corruption the boom and bust of eastasia

Corruption: The Boom and Bust of EastAsia

Governance and corruption have finalJy come to the fore of the development debate. While interest in governance began to surge in the earl)' 1990s, the East Asian crisis has catapulted the issue to prominence. Analysts and academics. in a spate of anides and books, have added their voices to the chon.s of criticism of the so-called Asian miracle. Their verdict: Bad governance and corruption did the "miracle" countries in.

Taking a different perspective. this book asks and attempts to answer how these countries were able 10 attract enormous amounts of investment and enjoy rapid growth (lver a thirty-year period despite being perceived as hotbeds of corruption As convelllional wisdom would have it. high rates of investment are inconsistent with high levels of corruption. While this may be true in general. the chapters in this volume suggest that we need to look illlO the nature of corruption. Different types of corruption have varying effects On investment.

I. Edgardo Call1IJOS is senior economist in the Strategy Policy Depanment of the Asian Development Bank.

I/a-/ooll Clumg is professor at the Faculty of Economics and Politics, Cambridge University.

Emmalluel S. de Dios is professor in the School of Economics. University of the Philippines.

Hadi Salehi Bfaltalli is professor in the Department of Economics. University of Illinois at Urbana-Champaign.

Allell Hickell is assistant professor at the Depanment of Political Science, University of Michigan. lie was previously assistant professor at the Gra(lllatc School of International Relations and Pacific Studies. Departmelll of Political Science, University of California at San Diego.

lomo K. S. is professor in lhe Department of Applied Economics, University of Malaya.

SI.llhe Li is associate professor in the Depanmelll of Economics and Finance. City University of Iiong Kong.

Peng Ua/l is director of Stalistical Research and Analysis. Nllmetrics Management Systems. Santa Clara. California.

DO/lflld Lien is professor of economics and finance at the Umvcrsity of Texas at San Antonio.

AlLdrew Macilltyre is professor in the Graduate School of International Relations and Pacific Studies, Departmcnt of Political Science. University of California at San Diego.

SalLjay PradlulII is senior governance advisor for the South Asia Region at the World Bank.

Ateneo de Manila University Press Kallpunan Avenue. Loyola His .• Q.C. P.O. Box 154, 1099. Manila 9

ISBN 971-550-377-2

CORRUPTION THE BOOM AND BUST OF EAST AsIA

Edited by J. EDGARDO CAMPos

ATENEO DE MANILA UNIVERSITY PRESS

-

ATENEO DE MANIlA UNIVERSITY PRESS Bellarmine Hall. Katipunan Avenue Loyola Heights. Quezon City P.O. Box 154. 1099 Manila. Philippines Tel.: (632) 426-59-84 I FAX: (632) 426-59-09 E-mail: [email protected]

Copyright 2001 by Ateneo de Manila University and J. Edgardo Campos

Cover and book design by J. B. de la Pena

All rights reserved. No part of this publication may be reproduced. stored in a retneval system. or transmitted in any form or by any means. electronic mechanical photocopying. recording. or otherwise. without the written permission of ;he Publisher:

The National Library of the Philippines CIP Data

Corruption: the boom and bust of East Asia I edited by J. Edgardo Campos; with contributions from Ha-Joon Chang . .. I et al. J - Quezon City: ADMU Press. c2001 1 v.

I. Financial crises - East Asia. 2. East Asia -Economic conditions. 3. East Asia - Politics and government - Corrupt practices. I. Campos. J. Edgardo. II. Chang. Ha-Joon.

HB3722 332 2001 POI 1000025 ISBN 971-550-377-2

ACKNOWLEDGMENTS

We gratefully acknowledge the financial support of the Foundation

for Advanced Study in International Develop ment (FASID) of Japan and

the World Bank Institute (WBI) for this manuscript. Special thanks go to

Danny Leipziger, fo rmer Chief o f the Regulatory Reform and Private

Sector Development Division of the WBI; Farrukh Iqbal, former East Asia

Regio n al C o o rdinator fo r the WBI; and Michiko Kakegawa, Program

Officer for FASID, under whose watch the various research papers were

initiated, and to Brian Levy and Stephan H aggard for their constructive

criticisms of the initial drafts of the chapter p apers. We also wish to thank

participants of the Fifteenth WBIIFASI D Joint Seminar on Governance

and Private Investment in East Asia for their comments and suggestions

on the revised versions of the chapter papers, H annah Moore fo r her

patient editing of the penultimate version, Alice W. Y. Chan and Rebecca

Hife fo r their research assis tance, Dan iele Evans fo r her pains taking

effo rts at organizing the workshops at which earlier drafts were pre

sented and discussed, and Flor Guce for making sure the final version

co nfo rmed to publicatio n guidelines .

.,.

CONTENTS

INTRODUCTION

]. Edgardo Campos . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1 CORRUPTION AND ITS IMPLICATIONS FOR INVESTMENT

]. Edgardo Campos, Donald Lien, and Sanjay Pradhan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1

2 INVESTMENT, PROPERTY RIGHTS, AND CORRUPTION IN INDONESIA

Andrew MacIntyre . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

3 STATE, CAPITAL, AND INVESTMENTS IN KOREA

Ha-]oon Chang . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

4 GOVERNANCE AND INVESTMENT IN CHINA

Shuhe Li and Peng Lian . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

5 CENTRALIZATION, POLITICAL TURNOVER, AND INVESTMENT IN THE PHILIPPINES

Emmanuel S. de Dios and Hadi Salehi Esfahani . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

6 GOVERNANCE, RENT-SEEKING, AND PRIVATE INVESTMENT I N MALAYSIA

]omo K. S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

7 GOVERNANCE AND GROWrH IN THAIlAND

Allen Hicken . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

NOTES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198

INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

INTRODUCTION ]. Edgardo Campos

In this day and age, it has become fashionable to talk about "go od

governance" and its importance in stimulating and sustaining economic

growth. The current heightened interest in this subject has been stimu

lated by the enhanced capacity of economists and political scientists to

model more rigorously the incentive dynamics within different gover

nance structures , to quantify the quality of governance, and to measure

its impact on economic performance (see, for instance, Kaufmann 1 996,

Urata and Kawai 1 999 , M auro 1 995) .

The East Asian financial crisis has heightened the concern not o nly

over good governance but also over the relationship between gover

nance and corruption. Many critics of the Asian miracle have argued that

the governance structures underpinning the East Asian economies have

been largely responsible for the crisis. Interestingly, however, the quan

titative indices that have been used to rank countries in terms of corrup

tion, and more generally rule of law, either did not change much before

and after the crisis set in or changed in an "unexpected" direction. ! China

and Indonesia, for example, had always been ranked among the m o st

corrupt countries in the world, followed not too far down by Thailand

and the Philippines . Before the crisis , Malaysia was always ranked among

those with better rule of law.

The term "goo d governance" is somewhat slippery and ambiguous

as numerous definitions permeate the l i terature. Whatever the defini

t ion, there a p p e ars to b e a c o n s e n s u s that good gove rnance m u s t necessarily encompass the protection of property rights. This h a s led to

the corollary that credible contract enforcement is necessary to attract

Introduction

productive investments and thus stimulate economic growth. Indeed,

there is now reasonable emp irical evidence that supports this thesis

(see, for instance, Keefer and Knack 1995) .

Implicit in much of the literature on private property rights is the

assumption that formal legal institutions, such as an independent judi

ciary, are critical to the credible enforcement of contracts (see, for instance,

North and Weingast 1 989; North 1990) and hence for stimulating invest

ment and growth.2 While not denying the importance of such institutions,

this volume questions the almost theological belief that countries with

out such institut ions are dest ined to remain p o o r and economically

underdeveloped. To be sure, it does not challenge the validity o f the

Northian thesis: as many historians have shown, over the very long haul,

an economy will eventually stagnate if institutions that promote the rule

of law fail to develop. The volume, however, does raise the issue of what

happens in the interim between now and the almost invisible long-term

horizon . For businessmen and policy makers in developing countries,

the No rthian prescription is of little utility as they, their childre n, and

perhaps even their grandchildren will have been dead by the time the

rule of law emerges in their countries.

East Asia's experience over the p ast thirty years provides a window

into the labyrinth between the "now" and North's long haul. As the case

studies in this volume maintain, in East Asia informal, nonlegal arrange

ments emerged (over a relatively short period of time) to fill the formal

institutional vacuum. These institutions made contracts enforceable and

thus encouraged inflows of private (and productive) investment. Indeed,

there is now a mountain of evidence indicating large flows of private

investment into East Asia, both domestic and foreign, despite the weak

ness or even absence of legal institutions.

The Asian economic crisis has brought governance and the rule of

law into the fo refront of discussions and debates about the s o - called

Asian Miracle . The cris is, many critics o f the miracle argue, erupted

because of pervasive, institutionalized corruption made possible by a

dysfunctional, politically malleable legal system. The resulting calls for

institutional reform have been deafening.

These critics, however, have lost sight of the obvious fact that thirty

years of impressive, extensively documented e c o n o mic perfo rmance

preceded the crisis . This volume attempts to address this seeming di

chotomy. To be sure, the volume does not purport to be another treatise

on the crisis . Rathe r, it situates the crisis within the larger co ntext o f

institutional change. A s many of t h e authors argue or imply, t h e crisis

2

Introduction

is on the one hand a manifestation of institutional inertia in the midst

of a rapidly changing environment, and o n the other a commentary on

the problems o f transition to a society governed by the rule of law.

The East Asian Paradox

The experience of the six countries presented in this volume-China,

Indonesia, Korea, M alaysia, Philippines, and Thailand-presents a dif

ficult paradox to proponents of "goo d governance." O n the one hand,

these countries have managed to attract large flows o f private invest

ment over a very long period (although the Philippines was a latecomer) .

On the other, with the exception of Malaysia, these countries have fea

tured p r o m i n e ntly i n the "world 's l i s t" o f m o s t c o r r u p t c o u n t r i e s .3

Moreover, as conventional wisdom would have it, corruption in these

countries is highly correlated with a perceived weakness of legal insti

tutions. Hence, the proponents of "good governance" are confronted with

exactly the o p p osite of their revered gospel : in East Asia, weak legal

institutions have existed side by side with high levels of investment (not

to mention rapid rates of growth) .

The volume attempts to resolve this p aradox. I n different ways, a

number of the autho rs argue that institutions that promote the credible

enforcement of contracts have indeed existed in many of these East Asian

countries. These institutions, however, are of the informal, nonlegal variety

which the above proponents often perceive (and believe) to be detrimen

tal t o e c o n o m i c growth b e c a u s e they p r o p agate r e n t - s e eking and

consequent large-scale corruption. Their assumption is that if institutions

foster rent-seeking and corruption, then they must be inimical to growth .

By contrast, the authors argue that rents and corruption have been essen

tial to the credible enforcement of contracts and thus to the large inflows

of investment. In his chapter on Indonesia, Macintyre makes this point

most crisply and vividly. He maintains that special features of the Suharto

regime had allowed it to function much like a joint monopolist trying to

maximize profits across complementary products. Specifically, he argues

that Suharto established and nurtured a political structure grounded on

two pillars, corruption and investment. The structure gave Suharto ample

opportunity to extract rents, to distribute it systematically across the bu

reaucratic and political landscape, and to keep the costs of generating the

rents from squeezing out long-term investments. A conscious decision to

open the capital account early in the regime's life effectively tied Suharto's

hands and credibly committed his regime to honoring agreements with

investors: investors could take their money out if they sensed any unfa-

3

Introduction

vorable change in economic policies. Hence, Suharto and his regime had

strong incentives to ascertain that private investors were not subjected to

independent, uncoordinated rent-seeking, bribe-taking efforts that discour

aged long- term investments. In sum, while investors might have had to

fork out considerable rents, whether in the form of bribes or shares, they

were assured that their investments would be protected from harassment

and that agreements they had made with the government were adhered

to. The rents and associated corruption involved have been the glue that

has tied this info rmal system together and has made the system work

effectively over thirty years .

Similarly, Li and Lian c o ntend that the p olit ical regime in China

behaves much l ike a "j oint monopolist ." They present an abstract sys

tem which they label market-preserving authoritarianism (MPA) , argue

that China fits this abstraction reasonably well, and then conclude that

the basic features of an M PA have led to a b alance between p olitical

centralization and economic decentralization that ultimately places con

straints on corruption in order to attract p rivate investment. Among the

more concrete, China - specific features of an M PA, they identify a set of

internal rules governing recruitment, promotion , and behavior within

the bureaucracy, an economic performance-based system of promotion

within the Communist Party, collective decision-making mechanisms that

increase transparency in the proj ect- approval process , a graduated al

l o c a t i o n of c o n t r o l or autho rity a t vert ica l l e v e l s o f p u b l i c - s e c t o r

management-meaning that lower-level officials have explicit limits to

what is within their authority, fiscal decentralization, and a court system,

which, while clearly weak and inadequate, renders impartial judgment

in cases where the verdict can be easily verified by a third party.4 Com

bined with the existence of a large overseas Chinese capitalist cadre,

these features , the authors argue, have led to the adoption of informa

tion- revealing mechanisms and the emergence of strong cross- regional

co mpetit ion as info rmal means to enforce investment agreements in

China, where formal legal institutions are weak, and, as a by-product, to

indirect means of containing corruption.5

In his chapter on Korea, Chang takes a sl ightly different route but

essentially arrives at a s imilar conclusion : co rruption is an essential

element of an "econo mic" governance system that has been very suc

cessful at st imulating private investment. The Korean government, he

argues , could and did set up a system of highly interventionist policies

that ( 1) made domestic investment much more attractive than consump

t ion , (2 ) created monopoly rents for large domestic firms (chaebols) in

4

Introduction

exchange for investing in productive , export- oriented activit ies , (3) pro

vided implicit (and illegal) wages to relatively poorly paid publ ic officials ,

(4) provided discretionary funds to local polit icians to enable them to

buy political support , and (5) l imited corruption flows to sectors that

were less important for international competitiveness . Like its counter

parts in Indonesia and China, this tightly knit , relatively well- thought-out

system was glued together by rents and corruption.

Institutional Change and the East Asian Crisis

Highly authoritarian regimes have governed each of the three coun

tries discussed above . One is thus tempted to deduce that democratizing

these regimes will improve governance and reduce corruption. Economic

historians indicate that over the long haul this is l ikely to be the case.

Yet if world history is any guide, the transition period is likely to be very

long. And in the transition , things may not get better until much later.

De Dios's and Esfahani 's study on the Philippines identifies a fun

damental d i l e m m a t h a t m a y co nfront c o u ntr ies u n d e r g o i n g s u c h a

transition. Democratization tends to distribute power and political influ

ence more widely across different groups . This creates more s o - called

veto p oints i n the dec is ion- making p r o c e s s and potentially leads to

gridlock. In the absence of firmly established democratic institutions , i t

leads to what Shleifer and Vishny (1993) call an "independent monopo

l i s t" regime of rent- seeking and corruption that s ignificantly increases

transactions costs (including rent- seeking costs and associated levels of

corruption) . A natural , almost knee-j erk response to this has been to

maintain a strong executive branch of government, as this is viewed as

a way to prevent gridlock and keep transactions costs from bursting at

the seams. As de Dios and Esfahani argue, this moves the system closer

to a "joint monopolist" regime in which the executive has strong incen

tives to keep rent -seeking and corruption from sucking up investment

and growth. Unfo rtunately, as these co authors so vividly i l lustrate in

their analysis of the Phi l ippines ' postwar experience , it also creates a

ser ious credible commitment problem: a strong executive b ranch i n

c r e a s e s t h e r isk to investors of h a v i n g a g r e e m e n t s r e a c h e d under a

particular regime "reconstructed" if key polit icians of that regime fail to

win reelection or, as in the case of the Philippines , are restricted by law

to term limits.6 The recent political events in the Philippines-the so- called

People Power Revolution 2-which has led to the unseating of a duly

elected president well within the constitutional term of six years , highlights the de Dios -Esfahani dilemma. The President, Joseph Estrada, exercised

5

Introduction

the full powers vested in him by the Constitution to influence decisions

in favor of individuals and groups who could fork out large sums of money

in bribes. While this practice may not have been unique to him, the manner

in which he had done so created considerable uncertainty among the

business community and eventually shut off private investment. Presiden

tial influence was exercised randomly, with little rhyme or reason, inevitably

affecting existing or proposed contractual arrangements; only the avail

ability and size of p ayoffs seem to have mattered. Even the supposed

built-in discipline of a "joint monopolist" came to be violated.7 As Fabella

aptly put it, the president had moved beyond the "Twilight Zone" of cor

ruption and rent-seeking, i . e . , what could be tolerated by the economy,

thereby creating uncertainty and strong negative reactions from the busi

ness community and eventually from many segments of civil society.s The

dilemma of balancing the need for a strong executive and the potential for

gridlock is indeed a very real dilemma for nascent democracies, especially

those in transition from an authoritarian state.

Implicit in de Dios's and Esfahani 's argument is the assumption that

both the judiciary and p olitical p arties are weak. As the experience of

many former communist countries indicates, this is likely to be the case

for countries undergoing the transit ion to d e m ocratic rul e . 9 Pol it ical

p arties are more likely to represent temporary c o al i t ions rathe r than

ideologically grounded o rganizations and the judiciary to be hampered

by lack of experience and resources.

The discussion on the Philippines brings us to an inextricably linked

topic of this volume, namely, institutional change and the Asian economic

crisis . The Asian economic crisis has turned into a convenient instrument

for lambasting the absence or weakness of legal institutions in East Asian

countries and how these inadequacies have been the principal culprit for

these countries' current woes. The criticisms, however, have lost sight of

the fact that most of these countries have experienced rapid growth and

significant reductions in poverty over the last thirty years despite these

presumed institutional deficiencies . Through the postwar experiences of

six East Asian countries, this volume addresses the flaw in the logic un

derlying these criticisms and examines an underexplored dimension to

the crisis-institutional change as so espoused by North ( 1 981) .

MacIntyre, Chang, and Li and Lian address this issue in their chap

ters. However, it is the chapter on Malaysia that more vividly illustrates

the dynamics of institutional change and how the crisis is but a reflec

tion of these dynamics. As North posits , institutions evolve in response

to technological change. Jomo contends that rapid financial Iiberaliza-

6

Introduction

t ion, which is a form of technological change, altered the Malaysian

economic landscape so drastically that institutions could not p ossibly

adapt to the changes quickly enough. The resulting institutional gap, he

concludes , has b rought forth the economic crisis .

Malaysia's postwar history and its experience with the current crisis

exemplify the difficulty of undergoing fundamental institutional change.

Among the six countries in this volume, Malaysia is unique in the sense

that it has ranked considerably high o n the "rule o f law" scale as re

flected in various international surveys of businessmen (or alternatively,

c o n s iderably low o n the c o rrup t ion rankings) . And yet , cr i t ics have

blamed rent-seeking and corrupt practices for the country's failure to

thwart the Asian contagion. Jomo's chapter offers a stinging rebuke o f

such criticisms. Like t h e other authors, he makes a strong case for rent

s e ek i n g and c o rr u p t i o n a s b e i n g p ar t a n d p ar c e l of " e c o no m i c"

governance and implicit contract enforcement in Malaysia. He emphati

cally argues , however, that financial l iberalizat ion created a deep and

wide inst i tut io n al gap that u l t imate ly t r a n s l a t e d i n t o arguably the

country's most serious postwar economic crisis . Financial liberalizatio n

required changes in regulatory and legal institutions; and these changes

directly challenged the institutional arrangements that underpinned the

country's economic governance system, i .e . , arrangements that had rent

seeking and corruption at the very core of the country's "shared gro\\<1h"

phenomenon. Hence , the required changes could not be expected to

emerge quickly. N o t surpris ingly, l ike a b o dy without the natural de

fenses to thwart a virus , Malaysia went into convulsion-the cris is .

In fact . J omo goes further in elaborating his thesis of institutional

inertia. He describes and analyzes in painstaking detail the constraints

current Prime Minister Mahathir confronted in trying to move the sys

tem away fro m the fo undations o f the N ew Economic Pol icy ( N E Pl.

which sought to redistribute wealth toward the economically disadvan

taged but politically more influential Bumiputeras at the expense of other

ethnic groups , in p articular the Chines e . Tomo concludes that, in the

final analysis , Mahathir had to build on the NEP in order to bring about

inst i tut i o n al change , a gradual process pushed along by a po l itically

well - i nformed strategy and which took more than a decade to unfold .

To h ave exp e c t e d the regu l a t o ry a n d legal i n st i tut i o n s to re s p o n d

promptly t o the new environment thrust upon them b y financial l iber

alization was thus , in his view, unreal istic.

The Thai exp erience il lustrates essentially the same phenomenon but with a sl ightly different twist . Hicken contends that financial l iber-

7

Introduction

alization was the proverbial final straw that broke the camel 's back. He

notes, however, that the makings of the crisis likely began a decade earlier.

Hicken compares the government's response to the macroeconomic

crisis of the early 1 980s with its response to the late 1 990s macroeco

nomic crisis brought forth by the Asian flu. Until the recent constitutional

change, Thai politics was characterized by a weak separation between

the executive and legislative branches of government, multiple political

p arties (each of which tends to be regionally based and includes com

p e t ing i n t e r n al fact i o n s ) , a n d an e l e c t o ral system b i a s e d towards

individualistic or personalistic campaign strategies-as opposed to strat

egies based on party reputation or a party's policy positions. On the one

hand , the first i s c o n ducive to the promot ion of welfar e - e nhancing

national policies and to swift responses to crisis; on the other, the sec

o n d and third encourage gr idlock , the p a s s age o f narrowly targeted

p olicies that award p articularistic benefits to a legislator 's constituen

cies , and the diversion of government resources through corruption to

raise campaign funds. Hicken argues that these features did not change

fundamentally between the two crisis periods, and yet the government's

response was much different . I n the earl ier p e r i o d , the government

managed to push p olicies that stabilized the macroeconomy, attracted

huge flows of private investment, and encouraged economic growth . In

contrast, in the latter p eriod, the government p roved incapable of ad

dressing the burgeoning problems in the financial sector even though

there was clear recognition in some corners that these problems would

eventually derail the economy.

He po sits that during the early 1 980s p olitical p arties needed the

military's support to maintain political stability. Back then the military

was still an important (if not the dominant) player in the political arena.

Moreover, the parties themselves were in constant disagreement, unable

to forge compromises on leadership arrangements. So the military was

seen as a stabilizing force. The result was the appointment of General

Prem as prime minister ( 1 980- 1 988) with a mandate to get the country

out of the crisis . Being a nonelected PM, Prem was not tied down to the

narrow particularistic tendencies of regional politics . Hence, he had some

flexibi l i ty to push more nationally encompassing economic po l ic ies .

However, he (and the military) recognized that he also needed the parties

to help govern the countryside; gone were the days when the military

was the all -encompassing force whose unmistakable presence was felt

throughout the country. This led to what Hicken calls the "policy- patron

age" compromise between Prem and the p arties : Prem would have the

8

Introduction

flexibility to fashion macroeconomic policies with little interference from

politicians and the p arties would have control over sectoral ministries

whose mandates were more conducive to generating pork barrel projects .

Prem thus managed to insulate the economic technocracy from political

interference , a p p ointing ( o r influencing the appointment of) highly

qualified and respectable professionals to key positions in the four key

elite economic agencies-the Planning Ministry (NESDB) , the Ministry

of Finance, the Budget Bureau, and the Central B ank.

Toward the late 1 980s and early 1 990s , the polity began to change

significantly with a s ignificant middle c lass s lowly emerging. As the

economy grew and the middle class exp anded, demands for democrati

zatio n increased as wel l , leading eventually to the first elected p rime

minister. As Hicken points out , however, this opening up of the political

system had a disastrous effect on the elite agencies that made up the

technocratic system. Whereas in the past these agencies were relatively

insulated from political interference, with greater democratization they

became part of the spoils that accrued to members of the winning coali

tion. Hence, each of the elite agencies tended to be controlled by different

political parties bonded together by convenience and not by any common

political persuasion. This greatly weakened coordination among the agen

cies and biased economic decision making toward narrow concerns. This

left the agencies less capable of responding to the new environment

imposed by rapid financial liberalization which, as the Malaysian experi

ence suggests, creates unrealistic demands on institutions .

The Thai experience illustrates once again the difficulties of under

going a transition from an authoritarian to a democratic setting. The

shift to unstable, coalition-based politics has had serious adverse con

s e q u e n c e s fo r e c o n o m i c manage m e n t . I n t ime, new i n s t i t u t i o n a l

arrangements will l ikely emerge to respond to t h e defic ienc ies . The

passage of the 1 998 Constitution is a step in the right direction. Yet given

the Philippines' experience, the evolution to a new, effective institutional

equilibrium will likely take a long time .

Indonesia , South Korea, Thailand, and Malaysia have indeed been

hit hard by a deep economic crisis which began as a financial cris is in

Thailand but quickly exploded into a ful l -b lown economic cris is and

spread rapidly to the other countrie s . While spared the worst of the

problems, the Philippines has not escaped the contagion. China, on the

other hand, appears to be weathering the storm, post ing a rather re

markable annual GDP growth rate of 7.8 percent for 1 998 while the rest

of the region's economies contracted or stagnated .

9

Introduction

The striking economic perfo rmance o f China in the midst of the

region's most serious economic crisis in the p ostwar period is perhaps

not surprising. Of the six countries studied in this volume, China is the

only one that still has considerable restrictions on financial markets and

these restrictions have insulated the country fro m the financial storm

that has ravaged the rest o f East Asia. Its experience thus far p rovides

some support to the thesis of other authors in this volume: rapid finan

cial liberalization is bound to lead to economic crisis . It also suggests

that gradual opening up of financial markets, rather than the "big bang,"

may be the appropriate approach for many developing countries.

Institutions d o change but they do s o very slowly and usually in

resp onse to-or pushed by-technological change. The liberalization of

financial markets in the East Asian countries analyzed here represent a

maj o r change in technology that demanded corresponding changes in

the institutional arrangements governing the public sector and, most

important, the rent-extraction regime. This was not well understood and!

or well appreciated by the leadership and governments in the affected

countries . The result was a sluggish (some would say hesitant) response

that inevitably led to a full-blown crisis . Unmistakably, corruption has been the boom and bust of East Asia.

Structure of the Volume

The volume is organized into seven chapters. It begins with an econo

metric piece presenting cross-country evidence of the impact of governance

on investment. Chapter one, by Campos, Lien, and Pradhan, presents a

nuanced argument about the impact o f "go o d" governance, whether

through formal or informal mechanisms, on investment. They show that,

indeed, governance matters, as reflected by the fact that countries with

lower levels of corruption do attract higher levels of investment. However,

they also show that, given the level of corruption, the "predictability" of

corruption also has a significant effect o n investment. Ceteris paribus ,

countries in which corruption is more predictable-meaning the likeli

hood that a payoff will lead to the actual granting o f the illicit favo r

sought-tend t o attract relatively higher levels of investment.

The rest of the volume presents six country case studies . In varying

degrees, each illustrates and concretizes the pheno meno n "predictabil

ity of corruption" and reconciles this phenomenon with the Northian

thesis. The six follow in sequence-Indonesia, South Korea, China, the

Philippines, M alaysia, and Thailand .

1 0

-

CHAPTER ONE

CORRUPTION AND ITS IMPLICATIONS FOR INVESTMENT

]. Edgardo Campos, Donald Lien, and Sanjay Pradhan

In the last few years , corruption in developing countries has come

to the forefront of development thinking. Tight fiscal situations at home

have made donor countries focus more o n the impact of their aid to

developing countries, raising concerns among bilateral and multilateral

aid agencies over the effect of corruption on economic performance. At

the same time, the trend towards democratization has made developing

country governments subject to greater scrutiny and accountability from

a broader segment of the general public. The fall of the Bucharam ad

ministration in Ecuador, the convictions of two former presidents in South

Korea, the collapse o f the Mobutu regime in Zaire, the surprising res

ignation of Suharto in Indonesia, a n d the peaceful midterm ouster of a

demo cratically elected president in the Philippines, Joseph Estrada, are

all testimony to the s alience of corruption as a key issue upon which

governments are increasingly being judged .

