Economic Development in East and Southeast Asia: Essays in Honor of Professor Shinichi Ichimura 9789814379373

Citation preview

Economic Development in East and Southeast Asia

Essays in Honor of

Professor Shiniehi Iehimura

I5EA5 INSTITUTE OF SOUTHEAST ASIAN STUDIES, Singapore The Institute of Southeast Asian Studies was established as an autonomous organization in 1968. It is a regional research center for scholars and other specialists concerned with modern Southeast Asia, particularly the multi-faceted problems of stability and security, economic development, and political and social change. The Institute is governed by a twenty-two m ember Board of 'Itustees comprising nominees from the Singapore Government, the National University of Singapore, the various Chambers of Commerce and professional and civic organizations. A ten-man Executive Committee oversees day-to-day operations; it is chaired by the Director, the Institute's chief academic and administrative officer. The ASEAN Economic Research Unit is an integral part of the Institute, coming under the overall supervision oft he Director who is also the Chairman of its Management Committee. The Unit was formed in 1979 in response to the need to deepen understanding of economic change and political developments in ASEAN. The dayto-day operations of the Unit are the responsibility of the Co-ordinator. A R~gional Advisory Committee, consisting of a senior economist from each of the ASEAN countries, guides th e work of the Unit.

.Jv

EAST-WEST CENTER, Honolulu

The East-West Center is a public, non-profit educational institution established in Hawaii in 1960 by the U.S. Congress. The Center's mandate is "to promote better relations and understanding among the nations of Asia, the Pacific, and the United States through co-operative study, training, and research". Some 2,000 research fellows, graduate students, and professionals in business and government each year work with th e Center's international staff on major Asia-Pacific issues relating to population, resources and development, the environment, culture, and communication. Since 1960, more than 25,000 men and women from the region have participated in the Center's co-operative programs. The Resource Systems Institute (RSI) undertakes policy studies on issues related to the economic growth and development of the Asia-Pacific region and on the implications that growth holds for U.S. relations with the region. Research conducted by RSI is grouped under four major programs - Development Policy, Energy, Minerals Policy and Special Studies. The Development Policy program analyses the economic performance of developing Asian countries and examines the effectiveness of their development policies in today's ever-changing and interdependen t economic and political environments. The vital role of resource development is stressed in the work undertaken by the Energy and Minerals Policy programs. The Special Studies program comprises research on rural transformation and marine resource policy.

Economic Development in East and Southeast Asia

Essays in Honor of Professor Shiniehi lehimura ... S81)1

Naya

.Jv

Resource Systems Institute East-West Center Honolulu

Edited by and

Ak.

Ira

Takayama

I5ER5 ASEAN Economic Research Unit Institute of Southeast Asian Studies Singapore

Published jointly by In.~itute

of Southeast Asian Studies Heng Mui Keng 'Ierrace Pa.sir Ftmjang Singapore 0511

and

.East-West Center 1777 .East-West Road Honolulu Hawaii 96848

All rights reserved. No part ofthis publication may be reproduced, stored in a retrieval syStem, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the Institute of Southeast Asian Studies and the East-West Center.

© 1990 Institute of Southeast Asian Studies and the East-West Center The responsibility for facts and opinions expressed in this publication rests exclusively with the authors and their interpretations do not necessarily reflect the views or the policy ofthe Institute and the Center or their supporters.

Cataloguing in PubHcatlon Data

Economic development in East and Southeast Asia : essays in honor of Professor Shinichi lchimura I editors, Seiji Naya and Akira Thkayama. 1. Asia, Southeastern-Economic conditions. 2. ASEAN countries-Economic conditions. 3. East Asia-Economic conditions. I. Naya, Seiji. II. Thkayatna, Akira, 193.2III. Institute of Southeast Asian Studies (Singapore). HC441 :&21 1990 sls90-40301 ISBN 981-3035-63-3 (soft cover) ISBN 981-3035-64·1 (hard cover) 'I)lpeset by The Fototype Business

Printed in Singapore by Loi Printing Pte Ltd.

PREFACE

This volume is compiled as a tribute to Professor Shinichi Ichimura who has contributed so much to creating a better understanding of development issues .and problems in Asia. As shown by the biographical information on the pages following the preface, his active involvement in joint projects and various institutions has enhanced our knowledge of development issues; but his accomplishments go beyond this. Through his active participation in academics and the development of institutions that are dedicated to studying development issues of the region, Professor Ichimura has also contributed to the welfare and development of young scholars who are interested in Asian economic development. Professor Ichimura's accomplishments are numerous and impressive. It is only fitting, therefore, to dedicate this volume to a man who has contributed so much and who continues to share his wealth of knowledge and insights. The articles that are collected in this volume span a wide range of topics.

vi

· Preface

As is befitting for a book dedicated to Professor Ichimura, all of the articles examine and discuss development issues and problems that have faced or are being faced by the countries of East and Southeast Asia. Both of the editors and al1 of the authors in this book have had the pleasure and honor of working with Professor Ichimura at one time or another; and each of us has gained from Professor Ichimura's k now ledge and experience. Our heartfelt appreciation goes out to Shinichi Ichimura for his dedication to the economics and academic profession, and for his many contributions to creating a better understanding of the development issues faced by the countries of the region. This volume represents the combined efforts and dedication of many persons. We would like to thank Professor Mitsuo Ezaki of Kyoto University for his generous support throughout this project. Special thanks go to janis Thgashi for her untiring efforts and outstanding support in preparing the volume for publication. We also acknowledge David Puhlick and Audrey Shono for their editorial assistance, and Cynthia Nakachi for the secretarial help in preparing the manuscript. Without the support, dedication and hard work of these people, this project would never have been completed.

SHINICHIICHIMURA, 1925-

Professor Shinichi Ichimura was born in Kyoto, japan in 1925. After being graduated from the Department of Indonesian Languages, Osaka College of Foreign Languages in 1941, he entered and was graduated from the Faculty of Economics, Kyoto University in 1949. After grad~ate work in economics at Columbia University in 1950-51, h e moved to the graduate program at the Massachusetts Institute ofThchnology, where he obtained a Ph.D. in Economics in 1953. In 1963, h e was awarded a Doctor of Economics (under the old system) from Osaka University. His professional life so far may be divided into two parts. In the first period, Professor Ichimura was a member of the faculty of Wakayama University (Faculty of Economics) from 1949-56, and of Osaka University (Institute of Social and Economic Resear ch) from 1956- 68. During this ·period h e also taught at Johns Hopkins University (1959-60), the University of California at Berkeley (1965-66), and the University of Pennsylvania (1966-67). His interests

viii

Shinichi Ichimura, 1925-

during this time included both the theoretical and empirical aspects of the then current economic issues including studies on related goods, consumer surplus, nonlinear business cycle theories, national income analysis, demand and suppy of money, international trade, and input-output analysis, and the japanese economy. He produced a number of professional articles and books on these subjects both in English and in Japanese. In the course of this first period, his interest shifted from theoretical research to empirical studies and began to focus more on the Japanese economy. Furthermore, in 1963, he was elected Fellow of the Econometric Society, and was coeditor of Economics Studies Quarterly from 1960-65. His move to the Center for Southeast Asian Studies at Kyoto University in 1968 signals the beginning of the second period of his professional life. At this time his interests changed dramatically and shifted to the study of the Southeast Asian economies. His research encompasses such topics as regional economic research on South Sumatra, agricultural development and the green revolution, the effect of climatic factors on the socio-economic structure of Southeast Asian countries, Japanese jointventures in Southeast Asia, cultural conflicts and labor-management relations, cultural and institutional factors and appropriate technology, economic development of Indonesia, the scope of economic development of Asia, political aspects of development policies, and debt accumulation in connection with the North-South problem. Not only has he generated a great deal of research in the study of East and Southeast Asia, but he has also continuously encouraged and assisted many young scholars in japan interested in the field. He has organized private study groups on the Southeast Asian economies, and has directly trained young students. In other words, he has been keenly interested in the welfare and development of young scholars who would like to study Southeast Asian countries. He is an educator as well as a scholar. Professor Ichimura served as the Director of the Center for Southeast Asian Studies at Kyoto University (the "Center") for ten years from 1969-79. In this period, the Center grew from an infant institution to a highly-respected research institution, and is now well-recognized as a true center for the study of Southeast Asian countries in Japan. During this second period, Professor Ichimura was also a visiting faculty member at the Universitat Bonn (1980), the East-West Center in Honolulu (1985), the National University of Singapore (1985), and Columbia University (1986). At the same time, he has energetically traveled the world at the request of international organizations and governments. Professor Ichimura has served on a number of advisory committees for various Ministers of the Government ofJapan. He has also been serving as a member of the advisory committee for Development Planning for the Director General of the United Nations since 1972. Thday, he is still seen in action in various corners of the world. Recently, Professor Ichimura with other prominent Asian economists established the East Asian Economic Association (EAEA). With its academic orientation and its emphasis on the application of economic theory to current

Shinichi Tchimura, 1925-

lX

issues and problems in East and Southeast Asia, EAEA is unique and is expected to be in the forefront of development studies of the region. Professor Ich imura has become the editor ofEA:EA'sjournal, Asian Economic]ournal. In March 1988, Professor Ichimura retired from Kyoto University and then helped to establish Osaka International University. He has become ViceChancellor, Director of the Institute ofinternational Relations, and Professor of Economics at the University. He continues, with even more elan, his study of Asian countries after his "retirement". For example two books were published in 1988 under his editorship: (1) Challenge of Asian Developing Countries (Thkyo: Asian Productivity Organization), and (2) Indonesian Economic Development (Thkyo: Japan International Cooperation Agency - an Indonesian edition is forth coming from the University of Indonesia).

