Privatization And Private Sector Development In Africa, By Tarun Das

PRIVATE SECTOR DEVELOPMENT PROGRAMMES IN SELECTED COUNTRIES IN EAST AND SOUTH EAST ASIA AND LESSONS FOR AFRICA

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DR. TARUN DAS Economic Adviser Ministry of Finance, Govt of India And Consultant, UN-ECA, Addis Ababa

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Prepared for the Development Management Division, Economic Commission for Africa (ECA), United Nations, Addis Abada, as a part of their Project on the Comparative Studies on Private Sector Development Programmes of Selected Countries in Asia and Latin America and Lessons for Africa.

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The report expresses personal views of the author, which do not necessarily imply the views of the Government of India or the United Nations. Author would like to express his gratitude to the Development Management Division of the ECA, particularly to their Director Dr. James Nxumalio for providing an opportunity to prepare this report and the Government of India for granting necessary permission for the same. October, 1998.

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CONTENTS

PART-I : Private Sector Development Strategy in East Asia And Lessons for Africa 1

Introduction and Overview

1.1 1.2 1.3 1.4

Background of the study Objectives and scope of the study An Overview of the study Profile of the regions Asia East Asia and South East Asia Sources of South East and East Asia's growth Efficiency of investment in South East and East Asia Africa

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Role of Public Sector in Asia and Africa

2.1 2.2 2.3 2.4

The Economics of public sector Public/private mix in Asia, Africa and Latin America Public Sector in selected Asian countries Reforms in public sector enterprises

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Prospects and Challenges for Privatisation in Asia and Africa

3.1 Different Forms of Privatisation 3.2 Global Trends of Privatisation Regional distribution Sectoral distribution Modes of privatisation Role of foreign investment 3.3 Selected country experiences in Asia (a) Korea, Republic of (b) Malaysia (c) Philippines (d) Singapore (e) Taiwan, China (f) Thailand 3.4 Privatisation in Africa (a) Middle East and North Africa (b) Sub-Saharan Africa 3.5 Lessons for Africa

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Role of Foreign Investment in Industrial and Infrastructure Development

4.1 4.2 4.3 4.4 4.5

Private capital flows to developing countries FDI - technology - growth nexus Regional distribution of FDI Sectoral distribution of FDI Foreign portfolio investment (a) Modes of foreign capital (b) Modes of portfolio investment 4.6 Development of infrastructure and services 5

Policies and Strategies in Private Sector Development in East Asia

5.1 Role of macro economic policies 5.2 Resource mobilisation 5.3 Foreign investment policies (a) Host country and home country policies (b) Fiscal and monetary incentives (c) Sectoral policies and regulation (d) Low wage rates and production costs (e) Market potentials and rates of return (f) Labour mobility 5.4 Role of financial sector 5.5 Export orientation and trade openness 5.6 Role of special economic zones 5.7 Role of Small and Medium-Sized Industries (SMIs) 5.8 Role of natural and human resources 5.9 Role of research and development expenditures 5.10 Role of legal and institutional set up 6

Private Sector Development Strategies and Policies in Selected Asian Countries

6.1 Hong Kong, China: Economic Reforms and Liberalisation (a) Recent economic situation and policies (b) Private sector development strategy 6.2 Indonesia: Economic Reforms and Liberalisation (a) Recent currency shock and economic crisis (b) Policy responses to crisis (c) Private sector development strategy 6.3 Korea, Republic of: Economic reforms and liberalisation (a) Private sector development strategy

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(b) Foreign investment

6.4 Malaysia:: Economic Reforms and Liberalisation (a) Recent economic situation and policies (b) Private sector development strategy 6.5 Philippines: Economic Reforms and Liberalisation (a) Recent economic situation and policies (b) Private sector development strategy 6.6 Singapore: Economic Reforms and Liberalisation (a) Current economic situation and policies (b) Private sector development strategy 6.7 Taiwan, China: Economic Reforms and Liberalisation (a) Recent economic situation and policies (b) Private sector development strategy 6.8 Thailand: Economic Reforms and Liberalisation (a) Recent economic situation and policies (b) Lessons from Thai economic crisis (c) Private sector development strategy 7

Regional Integration and Economic Cooperation

7.1 Regional economic cooperation in Asia (a) ASEAN experience (b) SAARC experience (c) APEC experience (d) ESCAP experience (e) Multilateral agreement on investment — Infrastructure Financing — South Asia — East Asia 7.2 Strengthening regional cooperation in Africa 8

Lessons for Africa

8.1 Basis of comparison between Asia and Africa 8.2 Macroeconomic policies (a) Pro-savings policies (b) Sustainable fiscal positions (c) General outward orientation (d) Investment on human capital development (e) Selective state intervention 8.3 Role of private sector (a) Private sector development strategy

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8.4 8.5

8.6 8.7 8.8

8.9

(b) Privatisation programmes and strategy (c) Private-public partnership (d) Development of infrastructure and services (e) Fiscal and monetary incentives Export development policies (a) Duty drawback schemes (b) Free trade zones Foreign investment policy (a) Host country policies for FDI (b) Host country pollicies for portfolio investment (c) Home country policies Role of small and medium sized industries Restructuring the financial sector Supporting implementation (a) Infrastructure and human resource development (b) Legal and institutional set up (c) Competent economic bureaucracy (d) Regulatory system (e) Role of R&D expenditure Regional integration (a) Regional integration and co-operation (b) Regionalisation and FDI complementaries (c) Technical assistance

PART-II : Recent Economic Crisis in East Asia And Lessons for Africa 9

Origin, Onset and Spread of the Recent Economic Crisis in East Asia

9.1 Anatomy of the crisis 9.2 Origin of the crisis (a) Victims of their own economic success (b) Changes in external environment (c) Macroeconomic management and exchange rate arrangement (d) Financial sector and other structural weaknesses 9.3 Onset of the crisis 9.4 Spread of the crisis 10 Response to the Economic Crisis 10.1 Current economic and social situation in crisis economies Main causes of economic recession Political and social factors 10.2 Role of multilateral financial institutions

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10.3 Summary of structural reforms in crisis countries (a) Financial and corporate sector reforms (b) Competition and governance policies (c) Trade reforms (d) Social policies 10.4 Thailand: The IMF-supported program of economic reforms 10.5 Indonesia: The IMF-supported program of economic reforms 10.6 Korea: The IMF-supported program of economic reforms 10.7 Early results and the outlook 11

Lessons from Asian Crisis for Africa and Other Developing Economies (a) Nature and causes of Asian financial crisis (b) Lessons from the Asian crisis and way forward (c) Policy lessons for crisis resolution and crisis prevention

Selected Bibliography List of Tables 1.1 1.2 1.3 1.4 1.5 1.6

Growth in GDP per capita in Asia and Africa in 1961-1997 (in per cent) Gross domestic savings as a share of GDP in Asia and Africa (in per cent) Sub-Saharan Africa: key economic indicators Sub-Saharan Africa: selected indicators by groups of countries International comparisons of saving and investment Savings and investment ratios in groups of countries in 1990-1996 (as per cent of GDP)

2.1 Public and private investment as percentage of GDP and GDI in groups of countries in 1980-1993 2.2 Share of state-owned enterprises in major economic variables in several regions in 1978-1985, 1986-1991 and 1978-1991 2.3 Share of the state-owned enterprises in GDP and other economic activity in selected Asian countries in 1990-1991 (in per cent0 2.3 Share of the state owned enterprises in GDP and other economic activity In selected Asian countries in 1978-1991 3.1 Share of the state-owned enterprises in GDP in selected industrial countries in 1979 and 1982 (in per cent) 3.2 Divestiture in developing countries- 1980-1993 3.3 Privatisation revenues in East Asia and the Pacific, 1988-1995 3.4 Privatisation revenues in Latin America and the Caribbean, 1988-1995 3.5 Privatisation revenues in Middle East and North Africa, 1988-1995 3.6 Privatisation revenues in South Asia, 1988-1995 3.7 Privatisation revenues in Sub-Saharan Africa, 1988-1995 3.8 Privatisation revenues by sector, 1988-1995 3.9 Foreign exchange raised through privatisation in developing countries, 1988-1995

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3.10 Portfolio investment and foreign direct investment in privatisation, 1988-1995 4.1 Net capital flows to developing countries by country groups and countries 4.2 Net foreign direct investment in developing countries, 1990-1996 4.3 Net foreign direct investment as a share of GNP by region and income group, 1990-1996 4.4 Gross portfolio flows to developing countries by region, 1990-1996 4.5 Composition of portfolio equity flows to developing countries by region, 1990-1996 4.6 Infrastructure financing raised by developing countries by By region and type of investment, 1986-1995 6.1 Hong Kong, China: Selected economic indicators, 1994-1997 6.2 A: Indonesia: Key economic indicators, 1993-1997 6.2 B: Tax efforts and effective tariff rates in selected countries in Asia and OECD 6.3 Korea, Republic of: Selected economic indicators, 1992-1997 6.4 Malaysia: Selected economic and financial indicators, 1994-1997 6.5 The Philippines: Selected Economic Indicators, 1992-1997 6.6 Singapore: Selected economic and financial indicators, 1994-1997 6.7 Taipei, Chins: Selected economic indicators, 1994-1998 6.8 Thailand: Key economic indicators, 1993-1997 8.1 Major economic and social indicators for the republic of Korea, The second-tier NIEs and Sub-Saharan Africa 9.1 Exchange rate changes and inflation rate in Asian crisis economies In June 1997 - May 1998 (per cent) 9.2 Annual growth rates of broad money supply, 1996-1998 In Asian crisis countries (in per cent) 9.3 Asian crisis countries: Selected economic and financial indicators In 1991-1998 (in per cent of GDP) 9.4 Asian crisis countries: Key economic indicators, 1990-1999

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ACRONYMS ADB Asian Development Bank AFTA ASEAN Free Trade Area APEC Asia Pacific Economic Cooperation ASEAN Association of South-East Asian Nations BOLT Build, Operate, Lease and Transfer BOO Build, Operate and Own BOT Build, Operate and Transfer ECA Economic Commission for Africa EEC European Economic Community EPZ Export Processing Zone ESCAP Economic and Social Commission for Asia and the Pacific FDI Foreign Direct Investment FTZ Free Trade Zone GATT General Agreement on Tariffs and Trade GDP Gross Domestic Product GNP Gross National Product ILO International Labour Office IMF International Monetary Fund MIGA Multilateral Investment Guarantee Agency NIEs Newly Industrializing Economies OECD Organisation for Economic Co-operation and Development OPEC Organisation of Petroleum Exporting Countries SAARC South Asian Association for Regional Cooperation SMEs Small and Medium-sized Enterprises SOEs State Owned Enterprises UN United Nations UNCTAD United Nations Conference on Trade and Development UNDP United Nations Development Programme UNIDO United Nations Industrial Development Organisation VAT Value Added Tax WB World Bank WTO World Trade Organisation Notes on Units Million = 1000 thousand Billion = 1000 million Trillion = 1000 billion Tons = 1000 kilograms Dollar $ = US dollars, unless otherwise specified

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Private Sector Development Programs of Selected Countries in Asia and Lessons for Africa

Dr. Tarun Das1 Economic Adviser, Ministry of Finance, India And Consultant to UN-ECA, Addis Ababa

The Report expresses personal views of the author and does not necessarily reflex the views of either the Ministry of Finance, Government of India or the UN-ECA, Addis Ababa. The author is grateful to the Development Management Division of the Economic Commission for Africa (ECA), United Nations for providing an opportunity to write this Report and the Indian Ministry of Finance to grant necessary leave of absence for the assignment. 1

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CHAPTER 1:

INTRODUCTION AND OVERVIEW

1.1 Background of the Study The present study is a part of a larger Project on the Comparative Studies on Private Sector Development Programmes of Selected Countries in Asia and Latin America and Lessons for Africa being conducted by the Development Management Division of the Economic Commission for Africa (ECA), United Nations. The private sector in most African countries is weak and anemic. It needs a positive environment and comprehensive assistance to flourish and gain competitive edge in the new international economic environment. ECA, in close collaboration with OAU, UNIDO, has been actively assisting African countries since its resolution 47/177 of 22 December 1992. The United Nations General Assembly adopted the Second IDDA programme for the adjusted period 1993-2003, to promote the industrialisation of the continent as a means of attaining national and collective self-reliance and selfsustainment of high economic growth. The findings of the mid-term evaluation of the Second Industrial Development Decade for Africa (IDDA) which was conducted in 1997 by ECA, OAU and UNIDO highlighted a number of impediments, shortcomings at implementation level, unfulfilled commitments, prerequisites not enforced by the main actors, namely governments and private sector operators. Therefore, it was recommended to recapture and refocus on the Decade objectives for the remaining years with full involvement of the private sector. In addition to the adoption of the findings of the mid-term evaluation of IDDA programme, the 13th session of the Conference of African Ministers of Industry (CAMI) resolved to call upon African countries to intensify their efforts to create and sustain an enabling environment for private sector. It also requested UNIDO, ECA and OAU to formulate a comprehensive programme of assisting African countries in the creation, promotion and development of indigenous industrial entrepreneurs. Indeed African governments should take necessary actions to adjust the IDDA II programme if the objective set is to be attained. These actions include creation of a conducive environment for private sector development including establishment of support institutions for development and promotion of entrepreneurial and technological capabilities. Governments should equally involve the private sector in policy formulation and decision-making affecting its operations through effective and constructive dialogue and cooperation. The private sector, which should mobilize, invest and manage resources in the productive sectors, is limited in most African countries. Moreover, the indigenous entrepreneurs are ill prepared to play their crucial role in the new environment. Therefore, they need to be assisted in their development through education and adequate continuous liquidity.

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The 13th meeting of CAMI recognised the role and responsibility of the private sector in industrial development and requested the Secretariat of ECA and other international organisations to provide the necessary support in this regard. Pursuant to these resolutions ECA included in its regular work programme for the 1998-1999 biennium publication of case studies on private sector development and programmes in selected countries in Africa, Asia and Latin America with a view to suggesting appropriate policies, approaches and supporting measures that are required for the expansion of the private sector in African countries. 1.2 Objectives and Scope of the Study The basic objectives of the are as follows: • • •

To review the experience of relatively successful Asian countries in promoting private sector development, To identify the lessons that they can provide for Africa, and Based on the above, to recommend policy measures conducive to private sector development in the light of positive experiences.

This report in two parts deals with studies in Asian countries, which include Hong Kong, Taiwan, South Korea, Singapore, Indonesia, Malaysia and Thailand. Part-I covers the policies and strategies of the selected Asian countries used to accelerate private sector development; the problems they encountered the success they achieved and suggest what African countries can learn from the experience of the Asian countries. Part-II, in particular, focuses on the recent economic crisis faced by the Asian countries, what caused the crisis, what they are doing to face the crisis and what African countries can learn from that experience so as to be able to avert similar crisis. Specifically, the scope of the study includes the following: •

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To review the strategies and approaches used to accelerate private sector development in the countries under study, in particular to highlight the influence of the following factors in the private sector development of the respective countries: (a) political and economic stability, (b) policy, legal, institutional and regulatory framework, (c) investment promotion strategies and incentive packages, (d) physical and institutional infrastructure development, (e) capital market and financial institutional development, (f) entrepreneurship and human resources development, (g) building alliances and networking and (h) partnership between public and private sectors. To highlight the problems encountered and success achieved in implementing the policies and strategies; To identify the lessons African countries can learn both from the success stories and failures; and to suggest how the positive lessons could be incorporated to private sector development strategies in Africa in the 21st century. To examine the role played by regional cooperative arrangements in the development of private sector; 11

• • • • •

To propose ways and means of building partnership between public and private sector as well as alliance and not working particularly with small and medium enterprises; To explain the role of privatisation in accelerating private sector development in Asian countries and lessons for Africa. To explain the causes of the recent economic crisis in the Region and why the strategies and policies in place failed to anticipate the crisis and make provisions for dealing with it; To explain how the countries responded to weather the storm; To identify the lessons African countries can learn from the crisis and fend off themselves against such eventualities in the future; and 1.3 An Overview of the Study

This report is divided into two parts consisting of eleven chapters. Part-I consists of the first eight chapters and deals with policies and strategies for development of private sector in selected countries of East and South East Asia and lessons for Africa. Part-II consists of chapters nine to eleven and deals with recent economic crisis in East and South East Asia, factors behind the crisis, measures taken to cope with the crisis and lessons for Africa. In addition to describing the background, objectives and scope of this study, the current chapter discusses briefly the economic profiles of Africa and East Asia. Chapter 2 provides an overview of the public and private sector mix in industrial and overall development in Asia and Africa and analyses the important role of public sector in providing infrastructure and investment in these regions. It also explains reasons for this importance and consequent problems for the public sector in terms of efficiency, financial viability and delivery system etc. and the need for strengthening the role of private sector in industrial and infrastructure development. Chapter 3 makes a critical review of past and existing privatisation mechanisms in Asian and other economies. It analyses reasons for failures and successes of privatisation process and provides lessons for other countries in privatisation matters. Chapter 4 deals with the role of private participation including foreign investment in industrial and infrastructure development in East Asian economies. Chapter 5 deals with broad policies, reforms and strategies for promoting private sector development in the East and South-East Asia. It examines particularly the role of macroeconomic policies and structural reforms in trade and industry, legal, institutional and regulatory set-up, the role of export-push strategy and the export processing zones and the role of small and medium sized enterprises (SMEs). It also analyses the role of human resource development, resource mobilisation, research and development (R&D) expenditure for promoting industrial and technology development.

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Chapter 6 describes some country experiences with respect to deregulation, liberalisation and other reforms in the spheres of trade, industry, investment, financial and public sectors to induce efficiency and to encourage private sector participation. The chapter also examines different privatisation instruments and mechanisms used by these countries. Chapter 7 reviews existing regional cooperation for private sector development under regional groups like ASEAN and SAARC and their efficiencies and constraints. It also discusses the role of international organisations like ADB, ESCAP, IFC and World Bank for private sector development and privatisation in the region. Chapter 8 summarises the basic issues and problems for private sector development and privatisation in Asian countries and identifies a set of lessons which African nations can learn from both the success stories and failures for formulating their own programmes for the development of private sector. Chapter 9 discusses the origin and development of recent crisis in East Asia, which started as a currency crisis, and latter was converted into a financial crisis and much wider economic and social crisis. Chapter 10 discusses the measures taken by the East Asian economies with the help of multilateral institutions to tackle the crisis. Chapter 11 identifies the lessons for African and other countries to avoid such crisis in future. The report ends with a list of selected bibliography on the subject. 1.4 Profile of the regions Asia In recent years Asian developing economies have shown remarkable economic vigor and dynamism by outperforming by a wide margin other developing regions and industrial countries as a group. As regards industrial growth, performance by the developing countries of Asia continued to outpace that in every other developing region and even the industrialised countries by about 5 percentage points. The continued robust growth in Asia is attributable to a number of factors such as widespread and sustained policy reforms in many countries and continued surge of foreign capital flows to these countries. The variations across countries in the last decade or so – in GDP growth, savings, investment, and export growth and diversification – have been enormous. The lowincome countries doing best have gone beyond broad macroeconomic reforms, conveying to their people – and the world – a commitment to market-oriented economies. They have introduced sustained reform programmes to stimulate internal and external competition and private investment by locals and foreigners. And they have succeeded in creating vibrant private sectors in a relatively short time.

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The best performers have been in Asia. China’s growth has been particularly spectacular, with real GDP growing at 11 percent a year and real per capita income at 10 percent during 1990-1997. Building on past investments in human, physical, and institutional capital, that growth was the result of an ambitious, comprehensive, and sustained programme. Reforms liberalised agriculture, redirected a large part of savings to the provinces, removed price controls, made economic zones attractive manufacturing platforms for export, and gradually liberalised trade and started to revamp the tax and financial systems. In South Asia, major economies grew by about 5.5 percent a year, permitting real per capita incomes to increase by about 3.5 percent a year. Fueling the growth were savings and investment rates of around 20-25 percent, mainly from domestic sources building on strong legal and political traditions and a growing pool of technical skills, Deregulation and trade reform increased internal competition, reduced production costs, and improved product range and quality. The increased private activity in Asia has stimulated the financial sector and is beginning to attract substantial foreign investment, particularly in infrastructure and the stock market. The mechanism that contributed the high growth of the Asian economies in these years can be summarised as export/investment-led growth supported by extremely low production costs. As judged by ratios to GDP, investments and exports made a much higher contribution to growth in Asia than in the other regions. Asian economies achieved high economic growth by introducing capital and technology from advanced countries, while enjoying the benefits of the huge markets that these advanced countries offer. In other words, the Asian economies are typical examples of “catch-up” type economic growth. The process of rapid growth in output and intraregional trade and investment in Asia is sometimes referred to as a “virtuous circle” of economic development. Foreign capital inflows have combined with a favourable policy environment, industrialisation and trade expansion to achieve a sustained acceleration in economic growth. The efficient use of resources, increased trade and rapid growth has, in turn, stimulated an increase in the flow of intraregional foreign investment. This process is gradually helping to internalise Asian growth and to reduce Asia’s vulnerability to external shocks. East Asia and South-East Asia Over the past three decades, the economies of East Asia made remarkable economic progress. Following on the heels of Japan’s double-digit growth in the 1960s, Korea, Taiwan Province of China, Hong Kong SAR, and Singapore grew at very rapid rates from the mid-1960s with their per capita incomes rising to match those in a number of advanced economies in western Europe. They were followed in the 1980s and the 1990s by the Southeast Asian economies (especially Indonesia, Malaysia, and Thailand) which then also grew exceptionally fast. All these countries experienced sustained economic growth at rates that exceeded those earlier thought achievable, with some attaining growth of 8-10 percent a year for a decade.

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In East Asia and Southeast Asia, GDP grew at average annual rates of 9.9 and 6.7 percent during 1961-1997, while annual population growth averaged 1.9 and 2.2 percent. During this period, GDP and population growth in Sub-Saharan Africa averaged 3.4 percent and 2.8 percent a year respectively. This pattern is even more striking if one looks at GDP per capita growth in Table-1.1. Africa’s economic performance begins to diverge from that of Southeast Asia around 1977, following the first oil price shock. Given a similar initial resource base and similar per capita GDP until that time government policies differed in the countries of the two regions leading to growing disparities between the regions. Table-1.1 Growth in GDP per capita in Asia and Africa in 1961-1997 (In per cent) Region Africa East Asia Southeast Asia South Asia

1961-1972

1973-1980

1981-1990

1991-1997

1.3 7.0 3.2 1.3

0.7 7.1 4.9 1.6

-0.9 9.4 4.3 3.3

-0.5 8.0 4.5 2.5

Source: Bank Economic and Social Data base (BESD), The World Bank, 1998. In the 1980s, Africa had generally higher budget deficits than Asia. Africa’s budget balances ranged from a small surplus of 0.3 percent of GDP in Nigeria to a deficit of 14.2 percent of GDP in Zambia. In Asia, they ranged from a surplus of 3 percent of GDP in Singapore to an average deficit of 11 percent of GDP in Malaysia. Most Asian countries ran small deficits, ranging from 0.3 percent in China to under 4 percent in Thailand. Savings rates of the Asian economies were generally higher than the Sub-Saharan Africa’s savings rates, especially in the 1980s. In East and Southeast Asia, most countries saved at least 20 percent of their GDP on average between 1967 and 1997, and many saved over 30 percent. In Africa, only a few saved over 20 percent, while most saved less than 7 percent of GDP. Foreign capital and aid appear to have compensated for Africa’s savings deficiency, as indicated in the higher investment rate during most of the past decade, but these tend to be used by the public sector rather than the private sector. East and Southeast Asian governments boosted savings through a combination of fundamental and interventionist policies. The former included maintaining macroeconomic stability – primarily controlling inflation, and ensuring the security of banks. Low to moderate inflation rates and largely positive real interest rates lowered the risk of holding financial assets, and hence encouraged financial savings. While nominal interest rates were low and were frequently controlled by the governments, these rates still assured positive real returns in the range of 3-6 percent per annum.

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Table-1.2 Gross domestic savings as a share of GDP in Asia and Africa (In per cent) Region

Sub-Saharan Africa East Asia Southeast Asia South Asia Sub-Saharan Africa East Asia Southeast Asia South Asia

1967-73

1974-80

1981-90

Gross Domestic Savings 15.7 20.7 21.1 28.4 18.9 28.1 14.4 17.1

12.6 33.2 31.9 19.1

Gross Domestic Investment 17.3 17.9 19.1 25.4 27.0 27.7 20.1 21.0 22.1 16.2 16.5 17.0

1990-1997

15.9 33.5 32.0 22.0 16.6 31.6 27.5 21.0

Source: Bank Economic and Social Data base (BESD), The World Bank, 1998. The rapid growth of the East Asian economies was accompanied by impressive advances in social development. Poverty, infant mortality, and adult illiteracy declined significantly, while life expectancy at birth rose considerably. Also, and again contrary to earlier conventional wisdom, rapid economic growth was achieved without increases in income inequality. Since mid-1997, however, a number of southeast Asian economies and Korea have been in the grip of severe financial crises that have thrown the region into a deep recession, while economic activity in Japan, after languishing since the busting of the asset price bubble in 1990, has also contracted fairly sharply since spring 1997. The severity of the “Asian crisis” has raised questions about the durability of the region’s rapid growth and the factors that underlay it. While there is no uniform model of development that was applied throughout East Asia, central to the performance of the successful East Asian economies was an emphasis on stability-oriented macroeconomic policies. The basic objectives of these policies were relatively low inflation and the avoidance of overvalued exchange rates; high rates of physical and human capital accumulation; and export-oriented production, which, among other things, encouraged the adoption of advanced technology. Favourable initial conditions also played a part in rapid economic progress. However, more differentiated across countries, and more controversial in their effects, were industrial policies and government intervention, particularly in financial and capital markets, aimed at mobilising and allocating savings. A major study namely “The East Asian Miracle: Economic Growth and Public Policy’’ made by the World Bank (1994) concluded that “exports push” and a combination of

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fundamentally sound development policy and selective interventions had been crucial to East Asia’s success. Developing countries, which want to follow the footsteps of East Asia, must limit policy interventions and focus on fundamentals. The study further concluded, “Of the many interventions tried in East Asia, those associated with export push hold the most promise for other developing countries”. The fundamentals focused by the East Asian economies included the following: • • • • •

Managing monetary and fiscal policy to ensure low inflation and competitive exchange rate. Concentrating public investment on education in primary and secondary levels of schooling, Fostering effective and secure financial systems to encourage savings and investment. Limiting protection so that domestic prices are close to international prices. Supporting agriculture by assisting the adoption of green revolution, technologies, and investment in rural infrastructure and limiting taxation on agricultural goods.

While overall the region performed impressively, there remain serious obstacles to sustained development for many countries of the region. Despite recent gains, the countries of the region have an average income per year, which is much below that in the developed countries. Serious environmental damages associated with rapid urbanisation, inadequate regulation and planning, and incorrect pricing of resources, continues to impose major costs. Another serious problem is the historical inadequacy of infrastructure investment relative to rapidly growing demand. As the region’s infrastructure needs are large, the private sector themselves and through foreign direct investment (FDI) will have to play an increasingly critical role in developing and modernising East Asia’s infrastructure base. In turn, governments of the region will need to establish the appropriate regulatory and legal frameworks to attract and secure such investment. The need for expanding competent management across most areas of development is emerging as a major issue in East Asia. Whether in pollution monitoring and control, design and implementation of monetary and fiscal policies, or traffic-management planning and deregulation, effective institutions are essential. Sources of South East and East Asia’s Growth The sources of East Asia’s rapid and sustained economic growth have been the focus of extensive research. Central to much of this research have been attempts to measure the relative contributions of factor inputs – physical and human capital – and technological progress to the persistently high rates of growth. A commonly used approach is to estimate the total factor productivity (TFP) growth as the residual of the growth in output per worker over a weighted average of the accumulation of physical and human capital per worker. TFP growth basically measures the increase in productivity brought about by technological advances and greater organisational efficiency.

