Governance and Growth:

Growth-Enhancing Governance Capabilities

Mushtaq H. Khan,

Department of Economics, SOAS

Governance for Growth Workshop, Russell Hotel July 2-3 2007

If good governance is not immediately achievable, neither is the achievement of low transaction cost markets

Critical governance capabilities are then likely to be related not only to regulating imperfect markets but vitally also with providing second-best responses to market failures

Attempts to correct market failures in developing countries have often failed because the institutions through which market failures were addressed could not be effectively enforced: appropriate governance capabilities were missing

Governance for growth

My disagreement with many heterodox economists (like Chang) is that neither institutions nor the broader governance capabilities of particular East Asian countries with respect to those institutions are replicable

Indeed, this is underlined by the fact that there are significant institutional differences in the ways in which market failures were addressed in different East Asian countries, reflecting differences in initial conditions and specific governance capabilities

However, we do know quite a bit about the general types of problems that successful Asian countries ‘solved’ using very different institutional rules, consistent with their different governance capabilities of enforcement

Institutions and governance capabilities from East Asia cannot be replicated

The successful developers are also misleading as role models because the pragmatic steps they took were compatible with their internal political conditions and could be easily implemented

In contrast, very similar institutional rules were often pragmatically introduced in other developing countries and could not be effectively enforced

In most poorly performing developers, there are high political costs of enforcing particular rules, and/or costly political and institutional reorganization is required.

Developing countries therefore need a more structured way of thinking through institutional choices and governance capabilities

Nor can we simply proceed in ‘pragmatic’ ways

A number of critical areas of business-government relationships in case studies of Asian success stories (but this is not necessarily a complete list):

• The identification and protection of critical property rights rather than all property rights

• The management of non-market asset and resource transfers to critical activities

• The acceleration of technology acquisition and learning through different types of rent-management strategies

• And overlapping with all of them, the organization of patron-client politics in ways that enabled effective enforcement of critical rules

Governance for growth

Property rights and non-market transfers

Econom ic In itia l Conditions:Low Productivity Econom y

(Unable to pay for property right enforcem ent across the board)

O rganization of politica l factions + Bureaucratic strategies and capabilities

In form al protection of rights and N on-m arket asset transfers (legal and illegal)

G radual Em ergence of a Productive Capita lism Resources captured by unproductive political entrepreneurs, u ltim ately w arlord ism

Market failures and the productivity gap

Productiv ity gap and m arket fa ilures prevent m oves up the

technology ladder

Strategies of rent capture in productive enterprises

m oving up the va lue chain

Politica l organization and institu tional strateg ies result in

e ffective rent m anagem ent/credib le exit stra teg ies

G rowth w ith m ovem ent up the va lue chain: rent seeking/corruption appears as

‘benign ’ profit sharing: S K orea, China

Politica l organization and institu tional strateg ies resu lt in

fa iled im plem entation/perm anent rent capture by ‘in fants’

Possib le spurt o f IS I grow th w ith eventual productiv ity prob lem s: rent seeking/

corruption is ‘m align ’ because it protects the ineffic ient and socia lly powerfu l

Patron-client networks, political stabilization and spillovers for growth

O rganization of patron-client networks and governance capabilities of state and politica l

parties

Suffic ient political stab ility for grow th and accum ulation, benign effects on protection of rights of productive sectors, the ir access to

resources, and technology polic ies

Dam aging effects on productive sectors, capture of technology policy rents, in extrem e

cases, fa ilure to m aintain po litica l stability

Political stabilization using off-budget resources and/or patron-client networks

Economic Initial Conditions:Low Productivity Economy

(Fiscal base inadequate for achieving political stability through generalized allocations)

Institutional rules and governance capabilities in selected countries: 1960-2000

S u p p o r tiv e o r O b s tru c tiv e G o v e rn a n c e C a p a b ili t ie s

C r it ic a l C o m p o n e n ts o f G ro w th -E n h a n c in g S tra te g y

E c o n o m ic O u tc o m e s

S o u th K o re a1 9 6 0 s to e a r ly

1 9 8 0 s

N o n -m a rk e t a s se t a llo c a tio n s (c o n so lid a tio n s , m e rg e rs a n d

re s tru c tu r in g o f ) .

Ta rg e te d c o n d itio n a l s u b s id ie s fo r to a c c e le ra te c a tc h in g -u p .

chaebo l

chaebo l

C e n tra liz e d a n d e ffe c tiv e g o v e rn a n c e o f in te rv e n tio n s b y a g e n c ie s w ith lo n g - te rm s ta k e in d e v e lo p m e n t.

E ffe c tiv e p o w e r to im p le m e n t a s s is te d b y w e a k n e s s o f p o li tic a l

f a c tio n s so th a t in e ff ic ie n t s u b s id y re c ip ie n ts a re u n a b le to b u y

p ro te c tio n f ro m th e m .

Ve ry ra p id g ro w th a n d c a p ita l is t

tr a n sfo rm a tio n

M a la y s ia 1 9 8 0 s 1 9 9 0 s

P u b lic s e c to r te c h n o lo g y a c q u is it io n s tra te g ie s u s in g p u b lic e n te rp r ise s w ith su b c o n tra c tin g fo r

d o m e s tic f irm s .

Ta rg e te d in f ra s tru c tu re a n d in c e n tiv e s fo r M N C s w ith

c o n d itio n s o n te c h n o lo g y tra n sfe r.

