How Asia Works
"How Asia Works" rejects the neoliberal Washington consensus on free trade and deregulated financial markets. This book got on my list because Bill Gates said it was one of his top 5 books of the year. Studwell looks at Asian countries that have done well over the last fifty years (Japan, South Korea, Taiwan, China) and those that have done poorly (Indonesia, Malaysia, the Philippines, Thailand) and asks what explains their divergent outcomes. He contends that the clear winners were countries that rejected the USA/WTO/IMF's advice about free markets / financial deregulation and instead implemented protectionist trade policies to develop their domestic economies. Studwell shows how free trade and financial deregulation have stunted the growth of countries like the Philippines (and oh does he dump on the Philippines) and caused their populations to be perpetually stuck performing low value labor with no real hope of escape.
Besides the IMF-bashing, Studwell includes a few other nuggets of wisdom that were new to me. The first is the importance of agricultural development in the industrialization process. Agriculture is one of those things where the more unskilled labor you put in, the more you get out. (I was shocked to hear that Chinese peasants were getting 2x the yield of American large-scale industrialized agriculture!) As such, it's a great base to start from and helps build up a base of semi-prosperous farmers whose savings can be used to fund further industrialization.
The second was the "stealth taxation" that countries use to fund their development. Basically, the farmers put money in the bank, the bank pays them way less than a market rate of interest, and then the state forces the banks to use the profit on the float to fund industrialization. Countries can only get away with this if they have strict capital controls and money can't leave the country to seek higher returns elsewhere. You can't play this game forever (the peasants begin to get rowdy!), but it can really boost your progress as long as you don't squander it.
The final surprising takeaway was Studwell's distinction between "efficiency economics" (what we read about in economics textbooks) and "development economics" which should be focused on industrial learning. While you're reinvesting the float from agricultural savings, you have to make sure that you're developing domestic expertise and understanding. You want to avoid just letting rent-seeking domestic businessmen suckle at the teat of "development" state support without doing the hard work of actually learning how to build things. The key is to only have state support for companies that are able to sell their product in world markets - a policy Studwell calls "export discipline". This is a metric that is very difficult to game and forces domestic companies to develop world-class capabilities while they're getting state support. I was also fascinated by the Japanese model of factories that essentially double as training schools - and by Studwell's observation that Japan's industrialization involved very few university-trained engineers.
Before this book, I hadn't thought much about development economics. I had always assumed that the free trade mantra that I had endlessly read about in my economics classes was the one true way. Studwell has made me seriously question that assumption - and that alone makes this book worth reading. As Studwell repeatedly (and forcefully!) points out, no major industrialized country has ever industrialized without highly protectionist measures. He also seems to have a personal vendetta against economists (in favor of historians) which provides some comic relief throughout.
It argues that there are three critical interventions that governments can use to speed up economic development.
The first intervention – and the most overlooked – is to maximise output from agriculture, which employs the vast majority of people in poor countries. Successful east Asian states have shown that the way to do this is to restructure agriculture as highly labour-intensive household farming – a slightly larger-scale form of gardening. This makes use of all available labour in a poor economy and pushes up yields and output to the highest possible levels, albeit on the basis of tiny gains per person employed. The overall result is an initial productive surplus that primes demand for goods and services.
The second intervention – in many respects, a second ‘stage’ – is to direct investment and entrepreneurs towards manufacturing. This is because manufacturing industry makes the most effective use of the limited productive skills of the workforce of a developing economy, as workers begin to migrate out of agriculture.
Finally, interventions in the financial sector to focus capital on intensive, small-scale agriculture and on manufacturing development provide the third key to accelerated economic transformation. The state’s role is to keep money targeted at a development strategy that produces the fastest possible technological learning, and hence the promise of high future profits, rather than on short-term returns and individual consumption.
But, with the onset of the Latin American debt crisis in 1982, Brazil crumbled amid currency depreciation, inflation and years of zero growth. It turned out that too much of Brazil’s earlier growth had been generated by debt that did not translate into a more genuinely productive and competitive economy.
What the Asian crisis clarified was that a consistent set of government policy interventions had indeed made the difference between long-run success and failure in economic development in east Asia. In Japan, Korea, Taiwan and China, governments radically restructured agriculture after the Second World War, focused their modernisation efforts on manufacturing, and made their financial systems slaves to these two objectives. They thereby changed the structures of their economies in a manner that made it all but impossible to return to an earlier stage of development. In the south-east Asian states – despite their long periods of impressive growth – governments did not fundamentally reorganise agriculture, did not create globally competitive manufacturing firms, and did accept bad advice from already rich countries to open up financial sectors at an early stage.
Part 2 moves on to the role of manufacturing. It investigates how Japan, Korea, Taiwan and China perfected ways to marry subsidies and protection for manufacturers – so as to nurture their development – with competition and ‘export discipline’, which forced them to sell their products internationally and thereby become globally competitive. This overcame the traditional problem with subsidy and protection policies, whereby entrepreneurs pocketed financial incentives but failed to do the hard work of producing competitive products. Firms were not able to hide behind tariff and other barriers and sell only to a protected domestic market because protection, subsidies and credit were conditioned on export growth. Firms that did not meet the export benchmark were cut off from state largesse, forced to merge with more successful companies, or occasionally even bankrupted. Governments thereby ended up with world-beating firms to justify their considerable investments of public funds.
Without successful large, branded companies of their own, south-east Asian economies remain technologically dependent on multinationals, eking out a living as contractors for the lower-margin parts of international production chains.
The main mechanism for making finance support state policy objectives was bank lending, which was manipulated to force export discipline on manufacturers.
In order to fund development, interest on bank deposits in north-east Asia and China was set well below market rates, a form of stealth taxation that helped pay for subsidies to agriculture and industry.
Premature financial deregulation in south-east Asia led to a proliferation of family-business-controlled banks which did nothing to support exportable manufacturing and which indulged in vast amounts of illegal related-party lending. It was a story of banks being captured by narrow, private sector interests whose aims were almost completely unaligned with those of national economic development.
Rapidly declining death rates – particularly for children – and rapidly rising working-age populations have been a big part of the east Asian developmental story since the Second World War. These demographic trends, largely the result of advances in medicine and sanitation, have facilitated unprecedented growth. The phenomenon is sometimes referred to as the ‘demographic dividend’. The flip side of this dividend is that it is followed by the faster ageing of populations – by which we really mean the increase of retired people relative to workers. After a tipping point, workforces start to shrink quickly, and older people consume their savings, devouring what were previously funds for investment.
In the end the size of your working-age population is still less important to your developmental progress than what you do with that population.
Here, the reason is that the evidence of a positive correlation between total years of education and GDP growth is much weaker than most people imagine.
The early success of Meiji Japan was achieved with surprisingly few engineers – the country only began to step up its vocational and scientific and technical education in the 1930s. In countries like Cuba and Russia, by contrast, vast numbers of engineers have been churned out without positive results.
It is that a lot of critical learning in the most successful developing countries takes place outside the formal education sector. It occurs, instead, inside firms.
In Japan, Korea, Taiwan and post-1978 China, by contrast, a lot of highly effective educational investment and research has been concentrated not in the formal education sector but within companies, and by definition – unlike the Soviet situation – within companies that are competing internationally. This may be critical to the rapid acquisition of technological capacity.
The miseries visited on ordinary people by a lack of attention to institutional progress deserve attention in their own right. Economic development is the subject of this book, but economic development alone is not a recipe for human happiness.
As with democracy, it is better to admit that the rule of law is not a principal driver of economic development, but rather is an integral part of overall development. We should expect developing countries to pursue both.
Part 1 - Land: The Triumph of Gardening
Why should land policy be so important to development? The simple answer is that in a country in the early stages of development, typically three-quarters of the population is employed in agriculture and lives on the land.
The problem with agriculture in pre-industrial states with rising populations, however, is that when market forces are left to themselves agricultural yields tend to stagnate or even fall. This happens because demand for land increases faster than supply, and so landlords lease out land at increasing rents. They also act as money lenders at high rates of interest. Tenants, facing stiff rents and expensive debts and with little security of tenure, are unable to make the investments – for instance, in improving irrigation or buying fertiliser – that will increase yields on the land they farm. Landlords could make the investments to increase yields, but they make money more easily by exacting the highest possible rents and by usury, which adds to their land holdings when debts cannot be paid and they take over plots that have been pledged as collateral.
In conditions of a growing population, low security of tenure and no restrictions on the charging of interest, a market in land arises in which concentration of ownership trumps improvement of yields as the easiest source of income for land owners.
It was, roughly speaking, to take available agricultural land and to divide it up on an equal basis (once variation in land quality was allowed for) among the farming population. This, backed by government support for rural credit and marketing institutions, agronomic training and other support services, created a new type of market. It was a market in which owners of small household farms were incentivised to invest their labour and the surplus they generated towards maximising production. The result was hugely increased yields in all four countries.
At an early stage, a poor country with a surfeit of labour is better served by maximising its crop production until the return on any more labour falls to zero. Put another way, you might as well use the labour you have – even if the return per man hour looks terribly low on paper – because that is the only use you have for your workers. A gardening approach delivers the maximum crop output, as any gardener knows.
The list of time-consuming interventions is almost endless. One of the most effective is to start off seeds in trays indoors so that they are only put in the ground for the more rapid maturation process. Soil-bed temperature also greatly affects yields and can be regulated by using raised beds in temperate climates or pits in tropical climates. Compost is most effective when applied with diligence – high-yield fruit and vegetable gardeners deploy fertiliser on a plant-by-plant basis. Targeted watering (taller plants, for instance, tend to need more) and constant weeding also have a big effect on crop size. The most productive plots utilise an almost solid leaf canopy because close planting minimises water loss and discourages weeds; but this rules out access for machines. The use of trellises, nets, strings and poles – all set up by hand – maximises yields through ‘vertical’ gardening; a single tomato plant can produce 20 kg of fruit. Inter-growing of plants with different maturities saves more space (the cognoscenti place radishes and carrots in the same furrow because the radishes mature before the carrots begin to crowd them out; but then the radishes can only be harvested by hand). Equally, shade-tolerant vegetables like spinach or celery can be raised in the shadows of taller plants to ensure that no space is wasted; but again, this must be done by hand.
In the United States, as one example, well-managed vegetable gardens yield 5–10kg of food per square metre (1–2lbs per square foot) per year, which equates to USD11–22 per square metre at shop prices.
So why doesn’t everyone do it? The problem is that the gardening level of output needs so much labour.
It is striking that in so many countries in both Asia and Africa, such as Malaysia, Kenya and Zimbabwe, where European colonists introduced large-scale agriculture, they actively discouraged smallholder competition by native farmers and subsidised large-scale production, either directly or more indirectly, by funnelling tax revenues to infrastructure that supported plantations. If scale plantation agriculture was so efficient, this should not have been necessary.
