Private appropriability issues: Government and market failures Elena Ianchovichina PRMED March 25, 2009

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

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

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 with low inflation rates Interest rates that are positive, but moderate in real terms Competitive real exchange rates Adequate international reserves

Issues are country specific and change with 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 discussions

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

Macroeconomic risks Examples Zambia – RER appreciation: a threat to inclusive growth before 2008 Brazil – a case of an over-borrowing state

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

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

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

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

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

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 creat 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

Indicators Taxes Tax base Complexity of tax rules Tax administration 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

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

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 While Benin scores higher than other SSA countries in terms of voice and accountability, political stability, government effectiveness, regulatory quality, and rule of law, Benin’s rank on all these indicators has declined during the period 1998-2006 (Table 22). There has been a particularly big drop in the past few years in Benin’s score on rule of law, control of corruption and political stability. [1] According to Transparency International in 2007 Benin ranked below Africa’s good performers - Ghana and Uganda. While its regional rank is mid-range, its global ranking is lower with two third of countries performing better than Benin.

Market failures Coordination failures Information 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

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

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

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

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)

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

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

Indicators of innovation efforts Measures of innovation efforts Number of new exports Number 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

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

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

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

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 New exports discontinued following year Source: Staff estimates using UN COMTRADE data, HS 4 digits.