Economic crisis and sub-Saharan African exports

The African financial sector was pretty much isolated from the financial crisis that wreaked havoc in the developed countries’ financial sector. All good. But, if the African exporters are dependent on external trade finance, then the real cost of the global crisis on Africa may actually be high, argue Berman and Martin.

African exports has nosedived after the financial crisis. The interesting question is how does the financial crisis in one country affects exports of another country? To find this out, Bernam and Martin study past financial crises (1976-2002) and its impact on bilateral trade flows. The explore the deviation of exports from their ‘natural’ level generated by financial crises.

Two channels through which financial crisis affect exports: income effect (leading to drop in demand of exported items) and disruption effect (leading to fall in trade credit). They find that the largest disruption effect occurs when the financial crisis hits industrialized countries. The African countries are affected more by income effect than disruption effect. In addition to the income effect, they find that, for an average exporter, the disruption effect due to a financial crisis in the partner country is moderate (a deviation from the gravity predicted trade of around 2 to 8%) and long lasting (around 7 years). For African exports particularly, due to disruption effect, the fall in trade (relative to gravity) is at least 20% more than for other countries in the aftermath of the crisis.

Fig: Exports after financial crisis in partner country, Africa. It shows the deviation of sub-Saharan African exports after a financial crisis that takes place in year t = 0, with respect to the average disruption effect. A positive (negative) excess trade ratio means that the effect of a financial crisis in the partner country on African exports is more positive (negative) than the average effect on exports.

Conclusion: “The underdevelopment of financial systems in Africa is not a "blessing in disguise" in the current crisis. If the cost of such low development is that African exporters are very dependent on external trade finance, then the real cost of the financial crisis on Africa may actually be higher due to the underdevelopment of financial systems.”

Population growth and technology

Growth in incomes was accompanied by unprecedented increases in population and exponential increases in the rate of scientific discoveries. More here.

Five reform agendas to kick-start Nepal’s growth

My latest piece is based on a simple set of crucial reforms that are needed to kick-start Nepal’s jammed growth engine. These reforms can be launched simultaneously or in any other form deemed appropriate and politically feasible.

Main point: “To achieve a 5 percent plus growth rate in an undeveloped but budding economy likes ours, it is necessary to start from something that will first lubricate the growth engine, then speed it up, then attain stability, and then ensure sustainability of growth rate.”

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Five Reform Agendas

If someone asked you to enumerate five reform agendas that will kick-start Nepal's jammed growth engine and sustain five percent plus annual growth rate, what would be your response? Recently, I was asked this question. By considering the pattern of reforms in countries that have passed through the existing development state of our economy and the evolution of institutions, culture, reforms and constraints in Nepali economy, my non-exhaustive list of reform agendas were: (a) Infrastructure (electricity and roads); (b) contemporary industrial policy; (c) overhaul of education and healthcare sectors; (d) governance and regulations (financial and non-financial sectors); and (e) social safety nets.

Before explaining the rationale behind this hierarchy of policy reforms, let me be clear about two key assumptions. First, it postulates that political situation will eventually be stable. Second, as is the case with the emerging economies, an increase in economic growth rate will lead to poverty reduction.

When macroeconomic situation is in a mess, we need to first ensure that fundamental variables are promptly taken care of. We need to identify the most binding constraints on economic growth in order to tackle the most troubling aspect of the economy. Studies have shown that the most binding constraint right now is a lack of infrastructure, mainly roads and electricity. With the supply of electricity about five times less than the demand, it is not only difficult for entrepreneurs to start new business, but is equally hard for the existing firms to keep their machines running. Note that Nepal has the highest electricity tariff (dollar per KWh) and lowest electric power consumption (KWh per capita) in South Asia.

An inadequate transport infrastructure increases transportation and transaction costs, leading to loss of competitiveness. Nepal has the highest transportation costs and lowest road density in South Asia. Provision of good infrastructure facilities incentivizes domestic entrepreneurs, both agricultural and non-agricultural. It facilitates the rise of small and medium enterprises (SMEs), the main source of employment for people and revenue for entrepreneurs. It kick-starts the growth engine but won't guarantee speeding up of the engine fast enough.

