5:41 AM Jun 23, 1994

FUND/BANK ASKED TO PROMOTE CONTROL OF HOT MONEY

Geneva Jun (Chakravarthi Raghavan) -- The Bretton Woods Institutions (BWI) should seize the current opportunity provided by convergence of theory and international concern over hot money flows to engineer a global tax on short-term flows and thus salvage their market friendly strategy, David Felix, Professor Emeritus in Economics of the Washington University in St. Louis, suggests in an UNCTAD discussion paper.

Prof. Felix also asks the Fund and the Bank to take a position on policing tax evasion in the Third World and pressure the advanced countries to rein in their transnational banks which have become major channels for moving Latin American funds to tax havens, and lean on the tax havens to release the true ownership data.

Felix makes these suggestions in his paper "Industrial Development in East Asia: What are the Lessons for Latin America?" -- a sharp critique challenging several of the Bank's analysis and conclusions in the 1993 policy research report "The East Asian Miracle: Economic Growth and Public Policy".

The Bank undertook the study because of the considerable economic literature challenging the Bank's views about the South Korean and Taiwan miracles, as also the official views of Japan at the Executive Board questioning the Bank's policy prescriptions.

The lessons for Latin America that the Bank study propounds, drawing from the experience of the High Performance East Asian (HPAE), have been blurred by the omissions and misinterpretations derived mainly from the study's a priori commitment to its market friendly development strategy, Prof Felix says.

In its "canonical delineation" in the 1991 World Development Report, (WDR), the World Bank described its "market friendly development strategy" as a modified neoclassical approach that acknowledged the presence of various market failures, but rejected most corrective interventions as likely to boomerang.

In the Bank's view "government failure" dominates market failure and hence the appropriate strategy is to leave most production decisions to private agents guided by domestic and international market forces, and to concentrate public development expenditures primarily on elevating the volume and quality of human capital and the physical infrastructure.

As a semi-official Bank policy study, Felix stresses, "The East Asian Miracle", thus faced the task of reconciling this view of "market friendliness" with the patently dirigistic policies within which Japan rose to global industrial giant and South Korea and Taiwan to regional economic powerhouses.

"Its three-layered reconciliation effort, however, throws more smoke than light on the ways that East Asian and Latin American dirigisme differed," Felix comments.

The study accepts the factual validity of the "revisionist view" that governments in these three economies extensively and selectively promoted individual sectors, but tries to cut down its importance by "adjectival spin" such as "price distortions were mild".

However, Prof Felix points out, the data in the study -- that relative prices in Japan, Korea and Taiwan deviated more from international prices than did those of notorious interventionists such as Brazil, India, Mexico, Pakistan and Venezuela -- refutes the mildness claim.

The study tries to restore validity to the claim by comparing average price "distortions" of all HPAEs with that of other third world regions -- thus loading the dice by including two free-trading city states (Singapore and Hong Kong) with the HPAE "distorters"

As a second layer of reconciliation, the study argues that mild or not, the selective interventions in East Asia was superfluous and that nearly similar industrial structures and benefits would have evolved "naturally" from market forces -- but this is done on some dubious assumptions.

The first assumption is that each national industrial structure decomposes into self-contained two-digit industries with minimal technological and other externalities between the industries. The contrary conviction of Japan, Korea and Taiwan that favourable economy-wide technological and skills spillovers could be obtained by promoting expansion of machinery and equipment sector early in the industrialization drive is given an a priori brushoff.

The second is that cross-country regressions of two-digit industry shares on GDP per capita and population are primarily proxies for relative factor endowments rather for varying mixes of endowments, domestic demand and policy differences.

The third layer of reconciliation effort is to point to other cases of interventionism from other third world regions, mainly Latin America, that have gone wrong -- and using heterogeneity of policies and outcomes between North Asians, ASEAN and Latin American NICs and using "distorting adjectival spin".

Examples of this are the attempts to infer that Latin American NICs were more restrictive of FDI and licensing and more aggressive in promoting buildup of machinery sector than Japan and Korea.