Increases in agricultural output are traditionally represented as important by economists because they lead to increased surplus, which implies more savings which can then be used to finance industrial investment. However, big yield gains also mean big increases in rural consumption – something that may be even more important when farmers create demand for consumer goods.
For instance, although poorly understood at the time, a large part of what undermined Latin America’s efforts to industrialise after the Second World War was that the region proved itself much better at increasing manufacturing exports than at increasing agricultural output. As a result, as incomes rose and people ate more food – including meat, which is more land-intensive to produce than vegetable crops – different Latin American countries either reduced their agricultural exports or increased their agricultural imports. Either way, the net effect was that agriculture tended to bleed away any foreign exchange that industrial exports (or reduced imports) created. Latin America was undone in the 1950s, 1960s and 1970s by a developmental strategy characterised by what the economist Michael Lipton dubbed ‘urban bias’, or the tendency of the urban elites that run poor countries to undervalue farmers.
Poor countries do not offer unemployment benefits or other welfare payments. In periods of economic downturn, the opportunity for laid-off migrant factory workers to return to their family farms is therefore of great importance.
In the United States, American government support for land reform in Japan, Korea and Taiwan was attacked domestically in the 1950s as socialism by the back door. But it was quite the opposite. It represented the creation in north-east Asia of the most idealised capitalist free market ever established for developing economies. For once, there were no landlords born with silver spoons in their mouths and (almost) no landless peasants without capital; everyone was given the chance to compete.
Deininger’s two big conclusions are that land inequality leads to low long-term growth and that low growth reduces income for the poor but not for the rich. In short, if poor countries are to become rich, then the equitable division of land at the outset of development is a huge help.
In just three decades after the Meiji restoration, Japanese modernisation was such that the country could defeat China (1895) and Russia (1905) in wars, be welcomed into a bilateral military alliance by Great Britain (1902), and begin to export its goods around the world. None of this could have occurred without the food, taxes and foreign exchange supplied by the countryside. The Meiji government discovered the developmental trick encapsulated in Michael Lipton’s dictum as: ‘If you wish for industrialisation, prepare to develop agriculture.’
Those with too little land, or rented land, or both, often had to sell their crops as soon as they were harvested, when the market was flooded and prices were low. Landlords stored their rice, and sold it later for better prices, before offering money at interest to those who sold early and now had no money left. Between the world wars, farmer debt in Japan rose eight-fold.
In the 1920s, when 85 per cent of Chinese people lived in the countryside, life expectancy at birth for rural dwellers was 20–25 years. Three-quarters of farming families had plots of less than one hectare, while perhaps one-tenth of the population owned seven-tenths of the cultivable land.
An eminent Chinese official stated that in Shanxi province at the beginning of 1931, three million persons had died of hunger in the last few years, and the misery had been such that 400,000 women and children had changed hands by sale.’
It was William Hinton, an American Marxist writer conducting research in the 1940s, who produced the classic outsider-insider’s tale of life in a Chinese farming village, one that was also located in Shanxi province. Hinton wrote about the mundane realities of death by starvation during the annual ‘spring hunger’ when food reserves ran out, and of the slavery (mostly of girls), landlord violence, domestic violence, usury, endemic mafia-style secret societies and other assorted brutalities that characterised everyday life.
Nationally, estimates of the death toll related to land reform in China range from hundreds of thousands of people to several million.
Overall, as Hinton observed, land reform was critical to the communist victory itself. The People’s Liberation Army secured many recruits during the civil war, first by giving their families confiscated land and then by organising supporters to farm it while the young men were away at the front.
In 1956, following the Russian and North Korean examples, Mao Zedong led a drive to create agricultural collectives in which hundreds of families pooled their land, tools and labour in units of production. These changes, together with an industrialisation drive, were presented as China’s Great Leap Forward. In reality, the disruption to agricultural output in the late 1950s was such that a famine occurred in 1959–61 in which an estimated 30–40 million people (slightly less than 10 per cent of the population) died.
The US contribution was a fitful one, reflecting the mixed emotions that land reform inspired among American politicians and their military commanders. There was early, decisive action over defeated Japan, vacillation in South Korea until events forced the US hand, far too little too late in mainland China, and a belated but important intervention in Taiwan.
‘I came to this [work] chiefly as a result of a lesson I learned from my experience before I left Russia in early 1921, namely that the communists would never have attained political power if they had not dealt with the land question resolutely, by turning the land over to the peasants.’
Land ownership in South Korea prior to reform was the most unequal among the north-east Asian states. Wolf Ladejinsky, writing about Korean agriculture before partition in 1945, quoted a 1928 US State Department research report which said that less than 4 per cent of households owned 55 per cent of agricultural land, while there were a quarter of a million landless squatter families.
The structural effects were the creation of a textbook market environment in which everybody had a small amount of capital, and an evening out of income distribution. When the share of property income in a society falls (here because fewer people were renting out land), income from current work is relatively more important and overall incomes diverge less. Household income surveys in Taiwan showed that the country moved from a Gini coefficient – the standard measure of equality, where 0 is perfect equality and 1 is perfect inequality – on a par with Brazil in the early 1950s (scoring 0.56) to a level in the mid 1960s that was unprecedented for a developing country (0.33).
To take one example of a popular new export vegetable, asparagus was calculated to require 2,900 times as much labour per hectare as rice, providing ample work in a country where industrial job creation did not begin to exceed the rate of population growth until the end of the 1950s. Processing of foodstuffs, which began with sugar and moved on to asparagus, mushrooms, tropical fruits and other crops, was Taiwan’s first ‘manufacturing’ export industry. The textile business did not begin to kick in until the second half of the 1950s.
There is much debate about how hard agriculture was squeezed in the aggregate, since government was also putting investment into the sector, but there is no doubt that the Taiwanese farmers helped to fund their country’s early industrialisation. And not only did their household savings pay to build factories, they also provided the key market for early manufactures as farm incomes more than doubled in real terms in the 1950s.
The more common developmental tale is one of ‘urban bias’, in which town and country, agriculture and manufacturing, remain worlds apart. That is what happened in south-east Asia. There, post-colonial governments toyed with land reform, but never followed through to fundamentally restructure their rural economies. And the United States failed to apply the external political pressure that it used to such positive effect in north-east Asia. This lack of domestic and international political conviction over the importance of household farming in development was the first step towards the relative economic underperformance of the south-east Asian region.
Bacolod is well past its heyday, which came in the 1970s. Back then, a large US import quota gave sugar producers in the former colony access to the heavily protected US market, where sugar prices – despite America’s free market claims – are among the highest in the world.
SDO, like other loophole mechanisms in the CARL such as Voluntary Land Transfer and Voluntary Offer of Sale, broke one of the cardinal rules of successful land reform as implemented in north-east Asia: do not let landlords negotiate directly with tenants. In such circumstances, landlords almost invariably manage to negotiate arrangements that are not favourable to tenants.
Today, an estimated 8.5 million of 11.2 million rural workers in the Philippines are landless. The majority of people in the countryside live in poverty. Yields are also shockingly low and not increasing. And all this in a country where cultivable land is one-third of the land mass – far more than in Japan, Korea or Taiwan – and climate and soil quality are more naturally conducive to high yields. In the Philippines, man’s capacity to seize failure from the jaws of opportunity is writ large.
Ironically, it is bourgeois consumers made rich in Japan and Korea off the back of proper land reform who are now the most significant buyers of the premium brown mascobado sugar sold by these Filipino farmers.
In north-east Asia, the remarkable growth of agricultural output was the result of the state itself mobilising effectively to redistribute land quickly and fairly and then to provide the credit, extension and sales support necessary to enable and incentivise households to maximise output. There has never been any equivalent focused effort in the Philippines. Instead, the weakest state among the major economies of east Asia has given rise, proportionately, to the largest number of NGOs – an estimated 60,000–100,000. Typically tiny, they scramble around desperately trying to make up for the state’s hopelessness.
Filipino farming remains grotesquely inefficient. Despite the insistence of Negros landlords that sugar growing can only be competitive on plantations of a minimum scale, yields have always been less than in the family-farmed areas of southern Taiwan and China: around 56 tonnes per hectare on average, compared with 85–90 tonnes.
The announcement of the details of the Stevenson scheme almost caused a peasant rebellion. Violent protests occurred around Malaysia. The reason was that the smallholder yield estimate bore no relation to reality. A new investigation was quickly announced. This revealed, much to the colonial government’s embarrassment, that smallholder rubber yields were consistently higher than plantation ones. Indeed, the average smallholder yield was more than 50 per cent higher than that of the average plantation, and in some cases several multiples higher.
The reasons for the higher smallholder yields were the usual ‘gardening’ ones. Peasants planted their trees more densely – often 200 per acre versus 100 on a plantation – and they tapped them daily, maximising their output at the expense of extra labour. The peasants were also far more resilient than the plantations to the global commodities depression, because they intercropped foodstuffs with their rubber and frequently also had secondary non-farming occupations. Without the overheads of the plantation owners, they were willing and able to take lower prices.
The rubber market in colonial Malaysia was a simple case of a market being rigged in such a way that higher-yield family farmers subsidised lower-yield big business.
Malaysia is not, it should be stressed, a country that faces a shortage of agricultural land. Most local agronomists say there are still several hundred thousand hectares that could be opened up to agriculture, while in periods of recession like the early 1980s thousands of hectares of existing agricultural land have lain idle. Instead, Malaysia is a country that has found a sub-optimal structure for its agricultural economy despite a surfeit of land. This is another reminder that, in order to thrive, smallholders require not only their fields, but also the extension, marketing and credit infrastructure that allows them to compete.
At the Thai court (the country was an absolute monarchy until 1932), the myth grew up of a happy, loyal peasantry tending rice in the provinces. When a minister of finance wrote Thailand’s first formal treatise on economics in 1906–7, and had the temerity to argue that credit and other support were necessary for smallholders who were struggling, King Vajiravudh was outraged. ‘I am able to attest,’ he pronounced, ‘that no other country has fewer poor or needy people than Siam.’ Both the finance minister’s work and the study of economics were banned.
A chasm-like division between Bangkok and the countryside, and an extreme urban bias in policymaking, have been a constant in Thailand.
North-east Asia, unlike south-east Asia, no longer has ‘peasants’. In Japan, Korea, Taiwan (and, from 1978, China), land reform – backed by the necessary institutional support – unleashed unprecedented agricultural growth, created markets and unlocked very considerable social mobility. However, this does not mean these states managed their agricultural development to perfection. Even the best policy is only a solution to the developmental challenges of a particular moment in time. As the economic environment unfolds, good policies that remain unchanged eventually turn into bad ones.