Despite t h i s , there remains a s ignificant degree o f ambivalence

among many policy makers about the real impact of corruption o n the

economy. This less- than-enthusiastic response is due in part to the so

called East Asian puzzle. In a number of East Asian countries , high rates

of growth had been sustained over a long period despite high levels of

corruption. A number of independent organizations that have conducted

extensive surveys of businessmen throughout the world, e. g . , Transpar

ency International (TI ) , have ranked China, Vietnam, Indonesia, and

Thailand among the most corrupt countries. Yet, as table 1 shows, up

till the recent economic crisis , these countries have grown at phenom

enal rates and, more important, attracted a considerable flow of private

11

Corruption and Its Implications for Investment

capital . This obs ervatio n has p o s e d a real chal lenge to the received

wisdom that corruption impedes economic performance : it is inconsis

tent with the theory that weak inst i tut ions o f governance , o f which

corruption is a concrete manifestation, discourage investments and thus

constrict growth.

Table 1 Corruption and Private Investment

Ave . Ratio of Private

Country TI Rankings ( 1 996) Ave . GDP Growth Rate I nvestment to GDP

(Max score: 1 0) ( 1 980-1995)" ( 1981-1993)

China 2.43 1 1 .05 % n .a .

Vietnam n .a . B.W n . a .

Thailand 3.33 7 .86 24.85 %

Indonesia 2.65 6.60 1 6 .35

India 2.63 5 .41 1 1 . 1 1

Egypt 2.84 3.78 8 .03

Kenya 2.21 3.27 1 1 .01

Brazil 2.96 2 .70 1 5 .74

Mexico 3.30 1 .07 1 3 .68

New Zealand 9.43 2 .40 n . a .

• From World Development Indicators 1 997.

t 1990-1995 0nly

Scholarly concern over corruption predates the emergence of corrup

tion as a highly controversial issue among practitioners . Many scholars,

including Rose-Ackerman ( 1 978) . Klitgaard ( 1 988) , and Wade ( 1 982) , have

sought to understand better the complexities that underpin the existence

and persistence of corruption. In fact, much of the intellectual discussion

on the implications of rent-seeking activities (Kreuger 1 974; Bhagwati 1 982;

Tullock et al . 1 988; Murphy, Shleifer, and Vishny 1 993) and the role of

institutions (North 1 9 8 1 and 1 990) for economic p erformance touched

implicitly on the potential impact of corruption.l However, because this

intellectual strand has, up till recently, not led to large cross - country

empirical testing, it has not been able to contribute effectively and con

vincingly to clarifying the consequences of corruption.

With the development of b etter datab ases , a number of scholars

have managed to undertake much-needed cross - country empirical re

search. In what is probably a seminal piece of work in this area, Mauro

12


( 1 995) has provided econometric analysis and evidence of the negative

imp act of corruption on investment and growth. More broadly, Keefer

and Knack ( 1 995) show empirically that weak institutions, as manifested

in part by the extent of corruption, impede economic growth. In a dif

ferent vein, Stone et al . ( 1 996) and Paul ( 1 995) use surveys to extract

evidence of high transactions costs that accompany activities commonly

believed to be associated with corruption, e .g . , customs . Nevertheless,

this research still fails to explain why a number of East Asian countries

persist as outliers .

Wei ( 1 9 9 7) has attempted the firs t e m p irical analysis that more

poignantly addresses the East Asia puzzl e . He shows that, controll ing

for o ther factors such as GD P ( gro s s do mest ic pro duct) I capita , the

impact of corruption on the flow of foreign direct investment (FDI) is

no different in East Asia relative to other countries . 2 The implication is

that in East Asia other factors swamp the negative effect that corruption

has on FDI. This offers a possible explanation for why East Asian coun

tr i e s h ave grown m ore r a p i dly d e s p i t e s i gn i fi c antly high l e v e l s of

corruption. There is , however, one problem with his analys i s : the in

flows and outflows of FDI are dominated by countries belonging to the

Organization for Economic Cooperation and Development (OECD) . I t

is quite possible that the results would be different if the OECD coun

tries were excluded from the sample as "hosts" of FDI or, alternatively,

if the dependent variable used was private investment (both domestic

and foreign) . 3

In fact. other empirical findings of Wei suggest that there is more to

the corruption story than meets the eye . H e finds that ethnic ties lead

to higher flows of FDI and, in particular, that much of the FDI that flows

into China comes fro m overseas Chinese . What this suggests is that

informal institutions may be an important omitted variable that affects

the nature of corruption and thus its impact on investment. It supports

the thesis that in East Asia, informal norms bound inseparably with illicit

exchanges help enforce intertemporal transactions that facilitate rela

tively larger inflows of FDI .

This thesis i s consistent with the work of Shleifer and Vishny ( 1 993) .

Shleifer and Vishny analyze different types of corruption regimes-mo

nopolistic versus independent "suppliers" of bribe- generating products

an approach that is also evident in Kaufmann's recent work (1996) . This

chapter follows thei r line of reasoning. That is, different corruption re

gimes have different effects on investment. In particular, we argue and

provide empirical evidence that regimes i n which corrupt ion i s more

13


"predictable" (in the sense that the favor, service, or product being sought

i s more likely to be granted) , ceteris paribus, h ave a smaller negative

impact on investment than those in which it is less p redictable . How

ever, we also show that the level of corruption matters as well. Given the

same degree of predictability, lower levels of corruption result in higher

levels of investment. In sum, we are able to categorize countries into

three broad typ e s : (1) those with high l evels o f corrupt ion and low

predictability are the worst off in terms of attracting private investment;

(2) those with high levels but greater predictability are better off than

those in (1) in terms of attracting relatively higher levels of p rivate in

vestment; and (3) those with low levels of corruption and high predict

ability are the most well -off. East Asia's "puzzling economies" are likely

to fall in the second category.

This chapter is divided into three parts . In the first, we present and

discuss a more generalized version of the Shleifer /Vishny approach. We

then describe our data ( including their l imitat ions) , the econometric

model we used for o u r analysis , and present o u r empirical findings .

Finally, we draw some conclusions and make some suggestions for future

empirical research on corruption.

Why Predictability Matters

The underlying logic of our approach can be illustrated with a simple

example . 4 Consider a situation in which s everal firms are confronted

with the need to bribe s everal government officials in order to obtain

a monopoly franchise to p rovide some public service . Each of the offi

cials has veto p ower over a firm's application but none have absolute

power to grant the franchise. Suppose further that each of the officials

comes from a different region in the country and each is biased toward

helping individuals who come from his or her region. Now contrast this

with a situation in which there is a single public official who can decide

on awarding the franchise and that official has no regional sympathies .

These two s ituatio n s differ in terms of the degree of uncertainty that

firms face about the possibility of actually obtaining the franchise should

it pay bribes . In the second, there is a much higher degree of certainty

b ar r i n g any u n fo r e s e e n i n t e rvent i o n s , t h e fi r m with the h i g h e s t

will ingness to p ay will g e t t h e franchise . In t h e first , there is no such

guarantee. In all likelihood, therefore, firms will invest less if confronted

with the first situation than when faced with the second, e .g . , the winning

firm ends up supplying completely depreciated general- purpose dump trucks (which would make them mechanically more troublesome than

14


average) fo r col lect ing the garb age as o p p o s e d to trucks s p e cifi c al ly

designed fo r garbage collection-perhaps even new ones .

The first situation is what Shleifer and Vishny refer to as a regime

with independent "suppliers," the second as one with a monopoly sup

plier. The key here , however, is not so much the distinction between

independent versus m o n o p oly s u p p l i e rs; i t i s one o f p redictabi l i ty.

Consider again the second case of a s ingle public official having m o

nopoly power over the granting of the franchise . That official obtains his

power from the office he or she holds . Suppose that the politics in the

country is such that ruling cliques change ever so often and with each

change comes a reshuffling or replacement of government officials . In

this case the s ingle public offic ial may be in office for a very l imited

time. When his replacement takes over, this individual could decide to

terminate the franchise (or make it extremely difficult for the existing

franchisee to operate) . Hence the firm that originally obtained the fran

chise can never be certain that it will indeed maintain the rights accorded

to it. It could possibly pay additional bribes to the new official but this

only shifts the uncertainty to the cost side of the equation. In either case

the firm will b e less willing to invest adequately to deliver the service,

e . g . , they will provide fully depreciated general - purpose dump trucks

instead of real and newer garbage trucks .

Does Theory Meet Reality?

In this section, we explore the implications of a unique database for

the particular thesis that we have proposed above . Specifically, we hy

pothesize that the predictability embodied in a corruption regime is as

important as the extent of co rruptio n . We test this using data fro m a

large-scale survey of firms conducted for the World Development Report

1997 of the Wo rld Bank. Below, we describe the data, discuss the vari

ables we used, and present our test results .

The Data

Though there has been considerable scholarly research on the issue

of corruption, only in recent years have large-scale cross- country empiri

cal studies emerged . The main problem with u ndertaking such a task was

the ahsence of data on corrupt ion . Because of the nature of the beas t ,

getting direct information on the extent o f corruption in any country and

espec ial ly in developing countries has been elus ive. With the adven t of

greater pol i t ical and economic openness worldwide , some independent

organization s have managed to conduct worldwide surveys of business-

1 5


men on a variety of issues, some of which relate to corruption, and have

been compiling and collating data from these surveys. Indeed, the empiri

cal work that has emerged in the last few years has made extensive use

of databases from one or more of these organizations.s

To the best of our knowledge, however, none of these surveys has

introduced questions that pertain specifically to the uncertainty surround

ing corruption in respondents' countries. As part of its efforts to prepare

and complete the World Development Report 1 997-The State in a Chang

ing Wo rld, the Wo rld B ank conducted a l arge cro s s - country survey o f

private businesses designed to obtain information on a number of in

stitutional issues : ( 1 ) the predictability of laws and policies, (2) political

instability and security of property, (3) government-business interface,

(4) bureaucratic red tape , and (5) the efficiency with which government

provides services. Questions pertaining to the extent and the uncertainty

surrounding corruption were included in (4) ; in fact, of the eight ques

tions, four dealt with corruption. The relevant questions for this chapter

are presented in table 2 .

Table 2 Survey Questions o n Corruption

1 . "It is common for fi rms in my l ine of business to have to pay some i rregular 'addit ional payments' to

get things done." This is true

( 1 ) a lways (2) mostly (3) frequenHy (4) sometimes (5) seldom (6) never

2 . "Fi rms in my l i ne of business usual ly know in advance about how much 'addit ional payment' is . "

This is true

( 1 ) a lways (2) mostly (3) frequently (4) sometimes (5) seldom (6) never

3. "Even if a fi rm has to make an 'addit ional payment' it always has to fear that it wil l be asked for

more, e.g . , by another official." This is true

( 1 ) a lways (2) mostly (3) frequently (4) sometimes (5) seldom (6) never

4. "If a firm pays the requi red 'addit ional payment' the service is usual ly also del ivered as agreed."

This is true

( 1 ) a lways (2) mostly (3) frequenHy (4) sometimes (5) seldom (6) never

The survey originated and was managed from the World Bank's head

quarters in Washington, D.c. , but its implementation was facilitated through

1 6


its field offices worldwide. The survey covered s ixty- nine countries ( in

cluding nine fro m the OECD) and drew responses from approximately

3 ,700 companies. The same questionnaire was used in all the countries ,

and the target respondents in each country were local businessmen.

The Variables

Our basic obj ective was to determine whether or not the "predict

ability" of corruption has a significant impact on economic performance.

By predictability, we mean the degree to which firms are confident that

they will in fact be able to obtain the "product" they are seeking, e . g . ,

a license or a franchise, if they pay bribes. To quantify a n d encapsulate

"predictability" in variable form, we used the responses to questions 2

and 4 in table 2 . Specifically, we calculated a country average (across

al l the responses from individual firms in the country that completed

the questionnaire) for each question. Then we constructed the variable

CORPRD as fol lows :

CORPRD = 7 - .5 x (country average for q.2 + country average for q.4)

We also wanted to test whether the extent of corruption mattered.

Previous empirical work indicated that higher levels of corruption im

pede economic performance. Moreover it is possible that the degree of

p redictability may be of more concern to firms than the extent of cor

ruption." By including a variable that represents the extent of corruption,

we could test this hypothesis . We used the responses to question 1 to

construct the variable COREXT. Specifically,

COREXT = 7 -country average for q.l .

In order to control for other factors that might affect investment, we

used the 1 990 values of GDP per capita (at purchasing power parity) and

as an alternative , secondary school enrollment.7

For the dependent variables we used the ratio of gross investment

to GDP and the ratio of p rivate investment to GDp'B For the gross invest

ment variable we used the average over 1 990 to 1 994 and had fifty- nine

observatio n s. Fo r the p rivate-investment variable , we u sed both the

average fro m 1 9 82 to 1 9 93 and fro m 1 99 0 to 1 99 3 . Ideal ly , the l atter

would have been the independent variable of choice. Unfortunately , the

develo ping countries fo r which we could obtain annual d ata on p rivate

investment flows did not map well onto the countries that were included

1 7

--


in the World Bank survey.9 Hence, we had fewer observations-between

twenty-one and twenty-three.

The Empirical Results

In table 3 below, we present results of OLS regressions using GDP

per capita and secondary enrollment alternatively as control variables .

In equations ( 1 ) and (4) , we test only for the impact and significance of

the extent of corruption and in equations (2) and (5) only for the pre

dictability of corruption . In equations (3) and (6) , we include both the

extent and the predictability. In all cases, the extent and the predictabil

ity variables have the correct sign. The predictability variable is significant

in all cases at least at the 5 percent level . The extent variable is at best

significant at the 5 percent level .

Table 3 OLS Regression Results

Gross I nvestment/GDP as the Dependent Variable

(t-statistics in parentheses)

Variables ( 1 ) (2) (3)

Intercept 9.222 3.204 4.046

( 1 .397) ( .4808) ( .6220)

Ln (Enrol l ) 2.443t 2 .353t 1 .286

(2. 1 1 2) (2.20 1 ) ( 1 .0997)

Ln (GDP)

COREXT 1 . 1 69 -4 .766t

( 1 .053) (-2 .003)

C O R P R D 2.987t 8 .464'

(2. 1 67) (2.779)

R2 . 1 7 1 9 .0759 . 1 306

adj . R2 . 1 423 .0429 .0995

No. of Obs. 59 59 59

(4) (5) (6)

-1 .679 -9.409 -3.296

(-. 1 47) (-.9057) (-.3064)

2.21 3t 2 .264' 1 .3 13

(2.092) (2.477) ( 1 .257)

1 .8 1 3 -4 .377;

( 1 .453) (-1 .782)

3.877' 8 .532'

(2.675) (2.869)

.0747 . 1486 . 1 951

.041 6 . 1 1 82 . 1 51 2

59 59 59

NOTE: Significant at the I percent level ( * J . at the 5 percent level (t J . at the 1 0 percent level m .

1 8


We undertook a considerable number of alternative regressions based

on potemial problems that in theory could arise. Among others, we tried

equations that included the cross-product of CORPRD and COREXT, equa

tions using vario u s p ermutations with and without one of these two

variables of interest, equations with both GDP per capita and secondary

enrollment as controls, and equations with a variable that reflects the degree

of policy distortions in the country as the control (or in addition to another

control variable) . In sum, we ran a considerable number of alternative

regressions to effectively test the robustness of our findings . Overall , the

basic findings held up: CORPRD has the right sign in all regressions and

is significant at least at the 5 percent level; COREXT also has the right sign

but is at best significant at the 5 percent level and in some cases not sig

nificant at all . We note, though, that in many cases, where both corruption

variables are included, the control variable was not statistically significant.

Table 4 Regression Results

Private Investment IGDP as Dependent Variable

Variables ( 1 ) (2) (3) (4) (5) (6)

I ntercept 1 1 . 141 5.791 -1 2.081 1 0.575 5 . 101 - 1 2 .558

(1 .46 1 ) ( .6402) (-.9593) ( 1 .259) .5096 (-.91 62)

Ln(Enroll) 1 .607 1 .645

(1 .087) ( 1 .006)

Ln (GDP) 2.3W 2.29 1 ;

( 1 .91 6) ( 1 .722)

COREXT -3 .844; -2.750 -5.792t -4 . 1 6 1 ; -3.042 -6.837t

(-1 .9 1 0) (-1 .227) (-2 .297) (-1 .877) (-1 .226) (-2.491 )

CORPRD 3.580 2.446 6.984t 4.085 2.925 8 .302t

( 1 .209) ( .7825) (2.30 1 ) ( 1 .252) (.8454) (2.514)

R2 . 1546 .2041 .499 . 1 497 .4992 .50 14

adj . R2 .07 .0784 .41 05 .0647 .3741 .41 34

NO. of Obs. 23 22 21 23 22 21

Note: Significant at the I percent l evel ( * J . at the 5 percent level ( t J . at the 1 0 percent level ( :j: ) .

1 9


In the above analys i s , we used gro s s investment to G D P as the

dep endent variable. We investigated whether or not we could use the

available data on private investment to GDP to derive information that

would be consistent with our findings (though not necessarily of any

statistical significance) . In table 4 below, we present OLS results using

the average of p rivate investment to GDP from 1 982-1 993 (columns 1-

3) and the average from 1 990 to 1 993 (columns 4-6) . These results are

based on a small subset of countries included in the World Bank survey

and for which we could retrieve private investment data. In both sets of

regressions, we used either GDP per capita or secondary enrollment as

the control variable .

When GDP per capita is used as the control variable, both the extent

and predictability variables have the right sign and are significant at 5

percent. The control variable is also of the correct s ign and significant

at the 10 percent level.

B ecause the sample s ize is small-twenty- one to twenty- three o b

s e rvati o n s in al l-th e s e r e s u l t s m u s t b e i n t e r p r e t e d with cauti o n .

Nevertheless , they p rovide further evidence supporting our hypotheses .

Conclusion

Empirical evidence indicating that corruption impedes growth and

investment has begun to emerge, with academics and scholars increas

ingly devoting more time to study the surrounding issues. These findings

p arallel the emerging concern of politicians and policy makers around

the world about the deleterious effects of corruption on economic per

formance and increasing efforts to try to address its underlying causes .

Despite these, there remains a lot to learn about corruption: i ts conse

quences , its causes , and effective strategies for controll ing it .

This chapter has been mo tivated by a s e e m i n g p aradox in East

Asia : the p o s itive c o rrelat ion b etwe en high rates o f investment and

growth with rel atively high levels o f corru p t i o n . Co nvent ional wis

d o m in e c o n o m i c t h e o ry suggests that weak p r o p e rty righ t s , o ft e n

manifested b y h i g h levels of corrupt ion , retard investment a n d thus

e c o n o m i c growth . East Asi a's exp e r ience has p o s e d a s e r i o u s chal

l enge to th is hypothesis . The chapter attempts to unravel this paradox.

Specifically, it argues that it is not only the level of corruption that affects

investment but also the nature of corruption. Corruption regimes that

are more p re d i c t able-in the s e n s e that th o s e s e eking favors fro m

gove r n m e n t d o o b t a i n t h o s e favors-have l e s s n e gative i m p a c t o n

investment than those that are l e s s predictabl e . In m any of East Asia's

20


miracle economies, corruption is said to be well organized and system

atic so that the degree of predictability is relatively high. This chapter

th uS suggests that , d e s p ite high levels o f co rrup t i o n , these miracle

e c o n o m i e s st i l l m a n a g e d t o attract s i g n i fi c ant ly h i g h e r levels of

investment than other developing countrie s . The result : compared to

many developing countries , these countries have grown faster despite

corrup tio n .

However, t h e chapter a l s o points out that whatever t h e degree of

p re dictabi l i ty, m o re corruption n e c e s s ar i ly m e a n s less inve s t m e n t .

Hence, to justify corruption on t h e basis of t h e E a s t Asian p aradox i s

misleading.

There st i l l i s much to learn about corruption and economic devel

opment. Research on this matter is very much in a nascent stage. One

issue that definitely needs studying is the implication of highly orga

nized (and thus more predictable) forms of corruption for sustaining

high rates of growth. The chapter suggests that countries can be clas

sified into three categories : those with high levels and a low degree of

predictab ility in corruption; those with high levels and a high degree

of predictability; and those with low levels and a high degree of pre

dictability. East Asia's miracle economies fall into the second category,

the developed countries into the third. The implication here is that for

East Asia's miracle economies to move o n to their next stage of e c o

nomic development, they would have to reduce t h e level of corruption.

The explos ion of the Asian economic cris is suggests that this may in

fact be the cas e .

T h e rest of t h e volume presents country case studies that elaborate

on this Asian p aradox and suggest why it is intimately l inked to the

crisis .

APPENDIX MODELS OF PREDICTABILITY

We present two simple models that encapsulate our notion of pre

dictabil ity. In the first , we present a two - p eriod monopol istic regime

which captures the effect of uncertainty over time. In the second, we

consider an " O - ring" type corruption regime. This setup is akin to Shleifer

and Vishny's ( 1 99 3 ) independent corruption regime.

"Monopolistic" Corruption and Uncertainty

Consider a firm that p lans to make an investment over two periods.

A bribe i s needed for a single firm to operate successful ly. Let us con-

21


sider two scenarios . In the first , both the period 1 and period 2 bribes ,

bl and bz ' are made known beforehand. By contrast, in the second, bl is

known but bz is unknown. We assume that the firm will operate in the

second period o nly if the bribe is affordable; the investment is simply

abandoned if the bribe is too high. We can show that less investment will

occur in the second scenario. The outcome predictability is lower as the

success or failure of a given bribe in the second p e rio d is not known

until the second period .

Let I be the investment l evel of a specific firm. The cost of capital

is c (I ) . The investment lasts for two periods . I t generates an income

stream of f(l) if it is in operation . To be in operation in p eriod i, a bribe

p ayment of b i is required , i = 1 , 2. We begin with scenario 1 in which bJ and b2 are b o th known b eforehand. Here the firm's profit is

where 8 is the discount rate. The resulting first order condition for p rofit

maximization is

1t 1 ' ( l ) = ( 1 +8)/ , (l ) - c '( l ) :<=; o .

A n interior solution J' satisfying 1t I ' (n = 0 exists if 1t J ' (n ;?: O . Other

wise , the firm will not invest at all .

For scenario 2 , we assume bl is known but b2 is a random variable.

In this case, the firm will simply quit if b2 is not affordable. The firm's

expected profit function is then

1t A l ) = ( / ( l ) -b d + 8 E [ max (f( l ) - b:!, O ) J -c ( l ) .

where E [ . J is the expectation operator. Let H ( . ) denote the probability

distribution function of b z . The first order condition for expected profit

maximization is

f( l ) 1t z ' ( l ) = f' ( l ) + 8 f !' ( l ) dH ( b 2 ) - c ' ( l ) :<=; O .

o

An interior solution 1" satisfying 1t z ' W ) = 0 exists if 1t2 W ) ;?: O . Oth

erwise, the firm will not invest .

Throughout t h e a nalys i s , we assume f( . ) i s a c o n c ave fun c t i o n

and c ( . ) is a convex funct ion to ensure the s e c o n d order condit ions are s atisfied . Because 1t z ' (n :<=; 0 , it follows that [O :<=; r. That i s , the firm

22


will invest less (if it ever does) when the second period bribe p ayment

is uncertain. l o

O - Ring Corruption

Now assume once again there is a single firm but this time it needs

separate approvals from two officials. I I Unless it obtains both approv

als, its investment will not be p roductive. We posit two scenarios. In the

first, the bribes offered to each official are made known beforehand; in

the other, o n ly one o f the bribes i s known b efo rehand. Moreover, in

either scenario, if the second required bribe p ayment is too high, the

firm simply quits and takes the loss equivalent to the first bribe and

whatever capital c o s ts i t has incurred . We show that less investment

occurs under the second scenario.

Herein, bl and b2 are bribe p ayments to the two corrupt officials . The

investment will n o t be in operation unless both p ayments are made .

Again, we consider two scenarios . In scenario 1 , both bl and bz are known.

The firm's profit function is given by

The corresponding first order condition for p rofit maximization is

1t l ' ( l ) = !'( l ) - c '( l ) :<=; O .

A n interior solution II satisfying 1t I ' (Id = 0 exists if 1t I (II ) ;?: O . Other

wise , no investment will be undertaken.

Under scenario 2 , the firm p ays b l first without knowing the exact

amount of b z . If b2 is affordable, it will be paid and the project will be

undertaken . If it turns out that b 2 is large, the firm may then choose to

quit and take a loss . In this instance, we assume the firm loses a portion

of the capital cost a c(1 ) as well as the first bribe p ayment b l . The firm's

expected profit function is given by

1t 2 ( l ) = E [ m ax ( f ( l ) - � ( l ) - bl - b2 , - a c(l ) - b ] ) J .

or, more p recise ly,

B

f (f(1 ) - c (1 ) - b l - b z ) dH (bz ) + f (- a c (l ) - b d dH ( b2 ) a B

where B = f(l ) - ( 1 - a ) c (l ) .

23


The resulting first order condition is 1t2 ' (l) ::; 0, that i s ,

(f (1) - c ' (1 ) ) Het(I ) - ( l - u ) c (1 ) ) - uc ' (1) [ 1 - H (f(I ) - ( l-a )c (I ) ) ] ::; O.

An interior solution satisfying 1tz ' (Iz) = 0 exists if 1tz (Iz) ;::: O. Otherwise,

no investment will be undertaken. Again, it is easily seen that Ii ;::: lz. That

i s , the uncertainty with the second bribe payment reduces the invest

ment amount.

24

CHAPTER TWO

INVESTMENT, PROPERTY RIGHTS, AND CORRUPTION IN INDONESIA

Andrew MacIntyre

The notion that investors , p articularly p rivate investors , require in

dep endent and effective legal instituti o n s to contain corrup t ion and

secure their property rights enj oys very wide currency in both the aca

demic literature (North 1 98 1 , North and Weingast 1 989 , Root 1 9 89) and

the policy community ( World Bank 1 997b and c, RESPONDACON III 1 996,

Elliot 1 996 , Transparency Internation al 1 99 7) . I t i s not hard to under

stand why the core idea here has been so widely embraced by economists

and political economists from Smith and M arx to the current generation

of institutional theorists centering o n Douglas North. If contracts cannot

be enforced in a reasonably obj ective way and if governments are not

constrained from acting corruptly o r capriciously, the risks to potential

investors are likely to become very high. And yet, as all students of East

Asia know, there are a number of countries in the region that have ex

perienced strong investment and strong economic growth over several

decades in an institutional environment bearing little, if any, compari

Son to that normally prescribed by the l iterature . I n d o nesia is one of these countries .

H ow are we to explain such cases? One recourse is to highlight the fact that fro m the viewpoint of economic history, s everal decades are

b arely remarkabl e and that over the l o n g e r haul the bi te of N o rth's

institutionalist logic will indeed be felt . In other words, the high- growth

economies of East Asia will e i ther develop an adequate inst ituti o n al framework o r their economic performance will fal l away. This may be

so. Indeed, some commentators would have it that this was the funda

mental l e s s o n o f t h e Asian e c o n o m i c c r i s i s of 1 9 9 7- 1 9 9 8 : lack o f

25

Investment, Property Rights, and Corruption in Indonesia

transparency, crony capitalism, and corruption finally caught up with the

region and, accordingly, the whole economic house of cards collapsed.

Yet this is much too simple. Asia's economic crisis was about very much

more than transp arency and property r ights , as i l lustrated by China's

abil ity to ride out the economic storm relatively unscathed.

