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«Policy Research Working Paper 5313 Public Disclosure Authorized Growth Identification and Facilitation The Role of the State in the Dynamics of ...»

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Too often, such industrial policy defied the prevailing comparative advantage of many poor countries where factor endowments were characterized by the abundance of labor. By implementing the capital-intensive heavy industry-oriented development strategy, they could not build firms capable of surviving in open, competitive markets. Because of their high capital needs and their structurally high production costs, these public enterprises were not viable. Even when they were well managed, they could not earn a socially acceptable profit in an undistorted and competitive market. A good example is that of Egypt’s industrialization program in the 1950s, which featured heavy industries such as iron, steel, and chemical manufacturing. The country’s per capita income represented about 5 percent of that of the U.S., the world’s most important steel producer at the time. Unless the government continuously provided costly subsidies and/or protection, Egyptian firms could not attract private investment. The limited fiscal resource capacities of the state made such large-scale protection and subsidies unsustainable. In such situations, governments have had to resort to administrative measures— granting market monopolies to firms in the so-called priority sectors, suppressing interest rates, over-valuing domestic currencies, and controlling the prices of raw materials—in order to reduce the costs of investment and continuous operation of their non-viable public enterprises (Lin 2009).

These various experiments provide valuable lessons for economic policy. They highlight conditions under which industrial policies can succeed or fail. Failures occur when countries target industries that are too advanced, far beyond their latent comparative advantage. In such circumstances, government-supported firms cannot be viable in open, competitive markets. Their survival depends on heavy protection and large subsidies through various means such as high tariffs, quota restrictions, and subsidized credit. The large rents embedded in those measures easily become the targets of political capture and create difficult governance problems (Lin 2010).31

4. A Framework for Growth Identification and Facilitation

The historical and contemporary evidence showing that governments always play an important role in facilitating industrial upgrading and diversification in all successful countries may not be enough to validate an idea that has been mired in controversy for so long. Many economists who agree with the general notion that government intervention is an indispensable ingredient to structural transformation have maintained their opposition to industrial policy because of the lack

                                                                                                                                                                                               

  included: 1) developing economies’ production structures were oriented heavily toward primary commodity production; 2) if developing countries adopted policies of free trade, their comparative advantage would forever lie in primary commodity production; 3) the global income elasticity and the price elasticity of demand for primary commodities were low; 4) capital accumulation was crucial for growth and, in the early stage of development, it could occur only with the importation of capital goods. Based on these stylized facts and premises, it was a straight step to believe that the process of development was industrialization, and industrialization consisted primarily of the substitution of domestic production of manufactured goods for imports (Chenery 1958).

The other reason for the failure of industrial policy in developing countries is that the policy targets industries that have already lost comparative advantage, but governments want to protect them for sociopolitical reasons (such as providing unemployment, often in urban areas).

17    of a general framework that can be used to guide policymaking. As Charles Schultze, chairman of the Council of Economic Advisers under U.S. President Jimmy Carter, once put it: “The first problem for the government in carrying out an industrial policy is that we actually know precious little about identifying, before the fact, a ‘winning’ industrial structure. There is not a set of economic criteria that determine what gives different countries preeminence in particular lines of business. Nor is it at all clear what the substantive criteria would be for deciding which older industries to protect or restructure” (1983).

It is therefore useful to draw on the theories of comparative advantage and the advantage of backwardness as well the successful and failed experiences of industrial policies discussed in Section 3 to codify some basic principles that can guide the formation of successful industrial policy. The first step is to identify new industries in which a country may have latent comparative advantage and the second is to remove the constraints that impede the emergence of industries with latent comparative advantage and create the conditions to allow them to become

the country’s actual comparative advantage. Here, we propose a six-step process:





 First, the government32 in a developing country can identify the list of tradable goods33 and services that have been produced for about 20 years in dynamically growing countries with similar endowment structures and a per capita income that is about 100 percent higher than their own.34

                                                            

The government refers to both the central and local governments. The process discussed here can also be used by multilateral development agencies and nongovernmental organizations to promote industrial upgrading and diversification in developing countries.

Tradable goods refer to manufactured products, agricultural products, and fishery as well other natural resources products. Because of the ascendance and dominance of international production networks in manufacturing industries, manufactured goods here refer not only to the final products but also to intermediate inputs of final products in manufacturing industries.

