Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability [1 ed.] 9781612090429, 9781611225419

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Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved. Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved. Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

GLOBAL ECONOMIC STUDIES

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DEVELOPING ECONOMIES: INNOVATION, INVESTMENT AND SUSTAINABILITY

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Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

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Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

GLOBAL ECONOMIC STUDIES

DEVELOPING ECONOMIES: INNOVATION, INVESTMENT AND SUSTAINABILITY

JOANNE M. CARCILLO Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved.

EDITOR

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LIBRARY OF CONGRESS CATALOGING-IN-PUBLICATION DATA Developing economies : innovation, investment and sustainability / editor, Joanne M. Carcillo. p. cm. Includes index.

ISBN:  (eBook)

1. Developing countries--Economic conditions. 2. Developing countries--Economic policy. 3. Developing countries--Environmental conditions. 4. Development economics--Developing countries. I. Carcillo, Joanne M. HC59.7.D42 2010 330.9172'4--dc22 2010041297

Published by Nova Science Publishers, Inc. † New York Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

CONTENTS Preface Chapter 1

Chapter 2

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Chapter 3

Chapter 4

Chapter 5

vii Service Entities in Open-Closed Innovation - the Growth of Service Economy for Smaller Firms Driven by Information Technology (IT) and Knowledge-intensive Services (KIS) Yumiko Kinoshita Embracing Change? An Update of the IFAC Compliance Programme in a Less Developed Economy Javed Siddiqui, Reazur Rahman Chowdhury and Dewan Mahboob Hussain Hong Kong‘s Economic Integration with China via FDI: Sustainable Growth of the HK-PRD Globalized Delta Economy Linda F. Y. Ng and Chyau Tuan Environmental Sustainability of Poverty Reduction in a Small Open Dualistic Economy: The Case of Wage Subsidy Policies and Industrial Pollution under Sector-Specific Capital Ichiroh Daitoh Do Political Freedoms Attract or Discourage Foreign Direct Investment? Evidence from Central and Eastern Europe and Former Soviet Union Jac C. Heckelman

1

97

135

157

175

Chapter 6

Regulation as a Protectionist Strategy Peter Lawrence and Arijit Mukherjee

Chapter 7

Black Money and Corruption in India –Necessary Evils to Survive?: A Commentary Pradeep Chaudhry

203

Does Higher Economic Integration of Trade Blocs Leads to Fair Trade? Christos Bezirtzoglou

211

Chapter 8

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vi Chapter 9

Contents Interactions between Economic Growth, Innovation, Financial Development and Sustainability in Emerging Countries Ozan Bakis, Fatih Karanfil and Sezgin Polat

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Index

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

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PREFACE This book examines the innovation, investment and sustainability of developing economies across the globe. Topics discussed herein include black money and corruption in India; the growth of information technology (IT) and knowledge-intensive services (KIS) in developing countries; the IFAC compliance program in a less developed economy; Hong Kong's economic integration with China via FDI; rural and urban wage subsidies as policies for reducing urban unemployment, decreasing pollution and improving welfare in a dual developing economy; and the relationship between political freedoms and foreign direct investment. Chapter 1 - The service sector consist 70-75% of the global economy in advanced countries. However, there is far less empirical and statistical studies performed with regard to the service sector than manufacturing sector. The productivity of the service sector has not been identified clearly in relation to the sectoral growth because the productivity of service sectors has not been improved for decades in major OECD countries. The growth of service sectors are important particularly from the viewpoint of small to medium-sized enterprises (SMEs), which consist a large part of the service sector even more than that of manufacturing sector. Based on major statistics and past literatures, this chapter addresses the role of SMEs in the development of today‘s economy, leading to structural changes in the service sector. To achieve economic development, it is important to consider the introduction of Information Technology (IT) and the development of expertise knowledge, by either internally, externally, or with public support, that aim to improve productivity. In this regard, Knowledge-intensive services (KIS) have a special role to play for facilitating productivity in the service economy. The impact of service research and development (R&D) is also focused in resent researches. In line with these trends, this chapter aims at arguing economic growth models for SMEs, in which R&D activities promote and transform innovation in the service sector with the appropriate use of KIS and IT services. By incorporating business size dimension, the firmlevel panel data analysis successfully reveals that a balanced combination of IT investment and KIS inputs achieve steady turnover growth for service sectors from both micro and macro perspectives. In addition, service intermediate inputs play a moderator role against fluctuations in the entire economy. Service R&D gives a certain impact on revenue trends although firm age, business size, and sectoral aspects in addition to the balance of tangible and intangible assets are related to the effectiveness of R&D activities. In conclusion, it is critically important for future economic directions and policies to remember that the balanced investment into IT and KIS will promote the growth of the entire economy through the

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

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viii

Joanne M. Carcillo

development of SMEs by means of structural changes and innovations associated with the service-oriented economy. Chapter 2 - The objective of this study is to investigate suitability of the IFAC statements of membership obligations (SMOs) in the context of a less developed economy. Past literature has identified the presence of a significant gap between accountants working in developed countries and LDCs in terms of skills and competence. Also, due to various socio-economic conditions, the perceptions of ethical conduct vary widely between developed and developing countries. However, despite this, international accounting bodies such as the IFAC have time and again attempted to promote a universal set of standards to ensure audit quality. Using the case of Bangladesh, this paper investigates the adoption and implementation process of IFAC SMOs in the contxt of an LDC. Interviews with policy makers, practicing auditors, senior accounting academics, and leaders of the accountancy profession, as well as a questionnaire survey with final year undergraduate students of accounting reveal the absence of the essential preconditions of ethical practice in Bangladesh, making the IFAC SMOs largely ceremonial. It is found that the auditing profession survives through its relationship with the state, and the dynamics of such relationship changes under threats of legitimacy. The paper also provides evidence of third party influence over the dynamics of the state-profession relationship. Overall, the findings suggest that the adoption of SMOs in Bangladesh may have been prompted by institutional reasons rather than reasons of efficiency, and a replication of the Bangladesh case in other LDCs will make IFAC‘s efforts to improve audit quality through a compliance programme largely unsuccessful. Chapter 3 - The goal of this paper is to study the growth of the Hong Kong-Pearl River Delta (HK-PRD) globalized delta economy and Hong Kong‘s evolution and progression from a city-state economy to a regional-metropolis upon its economic integration with China since her economic opening in 1979 as well as after the return of sovereignty in 1997. The authors examine (1) Hong Kong‘s development as a regional metropolis upon China‘s economic opening; (2) the formation of the HK-PRD economic region as induced by Hong Kong‘s industrial and trade restructurings via foreign direct investment (FDI) flows into China and particularly in PRD; (3) Hong Kong‘s rise as a service-dominated city core of a coreperiphery system by integrating economically with south China through the spatial expansion in PRD and the Pan-PRD common market; (4) Hong Kong‘s dominant role as China‘s most globally accessible core city, ,namely, the HK-PRD economy; (5) Hong Kong‘s post-Asian financial crisis success by continuously gaining international competitiveness; and (6) Hong Kong‘s critical role in becoming the most competitive international financial center in China beyond the recent 2008-global financial crisis and hence, the sustainable growth of HK-PRD. Future developments and challenges were also discussed. Chapter 4 - This chapter is the first attempt to examine the circumstances under which rural and urban wage subsidies as policies for reducing urban unemployment decrease pollution and improve welfare in a dual developing economy. In a specific-factor model of a small open Harris–Todaro economy with polluting urban manufacturing, an urban wage subsidy may decrease pollution in a realistically relevant situation where a dirty input is complementary to capital. GDP is likely to increase if rural technology exhibits strong diminishing returns to labor and if the urban population ratio is high. Welfare improves if, in addition, consumers‘ preferences shift toward a clean (rural) good as pollution increases. An urban wage subsidy could be consistent with environmental protection in increasing manufacturing employment and reducing urban unemployment while they work in opposite

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Preface

ix

directions in improving welfare. The optimal labor market policy under a given pollution tax is characterized by the uniform urban and rural wage subsidies. Chapter 5 - The evidence on the relationship between political freedoms and foreign direct investment (FDI) is mixed. Part of the problem in interpreting results is that past crosscountry studies have generally used a large sample of diverse nations and broad measures of political freedoms which do not vary much over time. In this chapter the relationship between political freedoms and FDI in the Central and Eastern European and Former Soviet Union nations is analyzed using recently developed political freedom indexes by Freedom House specific to the transition economies, over the period 1999-2008. By focusing on a specific region of the world which has undergone recent dramatic change in its political institutions, both in terms of positive reforms in certain nations and increased repression in others, a better estimation of the true impact of political freedom can be determined. It is found that greater political freedoms in general discourage FDI. However, not all types of political freedoms significantly hinder FDI. In particular, freedoms related to judicial framework, civil society, and corruption significantly limit FDI, while freedoms related to electoral process and governance do not. Finally, the results for media independence are dependent on specification. Chapter 6 – The authors show that, under certain conditions, strategic lobbying by the incumbent firms for a regulatory regime is a way to deter entry of competitors. The effect of cost-efficiency of the incumbent on the incentive for lobbying is ambiguous and depends on the cost differences between the incumbent and the entrant. They extend the authors analysis to incorporate the possibility of lobbying by the entrant, and show the importance of the cost of lobbying and the probability of successful lobbying by the incumbent. Chapter 7 - Black money is the actual flowing blood in the veins of traditional Indian business and commerce. It is the real fuel of high-pitched central, state and local election campaigns, the high-octane of most of the bollywood star contracts, the blowing fire of realestate deals and the dynamics of the bulk of the Indian share-market. The salaried middle and lower middle-class, intellectuals with integrity and principles are condemned to irrelevance and very often laughed upon in the society. Underground income is so widespread in Indian society that its existence no longer shocks or surprises anyone. Barring few exceptions, it is difficult to find political leaders, high profile government officers and self-earning professionals; not having wealth disproportionate to their known sources of income. Before independence, foreigners looted this country and sent the booty across seven seas but now the same task is being performed by a class of politicians, high flying officers, businessmen and industrialists by looting the country and depositing black money in to Swiss and Caribbean banks. Some innovative ways to arrest the spreading the black money in Indian society, checking corruption; means to sustain the social and economic system have been discussed at the end of the commentary. Chapter 8 - The paper is attempting a statistical analysis of the main defensive WTO trade remedy measures of four regional trade blocs of different level of economic integration in view of supporting the argument that higher economic integration among nations leads to less market distortions that need to be addressed by measures and thus fair trade. Chapter 9 - Combining different data sets, this study examines possible linkages between economic growth, innovation and energy and environmental efficiency. In the related literature, previous studies had looked for the link between: (1) financial development and economic growth; (2) energy consumption (or CO$_2$ emissions) and economic growth; (3)

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Joanne M. Carcillo

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innovation (or research and development) and economic growth. However, the authors believe that a larger and more detailed study is needed to provide insight into the possible interrelatedness and interaction between these variables. To do this work in this chapter, the authors carry out an empirical study employing the Arellano-Bond estimator. The results will increase our understanding of empirical relationships among the variables involved, thus having important implications for environmental, economic and innovation policies.

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

In: Developing Economies Editor: Joanne M. Carcillo

ISBN: 978-1-61122-541-9 © 2012 Nova Science Publishers, Inc.

Chapter 1

SERVICE ENTITIES IN OPEN-CLOSED INNOVATION - THE GROWTH OF SERVICE ECONOMY FOR SMALLER FIRMS DRIVEN BY INFORMATION TECHNOLOGY (IT) AND KNOWLEDGE-INTENSIVE SERVICES (KIS) Yumiko Kinoshita Assistant Professor, Graduate School of Interdisciplinary Informatics, The University of Tokyo, Japan

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ABSTRACT The service sector consist 70-75% of the global economy in advanced countries. However, there is far less empirical and statistical studies performed with regard to the service sector than manufacturing sector. The productivity of the service sector has not been identified clearly in relation to the sectoral growth because the productivity of service sectors has not been improved for decades in major OECD countries. The growth of service sectors are important particularly from the viewpoint of small to medium-sized enterprises (SMEs), which consist a large part of the service sector even more than that of manufacturing sector. Based on major statistics and past literatures, this chapter addresses the role of SMEs in the development of today‘s economy, leading to structural changes in the service sector. To achieve economic development, it is important to consider the introduction of Information Technology (IT) and the development of expertise knowledge, by either internally, externally, or with public support, that aim to improve productivity. In this regard, Knowledge-intensive services (KIS) have a special role to play for facilitating productivity in the service economy. The impact of service research and development (R&D) is also focused in resent researches. In line with these trends, this chapter aims at arguing economic growth models for SMEs, in which R&D activities promote and transform innovation in the service sector with the appropriate use of KIS and IT services. By incorporating business size dimension, the firmlevel panel data analysis successfully reveals that a balanced combination of IT investment and KIS inputs achieve steady turnover growth for service sectors from both micro and macro perspectives. In addition, service intermediate inputs play a moderator role against fluctuations in the entire economy. Service R&D gives a certain impact on revenue trends

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

2

Yumiko Kinoshita although firm age, business size, and sectoral aspects in addition to the balance of tangible and intangible assets are related to the effectiveness of R&D activities. In conclusion, it is critically important for future economic directions and policies to remember that the balanced investment into IT and KIS will promote the growth of the entire economy through the development of SMEs by means of structural changes and innovations associated with the service-oriented economy.

INTRODUCTION

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Service Economy and the Role of Innovation in Services1 Service is a primary growth driver for the present world market as the tertiary sector of the economy. The term, service, has a variety of associations and annotations as we aim to analyze its meaning, role, impact, and functionality in the contexts of the present and future economy. Economic trends surrounding service consider the question from the point of view of scientific knowledge and its creation. Albert Einstein once said, ―it might appear that there are no essential methodological differences between astronomy and economics…but in reality such methodological differences do exist. The discovery of general laws in the field of economics is made difficult by the circumstance that observed economic phenomena are often affected by many factors which are very hard to evaluate separately. In addition, the experience which has accumulated since the beginning of the so-called civilized period of human history has…been largely influenced and limited by causes which are by no means exclusively economic in nature‖ (1949). The importance of service has been recognized in a number of statistical sources, which clearly show the degree of its contribution to the growth of the global economy as well as fluctuations in the current market. According to the World Bank, most of the job losses were seen in the manufacturing sector in previous financial crises, but employment increased in services on average (2008, 2009). During this crisis, however, there have been substantial employment losses in service sectors primarily due to the serious impact on the trends of financial sector services, real estate and construction. Poverty is also expected to expand, or take a slower exit in a number of developing countries (World Bank, 2008, 2009). Sophisticated algorithms for designing financial products and distributing risks in a combination of them are one of the derivatives of accumulated technical and expertise knowledge in the said area (International Monetary Fund, 2009a, 2009b; Dekle, Eaton, & Kortum, 2008), having the impact of supportive technologies on the delivered services remain to be clarified. Einstein also mentioned that memory, the capacity to make new combinations, and the gift of oral communication have made possible development…(which) manifest themselves in…scientific and engineering accomplishments (and the like)…It is easy to raise (abovementioned) questions, but difficult to answer them with any degree of assurance (1949). A part of our scientific and engineering knowledge is, as he refers to, structure of 1 In this chapter, ‗the service sector‘ refers to the collection of non-manufacturing sectors as a whole in contrast to ‗the manufacturing sector.‘ Each sector in the service sector is mentioned as ‗service sector(s).‘ Each servicerelated activity or service as a product is expressed as ‗service(s).‘ Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

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Service Entities in Open-Closed Innovation

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information and means of communication. Researchers attend to a variety of issues including the relationship of service and the economy, with some degrees of uncertainties, in complicated structural attributes that are both economic and non-economic as articulated by Aoki (2001) and Sudoh (2005). The issue with regard to service has been articulated in many scientific fields in the past. Reviews on the service sector date back to the 1960s (Fuchs, 1965), being investigated thoroughly from the viewpoint of economic structural analysis. The service sector has also been analyzed in parallel with manufacturing in terms of measuring the degree of innovation, being referred to as ‗service innovation‘ (Barras, 1986; Eurostat, 1992-2009; Finnish Funding Agency for Technology and Innovation (TeKes), 2006; Miles, 2006; NESTA Policy and Research Unit, 2008; OECD, 1996) in more recent years. Different perspectives have been offered from the fields of Information Technology (IT), engineering, business management, and sociology with the efforts of establishing an interdisciplinary field called ‗service science‘ (Hidaka, 2006; IBM). In these efforts, the structures of information pertaining to service have presented multi-layered perspectives (Kinoshita & Sudoh, 2008) to those who would like to take a deeper look at the nature of service. Furthermore, the understanding of these concepts will help to have an overview of the future development of the service sector, leading us to the management of innovation and values generated in the service sector in a flexible, dynamic, and effective manner. Starting from the structural analysis on the service sector to find an answer to a number of economic questions, which have already presented years ago, such as elasticity of substitution, factor prices, intermediaries used in service, and idiosyncratic parameters of consumers (Fuchs, 1965), the ones addressed in recent years are the role of supporting technologies and its relation to expertise knowledge used to deliver diversified services (Finnish Funding Agency for Technology and Innovation (TeKes), 2007a; Miles, 2005; 2008). According to Eurostat, for instance, 43% of Science and Technology jobs in EU 27 countries are in the service sector (Eurostat, 2007). Not only global services but also locally traded services will be subject to systemic research and development (R&D) activities more than before (European Commission, 2008; Wolfl, 2005). The clarification of geographical locality, substitution of products, and heterogeneity of knowledge in the service sector are historical but ongoing problems for economists, out of which the degree of technology and knowledge intensiveness in services and the effective utilization of IT (Finnish Funding Agency for Technology and Innovation (TeKes), 2007b) are the front end of the spectrum. The investment into ‗knowledge‘ in general refers to the amount of input into R&D, education, and software besides the investment into capital including tangibles and intangibles (OECD, 2008b). These investments by themselves are a part of service activities. The issue of R&D in the service sector has been brought up to the table for discussion to find appropriate deflator for measuring the impact of service R&D accurately, and to discover the mechanism of sectoral and productivity growth (Djellal, Francoz, Gallouj, Gallouj, & Jacquin, 2003; Freeman & Soete, 2007; Fukao, 2007; Hall, 2007; National Science Foundation and National Institute of Standards and Technology, 2005; Nomura, 2004; OECD, 1980, 1996, 2005b; Timmer, O'Mahony, & Ark, 2007; Young, 1996). To transform the service sector based on potential innovativeness of knowledge generated through service, it is suggested furthermore that increasing connection and adoption of service-related technologies in other research fields, such as IT, genomics, and neurosciences, should be pursued (Atkinson & Castro2008; R. D. Atkinson & Wial, 2008; Council on Competitive-

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Yumiko Kinoshita

ness, 2004; European Commission, 2008; NESTA Policy and Research Unit, 2008; Prest, Tno, Arcs, and Servilab2006). To respond to these challenges, a critical issue is how we deal scientifically with the creation of knowledge, its process to evolve into the innovation in service, and the contribution to the growth of productivity and total output in the service sector. These issues stand at the crossroads of economics and informatics as it aims to consider the interpretation of economic entities and the creation of structured information in relation to the heterogeneity of technologies, namely IT, from the viewpoint of innovation in service (R. D. Atkinson & Wial, 2008; Forge, Blackman, Bohlin, & Cave, 2009; OECD, 2008c; Scott, 1999). In other words, this is a question regarding the state space for the creation of knowledge and its impact on total output. Simply enough, the reason why the growth of productivity leads to the increase of output has not been proved yet, which this chapter will be concerned with by articulating the nature of information and networks (Sudoh, 2005) as vital components for the analysis of innovation in service from the perspectives of knowledge, followed by empirical and qualitative studies. Furthermore, as we have witnessed recently in the financial crisis, the direction of future IT services and networking technologies, currently serving as a part of utilities for our daily lives (Buyya, Yeo, & Venugopal, 2008; Rimal, Eunmi, & Lumb, 2009), has a huge impact on the course of the entire service sector to take for years ahead. In addition, the number of smaller firms is increasing in the service economy. It is suggestive that the study on the development of the service sector is useful and effective as well as necessary for the issue of economic development for developing countries (Kinoshita, 2009a). The discussion on the size of firms is important in terms of finding the optimal scale of investment into IT system, and how we can design innovation system and policies for which a certain sector of the economy and a part of the population are allocated. According to statistics in U.S., U.K. and Japan where service sectors have been relatively developed, it is clarified that the Pareto distribution is shifted in service sectors compared to manufacturing. OECD (2008a, 2008d) also mentions that small to medium-sized enterprises (SMEs) are facing a structural change in the global economy, and that the role of SMEs is becoming important in the service economy, which we must perform detailed analysis. To return to a sustainable growth from the financial turmoil (Dekle, Eaton, & Kortum, 2008; World Bank, 2008), being as a short-term objective of economic activities, it is suggested from a longer perspective that the model for promoting the expansion of service sector should be studied further as we acknowledge the impact of information structure, being expressed in knowledge, inter alia, the effects of key technologies to play to that end, first and foremost, IT and other emerging and critical technological fields, such as biotechnology (Second OECD Ad Hoc Meeting on Biotechnology Statistics, 2001), and the diffusion of potential impacts of the expanding service sector into the variations of productivity growth and earnings structure among firms (Cainelli, Evangelista, & Savona, 2006; Griffith, Harrison, & Reenen, 2006; Koellinger, 2008). It is assumed that the factor for the growth of service sector is the existence of multiple technological fields, which allows for endogenous development of knowledge, achieving a shift in productivity distributions among firms. Innovation can be examined according to technological development phases. One way to describe economic phases is the life cycle of a technology system. It takes the following six steps: (1) the laboratory-invention phase with early applications in small scale, (2) the demonstration of technical and commercial feasibility with wide potential applications, (3) growth phase with structural, political and regulatory changes, (4) high growth with a wide

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acceptance of technology in leading economies, (5) profitability decline with challenges of new technologies, and (6) maturity stage with the possibility of co-existence with new technologies or slow disappearance (Freeman & Louca, 2001; Freeman & Soete, 1997). Trends of current business in IT sector, the optimal scale of investment into IT by businesses, and the evolution of IT services are standard points to be investigated, which can be associated with the foregoing points of discussion in terms of the behavior of service sector. As for the innovation in service, in particular, there are several models presented which explain the development phases of service in terms of quality, availability, and the like (Zeithaml, Parasuraman, & Berry, 1990; Lages & Fernandes, 2005; Service Innovation Research Initiative, 2009; 1990). A major example is Community Innovation Survey in European Union (Eurostat, 1992-2009). In such an existing framework of analysis, the issue of innovation is addressed typically as an environmental and complex structural attributes associated with diverse innovation systems. Meanwhile, the service sector consists of a major part of most advanced economies as well as a number of developing countries. Various research initiatives are underway to clarify how to improve the productivity of the service sector and enhance innovative capabilities for all sizes of firms. Freeman and Soete (2007) state that we should reconstruct our understanding on major economic indexes including Gross Domestic Product (GDP) due to the rise of the service economy. From the viewpoint of macroeconomics, it is important to create a service portfolio to provide services with diversification, differentiation, and competitive quality to gain competitiveness in local and global markets. Some services are not tradable and only locally delivered. Therefore, the businesses in the service sector can work together with preferences of users and consumers to gain maximum return for an area where service is being provided (Service Innovation Research Initiative, 2009). From the perspectives of SMEs, geographical elements, having been addressed by Krugman, Fujita and many others (Asheim & Gertler, 2005; Audretsch & Feldman, 1996; Coe, Helpman, and Hoffmaister, 2009; Fujita, Krugman, and Venables2001; Jonathan & Samuel, 2002; Kranich, 2009; Paul Krugman, 1997), must be considered in terms of productivity and opportunities for creating new services (Miozzo & Soete, 2001). The geospatial elements achieve two goals: to increase return on investment per area and to gain competitiveness in a global market by overcoming locality. To support these objectives, IT is used to create access to local entities as well as actors in the global market for improving productivity (Basu & Fernald, 2006; Bresnahan, Brynjolfsson, & Hitt, 2002; Jorgenson, Ho, & Stiroh, 2003; Scott, 1999; Shapiro, Varian, & Farrel, 2004; Stiroh, 2002). From micro-level perspective firms are required to enhance the degree of expertise in the production and delivery of knowledge more to compete in the global market due to the increasing introduction and diffusion of IT (Dikaiakos, Katsaros, Mehra, Pallis, & Vakali, 2009; Yu, Li, Li, & Hong, 2004). This aspect is also applied to the activities performed by smaller firms (OECD, 2005a, 2008a). In recent years, in particular, the systemic R&D efforts in the field of service are increasing, and firms are exposed more to the competition intensified to generate new knowledge pertaining to service, making them more knowledge and technology intensive (Miles, European Commission, 2008; 2005; OECD, 2006). In addition, as Coase (1937) mentioned, the existence of costs for information has been a reason for the establishment of firms and organizations. Due to the deepening integration of information technologies in economy and society, the costs for obtaining, managing, and utilizing information have been reduced, which allow for a new type of open organizational

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schemes to emerge. In such a situation, people are required to have knowledge and skills, in particular, to connect and negotiate with external organizations (Goldsmith & Eggers, 2004). Public administrative agencies have established more cooperative relationships with nonprofit organizations (NPOs) and private firms so that the government ministries and agencies shall be capable of developing comprehensive services by organizing multi-level (national and local) consolidated services (Sudoh, 2005, 2006, 2008). A large part of the transaction costs have been eliminated by automated technologies, leading to a decrease in the costs of partnership (Goldsmith & Eggers, 2004). According to Coase (1937), if partnership is more effective cost-wise than operating business on our own, more partnership, cooperation and outsourcing will be sought for. This propensity is also related to the trends of firm size and its turnover. Goldsmith et al. (2004) says that a system to deliver a service is properly designed and networked, in which it has a potential to create opportunities for different kinds of innovation. In line with this perspective, the innovation in service is going to be reviewed in a way that shows the diversification of profit structure at sectoral levels. With these observations, this chapter deals with innovation specifically in service by articulating the needs for designing an analytical framework for service innovation to measure the impact on economic growth focusing on SMEs, and by referencing panel data models with some modifications to reflect the role of knowledge in the service economy more precisely. Focal points of analysis in this chapter are as follows. The first point of analysis is the impact on productivity among firms in the service sectors. Based on preliminary observation on data, it is clarified that the distribution of turnover and firm size is distinctive in the service sector from that of manufacturing sector, thus leading to different structures for sectoral growth and productivity improvement. The second point is the role of investment into R&D in services in accordance with the roles of knowledge-intensive services (KIS) to play on productivity trends in relation to those of IT services. It aims to discuss the measurement methodology of investment into knowledge as the coordination of IT services and KIS to articulate its impact on elasticity of substitution of knowledge. For the entire discussion, IT is considered to be the foundation, or at least a major contributor, for creating new markets, improving productivity, and delivering services. In this chapter, the role of IT services and KIS are taken into account as two pillars to promote R&D in services and to achieve the innovation in service. Firstly, the recent trends of the service sector in the world is overviewed so that the scope of analysis in later sections is narrowed down and articulated clearly. This step is taken to identify growing service sectors, and find what factors are related with the growth of service sectors. For these purposes, data on international economy are reviewed from structural perspectives. The relationship of macro economy and service sectors suggests that tertiary attainment and Information and Communication Technology (ICT) capital formation are correlated with the growth of service sectors while multi-factor productivity (MFP) and investment into knowledge are not related. The empirical analyses refer to the models presented by Eaton, Helpman, and Kramarz (2009), Besanko and Doraszelski (2004), Pagano and Schivardi (2003), Acs and Audretsch (1988), Shefer and Frenkel (2005), Cohen and Klepper (1996), Koeller (2005), and Veugelers and Cassiman (2005). The firm size variations on output are examined, incorporating the effect of R&D in services (Duchêne, Lykogianni, & Verbeek, 2009; Jankowski, 2001; Young, 1996), by using Japanese firm-level financial data. The hypothesis to be analyzed is the shift

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of Pareto distribution among service sectors in that it is represented by the variations of profit structures by firm size. A thorough analysis on the relationship between firm size and turnover in the service sector has rarely been seen in past literatures in economics. In particular, this analysis encompasses the impact of R&D in services, which is, by itself, a new topic for empirical analyses for the area of services. Dynamic panel data models are used as a large amount of cross-section data are available while time-series data are short, in which lagged dependent variables appear in correlation with error term. Arellano et al. (1989; 2001), Hahn, Hausman, and Kuersteinerm (2002), Pakes and Ericson (1998), Pakes (2003), Ackerberg, Benkard, Berry, and Pakes (2007) and many others have approached to these issues using instrument variables (IV). This chapter focuses on structural parameters and imperfect instrument variables (IIV) based on Olley and Pakes (1996) and Ackerberg et al. (2007) incorporating the findings of Levinsohn and Petrin (2003), Patrick, Benkard, and Levin (2007), Andrews and Stock (2007), and Nevo and Rosen (2008). Details on methodology can be referred also to Kinoshita (2009a, 2009b). In this analysis, the relationship of knowledge spillover (Jaffe, Trajtenberg, & Fogarty, 2000), KIS, and the use of IT are focused. This analysis is conducted to find the impact of knowledge on the performance of firms by size variations so that the relationship of information and networks are clarified from the viewpoint of the innovation in service. In summary, the research deals with existing hypotheses on the relationship between firm size, its growth, and innovation by presenting a different scenario for the service sector as the role of service R&D is incorporated into analyses.

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1. THE WORLD ECONOMY AND THE GROWTH IN SERVICE SECTORS The following sections are concerned with, first of all, how the innovation of service has been generated and developed in the world economy, and which factors are important for the future economy to continue to promote the innovation in service. In particular, the role of R&D in services is focused, which has increased swiftly in recent years following the review on the role of IT and KIS in this process. The question of innovation is analyzed to clarify how the trends of the service sector have caused the variation of profit structures at a sectoral level in business size dimension.

1.1 Global trends by sector This section gives an overview of the service sector around the world to narrow down the scope of analysis to be described further in later sections. In the International Standard Industrial Classification (ISIC) Revision 2, services are defined as all activities in: ‗Wholesale and retail trade and restaurants and hotels,‘ ‗Transport, storage and communication,‘ ‗Financial, insurance, real estate and business services,‘ and ‗Community, social and personal services‘ (OECD, 2008b; United Nations Statistics Division). In ISIC Revision 3, services are defined more loosely including the following: ‗Wholesale and retail trade; repair of motor vehicles, motorcycles and personal and household goods,‘ ‗Hotels and restaurants,‘ ‗Transport, storage and communications,‘ ‗Financial intermediation,‘ ‗Real estate, renting and business activities,‘ ‗Public administration and defense; compulsory social security,‘

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‗Education,‘ ‗Health and social work,‘ ‗Other community, social and personal service activities,‘ ‗Private households with employed persons,‘ and ‗Extra-territorial organizations and bodies.‘ In ISIC Revision 4, certain categories, such as ‗Information and Communication‘ and ‗Professional, scientific and technical activities,‘ become more distinctive (US Economic Classification Policy Committee, Statistics Canada, Mexico's Instituto Nacional de Estadistica, & Geografia e Informatica)2. Based on the sectoral classification above, the trend of service sectors with high growth rates, moderate growth rates, and lower growth rates are shown in Figure 1, Figure 2, and Figure 3 respectively. The aggregate of banks, insurance, real estate and other business services has been showing a steady growth over the last decade while the total of transport, trade, hotels and restaurants has exhibited a moderate or leveled growth. The aggregate of government, health, education and other personal services has shown slower or negative growth rates. These growth trends seem fairly consistent across these major countries in the figures. 35 Australia 33

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OECD total 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Figure 1. Macroeconomic trends of services: value-added in banks, insurance, real estate and other business services2 (%).

Note: 1) Data period: 1995-latest year available. 2) Industry classification: International Standard Industrial Classification of All Economic Activities Rev.3.1 (ISIC Rev.3.1). Financial intermediation (J) includes 65-Financial intermediation, except insurance and pension funding, 66Insurance and pension funding, except compulsory social security, and 67-Activities auxiliary to financial intermediation. Real estate, renting and business activities (K) corresponds to 70-Real estate activities, 71-Renting of machinery and equipment without operator and of personal and household goods, 72-Computer and related activities, 73-Research and development, and 74-Other business activities. 3) Unit: Percentage of total value added. Source: OECD Factbook -Economic, Environmental and Social Statistics (2009). 2

For details on industry classification, please also refer to North American Industry Classification System (NAICS) at http://www.census.gov/eos/www/naics/, UK Standard Industrial Classification of Economic Activities 2007 at http://www.statistics.gov.uk/statbase/Product.asp?vlnk=14012, and Statistics Bureau, Ministry of Internal Affairs and Communication of Japan at http://www.stat.go.jp/english/data/service/2004/bunrui.htm.

For further information on pricing of services, please refer to International Labor Organization (ILO) at http://www.imf.org/external/np/sta/tegppi/index.htm, and transfer pricing for services at Japan‘s National Tax Agency. See http://www.nta.go.jp/foreign_language/08.pdf. Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

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Service Entities in Open-Closed Innovation 35 Australia

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Figure 2. Macroeconomic trends of services: value added in government, health, education and other personal services (%). Note: 1) Data period: 1995-latest year available. 2) Industry classification: International Standard Industrial Classification of All Economic Activities Rev.3.1 (ISIC Rev.3.1). Public administration and defense; compulsory social security (L), Education (M), Health and social work (N), and Other community, social and personal service activities (O) are included. 3) Unit: Percentage of total value added Source: OECD Factbook -Economic, Environmental and Social Statistics (2009) 35 Australia 33

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Figure 3. Macroeconomic trends of services: value added in transport, trade, hotels and restaurants (%). Note: 1) Data period: 1995-latest year available. 2) Industry classification: International Standard Industrial Classification of All Economic Activities Rev.3.1 (ISIC Rev.3.1). Wholesale and retail trade; repair of motor vehicles, motorcycles and personal and household goods (G), Hotels and restaurants (H), and Transport, storage and communications (I) are included. 3) Unit: Percentage of total value added Source: OECD Factbook -Economic, Environmental and Social Statistics (2009)

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To see the relationships of the service sector with macro economy in further detail from structural aspects, historical data are examined starting from 1970 to the latest years available 3 , 4 . The relationships of the service sector with the macro indicators below are investigated in terms of gross national income per capita, exports of services, imports of services, shares of information and communication technologies (ICT)5, investment in nonresidential gross fixed capital formation, Multi-factor productivity (MFP), investment in knowledge, tertiary attainment for age group 25-64, and participation of micro, small, and medium-sized enterprises (MSMEs)6 in the economy as a number of companies. The growth of banks, insurance, real estate and other business services is positively related to all the indicators above except for MFP. With investment in knowledge, it is weakly related in a positive direction. The growth of government, health, education and other personal services is also related positively with the macro indicators in a similar way with the previous category of services. It is suggested that the degree of correlation is weaker than the previous category. In addition, the correlation with MFP is not observed. Please note that the relatively stronger correlations with investment into knowledge and tertiary attainment are caused due to the output of education included in this category. The macroeconomic indicators such as output quantity, price deflator, productivity, and capital accumulation must exhibit significant variations across sectors (OECD, 1996). As 3

See Kinoshita (2009a) for collected figures. Data are examined based on value added in services as percentage of total value added. Countries are Australia, Austria, Canada, Denmark, Finland, France, Germany, Italy, Ireland, Japan, Netherlands, New Zealand, Portugal, Spain, Sweden, Switzerland, United Kingdom, and United States. Data period is 1970-2006 or latest year available for service, and 1997-2006 or latest year available for micro, small, and medium-sized enterprises (MSMEs). Industry classification is according to International Standard Industrial Classification of All Economic Activities Rev.3.1 (ISIC Rev.3.1). The following comparable data are observed: Gross national income per capita (USD, current prices and PPPs); Exports of services (USD bil); Imports of services (USD bil); Shares of information and communication technologies (ICT) investment in non-residential gross fixed capital formation (as a percentage of total non-residential gross fixed capital formation, total economy); Multifactor productivity (annual growth in percentage); Investment in knowledge (as a percentage of GDP); Tertiary attainment for age group 25-64 (as a percentage of the population of that age group); and Participation of micro, small, and medium-sized enterprises (MSMEs) in the economy as a number of companies. Source: OECD (2005c, 2009), International Finance Corporation (IFC) (2007), Australian Bureau of Statistics, Austrian Institute for SME Research, National Institute of Statistics and Economic Studies of France, Federal Statistics Office of Germany , Industry Canada (2005), International Finance Corporation and State Secretariat for Economic Affairs of Switzerland, Small Business Forum in Ireland (2005), Japan Statistics Bureau, New Zealand Ministry of Economic Development, Statistics Denmark, Statistics Netherlands, Statistics Sweden, U.S. Census Bureau, United Kingdom Small Business Service, and United Nations Economic Commission for Europe . 5 The OECD definition of the ICT sector is found at http://www.oecd.org/dataoecd/34/37/2771153.pdf. It includes the following 4-digit classes: Insulated wire cable (3130); Instruments and appliances for measuring, checking, testing, navigating and other purposes except industrial process equipment (3312); Industrial process equipment (3313); Wholesale of machinery, equipment and supplies (part only, where possible) (5150); Telecommunications (6420); Renting of office machinery and equipment (7123) as well as the following 2digit industries: Office, accounting and computing machinery (30); Manufacture of radio, television and communication equipment and apparatus (32); and Computer and related activities (72).

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Small and medium-sized enterprises (SMEs) are firms which employ fewer than a given number of employees. This number varies across countries, in which the most frequent upper limit is 250 employees, such as in the European Union. Some countries set the limit to 200 employees, while the United States considers SMEs to include firms with fewer than 500 employees. Small firms are generally those with fewer than 50 employees, while micro-enterprises have at most 10, or in some cases 5, workers. Financial assets are also used to define SMEs although in this chapter, these size classes are aligned with National Size Class (NSC 1-5), which corresponds to 1-9 (NSC1), 10-19 (NSC2), 20-99 (NSC3), 100-499 (NSC4), and 500+(NSC5) (OECD, 2002, 2005c, 2008b).

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previously mentioned, input deflators and the unit of measurement for service output are still not defined in a consistent manner (Bosworth & Triplett, 2007; Corrado, Hulten, & Sichel, 2009; Triplett & Bosworth, 2004). However, common and persistent trends in the service sector of the three economies are: (i) The share of ICT-related services and financial services compose a large share of the service sector. (ii) The fastest growing sector, however, is business-related services, which are primarily known as knowledge-intensive services (KIS). (iii) Healthcare, education, and public sectors (including defense) show heterogeneous trends in terms of factors for growth. The following section deals with another common and persistent trend in the service sector across major OECD countries, which is the relationship between firm size and the turnover of service sectors. There are several important points that are clarified in these data. Firstly, a part of service sectors contributes to the growth of output as well as the volume of trade both in export and import. Trade volume is growing particularly in European countries (especially within Europe) and Asian & Pacific countries (World Trade Organization, 2009). Secondly, the investment into ICT and educational level seem to be correlated to the growth rate of the service sector. The positive correlations of service sectors with total output and trade in addition to the investment into ICT and educational attainment seem consistent for the entire service sector. In contrast, MFP does not correlate with any of these three service categories. Data do not show the correlation between the service sector and MFP even at a country level. It is suggestive that the issue of MFP may be investigated with care for each service sector potentially as an issue with input deflators and statistical methodologies (Amiti & Wei, 2005; A. B. Atkinson, 2009; Diewert, Greenlees, & Hulten, 2009; Dunham, 2003; Jensen, Kletzer, Bernstein, & Feenstra, 2005; Triplett & Bosworth, 2004). The other important point is the participation of SMEs in the service sector. It is clear that the existence of SMEs is correlated with the trend of service sector well. Data on SMEs at a country level show that the growth of service sector is positively related with the number of SMEs in the economy in all seventeen countries in analysis except for Japan.

THE RELATIONSHIP OF FIRM SIZE AND PRODUCTIVITY Partly as the previous observation has shown, the participation of SMEs in the service sector increases as the service sector grows in the economy. The growth rates of real valueadded in services have been growing both in developed and developing countries. Meanwhile, how can we explain the stagnation of multi-factor productivity (MFP) growth that is commonly seen throughout the service sector in advanced countries? Is it possible to assume that the growth of the service sector can be achieved without a strong growth of productivity, meaning that primary growth factors are the input into capital and labor? This section is going to review this point by using data on the U.S., U.K., and Japan regarding turnover by sector and size of firm. It is also going to argue about the contradictory trend that is seen in the Japanese economy only, which is the negative correlation between the participation of SMEs and the growth of the service sector.

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Figure 4. Real value-added in services: Growth rates in 1995, 2000, and 2005. Source: OECD (2009).

The relationship of firm size and productivity has been a proved concept in a number of empirical studies in the past, such as Bensanko and Doraszelski (2004), Pagano and Schivardi (2003), Shefer and Frenkel (2005), and Veugelers and Cassiman (2005). Most recently, Eaton, Kortum, and Kramarz (2009) have proved that the number of firms and the profit of an industry do correlate, showing a Pareto distribution. These findings are based on the hypothesis that the firm size variation can be used as a proxy for the productivity distribution. This distribution is normally described as in Figure 5. These previous researches have been proved, with an occasional counterfactual finding, for example, Career and Thurik (1998, 2000), by using data in manufacturing sectors. Krugman (1989), Melitz (2003), Ottaviano and Melitz (2008), and Chaney (2008) discussed the issue of elasticity of substitution in terms of trade margin. Krugman (1989)

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argued that when the elasticity is high, the margin of export becomes high. On the other hand, Chaney (2008) discusses that a decreasing cost will increase the impact on trade flow when the elasticity of substitution is low and firms are heterogeneous, that scarcely substitutable products will be replaced less in the market, and that productive firms will become more sensitive to a change in fixed cost when market is open. These theoretical and empirical findings are important in that the relationship between the elasticity of substitution and firm‘s market share is expressed. These arguments are related to geographical elements, heterogeneity of products, and elasticity of substitution. According to the data on U.S., U.K. and Japanese economy in terms of turnover distribution by firm size, the curve shifts in various ways in the service sector. This brings us a question and one hypothesis that the service sector grows because of the profit structure variations by firm size even if the service sector maintains the same productivity level. Behind these variations, it is important to take a look at the trends of capital, labor, and productivity in each country and each service sector so that we can identify structural factors leading to these situations.

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Returns

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Figure 5. Distribution of returns and the number of firms (1) – Manufacturing (left) and Service (right).

According to Figure 8 on U.S. economy, the distribution of turnover is gradually shifted to larger firms, and the gap between smaller firms and larger firms are becoming large in manufacturing. The trend in services is different in that the turnover per employee is far larger than that of manufacturing and smaller firms are gaining more profits per employee than manufacturing. At the same time, the bottom of the curves in manufacturing shows that the turnover for smaller firms has not increased over the years. As for services, the curve has shifted upward and downward. Please refer to Figure 7 and Figure 8 for the trend in U.K. and Japan.

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Figure 6. Turnover per employee by size class (US): Manufacturing (Left) and Services (Right).

Note: 1) Unit: Turnover (USD mil) divided by number of employees. 2) International Standard of Industrial Classifications, Rev. 3, 4-digit level. 3) Years covered: 1991-1997, and 2002 (1997 and 2002 are benchmark years). 4) National Size Class (NSC 1-5) corresponds to 1-9 employees (NSC1), 10-19 (NSC2), 20-99 (NSC3), 100-499 (NSC4), and 500+ (NSC5) respectively. 5) Data on turnover by enterprise size class is taken from OECD instead. 7 Source: OECD databases including Structural and Demographic Business Statistics (SDBS) (2008e) , Statistics on Enterprises by Size Class (SEC), Structural Statistics for Industry and Services 8 9 (SSIS) , Business Statistics by Size Class (BSC), and Business Demography (BD) . 7

The first provides information on a number of economic variables broken down by 4-digit International Standard of Industrial Classification Revision 3 (ISIC Rev. 3) industries and is referred to as the Structural Statistics on Industry and Services database (SSIS). The second provides the same industry level of information as the SSIS database but this is also broken down by size classes of businesses, and is referred to as the Business Statistics by Size Class database (BSC) database at http://puck.sourceoecd.org/vl=286302/cl=26/nw=1/rpsv/~6678/ v2006n14/s1/p1l

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Figure 7. Turnover per employee by size class (UK): Manufacturing (Left) and Services (Right). 10

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Note: 1) Unit: Turnover (£ mil) divided by number of employees . 2) UK Standard Industrial Classification of Economic Activities (SIC) 2003/2007. 3) National Size Class (NSC 1-5) is employed. 12 Source: Small and Medium-sized Enterprise (SME) Statistics for the UK and regions (1994-2007) . 8

The SSIS database contains information relating to the economic activity, including employment, of industries at a very detailed level (International Standard of Industrial Classifications, Revision 3, 4-digit level). Variables include: turnover, value-added, investment, wages and salaries, employees and number of enterprises to name but a few. Monetary variables are typically, although not always, presented in millions of national currency, and employment variables in numbers of persons employed; hours worked are typically expressed in thousands, and number of enterprises/establishments in units. See http://lysander.sourceoecd.org/vl= 936377/cl=31/nw=1/rpsv/ ~4021/v165n1/s7/p1 9 The BD database contains information relating to business births (often referred to as business entries); business deaths (often referred to as business exits) and business survival rates. These variables are expressed as ratios and percentages, when multiplied by 100. 10

Turnover is defined as the value of sales, work done and services rendered. It excludes VAT. Turnover data for registered enterprises is obtained from the Inter-Departmental Business Register (IDBR). 11 Employment refers to the number of employees plus the number of self-employed people that run the enterprise. Both full-time and part-time employees are counted. Each part-time employee will be counted as one whole employee associated with the enterprise. Therefore, if someone has two part-time jobs, then the person is double counted.

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Figure 8. Turnover per employee by size class (Japan): Manufacturing (Left) and Services (Right).

Note: 1) Data period: 2004-2008. 2) Industry classification: Japan Standard Industrial Classification: Construction (E), Manufacturing (F), Information and telecommunication (H), Transportation (I), Wholesale and Retail (I), Real estate (L), Restaurant and lodging (M), and Services (Q). 3) Firm size classes: 1, 2-5, 6-20, 21-50, and +51. 4) Turnover (unit): Million yen. Source: Survey of SMEs business activity, The Small and Medium Enterprise Agency of Japan (20042008)

According to KLEMS data (National Institute for Economic and Social Research & Groningen Growth and Development Centre, 1970-2008)13, the contribution of IT stock to 12 13

See http://stats.berr.gov.uk/ed/sme/smestats2008-meth.pdf for methodology.

KLEMS database has information on capital input and its contribution to value added and gross output. Stock is divided into Computing equipment (IT), Communications equipment, Software, Transport Equipment, Other Machinery and Equipment, Total Non-residential investment, Residential structures, Other assets, ICT assets, Non-ICT assets, and All assets. Total manufacturing (D) including 'food, beverages and tabacco,' 'textiles,' 'leather and footwear,' 'wood and cork,' 'chemical,' 'rubber, plastics and fuel,' 'other non-metallic mineral,' 'machinery,' 'transport equipment,' and 'recycling.' The service sector is divided into Wholesale and retail trade (G), Hotels and restaurants (H), Transport and storage and

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value-added growth is very strong in U.S. financial sector, with a peak in 1998. In addition, the investment into software is large in this sector compared to the other service sectors. The contribution of non-IT stock is also seen with a peak in 1998, which goes down afterwards. In this sector, labor composition and labor hours by high skill workers also seem to contribute to the growth of the sector. In short, IT stock and human resources have contributed to the growth of both value added and gross output. Smaller firms are earning higher turnover per employee. In this sector, the contribution of non-IT stock to sectoral growth has been substantially strong. Moreover, the labor composition by high skill workers between ages 3049 has supported the growth of this sector. This labor category contributes to the growth of ‗Education‘ sector as well. As for ‗Education‘ and ‗Health and restaurants,‘ the contribution of IT stock seems to be weak. In U.K., labor composition and hours worked by high skill workers seem to be influencing the trend more than the other sectors. In addition, the stock of IT and non-IT both contribute to the growth of the sector substantially. The composition of high skill workers is high in ‗Education‘ and ‗Real estate, renting and business activities‘ while medium skill workers are dominant in ‗Health and social work.‘ Looking at KLEMS data from the 1980s through 2008, the contribution of IT stock peaked in 2001, which was slightly later than the peak of U.S. (1998) and U.K. (1999-2000). The growth rate of IT stock is far lower than U.S. and U.K. service sector. As for the stock of ICT, Japan has started accumulating from early 1980s ahead of U.S. and U.K. A distinct characteristic of Japanese service sector is the decrease of contribution of hours worked to value-added growth, which can be seen in all service sectors except for ‗Health.‘ High skill female workers compose a large share in ‗Education.‘ Factors that are common in all three countries are as follows. (i) There is a decrease in the input of short skill workers in all service sectors. (ii) There is a substantial increase in the input of high skill female workers between ages 30-49. (iii) Multi-factor productivity (MFP) has not grown in any of these countries. The fluctuation gap of productivity is narrowing down in U.S. and U.K., which means that the factor for output growth in the service sector has been shifting to the other factors. (iv) The stock of IT and the hours worked by high skilled workers are substantially increasing in ‗Financial intermediaries‘ and ‗business activities.‘ (v) The stock of communications equipment and other machinery equipment is becoming larger in ‗Real estate, renting and business activities‘ compared to the other sectors. Besides, government regulations on pricing and firm size on certain service sectors must be considered carefully, such as Japan‘s large-scale retail store law 14 that used to regulate maximum floor space for retail and wholesale stores.

14

communication (I), Finance, intermediation (J), Real estate, renting and business activities (K), Public admin and defense (L), Education (M), Health and social work (N), and Other community, social and personal services (O) (Timmer, et al., 2007). Formally known as ‗Act on the Measures by Large-Scale Retail Stores for Preservation of Living Environment.‘ Please refer to http://www.japaneselawtranslation.go.jp/law/detail_main?vm=&id=1852 for more detail.

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THE ROLE OF R&D IN SERVICES

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The previous section deals with the relationship between output growth and firm size. Another important aspect is the perspective of innovation. Innovation fosters competition and brings new goods and services. As for primary sources of innovation, there are numerous literatures explaining the relationship of firm growth, investment behaviors, and productivity as innovation will improve consumer‘s welfare and social welfare. The role and impact of R&D have been discussed in relation to innovation in a number of past researches, such as Coe et al. (1995; 2009), Cassiman and Veugelers (2002; 2005) and Melitz (2003) in terms of cooperation and knowledge spillover, the stock of knowledge and elasticity of substitution, the effect of deregulation and trade liberalization, and the impact on productivity. The appropriate quantification of service value and the measurement of its effect to economic growth are important questions in this regard. As for the value of service, the service sector is becoming more technology- and knowledge-intensive as we see particularly in ICT-related services and financial services. It is an on-going problem to measure the impact of these technologies and knowledge capital (tangibles and intangibles) used to provide such services. The definition of R&D is presented in Frascati Manual (OECD, 1980): ‗Research and experimental development (R&D) comprise creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society, and the use of this stock of knowledge to devise new applications‘ (Djellal, et al., 2003). Furthermore, the flow of knowledge is an important perspective with regard to the innovation in services. OECD says that it is less clear if the production, delivery and consumption of many services can occur at the same time (OECD, 1992, 2005b). Therefore, the innovation in services is distinguished by the following criteria: If the innovation involves new or significantly improved characteristics of the service offered to customers, it is a product innovation. If the innovation involves new or significantly improved methods, equipment and/or skills used to perform the service, it is a process innovation. If the innovation involves significant improvements in both the characteristics of the service offered and in the methods, equipment and/or skills used to perform the service, it is both a product and a process innovation. The government of the United Kingdom observed that service sectors draw heavily on suppliers and external partners for seeking expertise (Miles, 2006). The government takes the service sector growth led by trade and inter-regional businesses as a vital factor for current and future economic growth. This strategic direction is related to the assumption that the degree of knowledge expertise and its heterogeneity are vital factors for gaining competitiveness in the global market and the acquisition of knowledge is important for the promotion of service innovation both for large and small firms. Regarding these perspectives, EU has published a series of reports on this subject (European Commission, 2008; Jari; Kuusisto, 2008; Jari Kuusisto, 2008; Kuusisto & Viljamaa, 2006). To achieve these goals regarding the innovation in service and enhanced value-added services, the following items should be paid attention:

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Education and training of personnel in the social sciences and the humanities in universities and special institutions of higher and post-secondary education. Innovation activities defined as all those scientific, technical, commercial and financial steps necessary for the implementation of new or improved products or services and their commercial use. Other industrial activities including acquisition of technology, other capital acquisition, and production start-up and marketing for new and improved products. Production and related technical activities including distribution of goods and services and the various technical services, together with activities using social science disciplines, such as market research. Typical R&D activities in the service sector are summarized in Table 1. There are several sources, which explain the characteristics of innovation in service, for example, Barras (1986), Jankowski (2001), Miles (2005, 2007), and Hipp and Grupp (2005). The value of R&D investment can be counted in terms of return in market value (Hall, 2007; Hall, Jaffe, & Trajtenberg, 2001; Hall, Thoma, & Torrisi, 2007). However, there are different possible interpretations in productivity growth among firms if structural aspects are properly controlled, such as physical capital, human capital, firm size, and type of output (Lööf & Heshmati, 2002) as well as government regulations. It is suggested that R&D affects knowledge stock and flow, in a different way from those of manufacturing, leading to an increase in heterogeneity and/or the degree of expertise. As for the business size dimension, it is suggested that R&D investment is propensity to firm size (to the first approximation) while firm growth is independent of firm size in accordance with Gibrat‘s law (Gibrat, 1931). These propositions are discussed, for example, in Griliches et al. (Griliches, 1994; Klette & Griliches, 2000), Bayoumi, Coe, and Helpman (1999), Mulkay, Hall and Mairesse (2001), Pagano and Schivardi (2003), and Klette and Kortum (2004). Cohen and Klepper (1996) also describe typical characteristics with regard to the investment size of R&D by enterprises. The first fact is that the likelihood for firms to invest into R&D activities increases with firm size. The second stylized notion is that the likelihood approaches one as the firm size becomes larger. However, as Jankowski and others mention, R&D in services is likely to be performed by firms with less employees and smaller R&D budgets compared to manufacturing (European Commission, 2008; Jankowski, 2001; Miles, 2007) because project-based R&D activities engaging part-time personnel are seen in the service sector more than manufacturing (European Commission, 2008). In addition, a comprehensive evaluation study (Georghiou, 2003) suggests that use of services is highest in technology-oriented innovative small firms. There seem to be several differences from the conventional stylized facts regarding the relationship of firm size, innovation, R&D, and firm growth as we look at some counterfactuals from the behaviors of the service sector.

