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p. 52 of 54 BACK | NEXT I. Developing Asia and the World - Economic Developments and Prospects II. Economic Trends and Prospects in Developing Asia III. Asia's Globalization Challenge Introduction The Asian Growth Experience and Globalization Policies for Adapting to Globalization Institutional Options in a Globalizing Environment Conclusions - Toward a Framework for Globalization

Asian Development Outlook 2001 : III. Asia's Globalization Challenge

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Policies for Adapting to Globalization

The preceding section showed how some Asian countries achieved substantial progress in economic development and poverty reduction with variants of the basic strategy of external sector liberalization, high savings and investment rates, and technology transfer from industrial countries. However, even as some Asian countries approach the world technological frontier, a new economy is emerging. Moreover, national policymakers are increasingly concerned about the possible risks of globalization. Indeed, they must continue to improve their understanding and appreciation of the potential benefits as well as the challenges that globalization presents.

This section first looks at how policymakers can maximize the benefits of globalization through dynamic management of the national system of economic learning and by adapting to the economic realities of the new economy. Next, it considers how to minimize risks by managing the volatility that results from a more integrated global economy, and by protecting the most vulnerable groups of society from them.

Maximizing Benefits

Managing Economic Learning

Each country, either implicitly or explicitly, has a network of policies and institutions in place to manage innovation or economic learning.⁴ This network is the public and private institutional framework used to support R&D-led and market-mediated efforts to create, absorb, and adapt new technology for commercial use. International comparisons emphasize the diversity of such networks even within Asia (see e.g., Mowery and Oxley 1995). There are, however, sufficient similarities among the systems within the region to justify considering an "Asian approach" to development, innovation, and economic learning.

This Asian approach, in its early stages of development, was designed to bring in technologies from outside the region (emulation or imitation) rather than develop new technologies (innovation). This made sense for Asian economies that were relatively late to develop and could take rapid strides simply by importing and assimilating foreign technologies. Thus many countries emulated the 1950s Japanese Ministry of Economy, Trade and Industry "METI-model" of industry creation. Governments sought to promote-through techniques such as initial subsidies and cooperative industrial policies-industries thought to have export potential based on production cost advantages and the adaptability of foreign technology. There was no need to create technologies from scratch when technologies used abroad could be acquired and profitably exploited more quickly. Box 3.2 describes the stages of the development process through which these latecomers to particular industries that were already established in industrial countries overcame the technological barriers to entry.

But the longer the Asian rates of growth have continued to outstrip those in the US, Europe, and Japan, the closer DMCs have drawn to the technological frontier. This has important implications. As the frontier is approached, the opportunities for rapid progress through emulation diminish and the ability to innovate becomes increasingly important (Krugman 1985). Put another way, as convergence proceeds, growth responds less to capital formation and more to R&D and other sources of productivity advance. Yet the ability to adapt distant technologies to produce goods for distant markets on its own will not necessarily facilitate the transformation to innovative systems. The production of new technologies tends to take place close to a firm's home base (Freeman 1995, Patel 1995) and technological spillovers, particularly from new ideas, weaken with distance (Keller 2000), perhaps because this new knowledge is not yet standardized or widely understood. Thus there is an apparent need to redesign the Asian approach to encourage innovation rather than emulation as countries close in on the technological frontier. Indeed, the Asian approach is already evolving in this direction. Yet because institutions inevitably exhibit inertia, Asian economic systems remain less well suited to nurturing the radical innovations needed if they are to remain near the frontier in a dynamic, global economy. This will become more apparent through a brief review of traditional channels for technology acquisition and government policies used to support the Asian modality of economic learning and export promotion.

Channels. Channels for the acquisition of technology include capital goods imports, licensing arrangements, joint ventures, FDI, and outsourcing. Of these, capital goods imports, licensing, and joint ventures have long been the staples of the Asian approach. New technologies are usually embodied in new capital goods, and importing such equipment allows a country to immediately benefit from foreign technological advances and also opens up opportunities for learning through reverse engineering. The use of this mode of technology acquisition is evident from the fact that the NIEs have historically had a higher propensity to import capital goods in comparison to other developing economies.

The scattered data available on licensing arrangements suggest substantial reliance on this channel in some countries as a complement to the import of capital goods. OECD (1992) reports that Korean spending on licenses for technology grew 10-fold between 1982 and 1991. In developing national industries, Asian governments, with the notable exception of Singapore, historically preferred licensing or joint ventures that involve local management over standalone foreign operations, based on the belief that the former options offer greater scope for technology transfer while the latter allows the multinational corporation too much control.⁵ However, relative to capital goods imports and licensing, FDI has the advantage that it is a channel for transferring managerial and technical expertise, which comes bundled with foreign plant and equipment as well as marketing and distribution networks. Such expertise is particularly valuable when the importing country is attempting to implement relatively sophisticated foreign technologies with a high knowledge component. The technologies transferred through wholly owned foreign projects tend to be newer and closer to the technological frontier than those associated with joint ventures and licensing agreements.

Finally, in sectors where economies of scale are smaller and foreign managerial and technical expertise is less essential, multinational corporations frequently outsource elements of the production process and local firms can thus acquire foreign technologies via contract manufacturing and assembly operations. Such operations are a source of “learning by doing”. They become increasingly attractive relative to inviting in multinational corporations in a world where ICT allows domestic production to be networked with foreign production.⁶ Most of the economies in Southeast Asia, as well as PRC; Hong Kong, China; and Taipei,China have become part of such production networks in the past decade.

Table 3.4 shows the evolution of these different sources in the Korean case. The special importance of capital goods imports as a source of technology transfer to Korea is apparent throughout the period. Also evident, however, is the economy’s reliance on FDI in the early to mid-1970s. Thereafter, however, the importance of FDI declines relative to total flows, as policy sought to emphasize different channels for technology transfer and to protect indigenous producers from multilateral competition. In its place, licensing as a source of technology transfer was promoted. Comparable figures for Taipei,China would highlight that economy’s greater reliance on licensing, while those for Malaysia and Singapore would show the importance of FDI by multinationals.

Policies. Policies have been used to foster each of these channels of technology transfer. In addition to the application of uniform tariff rates that do not discriminate against capital goods, Asian governments have pursued policies designed to maximize the knowledge spillovers associated with licensing, FDI, capital goods imports, and outsourcing, and have often required licensing agreements as a condition for foreign multinationals to establish operations locally. This encouraged domestic firms to bundle imports of heavy electronic machinery with licenses to produce copies of the equipment, and supported entry by domestic producers into the production of this equipment (Ozawa 1985). Thus, Korea both protected domestic producers and placed pressure on foreign joint venture partners in the 1970s to withdraw and leave the field to indigenous firms (Matthews and Cho 2000).

Macroeconomic, financial, and trade policies can also be regarded as an important part of the Asian approach. Stable monetary and fiscal policies, complemented by favorable demographics, supported high and rising savings rates. Much of these savings were channeled through government-controlled banking (and postal savings) systems that provided concessionary credit to firms in technologically progressive sectors. More controversially, controls on financial capital exports were used by Japan; Korea; and Taipei,China early on to ensure that domestic savings, once mobilized, supported domestic capital formation, while the PRC continues to do so.⁷ Where economies of scale were important, and where multidivisional structure was seen as necessary to capture technological spillovers, the Korean Government provided preferential credit for the growth of chaebol. Large economies of scale (falling unit costs as the scale of production increases) or dynamic economies of scale (falling unit costs as the firm gains experience through learning by doing) characterize leading-edge technologies (e.g., integrated steel production in the 1970s and 1980s, semiconductor manufacture in the 1990s). Export promotion thus provided the dual benefits of allowing firms to overcome the constraints imposed by limited domestic markets, while exposing them to the discipline of foreign competition. The significance of all these policies is that they helped the small economies turn globalization to their advantage.

Asian countries are not the only ones to pursue policies to encourage the transfer of advanced technologies from abroad and to facilitate their dissemination, though some (particularly the PRC, the NIEs, and Southeast Asia) have arguably had more success in globalizing their economies than countries in other late-developing regions. Nelson (1992) and Matthews and Cho (2000) attribute the superior performance of the Asian model of economic learning to three factors.

