Post-crisis trade recovering (but not fast enough)!

Merchandise trade volume grew in the Q4 2009 in the G7 countries, albeit at a slower pace than in Q3 2009. Though trade volumes and values have recovered since the plunge in Q3 2008 and Q1 2009, their level is still below the pre-crisis levels of mid-2008 (by almost 20 percent lower to pre-crisis level). Import and export volumes from G7 countries rose 3.1% and 3.9% respectively. The more rise in imports by G7 countries, the better is the chance of developing countries benefiting from the trade recovery, assuming that majority of imports by G7 countries come from the developing countries!

 
 Here is real GDP figures (see the plunge!)

Industrial policy is back: Rodrik

Rodrik argues industrial policy was never dead! Successful economies always used it.

British Prime Minister Gordon Brown promotes it as a vehicle for creating high-skill jobs. French President Nicolas Sarkozy talks about using it to keep industrial jobs in France. The World Bank’s chief economist, Justin Lin, openly supports it to speed up structural change in developing nations. McKinsey is advising governments on how to do it right.

Industrial policy is back.

In fact, industrial policy never went out of fashion. Economists enamored of the neo-liberal

Washington Consensus may have written it off, but successful economies have always relied on government policies that promote growth by accelerating structural transformation.

The shift toward embracing industrial policy is therefore a welcome acknowledgement of what sensible analysts of economic growth have always known: developing new industries often requires a nudge from government. The nudge can take the form of subsidies, loans, infrastructure, and other kinds of support. But scratch the surface of any new successful industry anywhere, and more likely than not you will find government assistance lurking beneath.

Ten bad ideas for economic growth

It comes from a recent report about post-crisis growth and developing countries by the Growth Commission. The set of bad ideas for growth are:

1. Assuming the crisis is a “mean-reverting” event and the we will return to a pre-crisis pattern of growth, capital costs, trade and capital flows.
2. Interpret the need for better regulation and government oversight of the financial sector as a reason for micromanagement of the financial sector.
3. Abandon the outward-looking, market-driven growth strategy because of financial failures in the advanced countries.
4. Allow medium-term worries about the public debt to inhibit a short-term fiscal response to the crisis.
5. Adopt counter-cyclical fiscal policies without concern for the returns on public spending, and without a plan to restore the public finances to a sustainable path over time, once the crisis is past.
6. Ignore the need for more equitable distribution of gains and losses in periods of prosperity as well as in crisis.
7. Continue with energy subsidies on the assumption that commodity prices will not rebound after the crisis.
8. Treat the financial industry like any other, ignoring its external effects on the rest of the economy.
9. Focus monetary policy on “flow” variables like inflation, job creation and growth, ignoring potential sources of instability from the balance sheet (asset prices, leverage, derivates exposure).
10. Buy assets whose risk characteristics are hard to understand. The high returns are likely to reflect higher risk even though the latter may be hidden from view. They will be overpriced and salable, if at all, in a crisis only at distressed prices. Things that seem too good to be true, probably are.

Growth in developing countries after the crisis

The Growth Commission has published a report (Post-Crisis Growth in Developing Countries) assessing the financial crisis and its fallout on economic growth in the developing countries. I was planning to read it last month but couldn’t do so. This report assesses if the previous recommendations in The Growth Report still holds true after the 2008 financial crisis.

The conclusion is that the recommendations are still relevant but some restraint on capital controls and financial liberalization might be fruitful. The report emphasizes the crisis does not show the failure of market-based system but that of the financial sector. The outward-looking strategy is still relevant but it may not be as rewarding as it was before the crisis because of slower growth in trade, costlier capital, and a more inhibited American consumer.

Below are notes from the report. The figures are from WEO 2010:

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Economies that had sustained growth of 7 percent or more for 25 years or longer had some common features:

• Fully exploited the world economy; imported ideas, knowhow and technology; produced goods that met global demand, specialized and expanded rapidly without saturating the market.
• Maintained macroeconomic stability; inflation under control and sustainable fiscal paths.
• High rates of investment (25% of GDP), including public investment, financed by equally impressive rates of domestic savings.
• Followed the market signals while allocating resources; used industrial policy to bent the law of comparative advantage, by favoring some industries over others; the favored industries had to pass a market test by successfully exporting their products to foreign customers who did not have to buy them; relatively mobile labor; stagnant industries were allowed to fail; protected laid-off workers from economic misfortune 
• Strong, committed, credible and capable governments; their macroeconomic strategies and microeconomic regulations provided the setting in which market dynamics could work; provided a range of public goods such as schooling and infant nutrition that markets under-provide.

What did the crisis teach us? The crisis delegitimized an influential school of thought, which held that many financial markets could be left to their own devices, because self-interest of participant would limit the risks they took. At a huge cost, it taught an unforgettable lesson about how financial systems really work. But, the crisis is a failure of the financial system, not the market per se.

Before the crisis (September 2008), developing countries faced very high commodity prices for eighteen months, peaking in the spring and summer of 2008. When the crisis erupted, there were declines in investment, employment and trade. The crisis spread to the developing countries through financial channel (credit tightened everywhere) and real economy channel (trade collapsed more than economic activity). China was less vulnerable to mobile investment funds because of its capital controls. China's response to this crisis was a repeat of its response to the Asian financial crisis in 1997-98, but on a much larger scale.

