Friday, December 17, 2010

Chile: Catching up with the top performers

The best innovation capacity in Latin America
With a rank of 29 among the 131 countries included in the ICI, Chile is by far the best performing country in Latin America. Indeed, it has a rank a full 20 places ahead of Uruguay (49), the next best performer. Chile is firmly positioned among 12 members of the European Union, with some slightly ahead (e.g., Belgium, Austria, France, and Spain), and others slightly behind (Italy, Slovenia, the Czech Republic, and Portugal). Chile has the highest rank among countries with a broadly similar level of income per capita, with only Malaysia (34) exhibiting a similar performance. Chile has a rank of 1 in Latin America in several important indicators including government effectiveness, rule of law, absence of corruption, the fiscal balance (as a proxy indicator for the strength of macroeconomic policies), the number of schools connected to the Internet, the ease of paying taxes, broadband penetration rates, reliability of electricity generation, and a top 5 rank in a much larger set of indicators.

Chile’s strong performance in the Innovation Capacity Index is the result of a combination of several factors two of which have played a central role and are, therefore, desirable to highlight: first, the gradual build up of an institutional environment that has been broadly supportive of private sector development; and second, the introduction of a range of policies that have explicitly sought to enhance the role of high technologies in promoting gains in factor productivity. It will be useful to present here a brief overview of both.

Chile ranks 23rd among 180 countries in Transparency International’s Corruption Perceptions Index 2008, tied with France (23) and ahead of Spain (28), Portugal (32), and far ahead of Korea (40), Italy (55), Mexico (72), Brazil (80), and Argentina (109). In fact, the 22 countries with a better score than Chile are all high-income countries, as defined by the World Bank. In the ICI’s own Good Governance subindex—which also includes measures of voice and accountability, political stability, government effectiveness, rule of law, the property rights framework, and transparency and judicial independence—and in the Country Policy Assessment subindex, which captures various measures of the quality of public sector policies, Chile ranks 25 and 14 respectively, out of 131 countries in 2009.

Legitimizing market reforms
Market reforms in Chile have been legitimized in the eyes of the public because they have benefited the population in tangible ways, for instance, by increases in per capita income or, as noted earlier, sustained reductions in poverty levels. This contrasts sharply with other countries in the region, where the motivations for public policy have more often been a mixture of dubious ideology or some confusion about public ends and private benefits among the ruling elites. In addition, on those occasions when flaws in the public administration in Chile have emerged, the authorities’ response has been swift and effective. For example, Chile today has a demanding campaign contributions law that is tougher than those found in the statutes of many high-income democracies. Furthermore, the authorities have generally been very good about generating a broad consensus for their policies, which ensures sustainability in the policy environment. Successive governments over the past 19 years, following the country’s return to democracy, have been fairly successful in setting in motion processes of consultation, to elicit the views of various sectors in society, such as opposition political parties, trade unions, and various organizations of civil society. This has resulted in greater understanding on the part of the population, and elicited their commitment to the often painful measures that accompany the implementation of various economic adjustment measures. This approach has also led to a more equitable distribution of the costs of adjustment and contributed to political stability.

A solid macro environment
Together with the Nordics, Chile is part of a small group of countries in which the political process has resulted in broad-based support for fiscal discipline, where safeguards have been introduced, which effectively insulate the budget from the short-term horizon of politicians, and from the diverse demands placed upon it by economic agents in a pluralistic democracy. The net effect has been a virtuous fiscal policy, which has contributed to a sustained reduction in the levels of public debt, from close to 90 percent of GDP in the mid-1980s, to less than 7 percent of GDP in 2008. We find no example, either among industrialized countries or in the developing world, with as sustained a downward adjustment in debt levels as in Chile. In fact, quite the opposite is the case: the vast majority of OECD members have higher levels of public debt today than 10 years ago. Indeed, according to the IMF, against the background of the global financial crisis and the fiscal stimulus measures that have been taken to address the effects of the crisis, public debt in the advanced economies will rise from 75 percent of GDP in 2008 to 110 percent of GDP in 2014.

Chile’s policies have, in contrast, greatly reduced the debt-servicing burden of the public debt in Chile, contributed to sharply lower interest rates, and to the highest credit ratings in Latin America. Indeed, in 2009 Chile was the only country to have actually seen a rise in its credit ratings, at a time of massive ratings downgrades worldwide, affecting corporations and sovereign debt issuers alike. A lower debt burden has, of course, allowed spending to rise in other areas, including education and public health, and is very much behind the progress made in reducing the incidence of poverty, which fell from 38.6 percent in 1990 to 13 percent in 2006.[1]

Moreover, as noted above, not only has Chile done much to establish a clear, transparent framework for public policies, also involving a solid legal and regulatory framework—it has a ranking of 23 in the third pillar of the ICI, which captures several indicators measuring various obstacles to private sector activity—but the government has also played a leading role in promoting other innovation-friendly policies which have nicely complemented those aimed at improving the institutional climate.

Good innovation policies
The government has shown remarkable commitment to e-government, to increasing efficiency in public management, to diminishing the transaction and coordination costs between public entities, to facilitating innovation and creativity in management, to increasing the public value of services, improving government transparency and, more generally, to enhancing the quality of the services provided by the government to civil society.[2] Three areas in which this has been done in a particularly effective way, providing best practice, are those reforms introduced at the Internal Revenue Service and through the electronic platforms ChileCompra and Trámite Fácil. At the IRS, e-government has boosted direct interactions with tax payers and greatly facilitated tax compliance. Close to 100 percent of Chilean tax-payers now pay income taxes through the Internet and the Chilean IRS is acknowledged to be one of the most modern, efficient, high quality taxation administrations in the world, setting high international standards for tax compliance.

ChileCompra was launched in 2000 and is a public electronic system for purchasing and hiring, based on an Internet platform. It has earned a worldwide reputation for excellence, transparency and efficiency. It serves companies, public organizations, and citizens, and is by far the largest business-to-business site in Chile, involving over 1000 purchasing organizations which invoiced well in excess of US$2 billion in transactions by 2005. It has also been a catalyst for the use of the Internet throughout the country. Trámite Fácil is a government site coordinating the work of over 240 government agencies and bodies, and taking care of a broad range of processes online, including birth certificates, identity documents, pension fund payments, trademarks/patents, housing subsidies, university credits, and so on. The government’s efforts to integrate the Chilean school system with the Internet have been no less successful, and have involved heavy infrastructure investments, the training of over 90,000 teachers in the basics of ICTs, digital literacy campaigns, encouraging the study of English and several novel public-private partnerships aimed at bringing to the classroom the latest technologies and know-how.

Some challenges ahead to boost innovation capacity
The authorities in Chile have shown remarkable leadership, as well, in identifying the key challenges ahead to strengthening the role of ICTs in improving productivity and in boosting the innovation capacities of the public and private sectors and civil society. In this respect, they feel that it is necessary to expand and intensify the integration of digital technologies in the educational curriculum and to improve the education and training of highly qualified workers. It is also necessary, in their view, to enhance connectivity, especially among the lowest four-fifths of the income distribution, by overcoming unequal income distribution, restrictions facing micro- and small companies, and connectivity problems in rural and remote regions. They would also like to encourage the development by the private sector of computer packages for low-income households and micro-companies so that they can access the Internet more cheaply and effectively, and to continue government subsidies for rural and remote areas and low-income communities and microcompanies. Priority is also being given to increasing R&D in the use of ICTs to stimulate competitiveness of the main export sectors, to rectify limitations in the legal system, to provide an appropriate institutional framework to stimulate/encourage e-trade, e-government, and use of ICTs, and to assure public trust in electronic operations and platforms. Finally, priority is also being given to facilitating the takeoff of the ICT industry by improving virtuous cycles of cooperation between institutions of higher education and the business community. This is seen as essential for narrowing the skills gap that exists today between Chile and the average in the OECD, made evident by the results of the PISA tests.
1. For a discussion of the institutional framework in place for the implementation of fiscal policy in Chile, including the targeting of a surplus in the government balance since 2000, as well as other progress made in the implementation of a sound institutional framework, see: López-Claros, A. 2004. “Chile: The Next Stage of Development”, Global Competitiveness Report 2004-2005. Hampshire: Palgrave Macmillan. pp. 111–24.
2. For a comprehensive discussion of these issues, see: Alvarez Voullième, Carlos, Constanza Capdevila de la Cerda, Fernando Flores Labra, Alejandro Foxley Rioseco, and Andrés Navarro Haeussler. 2006. “Information and Communication Technologies in Chile: Past Efforts, Future Challenges.” Global Information Technology Report 2006, Hampshire: Palgrave Macmillan. pp. 71–87.

Friday, December 10, 2010

Korea: Impressive innovation capacity

Korea is ranked 11 in the 2010 edition of the Innovation Capacity Index, because it does extremely well in many of the areas captured by the Index.