First, the more successful Asian economies emphasized the importance of having the skilled labor force needed to understand the principles underlying foreign technologies, which facilitates the adoption of foreign techniques by domestic producers and allows substitutes for foreign capital goods to be produced at home with a relatively short lag.⁸ Hong Kong, China; Singapore; and Taipei,China have larger shares of post-secondary students enrolled in scientific and engineering fields than most other developing economies and encourage their best students to acquire advanced training abroad. One of Singapore’s first initiatives to support its efforts to attract foreign high-technology firms was to train a cadre of “knowledge workers” (Matthews and Cho 2000). Korea and Taipei,China established publicly funded advanced research institutes staffed by scientists and engineers trained in foreign universities, encouraging them to establish links with commercial firms. Such initiatives have likely enhanced domestic absorptive capacity for adopting and adapting foreign technology.

Second, Nelson, as well as Matthews and Cho, argue that the Asian model was successful because it was combined with an emphasis on export promotion. This meant that domestic firms were subject to relatively intense competition and this applied pressure on them to emulate best practice, specifically the best-practice techniques of their competitors—namely, foreign-owned and operated firms.

The third argument is that the Asian approach was successful because restraints on entry and other policy interventions were guided by well-defined rules and because technocrats enjoyed the bureaucratic autonomy necessary to avoid “capture” by domestic industry (World Bank 1993). Bureaucrats are protected by civil service systems that ensure adequate compensation, recruitment, and promotion based on merit (i.e., exams), and strictly enforced dismissal policies. Japan, Korea, and Singapore are the paradigmatic cases. In some cases, early land reform and support for small and medium-scale industries were similarly important for preventing the emergence of large interest groups positioned to capture the policy-making process.

The second and third points are widely debated. The intensity of domestic competition to which producers in Asia’s rapidly industrializing economies were exposed is debatable. Incumbent firms that enjoyed protection from both foreign competitors and potential domestic entrants may have, in some instances, devoted more energy to lobbying the Government against granting licenses to new entrants than to raising productivity. Moreover, domestic firms producing nontraded goods were not subject to as much competition as firms producing for export. The third argument became controversial as a result of the Asian financial crisis. Commentators, who once wrote approvingly of “bureaucratic autonomy,” now decry “crony capitalism.” Possibly, problems of capture have intensified with time. The longer industrial targeting policies are pursued, the more intimate the connections between the policymakers and the policy beneficiaries. In addition, as the economy becomes more technically sophisticated, monitoring the performance of the enterprises receiving preferential treatment becomes more difficult for the bureaucrats

Adapting to Globalization. Adapting to globalization is an ongoing process. The argument that the policies of bureaucratic direction that worked well at an earlier stage of Asia’s technological development will work less well today is a specific illustration of a more general point: economic learning is dynamic—its structure and operation vary over time. In their early stages of industrial development, Asian economies, particularly the NIEs, relied heavily on arm’s-length transactions—technology licensing and purchase of foreign capital goods—and less on FDI, joint ventures, and outsourcing.

Adopting licensed technologies arguably requires more limited adaptations of domestic economic structure than FDI and joint ventures, which will be attractive to foreign firms only if the economy is comprehensively restructured. Licensing also tends to be a source of less sophisticated technologies.⁹ Thus, as economies approach the technological frontier, they increasingly rely on FDI as a source of foreign technology. It is notable that Southeast Asia has rejected the arm’s-length approach and welcomed FDI in the 1990s. Because joint ventures also tend to transfer older and less sophisticated technologies than other forms of FDI (Smarzynska 1999), there is a similar tendency to move away from them as a country approaches the technological frontier. Economic evolution is also reflected in the growing R&D intensity of domestic firms and thus the gradual shift from emulation to innovation.

Although economic systems tend to evolve as economies mature, the policies and institutions developed for and appropriate to earlier stages of economic development tend to get locked in, posing obstacles to further development. Thus, if small firms are disproportionately responsible for the development of new technologies as numerous studies suggest (Acs and Audretsch 1987, 1990), industrial policies conducive to the growth of large conglomerates, such as those of Korea, will eventually become obstacles to innovation. If the development of new technologies requires venture capital allocated through securities markets, then the earlier forms of capital allocation—through intimate banking relationships that extend funding in large chunks to preferred customers with established technologies—will inhibit innovation.

Moreover, as globalization proceeds, economic learning and evolution as described may no longer be available to latecomers. The multinational corporations that are the sources of advanced technologies are inclined to license latecomers only when prevented from setting up their own operations in foreign markets. As more developing-country markets are thrown open to FDI, it becomes harder for individual governments to insist on licensing as an alternative. This is evident in the greater tendency for Singapore and Hong Kong, China and the countries of Southeast Asia to rely on FDI and to fit into modularized production networks involving a variety of outsourcing arrangements. Insofar as firms can outsource the production of components internationally, governments will find it more difficult to promote the transfer of advanced technologies by requiring the entire production process to be undertaken in their country.

Globalization makes it more difficult for Asian economies to approach the technological frontier by importing capital goods, luring FDI, and licensing foreign technologies. If it is correct that these economies, as they reach more advanced stages of technical development, must in any case rely more heavily on indigenous technical change, then the priority system of incentives will have to be reordered. More flexible, smaller firms and outsourcing arrangements will have to be further developed. Securities markets will have to grow. Governments’ command over resources and technocrats’ efforts to control their allocation will have to be reduced.

This is not to say that the Asian approach will become indistinguishable from that of its counterparts elsewhere. On the contrary, certain features of the Asian approach such as sound macroeconomic management, fiscal discipline, and maintenance of a low-inflation environment, are eminently well suited to a globalized, technically fluid world. These are strengths on which the Asian approach in the 21st century can build. Export orientation and the emphasis on export competitiveness remain admirable characteristics of economic systems faced with rapidly changing technologies and the globalization of production. Governments should still encourage and actively support collaboration between universities, technical institutes, and private-sector firms, as well as promote the commercialization of new technologies.

That said, the Asian approach has to be reoriented and those who do this quickly will be the first to reap the benefits. This will require the same concerted efforts that Asian economies employed to initiate industrialization and technology transfer from the West after the Second World War. The role of government in this process also needs to be reconsidered, given the desirability of a flexible and responsive private sector: this role will likely be to support the development of human resources, including engineers, scientists, and ICT and financial sector professionals.

Exploiting the New Economy

In the past 20 years, as the Asian approach allowed economic convergence of DMCs toward the economic structures prevailing in industrial countries, these industrial economies—and, indeed, the world economy—underwent a rapid transformation. The previous section Asian Growth and Globalization Experience reviewed evidence of the strong trend toward globalization: increased international trade in final products, intermediate and capital goods, and services; larger flows of financial capital, including commercial loans, FDI, and portfolio investment; and, to a lesser extent because substantial barriers to migration still exist, greater labor mobility.

An indication of the scope of this transformation is that economists estimate that more than half the world’s total output of goods and services is now contestable (meaning that producers must keep prices competitive to avoid losing market share to potential entrants). This process of globalization, itself unleashed by policies of economic liberalization and technological breakthroughs in ICT, is reinforcing the huge impact of those ICT forces reshaping the economic landscape into the new economy, (which is also known as the “information economy,” or the “knowledge-based economy”). This section reviews in more detail the characteristics of the ICT revolution, its impact on economic performance, and the implications for DMCs.

ICT Revolution. The ICT revolution is multifaceted. One aspect is the rapid development of computing hardware and software, including much greater power, smaller size, and lower prices. This triggered the rapid spread of powerful computers to offices and to nonpoor households around the world (although not to the poor, giving rise to the term “digital divide”). A second aspect is the development of high-speed transmission of information by relay stations, satellite, and fiber optic cables. This spurred massive public and private investment to upgrade information systems. A third aspect is the digitization of information—not only words and data but sound and video as well, generating new business applications such as computer-aided design (CAD) or practices such as teleworking. These technological advances resulted in an explosion in the use of fax machines, cellular phones, and the Internet, creating a services sector specializing in the provision and analysis of information that is growing much faster than the rest of the economy.

