Market or Government Failures?: An Asian Perspective

Market or Government Failures?

Also by A.S. Bhalla BLENDING OF NEW AND TRADITIONAL TECHNOLOGIES (co-editor) ECONOMIC TRANSITION IN HUNAN AND SOUTHERN CHINA ENVIRONMENT, EMPLOYMENT AND DEVELOPMENT (editor; also in Portuguese) FACING THE TECHNOLOGICAL CHALLENGE GLOBALIZATION, GROWTH AND MARGINALIZATION (editor; also in French) NEW TECHNOLOGIES AND DEVELOPMENT (co-editor) POVERTY AND EXCLUSION IN A GLOBAL WORLD (co-author) REGIONAL BLOCS: Building Blocks or Stumbling Blocks? (co-author) SMALL AND MEDIUM ENTERPRISES: Technology Policies and Options (editor) TECHNOLOGICAL TRANSFORMATION OF RURAL INDIA (co-editor) TECHNOLOGY AND EMPLOYMENT IN INDUSTRY (editor; also in Spanish) TOWARDS GLOBAL ACTION FOR APPROPRIATE TECHNOLOGY (editor) UNEVEN DEVELOPMENT IN THE THIRD WORLD: A Study of China and India

Market or Government Failures? An Asian Perspective A.S. Bhalla David Thomson Senior Research Fellow Sidney Sussex College University of Cambridge

© A.S. Bhalla 2001 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 0LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2001 by PALGRAVE Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world PALGRAVE is the new global academic imprint of St. Martin’s Press LLC Scholarly and Reference Division and Palgrave Publishers Ltd (formerly Macmillan Press Ltd). ISBN 0–333–66240–7 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Bhalla, A.S. Market or government failures? : an Asian perspective / A.S. Bhalla. p. cm. Includes bibliographical references and index. ISBN 0–333–66240–7 1. Business cycles—Asia. 2. Financial crises—Asia. 3. Intervention (Federal government)—Asia. 4. Asia– –Economic policy. I. Title. HB3808 .B48 2000 338.5'42'095—dc21 00–053067 10 10

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Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire

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To Praveen

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Contents List of Tables

ix

List of Figures

xi

Preface

xii

List of Abbreviations

xv

Acknowledgements

xvii

1 The Old and the New Political Economy From the old to the new political economy Institutions and organizations Different types of state Different types of markets Interactions between state, organizations and markets 2 Theories of Market and Government Failures Market failures Government failures Parallels between market and government failures The relevance of theories to East Asia Conclusion 3 Financial Crises: Cases of Market Failure Financial globalization Financial liberalization policies Financial crises in industrial and developing countries Why failures in financial markets? Lessons from financial crises 4 The Asian Financial Crisis A. S. Bhalla and D. M. Nachane

1 2 8 12 16 22 24 25 28 37 38 43 45 47 48 50 57 63

65

Key features of the crisis Theoretical explanations Diagnosis of the crisis

66 73 76 vii

viii Contents

Role of the IMF in the crisis The impact of the crisis Conclusion 5 The Impact of the Asian Crisis on China and India A. S. Bhalla and D. M. Nachane Vulnerability indicators Trade impact Impact on capital inflows Impact of domestic policies Impact on the future of reforms Need for financial reforms Conclusion 6. State Enterprises in China and India: A Case of Government Failure The soft-budget constraint Excess labour or overstaffing State enterprises in China and India The soft-budget constraint in Chinese state-owned enterprises (SOEs) The soft-budget constraint in Indian public-sector enterprises (PSEs) Conclusion 7 Conclusion: Implementation Failures Strategy/policy design Other implementation problems Conclusion

78 82 90

92 94 105 110 117 117 121 125

127 127 130 132 137 151 161 162 166 169 174

Notes

175

Bibliography

182

Author and Name Index

214

Subject Index

217

List of Tables 1.1 1.2 2.1 2.2 3.1 3.2 3.3 4.1 4.2 4.3 4.4 4.5

4.6 4.7 4.8 5.1 5.2 5.3 5.4 5.5

Characteristics of the old versus the new political economy A typology of Third World states A matrix presentation of Le Grand's theory of government failures Government supply, ownership and contestability Selected crises: Costs of restructuring financial sectors and non-performing loans Non-performing loans (% of total loans) Growth of bank credit to the private sector relative to the growth of GDP Trends in GDP growth in Asian economies (average annual % growth) Financial and forex indicators for the five Asian economies prior to the crisis Consolidated external financing of the five Asian economies ($ billion) Value of exports of the five affected Asian economies (1997±99) ($ billion) Export and import volumes of the affected Asian economies (1996±98) (Percentage change over previous year) FDI flows to Southeast and East Asia (1996±99) (US$billon) Forecasts of GDP growth for the five affected Asian economies (%) Increase in poverty due to the Asian crisis (1998 forecasts) Selected macroeconomic indicators for India and China Selected vulnerability indicators in the financial and forex sectors (India) India's ranking on crisis indicators vis-aÁ-vis the affected Asian economies Composition of trade: India and China (percentages of world totals) China's trade with major partners (first seven months of 1998)

ix

6 16 32 35 51 53 54 66 70 72 83

84 85 86 88 95 97 100 106 108

x List of Tables

5.6

Foreign capital inflows: India and China ($ billion and percentages) 5.7 Stock markets: China and India 6.1 Main features of the Indian public-sector enterprises (PSEs) 6.2 Main features of the Chinese state-owned enterprises (SOEs) 6.3 Losses in the Chinese state-owned industrial enterprises `as independent accounting units' (1978±94) 6.4 Estimates of excess labour in Chinese state-owned enterprises 6.5 Surplus labour, taxation and profitability in Chinese enterprises by ownership levels (1990±94 averages) 6.6 Increase in wages and bonuses in Chinese SOEs by level of control (1995±97) 6.7 Profitability of Indian central public-sector enterprises (Rs. billion) 6.8 Financial performance of state electricity boards in India 6.9 Government subsidy to Indian public-sector enterprises 6.10 Increase in Indian PSE wages and benefits

111 116 134 135 141 147 149 151 153 154 157 160

List of Figures 5.1 6.1 6.2

China's exports of primary and manufactured products Government tax revenue from Chinese SOEs and COEs State subsidies and loans to Chinese SOEs

xi

109 139 145

Preface Both government and market failures occur in developed and developing countries alike. Yet under the neoliberal paradigm, there is a tendency to place emphasis particularly on the former, suggesting implicitly that the market failures are not as serious in their consequences as the failures of the state, government organizations or bureaucracy. In the economic literature, state and government failures are often discussed interchangeably, which is strictly inappropriate. The concept of the state is much broader than that of the government, encompassing not only the government bureaucracy but also the whole apparatus of the political parties and process. The state `refers to a set of institutions that possess the means of legitimate coercion, exercised over a defined territory and its population, referred to as society. The state monopolizes rulemaking . . . through the medium of an organized government' (World Bank., 1997c, p. 20). Our concern is narrowly focused on the failures of the government and bureaucracy ± the agents of the state rather than the state itself. If both market and government failures occur one needs to undertake a comparative analysis to determine whether one or the other is more efficient and equitable in terms of outcomes. Williamson (1989, p. 93) notes that if market transactions are replaced by those of government, the relevant test is whether governments cope with these (measurement and production) difficulties better than markets or not. What matters is whether these supply conditions (affecting nonmarket goods and services) are responsible for differential effects, as between markets and governments, whereby the government comes off worse (or better) in the comparison. Our intention is not to choose between governments or markets, which is indeed a futile exercise considering that both are necessary and relevant and a good mix of the two (whatever way defined) is desirable. In the real world, a combination of both markets and governments may indeed be both economically and socially desirable. Improved market functioning itself requires appropriate regulatory action by the government. This was shown most recently and quite xii

Preface xiii

clearly by the Asian financial crisis. Governments in the Southeast and East Asian economies did not adequately regulate banking and financial institutions. Our main thesis is that when both market and government failures take place, it is not very helpful to concentrate on one or the other in isolation. Failures may occur due not so much to market and government imperfections but to lack of enforcement in the absence of rules, norms and institutions. We argue that it is the failures in implementation and enforcement of strategies, policies and goals in both public and private organizations with which one should be concerned. Effects of government and market failures reflected in lapses in enforcement highlight the importance of institutions and organizations. Chapter 1 makes a comparison of the old and the new political economy (NPE) arguments. It presents the NPE view of lean governments and examines conditions under which this view may be fallacious. Chapter 2 reviews various theories of market and government (non-market) failures and draws parallels between the two. It examines the relevance of the theories to the case of Southeast and East Asia and concludes that a combination of market and government activity through an appropriate interaction explains their success. Chapter 3 considers systemic financial crises occurring periodically in both developed and developing countries as a case of market failures. As we are interested in actual situations of market and non-market failures, Chapters 4 and 5 are devoted to the Asian financial crisis and its impact on the affected economies, on China and India and on the rest of the world. We show that the crisis was caused largely by a market failure ± a banking and financial crisis resulting from panic. Policy failures had very little to do with the crisis. In fact, one can argue that it was not too much government but too little (not enough attention was paid by the concerned Asian governments to regulate the banking sector and financial institutions) that contributed to the crisis. In an interdependent world the effect of the crisis was felt far and wide, much beyond the national boundaries of the five affected economies. We consider the example of state enterprises in China and India as a case of government failure in Chapter 6, which comes to the conclusion that the `soft-budget constraint' and associated problems led to poor performance reflected in low productivity and profitability. Lack of appropriate institutional mechanism for monitoring and control, principal-agency problems caused by inadequate and asymmetric information, all these factors contributed to problems of state production. Excess labour or overstaffing in state enterprises has resulted from rigid

xiv Preface

labour legislation and bankruptcy laws which discourage exit of firms. The redeployment of this redundant labour raises formidable implementation problems in conditions of labour surplus prevailing throughout the two economies. The final chapter briefly discusses constraints in implementation, namely, faulty strategy/policy design, ineffective administrative organization, political and resource constraints and so on. I am grateful to a number of friends and colleagues who have helped in the preparation of this volume in various ways, through stimulating discussions, reading of draft chapters and providing useful information. Notably among them are: Dr Christopher Bramall of Sidney Sussex College, Cambridge; Dr Ha-Joon Chang of the Faculty of Economics and Politics at the University of Cambridge; Professor Shujie Yao at the University of Portsmouth; Professor Dilip Nachane of the Economics Department at the University of Mumbai; and Nazy Sadeghat and Shufang Qiu of Cambridge. Finally, I owe a debt of gratitude to the staff of Marshall Library of the Faculty of Economics and Politics of the University of Cambridge, in particular, Ms Hua Zheng, for their untiring efforts in finding documents and undertaking computer searches. Cambridge, England

A.S. BHALLA

Abbreviations BIFR BIS BJP BOP CAC CAR CASS CDR COE CPE DSBB EDC EMS EPW FCNR FDI FII FONDAD Forex FPI GDCF GOI HDB HIID HKTDC ICC ICI ICRIER IDS IFC ILO IMF LSE M&A MITI

Board for Industrial and Financial Reconstruction Bank of International Settlements Bharatiya Janata Party Balance of Payment Capital Account Convertibility Capital Adequacy Ratio Chinese Academy of Social Sciences Consortium de ReÂalisation Collectively-Owned Enterprise Central Public (Sector) Enterprise Dissemination Standard Bulletin Board Enron Development Corporation European Monetary System Economic and Political Weekly Foreign Currency Non-Resident Account Foreign Direct Investment Foreign Institutional Investor Forum on Debt and Development Foreign Exchange Foreign Portfolio Investment Gross Domestic Capital Formation Government of India Hainan Development Bank Harvard Institute for International Development Hong Kong Trade and Development Corporation International Chamber of Commerce Imperial Chemical Industries Indian Council for Research on International Economic Relations Institute of Development Studies International Finance Corporation International Labour Office International Monetary Fund London School of Economics and Political Science Merger and Acquisition Ministry of International Trade and Industry (Japan) xv

xvi Abbreviations

MNC MOU NAFTA NBER NBFC NIE NPA NPE NRI OECD OPE OSE PAT PBC PPP PSE RBI REER SAEC SDDS SEB SEBI SEIR SIMEX SLR SOE SS SSB STICERD TFP TIC TVE UNCTAD UNDP UNECLAC UNU WIDER WTO

Multinational Company Memorandum of Understanding North Atlantic Free Trade Agreement National Bureau of Economic Research Non-Bank Finance Company New Institutional Economics Non-Performing Asset New Political Economy Non-Resident Indian Organization for Economic Cooperation and Development Old Political Economy Osaka Stock Exchange Profit After Tax People's Bank of China Purchasing Power Parity Public-Sector Enterprise Reserve Bank of India Real Effective Exchange Rate State Administration for Exchange Control (China) Special Data Dissemination Standard State Electricity Board Securities and Exchange Board of India Structured Early Intervention Resolution Singapore Monetary Exchange Statutory Liquidity Ratio State-Owned Enterprise Shiv Sena State Statistical Bureau Suntory and Toyota International Centres for Economics and Related Disciplines Total Factor Productivity Trust and Investment Company Town and Village Enterprise United Nations Conference on Trade and Development United Nations Development Programme United Nations Economic Commission for Latin America and the Caribbean United Nations University World Institute for Development Economics Research (UNU) World Trade Organization

Acknowledgements The author and publishers gratefully acknowledge the following for permission to use material from the following publications: 1. Economic and Political Weekly, 5±12 September 1998, for use of material in the article `Asian Eclipse: India and China in the Penumbra?' (jointly with D.M. Nachane) in writing Chapters 4 and 5. 2. Australian National University for the use of article `The Asian Crisis: Symptoms, Diagnosis, Implications' (jointly with D.M. Nachane) in the Development Bulletin (Australian Development Studies Network), no. 46, Winter 1998. 3. Nova Science Publishers New York for permission to use parts of my article `Chinese Stateowned Enterprises: A Case of Government Failure? in Current Politics and Economics of China (forthcoming). 4. Messrs H.-J. Chang, G. Palma and D.H. Whittaker, editors of Financial Liberalization and the Asian Crisis (London: Palgrave) (forthcoming) for using my chapter on `The Economic Impact of the Asian Crisis on China and India' (jointly with D.M. Nachane) in writing Chapter 5. 5. Professor D.M. Nachane for allowing me to use our joint articles (see 1, 2 and 4 above) as Chapters 4 and 5.

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1

The Old and the New Political Economy

In the 1950s and 1960s it was rare to find any mention of government failures or of national or global governance. Economic policies and government intervention were justified to overcome market failures or imperfections. In the world of today, the opposite view prevails: that is, almost all economic ills are ascribed to government failures and faulty macroeconomic and sectoral policies. A shift towards a market system involves competition and incentives which are seen as driving forces towards efficiency in resource allocation and use, as well as accelerated economic growth. This chapter examines the pros and cons of the old and the new political economy of development and its relevance to public policy in developing countries. It discusses different forms of the state and its agents, namely, government and bureaucracy. Parallel to this analysis, one needs a corresponding analysis of different types of markets. We argue that markets left to themselves cannot contribute to growth and equity. Government interventions are essential to overcome market failures and to `guide' markets towards broader development goals. As we shall discuss in Chapter 7, failures occur not only under non-market systems but also under market systems; most failures under the old and the new political economy frameworks can be attributed to poor design and/or implementation of public policies and programmes as well as private strategies of firms and corporations. It is, therefore, unfair to attribute the blame entirely to governments and public agencies. Much of the literature uses the terms `state' and `government' interchangeably although the two are distinct. In fact, the concept of the `state' is much broader and also more complex and problematic (see Evans et al., 1985). The state refers to `a set of institutions that possess the means of legitimate coercion, exercised over a defined territory and 1

2 The Old and the New Political Economy

its population, referred to as society. The state monopolizes rule making . . . through the medium of an organized government' (World Bank, 1997c, p. 20). Lal and Myint (1996, p. 305) note two opposite views of the state: the civil association view which defines the state as custodian of laws which facilitate `individuals to pursue their own ends' and the enterprise view which sees it as a `manager of an enterprise seeking to use the law for its own substantive purposes . . .'. Our concern in this book is somewhat narrowly focused on the agents of the state ± political leaders, government and bureaucracy ± rather than the state itself.

FROM THE OLD TO THE NEW POLITICAL ECONOMY Under the old political economy framework the role of the state in promoting social welfare was clearly recognized; so were such factors as historical tradition, social structures and institutions, in the shaping of economic policies and their implementation. As Meier (1993) notes, under the old political economy (OPE) framework, which was in vogue in the first few decades after the Second World War, the state and government bureaucracy were benevolent institutions working for the public good. Their role was to overcome market failures which explained poor development performance. The state was traditionally associated with a rational entity working for the maximization of social welfare. The protagonists of the new political economy view of development (NPE) start with the premise that government failures are the villains of the piece and that free functioning of markets and competition are preconditions for the success of economic policy. The NPE paradigm postulates that the state has extended its role and influence far beyond what the norms of efficiency and rational resource allocation would dictate. The rent-seeking behaviour of politicians and bureaucrats is believed to have led to an overextension of the state with a consequent waste of resources, economic inefficiency and corruption. In the NPE framework, most production of goods and services is left to markets in which producers offer their wares and consumers exercise their preferences and make choices. Economic reform measures adopted by many developing countries in the past several years are designed to diminish and redefine the role of the state by promoting privatization and enhancing the role of the markets in the allocation of resources. There is a growing trend towards market liberalization within the framework of stabilization and structural adjustment policies in developing countries and in the economies in transition in Central and Eastern

Market or Government Failures? 3

Europe. Markets and competition are looked upon as an effective framework for organizing the production and distribution of goods and services although their economic and social costs are increasingly debated. Nevertheless, in situations where subsistence production is significant, markets alone will be even more inadequate (Bhalla and Reddy, 1994; Stiglitz, 1997a). This has not been recognized perhaps partly because of the sudden collapse of the communist regimes, which was taken as a vindication of the superiority of market forces. In the countries of the erstwhile Soviet bloc, the OPE view has been equated with a state apparatus and bureaucracy responsible for government policy interventions and their implementation. In the early 1990s the people of the former Soviet Union and Central and Eastern Europe rejected this state apparatus and bureaucracy as an effective instrument of choice of goods and services. The fall of communism has led to renewed attacks on government control and ownership of resources. Under communism the state apparatus in these economies extended far and wide. The government and state bureaucracy is known to have failed to work for the public interest and social welfare. State control over production did not result in the production of goods and services of sufficient quantity and quality to satisfy consumer requirements. In the name of social welfare the state bureaucracy often assumed inordinate powers leading to corruption and malpractices. There is a tremendous mismatch in the production of goods and services between the choices made by the state bureaucracy and the preferences of the consumers. There is a growing feeling that whenever the bureaucracy makes these choices for consumers, it makes the wrong choices because unlike the market, a bureaucracy tends to be cut off from the valuable information and feedback that consumers provide on their preferences for goods and services. (However, this judgement is not peculiar to the communist environment; even in the capitalist environment, many bureaucratic choices can turn out to be disaster (see Chapter 2). Features of the New Political Economy The NPE has been defined as a `neoclassical economic theory of politics' analogous to `neoclassical economic analysis' (see Meier, 1991, p. 5). It argues in favour of a minimalist state on the grounds of directly unproductive activities of the state and rent-seeking behaviour of public agents and bureaucrats (Bhagwati, 1982; Buchanan et al., 1980; Findlay, 1991; Krueger, 1974; Srinivasan, 1985). Unproductive but profit-seeking activities include rent-seeking but also much more; for example, all

4 The Old and the New Political Economy

price distortions, tax and tariff evasion, smuggling, bribery, corruption, black markets, and so on (Bhagwati, 1982; Krueger, 1974). While Krueger was interested mainly in rent-seeking activities through trade restrictions, Bhagwati broadened the analysis to include all sorts of economic activities in which rent-seeking resulted from government restrictions which enable bureaucrats, industrialists and private individuals to generate private income (rent) from such controls. Rent-seeking associated with government intervention is distinct from any rents captured by individual economic agents in pursuit of profit-making (monopoly rents, for example). The state-induced rents are artificial in the sense that resources spent in generating and capturing them are a social loss since no resource creation (only reallocation) is involved (Chang, 1994a, pp. 27±31). The NPE paradigm attributes failures to implement public policy to rent-seeking because governments are assumed to act on behalf of particular interest groups rather than the public welfare. They deliberately introduce public interventions to maximize economic gains for these groups and ensure their distribution as well as power among them.1 Rent-seeking will influence administrative behaviour of implementors negatively because it leads a civil servant to rank accountability very low on his/her personal agenda. Moreover, it is reported that countries which receive the major share of their revenues through rents, realized through the export of commodities such as oil or other valuable minerals, are facing the same problem of lax attitudes towards state funds. Rent-seeking by government influences the administrative costs of enforcement of policies. Krueger (1993) notes that such rent-seeking creates a deadweight cost. But there can also be positive and growthinducing aspects of rent-seeking behaviour of governments. The Southeast and East Asian experiences show that rent-seeking can be devoted by governments to growth and public welfare. The governments created rents to increase investment to fuel growth rather than to benefit a few private and vested interests. Chang (1994a) argues that in late-industrializing countries market mechanism alone could not provide adequate rents. Decline in barriers to trade and big reductions in transport costs, inter alia, prevented such rents. The nature of new industries, the high investment costs and the risk involved necessitated government intervention to create rents for early entrants. Rent-seeking behaviour is not peculiar to governments and the political process; it is equally common in the private sector. Private organizations may deliberately make distorting decisions in order to seek rents and limit competition from outsiders (Boycko et al., 1996;

Market or Government Failures? 5

Edlin and Stiglitz, 1995; Stiglitz, 1997a). Streeten (1993) gives the example of private allocation of contracts to sub-contractors leading to rents in the same way as import quotas. When barriers to entry are high, privatesector firms become monopolistic and charge prices higher than what the production costs would dictate. Thus, to use Adam Smith's phrase, this reflects `the businessman's conspiracy against the public'. In such situations, government intervention through anti-monopoly legislation may actually reduce unproductive activity and raise output through greater competition. The relevant question is whether governments or markets lead to greater net negative result, when rent-seeking is common to both market and government failures. Toye (1991a, p. 321) notes two major features of the NPE: (a) `an unrelievedly cynical view of the state and a sharp disjunction between that view and the political requirements for the adoption of liberalization policies in the economic sphere', and (b) `the exclusion of international economic and political factors from the frame of analysis'. In an interdependent globalizing world of today it is unrealistic to ignore influences of such international bodies as multinational corporations, international banks and development institutions on changes in policy in developing countries. Toye also questions the generally held view that the rent-seeking literature provides the foundation for NPE. The pressures of interest groups in the political process need not always be negative. These groups have been interpreted as equivalent to competitive process in the political field, which ensures consensus and compromise in coalition building. Under the NPE, however, interest groups and competition among them are seen as negative agents which destroy public interest and lead to political fragmentation. The relevance of the NPE (developed initially in the context of advanced market economies) to developing countries is a matter of some controversy. While Findlay (1991) asserts its universal application, Grindle (1991) argues that its application to public policy making in developing countries is of a rather limited value. She draws a distinction between the `state-centred' and `society-centred' view of public policy making. Society-centred political economy models depict competition of interest groups as a threat to government to respond through rational economic policies. On the other hand, the `state-centred' view poses no such threat since politicians or the political elite are assumed to be as rational as the voters. It is only the state-centred view that is relevant to developing country situations. The `society-centred' view has limited validity in developing countries because public policy making is generally much less transparent and more closed than in developed countries

6 The Old and the New Political Economy Table 1.1 Characteristics of the old versus the new political economy Old Political Economy (OPE)

New Political Economy (NPE)

Market failures are responsible for poor outcome of economic policy

Government failures are responsible for poor outcome of economic policy.

Government is a benevolent institution working for the public good

Market, deregulation and prices will lead to efficiency and maximum economic/ social good.

Government intervention is efficient

Government intervention is inefficient

Interest groups are beneficial and can help promote political consensus

Interest groups are harmful as they promote rent-seeking

State ownership and control of private enterprise is necessary for equitable growth

State ownership (especially in industries where private enterprises can do better) distorts markets and causes inefficiency.

(Grindle and Thomas, 1989). The above argument is based on the assumption that interest groups in developing countries are weak and have limited access to the state. As a result, public policy making is centred in the high echelons of government. This view contrasts Bardhan's (1984) which explains rent-seeking in India through vested group interests. A contrast between the OPE and the NPE is summarized in Table 1.1 which depicts the characteristics of each.

A critique The black and white view of state versus markets is clearly exaggerated. The recent development debate seems to have over-romanticized the successful role of the private sector in promoting growth and reducing inefficiency. As noted above, the fall of socialist governments in the former Soviet bloc has encouraged some to believe that history has given a clear verdict in favour of capitalism and free enterprise. If state and bureaucracy have failed, does it follow that the instrument of markets and laissez-faire is necessarily superior? We argue that it does not for the following reasons. Firstly, in the so-called market economies, limitations of the market have become clear. Stiglitz (1997a) distinguishes between `traditional'

Market or Government Failures? 7

market failures (for example, externalities and public goods) and the `recent' analysis of market failures (concentrating on innovation and technology development, information imperfections, absence of markets, and their imperfections when they exist, as is reflected in unemployment, monopolistic situations, and so on) (see Chapter 2). The market for the development of technology may fail, thus calling for government intervention. There may be other market limitations ± equity, environment and similar other long-term considerations do not enter the balance sheet. These limitations have led to serious consequences in terms of the pitiable conditions of the poor, homeless and minorities, local and global environmental degradation and the neglect of human resources development. Secondly, government intervention may be essential to make markets function more effectively. In developing countries, markets function poorly for lack of institutions, social norms and human behaviour (Basu, 1986, 1992). Government has a role to play in introducing appropriate property rights and legal norms. (Social norms and human behaviour at any given point of time would be the result of historical and cultural heritage.) The role of the government may also remain important for the alleviation of poverty and ensuring equity through income transfers or redistribution of incomes. The government role cannot be replaced easily in the provision of public goods and services such as health and education, the maintenance of law and order, building and maintaining infrastructure and environmental protection. It should also be noted that in many developing countries a large proportion of the population is engaged in subsistence production outside the market. In this case the state and social organizations will need to be relied upon to channel goods and services to these people. Even where markets exist, a regulatory framework and legal norms need to be provided by the government for their efficient functioning. The extent to which the outcomes of public policy will actually contribute to these objectives will largely depend on the nature and type of the state (see below). Furthermore, the increasing transitional costs of globalization and economic interdependence between economies can enhance, not diminish, government's role (see Rodrik, 1996a, 1997). Finally, privatization, which is defended by the protagonists of markets, may be as distorting as a government monopoly. It may not necessarily offer lower prices to consumers. Stiglitz (1997a, p. 85) notes: `There is some evidence that, insulated from competition, private monopolies may suffer from several forms of inefficiency and may not be highly innovative.'

8 The Old and the New Political Economy

INSTITUTIONS AND ORGANIZATIONS A distinction between `institutions' and `organizations' is considered crucial in a study of transaction costs (North, 1990). While institutions provide a framework and rules of the game, organizations refer to groups of individuals guided by common purpose and objectives. The latter are agents of institutional change. The new institutional economics (NIE) provides a framework to explain the role of institutions and norms in reducing information and transaction costs to improve economic performance. North (1990) notes their role in reducing uncertainty and providing stable though not necessarily efficient social structures. It is the economic and social institutions rather than markets or governments whose imperfect operation constrains growth in productivity and efficiency (Harriss et al., 1995). The role of institutions and organizations as well as their interrelationships are important especially in developing countries because they reduce transaction costs, provide incentives which can enhance efficiency, and avoid or resolve conflict (Stern and Stiglitz, 1997). However, conflicts can be resolved only through partnerships and incentives for cooperative (rather than conflictual) behaviour (for example, partnership or relations between workers, management and government). There is a possibility, however, that while institutions lower transaction costs, the design and establishment of new institutions may incur high transaction costs since it involves risk and uncertainty. Furthermore, institutional rigidities exist; generally institutions take long to adapt to changing economic circumstances. Stern and Stiglitz (1997) note that all institutions may not meet the current needs of the economy, and can in fact, hinder change. But generally, even when legal structures and institutions are weak, social sanctions can help strengthen their enforcement (as for example, in East Asia). North (1990, p. 27) notes that `costliness of economic exchange distinguishes the transaction costs approach from the traditional theory'. Transaction costs have also been seen simply `as a way of describing the causes of market failure' (Khan, 1995, p. 74). Since transaction costs occur under both public and private institutions, alternative institutions need to be identified to lower these costs in order to improve net social benefits. The relevant issue then is transaction cost difference between state (government) intervention and non-intervention. It is possible that `intervention with rent-seeking may have lower overall transaction costs than laissez-faire with lower rent-seeking' (Khan, 1995, p. 75).

Market or Government Failures? 9

While there is continued debate on the precise nature of the state role and government intervention, nobody will deny the need to redefine this role in the light of new development paradigm and national and global governance. While in the old political economy framework the state was justified as a custodian of social justice, under the new framework it can be defended to correct market failures. Thus public policy decision-making and implementation may be intended to promote efficiency by eliminating price distortions, promoting competition by breaking down monopolies, and developing and fostering institutions which strengthen the functioning of factor and product markets. In writing on the role of investment and profits on East Asian È z and Gore (1994) note quite rightly that the industrialization, Akyu `attempt to isolate economic effects which can be attributed to government, as against the market, is misguided'. Datta-Chaudhuri (1990, p. 38) notes that the dichotomy is `fake' because `in a changing world the required institutional changes in markets do not always take place automatically'. The state can promote `the right kind of market institutions' and `where market signals alone are not effective guides to desirable action, appropriate nonmarket institutions are required to be created'. In reality, development cannot be achieved either by the private sector alone, or by the state sector alone. There is a role for both. An early World Bank Report (1991, p. 1) states: markets cannot operate in a vacuum. They require a legal and regulatory framework that only governments can provide. And at many other tasks, markets sometime prove inadequate or fail altogether. This is why governments must, for example, invest in infrastructure and provide essential services to the poor. It is not a question of state or market: each has a large and irreplaceable role There is no agreement yet on the precise assignment of roles and allocation of responsibilities between the state and the market. As Krueger (1990, p. 17) has noted, `an economically efficient division of economic activity between public and private sector will be based in part on the administrative and organisational requirements of the two alternatives'. Fishlow (1994, p. 1830) states: `what we lack are a full set of rules for determining the appropriate form and changing role of governmental policy'.

10 The Old and the New Political Economy

In the final analysis, the quality of government (as distinct from its extent) and responsibilities will determine its positive or negative role, which can be judged in terms of the quality of policy design and success in the implementation of policies and programmes (see Chapter 7). This can be illustrated by the experience of policy formulation in post-war Japan (1953±1973). Gore (1994) notes how government policy in Japan was formulated taking due account of the views of the business community, the main engine of economic activity. Cooperation between business and government facilitated implementation of policies. Government policy was characterized by both realism and flexibility. For example, although a competitive policy was encouraged, the government tempered competition in the case of small businesses which were exempted from anti-monopoly laws. Role of social organizations Social organizations (non-political and non-governmental institutions ± so-called civil society) can help overcome market inefficiencies besides providing checks and balances on the state. Some laissez-faire economists (for example, Coase (1960) argue that market inefficiencies can be resolved through collective action of individuals in the form of a social organization rather than through government intervention. This argument has been questioned by Dutt et al. (1994, p. 5) on the grounds that large transaction costs, free-rider problems and revealed preferences of individuals will make it difficult to achieve private optimal solution. Social organizations, like government entitites, may also suffer from narrow self-seeking interests which would lead to irrational economic outcomes. Some of the social organizations may be state-induced; they are promoted to take over some functions hitherto carried out by the government. This is the case of many recent associations in China. In postMao China, the Chinese Government encouraged the creation of semiofficial and popular social organizations like the Self-Employed Workers' Associations and Private Entrepreneurs' Associations for fulfilling different objectives, namely, regulating the market, social welfare and consultation in policy making (Howell, 1994). It has been noted that in Xiaoshan (China), the local government and the Association of Science and Technology jointly tackled the problem of land reclamation. The emergence of these associations is expected to achieve simultaneously the objectives of improved state performance, greater equity through provision of social welfare and greater popular participation in decision-making which in turn, is expected to improve the performance

Market or Government Failures? 11

of the Chinese State. In Indonesia and Malaysia the existence of kelompok (or small cooperatives) is noted to promote collective action (Barlow, 1999). Some non-political organizations (for example, farmers' movements in India) may also emerge more spontaneously as a response to economic and political circumstances. In India the new farmers' movements represent social groups created to fight for their economic and social rights and benefits. As distinct from the old peasant movements in India, the focus of new farmers' movements is not land but agricultural prices (Byres, 1994a). Their main objective is to obtain more remunerative input and output prices, particularly the procurement prices, for farmers. To press their case vis-aÁ-vis the government, the movements in different states in India have agitated by blocking the food transportation (both rail and road) system, blocking access to politicians in villages, and withholding crops from markets in order to raise prices (Brass, 1994). Of course, motivations of farmers' movements varies from state to state in India. In the Punjab, it is noted to be a reaction to a gradual erosion of prosperity brought about by the Green Revolution. Commercialization of agriculture leads to market integration of surplus-producing medium and small farmers. They are increasingly vulnerable to input and output price fluctuations. As a result, the Punjab farmers' demands include lower input prices, higher procurement prices, and crop insurance schemes. The farmers' movement in Gujarat on the other hand, seems to be linked to an integration of rural and urban commercial interests.2 In both industrial and developing countries traditional forms of civil society (labour unions, chambers of commerce, industry associations) and new forms of community organizations (for example, micro credit associations and other local community organizations) are engaged in the tasks of mitigating the economic and social hardships and `new' poverty resulting from social exclusion and economic globalization (see Bhalla and Lapeyre, 1999). Below we shall discuss different forms of the state, markets and nongovernmental social organizations to show that a dichotomy between the state and market is misplaced. There is a place for all these three institutions. We argue that a synthesis is required between the above three institutions. In this synthesis, advantages of the market need to be harnessed fully. But society must find a way to overcome the limitations of the market by correcting its equity-blindness, its indifference to environmental `externalities' and its preoccupation with the short term (see Chapter 2).

12 The Old and the New Political Economy

DIFFERENT TYPES OF STATE In the economic literature the state has been defined and characterized differently depending on the positive or negative view of it, its goals in terms of public (or national) interest versus that of interest groups, its autonomy from interactions with society, and so on. The degree and quality of state intervention in economic activity is another criterion for judging its nature. Bardhan (1991b, pp. 109±10) notes that in the bulk of the neoclassical literature the emphasis is on the extent of state intervention, particularly its harmful effects rather than its quality. He goes on to state that `almost all states in developing countries, successful or otherwise, are interventionist, and the important issue is not really the extent but the quality of that intervention'. The nature and quality of such intervention will vary between states. Generally the quality of state intervention is likely to be higher in states that pursue the collective good of citizens than in others which are selfserving. Having mentioned some criteria governing state quality, we now briefly discuss the different types of state discussed in the development literature. `Soft' v. `hard' state Ever since Myrdal's Asian Drama (1968) typologies of different types of the state have been presented. Myrdal referred to the `soft' and `hard' states. The `soft' states are those `where national governments require extraordinarily little of their citizens. There are few obligations either to do things in the interest of the community or to avoid actions opposed to that interest' (p. 896). These `soft' states are further characterized by `low level of social discipline' and high level of corruption, tax evasion and black marketeering (p. 894). In contrast, the `hard' states are those in which corruption and tax evasion are less marked. These states may be dictatorial or democratic, but they are characterized mainly by the greater ability to implement economic policies to promote rapid economic growth and social welfare. States can become strong or hard through a high level of `social control' which makes possible surplus accumulation. Three preconditions of a hard state are: compliance (of the population to state's demands), participation (in state-run institutions), and legitimation (acceptance by the citizens of the state's authority and their approval of state goals) (see Migdal, 1988). The differences in the states' capabilities over time and space can be explained in terms of the degree to which these preconditions are met. Poor enforcement of a state's rules

Market or Government Failures? 13

and laws and failures in implementation of its policies and programmes may be seen as its weakness caused by the lack of fulfilment of one or more of the above preconditions. The strength of the state is also determined by the nature and types of social structures under which the state operates. A hard state suggests a harmonious social structures whereas a weak state is indicative of social conflicts among various interest groups. Furthermore, centralization of power can be an important ingredient for the making of a hard or strong state. According to Migdal (1988, p. 34), `the highly centralized and the more diffused can be considered ``strong'' because the overall level of social control is high'. Migdal concludes with what he calls `sufficient conditions for creating strong states', namely, social dislocations leading to weakening of existing patterns of social control, existence of a serious external military threat which changes the risk calculus of state leaders, the basis for an independent bureaucracy, that is, `the existence of a social grouping with people sufficiently independent of existing bases of social control and skillful enough to execute the grand designs of state leaders' (p. 274), and skillful leaders favouring strong state control. Autonomous vs. factional state Lal and Myint (1996) have developed alternative models of the state, classifying it into two broad groups, (a) autonomous and (b) factional. The autonomous state follows its own objectives whereas a factional state represents some sort of collective decision-making. The autonomous state is further divided into the `predatory' (absolutist or `bureaucratic authoritarian') and `guardian' state. The autonomous state may be based on a one-party system which enables it to ignore interests other than its own. The `absolutist' or `predatory' state is not confined only to the erstwhile communist countries. It also depicts the situation in many developing countries where the state indulged in rent-seeking and exploitation of its citizens. To quote Meier (1993, p. 383): `an underdeveloped economy has given rise to an overextended state and to a negative or exploitative state. This implication appears in writings on price distortions (rent- seeking and directly unproductive activities), state-owned enterprises (patronage and bureaucracy), financial repression (politicized credit allocation and cheap credit to supporters), agricultural markets (pro-urban bias), inflation (populism) and tariffs and quotas (lobbying).

14 The Old and the New Political Economy

Predatory (or Leviathan) state While the traditional view of the state is that it is a benevolent entity, `maximising a social welfare function subject to resource and technological constraints', the new political economy views it as `predatory' (Lal, 1984). Grindle (1991, p. 43) notes, `recent neoclassical models have helped resolve the clash between theory and empirical observation by replacing the image of the benign state with its mirror opposite, the negative state'. Under the new political economy, regardless of the category the state is assumed to `prey on its citizens' and promote the interests of the few vested groups at the expense of general public good and social welfare. As North (1979, pp. 250±51) notes, many Social Scientists view the predatory state as: the agency of a group or class; its function, to extract income from the rest of constituents in the interest of that group or class. The predatory state would specify a set of property rights that maximised the revenue of the group in power, regardless of its impact on the wealth of society as a whole. A predatory state is not benevolent because it is rent-seeking, it tends to maintain overvalued exchange rates, it taxes trade and promotes a large and inefficient bureaucracy and distributes power and economic gains among a limited number of interest groups. The neoclassicists would like to restrict the activities of the government so that it has fewer resources to squander on these interest groups. The desired outcome of public policy may not occur if rent-seeking is unproductive, if the bureaucrats seek their self-interest and if different interest groups which support public policy exploit the state to their advantage. Guardian or platonic state In contrast to the predatory state a guardian state is interested in social welfare and the public good. According to Lal and Myint (1996, p. 261), `instruments of power in the Platonic state have citizen's welfare in their own objective function, whilst in the predatory state the rulers treat their citizens' welfare more as a constraint which restricts their pursuit of other objectives'. This benevolent view of the state is based on a number of premises: first, that governments and civil servants would work for the welfare of the people who themselves might be unaware of their interests; second, that the governments would provide for future

Market or Government Failures? 15

generations better than the poor people who generally have a very high rate of time preference (Krueger, 1993). The precise outcome of the state or government intervention (the two are used here interchangeably) will depend on a host of factors: relationship between the state and society; convergence or divergence of the interests of the state (and the bureaucrats) and those of the dominant social classes, and the nature of communication between the two groups (Dutt et al., 1994, p. 9). As we discuss in Chapter 2, market failures and inadequacies often justify state intervention which may improve outcomes by promoting competition and by selectively operating through the markets as has been the experience of East Asian economies (Stiglitz, 1994a; Wade, 1990). Owing to its `power of compulsion' and `universal membership', governments may be at a comparative advantage in overcoming market failures (see Stiglitz, 1991b). To quote Stiglitz (1994b, p. 32): `the government does have powers that the private sector does not have, powers that in certain circumstances . . . could result in a Pareto improvement' (for example, the case of prohibition of smoking or raising the cost of cigarettes through taxes which no private company could impose). A typology of Third World states The above discussion of different types of state shows that different categories overlap. For example, what Myrdal calls the `hard' state, may not be very different, in its essential features and objectives, from a benevolent state or an autonomous state. Similarly, a factional state may not be very different from a `soft' state. Essentially, the above categories boil down to (a) dictatorships and (b) democracies with different shades of each depending on the fulfilment of the objective of public good. In the political literature there does not seem to be a typology of states on a comparative basis. Findlay (1991) presents a rather crude typology of dictatorships and democracy. He notes: `Democracy versus dictatorship is one axis along which they might be situated, and market orientation and central planning is another, giving us four categories if each of these distinctions is applied dichotomously' (p. 19). Findlay arbitrarily allocates developing countries into `traditional monarchies', `traditional dictatorships', `authoritarian' and `democratic states'. He links the regime types to public finance strategies but does not present criteria for classifying states into different categories. The Lal±Myint typology discussed above is essentially a grouping of a number of state types into `autonomous' or `factional'. Developing countries are classified into

16 The Old and the New Political Economy Table 1.2 A typology of Third World states Type of state

Goals

Legitimacy

Compliance

Participation

Hard or autonomous state ± Authoritarian/ predatory ± Democratic Soft or Weak

People-centred

High

High

High

Self-centred

Low

Low

Low

People-centred ?

High Low/nil

High/Low Low

High Low

either autonomous (further sub-divided into `platonic' or `predatory') or factional (oligarchic and democratic). The authors conclude that in their sample of countries the autonomous states showed superior growth performance to that of factional states. We present an alternative version of the state typology (based on the above discussion of regime types) in a matrix where columns show state types, and rows, various criteria and goals, namely, legitimacy, compliance and participation discussed in Chapter 2 (see Table 1.2). Having discussed different types of states, we need to examine in some detail the nature and types of markets in developing countries.

DIFFERENT TYPES OF MARKETS There are different ways in which markets have been categorized. First, markets may be defined in terms of the nature of the product or input: thus there are product markets, factor markets or capital and financial markets. The second criterion generally used in economic literature is the degree of price competition: thus markets may be imperfect, oligopolistic or monopolistic. The third interpretation of markets is by non-economists or political scientists who see them as `culturally and politically specific' institutions representing interests of particular social groups. White (1993a, p. 1) notes that the neoclassical economic view of markets deals with an `ideal' type which ignores `the social, cultural, political and institutional dimensions of real markets'. Thus, markets represent power relations in the same way as do other pressure groups and governments. Dimensions of market power include the state, association, economic assets and sociocultural status. Sen (1999) discusses the role of markets in terms of freedom to exchange and entry or non-entry into the labour market (for example, non-entry of women and bonded labour as a case of unfree

Market or Government Failures? 17

markets). In discussing markets he suggests that efficiency sought through markets should be accounted in terms of individual freedoms instead of utilities. Markets may either function imperfectly or they may function well but in the wrong direction. Basu (1992, p. 341) notes: The problem with the Indian economy is not that its market is less or more free but that its freedom is in the wrong domains . . . in some domains the problem is that of excessive marketization: there is a price at which everything can be had. In other domains where the market ought to be more free, for example, international trade, industry and the entry and exit of firms, our markets are strapped up in bureaucratic red tape. The above Indian example is mentioned to underline the importance of the right kinds of institutions, social norms and human behaviour for markets to function effectively. Social norms are such that one can buy oneself out of traffic offences and purchase university degrees. When social norms are weak, transaction costs are high, laws may not be obeyed and contract enforcement will be very difficult. Of course, in principle, social norms can be enforced through policing and sanctions, but they may not always explain why an individual does not often default (for example, in making payment to a taxi driver) (Basu, 1986). In explaining non-market failures, Wolf (1988) cites information acquisition and control becoming an end in itself, leading to influence and power. While he recognizes the role of information in imperfectly competitive markets he concludes that price competition keeps cost inflation in check. However, there are also cases of absence of such competition. We examine different categories of markets below. Input and product markets In economic literature, input and product markets are the most frequently discussed types of markets. The input markets for labour (skilled and unskilled), capital, foreign exchange, land, and so on, and the product markets for consumer goods and intermediate and capital goods are perhaps some of the earliest notions of a market. In conventional neoclassical economic theory, perfect or `ideal' markets are characterized by perfect competition, complete information freely available to all the agents, and transactions taking place at a price on a selfregulating basis and on the basis of profit motive. Yet in practice,

18 The Old and the New Political Economy

especially in developing countries, production and dissemination of information is costly and weak because of inefficient institutions. Frequent structural changes make it even more difficult and costlier to collect and disseminate information (Stiglitz, 1997a). Imperfections in the labour, capital and foreign exchange markets (reflected in unemployment, credit rationing, and weak and unstable currencies) are common in most developing countries. As we note in Chapters 3 and 4, financial crises (which are not peculiar to developing countries) are a common form of market failure in open market-oriented economies. The recent liberalization and globalization of financial markets has made it even more common for developing countries with inadequate banking structures, information imperfections and poor institutions and infrastructure, to suffer from vulnerability through external shocks. Competitive or oligopolistic markets A competitive market is in equilibrium when supply of and demand for a good or service are equal at a particular price. Thus price mechanism is a self-regulating device. If demand is in excess of supply, price will go up. This will induce producers to raise supply so that a new equilibrium is reached. Milton and Rose Friedman (1980) note three important functions of prices in organizing economic activity and achieving equilibrium: namely, (a) transmitting information, (b) providing incentive to adopt least-cost methods of production, and (c) determining who gets how much of the product. They state: `One of the beauties of the free price system is that the prices that bring the information also provide both an incentive to react to the information and the means to do so' (p. 33). The above textbook competitive or `ideal' market is rarely found in practice. Actual prices do not always reflect scarcities of factors and products, and consumers and producers do not enjoy equal access to information about products and markets. Market failures also occur due in part to lack of informational capacity of economic agents (see Chapter 2). Stiglitz (1994b, p. 105) notes that competitive markets are an exception rather than the rule especially when such non-price factors as contracts and reputation (in allocating capital in capital markets) are important. In such a situation, prices may not be a good indicator of information on supply and demand. Neither are they suitable allocating devices. So prices will not equate marginal costs because rents are bound to persist when reputation mechanisms are at work. Furthermore, competitive markets should not be seen only in price terms; in today's world much of competition is in terms of achieving higher quality of products

Market or Government Failures? 19

(product differentiation) or producing better and new products to capture market niches. Barriers to entry and limits to competition may also arise because of the existence of transaction costs (discussed above) including costs of information search and processing, of organization and so on. The competitive view of markets abstracts from any power relations which determine price at which transactions occur. In contrast to the `ideal' markets, political scientists have presented the notion of `real' markets characterized by these power relations (see below). Financial vs. commodity markets3 Financial markets are different from other factor and commodity markets and these markets also differ in different capitalist countries, depending on their historical backgrounds as well as cultural and economic circumstances. To study differences between financial and other markets, it is useful to examine the functions of these markets. In the case of developing countries mobilization of savings for industrialization is considered as one of the main functions of financial markets. But there are other functions besides transferring capital from savers to borrowers, namely, selection of projects, monitoring, sharing and pooling of risks, recording transactions and so on (for a detailed discussion, see Stiglitz, 1994a, 1994b). Unlike commodity markets, financial markets are mainly concerned with information in its various forms: production, processing, dissemination and utilization. The latter markets are more `imperfectly competitive' (to use Stiglitz's phrase) because they are more information intensive and search: collection and processing of information can be costly. Two types of information are particularly important in the capital and financial markets: information about the borrower's capacity and promise to pay, and what the borrower is actually likely to pay on some future date (risk of default). Other types of information required relate to (a) solvency of financial institutions, which is of interest to investors, and (b) management of these institutions, which affects risk and rates of return on investment. The above types of financial information have the character of fixed costs which does not increase with an increase in the volume of lending. In financial markets (unlike the commodity markets), it is not easy to separate (a) exchange transaction, (b) the role of information and (c) risk of default. The price mechanism is unable to provide such information: it is better in matching supply and demand for goods than in matching supply of and demand for loan funds (Stiglitz, 1994a, 1994b). Also as Sengupta (1995, p. 40) states:

20 The Old and the New Political Economy

of all markets, the market for financial services is most prone to imperfection, and therefore to failure, and that failure occurs because the price of financial services more often than not fails to clear that market. Although interest rates (prices) do play a role as an allocative mechanism in the sense that they define the opportunity cost of funds, the allocative mechanism is basically a screening device in which prices play a secondary role (Greenwald and Stiglitz, 1986). The highest price (interest rate) offered by the borrower does not necessarily mean the highest expected return to the lender because of a possible risk of default which is higher with a greater amount of lending. In financial markets, therefore, contracts between borrowers and lenders and reputations of the borrowers are far more important for resource allocation than prices. These non-price factors are totally ignored in the neoclassical theory of welfare economics. Yet Stiglitz (1994b, p. 88) notes that contracts are essential in circumstances of incomplete markets. To quote: `contracts are required because there are simply not ``markets'' for all the possible commodities . . . and reputations are required simply because we cannot write down all the desired characteristics . . .'. Loan contracts by banks, for example, may include a host of provisions besides the price (interest rate): terms and conditions relating to collateral and risk of default, for example. Thus, unlike the conventional markets where the highest bidder obtains a commodity, in financial market, such an auction system will not work; financial institutions will perform a monitoring and screening function based on knowledge about the potential borrowers and their reputation. In conventional markets, competition may raise economic efficiency. But in financial markets, this is unlikely to be so; if banks as lenders promote fierce competition they may deprive themselves of repayment of loans from firms that may become bankrupt (Stiglitz, 1994b, p. 222). Free vs. governed markets In the context of East Asia, Wade (1990) introduces the concepts of free, simulated and governed markets. Free markets are those in which government intervention is minimal or absent. The role of the government is confined only to the provision of suitable environment for the free functioning of the market. In terms of the trade regimes, Wade (1990, p. 24) notes that the simulated free market theory refers to a situation where `any incentive for domestic producers to sell on the domestic market rather than export because of protection is offset by export

Market or Government Failures? 21

subsidies'. On the other hand, the free market theory refers to a liberal trade regime with few impediments to imports. The governed markets refer to markets which are not free but are regulated by the government through a system of controls, incentives and mechanisms. Wade (1990, pp. 26±27) defines the `governed markets' as follows: Using incentives, controls and mechanisms ± to spread risk, these policies enabled the government to guide or govern market processes of resource allocation so as to produce different production and investment outcomes than would have occurred with either free market or simulated free market policies. Real markets A non-economic analysis of markets replaces the price mechanism as an allocational device (used by economists) by power relations between different agents and actors, which may be based on exploitative behaviour or cooperation. As we noted above, real world market functioning is conditioned by social, political and institutional factors. White (1993a) analyzes four major political factors: the politics of (i) state involvement, (ii) market organization, (iii) market structure and (iv) social embeddedness. The state is involved in markets in different ways: taking over production in the state sector, providing key inputs such as energy to private firms and purchasing agricultural products from the primary producers. These three means of government involvement in the market are common to most developing countries. Secondly, certain powerful agents, the so-called rent-seekers for example, can exploit the market to their advantage at the expense of other weaker agents. In some cases, cooperation through formal associations and networks may be sought to extract these advantages (see below). What White (1993a) calls the politics of market structure is indeed within the realm of economic analysis. The monopolistic or oligopolistic market structures discussed above can reflect the economic as well as political muscle of market agents. Finally, as Polanyi (1957) notes, markets are `embedded' in wider values and institutions. This may mean that market agents are not necessarily guided by profit maximization or self-interest. Instead, they may be guided by culture, tradition and fairness in regulating market exchange.

