2008/SRMM/012

The Benefits of Structural Reform

Purpose: InformationSubmitted by: SRMM Deputies

Ministerial Meeting on Structural ReformMelbourne, Australia

3-5 August 2008

The Benefits of Structural Reform

Background Paper

CONTENTS

EXECUTIVE SUMMARY...................................................................................................1

INTRODUCTION..............................................................................................................2

WHAT IS STRUCTURAL REFORM?...................................................................................2Impediments to well-functioning markets............................................................................2Why are well-functioning markets important?.....................................................................3What is the role of government?.........................................................................................3

BENEFITS OF STRUCTURAL REFORM: STRONGER ECONOMIC PERFORMANCE...................4Efficiency (microeconomic) impacts...................................................................................4Economy-wide (macroeconomic) impacts..........................................................................7Benefits for trade and foreign direct investment...............................................................12

OVERCOMING SHORT-TERM ADJUSTMENT COSTS..........................................................13

Summary...................................................................................................................13

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Executive SummaryRemoving structural barriers to the operation of efficient markets and doing business in the APEC economies can bring with it significant benefits to citizen welfare. Structural reform can enhance allocative, productive and dynamic efficiency by helping to allocate scarce resources to best use, maximise the production of goods and services for a given quantum of inputs and spur innovation. These efficiencies lead to lower prices, better quality products and more choice for citizens.

From an economy-wide perspective, structural reform can enhance overall productivity in an economy, contributing to economic growth, employment and higher incomes. In addition, promotion of well-functioning and efficient markets encourage trade and investment, which in turn contributes to economic growth, employment and higher incomes over time.

Structural reform can also help prepare an economy for unexpected shocks, such as large capital flows, changes in investor confidence or changes in the price of important commodities such as oil. Efficient markets accurately transmit price signals in a timely manner, and a flexible economy unhampered by structural barriers is well placed to adapt to changed economic conditions.

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Introduction1. The Asia-Pacific region is one of the most dynamic regions in the world. It is home to rapidly developing economies, burgeoning global production networks and massive investment flows. It is also a major force of global economic growth. In its first decade, APEC member economies generated nearly 70 per cent of global economic growth and the APEC region consistently outperformed the rest of the world, even during the 1997-98 Asian financial crisis.1 The promotion of sustainable economic growth and improved living standards in the Asia-Pacific region through enhanced trade and economic integration lies at the heart of APEC’s mission.

2. As APEC’s trade agenda has advanced, there has been an increasing recognition that the removal of non-trade barriers has also played a significant role in achieving economic growth. The APEC agenda has, therefore, evolved to place an equal emphasis on the reform of structural or behind-the-border barriers in the region. Experience suggests that economies that pursue structural reforms to address domestic or behind-the-border impediments to business are more resilient to economic shocks, achieve greater macroeconomic stability, and experience increased productivity and higher living standards over time. This paper focuses on structural reform: what it means generally and in an APEC context, and its potential benefits for individual economies.

What is structural reform?3. Structural reform consists of improvements made to institutional frameworks, regulations and government policy so that ‘behind-the-border barriers’ to regional economic integration and improved economic performance are minimised. Structural reform helps foster an economic environment that supports the efficient functioning of markets; contributes to macroeconomic stability, productivity and economic growth; and ultimately enhances living standards in a sustainable way.

4. Structural reform is an evolutionary process that can provide on-going benefits for all APEC economies. While sweeping reforms may at times be necessary, even economies with highly efficient markets can benefit from ongoing and incremental reforms. Structural reform assists market forces to function properly — this includes facilitating investment in productive activities, regulating natural monopolies, building stronger businesses and letting new businesses enter and inefficient businesses exit a market through the removal of structural barriers.

Impediments to well-functioning markets5. Structural barriers impede the full and efficient use of an economy’s resources. Structural reform is intended to remove these barriers. There are two broad types of barriers. Cross-border structural barriers are direct restrictions on international trade and investment at the border. These external impediments impact on foreign investors. Examples of these barriers are tariffs, such as, duties, licences, quotas and subsidies. They can also include non-tariff barriers, such as, anti-dumping measures and countervailing duties or manufacturing or production requirements where imports are restricted for failure to comply.