CONTENTS Preface Shinichi Ichimura, 1925Introduction Seiji Naya and Akira Thkayama Contributors to This Volume

v

vii xiii

xix

I

Structural Change and Economic Development in Developing Asia in the 1990s Malcolm Dowling

1

II

Explaining the Success of the Four Little Dragons: A Survey George Hicks

20

III

'flliwan's Economic Miracle: A Singaporean Perspective Lim Chong.:Yah

38

IV

Singapore's Experience of Industrial Restructuring: Lessons for the Other Asian NIEs John Wong

57

v

Korean Industrial Policies for Declining Industries Ji-Hong Kim

72

VI

Vietnam: Recent Economic Developments and the World Econo.m y Nguyen Xuan Oanh

94

VII

Transition from Import Substitution to Export Expansion: The Thai Experience Narongchai Akrasanee and Somsak Thmbunlertchai

104

VIII

Adjustment Problems of a Small Oil-Exporting Country: Did Indonesia Suffer from the Dutch Disease? Mari Pangestu

121

A Quarterly Econometric Model of the Hong Kong Economy W.L. Chou and Thong-Biau Lin

138

IX

xii

Contents

X

The Effect of Ricardian Rent Extracting on Macroeconomic Performance Manuel F. Montes

155

XI

Direct Foreign Investment and the Economic Development of Korea Chung H. Lee

169

XII

japanese Investment in Thailand: Looking Back and Into the Future Mingsarn Santikarn Kaosa-ard

185

XIII

The Effects of Direct Foreign. Investment on 'Jaiwan: A Macroeconometric Investigation Eric D. Ramstetter

202

XIV

A Reform of the Foward Foreign Exchange Market and Foreign Exchange Rate Determination Policy in Korea, with For-eign Exchange Policy Experiences of 'Jaiwan Yen Kyun Wang and Wan-Soon Kim

228

XV

Interest Rate and Foreign Exchange Liberalization in 'Jaiwan in the 1980s Christina Y. Liu and Shirley W.Y. Kuo

242

XVI

Manifold Dilemmas behind External Debt Management Virabongsa Ramangkura and Pakorn Vichyanond

256

XVII

Agricultural Growth and Food Imports in Developing Countries: A Reexamination Romeo M. Bautista

266

XVIII

The Transformation of Rural Asia and Economic Development Theory and Policy William E. James

281

XIX

The ASEAN Summit and ASEAN Economic Cooperation Florian A. Alburo

299

XX

The Role of Developing Countries in the New GATT Round Mohammad Sadli

307

XXI

The Emerging Global Economy and the Role ofthe Asian NIEs Pang Eng Fong and Augustine H.H. Thn

319

Index

333

INTRODUCTION SEIJI NAYA and AKIRA TAKAYAMA

The dynamic economic performances ofthe East and Southeast Asian nations have caught the attention of many around the world. During the 1970s and 1980s, these economies as a group grew faster than most other countries in the world. Over the period 1970-79, for example, real GDP grew at an annual average rate of more than 9 percent in the newly industrialized economies (NIEs) - which include Hong Kong, Korea, Singapore, and Thiwan - and more than 7 percent in most of the ASEAN (Association of Southeast Asian Nations) countries. Even in the Philippines, real GDP grew at 6 percent in the 1970s, which was higher than growth in most other developing countries in the world in the same period. In the 1980s, despite ~he turndown in the global economy, the trend has continued with real GDP in the NIEs and the ASEAN economies (again except for the PhilipPines) growing at about 7 and 5 percent, respectively. As a result oftheir phenomenal performance, these countries have increased

.xiv

Introduction

their shares of world output and have also raised their share of world exports. In 1970, the NIEs and ASEAN countries comprised 0.8 percent and 1.0 percent of total world output. By 1987, these shares had increased to 1.8 percent and 1.2 percent, respectively. The growing importance of these economies in terms of world exports is even more dramatic. From 2.2 percent and 1.6 percent in 1970, the share of exports from the NIEs and ASEAN countries to total world exports have grown to 8.3 percent and 2.4 percent, respectively, in 1988. Indeed, this is the only region where some countries have graduated or are graduating from the ranks of the Third World. The successful development experiences of these Asian economies can serve as a laboratory to enrich economic theory and a large number of projects have been devoted to studying and analyzing their development strategies. In addition, the success of the NIEs and the nations ofASEAN has had a very favorable demonstration effect. As a result, countries such as China, India, and nations in Latin America have shown a great deal of interest in the development experiences of the East and Southeast Asian economies. This volume represents a comprehensive collection of papers covering a wide range of development issues and problems the East and Southeast Asian economies. have encountered, are facing, or will be confronted with in the near future. Because the topics for the papers were left at the discretion of the authors, the subject matter of the papers cover a wide range. At the same time, the papers cover timely issues. Thus, the volume is a good reflection of the many real world problems facing the economies of East and Southeast Asia. The papers by George Hicks, Malcolm Dowling, and Chong-Yah Lim give an overview of the economic development experiences of the East and Southeast Asian countries and provide a good launching pad for the remainder of the volume. George Hicks' article surveys economic development theory since the 1960s, and contrasts the development strategies that were chosen by the NIEs with other developing economies and looks at the outcomes of the policies that were followed. The article by Malcolm Dowling analyzes economic growth and the changing economic structures of the East and Southeast Asian developing countries, and assesses the prospects for growth in the region in the 1990s. Chong-Yah Lim's paper provides a different perspective on Thiwan's phenomenal economic success ant\ methodically examines the various factors that have been suggested as the sources ofThiwan's growth. The importance ofgood macroeconomic policies in achieving rapid economic growth and development, in particular, industrialization and employment policies, is highlighted in the papers by John Wong,Ji-Hong Kim, and Nguyen Xuan Oanh. Because of differences in history, culture, and initial conditions, every country cannot follow the exact path of the NIEs, but many countries in the region (as well as in other parts of the world) have moved toward outward-looking and market-oriented policies. The paper _by Nguyen Oanh showcases Vietnam as one example where a shift in industrial strategy has

lnlroduction

.rv

taken place in Asia. The essay by John Wong focusses on the industrial policies of Singapore in the 1970s and 1980s, and the impact of these policies in fostering employment and output growth. 1\vo lessons are brought out in the analysis: {1) A short-term policy, in Singapore's case the high-wage policy of the early 1980s, is an inappropriate policy tool for economic or industrial restructuring which is essentially long-term in nature; and (2) The optimal level of government involvement in an ·e conomy is a complex question and involves choosing an appropriate mix that combines a level of institution support with the working of an effective market system. The governments of many of the East and Southeast Asian countries have had to face or may soon have to deal with the problem of phasing out declining industries as their economies move up the ladder of comparative advantage into ·more capital- ·and technology-intensive industries. The government's response to these problems will be a significant factor and Ji-Hong Kim's analysis of the Korean government's policies toward two declining industriesthe shipbuilding industry and the coal mining industry in Korea - indicates that while government intervention may be necessary to ease adjustment "in certain declining industries, the government must be wary of contributing to further distortions in the market. 'frade has played an important role in the development of the East and Southeast Asian economies, and will continue to· be a ·significant factor in the future growth of these economies. The papers by Narongchai Akrasanee and Somsak 'Iambunlertchai, Marl Pangestu, and W.L. Chou and T.rong-Biau Lin examine the different trade issues facing these nations and the response of the governments in addressing the various problems facing them. While adoption of an import-substitution strategy can result in the creation of inefficient industries in a developing country, Narongchai Akrasanee and Somsak Thmbunlertchai argue that adoption of this strategy may be appropriate for some economies, such as Thailand, in the initial stages of development. They argue further that import substitution and export expansion are not necessarily mutually exclusive policies. At the same time, the authors note that export expansion and more outward-looking trade policies have been, and will continue to be, important faetors contributing to industrial and economic growth in Thailand. Mari Pangestu looks at another trade-related issue and examines whether Indonesia suffered from the Dutch disease effect. The analysis shows that the booming oil sector in Indonesia did in fact stifle growth in other sectors of the economy, and the government's devaluation of the Indonesian rupiah provided only temporary relief to the nonoil traded goods sector. The effects of devaluation of a domestic currency are also explored in the paper by W.L. Chou and Thong-Biau Lin. The impact of a devaluation .o f the Hong Kong dollar (as well as changes in government expenditure and investment) on macroeconomic aggregates is analyzed using an econometric model. In an innovative paper by Manuel Montes, a rent-generating model is employed to analyze the effect of rents that are earned from access to government

xvi

Introduction

subsidies or protection on the economy. The theoretical model suggests that increases in rents that are not reinvested in the domestic economy but that are spent on imports or capital flight will lead to slowdowns in domestic demand and rising unemployment. Attempts to maintain full employment in the economy through stimulation of aggregate dema;nd may then bring the economy closer to its foreign financing limit. Although the model was not empirically tested in the paper, the essay presents an original application of economic theory to practical issues facing the developing economies: In Asia, the share of direct foreign investment {DFI) to total capital formation is generally small, except in certain sectors such as the petroleum industry. In addition, the balance-of-payments effects ofDFI are not large either. Nevertheless, as noted in the paper by Eric R.amstetter, the magnitude and effect of DFI is not insignificant in the manufacturing sector of some countries, in particular Thiwan. Using a macroeconometric model that highlights the role of DFI, R.amstetter concludes that differences in the marginal product of capital between domestic and foreign firms can result in significant differences in production and that multinational corporations play an important role in the trade of developing economies. The paper by Chung Lee examines the pattern and trends of DFI in Korea and evaluates the impact ofthe country's DFI policies. The paper's conclusion that Korea's restrictive policy on DFI until the mid-1980s may or may not have been the optimal policy reflects the complexity and difficulty of analyzing effects of DFI. Lee concludes that the question cannot be fully answered without a careful analysis of the effectiveness of Korea's industrial policy. An important point about the extent of technology transfer arising from DFI is made in the paper by Mingsarn Santikarn Kaosa-ard. Many of the benefits of DFI come from the transfer of knowledge and technology; but technology cannot be simply bought or imported. A cbuntry must build its capacity to absorb the technology. Thchnology transfer is therefore not a static concept, but is a process that depends upon capacity-building by the recipient country through investments in human resource development and science and technology. Consistent with the movement toward a more market-oriented and outwardlooking development strategy, the East and Southeast Asian economies have undertaken a number of reforms in their financial markets and exchange rate systems. The paper by Christina Liu and Shirley Kuo examines the interest rate and foreign exchange liberalization that took·place in Thiwan since 1980. Their analysis of the Thiwanese experience supports the widely-accepted order of liberalization - that the domestic financial markets and the trade account should be liberalized prior to liberalization of the capital account in order to prevent speculative capital flows that may lead to other financial problems. In the essay by Yen Kyun Wang and Wan-Soon Kim, liberalization of the forward foreign exchange market is viewed as an important element of foreign exchange liberalization. A sound and active forward foreign exchange

l nt rodu.ctio n

.rvii

market would improve the country's export competitiveness by providing a means by which trade contracts can b e protected from foreign exchange rate chan ges. Debt has not been a major problem in East and Southeast Asia primarily because these countries h ave relied more heavily on good domestic policies to make necessary adjustments to external shocks and less on foreign debt. The Philippines is the exception, but indications are that the country is regaining strength though a large amount of foreign assistance will continue to be needed. Nevertheless, the straightforward presentation of the many options facing developing countries in terms of debt management by Virabongsa Ramangkura and Pakorn Vichyanond is instructive. As the East and Southeast Asian countries have developed, the size of the agriculture sector has declined. However, the agricultural sector remains an important one, and increases in agricultural productivity have been and will continue to be an important element in the region's growth. Agricultural growth and the transition toward industrialization are the topics of the papers by Romeo Bautista and William james. Increases in agricultural productivity that occurred in the region and the impacts these increases will have on food imports in the future are discussed in the paper by Bautista. james evaluates the agricultural transition that has taken place in the region and notes that industrialization should not take place at the expense of the agricultural sector, but should be accompanied by a raising of productivity in both the industrial and agriculture sectors. There has been much discussion recently in academic and political circles about economic integration among the countries of the Asia-Pacific region. While developing countries' attempts at integration have generally not been very successful, the Southeast Asian countries have been able to maintain their unity in the Association of Southeast Asian Nations (ASEAN) and in 1988 ASEAN was as strong as ever. Although ASEAN C{)operation has not achieved the kind of success that was initially envisioned, the organization has contributed to political stability and harmony in the region which is now providing the foundation for economic cooperation. The paper by Florian Alburo looks at the prospects for st rengthening ASEAN cooperation beyond political unity in the Indochina conflict by examining the results of the third ASEAN Summit Meeting that was h eld in late 1988. The commitment to expand economic cooperation with the Hrm goal toward a more marketoriented approach at the summit indicates that ASEAN is _likely to move forward toward its goal of regional economic cooperation. Despite the discussions surrounding economic cooperation in the region, the NlEs and ASEAN countries recognize their interdependence with the rest of the region and the world, and they have maintained th eir outwardlooking approach. As noted in Mohammad Sadli's paper, the Asian developing countries have been taking a more active role in seeking multilateral trade liberalization through the Uruguay Round, the outcome of which is ofvital importance to the region. However at this juncture, a successful round is