22 The Old and the New Political Economy

It is difficult to develop a neat typology of markets with diverse criteria for classification. What is relevant for our purposes is that markets in actual practice are never perfect since assumptions of perfect competition, zero transaction costs and so on are not valid. As Stiglitz (1994b) notes there is no such thing as `a complete set of markets'. The imperfections in competition may arise from information costs including fixed costs of obtaining information about how to produce a particular good. Furthermore, `there are costs associated with establishing a market' (Stiglitz, 1994b, p. 33). Asymmetric information (that is, buyers and sellers have different amounts and types of information) may explain many market imperfections be it in the insurance, equity or labour market. As we note in Chapters 3 and 4, crises in financial markets occur due to information failures and high degree of risk and uncertainty. The well-known problems of adverse selection and moral hazards in the insurance markets (which occur in other markets as well) arise from asymmetric information. Under such situations prices fail to provide complete information, and thus do not clear the market as they should under perfect competition.

INTERACTIONS BETWEEN STATE, ORGANIZATIONS AND MARKETS The state interacts with markets both directly and indirectly. In a direct manner, the development and control of the public sector ± through state corporations, parastatals and nationalized banks, the state participates directly in the market.4 This is the experience of both China and India which have large state sectors (see Chapter 6). It is also the experience of Africa particularly with the state marketing boards. Bates (1981) shows how government intervention in markets for agricultural commodities, urban goods and factors of production, extracted rural surpluses to finance capital-intensive industrial projects. Indirectly, the state interacts with the market by regulating it. It intervenes mainly to correct market distortions or to strengthen the functioning of the market instead of suppressing it by taking over production. The development literature on the state briefly reviewed above, takes a very aggregated view of the state. However, in a study of interactions between the state and other non-state institutions, it is more useful to disaggregate the state into its different levels of organization, namely, executive leadership, central agencies, and regional and local bodies (Migdal, 1988, p. 263). Interaction between the state, social organizations and markets is likely to be easier and greater when the state has several levels of organization and when decision-making is decentralized.

Market or Government Failures? 23

Rodrik (1992) argues that an autonomous state leads the private sector and the market whereas the `subordinate' or `soft' state (aÁ la Myrdal) would follow it. The latter lacks a `mechanism that would commit it to reward or punish the private sector according to whether the desired behaviour is carried out or not'. The precise nature of interaction between the two sets of institutions ± the state and the market ± may depend on the nature of a particular policy action. A policy may be intended to provide an economic incentive (for example, an export subsidy) or to correct a market failure. On the other hand, it may be motivated by a political objective of supporting some powerful groups which may create further market distortions rather than reducing them. As a free market economy is unlikely to lead to the achievement of social objectives, markets need to be guided to attain these objectives. Datta-Chaudhuri (1990) cites Japan's experience to show that governments can guide the `perceptions of producers and traders' to exploit their potential which might remain latent under an unguided market economy. Government also interacts with non-governmental organizations in different ways. Firstly, government may actually create these organizations (as in China) to transfer some of its erstwhile functions. Alternatively, these organizations may provide checks and balances to government interventions. They may also act as lobby or pressure groups to extract gains from the state. Various associations and organizations also participate in the market as agents representing particular interests. They influence price formation as well as supply of and demand for goods and services. Their role is particularly important in the foodgrains markets in developing countries (Harriss-White, 1993). Institutions such as those of traders and merchants may restrict market entry and control distribution which may not necessarily be socially desirable.

2

Theories of Market and Government Failures

Analysis of market failures and their causal factors is well established, but that of government failures is less so. It is for this reason that in this chapter our main concern will be with the latter. Non-market failures occur owing to difficulty in measuring non-market outputs independently of inputs and thus in determining their quality. Rise in costs and overstaffing, as in the case of state or public enterprises may also cause these failures (see Chapter 6). Competition and the profit motive, the two factors which explain cost-cutting in the market case, are missing in non-market activity. Market failure, on the other hand, is generally known to occur when resource allocation is not optimal and a change would improve the welfare of all consumers without making anyone worse off. While the neoclassical school recognizes market failures, it believes that government failures are more frequent. One of the reasons why a theory of non-market or government failures has not been as well developed as that of market failures is that the principles of market analysis are not as applicable to situations where markets do not exist. Markets and governments can be complementary as well as competitive institutions whose perfect functioning in a neoclassical sense is an exception rather than the rule. These two sets of institutions are distinguished, inter alia, by the force of competition which may generally be restricted or absent in non-market cases (see Chapter 6). In this book we argue that both market and non-market failures1 ultimately boil down to inadequacies and failures in the implementation of public policies and private corporate strategies. Therefore, almost equal, if not more attention needs to be paid to factors responsible for failures in the enforcement of both private and public strategies (see Chapter 7). However, traditionally these failures are attributed mainly to 24

Market or Government Failures? 25

the inadequacies of public policy. The periodic collapse of banks and financial institutions (see Chapter 3) clearly shows that implementation failures also occur in the private corporate sector. In this chapter, our concern is to review the main issues and theories relating to market and government failures. We leave implementation problems till the end since they are common to both public and private institutions and organizations.

MARKET FAILURES We noted in Chapter 1 that markets in developing countries may either not exist, or when they do, they may be incomplete and highly imperfect. In such situations, the market outcomes in terms of efficiency and equity may not be socially desirable. It is, therefore, assumed that the government needs to step in to promote social welfare. However, as we shall discuss below, the validity of this assumption is open to question. Government action may also result in undesirable distributional outcomes. Even apart from this problem, a link between efficiency and equity needs to be recognized. Highly unequal income distribution can lead to loss of efficiency through lowering of economic incentives (Stiglitz, 1989b). Market failures need not necessarily be defined in a narrow economic sense. For example, the perception of market failures in Japan deviates considerably from efficiency in resource allocation. The Japanese define market failure in terms of the inability of `the market mechanism to achieve the goals set by the government' (Gore, 1994). Thus markets may prove inadequate especially for the provision of essential infrastructure, satisfaction of basic needs, and the delivery of essential services to the poor. As enough has been written on market failures, it is not our intention to provide an exhaustive review. Following Stiglitz below we discuss market failures in terms of their conventional and more recent interpretations separately. Our concern in this book is much more with the recent interpretations, namely, information failures, absence of markets or their distortion and incompleteness, and unemployment. Conventional interpretations A theory of market failures is traditionally characterized by externalities, public goods and increasing returns (for a succinct discussion of these issues, see Chang, 1994a; Wallis and Dollery, 1999). The market test of failure is expressed in terms of loss of allocative or dynamic efficiency.

26 Theories of Market and Government Failures

Market outcomes are sub-optimal or less efficient in cases of externalities and public goods (for example, health, education, and environment). Positive or negative externalities (which may simply be defined in terms of a discrepancy between private and social costs and benefits) cannot be captured by the market. Owing to these discrepancies, private firms may underinvest in activities (for example, technology and knowledge generation and training) whose yields may not fully accrue to them. Workers trained in one firm can move to another firm. Similarly, firms may fail to keep the benefits of technological innovations from spilling over to competitors. Thus the state has to step in to make sure that technology generation, training and other ingredients of human capital formation and capacity building do not suffer neglect. Activities with positive externalities (for example, R and D) may need to be subsidized and those with negative externalities (for example, pollution) may require taxation at least in the short run (Chang, 1994a). Stiglitz (1997a, p. 64) notes three types of market inefficiencies: (a) product mix inefficiency when the market produces too much of one good and too little of other goods; (b) exchange inefficiency when some goods do not reach individuals who want them; and (c) production inefficiency when production is far inside the production possibilities curve. These notions overlap with those of allocative, productive and dynamic efficiency discussed in the following theories of government failure. Non-conventional interpretations 1.

Information failures

Imperfections in information prevents Pareto-optimality and leads to market failures. Adam Smith's postulate of self-interest leading also to public good was based on the assumption of perfect information which does not exist either in developed or in developing countries. Acquisition of information and its processing is costly for both public and private economic organizations. Stiglitz (1989b, 1994a) shows how markets with imperfections in information are fundamentally different from those which operate under perfect information. Information may also be imperfect and inadequate which leads to poor private as well as public decision-making. Furthermore, design of public policy and resulting implementation can be faulty for lack of informational capacity of governments (see also Chapter 7). Moral hazards (arising typically in the insurance markets) and adverse selection (employers' hiring practices) are noted to be the two main

Market or Government Failures? 27

problems of information failure (Stiglitz, 1997a, pp. 72±73). Governments can overcome the problems of externalities caused by these problems at least indirectly, if not directly. For example, even if a government cannot monitor smoking, it can discourage it by imposing tax on cigarettes. Similarly, governments can tackle market inefficiencies resulting from the selection of low-productivity workers by imposing taxes and subsidies with a view to raising labour force participation of high-productivity workers. In the case of developing countries in particular, weak institutions (including markets) (see Chapter 1) explain the inadequacies in production and dissemination of information. Furthermore, in these countries, those undergoing rapid growth incur significant structural changes which burden the informational capacity of the government and other institutions (see Chapter 7). 2.

Market distortions and unemployment

Lack of information leads to market distortions characterized by the following features: (i) Monopoly situation and imperfect competition; resource allocation is sub-optimal in these cases. (ii) In a market system, competition is supposed to promote allocative, productive (or X-efficiency) and dynamic efficiency. When competition is restricted, resource allocation would not be optimal and a change would improve the welfare of all consumers without making anyone worse off. Market distortions resulting from monopolistic and oligopolistic situations and externalities may account for such sub-optimality. (iii) Price dispersion occurs under imperfect competition, when firms charge different prices, or temporarily reduce prices. The high cost of searching the information accounts for this phenomenon. Lowpriced firms can steal customers from high-priced firms. The latter can still survive by serving those who can afford the high cost of search and who may fail to find low-priced firms. Price dispersion can, therefore, give rise to search and other activities aimed at reducing market imperfections (Stiglitz, 1994b, pp. 41±42). (iv) Market disequilibrium under which supply does not match demand (for example, cases of credit rationing or unemployment). Underutilization of manpower in the labour market is indeed one form of market distortion which becomes severe particularly during times of

28 Theories of Market and Government Failures

recession and depression. The failure of the market and prices to clear unemployment and surplus labour has become a serious problem particularly in Western Europe with chronic and high unemployment rates in many countries. The government performs an important economic role to correct the above types of market failures, which is essential even for the markets to function properly. This role is to provide what Stiglitz (1997a) calls `institutional infrastructure', consisting of: (a) a legal and contract system which represents a set of rules of the game for markets to operate properly, (b) a set of property rights, (c) physical infrastructure including financial services and telecommunications, and (d) intellectual infrastructure (through education, research and development (R and D), and technology.2 As we discuss in Chapter 6, many scholars on China attribute the failure of state-owned enterprises (SOEs) to lack of well-defined property rights.

GOVERNMENT FAILURES Defining government failures is more problematic than defining market failures. This is partly because the output of non-market organizations (including the government) is often hard to define, much less quantify. Government failures may occur when there is a shortfall in goal realization, or when governments lack the institutional capacity to implement their declared strategies and policies. In this sense, government failures may be the main source of implementation failures. Governments may fail to implement policy when private sector goals are at variance and it is unable to change these goals. Theories of government failures There is an abundant literature on the review of alternative theories of the state or government (see Chang, 1994a; Chang and Rowthorn, 1995; Wallis and Dollery, 1999). Therefore, it is not our intention to undertake yet another review. We present a brief sketch of various theories of government failures in an attempt to prepare an analytical framework for our empirical analysis of market and government failures in Chapters 3 to 6. As we noted in Chapter 1, the classification of the state is based on the benevolent or malevolent view of it. The public choice theory is one of the most significant approaches to explain government failures. The underlying postulate of this theory is the self-serving or egoistic behaviour of government bureaucrats. Thus, government failures may be

Market or Government Failures? 29

explained in terms of the pursuit of vested interests of politicians and bureaucrats. Politicians would tend to maximize the chances of their reelection and bureaucrats would seek rents and maximize budgets to wield power and capture public funds to private advantage (Niskanen, 1971). Corresponding to profit maximization by producers and utility maximization by consumers under the market failure case, under the government failure case, the goal adopted by bureaucrats would be security (of income and employment) maximization and by politicians, vote maximization. Wolf (1979a, 1979b, 1987, 1988) was one of the earliest writers to attempt to develop a theory of non-market (or government) failures. We present below his theory and a critique on it which inspired other writers such as Le Grand (1991) and Vining and Weimer (1990) to present alternative formulations of the theory. Stiglitz (1989a, 1989b) also juxtaposes market failures with non-market failures. A theory of non-market failures Wolf's theory (1979a, 1979b, 1988) explains that non-market failures may occur for the same sort of reasons as market failures. For example, just as there may be an absence of particular markets, as we noted above, there may also be absence of non-market mechanisms to reconcile private and social costs and benefits. To quote Wolf (1979a, p. 113): `Where the market's ``hidden hand'' does not turn ``private vices into public virtues'', it may be hard to construct visible hands that effectively turn non-market vices into public virtues.' 1.

Demand and supply considerations

Wolf outlines his theory of non-market failure in terms of demand and supply characteristics of governmental action and output. On the demand side, three characteristics are considered relevant: (i) demand for government action resulting from public awareness of monopolies, pollution and distributional inequity (this awareness is reflected in the enfranchisement of environment and women's groups and consumer groups, for example); (ii) political process culminating in premature (emphasis added) government action that may involve unintended outcomes because it is based on imperfect knowledge of the nature of the market failure to be corrected; and (iii) disjunction between the politicians' time horizons and the time required to examine market failure and propose remedial action. Demands for government action may also grow out of bureaucracy's perception that it is capable of remedying harmful effects of market failures. Similar to the government's perception may be

30 Theories of Market and Government Failures

the public perception that government action is a good remedy. In situations when these perceptions of market failure are distorted, the demands for non-market intervention may turn out to be `excessive', thus resulting in non-market failures and government `deficiencies'. On the supply side, several characteristics are noted: namely, (i) difficulty in measuring non-market outputs independently of inputs; (ii) problems in determining the quality of this output; (iii) limitations of evaluating government performance and the absence of suitable mechanisms (similar to a market test) for terminating unsuccessful government activity; (iv) production of non-market output by a single agency mandated to do so by legislation or executive decree; and (v) uncertainty and lack of undertsanding of technologies associated with such non-market outputs as welfare services. Wolf (1979a) underestimated the existence of mechanisms under non-market activity (corresponding to market test and consumer response under market system). However, to be fair Wolf (1988) does recognize the role of interest groups and majority voters. Under a democratic system the existence of pressure groups and a free press often provide checks and balances to keep governments on their toes. For example, Sen (1983) shows how India averted famines thanks to a free press which did not exist in China. 2.

Sources of failure

Corresponding to market failures, there may be several sources of government or non-market failure. Wolf argues that non-market failure may occur, in the absence of pressures for cost-cutting (as in the market case) and consumer response, through a rise in costs and overstaffing of bureaucracy (or increase in output). It may also occur in the form of what Wolf labels `internalities and private goals', which are standards and indicators used by public agencies to guide, regulate and evaluate their performance in the absence of a market test. Private goals refer to the individual and collective behaviour of individuals working in these agencies to pursue their own interests rather than those of the general public. Like the private agents, these public agents may also be guided by self-interest such as `survival, promotion, re-election or. . . other rewards' (Krueger, 1990). In the absence of market and consumer response, there is no incentive to devise standards and pursue goals which would achieve the public good at low cost. An increase in budgets, an obsession with new technological fixes and exploitation of information to exercise influence and power, and distributional inequities resulting from government action based on power and wealth, are some of the examples of `internalities' explaining non-market failures.

Market or Government Failures? 31

Internalities and private goals considered above for non-market activity may also apply to market situations. When competitive markets are imperfect, firms may be `satisficing' rather than `maximizing'; they may not be guided by the cost minimization criterion which would be imposed by proper price competition and consumer response. However, as Wolf notes, internalities in the non-market case are generally cost raising whereas those under market activity are generally cost reducing. Competition and profit motive, the two factors leading to cost reduction, are both missing in non-market activity. 3.

A critique and alternative formulations

In a review of Wolf's Markets or Governments (1988), Williamson (1989) argues that for a comparative analysis between government and market failures, it is important to show whether the supply conditions (presented by Wolf) lead to better or worse results under one compared to the other. Le Grand (1991) notes that Wolf's theoretical synthesis is neither clear nor comprehensive and that some explanations of Wolf's theory, namely, `disjunction between costs and revenue', `internalities and organizational goals' and `derived externalities' are concerned with the efficiency concept, whereas another, namely, `distributional inequity' pertains to question of social and economic injustice. Divergence between revenues and costs may result in different kinds of inefficiency. It may result in allocative inefficiency under which goods produced may not be wanted by consumers or when a reallocation of resources would make everyone better off. It may lead to what Leibenstein called X-inefficiency under which resources are wasted through underutilized capacity for example, and goods are not produced at the lowest cost.3 Le Grand questions Wolf's argument that all kinds of government intervention involves a divergence between revenues and costs. Such divergence may not occur when the product is produced by a government agency but marketed through private channels. This is not to suggest that the government intervention is not inefficient ± there may be other reasons for inefficiency. Also there may be the possibility of efficiency occurring if an appropriate incentives structure is put in place. Le Grand notes that Wolf fails to distinguish between different types of government intervention (monopoly versus competition, for example) which is likely to determine the precise efficiency outcome. `Provision, subsidy and regulation' failures Le Grand (1991) presents an alternative formulation of the theory of government failures based on the efficiency and equity consequences of

32 Theories of Market and Government Failures Table 2.1 A matrix presentation of Le Grand's theory of government failures Static allocative inefficiency I. Provision through: Wholly governmentowned monopoly Partially governmentowned (quasi-market form) II. Subsidy III. Regulation

Productive or X-inefficiency

Dynamic inefficiency

Inequity

‡

‡

?

‡

‡

‡

?

‡

‡ ‡

‡ ‡

‡ ‡

?

‡ denotes increase; ± denotes decline; ? denotes indeterminate outcome.

the three main governmental activities, namely, `provision, `subsidy' and `regulation'. But these government actions may themselves be wanting in the light of efficiency and equity criteria. Le Grand's theory can be summed up in a matrix which indicates efficiency and equity criteria in rows and types of government action in columns (see Table 2.1). Different types of government will have different outcomes in terms of inefficiency, inequity, and scope for innovations reflected in dynamic efficiency. Firstly, government monopoly is a clear case of inefficiency. A second kind of inefficiency occurs when government monopoly faces competition not from private profit-maximizing providers but from non-profit making organizations. Here it is not so much public ownership per se but the extent of competition which determines the nature and degree of inefficiency. There are different degrees of government ownership and different degrees of competition: full government monopoly, partial government monopoly with limited competition from within the government sector, and government organization suffering from private competition, government-cum-private firms with 50 per cent or lower equity, and so on. Chapter 6 discusses state enterprises in China and India and shows how widespread government ownership can be especially in China where competition from collective rural and urban enterprises was actively encouraged to promote allocative and productive efficiency of state-owned enterprises. Le Grand criticizes the empirical literature on government failures for placing too much emphasis on X-inefficiency (or productive inefficiency) and too little on the question of whether it was worth the

Market or Government Failures? 33

government providing the output under its ownership in the first place. While government role is legitimate for the provision of such public goods as health services, it is not obvious for many other private goods. As we shall examine in Chapter 6, both Chinese and Indian state enterprises provided goods which could have been equally or more efficiently provided by the private sector or a government-cum-private sector. Le Grand (1991, p. 434) leaves the possibility open that some government enterprises may be more X-inefficient than their private counterparts but they may still show higher allocative efficiency. Turning to the case where government provides a good and subsidizes its consumption, there will be excess demand for it, raising it to the level above that indicated by allocative efficiency. Subsidies and taxes introduce price distortions under which prices will diverge from their true social costs thus leading to allocative inefficiency. Excess demand may be met in one of two ways: either through a queueing or waiting-list procedure, or through delegation of decision to bureaucrats, managers or professionals. Subsidies and taxes are explicitly designed to promote better distributional outcomes but there is no guarantee that they actually do so. Le Grand notes that a targeted and means-tested subsidy can promote greater equality of consumption, assuming that the test does not discourage consumption. To the extent that subsidies and taxes create disincentives, they may lead to dynamic inefficiency by lowering work effort and reducing savings. Governments are used to introducing regulations which, based on imperfect information, can lead to inefficient outcomes. Through quantitative and qualitative controls, regulations can create disincentives leading to all three types of inefficiency noted in Table 2.1. Very stringent regulations (such as extremely high taxes) may create dynamic inefficiency by discouraging investment and innovation. It would raise allocative inefficiency by distorting prices and incentives in general. Thus a given government action can have different and conflicting outcomes in terms of allocative, productive or dynamic inefficiency. The impact of government regulation on equity may be indeterminate as it can work both ways. For example, it may redistribute incomes in favour of the poor by introducing minimum wage legislation or through direct transfers. It may also lead to greater inequity if producer groups can lobby with the government to twist the regulations to their own advantage. The soft-budget constraint examined in Chapter 6 in the context of Chinese and Indian state enterprises, though intended to overcome market failures, may have introduced greater inequalities by,

34 Theories of Market and Government Failures

for example, subsidizing workers in these enterprises at the expense of the general tax payer. Abundant literature exists on the economics and politics of regulation. Therefore, it is not necessary to dwell on it much further (for a critical review, see Chang, 1997b). However, it is important to point out that government regulations are necessary not only for the government's own functioning but also for regulating markets and creating them in the first place (see Chapter 1). As Chang rightly notes the problem of creating markets is more serious in developing and transition economies in which they are unlikely to emerge spontaneously, as is demonstrated by the experience of China. Lack of property rights and an effective legal framework for business operations has slowed down the process of market creation in China. Contestability, government supply and production Drawing on the literature on industrial organization, Vining and Weimer (1990) argue that failures are small in private organizations and large in public organizations because of the contestability of (a) government supply and (b) government ownership. Contestability of firms is defined as a situation of firms entering and exiting the market without any loss of investment (see Baumol et al., 1982; Bailey and Baumol, 1984). Thus many characteristics of the competitive market may exist under high contestability even when the market is served by a single firm. The firm would be on its guard and government regulation discussed above might not be necessary. Contestability of ownership implies a threat of change of ownership (for example, privatization) which may keep public organizations on their toes; the less contestable the ownership transfer the greater the likelihood of managerial and worker slackness and of lapses in the monitoring of public organizations. Cross-classification of low and high contestability and government supply and ownership is presented in Table 2.2. As we show in Chapter 6, Chinese and Indian state enterprises perform poorly due in part to lack of threat of privatization. As we shall discuss in Chapter 6, despite accepting the principle of privatization the Indian and Chinese governments have failed to privatize state-owned enterprises on any significant scale. Fiduciary theory of government imperfections This theory is associated with Stiglitz whose work on the role of the state and market failures (Stiglitz, 1977, 1989b, 1997a) is concerned with the provision of public goods (including local public goods), interpretations

Market or Government Failures? 35 Table 2.2 Government supply, ownership and contestability

Contestability of supply: High

Contestability of ownership:

Low

Perfect

Imperfect

C: Efficiency

C: Rent capture with some dissipation O: Ex ante rules to control fraud and abuse E: Contractor with sunk investment in expertise and trust C: Allocative and X-inefficiency O: Stringent ex ante rules to control waste

O: Ex post monitoring of managerial discretion E: Contractor providing good traded in competitive market C: X-inefficiency limited to profit dissipation O: Ex post monitoring with some ex ante restraints on managerial discretion E: State-owned enterprise selling in a competitive market

E: Bureau supplying pure public goods in return for lump sum budget

Source: Vining and Weimer (1990). C ± efficiency consequences; O ± dominant oversight mechanism; E ± example.

of the market and government failures and a critique of the protagonists of markets. Stiglitz (1989b) sees government as an economic organization which is distinguished from other organizations by two main characteristics: namely, (a) universality, and (b) powers of compulsion. The two are of course interrelated. The state enjoys the power of compulsion (for example, to impose taxes) because it is universal. To overcome market failures due to externalities, government introduces taxes and subsidies. The element of compulsion in raising resources through taxes imposes a `fiduciary responsibility of the State' which leads to constraints regarding (i) employment policy in terms of salary and tenure, and (ii) expenditure patterns resulting from equity concerns. The government's ability to hire the best persons and provide adequate incentives is constrained by the salaries it can pay. The government faces salary constraints which occur because opportunity cost of a worker, which should in principle determine the wage, is hard to measure. In the absence of appropriate incentives in the public sector, government may offer `rents' to friends and relatives through employment (see Chapter 6). Private corporations are in a better position than the government in designing proper incentives structures and hiring and firing policies, since profit motive reduces the risk of misappropriation, and salaries are linked to performance.

36 Theories of Market and Government Failures

Government's fiduciary constraints also influence its expenditure policy which is supposed to be equitable. Allocation of public expenditures to government programmes often turn out to be inequitable. Stiglitz notes that farm programmes in the US have benefited mainly large farmers; this is also the experience of many developing countries where the Green Revolution benefited large farmers much more than the small farmers. In practice it is often difficult to determine what is `equitable' or `fair'. The equity and fiduciary constraints noted above may lead to divergence of public and private interests and the failure of the publicsector industries to act in the public interest. This is due to two reasons: firstly, failure of managers to introduce incentives for improved performance especially in the absence of competition, and secondly, the multiple objectives of public enterprises offer scope to managers to pursue their own rather than the public interest. It has been suggested that managers in the Chinese state-owned enterprises claim that they are making losses because they are pursuing `social obligations' imposed by the state, which does not reflect their inefficiency or incompetence (Chapter 6). Stiglitz notes that in public enterprises there may be no individuals (corresponding to shareholders in private corporations) who have an economic incentive in promoting good management. However, he recognizes that there are instances of private or corporate inefficiency also. This is partly because it is very hard to determine what a good manager is. Even good private companies often turn bad on account of management inertia or failures. A successful manager may be one who implements a successful strategy, performing activities differently from rivals in order to maintain a competitive edge over them (Porter, 1996). Sull (1999, p. 42) notes that a private company's problems may arise from `managerial stubbornness to sheer incompetence'. He argues that even successful companies like Firestone and Laura Ashley failed because of what is called `active inertia': rigid mind sets, hardening of established processes into routines, failure to do new things in time. Lack or incompleteness of capital markets, indivisibility of investments and distributional equity are some of the reasons for the establishment of public-sector enterprises in developing countries. Chang and Singh (1993) argue that public-sector pricing policy intended to achieve distributional equity can actually overcome high information and monitoring costs involved in tax and subsidy schemes.

Market or Government Failures? 37

PARALLELS BETWEEN MARKET AND GOVERNMENT FAILURES Writers like Niskanen (1968, 1971, 1973) and Tullock (1976) present an anology between theory of the firm and that of the bureaucracy. Like the firm, the bureaucrats also maximize utlility subject to certain constraints and sell their skills to politicians, that is, producers of government policy (for a critique of this viewpoint see Peacock, 1979). They adopt such goals as security (of income and employment) maximization corresponding to utility maximization by consumers in the market case. They may tend to overproduce since they are not guided by profit or monetary rewards except as rent-seekers. In writing on East Asia, Wade (1990) defines government failures in terms of (a) inability to `pick winners' (or to choose the right industries) and, (b) failure through incompetence, corruption and abuse of power. While (a) may be an acceptable definition, (b) can also occur in the private sector and cannot thus be considered peculiar to governments. This is clearly demonstrated by the collapse of banks and other financial institutions (see Chapter 3). Monopolistic multinational corporations can abuse power in just the same way as some corrupt governments do. There are similarities between Wolf's theory and Stiglitz's theory of market and non-market failures. They both recognize that failures occur in both cases under different circumstances. In many cases, governments and large private organizations behave in a similiar fashion. Stern and Stiglitz (1997, p. 286) note three common elements between governmental strategy and a corporation strategy: namely, (a) formulation of objectives, (b) design of organization and implementation of objectives, and (c) identification of an agenda for action. One fundamental difference between the two types of strategies is that a corporation strategy is guided primarily by the limited objective of profitability whereas the objectives of a government are much more broadly defined in terms of improvement of living standards and social welfare. Furthermore, while corporations may enjoy coherence in decision-making, governments (particularly, democratic ones) may need to arrive at a consensus among different and opposing viewpoints. Government failures can occur for the same sort of reasons as market failures. While externalities and distributional inequity are used as two arguments in favour government action, government failures can also occur in these domains. Wolf (1988) developed a notion of derived externalities in the non-market case which operates in ways very similar to externalities in the market case. For example, public policy can

38 Theories of Market and Government Failures

lead to unanticipated side effects (`derived externalities') that are not realized by the policy-making body. Pressures for government intervention, the vague nature of quantity and quality of output and high time discounts of politicians may tend to exaggerate these unintended effects. These unintended externalities are hard to anticipate because they may be remote. Wolf gives the example of how the noise emission standards introduced by the Environmental Protection Agency (EPA) led to unintended strains in the US foreign policy relations with France and the UK over the noise levels of the Concorde supersonic passenger jet. Secondly, government interventions intended to overcome distributional inequities may themselves create them. Wolf (1988) notes that in the case of non-market activities, `distributional inequities are often indexed on power and privilege, rather than on income and wealth' (p. 81). Power and privilege are unequally distributed and rent-seekers tend to extract benefits at the expense of others. In conditions of asymmetric information and incomplete contracts, even large competitive cases might be reduced to `power relations of bilateral trading' (Bardhan, 1991a, p. 270). Thirdly, just as in the market case, consumers' behaviour provides a check on what producers produce and market, in the non-market case social organizations (see Chapter 1), voters and other pressure groups can provide checks and balances on public policy. Wolf (1988) describes the non-economic dimension of a comparison in terms of popular participation and accountability (through audit and evaluation). He argues that in the market case generally `participation and accountability depend respectively on wealth and purchases', whereas in the nonmarket case they depend on `voice and vote'. Although comparison involving participation and accountability are generally more appropriate within the non-market case, it may also apply in the market case. For example, the Coca-Cola Company had to withdraw a new sweeter beverage in 1985 in the light of a negative response from the consumers. In this case, the Coca-Cola management seemed to be accountable to the people's voice and vote (letters, phone calls and general public reaction) (Wolf, 1988).

THE RELEVANCE OF THEORIES TO EAST ASIA To what extent are the above theories relevant to the East Asian case? Below we briefly review the experience of Japan, the Republic of Korea and Taiwan in combining successfully the market and government

Market or Government Failures? 39

functions to achieve what has been popularly known as the East Asian Miracle. In some ways this experience presents a contrast to the experiences of India and China (discussed in Chapter 6) and that of most other developing countries. Although the miracle economies underwent a financial crisis (see Chapter 4), there is no denying the fact that they achieved unprecedented and sustained economic growth for several decades. They achieved growth with equity and social welfare which most other developing countries failed to do. As we discuss in Chapter 4, they are recovering from the financial crisis faster than expected because of the solid economic foundations laid during the past several decades. Both protagonists and opponents of the new political economy paradigm have used the East Asian experience in support of their arguments. The revisionist writers of the old school argue that the spectacular development in East Asia did not occur through a market friendly and laissez-faire approach, but rather through intelligent and strategic government interventions to promote long-term industrialization based on a dynamic instead of a static view of comparative advantage. This required substantial resource mobilization rather than mere efficiency in the allocation of available resources. The revisionist school views the rent-seeking activity of governments as a source of capital accumulation whereas the neoclassical school (led by Krueger) dubs it an example of inefficiency and corruption. The more liberal neoclassical economists and institutions argue that free market functioning and outward orientation are the two major factors explaining the East Asian miracle (World Bank, 1993a). There is no doubt that East Asians used government action to create a favourable environment for the healthy expansion of private-sector activities. But the experiences of the Republic of Korea, Japan and Taiwan show that public action provided a motive force for dynamic and carefully planned industrial growth (Wade, 1990, 1995). Positive role of government The neoliberals and new political economists would argue that East Asia did involve government intervention but such interference did not contribute to their success (for a summary of this debate, see Wade, 1995). Instead, the East Asian economies succeeded despite such intervention because of `market friendly' approaches to development (Lal, 1983). The fact of the matter is that in East Asia, government's role extended far and wide in the following sectors/fields (Chang, 1995):

40 Theories of Market and Government Failures

(i)

Industrial policy: direct government support for strategic industries, indirect support through private-sector cartels, government restrictions on capacity expansion, technology choice, pricing and free entry and exit of enterprises. (ii) Banking sector: state ownership of banks as in the Republic of Korea and Taiwan, strict regulation of private banking practices, subsidized loans to strategic sectors, control of capital outflows, foreign direct investment and foreign borrowings until the early 1990s. (iii) Labour market: formulation and implementation of incomes and wages policies, and protective labour legislation. In Japan the Ministry of International Trade and Industry (MITI) played an important role in bringing together the Economic Planning Agency and staff from each government ministry and the banks, economic organizations and involved enterprises. These institutions discussed which industries were to be developed as export industries and what new industries were to be initiated. Morishima (1984, p. 252) states: Such government-directed conferences of representatives of all sections of the economy seem, in the eyes of the foreigners, to be just like the board meetings of Japan Inc. and are subject to severe criticism as joint conspiracies to give full play to Japan's egoism on the international stage. However, if these meetings are viewed, in the way in which they should in essence be seen, as planning conferences to secure the most efficient use of capital, such conferences are necessary to some degree or other in any country. The Japanese government carefully controlled industrial capacity expansion through support of industry cartels. The state introduced special legal and administrative provisions to suspend anti-trust legislation during periods of booms and recessions. Investment cartels during boom periods are designed to prevent excessive entry, whereas recession cartels are meant to prevent price wars and excessive exits (Chang, 1995). In the Republic of Korea, policies of import-substitution and export promotion were carefully planned and implemented. In its industrial strategy, the Korean government was not guided by short-term comparative advantage; instead it aimed at long-term advantage and capability by promoting the growth of a selected number of strategic or key industries through cheap loans, development of infrastructure and tariff protection (Auty, 1990). Chang (1995, pp. 207±208) notes that one of

Market or Government Failures? 41

the purposes of state intervention in East Asia is `that of increasing the long-run flexibility of the national economy (which will help the economy attain higher growth, if nothing else) by increasing its capabilities, if necessary at the cost of suppressing short-run flexibility'. One of the secrets of the East Asian economic success was precisely this flexibility and adaptability of policies to a changing international environment which enabled them to withstand the external shocks such as the two oil crises of the 1970s and the currency appreciations of the 1980s. In terms of Wolf's theory discussed above, non-market failures in East Asia were limited because of the low negative outcomes of `internalities and private goals'. The East Asian governments ensured macroeconomic stability, fiscal discipline and control of budget deficits and distributional equity. Their justification for government intervention to correct market failures often led to the improvement of market functioning through public provision rather than public production. The World Bank (1993a) notes that policies which conflicted with macroeconomic stability and the control of subsidies (for example, a drive for heavy and chemical industries in the Republic of Korea and heavy industrialization in Malaysia) were modified or abandoned. Westphal (1990, p. 54) notes how plans `to build the first steel mill were postponed several times during the 1960s on the basis of information contained in successive feasibility reports, and targets for the export of automotive products were substantially reduced more than once in the 1970s to reflect emerging market trends'. In an otherwise successful and dynamic economy such as that of the Republic of Korea, failures in implementation took place in the 1970s. At the end of this decade, deterioration in industrial performance was the result of problems encountered in the development of heavy engineering industries including construction materials and steel furnaces. However, the government managed to overcome these problems through selective and careful intervention and the promotion of a limited number of infant industries. Special emphasis was placed on dynamic efficiency, comparative advantage and international competitiveness (Westphal, 1990). We noted in Chapter 1 distinctions between different forms of government and different types of markets. Wade (1990) found evidence, in Japan, the Republic of Korea and Taiwan, of both government-managed market and free market situations. He argues that the East Asian economies simply guided markets to achieve social objectives, but they did not replace them by direct government intervention. Similarly Gore (1994) distinguishes between government policy to expand the public

42 Theories of Market and Government Failures

sector and public action to manage the markets and guide competition as was done in Japan during the catching-up period. On the other hand, in most developing countries governments are involved in inflating the public sector and bureaucracy rather than managing the market to achieve public goals. Economic policy in East Asia was effectively enforced because it was insulated from political pressures. Other reasons for successful enforcement include a technocratic bureaucracy, limited political power of such social groups as trade unions and business, and adequate flow of information between public and private sectors (see Haggard, 1988). Also, as we noted in Chapter 1, rent-seeking was put to productive use whenever it occurred. Government-market interactions One of the unique features of the East Asian experience is what Wade (1990) calls `governing the markets' (see Chapter 1). It boils down to a healthy cooperation between government and market institutions. Rather than supplanting markets (which occurred in most other developing countries in the 1960s and 1970s), the East Asian countries improved their performance by creating a favourable policy environment. Wade (1990, p. 334) notes: `The governments of Taiwan, the Republic of Korea and Japan have not so much picked winners as made them . . . by creating a larger environment conducive to the viability of new industries ± especially by shaping the social structure of investment as to encourage productive investment and discourage unproductive investment.' Government-market interactions can be defined in terms of either a vicious circle (the NPE school) or a virtuous circle (the OPE view). The former suggests (as we discussed in Chapter 1) that too much government distorts markets, that gainers in these markets use their gains to subvert the state. In contrast, the latter which corresponds to the East Asian case, suggests that government action improves market functioning through provision of infrastructure (both physical and human) and enforcement of property rights (see Wade, 1995). Government and market interactions in East Asia (particularly the Republic of Korea and Taiwan) took several forms: government action in supporting strategic industries, protection in domestic markets but competition in export markets, promotion of cooperation among industries of strategic importance and so on. Government intervention was not encouraged by the vote-seeking politicians as the NPE school would expect, but instead by such technical criteria as the need to capture export markets, import of required capital and intermediate goods, and boosting of

Market or Government Failures? 43

military self-sufficiency. Wade (1995) notes that other countries in Asia and Eastern Europe were unable to achieve a healthy combination of government intervention and markets. While in countries like China and India, government intervention was paramount, there was little competition, which puts them apart from the East Asian economies. The relevant question is: why did the East Asian economies succeed in keeping in check government failures, which are significant in other developing and transition economies? The East Asian economies seem to have succeeded in keeping under control the problems of informational gaps and rent-seeking. Several reasons are put forward on how asymmetric information problems were overcome: technical and competent bureaucracy (similar to Evan's notion of the embedded autonomy), good sources of information in research and service organizations outside the government bureaucracy, and large investments in the acquisition and dissemination of information. Furthermore, industrial rents provided by government were used to improve growth in productivity. This was made possible by the `competitive-cooperative incentive structure' and government's ability `to withdraw rent-creating interventions' (Wade, 1995, p. 128).

CONCLUSION In this chapter we have reviewed several theories of government failures, notably those by Le Grand, Stiglitz, Vining and Weimer, and Wolf, Jr. Wolf's theory of non-market failures (one of the early ones) presents supply and demand aspects of governmental action in an attempt to demonstrate parallels with market failures. Le Grand, and Vining and Weimer do a critique of Wolf's theory and present alternative formulations of their own. Le Grand examines government failures in terms of efficiency and equity of three government activities: namely, provision of services, grant of subsidies and regulation of economic activity. The Vining±Weimer formulation within the framework of industrial organization literature, hinges on government supply of services, its ownership of economic activity and their degree of contestability. The fiduciary theory of government failure by Stiglitz shows that universality and powers of compulsion are two special characteristics of government which introduce constraints and inefficiency. A common element of the above theories is to use the test of efficiency which the government fails because of such constraints as low contestability, limited competition and information gaps. We have noted that both government and market failures occur. Government intervention, which is

44 Theories of Market and Government Failures

necessary to overcome market failures, may itself also suffer from failures. The reasons common for such failures, which will be the concern in the following chapters, are: imperfections in information, and distortions caused by market imperfections in the market case, and noneconomic factors such as political goals in the government case. But the government intervention is not inherently flawed. We show that in the cases of Southeast and East Asia the government played a positive role through macroeconomic stability, fiscal prudence and sound industrial policy. In Chapter 3 we discuss the case of financial crises in developed and developing countries as an example of market failure. It is supplemented in Chapters 4 and 5 by the case of the Asian financial crisis and its economic and social impact on China and India. The non-market case is illustrated in Chapter 6 by a discussion of the performance of state enterprises in China and India. The distortions explaining poor performance in both cases include political factors (the soft-budget constraint) and overstaffing of enterprises resulting from sociopolitical goals.

3

Financial Crises: Cases of Market Failure

financial markets are markedly different . . . the market failures are likely to be more pervasive in these markets; and . . . there exist forms of government intervention that will not only make these markets function better but will also improve the performance of the economy. (Stiglitz, 1994a, p. 20) The quotation above sums up the purpose of this chapter. In Chapter 1 we described differences between financial and commodity markets. Chapter 2 discussed theories of market and government failures. This chapter shows that failures in private banking occur in the same way (and often for the same reasons) as do government failures. The factors contributing to the collapse of many financial agencies were precisely the absence of appropriate mechanisms of control and supervision, poor-quality management, lack of accountability, absence of clear goals and strategy, and a failure to terminate an unsuccessful activity despite frequent warnings (equivalent to consumer response aÁ la Wolf) ± factors commonly attributed to non-market failures. Banking operations, as distinct from manufacturing, are similar to those of non-market activities in that output and productivity cannot be easily determined independently of input, and problems are encountered in determining the quality of output. In addition, banking and financial failures in Southeast Asia (see Chapter 4), in particular, highlight the risks involved due to lack of accountability which breeds recklessness in the absence of adequate controls. There is also the possibility of inadequate information and transparency which prevents timely action by financial agencies. In Chapter 1 we noted that the development debate had overromanticized the successful role of the market and the private corporate 45

46 Financial Crises: Cases of Market Failure

sector in promoting growth and reducing inefficiency. The financial crises in both industrial and developing countries (in the United States, Scandinavia, Latin America and Southeast Asia) (see Table 3.1) support this argument. Worldwide financial crises and banking failures (for example, the Bank of Credit and Commerce International (BCCI), Barings, Daiwa, the German Bank Bankhaus Herstatt, the stock market crashes of 1987 and 1989, the Mexican crisis of 1994 and the Southeast Asian crisis of 1997) suggest that this is not a peculiarity of developing countries, and cannot, therefore, be attributed only to the backwardness of their banking and other financial agencies. Causes of financial risks and volatility have to be sought elsewhere. Several types of financial crises have been noted: currency crisis (with a speculative attack on the exchange value of a currency resulting in a devaluation); banking crisis (when runs on banks force banks to suspend internal convertibility); systemic financial crisis (involving severe disruptions of financial markets leading to an economic crisis); and a foreign debt crisis when a country fails to service its debt. The above categories are not mutually exclusive. In fact, a severe financial crisis may involve a combination of currency crisis, banking crisis and foreign debt crisis. Although different, these three types of crises had two common features: namely, (a) in developing countries, capital account convertibility and financial liberalization preceding crises, and (b) sharp increases in capital inflows and sudden outflows causing currency instability (see Chapter 4). Since the breakdown of the Bretton Woods system in the early 1970s and the introduction of freely floating exchange rates, three different types of crises have occurred: the EMS in Europe in 1992 (a currency crisis) which did not threaten the financial or banking system; the US banking and real estate crisis . . . which did not cause any currency instability; and the Latin American crises of the late 1970s and early 1980s and the Southeast and East Asian (Asian for short) crisis of 1997 (the combined currency and banking crises) causing debt-servicing problems and external financial instability. Periodic financial crises have become a regular feature of the global economy since financial liberalization and globalization of finance took root in the 1980s and 1990s (see below). Despite the varying nature and symptoms of different crises in industrial and developing countries, most of them if not all have been preceded by financial liberalization. Are these crises, therefore, endemic features of the globalized economy characterized by increasing interdependence of financial markets? We believe that they are, and discuss financial globalization before examining specific national aspects of financial crises.

Market or Government Failures? 47

FINANCIAL GLOBALIZATION Of all the markets, financial markets are perhaps the most globalized today. Financial globalization is facilitated by the internationalization of production and the growth of global industries, the rapid pace of technological change and national policies of financial deregulation of capital and financial markets. Earlier restrictions (during the importsubstitution regimes) on geographical operation, lines of credit, and capital and foreign exchange controls across countries have now invariably been removed. This has had the effect of increasing global competition in the financial markets. New information technologies enable cross-border flow of financial data around the clock. They also make many financial services more tradeable across national boundaries. The IMF also put pressures on developing countries to liberalize the capital account (see below). Capital flows between countries include foreign direct investment, portfolio investments and commercial bank lending. Growth in FDI has been much faster than both trade and output growth. According to UNCTAD (1996), between 1980 and 1994, FDI stock to GDP doubled, FDI flows to domestic investment doubled and outflows of FDI to world GDP nearly doubled. FDI is the largest component of total resource flows, exceeding net private loans. But the importance of FDI is overshadowed by a growth of portfolio investments. There is a growing shift from longer-term FDI to more short-term and volatile investments in stocks and bonds. UNCTAD (1997) estimates that the volatility index (a statistical measure of the degree of variation of annual flows around an average over a given period of time) for portfolio equity flows to developing and transition economies is four times higher than that for FDI. However, this does not necessarily suggest that FDI is itself free from any volatility. Certain FDI components, for example, profits remittances and profits retained by subsidiaries of multinationals, may also contribute to volatility and fluctuations in inflows (South Centre, 1997). In the past decade, the composition and mix of resource flows (that is, FDI, commercial bank loans and equities and bonds) have been changing. Global firms require finance for production in different country locations which has raised the importance of international finance. Between 1983 and 1993, the value of cross-border assets of banks more than tripled; between 1986 and 1992, global foreign exchange transactions also tripled. The stock of global financial assets is equivalent to twice the GDP of OECD countries (see Oman, 1996a). It has grown much more rapidly than world trade.

48 Financial Crises: Cases of Market Failure

Financial globalization and increase in global competition has been hailed by the laissez-faire scholars as a positive development leading to greater efficiency in the allocation and use of financial resources across the globe. It may no doubt help users of funds to obtain easier and cheaper access to credit with longer maturities. This is beneficial particularly to developing countries with limited capital resources. But financial globalization and integration of financial markets is a double-edged sword. It involves many negative consequences which deserve highlighting. Deregulation and liberalization of financial flows have increased the volatility of asset prices. While they have brought some benefits, they have also led to greater risks for investors and the financial system. In the 1980s the task of stabilizing against high inflation, the debt crisis and structural adjustment preoccupied many governments. In the 1990s problems of coping with rapid swings in capital flows became more pressing, highlighted by Mexico's financial crisis. Suddenly the government was called upon to bail out the financiers who previously had preached the virtues of free markets. The danger of business failures is high and often financial institutions are bailed out by governments (as in the case of CreÂdit Lyonnais of France). Financial globalization has resulted in higher and less stable interest rates, less stable exchange rates, boom and slump in property prices, as well as gambling on asset values, interest and exchange rates. Private capital flows generally respond to short-term interest rates and exchange rate changes which may not be conducive to longer-term development. Instability in one country (for example, the financial crisis in Mexico) tends to spill over to neighbouring and distant countries alike when financial markets are internationalized. In writing on Latin America, Berry (1998) notes the negative effects of short-term flows in terms of macroeconomic instability, slowing down of rate of growth and disincentive to export production. The consequence of this integration of financial markets is that trade, employment, production and national economic policies in general have become more exposed to volatility and fluctuations in the financial market.