From a global development perspective, reduced protection in already-developed countries also gives other poor countries in turn the opportunity, in turn, to export their agricultural surplus in the period when their labour is cheapest; it keeps the developmental drawbridge down.
The household farming country in east Asia that largely gave up subsidies and kept farms small – China – has seen urban incomes rise to more than three times rural ones. This level of inequality was never acceptable to governments in Japan, Korea and Taiwan.
The average age of farmers across north-east Asia has been over fifty years since 1990; in essence, the first land reform generation stayed put on their small plots while their children left for the cities.
Even after reductions in recent years, the share of farm incomes in Japan and Korea accounted for by subsidies is one-half. This compares with one-quarter in Taiwan, one-fifth in Europe and one-tenth in the United States.
Almost anything – and perhaps everything – that grows is able to benefit from increased human attention. This is why there is so much evidence from so many countries that farm yields per hectare are in inverse proportion to farm size.
Developing countries are not just little ships blown about on the developmental ocean by the winds of rich states. In agriculture they have a greater capacity to chart their own course than in any other sector of the economy because land policy is entirely a domestic affair. In this respect, land policy is the acid test of the government of a poor country. It measures the extent to which leaders are in touch with the bulk of their population – farmers – and the extent to which they are willing to shake up society to produce positive developmental outcomes. In short, land policy tells you how much the leaders know and care about their populations. On both counts, north-east Asian leaders scored far better than south-east Asian ones, and this goes a long way to explaining why their countries are richer.
Part 2 - Manufacturing: The Victory of the Historians
The first is that manufacturing is based on the use of machines, and so it allows poor countries to mitigate their biggest constraint at the earliest stage of development – a shortfall of productive human skills. In manufacturing, a small number of entrepreneurs and technicians is able, through the medium of machines (imported to begin with), to have an outsized impact on economic development by focusing on mechanised production that employs large cohorts of unskilled and semi-skilled labour.
The second reason why manufacturing is so important is another relative advantage that it has over the service sector. This is that manufactures are much more freely traded in the world than services. Most manufactures can be put in containers and shipped to anyone willing to pay for them. Trade in services faces more practical and political impediments. In practical terms, some services – like call centres or software – are sold at distance down phone and computer lines. But most services require goods or people to travel in two directions, adding time and cost.
Evangelists of the free market do not really believe in free trade when it comes to unrestricted movement of people, and nor do rich country governments. Partly for this reason, in international trade agreements trade in services is opened up more slowly than that in manufactures.
Manufacturing allows for trade, and trade is essential to rapid economic development. Through it, poor countries learn productive skills from more advanced economies and acquire new technologies. Non-trading (‘autarkic’) developing states such as the former Soviet Union, China before 1978 and India before 1991 made painfully slow technological progress; indeed, so much so that their populations lost faith in the possibilities of economic advancement
Most of us are also unaware that, because of the extraordinary productivity gains that are possible in manufacturing, even the comparatively shrunken manufacturing sectors in rich countries today produce more goods than ever. In a manufacturing laggard such as the United Kingdom, the real value of manufacturing output is currently two and a half times what it was at the end of the Second World War. This expanded output is produced by less than one-tenth of the British workforce, compared with the one-third of employees who worked in manufacturing as recently as 1960.
Manufacturing firms are nurtured by the state in two ways: through protection and through subsidy. These interventions create breathing space for entrepreneurs while they learn to manufacture competitively. Unfortunately, protection and subsidy also bring with them a well-known risk – one which economists call ‘rent seeking’.
The problem is a very real one and has undermined industrial development efforts in many poor countries. The solution to the problem is to find mechanisms that force manufacturing entrepreneurs to become globally competitive at the same time as they are allowed to make profits for themselves. In other words, the interests of national development and business have to be forcibly aligned.
By far the most important of these was the presence – or absence – of what I call ‘export discipline’. This term refers to a policy of continually testing and benchmarking domestic manufacturers that are given subsidies and market protection by forcing them to export their goods and hence face global competition. It is their level of exports that reveals whether they merit state support or not.
Since the 1970s, there has been much talk about state industrial policy in western countries being an attempt to ‘pick winners’ among firms, something that most people would agree is extremely difficult. But this term does not describe what happened in successful developing states in east Asia. In Japan, Korea, Taiwan and China, the state did not so much pick winners as weed out losers.
The fact that north-east Asian governments concentrated on weeding out losers rather than picking winners also helps to explain the existence of large businesses which grew up without significant direct state support and outside state plans – like Sony and Honda in Japan, or Acer and HTC in Taiwan – in addition to ones which received more state largesse. Businesses that worked were always allowed to survive.
A third intervention in north-east Asia was to provide a great deal of bureaucratic support to manufacturers which exported successfully. In addition to domestic market protection and a supply of credit, states provided important assistance in the field of technology acquisition. Governments in Japan, Korea, Taiwan and China have variously undertaken collective bargaining operations to buy foreign technology – often forcing foreign firms to hand over know-how or to lower their price for it in return for local market access – and organised public sector or joint public–private research initiatives where individual firms were unable to undertake research and development investments alone.
To the modern economic ear, accustomed to ideas of free markets that are supposed to be ‘win–win’ for all participants, policies to protect local industry and create a forced march for exports may sound more like a list of crimes. In rich countries, we are raised to believe that all wealth is the product of competition. The shocking truth, however, is that every economically successful society has been guilty, in its formative stages, of protectionism. Outside of the anomalous offshore port financial havens such as Hong Kong and Singapore, there are no economies in the world that have developed to the first rank through policies of free trade.
Indeed, the economic historian Paul Bairoch has dubbed the United States ‘the mother country and bastion of modern protectionism’.
In short, protectionism has always been the rich man’s entry ticket to industrial development. Historians enjoy considerable consensus on this point. Most economists, however, find it impossible to admit that protectionism could be a precondition of industrial upgrading. The problem is that protectionism involves another of the temporary trade-offs that economics is at a loss to explain. Measured by economists at a single moment in time, protectionism is expensive and inefficient because it adds cost, punishes consumers and invites retaliation. However, as a means to the long-term end of industrial learning, protectionism makes possible the acquisition of strategically vital knowledge at a cost that is only temporary. The subsidies inherent in protection help shift the structure of an industrialising economy from a lower level of value-adding to a higher one. When the new level is reached, economists still say that protectionism is inefficient because of its costs, but without conceding that it was protectionism that changed the economy’s structure.
Alexander Hamilton, who as Treasury Secretary was responsible for shaping the early manufacturing policy of the independent United States, coined the expression ‘infant industry’ when setting out his arguments in favour of protection. The term was then picked up and widely employed in nineteenth-century Germany. The Meiji development theorist Sugi Kōji wrote of the need for Japanese businesses to be ‘protected until they are mature, just as children are by their parents and students by their teachers’.
Just as nineteenth-century European parents who could legally send 10-year-old children to work in factories avoided this if they could afford to, and kept their children in school until they were better educated, so successful governments of developing countries have focused on learning and higher future returns.
North-east Asian industrial policy was not invented out of thin air. Instead it was copied from examples of successful economic modernisation in the United States and Europe. Most directly, manufacturing policy was copied from the example of Germany, which in the late nineteenth and early twentieth centuries provided Meiji Japan with a contemporaneous case study of successful industrialisation.
The Meiji Restoration of 1868 took place three years before the Prussian-led unification of Germany – even if Japan’s level of development lagged. The oligarchs who ruled the new Japan were also a temperamental match for the Prussians who drove the modernisation of Germany. Both groups were politically conservative, both were committed to industrialisation, and both were concerned by territorial security.
Friedrich List, the group’s greatest luminary, contended that the free market evangelism emanating from Britain was motivated largely by opportunism based on the country’s global technological leadership.
List’s views on development had formed while he was living in the United States between 1825 and 1832, when he had studied the arguments for a protectionist industrial policy to nurture ‘infant industries’ set out by Alexander Hamilton in his Report on the Subject of Manufactures submitted to Congress in 1791.
Hirobumi, Japan’s first (and multiple) prime minister, spent two months in Berlin in 1882, meeting the Iron Chancellor, Otto von Bismarck.
The Japanese were pressured into signing international patent and copyright agreements, but they ignored them. ‘That [the agreements] posed no effective obstacle to Japanese copying of foreign designs,’ wrote the Japan historian William Lockwood, ‘was a constant complaint of manufacturers abroad.’
The unprecedented scale of Germany’s output meant that unit costs became lower than those of established industrial powers like Britain, whose earlier investments in smaller-scale plants became a liability. Germany’s economies of scale were such that its iron and steel works were able to soak up the transportation costs of importing half their iron ore (at a time when per-unit freight rates were far higher than they are today) and still remain Europe’s most efficient producers.
Only in the 1880s, after two decades of relying on raw silk as her main foreign currency earner, was Japan ready to emulate Germany by building factories on a grand scale. She began, as has every significant developing economy, with textiles, a business with limited capital requirements and ubiquitous markets.
The government sacrificed the interests of previously protected Japanese cotton farmers to those of industry, and by 1914 various textiles accounted for 60 per cent of all Japanese exports. The country’s chronic trade deficits ended. The First World War then disrupted European industrial output, allowing Japanese firms to move in on colonial Asian markets for all kinds of basic goods: textiles, bicycles, canned foods, and so on. There was an unprecedented export boom. (In European style, Japan also took Taiwan, in 1895, and Korea, in 1910, as captive colony markets for itself.)
The zaibatsu became huge – by 1928 the Big Four (Mitsui, Mitsubishi, Sumitomo, Yasuda) accounted for about 15 per cent of all the paid-up capital in the Japanese economy – but they frequently profited by putting the squeeze on downstream manufacturers. This meant that in the good times the manufacturers survived on thin margins and lacked the cash flows to move on to more complex activities; and when the bad times hit, they went bust.
The solution suggested by the cartel groups was a rebate system that gave raw material and component cost reductions only to production that was destined, directly or indirectly, for export. In effect this meant that German domestic prices – kept artificially high by tariffs – subsidised the development of manufacturing export markets. It marked the birth of a series of cartel-managed export subsidy regimes that triggered what the economic historian Clive Trebilcock called ‘the exuberant German export drive of the 1900s’.
However, it was the aggressive application of infant industry techniques in a relatively poorer country, Japan, that caught the world’s attention most forcefully. From 1952 Japanese manufacturing and mining output increased more than tenfold in only two decades. Japan became the first state to close in on sustained double-digit economic growth. Many people thought the country had discovered a new and unbeatable form of economic management. (The US and Japanese bestseller Japan as Number One came out in 1979.) In fact Japan had merely rediscovered old ideas, and built on earlier German refinements thereof. Moreover, while the Japanese capacity to burnish and improve those ideas was impressive, it was put in the shade by South Korea and Taiwan.