xviii

Introduction

very uncertain; and for a number of reasons, the GATT may not succeed in effectively liberalizing world trade. The paper by Pang Eng Fong and Augustine H.H. Thn examines some of the global economic problems from the perspective of the Asian NIEs. The trend toward greater protectionism and managed trade is viewed as a threat to the world economy in the 1~90s, and the shift in global economic power implies a need for the United States, the European Community, and Japan to better coordinate their policies and reduce the divergence in their national macroeconomic policies. As the editGrs of the volume, we take great pleasure in presenting these papers which are not only informative, but also yield significant insights into the issues confronted by the developing economies ofEast and Southeast Asia. It is especially pleasing to find that economic theory remains a fundamental component of research being conducted in the field and continues to be applied to practical problems.

THE EDI1'0RS

Seiji Naya is Director, Resource Systems Institute, and the Vice-President of Strategic. Planning, East-West Center, Honolulu, Hawaii. He is also Professor, University of Hawaii Manoa, Honolulu, Hawaii, USA. Akira 'Iakayama is Professor, University of Carbondale, Carbondale, Illinois, USA.

CONTRIBUTORS TO THIS VOWME Narongchai Akrasanee is Executive Vice-President, Thailand Development

Research Institute, Bangkok, Thailand. Florian A. Alburo is Deputy Director-General, National Economic and Development Authority, Manila, Philippines. Romeo M. Bautista is Research Fellow, International Food Policy Research

Institute, Washington, D.C., USA. W.L. Chou is a Lecturer, Department of Economics, Chinese University of Hong Kong, Hong Kong. Malcolm Dowling is Assistant Ghief Economist, Economics Office, Asian De-

velopment .Bank, Manila, Philippines. George Hicks is an independent researcher.

William E. james is a Research Associate, Resource Systems Institute, East-West Center, and Associate Professor, University of Hawaii at Manoa, Honolulu, Hawaii, USA.

Mingsarn Santikarn Kaosa-ard is Associate Professor, Faculty of Social Sciences, Chiang Mai University, Chiang Mai, Thailand. ]i-Hong Kim is a Fellow, Korea Development Institute, Korea. Wan-Soon Kim is Professor, &hool of Business Administration, Korea Univer-

sity, Seoul, Korea. Shirley W.Y. Kuo is Deputy Governor, Central Bank of China, and Professor,

National Thiwan University, Thiwan. Chung H. Lee is Professor, University of Hawaii at Manoa, and a Research

Associate, Resource Systems Institute, East-West Center, Honolulu, Hawaii, USA.

XX

Contributors to This Volume

Lim Chong-Yah is Professor and Head, Department of :Economics and Statistics, National University of Singapore, Singapore. Tzong-Biau Lin is Professor and Chairman, Department of Economics, Chinese University of Hong Kong, Hong Kong. Christina Y. Liu is Assistant Professor, City University of New York, New York, USA. Manuel F. Montes is a Research Fellow, Resource Systems Institute, East-West Center, Honolulu, Hawaii, USA. Nguyen Xuan Oanh is Director, Bureau of Economic Research; President, Economic Association of Vietnam; Deputy, National Assembly; and Adviser, Government of Vietnam, Vietnam. Pang Eng Fong is Associate Professor, Department of Business Policy, National University of Singapore, Singapore. Mari Pangestu is a Fellow, Center for Strategic and International Studies, Jakarta, Indonesia. Virabongsa Ramangkura is Program Director, Thailand Development Research Institute, Bangkok, Thailand. Eric D. Ramstetter is Associate Professor, Faculty of Economics, Kansai University, Osaka, Japan. Mohammad Sadli is Chairman, Institute for Economic Studies Research and Development, and Secretary General, Indonesian Chamber of Commerce and Industry, Jakarta, Indonesia. Somsak 'IQ.mbunlertchai is in the Faculty of Economics, Thammasat University, Bangkok, Thailand. Augustine H.H. Tan is Associate Professor, Department of Economics and

Statistics, National University of Singapore, Singapore. Pakorn Vichyanond is a Research Fellow, Thailand Development Research Institute, Bangkok, Thailand. Yen Kyun Wang is Professor, Department of Economics, Chung-Ang University, Seoul, Korea. john Wong is Associate Professor, Department of Economics and Statistics, National University of Singapore, Singapore.

I STRUCTURAL CHANGE AND ECONOMIC DEVELOPMENT IN DEVELOPING ASIA IN THE 1990S MALCOLM DOWLING

Introduction As the year 2000 approaches, interest in the economic prospects for the world economy, and Asia in particular, has quickened. A number of studies of developing Asia have been undertaken for the 1990s both by national governments (e.g., Korea and Philippines) and by multilateral agencies (e.g., Asian and Pacific Development Centre). This paper has been developed with the primary purpose of analyzing the structural changes that are likely to take place in the Asian developing countries over the next decade and the implications this will have for public investment needs (particularly development assistance), international trade, and the balance of payments. The level of foreign assistance required by the developing countries of the region will depend critically upon both domestic and external balance, which in turn will depend upon a number of factors, including the effectiveness with which the developing countries can mobilize savings, improve efficiency,

Malcolm Dowling

2

and promote exports. By exploring a scenario for growth and structural change, it is hoped th at this paper will make a small contribution to the continuing discussion on the future of developing Asia. In order to develop some perspectives for the future, it is important to review the past performance of these countries. Following this review a set ofbaseline projections for the 1990s is developed. These projections are point estimates representing my view of the most likely scenario. Due to time and space constraints, no attempt is made to derive a set of high and low scenarios for each country. The paper concludes with a discussion of some of the projected growth in terms of structural change, trade patterns and development strategy. World

Ec~nomic

Developments, 1970- 87

The sequence or" internationai events of the past decade and a half and the uncertainties which they have created for economic planners and forecasters are familiar. However, a short summary of these events is nevertheless useful in framing a view as to the future prospects of the world economy and of Asian developing countries in particular. From 1970 to 1987, the world economy recorded an annual average growth rate of 2.8 percent. Industrial countries expanded by 2.6 percent annually, while developing countries grew by 3.3 percent annually. Among the developing countries, Asia recorded the best performance, growing by more than 6 percent a year. In terms of improvements in per capita income, the Asian developing countries performed remarkably well compared with other regions; they also registered low rates of inflation and a rapid rate of increase in the volume of international trade. Inflation rates in developing Asia averaged 8.6 percent per year· versus 30.7 percent per year for all developing countries during the period 1970-87 and were nearly as low as those of the developed countries (5.8 percent). The region also posted an annual average increase of 10.3 percent in export volume, almost double that of Europe's 5.4 percent export growth, and recorded the highest annual percentage change in import volume at 7.2 percent (International Monetary Fund 1988). However, between 1972 and 1982, world economic growth was more volatile, primarily as a result of the commodity boom and the two oil shocks. Output growth in the industrial countries was subject to rather wide fluctuations, and, when combined with the severe inflation that followed the f"rrst oil shock and commodity boom, this created uncertainty among developing countries and resulted in greater fluctuation in demand for their exports. Recycling of oil surpluses following the first oil crisis resulted in a rapid buildup of debt and of debt servicing burden in ma'n y Asian developing countries. The debt crisis was exacerbated for oil-producing Asian developing countries when oil prices fell dramatically following the second oil shock. Other primary commodities-producing Asian developing countries were

Developing Asia in the 1990s

3

also adversely affected by the fall in nearly all commodity prices during the mid-1980s. A modicum of stability has returned to the world economy since 1982. There has been uninterrupted growth in income in the developed countries for nearly six years, living standards have improved in many developing countries, and, in contrast to the 1970s, there has been very little price inflation. International debt remains a problem in Latin America, but the debt crisis in Asia has abated. This return to stability is partly due to the continued strength of the U.S. economy and the relative stabilization of oil prices. But fundamental imbalances between the United States and its trading partners have developed which adjustments in exchange rates have not yet solved and which may yet create another crisis for the world economy. The Asia-Pacifzc region

In Asia, economic performance has been quite impressive. Rapid growth was achieyed primarily through structural changes, whereby the industrial sector grew rapidly while the slower growing agricultural sectors diminished in importance. The industrial sector in many Asian countries achieved higher productivity gains than could have been realized in agriculture. Rapid industrial growth has increased the number of jobs while higher incomes have facilitated higher rates of saving. Combined with outward-looking trade policies, this has led to rapid gains in output and exports. The latter is reflected in a near doubling of the region's share of world trade volume to over 10 percent between 1970 and 1987. East Asia is clearly the most rapidly growing subregion. Hong Kong, Korea, and Thiwan all posted average annual real growth of gross domestic product (GDP) in excess of 8 percent between 1970 and 1987. This represents more than a four-fold increase in living standards and a rate of economic growth that is unmatched anywhere in the world. Singapore is not far behind with an average annual growth rate of 6. 7 percent. These newly industrializing economies (NIEs) were able to grow rapidly through exploitation of foreign markets for manufactured exports, and this was complemented by a sharp increase in the share of the industrial sector in GDP (Asian Development Bank 1988b). As dependence upon trade increased, so did the subregion's sensitivity to disruptions in the international economy. GDP growth in the NIEs fell dramatically in both the 1974/75 and 1982/83 world recessions. However, the NlEs were quick to adjust to these disruptions and economic performance improved by the mid-1980s. This was aided by the fall of the dollar, which increased export competitiveness of these economies. During the 1970s, price increases for oil and other primary commodities boosted export earnings and contributed to impressive economic growth for the Southeast Asia subregion. However, the second oil shock, followed by weak commodity prices in the mid-1980s, slowed the performance of this

