East Asia Update, May 2007

Translation by World Bank:
What role has foreign aid played in the development of East Asia? Has it, according to you, effectively helped economic growth and poverty reduction? What are, according to you, the checks on this effectiveness? How can this aid be improved?

The role of foreign aid (ODA) in East Asia has changed over time and varies greatly across countries. For the region as a whole ODA has fallen to less than $10 billion a year, which is only about 0.4% of GDP. This is down from around 1% of GDP in the 1970s and 1980s. It is now also much less than the average for developing countries as a whole, which is also around 1% of GDP.

Historically East Asia provides a number of examples of countries which have used ODA quite effectively to help spark rapid growth and which have become less dependent on it over time. Korea for example used to have ODA worth over 5% of GDP back in the 1960s. This fell to 0 in the 1980s and 1990s and Korea is now itself emerging as a provider of foreign aid. In most middle income economies of the region it also down to less than 0.5% of GDP now. For example in China, ODA is now only about 0.1% of GDP.

But there is also a wide range of experiences. As you would expect, ODA levels are rather higher in the low income economies of the region. In recent years ODA has been averaging around 4% of GDP in Vietnam and 10-15% of GDP in Cambodia and Lao PDR. In some of the smaller Pacific Island economies ODA reaches even higher levels, sometimes as much as 30-50% of GDP.

Those economies that have been successful consumers of ODA have generally used it to strengthen some of the basic conditions for development, for example education and health, infrastructure and strengthening institutions and governance, while at the same time carrying out reforms that have encouraged entrepreneurship and private sector investment. In other words they have used it as a springboard for reforms rather than as crutch to avoid or delay reform.

This comparison has attracted a lot of interest in recent years, especially why is growth in China higher than in India.

The reasons behind the economic performance of any country are always very complex involving history, geography, culture, institutions and policies. And it is even more difficult to give satisfactory answers in comparing the performance of different countries which may differ in all these respects.
A first point to note is that while India’s growth rate has been less than China’s, it has been accelerating, getting closer to China’s in recent years. Poverty is also falling. I have visited India almost every year for the last 30 years. There are obvious and visible improvements in the living standards of the people.

One part of the answer to growth differences maybe simply that China started reforms in 1979, more than a decade before India, which began in 1991.
Partly as a result, China is today more fully integrated into the world economy, with much higher levels of international trade and FDI, and the benefits that go with integration. China also has a head start in building up its physical infrastructure. However, India is also making progress in these directions, and the game is far from over. Observers also note areas where India has advantages over China, for example in long established and better developed systems of corporate governance, business law, and other so called “soft infrastructure”. Income inequality is also lower in India than in China.

The last point I want to focus on is the question about democracy and its role in development. The first point to make is that people generally view democracy as something that is good in itself, apart from its relation to economics. To be able to have a voice in choosing one’s government and in deciding the policies of one’s country is something that adds to the sense of dignity and self worth of the individual, and it is valued as such.

Of course people also value other things, such as economic prosperity and security. Here the cross-country evidence suggests that there is no clear or simple relationship between democracy and economic growth. i.e on average long run growth rates in democratic countries are neither higher nor lower than in non democratic ones. However there is some evidence that growth is less volatile in democracies than in non-democracies, and also that democracies are better able to handle economic shocks because they provide better institutions for addressing the social conflicts that may intensify during shocks or crises.

I see four points to be raised here. It is true that rural poverty is much greater than urban poverty in East Asia. It should also be noted that East Asian population is largely rural, which is likely to change in the next 20 years.

The second point is the cities in East Asia are acting as magnets to the rural poor. In some countries, industries that depend on not highly skilled labor are booming together with East Asian economies. In these countries, areas will continue to act as a magnet to the rural folk, who may want to manage this flow of migrants better by achieving a more balanced economic growth.

On other countries, overpopulation of magnet of cities' reliance on the economy in a single metropolitan area are also signaling the need for more balanced growth.

Finally, it should be noted that this doesn't fail to recognize that cities are a major force in the region's fight against poverty.

I think that these two questions are fundamental to the issue of urbanization, and I would like to start by answering the second question: How will housing needs be supplied without getting to urban ghettos?

Basing on the previous answer that I just gave, as I mentioned, managing or influencing the flow of migrants is important. Some countries in the region are attempting to do just that by implementing different policy instruments, an effect which in turn may have unintended consequences such as affecting the terms of trade between rural and urban areas.