For this to happen we need to prop up firms that can exploit economies of scale and expand markets abroad. A contemporary industrial policy (IP) that can 'lead the market' and 'follow the market' is required to speed up growth rate. South Korea adopted 'lead the market' principle, where it picked potential winners and promoted 'winning' industries. Meanwhile, Taiwan adopted 'follow the market' principle, where the state 'nudged' firms to upgrade their technologies through appropriate incentives, performance requirements and facilitation of transfer of technical knowhow and capital. Any such promotion of domestic industries should have industry-specific sunset clauses to eschew misallocation of resources, price distortion, and repression of incentives.

The state has to play a vital role in propping up markets when there is substantial underinvestment in promising sectors. Just setting up 'enabling' environment is not enough amidst information asymmetries and coordination failures in the market. In Nepal's case, the state could speed up the establishment of Special Economic Zones (SEZs), Export Processing Zones (EPZs) and Garment Processing Zones (GPZs); extend tax holiday in key industries; guarantee investment insurance in hydropower sector; facilitate export of labor services to growing middle-income countries facing shortage of manual and semi-skilled labor; subsidize loans and provide easy credit to strategic firms; train human resources; promote tourism; facilitate trade; create backward and forward linkages in the industrial sector; and borrow new technology to enhance efficiency and productivity, among others. 

A good industrial policy helps to stimulate the economy and speed up industrialization, leading to absorption of surplus agricultural labor in industrial sector. A potential source of investment in the short term could be remittances, if only the policymakers can figure out how to channel it into the productive sectors for investment rather than for consumption of imported goods and for investment in real estate sector.

For a vibrant market and a sustainable growth rate, it is equally important to ensure smooth supply of quality human capital. To make the previous two reform agendas sustainable, it is necessary to reform the existing Nepali education and health sectors. An education sector that is geared towards the need of the domestic and international markets is vital to fulfill the demand for human resources in rapidly growing sectors. The banking sector is already suffocating from a short supply of competent human resources. Given the immature state of our financial markets, there is a huge demand for educated, well-trained young professionals who are capable of analyzing market fluctuations and investments. Along with the education sector, we need to improve on the provision of health services, especially in rural areas. It will ensure a constant supply of healthy, competent human capital to the industrial sector.

With booming economic activity also comes complexity. Some agents in the economy always want to earn more profits than others, often by going roundabout established rules. To keep unhealthy competition and risky investment activities at bay, it is necessary to have good governance and regulations. Nepal's notorious public sector, which is infested with corruption culture, needs to be reformed. This will not happen overnight. But we can at least take corrective steps by empowering the Commission for Abuse of Authority (CIAA), the main corruption watchdog, with more manpower, expertise and funding so that it can spread its wings to all districts. Furthermore, having proper regulation in place for the rapidly growing financial markets, which usually is the main artery from where investment spending is pumped out into the economy, is essential. This helps to check malpractices in the public and private sectors, and the financial markets.

Finally, with booming economic activity and growth of financial markets, also come unpleasant and unintended outcomes: rise in inequality, which retards growth rate, and increase in vulnerability of poor people. This is why we need to have adequate safety nets, which can be funded by taxing the richest people in the highest income quintile. This has to be done without killing incentives of entrepreneurs. To uplift living standard of the lowest quintile and to stimulate rural economy, we need public work programs, conditional (or unconditional) cash transfer programs, short-term employment during lean agricultural season, and training programs aimed at graduating low-skill workers with updated skills consistent with market demand.

Let me emphasize that these reform agendas are not comprehensive. Depending on objectives, there could be an entirely different set of hierarchy of reforms. However, to achieve a five percent plus growth rate in an undeveloped but budding economy likes ours, it is necessary to start from something that will first lubricate the growth engine, then speed it up, then attain stability, and then ensure sustainability of growth rate. Drawing out a simple set of national reform agenda endorsed by all political parties despite their divergent ideology would do a lot in terms of generating high and sustainable growth rate in Nepal.