4

Malcolm Dowling

subregion considerably and exacerbated the buildup offoreign debt as several countries borrowed heavily to maintain incomes at satisfactory levels. Nevertheless, Southeast Asia performed remarkably well over the period 1970-87, with annual GDP growth averaging 5.9 percent. Indonesia and Thailand expanded at impressive annual rates of6.7 percent and 6.1 percent, respectively, while the Philippines, which experienced constrained growth and even some absolute declines in GDP during the 1980s, managed to sustain GDP growth at an average annual rate of 3.9 percent. China posted a hefty annual growth rate of 8.3 percent as its economic performance benefitted from improved efficiency flowing from economic reforms. These r~forms emphasized greater decentralization of production and investment, stronger economic incentives, and greater use of market mechanisms to allocate resources. Not only have the economies of the Asian developing countries grown, but they have also undergone structural transformation as described by Hollis Chenery (1986). Many countries that were primarily agrarian 20 years ago now qualify as industrialized economies. In these countries, the industrial and service sectors flourished as agricultural productivity increased, making a surplus available for industrial investment and releasing labor to new industrial enterprises. The pace of industrialization and structural transformation has depended to a significant extent upon the regulatory environment and economic policies within the country. Those countries which adopted a relatively open international trading environment were able to promote exports and became efficient enough to compete in foreign markets. Consequently, they were able to grow and industrialize rapidly. Thking advantage of international markets to achieve economies of scale which their small domestic markets could not provide, the NIEs moved from production of labor-intensive goods to capital-intensive goods. As a result, value added from industry increased from about one-third of GDP in the early 1970s to nearly 50 percent in the late 1980s {ADB 1988b). In Southeast Asia, industrial growth has also been impressive but considerably more cautious. During the 1970s, new industrial enterprises were, for the most part, conf"med to the processing of primary goods. Only in recent years have these countries shifted into higher v8Iue added mam.ifacturing activities. Correspondingly, the industrial sector's share of GDP increased from 24 percent to 35 percent between 1970 and 1987, although the sector's share has fallen marginally since 1980 in some countries. With structural change and industrial growth came a decline in agriculture's share of GDP. The sector's share in value added fell from 36 percent to 24 percent in Southeast Asia and from 13 percent to 4 percent in East Asia. Nevertheless, agriculture remains a major source of employment and income in the region. Furthermore, it is only by increasing productivity and building up agricultural surpluses that developing countries can afford to pursue rapid industrialization. This has been achieved through better price incentives for

Developing Asia in the 1990s

5

producers, extension ofirrigation systems, more productive varieties (e.g. the Green Revolution) of crops, land reform and more effective use of auxiliary inputs, such as fertilizers and pesticides. The contribution ofthe service sector has also increased since 1970, accounting for 54 percent of value added in East Asia and 42 percent in Southeast Asia. Although much of the sector provides marginal employment in lowpaying jobs in both the formal and informal sectors, a growing component is involved in efficient and sophisticated financial services (especially in the NIEs) and in foreign exchange earning activities like tourism. Expansion of the service sector has been facilitated by the development of transport and communication services. Despite the structural transformation of most of the Asian developing economies, the bulk of the population in these countries still derives its income from agriculture, although there has been a visible declining trend since 1970. In Southeast Asia, the share of agriculture in total employment has dropped from 60 percent in 1970 to about 50 percent in 1987. In East Asia the drop has been more precipitous, from 30 percent to 10 percent over the same period. Among the NIEs, the service sector rather than the industrial sector has absorbed the bulk of labor released from agriculture. Rapid growth and industrialization has ameliorated the employment problem in the NIEs, where unemployment rates are negligible..Industrial growth has also contributed to rapid migration from rural to urban areas in these countries. In Southeast Asia, slower growth in recent years has resulted in high unemployment and underemployment rates in the Philippines and Indonesia. In both countries this has been exacerbated by rapid growth in the labor force as a result of rapid population growth in the 1960s and 1970s. The domestic saving rate is both an important determinant of the level of development expenditure and a gauge of the need for foreign f"mance. The rapid growth of real per capita income combined with relatively low inflation rates over the past two decades have provided a favorable background for improved saving mobilization in many developing countries in Asia. On average, domestic saving rates were higher in Asia than in other developing regions, with performance being particularly noteworthy in the NIEs and Southeast Asia. Generally, countries with high rates of saving achieved higher rates of economic growth, while countries with low saving rates were associated with slower rates of economic growth. Nevertheless, there remain significant variations in saving rates, even among countries with comparable levels of per capita income, as well as intertemporal shifts in saving performance within countries. Saving rates in Southeast Asia averaged over 20 percent, a significant improvement over the performance recorded in most of South Asia. Indonesia's saving performance showed an upward trend during the 1970s as a result of higher oil prices and subsequently higher government savings. However, saving performance declined following the second oil shock. In the Philippines, the gross domestic saving rate was relatively steady at over 20 percent during

6

Malcolm Dowling

the 1970s, but slow economic growth and political uncertainty hampered saving performance during the 1980s. By 1987, the saving rate had fallen to 14 percent. In Thailan!i, the saving rate declined between 1978 and 1983 but has since recovered. In Malaysia, the saving rate has been quite steady at about 30 percent since 1973. On the other hand, saving p'erformance among the NIEs has been quite remarkable. During the period 1970-87, Singapore and Thiwan posted average annual saving rates in excess of 30 percent, while Hong Kong and Korea averaged over 25 percent in the same period. Gross domestic investment ratios as a percentage of GOP have risen for many Asian developing countries between the 1970s and the 1980s. The NIEs, in particular, have had high and rising rates of investment. Singapore recorded the highest average investment ratio during the period 1970-87 at 42 percent, followed by Hong Kong and Korea at 30 percent each, and Thiwan at 27 percent. In Southeast Asia, average investment ratios ranged from 22 percent in the Philippines to 28 percent in Malaysia. For many of the countries that maintained investment rates in excess of saving rates, the saving-investment gap was financed with external capital flows in the form offoreign borrowiJ?.g. This led to accumulation of current· account deficits and the buildup of.external debt. The external debt of the Asjan developing countries rose rapidly from less than $50 billion in the early 1970s to over $250 billion in 1987. Much of this occurred in Southeast Asia following the two oil shocks and during the period of low primary commodity prices and weak world recovery in the mid-1980s. As a result, the current account position of these countries deteriorated during the 1980s vis-a-vis the 1970s. On the other hand, the current account position of the NIEs improved dramatically; by 1987, the combined current surplus ofthe NIEs was nearly as large as West Germany's. In Southeast Asia, reliance on foreign saving was minimal until the commodity boom faltered and oil prices began to escalate rapidly after the first oil shock. Thailand's dependence on foreign saving increased from 1.2 percent in the 1970s to over 30 percent in the mid-1980s. In the Philippines, foreign saving accelerated rapidly following the first oil crisis, reaching 25 percent of gross domestic capital formation (GDCF) in 1983. Since then, reliance on foreign saving has declined sharply as a result of the debt crisis and lower levels of investment. In Indonesia, reliance on foreign saving fluctuated with oil prices, falling sharply during the two oil shocks but increasing between these periods as development expenditure increased. However, in recent years, tight budgets adopted as a result of the oil price slump have reduced Indonesia's dependency on foreign saving. Likewise, the positive effect of the two oil shocks in Malaysia has enabled the government to reduce its reliance on foreign saving. However, in 1981, Malaysia embarked on an ambitious development program which boosted its reliance on foreign saving to over 30 percent in 1982 and ·1983. The rapid increase in foreign borrowing in the succeeding years coupled with slumping oil and commodity prices created

Developing Asia in the 1990s

7

significant financial problems for the government during the mid-1980s and resulted in a reduction in investment spending. In East Asia, Korea and Singapore relied extensively on foreign saving to finance its investment program. In Korea, reliance on foreign saving mushroomed during the periods in 1974-75 and 1979-82 primarily as a result of higher oil prices which increased import costs considerably. This was compounded by a severe drought in 1982. Since then, reliance on foreign saving has been significantly reduced as export and domestic saving performance have dramatically improved and by 1986, Korea had begun to accumulate current account surpluses. In Singapore, reliance on foreign saving was most prominent during the early 1970s and slowly declined in the 1980s after peaking in 1980 and 1981. In Hong Kong and Thiwan, dependence on foreign saving for investment f'mancing has been minimal due to their high national saving rates. By the mid-1980s, all the NIEs had current account surpluses, and, in the case of Thiwan, the surplus had reached $16 billion in 1987. Because the Asian developing countries have relied primarily on foreign borrowing to finance their expenditures, direct foreign investment (DFI) accounted for less than 15 percent oftotal capital inflows. With the exception of China, lower-income countries have relied almost exclusively on official sources, while in Southeast Asia and the NIEs, private sources have b ecome an increasingly important source of external finance. Following the two oil shocks and the commodity price slowdown of the 1980s, external debt and debt servicing requirements accelerated sharply for some countries in Southeast Asia. In 1986, external debt reached $28 billion and $42 billion, respectively, in the Philippines and Indonesia, and debt servicing, measured as a percentage of the export of goods and services, was 45 percent and 35 percent, respectively. In Thailand and Malaysia, both the level of external debt and debt servicing costs increased dramatically. However, the situation has recently improved in both of these countries as exports have picked up and government budgets for development expenditure have been tightened. China has increased its level of foreign borrowing in recent years to over $20 billion. However, debt servicing requirements remain low when compared with export proceeds. Asia has played an increasingly important role in world trade. Between 1970 and 1987, Asia's share of world trade nearly doubled to over 10 percent, and the growth rate for both exports and imports was significantly higher than in other regions. In the 1970s, export volumes from Asian developing countries grew at nearly twice the rate of developed countries and nearly three times as fast as export volumes of developing countries as a whole. In the 1980s, despite the slowdown in world export growth, the Asian developing countries still maintained relatively rapid rates of export growth. It is also noteworthy that the countries in the region with the high rates of economic growth also recorded rapid growth in foreign trade, particularly exports. The commodity composition of exports of Asian developing countries has changed significantly in the past two decades. In 1965, nonfuel primary

8

Malcolm Dowling

commodities comprised the bulk of the region's exports (88 percent and 50 percent in Southeast Asia and East Asia, respectively), although labor-intensive manufactured goods were of significant importance in Korea. By 1984, the share of nonfuel primary commodities had fallen to 46 percent and 7 percent, respectively, in the two subregions, while the share of labor-intensive and other manufactured goods respectively increased. In Thailand and the Philippines, labor-intensive manufactured goods accounted for 22 percent and 40 percent of exports by 1984. In Korea, capital- and skill-intensive goods accounted for over half of total exports in 1984, up from 13 percent in 1965. By 1987, the share was significantly higher as Korea has become a major exporter of automobiles, computers, and other electronic products. Import volume growth for the Asian developing countries exceeded that of exports and contributed to the increase in current account deficits. The rate of growth in import volumes for the region was nearly double that of developing countries as a whole but fell from almost 10 percent in the 1970s to 7 percent in the 1980s. While exports became more sophisticated with higher value added, imports have generally followed the reverse pattern. This was partly due to the two oil shocks and the corresp)

g 0 + g, OR + g 2 FG + g3 GDR

Identities

cs> rts to the United States (DECUS), the United Kingdom (DECUK), West Germany (DECG) and all other markets (DECR), with DECR treated as an exogenous variable. Hong Kong's domestic exports are greatly influenced by the economic conditions in its major overseas markets and the changes in exchange rates. A dummy variable (DUM9) is used to account for the effect of the recession years. The equation is, ln DECUS

=

c0 + c 1 ln USGNP _1 + Cz In EX_1 + c3 DUM9 + u 3 •

The determinants of DECUK include the lagged exchange rate variable (EX_:J, the linear spline variables T, T1, T2 and T3, and the l~gged value DECUK_4 • The spline variables account for the change in the time slope during the recession years. The equation is written as, DECUK

=

do+ d 1 EX_2 + d 2 DECUK_4 + d 3 T + d 4 T2 + d 5 T3 + U 4 •

Similarly, we can write the equation for DECG as, DECG = eo + e 1 EX_ 1 + e2 DECG_4 + e3 DUMG + u 5 , where DUMG is a dummy variable accounting for the effect of the recession period.

