60057 DIREC TIONS IN DE VELOPMENT Poverty Understanding Growth and Poverty Theory, Policy, and Empirics Raj Nallari and Breda Griffith Understanding Growth and Poverty Understanding Growth and Poverty Theory, Policy, and Empirics Raj Nallari and Breda Griffith © 2011 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org All rights reserved 1 2 3 4 14 13 12 11 This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2422; e-mail: pubrights@worldbank.org. ISBN: 978-0-8213-6953-1 eISBN: 978-0-8213-6954-8 DOI: 10.1596/978-0-8213-6953-1 Library of Congress Cataloging-in-Publication Data Nallari, Raj, 1955- Understanding growth and poverty : theory, policy, and empirics / Raj Nallari, Breda Griffith. p. cm. Includes bibliographical references and index. ISBN 978-0-8213-6953-1 -- ISBN 978-0-8213-6954-8 (electronic) 1. Poverty. 2. Economic development. 3. Development economics. I. Griffith, Breda. II. World Bank. III. Title. HC79.P6N35 2011 339.4'6--dc22 2010044914 Cover photograph: Michael Foley/ The World Bank Cover design: Naylor Design Contents Preface xvii Abbreviations xix Introduction 1 Part I Poverty, National Income, and Economic Growth 13 Chapter 1 Poverty and How We Measure It 15 Poverty and Well-Being 15 Measuring Poverty 17 Collecting Data 25 Household Surveys and National Accounts 27 Conclusion 27 Note 28 Bibliography 28 Chapter 2 National Income and How We Measure It 31 Macroeconomic Sectors 32 Macroeconomic Concepts 32 v vi Contents Determining Gross Domestic Product 34 The Business Cycle 40 The Balance of Payments 43 Some Basic Accounting Relationships 45 Conclusion 51 Notes 52 Bibliography 52 Chapter 3 Growth, Poverty, and Inequality: An Overview 55 Growth Theory, Then and Now 55 Institutions and Modern Growth Theory 60 Economic Growth and Poverty Reduction 64 Variations in Poverty Responses to Growth 67 Pro-Poor Growth 70 Conclusion 74 Note 75 Bibliography 75 Part II Government Policy, Growth, and the Poor 81 Chapter 4 Government and the Economy--Focus on Fiscal Policy 83 The Role of Government in the Economy 83 Fiscal Policy: Taxing and Spending 89 The Uses of Fiscal Policy 94 Conclusion 96 Note 96 Bibliography 96 Chapter 5 Monetary Policy, Inflation, and Exchange Rates 99 Definitions and Concepts 99 Inflation 102 Inflation and Economic Growth 104 Inflation and the Poor 106 Exchange-Rate Policy 107 Conclusion 109 Notes 110 Bibliography 110 Contents vii Chapter 6 Financial Development 113 Financial Development and Economic Growth 114 Four Decades of Financial Sector Reform in Developing Countries 115 Financial Development and Poverty Reduction 118 Widening Access to Financial Services 120 Microfinance and the Poor 121 Emigrant Remittances 124 Conclusion 128 Notes 128 Bibliography 129 Chapter 7 Development Assistance 133 Aid Sources and Trends 133 Aid in the Context of Overall Capital Flows 137 Does Aid Spur Economic Growth? 145 Ensuring That More Aid Means More Growth 149 International Initiatives to Improve the Effectiveness of Aid 156 Conclusion 161 Annex The Five Principles of the Paris Declaration on Aid Effectiveness 161 Notes 164 Bibliography 165 Chapter 8 External Debt 169 Measures of External Indebtedness 170 External Indebtedness, Growth, and Poverty 170 Debt Relief and Low-Income Countries 173 Debt Relief versus Development Assistance 177 Conclusion 180 Notes 180 Bibliography 182 Chapter 9 Trade Policy 185 The Rationale for Trade 185 Trade Barriers 187 Trade and Economic Growth 188 Trade, Inequality, and the Poor 191 viii Contents Conclusion 195 Bibliography 196 Part III Factor Accumulation and Structural Policy 199 Chapter 10 Institutions and Growth 201 Measures of Institutional Quality 204 Institutions and Economic Growth 210 Social Capital and Culture 215 Conclusion 216 Notes 217 Bibliography 217 Chapter 11 Education 221 Education, Growth, and Poverty Reduction 222 Global Education Initiatives 229 Development Assistance for Education 235 What Do We Know about Educational Policy? 236 Conclusion 237 Notes 238 Bibliography 238 Chapter 12 Health 241 Macroeconomics and Health 242 Health and Economic Growth 246 Macroeconomic Policy and Health 249 Beyond GDP 250 Investing in Health 253 Global Health Initiatives 254 Conclusion 260 Notes 260 Bibliography 263 Chapter 13 Labor Markets 269 Labor-Friendly Economic Growth 270 Labor Markets in Developing Countries 280 Conclusion 291 Notes 292 Bibliography 292 Contents ix Chapter 14 Land and Agriculture 295 Land Distribution in Poor Countries 296 Land Inequality and Rural Poverty 299 Land Inequality and Economic Development 300 The Role of Government in Land Markets 303 The Role of Agriculture in Reducing Rural Poverty 306 Conclusion 312 Notes 313 Bibliography 314 Chapter 15 Technology, Entrepreneurship, and Productivity 319 Total Factor Productivity 319 Spending on Research and Development 321 Technology Diffusion and Adoption 323 Information and Communication Technology 324 Are Entrepreneurship and Growth Linked? 324 Entrepreneurial Activity and Growth 328 Policy Implications 330 Conclusion 331 Notes 332 Bibliography 332 Chapter 16 Urbanization and Growth 337 Trends in Urbanization 337 Urbanization and Growth 340 Urbanization and Poverty 342 Key Issues in Urbanization 342 Conclusion 351 Notes 352 Bibliography 353 Chapter 17 Corruption and Poverty 355 Detection and Measurement of Corruption 355 Analytical Framework for the Study of Corruption 357 Causes of Corruption 359 Costs and Benefits of Corruption 361 Impact of Corruption on Economic Performance 362 x Contents Persistence of Corruption 367 Conclusion 368 Note 368 Bibliography 369 Chapter 18 Regulation and Economic Growth 373 Product-Market Regulation 374 Labor Regulation 374 Regulation and the Private Sector 379 Financial Regulation 382 Policy Lessons from the Recent Crisis 383 Regulation and Reform of the Infrastructure Sector 384 Impact of Regulation on Growth and Informality 387 Conclusion 390 Notes 391 Bibliography 391 Chapter 19 Shocks, Volatility, and Growth 397 Avoiding Economic Downturns 397 Interdependence of North and South 400 The Synchronized Movement of Developed and Developing Countries 400 The Complexity of North­South Links 402 Monetary Policies and Capital Flows 406 North­South Capital Flows 408 Globalization, Volatility, and Growth 410 The Financial Crisis of 2008 and Global Growth 411 Growth Booms 411 The Microeconomic Foundations of Growth 417 Conclusion 418 Notes 418 Bibliography 419 Chapter 20 The Politics of Growth and Poverty 421 Political Power and Economic Institutions 424 Economic Origins of Political Regimes 424 Do Democratic Countries Grow Faster than Dictatorships? 426 Contents xi The Interplay of Politics and Economics 427 Conclusion 433 Notes 434 Bibliography 434 Chapter 21 Climate Change and the Wealth of Nations 441 National Wealth and Genuine Saving 442 Consumption, Saving, and a Counterfactual to the Hartwick Rule 443 How Does Natural Capital Affect Well-Being? 445 High Carbon, High Growth 446 Mitigation of and Adaptation to Climate Change 447 Conclusion 450 Annex Empirical Evidence of the Causes of Growth 451 Notes 456 Bibliography 457 Conclusion What We Know and What We Do Not Know 459 Glossary 463 Index 479 Boxes 3.1 How to Achieve Pro-Poor Growth--The Case of India 72 4.1 Five Characteristics of an Efficient Tax System 91 10.1 Inequality, Institutions, and Growth 213 14.1 How Rural Poverty Is Created 299 15.1 What Is Technology? 320 17.1 How to Reduce Corruption 366 21.1 Climate Policy in the International Arena 448 Figures 1.1 Distribution of the Poor in Thailand 16 1.2 Proportion of Developing World's Population Living on Less than $1.25 a Day 18 2.1 Circular Flow of Income in National Accounts 33 2.2 The Business Cycle 41 2.3 GNI and Resource Use 49 xii Contents 3.1 Per Capita GDP Growth Rates by Country Groupings 57 3.2 Economic Growth and Poverty Reduction in Select Countries, 1990­2003 64 3.3 Average Per Capita Incomes and Growth 65 3.4 Land Distribution and the Pace of Growth 69 4.1 Central Government Revenue and Log Per Capita GDP in 105 Developing Countries 92 5.1 Money Demand and Money Supply 100 5.2 Path from Expansionary Monetary Policy to Inflation 105 6.1 New Links between Microfinance Institutions and Commercial Banks 124 7.1 Net ODA Disbursements Made by DAC Donors 135 7.2 DAC Members' Net ODA, 1990­2008, and Simulations of Net ODA, 2009­10 136 7.3 Summary Chart for all DAC Countries 139 7.4 Recipient Countries' Share of Total Aid 140 7.5 Net Private Capital Inflows to Developing Countries 143 7.6 Net Private Capital Inflows to Developing Regions 144 7.7 Economic Growth and the Type and Timing of Aid 148 7.8 Aid Scheduled for Disbursement versus Aid Actually Received in Select Countries 151 7.9 ODA Commitments by DAC Countries, 2005 151 7.10 Progress toward the 2010 Paris Declaration Targets 159 8.1 Debt's Inverse Relationship to Growth 172 8.2 Composition of Resource Flows to Africa, 2000­10 178 9.1 Growth in Real Per Capita GDP across Countries 190 10.1 The Williamson Hierarchy of Institutions 203 10.2 Link between Institutional Quality and Per Capita National Income 203 10.3 Regional Percentile Rank for Voice and Accountability 205 10.4 Regional Percentile Rank for Political Stability 206 10.5 Regional Percentile Rank for Government Effectiveness 207 10.6 Regional Percentile Rank for Regulatory Quality 208 10.7 Regional Percentile Rank for Rule of Law 208 10.8 Regional Percentile Rank for Control of Corruption 210 10.9 Correlation of Economic Performance and Institutional Quality 212 11.1 Net Primary Enrollment Rates by Region 223 Contents xiii 11.2 Average Educational Attainment by Region, 2000 224 11.3 Primary School Enrollment and Completion Rates for Select Countries 225 11.4 Primary Completion Progress in Africa, Middle East and North Africa, and South Asia 230 11.5 Primary Completion Progress in Latin America and the Caribbean, East Asia and the Pacific, and Europe and Central Asia 230 11.6 Primary School Completion Rates and Gross Enrollment Ratios in a Sample of Low-Income Countries, 1990­2000 233 12.1 Income and Life Expectancy 247 12.2 Health and Gross Domestic Product 248 12.3 Comparison of Full Income and GDP per Capita, Kenya 251 12.4 Spending on Health in the HIPCs That Have Reached the Decision Point, 1999 258 12.5 Annual Percentage Change in Health Spending and Social Indicators, 1985­99 258 13.1 Income Inequality (Gini Coefficient) in Select Countries, 1992­2007 287 13.2 Educational Attainment by Region 288 13.3 Child Labor Participation and GDP per Capita 291 14.1 Initial Land Distribution and Growth by Economy, 1960­2000 298 14.2 Agriculture's Contribution to Growth 308 15.1 Global Competitiveness Index 325 15.2 Changes in the Production-Possibility Frontier 326 15.3 Early-Stage Entrepreneurial Activity Rates and GDP per Capita 329 15.4 Global Entrepreneurship Monitor Model 330 16.1 Urban and Rural Populations of the World 338 16.2 Distribution of the World's Urban Population 340 16.3 Urbanization and Economic Growth 341 16.4 Share of Slum Population in Urban Areas in Select Asian and Pacific Countries 346 16.5 Global Distribution of Megacities 349 16.6 Investment Needs for the Energy and Water Sectors, 2005­30 350 18.1 Effect of (Higher) Minimum Wage on Employment 376 18.2 Cost of Mandated Benefits 378 xiv Contents 18.3 Average Per Capita GDP Growth and Ease of Doing Business 381 18.4 Regulation and GDP per Capita 389 18.5 Informal Economy across Several Countries and Sectors 390 19.1 Commodity Price Growth and Real GDP Growth in Sub-Saharan Africa, Three-Year Moving Average 399 19.2 Common Characteristics of the 13 Successful Economies 413 19.3 Obstacles to Growth 417 20.1 Economic Freedom and Political Rights Are Positively Associated 427 20.2 Politics and Inequality of Influence Can Be Measured: A Major Governance Challenge 431 21.1 Composition of Natural Wealth in Low-Income Countries, 2005 442 21.2 Resource Abundance and Capital Accumulation 444 21.3 Rise in Temperature Will Lower Per Capita Income 451 Tables 1.1 Percentage of People in the Developing World Living on Less than $1.08 and $2.15 per Day 21 1.2 Cambodia: Poverty Measures 25 2.1 Hypothetical Example of the Expenditure Approach to GDP 35 2.2 PPP-Adjusted GDP per Capita in the European Union, 1999 40 2.3 Examples of Credit and Debit Items in the Balance of Payments 44 3.1 Economic Policies and Growth--A Review of the Evidence 58 3.2 Examples of the Link between Economic Growth and Poverty 66 5.1 Growth, Inflation, and the Human Development Index 107 6.1 Possible Effects of Various Policies on the Financial System 116 6.2 Remittance Flows to Developing Countries 125 7.1 Net Disbursements of ODA by Donor Type 138 7.2 Net Capital Inflows to Developing Countries 142 7.3 Net Capital Inflows to Developing Regions 144 Contents xv 7.4 Net Official Flows to Developing Countries 145 7.5 International Action to Improve Aid Effectiveness 157 8.1 HIPCs: Paris Club Reschedulings by Type of Terms, 1976­98 175 8.2 Status of 39 Countries under the Enhanced HIPC Initiative--2010 177 10.1 Correlation between Institutions and Economic Performance 212 11.1 Primary Completion Progress (Population Weighted) 227 11.2 Proportion of Children Completing Primary School: Averages in Select Countries and Regions 228 11.3 Prospects for Achieving UPE by 2015 231 11.4 Benchmarks for Primary Education Efficiency and Quality 232 11.5 Current Expenditures on Primary Education 234 11.6 Estimated Annual Financing Gap by Region, 2000 235 12.1 Life Expectancy and Mortality Rates by Country Development Category 242 12.2 Summary of Studies of the Macroeconomic Impact of HIV/AIDS in Africa 244 12.3 Annual Growth Rate of Per Capita Income 249 12.4 Life Expectancy 252 12.5 Trends in Development Assistance for Health 255 12.6 Development Assistance for Health in Select Countries, 2002 257 12.7 U.S. President's Emergency Plan for AIDS Relief (PEPFAR) 260 13.1 Vulnerable Employment Shares, World and Regions 271 13.2 Working Poor Indicators, World and Regions ($1.25 a Day) 273 13.3 Working Poor Indicators, World and Regions ($2 a Day) 274 13.4 Employment Elasticities by Sector for 139 Countries, 1991­2003 275 13.5 Employment Elasticities and Average Annual GDP Growth by Developing Region 276 13.6 Employment Elasticities and Growth by Sector and Region, 1991­2003 277 13.7 Annual Real GDP Growth Rates, World and Regions 278 13.8 Output per Worker, Level, and Growth Rate 279 xvi Contents 13.9 Labor Supply Trends by World, Region, and Income 283 13.10 Unemployment Rates by World, Region, and Economy 284 13.11 Unemployment Rates for Youth by World, Region, and Economy 285 13.12 Labor Force Participation Rates of Females by World, Region, and Economy 290 14.1 Characteristics of the Three Economies 307 15.1 Indexes of Average Gross and Net TFP­Adjusted Prices in Selected African Countries Relative to China, 2000­04 321 16.1 Rate of Regional Urbanization 339 16.2 Urban Poverty Estimates, 2002 343 16.3 GDP of Urban Areas Compared with National GDP 344 16.4 Regional Characteristics of Slums, 2001 347 16.5 Housing Rates by Type and Country Income Group, 1990 351 19.1 Importance of Avoiding Downturns in Growth 398 19.2 North­South Links 405 19.3 Thirteen Successful Economies 412 21.1 Savings, Fuel Use, and CO2 Emissions by Region and Income Group 449 21A.1 Procedure: Random Effects GLS Regression (Dependent Variable: Log GDP) 453 21A.2 Procedure: Random Effects GLS Regression (Dependent Variable: GDP Per Capita Growth) 455 21A.3 Wealth Effect on GDP per Capita 456 Preface This volume is an introduction to the theories and policies that affect eco- nomic growth and poverty. It is a compilation of lecture notes used in face-to-face and e-learning courses presented by the World Bank Institute's (WBI) Poverty Program during 2004­08. The Poverty Program is one of WBI's core learning programs. The discussion is less technical than others, and the intended audience includes policy makers, policy ana- lysts, and representatives of donor agencies and civil society organizations. The volume is divided into three parts. Part I discusses basic concepts and measurement issues pertaining to poverty, national income, and economic growth. Part II deals with the macroeconomic policies that are critical for economic growth in the short term. It covers government- enforced fiscal and exchange-rate policies and the roles of financial institutions, development assistance (or aid), debt relief, and trade poli- cies. Part III covers the structural and sectoral policies that affect longer- term economic growth and poverty reduction. To underscore the impact of good governance and effective service delivery in growth and poverty reduction, separate chapters are devoted to institutional and technological development, education, health, labor, and land. Newer growth issues--urbanization, regulation, infrastructure, the informal economy, the political economy of policy making, volatility, and the xvii xviii Preface globalization of financial flows--are also discussed. So-called natural capital and climate change are introduced and linked to growth. The volume ends with a chapter that summarizes our knowledge of growth theory, reviews the process of growth in 13 successful countries, and draws out implications for other developing countries. We hope that this chapter may be of help to policy makers in identifying the con- straints to economic growth and development that may be unique to each country. Throughout, attempts have been made to bring together theoretical discussions with empirical evidence to give readers a clearer picture of the impact of economic policies on growth and poverty reduction. The lecture notes that underpin this volume were prepared under the guidance of Roumeen Islam. Research assistance from Indira Iyer and Oliver Rajakaruna and the financial support of the government of Japan are greatly appreciated. Abbreviations ADF African Development Fund AE adult equivalent AfDB African Development Bank AfDF African Development Fund AIDS acquired immune deficiency syndrome BMGF Bill and Melinda Gates Foundation C consumption CarDB Caribbean Development Bank CAMELS capital adequacy, asset quality, management soundness, earnings and profitability, liquidity, and sensitivity to market risk CAB current-account balance CBN cost-of-basic-needs CE Council of Europe CEPR Centre for Economic Policy Research CIS Commonwealth of Independent States CMH Commission on Macroeconomics and Health CPI consumer price index DAC Development Assistance Committee DAH development assistance for health xix xx Abbreviations EBRD European Bank for Reconstruction and Development EC European Commission ECA export credit agency EFA Education for All ESAF Enhanced Structural Adjustment Facility, IMF EU European Union FDI foreign direct investment FEI food-energy intake FTI Fast-Track Initiative G-3 Group of Three G-7 Group of Seven G-8 Group of Eight GAVI The Global Alliance for Vaccines and Immunisations GDP gross domestic product GEF Global Environment Facility GEM Global Entrepreneurship Monitor GER gross enrollment rate GF Global Fund GFATM Global Fund for AIDS, TB, and Malaria GHG greenhouse gas GNDI gross national disposable income GNI gross national income GNP gross national product HBS household budget survey HDI Human Development Index HIPC Heavily Indebted Poor Countries (Initiative) HIV human immunodeficiency virus I investment IAEA International Atomic Energy Agency IBRD International Bank for Reconstruction and Development ICT information and communication technology IDA International Development Association IDB Inter-American Development Bank IDP internally displaced persons IFAD International Fund for Agricultural Development IFC International Finance Corporation Abbreviations xxi IFI international financial institution IFMC International Monetary and Financial Committee ILO International Labour Organization IMF International Monetary Fund LSMS Living Standards Measurement Study M imports MDGs Millennium Development Goals MDRI Multilateral Debt Relief Initiative MFI microfinance institution NDP net domestic product NER net primary enrollment rate NGO nongovernmental organization NPV net present value ODA official development assistance OECD Organisation for Economic Co-operation and Development OLS ordinary least squares PCR primary completion rate PEPFAR/ Emergency Plan President's Emergency Plan for AIDS Relief PFM public financial management (system) PIU project implementation unit PPP purchasing power parity PRGF Poverty Reduction and Growth Facility, IMF PRSP Poverty Reduction Strategy Paper R&D research and development SAF Structural Adjustment Facility, IMF SAR Special Administrative Region SEEA System of Integrated Environmental and Economic Accounting TB tuberculosis TFP total factor productivity TI Transparency International UN United Nations UNAIDS Joint United Nations Programme on HIV/AIDS UNDP United Nations Development Programme UNECE United Nations Economic Commission for Europe UNESCO United Nations Education, Scientific and Cultural Organization xxii Abbreviations UNFCCC United Nations Framework Convention on Climate Change UNFPA United Nations Population Fund UNHCR United Nations Refugee Agency UNICEF United Nations Children's Fund UNRWA United Nations Relief and Works Agency for Palestine Refugees in the Near East UNTA United Nations Transitional Authority UPE universal primary education VA value added VAT value added tax VSL value of a statistical life WBI World Bank Institute WDI World Development Indicators WEF World Economic Forum WFP United Nations World Food Programme WHO World Health Organization WPI wholesale price index X exports All dollar amounts are U.S. dollars unless otherwise indicated. Introduction The story of growth and poverty reduction in our changing world is much debated. A half-century ago, the challenge was to lift low-income coun- tries from the trap of self-perpetuating low growth to a path of higher growth. Today, many economies in the developing world are growing quickly, but more than 100 countries remain mired in conditions of low growth and high poverty. Between 1960 and 2008, three major shifts affected our thinking about growth and poverty. These big shifts were (a) from the "commanding heights" of state-directed development to market-driven approaches; (b) from structural concerns with deregulation, liberalization, and privati- zation to a new view of the sectoral sources of growth, particularly agri- culture and financial services; and (c) from macroeconomic approaches to growth to microeconomic (and now macro­micro) ones. Somewhere along the way, the recognition grew that poverty reduction was a goal in itself and need not depend on how fast or slow a country was grow- ing. It was also recognized that, by riding the wave of globalization that swept the world beginning two decades ago, countries could grow very quickly indeed and lift millions out of poverty--China is the prime exam- ple. But the global economic crisis that reached a crescendo in 2008 threat- ens now to undo those gains. More shifts in thinking may be required. 1 2 Understanding Growth and Poverty In the 1960s, the conventional wisdom in economics was that invest- ment in physical capital would lead to growth and that, as long as there was growth, the benefits would trickle down to the poor. Import substi- tution policies were in vogue at the time. The importance of the private sector was acknowledged, and the International Finance Corporation (IFC)--the private sector arm of the World Bank--was set up in 1956. In the early 1970s, when the trickle had failed to materialize, a new mantra emerged. "Redistribution with growth" emphasized the basic needs of the bottom 40 percent of the population. Pro-poor policies for managing education, health, water, and demographics were deemed important. But the oil shocks of 1973 and 1979­80, as well as the accompanying com- modity price shocks (for example, in sugar and copper), riveted the atten- tion of economists and policy makers on ways to achieve macroeconomic stability by reducing domestic demand, curbing inflation, and improving the balance between the internal and external economies. Moreover, lend- ing under the International Monetary Fund's (IMF) structural adjustment facility, introduced in 1986, required loan recipients to agree to a macroeco- nomic program, underscoring the importance of a country's macropolicy environment. Concerns about getting prices right led to the deregulation of prices, the liberalization of trade and agriculture, and the privatization of public enterprises, along with a paring down of the role of the state. As the East Asian economies grew rapidly in the 1980s, with a spectacular record of exports, and as growth reduced poverty in those countries, export-led growth became the new rallying cry. China's rapid growth and its success in lifting millions of Chinese out of poverty appeared to confirm the ben- efits of open economies and free trade. But with the collapse of the Soviet bloc and its command economies, the key role of institutions that support the functioning of markets became plainly apparent, as policy makers in the Russian Federation, Central and Eastern Europe, and Central Asia struggled to make the transition from centrally planned economies to market-based ones. Economists developed a new appreciation for the role of property rights, the rule of law, and other institutions in sustaining growth and ensuring equity. A surge in the globalization of goods, services, capital, and labor after the East Asian crisis of 1997­98 ushered in a period of remarkable growth in the developing world, but that long run ended abruptly with the arrival of the global crisis of 2007­09, which now threatens the gains made since the 1990s. How that crisis will shape our view of the road to growth is not yet clear. But it is our hope that the half-century of accumulated experience reported Introduction 3 in this volume will influence economists and policy makers, enabling them to make choices that are well informed by the knowledge of what has gone before. Our overarching aim is to give the reader a broad understanding of the impact of economic policies on growth and poverty reduction in devel- oping countries. After describing basic economic relationships that sum- marize the workings and the measurement of the macroeconomy--and after confirming that growth is the most critical factor in alleviating poverty--we turn to individual policy areas. These include the various roles of government, among them setting fiscal policy and maintaining an environment conducive to the effective operation of a market economy. Policies governing money supply, exchange rates, and the financial sector are also covered. After assessing several decades of experience with development assistance, the aim of which has been to place poor countries on a path of sustainable long-run growth, our study turns to a discussion of external debt. In the 1980s and 1990s, debt contracted by low-income countries from commercial and official sources became unsustainable, crippling their growth, keeping millions in poverty, and forcing an international reappraisal of lending policies, the centerpiece of which was a set of debt-forgiveness policies that was put forward with the launch of the Jubilee 2000 debt relief campaign. The remainder of the volume examines problems that can keep the poor from moving out of poverty. Trade, institutional devel- opment, regulation, education, health, labor markets, land and agricul- ture, natural resources, urbanization, technology, and politics--all are core components of public policy and need to be handled correctly if poverty is to be addressed effectively. Because many developing countries lack the capacity to mobilize resources--administrative and financial-- to move the poor out of poverty, the international community must be actively involved. The first step in understanding the policies needed to reduce poverty in developing countries is to analyze poverty data. This requires an aggre- gate measure of poverty, a difficult task and the subject of chapter 1. While nonmonetary aspects of poverty (such as access to services) are critical, monetary aspects lend themselves more easily to measurement. Fairly narrow indicators of welfare based on individual household con- sumption are generally used. These are then compared with a minimum standard of those indicators, known as the poverty line. From that com- parison, summary statistics are computed to provide an overall measure of poverty in a given country. 4 Understanding Growth and Poverty The second step is understanding the key relationships among the var- ious economic agents in an economy. Macroeconomics is the branch of economics that studies those relationships in the context of the national economy. Three approaches, described in depth in chapter 2, are used to measure aggregate economic activity: production, expenditure, and income. With the tools of the first two chapters, we are equipped to ana- lyze the important questions of how various policies influence poverty in developing countries. Turning from theory to real-world findings in chapter 3, we find that sustained economic growth is the most critical factor in alleviating poverty. That said, there are differences across countries in how poverty responds to growth. The initial level of income inequality and changes in inequality over time play an important role here, as do growth patterns and stages of economic development. These differences have led to a focus on pro-poor growth, defined as the variants of the growth process that are most effective in raising the incomes of the poor. As discussed in the chapter, assessing whether growth is pro-poor requires detailed infor- mation on changes in income and its distribution--and the extent to which those changes improve the welfare of the poor. Focusing next on specific areas of public policy, we describe the roles that governments can play in an economy. Chapter 4 explores how gov- ernments can create conditions that are conducive to the effective oper- ation of a market economy. These include establishing a sound legal and social framework, providing public goods (such as roads), regulating eco- nomic activity, redistributing wealth, and stabilizing the economy. The chapter then examines fiscal policies, treating expenditure and taxation policies in turn, before looking at the impact of fiscal policy on the busi- ness cycle, private investment, and inflation. The chapter concludes by investigating the ways fiscal policy can benefit the poor, primarily through government expenditure. Monetary and exchange-rate policies also play an important role in the economy. After examining the nuts and bolts of monetary policy, chapter 5 explores the different forms, causes, and measures of inflation. We show that although a loose monetary policy can help the economy in the short run, it usually results in high and volatile inflation, the costs of which are typically borne most heavily by the poor. We also show that low infla- tion is good for long-term growth and for poverty reduction. Various exchange-rate policies are then examined, ranging from formal dollariza- tion to free-floating exchange-rate regimes. The choice of regime depends Introduction 5 on a country's characteristics, including its inflation performance, mone- tary credibility, trading patterns, and vulnerability to external shocks. The causal link between a well-functioning financial system and eco- nomic growth, as described in chapter 6, has been firmly established. The converse also holds: poor macroeconomic fundamentals, including imbal- anced growth and high inflation, can hinder development of the financial system. While the link between financial development and income inequality remains less clear, recent empirical studies have found that financial development tends to reduce income inequality. Where financial markets remain underdeveloped, policy measures are needed to widen access of the poor to financial services--by strengthening institutional infrastructures, liberalizing markets, and fostering greater competition. We describe how developing countries have progressively liberalized their financial systems in recent decades, freeing interest rates, improving legal and supervisory frameworks, and increasing transparency. The increasingly important role played by microfinance and emigrants' remit- tances is the final topic of the chapter. Is development assistance effective in spurring growth and reducing poverty? Because the record is mixed, the scaling up of aid poses a daunt- ing policy challenge for both developing countries and donors. For an understanding of how future aid flows might best be used, chapter 7 examines the international aid record from the 1950s to the present, comparing trends in both official and private capital flows to developing countries. Private flows have swelled in recent decades, while official aid dipped in the mid-1990s and began to recover only in 2005 before being imperiled again by the global economic crisis. If the Millennium Development Goals (MDGs) promulgated by the United Nations in 2000 are to come close to being met, it is important not only that aid be increased but also that it be made more effective. While the vast literature on the efficacy of aid is inconclusive, a key find- ing, one picked up by policy makers, is that aid works best in good policy environments. Recent literature also suggests that the type of aid matters-- that is, not all aid should be aimed at achieving higher growth. Chapter 7 also includes a discussion of the so-called Dutch disease, which can affect a country's competitiveness by causing its currency to appreciate as aid is scaled up. Recent research suggests that, generally, aid should be spent by the government over the long run, with the liquidity impact managed by the sale of foreign exchange by the central bank. This, of course, requires good coordination of fiscal and monetary policies. 6 Understanding Growth and Poverty In parallel with increases in development assistance, developing coun- tries' debts have been forgiven to free up funds for high-priority purposes and to avoid the negative outcomes associated with chronic debt "over- hangs." According to the debt-overhang theory, which appears to be borne out by the empirical evidence discussed in chapter 8, debt lowers growth by curtailing investment and social spending, thereby reducing the poten- tial for poverty reduction. We then turn to a discussion of the unsustain- able debt burden experienced by low-income countries beginning in the 1980s and the response of the international financial community. The chapter describes debt-relief programs, beginning with the first noncon- cessional arrangements of the 1980s and continuing through to the Heavily Indebted Poor Countries (HIPC) Initiative and the most recent Multilateral Debt Relief Initiative (MDRI) under which the debt burdens of the poorest developing countries have been written off in their entirety. The chapter ends with a discussion of the relative merits of development assistance and debt relief in the context of growth for devel- oping countries. In chapter 9, we investigate how developing countries (except those in Sub-Saharan Africa) have opened their economies to trade in recent decades. During the same period, flows of foreign direct investment to developing countries have intensified. Although the relationship between openness and inequality is inconclusive, the evidence suggests that trade is good for growth and that growth, in turn, is good for the poor. But to work best, the policies that a country uses to open itself to trade must be properly sequenced and coordinated. Domestic policies aside, advanced countries have the power to greatly increase the benefits of agricultural trade to the developing world. They could do so by reducing the subsi- dies they provide to their farmers, which make it nearly impossible for developing-country producers to compete in important global agricul- tural markets. The monetary value of such subsidies dwarfs the aid pro- vided to poor countries. The role of institutions and technology in promoting or discouraging growth is examined in chapter 10. Institutions are much more than build- ings and organizations. They include the informal rules and norms that govern personal and social behavior, as well as the formal rules and norms that provide the predictability needed for societies to function. We focus on institutional quality, property rights, and governance. Governance is a multifaceted concept that encompasses citizens' voices and government accountability, political stability, government effectiveness, regulatory quality, the rule of law, and corruption. The empirical literature clearly Introduction 7 shows that institutions matter greatly for economic growth. Far less is known about how to develop high-quality institutions that are appropri- ate for a given country's stage of development. Likewise, technological development has been shown to increase eco- nomic growth, but debate abounds on whether it is endogenous (inter- nal) or exogenous (external) technological change that drives the growth process. It is well documented, however, that latecomers can leapfrog across several stages of development and that the channels of technology diffusion are many. Turning in chapter 11 to public policy in developing countries, we first examine the role of education in the lives of the poor and its implications for economic growth and poverty reduction. The chapter begins by not- ing the positive impact of education in stimulating economic growth and combating poverty, a benefit emphatically confirmed in empirical litera- ture. Although major progress has been made in recent decades to improve access to education in developing countries, a proper education remains out of reach for many of the world's poor, particularly in Africa. Gender inequality is also a particularly severe problem in education, with girls receiving less education than boys. A number of global initiatives have accorded high priority to improving education in developing coun- tries. One of the MDGs, for example, is to achieve universal primary com- pletion by 2015. While some poorer regions appear on track to achieve that goal, this is not true for most countries in Africa, the Middle East, and South Asia. Many countries in these regions are not in a position to mobilize the resources needed to provide even universal primary educa- tion. We conclude the chapter by noting that, although the amount of aid devoted to education has increased in recent years, it still falls far short of what is needed. Basic health care is also critical for economic progress, yet for many of the world's poor this basic right remains out of reach. The disparity in health indicators across countries is still very wide. Developing countries' health records--and the responses of the international donor community-- are the subject of chapter 12. Corruption, mismanagement, weak admin- istrations, and a shallow pool of financial resources make it difficult to stop diseases that are easily prevented in better environments. At the same time, the widely acknowledged human and economic costs of poor health care in the developing world are being tackled at the international level. Health reforms adopted under national poverty-reduction strategies are being supported by donors, even as other forms of development assis- tance are scaled back. But even greater financial assistance is needed. 8 Understanding Growth and Poverty The labor market is one of the main conduits through which economic growth can reduce poverty. Chapter 13 examines labor markets in devel- oping countries. Countries in which the labor force is large or growing quickly often choose a pattern of economic growth that provides jobs. This is understandable, as employment is the surest way out of poverty. But the cost of labor-friendly economic growth often results in low labor productivity; thus, labor-friendly growth can become self-limiting. That said, because the labor force is growing quickly in many developing coun- tries, often accompanied by a shift away from agricultural employment, some form of labor-friendly growth may be called for if an increase in unemployment or an increase in so-called informal employment is to be avoided. Other labor concerns highlighted in the chapter are unequal wages and marked differences in access between men and women to the labor market. Access to and ownership of land are particularly important for helping the poor move out of poverty. Owners of land have a greater incentive than nonowners to make their land more productive, and land can be used as collateral to raise funds for investment in greater productivity. Chapter 14 examines constraints on access to and ownership of land in developing countries. It starts by examining how the history of land tenure in many developing countries prevented much of the population, particularly women, from gaining secure title to land. We go on to show how inequality in the distribution of land seriously affects three key aspects of economic development: institutional development, education, and financial development. Governments can play an important role in redressing problems in this area--for example, by establishing institutions to facilitate the transfer and exchange of land rights (and property rights more generally). A further legitimate role for government is the imple- mentation of second-generation reforms that address insecurity of land rights through registration and titling. The chapter ends on a cautionary note, indicating that, although such reforms have been successful in cer- tain regions, including Latin America, it is not clear that they would be effective (or are needed) in every region, given the hold of traditional sys- tems of informal tenure. Increasing productivity is a sure way to spur economic growth. Produc- tivity is defined as output growth (the sum) that is greater than the growth in inputs (the parts). Chapter 15 focuses on innovation and technological absorption as critical for improving productivity. Although most developing countries have policies designed to encourage the adop- tion of technologies generated by advanced economies, our knowledge Introduction 9 about the particular policies that will directly enhance technological suc- cess, and thus raise productivity, remains inadequate. Entrepreneurship appears to be a key factor in promoting technological innovation and the commercialization of new technologies. Small and medium-size firms, not large companies, are still the center of technological inno- vation and adoption. Urbanization signals modernization and industrialization and is viewed as a natural part of an economy's transition from low-productivity agri- culture to higher-productivity industry and services. At the same time, rapid urbanization puts stress on the provision of basic infrastructure services--water, sanitation, electricity, and roads. With the world's urban population projected to double by 2050, chapter 16 discusses the progress of urban growth across countries and lays out emerging issues in urbanization. These include unemployment, poverty, slums, megacities, land management, and housing. To meet the MDGs, countries must address these issues. Once optional, urban planning is now a necessity. Corruption, the topic of chapter 17, undermines growth and poverty reduction. The private sector and public employees share the blame. We focus on institutional and governance issues associated with the growth-- and control--of corruption. Those factors include the rule of law, crime and violence, voice and accountability, and transparency. The right amount of regulation of products, labor markets, businesses, and financial institutions is important for economic performance, as noted in chapter 18. Over- and underregulation are equally likely to strangle mar- kets, depriving governments of tax revenues. In almost all developing coun- tries, the failure to find the right level of regulation has driven economic activity underground, swelling the so-called informal sector. Bureaucratic harassment, corruption, and poor provision of essential infrastructure contribute to this unhealthy phenomenon. Managing growth in the face of externally induced economic shocks is a continuous challenge for governments in the developing world. Middle East oil producers and many African countries that export primary com- modities face a special challenge in responding to unpredictable dips and spikes in prices that make it difficult to maintain a consistent level of con- sumption at home and a steady pace of growth. Chapter 19 traces the channels through which shocks travel around the world. Through the effect of shocks on commodity prices, interest rates, and exchange rates, policies in the industrial world often hit developing countries in a man- ner similar to natural disasters such as tsunamis, floods, and earthquakes. Despite prodigious expansion in recent decades, the world's trade and 10 Understanding Growth and Poverty financial systems are still ill prepared to deal with large-scale, highly contagious financial crashes, such as those observed during the 1980s, the late 1990s, and 2007­09. During global crises, we still must expect that policy responses will be largely improvised and institutional arrangements ad hoc. Policy makers will face domestic pressure to resort to short-term fixes and policies, such as protectionism, that have been proven to be self-defeating. The maintenance of sound economic policies makes more sense, even during periods of crisis, and provides much greater opportunities for growth. Only 13 developing countries have been able to sustain high growth for 25 or more consecutive years. The economic policies common to those countries are discussed in chapter 19. The essence of those policies is the maintenance of macroeconomic stability, which involves keeping inflation in check, fiscal deficits and debt ratios low, and savings and invest- ment rates high. Other policies and practices common to the successful 13 were engagement with the global economy, reliance on markets, free movement of labor and capital, and strong political leadership. At the firm level, efficiency was promoted by improving the investment cli- mate to stimulate economic activity and sustain growth. For successful low-income countries, agricultural growth was also vital for reducing poverty and protecting overall growth. Economies rarely thrive in the throes of political instability, but that does not mean that stability will ignite or sustain growth. If the political system is stable but inequitable and stultifying, the economy will function only within narrow limits. Chapter 20 provides a glimpse into systems where elites benefit at the expense of the poor, where collusion among large firms, politicians, and the bureaucracy perpetuates traditional power structures. In such systems, a small group of elites monopolizes economic rewards--including public services--to the detriment of the poor and the middle class. Only sustained pressure from domestic advocacy groups and the international community can move elites in such countries to imple- ment the reforms necessary to increase equity and growth. Too often, growth has been based on the depletion of nonrenewable natural capital. Chapter 21 focuses on the problems of deforestation, high carbon emissions, and climate change. In such circumstances, it can be said that markets have failed in both a narrow sense, because those who reap benefits from actions that result in deforestation and pollu- tion do not incur the costs of those actions, and a broad sense, because sooner or later growth based on the exploitation of natural resources will sputter, as stocks of those resources dwindle. Ultimately, the problem Introduction 11 affects everyone on the planet. Global problems call for global solu- tions, with advanced and developing countries taking coordinated actions to dramatically reduce carbon emissions, combat deforestation, and encourage effective market mechanisms that recognize the full costs of economic transactions. The literature on growth and poverty is voluminous and still evolving. In the short chapter that concludes this volume, we attempt to distill the most important lessons from our experience with growth and poverty. We observe that poverty and inequality in income and assets are more persistent over time than is growth. Especially in Latin America, those conditions can be traced to historical factors, inherited economic struc- tures, and particular resource endowments. Yet even under such circum- stances, targeting policies and programs toward the poor can help reduce social inequities while simultaneously enhancing growth. Moving toward a virtuous circle of growth and poverty reduction requires complemen- tary policies in several areas. For instance, the poor have access only to substandard schools and receive public services of low quality. Poor regions are less likely than more prosperous regions to attract investments in infrastructure, which keeps them poor. Because poor people can expect lower returns on their investments in education and training, they are less likely to make those investments. Social safety nets that reduce the risks of unemployment in poorer regions might induce more poor people to invest in education. There is ample evidence that history, in the form of initial conditions, shapes long-term growth, while short-term fluctuations in output growth are driven primarily by shocks, especially commodity booms and busts. To weather the shocks, savings rates should be increased during booms, but it is unclear how best to accomplish that goal. To avoid the worst effects of downturns, expansionary fiscal policies that focus on essential infra- structure construction and on protecting the poor through social safety nets are appropriate. In some countries, high levels of remittances from migrant workers have acted as private safety nets during downturns and helped to smooth consumption in the short term. In the long term, resilience depends on political stability and market-supporting institu- tions that protect property rights, ensure the rule of law, process financial transactions efficiently, invest in robust infrastructure, and encourage the formation of human capital through education. With such institutions in place, openness to free flows of goods, capital, and skilled labor will enhance growth by promoting global competition, spreading new tech- nologies, and encouraging urbanization. Although economic development 12 Understanding Growth and Poverty is associated with dynamic manufacturing and service sectors (where innovation and technological adoption flourish), agricultural employment will remain important as a source of jobs in low-income countries as they make the transition to higher growth. Looking ahead, rates of growth and poverty will be determined by the way nations use knowledge, technology, and energy in firms and house- holds and by the effects of the warming climate on economic activities. Above all, the distribution of political and economic power within and among countries will determine the direction and dynamics of growth and development. The challenge today remains essentially that of the 1960s: how to lift people out of the trap of low growth and high poverty. We have traveled the world only to return home. PA R T I Poverty, National Income, and Economic Growth CHAPTER 1 Poverty and How We Measure It To design effective policies and strategies to reduce poverty, it is critical to understand its characteristics in a given country or region. The tech- niques of poverty measurement can shed light on whether poverty is increasing or decreasing and on whether economic growth is benefiting the poor. Poverty profiles of countries and regions can help governments identify the poor by region, level of education, ethnicity, gender, or form of employment. Figure 1.1, for example, depicts the distribution of the poor in Thailand in 1988, 1994, and 2002--the incidence of poverty decreased significantly between 1988 and 2002. With good poverty data, the effects of government policies on the poor can be evaluated, and the forms of growth that have a better chance of benefiting the poor can be identified and promoted. Poverty and Well-Being Measuring the characteristics and extent of poverty requires a definition of well-being, a concept that can be approached from many angles. Well- being can be defined as command over commodities or resources, as access to assets, or as the ability to function in society. Poverty, then, would be defined as a condition involving critical shortages of those 15 16 Understanding Growth and Poverty Figure 1.1 Distribution of the Poor in Thailand 1988 1994 2002 Source: Jitsuchon and Richter 2007, 244. Note: Each dot represents 10,000 people who are poor, measured by the Poverty Headcount Ratio. elements. As a practical matter, the measurement of poverty focuses on assessing whether individuals and households have enough resources to meet their basic needs. Although commonly used techniques for measuring poverty focus on the monetary aspects of poverty, nonmonetary dimensions are important and should not be forgotten. The poor are seldom poor only in income. In addition to having little money, they are more likely than the nonpoor to be cold, hungry, malnourished, illiterate, sick, unemployed, alcoholic, depressed, or excluded from society. Thus, poverty is not just a shortage of quantifiable resources but a more general state of vulnerability marked by a lack of access to health services and education, low self-confidence, and a sense of powerlessness. Generally defined as the risk associated with being poor or of falling deeper into poverty, vulnerability is a key compo- nent of well-being. It is only because these important concepts are diffi- cult to measure that they are excluded from most poverty measures. Most often, well-being is measured through inputs--the number of calories consumed in a day, or food consumption as a fraction of total spending. But it is also possible to measure outcomes, such as rates of malnutrition. At the community level, welfare can be evaluated by looking at life expectancy, infant mortality rates, or school enrollment. Properly viewed as complements to, rather than replacements for, the Poverty and How We Measure It 17 more commonly used measures of per capita consumption, these meas- ures provide a more complete and multidimensional view of the well- being of a population. In sum, there is no perfect measure of well-being or poverty. But that does not mean poverty should not be measured; rather, it argues for a degree of caution in our approach to poverty measures and for care in analyzing how the measures are constructed. Measuring Poverty Measuring poverty requires three basic steps: · An indicator of welfare must be defined. · A minimum acceptable standard of that indicator must be established to separate the poor from the nonpoor. That standard is often known as the poverty line. · A summary statistic must be devised to aggregate the information obtained from the distribution of the chosen welfare indicator. The position of that summary statistic relative to minimum acceptable standards must be determined. As noted, the broad concept of well-being forms the basis of our over- all approach to poverty, but the most common way of measuring poverty focuses on economic welfare--in other words, the monetary aspects of poverty, as in figure 1.2. Figure 1.2 shows the proportion of people living on less than $1.25 a day. Approximately one-quarter of the developing world's population, or 1.4 billion people, lived on less than $1.25 a day in 2005. This was an improvement on the 1981 figure of 1.9 billion people, or one-half of the developing world's population, but the progress across regions was uneven. Consumption- and Income-Based Measures of Welfare It is possible to measure household welfare by looking at household income (as opposed to household expenditures), but several complica- tions often make it a second choice for poverty analysts. For one thing, households may be reluctant to report income if they have engaged in tax evasion or have illegal earnings; generally, they are more willing to report what they have spent than what they have earned. In addition, some types of income are not always easy to measure, such as farm income or changes in the value of assets (for example, farm inventories or 18 Understanding Growth and Poverty Figure 1.2 Proportion of the Developing World's Population Living on Less than $1.25 a Day 90 80 70 % living below $1.25 a day 60 50 40 30 20 10 0 81 84 87 90 93 96 99 02 05 19 19 19 19 19 19 19 20 20 East Asia and Pacific Eastern Europe and Central Asia Latin America and the Caribbean Middle East and North Africa South Asia Sub-Saharan Africa total Source: Compiled from data in Chen and Ravallion (2008, 42). housing). In addition, the incomes of the poor often vary considerably over time, as, for example, in rural areas dependent on rain-fed agriculture. For these reasons, consumption-based measures of living standards are generally preferred to income-based measures. Consumption is likely to be more stable than income, and consumption-based measures mini- mize the reporting problems noted above. Consumption includes both purchased goods and services and those that are provided from one's own production ("in-kind" sources). Consumption as a measure of well-being is not free of complications, however. In order to make comparisons across households using consump- tion measures of poverty, it is necessary to calculate the value of durable goods owned by the household in the year of measurement, including both the depreciation of the item during the year and the interest cost of having money locked up in the item, as opposed to having that money in an interest-bearing account. It is important to measure durable goods because we know that even some households that cannot afford adequate quantities of food spend some of their money on other items (such as Poverty and How We Measure It 19 clothing). Those items, too, represent very basic needs of the household and should be included in our poverty measures. The potential for error in computing the value and depreciation of each durable good that the household owns can be quite large. Housing must also be included in con- sumption; generally, its cost is estimated by calculating actual rent pay- ments or, as in the case of owner-occupied houses, imputed rent payments (what the household would have to pay in rent if it did not own its home). If poverty is assessed based on household consumption or expenditure per capita, as discussed above, the analysis can include an "expenditure function." In simple terms, an expenditure function shows the minimum expenditure required to meet a given level of need--or, in economic terms, to derive a given level of utility. The level of utility is derived from a list of goods at given prices. If one takes into account those prices and certain household characteristics (such as the number of adults and young children in the household), the expenditure function will compute the amount of spending that is needed to reach a certain level of utility. Accounting for Differences in Household Consumption Since households differ in size and composition, a simple comparison of aggregate welfare can mislead us about the well-being of the individuals in a given household. The most straightforward way of dealing with this problem is to convert from a measure of household consumption to a measure of individual consumption by dividing household expenditures by the number of people in the household. This easy procedure does not take into consideration the fact that different individuals have different needs (a young child typically needs less food than an adult, for example) or that there are economies of scale in the consumption of nonfood items. We deal with this problem by assigning a system of weights, using an equivalence scale that measures the number of adult males to which the household is equivalent. In this way, each member of the household counts as a fraction of an adult male. There is no consensus on an appro- priate scale of equivalence, however, or on its usefulness in practice. Two methods are commonly used to deal with the problem. One is to choose a scale that is already being used; for example, the Organisation for Economic Co-operation and Development (OECD) scale assigns a two- adult household an "adult equivalent" of 1.7. Another is to estimate an equivalence scale for the population by looking at the aggregate house- hold consumption of various goods during a given survey period. The amount of a household's consumption is measured against the poverty line to determine whether that household is in poverty. The poverty line is obtained by specifying a bundle of goods and services 20 Understanding Growth and Poverty considered adequate for basic consumption needs and then estimating the cost of meeting those needs. The poverty line represents a minimum standard required by an individual to fulfill his or her basic food and non- food needs. In practice, it makes sense to define more than one poverty line, because there are many ways to evaluate whether or not an individ- ual or household is poor. A poverty line can be generated for all house- holds in a given group and adjusted from household to household, taking into consideration the differences in prices that they face, as well as dif- ferences in their demographic composition. For example, a small house- hold in a rural area may face low housing costs and relatively modest food prices. Thus, its poverty line (defined in money terms) may be low com- pared to that of a large household living in a city, where housing tends to be more expensive and food prices may also be higher. A poverty profile undertaken in Cambodia in 1999 used an approach along the lines described above, constructing one poverty line for each of the three major regions in the country based on the prices prevailing in those regions. Whether a household in a given region was poor was determined by comparing its expenditure per capita with the regional poverty line. Nominal poverty lines (as opposed to relative ones) can change over time, owing to changes in prices (typically from inflation) or revisions of the real poverty threshold. This raises the question of whether relative or absolute poverty lines should be used. Relative poverty lines. Focusing on the poorest segment of a given population at a given time enables the design of targeted programs geared toward that segment rather than toward those who are rela- tively better off. Relative poverty lines need to be tailored to the over- all level of development of a country; they tend to be revised upward with increases in per capita consumption. As relative poverty lines are defined in relation to the overall income distribution within a coun- try, comparison of relative poverty across countries may not be of any relevance. For instance, while the poverty line for a family of four in the United States in 2006 was $20,650,1 the incomes of those living in relative poverty in the United States cannot be compared to those living in relative poverty in Vietnam because living standards and prices in the two countries differ significantly. Absolute poverty lines. An absolute poverty line is fixed over time, enabling poverty analysts to judge the impact of antipoverty policies over Poverty and How We Measure It 21 a period of years and to compare poverty rates across countries (provided the same poverty line is used in all). The World Bank commonly uses two absolute poverty lines--per capita consumption of less than $1.25 a day (formerly $1 a day) and per capita consumption of less than $2 per day in 2005 purchasing power parity terms. Using improved price data from the latest (2005) round of the International Comparison Program at the World Bank, poverty estimates released in August 2008 show that about 1.4 billion people in the developing world (one in four) were living on less than $1.25 a day in 2005, down from 1.9 billion (one in two) in 1981. Table 1.1 reports some historical figures on the incidence of absolute poverty around the world. Table 1.1 Percentage of People in the Developing World Living on Less than $1.08 and $2.15 per Day 1981 1984 1987 1990 1993 1996 1999 2002 2004 $1.08 per day at 1993 PPP East Asia and Pacific 57.73 39.02 28.23 29.84 25.23 16.14 15.46 12.33 9.05 China 63.76 41.02 28.64 32.98 28.36 17.37 17.77 13.79 9.90 Europe and Central Asia 0.70 0.51 0.35 0.46 3.60 4.42 3.78 1.27 0.94 Latin America and the Caribbean 10.77 13.07 12.09 10.19 8.42 8.87 9.66 9.09 8.64 Middle East and North Africa 5.08 3.82 3.09 2.33 1.87 1.69 2.08 1.69 1.47 South Asia 49.57 45.43 45.11 43.04 36.87 36.06 34.92 33.56 30.84 India 51.75 47.94 46.15 44.31 41.82 39.94 37.66 36.03 34.33 Sub-Saharan Africa 42.26 46.20 47.22 46.73 45.47 47.72 45.77 42.63 41.10 Total 40.14 32.72 28.72 28.66 25.56 22.66 22.10 20.13 18.09 Total excluding China 31.35 29.69 28.75 27.14 24.58 24.45 23.54 22.19 20.70 $2.15 per day at 1993 PPP East Asia and Pacific 84.80 77.17 68.53 69.73 65.04 52.49 49.34 41.68 36.58 China 88.12 79.00 68.64 72.16 68.13 53.34 50.05 40.94 34.89 Europe and Central Asia 4.60 3.93 3.08 4.31 16.53 17.97 18.57 12.88 9.79 Latin America and the Caribbean 28.45 32.25 29.57 26.25 24.09 25.24 25.31 24.76 22.17 Middle East and North Africa 29.16 25.59 24.24 21.69 21.41 21.40 23.62 21.09 19.70 South Asia 88.53 87.01 86.57 85.62 82.22 82.12 80.41 79.73 77.12 India 88.92 87.89 86.98 86.30 85.33 84.12 82.67 81.37 80.36 Sub-Saharan Africa 74.52 76.98 77.36 77.05 76.09 76.42 75.85 73.81 71.97 Total 66.96 64.25 60.73 60.79 59.44 55.52 54.24 50.69 47.55 Total excluding China 59.08 58.87 57.89 56.78 56.43 56.26 55.63 53.85 51.58 Source: World Bank 2007. Note: PPP = purchasing power parity. 22 Understanding Growth and Poverty Several important conceptual problems come up when working with absolute poverty lines. First, it is often difficult to agree on a standard of living to be measured by the poverty line. In practice, almost all poverty lines are set in terms of the cost of buying a basket of goods (a commodity- based poverty line), but one can argue that individual standards of living, or "utilities," are independent--that is, a household of four with an income of $12,000 per year would not be considered poor in Indonesia, but when that household compares its position with that of a household with an average income in the United States, it may feel very poor. This implies that the commodity-based poverty line should rise as a country becomes more affluent, both in nominal terms and in terms of purchas- ing power, because the minimum level of resources needed to participate fully in society probably rises simultaneously. In addition, it may be diffi- cult to define the correct commodity value of the poverty line because both the size and demographic composition of households vary. One way to determine the poverty line is to set "objective" standards-- that is, to set the poverty line at a level that enables individuals to achieve certain capabilities, such as leading a healthy and active life and partici- pating fully in society. A common way of approaching this is to begin with nutritional requirements. Two common methods are the food-energy intake (FEI) method and the cost-of-basic-needs approach. The goal of the FEI is to find the level of consumption expenditure (or income) that allows the household to obtain enough food to meet its energy requirements. To do this, one must first determine the amount of food that is deemed adequate. Vietnam, for example, sets this value at 2,100 calories per day, while recognizing that different individuals may need more or less food. After the calorie level is set, food expenditure lines can be estimated by figuring the cost of obtaining the 2,100 calories each day. There are important weaknesses to this approach. For example, the cost and availability of food differ from urban to rural areas, influencing the type of calories that people consume and making comparisons difficult. The cost-of-basic-needs approach uses a consumption bundle that is deemed adequate, including both food and nonfood components, and estimates the cost of the bundle for various subgroups, such as urban and rural residents or the populations of different regions. The key difference in this approach is that the poverty line is measured in money, so it does not insist (as with the FEI) that each basic need must be met, only that it could be met. But this approach poses challenges of its own, among them how to measure the nonfood components of the poverty line, such as home heating needs (countries in colder climates Poverty and How We Measure It 23 will put more emphasis on the cost of energy needed for home heating than will countries in warmer climates). Measures of Poverty--Summary Statistics Armed with information on per capita consumption and a poverty line, several aggregate measures of poverty can be computed: Headcount index. By far the most widely used aggregate measure of poverty is the headcount index, which simply measures the proportion of the population that is counted as poor. The headcount index is simple to construct and easy to understand--both important qualities. But it has sev- eral weaknesses. For one, it does not capture the degree or depth of poverty. Thus, if a somewhat poor household were to give part of its wealth to a very poor household, the headcount index would remain unchanged, even though poverty as a whole would have dropped. The easiest way to reduce poverty as measured by the headcount index would be to target benefits to people living just below the poverty line, because they are the ones who can be moved across the poverty line most cheaply, even though they are not the neediest people in the population. In addition, the headcount index expresses the percentage of individuals who are poor, and not the percentage of households. When we use it, we make the critical assump- tion that all household members enjoy the same level of well-being, which may not be true. Poverty gap index. Another measure of poverty is the poverty gap index, which adds up the distances that poor people fall from the poverty line and expresses the sum as a percentage of the poverty line. The poverty gap index is thought of as a way to measure the total cost of bringing each poor member of a society up to the poverty line, but it depends for accu- racy on exact information on each poor member of society--information that very few governments have. The main drawback of the poverty gap index, however, is that, because it is a measure of the average gap between poor people's standard of living and the poverty line, it is not capable of capturing inequality among the poor. For example, the poverty gap index may be the same for two countries, but the poor population in one of those countries may be composed of very poor people and others who are close to the poverty line, whereas in the other country the poor popula- tion may show very little variation in the degree of poverty. Despite these important differences, the poverty gap index of the two countries would be similar. The main advantages of the poverty gap index are (a) that it 24 Understanding Growth and Poverty gives policy makers an idea of the minimum amount of financial resources that would be needed to tackle poverty and (b) that it high- lights the importance of identifying the characteristics of the poor, as it demonstrates the potential savings of well-targeted programs to alleviate poverty. Squared poverty gap. This is often described as a measure of the severity of poverty. While the poverty gap takes into account the distance separat- ing the poor from the poverty line, the squared poverty gap uses the square of that distance. Thus, the poverty gap is weighted by itself, giving more weight to the very poor. Poverty profiles. A poverty profile is a comprehensive poverty comparison that demonstrates how poverty varies across subgroups of society. After setting out the major facts on poverty and inequality, the poverty profile examines the pattern of poverty by geography (region, urban/rural, moun- tain/plain, and so on), by community characteristics (for example, com- munities with or without a school), and by household characteristics (for example, by education of household head or by size of household). A well-presented poverty profile can be immensely informative and use- ful in assessing how economic changes in a specific sector or region are likely to affect aggregate poverty, even if it uses relatively simple graphs and tables. Regional poverty comparisons are particularly important for targeting development programs to poorer areas. The 1999 poverty study for Cambodia, for example, showed that headcount poverty rates were highest in the rural sector and lowest in Phnom Penh in 1997. Approximately 40 percent of the rural population, 11 percent of Phnom Penh's population, and 30 percent of other urban residents lived in households that were below the poverty line (table 1.2). Poverty profiles can also show access to services by households in differ- ent regions and shed light on the relationship between education levels in a household and the likelihood that a household will be poor. The following are just some of the questions that can be included in a poverty profile: · Which are the most important goods in the consumption basket of the poor? · To what public services do the poor have access? · What is the quality of those services? · What are the main sources of income for the poor? Poverty and How We Measure It 25 Table 1.2 Cambodia: Poverty Measures percent Head count Poverty gap Poverty severity index index index 1993/94 1997 1993/94 1997 1993/94 1997 Food Poverty Line Phnom Penh 6.2 3.4 1.3 0.5 0.4 0.1 Other urban 19.6 15.4 4.4 3.3 1.4 1.1 Rural 21.9 20.0 4.0 3.9 1.1 1.2 Total 20.0 17.9 3.7 3.5 1.1 1.1 Poverty Line Phnom Penh 11.4 11.1 3.1 2.2 1.2 0.6 Other urban 36.6 29.9 9.6 7.5 3.6 2.7 Rural 43.1 40.1 10.0 9.7 3.3 3.4 Total 39.0 36.1 9.2 8.7 3.1 3.1 Source: World Bank, Describing Poverty Profiles; available at http://info.worldbank.org/etools/docs/library/103073/ ch7.pdf. · Do the poor have access to credit? · Are certain population groups in society at a higher risk of being poor than others? Vulnerability While poverty is being reduced in many countries, detailed analysis of household data indicates that in most countries, many households live with incomes barely above the national poverty line. When a household is near the poverty line, that household is said to be vulnerable. A natural disaster, economic shock, or change in policy may affect its consumption level and cause it to fall below the poverty line. Poor delivery of public services increases the chance that the near-poor will fall into poverty. Collecting Data The main instruments for collecting data to support poverty analyses are household surveys. It is important to understand the issues associated with setting up such surveys and interpreting the data they generate. Measures of poverty and inequality are always based on data that have been collected using samples of households. This has two impor- tant implications. First, it means, obviously, that measures of poverty and inequality are generated from a sample and not from the entire population. For that reason, they estimate the true state of the popula- tion with at least some degree of error, which should be acknowledged 26 Understanding Growth and Poverty in a statement of the "confidence interval" (the probability that a statis- tic is accurate within a certain range). Survey data may also need to be weighted to get the right estimates of certain measures, such as mean income and poverty rates. This requirement implies that information about the sample frame (essentially the design of the sample selected) must be clearly documented. Coverage of goods and income sources in the survey should be com- prehensive, extending over food and nonfood goods and encompassing all income sources. Consumption should cover monetary expenditures on goods and services, plus the monetary value of all consumption from income in kind, such as food produced on the family farm and the rental value of owner-occupied housing. Similarly, the definition of income should include income in kind. Valuation of nonmarket (untraded) goods can be quite complicated. None of the available tech- niques is widely preferred. A second issue is how to compare households at similar consumption levels. Households' size and demographic composition vary, as do the wages households receive and the prices they must pay. The general approach to measuring across households is to examine demand patterns to reveal consumer preferences for various market goods, and then to study the minimum total expenditure that would be required for a con- sumer to achieve his or her actual utility level, but at predetermined (and arbitrary) reference prices and with demographics fixed over all the households. This would give a monetary measure of utility, which could be deflated by a suitable price index and an equivalence scale. Ideally, one should not rely solely on a household-level survey in mak- ing interpersonal comparisons of welfare. A separate community survey (done at the same time as the household interviews, and possibly by the same interviewers) can provide useful supplementary data on the local prices of a range of goods and local public services. By matching these to the household data, one can greatly improve the accuracy and coverage of household welfare assessments. This has become common practice in the World Bank's Living Standards Measurement Study (LSMS) surveys. The LSMS surveys ask respondents about a wide variety of topics, not just demographic characteristics or other narrow issues. These surveys also include a household questionnaire that often runs to 100 pages or more and that can be adapted to the needs of each country. A related community questionnaire asks community leaders (teachers, health work- ers, village officials) for information about the whole community, such as the number of clinics, access to schools, tax collection, demographic data, Poverty and How We Measure It 27 and agricultural patterns. Another part of the LSMS is a price question- naire, which collects information about a large number of commodity prices in each community where the survey is undertaken. This is useful because it allows analysts to correct for differences in prices by region and over time. Household Surveys and National Accounts What is the best way of measuring whether or not economic growth is benefiting the poor? In recent years, that question has generated lively debate. The central issue is how to assess whether a unit of growth increases the income or consumption of the poor by at least as much as it does for the economy as a whole. Studies from the 1990s showed that in many cases, economic growth did not reduce poverty as much as expected, although there was no evidence that it increased inequality either. The main poverty-measurement issues revolve around the use of data from the household budget survey (HBS) versus data from national accounts (the topic of the next chapter) in assessing consumption levels, and how to deal with biases that may occur in the HBS data. There is strong evidence that rich households are less likely to comply with HBS reporting, for a variety of reasons, perhaps to conceal income or consump- tion. The result is that upper incomes are underrepresented in the HBS. By contrast, national accounts will pick up the transactions of upper-income households through key economic aggregates. Thus, average consumption as measured by national accounts tends to be higher than average consump- tion as revealed in the HBS data. But because the HBS instruments are bet- ter at capturing consumption that takes place in the informal sector, many argue that the HBS data more accurately reflect the consumption of the poor, even if national accounts provide a more accurate measure of the consumption of the population as a whole. This debate is particularly important for countries undergoing high rates of economic growth, but the issues are relevant for other countries as well. Conclusion Aggregate poverty measures are a prerequisite for any study of how eco- nomic policies affect the poor. Arriving at accurate measures is difficult, however, because poverty is multifaceted. While the nonmonetary aspects of poverty (such as political voice, access to health and education, and so on) are critical, the monetary aspects lend themselves more easily 28 Understanding Growth and Poverty to measurement and to comparisons across countries, regions, and time periods. To that end, fairly narrow indicators of welfare based on individual household consumption are generally used to measure poverty. These are compared with a minimum standard of that indicator, often known as the poverty line. By comparing the indicators with the standard, economists generate simple summary statistics--such as the headcount index, poverty gap index, and squared poverty index--to provide a broad overall measure of poverty. Macroeconomic growth and household (microeconomic) per- spectives are both important for poverty reduction. The developing coun- tries of East Asia have been more successful in reducing poverty than most other regions because of policies that promoted widespread education, trade, and infrastructure investment. Note 1. U.S. Department of Health and Human Services, The 2007 HHS Poverty Guidelines; available at http://www.hhs.gov. Bibliography Chen, S., and M. Ravallion. 2008. "The Developing World Is Poorer Than We Thought, but No Less Successful in the Fight against Poverty." Policy Research Working Paper 4703, World Bank, Washington DC. Jitsuchon, S., and K. Richter. 2007. "More Than a Pretty Picture; Using Poverty Maps to Design Better Policies and Interventions." World Bank: Washington DC. Ravallion, M., and S. Chen. 2004. "How Have the World's Poor Fared Since the Early 1980s?" Policy Research Working Paper 3341, World Bank, Washington, DC. World Bank. 1990. World Development Report 1990: Poverty. Washington, DC: World Bank. ------. 2002a. World Development Report 2000/01: Attacking Poverty. Oxford: Oxford University Press. ------. 2002b. PRSP Source Book. Washington, DC: World Bank. ------. 2003a. Poverty Reduction Strategy Papers--Progress in Implementation. Washington, DC: World Bank. ------. 2003b. World Development Report 2003: Sustainable Development in a Dynamic Economy: Transforming Institutions, Growth and the Quality of Life. Oxford: Oxford University Press. Poverty and How We Measure It 29 ------. 2004. World Development Report 2004: Making Services Work for Poor People. Oxford: Oxford University Press. ------. 2007. World Development Indicators. Washington, DC: World Bank. ------. 2008. Global Monitoring Report. Washington, DC: World Bank. ------. "Describing Poverty: Poverty Profiles." http://info.worldbank.org/etools/ docs/library/103073/ch7.pdf. CHAPTER 2 National Income and How We Measure It Measuring poverty is only the first step toward creating pro-poor eco- nomic policies. The second step--understanding how an economy works-- requires some knowledge of macroeconomics, the branch of economics that studies the economy as a whole with reference to key variables--among them the economy's output, inflation, unemployment, balance of pay- ments, and exchange rate. Macroeconomics explains changes in these vari- ables and guides policy makers in their pursuit of economic objectives such as economic growth and smooth business cycles, the central con- cerns of macroeconomics. The system of national accounts provides a framework in which macroeconomic data can be compiled and used for economic analysis. This chapter examines how economic growth is measured by identify- ing the components of growth and examining how these components relate to one another within the national accounts framework. It also introduces the external sector (the world beyond the nation's borders) to clarify key relationships between a country's national accounts and its balance of payments. Extensions to the national accounts in the form of environmental accounts, informal sector accounts, happiness, and national well-being are also briefly discussed. 31 32 Understanding Growth and Poverty Macroeconomic Sectors In macroeconomics, the economy is divided into five sectors--house- holds, enterprises, the financial sector, the government, and the rest of the world. · Households supply land, labor, and capital; they demand goods and services. They may also work as producers by forming unincorporated enterprises. They make decisions on how much to consume, how much to save, and how much to invest in financial markets. · Enterprises employ factors of production (such as land, labor, and capi- tal) to produce goods and services for the market. They make decisions about production and investment. · The financial sector provides financial services to households, gov- ernment, and enterprises. It includes the banking system and other financial institutions such as mutual funds, credit unions, pension funds, and insurance companies. · The government creates a regulatory and legal framework for economic activity; provides public goods such as education, health, infrastruc- ture, and a social safety net; oversees the tax system; and manages gov- ernment spending on the finished products of enterprises and direct purchases of resources, including labor. Government spending excludes transfers of government receipts to households. · The rest of the world refers to an economy's transactions with nonresi- dents. This category includes nonresidents' spending on local products and services and residents' spending abroad on products and services. The circular flow of income, expenditure, and financing captures the important relationships among the five economic sectors and the factor markets for labor, land, and capital (figure 2.1). Macroeconomic Concepts Arising from the interaction and behavior of the economic sectors are cer- tain key macroeconomic concepts that play a central role in macroeco- nomic analysis. These are defined as follows in the framework of the system of national accounts. · Gross output is the value of all goods and services produced in the economy. This measure suffers, however, from double counting, as when the value of wheat is counted first in the production of bread National Income and How We Measure It 33 Figure 2.1 Circular Flow of Income in National Accounts factor markets income factor government taxes taxes payments payments enterprises households interest and interest dividends savings loans financial institutions sales receipts consumption product markets Source: Mankiw 2002. and second in the sales of bread. The concept of value added provides a way around this problem. · Value added is the value of gross output less that of intermediate goods. A microchip bought by a computer company and used in the production of its computers is an intermediate good because the chip is ultimately purchased as part of a final good, the computer. Value added also distin- guishes between market output and nonmarket output, which includes subsistence farming and owner-occupied housing. · Consumption takes two forms. Intermediate consumption refers to inputs into production. Final consumption refers to goods and services-- both imported and domestically produced--used by households and the government. To return to the computer example: a microchip pur- chase by a computer maker is intermediate consumption; a computer purchase by a household is final consumption. The same computer, pur- chased by an enterprise, is investment; purchased by a government, it is government expenditure. · Gross domestic product (GDP) is the sum of value added across all sec- tors in the economy. It measures the value of the final goods and serv- ices in an economy. To ensure that total output is measured accurately, goods and services produced in a specific year must be counted only once. Most products go through several production stages before reach- ing the market and, thus, may be bought and sold several times. To avoid multiple counting of goods, which would exaggerate the value of 34 Understanding Growth and Poverty the GDP, only the market value of the final goods is included, not that of intermediate or secondhand goods. · Gross investment (gross capital formation) refers to additions to the physical stock of capital. This includes ° final purchases of machinery, equipment, and tools by business enterprises; ° construction; and 1 ° changes in inventories. · Depreciation, sometimes called the consumption of capital, reflects natural wear and tear over time. It is used to differentiate net from gross investment. The relationship between gross investment and depreciation indicates whether an economy's production capacity is expanding, static, or declining. · Net investment is gross investment minus depreciation. · Net exports are the value of exports of goods and services minus the value of imports of goods and services. The difference measures the impact of foreign trade on aggregate demand (the total demand for goods and services in an economy) and on GDP (total output). · Absorption, or domestic aggregate demand, is total final consumption by the sectors (including government) plus gross investment. Determining Gross Domestic Product GDP and "real GDP" (GDP adjusted for inflation) are key measures of the amount of economic activity in a country. If real GDP rises for a given year, more products and services were produced during that year. Higher production usually, but not always, means higher living standards. There are cases in which higher real GDP does not lead to a better standard of living--for example, where growth creates problems of environmen- tal degradation, imbalances between work and other aspects of life, and income inequality. But, as we will see in later chapters, a large change in real GDP, or, simply, greater economic growth, is the best measure of poverty alleviation in developing countries. Three Approaches to GDP GDP is obtained by calculating the total final value of all goods and serv- ices produced by a country's factors of production in a given time period, usually a year. Since output cannot be produced without inputs, the expenditures that make up GDP are closely linked to the employment of labor, capital, and other factors of production. Thus, GDP can be defined National Income and How We Measure It 35 using three basic approaches--production, expenditure, and income. They yield equivalent results, once statistical discrepancies are resolved. The production approach. In the production approach, GDP is the sum of gross value added (VA) in the economy, or, as defined above, the differ- ence between the value of production (output) and the value of all goods and services used in the production process (intermediate consumption): GDP = VA (2.1) where VA = the sum of value added across all sectors in the economy. The expenditure approach. Earlier we identified five economic sectors: households, enterprises, the financial sector, the government, and the rest of the world. The expenditure approach to GDP measures the spending by households, enterprises, government, and the rest of the world on final goods and services. The aggregates are defined as consumption (C) by government and households, investment (I) or gross private domestic spending by enterprises, and net exports or exports (X) minus imports (M). A hypothetical example of the expenditure approach to GDP is depicted in table 2.1. GDP = C + I + (X­M) (2.2) Table 2.1 Hypothetical Example of the Expenditure Approach to GDP US$ billions Year 1 Year 2 Year 3 Consumption 65.5 69.4 73.2 Public 5.9 7.2 7.2 Private 59.6 62.2 66.0 Investment 20.0 28.3 26.1 Public 6.8 7.2 7.0 Private 13.2 21.1 19.1 Changes in inventories ­0.9 1.5 ­2.9 Exports of goods and services 14.5 17.3 20.1 Imports of goods and services 16.2 20.0 24.0 Statistical discrepancy 0.3 0.8 1.1 Gross domestic product 83.2 97.3 93.6 Source: Authors. 36 Understanding Growth and Poverty where C = final consumption of durable and nondurable goods by government and households (Cg+Cp), I = gross investment (fixed capital formation and changes in inventories) both by government and enterprises (Ig+Ip), X = exports of goods and nonfactor services, M = imports of goods and nonfactor services. The income approach. GDP also can be measured as the sum of the incomes generated by resident producers. The following components are included: · Compensation of employees. This is the largest income category, com- prising primarily wages and salaries paid by businesses and government to suppliers of labor. It also includes wages and salary supplements such as social insurance, pension fund contributions, and health care paid by employers on behalf of their workers. · Rents. Rents consist of income payments received by households and businesses that own and therefore supply property resources. The rental income is what remains after depreciation is subtracted from gross rental revenues. · Interest. Interest is the money paid by private businesses to suppliers of capital. It includes interest on savings deposits. · Profits. What is generally termed "profit" can be broken down in national income accounts into proprietors' income and corporate profits. ° Proprietors' income is the net income of sole proprietorships and partnerships. ° Corporate profits may be collected by government as tax on corpo- rate income, distributed to stockholders (households or enterprises) as dividends, or retained as undistributed corporate profits that are invested in new plants and equipment, thus increasing the assets of the business. · Business taxes are taxes on production. Firms treat these as costs of production. They are added to the prices of products sold. · Subsidies. Subsidies received by the firm are subtracted from the prices of products sold. Therefore: GDP = W + OS + (T­SP) (2.3) National Income and How We Measure It 37 where W = compensation of employees as defined above OS = the gross operating surplus of enterprises, including profits, rents, interest, and depreciation as defined above T­SP = taxes less subsidies on products. Nominal and Real GDP Because GDP measures the total value of a nation's output in a given year, it captures both the changes in output and the changes in the prices of that output over time. To isolate changes in physical out- put over time, we differentiate between nominal and real GDP and deflate nominal GDP by an overall price index called the implicit GDP deflator. Nominal GDP measures the value of output of the economy at cur- rent prices. Real GDP, or GDP at constant prices, measures the value of a country's output using the prices of a single base year. Although not an ideal meas- ure of living standards or real income, real GDP is the most widely used measure of real income growth. It is useful in capturing real output growth. Implicit GDP is an index that measures the average price level of an economy's output relative to the base year. The index has a value of 100 in the base year. Thus, the percentage change in the GDP defla- tor measures the rate of price increases for all goods and services in the economy. The following relationships are found: · Nominal GDP = real GDP × GDP deflator/100 · Real GDP = nominal GDP/GDP deflator × 100 · GDP deflator = nominal GDP/real GDP × 100 In terms of the rate of growth: (1 + v) = (1 + g) × (1 + p) (2.4) where v = rate of growth of nominal GDP (percent), g = rate of growth of real GDP (percent), p = rate of inflation as measured by the GDP deflator (percent). 