Dani Rodrik

ADB tells Aquino to start “picking winners”

According to the Asian Development Bank, the Philippines needs to beef up its industrial policy if it is to achieve rapid and inclusive growth.

Taking the right road to inclusive growth, the report that Norio Usui penned is chock full of evidence in support of this position. The ADB has added its voice to UNIDO in arguing the case for industrial policy to be adopted by developing countries. This is against the grain of thought held by the World Bank, the IMF and the WTO which continue to hold on to the “Washington Consensus” that free markets and good governance are all that is needed for countries to prosper.

Unlike other reports that are full of analysis that mostly describe the problem but offer very little advice (mostly motherhood statements) this one drills down to specific prescriptions and targeted sites for intervention. Usui uses the analytical and methodological tools developed by Dani Rodrik of Columbia University and Ricardo Hausmann of Harvard (both of whom I have featured here and here) to plot out the “product space” into which the Philippines could best diversify its manufacturing and export base.

On a personal note, I was quite excited to see the “Top 20” charts he assembled of products which were closest to our current revealed comparative advantage, which had the greatest potential for spillover, and which had the greatest impact in terms of labour employment. Having done a similar exercise for a development agency in Australia which identified the technology intensity and revealed comparative advantage of the jurisdiction, I was never able to identify the areas in which to diversify. What Usui has done represents the cutting edge of developmental diagnostics at an industry level.

The irony is that the Philippines has demonstrated the capacity for producing highly sophisticated products which is normally associated with richer countries (a point that Hausmann made in The Economist). The problem is that without sufficient public intervention to deal with coordination and information problems and other market failures, such diversification will not occur.

Usui makes the point that while the decline of manufacturing has in part been offset by the growth of services (business process outsourcing being the most recent trend that supported growth throughout the 2000s), growth in employment, productivity and incomes have not kept pace with our ASEAN counterparts. To catch-up, growth would be required in manufacturing to supply “a second leg” with which the economy could pick up the pace.

Despite the presence of broad based programs to attract investments, reduce regulatory red-tape and corruption through the BOI and the PEZA, incentives have been largely redundant and used inefficiently. Although poor infrastructure and costly energy costs the oft cited reasons why investor shy away have some basis, Usui shows how that it may not necessarily be the overriding barrier or cost driver across the board.

In short, specific, targeted, industry-supported interventions and incentives are what would be needed for our manufacturing sector to grow and diversify. These interventions could range from supplying concessional loans or co-investment (something I discuss here), supporting the entrepreneurial process of self-discovery over how to adapt foreign technology to local capacity through research and development (something borrowed from Rodrik), coordinated infrastructure investments to providing subsidies for training (something I discuss here).

To counter the argument that such measures are difficult for weak governments to implement and merely give rise to cronyism and rent-seeking, Usui supplies the remedies acquired through practice by the East Asian economies in their path to development: sunset clauses and exit strategies, clear targets, monitoring and evaluation and contingent cost-recovery mechanisms.

In a previous post I have estimated the quantum of investment required to bring unemployment down to manageable levels along with the policy instruments required for encouraging such investments. What Usui has done is basically identify the sectors to target and engage.

If the government were to spend 200 billion pesos over the course of the next four years to co-invest in private-led initiatives that would generate five times that amount in counterpart funds (we currently have over one trillion pesos locked away in special drawing assets in the banking system) that would raise GDP by about 3% points a year. Add that to the 4-5% growth trend at present, and the government would just about hit its growth target of 7% over six years.

Unlike the scattergun approach being used to implement good governance which like the fiscal incentives program could prove highly inefficient and ineffective, I have recommended a targeted approach appropriate for our level of economic development by focusing on revamping the economic bureaucracy (covering both industry policy and revenue collection and enforcement). Usui supports this view by endorsing industry councils based on the East Asian model.

As I have mentioned before, it is not necessarily a lack of resources that is the problem (we can tap our foreign reserves if we have to, which incidentally will dampen our currency which at the moment is overvalued and hurting manufacturing). Rather it is the poverty of ideas and the ideological and dogmatic blinkers that have prevented successive governments from putting into practice pragmatic solutions to mend the country’s ills.