A Quarterly Econometric Model of the Hong Kong Economy

141

Domestic exports to China (OECC), which account for about 12 percent of Hong Kong's domestic exports, are treated as an exogenous variable because of the lack of quarterly income series.

The three import equations. Hong Kong's total imports (M) consist of imports of goods (MC) and imports of services (MS). Since Hong Kong takes up only a small portion of the world trade market, it would be reasonable to assume that the supply of Hong Kong's imports is also perfectly elastic. Since MS is treated as exogenous, only equations of demand for imports of goods are considered here. Imports of goods are further divided into retained imports of goods (RM) and reexports (RE). The model includes three stochastic retained imports equations explaining separately demand for retained imports under SITC 0 and 1 (RM01), SITC 3 (RM3), and SITC 5 to 9 (RM59). RE is an exogenous variable. The demand for retained imports depends on income and relative prices. The explanatory variables used in the demand equation for RM01 include the lagged income variable (GOP _4 ), the ratio of the price index of imported goods under SITC 0 and 1 to the domestic price index (PM011PE01), and the lagged value RM01 _4 • Our equation is of the form, ln RM01

=

f0 + f 1 ln GOP _4 + f2 ln (PM011PE01) + £:, In RM01_ 4 + u6 •

The equations for RM3 and RM59 may be similarly specified. The equation for RM3, which consists mainly ofimported petroleum and fuels, is dependent on three variables: the demand of the whole econom;Y (GDP_J, a measure of the seasonal effect (RM3_4), and a dummy variable (OUM3). The equation can be written as,

ln RM3

~

So+ g 1 In GOP_1 + g2 ln RM3 _4 + g 3 OUM3 +u7 •

RM59, the largest component of retained imports of goods, is mainly composed of capital goods and manufactured goods, and it depends on GOP, the ratio of the price index of imported capital goods and manufactured goods to the price index of domestically produ ced exporte~ goods (PM59/PE59), and a dummy variable (DUM7). The equation for RM59 can be written as, ln RM59 = h 0 + h 1 In GOP _4 + h 2 ln(PM59/PE59) + h 3 In RM59 _4 + h 4 DUM7 + u 6 •

The stochastic equations for the manufacturing sector It has been estimated that up to 90 percent of Hong Kong's manufacturing output is eventually exported (Hong Kong 1988). The output level of manufacturing industries (XM) is explained by the foreign demand for Hong Kong's domestic exports of goods (DEC) and its lagged value (XM_ 1). The equation for XM is, XM

=

io+i1 OEC + i2 XM_1 + Ug .

W.L. Chou and Thong-Biau Lin

142

Employment in the manufacturing sector (NIM) is a function of Hong Kong's domestic exports (DEC), its lagged value (NIM_1), and a dummy variable (DUM2). The· manufacturing sector accounts for the largest share of the total employed labor force. When foreign demand for Hong Kong's products is high, the level of manufacturing output is high, resulting in higher demand for labor. The inclusion of domestic exports of goods in the equation attempts to pick up the effect of foreign demand on the demand for labor in the manufacturing sector. The equation of employment in the manufacturing sector is of the form, NIM

=

j 0 +j 1 DEC_2 +j 2 NIM_1 +j 3 DUM2 +

U 10 •

An equation for the wage rate in the manufacturing sector (WMF), after removing the price effect (WMF/P), is included in the model. An upward trend. in the real wage has been observed historically. Employed labor would seek a wage increase equal to the habitual wage rate that has recently been experienced. It is assumed here for simplicity that the habitual wage rate is equal to the real wage rate in the previous period, (WMF/P)_1 • In addition, the real wage rate is related to the labor productivity of the manufacturing sector (XM/NIM). The wage rate equation is, WMF/P

=

ko + k 1 (WMF/P) . 1 + kiXM!NIM) + u 11 •

The price equations An important variable in the model is the price level. The implicit GOP deflator (P) is explained by the price index of total domestic demand (PDM) and its lagged value (P . 1 ). The consumer priee index (PC) is explained by three variables: the import price index (PIM), its lagged value (PC_J, and a dummy variable {PIM*DUM8). The dummy variable is designed to account for the effect of the change in Hong Kong's exchange rate system (which occurred in October 1983) on the slope of the import prices. The functions of the two price iq.dices are, ln P

=

In PC

lo + 11 ln PDM + 12 In P _1 '+ Uu, = ko ln PIM + k 1 PC_2 + k 2 0n PIM*DUM8) + u 13 •

The determinants of the export price index {PE) are: the general price level of the economy (P), the exchange rate (EX_ 1), and the lagged value (PE_1 ). The equation is, In PE

= q, + q 1 In P + 4 In EX_1 + q, ln PE.t + U14·

The stochastic equations for the nwnetary sector Tbe stochastic equations for the monetary sector consist of three equations explaining the demand for currency (CUR) and the demand for two bank

A Quarterly Econometric Model of the Hong Kong Economy

143

deposits: demand deposits (DD) and saving deposits (DS). Time deposits (UI') are treated as exogenous. Demand deposits are checkable deposits and are included in the narrowest money supply measure, Ml. DD is assumed to be a function of nominal GOP (GDP•P), the twelve-month time deposit rate (IT), and its lagged value (DD _1 ). The interest rate variable IT represents the yield on time deposits and measures the cost of holding noninterest-bearing demand deposits. The higher the interest rate loss from holding d emand deposits, the lower the amount of demand deposits people are expected to hold. Thus, the effect of the interest rate on DD is expected to be negative. Our demand deposits equation is of the form, DO= r 0 + r 1 IT+r2 (GDP•PL 1 +r3 DD_1 + u 15 • Demand for currency depends upon its lagged value (CUR_ 1 ), the nominal income variable (GDP*PL 1 , and the interest rate paid on time deposits (IT). The argument for the inclusion of the nominal interest rate IT is the same as that for demand deposits. If the interest rate is expected to rise, people will not be willing to hold more currency and will transfer currency into other forms of assets. The effect of the interest rate on CUR is negative. The currency function is written as, ln CUR

~

t0 + t 1 In IT + t.z In (GDP*PL 1 + t 3 CUR:-t + Uts·

Three variables are used to explain the effect on DS: nominal income (GDP•P), the saving deposits rate (IS), and its lagged value (DS_ 1 ). Saving deposits in Hong Kong may be withdrawn at any time without notice, and there are no restrictions on the number and the amount of the withdrawal. Individuals regard saving deposits as being close to money and serving some of the same functions. If yields on saving deposits increase, suggesting that the cost of holding money increases, the demand for saving deposits will increase. The interest rate effect on DS is expected to be positive. The equation forDS is, DS = w 0 + w 1 IS_2 + W 2 (GDP•P) + w 3 DS_1 + U 17 • Accuracy Analysis of the Model The two-stage least squares (2SLS) estimates of the quarterly model are. presented in appendix A. The historical simulation of the model has been made for the period from 1974 Ql to 1985 Q4. The simulated and the actual values for GOP and its components and for prices were compared. As a whole, the model appeared to reproduce the general trends for most variables. But for investment spending in plant machinery and equipment, the model failed to capture the sharp upturn that occurred during 1980 and 1981. Quantitative measures were also used to help evaluate the performance of the model. The frequently-used measures of predictive accuracy are root

W.L. Chou and TZong-Biau Lin

144

mean squared error (RMSE), root mean squared percentage (RMS%) error, and Theil's (1966) inequality coefficient (U).1 All three measures are zero if the forecasts are perfect·. For the Theil inequality coefficient, a value of one implies a no-change forecast (41P1, "'0). A U value g:.:eater than one means that the forecast is less accurate than the simple forecast of no change. Forecasting error may arise in different ways. Following Theil (1966), the mean squared error (MSE) may be decomposed 2 as, T 02

= 1/T E

(A,- P1) 2

=

(i5- A)2

+ (sp- rsA) 2 + (1- r 2 )sA2

t=1 where P andA are the means, Sp and sA are the standard deviations, and r is the correlation coefficient between A 1 and P1 • Dividing each item in the equation by 0 2 , we get, UM == (i5 -A)2102, UR

=

(sp- rsA)2/D 2 , UD

=

(1-rZ)sA2/l)2.

These quantities provide insight into the causes of forecast error. UM arises from systematic underestimation or overestimation of the average change, UR arises from incorrect regression slope, and UD is random. For optimal forecasts, both UM and UR should not significantly differ from zero, and, hence, UD should be close to unity. 'Thble 1 presents the RMSEs and Theil's U coefficients of historical simulation for ten selected endogenous variables. Judging by the modest size of the inequality coefficients, the results of the historical simulation are impressive. The mean value of U is 0.052. Systematic errors are virtually absent, and the mean value of UD shows that about 96 percent of the total forecasting error is random. Thble 1 Results of Historical Simulations of Selected Variables Theil's forecast error decomposition Variable CP IPPD PCF DEC EC

RMC MC GDP PC p

RMS error

Bias (UM)

Reg. (UR)

Dist. (UD)

u

1.0978 0.3652 0.3652 0.9837 0.9837 1.2624 1.2624 1.7386 0.0113 0.0176

0.028 0.000 0.000 0.008 0.008 0.009 0.009 0.018 0.001 0.000

0.075 0.010 0.044 0.082 0.082 0.002 0.000 0.030 0.000 0.009

0.897 0.989 0.956 0.910 0.910 0.989 0.991 0.953 0.999 0.991

0.0531 0.1303 0.0450 0.0591 0.0388 0.0683 · o.0466 0.0519 0.0105 0.0175

A Quarterly Econometric Model of the Hong Kong Economy

145

On the other hand, when calculating the Theil inequality coefficient, A, and P, represent actual and forecast percentage changes, respectively. The comparisons between the forecast and actual percentage changes for the selected variables are less accurate (table 2). Not surprisingly, the mean value ofU rose somewhat to 0.644. However, bias proportions (UM) and regression proportions (UR) remained low. UD shows that, on average, about 85 percent of the total forecasting error is random. In performing ex-post forecast, our model is simulated forward for the period from 1986 Q1 to 1986 Q4, and the forecast results are compared with the actual values. The comparisons of the forecast and actual percentage changes in variables are shown in table 3. Despite the larger systematic errors, the ex-post forecasts for real GOP and its components are generally good in view of the fact that their inequality coefficients do not exceed one. The forecasts for the price variables PC and P appear less accurate. More than 92 percent of the forecasting errors in the price variables are systematic errors. The inequality coefficient ofP is greater than one, suggesting that its forecasts are less accurate than assuming a no-change extrapolation> Impact and Dynamic Multipliers Simulation assumptions Because of its small and open nature, the economy of Hong Kong is vulnerable to external influences. The policy actions taken by the Hong Kong government to offset unfavorable external factors are generally believed to be ineffective. Thble 2 Results of Historical Simulations of the Percentage Changes in Selected Variables Theil's forecast error decomposition Variable•

CP IPPD PCF DEC EC

RMC MC GDP PC p

RMS error

Bias (UM)

Reg. (UR)

Dist. (UO)

u

0.0577 0.1535 0 .0478 0.0602 0.0428 0.0728 0.0533 0.0500 0.0113 0.0192

0.014 0.008 0.004 0.006 0.004 0.002 0.002 0.011 0.000 0.001

0.211 0.256 0.188 0.119 0.154 0.058 0.010 0.175 0.016 0.228

0.775 0.736 0.808 0.875 0 .842 0.940 0.988 0.814 0.983 0.771

0.8385 0.9243 0.7099 0.4326 0.3787 0.6641 0.5645 0.8043 0.4438 0.6831

NOTE:

a. Variables are in percentage changes.