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Table 1. Types of R&D in Services

Source: Bryson, Daniels, and Warf (2004) and Kuusisto (2008)

In U.S., $1,970 mil was invested in 1990 in R&D with regard to professional, scientific, and technical services (which corresponds to North American Industry Classification System (NAICS) sector 54)15. The amount increased to $8,167 mil in 2004, out of which 14.1% is purchased R&D. According to Eurostat, 43% of Science and Technology jobs in EU 27 countries are in the service sector (Eurostat, 2007). Employment in knowledge-intensive

15

The amount of investment consists of NAICS 5417 (Scientific R&D services). Please refer to satellite account at Bureau of Economic Analysis to be found at http://www.bea.gov/scb/pdf/2007/10%20 October/1007_rd_tables.pdf.

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service sectors stands approximately 30% across EU countries in 2008 (Eurostat, 2008)16. R&D in services has increased in line with the growth trend of the service sector, which started in different timeframes in U.S., U.K., and Japan. Although the level of R&D investment into services is still lower than those of manufacturing sectors, the growth rate of R&D in services in general has outpaced that of the entire service sector. Although the innovation in service should be identified, would it have caused any negative externality to sectoral growth? For instance, when the heterogeneity in information is low, then, the heterogeneity of knowledge and products are usually low. Then, for instance, even less productive firms can enter into market with a low fixed cost to make firms choose to transit from an old technology to new technology to adopt innovation (Helpman, 2006). When the heterogeneity is high, the fixed cost tends to become also high. In the latter case, the catch-up speed to the lead technology should be slow with a given absorptive capacity equipped with a firm. It is supposed that if the heterogeneity should be high in today‘s networked service economy, even smaller firms must invest more in knowledge (i.e. R&D and skill development) to afford the heterogeneity. In such a condition, IT stock and skilled workers have promoted the growth of certain sectors in services. For the other sectors, which the stock of IT and labor have failed to contribute to the output growth, it is important to clarify which factor has generated output and value added, either through geographical locality, elasticity of substitution, or heterogeneity of knowledge. For this purpose, it is necessary to discuss the relationship of these factors with the introduction of IT and knowledge creation activities. As previously mentioned, service sectors tend to rely on external sources for expertise knowledge, and SMEs are usually less capable of engaging in R&D than large enterprises although the ratio of R&D spending by smaller firms is larger than that of manufacturing (OECD, 2006, 2008a; Wolfl, 2005). It is important to consider what factors have contributed to lower the cost of adopting heterogeneous knowledge and/or technology, and thus explain a part of dispersed productivity growth.

THE FUNCTION OF KNOWLEDGE-INTENSIVE SERVICES (KIS) One of the areas that have been focused recently is the consideration on knowledgeintensive services (KIS) in economic growth models. OECD has published a report on KIS in 2006 (OECD, 2006). According to the report, KIS are defined as ‗the production or integration of service activities, undertaken by firms and public sectors in the context of manufacturing or services, in combination with manufactured outputs or as stand-alone services‘ (p.7) 17 , 18 . KIS include R&D, management consulting, information and 16 Last updated Mar 9, 2010. See http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1& language=en&pcode=tsc00012 17 KIS includes the following sectors according to Classification of Economic Activities in the European Community (NACE) and International Standard Industrial Classification of all Economic Activities (ISIC): Real estate activities (NACE 70.x/ISIC 70xx), Renting of machinery and equipment without operator and of personal and household goods (NACE 71.x/ISIC 71xx), Computer and related activities (NACE 72.x/ISIC 72xx i.e. Hardware consultancy, Software consultancy and supply, Data processing, and Database activities), Research and development (NACE 73.x/ISIC 73xx i.e. R&D in natural sciences, engineering, social sciences, and humanities), and Other business activities (NACE 74.x/ISIC 74xx i.e. Legal, accounting, book-keeping and auditing activities; tax consultancy; market research and public opinion polling; business and management

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communications services, human resource management and employment services, legal services (including those related to intellectual property rights), accounting, financing, and marketing-related service activities. KIS play a role to strengthen knowledge production activities not only in service sectors but also in manufacturing. KIS are a type of services to be consumed as final output but also influence the performance of other organizations and value chains beyond sectors by being consumed as intermediaries. Finland has transformed its economy into service-dominated market, by focusing on KIS, business services, and trade (Finnish Funding Agency for Technology and Innovation (TeKes), 2007a, 2007c). KIS influence the business performance of organizations and value chains as they contribute to some types of technological and service innovation directly and form a link of technologies and knowledge beyond sectors (OECD, 2006). These services are, as they are referred to, knowledge-intensive. Some of these services, such as financial services and information services, are also technology intensive. In other words, they are relatively labor intensive, which are generated and delivered by employees with high level of education and specialized expertise knowledge and skills without using production equipment or other types of plant-specific tangible capital. The knowledge capital pertaining to such workers can be firm-specific intangibles. Thus, it is considered that KIS can be an important contributor for economic growth as one of the fastest growing sectors among the other service sectors. According to OECD (2006), KIS include several functions in relation to R&D in services: Renewal service activities – i.e. R&D services and management consulting – are most closely related to innovation Routine services – i.e. accounting – contribute to the improvement, maintenance and management of various subsystems within organizations Compliance services – i.e. auditing and some legal services – help organizations to work within the legal framework and various regulatory regimes Network services – i.e. informal personal networks and professional networks – facilitate communication, knowledge exchange and flexible resource allocation Kuusisto (European Commission, 2008) says that as such KIS focuses on ‗service functions and activities‘ instead of the actors, and that activity perspective is appropriate from policy point of view because it deals with the flow of knowledge within and between the consultancy; holdings, Architectural and engineering activities and related technical consultancy, Technical testing and analysis, Advertising, and Labour recruitment and provision of personnel). According to Miles et al. (1995), traditional professional services, which are liable to be intensive users of new technology, include services i.e. marketing, training, design, a part of financial services, office services, building services, management consultancy, accounting and bookkeeping, legal services, and environmental services. New technology-based KIS, then, are services i.e. computer networks/telematics, telecommunications, software, training in new technologies, design involving new technologies, office services involving new office equipment, building services, management consultancy, technical engineering, environmental services involving new technology, and R&D consultancy. In contrast, non-KIS services include services i.e. health and medical services, post, transport and distribution, consumer financial and real estate services, education services, broadcast and other mass media, public administration, repair/maintenance, retail and wholesale, social welfare services, hospitality and catering, leisure and tourism, personal consumer services and entertainment. 18 Miles (2005) also says that KIS are characterized by the capabilities of providing new types of knowledge input through technologies, regulations and social change, and thus being increasingly internationalized and outsourced as tradable services.

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firms, value chains, clusters and regions. The report also says that the division of labor and the volume of knowledge are major drivers of KIS. These knowledge-intensive, or laborintensive, services generated partly through R&D activities, which are enhanced and innovated furthermore by the use of IT. The most of R&D in services is accounted for business services, post and telecommunications, and computer related services. R&D in IT services has been a public focus in a number of countries. For instance, Sweden has a program called Verket Foer Innovations System (VINNOVA)19 for developing IT platform to facilitate infrastructure for knowledge management in services. VINNOVA has also programs for small businesses that carry on R&D. This program encompasses: IT support services, services supporting new value chains and knowledge based platform, e-services in public administration, and IT in homecare and elderly care. In some cases, a wide range of services need to be aligned with new generations of IT, and biotechnology (European Commission, 2008). As such, IT is considered as a tool for creating new services. A variety of information technologies are being developed to implement innovative services so that the needs of today‘s economy will be met. Ubiquitous network encompasses web, overlay network, sensor networks, and grid computing with information filtering and search algorithms. There is a collaborative information network such as Cancer Biomedical Informatics Grid 20 , which promotes community-based research and communication. The practice and management of R&D is refined where a good match of demand and solution is made through web-based database of solution providers. IT services have had an important role regarding R&D process and organization. As previously mentioned, R&D activities in services are performed on a project basis in many cases. IT can be used to organize and facilitate R&D undertaken by multidisciplinary business units, teams, and firms. In this sense, skilled staff has an essential role to play for coordinating R&D in services enhanced by the introduction of IT. Publicly-funded R&D is likely to focus on the implementation and improvement of IT-related business environments with the support of educational training for IT skills. IT are used for the support of SMEs as a part of government policy measures. Some European governments support SMEs by implementing service-oriented public infrastructure (Borresen, 2007; Brun & Lanng, 2006; Stauning, 2007). The public infrastructure for SMEs can be designed for lowering barriers to entry to promote their participation in domestic and global market, optimizing business operation and reducing marginal cost and administration costs through the shared infrastructure. The other desired functionalities are web-based directory of firms for improved accountability and transparency, promoting peer-to-peer payment mechanisms, activity-based service charge for meeting the needs of customized services, and enhanced interaction between vendor and user as well as external professionals, such as KIS, for harvesting long-tail of service business and creating new services. These kinds of collaborative and innovative activities contribute to the growth of service sectors, which is common as well as distinctive from manufacturing. IT have a huge impact on innovativeness, adaptability, and quality of service development (NESTA Policy and Research Unit, 2008). Atkinson and Castro (2008) describe a list of benefits, which IT can bring. Among those is the benefit for developing countries. The World Economic Prospect (World Bank, 2008, 2009) articulate that the recent financial turmoil is bringing substantial 19

20

See http://www.vinnova.se/en/ See https://cabig.nci.nih.gov/

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uncertainty to developing countries due to swings of food and fuel prices, and that demand for commodities is not expected to outstrip supply over the long run. These new services offer channels for financing and commercialization, and access to education, healthcare, and expertise knowledge for SMEs and people who did not have access to any of those before. To continue to drive such technological innovation and, hence, promote the innovation in service, we may need to focus on the important, dynamic role of SMEs, and facilitate the coevolutionary process of IT with other technological fields i.e. biotechnology (European Commission, 2008). In today‘s socio-economic context, innovation in IT holds three-faced importance in relation to services: networking of knowledge and expertise, the promotion of business and trade, and a new solution for the development of global economy through service-oriented infrastructure (Atkinson & Castro, 2008). For the growth of service economy, Freeman and Soete (2007) express a surprising comment. ‗Frontiers and characteristics that were important last century may well no longer be so relevant today and indeed may even be positively misleading…GDP, probably the most widely-used economic indicator in the world, are beset with problems in their measurement, especially now that services account for between 60 to 80 per cent of total output in most developed countries‘. In response to such a circumstance, a number of countries and research institutions are challenging a task of establishing innovation performance measurement scheme and policy assessment methodology. In summary, the growth of services in relation to R&D activities and innovation, R&D activities in services are coordinated and facilitated with the utilization of KIS and IT, giving an impact on knowledge expertise in particular, which can be considered as one of determinants for innovation. Taking this connection of technological and knowledge innovation into consideration, the following section discusses Cobb-Douglas functions and modifies so that it would be useful for further statistical and empirical research in the service sector and emerging technologies.

PRODUCTIVITY AND INNOVATION IN SERVICE SECTORS Theories on firm size, R&D, and innovation Innovation has been measured generally by productivity (process innovation) and product characteristics (product innovation) in past researches. Suppose innovation is occurring in service sectors, we must be able to identify any improvement of products in terms of characteristics, and/or an addition of new characteristics (Ohashi, 2007). Two major elements which are seen commonly across service sectors are that service sectors draw heavily on suppliers and external sources for expertise (NESTA Policy and Research Unit, 2008), and that the size of firms are likely to be smaller than manufacturing sectors (OECD, 2008a). One possible hypothesis to explain these two conditions is that the relation between firm size and productivity is changing in service sectors with a given increase in the heterogeneity in firms and products. This situation is presumably related to the elasticity of substitution in terms of knowledge expertise.

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These phenomena can be understood partly from the nature of networks. When large enterprises had emerged mainly in manufacturing sectors, many individuals were working within large organizations in similar environments. In such a case, generally the multiplicity of individuals‘ information was said to be reduced. However, after a certain period of time while organizations had faced various situations, the heterogeneity of information pertaining to individuals increased. In addition, as organizations formed connections with each other, the context that gives meaning to the information became more complicated, this caused the multiplicity and heterogeneity of information to increase due to the existence of networks at both enterprise and individual levels. Meanwhile, firms are challenged to develop knowledge to afford the multiplicity and heterogeneity, and achieve profitability. Therefore, from the viewpoint of network economy, the innovation in service can be captured in the relationship of firm size and turnover given a certain level of heterogeneity in knowledge (Kinoshita, 2009b). In the context of service economy, it is important to review past literatures showing the relationship among firm size, profitability, and investment into R&D from the viewpoints of output growth, elasticity of knowledge, other types of co-investments into knowledge (i.e. software and education) to generate or facilitate the generation of knowledge, and productivity improvement in relation to IT infrastructures. It is also suggested that pricing and regulations on service sectors, conversion from flow to stock accounting of R&D investment, and impact of cash flow on R&D investment (particularly from the perspectives of SMEs) should be considered. In the following section, past literatures are going to be reviewed to clarify the focal points of analysis in panel data models that are going to be discussed and identified in later sections. Theoretical findings are reflected to the panel data models so that the service sectors are analyzed using data obtained from financial and statistical data on a condition that is closer to real situations and from the perspectives of service innovation. The details of financial and statistical data are outlined in this section. As for the relationship among firm size, R&D investment, and output growth and/or innovation, Mueller (1967) and Mansfield (1968) found in earlier days that R&D investment is related to firm size positively. Dosi (1988) was concerned with the determinants and effects of innovative activities. His paper aims to identify (a) characteristics of innovative process, (b) factors that are positively or negatively facilitate the generation of new processes and new products, and (c) processes to determine the selection of innovations and their effects on industrial structures. The selection depends on the nature of bridging institutions and own institutional factors. There are formal and informal diffusion and externalities regarding innovative activities, which are associated with (a) specific infrastructures, (b) scale economies, (c) complementary technologies, and (d) technical standards. Dosi observes that appropriability of firms is related to (a) patents, (b) secrecy, (c) lead times, (d) costs and time required for duplication, (e) learning-curve effects, and (f) superior sales and service efforts. Dosi (1988) said that industrial performance is the results of innovative learning by single firms (together with partners and public institutions), diffusion of innovative knowledge and products as well as processes, and selection among firms. As for patenting, Scherer (1983), Pakes and Griliches (1980) and Schwalbach and Zimmermann (1991) revealed that patents are also proportional to firm size. As for the adoption of technology at the frontier, especially in manufacturing, Dunne (1994) found a similar and positive relationship with firm size. Acs and Audretsch (1988) also argued by using regression models that innovation is positively related to R&D, skilled labor and the ratio of large firms in industries i.e. electronic

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computing equipment, process control instruments, radio and TV communication equipment, office machinery, and aircraft. Koeller (1995) used data on the share of R&D investment in the amount of sales in 1977 and showed that innovation improved substantially by high R&D intensity especially for small firms. Cohen and Klepper (1996) investigated the impact of R&D in process and product innovation and found that larger firms in general have an advantage in R&D because they are able to apply the outcome of R&D and spread the costs. Their findings assume that process innovation lowers average costs of production, and product innovation improves product features, and thus, the price that consumers are willing to pay can be increased. Parity is observed for new product innovations across firm size, which is also argued by Acs and Audretsch (1988) and Audretsch and Feldman (1996). In this regard, Pagano and Schivardi (2003) leave the same observation based on their analysis using Eurostat data in 1998. They found from regression analysis that R&D intensity is positively affecting the effect of average firm size in the industry on growth. Fishman and Rob (1999) investigated U.S. manufacturing and retail sectors. Profits of firms become higher if the cost at the beginning of a period is higher than the cost at the end of the period. They categorize firms into classes according to the customers with a certain level of search cost, and assume that R&D expenditures and prices on the customer base rise only firms go across the classes. R&D investment, then, depends on firm‘s cost cutting efforts in relation to the cost incurred according to the customer base, and so, it is suggested that larger firms invest more into R&D because they can spread the costs over their large size of customer base. This situation leads to a situation where large firms maintain lower marginal costs and prices on average, which generates higher profits. Klette and Griliches (2000) challendged several stylized facts on R&D and firm size, such as the following: (1) R&D intensities are independent of sales. (2) Firm growth is independent of size. (3) The size distibution of firms is highly skewed with persistent differences in firm sizes (2000). Klett and Kortum (2004) summarized several stylized facts about firm size, productivity and R&D, which goes in the same line with Klette and Griliches (2000). For example, productivity and R&D across firms are positively related, whereas productivity growth is not strongly related to firm‘s R&D investment. Larger firms are likely to invest into R&D more than small firms, which increases proportionally to sales although the intensity of R&D is heterogeneous and independent of firm size and some firms report zero R&D. In Klett and Kortum (2004), innovative intensity is expressed as a ratio of investment into R&D over stock of knowledge. In their arguments, it is assumed that the number of firms in a cohort decreases over time and the survivors grow bigger on average. The quality of innovation for growth is described according to a version of one product, and the contribution of innovation to utility is obtained from the amount of consumption of any version of the good multiplied by the default quality of the product. Shefer and Frenkel (2005) examined several determinants which influence R&D expenditure and innovation in addition to firm size, for example, organizational structure, ownership type, industrial branch and location. It is observed that the rate of investment in R&D is not correlated with firm size in industries such as plastics and metals. Cassiman and Veugelers (2002) investigated the role of external information, or incoming spillovers (i.e. publicly available information for innovation such as patent, specialist, conference, meetings, publications, trade shows, and seminars) on firm‘s decision making as well as approp-

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riability21 (i.e. ability to appropriate the returns from innovation by legal protection, secrecy, etc.). According to their results of first-step regressions, firm size is significantly related to firm‘s decision making on building cooperation with other firms at 0.135, incoming spillovers at 0.00514 (not significant), appropriability at -0.0137 (not significant), and permanent R&D at 0.0457 (not significant). They stated that larger firms are more willing to cooperate. Kramarz, Eaton, and Kortum (2008) analyzed the relationship of output and firm size based on Eaton and Kortum (2002) and Bernard, Eaton, Jensen, and Kortum (2003) although R&D is not explicitly included in their model. The market is divided across N geography separated areas in selling a product (the continuums of goods, J). Goods produced in country i with efficiency greater than z is J{1 exp[ (Ti / J ) z ]} . Each location is characterized by such as the measure of ideas Ti , or the average efficiency in the country, the input cost i , and the component of the entry barrier for goods. To sell in market, a firm must sell equal to or more than En , in which E is goods and σ is the heterogeneity in preferences. It is

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important to note that mean sales are expressed as x n

En , which shows that the sales 1 1/

distribution is Pareto with slope . Lotti, Santarelli, and Vivarelli (2009) investigated radio, TV, and communication equipment industry in Italy to test if Gibrat‘s law is accepted (please note that the role of R&D is not considered). The main argument is the relation between firm size and growth rate. It is found that Gibrat‘s law is rejected ex ante, and firm age and growth is inversely related. Besanko and Doraszelski (2004) applied Markov-perfect equilibriums and found that under price competition, the industry is likely to diverge into a large firm and one small firm with the depreciation of investment is positive. They also found that under quantity competition, the size of firms tend to become homogenous. They suggested that their models can be extended to investigate the impact on product differentiation. Please refer to Table 2 for the other past researches on R&D investment behaviors and cooperation in relation to firm size. In many cases, logit or probit are used. As for knowledge spillovers, Bayoumi, Coe and Helpman (1999) relate total factor productivity (TFP) to R&D investment and trade although they did not include firm size in their analysis. They hold the ratio of R&D expenditures to GDP constant. R&D investment is considered to give an indirect impact on output through capital accumulation, and direct impact on output through TFP. The effect of trade is expressed in learning from trade partners, and an increased variety of intermediate goods. In their model, TFP is determined endogenously by R&D capital22, international R&D spillovers23, and trade. Future increases in TFP are translated into an increase in current investment. They found that R&D investment can contribute greatly to the domestic GDP and of other countries. The outcome of R&D is expressed in the improvement of efficiency assuming constant marginal costs (Ericson & Pakes, 1995).

21

Cassiman and Veugelers (2002) mention that lower appropriability increases a chance for free ride on other firms‘ R&D investment. 22 R&D capital is an accumulation of R&D investment plus depreciation. 23 International R&D spillovers correspond to the effect of foreign R&D investment via import share. Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

28

Yumiko Kinoshita Table 2. Determinants on R&D Cooperation

Paper

Partner type

Major significant determinants

Sample

Econometric model

Bayona, GarciaMarco, and Huerta (2001) Belderbos, Carree, Diederen, Lokshin, and Veugelers (2004)

All types of firms

Firm (size[+], R&D intensity[+]), Industry

Logit

Competitor, customer, supplier, university, public research institute. All types of firms All types of firms

Firm (size[+], R&D intensity[+], incoming spillover), Industry

1652 Spanish firms (SMEs and large firms) 2194 Dutch firms (European Community Innovation Survey) 522 Italian firms (startups) 558 EU firms (SMEs)

Negative binominal

1800 German firms

Count data hurdle model

Firm (size[+], R&D intensity[+], subsidy or public support[+]), Industry Firm (size[+], R&D intensity[+], incoming spillover[+], cost and risk[+]), Industry Firm (size[+], R&D intensity[+], patent[+], group affiliation[+], subsidy or public support[+]), Industry, Country Firm (size[+], R&D intensity[+], patent[+]), Industry Firm (size[+], R&D intensity[+]), Industry

6026 Spanish firms

Simultaneous equations

2378 French firms

Logit

9191 French, German, Irish and Spanish firms

Trivariate probit

724 Japanese firms

Binary choice (not specified)

1275 UK firms

Logit

Firm (size[+]), Industry

325 Belgian firms

IV probit

Colombo and Grilli (2005) Fontana, Geuna, and Matt (2006)

University, public research institute

Fritsch and Lukas (2001)

Competitor, customer, supplier, public research institute All types of firms

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Lopez (2008)

Miotti and Sachwald (2003)

Mohnen and Hoareau (2003)

Vertical, competitor, university, public research institute University, public research institute

Motohashi (2005)

University

Tether (2002)

Competitor, customer, supplier, public research institute, consultant University

Veugelers and Cassiman (2005)

Firm (size[+], patent[+], venture capital financing), Founder, Industry Firm (size[+], R&D intensity[+], patent[+], subsidy or public support[+]), Industry, Country Firm (size[+], R&D intensity[+]), Industry, Region

Multivariate probit

Hazard, panel probit

Source: Okamuro, Honjo and Kato (2009).

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

29

Service Entities in Open-Closed Innovation

Jones and Williams (2005) examined surplus appropriability, knowledge spillovers, creative destruction, and duplication externalities. Consumer surplus is generally not perfectly appropriated to future investment, and the situation, referred to ‗underinvestment,‘ may lead to knowledge spillover problem. They assumed an elasticity of substitution between capital goods, and suggested that only a part of innovative firms increases the variety of intermediate goods, and the rest only upgrade existing intermediate goods. They define R&D as the search for new designs for intermediate goods, and suppose that there is a constant return to R&D investment, which is derived from current market value of the new design. Acemoglu, Aghion, Lelarge, Van Reenes, and Zilibotti (2007) addressed the problem of technological frontiers who are able to generate new technologies with limited information. In this case, the distance to the frontier technology is derived from the gap between a firm‘s productivity and the highest productivity in the industry. The issue of the distance from the frontier is also addressed in Griffith, Redding and Van Reenen (2003). They examined R&Dbased absorptive capacity, which is defined as the relative level of TFP defined as ln(TFP in frontier)-ln(TFP in conutry) , and that of multiplied by the number of employees engaging in R&D. Efficiency term (A) is denoted as either productivity of the quality of intermediate goods: Ai1t Ai1t 1

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Et 1 ln

Hˆ itR 1 ln

i

ln

AF1t 1 Ai1t 1

i

A Hˆ itR 1 i ln F1t 1 Ai1t 1

with expectation (E), the size of innovations (γ), the pace of autonomous technology transfer (μ), the probability of research success (λ), absorptive capacity of technology transfer, equilibrium research employment (H), and frontier country (F) . According to the result, the absorptive capacity is positively impacting the growth of productivity. Aw, Roberts and Xu (2008) investigated the relationship between export and R&D investment. They used a Markov process to estimate a firm‘s productivity in relation to R&D activity. Productivity (ω) is expressed in: it

g( 0

it 1

, dit 1 , eit 1 )

it

2(

it 1

1

it 1

)2

3

(

it 1

)3

4

dit

1

e

5 it 1

6

dit 1eit

1

it

d it 1 is firm‘s R&D investment, and eit 1 is export market participation in the previous

period. Productivity improvement in stochastic nature is , and expected increase in productivity is represented in α. It is found that a firm with a given productivity level, the firm is more likely to continue to invest into R&D and to export. However, R&D investment generates little impact on the return to exporting. As for the impact on R&D, which turns into the behavior of productivity, Mulkay, Hall and Mairesse (2001) incorporated the impact of output and cash flow24 on the amount of investment. They used Generalized Method of Moments (GMM) to find that the outputcapital gap is closed at a faster rate for ordinary capital and a slower rate for R&D investment in response to sales growth. The profit growth affects future investment pattern, which is 24

The ratio of cash flow is derived from net profits plus depreciation to the beginning of period capital stock.

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

30

Yumiko Kinoshita

observed in a lag of one year in their estimation. Standard deviation of sales growth and distribution of productivity are used to represent the heterogeneity, and the distance from the frontier technology is also expressed as the gap between the productivity of a firm and the highest productivity in the same industry. Bloom (2007) investigated how uncertainty gives impact on R&D investment as an issue of adjustment costs. It is mentioned that normally time constant uncertainty is assumed in order to derive analytical solutions, and the adjustment costs of changing knowledge stocks incurs due to a change in the rates of change of its stock (R&D). They found that higher uncertainty reduces the responsiveness to sales growth and increases the responsiveness to lagged R&D expenditure. Bloom (2007) assumes that R&D depreciates over time. Thus, the uncertainly increases temporarily, R&D will be reduced at the steady state. It is supposed that all of these issues regarding R&D are related to the depreciation of R&D capital in one way or the other. Hall (2007) discussed the measurement method in detail25 . For a certain level of capital stock (K) and R&D investment (R), it is described as Kit (1 ) Ki ,t 1 Rit . Then, the output elasticity (γ) of knowledge or intangible capital (K) with respect to the output elasticity (β) of tangible capital (A) is / cK* K / cA A with cost of capital (c). According to market value approach, the depreciation of R&D is derived based on ( ˆt / ˆt )*[( pitR Kit ) / ( pitI Ait )] (1 R /1 I )*[( pitR Kit ) / ( pitI Ait )] with the overall market movements in Tobin‘s Q denoted as α, in which R and I correspond R&D and tangible capital respectively. The problem of depreciation for R&D, both scientific and non-scientific, is discussed by Corrado, Hulten, and Sichel (2009). They reviewed past literatures and empirics to estimate R&D depreciation rates as Table 3.

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Table 3. Depreciation Rates26 Category Depreciation Rate Computerized information

% 33

(other than software) R&D, scientific

20

R&D, non-scientific

20

Brand equity

60

Firm-specific resources

40

Note: According to Corrado, Hulten, and Sichel (2009), 1) The depreciation rate for computerized information is taken from U.S. Bureau of Economic Analysis (five-year service life). 2) According to Bernstein and Mamuneas (2006), the depreciation rate is found to be 18% for U.S. Ishaq and Prucha (1996) presented a rate of 12%. Pakes and Schankerman (1979) obtained 25% for Europe. Pakes and Schankerman (1986) suggested a range of 11–26%. Source: Corrado, Hulten, and Sichel (2009).

25 26

Hall mentions that data are suggesting appreciation rather than depreciation of R&D capital over the period. In this chapter, the depreciation of R&D is taken from this table for the panel data analyses.

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

Service Entities in Open-Closed Innovation

31

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CONSTRUCTION OF MODELS- PANEL DATA ANALYSES In most literatures which are reviewed in the previous section, data from manufacturing industries are used for constructing the models. In addition, firm‘s capacity for innovation is not often addressed in a way which shows firm‘s competence to use external sources for expertise in the innovation in service, and to introduce IT for supporting their uses. Several reports published by EU say that system competent providers may have an important function in lowering the threshold for small firms, and the first experience of using external KIS27 can have far-reaching effects on the firm‘s future service use (EU Scientific and Technical Research Committee, 2008; European Commission, 2008, 2009). One of the reports mentions also that from the policy perspective, the system competence as a prerequisite of public sector funding is not purely a negative phenomenon (Kuusisto, 2008). It is true when public policy deals with projects such as e-invoicing for SMEs (Brun & Lanng, 2006). Public infrastructure is being provided to support SMEs business operation, participation into public procurement, and reduce administrative burdens. According to the above-mentioned reports, system competence can be a proxy for innovation potential, and more research are required to clarify the relationship of such system competence and growth potentials. This aspect is surveyed in Europe in 2009 so that the relationship with service differentiation (technical knowledge), productivity and service enhancement, all of which are related to value-added services, is analyzed. The survey intends to address the role of KIS providers for SMEs that represent potential users of expertise knowledge, because the use of KIS may suffice a limited use of financial, human and educational resources in SMEs, and as a source of external expertise, they may cover their lower system competence. In this sense, it is important to investigate the use of networks and IT infrastructure by SMEs. These situations can be written in the following production functions. To analyze the abovementioned conditions, this chapter argues macro-micro models which consist of two sets of methodology: macro and micro panel data models. The macromicro techniques combine macro and micro modeling with different degrees of integration (Bourguignonm & Pereira da Silva, 2003). This approach allows us to evaluate micro-level effects of macroeconomic policy. From macroeconomic perspectives, we need equations to build structural models with some assumptions i.e. utility-maximizing consumer under a budget constraint with tax-benefit system via the one-stop portal. After structural parameters are estimated in macroeconomic models, results are imputed into micro models (top-down) or vice versa (bottom-up). In this chapter, the analyses employ the bottom-up approach. Micro models are useful for the assessment of heterogeneous population, product characteristics, and firms. These models clarify a mechanism by which individuals and firms are allocated to a policy or market conditions. The heterogeneity stems from differences in demand patterns and socio-economic characteristics, and is observed in source data and exogenous factors (Essama-Nssah, 2007). The following sections will present micro and macroeconomic models in detail.

27

There is an empirical analysis on KIS using French micro-data. Please refer to Lelarge (2009).

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

32

Yumiko Kinoshita

DYNAMIC MICRO MODELS Dynamic panel data models are used when a large amount of cross-section data are available while time-series data are relatively short, in which lagged dependent variables appear in correlation with error term. Arellano et al. (1989; 2001), Hahn, Hausman, and Kuersteinerm (2002), Pakes and Ericson (1998), Pakes (2003), Ackerberg, et al. (2007) and many others have approached to these issues using instrument variables (IV). Data on public infrastructure have not been accumulated as a historical data over several decades, and the correlation with economic growth is yet to be confirmed. Therefore, this chapter focuses on structural parameters and imperfect instrument variables (IIV) based on Olley and Pakes (1996) and Ackerberg et al. (2007) incorporating the findings of Levinsohn and Petrin (2003), Patrick, Benkard, and Levin (2007), Andrews and Stock (2007), and Nevo and Rosen (2008).

Production functions First of all, the following Cobb-Douglas production function is defined for a firm j, which is utilizing the IT infrastructure: Y j Aj K j L j (2.3.1) a

k

l

where output ( Y j ) is a function of capital ( K j ) and labor ( L j ) with (unobserved) Hicksian neutral efficiency level of the firm ( Aj ). By taking the natural logarithmic of the equation, the following equation is derived: y jt

0

k

k jt

a

a jt

l

jt

jt

(2.3.2)

jt

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Based on Olley and Pakes (1996) and Ackerberg et al. (2007), efficiency level across firms.

and

jt

jt

0

is defined as the mean

represent knowledge networks and the deviation from

the mean respectively. When they are caused by known factors, the choice of labor for firm j is: 1

Lj

pj wj

1 l

e

0

j

l

(2.3.3)

Kjk

with price of output ( p j ), wage ( w j ), and Unobserved productivity ( F(

jt 1

|{

j

jt

}t 0 , l jt )

i

as a set of parameters ( jt , it ,

jt

).

) takes a form of the following function: F(

jt 1

|

jt

(2.3.4)

)

where I jt is the firm‘s information set at time t, and the equation follows an exogenous first order Markov process. Then, the capital accumulation of firm j is assumed to be: k jt

(1

T

)kTjt

1

(1

I

)kIjt

1

(1

rd

)rd jt

1

i jt

1

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

(2.3.5)

33

Service Entities in Open-Closed Innovation

The investment into tangibles may shift more towards the investment into intangibles so that the firm would accumulate knowledge capital to build up expertise. To observe the investment behavior, the equation above categorizes tangibles ( KTj ), intangibles ( K Ij ), and R&D expenditures with separate depreciation rates ( t is:

(k jt , ajt , in which

t

,

jt

T

, I , and

rd

). The firm‘s profit at time

(2.3.6)

, t ) c(ijt , t )

jt

captures the economic environment surrounding the firm (market size and

competition toughness), and c ( ) is the cost of investment function. The firm‘s maximization problem is then written as a Bellman equation: V (k jt , a jt ,

max

,

t

)

(k jt , a jt ,

jt

,

jt

,

jt

c(i jt ,

t

jt

)

| k jt , a jt ,

,

t

), max{k jt , a jt , i jt 0

[V (k jt 1 , a jt 1 ,

jt 1

,

jt

,

t

jt 1

jt

,

,

jt 1

i(k jt , a jt ,

jt

,

jt

,

t

,

,

t

}...

t 1

)...

(2.3.7)

, i jt ]}

with the given single-point profit condition in ( i jt

jt

) i(k jt , a jt ,

jt

,

jt

c) . The investment demand function is:

(2.3.8)

)

The demand for products in the entire industry is obtained from the distribution of ( zi , vi ) . Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved.

Marginal cost (mc) is log linear with observables ( rk , j ) and productivity (

j

), which is

assumed to be: ln mc j

rk , j

c k

(2.3.9)

j

where r includes the product characteristics (referring to x jt and

jt

in Equation (2.3.10) in

the following subsection), input prices, and the quantity produced. is a vector of parameters, and the superscript ―c― refers to the interactions of the product characteristic coefficients with total cost. Demand functions should be defined according to the type of product and industry sector of the firm. The utility of consumer i for product j at time t, which is produced or delivered by a SME, is written as: uijt

U ( x jt ,

jt

, zit , vit , yit ,0

yit , p

p jt , )

(2.3.10)

where x jt is a K-dimensional vector of observed product characteristics other than price,

jt

represents unobserved product characteristics, zit is a vector of observed differences

in consumer tastes, and vit is a vector of unobserved differences in consumer tastes, and p jt is Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

34

Yumiko Kinoshita

the price. Note that the consumer‘s income, yit , can be directly impacted if a member of the household is hired by a SME through the hiring portal. The potential amount of increase or decrease in income for such a consumer is denoted as yit , p , and thus yit , p becomes 0 if the consumer has not been employed by any SME which has an on-going access to the portal. According to Ackerberg et al. (2007), utility depends on the money available to spend outside of this market ( yit ,0 yit , p pit ). When consumer does not choose to purchase the product, the utility of outside good takes the following form: ui 0

U ( x0 ,

0

, zi , vi , yi ,0

yi , p

(2.3.11)

p0 , )

with x0 as a vector of characteristics of the outside good. Combining (2.3.10) and (2.3.11) makes the total market demand. When uijt is higher than the utility of any other product, the product j is chosen.

Decomposing productivity Service sectors tend to rely on external source for expertise, and SMEs are generally less capable of engaging in R&D than large enterprises due to the shortage of funds and skilled workers (OECD, 2006, 2008a; Wolfl, 2005). Therefore, it is important to observe how knowledge is gained and produced by SMEs after they start utilizing the shared IT infrastructure by using internal or external source as well as through knowledge spillover. Based on NISTEP (2008, 2009), the growth rate of total factor productivity (TFP) takes the following form:

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Ij i

Yj

Ej e

Yj

Sj s

Yj

j

(2.3.12)

in which the amount of investment into knowledge (i.e. R&D) is I, and the amount of knowledge purchased from external source (i.e. consultant) is E and the intra-industry knowledge spillover is S28. Each denotes a firm-specific factor to improve efficiency in knowledge production and transfer. Productivity ( jt ) in Equation (2.3.4) is defined as a composite effect of

it

and

it

determined based on the information that the firm has at time t. To derive the

productivity from actual datasets, we have Equation (2.3.12), which encompasses both internal and external efficiency terms to produce knowledge and transfer. This equation is based on the assumption that knowledge is a primary source of innovation, which boosts up productivity in various service sectors.

28

In this chapter, S is approximated by taking standard deviation of the number of firms (headoffice) and their subsidiaries, and then finding the quantiles of the variables against the quantiles of chi-squared distribution of firms and subsidiaries.

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

35

Service Entities in Open-Closed Innovation Now we need to decompose productivity 29 into a set of have:

it

and

it

. To estimate

, we

(2.3.13)

hit ( it , kit )

it

it

with the given amount of KIS ( it ). KIS are often used as intermediaries to facilitate intra- and inter-industry knowledge production and transfer (OECD, 2006). KIS include all three variables (I, E) in Equation (2.3.12). KIS tend to grow nearly at the same rate of output growth and productivity growth. In particular, SMEs are now facing the needs of developing expertise knowledge to compete in both domestic and foreign market, and offering customized services to meet the demand of fragmented services. The degree of specialty and customization makes their products less substitutable with the other products. In such circumstances, this explanation helps us to clarify the mechanism and effect of a small change of fixed and variable costs reduced by employing IT infrastructure with regard to the dispersion of productivity as well as the product substitutability in the context of a global equilibrium for both incumbent and existing SMEs. To verify the impact empirically, the data on firm sizes can be used directly to observe the change in productivity.

DYNAMIC MACRO MODELS This chapter follows Canova (2007) to model heterogeneous macro panels. First we have a maximization problem for country n with a given world interest rate30 with the constraint of:

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Cnt

K nt ' nt

1

K nt Lnt

Lnt (1

sant

1

) K nt

K

Lnt

(2.4.1)

(1 rt )sant

in which sait is lending to and/or borrowing from the world, rt is the rate of lending/borrowing, t is productivity including the efficiency term ( i , e , s ) adjusted by Pareto distribution in the global equilibrium. For capital accumulation, we have 1 rt

(1

K

)

' n

(2.4.2)

GDPnt / Knt

letting the depreciation rate

K

to be a weighted average of

T

and

I

, and the efficiency

term for capital, k . Based on Canova (2007), the following two equations are derived with regard to the maximization of utility: Lnt 29 30

1

(1

' n

) nt* Lnt* Lnt Cnt

(2.4.3)

Data can be also obtained from ‗productivity‘ in JSBRI surveys. In the empirical analysis in later sections, the rate of return on capital only is available as macro data, which is taken from EU KLEMS database.

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

36

Yumiko Kinoshita

Cnt letting

Et Cnt *

' 1

n n

'

'

1

* * n nt 1

Lnt* 11 (1

L

)

(2.4.4)

.

Then, we have the following equation to estimate the effect of ICT investment ( xi ) at time t:

ynt an1( ) ynt 1 an2 ( )xnt

n

nt

(2.4.5)

The long-run effect of xit on yit is derived as:

m1 (an )

E (1 an1 (1)) 1 an 2 (1)

(2.4.6)

EMPIRICAL ANALYSES

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Methodology and Data To perform these two types of analyses for all non-manufacturing sectors in addition to one manufacturing sector as a sample by using Japan‘s firm-level financial data as well as macro economic data, the following points are emphasized and elaborated in the formulation of regression models. Please refer to Table 4 for the list of sectors to be analyzed. In this section, the details of data, and variables are explained31. All regression models are tested by variance inflation factor (VIF) and residual plots, which graphs a residual versus fitted values. Outliers are removed if the value exceeds mean plus standard deviation multiplied by five32. As for the firm-level analysis, The first procedure is to perform regression in stepwise method (robust) with 1% (0.01) significance level for removing variables from the model. Dependent variable is revenue and independent variables are tangibles, intangibles, R&D, employment, and age, which are all in logarithmic form. The other variables are programmatically removed when collinearity is observed. As a supplementary procedure, regression analysis is performed particularly to test interactions of each variable in the previous regression model. The same regression is conducted as the second procedure with an additional variable of trade for firms engaging in trade. The third procedure is regression performed to take the impact of firm size class into account.

31 32

STATA ver.11 is used to perform all test procedures.

In a standard procedure, outliers are removed if it is more than the standard deviation multiplied by three. The author tried this procedure, and still found explicit outliers based on the residual plots. Therefore, the author removed values if it is more than the standard deviation multiplied by five.

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Service Entities in Open-Closed Innovation

37

In the fourth procedure, the regression model estimates the production function in the presence of selection bias and simultaneity by using the three-stage algorithm described in Olley and Pakes (1996)33. Dependent variable is revenue. As for independent variables, firm exit indicates the state of firm's exit. State variables are appearing in production function such as age and employment. Proxy variable for unobserved productivity is KIS. Free variable used in the second stage only is R&D. Additional variables used in both the first and second stages are tangibles, intangibles, and software. Bootstrap is set random-number seed to 1 performing 250 bootstrap replications with 99% confidence level. The fifth procedure estimates production functions using intermediate inputs to control for unobservable productivity shocks (Levinsohn & Petrin , 2003)34. As for independent variables, R&D is used as free variable specifying the free variable inputs. Proxy variable specifying intermediate inputs is KIS. Capital variables are intangibles and software. This procedure is specifically performed to test the impact of intermediate inputs, therefore, the impact of intangibles and software are taken into account. The generalized method of moments (GMM) estimator will be used for a grid search to minimize the criterion function35. Following the firm-level analysis, productivity is estimated in terms of capital and labor productivity. After importing datasets from the previous firm-level analysis, labor productivity is first defined as revenue per employee. Capital productivity is also provisionally defined as revenue divided by total amount of capital. Capital is defined according to Equation (2.3.5). Then, investment is defined as the level of capital for the year less lagged capital in the previous year. The capital productivity is regressed by size class with independent variables such as capital and investment. The labor productivity is regressed by knowledge spillover, external knowledge, and purchased technology to determine the efficiency (ρ)36 for the entire service sector. Revenue is estimated based on the level of capital or labor by including variables such as software and KIS. The same procedures are repeated for data on unlisted companies. In this case, detailed data on tangibles, intangibles, R&D, software, and KIS are unavailable. Therefore, these variables are not used in regression models. The major variables used in this analysis are capital, employment, profit, revenue, firm age, and firm exit in logarithmic forms. The first procedure is to perform regression in stepwise method, in which dependent variable is revenue, and independent variables are capital, employment, and age. The second procedure is to perform the same regression by size class. In Olley and Pakes model, age square and employment square are used as state variables. Proxy variable is capital and free variable is size class. In Levinsohn and Petrin model, age is used as free variable and employment is used as proxy. 33

The detailed description of this command can be found in st0145/opreg.hlp in STATA help file. This file is downloadable and readable online for non-STATA users. Please also refer to Yasar (2008) for the details on how to use opreg command. 34 The detailed description of this command can be found in st0060/levpet.hlp in STATA help file. 35 Please refer to Baum, Schaffer, and Stillman (2003) for the issue regarding the use of instrumental variables (IV) estimation and the generalized method of moments (GMM). This chapter discusses test procedures for heteroskedasticity, overidentification, and endogeneity when IV is used in estimation. 36 The efficiency term, or service productivity, is derived as a result of analyses performed on the following nonmanufacturing sectors in Nikkei Needs database (the number in paraenthesis is Tokyo Stock Exchange industry code: Land transportation (5050), Sea transportation (5100), Air transportation (5150), Storage and transportation (5200), Information and Telecommunication (5250), Wholesale (6050), Retail (6100), Real estate (8050), and Service (9050).

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Yumiko Kinoshita

As for macroeconomic analysis, the main focus is to use the efficiency level (ρ) for the service sector, which is determined from the firm-level analysis. The mean of ρ from the service sectors is measured and fed into this macroeconomic analysis. Another focus is to utilize the data on intermediate inputs on services. The ratio of service inputs to total intermediaries is used. The third focus is to utilize the data on ICT capital formation versus Non-ICT capital. The same way as service inputs, the ratio of ICT capital to Non-ICT capital is used in the analysis. Data on ICT consumption and Non-ICT consumption are also incorporated into the analysis. Capital (K) is defined as lagged ICT and Non-ICT capital plus the current level of service inputs and the other types of inputs. Consumption is determined based on the level of capital productivity with the efficiency (ρ) term. Labor is defined based on the same efficiency (ρ) and labor productivity. The first procedure is to regress gross output with independent variables such as capital, consumption, and the investment into IT. The second procedure is to regress gross output with independent variables such as intermediate service inputs and the investment into IT. The third procedure is to regress gross output capital, labor, and the investment into IT. Capital, consumption and gross output are detrended and used for the forth procedure, in which detrended output is regressed by consumption and IT investment. Revenue estimated in these four procedures is going to be used for the final procedure of simulation. In the simulation, ICT capital formation, service inputs, and/or ICT consumption are adjusted upward and downward to find the impact on macro economy.

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Table 4. Industry code Industry Code (33 classes) by Tokyo Stock Exchange

Description

Category: Manufacturing (1); Non-manufacturing (2)

3650

Electronics

1 (Alternative)

5250

Information and Telecommunication

2

6050

Wholesale

2

6100

Retail

2

8050

Real estate

2

9050

Service

2

Note: In the analysis section below, result for each industry is ordered alphabetically. The three manufacturing sectors are also analyzed to make a good comparative study.

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Service Entities in Open-Closed Innovation Table 5. Description of variables (1) Firm-level analysis: Listed companies Name Firm Code Data date List (flag) Nikkei Industry Code Affiliated company Tangible fixed assets Intangible fixed assets Patent Assets total Software Operating income

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Current income Revenue Export and sales profits R&D Capital expenditures

Employee

Sales fees Marketing Payment for patent and design Year Firm exit

Description

Unit

Date when the specific data are entered. 1: Traded. 0: Not traded or stop being traded.

Number of affiliated company Total of tangible fixed assets, land, and allowance for funds used during construction Goodwill, patent, industrial new design, software, consolidated adjustment account, and other intangible fixed assets Exclusive rights based on Patent Law and Utility Model Act as a type of mill ownership Current assets, fixed assets, and consolidated adjustment account Programs, system specifications, and related documentation such as flowcharts to run on computers Sales from merchandise, products, amount of completed work, sales income in industries such as transportation, storage, broadcasting, electricity, gas, entertainment, and sales revenue in industries such as trust, finance, and futures Operating and nonoperating income less costs, sales expenditures, administration overhead, and nonoperating expenditures Net income after tax Income from exports, amount of work completed in overseas, and operation of hotels and technical assistance and transfer Research and development

Millions of Japanese yen

Capital investment

Millions

Consolidated number of employees including those working as full-time, dispatched to the firm, exclusively for trade union, leave of absence, board members with multiple appointments, temporary, and dispatched to the other firm who incur human resource costs Sales fees, promotion fees, and provision for accrued fees dealer, wholesaler, sales agents and designated sales agents Advertisement, marketing, promotion and expansion Payment for the use of patent and design

Millions Millions Millions Millions

Millions

Millions Millions Millions Millions

Person

Millions Millions Millions

Distance from 2010 (Age = 2010 – year(date) ) Firms not surviving for more than seven years during 1991 and 2010

Source: Nikkei Needs Databases (Balance Sheet; Profit and Loss; Cash Flow). Data are taken in December 2009.

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Yumiko Kinoshita Table 6. Description of variables (2) Firm-level analysis: Unlisted companies Name Firm Code

Description

Industry Code

Data classified according to Industry Code (33 classes) by Tokyo Stock Exchange

Capital

Capital stock paid-in.

Profit Revenue Capital expenditures Employee Year Firm exit

Sales from merchandise, products, amount of completed work, sales income in industries such as transportation, storage, broadcasting, electricity, gas, entertainment, and sales revenue in industries such as trust, finance, and futures Net income after tax Capital investment corresponding to capital less lagged and depreciated capital stock Number of employees not including those working as part-timer and board members on single entity basis (not consolidated) Distance from 2010 (Age = 2010 – year(date) ) Firms not surviving for seven years during the dataset period from 2004 through 2010

Unit

Millions of Japanese yen Millions Millions Millions Person

Source: Toyo Keizai Databases on unlisted companies based on quarterly journal published by Toyo Keizai Inc. The number of firms in the database ranges from 15,000 to 20,000. Data are taken in January 2010.

Table 7. Description of variables (3): Macroeconomic analysis Name Year

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Gross output Intermediate inputs Intermediate service inputs Value added Employee Hours of work ICT capital formation Non ICT capital formation ICT capital compensation Non ICT capital compensation

Description 1973-2006

Unit

Gross output at current basic prices

Millions of Japanese yens

Intermediate inputs at current purchasers' prices

Millions

Intermediate service inputs at current purchasers' prices

Millions

Gross value added at current basic prices Number of employees Total hours worked by employee Nominal gross fixed capital formation of ICT Assets. ICT includes computing equipment, communications equipment, and software Nominal gross fixed capital formation of Non-ICT Assets including transport equipment, other machinery and equipment, residential structures, and other assets

Millions Thousands Millions

Capital compensation of ICT assets

Millions

Capital compensation of Non-ICT assets

Millions

ICT stock

Real fixed capital stock of ICT assets

Non ICT stock

Real fixed capital stock of Non-ICT assets

All stock

Real fixed capital stock of all assets

ICT consumption

Consumption of fixed capital of ICT assets

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Millions Millions

1995 prices 1995 prices 1995 prices 1995 prices

41

Service Entities in Open-Closed Innovation Non ICT consumption

Consumption of fixed capital of Non-ICT assets

All consumption

Consumption of fixed capital of all assets

Operating surplus Taxes Return on capital IT assets Other assets Compensation Capital productivity Labor productivity Efficiency for knowledge investment Efficiency for purchased knowledge Efficiency for intra-industry knowledge spillover Efficiency for all knowledge formulation patterns

1995 prices 1995 prices

Gross operating surplus

Millions

Other taxes minus subsidies on production

Millions

Industry rate of return on capital

%

Geometric depreciation rates of IT assets Geometric depreciation rates of other assets Compensation of employees Capital productivity (mean of all service industries) obtained from analysis 1 Labor productivity (mean of all service industries) obtained from analysis 1

% % Millions

Efficiency for I/Y obtained from the analysis on listed firms

Efficiency for E/Y obtained from the analysis on listed firms

Efficiency for S/Y obtained from the analysis on listed firms

Efficiency (mean) for the three variables above obtained from the analysis on listed firms

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Source: EU KLEMS database, Japan, November 2009 release.

RESULT OF MICROECONOMIC ANALYSIS 3.1.1

Industry: Electronics

Analysis (1) Type of firm: Listed Time series: 1991-2008 (year) Number of observation: 347 (grouped by firm ID)

Observation Electronics industry is first analyzed to compare the result with the other service sectors. R&D and tangible capital give the largest impacts on the change in R2 while age and age square are significantly most important in overall regression analyses. Olley and Pakes method presents the same trend, in which age and exit are the most important variables. Sales profit per employee is becoming larger according to firm size classes, and revenue shows

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growth with NSC 3 and 4 during the dataset period. Revenue with trade is growing most with NSC 3, and revenue with trade and R&D are also growing with NSC 4 and 5. Investments in R&D and software are highest with NSC 5. The gap between the two types of investment seems to be consistent across firm size classes, and the level of investments is growing for both R&D and software. The impact of IT and KIS turns from negative to positive as firm size class goes across from 4 to 5. Labor productivity is growing more strongly compared to capital productivity, and is highest with NSC 4, and it is lowered with NSC 5. It is suggestive that firms grow most with NSC 3 to 4, and that once IT and KIS reach a certain level, IT and KIS start giving a positive impact on revenue as we see with NSC 5 and cover the lower labor productivity in that size class. Table 8 Summary of Regression Results: Electronics (1)

Electronics Capital (tangible) Firm age R&D Employee Trade Capital (intangible)

(2) (3) OLS: OLS: OLS trade R&D 0.294* 0.407 0.426 (0.000)* (10.91)** (2.65)** -0.396* -0.345 (0.000)* (3.83)** 0.201* 0.207 0.258 (0.000)* (8.81)** (2.99)** 0.271* (0.000)* 0.197 (5.30)** (0.221) (1.970)

(4) OLS: NSC 4 -1.022 (2.91)*

(6)

(7)

(8)

(9)

OP

OP: trade

LP

LP: trade

0.205 (0.850)

0.088 (1.170) -0.77 (5.25)** 0.131 (3.95)** -0.051 -0.73 0.269 (3.46)** (0.036) (0.580) 0.013

0.202 (3.35)**

0.078 (1.050)

0.141 (5.07)**

0.123 (3.74)**

(0.038) (0.710) 0.077 (1.800) 0.343 (6.98)** 1.659 (5.97)**

0.244 (3.24)** (0.051) (0.890) 0.039 (0.850) 0.351 (6.47)** 0.456 (1.010)

854 0.52

603 0.48

0.404 (4.12)**

-0.423 (2.51)* 0.194 (1.980)

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(5) OLS: NSC 5 0.755 (4.69)**

(0.123) (0.430) (0.033) (0.260)

Capital investment Constant

1.226* (0.000)*

0.060 (0.230)

2.728 (3.12)**

12.932 (5.62)**

1.548 (1.570)

Exit Age2 Employee2 0.685 (2.90)*

Patent KIS Observations R-squared

1626 0.50

988 0.50

91 0.32

10 0.74

81 0.34

3.318 (3.73)** -0.029 -0.06 0.354 (1.740) (0.066) (0.490) 0.116 (1.080) 0.090 (0.920) 45 0.42

0.356 (6.57)** 0.857 (2.00)* -0.709 (4.06)**

603 0.50

Note: Robust p values in parentheses. + significant at 10%; ** significant at 5%; * significant at 1%. Grey shadow significant with t statistics.

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Analysis (2) Type of firm: Unlisted Time series: 2004-2010 (year) Number of observation: 353 (grouped by firm ID)

Observation From the analysis on unlisted firms, there is a similar trend in terms of revenue growth, which starts growing with NSC 3 and then 4. Interestingly enough, the gap between capital productivity and labor productivity become smaller as firm sizes become large. Capital productivity is higher than labor productivity for NSC 1 to 4. This order is reversed with NSC 5. It is supposed that the impact of capital becomes highest with NSC 4. In order for NSC 5 to keep and allow for revenue growth, it is important to invest into labor by utilizing IT and KIS.

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3.1.2

47

Industry: Information and Telecommunication

Analysis (1) Type of firm: Listed Time series: 1991-2008 (year) Number of observation: 595 (grouped by firm ID)

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Observation Tangibles and intangibles have an equal importance in the determination of R2. Capital investment is significant when the impact of KIS is incorporated into analysis. Both operating profit per employee and revenue per employee grow with firm sizes. Sales profit per employee is distributed widely at the beginning of the dataset period, and then the distribution diminishes and picks up again. The gap of revenue among firms is smaller at the beginning of dataset period, and the gap increases more recently. On the other hand, the gap of revenue with trade among firms is even while the gap of revenue with R&D is growing recently for both NSC 4 and 5. Productivity shows a level growth although the investment into R&D and software seems to give a positive impact on firm revenue. The introduction of KIS into analysis reveals a moderate and positive impact on predicted revenue. Currently, the investment into R&D seems effective as firms grow larger.