I do not dispute the not ion that the absence of reasonably secure

property r ights i s a ser ious obstacle to investment and growth . I do,

however, question the notion that this can only be achieved on the basis

of an i n d e p e n d e n t le gal system. B a s e d o n a novel interpretat i o n o f

Indonesia's experiences, I suggest that there are other mechanisms that

can function as satisfactory alternates in the interim, though their dura

bil ity is limited. In the long run , an independent legal system does seem

l ikely to be the most rel iable fo undati o n for securing property rights .

However, business people, policy makers, and even social scientists have

much shorter t ime hor izons . F o r them, such a p o s it ion is of l imited

immediate utility. I f a country can achieve strong investment flows and

strong economic growth for thirty-odd years without institutional trans

p arency and an e ffective legal framework, then p e o p l e interested i n

making money, i n making public pol icy, a n d i n theorizing the interac

tion between the two, have a strong interest in understanding how this

i s poss ib le .

T h i s chapter o ffe r s a thr e e - s t e p exp l a n a t i o n fo r t h e p u z z l e of

Indonesia's combination of pervasive corruption and strong investment

under Suharto. The first i s to point to standard economic factors influ

encing expected rates of return on i nvestment . I f there are very l arge

profi ts to be had, i nvestors are l ikely to be will ing to bear increased

costs associated with bribery and increased r isks assoc iated with less

certain property rights . These are fam il iar arguments , but impo rtant

nonetheless . The second step in the argument shifts the focus in a more

p o l i t ical d irecti o n . Drawing on the wo rk of Shleifer and Vishny ( 1 99 3 ) .

I argu e that the prevai l i ng p o lit ical structure in Indones ia during the

N ew Order period 0 966- 1 988) gave President Suharto the opportunity

and, more important, the incentive to allow corruption to flourish but

to ensure that its costs did not drive down investment. Key to this was

the p resident 's abil ity to monitor the behavi o r of offic ials and enfo rce

his core preferences, thereby minimizing agency loss . The third step is

to argue that while the incentives of pol it ical leaders are an important

part of the story, there sti l l remain s a miss ing l ink needed to reassure

investors about the future behavior of government. This last piece in the

puzzle involves the government tyin g its own hands in order to make

26


a credible commitment about the future pol icy environment to the in

vestment community.

In the next section I will lay out the relevant empirical evidence on

Indonesia's i nvestment record and its institutional - sett ing. The sect ion

following that contains the core analys is , proceeding through the three

stages of the argument outlined above . The fundamental argument here

is that while a N o rthian logic is compell ing over the long term, i t has

much less to tell us about the short and medium term and may obscure

rudimentary alternatives that can substitute effectively for a s ignificant

period of time. The final section draws the threads together and reflects

upon the current economic collapse and the sadly ironic likelihood that

movement to more open and transparent polit ics in Indonesia is l ikely

to lead to worse problems of corrupt ion and property rights .

The Empirical Record

The figure for total investment as percentage of GOP in Indonesia

like the corresponding figures fo r the other high- growth deve l o p i n g

economies of E a s t Asia-is not p articularly remarkable b y world stan

dards . As figure 1 shows, the average result for Indonesia between 1 966

and 1 994 was roughly comparable (25 .0 p ercent) with the weighted re

sult for all of developing Asia (22 . 1 percent) and all developing countries

(2l.4 percent) .

Figure 1 Average Total Investment as a Percentage of GDp, 1 966- 1 994

0 ' fa

I ndonesia

SOlJRCT: IfS Yearbook 1 996, 1 54-57.

All Developing Asia

NOTE: figures fo r reg i o n s are weighted averages.

27

All Developing Countries


If we focus on private investment, however, we see a quite different

story. As figure 2 shows, between 1 980 and 1 994 Indonesia (along with the

other high - growth East Asian economies) had a markedly higher average

level of private investment than other parts of the developing world.

Figure 2 Average Public and Private Investment as a Percentage of GDP,

1 9 80- 1 9 9 4

%

_ Private I/GDP Publ ic I /GDP

Indonesia East Asia South Asia Latin America Midd le East Sub-Saharan & Caribbean & North Africa Africa

SOIJHCI : J aspersen. Aylward . and Suml inski 1 99 5 .

Nm E: F igures fo r regions are s imple averages .

I f we disaggregate total investment to highlight the contribution of

foreign capital and local capital , Indonesia emerges as an intermediate

case by East Asian standards . As figures 3 and 4 show, FDI as percentage

o f t o t al inve s t m e n t in I nd o n e s i a has b e e n markedly l e s s than in the

m o re o p e n e c o n o m i e s o f Thai land a n d p a r t i c u l ar ly M al a y s i a and

Singapore, but greater than in the more restrictive Northeast Asian NICs ,

Taiwan and South Kore a . I f consis tent data ser ies were available up to

the outbreak of the Asian economic cris i s , they would show Indonesia

coming to resemble the pattern of the Philippines and Thailand , as for

e ign investment has cont inued to rise as a p o rt ion of total investment in the last few years .

28

Figure 3 Direct Foreign Investment as a Percentage of Total Investment:

Indonesia, Taiwan, and Korea, 1 965- 1 994

25%

a)%

15% Indonesia _ Taiwan _ Korea

10%

5%

0%

-5%

-10%

1005 1969 1972 1975 1978 1981 1984 1987 1 991 1994

SOURCE: IPS, various issues. NOTE: Three-year moving averages.

The surge of FDI into Indonesia in the late 1 960s and early 1 970s

represents the return o f "old" and "new" capital following the massive

capital flight fro m the country in the mid - 1 960s.

Figure 4 Direct Foreign Investment as a Percentage of Total Investment:

25 %

4) %

15%

10 %

5%

0%

-5 %

-10%

Philippines, Thailand, and Malaysia, 1 965-1 994

_ Phil ippines _ Thailand Malaysia

1005 1969 1972 1 975 1 978 1981 1984 1987 1991 1994 SOURCE: IrS. various issues.

NOTE: Three-year moving averages.

29


Why would pr ivate investo rs-wh ether local or fore ign-risk their

money in a sett ing where the legal system was of such doubtful stand

ing that S u p r e m e C o u rt j u s t i c e s r i d i c u l e d t h e i r c o l l e a g u e s as b e i n g

hopeless ly corrupt . where t h e p resident himself acknowledges that the

l egal system was b e s e t with d e e p - seated p r o b l ems o f co rrupt i o n . and

more pointe dly. where b u s i n e s s people largely abandoned the notion

that the legal system was an effective vehicle fo r arbitrating commercial

d i s p utes? Beyond wel l - recognized problems with i ts formal legal sys

t e m . I n d o n e s i a a l s o h a s a r e p u t a t i o n fo r s y s t e m i c c r o n y i s m a n d

c o rrupt ion i n the admi n istrat i o n of gove rn m e n t . I n the l a t e r years o f

Suharto's rule , endless comp l aints were directed at t h e rapacious rentier

business practices of his chi ldren, grandchi ldren , and business as soc i

ates , as wel l as the offspring and associates of other senior officials . Yet

this was scarcely a new phenomenon; if one were to scan the pages of

the press ten or twenty years ago one would encounter the same com

plaints about an o lder generation o f p l ayers . In short , although many

o f the characters surrounding Suharto h a d c h a n g e d , the same b a s i c

p attern had been in p lace s ince the early days o f the r e g i m e . I n d e e d ,

t h e l i terature on Indonesian pol itical economy groans u n d e r t h e weight

of anecdotal evidence of p e rvasive cl ientel ism and corruption (Robison

1 986 , Pangaribuan 1 99 5 , MacIntyre 1 994 . Muhaimin 1 99 1 . Schwarz 1 994 .

Winters 1 994) .

Private investors operating in Indones ia-ranging from U S telecom

municat ions c o m p a n i e s , J ap a n e s e car manufa c t u r e r s . and C a n a d i a n

goldmining companies to large I n dones ian construction companies and

smal l Indonesian rice farmers-all had to grapple with the importance

of pol i t ical connecti ons . Altho u gh there was some secto ral variat ion . in

general the bettcr one 's connect i o n s , the greater one 's chances of secur

ing the plum d e al s , o b t a i n i n g p rc fere n t i al regulatory treatment . and

e s c a p i n g inconve n i e n t co ntractual o b l i gat i o n s . C o nversely and more

worryingly, the weaker one 's connect ions the m o re vulnerable one was

to fal l ing vict im to the predatory trading pract ices of those wh o were

well connected . Such pract ices range fro m fi nancial imposts to fo rced

mergers and takeovers . I t i s scarcely surpri s ing t h e n that the interna

t ional indexes of nat ional corruption consistently gave Indonesia a very

low ranking. And yet , as we have seen . i n sp i te of the negative effects

one m i ght exp e c t this to h ave on r isk a s s e s s m e n t s and c a l c u l a t i o n s

a b o u t the c o s t o f d o i n g b u s i n e s s , fo reign and l o c a l fi rms have cont i n

u e d t o i nvest s trongly in I ndones ia . T h i s i s n o t what t h e convent ional i n s t i tu t i o n a l i s t wi s d o m wou l d lead one to exp e c t .

30


Explanations

How then are we to explain the co existence in Indonesia of strong

private investment and growth o n the o n e hand, and weak legal guar

antees of property rights with widespread corruption on the other? The

explanatio n developed here is in three p arts ; the first deals with trad i

tional economic factors , while the second and third focus o n p o li t i cal

variables u nderpinning governance arrangements .

Economic Conditions a n d Rates of Return

The recent upsurge of theoretical interest in governance should not

cause us t o lose s ight o f the importance o f more famil iar-and thus

perhaps less excit ing-economic variables that influence investors ' ex

pectations about rates of return. The essential point here is s imple , but

important nonetheless. I f the expected rate of return is sufficiently high.

investors will be willing to bear some increased costs associated with

bribe ry and some increased risk associated with the uncertainty of for

mal property rights. In Indonesia's case there were a number of impo rtant

factors that contr ibuted to the creat ion of a bus iness e nviro nment in

which good rates o f return could b e expected . These can b e organized

under four broad headings: the prevail ing rate of economic growth, the

macroe c o n o m i c set t ing . the m i c ro e c o n o mi c i n ce ntive s tructure . and

sector -specific factor endowments .

The first o f these is so obvious i t can easily b e overlooked: growth itself begets further investment. Once solid growth rates were being recorded in Indonesia in the late 1 960s and early 1 970s . this in itself became a major factor encouraging further investment. The importance of a generally sound macroeconomic framework for investors also requires l i ttle discussion. This has been one of the defining and most widely discussed features o f the New Order ( Hil l 1 99 6 ; B attacharya and Pangestu 1 99 3 ; Woo, Glassburner. and Nasution 1 994; Little et al . 1 993 ; Booth 1 99 2 ; World Bank 1 993a and b ) . By comparison with the record of macroeconomic manageme nt p r i o r to 1 96 6 . what fo l lowed seems s p ectacu larly g o o d . The key elements were stable exchange- rate management. a satisfactory inflatio nary record , a caut ious approach to s p e n d i n g , a good s avings rate , and investment in publ ic infrastructure and human capital .

S o m e w h a t more a m b i gu o u s , but n o n e t h e l e s s i m p o r t a n t . w e r e

microeconomic incentives . On t h e one h a n d . various rounds of l iberal

i z i n g t r a d e and i n ve s t m e n t r e fo rm s h ave b e e n w i d e l y h a i l e d as enco uraging inve s t m e n t by removing d i s t o r t i o n s and creat i n g a l e s s

3 1


uneven commercial playing field . On the other hand, and in seeming

contradiction, other illiberal microeconomic measures to restrict or elimi

nate competition in p articular sectors were also p owerful incentives to

other investors who stood to capture the rents thus created.

A final general category of factors that had a significant impact on

calculations of expected rates of return pertains to factor endowments.

The most glaring example of this was of course the oil and gas sector;

the natural resource rents that stood to be captured by investors in this

sector were very substantial indeed. Similar stories can also be told o f

the timber and mining industries , and indeed of the abundance of cheap

labor for the manufacturing sector.

To summarize, we need to be clear that traditional economic vari

ables bearing on p roj ected rates of return assuredly had an important

b e aring on the will ingness o f p rivate investors to commit capital to

Suharto's Indones ia . Although no ser ious emp irical measurement of

profitability in Indonesia is presented (such calculations would be ex

tremely problematic) , a priori there can be little doubt that conventional

economic variables play an important part in explaining the strong flow

of p rivate investment over the past thirty years .

This much is not difficult to agree upon. However, there remain good

grounds for believing that this does not provide the whole explanation

to our puzzle . Recent comp arative empirical works by M auro ( 1 995 ) ,

Keefer and Knack ( 1 99 5 ) , Jaspersen et al . ( 1 99 5 ) and the World Bank

( l 997b and c) point to some correlation between the quality of institu

tio nal arrangements and economic performance . Plainly, this is very

slippery ground, both empirically and theoretically. While these broad

gauge quantitative studies can be regarded as suggestive only, they do at

least provide s o m e emp irical s u p p o rt fo r the view that institutional

weakness will tend to produce a drag on investment and growth. And,

of course, this is a central tenet of the whole Northian institutionalist logic.

Assuming poor economic governance does indeed exert a s ignifi

cant negative influence on investment and growth once we control for

rates of return considerations , the remaining task becomes one of ex

plaining why this has not proven more of a p roblem in Indonesia. It is

to this more interesting challenge that I now turn .

Institutions and Political I ncentives

The second stage of my explanation fo cuses squarely on possible

connections between the inst i tut ional environment and the nature of

governance, and explores the incentives available to political leaders. I do

32


this by drawing on and adopting the now widely discussed work on cor

ruption by Shleifer and Vishny ( 1 993) . They draw an analogy from indus

trial organization theory to model the consequences of the political and

institutional environment on the level of corruption and the extent to which

it inhibits investment and economic growth. The underlying model is that

of Augustin Cournot's ( [ 1 838J 1 9 7 1 ) complementary monopolies, that is, a

contrast between the p ricing decisions of a single monopolist who pro

duces strongly complementary goods and multiple independent monopo

lists, each producing only one of the strongly complementary goods. The

single monopolist will have an incentive to price his goods in a concerted

fashion, because pushing up the price of one of his goods will tend to

push down demand for the others since consumers require all . Conversely,

where there are multiple independent monopolists , even though the goods

remain strongly complementary, they will tend to push up the price of

their respective p roducts and all will suffer.

Shleifer and Vishny take this insight and apply it to corruption by

focusing on bribery and the market for government regulato ry goods

(Le . , licenses and permits needed by firms to do business) . They assume

there are m u l t i p l e r e g u l at o ry g o o d s involve d a n d there is s t r o n g

complementarity among them all ( s o that potential investors will need

a building p ermit , and an import l icense, and employment contracts ,

etc) . For present purposes , the relevant point is the contrast they draw

between two stylized models of the market for government regulatory

goods under authoritarian or weakly democratic political conditions and

where corruption is rife (and, by implication, legal institutions are weak) ;

one highly centralized, and the other much less so. In the first, national

pol it ical leadership exercises a suffic iently strong grip on regulato ry

agencies that we can think of the relevant sections of the state as func

tioning almost like a s ingle centrally coordinated monopoly for bribe

collecting. Strong political leaders are able to prevent regulatory agen

cies from act ing independently and to ensure that a healthy share of

br ibes col lected flows upwards, with the remainder being distributed

proportionately and promptly among relevant o fficials . In short , o ffi

c ials i n regulatory age ncies are unable to o p e rate independ ently to

maximize their own take . Under this m o d e l , if a fi rm is se eking the

necessary permits to establish a factory it acquires secure property rights

to the package of regulatory "goods" thus purchased once i t has pro

vided the appropriate corrupt inducements .

The second model i s one in which p o l it ical control is weaker and

less central ized. Instead of a situation approximating a single monopo-

33


l i s t , there i s a mult i tude of independent m o n o p ol i s ts se l l ing c o m p l e

mentary regulatory g o o d s . B e c a u s e t h e pol i tical leadership is unable to

exercise effect ive control over bureaucratic agencies , officials ( o r their

r e s p e c tive age n c i e s as a who l e ) seek to maximize their own take by

act ing as independent monopol ists and pushing u p prices without re

gard for the effect on overall demand for government goods. Also, unlike

the single monopol i s t m o d e l , in this s i tuat ion the firm purchasing al l

these government goods can never be sure it has secure property rights

as any agency might subsequently seek to extract further br ibes . The

weaker the p olitical leadership's contro l , the greater the scope for inde

pendent and uncoordinated extract ion by o ffic ia ls pursuing their own

individual interests . Moreover, if the leader is not confident that coor

dinat ion can be enfo rced , h is or h e r best interests are served by acting

as an independent monopol ist as well , and competing directly with all

other officials . (Crudely, i f you can't beat them , j o in them. )

The key point t o be drawn from Shleifer and Vishny is that there may

be an important analytical distinction to be drawn between situations in

which corruption is p e rvasive but the framework of government is tightly

centralized and those where it is loosely centralized. I f the leader enj oys

strong control over regulatory agencies , then we can think of his or her

interests o n the pr ic ing o f br ibes as b e i n g equivale n t to tho s e o f the

s ingle monopolist under conditions of strong complementarity. As such,

he o r she has a direct interest in imposing c o o rdinat ion and ensuring

that no individual agency enriches itself at the expense of the system as

a whole , and the p o l it ical leadership in p articular. On the other hand ,

where the l e a d e r enjoys o nly weak contro l over regulatory agen c i e s ,

officials will be far l e s s constrained. Facing the incentive structure of the

independent monopolists under condit ions of s tro n g complementarity,

they wil l s e e k to maximize the i r own takes by driving u p the b r i b e s

necessary to o b t a i n the p art icular regulatory goods t h a t t h e y contro l ,

even though this will drive down overall demand. According to this logic,

stro ngly centralized government wil l produce lower ind ividual br ibes ,

but a higher level of overall rent collected (because m o re bribes wi l l be

c o l l e c t e d ) . A l o o se r, l e s s - c e ntral ized gove rn m e n t wil l p roduce higher

individual bribes , but lower overall rent collection (because fewer bribes

will be c o l l e c t e d ) - d e s p i t e p e rvas i ve co rru p t i o n i n b o t h . A n d , m o r e

important from a n overall e c o n o m i c viewp o i n t , c o r ru p t i o n u n d e r con

di t ions o f l o o s e l y c e n t ral i z e d g o ve r n m e n t w i l l b e more i n j ur i o u s to

economic growth because i t wi l l r e d u c e e c o n o m i c act iv i ty by d r i v i n g

down demand for the government g o o d s necessary fo r firms to go about

34


their product ive bus iness . Note the counteri ntuit ive result here : under

condit ions o f strong centralizat ion there wil l b e more br ibes co l lected

and higher tota l reve n u e extracted fro m the p r ivate s e c t o r, but l e s s

damage will b e d o n e t o t h e e c o n o my b e c a u s e t h e b r i b e s w i l l n o t b e

priced excessively (that i s , they wi l l not drive down demand significantly) .

Shleifer and Vishny's ins ight into the pricing of bribes and, by exten

sion, the security of property rights , i s a p owerful one. To ope rationalize

it , however, we need to dissect more carefully the political preconditions

for these stylized models they sketch. To think of a single monopol i s t

simply as a strong or centralized government is to s l ide too quickly over

key deta i l s . A s p ectrum of governments in the n o n d e m o crat ic world

would fal l under this heading, and yet fai l to behave according to expec

tations . The key issue is not regime - typ e , but the institutional capability

of the leader to minimize problems of agency loss-offic ia ls behaving

in a manner contrary to the leader 's wishes. Whi le there i s a range of

m e c h a n i s m s by w h i c h a g e n cy l o s s can be a l l e v i a t e d ( Ki e w i e t a n d

McCubbins 1 99 1 , c h . 2 ) , in most developing country contexts monitoring

and enforcement are p ivotal . Given that no leader can directly control

all decisions o n the sale of regulatory goods , his or her ability to mini

mize problems of agency loss wil l depend on the leader's abili ty to know

whether errant behavior is taking place and then to deter it . M any lead

ers-p art icu larly in authoritarian set t ings-have an abi l i ty t o punish ;

much less common is an ability to monitor effectively. Accordingly, few

pol itical leaders are in situations which give them the ability-and thus

the i n c entive-to enforce "coordinat i o n" among their rent - harvest ing

agents. Not surpris ingly, then, unpredictable and destructive patterns of

corruption (the multiple independent monopolists ) are very common in

deve loping countrie s .

I argue that I ndones ia was a b l e to escape this common syndrome

because for m any years the pol itical and institutional framework was a

remarkable approximation of the economically less destru ctive singl e

m o n op o l i s t m o d e l. The p o l i t i c a l fram ework deve loped under Suharto

did indeed centralize power heavily around the president and gave him

a credible capab i l i ty for m o n i tor ing the b ehavior of his agents in the

b ureauc racy and p u n i s h i n g tho s e that deviated s ignificantly fro m his

core p re fe re n c e s .

I n t e r m s of fo rmal government inst itut ions , the constitutional frame

work ti lted power m ass ively in favor of the president ( M acIntyre 1 999b) .

Although t h e r e were regu l ar e l e c t i o n s fo r t h e l e g i s l a t u r e , t h e gover n

ment h a d t h e a u t h o r i t y to vet a l l c a n d i d a t e s , i n c l u d i n g p a rty le ad ers .

3S


Elections were managed in an elaborate system that biased things heavily

towards the government party and more p articularly the executive ( in

cluding appointing military officers to 20 percent of seats) . Not surpris

ingly, although the legis lature had the right to initiate and amend or

block legislation, in practice it never did. Further, the president had very

wide- ranging decree p owers.

The president directly controlled the hiring and firing of those in all

senior positions (in all agencies, state enterprises , and the judiciary) in

the civilian bureaucracy-which is the point of sale of regulatory goods.

He also had effective formal monitoring mechanisms such as military or

former military officials (as inspector generals) in all public institutions

who reported back to the office of the presidency. The armed forces were

the most politically sensitive section of the bureaucracy. Here, too, the

president had appointment powers for all significant positions (actively

involving himself in decis ions at least as far down the o rganizational

hierarchy as colonel) . However, precisely because of the central impor

tance of the armed forces in Indonesian political life , all senior positions

were subj ect to regular rotation.

In the terms of the institutionalist literature concerned with agency

problems, all of these formal monitoring mechanisms were of the "po

l ice p atro l " variety, that i s , institutions des igned to detect and report

violations (McCubbins and Schwartz 1 984) . Less formal, but also poten

tially valuable, were "fire alarm" networks-arrangements in which third

p arties could alert the political leadership to an outbreak of problems.

Perhaps the most important of these was the relationship many local

and foreign firms would establish with one or more politically connected

individuals-such as a former military o fficer o r senior offic ial ( local

firms, being predo minantly Chines e , did this fo r po l itical protectio n ;

foreign firms for protection as well as for information) . If a firm encoun

tered seriously capricious action by officials that jeopardized operations,

it could use its connections to convey its grievances to a higher authority

through informal mili tary and bureaucratic networks.

The empirical point to b e made here is that Indones ia's pol it ical

architecture centralized power around the presidency; al l relevant play

ers owed their pos it ions directly to the president , and he maintained

effective monitoring capabil it ies of administrative behavior and, very

clearly, effective enfo rcement capabil it ies . This is not to suggest that

Indonesia had a finely tuned and efficiently coordinated bureaucracy

plainly this was far from the case. Nor is it to suggest that these various oversight mechanisms were used for the pr imary purpose of detecting

36


excessively corrupt official s-again, this was plainly far from the case .

Simply, my purpose is to argue that unlike many authoritarian leaders,

suharto did have access to quite extensive information about the behav

ior of regulatory agencies and did have the abil ity to punish officials

whose behavior deviated s ignificantly fro m his core preferences .

Suharto did not have to intervene often to keep the system going;

periodic demonstrations were sufficient. A striking il lustration was the

sudden and dramatic p r e s i d e ntia l decree to d i s e m p ower the ent ire

customs bureau in 1 985 when corruption on the waterfront became a

serious problem. Overnight, that bureaucratic function was instead del

egated to a foreign company (Nasution 1 9 8 5 , 1 3- 1 4) . In 1 98 6 , when it

became apparent that the textile industry was being jeopardized by an

overly greedy cotton import monopoly, executive action led to the dis

banding of the monop o ly and the firing of senior officials (MacIntyre

1 99 1 , ch. 4) . In 1 996, when corruption problems in the transport ministry

became too blatant, the minister was ultimately permitted to retain his

position, but only after being subj ected to public humiliation. None of

these interventions was designed to eliminate corruption-the entire

regime was built upon maximizing corruption-but al l had the effect of

curtailing corruption that had become sufficiently costly or disruptive as

to pose a serious threat to continued investor confidence in that sector.

Suharto was in a position whereby he could maximize his own interests

by allowing bounded corruption to flourish. The bounds were what the

market would b e ar. A p lethora of monitor ing mechanisms kept him

sufficiently informed if serious problems emerged and his far- reaching

powers enabled him to deal with greedy o r unrel iable offic ia ls who

endangered the system. To be sure, the system was neither foolproof

nor refined (as illustrated by any number of anecdotes from investors

who did become disenchanted) . My contention is that it was a rough

system of oversight and enforcement that worked sufficiently well to

keep a remarkable number of investors sufficiently happy for a remark

ably l o n g p e r i o d of t i m e . This syst e m p r o d u c e d b o t h wel c o m e and

unwelcome outcomes: investment and economic growth were remark

ably strong, and corruption penetrated almost every part of the economy.

If Indonesia's formal political institutions provided the president with

substantial monitoring and enforcement capabilities, its informal institu

tions gave him a strong incentive to maximize the flow of rents up to his

office. Permeating Indonesia's formal political institutions was a vast in

formal network of patron-client relationships through which coursed much

of the lifeblood of political l ife . Suharto was the paramount figure in this

37


network. Crucial to the sustenance of this hierarchical support network

was his abil ity to distr ibute patronage, most notably money. Thus , in

addit ion to any personal accumulatory impuls e s , the president had a

fundamental interest in maximizing the discretionary resources that flow

up to him, as they were critical to his political survival.

Institutionally, then, the pos ition of Suharto was m uch like that o f

t h e single monopol ist . H e had the ability and incentive to enforce co

o rdination o n the pric ing of bribes and preservation of property rights

of investors . This ensured both the maximizatio n of the rents captured

for his own use as well as an environm ent of predictability for investors

with regulatory goods being supplied at a price the market would bear.

Institutions and Credible Commitments

The Shleifer and Vishny m o del offers important insights into why a

political leader in a strong position has an incentive structure to ensure

that the pricing of b ribes and the incidence of capricious action are tem

pered by what the market will bear. The existence of this incentive struc

ture is dependent upon the institutional setting. This is the second key

step in resolving the puzzle. We now have a plausible explanation fo r

why a leader in p olitical and institutional circumstances, such as those

o f Suharto, had an unusually p owerful incentive to " hold the ring" and

e nforce moderati o n . H owever, the fact that a leader has an interest

even a strong intere st-in a particular course o f act ion by n o means

guarantees that he o r she wil l consistently follow that course of actio n .

Precisely because power in Indonesia was so heavily centralized, Suharto

was unconstrained by legal o r basic pol i t ical institutions : he could re

verse dire c t i o n at any p o i n t . D rawing on Shugart and Carey's ( 1 9 9 2 )

classification of the relative powers o f popularly elected presidents , Hadi

Esfah ani ( 1 996) has noted that the Phi l i p pine presidency is one o f the

m o s t powe rful (vi s - a - vis the legis lature ) in the d e m o cratic world and

argued that this creates real p r o b l e m s o f c o m m i t m e n t . Even a quick

glance at the I n d o n esian s i tuat ion reveals that the Indonesian presi

dency under Suh arto was even less constrained. Although it may b e in

the interest of the president to ensure moderation i n the pricing of brib

ery and capricious b ehavior by officials , what co nfidence can investors

have th at the president wil l in fact do so fo r the life of their investment

p lans , partic u l arly in a situation wh ere power is s o massively c o n c e n

t J'ated and judicial , legislative , and regulatory veto points so scarce? H o w

can investors have confidence that t h e government h a s a fundamental

c o m m itment to e n suring a to lerable bus iness e nviro n m e nt?