[Published in Republica, April 22, 2010, pp.6]

The role of state during the economic crisis

Source: Protecting People, Promoting Jobs, ILO

Lessons from the Chinese miracle

Here is a replication of Justin Lin's blog post at Africa Can...End Poverty

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Since beginning its transition 30 years ago, China’s economic development has been miraculous.

The average annual growth rate of GDP reached 9.8 percent, far exceeding the expectations of most people in the 1980s or even early 1990s, including Deng Xiaoping who initiated the reforms. Deng’s goal was to quadruple China’s economy in twenty years, implying an average annual growth rate of 7.2 percent per year.

In 1979, China was inward-looking and its trade as a percentage GDP was only 9.5 percent. Now China is the world’s largest exporter and the third largest importer, with trade contributing around 70 percent of GDP. Over 30 years, more than 600 million people got out of poverty.

1. What was behind China’s extraordinary performance?

After the industrial revolution, sustained growth in any economy depended on continuous technological innovation as well as industrial diversification and upgrading.

As Angus Maddison shows, before the 18th century, the average annual growth rate of per capita income in the West was only 0.05 percent for years. That means it took 1,400 years for Europe’s per capita income to double prior to the 18th century. In the 19th century, it took about 70 years; and in the 20th century, 35 years.
The industrial revolution sped the move away from an agrarian society where 85 to 90 percent of the labor force worked in traditional agriculture. The move from agriculture to nonagricultural and manufacturing sectors was gradual but inexorable. In the manufacturing sector, it was at first very labor-intensive, and then became more capital-intensive as technology advanced. Ultimately, the service sector dominated. Overall, the process was one of continuous structural change.

As a late-comer to this modernization process in 1949, China had the advantage of backwardness. To innovate, China did not have to invent the technology or industry by doing R&D. It could borrow technology, industries and institutions from the advanced countries with low risk and costs. East Asian economies, including Japan and the four small dragons as well as China after the transition in 1979, all tapped into this advantage.

2. Why Did China Fail before the Transition in 1979?

China didn’t tap into that potential until 1979 because it adopted a misguided modernization strategy.

Revolutionary leaders such as Mao Zedong and Zhou Enlai hoped to make China an advanced country immediately after the founding of the People’s Republic of China in 1949. They adopted a strategy to build up advanced capital- and technology-intensive industries even though China was an agrarian economy.

The government’s priority industries went against China’s comparative advantage. The government needed to protect them by giving them monopoly positions and subsidizing them through various price distortions, including suppressed interest rates, over-valued exchange rates and so on. The price distortions created shortages and the government was obliged to use administrative measures to mobilize and allocate resources directly to the non-viable firms in the priority industries.

Through those interventions the government was able to set up modern advanced industries, but the resources were misallocated and the incentives repressed. Economic performance was very poor. Haste made waste.

3. Why Didn’t Other Transition Economies Perform Equally Well?

Not only China but also all the socialist countries and most developing countries after WWII adopted a similar development strategy. In the 1980s and 1990s, they all engaged in reforms to transit to a market economy. However, their governments did not realize that the existing distortions were endogenous in a sense that they were instituted to protect the non-viable firms in the priority sectors.

Some of them eliminated the distortions immediately. The priority sectors collapsed, causing a contraction of GDP, surge of unemployment, and acute social disorder.  Others, to avoid this, continued to subsidize those non-viable firms through disguised subsidies and protection, and efficiency suffered.

China adopted a pragmatic, gradual, dual-track approach. On the one hand, the government continued to provide transitory protection to the non-viable firms in the priority sectors, and on the other hand, it liberalized private enterprises and allowed joint-ventures’ entry to labor-intensive sectors--areas in which China had comparative advantage, but were repressed before. In this way, China achieved stability and dynamic growth simultaneously.

4. What Costs Did China Pay for Its Success?

One of the main drawbacks of China’s gradual, dual-track approach to transition is the widening of income disparities. From a relatively egalitarian society in 1979, the Gini coefficient reached .47 in 2007.
The reason was the continuation of distortions in various sectors, including the overconcentration of financial services by the four large state-owned banks, the almost zero royalty on mining, and the monopoly of major service industries, including telecommunication, power, and finance.