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Empirical estimates of the contributions of factor inputs and TFP growth to east Asian economies’ output growth fall in a wide range, with capital accumulation generally found to have made the largest contribution. Productivity growth is found to have made smaller but still significant contributions. Thus one recent study found that over 1960-94, in all four of the Asian newly industralised economies and the three fast grown ASEAN economies – Indonesia, Malaysia, and Thailand – the contribution of capital per worker dominated growth in factor productivity in explaining growth in output per worker. Since the early 1980s, however, TFP growth appears to have played a larger role. Taking into consideration international differences in productivity levels, abundant opportunity exists for further technological catch-up in the East Asian economies. Real output per worker in Korea, one of the most advanced of the east Asian economies, is only about one-half of the level in the United States, and labour productivity in other east Asian economies represents s fractions of the U.S. level. Therefore, much of the catch-up in real GDP per capita in east Asia has occurred through increased capital intensity rather than growth in TFP, so that productivity gaps remain wide. Efficiency of Investment in South East and East Asia Notwithstanding the east Asian economies’ outstanding record of economic growth and their potential for continued productivity gains, the recent economic crisis has cast considerable doubt on their ability to sustain the very high rates of capital accumulation they experienced in recent years. Investment rates in Korea, Malaysia, and Thailand have been exceptionally high at around 40 percent GDP in the 1990s. But there is a variety of evidence that suggests that the East Asian economies may have been over-investing and that the efficiency of investment has declined. A measure of changes in the efficiency of overall investment is provided by the incremental capital-output ratio (ICOR), which measures the ratio of the rate of investment in any period to the period’s change in output. A rising ICOR may be interpreted as indicating a declining output response to investment and thus a falling efficiency of investment. It could also indicate, however, that output is decelerating, relative to capital, for other reasons: for example, the economy may be shifting to a production structure with a higher capital intensity, which is a normal feature of industrialisation. In almost all the crisis countries ICORs increased in the 1990s. In Korea and Thailand, (and also in Hong Kong SAR), ICORs approximately doubled between 1990 and 1995, suggesting that investment became less efficient in generating growth. In Indonesia (and also Singapore), in contrast, ICORs remained roughly constant. The increase in ICORs in several of the East Asian economies need not necessarily imply a declining efficiency of investment. It could be an indication that these economies were shifting to a more capital-intensive production structure. In recent years, in several of the East Asian economies, increased portions of investment have been in non-traded or protected sectors – such as real estate or petrochemicals in Indonesia, Malaysia, and Thailand – which generated low returns, or in sectors with high or excess capacity – such as semiconductors, steel, ships, and automobiles in Korea –

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which also yielded low or even negative returns. In Thailand, for example, value added in the construction and real estate sector grew by over 11 percent annually in real terms between 1992 and 1996, rising from 12 percent to 14 percent of GDP. During this period office vacancy rates increased, reaching 15 percent by the end of 1996. Similarly, in Indonesia, the construction and real estate sector grew at over 13 percent annually between 1991 and 1996, rising from 9.5 to 10.5 percent of GDP, while in Malaysia, the construction sector grew by over 14 percent annual between 1993 and 1997. Africa In recent years there has been significant turn-around in Africa’s economic situation. Growth of real GDP has improved from 1.6 per cent in 1990-1994 to 4.3 per cent in 1995-1997, that of real per capita GDP from –2.0 per cent to 1.4 per cent over the years (See Tables-13 to 1.5 for trends of major economic indicators of Africa in 1990-1997). Gross domestic investment as a ratio of GDP improved from 16.4 per cent to 16.9 per cent and domestic savings as a ratio of GDP from 15.7 per cent to 16.1 per cent over the period. Overall fiscal deficit and current account deficit also showed declining trends during 1990-1997. However, growth in Africa marginally slowed down in 1997 due to declining commodity prices and adverse weather conditions. The impact of the crisis can be expected to vary considerably among countries: oil and food importers will benefit from lower prices, while exporters of metals and oil and other fuels are particularly vulnerable. For subSaharan Africa growth in 1998 is not expected to be much higher than in 1997, and even this forecast may be over-optimistic. The need for public investment is much greater in SSA, where human and physical infrastructure is extremely inadequate, than in countries with higher levels of industrialisation and development. Moreover, given the rudimentary state of the entrepreneurial class, the public sector many still find necessary to invest in a number of areas, which elsewhere are normally in the domain of the private sector. Certainly, there serious problems in the allocation and efficiency of public investment in many countries in SSA, the resolution of which could provide significant one-off productivity gains, but there can be little doubt that a public investment rate of 5 per cent of GDP is barely adequate to ensure the improvement in the physical and human infrastructure needed for sustain growth. According to one view, the problem is not just the level of investment but its distribution. On this view the share of public investment in total investment in Africa is very high compared with other regions, constituting a major impediment to growth, since private investment tends to be much more efficient than public investment. This view, however, not only ignores the mounting evidence regarding the complementarity between public and private investments, but also is misleading when absolute levels of investment are compared. According to a recent study of 53 developing countries, including 10 in SSA, in the 1980s public investment appears to have been generally more productive than private investment. This was explained by a shift of public investment resulting from

19

insufficient complementary public investment. Moreover, the high share of the public sector in SSA is not due to excessive public investment. Indeed, as the figures in Table1.6 show, as a proportion of GDP the SSA governments invest less than any other region, in particular the Asian countries. It is also notable that the average share of public investment in the “recent strong performers” during 1990-1996 was greater than in other SSA countries by about one percentage point of GDP. Table-1.6: Savings and investment ratios in groups of countries in 1990-1996 (As per cent of GDP) Region

GDI

Private Investment

Public Investment

Sub-Saharan Africa Western Hemisphere Asia (excluding Japan) NIEs in Asia

16.6

11.9

4.7

20.3

15.3

27.8

Advanced countries

Gross Domestic Savings

Share of private Investment in GDI

Share of public investment in GDI

15.9

28

62

5.0

18.2

25

75

19.2

8.6

31.8

31

69

31.6

24.7

6.9

33.4

23

77

20.8

16.9

3.9

20.8

19

81

Source: S. Fischer, E. Hernandez-Cata and M.S.Khan, “Africa: Is this the turning?” IMF Paper on Policy Analysis and Assessment 98/6 (Washington D.C., 1998), table 3. Two themes have characterised until recently the development approach of most African economies: a strong economic role for the state and relatively inward-looking development policy. The broad lessons of development during the past decades are those countries with more market-friendly policies and outward-looking strategies do better both in generating growth and reducing poverty. While there is general agreement in African developing nations about the need of reforms, the pace has been uneven due to mainly political economy issues. Recent progress is most visible in reforms in taxation, industrial, external, public and financial sectors. Reforming African countries made considerable strides in reversing policies that had previously led to rapid declines in living standards, undermined institutions fundamental to the proper functioning of markets, and stifled private initiative. Supported by substantial external aid, they liberalised exchange rates, removed import restrictions, and gradually reduced tariffs – gradually because of their importance for fiscal revenue and a perceived need to phase in reductions in effective protection. They also removed price controls on agricultural products, and most manufactured product prices were decontrolled, except for petroleum – where government involvement has been extremely

20

costly, especially in countries with refineries. In the financial sectors, steps were taken to reduce financial repression, improve supervisory and regulatory frameworks, and address financial distress in the banks. The primary source of growth in reforming Africa was the private sector. Agricultural growth was close to that in China and South Asia. Small enterprises in industry and services, particularly the informal sector, gained because of increased access to production inputs, raising the demand for labour and increasing the low-wage employment in the informal sector. But the supply response in the formal economy, particularly in private savings and investment, has been muted by basic deficiencies in infrastructure and human resources and lack of confidence in the permanence of reform. The reason: few governments have undertaken the necessary structural reforms, particularly to improve a harsh business environment, reduce the dominance and losses of the public enterprises, develop a robust and competitive financial system, and upgrade infrastructure services.

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CHAPTER 2: ROLE OF PUBLIC SECTOR IN ASIA AND AFRICA

2.1 The economics of public sector In most developing countries government runs a large share of the economy. Government operates a casino in Ghana; bakes cookies in Egypt; assembles watches in India; mines salt in Mexico; makes matches in Mali, and bottles cooking oil in Senegal. More importantly, in developing countries in Asia and Africa, the inefficiency of the SOEs, combined with the attendant public sector deficits, are hindering economic growth, making it more difficult for people to lift themselves out of poverty. In many developing countries, SOEs absorb large amounts of funds that could be better spent on basic social services. SOEs often capture a major share of credits crowding out private sector credits. In Bangladesh, SOEs take 20% of domestic credit but account for only 3% of GDP. SOEs often pollute more than privately owned factories. In Indonesia, government factories discharge about five times as much water pollution per unit of output as private factories of the same size. Moreover, many new private businesses in the transitional economies are too small to compete with large scale activities of the SOEs. For example, despite the impressive performance of China’s township and village enterprises (TVEs), it is found that these enterprises have only one-tenth size of their SOE competitors. Even though China’s non-state enterprises have been able to grow rapidly since 1980s without privatisation or liquidation of SOEs, state subsidies to loss-making SOEs have created inflationary pressures. Non-divestiture reforms, such as hardening SOE budgets and instituting contracts between governments and the government-employed managers of state firms, have often failed to improve firm performance. While SOEs deficits have declined, they continue to be a significant burden on government finances and the banking system. It is observed that countries that improved the performance of the SOEs used all instruments such as divestiture, competition, hard budgets, financial sector reform, and changes in the relationship between SOEs and government. Indeed, they used them not as separate options but as mutually supportive components of an overall strategy (IBRD 1995). As SOEs inefficiency is a serious problem in most developing economies, improvement can yield substantial benefits as follow: (a)

Employing only a small fraction of the labour force, these enterprises preempt a large part of government expenditures and account for a large part of the non-performing assets of the banking system. Failure to deal with these losses threatens the reform programme and diverts resources from more demanding social needs.

(b) The fiscal space that the privatisation opens can be used first to help maintain macroeconomic stability, and then to expand investment in human resources and physical infrastructure, particularly in rural areas (where more than two-thirds of the

22

people live in low-income countries). It would also help finance social safety nets and targeted programmes to deal with the transitional costs of privatization and civil service retrenchment. (c) Ending SOEs operating subsidies would release public funds for more crucial needs, such as health and education. For example, in India, where 450 million people, about half the population, are illiterate, explicit government subsidies to centrally owned SOEs are five times the central government’s budget for education. (d) Improving SOEs efficiency may substantially reduce the fiscal deficit. For example, reducing SOEs operating costs by 5 percent would reduce the fiscal deficit by 53% in Bangladesh, and 41% in Indonesia. Over a decade, the savings would be sufficient to retire 10% of external debt in Bangladesh and 14% in Indonesia. (e) Divesting part of the SOEs equity can boost growth by improving productivity and resource allocation. Where SOEs account for 10 percent of GDP, typical for a developing country, divesting half the sector would increase GDP by about 1 percent. 2.2 Public/ private sector mix in Asia, Africa and Latin America Table-2.1 indicates the trends of public and private sector investment as percentage to gross domestic product and gross domestic investment in various regional groups of countries in 1980-1985 and 1986-1993. Table-2.2 indicates the average shares of state owned enterprises (SOEs) in Asia, Africa and Latin America in major economic activities like GDP, investment, employment, credit, fiscal deficit, external debt etc. It is observed from Table-2.1 that, in general, East Asia (25 per cent) and Latin America (27 per cent) had the lower share of public sector in the total investment than that (around 45 percent) in the other regions during 1986-1993. The share of public sector in total investment was the highest in Europe, Middle East and North America (50 per cent) closely followed by Sub-Saharan Africa (49 per cent) and South Asia (47 per cent) in 1980-1993. However, the share of public sector in gross domestic investment declined significantly in all the regions during the period 980-1993. It may be observed from Table-2.2 that in general among the developing countries in Asia, Africa and Latin America, SOEs in Africa had the highest shares in major macroeconomic variables like non-agricultural and overall GDP, gross domestic investment, employment, and external debt in 1978-1991; and Latin American SOEs had the lowest shares in these variables. Overall financial balance of SOEs was negative for all the regions in 1978-1985. While the SOEs financial balance improved to some extent in Asia in 1986-1991 and that in Latin America improved significantly and turned positive in 1986-1991, financial performance of SOEs deteriorated in Africa in 1986-1991.

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Table-2.1 Public and private investment as percentage of GDP and GDI in groups of countries in 1980-1993 Country groups

1980-1985

1986-1993

1980-1993

South Asia: GDFI/GDP PVTI/GDP PUBI/GDP PVTI/GDI PUBI/GDI

19.3 9.7 9.6 50.1 49.9

20.4 11.1 9.3 54.4 45.6

19.9 10.5 9.4 52.6 47.4

East and South East Asia: GDFI/GDP PVTI/GDP PUBI/GDP PVTI/GDI PUBI/GDI

28.0 18.6 9.4 66.5 33.5

30.6 23.0 7.5 75.3 24.7

29.5 21.1 8.3 71.5 28.5

Latin America and Caribbean: GDFI/GDP PVTI/GDP PUBI/GDP PVTI/GDI PUBI/GDI

20.7 13.7 7.0 66.2 33.8

19.8 14.6 5.3 73.4 26.6

20.2 14.2 6.0 70.3 29.7

Europe, Middle East and North America: GDFI/GDP PVTI/GDP PUBI/GDP PVTI/GDI PUBI/GDI

21.2 9.9 11.3 46.9 53.1

20.0 10.7 9.4 53.2 46.8

20.5 10.4 10.2 50.5 49.5

Sub-Saharan Africa: GDFI/GDP PVTI/GDP PUBI/GDP PVTI/GDI PUBI/GDI

20.6 9.4 11.3 45.4 54.6

16.9 9.4 7.5 55.7 44.3

18.5 9.4 9.1 51.3 48.7

Notes: GDP stands for gross domestic product, GDI gross domestic investment, GDFI gross domestic fixed investment, PUBI public investment and PVTI private investment. Source: J. D. Glen and M. A. Sumlinski (1995) Trends in private investment in developing countries, Discussion Paper No.25, International Finance Corporation.

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Table-2.2: Share of state-owned enterprises in major economic variables in several regions in 1978-1985, 1986-1991 and 1978-1991 (continued) (in per cent) Developing countries

1978-1985

1986-1991

1978-1991

Share in gross domestic product (GDP) Asian developing economies African developing economies Latin American developing economies

9.9 18.7 9.0

11.4 17.9 9.2

10.5 18.4 9.1

Share in non-agricultural GDP Asian developing economies African developing economies Latin American developing economies

13.5 22.1 9.9

14.6 20.9 10.1

14.0 21.6 10.0

Share in gross domestic investment Asian developing economies African developing economies Latin American developing economies

30.0 28.9 24.1

24.3 26.4 15.6

27.6 27.8 20.4

SOE’s investment as percentage of GDP Asian developing economies African developing economies Latin American developing economies

7.0 6.8 5.1

5.8 5.4 3.1

6.5 6.2 4.2

Share in employment Asian developing economies African developing economies Latin American developing economies

4.9 15.8 4.3

4.7 17.1 4.0

4.8 16.4 4.1

Share in gross domestic credit Asian developing economies African developing economies Latin American developing economies

10.4 16.2 8.0

9.7 18.2 12.6

10.1 17.1 10.0

Share in external debt Asian developing economies African developing economies Latin American developing economies

11.1 14.7 21.9

13.1 12.0 15.0

12.0 13.6 19.0

SOE’s external debt as percent of GDP Asian developing economies African developing economies Latin American developing economies

3.7 7.4 8.5

4.5 10.9 6.1

4.0 8.9 7.5

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Table-2.2: Share of state-owned enterprises in major economic variables in several regions in 1978-1985, 1986-1991 and 1978-1991 (completed) (in per cent) Developing countries

1978-1985

1986-1991

1978-1991

-3.4 -1.8 -1.1

-1.6 -2.3 1.8

-2.7 -2.0 0.1

1.1 1.6 -2.0

0.1 1.4 -2.4

0.7 1.5 -2.2

SOE’s overall balance as percent of GDP Asian developing economies African developing economies Latin American developing economies Govt.financial flows to SOEs as % of GDP Asian developing economies African developing economies Latin American developing economies 2.3 Public sector in selected Asian countries

Table-2.3 indicates the percentage shares of the State Owned Enterprises in economic activity in selected Asian economies (alongwith average figures for African and Latin American developing economies) in 1980 and 1991. Table-2.4 indicates SOEs shares in GDP, gross domestic investment (GDI), employment, gross domestic credit and external debt in the selected developing countries during 1978-1991. It may be observed from the tables that among the developing countries in general, SOEs shares in economic activities were the highest in the African economies, followed by the Asian and Latin American economies in both the years 1978 and 1991. Over the years during 1978-1991 the average shares of SOEs in economic activities had declined across the regions although there are significant variations among the countries. 2.4 Reforms in public sector enterprises Since 1980s several developing countries had undertaken credible reforms in public enterprises (PEs). These include disinvestment of government equities in public enterprises, outright sale or privatisation of many enterprises, restructuring of the lossmaking but potentially viable PEs and liquidation of unviable units, phasing out budgetary support to loss making units, elimination of PEs privileges such as entry barriers, preferential access to domestic and foreign finances, and purchase or price preference for the public sector, and abolition of the system of concessional credits to public sector enterprises. Developing countries had privatised a growing number of former state monopolies in telecommunications, power, water, railroads, roads, ports and gas. The value of sales of firms from privatisation exploded from only $2.6 billion in 1988 to $21.2 billion in 1995. Privatisation has been tried for many types of infrastructure monopolies, but most sales were concentrated in telecommunications (19 percent), banking (13 per cent), petroleum

26

(12 per cent), power (11 percent) and steel (7 per cent). This rapid growth may be due to government’s inability to meet expanding demand in telecommunications and power, partly because of fiscal constraints, and partly because of higher efficiency of the private enterprises than state enterprises. Table-2.3 Share of the State Owned Enterprises (SOEs) in GDP and other Economic Activity in Selected Asian Countries in 1980-1991 (in per cent) Country

Share in GDP 1980

Bangladesh India Indonesia Japan Korea,Rep.of Malaysia Myanmar Nepal Pakistan Philippines Sri Lanka Taiwan,China Thailand Industrial Countries Developing Countries -- Latin America -- Africa -- Asia

1991

Share in NonAgricultural GDP 1980 1991

Share in Gross Domestic Investment 1980 1991

2.1 3.4 9.1 13.6 17.7 13.0 10.4 10.2 17.0 2.5 2.0 8.0 11.5 1.6 3.0 10.3 6.2 5.6 5.4 4.3 6.0

3.5 13.9 23.3 12.2 6.1 12.8 2.1 7.2 4.5

5.4 19.0 17.0 11.2 21.0 4.3 16.0 3.9 13.5 6.0 6.2 6.2

6.7 41.1 11.1 10.6 27.6 9.9 48.2 35.0 35.5 18.4 36.2 27.8 17.7 8.8

25.8 42.5 18.7 4.9 8.9 14.4 11.9 53.5 25.6 2.2 18.5 17.0 13.3 6.2

10.6

10.2

12.6

12.0

26.4

17.9

9.5 8.4 18.2 17.3 9.6 10.7

10.4 21.2 13.2

9.3 20.1 13.3

22.8 29.8 30.3

12.1 24.2 22.8

Source: World Bank (1995). A World Bank (1995a) Study concludes that most countries have failed to improve the performance of SOEs, either because reforms were not properly designed or because well-designed plans were not implemented. Design problems arise when countries fail to combine key elements of reform- divestiture, competition, hard budgets, financial reform, and changes in the relationshilp between SOEs and government - into a comprehensive approach. Implementation problems arise when people who benefit from the SOE status quo (SOE employees, managers, and the buyers of subsidised SOE outputs) become an important force to block SOE reform.

27

Therefore, the SOEs reform must be carefully formulated after taking into account both economic factors and reform preconditions. Poorly designed or ill-timed SOE reform efforts not only waste scarce resources, they may even worsen a situation in several ways such as increased cynicism of public managers, adverse impact on the financial system, reduced pressure for SOE reform and tarnishing the reputation of SOE reform. Table-2.4 Share of the State Owned Enterprises (SOEs) in GDP and other Economic Activity in Selected Asian Countries in 1978-1991 (in per cent) _______________________________________________________________________ _ Country GDP NonGDI Employment Gross External Agricultural Domestic Debt GDP Debt _______________________________________________________________________ _ Bangladesh 2.7 4.6 21.2 19.9 0.4 India 12.1 17.4 41.0 8.3 11.8 Indonesia 14.8 19.9 12.8 4.9 Japan 8.2 Korea,Rep.of 9.9 11.3 21.5 1.8 12.8 Malaysia 17.0 21.0 16.4 15.9 Myanmar 44.2 Nepal 2.3 5.2 43.0 7.8 5.2 Pakistan 10.3 14.9 32.7 4.3 Philippines 1.9 2.3 12.3 0.8 8.6 16.5 Sri Lanka 10.4 13.5 28.7 13.9 7.2 Taiwan,China 6.9 7.8 24.5 2.1 Thailand 5.4 6.2 14.7 1.0 1.7 27.7 _____________________________________________________________________ Industrial countries

4.9

5.0

7.7

-

-

-

Developing 10.7 12.8 24.1 4.8 10.2 15.6 countries -Latin America 9.1 10.0 20.4 4.1 10.0 19.0 -Africa 18.4 21.6 27.8 16.4 17.1 13.6 -Asia 10.5 14.0 27.6 4.8 10.1 12.0 ______________________________________________________________________ Source: World Bank (1995). Notes : 1. GDP and GDI stand for gross domestic product and gross domestic investment respectively.

28

2. SOEs share in external debt has been estimated for only the nonfinancial state owned enterprises.

29

CHAPTER-3 PROSPECTS AND CHALLENGES OF PRIVATISATION IN ASIA AND AFRICA

3.1 Different Forms of Privatisation Any process which reduces the involvement of the state or the public sector in economic activities, and is generally in keeping with the spirit of liberalisation, deregulation and globalisation of the economy, is called privatisation. Narrowly defined, privatisation is the sale or transfer of state-owned enterprises to private investors through auction, stock flotation or distribution, management-employee buyout, or voucher or coupon privatisation. Broadly defined, privatisation also includes leasing, partial disinvestment, management contract or concession-type arrangements like Build-Operate-transfer (BOT), Build-Operate-Own (BOO), Build-Operate-Lease-Transfer (BOLT) and BuildOperate-Own-Transfer (BOOT) etc. Privatisation in a broader sense encompasses numerous forms as the following: • • • • • • •

Delicensing, deregulation and dereservation of industries for public sector. Transition to private sector business, commercial and managerial principles and methods. Closure, liquidation or transfer of state owned enterprises to private sector. Leasing of a State owned enterprise to a private party. Management contract of an enterprise to a private party. Divestiture and denationalisation- Divestiture of a part of the government share holding to workers, general public, private entrepreneurs, foreign institutional investors, or to mutual funds and financial institutions. Franchise financing, under which an infrastructure project is built and operated by a private sector under a regulatory structure, agreed to with the Government.

It is important to stress that the privatisation movement started since the late of 1970s was a totally new ideology, following a period when “capitalist” economies moved slowly toward a mixed-economy system. The percentage share of the State Owned Enterprises in economic activity in some “free market” economies in 1979 and 1982 (indicated in Table-3.1) was considered to be high and the countries desired to privatise some of these enterprises to enhance efficiency and to improve fiscal balance. Privatisation is a versatile tool to subserve many objectives such as (a) tackling acute fiscal stringency or a resource crunch, (b) achieving wider share ownership, (c) reducing state monopoly in certain sectors, (d) changing the public-private mix in a sector for more competition, (e) improving the performance of State Owned Enterprises (SOEs), (f) reducing the demand of SOEs on the time and energy of the bureaucracy and (g) reducing political meddling which is the bane of many SOEs.

30

During 1980s privatisation spread very fast in both developed countries (France, Germany, Austria, Italy, Netherlands, Portugal, Japan, USA) and developing countries (South Korea, Brazil, Argentina, Tunisia, Turkey, Indonesia, Malaysia). With the collapse of the former Soviet Union, privatisation has become a huge task in eastern Europe during 1990s. The number of countries selling SOEs increased in the 1980s, as divestiture spread from the industrial countries, notably the United Kingdom, to developing countries. In the 1990s, many countries intensified their efforts, selling more enterprises and shifting their attention from small firms to large monopolies. Mass privatisation also began in Eastern Europe and the republics of the former Soviet Union. It concerned not only countries with a very large government controlled sector, such as Austria or France, but also countries with a very small public sector. Japan embarked on one of the largest programmes, privatising such traditional public utilities as the railways, the airlines, the telephone utility. Privatisation have concerned all economic sectors such as industry, finance, transport, utilities although priorities can be established by any country depending on its resource endowment and objectives. Although critics claim that privatisation causes unemployment and disparity in capital ownership, it is now generally accepted that privatisation is a good prescription for high inflation, low productivity, low growth, low employment generation and lost opportunities for export competitiveness. 3.2 Global Trends in Privatisation There were more than five times as many privatisation transactions in the developing countries in the six years from 1988-93 as in the previous eight years (1980-87). While most of the increase was due to the explosion of privatisation activity in the transition economies of Eastern Europe and Central Asia, the number of divestitures increased more than fourfold in Latin America and more than threefold in the rest of Asia. As a result, developing countries accounted for 86 percent of transactions in 1988-93 compared with 66 percent in 1980-87 (Table-3.2). Regional distribution During 1988-1993, in the developing world, the bulk (57% by value) of privatisation took place in the Latin America and Caribbean region, followed by Asia (21%) and Europe and Central Asia with 19% of the share as against a minimal (3%) proportion in SubSaharan Africa and the Middle East and North Africa (Table 5.3). Developing country revenue from privatisation peaked at US $27 billion in 1992. Revenues fell slightly to US $24.2 billion in 1993 and further to $20.2 billion in 1994 due to reduced sales volume in Latin America as well Europe and Central Asia. However, sales picked up again in 1994. During 1988-1995 Latin America and the Caribbean accounted for the major share (53 per cent) of revenues from privatisation, followed by the Eastern Europe and Central Asia (19 per cent ) and the East Asia and the Pacific (19 per cent) as the distant second, and

31

South Asia (5 per cent), while Sub-Saharan Africa, and Middle East and North Africa had nominal shares of 2.3 per cent and 1.5 per cent respectively (Tables 3.3 to 3.8). Sectoral distribution Infrastructure sector has been dominant accounting for 36% of total revenue for the developing world in 1988-1995 (Table-3.9). Infrastructure, including energy, telecommunications, water and transportation played an important role in Latin America, the Caribbean, East Asia and the Pacific; while industrial enterprises accounted for half of all sales in Eastern Europe and Central Asia. Modes of privatisation In terms of techniques, direct sale was preferred, accounting for nearly 80 per cent of transactions and 60 per cent of revenues. In particular, direct sales targeted at prequalified strategic investors were the preferred means of transferring scarce management and technology skills to newly privatised medium-and large-scale enterprises in East Asia, Eastern Europe, and Latin America. Public offer sales with 15 per cent of number of transactions and 35 per cent of revenues were a distant second, followed by concessions, joint ventures and management buy-outs each accounting for less than 2 per cent of total revenues and number of transactions. The available information on the size and nature of divested enterprises supports the view that divestiture was not only more common but also more significant in 1988-1995 than in the previous period of 1980-1987. Early period sales involved relatively small SOEs, primarily in agribusiness, services and light manufacturing. In 1988-95, by contrast, divestiture included the sale of large state-owned enterprises in such important sectors as electric and water utilities, transportation, and telecommunications, as well as major firms in the financial and industrial sectors. In Asia, most countries, including China and India, have focussed on private entry using concessions and joint venture as the vehicles to increase the involvement of the private sector in infrastructure. Many countries find, however, that providing security for potential private investors in such arrangements is more complex and difficult than initially thought. Indonesia, for example, has taken five years to conclude its first private power deal. In India, Maharashtra state government scraped the Enron Power project in August 1995 even after three years of intensive negotiations and providing state and central government counter guarantees to the Power Purchase Agreement (PPA). However, the Enron project was subsequently re-negotiated after interventions by the courts. The lessons being learned are that it is necessary to make the negotiations and policies more transparent by all concerned parties. There is a strong link between privatisation and capital market development. In most cases, privatisation represents the first time when private voices are heard on SOE Boards, and leads to the improvements in accountability, operational and risk management, and security that the suppliers of capital require. Borrowing from banks tends to

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become more commercial and less the result of political pressure. At the same time, a large privatisation programme has a crucial effect on capital markets development; adding greatly to the stock and variety of corporate assets available to the public. This not only increases country access to foreign direct and portfolio investment and finance, but also stimulates domestic savings. Across all regions, however, stock markets continued to assist in and benefit from privatisation activity. In the Middle East and North Africa, market capitalization in Egypt, Kuwait, Morocco, and Tunisia has been enhanced by the sale of state enterprises through public offerings of shares. In Africa efforts are under way to establish bourses in Sudan and elsewhere that would help speed the privatisation process. In India and China, however, where public offers are the primary means of divestiture, stock market weaknesses actually slowed privatisation. Leases and concessions were the preferred method of divestiture for infrastructure and agriculture projects in Latin America and Africa; management and employee buyouts continued to be popular in Eastern Europe. Role of foreign investment Over the period, foreign investors were involved in nearly one third of these transactions and a total $58.5 billion in foreign exchange was generated by the sales representing approximately 45 per cent of total revenues from privatisation (Table-3.10). The participation of foreigners differs substantially by regions. Latin America and the Caribbean had the highest share (44 per cent) of foreign involvement followed by Eastern Europe and Central Asia (30 per cent) and East Asia (19 per cent), reflecting the serious lack of domestic capital for transactions of this nature. The proportion of foreign participation in total privatisation revenues was 38 per cent in Latin America, 71 per cent in Europe and Central Asia, 48 per cent in East Asia and pacific 54 per cent in Sub-Saharan Africa , while South Asia showed an extremely low share (6 per cent) of foreign investments in privatisation reflecting limitations on foreign participation in privatisation sales. 3.3 Selected country experiences in Asia (a) Korea Privatisation in Korea started in 1969 with the sale of the Korean Airlines to the Hanjin Group. In 1982 Korean Heavy Industries and Korean Oil were sold and seven major commercial banks were privatised. During the Fifth Five Year Plan (1982-1986) government also started corporatising certain departments such as Cigarettes, Railways and Communications as a first step towards disinvestment. In 1986 plan was launched to privatise 13 subsidiaries of government invested enterprises (SGIEs). The Korean Stock Exchange was fully privatised in 1986.