The government has to prevent a complete failure of the financial system and replace essential functions like credit provision until the normal channels reappear. It should also prop up economic activity and asset prices by filling the gap left by sidelined consumers and investors. Moreover, it has to act as a "circuit-breaker", interrupting the transmission of shocks from one part of the economy to the other. Fiscal stimulus reduces declines in the real economy, boosting employment, income and credit quality.

Post-crisis global economy

• The US consumer will become the US saver in an effort to repair the damage to household balance sheets. The world will also face a set of additional challenges: energy, climate and demographic imbalances, among others.
• Regulators and central banks cannot afford a narrow focus on consumer prices and employment, leaving asset prices and balance sheets to their own devices. They cannot hope to control inflation, manage growth, check overstretched balance sheets and ward off related sources of instability by manipulating short-term interest rates alone.
• The government has a legitimate reason to intervene to ensure that taxpayers' interests are safeguarded. Vulnerabilities in the financial sector represent contingent liabilities for the government and rest of the economy.
• Financial re-regulation should and will emphasize capital, reserve and margin requirements, seeking to limit the build up of systemic risk by constraining leverage.
• The cost of capital will increase, debt will be more expensive and less ubiquitous, and risk spreads will not return to the compressed levels that prevailed before the crisis.
• Joblessness in the advanced economies may not peak until late into 2010. Labor markets are still deteriorating.
• Some of the fundamental determinants of growth are relatively crisis-proof: demography or human ingenuity.
• The average rates of protectionism in the world economy, weighted by GDP, will increase as big emerging economies, which tend to have higher trade barriers on average than the industrial economies, grow in prominence.
• No magic bullet for getting out of the crisis: The economy should gradually right itself, as financial markets stabilize and the real economy follows, pulling the sea anchor of extended deleveraging along with it. Policies likely to err on the side of running short run inflation risk, rather than the reserve.

Growth strategies

Successful economies have generally found a formula that includes a dynamic and innovative private sector supported by government investment in public goods, effective regulation, and redistribution to protect the most vulnerable. That balance varies across countries.

The crisis represents a major failure of the financial systems in the advanced countries. In particular, the lightly and incompletely regulated model that was influential in many Western economies is fundamentally flawed and in need of change. There is no evidence of a more broad based failure of the market and capitalist economies. The debate should focus on the financial sectors' stability and performance, rather than on a more sweeping condemnation of the whole market-based system.

The government should do more to protect people during times of extreme economic turbulence. Safety nets are indispensable to maintain public confidence and support for the market-led outcomes. Some countries (such as Brazil, Mexico and India) have shown that it is possible to devise more permanent programs that can serve the economy both in good times and bad, expanding during crises to meet sudden spikes in need. "Leaky" safety nets buys political support. Broader coverage may be the political price we have to pay for a well-supported safety net. Countries should prepare an inventory of well-designed projects that can be taken "off the shelf" when the need arises.

Quantitative easing, capital injections into the financial sector, bail-outs in a number of other industries, and fiscal stimulus programs have all added to the government's scope and influence. Budget deficits, if left unaddressed, will eventually raise long-term interest rates, making debts even harder to sustain.

The state's expansion needs to be reversed as the crisis subsides. Fiscal stimulus packages need to be replaced by medium-term programs to restore fiscal balance, based on realistic (and perhaps diminished) estimates of future growth. The expanded central bank balance sheets need to shrink through the sale of assets over time to the private sector.

Road ahead for developing countries

Consumption cuts and increase in savings by the American consumer could mean a $700 billion or more shortfall in global aggregate demand, relative to the world economy's productive potential. This shortfall should be filled by an increase in domestic demand in surplus countries.

To grow rapidly, countries must reallocate resources from traditional, low-productivity activities, such as agriculture, to new industries, which allow for rapid gains in productivity that often spill over to the wider economy. As countries make economic progress, their production of tradable goods tends to rise rapidly, leading to trade surpluses. There is no necessary connection between increasing the share of tradable goods in GDP and running a trade surplus. Rodrik has shown that trade surpluses do not have any independent, positive effect on growth, once you control for the share of industry in GDP. The share of "industry" captures the importance of non-traditional, high-productivity activities in a country's economy. Countries grow by promoting these activities, not by promoting trade surpluses per se.

Domestic demand is not a perfect substitute for global demand,where countries can specialize in a narrow range of products to serve specific customers. To cater to domestic demand, countries need to produce a broad range of products, so as not to saturate any particular local market niche. The limits to specialization are tighter and depend on the evolving composition of domestic demand.

Developing countries should curb financial products they may be ill equipped to handle. Several countries, including Brazil, India and China make heavy use of reserve regulatory restrictions to dampen their banks' enthusiasm. China imposes different requirements depending on the kind of assets banks hold, thereby influencing the direction of credit as well as its quantity.

Developing countries should ensure that some banks remain domestically owned, even if they are not owned by the state. The government's focus is quite understandably on the domestic economy. But foreign entities will have divided loyalties at best.

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]