As the ADB points out, the country is well poised for economic growth given its openness to trade, sound banking system, and benign macroeconomic environment. External events like currency adjustments and wage inflation in China could also provide a precious window of opportunity for us. But there is no time to waste as other countries in the region are rapidly acquiring the capacity to produce highly sophisticated products as we have. The report concludes by saying

Structural transformation, by its nature, is a long process. Challenges may look overwhelming. It cannot happen tomorrow, but in a future within our reach. The Philippines has a huge potential to become a key production base within the regional production network … The government needs to be pragmatic enough to exploit the precious opportunities. Strategic public sector support that embodies a long-term vision of the economy makes it possible to change the economic structure that drives inclusive growth in the Philippines. Success is not always as distant as it seems.

I couldn’t agree more. Let’s hope someone in the Palace is listening.

They’re Baaaaaaack!

The APEC summit in Hawaii (photo courtesy of UPI.com)

In uncharacteristically blunt language, US President Obama as host of the APEC summit in Hawaii called on China to act like a “grown up” saying “enough is enough” and that it was time for the People’s Republic to “operate by the same rules that everybody operates” threatening dire consequences unless the yuan appreciates by 20-25%.

The US has been pressing China to allow its currency the yuan to appreciate more quickly to make American products more affordable to Chinese residents and similarly make Chinese exports less attractive to US based consumers. President Hu’s pragmatic response–allow imports to rise without necessarily liberalizing the currency exchange regime–is typical of the Middle Kingdom.

Unlike America’s faith in free markets, China would rather deliberately get prices wrong if it would allow it to maintain a healthy trade surplus with the US. This after all was the same path to development that the US took when it was still in its “catch-up” phase with Western Europe.

Yet America, with its penchant for universal principles (“we hold these truths to be self-evident”) is now in the game of preaching free trade, open markets and property rights in the Far East just as it preached democracy in the Middle East. China is instinctually groping for a particularistic response. Although sounding undiplomatic, I like Pres Obama’s rhetoric because it gave away an important concession in the development debate.

“Gaming the system” or the notion of applying the tools of industrial policy to generate a competitive advantage for nascent industries in global trade as a legitimate means to catch-up with more advanced economies while a country is still relatively underdeveloped has been acknowledged. In the local vernacular, “saling pusa” which refers to little children allowed to participate in a game without having the same rules applied to them would be the way America views the Chinese.

For those who believe that lowering trade barriers helps promote growth, the following graph taken from Dani Rodrik’s paper to the UN should help dispel that notion. It shows a positive albeit insignificant correlation between tariff levels and economic growth. At best, no correlation can be inferred between lowering barriers to trade and growth, which is why the Philippines despite having very low tariffs relative to its ASEAN neighbors, has not been growing strongly. As I mentioned in my last piece, higher barriers to entry actually have been found to induce domestic innovation that in turn leads to new exports.

Source: Dani Rodrik (2001), The Global Governance of Trade--As If Development Really Mattered: A UNDP Background Paper

This should help comfort those distressed by that CNBC press release that the Philippines is the worst place for doing business in Asia. It should also be noted that in their top ten worst places, India and Indonesia were included. If these are the sorts of countries that we are in league with, then we really should not be too bothered.

Despite that dubious title, one should actually pay attention to the fact that the CNBC pronouncement was based on the World Bank’s Doing Business Report. Many of the measures in this report simply do not apply to businesses within the special economic zones which is more relevant to foreign investors. Furthermore, petty corruption actually allows many of the so-called barriers for entry to be removed.

The main roadblock to foreign direct investments is actually the desire of business to operate with the same protection of contracts and property rights wherever they are along with low costs to entry without the necessary tax burden and industrial labor costs that are needed to foster this. On the other hand, ordinary citizens that politicians seeking re-election (as in the case of Obama) try to please don’t want unfair competition for their labor from less developed countries which try to create a system of arbitrage to attract foreign investors.

