The (insurmountable) level of crisis in the emerging countries

Dani Rodrik gives a feel about what the scale of the present financial crisis would be in the emerging countries. He thinks that the emerging countries would face much more severe crisis than the developed counterparts.

Emerging markets for the most part have weak and fragile fiscal systems, and the magnitude of the potential run is huge relative even to the large mountains of reserves that many of them have built up.  Socialization of private liabilities may enhance confidence in the rich countries; it will likely magnify the run in emerging markets.  So we are talking about economic collapses that could be significantly bigger than what the rich countries will experience.  And this time developing countries can legitimately say: it wasn't our fault!

It would be interesting to know what new ideas transpired/were floated when Rodrik, Rogoff, Stiglitz, Birdsall, and Sachs met with the UN Secretary-General Ban Ki-Moon recently. Rodrik sees a possible role for the IMF as a true global lender (massive) of last resort (without too many preconditions).

On a similar note, here is an interesting perspective: From capital flow bonanza to financial crash:

To examine the potential links with financial crises of various stripes, we constructed a family of country-specific probabilities. For each of the 64 countries, this implies four unconditional crisis probabilities, that of: default (or restructuring) on external sovereign debt, a currency crash, and a banking crisis. We also constructed the probability of each type of crisis within a window of three years before and after the bonanza year or years, this we refer to as the conditional probability of a crisis. If capital flow bonanzas make countries more crises prone, the conditional probability should be greater than the unconditional probability of a crisis.

For the full sample, the probability of any of the three varieties of crises conditional on a capital flow bonanza is significantly higher than the unconditional probability. Put differently, the incidence of a financial crisis is higher around a capital inflow bonanza. However, separating the high income countries from the rest qualifies the general result. As for the high income group, there are no systematic differences between the conditional and unconditional probabilities in the aggregate, although there are numerous country cases where the crisis probabilities increase markedly around a capital flow bonanza episode.

For sovereign defaults, less than half the countries (42%) record an increase in default probabilities around capital flow bonanzas. (Here, it is important to recall that about one-third of the countries in the sample are high income.) In two-thirds of the countries the likelihood of a currency crash is significantly higher around capital flow bonanzas in about 61% of the countries the probability of a banking crises is higher around capital flow bonanzas.

Most emerging market economies have thus far been relatively immune to the slowdown in the US. Many are basking in the economic warmth provided by high commodity prices and low borrowing costs. If the pattern of the past few decades holds true, however, those countries may be facing a darkening future.

Wasteful investment

This picture shows what happens when supply is created irrespective of demand. Wasteful investment!

These houses were built two years ago under the Maoists resettlement program. Two training centers and 80 houses (one for two family) were built. Some form of wearing and tearing (depreciation) is already seen in these houses without a single family residing on it. This is a complete waste of resources by the government.

Without first assessing whether the displaced families want to resettle in this particular location (Rupendehi) the government went ahead with the project. Officials now concede that the choice of location was wrong in the first place. This is a typical waste of resource resulting from lack of careful diagnostic of incentives and constraints to resettlement.

Money wasted: NRs 1 crore 65 lakhs (do the maths in dollars, US$1=NRs 74). More here.

Stiglitz for transparency, oversight and fair competition

Here is a piece from Joseph Stiglitz, who argues that letting financial markets run wild was a risky business and now there is a need for more transparency, oversight and fair competition. Always interesting to read his pieces! He claims that the financial markets are not fulfilling their function- to mobilize savings, allocate capital and manage risk, transferring it from those less able to bear it to those more able.

In America, and some other countries, financial markets have not performed these functions well. They encouraged spendthrift patterns, which led to near-zero savings. They massively misallocated capital. And they created risk, did not manage it well and left huge risks with ordinary Americans, who are now bearing huge costs because of these failures. These problems have occurred repeatedly and are pervasive. The failures in financial markets have effects that spread out to the entire economy.

There are three related reasons for these failures: poorly designed incentive structures, inadequate competition and inadequate transparency.

Strong competition is an essential aspect of well-functioning markets. But information imperfections often limit the extent of competition. America's financial markets have gone beyond these natural limitations of competition to engage in anti-competitive practices…The failure to have strong competition enforcement has meant that there are a number of institutions that are so large that they are too big too fail. That provided an incentive to engage in excessively risky practices.

