“S” for Labor Supply

Our moderator, Jan Jablonski, seems to say: assumptions, stupid!

In international economics there is always a moment when we go into a murky waters of international comparison. There are several traps that we should be aware of. One of the greatest sins of an economist is to uncritically employ the analytical apparatus which was previously invented. In other words, there is a high probability of a mistake of some sort if one uncritically uses analytical tools developed for the US and applies them to i.e. Cambodia. What is the most fragile part? As usual it is assumptions. One needs to check if they hold to a reasonable extent. The problem seems to be vital especially in the field of international comparison, given the tremendous variety between economies around the world. This brings us to the actual topic of this short text which is the differences in labor supply among countries that find themselves in different stages of development.

Why labor supply? It is the area in which making a mistake in a simple copying market model with its usual parameters might bring a serious mistake. Usually labor market is assumed to work as any other market. A negative slope of a demand function does not need a particular explanation. Positive slope of a labour supply has its nice explanation. When wage raises the cost of not working also rises and substitution effect (being stronger than income effect) guarantees that the amount of hours of labour supplied rises. Alternatively, when wage falls there is less incentive to work (you don’t work if they pay you hardly anything) and labor supply falls. Thus we have a usual supply and demand cross on a diagram. There is a nuance often put in microeconomic textbooks, namely the backward sloping supply curve. From some high level of wage on, the income effect dominates the substitution effect and the amount of hours supplied to the market actually drops when wage rises. The story behind it is that if you are already rich (high wage) the additional increase in wage will remind you about the beautiful world outside your working place and you’ll decide to spend more time on leisure still enjoying a high wage.

On an aggregated level the labor supply curve often boils down to positively sloped straight line as only few people actually are “too rich for work”. This might well be good approximation for western economies in general. What happens if we travel with this framework to some developing country? Will it still be reasonable?

Let’s go down the wage axis and think what happens to the labor supply. If you earn only a little, let’s say enough to meet the subsistence level and suddenly your wage falls, there is a high chance you wish to continue your existence, so you supply more labor. By doing so you restore your income back to the subsistence level. Why wasn’t it a case in a previous setup? Well, the (usually implicit) assumption was that non-labor income guarantees subsistence level. It is a reasonable assumption in developed countries where non-labor income consists mainly of capital income, but also unemployment and other social benefits. It might be simply a mistake to assume the same for a developing country. Fristly, because of the low level of capital accumulation the capital income might be too low to guarantee a subsistence level. Secondly, a developing country might be simply too poor to maintain an extensive social security system.

What happens to our supply curve if we remove the assumption about the sufficient level of non labor income? Obviously it is getting a negative slope – lowering the hourly wage results in more labour supplied to the market. In this case the negative income effect dominates the substitution effect. What is important is that additional assumption might be very handy. If you have both supply and demand curves with a negative slope you might start worrying about stability of such model. It would be most embarrassing if, in the case of the excess of labour supply, the downward pressure on wages would bring even higher excess of labour supply. You need to assume that when wage falls, the amount of hours of labor demanded rises faster than the amount of hours of labor supplied to the market. In other words you need a slope of the supply curve to be higher (in absolute terms, as they are both negative) than the slope of a demand curve or alternatively: the supply curve needs to be steeper than a demand curve.

Interestingly the cases discussed previously are not exclusive. Putting all the pieces together we get a labor supply curve (Ls on the graph) which has something like an S-shape. The part between point A and B on a graph is a standard representation of a labor supply curve. The part above the point B represents the discouraging effects of a rising wage on hours of labor supplied. The part below point A would represent the increase in hours of labor supplied due to decrease in income below the subsistence level. Which part of the supply curve is applicable to a particular case is a matter of assumptions you can allow.

A real life example often brought forward is the case of female labor force participation. The data investigation for Mexico confirmed a negative relationship between wages and labor supply for this group on low levels of income. The relationship turns positive when the income rises.

What might be the general conclusion? It is trivial, but also crucial: to be aware of assumptions that are required in order to proceed with the analysis. Otherwise one might arrive with conclusions very far from reality.

Author: Jan Jablonski

Literature:

Licona Gonzalo Hernández Reshaping the Labor Supply Curve for the Poor, LACEA Annual Meeting, Rio de Janeiro, Brazil, 2000, lacea.org.

Krueger Anne O., The Implications of a Backward Bending Labor Supply Curve, The Review of Economic Studies, Vol. 29, No. 4. (Oct., 1962), pp. 327-328.

Dessing Maryke, Labor supply, the family and poverty: the S-shaped labor supply curve, Journal of Economic Behavior & Organization, Vol. 49 (2002) 433–458.

Indonesia - On International Confidence

Indonesia’s Position and Potential in the International Economy

As an archipelago of 17,508 islands, located at a strategic position on major trade routes and possessing a rich variety of natural resources[1], Indonesia could have great potential in a capitalist world. Still, it is one of the target countries of the UN Development Goals (UNDP). The islands of Indonesia have experienced centuries of Dutch colonization. ‘Have been dominated by’ would perhaps be a better phrasing, because the development of Indonesia has been influenced greatly by the Dutch (Geertz, 1963: 47). One could argue that the current economic state of the country is entirely due to colonization and associated exploitation and violence, but given the efforts that have been made since 1945 to alleviate poverty and boost the economy, this is not a very likely hypothesis. Instead, a significant role should also be attributed to international confidence in the country. An analysis of the post-war national economy of Indonesia shows that growth rates fluctuate with foreign investment.

Starting with a historical introduction to the Indonesian economy, this article contrasts past foreign dominance to the current independent Indonesian economy. It examines in particular the latter’s current perception by international economic parties, mainly foreign investors. Indonesia’s position in the globalizing world economy is a relevant example of how national and international trends influence each other, and together determine the path that the economy of a development country will follow.

Colonization by the Dutch started shortly after 1600. The Dutch settled mainly on Java, where the company chose as its ‘headquarters’ the city of Batavia (the current Jakarta).[2] From this period onwards, Java was to be the center of Indonesian development. Jakarta, currently the capital city of Indonesia, is still the economic center of the country, and deep contrasts exist between the latter and the country side, which is more often than not characterized by extreme poverty.

On other islands, the Dutch initiated cultivation of former rainforest, in order to export goods like nutmeg, coffee, pepper and sugar. Because of Dutch interference, the original trade with continental Asia was paralyzed and villages were no longer self-sustainable. The infrastructural orientation changed profoundly. Village production was taken to the main export centers like Batavia, instead of being exported to continental Asian countries, as was done before the Dutch arrived. In and between these colonial centers (mostly located on Java), ports, road systems and railways were developed. Because of their ‘core’ function (politically and economically), capital accumulation occurred mainly here.

The main export industries were established during the 19th century. There was now more direct involvement of the Dutch in the Indonesian agriculture, including Dutch settlement and exploitation, mainly as resource depletion. This was linked, first, to the Cultivation System[3], which also resulted in more large scale land cultivation and massive migrations to Java, and later to Dutch traders leasing Indonesian land.[4] On the East-coast of Sumatra, plantation economy arose. (Britannica)

The main industrialization took place on Sumatra and Java, due to the relative wealth of, and the amount of Westerners on, these islands. Very influential were the new agricultural technologies that were introduced in this period. This enabled rubber and petroleum production and exports to rise during the early twentieth century (Library of Congress Country Studies, 1992). Mainly on Java and Sumatra, irrigation systems were introduced to flood the rice sawas.

Decolonization started in 1945, when Indonesia declared itself independent. Four years of severe violence followed, which were, of course, far from beneficial to the country’s overall well being.[5] Sumatran exports only recovered in 1965 to pre-war levels (Airries, 1991: 5). In the second half of the twentieth century, heavy population growth occurred and urbanization figures (mainly in Jakarta) exploded (figure 1 and 2).