It isn’t that investors want a level playing field. Consumers by and large don’t really mind whether a producer competes fairly for a slice of their hip pocket. That means for a country seeking to attract foreign investors increasingly ceding a lot of its national policy-making abilities to Western bodies and institutions to gain access to its markets. Hence the rhetoric of Obama who is trying to create a narrative that would pit the economies in the region against China.

Having ceded the scene for the better part of a decade to Beijing which has forged a free trade deal with ASEAN (CAFTA, the China-ASEAN Free Trade Area), Washington is trying to regain the initiative with its Trans-Pacific Partnership agreement that boasts the commitment of nine APEC countries and counting. China has objected to not being invited to join the agreement. This is clearly a bid by the US to isolate it and strengthen its economic clout in the region.

This week, as he travels en route to the East Asia summit in Bali, Indonesia, the US president is scheduled to make a stopover in Canberra to address the Australian parliament and sign a deal that would increase US troop presence in a base located near Darwin. The two nations have already beefed up the ANZUS mutual defense treaty by allowing allies to invoke it in the case of cyber attacks just as it was used in justifying Australian participation in the US war against terror.

This posturing is clearly aimed at containing Chinese ambitions in the region. America is trying to prevent Australia and its other allies (Japan, Korea, Thailand, and the Philippines) from following in the footsteps of Germany which has been compromised as a NATO ally due to its economy’s dependence on exports to China. Australia sees the need to boost its military capability to help counter the military build-up of China while relying on iron ore exports to China for sustaining health in its economy. Other countries in the region notably Vietnam and the Philippines will seek protection under the US security umbrella given tensions with China over the Spratlys.

PM Julia Gillard earlier this year commissioned her own white paper that would create a strategic road map for Australia in the “Asian century.” Upon her return to Australia, she announced a new position on uranium exports to India, the other emerging power in the region. This back-flip on her party’s existing position to maintain a ban until India signs the Nuclear Non-Proliferation Treaty occurred after a meeting with President Obama .

Meanwhile State secretary Hilary Clinton is set to travel through Bangkok and Manila en route to Bali. She will no doubt seek to emphasize the theme that America is back in business in the region. P-Noy has been keen to float his own ideas about a solution to the Spratlys among allies, but membership in the TPP is very much in doubt as certain hurdles including constitutional restrictions on foreign ownership and weak protection of intellectual property rights prevent the Philippines from being admitted.

This means that the Philippines will engage in free trade with China via CAFTA, while having a military alliance with the US. This is probably the best possible outcome–a good way to counter-balance each competing force on either side of the Pacific. Australian PM Julia Gillard put it best when she said this week,

It is well and truly possible for us in this growing region of the world to have an ally in the US and to have deep friendships in our region including with China.

But for how long this formula will work only time will tell.

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.

Crediting the Upgrade

The Makati Business Club which by and large supported the candidacy of PNoy paid him homage in his first year in office by crediting his administration for the numerous upgrades the country received from ratings agencies, but the underlying cause might be found elsewhere.

The MBC spoke of the way in which the administration fostered macroeconomic stability and investor confidence. Macroeconomic stability of course depends on both the national government’s fiscal policies (how it earns and spends money) and the Bangko Sentral’s monetary policies (how it regulates and intervenes in the financial system).

Although some credit is due to PNoy for the mandate he received which led to the smooth turnover of power and for not destabilizing markets or the economy, there is a more fundamental reason why rating agencies gave us an upgrade. The following chart provides a big clue as to what it was.

For the first time, the nation’s gross international reserves exceed its external debt obligations (both public and private). As of March 2011, they stood at 66 billion US dollars compared to the external obligations (both private and public) amounting to 61 billion. The reserves have been parked in fixed investments overseas, mainly US treasury notes I would imagine making the country a net lender to the rest of the world.

An examination of our balance of payments (the flow of payment in and out of the country) will tell us that the growth in our dollar reserves is due mainly to dollar remittances by overseas Filipinos and the inflow of portfolio investments into our stock market. Foreign income from our services industries contributes to it as well albeit minimally, while our export of goods continues to lag our import (see chart below).