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Yumiko Kinoshita Table 9 Summary of Regression Results: Information & Telecommunication

Information & Telecommunication Capital (tangible) Capital (intangible) R&D Employee

(1) OLS 0.237* 0 0.112* -0.001 0.178* 0 0.235* 0

(2) OLS: trade 0.145 (2.57)* 0.11 (2.59)* 0.164 (3.91)** 0.383 (4.75)**

(3) OLS: R&D 0.242 (3.51)* -0.341 (3.61)*

0.523 (7.60)**

Software Capital investment Trade Constant

1.814* 0

1.459 (4.82)**

3.065 (7.51)**

415 0.65

293 0.59

9 0.93

Firm age

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Exit Observations R-squared

(4)

(5)

(6)

OP: trade

LP

LP: trade

0.089 0.258 -1.12 (6.22)** -0.066 0.022 -0.83 -0.31 0.046 0.129 -1.01 (3.05)** 0.276 (2.07)* 0.011 0.084 -0.16 -1.2 0.288 0.15 (4.07)** (2.57)* 0.127 -1.38 1.498 2.597 (3.74)** (11.02)** -0.267 -0.95 -0.27 -1.27 217 301 0.68 0.66

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0.189 (2.98)** -0.059 -0.71 0.064 -1.36

0 0 0.261 (3.71)** 0.249 (4.20)** 1.463 (3.74)**

217 0.67

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Analysis (2) Type of firm: Unlisted Time series: 2004-2010 (year) Number of observation: 595 (grouped by firm ID)

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Observation Operating profit per employee is obviously declining with all Firm size classes. The distribution of both operating profit per employee and revenue per employee is becoming smaller in recent years, however, the gap of revenue by itself among firms are becoming larger as it comes towards recent years. Revenue shows growth for NSC 1 and 2, and decline for NSC 3, 4, and 5. Capital productivity shows an upward trend or level ground, however, the level of capital productivity is gradually lowered as Size class becomes large. Therefore, the effective utilization of labor and intermediaries seems important, which can support labor productivity growth.

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Service Entities in Open-Closed Innovation

3.1.3

Industry: Real estate

Analysis (1) Type of firm: Listed Time series: 1991-2008 (year) Number of observation: 143 (grouped by firm ID)

Observation Age gives the largest impacts on the change in R2 while intangible capital comes next. It is rare to find in the other service sectors that employment is statistically significant, however, employment is related to revenue growth when firms are engaging in R&D and/or firms are in NSC 4 in this sector. When KIS is incorporated into regression, R&D is also statistically significant. Revenue per employee grows when firms are in NSC 3. The distribution of revenue per employee is very small, which means that the gap of revenue among firms is small. Trade and R&D seem effective in terms of raising revenues when firm size is in 3 and/or 4. In these size classes, R&D expenditures and software investment are growing, in particular, with NSC 4. R&D expenditures drops when it comes to NSC 5 while software investment stays on. The impact of KIS becomes positive with NSC 5, which may indicate that firms in NSC 5 seek external services in addition to internal knowledge production to cover the declining productivity Table 10 Summary of Regression Results: Real estate (1)

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Real estate Capital (tangible) Employee

OLS 0.223+ (0.065) 0.622* 0.000

Trade

(2) OLS: trade

1.267 (9.66)** (0.322) (3.10)**

(3) OLS: NSC 4

(1.561) (3.46)*

Capital (intangible) R&D 1.322 (6.12)**

Software Capital investment Constant

1.395** (0.041)

2.221 (3.40)**

9.701 (4.33)**

48 0.69

30 0.84

8 0.84

Firm age Number of firm R-squared

(4)

(5)

(6)

OP: trade

LP

LP: trade

0.144 (0.460) 0.706 (1.170) (0.362) (0.920) 0.394 (1.340) (0.605) (1.630) 0.064 (0.190) 0.411 (2.260) 1.936 (0.360) (1.015) (0.810) 17 0.91

0.465 (1.580)

0.404 (1.150)

0.014 (0.070) (0.080) (0.140) 0.504 (1.880) (0.113) (0.530) 1.832 (1.380)

(0.683) (2.28)* 0.249 (0.660) (0.969) (3.16)* 0.588 (2.180) 0.330 (1.380) 5.917 (1.420)

29 0.48

17 0.88

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Analysis (2) Type of firm: Unlisted Time series: 2004-2010 (year) Number of observation: 162 (grouped by firm ID)

Observation Both operating profit per employee and revenue per employee are on the level ground from NSC 2 to 4. Revenue and capital productivity grow with NSC 1, and the level of capital productivity becomes lower as firm size grows. The gap between labor productivity and capital productivity is becoming larger for larger firm sizes. It is suggested that either investment into software or external services could be effective to improve labor productivity particularly as firm size becomes larger.

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3.1.4

Yumiko Kinoshita

Industry: Retail

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Analysis (1) Type of firm: Listed Time series: 1991-2008 (year) Number of observation: 73 (grouped by firm ID)

Observation Intangibles are the most important determinant in terms or R2. From regression analyses, age and age square are statistically most frequently significant while tangibles, R&D and patent seem to be related to each other. Revenue with trade and R&D do not grow, but the distribution of revenue becomes wider around 2004-5 and smaller afterwards. R&D expenditures grow with NSC 4, and software investment continues to grow with NSC 5. It is a distinguishing trend that the revenue trend for firms in NSC 5 shows the largest fluctuation, which is much bigger than the fluctuation with NSC 4. Capital productivity do not show growth, therefore, the reasons for revenue fluctuation are assumed to be the level of investments into R&D and software.

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Service Entities in Open-Closed Innovation Table 11 Summaries of Regression Results: Retail

(1) Retail Employee Capital (intangible)

OLS 0.807* 0 0.161** -0.025

Capital (tangible) Firm age R&D Software

(2) (3) OLS: OP: trade trade 0.841 (5.39)** -3.975 (.) -0.452 -3.761 (2.88)* (.) 2.575 (8.31)** 2.816 (.) -0.457 (.)

Capital investment Trade Constant

3.473 -1.89 10 0.96

(5)

LP

LP: trade

0.052 -0.39 -0.115 -0.59

-11.599 (.) -1.772 (.)

0.191 (2.65)** 0.12 (2.04)* 0.467 (5.07)**

6.995 (.) 0.012 (.) -13.007 (.) 1.187 (.) 153.636 (.) 7

2.74 (3.62)** 104 0.46

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Observations R-squared

0.076 -0.882 175 0.46

1.49 (.) 43.892 (.) 7

(4)

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Analysis (2) Type of firm: Unlisted Time series: 2004-2010 (year) Number of observation: 443 (grouped by firm ID)

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Observation While productivity does not show an upward trend for either capital or labor, the distribution of revenue shows some fluctuations in all firm size classes. According to the level of capital productivity, its gap between labor productivity is widest with NSC 2. The gap becomes smaller as firm grows large. The distribution of capital productivity becomes largest with NSC 5. This distribution may be the cause of the scattered revenues within the same size classes. Labor productivity with NSC 5 shows a higher level than the other size classes. Therefore, when firm size is smaller, it is important to invest into capital, and then as firm size grows, it is essential to focus on labor productivity growth.

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3.1.5. Industry: Service Analysis (1) Type of firm: Listed Time series: 1991-2008 (year) Number of observation: 525 (grouped by firm ID)

Observation Tangible capital and intangible capital are important in the change in R2. Operating profit per employee and revenue per employee are both showing the same level for all size classes. The distribution of operating profit per employee and revenue per employee is very small and consistent throughout the dataset period. Regression analyses show that independent variable, which are significant in both t and p statistics, are not consistent in different situations. Revenue with trade is shrinking recently especially with NSC 4. Revenues with both trade and R&D have a drop around 2005, and pick up again afterwards. The levels of R&D and software investment are on the same level for NSC 4 and 5. It seems effective for larger firms to continue to invest into R&D so that the revenue growth is maintained. As for the estimation of revenue, both IT and KIS give positive impact on revenue. Table 12 Summary of Regression Results: Service

Service

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Capital (tangible) Capital (intangible) R&D Employee

(1)

(2)

OLS

OLS: trade

0.237* (0.000)* 0.162* (0.000)* 0.149* (0.000)* 0.211* -0.001

Trade Firm age

0.27 (5.57)**

0.294 (2.64)** 0.235 (2.46)* -0.41 -1.68

Software Capital investment Constant

1.518* (0.000)*

0.695 -1.41

463 0.53

250 0.53

Exit Observations R-squared

(3) OLS: R&D

(4) (5) OLS: NSC OP: trade 5 -0.062 -0.83 1.058 0.145 (7.88)** -1.09 1.003 0.075 (2.96)* -1.15 -1.424 0.507 -1.9 (3.46)** 0.097 -0.83 -0.427 -1.5 -0.045 -0.38 0.213 (3.31)** -0.02 11.495 0.41 -0.02 (3.33)* -0.66 0.101 -0.51 15 11 165 0.75 0.71 0.62

(6)

(7)

LP

LP: trade

0.206 (4.03)** 0.267 (3.03)** 0.144 (3.08)**

0.054 -0.82 0.259 -1.85 0.063 -0.92

0.378 (3.63)**

-0.097 -1.63 0.244 (4.59)** 1.56 (5.67)**

-0.088 -0.75 0.164 (2.77)** -0.094 -0.15

257 0.58

165 0.59

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Analysis (2) Type of firm: Unlisted Time series: 2004-2010 (year) Number of observation: 1297 (grouped by firm ID)

Observation The distribution of revenue is converged among firms recently except for NSC 5 so as both types of productivity. The distribution of productivity is relatively not wide. The growth of revenue can be seen in all size classes, however, mean of operating profit per employee and revenue per employee are not growing. The trend of revenue seems correlated with the trend of productivity very well.

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3.1.6. Industry: Wholesale

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Analysis (1) Type of firm: Listed Time series: 1991-2008 (year) Number of observation: 432 (grouped by firm ID)

Observation Age is the most important variable in terms of R2 although the level of impact is not large. From regression analysis, age square and employment square are significant with Olley and Pakes model, which shows the speed and degree of growth in both variables are important in the determination of revenue. When the impact of KIS as intermediaries is considered, capital expenditure is important. When firms are engaging in R&D, tangible capital and patent are statistically significant although intangibles are not. Intangibles are only significant with NSC 4. In this size class, revenue with R&D and trade starts to grow, and the investment into both R&D and software starts to increase. Productivity of capital stays the same level across different firm sizes, and revenue per employee shows very small distributions and fluctuations throughout the dataset period. The amount of investment into capital and labor as well as its duration seem to be the key for revenue growth.

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Yumiko Kinoshita Table 13 Summaries of Regression Results: Wholesale (1)

Wholesale Capital (tangibles) Capital (intangibles) R&D Employee Age Trade Software

(2)

(3) OLS: R&D 0.576 (2.18)*

(4) (5) OLS: NSC OLS: NSC OLS OLS: trade 4 5 0.145** 0.248 1.044 -0.011 (3.76)** (3.88)** 0.139* 0.138 -0.855 1.225 0 (3.01)** (2.35)* (13.50)** 0.087* 0.127 0.588 0.408 -0.001 (3.45)** (2.84)** -1.87 0.374* 0.187 0 -1.83 -0.315* -0.006 0.171 (3.95)** 0.549 (2.92)**

(6)

(7)

(8)

(9)

OP

OP: trade

LP

LP: trade

1.604 (2.53)* 1.304 -1.51 -1.418 -1.76

0.507 (4.13)** 0.153 -1.21 0.004 -0.1 0.031 -0.25 -0.175 -0.63 0.208 (3.03)** -0.054 -0.51 0.126 -1.83 -1.049 -0.98 -0.201 -0.54

0.449 (5.01)** 0.061 -0.81 0.06 -1.43

0.522 (4.44)** 0.147 -1.17 0.003 -0.07

0.135 (2.01)* 0.009 -0.16 1.588 (2.92)**

0.206 (3.46)** -0.038 -0.36 0.128 (2.10)* -1.109 -0.99

158 0.53

305 0.46

158 0.53

0.471 -0.66

Capital investment Constant

2.109* 0

0.54 -0.93

-0.326 -0.21

-1.715 -0.95

-1.614 -1.92

27 0.51

15 0.73

Exit Age2 Employee2 -0.287 (2.75)**

Patent KIS 623 0.44

304 0.46

42 0.56

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Observations R-squared

26.593 -1.97 -2.481 -1.35 -1.733 (2.31)* -3.198 (2.32)* 0.778 -1.1 0.262 -0.44 18 0.65

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Service Entities in Open-Closed Innovation

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Analysis (2) Type of firm: Unlisted Time series: 2004-2010 (year) Number of observation: 912 (grouped by firm ID)

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Observation Looking at revenue trend, NSC 3 starts showing wider distribution of revenue among firms, which is maximized with NSC 4. For NSC 5, the distribution of revenue shrinks. To explain this situation, it is suggestive to look at productivity trend. The gap between capital and labor productivity starts to diminish from NSC 1. As it approaches NSC 4, the gap between the two types of productivity becomes smaller, and then with NSC 5 the level of labor productivity exceeds that of capital productivity. It is important to focus on the trend with NSC 3 where the diversification of productivity starts to emerge. At this point, it is suggestive that firms start focusing on labor by introducing, for example, education and knowledge accumulation efforts, to boost up the productivity. With NSC 5, R&D expenditures are said to be large according to the result from listed companies. Therefore, to invest more into human resources is a key for continuous revenue growth.

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RESULT OF MACROECONOMIC ANALYSIS37 In this section, the fundamental macroeconomic trend is observed first. Then, gross output is estimated in both conventional models as well as the models specifically designed in this chapter so that we can examine the impact of service inputs, ICT investment and service productivity (ρ) on macro economy more clearly. As for the fundamental economic indicators, first of all, Figure 9 shows that GDP had grown until early 1990s and has entered a leveled ground since then. Japan has exhibited a negative growth four times from 1993 to 2008. ICT capital formation tends to be on a leveled ground from the 1990s. The ratio of ICT capital to total assets shows an increase until 1990 and between mid 1990s to year 2000. After 2000, it shows a continuous decline. Meanwhile, the ratio of consumption of ICT is steadily growing and outpaces the growth of ICT capital. That of ICT capital also shows a linear and positive upward trend to GDP although the rate of increase is slower than the total capital. In line with this trend, the use of intermediate services is steadily increasing over the dataset period so as its share in total intermediaries. According to the estimation of gross output in Figure 10, the first methodology for the estimation (K, L, and ICT investment) shows the second closest fit to the actual GDP trend. One of the standard approaches (lagged value added and lagged ICT investment) and the model specifically designed for this chapter (service inputs in K, and service productivity) yield similar curves. The last one (service intermediate inputs in K, C and lagged ICT investment) shows the best fit to the actual GDP curve. Therefore, the curve of using productivity (service intermediate inputs, and service productivity) and the last one (service intermediate inputs, C and lagged ICT investment) are understood as valid estimation models. They are chosen for further analysis in simulation scenarios.

37

A part of this analysis is summarized in a paper and submitted to I3E 2010 as Kinoshita, Y., Open-closed Innovation –Analysis of Service-oriented Economy Driven by Information Technology (IT) and Knowledgeintensive Services (KIS), I3E 2010, Nov 3-5, Buenos Aires, Argentina, Springer.

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Yumiko Kinoshita 21

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GDP Estimated GDP (K,L,ICT)

Estimated GDP (lagged value-added, ICT) Estimated GDP (service intermediate inputs in K, service productivity) Estimated GDP (service intermediate inputs in K, C, lagged ICT)

Figure 10. Estimated GDP. Note: ‗GDP‘ refers to nominal gross output. Data are taken directly from EU KLEMS database. GDP is estimated in a regression model (‗Estimated GDP: K, L, ICT‘) with K, L, and x as independent variables. x is the investment into ICT so that the impact of ICT is clarified based on Eq.(2.4.5) and Eq.(2.4.6). ‗Estimated GPD: lagged value-added, ICT‘ is an estimation based on lagged value added and the amount of investment into ICT. ‗Estimated GDP: service intermediate inputs in K and service productivity‘ is related to the definition of K in Eq.(2.4.2), L in Eq.(2.4.3), and C in Eq.(2.4.4), which reflect the efficiency term ‗ρ‘ obtained from Eq.(2.3.12). ‗Estimated GDP: service intermediate inputs in K, C, lagged ICT‘ reflects the use of intermediates on the growth of GDP.

Figure 11 shows the difference of estimated GDP to actual GDP (estimation over real value). The trend curve picks up first. After some fluctuations, it drops sharply and then steadily shows an upward trend. This overall trend should be understood coupled with the

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trend of detrended GDP38. The detrended GDP shows a trend of gross output with the impact of productivity multiplied by laborforce subtracted so that the impact of capital (K) becomes more clear. According to the figure, the detrended GDP curve continues to decline from early 1990s, and the gap between the actual GDP and the detrended one is widening. It is assumed that the positive effect of productivity and labor force on GDP is rising contrary to the impact of capital formation. The estimation in Figure 11 shows the trend of GDP and the degree of impacts derived from ICT capital formation; however, it is limited to examine the behavior of service economy i.e. purchased knowledge services and knowledge spillover. Based on these understanding, the succeeding figures (Figure 12) show some more impacts that service sectors have had on the macro economy from the productivity point of view as well as the perspectives of service intermediate inputs. According to (a), the impact of an increase in service intermediate inputs and productivity is exhibited slower and weaker than that of ICT capital. ICT capital gives a stronger impact and shows a sharper decrease expressing a clear diminishing return. ICT has a positive effect for the growth of the economy through the improvement of service productivity. As for the service productivity, it has a positive impact on the economy when the amount of service inputs is increasing. Its impact is exhibited in the economy more slowly than that of ICT. According to (b), the difference in the amount of service intermediate inputs is shown more clearly. 1.003

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0.998

Figure 11. Impact of Productivity. 38

Yt

Detrended GDP is obtaind from yt

according to Basu, S., Fernald, J. & Kimball, M. (2006).

1

At1

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Yumiko Kinoshita 1.02

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Service intermediate inputs (130%)

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Figure 12. Simulation – Collective Views.

In line with these observations, Figure 13 uses a real value from KELMS data to show the individual impacts on GDP. In particular, according to the (a)‘s GDP curve, the scenario of increasing service intermediate inputs by 130% shows a positive impact on GDP, whose degree of impact is close to the scenario of decreasing service inputs by 20% and increasing ICT capital by 20%. The latter scenario yields a sharper curve with more distinctive diminishing return than the former scenario. The scenario of increasing service intermediate by 20% and reducing ICT capital by 20% shows a negative impact in terms of the effect of service intermediate inputs in the total economy. This result shows that the service inputs need to be supported by ICT capital formation, and that a possible expansionary policy for promoting ICT consumption does not yield a positive result for the overall economy by itself. Although the increase in service intermediaries gives not a sharp impact as the increase in ICT capital, service intermediaries take a role as moderator of total economic fluctuations and smoothes out the trend curve. The negative impact on ICT capital, then, becomes smaller. Besides, it is also proved that the growth trend of the economy would be negatively affected if ICT consumption only is promoted. As the left figure in Figure 9 shows, the consumption of ICT has been growing at a faster pace than that of ICT capital formation. This situation is suggesting that an expansionary policy targeting the increase of final demand in ICT is not effective and Japan needs to be aware of the co-evolving process of ICT capital formation and the utilization of service intermediaries. According to (b)‘s estimation results, the increase of service inputs gives positive effect on the trend of service productivity, and thus on the entire economy. The positive upward impact on the productivity and GDP becomes weaker if ICT capital formation is reduced. Overall, it is suggested that combination of the use of ICT capital and service intermediaries should be appropriately considered for the current and future economy. As for the service productivity, the impact of purchased external knowledge and knowledge spillover are relatively weaker compared to the internal investment into knowledge (i.e. R&D). Therefore, it is suggested that for appropriate measures should be taken to enhance the use of external expertise knowledge and promote its spillover for the future economic growth.

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Service Entities in Open-Closed Innovation 1.03

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Figure 13 Impacts on GDP – Individual Views.

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Note : (a) Estimated GDP (service intermediate inputs in K, C, lagged x); (b) Estimated GDP (service intermediate inputs in K, service productivity)

SUMMARY As an overview of the microeconomic analyses, it is suggested that it is important to observe service industries at sectoral level so that the distribution of revenue per employee can be examined in detail in relation to productivity. This chapter focuses on this micro-level analysis first so that it is linked to broader perspectives on macro economy. The relationships of firm size and turnover is discussed. It is pointed out that the ratio of SMEs in Japan‘s service sectors are decreasing while that of the other countries are increasing as the ratio of the service sectors to the entire economy has grown. The ratio of SMEs in Japan‘s industries is higher than that of the other countries; however, contrary to the other countries, the number of SMEs is decreasing. This is a unique characteristic pertaining to Japan. Based on the regression analyses that aim at revealing structural aspects for the growth of productivity for the service sectors, it is assumed, first of all, that productivity in the service sectors should be considered in a way which is expressed in the change of Pareto distribution curve. For these reasons, it is important to utilize the firm size distributions and the shift of the productivity curve within each sector so that revenue in the service sectors should reach an optimal level. If it is safe to say that the curve represents the revenue distribution well enough as a proxy, then, the fact that the number of SMEs in Japan is decreasing means that

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Japan is not being able to utilize the positive effect of a shift of productivity distribution among firm sizes, which is expressed in a different curve than manufacturing. It is suggested that this trend can be a cause of the current slower growth of the entire service sectors in Japan. Therefore, it is proposed that there is the need for promoting SMEs in Japan by utilizing service inputs in addition to IT infrastructure. Analyses are performed at sectoral level for all non-manufacturing sectors in addition to a manufacturing sector so that a good comparison can be made to find general trends for the service sectors. In general, when intangible capital comes first in terms of R2, patent and software are important variables for the determination of revenue. In the case where the impact of IT and KIS has been negative all the way through, the level of investment into software has been growing but at a low level compared to R&D expenditures. In some sectors, the diminishing returns in terms of size class (not in terms of duration of operation) for capital productivity can be observed very clearly. In general, for the sectors whose revenues are related to the level of R&D expenditures, and how long firms operate (or survive) in the industry is important, it is necessary to focus on labor productivity before the diminishing returns for capital productivity starts to exhibit. The role of IT and KIS combined, then, turns positive after the capital productivity becomes low for larger firms. When the level of software investment is higher than that of R&D, it is suggestive that the level of software investment is related to the impact coming from IT and KIS. It is assumed that the higher the level is, the earlier the impact of IT and KIS is exhibited. In some cases, capital productivity is slightly higher than labor productivity although the distribution gap is very small. Regression analyses show diversified results, in which significant independent variables are not consistent. The levels of R&D and software investments are at similar level. Meanwhile, one sector such as ‗Real estate‘ has the peak of revenue with NSC 3 and 4 for all firms whether or not they are engaging in R&D and/or trade. Age and intangible capital are important determinant for R2, and the number of employees is statistically significant with NSC 4 when firms are engaging in R&D. R&D expenditures are generally larger than software. According to the analyses on listed companies, the level of productivity does not seem to give an important impact on revenue trend. As for ‗Wholesale,‘ and ‗Information and Telecommunication,‘ revenue per employee peaks at NSC 4. Software investment is larger than R&D expenditures for these sectors and the impact of IT and KIS is always positive. The level of two types of productivity is almost the same although the distribution of capital productivity becomes wide with larger firms. Overall, a good balance of R&D investment and how long a firm continues to operate is one key for a successful turnover growth. This should be combined with expenditures on intangibles, in which a good combination of intangibles and software is important in the determination of the impact of KIS and IT on revenue growth by size class. The balance of tangibles and intangibles, which is represented in the distribution of capital productivity, seems to give an important impact on the revenue trend in each size class and sector. Intangibles are relevant to how effective KIS are in terms of the revenue growth. There is an optimal firm size in each type of investment into R&D and software. When such balances and combinations are not seen, such as in Service, revenue growth is not seen in any size classes over the dataset period, and the gap of profits and revenue is small. In general, for these sectors whose revenues are related to the level of R&D expenditures, and important is how long firms operate (or survive) in the industry, it is necessary to focus on labor productivity,

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though it is already high, before the diminishing returns for capital productivity starts to exhibit and the role of IT and KIS combined turns positive after the capital productivity becomes low for larger firms. This section addresses the issue of service innovation and the creation of structured knowledge utilizing technologies, namely IT. As we have witnessed recently in the financial crisis, the direction of future IT services and networking technologies has a huge impact on the course of the entire service sector to take for years ahead. As mentioned, the discussion on the size of firms is important in terms of finding the optimal scale of investment into IT system, and designing innovation policies. The hypothesis is the shift of Pareto curve among service sectors represented by the variations of profit structures by firm size. A thorough analysis on the relationship between firm size and turnover in the service sector has rarely been seen in past literatures. In particular, this analysis encompasses the impact of R&D in services, which is, by itself, a new topic for empirical analyses. The productivity is derived from the micro-level analysis, which is fed into the macrolevel analysis so that the growth of the entire economy is analyzed from the perspective of service sectors. The impact of IT capital and service inputs to macro economy is also clarified. According to the result, the impact of an increase in service inputs is exhibited in a slower and moderate curve than that of ICT capital. ICT capital gives a stronger impact and follows a sharper diminishing return. Service intermediaries take a role as moderator of economic fluctuations. The combination of the use of ICT capital and service intermediaries should be appropriately considered for the current and future economy. Is suggested that appropriate measures should be taken to enhance the use of external expertise knowledge and promote its spillover for the future economic growth.

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CONCLUSION In today‘s economy, the service sectors consist 70-75% of the economy in most advanced countries although we find that there is less empirical and statistical studies performed with regard to the service sector than manufacturing. Starting in the 1970s by Fuchs (1965), Hill (1977), Sasser, Olsen, and Wyckoff (1978), and Grönroos (Grönroos, 1990, 1999; Grönroos & Ojasalo, 2004), the characteristics of the service sector has been investigated. Service is defined as ‗a change in condition or state of an economic entity (or thing) caused by another‘ (Hill, 1977). In general, service is characterized by intangibility and inseparatability. Moreover, as mentioned above, various services are serving as a facilitator of innovation process within and outside the sector (Wolfl, 2005). Various statistical issues gather attention, one of which is how we measure real value added and productivity of service sectors. More recently, Jensen, Kletzer, Bernstein, and Feenstra (2005), Amiti and Wei (2005), Triplett and Bosworth (2004), and Diewert, et al. (2009) are articulating the issues of deflator to measure the output of services with more accuracy. Atkinson (2009) has analyzed public services to investigate an appropriate deflator while Hartwig (2008) focuses on financial industries to analyze productivity. In these situations, the productivity of the service sector has not been identified clearly in relation to the growth of the service sector because the productivity of service sector has not been improved if calculated in multi-factor productivity (MFP).

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As previously explained, the impact of capital input, labor input and productivity varies widely in each service sector. However, there are common aspects that IT stock and high skill workers tend to allow the turnover per employee to become preferable for larger firms. The contribution of non-IT stock to value added growth has been decreasing in general. It is important to articulate the importance of firm size variations, leading to the variations of profit structure in the service sector. The introduction of IT could connect markets, which used to be separated, and promote international trade. Local markets may face fierce competition against multinational enterprises, which may eventually lead them to lose their markets. The use of knowledge, either heterogeneous or expertise, to link these segmented markets is a tool to create new services and build up knowledge. This aspect must be carefully examined to allow for an optimal growth for the service sector. Another important point is the different trend that is seen only in Japan. The rate of SMEs participation in overall economy in Japan is very high compared to those of other advanced countries. For example, SMEs employment in total stands between 70-85% in Japan, 50% in both U.S. and U.K. in the 2000s (Japan Statistics Bureau; Kozak, 2007; U.S. Census Bureau). However, the participation of SMEs has been decreasing in the service sector. The issue of Japan that the percentage of SMEs is larger than major advanced countries while the turnover trend for SMEs is different from the service sector in the other countries must be analyzed to devise an appropriate policy for the growth of future service sector in Japan. In particular, the impact of regulations and pricing mechanisms in the service sector in Japan must be incorporated carefully into the analysis. As Krugman (1989), Melitz (2005; 2003) and Chaney (2008) argued, the issue of substitution is important to understand the effect of locality, elasticity of substitution of products, and expertise of knowledge when we think of the issue of trade either internationally or inter-regionally. These aspects must be investigated in relation to the impact of IT stock and worker‘s skill composition so that the optimal growth path for the service sector should be clarified. The ‗optimal‘ growth of the service sector relates to the fact that the introduction of IT and expertise knowledge, by either internally, externally, or with public support, that aims to improve productivity and benefit from scale merit does not always achieve the maximum output of the service sector. It is necessary to focus on maintaining geographical locality (‗inseparability‘ of service) for some locally-traded services while it is important to invest into R&D in services (‗intangibility‘ of service) to increase knowledge expertise and gain competitive edge in a global market. Taking this connection of technological and knowledge innovation into consideration, Cobb-Douglas function is used for the empirical analyses. The empirical analyses consist a firm-level analysis for both listed companies and unlisted companies, and macroeconomic policy. Various test procedures are performed starting from a standard regression. Several focal points, which are discussed and articulated in the previous sections, are incorporated in the test procedures one by one. The first point is the impact of firm size variations on revenue and productivity. The second point is the expenditures on R&D. The third point is the use of IT and KIS. The fourth point is the efficiency for the service sector in terms of the use of external knowledge. As a supplementary argument, the impact of trade is also tested. To verify all these points, various regression models are experimentally used. The highlight of these analyses is, first of all, the incorporation of function, which estimates the production function in the presence of selection bias and simultaneity by using the three-stage algorithm described

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in Olley and Pakes (1996). The second highlight is the use of Levinsohn and Petrin (2003) model, which estimates production functions using intermediate inputs to control for unobservable productivity shocks. According to the firm-level analysis for the service sector, intangibles are relevant to how effective KIS are in terms of the revenue growth. The balance of tangibles and intangibles, which is represented in the distribution of capital productivity, seems to give an important impact on the revenue trend in each size class and sector. There is an optimal firm size in each type of investment into R&D and software. The balance of R&D investment and how long a firm continues to operate is another key for a successful turnover growth. These observations can be an explanation of the stagnation of productivity in the entire service sector, and the structural factors that suggest the direction for future growth of the service sector. These analytical frameworks can be applied to other countries for investigating future economic trends and appropriate policies. As for the macro economic analysis, both the estimated productivity in the firm-level analysis and the productivity taken from official statistics are comparatively reviewed to check biases in the test procedures and to observe how the estimated productivity in the service sector yields a different curve in the context of the entire macro economy. By doing so, the impact of intermediate service inputs is addressed in relation to the formation and consumption of ICT capital. According to the result of simulations, the increase in service intermediaries gives not a large impact as ICT capital does although service intermediaries take a role as moderator of total economic fluctuations and smoothen out the trend curve. The diminishing return observed with ICT capital, then, can be alleviated by the co-investment into ICT and KIS. Therefore, the combination of the use of ICT capital and service intermediaries should be appropriately considered for the current and future economy. As previously explained, the level of capital, labor and productivity varies widely in each service sector. Based on the review on major statistics and past literatures, it is proposed to address the importance of firm size distributions, leading to the variations of profit structure in the service sector. Another important point is the different trend that is the growth of the service sector promoted by the introduction of IT and expertise knowledge services, by either internally, externally, or with public support, that aims to improve productivity. In this regard, it is articulated that KIS has a special role to play for facilitating innovation. The other point that gathers attention in a recent few years is the impact of service R&D, which is performed to increase knowledge expertise and gain competitiveness in a global market. In line with these trends, this chapter aims at arguing economic growth models based on the following assumption: innovation in the service sector is promoted and transformed with the appropriate use of KIS and IT services. There is a case where an open environment is promoted for active and free communication of diversified values and behaviors. In this case, knowledge is produced and disseminated in an irregular pace and form. On the other hand, expertise knowledge i.e. R&D is first accumulated in a closed environment and then applied to the open environment so that the knowledge is used according to a variety of values of consumers with a certain degree of efficiency in terms of generating profits. In today‘s economy, it is suggested that the latter case can be seen more often. For example, financial services are utilizing complex mathematical algorithms to distribute risks associated with financial services. General consumers normally do not know theory behind the products. The mechanism of pharmaceuticals using genome information is too hard for patients to understand, however,

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the products are used in healthcare where patients live with a variety of values and lifestyles. These examples can be called ‗open-close innovation.‘ The coexistence of openness and closedness in services represents a strategic positioning in the service-oriented economy.

ACKNOWLEDGMENT Professor Osamu Sudoh, the University of Tokyo, Professor Hideyuki Tanaka, and Associate Professor Reiko Gotoh, Ibaragi University have offered deep insights on the concept of service innovation and its measurement. Professor Sudoh has also provided theoretical foundation on network economy and the role of IT in the society and economy as well as policy and technical perspectives on public policies in Japan. Associate Professor, Syungo Skaki, Tokyo Institute of Technology, has offered important inputs regarding analysis methodology and the selection of data. I appreciate the feedback offered by Associate Professor Hiroshi Ohashi, the University of Tokyo, with regard to the measurement method of innovation and productivity. I acknowledge information on international trade in services from Associate Professor Yukiko Itoh, Tokyo Gakugei University as very useful. In addition, Assistant Professor Yun Jeong Choi, the University of Tokyo, were supporting data collection and offered feedback on measuring the impact on R&D. The author is responsible for any possible mistake in this chapter.

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Ottaviano, G. I. P., & Melitz, M. J. (2008). Market Size, Trade, and Productivity. Review of Economic Studies, 75(1), 295-316. PREST, TNO, ARCS, & SERVILAB. (2006). The future of R&D in services: implications for EU research and innovation policy: A report commissioned by the Science and Technology Foresight Unit of DG. ftp://ftp.cordis.europa.eu/pub/foresight/docs/ntw_ conf_services_report-en.pdf Pagano, P., & Schivardi, F. (2003). Firm Size Distribution and Growth. . Scandinavian Journal of Economics, 105(2), 255-274. Pakes, A. (2003). Common Sense and Simplicity in Empirical Industrial Organization. Review of Industrial Organization, 23(3), 193-215. Pakes, A., & Ericson, R. (1998). Empirical Implications of Alternative Models of Firm Dynamics. Journal of Economic Theory, 79(1), 1-45. Pakes, A., & Griliches, Z. (1980). Patents and R&D at the firm level: A first report. Economics Letters, 5(4), 377-381. Pakes, A., & Schankerman, M. (1979). The Rate of Obsolescence Of Knowledge, Research Gestation Lags, and the Private Rate of Return to Research Resources: National Bureau of Economic Research. Patrizio, P., & Fabiano, S. (2003). Firm Size Distribution and Growth. Scandinavian Journal of Economics, 105(2), 255-274. Rimal, B. P., Eunmi, C., & Lumb, I. (2009). A Taxonomy and Survey of Cloud Computing Systems. International Conference on Networked Computing and Advanced Information Management, 44-51. Sargent, T. J., & Williams, N. (2005). Impacts of Priors on Convergence and Escapes from Nash Inflation. Review of Economic Dynamics, 8(2), 360-391. Sasser, W. E., Olsen, R. P., & Wyckoff, D. D. (1978). Management of Service Operations: Allyn & Bacon. Schankerman, M., & Pakes, A. (1986). Estimates of the value of patent rights in European countries during the post-1950 period. Economic Journal, 96(384), 1052-1076. Scherer, F. M. (1983). The propensity to patent. International Journal of Industrial Organization, 1(1), 107-128. Schwalbach, J., & Zimmermann, K. F. (1991). A Poisson Model of Patenting and Firm Structure in Germany. In Z. Acs & D. B. Audretsch (Eds.), Innovation and Technological Change: An International Comparison: University of Michigan Press. Scott, J. T. (1999). The Service Sector's Acquisition and Development of Information Technology: Infrastructure and Productivity. The Journal of Technology Transfer, 24(1), 37-54. Second OECD Ad Hoc Meeting on Biotechnology Statistics. (2001). Biotechnology: Listbased Definition. http://stats.oecd.org/glossary/detail.asp?ID=218 Service Innovation Research Initiative. (2009). Proposal Towards the Establishment of an Informatical Foundation of Services to Realize Innovation: Division of University Corporate Relations, the University of Tokyo. http://www.ducr.u-tokyo.ac.jp/serviceinnovation/pdf/090331teigen-en.pdf Shapiro, C., Varian, H. R., & Farrel, J. (2004). The Economics of Information Technology: An Introduction: Cambridge University Press. Shefer, D., & Frenkel, A. (2005). R&D, firm size and innovation: an empirical analysis. Technovation, 25(1), 25-32.

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Yu, J., Li, M., Li, Y., & Hong, F. (2004). An Economy-Based Accounting System for Grid Computing Environments. Web Information Systems Workshops , 233-238. Zeithaml, V. A., Parasuraman, A., & Berry, L. L. (1990). Delivering Quality Service; Balancing Customer Perceptions and Expectations: Free Press.

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Chapter 2

EMBRACING CHANGE? AN UPDATE OF THE IFAC COMPLIANCE PROGRAMME IN A LESS DEVELOPED ECONOMY Javed Siddiqui1* Reazur Rahman Chowdhury2, and Dewan Mahboob Hussain2 1

University of Manchester, UK University of Dhaka, Bangladesh

2

ABSTRACT Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved.

The objective of this study is to investigate suitability of the IFAC statements of membership obligations (SMOs) in the context of a less developed economy. Past literature has identified the presence of a significant gap between accountants working in developed countries and LDCs in terms of skills and competence. Also, due to various socio-economic conditions, the perceptions of ethical conduct vary widely between developed and developing countries. However, despite this, international accounting bodies such as the IFAC have time and again attempted to promote a universal set of standards to ensure audit quality. Using the case of Bangladesh, this paper investigates the adoption and implementation process of IFAC SMOs in the contxt of an LDC. Interviews with policy makers, practicing auditors, senior accounting academics, and leaders of the accountancy profession, as well as a questionnaire survey with final year undergraduate students of accounting reveal the absence of the essential preconditions of ethical practice in Bangladesh, making the IFAC SMOs largely ceremonial. It is found that the auditing profession survives through its relationship with the state, and the dynamics of such relationship changes under threats of legitimacy. The paper also provides evidence of third party influence over the dynamics of the state-profession relationship. Overall, our findings suggest that the adoption of SMOs in Bangladesh may have been prompted by institutional reasons rather than reasons of efficiency, and a

*

Corresponding author: Manchester Accounting & Finance Group, Manchester Business School, University of Manchester, Crawford House, E: javed. siddiqui@mbs. ac. uk

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Javed Siddiqui, Reazur Rahman Chowdhury and Dewan Mahboob Hussain replication of the Bangladesh case in other LDCs will make IFAC‘s efforts to improve audit quality through a compliance programme largely unsuccessful.

Keywords: Auditing profession; IFAC; statements of membership obligations, LDCs, globalization.

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INTRODUCTION The ongoing rapid economic and political globalization has led to the emergence of the International Federation of Accountants (IFAC) as a global authority in auditing (Loft and Humphrey, 2006). The mission of IFAC, as stated in the organisation‘s much-publicised website is ‗the worldwide development of an accountancy profession with harmonised standards, able to provide services of consistently high quality in the public interest‘ 1. In 2006, IFAC issued seven statements of membership obligations (SMOs) to assist ‗high quality performance by professional accountants‘ (IFAC, 2006). The member bodies of IFAC, which includes national accountancy bodies from most of the countries in the world, are required to make their best endeavours to abide by the SMOs, and failure to do such without satisfactory explanations would result in suspension or removal of membership. The seven SMOs issued by the IFAC covers areas such as audit quality assurance, audit education, international accounting and auditing standards, code of ethics for professional auditors, and self-regulation of the auditing profession. Although member bodies are free to have their national standards accountants, such standards would need incorporate the provisions of the IFAC SMOs and should be at least, as stringent as the IFAC statements. Earlier, Cohen, Pant and Sharp (1992), investigating IFAC‘s prior globalization efforts, found that acceptance and implementation of international code of professional ethics for accountants could be affected by various national cultural and socio-economic factors. MacLullich and Sucher (2005) commented that harmonisation of auditing practices had been impeded by local culture and traditions on which ethics is historically constructed. Arnold (2009) points out that effort to harmonise national regulations with international practices may threaten the auditing industry in emerging economies even more, as this might allow a few multinational accounting firms to consolidate their power and control in those economies. Cohen, Pant, and Sharp (1992) pointed out that a significant gap exists between developed and less developed countries (LDC) in terms of auditors‘ education, competence, and ethical perceptions, and such difference would potentially make IFAC‘s globalization attempts ineffective. In a recent study, Clements, Neill and Stoval (2009) investigated the extent to which 158 countries had adopted the IFAC code of ethics. The paper found that, contrary to the hypothesis that lower income countries would be less likely to adopt the IFAC code of ethics due to socio-economic factors; such countries were actually more inclined towards the adoption of the IFAC code. Clements et al commented that although lack of resources in low income countries might have resulted in such whole-sale adoption of the IFAC code, the presence of various socio-economic factors would make it very difficult for these countries to implement the code. This sets the context for this study. The objective of this paper is to investigate the suitability of the IFAC code of ethics in an emerging economy, namely 1

IFAC website www. ifac. org

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Bangladesh. Using interview and questionnaire methods, we investigate whether the IFAC statements of membership obligations relating audit quality, education standards, code of ethics, and disciplinary procedures can actually be implemented in the socio-cultural environment within which the auditing profession in Bangladesh operates. In response to Chua and Poullaous (1993), this paper also investigates the dynamics of the state-profession relationship. The vulnerable political situation that prevailed in Bangladesh during 2007 and 2008 allows this study to explore the influences of donor agencies such as the World Bank on the relationship between state and the auditing profession under threats of legitimacy. Like many other low-income economies, Bangladesh has been an early adopter of the IFAC SMOs. Prior research has documented the lack of demand for audit services in Bangladesh. The competence of professional auditors has been doubted, and perceptions regarding auditor independence have remained poor. All these have contributed to the abysmal level of fees offered to auditors, which, in turn, has the potentials to affect audit independence further. Interviews with policy makers of the Institute of Chartered Accountants of Bangladesh (ICAB), the Securities Exchange Commission (SEC), senior accounting academics, and policy makers of the government, and questionnaire survey involving undergraduate students of accounting, reveal that the presence of a number of socio-economic conditions, such as, legal structure, judicial system, the profession‘s inability to attract quality students, and poor monitoring by the ICAB would make it very difficult to implement the IFAC SMOs in Bangladesh. This might have important policy implications, as our study indicates that if the Bangladesh case is being replicated in other LDCs, IFAC‘s efforts to globalise audit quality through their compliance programme may end up being largely ceremonial. The chapter is structured as follows. The next section outlines IFAC‘s compliance programme. This is followed by a section that incorporates the contextual information regarding the auditing profession in Bangladesh. A subsequent section then describes the research methods. Based on the interview and questionnaire responses, the status of the implementation of a number of IFAC SMOs are then examined in the context of Bangladesh. This is followed by a section that discusses the socio-political environment within which the auditing profession operates in Bangladesh. The discussion and conclusion section then iterates the findings.

HARMONIZING AUDIT QUALITY: IFAC’S COMPLIANCE PROGRAMME In 2004, IFAC issued seven statements of membership obligations relating to quality assurance, education standards, international auditing standards, code of ethics for professional accountants, standards for public sector accounting, investigation and discipline, and international financial reporting standards (IFRS). The objective of the SMOs was to provide ‗clear benchmarks to current and potential IFAC members to assist them in ensuring high quality performance by professional accountants‘ (IFAC 2004, pg 1). To seek and understand how the SMOs would be implemented, the IFAC initiated a compliance programme for its member bodies. The programme consisted of three components. Part one of the compliance programme involved assessment of regulatory and standard setting

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frameworks of the member bodies. Part two of the compliance programme required member bodies to complete self-assessment questionnaires to demonstrate their best endeavours to comply with the IFAC SMOs. Part 3 of the Compliance Program required members bodies to develop action plans to address areas identified through the part two self-assessment. SMO 1 (IFAC, 2004) relates to quality assurance and is to be applied by member bodies of IFAC to quality assurance review programs for their members performing certain audit engagements of financial statements. It requires member bodies to establish and publish quality control standards and guidance requiring firms to implement a system of quality control in accordance with the International Standard on Quality Control (ISQC). SMO 2 relates to international education standards for professional accountants. The SMO applies whether the member bodies issue such standards, or whether the standards are issued by another body. International accounting standards are covered by SMO 3 (IFAC, 2004). This statement sets out the obligations of member bodies of IFAC in relation to quality control, auditing and assurance standards for its members. SMO 4 provides a IFAC code of ethics for professional accountants. The statement sets out the obligations of member bodies of IFAC in relation to the IFAC Code of Ethics for Professional Accountants. SMO 5 deals with public sector accounting standards. Standards to be applied by member bodies of IFAC in the investigation and discipline of misconduct, including breaches of professional standards and rules by their individual members are dealt with in SMO 6, although acknowledging that legal systems are very different from country to country. SMO 7 sets out the obligations of member bodies of IFAC in relation to IFRSs issued by the International Accounting Standards Board (IASB). A number of studies (for example, Mir and Rahaman, 2005; Akhtaruddin, 2005 etc) have already investigated the process by which the international accounting and auditing standards are adopted in Bangladesh. Also, we acknowledge that auditing principles and procedures in the public sector are significantly different than those adopted in the private sector. Due to these reasons, our study is confined to investigate the applicability of four SMOs, namely, quality assurance, education standards, code of professional ethics, and investigation and discipline procedures in the context of Bangladesh.

THE PUBLIC ACCOUNTANCY PROFESSION IN BANGLADESH Although Bangladesh became politically independent in 1971, the accountancy profession has a much longer history. Bangladesh was a part of the British ruled India. Like many other colonies, it inherited the legal structure of its rulers. The Indian Companies Act (1882), promulgated by the colonial rulers, required mandatory audit of financial statements of public limited companies. However, at that time, auditors were not required to be professionally qualified. Rather, lawyers were recruited as independent auditors (Saeed, 1991). The Companies Act of 1913 required accounts to be audited by professionally qualified accountants. The government was empowered to grant auditors' certificates. The members of the English, Scottish and Irish Institutes of Chartered Accountants and the English Society of Incorporated Accountants and Auditors were recognised as qualified auditors. Saeed (1991) reports that at that time, there was neither any provision for training for the accountants in British-India, nor they had to pass any examinations. In 1918, the

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Embracing Change?

Government Diploma in Accountancy was introduced in Bombay, and provisions for examinations and training were introduced for those who wanted to obtain that Diploma, and subsequent certificate to practice. In 1932, the Government framed rules under Section 144 of the companies Act, 1913, called Auditors' Certificates Rules, 1932. The objectives of the rules, broadly, were to register apprenticeships, to conduct examinations, and to control and regulate the profession of auditing. The accountancy profession was at that time being supervised and controlled by the Ministry of Commerce of the Central Government. With a view to helping the Government in discharging the necessary responsibilities in respect of the accountancy profession, Indian Accountancy Board was established in 1932 (Saeeed, 1991). In 1947, the Indian sub-continent was freed from British rule, and two new nations, namely India and Pakistan, emerged. Bangladesh (referred to as East Pakistan at that time) became one of the major provinces of Pakistan. After independence, Pakistan adopted the Auditors' Certificates Rules 1932 with certain amendments in 1950, and this guided the auditing profession. Under the certificate rules, only a person who passed the Registered Accountants examinations and satisfied the practical training requirements as prescribed by the Ministry of Commerce could use the designation 'Registered Accountant'. The Companies Act, 1913, as adopted by Pakistan, allowed only a Registered Accountant to audit a public limited company. In 1961, the government of Pakistan passed the Chartered Accountants Ordinance (GoP, 1961). Subsequently, The Institute of Chartered Accountants of Pakistan was established on July 1, 19612. The Bengali (then East Pakistani) chartered accountants were members of this institute. When Bangladesh became liberated from Pakistan in 1971, it adopted the Companies Act of 1913. As a result, it found itself with laws that required audit of public limited companies, but no professional accountancy bodies (Parry and Khan, 1984). Subsequently, the Institute of Chartered Accountants of Bangladesh (ICAB) was established through the Chartered Accountants Ordinance of 1973. The auditing profession in Bangladesh is characterized by very low levels of audit fees reflecting poor demand for audited financial statements (Karim and Moizer, 1996), poor perceptions regarding audit quality (BEI, 2002), and direct absence of the Big 4 audit firms3. Siddiqui (2010) reports that despite having a very large population, the number of auditors in Bangladesh is surprisingly low even compared with its neighbouring countries, India, Pakistan, and Sri Lanka. At present, there are two accountancy bodies: the ICAB is an institute for auditors, whereas the Institute of Cost and Management Accountants of Bangladesh (ICMAB) caters to the needs of the cost and management accountants. Despite the short supply of qualified accountants, the legal structure in Bangladesh still does not recognize globally acceptable professional qualifications such as the ACCA. The ICAB has been criticized for failing to take actions against members involved in unethical practices. This has raised questions regarding the effectiveness of ICAB as a professional body, and users have expressed their concerns regarding the quality of financial reports audited by the members of this association (BEI, 2003). The Bangladesh government is dependent on various donor agencies such as the World Bank for financial assistance, and policy level interventions by such agencies, including in areas of accounting, auditing, and corporate governance are documented (for details, see Uddin and Hopper, (2005); Akhtaruddin (2005); Mir and Rahaman (2005); Siddiqui (2010) etc. ) .

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2 3

www. icap. org,pk Only one big 4 firm has offices in Bangladesh, where others operate through their local affiliates.

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RESEARCH METHODS The main sources of data were interviews and questionnaires. A total of 23 interviews were taken over an eight-week period between June and August 2009. Permission was received for recording all the interviews, and respondent anonymity was granted. A broad spectrum of respondents were selected for the interviews, including auditors, regulators, accounting academics, users of audited financial information, and members of the government with the capacity to make high level decisions regarding the auditing profession. Amongst auditors, interviews were conducted with present and past Presidents of the ICAB, council members of the ICAB, senior partners of all the major audit firms in Bangladesh, and non-practicing chartered accountants. A number of senior officials of the Securities and Exchange Commission (SEC), including the immediate past chairman, were interviewed. Also, a few accounting academics were consulted to gain better understanding of the accountancy profession in Bangladesh. User groups, such as finance directors of two MNCs operating within Bangladesh were also interviewed for their perceptions on the state of the auditing profession in Bangladesh. The cross checking of contradictory respondent comments, if any, with those of accounting academics, regulators, and policy makers, would increase internal and external validity (Miles and Huberman, 1994). All interviews were open-ended, allowing respondents to express their opinions. Interviews typically lasted between thirty minutes to an hour. A few follow-up interviews were taken over telephone at later stages for further clarification of comments made by respondents. Table 1 presents the profiles of the respondents. The documentation consulted included media reports, draft copies of regulations, websites of the ICAB and the SEC, and orders of the SEC with regards to disciplinary actions against auditors. To obtain the views of graduate students entering the auditing profession, we also conducted a questionnaire survey. Questionnaires were distributed in classrooms to 155 final year accounting students studying in the University of Dhaka, Bangladesh‘s oldest and most recognised university. Admission into this university is very competitive, and at the point of admission a merit list, that ranks students on the basis of their prior public examinations results as well as their score in the written admission test, is produced. Once admitted, the students are evaluated on the basis of a cumulative grade point average (CGPA) system. The questionnaire asked students to reveal their admission test merit ranks (at the point of admission into the university in 2004) as well as their current CGPA (at the point of graduation in 2008/09). Also, students were asked to rank their future career choice preferences. Eight preferences were given, namely, careers in the private sector, education sector, banking sector, public sector, chartered accountancy profession, cost and management accountancy profession, further studies, and others. Students not willing to take up chartered accountancy as a future career option were required to answer a further question. This question asked respondents to rank (from 1 to 8, 1 being the most important factor) the top factors that discourage them to enter into the accountancy profession. Out of the 155 responses, 13 were illegible. As a result, 142 usable responses were received, yielding a final response rate of 93.5 percent. The questionnaire responses were then analyzed using conventional statistical methods.

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Embracing Change? Table 1. Interviewee profiles Pseudo initials AA AK AMK

Position

Big 4 audit firm Big 4 audit firm Non practicing chartered accountant, ICAB

Partner Senior partner Member, Quality assurance programme, ICAB

AMP AS ASK

MNC University of Dhaka Big 4 audit firm, ICAB

ASMN

Big 4 audit firm, ICAB

AUC

Non practicing chartered accountant, ICAB SEC SEC Medium sized affiliated audit firm Small audit firm, ICAB Medium sized affiliated audit firm, ICAB Medium sized affiliated audit firm Big 4 audit firm

Finance Director Assistant professor of Accounting Senior partner in a Big 4 audit firm, former president of the ICAB, council member ICAB Senior partner in a Big 4 audit firm, former president of the ICAB, council member, ICAB Former president of the ICAB, council member, ICAB

FA FAS HAM HG HM

HsM MA MJA Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved.

Institutional affiliation

Executive Director Former Chairman Partner in a medium sized audit firm

Policy maker, Member of ICAB‘s ‗informal‘ delegation dealing with the FRC Regulator Regulator Auditor in practice

Senior partner

Auditor in practice, senior chartered accountant Policy maker

MR MZ

SEC

Executive Director

NUA

Non practicing chartered accountant, ICAB Medium sized affiliated audit firm, ICAB

Incumbent president, ICAB

Big 4 audit firm University of Dhaka Non practicing chartered accountant, MNC

Member of ICAB‘s ‗informal‘ delegation dealing with the FRC

Policy maker, senior chartered accountant Auditor in practice, involved in accounting standards setting

Senior partner in a medium sized audit firm, former president of the ICAB, council member of the ICAB Assistant Director

SK SKS SRA

Auditor in practice Policy maker Policy maker, currently working on ICAB‘s quality assurance programme, and its ‗twinning‘ project with the ICAEW User Accounting lecturer Policy maker, currently working on ICAB‘s quality assurance programme

Senior partner in small audit firm, former president of the ICAB Partner in a medium sized audit firm, and member of the standard setting committee of the ICAB Senior partner

Medium sized affiliated audit firm, ICAB SEC

QA

Reasons for inclusion

Senior partner in a medium sized audit firm, member of the disciplinary and quality assurance committees of the ICAB Partner in a Big 4 audit firm Professor of Accounting, former chair FD of an MNC

Auditor in practice

Deals with disciplinary procedures against auditors Regulator, involved with the preparation of the FRA Policy maker

Policy maker, involved with selfregulation within the ICAB

Auditor in practice Senior accounting academic User, , contested in ICAB‘s council elections

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UPDATE OF IFAC SMOS IN BANGLADESH As mentioned before, Bangladesh has been one of the early adopters of the IFAC SMOs. The country‘s profession has been willing to make the necessary adjustments, including introducing a quality assurance programme, initiating a twinning project with the ICAEW to enhance education standards, and adopting the IFAC code of professional ethics without any modifications (IFAC, 2009). However, although these steps might have been taken to demonstrate Bangladesh‘s compliance with the SMOs, the socio-cultural factor present in Bangladesh may impede the actual implementation of these standards. Based on interviews and questionnaires, this section attempts to shed some light on the possibility of implementing the SMO‘s in the context of Bangladesh.