Figure 1. Urbanization in Indonesia. Adapted from UN World urbanization prospects (2005)







Figure 2. Urbanization: Jakarta. Adapted from UN World urbanization prospects (2005)



Industry and agriculture were somewhat diversified. Garment became a major export category under Sukarno (Antlov. 1997, 1172), further shifting land use and the orientation of labor from agriculture to basic industry. The dominant picture since this period is one of small scale villages exercising handicraft on the countryside, while more and more administrative occupations were located on Java. These developments led to an even more clear-cut division between a ‘core’ region (centred around Java), and a peripheral region.

Globalization and the emergence of the tourist sector were mainly influential in the core, where much more capital was located than in the outer regions, enabling more investment in trade, tourism, industrialization and infrastructure. There is still great inequality between the ‘core’ and ‘peripheral’ regions in infrastructure and economic growth.

Clearly, the legacy of colonization has been far from positive. But what happened after 1945? Why has the economic potential of the fourth largest country in the world still not been realized? The lack of economic growth and the ‘underdevelopment’ of Indonesia are often mentioned as a result of integration in the world economy. As stated by Barro, however, until the Asian crisis of 1997, there was rapid economic growth in Indonesia:

“Before the 1997 financial crisis, the fast-growing economies of East Asia were favorites of economists and international investors. Then Indonesia, Malaysia, South Korea, and Thailand were hit hard with currency devaluations and high interest rates. A 40-year period of sustained rapid growth was replaced in 1998 by sharp economic contractions in these countries, ranging from 7% in South Korea to 15% in Indonesia.” (Barro, 2001: 1)

Also, in the 1970s, plantations’ exports rose from 445,611 tons to 951,985 tons (PBS 1985, 100), a more than 100% growth. Between 1965 and 1990, Indonesia’s rate of economic growth was twice as high as the World Bank figures for the Middle Income group of countries (Hill, 1994: 833). In fact, as can be seen in figure 4, it was the 1997 crisis that changed the economic situation, not only of Indonesia, but of the ASEAN countries in general.



Figure 4. Per capita GDP growth in Indonesia. Adapted from van Leeuwen, 2007.

Of the four countries mentioned by Barro, Indonesia is the slowest to recover from the 1997 crisis. Barro rightly points out that an important factor in this is the current lack of foreign investment (Barro, 2001: 1). He comments that “the failure of investment to recover suggests that businesses do not anticipate returns to the sustained high growth of the past.” Thus, logically, the current investment climate is caused by sharply decreased confidence in the economy, which can also be seen in the stock market.

That the national economy is indeed ready for, and, to be more precise, deserving foreign investment is clear from the flexibility that has assured fast recovery from former economic slumps and from the process of structural reformation of “banking sectors (…), protection (…), state enterprises (…), taxation structures (…).” (Hill, 1994: 834). The Indonesian government tries to stimulate a more positive image of the Indonesian investment climate, mentioning very positive numbers:

“The rupiah has appreciated from a low of 17,000 to the dollar to a steady 8,500. The budget deficit has shrunk from 4.8% of GDP to 1.8%, and government debt from 100% to 67%. Inflation, which peaked at 60% in 1998, is down to 6% and still falling. Buoyed by this parade of encouraging figures, the stock market has recently hit several successive three-year highs.” (Economist, 27 Sept. 2003).

However, the Economist also points out some less positive trends(27 Sept. 2003). Politics are still highly unstable, and it is mainly the IMF, not the Indonesian government, that made the figures the latter is so proud of come into being. The IMF program has ended in 2004, and corruption and bureaucracy persist. “During Indonesia's rainy season, the dirt tracks that connect Javanese villages to their fields often become impassable. According to one estimate, every dollar spent surfacing these roads--with sand, rock and gravel--brings benefits worth $3.30 over the roads' lifetime. (…) Some of the World Bank money allocated to village infrastructure ends up greasing palms, not smoothing gravel.” (Economist, 18 March 2006).

Corruption and political instability are the main reasons for a lack of international confidence. However, corruption has a particular origin in Indonesia. According to King, there were corruption-like practices in the traditional tribal society, already in the 10th century. These were not illegal, but constituted a system of reward: the king could grant a good civilian a position in which the latter was expected to engage in self-enrichment (King, 2000: 605). Later, the Dutch used these mechanisms in the same way (King, 2000: 606). Corruption rose to current numbers under presidents Soekarno and Soeharto, as a consequence of his ignorance and personal benefit to maintain the status quo (King, 2000: 607-609). For many, there was no other way to urn a living. Furthermore, law-enforcement was hardly exercised with respect to corruption, allowing a climate of disregard of the law to emerge. King remarks that during the initial post-war growth, corruption declined profoundly, mainly because of the favorable economic climate, idealism, and effective law-enforcement (King, 2000: 606). Thus, on the long term, there is hope for foreign investors, provided that the government resumes enforcement of the law. However, their contribution is also necessary to establish, via economic growth, more favorable conditions for the people.


References:

• Airries, C.A. “Global economy and port morphology in Belawan, Indonesia”. Geographical Review, Vol. 81, Issue 2, 1991.
• Antlov, Hans (Review author). [Kosuke Mizuno. “Rural Industrialization in Indonesia: A Case Study of Community-Based Weaving Industry in West Java”.] The Journal of Asian Studies, Vol. 56, No. 4 (November 1997), pp. 1172-1173.
• Barro, Robert J. “A 'YANKEE IMPERIALIST' OFFERS ASIA A ROAD MAP”. Business Week, Issue 3736, 2001.
• Britannica (Indonesia). Date of access: 18 September 2007. http://www.britannica.com/eb/article-22814/Indonesia
• Countryprofile (Indonesia). Date of access: 18 September 2007. http://www.asianinfo.org/asianinfo/indonesia/pro-history.htm
  
• Geertz, Clifford. Agricultural Involution. The Process of Ecological Change in Indonesia. London: University of California Press, 1963. Fourth ed. 1970.
• Hill, Hal. “ASEAN Economic Development: An Analytical Survey--The State of the Field”. The Journal of Asian Studies, Vol. 53(3), 1994.
• King, Dwight Y. “Corruption in Indonesia: a Curable Cancer?” Journal of International Affairs, Vol. 53(2), 2000.
• Leeuwen, van, Bas. (2007). Human Capital and Economic Growth in India, Indonesia, and Japan: A quantitative analysis, 1890-2000. Doctoral thesis Utrecht University.
• Library of Congress Country Studies (Indonesia). Date of access: 18 September 2007. Contents page: http://lcweb2.loc.gov/frd/cs/idtoc.html . Quotation from: http://lcweb2.loc.gov/cgi-bin/query/r?frd/cstdy:@field%28DOCID+id0021
• PBS (Pelabuhan Belawan statistik). 1985. Medan: Port of Belawan Statistics Department.
• UNDP (Indonesia). Date of access: 18 September 2007. http://www.undp.or.id/
• UN World unrbanization prospects, 2005. (Indonesia). Date of access: 18 September 2007. http://esa.un.org/unup/p2k0data.asp

[1] The resources listed by the CIA Factbook are: “petroleum, tin, natural gas, nickel, timber, bauxite, copper, fertile soils, coal, gold, silver” (CIA Factbook).
[2] Java was an interesting place for the company since it was already developed as a regional trade centre (Tichelman, 1980: 105). Infrastructural changes were, at first, hardly implemented, since these trade centres were located in the Pasisir (i.e. coastal) region of Java.
[3] The Cultivation System held that every village or settlement had to export the crops produced on one fifth of all its cultivatable land to Holland.
[4] There were conditions to prevent too rigorous exploitation. For example, Dutch entrepreneurs could only lease the land if that would not imply that the local inhabitants were enough denied resources to sustain their livelihood.
[5] As is quite usual when large scale violence occurs, there was no money or initiative to start building up an infrastructural network or invest in industrialization.

Carry Trade

Kasia Burzynska explains how to print money on your own. Kids, don't do it at home...

Printing money is not that difficult. Global traders have been doing it over the past few years thanks to the magical machine called carry trade. It all comes to the strategy in which an investor borrows a low-yielding currency and uses the funds to buy a higher-yielding one. Yen carry trade is the best example.