1 APEC (2005) APEC at a glance.

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6. Behind-the border structural barriers refer to domestic policies and institutions which impede the efficient operation of markets and the capacity of business to operate efficiently. Behind-the-border barriers may include regulatory systems, competition frameworks and governance structures, including domestic policies, rules, procedures and laws that unnecessarily hinder businesses from operating effectively, such as, excessive regulation, poor property rights and/or poor legal systems.

7. The existence of behind-the-border barriers has a detrimental impact on both domestic and foreign business. These barriers increase direct financial cost, which reduces business profitability and diverts resources away from productive use. For example, cost can be increased through licence fees or the compliance costs associated with understanding and complying with unnecessary regulatory requirements. These barriers can also limit business competition, which stifles innovation and removes incentives to increase efficiency within individual businesses and ultimately, increases costs to citizens. Measures that restrict entry to a market or impose price controls can also restrict competition. These barriers also increase risk, which reduces the incentive to invest and imposes cost to business in managing the risk. Inconsistent policy or uncertain property rights or unenforceable contracts can further increase risk.

Why are well-functioning markets important?8. Efficient and well-functioning markets can produce numerous benefits. Well-functioning markets allocate resources to their most valued use and facilitate competition. Scarce resources can act as a constraint on a domestic economy’s growth potential. By ensuring that resources such as land, labour and capital are efficiently utilised, an economy ensures that both output and the welfare of citizens can be maximised. Efficient markets facilitate the optimal allocation of resources by providing firms and citizens with timely and reliable information about the demand of a good relative to supply through price signals. Timely and accurate transfer of price information enables an appropriate response from citizens and firms, increasing competition. This leads to better quality products and services at lowest possible prices and better choice for citizens. Increased competition also encourages innovation and productivity gains and, ultimately, sustainable economic growth, improving the well-being of citizens. The economy as a whole benefits from the more efficient allocation of resources to industries in which it has a comparative advantage.

What is the role of government?9. Markets do not always produce the most efficient outcomes. There is a role for governments to manage the economy where markets do not produce efficient outcomes (market failures). Government intervention may be necessary to address market failures through information, the use of laws, regulation, taxation and payments.

10. In the case of public goods, markets do not optimally produce these goods because no one can be effectively excluded from using that good (non exclusive). Another characteristic of a public good is that consumption of the good by one individual does not reduce the amount of the good available for consumption by others (non-rival). The classic example is national defence — once an economy has provided for its national defence, all citizens enjoy its benefits. This means governments may need to provide these goods, financed through taxation.

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11. Externalities are another source of market failure, which sometimes require government intervention. Externalities are costs or benefits to third party stakeholders, which are not properly reflected in market transactions. For example, pollution affects everyone but is not often priced in the market, requiring governments to introduce carbon taxes or emissions trading schemes to ensure markets reflect proper costs and behaviours shift appropriately.

12. Markets also fail where there is inadequate information (information failure), and there is a role for governments to remedy information failures. For example, governments can address information failures by providing adequate information or regulating to make businesses disclose such information. These interventions will lead to better functioning markets.

Benefits of structural reform: stronger economic performance

Efficiency (microeconomic) impacts13. The immediate goal of structural reform is to create stronger and more efficient markets. Removing structural barriers in a market enhances competition, which is important for the efficient operation of markets. Competition stimulates allocative and productive efficiency, in which the most appropriate range of goods and services is produced using the least cost combination of inputs; and dynamic efficiency by spurring innovation in resource use, product design, production processes and management practices. Efficiently operating markets boost productivity, underpins stronger and more sustainable economic growth and enhances living standards.

14. Allocative efficiency is where resources (such as labour, capital and natural resources) are allocated to producing goods and services demanded by citizens, thus maximising citizen welfare. The efficient allocation of resources in this way will only occur where price signals, which reflect citizen demand and the scarcity of supply, are transmitted accurately and in a timely fashion. This allows producers to gauge the optimal mix of goods to produce. Strengthening the legal system as an example of structural reform, can increase allocative efficiency of an economy, as producers can invest in capital with certainty regarding the enforceability of contracts, the risk of the investment is reduced, which means producers no longer have to dedicate resources to managing that risk.