38


North and Weingast ( 1 989 , 804) argue :

A ruler can establish such commitment in two ways . One is by set

t i n g a p r e c e d e n t of " r e s p o n s i b l e b e h avi o r, " a p p e a r i n g t o b e

committed t o a set of rules that h e or she will consistently enforce.

The second is by being constrained to obey a set of rules that do not

p e rmit l eeway fo r vio l ating c o mmitments . We have very s e l d o m

observed t h e former, in goo d p art because t h e pressures and c o n

tinual strain of fiscal necessity eventually l e d rulers to " irresponsible

behavior" and the violation of agreements .

Under Suharto, the Indonesian government did both. As noted ear

lier, at the level of macroeconomic policy, there was clearly a sustained

effort from the late 1 960s on to maintain reasonably sound and consis

t e n t p o l i cy s e t t i n g s . A s o l i d r e c o r d o f r e l a t ively s t a b l e exchange

management, tolerable inflation, cautious spending, good savings, and

good investment in public infrastructure and human capital all presum

ably helped to encourage investor confidence over the years. As North

and Weingast point out, however, a goo d track record, although helpful,

provides no guarante e about future behavior.

Of greater importance in terms of providing a credible commitment

to restrain arbitrary behavior by state officials and minimize investment

threatening corruption was the decision to open the capital account and

make the currency fully convertibl e in 1 9 7 0 . This was crit ical in two

respects . First , given the country's d ismal economic reco rd up to the

mid - 1 9 6 0 s , this move was presumably p ivotal in reassuring investors

(both foreign and local) that they could get money out of the country

if things wen t wrong. Secondly, and in the longer run probably more

important, in adopting this measure (well before most other developing

countries) , the government was effectively tying its own hands. The open

capital account created a p owe rful early warn ing system o f inve s t o r

d i s c o n t e n t t h a t w o u l d exercise a p owerful disc ipl ine o n gove rnment

behavi o r. By al lowing capital to move freely, the gove rnment was , in

effect , enabling investors to punish it if the business environment de

teriorat e d . Unlike other aspects o f i ts e c o n o mic pol icy behavi o r, this

commitment t o guarantee an acceptable b u s i n e s s envi r o n m e n t had

strong credibility. Although the opening of the capital account had only

the status of a decree and was thus, in principle , easily changed, in practice

it would b e extremely costly to revoke. Abando ning it would be a mas

sive d i s i n c e nt ive t o fu rther inve s t m e n t ; wi th c o l l a p s i n g inve s t m e n t

creating ve ry s h a r p e c o n o mic and , u l t imately, p o l i t ica l c o s t s fo r t h e

39


government. More than any other single p olicy measure, this signaled

a commitment to investors . I t was a nearly irrevocable act of self- regu

l a t i o n t h a t provi d e d gro unds fo r broad confi d e n c e a b o u t the overall

nature of the p ol icy enviro nment .

To summarize the argument thus far, I have been concerned with the

puzzle of why, for roughly three decades, Indonesia was able to generate

strong investment flows and economic growth when its legal institutions

were s o weak and c o rrupt ion s o widespread. A thre e - p art answer has

been presented. First, various standard economic variables combined to

create an e nvironment wh ere high rates o f return could b e expected .

Second, building o n the logic laid out by Shleifer and Vishny, we can see

that the political and institutional circumstances of Suharto's Indonesia

were such that they gave the leader a powerful incentive to ensure that

bribes were not priced excessively and that arbitrary b ehavior was con

tained within tolerable l imits ; in short , to ensure that c o rruption was

c onducted in an orderly fashion within the l imits o f what the market

would bear. Note that this economic incentive structure was dependent

upon a political structure and a set of formal and info rmal institutional

mechanisms that reduced agency loss by permitting effective executive

oversight and punitive acti o n . This second step in the argument pro

vides us with a plausible explanation as to how and why Suharto was

able to ensure that while corrupt practices flourished, i t did s o within

limits tolerable to investors . Yet this second step in the argument also

introduces a paradox: the institutional conditions that underpinned the

president's ability and incentive to maintain orderly and market - consis

tent corrup tion also made future government policies uncertain since

they were so easy to reverse . That i s , the very factors that encouraged

the president to ensure moderation also had the p otential to increase

risk fo r investors . The third step of my argument tackles this problem

by fo cusing on alternative institutional mechanisms fo r promoting in

vestor confidence about future p atterns of governance. In the absence

of an independent legal system other fo rms of guarantees to investors

about the future are p o ss ible . In Indonesia's case , the o p ening o f the

capital account in 1 9 70 provided a powerful approximation of such a

credible commitment. Consciously or otherwise , this quickly came to be

a strong constraint on future policy action. B ecause it was such a potent

symbol to investors , the costs of reversing the rule b ecame extremely

high. Here, then, was a regulatory c o mmitment upon wh ich investors

could reasonably begin to plan, since in a fundamental sense, the gov

ernment was tying its own hands.

4 0


One of the implications of this argument is that we need to qualify the very widely accepted Northian argument that in the absence of solid legal institutions , economic development cannot take place . If we l imit ourselve s s tr ic tly to a N orthian framework, as reflected in e mphatic claims, such as "the inability of societies to develop effective , low- c ost enforcement of contracts is the most important source of both historical stagnat ion and contemporary unde rdevelopment in the Third Wor ld " (North 1 99 0 , 54 ) , it is difficult to account for thirty years o f sustained strong p rivate investment and economic growth in Indonesia. Indonesia's experience suggests that in the absence of an effective legal framework, private investment can still proceed at a heal thy pace if there are other factors that allay investor uncertainty. Given certain p olitical and institutional conditions, a leader presiding over a highly corrupt regime can have both the ability and the incentive to provide an attractive environment for investors . To an economic historian three decades o f strong economic growth may be o f l itt le moment, but to scholars and p o licy makers with shorter time frames this is not something that can b e lightly set as ide .

And yet , having taken p ains to develop this alternative argument, i t

must also be recognized that the system developed under Suharto could

not last indefinite ly. Even i f not destabi l ized by exogenous factors , i t

contained unavoidable s o urces o f e n d o genous breakdown. F irs t , the

system could o nly function for s o long as there are effective oversight

and punitive capabilities at the disposal o f the political leadership. The

political and institutional condit ions that provide for both of these s i

multaneously are not common. And even where they are present , they

can be displaced as a result of a change in leadership personnel if the

new leader is unable to sustain the structures of his or her predecessor.

Mo reover, even if it survives leadership transit ion, this system carries

the seeds of its own destruction, since sustained investment and growth

s o o n e r or later give r ise to s o c i o e c o n o m i c change and pressures fo r

demo cratizat i o n which , in turn, will tend to undermine the enabl ing

political and institutional conditions themselves . In short, the economic

success of the system is likely ultimately to undermine the political and

institutional foundations that sustain it. Second, while widespread but

market- tolerable corruption may b e economically acceptable to inve s

t o r s , i t i s l ikely, over t i m e , to p rove c o rrosive to the legitimacy o f the

regime, thus bringing its stability into doubt . Third, and perhaps more imp ortant , as an eco nomy matures and becomes more integrated re

gionally and globally, the additional costs associated with o perating in

4 1


this commercial environment that were at one time acceptable are l ikely

to b e c o m e decreas i n gly s o . As t h e b arr iers to l o c al a n d fo reign i n

v e s t o r s sh ift ing t h e i r m o n ey t o another ve n u e b e c o m e l ower, these

investors are less likely to accept added risks and cost arising from this

e nvironment .

Notwithstanding its econo mic utility over a prolonged period, I do

not propose that the system of economic governance I ndonesia had in

place under Suharto can b e viewed as a satisfactory long- term alterna

tive to a system o f robust and transparent prop erty rights maintained

through an independent judiciary. I do contend, however, that Indonesia's

experience suggests we need to recognize that there may be adequate

substitutes that can serve for a significant period as an alternative b asis

for investor confidence and, thus, growth.

Crisis, Collapse, and Consequences

As we now know, the system created under Suharto was swept away

by exogenous factors b e fore it could col lap s e fo r any of the internal

reasons mentioned above . This is not the place for a sustained analysis

o f the Asian economic crisis or the ensuing collapse of Suharto's rule . l

Nonetheless, some brief discussion i s necessary, for although the crisis

was clearly about very much more than corruption and property rights,

I argue that there was an important underlying connection between the

institutional foundations o f the system o f governance under Suharto

and the extent o f econo mic devastation which ultimately unfolded. In

very simplified terms, what happened in Indones ia after a contagion

effect introduced currency instability was a complete unraveling of in

vestor confidence. Witho u t doubt there were multiple factors at work

here. but important among these were the calculations local and foreign

inve s t o rs made a b o u t the l ikel ih o o d of the I n d o n e sian gove rnment

re s p o n d i n g e ffe c t ively t o t h e mount ing c r i s i s o f c o n fid e n c e . Wh i l e

Suharto's government d i d earn praise from the markets in the early phase

of the crisis for its decisive reform action , this was soon reversed as the

government action became increasingly erratic and unpredictable . with

Suharto reversing promises for reform almost as quickly as he was making

them. In a crisis situation this inconstant be havior was highly destruc

tive, for it suggested that Suharto was no longer committed to maintaining

a more or less sound economic policy environment. This robbed inves

tors o f that which they craved most-confidence that the president would

steer a steady course through economic turbulence as he had done in

the past .

4 2


In a political system as highly centralized as Indonesia's, Suharto's

actions were all - important, for there were no institutional constraints on

his pol ic?, behavio r. I f h e chose n o t to pursue p o licies demanded by

nervous Investors , there was no institutional mechanism fo r opposing

h i m . And h e r e , of c o u r s e , we r e t u r n t o the p r o b l e m e m b e d d e d in

Indonesia's p olitical structure discussed earlier: if there were no institu

t ional c o n s tra ints on p r e s i d e ntial act io n , how c o u l d inve s t o r s have

confidence in his policy promises? I argued above that this fundamental

problem had b e e n mitigated by a c o mbination of facto rs-a high ex

pected rate of return, a track record of reasonably sound macroeconomic

pol icy, and impo rtant , an open capital account . This combination of

factors, however, was o f little benefit in these radically altered circum

s t a n c e s . In the fa c e of c u r r e n c y u n c e rt a i n ty, i n ve s t o rs r u s h e d fo r

dollars-thereby negating the restraining by-products of the open capi

tal account. That is to s ay, while potent in normal times, the th reat of

capital rushing out ceased to be a meaningful constraint on government

behavior once capital was already rushing out .

In short, the very institutional conditions that produced such a highly

centralized p o litical system and underpinned Suharto's ability to con

tain corruption and arbitrary behavior within tolerable limits also ensured

that if he behaved erratically the damage to investor confidence could

be very great because there was no effective means of constraining him.

In such a situation, the only real option for investors was exit. And with

no means of removing him fro m o ffic e short of upheaval , Indonesia

continued to b leed cap ital through 1 99 8 unti l the ensuing e c o nomic

hardship fin ally produced a massive p olitical backlash. While they d o

n o t account for Suh arto's motives, w e c a n thus see political institutions

as a key factor in the system of governance that produced strong invest

ment inflows for many years , and also a key factor contributing to the

sudden and m assive outflow of capital in 1 99 7 and 1 99 8 . 2

Finally, it is worth pausing to reflect on t h e likely consequences for

corruption and the security of property rights of the massive p olitical

changes currently unfolding in Indonesia . At the time of this writing,

I�donesia appears to b e midway through a process of political transi

tion from a highly centralized pattern of authoritarian government to an

emerging demo cratic framework of government. While there are many potential pitfal l s , there is a good chance Indonesia will at least get to

exp e r iment with democracy. There are many ways in which this i s a

wel come deve l o p m e n t . A n d , if one fol lowed an unqual ified N o rthian

logic, one might conclude that this is a welcome development for inves-

43


tors as well , since this represents an important step in the direction of

m o re transparent governance and a more independent legal system.

Here again, however, it is critical to recognize that while this logic holds

true for the long run, the short- to medium- term outlook is very differ

ent . In practice, Indonesia's swing from centralized authoritarian rule to

more democratic government is likely to be associated with a decidedly

less attractive investment than in the past .

The road to a truly independent legal sys t e m i s a very long o n e

indeed, a n d there is no reason to expect that Indonesia will discover a

shortcut. For the p ast three decades a reasonable investment environ

ment has been maintained on the basis of highly centralized polit ics .

This is now all in the process of being swept away. Almost by definition,

it is very unlikely that the leaders of Indonesia's new political framework

will h ave the inst i tut ional and p olit ical capabil i t ies fo r oversight and

punitive intervention enj oyed by Suharto. As far as the issues of corrup

tion and property rights are concerned, Indonesia is thus l ikely to enter

a very uncertain intermediate zone-it has progre s s e d beyo n d t ight

p olitical centralization, but it is still a long way from a truly independent

legal system. I n terms o f the theoretical framework discussed e arlier,

Indonesia is thus l ikely to shift from a s ituation in which there is a single

monopolist for bribes to the much more distortionary situation in which

there are mUltiple independent monopolists . Ironically, then, the shift

fro m dictatorship to some semblance of democracy is l ikely to be ac

companied by a much more deleterious p attern of corruption. Crudely

p u t , the one thing worse than o rganized corrupt ion is d i s o rganiz e d

corruption.

I n closing, I cert ainly do not mean to suggest that the process o f

p olitical change in Indonesia is something to be feared or resisted. Far

from it. There are many important benefits that can come which reach

far beyond the investment environment. We should, however, be under

no illus ions that all go o d things necessarily come together.

44

CHAPTER T H R E E

STATE, CAPITAL, AND INVESTMENTS IN KOREA Ha-joon Chang

Korea's p e rfo rmance in rais i n g investments s ince the e arly 1 9 60s

has been impressive by any standard, especially given its poor perfor

mance during the earlier postwar p erio d . l As we can see in table 1 , until

the early 1 960s the share of investment in Korea's GDP (gross domestic

product) was very low ( 1 2 . 5 p ercent during 1 953-1 962) , and only about

one - third o f this was domestically finance d . The average n ational s av

ings rate during this p eriod was 4 percent, while per capita income was

$82. This compares unfavorably with the p erformances of countries like

Kenya ( $ 72 ) , Thailand ( $ 8 8 ) , and Sudan ( $9 1 ) , which, despite s imilar

per capita i n c o m e s , managed 1 5-20 p ercent investment rates . M o r e

over, some countries with even l ower p e r c a p i t a i n c o m e t h a n Ko rea,

such as Tanzania (then Tan ganyika) and Burma ( b o th $ 5 0 ) , managed

higher rates o f investment , although there were countries with higher

per c a p i t a i n c o m e s that had lower inve s t m e n t rates ( Paragu ay, the

Philip p i n e s , and Chile) . However, the Ko rean investment rate started

increasing rapidly beginning the e arly 1 9 6 0 s . By 1 9 66 , i t was already

over 2 0 percent and by the mid - 1 9 7 0 s , i t was nearly 3 0 percent (the

average fo r 1 9 7 4- 1 9 7 8 was 2 9 . 5 percent ) and rarely fal l ing below 30 percent thereafter.

Wh at i s e s p e c i ally notable a b o u t the Korean investment p e rfo r

m a n c e i s t h a t i t has b e e n achieved through a highly interve n t i o n i s t

investment governance regime (even b y t h e E a s t Asian standards) , which.

according to conventional wisdom. should lead to poor investment per

fo r m a n c e . I n d e e d . fo l l o w i n g the 1 9 9 7 d e b t c r i s i s , i t has b e c o m e

fashionable to argue that i t was precisely because of t h e inefficiencies

4 5

State, Capital, and Investments in Korea

and corruption generated by this interventionist investment governance

regime that the country had such a spectacular crash (Brittan 1 997 and

Krugman 1 99 8) .

Later in this chapter I shall argue that the recent crisis in Korea owes

a lot to the unraveling of the "traditional" interventionist governance

regime that began in the late 1 980s but accelerated after 1 993 , rather

than to i ts persistence (fo r more details, see Chang 1 998b and Chang et

a l . 1 998) . The main aim o f this chapter, h owever, is to descr ibe and

analyze the workings of Korea's "traditional" regime of governance as it

relates to investment, which, despite the many lessons that it provides

for other developing countries, has been misunderstoo d .

The "Traditional" Korean Investment Governance System, 1 96 1 - 1 993

The regime of investment governance that supported Korea's spec

tacular development was established in 1 96 1 , following the coup d ' etat

by Gen. Park Chung Hee in 1 96 1 . As soon as it came to p ower, the Park

regime nationalized all the b anks, which had initially been confiscated

fro m the Japanese c o l o n izers and put under government ownership

but were later p rivatized by the Rhee regime during the late 1 950s . At

the same t ime, the Park regime imprisoned many prominent business

men on the charge of having accumulated wealth through " illicit" means

( e . g . , using political connections) . H e then released them in return for

their promises to "serve the nation through enterprise," which basically

meant building new plants in state-designated industries (the so-called

Illicit Wealth Accumulation episode; see Jones and Sakong 1 980 , 69-70,

2 8 1 -82) .

With these two s evere blows, the business community suddenly

became morally questionable-criminals were paroled o n the condi

t ion that they did as they were told-and economically a paper tiger,

devoid of the power to make investment decis ions , the ultimate capi

talist prerogative .

The logic of this system has been analyzed and studied extensively

by a number of scholars (see , for instance. Amsden 1 989 . Chang 1 993 .

Campos and Root 1 996 , Haggard 1 990) . So we shall not delve into this

any further. The impo rtant point fo r this chapter is that the system

enabled the Korean government to formulate . implement. and enforce

a set o f interrelated p ol ic ies that created a gargantuan t idal wave of

productive investment . These pol ic ies became p art and parcel of the

governance regime. at first stemming from it but ultimately feeding into

and sustaining it.

46

p


Policies to Maintain Stability

The importance o f pol i tical and economic stabil ity in encouraging

investments i s freque ntly emphas ized i n m any internat i o n al p o l i c y

making circles . and a t this level of generality i t is very difficult t o argue

against such a statement. Pol i t i cal and economic instabi l ity obviously

shrinks the potential investors' t ime horizon. and wil l discourage c o m

mitments o f resources to p rojects whose returns are far in the fu ture and

often uncertain but which may be crucial for mod ern industrial devel

o p m e n t . The Keyn e s i a n n o t i o n of " a n i mal s p i r i t " and the n o t i o n o f

" investors ' c o n fidence" fre quently used i n pol icy discuss ions i n Korea

(and indeed i n other countries) ret1ect such concern.

M o re recently. however. there has been a tendency among main

stream economists to interpret th is issue o f stabil ity very narrowly and

basically reduce i t to the achievement (or o therwise) o f very low int1a

tion (say, below 5 percent) . And in this context the East Asian countries.

inc luding Korea . have o ften been paraded as examples o f the invest

ment - boo sting effect o f low int1at ion . However. as some recent studies

show, there i s n o stat ist ical co rrel at ion b e tween growth and int1at ion

rate i f the latter is moderate ( say. less than 40 p e rcent ; see Bruno and

Easterly 1 994) . Moreover. the East Asian experiences. especially those of

Japan and Korea during their earl i e r p e r i o d s of d evelo p m e n t . d o not

lend much support to this argument.

From 1 9 6 1 unti l the 1 9 80s . the Korean state pursued what can b e

called a "pro investment" macroeconomic p o l icy. putt ing emphas i s o n

maintain i n g high l evels o f investment . e v e n at the cost o f m o d erate

int1ati o n . rather than achi eving s p e c i fi c quantitat ive targets regarding

i n t1 a t i o n o r budget d e fi c i t s ( C hang 1 9 9 3 ) . Ave rage rat e s o f i n t1 a t i o n

( m easured b y t h e average annual growth of t h e consumer price i ndex)

in Korea were 1 7 . 4 percent in the 1 960s and 1 9 . 8 percent in the 1 9 70s .

h i gher than the int1at ion rates dur ing the s a m e per iod i n many Lat i n

American countries ( fo r who se "troubles" int1ation i s o ften blame d ) . "

Even dur i n g t h e early 1 9 8 0 s . w h e n K o r e a was in t h e m i d d l e o f i t s

biggest stabilization exercise since 1 9 6 1 (that i s . until t h e 1 997 cris is ) . the

government fine-tuned its macroeconomic policy to en sure that i t did not

kill off investors ' confidence (and thus investmen ts ) . even if that meant

allowing more int1ation. D ur i ng this per iod . the i n vestment / CD P rati o in

Korea was kept at a level only a fraction l ower than what it achieved during

the investment boom years under the h eavy and c h e mica l i n d ustrializa

tion (Hell program. As we see in tab le 1 . the investment rate averaged 29.8

47

State, Capital, and Investments in Korea State, Capital, and Investments in Korea

percent during the period 1 9 8 1 - 1 986, against 30.8 percent during the 1 974- Table 1 con tin ued

1 9 79 period, suggesting that the stabilization program in Korea did not 1981 29 .9 22 .9 1 7 .6 5 . 3 6 . 6

hurt investments (see Chang 1 987, for some detailed analyses of this sta- 1982 28.9 24.4 1 8 . 7 5 . 7 3 .6

bilization experience) . This was unlike similar situations in other countries. 1 983 29.4 27 .6 20 .8 6 .8 1 .9

1984 30 .6 29.9 23 .4 6 .4 1 . 5

Table 1 Investment and Its Financing in Korea, 1 953-1 993 1 985 30 .3 29 .8 23 .7 6 . 1 0 .9

(As percentage of GNP at current prices) 1986 29.2 33 .7 27 .7 6 . 0 -4 . 3

1987 30 .0 37 .3 30 .8 6 .5 -7 .2

Year Gross National Private Government Foreign 1988 3 1 . 1 39 .3 3 1 .5 7 .8 -7 .7 Investment Savings Savings Savings Savings

1 989 33 .8 36 .2 28 .4 7 .9 -2 .3

1953 1 5.4 8 .8 1 1 .2 -2.4 6.6 1900 37. 1 35.9 27 .4 8 .5 0 .9

1 954 1 1 .9 6 . 6 9 .3 -2 .7 5 .3 1991 39. 1 36 . 1 28 .3 7 .8 3 .0

1955 1 2 .3 5 .2 7 .6 -2 .4 7 . 1 1992 36.8 34 .9 27 . 1 7 .8 1 .5

1956 8.9 - 1 . 9 1 .0 -2 .9 1 0 .9 1 993 P 34.4 34 .9 26.4 8.5 -0 . 1

1957 1 5 . 3 5 . 5 8 .6 -3 . 1 9 .8

1958 1 2 .9 4 .9 8 .0 -3 . 1 8 .0 SOURCE: Bank of Korea, NationalAccounts, 1 987 (for the series between 1953 and 1970) and Bank

of Korea, National Accounts, 1 994 (for the series between 1970 and 1993) . 1959 1 1 . 1 4 .2 6 .9 -2 . 7 6 . 9 NOTES: The series between 1953 and 1970 a n d the series between 1970 a n d 1 993 are n o t fully

1960 1 0 .9 0.8 2 .9 -2 . 1 8 .6 compatible du e to changes in accounting method.

1961 1 3 .2 2 .9 4 .7 - 1 . 8 8 .6 p= preliminary estimates

1962 1 2 .8 3 .2 4 .8 - 1 .6 1 0 .7

1 963 1 8 . 1 8 . 7 9 . 1 -0.4 1 0 .4 Policies to Control Capital Flight

1964 1 4 .0 8 .7 8 .3 0 .4 6 .9 In any country, especially in the early stages of development, capital

1 965 1 5 .0 7 .4 5 .7 1 . 7 6 .4 flight has to be p revented in order to ensure that whatever investible

1966 2 1 . 6 1 1 .8 9 . 1 2 . 7 8 .5 surplus is generated in the economy stays in the country and therefore

1 967 2 1 .9 1 1 .4 7 . 3 4 . 1 8 .8 has a greater likelihoo d of being reinvested. The threat of capital flight

1968 25.9 1 5 . 1 9 .0 6 . 1 1 1 .2 is a common one among the developing countries , but it was even more

1 969 28.8 1 8 .8 1 2 .9 5 .9 1 0 .6 serious fo r Korea b e cause of the constant (real and imagined) threat

1 970 26.8 1 7 . 3 1 0 .8 6 . 5 9 . 3 from North Korea. Even during the best of times , this would have pro-

1 970 24 .3 1 8 . 1 1 2 . 1 6 . 0 6 .9 vided a very strong ince ntive fo r capital flight . Periods of he ightened

1 971 24 .8 1 6 . 1 1 1 . 1 5 .0 8 . 5 political tension (e .g . , the late 1 970s , right after the US withdrew a major

1 972 20 .9 1 7 .3 1 5 .0 2 .3 3 .3 military unit) or macroeconomic instabil ity and general economic down-

1 973 25 .2 22 .6 1 9 .6 3 .0 2 .2 turn (such as the early 1 9 80s ) p rovided even stronger incentive .

1 974 3 1 .8 20.3 1 8 . 1 2 . 1 1 0 .6 As a result, the Korean state implemented a very strict regime of capital

1 975 28.6 1 8 . 1 1 5 .6 2 .5 8 .9 controls. Every economic transaction involving foreign exchange had to be

1 976 26 .5 24 .2 1 9 . 7 4 . 5 1 . 1 made through the banks under government ownership and/ or control , and

1 977 28 .3 27 .5 23 . 1 4 .4 -0 . 1 major attempts at capital flight could b e punished with a death sentence.

1 978 32.5 29.9 24 .7 5 . 2 2 . 1 The effectiveness of capital control in Korea can be shown by the fact that

1 979 35 .8 28 .5 22 .2 6 .3 6 .4 in the build -up to the debt crisis of the early 1 980s , there was virtually no

1980 3 1 .9 23 .2 1 8 . 1 5 . 1 8 .5 capital flight from Korea, then the fourth largest debtor country in the world. Con tinued In contrast , other major debtor countries in Latin America (except Brazil)

48 49


suffered from massive cap ital fl ight , estimated by Sachs ( 1 984) to have

been sometimes as big as the total debt of the country. Some countri es ,

notably Indonesia and M alaysia , have managed to prevent capital flight

without strict control of capital outflow. This would not have been possible

in Korea until recently, when the growing economic and military power of

the country (especially vis - a - vis North Korea) alleviated the co nfidence

problem that the country's investors had for a long time.

Policies to Control Luxury Consumption

Keeping the investible surplus inside the national border through capital controls may have been the fi rst step toward guaranteeing its reinvest ment , but there is still a long way to go before it is actually invested. One obvious hurdle is that the potential investor classes who control such surplus may consume it in " luxury" goods, rather than invest it. The economics behind luxury consumption is not so simple as to allow us to say that higher luxury

consumption necessarily reduces investments or that restraint of such consumption necessarily requires government intervention.3 The issue is more than a mo ral one devoid of economic meaning , as many mainstream economists bel ieve (for a more detailed discussion on the economics of luxury consumption, see Chang 1 997 ; for some philosophical discussion o f the issue. see B erry 1 994) . Particularly in many developing countries where imports of l UXury goods (or the parts and components needed to produce them) are in comp etition for scarce foreign exchange with the capital goods necessary for investment, the control of luxury-goods consumption becomes even more important for encouraging investment.

