Private appropriability issues: Government and market failures

1. Private appropriability issues:Government and market failures Elena Ianchovichina PRMED, World Bank Joint Vienna Institute July 2009

2. Government failures • Macroeconomic risks • Macro stability is a necessary condition for growth • Elements of macro stability • Microeconomic risks

3. Macroeconomic risks • Macro stability is a necessary condition for growth • Poor macro management could result in macro volatility which has a negative impact on long run growth • Poor macro management could discourage long term investments by making it hard to predict future outlook • Elements of prudent macro management

4. Elements of prudent macro management • Fiscal policy discipline • Is the fiscal policy consistent with monetary policy? • Is fiscal policy consistent with debt sustainability? • Price stability • Interest rates that are positive, but moderate in real terms • Competitive real exchange rates • Adequate international reserves

5. Issues are country specific and change over time • Difference between market-access and low-income countries relying on official aid • Most countries ensured macro stability in recent years, but the current financial crisis calls for renewed focus on macroeconomic management • Good starting point: IMF’s special issues papers as well as any country analytic papers and CPIA ratings/discussions

6. Links between constraints • Poor macroeconomic management may be a reason for low domestic savings or high spreads on foreing borrowing • In this case, it is poor macro management that is the actual constraint manifesting itself in high cost and poor access to finance • But macro stability does not preclude problems in the financial sector

7. Short-run output contractions due to external shocks • Many developing countries have felt the financial crisis in the developed world through its impact on: • Volume of exports and a drop in export prices • Drop in remittances and capital flows • A rise in cost of finance • Implications – foreign exchange shortages in LICs • Given limited substitutability between domestic and imported goods, there will be a need for both: • Expenditure switching • Expenditure reduction -> drop in aggregate demand

8. Adjustment to a decline in aggregate demand Price AS 1. In the short run both prices and output decline, wage stickiness prevents return to full employment; 2. As recession persists, wages adjust and growth resumes E P E’ P’ P” E’’’ AD AD’ Y’ Y Output

9. Macroeconomic risksExamples • Tajikistan – weak macroeconomic management since mid-2000 make its economy vulnerable • Zambia – RER appreciation: a threat to inclusive growth before 2008 • Brazil – a case of an over-borrowing state

10. The case of Tajikistan

11. Macroeconomic performance deteriorated in Tajikistan after 2006 • Fiscal policy was pro-cyclical, exacerbating the remittance fuelled private consumption boom; • The fiscal deficit rose to about 7.3 percent of GDP in 2008

12. Inflation accelerated to over 20 percent by 2008

13. The current account deteriorated… • Net foreign reserves deteriorated; • Fragile domestic banking sector • Contingent liabilities and quasi-fiscal activities of SOEs • Occurrence of expenditure arrears

14. Remittance inflows have fallen sharply • Reasons for the contraction • Contraction of Russia’s economy • The depreciation of Russia’s currency against a basket of major international currencies • Reasons for the big impact on the BOPs • Tajikistan is one of the most remittance-dependent countries in the world • Remittances provide more than 3 times as much foreign exchange as all exports combined and amount to 80 percent of the value of total imports

15. Tajikistan is a remittance dependent countryRemittances (% of GDP) vs. per capita GDP (Average, 2006-07)

16. Composition of foreign exchange earnings, Tajikistan

17. Expected short-run effect of shortage in external financing on output Price AS Very limited fiscal space in TJK for public spending to stimulate aggregate demand E P E’ P’ AD AD’ Output Y’ Y

18. Weak macroeconomic management in the face of rising remittance inflows has resulted in RER appreciation in recent years

19. And Dutch disease type effects… Shares in world exports Source: COMTRADE, United Nations

20. and a loss in competitiveness… Tajik real unit labor costs have risen even after adjustments for productivity are taken into account Source: COMTRADE, United Nations

21. The case of Zambia

22. Main macroeconomic concerns in Zambia: 2007 and first half of 2008 • The appreciation of the Kwacha • Stable path from 2002 to early 2005 • Rapid rise from 2005 to first half of 2008 • Depreciation in the second half of 2008 • Led to substantial real exchange rate appreciation

23. Real exchange rate appreciation in Zambia • Factors driving these movements included: • Debt relief (Zambia passed HIPC completion point in 2005) • Scaling up of aid • Foreign direct investment flows into mining • Strong export perfomance • Tight monetary policy • At the time this effect was considered a major constraint to inclusive growth due to negative impacts on employment and exports in the tradeables sectors, e.g. agriculture • Underscored the need for productivity improvements