One would never learn from the study, Felix comments, that foreign TNC subsidiaries have since the 1950s controlled far larger shares of industrial production in Latin American NICs than in Korea and Taiwan, not to mention Japan nor that since 1960's Latin American NICs have been actively encouraging FDI in exporting.

The study also loads the dice by burying inter-temporal differences of outcome of Latin American NICs in "overly long time series" that incorporate observations from disparate policy regimes -- the import substitution strategy till the 1970s and the progressive defection from it towards "market friendliness" in the 1980s. The negative total factor productivity (TFP) growth for all of Latin America during 1960-1990 buries the evidence that TFP was strongly positive in six major Latin American NICs during 1950-1973, but declined during 1970s and probably turned generally negative in 1980s. Also GDP growth rates of some Latin Americans was respectably high even by East Asian standards prior to 1980s.

It was not that Latin Americans were on a roll until waylaid by market liberalization, but that both strategies stumbled over enduring institutional and behavioural impediments which have not been handled effectively.

The didactic messages directed by the Bank study at Latin America are a flawed mixture and the recurring problems of Latin American NICs with that strategy suggest that the Bank would be well-advised to reassess its viability in Latin America and its relevance to the HPAE experience, Felix says.

While the contrast between the high-savings and investment rates of the HPAEs and low Latin American rates -- no novelty to Latin American experts -- might be useful in raising consciousness, the study blurs the message by downplaying a related contrast: most HPAEs have been financing their higher investment rates with considerably less reliance on foreign savings than have Latin Americans with their lower investment rates.

The fast growth and relative equity of the HPAEs is another consciousness-raising message that gets blurred -- because of the study's reluctance to explore institutional and behavioural factors that might have been more favourable to distributive equity in HPAEs than in Latin America and assess whether redressing the inequities is compatible with the free capital mobility that the study favours.

Instead the study offers "technocratic insulation" -- ability of technocrats to formulate and implement policies with a minimum of lobbying for special favours from politicians and special interests -- as an all duty weapon against institutional and political obstacles, a "singularly inappropriate advice to a region where political instability and threats to democracy are still widespread".

In an attempt to explain the inter-regional contrasts in savings, investments and income-distribution, the study appears to be discarding "another World Bank totem" -- the Kuznets curve, in which inequality first rises secularly then falls as a natural outcome of sustained capital accumulation and rural-urban migration.

But the anti-thetical thesis that highly concentrated distributions of income and wealth create an unstable socio-political climate that deters private accumulation remains 'in dubious battle' with market friendliness. The study's functional growth framework omits the equitable distribution of land from its fundamentals and relegates declining income inequality to an outcome of economic growth -- as in the Kuznets curve.

"One suspects", Felix comments, "the Bank's 'Congregation for the Doctrine of the Faith' was once again herding the study's analysts into line".

Consumer preference and the addiction of affluent Latin Americans to high consumption with a strongly import-intensive-twist, Prof Felix says, can explain the Asian over Latin American industrial development. Asians have been able to sequence their industrial promotion more rationally than import-biased preferences of Latin American consumers.

The second favourable factor in Asia was the demand for indigenously designed traditional consumables, which favoured small industry growth unlike in Latin America. Asian NICs embarking on modern industrialization inherited large, diverse, craft-based industrial sectors along with consumer preferences that nurtured the sector's survival and gradual modernization. In Latin America, by contrast, artisanal share of industrial output declined.

Dirigistic industrialization was broadly market-conforming in both regions, but was shaped by different market dynamics, with Latin NICs being forced to give priority to motor car and other consumer durables.

The Bank study's attempts to focus on labour market interferences to explain intersectoral dualism. Japan and most other HPAEs successfully intervened to keep the relative domestic price of machinery and equipment well below that prevailing in the Latin American NICs. The lifetime employment policy of large Japanese firms (after World War II) weakens the flexible labour market contention. And the intersector dualism in Latin America has been far greater than can be accounted for by policy-induced blockages to labour market flexibility.