W.L. Chou and Thong-Biau Lin

146

Thble 3 Accuracy Analysis of Four-Quarter-Ahead Forecasts for Selected Variables Theil's forecast error decomposition

RMS

RMS

Variable

error

%error

Bias (UM)

CP IPPD PCF DEC EC RMC

O.b355 0.0966 0.0356 0.0671 0.0387 0.0939 0.0543 0.0779 0.0061 0.0152

3.7113 1.0083 1.3226 0.3857 0.2471 3.2567 0.7750 1.3458 0.7433 6.0249

0.399 0.080 0.094 0.511 0.508 0.503 0.495 0.927 0.816 0.903

MC GOP

PC p

Reg.

(UR)

Dist. (UD)

u

0.156 0.856 0.893 0.430 0.365 0.267 0.105 0.043 0.010 0.084

0.7390 0.5247 0.3132 0.3971 0.2507 0.6450 0.3843 0.8342 0.7142 1.1336

0.445 0.064 0.013 0.059 0.127 0.230 0.400 0.030 0.174 0.013

The Hong Kong government espouses an economic philosophy that is described as positive noninterventionism and the government makes no attempt to carry out any active policy. There are few instruments of monetary policy available to the government. Rather, most government policies are related to the budget by way of expenditure or taxation. The direct impact of increased government expenditures or tax cuts may be readily apparent, but the more complex feedbacks must be considered in a model system. This is also true when analyzing the effect of a depreciation of the Hong l(ong dollar. The purpose of this section is to perform policy simulations for the economy ofHong Kong on the basis of the estimated quarterly model. There are three policy simulations for analysis: (1) an increase in government expenditures (CG), (2) an increase in government investment (IG), and (3) a devaluation of the Hong Kong dollar against the U.S. dollar. Policy simulations are attempted for the sample est-imation period, 1974 Q1 to 1985 Q4. In the first policy simulation, CG is increased for each of the 48 quarters of simulation. The amount by which CG is changed is 201.1 million Hong Kong dollars, which is equivalent to 1 percent of real GDP in the first quarter of the simulation (1974 Q1). Policy 2 uses the same formula as the expenditure policy. The increase in IG from its baseline levels is taken to be 1 percent of the real GDP of 1974 Q1. Since there is no nominal exchange rate variable in the model, the policy instrument used in experiment (3) is the effective exchange rate index (EX). EX is decreased by 10 percent for each of the simulation periods.

Simulation results3 The effect of an increase in government expenditures (CG).

The increase in

A Quarterly Econometric Model of the Hong Kong Economy

147

government consumption expenditures raises economic activities in general and leads to an increase in real GDP. The reason for this increase is the rise in private consumption and investment. The impact expenditure multiplier for real GDP in the first period is 1.036, and, as the time horiwn progresses, the rise in GDP gets larger. The multiplier for GDP is 2.028 in the twelfth quarter and becomes smaller in subsequent periods. Imports of goods increase as they depend on real GDP, resulting in an increase in the visible trade deficit. Except for net exports, all components of GDP are affected positively by the expenditure increase. The GDP deflator rises because of the increase in domestic demand. The increases in real GDP and prices have a positive effect on the demand for money, and the money supply rises throughout the whole simulation period. The effect of an increase in government investment (IG). The increase in government investment also leads to an increase in GDP and has positive effects on all GDP components with the exception of net exports. The investment multiplier for real GDP is identical to that of the expenditure policy. However, the increase in government investment has a negative effect on the GDP deflator. The effect on the visible trade balance is larger than that of the expenditure policy. The effect ofa devaluation ofthe Hong Kong dollar. In the simulation results where there is a sustained decrease in the value of the Hong Kong dollar against the U.S. dollar, total exports of goods increase. However, total imports of goods are also higher since merchandise imports and exports are complementary. Nevertheless, the visible trade balance deficit narrows. The elasticity of real GOP with respect to the exchange rate index is 0.371 in absolute value in the first quarter, suggesting that a 1 percent decrease in the value of the Hong Kong dollar against the U.S. dollar will, on average, raise real GDP by 0.371 percent. The elasticities, in absolute value, grow as time passes, reach their peak value of 0.889 in the eighth quarter, and become smaller thereafter. Consumer prices rise because PIM is an explanatory variable in the price equation. The GDP deflator also rises due to the increase in the domestic demand deflator. The increases in real GDP and prices have a positive effect on the demand for money. As a result, the money supply {M2) increases. Summary of simulation exercises. When we compare the elasticities of real GDP for the three policy simulations, the elasticity with' respect to the exchange rate is found to be the largest, whereas the elasticity with respect to government investment is the smallest for the entire simulation period. The results suggest that the economy of Hong Kong responds more strongly to changes in the exchange rate than to policy actions taken by the Hong Kong government.

W.L. Chou and Thong-Biau Lin

148

ENDNOTES 1. Let Pit be the forecast of variable i for period t, and let Au be the actual value. Assuming that observations on Pi< and Ai1 are available for t = 1, ... ;r, the three measures are, T (1) RMSE = {1/ T I: (Ail - P;,f)11Z, t- 1 T (2) RMS % error • { 1fT E [(A;, - Pu}IA;1f )112 , t =1

T

T

(3) U = {1/T E (6.Ai1 - 6.Pi,)2}'12/{1/ T E (.6.A;,f}'/2 , t .. t t=1

a

where

in (3) denotes eith er absolute or percentage ch ange.

2. An alternative decomposition into variance and covarian ce proportions is often used. However, it will not be used here as Granger and Newbold (1973) have shown

that interpretation of the quantities is very difficult. 3. Contact the authors directly for detailed, quantitative results of the simulation, including the corresponding baseline solutions for real GOP, private consumption (CP), gross fixed investment (CF), total.exports of goods (EC), total imports of goods (MC), visible trade balance (TB), the price variables PC and P, and the money supply (MS2).

APPENDIX A

Estimated Equations of the Quarterly Model (T = 48)• ~

1. ln CP

-0.7486 + 0.4394 1n CP _4 + 0.7198 In GOP _1 (- 5.9) (4.47) (7.14) - 0.0190 (1n GOP • 1 x OUMG) (-2.79)

R~ =

2. IPPD R~ ~

0.9856 =

MSE .. 0.0018

DW .. 1.638

0.1587 + 0.0345 GOP + 0.6032 lPPD _4 (0.67) (2.35) (4.42)

0.8764

MSE - 0.1297

DW

-

=

d.f. = 44

0.5133 DUM5 (- 3.41) 1.458,

d.f.

=

44

3. PCF + rPPL + IPBC + IPPD + REDM 4. CF

=

PCF + IG

5. POD

=

CP + PCF + liS

6. TDD

=

PDD + IG + CG

7. In OECUS = -21.2987 + 2.9111ln USGNP _1 (- 6.60) (7.06) R2 = 0.8745

MSE'"' 0.0262

-

0.7799 In EX_1 -:-0.1515 OUM9 (- 2.88) (-2.28)

ow ..

1.372

d .f.

e

44

A Quarterly Econometric Model of the Hong Kong Economy 8. DECUK

2.4024 + 0.5812 DECUK_ 4 (3.39) (4.34)

=

-

149

2.1173 EX_2 + 0.0436 T (- 3.02) (3.18)

-0.0592 T1 - 0.0117 T2 - 0.0361 T3 (-2.53) (-0.87) (-0.67) R2

MSE - 0.0286

0.7914

-

9. DECG

= 0.43.66 (1.42)

R2

0.8202

"'

10. DEC

+ 0.8835 DECG _4 (9.10)

d.f.

DW - 1.390 -

0.1229 EX_ 1 ( - 0.59)

MSE "'0.0182

-

~

41

0.3132 DUMG ( - 6.14)

DW "' 1.096

d.( "' 44

DECUS + DECUK + DECG + DECC + DECR

=

11. EC = DEC + REC

12. In RM01 - -0.1192 + 0.5995 ln RM01 _4 + 0.1523 ln GDP _4 (- 0.78) (4.16) (1.95) - 0.4143 In (PM01/PE01) (-2.50) R2

0.8464

=

13. In RM3 R2

"'

MSE = 0.0044

= 1.703

- 0.5148 + 0.5368ln RM3 _4 + 0.2370 In GDP_1 (2.96) ( -2.27) (4.55)

=

MSE = 0.0076

0.8194

14. In RM59

DW

DW

d .( -

= 2.019

=

44

0.1557 DUM3 (- 5.10)

d.(

=

44

d.(

=

43

- 0.2157 + 0.6700 In RM59 _4 + 0.3494 In GOP _4 (-0.70) (5.45) (2.01)

=

- 1.3295 ln (PM59/PE59) - 0.2468 DUM7 (-3.70) (- 7.49) R2

0.9570

=

MSE

=

0.0084

DW"' 1.437

15. RMC = RM01 + RM24 + RM3 + RM59 16. MC

=

RMC + REC

17. GOP = TDD + EC - MC + NES 18. XM • 0.2119 + 0.6738 XM _1 + 0.1652 DEC (1.43) (15.42) (8.13) R2 = 0.9868

MSE

=

0.0889

ow= 1.640

19. NIM = 0.1008 + 0.8427 NlM_ 1 + 0.0024 DEC_2 (2.74) (13.45) (1.82) 20. WMFIP

=

-

d.f. = 45

0.0244 DUM2 (-2.47)

0.0373 + 0.9474 (WMF/PL 1 + 0.0020 (XM/NIM) (1.06) (17.09) (0.76)

R2 = 0.9629

MSE

=

0.0004

DW

=

1.738

d .(

21. PDM "' (CP x PCP + CG x PCG + CF x PF + liS x PUS)!rDD

= 45

150

W.L. Chou and Tzong-Biau Lin

22. In P "' 0.0061 + 0.4874 In P · l + 0.5369 In PDM (6.27) (6.56) (2.06) R2 = 0.9983 23. ln PC

~

MSE ·= 0.0002

DW

=

1.188

d.f.