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The years 1987-1989 were a turbulent policy period for the Korean government. Many SOEs were privatised during this period, and market liberalisation policies related to foreign investment were instituted. Policies re-emphasised export-led growth. More recently the Government directed the Conglomerates to reform and restructure themselves through disinvestiture. Each group is allowed to retain only 3 lines of business of their own choice. The parties concerned negotiate royalties and fees, and the authorities often automatically approve contracts stipulating royalties of up to 10% of net sales for 10 years or less. Recent technical know-how agreements reflect higher royalty payments by Korean companies. Royalties need not be based entirely on net sales, as is apparent in recent licensing agreements. Disinvestment in non-strategic SOEs amounted up to 10% during pre-privatisation period (1975-1979), whereas after reforms, disinvestment up to 80 per cent was allowed during 1980-1989. Progress in privatisation amounted to 30% during pre-reforms and 70% in post-reforms. Sale of Government stake was also allowed in Pohang Iron and Steel Plant in 1988, Korean Electric in 1991 and more recently in Korean Telecommunications Corporation and Citizen National Bank. (b) Malaysia Among the ASEAN countries Malaysia had substantial government participation in various infrastructure, manufacturing and service enterprises. In the early 1980s there were more than 1100 state-owned enterprises. Privatisation started in 1985 with the announcement of the New Economic Policy which aimed at encouraging greater private participation in industry and infrastructure. By 1989, 22 state-owned enterprises were privatised, including Malaysian Airlines System, Malaysian International Shipping Corporation, Cement Manufacture, Port Klang Container terminal Operations, Trade Winds and several water supply projects handled by the government. A Master Plan of privation was also drawn up to privatise 246 enterprises by 2000. However, only 54 enterprises were privatised until 1992. The major privatised enterprises include Telecom Malaysia in 1990 and Tenega National in 1992. (c) Philippines In support of the economic reforms aimed at enhancing the competitiveness of Philippine Industry, substantial progress has been achieved in reducing the Government’s rules in business. Government undertook a major programme of privatisation in 1986 by establishing the Commission on Privatisation (COP) and Asset Privatisation Trust (APT). From 1987 to 1992, 368 entities have been privatised, representing 70 per cent of the total number of entities planned for privatisation. Initially, most of the privatisation involved debt-equity swaps. By 1990, the new debt-equity conversion programme prohibited debt-equity swaps except for banks. Privatised enterprises range from cement, sugar, textile plants to public utilities, banking and financial services and airlines.

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The Government in close collaboration with the banking system and industry associations of the private sector, is presently undertaking an Industrial Restructuring Programme (IRP) which aims to make the manufacturing sector competitive by assisting firms to adjust to the competitive environment. Two types of restructuring are envisaged under the programme : (a) defensive - to scale down and revitalise uncompetitive sectors; and (b) positive - to accelerate and sustain the operations of competitive sectors. Under Phase-I of the IRP (1989-1990), studies were prepared for cement, textiles, pulp and paper, shipping and ship-repair, and the Development Bank of the Philippines has made available lending schemes to these sub-sectors. Phase-II of the IRP is involved with studies for the sectors such as wood and wood-based products; electrical appliance and household-wares; spinning and weaving; cocoa, chocolate and confectionery; canned, preserved fruits, fruit juices and vegetables; plastic products; fabricated metal products; and canned, preserved fish. (d) Singapore A ten-year privatisation programme for Singapore was prepared by a Public Sector Divestment Committee, established in 1986. The programme envisages slow and gradual reduction of government ownership in selected infrastructure, service and manufacturing enterprises. Since 1987, government holdings have been reduced in several government linked companies such as INDECO, Jurong Shipyard, Sembawang Shipyard, Keppel Corporation, Neptune Orient Lines, Resource Development Corporation, Singapore National Printers. In 1991-92 four companies of the Singapore Technologies Group, a technology based engineering and service group was privatised. In some cases government has sold its shares in joint venture arrangements with foreign partners, has privatised some statutory boards, which are government monopolies. (e) Taiwan, China Despite its strong private sector and export orientation, Taiwan has a number of stateowned enterprises primarily in the banking and financial sectors and also in industry. Although the privatisation programme started in 1985 and government intended to sell up to 51 per cent of its equity held in a public sector company, privatisation programme unfolded rather slowly during 1985-1992 due to labour problem. Privatisation was basically limited to the offering of shares (5-20 per cent) in six companies in the stock market. Subsequently, three banking and insurance companies, one shipping company, one iron works company, one engineering company and 18 other state-owned enterprises were privatised. State-owned enterprises in Taiwan are highly profitable and the objective of privatisation is to avoid competition with private-sector enterprises in these fields. (f) Thailand In Thailand government ownership in industry was very much limited than in most ASEAN countries with major ownership only in the financial, infrastructure and service sectors. In the 1980s government liquidated several loss-making industries such as jute

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mills, paper mills and mines. Among the largest privatisations were the sale of the Paper Mill Organisation, State Alum Organisation and North East Jute Mills and Sugar Mills. The privatisation programme has been limited to the sale of minority shares in certain enterprises such as Krung Thai Bank and selected infrastructure enterprises. 3.4 Privatisation in Africa (a) Middle East and North Africa Privatisation revenues in the Middle East and North Africa increased from only $2 million in 1990 to $657 million in 1995 and $1940 million in 1990-1995. Although many countries in the region have established or are setting up privatisation programmes, actual sell-off have been concentrated in only a few countries like Morocco, Egypt and Tunisia. The largest deal for Morocco in 1995 was BMCE, the country's second largest bank. Several other sales like Samir refinery and Sonasaid steel were postponed to 1996 due to depressed market situation. The pace of privatisation in Egypt remained slow, as the government continued to offer partial stakes in state enterprises to outside investors, with a portion reserved for employee buyouts. No sales have been effected since 1994, when three companies were sold outright to foreign investors. Fear of unemployment has been one of the main causes of the slowdown in privatisation. Iran revived its moribund programme, which had been suspended since mid-1994, with the sale of a 40 percent stake in a metal company. In Algeria a privatisation programme was put in place in 1995, but sales of enterprises did not commence until 1996. The United Arab Emirates took the first step in 1996 toward privatisation by setting up a joint stock company, Dubai Investments. Jordan, the first Middle Eastern country to receive a sovereign rating in 1995, also inaugurated its privatisation programme, with the sale of a 54 percent stake in the Intercontinental Hotel in 1996. (b) Sub-Saharan Africa In many countries of Africa, public enterprise losses are on the order of 8-12 percent of GDP. They absorb most domestic savings in Sub-Saharan Africa and are 2-3 times government spending on health and education. But for these losses, real per capita GDP growth in reforming African countries would have been 3-4 percent a year instead of only 1 percent. Public sector inefficiencies have limited job growth and in the process deprived a large part of the population of the benefits of reforms –undermining the political. Support for difficult structural changes needed to compete in a global economy. With encouragement from donor agencies, African countries continued to sell off stateowned enterprises, raising $3002 million in 1988-1995. Although the total value of privatisation proceeds in Africa is low compared with other regions, African countries have been actively engaged in selling or liquidating state-owned enterprises. The absence

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of an efficient functioning stock market in many African countries is one of the main obstacles to privatisation. Kenya raised the limit on foreign ownership in local companies from 20 percent Tao 40 percent in 1995, allowing KLM to purchase a 26 percent stake in state-owned Kenya Airways in December 1995. In 1996 another 48 percent of the airline’s shares were sold to local and foreign institutional investors and to the public. In Zambia, privatisation continued with the liquidation of loss-making state enterprises like Chailanga Cement. In Zimbabwe the government reduced its controlling stake in the largest company listed on the Zimbabwe stock exchange, Delta Corporation, a private placement of shares in 1996. 3.5 Lessons for Africa To speed the reform process for privatisation, successful governments in both Asian and African countries have taken the following actions: •

They persisted with and deepened macroeconomic reforms for establishing new relative prices and creating opportunities for job and income generation.

•

They have made efforts to inform their citizens, legislators, journalists, and academicians of the high costs of inaction in public enterprises reforms and potentials of divestiture. These efforts have often mobilised popular support and broken the opposition of vested interests.

•

They have used methods of direct sale combining with such broad ownership vehicles as trust funds and employee ownership options to enlist widespread participation in and approval for the privatization process. These methods address fears that only foreigners, the elite, or particular ethnic groups benefit from privatization.

•

They have streamlined – indeed privatized – the privatization process, by keeping the public agency lean and agile and by contracting out the details of implementation to private lawyers, accountants and investment bankers, both local and foreign.

•

Where privatization is difficult or not yet feasible, particularly for infrastructure firms, they have made greater use of methods of privatising management – such as asset leasing, franchising, concessions, and management contracts.

•

Recognising the importance and difficulty of putting good regulatory systems in place, they have adapted regulatory structures to fit market conditions and institutional capabilities.

•

They have begun to unbundle ancillary or social assets from enterprises and to transfer them to the private sector.

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•

They have established severance funds, training programmes, and other elements of a social safety net to assist those laid off in the reform process.

•

With donors and the international financial community, they are trying, selectively, to give limited comfort to investors through guarantees particularly in infrastructure.

Countries in Sub-Saharan Africa can learn from these experiences. However, economic conditions for privatisation in Sub-Saharan Africa are very much difficult. Their product markets are less competitive. Capital markets are thin. Investors perceive high risks. Public enterprises in infrastructure have a lower net worth and are less attractive to foreign buyers, except perhaps in telecommunications. Government resists selling to foreigners, and investors are reluctant to take an equity position in infrastructure firms before governments have established consistent policy and pricing practices. These serious obstacles delay or dilute reforms for privatisation. Development of efficient capital and money markets is also essential for implementing successful privatisation programme. Attracting reputable private banks will be difficult, unless government reduces the dominant position of public enterprises and develops an attractive environment to stimulate private investment and participation. A good part of the banking development in China, India, Pakistan, and Sri Lanka has been stimulated by the growth of a competitive private sector that demands a wider range of efficiently delivered services. In turn competitive banking system helps foster a competitive private sector, since borrowers are not limited to a few banks that service only selected and wellconnected clients. The presence of foreign banks also help to promote and facilitate FDI.

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CHAPTER-4 ROLE OF FOREIGN INVESTMENT IN INDUSTRIAL AND INFRASTRUCTURE DEVELOPMENT

4.1 Private capital flows to developing countries During 1990s there was a significant change in the composition of external financial flows to the developing countries with an increasing share of private capital from 44 percent in 1990 to 86 per cent in 1996 and a corresponding declining share of official development finance from 56 percent to only 14 percent over the period. Within private capital, flows of foreign investment comprising foreign direct investment (FDI) and portfolio investment increased five-and-half times surpassing other types of capital flows and constituting 54 percent of total capital flows to developing countries in 1996. In fact, FDI was often the only source of international private capital to most least developed countries which failed to receive the investment-grade ratings required for borrowing from abroad or tapping international capital markets. The private capital flows are likely to be more beneficial since they are generally accompanied by technology transfer and market access in the case of FDI; diversified investor base in the case of bonds; and a reduction in the domestic cost of capital in the case of equity portfolio flows. Asian region received the major share (50 percent) of private finance in 1996 among the developing economies (Table-4.1). While Latin America and Caribbean had a share of 31 per cent, Europe and Central Asia had a share of 13 per cent, Sub-Saharan Africa had a share of only 5 per cent and Middle East and North Africa only 3 per cent in total FDI flows to the developing countries. An analysis of trends of private capital flows in 1990s by the World Bank (1997) draws the following key conclusions : •

Countries with sound macro-economic management and well organised money and capital markets received large private capital inflows.

•

Private capital flows to developing countries continued their strong growth and reached $244 billion in 1996, a fivefold rise since 1990. The two largest low-income countries, China and India, experienced substantial inflows, and virtually the rest had gone to middle-income countries.

•

Capital market finance for infrastructure projects is an important component of international flows.

•

Foreign direct investment continued to grow and reached a broader range of countries. Like trade, it is an important channel of global integration and technology transfer. Many developing countries liberalilsed their trade and investment regimes

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by adopting most-favoured nation treatment, and level playing field for the foreign investors. •

All categories of private flows (i.e.bonds, portfolio investment, foreign direct investment, commercial bank lending, and export credits) increased significantly during 1990-1996.

Unlike other capital flows, FDI is a “package” which contains not only capital but also management, technology and skill. Experience in developing countries suggests that “unbundling” the FDI package by borrowing capital from the international banks, purchasing technology through licenses and negotiating management agreements, is less efficient in terms of productivity than the FDI package which brings capital, technology and management together. Mining operations are a notable large scale example. In Zambia, for example, copper mines became bankrupt as a result of nationalisation which involved replacement of equity by debt capital and use of management contracts instead of direct transnational corporation management (Hughes 1995). 4.2 FDI - Technology - Growth Nexus There are different types of FDI such as natural-resource seeking, market-seeking, technology seeking, cost-reducing, risk avoiding, export-oriented and defensive competitive FDI. Natural resource-seeking FDI, which consists of investment in mining, processing, textiles, oil and gas is the earliest type of foreign investment. Until 1980s market-seeking FDI was largely confined to the manufacturing sector motivated by “tariff jumping” to take advantage of the regulated market, but due to the recent trends of economic reforms and privatisation of infrastructure, sectors such as power, telecommunications and financial services are attracting increasing amounts of foreign investment. Industrial restructuring through mergers and acquisitions (M&As) have emerged as a favourite route to FDI. Export-oriented FDI is guided by the “product life cycle” theory of FDI, which postulates that as real wages increase due to economic growth in a country, labour-intensive industries will relocate to countries at a lower level of economic development. Regional groups (such as the European Union, NAFTA, MERCOSUR, APEC, ASEAN and SAARC) also facilitate regionally integrated production networks. Geographical distribution of direct foreign investment also favours neighbouring and ethnically related countries. Host countries can be classified according to four stages of development viz. factordriven (attracting FDI in processing, textiles and minerals exploitation), investment driven (heavy and chemical industries, power, construction, transport and telecommunications), innovation-driven (electronics, information technology, biotechnology) and wealth-driven (attracting FDI to meet domestic demand and also encouraging outward FDI flows). Global FDI reached $315 billion in 1995, and the FDI growth (12.1%) in 1991-1995 was substantially higher than that of exports of goods and non-factor services (3.8%), world output (4.3%) and gross domestic investment (4%). The recent boom in flows has

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expanded the world’s total FDI stock, valued at $2.7 trillion in 1995 held by some 39,000 parent firms and their 270,000 affiliates abroad. About 90% of parent firms in the world are based in developed countries, while two-fifths of foreign affiliates are located in developing countries. The global sales of foreign affiliates reached $6.0 trillion in 1993 and continued to exceed the value of goods and non-factor services delivered through exports ($4.7 trillion) - of which about 25% are intra-firm exports. Sales by foreign affiliates in developing countries were $1.3 trillion equivalent to 130% of imports from these countries. In 1993, $1 of FDI stock produced $3 in goods and services abroad. The pattern of investment and production in ASEAN followed the “flying geese” pattern of evolving comparative advantage, and promoted regional integration through “production sharing” which involved the setting up of multiplant production in different countries. Technological advances lowered transportation costs and improved telecommunications networks which made location of production more sensitive to cost differentials such as lower wages. ASEAN countries particularly attracted foreign automobile manufacturers through the Brand-to-Brand Complementation scheme, which provides for a diverse production base. Trade and FDI go hand in hand. FDI has grown fastest among the countries which participated fully in the multilateral trade negotiations. Within the traditional structures of manufacturing TNCs generating FDI-trade linkages, intra-firm sales tend to comprise mainly flows of equipment and services from parent firms to their affiliates. If foreign affiliates are located downstream, intra-firm trade consists mainly of parent firms’ exports to affiliates; if they are upstream suppliers, they generate intra-firm imports for parent companies. FDI has made significant contribution to economic growth in developing countries by promoting exports and providing access to export markets. The export propensities (measured by the ratio of exports to output) of U.S. foreign affiliates nearly tripled in the past two decades. This ratio more than doubled and reached 39 percent in Latin America, while the ratio remained high in Asia, ranging from 30 percent in the Republic of Korea to more than 80 percent in Malaysia. The export propensities of Japanese affiliates also have been increasing, most notably in East Asia, where their exports accounted for 34 percent of total sales in 1993. Japanese affiliates in China exported 53 percent of their sales in 1992, up from less than 10 percent in 1986, directing 43 percent of their sales to home markets in Japan. FDI adds to the capital stock of the host country in many ways viz. green-field FDI (establishing a new business), or ownership switching (through mergers and acquisitios) or raising equity shares in joint ventures. In developed countries, most FDI is ownership switching whereas it is mostly greenfield FDI or joint ventures in the developing countries. However, privatization related FDI has recently become an important form of ownership-switching FDI for developing countries, although such FDI accounted for less than 10% of cumulative FDI inflows to the developing countries in 1988-1993.

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The significance of FDI in domestic capital formation can be judged from the ratio of inward FDI flows in the gross fixed capital formation which reached the peak level of 24.5% in China in 1994, 26% in Malaysia in 1992, 47.1%% in Singapore in 1990, 37% in Fiji in 1990, 61.3% in Vanuatu in 1994 and 96% in the Pacific least developed countries in 1994. Share of FDI stock in GDP was as high as 86.6% in Singapore in 1990, 46.2% in Malaysia in 1994, 36.6% in Indonesia in 1990, 18% in China, 21% in Hong Kong and 36% in Maldives in 1994. FDI flows as a share of GNP (Table-4.3) also indicates the importance of FDI in overall economic development. In 1996 it reached 2% for developing countries as a whole, and 6.5% for Malaysia and Vietnam. East Asia has sustained inflows equivalent to more than 4% of GNP in the 1990s. These figures do not capture the full role of FDI as an agent for growth and structural transformation. In many countries FDI was instrumental in shaping industrial structure, technological base and trade orientation. Perhaps the most significant contribution of FDI is qualitative in nature. FDI embodies a package of growth and efficiency-enhancing attributes. TNCs are important sources of capital, technology, and managerial, marketing and technical skills. Their presence promotes greater efficiency and dynamism in the domestic economy. The training gained by workers and local managers and their exposure to modern organisational system and methods are valuable assets. 4.3 Regional distribution of FDI The FDI flows to developing countries have grown rapidly in 1990s and reached $100 billion in 1995 and $110 billion in 1996. The share of developing countries in global FDI flows increased from 19% in 1980 to 32% in 1995. As regards sources, more than 80 percent of global FDI inflows originate in OECD countries and the major home countries are the United States, United Kingdom, Germany, Japan and France which accounted for two-thirds of global FDI outflows in 1990s. The main suppliers of FDI to Latin America remain United States and Europe, while Japan has emerged as the predominant partner in Asia. The dominant role of FDI from the United States in Latin America and the Caribbean, from Japan in Asia and from Europe in Africa underline the tendency of the TNCs from the “Triad” in building up regionally integrated networks of affiliates. The Asia and the Pacific is the new growth centre of the global economy with China, ASEAN and NIEs as important players. FDI flows to Asia and the Pacific reached $65 billion in 1995 accounting for 21% of global FDI flows and 65% of FDI flows to the developing countries, compared with $20 billion in 1990 accounting for only 10% of global FDI flows. East and South-East Asia alone received $62 billion in 1995, while South Asia saw a doubling of inflows to $2.7 billion in 1995, mainly due to tripling of inflows into India. Inflows of FDI to ASEAN-4 (Indonesia, Malaysia, Philippines and Thailand) increased from $8.6 billion in 1994 to $14 billion in 1995. In 1990-1996 China and ASEAN had a share of more than 80% in FDI inflows to Asian countries, with Chinese share exceeding 50%. Asian developing economies themselves are increasingly becoming outward investors, reflected in the liberalisation of their outward FDI regimes and provision of incentives for

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such investments. In 1995, the region with $43 billion FDI outflows accounted for 90% of all developing country outflows with Hong Kong as the largest outward investor. Most outward FDI is going in the region to take advantage of cost differentials, liberal trade and FDI regimes and to allow export-oriented FDI to flourish. Malaysian and Thai TNCs directed 60% of their FDI outflows to Asia in 1995; some four-fifths of Hong Kong’s outward FDI went to China in 1995; a good part of Singapore’s outward FDI is distributed to other ASEAN countries and China; and 60% of China’s outward FDI remained in the region. Surveys of FDI from developing countries high-light the following general features (UNCTAD 1993a): (a) The geographic distribution of FDI favours neighbouring and ethnically and culturally related countries. (b) FDI tends to concentrate in industries using standardised technology and management skills or industries based on natural resources (processing, textiles and minerals) or export-oriented industries (food processing, automobiles, and electronics). (c) Most TNCs are involved in joint ventures, both to limit their capital commitments and to obtain local managerial and organisational skills or access to markets of their partners. 4.4 Sectoral Distribution of FDI The sectoral distribution of FDI in developing countries is not well documented, but it seems that in recent years services have increased their share to more than one third, while manufacturing declined to one-half, with the remainder accounted for by agriculture and mining. Within services financial services are a major component, with trade, construction, and tourism also important. Within manufacturing the trend was to move from lower-technology or labour-intensive industries (food, textiles, paper and printing, rubber, plastics) to higher-technology industries (electronics, chemicals, pharmaceuticals). Sectoral distribution differs among regions depending on their level of development. In most countries in Asia, FDI went primarily to the secondary sector (mainly manufacturing), although investment in the tertiary sectors was of major importance for some Asian countries. Some resource-rich countries like Indonesia, Papua New Guinea and Vietnam also attracted FDI into the primary sector (mainly oil production). In Latin America, new investment flows to the natural resources and services sectors have now surpassed that in the manufacturing sector. In Africa, the bulk of FDI went to primary sector. The size and dynamism of developing Asia made it a favourable base for TNCs to service rapidly expanding markets or to tap the tangible and intangible resources for their global production networks. In addition, the region’s infrastructure financing for the next decade will play a role in sustaining FDI flows to Asia. Countries are dismantling barriers to FDI in infrastructure sectors, giving rise to large investment opportunities for TNCs. Privatisation, although lagging behind other regions, is showing signs of taking off particularly in manufacturing, mining, power, telecommunications, petroleum and financial sectors. European union TNCs which neglected Asia in the 1980s are making

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large-scale investment in Asian developing economies to take advantage of new opportunities in power, petrochemicals and automobiles. Transnational corporations in retailing, and other trading firms also played an important role in the building up of export capabilities of several Asian economies. In addition to linking local producers to foreign customers, they deepened the ties of those economies to the international market-place. Asian experiences also indicate that contributions to international competitiveness and export performance are particularly high in developing economies that are open to both trade and FDI. 4.5 Foreign Portfolio Investment (FPI) Portfolio flows to developing countries increased to $81 billion in 1995 but remained below the peak level of $95 billion in 1993. Strong growth in equities and debt raised portfolio flows to a record $134 billion in 1996, accounting for 30% of net resource flows in 1996 compared with only 5% in 1990 (Table-4.4). Equity flows at $46 billion accounted for 34% of these investments. An increasing share of foreign funds was invested in local equity markets directly rather than through depository receipts or other cross-border private equity placements. Debt instruments - mainly international bonds have always accounted for most portfolio flows to emerging markets. Portfolio debt flows to developing countries - essentially bond issues in the international capital markets - registered a record increase by 80% and reached a record level of $89 billion in 1996 . (a) Modes of Foreign Capital Empirical evidence indicates that private capital contributed more to economic growth of the Asian developing countries than official aid, the relative importance of which in total resource inflows declined since 1980s. There was also a change in the structure of private flows. Until 1983, bank lending was the major mode of foreign private flow to the Asian developing countries. Subsequently, the relative significance of bank lending has declined and that of other modalities has increased. The share of foreign direct investment has increased the most followed by bond lending and foreign portfolio investment. The major alternatives to syndicated bank lending are bonds, financing through new instruments, foreign direct investment, foreign portfolio equity investment, and foreign quasi-equity investments (such as joint ventures, licensing agreements, franchising, management contracts, turnkey contracts, production sharing and international subcontracting). Out of these the most popular modes are FDI, portfolio investment and foreign quasi-equity investment as they involve risk-sharing, sharing of managerial responsibilities and the promotion of a more efficient use of resources. Foreign portfolio investment, in addition, has a favourable impact on local capital markets. The disadvantages are that there might be misuse of control and that foreign direct investment might introduce inappropriate technology.

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Country experiences indicate that the majority ownership was preferred mode of FDI in capital intensive industries like chemicals, equipment's, electronics and automobiles, whereas joint ventures were preferred in traditional and primary industries like textiles, food processing, paper products and metals. (b) Modes of Foreign Portfolio Investment (FPI) FPI in the emerging markets can be channeled through three main mechanisms: direct purchases on local stock markets, country or regional funds; and issues of depository receipts on foreign stock exchanges by the domestic companies. The size of direct purchases in local markets depends on market developments that facilitate and encourage such trading. In recent years, the opening of the local brokerage and investment banking business to foreigners has facilitated such purchases. Developing countries have also enhanced the limits of foreign equity which can be held by the foreign institutional investors (FIIs). In India FIIs and non-resident Indians are permitted to hold up to 30 percent of total paid up capital of any listed or unlisted companies. 4.6 Development of Infrastructure and Services Rapid technological developments in telecommunications and computers in the 1980s have made some services, especially information-intensive ones, more tradable. The “long-distance” type of service does not necessarily require physical proximity between the provider and the user. Live broadcasts, trans-border data transmissions, and traditional bank and insurance services fall under this category. The scope of long-distance service transactions has greatly increased with the advance of technology. In “long-distance” services, there is no need for any direct investment or movement of labour. In the last few years there has been an increasing interest on the part of both governments and private sector to enhance the role of foreign investment in infrastructure development in East Asia and Pacific, and the Latin American countries. However, there is a basic difference of experiences between Latin America and East Asia. Most countries in Latin America encouraged outright sale or transfer of management/ majority share of public enterprises, while East Asian countries encouraged private investment for creating new capacities (World Bank 1994). Because of lumpiness of huge capital, risk involved and the budgetary constraints, developing countries are increasingly financing their infrastructure projects by external commercial borrowing and increased use of bond and equity markets. Finance for infrastructure typically comes in a package with equity, debt, commercial bank loans, export credit guarantees, and contingent liabilities of the host government ranging from “full faith and credit guarantees” to “comfort letters”. Capital market finance for infrastructure increased more than eightfold since 1990 and reached $22.3 billion in 1995 (Table-4.5). The private sector outpaced the public sector in external infrastructure finance although with the help of substantial government guarantees. Compared to the public sector, the private sector relied more on loans than on

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bonds or equity. But the growth has been uneven across the regions, countries and sectors. East Asia raised the most finance (led by China, Indonesia, South Korea, Malaysia, Philippines, Thailand) followed by Latin America. Power generation, telecommunications and transport attracted the most external finance, while power transmission and distribution and water supply lagged behind. TNCs invest in infrastructure projects in the form of FDI (greenfield investments or acquisitions through privatisation), BOT, BOO, BOOT, BOLT, BTO or variants of these schemes. There are various forms of BOO and BOT schemes in the region such as those for toll roads in China, India, Malaysia, and Thailand; telephone facilities in Indonesia, Sri Lanka and Thailand; power generation in India, China, Pakistan and Indonesia; and energy, transportation and water resources in the Philippines. Various constraints such as high fixed or sunk costs, long gestation periods, price ceilings and other regulations on the operations of an infrastructure facility in host countries, and political risk (expropriation or nationalisation) have induced foreign investors to minimise equity commitments to such projects and to rely on debt (commercial loans and bonds) and non-equity financing (technical know-how, expertise, R&D cost sharing, trade credits and supply of capital goods). There are constraints that arise out of the very nature of some of the ways in which infrastructure projects are financed. Given the perceived risk, investors require high rates of return. This necessarily requires user fees commensurate with the rate of return, which, in many developing countries, are too high to be sustainable. There are also environmental issues associated with infrastructure projects. Consequently, negotiations of BOT/BOO and similar schemes - in developing and developed countries - are typically very complex and long drawn out. In recent years, a number of Asian investment funds have been created to mobilise international capital to finance Asia’s infrastructure. These funds provide medium and long-term finance (5-10 years) for infrastructure projects through equity (usually 10% or more) or convertible debt. Funds are raised from a diverse group such as institutional and private investors, TNCs, regional banks and multilateral organisations. The Asian Infrastructure Fund (AIF), in which the Asian Development Bank was an initial investor, was the first infrastructure investment fund in the region. The AIF is investing in utility, transportation and communications projects in China, Indonesia, Malaysia, Thailand, Philippines and Taiwan. Since then, several infrastructure investment funds, similar to international mutual funds, or unit trusts, have been set up.