When the Japanese economy faced the crisis in the 1990s, the Bank of Japan decided to maintain for a very long time zero interest rates policy. Till today the rates are kept very low – at the moment it is 0.5 percent. On the other hand, the benchmark rate in Euroland is currently 4 percent, in the United States 4.75 percent and in New Zealand as much as 8.25 percent.

The traders have been eagerly taking advantage of this yield gap. They could borrow 10 000 yen from a Japanese bank, convert the funds into New Zealand’s kiwi and re-loan it out. The spread of 7.75 percent (i.e. 8.25 percent - 0.5 percent) makes up profit. And it can be even bigger when we take leverage, that is popular method of increasing profit by using borrowed money, into consideration. Common leverage factor of 10:1 boosts profit to 77.5 percent.

But carry would not be that interesting without risk. And carry trade can be a risky business. First of all the interest rates can change. The investors got used to very low interest rates in Japan and take it for granted. But after nearly 6 years of zero interest rates policy, Japan’s central bank raised rates to 0.25 percent in July 2006, then to 0.5 percent in February 2007. As the economic situation in Japan seems to be gradually improving, the Bank of Japan is likely to continue the hikes (Chavez-Dreyfuss, 2007) and the narrowing of the interest rate gap makes carry trade less attractive. Secondly the cross-currency carry trade involves the risk of moves in the exchange rate. If the lower-interest rate currency rapidly rises, the cost of debt relative to assets increases and at the same time the value of assets relative to borrowing decreases. That is why any strengthening of the yen worries traders. They can lose a lot in no time without a warning.

The investors must mind the risk from other sides too. Very often the money from borrowing the yen is invested in places like emerging markets, which are more unpredictable and riskier. When the economic slowdown comes, the risky assets will lose in value, which will lead to the situation in which traders will want to receive their money back to repay the debts in yen. This may make the yen rise and even more traders will have to go back to the yen, deepening the trend.

What is even more interesting, no one really knows how much capital in carry trade is involved. Its total size is estimated to as high as $ 1 trillion (Lenzner, 2007). But theoretically it should not even exist or at least not for long. The carry trade is against economic theory that says the high-yield currency compensates investors for the risk of depreciation. Similarly the low-yield currency should have the tendency to appreciate. Nevertheless, yen remains weak. The very actions of traders can be a good explanation of why it happens. They sell yen and buy other currencies. The more investors enter into carry trade the more they strengthen the tendency for the yen to fall and other currencies like the kiwi or won to rise.

Carry trade has been used by the Japanese households to get higher returns by shifting the money from their bank accounts to relatively secure but higher–interest-rate assets like New Zealand, American or Australian bonds. International investors, like hedge funds, have found carry trade applicable also for more speculative, leveraged trades.

All these flows of cheap money cannot stay without impact on global economy. The Economist’s Big Mac index from July 2007 suggests that the yen is undervalued against the dollar by 33 percent. The weak yen favours the Japanese exporters. And the high-yielding currencies are getting stronger. As O'Brien and McIntyre (2007) report Australia's dollar has gained 18 percent versus the yen in the past 12 months and the New Zealand dollar strengthened 12 percent. The same tendency is seen in the value of the won – it has been rising against the dollar and meanwhile the yen has dropped against the dollar as well as the won. That is why South Korean Finance Minister Kwon Okyu says the low value of the yen is “deepening global imbalances” and sees carry trade as “a potential threat to the international financial markets”. Carry trade hurts a lot of exporters in South Korea or New Zealand too, first of all worsening the competitiveness of small and medium-sized businesses.

Latest report from UN Conference on Trade and Development (2007) draws attention to the danger of unwinding of carry trade. It can be a threat especially for developing countries. “The web of different funding and lending currencies of otherwise unrelated economies causes the countries involved to become interdependent and subject to reversals of perceptions and to contagion effects”. Unexpected changes in exchange rates can trigger “a large unwinding of investments and this can spill over to emerging market economies”.

Carry trade is a major source of financial liquidity in global markets. It causes asset prices to rise worldwide. Unwinding of carry trade and thus drying up of this source can create market volatility. When the traders suddenly begin to sell the assets in order to raise cash to pay back their short-yen currency positions, the yen will jump accelerating further selling. And so the declines will deepen, which can lead to global crisis.

For the time being, yen carry trade still exists and still works. But it becomes even riskier. Former Federal Reserve Chairman Alan Greenspan said: “at some point it's got to turn”.

Author: Kasia Burzynska

Reference:

Adam, S., Batchelor V. (2007), “APEC Says Flexible Currencies Will Reduce Imbalances”. Bloomberg.com.

Arnold, W. (2007), “Yen carry trade falling from favor”. International Herald Tribune.

“Carry on living dangerously” (2007). The Economist.
“Carry on speculating” (2007). The Economist.

Chavez-Dreyfuss, G. (2007), “Japan inflation shock could fuel carry unwind”. Reuters.

Chen, S.-C. J. (2007), “A Yen For Currency Trading”. Forbes.com.

Chen, S.-C. J. (2007), “Yen Carry Trade Unraveling Faster”. Forbes.com.

Da Costa, P. N., Kadoya T. (2007), “Greenspan says carry trade has limited room to run”. Reuters.

Lenzner, B. (2007), “A Meltdown From The Yen-Carry Trade?”. Forbes.com.

O’Brian, E., McIntyre E. (2007), “Australian and N.Z. Dollars Gain on Demand for Nations' Bonds”. Bloomberg.com.

Pesek, Jr. W. (2006), “Japan's Boom May Explode Yen-Carry Trade”. Bloomberg.com.

Smith, P., Pilling D. (2007), “Japan faces carry trade scrutiny”. Financial Times.

“What keeps bankers awake at night?” (2007). The Economist.

Young, A. (2007), “Eye on the Carry Trade”. Business Week.

The Miraculous Asian Tiger

Olga Muravjova looks at how Hong Kong came to power in the international economic arena.

"If you approach Hong Kong from the sea, you will sail through a narrow channel between the island on the south and the mainland to the north, thus coming into the great harbor from which the island-colony gets its name. For Hong Kong (pronounced in Cantonese Heung Gong) means “Fragman Harbour” (Hague, 1959, p.7).

Sea and harbour are important for Hong Kong not only as determinants of its geographical position. The sea and the harbour may be seen as the symbols of trade and openness. And these two elements together with appropriate policy measures (and a dose of geographical luck) actually constitute the essence of Hong Kong's success.

In this article, I would like to show that the development of Hong Kong was due to policies that adopted the city-state's economy to changes and fluctuations in the post-war world economy. I also try to show how the development of Hong Kong affected the development of the Pearl River Delta in the People's Republic of China.

Tiger is Born: 1940s-1970s

The role of Hong Kong as an “entrepot” changed with the establishment of the People’s Republic of China in 1949 and the outbreak of the Korean War. As a consequence of the war the United Nations put an embargo on China in 1951 (Chan, 1996). This resulted in great waves of refugees, entrepreneurs and manual labor from China to Hong Kong, bringing along with them managerial and entrepreneurial skills, capital, market knowledge as well as an abundant labor force to the territory, and setting the foundation for the first phase of industrial development of Hong Kong (Chan, 1998).

From the mid 1950s, labor intensive industries directed by export oriented strategies developed, taking advantage of Hong Kong’s geographical and economic positions. Also, as Yulong and Hamnett (2002) say, other favorable conditions at that time, such as the freer economic policy, the emergence of the New International Division of Labor (NIDL) as well as integration with the world capitalist system, (especially in the “regulations governing the operation of economy and trading”) brought new opportunities for Hong Kong to improve its industrial structure and also had an influence on rapid development of the city.