As discussed in Section 3, this is the most important principle for a developing country to reap the advantage of backwardness in its industrial upgrading and diversification. This is because for a dynamically growing country, its wage rate is increasing rapidly and likely to start losing comparative advantage in the industries that it has produced for many years. Therefore, the industries will become the latent comparative advantage of countries with a similar endowment structure but with a lower wage. The principle also means that when a country grows beyond the income level of 50 percent of the most advanced country, it will become increasingly difficult to identify industries that are likely to be the country’s latent comparative advantage. The country’s industries will locate increasingly close to the global frontier and its industries’ upgrading and diversification will increasingly rely on indigenous innovations in the country. Therefore, their governments’ policies to support industrial upgrading and diversification will increasingly resemble those of the advanced countries. The chance of those policies failing to achieve the intended goal will also increase. As for low-income countries with per capita income measured at about $1000 in PPP term now, in addition to identifying matured tradable goods in countries at about $2000 currently, it may also identify tradable goods produced in countries that had similar per capita income level 20 or so years ago and have been growing dynamically since then. Specially, China, Vietnam and India had a similar or even lower income levels 30 years ago than most of today’s poor Sub-Saharan countries. Therefore, for today’s poor countries, they may identify the list of goods and services produced in China, Vietnam, and India 20 years ago as references. They may also review their imports and identify the list of simple manufacturing goods, which are labor-intensive, have limited economies of scale, and require only small investments, as the targets of their industrial upgrading and diversification. The proposed idea is similar to that of monkeys jumping to nearby trees, proposed by Hausmann Klinger (2006), but the step proposed here is much easier to implement than the product space analysis proposed by them.

18     Second, among the industries in that list, the government may give priority to those in which some domestic private firms have already entered spontaneously,35 and try to identify: (i) the obstacles that are preventing these firms from upgrading the quality of their products; or (ii), the barriers that limit entry to those industries by other private firms.36 This could be done through the combination of various methods such as the value-chain analysis or the Growth Diagnostic Framework suggested by Hausmann, Rodrik, and Velasco (2008). The government can then implement policy to remove those binding constraints and use randomized controlled experiments to test the effects of releasing those constraints so as to ensure the effectiveness of scaling up those policies at the national level (Duflo 2004).

 Third, some of those industries in the list may be completely new to domestic firms. In such cases, the government could adopt specific measures to encourage firms in the higher-income countries identified in the first step to invest in these industries. Firms in those higher-income countries will have incentives to reallocate their production to the lower-income country so as to take advantage of the lower labor costs. The government may also set up incubation programs to catalyze the entry of private domestic firms into these industries.37  Fourth, in addition to the industries identified on the list of potential opportunities for tradable goods and services in step 1, developing country governments should pay close attention to successful self discoveries by private enterprises and provide support to scale up those industries.38

                                                            

This is because every industry requires some highly specific inputs such as knowledge, physical assets, intermediate inputs, labor skills, and so on. The existence of some private firms in the industry indicates that the economy at least partially possesses those crucial inputs.

Chile has produced wine for a long time. Its recent success in the wine industry is a good example. The change from a negligible wine exporter to the world’s fifth exporter in the 1970s benefitted greatly from the government’s programs to disseminate foreign technology to local farmers and vineyards through Grupos de Transferencia Tecnologica so as to improve the quality and promote Chilean wine abroad through Export Promotion Office, ProChile, to change the foreign consumer’s perception of Chilean wine (Benavente 2006).

Lessons from successful Asian countries can be of relevance here. When local Asian firms had no historical knowledge in a particular industry of interest to the country, the state often attracted foreign direct investment and/or promoted joint-ventures. After the transition to a market economy in the 1980s, China, for instance, pro-actively invited direct investment from Hong Kong -China, Taiwan-China, Korea, and Japan. This promotion policy helped the local economy to get started in various industries. Bangladesh’s vibrant garment industry also started with the direct investment from Daiwoo, a Korean manufacturer, in the 1970s. After a few years, enough knowledge transfer had taken place and the direct investment became a sort of “incubation.” It is found that local garment plants mushroomed in Bangladesh, and most of them could be traced back to that first Korean firm (Mottaleb and Sonobe 2009; Rhee, 1990; Rhee and Belot 1990). The booming cut-flower export business in Ecuador from the 1980s onward also started with three companies founded by Colombia’s flower growers (Sawers 2005). The government can also set up industrial park to incubate new industries. Taiwan-China’s Hsingchu Science-based Industrial Park for the development of electronic and IT industries (Mathews 2006) and the Fundacion Chile’s demonstration of commercial salmon farming (Katz 2006) are two successful examples of government’s incubation of new industries.

India’s information industry is a good example. Indian professionals in Silicon Valley helped Indian companies take advantage of expanding opportunities for outsourced IT work in the 1980s. Once the potential of software exports was demonstrated, the Indian government helped build a high-speed data-communications infrastructure that allowed many Indians in the diaspora to return home and set up offshore sites for U.S. clients. The Indian software industy has grown more than 30 percent annually for 20 years, with 2008 exports close to $60 billion (Bhatnagar 19     Fifth, in developing countries with poor infrastructure and an unfriendly business environment, the government can invest in industrial parks or export processing zones and make the necessary improvements to attract domestic private firms and/or foreign firms that may be willing to invest in the targeted industries. Improvements in infrastructure and the business environment can reduce transaction costs and facilitate industrial development. However, because of budget and capacity constraints, most governments will not be able to make the desirable improvements for the whole economy in a reasonable timeframe. Focusing on improvement in infrastructure and business environment in industrial parks or export processing zones is, therefore, a more manageable alternative.39 Industrial parks and export processing zones also have the benefits of encouraging industrial clustering.



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