Let us begin by highlighting a few facts about Korea’s innovation capacity. First, the information and communications technology industry is a powerful engine of economic growth, contributing over 40 percent to the total expansion of GDP growth in recent years. Second, expenditure on research and development in relation to GDP has risen from under 1 percent in the 1980s to close to 3.5 percent in 2009, well above the OECD average. Third, the share of R&D expenditure carried out by the private sector had risen from 29 percent in 1970 to over 70 percent by 2000. Fourth, the average number of patents granted in the United States to Korean firms rose from about 10 per year during the period 1963–1986 to an average of about 4,800 per year during the period 2002–2007, a close to 500-fold increase. Fifth, the share of ICT in total manufacturing in Korea is 20.2 percent, higher than in any other country in the OECD other than Finland, where it is slightly higher. Indeed, the share of ICT goods in total merchandise exports (close to 35 percent) is higher in Korea than in any other member of the OECD, except for Israel. Finally, Samsung, the company that perhaps best exemplifies Korea’s transformation over the past five decades from an agricultural society into a technology powerhouse now has research centers in Europe, the United States, Japan, Russia, India, and China, 27 manufacturing facilities in 12 countries, and an extensive network of sales organizations in 50 countries across the world.[1]

The role of government policy
What are some of the factors that have contributed to this impressive performance, perhaps matched only by Taiwan over the same period? Without doubt, a primary engine of change has been government policy, which at various times has provided critical support to the development of the ICT sector through a variety of policy instruments and incentives. The Korean economy has opened rapidly over the past 30 years and this has facilitated technology transfer, boosted international competition in the domestic market, and allowed economies of scale. A first step was taken in 1984 when the law regulating FDI was amended to broaden the sectors into which investment was permitted, with restrictions changed from a positive to a negative list, and restrictions on majority ownership relaxed. A second wave of liberalization for FDI came ahead of OECD entry in 1996. This was boosted further after the 1997–98 financial crisis, which had the effect of persuading the Korean authorities of the clear advantages of non-debt capital inflows to finance economic development. The New Foreign Investment Promotion Act (1998) brought about several incentives to promote inward FDI, including corporate income tax concessions, exemptions from customs duties on imported capital goods and various subsidies for firms setting up in specially designated economic zones. In parallel to the creation of an increasingly friendly environment for foreign investment—and thus a strong reliance on foreign technology—the capacity of Korean firms to enter into strategic alliances with companies abroad was significantly enhanced. For instance, over the past decade or so Samsung has signed a number of partnerships: with Nokia (2007) to co-develop technology for handsets; with IBM (2006) to co-develop and market technologies for industrial printers; with Sun Microsystems (2005) to cooperate on next-generation computing systems; with Sony (2004) for collaboration on development of 7th generation LCDs; with Hewlett-Packard (2003) to share technology for ink-jet printers; and with Microsoft (2001), to co-develop digital household electronics, to name just a few.[2] All of these companies, and many others, have established research centers in Korea.

The virtues of an open trade regime
A second dimension of increasing openness has been a fairly ambitious program of trade liberalization. For instance, average most-favored nation (MFN) tariffs for manufactures of electrical industrial machinery were reduced from 19.6 percent in 1988 to 4.6 percent by 2006. Tariffs on manufactures of radio, television, and communications equipment were reduced from 13.1 percent in 1988 to 1.1 percent by 2006. Similar tariff reductions applied to other ICT-related products. A particularly important instrument in this regard has been the WTO’s Information Technology Agreement, a comprehensive framework that came into force in 1997, when 40 nations, including Korea, accounting for over 90 percent of world trade in ICT products, agreed to the elimination of tariffs on a range of ICT products. As a result, the growth of imports of ICT products accelerated sharply, but that of exports grew even faster. Indeed, the trade figures for ICT products are nothing short of spectacular. Imports in 1999 were US$30.3 billion and had risen to US$54 billion by 2005. Exports in 1999 were US$48.5 billion and rose to US$102.3 billion by 2005. As a result, the trade surplus on ICT products rose from US$18.2 billion in 1999 to US$48.4 billion in 2005. The penetration of the Chinese market was particularly swift, with Korean exports rising from US$5.5 billion in 1999 to US$35.6 by 2005.[3] To take a specific example, total exports of mobile handsets rose from under US$600 million in 1995 to well over US$17 billion in 2006, a close to 30-fold increase—impressive by any standards. Indeed, as noted by Onadera and Kim (2008, p. 114), Korea’s “industrialization drive has been strongly led by exports,” with the export-to-GDP ratio rising from some 5 percent in 1962, to 43.6 percent by 2009, notwithstanding a vertiginous rise in GDP, among the highest in the world.

The latest technologies and human capital
Equally impressive has been the extent to which use of the latest technologies has penetrated Korea, both within the business community, government, and civil society. Broadband Internet subscribers per 100 inhabitants rose from 13 in 2000 to 32 in 2008. Internet usage per 100 inhabitants was 45 in 2000 and had risen to 77 by 2008. There were 57 mobile phone users per 100 inhabitants in 2000 and 95 by 2008. Similar increases can be noted in personal computer use, e-commerce, and Internet banking subscribership. These penetration rates often exceed those of other OECD members having much higher levels of income per capita. The UN e-Government Readiness Index ranks Korea as number 1 among 180 countries in its latest edition, reflecting the extent to which the growth of the ICT sector in Korea has affected every dimension of economic life, including the delivery of services by the government.

But trade and investment policies have only been one dimension of Korea’s approach to the rapid development of the ICT sector and the creation of an impressive innovation capacity. The government has also been aggressive in the way it has gone about developing a modern infrastructure for higher education and training. Korea has the highest tertiary enrolment rate in the world: 96.1 percent. The Electronics and Telecommunications Research Institute was established in 1976, part of ten government-sponsored research institutes created with a mandate to boost Korea’s science and technology capabilities, develop its skilled technological manpower, and promote private sector participation in research and development. The number of fully qualified researchers engaged in R&D in Korea rose from under 6,000 in 1970, to about 224,000 in 2007, a 37-fold increase.

Korea’s rise from a relatively simple agricultural society in the early 1960s to a leading industrial and technological power by the beginning of the new century is worthy of admiration, particularly when set against the background of the relatively pessimistic expectations after the Korean war; a country with such a difficult political geography and modest natural resource endowments might well have raised questions about its long-term viability. That a country could transform itself in so short a period into a high-income industrial giant with a huge footprint on the global economy highlights two important facts: a) the powerful role of sensible economic policies in enabling a country to embark on a path of self-sustaining economic growth, and b) the extent to which governments can, in fact, contribute to rising prosperity for their populations, notwithstanding the many limitations of the free market economy, so painfully evident during the latest global financial crisis.

1. Onodera, Osamu and Earl Kim Hann. 2008. Case Study 2: Trade and Innovation in the Korean Information and Communications Technology Sector. OECD, Paris.
2. Organisation for Economic Co-operation and Development (OECD). 2008. Handbook on Constructing Composite Indicators: Methodology and User Guide. Paris: OECD.
3. In 1999, the United States was Korea’s most important trade partner. By 2005, by a significant margin, the most important markets for Korean ICT exports were China and the EU, accounting for roughly half of the total.

Monday, November 15, 2010

Spain: Large scope for progress

The Innovation Capacity Index (ICI) gives Spain a rank of 29,1 somewhere between the Baltics and Chile. The rank itself is not bad, and it is not surprising that Spain scores below Sweden, Finland, Switzerland, Taiwan, Japan, Korea, Germany, and Israel, countries with a well established track record of innovation and highly-developed and sophisticated high-tech sectors. What is noteworthy about Spain is that, whereas in 2008, its PPP-adjusted income per capita was US$30,589, that of Chile was less than half (US$14,529) and those of the Baltics ranged from US$17,106 in Latvia to US$20,561 in Estonia. In other words, for its stage of development—a rich industrial country with the world’s 11th largest economy2—Spain’s innovation capacity is lagging behind its true potential. What are the factors that have contributed to this mediocre performance? We focus our attention on three: fiscal management, market regulation (including the dysfunctionalities in Spain’s labor market), and education.

Precarious public finances
The onset of the global financial crisis was met by calls from leading economists to respond to the contraction of demand with fiscal stimulus. It was essential to avoid repeating the mistakes of the Great Depression when the authorities, unwisely, sought instead to balance budgets and did not relax monetary policies to the extent that was necessary to revive domestic demand. The problem with fiscal stimulus in the middle of a crisis is that the authorities need to strike a careful balance between optimizing the benefits of increased expenditure, against the risk that too much stimulus might undermine confidence because the increase in public debt is perceived by investors as potentially unsustainable. This difficult balancing act is particularly important in countries that already have high levels of public debt, and where there is greater vulnerability to shifts in investor sentiment. If investors begin to question the solvency of the government, then what started out as an exercise aimed at softening the adjustment until consumer and investor confidence picked up and improved the economy’s growth prospects, can quickly turn into a vicious circle, in which the increase in the cost of debt becomes rapidly prohibitive, confidence is undermined, and economic revival is put off.