Badcock (2002) says that the economic success of Hong Kong in the 1970s was due to its ability to “mass produce” consumer goods at lower prices than its main competitors in other places. The production of different electronic devices and toys was common among the industries. These goods were usually produced by small and medium enterprises, and this led to the economic paradox of mass production, since usually big companies experiencing economies of scale carried out mass production, as the Fordist model explains. However, Augustin-Jean (2005) says that Hong Kong had never been an example of the Fordist paradigm, and the small and medium enterprises managed to benefit from their ability to produce “differentiated products in small quantities and in a short period of time” using simple technologies. This gave the possibility for entrepreneurs to quickly adjust their production to changes in demand, to modify their products several times a year in order to satisfy their most demanding overseas customers and when orders were too large, companies subcontracted parts of the production. Indeed, as Badcock (2002) mentions, Hong Kong’s industries had adopted flexible production characteristic for post-Fordist manufactories. However, the development of Hong Kong depended on its external relations, the importance of its port, its free port status as well as its existence as a specific economic entity.

Since Hong Kong’s beginning in 1841, the city was declared a free port, which fitted the laissez-faire ideology of the time, specifically that of a supporter of the “free economy”, which British Government was. At that time, the “British Government decided that…British taxpayers should not subsidize the running of the colony”, and therefore there were no taxes on products (Augustin-Jean, 2005).

But that was not all. Industries in Hong Kong received benefits from government actions in the 1970s. In response to rising world trade protectionism and competitive pressures from its Asian counterparts and lower wage developing countries, Hong Kong’s government “embarked on a series of laissez-faire financial policies”, such as the introduction of low taxes, abolition of exchange controls, and the accessibility of an extensive range of financial and technical services (Yulong & Hamnett, 2002). This started a shift in its economic development strategy which entailed a move to a “diversified economic structure particularly focused on the financial and service sector”.

Furthermore, Hong Kong’s location on China’s doorstep, as well as near the sea, is another factor that has greatly benefited Hong Kong’s economic expansion. Since the middle of the 20th century, Hong Kong has been the major link for China’s relations with the outside world. Furthermore, Hong Kong’s industries received huge benefits from the waves of migrants from the Mainland, since the effect of that was the great supply of labor. Additionally, China had supplied Hong Kong with basic daily necessities including fresh food and drinking water, even during the “Cultural Revolution” (Yulong & Hamnett, 2002). The importance of the connection with China and Hong Kong’s location rose especially after the “Open Door” policy was implemented, which I will discuss later.

Role of Government: Urban Planning Strategies

Yet, not everything was according to laissez-faire lines in Hong Kong. Despite their laissez-faire attitude, and a policy of minimal intervention, the colonial authorities had become increasingly involved in the management of land and public housing. After the World War II, there was a rapid economic development as well as a huge inflow of immigrants. The Hong Kong Government quickly understood that some planning actions were needed. A famous urban planner, Sir Abercrombie, came from England to Hong Kong in 1947, however, due to the liberation attitude of the time, there was little done during that period. Nonetheless, after a tragic event, when a gigantic fire completely destroyed a slum area in New Kowloon and left about 50,000 people without shelter, “one of the most ambitious public housing programs on Earth” had been started (Augustin-Jean, 2005). Simultaneously, in order to try to reduce the inevitable disturbance (noise and pollution) caused by industries to the residential districts, local government put into practice a relocation program for small and medium enterprises (SMEs) and encouraged the creation of industrial zones. The local authorities presented their program as a part of their mission to help the poor and I definitely can state that local economy benefited from the government intervention in the housing market. The system was very simple, did not involve much transfer of public funds, and was economically beneficial. Therefore, as Augustin-Jean (2005) says, it was not considered as a “contravening mechanism” of an ideology of a “free economy”.

International Environment and Roots of Economic Development from 1979s

Gar On-Yeh (1997) says that the most significant economic restructuring in Hong Kong occurred in the late 1980s after the adoption of economic reform and open door policy of China in 1978. The catch phrase of the Open Economy Policy was “to open to the outside world and to revive the economy of the island” (Chan, 1998). Hong Kong transformed from an industrial to an information society; the major international centre was founded not only on trade, shipping, banking, investment and finance, but also on property, tourism and entertainment. The laissez-faire financial policies of the beginning of the 70s appeared to be victorious, and by the beginning of the 1980s, Hong Kong became the fourth largest financial market in the world after New York, Tokyo and London (Yulong & Hamnett, 2002). In the meantime, this resulted in a market decline in the industrial and manufacturing sectors. The Hong Kong economy survived the oil crises of the 1970s, but the growing land prices and increasing labor wages have deteriorated its industrial production advantages. A significant amount of manufacturing production moved to cities and towns in southern China (Chan, 1996). Moreover, the competitiveness of the United States and Europe in the world market improved, after they started using flexible production systems. However, these developments did not frighten Hong Kong, and because of the economic reforms occurring in China at that time, Hong Kong did not have to take extreme measures to remain a competitive actor in the world market (Augustin-Jean, 2005). Therefore, it is important to examine economic developments in the People’s Republic of China in order to evaluate the economic restructuring of Hong Kong.

Hong Kong and China

China's economic reforms since the late 1970s and 1980s have had a far reaching effect on the economic restructuring of Hong Kong's economy. Guangdong Province is the first province in China which benefited from the Open Door Policy. The reason for this is that three out of four SEZs and two out of the 14 coastal open cities are located there. The province is believed to move “one step ahead” of the other provinces in the People’s Republic of China. This is also the province to have the largest impact on trade between China and Hong Kong. As Chan and Kam mention, Hong Kong and China are currently the largest trading partners (Chan, 1996; Kam, 1999). For example, trade amounted to 395 billion Hong Kong dollars in 1990, and it has been described that Hong Kong’s role vis-à-vis China as being a “trading partner”, “financier”, a “facilitator” and “middleman” (Chan, 1996). These definitions are especially correct with respect to the Pearl River Delta, a composite delta in Guangdong Province of south China, developed into one of the leading growth regions in the People’s Republic, and where most of the wealth is situated.

Hong Kong and the Pearl River Delta Region

The Pearl River Delta was fundamentally an agricultural region, however, since the 1980s its economic profile had experienced significant transformation, changing from an agricultural to a manufacturing area, dominated by “textile, food processing, footwear and electronic assembly enterprises”. More recently, some cities have focused on expanding commercial and service sectors (Chan, 1998). After China adopted the “Open Door Policy”, the industrial and manufacturing sectors have been decreasing. As Chan (1996) mentions, there was a relocation of the local industries and factories from Hong Kong to Shenzhen and other parts of the Pearl River Delta region. Hong Kong industrialists used these regions as a “backyard”, since while administrative operations stayed in Hong Kong, the production lines gradually moved to Guangdong and were decentralized. Such complementarity of the factors of production gives us a significant explanation of the success story of Hong Kong. “China can provide cheap land and labor; Hong Kong has the capital surplus and know-how” (Augustin-Jean, 2005). The migration from rural areas provided the labor supply. The government strictly controlled rural-urban migration on the Mainland until the establishment of the rural responsibility system, which consisted of a set of reforms aimed on giving the individual peasant households bigger responsibility of managing their own economic matters. As a result, the Pearl River Delta region has experienced massive migration of farmers traveling to township enterprises. Since the adoption of the “Open Door Policy”, the portion of the delta in Guangdong Province has become one of the largest economic regions and a massive manufacturing centre of mainland China, and there is an increasing integration between Hong Kong and the Delta. Chinese government hopes that the manufacturing in Guangdong, in a combination with the financial and service economy in Hong Kong will create an economic gateway attracting foreign capital throughout mainland China (Rohlen, 2000). The closeness of the Pearl River Delta region to Hong Kong attracts the overseas investors, which consequently stimulates the economy of both Hong Kong and the Delta region.

Urban Planning after 1979

The control of urban planning after the introduction of the “Open Door Policy” was significantly higher than before the reforms occurred in China. However, the economic restructuring that has occurred since the mid-1980s has created new challenges for urban planning in Hong Kong. New measures had to be developed to deal with the increasing cross-border traffic and to accommodate the changing needs of economy. Thus, a Territorial Development Strategy appeared in the early 1980s to coordinate land use and transport development in order to be able to provide a better living and working environment as well as to sustain economic development (Gar-On Yeh, 1997).