The man who defined Korea’s modernisation era was General Park Chung Hee, who came to power in a coup on 16 May 1961. Park had served as a lieutenant in the Japanese colonial military, in the elite Kwangtung army when it oversaw a huge industrialisation drive in Korea and Chinese Manchuria in the 1930s.
General Park therefore had Japanese ideas about how to run his country. However, he was also an amateur historian who specialised in the histories of rising powers. He was well read on German development, and followed closely that country’s swift, state-led re-industrialisation after the Second World War. He also knew in detail the stories of Sun Yat-sen, Turkey’s Kemal Pasha and Egypt’s Gamal Abdel Nasser and their efforts to nurture modern, large-scale industries. Nine months after taking power in Korea, the peasant-born Park published a book of his own, Our Nation’s Path: Ideology for Social Reconstruction, which contained a road map for what Park described as ‘co-ordination and supervisory guidance, by the state, of mammoth economic strength’. The next year Park published The Country, the Revolution and I, with chapters on ‘The Miracle on the Rhine’ and ‘Various Forms of Revolution’ in which he discussed different historical revolutions from an economic and developmental perspective.
Indeed, Korea became the most export-dependent developmental state the world had seen, with the government giving subsidised credit to any firm that sold abroad. The interest rate paid by exporters ranged between a quarter and a half of the rate paid by everybody else. In the high-inflation 1970s, the real, inflation-adjusted interest rate given to exporters was between –10 per cent and –20 per cent per annum. So long as they could raise their sale prices in line with inflation, exporters were being paid to borrow money.
Along the way, Korean bureaucrats were reading not the rising American stars of neo-liberal economics, or even Adam Smith, but instead Friedrich List. The Korea and Taiwan scholar Robert Wade observed when he was teaching in Korea in the late 1970s that ‘whole shelves’ of List’s books could be found in the university bookshops of Seoul. When he moved to the Massachussetts Insitute of Technology, Wade found that a solitary copy of List’s main work had last been taken out of the library in 1966. Such are the different economics appropriate to different stages of development.
As of the Second World War, almost seven-tenths of the paid-up capital of registered businesses in China belonged to state firms, most of them managed by the NRC.
The agency continued to expand, to a record head count of 33,000 staff and nearly a quarter of a million workers in its enterprises by late 1947, but it was unable to put most of its developmental plans into action. NRC bureaucrats in republican China had a reputation for relative competence and professionalism. Most of them stayed in communist China after 1949 and helped to hand over control of already state-run companies to the CPC; many went on to work in Mao’s state planning apparatus. The State Planning Commission (SPC) was created in 1953 and implemented numerous projects that had been conceived by the NRC – although personnel who had been employed under the Kuomintang later suffered persecution in political campaigns. The SPC is today called the National Development and Reform Commission (NDRC).
Taiwanese state enterprises underperformed Korean corporations because they faced less export discipline and less competition. They were allowed to be more dependent on foreign equity joint ventures for technology, and this weakened their capacity to originate their own technology.
At the industrial policy-making level, what stands out with the benefit of hindsight is that there was almost no role played in Japan, Korea or Taiwan by economists. Meiji Japan blazed its trail by following the Prussian, and earlier American, model which rejected the modern classical economics that began with Adam Smith and David Ricardo. The framers of the Meiji revolution were trained in Germany and at Tokyo University’s law school, which focused not so much on law as on European-style public administration. There was a strong prejudice against the theoretical approach associated with modern economics, and in favour of practical problem-solving.
The most prominent economists in circulation in north-east Asia in the 1950s and 1960s were the ones sent by the US government to try to ‘straighten out’ its new allies. Among these was Joseph Dodge, who was despatched to occupied Japan in 1949 to enforce fiscal austerity. His policies induced a deep, deflationary recession in the winter of 1949–50. The country only recovered with the onset of the Korean War from June 1950 and the concomitant demand for war-related supplies.
The governments in Seoul and Taipei not only structured infant industry programmes on the US buck, they made American consultants fit in with their objectives.
In Korea, economists ‘with their newly minted US PhDs’, as Jung-En Woo disparagingly put it, wrought havoc with the financial system in the 1980s, setting the stage for Korea’s 1998 financial meltdown. However, their entry on to the policy stage was becoming necessary at a time when Korea was already globally competitive in a number of manufacturing sectors, and needed to deregulate to progress further.
Sometimes these were local economists trained abroad – as with the so-called ‘Berkeley Mafia’ of five leading advisers to Suharto in Indonesia, who had all studied at the University of California.
More often, the economic advice came from the World Bank and the IMF, which were ready with their free market prescriptions for development, despite the fact that these prescriptions have never produced a successful industrial state.
The capability to make steel efficiently has, historically, signalled that a country will go on to make other things efficiently – a sort of entry-level test for the economic big time.
Korea and Malaysia point up the single most important commonality of all developing states in terms of manufacturing policy: that in most large-scale businesses the critical variable is the relationship between the state and private entrepreneurs. A government can try to circumvent the private sector by running every firm itself. But such an approach is not recommended by history. Instead, governments must use their power – particularly their discretion over state-controlled assets, business licences, credit and scarce foreign exchange – to make private entrepreneurs do what industrial development requires. In so doing, governments need to take a realistic view of entrepreneurs. Rather than plead with them to move voluntarily to some higher moral plane, it is better to accept the existence of the entrepreneur’s ‘animal spirits’, and use his desire to make as much money as possible to control him. The entrepreneur seeks to ‘get in and grab’, as the term indicates. The state has to force him to fulfill developmental objectives while this is going on. Development is therefore a thoroughly political undertaking. If governments allow entrepreneurs access to what economists call ‘rents’ – sources of income at government discretion – without contributing to developmental objectives, this is a political dereliction of duty.
Neo-liberal economists argue that developing countries should avoid the risk of crony capitalism by getting rid of economic rents. But while this might make sense in rich countries, in aspiring states it simply begs the question: How, in that case, will you get entrepreneurs to do what you need them to do in order to develop your economy? Were Park Chung Hee – who nurtured world-beating entrepreneurs but never trusted them – still alive, his answer would quite certainly be: You won’t. Rents are the bait with which the successful developing state catches and controls its entrepreneurs.
It was twelve days after the 1961 coup, on 28 May, that Park and his colleagues began arresting businessmen. They did so under a Special Measure for the Control of Illicit Profiteering. There are conflicting accounts of how many businessmen were held, where and for how long. But it is clear that scores of the country’s most senior entrepreneurs were locked up. Seodaemun was one detention point. A few top figures, including Samsung’s founder, Lee Byung Chull, had the good fortune – or, more likely, the forewarning – to be in Japan. But the great majority of the country’s business elite was taken in. Park put the frighteners on the business community in a manner unprecedented in a capitalist developing country. He declared that the days of what he termed ‘liberation aristocrats’ – crony capitalists who bought favours from Syngman Rhee’s government and did nothing for their country in return – were over. Imprisoned businessmen were required to sign agreements which stated: ‘I will donate all my property when the government requires it for national construction.’ In effect, this put the entrepreneurs on parole to do whatever Park required.
In the 1960s Pohang was an agricultural town of 67,000 inhabitants. Today it is an industrial city of half a million people and home to the world’s third biggest – and most profitable – steel producer. The urban area is unremittingly bland and shabby, and separated from the steel works by a river. Outside the main gates of the Pohang Iron and Steel Company is a big, dirty blue sign announcing ‘Clean and Green POSCO’.
Iron ore travels round the horseshoe and becomes finished goods ready for shipping in thirteen hours; Pohang turns out 16 million tonnes of product a year.
Construction speed ought to be a comparative advantage of the developing state, not least because of much lower health and safety standards. At Pohang, 24-hour building contributed to a construction cost per tonne of steel capacity that was one-quarter that of Brazil.
Third, the firm showed a relentless application to the job of learning everything there is to know about a steel plant. During the first and second phases of its construction, POSCO management refused to employ the computerised control systems recommended by their Japanese consultants lest they did not fully understand the equipment they were buying.
By the time that POSCO wanted to build a second mega-facility at Gwangyang in the 1980s, Japanese suppliers had lost so much intellectual property to POSCO that they were unwilling to become involved.
Warren Buffet’s Berkshire Hathaway bought a substantial chunk of POSCO equity – a solid indicator of its long-term profitability.
Given the role that learning plays in economic development, factories like Pohang become the schools in which successful developing nations learn. POSCO is a kind of vocational college that doubles as a steel maker. In the 1970s and 1980s it educated a first generation of Korean steel specialists and did so while POSCO was already producing and exporting product. The role of factory-based – as opposed to school-based – learning becomes clearer still at Hyundai’s manufacturing hub at Ulsan, only seventy kilometres to the south of Pohang.
There are presently 34,000 HMC employees in Ulsan making 1.6 million vehicles. It took 41,000 people to make 1 million in 1994, and vastly more again to make just 400,000 in 1986.
Toeholds in international markets were won battle by battle. In Europe, for instance, the Korean government told the protectionist French government that French train makers would have a better chance of supplying the Train de Grande Vitesse (TGV) for the Seoul–Pusan rail route if France bought Korean cars. After weighing the competing interests of its train and car producers, Paris eventually came up with a quota of 20,000 imports a year.
A second key to HMC’s manufacturing success was its ability to obtain foreign technology in such a way that the firm learned skills – and eventually learned how to originate its own technology – without becoming dependent on foreign multinationals.
Even after ten years’ production, in 1978 HMC was selling less than 60,000 cars. However, the firm was digesting technology and it was learning.
HMC’s US managers, backed by aggressive pricing and an advertising blitz, delivered a remarkable feat. They made the Excel the top imported compact model in the US in its first two years, selling more than 260,000 units per year in both 1987 and 1988.
In political terms, Malaysia is not a difficult country to understand. It was put together in its modern incarnation from a patchwork of sultan-ruled states which had been subjected to modestly varying colonial arrangements by the British. The colonialism was always of the ‘light’ variety in the sense that it did not take many Britons to run what is now Malaysia, and the local aristocracy was heavily co-opted. From 1957, the first post-independence prime minister, known to his countrymen as the Tunku (‘The Prince’), was Abdul Rahman Putra Al-Haj, a rich, clubbable, Anglicised, upper-class, womanising dilettante who took a particularly long time to complete his undergraduate degree at Cambridge.
He made the improvement of ordinary Malays his cause, although he grew up with a race-based view of the world that was stereotypical of the colonial era; the Malays, for Mahathir, were genetically constrained. Mahathir’s judgement of developmental issues would forever be clouded by the fact that he spent too much time worrying about race and not enough time understanding the basic structural requirements of technological learning.