Whether or not one believes that luxury-goods consumption has to be controlled at the early stage of development, it is very clear that there was a deliberate , and very effective , restraint on luxury-goods consumption in Korea ( fo r further e m p i ri cal detai ls , see Chang 1 99 7 ) . The cou ntry has imposed heavy tariffs and domestic taxes on, and sometimes even b�nned the domest ic production as well as the importation of, certain " l uxury" products especially in the earl ier days of its development . For examp ie , t h e government imposed h igh taxes on c a r ownership and gasol ine in order to discourage passenger-car ownership unt i l the hte 1 980s . Table 2 shows that Korea has had the lowest number of passenger cars compared with any of the advanced and developing countries at comparable levels of development-beat ing Japan , the runner- u p , by substantial margins . Similarly, foreign travel was banned unti l the early 1 9805 , and was onlv l iberalized-although there sti l l are restri ctions on

'the amount of mone�

one can take ahro ad-in 1 98 8 . After the l i h e ra l izat ion , foreign tour is� 50


expenditures increased fivefold in three years ( thus suggesting that the low

expenditure earlier was not due to any "cultural " aversion to spending as

is sometimes suggested) . O n e does n o t hear stories about Korean top

executives l iv ing i n two - bedroom flats as in e arly postwar Japan; st i l l ,

anecdotal stories and casual observations confirm that living standards o f

t h e investing class in Korea have been l o w by international standards . I

One important , and usually ignored , function o f control o n luxury

goods consumption is in the realm of polit ics , that is , its role in creating

a sense of " shared growth" (the term is fro m Campo s and Root 1 99 6 ) .

By restraining the extent to which the el ite could enj oy their wealth for

personal p leasure , this control on consumption created a sense o f na

tional "community" with a common goal , for which everyone is sharing

the burdens and the fruits of growth in a "fair" ( i f not equal) measure.

This in turn contributed to p olit ical stabi lity (which indirectly contrib

uted to investment growth by shoring up investors ' confidence)-more

than the mere existence of "equal income distribution" which has been

frequently c i ted as the source of East As ian p ol i t ical stabi l i ty.

Policies to Discipline the Recipients of the State-Created Rents

Having ensured that investible surplus stays at home and is not wasted

in luxury-goods consumption, there still remains the p roblem of ensuring

that the subsequent investments are made productively, as " b ad" invest

ments wil l s imply waste resources . Some would argue that the market

signals will direct the investors into the right areas, but we know that this

is simply not true as a general proposition. Especially in the context of late

development, industrial development requires the creation of rents by the

state to induce investments in industries where there are already estab

lished producers abroad. However, the statement that the creation of rents

by the state is a necessary condition for development does not mean that

it is suffic ient . This is because , once they are awarded the state- created

rents , the investors may have little incentive to raise productivity, as the

market discipl ine has been temporarily weakened (or sometimes el imi

nated altogether) . So it becomes crucial for the state to play the disciplinarian

role . The subject of state discipline has been rather extensively discussed

elsewhere, and thus does not require an elaboration; but let us make a few

remarks h e re ( fo r further discllss ions , Chang 1 99 3 ; see also Toye 1 98 7 ,

Amsden J 989 , and Evans 1 995 ) .

The Sllccess of the Korean state in disc ip l ining the recip ients of i ts

rents can be attributed at one level to the famously (or notoriously, de

p e n d i n g o n o n e 's p o s i t i o n ) e n o r m o u s p owe r t h a t i t wie lds ove r

5 1


corporations through its co ntrol over bank credit and other financial

sources. However, if it is to b e used productively, this power has to be

exercised with a commitment to productivity growth-otherwise it will be

a route to "crony capitalism" a la Marcos (Hawes 1 987) . In the Korean case,

such commitment essentially stemmed from its brand of develop mentalist

ideology, which put emphasis on catching up with the West through pro

ductivity growth. At a more practical level, the success of state discipline

in Korea is the result of a number of factors (for more detailed discussions,

see Chang 1 993) . First of all , the choice of "strategic" industries that were

to be supported by the state was made with a high degree of realism ( i .e . ,

a wholesale catch-up across a l l industries , as in the case of India , was

never attempted) even if the choice seemed too risky to many people (e .g. ,

the forays into steel and shipbuilding in the 1 970s) . Secondly, the empha

sis on exports made it possible for the state to judge enterprise performance

relatively "objectively" by watching their performances in the world mar

ket , altho ugh it was by no means bl indly accepting them as the only

p e rformance criteri o n . F inally, policies were designed o n the basis o f

detailed information on the state of the economy and business conditions

in state- supported industries . This information was collected from man

datory reports by the state- supported enterprises and by various public

and semipublic agencies (e .g . , the state trading agency KOTRA, together

with the embassies, collected information on export markets) .

One big contrast between the Korean state and its counterparts in

many developing countries i s perhaps that i t was wil l ing and able to

discipl ine even the most powerful conglomerates . This is confirmed by

the fact that until recently there had been a rap id turnover in ranking

among the top chaebols ( co nglomerates ) , which would not be there if

state- created rents s imply served the function of providing large firms

with a comfortable life as happened in many other countries . Only two

of the ten biggest chaebols in 1 966 were among the top ten in 1 974; only

five of the top ten in 1 9 74 were in the top ten in 1 9 80 ; o nly six of the

1 9 80 top ten were in the top ten in 1 985 (Chang 1 99 4 , 1 23 ) . This is an

impressive rate of turnover despite the recent stabilization in the rank

ing of the top chaebols (as the top ones grew so big it became difficult

to dislodge them-eight of the top ten in 1 985 were in the 1 989 top ten;

Chung and Yang 1 99 2 , tables 1 and 2, appendix to ch. 5 ) .

Policies to Control Foreign Capital Inflows

Korea has relied heavily on fo reign capital inflows but o nly in the

fo rm of l o ans . As we can see in table 3 , i ts rel iance o n F D r has been

5 2

LO § O> � � � to �

� � � � � � � � � �

53


among the lowest in the world . Until recently, befo re the Korean firms

became credit worthy enough to be able to borrow in the international

capital market , al l the fo reign loans were underwritten by the govern

ment'

and as a re s u l t had to b e app rove d by t h e government . Wh ile

there were some wel l - known cases of failed proj ects financed by foreign

loans, in general the government can be credited for having put empha

sis o n the (d irect and indirect ) fo reign - exchange - g e n e rating abil ity of

the proj ects when approving foreign borrowing. This contributed to the

c o u ntry 's s urvival o f the debt cr i s i s hy keeping the d e b t - s e rvice ratio

lower than other l arge debtor countries .

While the fo reign bo rrowing story is interest ing enough, the more

interesting part of the Korean investment gove rnance regime l ies in its

policies toward FDI (foreign direct investment) , especially given the cur

r e n t e n t h u s i a s m a b o u t gl o b al i z a t i o n and the r o l e of t r a n s n a t i o n a l

corporations, or TNCs (for criticisms of t h e globalization thesis , s e e Hirst

and Thompson 1 996 , Wade 1 996 , Evans 1 99 7 , and Chang 1 998a) . Unlike

some other developing countri e s , which ostensibly pursued " techno

logical self- sufficiency" only to end up reproducing obsolete technologies

imported decades ago in the absence o f independent R and D (research

and development) capabilities , Korea has always been keen on gaining

access to the most advan ced technologies that they can handle . The

country's policy makers have been of the view, though, that accepting a

"package" of finance, technologies, managerial skills, and other capabili

ties offered by TNCs is not as good for long- term industrial development

as enco uraging nat i o n al firms to construct their own pa ckage s , us ing

their own managerial skills-obvi ously with some necessary outsourcing

( fo r fu rther detail s , see Chang 1 998c ) .

Th u s , the Korean govern m e n t i m p o s e d restr ict ions o n the areas

where TNCs could enter. And even when entry was allowed, it encour

aged j o i nt ve nture s , p referably under l o cal maj o rity ownership , in an

attempt to fac il i tate the transfer o f core technologies and managerial

skil l s . For exampl e , unti l the mid- 1 980s , even in sectors where FDI was

a l lowe d , fo reign ownership ab ove 50 percent was p r o h i b i t e d exc e p t

where FDI was d e e m e d to b e of "strategi c " importance, which covered

only about 13 percent o f all the manufacturing industr ies (EPB 1 9 8 1 .

70) . " As a result of such policies , by the mid- 1 980s only 5 percent of TNC

subs id i aries in Korea were wh ol ly owned , wh ereas the correspo nding

figures were 50 percent fo r M exico and 60 percent fo r Brazil , countries

which are often bel ieved to have had much more "antiforeign" pol icies

than Korea ( Evans 1 9 B 7 , 2 0 B ) .

54


Table 3 The Ratio of FDI Inflows to Gross Domestic Capital Formation for

Various Regions and Selected Countries (annual average in %)

1 971-75 1 976-80 1 981--85 1 986-90 1 991-93

All Countries n .a . n .a . 2 .3 4 . 1 3 .8

Developed n . a . n . a . 2 .2 4 .6 3 .3 European Un ion n .a . n .a . 2 .6 5 .9 5 .6

Austria 1 .8 0 .9 1 .3 1 .5 1 .5 France 1 .8 1 .9 2 .0 4 . 1 7 .7 Germany 2 . 1 0 .8 1 .2 2 .0 1 .4 Netherlands 6 . 1 4 . 5 6 . 1 1 3 .3 1 0 .6 Sweden 0.6 0 .5 1 .6 4 .0 9 .5 U K 7.3 8 .4 5 .6 14 .6 1 0 .0 Switzerland n .a . n .a . 2 .3 5 .3 3 . 1 U S A 0 .9 2 .0 2 .9 6 .9 3 .2 Canada 3 .6 1 . 7 1 . 0 5 .8 4 .3 Japan 0 . 1 0 . 1 0 . 1 0 . 0 0 . 1

Developing n .a . n .a . 3 .3 3 .2 5 .7 Africa n .a . n . a . 2 . 3 3 . 5 4 . 6

Latin America n .a . n .a . 4 . 1 4 .2 6 .5 Argentina 0 . 1 2 . 1 5 .0 1 1 . 1 37 .6 Brazil 4 .2 3 .9 4 .3 1 . 7 1 .5 Chi le -7.3 4.2 6 .7 20.6 8.5 Mexico 3 .5 3 .6 5 .0 7 .5 6 .8

Asia n . a . n .a . 3 . 1 2 .8 5 .5 Bangladesh n . a . n .a . 0 .0 0 . 1 0 .2 China 0 .0 0 . 1 0 .9 2 . 1 1 0 .4 Hong Kong 5 .9 4 .2 6 .9 1 2 .9 5 .7 India 0 .3 0 . 1 0 . 1 0 .3 0 .4 Indonesia 4 .6 2 .4 0 .9 2 . 1 4 . 5 Korea 1 .9 0 .4 0 .5 1 .2 0 .6 Malaysia 1 5 .2 1 1 .9 1 0 .8 1 1 .7 24.6 Pakistan 0 .5 0 .9 1 .3 2 .3 3 .4 Phil ippines 1 .0 0 .9 0 .8 6 .7 4 .6 Singapore 1 5 .0 1 6 .6 1 7 .4 35.0 37.4 Taiwan 1 .4 1 .2 1 . 5 3 .7 2 .6 Thailand 3 .0 1 .5 3 .0 6 .5 4 . 7 Turkey n .a . n .a . 0 .8 2 . 1 3 .2

Eastem Europe n . a . n .a . 0 .0 0 . 1 1 2 .2

SOURCE: U NCTAD, World Irwestment Report, 1 993, annex table 3 ( for the 1 9 7 1 - 1 980 data) and

World In llestmellt Report, 1 995, annex table 5 ( for the rest) . Reproduced from Chang (forthcoming) .

Policy measures other than the ones c oncerning entry and ownership were also used to control the activities of TNCs. First o f all , the

technology that was to b e b rought in by the investing TNCs was care -

5 5


fully screened, and checked whether it was not overly obsolete or whether

the royalties charged on the local subsidiaries, if any, were not excessive.

Secondly, there were measures to maximize technology spillovers. Those

investors who were more willing to transfer technologies were selected

over the others who were not , unless they were too far b ehind techno

logically.6 Finally, local content requirements were quite strictly imposed,

in order to maximize technological spillovers fro m TNC presence. We

should note, however, that the targets for localization were set realisti

cally, so that they would not seriously hurt the export competitiveness

of the country-in some industries, they were less strictly applied to the

products destined for the export market-and that supporting policies

that facilitate localization (e .g. , support for R and D) were also provided.

Some Puzzles

According to conventional wisdom, the kind of investment gover

nance system that we find in Korea is an ideal recipe for disaster as it

creates inefficient resource allocation due to info rmational problems,

and is l iable to exploitation by self- seeking bureaucrats, and gives rise

to rent-seeking and c orruption. If these problems are real , how could

Korea sustain a spectacular eco nomic performance with its regime of

investment governance? Trying to answer this question may allow us to

draw some useful l e s s o n s as t o what should be the ingredients of a

successful investment governance system in a developing country.

Informational Problem

One common objection to government intervention in investment

decisions is that the government does not possess the necessary infor

mation to make intel l igent investment decis ions . While it cannot b e

denied that the Korean state has made a substantial number of " bad"

investment decisions , it is also true that many o f its investment deci

sions have been hugely, if unexpectedly, successful . Korea's decision to

enter into steel making and shipbuilding in the 1 9 70s face d criticism

both at home and abro ad, including o bj ections from the Wo rld Bank.

This suggests that the informational problem usu ally taken as insur

mountable by opponents of state intervention may not actually b e so

serious (for further elaboration, see Chang 1 99 4 , ch. 3 ) .

First of all , we should not forget that insufficient information does not

prevent us from planning our future economic life. Actually, the uncer

tainty of the future is exactly the reason why we plan for the future, though

given our " bounded rationality, " we should not have excessive trust in our

56


ability to control our future through planning. And indeed, overcomi n uncertainty is one of the most important functions of business manage� m e n t , e s p e c i ally in large m o d ern c o r p o rat ions ( Richard s o n 1 9 6 0 , Williamson 1 97 5 , Stinchcombe 1 990) . I t i s inadequate t o argue that the state should not attempt to plan the future of the national econo my because of insufficient information, when firms can and do plan their Own

future despite-or rather, precisely b ecause of-insufficient information.

Second, we need to question the widespread belief that the informa

tional problem fo r intelligent state intervention is so great as to m ake

intervention ineffective , while firms do not suffer fro m such a problem.

In fact , entrepreneurs themselves often operate on the basis of " informed

guesses" or "animal spirits" in making investment decisions. Moreover,

much of the information used by the firm to make investment decisions

( e . g. , estimates of present and future demands, the availability o f best

practice technology) are readily available to anybody, and not just to the

firm itself. I t should also be noted that a large part of the information

used by the firm is acquired from external sources, such as consultants ,

research institutes, and state agencies ( e . g . , central statistical b ureau) .

In addition, the common assumption that those who are "doing the

business" h ave " b e tter" information than those who are trying to inter

vene fro m " high ab ove" should n o t be b l indly accepte d . B ehind this

argument l ies the assumption that " local" information is always b etter

than "global" information b ecause it is more finely mesh e d . H owever,

people with " lo calized " information may make a substantively less ra

tional decision than those with more "global " information , due to the

"subgoal identification" problem (the term is from Simon 1 9 79) . I f the

aim of government policy is to imp rove the efficiency of the economy

as a whole, it may actually be better, under certain circumstances, not to

be affected by the "localized" information possessed by the firm. Particu

larly when the decision involves externalities which are not borne out by

the firm, the state can make a better decision solely due to the more global

nature of its o bj ective , and not b ecause it is a superior being.

Last but not least. the problem of identifying good investment oppor

tunities is far less serious for late-developing countries than for the countries

on the frontier of world technological progress. This is because late devel

opers have the "second- mover advantage , " by which we mean that they

can watch the frontier countries and learn from their experiences . 7 Even in

a country like Japan, which was pretty close to the frontier of industrial

development even during its postwar catch-up period, it is recognized that

"setting priorities, picking the next likely winners, has not been difficult

57


throughout the postwar period when the objectives of policy were prima

rily 'catching up' objectives" (Dore 1 986, 135 ) . In the case of Korea, which

lagged even farther behind, the problem has been even less .

Bureaucratic Self-Seeking

Another argument that is frequently employed against an interven

t ionist approach to investment governance is that , whether or not the

bureaucrats have the ability to make intelligent decisions, these decisions

should not be left with them because they would pursue their own selfish

objectives in making such decisions. And indeed we can observe this kind

of behavior-such as maximizing the budget they control rather than public

welfare-even in the most renowned bureaucracies, including that of Korea.

How, then, was it possible that bureaucratic self-seeking did not have such

an adverse impact in the Korean case?

First of all, it needs to be emphasized that, while it contains an impor

tant grain of truth, the self- seeking-bureaucrats argument is based on a

misconception of human motivation (for further details, see Chang 1 994,

ch. 1 ) . Bureaucrats , l ike any other individual , can and do act in a fashion

that is not solely self- interested, and they often think of themselves, rightly

or wrongly, as the guardians of the public (or national) interest and act to

promote it. It is another matter entirely whether their perceptions of the

public interest are correct ones. One such reason is that "public spiritedness,"

altruism, and so on are often held as genuine principles, and not as a thin

veil to disguise self- interest. If whatever moral concerns people have are

simply described as peculiar forms of self- interest, then the self- interest

hypothesis will in fact become empty. Secondly, as demonstrated by modern

experimental psychology, decision frameworks do influence people's de

cision ( Tversky and Kahnemann 1 986) . Bureaucrats usually face questions

put in terms of public interest, which will invoke a preference ordering that

differs from what is used in private decision- making situations .

Even with such qualifications, it cannot b e denied that bureaucrats

have the tendency to exploit the power conferred on them by their offices

in order to pursue their own interests. This makes the organizational structure

of the bureaucracy quite important, as it will shape the incentive structure

for the bureaucrats. However, the success of a bureaucracy in controlling

self- seeking by its members goes much further than setting fo rmal rules

against such behavior. As Simon ( 1 99 1 ) argues , a successful organization

has to be one that musters organizational loyalty among its members , as

otherwise the organization would have to spend an enormous amount of time and resources in bargaining and monitoring their performances. I n

5 8


this context, the remark from a top executive of the large Japanese steel company, Kobe Steel, whom I encountered in a World Bank conference, is instructive . The executive claimed that given the diversity and complexity of the company's operations, there was no way he and others sitting on the board could make an informed decision about most of the projects put forward to them by their subordinates. He argued, however, that they are not worried because they believe that most of their company employees are doing their best to advance the interest of the company. This would

sound like a non sequitur to those who believe in the neoclassical view

o f human nature, but this is essentially how a successful bureaucracy operates-be it the private-sector business bureaucracy of Kobe Steel o r

t h e respected government b ureaucracies of Korea, France, or Britain.

The existence of a "go o d " bureaucracy that has the o rganizational

structure and organizational culture that can prevent bureaucratic self

seeking has frequently been singled out by many people as one of those

conditions that enabled Korea (and other East Asian countries) to success

fully pursue an interventionist approach to investment governance. While

I absolutely agree with this view, I would like to warn the readers against

believing that the existence of such a bureaucracy was, to borrow a popu

lar but obfuscating phrase, a beneficial " initial condition" that the country

possessed for historical reasons . Contrary to the popular belief, the Ko

rean bureaucracy in the early postwar years was suffering from bad orga

nization, compromised meritocracy, and lack of technical expertise-it was

sending its bureaucrats for training to the Philippines and Pakistan until

the late 1 960s. Thus the country had to spend a lot of time and energy in

reforming the organizational structure of the bureaucracy and training the

bureaucrats before it could establish the kind of bureaucracy that it has

now (Cheng et al . 1 996) . B

Rent - Seeking and Corruption

One popular argum ent against state intervention in investment deci

sions is that it can lead to rent-seeking and corruption (for a comprehen

sive criticism of the theory of rent -seeking, see Chang 1 994, chs. 1 -2 ) . In

the current policy discourse, it is common to equate rent -seeking and cor

ruption (or more precisely, bribing) with each other, but these two need

to be clearly distinguished (Chang 1 994, 29-30) . Strictly speaking, what are

known as "rent-seeking costs" are essentially transaction costs arising from

the diversion of resources from other "productive" activities to "unproduc

tive" lobbying activities (based on the impo rtant but frequently ignored

assumption that the economy was previously in a state of full employment

59


and thus the diverted resources had already been productively employed

elsewhere) . B ribing, on the other hand, is essentially a resource transfer

to the holders of public offices and thus has no (or very little) transaction

cost implications. However, does the fact that bribery is a transfer mean that

corruption does not matter? Of course not, because there are important " in

direct" ways in which bribery matters for the efficiency of the economy.

Corruption and Capital Accumulation

One important way in which transfer of wealth through bribing can

have an impact on the economy is by transferring wealth between groups

with different savings l in vestments propensities. I f the wealth was trans

fe r r e d fro m an i n d i v i d u al (or a group) with a l o w e r c o n s u m p t i o n

propensity t o another individual (or another group) with a higher con

sumption propensity, the economy may suffer in the long run, as this

may reduce investment .

I t is not implausible that those who are b ribed ( i . e . , polit icians or

b ureaucrats) have a typically higher propensity to consume than those

who bribe ( i . e . , businessmen) . However, the distinction between busi

nessmen and politician s / bureaucrats in this regard is somewhat spurious,

b ecause many of the latter, especially in developing countries , double

as businessmen, if o nly as "sleeping p artners . " I f those who are taking

bribes do not have a higher propensity to consume than those who are

giving bribes , the presumed negative effect of corruption on investment

and capital accumulation may b e negligible . Actually, this may b e one

clue to how such a "co rrup t" co untry as Ko re a (as well as some other

countries in Asia , such as Japan or Indonesia) experienced a rapid capi

tal accumulation. All in all , without knowing the exact circuit of corruption

money in a particular country, it is not possible to predict how corrup

tion will affect capital accumulation.

However, there is another reason why corruption may lower capital

accumulation that is quite separate from differential consumption propen

sities. Wealth made out of bribes is more likely to b e shipped out of a

country than other forms of wealth (as this will reduce the chance of

detection for corrupt dealings and will make it easier for the bribe recipi

ent to flee the cou ntry in the worst case) . I f such cap ital fl ight occurs ,

domestic accumulation will have been harmed by corruption, even when

the corrupt official has the same savings propensity as the businessman

who gives the bribe . In a country like Korea, therefore , the existence of

capital control may have been more important than is often supposed in

ensuring high capital accu mulation, given the high level of corruption. "

60


Corruption and the Quality of Government Decision Making

The real trouble with corruption is not simply that it transfers money

to public officials but that i t is intended to influence the substance of

decisions by those officials. At this point , we should note that the influ

ence of bribery o n government decision making is not entirely negative .

Bribery may have positive indirect effic iency consequences when it is

used as a "signal " for one's superior ability as a producer to make profit

(as he avy advertis ing may be used as a " s ignal " fo r superio r - p roduct

quality) . O f course , the trouble i s that this s ignal is not noise - free , as

there is no necessary c orrelation b e tween someo ne's abil ity as a pro

ducer i n the p ar t i c u l a r i n d u s try wh e r e h e o r s h e i s tryi n g t o g e t

government support a n d h i s or h e r ability to mobilize funds in general .

For example, a person may be able to mobilize a lot of money b ecause

of his ability to make arbitrage gains, but that does not prove that he will

be a goo d manager of the industrial firm for which he is hoping to get

a license. If this is the case, the positive nature of the signaling function

of bribery may be severely limited . Indeed , so metimes the exact pur

pose o f bribery is to " j am the signal " s o that one could conceal o ne's

(relative) incompetence in the area in which one wants to be chosen for

government favor by using the money fro m other areas where one is

more competent .

Then how can we explain the fact that a corrupt country l ike Korea

could maintain a high degree of rationality in government decision mak

ing? There are a few possible explanations , although none of them can

be supported by robust empirical data, given the nature of the subj ect .

First , there has been some minimum threshold of business competence

that a firm has to possess before it can enter the " b ribery market ." In the

Korean case, this has been achieved by (implicitly) confining the poten

tial recipients of state -created rents to a small group of conglomerates ,

namely the chaebols , with already p roven business track record s , and

this way the m o s t e ffic iency- damaging cases o f c o rrup t ion could be

structurally prevented. Second, it can be argued that corruption in Korea

is confined to certain sectors that may not b e so important for interna

t i o n al c o m p e t i t ive n e s s . As is the c a s e i n many o t h e r c o u n t r i e s ,

nontradable sectors like defense, construction, urban planning, among

others have been the most popular areas of corruption in Korea, whereas

corrupt ion s e e m s to have b e e n l e s s in tradable s e c t o r s wh ere p o o r

performance c a n be quickly expo se d . ' o Third , i t is widely accepted i n

Korea that there h a s been less corruption i n t h e critical " technocratic " p art of the government where m any substantively important decis ions

6 1


are made, whereas it is quite widespread among the top politicians and

the lower-level b ureaucrats. Finally, the public commitment of succes

sive Ko rean p o li t ical regimes to productivity growth and catching up,

manifested in national and sectoral planning exercises , seems to have

put certain limits to the degree of "distortion" that bribing can have on

bureaucratic decisions .

Political Functions of Corruption: Implicit Wages,

Redistribution, and Legitimacy

Another possible explanation for the apparently weak (if not exactly

nonexistent) negative effect of bribery on the economy in countries like

Korea is that a substantial portion of bribery is in the form of what is called

tukkap (literally, "money for rice cakes" ) . It is not p aid to p articular public

officials in relation to a p articular project, but is p aid to most (if not all)

of the influential p oliticians and bureaucrats to keep them "sweet. " l l

To the extent that bribery takes the form o f tukkap and does not result

in specific instances of favoritism, it is a pure transfer which does not even

have the "signal j amming" effect that we mentioned above. I propose that

this kind of bribery is better understood as an element of " implicit wages"

for the politicians and bureaucrats who are bribed. Indeed, many Korean

bureaucrats and p oliticians claim that they would not take the bribes if

they were getting salaries comparable to what they could get if they were

employed in the private sector-of course, taking into account the higher

social status that government jobs carry. Indeed, one reason why Singapore

has little corruption seems to be that it pays its public figures salaries th at

are competitive with private sector salaries .

One addition al interesting twist to this story is that in Korea, as in

many developing countries , a large p art o f the tukkap -style bribery di

rected to the politicians ( i f not the bureaucrats) ends up being transferred

to their constituents, especially the poorer ones. Indeed, many politicians

claim that the need for this further transfer to their constituents is the

biggest reason why they take tukkap. And to the extent that this is t.rue, this

kind of bribery works as a channel for income redistribution.

Then the obvious question is why countries l ike Korea cannot raise

extra taxes from businessmen equivalent to the tukkap they are paying

anyway, and then use the money, first, to raise wages for pol iticians and

bureaucrats to take care of the " implicit wages" element, thus reducing

their needs to take bribes; and second, to set up a decent welfare state so

that the politicians do not need to take bribes for redistributive purposes

and make the redistribution less subj ect to things l ike p arty loyalty and

62

State, Capital, and Investments i,} Korea

personal connections. This way, the businessmen will pay exactly the same

amount of money in increased taxes rather than in bribes (or even less ,

as they do not have to pay the "risk premium" to those who are taking the

bribes) , the p oliticians and the bureaucrats wi l l get all the m o n ey they

used to get illegally or semilegally as a part of their legitimate salaries now,

and the poor will get the same amount of transfer from the rich , but now

through institutionalized welfare schemes rather than depending o n their

attractiveness to p articular politicians .

However, there are many political and ideological obstacles to such

obvious refo rms in Korea, m any of which also apply to other countries .

First of al l , regarding the " implicit wage" function of corruption, it should

be noted that the prevailing Confucian ideology regarding public service

requires that the public officials pursue a life of "clean poverty" (ch ungbin) ,

making it difficult to raise salaries for the politicians and the bureaucrats

in the Singaporean manner. Second, in relation to the "redistributive" func

tion of corruption, it should be noted that the absence of the welfare state

ideology and of the political coalitions to b ack it means that the Korean

government's p ower to raise taxes for redistributive purposes is l imited.