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CHAPTER 5: POLICIES AND STRATEGIES FOR PRIVATE SECTOR DEVELOPMENT IN EAST AND SOUTH East Asia

5.1 Role of macro-economic policies The central features of the high-growth East Asian economies were high rates of investment, saving, and human capital formation; export promotion; and stable macroeconomic conditions. Government policies and institutions played a large role in fostering these elements. Financial sector policies, in particular, played an important role in mobilising and allocating savings. In some cases, however, government intervention hindered financial market development and led to inefficient allocation of investment and other resources. Unlike many other developing countries that experienced numerous boom-bust cycles during the past three decades, the fast growing east Asian economies generally maintained a relatively high degree of macroeconomic stability until recently. Fiscal and current account deficits were less than one-half the average for other developing countries, and inflation for the most part was kept in the single digits. In some countries (for instance, Indonesia, Taiwan Province of China, and Thailand), legislation limited the size of public sector deficits, while in other countries (for instance, Korea, Malaysia, and Singapore) strong political support for anti-inflationary policies acted as a constraint on fiscal policies. Also, in Hong Kong SAR, the currency boards arrangement in place since 1983 has disciplined fiscal policy as well as containing monetary action. Disciplined macroeconomic policies provided a stable environment for private sector decision making, and contributed to the high rates of saving, domestic and foreign investment, and export growth that were ingredients in the region's growth performance. This generally favourable performance, however, was not without difficulties. Indeed, several of the east Asian economies experienced intermittent bouts of overheating pressures, indicated by rising inflation, at least in asset markets, and sizable current account deficits. In the period leading up to the recent crises a number of East Asian economies witnessed sharp increases in private capital inflows, attracted partly by the high rates of growth, which contributed to overheating pressures. Goods price inflation remained moderate, but asset prices – real estate and equity prices – rose at a rapid pace. In some countries real exchange rates appreciated, eroding competitiveness and exacerbating the deterioration of current account imbalances. With currencies essentially pegged to the U.S.dollar in many of the East Asian countries. The policy response to the capital inflows was often limited to sterilization of their monetary impact, which tended to be impractical given their size. By late 1996 and early 1997, the fine balance between macroeconomic stability with pegged exchange rates, high investment, and rapid growth began to unravel in many parts of east Asia, particularly in Thailand. Governments have an important responsibility to supervise and safeguard financial systems because of their central role in the payments mechanism and in the mobilization,

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intermediation, and allocation of savings. Governments may also need actively to intervene in financial markets because of market failures typically stemming from incomplete or asymmetric information. In the years leading to the recent crisis, the weaknesses in the financial system were aggravated by excessive investment in low-profitability projects and over-borrowing. Rapid economic growth, however, tended to mask the inefficient investments, while poor data disclosure and transparency, tax loan classification and provisioning practices and regulatory forbearance masked the true extent of financial sector weaknesses. These problems, however, should not lead one to overlook the many positive features of the east Asian economies, in particular, their outward orientation, their emphasis on human capital formation and technology transfer, and their high saving rates. Indeed, their prospects for rapid economic growth are still favourable, but will require significant changes from the policies based on very high rates of capital accumulation, and high reliance on capital inflows. Although relatively high investment rates are likely to be a feature of the east Asian economies for some years to come, more of the growth will have to come from efficiency gains; improved productivity performance, including through better use of capital. The crisis has particularly highlighted the incompatibility of government intervention in the financial sector and the investment process with highly integrated capital markets. The changing needs of an advancing economy, and the globalization of financial markets, both alter the role the government can effectively play in the economy to one of ensuring the regulatory, legal, and political institutional structures capable of supporting rapid economic growth. 5.2 Resource Mobilization East Asian economies began their take-off to rapid growth with an edge over many other developing countries in human capital and maintained that edge through explicit policies of investment in education. But critical to their superior growth performance was their ability to supply their work forces consistently with rapidly increasing amounts of physical capital. In Hong Kong SAR, Indonesia, Korea, Malaysia, and Thailand, gross fixed investment as a proportion of GDP rose steadily and markedly over the past three decades, to reach levels a little below one-third in the first two economies and close to 40 percent in the other three. The main exceptions are Taiwan Province of China, where investment has been a fairly stable share of GDP throughout, close to one quarter, and the Philippines, where investment rose from 19 percent of GDP in the 1960s to a steady level of around 23 percent in subsequent decades. Interestingly, despite its lower rate of capital accumulation, Taiwan Province of China’s growth performance has been as good as those of other East Asian economies.

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Table 5.1: Investment-GDP Ratios in selected countries (Per cent) Country China Hong Kong SAR Indonesia India Japan Korea Malaysia Philippines Singapore Taiwan Province of China Thailand Brazil Chile Mexico Germany Italy Spain United Kingdom United States

1960-1969 35 18 18 16 35 18 15 19 23 25 22 17 .. 17 26 27 .. 19 21

1970-1979 35 24 19 18 34 28 23 25 41 29 25 22 12 22 23 26 24 20 20

1980-1989 34 28 27 22 30 30 30 23 42 24 28 21 18 22 20 23 22 17 20

1990-1996 39 30 32 24 30 37 38 23 35 24 41 20 25 22 22 19 22 16 17

Counterparts to the rapidly rising investment rates were, of course, rapidly rising saving rates and inflows of foreign capital. Several factors such as a stable macroeconomic environment, especially low rates of inflation, positive real interest rates, and a fast pace of financial deepening contributed to the rapid rise in domestic savings. Perhaps most important was the rapid pace of economic growth, which, by raising income levels above subsistence, led to higher aggregate saving rates. The region’s demographics, in particular its relatively low dependency ratios, were also conductive to high rates. In some countries, particularly Malaysia and Singapore, well-developed mandatory saving schemes have been in existence since the 1960s and 1970s and may have also generated high propensities to save. Reliance on foreign saving differed widely across countries. The newly industralised economies (NIEs), except Korea, were less dependent on foreign saving than the ASEAN-4, even in the early years of their development, and since the mid-1980s have posted current account surpluses. The composition of foreign saving also differed across countries. Some countries (Malaysia and Singapore) relied on direct and portfolio investment to finance domestic investment, while others (Korea and Thailand) depended largely on foreign borrowing. In Korea, restrictive limits on foreign ownership alongwith capital controls influenced the composition of foreign funds, and until the 1990s, direct and portfolio investment constituted a minor fraction of total foreign inflows. Liberalisation of foreign ownership limits in the 1990s, however, led to a significant increase in foreign portfolio investment.

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5.3 Foreign investment policies (a) Host country and home country policies Inflows of FDI are determined by a complex set of economic, political and social factors and foreign investors look beyond the array of fiscal incentives offered. In recent years FDIs have been encouraged by economic reforms and particularly by liberal FDI regimes (in terms of currency convertibility, free repatriation, less performance criteria, tax holidays and other incentives, relaxation or abolition of screening requirements and limits on foreign equity etc.). Other major factors that influence FDI flows include low wage rates and low production costs, higher rates of return, huge domestic market, labour mobility, efficient infrastructure, an established legal and institutional set-up, administrative speed and efficiency, and above all liberal economic policies and stable economic situation. The formation of regional trading blocks such as NAFTA, ASEAN, APEC, SAARC etc. had also an important impact on the FDI pattern. In future, countries outside the regional blocks might have disadvantages in attracting FDI. Foreign investors dislike any screening of investment except for national security, public health, individual safety, and environmental protection. They also dislike performance requirements such as export orientation, local content, value addition and foreign exchange requirements. Such requirements distort and discourage trade and investment, and result in diminished returns to both investors and host countries. Foreign investors like to have better of national treatment and most favoured nation treatment, as it maximizes the free flow of capital. Other key factors attracting FDI include free transfer of profits and dividends, adherence to international law standards on expropriation, international arbitration, protection of intellectual property rights (IPR), and the right of the investor to employ management of its choice, regardless of any nationality. Since 1980, countries that guaranteed that profits could be repatriated attracted 93% of foreign investment flows. and countries adhering to the Convention of Settlement of Investment Disputes attracted 85% of foreign investment. In recent years there has been a surge of foreign portfolio investment, which includes both equity and bonds. Host country factors which are crucial for portfolio investment fall into three groups viz. the degree of political and macroeconomic stability and prospects for growth; the host country’s commitment to the process of economic and financial liberalization and reform; and the state of development of the host country stock exchange and the institutional and regulatory framework. Developing countries have established investment promotion programmes, which are often organised as a government department or as a quasi-government agency with private participation. In a few cases such as Mexico, Costa Rica, Venezuela and Honduras, the promotion agency is funded and run by the private companies. Ironically,

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as developing countries liberalise FDI and trade regimes, multilateral companies appeared in many cases to have improved their bargaining power vis-a-vis host countries. The macro-economic policy framework and reforms constitute only some of the factors, albeit vital ones, for encouraging foreign investment. The country’s economic potential, human and natural resources and political stability and other factors that affect the risk and profitability of investment are equally important. Membership in bilateral tax treaties, and multilateral and regional investment guarantee arrangements are also seen as an important element in providing a stable and attractive framework as it could reduce perceived risks. (b) Fiscal and monetary incentives Fiscal, financial and other incentives remained an important part of a country’s investment promotion package. When all other factors are equal, incentives can tilt the balance in investors’ locational choices. This appears particularly true for “footloose industries” which choose among production sites with comparative costs; automobiles and food processing industries, for example, seem to be sensitive to a package of fiscal, tariff and financial incentives given by host countries. Fiscal and monetary incentives play, however, only a minor role in the locational decisions of TNCs, and attract only those “fly-by-night” firms, which exist on exploitation of incentives. This is not surprising since investment decisions are typically made because they promise to be profitable on the basis of market conditions alone; if incentives are offered, they become “icing on the cake”. While the effects of incentives on stimulating new investments are difficult to measure, they nevertheless represent substantial economic costs. Where incentives already existed, their sudden removal might produce negative effects; where they did not exist, their introduction might not produce net gains. A rational, efficient, equitable and internationally competitive tax system is more conducive to FDI than fiscal incentives. (c) Sectoral policies and regulation Locational, safety and environmental regulations are necessary for the efficient functioning of industry, but these are a relatively small component of sectoral regulation. India’s complicated regulations, as in most countries, have their origins to offset market failures. The financial sector, transport and telecommunications, professional services and media all have special regulatory requirements, but most of these regulations are excessively detailed and outdated. The reduction, simplification and greater transparency to reduce the need for bureaucratic intervention are needed to ensure that a country can obtain benefits from foreign investment quickly. Mineral industries, including petroleum and gas, create particular problems for investment because resource rents have to be divided between local landowners, the States and the central governments. Private firms also seek a share of such rents to compensate them for the riskiness of mineral exploration and subsequent mine

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development. The efficient and equitable apportioning of mineral rents is thus an important aspect of the economic policy framework. Indonesia and Malaysia are among world leaders in dealing with foreign investment in petroleum, gas and other minerals. Papua New Guinea developed mineral resource taxes to tax mineral rents. With such policies in place, project by project negotiation can be avoided or minimised. Forestry, fisheries and hydroelectricity also generate rents that require special consideration. All these industries have environmental aspects that should be taken into account on a nationwide basis rather than project by project. Agriculture and real estate present difficulties for foreign investment because of complexities of land-ownership, and rules and taxes regarding tenancy, sale, purchase, transfer, lease or mortgage. Because of these problems, many countries like India donot allow foreign investment in agriculture and real estate. In the case of plantation, foreign investment in nucleus estates and processing facilities can provide a market for farmers and at the same time enable them to improve their productivity. Investment in minerals, including petroleum, has retained its share of total foreign investment. Indonesia led the way in devising agreements that gave an equitable share in mineral “rents” to the host country while satisfying investors. Forestry has attracted investors, mainly within the region, but with growing policy difficulties as the socioeconomic costs of forestry become evident and had to be funded. The mainstream of investment has been in manufacturing, (in protected markets and for export), and in service industries such as tourism, financial sectors and, on a smaller scale, in professional services. Investment in infrastructure is now beginning to take place. (d) Low wage rates and low production costs From the viewpoint of the advanced countries, Asia is still an extremely attractive place for establishing production bases because of its extremely low production costs. China, India and countries of ASEAN have large, low-income farming populations, implying the existence of a potentially huge supply of labour for the manufacturing sector. This reserve should enable manufacturers to secure an adequate labour force. Moreover, since younger people make up a larger proportion of the population of Asia, they can be expected to play a major role in ensuring a smooth supply of labour in the future. Besides low labour costs, various other production costs such as real estate rents, transport, communications and electricity charges are all substantially lower in Asia than in the advanced countries. 9

(e) Market potentials and rates of return

An important factor that determines the influx of direct investment into Asia is the ongoing globalisation of companies from the advanced countries to take advantage of low costs in the developing countries. Another factor that encourages Japanese companies to continue shifting their production bases into Asia is the generally high profitability of their overseas affiliates in the region. Compared with production bases in North America and Europe, production bases in Asia are far more profitable.

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In addition to their original role in producing goods for export, these production bases are now expected to play a growing role in producing goods for rapidly expanding consumer markets within the region. In a recent survey conducted by the Export-Import Bank of Japan in 1995, Japanese manufacturers were asked their reasons for investing overseas. In the case of China, the NIEs and ASEAN, a great deal of importance was attached to investments designed to ‘maintain and expand local markets”. In fact, overseas Japanese affiliates substantially increased their sales within the Asian region. Expanding regional consumer markets are expected to provide an impetus for further economic growth. Consumption of Asia continues to expand at a healthy rate. Compared with the developed countries in the world, the relative share of labour in GDP is still low in Asia. Even in more advanced economies in Asia such as South Korea and Hongkong, labour relative share is almost 10 percentage points lower than in Japan, the United States and Germany. This suggests that there is ample scope for an expansion in consumption as labor relative share rises. (f) Labour mobility Labour reform is another area of concern, particularly in large organised sectors. Though detailed information on labour markets is not available for many low-income countries, government regulation generally reduces labour mobility. Large firms bear the brunt of rigid labour laws that constrain them from restructuring their operations, force smaller capacity expansions than otherwise, and reduce employment creation by encouraging capital-intensive modes of production. ‘ Rigid labour laws have slowed the pace of economic reforms, privatisation, and state enterprise reforms. In India, where the organised industrial sector accounts for 80 percent of industrial value added, constraints on rationalising the labour force act as the heavy drag on industrial growth. In China, the competitiveness of a the state-owned sector has been adversely affected by the need to maintain high employment and provide workers with housing, medical care, schools, transport, and other social services not usually provided by other firms. Their labour costs are more than twice those of collectively owned enterprises are. The challenge is to unbundle these services and transfer them to municipalities or commercial entities so that firms can operate on a commercial basis and labour is free to seek opportunities elsewhere. 5.4 Role of the Financial Sector In several East Asian economies, the public sector created, owned, and managed financial institutions to encourage and intermediate savings, particularly where financial institutions were weak or did not exist. These institutions included postal saving systems, development banks, and state-run commercial banks. In Korea, Malaysia, Singapore and Taiwan Province of China, postal saving systems were established to encourage small savers by offering a secure and convenient way to deposit their savings through extensive post office networks. In these four economies, as well as in Indonesia and Thailand,

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development banks provided long-term credit to priority industries, small firms, agriculture, housing and poorer borrowers. All commercial banks were state-owned and managed in Korea from the early 1960s to the early 1980s, while in Taiwan Province of China, the largest commercial banks are still state-owned and operated. In most of the other east Asian economies as well, the government helped establish and continues to own some of the commercial banks. Moreover, most East Asian governments except those in Hong Kong, Singapore, and recently Indonesia, protected financial institutions from domestic and foreign competition by restricting entry and branch licensing. In Korea, government policies, such as access to easy credit through directed lending, played an important role in allowing the chaebols (the large conglomerates) to pursue growth and market share, with inadequate attention to profitability. Despite the drop in profits, easy access to credit induced the chaebols to continue to invest and diversify away from core businesses into other industries, often characterized by excess capacity. As a result, by 1996, the net profits of the 30 largest chaebols were close to zero, with six chaebols filing for bankruptcy in early 1997 before the beginning of the crisis. In large part, investment in the crisis economies was financed by bank lending. As the returns from investment fell in these countries, the quality of bank asset portfolios declined as well. In Thailand, non-performing loans of commercial banks reached almost 8 percent of total credit outstanding by mid-1996, and non-performing loans of other financial institutions were even larger. By comparison, non-performing loans in the United States, using a more strict classification, were around 1 percent of total lending in 1996 and peaked at around 4 percent during the banking crisis in the 1980s. In Indonesia, classified loans accounted for over 10 percent of total loans in late 1996, and property lending had increased to about 20 percent of total lending. Exposure to the property sector was high also in Thailand and Malaysia, where it had reached about 18 percent and 25 percent of total lending, respectively. In Malaysia, while non-performing loans had fallen substantially from a peak of over 35 percent in 1985 (following a banking crisis) to under 4 percent by 1997, banks were exposed by substantial lending for consumer credit and stock market investments, in addition to lending to the property sector. In Korea, commercial bank profitability, measured by returns on assets or equity, had declined substantially during the 1990s, falling to levels far below international standards by 1996. East Asian governments also guided the financial sector by way of tax incentives and subsidies, and by rationing access to limited credit and foreign exchange. For example, in Korea, and Taiwan Province of China, households were encouraged to use the postal savings system because interest income was tax-exempt at times, while in many east Asian countries, development banks’ policy loans to priority industries were subsidized. In Korea, in particular, companies that performed well in export markets were granted ready access to credit and foreign exchange. At times, East Asian governments also limited lending for consumer spending, housing, real estate, and equity purchases. The restrictions on lending for consumer spending and housing encouraged households to save before making large purchases, while the restrictions on lending for real estate and stock market investments discouraged

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speculative borrowing. These economies relied heavily on private sector debt as can be gauged using two measures, private sector credit as a percent of GDP, and debt-equity ratios. In most East Asian economies, private sector credit expanded rapidly during the 1980s and 1990s, and by 1995 the ratio of private sector credit to GDP was at least equal to that in the United States. Furthermore, the debt-equity ratio in Korea, the only crisis country for which data are readily available, was very high. In the period 1975-90, retained earnings financed, on average, about 30 percent of total corporate investment in Korea, and the ratio of debt to equity rose from around 90 percent in the 1960s to close to 350 percent in the mid-1980s, before declining to around 300 percent in the first half of the 1990s. On the eve of the financial crisis, however, the debt-equity ratio had reached nearly 400 percent. By comparison, in Taiwan Province of China, the debt-equity ratio was around 85 percent, in Japan around 200 percent, and in the United States just above 150 percent in the 1990s. The very high and rapidly growing debt levels in the east Asian economies show that both the banking and corporate sectors were becoming increasing vulnerable to adverse shocks. This fragility may have been exacerbated by the short-term nature of the debt and because credit growth was often led by non-bank financial intermediaries, such as finance companies. Although stock market capitalisation in East Asia rose very dramatically in the 1990s until 1997, securities markets in the region are relatively young and under-developed for a variety of reasons. The shares of many companies that are traded on the stock exchanges are closely held with the percent of shares actively traded being relatively low, despite improvements in market liquidity during this decade. Furthermore, unlike in industrial countries, equity markets also play a limited role in corporate governance, owing to the importance of family controlled firms. Other securities markets in the region, such as money and bond markets, are even less developed and liquid. Fixed-income markets typically develop after the creation of a government bond market. In East Asia, government securities markets have been slow to develop because governments either have not required substantial budgetary financing. The rapid expansion of financial intermediation in the East Asian economies was not always matched by a commensurate strengthening of regulatory and supervisory systems. Banking sector distress in these economies was caused by both external and domestic factors. External causes included increases in international interest rates (for several economies in the early 1980s), falling export demand in Korea or terms of trade shocks in Malaysia and the Philippines. Domestic causes included weak prudential regulations (in all of these economies), speculative borrowings (related mainly to real estate in Hong Kong SAR, Malaysia, and Thailand; equities in Malaysia; exchange rates in Thailand; and arbitrage across the yield curve in Taiwan Province of China), and lending on noncommercial criteria, often to clients connected to bank management or the government (in Indonesia, the Philippines, and Thailand). Government responded to the crises in different ways. In Hong Kong SAR and Taiwan Province of China, most insolvent financial institutions were merged, liquidated, or allowed to fail, and management was replaced when institutions were merged or bought

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by healthier banks. In contrast, in Indonesia, Malaysia and Thailand, although a few, generally small, financial institutions were allowed to fail, most institutions were allowed to remain in operation through government intervention, despite non-performing loans in the banking sector exceeding 25 percent of total assets. In Korea, where non-performing loans peaked at over 7 percent of total lending, no financial institutions were closed. Furthermore, even when financial institutions failed, most depositors were protected, notwithstanding the absence (except in the Philippines) of explicit deposit insurance. In almost all of these economies, prudential regulations and supervisory frameworks were tightened after the crises, but only in Hong Kong SAR and Singapore were reforms implemented in a systematic way. 5.5 Export orientation and trade openness Of the many policies tried by the East Asian countries for accelerating growth, those associated with their export push hold the most promise for other developing economies. Economic growth in Asia correlates strongly not only with export growth but also with high savings and investment rates. A trinity of openness to trade, high investment and high savings rates coexist in the fast-growing economies of Asia, and it is important to stress the presence of all these three factors to achieve higher growth. Trade has been pivotal to the economic success of the NIEs and the fast-growing economies of Southeast Asia. The benefits of a more liberal trading environment reached beyond the narrow efficiency gains highlighted by the theory of comparative advantage. Other benefits include more competitive goods and factor markets, increased investment including foreign investment, and the associated transfer of knowledge and technology. Initially endowed with abundant labour resources, they expanded their exports of low value-added and labor-intensive manufactured goods. Subsequently, as labor costs increased, they shifted the structure of manufacturing production and exports towards more sophisticated and higher valued-added products. A comparatively “level playing field” allowed both the traded and non-traded goods sectors to grow vigorously, complementing and supplementing each other in investment, production and trade. There is prospect for an improved world trading environment as a result of the conclusion of the Uruguay Round of tariff negotiations under the aegis of the General Agreement on Tariffs and Trade (GATT) and the subsequent formation of the World Trade Organisation (WTO). But there are still legitimate concerns in a number of areas. There is a view that the Uruguay Round agreement did not adequately cover investment; and much remains to be done to reduce barriers to trade in both services and agriculture. Some countries also fear that new obstacles to trade in the name of “social conditionalities” and “environmental protection” will take the place of old ones. There is also evidence that some industralised countries have bound themselves to maximum tariffs on agricultural goods that exceed the existing rates. “Dirty tariffication” as this practice is called, opens the way to reducing the potential gains from the WTO agreement.

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The export-push approach provided a mechanism by which industry moved rapidly toward international best practice and technology. Export-push strategies were, however, implemented in different ways by the East Asian countries (World Bank 1994). (a) Hong Kong and Singapore established free trade regimes, linking their domestic prices to international prices; the export push was an outcome of the limited size of their domestic markets alongwith neutral incentives for domestic and external markets. Both economies made export credits available, although they did not subsidise it, and Singapore focussed its efforts on attracting foreign investment in exporting firms. (b) In Japan, Korea, and Taiwan, China, incentives were essentially neutral between import substitutes and exports. Export incentives, however, were not neutral among industries or firms. There was an effort in Japan, Korea, Singapore, and Taiwan China, to promote specific exporting industries. In Korea, firm-specific exports targets were employed; in Japan and Taiwan, China access to subsidised export credit and undervaluation of the currency acted as an offset to the protection of the local market. One of the major factors for success of the export push in some countries like Japan and Korea, was the government’s ability to combine cooperation with competition. Export targets provided a consistent yardstick to measure the success of market interventions. The more recent export-push efforts of the Southeast Asian newly industrialising economies (NIEs) relied less on specific incentives and more on gradual reductions in import protection, coupled with institutional support to exporters and a duty-free regime for inputs into exports. Recent strategies to attract direct foreign investment in Indonesia, Malaysia, and Thailand have also been explicitly export-oriented. Many government policies assisted the export drive. Thus, despite high effective rates of protection, exporters had access to imports at close to world prices through a variety of channels, including free trade zones, export-processing zones, bonded warehouses, duty drawbacks, and tariff exemptions. In fact, comparisons of international and domestic price levels and their variability show significantly smaller price distortions in the East Asian economies than in other developing countries. Also east Asian governments typically provided preferential financing and tax incentives for exports, subsidized export-marketing efforts and export-related infrastructure, promoted the creation of international trading companies, and, particularly in the southeast Asian economies, provided incentives for foreign investment directed towards exports. Expanding intra-regional trade also played a critical role. A large part of this trade consisted of trade in intermediate goods, allowing the East Asian economies to generate economies of scale. This expansion was aided, in part, by the more advanced economies in the region, starting with Japan and subsequently Korea, Singapore, and Taiwan Province of China, investing directly and relocating firms to other East Asian economies. By the mid-1990s, about one-half of the exports of each of the East Asian economies went to other countries in the region, including Japan. The Philippines is the least regionally integrated economy, with more than one-third of exports destined to the United States. China and Indonesia are the most regionally integrated with almost 60 percent of

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their exports directed to other countries in the region. The increased regional trade integration has undoubtedly been a positive element in the region’s economic development, but it has also tended to exacerbate the regional spillovers of the recent financial crises, magnifying their effects on trade and activity within the region relative to their effects on the rest of the world economy. 5.6 Role of special economic zones Export processing zones are the most common form of subnational zones which provide a preferred customs treatment to goods entering the area compared with goods entering non-zone parts of the country. These preferences are normally restricted to export activities. Export processing zones also give preferences or privileges relating to the establishment of foreign-owned enterprises and to nontrade-related instruments of government policies such as tax holidays or deferments, duty drawbacks or exemptions for raw materials, reduced rates in taxes and duties for capital goods, investment subsidy, preferences in government loans. EPZs and other economic zones are generally equipped with good infrastructure and support facilities. A closely related form of subnational zone is the financial service zone, such as a financial offshore center. These zones essentially provide preferences for the finance service industries; analogous to those provided for manufactured goods in export processing zones. There are other subnational zones which are not international traderelated, such as science and technology parks. The number of these parks has increased rapidly in many Asian countries since 1980. Most science and technology parks in Asia have concentrated primarily on attracting foreign investors. Subnational zones are, therefore, an integral part of the wider pattern of intra-Asian trade development. Subnational and sub-regional zones have increased the intraregional share of total trade in goods and services and intraregional flows of FDI. Despite some failures, special economic zones have largely met their objectives by attracting FDI, creating employment and increasing exports. The rapid expansion of export processing zones (EPZs) in developing countries during the last two decades represents a significant development in the world economy. Ireland is credited with establishing the first modern EPZ in the world with the establishment of the Shannon Export Free Zone in 1955. The success of the Shannon experiment led to the rapid growth of EPZs in developing countries. The first developing country to set up an EPZ was India with the creation of the Kandla Free Trade Zone in 1965. Today there are more than 200 EPZs in 60 developing countries compared with just eight EPZs in 1970 and 55 EPZs in 1980. Nearly half of EPZs is located in Asia. There is undeniable evidence that the EPZ sector, although still small, has been among the most dynamic sectors in attracting FDI. EPZs accounted for more than 85 percent of FDI in Mauritius and over 70 percent in Mexico. FDI inflows to the oldest four special economic zones in China amounted to more than 30 percent of FDI inflows in 1989. Foreign investors account for a major portion of investment and employment in EPZs, which are characterised by the dominance of the textiles, garments or electronics.