The new leader failed to grasp the need for export discipline, and on trips to north-east Asia his Korean and Japanese hosts did not explain the dirty secrets of protectionism to him. This was hardly surprising when the self-interest of these states was now in selling turnkey industrial plants and construction services to countries like Malaysia.
The second divergence from Korean experience was that Mahathir rarely employed the private sector to lead his industrial investments and did not create competing ventures. He preferred one-off investments in state enterprises. By not licensing more entrants in businesses like car making, Mahathir threw away the power to cull losers. All he could do was change the management of state enterprises – firms he could not afford to let go bust because he had nowhere else to turn.
However, with the benefit of hindsight, the rather hasty, under-researched and breathless tone of The Borderless World was a pointer to the unlikelihood of its prediction that the world was becoming more favourable to the development of poor countries. It was not a good replacement for the work of Friedrich List. Hard-nosed infant industry protection of the kind recommended by List remains the only proven way of pushing a rising state up the technological ladder.
Mahathir’s strategy was to learn not by doing but by giving construction projects to firms from Japan and Korea. In 1984 he awarded what was then the biggest construction deal in Malaysia’s history – for the Dayabumi complex in Kuala Lumpur – to two Japanese firms, despite the fact that local companies put in lower bids. The Malaysian taxpayer footed the bill, but Malaysians learned nothing. Meanwhile Lim Goh Tong and his fellow Malaysian entrepreneurs grew fat on a diet of government-provided concessions.
Instead of Malaysia learning from the Japanese, many industry experts concluded that it was the Japanese who learned about a new technology on the Malaysian dollar.
The point is that, without commercial feedback from the international market, Malaysia’s most visionary leader made a series of disastrous decisions.
All technological learning, like all education, takes a long time and involves a lot of errors. As one Hyundai quality control manager put it, the secret of technological progress is ‘not repeating the same mistake’ over a very long period of time.
Malaysia today is a bit like a country that went to school and college for twenty years but failed to pay sufficient attention and now finds itself ill-equipped to live at the economic level to which it aspires.
The ideological driver of Indonesia’s industrialisation programme was a German-trained aerospace engineer, B. J. Habibie, who became Minister of Research and Technology, and later vice president, under Suharto.
In the past fifteen years, it is probable that Indonesia’s technological capacity has actually gone backwards.
The Philippines has no indigenous, value-added manufacturing capacity. At the end of the Second World War only Japan and Malaysia had higher incomes per capita in Asia. Then Korea and Taiwan overtook the Philippines in the 1950s. The country slid down past Thailand in the 1980s, and Indonesia more recently. From having been in a position near the top of the Asian pile, the Philippines today is an authentic, technology-less Third World state with poverty rates to match.
What created the Canons, the Samsungs, the Acers and so on in Japan, Korea and Taiwan was the marriage of infant industry protection and market forces, involving (initially) subsidised exports and competition between manufacturers that vied for state support.
The mix of plan and market recalls the British development economist Ronald Dore’s contemporary observation about foreign perceptions of Japan at the height of its industrialisation: ‘Left-wing... observers come back from Japan convinced they have seen a shining example of state planning,’ he wrote. ‘Right-wing visitors return full of praise for the virtues of Japan’s free enterprise system.’ The same, conflicting conclusions have been heard from different visitors to Korea, Taiwan and China.
Unfortunately, the recipe for manufacturing development – which is really not difficult to grasp, even if it varies in its details from country to country – is relentlessly over-complicated and confused by economists. They insist, in their ignorance of history, that efficiency considerations which are important in developed economies should also determine policy in poor countries. Developing states, however, need to invest in learning before they worry too much about efficiency.
the objective of industrialisation is technological learning, leading to the capacity to originate new technologies indigenously.
In failed, autarkic socialist states like the Soviet Union, and India and China in their pre-reform incarnations, the absence of export discipline and competition were the real developmental culprits, not who owned firms’ equity.
If manufacturing export discipline, domestic competition and the culling of losers are the closest thing to a magic recipe for industrial development, then the last thing to be stressed is the transience of the magic. Leaving aside the global issue of trade surpluses, poor countries which have used infant industry policies to lever themselves on to the rich man’s stage discover that those same policies bring new domestic problems – albeit rich(er) country problems. These can be characterised as the industrial equivalent of Japan’s 5 dollar apples – the ultimate outcome of Japan’s high-yield, but now grossly over-protected, household farming strategy.
Similar inefficiencies were apparent in services from airlines to tourism. Bill Emmott, in his 1989 book The Sun Also Sets, remarked of Japan’s legendary army of salary men: ‘If these sararīmen, as they are called, do work long hours, it is often because they are keen on overtime pay or because of a mixture of peer pressure and inertia. They spend ten hours doing what others manage to do in seven or eight. Many is the office that has an opened bottle of Suntory whisky on the shelf or the annual high school baseball tournament showing on the television.’
In the same vein as people who argue that land reform is too difficult, however, this reasoning assumes there is a viable alternative to infant industry policy. There is not. As the economic historian Angus Maddison wrote in his book Explaining the Economic Performance of Nations: ‘Technical progress is the most essential characteristic of economic growth.’ If technological progress is to occur in emerging states as part of accelerated economic development – rather than occurring over many, many generations – it requires state-orchestrated industrial policy.
But twenty years after India launched its current reform agenda in 1991, only 3 million people out of a population of 1.2 billion work in IT – a fraction of 1 per cent of the labour force. The service entrepreneurs, managers and technicians who graduate from the elite Indian Institutes of Technology and run firms like Infosys and TCS create far fewer jobs for others than they would had they been forced to manage factories.
There is no way that the specialist IT firms of Bangalore, or the financial services elite of Mumbai, will propel India as a nation to the kind of developmental success seen in Japan, Korea, Taiwan and China.
Enormous investments over very long periods are required to fund industrial learning and this continues to mean that big business plays a leading role in economic development. Indeed, my sense is that the role of big companies is very much more important than the role of big countries – there are lots of small or low-population countries with big firms, like Belgium or Sweden, that are rich, but no big countries that have become rich off the back of small firms.
Big-time entrepreneurs who are not effectively disciplined by a developing country government turn into the oligarchs of south-east Asia – or Russia, or Latin America.
The state never stops disciplining companies by providing the moral framework in which they operate – whether in the more dirigiste or more free market phase of economic development.
In a world of few developmental grown-ups and many, many children, the final word should be about the biggest grown-up of all, the United States, and its role in east Asian development. In the north-east, in the context of the Cold War, the US was an idealised responsible adult, supporting not only land reform in Japan, Korea and Taiwan, but also tolerating protectionist infant industry policies over long periods of time. Those economic children grew up, and by the 1980s the US was quite reasonably telling them to stop sponging. In south-east Asia, by contrast, the US did nothing to push land reform and then began to press for inappropriate, rich-country-style industrial and financial deregulation in states where GDP per capita was at most in the low thousands of dollars per year. The deregulation pressure mounted with the end of the Cold War. Today those countries, which were explicit US allies in the Cold War and sent soldiers to die alongside Americans in Korea and Vietnam, are adrift. Meanwhile, two countries which fought wars against the US and have not trusted American developmental advice, China and Vietnam, are in much better shape in economic terms. This rather begs the question as to what it means to be America’s friend.
Part 3 - Finance: The Merits of a Short Leash
Indeed, it is the close alignment of finance with agricultural and industrial policy objectives (something that had been much more difficult to achieve before the era of bigger governments and information technology took off in the twentieth century) that has facilitated the unprecedentedly rapid economic development of north-east Asia. At the same time, however, modern finance has greatly increased the risks to developing countries, both from mismanagement of larger domestic capital flows and, particularly, from speculative flows of international capital that are not properly regulated.
The alternative would have been for financial institutions to encourage more consumer lending, which tends to produce higher profits and is the focus of financial systems in rich countries. However, herein lies a far from attractive equilibrium for an emerging economy in which banks become very profitable and industry remains technologically backward. This is the situation in most of south-east Asia and Latin America today. The best banking returns in the east Asian region are produced in the region’s most backward countries – the Philippines, Indonesia and Thailand. The case for deregulating, and liberating, finance so that it seeks out the most immediately profitable investments is therefore not strong in the early stages of economic development. Far better to keep the financial system on a short leash for a considerable period of time and make it serve developmental purposes.
And the returns that citizens could earn on bank deposits and other passive investments were frequently crimped, increasing the surplus left at the financial system’s disposal, which could then be used to pay for development policy and infrastructure. This amounted to a hidden taxation, which was tolerated by people in these societies because they could see the economic transformation taking place all around them.
In Germany in the 1870s, industrialisation had been accompanied by the creation of powerful investment banks, described by the economist Alexander Gerschenkron as ‘comparable in economic effect to … the steam engine’.
Similarly, in the United States industrial progress was fostered by the high tariff policies, railway subsidies and cartel tolerance of the federal government. It was in this context that, at the turn of the twentieth century, banking magnates such as J. Pierpont Morgan invested heavily in the industrialisation process, creating business empires with huge economies of scale. In short, state-directed industrial policy came first, and finance second.
In 1960, the American government adviser W. W. Rostow predicted in his influential book The Stages of Economic Growth that an unprecedentedly large cohort of developing economies would soon be able to achieve savings and investment rates in excess of 15 per cent. In the event, every one of the nine major east Asian economies, from Japan to Thailand, delivered post-war savings and investment rates of 30 to 50 per cent. And so, in terms of financial clout, there was nothing to prevent any east Asian country – south-east Asian or north-east Asian – from joining the rich world. What caught some countries out was that they financed the wrong policies.
Worse still, as the failings of half-hearted, poorly planned agricultural and manufacturing strategies became apparent from the 1980s, governments were tempted by the siren calls of the incipient Washington Consensus – the free market agenda for economic development that was being pressed on developing countries with increased vigour by the IMF, the World Bank and the US government. The loudest and most evangelical message of these agencies was that deregulating the financial sector could put the development efforts of lagging countries back on track. States were encouraged to privatise existing banks and license new banks, to take a laissez-faire attitude to international flows of capital and to expand stock markets. The argument of the Washington Consensus was that liberated capital would then itself identify the right investments to spur economic progress. What actually happened, in 1997, was a financial catastrophe on a scale similar to that which afflicted Latin America after 1982. Financial sector liberalisation in south-east Asia led not to better allocation of capital, but to control of private banks by business entrepreneurs whose interests, because they were not required to manufacture and were not subject to export discipline, were not aligned with those of national development.
Once again, political leaders knew too little history and were too easily bewitched by economists.