After the establishment of People’s Republic of China, and after the Korean War, the industrial sector of Hong Kong was rapidly increasing because of the great labor supply, caused by the huge inflow of migrants from the Mainland to Hong Kong. Also, the flexibility of Hong Kong’s industries, and the ability to response quickly to demands, created big advantages. Hong Kong’s industries were either small or medium in size and also had simple and very flexible production systems. Other parts of the world would experience such flexible and post-Fordist way of production only decades later. Moreover, “free economy” (free port status and other laissez-faire policies) gave profits to local industries. Regarding the urban planning in Hong Kong, there was a significant intervention from the government, to a degree of paternalistic reasons.

The “Open Door Policy” influenced Hong Kong’s development in a major way, transforming the city from industrial to an information based society. Industrial and manufacturing activities moved to the Mainland, especially to the Pearl River Delta region. By that time, Hong Kong had become a major financial centre. The increase in the connection between Hong Kong and the Peal River Delta was economically beneficial. The connection with China on another hand made Hong Kong even more attractive for foreign investors. In the 1980s, the introduction of the Territorial Development Strategy in order to improve lives of people by sustaining economic growth was a major change.

Conclusions

Hong Kong had undergone many development phases before it achieved the status of developed city. Its geographical advantages, successful planning and openness to changing economic situations in the rest of the world, helped Hong Kong to become one of the most important cities and the fourth largest financial market in the world. Hong Kong may be a good example of how openness, free trade and, last but not least, appropriate government policies lead to economic prosperity. In this sense, Hong Kong is to a certain extent the child of an ongoing process of globalization.


Bibliography:

Asian Info – Hong Kong. 3 May 2007.
<http://www.asianinfo.org/asianinfo/hong-kong/hong_kong.htm>

Augustin-Jean, L., “Urban Planning in Hong Kong and Integration with the Pearl River Delta: A Historical Account of Local Development”, GeoJournal, Vol. 62, Issue: 1, pp. 1-13. 2005

Badcock, Blair. Making Sense of Cities – A Geographical Survey. London, Arnold. 2002

Bureau of East Asian and Pacific Affairs. “Hong Kong”. 2007. 2 May 2007.


Chan, R.C.K., “Cross-border regional development in Southern China, GeoJournal, Vol. 44, Issue: 3, pp. 225-237. 1998

Chan, R.C.K., “Urban Development Strategy in an Era of Global Competition: The Case of South China”, Habitat international, Vol. 20, Issue: 4, pp. 509-523. 1996

Hague Eric. In the Shadow of Nine Dragons. Hong Kong Sketches. London. 1959

Gar-On Yeh, A., “Economic restructuring and land use planning in Hong Kong”, Land Use Policy, Vol. 14, No. 1, pp. 25-39. 1997

Kam Ng, M., “Political economy and urban planning: a comparative study of Hong Kong, Singapore and Taiwan”, Progress in planning, Vol. 51, Issue: 1, pp. 1-90. 1999

Rohlen, P. Thomas. “Hong Kong and the Pearl River Delta: “One Country, Two Systems” in the Emerging Metropolitan Context”. 2002

The World Fact Book. “Hong Kong”. 2007. 1 May 2007.

Yulong, S., Hammett, C., “The potential and prospect for global cities in China: in the context of the world system”, Geoforum 33, pp. 121-135. 2002

Global public goods

A new approach to development or a fashionable speculation to revitalize aid-fatigued donor countries?


In these years, development institutions' capacity of delivering results to poorest countries has been questioned a lot. World Bank's mission creep – that can be summarized as starting from basic infrastructure building in the 1940s and arriving to the "working for a world free of poverty" motto – has lead to serious accountability and effectiveness problems, up to the point that today's Bank's mission has become so complex that seem hardly manageable. The IMF is in deep water as well. The words "structural adjustment" had become a catch-all phrase for the pain inflicted on the poor in developing countries by faceless austere bureaucrats in Washington, and the new implementations do not seem to satisfy all: the debate about IMF and WB reforms is still open.

To fight this lack of effectiveness a new rhetoric about developing institutions has arisen, starting with the Millennium Development Goals and UN declarations, which advertised human development, pace, equity, justice, gender equality, environmental safeguard as the new performance benchmarks for development institutions.

Surfing this wave, a new concept has been forged to provide theoretical strength for a broad approach to development and to revitalize "aid-fatigued" donor countries with new appealing evidence: the concept of global public goods. An increasing literature (Kaul et al., 1999, Agerskov, 2005 among others) recommends focusing on global public goods for boosting growth in poor countries.

In Prague, 2000, the World Bank and IMF Development Committee identified five priority areas for GPG intervention, recognizing the need for the Bank to define more precise targets. These areas are communicable diseases; environmental commons; development information and knowledge; trade and economic integration; international financial architecture (which is an IMF specific role). Actually, the architecture for Bank involvement in global programs seems to be increasing. In fiscal year 2004, 64% of the Bank's trust fund monies ($7.1 billion), went to global and regional programs, compared to 57% in 2003 (source: OED 2004). The share of single country operations, however, is still much higher, and multi-country operations among small groups of countries remain low.
The UN has also identified in 2004 six clusters of global challenges: war between states; violence within states; poverty, infectious diseases and environmental degradation; nuclear, radiological, chemical and biological weapons; terrorism; transnational organized crime.

What are global public goods exactly? What are the insights on development that this approach provides? Can this concept be a reference point for development programs? Let's try to find an answer to these questions.

The term "public goods" was first mentioned by David Hume, the Scottish philosopher and economist, and later properly introduced in the economic field in 1954 by Paul Samuelson (Economic Nobel Prize Winner in 1970). Samuelson defined public goods as a commodity or an activity with the characteristics of "non-rivalry" and "non-excludability" in consumption, i.e. where any one's person consumption of the good doesn't affect the available amount for others, and where it's hard to exclude anyone from accessing the good. Public goods' nature making this class of goods undersupplied by the market, the need to supply public goods besides market allocations traditionally justifies government involvement in the economy.

The concept of "global public goods" (GPGs), counterposed to national public goods, became widespread in the literature with the UNDP publication Global Public Goods (Kaul et al, 1999). A global – or international, the terms are almost interchangeable – public good is one where the elements in question are nations, rather than individuals. Thus, the joint and non-excludable benefits apply among nations, in a globalized environment.

While the subsequent broad literature accord on the main definition of GPGs, there are great semantic variations and different classifications among the authors. Let's quote some of the main views: Agerskov (2005) provides a very theoretical division among demand-related variations or supply-related variations on the general "public goods" concept. Focusing on spillovers, Kanbur et al (1999) distinguish three types of spillovers - national, regional and global; Sandler (2001) further analyze the geographical range to which the benefits apply: he divides local, national, regional, international and global benefits, in ascending climax. Morrissey (2002), analyzing the spatial range from a different point of view, considers three kinds of benefits that GPGs give rise to - risk reduction, enhancing capacity, and direct provision of utility – and classifies the national or international level of a public good according to benefits.
The broadest and most general attempt of classifying and analyze GPGs can be found, however, in Kaul et al. (1999). With less stress on precise economically-supported distinctions, they simply divide their book in six case studies, each of them analyzing one or two closely-related GPGs: equity and justice, market efficiency, environment and cultural heritage, health, knowledge and information, peace and security.

As these many classifications prove, the concept of "global public good" has become wide, multifaceted and increasingly unclear. So large is the basket of GPGs that the only definition of GPG that may "contain" all the examples and study cases provided in the literature is the definition given by Morrissey (2002), "a benefit providing utility that is in principle available to everybody (let's say many) through the globe". Yet it's not a very stimulating or sharp insight. The main question in defining GPG – the same question that is involved in many economical concepts – is whether we want a theoretical or an operative concept.

