (see previous posts on this) amounting to around fifteen billion dollars to fund these activities and assuming a one-for-one investment multiplier, a total of four hundred and fifty billion pesos worth of spending could be generated annually (adding 4.5% points to GDP growth!). This would fill up to eighty percent of the investment gap.

The need to diversify our exports is already apparent with an inordinately high specialization in electronics posing a huge risk to future growth in the face of uncertainty of demand from advanced economies. It is also clear that despite very benign inflation and low real interest rates, private firms fail to undertake investments that would lift the productivity of their idle capital. This underinvestment problem is why such a large proportion of our workforce remains unemployed or underutilized.

Stimulating demand for innovation and investment by addressing market failures should be the priority. The biggest barrier for the Philippines to adopting such a strategy will not be an inadequate bureaucracy as many of our top bureaucrats are well-informed and educated; it won’t be for lack of funds as a substantial amount of national savings remain untapped; it won’t be for lack of ideas as there is a wide gap between domestic and foreign technology that can be filled.

The biggest barrier will be attitudinal as it would mean countering the development mindset that has dominated for such a long time which is largely donor-driven. Having drunk the policy “cocktail” put together according to their orthodoxies to no avail, giving us the title of being “the sick man of Asia”, it is about time we developed our own recipes for stimulating economic dynamism in line with local conditions. I now leave you with a song about the coconut which should punctuate this final thought.

Jammed

Does public infrastructure represent the best use of private investment?

It seems that our corporate titans have nothing better to do with their excess cash than to pour it into the growing public utilities and infrastructure sector. Whether it is San Miguel the beverage giant which went heavily into power or the Metro Pacific group a major player in telecoms which operates the NLEX-SCTEX road networks, there does not seem to be anything which competes for their attention than this sector.

About one-and-a-half trillion pesos is sitting in Special Drawing Accounts with the BSP deposited by banks which are unable or unwilling to lend them out. With a country as underdeveloped as ours, one would think that such excess savings could be put to better use. Why for instance isn’t San Miguel investing to develop coco juice exports which it has the capital and expertise to do?

Since our lost decade in the 1980s when a banking crisis followed by a political upheaval reduced our economy to tatters, manufacturing has never really recovered from the heights it once achieved by the end of the 70s and early 80s (see chart). Meanwhile, our ASEAN neighbors Indonesia, Malaysia and Thailand overtook us in moving their economies towards industry. Our gross capital formation as a percentage of GDP is the weakest in the region as a result.

Vietnam, a relative latecomer in the game has seen its manufacturing sector grow by leaps and bounds, while Singapore cannot be held up as an example for us to follow since it is a city-state with a tiny population and workforce. It can afford to de-industrialize its economy, while we can’t. While some would argue the high value services sector is nothing to sneeze at, it still cannot be relied on to provide the kind of jobs that match the skills held by our bulging population. The answer lies with manufacturing.

The Philippine Development Plan identifies infrastructure as the “binding constraint” to speedier growth. The reason it claims Philippine goods remain uncompetitive is our inability to bring them to market efficiently. Apart from that there is the implicit “tax” that comes by way of corruption which increases the cost of doing business and the unfair competition from smuggled or pirated goods that discourages domestic manufactures, the result of weak rule of law.

With its low tax collection rate and chronic fiscal deficits, partly to do with an aggressive liberalization policy pursued since the 1990s, the government was more than willing to let the private sector fill the breach in public infrastructure.

Since private business seems so gung-ho about providing public goods, it seems the identification of infrastructural bottlenecks was the correct diagnosis of the problem of underdevelopment. One wonders, however, if these firms are moving into such projects because there is no attractive alternative in other sectors, or is it because of higher returns now currently on offer from public-private partnerships?