South-east Asia’s armageddon began in July 1997 when the Thai currency was forced off its US dollar peg by international demands for repayment of loans, triggering a global panic over the capacity of other Asian countries to service their debts. The crisis highlighted one clear developmental rule above all: that a state must keep its financial institutions aligned with its development strategy until basic agricultural and industrial policy targets have been achieved. The case for deregulation strengthens as an economy evolves, but the risks of premature deregulation are greater than those of tardy deregulation, especially in our world of globalised financial flows.
Banks are beholden to central banks as a source of additional and emergency funds, opening the way for governments to influence them to lend long-term to industry. Stock and bond markets, by contrast, are subject to instantaneous selling by investors in times of panic.
The state exercised control over the banking system via a mechanism called rediscounting, whereby the central bank provides loans to commercial banks against loans they have already extended. These ‘rediscounts’ increase a commercial bank’s loan book and therefore its profit potential, but also allow a central bank to set borrowing criteria that must be met.
The generous availability of rediscounts meant that Japanese banks tended to extend more credit than their deposits alone could justify, becoming – in banking parlance – ‘overloaned’. They therefore depended on continuing central bank credit to keep them liquid. It was this which allowed the Bank of Japan to turn the screw of moral suasion when issuing ‘advice’, not just about the use of rediscounted loans but about the priorities of banks’ overall loan books.
This approach was successful so long as the government had the financial whip hand. Eventually, however, the scaling-up of the chaebol into bigger and bigger groups – the level of corporate concentration in Korea was higher than in Japan or Taiwan – meant that the biggest borrowers ceased to fear their lenders. Once the HCI drive was complete in the early 1980s, the chaebol were very powerful beasts. In 1983, the three biggest groups, Hyundai, Samsung and Daewoo, were each consuming 10 per cent of credit. With the chaebol both huge and heavily leveraged (average debt was more than five times equity in the fifty biggest firms) the state banking system could no longer impose its will on businesses whose failure would bring down the banks themselves. The banks were increasingly compelled to lend whatever the chaebol wanted. In the 1980s the chaebol started to buy up smaller rivals rather than compete with them.They also began to use their cheap bank funds to speculate more heavily in real estate. They themselves lent money to the kerb at high interest. And they used domestic oligopolies to crush smaller competitors they did not buy, and to squeeze consumers ever more effectively. From a force for technological progress, the chaebol began to morph into economic bullies whose developmental contribution was much less clear.
In order to maintain the exchange rate, the Bank of Taiwan accumulated foreign exchange reserves of USD60 billion by 1987, second in the world to Japan’s USD63 billion, despite an economy less than one-tenth the size. Taiwan’s ‘cheap currency’ approach – today echoed in mainland China – supported its heavier dependence, compared with Japan and Korea, on low value-added export processing by multinational firms, which accounted for around a quarter of manufacturing exports in the 1980s, and on relatively lower value-added exports by domestic private firms. A chronically undervalued currency was probably a symptom of the failure to get industrial policy right. The cheap currency, however, was unable to change the fact that by the 1980s the quality and value-added of Korean exports were exceeding Taiwan’s, while Korea caught up with and surpassed Taiwan in GNI per capita in the next decade.
But from the early 1980s, Malaysia, Thailand and Indonesia each succumbed to the siren call of financial deregulation. This effectively meant handing over increasing control of the financial system to private entrepreneurs whose interests did not tally with those of national development. These same, un-export-disciplined entrepreneurs were also given much increased access to offshore sources of finance. Such developments set the fuse to the deep crises in Malaysia, Thailand and Indonesia that began in 1997, and from which these countries have still not yet fully recovered.
If Marcos had done what Park Chung Hee did, and marshalled the banking system to drive an industrial policy kept in check by export discipline, there is no reason why the Philippines could not have turned out like Korea. Instead, the Philippines went from being twice as rich as Korea to eleven times poorer in less than half a century. An absence of a clear focus on manufacturing for export coupled with a willingness to play fast and loose with financial tools led to the worst possible policy combination. With no objective performance standard to meet in the form of exportable goods, the Philippines’ entrepreneurial elite manipulated the banking system to such a degree that the country became the closest thing in our study to a kleptocracy.
Only five years after power was devolved to Manila in 1916, PNB was made bankrupt for the first time, having lent huge sums to local oligarchs who failed to repay their loans.
As the author of the leading study of the Philippine financial sector put it: ‘Unlike their counterparts in South Korea and Taiwan, Philippine entrepreneurs could quite easily take the money and run.’
The two big state institutions, Philippine National Bank and Development Bank of the Philippines, wrote down their assets (consisting mostly of loans) by 67 per cent and 86 per cent respectively after years of making ‘behest’ loans to Marcos’s cronies. In 1993, the government moved debts of USD12 billion from the balance sheet of the central bank to that of the treasury. All this was paid for, in large part, by a tripling of domestic government debt in the late 1980s. The debt was deliberately issued in large-denomination bonds, which were beyond the reach of ordinary citizens who continued to keep their funds in the banking system, usually at negative real rates of interest. Banks recovered by borrowing for free from the public and investing the money in high-yield national debt. It was much like Park Chung Hee’s interest moratorium in 1972, except that in the Philippines the banking system produced zero developmental upside. Today, banking is dominated by (mostly newly licensed) private and foreign lenders which are kept on a shorter regulatory leash, are not offered rediscounts, and make very good profits. Of course, they still fail to finance industrial upgrading.
The Philippines suffered everything that neo-classical economists warned in the 1950s and 1960s would come to pass in Korea because of Park Chung Hee’s aggressive approach to the banking system. But there was no catastrophe in Korea because Park was spending money to secure technological progress. In the Philippines, it was a case of financial madness without the method.
North-east Asian states employed interest rate ceilings throughout their core development periods because when banks are given the freedom to charge what they can, they move in the direction of consumer – as opposed to industrial – lending. This is exactly what happened in Mahathir’s Malaysia.
Uniquely among south-east Asian states, Thailand was never colonised. None the less, the country has a long history of accepting bad advice.
In the standard narrative the two financial meltdowns, separated by three decades, were the products of two opposing – capitalist and socialist – approaches to economic development. When viewed through the prism of financial policy and, more generally, the arguments put forward in this book, however, it becomes clear that both crises were precipitated by the same thing: the state’s failure to exercise control over the financial system, and to target its efforts at manufacturing and export development. Indonesia’s ‘socialist’ and ‘capitalist’ catastrophes were really variations on the same deficiency.
Visitors to the house when Om Liem lived here were struck by how little there was in it. Like Chung Ju Yung in Korea, the entrepreneur conserved his capital and did not change his home when he made it big; indeed, he continued to live in a part of town which is today considered distinctly unfashionable. The house, which Liem considered lucky, is a reminder that the nature of entrepreneurs is a constant in development; it is the policies which surround them that vary.
Soedradjad Djiwandono, the central bank governor in the run-up to the crisis, contends that rediscounting to exporters ‘was not really needed’ because most exports came from small enterprises which self-financed their activities. But this is to miss the biggest lesson that north-east Asia can teach us about financial system management: that governments must use their control of money to lure and cajole leading entrepreneurs into concentrating on manufacturing and international markets. Emil Salim, one of the five original Berkeley Mafia members, retorts with the stock response that the use of export subsidies leads to counter-measures by trade partners. ‘They retaliate,’ he says. But, as the cases of Japan, Korea, Taiwan and now China testify, trade relationships are not as simple or as symmetrical as that remark implies. It took a very long time for anyone to retaliate against the first three, and the same is proving to be the case with China. Moreover, to act on the basis that what worked for everybody else cannot work for you is – to adapt Friedrich List’s metaphor – like kicking away the ladder of progress yourself from below.
The essential takeaway from east Asian financial history is that all kinds of approaches to both monetary policy and financial system management have been tried, but what finance is acting on has been far more important than the financial arrangements themselves. The financier has not been the decisive element in the economic development puzzle that many economists claim. As a developmental actor, he is defined by and responds to the operating environment around him. It falls to governments to shape that environment and to decide what objectives finance will have. Control is the key. The successful developing state points financial institutions at the necessary agricultural and export-benchmarked infant industry policies. The state also closes out the possibility that finance will look offshore to alternative opportunities, or that flows of foreign funds will disrupt its plans. It does this by imposing capital controls. The financial deregulation urged by parties to the Washington Consensus does not present a viable alternative to this strategy. Deregulation policies do not empower a ‘natural’ tendency for finance to lead a society from poverty to wealth, they simply put short-term profit and the interests of consumers ahead of developmental learning and agricultural and industrial upgrading. There is no case for doing this when a country is poor.
Financial institutions like banks and bond and stock markets require very long periods of nurture, and considerable bureaucratic and institutional development, before they can be efficient components of a market economy. Even then, financial regulation is the most thorny area of governance for the most sophisticated states.
The easiest way to run developmentally efficient finance continues to be through a banking system, because it is banks that can most easily be pointed by governments at the projects necessary to agricultural and industrial development. Most obviously, banks respond to central bank guidance. They can be controlled via rediscounting loans for exports and for industrial upgrading, with the system policed through requirements for export letters of credit from the ultimate borrowers. The simplicity and bluntness of this mechanism makes it highly effective.
It is, tellingly, the capacity of bank-based systems for enforcing development policies that makes entrepreneurs in developing countries lobby so hard for bond, and especially stock, markets to be expanded. These markets are their means to escape government control. It is the job of governments to resist entrepreneurs’ lobbying until basic developmental objectives have been achieved. Equally, independent central banks are not appropriate to developing countries until considerable economic progress has been made.
Retail savers and borrowers have to be asked to pay the price of what economists call ‘financial repression’ for as long as is necessary to promote basic technological upgrading.
Part 4 - Where China Fits In
As we saw in part 1, however, agriculture is not like manufacturing, where scale is essential to low unit costs and to the technological learning process that enables firms to produce more sophisticated products. In agriculture, the product never changes – rice is rice and corn is corn. Yields are maximised by the application of fertiliser and more and more labour, which poor countries have in abundance. Premature mechanisation actually reduces yields and leaves rural inhabitants with nothing to do.
In Asian countries, including China and India, autarky throttled technological development after the Second World War because it removed firms’ capacity to buy, borrow and steal already-developed technologies from elsewhere in the world.
Through autarky, China failed to develop a single industrial product with which it could compete internationally.
Thereafter, China has benefited from the one characteristic of the CPC that from a developmental perspective has been unambiguously positive. It is that the Party has been relentlessly paranoid. In a world of bad developmental advice, the Chinese government did not make the mistake of south-east Asian states and listen like a patsy to the imprecations of the World Bank, the IMF and the US government to deregulate its economy prematurely. China worked closely with the World Bank – enjoying a great deal of project-specific technical support as well as considerable financing in the 1980s and 1990s – but very much on its own terms. The World Bank’s neo-liberal prescriptions for financial deregulation were not entertained.