This is what happened in Greece earlier this year and, in the context of a highly integrated region using a common currency, the Greek crisis led to contagion in Portugal and Spain, countries where the authorities were in the midst of implementing their own stimulus packages. In Spain, after having allowed the deficit to widen beyond 11 percent of GDP in 2009—a deficit without recent historical precedent—and having lost the confidence of investors, the government proceeded to introduce an adjustment package consisting of expenditure cuts and increases in taxes. This 180 degree turn in policy created social and political tensions, undermined the credibility of the government, and distracted attention from more urgent reforms, for instance in the labor market. Among the 131 countries ranked in the ICI, Spain’s budget deficit in 2009 was the sixth largest—that is, one of the worst in the world. The ICI, quite correctly, penalizes fiscal indiscipline because of the way it distorts resource allocation, for instance, constraining the ability of the government to spend more on education or on research and development. In Spain, R&D is equivalent to slightly less than 1.3 percent of GDP, well below the OECD average of 2.2 percent of GDP, and close to a quarter of the level in Israel.

Market regulation and a dysfunctional labor market
Of the five pillars used to build the ICI, Spain’s worst performance by a significant margin corresponds to pillar 3, on the regulatory and legal framework. The World Bank’s 2010 Doing Business Report database shows an extremely poor rank (146 out of 183 countries) for the “starting a business” indicators. In Spain it takes ten procedures and a total of 47 days to get a business started, compared to six procedures and six days in Portugal (a rank of 60) and five procedures and seven days in France (a rank of 22), Spain’s two neighbors. Moreover, Spain does not perform well in the indicator measuring protection of investors (a rank of 93). This indicator captures such concepts as disclosure requirements—to assess, for instance, the extent of related-party transactions—extent of liability of directors, and ease of shareholder suits—measuring how easily investors can access the courts when their interests are damaged.

In all of these concepts, Spain’s scores are mediocre at best, particularly considering Spain’s high income per capita and large industrial country status. Consistent with this, Spain’s ranking of 32 (a middling score of 6.1 on a 10-point scale) in Transparency International’s Corruption Perceptions Index is also mediocre. The worst ranks, however, concern those indicators that capture aspects of the operations of the labor market, such as the obstacles that businesses might face to hiring workers, the rigidity of hours, the degree of flexibility that employers might have to adjust the payroll to changing market conditions, the costs of separation, and so on. Spain has a rank of 157 in the employing workers DBR indicator, compared to a rank of 1 in Australia and 9 in Denmark.

Spain suffers from a segmented labor market that has served the country poorly over the past couple of decades, a fact eloquently highlighted by an unemployment rate of close to 20 percent in mid-2010, and twice that high for youth and women. One part of the labor market consists of permanent contracts with high levels of job security linked to extremely high severance payments, while the other is made of temporary contracts with much lower firing costs, accounting for some 27 percent of total employment, more than twice the average for the OECD. Not surprisingly, employers have responded to such incentives by hiring an increasing number of workers under temporary contracts, often beyond the legal limits provided by the legislation. In the public sector, workers cannot be sacked and, therefore, absenteeism is high (18 percent) and there is widespread abuse of sick leave. If a publicly owned company is privatized, the workers have to be taken on to the public payroll. Accordingly, demand for public sector vacancies is extremely high; according to The Economist, “300 people apply for each new clerical job advertised by the Madrid government.”3 Since the large severance payments for permanent workers are forfeited if they change employment, turnover is low, contributing to lack of motivation and sclerosis. Better-educated younger workers under temporary contracts are thus the “buffer” during periods of economic distress and end up being overqualified (and underpaid) for the jobs they hold. An economy in which the highest aspiration of university graduates is to secure employment with the government and become a bureaucrat is not one likely to encourage a spirit of entrepreneurship and a culture of innovation. Labor market reform and the gradual elimination of the duality in the market is an essential precondition to putting in place the incentives that will encourage greater entrepreneurship and risk-taking.

There is not a single Spanish university among the best 170 in the world.4 According to this particular set of rankings, the University of Barcelona is the best in Spain, with a rank of 171, and there are no others among the top 200. We have already made reference to the relatively low level of R&D spending in Spain, which, as might be expected, has a counterpart in the inadequate funding provided by the government and the business community to the universities. There is no well-established tradition in Spain of active collaboration between the universities and the business sector, a fertile source of innovations in those countries that have succeeded in nurturing this critical relationship. Consequently, there is little use made of internships as a way of building up relevant skills and familiarizing the student with the demands of the job market. Spanish universities are by and large public entities and suffer from the same perverse incentives as the public sector. Pay is relatively poor, no one can be fired—except those on temporary contracts—and there are few mechanisms in place to encourage excellence in teaching and research. The cost of tuition covers a very small fraction of the expense incurred by the state. One implication of this is that students have no leverage to demand higher standards; since salaries are low, the university is not in a position to hire staff of exceptional quality—a damaging vicious circle. Not surprisingly, the most able emigrate, unable to find a meritocratic working environment that rewards performance and academic achievement.

The teaching of English in secondary schools is deficient, and thus university students are ill-prepared for carrying out research at a sufficiently advanced level, with easy access to the vast library of research materials available in English. Student exchange programs are rare, depriving students of the expansion of intellectual horizons that these can bring. There is insufficient incorporation of the latest technologies into every aspect of the life of the university, whether it be for online course registration, access to bibliographical libraries, e-learning, and so on. Course curricula are not adequately updated, and thus do not reflect the rapidly changing needs of the Spanish labor market and the private sector. The concept of “advanced standing”—namely, that there will be students who because of earlier work experience could enter an academic program midway—is largely an alien concept. There is little effort to better integrate research, teaching, and work early on. Students are not adequately familiarized with various conventions, habits, and norms that govern academic life (academic literacies) and might encourage more in-depth learning. Teacher evaluations—a reliable source of feedback in the modern university—are seldom used. It is additionally worrisome that, given the largely public nature of the better Spanish university, often there is no arm’s-length relationship between government and university in terms of hiring, with the universities sometimes used to park out-of-work politicians. Excessive crowding is another problem, particularly in the early years of undergraduate training. Failure to address some of these glaring deficiencies will condemn Spanish universities to mediocrity and greatly hamper long-term innovation capacity—at all times and everywhere reliant on academic excellence.
1. Lopez-Claros, Augusto. The Innovation for Development Report 2010–2011. Hampshire: Palgrave Macmillan. p. 25.
2. Using a PPP-adjusted measure of GDP. At current market exchange rates Spain ranks 9th in the world, with a GDP equal to US$1,602 billion, just below Russia (US$1,677 billion), and ahead of Brazil (US$1,573 billion).
3. The Economist, 2010. The pain in Spain. 3 June.
4. According to:

Sunday, November 7, 2010

Brazil: Key innovation challenges

Brazil has taken important steps in recent years to modernize its economy and to lay a stable foundation for sustainable growth. Its ranking of 81 in this year’s ICI,1 however, is extremely low, given its level of per capita income—US$10,466 on a PPP-adjusted basis in 2008. India, for instance, has a broadly similar ICI rank, but a much lower income per capita of US$2,780. What are the factors which appear to be preventing Brazil from boosting its innovation capacity? We focus our attention on four, all of them fairly central when assessing a country’s ability to create an environment conducive to innovation.

Inefficiencies in resource allocation
Over the past decade and a half, successive Brazilian governments have done much to improve management of the public finances, at least when measured by the size of the government deficit and the magnitude of the public debt. Brazil had a long history of fiscal mismanagement, and improvements made in this area in recent years have, therefore, been extremely welcome. Indeed, it is noteworthy that Brazil’s public debt in relation to GDP is now much lower than that of most European countries and of the United States—a remarkable development. However, there are a number of outstanding problems which need to be addressed. Brazil suffers from serious rigidities on the spending side. These take various forms: one is the pervasive earmarking of revenues for assorted purposes, affecting as much as 80 percent of total primary spending (that is, net of interest payments). Another consists of automatic adjustments to expenditures to reflect movements in other variables, of which the most important is the linking of social and pension benefits to the minimum wage. According to the IMF,2 mandatory revenue transfers to local governments and inflexible labor legislation have also prevented a streamlining of the government payroll, which remains unduly large. A recent survey of the Brazilian economy notes that while only 6 percent of Brazilians are of pensionable age, they take the equivalent of 11.3 percent of GDP in pension payments. In sharp contrast, in the United States, the 12 percent of the population who are pensioners receive the equivalent of 6 percent of GDP in pension payments.3 Inevitably, this has led to a situation where Brazil spends far more in providing benefits to its older citizens than it does in educating the young, building a better educational infrastructure, or improving the country’s abysmally poor roads and ports infrastructure. A government that is constrained in terms of how it can allocate its resources will, not surprisingly, end up spending less on research and development and higher education. The data for Brazil bear this out. R&D intensity is about 1 percent of GDP, less than half of the OECD average.