The US is the leading exponent of these trends, as can be seen in labor-force and value-added statistics. The high-technology share of industrial value added in manufacturing in the US rose to over 25 percent in the late 1990s from 18 percent in 1970, while its share in GDP also increased. The services sector has grown at the expense of manufacturing as computer programmers, managers, and office workers have replaced, for example, riveters, forklift operators, and other manufacturing workers. Managerial and professional jobs have risen as a share of total employment (22 percent of the workforce in 1979 compared with nearly 30 percent in 2000), while the number of people employed in occupations requiring lower skills has fallen. In 1960, there were fewer than 5,000 computer programmers, 0.1 percent of the workforce; by 2000, their number had grown to over 1.3 million, almost 1.0 percent of the workforce.

The growth of ICT, computers, and the Internet has transformed the face of the US economy and its relationship to other economies. Housing and automobiles were the driving force behind economic growth for many years. Slowly they are being supplanted by ICT, which now accounts for about one third of total US GDP growth each year. Because of enormous gains in productivity in computers, the costs of ICT (adjusted for quality) have fallen significantly. This contributed to price stability, despite the fact that until recently the US economy has been in the longest peacetime expansion in its history. Some economic historians equate this trend with the technological breakthroughs that fueled the development of the railroads in the 19th century or of the automobile in the 20th century.

In that sense, ICT is a technology that transcends its own particular industry, spilling over into the entire economy, increasing productivity, and changing the way businesses operate. The new economy has brought with it a dramatic acceleration in innovation, an explosion of new products, shorter product cycles, greater competition, and improved business efficiency. There are more new firms being set up and more old firms going out of business. As part of the revolution in ICT, the world computer microchip market has grown at double digits for many years and its share in GDP has also increased, even though chip prices have fallen substantially. This is particularly true in several DMCs for which semiconductors are an important export.

Combined with the growth of the Internet, ICT has the potential to reduce costs and increase efficiency (through Internet-based transactions) to such an extent that levels of sustainable growth may increase substantially. Retailing over the Internet, known as business to consumer (B2C) selling is slowly taking hold. Such firms as amazon.com, a large Internet book retailer, pioneered this retailing method, but many large traditional retailers now have websites.

B2C transactions are expected eventually to be dwarfed by business to business (B2B) Internet transactions, which should reduce the search costs for firms seeking least-cost and high-quality suppliers. However, despite such examples of earlier adoption, such as the agreement between General Motors and Ford to develop a joint parts network, firms have been slow to switch to reliance on the Internet for B2B transactions because of uncertainty over reliability. Relations with suppliers are often nurtured over long periods. Currently, only a small fraction of all B2B transactions takes place over the Internet. Nevertheless, the potential cost savings are tremendous even if only a few percent of B2B transactions shift to the Internet in the next few years.

ICT and Economic Performance. The impact of the ICT revolution on economic performance is difficult to quantify. Measuring the impact of ICT, computers, and the Internet is complicated because these three components are interrelated and because long time series to analyze the data are lacking. Since 1996, a sharp acceleration in the rate of growth in labor productivity has been seen in the US. In manufacturing, for example, the annual growth rate of labor productivity, as measured by output per hour, has steadily increased, ranging from 2.81 percent in 1996 to 6.14 percent in 1999. This is unusual. Historically, labor productivity tends to fall in recession and accelerate in the initial stages of recovery. The current surge in productivity is the first time in the postwar period that the surge has come when the economy has been in a sustained upswing in output growth. Some experts have suggested that the ICT revolution is responsible for this.

There is some controversy about these results. The International Monetary Fund (IMF), for example, suggests that the productivity surge is the result of a rebound from lower productivity earlier in the 1990s and that estimates of TFP do not show a significant increase in recent years. IMF also argues that the improved trade-off between inflation and unemployment may be the result of demographic shifts that have moved more of the workforce into middle age where unemployment is low, while the proportion of teenagers in the labor force, where unemployment is high, has shrunk (IMF 1999a). Other economists have confined their study to the direct impact of computers on output in sectors where they have been heavily utilized, such as ICT, banking, and some parts of manufacturing. While the impact of computers on productivity in these industries is estimated to be large, the contribution to total productivity is relatively small, both because these sectors are still quite small (though growing rapidly), and because productivity enhancement is less apparent in other sectors of the economy. Nevertheless, it is clear that the ICT revolution is having a significant impact on the pace and character of world development, creating a new economic development paradigm for DMCs.

DMCs and the New Economy. The extent to which DMCs are integrated into the new economy varies across countries. In the US, electronic data processing and interchange (the first stage of the information revolution) have penetrated all levels of the economy and the use of ICT in banking and finance as well as industry is widespread. More recently, the use of the Internet has blossomed and is being used for retail sales (B2C), purchases by businesses (B2B), and inventory and management purposes. The success of auction sites demonstrates the possibility of consumer to consumer (C2C) transactions. In Europe, the use of the Internet is not as widespread as in the US, but Europe is similarly well developed in the use of ICT for banking and finance and for certain accounting and management functions. Some DMCs are at par with the US and Europe in certain areas, such as Singapore and Hong Kong, China; and perhaps Taipei,China; and Korea.

In varying degrees, the NIEs, PRC, India, and the ASEAN-4 countries have experience in production of electronics exports in which the new economy best business practices of outsourcing and flexible production systems are already highly developed. These economies might be relatively well placed to take advantage of unfolding opportunities in the new economy, provided they can adapt their economic systems (as discussed in the previous section). Several possible trends can be identified.

First, growth of trade will create additional opportunities to develop export markets. The volume of world trade has grown faster than GDP for several decades as barriers to trade have fallen. More openness in trade and the flow of capital should facilitate the spread of the new economy to DMCs, particularly those where international trade has played a significant role in economic development.

Second, the ICT revolution could create opportunities for DMCs to export skill-intensive services. India, Philippines, and Singapore have already developed substantial software and data entry platforms in the past decade. In the future, this expertise could be extended to help bring these economies into a position where they can enter the knowledge and information aspects of the new economy more fully.

Third, growth of the Internet may create a more level playing field. The capacity of poorer countries to market retail products and to bid for subcontracting jobs in industrial countries may be enhanced by the spread of the Internet. However, the extent of this penetration will depend to a large extent on whether these countries can compete in this market by supplying quality products or inputs in a timely manner. The Internet has the capacity to cut search costs and improve economic efficiency, but only if it is embraced throughout the economy. If this occurs, successful new Internet-based companies will be able to take advantage of economies of scale in a globalized market.

Fourth, DMCs will receive greater payoffs from improving education and skills. The returns to education are generally thought to be quite high. The emphasis in the past has been on returns to women’s education and the synergies that these investments have with health, fertility, population growth, and infant mortality. In the future there will also be high returns to investment in vocational and tertiary education in the fields of computer science (from data entry to advanced programming), software development, and the Internet. Already, private sector training in these occupations has expanded rapidly in India, Malaysia, Philippines, Singapore, and Thailand. This should be preferred to public education to minimize the waste of public resources since foreign companies often recruit ICT specialists, contributing further to an economy’s brain drain. Yet it should be noted that the ICT revolution might reduce the tendency for highly skilled labor to emigrate. Since many ICT applications are not bound geographically, labor services can be provided from separate locations. Moreover, numerous ICT professionals have emigrated and then returned to their home countries to start up new companies, particularly in India.

Fifth, more opportunities to develop niche markets through foreign partnerships, outsourcing, and strategic alliances will appear as the ICT revolution allows increased modularization of product delivery. Internet B2B transactions should improve the efficiency of existing supply chains, lead to more outsourcing opportunities, and increase the importance of strategic alliances such as those developed in small and medium-sized enterprises in Taipei,China that allowed them to compete internationally. These enterprises have been able to take advantage of their marketing and distribution networks worldwide even while they have offloaded production lines in which they have lost comparative advantage to other economies, particularly the PRC where labor costs are cheaper. Hong Kong, China; and Singapore, in which the traditional entrepôt businesses are booming because of the increase in world trade, have been aggressively expanding their ICT infrastructure to improve their ability to take advantage of the Internet and globalization.