FINANCIAL LIBERALIZATION POLICIES Deregulation of the banking sector and removal of capital controls before introducing a system of regulatory and monitoring devices can lead to financial crises, as we shall discuss in Chapters 4 and 5. Many developing countries introduced financial liberalization partly under pressures from the Bretton Woods organizations, and partly as a

Market or Government Failures? 49

response to increasing financial globalization. Difficulties in controlling the flow of such information led governments to lift restrictions and regulations on international financial flows (see Agosin and Tussie, 1993). But all developing countries did not liberalize their financial markets. For example, although the Republic of Korea and Taiwan reformed their financial systems in the 1980s, their governments continued to subsidize commercial bank credit (Amsden, 1993). Credit was kept artificially cheap for many strategic firms. Capital account convertibility In recent years the IMF has viewed capital account convertibility (CAC) as the natural follow-up to the establishment of current account convertibility ± free trade in goods and services is to be logically succeeded by free trade in financial and physical assets. At its annual meeting in Hong Kong in September 1997, the Interim Committee of the IMF issued a statement endorsing a move towards CAC. This goes far beyond the original obligations listed in the 1994 Articles of Agreement which included only `avoidance of restrictions on payments of current transactions and did not embrace capital account accountability as an obligation or even a goal' (Bhagwati, 1998, p. 7). In this context, it is interesting to note that Keynes had always viewed capital mobility as incompatible with the preservation of reasonably free multilateral trade (see Minsky, 1975). Further, the Bretton Woods Accords, reflecting this Keynesian perspective, had legitimized a range of policy responses (direct capital controls prominently included) to prevent hot money flows from destabilizing exchange rates and trade. In its new advocacy of CAC, the IMF is thus replacing an old orthodoxy by its antithesis. The crucial catch in the new orthodoxy seems to be a failure to recognize that financial markets are fundamentally different from goods markets (see Chapter 1; Felix, 1998). They are plagued by problems of asymmetric information, incompleteness of contingent markets and bounded rationality to a far greater extent than markets for goods. International financial markets are characterized by a whole range of problems, notably: rare access of international lender banks to high quality information about their borrowers but frequent guarantee of loans by host governments (a classic problem of asymmetric information coupled with implicit insurance, see Rodrik, 1998); mismatches between short-term liabilities and long-term assets of banks and companies in the borrowing country, which makes the system vulnerable to panics (see Radelet and Sachs, 1998); substantial dangers of excess volatility and contagion resulting from the herd behaviour of bank and company management in both

50 Financial Crises: Cases of Market Failure

borrowing and lending countries (see Scharfstein et al., 1990); and asset price deflation associated with financial market disruption which can impose heavy real costs on the economy (see Felix, 1998). Today even laissez-faire economists (Bhagwati, for example) have revised their opinions on the merits of CAC and have openly come out against the claims of enormous benefits from free capital mobility (greater availability of capital for developing countries, diversification of risky assets and increased efficiency of domestic financial systems). Bhagwati (1998) argues that these gains have not been empirically demonstrated and that at any rate, such gains can be obtained by direct equity investment. One must also recognize the possibility that the costs of CAC in terms of macroeconomic instability, overvalued exchange rates and reduced policy autonomy of countries, far outweigh the benefits (Griffith-Jones, 1998a, 1998b). Of course, restrictions on free inflows of portfolio capital may adversely affect FDI inflows but there is little evidence to suggest that this is necessarily so. The empirical evidence on CAC is mixed. Rodrik (1998) analyzed 23 countries in which capital controls were absent for prolonged periods after 1973. He concludes that `there is no evidence that countries without capital controls have grown faster, invested more, or experienced lower inflation' (p. 61). And such countries as China have achieved remarkably high growth rates without introducing CAC (see Chapter 5). As we discuss in Chapter 4, the Asian crisis has amply demonstrated the perils of free capital flows, unchecked by any regulatory device. Excessive borrowings of foreign short-term capital followed the liberalization of controls on capital account. Bhagwati (1998, p. 12) describes the supporters of CAC as the `Wall Street-Treasury complex' which is `unable to look much beyond the interest of the Wall Street, which it equates with the good of the world'.

FINANCIAL CRISES IN INDUSTRIAL AND DEVELOPING COUNTRIES Financial crises are not new; they have occurred frequently in the past in both industrialized and developing countries: in North America, Europe and Latin America including the Mexican crisis in 1994±95 and the Asian crisis in 1997 (see Table 3.1). Neither are the banking and financial crises recent phenomena. The Barings crisis of 1890 in the UK and the US exchange rate crisis of 1894±96 are but two examples from the nineteenth century. Apart from the crises noted in Table 3.1, the IMF (1998a, p. 76) studied currency and banking crises in 22 industrial and 31 developing

Market or Government Failures? 51

countries (mainly emerging market economies). It is perhaps because these crises are so common that in writing on their history Kindleberger (1978) did not even define them. Since the nature and characteristics of different crises vary, it may be useful to define what a financial crisis is generally understood to be. Goldsmith (1982, p. 42) notes financial crisis as a `sharp, brief, ultra-cyclical deterioration of all or most of a group of financial indicators ± short-term interest rates, assets (stock, real estate, land) prices, commercial insolvencies and failure of financial institutions'. Others (Bordo, 1987; Kindleberger, 1996) would add the following factors to these characteristics: change in expectations and money supply, and attempts to convert real or illiquid assets into money. Table 3.1 Selected crises: Costs of restructuring financial sectors and nonperforming loans Country/region

Years

Fiscal and quasi-fiscal costs*

Non-performing loans**

A. Developing countries Argentina 1980±82 1985 Brazil 1994±96 Chile 1981±85 Colombia 1982±87 Indonesia 1994 Malaysia 1985±88 Mexico 1994±95 Philippines 1981±87 Sri Lanka 1989±93 Thailand 1983±87 Turkey 1982±85 Uruguay 1981±84 Venezuela 1980±83 1994±95

13±55 ± 4±10 19±41 5±6 2 5 12±15 3±4 9 1 3 31 ± 17

9 30 9 16 25 ± 33 11 ± 35 15 ± ± 15 ±

B. Developed countries Finland 1991±93 Japan*** 1990s Norway 1988±92 Spain 1977±85 Sweden 1991±93 United States 1984±91

8±10 3 4 15±17 4±5 5±7

9 10 9 ± 11 4

Source: IMF (1998a). * ± Estimated in per cent of annual GDP. ** ± Estimated at peak of non-performing loans as per cent of total loans. *** ± Cost estimates through 1995 only. ± ˆ not available.

52 Financial Crises: Cases of Market Failure

As financial intermediaries lend against the value of assets, instability of prices is increasingly related to that of financial institutions (GriffithJones, 1995). In the emerging open market economies, lack of experience of financial institutions in managing risks in the face of stiff competititon may lead to riskier investments (for example, foreign exchange lending to residents supported by domestic sources) (BIS, 1997b). In a study of banking crises, Kaminsky and Reinhart (1996) note that 18 out of the 25 cases related to financial liberalization in the preceding five years. There is also another way in which liberalization policies may increase the vulnerability of the banking sector; that is, through a lack of proper sequencing and phasing of reforms. While the chances of this happening is greater in developing countries, such occurrences are not unknown in industrialized countries. Table 3.1 notes the costs of restructuring financial sectors as a result of the above crises. It shows that the financial crises were more frequent in developing countries (almost twice as many) than in developed, and that the costs of restructuring are generally much lower in the latter (with the exception of Spain). The nature of the crises also varies from developing to developed countries. For example, in developing countries the majority of banking crises are a consequence of large withdrawals of deposits and runs on banks whereas in industrial countries this factor has not been important in banking crises in the Scandinavian countries in the late 1980s and early 1990s (IMF, 1998a). In industrial countries, domestic financial disruptions do not generally lead to currency and payments crises. On the other hand, in developing countries, financial difficulties are invariably translated into other crises such as banking, financial and external debt (UNCTAD, 1998, p. 54). A high share of `bad' or non-performing loans is a symptom of a banking crisis (see Table 3.2). As we shall examine in Chapter 4, of the affected economies in Southeast Asia, Indonesia had the highest share of bad loans, followed by Thailand and Malaysia. In each of the two countries, however, during the 1980s, the average share of bad loans was much higher than during the mid-1990s. That bad loans are not peculiar to developing countries is shown by the fact that the shares of such loans in Norway and Sweden in 1992 (peak year of the Scandinavian financial crisis) were higher than those of Indonesia, Malaysia and Thailand. Growth in the ratio of bank credit to GDP in the affected Asian economies in the early 1990s was also unusually high (see Table 3.3). Very high growth rates created an increasing demand for credit in the early 1990s, which was much higher than in industrialized countries

Market or Government Failures? 53

such as Japan and the US, but much lower than in Mexico. Rapid credit expansion led to overheating of the economies and ever rising interest rates to cool them. This resulted in a credit squeeze in 1997. Large fluctuations in real estate and stock prices can also indicate crisis situations. Borrowers used loans to invest in real estate (except in the Republic of Korea where they were used for more productive purposes) and other non-tradeables. This was so particularly in Indonesia and Malaysia where property lending as a proportion of total lending amounted to nearly 20 per cent and 25.5 per cent respectively (Goldman Sachs cited in Sender, 1997). In the Republic of Korea, the property market and speculation was relatively controlled through capital gains taxes of up to 50 per cent. The boom before the crisis led to a sky rocketing of property and asset prices in Indonesia, Malaysia and Thailand. The Bank for International Settlements (BIS) (1997a, p. 106) notes that in the emerging Asian markets `the average increase in real prices during property upswings . . . has generally exceeded 20 per cent a year, compared with around 10 per cent a year typically experienced in the United States or the larger European economies'. The figures were much higher for Indonesia (54 per cent) and the Philippines (42 per cent). With the onset of the crisis in July 1997, the property and asset prices came Table 3.2 Non-performing loans (% of total loans) Crises in the 1980s

1990

1994

1995

1996

Year

Average

Indonesia Korea, Rep. of Malaysia Taiwan Thailand India*

Ð 1986 1988 1986 1983±88 Ð

Ð 6.7 30.5 5.5 15.0 Ð

4.5 2.1 20.4 1.2 9.7 ±

12.0 1.0 8.1 2.0 7.5 23.6

10.4 0.9 5.5 3.1 7.7 19.5

8.8 0.8 3.9 3.8 ± 17.3

Argentina Mexico** United States Italy

1985 1982 1987 Ð

30.3 4.1 4.1 Ð

12.3 14.4 1.3 9.3

9.4 12.5 1.1 10.1

Ð Ð Ð

Ð Ð Ð

16.0 8.6 2.3 10.5 3.3 1.9 5.2 8.1 (1992)*** 8.0 4.6 9.1 5.4 11.0 6.3

3.9 4.1 4.4

2.7 3.2 3.0

Finland Norway Sweden

Source: BIS (1997a). * ± Public sector banks only. ** ± Commercial banks only. *** ± 1992 was the peak year. Ð ˆ not available.

54 Financial Crises: Cases of Market Failure Table 3.3 Growth of bank credit to the private sector relative to the growth of GDP Average annual percentage changes (1981±89) Indonesia Korea, Rep. of Malaysia Philippines Thailand China** India Argentina Mexico Venezuela United States Japan

15.1 3.2 6.8 7.6 6.8 4.6 2.6 4.0 1.9 2.9 1.7 3.8

(1990±94)

(1995)

10.4 2.6 3.1 10.7 10.0 3.8 2.0 7.9 25.7 9.6 3.5 0.3

4.4 2.2 10.5 27.4 11.1 0.5 3.8 6.2 0.6 39.4 4.2 0.5

(1996)* 5.7 0.6 13.1 31.5 5.8 3.8 2.0 0.4 36.0 19.6 0.6 1.9

Source: BIS (1997a). * ± Preliminary. ** ± Credit other than to central government.

tumbling down in Indonesia, Malaysia and Thailand. Financial crisis made matters worse as rentals in property were paid in local currency whereas debts were paid in US dollars. Some specific examples of crises 1.

Collapse of Barings

Barings was reputed for corporate finance, asset management and trading for clients in emerging markets. It did not have much experience in making money by trading on its own account (or proprietary trading). But it is precisely this proprietary trading (by the trader Nick Leeson) that led to Barings' collapse. At the end of February 1995, Barings Bank suffered losses to the tune of £860 million ($1.4 billion). Barings' managers apparently failed to spot or did not react to the huge amount of cash that Barings Futures paid out to both SIMEX and OSE to support its futures positions. In less than two months the management in London authorized a transfer of £569 million to Singapore to pay for the margin calls and original transactions, apparently without raising any questions. This amount was well above the equity capital that European Union rules allow in any one investment without the approval of the Bank of England. Barings ignored the internal risk-

Market or Government Failures? 55

management procedures which the Bank of England had exhorted the banks to tighten. Large sums were borrowed by Barings from other banks to effect these transfers. A rival merchant bank noted: `Even Colombian drug barons don't throw that sort of money around without a few signatures.' Barings management hoped that the Bank of England would come to its rescue, but the Bank argued that tax payers' money should not be used to cover the failures of a few speculators. Instead, the market was allowed to take its own course. Barings was unable to raise private money from other banks to recapitalize it mainly because the astronomical size of Barings' positions in the Japanese derivatives contracts deterred banks.1 They were unwilling to take on these contracts without a fee or a guarantee from the Bank of England that it would cover further losses. Most of Baring's losses came from trading ordinary derivative instruments2 based on Japan's Nikkei225 stock market average. The trader's strategy was to make money through `arbitrating' ± taking advantage of differences in the prices of Nikkei-225 futures contracts listed on the Osaka Securities Exchange (OSE) and the Singapore Monetary Exchange (SIMEX). He bought futures contracts in OSE, betting on their rise here (`going long') and simultaneously sold them on the SIMEX betting on their fall (`going short') there. A similar gamble on the Nikkei-225 futures in September 1994 paid off when the trader (Leeson) allegedly earned Barings $150 million by the end of 1994. In an apparent bid to push the market up, Leeson went on a massive buying spree in the hope that it would push up the Nikkei futures market, but to no avail. When the nature and scale of his operations became known, he had incurred a loss of nearly $1 billion, which exceeded the Bank's capital, and led to its eventual collapse. Competition and incentives, the two factors that are known to contribute to efficiency and growth, may paradoxically have led to the collapse of Barings (UK). Competition between the Osaka Stock Exchange (OSE) and the Singapore Monetary Exchange (SIMEX) deterred them from cooperating and sharing information whereas big incentives to the trader (Leeson) in the form of exorbitant bonuses led to reckless risk taking and eventual downfall of Barings.3 Pressman (1998, p. 416) argues that the actions of the Barings trader (Leeson) were not carefully monitored or his future actions questioned because of the `halo' effect and `recency' effect which `occur when the most recent information we are given greatly influences our judgments'. Entrepreneurs with outgoing and convincing personalities tend to develop these effects. Leeson had built his reputation when he earned

56 Financial Crises: Cases of Market Failure

large amounts of money for Barings during his stay at the Jakarta Branch office of the bank. The senior management of the bank assumed that Leeson would similarly build fortunes for the Singapore operations. Leeson hid his losses from his superiors for fear of losing his job. By hiding his loss and taking on aggressive positions to recover the loss, he put Barings at risk. The internal supervision and control mechanisms failed, thus, perhaps, bringing about the collapse of Barings in February 1995. There is no agreement on the precise cause of Barings' demise. While some observers argued that poor internal supervision and monitoring were responsible, others believed that external regulation was required to prevent similar financial frauds. Goodhart et al. (1998, p. 39) argue that `the external regulation required . . . would have had to be so pervasive, so intrusive and so expensive as to be practically impossible'. They believe that in most cases regulatory failures are in fact failures of internal monitoring and supervision. But since the fraud case escaped the internal management of Barings, there was clearly a role for an external regulator to promote the enforcement of internal mechanisms of risk control management. It is true that the collapse of Barings did not lead to any systemic financial crisis partly because of the small size of the bank. But a bigger bank and a few runs on other similar banks could have led to such a situation. 2.

Bail-out of CreÂdit Lyonnais

CreÂdit Lyonnais of France, a state-owned bank, had frequent financial difficulties and had to be bailed out by the French government. According to official estimates, this bank lost F.Fr. 21 billion ($3.8 billion) in three years. In 1994 alone, the French government contributed about F. Fr. 23 billion. Under a plan to rescue the bank, F.Fr. 145 billion of the dud assets of the bank were transferred to a subsidiary known as the Consortium de ReÂalisation (CDR). The subsidiary was financed by a loan from a new state-owned entity backed by a F.Fr. 145 billion, 20±year loan from CreÂdit Lyonnais. There are two major differences between Barings and CreÂdit Lyonnais. While Barings was a private bank, CreÂdit Lyonnais is state-owned. The case of CreÂdit Lyonnais suggests that governments will intrervene when a bank failure is large enough to have systemic implications. CreÂdit Lyonnais is one of the biggest deposit-taking banks in Europe. Its disappearance would have caused havoc in the financial markets. Fear of a run on this Bank persuaded the French government to come to its rescue

Market or Government Failures? 57

on several occasions. In contrast, Barings was a very small bank whose disappearance did not cause any big ripples in the financial markets. If Barings was as prominent as it was in the 1890s, the Bank of England (that is, the UK government) would have rescued it. One factor which distinguishes private from public-sector banks is that those using private services accept the higher risk as a price to pay for higher earnings. One thing Barings and CreÂdit Lyonnais had in common was serious mismanagement. This common feature confirms what we stated above, namely, that management failures are not peculiar to state-owned enterprises.

WHY FAILURES IN FINANCIAL MARKETS? While discussing the earlier Latin American crises of 1982 and 1994 and the ongoing Southeast Asian crisis, Palma (1998) notes the appearance of two types of market failures: overlending by the international financial institutions to developing countries and overborrowing by the latter. Excessive liquidity and underregulation of the financial markets leads to pressures towards excessive lending, triggering a cycles of `mania, panic and crash' aÁ la Kindleberger. The demand for funds in developing countries (for growth and investment, for payment of debts and for debt servicing) is almost unlimited which explains why lenders continue to lend (as in the case of Southeast Asia ± see Chapter 4) even when financial market signals are deteriorating. Pressure to recycle liquid funds diminishes the `capacity of international lenders to assess and price risks properly and to allocate resources effectively' (Palma, 1998, p. 790). Confidence and over-optimistic expectations of the future performance of borrowing countries further vitiate optimal risk taking and assessment. Several cases of financial market failures which justify government intervention in these markets include information imperfections and lack of monitoring of financial institutions; externalities of monitoring, selection and lending; and financial disruption. We briefly examine these failures below. Imperfections in information and monitoring Failures in financial markets take place because of the lack of goodquality and timely information on various macroeconomic and sectoral indicators such as production, rate of inflation, investment, money supply, and such banking data as credit to the private and public sectors, short-term and long-term debt, central banks' liabilities, and

58 Financial Crises: Cases of Market Failure

transactions in derivatives. Asymmetric information and associated problems of adverse selection and moral hazard can cause banking and financial crises. These crises can cause havoc with the economies of developing countries in particular (Mishkin, 1997). As we noted in Chapter 1, financial markets are far more information intensive than commodity markets and are likely to suffer from imperfect competition because of the fixed-cost nature of information.4 Imperfections in information may also result from a lack of proper monitoring (its public-good nature so that action on the part of one shareholder raising the value of a firm's shares benefits all shareholders). Managers of financial institutions may become incompetent and take excessive risks in the absence of adequate regulation and poor monitoring (by the board of directors, for example). This is what may have led, inter alia, to the collapse of Barings in the UK and to the financial crisis in Asia (see Chapter 4). The clients and depositors may have even less information about trading activities than the management, thus raising a principal±agent problem. Thus the regulatory influence of the principal would be minimal in the absence of adequate information. Claims have been made that the onset of the Asian crisis (Chapter 4) could have been foretold if there was adequate and timely information on such indicators as governments' fiscal and debt positions and credit, and stock prices. However, this point is open to debate considering that the affected Southeast and East Asian economies (Indonesia, the Republic of Korea, Malaysia, the Philippines and Thailand) made data on macroeconomic variables freely available. Capital account convertibility, which they had introduced in the early 1990s, also meant that they regularly reported information on capital inflows and outflows. Also they reported regularly to the Bank for International Settlements (BIS) information on such banking data as short-term and long-term external debt. This being said, it is true that some types of information (for example, governments' capacity to manage capital flows and external debt) did not provide adequate indication of the scale and nature of the exposure of Asian banks to other countries in the region and outside (UNCTAD, 1998). There are also other types of banking and financial information (for example, accounting and financial reporting by national banks) which need further strengthening as we note in Chapter 5 on the impact of the Southeast Asian crisis on China and India. In the final analysis, informational capacity and disclosure is a double-edged sword. While timely and adequate information can be helpful in forestalling an impending financial crisis, it may not be

Market or Government Failures? 59

sufficient by itself. Furthermore, disclosure of information by the IMF and member countries can also be alarmist. For example, information on external assets and liabilities can lead to instability and volatility of capital flows. Public warning by the IMF to individual countries about the dangers of imminent crises can in fact provoke an onset of such a crisis. It is, therefore, a dilemma for the countries and financial institutions to decide what kind of information should be disclosed to whom and when. It may also be difficult to obtain some types of information, for example, on private capital flows and derivatives (Stiglitz, 1998). Yet information on financial derivatives, transactions which are not included in the balance sheets, may be particularly useful in anticipating crises. Adequate and reliable information on the health of financial sectors and institutions can also be tricky in the absence of any uniform standards and methodology of assessment. Even if the content, interpretation and availability of information can be improved there is no guarantee that investors will take more rational decisions in response to this information (Griffith-Jones, 1998a). As we show in Chapter 4 on the Asian crisis, adverse signals on the health of financial sectors were not heeded by investors who kept pouring finance into the affected economies assuming high returns and low risks in view of their rapid growth. Wade and Veneroso (1998) and Stiglitz (1998) argue that investors and lenders were aware of the problems but did not react until after the crisis had started. Since the Asian and the Russian crises, the IMF has been under attack for failures in anticipating the crises and acting slowly in overcoming them. The IMF±World Bank meeting in Hong Kong in September 1998 called for a reorientation and restructuring of the IMF operations in individual countries. The Clinton administration made some cautious proposals to allow the IMF to act in a more timely fashion and to intervene before the actual collapse of the currencies and spread of the crises. George Soros, the billionaire financier and investor urged the IMF to act as a lender of the last resort and an international central bank.5 As a response to the criticisms and proposals in handling the Brazilian crisis, the IMF established a `precautionary loan package' of $41 billion for Brazil, hoping to contain the crisis there and prevent it from spreading to the rest of Latin America and elsewhere. The Fund's approach of setting up `precautionary' packages and imposing conditions on countries without at the same time setting conditions on creditors, have not met with much approval either by the US government or by developing countries who fear a further

60 Financial Crises: Cases of Market Failure

erosion of their autonomy in formulating and implementing economic and monetary policies. As we noted above, deregulation of the financial sector and policies of liberalization of capital controls without prior introduction of regulatory and monitoring devices and measures can contribute to financial panic and crisis (see Chapter 4). The IMF has been criticized for lack of transparency and its failure to provide timely information on financial data on emerging market economies. Inadequacy of timely information stands in the way of either preventing crises or mitigating their adverse effects. To be fair, since the Mexican crisis of 1994±95, the IMF has strengthened machinery for improving data collection and reporting at both international and national levels. In 1996 it established the Special Data Dissemination Standard (SDDS) and the Dissemination Standard Bulletin Board (DSBB) on the IMF website. The SDDS was intended to act as an early warning system to prevent future financial crises, which it failed to do partly because of its limited coverage of information. Recognizing this limitation the IMF Interim Committee (1998) recommended broadening of its coverage and strengthening of its operations. The IMF has called upon emerging market countries to make public the results of their consultations with the IMF. Under the SDDS, countries are expected to furnish the IMF with the following sets of data: national accounts, production, labour market, prices, government's fiscal and debt positions, monetary aggregates, credit, interest rates, stock prices and so on. The IMF is undertaking several initiatives to provide information to mitigate the adverse effects of financial sector vulnerabilities (see Fischer, 1999). Externalities Failures in information discussed above can cause negative externalities. Failure of one bank can result in a run on another bank next door if depositors panic, because they are ill-informed. A single bankruptcy can lead to a financial panic and collapse of the financial system causing major macroeconomic imbalances. Externalities associated with problems of screening and selection of loan projects can cause difficulties in raising capital and can result in runs on banks. Existence of inefficient financial firms can raise costs of screening projects. One lender can create a negative externality for the other within the same market by restricting borrowers from obtaining funds from other sources, being worried that excessive borrowing might raise the risk of default (Stiglitz, 1994a). Externalities may also occur across financial markets when a bank's willingness to lend money (credit market) affects the firm's abil-

Market or Government Failures? 61

ity to raise equity capital (equity market) because the firm would probably be supervised by the bank (see Stiglitz, 1994a, p. 26). Furthermore, separation of ownership and control can imply a conflict of interest between the banks, investors and borrowing firms, which has implications for monitoring. When governments intervene, the familiar problems of moral hazard may arise; that is, financial institutions feel they are insured by the government and may thus take excessive risks (leading to soft-budget constraint discussed in Chapter 6 in the context of state enterprises in China and India). Financial market regulations, that is, government intervention in private financial markets (see Chapter 5), are intended to reduce the negative effects of moral hazard. But regulators themselves may be at a disadvantage over market actors. Because of information inadequacy they may fail to determine or underestimate the seriousness of systemic risks. When a new financial instrument is introduced in the market, its novelty and high profits involved may create certain excitement and `market knows best' sentiment to which regulators may themselves not be immune (Griffith-Jones, 1998c). Increasing financial globalization discussed above makes regulation of derivatives markets problematic. This is because a financial product (for example, futures contract) can be traded in several locations which makes the demarcation of regulatory responsibility difficult. O'Brien (1992, p. 24) raises the question whether `a futures product based on a market index is a stock product (to be regulated by the stock market regulator) or a futures product (to be regulated by a futures regulator). While they are both, the problems of rivalry between the stock market regulators and futures regulators make identification and location of responsibility very difficult.' Market imperfections Imperfections in financial information resulting in management failures (discussed above) can raise transaction costs limiting market activities (see Akerlof, 1970; Stiglitz, 1982). Competition in the financial markets of most countries is quite limited because of, inter alia, the reputation of customers and specialized information on them acquired by banks and other financial institutions. Thus market imperfections may restrict competition despite the existence of a large number of banks. Governments may be in a position to correct financial market imperfections since they have several advantages over markets in risk bearing: their ability to reduce moral hazard problems by requiring compulsory

62 Financial Crises: Cases of Market Failure

disclosure of information (for example, income-tax information can be used to reduce risks of loan default), their capacity to overcome adverse selection by imposing membership in insurance programmes, and their comparative advantage in handling social, compared to individual, risks. In the absence of a proper regulatory mechanism to deal with financial institutions, governments may feel a special responsibility to bear the costs of insolvencies which can threaten macroeconomic stability. Excessive incentives for risk taking Public-sector enterprises are often criticized for lack of adequate incentives and rewards system which leads to inefficiency and losses. Market enterprises are said to perform efficiently because of a better incentives structure. The collapse of several banks in both developed and developing countries suggests that unduly big incentives may also carry a very high price in the private sector. Very big incentives to traders in the form of lavish bonuses encourages them to take greater and greater risks to make more and more money. The salary and bonus system is also such that it offers incentives to gamble wildly with other people's money. It breeds a vicious circle in which incentives encourage greed which in turn leads to reckless risk taking. Clearly the big incentives are meant to compensate for high risk taking and for scarce expertise of the risk taker. The question is not whether these incentives are bad but in many cases, whether they are excessive. The dilemma lies in where to draw the line. Regulations, implementation of banking practices and control of traders and stock exchanges are the means to ensure that the extraordinary incentive system does not lead to recklessness and chaos. Some rules of the game are clearly needed to prevent gambling from getting out of hand and in turn to prevent financial markets, both national and global, from being destabilized. As we shall discuss in Chapter 4, the Asian financial crisis is a reflection of banking and financial failures caused largely by uncritical and indiscriminate foreign bank lending. This was made possible by the deregulation of financial markets by most of the affected economies, which further fed financial turbulence especially in conditions of structural economic weaknesses. These weaknesses are caused by underregulation and non-existent credit evaluation, defective corporate accounts, financial transactions based on non-economic considerations, inadequate equity of banks and private companies and state protection

Market or Government Failures? 63

and bailout of unprofitable banks and companies. National policy errors in the form of adherence to fixed exchange rates and too much reliance on short-term borrowings further caused the financial crisis. Sudden withdrawal of investor and business confidence occurred due to the misallocation of investment; maturity ± currency mismatch of assets and liabilities; and high debt±equity ratio. The governments are also partly to be blamed for insufficient financial regulation; government guarantees and bailouts (explicit or implicit) of unprofitable companies and banks; and misguided exchange rate/monetary policies (see Chapter 4). However, Stiglitz (1998) notes that the Asian countries affected by the crisis faced many problems because governments did too little rather than too much, and because they deviated from the earlier successful policies. In several countries for instance, poorly managed financial liberalization lifted some restrictions on bank lending to real estate, before putting in place a sound regulatory framework.

LESSONS FROM FINANCIAL CRISES The above discussion suggests that the fault lies not so much with the financial instruments such as derivatives as with the lack of internal as well as international supervision and control. At the national level, governments and regulatory financial institutions need to ensure a check on the fragility of the financial markets. Proper rules of the game and checks and balances are needed to regulate and oversee risky ventures in financial markets. This is essential because a failure of a large financial institution could trigger a chain reaction. Repercussions from a chain reaction are no longer likely to be confined to national boundaries. Thus, while internal rules and procedures are necessary, they are not sufficient. Increasing globalization of financial markets makes international regulators an essential element of any international action. One important lesson to be learnt from the collapse of several banks and financial institutions in both industrial and developing countries is that internal rules and regulations need to be better enforced. These rules need to apply not only to the internal functioning of the banks, but also to the stock exchanges, because over time, the banking industry has evolved from narrow services of lending money in traditional areas to securities, derivatives and other non-spot markets. Another lesson is that greater international cooperation is necessary between different regulators in the financial system. Some minimum international rules of the game are needed for these regulators. Can the Bank for International Settlements (BIS) (Basle) provide such rules? The

64 Financial Crises: Cases of Market Failure

BIS has already set capital adequacy targets which have been accepted by the Group of Ten countries. Can governments and global institutions afford the risk of free markets gone amok? The answer is no, since the effects of financial failures in one region (as in Asia) can have calamitous consequences throughout the world thanks to globalization (see below). Thus in the light of the Asian experience (see Chapter 4), addressing market failures seems particularly relevant. It begs the question whether tighter regulations and controls and timely interventions could have averted the Asian financial crisis, for example. While the job of governments may not be to prevent risk taking in the marketplace, it must still guard against such risks having adverse global repercussions which might affect the wider public interest. Of course, a case of market failure is not the same as that of an individual private enterprise. Failure of one enterprise, be it a bank or the Chrysler Corporation may not be due to any market failure, and a government decision to save a private enterprise may be based more on political or administrative grounds (see Chapter 6). However, the two may also be related, particularly in the case of financial markets which are more imperfect than other commodity markets. The functioning of a market is based on activities of agents (firms) and the price mechanism. As agents, banks may be so large and important as to represent a monopoly situation. The collapse of a large bank leading to a systemic failure would be very close to a market failure.

4

The Asian Financial Crisis A. S. Bhalla and D. M. Nachane

Economic reality has a way of confounding economic oracles and soothsayers; and even the traditional circumspection of the `on the one hand . . . on the other' variety with which economists are prone to cloak their predictions, is often an inadequate defence against the stealthy but inexorable march of events. The most recent and forceful manifestation of the profession's helplessness in anticipating economic catastrophes is the Asian crisis, which has struck some of the hitherto most rapidly growing economies of the world (see Table 4.1) with a vengeance, which was as harsh as it was unexpected. Neither economists, nor policymakers, nor any from the newly emerging breed of fashionable `market analysts' had even an inkling of the danger looming around the corner. Krugman (1994) is perhaps an exception, but he was hinting at a slowdown in East Asian growth rather than anticipating a crisis, and certainly not on the scale that has actually occurred. There is no clear agreement on the nature, causes and remedies of the recent financial crisis in Southeast Asia. The free market and laissez-faire economists like Summers blamed the governments and their policies for the failures, whereas the more `structuralist' non-neoclassical economists like Stiglitz lay the blame squarely not only on governments but also on the unmanaged international capital flows and the private-sector financial decisions (The Economist, 1998a). As noted in Chapter 3, even in a well-managed economy the impact of short-term capital flows can be turbulent. Such free flows tend to create stock market and property bubbles and busts as occurred in Southeast Asia. In this chapter we argue that the Asian crisis is a case of market failure ± a systemic failure of private banks, both domestic and foreign, which led to a financial crisis. While there were some policy failures in macro economic management, these were not the primary causal factors. The 65

66 The Asian Financial Crisis Table 4.1 Trends in GDP growth in Asian economies (average annual % growth) 1980±89 Low-income economies (exc. India and China) India China East Asia and Pacific Indonesia Korea, Republic of Malaysia Thailand

1990±96

2.9

1.4

5.8 10.2 7.9 5.7 8.0 5.7 7.2

3.8 12.9 9.4 7.2 7.7 8.8 8.6

3.1

1.8

World Source: IMF (1997a).

crisis, as we show, is the case of overborrowing by the domestic banks and overlending by foreign banks. Levels of risk in lending were excessive and exceeded the capacity of the affected economies to absorb such high doses of capital inflows. It is, therefore, ironic that capital inflows considered essential for rapid development were one of the causes of the crisis in conditions of capital account convertibility (CAC) and lack of careful monitoring and controls. This mismatch in demand and supply in the international financial market was not cleared. Instead, panic in the market resulted in massive capital outflows. Thus imperfections in the international capital market, ably analyzed by several scholars (Kindleberger, 1978, 1996; Stiglitz, 1992, 1999), are once again one of the major factors explaining the crisis in Southeast and East Asia (described as Asia for brevity). The four countries most severely affected by the crisis are Indonesia, the Republic of Korea, Malaysia and Thailand. To this list two more can be added, namely, Hong Kong and the Philippines, which have also been affected. However, in this chapter we leave out Hong Kong and concentrate only on the five economies. We concentrate on some general features typifying the crisis rather than studying each country in detail (for an individual country analysis, see Rao, 1998).

KEY FEATURES OF THE CRISIS There were several distinct elements to the crisis, and these could be taxonomically analyzed under four headings.

Market or Government Failures? 67

Firstly, most fundamental aspects of macroeconomic management remained sound throughout the pre-crisis period. Whatever deterioration occurred was a consequence rather than a leading indicator of the crisis. All five economies had followed responsible budgetary policies in the three years preceding the crisis. Monetary policies had been prudent too, as both short-term interest rates and the inflation rates indicate. Domestic savings and investment rates gave no cause for concern, suggesting that the tempo of growth was not contingent upon maintaining an adequate inflow of foreign capital. Aggregate external debt was high, though not excessively so (though its composition and maturity structure should have given some cause for worry). Finally, while current account deficits were high, capital inflows in the pre-crisis period were more than adequate to match them, so that foreign exchange (forex) reserves were showing a healthy buildup. In all cases, the forex reserves were well above four-months' import cover (except in the Republic of Korea where it was about three months). Secondly, world market conditions were not particularly adverse, at least not sufficiently to foretell a crisis (as, for example, was the case, when Latin American crisis began in the 1980s). World interest rates were unusually low, and key commodity prices (including oil prices) were reasonably stable so that there were no terms of trade shocks (a noteworthy exception to this observation is the slump in semi-conductor prices, which badly hit the Republic of Korea). The region's major trading partner, Japan, had been showing signs of sluggishness, but the US economy, forming a sizeable market for the region's exports, was booming. Thus, the blame for the crisis can hardly be laid at the door of global economic conditions. Thirdly, unhealthy signals were emanating from the financial sector and forex markets, which went unheeded. Let us consider the forex situation first. Real effective exchange rates (REER) had been continually appreciating following the wide breach in the current account deficit and large capital inflows. This appreciation began to be particularly pronounced after 1994, when the US dollar began its upward climb against the Japanese yen. In line with this appreciation, exports began to decelerate from 1996 onwards. The export slowdown was widely misinterpreted as short-term and attributed to temporary trends in the prices of a few commodities (such as semi-conductors). The deeper message, that this decline would tell on the quality of foreign investment and on debt serviceability, was ignored.

68 The Asian Financial Crisis

The financial sector was sending out even more acute distress signals. Credit to the private sector was expanding very rapidly, with increasing recourse to offshore borrowing by the banking sector to finance this credit. The problem was particularly acute in Malaysia, Thailand and the Republic of Korea with financial-sector claims on the private sector exceeding 140 per cent of GDP in 1996. In Indonesia and the Philippines credit was expanding, but in a more restrained fashion. Commercial banks and their supervisors were hard put to cope with these rapid changes (Caprio and Klingebiel, 1996; Demirguc-Kunt and Detragiache, 1998). Table 4.2 indicates how the foreign liabilities of the banking sector grew rapidly over the period 1993±96 in the cases of the Republic of Korea, Thailand and the Philippines (the maximum for 1996 being in Thailand where they stood at a staggering 26.8 per cent of GDP). However, in Malaysia and Indonesia, there was a marked decline in the foreign liabilities of the banking sector as a percentage of GDP. In Indonesia though, there was the dangerous build-up of private firms' direct borrowing from offshore banks (that is, without resort to domestic banks as intermediaries). Total claims by foreign banks on the five countries stood at $260 billion in 1996 ± of these, bank borrowings accounted for less than 45 per cent (that is, $115 billion). To get an even better picture of a country's vulnerability, it is probably useful to look at the consolidated cross-border claims (including local claims in foreign currencies such as dollar-denominated deposits). The Asian crisis led to an acceleration of capital flight through panic withdrawals of dollar deposits by local residents and companies ± unfortunately, in the absence of Bank for International Settlements (BIS) data on the breakdown of cross-border claims between local and international holders, we cannot provide quantitative justification for this claim. The growth of such cross-border claims was upwards of 25 per cent annually in all the five crisis-affected countries. What made a bad situation dangerous was the fact that the proportion of short-term claims (that is, of less than a year's maturity) was more than 60 per cent in Thailand, the Republic of Korea and Indonesia, and between 45 and 60 per cent in Malaysia and the Philippines. The danger was heightened by four additional features: (a)

short-term foreign currency borrowings were used to finance domestic investments in property, hotels and tourism; (b) maturity mismatch occurred in banks' portfolio as they were borrowing short-term offshore and lending long-term onshore; (c) banks were either exposing themselves to the risk of currency depreciation or spending considerably on buying forex cover by

Market or Government Failures? 69

borrowing in foreign exchange and lending in domestic currency; and finally, (d) banks indulged in indiscriminate lending in dollar-denominated loans to borrowers whose earnings were not in foreign exchange, and who thus faced bankruptcy in the event of steep depreciation. The ratio of short-term debt to foreign reserves provides a comparison of a country's short-term foreign liabilities to the assets available to service those liabilities. If this ratio exceeds 100 per cent, then knowledge that the country lacks enough forex resources to service its shortterm foreign liabilities may trigger a panic withdrawal of foreign funds. This ratio was substantially in excess of 100 per cent for the severely affected economies of Thailand, the Republic of Korea and Indonesia, though well below this threshold for the other two affected economies (Malaysia and the Philippines) (Table 4.2). Of course, a high ratio by itself may not bring on a crisis, but acting in conjunction with other factors, it can make the probability of such an occurrence quite high. Perhaps the most startling aspect of the Asian crisis was that it was totally unexpected. On the one hand, this may simply be yet another instance of the fallibility of economic forecasts, but on the other, since the crisis eluded both academic economists (who do not stand to lose their jobs if their forecasts go wrong) and market players and analysts (who do), the very unpredictability of the crisis is itself revealing. The crisis was unexpected because capital inflows remained strong throughout 1995 and 1996 (see Table 4.3), and in most cases well into 1997, and risk premiums on loans to the Asian economies were low and (except, to a slight extent, in Thailand) actually falling in the period preceding the crisis. Furthermore, credit-rating agencies such as Standard and Poor's, Moody's and Euromoney Country Risk Assessments, or leading investment banks such as Goldman Sachs, sounded no alarm bells concerning the growing risks. Long-term foreign debt ratings were left unaltered throughout 1996 and the first half of 1997 ± in fact Standard and Poor and Moody upgraded the rating for the Philippines in June 1997, a couple of months before the crisis. It was only after the crisis was well under way that the ratings were downgraded (Cline and Barnes, 1997).

Comparison with the Mexican crisis (1994±95) Before we turn to an analysis of the various explanations for the Asian crisis, it may be worthwhile to highlight the similarities and differences between the Asian crisis and the Mexican crisis of 1994±95. Of course,

121.7

121.2 (150)*

70.15 11.37 65.15

141.9 26.8

142.0 28.4

62.99 43.55 69.56

80 13.7

87 26.0

1. REER (1990 = 100) 89 2. Private sector 31.2 credit (% growth) 3. Financial sector claims on the private sector (% of GDP) 128.1 4. Foreign liabilities 21.6 of banking sector (% of GDP) 5. Consolidated cross-border claims a. US $ bn. 43.88 b. rate of growth (%) ± c. short-term claims 70.57 to total claims (%) d. short-term 105.6 claims to forex reserves (%)

1996

1995

1994

Thailand

156.8

56.60 ± 70.92

128.8 5.5

91 21.6

1994

165.5

77.39 36.73 69.94

133.5 6.9

88 19.2

1995

Korea, Rep. of

198.5 (210)*

99.95 29.15 67.53

140.9 9.3

88 17.0

1996

Table 4.2 Financial and forex indicators for the five Asian economies prior to the crisis

175.9

34.97 ± 60.88

51.9 6.5

92 23.0

1994

203.6

44.84 28.22 62.21

53.7 6.0

89 22.6

1995

Indonesia

187.1 (170)*

55.52 23.82 61.68

55.8 5.6

80 21.4

1996

70

144.6 9.2

22.23 32.64 50.27 41.38 (61.2)*

129.6 7.4

16.76 24.24 47.03 33.11

8.33 21.96 48.89 63.63

52.85

8.8

37.5

63 45.2

1995

6.83 ± 46.43

6.7

29.1

62 26.50

1994

Philippines

Sources: (1) Figures for REER are from Radelet and Sachs (1998). The rest of the figures are from IMF and BIS sources. Note:* refers to mid-1997 figures.

78 28.9

84 29.7

1. REER (1990 = 100) 86 2. Private sector 16.50 credit (% growth) 3. Financial sector 115.0 claims on the private sector (% of GDP) 4. Foreign liabilities 9.2 of banking sector (% of GDP) 5. Consolidated cross-border claims a. US $ bn. 13.49 b. rate of growth (%) ± c. short-term claims 48.75 to total claims (%) d. short-term 25.89 claims to forex reserves (%)

1996

1995

1994

Malaysia

77.37 (84.8)*

13.29 59.54 58.22

17.2

48.6

56 48.7

1996

71

72 The Asian Financial Crisis Table 4.3 Consolidated external financing of the five Asian economies ($ billion)

Net private capital flows of which: Direct equity Portfolio equity Private commercial bank credit Private non-bank credit Net official flows Net external financing (net capital flows plus net official flows)

1995

1996

1997

Swing from 1996 (% of preto 1997 ($ billion) crisis GDP)

77.4

93.0

12.1

4.9 10.6 49.5

7.0 12.1 55.5

7.3 11.6 21.3

‡0.3 23.7 76.8

‡0.02 2.25 7.31

12.4 3.6 81.0

18.4 0.2 92.8

13.7 27.2 15.1

4.7 ‡27.4 77.7

0.44 ‡2.61 7.4

105.1

10.0

Source: IMF (1998a). Note: The five Asian economies are: Indonesia, the Republic of Korea, Malaysia, the Philippines and Thailand.

the immediate triggers were identical in both cases, namely, (i) sizeable current account deficits, (ii) overvalued exchange rates, (iii) difficulties in rescheduling short-term debt, (iv) speculative attacks, and (v) capital flight. But the similarities end there. The underlying (as opposed to immediate causes) in the two cases were radically different, and this implies that the consequences can be expected to be widely dissimilar in the two cases. Firstly, Mexicans had used the capital inflows to finance a consumption splurge, whereas in Asia these inflows had found their way into property investments. The bursting of the property bubble and the associated asset-price deflation in Asia suggested a longer time-lag before recovery than the one-year recession that Mexico faced in the wake of the crisis. Secondly, the affected Asian economies have huge levels of internal debt. Total financial-sector lending as a percentage of GDP ± Thailand (140 per cent), Malaysia (170 per cent), the Republic of Korea (66 per cent), and Indonesia (55 per cent in 1997) ± was much higher than in Mexico around the time of the crisis (21.6 per cent). This fact has an important bearing on the scale of the financial adjustment involved. Thus, at the time of their respective crises, the percentage of non-performing to total loans was roughly similar in all economies at about 30 per cent, but whereas for Mexico this represented only 7 per cent of GDP,

Market or Government Failures? 73

for the Asian economies the corresponding proportion was much higher (56 per cent of GDP in the Malaysian case, for example). Thirdly, some self-correcting mechanisms operated during the Mexican crisis, which were absent in the Asian case. As a consequence of the crisis-induced devaluation, Mexico (which had joined the NAFTA just before the crisis) witnessed a 40 per cent upsurge in its exports in dollars and the bulk of these exports (about 90 per cent) were absorbed in the American markets. A similar export recovery has not taken place in Asia ± instead, except for the Philippines, most Asian exports fell (marginally) in dollar terms, in spite of the very sizeable devaluations. One possible reason for this is the steep hike in interest rates consequent to IMF-led structural adjustment programmes in Asia. With high interest rates on government debt, banks find it more profitable and safe, to lend to their central banks than to exporters. Further, many exporters found it increasingly difficult to secure letters of credit through local banks, since many of them had forfeited their international creditworthiness (especially in Indonesia). An even more important explanation for export stagnation is that exports were focused on the Asian region itself, so that the slump was mutually self-reinforcing. Further, the downturn in Japan aggravated matters considerably, as Japan is the kingpin of the region's trade. Thus the genesis and ramifications of the Asian crisis were of a fundamentally different order from the Mexican crisis. Hence, the danger of prescribing for the Asian crisis the same medicine, which may have worked well in the Mexican case.

THEORETICAL EXPLANATIONS Several explanations have been advanced for the Asian crisis (Nixson and Walters, 1999; Radelet and Sachs, 1998; Stiglitz, 1999). In this section we discuss the major elements of each, with a view to examining which explanation is most congruent to the observed facts. A.

Structural critique

An influential group of academic economists (for example, Summers, 1998) and policy makers (for example, Camdessus, 1998) tend to view the Asian crisis as a telling indictment of the particular brand of capitalism that has emerged in East Asia, in much the same manner as the East European collapse of the previous decade was viewed as the failure of socialism. Interestingly, left-wing economists have also given equally harsh criticisms of the Asian system from their own perspective (see Breman, 1998).

74 The Asian Financial Crisis

While significant institutional differences do exist between the various economies, there is also a sufficient commonality to warrant speaking of an `Asian model of capitalism' (Amsden and Singh, 1994; Okimoto, 1989). The salient features of this model include: a close and continuous relationship between government and business; `administrative guidance' rather than formal legislation as the preferred mode of government intervention; a long-term relationship between banks and corporations rather than the `arm's length' relationship characterizing financial systems in the US and the UK; labour-market imperfections stemming from life-long job security (the wave of nationwide strikes in the Republic of Korea was labour's reaction to the proposed withdrawal of this security); `strategic' rather than `complete' integration with the global economy. Critics claim that certain undesirable features in the system precipitated the crisis, which required a fully-fledged structural transformation. B. Macroeconomic mismanagement In contrast to the structuralist explanation, the crisis is viewed by some not as the inevitable culmination of a faulty economic system, but as the outcome of inappropriate macroeconomic policies. If one adopts the latter explanation, then the indicated remedies do not lie in the direction of a thorough overhaul of the system but rather in the less drastic direction of a fresh look at monetary and fiscal policies. The classical model of a balance of payments (BOP) crisis is due to Krugman (1979), based on the so-called monetary approach to the BOP. In Krugman's model, we have a pegged exchange rate which is maintained by the central bank until forex reserves fall below a critical level (R), after which the exchange rate is allowed to float. Assuming purchasing power parity (PPP), perfect foresight and free capital mobility in the fixed exchange rate regime, domestic and international rates are equal. In such a system budget deficits (if monetized) lead to a depletion of reserves, which heralds a capital flight when reserves approach the critical level R. C.