Today, Chinese rice yields are in line with those of the north-east Asian states and are among the highest in the world. Wheat yields are similarly among the highest in the world, and more than 50 per cent ahead of what is achieved by scale farming in the United States.
At China’s present level of development and incomes, global scale producers of rice and wheat cannot compete with Chinese families gardening their plots.
None the less, the income gap between rural and urban residents remains at more than three times. Only the increase in inequality has been arrested. There remains a much higher political tolerance of inequality in China than was the case in Japan, Korea and Taiwan. More specifically, the critical thing that separates the Chinese farmer from his or her cousins in north-east Asian states is that the Chinese peasant does not own his or her land. The historical reason for this is the essentially accidental nature of the reintroduction of household farming after 1978. Land that was divided up among households in that era belonged to collectives created in the 1950s. Since central government never intended a return to private household farming, it did not re-designate farmland as private property. Instead, in 1984 the government granted farmers 15-year ‘use’ rights for their plots and then, in 1998, issued a Land Management Law that formalised longer, 30-year use rights. Under Hu Jintao’s ‘harmonious society’ drive, a 2007 Property Law made farmers’ right to renew these leases a legal one, and clarified that ownership of land is vested in all members of a collective (not just the Party cadres who run the collectives). Legally, too, decisions relating to land must now be agreed by all members of the collective. China, however, is a place where the law and the application of the law are two very different things. The basic reality of life in the countryside is that land belongs to the collectives, not to individuals, and this has consequences. The most important consequence is that, unlike in Japan, Korea and Taiwan, farmers cannot sell their plots to private buyers. Collective-owned land is unsaleable in law. It can only be converted into government-owned land, in which case compensation is paid to farmers up to a statutory maximum equivalent to thirty years’ rental. Local authorities, however, can sell land converted to state ownership for development. This typically occurs at a big mark-up. Thirty years’ rent may sound like a lot, but China’s historically low yields per person (as opposed to per hectare) have also meant low rents; land redeployed for development or for commercial farming, by contrast, is massively more valuable. In Japan, Korea and Taiwan, many farmers became rich after the Second World War through the re-zoning of farmland – like Nishiyama Kōichi, who went from peasant to millionaire by virtue of selling some of his land to a developer. In China, this does not happen. Instead, when farmers lose their land it is typically with less compensation than they need to survive independently, while big re-zoning profits are divided between local government fiscal coffers and local government graft.
Farmers often only give up their land under duress from local government, but they are given some compensation – the average paid to a family in 2010 was RMB13,000 (USD1,900). Since the typical Chinese farmer is now in his or her mid-forties, and has an average thirty years left to live, this translates into about RMB430 a year, or 140 kilos of milled rice at the current price. The payment is not enough even for the nutritional needs of two people; however, the great majority of farm households have children working in towns and cities. Those children are forced to make up the difference between the compensation paid for land conversions and the money that their parents actually need to live.
China’s rural–urban divide is unpleasant, unfair and socially corrosive, but it is not terminal from the perspective of economic development. The farm sector has served its developmental function in terms of priming economic take-off, and continues to meet China’s food needs. So long as there is no large-scale civil unrest as a result of land redevelopment and conversion, the main concern for central government in the next few years will be that the rise of commercial farming is leading to reduced output of staple foodstuffs.
In short, the government retained full control of the upstream and service businesses which in less successful developing countries fall into the hands of tycoons whose interests are not aligned with industrialization objectives. And the government still made those businesses highly profitable.
Among the upstream oligopolies, which are the most clearly state-controlled part of the economy, Zhu Rongji’s reforms have created fierce competition between firms fighting for a bigger share of the rents that have accrued from the provision of key raw materials and services. This has made those firms both rich and powerful. However, price controls have so far prevented the upstream businesses from milking their oligopolies to the degree that the cartels of nineteenth-century Germany or the zaibatsu of pre-Second World War Japan did. The Chinese government retains bureaucratic price setting for all key upstream inputs into the economy, such as refined petroleum products and electricity. The oligopolies are allowed to make generous long-run profits, but are also used as ‘shock absorbers’ to cushion downstream enterprises from any big international price changes. This is helpful to all downstream manufacturers, public, private and hybrid.
The government’s capacity to siphon off more of the rents of the upstream behemoths and redeploy them to support independent manufacturers will be a key test of its industrial policy. In essence the question is how much the government wants to support independent manufacturers and a pluralistic economy.
The state sector producers’ goods companies are overseen by a bureaucratic planning apparatus that has been widely underestimated, not least because it is associated with a communist government. We know little about the inner workings of SASAC or, crucially, the National Development and Reform Commission (NDRC), the key industrial planning agency – far less than we do about equivalent agencies in Japan, Korea and Taiwan. However, with the benefit of hindsight, it is clear that China’s bureaucrats have usually made sensible, conservative decisions in nurturing state sector manufacturers, which have also benefited from their links to state-run research institutes.
The biggest enforcer of export discipline on public sector manufacturers is China Development Bank (CDB), China’s main investment bank and also the most efficient financial institution in the country. CDB is one of three ‘policy’ investment banks – zhengcexing yinhang – set up in 1994 as part of Zhu Rongji’s fiscal and financial overhaul; the policy banks are so called because they are mandated to lend in support of state agricultural and industrial policy. CDB has been run for the past thirteen years by the same highly rated manager, Chen Yuan, son of Chen Yun, the economist who rescued Mao Zedong and Deng Xiaoping from their worst policy follies. The institution built up its balance sheet by supporting large-scale, high-quality domestic infrastructure projects in the 2000s. It thereby also facilitated the growth of mid-stream manufacturers which supplied the projects.
The common pattern of the Chinese mid-stream businesses is that core technologies are imported and absorbed during an initial phase of operation in the domestic market. The firms then push up to the global technology frontier during a period of increased export discipline.
The second caveat about industrial development based on state-linked manufacturers of producers’ goods is that, unlike consumer-oriented business, much of what the Chinese companies sell internationally is subject either to state procurement or to government approval. In developing countries, selling to governments is frequently to China’s advantage. The Chinese government has few scruples about which regimes its firms do business with, and China’s policy banks attach no political strings to the loans they make. Partly as a result, Chinese firms have bagged major infrastructure deals in countries like Pakistan, Myanmar, Libya and Congo. In developed countries, however, selling to governments or to government-influenced sectors may not always be to China’s advantage. Already, Huawei lost out on a USD3 billion sale to Sprint-Nextel in the United States in 2010, and has been blocked from acquisitions which would have yielded it important technology on the basis of ‘national security’ concerns. Such impediments may affect more Chinese mid-stream firms in the future. Even if national security concerns are not invoked, developed country governments can deploy all kinds of other ‘non-tariff barriers’ to impede Chinese equipment sales. Since China does not itself operate open tenders for state procurement, and has not acceded to the WTO’s General Procurement Agreement (which regulates government purchases), the Chinese government has no legal recourse in such matters. Private firms from Japan and Korea have been able to enter rich countries by appealing direct to their consumers with cars, video cassette recorders and smart phones. China’s mid-stream equipment makers are more constrained to go through the political front door.
The third caveat about the mid-stream firms is that, while China seems to be making excellent technological progress, it is impossible to know precisely how real this is in what is a period of extremely aggressive investment. Put simply, China is investing so heavily to acquire technology at present that, superficially, the results are almost bound to look impressive. In some sectors, it will be a few more years before we have a clear sense of the progress that has been made versus the investment laid down. We do not yet know the extent to which China is still merely copying technology from elsewhere, as opposed to beginning to originate its own.
Again, there is a strong echo of the Taiwanese bias in favour of public firms over private ones, reinforced on the mainland by the unchallenged political leadership of the Communist Party of China. But whereas China’s national champion public enterprises may be doing better on aggregate than Taiwan’s as a result of superior policy implementation, private Chinese firms frequently suffer the same consequences from a deficit of policy support. The problem is particularly acute in the consumer-facing products sector where, as already noted, China’s state-linked companies have been found wanting. Just as Taiwan produced no equivalent of a Samsung in consumer electronics, or a Hyundai in automotive, there are doubts as to whether private Chinese companies are capable of becoming global brand-name businesses in consumer industries. Chinese private firms have all the flexibility and entrepreneurial hunger required to compete in consumer markets, but they tend to lack the cash, concentration and subsidy to challenge their multinational competitors.
The single biggest constraint for private firms is the relative lack of protection, procurement and subsidy they receive relative to the state sector. Private Chinese companies have to try to develop as rich countries would like them to – in open competition with more experienced, more technologically advanced and far better resourced multinational enterprises. The most common problem is that private firms lack the cash flows to increase the value-added content of their products. Their margins are too thin, and their credit lines too limited, to fund loss-leading product development over long periods. One manifestation of the cash constraint is that private companies are unable to attack enough of a product’s value chain to establish pricing power. This might mean they put together a product but cannot master critical components that command outsize margins, like a car’s drivetrain or engine. Or, very commonly, private firms cannot afford to integrate forward to control a product’s distribution and sales channels. The pioneering work of the economic historian Alfred Chandler showed how America’s original crop of nineteenth-century multinationals all succeeded by dominating distribution and sales of their products, and thereby acquiring pricing power.
In the computer and electronics business in which many private Taiwanese firms are active, the highest margins go to either brand-name designers, software firms and chip-makers at one end of the value chain, or to giant retailers at the other. A company like Acer, whose limited resources constrain it to focus on the middle of the chain – the low part of the smile – has seen its operating margins squeezed further and further. The Taiwanese firms’ enormous scale of production and global cost leadership do not yield higher returns because upstream firms compete by innovating more quickly while downstream ones control huge chunks of retail distribution. Private Taiwanese companies like Acer needed – and wanted – to make broader assaults on their industries in the global marketplace, but were not supported by their government to do so.
BYD’s market capitalisation peaked at USD25 billion in December 2008, after Buffet’s investment, but by summer 2011 the firm was worth less than one-tenth of that.
As they pursue their unequal struggle, private Chinese firms do have the advantage that in a globalised world it is easier than ever to buy foreign companies, and thereby acquire technology and different parts of a value chain. However, this opportunity is still constrained by inadequate cash flows. Money is required not only to buy firms, but even more so to ‘digest’ them in a timely manner. In 2010, another private auto firm, Geely, bought troubled Swedish car maker Volvo from Ford for USD1.8 billion. Geely’s margins and profits were so thin that in summer 2011 its market capitalisation was only USD2 billion. In other words, it was worth little more than the failed firm whose technology and marketing reach it was trying to absorb. Over time, it may be that with its entrepreneurial determination Geely will absorb everything worth having from Volvo. But by that point the technological frontier that Geely thought it was approaching will have itself moved outwards.