Also, if indeed there are “bottlenecks” causing the cost of doing business and cost of living to skyrocket, then one would expect the public would be willing to absorb the fees charged by private operators under existing PPP arrangements. That is not what has been observed though (think MRT and LRT). One would then have to conclude that either the private operators have negotiated prices above the market-clearing level or that the demand for such infrastructure was not sufficient to begin with.

Investing in public goods by their very nature would often produce a private return lower than the commercial rate of return. That is why it is often financed in capital scarce countries through “concessionary loans” from foreign governments and multilateral institutions. If private operators borrow at prevailing market rates, then they cannot possibly make a profit unless the government provides a subsidy to pay for the spread between the “risk free” government borrowing rate and the commercial lending rate.

Turnaround

The sudden flash of insight Sec Mar Roxas used to interject into the president’s faltering public-private partnerships roll-out was that it would be better for the government to borrow at the risk-free rate and contract out the construction phase of some projects in effect passing on the cheap cost of capital to contractors. It could then auction off the operations and maintenance contract separately minimizing the need to subsidize fees charged to customers.

The question then is can government afford to borrow more in order to finance its infrastructure roll-out? It could if it chooses take-up the BSP’s offer to borrow against the country’s excess international reserves that accumulate each year. The state would effectively be borrowing against itself. Given the total cost for the original projects of about one hundred billion pesos, the surplus of reserves flowing into the country each year of four to five billion dollars is enough to cover these projects twice over.

If the public sector is then able to deal with the cost of providing infrastructure, how can it stimulate complementary investments needed in the private sector? If the lack of domestic capital and skilled labor are not responsible for the observed underinvestment, neither are low rates of return (low taxes and labor market flexibility are found in special economic zones), then what else could it be?

There are a number of candidates. Government failures which include corruption or weak property rights and rule of law are one option. A second possible candidate is market failure due to inabilities to coordinate investments in complementary upstream and downstream sectors or to internalize the benefits of innovation and experimentation.

The first has been identified by the National Competitiveness Council and the government as an area of concern. The decline of the Philippines ranking in the latest Ease of Doing Business survey by the World Bank reflects the country’s inability to address government failure. On the other hand, if these are the causes for underinvestment, why is it that manufacturing has suffered a decline relative to services in terms of investment and output? Shouldn’t they all be suffering the same fate?

This leads me to identify the problem of market failures as well. The systematic break that occurred in the mid-80s when the country turned away from industry policy and underwent an aggressive reduction of tariffs unilaterally ahead of WTO commitments left our manufacturing sectors at a disadvantage vis-à-vis our ASEAN neighbors. This is perhaps the reason services have oustripped manufacturing since it represents non-tradables which can only be provided domestically. Think retail, housing, commercial property and yes, utilities. Mining is a similar story. How then could the government begin to stimulate activity within the tradable industries? The following five measures would represent the most important steps.

  1. Partially rollback tariffs to within acceptable levels still within WTO commitments targeting in particular greenfields. Sustainable technology is one example of greenfields. To partly offset the modest rise of inflation that would come with this, tax cuts and (conditional cash) transfers should be directed to low income families.
  2. Finalize the list of investment priorities to signal the areas that government wants growth to occur in. Government must consult with business groups in compiling this list, but it must also exert some independence and take the lead in some areas and not simply take a market follower approach.
  3. Rationalize fiscal incentives and gradually fine-tune the selectivity of sectors for promotion. This has already been initiated by the BOI, but follow through and institutional capacity building needs to occur, which leads to the next item.
  4. Strengthen the economic bureaucracy to solve investment coordination problems across related sectors. Improve the ability of state agencies like the BOI, PEZA, DTI and other government agencies to undertake a consultative and promotional role.
  5. Create a research and innovation fund jointly run by public and private enterprise to encourage commercialization of ideas. Given the excess foreign reserves cited earlier, the state can also afford to undertake this strategy in partnership with academe and the business community.

Compared to the strong-arm tactics being employed by Argentina and Brazil which like us bought into the liberal free trade argument in the 1990s and have like us seen their manufacturing sectors stagnate (see chart), these measures would be considered rather tame.