It is in sermonising against interventionist industrial promotion, Felix comments, that omissions and misinterpretations abound most in the study which strains credulity and statistical probity to show rapid growth of technological prowess in the northern HPAEs had little to do with their interventionist policies but all to do with their openness to foreign trade, investment and technology.

The study's view that whether or not dirigisme worked for the northern HPAEs, financial globalization and "GATTification" of trade create a less tolerant international environment today for dirigistic development strategies is indisputable.

But less justified, he says, is its failure to point out the corrective lessons for Latin America: that the higher level of intra-regional economic integration the HPAEs built up with the aid of dirigiste policies has enabled liberalization to proceed more gradually and less disruptively of inter-industry linkages in East Asia than in Latin America.

Above all, the East Asian Miracle, fails to address the fact that the Bank's market-friendly strategy no longer has a coherent exchange rate policy. At the research level, Bank and IMF economists are divided whether exchange rate should be adjusted to promote expansion of traded goods or subsidized to restrain inflation and promote capital flows.

At operational level, the issue has been decided in favour of stabilising the nominal rate -- as evidenced by the favourable treatment given to Mexico, Argentina and Peru.

That decision however is grounded in faith that the financial markets will forget the past and keep covering the growing current account deficits despite increasingly overvalued real exchange rates -- a faith at odds with neoclassical logic on which the market friendly strategy had originally been based, as well as with the financial market reality which eschews permanent involvement in Ponzi financing.

Also, the more crucial the economy's dependence on capital inflows, the more crucial are tax and spending initiatives to redress inequities subordinated to the need to sooth financial market apprehensions.

The spectre haunting exchange rate policy in Latin America also haunts the World Bank and the Fund. But the two institutions could promote modification of "market friendliness", based on the HPAE experience, that might help Latin American NICs to exorcise the spectre.

One set of modifications would strengthen domestic policy autonomy by separating the liberalization of goods markets from the excesses of global mobility of financial capital. The second would facilitate backward linkage industrial development in the Latin American NICs by modifying the liberalization of goods markets.

The centrepiece of the first set of modifications would be for the BWIs to help engineer a uniform tax to be applied by all member countries on foreign exchange transactions within their jurisdiction. Since the burden of such a tax declines as the turnaround period of investment lengthens, the tax would discourage hot money flaws but have little effect on FDI or long-term portfolio investment.

Globalizing the tax is needed since economies with fragile balance of payments, who most need protection against hot money flows, are least able to risk the tax, although currently even economies with robust balance of payments have been complaining of vulnerability.

"Since theory and international concern with controlling hot money are converging, and regulating international capital movements by member countries is allowed under Art. VI, section 3, of the IMF charter, the Fund and the Bank should seize the opportunity to help salvage their market friendly strategy by engineering a global tax".

Referring to the tax-evasion and flight capital issues, Felix complains that the Fund and Bank have taken the position that policing tax evasion via offshore tax havens is strictly the responsibility of the individual country. The incidence of such tax evasion in the advanced countries, with their more sophisticated tax collecting capability, has been much less than in Latin America where it has contributed to income inequality and a constant barrier against tax reform.

Replacing this bias would be another step towards salvaging market friendliness and this means the Bank and the Fund should pressure the advanced countries to rein in their international banks, which have been major channels for moving Latin American funds to the tax havens, and lean on the tax havens to release true ownership data.

The Bank could also use its intellectual and financial resources to encourage sub-regional integration efforts, such as Mercosur, as mechanisms for raising high-tech industrial development and intra-country economic linkages closer to East Asian levels.

"The transitional trade discrimination needed to advance such integration is permitted under GATT rules, and a common market like MERCOSUR," Felix adds, "is also, from a neo-classical perspective, less trade-distorting than is a free trade arrangement like NAFTA, and hence presumably more compatible with market friendliness.

"None of these modifications," Prof Felix concludes, "would ensure the success of the market friendly strategy under Latin American conditions. They could, however, improve the functioning of the strategy and thus give more time for the consciousness-raising lessons from East Asia to improve the political climate for tackling the more deeply ingrained institutional and behavioural obstacles to equitable development in Latin America."