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An analysis of the structure of employment by product group in EPZs of selected countries indicate that there is one dominant industry in each country: textiles and garments industry in Bangladesh, China, Dominican Republic, Egypt, Jamaica, Mauritius and Sri Lanka; and the electronics industry in Barbados, Brazil, Republic of Korea, Malaysia, Mexico and Taiwan, China. Concentration rates vary among countries and zones. In Jamaica, Mauritius and Sri Lanka, the leading industry, textiles and garments, accounts for almost 90 percent of total employment, whereas for the electronics industry, EPZs in Malaysia have the highest concentration rate of over 74 percent. 5.7 Role of Small and Medium Sized Industries (SMIs) SMIs constitute a rather dynamic force in the economic development; they provide a sound market environment for the economic growth; reduce rural-urban disparities; and can swiftly adapt relatively simple but advanced technology. A dynamic SMI sector helps not only to generate employment but also to earn foreign exchange, upgrade the quality of the labour force, diffuse technological know-how, and utilise rural savings, surplus labour and local raw materials that may otherwise remain idle and unutilised. Small enterprises provide a source and training ground for the development of entrepreneurship and business management skills for medium and large undertakings. Small and medium industries predominate output in a number of industrial sectors in many Asian countries such as Bangladesh, India, Pakistan, China, Korea, Indonesia and Philippines. Even they played a significant role in the economic development in Japan and Singapore (Das 1996, ESCAPE 1996). They are mainly in the textiles, garments, wood products, food processing, leather products, fabricated metals, machinery and equipment, rubber and plastic products, pottery, printing and publishing. In 1990 they accounted for 95% of establishments in Bangladesh, 98% in Thailand, 93% in Malaysia, 70% in Indonesia and 80% in the Philippines. In India the SSI sector accounts for 40% of the total turnover in manufacturing and 35% total exports. In China, SMEs accounted for 99% of the number of enterprises, 78% of employees, 64% of industrial turnover, 52% of corporate profits and 52% of fixed assets held by industry in 1990. In Japan, SMEs accounted for 99% of all business establishments, 74% of total work force, 52% of manufacturing exports, 62% of wholesale business sales and 7% of retail sales in 1991. In Taiwan, SMEs accounted for 90% of enterprises and 60% of exports in 1990. On the other hand, there have been criticisms regarding the ability of small industries to realise economies of scale in production, procurement and marketing. So, they may experience larger unit costs despite low labour costs and advantages due to their proximity to the local markets. In many sectors, small units exist on the strength of the costly government support programmes in terms of reservation, price and purchase preference, priority and confessional lending and fiscal concessions. 5.8 Role of Natural and Human Resources

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Many studies have found an inverse relationship between natural resource endowment and the level of industrial technology (Kakazu 1990) for the following reasons: (a) The first is the “Dutch Disease” hypothesis which maintains that over-concentration on resource-based production and exports may create an adverse environment for the introduction and diffusion of advanced technology. For example, rich mineral and forest resources for exports in Indonesia seem to have adversely affected its technological assimilation and improvement. (b) Second, India and Indonesia, relatively resource-rich countries in terms of the size of land and population, have been tempted to adopt more inward or domestic marketoriented policies compared with the Republic of Korea and Thailand. Import-substituting industrialisation has discouraged the adoption and dissemination of industrial technologies appropriate for labor surplus economies such as India and Indonesia. (c) The third explanation is that a resource-rich economy can sustain its growing population by exploiting extensively its natural resources and may not feel the pressure or need to adopt advanced technology to utilise given resources more efficiently. The availability of well-educated human resources is more important than the availability of natural resources in industrial technology development. Various case studies made recently by the Asian Productivity Organisation (APO) also found that a shortage of skilled and technical manpower is the major constraint to the digestion of new technologies in Asian developing countries. Indonesia’s institutional capability for technology development is limited due to several cultural and policy factors. The diversified geography with more than 6,000 inhabited islands and 2,000 ethno-cultural groups creates problems for institutional development in education, communications and administration. Recently Indonesia is attaching special importance for the development of basic infrastructure including human resources. In the Republic of Korea, scientists, engineers and skilled workers are the main actors who made it possible for the country to achieve such a remarkable progress. Korea broadened its educational base to increase technical manpower and thereby trained the required manpower within a relatively short span of time. Even the poorest of the Korean families do not spare any efforts to provide the kind of education, which the economy would consider necessary. Formal education is important to all Koreans. The government’s investment in education has expanded several times. But, the government expenditure on education represents only 30 percent of the total expenditure on education; the remaining being borne by the private sector. Human capital formation advanced at a rapid pace, both quantitatively and qualitatively, in almost all the rapidly growing East Asian economies. As early as 1965, primary school enrollment rates were already higher in this region than in many other development countries. Hong Kong SAR, Korea, Singapore, and the Philippines had achieved universal primary education and even Indonesia -–a populous nation and, at the time, one of the poorest developing countries – had a primary school enrollment rate of over 70

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percent. In the past three decades further significant progress was achieved, except in Thailand. In Korea, secondary school enrollment increased from around 35 percent in 1965 to virtually 100 percent in 1995, while Indonesia'’ secondary enrollment rate of close to 50 percent in 1995 was higher than in other countries with comparable levels of income. In Thailand, however, the secondary school enrollment rate of under 50 percent in 1995 was lower than that predicted by its income level. Associated with this were serious shortages of skilled labour in Thailand in recent years, resulting in significant upward pressures on wages. Not only enrollment rates, but also the quality of education improved significantly during the past three decades in most of the east Asian economies, as average expenditure per pupil rose and pupil-teacher ratios were reduced. 5.9 Role of Research and Development (R&D) Expenditures There is a high correlation between R&D expenditure and technological capability because a new technology, which depends upon R&D activities, must be developed domestically as a country attains technological maturity. The NIEs spent more and more on their own technology development as imported technologies became more costly and increasingly difficult to obtain from developed countries due to growing technology protectionism. The R & D expenditure in India at 0.9 percent of GNP and in Thailand at 0.5 percent of GNP in 1992 were considerably lower than that in U.S.A. (2.7%), Japan (3%), Germany (2.9%), and South Korea (2.8%). In USA the Federal government provided 43% of total R & D funds in 1992 and the industry, state governments, Universities and other non-profit institutions provided the remaining 57%. In Japan, while the government provided only 16% of R & D expenditure, the rest was provided by industry. In Germany, 35% came from government sources and the remaining 65% were borne by the industry. In South Korea, the ratio of government and private investment in R & D changed significantly from 97:3 in 1963 to 15:85 in 1992. In contrast R&D expenditures are mostly funded by the public sector in Thailand, Indonesia and India. India has built a wide array of institutions to support the development and diffusion of industrial technologies since the inception of planning in 1951. It has virtually all basic, applied, hardware and software and R&D institutions, some of which have world-class standards. But, these institutions have failed to commercialise R&D activities as these are virtually financed and controlled by the public sector without any linkage with the private sector. Since 1993 Government had encouraged private sector funding of research institutions by providing tax relief on R&D expenditure. The Indian government adopted a progressively more restrictive policy of technology imports from the mid-1960s due mainly to foreign exchange constraints. Imports of capital goods were liberalised to some extent during 1980s, but the import duties were high and irrational. Since July 1991 as a part of structural reforms in industry and trade, India has liberalised completely the import of capital goods and technology transfer with significant reduction of import duties on capital goods. 5.10 Role of Legal and Institutional Set up

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Many of the difficulties faced by governments in handling foreign investment, and by the foreign investors setting up in a host country, derive from the absence of a clear civil, commercial and criminal legal system. Given a set of laws, it is essential that foreign investors be treated equally with domestic investors. Not only is this a moral issue, but there are strong practical arguments against giving foreign investors privileges that domestic firms do not enjoy (and vice versa). Domestic firms will launder money to become foreign investors if this will give them subsidies that they cannot otherwise receive. Chinese publicly owned enterprises use transfer pricing at other than arms’ length to become foreign investors in China, or they form joint ventures within foreign firms to benefit from subsidies to foreign investors. Giving entrepreneurs of Indian origin special privileges by India are also inequitable and inefficient. Continued reforms will attract the worthwhile investors among them without incentives. In open economies, such as Singapore, Hong Kong or Mauritius, only minimal special foreign investment laws and regulations are necessary and administrative costs are negligible. Most developing countries like India are faced with a transition period. The experience of countries such as Indonesia, Malaysia, Taiwan and Thailand suggests that the transition can be managed well. The faster an economy is reformed, the easier the management of private investment including foreign investment. Regulations can be simple and their administration may be made efficient and transparent.

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CHAPTER-6 PRIVATE SECTOR DEVELOPMENT STATEGIES AND POLICIES IN SELECTED EAST ASIAN COUNTRIES

6.1 Hong Kong, China: Economic policies and liberalisation (a) Recent economic situation and policies The return of Hog Kong to the People’s Republic of China took place on July 1, 1997. The terms of the transfer, which are embodied in the Basic Law, included the establishment of the Hong Kong Special Administrative Region (SAR). The Basic Law also provides the SAR a considerable degree of autonomy over economic and other policies, and includes a commitment to the continuation of the existing free-market system for 50 years. The Basic Law’s requirements in the area of fiscal policy include the avoidance of fiscal deficits and the principle of keeping the budget commensurate with the growth rate of GDP. In 1997, a surge in land-related revenues caused the fiscal surplus to exceed the budget target of 2 per cent of GDP buy a substantial margin. As a result, fiscal reserves (including the balance of the Land Fund) increased to over 30 per cent of GDP. The Basic Law requires that Hong Kong’s currency be fully backed by foreign reserves, and the exchange rate is linked to the US dollar under a currency board-type arrangement. Real sector developments were generally favoarable in 1996 and the first half of 1997, but activity showed signs of slowing during the latter half of 1997, owing to the impact of the regional crisis. Real GDP growth accelerated to 5 per cent in 1996, following belowtrend growth of 3.9 per cent in 1995, reflecting strength in private investment and consumption, as well as the impact of a significant narrowing of the deficit in goods and non-factor services trade. During the first half of 1997, GDP growth reached 6.4 per cent, owing to strength in domestic demand that offset a widening of the trade deficit. Growth slowed in the second half of 1997 for an average of 5 per cent for the year as a whole as a result of the effect of the regional crisis on external trade, and the impact on domestic demand of higher interest rates and declines in stock and property prices. As a result of the pickup in activity to mid-1997, the economic slack that emerged in 1994-95 appeared to have been virtually eliminated. Output at mid–1997 exceeded potential, and the unemployment rate dipped to 2.2 per cent in the third quarter of 1997, compared with 2.6 per cent a year earlier. Reflecting labor market tightness, real wage growth accelerated to 1.7 per cent at the end of September 1997. The regional crisis contributed to substantial financial market volatility. Stock and property prices rose strongly during the first half of 1997-by mid 1997, property prices were a third higher than their trough in the second quarter of 1994, and the Hang Seng stock price index reached an historical peak in early August, having arisen by around d50 per cent during the pervious 12 months. 63

However, spillovers from the regional turmoil caused the Hong Kong dollar to come under speculative pressure in the latter half of 1997. Pressures on the exchange rate were successfully resisted by means of intervention in the foreign exchange market and a corresponding tightening of domestic liquidity. Nonetheless, higher interest rates, which resulted from spillovers from the financial turmoil in the region and the resultant pressures on the exchange rate, as well as weaker sentiment contributed to a substantial correction in stock and property markets. By 1998, the Hong Seng index was roughly 50 per cent below its 1997. Although spreads between rates on Hong Kong dollar deposits and US dollar deposits have narrowed, they remain well above the historical average. (b) Private sector development strategy Hong Kong has been a free port and open to FDI for several decades. Favourable impact of its liberalisation policy is evident from its economic progress. In spite of a lack of natural resources, it ranks third in Asia in terms of per capita GDP (US $ 21,700 in 1996) after Japan and Singapore, and seventh in the world in terms of total assets. FDI is allowed in all sectors. Japan, USA & UK are the major investors in Hong Kong. Restrictions on FDI exist only in banking where a license is required and in broadcasting where only a Hong Kong based company can operate. There is no discrimination among overseas and domestic investors, and no special conditions for overseas investment. Government follows a free enterprise and free trade policy based upon a philosophy of minimum interference with market forces and maximum support for business. Hong Kong Productivity Council provides a wide range of support, services and facilities to industry such as training, design, consultancy, strategic alliances for technology transfer, joint product development etc. Hong Kong Industrial Technology Centre Corporation facilitates technology development and application in Hong Kong’s industry by the technology based business incubation, technology transfer services and product design and development support services. A strong financial base exists in Hong Kong, and there is no exchange control or restriction on capital overseas. There is no restriction on employment of foreign labour provided there is a need to import labour from overseas. No local content or technology transfer requirements are imposed on the foreign companies. Comprehensive laws exist for protection of IPRs. Government supports industry with the provision of technical training facilities, consultancy, technology transfer, R & D etc. A low, simple, non-discriminatory and practicable taxation system exist in Hong Kong without any provision for tax holidays and other incentives for overseas investors. Corporate tax rate for unincorporated business is 15% and that for incorporated business is 16.5%. Property tax is charged on the owners of land and buildings in Hong Kong at a rate of 15%. There are no customs or excise duties except on cigarettes, alchohol, petroleum and automobiles. Cigarettes carry a tax of 100% while the rate on alcohol varies according to

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the type. This tax is imposed only to discourage consumption of these two products for health considerations. Automobiles face an initial registration tax of about 100% and petroleum attract tax of about 40-50%. This is done to discourage the use of private cars and ease the pressure on Hong Kong congested roads for environmental considerations. With labour costs in Hong Kong rising a huge chunk of Hong Kong’s manufacturing base has been shifted to Guangdong province of China. 75% of the total investment in Guangdong Province in China is from Hong Kong. Labour intensive industries are being shifted out and the hi-tech areas are being retained in Hong Kong. The aim is to convert Hong Kong into a Science & Technology island. By July 1997, sovereignty over Hong Kong have been transferred to China from the U.K. This will strengthen the existing linkages between China and Hong Kong. 6.2 Indonesia - Economic Reforms and Liberalisation (a) Recent currency shock and economic crisis In terms of the decline in economic growth, depreciation of the currency, social dislocation and other problems, Indonesia has suffered the most among the East Asian countries by the recent financial and economic crisis in East and South East Asia. The collapse of the exchange rate from 2500 Rupiah per US dollar to levels as low as 15000 Rupiah per US dollar has contributed to one of the largest real depreciation in the postWorld War II era in Indonesia. The fall in GDP growth rate by 22 percentage points (from positive 7.8 percent in 1996/97 to possibly negative 10-15 percent for 1998/99) dwarfs anything experienced in the OECD countries since the Great Depression. The $22 billion reversal of private capital flows, from inflows of $10 billion in 1996/97 to outflows of $12 billion in 1997/98, is nearly as large as total net capital flows in the entire decade during 1985-1995; The financial and economic crisis has been accompanied by natural disaster in 1008. The drought occasioned by EI Nino reduced rice harvests and agricultural production generally and severe localised droughts contributed to uncontrollable forest fires. The price of Indonesia’s key export, crude oil, has fallen to $13 a barrel in 1998, its lowest level in real terms in 30 years; enormous political changes are taking place. The Indonesia crisis originated from an ordinary currency problem, when rupiah suffered from sudden pressure in July 1997 due to the weakening and the floating of the Thai baht in early July 1997. Despite a series of policy responses by the government to correct the exchange and money markets, the problems spread rapidly and deeply to affect all sectors of the national economy, before finally having their impact on politics. Analytically, the Indonesian crisis originated from changes in market sentiment in the region that caused an external shock in the currency market which subsequently led to a contagion effect in the region. The shift in market sentiment was demonstrated by the rapid downgrading process of the region’s sovereign credit ratings, and the disillusion of the term ‘Asian miracle’ to be replaced by ‘crisis’, ‘chaos’ and ‘meltdown’. Confronted

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with the contagion effects, the national economy which had been suffering from inefficiency in the real sector (a high cost economy, crony capitalism, a weak financial and banking system) failed to cope with the shock. The domino effect of the weakening rupiah adversely affected the financial and real sectors of the economy. Thus, the spread from economic crisis to a social and political crisis was through a contagious process, facilitated by inherent weaknesses in Indonesian social and political systems. (b) Policy responses to crisis The initial policy response to the currency problem was prompt, starting with an immediate step to widen the central bank intervention bands in the foreign exchange market on the same day the Philippine peso was floated, and more than a week after the floating of the Thai baht in July 1997. Faced with persistent pressure on the rupiah, the government intervened in the foreign exchange market, first by selling dollar forward, and later in the spot market. When these efforts could not strengthen the rupiah, Bank Indonesia discarded the system of a managed float, and floated the rupiah freely in mid-August 1997, supported by monetary tightening through interest rates policy, sterilization as well as fiscal tightening. Realizing the fact that the problem had spread to the banking sector in early September 1997 the government launched a broad economic policy initiative, which encompassed not just monetary and fiscal measures, but also deregulation steps in the real sector. This was followed by an IMF-supported programme initiated at the end of October 1997. The programme consisted of the following three major areas, namely: • • •

A strong macroeconomic framework designed to achieve an orderly adjustment in the external current account, incorporating substantial fiscal adjustments as well as a tight monetary stance, A comprehensive strategy to restructure the financial sector, including early closing of insolvent institutions, and A broad range of structural measures which also improve corporate governance. (c ) Private sector development strategy

To maintain internal economic stability, Indonesia adopted the balanced budget policy since 1968 until it faced the severe currency and financial crisis leading to deep rooted economic crisis in 1997. The financial sector reforms, introduced in October 1988, liberalise the capital account of the balance of payments and encourage competition between financial institutions. In January 1991, the authorities adopted the BIS recommendation on prudential norms and regulations in banking industry. Essential elements of the credit policy include legal lending limits regulations which limit the credit allocation to insiders (bank owners, employees and groups of companies) and individual borrower. In addition, credit regulations also mandate national banks to allocate at least 20 percent of their credits to medium and small scale enterprises. Foreign

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and joint venture banks are required to channel at least 50 percent of their credit to export-related activities. Since 1986, the government has moved to dismantle the complex import licensing system. The share of imports subject to non-tariff barriers (NTBs) decreased from 43% in 1986 to 13% in June 1991, and the share of domestic production protected by NTBs declined from 41% to 22% over the same period. Nevertheless, some important subsectors in manufacturing, such as engineering goods, tires, paper products, glass, manmade fibers, textiles, iron and steel, plastics and food processing and most of agricultural goods remain subject to non-tariff barriers. Imports of restricted goods, such as essential agricultural commodities like rice, sugar, soybeans, fresh fruits, milk products, batik goods, garlic, some steel items and strategic minerals like coal, are permitted only when there are shortfalls in domestic production. During the past several years, Indonesia's revenue collections have varied between 16 per cent and 18 per cent of GDP broadly in line with the ratio for South Korea, Philippines, and Thailand, but below that in Singapore. Indonesia's revenue effort is similar to that of the US and Japan (which, however, have large local government operations) and significantly below major European countries (Table-6.2B). Table-6.2B: Tax efforts (in per cent of GDP) and effective tariff rates in selected countries in East and South East Asia and OECD Country

Thailand Australia Canada France Germany Indonesia Japan South Korea Malaysia New Zealand Philippines Singapore United Kingdom United States

Total Revenue

Tax Revenue

Personal Income Tax

Corporate Income Tax

18.3 25.8 20.7 40.6 30.4 17.9 19.9 18.8 28.3 38.7 17.8 32.3 36.0 19.7

16.3 23.0 18.3 37.7 28.9 16.1 17.1 16.2 20.8 33.9 15.2 15.9 32.9 18.1

2.3 12.4 8.7 5.3 4.0 1.2 5.4 3.5 2.4 17.0 1.8 .. 9.9 8.2

3.5 3.8 1.4 1.8 0.8 8.3 3.4 2.4 6.9 3.3 2.2 .. 3.1 1.9

Nominal Effective Tariff Rate 1990 11.0 8.1 2.9 0.03 0 5.8 2.6 8.0 4.9 4.8 15.4 0.7 0.1 3.5

Nominal Effective Tariff Rate 1995 7.1 4.7 1.7 0.02 0 5.0 4.0 4.7 4.0 3.9 14.1 0.3 0.1 2.6

Source: Government Finance Statistics, 1998 and World Economic Outlook, 1998.

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Tariff levels have considerably fallen since 1985 when the government announced an across-the-board reduction in the range and level of import duties. Indonesia, in its May 1995 trade reform package, initiated a program to top down its tariffs to 10.5 or 0% by 2003. The May package cut tariffs on some 500 items by 15-35 percentage points tariffs on some 1050 items by 10 percentage points and 4500 items by 5 percentage points. Further, the Government announced that tariffs in excess of 20% would be reduced to 20% by 1998 and 10% by 2003 while those below 20% would be reduced to 5% leaving a 10-5-0% tariff structure by 2003. All sectors were covered except five agricultural products (which protected by quantitative restrictions as well as tariffs); alcoholic beverages (which carried high tariffs for social reasons, a goal that would have been better served by high excise taxes) automobiles where a separate timetable was to be set up and chemicals and metals, where a separate timetable was to be set up to reduce tariffs to 10% by 2003 . The initial impact of the program was to reduce the unweighted average tariff from about 20% in 1991-94 to 15% in June 1995 (about the same as Malaysia; by comparison, India’s unweighted average tariff is about 32%). Indonesia’s final average unweighted tariff, under the 10-5% structure would be about 7% in 2003. In June 1996 a specific schedule was announced form cutting each group of tariffs, along with the second set of cuts. In the 1997/1998 agreements with the IMF, the approach was extended to 3 of the 5 omitted sectors agriculture, chemicals and metals, and quantitative restrictions on agriculture trade and exports were reduced. Indonesia promotes foreign investments that increase non-oil exports, encourage processing of raw materials into finished goods, use local products or components, transfer technology and skills and save foreign exchange. Most foreign investments are structured as joint ventures to foster the development of domestic industries. In 1994 Government shortened the negative list for foreign investors to 34 industries and relaxed ownership of foreign investors by allowing 95 percent of equity owned by foreigners in business ventures in Indonesia. The sectors opened for foreign capital in 1994 were seaports; the generation, transmission and distribution of commercial electricity, telecommunications, civil aviation, shipping, drinking water supply, railways, banks, finance, insurance and securities, nuclear power generation and mass-media. The negative list for foreign investors now consists of 9 sectors, including domestic distribution and retailing, advertising and sectors reserved for small scale firms. Foreign ownership is limited to 80% for total investment of at least US$1M. 100% foreign ownership for a maximum period of 15 years is granted if the total paid-up capital is at least US$50M; the company is located outside Java or in a bonded area and it is a 100% export-oriented unit. Indonesia has 2 duty-free zones at Batam Island and Surabaya. Projects in free trade zones are allowed 95% foreign ownership. Foreign ownership for commercial production is reduced to 49% or less within 20 years. Foreign investors who issue more than 20% of their equity through the capital markets are allowed to maintain up to 55% of shareholdings to qualify as a domestic market enterprise: this allows them to distribute goods at retail level and obtain credits from the 68

state banks. The “strategic” commodities such as agriculture products, palm-oil based products, paper products, plastics, and automotive sectors and machinery are still subject to either non-tariff barriers or high import duties or export taxes. Indonesia allows foreign investors to appoint own management, but they must use Indonesian labour except in positions where suitable nationals are not available. There is no restriction on repatriation of profits. Indonesia has bilateral agreements with a number of countries and is a signatory of MIGA protecting investments against political risk. However, Indonesian judiciary system is very weak with unclear legal rights. The tax bills of 1994 to 1996 broadened value added tax and property tax, reduced the highest income tax rate from 35 percent to 30 percent, and improved tax administration by giving greater authority to tax officials to check tax returns. The list of objects of the value added tax now includes a wide range of services, including franchising. The income tax bills reintroduce various forms of incentives for investment in remote locations, particularly in the Eastern part of Indonesia, pollution abatement and development of human resources. The fiscal incentives include reduction of the highest marginal tax rate from 30 percent to 25 percent and accelerated depreciation and amortisation. These also include a longer period for compensation of loss and a lower tax on dividends; exemption from import duty, import surcharge, excise and income tax for trade zones; and drawback of import duty and VAT for export manufacturers. In addition, a general exemption from import duties on capital goods and raw materials for two years production were also allowed for all business and industrial enterprices. Apart from an ad-hoc and case by case basis, until the recent economic crisis in 19971998, there was no systematic and transparent plan for corporatisation and privatisation of the state-owned enterprises. In general, the rates of returns of these companies are below the average returns both at home and in the neighbouring countries. As shown by the cases of privatisation in oil, gas and palm oil sectors, transfer of ownership only means transfer of lucrative business from the state owned companies to a well connected conglomerates without significant improvements in economic efficiency in the SOEs. 6.3 Korea, Republic of : Economic Reforms and Liberalisation (a) Private sector development strategy The performance of Korean economy over last 3 decades is a constant reminder to the developing world that industrialisation-export based development strategies can be implemented to achieve two objectives of development viz. growth and equity. The stabilisation and recovery were the Government’s top priorities in the early reform period. Stability was attained through exchange rate adjustments, which restored export competitiveness and reduced the import demands. To dampen inflationary pressures, officials tightened fiscal policy and initiated tax reform programmes. External trade was

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liberalised significantly except selected import restrictions. Foreign investment rules were liberalised to encourage inflow of foreign capital. Entry of foreign investment to the Korean economy has been significantly liberalised over the years. There are no specified limits on foreign equity participation except in the case of industries on the restricted list. There is no minimum cash requirement and Foreign Direct Investment may be entirely in the form of patents or technology transfer. In 1960’s when the foreign investment began to be introduced, investments centered in labour-intensive industries such as electricity, electronics, fiber and garments. As the economy began to make progress, foreign investment was gradually shifted to technology or capital-intensive industries such as chemicals and transportation means. In July 1984, Korea adopted the negative list system. Consequently, the foreign investment liberalisation ratio rose to 66% from 61% under the positive system. Since March 1993 the approval oriented system was changed to the notification-oriented system, which covers 91% of total businesses eligible for foreign investment regardless of foreign equity ratio (except for few sectors such as retail business and hotels). Manufacturing sector has been opened to FDI more rapidly than other industries, as indicated by the higher liberalisation ratio at 97.8 percent for it in 1993. Though the service sector has a far lower liberalisation ratio than manufacturing, those services which are of interest to foreigners such as finance, wholesale trade, and marine transportation are at least open to FDI. Korea has 1148 distinct business sectors. Of this 64 sectors are currently either restricted or banned for FDI. Restricted sectors include agriculture, finance, telecom and broadcasting. The banned sectors include rice farming, cattle breeding etc. All foreign companies in Korea enjoy a National status and get the same incentives, which are available to domestic companies. Mergers and Acquisitions of foreign enterprises are allowed subject to prior approval and the condition that they do not violate the norms of the restricted and banned sectors. Since the early 1980s, Korea has implemented a comprehensive program of trade liberalisation, and has achieved a significant reduction of quantitative controls and tariffs. By 1992, the import liberalisation ratio for manufactured products had risen to 99.9 percent, and that for agricultural products has increased to 87.1 percent. Korea successively reduced import tariffs since 1980s. The Korean Stock Exchange gradually expanded market access for foreign portfolio investments through introduction of various instruments such as investment funds for foreigners, issuance of equity-related overseas securities, operations of foreign securities companies through branch offices and joint ventures, and direct investment in the Korean stock market by the foreigners. Ongoing reforms may enhance the current 10% ceiling on foreign holdings of a domestic firm’s stocks. Foreign investors are provided with many incentives such as repatriation of earnings, protection for intellectual property rights, Investment Guarantee Agreement and Double

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Taxation Avoidance Agreement, tax exemptions and deductions, a favourable business environment for investors by constructing free export zones, facilitating the use of financial resources, and establishing a one-stop service center where government officials from relevant ministries worked together. The Korean tax system is composed of national taxes and local taxes. The national tax system includes corporate tax, income tax, value-added tax and special excise tax as its highest revenue sources, while local tax is dividend into provincial tax and city and country tax. In step with the current international economic trend of liberalisation and globalisation, the corporate tax rate has been reduced from 32% to 30% and the depreciation and tax accounting systems have been improved. In the case of large-sized utilised companies (including domestic companies having net worth of over 10 billion won), a 15% tax rate is levied on the excess accumulated earnings. However, the excess accumulated earnings used for reinvestment are exempted from the payment of the tax. Foreign investors receive exemption or reduction of income tax and corporate tax on dividends, royalties and other investment income. Foreign companies transferring advanced technology receive exemption or reduction of income tax and corporate tax for providing technology. Lenders of public loans get exemption or reduction of tax and public charges on loan interest. Foreign technical service providers related to public loans get exemption or reduction of income tax and corporate tax for providing services. Employment of foreigners in industry and trade is allowed. Taiwanese firms are importing labour from Bangladesh and Philippines to carry out low end jobs while upgrading Korean labour to higher skill levels. Companies are free to close down operations provided they are able to compensate the labour according to a formula set by the government. The Government is currently planning to open up more and more sectors such as wholesale and retail trade of grains, mutual credit companies, air and land freight handling services, inter-city bus transportation, hospitals, vocational schools, offset and commercial printing, employment agencies, manufacture of lubrication oil and gases, legal services, real estate, insurance brokerage, publication of newspapers etc. A New Foreign Direct Investment Act passed in January 1, 1997 announced that additional 28 sectors will be liberalised from June 1997, 11 sectors from Jan 1998, 6 sectors from Jan 1999 and another 6 sectors from Jan 2000. Investment related regulations are being brought in line with international standards. Conditions and procedures are being formulated for friendly Mergers and Acquisitions. Investor protection and establishment of an investment related dispute settlement procedure is an important part of this law. (b ) Foreign Investment Republic of Korea provides an excellent example of how a capital importing country can turn into a capital exporting country over time by sound economic management and judicious combination of both inward and outward looking policies. The sectoral distribution of inward FDI flows is also illuminating. In 1962-1995, out of total FDI

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inflows of $14.5 billion, manufacturing accounted for 60 percent and services the rest, but the sectoral distribution was completely reversed in 1994-95 with services accounting for 61 percent of FDI flows. Within services, emerging sectors are trade, real estate, finance and insurance as contrast to hotels and construction in earlier years. Chemicals, automobiles and electronics are the dominant areas attracting FDI in manufacturing. Distribution of FDI inflows in terms of equity ratios indicate that 70% of FDI was on a joint venture basis and 30% was on 100 percent foreign equity. Asian economies supplied 44 percent of inward FDI flows to South Korea in 1962-1995, while they received 46 percent of outward FDI from Korea in 1991-1995. Within Asia, China and Indonesia had been major destinations for Korean outward FDI. Korea has been seeking locations for its manufacturing investment in Asia. Although much of outward FDI was linked to trade prospects, a significant share of North America in the South Korea’s outward FDI reflects its desire to gain access to advanced technology from developed countries. 6.4 Malaysia: Economic reforms and liberalisation (a) Current economic situation and policies Since the late 1980s, Malaysia’s economy, sustained by high levels of investment and savings has achieved considerable success, reflected in high growth and substantial eradication in poverty. However, in recent years, strong demand pressures and rapid money and credit growth led to a widening of the current account deficit and sharply buoyant asset prices. Following the float of the Thai baht in July 1997, Malaysia experienced considerably pressures in its stock and foreign exchange markets. The authorities’ initial response focused on supporting the ringgit through exchange market intervention and a sharp hike in short term interest rates. Subsequently, the authorities allowed the exchange rate to depreciate, lowered interest rates almost to pre-crisis levels, and introduced a series of measures. ….. tightening fiscal policy and postponing major infrastructure projects, successively increasing constraints on credit growth and, more recently, raising interest rates. However, financial markets remained volatile reflecting, in part, severe and prolonged contagion. From the second half of 1997, economic activity has slowed, and the capital account has recorded a large outflow of short-term capital. Depreciation on exports, combined with deliberate policies to defer non-priority projects, have brought about a progressive and significant improvement in the current account, beginning in the second half off 1997. Reflecting the tightening of policy, monetary growth and latterly, credit growth have now also slowed considerably. However, reserves declined by US$ 7 billion from end 1996 to US$20% billion as of end April 1998, equivalent to 3 months of imports or 140 per cent of short term debt (including payments due in 1998 on medium and long term debt). The ringgit depreciated by 44 per cent and the stock market fell by almost 50 per cent between mid 1997 and January 1998; since then, the ringgit has strengthened by about 20 per cent and the stock market has recovered by 9 per cent.

