The Philippines has been trying to crack open the investment nut by lifting its competitiveness for such a long time but has not been getting very far. Here’s why.

Continuing on from the first part where we looked at the country’s investment gap of over [...]]]> Tweet

The Philippines has been trying to crack open the investment nut by lifting its competitiveness for such a long time but has not been getting very far. Here’s why.

Continuing on from the first part where we looked at the country’s investment gap of over half a trillion pesos a year, we now turn to the problem of how to fill it and bring unemployment down. The imperative to boost competitiveness is based on the notion that low social returns on investment are due to a lack of opportunities to invest due to poor governance, inadequate infrastructure, and bad local finance.

Government failures caused by macro risks like poor fiscal, monetary and financial policies along with micro-risks including corruption, high taxes and weak property rights lead to a lack of incentives for investing in new ideas. These failures block the supply of innovation and investment. While this forms conceivably part of the problem, it does not necessarily explain the entire puzzle.

A missing piece is the demand not forthcoming from entrepreneurs for existing technology and capital even when it is available due to market failures. Dani Rodrik and Ricardo Hausmann talk about how this comes about when there are significant hidden costs associated with information and coordination. I will try to explain these failures using the coconut analogy.

Imagine that several decades after Robinson Crusoe left the island of Despair, a number of coconut plantations were established. The owners of these plantations were competing for a shrinking share of the coconut trade that existed between several islands in the vicinity. To improve their earnings, they each could find different ways of using the coconut. The process of discovering what types of products could be made comes with a cost caused by free-riders.

The evidence shows that low income countries actually develop first by diversifying their exports. The degree of specialization follows a U-shaped curve with income (diversifying more until reaching about the same level of income as Ireland before specializing). They do this by imitating technology already developed in rich countries. Instead of competing by creating new technology, they find cheaper ways of using existing modes of production in diverse sectors.

This process of “self-discovery” as Rodrik termed it often comes at a cost to the first-mover within a country, a cost which imitators do not incur. This creates a market failure because no one is willing to invest in this process since the information generated by it (“which goods can be produced more cheaply at home”) usually cannot be protected by patents.

This random process of discovery is why such countries as Pakistan and Bangladesh with similar levels of development and competitiveness produce very different products (the former produces soccer balls while the other produces hats). Korea and Taiwan also offer the same lesson (one produces microwave ovens and hardly any bicycles unlike the other). For the entrepreneurs who first ventured into these markets and were protected from the free-riding copycats, huge profits were on offer.

Bailey Klinger and Daniel Lederman have shown that their measure of export diversification, the frequency a country introduces new products into its export mix, is directly related to the height of entry barriers. This is a stunning result since it goes against the prevailing consensus on efficient and well-functioning markets.

Rather than the Global Competitiveness Index cited in the first part of this piece, which is based on subjective surveys, Klinger and Lederman used the World Bank’s Doing Business indicators for measuring barriers to entry which are based on objective measures like the number of days for starting and closing a business. They found that the higher the cost, the greater the returns to innovation from self-discovery.

The barriers in effect performed the role of greenhouses, protecting fragile innovative start-ups from the harsh winds of the free market. This counter-intuitive conclusion robustly supported by the evidence is consistent with the market failure argument. It violates the prevailing theory that increased specialization for poor countries and lowering costs of doing business is the way they should attract investments.

This is also borne out by the development experience of Japan which used “administrative guidance” to encourage many players within emerging industries to consolidate into oligopolies, Korea which offered loan guarantees as a way to subsidize the discovery costs of large diversified business conglomerates, India with its licensing raj which allowed a few pioneering software companies to gain economies of scale without the fear of new entrants, and Brazil which sponsored competitions for innovation with significant exclusive licenses going to the winner.

Klinger and Lederman state that this does not imply that there are no negative effects due to protection. What their study shows is that the positive effects swamp them. This means that rather than justifying protectionism, what it does is build a case for state support for emerging industries. I will have more to say regarding this in a moment.

Moving on to the second form of market failure which is due to coordination costs, picture the island once again. To transport various coconut products to other parts of the area, investments in seafaring ships and the training of sailors are necessary. These complementary investments are needed for an expansion of production to occur. Unfortunately, no one is willing to coordinate with the other inhabitants who live near the shore who could profit from such activities, so nothing happens.

Taiwan’s experience with the orchid industry is illustrative. When the world price of sugar declined, the state figured that shifting farm production to this high end product would prove beneficial. This required coordinated investments in things like greenhouses and storage facilities which the state encouraged and subsidized. The same type of intervention was performed by Fundacion Chile a partly state-owned enterprise which gave rise to a new salmon exporting sector.

The faltering seaweed industry located mostly in the Autonomous Region of Muslim Mindanao and the nascent industry of coco juice seem to be suffering a combination of the market failure problems discussed above. Our electronics industry which is highly specialized in “screwdriver” assembly operations as South Korea once was could be expanded likewise to incorporate more value adding steps in the manufacturing process.

The usual ways by which governments address these market failures is by offering subsidies to defray the costs of “self-discovery” (by sponsoring contests which award a prize to the best solutions for example), financing high risk ventures at the pre-commercialization phase and coordinating complementary investments in specific areas such as research and development, infrastructure and general training.

Think of it this way: instead of borrowing from foreign governments to pay their suppliers to develop our infrastructure (think broadband and high-speed rail) we should be licensing their technologies and awarding these to local firms which can prove they can use it cost effectively to build what we need. This should also apply to contracts awarded to private firms partnered with foreign companies. They should be conditioned on meeting certain local content requirements. Defense contracts should increasingly source local producers as well.

The Department of Transportation and Communication is already on the right track by seeking to borrow to pay for the build while privatizing the operations and maintenance of certain projects like light railways. In time we could be exporting some of these products and services if we create local expertise. South Korea did this with its ship building industry in the 1970s with Hyundai Heavy Industries becoming the world’s leading exporter within a decade. It did this even as global demand for ships declined.

Where will the government get the money to do all this? From itself, by using the savings remitted by overseas Filipinos and stored with the central bank in the form of foreign currency reserves–an unorthodox view that even the “humbled” former dean of the UP Economics School holds! If the government were to set aside a third of the currency surplus flowing in each year (see previous posts on this) amounting to around fifteen billion dollars to fund these activities and assuming a one-for-one investment multiplier, a total of four hundred and fifty billion pesos worth of spending could be generated annually (adding 4.5% points to GDP growth!). This would fill up to eighty percent of the investment gap.

The need to diversify our exports is already apparent with an inordinately high specialization in electronics posing a huge risk to future growth in the face of uncertainty of demand from advanced economies. It is also clear that despite very benign inflation and low real interest rates, private firms fail to undertake investments that would lift the productivity of their idle capital. This underinvestment problem is why such a large proportion of our workforce remains unemployed or underutilized.

Stimulating demand for innovation and investment by addressing market failures should be the priority. The biggest barrier for the Philippines to adopting such a strategy will not be an inadequate bureaucracy as many of our top bureaucrats are well-informed and educated; it won’t be for lack of funds as a substantial amount of national savings remain untapped; it won’t be for lack of ideas as there is a wide gap between domestic and foreign technology that can be filled.

The biggest barrier will be attitudinal as it would mean countering the development mindset that has dominated for such a long time which is largely donor-driven. Having drunk the policy “cocktail” put together according to their orthodoxies to no avail, giving us the title of being “the sick man of Asia”, it is about time we developed our own recipes for stimulating economic dynamism in line with local conditions. I now leave you with a song about the coconut which should punctuate this final thought.