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PRIVATE SECTOR DEVELOPMENT PROGRAMMES IN

SELECTED COUNTRIES IN EAST AND SOUTH EAST ASIA


AND LESSONS FOR AFRICA

_______________________________________________________________________
_

DR. TARUN DAS


Economic Adviser
Ministry of Finance, Govt of India
And Consultant, UN-ECA, Addis Ababa

_______________________________________________________________________
_

• 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.

• 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 Background of the study


1.2 Objectives and scope of the study
1.3 An Overview of the study
1.4 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

2 Role of Public Sector in Asia and Africa

2.1 The Economics of public sector


2.2 Public/private mix in Asia, Africa and Latin America
2.3 Public Sector in selected Asian countries
2.4 Reforms in public sector enterprises

3 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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4 Role of Foreign Investment in Industrial and Infrastructure Development

4.1 Private capital flows to developing countries


4.2 FDI - technology - growth nexus
4.3 Regional distribution of FDI
4.4 Sectoral distribution of FDI
4.5 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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(b) Privatisation programmes and strategy
(c) Private-public partnership
(d) Development of infrastructure and services
(e) Fiscal and monetary incentives
8.4 Export development policies
(a) Duty drawback schemes
(b) Free trade zones
8.5 Foreign investment policy
(a) Host country policies for FDI
(b) Host country pollicies for portfolio investment
(c) Home country policies
8.6 Role of small and medium sized industries
8.7 Restructuring the financial sector
8.8 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
8.9 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 Growth in GDP per capita in Asia and Africa in 1961-1997 (in per cent)
1.2 Gross domestic savings as a share of GDP in Asia and Africa (in per cent)
1.3 Sub-Saharan Africa: key economic indicators
1.4 Sub-Saharan Africa: selected indicators by groups of countries
1.5 International comparisons of saving and investment
1.6 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

8
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

1
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.

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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 self-
sustainment 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:

• 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;

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• 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 low-
income 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 1961-1972 1973-1980 1981-1990 1991-1997

Africa 1.3 0.7 -0.9 -0.5


East Asia 7.0 7.1 9.4 8.0
Southeast Asia 3.2 4.9 4.3 4.5
South Asia 1.3 1.6 3.3 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 1967-73 1974-80 1981-90 1990-1997

Gross Domestic Savings


Sub-Saharan Africa 15.7 20.7 12.6 15.9
East Asia 21.1 28.4 33.2 33.5
Southeast Asia 18.9 28.1 31.9 32.0
South Asia 14.4 17.1 19.1 22.0

Gross Domestic Investment


Sub-Saharan Africa 17.3 17.9 19.1 16.6
East Asia 25.4 27.0 27.7 31.6
Southeast Asia 20.1 21.0 22.1 27.5
South Asia 16.2 16.5 17.0 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 –

18
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 sub-
Saharan 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 Table-
1.6 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 Public Gross Share of Share of


Investment Investment Domestic private public
Savings Investment investment
in GDI in GDI

Sub-Saharan 16.6 11.9 4.7 15.9 28 62


Africa
Western 20.3 15.3 5.0 18.2 25 75
Hemisphere
Asia (excluding 27.8 19.2 8.6 31.8 31 69
Japan)
NIEs in Asia 31.6 24.7 6.9 33.4 23 77

Advanced 20.8 16.9 3.9 20.8 19 81


countries

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.

21
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 macro-
economic 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.

23
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 19.3 20.4 19.9
PVTI/GDP 9.7 11.1 10.5
PUBI/GDP 9.6 9.3 9.4
PVTI/GDI 50.1 54.4 52.6
PUBI/GDI 49.9 45.6 47.4

East and South East Asia:


GDFI/GDP 28.0 30.6 29.5
PVTI/GDP 18.6 23.0 21.1
PUBI/GDP 9.4 7.5 8.3
PVTI/GDI 66.5 75.3 71.5
PUBI/GDI 33.5 24.7 28.5

Latin America and Caribbean:


GDFI/GDP 20.7 19.8 20.2
PVTI/GDP 13.7 14.6 14.2
PUBI/GDP 7.0 5.3 6.0
PVTI/GDI 66.2 73.4 70.3
PUBI/GDI 33.8 26.6 29.7

Europe, Middle East and North America:


GDFI/GDP 21.2 20.0 20.5
PVTI/GDP 9.9 10.7 10.4
PUBI/GDP 11.3 9.4 10.2
PVTI/GDI 46.9 53.2 50.5
PUBI/GDI 53.1 46.8 49.5

Sub-Saharan Africa:
GDFI/GDP 20.6 16.9 18.5
PVTI/GDP 9.4 9.4 9.4
PUBI/GDP 11.3 7.5 9.1
PVTI/GDI 45.4 55.7 51.3
PUBI/GDI 54.6 44.3 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.

24
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 9.9 11.4 10.5
African developing economies 18.7 17.9 18.4
Latin American developing economies 9.0 9.2 9.1

Share in non-agricultural GDP


Asian developing economies 13.5 14.6 14.0
African developing economies 22.1 20.9 21.6
Latin American developing economies 9.9 10.1 10.0

Share in gross domestic investment


Asian developing economies 30.0 24.3 27.6
African developing economies 28.9 26.4 27.8
Latin American developing economies 24.1 15.6 20.4

SOE’s investment as percentage of GDP


Asian developing economies 7.0 5.8 6.5
African developing economies 6.8 5.4 6.2
Latin American developing economies 5.1 3.1 4.2

Share in employment
Asian developing economies 4.9 4.7 4.8
African developing economies 15.8 17.1 16.4
Latin American developing economies 4.3 4.0 4.1

Share in gross domestic credit


Asian developing economies 10.4 9.7 10.1
African developing economies 16.2 18.2 17.1
Latin American developing economies 8.0 12.6 10.0