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Quality Assurance Although there is lack of empirical evidence regarding professional independence of auditors in Bangladesh, there is, at least, a perceived lack of audit independence. The Bangladesh Enterprise Institute (BEI), an independent think-tank, performed a questionnaire survey on the state of corporate governance in Bangladesh (BEI, 2003). The survey revealed that stakeholders (shareholders, CEOs and Managing directors) in Bangladesh did not believe that the audited financial statements presented a true and fair view of the state of the companies. Auditors were not considered to be independent, or sufficiently qualified to attest financial statements (BEI 2003, pg 62). The report revealed that the shareholders had the perception that the auditors were not protecting their interests, and audit was not adding any value, and were therefore not willing to increase audit fees. This was confirmed by the CEOs of the companies included in the survey, who stated that auditors in Bangladesh were not independent of the company they were supposed to audit. Most respondents that were interviewed for this study had negative perceptions regarding auditors‘ independence in Bangladesh. A finance director of an MNC remarked ‗Many auditors in Bangladesh will sign a fake document for even Tk. 50004. The small companies of Bangladesh generally go to this kind of (unethical) auditors (User AMP)’. Similar comments came from an SEC official in charge of carrying out investigations against auditors. The official mentioned fierce competition in the audit market as one of the major reasons for such unethical practices. Surprisingly, most auditors that were interviewed were of the opinion that the auditors operating in the Bangladeshi corporate sector were not independent. These perceptions are consistent with BEI (2003).

Presence of threats to audit independence Most of the interviewees identified low levels of audit fees as the main problem relating self-interest threat to the independence of the auditing profession. As one interviewee put itFee and fee are the only problems with the auditing profession in Bangladesh. (Practicing auditor HG)

4

Taka (Tk) is the Bangladeshi currency. As of January 1, 2010, £1= Tk 114.

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This is consistent with prior studies (for example, see Karim and Moizer (1996), Ahmed and Goyal (2005)). A number of interviewees, including auditors, regulators, and FDs, believed that the poor levels of audit fees stemmed from poor perceptions regarding quality of audit work, and if the quality of audit were higher, the market would be willing to pay more to auditors. One big 4 partner commented-Fee is one but not the main reason for low quality audit service. If better quality service can be ensured by the firms, clients will pay more. Fee is actually significantly low in Bangladesh. It is almost 4 times in Sri Lanka (Practicing auditor AK) This view was supported by the incumbent ICAB president, who mentioned that low audit fees could not be the reason for someone being unethical. The president also mentioned that due to low levels of audit fees, auditors did not apply due diligence I don’t accept that audit fee is the main reason for lack of audit quality…they do put forward this point a lot…but I cannot accept that. If I provide quality audit…I’m sure fee would increase…to survive why should I compromise my ethics. I am supposed to go through at least 10-15% of the vouchers…I only go through 5%. . . if I have conscience of my own why would I do that? (ICAB president NUA)

Also, a partner of another medium sized audit firm had similar perceptions regarding the state of audit quality in Bangladesh. This respondent also believed that the lack of audit quality was not a problem for the small audit firms only, rather, this existed across the industry, including the big 4 firms-

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Do you think that, if asked for, the big 4 will be able to provide the working papers? There is no working paper in most cases, so how would they provide these? (Practicing auditor QA)

This was supported by one senior partner of a big 4 firm (MA). The comments provide evidence of lack of integrity and due diligence from the part of the auditors in Bangladesh. Interview evidence suggests that, in addition to low audit fees, a number of other threats to audit independence are present in the regulatory environment within which the Bangladeshi audit market operates. For example, although APB (2004) mentions that the provision of NAS by incumbent auditors creates the self-review threat, the Bangladesh Companies Act (GoB, 1994) still allows auditors to provide non-audit services. However, a recent SEC order (2006) prohibits companies to purchase a number of NAS from their incumbent auditors. Interview evidence suggests that the auditors and companies in Bangladesh may have found ways around such requirements. One audit partner stated that they continued to provide the same services, and nothing had changed as a response to the SEC requirement relating to prohibition of non audit work in terms of their relationships with the clients. However, after the SEC order, they had set up an independent consulting business with a different name, and that consulting business was, in paper, performing the non-audit services for the client, whereas in practice, it still was the same group of people doing the audit and consultancy work. The audit partner of a medium sized firm did not see anything wrong with the provision of audit and non-audit servicesIf the clients want our services, why wouldn’t we offer it to them? I don’t see any independence problem in it. (Practicing auditor HM)

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Also, as a safeguard against familiarity threat, the SEC (2006) requires mandatory rotation of auditors for public limited companies every three years. Notionally, such actions, although debatable, seem appropriate and timely. Interviews revealed that similar sidetracking practices were also adopted in response to the provision for auditor rotation. One senior audit partner suggested that even one big 4 firm were involved with such practices. He mentioned that in order to retain clients, the big 4 firm has reached an agreement with a very small firm to accept their clients at the end of their three-year tenure. In paper, this small firm then becomes the ‗official‘ auditor for the client, whereas in practice, the audit is still being performed by the big 4 auditors. However, the audit partner was supportive of this practiceI know this may sound unethical to you. However, think about the big 4 client, likely to be a very large firm…would small audit firms have the skill to audit them? Therefore, for the client, isn’t it better that they still avail the services of the same big 4 firm, with a different name?(Practicing auditor ASMN)

Interviewees revealed that the poor quality of students coming in to the profession creates an intimidation threat to audit independence. One senior partner of a medium sized firm commentedWe seem to be attracting a particular class of students who are very good with the maths. But they lack communication skills. Auditing requires a lot more than just computational skills. You will have to communicate with the clients on a regular basis, and some of our articled students seem to be intimidated by the client management, which is sometimes run by smart MBAs from western schools. (Practicing auditor ASMN)

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The above discussion suggests that the auditing profession in Bangladesh is exposed to threats to auditor independence, both in appearance and in fact. Also, various unethical practices diffuse regulatory efforts to restore auditor independence.

Education Standards One important component of audit quality is the technical competence of the auditors (DeAngelo, 1981). Such competence is acquired through professional education, and training. Like auditors in many other countries, auditors in Bangladesh have to pass a number of examinations and complete a three-year training period in an audit firm. However, the quality of auditors coming out of this process still remains questionable. The World Bank, in a report on the observance of standards and codes in Bangladesh (ROSC), has identified poor levels of education and training as one of the major problems for the development of the auditing profession in Bangladesh (World Bank, 2003). The main problems with the education and training for professional accountants, as identified by the report, includes the failure of the profession to attract good quality students, the poor quality of accounting and auditing education offered at the undergraduate levels, and the inadequate training programmes offered by the ICAB. For the purpose of this paper, we will explore each of these factors to identify the problems associated with professional education and training of the auditors in Bangladesh.

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Quality of students attracted by the profession The World Bank report (World Bank 2003) suggests that the better quality students in Bangladesh are not attracted to the accountancy profession, as ‗it is not viewed as a stepping stone to a rewarding and prestigious career‘ (World Bank 2003, pg 1). To verify this statement, we conducted a questionnaire survey with the final year undergraduate students at the department of accounting and information systems at the University of Dhaka. This institution is nationally recognized as one of the major providers of accounting and auditing education at an undergraduate level. The final year students were asked about their career preferences once they graduate from the university with a degree in accounting. Tables 2, 3 and 4 present the questionnaire responses. Table 2. Accounting as a preference for students Quartile Starting point Q1 Q2 Q3 Q4

Quartile range 2 106. 75 252 305. 75 429

n 1 35 35 36 36

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Table 3. Reasons for not joining the profession Rank 1 2 3 4 5 6 7 8

Mean 2. 38 2. 68 2. 78 3. 87 5. 11 5. 24 6. 96 7. 02

Reason Time consuming Poor passing rate Poor salary for articled students Excessive work load Poor quality of audit firms Poor job prospect Not attractive as a profession Gender/other discrimination

Table 4. Career preference for accounting students Panel A: Student preference Rank 1 2 3 4 5 6 7 8

n 40 27 16 15 14 12 10 8

Percentage 28. 29% 19. 08% 11. 18% 10. 53% 9. 87% 8. 55% 7. 24% 5. 26%

Preference Chartered accountancy Private sector jobs (other than banks) Teaching Further studies Jobs in banks Cost and management accountancy Public sector jobs Others

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Q1 Q2 Q3 Q4 Overall

Panel B: Analysis of student preference based on academic performance N Banking Teaching Private CA CMA Public Others 34 2. 94% 17. 65% 20. 59% 47. 06% 5. 88% 0. 00% 2. 94% 36 8. 57% 5. 71% 8. 57% 37. 14% 20. 00% 2. 86% 5. 71% 35 8. 82% 5. 88% 20. 59% 26. 47% 2. 94% 17. 65% 0. 00% 37 17. 95% 7. 69% 23. 08% 7. 69% 7. 69% 10. 26% 12. 82% 142 9. 87% 11. 18% 19. 08% 28. 29% 8. 55% 7. 24% 5. 26%

Further 2. 94% 11. 43% 17. 65% 12. 82% 10. 53%

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The questionnaire survey reveals that in 2004, students ranging from merit positions 2 to 429 secured the 180 seats offered in accounting. Table 2 reveals that o that the top 35 students admitted into the accounting department in that year actually were not from the top 35 in the faculty based on the merit list, rather they were ranked up to 107th based on their prior results. This indicates that accounting as a subject did not attract the best students of business studies. The admissions division of the university of Dhaka also reports that amongst the students applying for studying in the faculty of business studies, (which offers undergraduate and postgraduate degrees in management, accounting, marketing, finance, hrm etc) accounting ranks third, after finance and marketing, as a popular choice. Commenting on this trend, one senior accounting academic, a former head of the department of accounting and information systems, revealedIn my long career, I have always seen students opting for accounting as their first subject option. It is only over the last 5-6 years that accounting has ranked lower as an option. It may be because of the growth of the banking and telecommunications sectors, who offer fabulous salaries to students graduating in finance and marketing. Also, it is time consuming to qualify as a chartered accountant, and the poor passing rate and the appalling stipends offered by the chartered accountancy firms do not help attracting students towards this profession (Accounting academic SKS).

This supports the findings of another World Bank report (World Bank, 2002) which claims that banks in Bangladesh prefer MBAs over professionally qualified auditors, and there is very little appreciation of the value added by the work of a professional accountant (World Bank 2002). Table 3 (panel A) indicates that chartered accountancy seems to be the most popular career choice for the respondent student group, with 28% students opting for it. This is followed by career choices in the private sector, teaching, and further education. To identify whether the best students are attracted to the profession, we then divide the student groups into four quartiles on the basis of the final-year CGPAs. Table 3 (panel B) presents the results. The results indicate that although accounting as a subject may not have the top quality students at the time of admission into the university, once chosen, significant number of accounting students falling in the top two quartiles (47% and 37% respectively) would actually choose chartered accountancy as a profession. Also, only five students falling in the first 25 percentile would opt for chartered accountancy as a future career option. The results also indicate that although working private sector is a popular career choice (ranked second as in Panel A), the sector does not really attract the top graduates majoring in accounting.

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Similarly, banks also seem to have failed to attract the attention of the top accounting students. Table 4 ranks the reasons for students not willing to take up the accounting profession as a career. The results indicate that the time consumed to qualify as a chartered accountant, the poor passing rates, and poor rates of stipends paid to the articled students are the top factors discouraging students majoring in accounting to pursue their careers as professional accountants. A number of interview respondents, mostly senior auditors claimed that auditors in Bangladesh did not enjoy the same levels of social prestige enjoyed by other professionals, such as doctors, and lawyers because ‘there is no use for an auditor’, and this might be a potential reason for the profession‘s failure to attract top quality students. A senior audit partner, who has been a past president of the ICAB summarized the social status of the auditors as follows- ‗if I had understood that the status of audit profession is like this in Bangladesh, I would have never thought of joining this profession’ (Non-practicing auditor HG). In addition to this, The ICAB president observed that the time and investment required to qualify as chartered accountants may be another contributing factor. This is consistent with the survey results that finds time consumed to qualify as a chartered accountant as a top discouragement factor for students graduating in accounting. The survey results as well as the comments of the respondents are consistent with Zebley (1956) who stated that the American accountancy profession, in its initial stages, also had problems with attracting the top quality students.

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Quality of accounting and auditing education at the undergraduate level The quality of accounting education at the undergraduate level has been the cause of major concern for the development of professional accounting education in Bangladesh. The World Bank ROSC report summarized this as followsThe quality of higher education suffers from the lack of modern curriculum and skilled instruction. Accounting courses in the bachelor’s degree program do not include practical application of national and/or international accounting and auditing standards. Many accounting teachers lack the experience and adequate knowledge to teach either the theoretical or practical aspects of IAS and ISA. Undergraduate-level teaching in accounting and auditing mainly focuses on elementary topics and application of some basic standards. The outdated curriculum and lack of appropriate literature leaves students without an applicable background for modern accounting and auditing. The academic programs do not challenge students to improve critical thinking. (World Bank, 2002, pg. 5)

The medium of instruction in the undergraduate programmes was another cause of concern. In Bangladesh, many universities still conduct their undergraduate programmes in Bengali, the national language. However, the professional accountancy courses run by the ICAB is in English. This creates difficulties for the students. Most of the auditors that we interviewed were of the view that the students seriously lacked communication skills. One senior partner of a big 4 firm commented-

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Student intakes are the backbones of the audit firms. But the education standard of the country has fallen. Students do not know how to communicate in English (Practicing auditor ASK)

Another partner of the same firm commented that sometimes, her entire day is wasted drafting and correcting letters whereas this could have been done by a student. She also mentioned that the students had trouble understanding basic reading materials written in English, let alone the international accounting and auditing standards that demand better understanding of the English language. This is consistent with World Bank (2002) which reported that students coming out of the education system in Bangladesh had problems tackling reading materials written in English at the professional levels. Concerns regarding communication skills were supported by another big 4 partner, who commented that he simply could not rely on the communication skills of his students, and had to take care of the letters written to the client himself. In addition to the communication skills, the World Bank report (2002) also identified lack of practical experience of the teachers teaching in the universities. This is consistent with Zebley (1956) who also underscored the need for academic accountants teaching in the undergraduate programmes. At present, Bangladesh has a serious lack of academic accountants. Although some of the university teachers are members of the ICMAB, none is a member of the ICAB. This may be a result of university policies of not valuing professional qualifications. Appointment and promotion of accounting academics in public universities depend on previous academic excellence and other academic qualifications, such as PhDs and MPhils. Professional qualifications are not considered as equivalent to academic qualifications. Also, the academically superior students want to join the academia rather than the public accountancy profession. This has resulted in the absolute absence of academic accountants in Bangladesh. In addition to this, universities lack proper training and library facilities, affecting intellectual development of the teachers. One university accounting teacher commentedThere is hardly any access to academic journals. The university library is not rich enough. As a result, we struggle to keep ourselves up to date with the recent developments in the area of accounting (Accounting academic AS).

This is consistent with the World Bank report (2002) that identified lack of updated curricula and availability of accounting literature as a major cause of concern for the development of professional accounting education in Bangladesh. Also, in a recent study, Siddiqui, Nasreen and Choudhury-lema (2009) found that due to lack of proper study materials, university teachers in Bangladesh sometimes relied on case-based studies developed in western countries, and this created misunderstandings amongst students regarding relevant accounting and auditing concepts.

Inadequate training programmes offered by the ICAB The World Bank (2002) reported a number of weaknesses in the education and training programmes offered by the ICAB. These include the lack of updated training materials, lack of knowledge of the instructors, and poor passing rate. The report mentioned that the ICAB pre qualifications curricula did not include the code of professional ethics, and sufficient

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depth in teaching functional, business management, and communication skills. A recent revision in the ICAB curricula, however, now includes the code of professional ethics. Like the undergraduate level, the ICAB pre qualification programme also suffers from lack of presence of any academic accountants, who would have both practical and research experience. Our interviews also reveal a number of problems existing at this level relating to teaching, curriculum development, and marking. One non-practicing auditor, who is also a member of the ICAEW and involved with the updating process of the curriculum followed by the ICAB, has the following view-

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At present there is no coordination between the examiner and the marker. As a result, the examiner does not know the real problems the students face in the examinations. There should not be any surprises in the questions. Our syllabus is not categorized according to students’ skills in different levels. As a result, students are being asked with the questions that they are not expected to answer at that level. Also, the lecturers may be delivering lectures in a way which is not comprehensible for students at different levels (Non practicing auditor AMK).

The same respondent also mentioned that because lecturers are not properly briefed of what is expected to be assessed at a particular level, they tend to impress the students by making things difficult for the students. Although, this may create a perception that the lecturers are very much knowledgeable; however, the real purpose of the training sessions is not achieved. Poor passing rate is also identified as one of the major problems in the accountancy profession. World Bank (2002) reports that between 1972 and end-June 2003, 11,026 students enrolled with the ICAB as trainee accountants. However, the current number of members in the ICAB is less than a thousand, indicating the poor passing rate, and high percentage of drop outs. One interview respondent blamed the poor quality of the student input as a reason for the passing rate (practicing auditor HM). One respondent also felt that there is a perception amongst some of the ICAB members that better passing rates would imply lower standards of accountants, and this mindset needed to changeOur job is to make the boys pass not fail. Higher pass rate means that the students are better prepared and not that the standards have gone down. I don’t see any problem in more students passing. We should rather concentrate on the application side of the profession (Non practicing auditor AMK).

In addition to concerns regarding the quality of education and examinations, interview evidence suggests that there are serious concerns regarding the quality of practical training provided by the firms. As mentioned before, to be a member of the ICAB, an individual not only needs to pass the professional examinations, but is also required to have at least three years training as an articled student. Auditors that were interviewed for the purpose of this research seemed to have the perception that the quality of such training varied widely. Whereas the big 4 firms and some other large firms provided quality training for their students, the quality of training in smaller audit firms remained questionable. One senior partner of a big 4 firm commented-

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Javed Siddiqui, Reazur Rahman Chowdhury and Dewan Mahboob Hussain There is a difference in the quality of the auditors in big firms and the quality of auditors in small firms. The outputs of the small firms are also not good. In many cases it happens that the students of small firms get and maintain the articleship by paying the CAs of the small firms. During their articleship, they do not perform any audit and do not learn anything. These CAs cannot contribute to the profession (Practising auditor AK).

The partner also questioned the level of ethics expected of the students passing out of this system. Several other respondents also agreed that such practices existed in smaller firms (Practicing auditor HM).

The Code of Professional Ethics In the year of 1973, ICAB introduced The Bangladesh Chartered Accountants Order 1973 (GoB, 1973) and the Bangladesh Chartered Accountants Bye-Laws 1973. Over the years, the institute updated and amended these two documents referred as Members‘ Handbook (Part I & Part II). In 2004, the institute replaced the Bangladesh Chartered Accountants Bye-Laws 1973 by publishing Bangladesh Chartered Accountants Bye-Laws 2004 (ICAB, 2004). In the forwarding of this new document, the then President of ICAB mentioned:

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Our previous bye-laws were drawn up in 1973 and reflected, in part, the situation arising, at that time out of circumstances immediately on formation of our institute. More than 30 years have gone by and our needs have changed. Although amendments have been made from time to time, it was felt by our members that a thorough change was required to bring us in line with best practices globally, regionally and locally.

In 2004, the institute again published an updated and amended version of the Bangladesh Chartered Accountants Order 1973. This document consists of thirty five articles and mainly provides with the rules and regulations regarding the operation of the institute. The Bye-Laws of 2004 covered issues like membership of the institute, election to the council, meetings and proceedings of the council, meetings and proceedings of the institute, standing and other committees/boards, regional committees, articled students, examination and training, suspension, exclusion and restoration etc. These two Members‘ Handbooks do not cover much about professional ethics (though the bye-laws of 1973 covered some issues on professional ethics). However, ICAB, in November 1993, published a document titled ‗Manual of Professional Ethics‘ (ICAB, 1993) which included main five sections in relation to professional ethics: (i) operating (ii) promotional practices, (iii) technical standards, (iv) relationship with the clients and the public and (v) relationships with fellow members. All of these sections highlighted several issues of professional ethics by referring to the previous bye-laws. Actually, this manual tried to explain in details the objectives and provisions various provisions of Schedules C and D of the Bangladesh Charted Accountants Bye-Laws 1973. The ICAB is a member of the South Asian Federation of Accountants, a regional accountancy body comprising of professional accountancy bodies from South Asia.

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Established in 1984, the SAFA had remained relatively ineffective, and its activities were involved organising yearly conferences for accountants in the south Asian region, and publishing occasional research papers. However, after the accounting scandals in 2001-02, SAFA, like other regional accountancy bodies around the world, also felt the necessity of being more pro active. In March 2004, SAFA came up with a code of ethics for professional accountants for its member countries (SAFA, 2004) including Bangladesh. In the foreword to the code of ethics, it is mentioned that although the IFAC code of professional ethics was being (at that time) revised as a response to the accounting scandals, it was necessary for SAFA to have its own code of ethics as South Asia as a region ‗has its own unique and

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diverse professional, legal economic and social framework‘ (SAFA 2004, pg 3). The code was established as a ‗regional model‘, and like the IFAC code, member states were expected to either adhere to the code or come up with their own codes which would have to be at least, as stringent as the SAFA code. The ICAB, as a member of SAFA, adopted the SAFA code in 2004. In response to IFAC‘s self-assessment questionnaire aimed at member body compliance with IFAC SMOs, including its code of ethics, the ICAB mentioned that it had already adopted the SAFA code of professional ethics considering the ‗ground realities of the south Asian countries‘ (IFAC, 2007). The ICAB response also mentioned that the differences between the SAFA and IFAC codes may be eliminated ‗if and when an individual SAFA country scenario can justify such elimination‘ (Pg 43). However, in January 2009, the ICAB adopted the IFAC code of professional ethics without providing any such justifications. The list presented in the IFAC website suggests at that point of time, Bangladesh was one of the very few countries to have adopted the IFAC code of professional ethics. The timeline presented to IFAC indicates that the ICAB only initiated a review of the IFAC code of ethics in November 2008 before it was actually adopted without any revision in January 2009 (IFAC, 2009). From the above discussion, it seems that the ICAB has adopted a number of different codes of professional ethics in different points of time, before eventually adopting the IFAC code of professional ethics. Earlier, the Treadway commission report (1987) identified notions of independence, competence, and self-regulation, seminal to the success of any code of ethics. As the time line suggests that the IFAC code of professional ethics seemed to have been adopted in a hurry, it would be interesting to evaluate whether those conditions were considered while adopting the code in the Bangladeshi context. Based on interview evidence, the next section will now look into the IFAC code adoption process and investigate the presence of the conditions deemed to be essential for the successful implementation of a code of professional ethics.

Adoption of the code of professional ethics As discussed before, the ICAB has adopted a number of codes of ethics in different points of time, the latest being the IFAC code of professional ethics, adopted in January 2009. However, most respondents to the interviews taken for the purpose of this research, taken between June and August 2009, seemed to be unaware of such adoption. When asked about the presence of a code of professional ethics, many respondents, especially the senior chartered accountants, actually referred to the ICAB bye-laws of 1973, although that was not a code of professional ethics. Also, none of the respondents mentioned the presence of an

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ICAB manual of professional ethics (ICAB, 1993). The incumbent ICAB president admitted to the presence of such misunderstanding regarding the adoption of the IFAC codeThere is a confusion regarding the code of ethics and the bye laws. The code of ethics supersedes the bye laws. We had an awareness seminar regarding this (ICAB President NUA)

The ICAB president also mentioned that the IFAC code of professional ethics supersedes other codes of ethics adopted by the ICAB in previous periods. To make accounting standards and code more acceptable to the stakeholders as well as to a wider audience, it is a common practice to obtain comments from various interested parties on exposure drafts before the final code is commissioned. The ICAB, in its self assessment questionnaire relating to the IFAC compliance programme, mentioned that it had reviewed the IFAC code before its formal adoption (ICAB, 2009). Therefore, it would be expected that the ICAB members would have the opportunity to comment on the draft code before it is adopted. However, interview evidence suggests that the ICAB did not seek comments from its members and other stakeholder groups regarding the IFAC code. This was confirmed by the ICAB president-

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We don’t give exposure drafts…we have a technical committee which provides comments…however, as we are adopting internationally accepted standards, it must have come through due process…(ICAB president NUA)

The lack of presence of a due process might explain why many respondents were actually unaware of the adoption of code of professional ethics. Earlier, Mir and Rahaman (2005) also pointed out the absence of due process in the ICAB‘s standard setting process, commenting that most accounting standards adopted by the ICAB are mere ‗carbon copies‘ of the international accounting standards. However, one member of the ICAB technical committee defended the adoption processWe have copied the IFAC code of ethics as there was nothing in it that contradicts our requirements. But I think there may be difficulties in implementation (Practicing auditor SK)

Commenting on the adoption process, one respondent, a member of the ICAB disciplinary committee, hinted that it was whims and inefficiency rather than rationale that had prompted such adoption processAccounting standards or any other codes (such as the code of ethics) are sometimes hurriedly adopted because the ICAB does not act on time. And then when the deadline allowed (by IFAC) approaches, there is a hurried adoption (Practicing auditor QA)

Investigation and Disciplinary Procedures The presence effective regulatory and rule-setting environment is considered to be an essential pre-condition for ethical practice of auditors (Treadway commission, 1987). This section will now explore this issue.

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The definition of a profession implies that members of a profession would regulate themselves so that they are seen to be acting in a socially acceptable manner. Like many other accountancy bodies in the world, the ICAB is also expected to self-regulate itself, and take disciplinary actions against its members whenever there is a deviation from acceptable behaviour. However, such self regulations have been largely ineffective, and disciplinary actions against members have been very few and far between (World Bank, 2003). On the basis of interview evidence, we have identified a number of issues that affect the self regulation process of ICAB, namely, the disciplinary process; lack of proactive initiatives; the mistrust between ICAB and the SEC; the legal environment; the political environment within the ICAB; and the code of professional ethics. We now discuss each of these issues in broader detail.

The Disciplinary process ICAB‘s disciplinary process is managed by an investigation and disciplinary committee. At present, the committee comprises of 27 ad-hoc members, one of whom act as the chairman. If the committee receives any complaint against any audit firm, it invites the members of the firm to defend themselves. The auditor firm is provided with certain time in which they provide their statement for defence. The committee then decides whether this statement is reasonable or not. If it is not reasonable, the audit firm is asked to appear for a hearing and explain their situation. If the committee still is not convinced, they can initiate the disciplinary process that may involve three stages. The first stage is called reprimand/warning. The second stage is fines/penalties. And, in the third stage, in case of extreme situations, the partner in charge can be suspended (from 6 months to 3 years), depending on the situations Although the disciplinary process seems impeccable, there is a perception that the ICAB is reluctant to take actions against its members (World Bank, 2003; BEI, 2003). Most of the senior auditors that we interviewed, however, refuted such allegations, mentioning that contrary to general views, ICAB does take disciplinary actions against its members whenever they receive a complaint. However, sometimes, such actions are constrained by lack of resources. One member of the disciplinary committee mentionedThe disciplinary members all work on an ad-hoc basis. We are not being paid for this job. But this (the disciplinary procedures) take a lot of our time, and you know, we auditors are busy people (Practicing auditor QA)

However, one non-practicing chartered accountant, pointed out a more fundamental problemThe institute’s disciplinary procedures are wrong. For example, sometimes members are suspended for two years. As a result, this member probably is working for some other audit firm and his/her ethical level remains the same. If the institute had mentioned that this member would have to attend a certain number of hours of CPE, then it would have made some sense. It is like you are sending a person to jail but not rehabilitating him properly. (Non-practicing auditor AMK)

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Javed Siddiqui, Reazur Rahman Chowdhury and Dewan Mahboob Hussain This view was supported by a number of other respondents.

Lack of proactive initiatives At present, the ICAB initiates disciplinary actions only upon receipt of any complain, although it has the power to take suo moto initiatives. Some senior chartered accountants that we interviewed hinted that such initiatives would create unnecessary controversies, and were therefore, not desirable at the moment. This is consistent with the World Bank finding that the investigation and disciplinary committee of the ICAB ‗is not proactive with respect to disciplining errant public practitioners‘ (World Bank, 2002). Like many other Asian countries, Bangladesh is generally a non-litigious society, there are very few complaints received against auditors from individuals, shareholders or any aggrieved parties. One senior chartered accountant commented that is his forty years of practice, he has never seen a court case against an auditor (HG). Regarding the lack of complaints against auditors, one respondent commentedComplaints would be lodged only if there is an aggrieved party. Shareholders in our country do not understand the financial statements and are not aware of the duties and responsibilities of the auditors. Therefore, they are not aggrieved against an auditor even if a material misstatement is detected in an audited financial statement. (Practicing auditor HsM)

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The ICAB president also admitted that there are very few complaints received by the ICAB, and the complaints mostly come from the Securities and Exchange Commission, the regulatory body for public limited companies in Bangladesh.

Mistrust between ICAB and the SEC As mentioned above, the SEC, as a regulator, plays a major role to ensure accountability and transparency of the financial reports of public limited companies in Bangladesh. Although the interview respondents from the ICAB claimed that they received frequent queries from the SEC, interviews with SEC officials reveal that such actions have been few and far between. In fact, although the SEC was established in 1992, the first investigation ever conducted against an audit firm by the SEC in Bangladesh was initiated as late as in 2006. The SEC chairman during that period revealedWhen I was appointed, the finance minister called me, and asked me to take actions against the auditors. The minister, himself a chartered accountant, mentioned that some of the auditors were involved with malpractice, and the SEC needed to stop them. As I have some accounting background, he mentioned that it would be easier for me. (Regulator FAS)

Table 5 presents a list of actions taken by the SEC against the auditors. The table shows that so far, only ten such incidents have occurred, and all these incidents have actually taken place after 2007. Out of these ten incidents, the auditors were penalized by the SEC is two occasions, whereas in two cases, the SEC lodged a complaint against the auditors with the ICAB. The other six cases were dropped on the basis of satisfactory responses received from the auditors. Interview evidence suggests the existence of high level tension and mistrust amongst SEC officials and ICAB council members. One senior SEC official commented-

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Embracing Change? We ask ICAB to take actions against the auditors, but they never do that. This has forced us to take actions against auditors (such as imposing penalties) which are within our jurisdiction. (Regulator MZ)

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Table 5. SEC actions against auditors Date August 09, 2007 May 28, 2008

Auditor M. N Islam & Company Howladar Yunus & Co

June 12, 2008 June 12, 2008

Basu Banarjee Nath & Co G. Kibria & Co

June 12, 2008

K. M. Alam & Co

June 12, 2008

M. J. Abedin & Co

December 1, 2008 January 12, 2009 April 07, 2009

M. J. Abedin & Co

May 21, 2009

Nasir Mohammad & Co

Marhk & Co Mowla Mohammad & Co

Reason for action Failure to mention defaulted loan Misstatement of accounting receivables and payables, failure to confirm balances with third parties Under-provisioning for workers participatory fund Physical verification of inventories, non-compliance with accounting standards Physical verification of inventories Related party transactions not reported Anomalies in financial reports Loan advanced to sister concern reported as accounts receivable Misstatements in financial reports concerning inventories, depreciation, and profit Misstatements in financial reports concerning inventories and profit

Action Penalty imposed on the auditor Warning issued against the auditors Warning issued against the auditors Warning issued against the auditors Warning issued against the auditors Warning issued against the auditors Warning issued against the auditors Penalty imposed on the auditor ICAB requested to take disciplinary actions ICAB requested to take disciplinary actions

The auditors, on the other hand, believe that such inactions take place because in many cases, the allegations made by the SEC are baseless. A number of respondents opined that the SEC neither had the resources nor the manpower to do their jobEC lacks qualified personnel. Most of the allegations against audit firms are baseless. This is because they don’t know their job. For example, two members of the SEC are former district judges. How can you expect accounting competence from them? (Practicing auditor HsM)

Commenting on this issue, the ICAB president also mentioned that due to lack to technical expertise, the SEC complaints mostly concentrated on trivial matters 5 , whereas material irregularities went undetected. One respondent, a senior partner of a medium sized audit firm, also believed that the SEC, as a government body, is dominated by powerful stakeholder groups, and hence, could not behave as independently as it should have (Practicing auditor QA). A number of research reports also support the notion that SEC in Bangladesh lacked the required technical expertise and resources. BEI (2003) identified a number of constraints5

The ICAB President mentioned physical verification of inventories as an example, this is supported by Table 2

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Javed Siddiqui, Reazur Rahman Chowdhury and Dewan Mahboob Hussain Right from the beginning, the SEC suffered from a lack of an adequate number of staff properly trained in capital market affairs. That lack still continues. The SEC does not have a full time Corporate Accountant in place. The current Chairman and members are not from a capital market background, and neither have most past chairmen and members been so; Commission members are usually retired public servants. (BEI, 2003)

The deficiency of technical staff was also identified by the World Bank in the report on observance of standards and codes (World Bank, 2003). Commenting on the lack of trained personnel, a former SEC chairman mentioned that employees of the SEC were paid in line with the government salary structure, and it would be impossible to find someone with experience and expertise with the capital market at that salary level. Why would a qualified accountant work for us? When I joined, I found a competent young officer. So I tried to groom him and he became sort of an expert regarding surveillance. However, as soon as he qualified as a professional accountant, the private sector offered him huge salaries, and he left us. I don’t blame him, what incentive could we offer him? (Regulator FAS)

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However, a senior official of the SEC believed that the accusations made by auditors regarding SEC‘s lack of skills were often baseless, as they did not want SEC to detect their malpractices (Practicing auditor HZ).

The Legal environment Most of the auditors and SEC officials that we interviewed mentioned the country‘s legal environment as one of the major obstacles for taking disciplinary actions against the auditors involved in unethical conduct. The main problem in the judicial process is the time taken to dispose off cases. At present, there is only one bench in the high court that deals with financial matters. The time consumed in the legal process has been a source of frustration for the ICAB. The president mentionedThe judicial process is so time consuming…whenever we take an action…for example, after a lot of efforts from me and the former president., we recently managed to take action against a senior auditor in practice…and the next day, he got himself a stay order from the court (ICAB President NUA)

A number of respondents believed that to make the disciplinary actions meaningful, the judicial system needed to be reformed to incorporate more benches dealing with financial matters. This is consistent with the BEI report that identified the need for a separate court to dispose off financial cases. Reforms proposed by the respondents included setting a deadline within which financial cases would have to be resolved, and inviting ICAB representatives to the hearing of the case (Practicing auditor ASMN). A senior SEC official also acknowledged the need for legal reforms, stating that unless the judicial process was quickened, disciplinary actions taken by SEC or ICAB would be completely meaningless.

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Politics within the ICAB A number of respondents hinted that politics within the ICAB also had a role in slowing down the self-regulation process. At present, the council members of the ICAB are elected by the members. The president is then elected by the council. This process has the potential for raising suspicion regarding the independence of the president and the council. One senior SEC official notedThe ICAB president is elected. So he would need votes. If someone needs votes, how would he take actions against his voters? (Regulator HZ)

This view was also supported by a non-practicing chartered accountant, who had contested in a council election (Non practicing auditor SA). One practicing chartered accountant, a partner of a big 4 firm, considered politics rather than the legal system as the principal factor harming the disciplinary processIt is the politics within the ICAB council that makes it difficult to take actions against the defaulting audit firms. Sometimes, the judicial process is cited as an excuse for ICAB’s inaction. However, this would have been logical if we were, for example, taking actions against 5 auditors every month, and all of those were blocked by the judicial process. However, I don’t think that the ICAB has taken actions against more than five audit firms over the last ten years. (Practicing auditor AK)

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However, most of the chartered accountants that we interviewed did not believe that such politics would restrain the ICAB from taking actions against their members, although they believed that politics had a role to play with the way some decisions are made. One respondent pointed out a caseThe code of professional ethics was adopted very hastily, so that the incumbent president could show this as an achievement during his tenure (Practicing auditor QA).

Like most other respondents, the current ICAB president also did not believe that politics affected the disciplinary process. However, he admitted that the fact that he was a nonpracticing chartered accountant made it easier for him to take disciplinary actions against auditors. This was also supported by another respondent who mentioned that he could play a more meaningful role in the quality assurance process as he was not a practicing chartered accountant, and did not have to care for votes (Non-practicing auditor AMK). The findings in this section suggest that the regulatory and rule setting environment for the auditing profession in Bangladesh is characterised by accounting profession‘s reluctance to regulate its members, perhaps triggered by the mistrust between the profession and its regulators and the lengthy judicial process. Also politics within the ICAB, and lack of activism by affected parties, such as the shareholders, might have contributed to making the regulatory initiatives largely ineffective. The primary objective of this paper was to investigate whether the socio-economic conditions of a developing nation like Bangladesh justifies the decision to adopt the IFAC code of professional ethics of accounting. In the previous section, we investigated whether

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SMOs relating to quality assurance, education standards, code of professional ethics, and investigation and discipline were applicable in the context of Bangladesh. Interview respondents confirm the poor perceptions regarding quality of auditors in Bangladesh, and majority of the respondents attribute this to the poor levels of audit fees that the companies are willing to pay. A number of respondents, however, seemed to believe that the poor levels audit fees are actually offered because of the unfavourable perceptions regarding audit quality. This is consistent with earlier observations made in a BEI report (2002) that the auditing profession in Bangladesh suffered from a vicious cycle with auditors not providing quality services because of the low fees, and users continuing to compensate for such poor services. Interview evidence also reveals the Bangladeshi company‘s law still allows for provisions that are considered to be malicious for the independent conduct of an audit. Although the SEC has tried to rectify this by issuing a number of orders, the audit firms seem to have found unethical ways around such prohibitions. The self-regulation efforts of the profession are affected by ICAB‘s lack of initiative, and probably intent, to discipline its members. The mistrust between the regulators and the profession has complicated the self-regulation process further, with the profession viewing the SEC as incompetent, and the regulator viewing the profession as inefficient. The disciplinary actions have been slowed down further by the appallingly time consuming judicial process. Our questionnaire survey results confirm the World Bank‘s observations that the public accountancy profession in Bangladesh has failed to attract the top quality students, who seemed to be keen to pursue careers in MNCs, banks, and in the public sector. However, our results do indicate that a significant number of students majoring in accounting are still inclined to pursue public accountancy as a profession. Students who are not willing to consider public accountancy as a future profession are largely discouraged by the time taken to qualify as professional accountants and the poor passing rates. The, the poor passing rate in the professional examination mean that students would take longer time to quality as professional accountants, and in Bangladesh‘s socio-economic conditions, very few students can afford to make such investments. The quality of students is also affected by the poor standards accounting education at the undergraduate and professional levels. Especially, interview respondents identified that lack of communication skills as a major problem for students coming into the profession. Interview evidence reveals that the ICAB did not consult various interested parties before making the crucial decision to adopt the code of professional ethics. Rather, the adoption decision seems to have been taken in haste. As a consequence, the code of professional ethics, as adopted by the ICAB, does not really reflect the opinions of various stakeholders. This is consistent with Mir and Rahaman (2005) who report that the ICAB did not follow due process even during the development of accounting or auditing standards, and ended up adopting the international standards without any modifications. Overall, our findings in the context of Bangladesh are similar to the Cohen et al. ‘s (1992) observation that the socio-economic conditions in the LDCs make it difficult for these countries to align themselves with internationally acceptable standards for ensuring audit quality. The next section will now explore some socio-economic factors prevailing in Bangladesh.

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THE SOCIO-POLITICAL ENVIRONMENT FOR AUDITING: BANGLADESH CONTEXT Many of our interviewees suggested that the socio-political scenario in Bangladesh was somewhat different from those of developed nations, and in some cases unique. More specifically, the interviews revealed two recurring themes that seem to be distinctive for Bangladesh: the social privileges received by the public accountancy profession, and the state-profession relationship. We now explore these two themes.

Social Privileges for the Profession As discussed previously, the functionalist perspective of professional development identifies a number of distinctive natures of a profession, such as knowledge, independence, altruism, self-regulation etc. In return for these attributes, the society provides the profession with a number of privileges, such as the right to operate in a monopoly, economic rewards, and social prestige (Barber, 1963). However, the above analysis of the attributes of the accountancy profession suggests that the auditing profession is deficient of some fundamental traits, such as independence, competence, and self-regulation. The society does not appreciate the need for auditors, and as a result, refuses to provide auditors with economic benefits. The BEI (2003) summarizes the state of the audit market-

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The auditing function would seem to represent a vicious circle; auditors are not perceived as independent and do not provide quality audits, therefore companies and shareholders are not willing to pay high fees for an audit. The low fee structure, in turn, does not provide an incentive for auditors to provide quality personnel and audits (BEI 2003, pg 62).

This is consistent with a World Bank report (2001) that states that there is little appreciation of the value added by company auditors in Bangladesh, resulting in poor levels of audit fees. Most of the interviewees were of the opinion that the company management did not see the value of audit, as audit did not offer any ‗tangible‘ benefits, as opposed to services such as tax consultancy. One senior auditor pointed out that, for services such as tax consultancy, the market had no problems paying high fees, whereas, ‗we find it difficult even to negotiate an increase of Tk 5,000 audit fees‘ (ZA). Similar comments came from a number of other auditors. Like many other developing countries, most companies in Bangladesh are either family owned or controlled by substantial shareholders (corporate group or government). Company managements are effectively just extensions of the dominant owners (Farooque et al., 2007). They are closely held small and medium-sized firms where corporate boards are owner driven. Consequently, most of the companies have executive directors, CEO and chairman from the controlling family. Farooque et al. report that, on average, the top five stockholders hold more than 50% of a firm‘s outstanding stocks. The Companies Act (1994) states that appointment and remuneration of the auditors should be decided in the annual general meeting (AGM) of the companies, involving the shareholders. However, due to such high

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ownership concentration, it becomes possible for the company management, which usually consists of directors coming from the same family, to dominate the AGM, and make decisions on the appointment and remuneration of the auditors. The ICAB president summarized the audit fee setting process as follows-

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The AGM is dominated by the management…so it is the management who do not want the AF to increase…shareholders do not have much say about this. If management has a concrete proposal regarding AF increase, I’m sure that would have been passed in the AGM. If the management is not convinced that AF needs to be increased, it is not going to happen (NUA).

A number of senior auditors also claimed that auditors in Bangladesh did not enjoy the same levels of social prestige enjoyed by other professionals, such as doctors, and lawyers because ‘there is no use for an auditor’. A senior audit partner, who has been a past president of the ICAB summarized the social status of the auditors as follows- ‗if I had understood that the status of audit profession is like this in Bangladesh, I would have never thought of joining this profession’ (HG). The society‘s apparent refusal to provide public accountants with economic and social prestige can be explained by the functionalist approach. Interview evidence and archival studies do suggest that auditors in Bangladesh lack professional independence and integrity, and have failed to provide the society with what is expected from a profession. However, despite such deficiencies, auditors in Bangladesh still enjoy the most coveted of the privileges offered by the society to a profession- the permission to operate in a monopoly. The functionalist approach does not offer any explanations for this, signifying the need for adoption of other approaches to study the existence of the auditing profession in Bangladesh. Uddin (2009) reveals that given the structural conditions such as political institutions, culture, and economic uncertainty, the Weberian framework seems appropriate for studying the role of accountancy in developing countries such as Bangladesh. A number of prior studies in developing country settings have also adopted this approach to study the development of accountancy professions (for example, see Uche (2001) adopted the neo-Weberian approach to study professional accounting development in Nigeria; Sian (2006) used similar approach to study accounting professionalism in Kenya). As discussed before, the neo-Weberian approach to development of professionalism is embedded on the notion of ‗closure‘, and relationship between the state and the profession occupies an important place within this perspective. Using this approach, the next section will now investigate the relationship between the state and the public accountancy profession in Bangladesh.

The Dynamics of State-Profession Relationship in Bangladesh Traditionally, the accountancy profession in Bangladesh has enjoyed a stable relationship with the state. One of the reasons for such stable relationship could be that the state approval for the accountancy professionals to operate in a monopoly was actually given by the Companies Act of 1882 by the colonial rulers of British-India, and the Bangladesh accountancy profession simply inherited such mandate. Therefore, unlike accountancy profession in many countries, the profession in Bangladesh did not have to attain professional

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status, rather they inherited this. Also, after independence of Bangladesh in 1971, the state did not feel the need for changing this mandate, possibly because of the lack of complaints received against the profession. The lack of complaints could be indicative of the society‘s lack of interest on the profession, as suggested by the interview evidence, rather than professional competence of the auditors. Although the profession has not played the desired role, it has enjoyed privileged relationship with the government, mainly because of the presence of a number of accountancy professionals in the government in important positions. The accountancy profession has so far produced a deputy-prime minister, the longest-serving finance minister in Bangladesh‘s history, and a number of other cabinet ministers. In the history of Bangladesh, professional accountants have held important government positions, such as permanent secretaries in different government ministries, head of regulatory bodies such as the SEC, and heads of parliamentary standing committees on finance. There are also evidences of state privileges given to professional auditors6, and lobbying activities of accountancy bodies7. One former permanent secretary of the ministry of commerce, which oversees the professional accountancy bodies, commented ‗The professional accountancy bodies come and see us frequently. Often, they just come to see us as a courtesy visit, to maintain liaison with the government. Lobbying by accountants is common, especially for getting government assignments and consultancies’. Currently, the Bangladesh government accepts audited financial statements for tax return purpose without any question, although the reliability of such financial statements remains doubtful8. However, the central bank of Bangladesh has recently produced a list of ten audit firms that are allowed to audit banking companies. This is an indication that the state also acknowledges that the majority of audit firms in Bangladesh are not competent enough to audit the banks. Like many other developing countries, Bangladesh also has a volatile political environment. Although country is a parliamentary democracy, invasion by military dictators is frequent. In 38 years of its existence, Bangladesh has been ruled by two military dictators between 1975 to 1978 and 1982 to 1990. Democracy returned in 1991 and continued up to 2007. However, in January 2007, the countries democracy was again interrupted by the military dictators, who installed a ‗military-backed‘ civil government. Democracy has again returned since January 2009. In addition to the political uncertainty, policy making is also influenced in Bangladesh by the significant presence of a number of donor agencies, such as the World Bank, and the Asian Development Bank. Bangladesh is a poor economy, and is dependent on these donor agencies for assistance. This has created scope for policy level intervention by these donor agencies 9 . The volatile nature of the government and the 6

For example, in 1993, the government allowed professional accountants to submit individual tax returns rather than tax returns as audit firms, reducing audit professional‘s tax burden significantly. The finance minister at that time was Mr M Saifur Rahman, who was an auditor by profession. 7 In 2002, cost audit was made mandatory for all manufacturing concerns in Bangladesh as a result of intense lobbying by the ICMAB 8 One tax lawyer interviewed for this research informed that the audited financial statements are actually prepared by tax lawyers for their clients, and there are some audit firms who would sign these for minimal fees. Also, the tax consulted mentioned that if they need to revise accounting numbers for tax purposes, they would take the audited financial statement back to the audit firm, and they would issue a revised statement again for further fees. 9 There are evidences of World Bank intervention in state-level policy decisions in Bangladesh, such as privatisation of state-owned industries (Uddin and Hopper, 2003); setting of accounting and auditing standards (Mir and Rahaman, 2005); and formulation of corporate governance regulations (Siddiqui, 2010) etc.

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influence of the donor agencies set the context for the study of the state-profession relationship in Bangladesh.

The FRC project In 2002, the World Bank initiated a review of standards and codes project in Bangladesh. Amongst other things, the ROSC report identified the need for establishing a new body to ‗monitor and enforce accounting and auditing standards and codes‘ (World Bank, 2003). The World Bank report also suggested the structure of the Financial Reporting Council (FRC)The proposed Financial Reporting Act should establish a new independent oversight body, which may be called Financial Reporting Council. The accountants in public practice should not dominate the operations and management of this Council, nor should professional accountants dominate the Governing Body. The members of the Governing Body of the Council may be drawn from the SEC, Bangladesh Bank, Federation of Bangladesh Chambers of Commerce and Industry, Dhaka Stock Exchange, Chittagong Stock Exchange, ICAB, ICMAB, Department of Accounting of Dhaka University, and Institute of Business Administration of Dhaka University (Word Bank, 2003, pg. 12) The World Bank report stated that the FRC should be entrusted with the setting and monitoring of accounting and auditing standards, and monitor and regulate the accountants in practice. All these functions were being performed by the ICAB at that point. It is noticeable that the establishment of the FRC would take away the standard setting and self-regulatory powers of the ICAB, which are essential attributes of the profession. Also, the proposed FRC would issue practicing license for the auditors. In line with the recommendations of the ROSC, the World Bank initiated an economic management and technical assistance programme in 2005 to ‗strengthen accounting and auditing practices in the corporate sector in Bangladesh‘ (World Bank, 2005). The scope of the project included ‗drafting the financial reporting act‘. Although the draft financial reporting act was prepared by the end of 2006, it was not placed before the parliament, as the then democratic government was preparing to step down to allow for general elections. However, in January 11, 2007, a military backed government was installed, and elections were postponed till December 2008. The military backed government was headed by a former World Bank official, and appointed another former World Bank official as the finance minister. The new government launched a number of populist anti-corruption drives against the politicians. However, as the government did not have any constitutional backing, it suffered from problems of legitimacy. Nevertheless, donor agencies, especially, the World Bank continued to provide strong support to this government10. During this regime, the draft financial reporting act was finalized. The draft FRA proposed the formation of a financial reporting council consisting of 7 to 12 members. Five of these members, including bureaucrats such as the governor of the Bangladesh bank (the state bank of Bangladesh), the chairman of the SEC; the chief controller of insurance; and the chairman of the national board of revenue (the internal revenue department) would be permanent members of the council, whereas there would be two professional accountants nominated by the ICAB, who would be part time members of the council (section 5(1), draft FRA, 2007). The principal functions of the council would include establishment and 10

In June 3, 2007, Praful C. Patel, vice president of the World Bank‘s South Asian region hailed the military backed government by stating ‗now the country is an unique position to institute reforms that will have a lasting impact…we are ready to assist the present administration‘ (Reuters, 2007)

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implementation of accounting and auditing standards; monitoring the accuracy and fairness of financial reporting; monitoring the practice of auditors with a view to ‗maintaining high standards of professional conduct‘; and monitoring and enforcement of application of financial reporting and auditing standards (Section 13, draft FRA, 2007). The FRC would also issue license of practice to registered auditors. The constitution and the functions of the proposed FRC are more-or less similar to what was mentioned by the World Bank ROSC in 2003. The draft FRA was presented and approved by the cabinet in December 29, 2008, a day before the government stepped down to pave way for new elections. The draft financial reporting act was not approved by the newly elected parliament, and was sent back for further review. The SEC officials interviewed for this study were supportive of the need for establishing an independent body for oversight of the public accountancy profession. One senior official of the SEC commented that they had supported the idea of the FRC since ICAB had failed to perform its standard setting and self-regulatory functions. The official informed that immediately after the ROSC report in 2002, the Asian Development Bank initiated a project relating to strengthening of corporate governance in Bangladesh. Among other things, the project included an evaluation of accounting standards adopted by the ICAB. The project found a number of defects in the standard setting process. As stated by the SEC official-

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When they adopted the international accounting standards, they left a few things out, making the standard useless. Sometimes, one international accounting standard is superseded by another. But the ICAB ends up adopting both (HZ).

Based on the findings of that project, the SEC then asked the ICAB to strengthen its accounting standards adoption programme. The SEC official informed that within two years, the ICAB finished the adoption process. It was found that most of the accounting standards adopted by the ICAB were mere copies of the international accounting standards. This is consistent with Mir and Rahaman (2005) who mention that the accounting standards adopted by Bangladesh were ‗carbon copies‘ of the international accounting standards. The SEC official also opined that although SEC was supposed to be an independent accounting body, there are political influences during democratically elected governments. However, during the military backed regime, it was relatively free from such influences, partly because the government did not have any political agenda, and also because the adviser in charge of finance had been a former chairman of the SEC. This gave SEC the chance to pursue the establishment of the FRC. An analysis of media reports suggests that the ICAB had tried to create public opinion against the promulgation of the draft FRA by organizing series of seminars. On May 17, 2007, soon after the military-backed government came to power, a delegation led by the then president of the ICAB met the finance adviser and ‗demanded amendment of the draft FRA11. In February, 2008, the then president of the ICAB stated in a seminar ‘From our study it was revealed that the proposed Financial Reporting Act is an effort to transplant the UK Financial Reporting Act but such an enactment in a developing country like Bangladesh may have adverse economic impact, resulting in increased cost of doing business’12. This suggests 11 12

Reported by The New Age on May 18, 2007 Reported by The Daily Star on February 20, 2008

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that ICAB‘s efforts to lobby the government regarding the FRA had apparently failed. In a newspaper column, Ahmed (2007), a chartered accountant himself, commented on the draft financial reporting act. The paper describes the context of the FRAThe World Bank, as did in many cases, compelled the interim caretaker government of Bangladesh to issue the draft Act in compliance with their prescription that is made in line with the developed countries. The context of the capital market is completely different in Bangladesh. The prescription for a developed country cannot work in a developing country. The interim government is going to swallow the World Bank prescription without considering the capital market scenario (Ahmed, 2007)

The paper then proceeded to identify the principal shortcomings of the proposed FRC. Ahmed pointed out that the main problem with the FRC was the way it was going to be constituted-

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Five of the seven members are non-technical in these fields. How will these non-technical members contribute to setting up financial reporting and auditing standards, which are so technical that requires years of study and practical experiences to understand?(Ahmed, 2007)

The paper also mentioned that frequent changes in the public administration in Bangladesh would mean that the government appointed members of the FRC would not have the chance to gain the experience required at this level. Ahmed (2007) opined that the inclusion of representatives from the business world could create the scope for political influence on the accountancy profession. The paper was also critical of the proposed FRC‘s role in overseeing professional and regulatory functions of the ICAB, claiming that this would put the independence of the profession in jeopardy. The interview responses suggest that the auditors in Bangladesh were overwhelmingly opposed to the creation of the FRC, and were of the opinion that if created, the FRC would be a failure. Similar to Ahmed (2007), a number of respondents were critical of the constitution of the proposed FRC, and the technical capabilities of its members. The President of the ICAB commented ‗It will not be effective as expected…because the members of the FRC are all bureaucrats or non technical persons…how can they come up with accounting standards…this is going to be yet another bureaucratic mess’ (NUA). One respondent also mentioned that because of the presence of government representatives in the council, the government will have the opportunity to exert political pressures on the profession. This is consistent with Ahmed (2007). A number of respondents pointed out the concept of the FRC were not consistent with the Bangladeshi culture, where bureaucrats enjoy huge social prestige and power. One former president of the ICAB also pointed out that the functions of the FRC would be disrupted by the current legal framework-

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If you think about Bangladesh, the law allows black money to be white13. So if you are allowing the client, how can you charge the auditors? But the FRC will have this capacity to charge the auditor. This is not consistent (ASMN).