Finally, markets often fail to produce efficient outcomes (let alone fair or socially just outcomes) when information is imperfect or asymmetric. But information imperfections and asymmetries are at the centre of financial markets - that is what they are about. Our financial markets have even worked hard to exacerbate these problems, as they created non-transparent products that were so complex that not even those who created them fully understood them. This non-transparency is a key part of the credit crisis we have experienced over recent weeks.

Here is what Stiglitz thinks is needed for the wild markets (we need more of some Keynesian stuff):

We need more transparency to ensure that incentive structures do not encourage excessively risky short-sighted behaviour and to reduce the scope of conflicts of interest - our financial markets are rife with them. At the very least, they need to be disclosed. We need countercyclical capital adequacy/provisioning requirements and speed limits. We need to proscribe predatory lending - many of our problems are a result of lending that was both exploitive and risky. We need a financial products safety commission to make sure that the products purchased by, say, a bank or pension fund are safe and appropriate, designed to manage the risks they face; and a financial systems stability commission, to assess the overall stability of the system.

Part of the problem has been our regulatory structures. If government appoints as regulators those who do not believe in regulation, one is not likely to get strong enforcement. We have to design robust regulatory systems, where gaps in enforcement are transparent. Relatively simple regulatory systems may be easier to implement and more robust, and more resistant to regulatory capture.

Structural shift in employment, migration and inclusive growth in Nepal

Nepal, which has a per capita GDP of US $470 (2007/08), has witnessed impressive progress in poverty reduction in the last decade. According to NLSS II, the headcount poverty rate declined from 42% to 31% between 1995/96 and 2003/04, urban poverty declined from 22% to 10%, and rural poverty declined from 43% to 35%. However, income inequality is increasing: 6.4% per year for the richest 20%, as compared to 3.7% for the next quintile, and 2.5% for the lowest 20%.

The main four reasons for decrease in poverty level are remittances, farm wages, urbanization, and decline in fertility. But this decrease in poverty level is not uniform among all the population groups. Two factors that account for this are shift in structural employment and discrepancy in migration, according to a paper on inclusive growth in Nepal. This is a pretty different explanation as compared to the earlier standard explanations from the WB and government reports. This probably is true for regional reduction in poverty. Also, the author argues that he finds a strong relation between social exclusion, as defined by the caste system, and economic poverty.

The main pathways out of poverty from 1995 to 2003 have been landless farm workers who became subsistence farmers, construction or manufacturing workers, and subsistence farmers who added to their income by working in the same trades of construction and manufacturing industries, or as migrants to India.

The high poverty rates among the Tamang and Rai people of the eastern hills are reflected in the high average poverty rate of the eastern hills as reported in NLSS (2005). The eastern hills of Nepal is the only part of the country where the poverty rate increased from 1995 to 2003. This supports the conclusion that labor migration is a main explanation for the decline in poverty…. migration is at the lowest in the eastern hills, and if they migrate they tend to migrate within Nepal. In the western hills, on the other hand, a large majority migrate to India. The high level of labor migration to India from the western hills may explain the reduction in poverty in this region.

Can more households follow the same pathways out of poverty? The paper states that this (quite predictably) depends on the economic policy of the government. The author suggests that the government can learn from the experiences of successful Indian states like Kerela and Punjab. Meanwhile, for inclusive growth in sustainable agricultural sector and manufacturing sector hold the key to path out of poverty—for instance, employing Dalits and marginalized groups in manufacturing and construction business in semi-urban areas and freeing permanent laborers from landlords in villages and enacting moderate land distribution schemes, the author argues.

A combination of a social security net with competitive markets and secure property rights, may foster domestic and foreign investments in productive physical and human capital. The role of the government will be to broaden the tax base, and spend the tax incomes, as well as foreign aid, on public goods in support of the combined goal of social security and economic growth. This implies investments in roads, transmission lines for electricity, irrigation, as well as primary education and subsidized health services. Nepal may also consider to copy the rural employment guarantee of India. With a sound social and economic policy Nepal may in general be able to copy the developments of the most successful states of India, with a combination of the policies of Kerala and Punjab, where Kerala focused early on the social sectors, while Punjab focused on agriculture. 

Note that the present government is run by the Maoists who have gained popular support on the back of land reforms and end to feudalism. But the question is how are they going to do land reforms with tempering market and individual incentives? Concerns of private appropriability is running high. I remain skeptical about land redistribution program because of the unclear policies of the Maoists in this regard. A Maoist land minister had to resign last month after he refused to refute and retune a land grab stint Maoists party cadres did on his leadership! My concerns about the land reforms under the red flag here.