The theoretical, idealistic concept of GPGs, which includes values as equity, justice and peace (I'll discuss later the advisability of such classification even in a wide contest), mainly focuses on the "underprovision" and "benefit-all" aspects of GPGs. This focus has the clear aim to revitalize with new incentives the "aid fatigued" donor countries, to give them a new boost for financial intervention. However, as Kanbur (2002) smartly points out, two concerns arise. First, the "there's something in it for us" argument used to stimulate the Northern public has less solid moral basis than assistance based on humanity and empathy. Second, and more economic related, the supposed unilateral positive spillover of aid from rich to poor countries is hardly sustainable; the empirical evidence on the efficacy of IMF's and World Bank's aid for promoting development is, at least, mixed.

The operative approach, on the other hand, moves from the definition of non-excludability and non-rivalry in consumption, and from the positive spillovers among countries, to underline the practical implication of GPGs for economic development, therefore to provide a new agenda focused on global and regional programs for international organizations, World Bank in primis, with new importance on effective cooperation among the recipient countries.

If our goal is to identify the reasons of the failure of unilateral aid approach, and to provide poor countries with new bases for development, an operative, narrower approach to public goods may be useful.

Let's analyze first the definition and the division provided by Kaul et al., to show their weaknesses and to underline the necessity of a narrower approach for development.

The authors, in the first chapter, traditionally define GPGs as something that "must meet two criteria. The first is that their benefits have strong qualities of publiciness (sic) – that is, they are marked by non-rivalry in consumption and non-excludability. […] The second criterion is that their benefits are quasi universal in terms of countries, […] people […] and generations […]. This property makes humanity as a whole the publicum." Taken literally, this definition can be either very broad, if we consider any kind of abstract concepts, or very narrow, if we consider "goods" as tangible goods. The former one seems to be the pattern followed by the authors. Later on, in fact, they explicitly further divide GPGs in final global public goods, which are "outcomes rather than goods in the standard sense", and which can be tangible (environment, common heritage of mankind), or intangible (peace, international stability), and in intermediate global public goods, which "contribute to the provision of final GPGs" (international regimes, economic growth).

Even considering "goods" not just in a strict sense, it's very hard to see how international regimes can really benefit the whole humanity (even organizations as UN and IMF face huge problems of representation and are not able to account for small countries), how economic growth can be non-excludable toward the whole humanity (just recognizing positive externalities doesn't mean that growth per se benefit all the globe, unfortunately), or how heritage of a culture can benefit everyone (how archaeological sites in Peru can benefit all the citizens of Russia, for example).

The standard definition applies neither to the equity nor justice nor peace, other GPGs mentioned in the book. Can we really define them as GPGs? Aren't them values to pursue and to be inspired by rather than "goods" to provide? How can equity concretely be part of a specific development program?

Regarding knowledge, it's at least curios to classify it as a GPG, after a whole branch of philosophy (epistemology and gnoseology) has been studying for centuries what knowledge is and how is provided. If we want to talk about externalities, we may consider public-made, shared knowledge rather than knowledge itself. And still, the implications are quite problematic: first, nothing assures that all "kinds" of knowledge will be shared to a global public and will become easily available; second, even when shared through printed documents, internet or mass-media (thus becoming "information"), strong prerequisites are necessary to access it – such as information technologies to physically access, education to fully take advantage of it. Thus, knowledge and information are everything but non-rivalry and non-excludable in consumption.

As for financial stability, market efficiency and security, they are classified as global public goods because they prevent global public "bads", i.e. financial crises, market failures and wars. Besides the appealing pun, the definition is again unclear: global public bads seem to be just negative externalities, and they do not really fall into the categories of non-rivalry and non-excludability. That does not mean that international institutions such as the IMF or NATO do not have to promote financial stability and security. It just means that not everything that is important for global growth can be labeled as GPGs.

Environment is maybe one of the few pure cases of GPGs: the stratospheric ozone layer and the stability of the climate affect the whole world, they are non-rivalry and non-excludable, and similarly reduction in the use of ozone-depleting chemicals and in the emission of greenhouse gases benefits the whole humanity. Moreover, they have practical connotations: the levels of emissions are scientifically measurable, and it's not hard to think about concrete project to enhance environmental protection. However, environmental problems usually have regional, not global, implications: water pollution, acid rain, biodiversity and resource conservation are examples of region-related problems.

As well as environment, health is a GPG that can have both a global and a regional connotation. Diseases such as AIDS, malaria and avian influenza may have worldwide spread, but they are mostly concentrated in specific regions (Africa, Asia).

Environment and health thus lead us to a question: are GPGs really global in a pure sense, or are they mostly regional? In the second case, does a "global approach" really make sense, and can it be operational and useful? Even if recent literature have mostly focused on the appealing concept of global public goods – so easy to link to the fashionable concept of globalization – besides few examples international public goods have more often regional rather than global implications. Consequently, a closer focus on narrower concepts such as regional public goods can be more useful for understanding public goods' potential for development.




References

* Addressing the challenges of globalization, World Bank Operations Evaluation Department, 2004

* Agerskov, A. H., Global Public Goods and Development – A guide for policy makers, in Global Development Challenges Facing Humanity, World Bank Seminar, May 2005

* Kanbur et al., The future of development assistance: common pools and international public goods, ODC, 1999

* Kanbur, R., International financial institutions and international public goods: operational implications for the World Bank, G-24 discussion paper series, December 2002

* Kaul et al., Global public goods, Oxford University Press, 1999

* Morrissey et al., Defining international public goods: conceptual issues, Overseas Development

* Sandler, T., Comment on "The growing importance of regional public goods by Marco Ferroni", February 2002

Phantom Menace of Chinese Banking

Remy Piwowarski looks at the messy Chinese banking system and ponders whether the financial crisis is looming.

Many fans of Star Wars hate it, but I love the first episode. And I actually don’t know why? Sure, Jar-Jar and all those Gungans are the quintessence of childishness, but the mood of the movie is really interesting: the Republic seems to be rather peaceful - there are of course some mysterious dangers on the horizon and not everybody knows about them, but the general picture is not as violent as in further episodes. There is peace, but a misleading one with dangers clear and present though largely invisible. My intuition tells me that the world economy is now in a similar situation. Where does the danger come from? China.

The problem with the fastest growing economy in history is that it has a bank-centred financial system. The Chinese banking system is the main source of capital in China, the main venue of people’s savings and the main instrument of investment policies. Therefore, the banking system plays a crucial role in the Chinese economy and as such its state is irreversibly linked to the world economy. Unfortunately, to put it euphemistically, the system itself is in a bad shape and the threat of a financial crisis is clear and present.

Looking into the past

As Berger et al (2005) write, before the 1978 the Chinese banking system was modeled after the Soviet one with a single bank, the People’s Bank of China, responsible for all major banking operations. The situation came to a change in 1978 when from the People’s Bank of China four big quasi - commercial banks were separated: China Construction Bank, Agricultural Bank of China, Industrial and Commercial Bank of China and the Bank of China. Today, these banks still dominate the China’s banking industry and are commonly referred as the Big Four.

In the 1980s, the aforementioned banks served mainly as policy-banks, financing government projects and providing loans to state-owned companies (SOEs). Furthermore, till 1985 their operations were legally constrained to their respective areas (agriculture, construction etc.), which hampered competition. In 1994, a major overhaul of the Chinese banking system took place when it turned out the banks amassed large amounts of non-performing loans (NPLs). The Chinese government recapitalised the banking system by creating state-owned asset-management companies and later established two policy-oriented investment banks.

The growth of the private banking was rather limited in the 1990s. The first private Chinese bank China Minsheng Banking Corporation was created in 1998 and, in 1990s, entrepreneurs in China established 12 private banks in total. The entry of western banks was slow. In 1979, US and European banks were allowed to open their representatives offices in special economic zones (SEZ) and since 1982 they have been permitted to open operational branches. The regulations expanded in the 1990s and in 1999, 25 foreign banks had permission to operate all over the country. Some of the foreign banks bought also minority stakes in the Big Four.

Nevertheless, despite all these reforms, the Chinese banking system is facing tremendous problems.