=

45

d.f.

=

44

0.0420 + 0.6787 ln PC_2 + 0.4178 In PIM (19.47) (22.35) (12.26) -0.1069 On PIM x DUMB) (- 7.01)

R2

0.9990

=

24. In PE = - 0.0011 + 0.7117ln PE_1

(-0.17) R2

0.9962

e

=

=

-

0.1979 ln EX_1 + 0.1648 In P • 1 (-4.10) (1.99) DW

MSE - 0.0003

0.1314 + 0. 7358 In CUR_1 ( - 2.36) (10.68)

R2 = 0.9963

MSE

=

~

1.199

d.f.

=

44

0.1755 IT + 0.0741 (GDP x P) . 1 ( -3.63) (3.12)

-

ow= 2.060

MSE = 1.1044

0.9704

26. In CUR

-

(6.89)

25. DD = 2.1464 + 0.8053 DD. 1 (3.38) (10.45) R2

DW- 1.691

MSE - 0.0001

-

0.0011

d.f. = 44

0.0395 In IT· + 0.2292 In (GOP x PL 1 (- 3.63) (3.97)

ow= 2.392

d.f. = 44

27. MS1 • OD + CUR 28. DS R2

=

-1.1771 + 0.8664 ( -1.04) (8.61) 0.9882

=

MSE

os-2 =

+ 0.2117 IS_2 + 0.2126 (GDP x P) (1.15) (1.44)

9.6378

DW

=

2.111

d.f.

= 44

29. MS2 = MS1 + DS + IIT + CD 30. TBUS = DECUS x UVIS - NRMCUS 31. TB

=

PE x EC - PIM x MC

Notes: Values in parentheses are t-values; R2 = coefficient of determination; MSE = mean squared error; DW = Durbin-Watson statistics; and d.f. = degrees of freedom. a. Estimation period: 1974 QI-1985 QIV.

Variables Used in the Quarterly Model

Endogenous variables 1. CP

: Private consumption expenditure, in constant (1980) dollars.

2. IPPO : Private investment in plant, machinery and equipment, in constant (1980) dollars. 3. PGF : Gross domestic fixed capital formation in the private sector, in constant (1980) dollars.

A Quarter·ly Ecorwmetric Model of the Hong Kong F.corwmy

151.

4. CF

Gross domestic fixed capital formation, in constant (1980) dollars.

5. PDD

Private domestic demand, in constant (1980) dollars.

6. TDD

1btal domestic demand, in constant (1980) dollars.

7. DECUS

Domestic exports to the United States, in constant (1980) dollars.

8. DECUK

Domestic exports to the United Kingdom, in constant (1980) dollars.

9. DECG

Domestic exports to Germany, in constant (1980) dollars.

10. DEC

Domestic exports of goods, in constant (1980) dollars.

11. EC

1btal exports of goods, in constant (1980) dollars.

12. RM01

Retained imports ofgoods under SITe 0 and 1, in constant (1980) dollars.

13. RM3

Retained imports of goods under SITC 3, in constant (1980) dollars.

14. RMS9

Retained imports ofgoods under SITC 5 to 9, in constant (1980) dollars.

15. RMC

Retained imports of goods, in constant (1980) dollars.

16. MC

Thtal imports of goods, in constant (1980} dollars.

17. GDP

Gross domestic product at market prices, in constant (1980) dollars.

18. XM

Value added in manufacturing sector, in constant (1980) dollars.

19. NIM

Persons employed in manufacturing sector, in million.

20. WMF

Nominal wage index (including fringe benefits) for manufacturing workers, 1980

21.

PDM

~

100.

Domestic demand deflator, 1980 "' 100.

22. p

GDP deflator, 1980 = 100.

23. PC

Consumer price index (A), 1980

24. PE

Deflator of total exports of goods, 1980

25. DD

Demand deposits with licensed banks, in current dollars.

26. CUR

Currency in hands of public, in current dollars.

27. MS1

Money supply definition M1, in current dollars.

28. DS

Saving deposits with licensed banks, in current dollars.

29. MS2

Money supply definition M2, in current dollars.

30. TBUS

Visible trade balance with the United States, in current dollars.

31. TB

Thtal visible trade balance, in current dollars.

=

100. ~

100.

Exogenous Variables CD

Negotiable certificates of deposit issued by banks, in current dollars.

CG

Government consumption expenditure, in constant (1980) dollars.

152

DECC

W.L. Chou and Thong-Biau Lin

Domestic exports to China, in constant (1980) dollars.

DECR

: Domestic exports to countries other than the United States, the United Kingdom, West Germany and China, in constant (1980) dollars.

ur

: Time deposits with licensed banks, in current dollars.

DUM2

: Dummy variable, with 1 assigned to 1974Q3-1975Q.2, 1982Q.1-1983Q.1 and 1985Q1-1985Q.4,· to account for low activities in manufacturing sector.

DUM3

Dummy variable with 1 assigned to 1974Q4-1975Q3, 1983Q1-1983Q4 and 1985Q1-1985Q4, to account for low demand for oil imports.

DUMS

Dummy variable, with 1 assigned to 1974Q.1:-1975Q2 and 1982Q.1-1983Q1, to account for low activities in property sector.

DUM6

Dummy variable, -with 1 assigned to 1974Q3-1975Q2, to account for structural change.

DUM7

Dummy variable, with 1 assigned to 1974Q.3- 1975Q2, 1982Q.1-1982Q4 and 1985Q.1-1985Q3, to account for economic recession.

DUM8

: Dummy variable, with 1 assigned to 1983Q4-1985Q4, to account for the implementation of the linked exchange rate system of 17 October 1983.

DUM9

Dummy variable, with 1 assigned to 1974Q.3-1975Q2 and 1985Q1-1985Q4, to account for economic recession.

DUMG

Dummy variable, with 1 assigned to 1977Q.1-1977Q4, 1981Q1-1982Q3 and 1985Q.1- 1985Q4, to account for recession in West German market.

EX

'll'ade-weighted effective exchange rate index, 18 Dec. 1971 +100.

IG

Gross domestic fixed capital formation in public sector, in constant (1980) dollars.

liS

: Increase in stocks, in constant (1980) dollars.

IPBC

: Private investment in building and construction sector, in constant (1980) dollars.

IPPL

: 'll'ansfer costs of land and buildings, in constant (1980) dollars.

IS

: Savings deposits rate paid by principal banks, percent per annum, end of period figure.

IT

: 'IWelve-month time deposits rate paid by principal banks, percent per annum, end of period figure.

NES

: Net exports of services, in constant (1980) dollars.

NRMCUS : Retained imports of goods from the United States, in current dollars. PCG

: Deflator of government consumption expenditure, 1980 = 100.

PCP

: Deflator of private consumption expt!nditure, 1980 .. 100.

PE01

Unit value index for domestic exports of goods under SITC 0 and 1, 1980 = 100.

A Quarterly Econometric Model of the Hong Kong Economy

153

PE59

: Unit value index for domestic exports of goods under SITC 5 to 9, 1980 ~ 100.

PF

: Deflator of gross domestic fixed capital formation, 1980

=

100.

PUS

Deflator of increase in stocks, 1980

PIM

Deflator of total imports of goods, 1980 - 100.

PM01

Unit value index for imported goods under SITC 0 and 1, 1980 "' 100.

PM59

Unit value index for imported goods under SITC 5 to 9, 1980 "' 100.

REC

Reexports of goods, in constant (1980) dollars.

REDM

Real estate developers' margin, in constant (1980) dollars.

RM24

=

100.

: Retained imports of goods under SITC 2 and 4, in constant (1980) dollars.

T

Time trend.

T1

Linear spline time dimension variable, max(T-12,0).

T2

Linear spline time dimension variable, max(T-32,0).

T3

Linear spline time dimension variable, max(T-44,0).

USGNP

Gross national product ofthe United States, in constant (1980) dollars, billions of U.S. dollars.

UVIS

Unit value index (or domestic exports to the United States, 1980 "" 100.

Note: All variables, unless otherwise specified, are measured in billions of Hong Kong dollars.

BIBLIOGRAPHY Ahlburg, D.A., 1984. "Forecast Evaluation and Improvement Using Theil's Decomposition", journal of Ibrecasting, Vol. 3: 345-351. Box, G.E.P., and G.M. jenkins, 1976. Time Series Analysis: Forecasting and Control, Revised edition. San Francisco, CA: Holden-Day, Inc. Fair, Ray C., 1984. Specification, Estimation, and Analysis ofMacroeconometricModels. Cambridge, MA: Harvard University Press. Friedman, M., 1965. "The Interpolation of Time Series by Related Series", American Statistical Association journal, Vol. 60: 729-757. Granger, C.WJ., and P. Newbold, 1977. Ibrecasting Economic Time Series. Orlando: Academic Press, Inc. _ _ .., 1973. "Some Comments on the Evaluation of Forecasts", Applied Economics, Vol. 5: 35-47. Hanssens, D.M., and Lon-Mu Liu, 1983. "Lag Specification in Rational Distributed Lag Structural Models",journal ofBusiness and Economic Statistics, Vol. 1: 316-325.

154

W.L. Chou and Thong-Biau Lin

Hong Kong, 1985. Estimates of Quarterly Gross Domestic Product, mimeo.

___, Hong Kong Monthly Digest of Statistics. Hong Kong: Government Printer. Lin, T.B., and W.L. Chou, 1985. "Hong Kong Model", in Shinichi Ichimura and Mitsuo Ezaki, eds., Econometric Models of Asian Link, pp. 9-34. Thkyo: Springer-Verlag. Liu, Lon-Mu, Gregory B. Hudak, George .E.P. Box, and George C. Tiao, 1983. The SCA System for Univariate Multivariate Time Series and General Statistical Analysis. Dekalb, IL: Scientific Computing Associates. Organisation for Economic Co-operation and Development (OECD), 1987. Quarterly National Accounts, No.3. Paris: OECD. Ormerod, Paul, ed., 1979. Economic Modelling. London: Heinemann Education Books, Ltd. Pindyck, R.S., and D.L. Rubinfeld, 1981. Econometric Models and Economic fbrecasts, Second edition. New York, NY: McGraw-Hill Company. Smyth, DJ., 1983. "Short-Run Macroeconomic Forecasting: The OECD Performance", journal of Forecasting, Vol. 2: 37-49. Theil, H., 1966. Applied Economic Forecasting. Amsterdam: North-Holland. _ _, 1961. Economic Forecasts and Policy. Amsterdam: North-Holland.