But this is not the whole picture. Distortions in the financial system—where the government maintains a heavy presence—continue to drive a large wedge between borrowing and deposit rates, which, in turn, have prevented a quicker expansion of investment and limited the availability of resources to small- and medium-sized enterprises, often the locus of innovation. The benchmark interest rate is currently in the 11–12 percent range, extremely high by international standards, at a time when interest rates are at record lows everywhere, and when the central bank’s own inflation target is nearer 4–5 percent, implying a very high real interest rate.

A culture of heavy bureaucracy
One of the functions of government involves the issuing of licenses and permits. From cradle to grave, the average citizen in any country has to enter into transactions with some government office or bureaucrat to obtain a birth certificate, get a passport, pay taxes, open up a new business, drive a car, register property, engage in foreign trade, sell a good or service to the government, hire an employee, use a public health service, build a house, etc. Indeed, red tape had become such a bountiful source of corruption in most countries that a few years ago the World Bank began to publish an entire report that systematically looked at the prevalence of regulation in member countries. As noted earlier, the Doing Business Report (DBR) is now the primary reference tool for assessing the burdens of business regulation in a large number of countries. The data from the DBR for Brazil suggests that the business community labors under a heavy burden of an entrenched culture of bureaucracy and red tape. It takes 120 days and 16 procedures to start a new business in Brazil, 411 days and 18 procedures to obtain a construction permit, 42 days to register property, 616 days to enforce a contract, representing 70 more days than was the case in 2005, at a cost of 16.5 percent of the claim. Indeed, among 183 countries ranked in the DBR, Brazil’s ranks are invariably low, sometimes abysmally so.

A number of surveys have shown that businesses allocate considerable time and resources to dealing with the demands of red tape. Often, they may feel that paying a bribe is the surest way to save time and enhance efficiency and, in many countries, possibly the only way to get business done, without undermining the firm’s competitive position vis-à-vis those who pay bribes routinely. Obviously, the more dysfunctional the economic and legal system and the more onerous the regulations, the greater the incentives for individuals and businesses to short-circuit it by paying bribes. Since there is a well-established correlation between the prevalence of red tape and corruption, it is not surprising that in Transparency International’s Corruption Perceptions Index Brazil ranked 75th in 2009, thirty places below its rank in 2002.4 Excessive bureaucracy and red tape and the corruption they inevitably engender will greatly discourage entrepreneurship and innovation, and may well be one of the most important factors explaining Brazil’s low ranking in the ICI, given its level of per capita income.

Lagging higher education
According to de Brito and de Mello,5 "Brazil’s poor record in educational attainment is among the key obstacles to the generation and diffusion of innovation" (p. 23). There are several interrelated problems. First, much of the efforts over the past decade have been focused on expanding school enrolment in primary and secondary education—now close to universal—with less emphasis put on the quality of the education actually delivered. As a result, to take one important indicator, Brazil has lagged behind other countries in the region in its scores on the Program for International Student Assessment (PISA). In particular, in science, mathematics, and reading its students’ performance has been behind those of Chile, Uruguay, Mexico, and Argentina and, it goes without saying, much further behind students in other higher-income OECD countries, even Spain and Portugal, themselves well behind the OECD average. Second, the tertiary enrolment rate is extremely low by international standards, given Brazil’s stage of development. At 30 percent, it is well below that of Chile (49.8 percent) and Uruguay (64.3 percent) and well below that of Argentina (68.1 percent). It is also far below that of Korea (96.1 percent), a country with a per capita income lower than that of Brazil as recently as the 1980s. Perhaps more than any other, this is an extremely troubling indicator, given the increasing complexity of the global economy and the proven success in the area of innovation of countries which have invested heavily in education over the past three decades. Of course, the rigidities in government expenditures alluded to above have sharply limited the authorities’ ability to invest more in productivity-enhancing areas, such as the building up of first-class educational institutions. Surveys carried out at Brazilian universities show students complaining about outdated libraries, the structure and content of the curriculum, and the limited availability of computer facilities. Third, spending in education—about 5 percent of GDP on an annual basis—is somewhat above the average for the region, albeit below that of the likes of Finland, New Zealand, Denmark, Iceland, and Sweden, where it is closer to 6–8 percent of GDP. Again, the issue here is one of priorities. Brazil manages to spend vast amounts in generous pensions for its public servants and can find the resources to subsidize the consumption of fuels by the population, but has not invested enough in strengthening its scientific infrastructure. According to the OECD study quoted above (p.24), the stock of engineers graduated per thousand population is 0.08 in Brazil, but it is ten times higher (0.80) in Korea. Fourth, there is limited collaboration between the universities and the business community, reflecting legal impediments to the transfer and sharing of financial proceeds associated with intellectual property rights.

Low penetration of new technologies
There is a general perception in Brazil that the country has kept pace with the adoption of the latest technologies. As with several indicators of education (e.g., enrolment rates at all levels of the educational ladder), the data on the penetration rates for mobile telephones, broadband Internet subscribership, Internet and personal computer use over the past decade shows two things: Brazil has definitely made improvements with respect to its history, but there is a large gap with respect to the top performers, many of which have moved farther, faster, and deeper. Mobile usage rates have perhaps moved up the fastest, with Brazil having penetration of about 78.5 per 100 inhabitants in 2009 compared to 26.4 in 2003—impressive progress, but still well behind Argentina, Chile, Colombia, Ecuador, Guatemala, Jamaica, Paraguay, Uruguay, and Venezuela and, of course, OECD countries. Internet use in Brazil stands at 37.5 per 100 inhabitants in 2008, compared to 76.5 in Korea. Personal computer penetration rates are 16.1 in Brazil as opposed to 58.1 in Korea. The data for broadband Internet subscribers shows an even larger gap in 2008, with Brazilian coverage around 5.3 per 100 inhabitants, compared to 32.1 in Korea.

In the 1970s, Brazil tried to develop a domestic computer industry by banning imports; the net effect was less to develop native manufacturing capacity, but more to cut Brazil off from new technologies. The trade regime is now more open, but import tariffs for capital goods and intermediate inputs remain high. Much of the spending on R&D is done by the state. To move Brazil’s business spending in R&D closer to the OECD average, it would have to rise by a factor of four, which highlights the challenges in creating an environment more conducive to innovation.

Like India, Brazil has great potential to move up the ranks of the ICI in coming years and, more generally, to develop local innovation capacity. But the authorities and the business community will have to join forces in addressing the glaring weaknesses identified above.
1. Lopez-Claros, Augusto. The Innovation for Development Report 2010–2011. Hampshire: Palgrave Macmillan. p. 25.
2. International Monetary Fund. 2005. Stabilization and Reform in Latin America: A Macroeconomic Perspective on the Experience Since the Early 1990s. Occasional Paper 238, Washington, D.C.
3. The Economist. 2010. In Lula's footsteps. 3 July. pp. 45–47.
4. Transparency International. 2009. Corruption Perceptions Index 2009. Annual Report. Berlin. Although this huge drop in rank is partly explained by the incorporation of new countries to the CPI (102 in 2002 vs. 180 in 2009), it must be noted that Brazil’s score in 2002 was 4.0 out of a possible 10, whereas it had dropped to 3.7 by 2009, suggesting a worsening of corruption.
5. de Brito Cruz, Carlos, and Luiz de Mello. 2006. Boosting Innovation Performance in Brazil. OECD Economics Department Working Paper No. 532.

Friday, October 29, 2010

China: Enormous potential in years ahead

The last year that China’s growth rate was below 7.5 percent was 1990. On a PPP-adjusted basis, Chinese GDP has already overtaken Japan and Germany, making China the world’s number two economy. This impressive growth performance has turned the Chinese economy into an important contributor to global growth, a major force in commodity markets, the most important destination for foreign direct investment and, hence, an emerging power in international trade. Chinese exports and imports in relation to GDP were less than 15 percent in the mid-1980s, but by 2008 had risen to 33 percent for exports and 26 percent for imports. Whereas Chinese exports were less than 1 percent of total world trade in 1984, this share 20 years later had risen above 5 percent. So, if the intent of the strengthened reform effort seen in China in the last 20 years was to contribute to its integration to the global economy, it has succeeded well beyond anyone’s expectations.

The above trends have all contributed to increasing the relative importance of the Chinese economy which, by 2009, accounted for some 7–10 percent of global GDP (the lower range corresponds to market exchange rates). They have also pulled hundreds of millions of people out of poverty, given them enhanced opportunities, and improved living standards, perhaps the most important achievement of the last 20 years.