ICT Infrastructure. ICT infrastructure will be increasingly critical, in all the DMCs, to an economy’s ability to capitalize on globalization. A case can be made for looking at the ICT (and related) sectors of the economy as an important special case for developing national policies with a sectoral focus. The sector is growing rapidly, provides an important linkage to the global economy and, from the experience of the US, has the potential to be a source of rapid productivity gains.

For the ICT sector in DMCs to flourish, several prerequisites must be met. First, ICT has to be supported by a vibrant telecommunications sector. This will require large expenditures in Southeast Asia and South Asia, to bring these subregions to par with the NIEs. It will also need a partnership between the public and private sectors as well as appropriate technological transfer from industrial countries and perhaps the NIEs. Education is also essential and it too involves a marriage between the public and private sectors. The public sector should be responsible for basic education and for the acquisition of computer literacy on a widespread basis, as well as upgrading science and mathematics training. The growth of the private sector is necessary to provide easy and economical access for students and others to ICT as well as to computer education. Policy support for private sector ICT development, including standards for assuring the compatibility of systems (hardware and software) is justified by the positive spillovers of ICT to the rest of the economy. Finally, intellectual property rights have to be safeguarded by strengthened laws on copyright and patent rights.

Minimizing the Risks

Volatility in a Globalizing World

Recent Asian experience suggests that globalization can be a source of macroeconomic volatility, which generally reduces economic welfare. The view holds that, as DMCs integrate into the global economy, they are increasingly exposed to external disturbances. For example, the slump in global semiconductor prices, an instance of an adverse terms-of-trade shock, is blamed for undermining the Korean economy and other countries in Southeast Asia in the run-up to the 1997/98 crisis (Goldstein 1998). And as markets become more globalized, economies become increasingly susceptible to contagious spillovers from national, regional, and global financial shocks. As an example of the size of these shocks, in the six quarters prior to the onset of the Asian financial crisis in July 1997, capital inflows into Indonesia, Korea, Philippines, and Thailand totaled $86.8 billion while in the subsequent six quarters there was an outflow of $77.9 billion.

That the PRC did not succumb to the financial crisis has been ascribed to the fact that it retained capital controls and consequently was not deeply integrated into global financial markets. More generally, Eichengreen et al. (1995) have shown that countries are more likely to be able to contain speculative pressure when they are not yet integrated into these markets. This is not to suggest that the costs of globalization swamp the benefits, but to emphasize the importance of developing institutions and pursuing policies aimed at limiting volatility and minimizing its adverse social consequences.

General Effects of Volatility. There is now ample evidence of the costs of macroeconomic volatility. Ramey and Ramey (1995) estimate that a unit increase in the standard deviation of the “innovation” in GDP reduces the rate of per capita GDP growth by one fifth of 1 percent per annum.¹⁰ Easterly and Kraay (1999) produce similar results. Upon controlling for other determinants of the rate of GDP growth, the Inter-American Development Bank (IDB) (1995) finds that growth is negatively influenced by volatility in the terms of trade, the real exchange rate, monetary policy, and fiscal policy. Using data ending in 1992, IDB estimates that real GDP (measured in growth rates) was half again as volatile in the NIEs, Southeast Asia, and South Asia as in the advanced industrial countries, primarily because of volatility in domestic macroeconomic policies. However, IDB’s estimates imply that this volatility reduced growth in the NIEs and Southeast Asia over the period 1960-1985 by only about a tenth of 1 percent a year, suggesting that the volatility was not particularly damaging to overall economic growth. There is also evidence that the variability of international capital flows played a prominent role in increasing volatility in Asian economies during the 1990s.

Effects of Volatility on Productivity and Investment. The negative association of volatility with growth reflects adverse impacts on productivity and investment. Productivity will suffer if unpredictable changes in relative prices lead firms to choose sub-optimal technologies. Countries where volatility is high also display relatively low investment rates, reflecting the reluctance of entrepreneurs to commit to projects when prices and macroeconomic conditions change unpredictably. While investment rates in the NIEs and Southeast Asia are quite high by international standards, recent empirical work suggests that they would have been still higher (by an additional two to three percentage points of GDP) if volatility had been as low as in the US, Europe, and Japan (see IDB 1995, Goldberg 1993, Kenen and Rodrik 1986).

The most damaging forms of volatility are financial crises. These crises are incompatible with growth: they lead to stop-go policies, interfere with the operation of the domestic financial system, cause distress to the corporate sector, and force governments to curtail public investment. According to Bordo and Eichengreen (2000), the typical post-1972 crisis cost the country in which it occurred a cumulative 9 percent of GDP—that is, more than one year’s growth for several Asian countries that were growing at between 7 and 10 percent during the late 1980s and early 1990s. Different types of crises have different output effects: the estimates of these authors suggest output costs ranging from 3 percent for banking crises, to 7 percent for currency crises, to 15 percent for “twin” crises (i.e., those with both banking and currency components).

Crises have multiple causes, but one unquestionably important cause is financial fragility, which becomes increasingly important as capital flows increase. Because creditors will rationally hesitate to tie up their funds in a volatile macroeconomic environment, volatility encourages reliance on short-term debt, which heightens the fragility of financial systems. Creditors will similarly hesitate to invest in assets denominated in domestic currency when exchange rates are volatile. This is a “double mismatch problem”. The balance sheets of domestic financial and nonfinancial firms display either a maturity mismatch (a combination of long-term assets and short-term liabilities) or a currency mismatch (a combination of assets denominated in domestic currency and liabilities denominated in foreign currency). This leaves domestic markets vulnerable to destabilization by sudden changes in financial conditions, such as the loss of investor confidence (as seen in the Asian financial crisis).

Effects of Volatility on Poverty and Social Indicators. Ample evidence now shows that volatility has undesirable consequences for the distribution of income, poverty, and educational attainment. The poor, unskilled, and uneducated are least able to protect themselves by hedging their incomes and diversifying their investments; it is not surprising that they should suffer disproportionately from volatility. Gavin and Hausmann (1995) find, in a cross-sectional study of countries, that the volatility of real GDP has a strong negative effect on the equality of income distribution. Other studies (e.g., Guitan 1995) have similarly found that countries with more volatile rates of inflation display higher levels of income inequality. Moreover, some evidence suggests that crises and the policy adjustments they entail are particularly bad for income distribution and that their unequalizing effects are especially pronounced in middle-income countries (the category into which many Asian economies fall—see Bourguignon et al. 1991).

Similar results are found for poverty rates. The poor and near poor tend to be employed in sectors and activities that suffer from volatility; and cuts in social spending in times of crisis fall disproportionately on their shoulders (Morley 1994). As noted above, households near the poverty line have the least savings, the worst collateral, and the most tenuous access to credit and insurance. Moreover, volatility aggravates poverty through its negative impact on growth. Ravallion (1997) estimates that the elasticity of poverty, as measured by the proportion of the population falling below the poverty line with respect to the growth of per capita income, lies between -1.5 and -3.5. Dollar (2000) obtains similar results for a larger sample of countries. Crises are an extreme case in point, in that the elasticity of poverty with respect to income rises sharply in crisis periods. In Indonesia in 1997/98, the rate of increase of poverty is estimated to have been 10 times the rate of decline in income and consumption. Poverty increased by 47.8 percent in Indonesia and by 13 percent in Thailand. In Korea, where most people live in cities, poverty rates doubled in urban areas. A simulation in Malaysia suggested a 36 percent rise in poverty.