From 1949 to 1959, the Philippines used heavy handed trade and industry policies similar to what LatAm countries pursued from the 1930s to the 1980s. This led to the fastest growth ever sustained in our history (and theirs). Unfortunately, it did not last long enough for investments to expand beyond light industries as Paul D Hutchcroft notes. The direpute to which import-substitution subsequently fell was the result of the Filipino First policy instituted in 1958 towards the end of the decade of growth, an over-reach of the “elite” nationalists. The poor administration and outright corruption that the policy bred stymied it and led to the liberal policies of the 1960s supported by the landed agricultural exporters.

Pres Marcos tried to weaken the landed aristocracy and revive our nascent industry sector in the 1970s, but the lack of checks to the predatory nature of his regime led to its collapse. The Philippines has been following the liberalization paradigm ever since. The stagnancy of our manufacturing and overall weak economic performance is hard to explain given the structural reforms undertaken from the late-80s. The Philippines since the early 2000s has become a net saving country due to overseas remittances and is rapidly accumulating foreign reserves (it has more than enough to pay off all our external debts). With some tweaking, we can unlock this capital and put it to better use.

So far from encouraging private investors to get into public utilities, the government should actually follow Sec Roxas’s advice to break-up build, operate and transfer contracts to lower their cost to the public. Finally, the government must look to revive investments in the industry sector (which includes high value agricultural and services too) through pragmatic policies. It must create as much policy space within existing WTO arrangements to maximize the benefits of industrialization. Without this its vision for a rapid, sustained and inclusive pace of development might simply come to naught.

Occupied

Restoring a meritocratic society is the goal of the 99 movement in America. Establishing it for once in the Philippines should be our national ambition.

The Nobel winning economist, Gary Becker, whose work on human capital I deeply admire wrote a piece called Deserving and Undeserving Inequality in the blog which he shares with Richard Posner. In it he distinguishes between good inequality (deserved) and bad inequality (undeserved) saying

The great majority of people in different cultures do not object to someone who has made lots of money when they have superior abilities and talents, and they work hard at producing what are considered useful goods or services.

The meritocratic society with upward and downward social mobility would be in Becker’s view the most acceptable form. In this just society, the cream always rises to the top. He cites actors like Tom Hanks and Jennifer Anniston, entrepreneurs like Bill Gates and Steve Jobs, and skilled professionals like transplant surgeons who have grown rich by applying their exemplary talents and skills.

In contrast, Becker poses the problem society seems to have with hedge fund managers who make use of arbitrage (momentary bargains unnoticed by the market) to make huge sums of money. He lumps them together with speculators, Russian oligarchs and monopolists who enrich themselves through unfair, uncompetitive means (the latter two through government fiat).

Becker of course uses human capital theory as his framework for addressing this issue. Under its framework, individuals who acquire knowledge and skill through education and training (one cannot gain it any other way as it cannot be inherited or passed on) deservedly earn private returns in the form of higher incomes over the remainder of their working lives.

A meritocratic society should in Becker’s view reward the investments made by individuals in themselves and not rely on some other criteria. Elitism, the polar opposite of meritocracy rewards individuals for investing in other things (political patronage, social standing or being raised on the right side of the tracks, marrying into the right family, etc). It all sounds rational and justified, which is why Becker says “the great majority of people in different cultures” accept the legitimacy of a certain form of inequality (I have some reservations which I expressed here).

The Occupy Wall Street protests that have spread all around the world is comprised of a disparate set of individuals, but at its core, it is a protest against what is seen as an illegitimate form of social structure perpetuated by a weak central government unable to constrain the greed of corporate elites.

The breakdown of social cohesion has occurred because of what is perceived to be the breakdown of a meritocratic society where one rule seems to apply to the rich who are becoming a new aristocracy while another set of rules applies to the rest.