A number of auditors also pointed out that the FRC would increase cost of audit, as the auditors would now have to be registered with the council. One respondent also hinted that the prevailing level of corruption in the country already necessitates unethical payment to government officials in pursuit of government assignments. As the FRC would be primarily run by government employees, there might be potentials for corruption, thus enhancing the cost of audit further. The respondent also mentioned that ICAB might have been an inefficient organization, but at least it was not a corrupt one. In response to the proposed FRA, the ICAB has constituted an informal group consisting of present and former presidents and other influential auditors to negotiate with the government. Interview evidence suggested that this had been a common practice by the ICAB, which had worked for them in the past. However, the ICAB found the military backed government very closed and unwilling to discuss FRC with ICAB, and the ICAB was only consulted at the later stages (in late 2007) of the preparation of the proposed FRA. The president of the ICAB mentioned that if consulted, the ICAB would have proposed cooptation of some representatives from the government into the ICAB council and disciplinary committees, as this tactic seemed to have worked for other professional bodies in this region-

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The problems could have been addressed in different ways…for example, if the government had consulted us, we would have proposed co-opting a few non-members in our council (like the BB governor, SEC chair, finance, commerce secretaries) in our council and disciplinary bodies…something that Pakistan has done (NUA).

The respondents were overwhelmingly of the opinion that the FRC was a product of the World Bank‘s influence on the Bangladesh government, and the influence seemed to have amplified during the military-backed regime. One past president of the ICAB, who was also a member of the informal ICAB group that discussed the FRA with the government, mentionedIt might have been easier for the WB to push the interim government. An anti corruption drive was going on. So it was easier to sell the FRC. We met the adviser a number of times, but he did not listen to us (ASMN).

This is supported by the newspaper report discussed before regarding the meeting between the ICAB and the finance adviser. The same respondent also felt that the Bangladesh government was more susceptible to World Bank pressure compared to its neighboring countries, and because of such attitude, the government approved the draft FRA one day before it was leaving power. Another past president of the ICAB, and also a member of the same informal group mentioned that when the World Bank approached the Bangladesh 13

Sec. 19A of the Bangladesh Finance Act (2009) states that the tax authorities shall raise no question about the source of any sum invested by any person in a company for setting up of new industry or physical infrastructure between July 01, 2009 to June 30, 2010, when the assesses pays 10% of the invested or investible amount as income tax before the filing of return. The list of new industry and infrastructure, referred to in this section, is quite exhaustive.

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government with proposals regarding the FRA, they had also approached the governments of India and Pakistan. India rejected such proposals, whereas Pakistan strategically managed such pressures by co-opting members of the government into its council (AUC). The respondent felt that the ICAB had failed to do so because of the lack of communication with the then newly establish military government which had its own agenda of gaining legitimacy through its anti-corruption drives. After the newly elected political government assumed power in 2009, the ICAB team again met influential members of the government, including the law, commerce, and finance ministers. The members of the ICAB team were of the opinion that the new political government was much more open in terms of communication, and seemed to have a favorable view of the FRCWe have tried to convince them (the new government), and they seem to agree with us, especially regarding the constitution of the FRC. We are also supposed to give a written representation to the finance ministry, which will review it(ASMN).

A senior SEC official opined that it was highly unlikely that the FRC would be formulated during the new regime, and even if it was, it would not have similar powers14.

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CONCLUSION The primary objective of this paper was to investigate whether the socio-economic conditions of a developing nation like Bangladesh justifies the decision to adopt the IFAC code of professional ethics of accounting. We looked at the adoption and implementation process of a number of SMOs. In doing so, we examined the presence of three pre-conditions, namely auditor independence, skill and competence, and regulatory and rule making environment, considered to be fundamental for ethical practice of professional accountants. We also investigated whether due process was followed in making the decision to adopt the IFAC code of professional ethics by the ICAB. Overall, our findings the auditing profession in Bangladesh generally enjoys a stable, two-way relationship with the state, where the accounting profession helps legitimize economic activities of the state, and the state reciprocates by allowing the profession to operate in a monopoly. The relationship between the state and donor agencies such as the World Bank also remains balanced, and two-way. Like many other developing countries, the Government of Bangladesh is heavily dependent on the donor agencies for economic development. This allows donor agencies such as the World Bank to play the role of a neoimperialistic power. Consistent with the notion of ‗imperialism of influence‘ (Anisette, 2000), the economy of a weaker country is so dependent on the World Bank, that the state allows policy level decisions to be influenced by, and governed by the interests of the World Bank . Neu and Ocampo (2007), using ‗financial mission‘ as a metaphor to investigate the lending practices of the World Bank, noted the bank‘s ability to encourage adoption of new practices in emerging economies through economic and political pressure. Also, Alawattage and Wickramasinghe (2008) report the formation of a hegemonic arrangement in emerging 14

Eleven months have passed since the new government assumed power, and the RFA has not been revised yet.

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economies between global capital agents, such as the World Bank, and the political state to facilitate global movement of economic capital. However, regime shift from democracy to military rule changes the dynamics of relationship between the state and the donors, which eventually affect the state-profession relationship. The loss of legitimacy of the state during the military backed regime in Bangladesh made foreign donors agencies such as the World Bank even more influential in Bangladesh, as the state strived for external legitimacy from these foreign agencies. The World Bank exploited this opportunity to promote its own agenda of establishing the FRC in Bangladesh, which it believed, would enhance accountability and create public sector led growth. The military government, in search of internal legitimacy with the people of Bangladesh, chose to carry out a number of populist anti corruption drive, ignoring, and sometimes harming the politicians. As the profession maintained relationship with the state through the politicians, this changed the dynamics of the state-profession relationship, and led to the subsequent withdrawal of state support towards the profession through the approval of the FRA. Although the FRA would still allow auditors to operate in a monopoly, it would have taken away the standard setting and self-regulatory functions of the ICAB, which are essential attributes of the auditing profession (see Walker (1991)). The poor passing rate in the professional examinations and the absence of any second tier accountancy body in Bangladesh is consistent with the concepts of exclusionary closure. The arguments against the FRC, as forwarded by a number of interview respondents includes the lack of skills of the proposed members of the FRC, suggests that the profession was attempting to confine the right to set accounting standards only to members of the accountancy profession, despite the previous failure of the profession in doing so. However, attempts to defend the existence of the profession were interrupted by changes in the stateprofession relationship caused by loss of legitimacy of the state. The study contributes to the existing literature by presenting evidence of influence of the dynamics of the state-profession relationship on the survival of the auditing profession in Bangladesh. The apparent loss of legitimacy of the state resulted in neo-imperialistic powers to be more influential in aligning the objectives of the states with its own objectives, and led to subsequent withdrawal of state support from the profession. However, as soon as the state‘s legitimacy was restored, the relationship between the state and the profession changed again. The study, therefore, provides evidence of third parties, such as the World Bank, being influential in defining the state-profession relationship in less developed countries, where the economic and political environment allows such agencies to intervene with the policies of the government, which seek legitimacy in return. The IFAC, through its compliance programme, is trying to globalise audit quality. However, as the Bangladesh case suggests, there are significant gaps between developed and emerging economies with regards to notions of audit ethics, skill and competence of the auditors, legal structure, quality of education, and culture. Although countries like Bangladesh may have ticked off all the right boxes in the questionnaire survey perhaps due to institutional reasons, interview evidence seems to suggest that they are far away from adoption the right path that would ensure ethical auditing practices. If other emerging economies follow a similar pattern, the IFAC‘s efforts for improving audit quality through the compliance programme is not likely to be as effective as it is aimed to be.

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In: Developing Economies Editor: Joanne M. Carcillo

ISBN: 978-1-61122-541-9 © 2012 Nova Science Publishers, Inc.

Chapter 3

HONG KONG’S ECONOMIC INTEGRATION WITH CHINA VIA FDI: SUSTAINABLE GROWTH OF THE HK-PRD GLOBALIZED DELTA ECONOMY Linda F. Y. Ng* and Chyau Tuan Department of Decision Sciences and Managerial Economics, The Chinese University of Hong Kong, Hong Kong, P. R. C.

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ABSTRACT The goal of this paper is to study the growth of the Hong Kong-Pearl River Delta (HK-PRD) globalized delta economy and Hong Kong‘s evolution and progression from a city-state economy to a regional-metropolis upon its economic integration with China since her economic opening in 1979 as well as after the return of sovereignty in 1997. We examine (1) Hong Kong‘s development as a regional metropolis upon China‘s economic opening; (2) the formation of the HK-PRD economic region as induced by Hong Kong‘s industrial and trade restructurings via foreign direct investment (FDI) flows into China and particularly in PRD; (3) Hong Kong‘s rise as a service-dominated city core of a coreperiphery system by integrating economically with south China through the spatial expansion in PRD and the Pan-PRD common market; (4) Hong Kong‘s dominant role as China‘s most globally accessible core city, ,namely, the HK-PRD economy; (5) Hong Kong‘s post-Asian financial crisis success by continuously gaining international competitiveness; and (6) Hong Kong‘s critical role in becoming the most competitive international financial center in China beyond the recent 2008-global financial crisis and hence, the sustainable growth of HK-PRD. Future developments and challenges were also discussed.

Keywords: FDI, economic integration, competitiveness, financial crisis, Hong Kong, China.

*

Corresponding author: e-mail: lindang@cuhk. edu. hk

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1. INTRODUCTION The economic success of Hong Kong had been built upon its industrialization and trading relations with the rest of the world since the 1950s, which enabled Hong Kong to transform from an entrepot to a manufacturing and export-oriented city-state during the 1950s to the 1970s. During this economic take-off period, the manufacturing sector served as the highest GDP and employment-contributing sector. Its exports increased from only 15% of the total exports in the early 1950s to more than 93% in 1970s. Rapid economic growth in terms of GDP and GDP per capita was observed during these decades. Other than export-led, industrial strategy is considered to be the dominant factor elucidating the post-war successful economic development. Hence, the engine of growth, the ―passive‖ industrial policy consciously adopted by the Hong Kong government since the 1970s to direct Hong Kong‘s industrial development, is another major factor contributing to the growth pattern of the city-state economy. To avoid benefiting any particular industry, only improvement in infrastructure would be provided for to the manufacturing sector as a whole, that is, during that time, the Hong Kong government did not consider any prevalent strategy such as ―public intervention in research and development at the private sector‖ as adopted by Japan and other Asian countries during the same period. Hong Kong basically encouraged the restructuring of the city-state economy toward a mixed manufacturing-service dominated economy. Therefore, it is almost the consensus of the government and the local people that any development of the economy should be able to enhance Hong Kong‘s cosmopolitan orientation. Given Hong Kong‘s economic integration with the Pearl River Delta (PRD) region in Guangdong, south China, through outward processing, and relocation activities, for more than three decades since China‘s economic opening in 1979, the potential development of Hong Kong from a city-state economy into a regional metropolis, starting from the return of its sovereignty in 1997, could be well derived. Table 1 provides the statistics of some major economic indicators in terms of GDP, employment, price, and trade performance for selected period of 1961-2006. The growth of GDP, employment, prices, and trade by sub-period from a city-state to a regional metropolis is shown in Table 2. Further, rapidly increasing crossborder economic activities derived from the evolving regional metropolis observed increasing cross-border employment, cross-border living and home purchases, and cross-border consumption. A summary of the economic development of Hong Kong from a city-state to a regional-metropolis is depicted by a flow chart as shown in Figure 1. Through research developed by the authors during the past two decades, this paper studies the growth of the Hong Kong-Pearl River Delta (HK-PRD) globalized delta economy with Hong Kong‘s evolution and progression from a city-state economy to a regionalmetropolis, upon its economic integration with China since her economic opening in 1979, as well as after the return of sovereignty in 1997. We examine (1) Hong Kong‘s development as a regional metropolis upon China‘s economic opening; (2) the formation of the HK-PRD economic region as induced by Hong Kong‘s industrial and trade restructurings via foreign direct investment (FDI) in China and particularly in PRD; (3) Hong Kong‘s rise as a servicedominated city core, of a core-periphery system, by integrating economically with south China through the spatial expansion in PRD and the Pan-PRD common market; (4) Hong Kong‘s dominant role as China‘s most globally accessible core city; (4) Hong Kong‘s post-

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Asian financial crisis success by continuously gaining international competitiveness; and (6) Hong Kong‘s critical role in becoming the most competitive international financial center in China beyond the recent 2008-global financial crisis, and hence, the sustainable growth of HK-PRD. Future developments and challenges were also discussed.

Source: updated from Tuan & Ng (2003). Figure 1. Evolution of Hong Kong from a City-State to a Regional Metropolis.

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Table 1. Hong Kong Macroeconomy from City-State to Regional Metropolis before the Global Crisis: Selected Major Economic Indicators (1961-2006) Economic Indicators Population (million) Labor Force Participation Rate (%) Unemployment Rate (%) GDP (HK$ billion) (2000 price) Per Capita GDP (HK$) (2000 price) Per-Capita Real GDP Average Annual Growth Rate (%) Commodity Trade (HK$ billion) Service Trade (HK$ billion)

1961 3. 13 38. 7 0. 7 -

1981 5. 00 50. 2 2. 0 48. 21

1987 5. 58 48. 9 1. 7 73. 31

1997 6. 49 49. 8 2. 2 121. 61

2005 6. 81 52. 0 5. 3 162. 35

2006 6. 86 52. 8 4. 4 173. 43

-

9,642

13,136

18,740

23,828

25,917

0. 99

7. 3 (61-81) 26. 14

6. 9 (81-06) 75. 60

5. 99 (87-97) 307. 10

3. 05 (97-05) 436. 72

3. 49 (97-06) 506. 08

0. 32

5. 71

15. 54

48. 53

76. 00

84. 62

Notes: The period experiencing the city-state economy is defined as 1961-1981 and that of a regional metropolis economy as 1981-2006; the ten-year period before and after Hong Kong‘s handover in 1997 refer to 1987-1997 and 1997-2006, respectively; US$ to HK$ conversion rate =1:7. 8.

Table 2. The Hong Kong Macroeconomy from City-State to Regional Metropolis: before the Global Crisis: Selected Major Economic Indicators by Growth Period (1961-2006)

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Economic Indicators (Unit=%) GDP GDP (2000 price) GDP Deflator (2000=100) Per Capital GDP (2000 price) Prices and Unemployment CPI (1999/2000)=100 Unemployment Underemployment Trade Domestic Exports Re-exports Service Exports Import of Commodities Imports of Service

City-State Economy 1961-1970 1971-1980

City-Core Metropolis 1981-1997 1997-2006

8. 9(a) 4. 2(a) 6. 2(a)

9. 1 10. 2 6. 5

6. 2 7. 6 4. 7

4. 2 -2. 2 3. 6

-

8. 6(b) 4. 6(c) -

8. 5 2. 5 1. 4(d)

-0. 4 5. 6 2. 7

15. 9 10. 8 12. 2(a) 13. 0(a) 11. 5(a)

19. 3 27. 8 16. 9 21. 0 21. 8

7. 5 25. 3 14. 5 17. 5 14. 6

-4. 1 7. 3 7. 4 5. 9 4. 3

Notes: (a) 1962-1970 average; (b) 1976-1980 average; (c) 1975-1980 average; and (d) 1983-1997 average; US$ to HK$ conversion rate =1:7. 8.

2. HONG KONG’S ECONOMIC INTEGRATION WITH PRD SINCE 1980 Hong Kong‘s outward investment in PRD in the form of manufacturing cross border operations (CBOs) performed by Hong Kong investors in the nearby Guangdong province

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have enhanced the economic integration and development between the two regions, Hong Kong and PRD, upon China‘s economic opening in 1979. Although the two regions remained institutionally and politically separated following the ―One-Country Two-System‖ arrangement, from the perspectives of economic development and growth, Hong Kong and the nearby cities of Guangdong, including Shenzhen, Zuihai, and other PRD cities, had evolved toward a mega-city economy with Hong Kong serving as the (gravity) center core of the delta region. From a spatial point of view, the relocation of Hong Kong‘s manufacturing firms to Guangdong, mainly concentrated in the proximate PRD areas, had not only facilitated the economic integration and the formation of a mega-economy between Hong Kong and PRD but also a labor division between the two regions.1

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2.1. HK-PRD Economic Integration: Formation of the HK-PRD Metropolis Regional Economy 2.1.1. Manufacturing’s outward processing in China China‘s economic opening provided both cheap labor and land resources together with ample business opportunities and incentives to pull foreign investors, especially Hong Kong manufacturers, to invest in mainland China in order to save production costs and maximize profits. Due to the push of high land and labor prices in Hong Kong and the pull of cheap resources in mainland China, especially in PRD, Hong Kong‘s investment in manufacturing outward processing had continued. Preferential governmental FDI policies in the economically opening China and the establishments of Special Economic Zones (SEZs), as well as preferential treatments and/or tax policies implemented by the Chinese government, together with the ―passive‖ industrial policies of the Hong Kong government, reinforced the pull and push factors for the relocations of Hong Kong manufacturing firms to Guangdong and the nearby PRD (Figure 1).2, 3 The production activities of Hong Kong‘s manufacturing in the 1980s were mainly reflected by outward investment in the form of cross-border operations (CBO) in the proximate PRD and then further diffusion in the form of plant relocations and more service operation components. Since 1992, the relocations of manufacturing and service-oriented operations (such as R&D, prototype manufacturing, quality control, and packaging), leaving in Hong Kong the upper- and lower-streams of production (such as order receiving, financing, management) had transformed Hong Kong‘s manufacturing sector into a sector engaged in 1

Following the theories of pattern of land use and the observations from the two decades of FDI diffusion process and pattern of geographical distribution, the nearby PRD areas have evolved as an integrated economic ―suburb‖ of Hong Kong with the highway distance or gravity from the center core to serving as a friction of FDI diffusion. The economic boundary of the HK-PRD economic integrated region coincides geographically within a radial distance of 196 kilometers from the center core or approximately three hours of travel time .. 2 The accumulative total amount of realized foreign direct investment (FDI) from Hong Kong to China reached a record high of US$259.? 7 billion for the period of 1979-2005, which accounts for an average of 42% of China‘s total national FDI receipts during the same period. In 1987, the recorded amount is US$1.? 6 billion representing 69% of the national total and increased to US$20. 6 billion or 46% in 1997 and to US$17.? 9 billion or 30% in 2005. $$$$$ Does the author mean billions in this paragraph? 3 The HK-PRD economic region (with an area of 40,000 km2) or with the periphery area lying within the three-hour travel time zone by highway from Hong Kong can be quite different from that of the Guangdong province (with an area of 179,000 km2) in terms of economic activities.

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manufacturing, management and services operations. The relocations of more manufacturing functions to PRD and eventually, the complete manufacturing process and whole production plants, deepened the region-wide division of labor in the management functions between the two regions of Hong Kong and PRD.

2.1.2. Industrial and trade structural adjustments (1) Industrial Restructuring between Manufacturing and Services The decline of Hong Kong‘s manufacturing sector was marked by its industrial restructuring from 1987 in both input-output content and employment, as well as industrial concentration measured by entropy (Ng, 1995).4 A structural change was found to occur in both manufacturing and services in 1987. Services expanded through the contraction of the manufacturing sector in terms of employment and establishments. The relocation of manufacturing firms to mainland China was considered to be the main source of such change, the result of which is retarded local manufacturing productivities. The manufacturing contribution to Hong Kong‘s GDP declined from 23. 7% in 1980 to 22. 0% in 1987, 17.6% in 1990, 7.2% in 1996, and further to 3.4% in 2006, with the corresponding gradual expansion of services to account for more than 95% of GDP as of 2006. Some major statistics of GDP shared by industrial sector are further presented in Table 3.

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Table 3. Hong Kong’s Industrial Structure: Percentage Share in GDP by Industrial Sector (1981-2006) Industry (Unit=%) Manufacturing Sector Service Sector Import/Export Trade Finance and Insurance Transportation Business Services** Wholesale and Retail

1981

1987

1997

21. 8

21. 1

6. 0

8. 7 7. 1 6. 7 2. 2 5. 0

13. 0 6. 7 7. 9 3. 0 4. 8

16. 1 9. 8 8. 1 4. 2 3. 5

2006 (A)* (B) 3. 4 5. 1 21. 9 12. 3 9. 8 4. 6 3. 4

16. 4 5. 3(a) 9. 4(b) 10. 5

Notes: Compiled by the authors; Column (A) represents market value and Column (B) represents employment percentage share; *2005 data; **excluding real estate; (a) financial services; (b) includes storage.

In evolving toward a more service-oriented economy, two major service sub-sectors can be classified: (1) traditional services including trade-related and tourism-related industries and (2) newly-developed services including financing, real estate, and business services. In terms of value added from the major service industries, import/export trade is still the most important industry sector among traditional services. It provided 21.9% of GDP and 16.4% of total employment in 2006 (Table 3). The newly developed service sub-sector showed increasing contributions to account for a total of 13.8% and 20.0% of GDP in 1987 and 1996,

4

1987 was the economic opening of the ―Greater‖-PRD region in Guangdong. PRD has nine cities including Shenzhen, Dongguan, Huizhou, Guangzhou, Foshan, Jiangmen, Zhongshan, Zhuhai, and Zhaoqing.

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respectively, and has continued to expand rapidly to become a significant sector contributing to the sustained growth of the economy.

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(2) Cross Border Operations and Trade Evolution Upon China‘s economic opening in 1979, in order to maintain the competitiveness of labor-intensive manufacturing goods in the export market especially during the decade of 1980s, Hong Kong‘s manufacturing was forced to adopt a horizontal expansion of production without capital or technology deepening in the form of outward processing in the proximate PRD. Through such cross-border (outward) manufacturing processing of Hong Kong firms in the PRD region, trade activities particularly in the form of outward processing trade (OPT) between the two regions increased tremendously. The further economic opening of the nine cities/counties in PRD in 1987 further enhanced Hong Kong‘s re-export to exceed its domestic export. Both domestic export and re-export were observed to increase 11.2 and 6.1 times from 1980 to 1986, respectively, and 3.0 and 6.1, respectively, for the period of 19871991. China‘s reconfirmation of her open door policy in 1992 attracted huge FDI inflows and further relocations of Hong Kong‘s manufacturing and hence, induced vigorous OPT activities. In 1992, it was estimated that 74.3% of domestic exports to China, 46.2% of the reexport, and 72.1 % of imports from China were of OPT in nature. Further, in 1992, the export values of Guangdong accounted for 32% of those of China while PRD constituted 74% of the export values of the whole Guangdong province, derived mainly from the outward processing manufacturing of Hong Kong‘s firms as OPT. A longrun relationship of trade by components in domestic exports and re-exports (secondary domestic exports) and output growth was observed using 1961-1995 as the study period. In response to the evolutions of Hong Kong‘s outward manufacturing processing and investment in PRD, three stages of trade development of can be examined as below: (i) Rapid annual growth in domestic exports averaging 11% per annum from the 1960s to 1987. (ii) Steady growth in re-exports (1988-1992) accompanied by a widening gap in domestic exports in terms of value. (iii) Re-export growth started to decline since 1992 (averaged at 9.1% for 1993-1999) with a rise of offshore trade including transshipments (or trade ―derivatives‖) and triangle trade. The dominance of commodity trade from 1961-1987, re-export trade from 1980-1992, and offshore trade from 1993-1999 (and now) explained the pattern of the trade evolution. Strong relationships between manufacturing and trade loans/advances coupled with corresponding commodity trade and trade derivative activities were observed while the weakening associations between the growth of manufacturing production (and trade) and the growth of institutional financing after 1987 illustrated the diminishing contributions of Hong Kong‘s financial services to local manufacturing. The evolving trade from conventional entrepot to domestic export-led dominance and then to re-export or outward-processing dominance provided great significance and impact on Hong Kong‘s GDP growth.

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2.2. HK-PRD Metropolis Regional Economy as a Core-Periphery System Krugman‘s (1991, 1998) idea of a core-periphery system (CPS) has provided the HKPRD regional relationship a theoretical stance. CPS can be considered an economic entity where well-diversified, comprehensive, and interrelated industries were developed and externalities in both production and consumption, via agglomerative effects, were generated such as described by Quiley (1998). In the HK-PRD economic integrated region, division of labor, within the economic region, between the core and the periphery was made possible while benefits such as scale economies, input sharing, etc., were also well generated. Hong Kong has become the major service provider of the HK-PRD CPS as well as the center core equipped with the unique function of high global accessibility.5 Hong Kong, a well-developed city-core metropolis, together with PRD, a developing economy, have flourished together by sharing the comparative advantages generated by the two economically integrated but yet politically and administratively separated regions. The agglomeration effects, derived from the HK-PRD economic integrated entity, were organized as a three-tier agglomeration economy being empirically verified to include three types of agglomerative effects. They are (i) agglomeration of a core-peripheral system (CPS), (ii) the city as an agglomeration, and (iii) intra-city agglomerations. Following the idea of the HK-PRD three-tier agglomeration economy and evolution during the three particular periods of economic integration since the 1980s, deepening agglomeration effects since the 1990s, and the period after Hong Kong‘s handover in 1997, a new perspective of the ―One-Country Two System‖ arrangement can be elaborated from an economic point of view. The HK-PRD economic growth can be well elucidated by the theories of city and regional growth with HK-PRD as an economic integrated entity being governed by two politically and legally separated local administrations needing good partnerships and close economic cooperation between Hong Kong and PRD. This HK-PRD economically integrated region has together functioned as a regional metropolis economy characterized by both the agglomerations of production/consumption and the formation of effective city links within the economic region. It has also become one of the two most Globalized Delta Economies (GDEs) and competitive economic regions in China.6 Hong Kong, given the ―One-CountryTwo-System‖ arrangement, would remain the most globalized city and globally accessible center (gravity) core of this HK-PRD economic integrated economy or GDE. With Hong Kong as the gravity center in promotion of FDI, PRD has also enjoyed sustained growth via the FDI inflows, productivity enhancement, and accumulation of human capital and research efforts.

5

From an economic development point of view, the HK-PRD regional economy has become one of the two most globalized delta economies (GDEs) in steering the regional growth in China. The economic growth and potentials of GDEs can be inspected by some major economic and visualized indicators via the following website: www. jlgis. cuhk. edu. hk/business. 6 The nine Pan-PRD provinces included Guangdong, Guangxi, Fujian, Hainan, Guizhou, Yunnan, Sichuan, Hunan, and Jiangxi.

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2.3. Hong Kong as a Service-Dominated City-Core in GDE Hong Kong has transformed from a manufacturing export enclave into the hub of a fulfledged, service-oriented cosmopolitan center. The cross-border manufacturing-led expansion of re-exports and transshipments has not only strengthened local trading industries but has nurtured the diversification and development of the service sector in the 1990s. General business views remained quite optimistic through the early 2000s even though the sovereignty transfer in 1997 inevitably affected the percepts of businesses on the region‘s investment environment and climate. The government‘s views on recognizing local comparative advantages and liberalization policy since the late 1980s have also encouraged the formation of a regional financial center, which further enhances the rapid rise and development of the newly developed service industries. The evolution and growth of the city-state toward a service-dominated economy since 1980, and before the return of sovereignity of Hong Kong to China in 1997, can be well characterized by its service-dominated economic activities as follows.

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(1) Sustained growth via spatial expansion in the proximate PRD. (2) Outward processing with scale economies, production and trade expansion particularly in OPT and its derivatives. (3) Stimulated growth of businesses and trade, finance and insurance, logistics, and business services. (4) Rapid growth of inward FDI, real estate, and financing industries. (5) Expansion of higher education and rise of the middle-class. (6) Facing China. After the return of sovereignty to China in 1997, two major financial turmoils, namely, the 1997-Asian Crisis and the 2008-Global Crisis, and together with some untimely macroeconomic economic policies (such as housing) promoted by the Hong Kong government during 1997/98, struck the service-dominated economy in terms of growth. Unemployment and underemployment rates reached their all time high to almost 8% in 1998 (except in 1975) and 5.3% in 2009. Macroeconomic adjustments and problems during the post-1997 period were observed: (1) Burst of the economic bubble, high unemployment/underemployment, and deflation. (2) Deepening of the service sector, resulting in low productivity increase and biased opportunities toward high-end services employment. (3) Merging economic activities under two economic systems: a market-oriented economy needing cooperation with the planned economy in mainland China. (4) Macroeconomic restructuring: economic growth and employment creation in a service-oriented economy (5) Change in population structure including aging and immigration problems. Even though confronted by the extensive outward investment to PRD, Hong Kong was able to maintain its sustained growth in the 1990s through the long-term growth of banking and finance, re-export trade, and induced ―trade derivatives‖. The following rapid developments of the dominating service sector were observed.

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Linda F. Y. Ng and Chyau Tuan (1) Rapid development and integrations of banking, insurance, management of mutual funds, and financial derivatives industries; and preliminary tests in RMB handling and trading. (2) A center for regional MNC headquarters promoted by tax-free preferential policies. The number of regional headquarters increased rapidly from 192 in 1980 to 924 in 1997 and 1,228 in 2006 representing a 6.4-fold increase from 1980 to 2006. (3) Import/export trade, transportation, storage, and supporting business services aided by information technology to form a supply chain of services, and hence, the formation of the ―logistic‖ industry. (4) Tourism and regional tourism combined with international exhibitions and convention center service provisions.

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3. ECONOMIC INTEGRATION OF THE HONG KONG-METROPOLIS AFTER THE ASIAN CRISIS: FROM PRD TO PAN-PRD China‘s favorable economic policies, particularly the FDI preferential policies and the economic opening of PRD, provided Hong Kong with opportunities to expand its manufacturing and other economic activities in terms of scale and space. The subsequent economic integration of Hong Kong with its proximate PRD to form the HK-PRD regionalmetropolis economy further ensured the region‘s competitiveness, sustainable growth and development. The successful economic growth and competitive position of Hong Kong and her economic integration with Guangdong before the handover in 1997 can be attributable to major factors including effective government and government institutions; well-developed infrastructure and supporting facilities; good business culture and networking; vital entrepreneurship; free port; and availability of a hinterland with close economic coordination and cooperation. After the financial crisis, unique factors attributable to the continuous success and sustainable growth, as well as regional competitiveness, further deepened the regional economic integration of Hong Kong with PRD and China. These factors included the preservation of the factors of success before the handover in 1997, rapid economic growth in China, continual openness of the economy in the political and economic system, and continuous implementations of favorable economic policies or arrangements by the China government to aid Hong Kong. The latter included Closer Economic Partnership Arrangements (CEPA) (2003), Pan-PRD Cooperation (2003), Individual Travel Scheme (2003), RMB handling by local Hong Kong banks (2005), Qualified Domestic Institution Investments (QDII) and Qualified Foreign Institution Investments (QFII) (2007), etc. In late 2003, the Guangdong government announced the Pan-PRD cooperation arrangement in the form of a common market to link Hong Kong (and Macau) with nine provinces in south and southwest China in terms of economic and trading activities.6 Such an economic arrangement further expands the spatial context of Hong Kong from HK-PRD (usually named as 9+1; that is, nine PRD cities plus Hong Kong) to HK-Pan-PRD (also called 9+1; that is, nine Pan-PRD provinces plus Hong Kong/Macau) in terms of economic activities. The Pan-PRD (9+1) common market is intended to provide and/or facilitate the

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following competitive advantages targeting mutual benefits and sustained growth of the PanPRD economic region:

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(1) Effective regional links: an effective regional free trade area to provide the Hong Kong/Macau-PRD cities with Guangdong and the other eight provinces with better economic linkages, coordination, and cooperation particularly in terms of trade; that is, Hong Kong/Macau linking the global market and Guangdong linking the other eight Pan-PRD provinces. (2) Reduction of barriers and costs: with better linkages, barriers to investments and trade among the nine Pan-PRD provinces and the associated transaction costs can be much reduced. (3) Complementarities of Pan-PRD provinces: the very different comparative advantages of the Pan-PRD members would complement each other and enhance regional competitiveness in that: (a) Hong Kong/Macau serving as (i) the contact point for international trade and financial networking; and (ii) a source/gateway of FDI. (b) Guangdong province to serve as (i) the demand center for agricultural products and labor; (ii) the supplier of consumer-oriented industrial products; and (iii) a source equipped with pioneering experience for intra-regional investments. (c) All other eight Pan-PRD provinces, following their different stages of development and equipped endowments, would serve as (i) learners of the Hong Kong/Macau/Guangdong experiences in investing in foreign markets, advanced managerial experience, and production of high-end consumer products; (ii) suppliers of natural resources, labor, agricultural products, and contact points of overseas manpower networking; and (iii) recipients of the relocation of more labor-intensive industries resulting from the industry up-grade in other more developed provinces/areas. The formation of the HK-PRD metropolis regional economy and its subsequent extension to the Pan-PRD common market provided important implications to the distinct role and significance of Hong Kong-metropolis in China. (1) As the most globally accessible city in China: Hong Kong, as the most globalized and globally accessible city of China, will continue to provide Pan-PRD and China with the highest global accessibility and enhance not only the metropolis economic growth but also that of PRD/Pan-PRD and China. (2) As a center core of CPS with effective city links: to serve as the facilitator in building the economic linkages between the HK-PRD metropolis region with Guangdong and Pan-PRD, and the global world. (3) As a core city of an efficient (Pan-PRD) common market: to be shared by PRD and the proximate Pan-PRD provinces.

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Figure 2 A Sketch of the Role of Hong Kong-Metropolis and Pan-PRD Common Market

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Pan-PRD (Eight Provinces)

Guangdong

Hong Kong/ Macau

Global Market

Figure 2. A Sketch of the Role of Hong Kong-Metropolis and Pan-PRD Common Market.

A brief sketch of HH-PRD-Pan-PRD common market relationships with global accessibility and the distinct role of Hong Kong played in this economic integrated region, as described above, is depicted in Figure 2.

4. BEYOND THE ASIAN CRISIS: HONG KONG INTERNATIONAL COMPETITIVENESS

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4.1. Gaining International City Competitiveness: Some Opinion Survey Evidence Given the mobilization of outward investment (FDI) from the core (Hong Kong) into its periphery (PRD), the HK-PRD economic entity has functioned as a regional metropolis economy in south China with Hong Kong remaining as the most globalized city and globally accessible center core in the HK-PRD GDE. Hong Kong‘s international competitiveness has been largely enhanced by the regional economic preferential and cooperative policy measures implemented by China especially after the return of its sovereignty in 1997. In measuring international competitiveness, the Pyramid of International City Competitiveness (PCC) model, constructed by the authors, depicts the competitiveness of an international city by three basic dimensions as: (i) Base for Sustainable Economic Growth (Dimension A), (ii) Investment Environment (Dimension B), and (iii) Image of Globalization (Dimension C).7

7

The PCC model has three major dimensions consisting of six components and 14 factors with 32 indicators in the measurement of international city competitiveness. The six components and 14 factors are: (1) Production Factors consisting of three factors, namely, Human capital, Technology base, and Environment for entrepreneurs (six measuring items); (2) Existing Economic Base consisting of three factors, namely, Institutional infrastructure, Business culture, and Economic and industry structure (eleven measuring items); (3) Policy for Social-Economic Development consisting of one factor, namely, Government and governance (three measuring items); (4) Environment for Business Operations consisting of four factors, namely, Rule of law, Administration of economic affairs, Openness, and Labor (eight measuring items); (5) Environment for Living consisting of two factors, namely, Living facilities and Environment protection (two measuring items); and (6) Image of Globalization consisting of two factors, namely, Acceptance of ―foreignness‖ and Degree of globalization (two measuring items).

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Table 4. Hong Kong-Metropolis Competitiveness after the Asian Financial Crisis: Survey Results of MNEs (2001-2007) PCC Dimension Dimension A Base for Sustainable Growth % Dimension B Investment Environment % Dimension C Image of Globalization % Dimension A-C Average %

2001

2002

2003

2004

2005

2006

2007

2001 vs 2007

3. 59

3. 85

3. 93

3. 91

4. 08

4. 02

4. 12

-

-

+0. 26 +7. 24

+0. 08 +2. 08

-0. 02 -0. 51

+0. 17 4. 35

-0. 06 -1. 47

+0. 10 +2. 49

+0. 53 +14. 76

3. 82 -

4. 05 +0. 23 +6. 02

4. 15 +0. 10 +2. 47

4. 13 -0. 02 -0. 48

4. 18 +0. 05 +1. 21

4. 13 -0. 05 -0. 29

4. 28 +0. 15 +3. 63

+0. 46 +12. 04

4. 14 -

4. 24 +0. 10 +2. 42

4. 22 -0. 02 -0. 05

4. 33 +0. 11 +2. 61

4. 42 +0. 09 +2. 08

4. 30 -0. 12 -2. 71

4. 49 +0. 19 +4. 42

+0. 35 +8. 45

3. 75 -

3. 93 +0. 18 +4. 80

4. 02 +0. 09 +2. 29

4. 00 -0. 02 -0. 05

4. 12 +0. 12 +3. 00

4. 08 -0. 04 -0. 10

4. 19 +0. 11 +2. 70

+0. 44 +11. 73

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Notes: and % denote year-on-year changes and percentage changes, respectively; a score of ‗5‘ represents ‗best‘ and ‗1‘ represents ‗worst‘.

The opinions of CEOs/senior management of MNC, in both Hong Kong and Shanghai, regarding the three basic dimensions of international competitiveness were collected in seven consecutive surveys conducted annually during 2001-2007.8 The survey results reported in Table 4, show that Hong Kong‘s overall international competitiveness had increased steadily from 3.75 in 2001 to 4.19 in 2007, representing a gain of 0.44 or 11. 7%. By the three basic dimensions (A-C), Base for Economic Growth (Dimension A) increased from 3.56 to 4.12, representing a gain of 0.53 or 14.8%, Investment Environment (Dimension B) from 3.82 to 4.28 or a gain of 0.46 or 12.0%, and Image of Globalization (Dimension C) from 4.14 to 4.49 or a gain of 0.35 or 8.5% (Table 4).9 From the survey findings, Hong Kong earned the highest score in Dimension C to be followed by Dimensions B and A. However, Hong Kong gained most in Dimension A, followed by Dimension B and C. The results were consistent during the seven study periods obtained. Such research findings of an international competitiveness progression may well reflect the continual success and further development of the economic integrated Hong Kong with China, after the Asian financial crisis, as a cosmopolitan and the center core (regional 8

Over 1,240 CEOs and senior management of MNE in both Hong Kong and Shanghai were surveyed from 20012007 in order to understand their expert opinions regarding the international competitiveness of both cities. The CEOs and senior management were requested to rate the achievements of both Hong Kong and Shanghai by a structuralized questionnaire on international city competitiveness based on the Pyramid of International City Competitiveness (PCC) model (Tuan and Ng, 2002a). Respondents were asked to score from ‗5‘ (best) to ‗1‘ (worst) on the three basic dimensions with 32 measuring items. 9 Hong Kong was found to lead in all the three dimensions during the seven-year survey period when compared with Shanghai, which is the top international city in China mainland.

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metropolis) of a core-periphery economy in the south China region, through the spatial expansion of its production base into its proximate PRD and Pan-PRD regions or hinterlands and improvement of its investment environment, particularly in the attraction of foreign investments. Further from the study, innovation capabilities contributing to the gain in international competitiveness include human capital, a favorable environment for entrepreneurs, and a technology base in terms of e-commerce/internet/information technology.

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4.2. Mobilization of International Investments: Evidence from MNCs Survey In the mobilization of international investments, in terms of direct investment flows, total direct inflows increased from HK$423.9 billion in 2007 to HK$464.3 billion in 2008 while total direct outflows decreased from HK$476.5 billion to HK$ 393.9 billion, respectively. China‘s mainland remained the predominant partner in terms of Hong Kong‘s FDI mobilization. As of 2008, China shared a total of 36.5% of Hong Kong‘s outward FDI and in terms of flows, supplied HK$179.7 billion or 38.7% of Hong Kong‘s FDI inflows, and received HK$215.2 billion or 54.6% of Hong Kong‘s FDI outflows reflecting the significance of China‘s direct investments as well as that of the China market. While China remained the top destination/recipient of Hong Kong‘s investment, Guangdong had been the most popular province to share 30.4% (or HK$798.4 billion) of Hong Kong‘s total outward investment in 2008.10 In order to study the strength and attractiveness of Hong Kong in mobilizing FDI in the region, the Hong Kong Government conducted a MNC Survey (June, 2008) by investigating a sample of 6,612 MNCs of USA, Japan, UK, and China origins and conducting businesses in trading, business services, banking and finance, and transportation. The findings of the survey revealed the ten most important factors of why these MNCs chose Hong Kong as the base to set up their businesses and headquarters and/or regional offices. These ten factors include (1) simple tax system and low tax rate, (2) free flow of information, (3) corruption free government, (4) political stability and security, (5) absence of exchange control, (6) rule of law and independent judiciary, (7) excellent infrastructure, (8) proficiency in English, (9) productivity of the staff, and (10) geographical location being a bridge to China and the rest of the world. Other factors that followed are free port, accessibility to business opportunity in China, and a business friendly economic policy. This survey study reaffirmed the unique investment environment of Hong Kong. Its free market economy, with ample business opportunities provided by the China hinterland and effective government, are the key factors in enhancing the competitiveness of Hong Kong as a competitive international city, particularly in FDI promotion and attraction.

10

In 2008, other than mainland China, British Virgin Islands accounted for another 32. 3% of Hong Kong‘s inward investment in stock and 23.8% in flow, and 43.8% of the outward investment in stock and 36.1% in flow. These two top FDI recipients and destinations together shared 88.2% of the total FDI outflows and 68.8% of the total inflows (in stock), and 90.7% and 62.5% (in flow), respectively, in 2008.

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5. BEYOND THE 2008-GLOBAL CRISIS: HONG KONG-METROPOLIS AS AN INTERNATIONAL FINANCIAL CENTER

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Because Hong Kong had evolved into a service-dominated economy with trading, finance, and transportation contributing to at least half of the economy‘s GDP, the recent global financial crisis in 2008 adversely affected its exports, GDP, and employment. Statistics from Tables 5-6 reveal the following impacts on the Hong Kong-metropolis following the global crisis. (1) Real GDP decreased by -2.7% in 2008/Q4 and -7.7%, -3.8%, and -2.4%, during the first three quarters of 2009. In 2009, immediately after the crisis, real GDP and per capita GDP decreased by -2.8% and -3.1%, respectively. Real GDO, however, quietly regained positive growth starting from 2009/Q4 with a strong rebound of 8.2% in 2010 Q1. (2) Both private consumption and private capital formation went down by three consecutive quarters until 2009/Q2 and 2009/Q3, respectively. Real private investment showed strong growth since 2009/Q4 by achieving 14.1% and 10.5% in 2009/Q4 and 2010/Q1, respectively. (3) Commodity exports decreased by 4.9% in the last quarter of 2008, and then by 22.7%, -12.8%, -13.2%, and -2.9% during the four quarters of 2009. Service exports also recorded negative growth rates during two quarters from 2009/Q1 and 2009/Q2 by -5.5%, and -3.89%, respectively. Both sectors regained strong positive growth in 2010/Q1 by 21.6% and 17.9%, respectively. (4) Seasonally adjusted unemployment rate jumped from 3.8% (2008/9-11) to 4. \1% (2008/10-12) and 5.4% (2009/4-6). However, unemployment started to improve since 2009/7-9 until 2010/3-5 at 4.4%, a record close to that of before the crisis. Underemployment rate has continuously decreased from its peak of 2.4% in mid2009 but remained at 2% during the most recent period of 2010/4-6. (5) During the 2008/09 period, CPI remained rather stable only with a mild deflation observed for the three consecutive months of June-August of 2009. Since April 2010, the economy recorded a modest inflation rate of 1.3% to 1.7% in June 2010. The statistics in Tables 5-6 also reveal the fact that the Hong Kong-metropolis has not been too seriously affected by and is recovering rapidly from the 2008-Global Crisis given the strong economic performance and supports provided by its PRD hinterland as well as that of China. Since the Hong Kong economy has, in fact, integrated economically with PRD/PanPRD and China, business confidence has been upheld by China‘s very impressive accomplishment by over-achieving its 8% annual growth target at 8.9% in 2009 even during the midst of the global crisis facing the rest of the world. Further observations also show that: (1) Tourism services, which accounted for 18% of the service exports in 2009, still recorded positive growth during the post-2008 crisis period. The number of incoming/outgoing passengers reached an all time high record of 220 million in 2009 due to China‘s policy of allowing residents of PRD and other major China cities to visit Hong Kong on an individual basis (Individual Travel Scheme, 2003).

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(2) To take advantage of the HK-PRD core periphery system and Hong Kong‘s ―free‖ market economy with high accessibility to the China mainland economy, capital inflows into the economy continued in 2009. According to the balance of payments figures, both the current and capital accounts recorded significant surpluses during the first three consecutive quarters of 2009. The total capital inflows during the 2008/09 crisis period were HK$147 billion representing 33.8% of Hong Kong‘s GDP in the 4th quarter of 2008 and HK$109 billion or 25.3% of GDP in the 3rd quarter of 2009 (Table 5). (3) It is also expected that the ever-growing China mainland market will stimulate commodity exports from Hong Kong by at least 5% in 2010, according to the figures estimated by the Hong Kong Trade Development Council (HKTDC) in 2010. The expected recovery in the rest the world will certainly reinforce the confidence of the territory in terms of economic growth. (4) Continuously improving the bilateral trading environment with the mainland and other Asian countries, such as CEPA, ASEAN 10+1, also seems to benefit Hong Kong in both the external trade of commodities and services.. (5) The gradually opening China financial sector and the expanding cross border operations, including services production activities (as facilitated by CEPA I-VI, 2003-2009), in particular, will provide increasing opportunities for Hong Kong investors. Other than the two different systems, the necessary conditions for an international financial center, such as financial infrastructure and developments of high-end financial products/instruments, well-trained workforce, global accessibility, and business networking, etc, are well provided for. Hong Kong is still well ahead of all other major cities on the mainland, including Shanghai, in terms of global accessibility and international competitiveness. It follows that being China‘s most internationalized city and gravity center core of PRD and GDE in south China, Hong Kong definitely plays a predominant role by serving as a gateway to China as well as linking China with the rest of the world. China‘s strong and impressive economic performance has also protected Hong Kong from the serious external shocks generated by the 2008-Global Crisis. Hong Kong, being China‘s most globally accessible core city and metropolis, will further strengthen its role as a service-dominated regional cosmopolitan center to become the top international financial center of China, not only in banking/financial services, but as a regional center for syndicate loans, and more importantly, in the mobilizations of China‘s inward/outward international investments with the world. The recent delegations, announced by China‘s central government, allowing local Hong Kong banks to conduct more RMB business for corporate clients and local business firms to issue RMB corporate bonds, and corporate clients to apply for bank loans/credit lines in RMB to finance projects, as well as to settle trade in RMB11, would definitely enhance the financial role of Hong Kong in doing RMB business. They also facilitate Hong Kong as a

11

The new measures announced recently in February 2010 by Hong Kong Monetary Authority (HKMA) have two major restrictions: first, RMB raised in the bond issuance or trade settlement activities cannot flow back to China mainland unless given China‘s approval so as to eliminate any pressure on RMB appreciation and second, business must use the proceeds for trade settlements or to finance projects and not for speculations in stocks, bonds or property.

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testing ground for the internationalization and convertibility of the RMB currency and further, enhance the development of her critical role as an offshore RMB center in China. Table 5. The Hong Kong-Metropolis Economy Beyond the 2008-Global Crisis: GDP, Aggregate Demand, Exports, and BOP (2006-2010)

GDP* % 2006 7. 0 2007 6. 4 2008r 2. 2 r 2009 -2. 8 Year/Quarter 2008Q3r 1. 1 2008Q4r -2. 7 2009Q1r -7. 7 r 2009Q2 -3. 8 2009Q3r -2. 4 r 2009Q4 2. 5 2010Q1p 8. 2 Year

GDP GDP Deflator# 2008=100 % 95. 7 -0. 3 98. 5 2. 9 100. 0 1. 5 100. 2 0. 2 100. 3 100. 7 100. 0 100. 6 99. 3 100. 9 100. 9

2. 1 -0. 5 0. 7 0. 9 -1. 0 0. 2 0. 9

Per-capita GDP* HK$ % 224796 6. 3 236767 5. 3 240096 1. 4 232599 -3. 1 n. a. n. a. n. a. n. a. n. a. n. a. n. a.

n. a. n. a. n. a. n. a. n. a. n. a. n. a.

C*

G*

% 5. 9 8. 5 2. 4 -0. 4

% 0. 3 3. 0 1. 8 2. 4

-0. 8 -2. 1 -1. 7 4. 1 0. 4 2. 0 -

-0. 4 1. 4 -0. 3 1. 8 0. 6 -0. 2 -

Private Investment Exports BOP Account I* Inventory Change# Goods* Services* HK$mil HK$mil % to GDP % % % 2006 7. 1 -1488 9. 3 10. 1 46735 3. 2 2007 3. 4 13543 7. 0 14. 1 114498 7. 1 2008r 0. 8 8394 1. 9 5. 0 263869 15. 7 2009r -1. 8 28460 -12. 7 0. 3 Year/Quarter 2008Q3r 4. 1 1931 1. 3 4. 0 51259 11. 9 r 2008Q4 -16. 7 3907 -4. 9 0. 2 147317 33. 8 2009Q1r -10. 3 -4921 -22. 7 -5. 5 68900 18. 2 r 2009Q2 -11. 8 -4570 -12. 8 -3. 8 143096 36. 6 2009Q3r 3. 2 16635 -13. 2 0. 8 106625 25. 3 2009Q4r 14. 1 21316 -2. 9 8. 9 230641 51. 8 p 2010Q1 10. 5 27198 21. 6 17. 9 20175 4. 8 Notes: *year-on-year percentage changes in real terms, #2008=100; r=revised figures p=preliminary figures; C, G, and I denote private consumption, G government expenditures, and I private investment, respectively, in real terms. Source: Hong Kong Census Statistics (2010), HKSAR.

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Year

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Linda F. Y. Ng and Chyau Tuan Table 6. The Hong Kong-Metropolis Economy Beyond the 2008-Global Crisis: Price Index and Unemployment (2007-2010)

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Year/Month

Composite CPI

Year/Month

CPI % 2007 104. 4 2. 0 2007 2008 108. 9 4. 3 2008 2009 109. 5 0. 5 2009 2010/1-6 111. 9 1. 3 2010/1-6 2008/10 108. 1 1. 8 2008/8-10 2008/11 110. 0 3. 1 2008/9-11 2008/12 109. 6 2. 1 2008/10-12 2009/1 110. 0 3. 2 2008/11-2009/1 2009/2 109. 2 0. 8 2008/12-2009/2 2009/3 109. 5 1. 2 2009/1-3 2009/4 109. 6 0. 6 2009/2-4 2009/5 109. 3 0. 0 2009/3-5 2009/6 109. 1 -0. 9 2009/4-6 2009/7 109. 2 -1. 5 2009/5-7 2009/8 107. 4 -1. 6 2009/6-8 2009/9 108. 2 0. 5 2009/7-9 2009/10 110. 5 2. 2 2009/8-10 2009/11 110. 6 0. 5 2009/9-11 2009/12 111. 0 1. 3 2009/10-12 2010/1 111. 1 0. 8 2009/11-2010/1 2010/2 112. 2 0. 8 2009/12-2010/2 2010/3 111. 7 0. 8 2010/1-3 2010/4 112. 2 1. 3 2010/2-4 2010/5 112. 0 1. 4 2010/3-5 2010/6 112. 2 1. 7 2010/4-6 Notes: *seasonal adjusted. Source: Hong Kong Census Statistics (2010), HKSAR.

Unemployment* % 4. 0 3. 6 5. 2 4. 5 3. 6 3. 8 4. 1 4. 6 5. 0 5. 2 5. 3 5. 3 5. 4 5. 4 5. 4 5. 3 5. 2 5. 1 4. 9 4. 9 4. 6 4. 4 4. 4 4. 6 4. 6

Underemployment % 2. 2 1. 9 2. 3 2. 1 1. 7 1. 8 1. 9 2. 1 2. 1 2. 1 2. 2 2. 3 2. 3 2. 4 2. 4 2. 4 2. 4 2. 5 2. 3 2. 2 2. 1 2. 2 2. 1 2. 0 2. 0

6. FURTHER CHALLENGES As far as sustainable growth is concerned, the impact of the 2008-Global Crisis upon Hong Kong may impose the following potential problems: (1) The trend of tightening regulations on the global financial market, such as institutional governance, operations, and innovations in financial products, will inevitably and adversely affect the local financial sector. As a regional financial center, a major share of the sector is foreign owned. If global regulations were

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moving toward a conservative direction, contraction in business values of the financial market would eventually follow. (2) Increasing protectionism in the commodity and service trade is expected for China‘s major trading partners in 2010 and the near future and its spillover effects upon Hong Kong is a major concern. (3) Rapid growth in the domestic market and expansion in private consumption in China have been recently observed. However, the rise of smaller private enterprises in China will continue. All these changes will exert enormous pressure on the needs of the Hong Kong‘s service economy to adjust its strategies in both production and geographic markets. Within the Hong Kong-metropolis entity, the following development and challenges are of major concerns: (1) Given the continuous future development of the HK-PRD economic region, development of infrastructural supports in transportation, environment protection, health care, social welfare, and education under the spirit of ―One-Country-TwoSystem‖ for furthering the administrative coordination and cooperation between the two regions (the core Hong Kong and its periphery PRD townships) are called for. (2) Active participation and utilization of China‘s ―Five Year Planning‖ in the PRD and Pan-PRD regional economies, and reductions of various forms of transaction costs generated from the two ―different (political/economic) systems‖ are the priorities. (3) Problems arising from macro-economy restructuring, employment creation in a service-dominated economy, and balancing growth and environmental preservations. (4) Problems with income distribution and equity in a service-dominated economy in

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Medicare, social welfare, and minimum wage/maximum work hours. middle-class expectations and frustrations.

(5) Keen demand for improving business environment for business operations, such as market competition policies and SMEs industrial policies. (6) Rising expectations on the performance of the Hong Kong Government and quality of civil servants and police force. (7) Balance of the rising political demand and economic growth The rise of non-government organizations, e.g., Green Peace, Anti-WTO, and human rights organizations emphasizing on the goal of equity. The quest of administrative-led tradition and pursue of check-and-balance between administration and legislation. The trade-off between social-political and economic goals becomes a reality.