Private firms do have access to stock markets to raise investment funds, but China shows what a poor substitute these are for government policy support and long-term bank credit when it comes to nurturing technological advance. The money that private companies can raise from initial public offerings is not nearly enough to fund their progress all the way to the technology frontier. There is a classic mismatch of expectations, with firms seeking long-term funds for technological upgrading and investors looking for short-term returns on a one-off investment. Hence the pattern that, after an initial euphoria, investors realise firms cannot deliver quickly the profits associated with technological leadership, and the stock is sold off. This in turn cuts off stock markets as further sources of investment capital, contributing to private companies’ entrapment in low-margin activities.
A third group of financial institutions – and the fastest growing by loans extended in the past decade – is the three policy banks created by Zhu Rongji in 1994. China Development Bank (CDB) is much the most important of these. The policy banks’ share of loans is around 15 per cent, a very significant slice. CDB alone had almost USD900 billion of loans outstanding at the end of 2011, or 10 per cent of all loans and well over twice what the World Bank lends globally. China’s policy banks have become the most focused part of the financial system in terms of financing agriculture and manufacturing policy objectives and enforcing export discipline. Their nearest equivalent in east Asian development experience was the state-owned Korea Development Bank (KDB). However KDB raised much of its money overseas, whereas China’s policy banks get all theirs from issuing domestic bonds.
At home, CDB in particular lends against the cash flows from government land sales. (In rural areas around towns and cities, such lending further encourages local governments to dispossess farmers.) CDB loans then often pay for infrastructure development which requires the procurement of subway systems, trains, roads, power stations and so on from China’s state producers’ goods manufacturers and construction enterprises. Investment in infrastructure has so far kept land prices rising, allowing local governments to service their debts. Internationally, the policy banks secure many loans against mineral rights – oil, gas, coal, copper – and also lend for infrastructure and industrial projects that procure Chinese construction services, transportation equipment, telecoms equipment, energy generating equipment, wind turbines and much more. A large chunk of policy bank ‘foreign’ loans in fact go direct to Chinese state-linked companies.
In order to pay for its pro-development financial system China, in the tradition of north-east Asian developmental states, guarantees its deposit-taking banks fat margins by setting minimum lending rates and maximum deposit rates; the commercial banks in turn fund the policy banks by buying policy bank bonds. The margin ‘spread’ at regular banks was increased substantially from the late 1990s to help the banks write off non-performing loans that were addressed as part of Zhu Rongji’s closure of loss-making state enterprises. Some bad loans were bought over by government, while others were gradually paid off with earnings from the gap between lending and deposit rates, which yields tens of billions of US dollars of profit a year. As in Japan and Korea, the manipulation of banking spreads has proven a highly effective means of raising money in a society where the institution of personal taxation is in its infancy. Deposits have not fled the banking system because of this stealth taxation. Fat spreads offset both losses and low margins from following government guidance on lending objectives in support of national development. The major prerequisite of the system is that the government’s industrial policy targets are realistic and not too wasteful of funds – something made more achievable by the closure of state sector ‘zombie’ firms in the 1990s.
Capital controls are the essential adjunct of a financial system that supports China’s development objectives because they prevent money leaving the country in search of better returns. The restrictions also prevent international investors from moving capital in and out of China at will, something which would make the government’s job of pointing the financial system at developmental targets much harder. Capital controls are policed by an enormous bureaucracy at the State Administration of Foreign Exchange, which falls under the control of the central bank.
In the end, the state will always lose the battle for financial control – even in China. The question is whether the state can ensure sufficient developmental schooling occurs before this happens.
When it comes to running developing country financial systems, legal and illegal shadow banking systems are infinitely preferable to allowing the capture of core banking institutions. This reflects another of the pragmatic compromises between plan and market that define successful development policy.
If one adds together different central government debts, local government debts for which Beijing is ultimately responsible and other near-term contingent liabilities (although not long-run liabilities like China’s huge state pension fund gap), then public debt is perhaps 80 per cent of GDP.
The lessons of north-east Asian finance – ones that were put to a much more extreme test in Korea – are borne out again in China. First, China shows that a financial system can be repressed to serve development policy without causing domestic panic or system instability. Second, this repressed financial system in combination with capital controls has allowed the country to run a high debt level to support development without either creating domestic instability or suffering speculative international attacks. (China’s debt profile is less risky than Korea’s was in the 1990s because it does not involve borrowing from foreigners.) And third, the acid test of financial policy is how much acquisition of technological capacity can be achieved in industry before the window of opportunity afforded by financial repression closes. China has made considerable gains, but there is much more to be done.
Finally, it should be said that there is one element of financial system policy in China that has almost certainly been unnecessarily inefficient. Again, it is something which echoes past Taiwanese practice: the aggressive undervaluation of the exchange rate.
An undervalued exchange rate is a form of subsidy. Subsidies are essential to nurturing world-class firms in developing economies, but an undervalued exchange rate is a very blunt one. It helps all firms to export, whereas subsidies delivered through a banking system and other targeted means support only firms whose technologies have been prioritised as part of infant industry policy. Suppressed exchange rates subsidise low-value added domestic manufacturers which are not pushing national technological capacity forward and, worse, support the processing operations of multinational businesses.
But if Taiwan is a guide, China will come to be seen as further proof that acute and chronic currency manipulation is not a useful long-term addition to the industrial policy tool cupboard.
The true break-out example in successful Asian development was Meiji Japan, and China is simply a follower in that tradition.
Is China’s continued rise inevitable and without limits? Not at all. Many people believe that the scale of the country and its domestic market guarantee success. But the size of China also makes it a difficult place for central government to run effective industrial policy and to curtail waste. China has yet to create truly world-beating firms, and history suggests that a state’s size is no great advantage in this respect. Many of the world’s most successful firms were created in rather small countries in Europe. Most big states – Brazil, India, Indonesia, Russia – are relative economic failures (even if the United States is not). This is because it is the quality of governance and policy-making that determine a country’s prospects. China will be no exception.
The economy can no longer be run simply by adding more and more people and investment each year. China has to adapt to a different demographic environment. In a comparison with Japan, Korea and Taiwan, the main point of interest is that China is reaching population stabilisation and demographic aging at a relatively lower level of GDP per capita, which may mean its long-run economic outlook is more challenging. There will be around 300 million pensioners by 2030 consuming savings, not creating them, and the population will be falling, having peaked at under 1.5 billion.
As well as a country of technological capacity, China needs to become a country of institutional systems. It is only a combination of the two that can take the country to the front rank of nations and allow Chinese people to be genuinely proud of where they come from. Thus far, institutional deficiency has not been a significant drag on China’s economic growth. But it will catch up with it eventually. The Chinese government already spends more money trying to micro-manage people’s lives through its domestic security apparatus than it does on defence. On its present trajectory, China is set to be a middle-income per capita, but profoundly institutionally retarded state.
Epilogue: Learning to Lie
An historical review of east Asian economic development shows that the recipe for success has been as simple as one, two, three: household farming, export-oriented manufacturing, and closely controlled finance that supports these two sectors. The reason the recipe worked is that it has enabled poor countries to get much more out of their economies than the low productive skills of their populations would otherwise have allowed at an early stage of development. Governments manipulated economies which thereby forged ahead and created wealth that paid for people – who cannot be neatly transformed by government policy – to catch up.
The message that east Asia – and indeed an historical understanding of development around the world – sends to economists is that there is no one type of economics. At a minimum, there are two. There is the economics of development, which is akin to an education process. This is where the people – and preferably all the people – who comprise an economy acquire the skills needed to compete with their peers around the world. The economics of development requires nurture, protection and competition. Then there is the economics of efficiency, applicable to a later stage of development. This requires less state intervention, more deregulation, freer markets, and a closer focus on near-term profits. The issue is not whether there are two kinds of economics that exist at different stages of development. The question is where these two stages meet. This is the difficult and interesting subject to which economists could more productively apply themselves.
Unfortunately, the intellectual tyranny of neo-classical ‘efficiency’ economics – the natural subject matter of rich countries – means that it is all but impossible to have an honest discussion about economic development. Poor states can only be successful by lying. They have to subscribe publicly to the ‘free market’ economics touted by the rich while pursuing the kind of interventionist policies that are actually necessary to become rich in the first place. It is a very hard thing to recommend lying, but in this instance one has to. The alternative – to rail against Western intellectual hegemony and to stick your rhetorical finger in the eye of its leader, the United States, as Mao, Sukarno and Mahathir did – is pure folly. Far better to take a page out of Park Chung Hee or contemporary China’s book: make public pronouncements about the importance of free markets, and then go quietly about your dirigiste business.
Economic development is only one part of a society’s development. The other parts, to do with freedom and the rights of the individual, are no less important. In China today, another government is claiming racial exceptionalism to justify deliberate institutional backwardness. China is putting off the creation of an independent legal system and more open, representative government until well after they are warranted. This is not what the Chinese people want. It does not matter that you can afford a small car or a motorbike if your friend or relative disappears into one of the country’s extra-legal ‘black jails’. Nor does a new kitchen seem so pleasant if the food you eat in it is poisoned for lack of environmental controls or by the addition of some low-cost but toxic ingredient, the use of which has been covered up with official connivance. Emerging countries could themselves help to frame a more honest debate about economic development by setting and meeting benchmarks for the other components of overall development. In China’s case, its government’s unwillingness to actively discuss political and social progress scares rich, free countries so much that a sensible discussion of the requirements of economic development becomes all but impossible.
Will we witness an economic transformation like Japan, Korea, Taiwan or China’s again? The answer is quite possibly not, for one simple reason. Without effective land reform it is difficult to see how sustained growth of 7–10 per cent a year – without fatal debt crises – can be achieved in poor countries. And radical land reform, combined with agronomic and marketing support for farmers, is off the political agenda.
South-east Asia remains a beacon for what not to do if you want economic transformation. Allow landlordism and scale farming despite the presence of vast numbers of underemployed peasants capable of growing more. Do not worry too much about export-oriented manufacturing, which can happily be undertaken by multinational enterprises. Leave entrepreneurs to their own devices. And proceed quickly to deregulated banking, stock markets and international capital flows, the true symbols of a modern state. That is how its politicians constructed the south-east Asian region’s relative failure.
What seems most wrong in all this is that wealthy nations, and the economic institutions that they created like the World Bank and the International Monetary Fund, provided lousy developmental advice to poor states that had no basis in historical fact. Once again: there is no significant economy that has developed successfully through policies of free trade and deregulation from the get-go. What has always been required is proactive interventions – the most effective of them in agriculture and manufacturing – that foster early accumulation of capital and technological learning.