Share in external debt


Asian developing economies 11.1 13.1 12.0
African developing economies 14.7 12.0 13.6
Latin American developing economies 21.9 15.0 19.0

SOE’s external debt as percent of GDP


Asian developing economies 3.7 4.5 4.0
African developing economies 7.4 10.9 8.9
Latin American developing economies 8.5 6.1 7.5

25
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

SOE’s overall balance as percent of GDP


Asian developing economies -3.4 -1.6 -2.7
African developing economies -1.8 -2.3 -2.0
Latin American developing economies -1.1 1.8 0.1

Govt.financial flows to SOEs as % of


GDP 1.1 0.1 0.7
Asian developing economies 1.6 1.4 1.5
African developing economies -2.0 -2.4 -2.2
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 loss-
making 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 Share in Non- Share in Gross


Agricultural GDP Domestic Investment
1980 1991 1980 1991 1980 1991

Bangladesh 2.1 3.4 3.5 5.4 6.7 25.8


India 9.1 13.6 13.9 19.0 41.1 42.5
Indonesia 17.7 13.0 23.3 17.0 11.1 18.7
Japan - - - - 10.6 4.9
Korea,Rep.of 10.4 10.2 12.2 11.2 27.6 8.9
Malaysia - 17.0 - 21.0 9.9 14.4
Myanmar - - - - 48.2 11.9
Nepal 2.5 2.0 6.1 4.3 35.0 53.5
Pakistan 8.0 11.5 12.8 16.0 35.5 25.6
Philippines 1.6 3.0 2.1 3.9 18.4 2.2
Sri Lanka - 10.3 - 13.5 36.2 18.5
Taiwan,China 6.2 5.6 7.2 6.0 27.8 17.0
Thailand - 5.4 - 6.2 17.7 13.3
Industrial 4.3 6.0 4.5 6.2 8.8 6.2
Countries
Developing 10.6 10.2 12.6 12.0 26.4 17.9
Countries
-- Latin America 9.5 8.4 10.4 9.3 22.8 12.1
-- Africa 18.2 17.3 21.2 20.1 29.8 24.2
-- Asia 9.6 10.7 13.2 13.3 30.3 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 Non- GDI 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 4.9 5.0 7.7 - - -


countries

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 Build-
Operate-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 Sub-
Saharan 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, tele-
communications, 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 pre-
qualified 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 mana-
gement, and security that the suppliers of capital require. Borrowing from banks tends to

32
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.

33
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.

34
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 state-
owned 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

35
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 state-
owned 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

36
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.

37
• 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 well-
connected clients. The presence of foreign banks also help to promote and facilitate FDI.

38
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

39
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. factor-
driven (attracting FDI in processing, textiles and minerals exploitation), investment
driven (heavy and chemical industries, power, construction, transport and tele-
communications), innovation-driven (electronics, information technology, bio-
technology) 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

40
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.

41
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

42
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

43
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.

44
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

45
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.

46
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,

47
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.

48
Table 5.1: Investment-GDP Ratios in selected countries (Per cent)

Country 1960-1969 1970-1979 1980-1989 1990-1996


China 35 35 34 39
Hong Kong SAR 18 24 28 30
Indonesia 18 19 27 32
India 16 18 22 24
Japan 35 34 30 30
Korea 18 28 30 37
Malaysia 15 23 30 38
Philippines 19 25 23 23
Singapore 23 41 42 35
Taiwan Province of China 25 29 24 24
Thailand 22 25 28 41
Brazil 17 22 21 20
Chile .. 12 18 25
Mexico 17 22 22 22
Germany 26 23 20 22
Italy 27 26 23 19
Spain .. 24 22 22
United Kingdom 19 20 17 16
United States 21 20 20 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.

49
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,

50
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

51
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 socio-
economic 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.

52
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,

53
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

54
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 non-
commercial 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

55
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.

56
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

57
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 trade-
related, 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.

58
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

59
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 market-
oriented 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

60
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.

62
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 below-
trend 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

64
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 post-
World 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

65
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

66
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, man-
made 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 Total Tax Personal Corporate Nominal Nominal


Revenue Revenue Income Income Effective Effective
Tax Tax Tariff Tariff
Rate Rate
1990 1995
Thailand 18.3 16.3 2.3 3.5 11.0 7.1
Australia 25.8 23.0 12.4 3.8 8.1 4.7
Canada 20.7 18.3 8.7 1.4 2.9 1.7
France 40.6 37.7 5.3 1.8 0.03 0.02
Germany 30.4 28.9 4.0 0.8 0 0
Indonesia 17.9 16.1 1.2 8.3 5.8 5.0
Japan 19.9 17.1 5.4 3.4 2.6 4.0
South Korea 18.8 16.2 3.5 2.4 8.0 4.7
Malaysia 28.3 20.8 2.4 6.9 4.9 4.0
New Zealand 38.7 33.9 17.0 3.3 4.8 3.9
Philippines 17.8 15.2 1.8 2.2 15.4 14.1
Singapore 32.3 15.9 .. .. 0.7 0.3
United Kingdom 36.0 32.9 9.9 3.1 0.1 0.1
United States 19.7 18.1 8.2 1.9 3.5 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 distri-
bution 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 1997-
1998, 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 four-
tiered 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 semi-
manufactured 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

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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 50-
60% 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, export-


oriented, 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 labour-
intensive 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 capability-


building 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 inter-
regional 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.

• 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.

• 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.

• 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 post-
war 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 Thailand-
with 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.
10
11 (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, pre-
shipment 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, Sub-
Saharan 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:

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• 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 economy-
wide 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 set-
up 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 market-
based 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 non-
financial 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 scale-
determined. 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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