Moreover, p olit icians who currently run " l o cal welfare states" have an

incentive to keep discretion over the exact manner of redistributive trans

fer, which will be threatened by giving everyone an entitlement to a certain

level of income through the welfare state. And those who are p aying the

tukkap also prefer to have their money redistributed through the polit i

cians, rather than directly to the poor, as this wil l increase their overall

influences on the politicians.

The inability of the Korean society to accept the function of corruption

as a channel to provide implicit wages to public sector employees and as

a channel of income redistribution to the poor has meant that the sorely

needed reforms of the taxation system, the public sector salary structure ,

and the social welfare system that will institutionalize the existing transfers

have not happened (or even been discussed widely) . This , in turn , h as

meant that the whole system of "corrupt" transfers persists because many

people need it. The problem is that the widespread corruption has led to

a legitimacy crisis for the country's political system , because accordin g to

the formal rules that currently govern the processes of income generation,

transfers, and entitlements, most of the "political transfers" that are going

on now are i l legal . Indeed, this inherent vulnerability to legitimacy crisis ,

rather than its effect on capital ac c u m u l at i o n o r gove r n m e n t decis i o n

rationality, may b e the biggest problem with corru p t i o n i n t h e Korean

society (and in m any other societies that suffer from a similar problem) .

63


The Demise of the " Traditional" Regime of

Investment Governance, 1 993- 1 997

Since the late 1 980s , but especially from 1 99 3 , when the Kim Young

Sam government took power, the Korean regime of investment governance

underwent important changes in more " l iberal " d i rect ions-the most

important changes being the abolition of the planning ministry (the Eco

nomic Planning Bo ard) , the severe weakening of industrial pol icy, and

l arge - scale financial l iberalization (more on these later) . What were the

forces driving such changes?

First of all , as the Korean economy approaches the world's technologi

cal frontier, the informational benefit that the government can derive from

the country's late- developer status (see above) has been diminished. And

as a result , there has b e e n a growing opinion ins ide and outside the

government that it is not so simple anymore to decide where to push invest

ments as it used to be, and therefore more and more things have to be " left

to the market." Of course, it is not clear whether this argument is convincing.

Korea is still some way away from the world's technological frontier except

in a few industries, and thus the loss of " latecomer's advantage in govern

ment intervention" is still not so complete. And the exp erience of Japan

shows that even in a highly advanced economy there are a lot of positive

things that the government can do in terms of physical investment coordina

tion or promotion of cooperative R and D investments. Nevertheless, by the

mid- 1 990s, the belief that the Korean economy finally reached a stage where

government orchestration of investment is at best redundant and at worst

harmful had established itself strongly among the Korean elite circles.

Second, the past (and present) association of the interventionist state

with polit ical authoritarianism and corruption has lent strength to the

opinion that a less interventionist state is needed to rid the country of such

undesirable features. Needless to say, such a simplistic view of state inter

ventionism is not warranted. For example , the Pinochet regime in Chile

combined a high degree of economic liberalization with political repres

sion. For another example , corruption in the Korean context cannot be

e l iminated without some structural reforms that I suggested in the previ

ous section, which m ay actually require an increased role of the state at

least in certain areas (such as taxation and social welfare) . Even so, the grip

that this opinion has over the public mind had been very strong, and gave

impetus to a generalized attack on state interventionism.

In addition, during the l ast s everal years , Korea has witnessed the

tremendous rise of free- market ideology, strongly influenced by its ascent

64


on the world scale. The limits of neoliberal free - market reforms are too

well known to discuss here, but the sway that the free- market ideology is

holding in the country during the last several years has been truly remark

able. Especially with their growing financial muscles and their increasing

outward investments, the chaebols have become much more aggressive

in asserting their b elief in a free market-the best manifestation of this

being the 1 99 7 document fro m the research institute attached to their

association (Korean Federation of Industries) , which was hastily withdrawn

after public uproar in response to its call for a radical reduction of state

activities ( e . g . , to abolish all government ministries except defense and

foreign affairs , to cut the number of government employees by 90 percent,

to deregulate every market imaginable, etc . ) Y

Added t o all these had been the increasing external pressures for lib

eralization. During the last decade or so, following the Korean success in

international markets, the US and the European Union have been engaged

in active " trade diplomacy" with Korea, which involves demands for do

mestic deregulation to enhance market access as well as trade liberalization.

The signing of the World Trade Organization ( WIO) agreement has also

reined in Korea's p olicy freedom more than before, although we should

not forget that the old General Agreement on Tariffs and Trade ( GATT)

system did not necessarily allow much more freedom to developing coun

tries than now, except perhaps in the area of TRIPs (trade- related intellectual

property rights; for more details, see Akyuz et al . 1 998) . Korea's accession

to the Organization for Economic Cooperation and Development (OECD)

has also obligated the country toward greater liberalization, especially of

the capital market.

All the above factors have conspired to bring about important changes

in the investment governance regime of Ko rea since 1 99 3 . While there

were also changes, such as the narrowing of the definition of "stabil ity"

(and thus more narrow concern for inflation) and the increasing relaxation

of lUXUry consumption control regime, the two most important changes

were the financial liberalization program that vastly reduced the state control

on capital inflows (and outflows to a lesser extent) and the abolition of

national and sectoral planning exercises , epitomized by the abolition of

the Economic Planning Board (EPB ) . This chapter argues that contrary to

conventional wisdom, it was these changes rather than the persistence of

the "traditional" regime of investment governance that led to the 1 997 crisis

(for further details, see Chang 1 998b and Chang et al . 1 998 ) .

First of all , the financial l iberalization program that was implemented

in 1 993-partly as a response to US pressure and partly in a bid to qualify

65


for OEeD membership-was wide- ranging in its scope, proposing, among

other things, to deregulate interest rates, abolish "policy loans, " grant more

managerial autonomy to the banks , reduce entry b arriers to financial

markets, and, most important, liberalize the capital account. The ultimate

result of these changes was the now well -known huge foreign debt build

up, where the country's foreign debt nearly trebled from $44 billion in 1 993

to $ 1 20 billion in September 1 997 (although it fell slightly to $ 11 6 billion

by November 1 997) . 1l The problem with this debt build - up was not pri

marily with its scale but with its maturity structure , where , exploiting more

lax regul ations on short - term loans , the share of short- term debt (debt

with less than a year's maturity) rose from an already high 43 . 7 percent in

1 993 to an astonishing 58 .3 percent at the end of 1 996 (BAl , 1 998) . 1 4 When

the "contagion effect" from the Southeast Asian crisis and a number of

high - p rofi le corpo rate failures (s teel - maker Hanbo and car- maker Kia)

shook international investor "confidence" in Korea in the last quarter of

1 9 9 7 , such poor maturity structure of fo reign loans meant that it was

impossible for the country to stem the outflow of foreign exchange.

The abolition of national and sectoral planning was also a critical factor

in the making of the 1 997 crisis . Soon after it came to power in 1 993 , the

Kim Young Sam government, in a gesture to show its commitment to free

market refo r m , ab o l i s h e d the E P B , whi c h had t i l l then orche strated

government economic p ol icy since 1 96 1 . I t a lso turned the ambiguous

attitude that the previous Roh Tae-Woo government showed toward sectoral

industrial pol icy into an outright aversion , and practically terminated

sectoral industrial policies, except in the form of technology support in a

few high-tech industries . Now free from the government coordination of

investments to avoi d "duplicative" investments, the chaebols went for an

investment spree fueled by foreign borrowing, which resulted in the build

up of excess capac ity i n a number of major industr ies (semico nductor,

steel . automobile, etc . ) that hurt export prices and corporate profitability.

At the same time , the abolition of planning, despite the initial expectation,

made the corruption problem worse. As revealed graphically through the

corrupt ion scandal that s u rrounded the meteoric rise and the dramati c

collapse of Hanbo Steel . the aboli t ion of planning now exposed even the

core manufacturing industries to co rrupti on, by eliminating the "rational "

criteria that put clear l imits on how influential politicians and bureaucrats

c o u l d extend favors to the ir "paying customers" (see ab ove) .

Thus seen , the changing economic , pol i t ical , and ideological condi

t ions that prevai led i n Korea s ince the late 1 9 80s , and espe cially s ince

1 9 9 3 , had led t o s i gn i fi c a n t changes i n Ko rea's reg ime o f i nvestment

66


governance . The unfortunate thing is that . even fro m the point of view

of those who think the traditional regime had more or less o u t l ived i ts

usefulness ( a viewp oint I do not not share ) , i t can be said that s o m e

critical elements of this regime were abolished without putt ing a l terna

tive mechanisms in place to take over what were regarded as legi t imate

functions . For example , l iberalizing international capital flows with o u t

establishing proper mechanisms for financial supervision was a cr i t ica l

mistake that resulted in the debt crisis . I n another example, abolit ion of

secto ral planning without establishing mechanisms through which the

manufacturers themselves could coordinate investments (as it happened

in Japan especially between the 1 950s and the 1 970s ) resulted in dupli

c ative investments that brought about c o rp o rate collapse and exp o rt

problems that c ontributed to the 1 99 7 cris is .

Conclusions

What conclus i o n s can we draw fro m our discussion?

First of al l , our discussion shows that investment governance is a subj ect

that spans an array of issues much wider than what the current discussions

of the subj ect typ ically cover: inflation , regulat ion , prop erty rights , and

social infrastructure. In the case of Korea, it involved controls on the extents

and the forms of capital inflows and outflows , disciplining the recipients

of state-created rents , and even controlling luxury consumption, all of which

were achieved through the use of a wide range of policy measures regard

ing taxation , credit allocation, ownership control , local contents require

ment, and so on. I t even has an important political dimension , as it i n

volved the construction o f the sense o f the national "community" through

controls on lUXUry consumption or restrictions on capital fli ght.

Second, the Korean experience shows that, while there are obvious

problems with an interventionist regime of investment governance (such

as informatio n al co nstraint , bureaucratic abuse, rent -seeking, and cor

rupti on) , such problems are by no means insurmountable . Our discus

sions suggest that there are a lot of misconceptions and exaggerations

i n the currently popular discourses on these problems. At various points ,

we argued that the origins of these problems are much more co mplex

than what is usually suggested. We also argued that these problems cannot

b e remedied in Korea, as in most deve lop ing co untries , by the means

that are usual ly sugge s t e d ( e . g . , ab o l i s h i n g r e g u l a t i o n s and d i s e m

powering the bureaucracy) , but req uire a fu ndamenta l ins t i tu t iona l re

form and the abandonment of the hypocrisy about the n ature of p u b l i c

servic e . I n d e e d , w e p o i n t e d o u t t h a t the fai l u re t o m a ke s u c h i n s t i t u -

67

T

I i i I


t ional and ideological changes might seriously damage the viabil ity of

the Korean regime of investment governanc e .

Third, o u r discussion of t h e Korean case shows that a "nationalistic"

governance of investments can be very successful , contrary to what many

proponents of the currently popular globalizatio n thesis argue . Policies

to prevent capital flight and keep the capital invested at home, govern

ment interventions to direct investments to "nationally" desirable areas,

the creation of a sense of national community with a common purpose

through (although not simply by) controls o n lUxury consumption, and

the controls on the extents and the forms of foreign direct investments

are all elements of such a regime. We pointed out that the globalization

thesis is , at least as yet, far too exaggerated, and that there is sti l l a large

scope for national p ol icy autonomy. Perhap s i t may sound too cynical

to suggest that the elite in many countries are now using globalization

as a convenient excuse for their abandonment of any attempt at build

ing a national co mmunity and pursuing a national agenda, tasks that

would require certain sacrifices on their part. However, in a world made

up of rather tightly bound national political units, the failure to construct

a regime of investment governance that i s firmly national in its basic

scope can only lead to economic stagnatio n and a fundamental desta

bil ization of the p olit ical units in the long run .

Finally, o u r analysis o f t h e recent changes in t h e Korean regime o f

investment gove rnance a n d i t s contribution to t h e country's 1 99 7 fo r

eign debt crisis shows the difficulties involved in institutional reforms.

Even accepting that Korea really needed the large - scale financial l iber

alization (especially capital account liberalization) and the abandonment

o f se lective indus trial p o l icy it undertook aft e r 1 99 3 (a view I d o not

agree with , as mentioned above ) , i ts recent exp e rience cle arly shows

how unwise it was to m ake these changes without putting in place a

d e ve l o p e d fi n a n c i a l s u p e rvis o ry sys t e m a n d i n t e rfi rm c o o rd i n a t i o n

mechanisms that can take over the functions that the government c o n

t r o l of t h e financial system a n d selective industrial pol icy have playe d

in the Korean investment governance regime. Even when some compo

nents of the investment governance regime (or for that matter any regime

of governance) are becoming less effective and are creating more un

de sirable side effects than before , radical changes to them should not

be made until the possible consequences of such changes for the work

ings of the overall regi m e have been tho ught through.

68

C HAPTER F O U R

GOVERNANCE AND INVESTMENT IN CHINA Shuhe Li and Peng Lian

One of the most challenging political - economic puzzles of the 1 990s

is how to explain the coexistence of large- s cale foreign direct investment

(FDI) and widespread corruption in China. On the one hand, according

to the I nternational Monetary Fund (IMF) , China has been ranked sec

ond after the United States as a h o s t co untry fo r F D I s ince 1 9 93 (see

table 1 ) . China's FDI i nflow - G D P (gross d o m e s t i c product) ratio was

also ranked second o nly to Singapore in 1 994 (see table 2 ) . I On the other

hand, China is generally regarded as one of the most co rrupt countries

in the world. According to a survey of the Political and Economic R i s k

Consultancy (Asian In telligence 1 995) , China was rated by fo reign m a n

agers a s the most corrupt among eleven Asian countries , including I n d i a

and Indonesia . China was also ranked b y Transp arency International a s

o n e of the most corrupt countries in the world i n 1 996 (see c h . 2 ) . Some

estimate that one- third to one- half of a l l deals s igned in China invo lve

some form of corruptio n, with bribes hovering between 1 - 1 0 percen t of

sales , and "there are probably as many typ es of corruption as there are

typ es of tea" ( Keijzer 1 99 5 ) .

The Chinese development experience seems to defy the pre s u m e d

wisdom a s stated b y the president of t h e Wo rld Bank: " We n e e d to deal

with the cancer of corruption. . . . We can give advice, encouragement ,

and support to governments that wish to fight corruption-and it is these

governments that , over t i m e , will attract the larger vo l u m e o f invest

ment. " 2 Clearly the co existence of widespread corruption and fast- growing

FDI in China is an intriguing puzzle for students of economic develo p

ment . As known, F D I will occur when there a r e high transaction costs

69

Governance and Investment in China

Table 1 Foreign Direct Investment Annual Inflow in Reporting Economy Table I contin ued

(Millions of us dollars) Greece 752 1 ,005 1 , 1 35 1 , 1 44 977 981 1 ,053

Country 1 989 1990 1991 1992 1993 1994 1995 Iceland -27 3 33 14 8 -1 4

I reland 85 760 1 ,062 1 ,438 1 , 1 1 3 934 2,3 1 7 Asia 1 4 ,269 1 8,421 20,779 25,597 44,970 52,5 1 5 63 ,223 I taly 2 , 166 6,41 1 2,401 3,950 4,383 2 , 1 63 4,879 Afghan ista n , I . S . of N / A N / A N /A N /A N /A N /A N / A Netherlands 8,563 1 2 ,349 6 ,3 1 6 7 ,790 7,661 5,6 1 6 1 0 ,228 Bangladesh N / A 3 1 4 14 11 2 N o rway 1 ,5 19 1 ,003 -398 716 2 ,003 623 N /A Cambodia N / A N /A N /A 33 54 69 1 51 Portugal 1 ,737 2,6 1 0 2,448 1 ,873 1 ,534 1 ,270 653 China , People's Republ ic of 3,393 3,487 4,366 1 1 , 1 56 27,5 1 5 33,787 35,849 Spain 8,428 1 3,984 12 ,493 1 3,276 8, 1 44 9,359 6,250 Fiji 9 80 15 51 29 65 67 Sweden 1 ,8 12 1 ,982 6,351 -5 3,705 6,241 1 4,273 India N /A N /A N /A N/A N / A N /A N /A Switzerland 2,827 4,961 3, 1 78 1 ,249 899 4 , 104 2 ,600 I ndonesia 682 1 ,093 1 ,482 1 ,777 2 ,004 2, 1 09 4,348 United Kingdom 30,553 32,427 1 6 ,21 3 1 6 , 1 35 1 5,544 1 0 ,295 32,208 Kiribati N / A N /A N /A N/A - 1 N /A N /A

Korea 1 , 1 1 8 788 1 , 1 80 727 588 809 1 ,776 SOURCE: I M F, Balallce of Payments Statistics Yearbook 1 996, 58 , 59 .

Lao People's Democratic Republ ic 4 6 7 8 48 42 77

Malaysia 1 ,668 2,332 3,998 5 , 1 83 5,006 4,348 N / A involved in exporting or licensing a product to a foreign company. In other

Mald ives 4 6 7 7 7 N/A N /A words, unlike trade , FDI typically involves long- term and asset- specific

Mongolia N /A N /A N /A 2 8 7 10 agreements . I n addition, foreign investors typically have less information Myanmar 8 161 238 1 72 N / A N / A N /A and connection to the host nation. How could the uncertainties and costs Nepal N / A N /A N /A N / A N /A N/A N /A

of transactions reSUlting from opportunistic behavior and the h o l d - up Pakistan 210 244 257 335 347 419 N/A

problem be reduced in an environment of corrupt legal and administra-Papua New Gu inea 203 1 55 203 294 -2 -5 453

Phi l ippines 563 530 544 228 1 ,238 1 ,591 1 ,478 tive systems? In p articular, given the fact that the s tate itself could b e

Singapore 2,887 5,575 4,887 2,204 4,686 5,480 6,9 12 predatory, how could China make credible commitments to attract FDI?

Solomon Is lands 12 10 15 14 N /A N /A N /A This puzzle is certainly not unique to China. In fact, it has been ob-

Sri Lanka 20 43 48 1 23 194 166 N /A served i n other Asian countri e s , such as Indones ia ( s e e ch . 2 ) , wh ere Thailand 1 ,775 2,444 2 ,014 2 , 1 1 3 1 ,804 1 ,366 2,068 corruption and FDI were both remarkably high before the recent financial Tonga N /A N / A N /A 1 2 N/A N /A crisis occurred. In his discussion of economic transition, Robert Hall high-Vanuatu 9 13 25 26 26 II 31

lights this puzzle as follows : " It is axiomatic that contract enforcement is Western Samoa N/A N/A N/A N /A N / A N/A N/A

Asia (not specified) 1 ,704 1 ,450 1 ,491 1 , 1 39 1 ,2 1 7 2,025 2,956 a key to successful Eastern European l iberalization . . . . It is noteworthy

I ndustrial Countries 1 66 ,514 1 69,604 1 1 2,911 1 1 7,691 1 36,459 1 39,51 3 208,909 that the m o s t rap id growth in the world in the past decade has b e e n

U n ited States 67,730 47,9 18 22,0 1 0 1 7 ,580 43,014 46,760 60,230 achieved in Asian countries where co ntractual relat ions are less h ighly

Canada 5,029 7 ,855 2,740 4,5 1 7 4,997 7,299 1 0,786 developed and enforcement is less reliable . . . . It is a fascinating topic for

Australia 8, 1 29 6 ,482 4,037 5,038 3,008 4,708 1 3,71 0 additio nal research to figure out why Asian countries have been so suc-

Japan - 1060 1 ,760 1 ,298 2,761 1 26 916 53 cessful " ( Werin and Wijkand er 1 99 2 , 34 1 ) .

New Zealand 1 ,627 1 ,735 1 ,290 2,086 2 ,469 2 ,524 2,509 This chapter attempts to provide some insights into the corrup tion-Austria 587 653 360 947 977 1 ,3 1 1 1 ,357 FDI puzzle in China. In the next section we submit a framework, the LCM, Belg ium-Luxembourg 7,020 8,047 9,363 1 1 ,286 1 0 ,750 7,464 N /A which highl ights three mechanisms : l o cal i nformation and information Denmark 1 ,090 1 , 1 32 1 ,553 1 ,0 1 7 1 ,7 1 3 5 ,006 4, 1 39

intermediaries (L) , cross- regional competition (C) , and market-preserving Finland 490 812 -233 396 864 1 ,496 897

authoritarianism (M) at the i ndividual , regional and n ation al level s , re -France 1 0 ,304 1 3 , 1 83 1 5 , 1 53 2 1 ,840 20,754 1 6 ,628 23,735

Germany 7 , 1 52 2,532 4 , 1 08 2,642 1 ,8 18 81 5 8,938 spectively. When it is too costly and too uncertain to use a corrupt legal

Con tinued system, such mechanisms can help enforce agreements and property rights.

70 7 1

---


Table 2 FOI! GDP and FOI! GNP in 1 994 ('Yo)

Country FD I 1 1 GDp2 F D I 1 IGN p3 Country FD I 1 I GDp2 F D I 1 IG N p3

Asia 2.89 0.78 Westem Samoa N A N A Afgrlan istan , I . S , of N / A N A Asia (not specified) N A N A Bangladesh 0,04 0,01 Industrial Countries 0.70 0.81 Cambodia N / A N A United States 0 .70 0 ,69 China, People's Republic of 6.47 1 . 1 3 Canada 1 .34 1 .25 F ij i N A 0 , 14 Australia 1 ,42 1 .46 I ndia N A N A Japan 0 ,02 0,03 Indonesia 1 .2 1 0 ,31 New Zealand 4,97 4,54 Kiribab N A N A Austria 0,67 0,84 Korea 0.21 0 , 1 8 Belgium-Luxembourg 3.28 3.65 Lao People's Oem, Republic N A N A Denmarl< 3.43 4,84 Malaysia 6 , 1 6 2,62 Finland 1 .53 1 .82 Maldives N A N A France 1 .25 1 .46 Mongolia 0,94 N A Germany N A 0,05 Myanmar N A N A Greece 1 .26 0,86 Nepal N A N A Iceland N A N A Pakistan 0 .81 0 , 1 6 Ireland 1 .79 1 .91 Papua New Guinea -0,09 -0,04 Italy 0.21 0.21 Phil ippines 2.48 0 ,87 Netherlands 1 .70 1 .94 Singapore 7.95 8,63 Norway 0 ,57 0 .72 Solomon Islands N A N A Portugal 1 .46 1 .07 Sri Lanka 1 .42 0,29 Spain 1 .94 1 .74 Thailand 0,95 0,34 Sweden 3. 1 8 4 , 14 Taw N A N A Switzerland 1 ,58 2 ,33 Vanuatu N A 077 United Kingdom 1 ,01 0 ,98

ScnJlll FS OF BASIC DAI ,\: 1 , I M F , B(lI(lllce o(Paymell ls Sta lislics YeariJook 1 996, 58, 59 ,

2 , The Wo rld Bank, World Delleiopmell l Report 1 996, 2 1 0 , 2 1 1 ,

:l, The Wo rld Bank, World Delleiopmen l Report 1 996, 1 88 , 1 89 , 222 (PPP based GNP) ,

After that , we specifica l ly explore the Chinese case . We argue that

overseas C h i n e s e capital i s ts , fiscal dece ntralizati o n and p o s t - M ao r e

gimes primarily facilitate t h e three mechanisms, respectively, and hence

contribute to the l arge - scale inflow of FDI . At the same time, howeve r,

government control and regional public ownership without an indepen

dent judiciary system have provided a hotbed for corruption in China's

transition economy. As nonowners of public assets but with significant

control rights , Chinese industrial bureaucrats have b o th incentives and

o p p o rtunit ies to take br ibes from private inve stors ( inc luding fo reign

investors) i n exchange fo r giving some public assets to the latter party, expl icitly or implicit ly. Although government control and public owner-

72


s�ip make corr�ption wides�r�ad (scope) , corruption is som ewhat pre -dictable , c o o rdmated, and l imited to not easily verifiab l e t l'an s . , act Io ns (degree) due to the LCM in China . Partly as a result , the co rru pt io n -ind

.uced unce

.rtainties for

. the

,returns to FDI are mitigated, thus making

Chma a relatively attractIve site for FDL In the last sectio n , we discuss the recent financial crisis in Asia and the implications for China in terms of state governance and F D L

State Governance, Informal Enforcement, and FDI

In this chapter, corruption is defined as the abuse of public assets or public authority for personal gain.3 By this definition, corruption generally occurs if public property rights and ! or public authority are not well defined. The scope of corruption is thus positively correlated with the range of ambiguity of public property rights and regulatory authority: When there are more distortions in prices, agreements, and regulations an

'd more noise,

there are more opportunities for corruption. Corrupt officials can purposely make confusing rules and change them randomly so as to create opportunities to increase bribe taking and to reduce the risk of b eing detected.

In the case of China , bureaucrats and managers o f s t a t e - owned enterprises (SOEs) and township and village enterprises ( TVEs ) are not owners o f publ ic assets , yet have s ignificant control rights over these assets . Thus they have both incentives and opportunities to take bribes from private investors by giving some public assets to the latter party, explicitly o r implicitly.4 This makes it p o s sible for a private investor to lower his average cost-the annualized value of the "fre e" public assets is greater than the bribe. Consequently, he would have litt le incent ive to reveal the situation . Product competition forces other private investors to bribe because otherwise their average costs wil l b e h i gher and they will lose market share .

Given the fact that corruption is widespread in China-fostered bv a legal system that leaves much to be desired in terms of enforcing agr�e ments and property rights-some informal and semiformal enforcement mechanisms must have contributed to the rapid expansion of FDL We submit that there are two fundamental forces that help enforce agreements informally or indirectly: local information (with partners) and competition (with rivals) . A person's local information about his business partner consists of his personal knowledge about the partner's identity, credit histo rv, reputation, financial status, and so o n . Local information

' is relatio n - sp�

cific , and it is generally accumulated among relatives , town mates , friends , and col leagues. Two parties with common local information can reduce

73


the uncertainties of their transactions and information asymmetry between

them. More important, if two parties do not have mutual local information,

but each of them has mutual local information with a common third party,

then the third party can play the role of an information in termediary. Contract

guarantee and perso nal recommendations are commo nly observed ex

amples of information intermediaries .

B y transitivity, a wid e network may be establ ished o n info rmation

intermediaries. \'\lhen such a network is interregional or international, it can

facilitate cross- regional or cross- country agreements. Such private ordering

can help enforce not o nly the kind of agreements that are not verifiable

by a third party, but also the kind of agreements that are verifiable by a

third party but nevertheless cannot be imp artially enforced by law.

\'\!hen it is too costly or too uncertain to use a corrupt legal system

to settle disputes, parties to a transaction can resort to local information

and information intermediaries to enforce agreements informally. Local

information shared among business partners can help them to conduct

business outside the l egal system, thus functioning as a substitute for

legal enforcement .

Competition provides another driving force for contract enforcement.