The other side of the question is specific to the urban side. There are several aspects that affect housing supply in cities. Some, like the availability of long-term lending markets, are outside the realm of local authorities; yet, others such as urban planning, housing and infrastructure standards, economic instruments that impact housing and locations are generally within the local authorities' sphere of influence.

In order to avoid, then, the ghettoing in urban areas, having a menu of policy instruments at the local level that is adequate to the capacity to implement it would, in effect, better balance the cities' growth, maintaining public goods, such as flood control and things like that, improving the cities' livability.

In the first question for Mali, that is, what are the likely implications of supply of water and food for the growing urbanization?
In reference to food, it seems to me food is a tradable commodity, and the region is fairly open to trade. So just as it is already happening, it is likely that in the future food will come from trading with countries that have comparative advantage in producing food.

On the other hand, water is much harder to trade with other countries, and water in some areas of East Asia is a major problem. Some of the region's mega citieis are located in very arid areas where water scarcity is a problem. In addition, water pollution is decreasing the availability of clean water for general use of the urban population, and for difference sources of economic growth such as industry.

By and large, throughout the world, water generally has very unclear property rights. So, the solution to this problem, in my opinion, comes by at least by clarifying property rights over water--in other words, who owns what, than allowing for water trading and enforcing water property rights.

One should also have appropriate pricing both at urban and rural water uses in order to allocate the water more efficiently. It should be noted that very often, in the world, water is used for activities that do not have the highest value.

In addition, one should have instruments and regulations in place that actually attempt to correct water-related market failures such as water pollution.

First it’s worth noting that Indonesia was the economy hardest hit by financial crisis of 1997-98. This was followed by a genuine political revolution, with a transition from authoritarian rule to democracy with a high level of decentralization.

Naturally it has taken some time for the new institutions to start functioning and for domestic and foreign investors to regain confidence.

Nevertheless the government is now pushing ahead with reforms, for example to improve the investment climate, strengthen the financial sector, tackle corruption and improve the rule of law. Some of the reforms have been tough, for example the decision to reduce fuel subsidies in 2005. That was needed to ensure that the government’s fiscal deficit did not increase in an unsustainable way, which could have led to loss of confidence and much worse economic volatility. The government softened the impact by putting in place a temporary Unconditional Cash Transfer program for the poor and it is now also increasing social spending programs at the community level.

The benefits of reforms are now coming through. Investment spending and economic growth were accelerating in the latter part of 2006. Growth exceeded 6% in the last quarter of 2006. Sustained fast growth supported by wise, inclusive economic and social policies is the surest way to ensure widely shared improvements in living standards in the long run.

We should start by noting that there is great diversity in economic levels and conditions in East Asia, more than in most other regions. Here some economies like Korea, Singapore, Hong Kong and Taiwan (China) have already reached high income status, while others are still in the low income category.
But it is true that many of these economies have achieved much higher growth rates over sustained periods of time than is the case in most other developing regions. This has been heavily studied but there is still no complete agreement on the sources of the so-called East Asia Economic Miracle. But many would probably agree with the following characterization. Most East Asian economies have put into place and generally followed what are widely accepted as sound economic principles and policies. But - and this is the more difficult part – they have also been very creative and flexible in finding the institutional forms needed to successfully implement these principles in the particular social and political conditions of these countries.

First, these countries have tended to have a strong focus and consensus among policy makers and elites on achieving rapid and broadly shared growth. The focus on ensuring that all levels of society share in the benefits of growth is important because it means that high growth is more socially sustainable over the long run. One of the ways East Asian countries have ensured social inclusiveness is by a strong focus on universal basic education and now, increasingly, on secondary and tertiary education, so that wide sections of society are able to contribute to and benefit from growth.

Second, they have generally followed prudent macroeconomic policies – limited fiscal deficits, cautious monetary policies and modest inflation. This has limited uncertainty and volatility and has tended to allow growth to be sustained over long periods.

They have generally encouragement of private sector activity and ensured protection for property rights, meaning basically that business people who undertake risky investments feel reasonably confident they will be able to secure the returns to those investments, rather than being expropriated by politicians, bureaucrats or other influential insiders. They have also generally taken an outward or export orientation, which requires firms to face the discipline of global competition, and therefore always to be under pressure to become more efficient.

Lastly, government institutions in these countries have been reasonably competent and effective in implementing government policies. This is important because East Asian governments have often taken quite activist approaches in addressing market failures, for example through public investment, use of fiscal incentives or other instruments. These require competent government to implement successfully. They have also been quite pragmatic in making such interventions, evaluating them on the basis of their contribution to overall development, making adjustments as needed and generally not letting interventions turn into major sources of waste and corruption.

