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.