M o d e ra te ly e ffe c tiv e c e n tra liz e d g o v e rn a n c e o f in te rv e n tio n s .

A s s is te d b y c e n tra liz e d tra n sfe rs to in te rm e d ia te c la sse s w h ic h re d u c e d

in c e n tiv e s o f p o li t ic a l fa c tio n s to se e k re n ts b y p ro te c tin g in e ff ic ie n t f irm s .

R a p id g ro w th a n d c a p ita l is t

tr a n sfo rm a tio n

Institutional rules and governance capabilities in selected countries: 1960-2000

S u p p o r tiv e o r O b s tru c tiv e G o v e rn a n c e C a p a b ili t ie s

C r it ic a l C o m p o n e n ts o f G ro w th -E n h a n c in g S tra te g y

E c o n o m ic O u tc o m e s

In d ia n su b c o n tin e n t 1 9 6 0 s 1 9 7 0 s

(W ith s o m e v a r ia tio n s th e se c h a ra c te ris tic s d e s c r ib e m a n y

d e v e lo p in g c o u n tr ie s o f th a t

p e r io d )

T a rg e te d s u b s id ie s to a c c e le ra te c a tc h in g u p in c r i t ic a l s e c to rs (u s in g p ro te c tio n , l ic e n s in g o f

fo re ig n e x c h a n g e , p ric e c o n tro ls a n d o th e r m e c h a n is m s) .

P u b lic s e c to r te c h n o lo g y a c q u is it io n in s u b s id iz e d p u b lic

e n te rp r ise s .

R e so u rc e tra n s fe rs to g ro w th se c to rs u s in g l ic e n s in g a n d p r ic in g

p o lic y.

M o d e ra te to w e a k g o v e rn a n c e c a p a c it ie s to d isc ip lin e n o n -

p e r fo rm in g re n t re c ip ie n ts . A g e n c ie s o f te n h a v e c o n tra d ic to ry g o a ls

d e f in e d b y d iffe re n t c o n s ti tu e n c ie s .

F ra g m e n te d p o li t ic a l fa c tio n s h e lp to p ro te c t th e re n ts o f th e in e ff ic ie n t fo r

a sh a re o f th e se re n ts .

S ta te c a p a c it ie s d e c lin e a s c o m m itte d a n d in te llig e n t in d iv id u a ls le a v e .

P u b lic a n d p riv a te se c to r in fa n t

in d u s tr ie s o fte n fa il to g ro w u p .

R e n t se e k in g c o s ts a re o f te n th e m o st v is ib le e ffe c ts o f

in te rv e n tio n .

M o d e ra te to lo w g ro w th a n d s lo w

tra n sfo rm a tio n

In d ia n su b c o n tin e n t 1 9 8 0 s 1 9 9 0 s

L ib e ra liz a tio n p r im a rily in th e fo rm o f a w ith d ra w a l o f im p lic it ta rg e te d su b s id ie s , in p a r t ic u la r th ro u g h th e re la x a tio n o f l ic e n s in g fo r c a p ita l

g o o d s im p o r ts .

M u c h m o re g ra d u a l w ith d ra w a l o f p ro te c tio n a c ro s s th e b o a rd fo r

d o m e s tic m a rk e ts .

M o d e ra te to w e a k g o v e rn a n c e c a p a c it ie s to im p le m e n t re m a in b u t

d o le ss d a m a g e a s th e sc o p e o f g ro w th e n h a n c in g p o lic ie s d e c lin e .

F ra g m e n te d p o li t ic a l fa c tio n s c o n tin u e to h a v e a n e ffe c t o n m a rk e t-e n h a n c in g g o v e rn a n c e b y re s tric t in g ta x re v e n u e s a n d m a k in g i t d iffic u lt to c o n s tru c t a d e q u a te in f ra s tru c tu re .

G ro w th le d b y in v e s tm e n ts in

se c to rs th a t a lre a d y h a v e c o m p a ra tiv e

a d v a n ta g e .

H ig h e r g ro w th b u t l im ite d to a fe w

se c to rs .

The emergence and growth of this low technology manufacturing industry was based on a fortuitous set of temporary rents created by MFA

The initial temporary rents were allocated through the BGMEA and the first generation entrepreneurs emerged through that process

Today employs around 2 million people, largest export earner but faces serious constraints in moving up value chain, and achieve scale economies

Main constraint in achieving scale economies is in acquiring contiguous land sites: entrepreneurs use political factions to acquire land

But constraints in moving up the value chain involve failures in credit markets: a new set of temporary rents are required

An example from the Bangladesh garment industry

Political organization, governance strategies and growth

Susta ined m arket fa ilures

Constra in ts on im m ediate

im provem ents in m arket e ffic iency

G overnance capabilities required to

respond to m arket fa ilures

G overnance stra teg ies have to be m atched w ith po litica l

conditions, in itia l institutional conditions and technolog ica l

challenges

G rowth enhancing only if the benefit o f intervention

outw eighs cost

Effective rent m anagem ent capacities a lready exist but need to be

im proved: China, V ie tnam , parts o f Ind ia

Effective rent m anagem ent capabilities do not exist

G row th based on existing m arket e ffic iency and com parative

advantage: U ganda, B angladesh, m uch of India

Lim ited grow th achieved: m any develop ing countries

Iterative changes in po litical organization and governance

strateg ies to enable m ore effective responses to m fs