Given the above, the confidence of the residents of Hong Kong toward the post-crisis development has been unfailing. As the core city in GDE in south China and being further enriched by the two ―different (political/economic) systems‖, the next challenge faced by Hong Kong is how to better utilize its unique role and positioning as China‘s gateway and the most international competitive city in the global market. Hong Kong is becoming the top international financial center of China with the leading role in directing China‘s international investment with the global world. After all, the economic success of the city has its unique formula by exploiting its comparative advantages including the three key elements of a

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business friendly investment environment, 12 an industrious quality labor force and human capital, and residents with a pragmatic mentality and vital entrepreneurship, which have remained unaltered throughout Hong Kong‘s history of development and growth.

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REFERENCES Alonso, W. (1964). Location and land use. Harvard University Press. Hazari, B., Tuan, C. & Ng, L. F. Y. (2000). A trade theoretic analysis of outward capital flows: With special reference to Hong Kong, Journal of International Trade and Economic Development, 9(1), 69-81. Krugman, P. (1991). Increasing returns and economic geography, Journal of Political Economy, 99, 483-499. Krugman, P. (1998). Space: The final frontier, Journal of Economic Perspectives, 12(2), 161174. Lam, R. L., Ng, L. F. Y. & Tuan, C. (2007). An Institutional Perspective to Foreign Direct Investment Patterns in China: Implications on Entry Strategies of MNEs into Emerging Markets, International Journal of Business Strategy, 8(1), 1-25. Ng, L. F. Y. (1995). Changing industrial structure and competitive patterns of manufacturing and non-manufacturing in a small open economy: An entropy measurement, Managerial and Decision Economics, 16, 547-563. Ng, L. F. Y. & Tuan, C. (1996). The industrial economic foundation of the growth triangle: Empirical evidence from the integration process of Hong Kong and South China, in The emergence of the South China growth triangle, Li, J. S. (ed. ), Taiwan: CHIER, 115-152. Ng, L. F. Y. and Tuan, C. (1997a). The changing investment environment and strategies in post-1997 Hong Kong: Responses to the transfer of sovereignty, Journal of Applied Business Research, 13(2), 23-36. Ng, L. F. Y. & Tuan, C. (1997b). Evolving outward investment , industrial concentration, and technology change: Implications for post-1992 Hong Kong, Journal of Asian Economics, 8(2), 315-332. Ng, L. F. Y. & Tuan, C. (2000). Outward FDI and Domestic Productivities, International Journal of Business Strategy, 1(2), 1-26. Ng, L. F. Y. & Tuan, C. (2001). FDI promotion policy in China: Governance and Effectiveness, The World Economy, 24(8), 1051-1074. Ng, L. F. Y. & Tuan, C. (2002). Building a favorable investment environment: evidence for the facilitation of FDI in China, The World Economy, 25(8), 1095-1114. Ng, L. F. Y. & Tuan, C. (2003). Location decisions of manufacturing FDI in China: Implications of China‘s WTO accession, Journal of Asian Economics, 14, 51-72. Ng, L. F. Y. & Tuan, C. (2004). Does Post-ante Investment Experience Matter?: Lessons from FDI in China, The World Economy, 27(10), 1631-1627. 12

Building a business friendly investment environment was found critical for the facilitation of FDI inflows. Even though short-run investment decisions are more affected by profit expectations, post-ante investment experience on investment satisfaction/dissatisfaction and environmental and institutional determinants are the prime factors in determining long-run investment decisions. Institutional determinants affected the entry strategies of MNEs and hence, the FDI investment patterns at the destination.

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Ng, L. F. Y. & Tuan, C. (2005). Industry technology performance of manufacturing FDI: Micro-level evidence from joint ventures in China, International Journal of Technology Management, 32(3/4), 246-263. Ng, L. F. Y. & Tuan, C. (2006). Spatial agglomeration, FDI, and regional growth in China: Locality of local and foreign manufacturing investments. Journal of Asian Economics, 17, 691-713. Ng, L. F. Y., Tuan, C. & You, A. S. (2008). Gaining metropolis-city competitiveness through innovations: The opinions of multinationals (2001-2006), International Journal of Knowledge and Learning, 4(6), 553-566. Quigley, J. M. (1998). Urban diversity and economic growth, Journal of Economic Perspectives, 12(2), 127-138. SCMP. New steps to expand HK‘s Yuan business: Firms can now issue bonds in the currency, South China Morning Post, February, 12, 2010. Tuan, C. & Ng, L. F. Y. (1994). Economic liberalization in China and structural adjustment of Hong Kong manufacturing, Seoul Journal of Economics, 7(2), 124-144. Tuan, C. & Ng, L. F. Y. (1995a). Evolution of Hong Kong‘s electronics industry under passive industrial policy, Managerial and Decisions Economics, 16, 509-523. Tuan, C. & Ng, L. F. Y. (1995b). Hong Kong‘s outward investment and regional economic integration with Guangdong: Process and implication, Journal of Asian Economics, 6(3), 385-405. Tuan, C. & Ng, L. F. Y. (1995c). Manufacturing evolution under passive industrial policy and cross-border operations in China: The case of Hong Kong, Journal of Asian Economics, 6(1), 71-88. Tuan, C. & Ng, L. F. Y. (1995d). The turning point of Hong Kong manufacturing sector: Impact of outward investment to the Pearl River Delta, Journal of International Trade and Economic Development, 4(2), 135-170. Tuan, C. & Ng, L. F. Y. (1998). Export trade, trade derivatives, and economic growth of Hong Kong: A new scenario. Journal of International Trade and Economic Development, 7(1), 111-137. Tuan, C. & Ng, L. F. Y. (1999). Regionalization of the financial market and the manufacturing evolution in Hong Kong: Contributions and significance, Journal of Asian Economics, 9(1), 127-145. Tuan, C. & L. F. Y. Ng (2001a). From cross-border processing to regional labor division in a mega-city economy, in Essays on Economic Development Research: Memory to Professor M. H. Shin, Taipei: Academic Sinica Research Institute of Economics, 167-201 (in Chinese). Tuan, C. & Ng, L. F. Y. (2001b). The post-industrialization economic growth of Hong Kong: Perspectives from a mega-city formation, in J. R. Behrman, et al. (eds.), Restructuring Asian Economics for the New Millennium, Amsterdam: Elsevier Science Publishing, 551532. Tuan, C. & Ng, L. F. Y. (2001c). Regional division of labor from agglomeration economies‘ perspective: Some evidence, Journal of Asian Economics, 12, 65-85. Tuan, C. & Ng, L. F. Y. (2002a). International city competitiveness: Shanghai versus Hong Kong, Web Journal of Chinese Management Review, 5(5), 120-140 (in Chinese). Tuan, C. & Ng, L. F. Y. (2002b). From manufacturing cross-border operations to regional economic integration: Evolution of Hong Kong‘s economy and the Guangdong Factor, in

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A. Yeh, et. al. (ed. ), Building a competitive Pearl Delta region: cooperation, coordination, and planning, Hong Kong: Center of Urban Planning and Environment Management, The University of Hong Kong, 81-97. Tuan, C. & Ng, L. F. Y. (2003a). FDI facilitated by agglomeration economies: Evidence from manufacturing and services joint ventures in China, Journal of Asian Economics, 13(6), 749-765. Tuan, C. & Ng, L. F. Y. (2003b). A Miracle via Agglomerations: The HK-PRD Connections, monograph (UNDP#CPR/91/161), The Chinese University of Hong Kong, 45 pages (in Chinese). Tuan, C. & Ng, L. F. Y. (2004a). FDI and industrial restructuring in post-WTO Greater PRD: Implications on regional growth in China, The World Economy, 27(10), 1609-1630. Tuan, C. & Ng, L. F. Y. (2004b). Manufacturing agglomeration as incentives to Asian FDI in China after WTO. Journal of Asian Economics, 15, 673-693. Tuan, C. & Ng, L. F. Y. (2006). FDI inflows and growth of private business in China, Journal of Entrepreneurship Research, 9(1), 101-132. Tuan, C. & Ng, L. F. Y. (2007). The place of FDI in China‘s regional economic development: Emergence of the Globalized Delta Economies, Journal of Asian Economics, 18, 348364. Tuan, C. & Ng, L. F. Y. (2008). ―China‘s FDI flows and manufacturing structural adjustments: Inter-city competition in the Globalized Delta Economies‖, in H. G. Blaine (ed.), Foreign Direct Investment, NY: Nova Science Publishing, 85-121. Tuan, C., Ng, L. F. Y. & Lin, H. (2006). The Globalized Delta Economies in China (YangtzeRiver Delta and Pearl-River Delta): Visualized economic indicators for investment environment, Institute of Space and Earth Information Science, The Chinese University of Hong Kong. Website: www. jlgis. cuhk. edu. hk/business. Tuan, C., Ng, L. F. Y. & Wong, C. S. (1998). Mega city formation and regional development, China Industrial Economy, 7, 52-58. (in Chinese) Tuan, C., Ng, L. F. Y. & Zhao (2009). China‘s post-economic reform growth: The role of FDI and productivity progress, Journal of Asian Economics, 20, 280-293.

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Chapter 4

ENVIRONMENTAL SUSTAINABILITY OF POVERTY REDUCTION IN A SMALL OPEN DUALISTIC ECONOMY: THE CASE OF WAGE SUBSIDY POLICIES AND INDUSTRIAL POLLUTION UNDER SECTOR-SPECIFIC CAPITAL Ichiroh Daitoh*

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Department of International Economic Relations, Graduate School of International Cultural Studies, Tohoku University, Sendai-City, Miyagi, Japan

ABSTRACT This chapter is the first attempt to examine the circumstances under which rural and urban wage subsidies as policies for reducing urban unemployment decrease pollution and improve welfare in a dual developing economy. In a specific-factor model of a small open Harris–Todaro economy with polluting urban manufacturing, an urban wage subsidy may decrease pollution in a realistically relevant situation where a dirty input is complementary to capital. GDP is likely to increase if rural technology exhibits strong diminishing returns to labor and if the urban population ratio is high. Welfare improves if, in addition, consumers‘ preferences shift toward a clean (rural) good as pollution increases. An urban wage subsidy could be consistent with environmental protection in increasing manufacturing employment and reducing urban unemployment while they work in opposite directions in improving welfare. The optimal labor market policy under a given pollution tax is characterized by the uniform urban and rural wage subsidies.

Keywords: Harris–Todaro model; urban pollution; wage subsidy JEL Classification: O13; O14; O17.

*

Corresponding author: Tel and FAX:+81-22-795-7595, E-mail:[email protected]

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1. INTRODUCTION For the last several decades the governments of many developing countries have pursued economic growth through industrialization to reduce domestic poverty in rural and urban areas. In recent years, however, the speed and scale of industrial growth have raised concerns about environmental quality in some developing countries. For example, Latin American countries such as Chile and Mexico have succeeded in outward-oriented (trade-induced) growth while they suffer severe pollution from metropolitan areas including their capitals (Beghin et al., 2002a, pp. 5–10). Some Asian countries such as China and India have suffered from heavy pollution from their urban manufacturing sectors. From these observations, the environmental sustainability of poverty reduction has gained practical importance for modern developing economies. As a form of poverty unique to developing economies, urban unemployment arising from rural to urban migration has been studied intensively in development economics. Many prominent economists have investigated how urban unemployment could be reduced by various economic factors including wage subsidy policies using the Harris and Todaro (HT) model (Harris and Todaro, 1970; Bhagwati and Srinivasan, 1974; Corden and Findlay, 1975; Khan, 1982, etc.). Even today, a reduction of urban unemployment is one of the most important development goals in these economies. Furthermore, urban unemployment has begun to receive considerable attention because environmental degradation may be particularly severe on poor, unemployed people (e.g., Millennium Development Goals). According to Rao (2000), research on the links between environmental protection and poverty reduction must address the problems of low-income urban areas, such as squatter settlements. Barbier (2002) pointed out that the welfare of a substantial and growing number of the poorest urban dwellers is threatened by the environmental hazards posed by pollution. In previous studies concerning environmental protection in developing countries, many authors have introduced pollution or environmental quality into Harris and Todaro (1970) models (Wang, 1990; Dean and Gangopadhyay, 1997; Chao et al., 2000; Daitoh, 2003; Beladi and Chao, 2006; Daitoh, 2006; Rapanos, 2007; Daitoh, 2008a; Tsakiris et al., 2008; Daitoh and Omote, 2009). They have predominantly examined the effects of environmental policy on urban unemployment, exploring the optimal environmental policy or conditions for welfare improvement by environmental policy reforms.1 However, no existing studies have investigated how policies for correcting urban unemployment may affect environmental quality in a developing economy. In the long history of policy studies on the HT economy, many studies have focused on wage subsidies as a tool for correcting urban unemployment. In particular, it is well known that the first-best optimum is attained by uniform rural and urban wage subsidies (Bhagwati and Srinivasan, 1974). Even if wage subsidies reduce unemployment, they may expand polluting production sectors and degrade environmental quality. Then wage subsidies may deteriorate welfare even

1

Daitoh (2008b) investigated how industrial capital accumulation may affect the environment, urban unemployment, GDP and welfare in a small open HT model with polluting urban manufacturing. A different strand of research that focused on the HT paradoxes has been provided by Tawada and Nakamura (2009) and Tawada and Sun (2010). They examined the stability of equilibrium under the adjustment process of the natural environment in HT models where pollution is generated by urban manufacturing production.

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if they correct the labor market distortions. It will thus be important to investigate under what conditions wage subsidies do not degrade environmental quality and improve welfare. This chapter is the first attempt to examine the circumstances under which rural and urban wage subsidies decrease pollution and improve welfare in a dual developing economy. I assume a small open HT economy with polluting urban manufacturing, taking into consideration the realistic examples of developing economies with outward-oriented growth mentioned above. Unlike previous studies on environmental protection in an HT model such as Beladi and Chao (2006), I assume away abatement activities. If abatement activities were present in the city, an urban wage subsidy decreases the abatement cost and thus stimulates abatement activities. Thus, it would not be surprising for an urban wage subsidy to decrease urban pollution. An interesting issue is the circumstances under which urban pollution decreases when there are no abatement activities. First, we show that a rural wage subsidy does not affect urban pollution. This is because a rural wage subsidy expands rural employment by absorbing some urban unemployed workers and thus has no effects on the city equilibrium (the set of equilibrium values of the urban manufacturing sector). More interestingly, an urban wage subsidy may decrease pollution in a realistically relevant situation when a dirty input is a complementary factor to capital in urban manufacturing. Second, an urban wage subsidy increases GDP if rural technology exhibits strong diminishing returns to labor and if the urban population ratio is high. It improves welfare if, in addition, consumers‘ preferences shift toward a clean (rural) good with a small marginal utility as pollution increases. Finally, an urban wage subsidy could be consistent with environmental protection in increasing manufacturing employment and reducing urban unemployment while they work in opposite directions in improving welfare. Furthermore, the optimal labor market policy under a given pollution tax rate is uniform urban and rural wage subsidies. Section 2 presents the model. Section 3 examines the effects of rural and urban wage subsidies on pollution and welfare. Section 4 explores the circumstances under which an urban wage subsidy could be consistent with environmental protection policy. Section 5 discusses the (sub)optimal wage subsidy policy under a given pollution tax. Section 6 provides concluding remarks.

2. A DUAL ECONOMY MODEL WITH URBAN POLLUTION Consider a specific-factor model of a small open HT economy. The rural product X is the numeraire and the relative price p of the manufactured good Y is determined in the world market. All firms in each sector and all consumers are identical. In the urban manufacturing sector, the institutionally-fixed high wage rate w M prevails. The representative manufacturing firm produces Y using labor LM, capital K and a dirty input (pollution) Z. Capital K is specific to this sector, and the domestic capital market is perfectly competitive and closed to the world market. The dirty input is any factor of production with negative externalities on consumers‘ utility functions. For simplicity, we assume away the

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market for Z.2 The government imposes a specific tax specific wage subsidy s

M

on the firm‘s use of Z and provides a

. Under constant returns to scale technology, the unit cost function

M

c( w , r , ) is concave in three factor prices. First, the rental rate of capital r is determined by the zero-profit condition p c ( wM

s M , r, ) .

(1)

Next, the constrained factor demand functions are linear in Y, namely,

LM

cW ( wM

s M , r , )Y ,

(2)

K

cR ( w M

s M , r , )Y ,

(3)

Z

c ( wM

s M , r , )Y ,

(4)

where the subscripts of the unit cost function represent the partial derivatives with respect to

c / wM ). the corresponding factor price (e.g., cW ( wM , r , ) We make two assumptions about the unit cost function. First, capital and labor are assumed to be substitute factors in the manufacturing production.

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Assumption 1. cWR ( wM , r , )

2

c / r wM

0 holds for all ( wM , r , ) 0 .

We also assume that a rise in r decreases the demand for capital K at a rate higher than that for a dirty input Z ( ( K / r ) / K ( Z / r ) / Z ), that is, Assumption 2. (cRR / cR ) (cR / c ) holds for all ( wM , r , ) 0 . This assumption seems quite natural because a change in the factor price has a stronger effect on its own demand than on the other factors‘ demands. The labor allocations in the city and in the entire economy are

LM

LU

LC ,

(5)

LX

LC

L,

(6)

where LU is the level of urban unemployment and LC, LX and L are city, rural and total population, respectively.

2

If manufacturing production pollutes clean air or water, for example, the amount of polluted air or water can be regarded as a dirty input. More realistic examples of Z are provided in Section 3. See also Pethig (1976) and McGuire (1982) for models with a dirty input.

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f ( LX ) with f '( LX ) 0 and 3 0 . The rural labor market is competitive and characterized by full employment.

The representative rural firm‘s production function is X f "( LX )

Under a specific wage subsidy s X , the wage rate w X marginal product of labor

wX

sX

s X paid by rural firms equals the

f '( LX ) .

(7)

The rural–urban labor allocation is determined by the ―Harris–Todaro migration equilibrium condition (HT condition)‖: the wage rate w X received by rural workers equals the expected urban wage rate, which is defined as the urban wage rate w M weighted by the employment probability (LM/LC) in the city.

wX

wM LM . LC

(8)

The representative consumer has a utility function U ( D X , DY , Z ) , which is homothetic in consumption of a rural good D X and a manufactured good DY .4 The marginal utility of each 2 good Di (i = X,Y) is positive (Ui U / Di 0) and decreasing (U ii U / Di 2 0) . The dirty input exerts negative externalities on the utility function (U Z marginal disutility of pollution is increasing (U ZZ

2

U/ Z

2

homogeneous of degree zero, utility maximization implies

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U X ( D X , DY , Z ) function as

0) and the

0) . Because

p

U i is

UY ( D X , DY , Z ) /

UY ( D X / DY ,1, Z ) / U X ( D X / DY ,1, Z ) . Denoting the relative demand

, we get

( p, Z ) with

U/ Z

p ( p, Z )

/ p

DX , DY

(9)

0 . The government provides wage subsidies using pollution-tax

revenue. If this revenue exceeds (falls short of) subsidy spending, it transfers the revenue net of subsidies to (collects the net revenue needed by imposing taxes on) consumers in a lumpX X sum fashion. Thus, the government‘s budget constraint is s L

s M LM = Z T , where T

3

The qualitative results would remain unchanged if rural firms also used capital or land, to the extent that these factors are sector specific. 4 If the utility were not homothetic, all the results except those for welfare improvement would remain unchanged. Under this more general utility function, condition (c) on a change in the marginal rate of substitution (MRS) in (iii) of Proposition 1 and Result 2 would be more complicated because of the income effect. However, the results would be the same qualitatively in that the welfare effects can be analyzed by decomposing it into changes in GDP, pollution and MRS.

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Ichiroh Daitoh

is the lump-sum tax. 5 The commodity market equilibrium is given by the equality of the aggregate consumption expenditure and the value of outputs. Denoting GDP as G X pY ,

DX

pDY

X

pY .

(10)

Given sX, sM, p, , wM, K and L are exogenously determined, (1) determines r and (3) determines Y. Then (2) and (4) determine Z and LM. Given LM, (5)–(8) determine LC, LU, LX and wX. Finally, (9) and (10) determine DX and DY.

3. WAGE SUBSIDY POLICIES AND THE ENVIRONMENT Let us first consider how a rise in sX affects pollution and welfare. Corden and Findlay (1975) pointed out that a rural wage subsidy does not affect the city equilibrium in specificfactor HT models. Because Z is determined at the city equilibrium in our model, it follows that a rural wage subsidy does not affect it. First, we will present this result. (Proofs of all the results and propositions are presented in the Appendix.)

Result 1 (Rural Wage Subsidy)

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A rise in a rural wage subsidy (i) does not affect pollution and (ii) always increases GDP and welfare. The reason for an increase in GDP is that urban unemployment decreases (because LX increases with LM fixed). Because Z remains unchanged, this effect leads to welfare improvement. In contrast, an urban wage subsidy will affect the city equilibrium. As the main proposition of this chapter, we show the effects of a rise in sM on pollution and welfare.

Proposition 1 (Urban Wage Subsidy) Suppose that an urban wage subsidy is increased with sX = 0. Then, under Assumption 1, (i) pollution decreases if and only if

(c / cR )(cWR / cW ) (cW / cW ) (c / cR )(cRR / cR ) (cR / cR )

(11)

holds, and (ii) GDP increases if and only if 5

Beghin et al. (2002b, p. 255) claims that ―revenue neutral‖ policy reforms should be potentially important in developing economies, because their governments tend to be short of tax revenues. However, we do not impose ―revenue neutrality‖ on the government‘s budget constraint because these kinds of policy reforms do not seem to be conducted in developing countries.

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Environmental Sustainability of Poverty Reduction in a Small Open Dualistic… dY ds M

p

wM 1

dLM ds M

163

(12)

( LC / w X )(dw X / dLC ) 0 is the rural wage holds in the initial equilibrium, where elasticity with respect to the urban population. (iii) A sufficient condition for welfare improvement is that (a) GDP increases, (b) pollution decreases and (c) U ( ( p, Z ),1, Z ) p ( p, Z )

UX

Z ( p, Z )

0

holds in the initial equilibrium. Under the utility function that is separable between consumption and pollution (with

Z

( p, Z )

0 ), the sufficient condition will be (a) and (b)

only.

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Let us explain this proposition in detail. Intuitively, a rise in sM tends to reduce the unit cost in (1) and thus raises r. Because these effects tend to decrease capital demand on the right-hand side of (3), Y must increase in order for capital demand to be equal to the fixed supply of capital. Therefore, manufacturing employment always increases because of the urban wage subsidy through the scale effect of a rise in Y and through the substitution effect of a rise in r. The economic explanation for (i) is as follows. The dirty input Z tends to increase through the scale effect above, but it may either increase or decrease through the substitution 6 effects. To understand (i), we separate three cases that are possible under cWR 0 . First, if Z is a complementary factor to K (cR 0 ), the substitution effects through a rise in sM and through a rise in r both tend to reduce Z. If these effects dominate the scale effect, pollution decreases. That is, an urban wage subsidy increases manufacturing employment LM substantially with clean capital K fixed, and instead the dirty input decreases. Indeed, (11) is more likely to hold when the substitution effects are stronger ( cW 0 and cR are larger). Second, if all factors are substitutes (cR 0 and cW 0) , a rise in r (one of the two substitution effects) will also increase Z. In other words, Z tends to decrease only through the substitution effect of a rise in sM. If this substitution effect is dominant, Z will decrease. Hence, (11) holds when cW 0 is so large that ( cWR cW ) is negative and small enough. Third, if Z is complementary to LM ( cW 0 and thus cR 0 ), Z needs to be a substitute to K. Thus, not only a rise in r but also a rise in sM will increase Z. That is, Z always increases: (11) never holds.

6

Because the dominant relation among factors is a substitute relation, three cases are possible under cWR

cW

(cR

0

cW 0) , (2) Z is complementary 0) and (3) Z is complementary to LＭ (cW 0 and thus cR 0) .

all factors are substitutes

and

to K

( cR

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0

0 : (1) and thus

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Ichiroh Daitoh

With regard to Z, the first case above must be more relevant in developing economies because one can easily find factors of production that are complementary to capital. First, assume that Z is an energy good such as firewood, coal or petroleum. Then K would be capital such as machinery, equipment or tools (they do not generate pollution unless operated) that operate using energy goods. Second, as a different interpretation, Z could be regarded as polluting capital (e.g., production machinery or transport vehicles operating in factories) and K as clean capital (e.g., factories and office buildings, pavements or warehouses). Then the urban wage subsidy would increase labor employment and instead reduce the quantity of polluting capital goods, keeping clean capital goods constant. Next, M

consider

(ii).

Because dY / ds M

(Y / cR )[cWR

M

M

cRR (cW / cR )] 0

and

M

dL / ds is so large that YcWW YcWR [dr / ds ] cW [dY / ds ] 0 hold, when (12) is satisfied, an urban wage subsidy increases GDP. To derive the economic implications of (12), we rewrite

wM 1 A large value of

wM C

X

X

( LX , wM ) 0 .

1 L f "( L ) / f '( L )

implies that rural technology exhibits strong diminishing returns to

labor ( f "( L ) / f '( L ) is large) and that the urban population ratio is high (LC is large with L X

X

fixed in the initial equilibrium). An intuitive explanation for the first implication is as follows. An increase in manufacturing employment leads to a rise in the expected urban wage rate. During the rural–urban migration process, the rural wage rate w X declines. When the rural

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wage elasticity

X is larger, w declines faster. Hence, a decrease in rural production will be

smaller until the expected wage rates are equalized. Then an increase in manufacturing output will be dominant and thus GDP will increase. Note that this explanation is based on the exogenous property of the rural technology. As for the second implication, LC is an endogenous variable. Thus, we should further explore how it depends on exogenous variables. By specifying the unit cost function as

c ( wM ) a r b

1 a b

a, b 1 ), solving (1)–(4) and eliminating wM LM by (8), we get

(0

C

C

L [ f '( L L )]

a p K M a b (w )

1/ b 1 a b

,

where the term on the left-hand side is increasing in LC. Therefore, the equilibrium value of LC depends positively on p and K but negatively on wM and . Note that by substituting

dLM / ds M and dY / ds M , one could give an alternative expression for (12) in terms of the exogenous properties of the unit cost function. However, we write (12) as it is because it is more convenient to derive economic implications from this expression. Finally, consider (iii). What is fundamental for welfare improvement is that (a) GDP increases and (b) pollution decreases. An additional condition (c) is needed so that the

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pollution externality does not cancel out these positive welfare effects. When a decline in Z decreases the relative demand for the rural product ( Z ( p, Z ) 0 ), we can conclude from (c) that the urban wage subsidy will improve welfare if the marginal utility UX is smaller than 7 U/(p+ ( p, Z ) ). This is because total utility declines to a small extent by a reduction in consumption of the rural product. In other words, the fact that consumers‘ preferences shift towards the clean (rural) good as pollution increases will play an important role in the urban wage subsidy improving welfare. In this sense, the role of green consumers may be useful in developing economies. An example of this utility function is X (Z ) Y 1 (Z ) U (D ) (D ) ( Z / ) with 0 ( Z ) 1 and 1 (the marginal disutility of pollution represented by the second term is increasing or constant). Given Z, the utility function is homothetic in DX and DY. The marginal rate of substitution MRS [ ( Z ) /1 ( Z )]( DY / D X ) is distorted when pollution increases. Green consumers correspond to the case of '( Z ) 0 .

4. CONSISTENCY WITH ENVIRONMENTAL PROTECTION

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We have investigated how an urban wage subsidy may affect the environment. Environmental protection policy, however, could work in the opposite direction to an urban wage subsidy: a rise in the urban pollution tax rate may reduce manufacturing employment and/or aggravate urban unemployment. In this section, we examine when an urban wage subsidy will be consistent with environmental protection by focusing on the conditions for improvement in environmental quality, manufacturing employment, urban unemployment and 8 welfare.

4.1. Effects of Pollution Tax In order to discuss the consistency of the effects of a higher pollution tax rate on urban manufacturing unemployment with the desired effects of an urban wage subsidy, we need information on the effects of a rise in on manufacturing employment and welfare. This is 9 reported in Propositions 1 and 3 in Daitoh (2008a), which I summarize as follows.

7

One can make a similar argument for the case of

Z

( p, Z ) 0 .

8

Environmental and labor market policies are often conducted by different governmental agencies. If the government were free to choose both policies, it would be important to derive the optimal combination of these policies. 9 I also present a detailed proof of these results in Appendix 3, because the proof in Daitoh (2008a) was somewhat abbreviated.

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Ichiroh Daitoh

Result 2 (Effects of Pollution Tax) Suppose that the urban pollution tax rate is raised. Then, under Assumptions 1 and 2, (i) manufacturing employment increases if and only if

cW

(cWR c / cR ) cW [(cR / cR ) (cRR / cR )(c / cR )]

(13)

holds, and (ii) GDP increases if and only if

p

dY d

wM 1

dLM d

(14)

holds in the initial equilibrium. (iii) A sufficient condition for welfare improvement is (a) GDP increases and (b)

UX

U ( ( p, Z ),1, Z ) p ( p, Z )

Z ( p, Z )

0

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holds in the initial equilibrium. Under a separable utility function with sufficient condition is (a) only.

Z

( p, Z ) = 0, the

The economic logic behind (i) is similar to that in Proposition 1, although the variables will move in opposite directions. A rise in tends to raise the unit cost of urban manufacturing and thus lowers r. This tends to increase capital demand. A rise in itself may either increase or decrease capital demand, depending on whether Z and K are substitutes or complements. Under Assumption 2, however, the overall capital demand necessarily increases and hence Y must decrease. Thus, the scale effect decreases Z. Even when we take the substitution effect into consideration, Z decreases because of the concavity of the unit cost function. Manufacturing employment tends to decrease both by the scale effect of a decline in Y and by the substitution effect of a decline in r. However, the substitution effect of a rise in increases (decreases) LM when Z is a substitute (complement) to LM. If this substitution effect 0 in (13) is large enough), manufacturing employment will increase.10 is dominant ( cW This can occur when Z is a complement to K and when the three factors are substitutes.11

10

Because the supply of capital is fixed, the capital input in equilibrium remains unchanged. Because the net effect of the changes in and in r is ambiguous, dLM / d 0 is possible. 11 M M If all factors are substitutes, L will increase when cW 0 is large enough. If Z is complementary to L ( cW

0 ), all three effects decrease LM.

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4.2. Relations between Urban Wage Subsidy and Environmental Protection Now we will discuss the circumstances under which an urban wage subsidy will be consistent with environmental protection policy, based on Proposition 1 and Result 2. First, from (i), an urban wage subsidy and a higher pollution tax could, although not always, decrease pollution in a realistically relevant situation when a dirty input is complementary to capital. In this situation, a rise in the pollution tax rate may increase manufacturing employment and thus be consistent with the purpose of the urban wage subsidy. Next, we show that a rise in the urban wage subsidy and a higher pollution tax rate are consistent in reducing the level of urban unemployment if the two policies move LM in the same direction. To see this, we use the next result reported in Daitoh (2003).

Result 3 (Condition for a Reduction of Urban Unemployment) Suppose that a policy change increases (decreases) manufacturing employment. Then (i) the rate of urban unemployment (LU/LC) decreases (increases). (ii) The level of urban unemployment declines if and only if the following relation holds in the initial equilibrium.

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( )

wM w X wX

(15)

A policy change that decreases LM is likely to reduce the level of urban unemployment if is small. Intuitively, a decrease in LM increases the rural population. When is smaller, wX declines more slowly and thus more people migrate from urban to rural areas until the expected wage rates are equalized. Then LU decreases. Rearranging (15) for the case where LM decreases, we get

wM f '( LX ) LC f "( LX )

1.

If rural technology exhibits weak diminishing returns to labor ( f "( LX ) is small) and if the urban population ratio is low (LC is low), the level of urban unemployment will decline.12 Finally, from (ii) and (iii) in Proposition 1 and Result 2, a rise in the urban wage subsidy and a higher pollution tax will move GDP in opposite directions, which plays a central role in welfare improvement. To see this, let us consider the implications of (14). If an increase in results in an increase in LM, rural–urban migration occurs and X decreases. Because Y 12

Daitoh (2003) did not mention the role of the urban population ratio. The relation of LC to the exogenous variables is the same as that explained in Section 3.

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Ichiroh Daitoh

decreases, G = X + pY necessarily decreases. That is, when a rise in the pollution tax rate reinforces the desired effect of the urban wage subsidy, it will reduce GDP. If an increase in results in a decrease in LM, (14) holds when > 0 is small and thus > 0 is large enough: a rise in the pollution tax rate increases GDP when rural technology exhibits weak diminishing returns to labor ( f "( LX ) / f '( LX ) is small) and when the urban population ratio is low (LC is small).13 This is because the level of urban unemployment will decline in this situation, as explained in Result 3. Because the urban wage subsidy is likely to decrease GDP when is large, it will work in the opposite direction to the environmental protection policy. An additional condition (b) in (iii) in Result 2 is needed so that the pollution externality does not cancel out the positive GDP effect. The implications from (b) are the same as that from (c) in Proposition 1. That is, a higher pollution tax will improve welfare when consumers‘ preferences shift toward the clean (rural) good as pollution increases. A rise in the urban wage subsidy and a higher pollution tax are consistent from this viewpoint. Let us summarize the conclusions mentioned above in the next proposition.

Proposition 2 (Relations between Urban Wage Subsidy and Environmental Protection)

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In a small open dualistic economy with urban unemployment, an urban wage subsidy could be consistent with environmental protection in increasing manufacturing employment and reducing urban unemployment while they work in opposite directions in improving welfare.

5. OPTIMAL WAGE SUBSIDIES UNDER POLLUTION TAX We have discussed the role of wage subsidies on the environment as the main theme of this chapter. In addition, we can see that given a pollution tax rate arbitrarily, the optimal labor market policy is characterized by the uniform urban and rural wage subsidies, as in Bhagwati and Srinivasan (1974). Note that this should be interpreted as at most the secondbest policy, because urban pollution is not regulated optimally. Let us first obtain the manufacturing production function Y = M(LM,K,Z) from the cost function using a duality approach (see Appendix 5). Then the efficient labor allocation under no wage subsidies is determined at point E in Figure 1, where the marginal product of rural X

labor f '( L ) is equal to the value of the marginal product of urban manufacturing labor

pM L ( LM , K , Z * ) , where Z * is the amount of dirty input under no wage subsidies. If the wage subsidies did not affect a dirty input, point E would be attained by providing the same wage subsidy sX = sM = s

13

wM

wE to rural and urban firms.

One can easily make an intuitive explanation similar to that for (ii) in Proposition 1.

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pML(LM,K,ZO） wM

ｗX EO

wO ｗE Ｅ

f '( LX ) OX

pML(LM,K,Z*） LO

OY

Figure 1. Optimal Wage Subsidies under Pollution Tax.

However, the urban wage subsidy actually affects Z and thus shifts the pM L ( LM , K , Z ) curve, while the rural wage subsidy has no effect on Z. By setting the urban wage subsidy that maximizes welfare under a given pollution tax, i.e., sM = sO, the pM L ( LM , K , Z O ) curve X

intersects the f '( L ) curve at point EO, where ZO is the level of pollution corresponding to the (sub)optimal subsidy rate sO. Figure 1 shows the case where the pM L ( LM , K , Z O ) curve is located above the initial pM L ( LM , K , Z * ) curve. Then, the optimal labor market policy is

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O

M

O

w w . Under these to provide the same rates of urban and rural wage subsidies s uniform wage subsidies, the rural wage rate received by rural workers is wX. The wage rate paid by rural firms is wO and thus rural employment is OXLO. The urban population is OYLO with no unemployment. Therefore, given arbitrarily, uniform urban and rural wage subsidies will lead to efficient labor allocation (point EO) in the economy as a whole.

6. CONCLUSION We have examined the circumstances under which rural and urban wage subsidies decrease pollution and improve welfare in a small open HT model with polluting urban manufacturing. A rural wage subsidy does not affect urban pollution. An urban wage subsidy may decrease pollution when a dirty input is complementary to capital. GDP is likely to increase if rural technology exhibits strong diminishing returns to labor and if the urban population ratio is high. Welfare improves if, in addition, consumers‘ preferences shift toward a clean (rural) good as pollution increases. An urban wage subsidy could be consistent with environmental protection policy in increasing manufacturing employment and reducing urban unemployment while they move welfare in opposite directions. Furthermore, the optimal labor market policy under a given pollution tax rate is uniform urban and rural wage subsidies.

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In closing, there are two qualifications. First, the first-best optimal combination of a pollution tax and wage subsidies should be derived, because one can find a realistic situations in which the government is free to choose both policies simultaneously. Second, we use the HT model with sector-specific capital. The qualitative results could be different under intersectoral capital mobility. These problems are left for future research.

APPENDIX 1. Proof of Result 1 Combining (7) and (8) and differentiating the resulting equation we have

dLX / ds X

L LX f '( LX )[1

sX

]

0.

Because a rise in sX does not change Y and increases LX and X, G increases. The change in welfare is dV / ds X

( p, Z ))](dX / ds X ) 0 .

[U ( ( p, Z ),1, Z ) /( p

2. Proof of Proposition 1 (i) By (1), dr / ds M

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(Y / cR )[cWR

0 . Differentiating (3) and using this, dY / ds M

cRR (cW / cR )] 0 under Assumption 1. Differentiating (4), dZ / ds M

YcR [dr / ds M ] c [dY / ds M ] .

YcW dZ / ds

cW / cR

M

Y {cW

Substituting

cR [cW / cR ] (c / cR )[cWR

(11) holds. (ii) dG / ds M

the

above

relations,

we

get

Ｍ

cRR (cW / cR )]} . Thus, dZ/ds < 0 holds if

0 is equivalent to p(dY/dsＭ)>－(dX/dsＭ). From X = f(LX), dX/dsＭ

= f '( LX ) (dL Ｘ /ds Ｍ ). By (8), dLX/dsM = {w M / [ LC f "( LX )

f '( LX )]} (dL Ｍ /ds Ｍ ). Then

dX/dsＭ = (LＸ,wＭ) (dLＭ/dsＭ). Hence, dG/dsＭ > 0 holds if (12) holds. (iii) Substituting (9) into (10), we get

dDY / ds M

[1/( p

( p, Z ))][(dG / ds M ) DY z ( p, Z )(dZ / ds M )] .

The indirect utility function is V = U( DY ( p, Z ) ,DＹ,Z) = DＹU( ( p, Z ) ,1,Z). Totally differentiating it with dp = 0, we get dV = U( ( p, Z ) ,1,Z)dDＹ+DＹ[UＺ+UＸ Using this, the change in welfare is

dV ds M

U ( ( p, Z ),1, Z ) dG p ( p, Z ) ds M

DY U Z

UX

U ( ( p, Z ),1, Z ) p ( p, Z )

Z

z ( p, Z )

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( p, Z ) ]dZ.

dZ . ds M

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171

A sufficient condition for dV/dsＭ > 0 is (a) dG/dsM > 0, (b) dZ/dsM < 0 and (c) {UX– [U( (p,Z),1,Z)/(p+ (p,Z))]}

Z

(p,Z)

0.

3. Proof of Result 2 (i)Under (1), dr / d

(c / cR ) 0 . Differentiating (3) and using this, dY / d

(Yc / cR )[(cRR / cR ) (cR / c )] 0 under Assumption 2. Differentiating (2), we get

dLM / d

YcW

YcWR [dr / d ] cW [dY / d ] . Substituting the above relations, we get

dLM / d Y [cW (cWR c / cR ) (cW cRR / cR )(c / cR ) (cW cR / cR )] . Thus, dLM / d 0 holds if and only if (13) holds. (ii) A similar proof to Proposition 1 immediately yields (14). (iii) By a similar procedure to that in Proposition 1, the change in the indirect utility is

dV d

U ( ( p, Z ),1, Z ) dG p ( p, Z ) d

DY U Z

U ( ( p, Z ),1, Z ) p ( p, Z )

UX

Z

( p, Z )

dZ . d M

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0 . To see it, because c( w , r , ) The concavity of the cost function implies dZ / d is a concave and thus quasi-concave function, the principal minors of the bordered Hessian matrix alternate in sign. That is,

0 cR

cR cRR

0 0 , cR c

cR cRR cR

0 c 0, R c cW

c cR c

cR cRR cR cWR

c cR c cW

cW cRW cW cWW

0.

From the second inequality, we get

0 cR c

cR cRR cR

Dividing both sides by

c cR = (cR )2 c c cR (c )2 c c

2cR c cR

(c )2 cRR

0.

0 and rearranging the terms, we obtain c cR

cRR cR

2

cR c

0.

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172

Ichiroh Daitoh The change in pollution is dZ / d

Yc

Yc R (dr / d ) Yc (dY / d ) . Substituting

c cR

cRR cR

dr / d and dY / d above, we obtain dZ d

Z

c c

2

cR c

0.

> 0 holds (a) if dG / d

Using dY / d 0 and UZ < 0, dV/d U/(p+ ( p, Z ) )] Z ( p, Z ) 0 hold.

0 and (b) if [UX –

4. Proof of Result 3 (i) By (8), an increase in LM reduces LX and thus increases w X and LM/LC. Then LU/LC decreases (and vice versa). (ii) From (8), dLX = {w M / [ LC f "( LX )

f '( LX )]} dLM. Using dLC

= － dLX, dLU=dLC －dLM < 0 is equivalent to [{wM /( f '( LX )

LC f "( LX ))} 1] dLM0 holds, {wM /( f '( LX )

LC f "( LX ))}

1 yields ( wM / w X ) 1

( LC / w X )

(dw X / dLC ) .

5. Derivation of the Manufacturing Production Function

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Because the constrained factor demand functions (2)–(4) are homogeneous of degree zero, they depend only on the ratios (r/wM) and ( / wM ). Solving Z for

K

(

/ wM ),

we

get

/ wM

( r / wM , Z / Y ) .

=

c (1, r / wM , / wM )Y Substituting

it

into

cR (1, r / w , / w )Y , we represent (r/w ) as a function of (Z/Y) and (K/Y), i.e., r/wM = M

M

M

( Z / Y , K / Y ) . Substituting

and

into LM

function of (Z/Y) and (K/Y), i.e., LM / Y Solving it for Y, we obtain Y = M(LM,K,Z).

cW (1, r / wM ,

cW (1, ( Z / Y , K / Y ),

/ wM )Y , we get LM/Y as a

( (Z / Y , K / Y ), Z / Y )) .

REFERENCES Barbier, E.B. (2002). ‗Development, poverty and environment‘. In J.C.J.M. van den Bergh (Ed.), Hand Book of Environmental and Resource Economics (pp. 731–744), Cheltenham: Edward Elgar. Beghin, J., Roland-Holst, D. & van der Mensbrugghe, D. (2002a). ‗Globalisation and the environment from a development perspective‘. In J. Beghin, D. Roland-Holst and D. van der Mensbrugghe (Eds.), Trade and the Environment in General Equilibrium: Evidence from Developing Economies (3–15), Dordrecht: Kluwer Academic Publishers.

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Beghin, J., Roland-Holst, D. & van der Mensbrugghe, D. (Eds.) (2002b). Trade and the Environment in General Equilibrium: Evidence from Developing Economies, Dordrecht: Kluwer Academic Publishers. Beladi, H. & Chao, C. C. (2006). ‗Environmental policy, comparative advantage, and welfare for a developing economy‘, Environment and Development Economics, 11, 559-568. Bhagwati, J. N. d Srinivasan, T. N. (1974). ‗On reanalyzing the Harris-Todaro model: Policy rankings in the case of sector-specific sticky wages‘, American Economic Review, 64, 502–508. Chao, C. C., Kerkvliet, J. R. & Yu, E. S. H. (2000). ‗Environmental preservation, sectoral unemployment, and trade in resources‘, Review of Development Economics, 4, 39–50. Corden, W. M. & Findlay, R. (1975). ‗Urban unemployment, intersectoral capital mobility and development policy‘, Economica, February: 59–78. Daitoh, I. (2003). ‗Environmental protection and urban unemployment: Environmental policy reform in a polluted dualistic economy‘, Review of Development Economics, 7, 496–509. Daitoh, I. (2006). ‗Pollution from manufacture, urban unemployment and economic welfare in a developing country: Implications of a non-separable utility function for environmental policy reform‘, Journal of the Graduate School of International Cultural Studies, 14, 1–14. (in Japanese). Daitoh, I. (2008a). ‗Environmental protection and trade liberalization in a small open dual economy‘, Review of Development Economics, 12(4), 728–736. Daitoh, I. (2008b). ‗Industrial capital accumulation, environment and urban unemployment in a developing economy‘, The International Economy, 12, 43–51. Daitoh, I. & Omote, M. (2009). ‗The optimal environmental tax and urban unemployment in a small open dualistic economy with intersectoral capital mobility: Does environmental protection reduce urban unemployment in the long-run?‘ mimeo., presented at the 2009 Fall Meeting of the Japanese Economic Association. Dean, J. M. & Gangopadhyay, S. (1997). ‗Export bans, environmental protection, and unemployment‘, Review of Development Economics, 1, 324–336. Harris, J. R. & Todaro, M. P. (1970). ‗Migration, unemployment and development: A twosector analysis‘, American Economic Review, 60, 126–142. Khan, M. A. (1982). ‗Social opportunity costs and immiserizing growth: Some observations on the long-run and the short‘, Quarterly Journal of Economics, 97, 353–362. McGuire, M. C. (1982). ‗Regulation, factor rewards, and international trade‘, Journal of Public Economics, 17, 335–354. Pethig, R. (1976). ‗Pollution, welfare, and environmental policy in the theory of comparative advantage‘, Journal of Environmental Economics and Management, 2, 160-169. Rao, P. K. (2000). Sustainable Development: Economics and Policy, Oxford: Blackwell. Rapanos, V. (2007). ‗Environmental taxation in a dualistic economy‘, Environment and Development Economics, 12, 73–89. Tawada, M. & Nakamura, A. (2009). ‗Environment and the Harris and Todaro paradoxes‘. In T. Kamihigashi and L. Zhao (Eds.). International Trade and Economic Dynamics, Essays in Memory of Koji Shimomura (pp. 87–99). Berlin: Springer-Verlag. Tawada, M. & Sun, S. (2010). ‗Urban pollution, unemployment and national welfare in a dualistic economy‘, Review of Development Economics, 14(2), 311–322.

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Tsakiris, N., Hatzipanayptou, P. & Michael, M. S. (2008). ‗Pollution, capital mobility and tax policies with unemployment‘, Review of Development Economics, 12(2), 223–236. Wang, F. S. L. (1990). ‗Unemployment and the backward incidence of pollution control‘, Journal of Environmental Economics and Management, 18, 292–298.

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Chapter 5

DO POLITICAL FREEDOMS ATTRACT OR DISCOURAGE FOREIGN DIRECT INVESTMENT? EVIDENCE FROM CENTRAL AND EASTERN EUROPE AND FORMER SOVIET UNION Jac C. Heckelman Wake Forest University, Winston Salem, North Carolina, U.S.A.

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ABSTRACT The evidence on the relationship between political freedoms and foreign direct investment (FDI) is mixed. Part of the problem in interpreting results is that past crosscountry studies have generally used a large sample of diverse nations and broad measures of political freedoms which do not vary much over time. In this chapter the relationship between political freedoms and FDI in the Central and Eastern European and Former Soviet Union nations is analyzed using recently developed political freedom indexes by Freedom House specific to the transition economies, over the period 1999-2008. By focusing on a specific region of the world which has undergone recent dramatic change in its political institutions, both in terms of positive reforms in certain nations and increased repression in others, a better estimation of the true impact of political freedom can be determined. It is found that greater political freedoms in general discourage FDI. However, not all types of political freedoms significantly hinder FDI. In particular, freedoms related to judicial framework, civil society, and corruption significantly limit FDI, while freedoms related to electoral process and governance do not. Finally, the results for media independence are dependent on specification.

INTRODUCTION Developing nations often rely upon foreign direct investment (FDI) to help finance their current account deficits. FDI is also a method of importing technology and is expected to have spillover benefits to other firms in the host country. For these and other reasons,

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governments openly court FDI to stabilize their current accounts and promote development of their economies. Structural reforms may even be undertaken to make their economies more attractive to foreign investors. Reforms can sometimes include the political landscape as well. Previous studies have found contrasting results on whether political freedoms in the domestic country help or harm FDI levels. Feng (2003) reports that a broad measure of political freedoms created by Freedom House, representing both political rights and civil liberties, is negatively correlated with FDI, in marked contrast to the typically positive correlation he finds between political freedoms and private domestic investment. Harms & Ursprung (2002) find that the overall level of political rights and civil liberties, either considered individually or combined into a single value, is beneficial to FDI inflows. In contrast, Adam & Filippaios (2007) find that civil liberties have a negative return to FDI whereas political rights have a positive return. Li & Resnick (2003) find that political freedoms increase property rights, but once controlling for property rights that political freedoms have a direct negative effect on FDI. Part of the problem in interpreting these results is that past cross-country studies have generally used a large sample of diverse nations and broad measures of political freedoms which do not vary much over time. In this chapter, I follow the lead of several other studies which have conducted region-specific analysis of cross-country FDI inflows, such as Asiedu (2006) for Sub-Saharan Africa, Chan & Gemayel (2004) for North Africa and the Middle East, and Bengoa & Sanchez-Robles (2003) for Latin America. None of these studies considered political freedoms as a potential determinant. Here, the focus will be on the transition nations of Central and Eastern Europe and Former Soviet Union (CEEFSU), where FDI has climbed dramatically in recent years from an average of just under 4% of GDP to over 9% of GDP in 2007. By focusing on a specific region of the world which has undergone recent dramatic change in its political institutions, both in terms of positive reforms in certain nations and increased repression in others, a better estimation of the true impact of political freedoms can be determined. Furthermore, this new index of political freedoms specific to the transition nations allows for a more nuanced approach because each nation is rated on six separate areas of political freedom. Regression analysis supports Feng‘s (2003) finding that greater political freedoms in general discourage FDI when using an aggregated measure of political freedoms, but further analysis reveals that statistical significance is limited to only three of the six categories of political freedoms which comprise the aggregated index.

MEASURING POLITICAL FREEDOMS Freedom House developed the Nations in Transit series of political freedom indicators beginning in 1997. This series covers six broad areas of political freedoms. The civil society index assesses the growth of nongovernmental organizations, their organizational capacity and financial sustainability, and the legal and political environment in which they function; the development of free trade unions; and interest group participation in the policy process. The judicial index highlights constitutional reform, human rights protections, criminal code reform, judicial independence, the status of ethnic minority rights, guarantees of equality before the law, treatment of suspects and prisoners, and compliance with judicial decisions. The media index addresses the current state of press freedom, including libel laws,

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harassment of journalists, editorial independence, the emergence of a financially viable private press, and Internet access for private citizens. The corruption index looks at public perceptions of corruption, the business interests of top policy makers, laws on financial disclosure and conflict of interest, and the efficacy of anticorruption initiatives. The electoral index examines national executive and legislative elections, electoral processes, the development of multiparty systems, and popular participation in the political process. The governance index considers the stability of the governmental system; the authority of legislative bodies; decentralization of power; the responsibilities, election, and management of local governmental bodies; and legislative and executive transparency. Each index ranges from 1 to 7, where 1 represents the highest level of freedom possible. The aggregated index score is simply the average of the six category rankings. Trends for the sample nations from 1999 – 2008 are presented in Table 1. Turkmenistan was rated the worst for political freedoms at the start and became even more repressive over time. Turkmenistan also garnered the worst rating at the midpoint, and again at the end of the sample period. Poland was initially rated the best in 1999, but slipped somewhat over time, to the point where by 2008 it was rated less free than six other nations. Yet, even the most politically free nation in 2008 (Estonia) was not as free as Poland was in 1999. Overall the average political freedom rating has become successively worse. Only six nations were given better ratings in both 2004 and 2008 than they had in 1999, whereas ten were rated successively worse in both 2004 and 2008. Meanwhile, Lithuania and Slovakia saw new reforms achieved by 2004 partially reversed by 2008. As repressed as Tajikistan already was in 1999, it allotted even less political freedom in 2008 despite a slight improvement by 2004. Overall, Bosnia experienced the greatest improvement between 1999 to 2008; its almost one and one-half point change representing more than a 25% rating adjustment. Conversely, Russia scored a 30% worse rating in 2008 compared to its 1999 rating of 4.58. Although the tendency of many studies has been to rely on the broadest freedom measures possible, there is reason to believe different types of political freedoms can have different effects on FDI. The civil society, judicial, and media categories of the Nations in Transit series describe various civil liberties whereas the corruption, electoral, and governance categories better represent political rights.1 As noted earlier, Adam & Filipanos (2007) found contrasting results from broad indexes of civil liberties and political rights. Even within this taxonomy, alternative measures can have contrasting effects because they work through different channels. For example, corruption and judicial framework directly affect business transactions and the potential for investment, whereas media independence and electoral process work more indirectly as potential oversight mechanisms. Each type of political freedom considered here can either help or hinder FDI inflows. On the one hand, greater civil society may promote free trade and foreign investment but interest groups and other nongovernmental organizations may just as likely try to block globalization and resist rapid change which can upset the status quo, especially in the newly independent Eurasian nations. An independent judiciary is better suited to the protection of property rights which would attract FDI, but also more likely to hold investors accountable for human rights violations and other illegal operations, which may scare them off. While foreign investors recognize that media independence can serve as a useful conduit for unbiased information, they may also fear exposure of their own unpopular or unlawful activities and therefore shy 1

See Heckelman (2010) for a detailed comparison.

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away from countries where the media are more independent. Foreign investors also may be hindered by rampant corruption and therefore seek countries where corruption is more limited, yet corruption can also be beneficial to investors in order to circumvent inefficient policies and bureaucratic red tape. Greater electoral control by the general public in determining leadership should in theory make the government more responsive to the public‘s needs. However, this also increases the likelihood of governmental party, and therefore policy, change. Roland (2002) believes this to be especially problematic for democracy in the transition nations where fundamental economic alterations could temporarily lead to recession during the adjustment period. Voters might not support reform candidates or quickly look to reverse economic policy at the first sign of distress. Foreign investors may prefer dealing with a stable autocrat rather than the uncertainty of the changing whims of the general public. Finally, greater decentralization of governance can result in an environment better able to adapt to local conditions but overlapping jurisdictions can also result in conflicting policies and greater bureaucracy.

