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«January 16, 2006 Howard Pack Kamal Saggi The Wharton School Department of Economics University of Pennsylvania Southern Methodist University 1400 ...»

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Beason and Weinstein (1996) examined the connection between industrial policy and sectoral TFP growth in Japan. Working with a 13 sector sample for the period 1955they failed to uncover evidence that preferential policies (measured by the effective rates of protection, taxes, or subsidies) targeted sectors with increasing returns to scale or that they contributed to the rate of capital accumulation in sectors or their TFP growth.

They did find some evidence that prior to the first oil shock, industrial policy targeted sectors with high labor usage. Lawrence and Weinstein (2001) extended this research employing a slightly different data set and found that differential corporate tax rates had an impact on sectoral TFP growth, while direct subsidies and subsidized loans did not.

Moreover, they find the paradoxical result the effective rate of protection was negatively associated with sectoral TFP growth and that imports, not exports, were positively associated with TFP growth.

The latter result can be explained by noting that there are at least two channels through which imports could contribute to increasing productivity. The first allows domestic producers to use new, improved, or specialized intermediate inputs to which they would not otherwise have access. The second is imports compete with domestic products and their availability acts as a constant spur to domestic producers to cut costs The following paragraphs are based on Noland and Pack, ibid. Chapter 2.

and improve quality. Lawrence and Weinstein divide imports into “competitive” and “noncompetitive” imports and in the case of Japan, find evidence to support the second hypothesis. From this they conclude that Japan’s growth would have been even faster if it had cut tariffs and exposed a greater share of its domestic producers to foreign competition!13 Lee (1996) following a method broadly similar to Beason and Weinstein finds a similar lack of impact of Korean industrial policies on sectoral capital accumulation or TFP growth. Pack (2000) follows a different strategy, assuming that TFP in favored manufacturing sectors was in fact increased in both Japan and Korea and estimates how much of an impact even an assumed successful policy could have had on the growth of gross domestic product. The most favorable estimate is a roughly.5 percentage point increase out of a total GDP growth rate of roughly 10 percent over the relevant periods.

While this is significant, it is hardly the magical key to accelerated growth.

It is possible that the impact of industrial policy is manifest largely in sectors that purchased inputs from the promoted sectors, even if the latter did not themselves benefit.

However, Pack (2000) finds that sectors that were encouraged in Japan and Korea had few linkages with non-favored sectors via input-output relations and there is little evidence of labor flowing from favored to neglected sectors, a likely mechanism for the transmission of knowledge.

Nevertheless, as noted at the beginning of this paper, the difficulty of constructing a single agreed upon counterfactual precludes a robust conclusion.

Moreover, all of the empirical analysis examines the contemporaneous impact of policies, for example, did Korean industries that were encouraged experience greater TFP growth in the period during which major promotion occurred, 1973-85. Someone doubting these results could point to the performance of some Korean firms such as Samsung and LG in the following two decades in such diverse product lines as plasma TVs, RAM chips, and cellular phones, and attribute these later successes to the earlier stimulation the firms received for other product lines. These more recent efforts by the firms that allowed them Japan’s Ministry of Finance apparently agrees. In a June 2002 report issued by its Policy Research Institute, it maintains that “the Japanese model was not the source of Japanese competitiveness but the cause of our failure” and specifically argues that sectors sheltered by MITI became bloated and inefficient, to succeed could be attributed, in this interpretation, to their earlier growth in other product categories. In this view, learning to perform R & D on microwaves, had future carryover effects on plasma TV. Fully resolving divergent views is impossible. Detailed firm histories by Kim (1997) or Hobday (1995) do not suggest such carryover.

Nevertheless, even if it should be shown that the success of a few firms could be attributed to earlier encouragement by the government, the aggregate effects just cited suggest there was not a major impact at the national level during the main period of growth acceleration. And any such effects would have to be weighed against the negative long run impacts in the financial sector cited by those skeptical of industrial policy. For example, the Asian financial crises of the late 1990s and Japan’s stagnation since 1990 can be interpreted as partly the result of the earlier government direction of lending that minimized the need of banks to learn modern techniques of evaluating individual projects and managing the riskiness of their overall portfolio.

4. New industrial policy Recent discussion of “new” industrial policy including the desirability of fostering learning and obtaining benefits from agglomeration economies offered by industrial clusters has received little systematic empirical evaluation.14 In principle, the development of clusters could facilitate growing productivity through the provision of overhead services by the organizers plus the interaction of the firms choosing to enter the cluster. Thus clusters could offer an alternative to dependence on either buyer or manufacturer led networks.





The benefit of clusters may arise from face-to-face interactions that are productivity enhancing (interactions between software writers and chip manufacturers), a pool of workers with the relevant skills, or reduced transportation costs. Individual market agents may not be aware of the externality they generate for others and this provides an additional market failure that could in principle be addressed by public intervention. The major example usually cited is that of Silicon Valley in California while those exposed to international competition tended to be more market-aware, efficient, and profitable (Issei Morita, Financial Times, 27 June 2002).

See Rordiguez-Clare (2004a) for an extensive discussion and (2004b) for a formal treatment of clusters.

which most accounts suggest arose spontaneously. Similarly, the rapid development of the software sector in Bangalore and other cities in India, discussed below, appears to be the outcome of the existence of a large group of well educated English speaking students and the entrepreneurial abilities of a small group of residents combined with activities of the large Indian expatriate community, particularly in Silicon Valley. Government participation was non-existent – for example, a critical communications satellite was financed by Hewlett-Packard. Positive government efforts followed the “takeoff” of the sector. Of course, publicly financed education institutions generated the fundamental resource, educated workers. This might be considered a generic policy not specifically targeted to the software sector but there was no explicit effort to galvanize the agglomeration economies that have since developed.