15. Structural reforms that enhance competition or restore market price signals also spur producers to remain competitive and seek productive or technical or supply-side efficiency. Technical efficiency occurs where goods and services are produced at the lowest cost possible, given the production of other goods. In other words, producers are able to maximise the production of goods and services for a given amount of inputs. For example, removing unnecessarily restrictive product manufacturing standards on goods can increase productive efficiency. Removal reduces cost for producers in complying with standards, which enables production of the same number of goods at a lower cost and therefore lower prices for citizens.

16. Finally, efficient markets encourage innovation. This is known as dynamic efficiency. Dynamic efficiency refers to spurring innovation in resource use, product design, production processes and management practices. Competitive markets create stronger incentives for producers to improve their productivity and quality and to

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innovate in order to achieve a competitive advantage. Removing barriers to entry can lead to significant improvements in dynamic efficiency. Many APEC economies have removed entry restrictions in their telecommunication markets, which has resulted in increases in the number of providers in the market. This competition encouraged providers to innovate, which has increased the range of products available to citizens.

17. Well-functioning markets that encourage competition and produce appropriate price signals can simultaneously reinforce allocative, productive and dynamic efficiency gains. For example, Box 1 shows the success of Viet Nam’s enterprise law reforms in stimulating investment growth. The increased investment stimulated by the reforms also led to an increase in the number of new businesses. This in turn led to an increase in competition and allocative, productive and dynamic efficiency gains.

Box 1: Viet Nam’s enterprise law reforms2

Relaxation of controls on the private sector in Viet Nam has been taking place since 1986, with the decision to embark on reforms known as the ‘doi moi’. In December 1989 the first legal guarantee for the private sector was established with the introduction of the Law on Company and Law on Private Enterprise. Support for private enterprise in Viet Nam was further achieved in 1992 with the explicit recognition of the role of the private sector in Viet Nam’s Constitution.

The reforms created a role for private enterprises and also reduced administrative barriers to the formation of new companies and addressed corporate governance issues. This led to an increase in the number of new companies. The reform is also estimated to have contributed to the creation of 2 million new jobs.

Most importantly, these reforms allowed the domestic private sector to invest in a broader range of private enterprises and stimulated additional investment from the domestic private sector. Following various reforms, the share of investment in GDP had increased from around 15 per cent in the late 1980s to almost 30 per cent by the mid-1990s. However, the investment share of GDP levelled out in the late 1990s. Following the implementation of the Enterprise Law in 2000, the investment share of GDP increased to more than 35 per cent (Figure 1).

Figure 1: Investment as a share of GDP and milestones in reform process

18. The case study of electricity generation in Chile (Box 2) illustrates the benefits to be gained from competition. In this case, competition stimulates allocative and productive 2 Investment Experts Group (2007), Enhancing investment liberalisation and facilitation in the Asia

Pacific region (stage 2), APEC.

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efficiency which become mutually reinforcing. The restoration of market price signals in a state-owned enterprise enhanced efficiency by allowing investment to flow according to market generated price signals, rather than determined administratively, in isolation from market prices. The introduction of competition into electricity generation also had dramatic effects on the efficiency of electricity generation and provision, leading to falling prices and higher citizen welfare.

Box 2: Electricity generation in Chile3

In the 1980’s Chile began a program of restructuring and privatisating its electricity sector. Chile’s restructuring sought to achieve competition in generation and freedom of users to purchase power from any generator or distributor. The state owned enterprises were vertically and horizontally split into generation and distribution companies.

Privatisation and regulation of the market has lead to dramatic efficiency improvements in Chile’s electricity industry. Labour productivity increased substantially, particularly in electricity generation, where gigawatt-hours generated per employee increased from 6.3 in 1991 to 34.2 in 2002.

The quality of supply has also dramatically improved. The average time for emergency repair service declined from five hours in 1988 to two hours in 1994. In addition, power outages due to transmission failures have fallen steadily since privatisation. Energy losses have also decreased, falling from 21 per cent in 1986 to 9 per cent in 1996.