24. Changes in the second half of 2008 • Kwacha significantly depreciated • Strengthening of the US dollar • Falling copper prices • Large withdrawal of portfolio investment • Domestic political uncertainty • This depreciation represents a correction of the overvaluation observed earlier

25. The case of Brazil

26. Brazil’s macroeconomic problems and links to the cost of capital story • Brazil faced the problems of a liquidity constrained country due to excessive debt accumulation • As foreign debt accumulates concerns crop up about the ability or willingness to pay • Cost of foreing borrowing rise or there may be a sudden stop (Brazil, 2002-2003) • High real exchange rate volatility • Instability in the access to foreign savings may be an important source of exchange rate volatility • RER appreciation – foreing savings increase demand for all goods but they typically fund imports • Price of tradables falls relative to non-tradables • Negative impact on growth

27. Microeconomic risks • High and distortionary taxes • Government ineffectiveness • Corruption • Poor regulatory quality • Poor contract enforcement • Labor market rigidities

28. When does the tax code become a constraint to growth? • Firm surveys often identify taxes as one of the top-most constraints to growth • Subjective firm and household data cannot be used as the only evidence that the tax code is a bottleneck to growth • Use indirect data: size of informal sector is an indicator that tax rates distort incentives and create activities designed to avoid paying taxes • Use objective data on several aspects of the tax code and enforcement: • Tax rates • Tax base • Complexity of tax rules • Tax administration

29. Indicators • Taxes • Corporate income tax • Labor tax • Other taxes • Total tax burden (% of profit) • VAT • Trade taxes • Tax base • Number of firms paying 90% of tax revenues • Number of firms reporting no profit or loss • Complexity of tax rules • Number of payments • Time to pay taxes • Tax administration • Number of days spent meeting tax inspectors

30. Tax code a binding constraint in Mongolia 2006 • Mongolia’s informal sector was large and growing, signaling indirectly that the tax code is a binding constraint to growth • The tax base was narrow: 100 taxpayers provided over 90% of revenues • Tax administration was weak; rent-seeking and tax evasion were wide spread • The tax code created: • incentives to avoid paying taxes by staying small • disincentives to start-up businesses • The windfall profit tax on copper and gold created issues with foreign investors • Export tax on raw cashmere encouraged smuggling to China, not downstream processing

31. Excessive taxes and tax policy that is inconsistent with the growth strategy of Tajikistan • Enterprises pay social security taxes that are 25% of their monthly wage bill -> discourages job creation • VAT taxes are 20% - at the high end of VAT worldwide • Some sectors are taxed excessively, and at the same time enjoy subsidized inputs • Number of taxes paid and the time it takes to prepare, file and pay taxes is substantial • Tax collection is hampered: • Corruption • Structure of tax collection department • Lack of computerization • Tax administration reflects an uncertain, nontransparent process that can lead to business closure or suspension

32. Government effectiveness Major obstacle to growth in Benin • Corruption was cited as the third most binding constraint to business growth in Benin’s 2004 ICA report • Nearly 85 percent of firms identified corruption as a severe obstacle to their operations • Benin’s rank on voice and accountability, political stability, government effectiveness, regulatory quality, and rule of law declined during the period 1998-2006 • Courts wer not operating in a transparent and independent fashion • Weak contract enforcement distorted incentives and raised transaction costs • According to Doing Business (2008), it costs 60% of a claim to enforce a contract in Benin. This is higher than all regional averages

33. Poorly defined property rights are a binding constraint to inclusive growth in Tajikistan • Country-level studies show that less secure property rights are correlated with lower aggregate investment and slower economic growth (Johnson, McMillan and Woodruff, 2002)

34. Market failures • Coordination failures • markets fail to respond to potential investors’ demand for services enabling scaling up, innovation and marketing of products • Information failures • firms fail to “discover” which products they can produce at low enough cost to be profitable and competitive • “Innovation” efforts • Defined in terms of what’s new to a country’s sector or groups of firms • Not defined as a shift of the global production frontier

35. Different types of coordination activities • Examples • Prioritizing the development of different types of infrastructure • Making decisions on the location of basic infrastructure to support agglomeration • Providing marketing training and information • Providing product quality and safety information • Establishing and supporting institutions involved in research and development, agricultural extension services • Limited incentives for firms in an industry to provide these kinds of services; efforts require multi-industry collaboration

36. Spatial economics • Resource allocation across regions • Especially challenging in LICs with limited resources, low population density and geographically-dispersed population (e.g. Mongolia, Zambia) • Difficult geographic terrain (e.g. Tajikistan) • Differences in country’s needs and circumstances • In China, where most of the poor are differs from where the highest incidence of poverty is • In India, the location of most poor people and the highest poverty incidence coincide • The use of maps to do analysis