With respect to PNG, it should be noted the country faces much more difficult conditions than most other East Asian countries. For example it has a difficult geography – very mountainous with great difficulties for transport and communications. There is extreme social fragmentation – for example 800 distinct languages (not just dialects). Human capital development is low.

As the question notes, countries heavily reliant on natural resources also face special problems. The rents from such resources can be easily captured by narrow interest groups rather than being used by broader development purposes. Fluctuations in international commodity prices can contribute to high volatility in expenditures, including excessive and wasteful spending during boom times. This is not inevitable. E.g. countries like Malaysia and Australia have successfully used natural resource wealth to promote broad development. But they have needed to develop good quality government institutions capable of managing natural wealth in an appropriate way.

We took up this question of so-called middle-income trap in our East Asia Update as part of our assessment of where the region has come 10 years after the East Asian financial crisis, which began in 1997. It's useful to just have a little bit of background on that. It was--remembering at the time of the crisis how much gloom and doom that it was about the possible prospects for the East Asia region. Many analysts were saying, for example, that the region, that so-called East Asia miracle was over, that the region might lose a decade of growth in a way that occurred in Latin America after the debt crisis.

But, in fact, things have turned out very differently in many ways. There has been actually tremendous progress in the 10 years since the crisis; for example, the dollar value of the GDP of the region has actually doubled, real per capita incomes have gone up around 75 percent, and real per capita incomes have exceeded pre-crisis levels in all of the economies that were affected by the crisis.

Poverty has fallen dramatically. The number of people at below $2-a-day income levels before the crisis was 50 percent of the population of East Asia. That has now fallen to around 29 percent, which is a dramatic improvement.
And, on our estimates by the year 2010, which is just a few years' time, more than 9 out of 10 people in East Asia is going to be living in a middle-income country, and that then raises some interesting questions, because middle-income countries face very different kinds of problems as compared to low-income countries.

When we look across the experience of developing countries around the world, one thing that is noticeable is that while quite a few countries are able to make the transition from low income to middle income, far fewer countries have made the transition from middle income to high income, and this seems to be because middle-income countries face much more complex challenges, complex in technical logistical terms, complex in terms of how to maintain social cohesion, complex in terms of finding a competitive niche for your country in the world economy, complex in political terms, et cetera.

And so, for example, we see there are many countries that are in, say, Latin America that achieve middle-income status many decades ago but which failed to become high income or remained middle income for a long time. Similarly, in the Middle East, there are similar economies.

The question would East Asian countries be in danger of falling into that trap, and in this report we focused on three challenge that is facing the region. The first one we said is maintaining growth in a sustainable way. And here there are two different questions. On the one side, you have China, which is really growing at very rapid rate, so there the question is not really how to increase growth, but there the question is maintaining high growth sustainably. And what we see is that while China has experienced this tremendous growth, it has also been accumulating a number of stresses and imbalances, the most obvious one, for example, is environmental costs. It's now estimated that 20 of the 30 most polluted cities in the world are in China. Growth has also--imbalances have also arisen, for example, with a very high reliance on investment relative to consumption, on industry relative to services, et cetera.

So, the Chinese authorities themselves have become much more conscious of this, and are aiming at rebalancing growth. So, that is one set of challenges.

In other East Asian countries, the challenge is, we noticed since the crisis in many of the post-crisis economies, growth has been something like a couple of percentage points less than what it was before the crisis, and in part this seems to be due to investment being rather lower than what it was before the crisis. And this is not exactly totally well-understood as to why investment is less in much of the rest of East Asia, especially in the middle countries, but part of it could be due to the fact that there was a tremendous advancement boom before the crisis, so maybe there is still some excess capacity that's left over.

And also, there may be questions when we look at surveys of firms, we also find firms in East Asia talking about uncertainty, partly to do with macro instability, particularly to do with policy uncertainty.

So, there is an agenda, we think, in terms of improving the investment climate in East Asia, but this is simply due to creating a more certain policy environment at the same time addressing other possible flaws in the investment climate, reducing unnecessary costs of red tape, focusing on strengthening infrastructure. Many countries refer to, for example, lack of adequate skilled workers or trained workers, so there is an agenda for improving education and workforce training, et cetera.

So, a number of areas there where countries need to focus on improving investment climate as a key to strengthening their long-run growth performance.