Foreign direct investments continue to be a pittance compared to our overall economy and to our neighbors. Foreign investments are mainly being channeled into domestic firms listed in our stock market. Assuming these portfolio investments are weighted in accordance with the Philippine Stock Index (a basket of the top listed companies), these flows simply reinforce the current industry structure (not to mention the pecking order). It also runs the risk of creating a property-debt bubble in a few years.

Last year when the country posted a fourteen and a half billion dollar balance of payments surplus (a net inflow of foreign currency), I posed the question what should it do with it. The appreciation of the peso is hurting our exporters and the families of overseas Filipinos despite efforts by the BSP to stem the rise.

The other related issue has to do with where the foreign remittances are being spent: mainly on consumer goods and real property. Banks have also been benefiting from these remittances, but have not found a productive use for them. The accumulation of savings has outstripped investments as shown in the following chart making the Philippines a net saving economy rather than a net borrowing one.

This leads me to think, given that the country has extra liquidity, why has there been no effort made to channel these resources to where they are needed the most? The problem with investments in the Philippines has nothing to do with the supply side any longer (or the availability of capital), but has more to do with the demand side (or the availability and attractiveness of projects to invest in).

The Western thinking MBC might contend that the reason why investors shy away is because of the poor economic and business environment, poor governance and inadequate institutions like bad laws, regulation and red-tape. There is some truth to that. The flow of ‘hot money’ into the stock exchange however tells me that investors don’t see bad governance as a major hindrance to the growth of privately owned companies.

Causes and Effects

The other main cause for weak investment flows could be a simple lack of information about the sectors that are worth investing in. The free rider problem where everyone is waiting until somebody else proves an idea is worth pursuing and then cashing in when it becomes viable could possibly be one major factor in this.

A third possible reason for the lack of investment is simply the fact that our government does not have enough capacity to cope with its infrastructure backlog. This is primarily due to the inadequacy of the tax system to raise sufficient revenues to fund them. While private investors can fill the gap somewhat through the build, operate, transfer scheme, they cannot fill it completely as the unmet demand for schools and hospitals will attest.

There are basically three policy implications and recommendations that follow from this discussion.

  1. Improve regulatory quality, bureaucratic capacity and predictability.
  2. Improve entrepreneurial risk-taking capacity.
  3. Improve capacity for infrastructure funding.

Enough has been written with regards to the first recommendation, and the MBC is already involved in that effort. What I would like to do is focus on the last two recommendations as I have some ideas on how to pursue them.

Hurdles and Hoops

The first hurdle of course is where to source the funding. As the the preceding analysis has shown, the nation has a net stock of foreign reserves in excess of its external obligations. It has gone up by about 4 billion dollars per year on average in the last four years. This is about the size of the public sector deficit (2% of GDP).

To prevent the peso from rising, what the government could do is coordinate with the BSP so that it could issue treasury notes and have the BSP purchase them (much in the same way the US Federal Reserve bought US treasury securities under Bernanke). This would lower the borrowing cost of the government given the BSP’s views that the country is actually of investment grade.

The proceeds of this could either go to funding the fiscal deficit, or as we reach a balanced budget over the next two to three years be used to set up two funds. The first could be called the Philippine Enterprise Innovation Fund or PEIF. The second could be called the Regional Philippine Infrastructure Fund or RPIF.

The first fund would either go towards funding Public Private Partnerships involving start-ups or be given as outright grants or concessionary loans to projects that would allow us to diversify our industry sectors or bring about the commercialization of new innovative business models.

The second would go to fund infrastructure projects in the regions where public investment is lacking. It could help bridge the education and health infrastructure gaps or to community projects or even to social and environmental projects. Priority could be given to remote places where the gaps are most severe.

Where credit is due

In crediting the upgrade to PNoy, the current problem of forced savings by the government whose surplus fetish makes it more subservient to the bond market than to the needs of the people is endorsed. It is a self-congratulatory remark to the business community as well which has failed to fund risky entrepreneurial projects that could be the source of future growth.

While the government’s good governance agenda should be continued in improving the overall environment for doing business, the capacity of the public sector in addressing ‘market failures’ and in providing much needed economic, social and environmental infrastructure must be boosted even more.