Financial panic

This explanation for a crisis suggests that, because of perverse market sentiment, external short-term creditors may suddenly withdraw from a solvent but temporarily illiquid economy. The economy-wide financial collapse is then similar in essence to a bank panic. Theories of bank panics can thus throw useful light on national crises. The earlier theories of bank panics (Bryant, 1980; Fisher, 1911; Friedman and Schwartz,

Market or Government Failures? 75

1963) viewed them as occurring in a situation where the banks' liquid but risky assets no longer covered their nominally fixed liabilities, so that depositors feared losses and withdrew. The currently most popular theory (Diamond and Dybvig, 1983) attributes bank runs to a sudden shift in expectations `which could depend on almost anything' (ibid., p. 404). An important contribution of Diamond and Dybvig is to draw attention to the fact that the real damage is not confined to the loss of collateral for the bank (which was Fisher's view) but affects the real sector through interruption of production schedules (via loan recall), and by the destruction of optimal risk-sharing among depositors. Empirically, bank runs have been associated with the following five features acting jointly or in conjunction: (a) short-term debts of the bank exceeding its short-term assets; (b) the absence of a single creditor large enough to supply all the credits necessary to cover short-term debts of the affected bank; (c) the absence of a lender of last resort; (d) the absence of deposit insurance; and finally (e) the absence of a suspension or a convertibility clause in the banking contract (whereby banks are allowed to suspend temporarily the conversion of their deposits into cash). In the analogous situation of a financial panic for the entire economy, corresponding considerations would indicate that such panics are more likely when a country's short-term debts account for an unduly large proportion of its forex reserves. The IMF does act as a lender of last resort to some extent, but it packages such lending with several adjustment measures. Besides, foreign commercial flows have now reached a staggering amount so that it is just not possible for IMF-led bail outs to cover all the short-term debts of a country. The ideas of deposit insurance and temporary suspension of convertibility at the global level will face formidable problems of international coordination. D.

Self-fulfilling debt crises

One explanation of crises has its roots in the newly emerged theory of `sunspots' and self-fulfilling prophecies. This explanation is advanced by Calvo (1988) and extended and applied to the most recent Mexican crisis by Cole and Kehoe (1996). If the initial level of government external debt is in a critical zone and if there are adverse expectations, a crisis may ensue. The same configuration of initial conditions with favourable expectations may not lead to a crisis. E.

Comparison of explanations

We have reviewed four distinct (but not unrelated) explanations of economy-wide crises. Before deciding which explanation (or

76 The Asian Financial Crisis

combination of explanations) fits the observed facts of the Asian crisis best, it would be useful to discriminate between the explanations on the following three grounds: predictability, consequences and remedies (see Radelet and Sachs, 1998). In the case of structural explanation, the predictability would be high (both on the part of academics as well as policy makers, though perhaps a bit lower on the part of market participants, who are usually better at reading short-term signals rather than long-term trends). The consequences on real economic activity would be crippling (as in the East European case) and the remedies would involve fundamental long-term restructuring of the economy. If macroeconomic mismanagement is the source of the crisis, its occurrence is most likely to have been anticipated (though not its exact timing). The consequences may not be very severe or long-lasting and the remedies lie in the direction of conservative policies such as budgetary prudence and domestic credit restraint (the usual IMF policies). A financial panic is rarely foreseen, not even by market participants. At the same time the damage to the real economy can be substantial. An appropriate remedy would be strengthened financial supervision with a select use of lender-of-last-resort functions by the central bank. An expansionary credit policy can act as a useful lubricant for the recovery process. With self-fulfilling prophecies, the size of the debt will be an important signal for the onset of a crisis (since the larger the debt, the greater the probability of repudiation). In this sense, the crisis will be predicted (though not, of course, its timing). The consequences for the real economy are not extensive (much less as compared to financial panic explanation, for example) and recovery is quick (the 1994-95 Mexican crisis is a case in point). The appropriate policy response involves a coordination with international agencies on issues relating to rescheduling and restructuring of the debt.

DIAGNOSIS OF THE CRISIS There are reasons to believe that the crisis partakes, in a large measure, features associated with a financial panic, especially its unpredictability and extensive damage to the real sector. The quintessence of a financial panic is a dramatic reversal of market and investor expectations, with the change far outstripping the sensible adjustment warranted by altered fundamentals. This `overshooting' of expectations was strongly

Market or Government Failures? 77

evident in the Asian crisis, where (most economists now agree) the currency depreciation and stock market adjustments were far in excess of what the situation at the time of the crisis justified. Nothing illustrates the dramatic overshooting of expectations more than the reversal of capital flows around the time of the crisis. Table 4.3 shows that capital inflows to the five economies, which peaked at $93 billion in 1996, were dramatically reversed to an outflow of $12.1 billion in 1997. Thus there was a switch of $105 billion which represented 10 per cent of the combined pre-crisis GDP of the five economies. The maximum outflow occurred in the case of commercial bank lending ($76.8 billion) followed by portfolio equity ($23.7 billion). Of course, we are not denying some structural flaws in the system, but we view them as contributory rather than primary factors in the crisis. Several shortcomings had emerged in the Asian model (Singh, 1998, 1999): too much capital made available to Asian companies at prices far below the true resource cost of capital to the economy (due to a plethora of subsidies and tax concessions to selected industries); foreign banks' indiscriminate lending, and a pegged exchange rate which overvalued the Asian currencies against the dollar. Secondly, Asian governments had a tendency to bail out troubled inefficient corporations rather than allowing them to fail, which acted as a drag on the financial system. Thirdly, an unreliable legal system, inadequate bank regulation, and lack of corporate transparency critically harmed the credibility and stability of the system. Many Western commentators have attributed systemic failure in Asia to corruption and `crony capitalism', which straddles the triangular relationship between government, industry and banks. It is claimed that market distortions were created through government action which protected business from competition. We need to distinguish between two distinct situations here. Firstly, that government±corporation axis, for example, would work reasonably well, if the industries singled out for favourable treatment were chosen on objective technical and economic grounds. Secondly, if `cronyism' is the guiding selection principle, the costs to the economy of protecting and subsidizing inefficient industries can be considerable. But there is no clear definition of `cronyism' and at any rate, it had been prevalent in the Southeast Asian economies long before the crisis and thus cannot be used as its major explanation. Chang (1998) notes five types of explanation of the crisis referring to the problem of moral hazard: industrial policy, cronyism, deposit insurance, the `logic of too big to fail' and the IMF bail-outs. He argues that these concepts are too ill-defined and thus lead to

78 The Asian Financial Crisis

conceptual confusion or `intellectual hazard' in providing simple explanations of the crisis. Cronyism needs to be distinguished from the industrial-policy arguments. Mixing up of the two originates from the fact that some cases of corruption and nepotism were disguised in the form of industrial policy in some of the Southeast Asian economies. Furthermore, cronyism was perceived to be diminishing on the eve of the crisis (except perhaps in Indonesia).1 Most of the above features are not inevitable characteristics of the Asian mode of capitalism, and even those that are, can be reasonably taken care of within the existing framework, by strengthening the powers and rights of shareholders (with a view to enabling them to play a leading role in disciplining company management) and by putting into effect proper bankruptcy laws (so that creditors do not suffer an indefinite locking-up of funds). Furthermore, there is no single model of Asian capitalism: the model of development in Southeast Asia was quite different from that followed by the Northeast Asian economies such as China, Hong Kong and Japan. Thirdly, one can argue that it was not so much excessive government as lack of adequate intervention in the financial sector at least in some of the affected economies. For example, the Korean government abandoned control over the industrial and financial sectors which, inter alia, exposed it to external vulnerability (Chang, 1998, 1999; Chang et al., 1998). Also in Thailand, liberalization of the banking sector and property investment were important factors explaining the crisis. The Asian crisis is primarily one of a financial panic, in which structural factors played a reinforcing role. This characteristic is common to the earlier financial crises in both developed and developing countries (see Chapter 3). Volatility of capital inflows and the launching of financial liberalization without adequate preparation were the main causes of financial panic. If this diagnosis is correct, remedies most likely to succeed will involve the provision of adequate safeguards (of a legal or administrative nature) for the financial sector and discipline on foreign portfolio investment and external commercial borrowings. Instead, what the IMF prescribed was a typical structural adjustment, which is an appropriate remedy for an economy suffering from flawed macroeconomic policies.

ROLE OF THE IMF IN THE CRISIS There is some reason to believe that the IMF stand-by agreements negotiated with the crisis economies (except Malaysia) aggravated the situa-

Market or Government Failures? 79

tion. The problem with IMF programmes is that whatever the disease, the prescribed medicine is the same. The IMF programmes, which were initially negotiated with the three Asian economies (Thailand, Indonesia and the Republic of Korea), comprised five distinct aspects: ii(i)

Monetary Policy: An overall target for the growth of domestic credit and floors for certain interest rates. i(ii) Fiscal policy: Targets for fiscal deficit. (iii) Banking Policy: Closure of non-viable banks and enforcement of capital adequacy norms. (iv) External Policy: A nominal devaluation and reduction of tariffs. i(v) Structural Changes: Opening up of sectors for foreign investment, labour market reforms, restricting monopolies, and so on. The rationale underlying the IMF's `fire fighting' strategy is supplied by Fischer (1998a) as well as other IMF Staff (1998a). Item (iv) was relatively non-controversial. It was generally agreed that the currencies were overvalued and both Thailand and the Republic of Korea had lost huge chunks of their reserves ($6 billion in the case of Thailand and $7.3 billion in the case of the Republic of Korea) in defending their pegs. There was less agreement on the reduction of tariffs and significant opposition came from the chaebols (industrial conglomerates) at the implied loss of protection. Nevertheless, this was a long-term measure as were the measures under item (v), so that their immediate impact was limited. However, much controversy arose over the first three items. At the heart of IMF policies is the so-called financial programming model, which (shorn of its fancy trimmings) may be essentially described as follows (see Killick, 1995; Khan et al., 1990; Williamson, 1980). The first equation is the standard quantity theory equation Y ˆ vM . . .

…1†

where Y is nominal income, M is money supply and v is the velocity of circulation. There is an import equation of the form Im ˆ mY . . .

…2†

where Im are imports, and m is the import elasticity. Exports (EX0 ) and capital flows (K0 ) are assumed to be exogenously determined. The changes in forex reserves (
R) are equal to the balance of payments (B), that is,

80 The Asian Financial Crisis


R ˆ B ˆ …EX0

Im † ‡ K0

…3†

The final equation defines the changes in the money supply (
M) as the sum of changes in forex reserves (
R) and changes in domestic credit (
DC)
M ˆ
R ‡
DC

…4†

The model described above allows us to examine the effects of IMF policies. The impact of credit ceilings is evident from a glance at (4). Once
DC is fixed, any outflow of capital has to be met either by (a) improving the trade balance or (b) a fall in reserves. The first requires not only a nominal devaluation but also a real devaluation, and additionally there would be a time lag between the devaluation and the improvement in the trade balance. This makes the second possibility the most likely outcome. But this involves a reduction in money supply commensurate with the loss in reserves. Thus the policy is highly contractionary, and could be one part of the explanation for the absence of recovery in the Asian economies even after IMF programmes were put in place. The logic for the floor on interest rates is that higher interest rates would aid in currency stabilization or even appreciation. But high interest rates actually undermined the profitability of banks and firms and aggravated the downturn in the Asian case causing economic and social hardships (see below). At the same time, currency depreciation continued unabated, reflecting the fact that the IMF had heavily miscalculated the state of expectations in the forex markets (Stiglitz, 1998). The IMF misdiagnosed the source of the problem in Asian economies by insisting on fiscal contraction. Initially the IMF insisted on a fiscal surplus of 1 per cent of GDP in each country ± this was particularly surprising in view of the fact that all the Asian economies had eschewed fiscal profligacy. The IMF insistence on this unrealistic target simply worsened the contraction already in effect. The IMF itself seems to have realized the harshness of its fiscal discipline and, in the later revised versions of its programmes, conceded that the Republic of Korea could run a balanced rather than a surplus budget and that Indonesia and Thailand be allowed to run small deficits of about 1 per cent of their GDP. The original IMF programmes focused on the closure of non-viable financial institutions rather than on comprehensive reform measures. In Thailand, 58 financial companies were suspended; in Indonesia, 16 banks were closed and in the Republic of Korea, 14 merchant banks. This terminal measure only served to increase the prevailing panic, with

Market or Government Failures? 81

depositors in other institutions fearing that they would be the next victims. It was not immediately evident how the foreign liabilities of the closed banks would be handled and this made foreign creditors jittery about rolling over their loans to other institutions. The second round of IMF programmes, recognizing the errors of the first, concentrated more on financial restructuring, but this too had its problems. The key emphasis in the restructuring programme was on bank recapitalization. While not denying the necessity of this measure, it appears to us that banks were being expected to do too much in too compressed a time frame. (Thus Indonesian banks, for example, were required to raise the capital adequacy ratio to 9 per cent by end-1997 and further to 12 per cent by end-2001.) Even though this target was later relaxed, the fact remains that under the imperative of capitalization, banks were forced to curtail lending sharply, accentuating the existing credit crunch. Thus, in all the affected economies, whereas the prime need in the wake of the crisis was an easing of financial stringency, what eventually happened was exactly the opposite. The re-capitalization should, of course, have been stressed but within a realistic framework so as to give the banks sufficient flexibility in compliance. This would have alleviated credit stringency. Martin Feldstein, former Chairman of the US Council for Economic Advisors, offered a fundamental critique of the IMF role in the Asian crisis (Feldstein, 1998). Apart from the standard criticism that the IMF programmes were based on a misdiagnosis of the situation and would prove unnecessarily contractionary, Feldstein emphasized three further limitations. Firstly, the painful and comprehensive reforms sent out the message to the emerging-market economies that the IMF should be called in only if it was inevitable. Thus, for example, Malaysia refused to negotiate an IMF loan and paid a heavy cost in the process (The Economist, 1998b). This is likely to produce two long-term consequences: (a) economies which could have consulted the IMF for technical advice and moderate amounts of financial help are likely to postpone `the visit to the dentist' until things get out of hand; and (b) to keep out of the IMF's clutches, countries will embark on unnecessarily large reserve accumulation (using export earnings to accumulate forex assets rather than importing new plants and equipment), which would constitute an avoidable drag on the economy's growth potential. Secondly, because the problem in almost all the affected economies was illiquidity rather than insolvency, the IMF should have focused on

82 The Asian Financial Crisis

restoring foreign creditors' confidence in the economy so that they could be persuaded to roll over existing credit lines. Instead, by harping on structural and institutional problems of `the Asian model of capitalism', the IMF only gave a further jolt to the already badly-shaken confidence of creditors. As if in support of this hypothesis, the international bond-rating agencies (such as Moody and Standard and Poor) downgraded the ratings for Thailand, the Republic of Korea and Indonesia after the IMF programmes were announced. Finally, Feldstein (1998, p. 32) would like to see the IMF play the more limited role of maintaining countries' access to global capital markets and international bank lending (apart from providing technical advice and some financial assistance). To quote: (the IMF should) eschew the temptation to use currency crises as an opportunity to force fundamental structural and institutional reforms on countries, however useful they may be in the long term, unless they are absolutely necessary to revive access to international funds. It should strongly resist the pressure from the United States, Japan and other major countries to make their trade and investment agenda part of the IMF funding conditions.

THE IMPACT OF THE CRISIS The immediate impact of the crisis was felt by the affected economies and the rest of the world which is discussed below. The impact of the Asian crisis on China and India is discussed in Chapter 5. On the affected economies The impact of the crisis on the affected economies is of both economic and social nature. Below we consider these two aspects one by one. A. The economic impact The following are the three major likely channels through which the crisis had an adverse effect on the affected countries: (a)

The direct and indirect impacts on intraregional and extraregional exports and imports due to the downturn in the Asian economies. (b) The impact on the inflow of foreign capital into the region, and (c) The impact of contractionary domestic policies initiated in response to the crisis.

Market or Government Failures? 83

We noted earlier that export growth of all the five affected Asian economies had considerably decelerated already in 1996 even before the onset of the crisis. Following the massive devaluations of the exchange rates in the second half of 1997, exports of these economies were expected to grow significantly as a consequence of their greater competitiveness through shifts in relative prices of traded goods. However, as Table 4.4 shows, this did not happen in practice. In all the five affected economies export values in the second quarter of 1999 were lower than those in the fourth quarter of 1997. Several factors explain this situation: import-intensive nature of exports, liquidity crisis and export credit squeeze. The affected economies seemed to be caught in a vicious circle. Foreign lenders (including private international banks) were reluctant to resume new lending, being unsure whether the restructuring programmes under way were making progress. The IMF (which had been monitoring the process) endorsement may not have had much credibility with the creditors in view of the severe criticism of the agency for its handling of the crisis. Yet successful restructuring itself depended on new credits from the international financial markets (see Park and Song, 1998). As a result of devaluations, while exports became more competitive, imports became more expensive. Since March 1998 the yen declined against the dollar thus raising the value of the currencies of the affected Asian economies against the yen, which partly offset the positive effect of currency depreciations on exports. Furthermore, importintensity of exports also hindered export expansion (some estimates show that on average in Thailand, Malaysia and Indonesia 30 per cent of imported parts, raw materials and equipment are used in export Table 4.4 Value of exports of the five affected Asian economies (1997±99) ($ billion) Country

1997 IQ

IIQ

IIIQ

IVQ

1998 IQ

IIQ

Korea, Rep. of Indonesia Thailand Malaysia Philippines

29.7

35.5

31.2

35.3

33.2

33.9 31.3 33.9 30.2 32.2

12.4 14.1 19.7 6.0

12.5 14.0 19.6 6.4

13.2 14.7 20.7 7.4

14.1 15.2 20.6 8.4

12.5 13.8 17.6 6.8

13.7 14.2 14.0 13.1 13.7 13.7 13.8 13.5 13.5 13.5 17.7 18.1 20.0 18.3 20.5 7.1 7.9 7.6 7.4 7.5

Source: IMF (1998d, 1999a). Q - Quarter.

IIIQ

IVQ

1999 IQ

IIQ

84 The Asian Financial Crisis

production; in electronics and motor vehicles, this ratio rises to 60±90 per cent of the export value (see UNCTAD, 1998, p. 37). For example, although the Thai baht plunged over 50 per cent against the dollar, the Bank of Thailand reported that exports in January 1998 had dropped by nearly 8 per cent (International Herald Tribune, 1 April 1998). Adjustment of trade balances of these economies is more due to the fall in imports than to an export expansion. In 1998, dramatic contraction of import volumes was recorded in Japan (10 per cent) and Southeast Asia excluding China (over 6 per cent) (see UNCTAD, 1999, p. 14). In the five affected Asian economies, the decline in the volume of imports ranged from 13 per cent in the Philippines to 27 per cent in Indonesia (see Table 4.5). The slowdown of imports in volume is also confirmed by a slowdown in value terms. It is estimated that in the first nine months of 1998 the value of imports of the affected Asian economies declined by onethird while exports declined by 3 per cent. Decline in overall exports is also explained by the decline in intraregional trade following a contraction of demand. During 1996, 52 per cent of Asia's total merchandise exports and 54 per cent of its total imports were intraregional (including developed countries like Japan) (UNCTAD, 1998). This ratio declined considerably in 1997 and the first half of 1998. Decline in domestic demand also adversely affected imports from within the region and from outside. This is particularly the case because of the Japanese recession. Japan's exports to and imports from the five affected Asian economies showed a sharp decline during the first quarter of 1998. In May 1998, exports from the Republic of Korea for the first time declined in absolute terms since the onset of the crisis in July 1997. As all the affected economies Table 4.5 Export and import volumes of the affected Asian economies (1996±98) (Percentage change over previous year) Country Indonesia Korea, Rep. of Malaysia Philippines Thailand

Export volume

Import volume

1996

1997

1998

1996

1997

5.5 13.0 7.2 20.3 1.8

10.2 23.6 8.8 17.6 6.6

9.4 12.2 4.2 16.9 4.6

7.8 14.8 4.2 21.1 0.9

17.2 3.8 8.3 14.4 10.0

Source: UNCTAD (1999).

1998 26.6 20.8 19.8 12.6 25.0

Market or Government Failures? 85

massively devalued soon after the crisis began, none could command a competitive advantage in export markets. The effect of the crisis on the capital inflows started being adverse, although till early 1997 FDI inflows remained unaffected (see Table 4.6). This is not surprising, considering that returns in the affected Asian economies were much higher than those in the industrial ones. Besides the Asian crisis in 1997 the yen depreciation against the dollar in early 1998, noted above, also lowered the propensity of Japan to invest in the affected Asian economies. UNCTAD (1998, p. 69) notes that `no net inflows are expected in 1998', although capital flows to Latin America and Eastern Europe are likely to be more or less maintained. While many observers expected the crisis to end in a year or so it has not done so. Although the affected economies recovered lost investor confidence somewhat in early 1998, a further wave of capital outflows started in May±June of that year (Wade, 1998). Forecasts by the International Institute of Finance (Washington DC) showed that private capital inflows would recover to over $39 billion in 1999. Foreign direct investment was expected to remain steady at $45±50 billion (Goad, 1999b). In 1998, FDI to the Republic of Korea and Thailand increased by 82 per cent and 26 per cent respectively and flows were also significant in 1999 (see Table 4.6).2 This situation may be a result of policies adopted in late 1997 to deregulate and liberalize FDI3. In Indonesia and Malaysia FDI actually declined with a sharp fall in the former. Worth noting is one particular effect of the crisis on capital inflows. The financial crisis led to bankruptcies of banks, companies and firms whose sale value had drastically declined. Devaluations have also led to a decline in production costs in terms of home-country currencies. Therefore, multinational enterprises from industrial countries and Singapore have started acquiring bankrupt banks and companies. For Table 4.6 FDI flows to Southeast and East Asia (1996±99) (US $ billion) Country Indonesia Korea, Rep. of Malaysia Thailand

1996

1997

6.2 2.3 5.1 2.3

4.7 2.8 5.1 3.8

1998 0.4 5.1 5.0 6.8

Source: World Bank (2000). Q1 ± first quarter; Q2 ± second quarter. ± ˆ not available.

1999 Q1 0.03 1.0 ± 1.0

Q2 ± 1.8 ± 2.2

86 The Asian Financial Crisis

example, in the Republic of Korea, Volvo of Swedon acquired Samsung's construction-equipment division, Germany's BASF bought up Daesang's animal-feed additive business, and the American energy company Enron, entered into a joint venture with SK Corporation to distribute natural gas (Far Eastern Economic Review, 24 December 1998). In the immediate aftermath of the crisis, output growth estimates were adjusted downwards by the IMF for the five affected economies. The decline in output was further revised downwards in May 1998. The UNCTAD estimates for 1998 were even more bleak than those of the IMF (see Table 4.7). The crisis, which was initially expected to be short-lived, was assumed to last longer. Actual growth rates achieved in 1999 by the Republic of Korea, Malaysia, and Thailand have disproved the pessimism among international organizations about the capacity of the economies to bounce back. The IMF and OECD forecasts of output growth for 2000 are much higher than for 1999 (see Table 4.7). However, the recovery prospects vary from country to country; recovery is faster in the Republic of Korea and Malaysia than in Indonesia. Korea has made a more rapid recovery thanks to growth of trade in electronics products (World Bank, 2000). Sustained economic recovery is difficult in conditions of rising unemployment and falling real wages which depress household incomes (OECD, 1999, p. 130). The more optimistic growth forecasts for 2000 are based on higher growth in Europe and Japan offsetting a slight deceleration of growth in the United States (Goad, 1999a). B. The social impact The drastic decline in growth rates shown in Table 4.7 contributed to an increase in unemployment and drop in incomes of nearly all income Table 4.7 Forecasts of GDP growth for the five affected Asian economies (%) Country

Indonesia Korea, Rep. of Malaysia Philippines Thailand

IMF December May 1997 1998

OECD 2000 1998 1999

UNCTAD 2000 1998 1999

2.0 2.5

5.0 0.8

2.6 5.5

13.7 ±

3.0 ±

3.0 ±

15.3 6.2

3.5 to 2.0 1.0 to 4.0

2.5 3.8 0.0

2.5 2.5 3.1

6.5 3.5 4.0

6.7 0.5 8.0

0.5 2.5 1.0

3.5 4.5 3.5

7.5 1.0 8.0

2.0 to 1.0 2.0 to 2.6 0.5 to 3.0

Sources: IMF (1998c, 1999b); OECD (1999); UNCTAD (1999). ± ˆ not available.

Market or Government Failures? 87

groups. Social hardships led to street riots in such countries as Indonesia where excessively high inflation has eroded the real value of savings besides lowering purchasing power. The Central Bureau of Statistics of Indonesia estimated unemployment in 1998 to reach 15 million (compared to 4.4 million in 1996), which is equivalent to 17 per cent of the labour force. In the Republic of Korea it was estimated to rise from 0.4 million in 1996 to over 1.5 million in 1998, and in Thailand, from 0.5 million to 2.0 million (IMF Staff, 1998b). The effect of the crisis on unemployment and underemployment has taken several forms: (a) substantial retrenchments in different sectors resulting from rapid fall in growth rates and declining demand, (b) drastic decline in new hiring which particularly hurts displaced workers and new entrants to the labour market, and (c) substantial entry of displaced workers and new entrants to the labour force in the rural and urban informal sectors which raises underemployment and lowers incomes there (see ILO, 1998; Lee, 1998). While the impact of job losses had adverse income effects for low-income rural and urban workers, collapse of property and real estate and stock prices hurt also the rich. Decline in social expenditures in the wake of the crisis also worsened the situation of the poor. With the exception of the Republic of Korea, none of the affected economies has any unemployment benefits to provide social protection. (Even in the Republic of Korea, social protection is limited in coverage and is of recent origin.) The social safety nets introduced by the countries with support from the World Bank are too small in relation to the magnitude of the problem. In conditions of rising unemployment, falling real wages, and inflation, the poverty situation has worsened in the affected economies. Table 4.8 shows the increase in poverty by the end of 1998 arising from rising unemployment and inflation in the wake of the crisis in three of the five affected economies. An additional 20 per cent of the population was forecast to become poor in Indonesia, and an additional 12 per cent in the Republic of Korea and Thailand. This is in sharp contrast to the rapid decline in poverty in these economies during the pre-crisis period. The human development indicators (poverty reduction and employment generation, social expenditures on health and education) which were high before the crisis, have been slipping. As we noted above, new poverty is growing and unemployment is rising rapidly in the affected economies. Although public expenditure on social sectors (as a percentage of GDP) before the crisis was not particularly high in these economies by international standards, high growth rates (with the exception of the Philippines) ensured that the absolute amounts of social

88 The Asian Financial Crisis Table 4.8 Increase in poverty due to the Asian crisis (1998 forecasts) Country

Increase in the number of poor millions

Indonesia Korea, Rep. of Thailand

39.9 5.5 6.7

Due to unemployment Due to inflation

% of millions population 20 12 12

12.3 4.7 5.4

% of millions population 30.8 85.5 80.6

27.6 0.8 1.3

% of population 69.2 14.5 19.4

Source: IMF (1998c; cited in Lee, 1998, p. 47).

expenditures would be rising. In the post-crisis period a drastic fall in growth rates made it impossible (Ranis and Stewart, 1998). Although the social and economic hardships of the crisis are severe, particularly in countries like Thailand and Indonesia, they are not as acute as they would have been if the countries had not made such tremendous progress in reducing poverty during the pre-crisis years through rapid and sustained growth and rapid employment increases. The effect of the crisis may be particularly severe on such target groups as women workers who have generally been discriminated in the labour market in the affected Asian economies in terms of lower payment of wages for similar work. Women are likely to be the first to lose jobs with the onset of any crisis or drastic fall in demand, since the employers consider them as secondary income earners. Since they are not well represented in decision-making, their bargaining position tends to be weaker. Thus the traditional vulnerability of women in the labour market may have been worsened. To conclude, adverse social effects of the crisis resulted from a fall in the demand for labour, sharp increases in prices of food and medicine, and cuts in public expenditure as part of the stabilization programmes (World Bank, 1998c). There seems to be no substitute for restoration of economic growth to bring the economies out of poverty and social hardships on a sustained long-term basis. On the rest of the world No doubt the worst effects of the crisis are felt on the affected economies as is noted above. However, in an interdependent world with mounting financial globalization discussed in Chapter 3, other countries and regions have not remained unaffected. Within the Asian region, Hong Kong, Singapore and Taiwan have felt the ripples from the crisis and

Market or Government Failures? 89

slowdown of the Japanese economy, although these economies are not as severely affected. But the economic and social situation in Hong Kong is of some concern. In the fourth quarter of 1998 the unemployment rate in Hong Kong rose to 5.8 per cent, the highest level ever recorded. The rate was expected to rise to 7±9 per cent in 1999 compared to an average of 2.9 per cent recorded between 1994 and 1998 (International Herald Tribune, 19 January 1999) (for the impact of the crisis on two other Asian countries, China and India, see Chapter 5). The impact of the crisis on industrial countries will occur in terms of the loss of markets for their export products and may slow down their economic growth. There are two ways in which income and employment in these countries is affected. Firstly, the trade of these countries (particularly the United States, and to a lesser extent Europe) is significant and growing. Secondly, multinational corporations from these countries have sizeable production facilities in the Asian region; imports from the affiliates of these enterprises are likely to suffer.4 So far the European Union has been relatively unaffected, partly because of the somewhat limited direct trade with the Asian economies. Indeed, the crisis is seen as having some positive effects in the form of terms of trade gains reflected in lower prices of oil and raw materials, and downward pressure on consumer prices resulting from Asian competition (Deppler, 1998). However, the effect of the crisis on the economies of the Western hemisphere (Canada, the United States and Latin American countries) is likely to be more adverse. Although in Canada and the United States the domestic demand remained strong immediately after the crisis, there have been warning signals of impending recession which led to a decline in interest rates as a stimulating measure. Since the affected Asian economies trade significantly with the US, recessionary tendency there is understandable.5 For the Latin American developing countries, UNECLAC (1998, p. 6) estimates that the Asian crisis will account for a decline of 1 percentage point in the growth rate of GDP of the region. The IMF staff estimated a slowing down of growth in the region from about 5 per cent in 1997 to roughly 3 per cent in 1998 (Loser, 1998). Capital flows started slowing in 1997 in the wake of the Asian crisis, and stock and bond prices fell sharply. Decline occurred in export revenues due to a decline in commodity prices and lack of exports to the Asian economies. However, with the exception of Chile and Peru the Asian market is not that important for the region. Although in volume terms Latin American exports may not have declined much, the Asian crisis had an adverse effect on the prices of Latin American exports.

90 The Asian Financial Crisis

The latest effect of the Asian crisis is witnessed in the Brazilian financial crisis in January 1999 when its currency, the real, had to be devalued. Already in the second half of 1997, Brazil was adversely affected because of growing fiscal and balance of payments deficits which are generally interpreted as a sign of an overvalued currency. Stock market and foreign exchange crises reflected in a sharp drop in stock prices encouraged capital outflows from Latin America. In October 1997, short-term capital outflows from Brazil amounted to $8 billion. The effect of the Asian crisis on Africa has been relatively limited because this region does not trade much with the affected Asian economies. Most of its trade is with the European Union and the United States. But the impact of the crisis was felt in the Congo, the United Republic of Tanzania and Zambia which export one-fourth of their export products to the Asian countries (UNCTAD, 1999). Africa has also suffered indirectly through decline in commodity prices in 1998 resulting from the Asian crisis.

CONCLUSION In this chapter we have shown that the Asian crisis is different from earlier crises. The economic fundamentals in the affected Asian economies remained sound throughout the pre-crisis period. World market conditions were not particularly adverse, at least not sufficiently to foretell a crisis. Unhealthy signals emanating from the financial sector went unheeded. Credit to the private sector was expanding rapidly with increasing recourse to foreign borrowing by the banking sector. The crisis was unexpected as the assessment of credit agencies was continuously favourable. We believe that despite some problems of macroeconomic management the crisis was mainly a banking and financial failure. Excessive short-term borrowing and foreign banks' indiscriminate lending were largely to blame. Thus our diagnosis of the Asian crisis is primarily one of a financial panic, in which structural factors played only a reinforcing role. Volatility of capital inflows and financial liberalization without adequate preparation were the main causes of the panic. Therefore, the successful remedies are: the provision of adequate safeguards for the financial sector and the introduction of measures to discipline foreign portfolio investment and external commercial borrowings. The IMF prescription is typical of structural adjustment, appropriate for an economy suffering from macroeconomic imbalances.

Market or Government Failures? 91

We show in Chapter 5 that India and China escaped from the serious adverse effects of the crisis due to the absence of capital account convertibility (CAC) which can be harmful if introduced without adequate preparation. The CAC proponents argue that sharp reversals of capital flows are simply symptomatic of deeper fundamental problems. We demonstrate that this is a misleading description of the Asian crisis.6

5

The Impact of the Asian Crisis on China and India A. S. Bhalla and D. M. Nachane

Ever since the outbreak of the Asian financial crisis, speculation has been rife about the likelihood of the `contagion' spreading and the extent of its possible spread. Policy makers in different countries have also been preoccupied with examining what measures could be taken to forestall a similar fate befalling their respective economies. This chapter addresses these issues with respect to the two Asian giants, India and China, which share certain common features such as size and geographical proximity to the crisis region, but differ widely in other respects. Apart from the well-known differences in their political systems and the role of markets, at least two other divergent features stand out. Firstly, attitudes to foreign investment in the recent past have differed sharply. Whereas India has been extremely cautious about foreign direct investment (FDI), but relatively open to foreign portfolio investment (FPI), the opposite seems to have been the case in China. Secondly, the Indian banking and financial system has evolved to a stage of maturity and sophistication that does not seem evident in China. The aim of this chapter is to assess the vulnerability of these two countries to the crisis. As we discussed in Chapter 4, it is now generally agreed that the Asian crisis was the logical culmination of an inappropriate strategy of financial liberalization with volatile capital flows acting as a triggering factor. Thus a careful scrutiny of the domestic financial system and the international capital account in both countries is a first step in our analysis. But there is also the possibility of a transmission of the crisis (from Southeast Asia to either India or China) via the following two channels: (i) the direct and indirect impact on exports due to the crisis, and (ii) the impact on the inflows of FDI and FPI. Finally, it is necessary to consider the possibility that contractionary domestic 92

Market or Government Failures? 93

policies initiated in response to the crisis, if not carefully designed, might bring about the very consequences that they were intended to avert. The impact of the crisis on both China and India has been limited so far but it has naturally raised concerns and provoked rapid responses on several fronts. There are also a number of differences between the impacts on India and China. While the Indian currency declined appreciably in the wake of the crisis, the Chinese yuan remained robust and actually appreciated somewhat, thanks to massive inflows of capital and a big trade surplus. Despite cheapened exports following devaluation in the affected economies, China remains more export competitive than India and has introduced measures to expand exports into new sectors and destinations. China may have benefited from its 1994 devaluation of the yuan, making it relatively more competitive then than the Southeast Asian economies. Some authors (for example, Makin, 1997) suggest that competition from China in the export markets following the devaluation triggered the Asian crisis. But the adverse effect on the latter's exports must have been much weaker than is often claimed, considering that the bulk of Chinese exports were already being traded at market exchange rate which did not change (The Economist, 1997; Fernald et al., 1999). Fernald et al. note that while Chinese export shares did increase between 1989 and 1993, largely at the expense of the Republic of Korea, Singapore and Taiwan, between 1993 and 1996 these shares were relatively stable across China and the major ASEAN economies. Thus the 1994 Chinese devaluation of the yuan is unlikely to have been responsible for the Asian crisis. The crisis has provoked a different response to liberalization from the two countries. The Chinese government has decided to accelerate reform of the financial sector, banking industry and state enterprises whereas in India where impressive strides had been made in the financial sector reforms during 1992±96 a certain deceleration of the pace has set in. The two countries, however, have shown a common response in one aspect, namely, attempts to stimulate domestic demand through expenditure on infrastructure. In the case of India there is one complicating factor unrelated to the Asian crisis but which could have increased its vulnerability to the crisis, namely, the fall-out of its nuclear tests. While the extent and seriousness of the US economic sanctions is anybody's guess, there is no denying that international opinion turned distinctly cool in consequence of the tests. Thus part of the responsibility for any possible future slowdown in the economy will lie squarely with India's nuclear power aspirations;

94 The Impact of the Asian Crisis on China and India

but disentangling this effect from the Asian crisis impact is well-nigh impossible. The first section of the chapter is devoted to an assessment of the vulnerability indicators in the two countries in respect of the domestic financial system and the international capital account. The second section discusses trade impact while the third focuses on the impact of the crisis on capital flows. The effect of domestic contractionary measures is discussed in the fourth section and the future of economic reforms, in the fifth. The sixth section presents the type of financial reforms needed to avert crises in the future. These reforms, as we show, will call for more government action rather than less. Conclusions are presented in the last section.

VULNERABILITY INDICATORS India In both India and China growth slowed down in the wake of the crisis (see Table 5.1). The Indian economy, which had achieved unusually high rates of growth (by past Indian standards) of around 7 per cent during 1994±97 suffered a sharp reversal in 1997±98 when growth slipped to 5.1 per cent. The Indian Finance Minister's Budget speech (1998±99 Budget) was sanguine about the following year's growth prospects ± few analysts, however, shared this optimism. On the contrary, most assessments pointed to a sharp deceleration in growth (see for example, The Economist, 1998c, 1998d, 1998f). In India, even though fiscal profligacy reasserted itself (the gross fiscal deficit in 1997±98 being placed at 6.1 per cent of the GDP), care was exercised to prevent a repetition of the 1991 scenario when the fiscal deficit spilled over into a current account deficit via external commercial borrowing. Keen to avoid a repetition of history, the government scrupulously steered clear of this route and the current account deficit was on course at around 1 per cent of GDP. Instead the government adopted the more conventional route of domestic public borrowing. The proposed net borrowings at Rs. 630 billion ($15.8 billion) (both central and state borrowing net of repayments) represented an increase of over 60 per cent during the corresponding period in 1997. The massive rise reflected the government's desire to pull up the economy by the infrastructure bootstraps. However, even though foreigners are now allowed to invest in gilt securities, the government pinned its hopes on the commercial banks to absorb this massive increase. In 1997, banks invested 36 per cent of their deposits in gilt (11 per cent in

Market or Government Failures? 95 Table 5.1 Selected macroeconomic indicators for India and China India

1994±95

Real GDP growth (%) Exports ($ billion) growth (%) Inflation (%) (consumer prices) Government budget balance (% of GDP) Gross investment ± GDP ratio (%) Forex reserves ($ billion) Total external debt ($ billion) External debt/GDP ratio External debt-service ratio (% of exports) External debt service (% of GDP)

1995±96

1997±98

7.2 26.9 10.2

7.1 17.5 10.2

6.8 5.2 9.0

5.1 n.a 3.7

6.0 26.9 19.69 101.95 32.3

6.0 27.1 17.92 92.98 28.3

5.2 27.3 25.7 93.43 26.2

6.1 n.a 24.33 94.40 26.4

26.2 2.16

24.3 2.38

21.2 2.57

19.5 2.45

China

1994

1995

Real GDP growth (%) Export growth (%)

12.6 11.5 (1980±90)

10.5 15.8 (1990±97)

21.7

Inflation (%) (consumer prices) Government budget balance (% of GDP) Forex reserves ($ billion) Total external debt ($ billion) External debt/GDP ratio (%) External debt-service (% of exports) External debt-service (% of GDP) Short-term external debt (% of total external debt)

1996±97

1996

1997

1998*

9.7 Ð

8.8 Ð

6.5 Ð

14.8

6.1

1.5

0.8

1.2 51.6

1.0 73.6

0.8 105.0

2.8 140.0

1.0 148.9

Ð 18.4

Ð 16.6

150.5 15.4

8.9

9.9

8.7

161.8 17.0 Ð

175.1 17.0 Ð

17.4

Ð

Ð

3.6

18.9

19.7

25.8*

Ð 27.6*

Sources: IMF (1998a, b, c); World Bank: World Development Report 1998; RBI: Annual Reports and Government of India Annual Surveys, Goldman Sachs (Hong Kong). Notes: * J. P. Morgan (1998) Ð ˆ not available.

excess of the statutory liquidity ratio, SLR) . It will be difficult to persuade them to absorb a higher percentage in 1998 unless interest rates are stiffened. Even prior to the Budget, the Reserve Bank of India (RBI) had signalled its intentions of ushering in a dear money policy by raising the bank rate by 2 per cent and the cash reserve ratio by 0.5 per cent. Thus the government's borrowing programme hacked at the

96 The Impact of the Asian Crisis on China and India

corporate sector ± the cost of funds were pushed up and simultaneously their availability squeezed (by a substantial locking up of bank funds in gilt). This is most likely to introduce the typical moral-hazard problems of credit-rationing and push up the non-performing assets (NPAs) from their current high level of 16.5 per cent even further. There will also be a squeeze on bank profitability. Thus, in contrast to the Asian economies (where the budget deficits were reasonable but the current account deficits were high), India had a relatively healthy current account. However, there are two primary connections between the twin deficits, which though elementary, need spelling out: (a)

a fiscal deficit with its inflationary consequences can push up the real exchange rate, which in turn may lead to a deterioration in the balance of trade; and (b) a fiscal deficit can also be interpreted as a signal of an impending crisis and dry up foreign capital inflows. Current account deficits will then have to be met by external commercial borrowings or by drawing down reserves. The real effective exchange rate (REER) appreciated by about 12.6 per cent over its 1990 level (see Table 5.2) and the trade balance deteriorated from 2.95 per cent of GDP (in 1994±95) to about 3.32 per cent of GDP (in 1996±97). The danger of trade balance deteriorating sharply enough to counterbalance the favourable showing on invisibles, and tilting the current account balance was real enough since export growth fell sharply in 1996±97 and declined even further in 1997±98. There is another potential consequence of the appreciating real exchange rate ± it makes non-tradeables more attractive for investment than tradeables. Both domestic and foreign investment is likely, as a consequence, to be diverted into non-tradeables such as real estate construction, hotels and tourism. This can lead to excessive exposure of financial institutions to these sectors ± a process very much in evidence in the Asian crisis economies. Fortunately, this has not yet happened in India for three reasons. Firstly, domestic banks have been severely restricted from lending to the real estate sector. Secondly, foreign capital cannot easily flow into these sectors because of the presence of capital controls. Finally, and most importantly, for the past few years the sector itself has been in the doldrums. However, foreign investors could be keen to invest in this sector if the current government's ambitious housing plans got under way (The Economist, 1998e).

Market or Government Failures? 97 Table 5.2 Selected vulnerability indicators in the financial and forex sectors (India)

REER (1990 = 100) Annual growth of total credit to private sector (%) Trade balance (% of GDP) Current account (% of GDP) Capital account (% of GDP) External liabilities of banks ($ billion) External liabilities of banks (% of GDP) External liabilities of non-bank private sector ($ billion) External liabilities of non-bank private sector (% of GDP) Claims held by foreign banks ($ billion) Claims held by foreign banks (rate of growth %) Short-term claims to total claims (%) Short-term claims to forex reserves (%)

1994±95

1995±96

1996±97

1997±98

84.2 10.3

82.8 19.5

81.0 11.9

87.4

2.95 1.1 3.1

3.46 1.8

3.32 1.0 9.8 2.8 30.2 8.5

14.76

15.72

18.78

19.2

6.5

19.46

47.11

45.39

41.24

35.32

39.83

30.13

Sources: IMF, International Financial Statistics; RBI Annual Report 1996±1997; Goldman Sachs; BIS Annual Reports ( June to June figures). Note: 1. In the case of REER, a decrease denotes appreciation.

That the high fiscal deficits have had (independent of the Asian crisis) an adverse impact on net foreign capital inflows is evident from Table 5.1. Between 1995±96 and 1996±97, foreign direct investment (FDI) declined marginally by about $90 million, but the fall in foreign portfolio investment (FPI) is far more precipitate (about $700 million). In the aftermath of the Asian crisis, foreign portfolio investors turned to net sellers of Indian stocks to recoup losses sustained in their Asian operations (The Banker, March 1998, p. 55). Matters were not helped by Moody's announcement in January 1998 that it was putting India on a rating watch. There was further bad news in May 1998 when Standard and Poor changed the outlook on India's credit rating from stable to negative. At the same time, the new `risk premium' attached to Indian corporate loans has had the effect of curtailing Indian com-

98 The Impact of the Asian Crisis on China and India

panies' access to external borrowing. However, the NRI deposits have been showing a healthy growth especially since under the new FCNR (B) scheme the exchange risk is borne by the banks. Table 5.2 shows for India, the evolution over recent years of indicators regarded as playing a key role in the possible onset of a crisis. The external liabilities of banks at 2.8 per cent of GDP in 1996±97 were of a size comparable to the domestic liabilities at 3.6 per cent of GDP. Thus bank borrowing abroad, while well below the Asian levels, was not insignificant. At $9.8 billion, these external borrowings now constitute about 38 per cent of the forex reserves. We do not have a break-down of the external liabilities by state-owned banks and private banks, but in all probability, the former would account for more than 80 per cent of the total. The foreign liabilities of stateowned banks have a strong element of sovereign guarantee (since a government will rarely allow a state-owned bank to fail). In China also, commercial borrowing (bank loans and bonds) represents the bulk (over 69 per cent) of all foreign debt (Beijing Review, 29 December±4 January 1998). The government rarely allows state-owned banks to fail (see Chapter 6). The external liabilities of the non-bank private sector are much higher at 8.5 per cent of GDP ± the bulk of this would be from finance companies, which were finding it increasingly attractive (until the recent risk premium alluded to above) to source funds from abroad.1 External liabilities of finance companies are technically not guaranteed sovereign debt. Nevertheless, given that the financial health of banks is intimately connected to that of finance companies, widespread failures among the latter can affect bank portfolios adversely. Thus, a close watch on the external borrowings of this sector is a necessity. Among international lenders, foreign banks are most prone to a herd mentality. Their refusal to roll over short-term loans was at the heart of the Latin American crises of the 1980s and the Asian crisis.2 Table 5.2 shows that in India, foreign bank lending from reporting BIS countries3 was growing at an average rate of 15 per cent during 1994±97. The key crisis-trigger is usually taken to be the ratio of short-term (less than one year) bank borrowing to a country's forex reserves. The rate of around 30 per cent (in 1996±97) may well be considered safely below the Plimsoll line of danger, and looks especially reassuring when compared with the extraordinarily high figure prevailing in the Asian economies (except Malaysia) around the time of the crisis (see Chapter 4, Table 4.2). However, this is no ground for complacency, as is evident from the

Market or Government Failures? 99

corresponding figure for Malaysia which was only slightly higher (at 41 per cent) when the crisis struck. Finally, a crucial vulnerability indicator is the overall health of the financial system, though this may be difficult to quantify. We have already noted that the financial fragility of the Asian economies played a major role in initiating and prolonging the crisis (and additionally contributing to its severity). The Indian financial system was in the throes of a serious financial crisis in 1991±92, when the $1.3 billion scandal erupted, involving several Indian and foreign banks. As a response to the scandal, the Reserve Bank of India (RBI) introduced prudential norms for the system, and state-owned banks were expected to attain a capital adequacy ratio (CAR) of 8 per cent by March 1996. At that time, the non-performing assets (NPAs) were estimated to account for about 25 per cent of the total assets in most state-owned banks, though for four identified weak banks this ratio was higher at 30 per cent. There is reason to believe that the level of NPAs in state-owned banks currently stands at about 16.5 per cent ± undoubtedly still a high figure. The non-bank finance companies (NBFCs), which have proliferated in the past decade, lent an additional dimension of volatility to the financial scenario. Currently, the number of NBFCs is estimated at about 40,000, with a wide range of activities (for example, leasing, hire purchase, stock brokering, and so on). By March 1996, the share of NBFC deposits in the net financial saving of the household sector was 17.5 per cent against the banks' share of 33 per cent. Thus banks seem to be facing stiff competition for deposits from NBFCs, which were virtually unregulated until January 1997. The NBFC sector ran into trouble after the severe downturn in the real estate and stock markets at the beginning of 1995. One of the large NBFCs (CRB Capital) was forced into liquidation in April 1997. Several other companies also faced panic runs and defaulted. The credit-rating agencies downgraded several top companies and additionally, NBFCs faced stiff competition from foreign companies (which have been allowed entry in the wake of the new WTO Agreement signed in 1993). As mentioned above, ill-health of the NBFCs can have an unfavourable impact on the banks' balance sheets, as loans and bills of accommodation turn bad.4 Our overall assessment of India's vulnerability shows that it weathered the crisis. India scored high on all indicators (for which data comparable with the Asian economies are available) except for the government budgetary deficit (see Table 5.3). Our discussion on the financial sector shows that potential problems do lurk below the surface, though

100 The Impact of the Asian Crisis on China and India Table 5.3 India's ranking on crisis indicators vis-aÁ-vis the affected Asian economies Indicator Government budget balance (% of GDP) External debt to GDP ratio External debt service (% of exports) (% of GDP) Current account to GDP ratio External liabilities of banks (% of GDP) Short-term claims/ forex reserves ratio

Korea, India Indonesia Rep. of Malaysia Philippines Thailand 6

2

5

3

4

1

1

4

±

3

4

2

2 1

4 4

± ±

1 3

± ±

3 2

1

3

2

4

±

5

1

2

3

4

5

6

2

6

5

1

3

4

Sources: Radelet and Sachs (1998); BIS (1996a, 1997a); RBI Annual Report (1996, 1997). Note: The ratings represent an ascending order of vulnerability: rank 1 corresponds to the least vulnerable country on that criterion and so on.

the overall situation was well under control. A determined effort at fiscal prudence, combined with strengthened financial supervision, could go a long way to buttress the economy's defences against the Asian crisis. China The impact of the Asian crisis on China has not been serious, but it has raised concern and provoked a rapid response. There are a number of differences between its impact on India and on China. While the Indian currency declined in value in the wake of the Asian crisis (see above), the Chinese yuan remained robust and actually appreciated in value somewhat, thanks to massive inflows of capital, big trade surplus and foreign exchange reserves (The Economist, 1997). Despite cheaper exports of neighbours after devaluation in the affected economies, China remained more export competitive than India and introduced measures to expand exports into new sectors and destinations. Furthermore, the Chinese response to the crisis was different from the Indian. For example, while the Indian government is wary of FDI and multinationals, the Chinese continue to attract FDI as a channel of technology transfer and means of ensuring international competitiveness. In the wake of the crisis, the Chinese government decided to accelerate reform of the financial sector, banking industry and state enterprises. Finally,

Market or Government Failures? 101

like India, China stimulated domestic demand through increased expenditure on infrastructure and housing. Unlike the affected economies and India, China's GDP growth remained high, although it slowed down from nearly 9 per cent in 1997 to 7.8 per cent in 1998, slightly below the target rate of 8 per cent, and a further slowing down was projected for 1999 (IMF, 1999b). The slowdown in growth in 1999 and after depends on the assumption of slackening of domestic and external demand, slowing down of export growth and capital inflows (see below). Unlike the affected Asian economies and India, China had no budget deficits; instead, it showed actual surplus. China's current account deficit at nearly 3 per cent of GDP in 1993 has turned into surplus since then thanks to massive FDI inflows and foreign exchange reserves (over $140 billion) (see Table 5.1). In the central budget for 1997, central expenditures exceeded revenues leaving a deficit of 56 billion yuan which is 1 billion yuan less than the budgeted amount. The revenue in the central budget for 1998 was 10 per cent higher than the figure for 1997, whereas the expenditure was only 7 per cent higher; the budget deficit in 1998 was 10 billion yuan less than that in 1997 (Beijing Review, 13±19 April 1998). The shares of short-term bank lending (up to oneyear maturity) is also much lower for China and India compared with those in the affected Asian economies. Between 1994 and 1997, the ratio of short-term lending was also lower in China although it had started rising after 1996. At the end of June 1997, short-term debt was 11.5 per cent of China's foreign debt of $118.6 billion (Beijing Review, 29 December 1997±4 January 1998) and at the end of 1997, it was about 14 per cent, higher than the Indian figure but much lower than the Korean and Thai figures. Commercial borrowing (bank loans and bonds) represents the bulk (over 69 per cent) of all foreign debt. The share of lending to the public sector declined and that to the non-bank private sector increased. The shares of loans to banks and non-bank private sector were quite similar. In general, in the affected economies an increase in non-bank private lending was explained by restrictions imposed on domestic banks and short-term capital inflows, fiscal consolidation and rapid expansion of international trade (BIS, 1996b, 1998b). In China similar factors accounted for growth of nonbank private lending (through rural and urban cooperatives, security firms, and financial institutions of such state bodies and ministries as State Science and Technology Commission). The Chinese government perceived the Asian crisis as a consequence of overborrowing of shortterm loans from abroad by enterprises and excessive lending by domestic

102 The Impact of the Asian Crisis on China and India

and foreign banks. It has, therefore, reaffirmed its policy of concentrating on FDI and medium- and long-term loans instead of short-term foreign borrowing which is to be subjected to greater scrutiny and control in future. Parallel to state banks, non-bank finance institutions such as rural and urban credit cooperatives and trust and investment companies (TICs) have grown, but not as rapidly as the non-bank financial institutions in India. Financing by rural cooperatives at the local level has continued to suffer from such abuses as speculative investment of rural deposits in the coastal areas and diversion of agricultural procurement funds (see Holmes, 1997). These non-banking institutions have not been functioning well and most TICs are known to be suffering from `triangular debt' which implicates the state banks and various government agencies. Their operations are overgrown and they are unlikely to survive without speculative investments which have now been curbed (100 TICs have already been disbanded). The collapse of the Hainan Development Bank is actually attributed to the financial problems of a large number of cooperatives which were merged with it (see below). According to the 1995 Commercial Banking Law, a narrow banking regime has been adopted under which banks are barred from investing in non-financial institutions or in trusts, securities and real estate business. Although China has escaped the fallout from the crisis, symptoms of a financial crisis do exist: high ratio of non-performing loans to total loans, ineffective supervision of the banking industry and high ratio of short-term debt to total reserves, for example. The non-performing loans are estimated between 20±25 per cent of the total loans, which are advanced to state enterprises and businessmen with strong political connections. However, not all these are `bad' loans which are said to represent only a little over 2 per cent; 20 per cent represent loans overdue for less than two years, which are rescheduled; another 3 per cent are loans outstanding for over two years (personal interview with Professor Jianglin Wu of the Development Research Centre of the State Council, London, 14 September 1998). The overall health of the Chinese banking and financial system is considered even shakier than that of the Republic of Korea and Thailand. The ratio of non-performaing loans in China is higher than the ratios in these two countries before the crisis. Also the top four state banks (the Industrial and Commercial Bank, the Bank of China, China Construction Bank and the Agricultural Bank of China) have equityto-assets ratios ranging from a little over 2 per cent to about 5 per cent, which is well below the BIS international capital standard (8 per cent).