The sharp increase in poverty in Korea is consistent with the surge in unemployment in that country. Korean labor markets are more formalized than those in the other crisis-affected Asian countries and wages are consequently less flexible. Whereas sharp falls in wages and the ability of the informal sector to absorb the unemployed softened the blow to employment in some of the other countries, in Korea more of the labor market adjustment occurred on the employment side. As a result, unemployment rose from 2.0 percent to 6.8 percent. Another contributing factor was the much smaller share of smallholder agriculture in Korea. Korean agriculture was consequently less capable of absorbing many of those who were displaced in the urban sector. This should be compared with Indonesia where real wages fell by 34 percent (against 12.5 percent in Korea) and where unemployment increased from 4.9 percent to only 5.5 percent. However, both the Korean and Indonesian figures hide considerable rises in underemployment. The increase in unemployment in Malaysia was also relatively moderate (2.5 percent to 3.2 percent), but primarily because Malaysia relies quite heavily on foreign workers who bore the brunt of the crisis. Many were retrenched and left the country.

There were further differences in changes in labor force participation rates across countries. People were discouraged from seeking work in Korea and Malaysia and participation rates fell. In Thailand, participation rates remained constant. In sharp contrast, participation rates in Indonesia increased substantially. Indonesia is the poorest of these countries, and the very poor have little option but to generate work for themselves and to search for work if traditional markets dry up or if they are made redundant. The increase in participation was much greater among women than men. In 1996, 55 percent of women over 25 years of age were in the labor force. This share had increased to 72 percent by 1998. Indonesian women are working longer hours for lower rates of pay than they were before the crisis.

Cutler et al. (2000), in a study of several successive Mexican crises, find that crisis-related volatility worsens health outcomes. In the 1995/96 crisis, mortality rates were 5–7 percent higher than in the immediate precrisis years. The greatest percentage increase was among the elderly. This effect seems to operate mainly by reducing incomes and placing a heavier burden on the medical sector, rather than by forcing less healthy members of the population into the labor force or by compelling primary caregivers to go to work.

Finally, volatility is associated with low levels of educational attainment. It affects education partly through its impact on inequality. In economies that are volatile, the poor, who are already on the margin of subsistence, may be forced periodically to withdraw their children from school so that they can contribute to household income, and this interruption of attendance hinders educational attainment. Governments, forced by crises to cut social services, may be unable to sustain adequate levels of spending on schooling and retain capable teachers.

Where volatility hinders the development of financial markets, families find it particularly difficult to insure against all these risks, forcing them to rely on their children for relatively inefficient insurance. These effects are likely to be most pronounced in poorer countries suffering larger shocks: thus school enrollment rates fell in Indonesia but not in Korea or Thailand in 1998 (Frankenberg et al. 1999).

Managing Volatility in a Globalizing World

If globalization can increase volatility and volatility—particularly in the case of crises—can slow growth and exacerbate poverty, then it is important to adopt policies and develop institutions to limit such volatility and minimize its impact on society’s most vulnerable groups. Although there is less than universal agreement on how to limit volatility and safeguard against crises, there appears to be a broad consensus in favor of the following.

First, although the positive impact on the growth of merchandise trade and FDI is now widely recognized, the benefits of portfolio capital flows continue to be questioned. In principle, the portfolio investment permitted by capital account liberalization should relax financial constraints on growth, deepen domestic financial markets, and make direct investment more attractive by facilitating the hedging of exposures and the repatriation of profits. Yet, some commentators are concerned that the interaction of portfolio capital flows with preexisting distortions can heighten volatility and create crisis risk. The results of Klein and Olivei (1999) can be interpreted in this light. The authors find that portfolio capital flows stimulate financial deepening and, by inference, growth in relatively high-income countries, where policy and market distortions are least; but if anything, such flows have a perverse effect on financial development in low-income non-OECD countries.

Second, however, as globalization proceeds, statutory restrictions on transactions on the capital account will become increasingly difficult to operate without disrupting other forms of economic activity. FDI and multinational production will lead to a growing volume of cross-border transactions by financially sophisticated agents attempting to circumvent controls. As small firms penetrate export markets, they will gain the ability to evade controls through leads and lags and over- and underinvoicing. The spread of information and communications technology will open up avenues for evasion by households—by facilitating international financial transactions via the Internet, for example. Thus, the effective operation of capital controls will require increasingly comprehensive and invasive restrictions on economic behavior, extending to domains well beyond the financial. This is something that individuals are unlikely to welcome and something that they can effectively oppose in an age of democratization.

In the final analysis, capital account liberalization is likely to become increasingly difficult to resist as economic and financial globalization proceeds. This heightens the importance of coordinating international financial liberalization with the elimination of distortions that would otherwise cause such liberalization to heighten volatility and crisis risk. In concrete terms, this means that the following actions should be taken.¹¹

Strengthening the Financial Sector. Capital account liberalization should follow rather than precede recapitalization of the banking sector, the reinforcement of prudential supervision and regulation, and the removal of blanket guarantees. If bank capitalization is inadequate, managers will be inclined to excessive risk taking, and the offshore funding available through the capital account will permit them to leverage these risks. If bank liabilities are guaranteed on the grounds that widespread bank failures would be devastating to a financial system dominated by banks, foreign investors will not hesitate to provide the requisite funding. A simple explanation of why the resolution costs of banking crises have been larger in the 1980s and 1990s than earlier decades, and larger in emerging than advanced economies, is the coincidence of these domestic financial weaknesses with premature capital account opening.

The removal of interest rate controls is necessary to avoid potential disintermediation when capital accounts are liberalized and depositors have overseas alternatives. Yet Hellman et al. (2000) have questioned whether deposit rate decontrol is desirable on the grounds that forcing banks to compete for deposits erodes franchise value and thereby encourages excessive risk taking when a financial safety net exists. However, reviewing evidence from the 1980s when deposit rate controls were prevalent, McKinnon and Mathieson (1981) and Edwards (1984) emphasize the risk of disintermediation if interest rate controls are maintained. Once the capital account is opened, the retention of deposit rate controls will no longer be feasible. Thus, it is essential to intensify prudential supervision and eliminate implicit guarantees to prevent financial institutions protected by the official safety net from taking on excessive risk.

The corollary is that capital account restrictions should remain in place until prudential supervision is strengthened and implicit guarantees are removed. Unfortunately, maintaining barriers to capital flows and foreign financial competition may diminish the pressure for restructuring; developing countries may never achieve the state where their domestic financial system has been strengthened enough to allow the capital account to be liberalized. This suggests using capital account liberalization to force the issue. But recent experience in Asia and elsewhere casts doubt on the notion that external liberalization that increases the urgency of complementary financial reforms will necessarily deliver the needed reforms before crisis strikes. The lesson from the Asian financial crisis is that the process of financial sector reform should proceed quickly, yet prudently.

Liberalizing FDI. FDI is the form of foreign investment that is most likely to come packaged with managerial and technological expertise. It is also the form least likely to aggravate weaknesses in the domestic banking system, or be associated with capital flight and creditor panic. This suggests liberalizing inward foreign investment as the first stage of financial-side opening. This advice would seem obvious but for the many governments that have failed to heed it. As of 1996, 144 of 184 countries surveyed by IMF still maintained some controls on FDI. One element of the Korean crisis was the Government’s reluctance to allow inward FDI and its readiness, in the face of foreign pressure, instead to open other components of the capital account.¹²

Some authors such as Dooley (1997) and Kraay (1998) question whether FDI is more stable than other capital flows. In fact, data on the volatility of flows do not generally suggest a strong contrast between direct investment and portfolio capital. But, as noted above, FDI was much more stable than portfolio flows during the Asian financial crisis. Moreover, there is an obvious sense in which a foreign direct investor cannot easily unbolt machines from the factory floor to take part in a creditor panic.¹³

Internationalizing the Banking System. The case for liber-alizing FDI early in the process of external financial opening extends to the banking system. Entry by foreign banks is a low-cost way of upgrading the banking sector’s risk-management capacity. The knowledge spillovers that figure prominently in discussions of other forms of FDI also apply to the financial sector. Moreover, insofar as their home-country regulators oversee foreign banks, opening the banking sector to foreign investment should raise the average quality of prudential supervision. And insofar as foreign banks are better capitalized, they are less likely to engage in excessive risk taking. For all these reasons, entry by foreign banks can accelerate the upgrading of domestic financial arrangements that is a prerequisite for further capital account liberalization (Demirgüç-Kunt et al. 1998).