Prices have been kept low due to increases in supply capacity. Wholesale prices fell 37 per cent and final prices fell 17 per cent between 1986 and 1996. Network expansion has also benefited the poorer citizens, with the share of the poorest citizens without a connection falling from 29 percent to 7 per cent in 1998.

19. Dynamic efficiency can be seen in the case of airline deregulation in the United States, as shown in Box 3. Removal of structural barriers to enhance competition led to dynamic efficiency gains, as firms started to innovate to create different services for citizens and new systems to deliver the services. This dynamic efficiency also enhanced airline companies’ productive efficiency, as these services were provided at the lowest cost possible via the creation of new management and route systems.

3 Fisher R and Serra P (2003), ‘Efectos de la privatización de los servicios públicos en Chile: casos sanitario, electricidad y telecomunicaciones’, Universidad de Chile, and Kessides (2004), Reforming Infrastructure: Privatisation, Regulation and Competition, World Bank Policy Research Report.

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Box 3: Airline deregulation in the United States4

In 1978 the Airline Deregulation Act abolished the Civil Aeronautics Board (CAB). Prior to 1978, the CAB exerted substantial control over the pricing practices and route structures of US airlines. Fare changes required CAB approval, and entry and exit on individual routes were subject to similar scrutiny.

The result of deregulation was the entrant of new airlines into the market, and also a substantial increase in competition over routes. The result of such competition was an increase in consumer welfare as fares decreased. Increased competition arising from airline deregulation is estimated to have resulted in savings for travellers of at least USD 6 billion annually in reduced fares.

However, the dynamic efficiency benefits that were achieved from deregulation are also significant, as airlines began to create new services in order to compete. Deregulation led to airlines offering customers different prices for seats on the same route, depending on the customer’s preferences. In addition, airlines developed management systems for selling unsold seats on flights in the most efficient fashion.

Deregulation also spurred airlines to find innovative, efficient methods of organising and managing flight routes in order to remain competitive. The ‘hub and spoke’ model of organising flight routes was developed. This model of organising routes became the most competitive and efficient method of scheduling flights for a large number of passengers at the lowest cost.5

Economy-wide (macroeconomic) impacts

Improved productivity and employment growth

20. As well as increasing productivity in a specific industry or sector, comprehensive structural reform can lead to economy-wide improvements in productivity6, which is a major determinant of long term economic growth. The efficiency improvements arising from structural reform mean that a greater amount of goods and services can be produced for a given amount of inputs. The World Bank Development Report 2005 illustrates that productivity gains account for over 40 per cent of growth measured among 84 countries from 1960 to 2000 (figure 2).

4 Chung, C and Szenberg, M (1996) ‘The Effects of Deregulation on the U.S. Airline Industry’ Journal of Applied Business Research, Vol. 12, Issue 3.

5 Brueckner, J K, Goebel, A and Niskanen, E (1997) ‘Airline deregulation: the American experience and prospects for Europe’, Government Institute for Economic Research Helsinki.

6 Productivity describes the efficiency with which labour, capital and natural resources are organised to produce outputs, and increasing productivity means that a greater amount of goods and services can be produced for the same amount of input (such as labour, capital or natural resources).

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Figure 2: The contribution of productivity to growth

Note: Sources of growth for 84 Countries from 1960-2000. ‘TFP’ is total factor productivity.Source: World Bank Development Report 2005.

21. Box 4 outlines Australia’s structural reform experience over the past three decades and illustrates that a package of comprehensive structural reforms can have significant beneficial effects on overall productivity in an economy.

Box 4: Australia’s microeconomic reforms7

In the last 30 years Australia has transformed its economy by removing barriers to competition. Prior to that, poor productivity performance, together with the declining terms of trade, led to a decline in livings standards. From being ranked 4th out of OECD economies in 1950, Australia’s position fell to 9th in the early 1970s and 16th by the late 1980s. This situation forced a rethink of institutional and policy frameworks and led to a substantial program of microeconomic reforms.