Second big challenge of the middle-income trap we refer to is what we call the challenge of maintaining social cohesion. What we notice is,, although poverty has continued to fall, at the same time inequality has been rising in several East Asian economies, in some cases, quite, quite sharply. For example, inequality has been rising in China, in Indonesia, in Philippines, also in Vietnam, and some other economies, and this matters because sharp inequality in the long run could hamper growth, in part, by creating instability, tension, social tension, and so on.

It's a difficult question to grapple because some of the causes of this rising inequality are precisely to do with the same factors that are stimulating high growth; so, for example, adoption of new technology is tending to increase inequality because new technology is increasing demand for skilled labor, and therefore the wage gap between skilled and unskilled labor has been going up.
Similarly, for example, in China, urban areas have been growing much faster than rural areas because urban areas are much more integrated into the global economy, receive much more foreign direct investment, et cetera, whereas rural areas have been lagging in growth.

So, the question is, how can countries tackle these difficult questions without reducing economic growth, and there are some ideas also that countries need to grapple with on this front, for example, strengthening education? If globalization is increasing, if technology is increasing skilled workers, then we should be training more skilled workers so we need to focus on secondary education, tertiary education, on improving workforce training, et cetera.

We also need to think in terms of improving access to credit for poor people, for small businesses is that poor people have a--are more able to set up their own businesses, are able to split the new opportunities that are being created. We need to think in terms of reducing impediments to the flow of workers from the country side to the city. That's one of the major ways in which people's income has been improving is by moving to better opportunities in the city.

Lastly, we could also mention improving social protection systems in East Asia, for example, in terms of things like unemployment insurance, health insurance, pension insurance, schemes and so on.

The last point is actually going to be addressed as part of the answer to another question, so I will come back to that later, and that has to do with tackling, reducing vulnerability to financial crises. This is the third big challenge that we think the region faces. There are a number of questions dealing with that, so I can either deal with that now or come back to that a little bit later on.

As is well known China has been very successful in attracting very large volumes of FDI, which have played an important role in its economic development strategy. Starting from the early 1990s, net FDI inflows to China jumped to between $20-40 billion dollars a year. In the last few years they have increased to $50-70 billion dollars. Relative to the size of the economy, FDI inflows were as high as 5-6% of GDP in the mid 1990s, but as China’s economy has got much bigger, this proportion has come down towards 3% of GDP.

FDI has been particularly important in the manufacturing sector and especially in stimulating the rapid growth of China’s exports. Here MNCs have been instrumental not only in providing investment capital, but more perhaps importantly in providing access to markets and market channels in the developed world, as well as in facilitating the flow of new technologies and ideas into China. Now FDI is increasingly moving into the services sector and this is likely to provide a further boost to China’s growth prospects.

In the long run increasing productivity is the central force driving improvements in living standards. Adoption of new technologies is one of the major ways in which productivity growth occurs. East Asia has been very good at fostering adoption of new technology by its firms.

At a basic level good macro policies, property rights and other factors have ensured that firms have an incentive to make investments in new technology. Secondly, outward oriented policies mean that East Asian firms have had a high level of engagement with firms from advanced countries which are the carriers and developers of most new technology. This engagement has helped East Asian firm to absorb new ideas and technologies. Sometimes this engagement has happened when East Asian firms act as suppliers to MNCs, as part of their global production networks, sometimes as recipients of foreign direct investment by these foreign MNCs. Thirdly, a subset of East Asian countries have now also developed strong domestic R&D and innovation capabilities, e,g, Korea, Taiwan (China), Singapore and increasingly China.

The latter parts of this question were addressed in earlier answers. On the last part, intra-regional trade has indeed been growing very rapidly. But it is interesting that much of this growth has occurred before or without the existence of Regional Trading Arrangements (RTAs). i.e. it has been market led, occurring because it has made business sense to companies. East Asia has also been been one of the major regions benefiting from multilateral global trade liberalization under the GATT and now the WTO.

Now there is also much interest in forming RTAs. The impact of RTAs will depend a lot on how well they are designed. On the positive side RTAs can provide a good forum for regional cooperation especially in tackling services liberalization, greater harmonization of national regulations and the tackling of various "behind-the-border" issues that might otherwise hamper the continued expansion of intra-regional business. For example, they can help facilitate greater consistency in rules governing treatment of Foreign Direct Investment, Intellectual Property Rights, competition policy and development of capital markets. At the same time RTAs need to avoid increasing discrimination against non-members, to avoid so called trade diversion effects. They also need to avoid creating complex and inconsistent rules of origin for the RTA, which can increase the costs of doing business for firms, possibly more than offsetting the expected benefits of the RTA.