38 Understanding Growth and Poverty Other Standard Aggregates Two things must be noted about GDP as a measure of total output. First, GDP refers to production that takes place within an economy. It includes the output of domestically owned corporations in the country (but not abroad) and of foreign-owned corporations operating in the economy. Second, GDP includes depreciation. Because GDP is a domestic concept--one that refers to the production of, and income arising from, goods and services by firms based in the country and by foreign firms operating in the country--it does not cover the economy's overall income from all sources. To get at the rest of the economy's income, we must investigate gross national income (GNI) and gross national product (GNP). GNI and gross national disposable income. GNI includes income gener- ated abroad and paid to residents but excludes income generated domes- tically and paid to nonresidents. The difference between the two is termed "net factor income" (Yf). Examples of factor incomes are (a) capital income, which includes dividends on direct investment and interest on external borrowing or lending; (b) labor income of migrant and seasonal workers; and (c) service income on land, building rentals, and royalties. GNI = GDP + Yf (2.5) where Yf refers to net factor income from abroad. But net income from abroad need not be related to factors of produc- tion. Private transfers of income may arise from workers' remittances; public transfers may arise from government grants. Allowing for net current transfers--the difference between transfers received by the resi- dents of a country and transfers made to nonresidents--we arrive at the concept of gross national disposable income (GNDI): GNDI = GNI + TRf (2.6) where TRf is net current transfers received from abroad. Savings. The total income available to residents for use in final consump- tion or savings is GNDI, as noted above: GNDI = C + S (2.7) where C = spending on final goods and services by government and households, S = gross national savings. National Income and How We Measure It 39 When final consumption is subtracted from GNDI, we are left with gross national savings: GNDI ­ C = S. (2.8) Gross national product. GNI deals with income, GDP with produc- tion and income. Neither allows us to differentiate between the nation- ality of producers and the location of production. To do so, we need the concept of GNP. GNP refers to the goods and services produced by national corporations in the country, plus goods and services produced by national corporations in other countries. GNI at market prices is the same as GNP. GDP is a "gross concept" and therefore includes depreciation. The cor- responding net concept is that of net domestic product (NDP), which strips out depreciation, and is given as NDP = GDP ­ D (2.9) where D = depreciation or consumption of fixed capital. In practice, depreciation at the level of the entire economy is difficult to measure precisely and is measured with some lag. Thus, GDP is the preferred aggregate for measuring total output, even though it may over- estimate production. How GDP Is Used The macroeconomic aggregates outlined above are used in economic modeling and analysis. GDP allows the comparison of economic data across countries. For meaningful comparisons, the GDP of each country must be expressed in terms of a common unit, such as the U.S. dollar. The unit may be nominal or constant (real). Adjusting GDP and GDP per capita to arrive at purchasing power parity (PPP) also facilitates compar- ison across countries, as the typical consumption bundle tends to be more expensive in richer countries, rendering comparison with poorer coun- tries less meaningful. PPP measures are designed to overcome this short- coming by using the "ratio of the prices in national currencies of the same good or service in different countries" to measure PPP-adjusted GDP (OECD 2008, 435). Countries can be compared and ranked using PPP- adjusted GDP per capita (table 2.2). Governments, research organizations, universities, and international organizations such as Eurostat, the International Monetary Fund (IMF), the World Bank, the Organisation for Economic Co-operation and 40 Understanding Growth and Poverty Table 2.2 PPP-Adjusted GDP per Capita in the European Union, 1999 EU-15 = 100 Index Rank High income Luxembourg 186 1 Denmark 121 2 Upper middle income Netherlands 114 3 Ireland 112 4 Austria 111 5 Belgium 107 6 Germany 106 7 Italy 103 8 Sweden 101 9 Finland 101 9 United Kingdom 101 9 France 100 12 Lower middle income Spain 82 13 Portugal 74 14 Greece 68 15 Source: Compiled from data in OECD 2006. Development (OECD), and the United Nations (UN) all use GDP as a measure of economic performance in their research and policy analysis. The Business Cycle The economic system traditionally cycles through booms and busts, a movement known as the business cycle. The purpose of macroeconomic policy is to smooth out the business cycle by balancing growth, unemploy- ment, and inflation. Policies that reduce unemployment might lead to a rise in inflation, whereas restraining inflation may prevent growth in jobs, at least in the short run. Thus, there is often a political struggle over infla- tion and unemployment levels. The black line in figure 2.2 represents a typical pattern of economic booms and busts, as measured by GDP growth. When we look at the GDP growth rate, we notice that it reaches maximum and minimum points (peaks and troughs) with some degree of regularity. Individual business cycles vary substantially in duration and intensity, but they all display common phases: · Peak. The peak is the point at which business activity has reached a temporary maximum (point A in figure 2.2). The economy is at full National Income and How We Measure It 41 Figure 2.2 The Business Cycle A smoothened GDP growth GDP growth GDP growth C B time Source: Authors. Note: A = peak, B = trough, C = recession. employment, and the level of real output is at or very close to its capacity. Prices may rise during this phase. · Recession. The peak may be followed by a period of decline in total output, income, employment, and trade lasting at least six months. This is known as a recession (point C in figure 2.2). During the reces- sion, activity in many sectors of the economy contracts, but prices are unlikely to fall unless the recession is severe and prolonged, as in a depression. · Trough. The trough of the slowdown is the phase in which output and employment reach their lowest levels (point B in figure 2.2). The trough may be short or long. · Recovery. In the phase of recovery, or expansion, output and employ- ment increase toward full employment. As recovery intensifies, prices may begin to rise before full employment is reached and before pro- duction has risen to full capacity. Economic developments are typically described in terms of move- ments of variables that are related in some way to output, such as GDP, GNP, growth, employment, unemployment, prices, job creation, interest rates, housing, and consumption. Some variables, such as consumption and imports, follow a cycle similar to that of GDP--when GDP is grow- ing faster, these variables also grow faster, and vice versa. These variables are said to be procyclical. Other variables move in the opposite direction and are said to be countercyclical. Examples are net exports and the unem- ployment rate. Still other variables are acyclical, meaning that they move in a way that is not linked systematically to GDP. 42 Understanding Growth and Poverty Other Changes in Business Activity Not all changes in business activity result from business cycles. Some examples include: · Seasonal variations. At certain times of the year, buying surges, causing considerable change in the tempo of business activity. The holiday sea- son at the end of the year is an example. · Secular trends. Business activity may expand or contract over a long period of years, a phenomenon known as a secular trend. All economic actors are affected by business cycles but in various ways and to different degrees. With regard to production and employment, service industries and industries producing nondurable consumer goods are typically most insulated from the most severe effects of any recession. By contrast, firms and industries producing capital goods and consumer durables are usually hard hit by recessions. Two factors explain this: · Ability to postpone. Within limits, purchases of durable goods can be postponed. During recessions, producers frequently delay the pur- chase of more modern production facilities and the construction of new plants, whereas in good times, capital goods are often replaced even before they depreciate fully. Similarly, during recessions, house- holds often delay the purchase of big-ticket items--automobiles, washing machines, refrigerators, dishwashers, and so on. · Monopoly power. Many industries that produce capital goods and con- sumer durables are highly concentrated--that is, a small number of large firms dominate the market. These firms can set above compet- itive prices to increase their profit. When recession hits, they are reluctant to lower prices for fear of upsetting the industry price structure and possibly sparking a price war. Their reluctance to lower prices means that the initial effects of a drop in demand are a decline in production and an increase in unemployment. Volatility Another important concept is that of volatility--the amplitude of devia- tions from the mean in a given series (usually measured using standard deviation). A variable is more volatile if it swings greatly from peak to trough. GDP is relatively volatile: by looking at the variables that constitute National Income and How We Measure It 43 it, their shares in the aggregate, and their relative volatility, we can gauge what factors influence GDP the most. For example, consumption of nondurables and services may account for roughly 60 percent of our measure of GDP, with broad investment and government consumption accounting for 20 percent each. Thus, large and unpredictable swings in consumption (perhaps because of drought or famine) will bring about volatility in GDP. The complex relationship between economic growth and macroeco- nomic volatility, usually measured by the standard deviation of per capita output growth, has become clearer in recent decades. During the 1980s, it was thought that macroeconomic volatility had a minor impact on eco- nomic growth, but research conducted in the 1990s (reported in Kose, Prasad, and Terrones 2004) suggested that macroeconomic volatility could reduce long-term economic growth in many developing economies. The same research found, however, that volatility and growth had a slightly positive relationship in industrialized and emerging market economies.2 The Balance of Payments The previous sections examined how we assess and measure a country's domestic economic activity, as represented by GDP. The balance of pay- ments allows us to assess and measure a country's international economic transactions. The balance of payments refers to exports and imports of goods and services and financial flows between a country and the rest of the world for a given period, keeping an account of payments to and receipts from nonresidents. Based on the double-entry accounting system, whereby each recorded transaction is represented by two entries with equal values but opposite signs--a credit and a debit--the sum of all credits should be equal to the sum of all debits. In other words, payments should always be in bal- ance. Some examples of items recorded as credits and debits are shown in table 2.3. In reality, of course, accounts tend not to balance, and thus all balance- of-payments accounts include an item known as "net errors and omis- sions." That item is recorded as a net item because of the possibility that credit errors might offset debit errors--that is, that an underestimation of exports might be offset by an overestimation of imports. Because it is a net item, the magnitude of net errors and omissions cannot be taken as an indicator of the relative accuracy of the balance of payments. 44 Understanding Growth and Poverty Table 2.3 Examples of Credit and Debit Items in the Balance of Payments Exports of goods and services Credit Imports of goods and services Debit Increase in financial liabilities Credit Decrease in liabilities Debit Increase in financial assets Debit Decrease in assets Credit Source: Authors. Main Components of the Balance of Payments The balance of payments has three main components--the current account, the capital account, and net errors and omissions (discussed above). Current account. The current account is subdivided into four smaller accounts--merchandise trade, services, investment income, and transfer payments. The current-account balance is the difference between the credits and debits in these subaccounts. · The merchandise trade account includes imports and exports of tangi- ble goods, such as cars, computers, and clothes. If a country imports more than it exports in this category, it is said to have a trade deficit. · The services account includes payments in exchange for services, such as transportation, construction, insurance, banking, education, and tourism. · The investment income account reflects domestic residents' investment earnings from foreign stocks, bonds, real estate, and other assets, minus foreigners' investment earnings from domestic assets. · The transfer payments account includes gifts from and payments by private citizens or the government to people living abroad, and vice versa. Capital account. The capital account includes a variety of subaccounts, all dealing with purchases and sales of financial assets or real estate-- stocks, bonds, land, buildings, businesses, and so on. The balance on the capital account is the sum of the changes in these subaccounts. Added to changes in the central bank's reserves during the period, it should equal the balance on the current account. If it does not, there is a statistical dis- crepancy. Given the magnitude of money flows and the difficulty of measuring and recording millions of international trade transactions, the discrepancy is sometimes substantial. National Income and How We Measure It 45 Analyzing the Nation's External Position Under the double-entry accounting system, the sum of credits equals the sum of debits, producing a zero balance. But it is possible to have imbalances--surpluses and deficits--in the external account. A surplus arises in the trade account when a country exports more than it imports; a deficit arises if the converse holds. The merchandise-trade balance is often a timely indicator of trends in the current account as a whole (because data on trade in goods are often easier to collect and more read- ily available than data on trade in services). The current-account balance is one of the most useful indicators of an external imbalance. Persistent large deficits in the current account call for policy adjustments, since a country cannot continue to finance deficits indefinitely by borrowing abroad or drawing down its reserves. The overall balance of payments equals the current-account balance plus the capital-account balance, plus any errors and omissions. The over- all balance is the leading indicator of the country's external payments position. Deficits are usually financed by a decline in net foreign assets or reserves. Changes in reserve holdings are commonly viewed as an indicator of the extent to which the central bank has been financing payments imbalances. Some Basic Accounting Relationships This section links four of the five macroeconomic sectors--households, enterprises, the financial sector, and the rest of the world--with the key macroeconomic concept of GDP. The government sector is examined in further detail in chapter 5. We introduce two sets of links between a country's national accounts and its balance of payments. These links, too, are basic accounting relationships that lie at the heart of macroeconomic analysis. The first set comprises the links between aggregate income and demand (or aggregate savings and investment) and the external current- account balance. The second set deals with the resource gap of the non- government (private) sector and its financing. Aggregate Income, Absorption, and the Current Account GDP, or the value of goods and services produced by the domestic econ- omy, can be derived from a basic macroeconomic axiom stating that the value of domestic production must be equal to the value of incomes that are domestically generated. Thus: GDP = C + I + (X ­ M). (2.10) 46 Understanding Growth and Poverty Given that absorption (A) or domestic demand equals C + I, then: GDP = A + (X ­ M). (2.11) In other words, total income equals absorption plus net exports. And given that GNI = GDP + Yf, then: GNI = A + (X ­ M + Yf). (2.12) And given that GNDI = GNI + TRf, then: GNDI = A + X ­ M + Yf + TRf (2.13) and so: GNDI ­ A = X ­ M + Yf + TRf. (2.14) X ­ M + Yf + TRf (2.15) equals the current-account balance (CAB). The identity GNDI ­ A = CAB is the absorption approach to the bal- ance of payments. Basically, the identity states that a current-account deficit arises whenever an economy spends beyond its means or absorbs more than it produces. Thus, to reduce a current-account deficit, a country must increase its income or reduce absorption. In the short term, increas- ing income requires the presence of unused production capacity; in the medium and long term, structural policies to help boost capacity are required. Domestic absorption can be reduced by shrinking either private or government consumption of goods and services. We can go one step further by remembering that GNDI ­ C = S. Thus: GNDI = S + C. (2.16) Substituting for GNDI gives us: S + C ­ A = X ­ M + Yf + TRf. (2.17) Given that A = C + I, then: S ­ I = X ­ M + Yf + TRf (2.18) or: S ­ I = CAB. (2.19) Thus, the current account of the balance of payments is equal to the gap between savings and investment in an economy. Accordingly, the National Income and How We Measure It 47 current-account balance may be viewed as a country's use of foreign savings. In a closed economy, savings must equal investment, but in an open economy any excess of investment over savings is met by recourse to foreign savings, creating a deficit that must eventually be covered by increased savings or reduced investment. The identity says nothing about the theory that underlies current-account behavior. Other factors such as the influence of exchange rates, interest rates, and exoge- nous shocks need to be considered when explaining current-account developments. The Resource Gap of the Private Sector and Its Financing The private sector, also known as the real or nongovernment sector, is defined as the sum of the household and enterprise sectors. Any gap between the income and expenditures of the private sector must be financed. The relationship can be expressed in accounting terms. Savings by the private sector are equal to the difference between the private sec- tor's disposable income and its consumption. The private sector is denoted by the subscript p in the following identities. Sp = GNDIp ­ Cp. (2.20) The private sector's absorption, or aggregate demand, can be expressed as Ap = Cp + Ip (2.21) where Ip is gross investment by the private sector. It therefore follows that: Ap = GNDIp ­ Sp + Ip Ap ­ GNDIp = ­(Sp ­ Ip) Fp = ­(Sp ­ Ip) where Fp = the private sector's financing gap. Thus, the gap between the private sector's savings and investment reflects an excess of absorption over income. To maintain balance, the gap must be financed from elsewhere in the economy, including the sector known as the "rest of the world." Examples of such financing include for- eign direct investment from abroad (FDIp), net borrowing by the private sector from abroad (NFBp), and private sector borrowing from the bank- ing system--the latter being identical to net credit from the banking sys- tem to the private sector (DNDCp). These financial inflows are offset by financial outflows from the private sector, such as lending to the banking 48 Understanding Growth and Poverty system in the form of increased currency holdings and deposits (DM2) and lending to the government, or nonbank borrowing by the govern- ment from the private sector (NB).3 Therefore: Fp= FDIp+ NFBp+ DNDCp­ DM2 ­ NB. (2.22) It follows that Sp ­ Ip + FDIp+ NFBp+ DNDCp ­ DM2 ­ NB = 0. (2.23) Environmental Accounts GDP as measured in the national accounts of countries does not consider depreciation, depletion, or degradation of natural capital or wealth (water, soil or land, air, forests, and other natural endowments) in the course of production of goods and services. Cleanup and abatement costs incurred to restore environmental wealth are also not considered in the present scheme of national-income accounting. Therefore, until the sys- tem of national accounts is revised to include environmental accounts that will encourage policy makers to consider natural resource manage- ment in their decision making, GDP will not be an accurate measure of sustainable income. In the System of Integrated Environmental and Economic Accounting, environmental costs, benefits, and natural resource assets, as well as expenditures for environmental protection, were presented as satellite accounts in a manner consistent with the accounting framework of the UN system of national accounts. In 2003, the Integrated Environmental and Economic Accounting Handbook (UN 2003)--presented jointly by the UN, European Commission (EC), IMF, OECD, and World Bank-- provided methods for estimating environmental and natural resource­related expenditures that were not effectively captured in the system of national accounts. These included accounts to track natural resource assets and stock depletions, the use of energy and fuel materials, and the generation of pollutants and wastes, as well as expenditures for environmental protection and resource management. The World Bank (2006) takes into account the GDP from national accounts and separately calculates "green data." If one uses Bolivia as an example, gross savings as revealed in the national accounts is about 20 percent of GNI. But when environmental accounts are considered, net savings falls to ­20 percent of GNI, where: Adjusted net savings = gross savings ­ consumption of fixed capital + education expenditures ­ [energy depletion, mineral depletion, net forest depletion, and emissions of carbon dioxide]. National Income and How We Measure It 49 As shown in a schematic representation in figure 2.3, Bolivia, for example, consumes a great deal of "environmental wealth" to generate its GDP. It is possible to convert GDP from national accounts into environmen- tal accounts using data from the World Bank's Wealth of Nations database. According to the Bank's system, the difference between a nation's wealth in a given year and its wealth the year before reflects its environment- adjusted GDP. Informal Sector Activities In recent years, the informal sector has been expanding in most develop- ing countries, representing about 30 to 50 percent of their economies by most accounts. The informal economy, casually referred to as the black market, is known also as the hidden, shadow, parallel, unreported, or cash economy--with some distinctions among the terms. Following the defini- tions of Feige (1987), an illegal economy consists of the income generated from economic activities pursued in violation of the legal statutes that define the scope of legitimate forms of commerce. An unreported economy consists of those legal and illegal economic activities that evade fiscal rules and tax laws. The informal economy comprises economic activities that cir- cumvent the costs of--and are excluded from the benefits and rights con- ferred by--the nation's laws and administrative rules governing property relationships, commercial licensing, labor contracts, torts, financial credit, and social systems. An estimate of the informal economy is the income generated by economic agents who operate informally. Figure 2.3 GNI and Resource Use 25 20 depreciation 15 of fixed education capital expenditure depletion percentage of GNI 10 of natural 5 resources 0 ­5 ­10 ­15 ­20 pollution damages ­25 gross savings net savings net savings plus depletion-adjusted adjusted education savings net savings Source: Hamilton 2006, 40, based on World Development Indicators. 50 Understanding Growth and Poverty There is a large body of literature on the factors that shape the infor- mal sector. Three broad factors are distinguished: · The burden of direct and indirect taxation, both actual and perceived. A rising burden of taxation provides a strong incentive to work in the informal economy. · The burden of regulation (as an indicator of the burden of all other gov- ernment activities). Increases in the burden of regulation are a strong incentive to enter the informal economy. · Citizens' attitudes toward the state. Attitudes toward the state are an indicator of individuals' readiness to leave their formal occupations and enter the informal sector. Although by definition the informal economy is not directly tracked by the government, its growth and contraction can be gauged by several indicators. If activities in the informal economy rise, for example, demand for currency is likely to increase. If the number of workers in the hidden sector increases, one should see a decrease in participation in the formal economy, expressed either as fewer workers or a contraction in hours worked. As inputs (especially labor) move out of the official economy and into the growing informal economy, the displacement can be expected to depress the economy's official growth rate. Happiness and National Well-Being Accounts Since the 1950s, measures of economic performance have expanded to include nonmonetary aspects--such as indicators of human development, gender equity, freedom and empowerment, poverty reduction, equal opportunity, sustainability, and even happiness. The "economics of happiness" is an approach to assessing subjective welfare that combines techniques used by economists and psychologists. Up to a certain threshold, increases in incomes result in increases in hap- piness, but beyond a certain level, further increases in incomes do not lead to higher levels of happiness. Among the specific findings from statistical "happiness" research are the following: · Money does buy a reasonable amount of happiness. But it is useful to keep this in perspective. Very loosely, for the typical individual, a dou- bling of salary affects happiness much less than marriage and other life events. National Income and How We Measure It 51 · At the national level, the picture changes. Whole countries--at least in the West, where almost all the research has been done--do not seem to get happier as they get richer. Sixty-four percent of Danes say they are happy, compared with only 16 percent of the French. What accounts for these large differences in happiness among countries? Across nations, women report greater well-being than men. Why? · There are twists and turns in the path. Unemployment and divorce clearly bring unhappiness. Education is associated with high reported levels of happiness, even after controlling for income. But good and bad life events wear off--at least partially--as people get used to them. For example, lottery winners are happy for a short period of time, but after a time, they revert to their old level of happiness. · Happiness often hinges on one's position relative to others. Experiments have shown that people care about how they are treated compared with peers. In the laboratory, they will even pay to hurt others to restore what they see as fairness. From large statistical studies, it appears that one's reported well-being depends on one's earnings rel- ative to an average or "comparison" wage. Wage inequality depresses reported happiness in a region or nation (controlling for many vari- ables), but the effect is not large. Overall, happiness is strongly correlated with good health and weakly correlated with income. Newer measures of well-being have been con- structed in some countries using survey questions on happiness, family satisfaction, job satisfaction, work stress, and tiredness. Conclusion After measuring poverty, the second step in assessing how economic poli- cies can affect the poor is understanding the key relationships among the various agents in an economy--households, firms, the financial sector, government, and the rest of the world. Those relationships are the subject matter of macroeconomics, the branch of economics that studies the national economy as a whole. The central concern of macroeconomics is the measurement of economic activity and growth, captured by GDP and its movements. An economy's position relative to other countries is meas- ured by the balance of payments. The links between the domestic econ- omy and the rest of the world can be expressed in the accounting relationships presented in this chapter. With the tools of the first two 52 Understanding Growth and Poverty chapters, we are now equipped to analyze the important questions of how various policies influence poverty in developing countries. Notes 1. Inventory changes are considered a part of investment for the year as long as they cover products made but not sold in that year. GDP includes as part of current production the market value of any additions to (or withdrawals from) inventories during that year, along with the value of goods that were manufactured and sold during the year. 2. Emerging market economies are also known as transitional economies, mean- ing that they are in the process of moving from a closed to an open market economy while building accountability within the system. Examples include the countries of the former Soviet Union and the nations that were once Soviet allies in Central and Eastern Europe. 3. The nonbank private sector consists of people, companies, building societies, and the rest of the private sector (except for banks). If the government's expenditure is greater than its revenue (tax and nontax), then the government has to borrow to cover this deficit. It does so by selling government securities to the nonbank private sector. Bibliography Acemoglu, D., S. Johnson, J. Robinson, and Y. Thaicharoen. 2003. "Institutional Causes, Macroeconomic Symptoms: Volatility, Crises, and Growth." Journal of Monetary Economics 50: 49­123. Agenor, P. R. 2003. Development Macroeconomics. Washington, DC: World Bank. Blanchard, Olivier, and Stanley Fischer. 1989. Lectures in Macroeconomics. Cambridge, MA: MIT Press. Bryant, Ralph, David Currie, Jacob Frenkel, Paul Masson, and Richard Portes, eds. 1989. Macroeconomic Policies in an Interdependent World. Washington, DC: The Brookings Institution. Bryant, Ralph, Dale Henderson, Gerald Holtham, Peter Hooper, and Steven Symansky, eds. 1988. Empirical Macroeconomics for Interdependent Economies. Washington, DC: The Brookings Institution. Feige, E. L. 1987. "The Anatomy of the Underground Economy." In The Unofficial Economy. S. Alessandrini and B. Dallago, eds. Aldershot, UK: Gower Publishing Company Ltd. Hamilton, K. 2006. Where Is the Wealth of Nations? Measuring Capital for the 21st Century. Washington, DC: World Bank. National Income and How We Measure It 53 Kahneman, Daniel, Alan Kreuger, David Schkade, Norbert Schwarz, and Arthur Stone. 2004. American Economic Review 94 (May): 429­34. Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. London: Macmillan. Kose, M. A., E. S. Prasad, and M. E. Terrones. 2004. "Taking the Plunge without Getting Hurt." Finance and Development (December): 44­47. Maddison, Angus. 2002. The World Economy: Historical Statistics. Paris: OECD. Mankiw, N. 2002. Macroeconomics. 5th ed. New York: Worth. OECD (Organisation of Economic Co-operation and Development). 2006. Eurostat-OECD Methodological Manual on Purchasing Power Parities. Paris: OECD. ------. 2008. OECD Glossary of Statistical Terms. Paris: OECD. Phelps, Edmund S. 1990. Seven Schools of Thought in Macroeconomics. Oxford: Oxford University Press. UN (United Nations). 2003. Handbook of National Accounting: Integrated Environmental and Economic Accounting--An Operational Manual. New York: United Nations. World Bank. 2006. World Development Report 2006: Equity and Development. Washington, DC: World Bank. CHAPTER 3 Growth, Poverty, and Inequality: An Overview Economists since Adam Smith have used growth models and related tools to answer a key question: Why have some countries grown rapidly over the past few centuries while others have not? Although a great swath of the economic literature over the past 50 years has focused on growth factors--primarily macroeconomic policies and institutions--our understanding of the root causes of growth remains incomplete. This chapter examines the strategies adopted by some successful countries, and the tools and techniques that economists use to understand and measure the growth process. Growth Theory, Then and Now The influential model of Robert Solow (1956) holds that growth in out- put is determined by inputs of capital and labor. Remarkably, the inven- tions and innovations that contribute to the increased productivity of all factors of production and that drive the entrepreneurial spirit of capital- ism are not part of the model. Instead, technical progress is exogenous-- that is, it is assumed to come from outside. In Solow's scheme, domestic economic policies cannot affect the steady-state, long-run growth rate. But structural policy reforms in trade, finance, and privatization--as well 55 56 Understanding Growth and Poverty as sectoral policy changes, especially in agriculture--have some, albeit minimal, impact on gross domestic product (GDP). Against this backdrop, the growth theory of Romer (1986) introduces the idea that incentives can affect technical progress and, therefore, that national policies can alter a country's long-run growth rate. But Romer's and related theories focus on expanding the technological frontier--thus, their relevance to policy making in developing countries is minimal. A decade later, institutions and government policies--called social infrastructure (Hall and Jones 1999)--came to be seen as important to the growth process because they affected both the level and the distri- bution of output across various groups and individuals in a country. Such theories form the basis for the current consensus view of growth in the developing world, a view supported by data from more than five decades of economic performance. Countries may start with similar endowments (land, natural resources, labor, and so on), but, because of differences in institutional structures (political, legal, and so on), they implement different macroeconomic and sectoral policies and follow different development paths. Structures that lead to success in one country may not, and often cannot, be replicated in others. But political leadership that favors market-oriented policies and private economic activity can trigger growth spurts, which may be short lived, as in several Latin American countries during the 1970s and 1980s. Turning points, or major policy changes, occur at different times in differ- ent countries. Patterns of economic performance vary across countries. There are high-growth and low-growth countries, as well as those that have grown at a consistently rapid pace and those that have experienced short-term spurts. Growth in the high-income countries averaged 2.7 percent from 1960 to 2000 (figure 3.1) and was accompanied by significant improvements in social indicators such as literacy, infant mortality, life expectancy, and so on. Regions such as East and Southeast Asia expe- rienced an average growth rate of 4.4 percent during the same period. But the gap between the per capita GDP of advanced and developing countries remains large. Rates of economic growth across countries do not appear to be closely related to initial levels of per capita income. By the 1960s, most develop- ing countries had gained independence from colonial powers and were roughly at the same level of income and development; 50 years later, some had increased their GDP many times, while others were even worse off than at their independence (Rodrik 2004). On the other hand, rates Growth, Poverty, and Inequality: An Overview 57 Figure 3.1 Per Capita GDP Growth Rates by Country Groupings 1995 US$ 100,000 1960­2000: 2.7% 10,000 GDP per capita 1980­90: ­0.8% 1990­2000: 1.6% 1960­80: 2.9% 1,000 1960­2000: 4.4% 1980­2000: ­0.8% 1960­75: 2.3% 1960­80: 1.2% 1980­90: 3.3% 1980­2000: 8.0% 1960­80: 2.0% 100 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 high income Latin America and the Caribbean South Asia Sub-Saharan Africa East and Southeast Asia (excl. China) China Source: Rodrik 2004. of population growth are negatively related to both per capita income and per capita GDP growth across countries. Growth in physical capital, human capital, and research and develop- ment spending explains only about half of the variation in output within or across countries. Other factors, such as savings rates, factor productivity, proclivity to trade, the generation and exploitation of knowledge, sound macroeconomic policy, and the extent and quality of government regula- tion, explain the rest (table 3.1). Countries that have high savings and investment rates, for example, tend toward higher GDP growth rates--and the opposite is true for countries with low savings and investment rates. Total factor productivity (defined as output produced per worker for a given cost or over a certain period) is more important than capital accu- mulation. But to understand total factor productivity, we need to know what drives knowledge accumulation and the use of new technologies. We also need to understand the incentives for knowledge creation. (These questions, and their answers, lie at the heart of a new field known as knowledge for development.) Having a high volume of trade with other countries (also called trade openness) is positively correlated with knowledge sharing, learning by 58 Understanding Growth and Poverty Table 3.1 Economic Policies and Growth--A Review of the Evidence Policy area Indicator category Econometric results I. Structural policies and institutions Education Enrollment rates, years [+]: Barro (1991, 2001); Mankiw, Romer, and of education Weil (1992); Loayza, Fajnzylber, and Calderón (2005) Quality of education [+]: Barro and Lee (2001) Allocation of talents [+]: Murphy, Shleifer, and Vishny (1991) R&D investment [+]: Coe and Helpman (1995) Financial Private domestic credit [+]: Levine, Loayza, and Beck (2000); Loayza, development (% GDP) Fajnzylber, and Calderón (2005) Liquid liabilities (% GDP) [+] via total factor productivity growth: Beck, Levine, and Loayza (2000) [+] only for countries with well-developed financial systems: Rioja and Valev (2004) Government Distortionary taxation [­]: Kneller, Bleaney, and Gemmell (1999) burden for OECD, Gupta and others (2005) for developed countries Corporate taxes [­]: Lee and Gordon (2005) Labor income tax, [0]: Lee and Gordon (2005) marginal tax rates Government consumption [­]: Loayza, Fajnzylber, and Calderón (2005) Infrastructure Infrastructure stocks [+]: Sanchez-Robles (1998); Bougheas, Demetriades, and Mamuneas (2000); Easterly (2001b); Esfahani and Ramirez (2003); Calderón and Servén (2004) Infrastructure, quality [+]: Calderón and Servén (2004) Governance Institutional quality [+]: Knack and Keefer (1995) (Business Environment Risk Intelligence; International Country Risk Guide) Absence of corruption [+]: Mauro (1995) Kaufmann et al. indicators [+]: Dollar and Kraay (2003); Acemoglu, Johnson, and Robinson (2001, 2002); Hall and Jones (1999) Trade Exports and imports [+]: Ben-David (1993); Edwards (1998); Dollar openness (% GDP) and Kraay (2003) Index of outward [+]: Dollar (1992); Sachs and Warner (1995); orientation/openness Wacziarg and Welch (2003) Openness adjusted by [+]: Frankel and Romer (1999); Loayza, geography Fajnzylber, and Calderón (2005) II. Stabilization policies Macroeconomic CPI inflation rate [­]: Fischer (1993); Loayza, Fajnzylber, and stabilization Calderón (2005) (continued next page) Growth, Poverty, and Inequality: An Overview 59 Table 3.1 Economic Policies and Growth--A Review of the Evidence Policy area Indicator category Econometric results [­] for high-inflation periods: Bruno and Easterly (1998); Fischer, 5ahay, and Végh (2002) External Real exchange rate [­]: Dollar (1992); Easterly (2001b); Loayza, imbalances overvaluation Fajnzylber, and Calderón (2005) [­] the larger the impact, the higher the overvaluation: Collins and Razin (1999); Aguirre and Calderón (2005) Financial Systemic banking crises [­]: Kaminsky and Reinhart (1999); Dell'Arric- turmoil cia, Detragiache, and Rajan (2005); Loayza, Fajnzylber, and Calderón (2005) Source: Lopez 2006, 77. Note: CPI = consumer price index; R & D = research and development. [+] implies a positive and significant rela- tionship between growth and the corresponding economic policy. [­] reflects a negative and significant relation- ship, and [0] denotes no statistical relationship between the variables. doing, and higher GDP growth rates. But questions about the relationship between trade and growth remain. A growing economy needs both more imports and lower tariffs. But is reducing tariffs and nontariff barriers enough to spur growth? The connection between financial liberalization and growth is similarly unclear. In the short to medium term, GDP growth is negatively related to large fiscal deficits, high inflation, high corporate taxes, excessive and unpredictable regulation, high interest rates, scarcity of credit, low rates of investment, and the misalignment of domestic currency. The Washington Consensus of the 1980s (a set of macroeconomic policies that sought to reduce distortions in prices and markets to spur growth) emphasized the need for fiscal discipline, competitive exchange rates, trade and financial liberalization, privatization, and deregulation. Economic policies adopted under this agenda came to be known as "first- generation reforms." The main criticism of these reforms was that they were adjustments without a human face, expressions of trickle-down economics and insensitivity to the social disruption and human suffering they caused. In the 1990s, "second-generation reforms" were introduced that focused on upgrading public financial management, reducing corruption, improv- ing corporate governance, providing social safety nets, and fighting poverty through well-targeted programs. Also, in the 1990s, it became evident that 60 Understanding Growth and Poverty although finance was important for growth, the direction of financial flows was observed to be from developing to developed countries. This phenom- enon, which has persisted, contrasted sharply with economic theory, which suggests that resources should flow toward countries that yield higher marginal rates of return--in other words, developing countries. Institutions and Modern Growth Theory Institutions are important because they determine how and to what extent public policies designed to encourage or discourage knowledge creation, technological adoption, and capital accumulation will be carried out. The right institutions, functioning properly, can provide incentives to accumulate physical and human capital, innovate, develop and adapt to new technologies, and reorganize the production and distribution of goods and services. Growth appears to occur in countries where private property rights are protected from infringement by individuals and gov- ernment, and where the legal system facilitates private transactions (for example, by providing for the enforcement of contracts). Also needed are institutions that provide incentives to adopt modern technology. Because technology forces the constant reorganization of productive units, it tends to generate forces opposed to further change. Technologies and institutions must change in tandem, but it appears that institutions evolve more slowly than technologies--and this mismatch creates problems. A country's ability to accommodate changes over decades depends on its political and economic institutions. But institu- tions that are good for one period in time may not be good for the next. This explains why, over the centuries, civilizations such as those of Egypt, Greece, Rome, and Persia declined. Economic, political, legal, and social institutions do not evolve independent of one another. But they develop at different speeds, complicating the tasks of economic manage- ment and forecasting. Although it is known that the rate of growth is shaped by property rights, the rule of law, and constraints on executive power, the exact way these factors affect national wealth and per capita income is not well understood. Even less well understood is how labor relations and the behavior of interest groups affect growth. Thinkers differ on whether presidential systems perform better than parliamentary ones, whether democracies perform better than autocracies, and whether income growth drives autocracies toward democratic systems. The studies con- ducted to date are inconclusive. Growth, Poverty, and Inequality: An Overview 61 Modern growth theory, as formulated by Acemoglu and Johnson (2007), deals with these unresolved questions and provides some measure of the factors necessary to generate and sustain growth over the long run. It links the proximate causes of economic phenomena to fundamental causes, in particular institutions. The central question of why some countries grow and others do not is tackled directly and formulated with greater breadth and precision than before. Acemoglu and Johnson go back in time, showing that intercountry growth differences began to show up as early as 1800. Those nascent differences were amplified during the Industrial Revolution, during which new organizational forms and technologies were adopted. At the dawn of the nineteenth century, some countries such as the United Kingdom, and, later, the United States and Canada, began a process of rapid industrialization based on the adoption of new tech- nologies. As industrialization took off, it produced a shift from agricul- ture to manufacturing--a structural transformation. Now, as then, some societies may fail to take off because they fail to adopt new production technologies, often because they lack the right type of institutions or firms. They may lack appropriate financial markets, labor skills, man- agers, and professionals. Often, the presence or absence of facilitating institutions can be traced to social choices--political and economic. Behind those choices are individuals and groups that stand to win or lose from a given change. The reward structures faced by firms and individuals play a central role in shaping whether they undertake the investments in new technology and human capital necessary for takeoff, industrialization, and economic growth. These reward structures are determined by policies and institu- tions, and politics plays a major role in shaping institutions, which, in turn, decide whether a society can embark upon modern economic growth. When no way can be found to compensate influential parties that are likely to lose from change, or when likely winners have insufficient political power, we may expect policies and institutions that are not growth enhancing. In such circumstances, distortionary policies may be adopted to block growth, usually to protect politically powerful incum- bent producers or to stabilize the established political regime. As technol- ogy, market structures, and factor endowments interact with those policies--at any given moment, myriad transactions are occurring among firms, consumers, and government agencies--the path of the nation's eco- nomic growth is shaped. Democracies and dictatorships are likely to make different policy choices and to create different types of reward structures. Although 62 Understanding Growth and Poverty there are no perfect political institutions, and each political arrangement is likely to favor some groups at the expense of others, authoritarian political systems (such as absolute monarchies, dictatorships, autocracies, and oligarchies) concentrate power in the hands of a small minority and pursue economic policies that are favorable to the interests of this minority. Authoritarian systems also usually rely on some amount of repression to maintain the unequal distribution of political power and economic benefit. They also adopt economic institutions and policies that protect incumbents and create benefits, known as "rents," for those who hold political power. Participatory regimes--systems in which people have a say in governance--place constraints on rulers and politicians (thus preventing the most absolutist tendencies in political systems) and give voice to new economic interests, so that a strict decoupling of political and economic power is avoided. Such regimes include constitutional monarchies, where broader sections of the society take part in economic and political deci- sion making, and democracies, where political participation is greater than in nondemocratic regimes. The distinguishing feature of participatory regimes is that they give voice and security (both economic and political) to a broader cross section of society than do authoritarian regimes. As a result, they are more open to the creation of new businesses and provide a more level play- ing field and more secure property rights to a larger portion of society. Thus, in some ways, the contrast between authoritarian political systems and participatory regimes can be expressed as a contrast between the growth-promoting cluster of institutions and growth-blocking, extrac- tive institutions. Returning to the earlier question of what factors matter most for growth, it now appears that although increases in capital, labor, and land contribute to (and may even be essential for) growth, technology adoption is more important than any of these over a longer period of time. There is no longer any doubt that technology is a prime driver of economic growth over the long term and a major factor in cross- country differences in economic performance--quite a change from a half-century ago, when Solow (1956) introduced his seminal theory. Using cross-country data, economists have made considerable progress in understanding the relationship of physical and human capital to investments by firms in technology and by individuals, families, and governments in education. Because investment decisions depend on the rewards that individuals, firms, and governments can expect from their Growth, Poverty, and Inequality: An Overview 63 investments, understanding differences in investment levels is intimately linked to understanding how reward structures differ across societies and how individuals respond to those differences. There are marked differences across societies in the institutions that influence technology adoption and diffusion. Most developing economies do not invent their own technologies, but adopt them from the world's technology leaders or adapt them from technologies in use elsewhere. The difference lies in how quickly and effectively new technologies are adapted and absorbed. Among the important questions that remain unanswered by modern growth theory are the role of contracts (broadly conceived) in the spread of innovation and the origin of structural transformations that affect rates of economic growth. The world comprises millions of implicit or explicit contracts. Suppliers enter into agreements with downstream customers; industrial firms have agreements with financial firms (such as banks); employers and employ- ees enter into contracts; governments agree to protect inventors' property rights in return for disclosure of their inventions. These understandings are all subject to ambiguities and other pitfalls and sticking points known to economists and lawyers as moral hazard, adverse selection, holdups, and principal-agent complications. How important are contracts to the process of economic growth? We are still far from understanding the contractual foundations of economic growth and their role in determining the pace of technology diffusion. It is not inconceivable that more secure contracts (better worded, better enforced) could stimulate innovation and technological upgrading in industrialized economies. Or that they could facilitate tech- nology transfer to the developing world. These are basic, but--as yet-- unanswered questions. Some structural changes in economies and societies can be viewed as by-products of economic growth. The increase in services relative to agriculture is a prime example. But other structural changes--including developments in financial markets, changes in legal regimes, growing urbanization, and the commitment of individuals and societies to edu- cation--are not simple by-products of economic growth, although they are intimately linked to economic development. To understand how structural transformations might delay or prevent economic growth, we require models with stronger theoretical foundations, a unified approach to these related issues, and a greater effort to link models of economic development to the wealth of research on economic behav- ior in less-developed economies. 64 Understanding Growth and Poverty Economic Growth and Poverty Reduction Sustained growth reduces poverty. The economic literature is firm on this point. Numerous cross-country studies have concluded that the main determinant of poverty reduction is the pace of economic growth. Kraay (2004) found that approximately "half of the variation in short-run changes in poverty can be explained by growth in average incomes. In the medium to long run, between 66 and 90 percent of the variation in changes in poverty can be accounted for by the growth in average incomes." A report from the Operationalizing Pro-Poor Growth Research Program (AFD and others 2005) revealed that in countries that experienced economic growth between 1990 and 2003 (11 of 14 studied), a 1 percent increase in GDP per capita reduced poverty (as measured by the annual change in poverty headcount) by 1.7 percent. For some countries, such as Vietnam, the reduction was spectacular--a halving of the poverty rate from 58 percent to 29 per- cent (or almost 8 percent a year). Poverty declined by rates of between 3 and 6 percent per year in El Salvador, Ghana, India, Tunisia, and Uganda (figure 3.2). Consistent with the positive relationship between growth and poverty reduction, it has also been found that incomes of the poor appear to rise proportionately with average incomes (Dollar and Kraay 2002). Plotting per capita incomes of the poor against average per capita income for 137 Figure 3.2 Economic Growth and Poverty Reduction in Select Countries, 1990­2003 10 annual change in poverty headcount (%) Romania Zambia Indonesia ­4 Burkina Faso 8 Bolivia Senegal Brazil Bangladesh Ghana Tunisia India Uganda El Salvador Vietnam ­10 annual GDP per capita growth, 1990s (%) Source: AFD and others 2005. Growth, Poverty, and Inequality: An Overview 65 countries, Dollar and Kraay found a strong, positive linear relationship between the two variables (with a slope of 1.07) (figure 3.3, panel a). Moreover, plotting the annual average growth in incomes of the poor against average annual growth in average incomes for 92 countries also Figure 3.3 Average Per Capita Incomes and Growth a. Correlation of per capita incomes of the poor with average per capita income for 137 countries, 1950­99: Levels 10 log(per capita income in poorest quintile) y = 1.0734x ­ 1.7687 9 R2 = 0.8846 8 7 6 5 4 3 3 4 5 6 7 8 9 10 log(per capita income) b. Correlation of annual average growth in incomes of the poor with average annual growth in average incomes for 92 countries, 1950­99: Growth rates 0.2 0.15 (per capita income in poorest quintile) average annual change in log 0.1 0.05 0 ­0.05 ­0.1 y = 1.185x ­ 0.0068 R2 = 0.4935 ­0.15 ­0.2 ­0.2 ­0.15 ­0.1 ­0.05 0 0.05 0.1 0.15 0.2 average annual change in log(per capita income) Source: Dollar and Kraay 2002. 66 Understanding Growth and Poverty yielded a strong positive, linear relationship between the variables, with a slope of 1.19 (figure 3.3, panel b). Other researchers, too, have found that poverty trends tracked growth trends very closely in the 1980s and 1990s. For example, according to Chen and Ravallion (2000), on average, growth in the consumption of the poorest fifth of the population tracked eco- nomic growth one for one over this period. Unsurprisingly, the converse also holds: low or declining economic growth leads to increases in the incidence of poverty. Thus, in the vast majority of countries studied by Chen and Ravallion (2000), economic decline led to falling consumption. In a more recent study, López (2004) found that economic decline in per capita income in Argentina (1993­2002) and Zambia (1991­98) led to increases in the incidence of poverty (table 3.2). Similarly, three of the countries in the Operationalizing Pro-Poor Growth study--Zambia, Indonesia, and Romania--that exhibited little or no economic growth over the study period (1990­2003) experi- enced increases in poverty. Few economists doubt that economic growth is necessary for the long- term reduction of poverty. But how close is the link between the two? In their 2002 study, Dollar and Kraay gathered information on the per capita income of the poor (defined as the bottom quintile of the income distri- bution) and on overall per capita income. Using data from 137 countries in panel a of figure 3.3 and 92 countries in panel b of figure 3.3 over five decades, Dollar and Kraay pieced together 418 sample periods (some countries had more than one observation) during which it was possible to measure changes in the income of the poor and of the country overall. Noting that the per capita income of the poorest quintile grew in line with overall per capita GDP for the 80 countries covered over the four decades, the authors drew the following conclusions: · Growth matters--and the poor generally are not left behind in the growth process. Table 3.2 Examples of the Link between Economic Growth and Poverty Annual change in Change in poverty Country Period income per capita (%) headcount (%) China 1981­2000 +8.5 50 > 8 Vietnam 1993­2002 +6 58 > 29 Argentina 1993­2002 ­0.18 21 > 55 Zambia 1991­98 ­2.4 69 > 75 Source: López 2004. Growth, Poverty, and Inequality: An Overview 67 · The incomes of the poor do not fall disproportionately during eco- nomic crises. · Greater economic openness, the rule of law, fiscal discipline, and low inflation all contribute to (or are at least associated with) faster eco- nomic growth and, thus, help the poor. · Democracy and greater public spending on health and education do not have a measurable effect, one way or another, on the incomes of the poor. The relationship between economic growth and poverty reduction appears to hold for both absolute and relative measures of poverty (López 2004). As demonstrated in chapter 1, an absolute measure is expressed as an income below a prespecified threshold, such as an adjusted purchas- ing power parity (PPP) of $1.25 per person per day, or a country-specific poverty line based on subsistence needs. A relative measure is expressed as a prespecified proportion of the population, usually the lowest quintile of the population. Variations in Poverty Responses to Growth Poverty responds to economic growth differently across countries. Key factors in determining the country's response are the presence (or absence) of productivity gains, the sector composition of growth (and its labor intensiveness), and the extent of inequality in the society. Understanding these factors enables us to view growth in a pro-poor con- text, a topic developed in more detail in the following section. Growth derives from economic inputs--capital and labor--and from the efficiency of their use. Because simply adding inputs typically becomes less effective in generating growth over time--a phenomenon referred to as diminishing marginal returns--it is usually necessary to make factors more productive to sustain growth. This is done through technological advances, improved management know-how, and increases in skills through education. Viewed through this prism, the robust growth experience of Uganda (more than 6 percent a year on average since the mid-1980s) and the country's consequent success in lowering poverty is not as impressive as commonly thought. Pattillo, Gupta, and Carey (2005) found that Uganda's growth achievements were predomi- nantly due to capital accumulation (investment) and had very little to do with productivity gains. "Because increasingly higher investment rates (and consequently, rising national or external saving) are not feasible," 68 Understanding Growth and Poverty noted the authors, slow growth in the productivity of the factors of pro- duction threatened Uganda's gains. The country would have to improve productivity to sustain its growth and consolidate its achievements in reducing poverty. The composition of economic growth also has implications for poverty reduction. The sectoral composition of economic growth can explain why given rates of economic growth can lead to different rates of poverty reduction. Growth that derives from the intensive use of unskilled labor will have a greater immediate impact on reducing the incidence of poverty than will growth built on skilled labor, given that the poor are more likely to be unskilled. Loayza and Raddatz (2006) showed not only that the incidence of poverty falls in the face of aggre- gate economic growth, but also that poverty reduction is stronger when growth has a labor-intensive inclination. The Operationalizing Pro-Poor Growth group (AFD and others 2005) found that most of the absolute reduction in poverty in countries experiencing economic growth occurred in rural areas, where the majority of the poor live and earn their livelihoods from agriculture. Land and labor policies affect the participa- tion of the rural poor in the economy, with consequent implications for economic growth and poverty reduction. These points are discussed in later chapters. The level of inequality in a society and how inequality changes over time are other important determinants of how the incidence and sever- ity of poverty will be affected by economic growth. Senegal and Burkina Faso had similar levels of economic growth--2.2 percent per capita per year--over a similar time frame (López 2004). But poverty declined by 2.5 percent annually in Senegal and just 1.8 percent in Burkina Faso. According to López, Senegal made more progress because it was a less unequal society. Is unequal distribution of income good or bad for a country's devel- opment? Opinions differ about the pattern of distribution that is most likely to produce growth--about whether, for example, the Gini coef- ficient, a measure of income inequality (see glossary), should be closer to 25 percent (as in Sweden) or to 40 percent (as in the United States) and whether the optimal distribution changes as national income changes. An excessively equal income distribution can be bad for eco- nomic efficiency. Take, for example, the experience of communist coun- tries, where deliberately low levels of inequality (with no private profits and minimal differences in wages and salaries) deprived people of incentives Growth, Poverty, and Inequality: An Overview 69 to participate in economic activities through diligent work and vigorous entrepreneurship. Among the consequences of attempts to equalize incomes were poor discipline and low initiative among workers, poor quality and limited selection of goods and services, slow technical progress, and, eventually, slower economic growth and more poverty. But, beyond this extreme, some studies suggest that countries with more equal distribution of certain assets (public goods, land, and so on) tend to grow faster (figure 3.4). Using a comprehensive cross-country data set, Deininger and Squire (1996) found that inequality generally tends to favor economic growth. They also found that inequality in the distribution of assets has a greater impact on growth than does income inequality, although the two are closely related. Despite this, Deininger and Squire suggest that certain redistributive policies, in particular those that improve access to credit for the poor, can help boost growth. Governments have, of course, tried redis- tributive policies in the past--for example, through land redistribution, employment programs, and subsidies, and by improving access to credit, public goods, infrastructure, health, and education--but with varying degrees of success. Further research on the impact of public spending on equality is urgently needed. Figure 3.4 Land Distribution and the Pace of Growth 7 6 average annual GDP growth 5 1960­90 (%) 4 3 2 1 0 95 85 75 65 55 45 35 initial land distribution Gini coefficient for land more equal Source: Deininger and Squire 1996. 70 Understanding Growth and Poverty Pro-Poor Growth From the previous section, we know that the incidence of poverty drops with economic growth. We also know that the precise effect of growth on poverty depends on the initial level of income inequality in the coun- try and how it changes with economic growth. The concept of pro-poor growth was introduced in the 1990s to provide greater insight into the relationship of economic growth, poverty, and income inequality. It cap- tures the way in which national economic growth improves the welfare of the poor through changes in income inequality. At its simplest, pro-poor growth is growth that raises the incomes of the poor. More formally, the literature suggests two definitions. The first focuses on whether the distributional shifts accompanying growth favor the poor--that is, whether poverty falls in response to growth by more than it would have if all incomes had grown at the same rate. The sec- ond focuses on whether economic growth benefits poor people in absolute terms, as reflected by changes in an appropriate measure of poverty. The measures of poverty generally used are the headcount index and the poverty gap. The concepts of relative and absolute poverty are used to detect underlying levels of inequality. Assessing whether growth is pro-poor requires knowledge of distrib- utional changes in income and the extent to which those changes have improved the welfare of the poor. To measure the extent to which growth is pro-poor, we break down poverty (as measured by the head- count index, for example) into a component attributable to economic growth and a component attributable to the change in income distribu- tion. This method, developed originally by Datt and Ravallion (1992) and more recently by Kraay (2004), has proved informative about the reasons behind variations in the rate of poverty reduction across coun- tries. According to Kraay (2004), the potential sources of pro-poor growth are three: (a) a high rate of growth of average incomes, (b) a high sensitivity of poverty (poverty elasticity) to growth in average incomes, and (c) a poverty-reducing pattern of growth in relative incomes. The outcome from the large sample of developing countries consid- ered by Kraay during the 1980s and 1990s is that more than 90 percent of the variation in poverty over the medium to long term is due to the growth in average incomes, suggesting that policies and institutions that promote broad-based growth should be central to the pro-poor growth agenda. The remainder of the variation comes from changes in relative income (or inequality). Kraay himself has acknowledged that although the evidence from these cross-country comparisons suggests trends, it Growth, Poverty, and Inequality: An Overview 71 provides little guidance about what policies and institutions will promote pro-poor growth. The distributional effect of growth on the rate of poverty reduction has also been explored. Using a log normal distribution (most studies use a linear model), Bourguignon (2003) showed that distributional changes in income were responsible for variations in the response of poverty to growth over time. He suggested as well that redistribution contributes to a permanent increase in the elasticity of poverty and thereby accelerates the rate of poverty reduction for a given rate of growth. Distributional changes have been important in explaining differing rates of poverty reduction in specific countries. Ravallion (2001) suggested that the median rate of decline in the $1/day headcount index was 10 percent per year among countries that combined growth with falling inequality, but only 1 percent per year for those countries for which growth came with rising inequality. Undeniably, extreme income inequality hampers the ability of growth to reduce poverty--in fact, it is a barrier. Ravallion (2001) found that for countries where inequality was very high, a 1 percent increase in average household income levels had a much lower impact on poverty (0.6 percent reduction) than it did in countries where inequality was low (4.3 percent). Rising inequality also reduced the impact of future economic growth on poverty reduction. Bourguignon (2003) found that a fall in the Gini coefficient from 0.55 to 0.45 (0.45 still indicat- ing relatively high inequality) would cause poverty to drop by more than 15 percentage points in 10 years. It would take 30 years to achieve the same reduction in poverty if inequality remained unchanged. While the literature is largely united on the point that growth tends to be neutral in its effect on income distribution (as discussed earlier in this chapter), it would seem that faster economic growth is necessary to reduce poverty in countries with high inequality. India provides a good example (box 3.1). Three important points emerge from this discussion. First, growth is the fundamental factor for poverty reduction. Second, progressive change in income distribution will accentuate the poverty-reducing power of growth. And third, high initial inequality reduces the impact of growth on poverty reduction. The economic literature suggests that the relative importance of growth rates and inequality in determining how growth will affect the poor depends on country conditions, notably the initial levels of income and inequality. In low-income countries, the need to accelerate pro-poor growth to reduce poverty has emerged as critical, 72 Understanding Growth and Poverty Box 3.1 How to Achieve Pro-Poor Growth--The Case of India Economic growth tends to reduce poverty. That does not mean, however, that every policy that promotes growth will reduce poverty. Economic policies often have distributional implications that cannot be ignored if one is interested in how those policies affect poverty. The case of India is instructive. The incidence of poverty in India has been falling at a rate of about one percentage point per year since about 1970, with an interruption owing to macroeconomic difficulties in the early 1990s. But some states have done far better than others, both historically and in the wake of the economic reforms of the past 10 years. And the growth rate needed to achieve a constant reduction in poverty has been rising over time. In other words, the responsiveness of poverty rates to increases in nonagricultural output and, to a lesser extent, agricultural yields has been declining. Here the geographic composition of India's growth has played an important role: widening regional disparities and limited growth in lagging areas have made the overall growth process less pro-poor. By and large, economic growth has not occurred in the states where it would have the most impact on poverty. These differences are compounded by differences in access to infrastructure and social services (health care and education) that make it harder for poor people to take up the opportunities afforded by aggregate economic growth (Ravallion and Datt 2002). Heterogeneity in the impact of growth on poverty holds important clues about what else governments need to do to reduce poverty, in addition to promoting economic growth. Some observers believe that growth alone is sufficient (Bhalla 2002b). Others believe that combining growth-promoting economic reforms with policies to help the poor participate fully in the opportunities unleashed by growth will reduce poverty more quickly than relying on growth alone. Source: Authors. particularly in the context of poverty reduction strategies and the efforts to accelerate progress toward the Millennium Development Goals. Economists agree that growth reduces poverty. But it also appears that the relationship is reciprocal--poverty reduction is good for growth. This is true because relief from poverty unleashes the productive power of the poor. The poor have limited access to financial services, infrastructure Growth, Poverty, and Inequality: An Overview 73 (roads, water, power, and telecommunications), education, and health services. Alleviation of poverty generally brings improvements in access to such services through both direct and indirect channels. When people have more money to spend, service providers of all stripes--water sellers, telecommunications companies, transport operators, and banks--have a greater incentive to extend their offer of services. The poor make use of those services to develop their productive potential--by carrying goods to market, communicating with potential employers or customers, investing in education, or protecting their health. Being able to afford food, medi- cine, and clothing also allows the poor to derive greater benefit from the services to which they already have access. Healthy people are more pro- ductive and more likely to prosper in their employment. Properly nour- ished children get more out of school. Workers with a little extra cash can use public transportation to reach better jobs. Free of the constant threat of hunger and ruin, they may be more likely to take advantage of a wide range of investment opportunities, from specialized agriculture to more education to microbusinesses. The task of crafting policies to assist lagging regions is complicated by the interconnectedness of the many factors that make for growth1-- including customers with money to spend, workers with skills to sell, and infrastructure that allows goods to be produced and transported at a com- petitive price. Enterprises naturally seek out areas that are already rich in such factors. The result is a self-reinforcing cycle: concentrations (agglomerations) of economic activity tend, because of their dynamism and generally higher returns to capital and labor, to attract more such activity, while areas poor in productive factors languish. This means that efforts to stimulate growth in poor areas must be coordinated to make incremental advances on multiple fronts. In the absence of coordinated policies, the investment of public funds to facilitate growth and labor mobility in regions with a legacy of poor access to markets, education, and infrastructure may have the perverse effect of lowering overall aggregate growth (by drawing resources away from more immediately productive uses), thus presenting governments with the dilemma of favoring either growth or equity. In many cases, however, coordinated policies--generally including conditional cash transfers for the poor-- can enhance both poverty reduction and long-term growth. The challenge of making simultaneous progress on multiple fronts is central to the fate of the large group of countries where the world's poorest billion people live. Located mostly in Africa, the Caribbean, and the Pacific, these mostly small nations have not shared in the benefits of 74 Understanding Growth and Poverty globalization that have accrued to most people in the developed and developing worlds (Collier 2007). The average per capita GDP growth of the economies of the bottom billion was 0.5 percent in the 1970s, 0.4 percent in the 1980s, and ­0.5 percent in the 1990s. In comparison, per capita GDP growth in other developing countries increased from 2.5 percent in the 1970s to 4.0 percent in the 1980s and 1990s. These countries and their populations have not benefited from global- ization for reasons too complex to present here. Trade policy is partly to blame. For example, Africa has failed to develop jobs in export manufac- tures, such as garments and textiles, because European countries impose tariffs and other restrictions on imports of garments from Africa. The sub- sidies that the United States and European Union pay to domestic agri- cultural producers prevent many smaller countries from competing in export markets for the protected products. (We return to this point in the chapter on trade.) Corruption and poor governance prevent poor coun- tries from making the most of cyclical booms in commodity markets. Instead of being invested, windfall profits from high oil and mineral prices are siphoned off by elites. Conflicts over control of natural resources and between ethnic groups have also stunted the growth of many countries and prevented them from participating, except as suppliers of raw mate- rials, in the global system. Again, a coordinated set of changes will be required if the bottom bil- lion are to share in the benefits of global growth. The industrialized economies have a major role to play--through trade reform, the provision of security commitments in areas beset by conflict, and more generous aid (for example, to improve governance). Conclusion This chapter offered a quick survey of theories of economic growth. Along the way, we identified points on which economists have reached consensus, as well as several important questions still to be answered. The core finding of the chapter, one firmly supported by the evidence, is that sustained economic growth is the most critical factor in alleviating poverty. The poor usually are not left behind in the growth process but share in the gains that result from growth. That said, the rate at which poverty shrinks as growth accelerates differs from country to country. The initial level of income inequality in the country and changes in inequality over time play important roles here, as does the pattern of economic growth--and especially whether growth is concentrated in areas where Growth, Poverty, and Inequality: An Overview 75 poor people live. The links among economic growth, poverty, and inequal- ity have led to a focus on what is termed pro-poor growth, that is, growth that raises the incomes of the poor. In a virtuous circle of causation, poverty reduction is also good for growth. Note 1. 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Beyond Economic Growth. 2d ed. Washington, DC: World Bank. ------. 2005. Pro-Poor Growth in the 1990s: Lessons and Insights from 14 Countries. Washington, DC: World Bank. PA R T I I Government Policy, Growth, and the Poor CHAPTER 4 Government and the Economy-- Focus on Fiscal Policy Perfect markets operating under ideal circumstances will allocate resources efficiently. Markets are not perfect, however, and circum- stances are rarely ideal, a state of affairs that suggests a role for govern- ment. For example, government can tax or regulate the undesirable (if unintended) consequences of business activity, such as pollution. It can produce public goods (such as roads and military defenses), redistribute income, and define and enforce property rights. Government may also have a role to play in stabilizing the economy using monetary and fiscal policies. Fiscal policy, which deals with the various uses of taxes and pub- lic expenditures, is the focus of this chapter, with special attention devoted to its effect on the poor. Monetary policy--which deals with money supply, interest rates, inflation, and exchange rates--is discussed in the next chapter. The Role of Government in the Economy The government provides the legal framework and services needed for the effective operation of a market economy. In the context of economic development, that mission has five primary parts: providing a legal and social framework for economic activity; providing public goods; regulating 83 84 Understanding Growth and Poverty economic activity; reallocating resources; and stabilizing the economy. We will deal with each in turn. The existence of a problem in the market (or market failure) does not necessarily imply that government intervention can allocate resources more efficiently. A substantial amount of information is required to find the optimal allocation of resources, meaning that "government failure" may end up being worse than the original market failure that government action was meant to address. Even where enough information exists to solve a problem in the market, governments might not act efficiently. Interest groups will always become involved in public policy issues that affect them directly, and their interests may not be consistent with the interests of the general public. At times, there will be conflicts among a government's many goals. If a government pursues redistributive goals--for example, by transferring income from one group of people to another through higher taxes--it may reduce the efficiency of resource allocation. Thus, there can be an explicit trade-off between efficiency and equity. Setting the Legal and Social Framework for Economic Activity By creating a sound legal framework, government establishes the legal sta- tus of business enterprises and ensures the right and protection of private ownership, a key factor in encouraging entrepreneurship within a country's borders. By establishing the rules of the game, government directs the relationships among businesses, resource suppliers, and consumers, thus improving resource allocation (which, in turn, supports efforts to allevi- ate poverty). The protection of individuals' rights to the goods and services they exchange in a market system is almost everywhere provided by govern- ment, although private sector protection often complements government protection. Three basic institutions protect individual rights in a market economy: police forces, national defense forces, and the court and crimi- nal justice systems. By protecting individual rights, government creates a system that allows individuals to interact with one another through vol- untary agreement, reserving the legitimate use of force for government. Another important function of government is the enforcement of con- tracts, so that citizens can make agreements with the confidence that legal recourse is available should a party fail to fulfill its commitments. The protection of rights and the enforcement of contracts are neces- sary for a functioning economy, and their enactment makes up a sizable portion of the public budget. Countries with well-developed laws and Government and the Economy--Focus on Fiscal Policy 85 regulations enjoy a higher level of economic activity than those that provide few safeguards. The democratic model of checks and balances uses one branch of government to constrain the others, while the demo- cratic election of officials circumscribes the overall power of government. Providing Public Goods and Ensuring Positive Externalities Public goods and externalities provide the main theoretical justifications for government production. Public goods are those that can be enjoyed by all citizens without exclu- sion. Some examples include lighthouses, national defense, the legal system, and parks. Public goods are also indivisible; they must be produced in such large units that they cannot ordinarily be sold to individual buyers. Because of these characteristics, it is not feasible to charge for their consumption, and private suppliers lack the incentive to supply them. Externalities, or spillovers, occur when some of the costs or benefits of an economic activity are passed on (or spill over) to parties other than the immediate seller or buyer. Some externalities have a beneficial effect on others and are referred to as positive externalities; those that have a detri- mental effect are referred to as negative externalities. Pollution is an example of a negative externality, whereas training, education, and invest- ment in research and development have positive effects and, thus, are positive externalities. The market, left on its own, will tend to produce too many goods and services that carry negative externalities (indicating a need to tax those externalities or impose restrictions on their emer- gence) and too few goods and services involving positive externalities (indicating a need for government provision or subsidization). Regulating Economic Activity Regulation is called for when the private sector allocates resources ineffi- ciently and when the imposition of rules can provide incentives for more efficient private production, thus avoiding the need for direct government intervention. The market does not regulate property rights, financial markets, or trade relations. It does not provide a judicial system for the enforcement of contracts. It does not enact or enforce standards to promote human health, ensure public safety, or protect the environment. The state must provide these services directly--or regulate their providers. Similarly, monopolies have no incentive to produce efficiently or to charge appropriate prices, so the state must regulate them. It does so either by regulating prices or by setting service standards under antimonopoly laws. 86 Understanding Growth and Poverty In cases where monopolies cannot be avoided and may have particularly detrimental effects, it may be best for the public sector to provide the good or service in question. Good regulations allow markets to operate efficiently; bad ones inter- fere with market operations. Developing countries tend to have too few of the good kind (property rights, a well-functioning judiciary, effective environmental and financial regulations) and too many of the bad kind (too many obstacles to obtaining business licenses, overregulation of trade, tight price controls, and so on). The stability of regulation is also important: one of the most damaging effects of ill-considered state action is uncertainty. Economic actors need to be assured that the rules and regulations of an economy, the protection of property rights, and the provision of public goods are not subject to continuous change. Only in this way can a society function optimally and attract investment. Reallocating Resources There are a few closely related reasons why a government may redistrib- ute income. One is to improve the well-being of those members of soci- ety who are least fortunate, thus providing a safety net for people who have fallen on hard times (perhaps in the course of economic fluctuation) and ensuring that everyone has access to a minimal standard of living. Another is to provide greater equality, where that is a desired social goal. Although these two goals seem interrelated, they are different and may require different public policies. Helping the poor is not necessarily the same thing as promoting greater equality. At the extreme, the goal of equality could be achieved by confiscating the wealth of those who hold above-average amounts and giving it to those with below-average amounts until everyone has the same amount. This would destroy the incentive to be productive, however, and thus create an inefficient society for everyone. Although a market economy benefits society as a whole, it does not benefit everyone all the time. There are always winners and losers. But whatever the origin of unequal income distribution, each society must decide how much state intervention to allow, and to what end. The fea- tures shared by the most egalitarian societies are a public education sys- tem, a health-care system, unemployment insurance, and a public pension system. Public education is redistributive in that it provides everyone with equal opportunity. The tax system (the subject of the second part of this Government and the Economy--Focus on Fiscal Policy 87 chapter) is another way of redistributing income, usually for the purpose of achieving greater equality (although not all policies will have this effect). Higher taxes on upper-income individuals are often intended to further the goal of equality, but they may reduce the incentives of those affected to earn income, thereby reducing total tax revenue and limiting the options available to the state to reduce poverty. Likewise, taxation of investment income may further the goal of equality, but it also can dis- courage savings and investment, making the economy less productive, reducing economic growth, and leaving those at the lower end of the income scale worse off. The design of the tax structure will depend on whether the goal of redistribution is to achieve greater equality or to pro- vide direct help to the poor and vulnerable. As individuals know how best to allocate funds to meet competing demands and so maximize their well-being, cash transfers targeted to the poor and destitute--those who cannot help themselves--are usually the best form of redistribution. But evidence has also shown that cash payments may be misused by the poor, in particular, men, who may spend them on alcohol, cigarettes, and entertainment. Also, targeted transfers may "leak" to the nonpoor; if it is impossible to control such leaks, cash transfers may not be the best policy. Community- and region-targeted programs are other vehicles of redistribution. In the long term, the best ways of reducing poverty are to ensure greater access to credit, land, schooling, and health care; to better enforce prop- erty rights; and to provide food in return for work. Work requirements are seen as a means of preventing welfare dependency, a situation thought to emerge when benefits (especially cash) are not based on quid pro quo. Recently, countries such as Brazil have been successful in introduc- ing conditional cash transfer programs that encourage parents to keep their children in school (or take some other desired action) in return for cash compensation. The Employment Generation Scheme in Mumbai, India, employs unskilled manual laborers in public infrastructure projects; anyone who wants a job is hired. Workers are paid in basic supplies, sug- gesting that the poor are assumed to have limited ability to manage their own finances. Poor people can become trapped in poverty. The reasons are many: lack of education, credit, land, jobs, or roads to get to work or to bring goods to market. Perversely, dependency on social safety nets and welfare programs (even those that provide access to education and health care) can become part of the problem. Thus, it is important to anticipate the 88 Understanding Growth and Poverty consequences of redistributive policies and to act quickly to correct those that are undesirable--because they induce dependency or have some other side effect that may outweigh the benefits achieved by the redistri- bution. Decades of empirical evidence from both developed and develop- ing countries suggests that optimal redistributive policy should comprise the following features: · Welfare payments are made in cash rather than in kind to allow recip- ients to exercise their judgment and discretion. · A relatively high level of guaranteed income is combined with a phasing out of benefits. · Benefit programs are not financed by overtaxing those with the highest marginal incomes. Stabilizing the Economy Stabilization policies are designed to address acute fluctuations in economic activity that may be caused by demand-side shocks (such as an abrupt drop in demand for a country's exports) or supply-side shocks (such as the quadrupling of oil prices in the 1970s). These fluctuations are addressed using the instruments of fiscal policy (discussed in the next section of this chapter) and monetary policy (the subject of the next chapter). Some stabilizers are automatic--that is, they are activated by move- ments in certain related indicators. A prime example is unemployment compensation: if the economy falls into recession, unemployment com- pensation payments increase as people become unemployed. Tax pay- ments also typically decline as economic activity decreases. Such stabilizers provide channels through which the volatility of economic activity is automatically suppressed as it moves through the business cycle. Other stabilizers require a conscious policy choice. So-called active sta- bilization policies were very popular in the period immediately following World War II, influenced by the conventional wisdom that one of the key reasons for the Great Depression was the failure of the U.S. Federal Reserve and the American government to cut interest rates and increase spending after the crash of 1929. This view was popular at least until the 1970s, when many governments found that expansionary policies would not work if the problem impeding growth lay not in demand but rather in supply. If a government attempted to use monetary or fiscal policy to cre- ate more demand when the supply side of the economy was either at full employment or could not expand because of another bottleneck or rigid- ity, the result would be inflation and, in an open economy, a balance of Government and the Economy--Focus on Fiscal Policy 89 payments deficit (as imports increased). The "stagflation" of the 1970s was an example of this phenomenon. Since the 1980s, skepticism has grown about the effectiveness of active, countercyclical macroeconomic policy, especially fiscal policy, which is typically harder than monetary policy to activate and fine-tune. Although monetary policy is seen to have some role in stabilizing economic activity, it is now widely believed that the primary goal of monetary policy should be to restrain inflation. That said, in excep- tional circumstances such as the ongoing financial crisis, monetary policy has an important role to play in helping to stabilize demand. Fiscal Policy: Taxing and Spending Simply stated, fiscal policy consists of taxing and spending, with the first needed to finance the second. This section reviews the purposes of pub- lic spending, how it is financed, and the role (and financing) of budget deficits and government borrowing. The Purposes of Public Expenditure Public expenditure, a measure of the value of goods and services bought by the state, plays five principal roles in the economy: it (a) contributes to demand for the economy's products and services; (b) stabilizes the economy; (c) increases the public endowment of goods; (d) redistributes wealth; and (e) creates positive externalities for the economy and society, especially through capital investments. Public expenditure can be classified according to the types of goods and services purchased (capital goods, consumption goods, personnel), the official body that finances the expenditure (central government ministry, regional or local authority), and the macroeconomic purpose the expenditure is designed to serve (justice and public order, educa- tion, health). No single level of government spending can be said to fit all circum- stances. But the aggregate level of spending must be consistent with a country's macroeconomic framework. If it is not, persistently high or ris- ing budget deficits can result in various forms of macroeconomic imbal- ances. For example, as we discuss later, excessive budgets can give rise to inflation and crowd out private investment. Financing Public Expenditure Government finances its expenditure through taxation, fees, revenues from state-owned enterprises, borrowing, grants (such as foreign aid), and 90 Understanding Growth and Poverty the creation of new money. In developed countries, most government revenue is raised through taxation. In countries where the tax system is not well developed, nontax revenue may be the primary source of gov- ernment finance. Nontax revenue comprises fees levied by government (such as customs and excise duties) as well as profits and dividends from state-owned enterprises. Taxes are commonly divided into the following categories: · Income tax, levied on the income of households and businesses · Corporate income tax, levied on firms' profits · Sales and excise taxes, levied on commodities. It is important to maintain a balance between direct and indirect taxation. Direct taxation is generally a better tool for improving income distribution: those who earn more pay more. By contrast, indi- rect taxation--such as through international trade duties or through sales or value added tax (VAT)--although it tends to generate revenues more easily and is thus conducive to macroeconomic stability, is con- sidered regressive because all purchasers pay the same tax on a given transaction, regardless of their income or ability to pay. That is, indirect taxes impose a disproportionate burden on the poor. This inequity is often addressed by exempting certain basic goods, such as food, from taxation. Government revenue may also come in the form of foreign grants, as discussed in chapter 7 of this book. Grants may be either transfers of cash or provisions of goods and services from bilateral or multilat- eral donors. Grants have obvious benefits: they do not detract from private sector incomes in the recipient country and they rarely affect interest rates and inflation. But the costs can be high: grants tend to create a dependency on international aid that may impede develop- ment of the domestic market and other institutions. In addition, they often come with conditions that compromise government autonomy and may be costly to fulfill or may distract from other goals important to citizens' well-being. The ideal tax system generates a stable and assured source of revenue at a low cost (relative to the revenue it generates). Its simple structure makes compliance easy. It is understood by both taxpayers and adminis- trators. It is broad based in its application and does not distort production, consumption, or trade. It distributes the tax burden in a manner that is perceived to be fair and equitable (box 4.1). Government and the Economy--Focus on Fiscal Policy 91 Box 4.1 Five Characteristics of an Efficient Tax System 1. Economic efficiency. The tax system should not interfere with the efficient allo- cation of resources. 2. Administrative simplicity. The tax system ought to be easy and relatively inex- pensive to administer. 3. Flexibility. The tax system should be able to respond easily (in some cases, auto- matically) to changed economic circumstances. 4. Political responsibility. The tax system should be designed so that individuals know or can learn what they are paying for and so that there is no disconnect between the preferences of individuals and the actions of the state. 