Skeptics

What’s the main problem with the Chinese banking? To put it shortly: Chinese bankers make many loans not because of the profitability of ventures, but because some mighty regional rulers want them to finance state-owned companies. And since state-owned enterprises are running losses (why? mainly because they are state-owned and because they know the banks will lend to them!), the amount of non-performing loans is soaring.

Is this path sustainable? Have recent reforms improved the situation? Economists take two positions on these issues.

Kashyap and Dobson (2005) from the University of Chicago take a more skeptical attitude in their newest paper. The authors point out huge and persistent inefficiencies in the Chinese banking system. Bad lending practices are still continuing, despite a government bailout in 1994 and reforms, e.g. introducing new risk assessment
techniques, creating a supervisory institution, limited liberalisation, or entry of foreign
banks.

The previous wave of bad loans was caused by the government’s willingness to keep state-owned enterprises (SOEs) operating. The privatisation of SOEs did not take place, since many of them would not have been able to survive market competition, which would create unemployment and possibly social unrest. Direct subsidies would mean, in turn, a huge stress on government’s budget. Hence, the Big Four banks were ordered to provide loans to SOEs. Furthermore, since loans to SOEs were backed by the state, the banks did not implement credible methods of risk assessment and moral hazard came into place.

All these factors played an important role in the 1990s and, as said earlier, the same factors seem to be at work today. The authors notice that banks are lending to previous NPL clients. Furthermore, the data show that there is absolutely no correlation between the regional profitability of SOEs and the amount of lending. In addition, huge banks discriminate against small and medium enterprises and the range of interest rates is small, which denotes poor skills of assessing clients’ creditworthiness.

The anecdotal evidence shows, in turn, that the boards of major banks are not populated by technocrats, but by party officials. As a result, politically-motivated managers favour lending to SOEs. In addition, according to the authors, the impact of minority foreign shareholders is small mainly due to the very fact that they are minority shareholders.

As we can see, the picture is rather gloomy, but it is not the only one.

Are optimists right?

A more optimistic perspective is provided by Yusuf et al. (2006) in their
book about the condition of SOEs. Yusuf et al (2006) write: “The current growth
momentum, the small size of the official public sector debt […] the size of the foreign
exchange reserves (over $660 billions in March 2005) [which act us a back-up for shortterm savings according to Guidotti – Greenspan principle – R.P.], and the sheer volume of domestic savings (47% of GDP in 2003) provide a cushion sufficient to offset for 9 several years the excess resource consumed by inefficient SOEs (…)” (Yusuf et al (2006) p. 19-20). Furthermore the authors point to the fact that past callings for a substantial overhaul of the SOEs and banks have been largely misplaced: nothing like a financial crisis or the slowing-down of the economic growth took place (an example of a past call for reforms is 1998 paper by Dornbusch and Giavazzi or a paper by Lardy from the same year). The only risk that the Chinese economy is facing comes from the globalisation and the increasing need for competivness in international markets. Hence, although the authors devote their book to SOEs, the implication is clear: there is no need for a substantive overhaul of the banking sector due to the aforementioned factors.

For a non-economist, the argumentation of the authors might seem convincing, but I would like to make an important points.

It is true that slowing down the market reforms may be a sound strategy because of social concerns. Nevertheless, such an argumentation may be a good excuse to do nothing to revamp the banking system and the economy at large. The point is that the reforms will have to be conducted finally and the Chinese policymakers should be aware of that. A parallel (though quite distant) can be built with the policies of the current Polish or Hungarian governments: high levels of growth may make the government irresponsible in regards to budgetary policies or structural reforms. Similarly,
repeating the mantra about the need to create jobs for village inhabitants may
contribute to the lack of responsibility.

On the other hand, we have to do justice to the authors’ claims that the fundamentals of the Chinese economy (low budget deficit, high levels of foreign reserves) are strong and comprehensive schemes to deal with social issues need time to be devised and implemented. Perhaps, a good solution is privatisation and liberalisation together with offsetting social problems by an increase in spending on welfare and healthcare, proposed also by Eichengreen and Park (2006) as a measure to solve global imbalance problem.

Financial Crisis?

Non-economic readers may be wondering? What does the problem with Chinese banking has to do with the world economy? The answer is: a lot. If the Chinese financial system collapses (i.e. a financial crisis takes place), the Chinese economy will slow down. I don’t think that I need to explain potential repercussions. But is the crisis really likely?

Probably the most comprehensive analysis of the likelihood of a deep financial crisis is provided by Allen et al (2005). The authors state that in China three types of crises may occur: a financial crisis, a currency crisis, and a twin crisis.

The outburst of a real estate bubble may cause a financial crisis, similarly to the case of Thailand in 1998. In such a situation, many banks (including the Big Four) may become insolvent and the inflow of foreign funds and credits into the Chinese financial system may end abruptly. The primary reason for the crisis will be the agency problem – the lack of control from international investors over the way Chinese banks allocate their money.

The financial crisis may also take place in the event of a slowdown in the Chinese economy, or the persistence of NPLs. The authors point out that a small government budget deficit and high amounts of foreign reserves should enable the Chinese authorities to “prevent the situation from getting out of control” (p. 61). On the other hand, the Shanghai real estate market experienced many bubble outbursts in the past and the next one may have dire consequences.

Another possibility is a currency crisis. High amounts of capital in China is speculative in character and allocated there in order to reap gains from the future revaluations of the Chinese currency. If the revaluation actually takes place, or if it is determined that no revaluation takes place, speculators will withdraw their capital from China in a very abrupt manner. In the event it happens, the role of the Chinese government will be crucial: if it allows the currency to float, a devaluation will take place quickly, which will limit further outflows of capital; if the government decides to keep the peg, a currency crisis will ensue, leading to a banking crisis through a rapid bankrun. This will be the instance of a twin (financial and currency) crisis.

So, in general, it seems that the likelihood of a financial crisis in China is not predicated that much on the shape of the Chinese banking system. A more important factor is the level of Chinese foreign reserves. The economists give different opinions on the question of whether reserve accumulation may prevent a financial, or a twin (financial and currency) crisis. As regards the risk of a financial crisis, Grifith-Jones and Gottschalk (2005) state that the Chinese foreign reserves are well above the levels needed for a successful management of a financial crisis and in the event of a major financial disruption, only a certain fraction of them would have to be used. Hence, possible slowdown in the Chinese economy, or the crash in the Shanghai real estate market may be manageable.

Prasad and Wei (2005) state that the levels of the Chinese reserves should be sufficient to counter the negative effects of a financial shock, but they do not make any definite forecasts on whether this will turn out to be true in the future.

According to Wyplosz (2004), in the situation of an abrupt speculative withdrawal of funds, the build-up of foreign reserves may not be sufficient to manage the crisis. As Wyplosz (2004) writes in his paper: “Large reserves of foreign currency, such as those which have been accumulated since the 1997-8 crisis, are open to the same limit: when a crisis is in full swing, it soon overpowers any limited stock of ammunition”.


Where do we go from here?

Clearly, the Chinese banking system is in a bad shape. Nevertheless, as we said, the Chinese economy has something peculiar: 1,602 bln USD of foreign reserves (as of April 2007) that could be used to fight the crisis. Are they sufficient to fight a financial crisis? Are they sufficient to fight all possible threats to the Chinese economy? What is the past experience? Clearly, the opinions presented so far do not provide much evidence nor argumentation on that. In my next article, I will try to answer these questions and present my own model of estimating losses.