Market or Government Failures? 103

Perceptions of international lenders to China have also changed for the worse as was indicated in early 1998 when Moody's Investors Service downgraded nine Chinese banks and their foreign currency debt (Lardy, 1998a). As we shall discuss in Chapter 6, the state-owned enterprises are not allowed to go bankrupt even though bankruptcy laws are now in place. The mounting losses suffered by these enterprises have raised the share of bad loans. Banks continue to provide working capital loans to lossmaking enterprises (`soft-budget' constraint) to allow them to remain afloat since they provide massive employment and social welfare services to workers. Excessive domestic credit is another vulnerability indicator. In China outstanding credit of financial institutions grew from 190 billion yuan in 1978 (about 53 per cent of GDP) to 7.5 trillion yuan in 1997 (or 100 per cent of GDP) (Lardy, 1998a). High growth in domestic credit is reflected in high debt-to-equity ratio of state-owned enterprises and large excess capacity in many industries such as automobiles. Financial liberalization in China, intended to build a financial system on the basis of market principles and decentralized decision-making, has not yet gone far enough. This is indicated by the fact that the People's Bank of China (PBC) still operates very much as it did before; that is, it continues to bail out state-owned enterprises by financing budget deficits under government instructions. This prevents the PBC from carrying out independent monetary policy. Lardy (1998a) notes the lack of independence of the Chinese central bank and its poor regulation of commercial banks. The largest banks are not subjected to independent audit. In November 1997 the Chinese Communist Party newspaper, People's Daily, recognized that some financial institutions operated in violation of laws and regulations and that criminal activities and corruption were widespread (cited in Lardy, 1998a). The banking reforms are tied up with other reforms particularly of state-owned enterprises which have so far been slow and limited (see below). Furthermore, no legal framework exists to deal with nonperforming loans, with the result that the banks cannot be held responsible for their profits and losses. Neither do they lend on the basis of commercial criteria: at the local level, branch offices of these banks are pressured by local governments to give loans even for dubious and non-profitable projects (see Chai, 1997). Regulatory oversight of banks and non-bank financial institutions remains lax for lack of national legal standards in the form of security law, trust law and bankruptcy legislation.

104 The Impact of the Asian Crisis on China and India

However, the collapse and closure of the Hainan Development Bank (HDB) in June 1998 suggests that the Asian crisis may have finally triggered serious banking reforms in China. This is the first bank to be closed in China since 1949. The bank was set up to finance Hainan's development which expanded rapidly by opening up branches even outside the province. In 1996, the bank showed signs of poor performance as its reserves against bad loans (14.5 million yuan) represented only 0.4 per cent of outstanding loans (Gilley, 1998). The provincial government made the HDB take over 28 credit unions (urban cooperatives) and their debt to the tune of 445 million yuan. It is widely believed that the financial crisis of the 33 credit unions (five were subsequently closed) occurred in the wake of the bursting of the property boom in the early 1990s. Many observers believe that the collapse of HDB would have been avoided if the merger of credit unions had not taken place. Mobilization of new capital from major banks, state enterprises and foreign investors by the central and provincial governments is a better solution to the weak financial institutions. The banking practice shown up in the handling of the closure of the HDB shows that China is very different from India and other developing countries. The central government forced the biggest bank, the Industrial and Commercial Bank of China (which has its own problem of bad loans) to pay back in full all the HDB creditors. The depositiors are separately insured by the government. In most other countries, creditors are treated the same way as shareholders so that they are not bailed out in the case of bank failure. The above government guarantee can worsen the moral-hazards problem by encouraging investors to keep pouring money into weak banks. The Chinese government, therefore, faces a serious dilemma. It would like to accelerate financial liberalization to promote economic and business efficiency and integrate more fully into the global economy. But unless the performance of the banking sector is first improved (a huge task without accompanying reforms of state-owned enterprises and institutional and legal reforms), exposing the sector to external competition can bring about a banking crisis as has been shown by the recent experiences of East Asia. It is perhaps for this reason more than any other that foreign banks operating in China are not allowed to make local-currency loans or take local-currency deposits. It is feared that deposits would be switched from the four state banks to branches of foreign banks thus leading to the former's collapse. To conclude, these failures raise risk premium for fund-raising by other state-owned companies and their subsidiaries listed in Hong

Market or Government Failures? 105

Kong (so-called `red chips'). Other symptoms of a financial crisis noted above include: a high ratio of non-performing loans to total loans (about 20 per cent to 30 per cent), low equity-to-asset ratios, ineffective supervision of the banking industry, and a high ratio of short-term debt to total reserves. Heavy lending to the Chinese state-owned enterprises, property lending and bad loans are features in common with the affected Southeast Asian economies (Lardy, 1998a, 1998b; and Chapter 6). There is also a lack of national legal standards of security and bankruptcy legislation.

TRADE IMPACT India The direct impact of the crisis on India's exports has been somewhat limited since (as Table 5.4 shows) the six crisis economies including Hong Kong account for 10 to 15 per cent of India's total exports. Exports to Hong Kong were moderately affected by the crisis, showing a decline in 1998. India exports mainly to the industrial countries, with the US and Japan being its two top trading partners. In contrast, China's trade with the other Asian economies (including Japan) is significant and is much higher than that of India. If we make the simplifying assumption that Indian exports succeed in maintaining their pre-crisis market shares in the major destination countries, the projected growth rate of Indian exports is simply the weighted average of GDP growth rates in the major markets, with the weights being the share of each market in India's exports.5 Such a calculation yields a figure of 3.21 per cent for India's export growth in 1998 on the basis of the IMF forecasts. If the more recent (and possibly more realistic) forecasts by The Economist are used, the rate is even lower at 2.79 per cent. These low figures are extremely worrying, coming as they do in succession to a record low rate of growth of exports of 4.1 per cent for 1996±97.6 How realistic is the assumption of constant market shares in this situation? There was very a steep depreciation of the currencies of the five crisis Asian economies,7 whereas the Indian currency depreciated only by 18 per cent (from June 1997 to June 1998). The affected Asian economies are India's competitors in several markets: (i) in the case of tea, Indonesia is a competitor in the major markets of Russia and the UK; (ii) in the case of coffee also, Indonesia is a competitor in the markets of Germany, Italy, Russia and the US; (iii) for rice the competition comes

106 Table 5.4 Composition of trade: India and China (percentages of world totals) Exports

Imports

1994 1995 1996 1997 1998

1994 1995 1996 1997 1998

India Industrial 58.4 55.0 55.1 54.1 56.6 countries US 19.3 17.4 17.0 19.3 20.9 Japan 7.9 7.0 7.3 5.6 5.1 Crisis Asian economies (incl. Hong Kong) 10.7 10.5 14.8 12.5 9.3 (excl. Hong Kong) 5.2 6.0 9.6 11.5 5.3 Indonesia 1.0 1.6 1.8 1.8 1.5 Hong Kong 5.6 5.9 5.2 5.8 4.6 Korea, Rep. of 1.1 1.3 2.4 1.4 1.4 Malaysia 1.0 1.2 1.6 1.6 1.1 Philippines 0.4 0.4 2.1 0.7 0.3 Thailand 1.5 1.5 1.7 1.2 1.0 World total ($ billion) 24.2 30.5 34.4 33.3 36.7 China Industrial countries US Japan Crisis Asian economies (incl. Hong Kong) (excl. Hong Kong) Indonesia Hong Kong Korea, Rep. of Malaysia Philippines Thailand World total ($ billion)

49.4 48.3 51.3 50.7 48.2 9.4 7.1

9.7 6.5

9.1 6.6

9.5 5.8

9.1 6.1

6.7

6.6

10.4

9.5

13.0

6.0 1.1 0.7 2.7 1.7 0.03 0.6

5.9 1.1 0.7 2.1 2.2 0.05 0.4

7.6 1.4 1.8 2.5 3.2 0.05 0.6

11.4 1.7 1.6 4.1 4.7 0.09 0.7

7.0 1.1 2.0 3.1 3.1 0.05 0.7

26.0 34.5 40.1 42.0 43.4

51.2 51.0 54.3 51.3 55.3 17.3 16.8 17.9 17.9 20.7 17.3 18.8 20.5 17.4 16.2

55.9 55.3 55.2 50.2 51.6 12.0 12.1 11.7 11.4 12.1 22.7 22.0 21.0 20.4 20.2

33.0 32.2 29.8 32.5 27.5

18.6 18.8 19.5 20.7 16.9

6.8 8.2 8.3 8.6 6.4 0.8 0.9 0.9 1.0 0.6 26.4 24.2 21.8 23.9 21.1 3.6 4.5 5.0 5.0 3.4 0.9 0.9 0.9 1.0 0.9 0.4 0.7 0.7 0.7 0.8 0.9 1.1 0.8 0.8 0.6

10.1 1.4 8.2 6.3 1.4 0.2 0.8

9.2 1.5 6.5 7.8 1.5 0.2 1.2

13.9 15.7 16.4 1.6 1.9 1.7 5.6 4.9 4.7 9.0 10.5 10.7 1.6 1.7 1.9 0.3 0.2 0.4 1.4 1.4 1.7

120.8 148.9 151.0 182.9 183.7 115.6 132.0 138.8 142.1 140.4

Source: IMF, Direction of Trade Statistics, various years. Note: Industrial countries include: US, Canada, Japan, Australia, New Zealand, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the UK.

Market or Government Failures? 107

from Indonesia and Thailand in the following major markets ± Bangladesh, Kuwait, Russia, South Africa, the UK and the US; (iv) for oil meals India faces competition from Malaysia and Thailand in the markets of China, the Republic of Korea, Japan, Singapore and the Philippines; (v) for marine products, India's major competitors are Indonesia and Thailand for markets in China, Japan, Spain, the UK and the US; (vi) for engineering goods, Indonesia, the Republic of Korea, Malaysia and Thailand are India's major competitors in the German, Singaporean, British and American markets; and (vii) finally, Indian textiles face competition from the Republic of Korea, Thailand and the Philippines in Germany, Hong Kong, the UK and the US. It was feared that the relatively steep devaluations by the Southeast Asian economies might price Indian goods out of several markets. However, at least in the short run this fear did not materialize for three reasons: (a)

a tight monetary policy and restructuring of the financial systems undertaken by the above economies under the IMF agenda hurt their exports. High interest rates pushed up exporters' costs (especially in Indonesia and Thailand) and the extensive public borrowings (by the governments from the banking system) meant that banks preferred lending to central banks rather than to exporters ± a classic case of `crowding out'; (b) a substantial amount of imports is used in the countries' exports (that is, exports are highly import-intensive) ± currency depreciation then cuts both ways; and (c) exporters had difficulty not only in securing letters of credit through local banks but also in finding containers to ship their exports (since imports collapsed in the wake of the downturn, very few ships called at the ports in the first place). The first quarterly figures for 1998 showed an average fall of 5 per cent in the Asian exports, leading credence to the above picture. Indonesia, a leading competitor for India in the textiles and footwear exports, faced serious adjustment problems in these sectors (Financial Times, 9 June 1998).8 Thus, while one perceived no immediate threat to Indian exports from the Asian devaluations, the above export forecasts for India focus exclusively on the demand side, more specifically on the income elasticities facing Indian exports in the importing countries. But there are several other non-income factors that have come into play. The RBI

108 The Impact of the Asian Crisis on China and India

Annual Report of 1997 has drawn attention in particular to the following structural factors: anti-dumping duties in the European Union (EU) on Indian textiles; import licensing requirements for a variety of food and agricultural products in such countries as Canada; health requirement legislation on leather products imported into the EU; issue of child labour in the carpet industry; close scrutiny by Indian courts of the environmental degradation caused by leather and tanning firms resulting in some dislocation of industrial firms and cost escalation; and fluctuations in the cost of international raw materials in the gems and jewellery sectors. If the above structural factors are taken into account,9 the assumption of constant market shares begins to appear over-optimistic, and exports may well enter a near-stagnation phase. China Continued slow growth and recession in the affected Asian economies led to a decline in China's export growth from nearly 26 per cent in July 1997 to 3.4 per cent in June 1998 (HKTDC, 1998). However, while Chinese exports to the Republic of Korea and Japan fell by 30 per cent and 4.3 per cent respectively during the first seven months of 1998, its exports to Australia, Russia, the European Union and the US continued to grow appreciably (see Table 5.5). If we take the sectoral composition, exports of resource-based primary products were particularly hard hit. For example, in the first five months of 1998, exports of mineral fuel dropped by 32 per cent, iron and steel by 25 per cent and cotton by Table 5.5 China's trade with major partners (first seven months of 1998) Country/region

ASEAN Japan Korea, Rep. of Australia Hong Kong European Union Russia Taiwan United States Source: Huang (1998).

Exports

Imports

Value ($ million) Growth (%)

Value ($ million) Growth (%)

59.1 161.0 34.2 12.3 241.2 155.7 11.7 21.1 201.9

70.0 154.3 85.6 14.1 37.0 101.2 20.8 92.6 90.0

13.7 4.3 30.3 ‡20.2 ‡2.0 ‡25.6 ‡39.2 ‡20.6 ‡18.2

‡4.3 ‡0.2 ‡8.0 17.9 2.7 ‡5.8 15.3 ‡5.5 0.3

Market or Government Failures? 109

17 per cent. While growth of manufactured exports has also declined, it is less affected (see Figure 5.1). Exports of such goods as garments, toys, footwear and electrical machinery continued to grow in the first half of 1998 particularly to the European Union and the United States (HKTDC, 1998). This suggests that China's exports remain price competitive despite the depreciation and realignment of Asian currencies. Besides price competitiveness there are quality aspects on which China has concentrated through technological and managerial improvements. In response to the possible negative impact of the crisis, the Chinese government introduced a series of special measures to maintain and expand exports: promotion of the export of high value-added hightech goods; simplification of the export tax-refund system; raising of export tax credits for textiles, machinery and electronics; increase in June 1998 of the export tax rebate on coal, steel, cement and shipping; permission to private firms to export and import directly (from 1 January 1999) without having to go through the state-owned foreign trade companies; relaxation of export licences on some commodities; exploration of new markets in Africa, Latin America and the Commonwealth of Independent States; and diversification of the commodity composition of exports (Beijing Review, 30 March±5 April 1998; Business Week, 1 June 1998). China has not considered devaluation as an option for expanding (%) 30 25

Manufactured Products Exports

20 15 10 Primary Products Exports

5

Total Exports

0 –5 –10 –15 –20 7/97

8/97

9/97

10/97 11/97 12/97 1/98

2/98

3/98

Figure 5.1 China's exports of primary and manufactured products Source: HKTDC (1998).

4/98

5/98

110 The Impact of the Asian Crisis on China and India

exports. A devaluation of the yuan would probably result in competitive devaluations by the neighbouring economies thus prolonging the Asian crisis. It would also erode the international support and goodwill that China has built up by not devaluing (CreÂdit Suisse, 1998).10 In the longer run, the effect on the Chinese and Indian exports will depend on the strength of the income and price effects on demand for these exports. They are unlikely to be adversely affected to the extent that these countries produce goods for export that are different from those of the affected Asian economies. This is particularly true in the case of China whose export volume contains over 50 per cent of processed goods involving labour-intensive assembly (Fernald et al., 1999).

IMPACT ON CAPITAL INFLOWS India The impact of the crisis on capital inflows is rather mixed. In India, liberalization in 1991 led to a steady inflow of foreign investment although such inflows were quite modest compared with those to China and East and Southeast Asian countries. As Table 5.6 indicates, even the modest capital inflows in the form of foreign direct investment (FDI) and foreign portfolio investment (FPI) showed signs of slackening for the fiscal year 1996±97; that is, even before the crisis. The fall in FPI was particularly pronounced, associated mainly with the steep downward movements in the Indian stock markets in the second half of 1996. In the wake of the crisis, in all probability, FDI into India from the Southeast Asian economies themselves may have declined, but as this constitutes a meagre 6.5 per cent of total FDI into India, the damage cannot be excessive.11 There had been a steady inflow of foreign investment into India in the wake of the 1991 liberalization. But these inflows were quite modest relative to those experienced in China and the other Asian countries. As Table 5.6 indicates, even the modest capital inflow was showing signs of slackening in the case of both foreign direct investment (FDI) and foreign portfolio investment (FPI) for the fiscal year 1996±97; that is, even before the Asian crisis. The fall in FPI was particularly pronounced, associated mainly with the steep downward movements in the Indian stock markets in the second half of 1996. But it is hard to judge whether this is a cause or a consequence. In principle, the immediate impact of the Asian crisis on FPI inflows into India could have been unfavourable for at least three reasons:

111 Table 5.6 Foreign capital inflows: India and China ($ billion and percentages) India

1990±91 1993±94 1994±95 1995±96 1996±97 1997±98

Foreign investment Foreign portfolio investment External assistance External commercial borrowings Non-resident deposits Total inflows Proportion of non-debt creating flows to debt creating flows (%) Foreign direct investment as percentage of gross fixed capital formation China Net private capital inflows Net official capital flows (FDI) UNCTAD estimates IMF estimates Official estimates FDI as % of gross fixed capital formation FDI as % of GDP Foreign portfolio investment External borrowing

0.10

0.6

1.23

1.96

2.52

3.12

0.09

3.6

3.58

2.73

3.3

1.78

2.2

1.9

1.52

1.01

1.12

0.9

2.25

0.61

1.02

1.37

2.82

3.87

1.54 7.18

1.2 9.69

0.17 9.16

1.15 4.68

3.35 11.29

1.15 10.98

179.28

78.57

97.17

n.a

1.7

223.5

224.3

0.3

1.7

1.4

2.3

2.9

1990

1994

1995

1996

1997

1.9*

14.6

13.9

23.0

50.1

Ð

2.9*

9.3

6.9

7.0

Ð

Ð

4.4* 3.5 3.5

33.8 33.8 33.8

35.8 35.8 37.5

40.8 40.2 41.7

45.3 44.2 52.4

Ð Ð 34.0

3.3* Ð

17.1 7.0

15.7 6.3

17.0 5.8

Ð 5.6

Ð Ð

0.6

3.9

0.7

2.4

7.7

Ð

6.5

9.3

10.3

12.7

12.0

Ð

1998**

Sources: UNCTAD (1997, 1998); World Bank: World Development Report 1998; IMF: International Financial Statistics and Balance of Payments Statistics; China Statistical Yearbook 1997; RBI: Annual Report 1997±98. Note:* ± 1991. ** ± forecast. Ð ˆ not available.

112 The Impact of the Asian Crisis on China and India

(a)

Firstly, funds from the affected Asian economies would have been recalled. (b) Secondly, those who suffered losses in the crisis economies would have been under intense selling pressure to liquidate their portfolios in other emerging markets, to meet their solvency requirements. (c) Finally, the fear of contagion spreading to other countries in the region would have made investors wary of investing in the region as a whole. To a large extent these were justified, with portfolio investors in India becoming net sellers in November 1997, as the crisis got into top gear. The medium and long-term impacts of the crisis on FPI into India are far more difficult to assess. It is possible that India could benefit from a substitution effect, whereby global investors switch their portfolios away from the Asian economies into other emerging economies. The crucial imponderable here is the stock market volatility. Examining the share prices in dollar12 (Table 5.7) from December 1997 to June 1998, Indian stock indices lost out to several other clear winners among the emerging markets (for example, China, Greece and Portugal). There is of course, a vicious circle here ± FPI will not be forthcoming unless stock markets revive, but such a revival itself depends (to some degree) on the sustained inflow of FPI. However, competition for portfolio equity is not restricted to emerging markets only. The stock market booms in industrial countries have meant a reappraisal of investment banks' approach to emerging markets. Lehman Bros. and Schroders are cutting back in Asia; ING Barings has retrenched its operations in Latin America, and Peregrine has gone bankrupt. What investment bankers in general seem to have overlooked, in the earlier euphoria over emerging markets, was that emerging market trading was not only subject to greater volatility, but that the trading operations also implied greater lock-up of capital. In adverse times shares are difficult to hedge. Hence to make markets in shares, traders must own some investment themselves. This need for extra capital handicaps smaller investment banks, which also find it difficult to supply the global services demanded by big investors. The general thinking among investors now seems to be to buy shares in mulitnational companies (MNCs) with a presence in emerging markets rather than investing directly in emerging market equities. There is also interest in investing in local debt instruments such as treasury bills, municipal bonds, and so on. This should be of more than passing interest to India with its large public borrowing programme ($15.5 billion for 1998±99).

Market or Government Failures? 113

India also opened up its domestic gilt market to foreign investors in January 1997, though the response so far at $400 million has been disappointing. The more important issue is how the crisis has affected global attitudes to the entire region. An UNCTAD/ICC survey (February 1998) covering 500 companies reported that the majority of respondents had not lost their confidence in the Asian region as an investment destination. Even though the survey was mainly focused on the troubled Asian economies, several perceptions carry over to other countries in the region, such as India. Among the favourable factors mentioned by the respondents were the following: (a)

Currency devaluations are particularly attractive to foreign investors, since they imply lower costs of production in dollar terms (this factor, however, is nullified under strong inflationary tendencies). (b) Lower property prices reduce the foreign currency costs of acquiring such fixed assets as land and buildings. (c) The restructuring of firms provides opportunities for MNCs to undertake direct investments in the region through mergers and acquisitions (M&As).13 The first two factors are certainly relevant in the Indian context (though obviously, to a much lesser extent than in the Asian economies). Takeovers were made possible by regulations introduced by the Indian government in 1997, but it is widely felt that they do not go far enough to allow full-scale market-driven M&As, which is what foreign investors are really looking for. One clause which has generated much dissatisfaction stipulates that anyone acquiring over 10 per cent of a company's shares must make a public offer of another 20 per cent. Another source of difficulty is that company directors can ward off predators by issuing cheap shares to big shareholders via preferential allotments. Takeovers by foreign companies face several additional problems.14 Of course, the crucial factor influencing FDI is the perceived official attitude to foreign investment. The Dabhol fiasco (the Enron Energy Project) drove home the strong message to foreign investors, that India was a market where formal contracts made with state governments, might not be honoured.15 Whatever the dubious economic gains secured at the end of a protracted and unsavoury drama, the fact remains that India's credibility suffered a serious dent in the international investors' psyche.

114 The Impact of the Asian Crisis on China and India

The signals being sent forth by the newly formed coalition government were hardly encouraging. The Budget (1998±99) was widely interpreted abroad as a roll-back of the liberalization process.16 Those who had expected the Budget to woo foreign investment to fill the breach occasioned by economic sanctions (in the wake of nuclear tests) and the freezing of official aid, were disappointed. No explicit measures to attract foreign investment were announced, except a verbal assurance from the Finance Minister of cutting red tape and speeding up the approval process. The future inflow of FDI will be the outcome of a `wait and watch' policy by investors. FDI may gather some momentum if the minority government is able to implement its limited agenda of domestic liberalization. In all probability, however, FDI will continue at its current meagre level, if not fall off altogether to the pre-1991 trickle. But even if this latter event materializes, the blame will lie much less with the Asian crisis, than with the Indian government's policies. China FDI inflows into China remain impressive with the level attained in 1997 much higher than in 1996, according to official statistics (see Table 5.6). However, in the first half of 1998, actual FDI fell by 1.3 per cent although contract foreign investment grew by 5.5 per cent (International Herald Tribune, 18±19 July 1998). Besides Japan, Chinese investors from Hong Kong, Malaysia, Singapore and Taiwan were the major sources of FDI prior to the crisis, accounting for 80 per cent of FDI (see Bhalla, 1998). The share of Hong Kong shrank from 55±60 per cent in 1996 to 46 per cent in 1997 and 48 per cent in the first quarter of 1998. However, according to Professor Wang Zhenzheng, Deputy Director of the Institute of CASS (Beijing), FDI from Taiwan has actually increased (personal interview, October 1998). Factors other than the Asian crisis also explain the slowdown in FDI inflows into China which occurred even before the crisis (during the first half of 1997): elimination of preferential treatment for foreign enterprises in the second quarter of 1996; greater selectivity in accepting foreign projects with emphasis on quality rather than quantity. With effect from 1 January 1998, preference is being given to FDI projects in agriculture, environmental protection, new technology and projects in the non-coastal provinces (World Bank, 1998b). China is making special efforts to restore foreign investors' confidence once again by offering them preferences. Thus from 1 January 1999, foreign investors will receive the tax rebate for exports as do local businesses; in Fujian, Jiangsu and Zhejiang, powers have been delegated

Market or Government Failures? 115

to city officials and trade and development zones to approve certain projects of up to $30 million; in Shanghai, procedures have been simplified for foreign investors registering and seeking approval of licences to run trading companies in the Waigaoqia Free Trade Zone. Purchase by foreign investors of state-owned companies is also being encouraged, except in such strategic industries as telecommunications and banking.17 Portfolio capital flows to China tend to be limited partly because of the limited size of an incipient stock market, which has, however, been growing very rapidly. Indirect investments in China's capital market via the Hong Kong stock market have been rising rapidly. The ratio of capitalization to GDP rose from 0.5 per cent in 1991 to nearly 23 per cent in 1997, whereas for India these ratios were 19 per cent in 1991 and 27.4 per cent in 1998. In China the number of listed companies increased dramatically between 1991 and 1998, whereas in India the increase has been less dramatic (see Table 5.7). The 1997 Asian financial crisis adversely affected the Chinese stock market. Chinese shares (in Shanghai, Shenzhen and Hong Kong) suffered substantial losses in 1998. China's central bank ordered all firms to repatriate unauthorized foreign currency abroad. With effect from 1 July 1999, China's first comprehensive securities law went into force. This law covers stock trading and functioning of stock exchanges and securities firms. The future functioning of stock markets is likely to be affected by the precise nature of the reform of local and central state enterprises. In China securities firms are expected to delink from state banks and the government plans to allow mergers and acquisitions (M&As) of these firms. A beginning has been made by including M&As in the activities of the China International Capital Corporation, a new Chinese foreign investment bank. However, the official policy on M&As of enterprises is unlikely to yield benefits in the absence of clear guidelines. China has traditionally given more credible signals to foreign investors than has India where official ambivalence continues due partly to a weak coalition government and political instability. Deals with Kodak and Citibank, noted above, reconfirm China's commitment to FDI inflows. Investment liberalization measures in China include special tax concessions, liberalized leasing of land to foreign enterprises in coastal cities, foreign participation in property and port development, power generation and retailing. As a result of guidelines issued in 1995, such sectors as transportation and communications, insurance and other service industries have also been opened up. Foreign-funded law

Source: IFC (1999).

Market capitalization ($ million) Market capitalization (% of GDP) Value of trade (% of GDP) Turnover ratio (%) Number of listed companies 14.0 31.3 329.0 540

0.2 ± 14

113,755

1996

0.5

2,028

1991

Table 5.7 Stock markets: China and India

41.0 231.0 764

22.9

206,366

1997

China

±

± 130.1 853

231,322

1998

9.6 56.8 2,556

19.0

47,730

1991

7.4 21.2 5,999

34.1

122,605

1996

14.1 41.6 5,843

33.7

128,466

1997

India

16.8 56.0 5,860

27.4

105,188

1998

116

Market or Government Failures? 117

and consultancy agencies are now being allowed to operate. An FDI Confidence Index Survey undertaken in February±April 1998 by a USbased management consulting firm ranked China as the third most favoured FDI destination after the US and Brazil (World Bank, 1998b).

IMPACT OF DOMESTIC POLICIES Attempts to ward off possible contagion from the Asian crisis have usually assumed the form of currency depreciation and tightening of the macroeconomic screw by squeezing liquidity. The latter places steep upward pressure on interest rates which may result in economic slowdown. A choice has to be made between a heavy currency depreciation and a rise in interest rates. Currency depreciation cannot continue indefinitely; at some stage contractionary policies have to be introduced. The sooner they are, the lower is the adjustment cost to the economy. If these policies are introduced early, that is, before the currency has lost substantial ground, they can help restore investor confidence to some degree. The contractionary policy can be slowly eased as foreign inflows return to normal levels. The Reserve Bank of India (RBI) (judging from its actions in the first half of 1998) leaned towards seemingly the lesser of the two evils by shoring up market interest rates rather than allowing very steep currency depreciation.18 Since 1993 China has pursued a contractionary policy and an austerity programme of credit squeeze to control inflation and curb speculation in property and stock markets. In 1998, this austerity programme gave way to that of expansion and spending in an effort to accelerate growth. Interest rates have been lowered and credit squeeze lifted. Thus in contrast to India's tight monetary policy, China has followed a policy of monetary expansion to counter the crisis.19 One indirect effect of the slowing down of capital inflows (particularly, FDI) into China could be the slowing down of the restructuring of state-owned enterprises which entails a significant reallocation of labour and capital for which substantial investment in new enterprises is required (Chapter 6 and Fernald et al., 1999).

IMPACT ON THE FUTURE OF REFORMS To put the following discussion in perspective it is perhaps best to spell out our own attitudes to liberalization explicitly. In tune with the prevailing paradigm, we do believe in the virtues of liberalization per se. However, its consequences would be crucially dependent on the

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contents, pace and sequencing of reforms. Following the conventional taxonomy we divide reforms into those bearing on: (i) domestic real sector (privatization, industrial delicensing and deregulation, subsidy removal and so on); (ii) domestic financial sector (banking sector deregulation and capital market reforms); (iii) international real sector (liberalization of trade and FDI); and (iv) international financial sector (liberalization of FPI, capital account and forex markets). The different aspects of the reform process are likely to meet varying degrees of political resistance in previously heavily regulated economies such as India and China. Hence progress in reform implementation is likely to be uneven and sometimes haphazard. Nevertheless, a certain `balance' between the different aspects is necessary ± a fact not always stressed in the literature on reforms. In our opinion, the early stages of reform should be characterized by an emphasis on the real sector (domestic and international) with particular attention to subsidy pruning, privatization, tariff reduction and liberalization of FDI. This should be accompanied by deregulation of interest rates and a move towards a market-determined exchange rate. Important domestic financial-sector reforms must follow on the heels of this development. In particular, financial institutions must be opened up to foreign competition and be freed from excessive government regulations. However, deregulation should be gradual and should not be equated with laissez-faire. It is necessary to put a strong financial supervisory system in place with the supervisor as an autonomous body free from government control. Another key component of financial-sector reforms is the capital market, where investor confidence needs to be built up through a credible supervisory authority and a general strengthening of shareholders' rights. Finally, our views on FPI and capital account liberalization are rather cautious. Recognizing that capital inflows can often be speculative and destabilizing we feel that they should constitute the last stages of a liberalization strategy. A premature freeing of the capital account could abort an otherwise well-conceived reforms package. In retrospect the Asian crisis seems to vindicate this caution. The most notable difficulty in assessing the Indian and Chinese governments' responses to the crisis stems from the fact that it will depend upon what these governments perceive as the underlying key factors. In India, the 1998±99 budget has provided us with an inkling of what to expect in the future. The Budget has three major thrusts: (i) an announcement of an explicit privatization programme (a maximum of 74 per cent of government equity to be divested in non-strategic

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public-sector enterprises); (ii) a significant rise in import duties; and (iii) a massive programme of public borrowing to finance a steep increase in public investment outlay. Privatization is definitely a much-needed step forward, and even though the budget intends it as a revenue-boosting fiscal measure (its feasibility and ultimate implementation is also much in doubt), it still serves the useful purpose of sending signals that the reforms agenda has not been completely thrown overboard. The raising of import duties on several items and the levy of a flat import surcharge could be explained either as an unequivocal assertion of the swadeshi (self-reliant) philosophy or as a temporary once-for-all response to the crisis.20 If the former interpretation is valid, it would mean rolling back much of the impressive progress in trade liberalization recorded in recent years. It could also presage several other importsubstitution measures under the nationalist guise of self-reliance. But the alternative explanation (of a temporary response to the crisis) cannot be altogether overruled. After all, if India's export markets are in danger of being squeezed by cheapened Southeast Asian products (though this has not happened so far), the government may well reason that Indian industries must have an assured domestic market to sustain their production levels.21 If the crisis is perceived as mainly a financial crisis, the appropriate remedies sought will be in the direction of strengthening financial supervision. The Chinese government has accelerated banking reforms since the crisis. Such initiatives as the chibor market (interbank market initiated in 1996 to supplant formal and informal markets in bank deposits) and the People's Bank of China (PBC) open market operations are steps in that direction. Other banking reforms include: recapitalizing banks, curbing rampant growth of finance companies with irregular practices, reducing the number of branches of PBC to curb local fraud and speculation; tightening of bank supervision and control; permitting bank branches to set interest rates for corporate loans based on risk within a prescribed band, and lifting of loan quotas so that banks are more flexible in responding to demand. The closure in June 1998 of China Venturetech Corporation, Hainan Development Bank and Guangdong International Trust & Investment Corporation are examples of China's determination and decisiveness to reform the debt-ridden banking system. It is a clear signal to the banks and state enterprises that in future bailouts and government guarantees cannot be counted upon. China's Cabinet has approved new regulations on the closing down of illegal financial institutions, which augurs well for a broader cleanup in future. As the restructuring programme for state

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enterprises makes progress, large amounts of bad loans ($200 billion) to these enterprises will have to be written off. To finance these write-offs the Central Government allocated substantial sums: 20 billion yuan in 1996, 30 billion yuan in 1997 and an estimated 40 billion yuan in 1998 (Lardy, 1998a). In February 1998, the Finance Ministry planned a $32.5 billion special bond issue with a view to raise capital for state-owned commercial banks (Far Eastern Economic Review, 12 March 1998) which is a step in the right direction although the amount is far below what is required for bank re-capitalization. Financial liberalization without adequate safeguards is generally viewed as one of the factors responsible for the crisis. China exercises central control on banks and corporations, which are not allowed to borrow or lend capital abroad without government approval. This makes the yuan much less vulnerable to changes in investor sentiment or speculative attacks. Indeed, hasty capital liberalization may be inadvisable until such time as the banking industry clears its bad debts and appropriate supervision mechanisms are properly implemented (see below). In the Indian case, there is a tendency to slow-pedal reforms in such areas as privatization, trade and capital liberalization (judging by the recent significant increase in import duties and a levy of flat import surcharge). China has also adjusted its import duties on equipment since 1 January 1998. But instead of raising them, it has exempted imports of equipment from import tax and value-added tax in order to encourage technological modernization (Beijing Review, 16±22 February 1998). However, some imported commodities continue to be subject to import tax in order to discourage importing of low-technology machinery and equipment that can be manufactured at home. China's response to the crisis is thus different from that of India. As noted above, China has in fact, accelerated restructuring and reform of state banks and state enterprises. The Chinese Premier, Zhu Rongji, has given state enterprises and state banks only three years to restructure even at the cost of social hardships in terms of worker retrenchment. The number of government workers is to be reduced by half with the abolition of several ministries. Privatization of housing (formerly provided by the state) has been announced to stimulate domestic demand to compensate for the fall in export demand resulting from the crisis. However, the failure to reform and privatize state enterprises in China is likely to act as a drag on banking and financial reforms. These enterprises are making heavy losses and most of the non-performing loans by the state banks are to these enterprises; part of the losses by such

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enterprises are, of course, attributable to the various social services provided to the employees (see Chapter 6). In the absence of state enterprise reforms, commercial lending criteria cannot be introduced by state banks. In June 1998, the Central Bank appealed to commercial banks to provide more working capital to loss-making state enterprises. Further in July 1998, the State Economic and Trade Commission ordered local governments to slow down the sale of state-owned enterprises for fear of social unrest. The three policy banks (the State Development Bank, the Exports and Imports Bank and the Agricultural Development Bank) set up to relieve state banks of policy-directed lendings, have not been very successful owing to uncertainty of funding resources and lack of well-defined procedures (Holmes 1997, p. 743).

NEED FOR FINANCIAL REFORMS We find ourselves on firmer ground, when we turn to the normative question of what should be the course of reforms in the wake of the Asian crisis. In line with our diagnosis of the Asian crisis as primarily a financial one, our recommendations fall into three major categories, namely, capital market reforms, banking sector reforms and the issue of capital account convertibility (CAC). A. Capital Market Reforms: The Indian and Chinese capital markets have been in the doldrums since the Asian crisis. For example, the promoters in Indian stock markets indulge in a variety of malpractices such as concealing vital information, fixing high premiums, inflating project costs and often raising funds for non-existent companies (for details see Bhole, 1995; Pratibandla and Prusty, 1998). Regulatory bodies like the SEBI lack power to penalize flagrant market violations. As a result, the primary market has been virtually killed in India. Two corrective measures are urgently needed: (a)

empowering regulatory authorities (such as SEBI) to punish market violations, without having to go through lengthy legal procedures. This means that the Department of Company Affairs will have to take the lead in making regulatory authorities both autonomous and accountable, while strengthening overall discipline in the capital market. (b) strengthening of shareholders' rights, which will go a long way in restoring investor confidence in stock markets. Indian stock markets are characterized by a dichotomy between dominant and

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minority shareholders (see Verma, 1997), the former being the promoters (who are usually also the managers) and the public financial institutions. The latter are subject to moral-hazard behaviour (as they operate with public funds), which means that, at best, they are passive partners and at worst, in active collusion with promoters in transferring assets across different units (see Pratibandla, 1997). Strengthening of minority shareholders' rights will definitely improve corporate governance and promote investor confidence. If capital market reform does take place in India, the foreign institutional investors (FIIs) who withdrew about $300 million from November 1997 to January 1998 (EPW Research Foundation, 1998b) may revise their long-term view of the Indian scene.22 A revised FII outlook, could in turn mean revival of the languishing Indian stock markets, as well as a shoring-up of the rupee. The capital market is much less developed in China partly owing to the weaknesses of the banking system which would face bigger competition with the growing capital market. Growth of the capital market has also been hindered by the fear that household savings might switch away from banks which are the main source of financing for inefficient state enterprises (Lardy, 1998b). Restructuring of these enterprises and commercialization of the banking system are preconditions for strengthening the Chinese capital market. Furthermore, other necessary reforms include the gradual phasing out of the credit plan which determines quotas for bond and share issues, interest rate liberalization and giving responsibility to stock exchanges for enforcing eligibility criteria for listing companies (World Bank, 1996a). B. Banking Sector Reforms: A detailed description of all the problems faced would be a monumental task. We, therefore, confine our attention to those aspects that need immediate attention. In India the current system of classifying assets as non-performing solely on the basis of payment status, leaves plenty of scope for `ever greening'; that is, making bad loans appear good by lending more to troubled borrowers. Loan classification should be made dependent not only on the payment status but also on other factors such as the market value of the collateral. Secondly, the legal system makes it extremely difficult for banks to seize or transfer the collateral behind delinquent loans. This means that banks' credit losses are unduly high. Legislation is needed to empower the Board for Financial Supervision with statutory authority to issue `cease and desist' orders to banks. Thirdly, there is a need to institute

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serious penalties against banks for submitting inaccurate or delayed financial statements on their consolidated exposures. Fourthly, a system of responsible credit ratings for both public and private sector banks needs to be introduced. Fifthly, in both Indian and Chinese contexts, bank supervision is liable to be subject to various kinds of pressures from the government and industry. In India the fact that a high official of the RBI or the Ministry of Finance is often on the Governing Board of banks, means that the regulatory authority (Board for Financial Supervision) located within the RBI hierarchy, would find its powers considerably constrained. In such contexts Benston and Kaufman (1993) recommend the adoption of a rule-based supervisory regime where prompt corrective actions are mandatory once bank capital hits successive capital zone tripwires. In the extreme case, the regulators are required to close the bank before the market value of the bank's capital turns negative. This system, called the Structured Early Intervention Resolution (SEIR) proposal, implies a reduction in the discretionary component of supervision. In China in general the government bails out failing banks and financial corporations although as we noted above, some major banks and financial institutions have been allowed to go bankrupt. China will have to do away with the `soft-budget' constraint as part of the banking reforms. China has opted for recapitalization of banks to promote commercialization of the banking system. It is planned to provide 270 billion yuan to the four largest state-owned banks. Large sums (over 40 billion yuan) are also allocated for writing off `bad' loans of stateowned enterprises (Lardy, 1998a). Additional reforms will be necessary in the form of incentives and greater competition through expansion of the capital market and allowing foreign banks to undertake domestic lending and currency business (see Lardy, 1998b). Most banks have now been put on the Basle standards of capital adequacy. But these standards have been mainly designed for industrial countries, where the financial environment is less volatile. In the risky environment of such emerging markets as the Indian and Chinese, a higher capital adequacy ratio may be desirable. In China at present the capital adequacy ratio ranges between 2±5 per cent, which is well below the BIS norm of 8 per cent. The Indian ratio is also below this norm. Incentives need to be created to encourage banks to accumulate capital above the stipulated minimum. One such incentive (see Goldstein and Turner, 1996) is to make a bank's range of permitted activities and its regulatory obligations a function of the level of its capital.

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In India, the approach to deposit insurance is that of `co-insurance' (that is, the coverage of deposit insurance is only partial). This, we feel, provides an incomplete insulation from moral-hazard problems. One solution could be risk-weighted deposit insurance premiums, whereby banks with riskier exposures pay higher premiums. Another solution could be `mutual liability' (making groups of banks liable for members' losses). This could operate by bringing peer pressure into play. Two other areas of concern relate to `connected lending' (that is, loans extended to banks' owners or managers and to their related businesses) and `maximum exposure' to a single borrower. In India, the maximum exposure limit is fixed at 25 per cent of a bank's capital and free reserves. This is substantially in excess of limits in the US (15 per cent), Japan (20 per cent), Mexico (10 per cent), Chile (5 per cent), Taiwan (3 per cent). Not only is the exposure limit high but the use of dummy accounts and fictitious names is rampant.23 The supervisors should be granted the authority to trace the use of funds once deposited in accounts. Simultaneously maximum exposure limits need to be reviewed. Finally, there is an urgent need to introduce more competition in the banking sector by encouraging the entry of private banks, foreign banks and money market mutual funds. Market-driven mergers among private banks should also be given more encouragement.24 Our analysis has focused almost exclusively on the banking sector but important reforms are needed in the area of NBFCs too. Most of these are, however, similar to the banking sector reforms discussed above (with appropriate modifications) ± a notable exception being the issue of competition. In India in the NBFC sector, competition is excessive rather than otherwise. The RBI has now come to the view that the NBFCs must be subject to the same discipline as banks, if they want to share the banks' privilege. In contrast, in China as we noted above, the state continues to limit competition to the specialized banks from the NBFCs for fear of transferring savings away from banks. Thus, the banks continue to be the major source of lending despite increase in the number of NBFCs. C. Capital Account Convertibility: It is now generally conceded that one of the main reasons why India and China have been relatively insulated from some of the more serious consequences of the Asian crisis, is because of their extremely cautious approach to capital account convertibility (CAC). Indian and Chinese corporations and banks are not allowed to borrow or lend capital abroad without government approval. This makes the rupee and yuan much less vulnerable to changes in

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investor sentiment or to speculative attacks. Groups of brash `proreformers', mostly in the astral world of high finance, have been trying to goad the government in the direction of CAC. It was indeed fortunate that the Tarapore Committee on CAC (1997), took a very considerate and cautious approach, which we support, and announced a gradualist programme of phased liberalization of the capital account (Rao, 1997). In China although the capital controls remain in place, recently on several occasions policy makers have announced a long-term plan towards full CAC with a view to integrating China fully into the global economy. This long-term goal, for which no deadline has been set, is partly a response to pressures by the IMF and partly to China's keenness to join the WTO. Also with the number of overseas investors and affiliates increasing rapidly, the government is finding it more and more difficult to exercise control over the capital account. However, it is clear that the Asian financial crisis will dampen any plans to introduce full CAC in the near future. Indeed, China reintroduced some financial controls in 1997 and 1998 to prevent capital flight in the wake of the Asian crisis.

CONCLUSION So far the impact of the crisis on China and India has been limited. We noted that the crisis can spread in several ways: through impacts on exports, foreign capital inflows and the effects of contractionary domestic policies in the wake of the crisis. Both countries have escaped external shocks possibly due to capital controls. The two currencies are convertible on current account but not on capital account. However, in both countries symptoms of financial ailments do exist. Therefore, reform of the capital markets and the banking industry is essential. Also a cautious approach is needed towards capital account convertibility. In recent years the IMF has viewed capital account convertibility (CAC) as the natural follow-up to the establishment of current account convertibility with free trade in goods and services to be logically succeeded by free movement of financial and physical assets (see Chapter 3). In this context, it is interesting to note that Keynes had always viewed capital mobility as incompatible with the preservation of reasonably free multilateral trade (see Minsky, 1975). The Asian crisis (Chapter 4) has amply demonstrated the perils of free capital flows, unchecked by any regulatory device. The Indian and Chinese governments should not make the fatal mistake of rushing into CAC without adequate preparation. This is one aspect of the reforms on which we can confidently recommend slow pedalling. In

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line with our diagnosis of the Asian crisis as primarily a financial one, we also recommend capital market and banking sector reforms. Capital market reforms call for the empowering of regulatory authorities mainly to punish market violations and strengthen overall discipline. Strengthening of shareholders' rights will also go a long way in restoring investor confidence in stock markets. In the risky environment of emerging markets, such as those of China and India, a ratio (in excess of the norm set by the Bank for International Settlements) may be desirable. Incentives need to be created to encourage banks to accumulate capital above the stipulated minimum. One such incentive (see Goldstein and Turner, 1996) is to make a bank's range of permitted activities and its regulatory obligations a function of the level of its capital. Competition needs to be introduced in the banking sector by permitting the entry of private banks, foreign banks and money market mutual funds, which will encourage market-driven mergers among private banks. Undue procrastination on these measures could make a hitherto reasonably stable situation in India and China a highly untenable one. It is clear from the above discussion that correcting the existing market failures and preventing of future ones will require appropriate government intervention. Thus it is not necessarily less government but different government that may be required. Having considered cases of market failures, we are now ready to examine a case of government failures in China and India in Chapter 6.