5. Fairness. The tax system ought to be fair in the way it treats all individuals. Source: Stiglitz 1984. Raising revenues by a few taxes with simple rate structures helps to contain administrative and compliance costs and avoids resentment of excessive taxation. By a broadening of the tax base and providing of limited exemptions, it is possible to raise revenues at lower rates and to make the revenue stream more predictable. For example, a VAT or a single-stage sales tax, when levied at a low and uniform rate on a broad base, is more efficient than the cumulative taxation of goods as they move along successive stages of production (a phenomenon known as cascading). By contrast, preferential tax rates and other fiscal incentives for investment are usually found to be ineffective in most developing countries. Government revenue collection depends not only on the structure of the tax system but also on its efficient administration, something that is often missing in developing economies. Perhaps for this reason, recent studies have shown that a country's government revenue, measured as a percentage of gross domestic product (GDP), correlates positively with its per capita income (figure 4.1). Deficits and Borrowing When a government spends more than it collects in revenue and grants, it is said to be running a budget deficit. Common wisdom holds that if a 92 Understanding Growth and Poverty Figure 4.1 Central Government Revenue and Log Per Capita GDP in 105 Developing Countries 50 BWA 40 IRL KWT LSO AGO MLT NAM TTO HKG CPV DZA OMN SGP 30 GAB VIN SWZ CZE EGY TUN GRD BHR ZWE JAM HRV GNQ MAR FJI BGR SKN COG SLBPNG JOR LCA POL ZMB CIV BLZ ZAF SVK SVN VNM VENMUS 20 TGO GMB MWI BDI ETH GNB KEN MDA MNG LKA BELIRN CYP MAC SEN INA PAN UKR URY KOR NGA GIN KGZ CMR COM ALB PHL NIC LVALTU TZA MOZ BEN MLI MDG RWA GHA BOL HND DOM PER CRI BRA PRY KAZ COL BGD BFA CAF HTI SLV 10 SLE NER GEO GTM TCD COD CHN ARG ARE 0 6 7 8 9 10 average log of per capita GDP Source: Gupta 2007. government cuts taxes and runs a budget deficit, then the private sector, including households, will respond to the increase in disposable income by saving and consuming more (according to each household's marginal propensity to consume, a concept introduced in chapter 2 of this book). But since household savings, for example, rise by only a fraction of the budget deficit, national savings (both private and public) must decline under deficit conditions. In a closed economy with no inflow of foreign savings, national savings are equal to domestic investment. In such an economy, a decline in national savings will push up real interest rates and reduce investment demand, increasing private savings--a cycle known as the crowding out of investment. A growing budget deficit leads to a buildup of public debt. Unless a government's budget deficit is covered by private savings minus invest- ment, it will create (in an open economy) a current-account deficit with the rest of the world, obliging the country to increase its net foreign debts to cover the deficit.1 If the government cannot finance the deficit by bor- rowing, pressure will build to finance it through depreciation of the national currency. Depreciation will lead to greater exports and, hence, reduce the current-account deficit. But depreciation leads to inflation, which cuts purchasing power--usually with serious political consequences. Government and the Economy--Focus on Fiscal Policy 93 Depreciation also increases the cost of servicing debts denominated in foreign currency. Financing Public Deficits Several options exist for financing public deficits, but not all of them are available or appropriate across contexts. The options include the following: · Issuing or selling debt instruments or obtaining domestic bank loans. Issu- ing debt or borrowing from local banks means that the government is borrowing from its citizens. This may be appealing, since costs are deferred while the government preserves its autonomy relative to the outside world. In addition, there is no risk of inflation in the short run. But selling debt competes for private savings at home, channeling money away from investment and raising the cost of borrowing for the private sector. · Borrowing from abroad. In recent years, some wealthier developing countries have gained access to international capital markets by obtaining a favorable credit rating from one of the large interna- tional rating firms. For most low-income countries, however, multi- lateral development banks (such as the World Bank, the Asian Development Bank, and the African Development Bank) and bilat- eral donors remain the only source of international finance. Regard- less of its source, foreign borrowing defers the costs of government programs without crowding out domestic investment or causing inflation, but it carries risks if loans must be repaid in foreign cur- rency. Foreign borrowing also obliges the borrower to comply with the lender's conditions. · Asset sales. The sale of government property to the private sector (pri- vatization) is another way of financing public deficits. Its appeal lies in the fact that the government need not make plans for repayment, since assets are being exchanged for revenue. But assets can be sold only once, so privatization cannot continue indefinitely. · Printing money. Printing money has the obvious appeal of immediately increasing the supply of ready cash, but its pernicious consequences last much longer--making this the last resort for most governments. Printing money has the perverse effect of lowering the amount of credit available to the private sector; investors, sensing risk, prefer to 94 Understanding Growth and Poverty purchase safer government securities. Even if more money is available overall, it is a harbinger of inflation, which distorts prices and erodes the value of household savings. The Uses of Fiscal Policy The government may attempt to use fiscal policy to smooth business cycles and redistribute income. While these are good goals, overreaching can crowd out private investment and trigger inflation. This section dis- cusses these important issues. Fiscal Policy and the Business Cycle Governments often have tried to smooth the business cycle through expansionary or contractionary fiscal policy. Under expansionary policy, the government spends money (or forgoes tax revenue) to stimulate aggregate demand in the economy, thereby boosting economic activity. The initial response of aggregate demand is typically greater than the gov- ernment expenditure (or loss of tax revenue) employed to induce it because of the multiplier effect. When the government raises spending or lowers taxes to increase aggregate demand, businesses respond to the increased demand by increasing investment. As businesses invest more, they hire more workers, increasing employment. There are now more workers with a paycheck, and their spending creates a further increase in demand for goods and services. Businesses respond to that increase by investing more. As they do so, they hire more workers and increase employment--the multiplier effect. With contractionary fiscal policy, the opposite happens. The fiscal policy the country chooses will depend on its economic sit- uation and the time frame envisaged by policy makers. Short-run fiscal policy may aim at smoothing the business cycle or reducing poverty, but over the long run the aim should be to keep the deficit at a low and sta- ble level to help underpin economic growth. As we will see, high and sus- tained deficits can discourage investment, ignite inflation, and cause balance of payment problems. Investment, Inflation, and the Effects of Deficits We have seen that unchecked government spending and expansionary fis- cal policies harm the economy by causing inflation and crowding out pri- vate investment. Under expansionary fiscal conditions, inflation is likely to rise as aggregate demand (spending) outstrips the aggregate supply of Government and the Economy--Focus on Fiscal Policy 95 goods and services. Under such conditions, businesses have difficulty keeping up with orders and respond to the excess demand by raising prices. Under tight labor-market conditions, employers may also be forced to raise wages to attract new workers and retain existing ones. Consider the same problem from the financing side. High and sus- tained fiscal deficits, if financed by printing money, set the stage for higher inflation. If the government finances its deficits by borrowing in the bond market or from private banks, rather than from the central bank, interest rates will increase or the terms on private bank loans will become more stringent. Either way, private investment is likely to be crowded out as investors and lenders prefer the sovereign borrower because it poses lower risk. By contrast, low and stable fiscal deficits send a positive message about a government's ability to service its debt. Such a stance may thus prevent the probability of economic crisis. Macroeconomic stability yields further benefits as well--higher rates of investment, growth, and educational attainment; greater distributional equity; and reduced poverty. Fiscal Policy and the Poor In a developing economy, taxation is generally less effective than spend- ing in promoting growth and improving the lot of the poor. The rich gen- erally have ways of avoiding high taxes on their income. Even exempting some staple items from consumption taxes (sales tax or VAT) may not benefit the poor, because the rich can afford to spend a larger absolute amount on the exempted good, so they derive the largest benefit. In such cases, repealing the exemption could yield revenue that could be spent in a more pro-poor way. On the other hand, there is evidence that increased spending on phys- ical and human capital formation can promote economic growth and reduce poverty. Even during times of fiscal consolidation, protecting investment in physical and human capital does more to ensure long-term economic health than the alternatives (increasing public sector wages, for example). Government spending on health and education contributes to the well-being of a population and increases worker productivity. Reducing communicable disease also increases worker productivity and helps to promote tourism and attract foreign direct investment (FDI). Governments regulate and prioritize public expenditure through the national budget. By ensuring participation of the poor in allocating resources, tracking expenditures, and monitoring service delivery, the budget can be made more demand driven and pro-poor. Participatory 96 Understanding Growth and Poverty budgeting has been used in many Brazilian municipalities since the mid-1980s. It involves, first, checking that the previous year's budget was executed in line with stated policies and, second, bringing together peo- ple from different geographical areas and interest groups to set spending priorities for the next budget. Participatory budgeting has allowed public expenditure to more closely reflect citizens' preferences. In Brazil, for example, participatory budgeting is predominant at the local government level. It has resulted in a large shift toward investment in water and sanitation, the top priorities noted by its citizens (Goldfrank 2007). Conclusion In this chapter--the first describing facets of public policy--we discussed the many roles that government can play in an economy, whether through fiscal policy or other means. The chapter first analyzed the pri- mary functions of government in providing the legal framework and serv- ices needed for the effective operation of a market economy. These include providing public goods, regulating economic activity, stabilizing the economy, and redistributing income--the most fundamental roles of government. We then looked at fiscal policy, including expenditure and taxation policies, before turning to the impact of fiscal policy on the busi- ness cycle and other economic phenomena, including inflation and the crowding out of private sector investment. We concluded by examining the ways in which fiscal policy can benefit the poor--primarily through government expenditure. Note 1. This was examined in the discussion of absorption, savings, and the current- account deficit in chapter 2 of this book. Bibliography Flug, K., A. Spilimbergo, and E. Wachtenheim. 1998. "Investment in Education: Do Economic Volatility and Credit Constraints Matter?"Journal of Development Economics 55 (2): 465­81. Goldfrank, Benjamin. 2007. "Lessons from Latin America's Experience with Participatory Budgeting." In Participatory Budgeting. Public Sector Governance and Accountability Series, ed. Anwar Shah. Washington, DC: World Bank. Government and the Economy--Focus on Fiscal Policy 97 Gupta, Abhijit. 2007. "Determinants of Tax Revenue Effort in Developing Countries." IMF Working Paper WP/07/184, International Monetary Fund, Washington, DC. Ray, D. 1998. Development Economics. Princeton, NJ: Princeton University Press. Rebelo, S., and W. Easterly. 1992. "Marginal Income Tax Rates and Economic Growth in Developing Countries." Policy Research Working Paper Series 1050, World Bank, Washington, DC. Stigler, George J. 1970. "The Case, If Any, for Economic Literacy." Journal of Economic Education 1 (2): 77­84. Stiglitz, Joseph E. 1984. "Price Rigidities and Market Structure." American Economic Review 74 (2): 350­55. CHAPTER 5 Monetary Policy, Inflation, and Exchange Rates As discussed in previous chapters, poverty can be reduced by increasing economic growth and by raising the poor's share in that growth. Economic growth can be fostered by a set of policies aimed at achieving and maintaining macroeconomic stability: low budget deficits, a low and stable rate of inflation, and sustainable external debt. Of central impor- tance to the rate of inflation in the economy are fiscal and monetary poli- cies. Chapter 4 focused on fiscal policy; here, we offer an introduction to monetary policy and its main instruments. We continue with a descrip- tion of inflation, its causes, and its impact on economic growth and poverty. We then discuss exchange-rate policies and fixed versus flexible exchange rates. Definitions and Concepts Monetary policy may be loosely defined as a central bank's decisions con- cerning money supply, inflation, and exchange rates. Monetary policy works through changes in money supply and interest rates. For example, in the face of a recession and high unemployment, the central bank may use expansionary monetary policy to stimulate demand. In such a case, with reference to figure 5.1, the central bank would expand the money 99 100 Understanding Growth and Poverty Figure 5.1 Money Demand and Money Supply Ms · When the interest rate rises, the opportunity cost of holding money B increases and the quantity of money r2 demanded falls. · The location of Md is determined by the level of income. interest rate Ms A r1 Md Qmd Qmd quantity of money Source: Authors. Note: When the prevailing interest rate is r1, the money demand Md and money supply Ms intersect at point A; the money market is in equilibrium at r1 and the quantity of money demanded is Qmd. When the interest rate increases to r2, the money supply curve shifts back, and the new equilibrium at point B corresponds to the new interest rate r2 and a lower quantity of money demanded, Qmd. supply (Ms) and bring down interest rates (from r2 to r1), spurring demand for money to rise. We can think of the interest rate as the price of money. If the supply of money increases relative to demand, the price (the interest rate) falls. Lower interest rates mean that it is cheaper to bor- row money, which stimulates business investment and induces consumers to spend more. As businesses invest, they hire more workers, increasing employment. Workers' spending creates an increase in aggregate demand for goods and services. Businesses respond to the increase by further increasing investment and employment, and so on. In managing the money supply, the central bank uses two types of monetary instruments: direct and indirect. Direct Monetary Instruments The central bank exerts direct control over the money supply in three ways: (a) through credit ceilings on individual banks, (b) through control of interest rates, and (c) through discriminatory capital-to-asset ratios. All of these instruments have fallen out of favor in industrialized countries, but most developing countries still use them. Monetary Policy, Inflation, and Exchange Rates 101 Once a national credit ceiling has been established, individual ceilings are then established for each major financial institution, based on past market shares. Credit ceilings are reasonably effective in preventing excessive credit expansion in the short term but lose their effectiveness over time because they tend to reduce competition among banks--once a bank reaches its credit ceiling, it has no incentive to attract additional deposits. Banks may concentrate on their established clients and be unwilling to finance new projects that might have proven more profitable. Thus, the flow of capital in the economy is restricted. Furthermore, when credit is disbursed based on administrative criteria rather than profitabil- ity, corruption tends to increase. Disaffected depositors and borrowers cre- ate incentives for financial dealings outside the control of the central bank. As credit operations are conducted outside the banking system, the central bank loses control of monetary policy. Interest rate controls are often introduced along with credit ceilings. Over time, these may be ineffective, as it is generally not possible to con- trol both the cost and quantity of credit. Fees on the credit extended may be imposed, thus raising the cost of credit and defeating the original pur- pose. Moreover, excessive fees and other restrictions on loans reduce the transparency of the price system in providing correct signals for the allo- cation of resources. The central bank may impose a minimum capital-to-asset ratio to force branches of foreign-owned banks to increase their capital. Indirect Monetary Instruments The central bank's indirect instruments of monetary policy include (a) reserve requirements, (b) lending facilities, (c) open-market operations, and (d) deposit management. Reserve requirements specify the amount of cash that banks must hold in their vaults or on deposit with the central bank. The requirements affect the money supply through the "money multiplier." An increase in reserve requirements typically raises banking system costs--because interest rates paid to banks for reserve holdings are typically less than the rates banks pay to depositors. Those costs tend to be passed on in the form of higher interest rates on loans. Frequent changes in reserve require- ments can confuse market participants and lead to excess holdings of reserves. This, in turn, can hamper the effectiveness of monetary policy. By expanding or restricting access to its credit and refinancing (or redis- counting) facilities, the central bank can influence credit expansion in the economy. But those facilities should provide only short-term or emergency 102 Understanding Growth and Poverty financing to the banking system. In some developing countries, political pressures have led to the use of this instrument to extend credit to com- mercial banks with inadequate reserves (such as state-owned banks) or to provide support to troubled financial firms. Reducing access to central bank rediscount facilities and credit is very effective in controlling the money supply, because it curtails credit to the private sector through the banking system, thereby reducing the money supply and controlling inflation. The discount rate--the interest rate that a bank must pay the central bank when it borrows money from it--is generally high to dis- courage borrowing by commercial banks, which could offset the impact of open-market operations, as discussed below. The central bank also operates as the lender of last resort in emergency circumstances. In doing so, it generally provides credit at high interest rates and only when bor- rowing banks are in a position to supply high-quality collateral. This encourages banks to first seek funds from the public or from the inter- bank market. Open-market operations are purchases and sales (or borrowing and lending) of securities by the central bank to increase or reduce liquidity in the economy. Open-market operations offer several advantages, includ- ing development of the money market and the flexibility such operations give the central bank in conducting monetary policy. The central bank manages government deposits. Transferring govern- ment deposits between banks and the central bank affects reserve levels. In so doing, the central bank performs its essential role as the govern- ment's fiscal agent; however, deposit management, viewed narrowly, is not the most transparent instrument of monetary control. It does noth- ing, for example, to encourage market development and competition. Inflation Inflation is a sustained rise in general price levels combined with a fall in the purchasing power of money. It is measured by weighting the prices of goods and services in order of importance and combining them to pro- duce one of several indexes: · The consumer price index (CPI) measures the price of a selection of goods and services purchased by the average consumer. CPIs are often used in wage and salary negotiations because employees seek pay raises that equal or exceed the increase in the cost of living, for which the best proxy is the rate of increase of the CPI. Monetary Policy, Inflation, and Exchange Rates 103 · The wholesale price index (also known as the producer price index) reflects changes in the prices paid for goods at various stages of distri- bution, among them prices of raw materials for intermediate and final consumption, prices of unfinished goods, and prices of finished goods.1 · The commodity price index measures the change in price of a selection of commodities. · The gross domestic product (GDP) deflator is a measure of the changes in prices of all goods and services produced in an economy. Although this measure has the advantage of being comprehensive, it typically is available only quarterly, with a long lag, and is subject to revision. When inflation is zero or very low, the economy enjoys price stability. Under conditions of price stability, inflation has no material impact on individual economic decision making. Moreover, a low, but positive, infla- tion rate (say, 2 percent a year or less) can have positive effects on the economy, because it allows relative prices and wages to adjust more eas- ily, keeping unemployment lower than it otherwise would be. But once inflation rises above a certain level, it can distort decision making and have negative effects on the economy and growth. Types of Inflation Economists distinguish between two types of inflation: · Demand-pull inflation occurs when too much money is chasing too few goods--that is, when the demand for goods and services by con- sumers, investors, and the government exceeds available supply. Because resources are fully employed, the business sector cannot respond to additional demand by expanding output, so firms typically react by pushing up prices instead. · Supply-side (or cost-push) inflation occurs when a firm passes on an increase in production costs to the consumer in the form of higher prices. The inflationary effect of increased costs may be the result of wage increases that lead to a wage-price spiral (when price increases spark a series of wage demands that lead to further price increases, and so on) or a wage-wage spiral (when one group of workers receives a wage increase that sparks a series of wage demands from other work- ers). Cost-push inflation may also be stimulated by increased import prices following a rise in world prices for imported raw materials or a depreciation of the local currency. 104 Understanding Growth and Poverty Central banks can affect inflation by adjusting interest rates and manipulating the other instruments of monetary policy. But they differ in their approach to fighting inflation. High interest rates are perhaps the most common method. The decline in production and rise in unemploy- ment that follow hikes in interest rates prevent price increases. Another school of thought advocates fighting inflation by fixing (or "pegging") the rate of exchange between the national currency and a stable reference, such as the U.S. dollar. This method has had varying success: in spite of efforts to curb inflation, some nations have experienced double- or triple- digit annual rates of inflation in recent years. Causes of Inflation As we have seen, inflation is typically caused by excess demand or by pro- ducers passing on higher costs in the form of higher prices. The central bank plays a role in creating and quelling both conditions. If the central bank pursues a tight monetary policy--by increasing interest rates or restricting the money supply--excess demand will be wrung out of the system, and producers will not be in a position to pass on all their costs in the form of higher prices. On the other hand, an accommodative mon- etary policy--low interest rates or rapid expansion of the money supply-- will allow price increases to continue or even accelerate (figure 5.2). Fiscal policy (as discussed in chapter 4) can support or hinder mone- tary policy operations. Prudent fiscal policy allows government to operate with little or no borrowing by the central bank, thereby lowering the risk of creating excess money. By contrast, profligate fiscal policy and high lev- els of borrowing can force a central bank into an unsustainable monetary stance. Inflation and Economic Growth While inflationary policies can stimulate economic growth in the short term, the economic literature suggests that, over the medium and long term, high rates of inflation are bad for economic growth. Cross-country studies show that countries with consistent positive growth records have, on average, much lower rates of inflation than other countries. Why might this be? The basic reason is that prices perform a critical signaling mechanism in any market economy, where resources are allo- cated based on prevailing relative prices. When inflation is high, these price signals become distorted--it becomes difficult to distinguish between relative and secular price changes--and resources are not allocated Monetary Policy, Inflation, and Exchange Rates 105 Figure 5.2 Path from Expansionary Monetary Policy to Inflation expansionary monetary policy higher money base lower interest rate growing private sector credit asset price more spending more output in inflation short run consumer price increase capacity inflation constraints, tight labor market Source: Authors. efficiently. Moreover, high inflation encourages consumption instead of saving. Higher prices induce people to purchase more products now (before they become more expensive) and discourage people from saving, because money saved for future use will have less value. Savings are needed for investments in capital goods and technology, the real engines of wealth. When investment is curtailed and productivity growth stunted, overall growth is impeded. In a seminal article, Fischer (1993), while noting a positive relationship between growth and low levels of inflation, showed that economic growth was negatively associated with high levels of inflation (and with large budget deficits and distorted foreign exchange markets). Subsequent studies confirm a nonlinear relationship between inflation and economic growth that is negative once a certain threshold level of inflation is reached. The threshold effect differs according to country con- ditions. The threshold above which inflation acts as a brake on economic growth is estimated at 1 to 3 percent for industrialized countries and 106 Understanding Growth and Poverty between 7 and 11 percent for developing countries (Khan and Senhadji 2000). Above these levels, the negative relationship between economic growth and inflation holds true regardless of the estimation method (that is, regardless of the level of the threshold, the exclusion of high-inflation observations, data frequency, and other model specifications). More generally, high rates of inflation are associated with poor macro- economic performance. The typical goal of macroeconomic policy is a high and sustained growth of output, alongside low and stable inflation. As noted by Fischer (1993), inflation serves as "an indicator of the over- all ability of the government to manage the economy." Because it is essen- tial for macroeconomic stability, inflation control is a central component of the macroeconomic policy of most governments and of the structural adjustment programs advocated by the International Monetary Fund. In recent years, African countries have succeeded in bringing down inflation, with average annual inflation on the continent dropping from 17 percent in 1990 to 10 percent in 2003 (in Sub-Saharan Africa, from 20 percent to 12 percent) (Rogoff 2003). Inflation and the Poor In the previous section, we noted the negative relationship between eco- nomic growth and inflation. Given the positive impact of economic growth on poverty reduction, it is unsurprising that many studies find that the costs of inflation are borne most heavily by the poor. A poll by Easterly and Fischer (2001) showed that inflation was more likely to be rated a top national concern by the poor than the rich. The survey showed that improvements in the share of per capita income retained by the poor were negatively correlated with the rate of inflation, as was the percentage decline in poverty and the percentage change in the real min- imum wage. Lower rates of inflation are associated with improvements in the Human Development Index (HDI), regardless of the country's start- ing point on the index (table 5.1).2 On a more practical level, the poor suffer disproportionately from inflation, particularly in rural areas. They lack the resources that enable the wealthy to diversify into inflation-proof assets. Furthermore, they have less access to the financial system and tend to hold their balances in cash, the value of which falls with inflation. The poor also depend heav- ily on wage labor. Given that wages and prices are sticky--that is, that they do not respond to changed market conditions in the short run--the poor suffer disproportionately when inflation rises rapidly. High inflation Monetary Policy, Inflation, and Exchange Rates 107 Table 5.1 Growth, Inflation, and the Human Development Index Growth in real Inflation Variability of inflation GDP per capita (percent change) (standard deviation) Low HDI (0­0.5) Slow change in HDIa ­0.22 91.50 259.83 Rapid change in HDIb 1.42 13.60 10.81 Medium HDI (0.51­0.70) Slow change in HDIc 0.63 151.85 311.03 Rapid change in HDId 1.85 54.81 179.01 High HDI (0.71­0.80) Slow change in HDIe 0.34 82.07 114.53 Rapid change in HDIf 5.34 14.77 22.82 Sources: Cashin, Mauro, and Sahay (2001, table 3); United Nations (2000); World Bank, World Development Indica- tors, various years; International Monetary Fund, International Financial Statistics, various years. Notes: a. Botswana, Burkina Faso, Burundi, Cameroon, the Central African Republic, the Democratic Republic of Congo, the Republic of Congo, Côte d'Ivoire, Ghana, Guinea-Bissau, Kenya, Lesotho, Madagascar, Malawi, Mauritania, Niger, Papua New Guinea, Senegal, and Togo. b. Bangladesh, Benin, Chad, the Arab Republic of Egypt, The Gambia, India, Indonesia, Mali, Morocco, Nepal, Nigeria, Pakistan, and Sudan. c. Brazil, Colombia, Dominican Republic, Ecuador, El Salvador, Fiji, Guyana, Jamaica, Mauritius, Mexico, Nicaragua, Paraguay, Peru, the Philippines, South Africa, Sri Lanka, and Zimbabwe. d. Algeria, Bolivia, China, Guatemala, Honduras, the Islamic Republic of Iran, the Republic of Korea, Malaysia, Saudi Arabia, Swaziland, the Syrian Arab Republic, Thailand, Tunisia, and Turkey. e. Argentina, Costa Rica, Hungary, Panama, Romania, Trinidad and Tobago, the United Arab Emirates, Uruguay, and República Bolivariana de Venezuela. f. Chile; Hong Kong SAR; China; Israel; Malta; and Singapore. tends to lower the real minimum wage and the share of national income commanded by the bottom quintile of the population. Exchange-Rate Policy Although this chapter is mainly concerned with inflation and its relation- ship to economic growth and poverty, we conclude with a brief analysis of exchange-rate policy. Flexible and Fixed Exchange Rates Flexible rates. Countries with flexible exchange rates allow their currency to rise or fall in value against other currencies, depending on the demand for and supply of the currency relative to other currencies. For example, if the U.S. government supplies many more dollars than the French gov- ernment supplies euros to the world economy--for example, through a more expansionary monetary policy--then there will be an increase in the relative world supply of dollars and a decrease in the relative supply 108 Understanding Growth and Poverty of euros. Consequently, barring other changes in demand, the price (value) of the dollar relative to the euro will fall (or depreciate), and the price of the euro relative to the dollar will rise (appreciate). An increase in relative demand can also cause the currency to fluctuate. If one assumes other variables do not change, an increase in demand for U.S. dollars relative to the euro (for example, because of an increase in demand for American goods or financial assets) will increase the price (value) of the American dollar and decrease the price of the euro. The advantage of fluctuating exchange rates is that the rates are more likely to reflect the true underlying value of the currency, thereby minimizing economic distortions. Fixed rates. Some countries prefer to keep the value of their currency fixed (or pegged) relative to other currencies, regardless of prevailing demand and supply. Advantages of this system include more predictabil- ity for businesses engaged in international trade. Fixed exchange rates also can perform a useful role in anchoring inflation expectations in a country that is determined to break from high inflation. The disadvantage is that countries often find it difficult to exit from a pegged exchange rate, even when the exchange rate clearly has become overvalued. In such a situa- tion, central banks often intervene to defend the currency by selling for- eign reserves. When central banks' reserves become depleted, however, countries are often forced to devalue their currency. This can lead to higher inflation and import prices--hurting the poor--and can damage the balance sheets of the government (by raising the burden of servicing foreign debt), of banks (if they have more foreign liabilities than assets), and of corporations (again, if they have foreign liabilities unmatched by foreign income streams). More and more developing countries have adopted floating or flexible exchange-rate arrangements during the past 15 years. Maintaining fixed exchange rates can cause a gradual erosion of competitiveness if domestic inflation is higher than that of trading partners (which is often the case for developing countries). China is a singular example; even as it has main- tained a fixed exchange rate, its exports have remained very competitive because its currency has been grossly undervalued.3 For the most part, how- ever, for developing countries that are heavily dependent on exports of a few commodities, flexible exchange rates often play a useful buffer role. Other Exchange-Rate Options Full dollarization. Under this option, followed by Panama and Ecuador among others, the local currency is abolished and a foreign currency Monetary Policy, Inflation, and Exchange Rates 109 (in this case, the U.S. dollar) is adopted as the sole legal tender. Although this has the advantage of providing stability, certainty, and low inflation rates (essentially, U.S. inflation rates), it also has several disadvantages. If a country's trade is not heavily weighted in favor of the adopted currency-- for example, if most of its trade was with countries that use the euro-- full dollarization might not be a satisfactory option. More generally, unless the country has very close ties with the parent country, adopting the par- ent's monetary regime may not make much sense. Another disadvantage is that by abolishing its domestic currency, countries give up seignorage-- the profits derived from issuing currency at very little cost. Currency board. Under currency board arrangements, a country retains its own currency but promises to exchange the domestic currency for a foreign currency at a fixed given rate. To back up this promise, the central bank holds reserves at least equal to the domestic base money supply (so that the exchange promise can be fulfilled) and allows the money supply to be determined solely by inflows and outflows of foreign exchange. Domestic credit expansion is prohibited under such a system, even for lenders of last resort. By providing a stronger exchange-rate commitment than regular exchange-rate regimes, a well-run currency board, such as that of Hong Kong SAR, China or that of Lithuania, can provide credibil- ity and anchor expectations--substantial advantages. At the same time, the exit problem is intensified and can result in terrible economic conse- quences, as in Argentina's forced exit from the currency board in 2001. Other. Most countries adopt neither of the solutions identified above. Few countries' currencies float freely (that is, free of intervention), and fixed rates rarely last long without some form of exit. Many countries practice "dirty" or managed floating exchange-rate regimes, normally refraining from intervention but resorting on occasion to foreign- exchange transactions when the market is thought to have strayed too far from equilibrium. Conclusion This chapter examined the role of monetary and exchange-rate policy. These policies can have a large impact on economic performance, espe- cially in the short term. Badly handled, they can impede economic growth and hurt the poor. The chapter began by examining the nuts and bolts of monetary policy operations and instruments. It described how developing countries still use direct instruments of monetary control, including credit ceilings and interest rate controls. Such policies can be 110 Understanding Growth and Poverty highly distortionary and have been largely abandoned by industrialized countries in recent decades in favor of indirect monetary instruments. Indirect instruments, also used by developing countries, include reserve requirements, central bank lending facilities, and open-market operations. Next, we discussed different inflation measures, different types of infla- tion, and the various causes of inflation. We saw that while loose (or expansionary) monetary policy can stimulate the economy in the short run, it can cause high and volatile inflation, the costs of which are borne disproportionately by the poor. We concluded with a brief analysis of exchange-rate policy and the various exchange-rate options open to pol- icy makers, ranging from formal dollarization to free-floating exchange- rate regimes. The choice of an exchange-rate regime depends on a country's characteristics, including its inflation performance, monetary credibility, trading patterns, and vulnerability to external shocks. Notes 1. The prices are the amounts paid by the purchaser, excluding any deductible value added tax or similar deductible tax, but including transport charges paid separately by the producer to deliver goods at the required time and place. 2. The HDI is a measure of well-being that includes three basic dimensions of human development: longevity (life expectancy at birth); educational attain- ment (literacy and enrollment rates in education); and living standards (GDP per capita at purchasing power parity). The HDI ranges between 0 (low human development) and 1 (high human development). 3. For over a decade, the Chinese government has pegged the value of China's currency--the renminbi--to an artificially low level relative to the U.S. dollar. Most economists believe that if China's currency were allowed to trade freely, it would be worth more. No one can know for sure how much more, but lead- ing economists have estimated that its value would be 10 to 40 percent higher than it is now. With its currency undervalued, China is discounting its own exports, so that exports from China are cheaper than they otherwise would be, helping China's economy grow. Low export prices are good news for con- sumers in other countries who pay less for the same good. But manufacturing industries outside China suffer because they cannot compete with low Chinese prices. Bibliography Anderson, Theodore W. 1971. The Statistical Analysis of Time Series. New York: Wiley. Monetary Policy, Inflation, and Exchange Rates 111 Ball, Lawrence. 1990. "Credible Disinflation with Staggered Price Setting." National Bureau of Economic Research Working Paper 3555. Cambridge, MA. Brayton, Flint, and Jaime Marquez. 1990. "The Behavior of Monetary Sectors and Monetary Policy: Evidence from Multicountry Models." In Financial Sectors in Open Economies: Empirical Analysis and Policy Issues, ed. Peter Hooper, Karen H. Johnson, Donald L. Kohn, David E. Lindsey, Richard D. Porter, and Ralph Tryon. Washington, DC: Board of Governors of the Federal Reserve System. Bryant, Ralph, Gerald Holtham, and Peter Hooper, eds. 1988. External Deficits and the Dollar. Washington, DC: Brookings Institution. Bryant, Ralph, Peter Hooper, and Catherine Mann, eds. 1992. Evaluating Policy Regimes: New Research in Empirical Macroeconomics. Washington, DC: Brookings Institution. Calvo, Guillermo. 1978. "On the Time Consistency of Optimal Policy in a Monetary Economy." Econometrica 46 (6): 1411­28. Cashin, P., P. Mauro, and R. Sahay. 2001. "Macroeconomic Policies and Poverty Reduction: Some Cross-Country Evidence." Finance and Development 38 (2): 46­49. Dornbusch, Rudiger. 1976. "Expectations and Exchange Rate Dynamics." Journal of Political Economy 84 (December): 1161­71. Easterly, W., and S. Fischer. 2001. "Inflation and the Poor." Journal of Money, Credit and Banking 33 (2): 160­78. Fischer, Stanley. 1990. "Rules versus Discretion in Monetary Policy." In Handbook of Monetary Economics, ed. B. Friedman and F. Hahn. Amsterdam: North- Holland. ------. 1993. "The Role of Macroeconomic Factors in Growth." Journal of Monetary Economics 32 (3): 485­512. ------. 1996. "Maintaining Price Stability." Finance and Development 33 (December): 34­37. IMF (International Monetary Fund). Various years. International Financial Statistics. Washington, DC. Khan, Mohsin S., and Abdelhak S. Senhadji. 2000. "Threshold Effects in the Relationship between Inflation and Growth." IMF Working Paper WP/00/110, International Monetary Fund, Washington, DC. McKinnon, Ronald. 1988. "Monetary and Exchange Rate Policies for International Financial Stability." Journal of Economic Perspectives 2 (1): 83­103. Rogoff, K. 2003. "Straight Talk: Unlocking Growth in Africa." Finance and Development 40 (December): 54­5. UN (United Nations). 2000. A Better World for All. New York: UN. World Bank. 2005. World Development Indicators. CD-ROM. Washington, DC: World Bank. CHAPTER 6 Financial Development A large body of theoretical and empirical literature supports a positive causal link between a well-functioning financial system and economic growth. In particular, the economic growth studies of the past decade show that financial sector depth provokes and sustains economic growth. In fact, it is one of the few robust determinants of the growth path of countries. An important related question is whether macroeconomic developments can stimulate the financial sector. They can, as we demon- strate below. Although the link between financial sector development and growth is well established, the relationship between financial development and the income of the poor remains unclear. Competing theories predict the impact of financial development on changes in income distribution and poverty alleviation. Recent empirical studies have, however, found that financial development reduces income inequality by disproportionately boosting the incomes of the poor. In particular, studies have found that countries with better-developed financial intermediaries experience faster reductions in poverty and income inequality. While financial development can be very beneficial, the data show that usage of financial services is far from universal in many developing coun- tries. Fortunately, countries can increase access to financial services by 113 114 Understanding Growth and Poverty strengthening their institutional infrastructures, liberalizing markets, fos- tering greater competition, and encouraging innovative uses of know-how and technology. This chapter analyzes each of these issues in turn. It concludes by dis- cussing other topics relevant to the general theme of financial develop- ment and poverty: the history of financial sector reform in developing countries in recent decades, the role of microfinance in providing credit to the poor, and the importance of emigrants' remittances for many developing countries. Financial Development and Economic Growth The proposition that financial sector development supports economic growth is fairly well established in the literature. Almost a century ago, Schumpeter (1911) argued that financial intermediation through the banking system played a key role in economic growth by improving pro- ductivity and technical change. The specific channels through which financial development can help economic growth include: (a) raising and pooling funds (allowing riskier investments to be undertaken); (b) allocat- ing resources to their most productive use; (c) allowing effective monitor- ing of the use of funds; (d) providing instruments for risk mitigation; (e) supporting firms' growth opportunities, especially for small and medium enterprises; and (f) reducing inequality. Turning to the empirical evidence, Jalilian and Kirkpatrick (2005) and Levine (2005) review the current state of play. Recent cross-country econometric analysis provides evidence that financial development is robustly related to economic growth (King and Levine 1993; Arestis and Demetriades 1997; Levine 1997; Rajan and Zingales 1998; Caprio and Honohan 2001). The link seems to work mainly through greater accumu- lation of physical capital and improvements in economic efficiency under well-developed financial systems. Recent econometric techniques that use the pooling of cross-country and time-series data make it possible to test the direction of causality between financial development and growth. Studies that employ these techniques--including those of Levine, Loayza, and Beck (2000) and Beck, Levine, and Loayza (2000)--also find a positive link between finan- cial development and growth. The causal factors include the contribution of financial development to private savings, capital accumulation, and productivity, with the last playing the most important role. Financial Development 115 In terms of the magnitude of this impact, Caprio and Honohan (2001) have found that a doubling of private sector credit as a share of gross domestic product (GDP)--a common measure of financial depth--is associated with a 2 percentage point increase in the rate of GDP growth.1 But the literature also finds substantial cross-country heterogeneity in the relationship between financial development and economic growth-- unsurprising, given structural, institutional, and policy differences in the economies included in the sample (Jalilian and Kirkpatrick 2005). That topic is covered later in the chapter. The development of a financial system will necessarily be affected by endogenous and exogenous factors and by the sociopolitical development of individual countries. Endogenous factors refer to indicators of the soundness of individual financial institutions. Commonly used to assess that soundness is the CAMELS framework. The acronym stands for cap- ital adequacy, asset quality, management soundness, earnings and prof- itability, liquidity, and sensitivity to market risk. Exogenous factors refer to macroeconomic developments that can affect financial system depth. Imbalances in economic growth rates may have a negative impact on the financial system of a country in at least two respects. First, low or declining aggregate growth rates often weaken the debt-servicing capac- ity of domestic borrowers and raise credit risk. Second, if an economy is overly dependent on one or two sectors for its economic growth, and if financial institutions are overly exposed in those sectors, an adverse real sector shock may have an immediate impact on the financial system. The system is even more vulnerable if those sectors are subject to exogenous forces, such as climatic conditions. The pattern and trend of inflation has a direct bearing on the stability and health of the financial system. High and volatile inflation complicates the task of accurately assessing credit and market risk in a financial institution's portfolio and its ability to manage and plan for the future. The relationship between financial system devel- opment and a country's external position, exchange rates, and interna- tional interest rates is complex (table 6.1). Four Decades of Financial Sector Reform in Developing Countries The early stage of financial sector reform in developing countries--from the mid-1970s up to the late 1980s--concentrated on liberalizing inter- est rates, moving to indirect instruments of monetary control (such as 116 Understanding Growth and Poverty Table 6.1 Possible Effects of Various Policies on the Financial System Indicator Pattern/movement Comment Current-account deficit Increasing May signal vulnerability to currency as share of GDP crisis if foreign investors judge the deficit as unsustainable, causing them to withdraw their investments, with negative implications for the liquidity of the financial system. External capital inflows Increasing May lead to asset price and credit booms. Ratio of international Low Seen by investors as a major indicator reserves to short-term of vulnerability. liabilities Terms of trade Fluctuating Poor terms of trade or a sharp decline in a small country with high export concentrations may precipitate a banking crisis. Terms that are too high or that increase sharply may lead to inflation and asset price bubbles. Composition, maturity Low investment ratios Current-account deficits and low of capital flows investment ratios may signal potential vulnerability of the financial system. Exchange rate and Volatile pattern The higher the volatility, the higher interest rates the foreign-exchange and interest risks for financial institutions, especially if the external debt burden is high or if foreign portfolio investments represent a high share of total foreign investment. Exchange rate Volatile Currency mismatches between bank assets and liabilities. Exchange-rate -- Considered major contributors to guarantees volatility in capital flows and excessive foreign currency exposures. Interest rates Increasing international Capital outflows. Adverse impact on rates emerging market borrowers. Interest rates Declining May promote capital inflows that could lead to risky lending. Source: Authors. Note: -- = not available. Financial Development 117 interest rates on reserves and open-market operations), dismantling directed credit, and opening the capital account. For these reforms to take hold and stimulate a broader liberalization of the financial sector, it was necessary to remove impediments to competition.2 That was done by pri- vatizing banks, introducing new legislation governing the entry and exit of banks from the market (including foreign banks), revising laws and reg- ulations on the taxation of banks and other financial intermediaries, and amending legislation on foreign ownership. But as world financial markets became more volatile in the 1990s and inflationary pressures in developing countries increased, financial sector reform came to mean something else. The middle stage of the reform movement concentrated on strengthening financial sector infrastructure and individual institutions. Macroeconomic stability and real sector reform were crucial to these requirements. In practical terms, financial sector reform expanded to include · the legal framework governing the operations of the central bank, with the establishment of independent central banks enshrined in legislation; · the legal framework for banks, through the establishment of pruden- tial regulations and banking law; · the regulatory framework for the nonbanking sector, through the establishment of rules governing the ratio of nonbank assets to finan- cial sector assets and the number of listed companies on the stock exchange; and · identification of rights and obligations of financial agents, through the establishment of liquidation and bankruptcy laws, payment systems, and accounting and auditing standards. Strengthening individual financial institutions required the establish- ment and enforcement of guidelines for supervision, restructuring, and institutional reform, a process that can be summarized as follows: · Better bank supervision--guidelines for the capacity and authority needed to provide effective supervision, licensing criteria, and super- vision systems · Bank restructuring--guidelines for capital replenishment, asset liquida- tion, and privatization · Institutional reforms--management information systems and human resource development programs. 118 Understanding Growth and Poverty The need for the latest stage of financial sector reform became appar- ent in the wake of the Asian financial crisis of 1997­98. The crisis demon- strated the links between the corporate and financial sectors and the problems that can arise when these sectors are at different stages of reform. The crisis also highlighted the need for greater transparency and accountability, especially where owners of financial institutions have close connections with those in political power. Improving transparency and accountability requires improved disclosure of macroeconomic information, stricter disclosure requirements for partici- pants in securities markets, more aggressive investor education, the estab- lishment of rating agencies and credit bureaus, and the adoption of global accounting and auditing standards. Reforms will be successful only when requisite conditions are in place. For example, interest rates should be dereg- ulated only if the regulatory framework is sound, bank supervision is effec- tive, accounting and auditing systems are adequate, financial markets are competitive, and banks have positive net worth and capable management and staff. To use another example, banks should be recapitalized only after systemic problems that allowed them to lose their capital in the first place have been addressed by ceasing lending to defaulters, establishing strong bank supervision and monitoring, and putting in place adequate informa- tion systems. At that time, management of insolvent banks should be replaced and state-owned banks should be made part of a privatization plan. Financial Development and Poverty Reduction Although the relationship between financial development and growth is well established, the same cannot be said for the direct link between finan- cial development and income inequality, beyond the growth relationship itself. Beck, Demirguc-Kunt, and Levine (2004) provide a comprehensive analysis of this important question. As the authors note, economic theory is ambiguous when it comes to the relationship between financial devel- opment and changes in poverty and income distribution. Some models imply that financial development enhances growth and reduces inequal- ity. According to these models, financial market imperfections--such as information problems, transaction costs, and contract enforcement costs--may be especially binding on poor entrepreneurs who lack collat- eral, credit histories, and connections. These credit constraints will impede the flow of capital to poor individuals pursuing high-return projects, thereby reducing the efficiency of capital allocation and wors- ening income inequality. Viewed from this angle, financial development Financial Development 119 reduces poverty by (a) disproportionately relaxing credit constraints on the poor and reducing income inequality, and (b) improving the alloca- tion of capital and accelerating growth. Other theories, however, question whether financial development reduces poverty. Some research suggests that the poor primarily rely on informal, family connections for capital, so that improvements in the for- mal financial sector tend to help the rich rather than the poor. For instance, Greenwood and Jovanovic (1990) developed a model that pre- dicts a nonlinear relationship between financial development and income inequality during the process of economic development. At the early stages of development, only the rich can afford to access and profit from financial markets--so financial development intensifies income inequality. At higher levels of economic development, financial development helps an increasing proportion of society. Other models imply that if financial development reduces income inequality, the reduction could slow aggre- gate growth and increase poverty. If the rich save more than the poor, the argument goes, a reduction in income inequality could reduce aggregate savings and slow growth, with adverse implications for poverty. A great deal more empirical evidence is needed before any of the competing the- oretical predictions can be declared the winner. Beck, Demirguc-Kunt, and Levine (2004) attempt to settle the issue by assessing the relationships among financial development, poverty alle- viation, and changes in the distribution of income. Employing broad cross-country comparisons, they find that financial development allevi- ates poverty and reduces income inequality. Their findings also indicate that financial development exerts a disproportionately positive influence on the poor. Their research yields three key findings: · Even when controlling for real per capita GDP growth, financial development reduces income inequality beyond the growth effects themselves. · Financial development induces a drop in the Gini coefficient, the lead- ing measure of income inequality. · Financial development reduces the fraction of the population living on less than $1 or $2 a day and shrinks the poverty gap. Jalilian and Kirkpatrick (2005) also find that financial development reduces income inequality, but only beyond certain income levels, in line with Greenwood and Jovanovic's (1990) prediction of an inverted-U relationship. 120 Understanding Growth and Poverty Widening Access to Financial Services Although financial services can have very beneficial effects, their use in developing countries is far from universal, as Claessens (2005) has noted. Instead of helping the poor, financial systems cater mainly to large enter- prises and wealthier individuals. Finance is often allocated on the basis of connections and other nonmarket criteria. Often, many segments of the enterprise and household sectors suffer from lack of access to finance at reasonable costs, hindering growth. Claessens (2005) finds that for most developing countries, basic bank account usage does not exceed 30 percent of households; in the lowest-income countries, usage is less than 10 percent. Although low usage may reflect lack of demand rather than lack of access, Claessens (2005) argues that this is unlikely in many developing countries, precisely because usage is so low. The supply of financial serv- ices in such countries is clearly limited, but why? Is it because banks are unwilling to supply financial services to the poor because they believe them to be unprofitable customers? Or are there barriers to supply? If so, can those barriers be removed, for example, through microfinance or through savings and payments services provided by postal and saving banks? Or is there some form of market failure that government interven- tion can address? Demand may be slack if financial services are too costly and not well tailored to customer needs. If this is the case, households and firms may rely instead on informal forms of finance. But there are some grounds for hope here. For instance, in 2004 in South Africa, the country's major banks launched a low-cost bank account aimed at extending banking services to low-income households. Initial take-up was reportedly very high. A sharp drop in the costs of international remittances also suggests that banking services are being extended at a more reasonable cost to wider segments of the population. For a sample of more than 90 countries, Beck, Demirguc-Kunt, and Martinez-Peria (2005) showed that those countries with better-developed financial systems have services that are more evenly distributed among banking clients. This suggests that the overall institutional environment can play a role in the supply of banking services. Furthermore, the insti- tutional environment--a sound legal system, secure property rights, and reliable sources of information--is especially important for the supply of credit to small firms. Banking-system regulations can also affect the rate of usage of financial services. For instance, restrictions on interest rates Financial Development 121 and other limits on lending can make it difficult for providers of financial services to offer profitable saving or lending instruments. Against this backdrop, it appears that many developing countries need to improve their legal and regulatory systems as these bear on financial services. Better infrastructure and systems related to information and payments appear to be needed as well. These are all difficult and time- consuming reforms. To complement them, Honohan (2004) suggests that an important way to enhance access--one often easier than improving the institutional environment--is to improve competition in banking sys- tems. For instance, small nonbank financial institutions (including depart- ment stores) might be allowed greater use of existing financial networks. Liberalizing entry by foreign banks can further enhance competition and access to banking services by the population at large. Claessens (2005) cites the example of Mongolia, where the failed government-owned Agricultural Bank was sold to a Japanese investor and quickly became a successful bank that provides far greater access to the population at large. Foreign ownership can also induce greater financial stability and improve the overall efficiency of financial intermediation. Whether universal usage should be a public policy goal is, however, an open question. The fact that the poor do not use financial services may be a problem of poverty more than one of access. Also, our knowledge of the benefits and impact of finance remains insufficient at the micro level. For example, access to credit may be a problem when it leads to overindebtedness, as the poor can be uninformed and overborrow, often on unfavorable terms. Public interventions may be useful in some cases, but they will need to be carefully introduced and tracked. Governments might try to make social security, tax, and other payments in a manner that encourages more bank access, notably by making them electronic when feasible. Authorities could also mandate that banks provide mini- mum banking services for otherwise excluded segments of the market. Microfinance and the Poor There is a growing awareness that building financial systems for the poor means building sound domestic financial intermediaries that can mobilize and recycle domestic savings for this segment of the population. Microfinance institutions (MFIs) have emerged over the past three decades to provide financial services to low-income clients, who for cen- turies had to rely on a wide range of informal credit providers, such as money lenders.3 122 Understanding Growth and Poverty Early microcredit agencies operated on a nonprofit basis and did not require collateral. They reduced risk through group guarantees, appraisal of household cash flow, and small initial loans to test clients. It soon became apparent that the poor were reliable in repaying uncollateralized loans and were willing to pay a somewhat higher cost for receiving serv- ices that would not otherwise be provided by the mainstream banking sector. Although their usage of financial services is not as great as that of wealthier segments of the population, as noted in the previous section, the poor need and use a broad range of financial services, including deposit accounts, insurance, and facilities to transfer money to relatives living elsewhere. Experience has shown that they can be served prof- itably, on a long-term basis, and, in some cases, on a large scale. Well-run MFIs can outperform mainstream commercial banks in portfolio quality and function in turbulent times. During Indonesia's 1997 crisis, for exam- ple, commercial bank portfolios deteriorated, but loan repayment among Bank Rakyat Indonesia's 26 million microclients barely declined. And, during the recent Bolivian banking crisis, MFIs' portfolios suffered but remained substantially healthier than those of commercial banks. Other studies illustrate the social function of microfinance. Microfinance has been credited with improving a large range of welfare measures, such as income stability and growth, nutritional needs, health, and school attendance. It also has been widely credited with empowering women by increasing their contribution to household income and assets. Moreover, examples of financially sound, professional MFIs suggest that microfinance can be made available for the long term, well beyond the duration of donor government subsidies. There is little doubt that microfinance is highly valued by the poor, as shown by their strong demand for such services, their willingness to pay the full cost of those services, and a high loan-repayment rate motivated by a desire to have access to future loans. On the policy level, microfinance has been embraced by politicians and the development community, with the predictable result that some of its merits have been oversold. To achieve the full potential of microfi- nance to serve poor households, MFIs will need to become fully inte- grated with the mainstream financial system in the countries in which they operate. This will require financially sound, professional organiza- tions capable of competing, accessing commercial loans, becoming licensed to collect deposits, and growing to reach significant scale and impact. The majority of MFIs do not yet fit into this category--most are Financial Development 123 weak, heavily donor dependent, and unlikely to ever reach scale or inde- pendence. But the commercial success of some MFIs is an encouraging sign. The form of their eventual integration into the financial mainstream will depend on the country context and the requirements of customers. The options being pursued include the following: · Partnership with a commercial bank · Adoption of microfinance methodologies by retailers, consumer finance groups, building societies, and other institutions that often are better placed than banks to provide the smaller account and transac- tion sizes required by customers with lower incomes · Licenses for MFIs · Allowing MFIs to tap into mainstream credit bureaus to increase their productivity and portfolio quality and to reduce the spreads between their borrowing and saving rates. Partnerships enable MFIs to cut costs and extend their reach, while banks can benefit from the opportunity to reach new markets, diversify assets, and increase revenues. Partnerships vary in their degree of engage- ment and risk sharing. In some cases, partnership refers to sharing or rent- ing front offices; in others, to banks making actual portfolio and direct equity investments in MFIs (figure 6.1). More MFIs are now obtaining their own licenses as banks or special- ized financial institutions. This allows them to secure financing by accessing capital markets and by attracting deposits from large institu- tional investors as well as poor clients. Several MFIs, especially in Latin America, have accessed local debt markets by issuing private placements that have been purchased by local financial institutions. Other countries are considering legislation to create new types of financial licenses, usu- ally with lower minimum capital requirements, specifically designed for MFIs. MFIs are beginning to tap into mainstream credit bureaus, which allows their clients to build a public credit history, making them more attractive to mainstream banks and retailers. More than 80 MFIs in Peru are registered to use Infocorp, a private credit bureau. Similarly, in Turkey, Maya Enterprise for Microfinance negotiated with a leading bank, Garanti Bankasi, to gain access to the national credit bureau. The central bank in Rwanda requires that MFIs communicate information about their borrowers to a credit bureau. 124 Understanding Growth and Poverty Figure 6.1 New Links between Microfinance Institutions and Commercial Banks higher level of engagement Sogebank (Haiti) created Sogesol, a bank creates loan-service company microloan service company in 2000. Jammal Trust Bank and Crédit Libanais bank invest equity in an MFI (Lebanon) have equity stakes in Ameen, a microfinance program. bank buys MFI portfolio or ICICI Bank (India) contracts microfinance contracts MFI operations operations with self-help groups and MFIs. Raffeissen Bank (Bosnia and Herzegovina) wholesale lending lends to multiple MFIs in Bosnia and Herzegovina. Microfinance Bank (Georgia) rents sharing/renting facilities space in its offices to Constanta, a local nongovernmental organization. lower level of engagement Source: Consultative Group to Assist the Poor (CGAP), reproduced in Littlefield and Rosenberg (2004). In general, improvements in information technology help to create new delivery channels for the provision of microfinance. To a large extent, the conduits are already in place--retail shops, Internet kiosks, post offices, lot- tery outlets; the challenge is to make it possible to provide financial serv- ices more cost-effectively in poorer and more sparsely populated areas. While welcome, such a trend poses a risk of taxing the capacity of supervisory authorities as they assume responsibility for other parts of the financial sector. Moreover, creating the infrastructure for specialized MFIs could also divert mainstream commercial banks and others from becom- ing involved in microfinance. Emigrant Remittances Emigrant remittances have come to represent an increasingly important source of financial flows between developed and developing countries in recent decades. Officially recorded remittances--comprising all unre- quited transfers from migrant workers to family and friends in their coun- tries of origin--climbed steeply in the decades between 1970 and 2000, declining only in the late 1990s. They then grew sharply after 2002 ($115.5 billion), peaking at $305 billion in 2008 before dipping in Financial Development 125 response to the global financial crisis (table 6.2).4 Future flows are bound to be affected by the simultaneous economic slowdown in the high- income countries--including the United States and Western Europe, which account for almost two-thirds of the remittances that migrants send home to developing countries--and in the developing countries that account for 10­30 percent of the rest. The fact remains that workers' remittances dwarf official aid (the subject of the next chapter) as a source of funds for the developing world. Improvements in banking technology that reduce the costs of formal remittance services and increase the geographical range over which remit- tances can be sent have steered unofficial remittances into the formal sec- tor, enabling them to be recorded (Chami, Fullenkamp, and Jahjah 2005). That trend is expected to continue. Nevertheless, a significant proportion of estimated remittance flows-- estimated at between 35 and 70 percent of official remittances--remain unrecorded. Unrecorded remittances are channeled through the informal sector and are not captured in official balance of payment statistics. While remittances that move outside the formal sector may be used for legiti- mate reasons, they also may be channeled to unproductive and illegal Table 6.2 Remittance Flows to Developing Countries US$ billion 2002 2003 2004 2005 2006 2007 2008e All developing countries 115.5 144.3 164.4 194.8 228.7 280.8 305.4 As % of GDP 1.9 2.1 2.0 2.0 2.0 2.1 1.9 By region: East Asia and Pacific 29.5 35.4 39.2 46.7 53.0 65.3 69.6 Europe and Central Asia 13.7 15.5 22.2 31.2 38.3 50.4 53.1 Latin America and the Caribbean 27.9 36.6 43.3 50.1 59.2 63.1 63.3 Middle East and North Africa 15.2 20.4 23.0 24.3 25.7 31.3 33.7 South Asia 24.1 30.4 28.7 33.1 39.6 52.1 66.0 Sub-Saharan Africa 5.0 6.0 8.0 9.4 12.9 18.6 19.8 Source: World Bank 2009. Note: Remittances are defined as the sum of workers' remittances, compensation of employees, and migrant transfers. See http://www.worldbank.org/prospects/migrationandremittances for data definitions and the entire data set; 2008e = estimate. 126 Understanding Growth and Poverty activities, such as money laundering, drug money flows, and the financing of terrorism. Examples of remittance channels, formal and informal, include · Interbank transfers · Formal nonbank money-transfer operators · Post office transfers · Cash and commodities carriers · Informal money-transfer operators (Kireyev 2006). Other channels are specific to a region or country, such as fei-ch'ien (China), padala (the Philippines), hundi (India), hui kuan (Hong Kong SAR, China), and phei kwan (Thailand). The hawala system, historically associated with South Asia and the Middle East, refers to an informal channel for transferring funds from one location to another through serv- ice providers--known as hawaladars--regardless of the nature of the transaction or the countries involved (El-Qorchi, Maimbo, and Wilson 2002). While some studies suggest that self-interest is the prime motive for remittance arrangements, most agree that the practice is primarily altru- istic (Stark and Lucas 1988; Chami, Fullenkamp, and Jahjah 2005) and mainly confined to transfers between family members. The concentration on the household has formed the basis of studies of the microeconomic impact of emigrant remittances. Those studies have shown that remit- tances raise household consumption, stimulate investment (notably in real property), and result in better education and health care (Kireyev 2006). Thus, from a microeconomic perspective, remittances should have a positive impact on growth. But the literature, most of it recent, is not definitive on the macroeco- nomic impact of remittances. For example, Chami, Fullenkamp, and Jahjah (2005) suggest that remittances have a negative impact on eco- nomic growth, whereas Aggarwal and Spatafora (2005) find no effect, and Giuliano and Ruiz-Arranz (2005) argue that remittances promote growth in countries with shallow financial systems but have no impact in countries with well-developed financial systems. The lack of a clear rela- tionship is not surprising. First, the impact on growth will depend on whether the remittances are spent on consumption or investment. To this end, the research suggests that remittances have primarily been used for consumption purposes, with little impact on long-run growth. Second, the research shows that remittance inflows are countercyclical, increasing Financial Development 127 during periods of weak economic growth in the receiving countries. This countercyclical nature makes it difficult to establish the true impact of remittances on economic growth. It does suggest, however, that remit- tances can play a large part in maintaining macroeconomic stability and mitigating the impact of adverse shocks. A number of papers (quoted in Spatafora 2005) have attested to this. The distributive effect of remittances has been the subject of a large part of the evolving literature. Not only have remittances been shown to mitigate the impact of adverse shocks on an economy, but they have also been linked with helping to reduce poverty (Aggarwal and Spatafora 2005). Kireyev (2006) suggests that the decline in the poverty rate in Tajikistan from 81 percent to 60 percent from 2000 to 2003 was helped by the significant level of remittances to that country (where flows of remittances had reached 50 percent of GDP). Moreover, children in households receiving remittances are more likely to receive better educa- tion and health care. But the distributive effects of remittances can also be negative. Kireyev (2006) outlines a number of negative effects of remittances for Tajikistan that also figure in studies of other countries. Remittance inflows may have any of the following negative effects: · They may impede monetary management and rekindle inflationary pressures, as the unpredictability and seasonal nature of foreign cur- rency inflows create uncertainties for monetary management. · They may lead to an appreciation of the national currency, hampering competitiveness. · They may contribute to the expansion of the trade deficit. In Tajik- istan, most remittances are used to finance imports. · They may create a strong disincentive for domestic savings. Declining savings can deplete the resource base for investment and may even turn it negative. · They may pose a serious moral hazard (see glossary) by reducing the pressure for reforms. Remittances enable households and private busi- nesses to support their own consumption or investment independent of the national government, thus reducing pressure on the authorities to create a better business environment and to deal with the problems that forced emigrant workers to leave the country in the first place. A related negative associated with migration is brain drain. Although migrants may learn skills that may be useful to their country of origin 128 Understanding Growth and Poverty when and if they return, the loss of human capital that comes with emi- gration hampers a country's development prospects. Mishra (2006) shows, for example, that the Caribbean countries--which have lost in excess of 70 percent of their best-educated labor force (those with more than 12 years of schooling)--are not fully compensated for brain drain by the significant inflow of remittances. Some research has focused on the policies and regulations that deter- mine the flow of remittances, but further research is needed on how to create a sustainable development path for the source country.5 In sum- mary, remittances represent a short-term fix for long-term problems. Conclusion The chapter began by demonstrating the well-established causal link between a well-functioning financial system and economic growth. It then identified the impact of macroeconomic fundamentals on the finan- cial system, showing, for example, that imbalanced growth and high infla- tion harm the financial system. While the link between financial development and income inequality remains unclear, recent empirical studies have found that financial development tends to reduce income inequality. From a brief history of financial sector reform in developing countries, we saw that reforms, which began in the mid-1970s, started by liberalizing interest rates. Later reform efforts concentrated on indirect instruments of monetary control and the dismantling of directed credit before moving on to strengthen the overall financial sector infrastructure, including legal, regulatory, and supervisory frameworks. The most recent reforms have included moves toward greater transparency and better auditing and accounting standards. The chapter then discussed policy measures that can be used to increase access to financial services by strengthening institutional infrastructures, liberalizing markets, and fos- tering greater competition. The chapter concluded with a discussion of microfinance and emigrants' remittances, both increasingly important channels of financial flows to the poor in developing countries. Notes 1. Debate persists. Aghion, Howitt, and Mayer-Foulkes (2005) raise serious questions about whether financial development affects steady-state growth or instead influences the rate of convergence with higher-income countries. Either way, however, financial development is positive for economic growth. Financial Development 129 2. Assessing the outcome of reforms requires an examination of the following variables: real positive interest rates, the term structure of interest rates, the ratio of M2 to GDP, banking system financial ratios, and the spread between lending and deposit rates. (M2 refers to money and close substitutes for money, i.e., the amount of money in circulation. M2 is a key economic indi- cator used to forecast inflation.) 3. This section draws on Littlefield and Rosenberg (2004). 4. Recorded flows to Latin America and the Caribbean began to stagnate in 2007 as the U.S. recession, especially in the construction sector, reduced the employment and income of Latin American (especially Mexican) migrants. 5. 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Aggarwal. 2006. "Do Workers' Remittances Promote Financial Development?" Policy Research Working Paper 3957, World Bank, Washington, DC. Mishra, Prachi. 2006. "Emigration and Brain Drain: Evidence from the Caribbean." IMF Working Paper WP/06/5, International Monetary Fund, Washington, DC. Pattillo, Catherine, Sanjeev Gupta, and Kevin Carey. 2005. "Sustaining Growth Accelerations and Pro-Poor Growth in Africa." IMF Working Paper WP/05/195, International Monetary Fund, Washington, DC. Rajan, R. G., and L. Zingales. 1998. "Financial Dependence and Growth." American Economic Review 88 (3): 559­86. Ratha, D. 2003. "Workers' Remittances: An Important and Stable Source of External Development Finance." In Global Development Finance 2003: Striving for Stability in Development Finance, 157­75. Washington, DC: World Bank. Schumpeter, J. 1911. The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and Business Cycle. Cambridge, MA: Harvard University Press. Spatafora, Nikola. 2005. "Workers' Remittances." IMF Research Bulletin 6 (4). Stark, O., and R. E. B. Lucas. 1988. "Migration, Remittances, and the Family." Economic Development and Cultural Change 36 (3): 465­81. World Bank. 2009. Global Development Finance 2009. Washington, DC: World Bank. CHAPTER 7 Development Assistance Foreign aid--often referred to as official development assistance (ODA)--can contribute to growth and development. The aim of making aid more effective is at the core of all development assistance and encom- passes numerous issues, from the predictability of aid flows to the use of country systems to the measurement of development results. Today, as governments face financial uncertainty and challenges such as the threat of climate change, it is more important than ever that aid be channeled to produce sustainable results. The effort to make aid more effective brings together development stakeholders, donor governments, multilateral donors, recipient country governments, civil society organizations, global programs, and many oth- ers. All must coordinate to align with every country's specific priorities, as well as with the development goals identified by partners. The next sec- tion focuses on aid sources and trends and the efficacy of aid to develop- ing countries, in particular through poverty reduction. Aid Sources and Trends The phenomenon of richer countries helping poorer ones through bilat- eral grants and loans at low rates of interest (known as concessional loans) 133 134 Understanding Growth and Poverty began after World War II. The prime motivation for early aid efforts, however, was not to promote growth or reduce poverty, the leading goals today, but rather to enlist allies in the geopolitical realignment that imme- diately followed the war. Until the 1960s, the bulk of aid was given for large infrastructure projects such as power generation and transportation networks. The 1970s saw a new focus on antipoverty programs. This trend continued into the 1980s and early 1990s, when another shift occurred. During the 1990s, a large portion of aid (approximately 40 percent) was allocated to infrastructure and productive sectors such as agriculture, industry, and trade. Since then, the trend has shifted toward supporting social services--health, education, and water supply and sanitation--and strengthening institutions and civil society. In 2003, social services were targeted by roughly one-third of aid flows--up from one-fifth in 1990. More recently, we have begun to see a reprise of investment in infrastruc- ture. Overall, aid today is viewed as a tool for providing budgetary support to developing nations, thereby helping to improve governance and institutions while also fighting hunger and poverty. ODA is provided by 22 member countries of the Organisation for Economic Co-operation and Development (OECD) plus the European Commission (EC) through the Development Assistance Committee (DAC),1 and by 14 other donor countries (many in the Middle East, plus Turkey) that are not DAC members but report their aid activities to it. In addition, countries such as Brazil, China, India, and the Russian Federation--themselves developing countries--have recently emerged as donors, although they still receive development assistance. ODA is provided for developmental purposes2 by governments or public funds as grants or as soft loans. ODA loans bear a grant element of at least 25 percent that is calculated at a rate of 10 percent, significantly less onerous than commercial transactions. ODA is provided to specifi- cally defined low- and middle-income countries that are not Group of Eight (G-8) members or European Union (EU) members or countries with accession dates to the EU. Eligible countries are reviewed every three years by the DAC, and countries may graduate from the list or change income groups (Smith 2008). For the more prosperous developing countries, ODA augments other financial resources available to meet long-term development needs. Those sources include loans and equity investments from private sources, direct investments by foreign firms (for example, firms operating natural resource concessions), and income sent home by migrant workers. Taking the developing world as a whole, all of those sources are greater in volume Development Assistance 135 than ODA. But for many of the world's poorest countries, ODA is the largest and most stable source of development finance. ODA disbursements by DAC members3 rose to $114 billion in 2008, up $10.5 billion (10.2 percent) from 2007 (figure 7.1). Allowing for debt relief aid, total net ODA from members of the DAC rose by 11.7 percent in real terms to $121.5 billion, representing 0.31 percent of the members' combined gross national income (GNI) (OECD-DAC 2010). ODA increased by nearly 30 percent in real terms between 2004 and 2008, an unprecedented increase boosted by enormous debt-relief efforts in the earlier part of the period. Also contributing was a 91 percent increase in ODA to Afghanistan and an 84 percent increase to Iraq. While aid com- mitments to Africa have failed to increase by $25 billion4--a pledge made at the Gleneagles G-8 Summit in 2005--aid5 to Africa increased by 37 percent over 2004­08. The proportion for Sub-Saharan Africa was 41 percent. At the Monterrey Financing for Development Conference in 2002, specific commitments to increase aid were made. These were further endorsed at the Gleneagles G-8 Summit in 2005 and reaffirmed at the UN Millennium +5 Summit in New York in 2005. In practical terms, these commitments led to an increase in aid from $80 billion in 2004 to $130 billion in 2010 (at constant 2004 prices). This would have repre- sented 0.36 percent of estimated GNI in 2010. Following the financial Figure 7.1 Net ODA Disbursements Made by DAC Donors 120 0.40 debt relief 100 ODA less debt 0.35 constant 2007 US$, billions relief / GNI (right scale) 80 0.30 percent 60 0.25 40 0.20 20 ODA less debt relief 0.15 0 0.10 91 94 97 00 03 06 08 19 19 19 20 20 20 20 Source: World Bank 2009, 88. Note: GNI = gross national income. 136 Understanding Growth and Poverty crisis of 2007 and the ongoing economic downturn, the dollar value of these commitments fell to $124 billion by 2010. According to the DAC (OECD-DAC 2010), most countries have maintained their commitments for 2010, although some large donors have reduced or postponed their pledges, as illustrated in figure 7.2. In sum: · expected ODA for 2010 is estimated at $107 billion, a $27 billion increase over the 2004 baseline, with ODA/GNI increasing from 0.26 percent to 0.33 percent; and · the shortfall ($17 billion) impacts Africa in particular (OECD-DAC 2010, 100). ODA reaches recipients through individual governments (bilateral donors), through multilateral agencies funded largely by wealthy nations, and through nongovernmental organizations (NGOs) funded by official and private sources. Until the 1960s, more than 90 percent of aid was pro- vided through bilateral channels. By the 1990s, however, only about two- thirds of ODA was direct bilateral financing, with the remainder provided in the form of multilateral financing and grants by NGOs. NGO grants now account for about 11 percent of total global aid.6 Figure 7.2 DAC Members' Net ODA, 1990­2008, and Simulations of Net ODA, 2009­10 2004 US$, billions 0.40 160 0.35 0.33 0.33 0.33 140 0.31 0.30 120 ODA as a % of GNI 0.26 0.28 0.25 (left scale) 100 net ODA percent 0.20 0.22 80 0.15 total 60 0.10 40 0.05 ODA to Africa 20 (right scale) 0 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 dashed line indicates the growth-adjusted trajectory envisaged at Gleneagles. dotted line for total and for GNI indicates the estimates based on reported intentions or current 2010 budget made by DAC members. dotted line for Africa indicates a DAC secretariat estimate. Source: OECD-DAC 2010, 98. Used by permission. Development Assistance 137 During the 2000s, the DAC members increased their share of ODA, reaching a high of 76 percent of total net disbursements in 2005 or $95.3 billion. By 2008, net disbursements from DAC members were valued at $87 billion, almost 68 percent of the total (table 7.1). Net disbursements from the multilaterals7 have averaged around one-quarter of the total since 2003; in 2008, they accounted for $33.9 billion, or 26.3 percent. Net disbursements of ODA from non-DAC countries8 are small, averag- ing around $3 to $4 billion in recent years, or 4 percent, although they reached $7.8 billion, or 6 percent of the total, in 2008 (table 7.1). Policies and guidelines for allocating ODA are recommended at the annual meetings of the Group of Eight industrial economies and the DAC. Multilateral donors--the World Bank, the International Monetary Fund (IMF), regional development banks, and specialized UN agencies-- get advice on aid levels from the International Monetary and Financial Committee (IMFC), which meets twice a year.9 Since 1996, total net flows of ODA have accounted for around 1 percent10 of gross domestic product (GDP) in the average recipient coun- try, having declined from a high of 2 percent in 1991 (World Bank 2006a)--a reflection more of growth in the developing world than of a decline in aid. Roughly half (50.8 percent) of ODA goes to least-developed and low-income countries, that is, those with a GNI less than $935 per capita in 2007 (see figure 7.3). Roughly one-third goes to lower-middle- income countries--those with a GNI per capita between $936 and $3,705 in 2007--whose populations include a substantial number of poor people (for example, Algeria, China, and Thailand). Just 6 percent of aid flows in 2008 went to upper-middle-income countries, or those defined with a per capita GNI between $3,706 and $11,455 in 2007 (examples are Argentina and Chile). Aid to countries in or recovering from conflict has risen substan- tially over the past few years. Iraq accounted for one-third of the aid to the top 10 recipients in 2008 (figure 7.3). In general, large, populous countries such as China and India tend to receive more aid in absolute terms, although in per capita terms, they receive less than small island economies such as São Tomé and Príncipe (figure 7.4). Exceptions include Mozambique (high absolute and per capita amounts) and Turkmenistan (low absolute and per capita amounts). Aid in the Context of Overall Capital Flows ODA accounts for just a portion of the capital that flows into the devel- oping world. Net international flows of private capital dwarf the amount 138 Table 7.1 Net Disbursements of ODA by Donor Type Constant 2008 US$, billions 2001 2002 2003 2004 2005 2006 2007 2008 $bn % $bn % $bn % $bn % $bn % $bn % $bn % $bn % Multilaterals 26.9 32.9 27.8 30.3 24.2 26.2 27.0 28.3 27.0 21.6 29.2 24.0 31.4 27.7 33.9 26.3 DAC members 53.6 65.6 60.1 65.5 64.5 69.6 64.9 68.0 95.3 76.0 87.3 72.0 77.2 68.3 87.0 67.6 Non-DAC members 1.2 1.5 3.8 4.1 3.9 4.2 3.6 3.8 3.1 2.5 4.8 4.0 4.5 4.0 7.8 6.0 Total 81.7 100 91.7 100 92.6 100 95.4 100 125.5 100 121.3 100 113.1 100 128.6 100 Source: Compiled from OECD statistics extracts. Figure 7.3 Summary Chart for all DAC Countries TOTAL DAC COUNTRIES Gross bilateral ODA, 2007­08 average, unless otherwise shown Change By income group (US$, millions) Net ODA 2007 2008 Clockwise from top 2007/08 Current (US$, millions) 103,485 121,483 17.4% 22,819 LDCs Constant (2007 US$, millions) 103,485 115,632 11.7% 24,366 Other low-income ODA/GNI 0.28% 0.31% Lower middle- Bilateral share 70% 71% income 6,217 Upper middle- 7,140 Top ten recipients of gross income ODA (US$, millions) Unallocated 1 Iraq 9,462 32,291 2 Afghanistan 3,475 3 China 2,601 By region (US$, millions) 4 Indonesia 2,543 Sub-Saharan Africa 5 India 2,263 South and Central 6 Vietnam 1,745 18,940 24,384 Asia 7 Sudan 1,743 Other Asia and 8 Tanzania 1,603 Oceania 9 Ethiopia 1,551 3,056 Middle East and 10 Cameroon 1,396 North Africa Memo: Share of gross bilateral ODA 7,317 Latin America and Top 5 recipients 22% the Caribbean Top 10 recipients 31% 11,478 Europe Top 20 recipients 43% By sector 15,848 Unspecified 11,818 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Education, health, and population Othersocial infrastructure Economic infrastructure Production Multisector Programme assistance Debt relief Humanitarian aid Unspecified 139 http://dx.doi.org/10.1787/788147304272 Source: OECD-DAC 2010, 103. Used by permission. 140 Understanding Growth and Poverty Figure 7.4 Recipient Countries' Share of Total Aid a. Larger countries receive more aid in dollar terms . . . (billion dollars, 2000­03 average, 2002 prices)a Top 10 aid recipients Indonesia Vietnam China Pakistan India Tanzania Mozambique Egypt, Arab Rep. Ethiopia Bangladesh Bottom 10 aid recipients Lesotho Republic of Congo Gambia, The Solomon Islands Togo Turkmenistan Vanuatu Sào Tomé and Príncipe Comoros Kiribati 0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 b. . . . but not in proportion to their populations. (aid per capita, 2000­03 average, 2002 prices)a Top 10 aid recipients Timor-Leste São Tomé and Príncipe Kiribati Vanuatu Nicaragua Solomon Islands Guyana Djibouti Mauritania Mongolia Bottom 10 aid recipients Turkmenistan Bangladesh Syria Philippines Indonesia Uzbekistan Myanmar Nigeria India China 0 50 100 150 200 250 300 Source: Siddiqi 2005, 14. Used by permission. a. Based on countries that recorded a 2004 GNI per capita of $1,575 or less, in accordance with the World Bank's operational category II: International Development Association eligibility or 20­year International Bank for Recon- struction and Development terms excludes the Democratic Republic of the Congo, since its data for 2003 reflect a major debt deal. Development Assistance 141 flowing as ODA. Since the 1990s, the role of private flows has become increasingly important, driven by market reforms, the lowering of global trade and investment barriers, and a fall in communications and transport costs. The increase continued in the first seven years of the new century (see table 7.2), thanks to improvements in developing regions' invest- ment climates, high corporate earnings, the liberalization of foreign own- ership rules, and a strong global recovery from the crises of the late 1990s and the bursting of the dot-com bubble in 2000­01. Investment was par- ticularly strong in East Asia and Pacific and in Europe and Central Asia. The pace of private investment slowed in 2007, however, as the sub- prime-lending crisis emerged in the United States. It dropped off starkly with the collapse of Lehman Brothers in October 2008. Prior to the ongo- ing financial slowdown, net private flows to the developing world were on an upward trajectory, reaching a record of $1.2 trillion in 2007, or 8.6 percent of the developing world's GDP (see figure 7.5). As can be seen from figure 7.6, the global financial crisis affected pri- vate capital flows to developing countries severely. In 2008, total net international flows of private capital to the developing world fell to $707 billion or 4.4 percent of average developing country GDP. Examining the three components of private capital inflows shows that net portfolio equity flows suffered the most, falling by almost 90 percent--from $139 billion in 2007 to just $16 billion in 2008. Short- term debt flows fell from $202 billion in 2007 to ­$16.3 billion in 2008 and accounted disproportionately for the fall in private debt flows from $499 billion in 2007 to $108 billion in 2008. Also contributing to the reduction in short-term debt flows was the decline in bond financing (from $85 billion in 2007 to just $11 billion in 2008) and the 40 percent fall in net medium- and long-term bank flows (table 7.2). While foreign direct investment (FDI) fared better (approximately $60 billion more in 2008), its rate of increase slowed compared with previous years. In fact, the devel- oping world increased its share of global FDI11 in 2008 to a record of 40 percent from an average of 25 percent over the previous decade. This was due to the sharp deterioration of FDI in the developed world (World Bank 2009, 41). Most of the increase ($63 billion) in FDI went to East Asia and Pacific and to South Asia, reflecting economic reforms and the open- ing up of additional sectors for foreign investment (World Bank 2009, 41). Across the Regions, Europe and Central Asia were the hardest hit, with net capital inflows falling by almost half--from $472 billion in 2007 to $251 billion in 2008 (see figure 7.6 and table 7.3). Although the amounts are lower for other Regions, the magnitude of decline was large--for Table 7.2 Net Capital Inflows to Developing Countries US$, billions 142 2001 2002 2003 2004 2005 2006 2007 2008e Current account balance 15.5 68.6 118.4 171.2 306.6 438.2 406.1 377.9 Financial flows Net private and official flows 224.2 162.4 258.6 370.7 498.7 668.3 1,157.7 727.3 Net private inflows 197.3 156.8 269.1 396.5 569.7 739.2 1,157.5 706.9 Net equity inflows 172.3 161.5 181.0 254.7 347.2 462.7 658.6 599.0 Net FDI inflows 166.0 152.5 155.5 216.0 279.1 358.4 520.0 583.0 Net portfolio equity inflows 6.3 9.0 25.5 38.7 68.1 104.3 138.6 15.7 Net debt flows 51.9 0.9 77.6 116.0 151.5 205.6 499.1 128.3 Official creditors 26.9 5.6 ­10.5 ­25.8 ­71.0 ­70.9 0.2 20.4 World Bank 7.5 ­0.3 ­0.5 1.6 2.8 ­0.4 4.9 7.1 IMF 19.5 14.1 2.5 ­14.7 ­40.1 ­26.7 ­5.1 10.9 Other ODA ­0.1 ­8.2 ­12.5 ­12.7 ­33.7 ­43.8 0.4 2.4 Private creditors 25.0 ­4.7 88.1 141.8 222.5 276.5 498.9 107.9 Net medium- to long-term debt flows 2.1 0.7 26.6 73.3 135.9 166.4 296.4 124.2 Bonds 10.2 10.1 20.4 36.0 56.2 26.6 85.4 10.5 Banks ­1.9 ­3.2 10.4 41.3 84.2 144.6 214.5 123.0 Other private ­6.2 ­6.2 ­4.2 ­4.0 ­4.5 ­4.8 ­3.5 ­9.3 Net short-term debt flowsa 22.9 ­5.4 61.5 68.5 86.6 110.1 202.5 ­16.3 Balancing item ­159.1 ­69.9 ­90.7 ­144.9 ­419.5 ­476.6 ­486.3 ­657.5 Change in reserves (­ = increase) ­80.4 ­160.6 ­285.5 ­396.2 ­385.5 ­629.9 ­1,077.3 ­447.3 Memorandum items Private inflows excluding short-term debt 174.4 170.7 203.9 340.7 483.3 629.1 955.0 723.2 Net FDI outflows 12.7 16.8 22.4 44.5 59.2 125.2 138.8 164.0 Net portfolio equity outflows 10.8 6.0 8.2 7.2 11.6 21.5 50.6 80.0 Workers' remittances 95.6 115.9 143.6 161.3 191.2 229.0 265.0 305.0 Source: World Bank 2009, 40. Note: e = estimate. a. Combination of errors and omissions and transfers to and capital outflows from developing countries. ODA = official development assistance. Development Assistance 143 Figure 7.5 Net Private Capital Inflows to Developing Countries 10 600 net private flows 8 500 per GDP (right-hand axis) 400 6 US$, billions percent 300 200 4 100 2 0 ­100 0 2000 2002 2004 2006 2008e debt FDI portfolio equity Source: World Bank 2009, 39. Note: FDI = foreign direct investment. 