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Table 1. Aggregated political freedom rating

Albania Armenia Azerbaijan Belarus Bosnia Bulgaria Croatia Estonia Georgia Hungary Kazakhstan Kyrgyzstan Latvia Lithuania Macedonia Moldova Poland Romania Russia Slovakia Slovenia Tajikistan Turkmenistan Ukraine Uzbekistan average std deviation

1999 4.75 4.79 5.58 6.25 5.42 3.58 4.46 2.25 4.17 1.88 5.50 5.08 2.29 2.29 3.83 4.25 1.58 3.54 4.58 2.71 1.88 5.75 6.75 4.63 6.38 4.17 1.54

Level 2004 4.13 5.00 5.63 6.54 4.29 3.25 3.83 1.92 4.83 1.96 6.25 5.67 2.17 2.13 4.00 4.88 1.75 3.58 5.25 2.08 1.75 5.71 6.88 4.88 6.46 4.19 1.68

2008 3.88 5.19 6.00 6.69 3.98 2.83 3.67 1.85 4.65 2.13 6.38 5.79 2.06 2.21 3.85 4.88 2.31 3.35 5.96 2.27 1.88 5.98 6.94 4.13 6.85 4.23 1.75

1999-2004 -0.63 0.21 0.04 0.29 -1.13 -0.33 -0.63 -0.33 0.67 0.08 0.75 0.58 -0.13 -0.17 0.17 0.63 0.17 0.04 0.67 -0.63 -0.13 -0.04 0.13 0.25 0.08 0.03 0.46

Change 2004-2008 -0.25 0.19 0.38 0.15 -0.31 -0.42 -0.17 -0.06 -0.19 0.17 0.13 0.13 -0.10 0.08 -0.15 0.00 0.56 -0.23 0.71 0.19 0.13 0.27 0.06 -0.75 0.40 0.04 0.32

1999-2008 -0.88 0.40 0.42 0.44 -1.44 -0.75 -0.79 -0.40 0.48 0.25 0.88 0.71 -0.23 -0.08 0.02 0.63 0.73 -0.19 1.38 -0.44 0.00 0.23 0.19 -0.50 0.48 0.06 0.64

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Thus it is an empirical question as to whether or not each type of political freedom on net benefits or limits FDI inflows. For these reasons, the regression analysis will consider each measure separately, in addition to the overall average effect. Previously, the most extensively analyzed component has been corruption, although that is not normally interpreted specifically as a political freedom. Egger and Winner (2005) find that corruption attracts FDI among a mixed sample of OECD and developing economies. In constrast, Asiedu (2006) finds corruption limits FDI inflows to Africa while Méon & Sekkat (2004) find no significant effect of corruption on FDI inflows into the Middle East. In an analysis of bilateral FDI inflows between 183 home economies to 106 host economies, Cuervo-Cazurra (2006) finds that greater levels of corruption in the host country attract more FDI from nations that are relatively corrupt themselves, but reduces FDI stemming from nations that have laws prohibiting engaging in bribery abroad. The net effect of corruption is found to be negative.

SPECIFICATION The sample consists of pooled cross-sectional data on 25 transition countries in Central and Eastern Europe and Former Soviet Union over two time periods for a total of 50 observations. Data span from 1999 – 2008, as determined by the availability of the Freedom House Nations in Transit political freedoms data.2 The specifications take the form of:

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FDIit = α + βINCOMEit + γINFLATIONit + λTRANSITIONit + δFREEDOMit + eit where for each country i in period t: FDIit = log ratio of foreign direct investment rate to GDP; INCOMEit = log of initial real per capita income; INFLATIONit = log of standard deviation of the inflation rate; TRANSITIONit = value of the EBRD transition index; FREEDOMit = value of the Freedom House index. The dependent variable, FDI, is measured as the log of average FDI to GDP ratio over each five year period, from 1999-2003 and 2004-2008. Initial income is included for a convergence effect. Poorer economies would need greater levels of investment to stimulate higher growth to be able to eventually catch-up to the wealthier nations. 3 A negative coefficient on INCOME would be consistent with such long-run income convergence. The importance of uncertainty [Brunetti and Weder (1998)] is captured by the log value of the standard deviation of inflation. Greater variance in prices would be expected to be inversely 2

Beginning in 2005, governance is measured by separate indexes for national and local governance. These are averaged together for consistency with the earlier years. 3 There is debate, however, as to the benefit of FDI in particular, as opposed to gross fixed investment, for generating greater growth. Campos and Kinoshita (2002) find a positive correlation between FDI and growth for their sample of 25 CEEFSU nations from 1990-1998 but Mecinger (2003) sharply criticizes the study as being irrelevant for including years in which FDI was not allowed for some countries. Mecinger limits his sample to only eight European Union candidate countries with more developed economies (relative to the FSU) and finds a significantly inverse relationship between FDI and growth.

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correlated with FDI inflows. Data for these variables are taken from the World Bank World Development Indicators on-line database. The European Bank of Reconstruction and Development (EBRD) Transition Index is included as a proxy for market distortions. The index runs from 1 to 4.33, where lower values indicate a control economy and higher values indicate the economy more closely resembles open policies as administered in the developed nations. Scores are determined by the EBRD‘s Office of the Chief Economist on 13 categories comprised of: large-scale privatization; smallscale privatization; enterprise restructuring; price liberalization; trade and foreign exchange; competition policy; banking reform and interest rate liberalization; securities markets and other financial institutions; water and waste water; electric power; railways; roads; and telecommunications. It is expected for FDI to be greater where the markets are more open. Finally, and most important for this chapter, the score representing the extent of political freedoms is included. As described above, ratings for the Freedom House Nations in Transit index range from 1 to 7, with lower values representing a greater degree of political freedom. To avoid confusion on interpreting the coefficients, each political freedom category index is inverted and standardized to a 0 – 1 scale so that higher values represent greater freedom. The aggregated index value is then the average of the normalized six component scores. Because each type of freedom can have different effects, additional regressions are also run using the normalized score of each political freedom category index separately. For the first set of regressions, the indexes representing the EBRD transition scores and the Freedom House political freedom scores are computed using the average values during the respective five year periods. This helps to avoid problems associated with single-year anomalies stemming from a sudden but not lasting change. Yet, this introduces a different potential problem in that index values may be endogenous if policy reforms respond to economic conditions. For example, Li & Reuveny (2003) find that FDI inflows have an initial positive influence on democratization which then weakens over time. Robertson & Watson (2004) find that greater changes (either increases or decreases) to FDI result in larger levels of corruption. Dutta & Roy (2009) find FDI is positively correlated with an index of media freedom. In addition, some scholars have also questioned if the organizations creating such subjective indexes are influenced in their perceptions by economic performance [Bollen (1993), Koelble & Lipuma (2008)]. Due to potential endogeneity concerns, a second set of regressions are presented using only the initial year values for these variables. Results are very similar, with one exception detailed below. The sample consists of the countries included in the Freedom House Nations in Transit index. Yugoslavia is rated until the 2004 index, when separate scores begin for Serbia, Montenegro, and Kosovo, so these nations are not included. In addition, the Czech Republic graduated from the EBRD and is no longer part of their Transition index. The remaining 25 CEEFSU countries listed in Table 1 constitute the regression sample. Descriptive statistics for all variables are listed in Table 2. Among the various political freedoms, the highest average rating is assigned to civil society. Only civil society and electoral process have average values exceeding 0.5 on the converted normalized scale. Clearly, there is plenty of room for improvement in these political freedoms. In the next section, it is determined if further political reforms would be expected to attract or deter FDI inflows.

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Table 2. Summary Statistics

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Variable FDI ratio FDI ratio logged GDP per capita GDP per capita logged Inflation Std Dev Inflation Std Dev logged Transition Index averages Transition Index initial values Political Freedoms – averages Aggregated Index Civil Society Judicial Framework Media Independence Corruption Electoral Process Governance Political Freedoms – initial values Aggregated Index Civil Society Judicial Framework Media Independence Corruption Electoral Process Governance

Mean 5.93 1.54 2476.61 7.34 6.94 1.18 2.78 2.68

Std Dev 4.55 0.70 2435.39 1.03 17.03 1.04 0.64 0.64

Minimum 0.66 -0.40 130.28 4.86 0.38 -0.94 1.21 1.19

Maximum 24.30 3.19 11421.10 9.34 119.99 4.78 3.89 3.83

0.47 0.56 0.44 0.46 0.44 0.51 0.43

0.28 0.27 0.26 0.29 0.26 0.32 0.26

0.00 0.00 0.01 0.00 0.01 0.00 0.00

0.91 0.95 0.90 0.91 0.86 0.95 0.85

0.47 0.56 0.44 0.47 0.44 0.51 0.44

0.28 0.27 0.26 0.29 0.26 0.31 0.25

0.00 0.00 0.00 0.00 0.00 0.00 0.00

0.91 0.95 0.87 0.91 0.87 0.95 0.87

EMPIRICAL ANALYSIS Regression results using the average values over each five year period for the transition and political freedom indexes are presented in Table 3. Regression results using initial year values (1998 and 2004) for the transition and political freedom indexes are presented in Table 4. For both tables, the first column uses the aggregated political freedom index comprised of the average value for all six categories, and the remaining columns use the value for each listed political freedom category individually. All regressions are estimated by Ordinary Least Squares (OLS) using White-robust standard errors. The control variables all have the expected sign, although GDP per capita is not statistically significant. Thus, conditional convergence through FDI among the CEEFSU nations is not supported. Lack of significance for national income is consistent with Feng (2003), although he also controlled for population size rendering his GDP per capita variable akin to a total GDP interpretation. Price uncertainty in terms of the standard deviation of inflation is significantly inversely correlated with FDI. Neither Brunetti & Weder (1998) nor Coates et al. (2010) found this to significantly reduce total investment levels. The contrasting

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result here suggests foreign investors may be more concerned with variation in domestic prices in the host country than are domestic investors, at least in this region. The positive and significant coefficient on the transition index indicates that the more the host country has policies which mimic other developed economies, the more FDI it attracts. Foreign investors, which are often dominated by developed economy actors, appear to be more comfortable investing in environments which more closely resemble their own. Greater market distortions, indicated by lower values of the index, appear to discourage foreign direct investment. These results are robust across all the reported regressions. The aggregated political freedom index is inversely correlated with FDI; as shown in the first column of Table 3, this is at borderline significance level. In general, it appears that greater political freedoms will result in less foreign direct investment. The remaining columns reveal why statistical significance of the aggregated index is weak. Although each of the political freedom indexes generate a negative coefficient, half of them are statistically significant while the other half are not. In particular, a more independent judicial framework, more freedom from corruption, and greater decentralization of power in governance significantly reduce FDI. However, freedoms pertaining to civil society, media independence, and electoral process do not significantly impact FDI levels. Table 3. Effect of political freedoms on FDI, average concurrent values

constant

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GDP Per capita Inflation Std Dev Transition Index Political Freedom

Aggregated 0.95 (0.82) [0.26] -0.13 (0.12) [0.29] -0.16* (0.085) [0.07] 0.79** (0.38) [0.04] -0.97* (0.54) [0.08]

Civil 1.37* (0.77) [0.08] -0.18 (0.12) [0.15] -0.16** (0.082) [0.05] 0.76* (0.44) [0.09] -0.76 (0.98) [0.44]

Judicial 0.41 (0.84) [0.62] -0.061 (0.13) [0.64] -0.17** (0.076) [0.03] 0.89** (0.34) [0.01] -1.58** (0.58) [0.01]

R2 0.25 0.23 0.28 White-robust standard errors in parentheses p-values in brackets * indicates significance at the 10 percent level ** indicates significance at the 5 percent level

Media 1.09 (0.86) [0.21] -0.13 (0.13) [0.30] -0.17** (0.083) [0.04] 0.73** (0.36) [0.05] -0.83 (0.55) [0.14]

Corruption 0.33 (0.89) [0.71] -0.057 (0.13) [0.66] -0.16** (0.077) [0.04] 0.92** (0.36) [0.01] -1.66** (0.61) [0.01]

Electoral 1.31 (0.85) [0.13] -0.16 (0.13) [0.23] -0.16* (0.084) [0.07] 0.67* (0.38) [0.08] -0.51 (0.54) [0.35]

Governance 0.42 (0.92) [0.65] -0.070 (0.13) [0.60] -0.16* (0.079) [0.05] 0.89** (0.37) [0.02] -1.52** (0.61) [0.02]

0.24

0.29

0.23

0.28

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Do Political Freedoms Attract or Discourage Foreign Direct Investment? Table 4. Effect of political freedoms on FDI, initial year values

constant

GDP Per capita Inflation Std Dev Transition Index Political Freedom

R2

Aggregated 0.85 (0.73) [0.25] -0.14 (0.12) [0.26] -0.15* (0.078) [0.07] 0.91** (0.32) [0.01] -1.21** (0.47) [0.01]

Civil 1.22* (0.70) [0.09] -0.18 (0.12) [0.15] -0.16** (0.075) [0.04] 0.91** (0.36) [0.02] -1.12 (0.94) [0.24]

Judicial 0.11 (0.78) [0.89] -0.043 (0.13) [0.73] -0.14** (0.070) [0.05] 1.06** (0.29) [0.00] -2.06** (0.57) [0.00]

Media 1.10 (0.78) [0.17] -0.14 (0.13) [0.26] -0.16** (0.079) [0.05] 0.80** (0.30) [0.01] -0.92** (0.45) [0.05]

Corruption 0.11 (0.78) [0.89] -0.043 (0.13) [0.73] -0.14** (0.070) [0.05] 1.06** (0.29) [0.00] -2.06** (0.57) [0.00]

Electoral 1.23 (0.76) [0.11] -0.17 (0.13) [0.21] -0.15* (0.077) [0.07] 0.77** (0.30) [0.02] -0.69 (0.45) [0.14]

Governance 0.11 (0.78) [0.89] -0.043 (0.13) [0.73] -0.14** (0.070) [0.05] 1.06** (0.29) [0.00] -2.06** (0.57) [0.00]

0.28

0.26

0.35

0.27

0.35

0.26

0.35

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White-robust standard errors in parentheses p-values in brackets * indicates significance at the 10 percent level ** indicates significance at the 5 percent level

Using the initial values for the transition index and political freedoms variables in Table 4 results in both larger magnitudes and stronger p-values across the board for these coefficients compared to in Table 3 which used the average values over each five year period. None of the results for the other variables are appreciably affected by this change. For the political freedom variables, this comparison suggests that if the contemporaneous averages are endogenously determined, the OLS estimates presented in Table 3 were biased toward zero. This could be the case if as an economy develops from increased FDI, greater political freedom reforms are enacted [Li & Reuveny (2003)], or if the government is perceived to be granting more freedom by the subjective evaluators [Bollen (1993)]. Thus, the extent of the harm to FDI from increasing political freedom was somewhat masked by using the concurrent endogenous averages instead of purely exogenous initial values. For example, the magnitude of the aggregated index increases by over 20% and the pvalue indicates it is now statistically significant at the 1% level. In addition, the importance of media independence is now revealed as well. Using the concurrent five-year average political freedom value, the coefficient on media freedom was negative but not statistically significant. Using the initial value, the coefficient on media freedom is more negative and statistically significant at the 5% level. Freedoms related to judicial, corruption, and governance, are significant at even higher levels than before. While freedoms related to civil society and electoral process have much stronger p-values in Table 4 than in Table 3, these variables would still not be considered statistically significant at conventional levels.

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CONCLUSION Political freedoms are often assumed to be a positive force for growth, but several studies have tended to undermine this connection. Mobarak (2005) finds political rights are not significantly related to growth. Baum & Lake (2003) reject a direct connection between political freedoms and growth. Stroup & Heckelman (2001) find the significance of political rights depends on econometric specification and regional sample. Using extreme bound analysis, de Haan & Siermann (1995) conclude the relationship between political freedoms and growth is not robust. Although political freedoms are positively correlated with many of the determinants of growth (such as human capital [Baum & Lake (2003)], economic freedom [de Haan & Sturm (2003)], and trade [Mobark (2005)]) this chapter uncovers a potential offsetting relationship between political freedoms and FDI, which Lee & Tcha (2003) have identified as a particularly important contributor to growth and development among the European transition economies. Previous studies which have investigated the relationship between political freedoms and FDI have produced conflicting results [Harms & Ursprung (2002), Feng (2003), Li & Resnick (2003), Adam & Filippaios (2007)] for various diverse samples of countries. Here, the analysis is specific to transition nations in Central and Eastern Europe and Former Soviet Union. Using data from the Freedom House Nations in Transit index which has a specific focus on the CEEFSU nations, it is found that greater political freedoms in general result in less FDI (as a percent of GDP). In particular, this relationship is strongest for freedoms related to judicial framework, corruption, and governance. The finding related to corruption in particular supports Egger & Winner‘s (2005) analysis on a large sample that did not include any FSU nations. No significant relationship was found for civil society or electoral process. Freedom of media was not significant using concurrent values, but was significantly negative using initial values. These results suggest that the enactment of further political reforms in CEEFSU nations will generally have an off-setting cost from reductions in FDI. Political reforms specific to civil society and electoral process will not significantly reduce FDI. A secondary finding is that using concurrent values of the political freedom indexes may bias estimates toward zero, suggesting political freedoms may be endogenously determined. Government leaders may grant greater political freedoms as the nation develops ([Helliwell (1994), Barro (1996)]), and the extent of FDI may be such an indicator. It is important to note that many of these political freedoms are also inter-related. Heckelman (2010) finds several political freedoms Granger-cause another political freedom. Alternatively, FDI may also be used to directly or indirectly impact political institutions. For example, investment in nongovernmental organizations (NGOs) can strengthen civil society. Recognizing the importance of human rights and involvement in the political process for increased worker productivity, activity by such NGOs may lead to improvement in judicial independence, electoral process and governance transparency. Foreign investors may also directly invest in media corporations and thereby push for greater autonomy. Finally, foreign investors may also be more resistant to corruption and use funds to ferret out existing corruption which hampers their business interests. These explanations are speculative and cannot be tested using the framework developed here. Further work in this area would be beneficial to systematically test if and how FDI has helped improve various political freedoms among the CEEFSU nations and elsewhere.

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Do Political Freedoms Attract or Discourage Foreign Direct Investment?

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REFERENCES Adam, A. & Filippaios, F. (2007). Foreign direct investment and civil liberties: A new perspective. European Journal of Political Economy, 23, 1038–1052. Asiedu, E. (2006). Foreign direct investment in Africa: The role of natural resources, market size, government policy, institutions and political instability. World Economy, 29, 63–77. Barro, R. J. (1996). Democracy and growth. Journal of Economic Growth, 1, 1-27. Baum, M. A. & Lake, D. A. (2003). The political economy of growth: Democracy and human capital. American Journal of Political Science, 47, 333-347. Bengoa, M. & Sanchez-Robles, B. (2003). Foreign direct investment, economic freedom and growth: New evidence from Latin America. European Journal of Political Economy, 19, 529–545. Bollen, K. (1993). Liberal democracy: Validity and method factors in cross-national measures. American Journal of Political Science, 37, 1207-1230. Brunetti, A. & Weder, B. (1998). Investment and institutional uncertainty: A comparative study of different uncertainty measures. Weltwirtschaftliches Archiv, 134, 513–533. Campos, N. F. & Kinoshita, Y. (2002). Foreign direct investment as technology transferred: Some panel evidence from the transition economies. The Manchester School, 70, 398419. Chan K. K. & Gemayel, E. R. (2004). Risk instability and the pattern of FDI in the MENA region. IMF Working Paper Series WP/04/139. Coates, D., Heckelman, J. C. & Wilson, B. (2010). The political economy of investment: Sclerotic effects from interest groups. European Journal of Political Economy, 26, 208221. Cuervo-Cazurra, A. (2006). Who cares about corruption? Journal of International Business Studies, 37, 807-822 de Haan, J. & Siermann, C. L. J. (1995). A sensitivity analysis of the impact of democracy on economic growth. Empirical Economics, 20, 197-215. Dutta, N. & Roy, S. (2009). The impact of foreign direct investment on press freedom. Kyklos, 62, 239-257. Egger, P. & Winner, H. (2005). Evidence on corruption as an incentive for foreign direct investment. European Journal of Political Economy, 21, 932–952. Feng, Y. (2003). Democracy, Governance, and Economic Performance: Theory and Evidence. Cambridge, MA: MIT Press. Harms, P. & Ursprung, H. W. (2002). Do civil and political repression really boost foreign direct investment? Economic Inquiry, 40, 651–663. Heckelman, J. (2010). Relationships among democratic freedoms in the former Soviet Republics: A causality analysis. Constitutional Political Economy, 21, 80-96. Helliwell, J. F. (1993). Empirical linkages between democracy and economic growth. British Journal of Political Science, 24, 225-248. Koelble, T. A. & Lipuma, E. (2008). Democratizing democracy: A postcolonial critique of conventional approaches to the ‗measurement of democracy‘. Democratization, 15, 1-28. Lee, M. & Tcha, M. J. (2007). The color of money: The effects of foreign direct investment on economic growth in transition economies. Review of World Economics, 140, 211-229.

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Li, Q. & Resnick, A. (2003). Reversal of fortunes: democratic institutions and foreign direct investment inflows to developing countries. International Organization, 57, 175–211. Li, Q. & Reuveny, R. (2003). Economic globalization and democracy: An empirical analysis. British Journal of Political Science, 33, 29-54. Mecinger, J. (2003). Does foreign direct investment always enhance economic growth? Kyklos, 56, 491-508. Méon, P. G. & Sekkat, K. (2004), Does the quality of institutions limit the MENA‘s integration in the world economy? World Economy, 27, 1475–98. Mobarak, A. (2005). Democracy, volatility and development. The Review of Economics and Statistics, 87, 348–361. Robertson, C. J. & Watson, A. (2004). Corruption and change: The impact of foreign direct investment. Strategic Management Journal, 25, 385-396. Roland, G. (2002) The political economy of transition. Journal of Economic Perspectives, 16, 29-50. Stroup, M. D. & Heckelman, J. C. (2001). Size of the military sector and economic growth: A panel data analysis of Africa and Latin America. Journal of Applied Economics, 2, 329 360.

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In: Developing Economies Editor: Joanne M. Carcillo

ISBN: 978-1-61122-541-9 © 2012 Nova Science Publishers, Inc.

Chapter 6

REGULATION AS A PROTECTIONIST STRATEGY Peter Lawrence1,† and Arijit Mukherjee2,3 1

Keele University, United Kingdom University of Nottingham and The Leverhulme Centre for Research in Globalisation and Economic Policy, United Kingdom 3 CESifo, Germany

2

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ABSTRACT We show that, under certain conditions, strategic lobbying by the incumbent firms for a regulatory regime is a way to deter entry of competitors. The effect of costefficiency of the incumbent on the incentive for lobbying is ambiguous and depends on the cost differences between the incumbent and the entrant. We extend our analysis to incorporate the possibility of lobbying by the entrant, and show the importance of the cost of lobbying and the probability of successful lobbying by the incumbent.

JEL Classification: L11; L41; L51 Keywords: Entry deterrence; Lobbying; Regulation.

1. INTRODUCTION This paper is concerned with regulation as a form of entry deterrence. The discussion on entry deterrence goes back to Bain (1956), which shows that entry of a firm into a market reduces profit of the incumbent firm and encourages the incumbent to adopt entry deterrence

We thank the participants of the Royal Economic Society Conference, the participants of the meeting of the Applied and Theoretical Microeconomic Group of the Economics Department at Keele University and particularly Roger Hartley and Gauthier Lanot for their valuable comments. The usual disclaimer applies. † Corresponding author: School of Economics, University of Nottingham, University Park, Nottingham, NG7 2RD, UK, E-mail: [email protected], Fax: +44-115-951 4159

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strategies. There are several ways in which incumbent firms can deter entry of new firms.1 However, if more conventional entry deterrence strategies are not effective, incumbent firms may use some regulatory mechanism to deter entry. We develop a model to demonstrate this, which allows for cost differences between the incumbent and the entrant, and the possibility of lobbying by both the incumbent and the entrant. We show that the incentive to lobby for regulation may increase or decrease as the incumbent firm becomes more cost-efficient. If the marginal cost of the incumbent is sufficiently higher (lower) than that of the entrant, the relatively more cost efficient incumbent has a higher (lower) incentive for lobbying. If both the incumbent and the entrant have the option of lobbying, the relationship between the cost of lobbying and the probability of successful lobbying by the incumbent determines the equilibrium outcome. Only the incumbent firm lobbies when it has a sufficiently large probability of success in lobbying. But, if the incumbent‘s probability of success in lobbying is not very high, in equilibrium, both firms may lobby. Our analysis of lobbying for regulation is not the outcome of a theoretical curiosity only. The evidence provided in the next section shows that it is relevant for many developing or transitional economies which are going through a liberalization process. Liberal economic reforms in many developing countries have resulted in the removal of various protectionist measures such as licensing, subsidies and other barriers to foreign direct investment (FDI), in order to encourage open competition from foreign competitors (Dornbusch, 1992). Our analysis is also equally relevant for those more developed countries where political and economic institutions are not fully developed and the opportunities for successful lobbying are still available. It must be noted that the main focus of this paper is not on lobbying. Instead, our lobbying game is very simple, and the entry deterring role of regulation may encourage the firms to lobby for regulation. We show how this incentive for lobbying changes with cost asymmetries between the firms. It may also worth mentioning why the incumbent needs to lobby for regulation rather than simply deter entry by its own strategic investment decision, which creates a price that it would seek under regulation. In such a case, the incumbent‘s strategic investment might not seen by the entrant as a credible commitment, if it is reversible. The entrant would believe that the incumbent‘s investment would be revised ex-post entry and the deterrent price would not be sustained in a subgame-perfect equilibrium. As a result, the incumbent would not be able to prevent entry through strategic investment. The remainder of the paper is organized as follows. Section 2 provides some related literature. Section 3 sets out the basic model where only the incumbent lobbies for regulation. Section 4 extends the model to the case where entrants can lobby. Section 5 concludes.

1

See, for example, Tirole (1988) for an extensive discussion on entry deterrence.

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Regulation as a Protectionist Strategy

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2. SOME RELATED LITERATURE In at least the semi-industrialised developing economies, there are typically local incumbents, which are either monopolies or oligopolies and, in the transitional economies2, former state-owned monopolies. They will have enjoyed various kinds of protection such as import controls, licensing and tariffs, but now face the threat of competition, often from foreign entrants, as a result of liberalization policies. Since the factors that usually deter entry, such as the costs of entry or the pre-commitment strategies of the firms, may not always exist, such firms are likely to look for other ways to keep out competition. One possibility is that they lobby for continued protection. The degree to which they are successful will depend on how far politicians respond to the lobbies. Brainard and Verdier (1994) have shown that where the gains to firms from lobbying are greater than those from adjustment, the degree to which they will succeed in getting protection is an increasing function of past protection they have received. They have also shown that by making lobbies pay a fixed cost in order to be able to pay variable lobbying costs, it is possible that they adjust rather than seek continued protection (Brainard and Verdier, 1997). Michaelis (1994) shows the gain to a more cost efficient firm from lobbying, which increases the marginal costs of the firms. Other possibilities of incumbent firms deterring entry emerge from recent literature on regulation. In a study of local telecommunications regulation in the US, Koski and Majumdar (2002) have shown that incumbent firms have responded to regulation by various strategies (such as increased advertising and where possible, increased access charges), which deter entry. Patibandla (2002) shows how in India the incumbent firms have increased their efficiency in order to compete successfully with the foreign entrants. They are less responsive in changing their organisational structures, but the efficiency losses from not doing this are outweighed by the greater knowledge they have of local institutions and markets. Entrants are still able to increase market share on the back of promotional expenditures, but they have relatively high entry costs in acquiring market information. Entry is deterred where set up costs are high and require large-scale outputs. It is the relationship between these costs of entry and the marginal cost of production of incumbent and entrant which under certain conditions will make price regulation an effective entry deterrent.3

3. THE MODEL AND THE RESULTS Consider an economy with two firms, called incumbent and entrant. The incumbent firm is already in the market and has incurred the sunk cost of entry. However, the entrant has to decide whether to enter the market or not. In the case of entry, the entrant needs to incur a sunk cost, K . We make the following assumption for the production technology of the firms. The incumbent and the entrant produce a homogenous product with constant marginal cost of

2

By transitional economies, we mean those former socialist economies principally of East and Central Europe and the former Soviet Union. 3 See Iozzi (2001) for a work on price-cap regulation with entry. Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

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production c i and c e respectively. We do not make any restriction on the superiority of the production technology of the incumbent and the entrant. Hence, we will conduct our analysis where ci

ce . For simplicity, we only assume that the marginal costs are such that both

firms produce positive outputs whenever they enter the market. As another simplification, we assume that there is no fixed cost of production. We assume that the inverse market demand function is

p

p( qi

qe )

,

(1)

where p is price of the product and q i , q e are the outputs of the incumbent and the entrant respectively. We assume that p

0 and p

0 . In the following analysis we use the

subscripts i and e for the incumbent and the entrant respectively. We consider the following game. At stage 1, the incumbent decides whether to lobby for 4 regulation. In case of lobbying, the government sets a maximum price for the industry. At stage 2, the entrant decides whether to enter or not. In our analysis we normalize the outside option of the entrant to 0 and assume that the entrant will enter provided it earns a net positive profit in this market. At stage 3, outputs are chosen and the profits are realized. We assume that in the case of entry the firms simultaneously choose their outputs in the product market like Cournot duopolists. If entry does not occur, the incumbent alone produces. Hence, our paper falls in the area of the literature with regulation under Cournot competition (see, e.,g., Molho, 1995, Roques and Savva, 2006 and Buehler et al., 2008). We solve the game through backward induction.

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3.1. Market Outcome under Non-Regulation Let us first consider the situation where the incumbent firm does not lobby for regulation. If entry occurs, profits of the incumbent and the entrant are respectively nr i nr e

(ci , ce )

( p * (qi*

(ci , ce )

( p * (qi*

qe* ) ci )qi* and qe* ) ce )qe* K ,

(2)

where the superscript nr signifies non-regulated, the first (second) argument in the * i

(.,.)

* e

stands for the marginal cost of production of the incumbent (entrant) and q , q are the equilibrium outputs of the incumbent and the entrant respectively. If entry does not occur, the incumbent produces the monopoly output in the market and earns the monopoly profit. Therefore, profits of the incumbent and the entrant are respectively

4

We assume that if the incumbent decides to lobby for regulation, it will have control over the maximum price allowed by the regulator.

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Regulation as a Protectionist Strategy nr i

(ci )

( p m (qim ) ci )qim and 0 ,

191 (3)

where superscript m signifies monopoly. So, the entrant will enter the market whenever nr e

(ci , ce ) K

0.

(4)

In the following analysis, we will assume that condition (4) holds. That is, the entrant will enter the market if the incumbent does not lobby for regulation. Otherwise, the incumbent does not face a credible threat of entry because the entrant cannot make net positive profits.

3.2. Market Outcome under Regulation

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Now consider lobbying for regulation by the incumbent. We assume that the incumbent firm can lobby to the regulatory body for an upper bound on the industry price. The regulated price is applicable to both firms. The incumbent, however, needs to incur a cost L for lobbying. We may interpret this cost of lobbying as disutility created by lobbying or the cost of bribes to corrupt officials (Saha, 2001). For simplicity, we assume that the cost of lobbying is fixed and does not depend on the degree of price regulation. We keep the lobbying game simple, since this is not the main focus of the paper. The main purpose of our analysis is to see how the cost differences between the firms affect the incumbent‘s incentive for a restricted price. It is trivial to note that whenever the incumbent lobbies for the regulation, it will ask the regulator to impose an upper bound on the industry price, say p , lower than the industry price charged by the firms without lobbying. That is, the regulated price will be lower than the price that is generated under unregulated Cournot competition between the firms. Otherwise, lobbying has no impact on the market outcome. It should also be clear that the incumbent would not lobby for any regulated price lower than c i , because, then the incumbent would not be able to earn positive profit. Further, since the regulated price is lower than the price under non-regulation, it is intuitive to argue that the incumbent will not lobby for a price which is lower than the price that prevents entry. Therefore, the regulatory price should be between c i and the price generated under unregulated Cournot competition. Since the regulated price is lower than the unregulated price under Cournot competition, the industry output would correspond to the total demand at the regulated price. If entry occurs under regulation, the incumbent and the entrant will share the industry demand between them. The profits of the firms, however, will depend on the way they share the industry output. As shown in Buehler et al. (2008), there can be multiple Nash equilibrium 5 outputs under price regulation in the presence of constant marginal costs. To by-pass this complication regarding the output choices under price regulation, we appeal to Schmalensee (1987) and follow the ‗proportional reduction technology‘, where the firms share the outputs 5

See Molho (1995) for the equilibrium outputs under price cap regulation in the presence of rising marginal costs. Chang (2004) considers price cap regulation under a Stackelberg competition.

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according to their relative market shares under unregulated duopoly. Hence, we consider the qe*

sharing rule se

q

* e

qi*

in our analysis. This assumption simplifies our calculation without

sacrificing the main insight. It must be clear from the following analysis that if we consider a different output sharing rule, which assigns more outputs to the entrant, it reduces the incumbent‘s incentive for lobbying for regulation. However, if the sharing rule is more biased towards the incumbent, it incrases the incumbent‘s incentive for lobbying for regulation. If the entrant does not enter under price regulation, the incumbent produces the total output corresponding to the regulated price. Therefore, if entry occurs under regulation, the entrant and the incumbent share the market as under unregulated duopoly but produce at a price, which is different from the price under unregulated Cournot competition. This immediately implies that the net profit of the 6 entrant would be lower under regulation than under non-regulation. The profit of the entrant under lobbying, constrained by the regulatory price, is

Max{0, where

r e

(c i , c e )

r e

(ci , ce ) K} ,

(5)

( p(q) ce ) se q . If the net profit of the entrant under the regulatory

regime is lower than the entry cost, the entrant does not enter the market and receives zero profit. The effect of regulation on the production of the incumbent, however, depends on the entry decision of the entrant. Profit of the incumbent under regulation is

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r i

(c i , c e ) L

or,

r i

r e

( p(q) ci ) si q L , when

(c i ) L

( p(q) ci )q L when

r e

(ci , ce ) K

(ci , ce ) K

0

(6)

0.

(7)

If entry occurs, the incumbent shares the industry output with the entrant and following the similar logic provided for the entrant, here the profit of the incumbent will be lower under regulation than under non-regulation. But, if entry does not occur under regulation, the incumbent would serve the total market. Hence, in this situation, the incumbent would act as a monopolist but constrained by the regulatory price. It is easy to check from (6) and (7) that for any regulated price, the profit of the incumbent is higher when the entrant does not enter compared to the situation when the entrant enters the market. Therefore, if regulation does not prevent entry, the incumbent earns a lower profit under regulation compared to non-regulation. Hence, the incumbent will have the incentive to lobby for regulation only if regulation prevents entry. 6

From

the

( p * (q i*

se

first

order

q e* ) c e )q e*

condition

K

( p(q i*

for

q

profit

maximization,

q i* ) c e )(q

is the entrant‘s market share under regulation and

q

q i* ) K

it

could

be

argued

(p c e )s e q K

is the industry output under regulated price

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that where

p.

193

Regulation as a Protectionist Strategy

Lemma 1: For any cost of lobbying, the incumbent will lobby for regulation only if regulation prevents entry. In this case, the price under regulation will be equal to the price that prevents entry.

3.3. Decision on Lobbying for Regulation We have seen in the last subsection that the incumbent lobbies for regulation only if regulation prevents entry. Though, under regulation, the incumbent earns higher profit under non-entry by the entrant compared to entry, it is not clear whether the former profit is still higher than the incumbent‘s profit under non-regulation. We find from (2) and (7) that the incumbent‘s profit under regulation would be greater than that of under non-regulation provided

( p ci )q ( p * (qi*

qe* ) ci )qi*

L.

It is clear that left hand side (LHS) of (8) is positive at p

(8)

p * but negative at p

ci ,

and it is monotonically increasing in p over [ci , p * ] . Hence, LHS of (8) is positive if the *

regulated price is not sufficiently lower than p . Therefore, the incumbent will never lobby for regulation if the regulated price, which is necessary to prevent entry, is sufficiently lower than the non-regulated price. Further, the critical regulated price that makes the incumbent indifferent between regulation and non-regulation increases with the cost of lobbying. Like the incumbent, the gross profit of the entrant under regulation, i.e., (

r e

K ) , also

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increases monotonically over [ci , p * ] . So, the amount of price reduction that is necessary to prevent entry reduces with higher cost of entry. Therefore, as the cost of entry increases, it increases the net profit of the incumbent under regulation compared to non-regulation and makes lobbying for regulation more likely. Next, consider the effects of the marginal costs of production on the incentive for lobbying. Define the LHS of (8) by , i.e., , where p

ce

K ( qi* qe* ) qe* q

. Differentiating with

respect to , we find that

X ci

1 * * [qe (qi qe*

* e

q ) q (c e

q c1 ) ci

qi* K ci

qi* * * (qe ( p q e*

q e* ce ) K ) ] . (9) ci

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We have and it is easy to check that general, the sign of

qe*

0 , and X ci

q* i ci

q*e ci

0,

X is ambiguous. However, ci

0 when ci

ce such that qi*

X ci

_

0 and

q ci

0 when ci

7

0 . Therefore, in

ce such that

0.

So, if the incumbent is sufficiently cost efficient compared to the entrant, the benefit from lobbying decreases as the incumbent‘s cost efficiency increases and therefore, the incentive for lobbying reduces with a higher cost efficiency of the incumbent. The reason is as follows. If the incumbent is sufficiently cost efficient, it does not face much threat from the entrant and becomes a near monopoly. Further cost efficiency of the incumbent reduces its incentive for lobbying for regulation as the regulation reduces the price of the product but does not increase the market share of the incumbent significantly. However, if the incumbent is sufficiently cost inefficient compared to the entrant, the benefit from lobbying increases as the incumbent becomes more cost efficient and hence, the incentive for lobbying increases. In this situation, the market share of the incumbent is significantly small. If the incumbent becomes more cost efficient, it makes entry deterrence easier, since relatively lower cost of the incumbent implies that a relatively higher regulated price can deter entry. Since, here entry deterrence increases market share of the incumbent significantly, a lower cost of the incumbent now increases its incentive for lobbying for regulation. The following proposition summarizes the above discussions.

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Proposition 1: (a) The incentive for lobbying for regulation increases with a higher entry cost and a lower cost of lobbying. (b) The incumbent‘s incentive for lobbying increases (decreases) with lower marginal cost of the incumbent if the marginal cost of the incumbent is sufficiently higher (sufficiently lower) than the marginal cost of the entrant.

7

The effect of

ci

on

qi*

and

qe*

can be found from the first order conditions of profit maximization by the

incumbent and the entrant respectively. The effect of K

condition under regulation. We find that

q c i

( q* q* ) i e 0 . Further, ( p c q p ) 0 since c e i q with the marginal cost ce . Therefore, 0. c i

ci

on

q

can be found from the entrant‘s zero profit

( q* q* ) q* i e ( p c )q e e c c i i . It is easy to check that * q ( p c qp ) e e

p

is lower than the monopoly price of the incumbent

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Regulation as a Protectionist Strategy

3.4. An Example In this subsection we provide an example for the above discussion. Assume that the inverse market demand function is linear and is given by . Under non-regulation, the profits of the incumbent and the entrant are respectively

( a 2ci ce )2 and 9

nr i

nr e

(a 2c c )2 e i 9

( a 2ce ci )2 non-regulation is positive if 9

K

K . The entrant‘s net profit under

0.

Regulation prevents entry when the price under regulation reduces to a price satisfying the following condition: . Since, p

(c,

(11)

a ci ce ) , we find that if , the entrant does not enter the market under 3

regulation, and the incumbent produces , the net profit of the incumbent under regulation is r i

1 (a 2ci ce ) 4

(a ce )

(a ce )

(a ce ) 2 4(ace

K (2 a ci ce ) ( a 2 ce ci )

) (12)

2

4(ace

K (2 a ci ce ) ( a 2 ce ci )

)

L.

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The net profit of the incumbent is higher under regulation compared to non-regulation provided 1 (a 2c c ) i e 4 (a 2c c )2 i e 9

(a c )2 4(ac e e

K (2 a ci ce ) ( a 2 ce ci )

) (a c ) e

(a c )2 4(ac e e

K (2 a ci ce ) ( a 2 ce ci )

)

(13)

L.

Suppose . We find that the incumbent will lobby for regulation provided . The upper bound on the entry cost is given by the condition for net positive profit of the entrant under non-regulation. The interval is non-empty provided . Therefore, if and , the incumbent has the incentive to lobby for regulation when the incumbent and the entrant have the same marginal cost of production. Since LHS of (13) is continuous in c i and c e , it should be clear that the incumbent may have the incentive for lobbying even if its marginal cost is either higher or lower than that of the entrant, which is in contrast to Michaelis (1994), where a firm asks for regulation if it is more cost efficient than the competitor. In Figure 1, we show the effects of cost differences between the firms on the incentive for 8 lobbying. We consider a numerical example with , , and . Given these values of the

8

We use ‗The Mathematica 4.2‘ (see Wolfram, 1999) for Figure 1.

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196

Peter Lawrence and Arijit Mukherjee

parameters, we plot the LHS of (13) for in Figure 1. This value of ensures that the entrant earns a positive profit under non-regulation. It is clear from Figure 1 that if is less than a critical value, lobbying for regulation is the profitable strategy for the incumbent. It is clear from Figure 1 that the incentive for lobbying may increase or decrease with lower c i . If c i is not very small, the benefit from lobbying and therefore, the incentive for lobbying increases with lower c i . But, if ci

0 , the benefit from lobbying reduces with

lower c i . Therefore, there exists a cost of lobbying such that the incumbent does not lobby if its marginal cost is either very small or very high. Note that Figure 1 also confirms that Proposition 1(b) provides sufficient conditions only. A lower ci may increase the incentive for regulation even if the incumbent is more cost efficient than the entrant. 0.02 0.1

0.2

0.3

0.4

0.5

0.6

0.7

ci

-0.02 -0.04 -0.06 -0.08 -0.1

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-0.12

Figure 1. Left hand side of (13) for

a 1 , ce

.49 , ci

[0, 1.249 ] , K

.00004

and

L

0.

4. LOBBYING BY THE ENTRANT We have so far assumed that in the face of possible lobbying by the incumbent for regulation, the entrant does not lobby against regulation. This is not an unreasonable assumption if the entrant is a foreign firm and has little knowledge of domestic institutions and for whom, therefore, the cost of lobbying is possibly prohibitive. However, even in the case of a foreign firm, it is possible for this knowledge to be acquired, the cost of doing so being part of the fixed costs of lobbying. 9 In lobbying against regulation, the entrant‘s objective is to get the market outcome under non-regulation. The questions are then first, under what conditions an entrant will lobby; and secondly, what is the best strategy for an incumbent to employ in the face of possible lobbying by the entrant. For simplicity, we assume that the costs of lobbying are the same for the incumbent and the entrant. It is trivial 9

There is the further possibility that a foreign firm could lobby through a domestic partner. Such a possibility is implicit in our analysis.

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Regulation as a Protectionist Strategy

that if the entrant faces a higher lobbying cost than the incumbent, it would reduce the entrant‘s incentive for lobbying. We consider the following game. At stage 1, both the incumbent and the entrant simultaneously decide to lobby. At stage 2, the entrant decides whether to enter or not. At stage 3, outputs are chosen and the profits are realized. In the case of entry, the firms compete like Cournot duopolists, and without entry the incumbent alone produces. We solve the game through backward induction. For the above game, the firms will face the payoff matrix illustrated in Table 1 when taking the decision at stage 1. When neither firm lobbies, net profits are the same as the market outcome under non-regulation (see subsection 3.1). When only the incumbent lobbies, and lobbying is optimal10, the payoffs are the same as the market outcome under regulation (see subsection 3.2). When the incumbent is not lobbying and the entrant is lobbying, the market outcome is similar to the former case except that the entrant incurs the lobbying cost, L. Finally, if both lobby, we assume that with probability, p (1-p), the incumbent‘s (entrant‘s) lobbying will be successful and hence deter (cannot deter) entry. The probability of successful lobbying may depend on the relationship between the firms and the bureaucrats. It is clear from Table 1 that it is not optimal for the entrant to lobby when the incumbent is not lobbying. Given that the entrant is not lobbying, it is always optimal for the incumbent to lobby since we assume that lobbying is optimal to the incumbent when the entrant is not lobbying. Given that the incumbent is lobbying, the entrant has the incentive to lobby nr

provided (1-p) ( e ( ci , ce ) -K) > L.11 If p is close to 1, LHS of the inequality tends to zero and hence, the entrant has no incentive for lobbying. In general, if p is greater than

(1

L nr e ( ci , ce )

) , it is not optimal for the entrant to lobby, given that the incumbent K

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is lobbying, and hence, the equilibrium is (Lobbying, Not Lobbying). Table 1. Net payoffs of the incumbent and the entrant when both can lobby Entrant Lobbying Incumbent

Lobbying

Not Lobbying

10 11

r

( ci ) + (1-p) i ( ci ,ce ) -L, nr (1-p) ( e ( ci , ce ) -K) –L

p

Not Lobbying

nr

r

i

i

( ci ) -L,

0

nr

nr

i

i

( ci ,ce ) , nr ( ci ,ce ) -K-L e

nr e

( ci ,ce ) , ( ci ,ce ) -K

We assume that the condition for optimal lobbying is as given in (8) in subsection 3.3. We assume that the sum of entry and lobbying costs is less than the entrant‘s profit under non-regulation.

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198

Peter Lawrence and Arijit Mukherjee If p is less than ( 1 −

L

π enr ( ci , ce ) − K

) , it is optimal for the entrant to lobby, given that

the incumbent is lobbying. Therefore, if the entrant lobbies, the incumbent will also lobby L . provided p > ( π ir ( ci ) − π inr ( ci , ce )) We find that whether ( 1 −

L ) is greater than, equal to or less than nr π e ( ci , ce ) − K

L depends on the value of L. For example, when L tends to 0, r ( π i ( ci ) − π inr ( ci , ce ))

L L tends to 0. But, if L ) tends to 1 and nr r nr π e ( ci , ce ) − K ( π i ( ci ) − π i ( ci , ce )) r nr L tends to π i ( ci ) − π i ( ci , ce ) then tends to 1, which is greater ( π ir ( ci ) − π inr ( ci , c e )) (1−

(

(1−

than

(1−

)

L

π enr ( ci ,ce

L

π enr ( ci ,ce

)− K

)− K

)

.

Since

L ( π ir ( ci ) − π inr ( ci ,ce ))

both

and

) are continuous in L, we can say that if L is sufficiently low (high),

L L ). is less (greater) than ( 1 − r nr nr ( π i ( ci ) − π i ( ci ,ce )) π e ( ci ,ce ) − K Let us first consider the situation where L is sufficiently low. If L is sufficiently low, Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved.

L ( π ir ( ci

) − π inr ( ci ,ce

than

is less than ( 1 −

))

L

( π ir ( ci ) − π inr ( ci ,ce )) in equilibrium.

L

π enr ( ci ,ce

and less than ( 1 −

)− K

) . Therefore, if p is greater

L

π enr ( ci ,ce ) − K

) , both firms will lobby

L , it is optimal for the entrant to lobby when the r ( π i ( ci ) − π inr ( ci ,ce )) incumbent lobbies. But, given that the entrant is lobbying, it is not optimal for the incumbent to lobby. However, we have already seen that if the incumbent does not lobby, it is not optimal for the entrant to lobby and when the entrant does not lobby, it is optimal for the incumbent to lobby. Thus, it is clear that if L and p are sufficiently low, there is no pure strategy equilibrium, but there will be mixed strategy equilibrium of the lobbying game, where the incumbent and the entrant will optimally randomize between lobbying and not lobbying. L is Next, consider the situation where L is sufficiently high so that ( π ir ( ci ) − π inr ( ci , ce )) If p is less than

greater than ( 1 −

L

π enr ( ci , ce ) − K

) . As we have already mentioned, the equilibrium will be

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199

Regulation as a Protectionist Strategy (Lobbying, Not Lobbying) when the values of p are greater than ( 1

L nr e ( ci , ce )

) . But, K

L ) , following the argument of the last paragraph, we can nr ( c , c ) K e i e say that, in this situation, the lobbying game will have a mixed strategy equilibrium where the incumbent and the entrant will optimally randomize between lobbying and not lobbying. The following proposition summarizes the above discussion. if p is less than ( 1

Proposition 2: (a) Suppose L is sufficiently low so that than ( 1

L nr e ( ci , ce )

is less

K

L nr e ( ci , ce )

) , only the incumbent will lobby. K

L

(ii) If p is greater than

( ir ( ci ) , both firms will lobby.

nr i ( ci , ce ))

L

(iii) If p is less than ( 1

nr e ( ci , ce ) between lobbying and not lobbying.

L nr e ( ci , ce )

and less than ( 1

L nr e ( ci , ce )

) K

) , both firms will optimally randomize K

(b) Suppose L is sufficiently high so that Copyright © 2011. Nova Science Publishers, Incorporated. All rights reserved.

nr i ( ci , ce ))

).

(i) If p is greater than ( 1

(1

L ( ir ( ci )

L ( ir ( ci )

nr i ( ci , ce ))

is greater than

). K

(i) If p is greater than ( 1 (ii) If p is less than ( 1

L nr e ( ci , ce )

) , only the incumbent will lobby. K

L

nr e ( ci , ce ) between lobbying and not lobbying.

) , both firms will optimally randomize K

5. CONCLUDING REMARKS We have shown that it is possible to conceive of a situation in which it is more profitable for the incumbents to lobby governments to institute regulation than it is in the case where there is no regulation. In our analysis, it pays the incumbent to lobby for regulation only if the regulated price deters entry. We have shown that an incumbent may lobby for regulation and can be either cost efficient or cost inefficient relative to the entrant. Whether more cost

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Peter Lawrence and Arijit Mukherjee

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efficiency of the incumbent increases or decreases its incentive for lobbying is ambiguous and depends on the cost differences between the entrant and the incumbent. We have also considered the situation in which the entrant can lobby, and we show that the decision to lobby depends on the cost of doing so and on the probability of securing a successful outcome by the entrant. An immediate extension of our analysis is to consider the case of multiple incumbents. However, it is easy to understand that, this situation may create a free rider problem about lobbying since, lobbying by one incumbent may provide the desired benefit to other incumbents. Therefore, lobbying may not occur in a non-cooperative set up, and the entrant may not be deterred. However, cooperative lobbying might be a possible solution to avoid the free rider problem in the presence of multiple incumbents. Of course, we have assumed a political institutional framework in which the governments accept to be lobbied. Firms may exert influence through politicians in constituencies where incumbents are threatened by entry. Firms may exert this influence either through donations to political parties or through appointments of influential ex-politicians to their boards of directors. Governments may be unwilling to risk the closure of incumbent firms because of the effects on employment and the regional/national economy. Regulation sought by the incumbents constitutes a way in which their interests can be protected without resort to protectionist policies. In allowing for the possibility of lobbying by the entrants, we are also assuming that channels may exist for governments to be influenced by new players, and especially by foreign investors. The dilemma for policy makers is whether allowing protectionism is likely in the longer run to lead to prices higher than they would be under open competition, as well as lead to a lower level of research and development by incumbent firms than would obtain under such competition. A further issue relates to different forms of entry. In the case of foreign entry, it may occur in different ways such as export and FDI. Avenues for further work lie in modelling dynamic R&D and regulatory behavior under different ways of market entry.

REFERENCES Bain, J. (1956). Barriers to New Competition, Cambridge, Mass: Harvard University Press. Brainard, S. L. & Verdier, T. (1994), ‗Lobbying and adjustment in declining industries‘, European Economic Review, 38, 586-595. Brainard, S. L. & Verdier, T. (1997). ‗The political economy of declining industries; Senescent industry collapse revisited‘, Journal of International Economics, 42, 221-237. Buehler, S., Burger, A. & Ferstl, R. (2008). ‗The investment effects of price caps under imperfect competition: a note‘, Discussion Paper No. 2008-17, Universität St. Gallen. Chang, S. (2004). ‗Ambiguous social welfare effects of price regulation under imperfect competition‘, Journal of Economics, 81, 53-60. Dornbusch, R. (1992). ‗The Case for Trade Liberalization in Developing Countries‘, Journal of Economic Perspectives, 6, 69-85. Iozzi, A. (2001). ‗Strategic pricing and entry deterrence under price cap regulation‘, Journal of Economics (Zeitschrift für Nationalökonomie), 74, 283-301.

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Koski, H. A. & Majumdar, S. K. (2002). ‗Paragons of virtue? Competitor entry and the strategies of incumbents in the U.S. local telecommunications industry‘, Information Economics and Policy, 14, 453-480. Michaelis, P. (1994). ‗Regulate us please! On strategic lobbying in Cournot-Nash oligopoly‘, Journal of Institutional and Theoretical Economics, 150: 693-709. Molho., I. (1995). ‗Price ceilings and imperfect competition‘, Scottish Journal of Political Economy, 42, 392-408. Patibandla, M. (2002). ‗Policy reforms and evolution of market structure in an emerging economy: the case of India‘, Journal of Development Studies, 38, 95-118. Roques, F. A. & Savva, N. S. (2006). ‗Price cap regulation and investment incentives under demand uncertainty‘, WorkingPaper, CWPE 0636 and EPRG 0616, University of Cambridge. Saha, B. (2001). ‗Red tape, incentive bribe and the provision of subsidy‘, Journal of Development Economics, 65, 113-133. Schmalensee, R. (1987). ‗Competitive advantage and collusive optima‘, International Journal of Industrial Organization, 5, 351-67. Tirole, J. (1988). The Theory of Industrial Organization, MIT Press, Cambridge, MA, USA. Wolfram, S. (1999). The Mathematica Book, 4th Ed., Wolfram Media, Cambridge University Press.

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In: Developing Economies Editor: Joanne M. Carcillo

ISBN: 978-1-61122-541-9 © 2012 Nova Science Publishers, Inc.

Chapter 7

BLACK MONEY AND CORRUPTION IN INDIA – NECESSARY EVILS TO SURVIVE?: A COMMENTARY Pradeep Chaudhry* Arid Forest Research Institute, Jodhpur, India

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ABSTRACT Black money is the actual flowing blood in the veins of traditional Indian business and commerce. It is the real fuel of high-pitched central, state and local election campaigns, the high-octane of most of the bollywood star contracts, the blowing fire of real-estate deals and the dynamics of the bulk of the Indian share-market. The salaried middle and lower middle-class, intellectuals with integrity and principles are condemned to irrelevance and very often laughed upon in the society. Underground income is so widespread in Indian society that its existence no longer shocks or surprises anyone. Barring few exceptions, it is difficult to find political leaders, high profile government officers and self-earning professionals; not having wealth disproportionate to their known sources of income. Before independence, foreigners looted this country and sent the booty across seven seas but now the same task is being performed by a class of politicians, high flying officers, businessmen and industrialists by looting the country and depositing black money in to Swiss and Caribbean banks. Some innovative ways to arrest the spreading the black money in Indian society, checking corruption; means to sustain the social and economic system have been discussed at the end of the commentary.