6

State Enterprises in China and India: A Case of Government Failure

In Chapter 2, we noted that both market and government failures take place. Having considered cases of market failure and their impacts in Chapters 3 to 5, we now turn to government failure. We argue that stateowned enterprises in China and India qualify as a case of government failure in raising significantly the economic performance of these enterprises despite various policy reforms and restructuring. This is not to deny that some of these enterprises have improved performance over the years in response to government efforts (particularly in China) but the fact remains that despite successive proclamations to reduce losses of these enterprises through an increase in productivity and economic efficiency, the results have been disappointing, especially in India. Are these failures inherent in the nature of public management of production which is often motivated by multiple and non-economic objectives? Are they due to asymmetric information and principalagency problems discussed in Chapters 1 and 2? Or are they due to failure to implement policies for various non-economic, political and humanitarian reasons? We attempt to answer some of these questions by examining the economic performance of state enterprises in China and India in the light of two main criteria, the `soft-budget' constraint and excess labour or `overstaffing'.

THE SOFT-BUDGET CONSTRAINT The concept of `soft-budget' constraint developed by Kornai (1980, 1986, 1993, 1998) to explain poor economic performance of state enterprises in Socialist countries is closely linked to that of the principal and 127

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agent, asymmetric information and rent-seeking discussed in Chapters 1 and 2. Managers of state enterprises do not own the firms; they act as agents of the principal (the public corresponding to the shareholders in the case of private firms). Because of asymmetric information, the principal is unable to control the agents' activities. In the case of state enterprises, there is a second layer of supervision and control exercised by the government (politicians and bureaucrats) on behalf of the principal. The agent exploits his better information and knowledge about the enterprise to seek rent from the principal. The agent will actively seek to maximize his rent (in the form of direct and indirect subsidies) rather than passively waiting for government assistance. Active rent-seeking is likely to be the act of bargaining between the principal and the agent for mutual benefits rather than a one-way support from the principal to the agent. Thus the principal may receive bribes and political support in exchange for grant of rent (subsidy) as seems to be the case in China particularly at tle local level of government (Raiser, 1997c). Kornai (1986, 1998) refers to the politicians' influence on the behaviour of enterprises as an element of soft-budget constraint. For example, the principal may be interested more in non-economic objectives than economic ones, and may try to gain political strength by raising output and employment of firms beyond what is dictated by the profit-making principle which the agent may prefer to pursue (see Shleifer and Vishny, 1994). Managers of state enterprises and banks are appointed by the state and are responsible for political decisions rather than economic principles. They bear less responsibility for their economic performance than those in private firms. In an economy dominated by state enterprises, loans are naturally issued to them by the state. In the absence of perfect information (difficulties of monitoring and coordination problems compound information problems) the government or state banks may finance uneconomic projects, and may not offer timely delivery of inputs. The principal is less informed than the agent (firm manager) about the requirements of the enterprise. Thus the government rather than the agent may be responsible for wrong decisions for which a compensation to enterprises may be necessary in the form of additional credits and subsidies (see Dewatripont and Maskin, 1995; Li and Liang, 1998). The budget constraint becomes `soft' when the excessive expenditure and subsequent losses of the state enterprises are covered by an external agency, the state or government-owned banks. However, as we shall discuss below in the context of India, this constraint also applies almost

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equally well to mixed economies with public and private sectors existing side by side. The soft-budget constraint may arise due to insider control or managers' control right (Li and Liang, 1998). Being the main decisionmakers managers may be able to borrow from large creditors even if they are not entitled to full rights over the firm's assets. In the face of losses, managers would oppose the firm's liquidation because they enjoy significant benefits associated with their control of the firm. Thus, many bankrupt enterprises may continue to survive because insiders successfully prevent their liquidation. Some may argue that regional decentralization (as in the cases of China and India) increases competition among provincial and local governments for investment funds which may raise the opportunity cost of subsidizing inefficient firms, thus hardening the budget constraint. But soft-budget constraint may still operate as long as local governments continue to enjoy easy access to credit through state banks at the local level as a consequence of decentralization of monetary and banking institutions (Qian and Roland, 1994). In both China and India state enterprises at both central and local levels face softbudget constraint.1 It follows from the above discussion that the soft-budget constraint refers to both financial (and economic) and political factors. At the political level it is the state's paternalistic and protective support to state-owned and private firms which may explain their continued existence despite their poor economic and financial performance. All funding of enterprises need not, however, be subject to a softbudget constraint. A distinction needs to be made between government payments in the form of subsidies to cover losses of enterprises and those as equity investments into profitable state enterprises (Hay et al., 1994). Our concern is mainly with government subsidies for `bail outs'. The soft-budget constraint can operate in several ways. It may take the form of subsidies by central and local governments to firms with excess expenditure over earnings, `soft taxation', subsidized credit (lower than market interest rates), increased borrowings, lower repayment of loans, government-controlled prices and so on (Kornai, 1986; Hay et al., 1994). While the concept was originally confined to the ex post financial situation of firms, it has many non-financial ramifications based on the ex ante expectations of firms, probability of obtaining support, and confidence that the support would be forthcoming. Thus, the behaviour of firms and government or bureaucrats (as decision-makers) forms an important element of the soft-budget constraint. For example,

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confidence in obtaining government support may cause `X-inefficiency' (see Chapter 2) and failure to cut losses and introduce innovations. It may also encourage overspending and overinvestment thus causing a shortage economy in the context of which Kornai originally developed the concept. The problems of measuring the extent of soft-budget constraint are formidable. Most attempts at quantification use such indirect indicators as low profitability, government subsidies, low-rate bank credit and so on. Kornai (1998) mentions an alternative way of measuring the softbudget constraint, namely, that of examining its primary and secondary effects in the form of declining efficiency and insensitivity of prices and costs. The difficulty with such an approach is that there are factors other than the soft-budget constraint which also affect efficiency. Below we examine the above-mentioned indicators for Chinese and Indian stateowned enterprises to assess the existence of the soft-budget constraint. EXCESS LABOUR OR OVERSTAFFING The soft-budget constraint may contribute to overstaffing which may also occur due to several other reasons. Besides failure to adjust to relative factor and product prices, employment of excess labour may be an important factor accounting for enterprise losses. However, the concept of excess labour (or overstaffing) in industry has not been carefully defined and it is not obvious what it means. The literature on labour surplus economy (Lewis, 1954; Fei and Ranis, 1964) refers to excess supplies of rural labour which can be productively reabsorbed in industry in the urban areas. This literature postulates redeployment of labour from low-productivity agricultural/rural occupations to high-productivity industrial/ urban ones. In such a model innovation and accumulation is a necessary condition for rapid labour absorption. Excess labour in industry and `overstaffing' are not foreseen. However, the latter situation can arise in the absence of accumulation by private enterprises and stateowned enterprises which may assume social welfare responsibilties (beside direct productive activity) including education and health and payment of pensions (as in China ± see below). Thus in this case excess labour or overstaffing may just be a form of unemployment insurance. Under a hard-budget constraint a firm would be forced to downsize or shed labour in order to cut down costs of production, but not so in a soft-budget situation where financing of losses by the government might perpetuate overstaffing and low labour productivity. For the study of state-owned enterprises (SOEs) our concern is to define excess labour in industry. Consistent with the early literature

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on surplus labour in developing economies, overstaffing can be equated with zero marginal product of at least some workers whose removal would not adversely affect output but would favourably affect cost of production. As agricultural activity differs from industrial activity in terms of seasonality, capacity utilization, profit maximization and so on, zero marginal product of labour concept alone may not be helpful in defining excess labour in industrial enterprises. Furthermore, as Harberger (1971) notes, this notion is restricted and oversimplified. A more appropriate measure of the opportunity cost of labour would be the product foregone in other sectors which may be well above zero. It is necessary to make some assumptions about the objectives of firms before one can define or measure overstaffing. In principle, a firm may aim at one of the following: (i) profit maximization, (ii) output maximization, and (iii) maximization of labour productivity. It would be interested in eliminating surplus labour to improve economic efficiency so that either output is maximized with given productive capacity and technology, or labour productivity is maximized with given level of output. Profit would be maximized when cost per unit of output is reduced to the minimum. Potential labour surplus is likely to be different under each of these options. Knight and Song (1995, p. 101), while recognizing the difficulty of estimating urban surplus labour in Chinese enterprises, suggest that `surplus labour is . . . any employment in excess of the profit-maximization benchmark'. How appropriate is it to assume profit maximization as a realistic goal for SOEs in China and India? Apart from failing to satisfy the neoclassical competitive condition, these enterprises are in the public sector precisely because they have multiple goals other than profit maximization. Jefferson (1998, p. 428) argues that the Chinese state-owned enterprise `is a kind of impure public good with clear externality and public-policy implications'. The concept of surplus labour in industry needs to be distinguished from that of labour hoarding. The above discussion relates to a static view of labour surplus at a point of time which does not allow for any `labour hoarding' which may be necessary for long-term capacity expansion and output maximization. The motivation to hoard labour may vary from firm to firm depending on market conditions and growth in output. Under a hard-budget constraint, a firm may hoard labour in conditions of recession, hoping that the cost of hoarding would be much less than that of firing and rehiring of labour when boom conditions return. Thus in a dynamic context it may be perfectly rational for a firm to hoard labour for future expansion of productive capacity in

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response to increase in demand. Therefore, a distinction needs to be made between `labour hoarding' of this kind and straightforward labour surplus or redundancy. Firms may hoard labour for several reasons. Firstly, there may be legal constraints on firing workers. In both India and China, labour legislation until recently prohibited any worker dismissal from state enterprises (and even private enterprises in the case of India). Thus in these conditions redundant labour may be the sum of excess labour (whatever way defined) and hoarded labour due to stringent labour laws (see below). Secondly, as we noted above, it may be costly to lay off workers and rehire them when demand conditions are more favourable.2 Thus labour hoarding or a temporary labour surplus will be consistent with long-run profit maximization. Thirdly, firms may have invested in skilled workers and may be reluctant to forgo return on that investment. Fourthly, technical inflexibility of production may militate against firing of redundant labour. Finally, strong labour unions may prevent employers from getting rid of redundant labour as in the case of India discussed below. The above discussion pertains to firms facing competition and enjoying freedom to hoard or shed labour. Under rigid labour-market conditions (as in China and India), firms may not be interested in labour hoarding as a voluntary strategy.

STATE ENTERPRISES IN CHINA AND INDIA The scope and interpretation of the state sectors in China and India is less straightforward than one may believe. Therefore, it is appropriate to begin with a discussion of what constitutes the state sector and enterprises in the two countries. In both countries, the state sector exists at the centre and state (province) levels. In India, besides the government sector, there are `departmental enterprises' such as the railways and posts and telecommunications which are run directly by relevant government departments. The provision of public goods by state enterprises is generally considered a legitimate activity. Furthermore, the state sector includes `non-departmental enterprises' which operate as independent companies (see Mohan, 1996). The debate on Indian public-sector enterprises has concentrated mainly on non-departmental enterprises especially in such directly productive activities as manufacturing. In China SOEs are both large and small; generally large SOEs are controlled by the central and provincial governments whereas the smaller ones are controlled by provincial and local governments.3 In India also, public-sector enterprises operate at the central, state and local

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government levels. While the central and state PSEs are engaged in manufacturing, trading, and financial services, those at the local level are concerned mainly with the provision of city transport, power supply and milk supply (Sankar et al., 1994). The structure of Chinese SOEs is quite different from that of the Indian public-sector enterprises. In China the difference between state and non-state enterprises (collective urban enterprises and town and village enterprises) is in terms of ownership and different levels of control and supervision (central, provincial, district, local) with implications for property rights. While SOEs are the responsibility of central and provincial bureaus, collective enterprises are controlled by local or township governments.4 Even when the central government delegates control rights over SOEs to lower levels of government it retains ultimate rights over their assets. The central government does not exercise similar rights over collectives. While SOEs carry social burdens in addition to undertaking production, collectives are confined mainly to production. SOEs obtain most inputs and sell outputs through a combination of plan and market activity whereas collective enterprises are largely outside the purview of planning and thus are more market oriented. It is generally believed that most collective enterprises face a hard-budget constraint whereas SOEs face a soft-budget constraint (see Broadman, 1995). Rural (township and village) enterprises in China are different from urban collectives in that they have to compete for inputs and product markets. Their ownership pattern is difficult to define as either public or private. On the one hand, they are supervised by local township governments and are thus state entities; on the other, they are most market oriented (Hussain and Zhuang, 1997). Unlike India, in China a healthy synergy exists between state and non-state enterprises; many SOEs own collective enterprises as subsidiaries or Sino-foreign joint ventures. There is a growing contracting out of production to non-state enterprises suggesting a business relationship similar to large and small businesses in Japan and elsewhere in market economies (see Chapter 1; Hussain and Zhuang, 1997). In both China and India state enterprises have formed a significant proportion of total number of enterprises since India's independence in 1947 and China's revolution in 1949. The contribution of these enterprises to India's economic development can be judged by their high share in GDP and employment (over 19 million in 1996). The share of the public sector in GDP rose from 12 per cent in 1965±66 to 25 per cent in 1997±98, suggesting its increased importance. However, gross domestic capital formation in the public sector declined from 50 per cent to 29

134 State Enterprises in China and India: A Case of Government Failure

per cent during the same period (see Table 6.1). In China, at the end of 1998 SOEs accounted for over 71 per cent of the urban labour force, or over 12 per cent of the total labour force; 28 per cent of total gross industrial output, and 54 per cent of total fixed investment (see Table 6.2). Although in absolute numbers employment in SOEs has declined as a proportion of urban labour force, it has remained remarkably high and stable between 1985 and 1998. Even as a proportion of the total labour force, SOE employment during the 1980s and 1990s was significant, varying between 15 to 18 per cent. Both China and India have introduced state-sector reforms as an important component of their overall economic reforms. Chinese SOE reforms consisted of gradual phasing out of central planning and the introduction of market and price system, introduction of profit-sharing schemes, and greater autonomy of state enterprises in decision-making. SOEs were intended to raise productivity and economic efficiency without changing their ownership pattern. First, a profit retention scheme was introduced under which enterprises could retain a certain proportion of total profits for innovation and investment. Gradually Table 6.1 Main features of the Indian public-sector enterprises (PSEs) Year

GDP from public sector as % of total GDP (1980±81 prices)

GDP from GDCF in central public sector PSEs as % of as % of total total GDP GDCF (at (1980±81 1980±81 prices) prices)

GDCF in central PSEs as % of total GDCF (at 1980±81 prices)

Employment in public sector as % of urban employment

Employment in central PSEs as % of urban employment

1965±66 1970±71 1975±76 1980±81 1985±86 1990±91 1991±92 1992±93 1993±94 1994±95 1995±96 1996±97 1997±98

12 14 16 20 22 25 25 25 25 25 24 23 25

± ± ± 9 8 12 13

± ± ± 21 28 27 29

± ± ± ± 26 25 24.4 23.9 23.3 22.7 22 21.5 20.6

± ± ± ± 3.3 3 2.8 2.7 2.5 2.4 2.4 2.2 2.0

50 38 46 41 46 38 40 36 40 34 27 27 29

Sources: Economic and Political Weekly (EPW) Research Foundation (1998a); GOI (1998b); Goswami and Bhandari (forthcoming); Mohan (1996) GDCF ± Gross domestic capital formation.

Market or Government Failures? 135 Table 6.2 Main features of the Chinese state-owned enterprises (SOEs) Year

Staff and workers (000)

% of urban labour force

% of total labour force

Total (%) fixed investment (billion yuan)

Gross industrial output (billion yuan)

(%)

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

89,900 93,330 96,540 99,840 101,080 103,460 106,640 108,890 109,200 108,900 109,550 109,490 107,660 88,090

72.7 72.9 73.0 73.4 73.5 73.6 73.5 73.6 73.5 73.3 73.5 73.7 73.4 71.4

18.0 18.2 18.3 18.4 18.0 16.2 16.4 16.6 16.4 16.2 16.1 15.9 15.5 12.6

168 208 245 302 281 299 371 550 793 961 1,090 1,201 1,309 1,537

630 697 825 1,035 1,234 1,306 1,495 1,782 2,772 2,620 3,122 3,617 3,599 3,362

64.9 62.3 59.7 56.8 56.1 54.6 56.2 51.5 57.3 37.3 34.0 36.3 31.6 28.2

66.0 66.6 64.6 63.5 63.7 66.1 66.4 68.0 60.6 56.4 54.4 52.4 52.5 54.1

Source: Based on data from Comprehensive Statistical Data and Materials on 50 Years of New China (Beijing: China Statistical Press) (1999). Note: Since 1996, the definition of `urban' was changed, the employment ratios for the earlier period may not be comparable.

bargaining over plan targets gave way to that over profit retention (Naughton, 1985a). In the 1980s, the emphasis was more on enterprises paying taxes. The reforms placed emphasis mainly on improved efficiency, managerial autonomy and accountability. Lardy (1998b) notes that early reform efforts (profit retention, price reforms and interest payments by SOEs on fixed and working capital) did not succeed. In the absence of these reforms greater autonomy of SOEs could not have improved efficiency in the use of resources. Although the second phase of reforms in the form of contract responsibility system (contracts between SOEs and their superiors concerning various physical and financial targets including profits and taxes) and greater price flexibility was an improvement, it failed to introduce a system of uniform market prices. Many SOEs continued to suffer from losses because of price controls. The final current phase of reforms relates to changes in SOE ownership through privatization particularly of small SOEs into joint-stock or shareholding companies designed primarily to separate government from business activity.

136 State Enterprises in China and India: A Case of Government Failure

In principle, three options were available to China and India for enterprise reforms: (a) sale of state enterprises (or privatization), (b) leasing, and (c) use of private management contracts. India chose option (a) and proposed to phase out loss-making state enterprises. On the other hand, China did not envisage privatization until 1997 when the 15th Central Congress of the Communist Party in principle accepted this option for the first time. Instead, until 1997±98 emphasis was placed on raising the efficiency of SOEs by exposing them to greater competition from collective and private enterprises, mergers of SOEs with non-state firms, the establishment of joint stock companies, and commercialization of banks (Bhalla, 1995a, 1995b; World Bank, 1996a). The latest phase of reforms involves the conversion of several SOEs into shareholding companies whose stocks are traded on the Shanghai, Shenzhen, Hong Kong and New York markets. This reform, heralded as one of the most ambitious since 1978 (Broadman, 1995), is being undertaken within the framework of the Company and Enterprise Laws which allows the establishment of corporations as legal entities separate from owners (shareholders) with modern Western-style boards of directors and management structure. Since 1995, China has gradually privatized small SOEs at the county level while retaining state ownership in large SOEs although, as noted above, the official policy towards privatization was adopted only in 1997. China's high savings rate and relatively low net worth (due to large debt±asset ratio) and thus sale price may have facilitated this process (Cao et al., 1999).5 Despite such privatization, however, the state continues to control private enterprises as they are joint-stock holding companies with the government and employees owning shares. There are also restrictions on share transfers. Operational autonomy to SOE management and corporatization (that is, introducing Western methods of corporate board management) remains limited (McNally and Lee, 1998). Lardy (1998b, p. 22) concludes that `reforms to date have failed in large portions of the state-owned sector'. Greater managerial autonomy (even if achieved) would not have raised SOEs allocative efficiency in the absence of an effective implementation of such reforms as profit retention, price reforms and interest payments by SOEs. Zhang (1998, p. 17) argues that `changes in the financial structure of SOEs and bankruptcy have failed to play a role in disciplining managers'. This is partly because managers have little stake in their firms despite the management contract (or leasing). In fact, managerial autonomy resulting from management contracts, has had adverse effects in the form of such phenomena as profit diversion and asset stripping (see below).

Market or Government Failures? 137

In India, the sale of public enterprises or privatization (or disinvestment as it is generally called) was explicitly adopted as a major policy goal at the time of economic liberalization in 1991. In December 1991 the SickIndustrial Companies Act 1985 was amended so that chronically `sick' enterprises (making losses and with net negative worth ± accumulated losses exceeding equity plus reserves) could be considered for rationalization, rehabilitation or privatization. The privatization of both profitmaking and loss-making PSEs was to be undertaken by offering government's shareholdings to mutual funds, financial institutions, workers' cooperatives and the general public. In 1996 a Disinvestment Commission was established to advise on the extent, timing, strategy and methodology of implementing disinvestment policy. The Indian strategy towards PSEs reforms aims at a combination of strengthening `strategic' PSEs (defence, space and atomic energy) (implying no disinvestment), a gradual disinvestment of core PSEs (power, telecommunications, steel, minerals and metals, coal and lignite and petroleum) without surrendering controlling interests, and eventual privatization of non-strategic and non-core PSEs (see Arun and Nixson, 2000). Measures to improve the long-term performance of core PSEs include their revival through the Board for Industrial and Financial Reconstruction (BIFR), financial restructuring, manpower rationalization, strengthening of management structure and formation of joint ventures. As we shall discuss below, for various political and humanitarian reasons the declared policy of disinvestment and privatization in India has not made much headway. The policy lacks clear focus on restructuring which receives much lower priority than revenue generation as has been noted in several reports of the Disinvestment Commission mentioned above.

THE SOFT-BUDGET CONSTRAINT IN CHINESE STATEOWNED ENTERPRISES (SOEs) SOEs are a burden on the Chinese economy in several ways. Firstly, subsidies, which cover SOE losses raise fiscal deficits and cause macroeconomic instability. Secondly, absence of SOE reforms blocks banking and financial reforms as noted in Chapter 5. State banks, which are often under political pressure to lend to loss-making SOEs, accumulate mounting bad debts. Thirdly, the slow pace of social welfare reforms hinders SOE reforms. Finally, SOEs suffer from underutilization of human resources in the form of redundant labour or `disguised unemployment'.

138 State Enterprises in China and India: A Case of Government Failure

Why have the Chinese SOEs continued to survive without going bankrupt, with few recent exceptions? The answer to this question may lie in the soft-budget constraint under which the government allows these firms to survive. Lin et al. (1998, 1999) argue that the SOEs suffer from `policy burdens' imposed by the government: social welfare costs, redundant labour and distorted prices, and social welfare (especially retirement pensions) which account for their large losses and failure to compete with non-state enterprises. Strictly speaking, the government should be responsible only for the losses incurred due to these policy burdens. But under asymmetric information the government is unable to distinguish between `policy-induced losses', for which it should be responsible and those that are `operational losses' of SOEs due to the managerial or worker slack, for example, for which SOEs should be responsible. The government ends up being responsible for all the losses of SOEs introducing the soft-budget constraint and worsening moral hazard and associated agency problems discussed above. The soft-budget constraint will persist as long as policy burdens are imposed on SOEs. Of course, it is possible that SOEs face hard-budget constraint in some respects and soft-budget constraint in others. On the basis of regression analysis using survey data from 300 SOEs in six Chinese cities, Kueh et al. (1999) show that: (a)

enterprise retained profit bore a weak relationship to the payment of workers' bonuses in the early phase of the reforms, which became somewhat stronger later on; (b) correlation of growth in enterprise capacity with past profitability declined between 1985 and 1988, suggesting a softening of the budget constraint; and (c) enterprise demand for such inputs as materials was price elastic (contrary to the hypothesis of soft-budget constraint) whereas that for bank loans was inelastic (supporting the soft-budget hypothesis). We now examine in detail below SOE profitability over time, subsidies, bank loans, social burdens, and excess labour, factors some of which are beyond the control of these enterprises. 1.

Profitability

SOEs continue to be responsible for their profits but not their losses. It is noted that in 1995, `about 40 per cent of state enterprises made losses . . . subsidies to these loss-making enterprises increased by more than 50 per cent between 1986 and 1994' (Huang and Duncan, 1997, p.

Market or Government Failures? 139

69). The share of loss-making state enterprises has actually been steadily rising; according to the World Bank (1996b) their share rose from 26.4 per cent in 1992 to 44 per cent in 1995. According to the State Economic and Trade Commission of China, 49 per cent of large and medium-sized state enterprises made losses in 1998. Of the 512 large state companies about one-third are reported to have suffered losses in the first half of 1998 (see World Bank, 1999, p. 21). These enterprises suffer from severe underutilization of productive capacity and growing indebtedness. Their debt±asset ratios are noted to be as high as 85 per cent (see Singapore Monetary Authority, 1997). A survey of 124,000 SOEs noted the asset±liability ratio between 71.5 per cent and 83.3 per cent (see South China Morning Post, 30 August, 1997). It is, therefore, clear that SOEs are a major burden on the state budget. The increasing losses of SOEs (see Table 6.3) have led to a decline in the government tax revenue from SOEs much more so than that from the collective enterprises (COEs) (see Figure 6.1). We need disaggregated data on profitmaking and loss-making SOEs to determine whether and how these enterprises face a soft-budget constraint. Two empirircal studies based 35 30

(%)

25 20 15 10 5 0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 SOEs: % of total revenue SOEs: % of GDP COEs: % of total revenue COEs: % of GDP Figure 6.1 Government tax revenue from Chinese SOEs and COEs. Source: Based on data from the Statistical Yearbook of China 1999.

140 State Enterprises in China and India: A Case of Government Failure

on detailed field surveys of SOEs have attempted to test the soft-budget constraint (Hay et al. 1994; Li and Liang, 1998). Using data on large SOEs for 1984±87, Hay et al. undertake a flow-of-funds analysis of (a) longterm loss makers, (b) short-term loss makers and (c) profitable firms. These firms have three main sources of funds: government subsidies, bank loans and firm's own resources. Their findings show that: subsidies for long-term loss makers are much higher (15 per cent) than those for short-term loss makers (4.1 per cent) and profitable firms (0.9 per cent); bank loans were an insignificant source for both long-term and shortterm losers; and firm's own resources were an important source for long-term losers. Li and Liang (1998) use data from two large surveys of SOEs in Jiangsu, Jilin, Shanxi and Sichuan covering the 1980±89 and 1990±94 periods. They conclude that SOEs financial losses were due to political interference, creditors' lack of information, and insiders' control. Excess supply of labour (largely non-production workers), excessive bonus payments to workers and bad investments were among the symptoms of the soft-budget constraint (see below). The financial performance of SOEs is generally measured by their profits or excess of revenues over costs because such data are easily available in their balance sheets. In Chinese SOEs profitability has been declining over time. The World Bank (1996c) notes that profits of industrial SOEs fell from over 6 per cent of GDP in 1987 to about 2 per cent in 1994. Jefferson et al. (1994) show, on the basis of World Bank firm-level data, that profit rates have been declining over time in SOEs, urban collectives and TVEs, but export-oriented enterprises were more profitable than the non-exporting enterprises. A survey of SOEs, collective enterprises and TVEs during 1990±94 in Jilin, Shaanxi and Sichuan interior provinces, compared to an earlier survey of similar enterprises in coastal provinces (namely, Guangzhou, Shenzhen, Xiamen and Shanghai), shows that average net rate of return (gross profits less net of all taxes paid over the net value of fixed assets) was 13 per cent in TVEs compared with 7 per cent in SOEs and collective enterprises (Raiser, 1997b). Several factors explain the declining SOE profitability: growing competition in product markets as a result of entry of non-state enterprises reducing SOEs market share (Fan et al., 1998; McMillan and Naughton, 1993), loosening of government control on wages resulting from greater enterprise autonomy which raises non-wage costs (Fan and Woo, 1993; Huang et al., 1999), and social burdens of SOEs in the form of expenditure on workers' education, health and pensions which are not incurred by non-state enterprises. These social burdens noted above also involve employment of extra workers to administer these schemes which are

Market or Government Failures? 141

unnecessary for production, which partly explains large magnitudes of surplus labour in SOEs (see below). Competition alone cannot explain falling SOE profits. If this were so, there would be low profitability across-the-board, that is, in SOEs, COEs and TVEs, which is actually not the case. Profits of COEs and TVEs are larger (Fan and Woo, 1996). Using enterprise survey data Huang and Duncan (1999) found no negative relationship between competition and profitability.6 Substantial increase in SOE losses (see Table 6.3) has accounted for a declining rate of return on SOE investments. Lardy (1998b, p. 34) notes that `in the first quarter of 1996 the state-owned sector as a whole, for the first time ever, was in the red'. Price controls under which SOEs were required to sell the bulk of their output at below-market prices are also reported to have accounted for SOE losses (see Lin et al., 1999). However, this explanation may be more relevant to the early 1980s than in the later period when price liberalization on most products was effective.7 Table 6.3 Losses in the Chinese state-owned industrial enterprises `as independent accounting units'8 (1978±94) Year

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Amount of losses

Total SOE profits

Losses as % of profits

Total profit before tax

Losses as % of profit before tax

(billion yuan) (billion yuan) (%)

(billion yuan) (%)

4.2 3.6 3.4 4.6 4.7 3.2 2.7 3.2 5.4 6.1 8.2 18.1 34.9 36.7 36.9 45.3 48.2

79.1 86.4 90.7 92.3 97.2 103.3 115.3 133.4 134.1 151.4 177.5 177.3 150.3 166.1 194.4 245.5 287.6

Source: Xiang (1998).

50.9 56.3 58.5 58.0 59.8 64.1 70.6 73.8 69.0 78.7 89.2 74.3 38.8 40.2 53.5 81.7 82.9

8.3 6.5 5.9 7.9 8.0 5.0 3.8 4.4 7.9 7.8 9.2 24.2 89.9 91.2 69.0 55.4 58.2

5.3 4.2 3.8 5.0 4.9 3.1 2.3 2.4 4.1 4.0 4.6 10.2 23.2 22.1 19.0 18.4 16.8

142 State Enterprises in China and India: A Case of Government Failure

An evaluation of profitability of SOEs is a mammoth task under distorted price structure and incomplete and imperfect markets. Under monopolistic or imperfect market conditions profitability and rates of return would be a poor index of efficiency since enterprises could enjoy profits without any increase in economic efficiency. Therefore, one needs to be careful in deriving any definite conclusions about SOEs' economic performance. It may be better to examine growth of total factor productivity (TFP) (although its estimation also suffers from various methodological problems) or partial productivity. Several studies on TFP in SOEs show rather conflicting results (for a resume of these studies, see Huang et al., 1999). Actual estimates are sensitive to the price deflators used for input and output. Chen et al. (1988) estimated that TFP in SOEs increased by 4±5 per cent per annum between 1978 and 1985, while it stagnated between 1957 and 1978. A comparison between state and collective enterprises shows that productivity increased in both but it grew faster in collective enterprises (COEs). Woo et al. (1994) show that during the 1980s growth of TFP was zero or negative for SOEs, whereas it was positive for TVEs. But the opposite may also be true. Jefferson et al. (1992) suggest that TVEs are concentrated more on expanding scale and sales rather than raising profit (see also Jefferson, 1999). It is generally believed that TFP has been rising in SOEs although not as fast as that in COEs. How does one reconcile rising productivity with falling profits? This paradoxical situation may be explained by the softbudget constraint under which corruption by enterprise managers (for example, deliberate underpricing of products in exchange for kickbacks) persists under uncertain property rights in the form of managerial shareholding. The perception of managers makes them confident that the state will bail them out (see Xiang, 1995, 1998). 2.

Asset stripping

Greater autonomy of local governments and SOEs is also known to lead to asset stripping or depletion of state assets in various ways. It is defined as `a situation where ``insiders'' ± government officials, management and workers±obtain private windfalls. It occurs when these groups take the good assests of SOEs leaving their liabilities with the banks and the government.' (Smyth, 200, p.3). Asset stripping may take several forms: use of state assets for personal gain by, for example, transferring assets to subsidiaries not subject to government controls, giving away of state assets to workers as bonuses, undervaluation of assets when establishing joint ventures, illegal sale of assets, and tax avoidance and evasion.

Market or Government Failures? 143

Illegal sale of assets or legal sale at below market prices occurs because sales are not negotiated through the open market, but through property rights transactions centres which exist in several major cities. Tung (1996, p.11) reports an estimated half a million black market land transactions resulting in a loss of state assets to the tune of over 20 billion yuan. The widespread phenomenon of asset stripping may have discouraged restructuring of Chinese SOEs. It is possible that local officials fear accusation of undervaluing of state assets at a time when special government efforts are being made to check asset depletion (see Smyth, 2000). TVEs are reported to have bought SOE assets at below-market prices. Lack of managerial ownership and asset holding in SOEs (lack of adequate property rights) seems to have encouraged these buy-out transactions (see Xiang, 1998). Another example of asset stripping is the leasing out of enterprise assets to workers. Short of asset stripping, SOEs may borrow loans from state banks at low interest rates and relend them to collective enterprises at much higher interest rates. This drain of state assets has been estimated at 230 billion yuan between 1987 and 1992 (or an annual sum of 33 billion yuan) and 300 billion yuan between 1990 and 1995 (or an annual sum of over 50 billion yuan (see Lardy, 1998b, pp. 51±52). This depletion of state assets represents an interesting example of divergent interests of the principal and the agent discussed in Chapter 1. 3.

Government subsidies

Discussion of subsidies and their magnitude is of interest for two main reasons. Firstly, subsidies create budgetary deficits which in turn cause macroeconomic instability. Secondly, subsidies, if granted over a long period, can create a disincentive for efficiency improvements. In China the state enterprises very rarely go bankrupt despite laws having been promulgated to that effect. Their losses are covered either by state subsidies out of the government budget or by loans from the state banks offered under government directives. In recent years the government has been cutting down subsidies; the losses of SOEs are increasingly covered by bank loans. Apart from direct subsidies, indirect subsidies may include not only subsidized loans at below-market rates, but also subsidized raw materials and other inputs, and relaxation of government taxes on profits of SOEs from the use of state-owned fixed assests (Perkins and Raiser, 1994). In estimating subsidies to SOEs, Sachs and Woo (1994) assume that `half of the new bank credits not financing the central

144 State Enterprises in China and India: A Case of Government Failure

budget deficit are used for financing of state-owned enterprises'. Thus estimated the Sachs±Woo figure of indirect subsidies is much higher than that by the World Bank (1996a) which we use in Fig. 6.2. The World Bank report does not give the methodology underlying their estimate so that it is difficult to explain the discrepancy between the two estimates.9 Sachs and Woo (1994) erroneously include price subsidies in estimating total subsidies to SOEs which are shown to be 8 per cent of GDP in 1991, a figure more than twice as high as the official estimates of direct subsidies. Although price subsidies may have an indirect effect on SOEs (in the sense that they can enable managers to offer lower wages to workers) they are not targeted directly at SOEs; instead, they are subsidies intended for the benefit of urban consumers and are thus likely to move in step with inflation. A declining share of state subsidies to SOEs does not necessarily mean that SOE losses have gone down or loss-making SOEs have been closed down. The decline in subsidy may have been made up by an increase in state bank loans to SOEs under political pressure by the central and local governments. As Table 6.3 shows, the losses of SOEs have been going up since the reforms began in 1978. The ratio of subsidies to losses of SOEs, though declining is still quite high. In 1991, subsidies to industrial SOEs were equivalent to 70 per cent of the losses of these enterprises (see Lo, 1997a). Furthermore, subsidies continued to be a substantial proportion of total government expenditure (24.5 per cent in 1990 and about 11 per cent in 1994) (World Bank, 1996a, Table 22). A decline in central government subsidies may have been matched by an increase in indirect financial support through banks at the local level. Local governments in China own and control the bulk of SOEs. Under regional decentralization, their much greater autonomy implies that they can thwart the central government plans. 4.

Bank loans

Industrial SOEs rely heavily on banks for loans for bailing them out. Most of the non-performing loans go into covering losses of these enterprises. In conditions of low interest rates, these bank credits are an indirect form of subsidy to enterprises. Since the reform of the early 1980s, bank financing of SOEs replaced fiscal transfers (subsidies) by the state. The sources of SOE finance include (i) government subsidy, (ii) bank loans and (iii) self-financing out of SOEs profits. While the opportunity cost of direct government subsidy is zero, the cost to SOEs of self-financing will depend on market rate of interest. If it is higher

Market or Government Failures? 145

than the state bank loans, there will be incentive to rely on `soft' loans. Hussain and Stern (1991b) show that the government allocation of funds and tax policy make loans more attractive than self-financing. They note that both the interest on loans and the repayment of principal sum by the SOEs is tax deductible which encourages borrowing and narrows the tax base. Secondly, soft-budget constraint is indicated by the very low nominal interest rates, and low or even negative real interest rates on which loans are advanced by the banks. We assume that state bank annual loans to SOEs consist of loans to industrial and commercial enterprises (loans to construction companies are quite small and are excluded) almost all of which are SOEs. These annual loans to SOEs are much higher than the magnitude of enterprise loss subsidies. However, it is not appropriate to assume that all loans to SOEs reflect a soft-budget constraint. We need information on policy loans to SOEs at below-market interest rates, which is not available. There is some indication that policy loans (those advanced at the central and local levels under instructions from the government) have been 12 10 8

(%)

6 4 2 0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 –2 Enterprise loss subsidies as % of GDP Financial sector subsidies as % of GDP State bank loans as % of GDP

Figure 6.2 State subsidies and loans to Chinese SOEs Sources: Statistical Yearbook of China; Comprehensive Statistical Data and Materials on 50 years of New China (1999). Notes: (1) Loans of SOEs=industrial plus commercial loans; construction loans are not included as separate data are not available. However, construction forms only a small proportion of total loans. (2) Data on loans refer to annual loans.

146 State Enterprises in China and India: A Case of Government Failure

increasing in the 1990s. At the end of 1995 outstanding state bank loans to SOEs amounted to 3.36 trillion yuan, or 83 per cent of all outstanding bank loans. Bank lending for fixed investments (also concentrated on SOEs) by the Industrial and Commercial Bank of China accounted for more than 90 per cent of the total (Lardy, 1998b, p. 83). There is also evidence to suggest that local governments collude with local branches of banks to obtain `soft' loans for SOEs under their control. Fig. 6.2 shows changes over time in (a) enterprise loss subsidies, (b) financial sector subsidies (indirect subsidies in the form of low-interest loans to SOEs and unpaid principal and interest), and (c) state bank loans as a proportion of GDP. While (a) has been steadily going down since 1985, there is no clear trend in (b) which shows a trough between 1989 and 1991 before rising again in the early 1990s. Loans by the state banks to SOEs as a proportion of GDP have been rising between 1988 and 1991; although they declined somewhat in the 1990s, they have generally been rising while the state subsidies as a proportion of GDP have been falling. Loans to urban collectives and rural credit cooperatives have been rising less rapidly, and those to rural credit cooperatives and to individual businesses remained stagnant. Xu (1998, p. 160) notes that `more than 70 per cent of the specialized banks' assets are tied up in loans to loss-making state enteprises'. As we noted in Chapter 5, a large proportion (estimates vary from 20±30 per cent) of total loans to state enterprises remain unpaid. Since the banks are still state-owned, they are under constant pressure to lend to SOEs on the basis of political rather than commercial considerations. This is particularly so at the local government level. Xu (1998, p. 157) notes that `bank credit, which was lent out as policy loans, was in effect like fiscal grants, the use of which was beyond the banks' control'. The banks' lending behaviour may continue to be based on the perception that lending to SOEs would continue to be implicitly guaranteed by the government on moral and social grounds. 5.

Excess labour, wages and bonuses

Estimates vary on the size of redundant labour in the Chinese SOEs. This is all the more so because of a lack of agreement on the methodology of estimation. Enterprise surveys are a common method for estimating surplus labour in SOEs (Fan et al., 1998). Chinese managers in SOEs are generally asked whether they could produce the same output with less labour, and if so, by how much. Various official and unofficial estimates of labour surplus in Chinese SOEs are presented in Table 6.4. Lim et al. (1996, p. 31) estimate labour

Market or Government Failures? 147

surplus in Chinese industrial SOEs and other forms of ownership on the basis of a field survey undertaken in February±March 1995. `In job' labour surplus was estimated by asking enterprise managers whether the same level of output could be achieved with fewer workers, and if so by what percentage. Enterprises responded that labour could be cut by 17 per cent of their current total workforce. Amongst all the ownership categories, the highest level of labour surplus was reported in jointstock companies (18.9 per cent) followed by labour service enterprises (16.4 per cent) and state-owned enterprises (15.6 per cent). In addition to the `in job' labour surplus, a phenomenon peculiar to China is that of `on leave' surplus labour (xiagang or lay-offs) which represents a phased labour redundancy in SOEs. Although these workers vacate their posts they continue to be paid a partial salary or allowances during a specified period during which they are encouraged to look for alternative jobs. There were about 5.6 million such workers in 1995 whose number increased to 16 million in 1998 (see Yang and Tam, 1999). This dramatic increase in `on leave' workers may be explained by an increase in the number of SOEs bankruptcies. This Table 6.4 Estimates of excess labour in Chinese state-owned enterprises Source

Estimate

Lim et al. (ILO) (1996)* 18.4 % of urban workforce World Bank I (1993b) 11% Broadman (1995) World Bank II (1999) China I

30±40% of SOE employees 30% of SOE employees 10±12% of urban SOE employees

China II

25% of SOE employees

China III

15±20% of urban SOEs

China IV

20±25%

China V China VI

Over 33% of workforce 20% of employees

Comments Based on current output Based on 100% capacity utilization Resident Mission in China Ministry of Labour; based on 15,000 enterprises in 11 provinces Officials in charge of planning and systems reform State Economic and Trade Commission Estimates of research institutes Survey of 45 reforming SOEs in Shanghai

Sources: World Bank (1993b, 1999); Broadman (1995); Lim et al. (1996); Knight and Song (1999). Note: * includes `on leave' and `in job' surpluses.

148 State Enterprises in China and India: A Case of Government Failure

slow retrenchment no doubt softens the blow and social hardship, but in terms of budget constraint, it continues to remain a financial burden on SOEs at least temporarily. Apart from receiving a partial salary xiagang workers continue to receive subsidies and social insurance fees from their employing SOEs. In contrast fully redundant workers do not benefit from such assistance although they may receive some unemployment benefits from the local labour bureaus. Two notable features of the labour surplus estimates in Table 6.4 are (a) a very wide range and (b) their partial and micro nature. The estimates vary depending on the assumptions and the perceptions of enterprise managers since most estimates are made on the basis of interview surveys. In the literature, it is taken for granted that there is abundant surplus labour in Chinese SOEs. Knight and Song (1995, p. 97) note that China is `a labour surplus economy par excellence and the institutions of the labour market have to be viewed in that light'. Li and Liang (1998, p. 106) assume that non-production workers in SOEs are potentially redundant and that their removal would on an average reduce SOE financial losses by about 38 per cent. We noted earlier that estimation of labour surplus in industry is fraught with major problems, even in industrial countries where far more emphasis has been placed on studying the underutlization of capital than of labour. Without an appropriate conceptual and measurement framework, the estimates of surplus labour in Chinese SOEs are no more than rough orders of magnitude, which do not give any true picture of the extent of labour surplus in Chinese industry as a whole. Surplus labour by level of ownership has also been estimated and compared with net profit to net fixed capital and total tax to net value added in SOEs, COEs and TVEs (see Table 6.5). Surplus labour estimate for SOEs (14 per cent) is lower than that for COEs (18 per cent) and higher than that for TVEs (11 per cent). The net profit to capital ratio is very close for both SOEs and COEs. This implies that higher surplus labour in COEs has no adverse influence on their profitability. Furthermore, if the results were reliable, one could not agree with those who claim that COEs increasingly face a hard-budget constraint (see above) under which they should record much lower surplus labour. As we noted above, a distinction between SOEs and COEs is quite fuzzy as both are strictly speaking state-owned. Therefore, it is unlikely that the behaviour of COEs would be very different from that of SOEs. We do not question the existence of surplus labour, but the feasibility of removing it at least in the short run in a labour surplus economy. One

Market or Government Failures? 149 Table 6.5 Surplus labour, taxation and profitability in Chinese enterprises by ownership levels (1990±94 averages) SOEs Optimal employment to current employment Net profit to net fixed capital (%) Total tax to net value added (%)

0.86 7.4 16.6

COEs 0.82 7.6 15.5

TVEs 0.89 13.0 20.5

Source: Raiser (1997b). Note: Surplus labour was subjectively estimated on the basis of managers' responses to a qualitative questionnaire.

needs to distinguish between labour surplus economy (a macroeconomic issue) where excess labour is disguised for lack of any formal or informal unemployment insurance mechanism, and surplus labour in enterprises (a microeconomic issue) with which most of the Chinese literature is concerned. Whether shedding of labour surplus in Chinese SOEs will harden the budget constraint and improve economic efficiency will depend inter alia, on the reasons for labour surplus in the first place. In the pre-reform period, to ensure full employment the Chinese government used SOEs as an employment-generating mechanism and expected enterprises not only to take on workers who were not necessary for production but also to provide jobs to the children of their workers. Although in theory, the Chinese government now allows SOEs to lay off workers, in practice labour market flexibility (hiring and firing) is not common, due in part to the failure of a comprehensive social security system and limited resources at the level of local governments to take responsibility for their social welfare. Labour mobility is restricted by the fact that workers will forgo social welfare benefits of housing, education and health services (and even pensions) once they leave SOEs. These benefits are not available to the workers employed under other forms of ownership, for example, joint ventures, and collective and private enterprises. Under hard-budget constraint, surplus labour may arise from slack in demand, technological modernization, or reorganization of production. In a dynamic context, labour surplus arising from these factors can be laid off to improve efficiency. In the ILO survey reported in Lim et al. (1996) the enterprise respondents noted the following reasons for the existence of labour surplus:

150 State Enterprises in China and India: A Case of Government Failure

(a)

developments in the product market (26 per cent of the respondents); (b) technological and organizational changes (22 per cent); (c) poor labour quality (15 per cent). There is evidence that the Chinese government, faced with the problem of massive lay-offs and resulting social instability, has often discouraged SOEs from shedding surplus labour (see Lim et al., 1996). Wages and bonuses Payment of wages and bonuses under hard-budget constraint would be linked to economic performance and would reflect reward for aboveaverage worker productivity. However, in China even loss-making SOEs are known to have raised wages and disbursed bonuses. Li and Liang (1998) estimate that 39 per cent of the SOE losses were due to excessive bonus payments, and that about 81 per cent of SOEs in their sample distributed excessive bonuses. Sachs and Woo (1994, p. 119) note incentives for managers (under the soft-budget constraint) to `strip the state enterprise income and assets to their personal benefit . . . by distributing profits in the form of higher compensation . . . (since) nobody is in place to defend the interests of the enterprise capital'. Under the Chinese enterprise reforms, bonuses (not exceeding 25 per cent of the basic wage bill) were allowed in order to induce increase in labour productivity. There are indications that wage bonuses and allowances for increase in cost of living paid by many SOEs were well in excess of this ceiling even when they were making losses. Fan et al. (1998, p. 37) note that in `1993 the bonus payment accounted for more than 22 per cent of the total wage bill in coal mining and oil extraction even though the two sectors have suffered consistent losses'. If losses are attributed to such exogenous factors as price and foreign exchange controls, SOEs (the agent) can successfully negotiate with the principal (their supervisory government bodies) hidden or open financial support. Wage increases have also exceeded labour productivity increases by a wide margin particularly in loss-making SOEs (World Bank, 1996a). Such increases would not be possible without the tacit support of the government or the financial sector. According to estimates based on the World Bank enterprise survey data, `during the early 1990s the bonus share in the total money compensation was fairly uniform across ownership types, registering the lowest in urban cooperatives, and township and village enterprises and the highest in

Market or Government Failures? 151

joint ventures' (see Jefferson et al., 1999, p. 175). These estimates show increasing sensitivity of bonuses in SOEs to labour productivity which is not necessarily the case in other ownership categories. Wages and bonuses have risen more rapidly in the state sector than elsewhere. Wage shares in value added in Chinese SOEs show a steady increase since 1978, rising from 23 per cent in 1978 to nearly 53 per cent in 1995 (see Hussain and Zhuang, 1998, p. 48). In non-SOEs the wage share was higher than in SOEs in 1978 (34.8 per cent) but much lower in 1995 (38.1 per cent). Such factors as decentralization of wage determination, scope of increased wage bargaining in the absence of threat of bankruptcy or lay-offs are responsible for a rapid increase in the wage share in Chinese SOEs. The enterprise reforms and resulting SOE autonomy seem to have had the opposite effect to what was intended by the Chinese reformers. Instead of raising profits they have led to overconsumption due to the soft-budget constraint. This is particularly so at the local (county) level where wage bill including bonuses, subsidies and allowances increased more than at the higher levels between 1995 and 1997 (see Table 6.6). Table 6.6 Increase in wages and bonuses in Chinese SOEs by level of control (1995±97) Control/administrative level

1995 (billion yuan)

1997 (billion yuan)

Increase % over 1995 increase (billion yuan)

SOEs under central government SOEs under provincial government SOEs under prefectural government SOEs under county government National Total

173 114 151 169 608

214 135 173 216 735

41 21 22 47 127

23.7 18.4 14.6 27.8 20.9

Source: China Labour Statistical Yearbook, 1997, 1998.