There are interesting descriptions of a number of clusters in OECD nations but few normative evaluations of their success employing social cost benefit analyses or even grosser measures such as growth of exports relative to firms outside of the cluster but in the same sector.15 However, some insights can be obtained about whether some recent success stories in Asia conform to the contours of the new industrial policy. We consider in detail the evolution of the Indian software sector centered in Bangalore.

The development of the Indian software sector was attributable primarily to activities of private actors. Its achievement reflected a complex set of interactions between domestic and foreign responses to perceived opportunities. Many of the same patterns, with different details, can be documented for other success stories such as the Hsinchu Science Park in Taiwan (Saxenian 1999, 2001), the Special Economic Zones in China (Rosen, 1999, Huang, 2002), and Bangladesh’s rise as a clothing exporter (Rhee, 1990). In the Indian software sector and the Bangladeshi garment sector, the initiating force was private, the government playing almost no role except for the fundamental one in India of providing good education, a policy that does not fall into the domain of selective industrial policy.

In Taiwan (China) the establishment of a science park and legislation in China to allow special economic zones to attract FDI were due to an initial government stimulus.

Humphrey and Schmitz 2002 provide an extensive survey of the empirical literature on clusters as well as a useful discussion of whether they offer a locally controlled alternative to participation in networks.

A critical input for the success was foreign participation that dealt with some of the roles cited above as requisites of industrial policy (source of new technology, facilitation of learning, source of new product ideas, centralized marketing allowing economies of scope, coordination of entry of complementary firms). In China, the SEZs mimicked the effect that would have arisen from a free trade policy, i.e., it negated previous adverse public policies. It did not discriminate among sectors. The decision to foster a science park by Taiwan (China) comes closer to a proactive industrial policy. Unfortunately, the experience at Hsinchu has not been systematically evaluated. Many nations have attempted to use export-processing zones of one form or another to catalyze foreign direct investment and perhaps generate agglomeration economies. Evaluation of these suggests that while potentially a useful instrument, they have had indifferent results.16 Success stories can be pointed to in Korea and Taiwan (China) in the 1950s and early 1960s, and of course in the special economic zones of China. But there have been more than a thousand such efforts. There are few clues in the existing literature about why some EPZs have been successful, while most have failed.17 A. The Indian software sector In India, the preconditions for the development of the software sector were high quality education in junior colleges and universities financed by the government. A critical role was played by university graduates who went abroad for further training, remained as expatriates in the high tech sector, and later returned home or interacted intensively with newer Indian firms. The lamented brain drain became, with some lag, a source of strength and a critical catalytic input (this was also true in the case of Hsinchu).

In the 1980s there were a growing number of programming graduates and many were underemployed. There were a large number of graduates at levels ranging from post secondary technical schools to those trained at the Indian Institutes of Technology.

Almost all of the students trained in programming had been educated in English. The government’s continuing investments in education had resulted in over 1,800 educational institutions and polytechnics producing 70,000 to 85,000 computer science graduates An extensive set of references is provided in World Bank (2004).

A careful evaluation of the Philippine experience is provided by Calanog (2006).

every year.18 Many Indian graduates also had a second university degree or post-graduate degree from the United States or the United Kingdom, often in computer technology.19 Other Indian software programmers received training in private software institutes to keep abreast of latest developments in the software industry and acquired a breadth of software skills. Hence, many were familiar with major computer hardware systems (IBM, UNISYS, DEC, HP and DG20), computer-aided software engineering tools, objectoriented programming, graphical user interface and client networking.21 The major impetus to demand came from abroad from of a set of “accidents.” In the 1990s the ratio of world prices for programming services relative to those in India increased due to a global shortage of programmers and the demands for solutions to the anticipated Y2K problem. Enterprising businesses in India capitalized on this opportunity by setting up firms that were essentially employment agencies. Indian software programmers were hired by local firms on behalf of clients in the United States on short-term contracts (either for a fixed period of time or on a project basis) to provide onsite services. ‘Bodyshopping’, as this practice was called, became the predominant mode of Indian software exports because the development work was performed on the client’s premises, saving software firms the high costs of acquiring computer hardware.

NASSCOM, the software trade association reported that the software sector earned $2.5 billion from Y2K billing from 1996 to 1999, a critical period in the growth of the industry. As late as 1988 software exports had been less than $200 million but rose to $3.6 billion by 1998, accounting for over 10 percent of total Indian exports.

Indian software firms also benefited from another serendipitous event, the European Union’s move to the Euro. Many Indian software professionals were actively involved in adapting existing computer systems and databases to accommodate the Euro.

Between 2000 and 2002, it is estimated that India earned approximately $3 billion in revenues from these Euro-related IT projects. Clearly a contributing factor was the low relative level of programming costs in India that conferred a Ricardian comparative advantage in some sub-sectors of software. As late as 1995, after substantial wage

James (2000).

Deshmukh (1993).

Lakha (1990).

Lekshman and Lal (1998)

increases because of a rising demand for Indian software, the annual wages of Indian software professionals were only 14% to 59% that of their counterparts in Switzerland, USA, Canada and the UK. Given the skills of Indian programmers, these cost savings led firms in some of the industrial countries to outsource their software development requirements to India.



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