While the Chinese authorities are to be praised for effective macroeconomic management—sometimes carried out against the background of a difficult international economic environment—it is useful to review briefly the challenges that remain, particularly those that pertain to improving the country’s innovation capacity. In the medium-term perspective, the sources of Chinese growth will gradually shift to technological progress and innovation; thus, it is important to analyze those factors that might be holding the country back. This year’s ICI ranking for China is 64,1 broadly in the same ballpark as that of Mexico, Turkey, and Greece.

Market regulations
The OECD has compiled an extremely useful set of market regulation indicators to “assess the extent to which the regulatory environment promotes or inhibits competition in markets where technology and market conditions make competition viable.”2 These indicators include a measure of the extent of price controls, the licensing and permit system, communication and simplification of rules and procedures, administrative burdens for sole proprietor firms, legal and regulatory barriers, discriminatory procedures, tariff policy, the degree of government control over business enterprises, among others. These are aggregated into three broad families which capture state control, barriers to entrepreneurship, and barriers to international trade and investment. Two major conclusions that are derived from a review of these measures are that

  1. China’s product markets have become increasingly competitive in recent years and market forces are now playing the leading role in the setting of prices and the behaviour of agents in the broader economy;3
  2. China remains a difficult country to do business in; product market regulation is such as to continue to restrict competition in a major way.

Indeed, the OECD data suggests that market regulations are more restrictive in China than anywhere in the OECD countries, including all its transition-economy members. The gaps are large across all three major areas: state control, barriers to international trade and investment, and barriers to entrepreneurship. These results are strongly corroborated by the Doing Business indicators compiled by the World Bank which show poor scores/rankings for starting a business, dealing with licenses, construction permits, employing workers, and paying taxes. The indicators measuring the extent of investor protection are likewise mediocre.

China’s weaknesses in the regulatory and legal framework highlighted by the OECD and World Bank indicators are consistent with members of the business community surveyed in China, who complain of arbitrariness in the application of rules, lack of evenhandedness in the treatment of foreign and domestic investors, and high levels of corruption; the latter is strongly corroborated by a rank of 79 in the Corruption Perceptions Index 2009, which puts China on a par with Burkina Faso and Trinidad and Tobago. A recent report in the Financial Times commenting on the frustrations of doing business in China notes that “the risk-reward calculation between staying quiet and speaking up has shifted towards the latter. With China employing policies including ignoring intellectual property rights, forced technology transfer, and government procurement skewed towards domestic companies, some foreign businesses feel they are being pushed out of the country.”4

Human capital, ICT and R&D
There are a number of other indicators used in the ICI in which China does not score very well, and which thus contribute to dragging its score down. Tertiary enrolment rates of 22 percent are better than in India, but below the majority of countries in Latin America, and below all OECD members, the latter by a significant margin. As might be expected, given China’s stage of development and still relatively low income per capita, the gap is also huge with respect to Japan, Taiwan, Korea, and Singapore. Spending in education, at slightly less than 2 percent of GDP, is also low by international standards. Despite rapid urbanization, China has a sizable rural population engaged in agriculture. Though the literacy rate in the country (93 percent) is well above that of India (66 percent), the fact remains that there are hundreds of millions of people in China who need to be educated and trained to increase their productivity. This will surely be one area where the government will have to do more in coming years, a need made more urgent by China’s rapid integration into the global economy, and a gradual shift in the sources of Chinese competitiveness, from low labor costs and an undervalued exchange rate, to technology and innovation.

As with indicators of education, China, likewise, has mediocre scores in a broad range of indicators that capture the extent of penetration of the latest technologies. As in other parts of the world, progress has been made in recent years in boosting Internet penetration, mobile phone coverage, computer use, access to broadband Internet, and so on. But given China’s large rural population, it is perhaps not surprising that the use of these technologies is still in its early stages. For instance, personal computer use per 100 inhabitants is 5.6, higher than in India (2.8) but about ten times lower than in Korea. China’s rapidly rising income per capita should allow it to narrow these gaps fairly rapidly over the next decade. In the meantime, however, there is little doubt that they slow down innovation capacity.

Research and development expenditure in China is about 1.5 percent of GDP, below the average for the OECD of 2.2 percent of GDP. According to the OECD, if one further looks at R&D spending by industry, the gap with respect to the OECD is much higher, particularly for high-tech industries. This is specially the case for high-tech export industries “which lack a large R&D base in China and continue to rely heavily on foreign-sourced technology embodied in FDI and imported inputs”.5

Improving the social infrastructure
One of the more noticeable trends in China in recent years has been the massive shift of rural populations into urban environments. Whereas in 1980, less than 20 percent of China’s total population of close to 1 billion was living in urban areas, by 2000 this share had risen to 33 percent. The urban population during this period expanded from about 190 million to over 420 million, an impressive growth of over 120 percent. Indeed, at least a few percentage points of the high annual GDP growth rates seen during this period is accounted for by these internal migratory flows, since labor productivity in urban areas is much higher. This trend is expected to continue in coming years and will require careful management. There are several aspects to this.

As is well known, and as in other transition economies, there have been transitory increases in unemployment linked to the inevitable—and much needed—restructuring of the enterprise sector. This has necessitated the introduction of unemployment compensation schemes and, more generally, the buildup of safety nets to mitigate the impact of these adjustment costs on the population, particularly its most vulnerable groups. Like other countries in the industrial world, China will also have to make provisions for its aging population, and more attention will have to be given, therefore, to the development of efficient and modern systems of social protection, particularly pensions. This, in turn, will have implications for the budget. The need for further reforms in this area is highlighted by the fact that by 2030, China’s urban population may well have exceeded 1 billion. Well before the country reaches this threshold, the need for a well-functioning and well-funded social infrastructure will have become a political necessity, especially if the current rural-urban income disparities continue to widen, as they have in recent years. Indeed, China’s political stability will hinge critically on the speed with which the government is able to make progress in this area, at a time when rising protectionist sentiment against booming Chinese exports begins to create a more challenging external environment for the country. An additional benefit of an improved framework for social protection will be that the Chinese population will feel less of a compulsion to save (for old age) and this would stimulate domestic consumption, thereby contributing to reduce China’s huge trade surplus, a constant source of tension with trade partners. Better mechanisms of social protection will also encourage entrepreneurship and long-range planning, key ingredients of successful innovation.

Managing the growth process
For some time now there has been a vigorous debate about the risks that rapid growth rates might pose for macroeconomic stability. Sceptics have pointed out that China’s relatively good inflation performance and some slack in the labor markets suggest that growth could be sustained at the 9+ percent range. However, in recent years, credit growth has at times reached extremely high levels, and a consensus has emerged that managing the growth process in a way that preserves and builds upon the important gains of the past is a key priority for policymakers. This view has been buttressed by a growing perception that rapid growth is leading to a sharp deterioration of the environment, with unforeseen future consequences for public health. However, monetary policy measures—interest rate and reserve requirement increases—are not likely to be enough. There may also be a role for fiscal policies aimed at withdrawing stimulus from the economy. Fortunately, with a low revenue-to-GDP ratio, the authorities have considerable room for maneuver and should not hesitate to use it. Beyond this, further structural reforms, particularly those that boost competition in the economy, reduce the sort of barriers faced by entrepreneurs to start new businesses, and increase transparency and the rule of law will all help to make the Chinese economy more flexible, and will enhance the economy’s productivity and boost its innovation capacity.

The process whereby China plays an increasingly important role in shaping the global agenda will be enhanced if the government sets in motion processes of political reform—the 21st century counterpart of the impressive reforms in the economic area implemented during the past two decades, which have done so much to boost the standards of living of the Chinese population. A China that gradually moves in the direction of giving some political voice to its people can only contribute to enhancing its own ability to nourish an environment conducive to greater innovation.
1. Lopez-Claros, Augusto. The Innovation for Development Report 2010–2011. Hampshire: Palgrave Macmillan. p. 25.
2. Organisation for Economic Co-operation and Development (OECD). 2010. Economic Survey: China. Paris. p. 103.
3. ———ibid, pp. 105–7. In 1978, state-owned enterprises accounted for 78 percent of total industrial output and employed 60 percent of the non-farm work-force. “Collectively-owned enterprises accounted for the rest, with no other type of business enterprise permitted at the time.” By 2007, the state controlled 31 percent of industrial output and employed 22 percent of the non-farm workforce.
4. Financial Times, 2010. ‘Foreign Friends’ Lose Reluctance to Criticize China. 20 July. The article quotes an official at the US Information Technology Industry Council saying that “We are feeling less and less welcome in China, which is why you are seeing more people speaking out and reconsidering their futures in China.”
5. OECD, op. cit., p. 25.

Friday, October 22, 2010

Sweden: Why is its innovation outlook so bright?