Table 1: Change in Australia’s policy frameworks1970s 2000s

Fixed exchange rates Floating exchange rate

Capital controls Capital account and interest rate controls liberalised

High trade barriers Low trade barriers

Weak competition policy Stronger competition policy

Centralised labour market Decentralised labour market

Macroeconomic policy not anchored Macroeconomic polices credibly anchored to medium term targets.

As a result, Australia’s multifactor productivity growth more than doubled during the 1990s, averaging 2.3 per cent. Accompanied by an increase in labour utilisation, this led to annual growth in per capita incomes of around 2.5 per cent in the decade. It has been estimated that Australia’s household incomes are AUD 7,000 higher as a result of these reforms.

22. Box 5 shows that introduction of greater competition even in one industry, such as telecommunications, can have positive effects by lowering prices and stimulating economic and employment growth.

7 Wonder, B (2006) Policy determinants of Productivity Growth in Australia, East Asian Bureau of Economic Research Working Paper Series.

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Box 5: Papua New Guinea (PNG) mobile telecommunications reformPapua New Guinea undertook a major reform in 2007 with the introduction of competition to the mobile telecommunications market. Following an open tender process, two additional mobile licenses where issued to Digicel and Greencom. This reform introduced competitors to the State owned subsidiary company of Telikom, B-Mobile, ending the monopoly in PNG’s mobile telecommunications market.

This reform has also brought significant benefits to businesses and private citizens through reduced prices, for both calls and handsets, and increased output, as access and availability of services has greatly improved.

This reform is a significant milestone in PNG’s telecommunication sector, having considerably improved the service reliability and produced a rapid increase in telecommunications coverage. Rural and urban areas that have never had access to telephone services in the past are now enjoying the success of competition. In 2007, the economy has been estimated to have grown by 0.9 percent as a result of introduction of the mobile competition.

The reform has also seen a large increase in local employment. These employees are learning new skills which can potentially be transferred to the wider population increasing the capacity of PNG’s labour market. These benefits have translated into tangible improvements in people’s daily lives, as communication flows are improved and employment opportunities increase.

23. The ability to produce more goods and services for the same amount of input when productivity increases means that the economy has created more wealth for distribution amongst citizens in the form of lower prices. Citizens are able to purchase more goods and services from the same amount of income and accordingly, their real incomes rise.

24. Initially, higher incomes may increase private consumption, business investment, government taxation to fund government spending and savings. This may lead to additional increases in capital and labour supplies and a further increase in economic activity. Rising incomes are likely to entice more workers to join the labour force. Rising capital returns is likely to encourage more investment, which is financed through domestic and overseas savings. By increasing the supply potential of the economy, structural reform allows the economy to grow further before inflationary pressures arise. Ultimately, this allows stronger sustainable growth in incomes and employment.

25. Recent OECD analysis found that, for developing economies, pro-competitive reforms, including competition, investment and trade reforms, had the potential to increase, on average, income per capita by 7.7 per cent.8

8 Miroudot, S, Pinali, E and Sauter, N (2007), ‘The Impact of pro-competitive reforms on trade in developing countries, OECD Trade Policy Working Paper No. 54, OECD.

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Table 2: Potential GDP per capita gains from pro-competitive reforms in developing economiesEconomy % increase in GDP per

capitaEconomy % increase in GDP per

capitaAlgeria 7.7 Malaysia 6.6Argentina 7.6 Mauritius 7.7Bangladesh 8.6 Mexico 4.9Belarus 8.7 Morocco 7.7Bolivia 7.4 Pakistan 7.7Brazil 8.3 Panama 4.0Cameroon 8.8 Paraguay 9.0Chile 3.5 Peru 6.6China 7.9 Philippines 6.8Colombia 7.4 Senegal 8.5Costa Rica 6.6 South Africa 5.5Croatia 9.0 Sri Lanka 6.8Egypt 9.2 Tanzania 10.2Georgia 9.8 Tunisia 8.2India 7.7 Turkey 6.8Indonesia 8.4 Uganda 9.7Jordan 8.3 Uruguay 4.6Kenya 9.3 Venezuela 10.5Korea 4.7 Zambia 9.0Macedonia 8.2 Zimbabwe 10.4Madagascar 8.6 Average 7.7

Source: Miroudot, S, Pinali, E and Sauter, N (2007), ‘The Impact of pro-competitive reforms on trade in developing countries, OECD Trade Policy Working Paper No. 54, OECD.