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The weakening economy, combined with the high level of corporate leverage, resulted in increased pressure on Malaysia’s financial system, notwithstanding the generally well developed supervisory and regulatory framework,. Non-performing loans increased to 8.7 per cent by February 1998, reflecting also the tightening of loan classification guidelines that took effect on January 1, 1998. In addition, in November and December 1997, there was some shift in deposits from small to large financial institutions, accompanied by segmentation in the inter-bank market, which required temporary liquidity injections by Bank Negara. In response, the authorities tightened provisioning and disclosure standards, accelerated mergers of finance companies, announced a deposit guarantee, and reduced the statutory reserve requirement improve liquidity flows in the inter-bank market these measures also helped reverse segmentation. In 1998, government announced new package of measures, which builds on the earlier initiatives and is designed to broaden the overall policy response within the changed macroeconomic framework. The centerpiece is a series of preemptive actions to strengthen the financial sector and address emerging problems in financial institutions. The package also includes a rebalancing of the macroeconomic policy mix. While fiscal policy is targeted at ensuring a small surplus, increasing spending is allowed to strengthen the social safety net. Policies aim at a significant reduction in credit and monetary growth and more active use of interest rates to stabilize the foreign exchange market and restrain inflation. The government also committed to improve transparency and to the steady implementation of structural measures aimed at improving corporate governance and competition. Financial markets, which had strengthened in anticipation of the package have since moderated somewhat, owing partly to contagion effects from weaknesses in Japan. (b) Private sector development strategy Foreign ownership is allowed if investment in fixed assets (excluding land) is at least RM50M or has at least 50% value added; products do not compete with existing domestic production; and for projects in extraction or mining or processing of mineral ores. No foreign equity limit is imposed on manufacturing projects that export 80% or more of total production. 100% foreign ownership is allowed for high-technology projects and other priority products for the domestic market. Maximum foreign equity of 60% is prescribed for sales to the domestic market, Although investment is promoted in all areas, certain targeted sectors and activities such as agriculture & agro-processing, forestry, manufacturing, hotel & tourism projects and the film industry are promoted by the government. The Free Trade Zone Act of 1972 established FTZs designed for establishments producing or assembling goods for export. Lubuan island is being promoted as an international offshore financial centre. From 1994-95, Malaysia further liberalised foreign investment in its financial services and increased entry of foreign banks, enhanced equity participation in insurance, and liberalised the shipping, telecommunications, and transport sectors. It has also opened 64 service sectors including computers, audio-visual, transport and business services.

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The government enforces import controls through a system of import licensing to protect domestic producers from imports and to ensure adherence to sanitary, safety, security, environmental and copyright requirements. Import duties in Malaysia are relatively high ranging from 0% to 300% though most goods fall within the 15% to 25% tariff range. In implementing the Uruguay Round commitments for market access, Malaysia has unilaterally accelerated the tariff cuts on a number of items. Malaysia allows free repatriation of profits and capital, and provides bilateral protection against nationalisation and expropriation. Based on British model, legal system and company laws are generally well developed in Malaysia and provide investors protection and fair arbitration disputes. Malaysian society is not generally anti-foreign, but its New Economic Policy (NEP) extends preferential treatment to ethnic Malaysians and limits foreign control over the economy. The government allows the employment of technical and skilled foreign personnel in areas where there is shortage of local talent. But it requires a training programme to transfer skills to locals. Fiscal incentives include tax exemptions for 5 years for 85% of income for pioneer industries; lower income tax at the rate of 30 percent of income for 5 years for the potential pioneer status industries. Incentives also allow full exemption from import duty on raw materials or components used for export production or for production in promoted zones; partial import duty relief for goods produced for the domestic market; and full drawback of import duty and sales tax on parts, components or packaging materials used in the manufacture of goods exported. 6.5 The Philippines: Economic policies and liberalisation (a) Recent economic situation and policies Over the past four years, the Philippine economy has benefited from a decade of structural adjustment that has focused economic policies on trade liberalization and increased domestic competition, privatization, and greater private management and investment in infrastructure. Favorable investor reaction to these changes has induced significant increases in private investment and capital inflows contributing to higher growth. In 1996 economic growth accelerated to 6.9 per cent (GNP), year-end inflation fell, investment and saving rates rose driven primarily by the private sector, export growth was the highest among market economies in East Asia. While fiscal restraint was maintained, the trade deficit continued to rise to 13 per cent of GNP. Private capital inflows rose to nearly 10 per cent of GNP and worker remittances amounted to another 12 per cent of GNP in 1996, contributing to the continued strengthening of the Philippine peso in real terms and an acceleration in credit growth. The economic turnaround of the mid-1990s has contributed to improving social welfare although the incidence of poverty remains a major development issue, particularly in rural areas. About 3.5 million jobs were generated during 1993-96, reducing the unemployment rate to 8.6 per cent in 1996 from over 10 per cent in 1991-92. Functional

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literacy has risen to 88 per cent from 75 per cent in 1989. Life expectancy increased from 62.5 in 1992 to 69.5 in 1997. Over the same period, the infant mortality rate declined from 53.6 to 45.8 per cent 1,000 live births. Poverty rates declined from 40 per cent in 1996 to 36 per cent in 1994; the trend of other welfare indications since 1994 suggest a further subsequent decline in poverty, An integral element of the Philippines’ economic turnaround in the mid-1009s has been a parallel rise in trade and capital flows in proportion to the domestic economy. Faster integration into the global economy is the result of falling transport and communications costs increasing diversification of investment funds, as well as the substantial liberalization of trade and capital flows enacted by the Philippines. More rapid integration has brought with it greater opportunities for trade and investment, which have been instrumental in fostering greater competition within the domestic economy and contributing to a foreign direct investment (FDI)-led export boom within the electronics sector. At the same time, the volume and volatility of private capital flows have increased at a much faster pace than trade. Such flows have, hence, played an increasingly important role in real exchange rate determination and motivated the financial market turbulence in 1997. Financial Market Instability: Causes and Consequences The trigger for the shift in investor sentiment in early 1997 was Thailand’s intensifying crisis. The appreciating real exchange rate, rising trade deficit, rapid growth of private credit facilitated in large part through inter-mediation in foreign currency, associated buildup in real estate prices in Metro Manila, and the long-term consequences for the banking system of these trends were the major concerns prior to the exchange rate adjustment in July, 1997. The 29 percent depreciation of the peso since July 1997 the sharp increase in the level and volatility of interest rates, and the 40 per cent decline in equity prices in 1997 posed potentially severe problems for corporations. The risks in the current situation are aggravated by the prospect of grater fiscal, corporate and banking stress, slower economic growth and higher inflation and the adverse impact of these on investor confidence and external capital availability. Tight monetary policies were called for to adjust to the diminished demand for domestic assets, to limit the extent of exchange rate depreciation and increase in inflation, and to maintain the confidence of international creditors, exporters and overseas workers. The adjustment to the new market reality has been relatively rapid in the Philippines, and the financial policies enacted since the decision to allow a more market determined exchange rate have on balance been appropriate. Notwithstanding these concerns and conflicts, in a number of aspects the Philippines’ recent performance and attributes can be differentiated from the other countries in Southeast Asia affected by the regional currency crisis. For example:

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•

The period of significant foreign borrowing by the private sector and rapid credit growth was shorter in the Philippines relative to its neighbors. As a result, the ratio of private credit/GNP is more modest, large corporations appear less leveraged, and vacancy rates of vulnerable segments of the real estate market appear lower.

•

Export growth since 1995 has been the highest among market economies in the region.

•

Over the past decade, the Philippines has made significant progress in the areas of structural reform and deregulation, and has developed transparent approaches to the design of economic policy. (b) Private sector development strategy

Philippines encourages investments in sectors that provide significant employment opportunities, increase the productivity of resources, improve technical skills and strengthen inter-national competitiveness. Under the 1987 Omnibus Investments Code, a 60% - 40% equity rule prevails in favour of local enterprises. The Foreign Investment Act of 1991 allows 100% foreign equity in any business except those in the Negative List without any incentives. The Negative List restricts foreign participation to a maximum of 40% and prohibits foreign equity in areas mandated by the Constitution such as mass media, engineering and accountancy. In recent years, the Government has implemented reforms to further reduce barriers to investments and simplify regulatory and administrative procedures to encourage FDI. In particular, the New Foreign Investments Act, passed in July 1991, allows foreigners to invest up to 100 per cent equity in domestic enterprises, except in few areas included in the negative list. The government also allows the full and immediate repatriation and remittance privileges for all types of investments. The foreign investment policies provide the basic rights and guarantees for the protection of foreign investments such as repatriation of equity and profits; the right to foreign loans and contracts; freedom from expropriation of property; and non-requisition of investment. Foreign investments are treated equally as domestic investments, except in the areas listed in the Foreign Investment Negative List. The Bureau of Investment allows foreign investments with incentives to the extent of 40 per cent foreign ownership in priority sectors. Foreign equity participation up to 100 per cent is allowed in the “pioneer” status activities or where at least 70 per cent of total production is sold in the foreign markets. The Special Economic Zone act of 1995 created eco-zones or selected areas which are found in highly developed regional growth centres with adequate infrastructure, industrial capacity and availability of labour. These zones have the potential to be developed into industrial, tourist/recreational, agro-processing, commercial, banking, investment and

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financial centres. This includes the Subic Bay Freeport, Clark Special Economic Zone and three major EPZs with plans for expansion. Philippines liberalised recently its financial sector to promote more innovation in terms of products, services as well as technology. Since 1994, foreign banks have been allowed entry and further liberalisation of the sector is planned. Foreign banks are also allowed to establish subsidiaries and enter into joint ventures. The insurance, financing and securities industry is generally open to foreign firms. Recent policies are also being adopted to liberalise and deregulate the telecommunications, shipping and energy sectors. However, the media and retail trade remains closed under the negative list. Generally, all merchandise imports are freely allowed. However, the government prohibits the imports of some products for reasons of health, morality, balance of payments and national security. The Philippines likewise sets technical standards and regulations. In 1990 import tariffs ranged between 10 to 30% with four-tiered bands. In 1991, a more gradual tariff reduction was adopted with 95% of the tariff lines set in the range of 3% to 30% with four layers: 3%, 10%, 20% and 30%. Beginning 1996, the fourtiered tariff system was narrowed further to two tiers in preparation for a uniform tariff rate of 5% by 2004. The country is generally open. Its strong relationship with the US and the widespread use of English make Filipinos more open to foreigners. Philippines has a well-established judicial system, but enforcement is rather non-effective and lax. The constitution limits foreign ownership of property and so-called strategic industries. Foreigners need to obtain work permits and are required to train local counterparts. Foreigners may retain top management positions if the majority of capital stock is foreign-owned. But, the foreign nationals employed in supervisory, technical or advisory positions cannot comprise more than 5% of total workforce. The government also allows the full and immediate repatriation and remittance privileges for all types of investments. The foreign investment policies provide the basic rights and guarantees for the protection of foreign investments such as repatriation of equity and profits; the right to foreign loans and contracts; freedom from expropriation of property; and non-requisition of investment. Foreign investments are treated equally as domestic investments, except in the areas listed in the Foreign Investment Negative List. The package of incentives, which are competitive with those provided by other ASEAN countries, take the form of income tax holiday for four to eight years; duty free imports of capital goods and components, breeding stocks and genetic materials; provision of tax credits on capital goods bought locally and raw materials, supplies and semimanufactured products used in the manufacture of products and/or forming parts thereof for export; additional deduction for labour expense; exemption from the payment of contractor’s tax, warfare dues and any export tax. Additional incentives such as tax holiday for 6 years and exemption of major infrastructure costs and wages from the taxable income etc. are provided for projects

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located in less-developed areas as categorised by the National Economic Development Authority (NEDA). During 1981-1992 foregone revenue through the grant of fiscal incentives represented 0.64 percent of GDP. Foreign investment Manufacturing, services and financial institutions are the major sectors attracting FDI inflows to Philippines, while USA, Japan and Hong Kong have been the major sources of FDI. Asian countries accounted for 64 percent of FDI flows to Philippines in 1994. Foreign equity contribution to total equity ranged from 41% to 53% between 1986 and 1991, but the foreign equity share dropped to 26% in 1992. There is a high degree of correlation between foreign equity investments and technology transfer in the Philippines. Of the top 10 countries ranked according to size of foreign direct investments in the Philippines, seven are also the leading sources of technology imports: the United States, Japan, the Republic of Korea, the United Kingdom, the Netherlands, Australia and Singapore. The energy sector received the biggest cumulative foreign investments until 1995 due to the Government’s efforts to promote energy development. Of the many types of technology transfers, those which involved the actual transfer of know-how, trade-marks, and patents constituted two-thirds of collaboration contracts in 1986-1996. Majority of such technology is manufacturing-related. 6.6 Singapore: Economic policies and liberalisation (a) Current economic situation and policies Singapore's economy, which is very sensitive to developments in the world electronics market, experienced a slowdown in mid-1996, mainly on account of the decline in the global demand for computers and semiconductors which dampened manufacturing output and exports. The slowdown was helpful in reducing the positive output gap that had built up during 1993-95 as a result of the near double digit expansion posted in those years. Consumer price inflation, which had averaged about 2 per cent in Singapore over the previous decade, fell to a low of 1.4 per cent in 1996, and property price inflation, which had averaged 30 per cent annually during 1993-95, fell to 5 per cent in 1996, following measures introduced in May to curb speculative demand in the private residential housing market. The slowdown of mid-1996 proved short-lived, however, with activity picking up in the last quarter of the year and further in 1997 fueled by a rebound in the global electronics market and an easing of macroeconomic policies. As a result, for 1997 as a whole, growth increased to nearly 8 per cent while consumer price inflation picked up to 2 per cent. By contrast, property prices fell 12 percent in 1997, reflecting the impact of the May 1996 measures and additional policies introduced in April 1997 and August 1998 aimed at the resale market for public housing. The external account remained in very sizable surplus in 1997, and reserves, although falling in US$ terms in 1998, remained at about 7 months import cover at the end of the year.

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At end 1997, local financial institutions had capital ratios above the mandated 12 per cent level, and were fully provisioned for classified loans, which represented 2.3 per cent of global assets. Aggregate loan exposure of local banks to Malaysia, Indonesia, Thailand, Korea, and the Philippines constituted 16 per cent of total assets at end – 1997. The proportion of classified loans among the banks regional loans was 5.7 per cent. Exposure to the local property sector was also sizable, comprising about one third to total domestic bank lending. With regard to fiscal policy, which has a medium-term focus in Singapore, the primary operating surplus declined from 6 per cent of GDP in 1995/96 (April-March) to 4 per cent in 1996/97. Reflecting mainly sizable increases in development expenditures associated with a number of infrastructure projects. A further decline to about 3 per cent was targeted in 1997/98 budget A number of fiscal incentives to the financial sector (especially to boost activity for Asian Currency Units and fund management) were included in 1997 and 1998 budget. Monetary policy, which is the principal instrument of demand management and is centered on the exchange rate, was eased in response to the economic slowdown. As a result, rather than appreciating by about 3 per cent a year as it has for the past decade, the nominal effective exchange rate depreciated by about 1 per cent during 1997 the real effective exchange rate Laos depreciated slightly during 1997. In response to heightened regional currency instability since July, the authorities allowed the nominal effective value of the Singapore dollar to fluctuate within a wider range. In line with regional developments, the Singapore dollar experienced several bouts of downward pressure against the US dollar since mid-1997, resulting in a cumulative bilateral depreciation of 18 per cent through mid-August 1998. Singapore main stock market index declined by about 25 per cent over the same period. Over the years 1997 and 1998 Singapore had been faced with a number of economic challenges-including the slowdown in the electronics industry, a downturn in equity and property markets, and regional financial market turbulence but the authorities their economic policies successfully under difficult circumstances. Singapore’s strong fundamentals including its high saving rate large fiscal and external current account surpluses, flexible markets, robust reserve position, and high standard of regulation and supervision for domestic financial institutions had helped to shield its financial market from the regional turmoil and had allowed foreign investors to remain confident about Singapore’s short and medium term prospects. (b) Private sector development strategy Singapore is one of the most open economies in the region and allow foreign investments in almost all sectors of the economy. It is relatively open to foreign investment in banking and other related institutions, energy, services and trading firms. It has no limits on foreign investment except in public utilities, media, transport and telecommunications.

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The Singapore government initially introduced quotas for protection of infant industries like textiles, and used import licensing to regulate the trade of a limited range of goods (such as films, publications, live animals, food, ornamental fish, fresh or frozen meat, arms and explosives, medicines and drugs) for social or security reasons. Free trade zones which facilitate entrepot trade and promote the handling of transshipment cargo have been in operation since 1969. The country has presently six free trade zones. Tariff levels in Singapore are the lowest compared to its ASEAN neighbours with 70% of its tariff lines set between 0-10%. The government aims to reduce tariff bound rates for 2480 tariff lines under the Uruguay Round (UR) standard of 10% to 6.5% and bind additional 291 tariff lines at a maximum rate of 6.5% thus extending UR tariff binding coverage from 70% to 75% of all tariff lines. Legal system in Singapore is highly developed, fair and efficient. Singapore readily interacts with foreigners, encouraging multinationals to set up shops in the country. However, foreigners are required to obtain work permits, limited in duration, and restricted for certain categories. An important characteristic of foreign investment in Singapore, not shared by other ASEAN countries and Asian NIEs, is the overwhelming dominance of FDI over portfolio investments. More than 95% of net long-term capital inflows into Singapore is in the form of FDI which has been the driving force behind Singapore’s phenomenal growth over the last three decades. It brought capital, technology, management expertise and access to world markets. It transferred Singapore from a labour surplus economy to a labour tight economy. The foreign share of total investment in Singapore has been about 70 percent in manufacturing and more than 80% in services in recent years. Foreign investment is dominated by 100% foreign or majority foreign owned companies which account for more than 60 percent of the companies with foreign equity capital. The USA leads the foreign investors in both manufacturing and services, followed by Japan and Europe. While Japan’s share has increased over time and Europe’s share has declined. Foreign investment is highly export oriented, with 85% share in manufacturing exports. Singapore’s latest strategy has been to promote outward FDI aggressively to develop an external “wing” with strong linkages with the domestic economy. It has introduced various incentives schemes to encourage local companies to go abroad. The most popular destination for local companies has been Asia which had a share of about 65 percent of Singapore investment in 1994. 6.7 Taiwan, China: Economic reforms and liberalisation Taiwan has always followed a relatively liberal policy over the past 30 to 40 years. FDI up to 100% of total equity is welcome in most areas except for a restricted list and the prohibited list. Prohibited industries include those industries which violate good public morals, are highly polluting, and are legal monopolies or legally prohibited. Restricted industries include public utilities, banking and insurance, news media and publishing, and 80

other industries for which investment is restricted by law. There are equity caps on the restricted industries which vary from sector to sector. All FDI applications are submitted for approval to the Investment Commission (IC) which grants licenses to operate in Taiwan. Foreign companies enjoy the same incentives as the domestic companies of the same type. There is no restriction on the repatriation of profits. Equity is also repatriable at any time after completion of the project. There is no restriction on mergers and acquisition by foreign companies so long it does not violate the norms prescribed in the restricted list. There is no restriction on importing labour from other countries subject to grant of Visa. Taiwan companies are free to exit provided they compensate the labour according to a formula set by the government. The duty structure in Taiwan by and large confirms to OECD regulations and the average tariff rate is around 6% in nominal terms and 4.6% in real terms. Automobiles attract the highest duty rate of 35%. Raw materials, machinery, oil seeds and grains etc. attract zero duty. There is a 5% VAT imposed in Taiwan. Foreign companies are subject to a withholding tax of 15% and corporate tax at the rate of 20%. Companies in high tech areas or those with a lower investment can choose between 5 year tax holiday or a 20% investment allowance against their income tax. R&D or production equipment not produced in Taiwan is exempted from import tariffs. A 2-year depreciation is allowed for instruments and equipment for R&D quality inspection and energy conservation. Investment tax credits are given for investment in backward areas, procurement of at least NT$0.6 million worth of automated production equipment and pollution control equipment within a single year, an expenditure of NT$ 3 million or more on R&D and of NT $0.6 million or more on personnel training within a single year and for the promotion of the “Made in Taiwan” label. Preferential loans are given at reduced interest rates and longer repayment periods for the following purposes: upgrading, procurement of domestically produced automated machines and equipment, procurement of imported automated machinery and equipment, economic revitalisation programme, encouraging private participation in infrastructure projects, and re-accommodation of foreign exchange funds. Subsidies at the rate of 5060% of investment up to certain limits are given for the development of a new product, turnkey automation, product upgradation, improvement of the process technology, and for strategic technology applications. Over time, labour has become expensive thus causing Taiwan to turn towards modern technology-intensive industries. Traditional industries have shifted their production base to China, and are now looking at other markets like the ASEAN countries and India. Till now the Taiwanese concentrated on Trade as an Engine of Growth. 75% of their GDP originate from trade. Resigned to the fact that the Taiwanese will have to restrict themselves to that island and cannot return to the mainland, they are now investing in their infrastructure. Their aim is to convert the island into a science & technology island

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as well as a Asia Pacific regional operations centre for sea and air transport, manufacturing, financial services, telecom and media. During 1952-1994 Taiwan attracted $19.4 billion of FDI, around 86% of which was private foreign investment from the developed industrial countries. The balance of FDI came from oversees Chinese from different locations. Electronic and electrical products and chemicals were the dominant industries accounting for 38 percent of the cumulative FDI inflows. In recent years, Taiwan has liberalised its service sectors (including banking and insurance) which attracted 30 per cent of FDI in 1952-1994. Taiwan became a major foreign investor with cumulative outward FDI flows of $8.9 billion during 1952-1994. USA and Malaysia were major destinations accounting for 28 percent and 13 percent, respectively, of cumulative outward FDI. Taiwan’s overseas investment provides an empirical evidence of the investment life cycle theory, in which an investing country initially generates the capacity to export and then turns host to foreign investment aimed at jumping the protectionist barriers. Chemicals, electronics and electric products, and banking and insurance were the major sectors accounting for 43 percent of cumulative outward FDI in 1952-1994.

6.8 Thailand - Economic Reforms and Liberalisation (a) Recent economic situation and policies Thailand’s economy for decades characterized by rapid growth, has fallen into severe recession. In 1998, real GDP could contract significantly, more than in most of its neighbors. Only part of this decline can be considered cyclical many sectors face a prolonged downturn, while others will require considerable restructuring for a sustained recovery. The wealth effects of the economic crisis, through falls in asset prices and property values, have been particularly sever, and financial flows to many sectors have been interrupted New private investments and debt restructuring needed to recapitalize financial institutions and corporations, and to reduce the private debt overhang, Government also strengthened the social safety net to protect those suddenly displaced from employment, and to maintain the consensus for comprehensive reform. Though the recent recession has affected the whole economy, the most affected sectors are those which are predominantly domestically oriented such as automobiles, petrochemicals, and construction. The outlook is best in sectors with a relatively large internationally traded goods component (such as electronics), the food sector (which has benefited from a major improvement in the internal term of trade) and textiles. Though Thailand's economy has shown considerably wage flexibility during the recession, this has not been able to stem a marked increase in both unemployment and underemployment. The trends in the real economy have brought to the fore a range of poverty and social safety net issues. While there has been a considerable decline in Thailand poverty during

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the three decades of its rapid economic growth regional concentrations of poverty have persisted (in the North and Northeast), differences in educational achievement have contributed to income inequality remaining high, and the existence of only a rudimentary social safety net has left Thailand vulnerable to the Social cost of the present economic crisis government has undertaken the short term and medium term efforts with the help of World Bank, the Asian Development Bank, and other institutions to strengthen the safety net. The behavior of trade goods prices is shown to explain much of the recent increase in inflation, raising the index of wholesale prices by much more that the increase in consumer prices. Institutional factors have also played a part in the divergence between wholesale and consumer prices. There is a limited pass through about one third from the exchange rate to consumer price inflation. The recent widening of the fiscal deficit underlines the importance of maintaining the structural strength of Thailand’s fiscal position. Thailand is attempting to rationalise the tax structure by phasing out tax exemptions, extending the coverage of the value added tax VAT to include the financial sector, and further reducing its effective tariff rate structure toward that of its ASEN neighbors while improving customs administration. The Financial Institutions Development Fund (FIDF) which has been at the centre of the provision of liquidity and solvency support to Thailand’s financial system is also the agency change with honoring the comprehensive guarantee extended to depositors and creditors in the wake of the financial crisis of 1997. It sizeable lending operations (financed by short term borrowing form the overnight repurchase market), have contributed to the reluctance of the surplus banks to lend to the real economy. There are ongoing initiatives to better match the maturity structure of the FIDF lending and borrowing through the issuance of long term government bonds, while maintaining punitive interest rates for new borrowers from the FIDF. A number of conclusions can be drawn from the recent economic crisis of Thailand: •

The present recession is exceptionally severe by international standards, and unprecedented in Thailand’s recent economic experience.

•

By increasing real debt burdens and creating a credit crunch, Thailand's financial crisis has intensified the recession in the real economy.

•

Though the financial crisis has exacerbated Thailand’s economic problems, tensions in the real economy were present prior to 1996 devaluation.

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(b) Lessons from Thai economic crisis The unfolding Thai economic and financial crisis provides ample insight for emerging market economies. Over the past decade, Thailand recorded among the highest economic growth, investment and saving rates in the world, maintained inflation at close to OECD levels, consistently ran fiscal surpluses prior to 1997, and witnessed an export boom prior to 1996. Large current account deficits in the 1990s were readily financed by bank borrowing permitting substantial reserve accumulation through 1996, when gross reserve amounted to more than 6 months of imports. The practically fixed exchange rate against the dollar, coupled with higher domestic borrowing costs provided incentives for borrowing abroad to finance domestic investment. Thailand’s strong credit-worthiness ratings rendered foreign banks eager to supply such credit, although in recent years the nature of external financing had begun to shift toward short term loans and away from FDI. The easy availability of foreign credit fueled a credit boom, which in turn was increasingly channeled into consumption and the real estate sector, generating a boom in construction as well as property prices. When market sentiment began to shift in 1996 and the first half of 1997 the Thai authorities initially resisted allowing the currency to depreciate, primarily out of concern over the impact on the financial system heavy exposure to foreign exchange liabilities. Defending the exchange rate following the shift in sentiment required substantial use of reserves, a prolonged period of increased interest rates, and capital controls. Nevertheless, the authorities ultimately were forced to shift to a managed float exchange regime on July 2, 1997. In the meantime, the extended period of high interest rates and slowing economic activity had further weakened the financial system and adversely affected international creditworthiness, exacerbating the costs of the economic adjustment that followed the shift in exchange rate regime. Three lessons can be learnt from the boom-bust cycle in asset prices and the subsequent currency crisis leading to wider financial and economic crisis and its management: •

The costs to the Thai economy and financial system would have been less significant had Thailand permitted greater flexibility in the exchange rate with less delay, once it was clear that investor sentiment had fundamentally shifted.

•

Another lesson from the Tai crisis is that prudent fiscal policy does not suffice to ensure stability in the size of the current account deficit and the nature of its financing matter, even if these are entirely driven by private agents. Private agents generally respond to economic signals including the perception of official policy favoring a stable exchange rate.

•

Finally, lapses in supervision of the financial system can be extremely costly to the economy. As a corollary, efforts to upgrade the regulatory and supervisory infrastructure for the financial system can be a sound investment that can generate substantial payoffs in terms of economic benefits.

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(c) Private sector development strategy The Thai policy makers had always held the view that the government should play a limited role in the economy and the private sector should be the engine of growth. Thailand’s public enterprise sector is small and more profitable than in many developing countries. Over time, public sector activity shifted away from direct involvement in industrial production toward the provision of public infrastructure and services. This, together with the pro-business orientation in tax laws and industrial policy, has served to create a dynamic private sector. The Thai financial system at the beginning of the 1970s was, similar to that in many developing countries. The financial system was dominated by a small number of commercial banks with a high degree of concentration of ownership and a limited role by the foreign banks. Lending and deposits were subject to ceilings, selective credit programmes were used to allocate credit to priority sectors and the market for long-term capital was not well developed. Banks were required to hold a proportion of their deposits in the form of government securities, but interest rates paid on government debt were positive in real terms. In 1990 interest rate ceilings were lifted on a wide range of deposits. Banks were allowed to offer foreign currency deposit accounts and capital outflows were liberalised. Further liberalisation in 1992 eliminated ceilings on lending rates. The spread between deposit and lending rates in Thailand, which averaged 6.5 percentage points during 1980s compared to 1-2 percentage points in Malaysia and Korea, 3-4 points in Indonesia and Singapore, and 5-6 points in Sri Lanka and the Philippines, narrowed significantly since the early 1990s. Thailand’s adjustment experience since 1980 has, in general, been impressive. Despite having been subject to adverse external shocks in the late 1970s and early 1980s, Thailand, unlike many developing countries, did not experience a major “investment pause”. Since 1986-87, Thailand experienced an unprecedented economic boom led by a surge in private investment and manufactured exports. Factors that contributed to this rapid growth include a sustained improvement in external competitiveness, a relatively high degree of labour mobility, lower labour costs relative to its trading partners, the elimination of export taxes and the introduction of other incentives aimed at export promotion and providing a favourable environment for private investors. The fiscal consolidation since the mid-1980s also resulted in substantial surpluses and made it possible to accommodate the surge in capital inflows and the investment boom without high inflation or a real appreciation of the baht. Thailand prefers foreign investments in activities that are labour-intensive, exportoriented, raw material-intensive, and import substituting. It also encourages investment for construction, infrastructure, R&D services, agro-industries, and telecommunications. The Alien Business Law of 1972 allows foreign participation in certain enterprises provided that Thai ownership is more than 50%. Presently the Law is under revision to further liberalise trade and industry. Currently, any firm that exports at least 80% of its

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production may be completely foreign owned, although full ownership may be negotiated on a case by case basis for lower levels of export obligations. For projects in agriculture, fishery, mining and services, foreign investors may hold majority or all shares if capital investment is over 1M Baht. However, Thai nationals must acquire at least 51% control within 5 years of operation. Foreign equity participation cannot exceed 49% in manufacturing projects for the domestic market, although majority foreign ownership is allowed for enterprises that export at least 50% of its total sales. Thailand has a Negative List of areas closed to foreign investments. The Thai government has divided the country into 3 zones for the purpose of decentralisation. Zone 3 or the Investment Promotion Zone allows full foreign ownership for manufacturing. Thailand plans to transform its economy into a strong regional financial centre by 2000 and has recently allowed more foreign banks to set up branches in the country. The Thai Government uses import licensing mainly for protection of infant industries. There are local content rules on dairy products, tea and motor vehicles as a way of aiding local producers. The government also regulates imports to meet certain technical regulations and standards for health and safety reasons. Around 100 product categories are subjected to import licensing and about one-fourth of these are agricultural commodities such as rice and sugar. Industrial products covered by import licensing include certain textile products, machinery items, motor vehicles, motorcycles, paper products, chemicals, porcelain items and building stones. The Thai economy has traditionally been outward-oriented and at the same time there was a fair degree of government intervention in the trade system. The main instrument of intervention has been tariffs. The system of protection was biased against the agricultural sector, agro-based and labour intensive products and favourable towards capital-intensive and import substituting industries such as automobiles and pharmaceuticals. The labourintensive textile industry was also heavily protected. After a period of heavy protectionism in the late 1980s when relatively high tariff rates were adopted, Thailand has recently embarked on a tariff reduction programme in compliance with its commitment under AFTA. Tariffs on fast-track products will be reduced from 25% to 0- 5% by 2000. Normal-track tariffs are subject to 30% taxation. In the case of 3908 items, which now attract rates up to 100%, tariffs will be reduced to 30% or less. Thailand is a relatively open society and does not vigorously oppose foreign influence. Although it has an independent judiciary system, enforcement is rather arbitrary and lax. Foreign employment is subject to the Alien Occupation Law which requires all aliens to obtain work permits. In Thailand, roughly one half of tax revenue is generated by consumption taxes (VAT), one third by income taxes, and the remainder by taxes on international trade. These main sources of revenue account for more than 95 per cent of tax revenue. Non-tax revenues are relatively minor (about 2 per cent of GDP) and consist mainly of receipts from profit remittances from the Bank of Thailand and state enterprises.