The teapartiers detest the privilege accorded to the global capitalists/Wall Street at the expense of local merchants and tradesmen/main street, while OWS expresses their distaste mathematically by stating they represent the 99% who play by the rules but have to bailout the 1% who don’t.

It is curious to see how the OWS protest that began in NY mutates as it travels to each city throughout the world deriving a local “strain” in each place. In the Philippines, which has witnessed a high level of social inequality, there has not been a similar groundswell of support outside the usual suspects of BAYAN MUNA and other groups who coalesce under anti-American imperialist banners.

The reason being I think that the broad sections of our society by and large aspire towards a meritocracy and see their lack of social mobility as either the result of divine providence or misfortune. The masses have not coalesced around a universal sense of rights and entitlements that has taken hold in the West perhaps because they still depend on ties of patronage from local elites.

The state has had a long history of either colluding with or acceeding to our elites. They have given concessions to the “peasantry” whenever popular movements have challenged their ascendancy but withdrawn them when the threats have passed. Charismatic populist leaders like Ramon Magsaysay and Joseph Estrada sought to appease them, not undertake reforms aimed at genuine social restructuring.

The only time when the state sought to weaken the landed elite by expropriating their assets was under Martial Law. Even then there were limits to what it could do as it sought to make its authority legally and constitutionally binding in the eyes of the world. The problem was that once it had weakened any challenge to its authority, nothing prevented the regime from plundering as well.

The lack of accountability under Martial Law made the state susceptible to a new form of super-sized impunity. This was not inevitable though as in the case of East Asia with their benevolent dictators. Had Mr Marcos fostered a new meritocracy in both the bureaucracy and the wider economy, things might have been different.

His wife Imelda widely reviled for her pompous display of wealth had actually promoted a meritocracy in the arts. Through her sponsorship of young scholars and aspiring artists through competitions and venues for the demonstration of their capabilities, she enabled a flowering of talent that was not based on birth or privilege. This is the one legacy for which she can be rightly credited.

If only the same thing had happened in the technology sector where innovation and risk-taking could have been encouraged, instead of the crony capitalism that created a new elite not based on productive but predatory activity, the Marcos years might have come out smelling a bit better.

Contemporaneous with the Marcos era, during the 1970s and 1980s, Brazil and India embarked on a policy of giving birth to technology firms. The state agencies that were engaged in this “midwifery” role were not perfect, but as discussed by Peter Evans in his book Embedded Autonomy, despite their imperfections, at the end of the 1980s they still had something to show for it.

After seeing efforts at producing local operating systems and PC clones flounder, Brazil’s IT sector survived by specializing in financial automation for their banking sector (emblematic of this were companies like Itautec of the Itau Banking group). In India, state investments in skills produced manpower to work in systems integration services combining hardware and software engineering which became their strength. Today some of these Indian firms have successfully expanded their operations overseas (Mahindra Satyam and Tata Consulting Services are prime examples).

Korea which was most successful in fostering growth of this sector focused on the assembly of computers, consumer electronics and semiconductors through concessionary loans and state sponsored and financed research and development. In 1989 Samsung and IBM signed a co-licensing deal allowing them to tap into each other’s portfolio of patents. Today IBM no longer makes PCs, but Samsung is challenging Apple for the handheld tablet market.

Brazil of course was under a military dictatorship during this period. India was except for a brief period in the 70s a rambunctuous democracy like the Philippines is now. Korea was still being ruled by an autocratic president. In other words, the type of political system did not prevent the sorts of policies needed for promoting a meritocracy from emerging in productive sectors.

This was Pres Marcos’s greatest moral failing: neglecting the national development project and engaging in pure predatory behavior. The “Freedom Constitution” that followed his fall sought to put a system of checks and balances in place to restrain the executive has unfortunately not produced a meritocracy either. It simply revived the old aristocracy to power which has picked up where it left off prior to Martial Law by engaging in booty capitalism.