Economic stability

26. The removal of structural barriers can help an economy maintain macroeconomic stability when exposed to large, often international, shocks. These shocks might involve large capital flows, changes in the price of important commodities such as oil; and political crises that affect market confidence. This is because improvements to market efficiency provide an economy with more flexibility and the ability to more smoothly transition in response to shocks.

27. Efficient markets rapidly transfer economic shocks into prices, allowing the players in an economy to react and adjust quickly to the altered economic environment. Efficient markets also provide a second round effect. When the investment community assesses that an economy has well-functioning markets then business expectations are framed accordingly and minor shocks are somewhat mitigated by business confidence in the market to adjust accordingly. Box 6 below outlines Singapore’s resilience to economic shocks largely due to its advanced state of structural reform efforts.

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Box 6: Singapore’s resilience to economic shocks9

Singapore’s total trade in goods and services was 338 per cent of gross domestic product in 1997, while foreign investment penetration was extensive at 80 per cent of gross national product in 1996.10 When the Asian financial crisis swept through East Asia in July 1997, Singapore’s high level of openness to trade and financial flows meant that it could not remain unaffected by crisis in the region, despite Singapore’s strong macroeconomic and financial fundamentals.

However, strong public institutions and good business norms which encouraged good public and private sector governance sheltered Singapore from the worst of the crisis. Three decades of financial market liberalisation coupled with appropriate prudential regulation had resulted in a strong financial sector able to intermediate large capital inflows. Well-managed banks were able to prudently assess risks and contain the incidence of non-performing loans.

The relative stability maintained by the economic system in the face of the catastrophic external shock meant that Singapore had time to plan incremental, surgical measures to prepare the Singapore economy for the next upturn rather than having to undertake sweeping emergency reforms to deal with immediate crises.

The experience highlighted the importance of ensuring the structural integrity of the economic system at all levels on an ongoing basis, from business corporate governance to government regulation. Apart from the government platforms facilitating regulatory reform documented in the 2007 APEC Economic Policy Report, other examples include the institutionalisation of the Accounting & Corporate Regulatory Authority and the Competition Commission of Singapore which provide greater assurance of corporate governance and a level playing field within Singapore.

Ultimately, the best reflection of the structural integrity of the Singapore economy is the continued confidence that businesses have in Singapore and the ease with which they are able to do business in Singapore.

28. The impact of shocks can be further dampened by optimal policy and institutional settings. Structural reforms that introduce automatic stabilisers, such as, floating exchange rates or fiscal polices, can moderate income loss by making exports relatively cheaper and reducing taxes.

29. However, some policy and institutional frameworks that dampen shocks may actually work against the market adjustment to increase the persistence of the shock. For example, labour market policies aimed at supporting employment and private consumption, such as, strict employee protection legislation may deter firms from laying off workers in the short-run. However, this delays the return of output and employment to their initial levels by impeding the reallocation of labour to more productive jobs.

Benefits for trade and foreign direct investment30. Domestic structural reforms that improve market efficiency have spill-over effects that increase trade and foreign direct investment. Trade is sensitive to the business 9 Adopted from APEC Economic Committee (2006), Economic Policy Report, APEC.10 Department of Statistics, Singapore.

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environment in an economy and structural barriers that increase risk, cost or reduce competition in an economy. Structural reforms to remove these barriers reduce transaction and production costs in that economy. As the economy becomes more attractive, trade and foreign direct investment opportunities expand. For example, reforms to assist domestic business such as reducing regulatory compliance costs will not only create more efficient markets but improve an economy’s competitiveness by reducing the cost of trading. The relationship between structural reform and foreign direct investment is demonstrated by the International Monetary Fund (IMF) (Box 7).