2008 figures are estimated. example, a 41 percent decline for Latin America and the Caribbean and Sub-Saharan Africa. Private capital inflows increased by 11 percent between 2007 and 2008 for Middle East and North Africa. The decline in private capital flows across the Regions was concen- trated in short-term debt flows. Short-term debt flows fell by 47 percent for all Regions between 2007 and 2008. The decline was particularly severe in East Asia and Pacific (a decline of 67 percent), South Asia (a decline of 56 percent), and Europe and Central Asia (45 percent). Portfolio equity flows declined by 26 percent for all developing regions between 2007 and 2008, with the decline felt most strongly in Sub- Saharan Africa (66 percent) (World Bank 2009). The global financial crisis has placed considerable strain on the external financing needs of developing countries,12 and official creditors have stepped up to the challenge (see table 7.4). Net official lending increased to $20.4 billion in 2008. As can be seen from table 7.4, net lending by offi- cial creditors was negative in the previous five years owing to favorable eco- nomic conditions in developing countries, which led to reduced demand for multilateral lending, and significant repayments and prepayments to the 144 Understanding Growth and Poverty Figure 7.6 Net Private Capital Inflows to Developing Regions ­$221 500 (­47%) 400 ­$78 300 (­28%) US$, billions ­$88 (­41%) 200 ­$46 (­41%) 100 ­$19.5 (­35.3%) $2.5 (+11%) 0 be nd ic ia a Af and lA d ric cif As ra an rib a a sia an a Af Pa ric rth ast h nt e Ca ic ut Ce rop n d e er No e E ra So an Am Eu ha dl ia Sa id As tin b- M th La st Su Ea 2007 2008e Source: World Bank 2009, 40. Note: e = estimate. Table 7.3 Net Capital Inflows to Developing Regions US$, billions 2005 2006 2007 2008e Total 570 739 1,158 707 Region East Asia and Pacific 187 206 281 203 Europe and Central Asia 192 311 472 251 Latin America and the Caribbean 113 85 216 128 Middle East and North Africa 19 25 21 23 South Asia 25 72 113 66 Sub-Saharan Africa 33 40 55 36 Source: World Bank 2009, 40 Note: e = estimate. Development Assistance 145 Table 7.4 Net Official Flows to Developing Countries 2002 2003 2004 2005 2006 2007 2008e World Bank ­0.3 ­0.5 1.6 2.8 ­0.4 4.9 7.1 IMF 14.1 2.5 ­14.7 ­40.1 ­26.7 ­5.1 10.9 Other ODA ­8.7 ­13.3 ­12.8 ­34.0 ­43.8 0.2 2.4 Total 5.1 ­11.3 ­25.9 ­71.3 ­70.9 0.0 20.4 Source: World Bank 2009, 84. Note: e = estimate; ODA = official development assistance. Paris Club. Contributing to the drop in lending between 2002 and 2007 was the increasing importance of grants from the International Development Association (IDA), which were not included in the net lending data (World Bank 2009, 85). Does Aid Spur Economic Growth? Many studies have examined the relationship between aid and growth. Some have found that aid has no effect on growth and may actually undermine it (for example, Easterly 2001, 2006); others have sug- gested that, on average, aid has a positive relationship to growth, although not in every country and with diminishing returns. Still others find that aid has a conditional relationship to growth, accelerating it only under certain circumstances (Radelet, Clemens, and Bhavnani 2005). Rajan and Subramanian (2005) find no clear effect at all, posi- tive or negative. Their finding holds across time periods, regardless of the donor or type of aid, and regardless of the characteristics of the recipient country. "No, Aid Hobbles Growth" The critics of aid assert that it is often misappropriated or spent unproductively--on limousines and presidential palaces, for example. Some empirical evidence suggests that aid may distort or weaken private sector incentives. Large amounts of aid may also cause currency to appre- ciate, thus making a country's traded goods less competitive--an effect known as Dutch disease. It has also been asserted that food aid can reduce agricultural prices in the recipient country and adversely affect farmers' income if not effectively managed. There is also evidence that revenue collections are lower in highly aided countries. 146 Understanding Growth and Poverty Aid can stunt growth in three ways. First, by stimulating demand, it pushes up the price of goods and services and inflates the salaries of pro- fessionals such as aid managers, the engineers who work on roads and power connectivity, doctors and nurses, and building contractors. As wages rise, the nontradable sector will increase prices to maintain prof- itability. The tradable sector lacks this flexibility, however, because it faces external competition that limits the prices it can charge. Producers of tradable goods face a choice between forgoing profits and losing their competitive edge. By pushing up wages of certain goods and services, aid puts pressure on all other sectors to increase wages, leading to a general- ized rise in wages throughout a given country. Second, in a flexible exchange-rate regime, aid inflows will push up the nominal exchange rate of the recipient nation's currency, further reduc- ing the tradable sector's competitiveness. To counter this, aid inflows should be spent in ways that benefit the tradable sector (imported capi- tal and machinery, intermediate goods, and so on). Third, aid inflows weaken incentives for a country to improve tax col- lection and administration and to operate efficiently and transparently. With free money flowing in, the government may be better able to avoid accounting for what it spends. "Yes, Aid Promotes Growth" Other studies point to a positive relationship between aid and growth. Most do not conclude that more aid leads to more growth but suggest instead that "higher aid flows have been associated with higher growth" (Radelet, Clemens, and Bhavnani 2005). Some investigators have found that although a scaling up of aid pro- motes the transfer of real resources from rich to poor countries, beyond a certain threshold (about 5 percent of GDP per year), a surge in aid poses macroeconomic problems and can have a negative impact on growth in the long term, particularly if most of the aid is channeled toward consumption rather than investment. During the 1990s, economists began to ask whether returns on aid flows would diminish as the share of aid in GDP rose. Working along these lines, Clemens, Radelet, and Bhavnani (2004) find diminishing returns once total aid reaches about 17 percent of GDP (or once the subset of aid aimed directly at growth reaches 8 percent of GDP). Burnside and Dollar (2000) argue that aid positively influences long- term growth in countries that maintain good policies. This makes sense. Building schools, hospitals, roads, and power plants seems like a good idea. But a new school will do little good unless it is filled with teachers who are paid well enough to show up regularly to teach and students who Development Assistance 147 are fed well enough to learn. Hospitals cannot improve health care with- out trained personnel, adequate supplies, reliable power, and clean water. "Aid Stimulates Growth under Certain Circumstances" The conditional view of development assistance suggests a positive impact on economic growth depending on certain variables--for example, the characteristics of aid recipients or the efficacy of donor practices. World Bank research conducted in the mid-1990s showed higher returns from aid in countries with stronger civil liberties (Isham, Kaufmann, and Pritchett 1995), good policies (Burnside and Dollar 2000), and effective institutions. Further, recipient-country characteristics--such as vulnerability to trade shocks, climate, institutional quality, political conflict, and geography--have all been studied as conditional variables affecting the aid-growth relationship, although Radelet, Clemens, and Bhavnani (2005) raise doubts about the statistical robustness of such findings. Nevertheless, the view that aid works best in countries with sound policies and institutions is widely accepted among donors, includ- ing multilateral development banks. (That view is the rationale behind the U.S. Millennium Challenge Account.) Reflecting the acknowledged importance of host-country conditions, recipient countries have had a greater say in recent years in setting pri- orities and designing programs in cooperation with donors and civil society. Greater "country ownership" of aid goals and broader participa- tion in the formulation of those goals and in the implementation of aid projects are believed to increase the efficacy of aid. The effect on growth of various donor practices has received very lit- tle systematic research, although many opinions can be found on the mat- ter. Multilateral aid is generally considered more effective than bilateral aid, for example (because it is less likely to be politically motivated or to have burdensome conditions), and aid that is not earmarked for specific purposes is widely believed to generate higher returns than aid limited to prescribed uses. Recent research into the connection between growth and aid also sug- gests that the type of aid--in substance and timing--matters. The pio- neering work of Clemens, Radelet, and Bhavnani (2004) focuses on aid aimed primarily at economic growth. They reveal that most studies on aid and growth have examined the relationship of total development assis- tance to growth, even though only a portion of assistance is designed to stimulate growth. Humanitarian and food aid, for example, are not aimed at spurring growth; neither are educational materials or judicial reform. The same authors also note that most studies used cross-sectional data at 148 Understanding Growth and Poverty intervals of four years--too short a period to capture the impact of aid on growth. (On the other hand, the authors acknowledge that problems of causality arise if the time period is too long.) Based on their hypothesis that "not all aid is alike," Clemens, Radelet, and Bhavnani (2004) examine the effects of (a) humanitarian aid, (b) early-impact aid, and (c) late-impact aid on economic growth. Their results show that (a) and (c) have very little or no effect on growth (figure 7.7). On the other hand, early-impact aid--aid to build infrastructure and support productive sectors and budgets, which accounts for about half of total aid--has a positive relationship to growth over a four-year period. Figure 7.7 Economic Growth and the Type and Timing of Aid Not all aid is alike Some types of aid have a much bigger impact on growth than others­possibly why some studies examining aggregate aid find weak results. 3 Early impact aid GDP growth (percent) 2 Total aid (net of debt repayments) 1 Late impact aid 0 Humanitarian aid ­1 1 2 3 4 5 6 7 8 Aid (percent of GDP) Humanitarian aid Early impact aid Late impact aid Disaster relief Transport and storage Government and civil society Emergency aid Communications General environmental protection Humanitarian relief Energy generation and supply Women in development Food aid Most banking and financial services Health Business and other services Education Agriculture, forestry, and fishing Populations policies Industry, mineral resources, and mining Water supply and sanitation Construction Policy and administrative management Structural adjustment assistance Support to nongovernmental Budget support organizations Debt relief Other social infrastructure and services Source: Radelet, Clemens, and Bhavnani (2005), citing Clemens, Radelet, and Bhavnani (2004). Used by permission. Note: All three curves are estimated using a similar model and include a nonlinear relationship between aid and growth (which is hard to detect visually in the curve for late impact aid). The curve for humanitarian aid is cut off at 2 percent of GDP because there are no data in our sample beyond this point, and to show an upward curve would be misleading. Although only the coefficient on early impact aid is statistically significantly different from zero, the weaker relationships for late impact and humanitarian aid do not necessarily mean these flows have no impact on growth, but rather that a different modeling technique is required to explore these relationships (which we leave for future research). Development Assistance 149 The findings on the effect of early-impact aid on economic growth include the following: · The positive effect of early-impact aid on economic growth is not reversed over time. · Each dollar in early-impact aid yields $1.64 in increased income in the recipient country in net present value terms, or a return of 13 percent per country. · The relationship between early-impact aid and economic growth is stronger for countries with good policies and institutions. · Typically, the maximum growth rate occurs when early-impact aid represents 8 to 9 percent of GDP. · Development assistance is partially fungible--aid flows intended for different purposes have significantly different relationships to eco- nomic growth. Aid has multiple objectives, not often directly related to economic growth. Development aid goals include peacekeeping, fighting terrorism and drug trafficking, disaster relief, and the strategic political and diplo- matic support of friendly governments. For example, a large part of devel- opment aid received by the Arab Republic of Egypt and Israel is devoted to supporting the Middle East peace process. Aid to conflict-ridden Côte d'Ivoire would be found ineffective if judged only by growth perform- ance. A large fraction of aid to many countries is also designed to support the fight against terrorism. In these situations, there is no immediate effect of aid on growth; instead, it is hoped that aid will promote a more stable economic environment in the long term and thus lead to growth and poverty alleviation. This goes to show that aid effectiveness is to be understood in a larger multidimensional framework. It also leads us to conclude that the seemingly paradoxical effects of aid on growth and poverty reduction are inevitable. Ensuring That More Aid Means More Growth There have been increases in official aid in recent years to help develop- ing countries reach, by 2015, the Millennium Development Goals (MDGs) promulgated in the Millennium Declaration of September 2000, which was signed by 189 countries. The MDGs are a set of eight objectives for poverty reduction; improvement in indicators of well-being (health, education, and infant mortality); and the promotion of sustainable 150 Understanding Growth and Poverty development. They represent the international community's commitment to narrowing the gap between rich and poor countries. That commitment has been reaffirmed in successive international meetings, and public aid flows have significantly increased--though still not to the promised levels.13 It is safe to say, however, that poverty reduction is now firmly back on the global policy agenda, this time with specific targets and deadlines. Rich countries have committed to boosting development aid, canceling debts, and promoting trade access for developing countries. This section discusses the impact of scaling up aid on government budgets, on national competitiveness, and on the macroeconomic health of recipient countries. The section concludes with an examination of current initiatives to improve aid effectiveness. Aid and the Government Budget A scaling up of development aid may facilitate greater expansion of pub- lic services, but increased flows also involve the challenges of managing and delivering that extra aid. Aid flows are volatile and may not arrive on schedule, and this can create serious problems for the budgets of indi- vidual ministries. When the volume and duration of development aid are not clear, and when questions surround the manner and timing of dis- bursements, government ministries are hard pressed to produce accurate, sustainable budgets. Celasun and Walliser (2008) found that about 30 percent of development assistance to a sample of 13 countries between 1992 and 2007 did not arrive on time, leading to budgetary shortfalls in countries that had projected these inflows in budget estimates. A 2008 survey by the OECD showed that for the average country, just 45 per- cent of aid arrives on time. Figure 7.8 shows the wide gaps that exist between the levels of aid scheduled by donors for disbursement and the actual amounts received in five countries. Complications also arise when the increase in aid is subject to per- formance criteria or tied to a specific sector or policy. It is difficult to commit to new service delivery under such circumstances, particularly if the government lacks the capacity to substitute domestic funds (either through tax increases or borrowing from domestic banks) in the case of a budgetary shortfall. Donors still practice earmarking, favoring projects and technical cooperation over general budgetary support even at the risk of causing misalignment with recipients' inter- and intrasectoral priorities (figure 7.9). When development aid is targeted to sectors and projects, the chal- lenge facing the particular sectoral ministry is how to achieve stability and Development Assistance 151 Figure 7.8 Aid Scheduled for Disbursement versus Aid Actually Received in Select Countries 1,200 1,000 800 US$, millions 600 400 200 0 Congo, Dem. Kenya Zambia Albania Bolivia Rep. aid scheduled for 2007 aid disbursed in 2007 Source: Deutscher and Fyson 2008, citing OECD-DAC 2008a. Figure 7.9 ODA Commitments by DAC Countries, 2005 50 40 US$, billions 30 20 10 0 Africa Asia other countries total general budget support sector program assistance technical cooperation and investment projects Source: Curto 2007, 20. 152 Understanding Growth and Poverty sustainability in the sector. Aid spikes may exceed the absorptive capac- ity of a sector. For example, higher flows to health and education may encounter shortages of staff and personnel. Public financial management systems in many developing countries are ill-equipped to meet the chal- lenges of substantial increases in aid. A 2005 World Bank­IMF study of semiautonomous agencies and extrabudgetary funds found weak budget formulation; weak classification systems; poor commitment controls; and inadequate cash management, budget reporting, auditing, and regulatory capacity (Heller 2005). A scaling up of aid may also present organizational challenges. As noted by Heller (2005), a department that functions well on one scale may not be able to make the transition to a larger one. Ensuring That Aid Does Not Compromise Competitiveness As noted earlier, an increase in development aid flows may generate a Dutch disease effect, whereby the increased inflow of foreign currency boosts demand in both the nontradable and tradable goods sectors, push- ing up prices while causing the domestic currency to appreciate and compromising the competitiveness of the recipient country's exports. While increased demand for traded goods can be met by increased imports, this is not the case for nontraded goods, such as housing. We have already noted that excess demand here can lead to production bot- tlenecks and higher wages, increasing inflation and the real exchange rate. A higher real exchange rate may adversely affect a country's inter- national competitiveness, thus hampering its gains from international trade and its capacity for growth and investment. Heller (2005) identi- fies three questions a government should ask if an exchange rate is likely to appreciate: · Does development assistance induce higher productivity in the non- traded goods sector to offset the effect of a currency appreciation? · Can the effect on exchange rates be moderated by pursuing macro- economic and microeconomic policies? · Taking into account adverse effects, will aid's net effect on growth and poverty reduction still be positive? A nation's central bank may try to keep the pressure off the nominal exchange rate by intervening in the foreign exchange market (buying foreign exchange) and offsetting the monetary impact of increased cur- rency flows by conducting open-market operations. But the capacity of Development Assistance 153 developing countries' central banks to absorb liquidity may be limited by a lack of suitable monetary policy instruments. The result may be an appreciation of the real exchange rate through domestic inflation. Tight fiscal policies--used to keep domestic inflation in check--may also lead to higher interest rates and a crowding out of private investment activities. In their attempts to ward off a Dutch disease effect, governments may take advantage of resource transfers. Governments may introduce policies that affect the demand for imports. In particular, if resource transfers facilitate the removal of bottlenecks, productivity in the non- traded sector may increase. Furthermore, increasing the supply of nontraded goods in the economy may relieve price pressure and even expand investment and growth in the economy, with the increased supply of nontradables leading to investments in physical infrastruc- ture and human capital. Heller (2005) argues that it may be sensible for a low-income country to accept some loss in competitiveness by implementing policies that lead to a real transfer of resources from the traded to the nontraded sector. Furthermore, Heller suggests that if increased development assistance is successful in achieving the MDGs, the resulting economic environment will foster productivity and competitiveness. But Heller cautions that uncertainty regarding the continuity of aid may make accepting the loss in competitiveness a risky venture. Thus, governments need to choose their exchange-rate policy in full cognizance of the possibility of future changes, up or down, in the volume of development assistance. Handling Increases in Aid Successfully at the Macroeconomic Level Aiyar, Berg, and Hussain (2005) examine the macroeconomic challenges of five African countries--Ethiopia, Ghana, Mozambique, Tanzania, and Uganda--that experienced a large increase in development assistance. All five countries are considered good performers with strong institutions that have benefited from the general rise in aid and from the World Bank's Heavily Indebted Poor Countries (HIPC) initiative, which allowed these countries to greatly reduce their debt burden. To examine the macroeconomic management of aid inflows, Aiyar, Berg, and Hussain (2005) examine how fiscal and monetary policy inter- act with ODA. In a typical case, fiscal policy concentrates on directing aid to high-priority projects, while concerns about competitiveness and infla- tion drive monetary and exchange-rate policies. The trouble is that when undertaken in isolation from each other, fiscal and monetary policies may blunt the positive impact of aid. 154 Understanding Growth and Poverty The authors concentrate on the classic case, in which aid dollars flow to the government, which immediately sells them to the central bank and then uses local currency to increase spending on domestic goods. Their framework is underpinned by two distinct but related concepts: absorp- tion and spending. · Absorption is defined as the widening of the current-account deficit (excluding aid) because of the presence of incremental aid. It meas- ures the extent to which aid engenders a real transfer of resources through higher imports or through a reduction in the domestic resources devoted to producing exports. Absorption depends on both exchange-rate policy and on policies that influence the demand for imports. The central bank controls the exchange rate through its sales of foreign exchange, while monetary policy can be used to control aggregate demand--and the demand for imports. · Spending is defined as the widening of the fiscal deficit, excluding incremental aid. The combination of absorption and spending defines the macroeconomic response to a scaling up of aid. Broadly speaking, there are four possible responses to an aid surge in the short to medium term: (a) absorb and spend; (b) neither absorb nor spend; (c) absorb, but do not spend; and (d) spend, but do not absorb. In their analysis, Aiyar, Berg, and Hussain (2005) look at how the five coun- tries in their sample responded and performed. Absorb and spend. The government spends the new aid on domestic goods, and the fiscal deficit increases. The central bank then sells foreign exchange to sterilize the local currency spent by the government (that is, to prevent the new spending from causing inflation). In this way, the for- eign exchange pays for a widening of the current-account deficit, as the aid is absorbed by the economy. A key point here is that some apprecia- tion of the real exchange rate may be appropriate because, if aid is used to increase net imports, higher aggregate demand or appreciation of the real exchange rate is needed. In general, absorb-and-spend is the best response to an increase in aid. Absorption ensures a real transfer of resources to the recipient country, while government spending draws resources away from the traded goods sector. Other responses may be justified under particular circumstances for a short time, but in the long run the only sensible alternative to absorbing and spending is to forgo aid altogether. Development Assistance 155 Aiyar, Berg, and Hussain (2005) found, however, that the absorb- and-spend strategy was surprisingly rare. No country in their sample fully absorbed and spent the incremental aid it received during a surge of assistance. In four of the five countries, less than one-third of the incre- mental aid was absorbed. Neither absorb nor spend. In this case, the government does not spend the aid but keeps it in the central bank. Governments may choose this option because they want to build up international reserves from a low level or smooth volatile aid flows. In two of the sample countries-- Ethiopia and Ghana--absorption and spending were both very low. Both countries entered the aid-surge period with a low level of reserves--2.2 months of imports in Ethiopia and 1.3 months of imports in Ghana--and used the incremental aid to increase their import coverage. The reserve buildup meant that aid was effectively not available to finance increased domestic spending. But neither was the surge accompanied by a signifi- cant widening of the fiscal deficit or an increase in inflation. Absorb, but do not spend. This response substitutes aid for domestic financing of the government deficit. The government keeps expenditures steady, and the money supply shrinks as the central bank sterilizes liquid- ity through sale of foreign exchange. Such an approach can help stabilize the economy when domestically financed deficit spending is too high. No country in the sample chose this approach for the entire surge period, but it was used for particular periods--for example, in Ethiopia in 2001, when the strategy helped hold liquidity in check and avoided an inflation surge. This approach can also be used to reduce domestic public debt and "crowd in" the private sector (if there is an increase in private consump- tion or investment due to the government's action on spending or taxa- tion) if the central bank uses the proceeds from its foreign exchange sales to buy back government debt. Spend, but do not absorb. This is a suboptimal response that often reflects the inadequate coordination of monetary and fiscal policy. Unfortunately, it is all too common. Under this approach, the govern- ment increases expenditures, but keeps aid dollars in the central bank as reserves. This response is similar to fiscal stimulus in the absence of aid because the increase in government spending must be financed domes- tically since there is no real resource transfer (net imports do not increase). This can lead to increases in the money supply and in inflation, 156 Understanding Growth and Poverty unless sterilization is undertaken by sales of government paper (instead of foreign exchange). Aiyar, Berg, and Hussain (2005) find that Mozambique, Tanzania, and Uganda adopted this suboptimal approach. In all three countries, con- cerns about the negative impact of a real appreciation of competitiveness dictated the pattern of aid absorption and the monetary response (foreign- exchange sales being held in check to rein in upward pressure on the domestic currency, with sterilization instead being undertaken by sale of government paper). In these three countries, unlike in Ethiopia and Ghana, the level of import coverage afforded by gross reserves was quite high, with reserves accumulating steadily. A more suitable response to increased aid inflows might have been to combine a widening fiscal deficit with sterilization through sale of foreign exchange. In Tanzania and Uganda, such a strategy would have relaxed the need for open-market operations and the sharp rise in interest rates. In Mozambique, it would have reduced inflation by reining in base money and limiting nominal depreciation. International Initiatives to Improve the Effectiveness of Aid In addition to lack of aid predictability and lack of coordination, aid frag- mentation further constrains aid effectiveness. Deutscher and Fyson (2008, 16) identify more than "280 bilateral donor agencies, 242 multi- lateral programs, 24 development banks, and about 40 United Nations agencies working in the development business." Added to that are the increasing number of private foundations, NGOs, and "an estimated 340,000 development projects around the world" (Deutscher and Fyson 2008, 16). The fragmentation of aid means that (some) countries receive small amounts of aid from a plethora of donors, all requiring adherence to dif- fering procedures and standards. A 2008 OECD survey found that dur- ing 2005­06, 38 developing countries received aid from 25 or more DAC and multilateral donors. A 2006 OECD survey found that government authorities in Vietnam in 2005 received 791 visits from donors, while health workers in Tanzania spent a quarter of their working days writing reports for donors (Deutscher and Fyson 2008). Meanwhile, some countries are ignored altogether. A series of four high-level meetings since 2002 have produced a prom- ising plan to make aid more effective by 2010 (table 7.5). A major meet- ing will be held in 2011 to assess whether the targets have been met. Development Assistance 157 Table 7.5 International Action to Improve Aid Effectiveness Date Initiative Venue Output 2002 International Conference on Financing Monterrey The Monterrey Consensus for Development 2003 High-Level Forum on Harmonization Rome The Rome Declaration on Harmonization 2005 2nd High-Level Forum on Aid Effectiveness Paris Paris Declaration on Aid Effectiveness 2008 3rd High-Level Forum on Aid Effectiveness Accra Accra Agenda for Action 2011 4th High-Level Forum on Aid Effectiveness TBD Assessment of whether targets have been met Source: Authors. Note: TBD = to be determined. The International Conference on Financing for Development, organ- ized by the United Nations in Monterrey, Mexico, in March 2002, brought together an unprecedentedly large number of participants involved in development finance--both donors and recipients. The forum yielded recommendations in six areas: mobilizing domestic financial resources for development; mobilizing international resources for devel- opment (including FDI and other private flows); international trade as an engine of development; international financial and technical cooperation for development; external debt; and several systemic issues (enhancing the coherence and consistence of the international monetary, financial, and trading systems in support of development). The Monterrey Consensus was adopted by the participants, along with a commitment to a larger volume of more effective aid. The following year, high-level representatives from the major multilat- eral and bilateral donor institutions met in Rome with representatives of aid recipients to continue the discussion of how to improve the effective- ness of aid. The resulting Rome Declaration on Harmonization articu- lated the following goals: · Ensure that harmonization efforts are adapted to the country context and that donor assistance is aligned with the recipient's priorities. · Expand country-led efforts to streamline donor procedures and practices. · Review and identify ways to adapt institutions' and countries' policies, procedures, and practices to facilitate harmonization. 158 Understanding Growth and Poverty · Implement the good practices, principles, and standards formulated by the development community as the foundation for harmonization. The same set of participants met again in Paris in early 2005. The Paris Declaration on Aid Effectiveness committed the parties to specific actions that would promote the effective use of aid funds. The Paris Declaration was grounded on 5 mutually reinforcing principles and 12 indicators by which progress was to be assessed. Targets for 11 of those indicators were set in 2010 (see annex).The five principles (and associ- ated indicators) are as follows: · Ownership. Partner countries exercise effective leadership over their development policies and strategies and coordinate development actions (indicator 1). · Alignment. Donors base their overall support on partner countries' national development strategies, institutions, and procedures (indica- tors 2­8). · Harmonization. Donors' actions are more harmonized, transparent, and collectively effective (indicators 9 and 10). · Managing for results. Managing resources and improving decision making for development results (indicator 11). · Mutual accountability. Donors and partners are accountable for devel- opment results (indicator 12). A first round of monitoring took place in 2006 based on activities undertaken in 2005 in 34 countries where some progress was noted but significant efforts were still needed. A second round of monitoring took place in 56 countries in 2008 prior to the Third High-Level Forum on Aid Effectiveness in Accra. The Accra Agenda for Action noted that, despite the progress made on reducing poverty, much more needed to be done if the MDGs were to be met. Similarly, much more needed to be done to improve the effective- ness of aid. A 2008 survey conducted by the OECD prior to the Accra meeting examined progress in 33 countries toward the 2010 targets set forth in the Paris Declaration (figure 7.10). Progress was not stellar. The report identifies three indicators for which targets were on track in 2010. First, good progress has been made in aligning and coordinating technical cooperation (indicator 4). Public financial management systems were also on target (indicator 2): 36 percent of countries within the sam- ple (10 of 28 countries surveyed in 2006 and 2008) had improved their Figure 7.10 Progress toward the 2010 Paris Declaration Targets 2005 indicator 2010 targets baseline 1 operational development distance to target (in 2007) strategles 17% 24% 75% 2 reliable public financial 50% of countries management (PFM) systems 36% improve score 3 aid flows are recorded 42% 48% 85% in countries' budgets 4 technical assistance is 48% 60% 50% aligned and coordinated 5a donors use country 40% 45% (80%) PFM systems 5b donors use country 39% 43% (80%) procurement systems 6 donors avoid parallel, PIUs 1,817 1,601 611 7 aid is more predictable 41% 46% 71% 8 aid is untied progress 75% 88% over time 9 donors use coordinated 43% 46% 66% mechanisms for aid delivery 10a donors coordinate their 18% 20% 40% missions 10b donors coordinate their country studies 42% 42% (no progress) 66% 11 sound frameworks 7% 9% 38% to monitor results 12 mechanisms for 22% 24% 100% mutual accountability 159 Source: OECD-DAC 2008a, 22. Used by permission. Note: PIU = project implementation unit. For more detail about each indicator, see annex. 160 Understanding Growth and Poverty systems.14 Progress has also been made toward untying aid (indicator 8). The share of untied aid increased from 75 percent in 2005 to 88 percent in 2006. Three further indicators are on track for 2010 if country efforts are significantly scaled up. The incidence of parallel project implementation units (PIUs) has declined, and if no new PIUs emerge, the target should be reached (indicator 6). Improving transparency and accountability in a country's budget by accurately recording aid is the objective of indica- tor 3. Only marginal progress has been made, but greater coordination at the international level and greater commitment at the country level are needed to ensure that aid flows are accurately recorded in national budg- ets. Indicator 7 calls for greater predictability in the disbursement of scheduled aid. Despite some improvement, further effort between donors and partner authorities will be needed to reach the target by 2010. The remaining indicators will require significant effort by donors and countries. The report makes three major policy recommendations aimed at accelerating progress and transforming the aid relationship into a full partnership between donors and recipient countries: (a) step up the use and capability of national institutions as a way of reinforcing country ownership, (b) strengthen accountability for development resources, and (c) make aid management more cost effective. Deutscher and Fyson (2008) highlight the challenges in meeting these recommendations. Achieving country ownership is difficult in an environ- ment where a country's strategic vision is not linked to a specific fiscal policy or budget process or where capacity is lacking. Even where frame- works for accountability exist, they are often weak. Finally, transparency in how public funds are spent, how contracts are procured, and how results are monitored--all prerequisites for cost-effective aid manage- ment--is scarce nearly everywhere in the developing world. The same authors suggest the following paths for improving aid effectiveness: · Focus on results, not on getting credit. Donors like to be acknowl- edged for the aid they provide, but this must not distract from the objective of making aid more effective. · Encourage political leaders in the developing world to demand aid effectiveness and help reduce the fragmentation of aid, even if this means refusing aid that is not aligned with their development agenda. · Stem the proliferation of aid agencies--aid effectiveness is compro- mised by too many donors with too many conflicting systems. Development Assistance 161 · Increase communication and accountability between donors and the public and between donors and recipient countries.15 Conclusion Development assistance is based on the idea that rich countries can and should help poor countries find the path to sustainable economic growth and poverty reduction--especially those that lack other sources of capi- tal. The chapter began by identifying the sources and composition of net capital flows to developing countries--highlighting the respective roles of private and public flows. We then discussed the arguments and evidence on both sides of the raging debate on whether aid is effective in promot- ing economic growth. The evidence of a direct effect of aid on growth is not conclusive. Does this mean that aid should be cut back? Not neces- sarily. The impact of aid should be evaluated not only in relation to its direct effects, but also in terms of its role in improving governance and economic management, and its contribution to social objectives--notably education, health, and infant mortality. Annex The Five Principles of the Paris Declaration on Aid Effectiveness Ownership Target for 2010 1 Partners have operational development At least 75% of partner countries have strategies--Number of countries operational development strategies. with national development strategies (including PRSs) that have clear strategic priorities linked to a medium-term expenditure framework and reflected in annual budgets. Alignment Targets for 2010 2 Reliable country systems -- Number (a) Public financial management -- of partner countries that have Half of partner countries move up procurement and public financial at least one measure (i.e., 0.5 points) on management systems that either the PFM/ CPIA (Country Policy and (a) adhere to broadly accepted Institutional Assessment) scale of good practices or (b) have a reform performance. programme in place to achieve these. (b) Procurement -- One-third of partner countries move up at least one measure (i.e., from D to C, C to B or B to A) on the four-point scale used to assess performance for this indicator. (continued next page) 162 Understanding Growth and Poverty (continued) Alignment Targets for 2010 3 Aid flows are aligned on national Halve the gap--halve the proportion of priorities--Percent of aid flows to the aid flows to government sector not government sector that is reported on reported on government's budget(s) partners' national budgets. (with at least 85% reported on budget). 4 Strengthen capacity by co-ordinated 50% of technical co-operation flows support--Percent of donor are implemented through co-ordinated capacity-development support programmes consistent with national provided through coordinated development strategies. programmes consistent with partners' national development strategies. 5a Use of country public financial Percent of donors management systems--Percent Score Target of donors and of aid flows that use 5+ All donors use partner public financial management systems countries' PFM systems. in partner countries, which either 3.5 to 4.5 90% of donors use partner (a) adhere to broadly accepted countries' PFM systems. good practices or (b) have a reform Percent of aid flows programme in place to achieve these. Score Target 5+ A two-thirds reduction in the % of aid to the public sector not using partner countries' PFM systems. 3.5 to 4.5 A one-third reduction in the % of aid to the public sector not using partner countries' PFM systems. 5b Use of country procurement systems -- Percent of donors Percent of donors and of aid flows Score Target that use partner country procurement A All donors use partner coun- systems which either (a) adhere to tries' procurement systems. broadly accepted good practices or B 90% of donors use partner (b) have a reform programme in place countries' procurement to achieve these. systems. Percent of aid flows Score Target A A two-thirds reduction in the % of aid to the public sec- tor not using partner coun- tries' procurement systems. B A one-third reduction in the % of aid to the public sector not using partner countries' procurement systems. (continued next page) Development Assistance 163 (continued) Alignment Targets for 2010 6 Strengthen capacity by avoiding parallel Reduce by two-thirds the stock of implementation structures -- Number parallel project implementation units of parallel project implementation units (PIUs). (PIUs) per country. 7 Aid is more predictable -- percent of aid Halve the gap -- halve the proportion disbursements released according of aid not disbursed within the fiscal year to agreed schedules in annual or for which it was scheduled. multi-year frameworks. 8 Aid is untied -- Percent of bilateral aid Continued progress over time. that is untied. Harmonization Targets for 2010 9 Use of common arrangements or 66% of aid flows are provided in procedures -- Percent of aid provided the context of programme-based as programme-based approaches. approaches. (a) 40% of donor missions to the field are joint. 10 Encourage shared analysis -- Percent (b) 66% of country analytic work is of (a) field missions and/or (b) country joint. analytic work, including diagnostic reviews that are joint. Managing for results Target for 2010 11 Results-oriented frameworks -- Number Reduce the gap by one-third -- of countries with transparent and Reduce the proportion of countries monitorable performance assessment without transparent and monitorable frameworks to assess progress against performance assessment frameworks (a) the national development strategies by one-third. and (b) sector programmes. Mutual accountability Target for 2010 Mutual accountability -- Number of All partner countries have mutual assess- partner countries that undertake ment reviews in place. mutual assessments of progress in implementing agreed commitments on aid effectiveness including those in this Declaration. Source: OECD 2009, 161­62. Note: CPIA = Country Policy and Institutional Assessment; PFM = public financial management; PIU = project implementation units; PRS = Poverty Reduction Strategy. 164 Understanding Growth and Poverty Notes 1. The objective of the DAC is to improve development assistance through coordination and collaboration with major stakeholders and to collect and synthesize data on aid and foreign assistance before delivering that data to the public. 2. Examples of ODA activities include development projects such as schools, clinics, and water supply systems; emergency aid for natural or man-made dis- asters; contributions for multilateral development agencies; food aid, both emergency and developmental; aid to refugees and internally displaced per- sons (IDPs); debt relief under the Paris Club Agreement; and officially financed scholarships for students in developing countries (Smith 2008). 3. The 22 country members are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The 23rd member is the EC. The Republic of Korea joined in January 2010, bringing the number of DAC members to 24. The data discussed in this chapter refer to the 22 members plus the EC. 4. The estimated total from 2004 to 2010 is less than half this--$12 billion (in 2004 prices) (OECD-DAC 2010, 100). 5. Excluding debt relief. Including debt relief the proportions, in real terms, are 24 percent for Sub-Saharan Africa and 22 percent for Africa as a whole (OECD-DAC 2010, 100). 6. Official data are, however, almost certainly understated. Only the officially funded component of aid from NGOs is counted as ODA. 7. AfDB, AfDF, CarDB, Council of Europe, EBRD, EC, GAVI, GEF, Global Fund, IAEA, IBRD, IDA, IDB Sp. Fund, IFAD, IFC, IMF (SAF, ESAF, PRGF), IMF Trust Fund, Montreal Protocol, Nordic Dev Fund, UNAIDS, UNDP, UNECE, UNFPA, UNHCR, UNICEF, UNRWA, UNTA, WFP, and Arab agencies. 8. The Czech Republic, Hungary, Poland, the Slovak Republic, Turkey, the Arab countries, and other countries. 9. The IMFC was established on September 30, 1999, by a resolution of the IMF Board of Governors, to replace the Interim Committee of the Board of Governors on the International Monetary System (usually known simply as the Interim Committee), which had been established in 1974. The IMFC has 24 members appointed by member countries of the IMF. 10. For the poorest recipient countries, ODA has averaged just over 2 percent of GDP since 1996--down from a high of 3.7 percent in 1992 (World Bank 2006a). 11. Global FDI amounts to roughly $1.4 trillion (World Bank 2009, 41). Development Assistance 165 12. World Bank projections suggest that net private capital flows will be insuffi- cient to meet the external financing needs of 30 of the 40 low-income coun- tries for which data are available. Furthermore, if official capital flows to those countries remain at the 2007­08 levels, they would cover just 2 of the 30 countries in the base-case scenario and not a single country in the low case (World Bank 2009, 84). 13. Deutscher and Fyson (2008) caution that the commitment gap between the spending plans of 23 members of the DAC (the World Bank; the African, Asian, and Inter-American development banks; the main UN organizations; and the global funds for health and the environment) fall short (by $30 billion) of the overall aid targets set by the DAC members individually for 2010. 14. Deutscher and Fyson (2008) disagree, pointing to the Democratic Republic of Congo and the Arab Republic of Egypt, where public financial manage- ment systems deteriorated between 2005 and 2007. 15. 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Washington, DC: World Bank. Celasun, O., and J. Walliser. 2008. "Managing Aid Surprises." Finance and Development 42, No. 3 (September). Clemens, Michael, Steven Radelet, and Rikhil Bhavnani. 2004. "Counting Chickens When They Hatch: The Short-Term Effect of Aid on Growth." Working Paper 44, Center for Global Development, Washington, DC. Curto, Stefano. 2007. "Changing Aid Landscape."Finance and Development 44 (4): 20­21. 166 Understanding Growth and Poverty Deutscher, E., and S. Fyson. 2008. "Improving the Effectiveness of Aid." Finance and Development 42 (3): 15­19. Easterly, William. 2001. The Elusive Quest for Growth--Economists' Adventures and Misadventures in the Tropics. Cambridge, MA: Massachusetts Institute of Technology Press. ------. 2006. The White Man's Burden--Why the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good. London: Penguin. Eifert, B., and A. Gelb. 2005. "Coping with Aid Volatility." Finance and Development 42 (3): 24­27. FRIDE (Foundation for International Relations and Foreign Dialogue). 2003. Towards a New Era in Development Aid. Madrid: FRIDE. Gilman, M. G., and J. Wang. 2003. "Official Financing: Recent Developments and Selected Issues." World Economic and Financial Surveys, International Monetary Fund, Washington, DC. Gupta, S., R. Powell, and Y. Yang. 2005. "The Macroeconomic Challenges of Scaling-Up Aid to Africa." IMF Working Paper WP/05/179, International Monetary Fund, Washington, DC. Heller, P. S. 2005. "Making Aid Work." Finance and Development 42 (3): 8­13. IMF (International Monetary Fund). 2006. "The Multilateral Debt Relief Initiative (MDRI)." MDRI Factsheet, IMF, Washington, DC. Isham, Jonathan, Daniel Kaufmann, and Lant Pritchett. 1995. "Governance and Returns on Investment: An Empirical Investigation." Policy Research Working Paper 1550, World Bank, Washington, DC. Jamison, D. T., and S. Radelet. 2005. "Making Aid Smarter." Finance and Development 42 (2): 42­46. Masud, Nadia, and Boriana Yontcheva. 2005. "Does Foreign Aid Reduce Poverty? Empirical Evidence from Nongovernmental and Bilateral Aid." IMF Working Paper WP/05/100, International Monetary Fund, Washington, DC. OECD (Organisation for Economic Co-operation and Development). 2009. Aid Effectiveness: A Progress Report on Implementing the Paris Declaration. Paris: OECD. OECD-DAC (Organisation for Economic Co-operation and Development, Development Assistance Committee). 2006. 2006 Survey on Monitoring the Paris Declaration. Paris: OECD. ------. 2008a. 2008 Survey on Monitoring the Paris Declaration: Making Aid More Effective by 2010. Better Aid, http://dx.doi.org/10.1787./9789264050839­en, http://www.oecd.org/dac/pdsurvey. Paris: OECD. ------. 2008b. Scaling Up: Aid Fragmentation, Aid Allocation and Aid Predictability--Report of 2008 Survey of Aid Allocation Policies and Indicative Forward Spending Plans. Paris: OECD. Development Assistance 167 ------. 2010. Development Co-operation Report 2010. http://dx.doi.org/ 10.1787/dcr-2010-en. Paris: OECD. Radelet, S., M. Clemens, and R. Bhavnani. 2005. "Aid and Growth." Finance and Development 42 (3): 16­20. Rajan, R., and A. Subramanian. 2005. "Aid and Growth: What Does The Cross Country Evidence Really Show?" IMF Working Paper WP/05/127, International Monetary Fund: Washington DC. Siddiqi, B. 2005. "Picture This. Aiding Development: Tracking the Flows." Finance and Development 42 (3): 14­15. Smith, K. 2008. The DAC and ODA (Official Development Assistance) Statistics. http://www.docstoc.com/docs/1003544/The-DAC-and-ODA-Statistics. Tressel, Thierry. 2007. "Is There a Foreign Aid Paradox?" IMF Research Bulletin 8 (4): 1, 4. Mishra, P., and D. Newhouse. 2007. "Does Health Aid Matter?" Unpublished paper, International Monetary Fund, Washington, DC. World Bank. 2005. Global Development Finance. Washington, DC: World Bank. ------. 2006a. Global Development Finance. Washington, DC: World Bank. ------. 2006b. Global Monitoring Report. Washington, DC: World Bank. ------. 2006c. World Development Indicators. CD-ROM. Washington, DC: World Bank. ------. 2007. Global Development Finance. Washington, DC: World Bank. ------. 2009. Global Development Finance. Washington, DC: World Bank. CHAPTER 8 External Debt In national finance--as in corporate and personal finance--credit is good, and excessive debt is bad. When a country's debt burden becomes too great, investment evaporates and growth is choked off. Social spending drops and people suffer. By the late 1980s, many low-income countries had contracted an unsustainable amount of foreign debt; it was widely realized that a wide- ranging program of debt relief would be required if such countries were to avoid becoming hopelessly mired in debt. A round of debt-relief initia- tives that began with a summit in Toronto in 1988 culminated in the Multilateral Debt Relief Initiative (MDRI) of June 2005. The MDRI pro- vided for the full cancellation of official debt to qualified low-income countries that agreed to use the savings to reduce poverty, establish sound macroeconomic policies, and improve social outcomes. Between January 2006 and December 2007, 25 heavily indebted developing countries saw $3.3 billion in external debt canceled by private and official creditors, thus freeing up resources to help those countries reach the Millennium Development Goals (MDGs), the major aim of which is to halve poverty by 2015. But while debt forgiveness brought benefits to many countries, con- cern persisted that in times of plentiful credit (such as 2002­07), some 169 170 Understanding Growth and Poverty countries would borrow too much, making themselves vulnerable to sud- den increases in interest rates. In 2008, in fact, private investment flows to developing countries shrank by more than 40 percent, as access to international debt markets dried up and inflows of portfolio equity all but ceased (World Bank 2009). The current crisis has affected the external financing position of all developing countries--but not equally. Those that have high levels of exter- nal debt, large current-account deficits, and shallow foreign reserves are more likely to encounter difficulties in obtaining the finance they will need to avoid a severe contraction in growth. Many private firms in the develop- ing world will be hard pressed to service their foreign-currency liabilities with revenues earned in sharply devalued domestic currencies. The World Bank (2009) predicts that the likelihood of balance of payment crises and the restructuring of corporate debt in these countries is very great. Measures of External Indebtedness Conventional measures of a country's debt burden are as follows: · The ratio of external debt to gross domestic product (GDP) or to exports of goods and services, sometimes including workers' remit- tances and other current-account receipts is used. These measures point to a country's ability to service its debts, particularly in terms of foreign exchange. · In an elaboration of the simple debt-to-exports ratio, the discounted present value of future debt service is compared with the dis - counted present value of future export receipts. The calculations of discounted present value include all future debt-service obligations divided by the appropriate discount factors. · The ratio of scheduled debt service (interest payments and amortiza- tion) to government revenues provides an indication of the fiscal impact of external debt and a country's capacity to repay its obligations. External indebtedness is likely to affect poverty both directly, by shrinking government resources available for poverty-related spending, and indirectly, through its impact on economic growth. External Indebtedness, Growth, and Poverty Studies of the link between external debt and growth emphasize the mediating role of investment. According to the "debt overhang" hypothesis, External Debt 171 large debts lower growth by hindering investment, as ever-larger shares of a country's resources are transferred abroad to service debts. The debt burden may also raise domestic interest rates, slowing investment. Once the level of debt becomes large enough, investment will remain ineffi- ciently low until the unsustainable portion of the debt is either forgiven or rescheduled. As debt increased in the 1980s, growth slowed in the developing world; it picked up again as debt was reduced in the 1990s (figure 8.1, panels a and b). As outstanding debt increases beyond a threshold level--to debt over- hang levels--a country's ability or willingness to repay its debts begins to fall, especially as governments begin to default on debt to avoid the dam- aging effects of very high debt service. As debt rises, the erosion of expected repayments is known as the Laffer debt curve. International financial markets and aid donors tend to view excessive debt as a sign of economic mismanagement and bad governance, both of which make investment more risky. In this way, high indebtedness can trigger a decline in new flows of external resources, leading, in turn, to a reduction in poverty-related spending. As debt grows, so does the likelihood that its servicing will be financed through inflationary measures, punitive taxes, arbitrary spending cuts, or other distortionary policies. Expecting such policies, private investors typ- ically choose one of three paths: they invest less, they divert their resources to risky ventures that produce quick financial returns, or they transfer their money into safer investments abroad (capital flight). Another channel through which debt affects growth is by crowding out social spending. Proponents of debt relief argue that fiscal resources freed up by debt relief can and should be used to support health, educa- tion, water, sanitation, and other essential services to the poor, in the belief that increased social spending leads to better social outcomes.1 In addition, such spending is widely regarded as crucial for low-income countries to achieve the MDGs, which include targets for reducing child and infant mortality, and raising educational enrollment. Notwithstanding the attractiveness of the debt-overhang hypothesis as an explanation for slow growth in highly indebted countries, empirical evidence of the effects of debt overhang is mixed. For example, Claessens (1990) found that 5 of the 29 middle-income countries in his sample were on the wrong side of the Laffer debt curve, suggesting that partial debt reduction would decrease the expected repayment to creditors. For middle-income countries, Warner (1992) concluded that the debt crisis did not depress investment. Several other studies have concluded that it is difficult to disentangle the impact of debt variables on growth. 172 Understanding Growth and Poverty Figure 8.1 Debt's Inverse Relationship to Growth a. 1973­97 500 3.0 real GDP per capita growth 400 2.0 percent of exports 300 1.0 200 0.0 100 ­1.0 73 76 79 82 85 88 91 94 97 19 19 19 19 19 19 19 19 19 debt to exports net present value of debt to exports real GDP per capita growth (right scale) b. 1989­2007 6 0.9 0.8 5 ratio of external debt/GDP 0.7 4 0.6 growth rate 0.5 3 0.4 2 0.3 0.2 1 0.1 0 0.0 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 growth rate (left scale) external debt stocks (PPG) as GDP (%) external debt stocks (PNG) as GDP (%) Sources: Reprinted from Pattilio, Poirson, and Ricci 2002. Note: PNG = private nonguaranteed; PPG = public debt and public guaranteed debt. The sample consists of 93 developing countries. The data consist of three-year moving averages over the 1972­88 period. External Debt 173 The second difficulty relates to the "crowding-out" effect. Most stud- ies of the interplay of investment and growth conflate crowding out with the debt-overhang effect. It is important, however, to distinguish between the debt-overhang effect--which can be captured with a variable repre- senting the burden of future debt service, such as the debt stock or the net present value (NPV) of future debt service--and crowding out, the proxy for which is a contemporaneous debt-service ratio in the regression analysis. Patilio, Poirson, and Ricci (2002) found a nonlinear, Laffer-type rela- tionship between debt and growth in the 93 developing countries that they examined. The average impact of external debt on per capita growth appeared to be negative for debt levels (measured in NPV terms) above 60­70 percent of exports and 35­40 percent of GDP. Furthermore, their results suggest that doubling debt levels slows per capita GDP growth by about 0.5­1.0 percent. The same authors also found that the investment level did not appear to be the main channel through which excessive external indebtedness reduced growth and that the debt-overhang effect was greater than the crowding-out effect. Debt Relief and Low-Income Countries External debt emerged as a grave problem for developing countries in the 1980s. Middle-income countries were borrowing from private creditors-- chiefly commercial banks--to fund infrastructure projects and cover shortfalls in their balance of payments, while low-income countries with- out access to private finance borrowed from developed countries--often through export credit agencies or from banks in the form of loans insured by the agencies.2 Official creditors were willing to take the risks of what was called "national-interest" lending and saw the provision of commer- cially priced export credit guarantees as a complement to the grants and concessional loans they offered. Many low-income countries began to have difficulty servicing their debts--paying the interest and principal on the scheduled due dates--in the early and mid-1980s. Their mounting difficulties quickly became a debt crisis. To cope with the crisis, an informal group of official creditors known as the Paris Club3 agreed to reschedule debt to poor countries (at unchanged interest rates) to preserve growth and economic viability in the affected countries. From 1976 to 1998, the Paris Club resched- uled loans to 81 countries--27 of which came to be identified as heavily indebted poor countries (HIPCs)--delaying payments of about 174 Understanding Growth and Poverty $23 billion (table 8.1).4 This approach provided these countries with sub- stantial cash-flow relief for financing reform programs. At the same time, however, their stock of outstanding debt steadily increased. A new approach to the debt problem was initiated in 1988 at the Group of Seven (G-7) summit in Toronto, where, for the first time, it was decided to reschedule the Paris Club commercial loans to low-income countries at below-market interest rates. For the first time, governments were being asked to accept concessional reschedulings on export credit agency debts.5 A combination of proposals from France, the United Kingdom, and the United States that came to be known as the Toronto terms reduced the NPV of eligible debt by up to one-third. The Toronto terms were the first of several schemes to provide debt relief to poor countries. Those schemes considerably reduced the external debt of middle-income countries.6 But many low-income countries-- especially in Sub-Saharan Africa--continued to suffer from heavy exter- nal debt burdens and high rates of poverty. These countries had difficulty meeting their external debt commitments owing to a confluence of factors, including the accumulation of nonconcessional debt from offi- cial export credits, poor debt-management practices, worsening terms of trade, weak macroeconomic policies, poor governance, civil wars, and drought. During the same period, new initiatives aimed at promoting debt relief for low-income countries were introduced by multilateral institutions. At the G-7 summit in Venice in 1987, the International Monetary Fund (IMF) had unveiled the Enhanced Structural Adjustment Facility (ESAF), designed to provide new concessional IMF lending for low-income coun- tries, financed by grants from wealthier member countries. The ESAF succeeded the Structural Adjustment Facility (SAF) that had been estab- lished in 1986. It was itself succeeded by the Poverty Reduction Growth Facility (PRGF) in 1999. Available to low-income member countries fac- ing protracted balance of payment problems, the ESAF provided resources at an annual interest rate of 0.5 percent, repayable over 10 years, including a grace period of 5.5 years. The PRGF offered the same terms. In September 1996, the World Bank and IMF together launched the HIPC Initiative to reduce the external debt burden of eligible countries "to a sustainable level in a reasonably short period of time" in return for "strong programs of macroeconomic adjustment and structural reforms" (Andrews and others 1999). A country was judged to have reached a sus- tainable level of external debt if it could meet its current and future Table 8.1 HIPCs: Paris Club Reschedulings by Type of Terms, 1976­98 Amount Stock of debt Number of Number of consolidated Stock or operations Paris club terms Dates reschedulings countries (US$, millions) flow deals (US$, millions) Nonconcessional before Oct. 1988 81 27 22,803 Flow only -- Toronto terms Oct. 1988­June 1991 28 20 5,994 Flow only -- London terms Dec. 1991­Dec. 1994 26 23 8,857 Flow only -- Naples terms since January 1995 34 26 14,664 7 stock deals 2,518 Lyon terms since December 1996 5 4 2,775 2 stock deals 709 Source: Daseking and Powell 1999, table 1. Note: Table excludes Nigeria. 175 176 Understanding Growth and Poverty external debt-service obligations in full without recourse to debt relief, rescheduling of debt, accumulation of arrears, or curtailment of growth. At the outset, 41 countries7 were identified as HIPCs; 32 of these had a gross national product (GNP) per capita of $695 or less in 1993, a debt- to-export ratio of 220 percent or higher, or a debt-to-GNP ratio of 80 percent or higher. The remaining nine countries were those that had received or were eligible for concessional rescheduling from Paris Club creditors. The HIPCs had to be eligible for the ESAF and for loans from the International Development Association (IDA), the World Bank's con- cessional lending arm. They were required to show a strong record of per- formance under IMF- and World Bank­sponsored programs (Andrews and others 1999). After 1999, the Enhanced HIPC Initiative provided deeper, faster, and broader debt relief,8 and a stronger focus on poverty reduction through the preparation and adoption of a new vehicle--the Poverty Reduction Strategy Paper (PRSP). The PRSP was designed to be a comprehensive, nationally "owned" strategy for reducing poverty through rapid economic growth, macroeconomic stability, and structural reforms. Prepared in con- sultation with community groups, nongovernmental organizations (NGOs), and donors, the Strategy Paper would identify specific targets tied to the MDGs. At first it was optional for countries to participate in the Enhanced HIPC Initiative, but this was later made a mandatory con- dition for passing the decision point for obtaining debt relief under the HIPC Initiative. As of December 2007, debt-reduction packages had been approved for 32 countries (26 of them in Africa), providing $46 billion (in NPV terms, as of the decision point) in debt-service relief over time. Twenty-three9 had reached the completion point and were receiving irrevocable debt relief. Nine countries10 had reached the decision point and were receiving interim relief. Social difficulties--internal civil strife, cross-border armed conflict, and governance challenges--prevented the remaining nine coun- tries from obtaining debt relief. In June 2005, the Group of Eight (G-8) industrial governments pro- posed canceling the debts of HIPCs under a new measure, the Multilateral Debt Relief Initiative, mentioned at the start of this chapter. The MDRI was designed to provide additional financial support--up to 100 percent debt relief--to countries that had graduated from the Enhanced HIPC Initiative, to better position them to achieve the MDGs. Unlike the HIPC Initiative, the MDRI did not propose any paral- lel debt relief on the part of official bilateral creditors, private creditors, External Debt 177 Table 8.2 Status of 39 Countries under the Enhanced HIPC Initiative--2010 Post Completion Point Countries (27) Afghanistan Ghana Niger Benin Guyana Rwanda Bolivia Haiti São Tomé & Príncipe Burkina Faso Honduras Senegal Burundi Madagascar Sierra Leone Cameroon Malawi Tanzania Central Africa Republic Mali Uganda Congo, Rep. Mauritania Ethiopia Mozambique Gambia, The Nicaragua Interim Countries (Between Decision and Completion Point) (7) Chad Guinea Togo Congo, Dem. Rep. Guinea-Bissau Côte d'Ivoire Liberia Pre-Decision Point Countries (5) Comoros Somalia Eritrea Sudan Kyrgyz Republic Source: Daseking and Powell 2010, 4. or multilateral organizations except for the IMF, IDA, and the African Development Fund. The bulk of the debt relief was to be provided by the IDA, which began to implement the MDRI in July 2006. The IMF began implementation in January 2006. All countries that reach the completion point11 under the Enhanced HIPC Initiative, and those with per capita income below $380 and outstanding debt to the IMF at the end of 2004, are eligible for the MDRI. According to these criteria, 25 countries had qualified as of December 2007. These included 23 HIPCs that had reached completion point and 2 non-HIPCs (Cambodia and Tajikistan) whose per capita income was below $380. The cost of the debt relief under the MDRI was $3.3 billion by the end of December 2007 (Daseking and Powell 2010). Table 8.2 shows the most recent list of countries that are eligible or potentially eli- gible for HIPC Initiative assistance as of January 30, 2010. Debt Relief versus Development Assistance As discussed in chapter 7 of this book, resources for development are directed toward low-income countries through debt relief, development 178 Understanding Growth and Poverty assistance, or both. For example, in Africa in recent years, debt relief has become a more important component of total resource flows, with the bulk of aid increases being channeled to debt relief (figure 8.2). In this context, both donors and policy makers in recipient countries often debate which form of resource flow is more effective in promoting growth and alleviating poverty. One view is that the relative merits of development assistance versus debt relief depend on the type of country. Debt relief is more effective in countries suffering from a severe debt overhang, where there is an urgent need for resource flows to jump-start the development process. In other countries, development assistance is more efficient than debt relief because it helps develop market institutions and better policies and is more targeted toward projects and sectors that help growth and reduce poverty. Figure 8.2 Composition of Resource Flows to Africa, 2000­10 US$, billions 50 40 30 20 10 0 e et 00 01 02 03 04 05 at rg tim 20 20 20 20 20 20 ta es 10 20 06 20 development assistance committee members (excluding debt relief) multilaterals (excluding debt relief) debt relief other donors Source: Curto 2007. Note: Other donors include non-DAC donors reporting to the OECD-DAC. External Debt 179 Another view is that, in general, debt relief is more effective than aid for most developing countries because (a) "tied" aid (for which donors place conditions on recipient countries to purchase goods or services from the donor country) reduces the value of aid by 11 to 30 percent (UN 2005), while debt relief cannot be tied; and (b) debt relief provides flexible budget support and increases government accountability because it makes it possible for governments of recipi- ent countries to set their own priorities instead of focusing on projects proposed by donors. Debt-relief programs are typically justified on the basis that they free up resources that would otherwise have been used for debt servicing and on the assumption that these freed-up resources will be spent on social programs--such as those focused on education and health--to alleviate poverty and promote growth. There is some evidence that social-service spending has risen in response to past episodes of debt relief. The IMF has estimated that poverty-reducing expenditures in the HIPCs rose from 6.4 percent of GDP in 1999 to 7.9 percent in 2004. But it is far from clear whether the increase was the result of debt relief rather than a boost in development assistance.12 As seen in the last chapter, donors earmarked much of that boost for sectoral assistance and investment projects, which have a more immediate impact on social sector spending than does debt relief. It is important to remember that greater health-care spending does not necessarily mean better health, and more money for schools does not necessarily mean more children in school. Other factors such as poor governance and lack of institutional capacity often decide outcomes. IMF chief economist Raghuram Rajan (2005) has argued that if the main obstacle to growth is a bleak investment climate, then reducing the level of debt without providing additional resources or improving policies is unlikely to have any positive effect on growth and poverty reduction. Individual views on the relative effectiveness of debt relief and devel- opment assistance may turn on the perceived value of donor agency involvement. Those who believe that such agencies can increase the pos- itive impact of public expenditure by directing external resources toward the development of better institutions and infrastructure tend to favor development assistance. Those who believe that donor agencies add to bureaucratic and institutional challenges by placing conditions on aid allocation tend to favor debt relief. 180 Understanding Growth and Poverty We return to this discussion in chapter 15, where we urge that the con- tribution of both development assistance and debt relief to growth and poverty reduction should be seen in the larger context of the various fac- tors affecting long-term growth in a country, including geography, macro- economic policies, human capital, infrastructure, institutions, trade, and socioeconomic conditions. Conclusion Mounting external debt hobbles economic growth by limiting invest- ment. It also reduces countries' capacity for poverty reduction by curtail- ing social spending. By the late 1980s, many low-income countries had accumulated such high levels of external debt that their ability to repay that debt--while continuing to grow and fight poverty--was question- able. A host of debt-relief initiatives brought substantial reductions in the official debt of qualified low-income countries. Debt relief effectively provides predictable budgetary benefits and, in this way, has helped coun- tries move toward the MDGs. Notes 1. In a wide-ranging study of 48 Sub-Saharan African countries for the period 1980­99, Lopes (2002) found that greater social spending did indeed produce better social outcomes (or outputs). The outcomes for education, for exam- ple, are gross enrollment rates, pupil-teacher ratios, adult illiteracy rates, and so on; outcomes for health are infant mortality rates, life expectancy at birth, physicians per 1,000 people, number of hospital beds, and so on. 2. The purpose of export credit agencies is to support domestic exports by pro- viding trade loans to developing countries that cannot obtain credit from pri- vate lenders, often because of their unstable politics. The provision of export credit guarantees stimulated industrial-country exports and--by extension-- domestic employment, while cementing ties with trading partners. 3. The Paris Club is an informal and voluntary gathering of a group of official creditors whose role is to find coordinated and sustainable solutions to the payment difficulties experienced by debtor nations. The first meeting with a debtor country was in 1956, when Argentina agreed to meet its public credi- tors in Paris. Since then, the Paris Club or ad hoc groups of Paris Club credi- tors have reached 400 agreements with 83 debtor countries. 4. Subsequent paragraphs discuss the initiatives put in place by the international financial institutions (IFIs) for external debt from 1998 to 2010 and identify the countries that have benefited from these initiatives. External Debt 181 5. Concessional rescheduling on official development assistance was already being provided. "Paris Club practice had always rescheduled aid debts using the concessional interest rate of the original loan contract which implies a reduction in its present value." (Daseking and Powell 1999). 6. The decrease in external debt for middle-income countries has, however, been associated with an increase in domestic debt that has its own inherent risks. 7. The group of 41 countries consisted of Angola, Benin, Bolivia, Burkina Faso, Burundi, Cameroon, the Central African Republic, Chad, the Republic of Congo, Côte d'Ivoire, the Democratic Republic of Congo, Equatorial Guinea, Ethiopia, Ghana, Guinea, Guinea-Bissau, Guyana, Honduras, Kenya, the Lao People's Democratic Republic, Liberia, Madagascar, Mali, Mauritania, Mozambique, Myanmar, Nicaragua, Niger, Nigeria, Rwanda, São Tomé and Príncipe, Senegal, Sierra Leone, Somalia, Sudan, Tanzania, Togo, Uganda, Vietnam, the Republic of Yemen, and Zambia; Malawi was subsequently added to the group (Andrews and others 1999). 8. Deeper debt relief involved lowering the debt-to-export ratio from 250 to 150 percent and dropping the requirement for a country-specific vulnerabil- ity analysis; lowering the debt-to-fiscal revenue target from 280 to 250 per- cent; lowering the export-to-GDP ratio from 40 to 30 percent; lowering the revenue-to-GDP ratio from 20 to 15 percent; and changing the basis for debt relief to actual data based on the year prior to the decision point (rather than on projections for the completion point). Faster debt relief allowed the IFIs to provide interim relief between the deci- sion and completion points, and the introduction of floating completion points, which allowed assessment of a country's performance to be based on specific outcomes of policy reform and macroeconomic stability, rather than the length of a track record. Broader debt relief facilitated a "greater safety margin for the achievement of debt sustainability, providing a clear and permanent exit from unsustainable indebtedness at the completion point." (Andrews and others 1999). 9. Benin, Bolivia, Burkina Faso, Cameroon, Ethiopia, The Gambia, Ghana, Guyana, Honduras, Madagascar, Malawi, Mali, Mauritania, Mozambique, Nicaragua, Niger, Rwanda, São Tomé and Príncipe, Senegal, Sierra Leone, Tanzania, Uganda, and Zambia. 10. Afghanistan, Burundi, the Central African Republic, Chad, the Republic of Congo, the Democratic Republic of Congo, Guinea, Guinea-Bissau, and Haiti. 11. The requirements for an HIPC to reach the completion point include showing satisfactory performance in (a) macroeconomic policies, (b) public expenditure management, and (c) implementation of a poverty-reduction strategy. 182 Understanding Growth and Poverty 12. Development aid inflows averaged nearly 60 percent of total public expendi- ture in the 14 Sub-Saharan Africa completion-point HIPCs (Moss 2006). Bibliography Andrews, D., A. R. Boote, S. S. Rizavi, and S. Singh. 1999. "Debt Relief for Low- Income Countries: The Enhanced HIPC Initiative." Pamphlet Series No. 51, International Monetary Fund, Washington, DC. Bhattacharya, R., and B. Clements. 2004. "Calculating the Benefits of Debt Relief." Finance and Development 41 (4): 48­50. Claessens, S. 1990. "The Debt Laffer Curve: Some Estimates." World Development 18 (12): 1671­77. Clements, B., R. Bhattacharya, and T. Q. Nguyen. 2005. "Can Debt Relief Boost Growth in Poor Countries?" Economic Issues 34, International Monetary Fund, Washington, DC. Curto, Stefano. 2007. "Changing Aid Landscape." Finance and Development 44 (4): 20­21. Daseking, C., and R. Powell. 1999. "From Toronto Terms to the HIPC Initiative: A Brief History of Debt Relief." Working Paper WP/99/142, International Monetary Fund, Washington, DC. ------. 2007a. "A Factsheet: The Multilateral Debt Relief Initiative (MDRI)." International Monetary Fund, Washington, DC. ------. 2010. "Debt Relief under the Heavily Indebted Poor Countries Initia- tive (HIPC)." IMF Fact Sheet, February 18, International Monetary Fund, Washington, DC. Lopes, Paulo Silva. 2002. "A Comparative Analysis of Government Social Spending Indicators and Their Correlation with Social Outcomes in Sub- Saharan Africa." IMF Working Paper 02/176, International Monetary Fund, Washington, DC. Moss, Todd. 2006. "Briefing: The G8's Multilateral Debt Relief Initiative and Poverty Reduction in Sub-Saharan Africa." African Affairs, April 3. Pattilio, C., H. Poirson, and L. Ricci. 2002. "External Debt and Growth." Finance and Development 39 (2): 32­35. Rajan, Raghuram. 2005. "Debt Relief and Growth." Finance and Development 42 (2): 56­57. UN (United Nations). 2005. Human Development Report: International Cooperation at a Crossroads: Aid, Trade and Security in an Unequal World. New York: UN. External Debt 183 Warner, A. M. 1992. "Did the Debt Crisis Cause the Investment Crisis?" Quarterly Journal of Economics 107 (November): 1161­86. WHO (World Health Organization). 2001. Investing in Health for Economic Development. Geneva: Commission on Macroeconomics and Health. World Bank. 2006. "Debt Relief. News and Broadcast." World Bank, http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK: 20040942~menuPK:34480~pagePK:34370~theSitePK:4607,00.html. ------. 2009. Global Development Finance. Washington, DC: World Bank. CHAPTER 9 Trade Policy The share of international trade in developing countries' output grew from 35 percent in 1980 to 57 percent in 2007. Although most econo- mists agree that trade liberalization promotes growth and reduces poverty, concern about its negative effects has not abated among policy makers or the general public. Greater integration of the global economy over the past three decades has opened new markets for producers in the developing world and brought enormous benefits to developing coun- tries, but it has also widened channels through which a slowdown in eco- nomic activity in one group of countries can spread to others. After first presenting the rationale for trade, this chapter reviews the links between openness to trade, growth, and poverty reduction. The Rationale for Trade Trade is motivated by the expectation of economic gain. According to the theory of absolute advantage, nations gain by producing goods that require fewer domestic resources and by exchanging their surplus for goods produced abroad with fewer resources. Each country can benefit from specialized production, which encourages trade. The theory of absolute advantage is incomplete, however, because it ignores the gains available through trade even when one party has an absolute advantage in 185 186 Understanding Growth and Poverty the production of all goods. Those gains are explained by the theory of comparative advantage, which holds that mutually beneficial trade is always possible between nations whose pretrade relative costs and prices dif- fer. According to the theory, international trade occurs when two coun- tries begin to explore the benefits of trade. When trading countries concentrate on producing goods and services in which they have a com- parative advantage, they benefit, and world output of goods and services is maximized. Differences in endowments of natural resources, human resources, and capital give rise to comparative advantage. The theory of comparative advantage assumes free trade across countries--that is, free access of each country to the markets of other countries. It also assumes fair trade among countries. Fair trade implies that all countries have perfect market information and perfect access to credit, and that producers have the ability to switch production tech- niques and outputs in response to market information and demand. The theory recognizes that policies can be "trade creating" or "trade diverting." Outward-oriented policies, which encourage production for export, are trade-creating policies. Trade diversion occurs when policies are oriented inward and do not encourage production for export. By engaging in trade, most countries expect to increase incomes for their producers and reduce the cost of goods for their citizens. The global value of income and output is maximized if the opportunity costs of pro- ducing everything in every country are minimized--that is, if all produc- tion inputs have been put to their most efficient use. By encouraging efficient allocations of capital, labor, and land, trade improves the opera- tion of many sectors of the economy, even those that produce goods and services that are not traded internationally. Additionally, trade is a source of government revenue from license fees and trade taxes. Through exports, it is a source of foreign exchange. Exchanges of goods and services encourage better relationships among countries. Countries that trade with one another are more likely to seek a peaceful solution to conflicts to avoid disrupting trade. Millions of people depend on trade for a livelihood. From production to retail to import and export, trade is a necessary way of life for many people. Efficient trading patterns permit people everywhere to enjoy higher living standards. A number of factors ensure positive gains from trade at the interna- tional level. Specialization. Specialization gains arise from producing and selling goods for which a country enjoys a comparative advantage and buying other goods from countries that can produce them at a lower cost. Access Trade Policy 187 to export markets widens the scope for specialization gains, while simul- taneously giving producers access to intermediate goods at lower costs than would be available solely by means of domestic production. Uniqueness. In some regions, local sources of certain goods do not exist. Technology gaps, for example, may affect a country's capacity to produce a good or exploit a resource. Gains arise from trading goods that are not locally available. Scale. Specialization gains may be limited by market size. Moving into the international market permits expanded production. Gains from scale occur when access to export markets stimulates production of larger amounts of goods at lower average costs. Dynamism. Dynamic gains occur when trade accelerates economic growth and development by spreading technology, accelerating capital formation, or encouraging innovation in the anticipation of succeeding in lucrative export markets. Political stability. Political gains from trade arise when economic inter- dependence facilitates international political stability. Mutually beneficial trade is a powerful incentive for countries to avoid conflict by engaging in peaceful negotiations. The interdependence created by trade reduces the likelihood of war. Trade Barriers Despite the many gains to be derived from trade, countries erect various barriers to trade. They have a variety of reasons for doing so. States that have limited sources of revenue (because of a narrow tax base, for example, or limited capacity for collecting taxes) use trade barriers as a method of raising revenue. Trade barriers may also be attractive because they pro- tect domestic industries, which may constitute a powerful political con- stituency, capable of lobbying effectively to protect their interests. Some countries also prefer not to be dependent on other countries, believing that self-sufficiency in as many economic sectors as possible (a largely discred- ited policy known as autarky) will protect their stability and sovereignty. Barriers to trade come in two basic forms: border barriers (also known as tariff barriers) and behind-the-border barriers (nontariff barriers). Border Barriers Border barriers consist of tariffs, quotas, and voluntary export restrictions. Tariffs. A tariff is an excise tax that applies only to imported goods. Its purpose is either to generate revenue or to protect domestic firms. 188 Understanding Growth and Poverty Protective tariffs put foreign producers at a competitive disadvantage when selling in domestic markets. By raising the domestic prices of goods, they stimulate domestic production. When a tariff is very high, it becomes a disincentive to trade. A high tariff may divert trade away from the country to other countries where tariffs are lower. Low tariffs encour- age trade but generate lower revenue for the state. Unlike nontariff barri- ers, tariffs are usually transparent; that is, they are of known magnitude. Quotas. Quotas limit the amount of goods that may be imported or exported, whether absolutely or at a given tariff rate (tariff rate quotas). Quotas raise the price of imported goods. A product may be imported in high quantities despite high tariffs if demand is sufficiently strong, but low absolute import quotas may completely prohibit imports once quotas have been filled. Quotas have particularly pernicious side effects, as profits from import licenses increase the potential for bribery and corruption. Voluntary export restrictions. These are agreements in which foreign firms "voluntarily" limit the amount of their exports to a particular coun- try. Exporters agree to such restrictions, which have the effect of quotas, in the hope of avoiding more stringent trade barriers. Behind-the-Border Barriers Nontariff barriers take many forms, among them licensing requirements, unreasonable standards pertaining to product quality and safety, and cumbersome documentary or administrative requirements designed to discourage imports. Growing concern in some countries about the envi- ronment and food safety has led to the adoption of regulatory require- ments that in some instances function as nontariff barriers to trade. Poor physical infrastructure (ports, roads) may also have the effect of imped- ing or limiting trade by raising costs and increasing risks (of spoilage or theft, for example). Creaky financial infrastructure, too, may frustrate trade--for example, if short-term financing for trade transactions is unavailable or onerously expensive. Trade and Economic Growth Most economists believe that openness to trade is good for economic growth. Berg and Krueger (2002) cite a number of economists who have found that differences in output per capita across countries are explained by differences in openness to trade. These results hold even when using different measures of openness, adding other variables that might explain differences in income, and controlling for reverse causality Trade Policy 189 (that is, the possibility that growth engenders trade, rather than the other way around). Openness to trade promotes competition in domestic markets, increases pressure on firms to be competitive and innovative, provides consumers with a wider choice at lower prices, and allows firms to bring in new skills and technologies to fully exploit their comparative advantage. Firms that export are highly productive, and exporting allows them to grow faster. Trade also raises the marginal returns of other reforms, in that better infrastructure, telephones, roads, and ports translate into better performance by the export sector. By contrast, the path of self-reliance, or autarky, followed by many developing countries in the past, causes eco- nomic distortions that ultimately hamper growth. Quantitative restric- tions, licensing requirements, and prohibitive tariffs keep imports out of the domestic market, leaving the market to inefficient local producers that have little incentive to become more productive. International trade helped to drive postwar global growth. In the 1950s, global merchandise exports accounted for approximately 8 percent of gross domestic product (GDP), a proportion that had increased to almost 26 percent by 2004 (Krueger 2004). In-depth analyses by Srinivasan and Bhagwati (1999) of country experiences during the 1960s and 1970s show that trade continued to create and sustain higher growth during this period. In the two decades following 1980, international trade continued to drive economic performance, growing twice as fast as worldwide income. Dollar and Kraay (2001b) claim a "statistically significant and economically meaningful effect of trade on growth," finding that when trade as a share of GDP is increased by 20 percentage points, growth increases by between 0.5 and 1 percentage point a year. The same authors examine the growth experience of countries differ- entiated by their openness to trade between 1960 and 2000, after con- trolling for correlation across growth-enhancing variables and addressing difficulties in determining causation. They identify three groups--rich countries, globalizers, and nonglobalizers (figure 9.1). Globalizers are those developing countries that experienced a particularly large propor- tionate increase in trade as a share of GDP--doubling, on average, from 16 percent of GDP to 33 percent in 20 years. The rich countries showed a 70 percent increase over the same period (from 29 percent to 50 per- cent). The nonglobalizers, which make up two-thirds of all developing countries, experienced a decline in trade as a share of GDP. The globaliz- ers experienced an increase in their growth rates from 2.9 percent per year in the 1970s to 3.5 percent in the 1980s to 5 percent in the 1990s, 190 Understanding Growth and Poverty Figure 9.1 Growth in Real Per Capita GDP across Countries 6.0 5.0 real per capita GDP growth (%) 4.0 3.0 2.0 1.0 0.0 s s s s 60 70 80 90 19 19 19 rich countries globalizers 19 nonglobalizers Source: Dollar and Kraay 2001b. while the nonglobalizers saw annual growth decline from 3.3 percent to 0.8 percent over the first two decades, before recovering to 1.4 percent in the 1990s. The results provide robust evidence of the effect of open- ness on growth. There are a few dissenters from this positive view of trade and growth, notably Rodriguez and Rodrik (2000), who argue that the high correla- tion between trade openness and other explanatory variables such as geo- graphic characteristics and domestic policy choices mar the literature's results. Despite these methodological disagreements, it remains generally accepted that trade is good for growth. Trade certainly is correlated with growth. But the direction of causation between trade and growth is unclear. For example, as an economy expe- riences growth, its opportunities for trading will increase, but the con- verse is not necessarily true: simply dismantling or reducing tariffs does not guarantee economic growth. The challenge is to provide a framework in which trade can thrive and exert its growth-promoting power. Here, trade liberalization is the key. Experience with trade liberalization suggests that free trade has to be phased in according to a realistic timetable. The first steps are to eliminate Trade Policy 191 trade bias by adopting a realistic exchange rate and to reduce impedi- ments to exports by eliminating quantitative restrictions on exports and imported inputs. Lowering protection levels and making protection trans- parent and nondiscriminatory should follow. Zagha, Nankani, and Gill (2006) note that in several South American countries in the 1990s, trade liberalization failed to produce positive economic benefits and poverty reduction because rising exchange rates eroded export competitiveness. In other countries, such as China and India, trade liberalization that was better timed improved economic growth and reduced poverty. Trade, Inequality, and the Poor Open trade is good for overall economic growth (and, by extension, poverty reduction), but what effect does it have on inequality? Trade liberalization tends to reduce monopoly rents and the value of personal connections with bureaucrats and politicians, thereby reining in the rich. In developing countries, it may be expected to increase the relative wages of low-skilled workers, who are likely to be scarcer in the world economy than at home. Multilateral liberalization of agricultural trade may increase rural incomes but expose urban dwellers to higher food prices. And, in many countries, trade openness may have adjustment costs with which the poor are ill-equipped to cope. The relationship between trade and inequality is complex. Trade reform in developing countries took off in the late 1970s. Until then, developing countries had pursued inward-looking policies by pro- moting import-substituting industrialization strategies. The aim was to encourage domestic production and restrict foreign investment by multi- national firms to support the growth of domestic firms. But not only do inward-looking policies create many distortions, as noted above, they also tend to benefit relatively rich and powerful groups at the expense of the poor (Dollar 2004). Since the late 1970s, developing countries have become more inte- grated with the world economy through foreign trade, foreign invest- ment, and immigration. Integration has been driven by technological advances in transport and communication and by deliberate policy changes. China's ratio of trade to national income has more than doubled since it opened to the world in the early 1980s, and countries such as Bangladesh, India, Mexico, and Thailand have seen large increases as well. While the popular press is almost uniform in its view that trade reform is bad for the poor, economists paint a completely different picture. While 192 Understanding Growth and Poverty the relationship between trade and inequality remains unclear, the rela- tionship between trade and growth is strong and positive, as we have seen, meaning that trade is most definitely pro-poor. According to Dollar and Kraay (2001b), increased trade generally accompanies rapid growth, while having no effect on inequality (measured as the income share of the poorest). Thus, increased trade translates into proportionate increases in the income of the poor and goes hand in hand with improvements in the well-being of the poor. This finding is also borne out by Berg and Krueger (2002), who point out that although the vast literature on the effects of trade liberalization on income distribution reveals no system- atic relationship between openness and the income of the poorest, the positive effect of openness on overall growth and, in turn, on poverty, is firmly supported. In support of the pro-poor argument for trade, Dollar (2004) identifies positive trends in growth rates and poverty reduction that followed trade liberalization starting from 1980. Poor country growth rates have accelerated (developing countries on average grew 3.5 percent per capita in the 1990s and 6.4 percent in the first seven years of the present decade [IMF 2008]) and are higher than rich country growth rates for the first time in modern history. The num- ber of poor people in the world has declined significantly (by 375 million since 1981), and the share of the developing world population living on $1 a day or less has declined by 50 percent since 1981. To what extent can these developments be ascribed to trade? Trends toward faster growth and poverty reduction have been strongest in those developing countries that have embraced trade liberalization. In contrast to this generally positive picture, there are reasons that trade reform may not benefit the very poorest members of developing countries. The following paragraphs, based on Bannister and Thugge (2001), deal with the possible impacts of trade liberalization on the wel- fare of the poor. Trade liberalization normally increases real income by reducing the prices of imports and of substitutes for imported goods. In general, this is seen to have a positive impact on the poor. Imported products such as basic foods, pharmaceuticals, other medical supplies, and used clothing are important for the poor. Moreover, the poor may benefit from the removal of export taxes to the extent that they are net producers of exports, which is often the case in agriculture, for example. An open trade regime improves access to new products and the importation of new technologies and processes that may have positive effects for the poor. Trade Policy 193 The effect of trade liberalization on wages and employment depends on the level of labor regulation in the country. In a highly regulated labor market, the adjustment to changes in the prices of outputs will translate into changes in real wages. If firms are constrained from reducing their workforces, wages will decline. Where minimum wages prevail and labor mobility is high, the adjustment will take place through changes in employ- ment. Generally, however, the poor work in rural and informal urban sectors that are unregulated and are characterized by flexible labor mar- kets. Here, adjustment to trade shocks will take place through changes in employment rather than in wages. In other words, the poor will suffer higher rates of unemployment. Furthermore, if the impact of trade liber- alization is to remove protective barriers from sectors in which the poor predominate, we would expect a lowering of relative wages for the poor. Examples from Latin America (Ravallion and Chen 2004) suggest that trade liberalization has increased wage disparities, benefiting higher income groups more than the poor. There are concerns that trade reform, by lowering trade taxes, will lead to lower government revenues in the short run. This, in turn, will lead to lower government spending in sectors such as health and education and a decrease in the welfare of the poor. But this concern is unsubstantiated. It is likely, in fact, that reform as actually practiced will raise government revenue by replacing nontariff barriers with tariffs and eliminating tariff exemptions. Moreover, lowering high tariffs may reduce the incentives for smuggling and corruption and therefore increase the amount of goods recorded at customs. Finally, simplifying the tariff regime and thereby promoting transparency may boost fiscal revenue. In the long run, however, lower tariffs may lead to lower government revenues. In that case, policies to increase revenue--tax reform or spend- ing cuts in other areas--may be needed to minimize the adverse effect of revenue losses on the poor. Trade liberalization brings about a more efficient allocation of resources that favors economic growth--and, as we have seen, economic growth is one of the best ways to alleviate poverty. Sustaining that growth, how- ever, requires complementary macroeconomic and institutional reforms that are discussed below. Trade liberalization deepens economic integration. Although integra- tion brings many benefits--such as less dependency on a single export market or product, and less dependency on the domestic market-- adverse external shocks can significantly affect economic growth and the welfare of the poor by affecting the sectors in which they are employed. 