Policy interventions for inclusive growth:

Education and training programs leads to improved human capital. Subsidized health services insure people against major risks, which, in turn, allow them to make profitable investments rather than investments that make them able to handle different types of risk. Investments in physical capital, like transmission lines, roads and irrigation is necessary for economic growth, and a broad-based tax system is necessary to finance these and other costs. Finally, some targeted programs may be beneficiary, such as land redistribution to landless Dalits in remote villages of terai, and experiments with a rural employment guarantee in the same areas.

More on poverty in Nepal here.

Former Botswana President Mogae wins the Mo Ibrahim prize

Former Botswana President Festus Mogae was awarded the Mo Ibrahim Prize for Achievement in African leadership, which is also the world’s largest individual award with a price tag of $5 million (the Nobel prize is $1.4 million). This prize is awarded annually to a former African executive Head of State or Government who has demonstrated excellence in African leadership. All this to promote good governance, one of the main factors lacking in Africa!

Key facts about Mogae’s leadership:

- Mogae served two terms in office, nearly 10 years, before handing over to Seretse Khama Ian Khama in a peaceful transition in April 2008. Before that he was vice president for six years.

- He studied economics in Britain, before becoming a civil servant in Botswana. He has held roles at the International Monetary Fund and Bank of Botswana.

- Botswana's GDP per capita is the highest in sub-Saharan Africa, and the country is ranked the continent's least corrupt by Transparency International.

Mo Ibrahim is a Sudanese-born telecommunication tycoon who is the founder of Celtel International, one of Africa’s most successful private companies. He believes that good governance requires an environment conducive to peace, security, and development, based on the rule of law and respect for human rights.

The (limited) impact of foreign investment in the Americas

It is expected that the level of foreign investment has a direct positive relationship with stimulation of investment and hence the economy in a given investment-deficient country. Actually, in reality this depends on whether FDI acts as a complement (crowd in) or substitute (crowd out) to the level of domestic investment in an economy. (more below)

A study (Foreign Investment and Sustainable Development: Lessons from the Americas) by the Working Group on Development and the Environment in the Americas finds that foreign investment has fallen short of stimulating “broad-based” economic growth and sustainable development in Latin America. The working group studies the impact of foreign investment on economic growth, environment policy, and the political economy of Argentina, Brazil, Bolivia, Chile, Costa Rica, Ecuador, Mexico, Uruguay, and Venezuela.

They studied various regional and bilateral agreements like NAFTA, US-Chile FTA, CAFTA, US-Peru FTA, etc and looked at the impact of investment liberalization (a part of the Washington Consensus) on the Americas. What did they find? This wave of liberalization that started in the 1990s did not produce significant results as was expected. Economic growth in per capita terms in the region was slower than in the final decades of the import substitution period, according to the report.

Major findings of the report:

• 80% of all the FDI was concentrated in Brazil, Argentina, Chile, and Venezuela.
• Foreign firms in Mexico were export platforms to the US and those in the South America tended to sell in their own domestic market.
• Foreign firms tended to have higher level of productivity and higher wages.
• FDI fell short of generating spillovers and backward linkages that could help stimulation of domestic economy through emergence of local small and medium sized businesses. In fact, FDI tended to displace and kill local businesses. R&D expenditures in the host economies were not upped.
• Environmental performance of foreign firms was mixed, sometime better and sometimes worse performance than domestic counterparts.

Note that the report does not label that the FDI’s impact on economic growth and environmental sustainability was a complete flop- it had a limited success in Latin American countries. There are cases where FDI has been a crucial factor behind rising economic growth like in China, South Korea, Bhutan, Taiwan, Malaysia, Singapore, and Mauritius, among others. The report slides in a space where there is always a trade off between growth objectives and impact on environment arising from increasing investment (both domestic and FDI). Cost is always high when considering the impact of an investment plan in an environmentally conscious manner.

Important lessons from the Latin American experience:

• FDI is not an end but a means to sustainable development. Simply attracting FDI is not enough to generate economic growth in an environmentally sustainable manner.
• FDI policy needs to be paired with significant and targeted domestic policies that upgrade the capabilities of national firms and provide a benchmark of environmental protection.
• There needs to be policy space to accommodate domestic concerns in international agreements.