In particular, cross- regional competition will force each region to reduce

uncertainties and costs of transactions in its j urisdiction . The initial driving

fo rce may come fro m product competit ion in a s p o t market , such as

exchanges of fi nal products (especially c o n sumption goods fo r which

enforcement is rel atively easy) , and the resultant taxes that market ex

c h a n g e g e n e r a t e s . The r e g i o n s with m o r e e ffe c t ive e n fo r c e m e n t

mechanisms have competitive advantages , such a s l ower costs over rival

regi o n s , and thus w i l l attract m o re e c o n o m i c act ivity. Thus , product

c o m p e t i t i o n may tr igger c o m p e t i t i o n in the d e s i g n o f e n fo r c e m e n t

m e chan i sms. I n equi l ibr ium all regi o n s or groups may b e "fo rc e d " t o

adopt efficient (tho ugh info rmal) enforcement mechanisms . "

However, a proper governance structure i s n e e d e d to facilitate these

two fo rces. First , fo r local information to b e utilized effect ively, it must

be the case that individuals have economic freedom to co nduct tran s

actions and to choose business partners, and that there i s a (minimum )

political order i n the society such that there i s n o ramp ant robbery and

arb itrary confiscation." Second, fo r comp etitive fo rces to be effective. i t

must b e the case that firms and regional govern ments h ave auto n o my

to make primary economic decisions in res p o n s e to compet i t ive pres

sures but cannot erect trade barriers . I n countries where rule of law and

democratic principles have been ingrained, these conditions are gener-

74


ally met . In countries wh ere they are n o t , a regime that is p o l i t ical ly

more central ized and economically m o re decen tral ized may be a rea

s o n a b l e a l tern ative . That i s , c i t i z e n s m ay be fo rb i d d e n t o organize

opposition pol itical parties and to demonstrate on the streets , but they

are allowed to trade and invest . Local governments may be granted a

large degree of autonomy over economic decis ion making, though the

ultimate p olitical authority is the central government , and the national

government is able to maintain a common marke t . '

C ro s s - r e g i o nal c o m p e t i t i o n i m p l i e s that regi o n s charging m o r e

bribes and giving up fewer col le ctive a s s e t s will l o s e F D I to o t h e r r e

gions . H e n c e , in equilibrium, bribes will b e l o w enough to keep business

profitable . Indeed, from the viewpoint of bribe givers, it is possible that

the value of b ribery- induced favorable treatments is larger than the bribe

itself, and thus the bribe giver can be better o ff as a result . This is b e

c a u s e c o m p e t i t i o n a m o n g d i ffe r e n t r e gi o n s ( b r i b e takers ) t e n d s t o

increase the value of favorable treatments and decrease the size of b ribes .

Competit ion among bribe givers may l imit potential ineffic iencies

from corruption. I n fact , under certain conditions bribery is equivalent

to competitive bidding (Beck and Maher 1 986) . I f the bribe taker cares

only about the amount of the bribe ( i . e . , he does not discriminate among

bribe givers) and there is sufficient information , then the most efficient

bribe giver can defeat all others since he is able to submit the l argest

( "p ro fitabl e " ) bribe. Thus , resources are al located to the most effic ient

user despite corruption .

In sum, before democracy and the rule of law are firmly established,

we need a governance structure to fulfil l three basic institutional con

d i t i o n s : fi r s t , h o u s e h o l d s a n d fi r m s h ave aut o n o my t o m a k e

microeconomic decis ions ; s e c o n d , firms and local governments a r e n o t

able to e r e c t trade barriers ; third , there is no rampant robbery a n d ar

bitrary confiscatio n . These condit i o n s create an environment that e n

c o urages the u s e o f l o c al i n fo rmati o n / intermediar ies and p r o m o t e s

cross - regio nal comp etitio n .

N o t e that these are also the conditions that preserve markets . In Li

and Lian ( 1 999) , we argue that these conditions can be met under market

preseruing a u thoritarianism (MPA) .

We define an MPA as follows : A state is authoritarian if there exists

a dominant group of pol it icians who s e control over the country rests

more upon the obedience of the citizen s than upon their p articipatory consent. An autho ritarian state in a developing or industrializing economy

is market-p reserving if the fol lowing condit ions hold :

75


M l . Subj ect to changing international and domestic constraints, in

particular competitive pressures, senior leaders (or the dominant

party) perceive that it is in their best interests to preserve the

market in order to facilitate catching-up;

M2. Senior leaders (or the dominant party) are able to make their

policy on market-based catching-up more credible, i .e . , not easily

subj ect to political whim, by imposing self-constraints through

allocating sufficient autonomy (including authority, information,

and resources) to a large set of pol itical and, more important,

economic decision makers in an institutionalized way;

M3. Senior leaders (or the dominant party) are able to control agency

problems of bureaucrats and businessmen, as well as other politi

cians, by imposing constraints on them by designing and fostering

institutions, such as incentive schemes, checks, coordination, and

enforcement devices , i . e . , balancing autonomy and control.

Given the fact that senior leaders have dominant p ower in an au

thoritarian regime, Ml is a necessary condition for economic catching-up

under authoritarianism. M l assures the compatibility of the senior lead

ers' incentives with the preservation of the market . Both constraints and

experiences shape the perceived interests of pol it ician s . Politicians will

adopt pol ic ies that are i n their b e s t perceived interests . I nternatio nal

constraints may range fro m foreign occupation, military threat, interna

t ional sanctions (or support) to economic competition . 8

To make their commitment to market-based catching-up policies cred

ible, senior leaders (or the dominant p arty) in an authoritarian regime

have to tie their own hands with both international and domestic con

straints. The former includes signing international treaties and opening up

markets. Violating treaties and reversing open-door policies may ruin the

country 's international reputation and poss ibly result in international

sanctions, an d thus can be very costly. Open markets provide opportuni

ties for investors to escape should predatory behavior occur. A predominant

means of tying the politicians' hands with domestic constraints is to allo

cate sufficient autonomy systematically to a large segment of the population.

This may take the fo rm of allocating authority of policy implementation

to technocrats , autonomy to local governments, and economic freedom to

firms and individuals in an institutionalized way.

Autonomy, however, needs to be counterbalanced with appropriate

controls . Agency problems can be managed through checking and coor

d i n at i o n devices a l o n g t h r e e d i m e n s i o n s : vert i c al (or h i e rarchical ) ,

horizontal (or cross-function) , and intertemporal (or cross-time) . Examples

76


of checking devices are 0) vertical checking-hierarchical review, moni

toring, graduated controL and regular reporting to a higher authority; (2 )

horizontal checking-collective decision- making mechanisms and infor

mation exchange / peer monitoring of performance through deliberation

councils; and (3) intertemporal checking-term limitations, rotations, and

the exchange of positions among p oliticians and bureaucrats .

Examples of coordination devices are ( 1 ) vertical coordination-joint

efforts under the guidance of a pilot agency or one or more designated

p olit ical leader ( s ) ; ( 2 ) horizontal c o ordination-deliberation c o u nci ls ,

industry- specific and cross- industry business associations, antitrust and

antilo c al - p rotect ionism regulat ions , i nformal s o cial networks ; and ( 3 )

intertemporal coordination-mechanisms that reduce undesirable policy

swings and sho cks and induce long- term and stable cooperatio n , such

as the smooth and p artial replacement of politicians and bureaucrats , as

well as meritocratic recruitment of bureaucrats , and a balanced seniority

cum merit - b as e d promotion system in the bureaucracy.

Clearly, an M PA fosters the three institutional conditions : autonomy,

no trade barriers, and political order. This implies that the two informal

mechanisms ( l o c al i n formatio n and c ro s s - regional c o m p e t i t i o n ) can

funct ion in an M PA . First , M l implies that senior leaders have strong

incentives to maintain public order and to give firms and households

the freedom to make micro economic decis ions . M2 assures that house

holds and firms wil l i n fac t have auto n o my t o make micro e c o n o m i c

decisions ( in response to competitive p ressures ) . M3 assures that firms

and local governments will not easily be able to erect trade b arriers . It

also implies that some modicum of p olit ical order can b e maintained.

An MPA constrains corruption indirectly through facilitating cross-re

gio nal comp eti t ion and the use o f l o c al informat i o n mechan i s m s . As

described above (M3) , control mechanisms can constrain corruption directly.

For example, appropriately designed arrangements governing recruitment,

promotio n , and c o nduct within the bureau cracy have b e e n sh own to

constrain bribe-taking (Evans and Rausch 1 996) . The same is true of collective

decision- making mechanisms that increase transparency in the proj ect ap

proval process. When a project requires collective approval, it becomes more

difficult for individual decision makers to extract rents unless they can collude.

As another example, "graduated allocation of control or authority" at vertical

levels of management ( in the public sector) places explicit limits to what is within an official 's authority, which in turn puts upper limits on bribesY

M3 includes cross- checking devices , e . g . , appeals courts , antibribery

bureaus , party discipline committees, that make it easier to detect court

77


verdicts that are unequivocably wrong. This implies that disputes whose

contentions can be easily verified by a third party, e .g. , the appeals court,

will be less susceptible to corruption since the judges would be more hesitant

to bias decisions incorrectly. l O Hence, corruption will tend to be concentrated

mainly on disputes that are not easily verifiable by a third party, e.g. , those

that involve complex technical issues. For purposes of discussion, we will

call this type of corruption " implicit " : corruption is more l ikely to occur

because of the technical complexity involved in the dispute.

Corruption varies fro m sector to sector, tending to be more severe in

sectors where the rents are large and where agreements are technically

more specific, making it harder to detect corruption. Such sectors include

aircraft and construction (Hines 1 995) and new technologies. I I Since FDI

fro m developed countries to developing countries generally brings new

technologies to the host country, it provides good opportunities for brib

ery. However, it is important to note that corruption in this case (which is

implicit) may not necessarily imply serious contract enforcement prob

lems . Surely the host party, generally, has b etter local information and

connection with the local courts. However, it is the foreign investor's de

faults that are often harder to be verified by a third party, given that typi

cally the foreign investor provides complex technology and the host pro

vides land and labor. The foreign investor does n o t need to wo rry too

much about breach of contract by the host since this can be easily verified

by a third p arty and hence be enforced by a court . Inversely, given its

b etter connection to local courts, the host need not worry too much about

breach of contract by the foreign investor, either. Moreover, as long as the

courts in the host country are only implicitly corrupt, and the contracting

parties have freedom to choose international arbitration, FDI agreements

can be indirectly enforced by wel l -defined mechanisms in some devel

oped countries . This is b ecause ( international) arbitrated awards them

selves can be easily verified by a third party and enforced in the courts of

the host country. I " We believe that, overall , more corruption may increase uncertainties

and costs of transactions and hence reduce FDI . Wei ( 1 996) reports that

corruption and FDI are negatively correlated and there is no exception for

Eastern Asian countries. The negative effects of corruption are often exag

gerate d , however. This is because bribes may not o nly work as t ips to

speed up bureaucratic procedures and to get around inefficient rules, but

also as indicated , under certain conditions bribery is equivalent to com

petitive bidding. More important, the damage fro m corruption crucially

depends on the nature and structure of the corruption regime. In the case

78

•


of China, although corruption is widespread in scope, its character is shaped and its impact constrained by the MPA directly through M3 and indirectly through facilitating cross-regional competition. In addition , since an MPA is a relatively centralized governance structure politically, it helps "coordinate" corruptio n . Sup p o s e , for instance , there are several gove rnment agencies that supply complementary publ ic goods and act l ike a j o int monopolist . \3 The effect of corruption on private investment would then approximate that of a local tax (Shleifer and Vishny 1 993) . 1 4

I n the following section, w e argue that overseas Chinese capitalists , fiscal decentralizati o n , and the p o s t - Mao regime have primarily fac il i t a t e d t h e t h r e e m e c h a n i s m s ( t h e LC M ) , re s p e c t ively, a n d h e n c e contributed to t h e large - scale fl o w o f F D I into China.

The Chinese Case

The Role of Formal Enforcement Devices in FDI

I n the last two decades , China has enacted various l aws and regu

latio n s t o govern F D I and to curb c o rrup t i o n . There are three m aj o r

types of F D I i n China and they are governed b y the Law of E quity Joint

Ventures (passed in 1 9 79 and revised in 1 990)'

the Law o f Wholly For

eign- Owned Enterprises ( 1 986) and the Law of Contractual Joint Ventures

( 1 988) . Equity j oint ventures are j o int - stock enterprises held by Chinese

and foreign p artners with the latter's share amounting to no less than

25 percent in general . Once an equity jo int venture is established, chang

ing the r e g i s t e r e d c a p i t a l w o u l d r e q u i r e g o ve r n m e n t a p p r o val . I n

contractual ( o r cooperative) j o int ventu res , profits can be distributed at

any proportion agreed upon and each party has separate liability. Typi

cally, t h e fo reign partner provides technology and machinery, while the

Chinese s i d e p rovi d e s l a n d , l a b o r, and mater ia ls . In wholly fo re ign

owned enterprises , 1 00 percent of the capital is provided by the foreign

investor who holds both residual control and residual claims; there are

restrictions on such investment in industries as public utilities, transpor

tatio n , real estate , insurance , and banking.

Corrupt bureaucrats may favo r j oint ventures more than wholly fo r

eign- owned enterprises. In exchange for bribes from foreign investors, the

Chinese party may deliberately underestimate the value of state assets as

shares in equity j o int ventures , and agree to a lower state share of profits

in contractual joint ventures. This prediction is consistent with the observation

that the proportion of wholly foreign- owned enterprises remained low until

the early 1 990s when legal development b egan to accelerate (see table 3) .

79

-


Table 3 Accumulated Foreign Direct Investment from 1 979 to 1 993

(Value Unit: in US$ billion)

Mode

Total Equity Joint Venture Cooperative Joint Venture Wholly Foreign-funded Enterprises Joint Development

Number of Projects

1 74,228 1 1 3,041 27,245 33,847

95

Contractual Investment Amount

221 .896 1 05.629 57.061 55.442 3.764

SOURCE: Almanac of China 's Foreign Rela tions and Trade 1 994, 48.

Actual Realized Amount

61 .797 32.894 1 3.552 1 1 .590 3.761

I t is interesting to assess the impact of the American Foreign Corrupt

Practices Act of 1 977 that prohibits American individuals and corporations

from bribing foreign government officials. Empirical studies, such as Hines's

( 1 995) and Wei 's ( 1 997) , suggest that this act tends to reduce American

investments in corrupt countries. We believe such effects are very limited

(as reported by Wei 1 996) , not only because this act may provide a com

mitment device for American investors to say no to foreign demand for

bribery, but also, more important, because there are many implicit ways

of corruption and there is a lack of incentive for people to report on them.

M any American firms get third-party consultancies to do the bribing for

them. In the case of China, " by far the most common form of corruption

is the solicitation of trips abroad . . . . Perhaps the ultimate gift is education

. . . many companies have sponsored individuals whom they met in the

course of business negotiatio ns" ( Keijzer 1 9 9 5 , 1 84-86) . Since the act

punishes American investors when they or their partners in the joint ven

tures bribe local officials, some American investors in China may prefer

wholly foreign- owned enterprises over joint ventures because of the For

eign Corrupt Practices Act.

To safeguard fo reign investors ' property rights , China enacted the

Economic Co ntract Law I nvolving Foreign Interest in 1 98 5 . I t stipulates

that for matters not covered by the law of the People's Republic of China

(PRC) , international practice should be followed, and that parties have the

freedom to choose the means of dispute settlement: negotiation, media

tion, arbitration, or litigation. The Arbitration Law enacted in 1 994 specifies

that contracting parties have the freedom to choose Chinese or interna

tional arbitration, and the people's courts in China enforce both Chinese

and international arbitral awards (see also the Civil Procedure Law en

acted in 1 99 1 ) . China has signed treaties of bilateral protection of foreign

80


investments with more than seventy countries since 1 982. China is now a

member of the " International Convention of Investment Disputes between

Host Country and Foreign Private Investors . "

To curb corruption, China has enacted more than twenty laws and

regulations since 1 98 2 . The maj o r ones are articles 1 5 5 and 1 85 of the

Criminal Law (passed in 1 982) , and the supplementary regulations regard

ing the punishment of crimes of corruption and bribery (passed in 1 988)

are the major ones among more than twenty laws and regulations enacted

since 1 982 to curb corruption. Furthermore, China set up two major orga

nizations: the Ministry of Supervision in 1 987, and the Department of Anti

Embezzlement and Bribery (within the Ministry of Procurators) in 1 99 5 .

Given t h e fact that t h e judiciary system is n o t independent. it is n o t sur

prising that such anticorruption agencies are not independent either. 1 5 In

addition, the designed framework of legal procedures itself is vulnerable

to j udges' discretion. I t is not considered illegal for j udges to meet pri

vately with litigants or their agents. Some organizations, such as banks and

customs, are not allowed to release evidence to litigating parties or their

lawyers; thus judges must gather and can control such evidence.

Although such "formal rules" cannot impartially enforce agreements

and eliminate corruption, they do play two important roles. First , they,

along with other checking devices, set limits on corruption. The point is

that although government control and public ownership result in wide

spread corruption, the degree of corruption is largely implicit. Second, the

formal rules serve as coordination devices among transaction parties, and

as a benchmark for dispute settlement through negotiation, mediation,

and arbitration. In other words, the informal and semiformal settlement

of disputes are affected by the formal rules . I t is the j oint functioning of

both informal and formal enforcement mechanisms that reduces overall

uncertainties and costs of transactions and contributes to the large inflow

of FDI into China. However, as will be elaborated on later, at the outset

of reform. informal enforcement mechanisms perhaps played a more

important role . As reform proceeds. formal enforcement mechanisms have

become increasingly more binding and effective .

The Role of Local I nformation and Information Intermediaries in FDI

Wank ( 1 996) . in his field study of guanxi-Chinese for local relation

ships. or connections- and market expansion in Xiamen. Fuj ian province

in 1 9 88- 1 9 9 0 . examines how businessmen cultivate connect ions with

bureaucrats or " invest" in building the connections. and how such connec

tions help reduce uncertainties and facilitate cross- regional exchanges . In

8 1


particular, in exchange for bribes, bureaucrats can help businessmen to get

licenses, loans, materials , and projects, and protect businessmen from erup

tive policy shocks and discretio nary regulato ry abuses . The mechanism

works b e tween local o r foreign businessmen and Chinese bureaucrats .

Among foreign investors in China, overseas Chinese capitalists are the

most conspicuous.

The distribution of sources, as well as cross- regional destinations, of

F D I in China clearly support the hyp o thesis o n l ocal information and

info rmation intermediari e s . F D I in China is mainly from Hong Kong,

followed by investment from Taiwan, especially in the 1 980s. As shown in

table 4 , for accumulated FDI from 1 979 to 1 993 , about 68 percent came

from Hong Kong and 8 percent from Taiwan. Even in 1 994, about 60 percent

came from Hong Kong, and 1 0 percent from Taiwan. These figures hold

despite the fact that the figures for Hong Kong's investments in China are

exaggerated for two reasons. Part of Hong Kong's investments in China are

"round trip" investments by mainland investors seeking favorable treat

ment for foreign investments. Another is "stop trip" investments by Western

investors using Hong Kong as an information intermediary.

Table 4 Accumulated Amount of Investment from Major Countries 1 979- 1 993

Country (Region) Number of % of the Contractual % of the Per-project Projects Country's Investment Country's Investment Amount

Total ( in US$ bi l l ion) Total (in US$1 ,OOO)

Hong Kong & Macao 1 14 , 147 65.5 1 50.929 68.0 1 ,320 U S 1 2,011 6.9 14.426 6.5 1 ,200 Taiwan Provincial 20,982 1 2.0 18 .432 8.3 870 Japan 7, 1 80 4 . 1 8.895 4.0 1 ,230 Germany 569 0.3 1 .457 0.7 2,560 Singapore 3, 1 22 1 .7 4.843 2.2 1 ,550 Britain 616 0.4 3.025 1 .4 4,9 10 Thailand 1 ,399 0.8 2.095 0.9 1 ,490 Australia 1 ,309 0.8 1 .247 0.6 950 Canada 1 ,540 0.9 1 .81 0.8 1 , 1 70

SOURCE: Almanac o(China's Foreign Rela tions and Trade 1 994, 49.

Western investors (as well as big companies in Hong Kong) began

s ignificant direct inve s t m e n t s in China only aft e r 1 9 9 2 and many of

them invest in China through Hong Kong. I nvestors fro m Hong Kong

and Taiwan are m o s tly Chinese and most have relatives in China ( e s

pec ially in Guangdong and Fuj ianJ . and hence have l o c a l info rmatio n

82


in their hometowns. According to the Australian government 's East As ia Analytical Unit in Canberra, there are about fifty million ethnic Ch in ese residents in Southeast Asia, and a majo rity of those are descendants o f southern Chinese . I t is not surprising, therefore, that FDI in Guangdo ng alone accounts fo r 20 to 3 0 percent o f all FDI in China.

In his study of Hong Kong's production subcontracting activities in the Pearl River Delta of Guangdong from 1 986 to 1 989, Leung ( 1 993, 284) found

that among forty-seven surveyed agreements, thirteen were through kin

ship; sixteen were through other Hong Kong firms, who invested earlier in

the delta region and served as information intermediaries; and eight were

through other l arge Chinese SOEs, who served as intermediaries and to

whom the Chinese subcontractors were affiliated. Of the subcontractors

through kinship, the maj o rity were in the hometowns and the rest were

often in the contractors' immediate neighboring counties. In general, there

were not many serious disputes between the Hong Kong investors and the

Chinese subcontractors. O nly two Hong Kong firms expressed strong dis

satisfaction. Thus, such informal enforcement based on local information

and information intermediaries seems to be effective .

The geographic distribution of Hong Kong's investment in the delta

region was attributed, according to Leung ( 1 993) . mainly to the distribu

tion of guanxi, and to a lesser extent to the differences in location , labor

cost and quality, and land availability. In other words , factors related to

informatio n and enforcement are primary determinants of FDI destina

tions, while the conventional factors are secondary.

The investment of Hong Kong-listed China Strategic Holdings (CSH)

in China p rovides an illuminating case . By the mid - 1 990s CSH had be

come perhaps the second largest foreign investor in China , controll ing

more than eighty companies and owning stakes in well over 1 00 others

(Hsieh 1 996) . I ts chairman, Oei H o ng Leong, a son of the chairman of

Indonesia's Sinar Mas, is a master of l ocal information and information

intermediaries. In 1 992, he took over forty-one SOEs (including some beer

companies) in his hometown Quanzhou in Fuj ian province, and a large

tire SOE in Shanxi province where he stayed during the Cultural Revolu

tion. In both places, he has good local information. Part of his investments

were covered by loans from Western banks, and the loans were guaranteed

by his father's Sinar Mas. His father served as an information intermediary

between him and the Western banks. In 1 99 3 , Oei l isted the Sh anxi tire

company (reorganized with some other tire companies in China) in the

New York Stock Exchange and Goodyear acquired 24 percent of the shares.

In 1 995 , Oei sold 75 percent of the shares of some of his beer companies

83


to the second largest beer company in Japan. Note that Oei served as an

information intermediary between the Chinese companies and other for

eign companies. A similar case is that of Robert Kuok, a Chinese Malaysian

tycoon, selected as Coca-Cola's exclusive partner in China because of his

extensive network in Southeast Asia and China, as well as his extraordi

nary ability to use information intermediaries . 1 6

Cross- Regional Competition for FDI

The distribution of jurisdictional destinations of FOI across different

levels of government is consistent with our hyp othesis of cross- regional

competition fo r FOI , which has mainly gone to the j urisdictions of re

gional and local governments. Among 2998 firm -specific operations of

multinational corporations in China, from 1 979 to 1 993 ( Tse, Pan, and Au,

1 996, table 2) , about 30 percent of all operations worked with provincial

governments, about 50 percent with municipal / county governments, and

the remaining 20 percent with the central government. To get around gradu

ated control , a local government often divides a big proj ect into several

small proj ects for approval within its own sphere of authority.

To compete for FDI , governments at the provincial level and, more

important, at the municipality/ county level , designed institutions to re

duce uncertainties and costs of transactions. For instance, to compete with

neighboring counties, Nanhai, Shunde, and Zhongshan in the Pearl River

Delta of Guangdong, Dongguan county set up an "FOI Service Company"

in 1 984 to serve as a coordinated and organized FDI contract approver as

well as an enforcer. Befo re this company was set up, a foreign investor

needed to go to more than ten government agencies, such as the Bureau

of Administration for Industry and Commerce, the Commission of Foreign

Trade and Economic Cooperation, and the land bureau and environmental

agency, to have a proj ect approved. Now he only needs to go to the service

company to get all the approvals within a few hours. The service company

also serves as a mediator for contract disputes involving foreign interests.

Such regional development is a result of the restructured capacity and

incentives of local governments in the reform era, which has been part of

the market- preserving authoritarian regime in China since 1 978.

M arket - Preserving Authoritarianism

The inflow of FOI into China started in 1 9 79 and accelerated after

1 992, mirroring the changing political - economic institutions in China. l 7 In

this section, we apply the MPA framework p reviously developed to ana

lyze China's credible commitment to preserve the market for catching-up

84

•


under autho ritarianism during the 1 9 78- 1 998 period. Corresponding to M l , M2 , and M3 specified under a market-preserving authoritarianism, We

shall discuss incentive compatibility (competition) , autonomy (decentralization) , and control (coordination) , in turn.

Competitive pressures and experiences (Ml)

After initiating economic reform in 1 978, Deng Xiaoping and his col

leagues shaped the regime as market-preserving authoritarianism. They

imitated the market-preserving authoritarianism of other East Asian coun

tries such as Taiwan, Singapore, and South Korea from the early 1 960s to

the late 1 980s. Both competitive pressures and experiences led Deng and

other senior leaders to preserve the market in order to facilitate catching-up.

In the late 1 970s, China faced a strong military threat from the Soviet Union

as well as economic competition from Japan and the four little dragons.

Economic catching-up was thus vital to the nation and the regime. Inter

nally, the Deng faction had to compete with the Hua Guofeng faction, which

represented the legacy of Mao. To defeat the Hua clique, Deng had to come

up with more efficient policies to mobilize mass support.

At that t ime, the centralized economic planning system had been

practiced in China for three decades already and had led to disastrous

economic consequences . By this time, market mechanisms adopted in

neighboring economies , such as Japan and the four l itt le dragons , had

brought double-digit annual growth for decades. I S In particular, the sharp

contrast in performances between mainland China and Taiwan, between

North Ko rea and South Ko rea , and b e twe en East Germany and We st

Germany, confirmed the superiority o f the market mechanism over the

planning system.

Like in other East Asian countries , China's strong landlord class had

been wiped out after land reform in the late 1 940s and the early 1 950s .

Labor unions were restricted, and the military was controlled tightly by the

party and the senior leaders. As a result, at the outset of reform, senior

leaders did not foresee an imminent (internal) threat from a strong interest

group; and by designing proper control devices and adopting a shared

growth policy, they could avoid threats from an emerging strong interest

group in the process of development . In addition, senior leaders used

various tactics to balance different interests . For instance, Mao analyzed

the balancing of the so- called Ten Great Relationships, such as develop

ment between agriculture and industry and development between coastal

regions and inland regions . At the same time, development could help

upgrade military technology and better finance the armed forces , thus

8 5

rr I '

I Governance and Investment in China

minimizing external military threats , which were increasingly replaced by

international economic competition after the end of the Cold War. Mini

mized external military threats or increased international economic com

p etit iveness resulting from developmental pol ic ies , in turn, can further

strengthen the position of an authoritarian regime. 1 9 In short, for Deng and

other senior leaders in his faction, it seems that the perceived risk of regime

collapse resulting from market development and catching-up was suffi

ciently low. On the other hand, they expected the market-based catching

up to strengthen their positions.

Decentralization of authority and autonomy (M2)

Given that senior leaders are motivated to adopt market-based catch

ing-up policies, they need to make their policies credible in order to achieve

their goals. As discussed previously, for this purpose the senior leaders have

to restrain themselves with both international and domestic constraints. The

former include the signing of international treaties and the opening up of

markets. For the latter, senior leaders need to impose self- constraints by

allocating sufficient autonomy to a large set o f political and economic

decision makers in an institutionalized way, so that it is infeasible or too

costly to reverse . Since 1 978 Deng and his colleagues have gradually but

systematically opened China's door to the rest of the world, and they have

allocated and granted significant autonomy (including authority, informa

tion, and resources) to households, firms, local governments, and minis

terial bureaucrats , while reducing or restricting their own authority.