194 Understanding Growth and Poverty Thus, it is important that other macroeconomic reforms should be pur- sued in line with trade reform to maximize and sustain the beneficial effect of trade reform on poverty. For example, if the country's exchange rate is overvalued, policy makers may choose to implement changes to improve competitiveness and avoid impeding the additional growth that would otherwise be possible as a result of trade liberalization. Most economists agree that the adjustment costs of proposed trade reforms may be high in some countries--and may affect the poor dispro- portionately. In other words, any reform plan will create some losers among the poor, especially in the short run, as well as many winners. But a transitory loss in income has a deeper impact on the poor than on other citizens and can reduce their chances of escaping poverty. Because the poor are disproportionately vulnerable, trade liberalization policies should include a social safety net. What poor people lose from trade reform in the short term they may recover later on; in the long run, most researchers agree that changes in investment and technology will lead to higher growth that will benefit the poor. Ravallion and Chen (2004), who found that periods of greater trade liberalization in China did not coincide with periods of poverty reduction, concluded that, over time, trade reform would produce both gainers and losers and that long-run productivity gains would have a pos- itive impact on growth and poverty reduction. To make trade liberalization more egalitarian, Bannister and Thugge (2001) argue for broad-based liberalization, so that the costs of adjustment are spread across a wide range of sectors. It may be necessary to sequence reform at different speeds for different sectors. Furthermore, exchange- rate flexibility will facilitate a faster adjustment to trade reform and dissi- pate reform-related shocks throughout the economy. As already mentioned, trade reform will have a more positive impact if it is accom- panied by other reforms. The authors identify three areas in particular-- infrastructure development, development of markets, and labor mobility and training. Rich countries can help developing countries achieve and benefit from trade liberalization. The requirements for joining and settling disputes within the World Trade Organization are onerous for poor countries. Meanwhile, the advanced economies maintain extensive and expensive programs of protection for domestic producers, especially in agriculture and labor-intensive products. In high-income countries, subsidies of various sorts account for nearly one-third of agriculture revenue. The subsidies provided to developed- Trade Policy 195 country farmers amount to some $350 billion per year, almost five times the aid that developed countries send to the developing world. Most agri- cultural subsidies are provided through mechanisms that artificially boost production and undercut the market for farmers in developing countries. The group known as the West Africa 4 (Benin, Burkina Faso, Chad, and Mali) can produce high-quality cotton at the lowest cost in the world. Despite their productive efficiency, however, the West Africa 4 lag far behind the world's largest producer, the United States, where cotton is heavily subsidized. This leads to paradoxical results. Because of cotton sub- sidies, which cost the United States up to $4 billion each year, Mali loses $43 million in cotton earnings each year, while receiving $37 million in U.S. aid. As the production of cotton supports 10 million people in West Africa, but just 25,000 farmers in the United States, protectionist policies seriously impair poverty-reduction strategies by depriving farmers in developing countries of their livelihood. Sugar and dairy subsidies pro- vided by the European Union (EU) have the same effect. In recent years, the apparent unwillingness of the advanced economies to modify protection programs has lowered the incentive for developing countries to pursue multilateral trade liberalization or to undertake uni- lateral reform. Disputes over this issue led to the collapse of the most recent round of multilateral trade talks in 2003, the Doha Round. The impasse is not likely to be resolved soon. With multilateral progress stalled, the growth of regional trade agreements has proceeded. Such agreements offer many benefits to individual blocs of countries but are not a substitute for further multilateral liberalization. Conclusion Trade openness has been an unequivocally positive development for the poor in developing countries. Evidence on the relationship between trade development and inequality, on the other hand, is plentiful but inconclu- sive. Nevertheless, it is clear that trade is good for growth and that growth is good for the poor, particularly in the long term. To work best, policies that open a country to trade must be sequenced properly and accompa- nied by complementary reforms, so that the growth benefits of opening to trade can be maximized. Advanced countries have a role to play in helping developing countries reap the benefits of trade. Trade subsidies provided to agricultural produc- ers in advanced countries are distortionary and hurt poorer countries. Their harmful effects far outweigh the amount of aid typically provided 196 Understanding Growth and Poverty by donor countries. As the same time, it is also fair to say that trade dis- tortions within poorer countries themselves are also highly damaging. Further progress is needed in this area if the full growth potential of inter- national trade is to be realized. Bibliography Bannister, Geoffrey J., and Kamau Thugge. 2001. "International Trade and Poverty Alleviation." Finance and Development 38 (4): 48­51. Berg, Andrew, and Anne Krueger. 2002. "Lifting All Boats: Why Openness Helps Curb Poverty." Finance and Development 39 (2): 16­19. ------. 2003. "Trade, Growth, and Poverty: A Selected Survey." IMF Working Paper WP/03/30, International Monetary Fund, Washington, DC. Claessens, S., and R. C. Duncan, eds. 1993. Managing Commodity Price Risk in Developing Countries. Baltimore, MD: Johns Hopkins University Press. Corden, W. M. 1990. "Protection, Liberalization, and Macroeconomic Policy." In Trade Liberalization in the 1990s, ed. H. W. Singer, N. Hatti, and R. Tandon. New Delhi: Indus Publishing. Dollar, D. 2004. "Globalization, Poverty, and Inequality since 1980." Policy Research Working Paper 3333, World Bank, Washington, DC. Dollar, D., and A. Kraay. 2001a. "Growth Is Good for the Poor." Policy Research Working Paper 2587, World Bank, Washington, DC. ------. 2001b. "Trade, Growth, and Poverty." Policy Research Working Paper 2615. World Bank, Washington, DC. ------. 2006. "Trade, Growth, and Poverty." Finance and Development 38 (3): 16­19. Findlay, Ronald, and Kevin H. O'Rourke. 2003. "Commodity Market Integration, 1500­2000." In Globalization in Historical Perspective, ed. M. D. Bordo, A. M. Taylor, and J. G. Williamson. Chicago: University of Chicago Press. Frankel, Jeffrey A., and David Romer. 1999. "Does Trade Cause Growth?" American Economic Review 89 (June): 379­99. Gourinchas, Pierre-Olivier, and Olivier Jeanne. 2003. "The Elusive Gains from International Financial Integration." NBER Working Paper 9684, National Bureau of Economic Research, Cambridge, MA. IMF (International Monetary Fund). 2008. World Economic Outlook. Financial Stress, Downturns and Recoveries. Washington, DC: IMF. Krueger, A. 2004. "Expanding Trade and Unleashing Growth: The Prospects for Lasting Poverty Reduction." IMF Seminar on Trade and Regional Integration, Dakar, Senegal, December 6. Trade Policy 197 Nash, John, and Donald Mitchell. 2005. "How Freer Trade Can Help Feed the Poor." Finance and Development 42 (1): 34­37. O'Rourke, Kevin H., and Jeffrey G. Williamson. 2002. "From Malthus to Olin: Trade, Growth, and Distribution Since 1500." Working Paper 8955, National Bureau of Economic Research, Cambridge, MA. Ravallion, M., and S. Chen. 2004. "How Have the World's Poor Fared Since the Early 1980s?" Policy Research Working Paper 3341, World Bank, Washington, DC. Rodriguez, F., and D. Rodrik. 2000. "Trade Policy and Economic Growth: A Skeptic's Guide to the Cross-National Evidence." In NBER Macro Annual 2000, ed. Ben Bernanke and Kenneth Rogoff. Cambridge, MA: National Bureau of Economic Research. Srinivasan, T. N., and J. Bhagwati. 1999. "Outward Orientation and Development: Are Revisionists Right?" Unpublished paper, Economic Growth Center, Yale University, New Haven, CT. Watkins, K. 2002. "Making Globalization Work for the Poor." Finance and Development 39(1): 24­27. Winters, L. A., N. McCulloch, and A. McKay. 2004. "Trade Liberalization and Poverty: The Empirical Evidence So Far." Journal of Economic Literature 42: 73­166. World Bank. 2002. Development, Trade, and the WTO: A Handbook. Washington, DC: World Bank. ------. 2003. Global Economic Prospects 2004: Realizing the Development Promise of the Doha Agenda. Washington, DC: World Bank. ------. 2004. Global Economic Prospects 2005: Trade, Regionalism, and Development. Washington, DC: World Bank. Zagha, R., G. Nankani, and I. Gill. 2006. "Rethinking Growth." Finance and Development 43 (1): 7­11. PA R T I I I Factor Accumulation and Structural Policy CHAPTER 10 Institutions and Growth At their most fundamental, institutions are the formal and informal rules and norms that govern economic, social, and political life. Occupying a broad spectrum from the establishment of rules to "actual organiza- tional entities, procedural devices, and regulatory frameworks" (IMF 2003), they provide the predictability needed for societies and markets to function. Institutions can be more or less effective in facilitating exchange, production, and market operations. Studies have shown that institutional quality strongly affects growth--and that institutions are very difficult to change. Although institutions perform similar functions across societies, the form they take in doing so varies considerably. Unfortunately, very little of the empirical work done to date on the importance of institutions examines the link between institutional form and performance. Researchers have instead focused on the link between institutional per- formance and economic performance.1 This is important, but it does not tell us how to improve institutional performance and so, in turn, foster economic growth. We do know, however, that adopting in one country the laws and formal regulations of another will not necessarily produce the same institutional performance or, indeed, economic performance. The Washington Consensus that held sway in the 1980s suggested that 201 202 Understanding Growth and Poverty developing countries would improve their fiscal position by liberalizing their banking systems, reforming and privatizing state enterprises, and reforming tax structures.2 The success of these policy prescriptions depended, however, on the presence of a complex set of properly func- tioning institutions. Developing countries that lacked the necessary reg- ulatory and legal frameworks, backed by government policies and commitment--in effect, good governance--ended up in far worse macroeconomic positions after implementing the reforms prescribed by the Washington Consensus. An important focus of the recent literature on institutional econom- ics is the link between good governance and economic growth and devel- opment.3 This builds on neoclassical economic theory to examine the relationship between buyers and sellers. Every transaction between a buyer and seller carries costs, including uncertainty about the honesty and reliability of one's counterpart and efforts to reduce that uncer- tainty. "Institutions are formed to reduce uncertainty in human exchange," observes Douglass North (1990). "Together with the technol- ogy employed," North continues, institutions "determine the costs of transacting (and producing)."4 The presence of institutions not only reduces transaction costs but also allows markets for the exchange of goods and services to grow in size and scope. Unwritten rules--social customs, norms, and religious practices-- are informal institutions. Slow to change and enforced by various groups within society, they represent the first level of Williamson's (2000) six-level classification and hierarchy of institutions (figure 10.1). Formal rules, on the other hand, are written into constitutions and laws and enforced by the state. These are political institutions in Williamson's hierarchy. They, too, are slow to change, but not as slow as informal institutions. Legal institutions--many designed to mini- mize uncertainty--are the fourth level. Examples are institutions that govern market-oriented economic activities, such as stock markets and securities regulators. In recent years, considerable literature has evolved around the links among economic growth, development, and institutions. Driving this lit- erature has been empirical evidence suggesting that cross-country differ- ences in income are correlated with differences in indicators of institutional quality (figure 10.2).5 The following section examines meas- ures of institutional quality relating to the perceptions and assessments of public institutions. The chapter concludes with a brief overview of the link between institutions and economic growth. Institutions and Growth 203 Figure 10.1 The Williamson Hierarchy of Institutions human motivations Evolve over millennia, only partially adapted to modern society. Not really an institution but important in determining institutional structures and the effectiveness of institutions. social structure Evolves over centuries. Medieval social structures in Italy, for example, are closely related to modern social structures and economic performance. political institutions Take decades to coalesce. Democracies laid the foundations of property rights that protected citizens from the state. legal institutions Take years to be legislated. Establishing the rule of law (including its effective enforcement) can take longer. The impact of democracy on corruption is much clearer in stable democracies that have been democratic for several decades. private institutions Contracts are an example of a private institution. resource allocation, economic activity, and welfare Source: Williamson 2000; Azfar 2002. Figure 10.2 Link between Institutional Quality and Per Capita National Income 12 log of real gross domestic product per capita, 1995 10 8 6 4 2 ­2.0 ­1.6 ­1.2 ­0.8 ­0.4 0.0 0.4 0.8 1.2 1.6 2.0 aggregate governance measure advanced economies developing economies Source: IMF 2003. Note: Aggregate governance measure represents the overall quality of governance, including the degree of cor- ruption, political rights, public sector efficiency, and regulatory burdens. 204 Understanding Growth and Poverty Measures of Institutional Quality In the literature on economics and political science, the concept of insti- tutional quality has been translated into attempts to measure the quality of governance. Ways of measuring governance have been explored and developed in depth by the World Bank in recent years. The main instrument being used is the country diagnostic study, which tabulates the results of in-depth, country-specific surveys of thousands of public-service users, firms, and public officials to gather specific information about institutional vulnerabilities in a country. The surveys gather informa- tion on various dimensions of governance, chiefly corruption in four forms: in the obtaining of services; in public procurement; in the budget process; and in the shaping of the formation of policy, legal, and regulatory frameworks. The latter dimension, also known as "state capture," has occupied a particularly central place in studies of gover- nance in the countries of the former Soviet Union. Six dimensions of governance appear repeatedly in the literature. These are (a) voice and accountability, (b) political stability and absence of vio- lence, (c) government effectiveness, (d) regulatory quality, (e) rule of law, and (f) control of corruption (Kaufmann, Kraay, and Mastruzzi 2007).6 Measures of voice and accountability attempt to gauge the participation of the various strata of a population and how accountable the political regime is to the needs and wishes of its people. Among these measures are various aspects of the political process--notably civil liberties, political rights, and media independence (because independent news sources monitor those in authority and hold them accountable for their actions). Voice and accountability are cornerstones of the emerging literature on social accountability, which seeks to improve the responsiveness of govern- ment and other power holders to the needs of the governed--especially those whose voice is weak or obscured. Data on voice and accountability are collected by the World Bank to facilitate cross-country comparisons and changes over time and across countries. Figure 10.3 examines the percentile ranking of regions for voice and accountability between 1996 and 2008. The Organisation for Economic Co-operation and Development (OECD), the Caribbean, and Eastern Europe and the Baltic states score highest for this indicator of gover- nance, with almost a 30 percentage point difference between the top- scoring OECD and the next highest, the Caribbean. The countries of the former Soviet Union and the Middle East and North Africa score lowest. Eastern Europe and the Baltic states made the most progress Institutions and Growth 205 Figure 10.3 Regional Percentile Rank for Voice and Accountability Sub-Saharan Africa South Asia OECD Middle East and North Africa region Latin America Former Soviet Union Eastern Europe and the Baltic states East Asia Caribbean 0 50 100 percentile 2008 2004 2000 1996 Source: Compiled from Worldwide Governance Indicators (http://info.worldbank.org/governance/wgi/index.asp). over the 12 years, and East Asia experienced the least amount of change in its percentile rankings. Political stability, the second of the six common dimensions of gover- nance, captures a population's perception of the stability of its govern- ment. The perceived likelihood that the incumbent government could be overthrown by violent or unconstitutional means compromises stability, as does uncertainty about the ability of a country's citizens to peacefully elect and replace those in power. The ability of political and economic institutions to coordinate and to promote stability determines capital accumulation, investment in new technologies, and, thus, economic growth and poverty reduction. Political stability is weakest in countries wracked by conflict. Once a conflict ends, there is likely to be insecurity both at the household and macroeconomic levels. Conflict usually leaves behind armed civilian pop- ulations prone to violence (such as in Somalia and Sudan). At the macro level, whether the conflict has been resolved by military victory (Ethiopia, Uganda) or through a negotiated settlement (Cambodia, Mozambique), there are significant risks that the government may not survive for long. Figure 10.4 examines the regional percentile rankings for political sta- bility. The top-ranking regions are the same as those for voice and 206 Understanding Growth and Poverty Figure 10.4 Regional Percentile Rank for Political Stability Sub-Saharan Africa South Asia OECD Middle East and North Africa region Latin America Former Soviet Union Eastern Europe and the Baltic states East Asia Caribbean 0 50 100 percentile 2008 2004 2000 1996 Source: Compiled from Worldwide Governance Indicators. accountability, with East Asia replacing Eastern Europe and the Baltic states in third place. The percentile ranking for Middle East and North Africa, Sub-Saharan Africa, Latin America, and the countries of the for- mer Soviet Union7 changed little between 1996 and 2008. The percentile ranking for South Asia has deteriorated over time, while East Asia and the Caribbean have made the most progress toward political stability. Government effectiveness, as a measure of governance, refers to the inputs that a government needs if it is to produce and implement sound policies and deliver public goods. The competence and independence of the civil service and the government's commitment to the development and implementation of sound policies are keys to effectiveness. An effec- tive government is free of the pitfalls of the predatory state (rent seeking, corruption, theft, conflict, and the risk of expropriation). An effective government is credible. Figure 10.5 examines the percentile rank by region for government effectiveness over the period 1996 to 2008. The OECD ranks highest with relatively little change over the period. The Caribbean, the countries of the former Soviet Union, and Eastern Europe and the Baltic states all improved their percentile rankings, with the countries of the former Soviet Union emerging from a very low base. South Asia and East Asia show a marked deterioration, as did Sub-Saharan Africa to a lesser degree. Institutions and Growth 207 Figure 10.5 Regional Percentile Rank for Government Effectiveness Sub-Saharan Africa South Asia OECD Middle East and North Africa region Latin America Former Soviet Union Eastern Europe and the Baltic states East Asia Caribbean 0 20 40 60 80 100 percentile 2008 2004 2000 1996 Source: Compiled from Worldwide Governance Indicators. Regulatory quality refers to the policies developed and implemented by a government. Indexes of regulatory quality reflect how friendly govern- ment policies are to growth. Policies that promote red tape, excessive regulation, price controls, and inadequate supervision of the financial sec- tor make for poor governance. They retard growth--if not immediately, then down the road. Regional regulatory quality is examined in figure 10.6. Eastern Europe and the Baltic states, the Caribbean, and the countries of the former Soviet Union made the most progress in improving their ranking, the last from a low base. Latin America and South Asia declined over time; Middle East and North Africa and East Asia more or less maintained their rankings. The rule-of-law indicator measures the extent to which economic and social interactions are governed by duly constituted, clearly articulated, and reliably enforced laws and regulations. Institutions that protect property rights (both from criminals and from the predatory power of the state) and enforce contracts promote the rule of law and allow economic activity to flourish. Democratic institutions--including an independent, well-trained judiciary and a well-codified legal system--promote freedom, scrutiny, and debate, which in turn reinforce the effectiveness (credibility) of government. 208 Understanding Growth and Poverty Figure 10.6 Regional Percentile Rank for Regulatory Quality Sub-Saharan Africa South Asia OECD Middle East and North Africa region Latin America Former Soviet Union Eastern Europe and the Baltic states East Asia Caribbean 0 20 40 60 80 100 percentile 2008 2004 2000 1996 Source: Compiled from Worldwide Governance Indicators. Figure 10.7 Regional Percentile Rank for Rule of Law Sub-Saharan Africa South Asia OECD Middle East and North Africa region Latin America Former Soviet Union Eastern Europe and the Baltic states East Asia Caribbean 0 20 40 60 80 100 percentile 2008 2004 2000 1996 Source: Compiled from Worldwide Governance Indicators. Institutions and Growth 209 Percentile rankings for rule of law improved most noticeably for the Caribbean, East Asia, and South Asia when comparing 1996 with 2008. Latin America and the former Soviet countries slipped; Middle East and North Africa, Sub-Saharan Africa, and Eastern Europe and the Baltic states more or less maintained their rankings. These are examined in figure 10.7. Secure property rights--the protections accorded to private property in a society--are critical to economic development. Without them, invest- ment and trading incentives will be severely curtailed (De Soto 2000), with a deleterious effect on economic activity. Secure property rights have been achieved through a variety of arrangements. China's institutional arrangements differ greatly from those of India, for example. But in both countries, investors and entrepreneurs can be relatively confident of obtaining a return if they do their work well; that security creates a favor- able backdrop for market activities and growth. Similarly, financial systems in the United States and the European Union (EU) have different institu- tional foundations, but both perform at comparable levels of efficiency. In Indonesia under the leadership of Haji Mohammed Suharto, by contrast, the enforcement of property rights depended on closeness to the ruling elite, with adverse consequences for investment and growth. In many developing countries, the rule of law is spotty, ineffective, or absent. In such countries, private institutions and customs--for corporate governance, long-term relationships, dispute resolution, and information dissemination--have proliferated in place of formal public institutions. Even in countries with strong formal institutions--including legal sys- tems--customary mechanisms may continue to function alongside formal ones. For example, disputes are typically resolved through arbitration and other methods, with the courts left as a last resort. Measures of corruption have generated the most attention in the liter- ature on governance and investment climate. Transparency International, a nongovernmental organization that has fought corruption since its inception in 1993, has become the key source for data and information on the level of corruption in developed and developing countries alike. Transparency International defines corruption as the "misuse of entrusted power for private gain," whether "according to rule" or "against the rule." So-called facilitation payments, whereby a bribe is paid to receive some- thing that the receiver of the bribe is required to do by law, are an example of the former. A bribe paid to obtain services that the bribe receiver is prohibited from providing is an example of the latter. The incidence of corruption varies widely from country to country and from region to region, according to the measures established by the 210 Understanding Growth and Poverty Figure 10.8 Regional Percentile Rank for Control of Corruption Sub-Saharan Africa South Asia OECD Middle East and North Africa region Latin America Former Soviet Union Eastern Europe and the Baltic states East Asia Caribbean 0 20 40 60 80 100 percentile 2008 2004 2000 1996 Source: Compiled from Worldwide Governance Indicators. Governance Group at the World Bank Institute (figure 10.8). The Caribbean and Eastern Europe and the Baltic states have improved their percentile rankings for this indicator while the OECD, Middle East and North Africa, and Sub-Saharan Africa have changed little. Comparing the 1996 percentile score with that of 2008, South Asia and East Asia declined slightly, while Latin America improved. Institutions and Economic Growth Differences in the accumulation of economically important inputs such as natural resources, financial capital, and human capital explain some, but not all, of the observed variance in rates of economic growth across countries. Institutions explain much of the rest. A given set of inputs will produce different amounts of growth depending on the institu- tional filters through which it passes. The right institutions encourage appropriate policies both for the accumulation of inputs themselves (land, capital, and labor) and for developments that improve productiv- ity (new technologies, managerial processes, education)--all of which affect growth. Institutions and Growth 211 There is ample evidence that good governance causes higher income growth. Edison and others (2002) suggest that improving institutional quality by one standard deviation in their sample would increase average annual growth in income per person by 1.4 percentage points. Rodrik and Subramanian (2003) find that the quality of institutions (measured by a composite that includes protection of property rights and rule of law) is the only significant determinant of income levels. If Bolivia and the Republic of Korea had the same institutional quality, they maintain, Bolivia's gross domestic product (GDP) per person would be close to $18,000, more than double its current level of $7,200. Acemoglu (2009) ascribes a key role to institutions (and policies) in determining whether an economy can embark on a growth path. Policies and institutions work together to · determine society's reward structure, which shapes whether invest- ments in human and physical capital and technological innovation are profitable; · determine whether the infrastructure and contracting arrangements necessary for modern economic relations are present; · influence and regulate market structure so that new firms come to the fore and replace less-efficient firms; and · (sometimes) prevent the adoption of new technologies to protect politically powerful incumbents or stabilize the established political regime (Acemoglu, 2009). Using an aggregate measure of governance, the International Monetary Fund's (IMF) World Economic Outlook (IMF 2003) finds that institutional quality explains almost three-quarters of cross-country variation in income per person. Figure 10.9 shows the benefits to Sub-Saharan Africa in particular of improving institutional quality from 0.49 to the average of developing Asia ( 0.19), suggesting an 80 percent increase in its per capita income (from $800 to over $1,400). In fact, differences in GDP per person, the growth rate of GDP, and growth volatility across countries all appear to be closely correlated with indicators of institutional quality (table 10.1). The level of inequality in a society, as expressed in and transmitted through social institutions, also affects growth, almost always in a nega- tive way (box 10.1). Improving institutional quality also has positive effects on economic volatility. The higher the quality of institutions, as measured by the 212 Understanding Growth and Poverty Figure 10.9 Correlation of Economic Performance and Institutional Quality 1.4 28,000 1.2 24,000 1.0 20,000 U.S. dollars 0.8 16,000 average score 0.6 12,000 0.4 8,000 0.2 4,000 0.0 0 ­0.2 ­0.4 ­0.6 Sub-Saharan Middle East Developing Western advanced Africa and Turkey Asia Hemisphere economies 1995 real GDP per capita (right-hand scale) aggregate governance measure (left-hand scale) Source: IMF 2003. Table 10.1 Correlation between Institutions and Economic Performance GDP Aggregate Constraint on per Growth Growth governance Property power of Variable capitaa rateb volatilityc measured rights executive GDP per capita 1.00 Growth rate 0.65 1.00 Growth volatility ­0.53 ­0.36 1.00 Aggregate governance measure 0.86 0.59 ­0.61 1.00 Property rights 0.76 0.54 ­0.62 0.79 1.00 Constraint on power of executive 0.72 0.45 ­0.64 0.73 0.63 1.00 Sources: Kaufmann, Kraay, and Zoido-Lobatón 1999; Heritage Foundation 2003; Gurr and Marshall 2000; and World Bank 2002. Note: All correlations are significant at the 5 percent level. a. Real GDP per capita in U.S. dollars in 1995. b. Average annual growth rate of real GDP per capita for the period 1960­98. c. Standard deviation of annual growth rate of real GDP per capita for 1960­98. d. Aggregate institutional quality measure from Kaufmann, Kraay, and Zoido-Lobatón 1999. Institutions and Growth 213 Box 10.1 Inequality, Institutions, and Growth History shapes the growth of institutions and economies, as well as the role of inequality in this process. In 1800, Argentina's per capita income was equivalent to that of the United States, whereas that of Brazil, Chile, Mexico, and Peru was between 40 and 50 percent of that of the United States. Two centuries later, Argentina's per capita income is one-fifth that of the United States; that of Brazil, Mexico, and Peru are one-fifth or less; and Chile's has remained at about the same relative level. What accounts for this divergence in economic performance? The answer is that, somehow, the United States was able to create a far greater flow of economic opportunities; that is, access to economic, social, and political opportunities became much greater in the United States than in the other countries. Whereas less than 2 percent of the population of Argentina, Brazil, or Chile voted at the end of the 1800s, more than 10 percent voted in the United States, and the voter par- ticipation rate also increased much more rapidly. Three-fourths of the U.S. popula- tion owned land, whereas less than one-fifth did in Argentina, and fewer in Brazil. Access to education was similarly better distributed in the United States. Because population densities were much lower in the United States than elsewhere, there were fewer incentives to establish predatory institutions oriented toward extract- ing rents for the benefit of a small elite. The conclusion is that, except in the United States and Canada, growth in for- mer European colonies has been influenced by the concentration of economic and political power, which limited access to economic and social opportunities, created less secure property rights, and influenced the course of development for several centuries. Recent examples of the interplay of institutions, economic growth, and inequality can be found in India. Maharashtra's less fertile western region has sugar cane yields superior to those achieved in the more fertile eastern region because land is more equally distributed there. In the eastern region, the wealth- ier owners control the sugar cooperatives and set low prices for the other members--thereby reducing incentives for increases in productivity. Another example comes from the Indian state of West Bengal, where tenancy reform in the late 1970s increased the share of output that tenants could retain and strengthened tenancy rights. A sharp increase in yields ensued. Source: Authors. 214 Understanding Growth and Poverty aggregate governance measure used in the IMF's (2003) World Economic Outlook, the lower the volatility of growth. In the standard growth model used in the World Economic Outlook, economic growth measured by the annual average growth rate of GDP per capita is regressed on initial lev- els of income and schooling to capture the effects of institutions on cross- country growth differentials. Institutional quality is proxied by governance measures and financial development. Improving institutional quality by one standard deviation implies an increase in average annual growth in GDP of 1.4 percentage points and a decrease in volatility of similar magnitude ( 1.2 percentage points). What lies behind the strong correlation of economic growth and institutional quality? One would expect that strong economic performance induces institutional change. Countries with positive growth records are more likely to strengthen their financial and real markets by improving underlying legal and regulatory frameworks. Thus, institutions are endogenous to eco- nomic growth. Endogeneity indicates reverse causality--that is, good institutions stimulate growth, and growth encourages the development of good institutions. Economic policies have important consequences for institutional qual- ity, and vice versa. Openness to trade, stronger competition, and greater transparency are positively associated with institutional quality (Islam and Montenegro 2002; IMF 2003). Consider the positive effect of the EU accession process on institutions in Central and Eastern Europe. Rodrik and Subramanian (2003) find that globalization and international trade also have a positive impact on institutional quality overall. The success of policies, in turn, depends on the quality of institu- tions--policies aimed at improving human capital and trade openness are unlikely to be as effective if underlying institutions (political and other) are weak. Turning to the possible exogenous factors that influence institutional quality, we see that literature has concentrated on "the role played by geo- graphical and historical influences on institutional formation" (IMF 2003). The effect of these exogenous factors on institutional quality is not conclusive--the success of institutional quality is not a given based on a country's geography or history--although causal links have been found. Geographical factors such as a country's location and its resource endow- ments are known determinants of economic growth--and institutions are a key intermediary between economic performance and the geographic factors of latitude, distance from main markets, climatic conditions, and resource endowments. Institutions and Growth 215 The evolution of institutions and institutional quality has been linked in recent years to historical factors such as settlement and colonization. Acemoglu (2009) suggests that in Australia, Canada, the United States, and other "new worlds" where people settled in large numbers, institutional developments encouraged participative approaches to economic activity that favored innovation, growth, and investment. On the other hand, where settlement was more confined and power rested in the hands of an elite, institutional developments revolved around maintaining that power, which hampered economic growth. Some of the work in this area (see Acemoglu [2009] for references) has considered the legal framework bequeathed by different colonial masters to suggest that common law is more conducive to the development of good institutions than civil law. Social Capital and Culture The World Bank defines social capital as a feature of both government and civil society that facilitates collective action for the mutual benefit of a group, whether a household, village, community, province, or country. It includes knowledge, skills, and informal institutions (Dasgupta 2002). Other economists separate the social capital inherent in the government from civic social capital (or culture). The first category includes institu- tions that support the enforcement of contracts, the rule of law, and the protection of civil liberties. Government social capital is usually quantified by economic freedom (for example, as measured by the Heritage Foundation index), the political and civil rights index (Gastil 1990), and the Worldwide Governance Indicators generated by Daniel Kaufmann and his team at the World Bank Institute. Civil social capital, by contrast, encompasses common values, attitudes, and beliefs, including social norms, informal networks, and local associa- tions that affect the ability of individuals to work together to achieve common goals. Savings and credit associations, irrigation management systems, credit cooperatives, and civic associations are also defined as social capital--a productive asset. Other examples may include extended kinship, lobbying organizations, and hierarchical relationships such as those associated with patronage (for example, the Hindu jajmani system, the Sicilian Mafia, and even street gangs). The impact of social capital on welfare may be positive or negative. For example, Olson and Norton (1996) suggest that social capital within one group generally has negative effects on other groups and on a country as a whole. In contrast, Putnam (1993) takes the view that social capital held 216 Understanding Growth and Poverty by one group has positive effects on all groups, because cooperation among members of a group forms habits of serving the greater good that carry over to members' interactions with nonmembers. Most of the evi- dence supports the hypothesis that social capital, measured at the national level, is associated with improved economic welfare of societies, as measured by growth, investment, and poverty indicators. Weil (2005) looks at individual aspects of culture, such as openness to new ideas, belief in the value of hard work, saving for the future, and mutual trust. Weil finds that Japan's openness to new ideas and willing- ness to adopt foreign technology helped the country catch up with Europe and the United States after World War II, whereas India and China were unwilling to adopt new ideas until much later. Weil regrets the absence of data to test this notion. Asian countries generally have higher savings rates, possibly because Confucianism, Buddhism, and Hinduism all teach moderation in life. But despite high savings, India languished at a low rate of growth for decades (the so-called Hindu rate of growth of less than 2 percent) because of investment policies that were inefficient and unproductive. Interpersonal trust (as defined by Fukuyama 1995) can affect eco- nomic performance by reducing transaction costs, making contracts more effective and secure and improving individuals' access to credit (Greif 1993; Zak and Knack 2001). Trust may also be considered a substitute or complement for the courts and the rule of law. Putnam (1993) demon- strated strong relationships in the regions of Italy between civic commu- nity and government performance, and between civic community and citizen satisfaction with government. Helliwell and Putnam (1995) rigor- ously tested Putnam's (1993) hypothesis on the role of social capital in economic performance by focusing on three alternative indicators of regional social capital--citizen satisfaction, an index of regional govern- ment performance, and an index of civic community. They found all three to be positively and significantly related to growth from 1950 to 1990, controlling for initial per capita income. Narayan and Pritchett (1999), by analyzing statistics on household expenditure and social engagements in a sample of some 50 villages in Tanzania, found that households in vil- lages that participated in village-level social organizations on average enjoyed greater income per capita. Conclusion This chapter provided a brief overview of how economists think about institutions. In the broadest sense, institutions include the informal rules Institutions and Growth 217 and norms that govern personal and social behavior, as well as the formal rules and norms that provide the predictability needed for societies to function. Our investigation focused on governance--a multifaceted con- cept that includes the notions of voice and accountability, political stabil- ity, government effectiveness, regulatory quality, rule of law, and control of corruption. We then discussed empirical evidence of how the quality of institutions has a strong impact on economic growth. Notes 1. In practical terms, a large proportion of the work on institutions and economic growth has focused on measuring how well public institutions function and their impact on private sector behavior. 2. The Washington Consensus is a term coined by the economist John Williamson in 1989 to describe a set of 10 policy prescriptions that he felt should guide the Washington-based international financial institutions as well as the U.S. Treasury when dealing with crisis-wracked countries. 3. The new institutional economics "examines the effects of institutions (rules and rule enforcement) on the behavior of rational individuals in environments with uncertainty and other transactions costs, and examines the consequences of this behavior in terms of individual and collective wel- fare." (Azfar 2002). 4. North identifies Ronald Coase (1937, 1960) as the scholar who connected institutions, transaction costs, and neoclassical theory. 5. The evidence for this statement is presented later in this chapter. 6. Interactive data-based tools (available at http://www.worldbank.org/wbi/ governance/data) allow users to compare countries and world regions on each of these dimensions. 7. 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Education is also positively linked with technologi- cal adaptation, innovation, and increased productivity, which help gen- erate economic growth. Yet for many of the world's poor, education remains unattainable. Achieving universal primary education (UPE) by 2015 is one of the Millennium Development Goals (MDGs) adopted by the interna- tional community in 2000. Education for All (EFA), a related interna- tional initiative launched in 1990, goes further, committing the nations of the world to provide education for all of their citizens by the year 2015. Because education affects child and reproductive health and enhances human skill and capital, it is critical to the suc- cess of the other MDGs. In this chapter, we examine educational progress in the developing world and the challenges that remain. We examine initiatives for achiev- ing UPE, giving special attention to the financial resources needed to achieve this goal. 221 222 Understanding Growth and Poverty Education, Growth, and Poverty Reduction Education directly benefits its recipients and improves society by increas- ing productivity, raising rates of innovation and invention, and enabling the adaptation of new technologies. Many developing countries have pur- sued UPE over the past several decades. Relevant global initiatives include: · An international commitment, EFA, launched in Jomtien, Thailand, in 1990 to bring the benefits of education to "every citizen in every soci- ety." Partners comprised a broad coalition of national governments, civil society groups, and development agencies such as the United Nations Education, Scientific and Cultural Organization (UNESCO) and the World Bank. · The reaffirmation of this commitment in Dakar, Senegal, in April 2000, and then again in September 2000, when 189 countries and their partners adopted two of the EFA aims within the MDGs, speci- fying that UPE was to be achieved by all countries by 2015. · The EFA Fast-Track Initiative (FTI), launched in 2002 by the World Bank in partnership with developing countries and donors to acceler- ate progress toward UPE by 2015. Researchers note that while educational attainment may be correlated with economic growth, this does not suggest a causal relationship. Higher overall rates of educational attainment hide disparities connected to family income, gender, and geographic location. Furthermore, rates are often exag- gerated because of a high incidence of repeat students. Hence, other consid- erations such as the enrollment rate versus the completion rate, the quality of education, and the frequency and adequacy of testing and feedback are also important measures of education's effect on economic growth. Hanushek and Kimko (2000) gathered international test scores in mathematics and science from 1960, formed these into a composite measure of school quality, and related this to differences in cross-country growth rates. They also included income level, years of schooling, and population growth in the model. All of the variables helped explain dif- ferences in growth rates--and the quality of schooling proved highly sig- nificant. One standard deviation difference in test performance correlated to a 1 percentage point difference in annual growth of gross domestic product (GDP) per capita (Hanushek 2005). Moreover, test scores as a measure of school quality are strongly linked to an individual's earnings and productivity--the higher an individual's test scores, the higher the Education 223 earning advantage. Although developed countries have supplied most of the data, this relation appears to hold for developing economies as well (Hanushek 2005). The World Bank (2007b) concurs that educational qual- ity, as measured by what people know, positively affects individual earning levels as well as economic growth and the distribution of income. Educational quality is directly related to school attainment. While school quality and student performance provide a qualita- tive measure of education, the most common quantitative measure is the net primary enrollment rate (NER). NER is the ratio of the num- ber of children in the official primary school age group enrolled in school to the total number of children in this age group. The NER for developed countries was 96 percent in 2006, a rate matched only by Latin America and the Caribbean among the developing regions (figure 11.1). Among developing regions, Sub-Saharan Africa had the lowest NER--just 71 percent compared to 96 percent for Latin America and the Caribbean. Figure 11.1 shows, however, that between 2000 and 2006, NER increased the most in Sub-Saharan Africa (a 13 percent- age point increase) and South Asia (a 10 percentage point increase). Figure 11.1 Net Primary Enrollment Rates by Region 100 net enrollment rate (percent) 80 60 40 20 0 cif d lA d be nd Af and ia ca Pa an ra an As ri rib a a ic sia an a Af ric sia nt pe rth ast h Ca ic ut n Ce uro tA e er No le E ra So Am ha s E d Ea Sa id tin M b- th La Su 2000 2006 Source: World Bank 2007a. 224 Understanding Growth and Poverty A less strict standard than the NER is the gross enrollment rate (GER), which captures the ratio of the number of children enrolled in primary education--regardless of age--to the population of the nationally defined primary school age group. For example, Africa's GER increased remarkably during the 1990s-- from 73 percent in 1992 to 83 percent in 2000 and 91 percent in 2002, with partial data for more recent years confirming a continued increase (Fredriksen 2005). Given that 20 percent of students have to repeat grades, however, Africa would need a GER of 120 percent to enroll all children of primary school age (Fredriksen 2005). Cohen and Bloom (2005) note other advances in school enrollment, including an increase in literacy among developing countries--from 25 to 75 percent in the 20th century--and an increase in average years of schooling, from 2.1 to 4.4 years. Furthermore, the number of students enrolled in secondary school increased from 50 million to 500 million in the past 50 years. Figure 11.2 depicts the average years of schooling com- pleted in various regions. Although overall enrollment rates have increased in developing coun- tries, they remain subpar. Furthermore, enrollment does not guarantee attendance, and attendance is not necessarily a reliable predictor of edu- cation completion (figure 11.3) or high-quality education. Standardized test scores show a huge disparity between children from industrial coun- tries and those from developing countries. The global commitment to achieve UPE as outlined in the MDGs and the even broader education Figure 11.2 Average Educational Attainment by Region, 2000 12 average years of schooling 10 9.68 9.76 8 completed 6.06 6 5.44 4.57 4 3.52 2 0 ca ia Af and be nd ie n tri d ri om tio un ce As Af rib a a a an s es co van on si ric rth ast th n Ca ic ec tran ra u e er No le E ad So ha th Am d Sa id tin b- M Su La Source: Bruns, Mingat, and Rakotomalala 2003. Education 225 Figure 11.3 Primary School Enrollment and Completion Rates for Select Countries primary gross enrollment rate primary completion rate Niger Niger Burkina Faso Burkina Faso Ethiopia Ethiopia Burundi Burundi Tanzania Tanzania Guinea-Bissau Guinea-Bissau Chad Chad Ghana Ghana Benin Benin Gambia, The Gambia, The Kenya Kenya Rwanda Rwanda Nicaragua Nicaragua India India Uganda Uganda Honduras Honduras Indonesia Indonesia Bolivia Bolivia Bangladesh Bangladesh Malawi Malawi 100 50 0 50 100 percent Source: Bruns, Mingat, and Rakotomalala 2003. goals agreed to at the World Education Forum at Dakar, Senegal, in 2000, are responses to the present, unacceptable situation (Cohen and Bloom 2005; Sperling and Balu 2005). Facts to consider include the following: · Over 100 million primary school age children are out of school · Roughly 380 million children are not enrolled in school (28 percent of the primary school age group) · Of school age children who enter primary school in developing coun- tries, more than one in four drop out before attaining literacy · Fewer than one-third of children in Africa and South Asia can read and write 226 Understanding Growth and Poverty · One in five children in primary school in Africa repeat a grade · Of children enrolled, 150 million are likely to drop out before com- pleting primary school · More than half of all girls in Africa never enroll in school. The research on inequality and education is strongly established; illit- eracy is one of the strongest predictors of poverty, and unequal access to educational opportunity strongly correlates to income inequality (Bruns, Mingat, and Rakotomalala 2003). O'Connell and Birdsall (2001) and Birdsall and Londoño (1998) suggest that inequality in education has a strong negative effect on growth, independent of education levels and other factors.1 Improving school completion rates is of critical importance for devel- oping countries (figure 11.3). Research indicates that completion of five to six years of primary school--the length of a primary school cycle in most countries--is critical to sustaining lifelong literacy and basic numeric skills. Moreover, low levels of education (fewer than six years of schooling) are inadequate to achieve sustained economic development and stable governmental institutions or to reduce poverty (Bruns, Mingat, and Rakotomalala 2003). Countries that pass the threshold of six years of schooling can achieve a higher steady state of macroeconomic growth. The disparity between enrollment and completion rates (highlighted in figure 11.3) indicates that enrollment rates--whether net or gross--are only weakly correlated with completion rates. Bruns, Mingat, and Rakotomalala (2003) note that the average enrollment ratio masks the fact that many more children begin school than complete it. They cite examples from Brazil and Indonesia in the 1980s. In both countries, close to 100 percent of children were enrolled at grade 1, yet only 60 percent completed five grades in Brazil, compared with 90 percent in Indonesia. In the decade following 1990, primary school completion in devel- oping countries for boys and girls together increased from 73 percent to 81 percent (table 11.1). In Africa, however, the changes were marginal, with a slight decrease in primary completion for boys offset by a small increase in girls' completion ratios. Completion ratios in Africa are roughly 50 percent and remain far below the developing countries' average. Explanations for the lack of a strong relationship between enrollment and completion include: (a) family circumstances, (b) geographic loca- tion, and (c) gender differences. Education 227 Table 11.1 Primary Completion Progress (Population Weighted) percent 1990 Most recent year a Region Girls Boys Both Girls Boys Both Africa 43 57 50 46 56 51 East Asia and Pacific 92 97 96 98 98 97 Europe and Central Asia 85 95 90 93 95 93 Latin America and the Caribbean 71 64 69 85 81 83 Middle East and North Africa 71 84 78 78 86 83 South Asia 59 77 68 63 84 74 All developing countries 65 79 73 76 85 81 Source: Bruns, Mingat, and Rakotomalala 2003. a. In most cases, 1999/2000. Family circumstances. Family illness, a lack of material resources, and family need for communal labor may all play a role in keeping children out of school. Geographic location. Children from rural areas generally have lower completion rates than children from urban areas. Girls from poor families in rural areas are less likely to complete primary school than boys in sim- ilar circumstances, although boys are also at a disadvantage. This could reflect the need for child labor on family farms or cultural factors (rural areas tend to hold more conservative views on the employment of girls) (table 11.2). Gender differences. The enrollment and completion rates for girls in developing countries are significantly less than those for boys. In the case of India, Filmer (2000) found that the enrollment rate for six-year-old boys in India in 1992 exceeded that of girls by 2.5 percentage points among children of the richest households; the difference for children of the poorest households was 24 percent in favor of boys. Globally, the enrollment rate for girls from rich households exceeded that of girls from poor households by 55.4 percentage points, and the difference for boys was 34 percentage points (Cohen and Bloom 2005). Increasing these rates for 228 Understanding Growth and Poverty Table 11.2 Proportion of Children Completing Primary School: Averages in Select Countries and Regions percent Percentage of age group Primary gross completing primary cycle Region or country enrollment rate Total Rural Rural girls Africa 77 45 n.a n.a Niger 31 20 12 7 Burkina Faso 45 25 16 10 Guinea 62 34 25 11 Benin 86 39 27 14 Mauritania 88 46 42 38 Mozambique 78 36 21 14 Madagascar 90 26 12 11 Togo 115 68 57 46 South Asia 100 70 n.a n.a Latin America and the Caribbean 113 85 n.a n.a Middle East and North Africa 95 74 n.a n.a Source: Bruns, Mingat, and Rakotomalala 2003. Note: n.a. = not applicable. girls is critical given the marked gender differences in schooling that pre- vail in many developing countries. Studies have shown that the following: · A year of schooling for the mother reduces child mortality by about 10 percent. · An additional year of female education reduces the total fertility rate by 0.23 births. · Educated women are more likely to send their children to school-- and keep them there. · An increase of 1 percentage point in the share of women with second- ary education is estimated to raise per capita income by 0.3 percent- age points. · Education increases women's productivity and participation in the workforce. · Improvements in women's education in 63 countries accounted for 43 percent of the decline in malnutrition from 1970 to 1975 (Smith and Haddad 2000). The arguments for improving enrollment and completion rates--and achieving UPE--extend beyond economic ones. Education helps in the achievement of all other MDGs, such as poverty reduction, gender equity, Education 229 child and maternal health, lower rates of HIV/AIDS and other commu- nicable diseases, and environmental stability (Bruns, Mingat, and Rakotomalala 2003). Recent research has found that increases in educa- tion for both boys and girls have a strong effect in decreasing the spread of HIV/AIDS (Vandemoortele and Delamonica 2000; Kelly 2000; Gregson, Waddell, and Chandiwana 2001). Researchers also found that better-educated individuals have lower rates of infection, especially among younger people. Global Education Initiatives A number of global initiatives currently express the goal of "education for all." How close are we to achieving that goal?2 The MDG for education, reaffirming the goals established at the Dakar World Education Forum, aims for the following: · Ensure that, by 2015, children everywhere--boys and girls alike--will be able to complete a full course of primary schooling. · Eliminate gender disparity in primary and secondary education at all levels of education no later than 2015. Completing a full course of primary schooling would suggest a UPE rate of 100 percent. Using the progress achieved over the 1990s, Bruns, Mingat, and Rakotomalala (2003) estimate that the global primary com- pletion rate (PCR) in 2015 will not exceed 83 percent. But even this fig- ure masks enormous regional differences (figures 11.4 and 11.5). By 2000, just over half of all school age children in Africa had com- pleted primary school. In South Asia, the increase between 1990 and 2000 was more dramatic, but the average completion rate leveled off around 70 percent. The Middle East and North Africa experienced a decade of slight decline and stagnation, with the average completion rate settling around 74 percent in 2000. Regional differences also mask coun- try differences--South Africa and The Gambia registered increases in PCRs while Zambia, the Republic of Congo, Cameroon, Kenya, Madagascar, Qatar, the United Arab Emirates, and Bahrain all registered significant declines. Afghanistan dropped from a low 22 percent in 1990 to 8 percent in 1999 (Bruns, Mingat, and Rakotomalala 2003). Emerging Europe and Central Asia were the regions closest to UPE, registering 92 percent in 2000--followed by Latin America and the Caribbean (85 percent) and East Asia and Pacific (84 percent). 230 Understanding Growth and Poverty Figure 11.4 Primary Completion Progress in Africa, Middle East and North Africa, and South Asia 100 primary completion rate (percent) 80 Middle East and North Africa South Asia 60 Africa 40 1990 1995 2000 2005 2010 2015 required trend to achieve MDG current trend Source: Bruns, Mingat, and Rakotomalala 2003. Figure 11.5 Primary Completion Progress in Latin America and the Caribbean, East Asia and Pacific, and Europe and Central Asia 100 primary completion rate (percent) Europe and Central Asia 90 East Asia and Pacific 80 Latin America and the Caribbean 70 60 1990 1995 2000 2005 2010 2015 required trend to achieve MDG current trend Source: Bruns, Mingat, and Rakotomalala 2003. How are developing countries progressing toward achieving the tar- get of UPE by 2015? Bruns, Mingat, and Rakotomalala (2003) gauge each country's progress and forecast its potential for achieving this goal (table 11.3 expresses their results). Of the 37 countries that have already achieved--or are close to achieving--UPE, the majority (26) are middle-income countries. Another 32 countries--again primarily Education 231 Table 11.3 Prospects for Achieving UPE by 2015 Low-income Middle-income All developing Progress rating countries countries countries On track 22 47 69 Achieved UPE 11 26 37 On track to achieve UPE by 2015 11 21 32 Off track 51 19 70 Off track to achieve UPE by 2015 28 15 43 Seriously off track 23 4 27 No data available 9 7 16 At risk, subtotal 60 26 86 Total 82 73 155 Source: Bruns, Mingat, and Rakotomalala 2003. middle income--are on track to achieve it by 2015. The remaining 86 countries--more than 50 percent of the total--are at risk of not achieving UPE. Some of these countries (43) are making good progress, but stagnation in the 1990s makes UPE difficult to reach by 2015. The majority (28) of these are low-income countries. Of greater worry are the 27 countries--23 of which are low income--that are off track. Following current trends, their completion rates will lie at or below 50 percent in 2015. No data were available for 16 countries--including Somalia, Liberia, and Myanmar--but it is highly likely that they are also at risk. Bruns, Mingat, and Rakotomalala (2003) identified several characteris- tics of the educational systems in 55 low-income countries that influence enrollment and completion rates: · Average annual teacher salary · Pupil-teacher ratio · Spending other than for teacher salaries · Average repetition rate · Government revenues · Recurrent spending on education · Recurrent spending on primary education · Private enrollment. The 55 low-income countries exhibit enormous variance in these indicators (table 11.4), which translates into huge variance in GERs (ranging between 30 and 120 percent) and PCRs (ranging between 232 Understanding Growth and Poverty Table 11.4 Benchmarks for Primary Education Efficiency and Quality Sample mean in 1999­2000 Highest Sample range Adjusted completion 2015 Variable in 1999­2000 sample countries benchmarks Service delivery Average annual teacher salary (as a multiple of per capita GDP) 0.6­9.6 4.0 3.3 3.5 Pupil-teacher ratio 13:1­79:1 44:1 39:1 40:1 Spending on inputs other than teachers (as % of primary educa- tion recurrent spending) 0.1­45.0 24.4 26.0 33.0 Average repetition 10.0 or low- rate (%) 0­36.1 15.8 9.5 er System financing Government revenues (% of GDP)a 8.0­55.7 19.7 20.7 14.0/16.0/18.0b Education recurrent spending (as % of government revenues) 3.2­32.6 17.3 18.2 20.0 Primary education recurrent spending (as % of total recurrent spending for education) 26.0­66.3 48.6 47.6 50.0c Private enrollments 0­77.0 9.4 7.3 10.0 Source: Bruns, Mingat, and Rakotomalala 2003. a. Government current revenues, excluding grants. b. Staggered targets proportional to per capita GDP. c. For six-year primary cycle; otherwise, prorated for length of cycle. 20 and 100 percent). Bruns, Mingat, and Rakotomalala (2003) classify the countries into four groups. Members of group 1 were deemed rela- tively "successful countries," with a GER of 85 percent or above and a PCR of 70 percent or above; group 2 countries were deemed "high inef- ficiency countries" with a high GER (80 percent or above) but low PCR (60 percent or lower); group 3 countries, or "low coverage countries," had a low GER and PCR (both 60 percent or lower); and group 4 countries fell within the ranges of the other three groups. Figure 11.6 depicts these groups, with the diagonal representing a perfect one-to-one correspon- dence between GER and PCR. Education 233 Figure 11.6 Primary School Completion Rates and Gross Enrollment Ratios in a Sample of Low-Income Countries, 1990­2000 110 group 1 primary completion rate (percent) 100 90 80 70 60 50 40 group 3 30 group 2 20 10 0 0 20 40 60 80 100 120 140 gross enrollment ratio (percent) group 1 group 2 group 3 group 4 Source: Bruns, Mingat, and Rakotomalala 2003. Group 1 countries were more likely to · Devote a higher share of their GDP to public primary education · Have unit costs that fall in the middle of the range · Pay teachers an average annual wage of 3.3 times per capita GDP · Spend slightly more on complementary, non-teacher-salary inputs · Have an average pupil-teacher ratio of 39:1 · Have average repetition rates below 10 percent. Group 2 countries had lower average spending and much higher rep- etition rates (28 percent compared to less than 10 percent for group 1 countries), and group 3 countries had much higher unit costs--about 70 percent higher--than the other groups, primarily due to higher average teacher salaries. These findings provide an outline for educational reform in countries with low PCR and low GER. Spending on primary education varies widely among the World Bank Regions, ranging from $46 per head in South Asia to $878 per head in Eastern Europe and Central Asia (table 11.5). Public spending on educa- tion in low-income countries ranges from less than 2 percent of gross national product in Chad, Guatemala, Guinea, and the Lao People's Democratic Republic to 10 percent in Botswana and Namibia (Mingat 234 Understanding Growth and Poverty Table 11.5 Current Expenditures on Primary Education Percentage of Total public population covered Public spending spending by public Region per student (US$) (US$, million) spending data South Asia 46 6,900 98 Sub-Saharan Africa 68 6,100 98 East Asia and Pacific 103 21,200 96 Latin America and the Caribbean 440 28,200 90 Middle East and North Africa 519 14,200 60 Eastern Europe and Central Asia 878 5,200 22 Developing world 151a 81,800 88 Source: Cohen and Bloom 2005. Note: Public spending figures are more reliable in regions where public spending data are available for a higher fraction of the population. a. Averages weighted by number of pupils. and Winter 2005). Usually, greater spending results in higher quality edu- cation, although this is not a foregone conclusion3 (Cohen and Bloom 2005). Mingat and Winter (2005) note that Senegal and Burkina Faso spend almost the same on each primary school student, yet achievement is much higher in Burkina Faso. Moreover, more money for education does not always mean more coverage--public spending on education in El Salvador, Ghana, and Sri Lanka is a relatively small percentage of their respective gross domestic products, yet the coverage is wide. According to simulations made by Bruns, Mingat, and Rakotomalala (2003), many countries are not in a position to mobilize the resources needed to achieve UPE by 2015. Low-income countries have a small tax base and have difficulty raising revenues because of limited administrative capacity. The cost for 47 countries4 to reach the education-related MDGs by 2015 would require an increase in domestic funding from approxi- mately $8.5 billion in 2000 to $21 billion in 2015. Even with maximum effort at the domestic level, the countries sur- veyed above will not be able to achieve the MDGs in education by 2015 without significant external financing. The 47 countries (plus Afghanistan) require an estimated $2.5 billion a year in external financing. The financ- ing gap ranged from $1 billion in 2000 to $3.6 billion in 2015, which rep- resents 15 percent of total expenditures. Regionally, the estimated annual Education 235 financing gap ranged from a high of 76 percent in Africa to 1.5 percent in East Asia and Pacific (table 11.6). Africa suffers from the largest financ- ing gap. Thirty-three African countries account for $1.9 billion of the $2.4 billion annual gap internationally (excluding Afghanistan); yet official dis- bursements have averaged $500 million per year over 1998 to 2000, with new commitments averaging just $600 million per year. Development Assistance for Education The Heavily Indebted Poor Countries (HIPC) Initiative (1999), the Poverty Reduction Strategy Paper (PRSP) process (both discussed in chapter 8), and the FTI (2002) should ease developing countries' difficul- ties in achieving UPE. The HIPC Initiative directs some of the resources that become available after debt cancellation toward increased social spending. Since countries within the HIPC program are required to prepare PRSPs, these additional resources target education goals within the overall national development priorities set by the PRSPs. Mingat and Winter (2005) note that, in Madagascar, education spending as a proportion of GDP is expected to increase from 2.2 percent to 3.4 percent in 2005, with about one-third of the increase arising from resources freed up under the HIPC Initiative. Fredriksen (2005) notes that countries benefiting from the HIPC program have committed to using an average of 40 percent of their debt payment savings on basic education. A recent review shows that countries are largely meeting this commitment. Table 11.6 Estimated Annual Financing Gap by Region, 2000 Constant US$, millions Middle Latin East East Europe Share America Asia and and of total Type of South and the and North Central financing financing Africa Asia Caribbean Pacific Africa Asia Total gap (%) Recurrent 1,127 97 14 30 21 34 1,323 55 Operation 841 97 14 30 21 34 1,037 43 AIDS 286 0 0 0 0 0 286 12 Capital 725 300 34 6 49 0 1,114 45 Total 1,852 397 48 36 70 34 2,437 100 Percentage 76.0 16.3 2.0 1.5 2.9 1.4 100 n.a. Source: Bruns, Mingat, and Rakotomalala 2003. Note: n.a. = not applicable 236 Understanding Growth and Poverty The FTI,5 agreed upon by developing countries and donors in 2002, aims to achieve UPE for boys and girls by 2015. The FTI functions as a co-coordinating mechanism for disbursing funds once a country has been accepted to the FTI6 (which requires submitting a country plan for education). The Fast-Track partners (major bilateral donors, regional development banks, the United Nations Children's Fund, and the World Bank) meet regularly to review education plans at the inter- national and country levels. FTI has coordinated with UNESCO to develop uniform benchmarks for an EFA plan, including the allocation of 20 percent of national budgets to education; the elimination of school fees; a targeted 40:1 student-teacher ratio; and repetition rates not above 10 percent. FTI has been criticized for not doing more to bridge the financing gap. Despite a 2005 increase of $348 million in commitments to the 12 coun- tries included in the initiative, an annual financing gap of $289 million remains. Moreover, the FTI includes only eight countries identified as being off track for reaching UPE by 2015. Sperling and Balu (2005) note that no donor country has made the FTI or even EFA a high priority, although some recent initiatives such as the U.K. Commission on Africa and the UN Millennium Project Task Force on Gender Equality and Education issued reports calling for predictable funding through the FTI. External financing for education has increased since 2000, when world leaders at Dakar committed to achieving the EFA goals by 2015, although current levels of aid fall far short of the sums required to do so. The International Development Association is the largest source of education assistance to low-income countries. Under the International Development Association, lending for education has grown steadily to reach almost $1.5 billion in 2005. Roughly 86 projects amounting to nearly $4.3 billion in lending were under implementation in 2005. Africa accounted for 40 per- cent of the total, and Asia accounted for 20 percent. Support for primary education amounted to almost half of total lending over the period 1999 to 2005. What Do We Know about Educational Policy? Cross-country data from 1960­90 suggest that (a) richer countries invest a higher proportion of their incomes in education; (b) higher education levels in 1960 (the initial condition) predicted faster subsequent income growth (that is, countries that are better educated are likely to grow faster); and (c) there seems to be little relationship between educational Education 237 investment (measured by the increase in the number of years an average person spends in school) and income growth. An individual's level of education, savings rate, and health indicators appear to be strongly correlated. But knowledge of the causal relation- ships among these variables is limited. Teacher attendance, quality of education, and test scores in private schools are all higher than those in public schools. In almost all coun- tries, a significant gap between public and private schools is found. Surprisingly, Indian private school teachers have lower salaries than public school teachers, and yet the private teachers perform better as evidenced by student test scores. Clearly, quality of teachers must be an issue. Community control of public schools and parent-teacher associations can improve public education. Communities and parents are most con- cerned with the interests of children and know which issues plague local schools; increasingly, they have the authority to monitor, hire, and fire teachers. Unfortunately, parents in rural areas are less educated and may not have the capability to monitor teacher performance. Some evidence suggests that parents in rural areas are not interested in education. Offering cash transfers conditioned on children's school attendance may be one way to lure parents to send their children to school. School choice and vouchers for education are another policy option that could allow parents to decide on public versus private schools and help monitor the quality of education. Conclusion Education contributes to economic growth, poverty reduction, and indi- vidual economic success. All developing regions, including Africa, have experienced improvements in education, but large educational disparities persist between the developed and the developing worlds, even at the pri- mary level. Research has shown that the development of basic numeric and literary skills requires six years of primary schooling, but even this remains out of reach of most of the poor in the developing countries-- particularly in Sub-Saharan Africa. A number of global initiatives have the primary goal of achieving UPE by 2015. The costs of achieving this goal remain high and have implications for domestic and international financial resource mobilization. The chapter ended with a brief discussion on what we know and do not know about inputs, outputs, and outcomes in education. 238 Understanding Growth and Poverty Notes 1. Including variables such as trade openness and natural-resource endowments. 2. This section is based on research conducted by Bruns, Mingat, and Rakotomalala 2003. 3. Cohen and Bloom (2005) refer to a 2001 Latin America study by Marquis (2001) that showed that although its spending was the lowest in the region (less than $1,000 a student), Cuba was a leader in test scores, literacy, and completion rates. 4. Angola, Armenia, Bangladesh, Benin, Burkina Faso, Burundi, Cambodia, Cameroon, the Central African Republic, Chad, the Democratic Republic of Congo, the Republic of Congo, Côte d'Ivoire, Eritrea, Ethiopia, The Gambia, Georgia, Ghana, Guinea, Guinea-Bissau, Haiti, Honduras, India, Kenya, Lao People's Democratic Republic, Lesotho, Madagascar, Malawi, Mali, Mauritania, Moldova, Mongolia, Mozambique, Nepal, Nicaragua, Niger, Nigeria, Pakistan, Rwanda, Senegal, Sierra Leone, Sudan, Tanzania, Togo, Uganda, the Republic of Yemen, and Zambia. 5. The FTI is a new compact for the education sector that links increased donor support for primary education to recipient countries' policy performance and accountability for results. Initiated by 22 bilateral donors, development banks, and international agencies active in supporting education in low-income countries, the FTI is cochaired on a rotating basis by one Group of Eight and one non­Group of Eight donor, and supported by a steering committee and a secretariat, which is housed in and managed by the World Bank. 6. A first set of 18 low-income countries was invited to join the FTI when it started in 2002: Albania, Bolivia, Burkina Faso, Ethiopia, The Gambia, Ghana, Guinea, Guyana, Honduras, Mauritania, Mozambique, Nicaragua, Niger, Tanzania, Uganda, Vietnam, the Republic of Yemen, and Zambia. Five countries that did not have education plans or national poverty reduction strategies in place were also invited--Bangladesh, the Democratic Republic of Congo, India, Nigeria, and Pakistan (Bruns, Mingat, and Rakotomalala 2003). Bibliography Barro, R. J. 2000. "Inequality and Growth in a Panel of Countries." Journal of Economic Growth 5 (March): 5­32. Barro, R. J., and J.-W. Lee. 2000. "International Data on Educational Attainment Updates and Implications." NBER Working Paper 7911, National Bureau of Economic Research, Cambridge, MA. Birdsall N. and J. J. Londoño. 1998. "No Tradeoff: Efficient Growth Via More Equal Human Capital Accumulation in Latin America." In Beyond Trade-Offs: Market Reforms and Equitable Growth in Latin America, ed. Nancy Birdsall, Education 239 Carol Graham, and Richard Sabot, 111­206. Washington, DC: Brookings Institution and Inter-American Development Bank. Bloom, D. E., D. Canning, and D. T. Jamison. 2004. "Health, Wealth and Welfare." Finance and Development 41 (1): 10­15. Bloom, David E., and Joel E. Cohen. 2002. "Education for All: An Unfinished Revolution." Dædalus 131 (3): 84­95. Bruns, B., A. Mingat, and R. Rakotomalala. 2003. Achieving Universal Primary Education by 2015: A Chance for Every Child. Washington, DC: World Bank. Cohen, J. E., and D. E. Bloom. 2005. "Cultivating Minds." 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Educational Quality and Economic Growth. Washington, DC: World Bank. Kelly, M. J. 2000. The Encounter Between HIV/AIDS and Education. UNESCO Sub-Regional Office for Southern Africa: Harare: Zambia. Marquis, Christopher, "Cuba Leads Latin America in Primary Education, Study Finds." New York Times, December 13, 2001. Mingat, A., and C. Winter. 2005. "Education for All by 2015." Finance and Development 42 (2): 32­35. O'Connell, L., and N. Birdsall. 2001. "Race, Human Capital Inequality, and Income Distribution in South Africa, Brazil and the United States." Discussion Paper 4, Carnegie Endowment for International Peace, Washington DC. Smith, Lisa C., and Lawrence James Haddad. 2000. "Overcoming Child Malnutrition in Developing Countries: Past Achievements and Future Choices." 240 Understanding Growth and Poverty 2020 Vision Discussion Papers 30. Washington, DC: International Food Policy Research Institute. Sperling, G., and R. Balu. 2005. "Designing a Global Compact on Education." Finance and Development 42 (2): 38­41. Vandemoortele, J., and E. Delamonica. 2000. "Education, `Vaccine' Against HIV/AIDS." Current Issues in Comparative Education 3 (1): 6­13. Viaene, J. M., and I. Zilcha. 2003. "Human Capital Formation, Income Inequality and Growth." In Growth and Inequality: Issues and Policy Implications, ed. T. Eicher and S. Turnovsky, 89­118. Cambridge, MA: MIT Press. World Bank. 2002. "Fast Track Initiative Indicative Framework." World Bank. http://www1.worldbank.org/education/efafti/harmonization.asp. ------. 2006a. "IDA Support for Education Fact Sheet." World Bank. http://web.worldbank.org/WBSITE/EXTERNAL/EXTABOUTUS/IDA/. ------. 2006b. World Development Report: Equity and Development. Washington, DC: World Bank. ------. 2007a. World Development Indicators. Washington, DC: World Bank. ------. 2007b. Education Quality and Economic Growth. Washington, DC: World Bank. CHAPTER 12 Health International law guarantees the basic human right to receive health care, which is a critical component of economic progress (Sen 1999). Yet for millions of the world's poor, basic health care remains out of reach. Developing countries account for 90 percent of the world's disease bur- den (Gottret and Schieber 2006). HIV/AIDS, malaria, tuberculosis (TB), maternal and prenatal conditions, childhood infections, tobacco-related illnesses, and nutritional deficiencies caused roughly 16 million deaths in 1998 (WHO 2006). Almost 11 million children under age five, mostly in developing countries, died from diseases in 2000; of these, 8 million were infants--half of whom were just one month old or less. Many of these dis- eases are, however, treatable. The international community's commitment to the Millennium Development Goals (MDGs)--three of which are directly related to health1--attest to its recognition that investment in health is vital to human development, economic growth, stability, and reduced poverty. This chapter examines health within a macroeconomic context, address- ing indicators, the disparity between low-income countries and the rest of the world, economic growth, and policy solutions for low-income countries. The chapter finishes with an examination of some current global health initiatives and the status of development assistance for health (DAH). 241 242 Understanding Growth and Poverty Macroeconomics and Health The examination of health in the macroeconomic framework of develop- ing countries is a recent phenomenon. Critics of the old Structural Adjustment Facility (SAF)2 noted its lack of emphasis on health in pro- grams that targeted macroeconomic adjustment and structural reforms. The international financial community has increased its focus on poverty reduction in recent years, and recognized the role of health in economic growth and development. Initiatives such as the Poverty Reduction Strategy Paper (PRSP) in 1999 and the Heavily Indebted Poor Countries (HIPC) Initiative reflect this development. The World Health Organization (WHO) established the Commission on Macroeconomics and Health (CMH) to examine how investment in health could tackle mass premature death and thereby improve economic development. Other global initiatives on health--such as the Global Alliance for Vaccines and Immunizations (GAVI) and the Global Fund for AIDS, TB, and Malaria (GFATM)--reflect the critical connections among health, poverty reduction, and economic growth. The disparity in health indicators among the various country devel- opment categories is stark (table 12.1). The combined population of the least-developed and lower-middle-income countries in which many of the world's poor live (such as India and China) was approximately Table 12.1 Life Expectancy and Mortality Rates by Country Development Category Infant mortality Under-five Life (deaths before mortality (deaths Population expectancy at age 5 per 1,000 before age 5 per Development (millions) birth (years) live births) 1,000 live births) category CMH 2003 CMH 2003 CMH 2003 CMH 2003 Least-developed 643 675 51 51 100 94 159 150 Lower-middle- 2,094 2,655 70 69 35 31 39 39 income Upper-middle- 573 333 71 74 26 18 35 22 income High-income 891 972 78 78 6 5a 6 7a Sub-Saharan Africa 642 705 51 46 92 101 151 171 Source: CMH 2001; updated for 2003 (2002a) using World Development Indicators (WDI), World Bank 2005. Note: CMH data refer to a year between 1995 and 2000. a. Data are for 2002. Health 243 3.3 billion in 2003. An individual born in a least-developed country can expect to live to the age of 51, compared with 78 in a high-income coun- try. The health indicators for Sub-Saharan Africa have dramatically wors- ened over the study period (1995­2000 and 2003). Life expectancy at birth has fallen from 51 to 46 years of age, and infant mortality deaths (before the age of 1) have increased from 92 per 1,000 live births to 101. Mortality rates of children under 5 have likewise worsened in Sub- Saharan Africa--from 151 per 1,000 live births to 171. By contrast, life expectancy and mortality rates have improved or remained constant for the remaining country groupings. Based on current projections, low-income countries are unlikely to meet the MDGs. Hsiao and Heller (2007) note that to meet the MDG of reducing under-five mortality,3 mortality rates would have to fall on aver- age by 4.3 percent per year; the current annual rate is 2.3 percent. For a reduction of maternal mortality by three-quarters between 2000 and 2015, maternal mortality rates would have to fall 5.4 percent per year compared to the present rate of 2.4 percent. Common factors that prevent developing countries from making health progress are HIV/AIDS, low levels of tax resources available for discretionary spending, and limited resources for health (Hsiao and Heller 2007, 31). HIV/AIDS has had enormous negative macroeco- nomic effects on labor supply, human capital, foreign investments, and economic growth. Table 12.2, taken from Hsiao and Heller (2007), doc- uments a number of studies that highlight the macroeconomic impact of HIV/AIDS. Furthermore, basic health-care services in low-income countries have suffered as resources are diverted toward treating and preventing HIV/AIDS, especially in Africa, where the pandemic is especially preva- lent. While various global initiatives have increased funding for health care (see below), their targeted nature has taken away from spending on other preventive and curative services. Widespread disease stunts farming, migration, and trade. Bad health saps job productivity and retards intellectual, physical, and emotional development. In other words, ill-health pushes the poor deeper into poverty. A diminished threat of disease would ease the pressure to have many children, and families could invest more in the health of each child. These improvements in health would, in turn, translate into higher incomes, higher economic growth, and reduced (and more sustainable) population growth. 244 Table 12.2 Summary of Studies of the Macroeconomic Impact of HIV/AIDS in Africa Country Period of most Results (comparison with and period of recently used non-HIV/AIDS scenario) Growth economic data HIV/AIDS data Growth of GDP Growth of GDP per capita Dixon, McDonald, and 41 countries late 1990s GDP growth rates reduced by 2%­4% -- Roberts (2001) (1960­98) a year; large variation across countries, in line with prevalence of HIV World Bank (2001b) Swaziland early 1990s Average annual growth rate of GDP Average annual growth rate of GDP per during 1991­2015 will be 1.3% lower capita during 1991­2015 will be 0.2% higher World Bank (2001a) Namibia early 1990s Average annual growth rate of GDP Average annual growth rate of GDP per during 1991­2015 will be 0.8% lower capita during 1991­2015 will be 0.1% higher World Bank (2000) Lesotho early 1990s Average annual growth rate of GDP Average annual growth rate of GDP per during 1991­2015 will be 1.4% lower capita during 1991­2015 will be 0.3% higher Bonnel (2000) About 50 mid-1990s -- Rate of growth of GDP per capita in Africa countries reduced by 0.7% per year in the 1990s (1.2% (1990­97) for a country with HIV prevalence of 20%) Quattek and Fourie (2000) South Africa mid-1990s Average rate of GDP growth over next 15 -- years will be 0.3%­0.4% lower per year Arndt and Lewis (2000) South Africa -- Annual growth rate of GDP is lowered by GDP per capita will be 8% lower in 2010 about 0.5% in the late 1990s, rising to than in the absence of AIDS; implies that 2.5%­2.6% during 2008­10 AIDS lowers average annual growth rate of GDP per capita by 0.7% during 1997­2010 Greener, Jefferis, and Botswana late 1990s During 1996­2001, annual growth rate Little effect; annual per capita GDP growth Siphambe (2001) of GDP reduced by 1.1%­2.1%, 1.5% in rate between 0.6% lower and 0.4% higher the scenario considered most likely due to AIDS; 0.1% lower in the scenario considered most likely. BIDPA (2000) Botswana late 1990s Average rate of growth of GDP in -- 2000­10 reduced by 1.5% per year Bloom and Mahal (1995) 51 countries early 1990s Statistically insignificant effect on -- (1980­92) income growth Cuddington and Malawi early 1990s Average rate of growth of GDP in 1985­ Average growth of per capita GDP Hancock (1994) 2010 reduced by up to 1.5% per year reduced by up to 0.3% per year a Cuddington (1993a, 1993b) Tanzania early 1990s Average annual rate of growth of GDP in Average annual growth reduced by 1985­2010 reduced by up to 1.1%. up to 0.5% Kambou, Devarajan, and Cameroon -- GDP growth rate over 1986­91 -- Over (1992) reduced by 1.9% per year Over (1992) 30 Sub-Saharan early 1990s Average annual growth rate of GDP during Average annual growth rate of GDP per countries 1990­2025 reduced by 0.9% on average capita reduced by 0.15% per year (up to 1.5% in 10 worst affected countries) (up to 0.6% in 10 worst affected countries) Source: Hsiao and Heller 2007, 33. Note: References to effect on GDP growth or per capita GDP growth rates refer to average annual growth rates for the period mentioned, expressed as percentage-point differences from a "no AIDS" scenario. -- = not available. a. For "extreme" assumption about future AIDS prevalence. 