One of the lessons from the report is that FDI does not necessarily crowd in domestic investment. Actually, the impact of FDI on domestic investment is mixed. In Latin America, FDI has in crowed out domestic investment, as shown by this report, but in Asia (East Asia especially) and Africa, FDI has led to crowding in of domestic investment. FDI tend to be a substitute for domestic investment when there are lot of domestic firms. Meanwhile, FDI tend to be complementary when there are few domestic firms (whole sorts ancillary firms will emerge because of R&D and knowledge spillovers from MNCs). The existence of backward and forward linkages from the establishment of foreign investors is a key consideration for determining the total impact of FDI on capital formation.

Background working papers leading to the report are available here.

Roads, growth, and development

After reading my latest op-ed, some readers emailed me interesting (and positive) remarks. The piece was about Krugman and application of his New Economic Geography theory in the context of Nepal. Towards the end of the op-ed, I tried to draw in some policy implications and said that for development and poverty reduction, the government should try to induce spread of industries from "core" to "periphery". And, one important step in this direction would be to build, build, and build roads (I mean transportation services). It means high public expenditure and an activist policy. I also suggested the way in which the private sector can be engaged in this effort. Okay!

Today, Shailee Pradhan published an op-ed arguing that "the creation of roads does not always lead to development and prosperity". To be frank, this was the subtitle. The main title was: Road to development. It is up to the readers to judge how contradictory the main title and the subtitle of the op-ed is!

High transportation costs have led to industries clustering in select few locations, creating an uneven development process. The difference between the urbanised "core" and the lesser developed "periphery" is troubling. While the question of how to ensure the formation of such cores in the villages is an important one, it is first necessary to ask where to encourage such cores and what sectors to specialise in.

...However, it is critical to plan where to build roads by identifying and prioritising key areas based on the population and their needs. How important was it to build the road to Jomsom? With a population of less than 10,000, Mustang district (Jomsom is the district-headquarters) is sparsely populated. Mustang is not a high food-producing area either, except for apples of which only about 20,000 tons are produced annually.

Furthermore, the ecosystem around the Annapurna Circuit is very fragile as these are young mountains made of sedimentary rocks. The road construction process involving heavy blasting as well as the additional traffic flowing in now have put serious pressure on the ecosystem and the biodiversity here.

...It is necessary to diversify "cores" for a more even development, but building roads and creating industries is not the only way to diversify such cores. Where the costs of building roads, monetary and environmental, are extremely high, alternative modes of transportation such as cable cars and airplanes should be considered.

Let me take on some of the issues. I agree that there is some form of trade-off between building roads and environment. Also, there is no doubt that health of ecosystem and negative externalities should be kept in mind before building roads. Period.

Regarding this op-ed, I have two points to say: (i) the concept of "core" and "periphery" is primarily related to the nature of location or clustering of industries in one location, (ii) industries tend to cluster around locations where there is relatively easy availability of backward and forward linkages, where there is potential consumer, and where there is low transportation costs. With this, this process is self-sustaining (some form of endogenity will come into play).

To induce spread of industries in other places except in few industrial hubs only, I argued for government intervention to create necessary conditions (one of them to build roads) to decrease transportation costs. This was in context of explaining the theory I was discussing about. It is not possible to have "cores" in an area like Jomsom, where per capita purchasing power is very low and the population itself is not considered to be worthy of generating enough effective demand to fend off associated costs of establishing new industries. By arguing for activist policies to induce spread of industries, I meant to focus on building roads in places where the two conditions discussed above are satisfied.

Yes, there are places like Syangja, Palpa, Butwal, Baglung, etc. where the two conditions are fairly fulfilled. Obviously, this also means that Mustang is out of consideration. Moreover, I not only argued for building roads. Where it is not feasible, it is fruitful to build other means of transportation like cable car, airports, and railways. In places like Jomsom, these means of transportation can only link the outlier districts with the urban places. Except for railways (which is not feasible due to budget constraints and topographical issues), the other two modes of transportation will not decrease transportation costs. It will, in fact, increase the cost of production. Furthermore, road construction project should not be carried out if the marginal cost of making it is higher than the private cost.

Roads are one of the most effective means to link production site to markets  and vice versa. This is actually one of the necessary conditions for long term economic growth. This is essential both for economic growth and long term development. And yes, it can be done in a sustainable fashion.