37. Different activities have different needs • Activities grounded in natural resources will benefit from investment in the regions where the resources are located • Activities grounded in new economy will benefit from agglomeration effects -> importance of giving poor people opportunity to invest in portable assets – education, health

38. Types of countries • Distance to markets is large: a challenge for landlocked countries • Lack of access to inputs, lack of access to export markets • Development of infrastructure with a thought to where demand is: local or global • Distance and density, i.e. many poor people far from economic areas • Solution – improving connectivity and investment in portable assets • Distance, density and conflict acting as a barriers to factor mobility and delivery of services

39. The role of knowledge clusters • Network organizations – or knowledge clusters – are the main strategic competitive assets of the Swedish forest industry • The network of institutions is essential to: • developing and maintaining international competitiveness; • dissemination of skills and research from universities and research organizations to the industry • Undertaking multi-industry projects

40. Negative coordination externalities in Mongolia in 2006 • Large informal exports of raw cashmere to China were indirect signal that the government had failed to address coordination issues in the cashmere industry • Herders lacked finance, information and infrastructure to improve raw cashmere quality • Processors lacked incentives and were reluctant to form strategic links with herders • Some of the consequences were: • Shortages of quality raw cashmere • forced processors to operate below capacity • Were an obstacle to FDI from luxury makers of cashmere goods • Environmental degradation • Coordination of transit trade and logistics had been poor • SPS restrictions on meat products in China and Russia had eliminated meat exports from Mongolia to these markets • Firms were competitive in global markets as they did not have access to modern technologies, market, and product quality information

41. Rural-urban differentials in connectivity service provision in Zambia in 2007 • Poor access and high cost of basic services were major constraints to growth • Rural areas were at a disadvantage relative to urban areas Number of households with access to facilities within 5 km • Farm level productivity was negatively correlated with weak service performance • Examples where there were positive coordination externalities (e.g. outgrower schemes)

42. Coordination externalities were not a binding constraint to growth in Benin in 2008 • Effective coordination with domestic and international partners • Benin had taken an active role in coordinating its policies, laws and regulations with WAEMU and ECOWAS • Success stories where coordination had created positive externalities • Mutual saving and loan associations were established to remedy the lack of financing through official channels • Common facilities workshops were established to provide production services on a fee-paying basis for some types of equipment • The networks enabling re-export trade were dynamic, organized, sophisticated and ingenious, indicating high potential for a thriving market economy; The challenge is to steer this creativity and energy in a productive direction and away from illegal activities

43. Innovation strategies • Draw on global knowledge • Create and disseminate knowledge domestically • Innovation activities depend on • Broader economic incentives and institutional regime • Education and training • Underlying ICT infrastructure

44. Indicators of innovation efforts • Measures of innovation efforts • Number and value of new exports • Number and value of new exports that disappear the next year • Education • Skilled labor training • Tertiary education • Acquiring Global Knowledge - Trade • Trade as a share of GDP • Exports as a share of GDP • Tariff and non-tariff barriers • Export processing arrangements

45. Indicators of innovation efforts • Acquiring global knowledge – FDI and licensing • FDI as a share of GDP • Royalty and license fee payments/million population • Number of export processing zones and number of firms in export processing zones • Investing in domestic R&D • Researchers in R&D • Researchers per million population • R&D spending as a percent of GDP • Scientific and technical articles • Patents per million population

46. Disseminating knowledge • Wide productivity differences across firms in any sector in developing countries • Raising the average level to the best local use can lead to sizable gains in efficiency • Still more can be gained by raising average best local use to global best practice

47. Did Mongolian firms “innovate”? • Mongolia’s manufacturing base has been narrow but this is not because firms have not attempted to export new products • Every year in the period 2002-06 • New exports were 30% of exports at the 4 digit HS level • Of these, 70 to 80% were new manufactured exports • But half of new exports were discontinued the following year, and manufactured exports represented a large share of these discontinued exports • The process of “self-discovery” has been hampered by limited access to new technology & knowledge and access to markets

48. Did Beninese firms “innovate”? • “Innovation” efforts in Benin have been low relative to other countries in the region and the rest of the world • Contribution of manufacturing to value added was insignificant and stagnated • Exports of manufactured goods declined dramatically as a share of gross exports (from 22% to 1%) Measuring “innovation” effort in Benin Source: Staff estimates using UN COMTRADE data, HS 4 digits.