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The Thai tax system has gradually evolved toward a relatively greater reliance on consumption and personal income taxes. In contrast, the reliance on taxes on international trade has been significantly reduced. The reduction in trade taxes was due to a gradual reduction in tariff levels, based on Thailand’s obligations under the ASEAN agreements. Although the nominal tariff rates for Thailand have come down from 11 per cent in 1990 to 7 per cent in 1995, the effective rate is still higher than that in other East Asian countries except for Philippines (Table-6.1). Besides standard exemption, exemptions exist for agriculture and financial services. While the agricultural sector entirely escapes the tax net, financial services are subject to a Specific Business Tax which is levied at 3.3 per cent on gross interest receipts, before any deduction of expenses. An invoice credit based value added tax was introduced in Thailand on January 1, 1992, replacing the Business Tax initially levied at 7 per cent, the rate was increased to 10 per cent in August 1997. Exports are zero rated, and exemptions exist for books, education, hospitals and other socially sensitive goods. Small businesses under the threshold turnover of B 600.000 are not expected to pay VAT, but are subject to a small business tax of 1.5 per cent of turnover. Business between B 600.000 - B1,200,000 may choose between the VAT and the small business tax. The specific business tax provides incentives for domestic banks to adjust their assets towards equity holdings and away from loans, as the return on stocks escapes taxation under the specific business tax. In addition, offshore banks not only pay a lower corporate income tax rate but are also exempt from the specific business tax, generating additional incentives to borrow in foreign exchange rather than in domestic currency. Thailand allows free repatriation of profits and capital. Fiscal incentives include tax holiday for 3-8 years depending upon zone, exemption or 50 percent reduction of import duties and business taxes on imported machinery, reduction of import duties and business taxes of up to 90 per cent on imported raw materials and components; and additional incentives for investments in outlying areas and export firms.

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CHAPTER-7 REGIONAL INTEGRATION AND ECONOMIC COOPERATION

7.1 Regional economic cooperation in Asia Regional economic cooperation facilitates the free flow of goods, services, capital and labor across national boundaries and acts as an effective instrument for securing efficiency in the use of resources and thereby enhancing growth of all member countries. Intraregional capital flows, particularly FDI, have grown very rapidly over the past decade. They also entailed an increasing flow of technology associated with individual projects and embodied in the flow of capital equipment and intermediate inputs arising from projects. Japan and the NIEs are the source of much of this intraregional FDI. (a) ASEAN Experience ASEAN covering most of the Southeast Asian economies, has evolved a comprehensive regional trading arrangement, the ASEAN Free Trade Area, with an explicit time table for eliminating tariffs within the group by the year 2003 and for introducing its Common Effective Preferential Tariff (CEPT). Members have agreed to eliminate quantitative restrictions and nontariff barriers on trade in products in the CEPT, to cooperate in some areas of service trade and to explore cooperation in some non-border issues such as harmonisation of standards, reciprocal recognition of tests and certification of products, and removal of barriers to FDI. An important feature of this Agreement is the intent to free the movement of capital and to increase investment, industrial linkages and complementation among members. As regards industrial cooperation, some positive results have been achieved in the ASEAN Brand-to-Brand complementation (BBC) in the automotive industry, which envisage manufacturing different components of a vehicle in different countries. ASEAN Industrial Cooperation (AICO) Scheme is the latest industrial cooperation program in the ASEAN, under which two participating companies from two different ASEAN countries should involve not only in the physical movements of goods but also in resource sharing and industrial complementation. Outputs of these companies enjoy a preferential tariff rate in the range of 0-5%. To promote and protect intra-ASEAN investment, the ASEAN countries since 1976 have an Agreement providing most-favoured nation treatment to intra-ASEAN investment. Other important ASEAN integration efforts related to their efforts towards joint resource mobilisation and intra-ASEAN infrastructures. For example, the “ASEAN Minerals Cooperation Plan” was designed to develop downstream industries. Similarly, different ASEAN subsectoral programmes in energy cooperation promoted efficient use of coal in the subregion. The gas pipeline projects across the member States also proved useful for the subregion.

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(b) SAARC Experience South Asian Association for regional Cooperation (SAARC) was established in 1985 and is the counterpart of ASEAN for the South Asian countries comprising India, Bangladesh, Bhutan, Maldives, Nepal, Pakistan and Sri Lanka. ASEAN is far more open than SAARC due to long-followed policies of export promotion and foreign investment. FDI inflows into ASEAN have been far more significant and instrumental in raising the industrial linkages and complementarities in the region. SAARC, on the other hand, has so far made little contribution to either regionalism or globalisation. Only recently SAARC has included activities on trade and investment as a part of its regional cooperation. There is, however, hope that as a first step SAARC members, having agreed on a free trade area, will promote regional trade cooperation as a building block towards globalisation. For its success, SAARC will need to agree on a clear policy towards foreign investment as a vehicle of technology upgradation and overall growth. While there are only two formal regional trading arrangements in Asia - ASEAN Free Trade Area (AFTA) and SAARC Preferential trading Arrangements (SAPTA), there are various economic cooperation of a more informal nature among countries in the region. These sub-regional economic zones (SREZs) are popularly referred to as growth triangles, growth polygons, or simply growth areas. The main focus of the SREZs is on the transnational movement of capital, labour, technology, and information and on the inter-country provision of infrastructure rather than on trade in goods and services. India, Thailand, Bangladesh and Sri Lanka, having a coastline on the Bay of Bengal, have formed a regional trade group on June 6, 1997, called the Bangladesh, India, Sri Lanka, Thailand Economic Cooperation (BIST-EC). Trade between these countries currently totals only $1 billion and is expected to improve substantially in the next decade due to predicted economic boom in South Asian economies. Attempts are also being made to form a sub-regional economic group through the Bangladesh, Bhutan, Nepal and India “growth quadrangle” (BBNI-GQ). (c) APEC Experience The most comprehensive form of multi-government cooperation in terms of both countries and the scope of issues addressed is the Asia Pacific Economic Cooperation (APEC). This organisation was established in 1989 and currently has 18 member countries in Asia and the Pacific including the Unites States. The APEC forum is of special significance, as it is not founded on a formal agreement in accordance with the GATT. The member countries have agreed by consensus on a program of action to achieve a state of “free and open trade and investment” by the year 2010 for industrial country members and 2020 for developing country members. Many of the members have already made significant unilateral tariff reductions before the target date. There is an agreement on a set of APEC Nonbinding Investment Principles for investment flows in the region. These are intended to reduce restrictions on the international flow of portfolio investments.

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(d) ESCAP Experience From its inception ESCAP has promoted economic co-operation in the Asian and Pacific region. ESCAP conceived the integrated communications infrastructure for the Asia and promoted regional cooperation in shipping, ports and technology transfer. Financial and developmental institutions like the Asian Development Bank, Asian Clearing House, The Asian and Pacific Centre for the Transfer of Technology, the Asian Reinsurance Corporation etc. were established at the initiative of ESCAP in order to promote economic co-operation in Asia. Increasing levels of intraregional trade and investment are gradually shaping a truly interdependent regional economy in the Asia-Pacific region, based on the linkages of production structure and regional division of labour. They succeeded significantly in utilising the technological revolution to enhance their national comparative and competitive advantages. First, Japan and then the advanced countries of the region have become critical growth centres supplying foreign investment and technology to other economies of the region. Although regional economic cooperation in ESCAP is being worked out at various levels, actual progress is limited due to a number of reasons: (a) All the subregional groups except ASEAN and the South Pacific Forum are about a decade old and it takes much time to build up confidence and trust among the members. (b) Asian regional groupings are only intercountry institutions and donot have supernational powers like the EC. (c) There is hardly any linkage or dialogue among the regional or subregional groups. The opportunities for regional cooperation in the endogenous technological capabilitybuilding of ESCAP member countries are enormous. While advanced developing countries such as the NIEs have adequate domestic resources to attract technology and capital and to expand their technological capacity, a number of developing countries in the region (LDCs, island developing countries and disadvantaged traditional economies) remain outside the mainstream of economic development primarily because of poor, inappropriate or unfavourable local conditions in terms of skills, market size, technological and physical infrastructure. (e) Multilateral Agreement on Investment (MAI) The vigorous growth of bilateral and regional investment agreements, the inclusion of certain FDI-related issues in the Uruguay Round agreements and the beginning of negotiations on a Multilateral Agreement on Investment in the OECD clearly indicate that both the developed and developing countries are moving towards liberalised trade and investment regime. At the regional level, the mix of investment issues covered is broader than that found at the bilateral level, and the operational approaches to deal with them are less uniform. Most regional instruments are legally binding. Issues typically dealt with at the regional level include the liberalisation of investment measures; standards of treatment; protection

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of investments and disputes settlement; and issues related to the conduct of foreign investors (e.g. illicit payments, restrictive business practices, disclosure of information, environmental protection, and labour relations). At the multilateral level, most agreements relate to sectoral or to specific issues. Particularly important among them are services, performance requirements, intellectual property rights, insurance, settlement of disputes, employment and labour relations, restrictive business practices, competition policy, incentives and consumer protection. It is at the multilateral level that concern for development is most apparent. This is particularly so in the case of the GATS, TRIPS and TRIMs agreements, as well as the (non-binding) Restrictive Business Practices Set, where special provisions are made that explicitly recognise the needs of developing countries. 7.2 Strengthening regional cooperation in Africa Developing countries in both Asia and Africa are going through a phase of economic liberalisation which provides a solid foundation for the success of intra- and interregional cooperation. They need to make greater efforts to create a more liberal trading and investment environment for reduction of wide disparities in the levels of income and market size, and to have cost-sharing and distribution of benefits. The economic exchange and cooperation among the economies can be strengthened by the following measures: •

At the regional level, host countries can increase their locational attraction for foreign investment if closer linkages are established with neighbouring countries in order to generate larger markets and complementary locational advantages.

•

Since almost all countries in the region are trying to attract foreign direct investment, a lot of competitive overbidding and unnecessary loss of resources could be avoided through some harmonization of policies of different economies at national, bilateral, regional and global levels.

•

Instead of competing for foreign capital, the countries should undertake appropriate policy reforms which will not only encourage more savings and investment internally but also help the return of flight capital to the region.

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At the regional level, countries should cooperate with one another to modernise their financial systems to cope with the increase in trade and cross-border capital flows.

•

Another aspect of regional cooperation that is of growing importance is the sharing of information. Regional cooperation can reduce the transaction costs of gathering information can reduce the research and development costs. The sheer magnitude for investment required for technological R&D needs subregional pooling of limited resources (financial, physical and human) to obtain the best possible leverage.

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•

National governments as well as regional trade, industry and business organisations must facilitate contacts, cooperation and mutually business relations among enterprises and entrepreneurs for building up internal strength of industries.

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It may be desirable to establish a regional investment guarantee facility. A major problem in attracting investment funds to the developing countries is the perceived risk of confiscation, civil strife, and political turmoil.

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For the least developed countries, which lack the capacity to undertake comprehensive efforts for development of local capacity, there is an urgent need for more active support by the donor community in such areas as strengthening the private sector and local entrepreneurship, building institutional capacity, improving physical infrastructure and enhancing human resource development.

•

At a broader level, the African Development Bank (AFDB), can play a complementary role in enhancing regional cooperation to attract more private capital into the African region. AFDB can also expand its catalytic role in private sector financing and augment its resources for infrastructure development.

•

Other multilateral financial institutions will also have to strengthen their catalytic role through co-financing and guarantee with a view to encouraging participation of private capital in the development process, particularly in Africa.

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CHAPTER 8

LESSONS FOR AFRICA

8.1 Basis of comparison between Asia and Africa This chapter deals with the following questions: • •

What can the African countries learn from the experience of East Asia, and To what extent is this experience relevant for Africa and other developing countries?

Some would say that there is no basis for a comparison or drawing lessons, given the relative levels of development of the two regions. Indeed, for African countries now faced with the challenge of reversing their economic deterioration and accelerating growth, Asia’s dominant position in the 1990s may appear somewhat discouraging in terms of inherent opportunities. However, the economic situation in some of the Asian economies in 1965 was not significantly different from that in Africa in 1990. In 1965, Asia’s economic structure in terms of the shares of agriculture, manufacturing, investment and exports in GDP, and the proportion of population in urban areas were almost similar to that found in Africa today (Table-8.1). Economic conditions in the postwar era did not necessarily favour Asia, where poverty and population pressures were mounting, and governments seemed unstable. Africa, although behind in stocks of human capital, was much less densely populated, had a five times greater ratio of agricultural land per worker than Asia, and held great promise in the immediate post-colonial period. A more important point is that as in the case of the successful East Asian economies, the countries of SSA reflect diverse economic situations. One needs to distinguish between two groups of countries so as to focus on practical guidelines for African policymakers. One group of countries may gain most from the “basic” policies that seem to have promoted resource allocation and mobilisation in the high performing East Asian countries. The other group consists of countries that are reasonably advanced in their basic reform efforts and are now able to deploy a broader range of instruments that have yielded substantive results elsewhere. Economic stability is yet to be achieved in many SSA countries, and future efforts need to be concentrated on the set of basic stabilisation policies and macroeconomic reforms. For the leading countries of SSA, however, there is a need for closer examination of policies, instruments, and institutions that have promoted rapid manufacturing and export growth in the East Asian high performers. East Asia, although referred to as a single group, does not present a uniform model of success. The histories, size of the economies, and resource endowments of these countries are quite diverse, and economic approaches within the group show considerable variation over time. The three Southeast Asian countries (SE) – Indonesia, Malaysia and Thailandwith their rich natural resources of productive farmland, forests and minerals, and the weaker human capital base of three decades ago, have much in common with Africa

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today. Natural resources and primary exports played a pivotal role in industrialisation in these countries. East Asian countries are generally homogeneous in ethnic composition, and relatively stable in political terms. Southeast Asian economies, in contrast, had to cope with the problems raised by ethnic diversity and significant political instability. Consequently, for African countries faced with increasing pressures to efficiently diversify production and exports, Southeast Asia presents a much more relevant model than East Asia. Similarly the experiences of the large East Asian countries – Japan and Korea – may be less relevant. The small East Asian economies – the city-states of Hong Kong and Singapore – are insecure islands, with physical endowments and economic structures quite different from those found in Africa. These countries had rich stocks of human capital in the early stages of development, but lacked natural resources and an agricultural base. The lessons for Africa from Hong Kong and Singapore seem relevant only for Mauritius, which is also an island state. 8.2 Macroeconomic policies The five pillars of macroeconomic stability in the East Asian economies were pro-savings policies, maintenance of sustainable fiscal positions; investment on human capital and physical infrastructure, greater outward orientation; and rapid corrective responses to macroeconomic dis-equilibriam situations. Clearly, these pillars are mutually reinforcing. (a) Pro-Savings Policies The keys to accelerated growth are much higher investments and domestic savings, combined with systematic structural reforms – necessary to maintain macroeconomic stability and significantly improve productivity. The slow-growing economies need to raise their savings and investment rates from the current 12-16 percent of GDP to at least 20-25 percent – levels already achieved or exceeded by India, Kenya, and Zimbabwe. Initially most of the change will have to come from reducing government dissaving – since the private sector usually responds slowly to sustained reform. Almost all low-income countries need urgently to reduce the budgetary drain of public enterprises and to put their physical – and human resources to more efficient use. Major changes will thus have to be made in the size and structure of government revenues and expenditures. Raising revenues calls for measures to broaden the tax base – by simplifying tax regimes, abolishing exemptions, reducing the discretionary authority of tax and customs administrators, and improving collection capacity. But the biggest impact will come from reducing the budget outlays on public enterprises and stopping at the leakage from the banking system, which eat up most domestic savings in many African countries.

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(b) Sustainable Fiscal Positions Developing an absolute standard for the appropriate size of a fiscal deficit is impractical. The sum of taxation, seigniorage transfers, and domestic borrowing by the government of the East Asian economies has been a significantly larger proportion of output than among most SSA countries. However, the sustainability of a fiscal position was a key determinant of macroeconomic stability in East Asia. The evidence of both central government and public sector budget deficits in the East Asian economies shows that, except for brief period when budget deficits became excessively large, they were generally managed at sustainable levels. Several practical guidelines may be developed for SSA countries: •

First, the external debt problem (and increasingly domestic debt in many countries) looms larger in SSA macroeconomic policy-making than elsewhere among developing countries. It is, therefore, desirable that in the first instance, rating the sustainability of a particular fiscal position should begin with the use of simple, but robust, measures developed in the context of the debt dynamics models.

•

Second, given the low level of private savings, there is a need for greater attention being paid to government savings. A critical factor in achieving macroeconomic stability in East Asia has been the early focus on improved revenue effort and, perhaps more important, curbs on government consumption. Several East Asian economies ran budget surpluses for long periods.

•

Third,. continuous attention to the sources of deficit financing is justified. In addition to evaluation of the inflationary consequences of alternative forms of financing, it is useful to measure the total “take” of the government from the general resource pool. Evidence from Latin America suggests that too large a “capture” by the government may have a severe effect on both savings and investment by the private sector.

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(c ) Greater outward orientation

Rapid export growth provided the foundation for industrialisation in East and Southeast Asia.. While primary exports played a prominent role in the 1960s and 1970s in Indonesia, Malaysia and Thailand, the share of manufactured exports in total exports rose from 6 percent or less in 1965 to 41 percent, 61 percent and 77 percent respectively in 1992 in these countries. On contrary, the manufacturing share of exports in Africa increased marginally from 7 percent in 1965 to only 8 percent in 1990. During the 1960s, export volumes from Africa grew on average by 6 percent a year. Since 1973, Africa’s total export volume (including that of oil exporters) has declined by about 0.7 percent a year. Agricultural exports, which had grown at 2 percent a year during the 1960s, declined in the 1970s through mid-1980s. African exporters have failed even to maintain their world market shares in the commodities in which they had a comparative advantage. In cocoa, coffee, rubber, spices, topioca and vegetables, African countries

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have lost their world market shares to Indonesia, Malaysia and Thailand. The structure of Africa’s exports has remained largely unchanged since the early 1960s, with a heavy reliance on primary commodities, including oil. These accounted for 83 percent of merchandise exports in 1970 and 76 percent in 1992. Africa’s economic decline is frequently attributed to external factors, mainly unfavourable terms of trade. During 1980-1985, Africa’s terms of trade showed a declining trend but remained higher than that in the 1960s. Overall, the Africa region has experienced a positive income effect of terms of trade changes since 1961, although there was variation in export price trends in various countries. As yet, just one of the three lessons (trade liberalisation, manufactured export promotion, and openness to foreign technology and investment) from the outward orientation of the East Asian successes has been internalised in terms of practical guidelines for policymakers in SSA countries. The pattern of trade liberalisation adopted by several SSA reformers is similar to that of East Asia. It is marked by gradualism, even in the removal of non-tariff barriers, although it could be argued that many import regimes in SSA continue to be less transparent than elsewhere. In terms of policy, one of the most significant lessons from the second generation East Asian successes for trade liberalisation in African economies is the need to abolish import licensing and enhance currency convertibility on the current account of the balance of payments. A vast body of evidence from surveys of private firms in SSA indicates that access to import licenses and foreign exchange are critical constraints on production and investment. In a few instances, East Asian style manufactured export promotion efforts have been initiated in the SSA countries. In several countries – for example, Kenya, Ghana and Zimbabwe– programmes have begun to provide free trade status to exporters, preshipment financing, and firm level assistance on technology and market penetration. Such policies have been supported by changes in the incentive regime, chiefly the real exchange rate. However, most efforts are still relatively uncoordinated, lacking the single-mindedness with which the export push was pursued in the East Asian successes. Despite policy pronouncements to liberalise foreign investment and technology acquisition, there continues to be an aversion in most SSA countries to direct foreign investment. This attitude, rather than lack of investor interest, may be the first order of problem that needs to be tackled. African nations appear to attach relatively greater emphasis on investment codes and regulatory mechanisms than on investment promotion. The greater need among most SSA countries is to increase the total volume of foreign investment. This is achieved best through an integrated programme of macroeconomic and structural policy measures, as in the East Asian economies.

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(d) Investment on human capital development In nearly all the East Asian high performers, the growth and transformation of educational and training systems during the past three decades has been dramatic. The quantity and quality of schooling and training in the home improved simultaneously. However, higher shares of national income devoted to education cannot fully explain the larger accumulation of human capital in the high-performing Asian economies. In both 1960 and 1989, public expenditures on education as a percentage of GNP was not much higher in East Asia than elsewhere. In 1960, the share was 2.2 percent for all developing countries, 2.4 percent for Sub-Saharan Africa, and 2.5 percent for East Asia. During the three decades that followed, governments in other arraigns as well as in East Asia increased the share of national output they invested in formal education. In fact, SubSaharan Africa’s share of 4.1 percent was higher than East Asian’s 3.7 percent, and the rest of the developing world’s 3.6 percent. High-income growth, early demographic transitions, and more equal income distribution were all enabling factors. However, the decision factor in East Asia’s success was the allocation of public expenditure between basic and higher education. East Asia consistently allocated a higher share of public expenditure on education to basic education than elsewhere. (e) Selective state interventions The success of East Asia has been erroneously attributed to the selective strategic interventions that were undertaken by them to speed industralisation. All SSA countries are characterised by long periods of extensive intervention, with a significantly wider ambit than in any of the Asian successes. Such interventions have been justified by a multiplicity of goals – changes in ownership, correction of rural-urban imbalance, food security, and rapid industrialisation. Although public policy is expected to serve a number of goals simultaneously, it is unclear whether an adequate distinction was made to match instruments to objectives, nor is evident that the “rules of the game” were transparent and arbitrated impartially. Most economies followed often-contradictory policies and programmes, each offering high rents to selected segments of their populations. There is need for greater clarity of objectives, and a fuller understanding of the effects of particular instruments on specific and economy-wide outcomes. 8.3 Role of Private Sector In terms of the role of the private sector, East Asian governments have explicitly taken the attitude that what is good for the private sector is also good for them (in terms of taxes, public welfare, economic growth etc.). Therefore, the role of the state with respect to the private sector is to do everything necessary to ensure the sector’s success, and to work with the representatives of the private sector to design government policies accordingly. In terms of export development strategy, it is not simply a question of reluctantly removing barriers to trade, or grudgingly handing over tax rebates. The East Asian countries put the development of exports as the central economic strategy, in the belief that this would be the source of economic success in other spheres.

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East Asian governments developed a long-term vision for their economies and societies and set out with determination to design and implement policies to realise this vision. It is a lack of this sort of vision and commitment that has contributed to Africa’s lack of development success. The greater commitment to development of many African governments that have come to power in recent times – in Malawi, Ghana, Cote d’Ivoire, Zambia and Benin to name a few – lends hope that such a vision can now be developed. (a) Private sector development strategy Though pivotal, private sector development must be a part of an overall strategy for sustainable development that embraces such other elements as health, education, infrastructure, and environmental protection. For private sector development to promote accelerated growth, progress on the macroeconomic front has to be buttressed with structural and institutional reforms to: • • • •

Improve business environments that remain harsh. Reduce the drain of public enterprises Build robust financial systems. Increase the supply and quality of human resources and physical infrastructure.

Specifically, the strategy requires those low-income countries: •

Must sustain sound macroeconomic management to avoid the stop-go policies that have undermined private sector confidence.

•

Must establish a more favourable business environment to promote competition and reduce risk and the high cost of doing business, which have especially stunted the growth of firms in the informal sector and small and medium-size enterprises. This means pressing ahead on an array of policy, legal, regulatory, and institutional reforms in partnership with business and labour.

•

Go farther and faster on public sector reform by privatising the utilities and the largest enterprises, and by liquidating major loss-making enterprises.

•

Accelerate financial reform by restructuring and privatising banks, allowing private entry, strengthening prudential norms for capital adequacy, regulation and supervision, and developing basic financial infrastructure to service a broad segment of the population.

Many low- and middle-income countries have implemented elements of the complex mosaic of private sector development. And the private sector response has been impressive. But even in countries with well-established institutions and legal systems – and the human resources to translate commitment into action – systemic reform has been a long process (often exceeding 15-20 years) subject to reversal and fragility. Moreover,

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the poorest countries lack many of the prerequisites – and have little latitude for error. The challenges are particularly daunting in Africa, where the environment for entrepreneurs is highly uncertain, markets are smaller, skills are shallower, the supporting infrastructure is weaker, and the legal and regulatory environment very restricting. The poorest countries thus still need assistance from multilateral and bilateral sources in designing and implementing their reform programmes. Low-income countries are also adapting elements of the reform agenda to their cultural, social, political, economic, and institutional conditions. The lessons from the experience of the East Asian countries can contribute significantly to the learning process. But the task of reform is not purely technical. A broad consensus for reform and full government support of this difficult long-term agenda is essential for success. And when governments do adopt comprehensive and consistent reforms, donors must be ready to step in, in a coordinated way, with the necessary support to sustain their implementation. The economies which strive to grow rapidly through a medium of private sector have to maintain macroeconomic balances as indicated by sustainable balance of payments deficit, minimization of external debt- overhang, declining fiscal deficit and reasonably stable inflation rates. In absence of this, a stab at regulatory reforms would not only not yield optimal results but would in fact weaken the economic system. Real incentives for the private sector are generated from a stable economic situation which assures growing markets, scope for enterprise, and innate urge for seeking profit opportunities and these incentives are stronger than the disincentives stemming from regulatory system per se. It is necessary that the governments refrain from changing the direction of their reform policies once they are set in motion. If the authorities consider that economic fundamentals are such that they make reversal unavoidable, they should, from the start, introduce reforms in discrete steps so that they would stay put even if economic situation changes for worse. (b) Privatisation programmes and strategy The efforts of many developing countries at public sector reforms without complete privatization of non-core public enterprises rarely produced the desired results. Many of them turned to partial privatization, but almost none has divested an economically significant portion of its public enterprise sector. Yet, in the few instances where large private investors have been attracted (in power and telecommunications in India and Pakistan, for example), there has been significant impact on macro-economic aggregates. Stronger actions are needed to reform public enterprises and faster and deeper programmes of privatization – to produce macroeconomic improvement through major reductions in fiscal deficits and general improvements in business conditions. Simultaneous action is needed on both fronts – public enterprise reform and privatization are not “either-or” propositions.

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Countries succeeding in this process have avoided investments in the public sector that could better be handled by the private sector – and imposed a hard budget constraint on the remaining public enterprises. Experience reveals that the way forward is to: •

Sell public enterprises producing tradables and operating in competitive markets. If they cannot be sold, they should be liquidated. Prime candidates are the largest public enterprises having adverse impacts on the budget and the economy – the loss making banks and financial institutions, the large manufacturing enterprises, the marketing boards, and the procurement, refining, and distribution of petroleum products. Even where proceeds might be modest, as in much of Africa, ending the financial drain can generate substantial public savings.

•

Involve the private sector in the commercialization, management, financing, and as much as possible in the ownership of infrastructure – as in China, India, and Pakistan.

•

Divestiture is neither a panacea nor an end in itself. But, it is a powerful tool that not only brings better performance at the firm level, but also helps repatriate flight capital, attract foreign direct investment, and broadens and deepens access to international capital markets.

•

These positive macroeconomic effects are enhanced when privatization’s proceeds are devoted to retire the high-cost government debt that is crowding out the private sector and increasing real interest rates.

•

Infrastructure utilities are attractive candidates for divestiture. The financial, economic, and psychological impact of increased private involvement is generally large. The need for improved services is incontestable – consumers always applaud increases in the quality or reliability of services, and investors are willing to act.

•

Moreover, privatising infrastructure services facing growing demand such as telecommunications or power typically results in little loss of employment. And efficiency still rises because of increased investment and proper pricing. (c ) Private-Public sector partnership

Cooperation and close collaboration between business and government has been one of the hallmarks of the East Asia’s success in industrialisation. Formal institutions, called deliberation councils, have facilitated the policymaking process in Japan, Korea, Malaysia, Singapore, and Thailand. These councils generally consist of high-ranking government officials, representatives of the business community, academia, consumer groups and labour. A council serves as a forum through which government officials and private sector groups can interact repeatedly in the formulation of policies. It creates a basis for nurturing trust and for developing cooperative relations. Making a council system work has several requisites: 100

• • • •

First, the government must have a reasonably competent economic bureaucracy. Second, there should be participation of equally competent individuals from the private sector who have the requisite skills to run a business enterprise. Third, it is important for the (current) political regime to have some reasonable degree of longevity. Finally, for cooperation to emerge, there has to be a minimum level of mutual trust and confidence between the government and the private sector.