Those distortions are used to subsidize or protect the non-viable firms in the old priority sectors. They also favor big corporations and rich people. For example, the interest rates that big banks charged are kept artificially low, allowing big companies and rich people to benefit at the expense of middle class depositors who have limited access to credit services.

The result is a widening of income disparities.The large corporations and rich people have a higher saving propensity than low-income households. The widening of income disparities also contributes to the saving-consumption imbalance and China’s large trade surplus, which reflects the disparity in saving and consumption in recent years. Therefore, it is imperative for China to remove the remaining distortions and complete the transition to a market economy.

5. Can Other Developing Countries Replicate the Miracle?

Other developing countries can replicate China’s performance. Every developing country has a similar opportunity if they know how to tap into the advantage of backwardness, learn to borrow technology from advanced countries and upgrade their industries step by step.

Most developing countries also have all kinds of distortions and non-viable firms due to their governments’ past development strategies and inappropriate interventions. In this respect, China’s experience in the past 30 years provides useful lessons.

In the transition process, it may be desirable to adopt a dual-track approach, providing some transitory protection to those non-viable firms to maintain stability, but liberalizing entry to sectors in which the country has comparative advantage.

Ultimately, however, sustained and inclusive growth requires eliminating all distortions and completing the transition to a well- functioning market economy.

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IMF proposes new taxes on financial institutions

In the paper called "A Fair and Substantial Contribution by the Financial Sector", the IMF argues the case for two new levies to be applied on financial institutions in as many countries as possible: More here and here. The full document is here.

(1) A "financial stability contribution" to pay for "the fiscal cost of any future government support to the sector". The levy would be paid by all financial institutions, not just banks, initially at a flat rate but eventually refined so that riskier institutions paid more.

(2) A "financial activities tax", which would be levied on the sum of financial institutions' profits and the remuneration they pay.

Industrial Policy of Nepal 2010

Finally, the Nepali government is going to update its outdated industrial policy of 1992 with a new one. I have not got hold of the official document yet. The following is a brief highlight of what is coming:

• High priority industries: IT, cement, hydropower, vehicle and motor parts, chemical fertilizer, bio-technology and adventure tourism
• Priority industries: Agriculture, forest-based Ayurvedic and homeopathic medicine, manufacturing, minerals and handicrafts
• Finance support to construct infrastructures such as roads, electricity lines and water supplies up to factory sites.
• Promotional incentive package for export-oriented industries, specially SMEs. It promises 25 percent income tax concessions to small, medium and large industries that directly employ 100, 300 and 600 people, respectively.
• Industries promoted by women to get income tax incentives.
• Tax holidays for 10, 7 and 5 years to firms that invest respectively in highly underdeveloped, undeveloped, and underdeveloped industrial regions.
• Promotion of Special Economic Zones (SEZs) and Agro-Export Promotion Zone (AEPZ). Firms located within in these zones to be exempted from customs duty, excise duty and VAT.
• Income tax deductions for R&D and market promotion.
• Simple exit policy to promoters, freeing them from long-term labor and other liability.
• Subcontracting of production to promote specialization in the manufacturing process and to enable firms to meet international orders without investing further in its production units. This is expected to foster backward linkages.
• Differential tariff rates for raw material imports and import of finished goods. The protection rate (difference in tariff favoring local manufacturing over direct import) will be 25 percent.

It sounds all good. I will have to see the full document to comment on specific topics. But, a general observation reading this article is that there seems to be no sunset clauses for industries. Any policy to help domestic industries should have a clear end sight, i.e. sunset clause. Policy help cannot be for infinite time as this dampens competition and leads to inefficiency. There should be policies to deliberately promote domestic industries without violating international trade treaties but it also should have clear sunset clauses. More comments when I get and read the full document.

Meanwhile, here is a list of loss making public enterprises, which borrowed Rs 1.6 billion in ten months instead of the allocated Rs 800 million for the whole fiscal year, in Nepal.