245 246 Understanding Growth and Poverty Health and Economic Growth Health and economic growth have a reciprocal relationship. On the one hand, individuals with higher incomes can afford better nutrition, sanita- tion, and health care.4 On the other hand, a healthier individual is less likely to miss work for health reasons and is likely to be more productive. Healthier children have higher rates of school attendance and higher cog- nitive abilities.5 Individuals are also less likely to save for retirement when mortality rates are high. Falling mortality rates in many developing countries have opened up new incentives to save. Consequently, national saving rates have risen, which has boosted investment rates and per capita income. Bloom and Canning (2009) identify four difficulties faced by studies examining the relationship between health and economic growth: · The use of morbidity (chiefly used in microeconomic studies) versus mortality (chiefly used in macroeconomic studies). · The issue of causality. · The issue of timing based on growing evidence that indicates early childhood health affects productivity as an adult; therefore, health effects in the macroeconomy may have long lags. · Partial versus general equilibrium--some studies focus on the former while others focus on the latter, again making comparisons difficult. Income and Health In examining the cross-country relationship between average income and increases in life expectancy, Preston (1975) finds that increases in aver- age income among poor countries are strongly associated with increases in life expectancy. Figure 12.1 shows the relationship between income and life expectancy for 2005. As income per capita rises, this relationship flat- tens: for rich countries, the relationship is weak or absent. Deaton (2001) finds income has a much stronger effect on reducing the probability of death at the lowest-income distribution bracket than at the highest. Thus, a redistribution of income in poorer countries--even without an increase in average income--should improve average health and reduce infant and child mortality. As Deaton (2001) notes, however, average income matters more for population health than income inequality in poor countries. A number of authors6 quoted in Bloom and Canning (2009, 55) find that "the major forces behind health improvements have been improve- ments in health technologies and public health measures that prevent the spread of infectious disease, and not higher income." They further find Health 247 Figure 12.1 Income and Life Expectancy 90 life expectancy (years) 80 70 60 50 40 30 100 1,000 10,000 100,000 income per capita (log scale) Source: World Bank 2007. Note: Data are for 155 countries in 2005. Income is in current international dollars, measured at purchasing power parity. that by plotting the relationship between population health and national income at different points in time, upward movements of the curve account for 75 percent of health gains, while movements along the curve explain less than 25 percent of gains, suggesting that health interventions can improve population health without requiring higher incomes. Health and Income Poor health reduces gross domestic product (GDP) per capita by reduc- ing or restricting labor productivity, investment in physical capital, access to natural resources and the global economy, and schooling and cognitive capacity. Figure 12.2 illustrates this relationship. Adult illness, malnutri- tion, and early retirement also reduce the labor force. The lower ratio of workers to dependents that results from a reduced labor force translates directly into lower GDP per capita. The HIV/AIDS epidemic in Sub- Saharan Africa has already increased adult mortality and could eventu- ally follow the pattern illustrated in figure 12.2, with consequent adverse effects for investment, education, and retirement savings. Bloom, Canning, and Sevilla (2004) identify the initial health of a population as one of the most robust factors contributing to future eco- nomic growth7: one extra year of life expectancy raised steady-state GDP per capita by about 4 percent; and a 10 percent improvement in life expectancy at birth is associated with a rise in economic growth of between 0.3 and 0.4 percentage points per year, all other growth factors being constant. Therefore, the difference in annual growth between a high-income country (where life expectancy at birth is around 77 years on average), and a typical poor country (where it is 49 years on average) is 248 Understanding Growth and Poverty Figure 12.2 Health and Gross Domestic Product Health's links to GDP Poor health reduces GDP per capita by reducing both labor productivity and the relative size of the labor force. higher fertility higher labor force reduced and dependency by mortality and early child mortality ratio retirement lower GDP per capita adult illness reduced labor child illness and productivity malnutrition reduced access to child natural resources and malnutrition global economy reduced schooling reduced investment and impaired in physical capital cognitive capacity Source: Reprinted with permission from Bloom, Canning, and Jamison 2004. about 1.6 percent a year. The effects compound over time. Thus, even after controlling for other macroeconomic variables, health status can explain part of the difference in growth rates between rich and poor countries. Table 12.3, taken from Bloom and Canning (2009), provides further evidence that health is a predictor of economic growth. Countries with higher initial levels of life expectancy experience more rapid economic growth at each level of income. Various studies disagree on how to interpret the link between meas- ures of population health and future economic growth.8 Health does not have a direct effect on growth but acts as a proxy for European settlement that was more successful in countries with a low burden of infectious Health 249 Table 12.3. Annual Growth Rate of Per Capita Income % growth (number of countries) Initial income, 1960 Initial infant mortality rate (constant 2000 US$, PPP) 50 and under 51­100 101­150 151+ 1,000 and under -- 3.9 (1) 2.0 (11) 0.8 (9) $1,001­$2,000 -- 4.8 (3) 1.5 (7) 0.5 (7) $2,001­$3,500 -- 1.6 (6) 1.7 (6) 1.0 (4) $3,501­$7,000 3.5 (6) 2.1 (9) 0.7 (2) 1.0 (1) Greater than $7,001 2.5 (17) 0.9 (1) -- -- Source: Bloom and Canning 2009. Note: The number reported is the average growth rate of countries in that income and infant mortality rate interval. The numbers in parentheses represent the number of countries in the interval that are used in constructing the average. PPP = purchasing power parity, -- = not available. diseases (Bloom and Canning 2009). Acemoglu and Johnson (2007, 2009), using the initial disease burden and worldwide technological progress in disease-specific interventions as a measure of health, find no predictive impact on the level of income. Bloom and Canning (2009) attribute this to the fact that health improvements have delayed effects. Acemoglu and Johnson (2009) concur but note that improved population health leads to greater longevity and population growth that places a strain on other factors and causes income per capita to decline. In their review of the empirical macroeconomic literature, Jack and Lewis (2009) note that national public health investments, such as vacci- nations, improve a country's overall health and can therefore have a small effect on improved investment opportunities that are linked to economic growth. But they caution that the lack of a solid macroeconomic link between health and growth is insufficient reason to withdraw money from the health sector. As noted earlier, improved health may have a delayed effect on economic growth. On the other hand, they find much more robust evidence at the microeconomic level that points to a strong causal relationship between health, earning potential, and income. At the margin, investments in nutrition, early childhood education, education in general, and mother's education improve productivity. Macroeconomic Policy and Health Increased health spending does not always correlate with improved health outcomes. Hsiao and Heller (2007, 83) note that this is especially true in a low-income setting where the "systematic lack of information on many issues relating to the health sector" prevents macroeconomists and 250 Understanding Growth and Poverty country policy makers from formulating sound health policy. They sug- gest the following steps for low-income countries: · Ensure the availability and collection of crucial health information-- National Health Accounts should be collected annually and a report issued on the health and education outcomes of the poor. Data can be collected with Rapid Field Assessment instruments.9 · Warn policy makers of market anomalies in the health sector. Health care consists of more than a dozen markets, most of which are suscep- tible to serious market failures.10 · Promote rational health policies. Sound health policy requires a well- designed combination of regulation and competition, public and pri- vate financing, and institutional capacity building. On a broader level, Hsiao and Heller (2007) make the point that huge gaps in knowledge11 prevent macroeconomists from prescribing anything other than "blunt policy instruments"12 to close budgetary financing gaps. They argue that all countries face similar problems when financing or investing in health care based on limited evidence. In their eyes, "evidence- based health care" as a global public good may be underfunded, and they suggest creating a commonly financed agency to disseminate knowledge of health-care policy. Beyond GDP Health indicators can vary widely for the same income level. Therefore, GDP is a limited measure of a country's economic performance. A more accurate measure is full income, which captures changes in life expectancy by including them in a measure of economic welfare.13 A proxy for full income is the value of a statistical life (VSL), or the will- ingness to pay to avoid risks, defined as the observed amount required for accepting a risk divided by the level of the risk. Bloom, Canning, and Jamison (2004) give the example of a worker who demands $500 more a year to accept a more risky but similar job for which the increase in the mortality rate is 1 in 10,000. Thus, the VSL is [$500/(1/10,000)] = $5,000,000. Based on research by Viscusi and Aldy (2003), a country's VSL values range between 100 to 200 times its GDP per capita. The will- ingness to pay to avoid risks increases with income, and richer countries therefore tend to have higher VSLs. Since lower mortality rates translate Health 251 into higher VSLs, the benefits of health investment can be described in terms of a monetary gain. Bloom, Canning, and Jamison (2004) estimate full income for Africa in an attempt to measure the impact of AIDS. Even though life expectancy in Sub-Saharan Africa has declined to 46 years, and almost 21 percent of deaths were directly attributable to AIDS (2001 figures), little impact was found on GDP per capita.14 Using the change in GDP per capita and the value of changes in mortality rates (calculating the impact of AIDS on mortality rates) as a measure of full income, the authors suggest that income declined by 1.7 percent a year from 1990 to 2000--much higher than existing estimates of this effect. Furthermore, prior to 1990, improvements in adult health suggested larger economic benefits relative to changes in GDP per capita. When one compares full income with GDP per capita, Kenya's economic performance before 1990 was signifi- cantly underestimated and has been overestimated since (figure 12.3). Although AIDS has undone earlier health progress in some regions (table 12.4), the challenges to further improving health indicators are not insurmountable. The CMH (2001, 4) noted that the "epidemiolog- ical evidence conveys a crucial message: the vast majority of the excess disease burden is the result of a relatively small number of identifiable conditions, each with a set of existing health interventions that can dramatically improve health and reduce the deaths associated with these conditions."15 Figure 12.3 Comparison of Full Income and GDP per Capita, Kenya 10 average annual percentage change 5 0 ­5 ­10 1960­70 1970­80 1980­90 1990­2000 full income per capita GDP per capita Source: Bloom, Canning, and Jamison 2004. 252 Understanding Growth and Poverty Table 12.4 Life Expectancy Life expectancy (years) Region 1960 1990 2001 2002 2003 East Asia and Pacific 39 67 69 69 70 Europe and Central Asia -- 69 69 69 68 Latin America and the Caribbean 56 68 71 71 71 Middle East and North Africa 47 64 68 69 69 South Asia 44 58 63 63 63 Sub-Saharan Africa 40 50 46 46 46 Low- and middle-income 44 63 64 65 65 High-income 69 76 78 78 78 World 50 65 67 67 67 Source: World Bank 2005. Note: -- = not available. While corruption, mismanagement, and a weak public sector hinder improvements in health, the poor often lack the financial resources neces- sary to utilize existing interventions. The CMH (2001) estimated that the cost of these health interventions, including those for AIDS, would amount to $30­$40 per person annually. Yet average health spending in least- developed countries is only $13 per person annually--of which budgetary outlays account for $7. For comparison, average health spending in high- income countries is at least $2,000 per person annually. More efficient and greater resource mobilization among poor countries will not bridge the gap in financing; donor finance is needed. The CMH (2001) suggested that a scaling up of health investments would require $27 billion per year in donor grants by 2007, compared to $6 billion in 2001. As noted in previous chapters, rapidly scaling up aid flows may gener- ate inflation and macroeconomic instability, increase the debt burden (when the aid comes in the form of loans rather than grants), and create short-term volatility in exchange and interest rates. In particular, where aid is used to purchase local goods and services, costs may rise faster than supply. This would especially affect the health sector in which "local costs are typically 70 to 75 percent of total spending and where the number of skilled staff cannot be increased quickly" (WHO 2005, 64). Therefore, aid flows are most effective when they are predictable and persistent, when disbursement timing matches national budget cycles, and in countries that have already initiated improvements in health and macroeconomic stability. In addition, increased aid inflows may target other sectors, such as road construction and sanitation, that indirectly affect health and have less potential for inflationary and macroeconomic instability. Health 253 Investing in Health The relationship between health investment and economic growth is cyclical: improvements in health directly affect productivity, which increases the economic growth that in turn facilitates further health improvements. This pattern of cumulative causation increases for a time before diminishing returns to health set in as the population ages. Bloom and Canning (2009) review the literature on health and welfare, focusing on four components of productivity--human capital, education and cog- nitive ability, savings, and demographics. Studies that view health as a part of human capital find that early childhood health significantly influences adult health and earnings.16 Schultz (2002) measures health by comparing adult height with child- hood height and considering nutrition an input. He finds that each cen- timeter gain in height due to improved inputs as a child in Ghana and Brazil leads to a wage increase of between 8 and 10 percent (Bloom and Canning 2009, 57). Other referenced studies,17 using different methods of analysis, reach similar conclusions on the importance of early child- hood investment in health for later adult productivity. But it is unclear which types of early interventions are most important or what the likely rate of return on health investment in human capital would be in all cases (Bloom and Canning 2009).18 Jack and Lewis (2009, 31) also suggest that at the macroeconomic level, health and income are "at least as likely to be jointly determined by such intangible features as institutional quality, cor- ruption, and public sector accountability." Health affects education and cognitive ability through two channels. First, improved health directly affects school attendance, cognitive ability, and learning. Poor childhood health and poor nutrition directly affect children's ability to attend school and prevent the development of cogni- tive abilities necessary for success at school.19 Poor maternal nutrition and health can also have adverse consequences for the health of offspring.20 Bloom and Canning (2009) identify helminthic infections, micronutrient deficiencies, and chronic protein malnutrition as the most important causes of morbidity among children. Second, impaired health directly affects savings. Medical expenses arising from health problems can consume a large part of disposable income, which limits saving. This is especially worrisome in developing economies with underdeveloped or absent private and public health insurance markets. In "India[,] 83 percent of health spending comes from the private sector and 94 percent of private sector spending comes from out-of-pocket expenses" (Bloom and Canning 2009, 59). Moreover, 254 Understanding Growth and Poverty because poor health is associated with shorter life spans, households may choose not to save.21 Bloom and Canning also consider household invest- ment behavior and note that investment is critical for accumulating wealth. Household savings in poor economies may be invested in assets that directly affect productivity. At the national level, foreign investors are more likely to shun envi- ronments in which the labor force suffers from a high disease burden. Infrastructure projects and entire industries--such as agriculture, min- ing, manufacturing, and tourism--suffer from a lack of investment when disease is prevalent. Endemic diseases (such as river blindness) can pre- vent individuals from exploiting land and other natural resources. The association between health and demography has implications for economic growth. Conclusions from Bloom and Canning (2009), who note that the 20th century global population explosion initially stemmed from a fall in infant mortality, suggest the following: · Improvements in health and decreases in infant mortality rates can catalyze a transition from high to low rates of fertility.22 · Subsequent health improvements tend to primarily affect the elderly, reducing old age mortality and lengthening life spans. · High birth and low death rates generate population growth but have different effects on economic growth given their differing effects on the age structure; for example, as long as the baby boomers are of working age and productively employed, economic growth increases. · Healthy aging leads to a later onset of physical dependency among the elderly. · Consequences for economic growth depend on the policy environment. Many of the benefits of health investment remain beyond the reach of developing economies. Through global initiatives and DAH, the global economy is addressing the poor's right to basic health care. Global Health Initiatives The CMH (2001) concluded that health spending in low-income coun- tries was insufficient to address their health challenges and that a scaling up of financing was needed in tandem with government-wide reform pro- grams. Reforms should establish better planning and coordination within and between ministries of health and ministries of finance and planning. Stronger collaboration among development partners in the international community can in turn support a concerted effort at the national level. Health 255 The following subsections examine the contributions of multilateral and bilateral donors toward raising the profile of health in the national devel- opment objectives of low-income countries. Development Assistance for Health Bilateral and multilateral agencies provide approximately 90 percent of total DAH (Michaud 2003). Total DAH from sources such as the European Community, the GFATM, and the Bill and Melinda Gates Foundation (BMGF) increased from $6.4 billion on average during 1997­99 to $8.1 billion in 2002--an increase of almost a quarter (table 12.5). The majority of funds from both public and private sources were allocated for HIV/AIDS and TB. Table 12.5 Trends in Development Assistance for Health Selected major sources of funds (US$, thousands) 1997­99 2002 2003 Bilateral agencies 2,559.8 2,875.2 -- U.S. Agency for International Development 920.8 1,134.9 1,474.0 Multilateral agencies 3,401.5 4,649.2 -- United Nations 1,575.5 2,036.3 -- World Health Organization 864.2 1,140.5 -- Regular budget 406.1 461.1 -- Extrabudgetary contributions 458.1 776.5 -- Pan American Health Organization 84.3 93.4 -- United Nations Program on HIV and AIDS 58.2 91.9 -- United Nations Children's Fund 275.8 391.0 -- United Nations Fund for Population Activities 293.0 319.5 -- Development Banks 1,522.0 1,405.5 -- World Bank 1,124.9 983.0 1,171.8 International Development Association 713.5 536.4 586.2 International Bank for Reconstruction and 411.4 446.6 585.5 Development Inter-American Development Bank 245.7 205.0 0.0 Asian Development Banka 287.7 -- -- African Development Bank 151.4 217.5 -- Other multilateral 304.1 1,207.4 -- European Commission 304.1 244.5 -- Global Fund to Fight AIDS, Tuberculosis 0.0 962.8 979.2 and Malaria Private nonprofit Bill and Melinda Gates Foundation 458.0 595.9 -- Total 6,419.3 8,120.3 -- Source: Michaud 2003. Note: -- = not available. a. Not included in totals (pending update) to increase comparability of total DAH. 256 Understanding Growth and Poverty Bilateral aid for health initiatives has fared better than aid as a whole.23 Bilateral commitments to official development assistance (ODA) for health increased from an average of $2.6 billion in 1997­99 to $2.9 billion in 2002. The largest increase in commitments came from the United States, which pledged $1.5 billion in 2003--up from $920 million three years previous (1997­99). In 2003, the United States committed a further $300 million to other multilateral agencies and the GFATM. The United Nations (UN) agencies increased funding from $1.6 billion to $2 billion over the study period--thanks largely to the extrabudgetary contributions of the WHO. Contributions from the World Bank, after increasing over the 1990s, now stand at $1 billion. The BMGF is the major nonprofit donor agency focusing on global health. The BMGF has focused its funding in two main areas: (a) improving the poor's access to existing vaccines, drugs, and other tools to fight diseases common in developing countries; and (b) funding research projects to develop health solutions that are effective, affordable, and practical. Commitments from the BMGF amounted to $0.6 billion in 2002. Of the $6.5 billion provided by the above donors, the largest share went to support country and regional activities ($5.2 billion), with the remainder going to interregional and global activities (Michaud 2003). More than one-third of the funds went to Africa, and $1.25 billion was allocated to HIV/AIDS, malaria, and TB. The United States was the largest donor for HIV/AIDS, committing $790 million--more than dou- ble that of the next-largest donor in 2002. The GFATM allocated over half (56 percent) of total commitments to HIV/AIDS, with 27 percent going to malaria and 15 percent to TB (Michaud 2003). The largest increase in DAH was allocated toward fighting AIDS in Sub-Saharan Africa (table 12.6). Michaud (2003) reaches the following conclusions in his study on DAH: · DAH maintained a steady level during the 1990s even when total ODA was falling. · DAH allocation has responded to geographical needs, at least for HIV/AIDS, malaria, and TB. · The establishment of the GFATM (as suggested initially by the CMH) has generated increased commitment from the developed world to fight major health problems in developing countries. · Funds increased by $1.7 billion from 1997 to 2002 but continue to fall short of needs. Health 257 Table 12.6 Development Assistance for Health in Select Countries, 2002 Development Assistance for Health Population Per DAH total HIV/AIDS Malaria Tuberculosis Country (thousands) capita ($) ($ thousands) ($ thousands) ($ thousands) ($ thousands) El Salvador 6,154 28.0 172,187 500 0 250 Zambia 8,976 16.7 150,222 25,933 5,978 27 Namibia 1,695 12.7 21,445 4,287 41 15 Gambia, The 1,268 12.2 15,488 47 57 6 Jamaica 2,560 11.9 30,368 12,728 0 4,009 Senegal 9,240 11.7 107,986 6,001 2,726 1,000 Honduras 6,316 9.6 60,820 3,888 220 650 Benin 5,937 7.3 43,250 2,861 1,564 3 Burundi 6,565 7.0 45,902 189 437 2,019 Lesotho 2,108 6.6 13,926 1,239 0 0 Source: Michaud 2003. Note: Countries with populations of less than 1 million were not included. · Political commitment is at an unprecedented high--for example, in the early 2000s, the United States committed $15 billion to fight AIDS in 14 countries over a five-year period. Poverty Reduction Strategies and Funding for Health Since the late 1990s, multilateral organizations--working through the Enhanced HIPC Initiative and the PRSP--have recognized the importance of social spending on health in the macroeconomic framework. According to Gupta and others (2001), countries can use the savings freed up by debt relief toward social spending, which could substantially increase public spending on health from its present level of 2.1 percent of GDP in the HIPCs (figure 12.4). Many countries include measures to increase access to health care in their PRSPs. By contrast, total public spending and total revenues (including grants) were almost 24 percent and 21 percent, respec- tively (figure 12.4). However, the increased focus on poverty-reduction programs in the PRSP will likely change the composition of total public spending and increase the budget allocation for health. Twenty-three countries reached their decision point in 2001,24 and their PRSPs contain measures for increased spending on primary and preventive health care.25 These countries have significantly increased their public health-care spending in per capita terms compared to non-HIPCs (figure 12.5). But health-care spending as a proportion of GDP in the HIPCs still lagged behind that of other non-HIPC countries eligible for debt relief under the IMF's Poverty Reduction Growth Facility (PRGF). For example, 258 Understanding Growth and Poverty Figure 12.4 Spending on Health in the HIPCs That Have Reached the Decision Pointa, 1999 30 25 23.6 20.5 20 % of GDP 15 10 5 2.1 0 health spendingb total revenue total spending and grantsc and net lendingc Source: Gupta and others 2001. a. 1999 or the most recent data available. b. Refers to 19 of the 23 decision-point HIPCs. c. Refers to all decision-point HIPCs, except São Tomé and Príncipe. Figure 12.5 Annual Percentage Change in Health Spending and Social Indicators, 1985­99a 8 7.1 6.1 6.1 6 5.7 4.8 percent 4.0 4 2 1.8 1.7 0 real per capita infant contraceptive immunization spending mortality prevalence DPTc (13) (8) (12) (7) (5) (3) (18) (8) decision-point HIPCs non-HIPC PRGF-eligible countriesb Source: Gupta and others 2001. Note: a. Average improvement between the first year since 1985 in which the country embarked on an IMF- supported program and the most recent year for which data are available. Number of countries are in parentheses. b. Excludes transition economies. c. Diphtheria, pertussis, tetanus. in 1999, non-HIPCs spent about 1 percent more of GDP on health care than the HIPCs. In per capita terms, the HIPCs' spending on health ranged from $3 a person in Madagascar to $35 a person in Bolivia and Guyana. Targeting public health care alone may not be the most judicious use of funds made available under debt relief; improvements in other Health 259 high-priority areas such as water, sanitation, and nutrition can also improve the health of the poor. In fact, available evidence suggests that increased outlays on health care do not always translate into better health-care indi- cators, although indicators as a measure of government policy alone can be misleading. Limited data and changes in the methodologies used can affect these indicators, as well as factors other than government expenditures, such as household income, general economic conditions, improvements in health technology, and the activities of nongovernmental organizations and other private sector providers (Gupta, Clements, and Tiongson 1998). A more comprehensive strategy for improving health-care spending would focus on removing inefficiencies and reallocating funds to programs more beneficial to the poor, such as prenatal care and vaccinations against pre- ventable diseases (Gupta and others 2001). President's Emergency Plan for AIDS Relief In January 2003, U.S. President George W. Bush announced the President's Emergency Plan for AIDS Relief (PEPFAR/Emergency Plan), the largest commitment ever by any nation for an international health initiative ded- icated to a single disease. It is a five-year, $15 billion, multifaceted approach to combating the disease around the world. The cumulative dis- bursements in fiscal years 2004­06 were $8.3 billion (table 12.7). The PEPFAR/Emergency Plan now leads the world in its level of support for the fight against HIV/AIDS, along with other international agencies such as the GFATM, BMGF, the World Bank, and UN agencies, led by the Joint United Nations Programme on HIV/AIDS (UNAIDS). The most recent available information from PEPFAR's website (www.pepfar.gov) suggests: · Through its partnerships with more than 30 countries, as of September 30, 2009, the PEPFAR directly supported life-saving antiretroviral treatment for over 2.4 million men, women, and children. They repre- sent more than half the estimated 4 million individuals in low- and middle-income countries on treatment. · In addition, through September 30, 2009, the PEPFAR partnerships have directly supported care for nearly 11 million people affected by HIV/AIDS, including 3.6 million orphans and vulnerable children. · In fiscal year (FY) 2009, the PEPFAR directly supported prevention of mother-to-child transmission programs that allowed nearly 100,000 babies of HIV-positive mothers to be born HIV-free, adding to the nearly 240,000 babies born without HIV because of the PEPFAR sup- port during FY2004­08. 260 Understanding Growth and Poverty Table 12.7 U.S. President's Emergency Plan for AIDS Relief (PEPFAR) US$, millions FY2004 FY2005 FY2006 FY2004­06 Programs enacted enacted enacted cumulative total Focus countries 845 1,370 1,756 3,971 Global Fund 547 347 545 1,439 Other bilateral programs 444 455 428 1,327 Other activities (including National 475 547 561 1,583 Institutes of Health research and TB programs) Total emergency plan 2,311 2,719 3,290 8,320 (without malaria) Source: PEPFAR 2007. Note: FY = fiscal year. · In FY 2009, the PEPFAR also directly supported HIV counseling and testing for nearly 29 million people, providing a critical entry point to prevention, treatment, and care. · From FY 2010 onward, the PEPFAR will report on partner countries' national achievements in service delivery and health systems strength- ening, as well as the PEPFAR's direct contributions to those achieve- ments. The new national health systems indicators are being developed in collaboration with partner countries and multilateral organizations. Conclusion The provision of basic health care is critical for economic progress, yet it remains out of reach for many of the world's poor. Health indicators vary widely across countries, and many early deaths in developing countries are preventable. Corruption, mismanagement, weak public sectors, and a lack of financial resources inhibit prevention and proper care. The inter- national community increasingly recognizes the costs of substandard health care in both human suffering and forgone economic growth. Even as some forms of development assistance are being scaled back, donors have increased their provision of health assistance in line with new health reforms included in country-owned PRSPs. Notes 1. MDG 4 targets the child mortality rate; MDG 5 targets the maternal mortal- ity rate; MDG 6 targets the number of people living with HIV/AIDS. Health 261 2. The International Monetary Fund (IMF) began providing financial assistance on concessional terms to low-income member countries in the mid-1970s, first through the Trust Fund, and then, beginning in 1986, through the SAF. Starting in December 1987, the IMF provided concessional financial assis- tance through the Enhanced Structural Adjustment Facility (ESAF). The ESAF was replaced by the Poverty Reduction and Growth Facility (PRGF) in November 1999. 3. The MDG calls for reducing under-five mortality by two-thirds between 1990 and 2015. 4. Bloom and Canning (2009) reference Fogel (2004) on the role of access to food, Deaton (2006) and Cutler and Miller (2005) on public health measures such as clean water and sanitation, and Cutler and McClellan (2001) on the increasing contribution of medical care to health outcomes. 5. A number of studies have shown the positive effects of health and nutrition on school attendance and cognitive ability (Pollitt 1997, 2001; Bhargava and Yu 1997; Kremer and Miguel 1999). 6. Easterly (1999); Cutler, Deaton, and Lleras-Muney (2006). 7. Among the other factors identified by Bloom, Canning, and Jamison (2004) are the initial level of income per capita, geographic location, institutional environment, economic policy, initial level of education, and investments in education. 8. See Jack and Lewis (2009) for a review of the literature on interpreting the correlations between health and income that highlights the methodological challenges in measurement and estimation. 9. "Despite intense efforts made by WHO and [the World Bank], most low and middle-income countries are not compiling [National Health Accounts] on a regular basis." (Hsiao and Heller 2007, 84). 10. See Evans (1984), Massaro, Nemac, and Kalman (1994), and Hsiao (1995) for a review. Hsiao and Heller (2007, 84) state that "health policy cannot auto- matically follow the free market strategy often used in economic develop- ment for economic goods." 11. Knowledge relating to what policy makers are doing in other countries, what problems they face, and how they may have resolved these problems. Similarly, public and private health insurance organizations have an interest in knowing about the cost effectiveness of new drugs and technologies. 12. For example, rationing, limits on wage rates, controlling prices, and global budget constraints. 13. Alleyne (2009, 50) notes, citing Nordhaus (2003), "in the first half of the past century, more than half of the growth in the United States, if measured in terms of full income, was due to health inputs and that, in the second half, almost as much growth in full income was due to health improvements." 262 Understanding Growth and Poverty 14. This does not preclude GDP per capita from decreasing in the long run, as education and savings rates may fall because of high mortality rates. Two stud- ies undertaken for the WHO and IMF concluded "that the AIDS epidemic in the 1990s had far more adverse economic consequences than its effects on per capita GDP would suggest" (Bloom, Canning, and Jamison 2004). 15. The CMH identifies HIV/AIDS, malaria, TB, childhood infectious diseases, maternal and prenatal conditions, tobacco-related illnesses, and micronutrient deficiencies. 16. Case, Fertig, and Paxon (2005), quoted in Bloom and Canning (2009, 57). 17. Basta, Soekirman, and Scrimshaw (1979) find sizable effects on worker pro- ductivity in Indonesia when iron supplementation was used to reduce iron deficiency. Bleakley (2003) found that children in the American South not exposed to hookworm and malaria after eradication of these diseases had higher incomes as adults compared with those born before eradication. 18. Alleyne (2009) laments the lack of a "vulgar metric" for health and worries that too little attention is being paid to developing a useful metric such as years of schooling for education. Hsiao and Heller (2007, 83) note that "most non-[Organisation for Economic Co-operation and Development] countries have not gathered the basic data on inputs and outputs of their health system, for example, total health spending; the poor's access to health care; the effi- cacy of resources used; operations in the private market; the proportion of households that may be driven into poverty by the need to incur large med- ical outlays; and consumer satisfaction." 19. Behrman (2009), referencing Walker and others (2007), identifies the follow- ing risk factors for children under five born into poverty: stunting, inadequate cognitive stimulation, iodine deficiencies, and iron deficiency anemia. 20. The United Nations (UN) estimates that, every year, roughly 30 million chil- dren born in developing countries have impaired physical development as a result of poor nutrition in utero (Bloom and Canning 2009). 21. A longer life span suggests greater savings for retirement. 22. Lee (2003) refers to this as the demographic transition. 23. The share of total bilateral aid allocated to the health sector increased from 3.8 percent in 1990 to 6.8 percent in 2002 (Michaud 2003). 24. Benin, Bolivia, Burkina Faso, Cameroon, Chad, The Gambia, Guinea, Guinea- Bissau, Guyana, Honduras, Madagascar, Malawi, Mali, Mauritania, Mozambique, Nicaragua, Niger, Rwanda, São Tomé and Príncipe, Senegal, Tanzania, Uganda, and Zambia reached the decision point in 2001, and they became eligible for interim debt relief. 25. "Some PRSPs also call for increased spending on water and sanitation (9 coun- tries), roads and road maintenance (7 countries), and rural development Health 263 (8 countries), and some include programs that provide housing for the poor and measures to strengthen social safety nets" (Gupta and others 2001). Bibliography Acemoglu, D., and S. Johnson. 2007. "Disease and Development: The Effect of Life Expectancy on Economic Growth." 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"Further Results on the Macroeconomic Effects of AIDS: The Dualistic, Labour-Surplus Economy." World Bank Economic Review 7 (3). Cuddington, J. T., and J. D. Hancock. 1994. "Assessing the Impact of AIDS on the Growth Path of the Malawian Economy." Journal of Development Economics 43: 363­68. Cutler, D. M., and M. McClellan. 2001. "Productivity Change in Health Care." American Economic Review 91 (2): 281­86. Cutler, D. M., and G. Miller. 2005. "The Role of Public Health Improvements in Health Advances. The Twentieth Century US." Demography 42 (1): 1­22. Cutler, D. M., A. S. Deaton, and A. Lleras-Muney. 2006. "The Determinants of Mortality." Journal of Economic Perspectives 20 (3): 71­96. Deaton, A. 2001. "Health, Inequality and Economic Development." Working Paper Series WGI:3, CMH and WHO, Geneva, Switzerland. ------. 2006. "The Great Escape: A Review Essay on Fogel's `The Escape from Hunger and Premature Death, 1700­2100.'" Journal of Economic Literature 44 (1): 106­44. Dixon, Simon, Scott McDonald, and Jennifer Roberts. 2001. "AIDS and Economic Growth in Africa: A Panel Data Analysis." Journal of International Development 13. Easterly, W. 1999. "Life during Growth." Journal of Economic Growth 4 (3): 239­76. Evans, R. 1984. Strained Mercy--the Economics of Canadian Health Care. Toronto: Butterworths. Fogel, R. W. 2004. The Escape from Hunger and Premature Death, 1700­2100: Europe, America and the Third World. Cambridge, U.K.: Cambridge University Press. Health 265 Gottret, P., and G. Schieber. 2006. Health Financing Revisited: A Practitioner's Guide. Washington, DC: World Bank. Greener, Robert, Keith Jefferis, and Happy Siphambe. 2001. "The Macroeconomic Impact of HIV/AIDS in Botswana." AIDS Analysis Africa 11 (4). Gupta, S., B. Clements, and E. Tiongson. 1998. "Public Spending on Human Development." Finance and Development 35 (3): 10­13. Gupta, S., B. Clements, M. T. Guin-Siu, and L. Leruth. 2001."Debt Relief and Public Health Spending in Heavily Indebted Poor Countries." Finance and Development 38 (3): 10­13. Hsiao, W. 1995. "Abnormal Economics in the Health Sector." Health Policy 32 (1­3): 125­39. Hsiao, W., and P. S. Heller. 2007. "What Should Macroeconomists Know about Health Care Policy?" IMF Working Paper WP/07/13, International Monetary Fund, Washington, DC. Jack, W., and M. Lewis. 2009. "Health Investments and Economic Growth: Macroeconomic Evidence and Microeconomic Foundations." In Health and Growth, ed. M. Spence and M. Lewis, 1­40. Commission on Growth and Development. Washington, DC: World Bank. Jamison, Dean. 2004. "External Finance of Immunization Programs: Time for a Change in Paradigm?" In Vaccines: Preventing Disease and Protecting Health, ed. C. de Quadros, 325­32. Washington, DC: Pan American Health Organization. Kambou, Gerard, Shantayanan Devarajan, and Mead Over. 1992. "The Economic Impact of AIDS in an African Country: Simulations with a General Equilibrium Model of Cameroon." Journal of African Economies 1 (1). Kremer, M., and T. Miguel. 1999. "The Educational Impact of De-Worming in Kenya." Paper presented at the Northeast Universities Development Conference, Harvard University, October 8­9. Lee, R. 2003. "The Demographic Transition: Three Centuries of Fundamental Change." Journal of Economic Perspectives 17 (4): 167­90. Massaro, T. A., J. Nemac, and I. Kalman 1994. "Health System Reform in the Czech Republic--Policy Lessons from the Initial Experience of the General Health Insurance." Journal of the American Medical Association 271 (23): 1870­74. Michaud, C. 2003. "Development Assistance for Health (DAH): Recent Trends and Resource Allocation." Paper prepared for the Second Consultation of the CMH, Geneva, Switzerland, October 29­30. Nordhaus, W. 2003. "The Health of Nations: The Contribution of Improved Health to Living Standards." In Measuring the Gains from Medical Research: An Economic Approach, ed. K. M. Murphy and R. H. Topel, 9­40. Chicago: University of Chicago Press. 266 Understanding Growth and Poverty Ntozi, J. P. M., and F. E. Ahimbisibwe. 1999. "Some Factors in the Decline of AIDS in Uganda." In The Continuing African HIV/AIDS Epidemic, ed. J. C. Caldwell, I. O. Orubuloye, and J. P. M. Ntozi, 93­107. Canberra: Australian National University, National Centre for Epidemiology and Population Health, Health Transition Centre. Over, M. 1992. "The Macroeconomic Impact of AIDS in Sub-Saharan Africa." Technical working paper No. 3, World Bank, Washington, DC. PEPFAR (President's Emergency Plan for AIDS Relief). 2007. "The Power of Partnerships." Third Annual Report to Congress on PEPFAR, Washington, DC. Pollitt, Ernesto. 1997. "Iron Deficiency and Educational Deficiency." Nutrition Reviews 55 (4): 133­41. ------. 2001. "Nutrition in Early Life and the Fulfillment of Intellectual Potential." Journal of Nutrition 125 (4 Supplement): 1111S­1118S. Preston, S. 1975. "The Changing Relation Between Mortality and Level of Economic Development." Journal of Population Studies 29 (2): 231­48. Quattek, K., and T. Fourie. 2000. Economic Impact of AIDS in South Africa: A Dark Cloud on the Horizon. Johannesburg, South Africa: ING Barings, South African Research. Sala-i-Martin, X., G. Doppelhofer, and R. I. Miller. 2004. "Determinants of Long- Term Growth: A Bayesian Averaging of Classical Estimates (BACE) Approach." American Economic Review 94 (4): 813­35. Schultz, T. P. 2002. "Wage Gains Associated with Height as a Form of Human Capital." American Economic Review, Papers and Proceedings 92 (2): 349­53. Sen, A. K. 1999. Development as Freedom. New York: Knopf. Viscusi, W. K., and J. E. Aldy. 2003. "The Value of a Statistical Life. A Critical Review of Market Estimates from Around the World." Journal of Risk and Uncertainty 27 (August): 5­76. Walker, S. P., T. Wachs, J. M. Gardner, B. Lozoff, G. Wasserman, E. Pollitt, and J. Carter. 2007. "Child Development: Risk Factors for Adverse Outcomes in Developing Countries." Lancet 369 (9556): 145­57. World Bank. 2000. "Lesotho: The Development Impact of HIV/AIDS: Selected Issues and Options." Macroeconomic Technical Group, Africa Region, Report No. 21103-LSO, Washington, DC. ------. 2001a. "Namibia: Selected Development Impact of HIV/AIDS." Macroeconomic Technical Group, Africa Region, Report No. 22046-NAM, Washington, DC. ------. 2001b. "Swaziland: Selected Development Impact of HIV/AIDS." Macroeconomic Technical Group, Africa Region, Report No. 22044-SW, Washington, DC. Health 267 World Bank. 2005. World Development Indicators. Washington, DC: World Bank. ------. 2007. World Development Indicators. Washington, DC: World Bank. World Health Organization. 2001. "Key Facts and Findings on the Linkages of Health and Development." World Health Organization. http://www.who .int/macrohealth/background/findings/en/print.html. ------. 2003. "Increasing Investments in Health Outcomes for the Poor." Second Consultation on Macroeconomics and Health, Geneva. ------. 2005. "Health and the Millennium Development Goals." World Health Organization, Geneva. ------. 2006. "Working Together for Health." World Health Report 2006, World Health Organization, Geneva. CHAPTER 13 Labor Markets The labor market is one of the main conduits through which economic growth can help reduce poverty. Economic growth arises from increased employment and productivity. On the flip side, an economy's failure to translate economic growth into employment opportunities can retard efforts to reduce poverty. Labor is the main asset of the poor, and jobs are the highway out of poverty.1 The functioning of countries' labor markets is affected by a wide array of factors, among them labor market conditions (affected by labor and tax regulations, among other things), natural resources, cultural factors, and long-run economic performance. In addition, external factors such as globalization and technology play an increasing part in determining labor market outcomes within countries. Improving labor market conditions to tangibly reduce poverty requires both immediate and long-term actions. In the short run, the labor mar- ket must be made more flexible; in the long run, closing the gap between labor supply and demand requires improvements in human capital and training. This chapter first analyzes the "labor friendliness" of economic growth-- a recurring theme in the literature on developing economies. We will see that such employment-intensive economic growth, while sometimes 269 270 Understanding Growth and Poverty effective, is a double-edged sword--as it may also impede improvements in labor productivity. After analyzing the link between investment climate and labor market performance, we conclude by examining labor supply trends of particular interest to developing countries, including trends in labor force growth rates, unemployment, wages, skills, and gender issues. Labor-Friendly Economic Growth If economic growth is to reduce poverty, it must be labor friendly. What does this mean? If growth in output is not translated into growth in employment, unemployment may actually increase or more people may be driven into marginal jobs in the informal sector. In recent years, strong economic growth in the economies of the former Soviet Union has been accompanied by large and increasing rates of unemployment. The unem- ployment rate in Montenegro, Poland, Serbia, and the Slovak Republic has been close to 20 percent, with declining labor force participation rates. A similar tale can be told in Latin America, where the unemploy- ment rate doubled to more than 10 percent in Argentina, Brazil, and Chile during the 1990s--accompanied by an expansion of the informal sector, an increase in the ranks of the working poor, and rising wage and income inequality. Although many countries in East and South Asia man- aged to successfully combine strong economic growth with increasing employment, for many other developing regions (especially Sub-Saharan Africa), increases in the working-age population outstripped the growth of job opportunities in the formal sector, resulting in an increase of infor- mal sector jobs. In developing countries, where social protection for unemployment is inadequate or absent, unemployment is not really an option for most peo- ple living in poverty. For the working poor, insufficient compensation means living below an accepted poverty line. Meanwhile, vulnerable employment is characterized by inadequate earnings, low productivity, and difficult work conditions that undermine workers' fundamental rights (ILO 2010, 18). Vulnerable employment shares are indicative of informal economy employment in developing regions (ILO 2010, 18). Vulnerable employ- ment shares in the world and by region are examined in table 13.1. As would be expected, the share of vulnerable employment in the developed economies and the European Union (EU) pales in comparison to that in the developing world. South Asia and Sub-Saharan Africa suffer most, with over three-quarters of employment deemed vulnerable. Labor Markets 271 Table 13.1 Vulnerable Employment Shares, World and Regions percent 2009* 1998 1999 2000 2005 2006 2007 2008* S1 S2 S3 World 53.4 53.3 52.8 51.3 50.8 50.6 49.5 49.4 50.6 52.8 Developed economies and EU 11.1 10.9 10.7 10.1 9.9 9.8 9.7 9.9 10.3 10.7 Central and Southeastern Europe (non-EU) and CIS 22.2 25.0 24.6 22.0 21.5 20.5 19.5 18.0 21.5 26.2 East Asia 61.5 60.2 59.0 56.4 55.9 55.9 53.2 52.0 53.3 56.4 Southeast Asia and Pacific 63.4 65.8 64.9 62.5 62.2 61.8 60.7 59.7 61.5 64.1 South Asia 80.2 79.8 80.3 78.8 78.6 78.0 76.9 76.9 77.4 78.6 Latin America and the Caribbean 34.7 35.0 34.4 32.4 32.4 31.1 31.0 31.8 31.9 33.6 Middle East 51.1 46.6 43.7 39.9 39.9 39.1 38.1 38.3 39.0 45.5 North Africa 43.8 42.1 40.7 40.7 40.7 39.0 37.9 37.3 40.4 43.1 Sub-Saharan Africa 81.9 81.4 81.1 77.2 77.2 76.7 75.5 75.7 76.9 79.6 Source: ILO 2010, 53. Note: * = preliminary estimate; CIS = Commonwealth of Independent States; EU = European Union; S = scenario. Against the background of favorable growth rates in the developing world (see table 13.2) and prior to the ongoing global financial crisis, vulnerable employment shares were declining across all regions. Vulnerable employment decreased globally by 3.9 percentage points between 1998 and 2008. Between 2007 and 2008, vulnerable employ- ment fell by 10.5 million people (ILO 2010, 18). This trend is unlikely to continue in the wake of the financial crisis; the International Labour Organization (ILO) suggested two possible outcomes for 20092--either a reversal of the gains since 2007 (table 13.1, S2) and a worldwide vul- nerable employment share of 50.6 percent, or a reversal of the gains since 2000 (table 13.1, S3) and a vulnerable employment share of 52.6 percent. These shares are equivalent to 1.48 and 19.59 billion vulnerable workers, respectively, worldwide (ILO 2010, 18). Moreover, the ILO expected that the crisis would further increase the share of vulnerable workers, particularly males, in the three Asian regions and Sub-Saharan Africa, given the lack of job security in these regions. It expected that Central and Southeastern Europe (non-EU), the Commonwealth of Independent States (CIS) members, and the Middle East and North Africa would be 272 Understanding Growth and Poverty worst hit, with vulnerable employment increasing by more than 5 per- centage points in the worst-case scenario (table 13.1, S3). The number of working poor was also on a downward trend prior to the global financial crisis, suggesting a 16.3 percentage point decline between 1998 and 2008 for those falling below the $1.25 a day line and a 17 percentage point decline for those falling below the $2 a day poverty line (tables 13.2 and 13.3, respectively). Worldwide, the share of working poor was 21.2 percent, or 633 million people living on less than $1.25 a day (table 13.2); meanwhile, 39.7 percent of workers, or 1.2 billion peo- ple, were classified as working poor (living on $2 a day) (table 13.3). It is likely that the global financial crisis has also had an impact on the numbers of working poor. Refuting the small decreases that might have occurred in 2009 had the working poor maintained their historical down- ward trend,3 the ILO suggests that at the $1.25 a day poverty line, an increase of 7 percentage points in the working poor was possible. This would translate into an additional 215 million workers (table 13.2). At the $2 a day poverty line, the ILO estimates an additional 5.9 percent of workers joining the working poor, or 185 million (table 13.3). Again, the regions likely to suffer most are South Asia, Southeast Asia, and Sub- Saharan Africa, reflecting the fact that many workers are just above the poverty line there (ILO 2010, 22). Employment and Productivity during Economic Growth An examination of the concept of employment elasticity sheds some light on the employment intensity of growing output. Employment elasticity measures (in percentage points) the change in the number of employed persons in a country or region associated with an increase in economic output, measured by gross domestic product (GDP). Essentially a ratio of the growth in employment (numerator) to the growth in output (denom- inator), employment elasticity varies across countries and across time. Research at the ILO shows that labor supply growth, the size of a country's service sector, instability, uncertainty, and taxes on labor earn- ings are relevant in explaining the intensity of a country's growth in employment (Kapsos 2005). Examining changes in output, along with changes in employment elas- ticity, helps explain whether growth is bringing gains in employment and labor productivity, or whether it is balanced between the two. Globally, employment elasticities ranged between 0.3 and 0.38 percentage points from 1991 to 2003 (Kapsos 2005). Thus, for every percentage point increase in GDP, employment growth grew by one-third and productivity Table 13.2 Working Poor Indicators, World and Regions ($1.25 a Day) Numbers of people (millions) Share in total employment (%) 2009* 2009* 1998 2003 2008* S1 S2 S3 1998 2003 2008 S1 S2 S3 World 945 778 633 632 744 849 37.5 28.5 21.2 21.1 24.8 28.3 Central and Southeastern Europe (non-EU) and CIS 11 9 7 7 8 10 7.3 6.1 4.0 4.1 5.3 6.3 East Asia 372 201 87 78 100 124 52.0 26.5 11.0 9.7 12.6 15.6 Southeast Asia and Pacific 101 81 64 64 78 92 44.9 32.5 23.3 23.0 27.8 32.7 South Asia 276 285 274 275 328 374 56.7 53.0 45.5 44.9 53.5 61.0 Latin America and the Caribbean 26 28 17 18 21 25 13.4 12.8 6.6 7.0 8.5 9.9 Middle East 4 5 5 5 7 8 9.5 9.5 8.1 8.1 10.4 12.7 North Africa 10 10 9 9 10 12 19.9 19.9 13.7 13.6 15.6 17.7 Sub-Saharan Africa 146 160 172 177 191 204 66.5 63.0 58.6 58.7 63.5 67.7 Source: ILO 2010, 54. Note: * = preliminary estimate; CIS = Commonwealth of Independent States; S = scenario. 273 274 Table 13.3 Working Poor Indicators, World and Regions ($2 a Day) Numbers of people (millions) Share in total employment (%) 2009* 2009* 1998 2003 2008* S1 S2 S3 1998 2003 2008 S1 S2 S3 World 1,429 1,328 1,185 1,187 1,283 1,368 56.7 48.6 39.7 39.5 42.8 45.6 Central and Southeastern Europe (non-EU) and CIS 31 24 21 22 25 29 21.2 15.6 12.8 13.6 15.5 18.0 East Asia 549 390 231 214 244 272 76.7 51.4 29.3 26.8 30.6 34.1 Southeast Asia and Pacific 158 156 142 144 161 175 70.0 62.6 51.5 51.4 57.4 62.5 South Asia 419 454 479 485 510 529 86.2 84.4 79.5 79.1 83.2 86.2 Latin America and the Caribbean 54 57 38 41 47 53 27.7 26.0 15.3 16.2 18.7 21.3 Middle East 11 13 14 15 17 20 24.3 24.5 22.9 22.8 26.6 30.7 North Africa 20 20 20 20 24 29 40.6 36.9 30.7 30.4 36.9 43.5 Sub-Saharan Africa 188 214 239 246 255 262 85.8 84.4 81.6 81.6 84.7 86.9 Source: ILO 2010, 54. Note: * = preliminary estimate; CIS = Commonwealth of Independent States; S = scenario. Labor Markets 275 growth by two-thirds. Positive economic growth accompanied by an employment elasticity of greater than one indicates declining labor pro- ductivity and an increase in lower-productivity jobs. Opinion varies on whether employment-led or productivity-led growth is more advanta- geous from a development perspective. The employment elasticity in individual sectors--where value added in an economic sector such as agriculture, manufacturing, or services replaces GDP in the denominator--links employment growth to changes in the sectoral composition of employment. Low employment elasticity and pos- itive sectoral growth for a given sector suggest productivity growth. If this scenario continues and is accompanied by reduced employment in the given sector--and if overall economic growth is positive--then it is prob- able that structural change is occurring. At the early stages of develop- ment, structural change is indicative of a movement away from agriculture to manufacturing, and, at later stages of development, low-employment elasticities and positive sectoral growth suggest a movement out of manu- facturing into services. Based on data from 139 countries, table 13.4 shows employment elasticities by sector and value-added growth rates in each sector during the period 1991­2003 (Kapsos 2005). The services sector was the fastest growing (3 percent) in the 139 countries; it also provided the most job-intensive growth: for every per- centage point of growth in the services sector, employment increased by 0.57 percentage points, as shown in table 13.4. On the other hand, productivity growth contributed more to growth in the agricultural and industrial sectors over the period. Structural change-- that is, a movement from agriculture and industry to service sectors-- played an important role in these divergent results; nevertheless, new jobs were created in both agriculture and industry, and agriculture remains the world's largest employment sector (1.2 billion workers in 2003), reflecting its importance in developing economies. Gutierrez and others (2007) find that what matters for poverty reduc- tion is the sectoral pattern of employment and productivity growth. In the Table 13.4 Employment Elasticities by Sector for 139 Countries, 1991­2003 Agriculture Industry Services Sector value-added elasticity 0.41 0.28 0.57 Average annual value-added growth rate (%) 2.0 2.1 3.0 Source: Kapsos 2005. 276 Understanding Growth and Poverty short run, the overall employment intensity of growth is largely irrelevant for poverty reduction. Employment-intensive growth in the manufactur- ing sector was associated with decreases in poverty, whereas productivity growth in agriculture promoted poverty reduction. Thus, focusing solely on employment intensity of overall growth misses the details. Examining manufacturing employment and agricultural productivity has lessons for poverty reduction. Turning to a regional analysis, East Asia witnessed the most growth over the period 1991­2003, with average annual GDP growth of almost 10 percent, while Latin America experienced a declining growth rate, reflecting, in part, deep financial crises across several countries during the study period (table 13.5). In terms of the employment intensity of growth, economic growth in Latin America was much more employ- ment intensive than growth in East Asia. Employment elasticities ranged from 0.45 to 0.70 in Latin America compared with 0.14 to 0.16 in East Asia, suggesting that growth in East Asia was driven by increased labor productivity. The high employment elasticities shown for the Middle East (in excess of 1) suggest that labor productivity actually declined over the majority of the study period. Similarly, the high employment elasticities for North Africa and Sub-Saharan Africa suggest a high employment intensity of economic growth, reflecting the region's very high population growth rate. Trends in employment elasticities can also indicate structural shifts in an economy (table 13.6). For example, a 1 percentage point increase in GDP in South Asia between 1991 and 2003 was associated with Table 13.5 Employment Elasticities and Average Annual GDP Growth by Developing Region Total employment elasticity Average annual GDP growth 1991­95 1995­99 1999­2003 1991­95 1995­99 1999­2003 East Asia 0.14 0.14 0.16 11.6 7.4 7.7 Southeast Asia and Pacific 0.39 0.20 0.38 7.4 1.6 4.8 South Asia 0.40 0.49 0.49 6.0 5.8 5.1 Latin America 0.65 0.70 0.45 3.5 2.7 1.4 Caribbean 0.43 0.37 ­0.42 1.9 5.2 2.5 Middle East 1.10 1.29 0.91 3.9 3.0 4.1 North Africa 0.30 0.74 0.51 2.2 4.8 4.1 Sub-Saharan Africa 0.73 0.82 0.53 1.1 3.2 3.2 Source: Kapsos 2005. Labor Markets 277 Table 13.6 Employment Elasticities and Growth by Sector and Region, 1991­2003 Average annual value-added Employment elasticity growth rate (%) Agriculture Industry Services Agriculture Industry Services East Asia 0.23 0.06 0.50 3.7 12.5 8.8 Southeast Asia and Pacific 0.20 0.68 0.99 2.1 5.4 4.6 South Asia 0.71 0.37 0.36 2.9 5.9 6.9 Latin America ­0.33 0.54 1.04 2.5 2.2 2.6 Caribbean ­0.11 0.05 0.99 2.5 3.7 3.8 Middle East 1.94 0.26 0.70 3.9 1.3 4.6 North Africa 0.55 0.43 0.76 2.4 3.2 4.0 Sub-Saharan Africa 0.82 0.90 0.79 2.3 2.0 2.8 Source: Kapsos 2005. an increase in agricultural employment of 0.71 percent, an increase in industrial employment of 0.37 percent, and an increase in service sector employment of 0.36 percent. This trend suggests that South Asia is not exhibiting a significant degree of structural economic change away from agriculture and into industry and services. On the other hand, in Latin America and the Caribbean, a 1 percentage point increase in GDP was associated with a decrease in agricultural employment of ­0.33 percent and ­0.11 percent, along with an increase in service sector employment of 1.04 and 0.99 percent. This evidence indicates ongoing structural changes in the region--in particular a movement away from jobs in agri- culture toward those in the service sector. There was unprecedented growth over the 2003 to 2007 period (see table 13.7); all regions, except the developed economies and EU, recorded growth rates in excess of 5 percent in 2007. But given the vagaries of the regional labor markets,4 translating this growth into employment is not always easy. We return to this point below. Following the onset of the financial crisis in 2007, growth rates were down in all regions in 2008, with the largest decline in East Asia--almost a 4 percentage point decrease. Preliminary estimates for 2009 showed that the developed economies and the EU, Central and Southeastern Europe (non-EU), and the former CIS were particularly hard hit. Estimates for all other regions, except East and South Asia, were below 5 percent in 2009. Projections for 2010 suggest a recovery in late 2009 that will see growth rates increase for all regions, albeit at significantly lower rates than those prevailing in the mid-2000s. 278 Understanding Growth and Poverty Table 13.7 Annual Real GDP Growth Rates, World and Regions percent 2004 2005 2006 2007 2008 2009* 2010p World 4.9 4.5 5.1 5.2 3.0 ­1.1 3.1 Developed economies and European Union 3.1 2.6 2.9 2.6 0.6 ­3.5 1.1 Central and Southeastern Europe (non-EU) and CIS 8.3 7.0 7.9 7.6 4.5 ­6.5 2.4 East Asia 8.9 8.9 10.0 11.2 7.3 6.1 7.9 Southeast Asia and Pacific 6.5 5.9 6.2 6.5 4.4 0.5 4.0 South Asia 7.6 8.8 9.1 8.7 6.6 5.0 6.0 Latin America and the Caribbean 6.0 4.7 5.7 5.7 4.2 ­2.5 2.9 Middle East 6.4 5.8 5.5 6.1 4.9 1.4 4.1 North Africa 4.7 5.0 6.1 5.8 5.5 3.7 4.3 Sub-Saharan Africa 7.2 6.1 6.3 6.8 5.4 1.2 4.1 Source: ILO 2010, 45. Note: * = preliminary estimate; p = projection. Examining output per worker sheds some light on how employment responded to the impressive growth rates experienced over the period. Table 13.8 shows output per worker for the world and regions. Labor pro- ductivity in 2006 and 2007 was greater than that in the previous five years (2000­05) for all regions, except the developed economies and EU. Following the crisis, labor productivity declined in all regions and while most (except Southeast Asia and Pacific and the developed economies and EU) maintained a productivity level greater than that in 2000­05, the percentage point difference between 2007 and 2008 ranged from a fall of 0.3 percentage points in Central and Southeastern Europe (non- EU) and CIS to a fall of 3 percentage points in East Asia. The Middle East and North Africa actually increased their labor productivity in 2008 over 2007. Preliminary estimates for 2009 show negative growth, suggesting that the declines in GDP were greater than the declines in employment in all regions except East Asia, South Asia, and North Africa. Declines in output per worker put downward pressure on working conditions, with implications for wages and earnings, especially in regions with low labor productivity. So far, we have emphasized the distinction between labor productivity and employment intensity in contributing to overall growth and sectoral value-added growth. In fact, both goals should be pursued in tandem Labor Markets 279 Table 13.8 Output per Worker, Level, and Growth Rate 2009* Annual growth (%) CI lower Preliminary CI upper 2000­05 2006 2007 2008 bound estimate bound World 1.9 2.9 3.0 1.8 ­2.9 ­2.5 ­2.2 Developed Economies and European Union 1.4 1.3 1.0 0.2 ­1.4 ­1.3 ­1.2 Central and Southeastern Europe (non-EU) and CIS 4.9 6.3 5.3 5.0 ­4.9 ­4.7 ­4.3 East Asia 7.3 9.4 10.6 7.6 3.6 4.0 4.3 Southeast Asia and Pacific 3.3 4.0 3.8 2.1 ­2.1 ­1.8 ­1.6 South Asia 4.4 6.3 6.1 4.4 2.2 2.6 2.9 Latin America and the Caribbean 0.2 2.1 3.3 1.9 ­3.9 ­3.5 ­3.2 Middle East 1.7 2.2 2.9 3.7 ­3.1 ­2.5 ­1.9 North Africa 1.0 1.8 2.9 3.2 ­0.2 0.6 1.3 Sub-Saharan Africa 1.8 3.1 3.4 2.0 ­2.1 ­1.7 ­1.4 Source: ILO 2010, 49. Notes: * = preliminary estimate; CI = confidence interval. Calculations are based on constant 2005 purchasing power parity­adjusted international dollars. to further economic development. To do this, one needs information on other labor market indicators--job quality, demographics (labor supply), labor demand, and so on--to be able to fully examine the link between labor market improvements and economic development. Economic growth reduces poverty when there is a strong link between labor market improvements and economic development. Job Quality, the Informal Labor Market, and the Investment Climate Employment intensity and labor productivity offer no information on the quality of jobs created. Yet the type of jobs created is important in a developing economy, where so much of the labor market is in the infor- mal sector. The mismatch between job gains and losses in this context often swells the informal sector. Minimal unemployment benefits mean that dismissed workers cannot afford to be unemployed and are left with no choice but to seek work in the informal sector. Macro and structural reforms in the labor market should strive for greater equity and efficiency to increase workers' economic opportunities and broaden access to the labor market. As noted in the World Bank's 280 Understanding Growth and Poverty World Development Report for 2006, the "playing field may be uneven if protection for formal-sector workers, while bringing valued benefits to some, slows processes of restructuring and job creation for other workers" (World Bank 2006)--and if it maintains a large informal sector domi- nated by undesirable jobs. Besley and Burgess (2002) analyze the link between labor regulations (including the bargaining power of labor and modes of settlement of labor disputes) and the output of registered manufacturing firms in sev- eral Indian states over a long period. Their evidence shows that regulating in a pro-worker direction was associated with lower levels of investment, employment, productivity, and output. Regulation that is too favorable to labor can also affect the investment climate. It is widely accepted that investment-climate reforms--including changes in trade barriers, products, and labor markets--are essential to set countries on a path to growth that is sustainable in the long term. Where the investment climate is good and the labor market functions well, one finds greater employment opportunities, lower levels of informal work, better working conditions, and the potential for rising wages. But in the short run, efforts to improve the investment climate can be costly to workers. As the investment climate improves, for example, domestic firms may experience a reduction in trade barriers, reduced state support, and increased competition from foreign-owned firms, which may lead them to cut jobs, at least in the short run. Labor Markets in Developing Countries Eighty percent of the world's labor force works in developing countries, where labor markets are very different from those in developed countries. In many developing countries, more than half the population of working age labors in the informal economy, where working conditions can be poor (World Bank 2005). Behrman (1999) notes additional differences. In the developing world, agriculture and other rural labor activities are much more important than they are in the industrial world. Nonwage labor (such as that of unpaid family workers) plays a much more impor- tant role in the economy, particularly in agriculture. Labor forces grow more rapidly, and labor force participation rates among those ages 15­64 are higher (particularly for low-income countries, in part because of lower school enrollment rates). Human capital investment is lower, with larger gender gaps, and nonlabor production inputs per worker are much smaller. In the developing world, social protection such as unemployment Labor Markets 281 insurance either does not exist or has very limited coverage. Few house- holds have the resources to weather a period of unemployment. Therefore, many who lose their jobs must look for work in the informal sector and have no option but to choose undesirable jobs (Bourguignon 2005). The ILO (2010), in a synopsis of regional developing labor markets, noted the following: · The limited increase in the unemployment rate in Sub-Saharan Africa (to 8.2 percent in 2009 from 8.0 percent in 2008, see below) is not indicative of the true state of the labor market--the share of vulnerable and working poor should also be consulted. Furthermore, discouraged workers are an important phenomenon in Sub-Saharan Africa. · The labor market in North Africa continues to face a large number of challenges, namely, a rapidly growing labor force (2.6 percent annually over the past 10 years); high unemployment rates, especially among youth; low labor force participation rates among women; slow increases in productivity, with repercussions for wages and earnings; and large shares of the vulnerable and working poor. · Youth unemployment and large shares of vulnerable and working poor also characterize the labor market in the Middle East. Furthermore, there are large gaps between the sexes in labor force participation rates, with female participation rates just over one-third of male rates. The 2009 estimate of 25.4 percent of women is the lowest among all regions. · Favorable economic conditions in Latin America and the Caribbean-- rapid economic growth, rising exports, high commodity prices, and abundant financing--yielded positive spin-offs for the labor market over the past decade as seen in reduced rates of vulnerable employ- ment and reduced unemployment rates. This has been curtailed in the wake of the global financial crisis with negative effects for the work- ing poor, vulnerable employment, and unemployment. · East Asia boasts the highest employment-to-population ratio among all the regions--almost 70 percent of the working-age population is employed. The figure has been declining, however, as young people spend longer in school and older workers retire and exit the labor market. The share of workers in salaried employment has grown 282 Understanding Growth and Poverty significantly in East Asia in recent years, reaching 45 percent in 2008. Significant gains have been made among the working poor in the past decade, with an estimated 29 percent living with their families on less than $2 a day and 11 percent living with their families on less than $1.25 a day in 2008--versus 75 percent and 50 percent, respectively, a decade earlier. The negative impacts of the ongoing crisis are expected to be offset by declining commodity prices, and economic growth is expected to rebound sharply with unemployment expected to decline slightly to 4.3 percent (see below). · Southeast Asia and Pacific are heavily dependent on foreign trade and investment flows, and thus have been hit hard by the ongoing crisis. Unemployment has increased, especially among men. Youth unem- ployment is a big concern in this region and there is a large gender gap in labor force participation. Labor force participation among the youth has declined, which may suggest more youth staying on in education or becoming discouraged. Vulnerable employment and the working poor remain big issues in this region. · South Asia suffered least from the recent crisis, due principally to the fact that its two largest countries--India and Pakistan--are less reliant on exports than many of the other countries in the Asian regions. The region's workforce has a large proportion of working poor and many in vulnerable employment. Progress has been made in extending social protection in the region but much remains to be done. Labor Supply and Unemployment Labor supply depends on population--its age composition, gender com- position, skill level, global distribution, and migration patterns. Table 13.9 examines labor supply trends by region for 1990 and 2006 and forecasts for 2016. Developing economies account for 64 percent of the global working-age population (World Bank 2008); these economies' labor forces are expected to expand very rapidly. Across the regions, the labor force in Sub-Saharan Africa, South Asia, and the Middle East and North Africa increased by at least 2 percent per year. Population growth is the principal factor driving labor force growth, and while the rate of popula- tion increase has slowed in most developing countries, the working-age population continues to grow, at least for the time being. (Changes in population growth affect the labor force only after a lag of some years.) We know little about rates of unemployment and underemployment in the developing world, compared with the wealth of data collected by Labor Markets 283 Table 13.9 Labor Supply Trends by World, Region, and Income Working-age Average Share of (15­64 years) annual women in population labor force Average annual labor force (millions) growth (%) population growth (%) (%) 2006 1990­2006 1990­2006 2006­16p 1990 2006 East Asia and Pacific 1,317.8 1.4 1.1 0.8 44.1 43.5 Eastern Europe and Central Asia 317.3 ­0.1 0.1 0.0 45.7 44.7 Latin America and the Caribbean 356.5 2.6 1.5 1.1 33.9 40.8 Middle East and North Africa 195.7 3.4 2.0 1.7 22.9 28.0 South Asia 928.1 2.0 1.8 1.4 29.7 29.3 Sub-Saharan Africa 419.0 2.7 2.6 2.3 43.0 42.2 High-income economies 691.6 0.9 0.7 0.4 41.4 43.4 World 4,223.6 1.6 1.4 1.1 39.7 39.9 Source: World Bank 2008. Note: p = projection. labor economists in the industrial economies. The data that do exist are often unreliable and not susceptible to cross-country comparison. They are notoriously incomplete in Africa and South Asia, where large rural and informal sectors exist. In Latin America, the term unemployment often refers to urban unemployment only. Unemployment increased in all the developing countries during the 1990s (Betcherman 2002). The scenario during 2000 to 2007 was much different, reflecting the favorable growth rates experienced by the regions, as outlined in table 13.7. The unemployment rates in 2007 represented a marked decrease from those in 1999 (table 13.10) across all regions except South Asia and to a lesser extent Southeast Asia and Pacific. Following the onset of the global financial crisis, in 2008, a number of the developing regions had the same unemployment rate as in 2007 or only a marginally lower rate (the Middle East, South Asia, Southeast Asia and Pacific, North Africa, and Sub-Saharan Africa). The preliminary esti- mates for 2009 indicated an increase in unemployment in all regions; some regions--Sub-Saharan Africa, the Middle East, Latin America and the Caribbean--were expected to return to 1999 rates (table 13.10). Those regions reliant on international trade were hard hit, and the progress made over 2000­07 was reversed in many regions, with adverse implications for the working poor and those in vulnerable employment. Meanwhile, the issue of youth unemployment continues to be a major worry for many regions. Table 13.11 examines the share of youth 284 Table 13.10 Unemployment Rates by World, Region, and Economy percent 2009* CI lower Preliminary CI upper For men and women 1999 2000 2004 2005 2006 2007 2008 bound estimate bound World 6.4 6.2 6.4 6.3 6.0 5.7 5.8 6.3 6.6 6.9 Developed economies and European Union 7.0 6.7 7.2 6.9 6.3 5.7 6.0 8.3 8.4 8.5 Central and Southeastern Europe (non-EU) and CIS 12.4 10.6 9.7 9.4 9.0 8.3 8.3 10.0 10.3 10.6 East Asia 4.7 4.5 4.2 4.2 4.0 3.8 4.3 4.1 4.4 4.8 Southeast Asia and Pacific 5.1 5.0 6.4 6.5 6.1 5.4 5.3 5.4 5.6 5.9 South Asia 4.3 4.5 5.2 5.3 5.1 5.0 4.8 4.8 5.1 5.5 Latin America and the Caribbean 8.5 8.4 8.4 8.0 7.4 7.0 7.0 7.9 8.2 8.5 Middle East 9.3 9.5 9.3 10.0 9.5 9.3 9.2 8.8 9.4 10.0 North Africa 13.1 14.0 12.3 11.5 10.4 10.1 10.0 9.8 10.5 11.1 Sub-Saharan Africa 8.2 8.3 8.2 8.2 8.2 8.0 8.0 7.9 8.2 8.5 Source: ILO 2010, 46. Notes: * = preliminary estimate; CI = confidence interval. Table 13.11 Unemployment Rates for Youth by World, Region, and Economy percent 2009* CI lower Preliminary CI upper 1999 2000 2004 2005 2006 2007 2008 bound estimate bound World 12.6 12.5 13.0 13.0 12.4 11.8 12.1 12.7 13.4 14.0 Developed economies and European Union 13.9 13.2 14.4 14.1 13.0 12.2 13.1 17.5 17.7 17.8 Central and Southeastern Europe (non-EU) and CIS 22.7 19.9 19.6 19.1 18.5 17.5 17.1 20.9 21.5 22.0 East Asia 9.2 8.9 8.5 8.4 8.2 7.8 8.7 8.3 9.0 9.7 Southeast Asia and Pacific 13.1 13.2 17.0 17.9 17.2 14.9 14.4 14.6 15.3 16.0 South Asia 9.8 10.2 10.3 10.4 10.0 9.9 9.9 10.0 10.7 11.5 Latin America and the Caribbean 15.6 15.5 16.5 16.1 15.1 14.1 14.3 16.1 16.6 17.5 Middle East 20.5 21.1 20.8 22.6 21.6 21.4 21.7 20.9 22.3 23.8 North Africa 27.3 29.9 27.2 26.8 24.2 23.6 23.5 23.2 24.7 26.1 Sub-Saharan Africa 12.6 12.6 12.6 12.4 12.4 12.3 12.3 12.0 12.6 13.0 Source: ILO 2010, 47. Notes: * = preliminary estimate; CI = confidence interval. 285 286 Understanding Growth and Poverty unemployment in recent years and its estimated response to the onset of the global financial crisis. Similar to the total unemployment rate (table 13.10), the largest increases in youth unemployment between 2008 and 2009 (estimated) occurred in the developed economies and the EU (an increase of 4.6 per- centage points between 2008 and 2009), in Central and Southeastern Europe (non-EU) and CIS (a 4.4 percentage point increase), and in Latin America and the Caribbean (a 2.3 percentage point increase). Youth unemployment is a major concern in the Middle East and North Africa, with one in five of the regions' youth classified as unemployed. Wages Conclusions on wages and worker compensation in developing countries are also difficult to make owing to poor and incomplete data. Often the only data collected are for manufacturing. In countries with large rural and informal sectors, such data fail to give an accurate picture of worker com- pensation. It is difficult to compare trends over time and across countries because of data inconsistencies and differences in productivity, the bargain- ing power of workers, and social security (Betcherman 2002). Nevertheless, the ILO and the World Bank do the best they can to collect data on workers' compensation, as measured by payroll costs, not just wages. Keeping these caveats in mind, let us consider some of the disparities that appear across countries. For example, an average worker in manufac- turing in Kenya earned less than $100 a year in the early 1990s, whereas an average worker in Brazil earned more than $14,000 a year. In terms of earnings growth, East Asian countries experienced increases in real wages of between 25 and 31 percent in the early 1990s, while real wages declined in South Asia and Sub-Saharan Africa, with mixed trends in the Latin American region.5 Within regions, the best measure of wage inequality is income inequality (because, in most countries, wages are the primary source of income). Data on various inequality measures, and in particular the Gini coefficient--as quoted in Betcherman (2002)--show that inequality varies dramatically across countries, with developing countries exhibiting much higher and increasing levels than developed countries. The United Nations Development Programme (UNDP 2009) tabu- lates the Gini coefficient for 148 countries for the period 1992­2007 (figure 13.1). We selected a number of countries to show the range of values. Denmark had the lowest Gini coefficient of 24.7 and Namibia had the highest, 74.3. The greatest proportion of the 148 countries had Labor Markets 287 Figure 13.1 Income Inequality (Gini Coefficient) in Select Countries, 1992­2007 Namibia Comoros Botswana Bolivia South Africa Brazil Ecuador Guatemala Côte d'lvoire Mozambique Cameroon Ghana Russian Federation Estonia Spain Hungary Germany Japan Denmark 0 20 40 60 80 Gini coefficient Source: UNDP 2009. values between 30 and 39. Many countries in Africa scored in the 40s and 50s, as did some Latin American economies. Skills The link between education (and other forms of human capital invest- ment) and sustainable long-run economic growth is strong, as we saw in chapter 11 of this book. Pierre and Scarpetta (2004b) note that "a simple decomposition of the sources of economic growth over the past decades suggests that the combined effect of greater utilization of labor and enhancement in human capital have generally made a significant contri- bution to improvements in output per capita." No wonder, since a skilled workforce attracts new firms while enabling existing firms to become more efficient and productive. Surveys6 conducted regularly by the World Bank reveal that many firms in developing countries rate inadequate worker skill and education as a major obstacle to their operations. Although educational attainment has improved in all developing regions--particularly in East Asia and Pacific and the Middle East and 288 Understanding Growth and Poverty North Africa--it remains low in many developing countries. In Sub- Saharan Africa and South Asia, more than 40 percent of those aged 25 and over in 2000 had not completed any formal education. And while there have been significant improvements in the proportion of adults who have completed secondary and higher education in all regions, their share in the working-age population remains very low in many countries (figure 13.2). The link between education and growth can break down under extreme circumstances, in developing and developed countries alike. Many African countries have seen poor growth performance even with rapid increases in education. For investments in education to reap posi- tive returns, the investment climate must be favorable, the quality of edu- cation must be high, firms must have incentives to hire more skilled workers, and graduates must have opportunities to use their newly acquired skills in productive settings, rather than in bloated bureaucracies and overstaffed state enterprises (World Bank 2005). The World Bank (2007) notes the following: · Educational quality--measured by what people know--has powerful effects on individual earnings, on the distribution of income, and on economic growth. Figure 13.2 Educational Attainment by Region 1980 2000 developed countries Europe and Central Asia East Asia and Pacific Latin America and the Caribbean South Asia Middle East and North Africa Sub-Saharan Africa 0 20 40 60 80 % of population with secondary or higher education Source: World Bank 2005. Note: Population is persons age 25 and over with secondary or higher education attainment as a share of total population age 25 and over. Labor Markets 289 · The educational quality in developing countries is much worse than the educational quantity (school enrollment and attainment)--a pic- ture already quite bleak. · Just providing more resources to schools is unlikely to be successful-- improving the quality of education will take major changes in institu- tions (World Bank 2007, 2). Investments in education also yield higher returns when combined with or preceded by investments in health and nutrition. Behrman (1999) shows that initial 1965 investments in health and nutrition--represented by life expectancies at birth relative to those predicted by per capita income in a cross-section for that year--had more predictive power for economic growth over the coming quarter-century than did initial invest- ments in schooling. It is reasonable to expect that with better health and nutrition, the expected returns on schooling would be far greater. The links between skill and health generate a cycle in which good education and health enable growth, which in turn promotes further investment in them (World Bank 2005). Women and Children in the Labor Force Between 1999 and 2008, the proportion of women in the labor force increased in all regions except East Asia and Southeast Asia and Pacific (see table 13.12). Globally, the proportion of women in the labor force decreased by 0.1 percentage points during the same period. There is a great deal of variation across the regions. The relatively low share in the Middle East and North Africa--24.9 percent and 27.5 percent, respectively, in 2008--compared with the other regions has been linked to the nonenforcement of legislation protecting women's employment rights and family laws that translate into women being less employable than men. On the other hand, women are more likely than men to be employed in the informal sector, with the result that their overall weight in the labor force is greater than official statistics would suggest. Child labor is primarily a rural and agricultural phenomenon, with children working either on family land or as hired farm laborers, and is found disproportionately in poor countries (figure 13.3). Girls work in the household or are hired out as domestic help. While they are work- ing, children are not in school, which limits their own potential and that of their social group. Even where free schooling is available, parents may prefer that their children help out on the farm or in the house- hold. If fees must be paid for education, many parents worry that their 290 Table 13.12 Labor Force Participation Rates of Females by World, Region, and Economy percent 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009* World 51.8 51.6 51.6 51.5 51.4 51.4 51.5 51.6 51.6 51.7 51.6 Developed economies and European Union 51.8 51.9 51.9 51.9 52.0 52.0 52.4 52.7 52.8 53.2 52.9 Central and Southeastern Europe (non-EU) and CIS 49.8 49.4 49.7 50.1 49.9 49.7 49.9 50.2 50.5 50.7 50.6 East Asia 69.9 69.6 69.2 68.8 68.3 67.9 67.5 67.1 66.8 66.6 66.5 Southeast Asia and Pacific 58.0 57.5 57.7 57.4 57.3 57.1 57.2 57.0 57.2 57.4 57.4 South Asia 34.3 34.1 34.0 33.9 33.9 33.8 34.2 34.6 34.8 35.1 34.9 Latin America and the Caribbean 46.6 46.8 47.0 47.9 48.3 49.3 50.0 50.8 51.0 51.6 51.7 Middle East 22.6 22.8 23.1 23.4 23.7 24.1 24.4 24.6 24.8 24.9 25.4 North Africa 26.6 26.6 26.2 26.3 26.7 26.9 26.9 27.1 27.3 27.5 27.4 Sub-Saharan Africa 60.4 60.8 61.1 61.3 61.5 61.6 61.8 61.8 61.9 62.1 62.6 Source: ILO 2010, 50. Note: * = preliminary estimate. Labor Markets 291 Figure 13.3 Child Labor Participation and GDP per Capita 60 child labor participation rate (%) 50 40 30 20 10 0 0 500 1,000 1,500 2,000 2,500 3,000 GDP per capita Source: World Bank 2006. investments will not be repaid, particularly if employment prospects are bleak. Mothers are more likely than fathers to make sacrifices and invest in children. Therefore, transfer programs that help women (such as Mexico's Progresa program) are also likely to benefit children. Bans on child labor, trade sanctions, and boycotts have proven to be ineffective, even where they are enforced, as children wind up working in illegal or unregulated activities. Conclusion The labor market represents one of the main conduits through which economic growth can help reduce poverty in developing countries. While labor-friendly economic growth can be useful--especially where demand for jobs is high and rising--an accompanying cost may be slow growth in labor productivity. The labor force is growing rapidly in many developing countries, accompanied in many cases by an ongoing shift from agricultural employment. This would appear to call either for some form of labor-intensive growth or for a marked increase in growth itself, if an increase in unemployment or a shift to the informal sector is to be avoided. Other notable developing-country concerns highlighted in this chapter are wage inequalities across coun- tries and marked differences in labor market access for men and women. 292 Understanding Growth and Poverty Notes 1. Narayan and others (2002), quoted in Pierre and Scarpetta (2004a), "found that for more than 70 percent of the poor, finding a job--whether salaried or self-employed--is the main way out of poverty. And in most developing and emerging economies about 90 percent of jobs are created by private firms." 2. The ILO dismisses the first scenario--which includes revisions to GDP growth--as unlikely. The ILO suggests that "vulnerable employment is a long- term trend indicator that tends to lag changes in GDP growth. Accordingly, the lower bound of the range (which is based on the historical relationship between vulnerable employment and GDP growth in each country) should be viewed as the long-term path that the world was on prior to the onset of the crisis, rather than a likely estimate for 2009" (ILO 2010, 18). Nevertheless, the share of vulnerable employment is shown in the S1 column. 3. Tables 13.2 and 13.3, S1. 4. For example, the large proportions of vulnerable and working poor. 5. The data refer to the periods before the financial crises in Asia and Latin America. 6. The World Bank maintains an index of the ease of doing business in 183 economies and select cities at the subnational and regional level and publishes these reports. See http://www.doingbusiness.org for further details. Bibliography Behrman, J. R. 1999. "Labor Markets in Developing Countries." In Handbook of Labor Economics, ed. O. Ashenfelter and D. Card, 2859­939. Amsterdam: Elsevier Science Publishers. Besley, T., and R. Burgess. 2002. "Can Labor Regulation Hinder Economic Performance? Evidence from India." Unpublished paper, London School of Economics. Betcherman, G. 2002. "An Overview of Labor Markets World-Wide: Key Trends and Major Policy Issues." Discussion Paper 0205, Social Protection Unit, World Bank, Washington, DC. Bourguignon, F. 2005. "Development Strategies for More and Better Jobs." Presentation at the Carnegie Endowment for International Peace conference "Help Wanted: More and Better Jobs in a Globalized Economy," Washington, DC, April 14. Gutierrez, C., C. Orecchia, P. Pierell, and P. Serneels. 2007. "Does Employment Generation Really Matter for Poverty Reduction?" Poverty Reduction Group, World Bank, Washington, DC. Labor Markets 293 ILO (International Labour Office. 2010. Global Employment Trends. Geneva: ILO. Kapsos, S. 2005. "The Employment Intensity of Growth: Trends and Macroeconomic Determinants." Employment Strategy Paper 12, International Labour Office, Geneva. Narayan, D., and P. Petesh. 2002. Voices of the Poor--From Many Lands. Washington, DC: World Bank. Pierre, G., and S. Scarpetta. 2004a. "Employment Regulations Through the Eyes of Employers: Do They Matter and How Do Firms Respond to Them?" Background note for World Development Report 2005: A Better Investment Climate for Everyone, World Bank, Washington, DC. ------. 2004b. "How Labor Market Policies Can Combine Workers' Protection with Job Creation: A Partial Review of Some Key Issues and Policy Options." Background paper for World Development Report 2005: A Better Investment Climate for Everyone. World Bank, Washington, DC. Ravallion, M., and G. Datt. 1999. "When Is Growth Pro-Poor?" Policy Research Working Paper 2263, World Bank, Washington, DC. UNDP (United Nations Development Programme). 2009. Human Development Report. New York: United Nations. World Bank. 2004. "Unlocking the Employment Potential in the Middle East and North Africa: Toward a New Social Contract." Middle East and North Africa Development Report, World Bank, Washington, DC. ------. 2005. World Development Report: A Better Investment Climate for Everyone. Washington, DC: World Bank. ------. 2006. World Development Report: Equity and Development. Washington, DC: World Bank. ------. 2007. Education Quality and Economic Growth. Washington, DC: World Bank. ------. 2008. World Development Indicators. Washington, DC: World Bank. CHAPTER 14 Land and Agriculture Land is of critical importance to the poor, particularly in rural areas. Owners of land have an incentive to make it productive, raising house- hold incomes and contributing to national growth. Land can be exchanged in the market, as well as through nonmarket channels such as inheritance. It can also be used as collateral to raise funds for further investment. In short, land widens the economic choices open to those who possess it. But inequality in access to and ownership of land is a serious problem in most developing countries. When inequality becomes a serious brake on growth, the state may step in to achieve socially desirable land alloca- tion and utilization, in particular where unequal land distribution has kept large sections of the population in poverty. We begin this chapter by looking at why land inequality is so prevalent in the developing world, then go on to explore the impact of inequality on economic growth and poverty, particularly among the rural poor. Land inequality has been shown to affect three key aspects of economic devel- opment: education, institutions, and financial development. We examine the relevant literature on these subjects. The final section examines the role that government can play in bringing about a more equal distribution 295 296 Understanding Growth and Poverty of land. The chapter concludes with an examination of the pros and cons of land titling, a modern property rights tool. Land Distribution in Poor Countries The history of land ownership in many developing countries has the notable fault of excluding much of the population, especially the rural poor, from secure tenure. Formal tenure covers only 2 to 10 percent of the land in Africa, for example. Property rights are often imposed by out- side forces or local elites, whose objective is to seek surpluses from local populations or force them into wage labor without promoting opportu- nities for land ownership. The result is an unequal distribution of land and a large landless population. Of the periurban population, more than 50 percent in Africa and more than 40 percent in Asia live under infor- mal tenure, with highly insecure land rights (World Bank 2003a). Paralleling the exclusion of the poor from land access and ownership is the absence of institutional systems for titling land. Overlapping institu- tions have evolved over long periods and often provide little clarity on how land rights are defined, how ownership and possession are deter- mined, and how conflicts are resolved. Some forms of land distribution that add ambiguity to an already murky picture of access and ownership are land owned by communities (for example, communal land among indigenous people), land handed down from generation to generation through customary practices (for example, primogeniture, where the eld- est son inherits the father's land), and land taken over by the state (for example, "crown land"). In many countries, the state continues to own a large portion of valu- able land despite evidence that such ownership is conducive to misman- agement, underutilization of resources, and corruption. Because discretionary bureaucratic interventions and controls remain a major source of corruption and a barrier to the start-up of small enterprises in many developing countries, campaigns to achieve broad, egalitarian own- ership can significantly improve governance by strengthening the voice of the poor, allowing them greater participation in the political process, and improving public services, especially at the local level. Land is the primary physical asset of poor households. In Uganda, for example, it constitutes between 50 and 60 percent of their total assets. Securing title to that land is critical for improving welfare and stimulating investment and the accu- mulation of wealth for current and future generations. As noted by the World Bank (2003a), a secure title to land enables households to survive Land and Agriculture 297 and generate a marketable surplus, defines their social and economic status and often their collective identity, increases their incentive to use land in a sustainable manner, and enables them to self-insure and main- tain access to financial markets. The scope for economic growth is limited where land tenure is not secure or property rights poorly defined. For example, in many African countries, the vast majority of land (more than 90 percent on average) remains under customary tenure, which often lacks legal recognition. To avoid leaving the occupants of this land effectively outside the rule of law, many African countries have recently given legal recognition to land tenure arrangements that have been in operation for generations as well as to the institutions administering it. But lack of institutional capacity to administer and implement these laws remains a major challenge (World Bank 2003a). Informality is also widespread in urban areas. This is of particular con- cern because, in many countries, growing populations and expanding nonagricultural demand lead to an appreciation of land values and increase the potential for land-related conflict. Defending one's land becomes a costly endeavor that diverts efforts from more productive pur- suits, such as investment. Where land titles are secure, by contrast, economic opportunities and social advantages multiply (figure 14.1). In other words, economic growth follows secure land titles. First, greater security against eviction is likely to increase land-related investment. Second, greater ability to trans- fer land will increase the payoff from land-connected investments because it allows investors to benefit even if they are unable to use the land themselves. Third, greater security of tenure can improve access to credit, thereby increasing investment in situations in which limited credit supply may have constrained it. Land ownership is particularly important for women's welfare, though women's ownership rates are disproportionately low. In addition to ensuring a more equitable society, more attention to women's land rights would have far-reaching economic consequences in areas where women are the main cultivators, male emigration rates are high, control of productive activities is differentiated by gender, or high adult mortal- ity rates and unclear inheritance regulations undermine widows' liveli- hoods. Several studies have shown that productivity increases when women both own and control land. Udry (1996) showed that the trans- fer of plots from men to women in Burkina Faso increased output by 6 percent. But Adesina and Djato (1997) found no significant difference between the efficiency of women and men on plots in Côte d'Ivoire. 