Two caveats should be noted here. First, foreign entry tends to squeeze margins, reduce franchise values, and intensify pressure on weak intermediaries. Hence, the stabilizing impact of opening the banking system may take some time to work. The first-best solution is to strengthen the domestic financial system early in the process of capital account opening (as emphasized above). Failing that, it may be desirable to phase in competition from foreign banks (rather than throwing the domestic market open to foreign entry all at once). This is the method that several Asian economies have chosen.

Second, entry by foreign banks will undermine the effectiveness of measures designed to limit portfolio flows. International banks with local branches and ongoing relationships with domestic broker-dealers will find it easier than other international investors to purchase the domestic securities needed to short the currency, whether controls are in place or not. It follows that banks should be permitted to fund themselves offshore only late in the process. This is a lesson of the financial crisis, particularly in Korea, and is seen in the literature on sequencing capital account liberalization. Equally, it is important to avoid creating artificial incentives for bank-to-bank lending. Thailand opened other components of the capital account before giving banks access to offshore funds. But it then created the Bangkok International Banking Facility, under which Thai banks borrowing offshore (and loaning the proceeds in domestic currency) received favorable tax and licensing treatment. In part this policy can be understood as an attempt to develop Bangkok as an international financial center; in part it reflects the Government’s tendency to use banks as an instrument of industrial policy. Either way, it is indicative of policies that are incompatible with the goal of limiting volatility.

Regulating Foreign Exposure. The preceding discussion might be taken as encouragement for governments to micro-manage the process of liberalization. But efforts to fine-tune the capital account carry their own dangers. They threaten to create a heavy administrative bureaucracy prone to rent seeking and capture. Financial development makes it progressively easier for participants to evade the authorities’ efforts by relabeling positions and repackaging obligations. Interventions that rely on markets rather than on bureaucrats minimize these risks. This is the attraction of the Chilean approach to capital-import taxes. The Chileans required a noninterest-bearing deposit of one year’s duration from investors seeking to import capital from abroad. The tax was initially set at 20 percent in 1991, raised to 30 percent in 1992, reduced to 10 percent in June 1998, and set to zero in October that year, while the scope of capital flows to which it was applied was progressively widened. Investors could opt to pay the central bank a sum equivalent to the forgone interest without actually placing the deposit with the bank, and some investors chose to do this.

Since the deposit had to be maintained for a year, the implicit tax fell more heavily on investors with short horizons than on those prepared to stay for the long term. It was transparent and insulated from administrative discretion. It also offered less scope for evasion than other taxes designed to fall on some foreign investments but not others. However, the effectiveness of these measures has been highly debated (Ulan 2000).

Developing Stock and Bond Markets. The sudden withdrawal of foreign deposits can jeopardize the stability of the banking system. In contrast, when investors liquidate their positions in stock and bond markets, securities’ prices adjust, which is less destabilizing to the financial system. Certainly, a stock or bond market crash can damage the balance sheet position of banks that hold stocks and bonds. It can make life difficult for entities, including the government, with funding needs and for which the prices of their liabilities are an important signal of creditworthiness.

When banks and firms can fund themselves by floating bonds as well as by issuing short-term debt, the destabilizing impact on their balance sheets of sharp changes in market interest rates will be reduced. And when they can fund themselves by issuing bonds denominated in domestic and foreign currency, the destabilizing financial impact of sharp changes in exchange rates will be reduced. This suggests developing bond markets as a way of diversifying the sources of corporate debt, and stock markets as a way of avoiding excessive reliance on debt in general. It also suggests liberalizing foreign access to domestic stock and bond markets before freeing banks to fund themselves offshore.

Stock and bond markets tend to develop only after bank finance is well established. In part, this is due to the additional information requirements of these markets. Moreover, bond markets tend to develop only once a reliable market has arisen in a benchmark asset, typically treasury bonds, involving transactions that provide liquidity and minimum efficient scale and whose prices provide a reference point for other issues. And the development of a deep and liquid treasury bond market in turn requires a government with a record of sound and stable macroeconomic and financial policies. Otherwise, banks become the captive customers for government bond placements (which is not good for their balance sheets) in return for which they receive other favors (such as guarantees) that give rise to financial sector problems.

Firms in countries where equity finance is available are likely to enjoy additional advantages in a globalized world. In terms of managing volatility, firms in countries with well-developed equity markets will be less dependent on short-term finance and less susceptible to liquidity crises. Such firms will also be less highly leveraged than those in countries (such as in Asia) where debt finance is the norm, which makes their balance sheets less sensitive to the changes in interest rates that exposure to globalized financial markets can bring. Compared with countries where debt is denominated in foreign currency, they will suffer less damage from exchange rate changes. And in a technologically dynamic world, where firms are forced to choose between as yet unproven competing technologies, equity finance has advantages in terms of competitiveness and innovation.

In the absence of financial disclosure following recognized auditing and accounting practices, firms will find outsiders reluctant to purchase their securities for fear of market manipulation by insiders; hence, stock market capitalization and turnover will be low. With inadequate contract enforcement and equitable bankruptcy procedures, investors will be reluctant to invest for fear that issuers will walk away from their obligations. And when adequate mechanisms for corporate control are lacking, investors will be reluctant to purchase minority stakes in publicly traded enterprises for fear of being expropriated by majority stakeholders. This is why significant stock market capitalization and turnover tend to be observed relatively late in the process of financial development. It is why many countries, and developing countries in particular, rely on banks for intermediation services—banks having a comparative advantage through long-term relationships with their clients in assembling information and enforcing contracts.

Creating active stock and bond markets thus requires putting in place a regulatory framework mandating the disclosure of accurate and up-to-date financial information, the use of recognized auditing and accounting standards, penalties for insider trading and market manipulation, and statutes protecting the rights of minority shareholders. In the US, putting these prerequisites in place took several decades (Bordo et al. 1999). Late-developing economies in Asia and elsewhere can expedite this process by importing proven regulatory processes.¹⁴ Still, developing deep and active stock and bond markets is a long and challenging process. Success will not be achieved overnight and it is a relatively expensive undertaking.

Accumulating Reserves. The response of many Asian countries to the volatility of 1997/98 has been to accumulate a cushion of international reserves. The strategy has met with support from academics and officials. Feldstein (1999) has encouraged emerging markets to accumulate reserves as insurance against the disruptive domestic financial effects of abrupt capital outflows. Guidotti (1999) and Greenspan (1999) have similarly suggested that countries hold foreign exchange reserves equal to all the short-term debt scheduled to fall due over the next 12 months. They point to the success of economies with substantial reserves (Taipei,China for example) in withstanding the financial crisis. An IMF study (Bussière and Mulder 1999) suggests that countries may want to hold even larger reserves, perhaps as much as twice that suggested by Messrs. Guidotti and Greenspan. Countries that run chronic current account deficits should hold still larger reserves, as should those seeking to limit exchange rate variability.

This advice can be questioned. First, even large foreign exchange reserves such as Taipei,China’s are small relative to the liquidity of the markets. A confidence crisis can cause investors to try to transfer abroad not only short-term foreign liabilities but also domestic assets. Converting these claims into foreign currency is likely to be impossibly expensive for a government or central bank seeking to support a currency peg. Moreover, large reserves can create greater volatility in bank-to-bank lending. Normally, interest rates are lower in the major money centers than in an emerging market that has recently stabilized and opened its capital account, encouraging foreign investors to funnel money into the country. The larger the reserves are, the more confident investors will be that they will be able to take out their investment without suffering losses when sentiment turns and the banking system comes under pressure. Hence, bank-to-bank lending will be greater, and the costs of a banking crisis will be higher.

Moreover, holding reserves against short-term external liabilities is expensive, since US treasury bonds bear lower interest rates than Thai or Korean bank deposits. The implication is straightforward: if short-term foreign borrowing comes with risks that are expensive to insure against, is it not better to avoid it in the first place? Clearly, countries seeking protection from volatility should accumulate a cushion of reserves. But this must be balanced against the costs.