Waelbroek,J., 1975. "A Survey ofShort-Run Model Research Outside the United States", in G. Fromm and L.K. Klein, eds., The Brookings Model: Perspective and Recent Development. Amsterdam: North-Holland. Yik, Y.M., 1982. "Quarterly Macroeconometric Model of the Hong Kong Economy". Ph.D. dissertation, Chinese University of Hong Kong, Thipei. Zarnowitz, V., 1979. "An Analysis of Annual and Multiperiod Quarterly Forecasts of Aggregate Income, Output, and the Price Level",journal ofBusiness, Vol. 52: 1-33. Zellner, Arnold, and Franz Palm, 1974. "Time Series Analysis and Simultaneous Equation Econometric Models", journal of Econometrics, Vol. 2: 17-54.

X THE EFFECT OF RICARDIAN RENT EXTRACTING ON MACROECONOMIC PERFORMANCE MANUEL F. MONTES

Introduction Rent-seeking has become a current explanation for the problems of the Philippine economy. But although the actual channels ofinfluence on the Philippine economy have been hypothesized extensively, positive analysis is at an infant stage. In discussion s among mainstream economists in the Philippines, the policy suggestions toward liberalization (i.e., of imports, the financial sector, and exchange-rate setting) are premised on two things. First, it is implicitly held that these liberalizations will permit domestic prices to be more closely aligned with world prices and thereby promote efficiency. Second, it is assumed that these liberalizations will promote competition by destroying special privileges granted by the government. Yet, empirical evidence suggests that the most successful export-oriented developing countries, except for the twentieth century reincarnation s of Venice and Florence in Hon g Kong

156

Manuel F. Montes

and Singapore, have been the most protectionist and laden with distorted internal prices. Analytically, it can b~ argued that if rents represent nothing but pure in.c ome transfers, then rent-seeking does not inflict distortions in the economy. Moreover, it has been argued that if indeed economic agents are genuinely profit-maximizing, distortiona'ry rents should provide entrepreneurs with the resources they need to improve their efficiency and expand their output (including the motivation to sell overseas) (Rodrick 1988). Frustrated developing countries, such as the Philippines, also provide a fertile ground for political economy discussions about the nature of underdevelopment. Currently, there is a debate on whether the Philippine economy can be characterized as "capitalist" or "pre-capitalist". The importance of the discussion originates from the effort to specify development strategies alternative to the ones that have been implemented thus far in the Philippines. Those who take the position that the Philippines is a capitalist economy take their inspiration from the dependency school and ·o ften describe the economy as "peripheral", "backward"~ or "dependent". According to this view, the Philippine economy was established through the penetration of a " world capitalist system". Thus, the_suggestion that .a "socialist" economy is the solution to Philippine underdevelopment is made. As noted in a document at the Second Congress of the Orga.nization for the Development of Social Thought and Practice, " We have consistently characterized the Philippines as an underdeveloped and dependent capitalist society with remnants of feudalism. The capitalist rather than the feudal sector is the most dynamic aspect ·o f this social system. It is expanding while the feudal sector is shrinking, and the growth of the capitalist sector sets the pace and direction of the development of the country as a whole.'' (Bukluran sa Ikauunlad ng Sosyalistiang Isip at Gawa 1987, p. 27) According to this view, the empirical riddle is that if indeed the capitalist sector is dominant, there should have been vigorous reinvestment and expansion in response to the highly protectionist microeconomic environment in the Philippines. That U.S. firms, presumably quite moder_n and profit-motivated, vigorously participated in an import-substitution experiment which did not evolve into successful export performance both confirms the intensity of the inward-looking policy environment and deepens the empirical riddle. The analytical issue that the dependency view appears to beg is the question of how the capitalist sector interacts with (and, presumably, causes the shrinkage of) the feudal sector. Why is there, for example, limited motivation for agrarian reform or for the .promotion of manufactured exports if indeed the capitalist sector is dominant? It may be that the inadequacies of both views stem from an insufficient understanding of the relationship between profit-making and rent-seeking.

The Effect of Ricardian Rent Extracting on Macroeconomic Performance

157

1b fill this gap, this paper explores a model in which capitalists actually maximize profit and decide how much employment occurs in the economy. But because of the rentier nature of the economy, their room for expansion is constricted. It is further demonstrated that the employment rate is lower in a rentier economy than that which would prevail if rentier income were not a structural characteristic of the· economy. Thus, this paper argues that while "dynamism" in the capitalist class does indeed exist, this dynamism is circumscribed by the rentier nature of the Philippine economy (Ferrer 1987). The discussion utilizes a rent-generating model first suggested by Ricardo (1817) and formalized by Pasinetti (1977). The actual manner by which rent is generated in the Philippine context should be a subject of more empirical research.1 However, Ricardo's model is adequate for the present purpose to the extent that rent arises from special access to more productive economic assets. The losses imposed by rent in this model stem from its macroeconomic role in the model. This is as opposed to its microeconomic (allocative efficiency) effect commonly used in neoclassical economics. The model is first explained from the supply side and then from the demand side. This is followed by a discussion of the dilemmas in the growth process generated by the type of economy described. The Supply Side The supply side is a modification ofPasinetti's model of a Ricardian economy. The equations of the model are:

(1) Y ~ f{N; K) = f{N), (1a) f"(N) < 0 for all N; (2) R = f{N) - N f'(N), (3) W = (w/p) N, (4) S = Y - R - W,

where Y is real output in physical units, N is the number of workers employed, K is the existing stock of physical capital, w is the nominal wage rate, p is the overall price level, R is real rental income (in physical units), W is the real wage bill (in physical units), and S is real profit income. Equation (1) is a standard one-input, one-output production function. Here we assume that the macroeconomic problem takes place in the context of an existing capital stock, i.e., K is assumed to be fixed. Capitalists decide how much labor to hire in each time period. Condition (1a) embodies the assumption of diminishing marginal returns and, as in other optimization exercises, will ensure that a finite solution exists.

Manuel F. Montes

158

It will be convenient to analyze only levels of employment in which the

marginal product of labor is positive, i.e., (1b) f'(N) > 0 for all ·N. When production takes place, rents are paid through equation (2). This equation embodies the· Ricardian view that as the less productive resources are put into operation, owners of the more productive assets are able to capture the "differential" rent. Rental income here is quite different from rental income in Marxian models, which often estimates rental income from interest earnings on financial lending and rental income in the national account statistics, which includes all income from property. Equation(3) determines the wage bill. Equation (4) embodies the structural characteristic whereby profits are made only after rents and wages are paid. Thus, the model as defined has four equations and seven unknowns, Y, N, R, W, w, p; and S. If it is assumed that the overall price level in the macro economy is determined in conjunction with the aggregate demand schedule, we are left with six unknowns to determine on the supply side. One way to close the model is to assume full employment of existing resources, i.e., (5) N = Nr

(6) W = Wr where Nr is the full employment level of labor. Wr is the full employment level of working capital, which is equal to the wage bill in this model. Under this assumption, given W and p, the nominal wage rate is endogenously determined. On the other hand, in Pasinetti's interpretation, Ricardo closes the model in the following way: · · (7) W

=

W

0

/p

(8) W =We.

According to these equations, the real wage rate is at the equilibrium level when it is at the "natural rate", i.e., wnfp. At this natural wage rate, the population is constant and working capital is fully employed; it is the rate of employment, N, that is endogenous. For our purposes, however, the nominal wage rate is assumed to be fixed at some prevailing level: (9)

W

=

Wu

and the level of profit is assumed to be the outcome of the following maximization process: (10) max { N }

S

The Efftct of Ricardian Rent Extracting on Macroeconomic Performance

159

Capitalists, in turn, determine the level of employment which maximizes their profit from operations. In Keynesian fashion, this level of employment could occur where part of their existing working capital could be unemployed (aside from the fact that it could also mean that part of their standing physical capital stock could be unemployed). The first order condition of the maximization program requires that (11)

dS _ d{f{N) - [f{N) - N f'(N)] - (wu/p)N} dNdN

=

O

or that the solution Nr must be such that (12) f'(Nr) "" w ufp - Nr fH(Nr) where Nr is the level of employment which maximizes profits when rent has to be paid. Given N" the level of output (Xr) is determined from equation (1), rental income (R) from equation (2), the wage bill from equation (3) assuming p is determined elsewhere, and the resultant level of profits from equation (4). Under this model, there is no guarantee that the outcome involve the full employment of working capital or labor. This is discussed briefly in the next subsection.

will

Unemployment An implication of the model is that the level of employment, Nn can be lower than that in a nonrentier economy. If the fixed prevailing wage rate is set above that which would make labor markets clear, Nr would be below full employment. But In this model there is another source of unemployment arising from the rental extraction in the production process. Even when the prevailing wage rate is set below the supply price of workers, the level of employment would be lower than that in a competitive economy. In a «capitalist" economy, the level of employment will be determined as follows:

(13) max

y -

w

{N } where the first-order condition requires that the marginal productivity of labor condition be satisfied, i.e., (14) f'(Nc) -= wjp

where N0 is the rate of employment determined by profit-maximizing capitalists who do not have to pay rent. For any given real wage (wu/p), diminishing marginal productivity (1a) and conditions (12) and (16) imply that (15) Nr


O requires that f'(N)>(w/p), i.e., the marginal product oflabor must always exceed the real wage. Because of diminishing marginal

The Effect of Ricardian Rent Extracting on Macroeconomic Performance

161

productivity, there will be some level of employment, Nk, beyond which capitalists will not hire additional labor. If Nk exceeds the total amount of labor available, N n then. N r corresponds to the maximum employment pos~ible. (In a capitalist economy, the constraint is that profits are positive as long as real output exceeds the wage bill.) If Nk is less than Nr, which is likely in a labor surplus economy, then Nk would correspond to the level of output at which the aggregate supply curve turns upward even before full employment is reached. What is the relationship between the level of employment (and output) and rental income? Differentiating equation (2) with respect to N, we get (20)

~~

=

-

NfH(N)

>

0.

Thus, on the supply side of the economy, rental income increases as long as employment and output increase. Figure 1 depicts these properties of the aggregate supply curve.

Figure 1 Aggregate Supply

p

Y(~ Y(~)

Manuel F. Montes

162

Effect of rental extraction through monopolization What happens when the rate of rental extraction increases? We can expand the model by adding a parameter to represent this factor. The rate of rental extraction will depend on the degree of monopoly power and political concentration in the society. Let m > 0 represent an index of rental extraction and redefine equation (2) as (2') R ·"" m [f{N) -

N f'(N)].

The profit function (4) becomes (21) Sm

= (1

- m) f{N) + m N f'(N) - (w/p) N.

If m > 1, the first term in equation (21) is negative, and the only term contributing to positive profits is the second term. Profit maximization requires that (22) f'(N,.,) = wJp - m N fN(Nm).

Based on equation (22), it is clear that Nm < Nc. Equation (20) implies that for a given (w/p): Nm = Nr (23) Nm > Nr Nm

< Nr

form= 1 for 0 < m < 1 form> 1.

For the extended problem, the sufficient condition for a maximum requires that (24) (1 + m) f'(NmJ + m Nm f"'(Nm)