THE SOFT-BUDGET CONSTRAINT IN INDIAN PUBLICSECTOR ENTERPRISES (PSES) Like Chinese SOEs, Indian PSEs are also a major burden on the national economy. Their continued losses and government's bailing out involves major budget deficits at both the central and state levels. Financing of investments in PSEs consist of internal resources, support from the central and state budgets in the form of direct subsidies and state bank

152 State Enterprises in China and India: A Case of Government Failure

loans. While loans have to be repaid with interest, many loss-making PSEs may request an interest subsidy, postponement of interest payments, writing off of the loan or its rescheduling and so on (see Gupta, 1988). The central and state governments generally provide revenue support to these enterprises through what are called `non-Plan' loans (Jalan, 1991). Gupta (1988, p. 2698) notes that `there is reason to believe that many CPEs (central public enterprises) receiving budgetary support do not make any contribution to the GOI's (Government of India's) receipts by way of loan repayments, interests, dividends and business income taxes . . . GOI's budgetary support to such CPEs . . . are tantamount to government grants'. Indian PSEs (unlike Chinese SOEs) are not responsible for extensive social welfare of their workers. However, they do undertake responsibility for the provision of housing facilities especially in remote areas (GOI, 1997±98). Also, somewhat similar to Chinese SOEs, Indian public-sector enterprises have acted as a source of employment (see below). As we discuss below, excess labour in PSEs is one of the reasons for their inefficiency. Overstaffing in these enterprises is partly due to political appointments and employment of friends of politicians somewhat analogous to the Chinese experience. The location of most central PSEs (for example, steel plants) was based on political considerations rather than economic ones, which opened the door for political interference right from the beginning. Jalan (1991, p. 74) notes that `the role of powerful political and other interests in perpetuating the inefficient operation of public enterprises cannot be denied'. As PSEs are subject to several layers of government or parliamentary control, their poor financial performance (see below) is often due to such exogenous factors as long bureaucratic delays in the pricing of their products. Other reasons for poor performance have to do with low degree of capacity utilization, excessively high capital±output ratios and poor investment decisions due in large part to lack of accountability and control of costs of production. Majumdar (1998) compares 67 PSEs, 63 private Indian firms and 27 foreign firms operating in India, and shows that the PSEs consume far more materials and capital and employ a much larger number of workers. It is estimated that the PSEs consume excess resources by the amount of Rs. 30 billion annually to produce existing output levels, or with existing inputs they could raise annual output by Rs. 56 billion (ibid., p. 392). The soft-budget constraint prevents managers of PSEs from improving their performance. Direct and indirect subsidies by the central govern-

168

87.3 115.5 182.3 14.2 0.4 1.8

13.2

7.8 0.2 1.6

87

18.2 22.0 36.5 1.5 0.2 0.0

9.5

4.0

0.6

0.1

1980±81

3.9

3.4

10.9

17.9

432.4 588.7 1020.8 111.0 35.0 22.7

236

1990±91

4.6

3.6

11.4

18.0

519.4 705.3 1401.1 159.6 50.8 32.7

239

1992±93

5.7

4.2

11.6

17.3

559.7 795.3 1598.4 185.6 66.6 45.5

240

1993±94

Sources: GOI, Economic Survey 1998±99, p. 104; GOI, Economic Survey 1999-2000, p. 120.

No. of enterprises Paid up capital Net worth Capital employed Gross profit Pre-tax profits Profit after tax (PAT) Ratio of gross margin to capital employed (%) Gross profit to capital employed (%) Pre-tax profit to capital employed (%) PAT to net worth (%)

1970±71

Table 6.7 Profitability of Indian central public-sector enterprises (Rs. billion)

8.0

6.0

13.9

20.6

582.9 899.5 1624.5 226.3 97.7 71.9

241

1994±95

9.6

7.8

15.8

23.1

595.9 991.8 1739.5 275.9 136.2 95.7

239

1995±96

8.8

7.5

15.2

22.2

624.3 1138.9 2015.0 306.1 152.1 99.9

238

1996±97

10.4

8.7

16.2

23.6

657.6 1324.4 2230.5 360.9 193.8 137.2

236

1997-98

153

154 State Enterprises in China and India: A Case of Government Failure

ment and legal restrictions on firms' entry and exit (see below) are key elements in generating the soft-budget constraint. 1.

Profitability

Indian central public-sector enterprises are known to make losses which are covered by substantial government subsidies.10 Since liberalization these enterprises have been exposed to domestic and foreign competition, which has led to some improvement of gross profits and gross margin as a ratio of capital employed till 1995±96, but the overall profitability declined in 1996±97 (see Table 6.7).11 This situation contrasts with that of China where profits of SOEs have been declining over time due, inter alia, to growing competition from collective enterprises. There seems to be another difference; we noted earlier that some of the losses of Chinese SOEs may be explained by low prices fixed by the government for their products. In India also there are restrictions on the price PSEs can charge, but this does not seem to have adversely affected their profits, which have been rising. But there may be other adverse consequences in terms of loss of economic efficiency. Apart from reducing the revenues from sales, losses may result in cross-subsidization within the enterprise since they will need to be recovered from its more profitable trading elsewhere (see Roy and Tisdell, 1998). PSEs' debts may accumulate which may lead to further borrowing from state banks at subsidized rates. Table 6.8 Financial performance of state electricity boards (SEBs) in India 1992±93 1993±94 1994±95 1995±96 1996±97 Losses of SEBs (Rs. million) Before subsidy After subsidy Rate of return on capital (%) Without subsidy With subsidy Average cost (Rs.) Average realization (per Kwh) Transmission & distribution losses (%) (per kwh) Plant load factor of SEB thermal stations (%) Source: Ahluwalia (1998). Note: ± ˆ not available.

45,600 27,250

52,890 30,070

66,420 32,430

75,240 54,080

12.7 7.6 1.28 1.05

13.3 7.6 1.44 1.19

14.4 7.0 1.58 1.29

14.6 10.5 1.73 1.44

19.8 54.1

19.4 56.6

19.5 55.0

18.5 58.0

100,000 74,200 17.9 13.7 1.86 1.49 ± ±

Market or Government Failures? 155

There are also public enterprises at the state and local levels. The size of these enterprises generally tends to be smaller. Their economic performance and profitability is known to be worse than that of the central public enterprises. State-level enterprises, particularly the State Electricity Boards (SEBs), have been running at losses since 1992±93 when their rate of return was negative as it has been throughout the transition, worsening from 7.6 per cent (net of subsidy) in 1992±93 to nearly 14 per cent in 1996±97 (see Table 6.8). The SEBs suffer from losses because of poor collection efforts, overstaffing and pricing electricity below long-run marginal cost. Both political and economic reasons explain underpricing of electricity for farmers. Political considerations have stood in the way of raising minimum charge for electricity for agricultural purposes.12 Profitability of Indian public-sector enterprises is shown to be lower than that of private enterprises (Chhibber and Majumdar, 1998; Joshi and Little, 1994; Sankar et al., 1994). The results of a study of 541 public and private limited companies (relating to 1983±84 to 1985±86) show that private firms realized higher returns on capital (in terms of the ratio of profits before tax plus interest to total capital employed) than public enterprises. This experience is similar to that of Chinese SOEs discussed above. However, if the `sick' enterprises are excluded, the difference in profitability narrows down to only 1±2 per cent. Profitability of public enterprises in petroleum and related sectors was higher than that in other sectors. Chhibber and Majumdar (1998) show that the state ownership does affect firm performance, but it varies with the degree of ownership. The increasing government ownership in Indian mixed-enterprises has a negative influence on rates of return. The above empirical tests of relative profitability of public-sector enterprises are analytically flawed in so far as monopolistic public enterprises are compared with competitive private enterprises under different market and price structures. It may well be that the inefficient public enterprises are so because of their monopolistic rather than ownership structure. Thus profitability estimates may not be a good indicator of economic efficiency of PSEs. Given the ownership pattern, public enterprises do become more profitable under competition during transition (see Table 6.7). The pertinent question really is whether competition and profitability can improve significantly without private ownership. In India privatization of public enterprises, a major component of liberalization, has failed to make much headway. The private domestic sector is reluctant to take over loss-making public-sector enterprises, and

156 State Enterprises in China and India: A Case of Government Failure

divestment of profit-making enterprises implies a revenue loss for the government. The sale of these enterprises to foreigners is not politically palatable. Foreign investment has played an insignificant role in the `disinvestment' process since foreign investors prefer to collaborate with private rather than public sector (Arun and Nixson, 1997).13 It is noted that the `disinvestment programme is seen as threatening the material interests of politicians, organized labour and civil servants in India' (Arun and Nixson, 2000, p. 29). It is not certain that privatization of public-sector monopolies into private-sector monopolies will necessarily lead to improved economic efficiency. Many public enterprises make profits only because of their monopolistic position. An alternative to privatization is competition and the easing of entry barriers which are essential for improved economic performance of public enterprises as has been shown by the Chinese experience discussed above. However, competition alone is unlikely to `ensure responsibility in investment and management decisions' (Bardhan, 1993). It is rather surprising that studies on economic performance of publicsector enterprises rarely discuss changes in total factor productivity or partial productivity of labour and capital. Most of these estimates relate to the 1960s and 1970s. For example, Dholakia (1978) shows that total factor productivity (TFP) grew very slowly during this period. However, labour productivity rose faster with rising capital intensity. But capital productivity declined. More recent estimates, based on 11 groups of manufacturing industries among PSEs for 1971±72/1987±88 show a falling trend in TFP in consumer goods and steel production, and a rising trend in minerals and metal, power, petroleum, chemicals, engineering and transport equipment (see Kumari, 1993). The declining trend is alleged to be explained by the poorer management±labour relations. More recent estimates of productivity are not available but some evidence suggests that there may have been an improvement. In the 1990s, PSE output and profitability grew steadily while fixed investment growth rate and absolute employment fell.14 2. Government subsidies In the pre-liberalization period, governmental support for these enterprises was based more on social grounds than economic efficiency. `Sick' public enterprises (and even private ones) were bailed out by the central government on the grounds of their strategic importance, their large investment requirements which the private sector would be unwilling to make and their role in creating employment and preventing labour

Market or Government Failures? 157 Table 6.9 Government subsidy to Indian public-sector enterprises Type of enterprise

Total cost of service (Rs. million)

Total recovery (Rs. million)

Subsidy (Rs. million)

Subsidy as % of total subsidy

Subsidy as % of total cost of services and transfers

Departmental enterprises Non-departmental enterprises Cooperatives All public enterprises of which: Central public enterprises State public enterprises

231,800

155,610

76,190

18.0

8.3

99,170

30,490

68,680

16.2

7.5

7,380 338,360

1,460 187,560

5,930 150,800

1.4 35.6

0.6 16.5

238,140

146,010

92,130

21.8

10.1

100,210

41,550

58,660

13.9

6.4

Source: Mundle and Rao (1991).

expolitation (in mines, for example). These enterprises were protected from domestic and external competition. They also enjoyed preferential access to imports and foreign technology. Enterprises which were hitherto in the private sector were brought under public ownership and control (for example, nationalization of banks, coal mines and life insurance) and new state-owned enterprises (namely, atomic energy, heavy engineering, railway locomotives and so on) were established even in those sectors where private industry was operating efficiently (for example, steel production). Estimates of direct and indirect subsidies to PSEs are hard to find. The most commonly cited source for subsidy estimates is Mundle and Rao (1991). According to this source, in 1987±88 the government subsidy to PSEs (total cost of service minus total recovery) amounted to Rs. 150,000 million of which Rs. 92,130 million (or over 63 per cent) went to central PSEs. At the state level, subsidies amounted to Rs.58,660 million (see Table 6.9). A more recent estimate of subsidy to the central PSEs for 1994±95 is Rs.46, 670 million (see Srivastava and Sen, 1997). This estimate (based on a survey of 248 central public enterprises) is not comparable with the Mundle±Rao estimates (Table 6.9) or the Tiwari (1996) estimate on account of differences in methodology, data sources and state coverage.15 Srivastava and Sen (1997, p. 29) note that `a comparison of group-wise figures for retained profit/loss for 1994±95 indicates that heavy subsidies are involved even in those sectors

158 State Enterprises in China and India: A Case of Government Failure

which are generating profits in the aggregate, for example, steel, minerals and metals, coal and lignite, power, chemicals and pharmaceuticals'. Indirect subsidies to PSEs include tax relief and preferential loans (the PSEs' interest rate advantage over private firms being over 4 per cent). While private firms' capital structure includes both equity and loan financing, the PSEs are funded mainly by loans which is explained largely by the negative net worth of PSEs. Jalan (1991) estimated the cost of equity-deficit at Rs. 130 billion (which is borne by the state) and Rs. 70 billion per annum as an indirect subsidy in the form of annual interest costs of capital. A more recent estimate for 1994±95 puts this cost of capital at Rs. 78 billion (see GOI, 1997). Buiter and Patel (1995, p. 2) note that `public-sector enterprises (PSEs) continue to be a large net drain on the financial resources of the government'. Despite several years of liberalization, these enterprises continue to operate under `soft-budget' constraint, as is reflected in the Reserve Bank of India guidelines for them. `Sick' enterprises continue to receive loans at more favourable rates than the non-sick enterprises; favourable reports on their performance often justify further loans, and bad debts continue to be written off. A generous equity to debt leverage combined with highly subsidized incremental debt makes it more advantageous to remain sick than to aim at making profit. All these factors tend to perpetuate industrial sickness (ILO, 1996, p. 87). 3. Bank loans Like China, non-performing bank loans to `sick' companies is also a serious problem in India. Joshi and Little (1996, p. 123) note that in March 1993 `total bank credit locked up in sick units was Rs. 13,100 crores (Rs. 131,000 million) constituting 9 per cent of total bank credit and 16 per cent of bank credit to industry'. However, it should be noted that in India `sick' companies include both PSEs and private firms. It is estimated that a quarter of this lending went to small industry. It may be assumed that as a rough approximation, about half of bank credit to industry (or 8 per cent) went to PSEs. 4.

Excess labour and wages

The restructuring of public-sector enterprises was one of the important components of the Indian liberalization policies. Deregulation of industry, privatization and competition were introduced to ensure ease of entry, and an `exit' policy was formulated to enable inefficient or `sick' enterprises to disappear. In December 1991 the Sick Industrial Companies Act 1985 was amended so that the `sick' public enterprises could be

Market or Government Failures? 159

referred to the Board for Industrial and Financial Reconstruction (BIFR) for their rationalization and rehabilitation. Between May 1987 and March 1998, BIFR considered 2,145 cases including 65 central publicsector enterprises and 87 state public enterprises. Of these only 296 enterprises were wound up (Gupta, 1998b). The policies of privatization of public enterprises and exit of `sick' private enterprises have not yet been vigorously implemented. Despite efforts to shed surplus labour in the public enterprises the results have been dismal thanks to powerful opposition from the trade unions. Lack of such opposition in China facilitated some labour shedding there in the interest of cost reduction and competitiveness. In India on the other hand, sale of public enterprises is motivated more by the need to reduce government borrowing and fiscal deficit than any genuine industrial restructuring to raise economic efficiency (Bhaduri and Nayyar, 1996, p. 41). There are no systematic studies on labour redundancy in Indian industry, either public or private. One recent crude attempt compares labour surplus in both public and private enterprises and shows that it is substantial in both (ILO, 1996, pp. 93±94). Labour surplus in the central PSEs is estimated at nearly 18 per cent of total employment, or 0.38 million for 1990±91, and that for the private sector, 0.99 million, or nearly 13 per cent. An additional 1.3 million workers are estimated to be made redundant in the public-sector enterprises at the state level. Growth of employment in the sector has slowed down due partly to worker retrenchments and a decline in output growth of the sector. Employment growth declined from 2.1 per cent per annum during the 1980s to 0.38 per cent between 1991±92 and 1996±97 (GOI, 1998a). Expectations of private-sector employment making up for this decline may not materialize in conditions of increasing global competition and low Indian industrial productivity. Furthermore, employment elasticity of output in Indian industry has declined from 0.35 per during the last decade to 0.02 per cent currently (Gupta, 1998a; cites Papola study). PSEs were to receive priority allocations from a National Renewal Fund created in 1992 as a social safety net to alleviate the problem of labour redundancy. In practice however, Gupta (1998b) notes that `one of the major objectives of the Fund, to provide funds for employment generation . . . has not been touched so far'. The bulk of allocations from the Fund have been made for a Voluntary Retirement Scheme; allocations for retraining and redeployment of displaced labour have actually declined. In addition to the problem of large-scale labour redundancy, necessary institutional and legal reforms need to be implemented to facilitate the

160 State Enterprises in China and India: A Case of Government Failure

`exit' of `sick' enterprises. Labour laws, which remain unchanged under liberalization, forbid worker dismissal and do not allow autonomy to public enterprises in recruitment and wage policy. The Industrial Disputes Act will require amendments so that labour can be retrenched without prior permission of the State governments. Under the Urban Land Ceiling Act the restructuring of `sick' enterprises requires the permission of state governments to dispose of the real estate to settle creditors' claims. In the past State governments, hostile to reforms are known to have blocked such permission (see Bhalla, 1995a). Wages and benefits Average annual wages and benefits including bonuses have increased significantly in Indian PSEs (see Table 6.10). Between 1996±97 and 1997±98, these wages and benefits increased by 13.5 per cent. The most significant increases (ranging between 21 per cent to 34 per cent) were in PSEs in power, petroleum and transport equipment. Table 6.10 shows an annual increase of at least 6 per cent, 1995±96 recording the highest increase of 29.5 per cent over the previous year. Since 1986±87 the annual percentage increase in wages and salaries including bonuses has been consistently higher than that in GDP per employee, used as a proxy Table 6.10 Increase in Indian PSE wages and benefits Year

GDP per employee (Rs. 000)

% increase over Average annual % increase over previous year wages and sal- previous year aries (Rs. 000)

1984±85 1985±86 1986±87 1987±88 1988±89 1989±90 1990±91 1991±92 1992±93 1993±94 1994±95 1995±96 1996±97 1997±98

151.6 165.9 173.6 185.8 202.4 220.3 228.8 255.9 264.7 284.7 297.3 330.3 ± ±

± 9.4 4.6 7.1 8.9 9.6 3.8 11.8 3.4 7.5 4.4 11.1 ± ±

Source: GOI (1998). Note ± ˆ not available.

24.3 25.9 28.8 32.5 39.4 43.7 49.2 56.5 65.0 72.0 82.5 106.9 113.0 132.2

± 6.4 11.3 12.9 21.1 10.8 12.6 14.9 15.0 10.9 14.5 29.5 5.7 17.0

Market or Government Failures? 161

for labour productivity. This result is similar to that noted for China above.

CONCLUSION In this chapter we have explained government failures in terms of softbudget constraints in state enterprises in China and India. There are striking similarities between the experiences of the two countries. In both countries these enterprises were at the `commanding heights' at the beginning of reforms, but in the process of liberalization, they both realized that the state enterprises were draining state assets too much and needed to be reformed to successfully compete in the global market. Direct and indirect subsidies (direct financial support from the central budget, tax concessions, subsidized loans and so on) propped the enterprises in both countries, which acted as a disincentive for managers to improve their economic performance. Failure of the government to allow bankruptcy, despite China having promulgated bankruptcy laws and India having formulated an `exit' policy, meant loss of credibility in both countries. Introduction of a hard-budget constraint as a stopgap arrangement is unlikely to change the behaviour of enterprise managers from passiveness to active pursuit of economic goals. A shift from a soft-budget constraint to a hard-budget constraint calls for credibility and commitment on the part of the government both of which may be thwarted by political constraints (Kornai, 1993, 1998). This is precisely what happened in China and India. In China, after having declared that the state would no longer bail out SOEs either directly or through soft loans by state banks, for political and humanitarian reasons in 1998 (when threat of massive unemployment and resulting social unrest became imminent) the government urged the banks to grant additional policy loans to these enterprises. Similarly, an `exit' policy formulated by the Indian government could not be implemented for social and political reasons. Trade union pressures and fear of massive unemployment in view of government's inability to reabsorb redundant workers slowed down privatization. It is these issues of public enforcement and implementation to which we turn in the concluding chapter.

7

Conclusion: Implementation Failures

The bulk of the literature on contracts and transaction costs invariably assumes enforcement and implementation as given, `assuming either that it is perfect or that it is constantly imperfect' (North, 1990, p. 54). In practice, the structure of enforcement mechanisms would influence the outcome. Two main reasons may explain limitations in enforcement. Firstly, the behaviour of enforcement agents is relevant; their own utility function may conflict with enforcement. Secondly, the cost of contract enforcement may be too high especially in developing countries characterized by the lack of adequate institutions or the existence of poorly functioning ones. In these countries, institutional imperfections may also be reflected in the misuse of legal instruments, rules and regulations. We noted in Chapters 1 and 2 that both market and non-market failures are ultimately translated into failures in the implementation of public and private strategies and policies. However, traditionally these failures are attributed mainly to inadequacies of public policy. The collapse of banks and financial institutions discussed in Chapter 3 clearly shows that failures also occur in the private corporate sector. Crises in the financial markets around the world occurred because of management failures, informational inadequacies and the absence or lack of enforcement of regulatory practices and norms. Implementation failures under the market or private sector, for example, of corporate strategies of multinational organizations and other firms, may also be ascribed to imperfect functioning of market institutions, high costs of production, low quality of product and poor consumer response. Such institutional factors as managerial and organizational inadequacies and poor transportation and communication facilities may account for implementation failures under a market system. These institutional 162

Market or Government Failures? 163

factors are common to both market and non-market situations. Until recently the economics literature rarely consisted of any analysis of successes and failures in implementation, or reviews of public policy or corporate strategy, which were considered the domain of the political scientist. In this book, we show that a dichotomy between the role of government and markets in development is not very helpful. The negative impact of both market and government failures needs to be overcome. When self-enforcement of contracts is not possible, a third party is required for enforcement. Such a third party is the government. Government interventions need to be justified after a careful and comparative assessment of actual market failures and potential non-market failures (Wolf, 1979a). Such comparisons and assessment of the nature and types of policy intervention are essential to determine which ones approximate a socially desirable outcome. An important role for government intervention is to achieve the equity objective which the market fails to do. But there is no guarantee that such intervention will necessarily achieve equity. Bureaucrats or civil servants responsible for enforcement may be more interested in their own selfish goals than those of the public at large. Similarly, managers of private organizations may ignore the interests of a large number of shareholders who are remote from day-to-day operations. Although the market mechanism may not be good for achieving equity or social welfare, it is more effective than government for achieving the efficiency objective. Therefore, government and markets are both essential to achieve these twin objectives of equity and efficiency. In fact, at an early stage of economic development both state and market can increase in power (Lipton, 1991). In this book we critically review analytical premises of market and nonmarket failures and apply them to specific country situations in Asia. We demonstrate in Chapter 4 how the Asian crisis was caused not so much by public policy failures as by failures in the financial markets. The fundamental aspects of macroeconomic management (budgetary and monetary policies, interest rate and inflation) were sound at the time of the crisis in 1997. Although current account deficits were high, so were capital inflows and foreign exchange reserves. But the worrisome signals emerged from the financial sector and foreign exchange markets. Such signals as appreciation of the real effective exchange rates and rapid growth of credit to the private sector leading to offshore borrowing by the banking sector were cause for worry but seemed to be ignored. We reviewed different theoretical explanations of the Asian crisis, namely, macroeconomic mismanagement, structural problems of the

164 Conclusion: Implementation Failures

Asian brand of capitalism, and financial panic. We come to the conclusion, which is now generally accepted, that the Asian crisis represents a case of financial panic and private banking failures. Foreign banks' indiscriminate lending notwithstanding, the worrying signals noted above suggests their blind faith in the rapidly growing East Asian economies and the high rates of return that they offered. The governments of the affected Asian countries made capital available to selected industries too cheaply which may have contributed to the crisis. However, we reject the view that the Asian crisis was the result of rampant corruption and crony capitalism. This is so not because we do not accept the existence of cronyism or corruption but because these features preceded the crisis. They are not inherent in the Asian model of capitalism. As we indicated in Chapter 4, the above problems can be tackled by strengthening the power of the shareholders in corporate management and introducing proper bankruptcy laws. Both these actions require public policy and action in the financial sector. We do not rule out government failures, however. Chapter 6 discussed how the operation of the public sector in both China and India resulted from failures of the two governments in putting into effect policy packages to improve the economic performance of state enterprises. In both cases failures occurred more because of lapses in implementation than in the formulation of policies and programmes. In India, privatization of state enterprises, a clear government policy, is not being rigorously enforced. It is also true that the Indian government has not introduced changes in labour or bankruptcy legislation presumably for political and humanitarian reasons. Chapter 6 shows that economic problems of state enterprises in China and India result from soft-budget constraints ± too much political interference and failure to separate ownership from management and control. The budget constraint of state enterprises has not really been hardened in either China or India despite some rhetoric. Although some attempts have been made to separate management from ownership in both countries, results on growth of productivity have not been particularly encouraging. In developing countries (or developed for that matter) privatization of state enterprises may not necessarily offer better economic results. Like state enterprises, private firms also suffer from principal±agent problems. Effective monitoring of the behaviour of private managers may be just as difficult in conditions of divergent objectives of shareholders. When the number of shareholders is very large (as is the case in large corporations) an individual shareholder has no incentive to monitor the managers since he or she is unlikely to benefit directly

Market or Government Failures? 165

from such action. The improved performance would benefit every shareholder (see Chang and Singh, 1993). Similar problems arise in state enterprises. The `private' goals of different public agents (politicians, bureaucrats and technical advisers) are likely to be in conflict, raising principal±agent problems which weaken the will to implement policies and reform measures. We also conclude that corresponding to the market test and consumer behaviour, under the nonmarket system the existence of different pressure groups outside the government is a useful instrument of checks and balances. These checks and balances are not automatic in imperfectly functioning markets; they may need to be put in place through public policy. Two such noneconomic mechanisms are (a) participation and (b) accountability. Participation is defined as `the degree to which people who are affected . . . by a given choice between markets and governments, participate in the planning and implementation of the choice'. Accountability is defined in terms of `the degree to which the outcome of a market or non-market choice is subject to a rigorous process of evaluation and post-audit concerning its effectiveness and acceptability' (see Wolf, 1988, p. 128). As we noted in Chapter 1, in the market case, consumer choice, purchasing power, marketing, and advertising determine participation and accountability, whereas in the non-market case, it is the people's voice and votes that provide the relevant criteria for checks and balances. Generally, two related issues determine failure or success: (a) the design of policies and programmes and their implementation, and (b) enforcement of laws and regulations. Both may depend on such factors as participation and accountability. It is assumed that widespread consultation, involvement and participation of civil society enhances chances of enforcement of rules and regulations and implementation of economic policy. Similarly, accountability of politicians, bureaucrats and civil servants to higher authority, and in the final analysis to voters, can keep them on their toes and committed to implementation. Popular participation may be particularly important for the implementation of grass-roots programmes whose success would depend on the existence of effective and dedicated local organizations and individuals. Johnston and Clarke (1982, p. 170) define participation as an ex ante involvement of local organizations which can greatly increase the ability of the rural poor to solve local problems and to make demands on the larger social system. However, the cost of ensuring local participation in terms of time and energy as well as freedom of participants is often underestimated. Even in the industrialized countries with much better organizational resources at the local and community level, people

166 Conclusion: Implementation Failures

often prefer not to participate. Even when local organizations exist in developing countries, participation may be misdirected if these organizations follow their own narrow objectives rather than those of people in general. It has been noted that the community development movement failed in many developing countries precisely because it mistakenly treated the traditional village as a self-contained development unit without any need of external inputs. Indeed, it has been noted that in India the delegation of power to individuals at the local level often led to blocking of national policies (Weiner, 1977). Implementation failures can be kept in check by reining in bureaucracy which is not guided by any profit motive. A competent bureaucracy is more likely to be committed to enforcing rules and regulations and implementing programmes than the one that is ridden by internal squabbles and lack of technical competence. A system of evaluation and audit, and performance criteria are other independent mechanisms to ensure that management errors are minimized and corrective and timely action is taken. By using the experiences of Japan during the post-war period, and the subsequent experience of East Asia, India and China during the Asian Crisis, we demonstrate that a more attractive approach (than a dichotomy between market and government) is to examine why implementation failures take place±whether they are due to ineffectiveness of markets or of governments. Lack of implementation of economic reforms in developing countries is determined not only by this inadequacy of markets and other institutions but also by the political economy factors. Weaknesses in the formulation and implementation of many strategies and policies can be explained by political factors, and social structures and norms which will, inter alia, determine the nature of their outcomes. Success in implementation is defined in terms of the extent to which a strategy and accompanying policies and decisions are actually put in practice. It may also be defined in terms of the degree to which the effects of strategies and policies match the planned or intended outcomes (Craig, 1990). Implementation or enforcement is more likely to take place if those involved in the design of a strategy or policy are in some ways also concerned with its execution.

STRATEGY/POLICY DESIGN Development decisions regarding strategies and policies to be adopted are made on the basis of certain assumptions about the behaviour and

Market or Government Failures? 167

functioning of institutions and markets, availability of resources and their utilization, capacity of administration and political goals; that is, factors which, in one way or another, directly or indirectly influence the implementation process. Implementation of strategies, policies and programmes may succeed or fail depending on how well they are designed, who supports or opposes them and how they are executed. We shall examine these factors below. The nature and quality of strategy, policy and project design and their consistency with development goals and objectives are crucial prerequisites of successful implementation. Before considering the role of strategy and policy design it may be useful to discuss the meaning of these terms. A strategy may be defined as a set of interrelated policies designed to achieve a selected number of goals and objectives. Thus a government strategy will need to be backed by public policy and action to achieve defined goals. Also as noted earlier, public policy may be required for strengthening market institutions and creating non-market ones when market signals do not lead to desirable outcomes. A strategy by a private firm in the corporate sector may be designed to introduce policies and measures to reduce cost, improve quality and marketing with a view to maximizing profits or capturing a market niche. Some would argue that strategy and its implementation should be treated separately. Once the strategy design is adopted it is considered a simple matter for the relevant administrative agency to implement decisions. This linear model of implementation gives much greater weight to the formulation of strategy and the decision to introduce policies than to its implementation. Bruton (1985) notes that a distinction between policy design and implementation is unhelpful and that a policy which cannot be implemented is not a useful policy (see below). In contrast to the above linear model of implementation, Grindle and Thomas (1991) present an interactive model of implementing policy reforms under which a number of conflicting pressures may be imposed on different stakeholders in the reform process, namely, policy makers, government civil servants, managers of the implementation process and controllers of the purse strings. These pressures often lead to a reformulation of policies. Thus policy design and its implementation is a continuous and interdependent process. Successful implementation of any policy action depends in large part on how well-conceived the strategy is. The process of decision-making at the design and formulation stage influences the specificity and feasibility of goals and objectives and the shape of action programmes and projects that are necessary to achieve those goals (Grindle, 1980). But

168 Conclusion: Implementation Failures

good design is a necessary but not a sufficient condition for good implementation as we shall discuss below. What is a good or `optimal' policy design? The quality of a design needs to be examined in relation to developmental goals, expected or intended outcomes of a policy and some notion of its feasibility or implementability. Furthermore, the character of a `good' or `bad' design raises the question: good or bad for whom? The policy makers? The implementers of policy? Special target groups? Or the population at large? Therefore, it is essential to consider the content of a good policy design, which is likely to be characterized by the following factors: (a)

Consistency: at both macroeconomic and microeconomic levels a strategy or policy is required to aim at the achievement of a number of objectives. A good strategy will be that which succeeds in reconciling and harmonizing conflicting objectives. Failure to achieve consensus on strategic objectives may lead to half-hearted efforts to put the strategy into practice. A strategy which is consistent with the goals is more likely to achieve results than the one which ignores these goals. Consistency is more difficult to achieve under multiple goals than under a single well-defined goal. For example, we noted in Chapter 6 that state enterprises in China and India were expected to achieve several goals at once: employment, social welfare, economic efficiency, which are mutually inconsistent and thus could not all be achieved fully. (b) Flexibility: a strategy which has built-in flexibility and scope of adaptation in response to exogenous and unforeseen factors as well as endogenous factors (like a change of government) is likely to be more easily implementable than one with a rigid design. In Chapter 2 we discussed how East Asian countries either abandoned or modified policies which were found inconsistent with objectives or required alteration due to changed circumstances. In the 1970s the Republic of Korea revised its export targets for automobiles in response to emerging market trends. We also noted that the governments of East Asian economies aimed at achieving longer-term flexibility of their economies. These economies achieved greater economic success than other developing economies thanks to the flexibility and adaptability of their government policies to changing national and international environment. (c) Feasibility: a strategy and accompanying policies that take due account of political expediency, and feasibility of implementation would enjoy a better chance of success than others. To be feasible or

Market or Government Failures? 169

realistic a strategy or policy must be formulated in the light of such constraints as resource availability (resources defined to include financial, technical, bureaucratic and managerial, as well as institutional capacity to review, monitor and evaluate policies and programmes), socioeconomic environment for implementation and possible opposition from vested groups. A strategy is workable if its formulation takes into account the modalities of implementation and the administrative and organizational capacity to implement. A strategy or policy may fail to take account of social and attitudinal changes which can occur only in the long run. (d) Political legitimacy: a strategy or policy is more likely to be implemented if its architects mobilize political support in favour of those who would be affected most directly or indirectly. Legitimacy may be more difficult to achieve when a large number of heterogeneous interest groups are involved. These characteristics of good policy design are often missing in many developing countries. However, as we discussed in Chapter 2, Japan and some East Asian economies are characterized by highly successful process of policy formulation and its implementation. Rodrik (1996b, p. 19) notes: `There was clearly something special about the ability of the Taiwanese and South Korean policy makers to discipline their private sectors and their bureaucracies.' But why did such ability exist in these two countries but not in most other developing countries? According to Rodrik, two factors may explain the difference: more favourable initial conditions (for example, a well-educated labour force) at the time of policy reform and egalitarian income distribution which helped the policy makers to insulate policy implementation from pressures of interest groups. Similar argument has been presented by Wade (1988, 1990) who argues that economic success in these two countries was important for long-term political legitimacy of the regimes.

OTHER IMPLEMENTATION PROBLEMS We noted above that inadequacies in the design of strategies and policies can contribute to implementation failures. But good policy design by itself cannot ensure effective implementation. Some outcomes, whether they are the result of an explicit strategy or an unplanned process of development, are likely to result from shortcomings in implementation or exogenous factors or unforeseen events on which a government strategy had no control.

170 Conclusion: Implementation Failures

While the process of implementation determines certain outputs (for example, operation of health clinics), it may give no indication of the outcome, that is, the effectiveness with which the output is channelled towards particular goals. Successful implementation must take into account efficiency or quality considerations even though they are necessary but not sufficient to judge the realization of a policy goal. However, some authors argue that economists may have been partly to blame for over-emphasizing efficiency considerations with the result that economic policies often become politically unfeasible and thus may not be implemented. Nelson (1987) gives an example of how American economists supported proposals such as pollution emission fees as a market-based mechanism in preference to an equally efficient system of marketable pollution permits. The latter, he argues, is `politically more promising' as a means of `manipulating market incentives to achieve environmental protection'. The process of implementation is far more complex than might appear on the surface. While the design of strategy may have a decisive influence on its implementation, there are other institutional factors which may be totally unrelated to the strategy itself. The following are some of the important institutional factors that may affect the degree and quality of implementation: the nature of the prevailing political system, the organizational structure (centralized or decentralized) of the administrative machinery, the nature of coordination among different administrative bodies, and availability and allocation of adequate resources. Nature of the political system The pattern of administrative behaviour of implementing institutions and implementers (the bureaucrats or civil servants) tends to vary with the nature of political regimes (see Chapter 1). For example, under a military regime or one-party system in the absence of checks and balances, the administrative machinery may become passive and ineffective thus leading to poor or slow implementation. It can be argued that political freedom, manifested by personal security, political participation and equality of opportunity, can accelerate the path of development (UNDP, 1992). Participation and equal opportunity can raise the enthusiasm of people to implement programmes and projects. Ardito-Barletta (1991, p. 285) notes: `Nothing contributes as much to a successful policy change in a democratic environment as participation by different groups in the negotiation and formulation process.' Arguments can also be presented

Market or Government Failures? 171

in favour of more rapid implementation of policies (and the resulting growth) under situations when political freedom is curtailed. The Chinese experience suggests that autocratic regimes can also achieve rapid economic and social progress, given the political commitment and seriousness of purpose. Administrative organization Whether a government bureaucracy or a private corporation is centralized or decentralized will affect the process of implementation. At a conference in Lake Paipa, the participants concluded that `policy implementation is generally most effective when the power to make decisions about the use of policy instruments is centralized' (cited in ArditoBarletta, 1991). While this argument may be true in the case of some macroeconomic policies (for example, fiscal and monetary policies centralized in the Ministry of Finance), it is less likely to be so in the case of many sectoral policies (namely, agriculture, industrial development, health and education). A centralized bureaucracy may be less successful in implementing policies and programmes (especially in large countries) than a decentralized one. The latter offers a better opportunity for social participation of potential beneficiaries, thus ensuring compliance of policies. Yet in developing countries decentralization of decision-making is much more limited than in industrialized countries. One needs to distinguish between `actual' and `pro forma' administrative decentralization. The latter occurs quite often in sub-Saharan Africa; decentralization is aimed at building a smokescreen of responsibility between the government and the population. For example, by establishing a developmental and administrative base at the district level, the population is either distracted from governmental responsibility, or is discouraged from taking part in politics because of the obvious impotence of their district counterparts. In the case of multinational corporations, decentralization may be increasingly seen as profit-enhancing. With increasing global competition, decentralization enables subsidiary firms to respond quickly to changing consumer demand and global market conditions. Very often the implementation process involves not only different actors at different administrative levels but also various sections (ministries, for example) of the administration. If they do not harmonize, communicate and coordinate their actions and intentions, the most likely outcome of their actions is contradictory policies or paralysis in their implementation.

172 Conclusion: Implementation Failures

In the final analysis, the influence of centralized or decentralized organization will depend on the differences in information collection, processing and dissemination. Stiglitz (1989, p. 35) notes that `different decision structures (centralized versus decentralized) result in differences not only of how much and what information is collected and processed, but also of how that information is aggregated, or put together to form a decision'. The case in favour of decentralization rests on the assumption that it reduces informational constraints. Besides reducing failures due to imperfections, decentralization may offer an opportunity for risk diversification (spreading risks over good and bad leaders), new ideas and more projects and experiments and learning by doing in general (Stiglitz, 1989b, 1989c). Rent-seeking The new political economy paradigm discussed in Chapter 1 has attributed failures to implement public policy to rent-seeking behaviour of government and its agents. Rent-seeking is supposed to influence administrative behaviour adversely because neither government nor its agents work in the public interest. Although rent-seeking behaviour may no doubt influence the administrative costs of implementing policies, as we discussed in Chapter 1, such behaviour is not peculiar to governments and the political process. It is equally common in the private sector. Even when it exists in the public sector, we noted that `rents' may be used productively as seems to have been done in East Asia. Opposition groups The adoption and implementation of strategies and policies depend on a number of actors and interest groups at the national, regional and local levels. Grindle (1991) distinguishes between state-centred and society-centred interests. The former refer to the interests of the State, the policy elite, the civil servants and the decision-makers and so on. The society-centred interests include those of different social classes and income groups, political parties and voters. These two sets of interests may be in conflict and their political power and influence may vary. Any major policy change and its implementation is likely to involve gainers and losers. The losses incurred may be economic but more often they are also social and political. Specific social groups may feel threatened and others may feel politically weakened. Certain sections of society may feel that their power and capacity to influence policies is being eroded. To implement certain economic reforms successfully it

Market or Government Failures? 173

may be necessary to change institutional structures and legislation. Although some social groups may not object to reforms as such, they may object to the institutional and structural changes that are essential for implementing those reforms. This seems to be the case in India (see Chapter 6) where trade unions do not object to economic reforms in general but they would oppose any change in bankruptcy laws and labour legislation which allow laying off of workers.1 Smooth implementation presupposes that the government can keep in check such strong vested interests and powerful lobbies as are likely to block the reform process. Within the non-market or `government sector' also there are different actors and pressure groups (for example, politicians, bureaucrats, managers of public corporations and technocrats such as economic and scientific advisers) whose interests may not converge. In terms of Wolf's analysis of private and collective goals of these public agents discussed in Chapter 2, one can expect conflict which may tend to weaken the will to implement policies and programmes. A conflictual situation may prevent the emergence of `collective' goals of public agents. For example, in India the politicians at the centre and in the states had opposing view of economic reforms when they were introduced. The states opposed the reforms partly because they were not invited to participate in their formulation. Similarly, even if the politicians are a cohesive group with collective goals, they may be guided by motives and constituencies which are very different from those of other public agents like bureaucrats and technocrats. Therefore, an effective implementation of policies and programmes requires support from dominant interest groups. Failures in implementation may result partly from a strong political opposition by powerful groups or neutralization of conflicting interests of potential gainers and losers (Grindle, 1980).2 Resource constraints Implementation of policies and programmes partly depends on the adequacy of resources at the disposal of the implementing agency and their efficient utilization. These resources are not only financial but also organizational and managerial. The latter tend to be far more scarce in most developing countries. One of the main bottlenecks in implementation is likely to be the shortage of this input. Policies which are not `administration-intensive' are much more likely to be implemented than others that call for the use of managerial and administrative resources. Experience of the implementation of IMF agreements in Africa is a case in point. An IMF review found that the root cause of

174 Conclusion: Implementation Failures

non-fulfilment of targets and default on loan payments were `political constraints' and/or `weak administrative constraints' (Cohen et al., 1985).3

CONCLUSION Measurement of the degree to which policies and programmes are implemented requires a systematic methodology. A familiar method for analyzing and rating the performance of policy implementation is to translate the objectives and aims of such policy into quantifiable targets, the achievement of which can be monitored periodically. Full implementation will mean 100 per cent achievement of targets, whereas the average rating would be around 50 per cent. Thus, the rate of implementation of targets determines the nature and level of `success' or `failure'. Both these concepts are relative and need to be defined in the context of some benchmark or specific goal. Shortfalls in implementation may also be examined in terms of an increase in the cost of implementing programmes and a decline in their effectiveness below what was targeted or anticipated (Wolf, 1988). This approach will require the breaking down of objectives and policies and programmes into well-defined components and sequential steps to be expressed in quantitative targets at each step. This disaggregative approach may also allow an analysis of likely bottlenecks in target implementation. In an earlier attempt to link science and technology indicators to the development process, a similar approach was proposed (Bhalla and Fluitman, 1985).4 One of the difficulties with quantitative indicators and targets is that they may conceal a qualitative dimension of their achievement. This can be illustrated by the example of rural health policy in China during the Mao period (Bhalla, 1991, 1995a). In order to improve access to medical attendance in rural areas, the length of medical training was reduced, which eventually resulted in a larger number of doctors, but at the cost of their quality. It can be argued that the strategy has been a success because the doctor-to-population ratio has improved. However, for a qualitative assessment it would be necessary to compare the general state of rural health before and after the introduction of the scheme. Furthermore, for the analysis to be meaningful one would need to compare the output of the policy with the possible alternative, that is, better educated/trained but fewer doctors. Thus quantitative targets alone can be misleading and can hide the undesirable effects of policy implementation.

Notes 1

The Old and the New Political Economy

1 Ardito-Barletta (1991, p. 286) notes how in Latin America, favouritism is widely prevalent: `the system is structured to dispense economic favours to all groups that have claim on power. The business and investor groups get concessions on protection and various incentives for capital formation and savings, the populist groups get concessions on wages, social security, and price subsidies'. 2 Over the years, the farmers' movements have grown important in different Indian states. For a discussion see the Special Issue of the Journal of Peasant Studies (April±July 1994) on New Farmers' Movements in India. 3 This section draws heavily on Stiglitz (1994a; 1994b). 4 Writing on Africa, Lipton (1991) notes that at an early stage of development both state and market can increase in power. He states: `both State and market must increase in power, yet as each does so it tends to weaken or subvert the other. In most cases, only institutions of public overview, some self-seeking and others not, able to interact freely through ``civil society'', can inhibit such weakening and subversion, soften the State-market dilemma and premit sustained economic development' (p. 21).

2

Theories of Market and Government Failures

1 Non-market or institutional failure is a broader concept which, apart from government, also includes such organizations as foundations, universities, churches, and so on (see Wolf 1979a, 1988). 2 Of course, such infrastructure as roads, telecommunications and education can also be provided and financed and administered by the private sector. Nevertheless, government may need to put an appropriate regulatory mechanism in place (Stiglitz, 1997b, p. 88). 3 Le Grand (1991) notes the differences between different types of efficiency. He argues that allocative efficiency is a broader concept than either X-efficiency or dynamic efficiency. It includes X-efficiency `in the sense that if the production of a commodity is X-inefficient, it will also be allocatively inefficient'. (p.425). Allocative efficiency is also broader in another sense, that is, it takes account of whether the commodity concerned meets consumer wants effectively. Dynamic efficiency is less well-defined since it can have both microeconomic and macroeconomic connotations. At the microeconomic firm level, it refers to the capacity of the firm to innovate whereas at the macroeconomic level it is defined as a higher rate of growth of an economy.

175

176 Notes

3

Financial Crises: Cases of Market Failure

1 In October 1993, the Chairman of Barings, Mr Peter Baring noted (at the launching of the Bank's joint venture in derivatives with the Abbey National of the UK) that `derivatives need to be well controlled and understood, but we believe that we do that here'. 2 Derivatives are financial instruments like futures and options whose value is derived from an asset such as a commodity (for example, cocoa), bonds, shares or currencies. The price of these assets fluctuates a great deal. Derivatives cover `all trading outside the spot (cash) markets, including futures and options markets, swaps, and stock index options'. Futures and options are the simplest of derivatives which specify an agreement to buy or sell a particular asset at a certain price on a defined future date. The more complex forms of derivatives are based on complex mathematical formulae which enable speculative profitmaking through wide gaps between outlays and potential rewards. 3 Why did the Tokyo or Osaka Stock Exchanges not offer information when they were concerned? It appears that the Osaka Exchange knew that the Barings' position was bigger than the rest of the market put together. This was unusual for a small bank. As the Osaka Exchange is a competitor of SIMEX of Singapore, it may have been reluctant to express its concern. In imperfectly competitive markets information tends to be restricted for fear of competitors taking advantage. 4 For a brief review of problems of asymmetric information in financial markets see Griffith-Jones (1998b); Stiglitz (1994a). 5 In a speech before the American Economic Association in December 1998, Professor Stanley Fischer, the Deputy Managing Director of the IMF, explained how the new lender-of-the-last-resort function of the Fund would operate in practice. The countries which supervise their banking systems properly and provide timely and adequate information to the Fund would be rewarded with quick assistance from the Fund. Those who do not, would not qualify for such financial support. The latter countries may also be charged higher interest rates as a penalty for failing to comply with the Fund's criteria and conditions (International Herald Tribune, 7 January 1999). For more recent views of the IMF on its restructuring and reform, see Fischer (1999).

4

The Asian Financial Crisis

1 Transparency International has compiled a `corruption perception index' which shows diminishing corruption at least in some of the affected economies. For example, on a scale of 0 (very corrupt) to 10 (very clean), the score for Korea went down from 3.93 during 1980±85 to 3.50 during 1988±92, but rose to 5.32 in 1996. In Indonesia, the score was: 0.20, 0.57 and 2.65 for the same periods (cited in Chang, 1998). 2 The FDI estimates in Table 4.6 include mergers and acquisitions involving existing enterprises besides new investments. 3 Liberalization of FDI in Korea included granting foreigners right to purchase all the shares of a domestic firm, abolition of the ceiling on foreign stock investment, exemption of certain corporate taxes, financial support to local

Notes 177 governments to attract FDI, and the establishment of foreign investment zones. In Thailand, the following measures were adopted: replacement of the Alien Business Law by sectoral liberalization measures, allowing foreign firms 100 per cent equity in banks and finance companies for up to 10 years, opening up of transportation and pharmaceuticals to foreigners. In Malaysia, the liberalization measures included: suspension of restrictions on foreign holdings in new export-oriented manufacturing projects, and relaxation of foreign ownership limits. In Indonesia, since May 1999 foreign ownership of up to 99 per cent banks and 100 per cent shareholdings in existing establishments has been allowed (World Bank, 2000). 4 It is estimated that the US companies import 19 per cent of their total imports from Thailand, 18 per cent from Malaysia, and 14 per cent from Indonesia (these imports from Korea and the Philippines are not significant) (see Kregel, 1998). 5 Goldman Sachs estimated that the US growth would decline by 0.4 percentage points, and Europe's by 0.3 percentage points compared to Japan's by over 1 per cent (cited in The Economist, 1 November 1997). 6 As Rodrik (1998, p. 58) states: `the simple fact is that commercial banks either got it terribly wrong in 1996 (and before) in showering Asian countries with loans or they were terribly wrong in completely pulling out thereafter'.