298 Understanding Growth and Poverty Figure 14.1 Initial Land Distribution and Growth by Economy, 1960­2000 8 Taiwan, China 6 Rep. of Korea average GDP growth, 1960­2000 (percent) China Thailand Vietnam Japan 4 Malaysia Indonesia Dominican Rep. Egypt Brazil Sri Lanka India Colombia 2 Mexico Paraguay Costa Rica Guatemala Kenya Argentina South Africa Peru El Salvador Honduras 0 R.B. de Venezuela Nicaragua ­2 0.9 0.7 0.5 0.3 initial land distribution (Gini coefficient) Source: Deininger 2003, 18. Note: The Gini coefficient measures the degree of concentration (inequality) of a variable in a distribution of its elements. It compares the Lorenz curve of a ranked empirical distribution with the line of perfect equality. This line assumes that each element has the same contribution to the total summation of the values of a variable. The Gini coefficient ranges between 0, where there is no concentration (perfect equality) and 1, where there is total concentration (perfect inequlity). Women's land rights in many developing economies are acquired through husbands or male relatives. Widows often have only indirect access to land, and even this access is insecure. In India, for example, laws and prevailing practices are often heavily biased against women (Saxena 1999). A woman's right to own land still needs to be legally recognized and enforced in many developing countries. Reforming inheritance laws is one way of achieving this goal. Embedding gender equality in the constitution (to supersede contrary legislation) is another. Developing countries in Asia, Latin America, and Africa have embraced some of these options, but much more needs to be done. Land and Agriculture 299 Land-policy initiatives targeted at women also play a positive role in enhancing nutrition and accumulating human capital. A study by Quisumbing and Otsuka (2001) shows that the introduction of export crops in Ghana increased the demand for female workers and resulted in improved spending on female education and health.1 Land Inequality and Rural Poverty On average, rural poverty accounts for nearly 63 percent of poverty worldwide (see box 14.1). The rural poor account for 90 percent of those in poverty in China and Bangladesh and between 65 and 90 per- cent in Sub-Saharan Africa. In Latin America, by contrast, poverty is concentrated in urban areas (Khan 2000). Among the rural poor, those who are landless suffer more than landholders. Because the rural poor depend mainly on income from agriculture, forestry, fishing, and, in some cases, small-scale industries, agricultural growth has almost always con- tributed to a reduction in poverty, even when land holdings are small and technology is sparse (Khan 2000; Gaiha 1993; and Datt and Ravallion 1998). In spite of this, government policy has often disfavored the agri- cultural sector and rural infrastructure, both social and physical. Box 14.1 How Rural Poverty Is Created · Political instability and civil strife · Systemic discrimination on the basis of gender, race, ethnicity, religion, or caste · Ill-defined or unfair enforcement of rights to agricultural land and other natural resources · High concentration of land ownership and asymmetrical tenancy arrangements · Corrupt politicians and rent-seeking public bureaucracies · Economic policies that discriminate against or exclude the rural poor from the development process and accentuate the effects of other poverty-creating processes · Large and rapidly growing families with high dependency ratios · Market imperfections caused by distortionary public policies and the high con- centration of land and other assets · External shocks stemming from natural causes (for example, climatic changes) and fluctuations in the international economy Source: Khan (2000), drawing on Jazairy, Alamgir, and Panuccio (1992) and Gaiha (1993). 300 Understanding Growth and Poverty Land differentiates the rural poor. Cultivators have access to land as small-scale landowners and tenants, whereas noncultivators are landless, unskilled workers (Khan 2000). Cultivators account for the majority of the rural poor and are directly involved in agricultural production. In most cases, they are unable to sustain themselves on their own holdings and therefore offer their labor to larger-scale landholders. Noncultivators are generally the poorest of the rural poor, and their numbers have been increasing in developing countries because of a natural increase in pop- ulation and "depeasantization"2--public policies aimed at moving small- scale landholders out of agricultural production. Noncultivators are particularly vulnerable to changes in the demand for labor, wage rates, and food prices. Furthermore, they are typically isolated from public infrastructure services and public safety nets, such as food rations. As noted in the previous section, rural women suffer more than rural men because of their lower social status and because of institutional discrim- ination, such as in inheritance laws. Khan (2000) offers some policy prescriptions to deal with the problem of rural poverty. These include · land reform through titling, redistribution, and fair and enforceable tenancy contracts; · improvements in health, education, and infrastructure (including irri- gation, transport, and communications) and the involvement of local government and civil society in devising and implementing these improvements; · rural credit programs that target the needs of the rural poor, perhaps through the extension of community-based credit programs; · a flexible public works program to smooth out household consump- tion and decrease the poverty of the landless; and · public safety nets, such as food-supplement programs, that could be provided through schools, health-care clinics, and community centers in times of need. Land Inequality and Economic Development Land inequality has been linked to low levels of economic development, with adverse consequences for the poor. The facets of the economy that appear to suffer most from the unequal distribution of land are educa- tion, institutions, and finance. According to theories that attempt to explain the relative success of developing countries in raising incomes Land and Agriculture 301 over time, no part of the economy develops optimally in the face of land inequality. These theories have been bolstered by empirical cross-country studies (using a Gini coefficient to measure the distribution of land within groups of landowners across countries) that found a negative rela- tionship between land inequality and institutional development, educa- tion, and financial development (Deininger and Squire 1998). The theory linking land inequality and economic development is quite clear in differentiating between those who own land (and the inequality in land distribution within this group of landowners) and those who are landless. But, until recently, empirical work failed to make this distinction. Erickson and Vollrath (2004) derived a measure of land inequality that encompassed both agricultural landowners and landless individuals.3 They found a significant negative relationship between education and land inequality--but only for landless individuals. They found no signifi- cant relationship between land inequality and financial institutions for either landholders or landless persons. So the jury is still out. The following sections examine the literature behind the hypothetical relationships between land inequality, on the one hand, and institutional development, education, and financial develop- ment on the other. Institutions and Land Inequality Engerman and Sokoloff (1997, 2000) first highlighted the negative rela- tionship between institutions and land inequality. Examining the eco- nomic development of Latin America following colonization, they found that land inequality dated from the existence of vast plantations worked by slave labor--a system that perpetuated inequality in access to resources. Unequal resource allocation led to the development of institutions designed specifically to protect the interests of the elite, hampering eco- nomic growth and development. The hypothesis that land inequality favored such allocation practices and promoted the development of bad institutions was taken up by Easterly (2002), who suggested that this relationship held across time and regions. Easterly and Levine (2003) also found that natural resource endowments affected growth through institutions. For example, environ- ments where crops were most effectively produced, such as on large plan- tations, quickly developed political and legal institutions that protected a landholder minority from a peasant majority--some even included slav- ery. Even when agriculture receded from the economic spotlight, endur- ing institutions continued to thwart competition and, hence, economic 302 Understanding Growth and Poverty development. In colonies with inhospitable climates, the colonial powers established extractive institutions so that a few colonialists could exploit available natural resources. Where the climate was more hospitable, colo- nial powers established settler institutions. According to this view, the institutional structures created by colonialists in response to particular environments endured even after the end of colonialism. Thus, the impact of the environment on economic development is felt through the shap- ing of institutions. Education and Land Inequality Empirical work on the relationship between land inequality and educa- tion has focused on land inequality and the public provision of educa- tion. Mariscal and Sokoloff (2000)--in extending the work of Engerman and Sokoloff (1997, 2000)--found a negative relationship between the public provision of education and land inequality. Their hypothesis was that, assuming education to have a smaller complemen- tarity with agriculture than with manufacturing, landowners were reluctant to fund education because they believed the costs to outweigh the benefits, particularly in an agricultural setting. Galor, Moav, and Vollrath (2003)--examining the incentives of landowners to provide education--argue that the provision of education decreases as land dis- tribution becomes more unequal. Deininger and Squire (1998) found a negative relationship between levels of education attained and land inequality. But their study was not able to distinguish whether this was due to poor public provision of educational resources or limited demand for education based on available assets--or a combination of both factors. Erickson and Vollrath (2004) tested the hypothesis that the public provision of education--as measured by spending as a proportion of gross domestic product (GDP)--is limited by land inequality. Between 1965 and 1979, they found that greater land inequality across the agri- cultural population was associated with lower spending on education for landless populations. Financial Development as a Constraint to Land Equality The effects of inequality in physical assets such as land can be trans- mitted through financial markets. For example, access to credit is con- ditional on ownership of assets, and--in the context of a developing economy--land is the most common asset. The distribution of assets, as well as average income, will determine how many people are able to Land and Agriculture 303 undertake investment in, for example, physical and human capital. In societies where the distribution of land is unequal, fewer people will be able to take up investment opportunities, thus leading to lower stocks of human and physical capital and lower levels of economic growth in the long run. The literature on land inequality and the financial sector is extensive. A broad consensus suggests that land inequality (a) hampers financial development, (b) results from and persists because of poor financial development, and (c) implies fewer potential users of financial sector products, such as credit, deposits, insurance, and so on. The literature also finds that, where rural elites prevail, the govern- ment may be the main provider of credit, thus retarding the development of the private financial sector. The absence of a properly functioning financial sector with markets for risk and credit contributes to unequal land allocation. Individuals have no choice but to retain their holdings in the face of external price shocks. As noted by Erickson and Vollrath (2004), farm workers may have no incen- tive to change the status quo of land concentration, given that production risks are borne by the landowner. In a society where land is concentrated among a landholding minority, there are few incentives to provide finan- cial services because demand is so low. The Role of Government in Land Markets The rights to own and exchange land are established and protected by governments. Governments may also have a role in equalizing land allo- cation and use if inequalities have led to widespread poverty or stifled economic growth. The World Bank (2003a) suggests that property rights in land should have the following characteristics: · The time frame for securing land rights should be long enough to ensure an adequate return on investment. The potential for invest- ment in urban areas is greater than in rural areas, so the time frame should reflect this. Although property rights given for an indefinite period are the best option, long-term rights that can be renewed automatically are the next-best alternative. · Property rights should be defined in a way that makes them easy to observe, enforce, and exchange. This requires the existence of recog- nized institutions that are accessible by the general populace and that 304 Understanding Growth and Poverty render decisions backed by the power of the state. The need for universal legitimacy is particularly evident in Africa, where rights to 90 percent of the land are determined outside the legal system. Informal institutions of land administration cannot offer universally recognized mechanisms for enforcing property rights. On the other hand, formal institutions make little difference to the lives of ordinary people if their scope is limited. · If the government is engaged in land allocation reforms, it must decide whether it is more appropriate to confer property rights on individu- als or on groups. Group rights are more appropriate in situations char- acterized by economies of scale in resource management and high-risk markets. While a group system of property rights may be advanta- geous in the early stages of development, the likelihood of technical progress and demographic changes suggests that one should expect property rights to become individualized over time. This is not an automatic evolution, however, but one that will be shaped by political and economic factors. The governments of many developing countries have already started implementing a first generation of reforms encompassing significant steps toward greater economic liberalization--including the establishment and protection of property rights. But there is a further role for government in the implementation of second-generation reforms that address through registration and titling the persistent insecurity of land rights. Formalizing land ownership can deliver large productivity gains. It is especially bene- ficial where indigenous tenure systems are weak, the potential return on investment on land is high, and collateralized lending is in place. Second- generation reforms have been progressing over the past decade in Latin America, for example, where unequal distribution of land is historically common. Both the World Bank and the Inter-American Development Bank have funded projects in land titling and registration. While land titling and registration have been largely positive in Latin America, it is not clear whether similar reforms are successful in every region. In particular, the effectiveness of titling and land registration has been questioned for Sub-Saharan Africa (Atwood 1990; Migot-Adholla and others 1991). Jacoby and Minten (2005, 1) write that "Sub-Saharan Africa lacks the infrastructure, factor market development, and other pre- requisites for land tenure reform to promote agricultural intensification and productivity growth." Land and Agriculture 305 Incidences of land titling in Africa are relatively rare. This is unsurpris- ing given that most land in the region is unsecured. Some tenure reform has taken place in Kenya, but the resulting literature suggests little eco- nomic impact (Carter, Weibe, and Blarel 1997; Place and Migot-Adholla 1998). Based on their study of investment, productivity, and value between titled and untitled plots worked by the same household, Jacoby and Minten (2005) conclude that a formal land-titling system should not be extended to rural Madagascar. They find that the presence of a title has no significant effect on land-specific investment, with weak effects on land productivity and values. Indeed, as noted by Jacoby and Minten (2005), proceeding with land titling and registration in an unsecured, indigenous tenure system may not reduce insecurity to any appreciable extent and might even increase it. In most cases of unsecured land, an informal system evolves over time to govern community land use and transfer. Imposing a formal structure on arrangements that have worked for years may do no more than create opportunities for rent seeking. These concerns are captured by Atwood (1990) and quoted in Jacoby and Minten (2005, 2) as follows: Members of a local community may face far fewer risks of loss of land under the existing informal system than an outsider would face. In addi- tion, while land registration might reduce the risks faced by an outsider, it may increase the risks and insecurity faced by local people as family mem- bers or peripheral land claimants jockey to see in whose name a parcel will be registered . . . For many local people, therefore, registration can create rather than reduce uncertainty and conflict over land rights. To strengthen development and reduce poverty, land policies must take history and traditional customs into consideration. Without exceed- ing institutional capacity, they should aim to provide secure tenure to land to improve the welfare of the poor. Government land policy also has a key role in promoting and contributing to socially desirable land alloca- tion and utilization. For example, in the countries of the former Soviet Union, farm restructuring was a necessary step in decollectivization and land reform. In some East and West African countries with a highly unequal distribution of land ownership, where land issues are often key elements of social strife, a clear and equitable postconflict land policy is needed. Land policy also has a central role to play in devising appropriate incentives for sustainable land use, which is required to avoid the irre- versible degradation of nonrenewable natural resources. 306 Understanding Growth and Poverty The Role of Agriculture in Reducing Rural Poverty4 Agricultural development is vital for achieving the first Millennium Development Goal (MDG): to halve by 2015 the share of people suffer- ing from extreme poverty and hunger. As noted, three out of every four poor people in developing countries live in rural areas, and most of them depend directly or indirectly on agriculture for their livelihoods. Two world regions offer great promise but present acute challenges. For much of Sub-Saharan Africa, agriculture is a strong option for spurring growth, overcoming poverty, and enhancing food security. Improvements in agricultural productivity are vital for stimulating growth in other parts of the economy. But accelerating growth will require a sharp increase in the productivity of smallholder farming, combined with more effective support to the millions coping as subsistence farmers, many in remote areas. In Asia, the challenge of overcoming widespread poverty hinges on confronting widening rural-urban income disparities. Asia's fast-growing economies remain home to more than 600 million rural people who live in extreme poverty. Despite massive rural-urban migration, rural poverty will remain dominant for several decades to come. It is therefore essential to generate many more rural jobs by diversifying into labor-intensive, high-value agriculture linked to a dynamic rural, nonfarm sector. With land and water becoming scarcer in all regions of the world, the future of agriculture is tied to better stewardship of natural resources. With the right incentives and investments, agriculture's environmental footprint can be lightened, and environmental services harnessed to pro- tect watersheds and biodiversity. Today, rapidly expanding domestic and global markets; institutional innovations in markets, finance, and collec- tive action; and revolutions in biotechnology and information technology all offer exciting opportunities for agriculture to promote development. But seizing these opportunities will require the political will to move forward with reforms that change how agriculture is managed. Assessing Agriculture's Contribution to Growth How much can agriculture be expected to contribute to economic growth? To answer that question, we group the countries of the developing world into three categories: agriculture-based countries (including India and many of the world's poorest countries), transforming countries (including China and Indonesia), and urban countries (such as Brazil). Key character- istics of each of the three groups of countries are presented in table 14.1. Land and Agriculture 307 Table 14.1 Characteristics of the Three Economies Agriculture-based Transforming Urban countries countries countries Rural population (millions), 2005 417 2,220 255 Share of rural population (%), 2005 68 63 26 GDP per capita (2000 US$), 2005 379 1,068 3,489 Share of agriculture in GDP (%), 2005 29 13 6 Annual agricultural GDP growth, 1993­2005 (%) 4.0 2.9 2.2 Annual nonagricultural GDP growth, 1993­2005 (%) 3.5 7.0 2.7 Number of rural poor (millions), 2002 170 583 32 Rural poverty rate, 2002 (%) 51 28 13 Source: Compiled from table 1.1. in World Bank 2007, 31. Note: Poverty line is $1.08 a day, in 1993 purchasing power parity dollars. Agriculture's average contribution to GDP growth differs markedly by category (figure 14.2). The sector accounts for 32 percent of growth on average in agriculture-based countries, 7 percent in transforming coun- tries, and 5 percent in urban countries. Toward Effective Agricultural Development Policies Given agriculture's leading role in the growth of the poorest countries, the size of the rural population in the agriculture-based and transforming coun- tries, and high rates of rural poverty in both groups of countries, policy makers need to implement effective policies of agricultural develop- ment. Several areas where good policies are needed are described below. Increase access to assets. Among household assets, land, water, and human capital are the major determinants of the rural poor's ability to participate in agricultural markets, secure livelihoods in subsistence farm- ing, compete as entrepreneurs in the rural nonfarm economy, and find employment in skilled occupations. Enhancing assets requires significant public investments in irrigation, health, education, and institutional development, such as enhancing the security of property rights and the quality of land administration. Increasing assets may also require affirmative action to equalize chances for disadvantaged or excluded groups, such as women and ethnic minorities. Improve land markets. Land rental markets in many areas are hobbled by insecure property rights, poor contract enforcement, and legal restrictions 308 Understanding Growth and Poverty Figure 14.2 Agriculture's Contribution to Growth 80 agriculture's contribution to growth, 1990­2005, % agriculture-based countries 60 India 40 (1965­94) 20 China (1981­2001) Brazil Indonesia 0 (1970­96) (1970­98) transforming countries urbanized countries ­20 0 0.2 0.4 0.6 0.8 1.0 rural poor/total poor, 2002 actual poverty data predicted poverty data poverty data over time Source: World Bank 2007, 31. Note: Arrows show paths for Brazil, China, India, and Indonesia. that discourage those who work the land from raising productivity, diver- sifying their incomes, or abandoning agriculture for another pursuit. Safety nets and access to credit are widely needed to minimize distressed land sales because of shocks. Land reform is needed to promote smallholder entry into the market, reduce inequalities in land distribution, increase efficiency, and recognize women's rights. Targeted subsidies to facilitate market-based land reform are already used in Brazil and South Africa. Expand irrigation, and make it more efficient. Irrigated land is more than twice as productive as rainfed land, on average, yet in Sub-Saharan Africa only 4 percent of cultivated land is under irrigation, compared with 39 percent in South Asia and 29 percent in East Asia. Among the essen- tial steps are revamping existing irrigation schemes, expanding small-scale schemes, and improving measures to harvest and store water. Encourage technical education. Education levels in rural areas tend to be dismally low worldwide, yet rural people need education to pursue opportunities, obtain skilled jobs, start businesses in the rural nonfarm economy, and migrate successfully. Demand for education, including Land and Agriculture 309 vocational training that can provide technical and business skills, can be enhanced through cash transfers conditioned on school attendance (as in Bangladesh, Brazil, and Mexico). Protect the health of rural dwellers. Illness and death from HIV/AIDS and malaria have greatly reduced agricultural productivity and devastated livelihoods in many countries. In Zambia, for example, 19 percent of people age 15­24 in 1990 were dead by 2000. Irrigation may have con- tributed to the spread of malaria. Avian influenza caused by the proximity of humans and animals poses a growing threat to human health. Raising Productivity among Smallholders Harnessing agriculture to promote economic growth and move the large numbers of smallholder farmers and those coping as subsistence farmers in remote areas out of poverty is a key development challenge. A broad array of policy instruments can be used to raise productivity among com- mercial smallholders and subsistence farmers. Those policies include · improving price incentives for poor farmers by liberalizing agricultural trade; · improving product markets, including those for food staples, bulk exports, and high-value items for domestic consumption; · widening access to financial services and reducing exposure to unin- sured risks; · enhancing the performance of producer organizations; and · promoting innovation through science and technology. We will expand briefly on these points below. Improving price incentives for poor farmers by liberalizing agricul- tural trade. International trade in agriculture is heavily distorted by the subsidies that most developed-country governments provide to their domestic producers. Those subsidies cost the average family in the European Union, Japan, and the United States more than $1,000 each year, while depressing global prices for the products that poor farmers produce in the developing world. Further distortions are caused by the taxation and tariff policies of governments in much of the developing world. The challenge of unwinding those distortions for the greater good of the world's producers and consumers proved to be so politi- cally sensitive that, in September 2003, it scuttled the Doha Round of 310 Understanding Growth and Poverty international trade talks, launched in 2001. An effort to revive the talks was unsuccessful. Considered as a purely technical matter, the World Bank (2003b) believes that rich and poor countries alike stand to benefit greatly from full multilateral liberalization of agricultural trade. The Bank estimated that a "pro-poor tariff reduction program," combined with an end to agri- cultural subsidies as presently practiced, had the potential to produce gains for developing countries of nearly $350 billion in additional income by 2015 (the target date of the MDGs). Those gains would mean that by 2015, 140 million fewer people would be living in poverty (that is, living on less than $2 a day). The same program would also have pro- duced gains for rich countries on the order of $170 billion. Although the prospect for implementation of such a multilateral program are presently almost nil, developing countries have many opportunities to benefit from uni- lateral liberalization. Improving product markets, including those for food staples, bulk exports, and high-value items for domestic consumption. Amid structural changes in agricultural markets and the entry of powerful new actors, a key issue for development is enhancing the participation of smallholders. Reducing transaction costs and risks in food staples markets can offer the promise of quick improvements to promote faster growth and bene- fit the poor (comparatively faster than infrastructure investments, for example). Innovations include commodity exchanges, market information systems based on rural radio and short messaging systems, and market- based risk management tools. Insurance through exchange-traded futures contracts can sometimes manage price risks. The long downward trend in world market prices of exports such as coffee and cotton threatens the livelihoods of millions of producers. Reduced taxation, greater liberalization of export markets, more efficient production and supply-chain processes, and better quality have improved incomes in many settings, including Zambia. High-value markets for domestic consumption are the fastest-growing agricultural markets in most developing countries, expanding up to 6 to 7 percent a year, led by livestock products and horticulture.5 Widening access to financial services and reducing exposure to uninsured risks. Recently, the range of financial products6 available to the rural poor has broadened to include savings, money transfers, insurance services, and leasing options. Information technologies are reducing transaction costs and making loans less costly in rural areas. Land and Agriculture 311 Exposure to uninsured risks--the results of natural disasters, health shocks, demographic changes, price volatility, and policy changes--has high costs for rural households, sapping efficiency and welfare. Farmers tend to forgo actions that might offer higher incomes if they have no way of guarding against the associated risk. Index-based insurance for drought risk (in India and elsewhere) could reduce risks and unlock agricultural finance. Children suffer long-term consequences when they are taken out of school in response to shocks or are malnourished. But despite multiple initiatives, progress has been slow in reducing uninsured risks in small- holder agriculture, largely because state-managed schemes have been ineffective. Enhancing the performance of producer organizations. For smallholders, producer organizations are essential to achieve competitiveness, market- ing, input provision and credit, greater civil society participation, and governance.7 But they must overcome legal restraints, low managerial capacity, elite capture, exclusion of the poor, and nonrecognition by the state. Promoting innovation through science and technology. Developing countries invest far too little in agricultural research and development.8 The agro-ecological features of Sub-Saharan Africa limit the degree to which the region can benefit from international technology transfers, while the small size of many African countries prevents them from cap- turing economies of scale in agricultural research and development. These factors have resulted in a widening cereal yield gap with the rest of the world. In addition, many public research organizations face leadership, management, and financial constraints that require urgent attention if Africa's producers are to take advantage of openings in higher-value mar- kets. Less-favored regions require better technologies for soil, water, and livestock management and more sustainable and resilient agricultural systems, including crop varieties more tolerant of pests, diseases, and drought. The potential benefits of technologies such as genetically modi- fied organisms will be missed unless the international development community sharply increases its support to interested countries. Making Agriculture More Sustainable The environmental agenda is inseparable from the broader agenda of agri- cultural development for the simple reason that agriculture cannot con- tinue to prosper without better stewardship of the natural resource base on which it depends. Agriculture poses a multiplicity of environmental 312 Understanding Growth and Poverty problems linked to agricultural intensification (reduced biodiversity, mis- managed irrigation water, agrochemical pollution, and health costs and deaths from pesticide poisoning) and livestock breeding (pollution and contamination from animal waste and the spread of animal diseases such as avian influenza). Less-favored areas suffer from deforestation, soil ero- sion, desertification, and degradation of pastures and watersheds.9 More sustainable production systems and enhanced environmental services in agricultural areas will depend in large part on whether we can learn to handle water more wisely. Necessary steps include reducing water pollution and arresting the unsustainable mining of groundwater while meeting the demands of all users. We can start by discouraging wasteful water usage, devolving water management to local user groups, investing in better technologies, and regulating water usage (and agricul- tural production in general). Better water measurement (remote sensing) and quality of irrigation services reforms could gain support for otherwise unpopular reforms. Payments by beneficiaries for environmental services can help overcome market failures in managing environmental externalities such as watershed and forest protection to create environmental services (clean drinking water, table water flows to irrigation systems, carbon sequestration, and protection of biodiversity).10 Conclusion Access to and ownership of land shapes the capacity of the poor to escape from poverty. In most of the developing world, however, both access and ownership are very unequally distributed, with negative consequences for economic growth and poverty reduction. Certain groups, notably the rural poor and women, suffer disproportionately from land-related inequality. Governmental efforts to reduce inequality in access to land have focused on improving land titling and registration. Such efforts--while generally positive in the long run--have carried negative implications in some cases, as poor people have lost access to land without gaining ownership. Agriculture remains a potent weapon in the fight against poverty. Countries with a predominant agricultural base and close to two-thirds of their population living in rural areas experience a high incidence of poverty. Growing and developing the agricultural sector in a sustainable manner represents the only viable way out of poverty. Policy makers have a critical role to play in making agriculture work for the rural poor. Unleashing the full development effect of agriculture calls for a number Land and Agriculture 313 of policies in different areas of the economy. Among the initiatives dis- cussed were achieving higher productivity, improving access to education and resources, and better stewardship of natural resources. Moreover, the gains from a pro-poor tariff reduction program, combined with a multi- lateral liberalization of agricultural trade, would decrease the numbers of people living in poverty. Notes 1. Other studies--in West Africa and Kenya--show that the introduction of export crops actually decreased the demand for female laborers, with men taking over the land previously farmed by women--thus weakening women's rights to land (Kevane and Gray [1999] for West Africa; Dolan [2001] for Kenya). In Ghana, the demand for women's labor increased in the face of export crops, leading to an improvement in women's rights to land. Husbands had to make a gift of the plots to their wives in return for labor on the cocoa plots (Quisumbing and Otsuka 2001). 2. Khan (2000, 27) states that small-scale landowners and tenants are under pressure to get out of the agriculture sector altogether because of the under- lying "market forces and policies affecting landholdings, rents, prices, credit, inputs, and public investment in the social and physical infrastructure." 3. Erickson and Vollrath (2004) argue that given the significant role that agricul- ture plays in the lives of the poor--agricultural production continues to account for a substantial fraction of total production in most developing countries, particularly the poorest--it is critical to examine the role of agricul- tural inequality and how, or whether, it relates to institutional development. 4. This section draws on World Development Report 2008 (World Bank 2007). The focus of the report was on agriculture for development. We summarize here the overview to this report highlighting the contribution that agricul- ture can make to development. 5. Fresh and processed fruits and vegetables, fish and fish products, meat, nuts, spices, and floriculture now account for 43 percent of agricultural and food exports from developing countries, worth about $138 billion in 2004. 6. Credit reporting bureaus covering microfinance institutions and the lower tier of commercial banks also help smallholders capitalize on the reputations they establish as microfinance borrowers to access more commercial loans. Many of these innovations are still at the pilot stage, requiring evaluation and scaling up to make a real difference for smallholder competitiveness. 7. Between 1982 and 2002, the percentage of villages with producer organiza- tions rose from 8 percent to 65 percent in Senegal and from 21 percent to 91 percent in Burkina Faso. The Indian Dairy Cooperatives Network has 314 Understanding Growth and Poverty 12.3 million individual members (many of them landless and women) and produces 22 percent of India's milk supply. 8. Investment in agricultural research and development tripled in China and India over the past 20 years, but increased by barely a fifth in Sub-Saharan Africa (declining in about half of the countries there). 9. In the East African highlands, soil erosion can result in productivity losses as high as 2 to 3 percent a year, in addition to creating off-site effects such as the siltation of reservoirs. 10. In Nicaragua, payments induced a reduction in the area of degraded pasture and annual crops by more than 50 percent in favor of silvopastoralism, half of it by poor farmers. Environmental certification of products also allows con- sumers to pay for sustainable environmental management, as practiced under fair trade or shade-grown coffee. Bibliography Adesina, A. A., and K. K. Djato. 1997. "Relative Efficiency of Women as Farm Managers: Profit Function Analysis in Côte d'Ivoire." Agricultural Economics 16 (1): 47­53. Agarwal, B. 1994. A Field of One's Own: Gender and Land Rights in South Asia. South Asian Studies. Cambridge, U.K.: Cambridge University Press. Arnold, J. E. M. 2001. "Devolution of Control of Common Pool Resources to Local Communities: Experiences in Forestry." 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In Searching for Land Tenure Security in Africa, ed. J. Bruce and S. Migot-Adholla, 215­22. Dubuque, IA: Kendall/Hunt. Land and Agriculture 315 Coleman, J. 1988. "Social Capital in the Creation of Human Capital." American Journal of Sociology 94 (Supplement): S95­S120. ------. 1990. Foundations of Social Theory. Cambridge, MA: Harvard University Press. Datt, G., and M. Ravallion. 1998. "Farm Productivity and Rural Poverty in India." Journal of Development Studies 34 (4): 62­85. Deere, C. D., and M. Leon. 2001. Empowering Women: Land and Property Rights in Latin America. Pitt Latin America Series. Pittsburgh, PA: University of Pittsburgh Press. Deininger, K. 2003. "Land Policies for Growth and Poverty Reduction." World Bank Policy Research Report, World Bank, Washington, DC. Deininger, Klaus, and Lyn Squire. 1996. "A New Data Set Measuring Income Inequality." World Bank Economic Review 10: 565­92. ------. 1998. "New Ways of Looking at Old Issues: Inequality and Growth." Journal of Development Economics 57 (2): 259­87. De Janvry, A., G. Gordillo, J. P. Plateau, and E. Sadoulet, eds. 2001. Access to Land, Rural Poverty, and Public Action. Oxford, U.K.: Oxford University Press. Dolan, C. S. 2001. "The `Good Wife': Struggles Over Resources in the Kenyan Horticultural Sector." Journal of Development Studies 37 (3): 39­70. Easterly, W. 2002. "The Middle Class Consensus and Economic Development." Journal of Economic Growth 6 (4): 317­35. Easterly, W., and R. Levine. 2003. "Tropics, Germs, and Crops: How Endowments Influence Economic Development." Working Paper W9106, National Bureau of Economic Research, Cambridge, MA. Engerman, S. L., and K. L. Sokoloff. 1997. "Factor Endowments, Institutions, and Differential Paths of Growth Among New World Economies: A View from Economic Historians of the United States." In How Latin America Fell Behind, ed. S. Harber, 260­96. Palo Alto, CA: Stanford University Press. ------. 2000. "Institutions, Factor Endowments and Paths of Development in the New World." Journal of Economic Perspectives 14 (3): 217­32. Erickson, L., and D. Vollrath. 2004. "Dimensions of Land Inequality and Economic Development." Working Paper 04/158, International Monetary Fund, Washington, DC. ------. 2005. "How Are Land Inequality and Development Related?" IMF Survey 34 (1): 12­13. Gaiha, R. 1993. "Design of Poverty Alleviation in Rural Areas." United Nations Food and Agricultural Organization, Rome. Galor, O., O. Moav, and D. Vollrath. 2003. "Land Inequality and the Origin of Divergence and Overtaking in the Growth Process: Theory and Evidence." Brown Economics Working Paper, Brown University, Providence, RI. 316 Understanding Growth and Poverty Grootaert, Christiaan. 1998. "Social Capital: The Missing Link?" Social Capital Initiative Working Paper 3, Social Development Family, Environmentally and Socially, Sustainable Development Network, World Bank, Washington, DC. Jacoby, H., and B. Minten. 2005. "Is Land Titling in Sub-Saharan Africa Cost- Effective?" World Bank, Washington, DC. http://siteresources.worldbank.org/ DEC/Resources/LandTitles_Mad.pdf. Jazairy, I., M. Alamgir, and T. Panuccio. 1992. The State of World Rural Poverty: An Inquiry into its Causes and Consequences. New York: New York University Press. Kevane, M., and L. C. Gray. 1999. "A Woman's Field is Made at Night: Gendered Land Rights and Norms in Burkina Faso." Feminist Economics 5 (3): 1­26. Khan, H. M. 2000. "Rural Poverty in Developing Countries." Finance and Development 37 (4): 26­29. Lipton, M. 1998. Successes in Anti-Poverty. Geneva: International Labour Office. Mariscal, E., and K. L. Sokoloff. 2000. Schooling, Suffrage and the Persistence of Inequality in the Americas, 1800­1945. Palo Alto, CA: Hoover Institution Press. Migot-Adholla, S. 1993. Indigenous Land Rights Systems in Sub-Saharan Africa: A Constraint on Productivity? Oxford, U.K.: Oxford University Press. Migot-Adholla, Shem E., Peter Hazell, Benoit Blarel, and Frank Place. 1991. "Indigenous Land Rights Systems in Sub-Saharan Africa: A Constraint on Productivity?" World Bank Economic Review 5 (1): 155­75. North, D. 1990. Institutions, Institutional Change, and Economic Performance. Cambridge, U.K.: Cambridge University Press. Olson, Mancur. 1982. The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities. New Haven: Yale University Press. Pathan, R., N. Arul, and M. Poffenberger. 1993. "Forest Protection Committees in Gujarat--Joint Management Initiatives." Reference Paper 8, prepared for Sustainable Forest Management Conference, sponsored by the Ford Foundation, Delhi. Place, F., and S. Migot-Adholla. 1998. "The Economic Effects of Land Registration on Smallholder Farms in Kenya: Evidence from Nyeri and Kakamega Districts." Land Economics 74 (3): 360­73. Putnam, R. 1993. "The Prosperous Community--Social Capital and Public Life." American Prospect 13 (Spring): 35­42. Putnam, R., R. Leonardi, and R. Nanetti. 1993. Making Democracy Work: Civic Traditions in Modern Italy. Princeton, NJ: Princeton University Press. Quisumbing, A. R., and K. Otsuka. 2001. "Land, Trees, and Women: Evolution of Land Tenure Institutions in Western Ghana and Sumatra." Research Report 121, International Food Policy Research Institute, Washington, DC. Land and Agriculture 317 Ravallion, Martin, Shaohua Chen, and Prem Sangraula. 2007. "New Evidence on the Urbanization of Global Poverty." Policy Research Paper 4199, World Bank, Washington, D.C. Saxena, N. C. 1999. "Rehabilitation of Degraded Lands in India through Watershed Development." Government of India, Planning Commission, New Delhi, India. Stiglitz, J. 1996. "Some Lessons from the East Asian Miracle." World Bank Research Observer 11 (2): 151­77. Udry, C. 1996. "Gender, Agricultural Production, and the Theory of the Household." Journal of Political Economy 104 (5): 1010­46. 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CHAPTER 15 Technology, Entrepreneurship, and Productivity More than six decades of empirical evidence from developing countries suggests that total factor productivity (TFP, defined as the efficiency with which physical and human capital, land, and natural resources are used to produce outputs) influences growth more than the accumulation of phys- ical and human capital. But economists do not know which factors (such as national policies and institutions) drive the accumulation of new tech- nology, nor do they agree on a definition of technology (box 15.1). This chapter explores whether the adoption of new technology prompts growth in income, employment, and productivity or if such adoption-- especially if it takes place too rapidly--leads to job insecurity and job losses as old skills become obsolete. Some evidence suggests that the fac- tors most important for growth differ depending on the income level of the country: physical capital is most important in low-income countries (at the early stages of development), human capital in middle-income countries, and new ideas and technology in advanced countries. Total Factor Productivity Cross-country differences in TFP lead to different rates of gross domestic product (GDP) growth. Unfortunately, measuring TFP is difficult because 319 320 Understanding Growth and Poverty Box 15.1 What Is Technology? Technology is usually thought of as a process of invention, innovation, develop- ment, and diffusion/adoption (also called knowledge). Organizational structures, management skills, and culture (including social organizations) are considered part of technology. Technological inventions and innovations are extremely unpredictable (for example, which research is relevant and for what purpose is usually not known except in hindsight); therefore, the time path of technological change is uncertain. Also, the various components of technology interact with the growth process in different ways. While most growth has historically been attributed to exogenous technological changes, some recent research, particu- larly by Dale Jorgenson (2001), who treats technology as knowledge, indicates that improved measures of physical and human capital can reduce the impor- tance of innovation and knowledge-based spillovers in explaining growth. In contrast, some economists believe that the knowledge that leads to technologi- cal advances differs from physical and human capital, as investors cannot fully internalize the benefits of accumulating knowledge (that is, spillovers from pri- vate investment in knowledge). The rate of accumulation of knowledge is an important factor in the growth process even with modest spillover effects. Source: Authors. (a) small differences in assumptions can lead to big differences in TFP growth estimates; (b) data on the depreciation rate, flows of new invest- ment, and initial stocks of human and physical capital, among other things, are limited and subject to measurement errors; and (c) increasing returns to scale, imperfect competition in labor and product markets, and gains from sectoral reallocation of inputs can skew results. Further, there are econometric problems, as the residuals of TFP in a simple regression are correlated with the growth of inputs. In other words, the ordinary least squares method of regression is invalid and an instrumental variables approach must be used to obtain meaningful estimates. For example, Ethiopia, Kenya, Mozambique, Senegal, and Tanzania, as a group, have exhibited relatively fast growth during the past 15 years (table 15.1). But because of slower TFP growth, these fast-growing African countries trail other developing countries in real GDP growth. The aggregate TFP growth of these five economies averaged 0.41 per year Technology, Entrepreneurship, and Productivity 321 Table 15.1 Indexes of Average Gross and Net TFP­Adjusted Prices in Selected African Countries Relative to China, 2000­04 Gross TFP Net TFP Ethiopia 0.50 0.25 Kenya 0.70 0.35 Mozambique 0.30 0.25 Senegal 0.80 0.65 Tanzania 0.65 0.40 Source: Eifert, Gelb, and Ramachandran 2005, 26. during the 1990s. More detailed firm-level TFP estimates by Eifert, Gelb, and Ramachandran (2005) show that the gross TFP growth of several fast-growing African countries from 2000 to 2004 was 40 to 80 percent lower than that of China and that net TFP (gross TFP growth adjusted for indirect costs of infrastructure, transport, and other costs external to the firms) was 20 to 40 percent lower. As shown in table 15.1, Senegal has the highest TFP growth among the few countries for which data are available. Eifert, Gelb, and Ramachandran (2005) argue that the relatively low economic performance of African countries is due largely to inadequate private sector activities. In their view, collusion between African private business elites and polit- ical elites, who depend on rent-seeking activities aided and abetted by a deep-seated and widely accepted bureaucracy, keep the economies of these countries at a lower equilibrium level than otherwise.1 Spending on Research and Development The production function of each country differs depending on its diffu- sion of technology, infrastructure stock and human capital, and natural resources endowment. Theoretically, a country can experience growth for a long period without technological progress by accumulating physical and human capital. But productivity growth of this sort cannot continue indefinitely. The large sums spent on research and development (R&D)-- which may be distorted by tax credits that encourage firms to classify current expenditure as investment--and variations in incentives for inno- vators lead to varying levels of innovation endogenous to firms and the economy. Broadly defining technology as the difference in productivity across countries explains most of the disparities in per capita income across 322 Understanding Growth and Poverty countries (De Long 1996), whereas defining technology as most modern machinery and manufacturing processes does not. For example, Clark (1987) shows that during the early twentieth century, textile mills in dif- ferent countries used the same machinery but experienced large differ- ences in output per hour. Similarly, with comparable technology, Japan is 47 percent more productive than the United States in steel production but 67 percent less productive in food processing (McKinsey Global Institute 1993). Recent growth theories emphasize the importance of endogenous technological change to explain growth patterns. Increasing R&D expenditures while effectively using human capital and the existing knowledge stock leads to innovation and inventions, which firms use to permanently increase the growth rate of output. Data available on 20 Organisation of Economic Co-operation and Development (OECD) and non-OECD countries indicate that innova- tion has a positive effect on the per capita output of both developed and developing countries. Not only are the OECD countries with large mar- kets able to increase their innovation by investing in R&D, but the remaining OECD countries seem to promote their innovation by using the know-how of other OECD countries. In particular, a 1 percent increase in innovation raises per capita income by around 0.05 percent in both OECD and non-OECD countries, while a 1 percent increase in the R&D stock increases innovation by about 0.2 percent only in the OECD countries with large markets (which includes the Group of Eight). This finding implies that innovation, such as capital stock, leads to only short- term increases in the growth rate of output and cannot explain perpetual economic growth. As neither patent nor R&D data are complete meas- ures of innovation, these figures should be interpreted cautiously. In both advanced and emerging economies, government is a large source of financing for research. The social rate of return to innovation is substantial in leading industries, indicating that governments should pro- vide modest incentives for R&D only for these industries and not for tra- ditional or declining industries or sectors. Also, links between public R&D spending and private industries should be encouraged, except in the case of strategic technology (for example, nuclear technology). Questions still remain that require further research. How strong is the causal link between research activity and innovation? Would growth lead to more R&D and therefore technological change, or do more R&D and technological change lead to growth? Is innovation more depend- ent on technological opportunities and luck than on incentives and spending on R&D? Technology, Entrepreneurship, and Productivity 323 Technology Diffusion and Adoption Technology has driven economic and social progress since the industrial revolution. Measuring technology as TFP explains most of the differences in both the level and rate of income growth across countries (see, for example, Hall and Jones 1999). Defining technology as scientific innova- tion and invention, however, delegates it almost exclusively to richer countries, albeit ones in which many developing-country nationals do much of the research (for example, a large proportion of engineers in Silicon Valley and researchers at the National Aeronautics and Space Administration, or NASA, are foreign born). Firms throughout the rest of the world then adopt and adapt the preexisting technologies. Openness to trade, foreign direct investment (FDI), and domestic investments in human capital are critical to rapid diffusion. Technology is therefore both a determinant and an outcome of rising incomes. Older technologies such as fixed-line telephones, electric power, trans- portation, and health-care services remain in high demand in low- and middle-income developing countries. Because of the large initial invest- ments, high maintenance costs, and need for highly skilled engineers, the government usually provides these services. In contrast, newer technolo- gies such as the Internet, cell phones, and computers are cheaper to adopt and easier to maintain and use. Still, technology adoption remains very uneven in most developing countries, creating rural-urban gaps such as that in India. Why does rapid diffusion of ideas fail to eliminate cross-country tech- nological differences as predicted by economic theory? For one, the tech- nologies of the world frontier may not serve the needs of specific countries. The OECD countries conduct more than 90 percent of the world's R&D. Accordingly, new technologies tend to be less appropriate for the conditions, skills, and capital intensity of developing countries. A notable exception is the case of pharmaceuticals (for example, HIV drugs), which could be used both in the OECD and developing countries. Similarly, the technologies developed for the capital-intensive production processes in the OECD countries may be of little use in labor-abundant, less-developed countries. One theory suggests that the entry of new and more productive plants and the exit of less productive plants--the process that Joseph Schumpeter (1934) dubbed "creative destruction"--can explain pro- ductivity differences across firms. But available evidence indicates that entry and exit account for only about 25 percent of average TFP growth, 324 Understanding Growth and Poverty with the remaining 75 percent attributable to existing plants, where firms regularly invest in technology and productivity. A review of empirical evidence on technological adoption by Chandra (2006) concludes that (a) latecomers can leapfrog over several stages of development--India and Ireland appear to be riding on a wave of out- sourcing of international business operations, while Taiwan, China, increased its per capita income tenfold within four decades largely due to the rapid expansion of electronic exports--and (b) technological learning, involving technological mastery first and deepening later, was key to the latecomers' success. The channels of technology transfer included the following: · Intrafirm transfers through FDI (from parent to subsidiaries--for example, wine in Chile; floriculture in Kenya; electronics in Malaysia and Taiwan, China; and Nile perch fisheries in Uganda) · Licensing, contracting, and subcontracting because buyers must develop their own marketing capabilities (this, however, appears to be a more limited channel) · Technology embodied in capital goods imports · Formal R&D · Harnessing of the diasporas to disseminate technological knowledge to local firms (for example, software from India and electronics from Taiwan, China). Information and Communication Technology Information and communication technology (ICT) is now the main technological driver for productivity growth in a number of developing countries. According to a study by the Centre for Economic Policy Research, countries with mobile phone penetration of 10 percent of the population have a 0.59 percent higher GDP per capita growth rate. Furthermore, strong empirical evidence suggests that investment in ICT and higher education--partly by allowing for the better use of ICT-- strongly improves competitiveness (figure 15.1). Are Entrepreneurship and Growth Linked? North (1990, 83) explicitly links economic growth and the entrepreneur: "The agent of change is the individual entrepreneur responding to the incentives embodied in the institutional framework." Schumpeter (1934) defines the entrepreneur as the bearer of the mechanism for change and economic development and entrepreneurship as the undertaking of new Technology, Entrepreneurship, and Productivity 325 Figure 15.1 Global Competitiveness Index Impact of Investment in ICT 6.5 6.0 United States Finland Denmark Germany Japan global competitiveness index (overall score) 5.5 Singapore Korea, Rep. Israel 5.0 Luxembourg United Arab Emirates 4.5 Malta 4.0 Brazil 3.5 Pakistan 3.0 y = 0.0155x2 + 0.7831x + 4.2171 Ethiopia Mali 2 R = 0.9177 Chad 2.5 2.0 ­2.0 ­1.5 ­1.0 ­0.5 0 0.5 1.0 1.5 2.0 2.5 networked readiness index: ICT usage component (score) Source: Ndulu and others 2007, 172. ideas and new combinations (that is, innovations). He describes five man- ifestations of entrepreneurship (Schumpeter 1934, 66): a new good, a new method of production, a new market, a new source of supply of intermediate goods, and a new organization. Kirzner (1973, 17) argues that "entrepreneurship is inherent in the competitive market process" and that the entrepreneur's activities are essentially competitive: "The `pure' entrepreneur observes the opportunity to sell something at a higher price than that at which he can buy it." Vosloo (1994, 147) offers another view, describing the entrepreneur "as a person who has the ability to explore the environment, identify opportunities for improvement, mobilize resources and implement action to maximize those opportunities." Several studies (Acs 1996; Baldwin and Johnson 1999; Audretsch and Thurik 2001) support the view that smaller firms (employing fewer than 500 persons) have contributed more toward innovative products2 than larger firms. Yu (1997) argues that Schumpeter's entrepreneur, the creative destroyer, prevents the economy from reaching a stationary equilibrium, while Kirzner's entrepreneur brings the economy into equilibrium by spotting and profiting from disequilibria. Landström (1999) illustrates their differences on a production possibility curve (figure 15.2). 326 Understanding Growth and Poverty Figure 15.2 Changes in the Production-Possibility Frontier product A equilibrium frontier Schumpeter Kirzner product B Source: Landström 1999, 49. By introducing new ideas, processes, and products and services, Schumpeterian entrepreneurs renew the economic activities of firms, industries, and--on a larger scale--regions. Aggregated and evaluated in terms of their economic impact at a territorial level, these entrepreneur- ial initiatives could spur economic growth. Furthermore, the larger the share of innovative entrepreneurs in the workforce, the faster the pace of economic growth. Karlsson, Friis, and Paulsson (2004) observe a structural shift in the OECD countries from "managed economies," dependent on large compa- nies, to "entrepreneurial economies," populated by smaller companies relying on knowledge, initiative, and flexibility. This transition appears to have taken place between the mid-1970s and the early 1990s. The researchers use Chandler's (1990, 3) characterization of the econ- omy as the "three-pronged investment in production, distribution and management that brought the modern industrial enterprise into being."3 Competitive advantage remains in economies of scale or scope, which allow the product to reach a large market. Therefore, large firms drive the economy, while the entrepreneurial economy depends on knowledge and flexibility as the key factors of production. Successful entrepreneurship, combined with dynamic corporations, contributes to a nation's economic development, though in different ways depending on the national income level as measured by GDP per Technology, Entrepreneurship, and Productivity 327 capita. At low levels of national income, self-employment provides job opportunities and scope for the creation of markets. As per capita income increases, the emergence of new technologies and economies of scale allows larger and more established firms to satisfy both the demand of growing markets and their role in the overall economy. Entrepreneurship results in new businesses; creates new jobs, products, and services; and may increase productivity through technological change. Therefore, higher entrepreneurship can be associated with higher economic growth. Acs (2006) describes two types of entrepreneurship: "necessity entrepreneurship," which emerges when other options are lacking, and "opportunity entrepreneurship," in which a new enterprise exploits an existing or latent opportunity. Using data from 11 countries, Acs claims that necessity entrepreneurship has no effect on economic development, while opportunity entrepreneurship has a significant positive effect. The Global Entrepreneurship Monitor (GEM) model research pro- gram, initiated in 1999 with data on 10 countries, expanded in 2005 to cover 39 developed and developing countries. In a "harmonized assess- ment" (that is, one applying uniform definitions), the GEM surveys a large sample of entrepreneurs (1,000 to 27,000 individuals) from each participating country. To counter enthusiasm bias and ensure accuracy, the GEM uses a ratio of "opportunity-necessity" as a composite indicator of entrepreneurial activity and economic development.4 The GEM shows that some developing countries have higher levels of both opportunity and necessity entrepreneurship than high-income countries. Economists attribute the "patterns of structural change" (Syrquin 1988) to three stages in development. The first stage is agriculture. The second stage is marked by a shift toward small-scale manufacturing with increasing specialization, followed by a move toward services. The decline in entrepreneurial activity results in decreasing employment rates, including self-employment (Kuznets 1966); marginal managers can earn more money being employed by someone else. In the third stage, entrepreneurial activity in developed, industrial countries moves toward larger organizations. Interestingly, a series of studies found that in the mid-1970s, this trend began to reverse itself (Blau 1987). More studies have confirmed that, in developed countries, firm-size distribution shifted away from larger corporations toward entre- preneurial activity. Acs (2006) lists three explanations. First, in the past 30 years, all industrial economies have experienced a decline in manufac- turing and a relative increase in the service sector. But while service firms are generally smaller than manufacturing firms (leading to an overall 328 Understanding Growth and Poverty decrease in firm size across the economy), their growth provides more entrepreneurship opportunities, as in the case of the European Union and the United States. Second, technological changes, especially in communi- cations, have been favorably biased toward industries in which entrepre- neurial activity is important and associated with increased returns (Jorgensen 2001). Third, in contrast to Lucas's (1978) finding that higher development leads to larger firm size, recent research (Aquilina, Klump, and Pietrobelli 2006) suggests that the high value of the elasticity of factor substitution leads to capital concentration (more capital per capita), easier entrepreneurship, and smaller firms. Therefore, economies in the early or middle stage of development are likely to have relatively little entrepreneurial activity, since workers are moving from self-employment to wage employment, whereas developed economies are likely to experience entrepreneurial activity as people shift from wage work to entrepreneurship. As figure 15.3 indicates, this frame- work implies a U-shaped relationship between entrepreneurial activity and economic development in the global economy. Colombia, Indonesia, and Jamaica have high levels of entrepreneurial activity and low per capita income, while Ireland, Slovenia, and Sweden have precisely the opposite situation: high per capita income and relatively low entrepre- neurial activity. Countries in the midst of the transformation from a middle-income level to a higher-income level have rising entrepreneurial activity and compose the middle. High-income countries such as Belgium, Finland, France, Germany, and Italy have relatively low levels of entrepreneurial activity, while Japan and the United States are outliers. Figure 15.3 illustrates the association between entrepreneurship and the level of economic development: (a) early-stage entrepreneurial activity is generally higher in those countries with lower levels of GDP; (b) early-stage entrepreneurial activity is relatively low in high-income countries, especially for the core countries of the European Union and Japan; and (c) countries with the highest levels of GDP show increas- ing early-stage entrepreneurial activity, suggesting a new increase in opportunity-related entrepreneurship. But this cross-sectional approach does not imply any specific causal relationships between entrepreneurial activity and economic development. Entrepreneurial Activity and Growth Traditional analyses of economic development tend to focus on large corporations and neglect the innovations and competition that small Technology, Entrepreneurship, and Productivity 329 Figure 15.3 Early-Stage Entrepreneurial Activity Rates and GDP per Capita 25% percentage of population between 18­64 years involved in CO JA PH 20% ID early-stage entrepreneurial activity estimated parameters fitted trendline: CN y = ­4E­15x3 + 5E­10x2 ­ 2E­05x + 0.2466 TH R2 = 0.58 15% UY BR MY AU IS IN AR US 10% HR NO CL CZ GR ES CA IE LV UK TR SA CH FI DK 5% MX NL RU SG SL FR GE IT SE AE JP BE 0% 0 10,000 20,000 30,000 40,000 50,000 GDP per capita 2006, in power purchasing parities [PPP] early-stage entrepreneurial activity (TEA rate) 2006 TEA rate United Arab Emirates fitted 3rd order polynomial-Arab Emirates and Peru excluded Source: Reprinted with permission from GEM 2006, 11; GDP levels were taken from IMF 2006. Note: Permission to reproduce this figure from the Global Entrepreneurship Monitor 2006 Summary Results has been kindly granted by the copyright holders. The GEM is an international consortium and this report was produced from data collected in, and received from, 42 countries in 2006. The report was made possible by contributing authors, national teams, researchers, funding bodies, and others. AR = Argentina; AU = Australia; BE = Belgium; BR = Brazil; CA = Canada; CL = Chile; CH = China; CO = Colom- bia; CN = Croatia; CZ = Czech Republic; DK = Denmark; FI = Finland; FR = France; GE = Germany; GR = Greece; HR = Hungary; IS = Iceland; IN = India; ID = Indonesia; IE = Ireland; IT = Italy; JA = Jamaica; JP = Japan; LV = Latvia; MY = Malaysia; MX = Mexico; NL = Netherlands; NO = Norway; PH = Philippines; RU = Russian Federation; SG = Singapore; SL = Slovenia; SA = South Africa; ES = Spain; SE = Sweden; TH = Thailand; TR = Turkey; AE = United Arab Emirates; UK = United Kingdom; US = United States; UY = Uruguay. Peru not shown in this graph. firms contribute to the economy. Country-specific business conditions influence large corporations' ability to affect national economic growth. These corporations influence economic growth primarily through the construction of new plants and the creation of jobs. When an old plant is replaced, the use of new technologies results in increased productivity and contributes to the country's growth. In general, "national framework conditions" apply to ongoing business operations, while start-ups encounter "entrepreneurial framework conditions" (figure 15.4). These conditions together affect the entrepreneurial process and can lead to 330 Understanding Growth and Poverty Figure 15.4 Global Entrepreneurship Monitor Model major general established firms new national (primary economy) establishments framework conditions national economic micro, small, and growth medium firms social, cultural, (secondary economy) political context (jobs and technical innovation) entrepreneurial opportunities entrepreneurial early-stage framework entrepreneurial conditions entrepreneurial activity capacity skills motivation Source: Reprinted with permission from GEM 2007, 8. Note: Permission to reproduce this figure from the Global Entrepreneurship Monitor 2007 Global Report, which appears here, has been kindly granted by the copyright holders. The GEM is an international consortium and this report was produced from data collected in, and received from, 42 countries in 2007. The report was made possible by contributing authors, national teams, researchers, funding bodies, and others. innovation, competition, and development in the marketplace and con- tribute to economic growth. Figure 15.4 suggests a complicated relationship among entrepreneur- ship, corporations, and economic development. Note also the importance of GDP per capita. At low levels of national income, self-employment provides market opportunities. Increasing GDP per capita will result in new technologies, while economies of scale allow large and established firms to satisfy the increasing demand of growing markets. At the same time, the number of business start-ups decreases as more people find sta- ble employment. Policy Implications Karlsson, Friis, and Paulsson (2004) suggest organizing the "institutional rules of the game" to provide and support incentives for innovation and facilitate the entry and growth of new and small firms (Davis and Henrekson 1999; Fölster 2002; and Henrekson 2002). They recom- mend several means of support: (a) encourage immigration of individu- als with key knowledge; (b) provide education and training to nationals in foreign countries where critical new technology and knowledge is being used; and (c) provide loan guarantees for rapid adoption of critical for- eign technology (Baumol 1993) to encourage changes in entrepreneurial Technology, Entrepreneurship, and Productivity 331 behavior according to the "rules of the game." Karlsson, Friis, and Paulsson (2004) also suggest the following policy measures: · The wage formation and labor markets, in general, should be deregu- lated. This would support the growth of firms by making it easier to hire (and fire) staff. · The tax system should not discourage small and new firms. Furthermore, low income taxes promote the accumulation of wealth necessary for the birth of new firms. · Entry of firms should be free across the entire economy--that is, reg- ulated public sector monopolies should be abolished. As income increases, more individuals have the resources to go into busi- ness for themselves (provided that the business environment encourages the exploitation of opportunities). In high-income economies, through lower costs and accelerated technology development, entrepreneurial firms will enjoy a newfound competitive advantage. Therefore, entrepreneurs in countries with different levels of GDP per capita face different challenges and, as a result, policies and conditions favorable to entrepreneurship in one country (or region) may not be effective or favorable in another. Before focusing on the entrepreneurial sector, less-developed coun- tries should develop policies that reduce the number of self-employed workers and strengthen existing small and medium-size firms. For exam- ple, improved working conditions, the rule of law, labor market flexibil- ity, infrastructure, financial market efficiency, and management skills attract FDI and thus promote employment, technology transfer, exports, and tax revenues. Similarly, a strong commitment to education is impor- tant. Those with less education in developing countries tend toward necessity entrepreneurship. To encourage opportunity entrepreneurship, developing economies must improve technology transfer; increase the availability of early-stage funding; and support entrepreneurial activity in the state, corporate, and educational sectors (especially at the university level). The higher educa- tion systems need to play an important role in R&D and technology com- mercialization. Conclusion Total factor productivity is the main driver of growth. But we know lit- tle about innovation and its contribution to productivity and growth. 332 Understanding Growth and Poverty Most developing countries adopt new technologies generated by advanced economies. Several policies may encourage technological inno- vation and adoption, but there is little empirical evidence of a strong causal link between a particular policy and technological success. Entrepreneurship appears to be a key driver of technological innovation and commercialization. Small firms, not large companies, are still at the center of technological innovation and adoption. Notes 1. Eifert, Gelb, and Ramachandran (2005, 31) use the findings of the Afrobarometer surveys to validate this assertion. A majority of the respon- dents in several countries prefer government-led growth and job creation and a large bureaucracy even when the government cannot pay decent wages. Further, only 35 percent of respondents support the privatization of public enterprises, and only 32 percent support civil-service reform. 2. Innovative products are defined here as electronic computing equipment, process control instruments, electronic components, engineering and scientific instruments, and plastic products. 3. See Acs 1996, 1999; Acs and Audretsch 2001; Audretsch and Elston 2002; Carree, Thurik, van Stel, and Wennekers 1998; Carree, Klomp, and Thurik 1999; Carree, van Stel, Thurik, and Wennekers 2002; Thurik 1996; Thurik, Verheul, and Uhlaner 2003. 4. Stating that the program's inability to effectively compare entrepreneurial activity in developed and developing countries is a "major shortcoming," the GEM cites the example of low-income countries such as Ecuador, Peru, and Uganda (which have very high levels of self-employment and therefore high levels of entrepreneurial activity) versus high-income countries such as Germany, Japan, and Sweden (which have much lower levels of entrepre- neurial activity). As a solution, the "opportunity-necessity ratio" is used as a composite indicator of entrepreneurial activity and economic development. Bibliography Acs, Zoltan. 1996. "Small Firms and Economic Growth." In Small Business in the Modern Economy, ed. Z. J. Acs, B. Carlsson, and R. Thurik, 1­62. Oxford, U.K.: Blackwell Publishers. ------. 1999. "The New American Evolution." In Are Small Firms Important? Their Role and Impact, ed. Z. J. Acs, 1­20. Dordrecht, The Netherlands: Kluwer Academic Publishers. ------. 2006. 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Working Paper 56, CGD: Washington, DC. 334 Understanding Growth and Poverty Fölster, S. 2002. "Do Lower Taxes Stimulate Self-Employment?" Small Business Economics 19 (2): 135­45. GEM (Global Entrepreneurship Monitor). 2006. Results 2006. Babson Park, MA: Babson College; London: London Business School. ------. 2007. Results 2007. Babson Park, MA: Babson College; London: London Business School. Hall, R. E., and C. I. Jones. 1999. "Why Do Some Countries Produce So Much More Output Per Worker than Others?" Quarterly Journal of Economics 114 (1): 83­116. Henrekson, M. 2002. "Entrepreneurship--A Weak Link in the Mature Welfare State." SSE/EFI Working Paper 518, Stockholm School of Economics, Stockholm. Holcombe, Randall G. 1998. "Entrepreneurship and Economic Growth." Quarterly Journal of Austrian Economics 1 (2): 45­62. Hülsmann, Jörg Guido. 1997. "Knowledge, Judgment, and the Use of Property." Review of Austrian Economics 10 (1): 1­22. ------. 1999. 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CHAPTER 16 Urbanization and Growth1 A number of countries on high and sustained growth paths share common strategic factors. These factors include the maturation and deepening of market institutions, effective macroeconomic policy management, high levels of savings and investment, openness to trade and financial flows (and adoption of technology), and the presence of fast-growing urban areas.2 This chapter will analyze the urbanization process, discuss its con- tribution to growth and poverty alleviation, and outline emerging issues in the urbanization of developing countries. Trends in Urbanization The year 2008 was a landmark in history: for the first time, more than 50 percent of the world's population was living in urban areas (figure 16.1). Cities cover just 2 percent of the world's land area, but they consume more than 75 percent of the world's resources and generate more than 70 percent of the world's greenhouse gases. Urbanization signals modernization and industrialization and is viewed as a natural part of an economy's transition from low-productivity agriculture to higher-productivity indus- try and services. Historically, no country has industrialized without urbanizing. At the same time, many critics view urbanization as the result 337 338 Understanding Growth and Poverty Figure 16.1 Urban and Rural Populations of the World 7,000 6,000 5,000 population (millions) 4,000 3,000 2,000 1,000 0 50 60 70 80 90 00 e e e e e 20 30 40 50 10 19 19 19 19 19 20 20 20 20 20 20 urban population rural population Source: United Nations 2007b. Note: e = estimated. of a bias toward cities in government policies and investment, a bias that presses people to migrate from rural areas to cities in search of jobs. Rapid urbanization places stress on cities' basic infrastructure--water, sanita- tion, electricity, and roads--and, when unplanned, can lead to sprawling slums and rising levels of inflation, poverty, crime, and environmental damage. Given the current and projected global trends in urbanization, it is important to understand and resolve these opposing viewpoints and develop effective programs and policies for sustainable economic devel- opment in the years ahead. Rapid urbanization first started in today's more developed regions. In 1920, just under 30 percent of Europe, North America, and Oceania's population lived in urban areas, compared to more than half in 1950. By 2007, over 70 percent of the population of Australia and New Zealand and over 80 percent of the population of North America lived in urban areas. Among the less-developed regions, Latin America and the Caribbean had a similarly high level of urbanization--78 percent in 2007--even higher than that of Europe. Africa and Asia, in contrast, remained mostly rural, with 38 percent and 41 percent, respectively, of their populations living in urban areas (table 16.1). Over the coming decades, urbanization is expected to increase in all the major areas of the developing world, Table 16.1 Rate of Regional Urbanization Percentage urban Rate of urbanization (percentage) Major areas 1950 1975 2007 2025 2050 1950­75 1975­2007 2007­25 2025­50 Africa 14.5 25.7 38.7 47.2 61.8 2.28 1.28 1.10 1.08 Asia 16.8 24.0 40.8 51.1 66.2 1.42 1.66 1.24 1.04 Europe 51.2 65.7 72.2 76.2 83.8 1.00 0.29 0.30 0.38 Latin America and the Caribbean 41.4 61.1 78.3 83.5 88.7 1.56 0.78 0.36 0.24 Northern America 63.9 73.8 81.3 85.7 90.2 0.58 0.30 0.29 0.20 Oceania 62.0 71.5 70.5 71.9 76.4 0.57 ­0.05 0.11 0.24 Source: United Nations 2007b. 339 340 Understanding Growth and Poverty with Africa and Asia urbanizing more rapidly than the rest. Nevertheless, by midcentury, Africa and Asia are expected to have the lowest levels of urbanization in the world. Despite its low level of urbanization, Asia was home to about half of the world's urban population in 2007; Europe had the second-highest share, at 16 percent (figure 16.2). It is estimated that over the next four decades, Africa's urban population will triple and Asia's will more than double. By midcentury, most of the world's urban population will be con- centrated in Asia (54 percent) and Africa (19 percent). Urbanization and Growth The world's urban population is expected to nearly double by 2050, increasing from 3.3 billion in 2007 to 6.4 billion in 2050--the same size as the world's total population in 2004. Urban areas of the less-developed regions, whose population is projected to increase from 2.4 billion in 2007 to 5.3 billion in 2050, will absorb most of the world's population Figure 16.2 Distribution of the World's Urban Population 60 54 50 50 40 38 32 percent 30 19 20 16 14 15 11 11 10 9 9 8 6 4 1 1 1 0 a ia pe be nd ica ia ric As n ro rib a a er an ea Af Eu Am Oc Ca ic e er rth th Am No tin La 1950 2007 2050e Source: United Nations 2007b. Note: e = estimated. Urbanization and Growth 341 growth. The urban population of the more-developed regions is projected to increase modestly, from 0.9 billion in 2007 to 1.1 billion in 2050. The urban growth rate of less-developed regions reached a high in 1995­2000 of 3 percent per year, compared to 0.5 percent in the more developed regions. The urban growth rate in less-developed regions is expected to be particularly rapid, averaging 2.4 percent per year during the period 2000­30. Productivity gains can explain some of the economic growth associ- ated with urbanization. According to Quigley (2008), these gains arise from specialization; lower transaction costs and complementarities in production; education, knowledge, and mimicking; and greater proximity to large numbers of economic actors. Productivity gains translate to higher per capita incomes. Bloom and Khanna (2007) find a positive cross-country association between income and urbanization, as shown in figure 16.3, which plots country-level data on the real gross domestic Figure 16.3 Urbanization and Economic Growth (83%, $50,800) 40,000 real GDP per capita (constant 2000 US$) 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 20 40 60 80 100 share of urban population (percent) 1960a 2004a Source: Bloom and Khanna 2007, 11. a. Sample size N = 97 in 1960 and N = 79 in 2004. 342 Understanding Growth and Poverty product (GDP) per capita and the share of the population living in urban areas during 1960 and 2004. The curves are initially very flat, implying that the links between urbanization and income are relatively weak at low levels of development. In a study on urbanization in the East Asia region (Iimi 2005), the elasticity of economic growth to urbanization rate was estimated at 2.71--in other words, a 1 percent increase in the urbaniza- tion rate raises the GDP per capita by 2.71 percent. This figure supports the view that urbanization is an engine for growth. But this may not be true for all countries. While rapid economic growth has accompanied urbanization in Asia over the past 45 years, in Africa, where urbanization has been nearly identical, economic growth has been sluggish. This does not rule out a link between urbanization and economic growth (incomes in Africa might have grown even more slowly without urbanization, for example), but it does suggest that factors other than urbanization are more important determinants of income growth. Urbanization and Poverty An estimated one-third of urban residents are poor, representing one- quarter of the world's total poor (Baker 2008). Many of these people live in small cities and towns, where poverty is more prevalent than it is in big cities. With continued urbanization, however, the number of urban poor is predicted to rise, and poverty will become an increasingly urban phenomenon. The incidence of urban poverty (the share of the poor as a proportion of the urban population) is highest for South Asia (35 percent) and Sub- Saharan Africa (40 percent), as shown in table 16.2. Latin America and the Caribbean and Europe and Central Asia have the greatest proportion of urban poor relative to total poor because of high urbanization rates in these regions. The urban poor account for 66 percent and 50 percent of the total poor in these two regions, respectively. Overall, the Middle East and North Africa has the lowest incidence and share of urban poverty. The incidence of urban poverty is notably lower in East Asia and Pacific, Europe and Central Asia, and the Middle East and North Africa com- pared to the other regions, reflecting better initial conditions. Key Issues in Urbanization Rapid urbanization has raised some key issues that have to be addressed if urban growth is to be sustainable. These include limited access to Table 16.2 Urban Poverty Estimates, 2002 Number of Number of urban poor urban poor Headcount Headcount Urban share Urban share Urban share (millions) (millions) index index of the poor of the poor of the $1/day $2/day (%) $1/day (%) $2/day $1.08/day $2.15/day population East Asia and Pacific 16 126 2.2 17.7 6.7 15.1 38.8 China 4 53 0.8 10.7 2.2 9.5 37.7 Europe and Central Asia 2 32 0.8 10.7 33.4 49.9 63.5 Latin America and the Caribbean 38 111 9.5 27.5 59.0 65.6 76.2 Middle East and North Africa 1 20 0.7 12.4 19.9 29.3 55.8 South Asia 135 297 34.6 76.2 24.9 25.2 27.8 India 116 236 39.3 80.1 26.0 26.0 28.1 Sub-Saharan Africa 99 168 40.4 68.5 30.2 31.1 35.2 Total 291 754 13.2 34.0 24.6 26.4 42.3 Source: Baker 2008, 3 (citing Ravallion, Chen, and Sangraula 2007). Note: Table uses $1.08/day and $2.15/day poverty lines in 1993 purchasing power parity values. The headcount index represents the urban poor as a proportion of the total poor. 343 344 Understanding Growth and Poverty income and employment in urban cities; urban slums; megacities and urban agglomeration; and urban land management and housing. The fol- lowing subsections discuss these issues in detail. Income and Employment Cities draw rural migrants seeking more economic opportunities. Duranton (2008) points out that labor mobility generates new ideas and opportuni- ties and is crucial to growth. Labor mobility responds to wage differentials across different locations. A study by Prud'homme (1996) indicates that the GDP per capita in most cities in Asian developing countries is higher than the average national income. As seen in table 16.3, the per capita income in Shanghai was 3.66 times the national average, and in Seoul it was 1.13 times the national average. But not everyone who lives in an urban area gets a job in the formal sector. In fact, evidence shows that the bulk of urban jobs are in the infor- mal sector, which accounts for 30 to 70 percent of the GDP in develop- ing countries. While the informal sector provides employment for many who cannot enter the formal labor market and supplies goods and serv- ices typically not offered by the formal sector, it is also characterized by relatively poor working conditions, lack of social insurance, operations outside the legal system, and vulnerability to economic fluctuations, which particularly affect the poor, who have relatively little savings. The majority of the urban poor work in the informal sector. Unemployment and underemployment are typically higher for the urban poor than for urban residents who are not poor. For example, a World Bank (2007) study found that the unemployment rate for the Table 16.3 GDP of Urban Areas Compared with National GDP (A) (B) City GDP City National GDP per capita ($) City GDP per capita ($) (B/A) ($ billion) Tokyo 25,430 35,600 1.40 890.1 Osaka 25,430 32,300 1.27 339.1 Seoul 5,400 6,080 1.13 66.9 Bangkok 1,420 4,900 3.45 34.8 Shanghai 370 1,350 3.66 18.0 Manila 730 1,400 1.92 12.5 Jakarta 570 1,230 2.15 11.3 Calcutta 350 875 2.50 9.4 Source: Prud'homme 1996, 101­03. Urbanization and Growth 345 poorest male workers in Dhaka, Bangladesh, is about 10 percent--double the rate for the wealthiest (5 percent). About 25 percent of poor women in Dhaka are unemployed, compared to 12 percent of the nonpoor. Youth unemployment is a major problem in many cities and is increasingly linked to social unrest. An International Labour Organization (ILO 2004) study indicated that average youth unemployment rates in 2003 were highest in the Middle East and North Africa region (25.6 percent) and Sub-Saharan Africa (21 percent) and lowest in East Asia (7 percent). The United Nations Population Fund (UNFPA) predicts that by 2030, 60 percent of those living in urban areas will be under the age of 18. The proportion of young people is particularly high in slum areas, where employment opportunities are limited. This combination of youth and poverty can lead to high crime rates. Some demographers have forecast that the increasing concentration of populations in big cities will lead to major conflicts affecting both urban areas and entire countries. Child labor also goes hand in hand with urban poverty in many coun- tries, particularly in Sub-Saharan Africa. The latest International Labour Organization estimates for several African countries indicate that more than 26 percent of children ages 5­14 were economically active in 2004. While child labor typically had been a rural phenomenon, with children working overwhelmingly with their families, it now also exists in cities, with children working in the service sector, construction, and manufac- turing. Girls are typically the most vulnerable, as they are often sent to work in the informal economy and as domestic workers. High levels of child labor translate into very low levels of school enrollment, which affects the children's opportunities later in life. Urban Slums Because quality urban housing is costly, increasing numbers of urban poor live in slums where water and sanitation facilities are inadequate and liv- ing conditions are crowded and often unhealthy. The United Nations (UN) (UN-Habitat 2006, vi) estimates that the number of people living in slums exceeded 1 billion in 2007 and could reach 1.39 billion in 2020, although there are large variations among regions. In Asia and the Pacific, two out of five urban dwellers live in slums; in Africa, the figure is three out of five. In Sub-Saharan Africa, about 72 percent of city dwellers live in slums. Asia has by far the highest number of city dwellers living in slums, and the problem is worst in South Asia, where half of the urban population is 346 Understanding Growth and Poverty Figure 16.4 Share of Slum Population in Urban Areas in Select Asian and Pacific Countries Afghanistan Nepal Bangladesh Pakistan Cambodia Lao PDR Mongolia India Vietnam Iran, Islamic Rep. Bhutan Philippines China Korea, Rep. Myanmar Indonesia Turkey Sri Lanka Thailand 0 20 40 60 80 100 percent 2001 1990 Source: United Nations 2007a. composed of slum dwellers. Figure 16.4 illustrates the share of slum population in some Asian and Pacific countries. In 2001, as much as 99 percent of Afghanistan's urban population lived in slums, while 92 per- cent and 85 percent of urban populations lived in slums in Nepal and Urbanization and Growth 347 Bangladesh, respectively, two countries that have had some success in containing the problem since 1990. Understanding slums has become a priority for policy makers. The Millennium Development Goals (MDGs)--in particular, goal 7, target 11--call for the improvement of the lives of at least 100 million slum dwellers through a rapid, sustained decline in slum-growth rates.3 Few countries are on track for reaching these goals, however. According to Baker (2008), the countries that are farthest behind are mainly in Sub- Saharan Africa (table 16.4), where slums grew at an annual rate of 4.53 percent over the period 1990­2001, mainly because of local govern- ments' inability to accommodate a rapid increase in migration to cities. The largest and most overwhelming slum in Africa is Kibera in Nairobi, where between half a million and a million people reside. The UN-HABITAT sta- tistics are both illustrative and alarming: in Zambia, 74 percent of urban dwellers live in slums; in Nigeria, 80 percent; in Sudan, 85.7 percent; in Tanzania, 92.1 percent; in Madagascar, 92.9 percent; and in Ethiopia, an astounding 99.4 percent. The burgeoning slums are partly attributable to the lack of an appro- priate urban-planning strategy. Most governments have moved away from the ill-advised policy of eliminating city slums through demolition and now attempt to upgrade or relocate them. Very few governments, how- ever, are actively planning at the appropriate scale to prevent future slums. One exception is Malawi, which has set aside decent land in cities such as Lilongwe for low-income housing projects. With urbanization set to rapidly increase in the near future, it is imperative that other govern- ments plan for the influx of new urban residents with policies that pro- mote growth and ensure a higher quality of life for the urban poor. Table 16.4 Regional Characteristics of Slums, 2001 Estimate of slum Slum dwellers as Slum annual dwellers proportion of urban growth rate Region (millions) population (%) (1990­2001) Sub-Saharan Africa 166.2 71.9 4.53 Middle East and North Africa 21.3 28.2 ­0.15 Latin America and the Caribbean 127.5 31.9 1.28 South Asia 253.1 59.0 2.20 Southeast Asia 56.8 28.0 1.34 East Asia 193.8 36.4 2.28 Europe and Central Asia 45.2 6.0 0.72 World 912.9 31.2 2.22 Source: Baker 2008, 7 (citing UN-HABITAT 2006). 