Arranging Commercial Credits. The other approach to ensuring the availability of adequate liquidity in an emergency is to negotiate commercial credit lines in advance. From the standpoint of the borrowing countries, these lines would provide additional resources to insure against shocks to investor confidence. If foreign investors refuse to renew their maturing loans, the authorities can draw on their credit lines to finance the lender of last resort operations appropriate for dealing with a liquidity crisis.

Argentina, Mexico, and Indonesia negotiated facilities with international banks that, in return for a commitment fee, allowed them to draw on hard currency credits. These facilities typically omit the clause on no adverse material change that permits banks to back out of an agreement in the event of a crisis. Indonesia made two drawings on its standby facilities, totaling $1.5 billion.

That these credits are a form of insurance again raises the issue of how adverse selection is overcome. The success of Argentina, Mexico, and Indonesia in purchasing this insurance suggests that the problem of asymmetric information that might otherwise cause the market to break down can be overcome at least partially by posting collateral. These countries’ success in negotiating these arrangements suggests that at least some other countries, which can show evidence of institutional reform and a record of strong policies, could do likewise. However, commercial credit lines are likely to be available only to countries with relatively strong policies.

Insurance unavoidably creates the danger of moral hazard. Moreover, these arrangements are essentially unconditional; in contrast to IMF loans, access is not contingent on the country agreeing to specific adjustment measures. Consequently, access to additional funds may encourage some governments to engage in additional risk taking and put off adjustment. The “penalty rate” they pay to draw on these lines may be some deterrent, but the question remains whether it is enough.

A further weakness of these arrangements is that the international banks will be able to hedge their exposures. At the same time that they provide additional credits, they can draw down on their other exposure to the country or sell short government bills and bonds. The sell-off in the Mexican bond market that occurred when the Government drew on its lines in the Fall of 1998 may have been an instance of this effect. Thus, countries relying on this technique may have less insurance than they think.

Strengthening Monetary and Fiscal Institutions. Limiting volatility in a financially globalized world requires building credible policy-making institutions. The greater the credibility of the individuals and institutions responsible for monetary policy, the less the danger that a shock will incite an investor panic and a self-fulfilling crisis. As a matter of fact, if policymakers have accumulated sufficient credibility, the markets will do much of the stabilizing work for them. If inflation accelerates, for example, pushing up interest rates and depressing the prices of short-term interest-bearing assets, investors anticipating that the acceleration of inflation is only temporary will buy into temporarily depressed fixed-income markets, thereby stabilizing asset prices and interest rates. If the currency depreciates, investors will similarly purchase assets denominated in domestic currency at their temporarily depressed prices, providing capital inflows that work to strengthen the exchange rate.

Similarly, the more credible fiscal policy is, the greater will be the fiscal authorities’ capacity to pursue countercyclically stabilizing budgetary policies. If they are committed to running budgets that are balanced over the cycle, they will be able to borrow and run deficits in recessions. If, on the other hand, their intentions are suspect, they will have to cut spending and/or raise taxes in recessions, rendering fiscal policy pro-cyclical and aggravating rather than limiting volatility. One possible option that enhances credibility and provides a degree of flexibility for dealing with volatility is to give the authorities a mandate and the independence to pursue it. For monetary policy this is the well-known formula of independence for the central bank and a mandate to pursue price stability. For fiscal policy there is an analogous argument for creating an independent fiscal authority responsible for setting a ceiling for the budget deficit and a set of rules for cutting expenditure in the event that the fiscal authorities overrun it (Eichengreen et al. 1999).

This is only one of a variety of possible formulas for enhancing the credibility of policy-making institutions. An increasingly popular approach in many parts of the world is inflation targeting. Here a regime in which the central bank is given a mandate to pursue an explicit target for inflation may share with the public its forecasts and its model of the links from monetary policy to inflation, and it is held accountable for missing that target. Its advantages are greater flexibility than a rigid monetary rule but it has the same stabilizing impact on market expectations. Its principal limitation is that it can make policy credible only when the central bank has the independence required to pursue it. Not only must the central bank enjoy statutory independence, but it must also have political support for its independent status to limit the prospect that its autonomy will be compromised if it pursues policies that are not congenial to the government. Moreover, its mandate to pursue low inflation must be supported by a broadly compatible government economic policy stance. In particular, if the fiscal authorities are prone to chronic deficits, monetary policy may have to be used to fill the fiscal gap (the “fiscal dominance” problem), in which case the stated objective of pursuing policies of low inflation will lack credibility.

In the case of fiscal policy, alternatives to rigid rules include delegating more agenda-setting and vetoing power to a single agent—typically, the finance minister or the prime minister. They may have more of an incentive to internalize the externalities associated with excessive deficits, and to adopt more centralized and hierarchical budgetary procedures (von Hagen and Harden 1994, Alesina and Perotti 1994). Still other means of building credibility are conceivable. But, whatever the solution, policy credibility is essential to sustain the confidence of investors in a globalized world.

Managing Exchange Rates. One of the most difficult challenges posed by globalization, recent experience suggests, is how to manage the national currency in a financially interlinked world. Since the fixed rate system established at Bretton Woods was abandoned in 1972, countries have been free to establish their own exchange rate system. There are three possibilities. First is the hard peg where a currency is fixed using a currency board or where the currency of another country has been adopted. Second is a series of arrangements often referred to as a “soft peg” where the currency is tied to another currency or a basket of currencies either through a peg, a crawling peg, or bands around a reference rate. Finally is the free float, where the value of the currency is either allowed to fluctuate freely or where there is a managed float. In the managed float no central rate is specified but the central bank may intervene to influence the exchange rate.

In the past decade there has been a movement toward the first and last solutions (see Figure 3.6). There are several reasons for this. Each of the major financial crises in the past few years has involved countries with a soft peg.¹⁵ Large and liquid international capital markets make it more difficult for national authorities to support a shaky currency peg, since the resources of the markets far outstrip the reserves of even the best-armed central banks and governments. Effective defense of the exchange rate requires raising interest rates and restricting domestic credit, something that will have significant costs unless the economy is strong.¹⁶ If the markets detect a chink in the country’s armor—high unemployment, a heavy load of short-term debt, or a weak banking system—that could render the authorities reluctant to raise interest rates to defend the currency, then they will pounce, exposing the authorities’ weakness.

Maintaining an exchange rate peg or band in open capital markets can be especially difficult for emerging market economies. Many of these depend on exports of a few primary commodities, rendering them vulnerable to terms-of-trade shocks. Their financial systems are small in comparison with world markets, even with the assets of a handful of hedge funds and investment banks. Their fragile banking systems are incapable of withstanding sharp hikes in interest rates, while their political systems cannot deliver a broad-based consensus in favor of exchange rate stabilization over and above all other economic and social goals.

Moreover, while the devaluation of a previously pegged currency can enhance international competitiveness and even stimulate growth, the Mexican and Asian crises suggest that currency devaluations in developing countries can be strongly contractionary. When developing countries borrow in foreign currency, depreciation increases the burden of debt service and worsens the financial condition of domestic banks and firms. Because those banks and firms do not hedge their foreign exposures, they are hard hit when the currency band collapses.

Indonesia illustrates the consequences. For some time prior to the outbreak of the Asian financial crisis, the country had been operating a crawling band, allowing for fluctuations of plus or minus 4 percent against a basket of currencies. Typical of many emerging economies, it had relatively high interest rates, which made it attractive to international investors. These large capital inflows worked to push the rupiah toward the strong end of its band. Because the authorities were committed to limiting exchange rate fluctuations (and because the strength of the currency lent credibility to that commitment), domestic banks, and more particularly corporations, accumulated unhedged foreign exposures.

When the Thai baht depreciated, capital flows in Indonesia reversed direction. In one day, 13 August 1997, the rupiah went from the strong edge of the band (which had been widened to 6 percent) to the weak edge. This 12 percent depreciation was a sharp shock to Indonesian corporations with unhedged exposures, whose solvency was now cast into doubt. Now openly questioning the stability of the economy, investors scrambled out of the rupiah. Further interest rate increases to defend the currency were out of the question, given the financial distress in the corporate sector and the banking system. Instead, the authorities abandoned the band, allowing the exchange rate to drop further. With the damage already done to the economy, it dropped precipitously, falling by as much as 10 percent a day.