Given these requisites, full-blown East Asian type government-business partnership may not be feasible immediately in Sub-Saharan Africa, but steps can be taken to move in this direction. Joint Councils may be created and charged with initially more straightforward tasks such as FDI promotion strategies, legal and institutional set-up etc. before moving on to more complex and sector specific strategies or more sensitive issues such as privatisation and tariff reforms. This requires a careful approach to terms of references and selection of council members, but a modest attempt seems preferable either to a “hands-off” approach or to the present condition of mistrust. (d) Development of infrastructure and services The private sector participation in management, financing or ownership will in most cases be needed to ensure a commercial orientation in infrastructure. Public-private partnership has promise in financing new capacity. Guarantees from host governments, multilateral institutions and export credit agencies play an important and legal role to mitigate the policy uncertainties and commercial and foreign exchange risks inherent in large-scale infrastructure financing. But, these should not be taken as substitutes for correcting sectoral distortions or removal of market imperfections. The lessons of experience in East Asia indicate that African countries are required to have priority attention in the following five areas while formulating country strategies to enhance private participation in the provision of infrastructure: * Overall country objectives, strategy and priorities; * Reform of policy, legal and regulatory framework; * Facilitation and increased transparency of government decisions * Unbundling and mitigation of risks; and * Mobilisation of private terms lending. (e) Fiscal and monetary incentives Although all the countries under examination had introduced a variety of incentive schemes– fiscal, credit, marketing and technical, they were either inadequate or overborne by a set of direct regulations. If the emphasis were mainly on the former, the rent seeking could have been much less and industrial growth would have been higher.

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The promotional policy particularly in regard to small-scale industry through reservation of products tends to discourage capacity creation and competition from large-scale industry whether or not. Therefore, the focus of promotional activities should be on access issue and not on subsidies, tax holidays or reservation. 8.4 Export development policies Of the many policies tried by the East Asian countries for accelerating growth, those associated with their export push hold the most promise for other developing economies. Export development policies such as duty draw-back/ duty exemption schemes and development of free trade zones (FTZs) and 100% export oriented units (EOUs) have been a critical part of East Asia’s success and merit consideration.

(a) Duty Drawback Schemes Duty exemption and duty drawback systems have failed in Sub-Saharan Africa for reasons of trust and capacity, cumbersome procedures, and because the costs from delays and paperwork outweigh the reductions in duty. In the case of drawback schemes, administrations are often unable to repay duties prepaid by exporters. In order to improve Africa’s competitiveness in manufactured exports, governments must take a new initiative to widen the use of these schemes and assure speedy access to exemptions and drawbacks for all exporters, through modernised administrative mechanisms.. One of the key elements of a modernised export promotion scheme in Africa should be the development of a system of pre-tabulated and published input-output coefficients on the basis of experiences drawn from Korea, Taiwan, China, India and Bangladesh. The new GATT rules on export subsidies also require the systematic documentation of the input-output coefficients. Another key element of export support is the assurance of export credit supply for exporters, especially for pre-shipment finance. Another consideration in Africa is the weakness of Customs Administrations, which contributes to the difficulties facing exports. Not only does this come in the form of slow or nonexistent rebates, but also in negative effective protection as exporters face duties on inputs but final goods are smuggled. (b) Free Trade Zones The free trade status for export activities can be achieved through: (I) fenced private or public free trade zones (FTZs); (ii) nonfenced FTZs, (iii) bonded drawbacks/ rebates. These specialised schemes have been widely and effectively used in countries at the early stages of development. The fundamental feature of Korea’s pioneering export promotion drive was the duty drawback scheme, implemented through the domestic letter of credit (DL/C) and the export finance system. In Korea, the Input Coefficient Administration, which estimates and publishes detailed input-output coefficients, the fixed and individual drawback schemes, and the back-to-back credit system offered through Domestic Letters of Credit (DL/Cs), has efficiently provided tax free inputs and ready access to working capital finance to direct and indirect exporters. Taiwan, China, Indonesia, Malaysia and Thailand also applied export support instruments including tax incentives, duty drawbacks and exemptions, and export and investment finance.

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Among Sub-Saharan Africa’s FTZs, the Mauritius EPZ has met with remarkable success, while the experience with Senegal’s Industrial Free Zone of Dakar (IFZD) has been quite the opposite. In Mauritius, macroeconomic balance, a politically stable democratic system of government, open trade policies, a dynamic local business community, combined with strong government support have contributed to the zone’s development. The Mauritius EPZ has succeeded in attracting a major financial commitment from its investors. The share of equity capital from Hong Kong has risen from 33 percent during 1970-76 to 86 percent in the period 1985-1990 with many 100% controlled units. French investors have preferred joint ventures with shares of between 35 percent and 80 percent. EPZ firms have also been able to raise funds in the local market. On contrary, Senegal illustrates an example where even most appealing fiscal concessions do not attract foreign investment nor ensure the success of a FTZ in the absence of a good business climate. In Africa, the economic benefits of FTZs as a tool of export promotion need to be carefully evaluated. It is clear for many African countries that any attempt to use this mechanism instead of promoting general reform is most unlikely to succeed. Four broad conclusions can, therefore, be drawn : •

Where the general economic climate is reasonable, or becoming so, the development of FTZs can be a useful encouragement to the development export-oriented industry, as it can lower initial investment costs for investors, and encourage economies of agglomeration.

•

FTZs should be a component of a broader outward-oriented development strategy, rather than a substitute for such a strategy, or an excuse to delay needed economywide trade reforms.

•

The benefits from FTZs in terms of foreign exchange earnings, employment, technology transfer and linkages with domestic markets may be limited, unless accompanied by an appropriate policy framework and human capital development for sustained export development.

•

While accepting that market failure justifies a potential role for the public sector in this area, the pricing of space in such zones should not be subsidized. Similarly, as part of a general programme to promote foreign investment, governments should be sure to remain open to the private development of such industrial estates, as is occurring in Malawi and Kenya.

8.5 Foreign investment policy Foreign direct investment (FDI) can be critical in introducing widespread technological change, improving the agility and competitiveness of firms, and providing access to skills and global markets. This is evident in China, and to a lesser extent in Bangladesh, India, and Kenya, where FDI is increasingly generating spillover effects in many sectors.

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Successful cases show the importance of having governments promote and welcome FDI, particularly in infrastructure such as communications and energy. They also show the importance of true such as communications and energy. They also show the importance of avoiding excessive regulation and restrictions on expatriates and financial flows and the business activities of firms. The need for FDI is greatest in Sub-Saharan Africa, but little has been received outside the enclaves of mining and oil. Indeed, there is concern about considerable foreign disinvestment from Africa in response to the uncertain political and economic environment, the high cost of doing business, and the fears that policies and regulations discriminate against foreign investors, who have many other opportunities all over the world. FDI inflows and FDI stock already in the country would benefit from a more stable and dynamic environment – and a willingness to accept investment from all sources, including minorities and ethnic groups. (a) Host Country Policies for FDI For host countries, the policy agenda for increasing FDI inflows and for drawing maximum benefits from them must include the following priorities: • • • •

ensuring a stable economic environment conducive to sustained economic growth; encouraging the development and upgrading of local industrial and technological capabilities; strengthening infrastructure and human resource development, and providing requisite legal, regulatory and institutional set up.

Those countries that have only recently been open to FDI need to ensure that the “open door policy” is maintained and remains stable. They should examine the possibility of a further liberalisation of FDI regimes; the harmonisation of FDI and related policies on industry, trade and technology; and improving the efficiency of their administrative setup for investment approvals. To the extent possible, host countries should seek to avoid competitive bidding, enhance exchanges of information and promote transparency in order to reduce unnecessary transaction costs. All countries in the region should pay particular attention to the firms from neighbouring countries, so as to capitalise the growing intra-regional investment. Special attention needs to be given to small and medium-sized enterprises whose special needs - dictated by their limited financial and managerial resources and insufficient information - may call for incentives for the joint ventures among the small and medium-sized TNCs. Successfully enticing one important TNC to locate in a country can trigger a chain reaction that leads to substantial sequential and associated investment. The most obvious targets are firms already established in a country. Governments can strive to encourage sequential investment (including reinvested earnings),, which can provide positive demonstration effects for potential new investors. A satisfied foreign investor is the best commercial ambassador a country can have.

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Policy makers should be concerned when foreign investors leave the host country due to deteriorating local conditions. Emphasis on after-investment and investment-facilitation services for current investors is therefore crucial. Free, prompt and unrestricted transfers in any freely usable currency should be permitted for all funds related to an investment. The bottom line to a business is the ability to make profits and to distribute funds to partners and shareholders. Expropriations should only occur in accordance with international law standards and be subject to due process. An expropriation should be for public purpose and nondiscriminatory, and prompt, adequate and effective compensation must be paid. Firms must be confident that they can obtain a fair hearing in the event of a dispute, and must have reciprocal ability to seek international arbitration. Investors should have full access to the local court system, but also have the choice to take the host parties directly to third party international binding arbitration to settle investment disputes. The legal framework governing labor markets must be reformed to institute a marketbased bargaining process that is free from interference by the government or trade unions, and a system of severance liabilities that conform free market conditions and developing country norms. Facilitation of exist is as much crucial as entry which is addressed by deregulation. In addition to this, employment schemes paid for with wage goods, tried in countries like India can be implemented. In short, labour market reforms should be considered as a sine qua non of the industrial policy reforms. (b) Host Country Policies for Portfolio Investment The strengthening of local capital and stock markets is essential for the development and broadening of the domestic investor base and the establishment of a healthy private sector. In this respect, privatization has a role to play in broadening the investment base. A prudent regulatory framework alongwith transparency and efficiency of price dissemination are also necessary to ensure investors’ confidence in the stock market. Among the main issues to be tackled for BOT financing schemes in infrastructure are the need to restructure some utility sectors, the need for an improved regulatory environment, and measures to reduce demand risks and foreign exchange risks. (c) Home Country Policies With domestic outward FDI policies liberalised, developed home countries must supplement their domestic policies with international instruments aimed at protecting and facilitating outward FDI. They should improve FDI liberalisation standards generally and encourage level playing field among themselves. Few developing countries and

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economies in transition have paid due attention to outward FDI policies; typically these are subsumed under general capital-control policies which, in turn, are quite restrictive. There is a need to liberalise furthers capital markets and foreign exchange rules and regulations so as to move towards full convertibility on capital account. As regards portfolio investment, the enormous potential represented by the pool of savings held by institutional investors in the OECD countries may increasingly seek investment outlets other than those offered by the mature markets. However, home country regulations concerning outward portfolio investments can be a major constraint on outward portfolio investment. In most developed countries, savings institutions such as insurance companies and pension funds face ceilings on the share of foreign assets in their portfolio and are usually subject to prudent investment and diversification norms. As the investment managers become more familiar with emerging markets, a relaxation of home country policies concerning portfolios of institutional investors could lead to a multiple increase of portfolio investment to developing countries. 8.6 Role of Small and Medium Sized Industries (SMIs) A wide range of opportunities can be seized by small-scale, labour-intensive industries. It is particularly so in the Asian and African region where horizontal division of labour through trade and joint venture projects are increasing sharply.. The following measures need to be given priority for strengthening the SMI sector : •

It is necessary to facilitate the transfer of technology to the SMEs by suitable arrangements such as regional information networks and provision of timely and adequate finance to SMEs.

•

Adequate backward and forward linkages need to be established between small and large units in terms of sub-contracting, production sharing and manufacture of parts.

•

Suitable measures may be taken to enhance the access of the SMI sector to information particularly relating to external markets and foreign investment.

•

Vertical expansion of the SMEs may be limited due to reservation of items and limits on investment. A review of the reservation policy and investment limits is necessary to facilitate capacity expansion, technology upgradation and economies of scale.

•

Much of the existing growth of SMEs has taken place in and around the metropolitan areas, but the balanced regional growth requires that the process of industrialisation needs to be extended to the countryside. In this respect, the experience of China in setting up Township Enterprises on a large scale may be particularly relevant for other developing countries.

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•

SMEs are most vulnerable to trade protectionism and exchange rate fluctuations. Undesirable tariffs and non-tariff restrictions on their products must be removed to enhance the export potentials of SMEs. 8.7 Restructuring the financial sector

For the five most affected East Asian economies viz. Indonesia, Malaysia, Philippines, South Korea and Thailand, the average total debt to GDP ratio is 230 per cent and debt service ratio is 27 per cent. While much is made of external debt overhang, the real problem is with domestic debt to GDP. After many years of excessive credit growth, over-investment (i.e. on the basis of price appreciation rather than yield) and inadequate banking supervision, domestic debt to GDP is 125 per cent on an average. The capital flight from foreign banks, residents and domestic corporations has triggered a massive credit squeeze forcing real interest rates to soar and triggering nation-wide recession. Financial stabilization to foster the initial turnaround in economic activity is the first order of business. To build the basis for a sustained and strong recovery of activity over the next several years, major efforts are also needed, and are under way, to restructure the financial and corporate sectors. In conjunction with bank restructuring and recapitalisation there is a need for financial reconstruction of the corporate sector. The crises have led to large increases in domestic and foreign debt burdens of both the private and public sectors. At the end of 1997, total (domestic and foreign) debt of private and public sectors in Korea, Malaysia, and Thailand exceeded 225 percent of GDP, while in Indonesia it stood at around 190 percent of GDP. Unlike in the Latin American debt crisis of the 1980s, most of the debt is private rather than sovereign. In Korea, Malaysia and Thailand, private sector debt accounted for over 85 percent of total debt at end –1997 while in Indonesia and the Philippines private debt amounted to 70 and 60 percent, respectively, of total debt. Besides the needed restructuring and recapitalization of the banking system and the nonfinancial corporate sector, financial reforms are required to prevent a recurrence of similar crises. There is a clear need for stronger prudential, supervisory, accounting, and legal standards, as well as improved corporate governance and the establishment of more transparent relations between government, banks, and corporations. From a long-term perspective, a fundamental question facing the East Asian economies is whether they can gradually shift from mainly input-driven growth to growth based more on stronger gains in efficiency. That will depend on continuing improvements in the institutional infrastructure to provide a supportive climate for investment and the supply of finance, risk-taking and innovation, and the efficient allocation of investment. 8.8 Supporting implementation The strategy outlined here implies a major change in the role of the government – from an owner and operator to a policymaker and regulator that works closely with the private sector in developing a competitive, outward-looking economy. Fundamental to the success of this orientation is accelerating the efforts of many governments to build

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competent and agile institutions that can help firms respond quickly to changing market conditions. (a) Infrastructure and Human Resource Development Efficient physical infrastructure and human capital are critical overheads that investors seek. For the more dynamic traded goods and services, telecommunications are the most important facilitator of investment, and technological and organisational innovations drive foreign investment into those countries which have trained and skilled workforce and fairly high educational standards. This points to the overriding importance of developing countries to invest more in the development of human resources, infrastructure and services. It also highlights the risk of being marginalised for the least developed countries with a low level of skilled labour force and infrastructure constraints. The existence of a dynamic local business sector creates a supportive environment through efficient networks of local suppliers, service firms, consultants, partners or competitors. It is, therefore, necessary to concentrate efforts on the development of local entrepreneurship. Equally important is the availability of high quality telecommunications and transport systems, energy supply and other utilities. (b) Legal and Institutional Set-up Many of the difficulties faced by governments in handling foreign investment, and by the foreign investors setting up in a host country, derive from the absence of a clear civil, commercial and criminal legal system. Given a set of laws, it is essential that foreign investors be treated equally with domestic investors. Not only is this a moral issue, but there are strong practical arguments against giving foreign investors privileges that domestic firms do not enjoy (and vice versa). Domestic firms will launder money to become foreign investors if this will give them subsidies that they cannot otherwise receive. Chinese publicly owned enterprises use transfer pricing at other than arms’ length to become foreign investors in China, or they form joint ventures within foreign firms to benefit from subsidies to foreign investors. Giving entrepreneurs of Indian origin special privileges by India are also inequitable and inefficient. Continued reforms will attract the worthwhile investors among them without incentives. In open economies, such as Singapore, Hong Kong or Mauritius, only minimal special foreign investment laws and regulations are necessary and administrative costs are negligible. Most developing countries like India are faced with a transition period. The experience of Indonesia, Malaysia, Taiwan and Thailand suggests that the transition can be managed well. The faster an economy is reformed, the easier the management of foreign investment. Regulations can be simple and their administration transparent. (c ) Competent economic bureaucracy The experience of the economies of Japan, Korea, and Taiwan, China, suggests that the first prerequisite for the proper conduct of targeted industrial policy is a stable macroeconomic environment. In essence, prudent macroeconomic management is needed

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to prevent inefficiencies, which generally impinge on macroeconomic variables such as the budget deficit and inflation, e.g., subsidies become burdensome. Unless there are institutional constraints that keep the deficit and inflation from exploding, the inefficiencies would continue and ultimately cause considerable harm to the economy. An important institutional prerequisite appears to be the establishment of a competent economic bureaucracy. The complexity and difficulty of managing targeted industrial policies places high demands on the economic bureaucracy, which must be able to balance financial support for targeted industries with penalties for non-performance. The economies of Japan, Korea, and Taiwan, China all had economic bureaucracies capable of imposing discipline on private industry. In short, running a set of successful industrial policies of the East Asian type requires a deep commitment to a stable macroeconomic framework, and an economic bureaucracy capable of running complex pricing policies, and objectively running public subsidy schemes. (d) Regulatory system As regards the limits and nature of government intervention in private sector activity, it is necessary to devise optimal rules for operating regulatory system, which while servicing its legitimate purpose will not transcend its limits to the disadvantage of the private sector development. First, any policy affecting allocation of resources, and regulation of private sector needs to be pursued if and only if there is a specified set of procedures. Second, even when there is strong presumption in favor of government intervention, it is imperative to limit it to minimum necessary scale as efficiency of regulation is scaledetermined. Three, from amongst the available alternative regulatory sets, it is necessary to go in for one which will provide the least scope for rent seeking. Alongwith with deregulation, more important measures are needed to be directed towards creating a legal and institutional infrastructure for the smooth functioning of the private sector. This has been well illustrated by the Indonesian experience. Though Indonesia’s industrial policy, trade and financial sector reforms were deep and sweeping, they failed to get a full pay-off as Indonesia lagged in changing its corporate law and other laws vital to trade and industry. Similar was the case with issues of land and property rights. An important lesson from the East Asian development experience is that a holistic approach to deregulation is more productive than a partial deregulation in any one sphere say in industrial policy which is divorced from any reform in other areas. Domestic deregulation should proceed pair pass with liberalisation of trade and tariffs in order to ensure optimal allocation of resources between traded and no-traded goods. (e) Role of R&D Expenditures The R&D expenditure in many developing countries like India (0.9% of GNP), Pakistan (0.6%), Philippines (0.7%) and Thailand (0.5% of GNP) are considerably lower than that in USA (2.7%), United Kingdom (2.3%), Japan (3%), Germany (2.9%) and South Korea (2.8%). The situation may not be very much different for the African developing

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countries. Developing countries in Asia and Africa must allocate more resources on R&D and encourage private sector funding of research institutions engaged in R&D. For effective role of R&D in the generation, development, adaptation, assimilation and diffusion of industrial technologies, public research institutions must try to commercialise R&D activities with necessary linkages with the private sector and production activities. 8.9 Regional integration (a) Regional integration and co-operation The competition among the host countries to attract FDI has intensified the use of incentives to such an extent that the situation is often referred as an “investment war”. Host countries get trapped in the “prisoner’s dilemma” leading to competitive bidding in which all participants are left worse off than the situation of no bidding. It will be beneficial for the host countries to arrive at a harmonisation of policies, to ensure more transparency on FDI regime, and to exchange information about their regulatory regime and other FDI-related policies and to share their experiences on the impact of FDI on the costs and benefits to the economy. There are strong aspirations for regional integration in Africa. Indeed, many countries are starting to coordinate and harmonize policies for tariffs, taxation, investment, and business regulations. But the biggest and most productive impetus to regional integration would come from removing the restrictions on movements of goods, capital, and people. These restrictions have severely limited trade and encouraged smuggling. In addition, there is considerable untapped potential for regional cooperation in power, transport, and the distribution of petroleum products (oil and gas) to reduce the costs of supplying these services. Regional integration is also likely to get a boost from the development of regional growth poles –South Africa and Zimbabwe in the south, Coted’Ivoire, Ghana, and Nigeria in the west, and Kenya, Tanzania, and Uganda in the east. These could produce important pull effects on growth throughout the continent if the limitations and impediments on local and foreign investors and movements of goods, people, and capital are removed. They would also help promote FDI by enlarging markets. But regional integration should not be a substitute for opening up to the global economy. It should be seen as the way to help firms connect to global markets at lower cost.

(b) Regionalisation and FDI complementarities Major benefits will come from removing restrictions that impede flows of people, capital, and goods, and those segment geographically contiguous markets. In addition, there is considerable untapped potential for regional cooperation in power, transportation, and distribution ( particularly petroleum products), which would reduce the costs of doing

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business. There will be an important pull effect on growth throughout Asia if the remaining impediments to local and foreign investors are removed. Such regional cooperation and integration should be seen not as a substitute for opening up to the global economy, but as a way of assisting firms to connect to global markets at lower cost. Three lessons can be drawn from past developments on FDI policies. First is that progress in the development of international investment rules is linked to the convergence of rules adopted by individual countries. Second is that an approach to FDI issues that takes into account the common advantage, is more likely to gain widespread acceptance and to be more effective. Third is that in a rapidly globalising world economy, the list of substantive issues entering international FDI discussions is becoming increasingly broader and complex and include the entire range of questions concerning factor mobility. (c ) Technical Assistance Industrial and technology development depends crucially on the development of basic infrastructure. Multilateral agencies including the International Development Association (IDA) can help the developing countries by providing financial and technical support and investment guarantees for the development of infrastructure and human resources. They can also play a more catalytic role in mobilising funds from a wide range of private sources using all the available means. Multilateral financial and development institutions and bilateral donors have played an important role by providing financial and technical assistance to the countries of South Asia in the areas of improved education, health services and family planning. External assistance should further be increased and continued to be provided on concessional terms, given the long term nature of investment in human capital and its link to poverty alleviation, skill formation and enhancement of industrial productivity and efficiency. The World Bank, IFC, African Development Bank, Economic Commission for Africa, UNDP, UNICEF, UNIDO and UNCTAD are engaged in the provision of technical assistance, consultancy and advisory services with regard to the development of the private sector, human resource development, and promotion of non-debt-creating financial flows, and FDI in particular. Although the experience with technical assistance received from these institutions have been found to be very valuable, there is scope for improvement in the following fields: •

Promotion of regional cooperation in human resource development, R&D, S&T development, technology blending, use of information technology, and computer training and facilities.

•

Studies on public sector enterprise reforms, privatisation and industrial restructuring.

•

Consultancy and training aimed at technology upgrading and skill improvement for the growth and globalisation of SMEs with special attention to entrepreneurs from

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rural areas, ethnic minority areas, economically backward areas, ethnic and backward classes, and women and young entrepreneurs. •

Regional technical assistance programmes on harmonisation of national and regional policies and plans for private sector development and foreign investment.

•

Promotion of technology management, evaluation, assessment and enterprises cooperation for the blending of indigenous technology and imported technology.

•

Improvement of the institutional machinery, administrative and legal framework with a view to facilitating foreign investment flows and improving the database on FDI and portfolio flows.

•

Advisory services for developing countries to strengthen capital markets and to attract foreign portfolio investment.

•

Technical support for developing countries and countries in transition to upgrade their institutional capacity to identify, design, negotiate, and implement schemes on BOT/BOO/BOLT.

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Selected Bibliography Asian Development Bank (1995). Asia : Development Experience and Agenda, ADB Theme Paper 3, Asian Development Bank, Manila. ______(1997). Emerging Asia - Changes and Challenges, Asian Development Bank, Manila. Brooks, D.H. and Leuterio, E.E. (1997). Natural resources, economic structure and Asian infrastructure, in Investing in Asia, ed. C.P. Oman et. el. 1997, OECD. Chakwin, Naomi and Hamid, Naved (1997). Economic environment in Asia for investment, in Investing in Asia, ed.C.P.Oman et.el.1997. Chia, Siow Yue; and Tsao Yuan Lee (1994). Economic Zones in Southeast Asia, in Asia Pacific Regionalisation: Readings in International Economic Relations, ed. R. Garnaut and P. Drysdale, Pymble, Haeper Educational Publishers. Das, Tarun (1993). Macro-economic Framework, Special Economic Zones and Foreign Investment in India, Ad-Hoc Working Group on Investment and Financial Flows: NonDebt Creating Finance for Development, Country Report No.TD/B/WG.1/Misc.3/ Add3/ UNCTAD, United Nations, Geneva, pp.1-75, June 1993. ______(1996). Policies and Strategies for Promoting Private Sector’s Role in Industrial and Technological Development, Including Privatisation in South-Asian Economies, ST/ESCAP/1696, United Nations, New York. _______(1997), Promoting Industrial Investment - Technology Transfer - Growth Nexus Towards Greater Regionalisation and Complementation of Manufacturing Production and Technology Upgrading, United Nations, New York. Dasgupta, Biplab (1996). New Political Economy and the East Asian Development Experience, mimeo, December 1996, New Delhi. ESCAP (1993). Economic and Social Survey of Asia and Pacific 1992, Part 2, Expansion of Investment and Intraregional Trade as a vehicle for Enhancing Regional Economic Cooperation and Development in Asia and Pacific, United Nations, New York. ______(1994a) Proceedings of the Regional Seminar on Investment Promotion and Enhancement of the Role of the Private Sector in Asia and the Pacific, United Nations, New York. ______(1994b) Privatisation: Issues and Prospects, ST/ESCAP/1439, United Nations, New York.

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______(1996) Policies and Strategies for Promoting Private Sector’s Role in Industrial and Technological Development, Including Privatisation in South-Asian Economies, U.N., New York. ______(1997) Economic and Social Survey of Asia and the Pacific 1997- Asia and the Pacific into the Twenty First Century: Development Challenges and Opportunities, U.N, New York. Fischer, Stanley; Hernandez-Cata, Ernesto, and Khan, Moshin S. (1998) Africa - Is This the Turning Point?, IMF Paper on Policy Analysis and Assessment, No.PPAA/98/6, International Monetary Fund, May 1998, Washington, D.C. Glen, Jack D. and Sumlinski, Mariusz A. (1995) Trends in Private Investment in developing Countries 1995 - Statistics for 1980-1993, International Finance Corporation, Washington, D.C. Harrold, Peter; Jayawickrama, Malathi and Bhattasali, Deepak (1996) Practical Lessons for Africa from East Asia in Industrial and trade Policies, World Bank Discussion Papers, African technical Development Series, The World Bank, Washington, D.C. Industrial Bank for Reconstruction and Development (IBRD) 1995, Bureaucrats in Business: The Economics and Politics of Government Ownership, June 1995, Washington, D.C. International Finance Corporation (IFC), 1995. Privatisation - The IFC Experience, Washington, D.C. International Monetary Fund (1997). World Economic Outlook - Globalisation, Opportunities and Challenges, May 1997, Washington, D.C. ______(1998) World Economic Outlook - Financial Crises Causes and Indicators, May 1998, Washington D.C. Khatkhate, Deena R. (1992) The Regulatory impediments to the Private Industrial Sector Development in Asia - A Comparative Study, World Bank Discussion Papers, No.177, World Bank, Washington, D.C. Kochhar, Kalpana; Loungani, Prakash, and Stone, Mark R. (1998) The East Asian Crisis: macroeconomic developments and policy lessons, IMF Working Paper No.WP/98/128, International Monetary Fund, Washington, D.C., August 1998. Oman, C.P., Brooks, D.H. and Foy, C. (1997). Investing in Asia, Development Centre, The Organisation for Economic Co-operation and Development (OECD). UNCTAD (1992). World Investment Report 1992: Transnational Corporations as Engine of Growth, United Nations, New York and Geneva.

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______(1993b). Report of the Ad Hoc Working Group on Investment and Financial Flows; Non-Debt-creating Finance for Development; No. TD/B/40(1)/12 and TD/B/WG.1/8, July 1993, U.N., Geneva. ______(1996). World Investment Report : Investment, Trade and International Policy Arrangements, United Nations, New York and Geneva. ______(1998) Trade and Development Report, 1998 - Financial Instability and Growth in Africa, United Nations, New York and Geneva. World Bank (1992) Privatisation: The Lessons of Experience, Washington, D.C. ______(1993). The East Asian Miracle: Economic Growth and Public Policy, Oxford University Press. ______(1994a). World Development Report - Infrastructure for Development, Washington, D.C. ______, 1994b. Private provision of infrastructure services in East Asia and Pacific Some stylized facts and lessons from early experience, Staff Discussion Paper, Washington, D.C. ______(1994c). Infrastructure Development in East Asia and Pacific: Towards a New Public-Private Partnership, Washington, DC. ______(1995). Private Sector Development in Low-Income Countries, Washington D.C. ______(1997). Global Development Finance, Washington, D.C. ______(1998) The World Bank Group: Supporting Private Sector Development: A Status Report, September 1998, Washington, D.C. World Economic Forum (WEF) (1997). The Global Competitive Report 1996, Geneva, Switzerland. Yamazama, Ippie (1997). APEC and investment, in Investing in Asia, ed. C.P. Oman et. el. 1997, OECD.

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