An impressive performance
Sweden was the top-ranked country in the 2009—and now just recently in the 2010—edition of the Innovation Capacity Index,1 because it does exceptionally well in all the areas captured by the Index. Sweden is an exceptionally good performer, very often placing in the top ranks in those areas identified as being particularly important to assessing innovation capacity. Indeed, Sweden has a rank of number one among 131 countries in transparency and judicial independence, corruption perceptions, gender equity, e-government readiness, personal computer penetration rates, receipts of royalties and license fees, as well as the “doing business” indicators for the time and number of procedures required to register property. It has a rank of 2 in scientific and technical journal articles per capita, environmental sustainability, and research and development expenditure in relation to GDP, where it is second only to Israel. There are 12 other indicators in which Sweden has a top 8 rank, including the quality of its public administration, the effectiveness of its government, rule of law, the more egalitarian distribution of national income, Internet penetration rates, as well as other indicators of good governance.

Sweden’s rank is richly deserved. It is a country that has had an extremely virtuous fiscal policy for the past decade, running budget surpluses with the aim of saving resources to deal with the long-term effects of population aging, but also generating, in the short term, substantial resources to invest heavily in knowledge and training, to earn a top position in terms of labor productivity growth among high income countries. On a per capita basis, Sweden has the largest university system in the world. According to the OECD, “Swedish research is, in relation to the size of its population, leading in the world in terms of scientific output, measured by the number of publications in internationally acknowledged scientific journals.” Sweden is also a leader in terms of patent registration.

Openness and transparency
Sweden has in impressive record of openness and transparency in government. It has put in place comprehensive safety nets which provide security to vulnerable groups in the population. It has thus been able, during periods of economic stress—such as in the context of the 2008–09 world financial crisis—to shelter its population from the effects of the global economic slowdown. Since it also has levels of public debt that are well below those prevailing among competitor countries, Sweden has greater flexibility when it is time to provide fiscal stimulus.

Women in Sweden have access to a wider spectrum of educational, political, and work opportunities and enjoy a higher standard of living than women in other parts of the world. They also have achieved the highest echelons of political power and have an important presence in the business world. Sweden is also an egalitarian society with a more even income distribution than most countries in the OECD and, thus, a strong sense of solidarity and stable labor relations. The country has also achieved an enviable record in terms of caring for the environment; it ranks second in the world in the Environmental Sustainability Index.

Sweden’s public sector is highly qualified and enjoys unusually high degrees of credibility with the business community and civil society. Although the country has high tax rates, there is no evidence that this has discouraged entrepreneurship and innovation. More likely than not, this reflects the fact that the relatively high levels of revenue collection are then reinvested in the economy at large in education, infrastructure development and modernization, public health, and other components of the safety net, as well as training and other productivity-enhancing initiatives, all of which are directly beneficial to the private sector. Having an honest public administration—as demonstrated by Sweden’s privileged and consistently high rankings in Transparency International’s Corruption Perceptions Index—suggest that what matters is not whether tax rates are high or not, but rather whether the government uses the taxes collected in ways that will be productive and that will boost its credibility with economic agents.

A leader in ICT
The government has also played an important catalytic role in encouraging the use of the entire spectrum of information and communication technologies, as made clear by the very high penetration rates of mobile phones, computers, broadband, and the Internet. Not only does the government spend generously in research and development (particularly through institutions of higher education), but the Swedish business sector has also been a driving force in R&D spending, particularly in the telecommunications and pharmaceutical sectors. Sweden has benefited from an economy that, according to the OECD, is dominated by public-private partnerships between manufacturing groups that allocate considerable resources to R&D on the one hand, and public agencies and companies, on the other. This has led, in turn, to the emergence of a manufacturing sector that spans “all of the high-technology and medium high-technology industries”.2

A virtuous cycle of development
Sweden is likely to retain a privileged position in future editions of the Innovation Capacity Index. A combination of solid institutions, good policies and a public administration strongly committed to the idea of building upon past achievements has pushed the country into what one might call a virtuous cycle of development. Successive governments have implemented policies whose primary motivation has been the public good. This in turn has transformed the business community and civil society into active, well informed participants in the shaping of public policies. Just as citizens and corporations pay their taxes because the benefits of doing so are tangible and transparent, governments have been empowered to focus their energies and talents in devising innovative ways to improve the quality of governance. Sweden and its Nordic neighbors provide a useful template for other countries to examine, and, where feasible, to emulate. There is much in their approach to development—combining key elements of modern capitalism without some of its excesses, with a strong commitment to social policies that are fundamentally egalitarian in nature—that is worthy of close examination and study.
1. Lopez-Claros, Augusto. 2010. The Innovation for Development Report 2010–2011. Hampshire: Palgrave Macmillan. p. 25.
2. Organisation for Economic Co-operation and Development (OECD) and European Communities. 2005. Oslo Manual: Guidelines for Collecting and Interpreting Innovation data, Joint Publication of the OECD and the Statistical Office of the European Communities. p. 190.

Monday, October 18, 2010

Russia’s unfulfilled potential

Russia is in many ways a unique case, with a relatively mediocre ranking of 56 on the Innovation Capacity Index (ICI),1 well below the rank of countries such as Chile (31), Malaysia (39), and Poland (40), which share broadly similar levels of income per capita. Russia has a solid human capital endowment, reflecting decades of investment in education in science and technology. If Latin America has a grand total of three Nobel Laureates in science, there are at least ten Russian Nobel Laureates in physics alone. And had Alfred Nobel created a category for mathematics, there is little doubt that Russian mathematicians would have been awarded many prizes, perhaps more than any other nation. At the same time, however, it is a country where there is a huge gap between the stock of resources spent in past decades to foster contributions to knowledge, on the one hand, and, on the other, the kind of output that we would normally recognize today as reflecting achievements in scientific innovation, such as, for instance, patent registration or the presence of identifiable Russian brands in manufactured exports. Soviet technology was able to send the first man into space; it made significant advances in nuclear energy technology; but the context of the Cold War and the inefficiencies of central planning misdirected vast resources to the military-industrial complex, at huge cost in terms of living standards. By the time the Soviet Union collapsed in 1991, it was producing large nuclear submarines, MIG aircraft, and other weapons (sold on credit to its allies in the developing world), but not many consumer goods, and few, if any, manufactured goods with even minimal presence in the global economy. The 1990s witnessed a disorderly transition to a sort of market economy which involved redeployment of labor from the military-industrial complex and other heavy and inefficient industries to the private non-defense sector, particularly light manufacturing, services, and other industries long neglected under the state planning system.

A difficult business environment
There are several factors that help explain the persistence of this gap between its relatively solid educational base and Russia’s notable absence among international innovators. First and foremost, 19 years into its transition, Russia has still not established a particularly nurturing business environment. In fact, a case can be made that in some areas, such as levels of corruption, the property rights climate, the lack of independence of the courts, the general level of transparency in the public sector, and in the relations between the government and the business community—what the OECD calls “framework conditions” but which fundamentally refer to the stability and efficiency of the institutions that underpin the market economy—Russia is worse off today than it was six years ago.

This is certainly made unambiguously clear from the good governance indicators compiled by the World Bank and used in the institutional environment pillar of the ICI, as well as by Russia’s embarrassingly low rankings in Transparency International’s Corruptions Perceptions Index—147 among 180 countries in 2008, a drop of 61 positions since 2003.2 Russia’s deteriorating property rights climate, including for intellectual property, is particularly noteworthy—piracy is rampant in Russia—and perhaps more than any other indicator suggests the severe obstacles which at present exist for the creation of an institutional framework that will encourage innovation.

The high incidence of crime and corruption (ranging from “visits” from tax and fire inspectors to politically motivated expropriations by the state) remains a heavy burden on businesses, imposing heavy costs on them, and, therefore, undermining the ability of Russian companies to compete abroad.3 Accounting and auditing standards are weak, raising yet another set of concerns about the investment climate. Increasing restraints on freedom of the press highlight the risks for the abuse of power, and the difficulties for civil society to emerge as a constructive counterweight to the growing power of the state. The World Bank’s Doing Business Report (which provides the indicators that go into the regulatory and legal framework pillar of the ICI) paints a rather uncharitable picture of bureaucracy and red tape in Russia: from rigid labor-market laws and mind-numbing obstacles to the obtaining of licenses—it takes 54 procedures and an average of 704 days to obtain one, at a cost of close to 3,800 percent of income per capita—to difficulties in the payment of taxes and to impediments to international trade. Trading across borders is so laden with red tape in Russia that the country ranks 155th among 181 countries in this particular indicator of the Doing Business Report. This is a particularly perturbing indicator, given the need to encourage exports other than resource-based commodities, on which the Russian economy is totally dependent. According to the OECD, the share of high-value added goods in manufacturing exports from Russia to OECD countries is less than 1 percent and is even lower (0.2 percent) in the case of ICT goods. (In Taiwan, in contrast, close to 50 percent of manufactured exports are high-tech exports).