Cambodia's economy is doing very well of late, with growth exceeding 10% for 3 years running. This is underpinned by 4 pillars – garment exports, tourism, construction and agriculture. Poverty is also falling.

There is significant progress on economic reforms in anumber of areas, for example on public sector financial management, and reducing import restrictions There is also some progress on banking reform. But much also remains to be done especially on the social side, for example on education and health.

There are a number of questions that have been asked about whether East Asia is vulnerable to or on the way to another financial crisis, and I would really have to disagree in some respects with that perception, in that the conditions right now are in many respects quite different from what they were before the 1997 crisis. At that time, you remember that one of the chief vulnerabilities was that firms and banks had taken on excessive amounts of short-term foreign debt, especially relative to the foreign exchange reserves that the countries had available to them, and financial institutions in many of these countries were also very poorly regulated; and so, for example, banks and other financial institutions, after borrowing heavily from abroad, increased lending very rapidly, often into quite speculative sorts of ventures, and then when the time came for foreign investors suddenly changed their minds and decided to pull their money out, then that provoked a very severe economic crisis in several of these countries.

Now, if you look at the situation today, in some important respects it's quite different. One is that most of these economies over the last 10 years have been accumulating very, very large foreign exchange reserves. For East Asia as a whole, the level of foreign exchange reserves now is around $2 trillion, and China alone it is $1 trillion.

By most estimates, this level of foreign exchange reserves is actually much higher than what what those countries need to maintain as a buffer or security blanket against the threat of future financial crises of the type that occurred in 1997; in other words, of the type that occurred as a result of a sudden stop in capital inflows and sudden outflows of capital.

I mean, in general, these reserves are now several times higher than the level of short-term debt that many of these economies have, so that's one point.
The other point is that countries have been putting in a lot of effort to strengthen the quality of public supervision and regulation of the financial sector. And this, again, is a work in progress. There are many areass where more work needs to be done in terms of strengthening supervision and regulation, but there has been a lost progress compared to where things were in 1997. So, that is also a factor which should help these countries be more robust to the threat of new financial crises.

And lastly, we could also note that the financial sector has become much more diversified also. Traditionally, East Asia, like many developing regions, has relied very heavily on the banking sector for its financial services and financial intermediation. Now, in the last 10 year, there has also been growth in other kinds of capital markets; for example, in the equity markets, in bond markets, et cetera. That experience suggests that a more diversified financial sector also tends to be more robust in terms of sets of volatility and financial crises, and it's also better for long-run economic growth; that again is a work in progress.

Lot more needs to be done, for example, in terms of developing an institutional investor base to support these capital markets. There was a question amongst the questions about the role of insurance sector. The insurance sector, again, is a factor that needs to be further developed in these regions and so on. But again, the trend seems to be in the right direction.

Now, does this mean that the economies are invulnerable to financial crises? No. That's not true. In fact, probably no economy is invulnerable to the threat of financial crisis. There are certain areas we could point to where policy makers need to pay a lot of attention and care to avoid the buildup of risks.

One thing that is partly related to the fact, we noted that foreign reserves are very high, and, in fact, this is in large part due to the fact that countries have been running very large current account surpluses, and several of them nowadays are also enjoys large capital inflows. And one side effect of this is that it creates pressure for rapid expansion of domestic liquidity, domestic credit expansion, and if that is not properly managed, that kind of liquidity or expansion could again lead to some of the phenomena that we saw before the financial crisis, for example, overheating of domestic economies, large increases in asset prices, and the formation of asset price doubles, imprudent lending, et cetera, which could at the end of the day then lead to gene the emergence of bad debt or nonperforming loans.

So, economies need to watch those trends carefully to prevent the buildup of similar kinds of vulnerabilities. One of the policy measures that they are increasingly taking, which could be helpful, is they are moving towards greater exchange rate flexibility, and this has been happening in many of these question economies over the last several year, ask this is helpful in the sense that over time exchange rate flexibility could address the underlying problem of very large current account surpluses, could help address that problem and could therefore diminish some of this pressure for program buildup of liquidity in the domestic economy, so, that's one area where policy makers need to keep a careful watch and to prevent the buildup of vulnerabilities.

The parts of this question on China have hopefully been addressed in other answers. On the last part, poverty falls when the incomes of the poor increase, so that for example, a person who had income of less than $1 a day now has income more than $1 a day. However declines in poverty can occur at the same time as rising inequality, because the incomes of higher income groups are rising even faster than those of the poor.