5

The Impact of the Asian Crisis on China and India

1 For example, for 1995±96, domestic liabilities of the finance companies in the forms of deposits and loans stood at 2.62 per cent of GDP (Economic and Political Weekly Research Foundation, 1997). 2 Foreign banks tend to overextend credit, driven by the search for high returns. Another problem is the sheer size of many of these banks ± the sums lent out are small in relation to their balance sheets but could be of `dangerous size' for the recipients. It is interesting to note that the Bank for International Settlements (BIS) Annual Report for 1997±98 (1998a) draws pointed attention to the role that European banks played in the Asian crisis by consistently ignoring BIS data, which clearly indicated liquidity problems in Asia. 3 G-10 countries, Austria, the Bahamas, Bahrain, Cayman Islands, Denmark, Finland, Ireland, Luxembourg, the Netherlands Antilles, Norway, Singapore, Spain, and the offshore branches of the US banks in Panama. 4 Banks are also affected since the settlement functions of the finance companies (for example, payment of dividends to shareholders) are usually done via banks, as NBFCs are not allowed to issue or clear cheques. 5 We calculate these weights as the average of four years, 1994±97. 6 All export growth rates refer to exports in US dollars. 7 The Hong Kong currency is pegged to the US dollar. The currency depreciation from June 1997 to June 1998 in the other five economies was: Indonesia (589 per cent), the Republic of Korea (60 per cent), Malaysia (56 per cent), Philippines (55 per cent) and Thailand (72 per cent). 8 The volume of yarn and fabric exports fell by over 50 per cent between the second and third quarters of 1997 while synthetic fibre exports fell by about

178 Notes

9 10

11

12 13 14

15

16

17

25 per cent and exports of shoes, half of which go to Nike, plunged by about 30±40 per cent. The resolution of these factors seems difficult in the short term as many of them involve international cooperation which may not be easily forthcoming in view of India's nuclear defiance of global opinion. Other adverse effects of devaluation of the yuan may be a possible decline in FDI and pressures on the Hong Kong dollar. However, some observers believe that Hong Kong may actually benefit from a devaluation since increase in mainland exports will pass through Hong Kong using its ports, airports, shipping agents, bankers and insurance firms. There is one important difference between the way FDI is measured in India and China. The concept used in India does not include mergers and acquisitions (M&As) by foreign players as also the allotment of preference shares by them. The Chinese concept does. Making this adjustment would increase the total Indian FDI figure from $12 billion to $15 billion. Since foreign investors were worried about the dollar price of their stocks. Take the case of GE Capital which has already taken over a big Japanese life insurance firm, Toho Mutual, several Thai auto and equipment finance firms and the Philippine Asia Life Assurance. For example, consider the case of Imperial Chemical Industries (ICI), a UK company which since August 1997, has been trying to acquire a 9.1 per cent stake in the family-controlled Asian Paints. The Foreign Investment Promotion Board refused to approve the sale unless the directors of Asian Paints agreed. In 1991, the Enron Development Corporation (EDC) negotiated a US$2.8 billion investment in the Dabhol Power Project in the state of Maharashtra. At that time the Congress Party ran governments at the Centre and in Maharashtra. Problems erupted after the victory in Maharashtra of the Shiv Sena (SS) and Bharatiya Janata Party (BJP) coalition. By the end of June 1995, a State ministerial committee had recommended cancellation of the FDI and the cancellation was actually effected in August. Renegotiations, however, were soon initiated with the EDC and a revised agreement with the Maharashtra government came into force on 8 January 1996. It is a matter of debate whether the new terms really took into account some of the criticisms of the earlier SS±BJP coalition. Ahok Desai has aptly described the Budget as a landmark: `It declares that the reforms are over and we have returned to the normal Indian political game . . . the budget displays a worrying tendency to tinker with the tariffs to help favoured industries ± at best picking winners, at worst bailing out influential dinosaurs' (Financial Times, 3 June 1998). For example, Citibank was allowed to establish a joint venture with a Chinese airconditioner maker (rather quickly as government approval was granted in the remarkably short period of four months). The former will own 40 per cent equity and the Guangdong Kelon Airconditioning Co., 60 per cent (Saywell, 1988). In March 1998, Kodak Co. agreed on a $380 million deal to establish two companies, Kodak (China) and Kodak (Wuxi), which involved the taking over of three Chinese loss-making state enterprises. In 1998, Unilever purchased a leading Shanghai Soy Sauce manufacturer (Chai, 1998; Motoyama, 1998).

Notes 179 18 This should not be construed as support of the contractionary IMF policies in the Southeast Asian crisis, which we believe aggravated the situation. The crucial difference is that here we are talking of high interest rates as a preventive measure. Once a crisis sets in and the expectations of foreign investors turn adverse, contraction can worsen matters. The latter seems to have been the case in post-crisis Southeast Asia. 19 As a result of this policy in September 1998 broad money supply M2 (total cash and all deposits) reached $202 billion, which reflects an increase of 16 per cent over the same period in 1997. This figure is higher than those for the first and second quarters of 1998 by 7 percentage points and 1.4 percentage points respectively. Narrow money supply M1 (total of cash and demand deposits) also grew, up 1.5 percentage points and 4.5 percentage points over the first two quarters of 1998 respectively. At the end of September 1998, outstanding M1 values were $439.77 billion. Loan expansion has also occurred; loans of financial institutions were at record high ($966 billion) in the third quarter of 1998, which is the highest level recorded during the first seven months of 1998. 20 The U.S. economic sanctions could be cleverly invoked to provide the moral basis for this kind of jingoism. 21 This interpretation is supported by the fact that in his Budget Speech in 1998 the Finance Minister did not indulge in any anti-foreign investment rhetoric. On the contrary, he promised to expedite the approval of foreign investment proposals. 22 We realize of course, that this withdrawal is related more to the FIIs' (foreign institutional investors') need to recover losses on the Asian front than to their outlook on the Indian capital market. Nevertheless, FIIs have often complained that the Indian stock markets are veritable `snake-pits' for the uninitiated. 23 The recent MS shoes scandal bears this out. 24 Currently, the Reserve Bank of India (RBI) is empowered to allow mergers and acquisitions (M&As) only in exceptional situations. Anyone wanting to acquire more than 1 per cent of a bank's share capital requires prior clearance from the RBI.

6

State Enterprises in China and India: A Case of Government Failure

1 In actual practice, there is considerable overlap of administrative control among central, provincial and local authorities. Local enterprises (provincial and country level) under the administrative level of local government may also be subject to some central government control (Huang, 1996). 2 Bowers et al. (1982), reject this explanation of labour retention during a slump in the context of British industry. 3 Granick (1990) argues that in China SOEs operating at the provincial level face hard-budget constraints as they must remit taxes to the central authorities, whereas SOEs controlled by the central government face soft-budget constraint. We show as did Hay et al. (1994) for China that soft-budget constraint operates at both levels.

180 Notes 4 State enterprises in China are often distinguished from `collectives' and town and village enterprises (TVEs) which are run by the local county governments rather than the central government. Although they are sometimes labelled as `non-state' sector in the literature, strictly speaking they are also local state enterprises since they rely on the local governments for raw materials and other inputs. 5 Comparing privatization in China, Russia and Taiwan, Jian (1996) argues that the share of SOEs in China is relatively smaller than that in Russia which has a sizeable non-state sector. The loss of employment resulting from privatization in China is, however, greater and more acute. 6 Data on 800 SOEs for 1980±94 were used to run regressions to determine the association of such variables as firm size, technology, share of bonuses in total wage bill and share of bank loans in total investment. However, regressions determine only association, not causality. 7 In some sectors, namely, energy, raw materials and communications, price controls remain in force. To the extent that these products and services are inputs to other sectors, their price increase subsequent to liberalization would exercise a cost-push effect (see Lin et al., 1999). Zhou et al. (1994) estimate that price controls account for about half of state subsidies to Chinese SOEs. 8 Independent accounting units are defined as independent administrative organizations which enjoy autonomy in respect of profits and losses, signing of contracts with other enterprises and holding of independent accounts, and bank accounts. About 77 per cent of SOEs (or 80,586) are classified as independent accounting units (see Broadman, 1995). 9 Our inquiry to the World Bank headquarters to seek clarification on their methodology remained unanswered. 10 A large body of literature exists on the economic inefficiency of Indian public-sector enterprises (see Ahuja and Majumdar, 1998; Ahluwalia, 1985, 1991; GOI, 1991; Goldar, 1986; Majumdar, 1998; Mohan, 1996). 11 A system of memoranda of understanding (MOU) has been introduced to improve the autonomy and accountability of public-sector enterprises. The MOUs include ground rules of relationship between the enterprises and their supervising ministries and cover such issues as criteria selection, weights to be attached to them and the method of performance evaluation (see Bhat and Mishra, 1996). In the annual performance evaluation, the Department of Public Enterprises noted that out of 110 enterprises which signed MOUs in 1996±97, 46 were rated excellent, 27 very good, 19 good, 11 fair and 7 poor (GOI Economic Survey 1997±98, p. 103). It is not clear whether MOUs in fact raise autonomy and accountability or whether they simply act as an unnecessary bureaucratic burden on enterprises (Joshi and Little, 1996). 12 In March 1992 the power ministers of different Indian states agreed to raise the minimum charge for electricity, but a powerful lobby of rich farmers (on whose support many regional political parties depend) blocked the implementation of the government decision. 13 The Indian government generally does not use the term privatization. It prefers to use the term `disinvestment' of government holdings in the equity share capital of public-sector enterprises. Arun and Nixson (2000) note that

Notes 181 as of 1996 none of the PSEs had government shares lower than 51 per cent, which essentially amounted to continued government ownership. 14 Based on personal communication with Dr R. Nagaraj of the Indira Gandhi Institute of Development Research, Mumbai, India. 15 The following are the major differences in methodology and coverage of Srivastava±Sen (1997) study and earlier studies: (a) earlier studies used a uniform interest rate whereas Srivastava-Sen study used a vector of interest rates giving separate rates for the Centre and each of the States; (b) Mundle ± Rao (1991) study was limited only to 14 Indian states whereas Srivastava±Sen study covers all states; (c) The method of aggregation of sector-wise subsidies is different in different studies.

7

Conclusion: Implementation Failures

1 A comparative study of Ghana and Zambia shows that reforms were more successfully implemented in Ghana partly due to the insulation of the state from political pressures. In contrast strong trade unions and organized political opposition made enforcement of reforms in Zambia more difficult (Callaghy, 1987; cited in White, 1990). 2 For example, Lindenberg (1988) reports that in Panama strong opposition from the private sector, labour unions and public employees expressed in the form of a national strike, led the Barletta government to rescind the law on new taxes and a wage freeze one month after it was promulgated. Of course, conflicts can also be minimized or resolved if implementers can ensure compliance from potential opponents. If the above non-economic forces are unimportant, the outcome of policies and programmes may turn out to be as intended. 3 Writing on the implementation of education policies in Africa, Craig (1990) distinguishes between resource constraints that are foreseeable and others that are unpredictable. He argues that `resource constraints do not appear to have had a major effect on the implementation of educational policies in Africa'. There were cases of governments failing to fulfil funding commitments. Also noted are situations in which mistakes were made at the design stage (underestimating or ignoring important resource costs) and the policymakers were over-optimistic about domestic or foreign funding. 4 Bhalla and Fluitman (1985) defined indigenous technological capacity in terms of its components in order to explore quantifiable indicators which could be related to national objectives.

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Author and Name Index Agosin, M.R. 49 Ahluwalia, I.J. 180 Ahluwalia, M.S. 154 Ahuja, G. 180 Akerlof, G.A. 61 È z, Y. 9 Akyu Amsden, A. 49, 74 Ardito-Barletta, N. 170, 171, 175 Arun, T.G. 137, 156, 180 Auty, R.M. 40 Bailey, E.E. 34 Bardhan, P. 6, 12, 156 Baring, P. 176 Barlow, C. 11 Barnes, K. 69 Basu, K. 7, 17 Bates, R.H. 22 Baumol, W.J. 34 Benston, G. 123 Berry, A. 48 Bhaduri, A. 159 Bhagwati, J. 3, 4, 49, 50 Bhalla, A.S. vii, viii, 3, 11, 65, 114, 136, 160, 174, 181 Bhandari, L. 134 Bhat, K.S. 180 Bhole, L. 121 Bordo, M.D. 51 Bowers, J. 179 Boycko, M. 4, 7 Brass, T. 11 Breman, J. 73 Broadman, H.G. 133, 147, 180 Bruton, H. 167 Bryant, J. 74 Buchanan, J.M. 3 Buiter, W. 158 Byres, T.J. 11 Callaghy, T.M. 181 Calvo, G. 75 Camdessus, M. 73

Cao, Y. 136 Caprio, G. 68 Chai, J. 103, 178 Chai, J.C.H. 103 Chang, H.-J xiv, 4, 25, 26, 28, 34, 36, 39, 40, 77, 78, 165, 176 Chen, K. 142 Chhibber, P. 155 Clarke, W.C. 165 Cline, W.R. 69 Coase, R.H. 10 Cohen, I. 174 Cole, H. 75 Craig, J. 166, 181 Datta-Chaudhuri, M. 9, 23 Demirguc-Kunt, A. 68 Deppler, M.C. 89 Desai, A. 178 Detragiache, E. 68 Dewatripont, M. 128 Dholakia, B.H. 156 Diamond, D.W. 75 Dollery, B. 25, 28 Duncan, R. 138, 140, 141 Dutt, A.K. 10, 15 Dybvig, P.H. 75 Edlin, A.S. 5, 7 Evans, P.B. 1 Fan, G. 140, 141, 146, 150 Fei, J.C.H. 130 Feldstein, M. 81, 82 Felix, D. 49, 50 Fernald, J. 93, 110, 117 Findlay, R. 3, 5, 15 Fischer, S. 60, 75, 79, 176 Fisher, I. 74, 75 Fishlow, A. 9 Fluitman, A.G. 174, 181 Friedman, M. 18, 74 Friedman, R. 18 214

Author and Name Index 215 Gilley, B. 104 Goad, G.P 85, 86 Goldar, B.N. 180 Goldsmith, R. 51 Goldstein, M. 123, 126 Goodhart, C. 56 Gore, C. 9, 10, 25, 41 Goswami, O. 134 Granick, D. 179 Greenwald, B. 20 Griffith-Jones, S. 50, 52, 59, 61, 176 Grindle, M.S. 5, 6, 14, 167, 172, 173 Gupta, A.P. 152 Gupta, S.P. 159 Haggard, S. 42 Harberger, A.C. 131 Harriss, J. 8 Harriss-White, B. 23 Hay, D. 129, 139, 140, 179 Holmes, W.D. 102, 121 Howell, J. 10 Huang, G. 108 Huang, Y. 138, 140, 141, 142, 179 Hussain, A. 133, 144, 145, 151 Jalan, B. 152, 158 Jefferson, G.H. 131, 140, 142, 151 Jian, T. 180 Johnston, B.F. 165 Joshi, V. 158, 180 Kaminsky, G. 52 Kaufman, G. 123 Kehoe, T. 75 Keynes, J.M. 49, 125 Khan, M. 79 Khan, M.H. 8, 9 Killick, T. 79 Kindleberger, C. 51, 57, 66 Klingebiel, D. 68 Knight, J. 131, 147, 148 Kornai, J. 127, 128, 129, 130, 161 Kregel, J.A. 177 Krueger, A.O. 3, 4, 9, 15, 30, 39 Krugman, P. 65, 74 Kueh, Y.Y. 138 Kumari, A. 156

Lal, D. 2, 13, 14, 15, 39 Lapeyre, F. 11 Lardy, N. 103, 105, 120, 122, 123, 135, 136, 141, 142, 143, 144, 146 Lee, E. 87, 88 Lee, P.N. 136 Leeson, P. 54, 55, 56 Le Grand, J. 29, 31, 32, 33, 43, 175 Leibenstein, H. 31 Lewis, W.A. 130 Li, D.D. 128, 129, 139, 140, 148, 150 Liang, M. 128, 129, 139, 140, 148, 150 Lim, L. 146, 147, 149, 150 Lin, J.Y. 138, 141, 180 Lindenberg, M. 181 Lipton, M. 163, 175 Little, I.M.D. 158, 180 Lo, D. 143 Loser, C.M. 89 Majumdar, S.K. 152, 155, 180 Makin, J. 93 Mao, Zedong 174 Maskin, E. 128 McMillan, J. 140 McNally, C.A. 136 Meier, G.M. 2, 3, 13 Migdal, J.S. 12, 13, 22 Minsky, H. 49, 125 Mishkin, F.S. 58 Mishra, R.K. 180 Mohan, R. 132, 134, 180 Morishima, M. 40 Motoyama, Y. 178 Mundle, S. 157, 181 Myint, H. 2, 13, 14, 15 Myrdal, G. 12, 15, 23 Nachane, D.M. vii, viii, xiv, xvii, 65, 92 Nagaraj, R. 181 Naughton, B. 135, 140 Nayyar, D. 159 Nelson, R. 170 Niskanen, W.A. 29, 37 Nixson, F. 73, 137, 156, 180 North, D.C. 8, 14, 162 O'Brien, R. 61 Okimoto, D.I. 74 Oman, C. 47

216 Author and Name Index Palma, G. 57 Papola, T.S. 159 Pareto, V. 15, 26 Park, Y.C. 83 Patel, U. 158 Peacock, A.T. 37 Perkins, F.C. 143 Polanyi, K. 21 Porter, M.E. 36 Pratibandla, M. 121, 122 Pressman, S. 55 Prusty, R. 121 Qian, Y. 129 Radelet, S. 49, 71, 73, 76, 100 Raiser, M. 128, 140, 143, 149 Ranis, G. 88, 130 Rao, B.V. 66 Rao, M.G. 157, 181 Rao, M.J.M. 125 Reddy, A.K.N. 3 Reinhart, C. 52 Rodrik, D. 7, 23, 49, 50, 169, 177 Roland, G. 129 Rowthorn, R. 28 Roy, K.C. 154 Sachs, J. 49, 71, 73, 76, 100, 143, 144, 150 Sankar, T.L. 133, 155 Saywell, T. 178 Scharfstein, D.S. 50 Schwartz, A.J. 74 Sen, A.K. 16, 30 Sen, T.K. 157, 181 Sender, H. 53 Sengupta, A. 19 Shleifer, A. 128 Singh, A. 36, 74, 77, 165 Smith, A. 5, 26 Smyth, R. 142, 143 Song, C-Y. 83 Song, L. 131, 147, 148 Soros, G. 59 Srinivasan, T.N. 3 Srivastava, D.K. 157, 181 Stern, N. 8, 37, 144, 145 Stewart, F. 88

Stiglitz, J.E. 3, 5, 6, 7, 8, 15, 18, 19, 20, 22, 25, 26, 27, 28, 34, 35, 36, 37, 43, 45, 59, 60, 61, 63, 65, 66, 73, 80, 172, 175, 176 Streeten, P.P. 5 Sull, D.N. 36 Summers, L. 65, 73 Tam, C.H. 147 Thomas, J.W. 6, 167 Tisdell, C.A. 154 Tiwari, A.C. 157 Toye, J. 5 Tullock, G. 37 Tung, R. 143 Turner, P. 123, 126 Tussie, D. 49 Veneroso, F. 59 Verma, J.P. 122 Vining, A.R. 29, 34, 35, 43 Vishny, R.W. 128 Wade, R. 15, 20, 21, 37, 39, 41, 42, 43, 59, 85, 169 Wallis, J. 25, 28 Walters, B. 73 Wang, Z. 114 Weimer, D.L. 29, 34, 35, 43 Weiner, M. 166 Westphal, L. 41 White, G. 16, 21, 181 White, L.G. 181 Williamson, J. 79 Williamson, O.E. xii, 31 Wolf, C. Jr. 17, 29, 30, 31, 37, 38, 43, 45, 163, 165, 173, 174, 175 Woo, W.T. 140, 141, 142, 144, 150 Wu, J. 102 Xiang, B. 141, 142 Xu, X. 146 Yang, M. 147 Zhang, W. 136 Zhou, X.L. 180 Zhu, Rongji 120 Zhuang, J. 133, 151

Subject Index accountability criteria of 4, 38 definition of 165 government 165, 180 lack of 45, 152 managerial 135 administrative capacity 169 adverse selection 22, 26, 58, 62 Africa 22, 109, 181 agents 64, 128, 173 Agricultural Bank of China 102 Agricultural Development Bank (China) 121 Alien Business Law (Thailand) 177 anti-dumping duty 108 anti-monopoly legislation 5, 10 arm's-length relationship 74 Articles of Agreement (IMF) 49 ASEAN 93, 108 Asian crisis and capital flows 125 and poverty 87±88 and the IMF 78±82 comparison with the Mexican Crisis 69±73 diagnosis 76±78 economic & social impact 82±88 features 66±69 impact on China and India 92±126 on rest of Asia 82±88 rest of the world 88±90 theoretical explanations of 73±76 asset stripping (China) 136, 142±43 and restructuirng of SOEs 142, 143 Association of Science and Technology 10 Australia 108 bank bankruptcies 69, 85 collapse 25, 37, 62, 63, 162 contract 20

credit 49, 52, 54, 68, 72, 143, 144, 146, 158 domestic 65, 66, 96 failures 46, 56, 62, 65, 164 foreign 62, 65, 66, 77, 102, 104, 124, 164, 177 indiscriminate lending 62, 69, 77, 164 liabilities 49, 57, 63, 68, 69, 81, 97, 98 loans 47, 98, 101, 102, 139, 143, 144±46, 151±52, 158, 180 local 73, 107 monitoring and supervision 45, 56, 61 offshore borrowing 68, 98 portfolio 68, 98 private 45, 56, 65, 83, 98, 123, 124 recapitalization 81, 120, 123 regulation 62, 77, 103 runs 46, 52, 60 state-owned 98, 99, 102, 104, 120, 123, 128 Bank for International Settlements (BIS) 52, 53, 54, 58, 63, 64, 68, 71, 97, 100, 101, 102, 123, 126, 177 Bank of China 102 Bank of Credit and Commerce International (BCCI) 46 Bank of England 54, 55, 57 Bankhaus Herstatt 46 banking reforms (China) 103 bankruptcy laws/legislation 78, 103, 105,160, 164, 173 Barings Bank 50, 54±56, 57, 58 Board for Industrial and Financial Reconstruction (BIFR) (India) 137, 159 Board for Financial Supervision 123 bonuses 55, 62, 138, 146, 150±51, 160 bounded rationality 49 Brazil 51, 59, 90, 117 Brazilian financial crisis 51, 59, 90

217

218 Subject Index Bretton Woods 46, 48, 49 bubbles and busts 65, 72 bureaucrats accountability of 165 competent 43, 166 maximization of security by 29, 37 rent-seeking 29, 37 selfish goals of 163 technical 43, 66 business operations 34 capital account 47, 49, 118 adequacy ratio/target 64, 79, 81, 99, 123 controls 40, 47, 48, 49, 50, 60, 96, 125 equity 61 flight 68, 74 foreign 82, 96, 97 inflows 46, 48, 50, 65, 66, 67, 69, 72, 77, 79, 82, 85, 91, 93, 96, 97, 100, 101, 110±117, 125, 163 market 17, 18, 19, 36, 66, 82, 115, 118, 121, 122, 125, 126, 179 mobility 49, 50, 74 outflows 40, 46, 66, 77, 80, 85, 90 private 59 short-term flows 48, 65 volatility of 59 capital account convertibility 46, 49±50, 58, 66, 91, 124±25 capitalism `crony' 77±78, 164 Asian model of 77, 78, 82, 164 Central Bank (China) 121 Central and Eastern Europe 2±3, 85 Central Bureau of Statistics (Indonesia) 87 chaebols 79 Chile 51, 89, 124 China banking reforms 122±23 capital account convertibility 124±25 commodity composition of trade 106, 109 impact of Asian crisis on 100±105, 108±110, 114±117

local government in 144 privatization in 136 soft-budget constraint in SOEs 137±51 state-owned enterprises (SOEs) 132±37 vulnerability indicators 100±105 China Construction Bank 102 China International Capital Corporation 115 China Venturetech Corporation 119 Chinese Academy of Social Sciences (CASS) 114 Chrysler Corporation 64 Citibank 115, 178 Clinton administration 59 civil society 10, 11, 165, 175 Coca Cola Company 38 Colombia 51, 55 Commercial Banking Law 102 community development movement 166 companies finance 98, 102, 177 non-bank finance 99, 102, 103, 124, 177 Company and Enterprise Laws (China) 136 comparative advantage dynamic 39, 41 static 39 competition absence of 36 and economic efficiency 55 and profitability 140 domestic 152 external 104, 107, 152 from collective enterprises 32, 152 fierce 20 global 48, 159 imperfect 27, 58 competitiveness 18, 41, 83, 100, 109, 158 price 18, 109 quality 18, 109 compliance 12, 16, 81, 171, 181 consistency macroeconomic 168 microeconomic 168

Subject Index 219 of goals 167, 168 Consortium de ReÂalisation (CDR) 56 consumer behaviour 165 choice 165 demand 31, 171 groups 29 preference 2, 3 prices 89 response 30, 31, 38, 45, 162 contagion 49, 92, 112, 117 contestability high 35 low 35 of government supply 34, 35, 43 of government ownership 34, 35 cooperatives rural 102, 146 urban 102, 150 corporate management 164 corporation government 35 inefficient 77 private 35, 36, 74, 77, 171 public 173 strategy 37 `corruption perception index' 176 cost administrative 172 divergence between revenue and 31 minimization 31 credit access to 49, 129 allocation 13 cooperatives 102, 145 excessive domestic 103 market 60 -rating agencies 69 rationing 96 subsidized 129 to the private sector 54, 68, 90, 163 unions 104 CreÂdit Lyonnais 48, 56±57 CreÂdit Suisse 110 crisis Asian 65±91, 164 balance of payments 52, 74

banking 46 comparison between Asian and Mexican 69±73 currency 46, 52, 82 debt 46, 48 definition of financial 51 diagnosis of Asian 76±78 features of Asian 66±73 financial 45, 46 impact of Asian 82±90 role of the IMF in Asian 78±82 specific examples of financial 54±57 unpredictability of 69, 76 cronyism 77±78, 164 cross-border flows 47 currency depreciation 68, 77, 83, 85, 113, 117, 177 stabilization 80 current account 49, 67, 96, 97, 100, 101, 125, 163 Daiwa Bank 46 debt crisis 46, 48 ±equity ratio 63, 103 external 46, 52, 58, 67, 69, 75, 95, 100, 101 internal 72 long-term 57, 58, 69 management of 58 rescheduling of 72, 76, 102 restructuring of 76 self-fulfilling crises 75 servicing 46, 57, 100 short-term 57, 58, 72, 75, 101, 102, 105 `triangular' (China) 102 decentralization administrative 171 by multinational corporations 171 of decision-making 103, 171 regional 129, 144 deficit budget 41, 74, 101, 103, 143, 151 current account 67, 72, 94, 96, 101, 163 fiscal 79, 94, 96, 97, 137

220 Subject Index delegation of power 166 democracies 15 Department of Company Affairs (India) 121 deregulation 6, 47, 48, 60, 118, 158 derivatives 55, 59, 61, 63, 176 devaluation 46, 73, 80, 83, 85, 93, 100, 107, 109±110, 113, 178 Development Research Centre of the State Council (China) 102 dictatorship 15 Disinvestment Commission (India) 137 Dissemination Standard Bulletin Board (DSBB) 60 East Asia economies 20, 43, 58, 89, 164, 168, 169 experience with government implementation 39±42 policy 42 positive role of government 39±42 East Asian miracle 39 economic agents information capacity of 18 Economic and Political Weekly (EPW) Research Foundation (India) 122, 134, 177 Economic Planning Agency (Japan) 40 economic reforms banking sector 93 financial 93 future of 117±21 efficiency allocative 25, 27, 32, 33, 136, 175 and equity 163 dynamic 25, 27, 41, 175 economic 20, 127, 131, 134, 141, 148 index 141, 155 productive 27, 32 X-efficiency 27, 32, 175 embedded autonomy 43 employment elasticity of output 159 enforcement administrative cost of 4 contracts 17, 162, 163

mecahnisms 162 of property rights 42 of rules 12±13 public 161 regulations 165 strategy 24 Enron Corporation (USA) 86, 113, 178 enterprises collective (China) (COEs) 32, 133, 136, 139, 140, 142, 148, 149, 152, 180 departmental (India) 132, 157 foreign 114 level of control and supervision (China) 132, 133, 151 local 179 non-departmental 132, 157 ownership of 134, 135 private 64, 130, 132, 149, 154, 155, 158 profitability 148 public sector (India) 132±37, 151±60, 180 rural 32 `sick' (India) 137, 154, 156, 157, 158, 159, 160 state-owned 103, 104, 132±37, 138±51, 152, 156, 180 surveys 140, 146, 150 town and village (TVEs) (China) 133, 140, 142, 148, 150, 180 Environmental Protection Agency (EPA) (USA) 38 equity and efficiency 25 blindness 11 criteria 32 distributional 25, 29, 36, 38, 41 to-asset ratio 102, 105 Euromoney Country Risk Assessment 69 Europe 86 European Monetary System (EMS) 46 European Union (EU) and anti-dumping duties 108 and the Asian crisis 89, 109 rules 54 trade with China 109

Subject Index 221 trade with Southeast Asia 109 excess labour 28, 90, 127, 130±32, 146±49, 158±60 exit policy (India) 158, 160, 161 expectations change in 51 investor 76 overshooting of 76, 77 export cheap 93, 100 Chinese 106, 108±110 commodity composition of 109 competitive 83, 93 decline in 84 earnings 81 extra-regional 82 growth 83, 95, 101, 105, 108, 109 import-intensive 83, 107 income elasticity of 107 Indian 105±108 intraregional 82, 84 Japanese 84 Latin American 89 licences 109 market 42, 93, 119 promotion 40 recovery 73 revenue 89 share 93 stagnation 73 subsidy 20±21, 23 targets 168 tax refund system 109 value 83 volume 84, 110 Exports and Imports Bank (China) 121 externalities cause of market failure 7, 25, 60 `derived' 37, 38 environmental 11 in financial markets 60±61 negative 26, 60 positive 26 problems of 27 failures fiduciary theory of government 34±36

in financial markets 90 in implementation 162±74 Le Grand's theory of government 31±34 market xiii, 25±28, 64, non-market xiii, 28±36 parallels between market and government 37±38 private corporate sector xiii, 1, 36, 64 sources of 30±31 systemic 64, 77 Wolf's theory of government 29±31 Farmers' Movements (India) 11, 175 feasibility and political expediency 168 of implementation 168±69 FDI Confidence Index Survey 117 financial crises cases of market failure 45±64 industrial and developing countries 50±57 lessons from 63±64 Firestone Company 36 firms' entry and exit 154 fiscal prudence 44, 100 flexibility built-in 168 labour market 149 long-term 41, 168 of government policy 168 short-term 41 forecasts economic 69 export 107 IMF 86, 105 of GDP growth 86 foreign exchange controls 47 crises 90 transactions 47 Foreign Institutional Investors (FIIs) 122, 179 Foreign Investment Promotion Board (India) 178 France 38, 48 freedom individual 17 political 171

222 Subject Index freedom ± continued to exchange 16 free-rider problems 10 gainers and losers 173 globalization economic 7, 11 financial 18,46, 47±48, 61, 88 Goldman Sachs 53, 69, 95, 97, 177 governance global 1, 9 national 1, 9 government checks and balances on 10, 23, 30, 38, 165, 170 ±corporation axis 77 democratic 37 expenditure policy 36 informational capacity of 26, 27 intervention 1, 4, 7, 9, 15, 22, 23, 31, 38, 39, 41, 43, 44, 57, 74 126, 163 local 103, 128, 129, 133, 144, 146, 149, 179, 180 market interactions 42±43 monopoly 32 ownership 32 positive role of 39±42 powers of compulsion 15, 35, 43 production 34 quality 10 regulation 33, 34, 43 subsidies 27, 31±32, 33, 35, 36, 43, 77, 143±44, 151, 152, 156±57 supply 34, 35, 43 tax revenue 139 universality 15, 35, 43 government failures fiduciary theory of 34±36 parallels with market 37±38 relevance of theories to East Asia 38±43 theories of 28±36 Green Revolution 11, 36 Group of Ten countries 64, 177 growth and equity 1 Chinese 101 Indian 94

of GDP 66, 95, 101, 105 Guangdong International Trust and Investment Corporation (China) 119 Hainan Development Bank (China) 102, 104, 119 hard-budget constraint 130, 131, 133, 138, 148, 149, 150, 161, 164, 179 Hong Kong 59, 66, 78, 88, 89, 105, 106, 107, 108, 114, 115, 177, 178 hot money flows 49 Imperial Chemical Industries (ICI) (UK) 178 implementation complexity of 163, 170 design 166±69 factors affecting 169±74 failures 24, 28, 41, 127, 162±74 feasibility of 168±69 interactive model of 167 linear model of 167 of private corporate strategy 24, 25, 162, 167 organizational/administrative capacity for 169 policy 24 , 162, 163, 167, 169, 174 quality 170 reforms 118, 166, 172, 173 strategy 162, 166, 167 import-substitution 40, 47, 119 incentives 8, 33, 35, 36, 43, 62±63, 123, 126, 144, 149 independent accounting units (China) 141, 180 India banking reforms 123±24 capital account convertibility 124±25 impact of Asian crisis on capital inflows 110±114 privatization in 137, 155±56, 158, 180 public-sector enterprises (PSEs) 132±37, 151±61 soft-budget constraint in PSEs 151±61

Subject Index 223 trade impact of Asian crisis 105±108 trade composition 106 indicators financial 70±71 human development 87 macroeconomic 57, 95 vulnerability 94±105 Indonesia 51, 52, 53, 54, 58, 66, 68, 69, 70, 72, 79, 80, 81, 82, 83, 84, 85, 86, 87, 88, 105, 106, 107, 176, 177 Industrial and Commercial Bank (China) 102, 104 Industrial Disputes Act (India) 160 inefficiency allocative 27, 32, 33, 35 corporate 36 dynamic 26, 27, 32, 33 exchange 26 product-mix 26 production 26 productive 26, 27, 32 static 32 X- 27, 31, 32, 33, 35, 130, 175 infant industries 41 inflation 13, 48, 67, 87, 88, 95 information acquisition 19, 43 asymmetric 22, 38, 49, 58, 127, 128, 138 capacity 58 collection 19, 172 complete 22 constraints 22, 172 cost 19, 22, 27, 36 disclosure 58, 59, 62 dissemination 18, 27, 43, 172 failures 26±27 imperfections in monitoring 57±60 intensive 19, 58 perfect 22 processing 19, 172 production 18, 19, 27 types of 22 utilization 19 infrastructure expenditure 93, 94, 101 institutional 28 intellectual (human) 28, 42

physical 28, 42 institutional factors 8, 162, 170, 173 institutions and organizations 8±11 banking 129 cooperation between government and market 42 financial 20, 48, 51, 52, 57, 61, 103, 104, 118, 119, 123, 162 global 64 management of 57, 58 market 9, 162, 167 new 8 non-bank financial 99, 103, 124 non-market 9, 167 non-viable 80 private 8 public 8 interactions government±market 42±43 between government and social organizations 22±23 interest groups 4, 5, 6, 169, 173 Interim Committee (IMF) 49, 60 International Chamber of Commerce (ICC) 113 International Finance Corporation (IFC) 116 International Institute of Finance (Washington DC) 85 International Labour Office (ILO) 87, 147, 149, 158, 159 International Monetary Fund (IMF) 47, 50, 51, 52, 59, 60, 66, 71, 72, 73, 75, 76, 77, 78, 79, 80, 81, 82, 83, 86, 87, 88, 89, 90, 95, 97, 101, 105, 106, 111, 125, 176 and capital account convertibility 125 and the Asian crisis 78±82 as lender of last resort 59, 75 bailouts 75, 77 disclosure of information by 60 firefighting strategy 79 forecasts 86, 105 policies/ programmes 79, 80, 81, 179 restructuring of operations 59 standby agreements 78, 173

224 Subject Index investment cartels 40 domestic 68 foreign direct 47, 72, 85, 92, 96, 97, 100, 110, 111, 113, 114, 117, 176, 177 foreign portfolio 47, 72, 78, 92, 97, 110, 111, 112, 118 indivisibility of 36 volatile 47 Japan 25, 38, 39, 40, 41, 42, 51, 53, 54, 67, 73, 78, 82, 84, 86, 105, 106, 107, 108, 114, 124, 169 exports to affected Asian economies 84 recession in 73 job security 74 joint-stock companies 135, 136, 147 joint ventures 133, 137, 149, 176, 178 Kodak 115 Korea, Republic of 38, 39, 40, 41, 42, 49, 53, 54, 58, 66, 67, 68, 69, 70, 72, 74, 78, 79, 80, 81, 83, 84, 85, 86, 87, 88, 93, 106, 107, 108, 168, 169, 176

Latin America 46, 59, 85, 89, 90, 109 Laura Ashley 36 legitimacy political 16, 169 legitimation 12 liberalization FDI 118, 176±77 financial 46, 48±49, 60, 63, 78, 92, 103, 104, 120 market 2 policies 5, 48±49 price 141 trade 118, 119, 120 loan bad 52, 103, 105, 120, 122, 123 default on payment 19, 20, 62, 174 non-performing 51, 52, 53, 102, 103, 105, 120, 144, 158 `non-Plan' (India) 152 policy 144, 146, 161 private 47 `soft' 145, 161 lobby 23, 173 losses (enterprise) operational 138 policy-induced 138

labour bonded 16 entry into market 16 (market) flexibility 149 hoarding 131, 132 laws/legislation 40, 132, 160, 164, 173 local bureaus (China) 148 ±management relations 156 market 22, 27, 40, 147, 149 mobility 149 opportunity cost of 35, 131 productivity 130, 131, 150, 151 quality 150 redeployment 130 service companies (China) 146 surplus 130±32, 146±50 zero marginal product of 131 laissez-faire 6, 9, 10, 39, 48, 50, 65, 118

macroeconomic (mis)management 65, 67, 68, 74, 76, 90, 163 macroeconomic (in)stability 41, 44, 48, 50, 62, 143 Malaysia 41, 51, 52, 53, 54, 58, 66, 68, 69, 71, 72, 78, 81, 83, 84, 85, 86, 98, 99, 106, 107, 114, 177 managerial stubbornness 36 `mania, panic and crash' 57 market absence of 6, 25 and power relations 21 as cultural and political institutions 21 capital 17, 18, 19, 36, 66, 82, 115, 118, 121, 122, 125, 126, 179 commodity 19±20, 45, 58, 64 competitive 18±19 deregulation of 62

Subject Index 225 dichotomy between state and 11, 163, 166 different types of 16±17 disequilibrium 27 distortions 22, 25, 27±28, 44, 47 equilibrium 18 exchange 21 factor 9 financial 19±20, 45, 60, 61, 64, 163 foodgrains 23 foreign exchange 18 free 20±21 futures 55 global capital 82 governed 20±21 guided 23 ideal 17 imperfections 6, 16, 25, 27, 44, 61±62, 142 incomplete 20, 25 inefficiency 27, 35 input 16, 17±18 interaction with state and organizations 22±23 labour 17, 18, 27, 60, 88 monopolistic 16, 21, 142 oligopolistic 16, 18±19, 21 organization 21 power 16, 21 product 9, 16, 17±18, 150 protagonists 35 real 19, 21±22 structures 21 typology of 22 unfree 16±17 market failures and government intervention 1 conventional 25±26 in financial markets 57±63 non-conventional 26±28 theories of 25±28 maximization income and employment 37 of labour productivity 131 output 131 profit 29, 131, 132 rent 37 utility 29, 37 vote 29

Memorandum of Understanding (India) 180 mergers and acquisitions (M&As) 113, 115, 179 Mexico 48, 51, 53, 54, 72, 73, 124 Mexican crisis 46, 48, 50, 51, 60, 76 Ministry of International Trade and Industry (MITI) (Japan) 40 monetary policy 60, 67, 74, 79, 103, 107, 171 monitoring 19, 20, 36, 48, 56, 57, 58, 60, 61, 63, 83, 128 Moody's Investors Service 69, 82, 97, 103 moral hazards 22, 26, 58, 61, 77, 96, 104, 122, 124, 138 multinational corporations 5, 37, 47, 85, 89, 100, 112, 113, 162, 171 NAFTA 73 National Renewal Fund (India) 159 Nikkei futures market 55 non-bank finance companies (NBFCs) 99, 124 non-market failures (see also government failures) 17, 29±31, 45, 163, 175 non-price factors in financial markets 18, 20, 61 non-production workers 140, 147 non-tradeables 53, 96 norms legal 7 social 7, 8, 17, 166 objectives conflicting 168 economic 128, 160 equity 163 feasibility of 167 formulation of 37 multiple 36, 131, 168 non-economic 127, 128 political 23 social 41 opposition groups 172±73 organization administrative 171±72 local 165, 166

226 Subject Index organization ± continued non-governmental 23 private 37, 163 profit-maximizing 32 public 37 social 10±11, 38 Organization for Economic Cooperation and Development (OECD) 86 Osaka Stock/Securities Exchange 55, 176 overborrowing 57, 66, 101 by domestic banks 66 by foreign banks 66, 101 overlending 57, 66 overstaffing 24, 30, 44, 127, 130±32, 146±50, 151, 154, 158±60 panic bank 49, 74 financial 49, 57, 60, 74±75, 76, 78, 90, 164 theories of bank 74±75 Pareto optimality 15, 26 participation 16 in negotiations 170 in policy formulation 165, 170 local 165 popular 10, 16, 38, 170 political 170 People's Bank of China 103, 119 Peru 89 Philippines 51, 53, 54, 58, 66, 68, 69, 71, 72, 73, 83, 84, 86, 87, 106, 107, 177, 178 picking winners 37, 42, 178 policy administration-intensive 173 checks and balances on public 38 content of 168 domestic 92±93 feasibility of implementation 168±69 financial liberalization 48±50 formulation of 164, 169 impact of domestic 117 implementation of 163, 164, 169 incomes and wages 40 industrial 40, 44, 77, 78

macroeconomic 171 optimal 168 political economy a critique of new and old 6±8 comparison with new 2±6 features of 1±8 new 1, 2, 3±6 old 1, 2 political pressures 42, 144, 181 political systems/regimes autocratic 171 democratic 12, 15, 16, 30 dictatorial 12, 15 nature of 170±71 one-party 170 politicians rent-seeking 29 vote-seeking 29, 42 poverty alleviation 7 decline in 87 increase in 87, 88 new 11 precautionary loan package (IMF) 59 pressure groups 23, 30, 38, 165, 173 price as allocative device 18, 20, 21 asset 51, 53, 72 below-market 141, 143 commodity 67, 89, 90 controls 129, 141 dispersion 27 distortions 4, 9, 27 formation 23 semi-conductor 67 wars 40 principal±agent problem 58, 64, 127, 128, 138, 142, 143, 164, 165 Private Entrepreneurs' Association (China) 10 privatization 7, 34, 118, 119, 120, 135, 136, 137, 155, 156, 158, 159, 161, 164, 180 private sector 4, 6, 9, 23, 25, 37, 45±46, 54, 62, 65, 68, 96, 98, 129, 136, 137, 155, 156, 158, 159, 162, 164, 169, 172, 175 privilege 38

Subject Index 227 production cost 152 non-market 7 public 41 state control of 3 subsistence 3, 7 productivity capital 156 labour 130, 131, 149, 150, 155, 160 maximization of 131 partial 142, 156 total factor 142, 156 profitability as index of efficiency 155 of state enterprises 138±42, 148, 153±56 of collective enterprises 140, 148 of town and village enterprises 140, 148 profit retention scheme 134, 135, 136 property rights 7, 14, 28, 34, 42, 142 public choice theory 28 public goods 7, 25±26, 34, 131 public policy society-centred 5, 172 state-centred 5, 172 public provision 41 public-sector enterprises (India) 119, 151±60 and soft-budget constraint 151±54 bank loans to 151, 157, 158 economic performance of 152, 155 in developing countries 36 loss-making 155 pricing policy of 36 privatization of 155 profitability of 154±56 resructuring of 137 subsidies to 156±58 purchasing power partiy 74 real effective exchange rate 67, 96, 97, 163 reforms banking sector 122±24, 126 capital market 121±22, 126 financial 121±25 future of 117±21 sequencing of 118

regulation bank 62 economics and politics of 31±33 enforcement of 63 external 56 internal 56 regulators cooperation between 63 external 63 futures 61 internal 63 stock market 61 regulatory mechanism/device 48, 50, 60, 62 rent-seeking and administrative cost of policy implementation 172 government/ bureaucrats 2, 4, 9, 13, 14, 35, 37, 39, 172 in the private sector 4, 21, 172 positive aspects of 4 through trade restrictions 4 reputation mechanisms 18, 20 Reserve Bank of India 95, 97, 99, 100, 107, 111, 117, 123, 124 , 179 resource allocation 1, 20, 21, 24, 27 constraints 173±74, 181 creation 4 efficiency 25 organizational/managerial 173 utilization 173 restructuring 52, 120 retrenchments 87, 120, 146±47, 159 risk control management 56 diversification 172 financial 46 management procedures 54 of loan default 19, 20, 60, 62 premium 98, 104 sharing 75 taking 57, 61, 62±63, 64 rules and regulations 162, 165, 166 Russian crises 59 sanctions economic 93 social 8, 17

228 Subject Index Scandinavia 52 Self-Employed Workers' Associations (China) 10 shareholders 36, 58, 104, 113, 118, 121, 136, 163±65 Sick Industrial Companies Act (India) 137, 158 SIMEX (Singapore) 54, 55, 176 Singapore 56, 85, 88, 93, 107, 114, 177 social embeddedness 21 social safety net 87, 159 social welfare 2, 3, 10, 14, 37, 39, 103, 130, 137, 138, 149, 152 soft-budget constraint 33, 44, 61, 103, 127±30, 133, 137, 138, 139, 140, 142, 145, 150, 151±52, 158, 161, 163, 179 concept 127±30 indicators of 130 measurement the extent of 130 solvency of financial institutions 19 South Centre 47 Southeast Asia 44, 45, 52, 57, 58, 65, 66 Spain 51, 52 Special Data Dissemination Standard (SDDS) 60 stabilization policies/programmes 2, 88 Standard & Poor 69, 82, 97 state absolutist 13 access to the 5 agents of the 2 as rational entity 2 authoritarian /bureaucratic 13, 15 autonomous 13, 15, 16, 23 capability 12 checks and balances on 10, 23 `civil association' view of the 2 democratic 12, 15, 16 dictatorial 12, 15 different types of 7, 12 `enterprise' view of the 2 extent 10, 12 factional 13, 15 fiduciary responsibility of 35

guardian 13, 14 hard 12, 15, 16 interaction with markets and organizations 22±23 intervention 12, 15 Leviathan 14 minimalist 3 overextended 2, 13 Platonic 14, 16 predatory 13, 14, 16 redefining the role of 2 relationship with society 15 soft 12, 15, 16, 23 subordinate 23 typology of Third World 15±16 State Development Bank (China) 121 State Economic and Trade Commission (China) 121, 139 State Electricity Boards (India) 154, 155 state-owned enterprises (China) and profitability 138±42 and overstaffing 146±50 and soft-budget constraint 137±38 autonomy of 136 bankruptcies 143, 146, 150 debt±asset ratio of 136, 139 economic performance of 142, 164 leasing of 136 losses of 138, 139, 140, 141, 143, 145, 147, 152 policy burdens of 138, 140 sale of 136 state bank loans to 144±46 state subsidies to 139, 143±44, 145 wages and bonuses of 150±51 State marketing boards 22 State Science and Technology Commission (China) 101 Statutory Liquidity Ratio (SLR) 95 stock market booms 112 busts 65 Chinese 115, 116 Hong Kong 115 Indian 110, 116, 121, 179 speculation in 117 strategy corporate 167

Subject Index 229 design 166±69 private 167 public 167 structural adjustment policies/ programmes 2, 48, 73, 78, 90 structural changes 18, 27, 79, 173 Structured Early Intervention and Resolution (India) 123 subsidies direct 143, 144, 152, 157 indirect 143, 144, 145, 152, 157, 158 price 144 state 143, 144, 154, 156, 157 swadeshi philosophy (India) 119 Taiwan 38, 39, 40, 41, 42, 49, 53, 88, 93, 108, 114, 124, 169 Tarapore Committee (India) 125 target groups 168 implementation 174 monitoring of 174 plan 135 qualitative 174 quantitative 174 Thailand 51, 52, 53, 54, 58, 66, 68, 69, 70,72, 78, 79, 80, 82, 83, 84, 85, 86, 87, 88, 107, 177 theories of government failure 28±29 market 25±28 non-market failures 29±31 relevance to East Asia 38±43 Third World 15±16 Tokyo Stock Exchange 176 tradeables 47, 96 trade unions opposition from 159 power of 42, 132, 181 pressures 161 transaction costs 8±9, 10, 17, 19, 22, 61, 162 Transparency International 176 Trust and Investment Companies (China) 102 UNCTAD 47, 52, 58, 84, 85, 86, 90, 111, 113

UNDP 170 UNECLAC 89 unemployment 25, 27±28, 86, 87, 88, 89, 137, 161 benefits 87, 148 disguised 137, 149 insurance 149 United Kingdom 38, 50, 55, 57, 58, 74, 105, 107 United States 38, 46, 50, 51, 53, 54, 59, 67, 74, 81, 82, 86, 89, 93, 106, 107, 108, 109, 117, 124 unproductive activities 3, 5, 13 urban collectives (China) 146 Urban Land Ceiling Act (India) 160 vested interests/groups 6, 14, 29, 30, 169, 173, 175 volatility and macroeconomic instability 48, 59 and market trading 112 causes of 46 dangers of 48 exposure of national policies to 48 index 47 of asset prices 48 of capital inflows 59, 78, 92 stock market 112 Voluntary Retirement Scheme (India) 159 vulnerability country's 92 financial (sector) 60 indicators/index 94±105 of China/India to the Asian crisis 92 of the banking sector 49, 52 of women 88 through external shocks 18 to panics 49 wage and bonus payments 158±61 and incomes policy 40 bargaining 151 bill 150, 180

230 Subject Index wage ± continued by level of administrative control 151 determination 35, 151 falling real 86, 87 increase 150 legislation 33 of state-enterprise workers 151, 160 policy 40, 160 share 151

Wall Street 50 World Bank xii, 2, 9, 39, 41, 59, 85, 86, 87, 88, 95, 111, 114, 117, 122, 136, 139, 140, 144, 147, 150, 177, 180 WTO 99, 125 150,

X-inefficiency (see also productive inefficiency) 33, 130 xiagang (lay-offs) 147±48