348 Understanding Growth and Poverty Megacities and Urban Agglomeration Dramatic decreases in the costs of information and communication tech- nology and transport should have reduced spatial disparities in economic activities and moved us toward a "global village." Yet in both industrial and developing countries, economic activities are concentrated in a few centers, and regional disparities persist. For example, only about 15 per- cent of the world's population live in temperate zones, but they produce 50 percent of the world's GDP. In the United States, counties occupying only 2 percent of the land area account for more than half of GDP. Similarly, in a few countries, poverty is concentrated in a few pockets. It was Krugman (1991) who deduced that agglomeration economies accrue at the plant level; hence, firms are located in a single area near consumer demand in large urban areas, minimizing transport costs. In other words, the location of economic activity matters, and a tiny (initial) difference may soon lead to the concentration of economic activity around a center and ultimately to the formation of an industry cluster in the same space. Agglomeration economies accrue at the level of the plant, industry, city, or region. Successful cities are centers of entrepreneurship and innovation that attract talented and skilled workers and foster productivity and growth. But as cities grow bigger and develop into megacities--those with more than 10 million people--they can also develop megaproblems. Most megacities are in Asia (figure 16.5). The concentration of population, which partly accounts for a metropolitan area's dynamism, also causes conges- tion, environmental degradation, housing shortages, and the formation of ghettos. The governance of a sprawling metropolitan area can be complex and difficult. The Commission on Growth and Development (2008, 58) has noted that "cities thrive because of . . . agglomeration economies. When activities are clustered closely together, they can reap economies of scale and scope." There is substantial evidence that urban agglomeration improves productivity and promotes economic growth. Au and Henderson (2006) used aggregate data on 285 Chinese cities to estimate the effects of urban agglomeration on productivity. As expected, the authors found that the aggregate productivity relationship exhibits an inverted U shape in met- ropolitan size and scale. The estimated urban agglomeration benefits are quite high, and it appears that a large fraction of cities in China are under- sized due to migration controls imposed at the national level. Lall, Koo, and Chakravorty (2003) also provide strong evidence, using plant-level data from India, that urbanization helps reduce costs per unit of output. Urbanization and Growth 349 Figure 16.5 Global Distribution of Megacities Asia South America North America Africa Europe 0 5 10 15 number of megacities 2005 2015e Source: United Nations 2007b. Note: e = estimated. This finding is consistent across all industries and size classes of Indian plants and is perhaps applicable to other developing economies as well. The increasing population in urban areas, however, can lead to decreas- ing returns over the long term. Quigley (2008) suggests that while larger cities facilitate greater complementarities and specialization, land and transport costs and unpriced externalities such as greater congestion, pol- lution, and the risks of epidemics limit cities' size and efficiency. In addi- tion, urban agglomeration requires huge concomitant increases in urban infrastructure, especially in Asia. Deutsche Bank Research (2008) esti- mates that by 2030, Asia's energy networks and power stations will require an investment of nearly $4.5 trillion (figure 16.6). This represents nearly half of the global investment required in this sector. Duranton (2008) asks whether cities actually favor economic effi- ciency. He concludes that while megacities provide large efficiency bene- fits and do not appear to systematically hurt particular groups, they can nonetheless be a drag on growth. In his recommendations to the Commission on Growth and Development, Duranton suggests shifting the focus of public policy from within-city efficiency to between-city effi- ciency by favoring the mobility of resources across cities and regions rather than their concentration in only one city. This would enable a more efficient and equitable distribution of scarce public funds over a longer time horizon. 350 Understanding Growth and Poverty Figure 16.6 Investment Needs for the Energy and Water Sectors, 2005­30 US$ trillions Asia (including Oceania) North America South and Central America Europe Africa Middle East 0 5 10 water energy Source: Deutsche Bank Research 2008. Urban Land Management and Housing It is not easy to control migration into a city. Therefore, cities become overcrowded and marked by intense competition for space, mobility, and resources. In the past 30 years, the urban population in East Asia and Pacific has increased by 560 million people (or 260 percent), and in the next 30 years it is expected to increase by about 1.45 billion people (or 250 percent). This unprecedented urbanization process has been fueled by rapid economic growth and even more rapid industrialization. Well-functioning cities, however, require efficient and equitable land markets. Most cities in developing countries suffer from land market dis- tortions caused by poor land development and management policies. These include a lack of planning, slow provision of infrastructure and services, substandard land information systems, cumbersome and slow land transaction procedures, and underregulation of private land develop- ment, which leads to unplanned or ribbon/corridor development of land in the urban periphery. In addition, the natural population growth in urban areas and the influx of new migrants have made urban land scarcer. Together, a scarcity of urban land and distortions in the land markets give rise to land speculation, which often forces the poor out of the for- mal land markets and into informal markets such as slums, squatter set- tlements, and illegal subdivisions on the periphery of cities. This leads to longer commutes, higher commuting costs, and very poor living condi- tions (because of a lack of adequate infrastructure and services) that cause Urbanization and Growth 351 poor health, thereby entrenching the cycle of poverty. The Commission on Growth and Development (2008) has noted that urban land manage- ment is crucial to creating sustainable cities, preventing spiraling prices, and reducing poverty. Rapid urbanization severely strains urban housing, particularly in countries with a large informal sector. Unauthorized housing violates regulations concerning land ownership, land use and zoning, and build- ing construction. Arnott (2008), while studying the housing patterns in developing countries, notes that in 1990,4 about two-thirds of housing units in low-income countries were unauthorized, while practically none were in high-income countries (table 16.5). The large proportion of unauthorized housing affects the government's housing policy. If the gov- ernment were to simply regularize unauthorized housing, developers would have little incentive to conform to regulations in the first place. Thus, the government must strike a balance between discouraging unau- thorized housing and ensuring that such housing is safe once built. Conclusion Urbanization is rapidly increasing. Between 2005 and 2030, the world's urban population is expected to grow at an average annual rate of 1.78 percent--almost twice the growth rate of the world's total population. The proportion of people living in rural areas will shrink significantly after 2015. While increasing urbanization has led to greater per capita income and productivity, it has also led to a growing informal sector, greater urban poverty, more slums, scarcity of housing, spiraling urban real-estate prices, and inadequate infrastructure facilities. Given this phe- nomenon of economic concentration in one area and spatial disparities elsewhere, should rural labor move for jobs or should jobs move to rural Table 16.5 Housing Rates by Type and Country Income Group, 1990 percent Country type Lower-middle Upper-middle Housing type Low-income income income High-income Owner occupancy 33 59 57 59 Unauthorized housing 64 27 9 0 Squatter housing 17 16 4 0 Source: Arnott 2008. 352 Understanding Growth and Poverty areas? Finance and labor do not automatically move toward poorer areas. Evidence from across the world suggests that policy makers should strive to remove impediments to capital and labor flows and reinforce agglom- eration economies. This can be done by encouraging labor movement, abolishing national minimum wages, cutting unemployment benefits and social benefits, and abolishing rent control to increase the supply of housing. Similarly, governments can affect firms' decisions on where to locate their productive activities by improving the business climate, increasing access to finance (including microfinance and availability of credit to small enterprises), and developing infrastructure services. Strengthening provincial and local governments' ability to provide essen- tial services is particularly key to reducing economic concentration and spatial disparities. Addressing these development issues in cities is essential to meeting the MDGs. Urban planning is no longer a luxury; it is a necessity. The Commission on Growth and Development (2008, 60) summarizes the urbanization process as follows: [I]f history is any guide, large-scale migration to the cities is part and par- cel of the transformation economies must go through if they are to grow quickly . . . Ultimately a successful city will need urban planning, building codes, and robust property rights. It will need drainage, sewerage, rapid transit, and a sophisticated financial system capable of mobilizing the funds for these. But accumulating this infrastructure, expertise, and sophistication takes time. Governments should avail themselves of whatever shortcuts they can find, including the experience and expertise of other cities that have gone through this turmoil before them. Notes 1. This chapter was written by Raj Nallari and Indira Iyer. 2. The Commission on Growth and Development identified 13 economies with successful growth experiences, defined here as achieving at least a 7 percent rate of growth over 25 years or more. These economies are Botswana; Brazil; China; Hong Kong SAR, China; Indonesia; Japan; the Republic of Korea; Malaysia; Malta; Oman; Singapore; Taiwan, China; and Thailand. 3. This target actually represents a relatively small proportion of existing slum dwellers, approximately 10 percent. 4. Data for other years are yet to be compiled. Data for 1990 are from Angel (2000). Urbanization and Growth 353 Bibliography Ahmad, E. 2007. "Big or Too Big?" Finance and Development 44 (3): 20­23. Angel, S. 2000. Housing Policy Matters: A Global Analysis. Oxford, U.K.: Oxford University Press. Arnott, Richard. 2008. "Housing Policy in Developing Countries: The Importance of the Informal Economy." Working Paper 13, Commission on Growth and Development, World Bank, Washington, DC. Au, Chun-Chung, and J. V. Henderson. 2006. "Are Chinese Cities Too Small?" Review of Economic Studies 73 (3): 549­76. Baker, J. L. 2008. "Urban Poverty, A Global View." Urban Papers UP-5, World Bank, Washington, DC. Bloom, D., and T. Khanna. 2007. "The Urban Revolution." Finance and Development 44 (3): 8­14. Commission on Growth and Development. 2008. The Growth Report: Strategies for Sustained Growth and Inclusive Development. Washington, DC: World Bank. Deutsche Bank Research. 2008. "Megacities: Boundless Growth?" March 12, Germany. Duranton, Gilles. 2008. "Cities: Engines of Growth and Prosperity for Developing Countries?" Working Paper 12. Commission on Growth and Development, World Bank, Washington, DC. Iimi, Atsushi. 2005. "Urbanization and the Development of Infrastructure in the East Asian Region." JBICI Review 10 (March): 88­109. ILO (International Labour Office). 2004. "Global Employment Trends." Geneva, Switzerland (ILO). Krugman, Paul. 1991. "Increasing Returns and Economic Geography." Journal of Political Economy 99 (3): 483­99. Lall, Somik V., Jun Koo, and Sanjoy Chakravorty. 2003. "Diversity Matters: The Economic Geography of Industry Location in India." Policy Research Working Paper 3072, World Bank, Washington, DC. Prud'homme, R. 1996. "Management of Megacities: Institutional Dimensions." In Megacity Management in the Asian and Pacific Region: Policy Issues and Innovative Approaches, Vol. 1, ed. J. Stubbs and G. Clarke, 99­132. Proceedings of the Asian Development Bank and the World Bank Regional Seminar on Megacities Management in Asia and the Pacific, Asian Development Bank, Manila, October 24­30, 1995. Quigley, John. 2008. "Urbanization, Agglomeration and Economic Development." Working Paper 19, Commission on Growth and Development, World Bank, Washington, DC. Ravallion, Martin. 2007. "Urban Poverty." Finance and Development 44 (3): 15­17. 354 Understanding Growth and Poverty Ravallion, Martin, Shaohua Chen, and Prem Sangraula. 2007. "New Evidence on the Urbanization of Global Poverty." Policy Research Working Paper 4199, World Bank, Washington, DC. United Nations. 2007a. Statistical Yearbook for Asia and the Pacific 2007. New York: Economic and Social Commission for Asia and the Pacific, UN. ------. 2007b. World Urbanization Prospects: The 2007 Revision. New York: Department of Economic and Social Affairs/Population Division 5, UN. UN-HABITAT. 2006. "State of the World's Cities 2006/7." The Millennium Development Goals and Urban Sustainability. London: Earthscan. World Bank. 2003. "Urban Poverty in East Asia: A Review of Indonesia, the Philippines, and Vietnam." Urban Development Working Paper 11, World Bank, Washington, DC. ------. 2007. Dhaka, Improving the Living Conditions for the Urban Poor. World Bank Report 35824-BD, World Bank, Washington, DC. CHAPTER 17 Corruption and Poverty The literature on corruption is large and growing. This chapter provides some empirical evidence on the impact of corruption on growth and poverty reduction. Corruption--which includes bribery, rent seeking, extortion, and embezzlement--is perceived as a major problem in many countries. It is commonly defined as the misuse of public office for pri- vate gain. This does not mean that corruption is nonexistent in the pri- vate sector; in fact, it is quite common in (private) financial firms. But corruption is more severe in the public sector. One of the first known articles on corruption and its punishment is in Kautilya's Arthasastra, which dates back to 14 BC.1 In that work, corruption is intertwined with a country's social norms, formal and informal rules, culture, and legal environment. Corruption connotes illegal or immoral behavior and is treated as "socially and culturally deviant." If it is not controlled, high- level corruption can lead to political instability and reduce citizens' trust and faith in institutions. Detection and Measurement of Corruption Indirect measures must be used to quantify corruption because the meas- ured corruption index is subject to the victimization bias--that is, only 355 356 Understanding Growth and Poverty aggrieved parties speak out, while the vast majority who benefit from cor- ruption do not. Firms may bribe officials to avoid legal problems, avoid paying taxes, or hide their noncompliance with regulations. Obviously, such transactions are not reported or recorded. Attempts at measuring corruption include the corruption perception index (CPI) of Transparency International (TI), the "control of corrup- tion" indicators of the World Bank Institute (WBI), the Business Environment and Enterprise Performance Survey (BEEPS, a World Bank survey of 26 countries on the extent of bribe payments in 1999), and the bureaucratic efficiency index. Some estimates of the worldwide scope of corrupt practices (Kaufmann, Kraay, and Mastruzzi 2006) are reported below. Worldwide Bribery: Around $1 Trillion Kaufmann (2005, 81) estimates worldwide corruption to be around $1 trillion, with a confidence interval ranging from $600 million to $1.5 billion. He bases his estimate on data from surveys in which firms and households report "average annual bribery payments as a share of sales (for enterprises), or incomes (households)." Working under the assumption that the overall population exhibits patterns similar to those of the sampled population, Kaufmann (2005) extrapolated the results to include countries not covered in the surveys. Kaufmann (2005) included two enterprise surveys for his estimate: the World Bank Enterprise Survey (World Bank 2000), which was carried out in 2000 in 81 countries and elicited 10,033 responses from firms, and the Global Competitiveness Survey (2004), which was carried out in 104 countries and elicited 8,729 responses. He also used the results from household surveys carried out by the World Bank in the context of 16 governance and corruption diagnostic surveys. The main objective of the exercise was to arrive at a preliminary range of estimates rather than a precise estimate. Unofficial Economy: Between $3.4 Trillion and $5.1 Trillion Worldwide Estimates on the size of the "unofficial economy" rely on studies by Schneider and Enste (2002) and Friedman and others (2000). For money laundering, Kaufmann (2005) used an International Monetary Fund (IMF) study (Camdessus 1998), as well as a paper by John Walker (1999); for other bribery estimates, he used the results of an online survey and a report on a recent survey of corruption in the Russian Federation. Kaufmann Corruption and Poverty 357 computed the unofficial economy as the sum of the products of individual countries' unofficial economy figures in 1997 and the associated gross domestic product (GDP) in 2002. The higher estimate was drawn from Schneider and Enste (2002), who provided estimates of the large shadow economy in 76 developing and developed economies. For 21 Organisation for Economic Co-operation and Development economies, they estimated the size of the underground economy as having grown from $2 trillion (12.7 percent of GDP) in 1989 to $3.4 trillion (16.7 percent of GDP) in 2001. Kaufmann notes that unofficial economy transactions are not neces- sarily corrupt and, conversely, that bribes and corrupt transactions do not necessarily take place in the unofficial economy. Worldwide Money Laundering: $600 Billion to $2.8 Trillion A 1998 IMF study estimated that the world's money-laundering economy could be as large as 2 to 5 percent of the world's GDP, or $600 billion to $1.5 trillion (Vogl 1998). In an unrelated study, John Walker (1999) esti- mated a worldwide money-laundering economy of $2.8 trillion. Other Bribery Estimates: $1 Trillion and Up An estimate of bribes and inappropriate fees paid worldwide in procure- ment processes was made using data from an online governance survey carried out in 2003 by the WBI. The estimate was computed as the sum of the products of regional procurement figures (using 1998 worldwide procurement figures of $5.5 trillion) and the associated bribe share in procurement. The resulting estimate was about $1 trillion. It should be noted that this estimate focuses on one area of bribery and that margins of error and sample biases may be particularly large because the figures were derived from voluntary surveys on the Web. Analytical Framework for the Study of Corruption The principal-agent relationship is the main framework under which Kaufmann (2005) studies corruption. Under this framework, the princi- pal (employer, owner, government, or banker) must induce the agent (employee, contractor, tax inspector, or borrower) to act in the principal's best interest. Difficulties arise when missing or incomplete information, unforeseen contingencies, or informational asymmetry prevent the prin- cipal from writing a complete contract or establishing incentives that induce the agent to act optimally on the principal's behalf. The agent has an opportunity to raise money for himself in relationships involving a 358 Understanding Growth and Poverty government tax inspector and a taxpayer, a regulator (of, say, pollution) and a firm, a police officer and a potential criminal, a government provider of services and a consumer, and so on. Corruption occurs when a third party, such as a polluting firm, offers money to the inspector (agent) that is not passed on to the principal (regulator or government). Some economists use the principal-agent-client relationship, the principal-supervisor-agent relationship or the provider-consumer rela- tionship to reflect the three-tier connection. Several scenarios of principal- agent corruption are prevalent in the real world. First, the supervisor's role may be limited to information gathering (say, the estimating of individual incomes or pollution levels among firms). As such, his power comes from an ability to distort such information (for example, in enforcement cases involving taxes, regulations, or policing). Second, the principal (government) sets broad objectives (say, tax rev- enue targets) for the supervisor but delegates to the supervisor the authority to put in place any incentive mechanism for the agent. This is a common situation in large bureaucracies involving policy design and pro- vision of social services. Third, the principal (government) may transfer all the power to the supervisor (for example, monopoly power to issue permits or licenses or set import-export quotas). The supervisor and his inspectors can vary the price of permits sold to businesses, especially when the government does not or cannot monitor the number of permits sold and the price of each permit. Fourth, in several such cases, the supervisor, who has information- gathering responsibility (for instance, estimation of income tax), and the agent (inspector), who uses the information to collect taxes, can collude. The principal (government) must use incentives to prevent such collu- sion or must hire additional monitoring staff. Collusion possibilities expand bureaucracy further and limit the principal's ability to implement policy and incentive mechanisms. Fifth, in the real world, the supervisor can collude with the agent to produce a report favorable to the agent--or use the threat of an unfavor- able report to demand a bribe from the agent (for example, extortion of a lower-level staff member by a higher-level official). Several forms of corruption and many complex economic scenarios cannot be understood within this framework. For example, with politi- cal corruption--in which the citizens are the principals and the elected politicians the agents--the incentive system is different. The citizens' control is limited to their ability to reelect or vote out the corrupt Corruption and Poverty 359 politician. The citizens here are multiple principals, and the assets cap- tured by a powerful few add to the complexity of the problem, which cannot be analyzed using the principal-agent theory. Causes of Corruption Corruption is likely when one or more of the following conditions are in place: (a) the motivation to earn more income is extremely strong, com- pounded by poverty and low, declining civil service salaries; (b) public officials with broad discretion in economic matters exhibit rent-seeking behavior; (c) accountability is weak; (d) political competition and civil liberties are restricted; and (e) laws and penalties are poorly developed and enforced. Low wages are often cited as a major inducement for corrupt behav- ior among government employees. When low-paid employees meet wealthier private sector clients, they look for ways to close the gap in living standards and climb the social ladder; hence, they turn to corrup- tion. Higher wages for government employees effectively work as a fine for bribe taking and act as "efficiency wages" that could deter corrupt behavior. In countries where corruption is harder to eliminate, however, higher public sector wages, more bureaucracy, and widespread corrup- tion may coexist. The causes of corruption can be quite complex, including rational but inconsistent human behavior (as proclaimed by behavioral economists). For example, officials may resort to bribery to avoid noncompliance with pollution regulations or taxes. Honest firms threatened with extortion by inspectors may be similarly tempted to avoid taxes. Finally, several layers of government corruption--including, for example, collusion between supervisors and inspectors--combined with an inept judiciary can leave the average citizen little choice but to pay bribes. What wage and commission rates are optimal to prevent bribery and ensure better monitoring and more truthful reporting (say, of pollution levels or tax evasion)? What happens when corruption's rewards exceed the penalty for taking bribes or the compensation for truthful reporting? The best way to contain corruption is to impose a large penalty for bribery. Providing a commission or incentive for truthful reporting can also induce corruption; for example, a corrupt inspector could extort a firm by overreporting its pollution level. Van Rijckeghem and Weder (2001) find that an increase in civil service salaries relative to those paid in the manufacturing sector also has a favorable impact on the corruption 360 Understanding Growth and Poverty index. Civil service wages are highly correlated with the measures of rule of law and quality of bureaucracy as well. (Other studies did not find strong support for this negative relationship between relative wages and corruption, however.) Would paying higher wages to employees in a bloated bureaucracy be fiscally sustainable in developing countries, or would doing so entail comprehensive civil service reforms that pare down the number of employees while modernizing the financial management and human resource systems? A related issue is whether government officials responsible for the fiscal management of a country should be paid bonuses, particularly when public sector wage levels are relatively low. Chand and Moene (1997) find that such bonus payments help promote less-corrupt outcomes, but corruption at higher levels of government needs to be contained as well, and that means reforming the state. There is some evidence that countries dependent upon the extraction of natural resources have high economic rents, which are a breeding ground for corruption. The same is true for countries with high per capita aid flows. While one study has found that high educational spending does not coincide with high corruption, other studies indicate that the social sectors and infrastructure sector are more prone to corruption than the agriculture, industry, and services sectors because they are largely financed by aid and involve brick-and-mortar activities (Mauro 1995, 1998, 2002; Kenny 2009). Corruption varies across countries as well as within countries. In a study examining the pattern of corruption across public agencies of eight countries using microdata, Recanatini, Prati, and Tabellini (2005) found that the internal design of the organization is perceived by agency insid- ers and by customers to be systematically corrupt. However, corruption is lower when internal decisions on budget, procurement, and personnel are regularly audited, when these same decisions are made in an open and transparent manner, and when personnel decisions are based on merit and clearly stated professional criteria. Opportunities for corruption can depend on a country's organiza- tional structure. While a centralized state may reward the bribe-paying rich in a country, decentralization may not necessarily reduce corruption because the capture of the state by local elites is an obvious possibility. In a randomized experiment in India, however, Duflo and Hanna (2005) find little state capture by powerful elites in villages. They also find that the inclusion of minorities in decision making increases the likelihood that some resources will be redistributed to disadvantaged groups. Corruption and Poverty 361 Economic and Political Competition Increased competitiveness within an economy generally means lower profit margins and lower corruption (especially in pollution or other areas of market failure). But this does not preclude corruption in other sectors. For example, high-cost, low-profit firms forced to pay bribes may exit the market, thereby reducing competition and increasing the profit margins for the remaining firms. Inspectors may also be willing to accept smaller bribes from low-profit firms. Ades and Di Tella (1997) find evidence of a negative relationship between the competitiveness of firms and the CPI. When firms enjoy higher rents, bureaucrats will have greater incentive to engage in corrup- tion. But despite deregulation and price liberalization under the adjust- ment programs of the 1980s and 1990s, most countries have experienced an increase in corruption. It is therefore possible for greater competition to coexist with higher corruption. The degree of political competition also matters. For example, proportional representative elections with lower weight for individual accountability of candidates are associated with higher corruption. Charap and Harm (1999) contend that corruption is endogenous to political structures and helps maintain equilibrium among different population groups. Elimination of corruption in such instances could then destabilize existing political systems and lead to anarchy, rather than enhancing economic efficiency. Under these conditions, a com- prehensive reform of the civil service could be implemented only if a ruler gains stability from benevolence, rather than patronage. If the survival of the regime is threatened, this reform program is likely to be rejected. Costs and Benefits of Corruption The argument that corruption is ultimately beneficial because it cuts down red tape and bureaucratic inefficiency has no empirical basis. Corruption tempts even honest officials to slow down the processing of requests in an effort to avoid responsibility and put off decisions that they might regret in the future. If corruption were beneficial to society, such corrupt practices would be legal. How does one explain the high level of corruption in a large number of countries despite repressive laws to control it? Everyone now accepts that some level of corruption is inevitable in every combination of mar- ket and government. Politicians and bureaucrats have a vested interest in 362 Understanding Growth and Poverty increasing and overextending their reach into the marketplace. Therefore, a minimalist state helps curb corruption and corrupt practices. There appears, however, to be a link between government corruption and market failures. Governments intervene with the best of intentions in the case of market failures and use subsidies and transfers to divert resources from gainers to losers or vulnerable groups. This flow of money creates corruption opportunities that undermine the very purpose of gov- ernment intervention. Government intervention requires bureaucrats (agents) to collect information, make decisions, and implement policies and programs. Hiring officials to control corruption diverts talented indi- viduals away from productive activity. Corruption in the form of rents for bureaucrats clearly induces a misallocation of resources and rapidly expands the size of the bureaucracy. Because it is difficult to eliminate completely, however, we must reconcile ourselves to a "second-best" world in which some bureaucrats will always be taking bribes. Transaction costs related to corruption are also higher than those for legal contracts. Also, corruption does not allow for legal recourse; there- fore, partners are locked in long after the exchange of goods and services has been completed. Impact of Corruption on Economic Performance Bribery is widespread in many countries, to varying extents. Bribery raises transaction costs and uncertainty in an economy, leads to inefficient eco- nomic outcomes, impedes long-term foreign and domestic investment, misallocates talent to rent-seeking activities, diverts assets from important projects such as agricultural and rural development to "roads to nowhere" and large defense projects, pushes firms underground, lowers revenue col- lection, and acts as a regressive tax against smaller firms, with the cumu- lative effect of sending the economy into a vicious downward spiral. The World Economic Forum's (WEF) Global Competitiveness Survey for 1997 indicates that enterprises reporting a greater incidence of bribery also tend to spend a greater share of their management time with bureau- crats and public officials negotiating licenses, permits, signatures, and taxes. In a seminal paper, Murphy, Shleifer, and Vishny (1993) postulate that corruption reduces the returns of productive activities. This is espe- cially true when corruption and rent seeking yield higher returns than productive activities, thereby draining human resources away from the productive sector. Mo (2001) estimates that this tendency accounts for about 14.8 percent of the negative effect of corruption on growth. Mauro Corruption and Poverty 363 (1995) also shows the negative impact of corruption on investment and thereby on growth. Pak (2001) estimates that a 1 percent increase in cor- ruption could reduce the growth rate (through the investment channel) by about 0.72 percent, which translates to about 21.4 percent of the effect of corruption on growth. In a recent IMF book titled Governance, Corruption, and Economic Performance, edited by Abed and Gupta (2002), cross-country analysis shows that high-corruption countries have lower tax revenues, lower per capita income, a higher incidence of poverty, and worse social indicators than low-corruption countries. The book further illustrates that corrup- tion and rent-seeking behavior affect both the expenditure and revenue sides of the budget. By using cross-sectional data, Mauro (2002) shows that corruption is negatively associated with government expenditure on education. An increase in corruption by one unit (on a scale of 0 to 10) lowers the ratio of public spending on education by 0.2 percent of GDP. Corruption, therefore, could lead to a suboptimal composition of govern- ment expenditure. The reason for this is that education programs are less prone to rent seeking. Gupta, Davoodi, and Tiongson (2002) show that a high level of cor- ruption has adverse consequences for a country's child and infant mortal- ity rates, the percentage of low-birthweight babies in total births, and primary school dropout rates. For example, an increase in corruption by one unit (on a scale of 0 to 10) raises the child mortality rate on average by 1.1 to 2.7 deaths per 1,000 live births. These results are consistent with predictions stemming from theoretical models and service-delivery surveys. An important implication of the results is that improvements in health and education outcomes do not necessarily require higher public spending, but rather better control over existing resources that are being diverted through corrupt channels. Tanzi and Davoodi (2002) provide further evidence on how corrup- tion leads to allocations in favor of less-productive investment projects and against nonwage operations and maintenance expenditures, such as books and medicines, thereby reducing the quality and productivity of existing infrastructure. Corruption affects other types of public spending as well. Gupta, de Mello, and Sharan (2002) show that corruption is associated with higher military spending as a share of both GDP and total government spending, as well as with arms procurement in relation to the GDP and total government spending. Military spending is a monopoly of the state, and contracts are often drawn up in secret, with authorities exercising 364 Understanding Growth and Poverty considerable discretionary power over how money is spent. The results from the study suggest governance indicators should account for defense spending. A considerable and growing amount of public spending takes place at subnational levels in a number of countries. De Mello and Barenstein (2002) find that decentralization of control over expenditure to subna- tional governments can enhance governance. The higher the share of total government expenditures that is spent on a subnational level, the stronger the positive association between decentralization and governance. The relationship between decentralization and poor governance also depends on how subnational expenditures are financed--in general, the higher the share of nontax revenues in total revenues as well as grants and transfers from higher levels of government in total expenditure, the stronger the association between decentralization and corruption. Poor governance also affects a country's income distribution and poverty. Dabla-Norris and Wade (2002) present a model to explain why relatively wealthy people choose to engage in rent-seeking activities such as employment in the government bureaucracy, army, or police rather than in productive and entrepreneurial activities. Given imperfect capital markets and lump-sum entry fees associated with rent seeking, those who are relatively wealthy to begin with tend to engage in rent seeking to pro- tect their wealth from expropriation. Deregulation, liberalization, privati- zation, strengthening of the budgetary process, and institution building have helped to improve economic governance and reduce the opportuni- ties for rent-seeking behavior. Corruption impedes growth by limiting the development of small and medium-size enterprises: rather than building their businesses, entrepre- neurs have to devote their valuable time to bribing officials. Of course, causation is an issue in all such countries. Are poor countries with weak implementation capacity in all facets of economic management likely to have high levels of corruption, or are corrupt countries likely to have low per capita income and a high incidence of poverty? Do stagnating coun- tries breed corruption, or does corruption cause countries to stagnate? A high degree of income inequality, as in Latin American countries, gives poor people a strong incentive to engage in illegal or corrupt activ- ities. This situation threatens the institution of private property as well as law and order and could have a negative effect on growth. Mo (2001) estimates that the uncertainty induced by such threats accounts for more than 53 percent of the total effect of corruption on growth. Using a sam- ple of worldwide governance indicators, such as corruption, voice and Corruption and Poverty 365 accountability, and rule of law, covering 175 countries for the period 2000­01, Kaufmann, Kraay, and Mastruzzi (2006) show (a) a strong pos- itive causal effect running from better governance to higher per capita income, thereby confirming the importance of good governance for eco- nomic growth, and (b) a weak--even negative--causal effect running in the opposite direction from per capita income to good governance, indi- cating that the absence of higher income leads to further improvement in governance. Economic growth is possible without improved governance. The above discussion depicts the complexity of dealing with corrupt behavior. While some studies show that providing higher wages to gov- ernment employees (along with giving incentives and imposing penalties) can reduce bribery, other studies indicate the need for bolder policy changes to reduce opportunities for corruption (box 17.1). These include enhancing transparency in public transactions and increasing the account- ability of public officials, with the media and civil society playing a "watchdog" role. The following are some of the major economic policy changes that will unambiguously reduce opportunities for corruption: · lowering tariffs and other barriers to international trade; · unifying market-determined exchange rates and interest rates; · eliminating enterprise subsidies; · minimizing regulations, licensing requirements, and other barriers to entry for new firms and investors; · demonopolizing and privatizing government assets; and · transparently enforcing prudent banking regulations and auditing and accounting standards. Corruption cannot be substantially reduced without modifying the way governments are organized and operate. Such modifications require a multipronged strategy, including a reduction in excessive and complex regulations; reform of the civil service; improved budgeting, financial management, and tax administration; and stronger legal and judicial sys- tems. Such reforms should involve changing government structures and procedures, placing greater emphasis on competition and incentives within the public sector, and strengthening internal and external checks and balances. As a complement to these broader reforms, the transparent implementation of enforcement measures, such as prosecuting some prominent corrupt figures, can also have an impact. Other studies point to the role of timely audits and monitoring. For example, a randomized field experiment examined several approaches to 366 Understanding Growth and Poverty Box 17.1 How to Reduce Corruption Transparency improves governance and reduces corruption and is required for better development and faster economic growth. A basic checklist of concrete reforms to promote transparency might include the following items: · Public disclosure of assets and incomes of candidates running for public office, public officials, politicians, legislators, judges, and their dependents · Public disclosure of political campaign contributions by individuals and firms and of campaign expenditures · Public disclosure of all parliamentary votes, draft legislation, and parliamentary debates · Effective implementation of conflict of interest laws separating business, politics, legislation, and public service, and the adoption of a law governing lobbying · Public blacklisting of firms in public procurement (as done by the World Bank) that have been shown to bribe and a requirement to "publish what you pay" for multinationals working in extractive industries · Effective implementation of the freedom of information laws, with easy access for all to government information · Freedom of the media (including the Internet) · Public disclosure of central and local budgets, adoption of the IMF's reports on the standards and codes framework of fiscal transparency, detailed government reporting of payments from multinationals in extractive industries, and open meetings involving the country's citizens · Disclosure of the actual ownership structure and financial status of domestic banks · Transparent (Web-based) competitive procurement · Periodic implementation and publicizing of country governance, anticorrup- tion, and public-expenditure tracking surveys, such as those supported by the World Bank · Transparency programs at the city level, including budget disclosure and open meetings Source: Kaufmann 2005, 92. reducing corruption in more than 600 village road projects in Indonesia by having engineers independently estimate the prices and quantities of all inputs used in each road and then comparing these estimates to villages' official expenditure reports (Olken 2005). Announcing the Corruption and Poverty 367 certainty of a government audit (top-down monitoring) reduced theft by 8 percent of expenditures, and increasing grassroots participation in the monitoring process reduced theft of villagers' wages (but this was almost entirely offset by corresponding increases in theft of materials, which are public goods). The scorecard method advanced by an Indian nongovernmental organ- ization from Bangalore, whereby users rated local service-providing agen- cies, has already resulted in the firing of officials, improved service delivery, and a decreased incidence of bribery (Van der Meer-Kooistra and Vosselman 2004). This approach has been found to be effective in a num- ber of other states and cities in India and in several developing countries. At least in some cases, the free press disseminated information about cor- ruption and triggered some changes. Persistence of Corruption Is corruption the norm in certain countries, or is it a deviation from the norm? The very definition of corruption as a misuse of public duties for private gain implies a deviation. It also raises questions of ethics, cultural values, and social behavior. Norms are persistent social traditions or behav- iors. Does corruption persist because of imperfect information, underlying beliefs, the ease of collusion at all levels, or because it is self-replicating? Does the introduction of a few corrupt individuals into an otherwise hon- est society lead to pervasive corruption over time? Mishra (2006) suggests that self-replicating behavior may be the problem, as youth look up to cor- rupt but successful people, wanting to assume their role. Economists view this as a multiple equilibria problem--different soci- eties at similar levels of economic and political development (per capita income, political structure, judicial efficiency) may exhibit varying degrees of corruption, tax evasion, and other noncompliant behavior. This multi- plicity of equilibria may arise because of complementarities, but why do some societies get trapped in such a bad equilibrium? The answers are complex. If people in a country expect corruption, then the expected cost of being corrupt and getting caught will be low, which then will lead to more corruption. While incentives and rewards can get one out of a bad equilibrium and move from high to low corruption, they do not solve other problems, such as agency costs and expensive information gathering, which also lead to multiple equilibria. We may have a low-corruption equilibrium if few firms choose to pollute or if the inspector spends substantial time and effort gathering information on when and how firms pollute. On the other hand, we may 368 Understanding Growth and Poverty have a high-corruption equilibrium if the inspector is uninformed about firms (and wants to be uninformed) and a high proportion of firms take a chance and pollute. Evolutionary social dynamics can also explain a multiplicity of equilib- ria. An individual chooses to be corrupt because everyone else is corrupt and this is an accepted social norm. How does an honest leader, say, bring about a new social norm of low corruption? Recanatini, Prati, and Tabellini (2005) find that both corruption and the design of an organization can be influenced by the individuals at the very top of the agency. In fact, the procedure for appointing the head of the agency is one of the major determinants of both corruption and the design of the agency's internal organization. Agencies whose head is pop- ularly elected are systematically more corrupt and have worse internal organization than agencies whose head is appointed by a political body. Finally, the data show that corruption is influenced by demand-side fac- tors. Agencies that provide services to firms are more prone to corruption than those that provide services to households, particularly if alternative providers are not readily available in the marketplace or elsewhere. Conclusion Despite all the checks and balances, the imposition of penalties, the enforcement of civil service rules, and other major reforms, both private sector representatives (givers) and public employees (receivers) find ingen- ious and unique ways of colluding for profit--and avoiding charges. A high level of corruption is only one indicator of misgovernance. Therefore, any study of corruption may have to cover other institutional and governance issues such as rule of law, crime and violence, voice and accountability, transparency, and so on. Rapid technological changes, the changing role of media in society, and the use of the Internet for information dissemination have brought about greater transparency. But given that the rich and pow- erful own the media, and that the media are likely targets of corruption, how can one ensure truthful reporting and transparency? There is much more to know about corruption in the private sector and its motives. Note 1. "Just as it is impossible not to taste honey or poison that one may find at the tip of one's tongue, so it is impossible for one dealing with government funds not to taste, at least a little bit, of the king's wealth" (Shamasastry 1961). Corruption and Poverty 369 Bibliography Abed, George, and Sanjeev Gupta, eds. 2002. Governance, Corruption, and Economic Performance. 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Policy Research Working Paper 3630, World Bank, Washington, DC. ------. 2006. "Measuring Governance Using Cross-Country Perceptions Data." In International Handbook on the Economics of Corruption, ed. S. Rose-Ackerman, 52­104. Cheltenham, U.K.; Northampton, MA: Edward Elgar. Kenny, C. 2009. "Measuring Corruption in Infrastructure: Evidence from Transition and Developing Countries." Journal of Development Studies 45 (3): 314­32. Mauro, Paulo. 1995. "Corruption and Growth." Quarterly Journal of Economics 110 (3): 681­712. ------. 1998. "Corruption and the Composition of Government Expenditure." Journal of Public Economics 69 (August): 263­79. ------. 2002. "The Persistence of Corruption and Slow Economic Growth." IMF Working Papers 02/213, International Monetary Fund, Washington, DC. Mishra, A. 2006. "Corruption, Hierarchies and Bureaucratic Structures." In International Handbook on the Economics of Corruption, ed. Susan Rose- Ackerman, 189­215. Cheltenham, UK; Northampton, MA: Edward Elgar. Mo, P. H. 2001. "Corruption and Economic Growth." Journal of Comparative Economics 29 (1): 66­79. Murphy, K. M., A. Shleifer, and R. W. Vishny. 1993. "Why Is Rent-Seeking So Costly to Growth?" American Economic Review 83 (2): 409­14. Olken, B. A. 2005. "Monitoring Corruption: Evidence from a Field Experiment in Indonesia." NBER Working Paper Series 11753, National Bureau of Economic Research, Cambridge, MA. Pak, Hung Mo. 2001. "Corruption and Economic Growth." Journal of Comparative Economics 29 (1): 66­79. Recanatini, F., A. Prati, and G. Tabellini. 2005. "Why are Some Public Agencies Less Corrupt than Others? Lessons for Institutional Reform from Survey Data." Paper presented at Sixth Jacques Polak Annual Research Conference, International Monetary Fund, Washington, DC, November 3­4. Corruption and Poverty 371 Schneider, F., and D. Enste. 2002. Hiding in the Shadows: The Growth of the Underground Economy. Washington, DC: International Monetary Fund. Shamasastry, R., trans. 1961. Kautilya's Arthasastra. Mysore, India: Mysore's Printing and Publishing House. Tanzi, Vito, and Hamid R. Davoodi. 2002. "Corruption, Growth, and Public Finances." In Governance, Corruption, and Economic Performance, ed. G. Abed and S. Gupta, 197­224. Washington, DC: International Monetary Fund. Van der Meer-Kooistra, J., and E. G. J. Vosselman. 2004. "The Balanced Scorecard: Adoption and Application." In Advances in Management Accounting, vol. 12 ed. Marc J. Epstein, John Y. Lee, 287­310. Amsterdam; Boston: Elsevier. Van Rijckeghem, Caroline, and Beatrice Weder. 2001. "Bureaucratic Corruption and the Rate of Temptation: Do Low Wages in Civil Service Cause Corruption?" Journal of Development Economics 65 (2): 307­31. Vogl, F. 1998. "The Supply Side of Global Bribery." Finance and Development 35 (2): 30­33. Walker, J. 1999. "Measuring the Extent of International Crime and Money Laundering." Paper prepared for Kriminal Expo Conference, Budapest, June 9. WEF (World Economic Forum). Global Competitiveness Survey for 1997. Davos, Switzerland: WEF. World Bank. 2000. World Bank Enterprise Survey. Washington, DC: World Bank. CHAPTER 18 Regulation and Economic Growth Since the 1980s, developing countries have regulated and deregulated infrastructure, production, labor, security, finance, and banking sectors in an effort to liberalize their public services. Effective regulation encourages competition while mitigating the adverse impact of market failures; yet the regulations of most developing countries in fact limit productivity, growth, and service delivery--and cost three times more than those of advanced economies. At the same time, property rights protection in developing countries is half that of advanced economies. Costly labor-market regulations pro- tect jobs rather than people. For example, minimum wage requirements limit the creation of new low-skill jobs, especially in the services sector. Similarly, land and property regulations hamper private investment, industrial expansion, and growth. In several developing countries, 60­70 percent of people do not have legal title to their land, which limits the use of land as collateral for access to financing. While product safety standards protect consumers (for example, by ensuring that appliances are not fire hazards), product-market regulations limit firms' productiv- ity (for example, Germany restricts the hours during which retail stores can be open). 373 374 Understanding Growth and Poverty Regulations should encourage competition and break up monopolies where possible; be simple and transparent yet dynamic and responsive to specific industries and changing markets over time; and be evenly enforced across sectors and industries. They should protect people and not jobs; be customized to national needs (and not simply mimic those in advanced economies); and be explicit, particularly in the regulation of prices and natural monopolies (for example, utilities). Product-Market Regulation Schiantarelli (2005) provides a critical overview of recent empirical research on how regulations affect the product market. He suggests that regulations affect allocative efficiency--that is, the allocation of resources among sectors producing different goods and among firms with different productivity within each sector, the productivity of existing firms, and the pace of productivity growth--by altering the incentives to innovate and determining the speed with which new products and processes replace old ones. As regulations reduce the gap between prices and marginal costs and allocate capital and labor to produce those goods most demanded by consumers, markets become more competitive. This competitive climate pressures less-efficient firms to exit, and market share shifts from lower- to higher-productivity firms, leading to a more efficient allocation of the factors of production. Product-market reforms1 have both short- and long-term effects. For instance, an increase in the degree of substitutability between goods leads to lower markups and allows firms to exit the market with no long-term effects on the economy. It also increases employment and higher real wages. Product-market reforms that decrease entry costs thus have posi- tive long-term effects: as new firms enter the market, markups fall and employment and real wages rise. Labor Regulation Boeri, Helppie, and Macis (2008) claim that labor regulations are detri- mental to economic efficiency and therefore impede growth and prosper- ity. Others claim that they correct market imperfections and allow for redistribution without hampering efficiency (Freeman 2005). Considerable changes in income distribution have accompanied recent globalization. But contrary to what most trade models predict, the distributional changes have not favored the less-skilled workers abundant Regulation and Economic Growth 375 in developing countries (Goldberg and Pavcnik 2007). With the rise of globalization, labor-market protection--especially of the most vulnerable segments of the population--has become increasingly important. Economic theory cannot always predict the effects of labor-market regulation in developing countries. Standard competitive models of the labor market predict that minimum wages reduce employment. On the other hand, in models that include some form of modern monopsony or other market imperfection that results in job matches yielding economic rents (for example, Mortensen and Pissarides 1994), minimum wages redistribute the rent without necessarily affecting employment levels or overall economic efficiency. In some circumstances, minimum wages might even increase employment. Because of the ambiguities of theoret- ical predictions, any assessment of the effects of labor-market regulations ultimately relies on empirical studies. Labor-market regulations can affect firms' choices of inputs, investments, technology, and output and can influence the allocation of resources across firms and sectors. Because of job reallocation's critical role in economic development (see Caballero and Hammour 2000; Krizan, Haltiwanger, and Foster 2002; Bartelsman, Haltiwanger, and Scarpetta 2004), under- standing whether labor market institutions help or hinder reallocation is an important task. Strict labor regulations are associated with larger unof- ficial economies, which in turn may suggest worse working conditions and poorer job quality. It is important to assess whether stricter regula- tions actually cause such conditions. Minimum Wages To improve the earnings of disadvantaged workers, governments typically set minimum wage limits and mandate that employers provide nonwage benefits to their workers, such as health care, paid vacations, and mater- nity leave. Minimum wage regulations are most likely to affect females, teenagers, minorities, and other low-wage earners. As indicated in figure 18.1, if wage and employment are deter- mined in a competitive labor market, a legal minimum wage set above the market-clearing wage level will result in an employment reduc- tion, the magnitude of which depends on the actual wage increase and on the elasticity of labor demand. If this is the case, the cost of higher wages for employed workers is unemployment for other workers. The net effect on total welfare is then ambiguous, depending on the magni- tude of the employment effect and the alternatives available to those who remain without a job. 376 Understanding Growth and Poverty Figure 18.1 Effect of (Higher) Minimum Wage on Employment wages de or m lab an d of fo ly rl pp ab su or minimum wage equilibrium employment unemployment Source: Authors. The predicted effects depend on a series of institutional variables, including the degree of compliance, enforcement, penalties for noncom- pliance, and the existence (and size) of uncovered sectors (more relevant in developing countries). Because of some market frictions, a mandated minimum wage can result in a redistribution of the surplus from employ- ers to workers without reducing employment. If enforcement is ineffec- tive or if the penalties for paying wages below the minimum are only modest, there is little reason to expect compliance--and so the effects of minimum wages will be negligible. Moreover, minimum wage limits and other labor-market regulations do not apply or are not enforced in the informal sector. Competitive models predict that a binding minimum wage prices out workers whose marginal product falls below the wage floor into the sec- tor where the minimum wage is not applicable. Boeri, Helppie, and Macis (2008) find that the minimum wage reduces the employment rates of young and unskilled labor and raises those of older and skilled workers. In Mexico, the minimum wage adversely affected employment for females of all ages and had positive employment effects for males ages 55­64 years (Feliciano 1998). In Indonesia, the minimum wage Regulation and Economic Growth 377 negatively affected the employment of blue-collar workers and positively affected that of white-collar workers. Efficiency-wage-type models suggest how minimum wages could reduce poverty. In very low-income countries where workers' malnutri- tion is often an issue, higher wages could increase productivity through improved nutrition. Empirical evidence on the effects of the minimum wage on poverty and welfare is scant and displays mixed results. But two studies--cross-sectional data from several countries in Latin America (Morley 1995) and longitudinal data from Latin America, Asia, and Africa (Lustig and McLeod 1997)--suggest a negative correlation between higher minimum wages and poverty. On the other hand, the analysis of the Brazilian case by Neumark, Cunningham, and Siga (2006) finds no evidence of positive effects of the minimum wage on poverty and income inequality, and Gindling and Terrell (2007) find that minimum wage increases led to only modest poverty reduction in Honduras. Mandated Benefits There are two types of mandated benefits: those that vary with hours, such as additional wages or taxes (variable costs), and those that impose a fixed cost of employment per worker. The former can encompass man- dated bonuses, vacation pay, maternity leave, or disability programs that are funded by an employer. In a standard static model of the labor market, such mandated bene- fit contributions will shift the labor demand curve downward by the amount of the contribution, resulting in a lower direct wage and lower employment in equilibrium. Moving from point L, W to point L', W' in figure 18.2, panel a, shows the effect of a mandated benefit on the market in the case where the employee values the benefit at less than its cost to the employer. The predictable effect in this situation is a decrease in both employment and wages. On the supply side, if workers value benefits at less than the cost of the employer's contributions, they will have an incentive to seek out noncomplying work contracts. If the expected penalty for offering such work contracts is sufficiently low, profit-maximizing firms may prefer to employ such workers and capture some of the resultant rents. Thus, the formal sector might experience very different effects from mandated benefits than the informal sector, and analysis of official employment data may miss the employment, wage, or efficiency effects of such policies. If a worker values a benefit at or above its cost, the effects of a mandated benefit on the labor market are less clearly negative. The direct wage is still 378 Understanding Growth and Poverty Figure 18.2 Cost of Mandated Benefits a. Constant hourly cost of mandated benefit, no binding minimum wage real wage LS (excluding benefits) LS' employee valuation 1 employee valuation 2 W LS'' W' W'' cost to employer LD LD' L' L L'' labor b. Cost of mandated benefit in proportion to hours worked, with minimum wage real wage LS (excluding benefits) LS' W* min wage UE LD' LD Ld L* Ls labor Source: Boeri, Helppie, and Macis 2008, 22­23. Note: LD = labor demand; LS = labor supply; W* = equilibrium wage; UE = unemployment. Employee valuation 1 indicates labor-supply effects with low valuation of the benefit. Employee valuation 2 represents the valuation of benefits above the cost to the employer. Point L, w represents equilibrium employment before a benefit is mandated. Point L', W' indicates a possible equilibrium under low employee valuation, and point L", W" shows a possible outcome if a mandated benefit is highly valued by workers. In illustration b, the imposition of a mandated benefit may cause a minimum wage to bind (or exacerbate the effects thereof in cases where it already binds), causing unemployment even if a benefit is highly valued. Regulation and Economic Growth 379 expected to fall, but the employment effect can be zero or positive (see point L", w" in figure 18.2, panel a) because of increased labor supply. The relative size of the wage effect compared to the employment effect clearly depends on the relative elasticities of the curves. It is important to note that an empirical finding of wage shifting and zero employment effects could be due to high employee valuation or to a highly or perfectly inelastic labor supply curve. In the former case, there would be no deadweight loss; in the latter, employees would bear the full deadweight loss. Under this standard model, a binding minimum wage will exacerbate unemployment in the covered sector, since law-abiding employers will reduce employment if a wage reduction drops wages below the legal min- imum. See figure 18.2, panel b, for an illustration of a mandated benefit that, while highly valued, creates or contributes to significant unemploy- ment. This case of a binding minimum wage is particularly salient in devel- oping countries where legal minimum wages apply to a large portion of the workforce. A mandated benefit may lead employers to shed workers or avoid hiring, causing unemployment even if the benefit is highly valued. Regulation and the Private Sector Market failures generally justify regulations. A common such failure involves externalities--cases where activities have spillover effects on others that the original sector does not consider. A second type of market failure is information asymmetry, where the producer may have more information about the safety or reliability of its products than the con- sumer. A third is monopoly power--market power that can be used to raise prices and lower output to maximize a firm's rent at the expense of the consumer. These market failures drive a wedge between the private interests of firms and those of society. They can also inhibit productive investments and growth. Thus, regulations can play a critical role in pro- tecting society and consumers and promoting greater equity in private sector development. Governments, however, must be careful to avoid overreaching in cor- recting these failures. While underregulation may fail to address social interests or externalities, overregulation can stifle the ability to pursue opportunities and curtail growth. In extreme cases, governments can set up regulations to extract rents or bribes. Such cases of "tollbooth" policies in "grabbing hand" states reinforce the benefits of simple, transparent, and enforceable regulations. The share of firms that perceive a major or severe constraint to their business growth is much lower in high-income countries than in developing 380 Understanding Growth and Poverty countries, according to the World Bank's cost-of-doing-business surveys. The share in high-income countries is often half that of lower-income ones, with the exception of licenses and permits and labor regulations, where the share is only marginally lower than for middle-income coun- tries. Because the conditions in higher-income countries are generally better--for example, electrical outages are less common--their financial systems are more developed, and the procedures to comply with regula- tions are often more streamlined. Access to electricity and finance are two top-priority issues in low- income countries, but their importance decreases dramatically as a country's income rises. This is true for other infrastructure variables, although telecommunications overall is not reported as too constraining in any area. A number of areas related to regulations and governance are reported as most significant in middle-income countries. These are taxes, tax adminis- tration, informality, and corruption. It is often the low-income countries that have the most regulatory procedures and time delays associated with compliance. As income rises, these procedures and delays tend to decrease. On the other hand, enforcement of regulations often strengthens as income rises. Therefore, while the formal requirements may decrease, greater enforcement could explain why entrepreneurs in middle-income countries report more regulatory constraints. The results also suggest that corruption and regulatory constraints may go together. Many studies show that the regulatory and institutional environment, access to finance, and infrastructure services are closely associated with firm performance (Dollar, Hallward-Driemeier, and Mengistae 2005). In particular, weaknesses in the business environment have been shown to shift the size distribution of firms downward (Aterido, Hallward- Driemeier, and Pages 2007). Interruptions in access to power are particu- larly significant in reducing the growth of large firms while encouraging the spread of small, more labor-intensive firms. A lack of access to finance lowers growth across the size distribution. Because the benefits of finance are particularly strong for small firms, a lack of access hurts them dispro- portionately (Beck and others 2004). Busse and Groizard (2006) and others (see Hermes and Lensink 2003; Alfaro and others 2004; and Durham 2004) examine regulations to attract or deter foreign investors. They find that countries with better financial systems and financial market regulations can exploit foreign direct investment (FDI) more efficiently and achieve higher growth rates than countries that lack such systems and regulations. Some studies Regulation and Economic Growth 381 argue that countries need both a sound banking system and a functioning financial market to encourage entrepreneurship. Excessive regulations that prevent the reallocation of human and capital resources are likely to restrict the potential economic growth stemming from FDI. Further, costly regulations involving bureaucratic procedures that require entre- preneurs' time and resources can restrict the reallocation of capital flows to the most productive sectors. Busse and Groizard (2006) use the Ease of Doing Business database (World Bank 2004) on government regulations to confirm that countries with restrictive regulations cannot exploit FDI inflows efficiently. They also find that FDI does not stimulate growth in economies with excessive business and labor regulations. Governments must first improve regula- tory quality to reap the benefits of increased openness to foreign capital. Figure 18.3 shows one indicator of the relationship between "ease of doing business" and average per capita growth of gross domestic product (GDP) for 2000­05. Numerous studies have established that regulatory quality is an impor- tant determinant of overall income levels, and regulation is strongly (neg- atively) correlated with income per capita levels. Similarly, the regulation indicator is also negatively associated with GDP per capita growth rates and FDI. Figure 18.3 Average Per Capita GDP Growth and Ease of Doing Business 8.0 average per capita GDP growth (2000­05) 6.0 4.0 2.0 0 20 40 60 80 100 120 140 160 180 200 easiest toughest Source: Authors' computation from World Bank data on growth and the Doing Business database (World Bank 2009). 382 Understanding Growth and Poverty Financial Regulation Barth, Caprio, and Levine (2001a) use two broad and competing theo- ries to evaluate the merits of bank regulation by the government: (a) the helping-hand approach, in which governments regulate to correct market failures, and (b) the grabbing-hand approach, in which governments reg- ulate to support political constituencies. More important, they assess the impact of regulatory and supervisory practices on banking sector devel- opment and fragility.2 The helping-hand approach grants an important, powerful role to official regulators and supervisors, who believe that they can ameliorate market failures through proper supervision. Banks are costly and difficult to monitor. Informational asymmetries can make banks prone to contagious and socially costly bank runs. Many countries also adopt deposit insurance schemes, which (a) create incen- tives for banks to take excessive risks and (b) reduce the incentives for depositors to monitor banks. Strong government supervision can amelio- rate these market failures, improving bank performance and stability. On the other hand, there are several theoretical reasons for enforcing fewer regulatory restrictions on banks (the grabbing-hand approach). First, doing so would permit the exploitation of economies of scale and scope in gathering and processing information about firms. Second, it would permit banks to better manage different types of customer risk, advertise and distribute financial services, enforce contracts, and build reputation capital among customers (see Barth, Brumbaugh, and Wilcox 2000; Claessens and Klingebiel 2000). Third, fewer regulatory restric- tions may increase the franchise value of banks and thereby augment incentives for banks to behave prudently. Fourth, broader activities may diversify income streams and thereby create more stable banks. Finally, the grabbing-hand view holds that governments do not restrict bank activities to ease market failures. Instead, regulatory restrictions promote government power, create a bigger role for corruption through the grant- ing of exceptions to the rules, and thereby hinder bank performance and stability. Specific regulations affect country performance in different ways: · Excessively generous official deposit insurance regimes inhibit bank development and increase bank fragility. · Fewer restrictions allow banks to perform better, subject to a lower probability of crisis. · Fewer limits on foreign bank entry enhance banking sector stability. Regulation and Economic Growth 383 · Policies that promote the private monitoring of banks improve bank performance and reduce corruption. This supports the view that legal and regulatory reforms that promote and facilitate private monitoring of financial institutions constitute a useful financial reform strategy. Finally, these findings raise a cautionary flag over reform strategies that rely on countries to adhere to an extensive checklist of regulatory and supervisory practices (such as direct government oversight of and restric- tions on banks). Instead, the findings suggest that regulatory and supervi- sory practices that (a) force accurate information disclosure, (b) empower private sector oversight of banks, and (c) foster incentives for private agents to exert corporate control best promote bank performance and stability. Policy Lessons from the Recent Crisis The securitization meltdown of 2007 directly affected only a few devel- oping countries. The rise in risk premiums--spreading recessionary pres- sures across most high-income countries--provided the main source of problems for these developing countries. In most crises, the periphery of financial-center countries suffers the most. The lessons for regulation and supervision afforded by crises are as relevant for regulators in developing countries as for anywhere else, and the breakdown of official supervision in several of the world's most developed countries shows the difficulty of aligning incentives. But transparent policy making can always remedy institutional weaknesses that undermine government accountability (Caprio, Demirgüç-Kunt, and Kane 2008). Other important considera- tions are as follows: · Identifiable shocks that end booms or bubbles often reveal crises, although the underlying distortions accumulated over time. · Over time, regulation-induced innovation leads to progressively more complex and less transparent risk shifting. · Because institutions can count on the mismanagement of crisis resolu- tion, safety-net subsidies flow to institutions willing to risk insolvency. · The resolution of a crisis affects the frequency and depth of future crises. · Past crises provide important lessons that are often ignored. Financial crises expose weaknesses in the underlying incentive frame- works and the regulation and supervision systems that are supposed to 384 Understanding Growth and Poverty reinforce them. Given the risky nature of the financial sector, it is not pru- dent to assume that regulation and supervision can eliminate the risk of crises. Yet reforms may improve the incentive structure of regulators and thus improve effectiveness. Neither monetary policy nor capital controls can take the place of pru- dent regulation. While most observers agree that lax monetary policy in the United States in the early 2000s helped fuel the housing bubble, iden- tifying such bubbles in a timely manner is very difficult. More broadly, monetary authorities in most countries face two objec- tives: price stability and financial stability. Attempting to achieve two objec- tives with one instrument is not a promising strategy. A second instrument is needed for financial stability, and this is primarily a task for financial reg- ulation. Capital requirements that can automatically be adjusted over the business cycle are an important pillar of regulation, providing incentives for financial intermediaries to hold more liquid assets in good times. Provisions, leverage ratios, and additional capital buffers can all be countercyclical. By switching the basis of capital adequacy requirements from levels of risk-weighted assets to their rates of growth, these measures require additional capital and liquidity when bank lending and asset prices are rising fast--and the relaxing of such requirements during downturns. Despite their inherent fragility, financial systems underpin economic development. The challenge of financial sector policies is to align private incentives with public interest without unduly taxing or subsidizing pri- vate risk taking. Public ownership or overly aggressive regulation would simply hamper financial development and growth. Striking this balance has become increasingly complex in an ever more integrated and global- ized financial system (Demirgüç-Kunt and Servén 2009). Regulation and Reform of the Infrastructure Sector3 Basic infrastructure services--such as electricity, water, telecommunica- tions, and transport--play a crucial role in supporting economic growth in developing countries. But such services are often highly politicized and susceptible to corruption, leading to poor performance that is a drag on economic growth and development. Infrastructure services have suffered from poor management. Typically, technical performance is compromised because of widespread equipment outages, large amounts of excess labor, and low productivity. Often, prices are set too low to recover the costs of providing services, and sector enterprises have poor cash flows and encounter difficulties in mobilizing Regulation and Economic Growth 385 the financial resources needed to maintain equipment and construct addi- tional capacity. Demand for infrastructure services is also compromised; many people are unable to secure these services because of high prices or are otherwise not connected without resorting to informal mechanisms such as bribery, theft, and political influence. Historically, many of these services have been state-owned, vertically integrated "natural" monopolies, assigned with supply responsibilities, as was the case in the developed economies. But their services are poten- tially competitive, even though many require access to monopoly net- work facilities. Infrastructure sector reform may include privatization, restructuring to promote competition, or regulatory reform. The choice of reform program will depend on basic market institutions, income dis- tribution and social concerns, legal and political institutions, and the eco- nomic attributes of different infrastructure sectors. Lessons drawn from the reform experiences of industrial countries should not be applied mechanically to developing countries. Reasons for Poor Performance Investments in infrastructure tend to be capital intensive and characterized by economies of scale and scope. A developing economy may not be in a budgetary position to finance and support extensive investments in infra- structure. Furthermore, political considerations may have led infrastructure prices to be set too low to meet operating costs and recover investments. To attract new capital, regulatory and legal institutions need to provide credible commitments so that potential investors are certain of recover- ing their investment costs. Investors need to be aware of the prevailing legal restrictions on FDI as some infrastructure sectors may be prohibited from securing foreign capital. Furthermore, it is difficult to attract investors when corruption is rampant, when property rights and contract- ing institutions are poorly developed, and when infrastructure sectors are used to pursue social and political goals that siphon off revenues and increase costs. Reforming Regulated Natural Monopolies Joskow (1999) suggests specific ways of improving the performance of regulated natural monopolies: · Prioritize regulatory reforms for the infrastructure sector. · Address efficiency and rent distribution issues in the design of regula- tory institutions. 386 Understanding Growth and Poverty · Provide credible, legal commitments to potential investors for respecting and enforcing private property rights and contracts. · Set prices high enough to cover the costs of supplying and maintain- ing services at an appropriate level so as not to exploit consumers. In sum, regulatory authorities must provide credible assurance that investors will not be exploited, that consumers will be protected from excessive prices and poor service, and that other goals for the sector will be achieved. Reform Models Joskow (1999) suggests a list of standard reform measures, arguing that a mix of several is more effective than pursuing a single strategy of privati- zation or deregulation. As a first step, he recommends developing effec- tive regulatory institutions and competition policies to define the public policy goals for each infrastructure sector. Such goals might include · improving the sector's ability to mobilize adequate financial resources and thus support the investments required to balance supply and demand efficiently; · increasing sector productivity by reducing operating costs and invest- ing in efficient plant and equipment; and · aligning prices with costs to provide consumers with good price signals. Good Organization and Procedures for Regulatory Agencies The standard prescription for designing good regulatory institutions typ- ically includes terms such as independence, transparency, accountability, expertise, and credibility. These terms convey important principles, the implementation of which relies on the legal and political institutions of different countries. But in reality, independent regulatory agencies are found in few countries. In most of these, including Canada and the United States, the independent regulatory commission has had nearly a century to evolve. Moreover, institutions using this conceptual procedure are obli- gated to make decisions based on a logical evaluation of the facts in light of their statutory responsibilities and subject to judicial review. This is alien to countries where policy decisions are made behind the closed doors of government ministries and departments and with limited due process. Joskow (1999) advocates strongly that regulatory institutions should be an integral component of infrastructure sector reform, not an afterthought. Regulation and Economic Growth 387 These institutions must be part of a framework that protects consumers from abuses of market power. They must promote efficient supply behavior by firms that provide residual monopoly services subject to public regulation. They must facilitate competition by implementing appropriate terms and conditions for access to bottleneck network facil- ities. Moreover, they must guard against cross-subsidization and unrea- sonable discrimination among competitors. Investors should perceive regulatory rules and procedures as credible commitments on which they can rely. Creating effective regulatory institutions takes time. Perhaps the best way to begin is with simple regulatory rules and procedures, to be refined as information and experience accumulate. This would allow regulatory procedures to evolve in response to sector developments and regulator abilities. There is a trade-off between regulatory rigidity and flexibility. Going too far toward either extreme is not likely to yield regulatory insti- tutions that perform well over long periods. Impact of Regulation on Growth and Informality Loayza, Oviedo, and Servén (2005) use seven indexes across a large sam- ple of industrial and developing countries4 to examine whether regulation hinders economic growth. Their data are based on surveys conducted in the late 1990s. They construct a product-market index by averaging the scores of five components, while an overall index consists of all seven. Figure 18.4 depicts scatter plots as to how the log of GDP per capita is affected by the (a) overall regulation (­0.41), (b) product-market regula- tion (correlation: ­0.42), (c) labor regulation (not significant: ­0.14), and (d) fiscal regulation (0.17). The results of their analysis clearly suggest that high levels of regula- tion in product and labor markets are associated with lower growth. First, there is the distortionary effect of regulation on firm dynamics. Second, the disincentive because of regulation may create an opportunity for firms to work outside the legal framework, yielding to an informal sector.5 Thus, increased regulation in the product or labor market could lead to its expansion whereas an increased quality of governance has the poten- tial to mitigate informality. Similarly, if governance is not too low, an increase in fiscal regulation decreases informality, as does the provision of better public services and the enforcement of tax compliance. The overall regulation plot suggests that heavily regulated economies tend to grow less and be more informal--a scenario found most commonly 388 Understanding Growth and Poverty in developing countries--while developed economies tend to occupy the other end of the distribution. Product-market regulation and, to a lesser extent, labor regulation seem to slow growth the most. Conversely, greater fiscal regulation seems to drive better economic growth and fos- ter a smaller informal sector. Interestingly, the analysis of Loayza, Oviedo, and Servén (2005) suggests some predictions. If a typical developing country decreases its product- market regulation to the median level of industrialized countries while maintaining its level of governance (equal to the median of developing countries), then its annual growth rate would rise by about 1.7 percentage points. Similarly, if a country's index of labor regulation increased by one standard deviation in the cross-country sample and its level of gover- nance was equal to the world median, then its annual rate of per capita GDP growth would decrease by 0.3 percentage points. These findings imply that streamlining regulation and strengthening governance in highly regulated countries could have a significant payoff in economic growth. Informal companies evade fiscal and regulatory obligations, including value added taxes (VAT), income taxes, labor-market obligations (such as social security taxes and minimum wage requirements), and product- market regulations (including quality standards, copyrights, and intellec- tual property laws). Evasion varies by sector and by the nature of business. Informal retailers tend to avoid paying VAT, informal food processors ignore product-quality and health regulations, and informal construction firms underreport the number of employees and hours worked. Conventional wisdom has it that informality stems from corrup- tion and lack of government resources. Farrell (2006) claims that govern- ments are insufficiently aware of the huge positive economic and social gains that stem from reducing informality. Moreover, governments do not devote enough resources to the adequate enforcement of tax laws and other regulations (figure 18.5). Three factors contribute to informality: (a) limited law enforcement of legal obligations--a result of poorly staffed and inefficiently organized government enforcement agencies; (b) the costs of operating formally (red tape, high taxes, and costly product-quality and worker-safety regu- lations); and (c) social norms--in some developing countries there is lit- tle social pressure to comply with the law. Many people see evading taxes and regulations as a legitimate way for small businesses to counteract the advantages of large, modern players. Informality stifles economic growth and productivity in two ways: (a) the powerful incentives and dynamics that tie companies to the "gray" Regulation and Economic Growth 389 Figure 18.4 Regulation and GDP per Capita Overall regulation and GDP Product market regulation and GDP 12 12 CHE DNK SWE JPN CHE JPN USA NLD NORBEL ISL AUT FRA DNK NOR 10 AUS FIN GBR CAN IRL SWE AUT USA ISL NLD BEL FIN FRA ESP ITA ISR 10 AUS IRL CAN GBR ITA log GDP per capita log GDP per capita KOR GRC PRT ESP ISR ARG PRTGRC KOR URY ARG CHL MYSBWA TTO CRI MEX BRA VEN ZAF CHL URY MYS TTO BRA VEN ZAF MEX 8 TUR COL PAN CRI TURBWA PAN JAM THA PER TUN 8 THA JAMCOL TUN PER SLVGTM JORPRY IRN DOM ECU MAREGY SLVGTM DOMIRN JOR PRYECU PNGPHL BOL IDN MAR PHL LKA HNDCIV SYR COG IDNEGYBOL PNG SYRCOG ZWE LKA CIV HND PAK SEN ZMB GHA NIC GMB HTI PAKZWE SEN 6 KEN BGD IND TGO NGA NER 6 KENINDNIC ZMB GHA BGD NGA GMB TGO HTI MDG BFA MDG NER BFA MWI MWI 4 4 .2 .3 .4 .5 .6 .7 0 .2 .4 .6 .8 overall regulation index product market regulation index correlation: ­0.81*** correlation: ­0.87*** Labor regulation and GDP Fiscal regulation and GDP 12 12 CHE JPN DNK FRA NLDSWE CHE JPN AUT NOR BEL DNK 10 USA GBR CANAUS IRL ITA FIN USA NOR SWE FRA BEL ISL FIN AUT NLD ISR ESP 10 IRLGBR AUS CAN ISR ITA Log GDP per capita log GDP per capita KOR GRC PRT ESP KOR GRC PRT ARG ARG URY MYS TTOZAF CHL BRA VENMEX CHL URY MYS TTO BRA 8 BWA TUR CRI THA COL PAN 8 VEN PAN CRI MEX THA BWA TUR ZAF JAM TUN PER DOM IRN ECU GTM SLV MAR PRY JOR PRY GTMJAM COLJOR DOM SLV ECU PER TUN IRN IDN PHL EGY MAR PNG LKA CIV HND BOL COG SYR BOL PHL PNG CIV COG EGY IDN LKA SYR ZWE SEN PAK HND SEN ZWE ZMB NIC TGO PAK 6 KENGHA IND HTI 6 HTI GMB NIC KEN BGDTGO ZMB IND GHA NGABGD NER BFA MDG NGA MDG BFA MWI NER MWI 4 4 0 .2 .4 .6 .8 0 .2 .4 .6 .8 1 labor regulation index fiscal regulation index correlation: ­0.09 correlation: 0.49*** Governance and GDP 12 JPN CHE DNK BEL AUT NOR E FRA USA SW NLD ISL FIN 10 IRL AUS CAN ISR ESP GBR ITA log GDP per capita KOR GRC PRT ARG URY ZAF CHL BRA TTO VEN MYS CRI 8 PAN MEX BW A TUR COLPER JAM THA TUN PRY SLV ECUJOR GTM MARDOM EGY PHL IRN IDN BOL PNG COG HNDCIV SYR LKA PAK ZW E ZMB SEN 6 HTI TGO BGD KEN GHA GMB NIC IND NGA NER BFA MDG MW I 4 0 .2 .4 .6 .8 1 governance quality index correlation: 0.87*** Source: Loayza, Oviedo, and Servén 2005, 18. *** denotes significance at the 1% level. 390 Understanding Growth and Poverty Figure 18.5 Informal Economy across Several Countries and Sectors a. Estimated share of nonagricultural b. For developing countries: estimated workforce that is informal (%) share of value-added activities that are informal, by industry (% of GDP) Sub-Saharan Africa 80 construction 85 India, Indonesia, apparel 80 70 Pakistan, Philippines retail 80 Brazil, Thailand, 50 Turkey auto parts 30 Mexico 40 food processing 30 Chile 38 cement < 30 steel < 30 Portugal 30 consumer electronics 20­25 software 20 Source: Farrell 2006, 144. economy constrain their productivity, and (b) the cost advantages of avoiding taxes and regulations help informal companies steal market share from bigger, more productive formal competitors. Consequently, the adverse effects of informality are both economic and social (work- ers' income and health regulations are compromised, for example). Informal players persistently drag down a country's overall productivity and standard of living. In Portugal and Turkey, for instance, informality accounts for nearly 50 percent of the overall productivity gap with the United States. Conclusion Regulation should encourage competition while mitigating the adverse impact of market failures. Poor regulations limit productivity, growth, and service delivery in most countries. As such, regulations should be enacted with care, should be explicit and transparent, and should be enforced evenly. They should be adjusted on the basis of what works and does not work. The role of an effective regulatory regime is crucial in promoting productivity, investment, industrial expansion, economic growth, and development. The building of effective regulatory structures in developing Regulation and Economic Growth 391 countries involves both the technical design of appropriate regulatory instruments and the presence of good-quality supporting regulatory insti- tutions. The ability of the state to provide effective regulatory institu- tions can strongly affect economic performance. Notes 1. By which we mean reforms to product markets that stimulate competition, innovation, and economic growth. 2. These include regulations of (a) bank activities, (b) banking and commerce, (c) domestic and foreign bank entry, (d) capital adequacy, and (e) information disclosure. They also include deposit insurance system design features; super- visory power, independence, resources, loan classification stringency, provi- sioning standards, diversification guidelines, and prompt corrective action powers; the fostering of private sector monitoring of banks; and government ownership of banks. 3. In a comprehensive analysis titled "Regulatory Priorities for Infrastructure Sector Reform in Developing Countries" that was contributed to the "Annual World Bank Conference on Development Economics," Paul L. Joskow (1999), Elizabeth and James Kilhan Professor of Economics and Management, Massachusetts Institute of Technology discusses some important aspects of the topic summarized here. Interested readers are referred to the original article. 4. They are firm entry, labor markets, fiscal burden, trade barriers, financial mar- kets, contract enforcement, and bankruptcy regulation. They are derived from the Ease of Doing Business database (World Bank), Index of Economic Freedom (Heritage Foundation), Economic Freedom of the World (Fraser Institute), the Labor Market Indicators Database (Rama and Artecona 2000), the Corporate Tax Rates Survey (KPMG), and the International Country Risk Guide (PRS Group) to study 75 countries. 5. The "informal" sector comprises (noncriminal) economic activities that go undeclared specifically to avoid compliance with costly regulations (such as employment-protection laws), tax payments, and social security contributions. Bibliography Aghion, P., and P. 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In The Private Sector in Infrastructure: Strategy, Regulation, and Risk, ed. World Bank Group, Finance, Private Sector, and Infrastructure Network, 9­12. Washington, DC: World Bank. World Bank. 2004. Ease of Doing Business Survey. Washington, DC: World Bank. ------. 2009. Ease of Doing Business Survey. Washington, DC: World Bank. CHAPTER 19 Shocks, Volatility, and Growth Throughout business cycles, economies face both negative and positive shocks. In 2007­08, three major negative crises hit the global economy: food, fuel, and financial. Oil prices doubled in a few months in 2008, while rice, wheat, and corn prices jumped by 40 to 50 percent during the same period. The bursting of the housing bubble in the United States and Europe led to the failure of commercial and investment banks, exacer- bated the credit crunch, and resulted in global financial turmoil by September 2008. Standard policies could have handled any of these three shocks independently. Their interplay, however, made policy decisions much more difficult. This chapter investigates both crises (negative shocks) and booms (positive shocks). The focus will be on common elements of fast-growing countries. Avoiding Economic Downturns Studies indicate that sustainable long-term growth requires macroeco- nomic policies that absorb commodity price shocks, asset shocks, and banking crises, and reduce the risk and frequency of financial crises. "Successful" countries--defined, for this purpose, as those reducing their 397 398 Understanding Growth and Poverty per capita gross domestic product (GDP) gap with industrial economies-- more effectively responded to macroeconomic shocks than others. Table 19.1 shows that, on average, developing countries experience a year of negative per capita growth once every three years, East Asian "miracle" economies once every six years, and Organisation for Eco- nomic Co-operation and Development (OECD) countries once every nine years. The success of East Asia's economies was partly a result of the macroeconomic policies that steered them away from downturns and periods of low growth. But African countries are different. African exports are mostly primary commodities: oil in Angola, Nigeria, and Sudan; cotton in several West Table 19.1 Importance of Avoiding Downturns in Growth Year in which growth rate from 1960­2002 was Below 1 Below 2 Above 2 Negative percent percent percent All developing countries 14 19 24 18 Sub-Saharan Africa (28) 18 22 27 15 Botswana 2 3 4 38 Lesotho 10 15 16 26 South Asia (5) 8 11 17 25 Bangladesh 11 15 21 21 India 8 10 14 28 Nepal 10 18 22 20 Sri Lanka 4 6 14 28 Middle East and North Africa (6) 15 18 22 21 Egypt, Arab Rep. 4 10 15 27 Latin America and the Caribbean (21) 12 19 25 17 Chile 7 11 18 24 East Asia and Pacific (7) 7 8 10 32 China 5 6 7 35 Indonesia 7 8 10 32 Malaysia 5 5 7 35 Thailand 2 2 6 36 High-income OECD (22) 5 8 16 27 Korea, Rep. 3 3 4 38 Source: World Bank 2003. Note: The table shows evidence for the 89 countries for which growth data were available for the four decades 1960­2002. Regional aggregates are medians. The Republic of Korea "graduated" into a high-income category in the early 1990s and is thus classified here in the high-income OECD group rather than in the East Asia and Pacific group. Shocks, Volatility, and Growth 399 Figure 19.1 Commodity Price Growth and Real GDP Growth in Sub-Saharan Africa, Three-Year Moving Average 6 2 4 % of growth in real commodity prices 1 2 % of growth in real GDP 0 0 ­2 ­1 ­4 ­6 ­2 1967 1970 1975 1980 1985 1990 1996 growth in real GDP growth in commodity prices Source: Deaton 1999. African countries; tobacco in Malawi; tea and cut flowers in Kenya; cop- per in Zambia; diamonds in Botswana and South Africa, and so on. World prices for most of these commodities are unpredictable and volatile, and the upward and downward fluctuations in prices are not symmetrical. This creates economic fluctuations in export revenues, local-currency- exchange-rate appreciation, and the so-called Dutch disease that affects wages in the booming sectors. Short-term agricultural price effects are different from the oil and other nonagricultural price changes. Figure 19.1 shows a strong correlation between growth of commodity prices and real economic growth, both in the short and long term: the former leads to the latter. Import-substituting industrialization, financed by the commodity booms of 1970s and 1980s, did not work in Africa. Commodity booms and busts are frequent in natural-resource-dependent economies. African countries need more human capital to capitalize on surpluses and diversify their economies. 400 Understanding Growth and Poverty Interdependence of North and South As the world's developed countries (the "north") and developing coun- tries (the "south") become increasingly interdependent, the impact of the economic policies of the north on the south increases. Developing coun- tries commonly complain that the global financial system is run by cred- itors and, as such, that advanced countries place more importance on maintaining the stability of the financial system than on mitigating finan- cial crises. Globalization--defined as the increasingly free flow of ideas, people, goods, services, and capital that leads to the integration of economies and societies--has become a major driver of world change; however, the Washington Consensu