Reference:


Allen Franklin, Jun “QJ” Qian, Meijun Qian(2004) “China’s Financial System: Past,
Present, and Future”. Last Revised: April 4, 2006
http://www2.bc.edu/~qianju/China-finsystem-book-072105-ALL.pdf

Berger Allen L., Iftekhar Hasan, Mingming Zhou (2006). Bank Ownership and
Efficiency in China: What Will Happen in the World’s Largest Nation?
http://weatherhead.case.edu/bafi/Documents/Bergerpaper.pdf

Eichengreen, Barry and Yung Chul Park (2006). “Global Imbalances: Implications for
Emerging Asia and Latin America”.
http://www.econ.berkeley.edu/~eichengr/matter.pdf

Griffith-Jones s., R Gottschalk . Financial Vulnerability in Asia.
- IDS Bulletin, 2006 - asia2015conference.org
http://www.asia2015conference.org/pdfs/Griffith-Jones&Gottschalk.pdf

Kashyap, Anil K and Wendy Dobson. “The contradiction in China’s gradualist banking
reforms.” National Bureau of Economic Research. October 2006
http://faculty.chicagogsb.edu/anil.kashyap/research/chinabanksoctfullpaper.pdf

Lardy, Nicholas R. and Morris Goldstein (2004)
“What Kind of Landing for the Chinese Economy?”Institute of International Economics. Policy Briefs. www.iie.com/publications/pb/pb04-7.pdf

Prasad, Eswar and Shang-Jin Wei (2005). “The Chinese Approach to Capital Inflows:
Patterns and Possible Explanations”. IMF Working Paper.

Wyplosz, Charles. (2004) “Regional Exchange Rate Arrangements: Lessons from Europe
for East Asia”. Graduate Institute for International Studies, Geneva and CEPR
First draft: February 2002

Yusuf (2006) Shahid, Dwight H. Perkins, and Kaoru Nabeshima. “Under New
Ownership Privatizing China’s State-Owned Enterprises”. In: Palo Alto. Stanford
University Press.

Growth, Inflation and Globalization - Reviving the debate on causes of inflation

In June, Brazil’s Central Bank changed its forecasts for inflation and GDP growth. The latter was increased from 4.1% to 4.7% for 2007, which ceteris paribus should imply lower unemployment and thus higher inflation when compared to the previous forecasts, but interestingly enough, expected CPI inflation was reduced from 3.8% to 3.5% for the same year! In Bloomberg’s piece of news reporting this contradiction, it’s argued that the “accelerating economic growth in Latin America's biggest economy isn't sparking inflation as a currency rally slashes the cost of importing goods”, but can this be true?

Estimates of exchange rate pass-through on inflation show a modest effect when the home currency is depreciating. When the currency appreciates, as in this case, downward price inflexibility further reduces the effect import prices have on the aggregate price level, making it implausible the argument that the Real’s higher value has a stronger effect over inflation than the business cycle dynamics.

A solid explanation must show how the determinants of inflation may shift and lead to this unlikely combination, in other words, must show why the ceteris paribus assumption doesn’t hold. Because the goal here isn’t to discuss the Brazilian economy, we shall leave aside other considerations and show that the main and ultimate reason for the inflation to fall as the GDP rises is in this case a positive supply shock brought about by globalization.

For the higher GDP to be consistent with lower inflation, one of variables usually taken as constant must be changing, for example, if the potential growth were to increase by more than the expected actual growth, then inflation should fall. The only problem is that potential output depends on the structure of the economy and it makes no sense to think a priori it increased.

Alternatively, if we consider an augmented Phillips Curve, one of the other determinants of inflation may be pushing it down by more than the output gap’s upward pressure. This could be the case of a reverse oil shock – but the oil prices are on the rise –, increased central bank credibility – but that still doesn’t account for the higher GDP growth –, or even currency appreciation – but this isn’t enough to outweigh the business cycle pressure, as said above. It could also a positive productivity shock, however the last we saw was the personal computers revolution in the 80s. Or was it?

As presented in the World Economic Outlook (2006), globalization increases “pressures to innovate and other forms of nonprice competition”, raising productivity growth. This allows higher output without accelerating inflation. If the Central Bank recognizes the positive supply shock ahead of the private sector, “it can take advantage of its better forecasting to opportunistically lower inflation while delivering output growth rates that pleasantly surprise the private sector”. This is what Rogoff (2006) calls “opportunistic disinflation” and perfectly fits the Brazilian case.

Such explanation implies a permanent effect from globalization on inflation, for the Central Bank now targets a lower inflation rate – despite the official government target of 4.5% for 2008, the monetary authority already announced it will actually aim at 4%. Of course there’s no free lunch and the country gave up the opportunity to have an even larger GDP growth without accelerating inflation.

Because there’s general consensus that the long-run price level is determined by the money supply, economists agree that monetary policy would have to be altered for globalization to impact the inflation trend. And we have just shown how it can do so by creating policy incentives. Another way globalization can affect inflation is temporary shocks that change its short-run behavior, but theory for explaining it is not as widely accepted. For instance, Ball (2006) says “applied economist typically analyze short-run inflation behavior with a Phillips Curve”, but what to include varies a lot. In his paper he estimates 2 specifications and mentions a few other possible modifications.

In both cases he finds little to no effect: when testing the relevance of foreign output gap, he “pooled annual data” for a number of countries and found it “barely significant” and “at most a secondary influence on inflation”; when testing the role of trade, it had “at most a small effect”.

The problem is such results are contrary to the most prominent literature on the theme and his methodology way too simplistic to deal with the econometric difficulties. When assessing the role of trade, our pooled OLS estimates also resulted in small and statistically insignificant coefficients for openness, but tests on fixed and random effects strongly indicated that simultaneity was an issue that had to be addressed. Using instrumental variables to control for it, openness came with the expected sign and statistically significant.

As for the theoretical arguments, it may be useful to analyze Mankiw’s comment on Ball’s article for a Fed meeting. They both agree it’s possible competition may have lowered the “typical markup of price over marginal cost” and provided a “one-off beneficial shock to the inflation process”, but what really matters for the cyclical behavior of inflation is the sensitivity of mark-up to the business cycle.

Mankiw explains that very well, however both of them take for granted that “firms face diminishing returns as their output expands”. This neglects that the best reason for firms resort to outsourcing is to exploit economies of scale, and ignoring that is ignoring an essential feature of today’s globalization. In such a world, markups may still not be countercyclical, but part of firms’ desired prices is. Firms’ average costs go down as their production increases, for they benefit from EOS, and, ceteris paribus, prices fall. Of course prices don’t actually have to fall, firstly because markups may be acting on the opposite direction and secondly because actual prices also depend on the rate of adjustment. The important thing is globalization can put pressures on prices, dampening or compounding with other determinants. The more firms outsource, for example, the greater benefits they reap from EOS and the larger the impact on price dynamics.

We have thus a way for globalization to change the inflation process by affecting desired prices, in line with models of trade with imperfect competition and scale economies, and there is evidence from sound econometrics corroborating it [See WEO (2006)]. Additionally, one can consider the direct role of import prices and the exchange rate, which has been shown to have a marginal yet significant effect. Finally, as argued in the literature, globalization provides policy incentives that can alter long-term inflation trends, which fits the Brazilian recent development.

The extent to which these channels can alter the domestic price level is yet to be measured in consensus, but it is harder and harder to claim globalization is not crucial for the analysis of inflation.

-- André Luis Pulcherio

References:

• Bloomberg’s report on the Brazilian news: “Brazil's Central Bank Lifts 2007 GDP Forecast to 4.7%”
• Recent work on globalization and inflation, with sound econometrics and well organized: HELBLING, Thomas et al. in IMF (International Monetary Fund), “How Has Globalization Affected Inflation?”, World Economic Outlook, Spring 2006
• Major article on the theme: ROGOFF, Kenneth, “Impact of Globalization on Monetary Policy”, Paper for 2006 Jackson Hole Conference, Harvard University.
• Strong critiques to impacts of globalization on inflation: BALL, Laurence M., “Has Globalization Changed Inflation?”, NBER Working Paper 12687, November 2006.
• Comment to Ball’s article, a must-read for it elaborates some of the main points: MANKIW, Gregory, “Globalization and the Phillips Curve”, in Greg Mankiw’s Blog, October 4, 2006.
• Short yet informative article on the reasons for outsourcing: MEYER, Dean, “4 Advantages to Outsourcing” in Sourcingmag.com, 2005.