Innovation policies
These extremely unfavorable business environment conditions have had a number of undesirable repercussions. The country is a major exporter of talent. Not surprisingly, capable Russian researchers with a modicum of ambition emigrate at the first available opportunity. There is no significant engagement between the scientific community and the business world. The sort of collaboration and interaction between institutions of higher education and the enterprise sector which have been so instrumental in the development of a vibrant ICT industry in Israel and Taiwan is largely absent in Russia. State funding for research and development to institutions of higher education accounts for less than 5 percent of total state funding to such institutions. This, in turn, means that state funding to science does not play the catalytic role that it has played in other countries to spur innovation. Instead, as noted by the OECD, the emphasis on “institution-based financing tends to protect incumbents and creates few incentives to increase efficiency, productivity or innovation. On the contrary, since much funding is ‘cost-based’ and allocated with reference to employment levels and fixed assets, greater efficiency could lead to loss of funding”.4

The government has attempted to steer policies in the direction of better support for R&D, with the aim of encouraging the emergence of a culture of innovation. It is aware that while levels of overall R&D spending are not low by emerging market standards, such spending remains unduly concentrated on a few sectors, and consists overwhelmingly of state funding, in sharp contrast with other countries, where much of R&D spending comes from the private sector. One way in which a better balance could be achieved in this area would be to phase out fiscal disincentives to enterprise R&D spending through accelerated write-offs. A law passed in June of 2005 on Special Economic Zones was intended to contribute to diversification of Russia’s industrial structure and to stimulate innovation. Unfortunately, Russia does not have a good history with such special zones, although they have been a staple of Russian structural reforms since the 1990s. In the specific case of the 2005 law, we are skeptical that it will have the desirable effects—particularly in terms of attracting foreign investment, as Taiwan and Israel have been brilliantly successful in doing—given that “disputes concerning the creation and operation of SEZs are to be settled in Russian courts under Russian law”.5 In the absence of mechanisms of international arbitration, it is unlikely that foreign investors may want to expose themselves to the lack of independence and arbitrariness of Russian judges and courts and, more generally, to the primitive, opaque nature of the Russian legal system.

Low ICT penetration
Finally, Russia does not do as well as might be expected in the ICI because, with the exception of mobile telephony, it does not have particularly impressive penetration rates for the latest technologies. Even in the area of personal computers—where notable progress has been made in recent years in terms of expanding their use in businesses and households—PC use per 100 inhabitants is about 13.3, putting Russia in 56th place in the world, slightly worse than its rank of 52 in 2006, and broadly in the middle among the 131 economies covered in the ICI. Similar results hold for Internet use: improvements with respect to the recent past, but absolute levels that are not high enough to put Russia above its 64th place in the world.

Other weaknesses undermining innovation potential
Other factors are likely to complicate the authorities’ attempts at boosting innovation capacity over the medium term: first is the weakening of a culture of meritocracy in the public sector, with many senior positions in government now going to people with links to the security establishment, who increasingly—and presumably without the required qualifications—find themselves running large state enterprises in the energy and other sectors; second, the return to old authoritarian traditions which sit uncomfortably with the openness and willingness to “challenge the system” that are so common in successful cases of innovation; third is the country’s long-term demographic trends, which foresee a rapidly aging and declining population, limiting the role of the labor force as an engine of economic growth in coming years; finally, an ambivalent attitude toward foreign direct investment, which is welcomed one day, but quickly followed by “renegotiations” of previously agreed contracts with foreign partners, all of this accompanied by the return of old fashioned ideas about “strategic sectors” which should remain under state control. This has led to a marked increase in the presence of the state in the energy and raw materials sectors. Furthermore, the 2008–2009 financial crisis led to a close to 8 percent drop in GDP growth in 2009, and a massive widening of the budget deficit, creating a likely setback for the government’s efforts to do more in this critically important area. The sum total of the above suggests that Russia is a classic case of unfulfilled potential—a giant still playing in the little leagues.
1. Lopez-Claros, Augusto. 2010. The Innovation for Development Report 2010–2011. Hampshire: Palgrave Macmillan. p. 25.
2. In fact, between 2003 and 2008, Russia has been one of the world’s worst performing countries in the
Corruption Perceptions Index, sharing (undistinguished) company with the likes of Belarus, the Islamic Republic of Iran, Sudan, Uzbekistan, Syria, and Gambia. China’s rank fell from 66 to 72; India’s rank moved from 83 to 85, and Brazil’s from 54 to 80, with Russia having, by far, the worst performance among the largest emerging markets.
3. According to Richard Pipes, “Russia’s Pride Could Diminish Its Power.”
The Wall Street Journal. 24 August 2009: “One of the major obstacles to conducting business in Russia is the all-pervasive corruption. Because the government plays such an immense role in the country’s economy, controlling some of its most important sectors, little can be done without bribing officials. A recent survey by Russia’s Ministry of the Interior revealed, without any apparent embarrassment, that the average amount of a bribe this year has nearly tripled compared to the previous year, amounting to more than 27,000 rubles or nearly US$1,000. To make matters worse, business cannot rely on courts to settle their claims and disputes, and in extreme cases resort to arbitration.”
4. Gianella, Christian and William Tompson. 2007. “Stimulating Innovation in Russia: The Role of Institutions and Policies.” Economics Department Working Paper. Paris: OECD. p. 20.
5. ibid. p. 27.

Tuesday, October 5, 2010

India: Priority areas for boosting innovation capacity

Viewed in a long-term perspective, India’s recent economic performance has been quite impressive. According to the OECD, GDP per capita has accelerated from 1.2 percent in the 30-year period to 1980 to 7.5 percent currently, a growth rate, which, if sustained, would double income per capita in a decade. This is clearly an important achievement that has brought with it a substantial reduction in the incidence of poverty, from 36 percent in 1994 to some 27 percent by 2005.1

Inevitably, the global financial crisis has contributed to a deceleration of India’s economic growth in 2008 and 2009, and the emergence of other problems, such as a substantial widening of the budget deficit. However, assuming this to be a temporary phenomenon, the key question for Indian economic policy for the foreseeable future will be what policies will allow it to sustain or, indeed, accelerate its growth performance over the next decade. Just as China has benefited from a massive process of urbanization in the past two decades which has contributed in an important way to its high economic growth rates, India has a similar structural feature: favorable demographics, which is likely to fuel growth. For the next 20 years, the share of the working age population will rise, and India will have to find ways to bring its masses of young people into the mainstream by spending on education and improving the quality of its educational institutions, in order to boost the productivity of its young, particularly the poor.

There has also been a significant improvement in recent years in the quality of India’s policy environment and the degree of sophistication of its private sector. In those areas in which the government has decided to open up participation to the private sector—telecommunications, civil aviation—the response has been impressive. According to the OECD, India’s telecommunications sector has become the third largest in the world. In contrast, in electricity generation, where public enterprises are still dominant, shortages are common, and there is a serious problem of non-payment due to “poor management of distribution enterprises and a failure to eradicate theft” (OECD, 2007). There would thus appear to be wide scope for gains in efficiency in resource allocation in India, with corresponding gains in productivity and economic growth.

India does not do well in the Innovation Capacity Index, with an overall ranking of 85 among 131 countries. Looking at the various pillars of the ICI, India’s worst ranking (94) corresponds to human capital, training, and social inclusion, followed by adoption and use of information and communication technologies (93). To boost its capacity for innovation, policymakers in India will have to address a number of important weaknesses, of which the most important are discussed below.

Education and labor market
India continues to have high illiteracy rates—its rank in the ICI on this particular indicator is 110—suggesting that illiteracy still afflicts several hundred million people, not surprisingly a serious blight on innovation capacity. School enrolment rates remain low by international standards, with its rank for secondary school level an unimpressive 94. The scope for improvement in girls’ education is especially intense—the ICI attaches to India a rank of 89 on the gender equity index. Given the wide range of positive payoffs associated with improvements in girls’ education and, more generally, gender equity, much more will have to be done over the longer term to integrate women into the economy, the educational system, and India’s political establishment. India will also have to educate and train its young poor, to enable them to join the labor force with usable skills, particularly in those sectors with potential comparative advantage. There is every expectation that world demand for out-sourcing will rise in coming years, reflecting the continued shift of backroom operations associated with further reductions in the cost of communications. For India to be able to take full advantage of these opportunities, it will have to improve the level of skills and training of its workforce. In this respect, it is particularly worrying to see that India suffers from huge inefficiencies in its labor market, with laws governing regular employment contracts much stricter than in many emerging markets, and in virtually all members of the OECD. As noted by the OECD, one major reason for this is “the requirement to obtain government permission to lay off just one worker from manufacturing plants with more than 100 workers.” Not surprisingly, a rigid labor market will prevent India from deriving the full benefit of its comparative advantage in labor-intensive industries.

