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

Government failures  Macroeconomic 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  Interest rates that are positive, but moderate in real terms  Competitive real exchange rates  Adequate international reserves

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

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

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

Adjustment to a decline in aggregate demand Price Output AS AD AD’ E Y P P’ Y’ P” E’ E’’’ 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

Macroeconomic risks Examples  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

The case of Tajikistan

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

Inflation accelerated to over 20 percent by 2008

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

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

Tajikistan is a remittance dependent country Remittances (% of GDP) vs. per capita GDP (Average, )

Composition of foreign exchange earnings, Tajikistan

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

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

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

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

The case of Zambia

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

The case of Brazil

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, )  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 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

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

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

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

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  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

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)

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

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

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

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

Types of countries 1. 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 2. Distance and density, i.e. many poor people far from economic areas Solution – improving connectivity and investment in portable assets 3. Distance, density and conflict acting as a barriers to factor mobility and delivery of services

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 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

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 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”? Source: Staff estimates using UN COMTRADE data, HS 4 digits.  “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