This synopsis makes an essential point about the fragility of currency bands and the high costs of their collapse. With hindsight, it did not really matter whether Indonesia had a currency band or not. All the Asian currencies were tied in one way or other to the US dollar and many of them collapsed because of the size of the unhedged short-term capital that had flowed in during the 1993 to 1996 boom and that then flowed out in 1997 and 1998.

For which extreme should Asian economies opt—a hard peg along Hong Kong, China lines or a free float in the Korean style? The choice is typically framed in terms of the trade-off between credibility and flexibility. With the adoption of a hard peg, domestic monetary policy is dictated by the central bank of the country whose currency provides the external anchor, and the peg automatically acquires all the credibility accumulated by the issuer of the anchor currency. The commitment to the currency peg is enshrined in the adoption of a constitutional amendment or requires a super-majority vote in the parliament or congress mandating the central bank or government to defend the rate. By ensuring greater exchange rate stability, the economy’s access to foreign capital is enhanced.

Floating rates, in contrast, maximize the flexibility with which the authorities can use monetary policy for economic stabilization. They leave the central bank free to intervene as a lender of last resort to financial markets. However, some commentators dispute the stabilizing value of exchange rate changes when shocks are real rather than monetary and a country’s external obligations are denominated in foreign currency. They similarly question the capacity of the central bank to act as an effective lender of last resort when domestic banks and firms incur debts denominated in foreign currency.¹⁷

Which approach will be more attractive to most DMCs? Again, the diversity of economic structures and different stages of economic and financial development in the region hinders any attempt to generalize. But insofar as most DMCs are quite open, standard arguments on optimum currency areas favor hard pegs. At the same time, the diversification of DMC exports across markets—and the tendency of exporters in the region to sell to the Japanese and US markets simultaneously—makes a hard peg to any single currency less attractive. Because DMCs have relatively underdeveloped domestic bond markets, they borrow long term mainly in foreign currency, and sharp exchange rate changes can then wreak havoc with the domestic currency cost of external debt servicing. In other words, a flexible exchange rate will make obtaining foreign funding difficult. But because savings rates in Asia are so high, foreign funding is less essential: banks and firms seeking external finance can obtain it at home via the banking system and supplier credits. To the extent that the real side of many DMCs is relatively flexible, the value of monetary autonomy is less. But insofar as policies and policy-making institutions are relatively credible by international standards, the capacity to exploit the advantages of such credibility is greater.

The existence of so many cross-cutting considerations suggests that not all DMCs will prefer the same exchange rate arrangement. Currently only PRC; Hong Kong, China; and Malaysia have adopted pegs and the rest are floating. The float is generally free but some DMCs seem to be returning to soft pegs. Along these lines, a recent study by Calvo and Reinhart (2000) shows that many countries that are categorized as having floating currencies are, in effect, holding loose pegs. They found a high correlation between exchange rates and central bank reserves that suggest significant central bank intervention. This interventionist tendency has accelerated in recent months—in the immediate aftermath of the financial crisis, exchange rates were much more flexible (see Table 3.5)—and one possible reason for this is the expectation that loose pegging will have the same effect as a free float but with less volatility.

Policies to Minimize Risks to the Poor

Globalization will be accepted most readily if its benefits are widely shared. The fact that economies that are more deeply integrated into global markets tend to have larger public sectors can be understood as providing social protection for those who cannot protect themselves from the volatility and pressures of globalization (Rodrik 1998). Such protection helps support the broad-based political coalition needed to sustain a commitment to openness. In addition, it facilitates the quick policy adjustments needed to absorb globalization-related shocks, since people will see that the immediate costs of adjustment, like the benefits, are being equitably shared.¹⁸

For countries seeking to capitalize on globalization, two policies may help in minimizing the risks to the poor of globalization. For the short term, insurance against shocks is needed. For the long term, measures are required to foster the accumulation of forms of human capital that are useful in an economically globalized world, specifically among socioeconomic groups that have not traditionally possessed them.

In the context of globalization, risks can range from sharp changes in relative prices on world markets to full-blown economic and financial crises. Building an effective social safety net and ramping up programs in response to a crisis can be inefficient and time-consuming, and is therefore difficult. This makes it important to put in place lasting social infrastructure protection. Whereas general principles underlying social safety nets are well documented, specific programs need to be designed in light of particular financial and country-specific conditions.¹⁹

The short-term safety net should provide employment for those able to work. Public works programs providing jobs for the poor, often referred to as workfare, have been shown to be a relatively efficient way of providing immediate relief, especially where local input is used in selecting projects and where the workers are the beneficiaries of the public works (see Ravallion 1999). Workers can be offered public employment at a wage equal to, say, 90 percent of the wage for unskilled agricultural labor. Workfare designed in this way will protect the poorest workers against the loss of income without drawing other workers away from private employment or encouraging welfare dependency.

South Asia has been a pioneer among developing countries in the development of workfare programs. The Indian state of Maharashtra is known for its Employment Guarantee Scheme, which targets the poor.²⁰ Bangladesh has experimented with similar programs, though these have been limited by the availability of donor resources to finance them. Sri Lanka’s Janasaviya Program makes entitlement to food coupons conditional on a household supplying 24 days of labor monthly to rural public works projects; it enjoys dedicated budgetary funding. These programs are not free of shortcomings: women receive only a small proportion of the benefits that a man receives, many of the assets created are of poor quality, maintenance of the assets is inadequate, and wages are often too high to provide efficient self-targeting (Subbarao et al. 1995). Still, they are an obvious element of the social safety net that societies need to build to protect their poorest members (see Box 3.3).

Aside from crisis management what difference, if any, does globalization make to the poverty agenda? The standard agenda for poor countries like those of South Asia is land reform, education, the abolition of pricing policies that discriminate against agriculture, and the creation of stable macroeconomic and legal frameworks. A relatively equal distribution of land encourages family farmers to adopt economically and organizationally efficient modes of cultivation. Education is associated with the adoption of relatively innovative agricultural technologies, which—perhaps more importantly from the point of view of income distribution and poverty reduction—facilitates the movement of labor to jobs that are often higher paid. Market liberalization and stable macroeconomic and legal frameworks stimulate growth, which benefits the poor. These points are well known. So what difference, if at all, does globalization make to the antipoverty agenda?

Because globalization exposes national economies to external shocks, it requires workers as well as firms to act quickly. The implication is that educational spending should impart general knowledge rather than technical training and sector-specific skills. The literature on this subject (e.g., Heckman 2000) shows that such general knowledge is imparted most efficiently in the early stages of the education process. This suggests targeting educational subsidies at primary education and ensuring that the poorest (especially females) are included. The first point feeds into an obvious Asian strength: the high-performing Asian economies have long allocated a substantial share of educational spending to basic as opposed to higher education.²³ In contrast, the second observation points to the need to reorient the approach to educational planning in Asia, which has traditionally focused on vocational training of sorts that are likely to be less easily transferred in a rapidly changing high-tech world.

Recent contributions to the development literature (e.g., Lopez et al. 1998) suggest that more equal access to education has a positive impact on average per capita income. The obstacle to more equal distribution of education, according to much of the development literature, is the poverty trap—the fact that the extra income from child labor, which is indispensable to poor families, comes at the expense of the child’s longer-term prospects of escaping poverty through education.²⁴

Insofar as openness leads poor countries to specialize in the production and export of labor-intensive goods, there is the danger that globalization may draw poor children out of school. Targeted subsidies for school attendance are the obvious policy response. Bangladesh’s Food-for-Education Program, which offers a stipend to selected participants (somewhat more than the equivalent of 13 percent of monthly earnings for boys and 20 percent for girls) has demonstrated an ability to ensure nearly full school attendance by those who participate.

Early evidence similarly suggests that Indonesia’s Stay-in-School Program, which provides grants to the poorest schools and transfers to the poorest students, has been similarly effective (see Birdsall and Haggard 2000). Such programs have the additional advantage that local schools are important stakeholders, leading them to become actively involved in monitoring and administering their operations.

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