A serious fiscal deficit problem
For many years now India has had a serious problem with its public finances. Essentially, it has been running deficits of some 6-10 percent of GDP for the past decade, among the highest in the world. This problem has many dimensions and it is worthwhile to highlight several here. First, India’s public debt level, at 83 percent of GDP in 2009, is already very high by international standards; indeed, it is larger than that of Brazil and Argentina, twice that of Turkey, four times that of China, and well over ten times larger than that of Russia, as well as of most OECD countries. Second, with total revenue collection in the neighborhood of 18 percent of GDP (again, extremely low by international standards) due to its very narrow revenue base—the central government collects no more than about 11 percentage points of GDP in taxes—the revenue-to-debt ratio is among the lowest in the world.

In an attempt to bring about some measure of medium-term fiscal adjustment, the government brought into force in 2003 a Fiscal Responsibility Budget Management Act (FRBMA) which established a path of deficit reduction through 2009. The high economic growth rates during the period 2004–07 boosted government revenue and some progress was made in reducing the deficit, but the 2008 financial crisis and the need to respond to the weakening of economic activity through fiscal stimulus means that the deficit in 2009 will be back to some 10 percent of GDP. In any case, the law has generally applied to the central government only, whereas, in fact, a large share of the deficit problem is with the states. Moreover, it does not contain a medium-term debt target that might act as a binding constraint on the public finances. The law also does not establish any penalties or sanctions for departures from the path of fiscal adjustment laid down in the FRBMA. According to the IMF, “despite the apparent consolidation, off-budget activities increased, deadlines to comply with fiscal targets were extended and the fiscal adjustment was not underpinned by expenditure reform.”2 India’s fiscal situation is, without doubt, a severely limiting constraint on the country’s ability to boost its innovation capacity.

A large public debt constrains the ability of the government to allocate greater resources to education and public health, and to improve the country’s dilapidated infrastructure, all areas where India, as noted earlier, is lagging behind. The inability of the government to introduce expenditure reform is, likewise, a major constraint on policies that might seek to direct greater resources to more productivity-enhancing areas. This year, India is spending close to 4 percent of GDP on regressive subsidies on petroleum, diesel, and various other products, a sum roughly equivalent to what it spends on education and health combined. This is a shocking statistic that highlights the significant need to improve the macroeconomic environment.3 Without doubt, the deficit is a drag on the economy. A much lower deficit would have been associated with higher growth rates and higher levels of revenue, which would have boosted the ability of the government to respond to pressing social needs. Not doing business It takes 13 procedures, a total of 30 days at a cost of 70 percent of income per capita to open up a business in India. In the World Bank’s Doing Business Report 2009, India ranked 121 (among 181 countries) in this indicator, representing a drop of seven places with respect to 2008. Among the 131 countries ranked in the ICI, India has a rank of 100 for the cost of registering property, a rank of 116 for the ease of pay-ing taxes, and a rank of 180 for enforcing contracts. The fact is that bureaucratic red tape and excessive regulation remain serious problems in India, a country afflicted with a pervasive culture of government intervention and control, which adds to business costs, discourages the development of small and medium-sized enterprises, and, given the important role played by entrepreneurship in most forms of innovation, is thus a heavy burden on India’s innovative capacity.
1. This progress notwithstanding, China has grown more quickly than India over the same period and, consequently, has seen much faster reduction in poverty levels, regardless of the poverty line chosen. China has much lower infant mortality, higher life expectancy, and lower illiteracy rates than India.
2. International Monetary Fund, 2009b, India: Selected Issues. International Monetary Fund Country Report No. 09/186. June. p. 34.
3. There is yet another dimension to the fiscal deficit problem which will not be addressed here, having to do with the impact of debt financing on the financial system; it is much easier for the banks to lend to the government than to lend to small and medium-sized enterprises, which are so much at the center of the innovation chain in other countries.

Thursday, May 27, 2010

Lessons from the European Crisis

The latest forecasts put out by the IMF for global economic growth are cautiously encouraging. Following a 0.6 percent contraction in 2009 (more brutal in the United States, Europe and Japan, softened by rapid growth in Asia, particularly China and India) world output is expected to expand in 2010 by 4.2 percent and to continue at that pace in 2011. These forecasts assume that interest rates in the advanced economies will remain at near zero levels and that public debt levels will rise from 75 percent of GDP in 2008 to some 110 percent by 2014.

A huge increase in public indebtedness by the industrial countries is perhaps one of the most distinctive and worrisome features of the current global economic situation. The onset of the financial crisis was met by calls from leading economists such as Paul Krugman and Larry Summers to respond to the contraction of demand with fiscal stimulus. It was essential to avoid repeating the mistakes of the Great Depression when the authorities in a misguided fashion sought to balance budgets and did not relax monetary policies to the extent that was necessary to revive domestic demand. The problem with fiscal stimulus in the middle of a crisis is that the authorities need to strike a careful balance between optimizing the benefits of increased expenditure, against the risk that too much stimulus might undermine investor confidence because the increase in public debt is perceived as potentially unsustainable. This difficult balancing act is particularly important in countries that already have high levels of public debt and where there is greater vulnerability to shifts in investor sentiment. If investors begin to question the solvency of the government then what started out as an exercise aimed at softening the adjustment until consumer and investor confidence picked up and improved the economy’s growth prospects, can quickly turn into a vicious circle in which the increase in the cost of debt becomes rapidly prohibitive, confidence is undermined and economic revival is put off. This is what happened in Greece earlier this year and, in the context of a highly integrated region using a common currency, the Greek crisis led to contagion in Portugal and Spain, countries where the authorities were in the middle of implementing their own stimulus packages.

In my opinion the IMF played a somewhat unhappy role in the instability which the financial crisis precipitated in the Euro area. The Fund’s managing director Mr. Strauss-Kahn abdicated on behalf of the Fund its traditional role as the guardian of the soundness of its members’ public finances, giving implicit support for massive fiscal loosening in countries like Greece, Portugal and Spain, countries where fiscal stimuli involved a fair amount of populism and inefficient expenditures. The IMF underestimated the response of the markets to double digit fiscal deficits in these countries and its responsibility for the mess that followed is not diminished by its financial contribution to the subsequent rescue package put together with the EU for Greece.

The problem with high public indebtedness is that it creates a terrible dilemma for governments. Scarce public resources which could be allocated to education, public health or to improve countries’ infrastructure—all areas that help to improve competitiveness—have to be increasingly dedicated to debt service. The primary aims of economic policy get subverted. Instead of worrying about reforms aimed at boosting productivity, governments increasingly have to worry about keeping the markets happy, making sure that debt rollovers take place smoothly and so on—day-to-day cash management. In Spain, after having allowed the deficit to widen to 11.2 percent of GDP in 2009 (a deficit without recent historical precedent) and having lost the confidence of investors, the government is now negotiating an adjustment package consisting of expenditure cuts and increases in taxes. This 180 degree turn in policy has created social and political tensions and undermined the credibility of the government and detracted attention from more urgent reforms, for instance in the labor market. Similar situations have emerged in Greece, Portugal, Italy and the United Kingdom.

Fortunately, not all countries paid attention to the IMF in 2009. Sweden, for example, is as integrated to the global economy as any other country in the world but in 2009 it had a tiny budget deficit of 0.5 percent of GDP, having registered surpluses during much of the past decade. The authorities understand that the country’s demographics are leading to the ageing of the Swedish population. If the country is to be able to finance future pensions and other social commitments it has to save now. This demographic reality was not altered by the global financial crisis and hence they opted for a cautious response to the crisis, not an irresponsible loosening of fiscal policies. Other countries in Europe—Germany, Austria, Finland, Denmark, Estonia, Luxembourg—all acted cautiously in 2009 and, not surprisingly, have better growth prospects for 2010-2011 than Greece and Spain.

Some analysts have written about the possible collapse of the Euro area and the disappearance of the euro, with potentially grave consequences for the global economy. I do not share this pessimism. The 53 years of European Union history are characterized by severe crisis followed by institutional innovations which have strengthened the Union. The current crisis has demonstrated that you cannot have a single currency without much higher levels of coordination of fiscal policies among members. This means that if Greece and Spain want to continue to remain in the euro area they will, in the future, have to accept a much higher level of supervision of their budgets and, of course, they will also have to sustain several years of austerity to undo the damage done in 2009. Both countries will also have to implement structural and institutional reforms that will reduce their vulnerability to shocks and future crisis.

The worry at the moment is not the immediate future of the euro, nor the pace of economic recovery which I expect to continue in coming quarters. The worry is that the response to the 2008-2009 crisis has dramatically reduced our room for maneuver in the future. With public debt levels in the advanced economies soon to exceed 100 percent of GDP, a future crisis will find us far less prepared than we were at the end of 2008, when the gates of public spending were unleashed and governments rushed to bailout their banking sectors from decades of incompetence and excess. This response was made possible in no small measure by the fact that levels of debt were not unsustainably high, particularly in the United States. This is no longer the case. We have used much of our ammunition and one can only hope that future shocks to the global economy will not put onerous demands on public resources since, unfortunately, we no longer have them.