Industrial Policy with Imperfect GovernanceIEA-World Bank Roundtable on New Thinking on Industrial Policy

Washington May 22-23rd 2012

Mushtaq H. Khan, SOAS

Market failures and Industrial Policy The policies and governance capabilities required to accelerate technology adoption depend on the underlying market failure We know about market coordination failures and appropriation problems related to positive externalities of investments in skills and discovery However, a number of case studies show the importance of a somewhat different problem: financing the learning-by-doing that is required to acquire tacit knowledge while ensuring high levels of ‘effort’ in learningDeveloping countries with low wages and sufficient formal training for particular technologies often fail to adopt because of low levels of productivityTypically, in these cases the required tacit knowledge is missingWe know acquiring this requires ‘learning-by-doing’ but ‘doing’ is not sufficient without high levels of effort in learning

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Competitiveness and Learning

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Learning and Effort

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Significant incentive alignment problem for effort: success ‘achieves’ a loss of the financing rents and exposure to market competition

Political Settlements and Industrial Policy Political Settlements describe a macro political equilibrium between institutions and organizations and in developing countries both have a large element of informality The macro political equilibrium determines the cost of enforcing particular institutions (because every institution implies a distribution of benefits)Weak or strong governance in developing countries cannot be assessed in terms of adherence to ‘good governance’ because no developing country achieves a high level of formal enforcement of formal institutions But the political settlements of developing countries differ widely The early industrial policy regimes in many developing countries were attempting methods of financing learning that could not achieve credible compulsions for effort in their evolving political settlements

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Effort depends on the credibility of the financing instrument in a particular political order

e = f (FI, GA, FS, PS)e = effortFI = financing instrument GA = relevant governance agenciesFS = firm structure PS = political settlement

The relationship described is qualitative and the case study evidence strongly suggests it is non-linear: good outcomes depend on compatible combinations of variables that induce high effort Broad-based and generalized industrial policy failed to produce good results in most developing countries except those with ‘strong patrimonial’ political settlements Since political settlements are difficult to change, the question for the others is whether other instruments for financing learning may perform better

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The effects of early South Asian industrial policy

South Asian industrial policies created new technological capabilities but not enough learning in the qualities attempted to become globally competitive.

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India’s motor car industry

By the 1960s, India’s protected car industry produced 50,000 cars annually but of low quality

The dramatic change in this sector happens in the 1980s and by 2009, India produces 1.8 million cars and becomes the fourth largest global exporter

The turnaround happens at the time of ‘opening up’ so it appears that the market forced quality and productivity growth on the protected sector exactly as liberal market theory predicts

A closer examination reveals a more complex learning strategy The turnaround begins with an accidental train of events set off by

Sanjay Gandhi who decided to build a ‘People’s Car’: the Maruti Early attempts to interest Volkswagen were not successful and

Sanjay died in an air crash in 1980 Prestige issues for the Gandhi family made Indira’s government

adopt pragmatic strategies that created incentives for Suzuki to co-finance learning with credible compulsions on all sides for high levels of effort 8

India’s motor car industry

Maruti Udyog set up in 1982 with a 26% Suzuki equity stake For Suzuki, the co-financing deal was attractive because there

were significant rents to be captured in the protected domestic market: tariffs on automobiles were 85% and only declined to 60% by 2006-07

But there was a price for Suzuki: The Indian government’s Phased Manufacturing Programme required 95% local content in 5 years

Suzuki agreed that of the 70% non-company value addition, 60% had to be locally produced: this was the basis of India’s Tier 1 and Tier 2 producers developing global competitiveness: the transfer of organizational knowledge had to be intense and rapid

On its side the Indian government gave Suzuki considerable management autonomy (Suzuki eventually took over the company) and allowed critical imports like gearboxes despite strong opposition from the Indian machine tools industry

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India’s motor car industry

Success in technology transfer was rapid: by 1983 Maruti captured more than 50% of the domestic market, more important by late 1990s Indian auto component producers were winning Deming Prizes for quality and became the foundation of the domestically owned Indian auto industry

Even after the liberalization of the automobile industry in 1992, domestic content requirements were only reduced to 50 per cent by the third year and 70 per cent by the fifth

This period saw further technology transfers by foreign car manufacturers and the emergence of domestically produced cars (Tata, Mahindra and Mahindra)

India joins WTO in 1995 which eventually removed the instruments behind this success story: domestic content requirements and high tariffs10

Bangladesh’s garment industry

The dramatic growth of the labour intensive garment industry in Bangladesh in the 1980s is at the other end of the technology spectrum but is also a very specific learning story

Here too there was a combination of publicly created rents, private co-financing and government commitment to a particular project

Success measured by double digit growth rates for most of the last three decades with Bangladesh becoming the third largest garment exporter in the last few years

‘Public rents’ came from the accident of the Multi-Fibre Arrangement or MFA, set up in 1974

Created ‘quota rents’ for non-quota countries like Bangladesh, which effectively pushed up the competitiveness curve but not by very much

Again, created strong incentives for private co-financing: South Korean Daewoo needed an offshore partner, and the improvement in competitiveness reduced the mountain that had to be climbed11

Bangladesh’s garment industry

The pioneering Bangladeshi firm was Desh Garments which entered a collaboration with Daewoo in 1979

The founder of Desh was an ex-bureaucrat who had benefited from the primitive accumulation of the 1970s. The military-backed government of Zia-ur-Rahman supported the project with specific institutional changes: Back to Back LCs and bonded warehouses

The private co-financing was unique: Desh purchased the know-how from Daewoo: Daewoo hosted around 130 mid-management Bangladeshis at its factory in Busan to learn modern garment manufacturing.

Only the cost of hosting was borne by Daewoo and this too was to be repaid with an 8% royalty on the eventual sales of Desh

Learning was rapid: Desh had planned a 5 year collaboration with Daewoo, but the deal was terminated after less than 2 years

Desh grew at around 90 per cent a year between 1981 to 198712

Bangladesh’s garment industry

The financing arrangement created strong incentives for Daewoo to push the learning and for the Desh employees to absorb it

Desh continued to sustain incentives for high levels of managerial effort in raising competitiveness by allowing managers to depart: Of the 130 mid-level managers who went to Busan for Desh, 115 eventually set up their own garment factories!

Desh’s calculation was right: clustering brought benefits while the negative impact of imitation in raising wages and costs was negligible (Hausmann-Rodrik argue that this mechanism results in disincentives for investments in discovery).

The Bangladesh garments story suggests that the mechanism blocking the private financing of discovery is at best very weak

If capabilities are not growing, the primary market failure that needs to be addressed is the organization of high-effort learning13

Industrial policy with ‘imperfect governance’

A number of globally competitive sectors have emerged in countries with political settlements characterized by competitive clientelism

In our case studies public rents were important for a number of reasons: reducing the risk for private investors and creating incentives for transferring learning, but public rents may not have sufficed on their own in these political settlements

There were specific private co-financing arrangements that created compulsions for high effort learning that did not require the enforcement of rules that were beyond the capacity of the relevant governance agencies

Government commitment was very important for addressing specific problems

The WTO has done away with some of these instruments but the general point of devising financing for learning that is likely to work in particular political settlements remains a policy challenge

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