The weakness of the judicial system has served to deny a system of justice to the dispossessed and the poor. So unlike the Occupy Wall Street protesters who camp outside the headquarters of the global elite, our own version of the downtrodden live in slums outside the gated communities of local elites. They are forced to work in the informal sector without legal entitlements such as social security, healthcare or retirement funds, for the most part having acquired very little in the form of human capital.

The present dispensation is beset with many challenges all around which include fostering good governance and promoting economic growth. These projects will take time to bear fruit. While it is seeking to free the poor from local patron-client relationships through social insurance programs, it eventually needs to buckle down to the difficult task of generating employment through industrial promotion strategies and policies.

Having fostered the emergence of the electronics and business process outsourcing industries in the interim, the government faces the more difficult task of expanding the scope of these industries in the international division of labor (what Evans terms the role of “husbandry”) into more value added activities.

It would be good if aside from producing the domestic equivalents of Tom Hanks and Jennifer Anniston (a legacy of our showbiz, pop mentality from the Imeldific years) we could also foster the development of our own Bill Gates or Steve Jobs (the burgeoning industries out of Silicon Valley of course received tremendous government support through the defense industry).

Globalization was meant to usher in a kind of meritocracy among nations in the division of labor. What the experience of emerging countries has shown is that to rise to the top, state involvement in the development of industries is necessary. The ultimate goal should not be to one day attract a greater share of foreign companies to our shores; the national ambition should be to one day join our brothers in emerging markets in buying out foreign companies within their own shores.

Perhaps it is this vision that should occupy our hearts and minds as we look to the future.

Shall We Dance (Cha-cha-cha)?

As foreign ownership of land is talked up in the Philippines, other countries like Brazil and Australia are looking to limit it.

Brazil began last year when it decided to treat farmland as a strategic asset on par with oil when the government invoked an old law from 1971 limiting the amount of rural land that foreigners are able to buy. It is estimated that as a result of this about $15 billion of planned agriculture investments will be dropped.

Australia followed suit early this year when its Parliament passed a resolution that would see for the first time their bureau of statistics (the ABS) collate a list of direct foreign ownership of agricultural land, water rights and businesses. This is seen as a first step towards taking any necessary action to safeguard the food security of the nation.

What spooked the federal governments in both cases were growing reports of sovereign wealth funds and state owned or state-backed enterprises buying up vast tracts of prime agricultural land. With the world population set to rise from 7 billion to about 9 billion by mid-century, the quest for food security is forcing countries like Qatar, China and Singapore to look overseas for their food supply.

Unlike the Philippines which has a constitutional restriction against foreign ownership of any kind of land, Brazil and Australia are not seeking to resrtrict foreign ownership, but merely monitor and manage it, to ensure that it doesn’t pose a national security risk or lead to speculative bubbles.

I think these considerations should give our legislators reason to pause and consider their plans for liberalizing participation of foreigners in certain sectors like communications, education, professional services and land. Liberalizing services may be necessary for the Philippines to join the Trans-Pacific Partnership and gain market access to signatory countries in the Asia-Pacific. Opening up real property is another matter.

Opening up land to foreign acquisition would require us to have a few necessary safeguards in place. How would the country maintain food security for instance? Should there be a requirement to seek government approval once the scale of land purchase breeches a certain amount? If so, what should that amount be?

The case involving the lease of one million hectares to Chinese interests for grains and bio-fuel crops which was halted by a petition to the Supreme Court due to its constitutionality will almost certainly become mute once constitutional restrictions are removed.

If stronger states such as Australia and Brazil start to place increasing scrutiny towards the use and sale of their land to foreigners, will the affected foreign firms turn to weaker states like the Philippines in order to pursue their agenda? Once these assets are sold, it will be very hard to retrieve them.

It makes the question of lifting constitutional restrictions all the more poignant. While it is true that it might stimulate much needed investments and exports, what will happen to us as a nation once our ability to feed our people is traded away?