INTRODUCTION The present commentary relates roughly to one fourth population of India as rest of the population cannot stand on its legs without assistance of Government (Central and States). There are various estimates of population below poverty line in the country. A World Bank report says 42 % of Indians were below poverty line in 2005. Suresh Tendulkar Committee *

Corresponding author: E-mail: [email protected]

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Pradeep Chaudhry

report mentions 37.2 % of population or nearly one hundred million families living below poverty line. Arjun Sen Gupta report says 77 % of country‘s population needs government assistance as their daily earning was less than Rs 20/- per day (less than half US $) and rest 23 % of people are in position to take care of themselves. Therefore, roughly 25 % of Indian population (nearly seventy million families) is the topic of discussion here. Going by the statistics the world-over, estimated figures reveal that in Australia 43% and in Canada 48% of total population are the income tax payers, whereas in America, barring non-earning students and senior students; remaining entire population comprising 62% of total Americans pay income tax. In India, the number of income tax payers has hardly reached to the 3% of total population, that too after implementing the well publicised "one out of six" scheme (Malhotra, 2003). This percentage seems to be on extremely lower side as well as contrary to the findings of NCAER, New Delhi, who has estimated during a study on different income classes in India that from 1992 - 93 to 1998 -1999, there is a clear movement of a large number of Indians from lower and lower-middle classes to middle and uppermiddle classes, due to which large number of multinationals are eyeing this group in the field of consumer goods (Technopak, KSA, 2003). As per the records of Ministry of Finance, Government of India, number of income tax payers in 2004-05 was 2.72 crores (27.2 million) and it reached to 3.26 crores (32.6 million) during next four years but during 2008-09, a shortfall of 3 % was observed. When GDP of India was increasing at the rate of 8 % each year, then how to account for this shortfall? Share of service sector in the total GDP of India is around 52% (it is as high as 71% in the USA, 60% in Japan and 67% in the U.K), however the share of service tax in the total indirect taxes is negligible (Misra, 2003). Having failed in recovering huge income tax arrears and other accumulated black money, central government announces schemes time to time so as to enable people having black money to declare their assets and income. One of such schemes named ―voluntary disclosure scheme of black income‖ appeared in the year 1997. Different categories of such people i.e. businessmen, industrialists, agriculturists etc. very efficiently utilized this golden opportunity to convert their black income in to white. How cleverly a nexus among the income tax department, valuers, declarants, banks, proprietors of fake firms, lawyers and chartered accountants managed to declare the total income and assets under the scheme, as Rs. 25000 crores only instead of Rs. 50000 crores, therby causing a net Rs. 7500 crores income tax loss or fraud; this fact has been shown in the findings of the investigation conducted in to the scheme by the Punjab Human Rights Organization. Later on, President of India, had to ask the top income tax authorities to investigate the matter to find out the truth (Bains, 2003). This trend of corrupt duplicity was clearly visible during socio-economic data collection stage in a survey among respondents of northern region of country belonging especially to businessmen, private sector and so called agriculturist group, when monthly income stated by them was quite on a lower side and at the same time they were maintaining luxury cars, staying in expansive hotels and children studying in costly boarding public schools as revealed through unstructured interview schedule along with structured one and participant observation method. A detailed narration is given in coming paras on this survey.

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Black Money and Corruption in India – Necessary Evils to Survive?

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Extent of Black Money Schmeider (1999) attempted to measure the size of the black/shadow economy in 76 developed and emerging economies of the world. In his sample of 76 countries, most of the developed countries have been included and on an average, underground activity has been found equivalent to 15% of officially recorded GDP in rich/developed economies and around one-third of GDP in emerging/developing ones. This trend of black economy is also reflected in the ―Corruption Perception Index‖ (CPI), an indicator of relative corruption in the world‘s more than one hundred countries, which includes all developed and most of the developing countries. This index is published by a Berlin-based NGO named "Transparency International" (TI), every year on a scale 1 to 10. A score near ―10‖ means a country is perceived to be ―highly clean‖ while towards ―0‖, it is ―highly corrupt‖. India‘s score is nearly constant with CPI ranging between 2.7 to 3.5 for the years 2000 to 2008 (Transparency International, 2000-2008). From the analysis of Transparency International, it is clear that nine out of every ten developing countries has CPI below 5, indicating highly corrupt administration and related black money. India is no exception to this analysis. A 2005 study done by TI in India found that more than 50 % of Indian people had the experience of paying bribe in offices. A 2009 survey of leading economies of Asia, revealed Indian bureaucracy to be the least efficient out of Singapore, Hong Kong, Thailand, South Korea, Japan, Malaysia, Indonesia, Vietnam, China and Taiwan. It further says that working with India‘s civil servants was a slow and painful process (TOI, 2009). The existence of black money is not unique to India. What is unique, however, is its size, conservatively estimated to be about 50% of the recorded economy and thus significantly larger than in other industrializing countries such as Brazil, S. Korea, Mexico and even China (Varma, 1998). According to a World Bank estimate at the beginning of the nineties, the unaccounted money of the Indians in various tax havens abroad was of the magnitude of $ 100 billion (Rs. five thousand billion). Another estimate at the end of the eighties quantified the approximate figures of the corrupt fast breeding tribe of hoarders, speculators, middlemen, real estate operators, traders etc. close to fifty millions (or five crores), of which traders formed the single largest component. Money acquired in such a manner and so easily stipulates that these amounts could not be entirely hidden. Much of it found expression in the status symbols of the upper middle class life (Varma, 1998). The number of income tax assesses (income tax payees are still lesser) in India were 33 millions by April 1, 2003 (Singh, 2003). This figure is very much below than the figure of fifty millions quoted by Varma (1998) at the end of eighties and this means that a lot of big fishes are still out of tax net in India. Over the last few years of post-liberisation era, a new affluent class has come up in India, which was not there before. This class does not pay taxes. It cheats on taxes, just as it cheats on everything else. Net result is that the proportion of black money goes on increasing and the more the black money, the more one can spend on five-star hotels, foreign jaunts and domestic hill-stations (Dubashi, 2002). Harris-white‘s (2003) study of the local hegemony of the Indian small towns leads her to conclude, ―Fraud and tax evasion are part and parcel of Indian capitalism ----- The bulk of economy is beyond the direct control of the state‖. Economic scams, which are being unearthed in the country, layer by layer, every year, prove this fact. Recently unearthed fraud of about 30,000 crores (may be more) stamp paper scam is the latest one and one of the biggest one so far in the country, as far as money involved is concerned. The corruption level in some of the developing countries is so alarming that even

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Pradeep Chaudhry

World Bank had to suspend loans worth $ 300 millions to Kenya, saying that the country had failed to tackle high level corruption (Gandhi, 1997).

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Field Survey Results The author had the opportunity to conduct a questionnaire survey among domestic tourists visiting Chandigarh city (capital of Punjab and Haryana states of India) during 200203. This was done as a part of his doctoral study for valuing recreational benefits of urban forestry of the city (Chaudhry, 2006). Only those respondents were covered, who came to the city with the sole objective of tourism and not other reasons. Several questions related to socio economic status of the tourists were asked from them like monthly income, mode of transport used for visiting city, educational status, profession etc. A trend of corrupt duplicity was clearly visible during data collection stage among respondents of northern region of country belonging especially to businessmen, private sector and so called agriculturist group of tourists, when monthly income stated by them was quite on a lower side and at the same time they were maintaining luxury cars, staying in expansive hotels and children studying in costly boarding public schools as revealed through unstructured interview schedule along with structured one and participant observation method. Based on information provided by the tourists it was found that, except for government servants and a few professional category tourists like doctors, advocates and chartered accountants; more than 50% (175/334) of other categories (businessmen, agriculturists and private sector tourists) owning cars belonged to net household income band of Rs 5001/- to Rs 10,000/- or even below Rs 5000/- per month. Maintaining a car in India in this range of monthly income is nearly impossible, when average monthly income of even a slum dweller living in Chandigarh city is around Rs 7500/- to Rs 10,000/-. In twenty-seven cases of tourists, it was found that even traveling car was deliberately mentioned as small car e.g. Maruti-800, during the survey. In actual, such tourists mostly quoted low monthly household incomes and used luxury cars for traveling out like Honda-City, Mitsubishi-Lancer, Ford-Ikon, Hyundai-Accent etc. as revealed by "Participant observation method" (Chaudhry and Tewari, 2006; Chaudhry et al, 2007). The author has concluded in the study that people in India often hesitate to reveal actual income and profession. The real status of such people can be judged through their market behavior. It means how are they travelling (expensive or cheap means), where are they staying at a tourist destination, where their children are studying, how are they spending on social functions etc. However this survey could not find out correct picture on government servants as they were mostly on LTC (government providing funds for family travelling) and Indian government officials generally have no hesitation in revealing correct monthly income received from government.

Some Recent Cases Large scale corruption had penetrated all levels of governance and become a major threat to national security in India. The legal and administrative steps taken so far to improve ethical norms in the judiciary, executive and legislature have proved inadequate (Ansari, 2010).

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These are the remarks of the present Vice president of India before students & other luminaries of Panjab University, Chandigarh, who has further mentioned that the rising levels of corruption in various segments of India‘s economy was resulting in large scale generation of black money, serious economic offences, fraud and money laundering leading even to funding of terrorist activities which, in turn, had created a grave situation. The situation of corruption in higher offices of government could be gauged from a latest report of Comptroller and Auditor General of India where it was mentioned that a loss of around Rs 260000 million was caused to government exchequer by allotting telecom licenses in 2-G spectrum to private operators without competitive bidding at a nominal rate based on prices fixed in 2001(CAG, 2010). Central bureau of investigation (CBI), a central government investigating agency, had filed a complaint (FIR) in November 2009 against some Department of Telecom (DoT) officials and executives of some private telecom companies for a possible collusion in a bid to get new licenses in the case and now CAG of India reaching same conclusion on the issue. Thus CAG report would make the CBI‘s case stronger (ETD, 2010). It is worth mentioning that when auction was held properly; following all norms under transparent conditions in April-May 2010 for 3-G spectrum, Rs 677100 million were collected against a meager Rs 107720 million collected for 2-G spectrum. Both officers and concerned Minister incharge of Telecom ministry are under CBI and CAG scanner for this affair (Dadhich, 2010). Though Hockey is the national game of India, but Cricket is always enjoying upper hand among all other games in the country. Board for control of Cricket in India (BCCI) is the supreme agency (a private organization) managing Cricket in the country. Politicians always try to grab important positions in these central and state cricket agencies. Reason is simple i.e. investment and generation of more black money. This has become evident after Indian Premier League‘s (IPL) affairs were the main topic of discussion in the newspapers, magazines and parliament of the country. Commissioner of this Twenty-20 cricket tournament was suspended and given show cause notice in April-May 2010. Organising committee of the XIX Commonwealth Games held in New Delhi during October 2010, headed by a politician, is also under the scanner of investigating agencies for corruption charges. In USA, where Football and Baseball are the popular games, politicians have no role to play. Similarly ‗CRICKET AUSTRALIA‘ does not have politicians to manage its affairs. But in India, there is hardly any game where politicians are not the head of its governing body. When grabbing political power/seat becomes the sole aim for political parties, then developmental parameters and people‘s welfare are left far behind. The mineral rich Indian state created ten years ago, has seen seven chief ministers in these ten years. Reason for the political instability is the extreme greed of state‘s politicians. It seems that they have taken this state as a hen laying golden eggs and each party is eager to consume the hen itself than eggs (RP, 2010). Madhu Koda‘s (former Jharkhand Chief Minister) life reads like rags to riches tale from Bollywood. During Oct 2009, he was charged with laundering money worth over Rs. 4000 crores (40,000 million). Investigating agencies found illegally amassed properties not only in India but hotels in Thailand and mines in Liberia. The alleged scam is said to be the second largest unearthed in India after Harshad Mehta‘s share market scam. During the early months of 2010-11, a chairperson of Medical council of India was caught taking bribe of Rs twenty millions for the favor of granting recognition to a medical college in Punjab state. An IAS officer couple in Madhya Pradesh state was booked for amassing wealth

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Pradeep Chaudhry

and assets beyond their known sources of income. The office and houses of a secretary level officer IAS officer were raided in Chattishgarh state after a case of corruption was registered. What is interesting here is the fact that all the illegally amassed wealth and assets were intact with such personalities till they are proved culprits/wrong doers in the court of law. The story of Indian courts and justice system is a never ending process and in most of the cases people pass away but case is not decided. Such people very well take advantage of this loophole in the relevant law. Now Bihar state of India has formulated a law in this direction where it would be possible to confiscate the property of person booked under Prevention of Corruption Act after giving three months notice. Special courts are proposed to be set up in this state to speed up trials related to such cases within 100 days. If culprit is declared innocent by the court later on, the confiscated money would be returned with 5 % interest. Orissa state has also initiated such act. But in other states of India, big fishes amassing illegal wealth are still enjoying such money for years together and keep on delaying the court process by throwing illegal money on lawyers. The relevant laws of India have become more than 100 years old and have become more or less irrelevant in present times.

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Innovative & Bold Steps Needed Perception of people in India, especially middle and high middle class, about corruption has also changed over a period of time. This fact has been noticed not by the author alone but by the judges of High Court also. If it is mentioned in parties/social get together/meetings that a particular person was corrupt, people tend to ignore the message but when it is told that particular person was honest; same persons get attentive and would promptly say how do you know this? (Bhalla, 2010). There is a need to reverse this trend by some bold steps. Few years back, few honest and upright officers from Indian Administrative Service (Uttar Pradesh state Cadre) took a bold initiative when the state IAS officers‘ association decided to point out three most corrupt officers from their service in the state every year by way of secret ballot. The scheme took off well but was fizzled out later because of opposition from the corrupt officers, who were in majority. Generally politicians of the states, who have to depend on top most officers ready to accept their unreasonable and unjustified dictates, also do not favor such moves. Nevertheless, such initiatives need encouragement from Central and State Governments if corruption at the top level is to be removed. Elections, right from village panchayat (village level administration) level to Lok Sabha (parliament) level, are very costly affairs in India. There is a ceiling of Rs 25 lakh (Rs 2.50 million) in Lok sabha elections whereas for state level Vidhan sabha elections, this limit is Rs 1.00 million. It is extremely difficult to fight election in this limit. Baring a few exceptions, normally each candidate has to spend a lot more than the prescribed limit. Government funding on elections is one of the way to this problem. It would be a good idea to distribute battery operated transistors and two/ three cells to electorates during elections so that they can listen to their beloved political leaders and their election manifesto. This would save lot of travelling, fuel, hospitality arrangements on the part of candidates fighting elections. Agricultural income is not taxable in India. This clause is very cleverly used by most of the corrupt people to conceal black income. Such people always raise their voice against any move to tax agricultural income. No doubt, agriculture in India is a very risky affair given the

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moods of monsoon rains. But at least the farmers having more than ten hectare of land can be taxed. Completion of land reforms and distribution of surplus land among landless people is another option to reduce gap between have and have nots. Putting sudden ban on big denomination currency notes like Rs 500/- and 1000/- is another possible solution. It is easy to conceal an ill gotten or stolen motor cycle in a house but not an aero plane. People having black money would surely oppose this move. People having known sources of income can get their Rs 500/- or Rs 1000/- notes exchanged in banks with in some limit prescribed by government but people having millions of black money in gunny bags won‘t be able to get this facility for whole of their money. Political willingness of the government or party in power is a must for this move. Real estate is another field where lot of transaction is made in cash to avoid payment of stamp duty or other taxes of government. This is the area where income tax department must concentrate. Properties where transaction is made with low or very low cheque amount w.r.t market value can be purchased by the department in the same cheque amount and put to auction in open market.

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REFERENCES Ansari, Hamid (2010). Corruption a threat to national security. The Tribune, English Daily published from Chandigarh, India, April 10. Bains, Justice A. S. (2003). Government loses Rs. 7500 crores in IT fraud, says rights panel. The Tribune (Chandigarh edition). Sep., 22, 2003. Bhalla, J. C. (2010). Corruption in NAREGA. The Rajasthan Patrika, an Hindi Daily published from Jodhpur, India, April 13. Chaudhry, P. (2006). Recreational use value of Chandigarh city‘s urban forestry. Current Science, 91(11), 1440-41. Chaudhry, P & Tewari, V. P. (2006). A comparison between TCM and CVM in assessing recreational use value of urban forestry. International Forestry Review, 8(4), 439-448. Chaudhry,P; Singh,B & Tewari, V. P. (2007). Non-Market economic valuation in developing countries: Role of participant observation method in CVM analysis. Journal of Forest Economics, 13(4), 259-275. Comptroller, and Auditor General of India (2010). Mathematics of week. The Rajasthan Patrika, an Hindi Daily published from Jodhpur, India, April 11. Dadhich, B. S. (2010). King of spectrum fraud. Dainik Jagran, an Hindi Daily published from Hissar, India, May 24. Dubashi, J. (2002). Crack down on black money. In: Free Press journal (Mumbai edition). Aug, 19. Economic Times Delhi (2010). Rapped hard, Centre lost 26,000 crore due to Raja: CAG, an English daily, April 7. Gandhi, R. (1997). Combating corruption. In: A national agenda. Forum of Free Enterprise, Mumbai, 9. Harris-White, B. (2003). India working: Essays on Society and Economy. Cambridge University press, Cambridge, 316.

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Malhotra, R. P. (2003). Reducing the burden of taxation. The Tribune (Chandigarh edition). Mar.14. Misra, S. K. (2003). Excise department fails to check service tax evasion. The Tribune (Chandigarh edition). Aug. 27. Rajasthan Patrika, (2010). Editorial. Fate of Jharkhand. June 2. Schmeider, F. (1999). The Black hole - shadow economy. The Economist Newspaper of the Economist group. The Economist print edition. Singh, S. P. (2003). Budget, circumstances and ideologies; deficit financing may hit poor hard. The Tribune (Chandigarh edition). Feb.27. Technopack, K. S. A. (2003). Urge to splurge. India Today (weekly magazine), June 9,. Transparency International 2000-2008. Yearly Report on corruption perception index in different countries. Berlin, Germany. Times of India. (2009). Indian bureaucracy ranked worst in Asia: Survey, June 3, 2009 Varma, P.K. 1998. The writing on the wall. In: The great Indian middle class. Penguin books India (P) Ltd., New Delhi, 92-93.

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In: Developing Economies Editor: Joanne M. Carcillo

ISBN: 978-1-61122-541-9 © 2012 Nova Science Publishers, Inc.

Chapter 8

DOES HIGHER ECONOMIC INTEGRATION OF TRADE BLOCS LEADS TO FAIR TRADE? Christos Bezirtzoglou European Commission, Brussels, Belgium

ABSTRACT

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The paper is attempting a statistical analysis of the main defensive WTO trade remedy measures of four regional trade blocs of different level of economic integration in view of supporting the argument that higher economic integration among nations leads to less market distortions that need to be addressed by measures and thus fair trade.

Keywords: WTO, GATT, RTA, TDI, AD, AS, Trade bloc, Economic integration, Trade remedy measures, Fair trade

INTRODUCTION The focus of this paper is on international trade on goods and in particular the usage of the main defensive trade remedy measures (anti-dumping and anti-subsidy/countervailing proceedings) by a group of four most representative geographical trade blocs at different levels of economic integration and with different characteristics (i.a. number of participating nations, population, GDP). Through the statistical analysis of the trade defence activity the author would like to argue that higher economic integration among nations leads to less market distortions and thus free and fair trade.

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INTERNATIONAL TRADE AND TRADE BLOCS The origins of trade (Bethlehem et al., 2009) are found in the beginning of human history and social organization. In the case of ancient Greece, trade was a means to acquire commodities and to further the social interactions among communities at the same time as being an economic relationship to increase wealth. For example, the Greek city-state of Athens was dependent on trade and its development was partially attributed to its commercial activities with other traders. Athens exported mainly olive oil and imported mainly grains for food consumption. International trade is the exchange of capital, goods, and services across international borders or territories. While international trade has been present throughout much of history (i.a. Silk Road, Amber Road), its economic, social, and political importance has been on the rise in recent centuries. Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Without international trade, nations would be limited to the goods and services produced within their own borders (Inama and Vermulst, 1999). International trade is in principle not different from domestic trade as the motivation and the behavior of parties involved in a trade does not change fundamentally depending on whether trade is across a border or not. The main difference is that international trade is typically more costly than domestic trade. The reason is that a border typically imposes additional costs such as tariffs, time costs due to border delays and costs associated with country differences such as language, the legal system or a different culture. Another difference between domestic and international trade is that factors of production such as capital and labor are typically more mobile within a country than across countries. Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labor or other factors of production. Then trade in goods and services can serve as a substitute for trade in factors of production. Instead of importing the factor of production a country can import goods that make intensive use of the factor of production and are thus embodying the respective factor. A Trade Bloc is a type of intergovernmental agreement, often part of a regional intergovernmental organization, where regional barriers to trade (tariffs and non-tariff barriers) are reduced or eliminated among the participating states. Another terminology used in the bibliography is Regional Trade Agreements1 (RTAs). Advocates of worldwide free trade are generally opposed to trading blocs, which, they argue, encourage regional as opposed to global free trade (Milner, 2002). Trade blocs can be stand-alone agreements between several states (such as the North American Free Trade Agreement) or part of a regional organization (such as the European Union [EU]). Depending on the level of economic integration, trade blocs can fall into five different categories, notably: preferential trade agreements2, free trade areas, customs unions, common markets and economic and monetary unions. Free Trade Area (FTA) is a type of trade bloc, a designated group of countries that have agreed to eliminate tariffs, quotas and preferences on most (if not all) goods and 1 2

http://www.wto.org/english/tratop_e/region_e/region_e.htm Considered as the first stage of economic integration.

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services traded between them. It can be considered the second stage of economic integration. Countries choose this kind of economic integration form if their economical structures are complementary. A Customs Union is a type of trade bloc which is composed of a free trade area with a common external tariff. The participant countries set up common external trade policy. Purposes for establishing a customs union normally include increasing economic efficiency and establishing closer political and cultural ties between the member countries (Terra, 1995). It is the third stage of economic integration. A Common Market is a type of trade bloc which is composed of a customs union with common policies on product regulation, and freedom of movement of the factors of production (capital and labour) and of enterprise. The goal is that the movement of capital, labour, goods, and services between the members is as easy as within them3. This is the fourth stage of economic integration. Sometimes a Single Market is differentiated as a more advanced form of common market. In comparison to a common market a single market envisions more efforts geared towards removing the physical (borders), technical (standards) and fiscal (taxes) barriers among the member states (Lasok, 1998). An Economic and Monetary Union4 is a type of trade bloc which is composed of a single market with a common currency. This is the fifth stage of economic integration. The World Trade Organization (WTO) is a global international organization dealing with the rules of trade between nations. The core of the WTO system, referred to as the multilateral trading system, are the WTO agreements which lay down the legal ground rules for international trade as well as the market-opening commitments taken up by its Members. These agreements are negotiated and signed by all Members of the WTO, and ratified in their parliaments. The goal is to help producers of goods and services, exporters and importers to conduct their business. The WTO was established in 1995 as a result of the Uruguay Round of multilateral trade negotiations (1986-1994), but the General Agreement on Tariffs and Trade (GATT) had provided the rules for the trading system since 1948 (Stanbrook and Bentley, 1996). As of 2009, 153 countries are members of the WTO. All 27 EU member states are individually members of the WTO, but the EU negotiates and acts within the WTO as a single body, since it is a customs union.

Free and Fair Trade in Goods Whereas WTO and its agreements now cover trade in services, and in traded inventions, creations and designs (intellectual property), GATT had mainly dealt with international trade in products (Lyons, 2001). The workings of the GATT agreement are the responsibility of the Council for Trade in Goods (Goods Council) which is made up of representatives from all WTO member countries. 3 4

Known as the four freedoms in EU terminology. Not to be confused with the European and Monetary Union

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The Goods Council5 has 10 committees dealing with specific subjects (i.a. subsidies and countervailing measures, anti-dumping and safeguards). Binding tariffs and applying them equally to all trading partners (most-favoured-nation treatment) are key to the smooth flow of trade in goods. The WTO agreements uphold the principles, but they also allow two types of Trade Defence Instruments (TDI) proceedings exceptions, notably defensive and offensive (i.a. Trade Barriers Regulations) trade remedy measures, in view of protecting the free and fair trade. The three defensive TDI proceedings with the goal of maintaining the free and fair competition on the WTO member markets are: Actions against dumped imports (AD) If a company exports a product at a price lower than the price it normally charges on its own home market, it is said to be ―dumping‖ the product (Vermulst and Waer, 1996). The WTO agreement allows acting against dumping where there is genuine (―material‖) injury to the competing domestic industry. In order to do so, dumping should be shown that is taking place, the extent of dumping has to be calculated (i.a. how much lower the export price is compared to the exporter‘s home market price), and it has to be shown that the dumping is causing injury or threatening to do so. Measures against imports of subsidized products and special “countervailing” duties to offset the subsidies (AS) Anti-subsidy measures counteract trade distortive subsidies which make subsidised goods artificially competitive (e.g. cheaper) compared to non-subsidised goods (Adamantopoulos and Pereyra, 2007). The relevant WTO agreement disciplines the use of subsidies and regulates the actions countries can take to counter the effects of subsidies. Emergency protection against unforeseeable surge of imports A WTO member may restrict imports of a product temporarily (take ―safeguard‖ actions) if domestic industry sectors are injured or threatened with serious injury caused by a sudden unforeseeable surge in imports. The measure is intended to give time for these industry sectors to adapt to the new market situation.

Categorizing Trade Blocs The table below, based on data obtained from the United Nations Statistics Division6, includes the selected representative sample of geographical trade blocs (one per each level of economic integration). The European Economic and Monetary Union (EMU) consists of three stages coordinating economic policy, achieving economic convergence (that is, their economic cycles are broadly in step) and culminating with the adoption of the euro, the EU's single currency. Although by definition all EU Member States form a custom union, only sixteen of them are currently members of the euro area and by extension EMU members (Fabio, 2009).

5 6

http://www.wto.org/english/tratop_e/tratop_e.htm http://unstats.un.org/unsd/snaama/selbasicfast.asp

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Does Higher Economic Integration of Trade Blocs Leads to Fair Trade? Gross domestic product (USD) 2008 per capita 5th stage - Economic and monetary union EMU 326,394,712 14,060,431,403,536 43,078 16 nations

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Trade bloc

Population

215

Members

Austria Belgium Cyprus Finland France Germany Greece Ireland Italy Luxembourg Malta Netherlands Portugal Slovakia Slovenia Spain

4th stage - Common market CAN 97,024,333 4 nations

376,163,339,041

3,877

Bolivia Colombia Ecuador Peru

3rd stage - Customs union MERCOSUR 269,562,315 5 nations

2,169,167,948,805

8,047

Argentina Brazil Paraguay Uruguay Venezuela

2nd stage - Free trade area NAFTA 453,480,828 3 nations

15,170,294,139,084

33,453

Canada Mexico United States

The Andean Community (Spanish: Comunidad Andina - CAN) is a trade bloc founded in 1969. Mercosur or Mercosul (Spanish: Mercado Común del Sur, Portuguese: Mercado Comum do Sul) is a Regional Trade Agreement (RTA) founded in 1991. The development of Mercosur was arguably weakened by the collapse of the Argentinean economy in 2001.

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The North American Free Trade Agreement (NAFTA) is an agreement signed by the governments of the United States, Canada, and Mexico creating a trilateral trade bloc in North America (Weiler, 2000). The agreement came into force on January 1, 1994.

The Statistical Portrait

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The portrait of the selected trade blocs activity in the area of the TDI proceedings since 2004 was constructed on the basis of publicly available information obtained from official WTO documents reported to the relevant Committees7. It should be noted that the quality of data available across countries varies substantially and to the extent that county notifications were unclear, there are likely to exist some inconsistencies. The database contains information for 1235 cases at different stages of the proceedings, notably 202 on-going investigations, 77 cases with provisional and 645 with definitive measures, 269 terminations (with and/or without measures) and 42 expirations/revocations. Statistics for Non-WTO countries (i.a. Algeria, Iran, Kazakhstan, Russia) as importers by definition are not available in the WTO secretariat, thus in the table below there are data available only in their capacity as exporters. Throughout this paper, proceedings are counted in accordance to the WTO methodology, notably by looking at the product investigated, country concerned and type of investigation (AD or AS). The most active trade bloc is NAFTA with 205 cases, followed by MERCOSUR with 154, EMU with 138 and CAN with 41. It is interesting to note the existence of intra-trade bloc rivalry among its members, notably 24 proceedings in the case of MERCOSUR (3rd stage of economic integration) and 20 in NAFTA (2nd - more loose - stage of economic integration).

Importing Trade Bloc EMU CAN MERCOSUR NAFTA Other WTO Members Total Grand Total

7

Type AD AS AD AS AD AS AD AS AD AS AD AS AD/AS

CAN

EMU

3

9

1

14

4

24 1 47 1 48

4

Exporting Trade Bloc MERCOSUR NAFTA Non-WTO countries 1 6 13 2 5 4 1 24 13 1 10 3 15 2 55 5 60

18 2 50 1 92 5 97

5 34 53 53

Other WTO Members 108 8 31 103 1 117 35 563 7 922 51 973

Reports are available through the WTO ―Documents Online‖ website at http://docsonline.wto.org/

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Grand Total 128 10 40 1 153 1 165 40 686 11 1173 62 1235

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The case distribution among the two proceeding types is bigger than 90% of AD cases (1173) in comparison to less than 10% of AS cases (62). NAFTA is by far the more active trade bloc with 40 AS proceedings versus 10 in the EMU.

First Level Analysis Trying to interpret the data of the above table, we present a series of interesting conclusions alongside there corroborating arguments: TDI is an instrument of trade and/or foreign policy

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Trade flows have not followed theoretical econometric models, but rather the internal economic and wider political considerations of the nations (i.e. the trade 8 policy of the main NAFTA nation - the USA - is a foreign policy tool ). It is interesting to compare the modest number of investigations and definitive measures imposed by the EMU with the disproportionate high numbers of other trade blocs with much smaller import trade volume (i.a. MERCOSUR). Being a pioneer of trade, the EMU leading by example is applying higher than required by WTO initiation and investigation standards (i.a. Lesser Duty Rule and Community Interest test). The other size of the coin is the fact that the Community is one of the main targets of anti-dumping action by third countries, which often apply inferior standards (i.a. lower level of proofs for the prima facie initiation of investigations, poor injury and causality analysis and disregard for the rights of defence of interested parties). TDI, rather than being a barrier to rapid trade liberalisation, provides a pressure valve for liberalising sectors to adjust to new situations. Therefore, most liberalising shocks, such as quota dismantling, were accompanied by the use of TDI by the industries concerned (i.a. the case of footwear industry in EMU). In contrast to developing countries, the industrialized nations insist that conditional domestic protection is key to gradually liberalizing international trade.

Higher economic integration results to less rivalry among members The statistics show that the trade blocs in a higher stage of integration (above common market stage) usually do not recourse to TDI measures. By definition there are no tariff and/or non-tariff barriers in a single market. That is the reason why in the EMU trade bloc (= a single market with a common currency, the Euro), there are no proceedings against its members. In contrast, in a FTA usually the most important financial member gets the benefit of the relevant competitive advantage.

Soaring industrial GDPs contribute to higher TDI activity According to the 2008 classification of leading exporters and importers in world merchandise trade (excluding intra-EU trade), the EMU trade bloc is occupying the first position both in the importer and exporter segments, closely followed by the 3 NAFTA nations (Top 10 positions). Only the biggest (Brazil) of the 5 MERCOSUR nations occupy a position in the last Top 20 places. Statistics shows that trade blocs 8

For example, the US Trade Representative delayed signing RTAS with Chile and New Zealand after the countries openly opposed the US war in Iraq.

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Christos Bezirtzoglou with higher industrial GDP (i.a. NAFTA) contribute also the highest number of complaints (WTO, 2009). Demographical trends in trade bloc with high GDP have an impact on the production factors, i.e. the lack of workers, in particular low skilled, is often accommodated by the de-location of the industry to a nation with lower GDP.

The EMU is a prudent user of TDI The EMU has created a legal framework in the European Union which allows the Community industry only to launch complaints when the competitive distortions are substantial and they are injured by them (Giannakopoulos, 2006). The Lesser Duty Rule provide that the amount of AD duties may not exceed the dumping margin, but it should be less if such a lesser duty would be sufficient to remove the injury (Farr, 1998). The end result is that in a big majority of cases the duty has been reduced. Public Interest considerations or Community Interest in EU terminology, as a precondition for the imposition of anti-dumping measures is currently used mandatory only by the EMU trade bloc (Mueller et al., 2009). In the EMU the parties with relevant interests are the Community industry and other Community producers, the upstream industry, the unrelated importers and traders in the Community, the final consumers and the users.

TDI is a trade tool for multi-national corporations

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Today the Multi-National Corporations (MNCs) represent the most important factor in the internal economy. In the Top 100 economies of the world, a whooping 51 correspondents to MNCs. The distribution of the headquarters of the Top500 9 companies in the study trade blocs are: NAFTA 193, EMU 163, MERCOSUR 5 and CAN 0. There is a polemic whether MNCs, due to their size, are able to use easier the TDI vis-à-vis the SMEs, as well as whether the nations that accommodate them are more likely to open TDI investigations. The figures seem to corroborate the truth of this argument.

9

Fortune magazine, July 2008.

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Anti-subsidy activity remains marginal compared to Anti-dumping Even though anti-subsidy is often surrounded by significantly less controversy than anti-dumping given the political consensus that subsidisation can lead to unfair distortions in trade, industry seems to have difficulties in putting AS complaints together.

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CONCLUSIONS FOR FURTHER RESEARCH This paper presented a portrait of the differences in the usage of the main defensive trade remedy proceedings by representative trade blocs at different levels of economic integration. Against the background of the common multilateral framework, they still exist significant differences between the trade remedy practices of the divers' trade blocs. Our analysis showed that regional trade agreements with higher economic integration results to less rivalry among their members. The author highlighted the responsible way that the EMU is applying trade remedies in an environment where higher industrial GDPs are translated to a higher TDI activity and in a milieu that harbours half of the biggest multi-national corporations. The explanation why anti-subsidy activity remains marginal compared to anti-dumping may be linked to the fact that anti-subsidy investigations require broader expertise and better trained resources both from the side of the industry as well as from the side of the investigating authorities. The author hopes that the trade bloc approach will spawned additional research into the practices of the RTAs, thus improving transparency and allowing for better scientific understanding over the implications of the main defensive trade defence policy instruments in a multi-lateral trading system.

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Selected Websites Tackling Unfair Trade - The European Union trade remedies site WTO Trade Topics – The World Trade Organisation Trade topics site OECD Trade - The Organisation for Economic Co-operation and Development Trade issues site Global Antidumping Database - Data of major users collected by Chad Bown in conjunction with the World Bank. U.S. Antidumping and Countervailing Duty Database - Case-specific data on U.S. antidumping and countervailing duty activity Antidumpingpublishing.com – A web portal managed by Cliff Stevenson that provides up-to-date news and information on antidumping events worldwide.

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INDICATIVE BIBLIOGRAPHY Adamantopoulos, K. & Pereyra, M. (2007), ―EU Anti-subsidy Law & Practice‖, London: Sweet&Maxwell. Bethlehem, D., McRae, D., Neufeld, R. & Van Damme, I. (2009), "International Trade Law", New York: Oxford University Press. Fabio, M. (2009), ―Customs Law of the European Union‖, Kluwer Law International. Farr, S. (1998), ―EU Anti-dumping Law‖, Palladian Law Publishing. Giannakopoulos, T. (2006), ―A concise guide to the EU Anti-dumping/Anti-subsidies procedures‖, Kluwer Law International. Inama, S. & Vermulst, E. (1999), "Customs and Trade Laws of the European Community", Kluwer Law International. Lasok, D. (1998), "The Trade and Customs Law of the European Union", Kluwer Law International. Lyons, T. (2001), "EC Customs Law", New York: Oxford University Press. Milner, Helen V., "International Trade" in Carlsnaes, Walter; Thomas Risse, Beth A. Simmons (2002). Handbook of International Relations, London: SAGE Publications. Mueller, Wolfgang, Khan, Nicholas & Scharf, Tibor, (2009), "EC and WTO Anti-dumping Law: A Handbook", New York: Oxford University Press. Stanbrook, C. & Bentley, P. (1996), ―Dumping and Subsidies‖. Kluwer Law International. Terra, B. (1995), "Community Customs Law", The Hague: Kluwer Law International. Vermulst, E. & Waer, P. (1996), "E.C. Anti-dumping Law and Practice", London: Sweet & Maxwell. Weiler, J. (ed.) (2000). "The EU, the WTO and the NAFTA", New York: Oxford University Press. Wikimedia Foundation contributors (2009), Terms of Use [Internet], Wikimedia Foundation. WTO (2009), "World Trade Report 2009: Trade policy Commitments and Contingency Measures", World Trade Organisation.

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Does Higher Economic Integration of Trade Blocs Leads to Fair Trade?

221

ABOUT THE AUTHOR

Christos Bezirtzoglou was born in Athens (Greece) in 1966. He studied Physics with specialisation in Electronics and Computers. He worked as a trainer and consultant in Information and Communication Technologies for ten years. In 1994 he moved to Brussels (Belgium) to join the European Commission, where he occupied different posts both in policy Directorates-General (Environment, Competition, Regional Policy & Trade) as well as in policy coordination (Secretariat-General & Cabinet of Commissioner Diamantopoulou).

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Endnotes It ought to be noted that all information presented in this paper is considered to be of a preliminary nature and users should contact the relevant competent authorities and other public or private organisations for further details or advice concerning any particular course of action. The author would like in particular to thank Stefania Nardelli for commenting on an earlier version of this paper. The paper does not reflect the official position of the European Commission. Neither the European Commission nor the author or any person acting on their behalf is responsible for the use which might be made of the information contained herein.

Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

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In: Developing Economies Editor: Joanne M. Carcillo

ISBN: 978-1-61122-541-9 c 2011 Nova Science Publishers, Inc.

Chapter 9

I NTERACTIONS BETWEEN E CONOMIC G ROWTH , I NNOVATION , F INANCIAL D EVELOPMENT AND S USTAINABILITY IN E MERGING C OUNTRIES Ozan Bakis∗, Fatih Karanfil†and Sezgin Polat‡ Department of Economics and Galatasaray University Economic Research Center (GIAM), Galatasaray University, Turkey

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Abstract Combining different data sets, this study examines possible linkages between economic growth, innovation and energy and environmental efficiency. In the related literature, previous studies had looked for the link between: (1) financial development and economic growth; (2) energy consumption (or CO2 emissions) and economic growth; (3) innovation (or research and development) and economic growth. However, we believe that a larger and more detailed study is needed to provide insight into the possible interrelatedness and interaction between these variables. To do this work in this chapter, we carry out an empirical study employing the Arellano-Bond estimator. The results will increase our understanding of empirical relationships among the variables involved, thus having important implications for environmental, economic and innovation policies.

Keywords: Economic growth, Innovation, Financial development, Energy and environmental efficiency.

1.

Introduction

During the past two decades the sustainability and environmental degradation issues have gained importance in both political and academic circles. Several conferences have been ∗

E-mail address: [email protected] E-mail address: [email protected] ‡ E-mail address: [email protected] †

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Ozan Bakis, Fatih Karanfil and Sezgin Polat

organized in order to reach some agreements on the subject. Mainly, starting from the Earth Summit (Rio de Janeiro, June 3-14, 1992) the negative effects of global warming have been accounted for more accurately. The Earth Summit succeeded by an agreement on the Climate Change Convention which have evolved into the Kyoto Protocol (Kyoto, December, 11, 1997). Article 2 of this protocol defines the “ultimate” objective of the Climate Change Convention as “stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system” (UNFCCC, 1992). This reflects clearly the will of countries that have signed and ratified the protocol, to reduce greenhouse gases (GHG) emissions.1 Recently at the United Nations Climate Change Conference (Copenhagen, December, 7-18, 2009), 115 world leaders including heads of state, heads of government and ministers worked, once again, on the Climate Change Convention in order to make an account of energy and environmental policies implemented so far. We would like to mention here some sections of the Copenhagen Accord, which can provide the motivation of the present chapter. Article 1 of this accord defines the climate change as one of the today’s greatest challenges. According to this accord, participating leaders emphasize their “strong political will to urgently combat climate change in accordance with the principle of common but differentiated responsibilities and respective capabilities”. From this statement we can deduce two arguments: first, each country has different responsibility for the current state of the climate change and second, each country has different capabilities to combat it. How to do so, although not very precise, is explained in the following articles of the accord. Article 2 focuses on the cooperation issue citing that countries “should cooperate in achieving the peaking of global and national emissions as soon as possible, recognizing that the time frame for peaking will be longer in developing countries and bearing in mind that social and economic development and poverty eradication are the first and overriding priorities of developing countries and that a low-emission development strategy is indispensable to sustainable development”. It is seen clearly that the accord recognizes the fact that developing countries have other priorities than GHG emissions, such as economic development and poverty. However, it is also mentioned that development strategies in these countries should be designed in accordance with the global stabilization of GHG emissions. This is in fact a sine qua non condition of sustainable development. For this purpose, according to Article 7 of the accord, “developing countries, especially those with low emitting economies should be provided incentives to continue to develop on a low emission pathway”. It is not clear what kind of incentives are envisaged, although in Article 3, it is stated that the parties “agree that developed countries shall provide adequate, predictable and sustainable financial resources, technology and capacity-building to support the implementation of adaptation action in developing countries”. This final statement puts in evidence the impact of other non environmental factors in the GHG emissions scheme. Implicitly the statement assumes also that there are some linkages between the level of financial development, the technology and the polluting emissions. To test for the validity of this assumption is the main motivation of this chapter. We believe that detailed study are needed in this research area in order to provide insight into the possible interrelatedness and interaction between 1

A more detailed discussion on both the Earth Summit and the Kyoto Protocol goes beyond the purpose of this chapter. Detailed documentations and reports are provided on line by United Nations Framework Convention on Climate Change (http://unfccc.int). Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

Interactions between Economic Growth, Innovation, Financial Development ... 225 these variables. The results of such studies will increase our understanding of empirical relationships among the variables involved, thus having important implications for environmental, economic and innovation policies. The rest of the chapter is organized as follows. In Section 2, we provide a brief literature survey to position our research in the existing literature. In Section 3, we describe the data used in the study and discuss the methodologies employed. Section 4 presents the main results obtained and Section 5 concludes the chapter.

2.

Literature Survey

Environmental and energy economics literature, as in many other domains, consists of both theoretical and empirical researches. So far, in the field of theoretical economics an increasing number of papers have introduced the sustainability issue in such a way that they analyze the conditions under which economy could have a positive long-run growth in the presence of a non-renewable (in most cases, also exhaustible) natural resources. Furthermore, the problem is mostly posed in the standard utilitarian framework and solved for an optimal depletion policy. A very general formulation of the problem to be solved by the decision maker is the following. max

Z

∞

eρt u(Ct )dt

0

K˙ t = F (Kt, Rt) − Ct S˙t = −Rt

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Ct ; Kt; Rt; St ≥ 0 K0 ; S0 given. where the decision maker discounts future utility, u that is increasing function of consumption C, at rate ρ. Production factors are capital K and natural ressource R. While the accumulation of capital stock K˙ t is given by the difference between production and consumption, the stock of the resource is depleted S˙t with its extraction and its use in the production. The solution of this dynamic system gives the conditions for the durability of C˙ the optimal consumption path (that is, C > 0). The aforementioned system of equations has been further developed in order to introduce other economic environmental and economic variables and thus to consider a more realistic framework. For example, since the pioneering studies of Solow (1956), Stiglitz (1974) and Dasgupta and Heal (1974), many theoretical papers have investigated the impact of technological change (or more specifically, energy saving technical progress) on both the use of natural resource in the production (production side) and, in the form of air quality or pollution for instance, the consumers utility (consumption side). Other directions in this field, such as environmental taxation, human capital and knowledge have also been studied.2 2

Since it is not possible to review in detail all studies in this field, we refer the reader to more comprehensive reviews in Loschel (2002) and Ricci (2007). Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

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Although the results depend largely on the model specifications, this kind of theoretical works have provided useful insights into the sustainability problem. In parallel with the developments in the theoretical literature, empirical research in environmental economics has gained impetus in recent years and today there is a large number of published work in this field, even more abundant than the theoretical one. Empirical studies employing time-series or panel data and cross-country regressions constitute the majority of this literature. Among the main subjects studied, (1) the economy-environment relationship, more specifically, the impact of economic development on environmental degradation and (2) the investigation of the causal linkages between economy-related variables and energy-related variables, are those which are dominant subjects in this field and related to this chapter. The first group of literature is about estimating for different countries the relationship between economic development and pollution (or pollutant emissions) employing econometric techniques. Since the pioneering study by Grossmann and Krueger (1993), representation of economic development and pollutant emissions (i.e. carbon dioxide, CO2 ) or energy consumption by an inverted-U curve became popular among the environmental economists.3 The intuition behind such a relationship, that is called environmental Kuznets curve (EKC) hypothesis4, is that in the early stages of economic development, both economic growth and polluting emissions may increase and there may exist a “turning point” income beyond which economic growth may lead to a decrease in emissions. More specifically, we may formalize this intuition in the following fashion:

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lnet = α + δ1 lnyt + δ2 (lnyt )2 + t where ln indicates natural logarithms, et is an indicator of environmental degradation (for example per capita CO2 emissions), y denotes income per capita (for example per capita GDP) and t and α represent respectively the stochastic error term and the constant. The shape of a possible curve is determined by the parameters δ1 and δ2 . The simple idea is that the relationship between per capita CO2 emissions and per capita GDP may have an inverted U-shape if δ1 > 0 and δ2 < 0. On the other hand the “turning point” income, where CO2 emissions reach their maximum level, can simply calculated by lnyt = −δ1 /2δ2 , hence yt = exp(−δ1 /2δ2 ). Estimating the equation above using time-series data (in the case of country-specific analysis) or panel data shows whether the EKC hypothesis is supported or not. Still in the first group, one should also consider convergence studies which discuss the issue of cross-country CO2 emission convergence. In these studies, absolute convergence (only emissions are considered) or conditional convergence (other explanatory variables, such as GDP, population, industrial value added, are also accounted for) hypothesis has been tested using econometric tools. The contribution of such studies is that time paths of emissions of different countries are analyzed together and that the effectiveness of environmental policies, aiming at having a sustainable economic growth, in a multinational 3

See Stern (2004) for an excellent literature review on this subject. Simon Kuznets, who received the Nobel Prize in Economics in 1971, introduced first the inverted-U curve relationship between economic development and degree of inequality. Then the same idea has been used to identify the development-environment nexus, which is thus called EKC hypothesis. 4

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Interactions between Economic Growth, Innovation, Financial Development ... 227 approach can be discussed more accurately.5 The second group of literature focuses on the causal relationship between the variables of interest. The standard Granger (1969) causality test has been used in the related literature to test the causality hypothesis between two variables. The idea of this causality is given by Granger (1988, p.200) who states that “if yt causes xt , then xt+1 is better forecast if the information in yt−j is used than if it is not used”. In a more technical fashion we can rewrite this statement as follows. Consider two variables (time-series) X1 and X2 . The variable X2 does not Granger cause the variable X1 if

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E(X1t/It−1 (X1 ), It−1 (X2 )) = E(X1t/It−1 (X1 )) where It−1 (Xi ) is the space generated by the linear combinations of the past values of Xi . As in the EKC hypothesis testing, the causality hypothesis can be tested for a country (using time series data) or for a group of country (using panel data). The results of this kind of causality studies address the sustainability issue in the sense that if there is a causal relationship running from economic growth to energy consumption (or CO2 emissions) environmental policies should be implemented in order to prevent environmental degradation caused by the pollution and depletion of natural resources. However, if the causality runs in the opposite direction, then environmental policies may impede economic growth. 6 As pointed out by Karanfil (2009), more reflections in this research area are needed and new techniques and new variables should be used in order to increase our understanding of the economy-environment relationship. In this view, for example, recently Sadorsky (2010) provided a study for 22 emerging countries covering the period 1990-2006, and showed that there exist some relationships between financial development and energy consumption. This chapter considers the sustainability issue by analyzing the long-run relationships between emissions, energy consumption, economic and financial variables, technology and communication indicators. Passing from a bivariate to a multivariate frameworks, it extends the environment-economy relationship and aims at providing useful insights in this context. A relatively novel approach, the Arellano-Bond estimator is employed to do this work.

3.

Data and Methodology

We have chosen nine emerging economies to compare the cross-country pattern of the sustainable development perspective which gained momentum with the second half of 1980s. We know that countries like Argentina, Brazil, Chile, Korea Republic, Malaysia, Mexico, Poland, South Africa and Turkey have undergone similar course of liberalization of international trade which led to a growing use of technology under the export-promoting development strategy. Throughout the two decades, it is possible that the diffusion of technological adaptation produces similar externality effects on the energy use and on the environmental pollution as in early developed countries, though these countries differ by their economic and political institutions. We will try to combine some of the institutional indicators with 5

In a very recent study, Jobert et al. (Forthcoming) analyzes the convergence issue in the European Union context and provides also a nice overview of the literature in this field. 6 More discussion on this subject can be found in Jobert and Karanfil (2007) and Karanfil (2008) who provide a literature survey and review methodological issues in the Granger causality testing procedure. Developing Economies: Innovation, Investment and Sustainability : Innovation, Investment and Sustainability, edited by Joanne M. Carcillo, Nova

228

Ozan Bakis, Fatih Karanfil and Sezgin Polat Table 1. Description of variables

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Variable name gdp rural co2 alter en el credit ict ict spend merch ex trade internet cell phone tphone regulation political

Variable definition GDP per capita (constant 2000 US$) Rural population (% of total population) Per capita CO2 emissions (metric tons per capita) Alternative and nuclear energy (% of total energy use) Per capita energy use (kg of oil equivalent per capita) Per capita electric power consumption (kWh per capita) Domestic credit provided by banking sector (% of GDP) ICT goods trade volume (% of total goods traded) Information and communication technology expenditure (% of GDP ) Manufactures exports (% of merchandise exports) Merchandise trade (% of GDP) Internet users (per 100 people) Mobile cellular subscriptions (per 100 people) Telephone lines (per 100 people) Regulatory quality index Political stability and no violence index

the development indicators reflecting the production and use of information and communication technologies to have a more comprehensive model. Our dataset are gathered from two different sets of indicators supplied by the World Bank. Most of the data are selected from the World Development Indicators (WDI) which provide a comprehensive selection of economic, social and environmental indicators, drawing on data from the World Bank and more than 30 partner agencies. Other data source that our study uses is the new 2009 update of the Worldwide Governance Indicators (WGI) research project, measuring six dimensions of governance between 1996 and 2008. These aggregate indicators are based on hundreds of specific and disaggregated individual variables measuring various dimensions of governance and they are taken from 35 data sources provided by 33 different organizations. These indicators are constructed using an unobserved components methodology. The six governance indicators are measured in units ranging from about -2.5 to 2.5, with higher values corresponding to better governance outcomes. We only used two of them which are more relevant for our model namely Political Stability and Absence of Violence/Terrorism and Regulatory Quality. Table 1 gives the definition of each variable used in the estimations. Our observation period covers the years between 1985 and 2006 providing enough information about the development trajectory of the mentioned countries. To conduct our econometric study, we employ the Arellano-Bond dynamic panel General Method of Moments (GMM) estimator (Arellano and Bond, 1991). The idea behind the Arellano-Bond estimator is to estimate a fixed-effects model for a short panel when lagged values of dependent variables are also regressors. The fixed-effect is eliminated by firstdifferencing. To obtain consistent estimates for this first-differenced model, we need to use

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Interactions between Economic Growth, Innovation, Financial Development ... 229 appropriate lags of regressors as the instruments. This estimator is called Arellano-Bond estimator. The typical equation to be estimated is the following: yi,t = β1 yi,t−1 + · · · + βp yi,t−p + Xit0 α + ai + ei,t ,

t = p + 1, . . . , T

(1)

where y denotes per capita CO2 emissions, X is a covariate vector including different variables depending on the model specification. Moreover, X is assumed to be uncorrelated with error term eit . From Eq. (1), our aim is to consistently estimate the parameters β and α when ai is a fixed effect. There are several reasons that cause correlation in y over time: true state dependence (through y in preceding periods); observed heterogeneity (through X ); and finally unobserved heterogeneity (through unobserved time-invariant individual effect ai ). It is known that the fixed-effect estimator is inconsistent if lagged variables are used as covariates. The reason is that the time demeaned regressors yi,t−1 − y¯i are correlated with the time demeaned error term, ei,t − e¯i (Cameron and Trivedi, 2009, pp. 287-8). Given that, one can not use instrumental variable (IV) estimation based on lagged variables because any lag of the dependent variables will also be correlated with the average error term. However, IV estimators of the first-differenced (FD) estimators using appropriate lags of the dependent variables as instruments yield consistent estimators in spite of the fact that the first-differenced OLS estimators are inconsistent. The FD model can be written as follows.

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∆yi,t = β1 ∆yi,t−1 + · · · + βp ∆yi,t−p + ∆Xit0 α + ∆ei,t ,

t = p + 1, . . . , T

(2)

The reason why he regressor ∆yi,t−1 = yi,t−1 − yi,t−2 is correlated with ∆ei,t−1 = ei,t−1 − ei,t−2 is that yi,t−1 is correlated with ei,t−1 . But ∆ei,t will be uncorrelated with yi,t−k if k ≥ 2. One of the crucial assumption of the Arellano-Bond estimator is that ei,t are serially uncorrelated. Modern statistical packages implement Arellano-Bond estimator and their proposed tests for this crucial assumption (i.e. the error terms are serially uncorrelated).

4.

Results and Discussion

In this section, three different model specifications will be considered in order to obtain an accurate view of the relationships between the variables involved in the analysis. The models are specified as follows. • Model 1: The only endogenous variable is lgdp. We instrument this variable by its second lag. • Model 2: We continue with Model 1 but assume ict, ict spend, credit, trade, merch ex to be endogenous also. As above we use their second lags as their instruments. • Model 3: This is similar to Model 2. The only difference is that political, regulation and rural are assumed to be predetermined variables. Both their current level and

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Ozan Bakis, Fatih Karanfil and Sezgin Polat

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Table 2. Results VARIABLES L.co2 L2.co2 L3.co2 L4.co2 L5.co2 L6.co2 political L.political regulation L.regulation rural L.rural lgdp ict ict spend credit trade merch ex alter len lel tphone cell phone internet D.lgdp Constant

Model 1 0.13 -0.24** 0.19* -0.07 -0.07 -0.34*** 0.09

Model 2 0.10 -0.27** 0.17** -0.09 -0.06 -0.32*** 0.11*

-1.39***

-1.28***

0.08

0.05

8.21*** 0.00 -0.09 0.00 0.01 -0.01 -0.12*** 3.86*** -2.22 -0.00 -0.02*** -0.03*** -2.87 -72.72***

7.18** 0.00 -0.08 -0.00 0.01 -0.00 -0.11*** 3.83*** -1.94 -0.01 -0.02* -0.03*** -2.67 -64.97***

Model 3 0.96*** -0.03 0.50*** -0.12* -0.35*** -0.41*** 0.50*** 1.15*** -3.44*** -2.87*** 0.77*** 0.45*** 15.73*** -0.02* -0.32*** -0.01*** -0.04*** -0.10*** -0.33*** 2.30*** -1.18* -0.00 -0.04*** 0.02*** 1.60 -152.82***

*** p