31. Structural reforms to increase competition in markets can also be crucial to realising the gains from trade liberalisation. APEC has been very successful in increasing trade in the region. The benefits from lower trade barriers will be further realised in the region as economies continue to pursue well functioning markets. Some economies have found it difficult to fully exploit the benefits from lower trade barriers. This is because gains from trade are realised through well-functioning markets. Even if trade is possible with an economy, foreign businesses are unlikely to invest unless they can access a competitive market. Thus, domestic reforms complement APEC’s trade and liberalisation facilitation agenda and contribute to APEC pursuits of economic integration in the region.

Box 7: FDI and structural reform: Evidence from Latin America and Eastern Europe11

Both Latin America and transition economies of Eastern Europe undertook extensive structural reforms, starting in the 1990s. Financial markets were liberalised, trade barriers reduced and state-owned enterprises were privatised to a large extent.

The successful implementation of structural reforms by the host governments increased the confidence of investors because it implied a reduction in risks associated with investment in that economy. In addition, these structural reforms generated real benefits by encouraging foreign direct investment through the creation of, and support for, robust and efficient financial and other markets. Foreign investors are also attracted to countries with stable macroeconomic environments and higher levels of economic development and infrastructure, all of which are facilitated by appropriate structural reform.

A strong empirical relationship has been found by the IMF between structural reforms and foreign direct investment. For Latin America, both privatisation and trade liberalisation were found to have a strong relationship with foreign direct investment flows. In addition, financial sector development was found to have a strong relationship to foreign direct investment flows.

Moreover, it was found that countries’ efforts to develop well-functioning financial sector also encouraged greater foreign direct investment, even after controlling for the level of financial development.

Overcoming short-term adjustment costs32. Structural reform can create short term adjustment costs, however in the longer term these costs should be more than offset by the benefits generated by well targeted 11 Campos, N F and Kinoshita, Y (2008), ‘Foreign Direct Investment and Structural Reforms:

Evidence from Eastern Europe and Latin America’, International Monetary Fund Working Paper 08/26.

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reforms. IMF studies have shown that while structural reforms may have short-run costs, in the long run, structural reforms have been found to have significant positive effects on productivity growth, potentially increasing productivity growth by 0.3 percentage points on average.12

33. Those disadvantaged by structural reform in the short term may include industries and occupations confronted with large reductions in specific industry assistance or large increases in the cost of key inputs. The adjustment costs and risk borne by these disadvantaged industries and occupations can also be managed and minimised by government through transfer mechanisms. Automatic stabilisers, such as the welfare payments system and the tax system can support those who lose employment or income as a result of structural adjustment. For example, through payment of unemployment benefits to individuals that cannot find employment and job retraining programs, or through a progressive tax system that provides an incentive for individuals to engage in the workforce. With appropriate use of the tax and welfare systems, it is possible to distribute efficiency gains from structural reform in a way that equity objectives are achieved.

34. Governments may also introduce initiatives to improve the capacity of employees. Initiatives such as skill development programs can assist employees to transfer to more productive industries and occupations.

35. The design of reforms may be able to mitigate some of the short term costs of reforms. Further, an economy in a strong fiscal position will be well placed to smooth the transition and ease the adjustment process for citizens. The challenges to government in managing and minimising these adjustment costs and the distribution of benefits are outlined in the discussion paper, ‘The Political Challenges of Structural Reform’.

Summary36. All economies face significant challenges in undertaking structural reform. The reform of structural policies is an ongoing process and that presents problems and challenges for all economies. While structural reform is not an easy path, the benefits that can be realised are too significant to overlook. A well-implemented structural reform agenda can stimulate business profitability, encourage economic growth and boost productivity. By building strong and efficient markets that are capable of stable and sustainable economic growth, member economies will be well placed to utilise resources for maximum gain. There is growing consensus that structural reform that facilitates well functioning markets is crucial in responding to emerging economic challenges, such as ageing, new technologies and globalisation. Further, structural reform has the potential to build on the growth and prosperity that trade liberalisation has already brought to the citizens of APEC economies. The path of ongoing structural reform provides the mechanism by which economies can continue to improve the living standards of citizens in a sustainable manner.

12 Salgado R (2002), ‘Impact of Structural Reforms on Productivity Growth in Industrialised Countries’, International Monetary Fund Working Paper 02/10.

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