International constraints. I n 1 978 Deng and his colleagues adopted

an open-door policy. Thereafter China signed dozens of multilateral inter

national treaties and many bilateral agreements. In particular, as indicated,

by the end of 1 994 China had signed treaties o n (mutual) protection of

foreign investment with s ixty-seven countries. At the same time, China has

opened up markets in an increasing number of regions and industries .

Since 1 993 China has ranked second only to the US in attracting foreign

direct investment. More recently, in o rder to meet the requirements of

j o ining the World Trade Organization, wider opening-up is under way.

Increasing economic freedom of households and individuals. First .

the h o u s e h o l d responsib i l i ty system w a s widely a d o p t e d in t h e e arly

1 980s . Although land continues to be collectively owned (usually at the

village level ) , rural households have gai ned almost c o mplete land - u s e

rights by leasing contracts . Land leases have been extended from short

term (e .g . , three to five years) to long term ( e . g . , ten to thirty years) by

national regulations. Second, after the early 1 980s local residents began

86


to directly elect del egates to th e p e o p l e's c o n gresses at both the town ship and c o u n ty levels . People 's c o ngresses h ave b e c o m e i n creasi n gl y influential . Beginning in 1 987- 1 988 , the heads of vil lage com mittees were directly elected. The direct election o f township heads was p l a n n e d i n

the F ifteenth Party Co ngre ss held in 1 9 9 7 . Third, a n d m o re g e n e ral ly,

individual e c o n o m i c and civil fre e d o m s h ave b e e n s i g n i fi c a n t l y e x

pan d e d . I n d ividuals i n b o th r u ral and u r b a n a r e a s are i n c r e a s i n g l y

allowed to trade, invest , and migrate freely, and more importan t , to set

up private enterprises . Private business enterprises have spread rapidly

fro m craft s , fo o d processing, and retail ing to textile s , e lectro nics , and

raw material s , especially after the e arly 1 9 90s .

I n 1 99 3 , the State Administration of Industry and Commerce issued

" Some Points o n Enhancing the Development of I ndividual and Private

Business ." It specifies the following measures to stimulate private business :

l . Resigned and retired p arty and government officials can conduct

p rivate business ;

2 . Unless specified otherwise in state laws and regulations , privat e

b u s i n e s s e s can op erate in a n y s e c t o r a n d in a n y form;

3 . Private enterpr ises can t a k e o v e r s t a t e - owned a n d c o l l e c t i ve

enterprises .

Th e s e m e as u r e s h ave great ly e n l arged the autonomy o f pr ivate

enterpris e s and have sped up the development of p rivate b u s i n e s s e s .

Increasing autonomy of state-owned enterprises. T h e autonomy of

(urban) SOEs was exp anded in three steps . F irs t , in the late 1 9 70s a n d

the early 1 980s , SOEs began t o have some limited operational auto nomy

and to have the right to retain some of the profits . Second, fro m the mid-

1 9 80s to the early 1 9 90s , more auto n o my was institutional ized in t h e

management co ntract respo nsibi l i ty system ( M CRS) . Under t h e M C R S ,

industrial bureaucrats and m a n agers sign c o n tracts specifyi n g p e rfo r

m ance targets , control rights , and c o m pensat ion sch e m e s . The M C R S

became widespread after 1 987 , a n d b y 1 989 most SOEs had adopted the

MCRS. Third , since the early 1 990s an increasing number of SOEs as wel l

a s TVE s h ave b e c o m e s h a re - h o l d i n g c o m p a n i e s o r h ave b e e n fu l l y

privatized . I n 1 9 7 8 , a l m o s t 8 0 p e rcent o f the tota l n a t i o n a l i n d u str ia l

outpu t was der ived fro m S O E s . By 1 9 9 5 , the SOEs ' s h a re o f t h e tota l

industrial o u t p u t had shrunk to on ly o n e - th ird ( Ch illa Sla tistica 1 Yen r

book 1 996, 403 ) . A recent survey est imates that m ore than 70 percent of

the small SOEs in Shandong and several other p rovinces have been fu lly

or p artially p rivatized ( China Refo r m F o undat ion 1 9 9 7 ) .

87


The mirror image of the expanding auto n o my of S O E s and other

enterprises and privatization has been the shrinking authority of economic

and industrial bureaus. According to a survey conducted in 1 99 5 , about

5 0-60 percent of the surveyed bureaus reported that their authority had

decreased over the previous year, and 30-40 percent reported that their

authority remained unchanged. 20 I n 1 998 the First Session of the Ninth

National People's Congress adopted a blueprint to restructure the State

Council drastically within three years : some forty ministries and commis

sions have been reduced to twenty-nine; most industry- specific ministries

have been abolished; the number of staff members has been cut by about

half. Local governments will be similarly streamlined , resulting in the

significant reductio n in the government's economic authority.

Autonomy of intermediary business organizations. The autonomy of

enterprises has been strengthened by the forming of various intermediary

business organizations. Enterprises are allowed or encouraged to organize

various enterprise groups and business associations . Enterprise groups

first began to emerge when the then-State Planning Commission and the

State Economic Commission issued "Several Points on Establishing and

Developing Enterprise Groups" in 1 987 . 2 1 In 1 995 the government issued

" Provisional Regulations on the Establishment and M anagement of Enter

prise Group s" that set forth the principle o f voluntary p articipation of

individual enterprises in enterprise groups. The resultant Chinese enter

prise groups are likely to resemble the Japanese keiretsu o r the Korean

chaebol (conglomerates) in the coming decades.

Increasing autonomy of local governments. The autonomy o f local

governments has increased through the fiscal revenue- sharing system ,

the 1 982 Constitutio n , and various other decentralization policies . The

fiscal revenue- sharing system was first intro duced in 1 98 0 , renewed in

1 9 84 and 1 9 88 with some modifications , and continued through 1 993 .

Under this system, l ower- level governments had an obligation to sub

mit a fixed amount or a fixed proportion of their fiscal revenues to the

government level just ab ove them and they were allowed to retain the

remainder fo r themselve s . Thus , local govern m e n t s had the right o f

residual claims. The 1 98 2 Co nstitution granted p rovincial - level gove rn

ments the authority to make broad regional economic regulations . The

central government has also granted control rights over a great number

o f state- owned enterprises to local governments . By the end o f 1 9 83 ,

control rights over the maj ority of state- owned enterprises were trans

ferred to local governments . By 1 98 5 , state- owned industrial enterprises

controlled by the central government accounted for only 2 0 percent of

88

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total industrial output of all enterprises at or above the townshi p l e ve l (Qian and Weingast 1 995) . By 1 99 4 , it was estimated that local gove r n ments at various levels controlled about 65 percent of the assets of a l l state - owned enterprises (China Reform F o u ndation 1 9 9 7 ) .

The decentralization policy has granted local governments great a u

tonomy to control their economies , including autonomy to establish new

firms, to make investment with "self- raised funds , " and to manage and

restructure their firms. Consequently, decentralization forced local govern

ments to compete \Nith one another and helped to marketize the national

economy. Although local governments may still use some planning mecha

nisms to control their enterprises, they can do business with other regions

only through bargaining, since no one region has authority over the oth

ers. The relationship between provinces , cities, counties, townships , and

villages is more or less market-oriented ( for more details on this aspect

of decentralization , see Li , Li , and Zhang 1 998) .

At the e arly stage of decentralizatio n , many local governments attempted to protect their enterprises from competition from other regions by erecting trade b arriers . However, as the size of each local econo my becomes smaller and the number of local economies increases at lower government levels , the erection of trade b arriers by a local government becomes m o re cost ly, and hence c o m p e ti t ion becomes m o re intense . Protectionism often failed because efficiency gains from exchange s ignifi cantly exceeded the net benefits of erecting trade barriers, as both informal and formal arrangements emerged to capture the gains. In the late 1 980s, local governments b egan to formulate treaties pledging to protect each

other's enterprises as their own. For instance, it i s reported that Shanghai signed agreements for "the protection of the legitimate rights and interests of enterprises" with nine provinces.22 In 1 99 1 , sixty- four courts from eight prefectures and municipalities along the Yangtze River in Hunan and Hubei provinces s i gned agreements for the judiciary cooperation of the sett lement of cross- regional economic disputes . The two highest courts of the provinces initiated these agreements to m itigate local protecti on ism i n lower-level courtS . Ll In 1 993 , t h e central government enacted the " Law o f Anti- i mproper Competition," i n which article 7 prohibits local governments from using administrative means to erect trade barriers.

Increasing autonomy of technocrats. The auto nomy o f technocrats

has also expanded significantly. Bureaucratic elite transformation , aimed

at replacing the old and less educated with young professio nals , hegan

in the early 1 980s , and was l argely completed in the early 1 990s by vari ous forms of mandatory retirement programs ." " After 1 984 , personnel co ntrol

89


was decentralized as the "two - level down management" was replaced by

the " o n e - l evel down manage m e n t " at each l evel of government . F o r

instance. the Ce ntral Party Personnel Agency. formerly t h e Central O r

ganization Department. n o w directly controls only t h e ministers a n d vice

ministers of the central government and governors and vi ce governors

of the provincial governments . I n 1 98 7 . the Thirteenth Congress of the

Chinese C o mmunist Party decided to set up a civil service system. In

1 99 3 . after experiments in six bureaus of the State Council. in H arbin and

in Shenzhen (Deng 1 9 9 4 . 3 ) . a formal civil service system emphasizing

a merit- based selection (such as entrance exams) and promotion system

was implemented . Thus. in the reform era the bureaucracy has become

increasingly stable and independent (as discussed b elow) .

Such widely diffused autonomy makes it very costly or infeasible for

senior leaders to retrieve the decentralized authority fro m the hands of

such a vast number of households . firms. local governments. and bureau

crats. The public can use the information and resources available to it to

defend and to conceal its vested authority and interests in case of a policy

reversal . The decentralization of authority has been further strengthened

by self- imposed constraints o n the senior leaders themselves. To make

their market-based developmental policies more credible. Deng and his col

leagues designed the Central Advisory Commission in 1 982 to restrict the

authority of the powerful first -generation senior leaders. including them

selves . Influential party and military veterans were called to resign from

their active posts to become members of the advisory commission. which

had only symbolic authority. The commission was abolished in 1 99 2 .

Control devices (M3)

Authority decentralization and autonomy are necessary but not suffi

c ient for market-based catching- up under authoritarianism. As indicated

in M3. autonomy needs to be balanced by con trof.2" The key mechanisms

of control include incentive schemes. checking. coordination and enforce

ment devices in governmental agencies. intermediary agencies. and private

agencies . Institutional devices. such as checking and coordination devices.

can be designed along vertical . horizontal. or intertemporal dimens ions .

Incentive schemes. Performance-based incentive schemes have gradu

ally developed within both the party and the bureaucracy since 1 978. They

were partially institutionalized in the "cadre co ntract resp onsibi l ity sys

tem" introduced in t h e mi d - 1 9 8 0 s . Under this syste m . a higher- l evel

government designs and supervises perfo rmance-based contracts with its

immediate subordinate governments . Typical ly. such economic p erfo r-

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mance goals as output and p ro fits are among the key determi n an ts o f payments and promotion. Performance-based incentive schemes Wi th i n the bureaucracy became m ore inst itutio nalized after 1 98 7 when a c iv i l service system was advocated. and especially after 1 993 when a civi l sys tem was fo rmally introdu c e d . In the civil service system are guid i n g

principles o n rewards and punishment. and o n the distribution o f rewards

along vertical (hierarchy) . horizontal (cross -function) . and intertemporal

(cross- time) dimensions based primarily on (fifteen) ranks. The distribu

tion of reward s based on rank i n the civil service system i s taken a s a

reference for party and military officials as well as other staff members in

public agencies .

Specifically. the incentives fo r party and government officials have

been structured along the following l ines . F irst . overall compensation

for officials includes both pecuniary and nonpecuniary rewards obtained

during and after office hours. The rewards include personal income. on

the -job consumption. benefits from social status and from power (con

trol rights) . benefits for their family members. relatives . and friends. and

future benefits for the officials themselves. When an official leaves office.

he may b e promoted to an upper- level government position. o r he may

become a manager in an enterprise that was previously under his con

trol . E i ther way. returns after leaving office may depend on one 's pr ior

perfo rmance in office . Second. the fiscal revenue- sharing system pro

vided incentives for an upper- level of government to adopt p erformance

based compensat ion schemes fo r o fficials of lowe r - l evel governments

under its jur isdict ion . Under the fiscal revenue- sharing syste m . a local

government takes the "residual " after subm itting the specified tax rev

enues to the upper- level government . Given that tax reve n u e is p o s i

tively c o rrelated t o total o u t p u t . a local governm e n t i s provid ed wi t h

incentives to l ink the promotion o f lower- l evel governm ent o ffi c i als t o

their economic p e rformance .

Checking devices. Both the cadre con tract responsibil ity system and

the civil service system have built- in ex ante and interim checki ng devices.

Ex ante checking devices refer to predesigned measures to reduce or e l i m i

nate opportunities for corruption and misconduct. Interim checking devices

refer to monitoring measures in the process. Ex ante and interim checking

devices include ( 1 ) vertical checking devices. such as hierarchical review,

monitoring. graduated control. and regular reporting to higher authorities;

(2) intertemporal checking devices. such as term l im itations. rotat ions , and

the exchanging of positions amongst pol iticians and bureaucrats ; (3) hori

zontal checking devices . such a s col lect ive decis i o n - m akin g mechanisms

9 1


and deliberation councils (to be discussed in further detail below) ; and (4)

other c hecking devices . such as the "challenge system" (huibi zh idll) .

Ex post checking devices are also designed to check corruption and

misconduct after they occur. Such devices include the Central Party Dis

cipl ine Commission for the party. and the Mi nistry of Supervision (estab

l i shed i n 1 949 , abolished i n 1 959 , and restored in 1 987) , and the Depart

m e n t of Anti - Embezzlement and Bribery ( se t up under the Ministry of

Procurators in 1 995) for the bureaucracy.' " Moreover, there are bureaus

corresponding to these organizat ions at various local government levels .

Such devices at the subnational levels become more effective as cross

regional competition intensifies. Facing economic competition from neigh

boring regions , each local government is "forced" to improve its institu

tional arrangements . including checking devices , to attract investment.

Coordination devices. We now examine the coordination devices within

the party and the bureaucracy. Politicians in China are organized under

the Chinese Communist Party committees at various leve ls . The p arty

committee at each level directly controls the top p ersonnel of the party

committees immediately below it . At the national level, the representative

p arty organization is the Central Committee, and the main working orga

nization is the Political Bureau. The core organization nested in the Political

B ureau is the Political B ureau Standing Committee (PBSC) , which coordi

nates the senior leaders. The PBSC serves as a "board of directors" of the

Chinese Communist Party-a "nesting structure" that functions as a verti

cal coordination devi c e .

Starting in the Deng era. the seven members of the PBSC are supposed

to represent d i fferen t maj o r interest groups or organizations , thus func

t ioning as a horizontal coordinat ion device. The PBSC typically consists of

the paramount leader, and two old. two medium- aged , and two relatively

young senio r leaders . Each term of the PBSC is five years and, i n each

s u c c e s s ive term . the two o l dest m e mbers general ly will res ign and be

r e p l ac e d b y t h e younger o n e s . T h i s arrange m e n t fu n c t i o n s as an

intertemporal coordination device to facilitate smooth transition. A similar

"graduated-age- structure" i s also built into the civil service system to fa

c i l itate smooth personnel transit ions i n the bureaucracy (Deng 1 994 , 5 ) .

B ureaucratic agencies are generally organized around a pilot agency.

T h i s arrange m e n t fu n c t i o n s as a vert ical c o o r d i n a t i o n device i n the

bureaucracy. At the nat io nal level . l ike i t s c o u n t e rparts i n Japan ( the

M i n is t ry o f I n ternat i o n al Tra d e and I nd u s try ( M I T! ) ) and Ko rea ( t h e

E c o n o m i c Planning Board ) . t h e State Planning Commission (SPC) func

t ioned as a pilot agency befo re 1 99 3 . a n d t h e State Economic a n d Trade

92

+


Commiss ion ( S ETC) became a p i l o t agency after i t s es tabl i shment in

1 9 9 3 , and e s p e c i al ly after i t s c o n s o l i d a t i o n in 1 9 9 8 u n d e r t h e maj o r

restructuring of the State Counci l . As most industry- specific m i n istries

wil l cease to exis t , their regulatory funct ions will be transferred to the

newly establ i shed industrial bureaus within the SETC.

Within the SPC, the SETe, and other agencies, important decisions are

generally d e c i d e d col lectively and implemented by individualsY T h i s

mechanism is known a s "collective leadership and individual responsibility"

or "democratic centralism." Cross-ministerial joint decisions are generally made

in some form of deliberation councils . Like the deliberation councils ini

tiated by MITI in Japan and the export-promotion meetings in Korea, there

are "joint meetings" ( lianxi huiyi) , "joint approval meetings" (huiqian h ll iyi) ,

and " State Council official meetings" (gllowuyuan bangollg h u iyi) at the

national level, and "on-site official meetings" (xianchang bangong hlliyi) at

various local levels in China. One type of j oint meeting is the "state- owned

enterprise reform j o int meeting." On the average, once per quarter, the

SETC, the SPC, and other agencies, such as the State Commission for Re

structuring Economic System (also to be restructured) , the Ministry of F i

nance, and the People's Bank of China , j ointly discuss matters regarding

SOE reform. These are examples of horizontal coordination devices .

The intertemporal coordination devices include the smooth and par

tial replacement of bureaucrats, and the long- term merit - a n d - seniority

based promotion schemes in the civil service system. The bureaucracy in

China is remarkably stable . As shown in table 5 and 6, the average tenure

of premiers has been more than ten years. Tables 7 and 8 show that when

Li Peng succeeded Zhao Ziyang as premier in 1 988, only about half of the

ministers were replaced, and the vice ministers and bureau heads remained

largely unchanged.

Table 5 The Tenure of Premiers in the State Council of China

Premier

Zhou Enlai Hua Guofeng (Acting Premier) Hua Guofeng Zhao Ziyang Li Peng (Acting Premier) Li Peng Zhu Rongji

Tenure

Oct 1 949 - Jan 1 976 Jan 1 976 - Apr 1 976 Apr 1 976 - Sep 1 980 Sep 1 980 - Nov 1 987 Nov 1 987 - Apr 1 988 Apr 1 988 - Mar 1 998

Mar 1 998 -

SOURCE: M a l c o l m Lamb. Direcrory o/Officia/s (Il 1d Org({l l i::ariolls ill Chilla (New Yo rk: M . F . Sharpe. 1 994) . 1 67 .

93

r

Table 6 Average Time in Office

Period Duration

Premier 1 949-1 995 46 Secretary Generala 1 949-75, 79-95 42

Foreign Affa i rs 1 949-1 995 46 State Plann ing Commission 1 952-95 43 State Economic & Trade Commission 1 993-95 2

State Commission for Restructur ing Economy 1 982-95 13

State Education Commissionb 1 949-70, 75-95 41

State Science & Technology Commissionc 1 958-67, 77-95 27

National Defensed 1 954-71 , 75-95 37

National Defense Science , Technology & I ndustry Commission 1 982-95 1 3

State National ities Affa i rs Commissione 1 949-70 , 78-95 38 Pub l ic Securityf 1 949-73, 75-95 44 State Secu rity 1 983-95 12

Supervis ion9 1 949-59, 87-95 18

C iv i l Affa i rs 1 978-95 17

Justiceh 1 949-59, 79-93 24

Finance' 1 949-54 , 70-95 30 I nternal T rade 1 993-95 2

Fore ign Trade & Economic Cooperation 1 982-95 13

Personnel' 1 950-54 , 88-95 11

Labor* 1 949-54 , 88-95 12

Geology & Mineral Resou rces 1982-95 13

Construction 1 988-95 7

Power I ndustryl 1 979-82, 93-95 5

Coal l ndustryk 1 955-70, 75-88 , 93-95 30 Rai lwaysl 1 949-70 , 75-95 41

Communicatlonsm 1 949-65 , 70-95 41

Mach i ne-Bu i ld ing I ndustry Commissiont 1 982-88 , 93-95 8

Electron ics I ndustryt 1 982-88 , 93-95 8

Meta l lurg ical l ndustryn 1 956-66, 70-95 35 Chemical l ndustryO 1 956-62, 67-69 , 78-95 25

Posts & Commun icalionsP 1 949-70 , 73-95 43 Water Resourcesq 1 949-58, 79-82 , 88-95 19

Agriculturer 1 949-56 , 79-82 , 88-95 17

ForestryS 1 949-59, 1 967-70 , 79-95 29 Culture! 1 949-70 , 75-95 41

Rad io , C inema & Televis ion 1 982-95 13

Pub l i c HealthU 1 949-67 , 73-85 30 State Fami ly P lann ing CommisSion 1 981 -95 14

State Physical Culture & Sports Commiss ionv 1 952, 7 1 -95 25

94

No. of officials

4

9

7

7

4

12

3

8

2

4

9

2

4

3

6

9

2

4

3

4

3

2

3

8

10

10

3

4

7

7

6

4

7

8

8

3 7

4

6

Average time in office

1 1 .5

4.67

6 .57

6 . 14

2

3.25

3.42

9

4.63

6 .5

9 .5

4.89

6

4.5

5.67

4

3.33

1

3 .25

3.67

3

4.33

3.5

1 .67

3.75

4 . 1

4 . 1

2.67

2

5

3 .57

7 . 1 7

4.75

2.83

3.63

5 . 1 3

4 .33

4.29

3.5 4 . 1 7

Con tin ued

Table 1 continued People's Bank of Chinaw Auditor-General 's Department

1 949-64 , 73-95

1 983-95 37

12 10

3 3 .7

4

SOURCES OF RAW [HLI: Director), of Officials alld Orgall izations in Ch ina, 1 994, An Last (;(1 /(' Book. The GOllemment Lt!aders ofPR. Ch ina, 1 995, Ca n ada Mirror Books.

Nrm,s:

, Abolished in 1 954; amalgamated with the newly established Ministry of Labor and Personnel

in May 1 982 to Apr. 1 988 and restored in Apr. 1 988.

t Amalgamated with the newly established M inistry of Mach i n e Building and Electronics

Industry during Apr. 1 988 to Mar. 1 993 and restored in Mar. 1 993 .

a. Abolished in 1 975 and restored in 1 978.

b . Abolished in June 1 970 and restored i n Jan. 1 975 . c . Established in 1 958 and suspended during the Cultural Revolution; resumed operations in

Sept. 1 977.

d . No officials were identified during Sept. 1 9 7 1 to Jan. 1 975 .

e . Abolished in June 1 970 and restored i n M ar. 1 9 78.

f . No officials were identified during Aug. 1 973 to Jan. 1 975 .

g . Abolished in 1 959 and restored in Dec . 1 986.

h . Abolished in 1 959 and restored in 1 979.

i . No officials identified during June 1 954 to June 1 970.

j . Amalgamated with the Ministry of Water Conservancy in Mar. 1 982-Mar. 1 993 and then

restored.

k. Amalgamated with the Ministry of Fuel and Chemicals Industries during Nov. 1 970 to Jan.

1 975 and then restored; became part of the newly established Ministry of Energy Resources from Apr.

1 988 to Mar. 1 993 and then restored.

I. Absorbed by the newly establ ished Ministry of Communications in Nov. 1 970. Restored in

Jan. 1 975 .

m. No officials were identified during 1 966 to 1 969. The ministry absorbed the Ministry of

Rai lways i n Nov. 1 970. n . No officials were identified during 1 967 to 1 969.

o . No officials were identified in 1 963-1 966. Amalgamated with the Ministry of Fuel and

Chemicals Industries in Nov. 1 970. Restored in Mar. 1 978 as a result of the d ivision of the Ministry of

Petroleum and Chemicals Industry.

p. Amalgamated with the Ministry of Rai lways and Ministry of Communications in 1 970 . Restored in May 1 973 after the abolition of the directorates of Posts and Telecommunications.

q . Amalgamated with the Ministry of Power and formed the Ministry ofWater Conservancy and Power during Feb. 1 958 to 1 979 and Mar. 1 982 to Apr. 1 988; restored in Apr. 1 988 since the abolition of the Ministry of Water Conservancy and Power.

r. No officials were identified in 1 957- 1 978 under the name of the M inistry of Agri culture. Absorbed by the Ministry of Agriculture and Forestry in Nov. 1 970. Restored i n Feb. 1 979 with the division of the Ministry of Agriculture and Forestry, renamed and given expanded roles in May 1 982. Between then and Apr. 1 988, the organization was styled Ministr1' of Agriculture, Animal Husbandry and Fisheries .

s . No officials were identified in 1 960-- 1 966 under the name of the :vlinistrv ofForestrv; absorbed by Ministry of Agriculture and Forestry in Nov. 1 970 and restored in Feb. 1 9 79 .

.

t . Abolished in 1 970 and restored in Jan. 1 975 after the abolition of the Culture Group under the State Council .

u . No officials were identified in 1 967- 1 971. v . No officials were identified in 1 953- 1 970 . Recommenced operations fol lowing the Cultural

Revolution in June 1 970. w. No officials were identified in 1 965-Ma1' 1 973.

9 5

Table 7 Change of Vice Premiers, State Councilors, and Ministers in 1 988

Under Premier Zhao ( 1 987)

Under Premier Li ( 1 988)

No. of previous officials i n 1 988 as % of the total no .

o f officials in 1 987

Total no. of officials Total no. of officials No. of previous officials

Vice Premiers 5 3 2 40

State Counci lors 11 9 2 18 . 18

M in isters 46 42 24 52. 1 7

Total 62 54 28 45. 1 6

SOURCE O F RAW DATA: People�1 Republic of Ch ina Year/wok 1 987. 1 .988 (Hongkong: Evergreen

Publishing) .

Table 8 Change of Vice Ministers and Heads of Bureaus in 1 988

Min istry/ Commission No. of Vice m in isters No. of heads of bureaus

Under Under No. of Under Under No. of Premier Premier previous Premier Premier previous

Zhoo Li officials Zhoo Li officials (Nov 87) (Dec 88) in 1 988 (Nov '87) (Dec 88) in 1 988

as % of as % of Tda Tda No. of the total no. Tda Tda No. of the total no. nO. of no. of previous officials no. of no. of previous officials

officials officials officials in 1 987 officials officials officials in 1 987

State Planning Commission* 23 10 10 43.5 52 49 22 42.3

Min istry of Finance 5 5 3 00 16 18 16 100

People's Bank of China 4 5 4 100 34 36 33 97. 1

Ministry of Foreign Trade

& Economic Cooperation 8 11 6 75 17 19 15 88.2

Min istry of Commerce 5 5 3 00 13 14 13 100

State Reconstructon of the

Economy Commission 3 2 0 0 13 22 13 100

Ministry of Justice 3 2 2 66.7 7 7 7 100

Central Bureau of

Industry & Commerce 5 5 5 100 4 6 4 100

SO l i KeE Ol RAI\' D.IT.\: M alcolm L a m b . Directory ot()fticia/s a lid Or{!,(lII i�ario l lS il l Ch illa U";e,,·

Yo rk: M . E . Sharpe. 1 994 ) . ' I n April 1 988 the State Economic Commission was abol ished and much of i ts work was taken

over by the State Planning Commission and p rovincial authorit ies . To make a consistent comparison ,

figures i n N o v e m b e r 1 987 inc lude o ffic ia ls o f the S t a t e Economic Commiss ion.

96

Governance and I nvestment in China

N o te that b e s i d e s serving as h o rizontal coord inat ion d e v i c e s , t h e

col lective decis io n - making mechanisms a n d del iberati on c o u ll c i l s a lso

function as horizontal checking d evices. Whe n decis ions are co l l ect ive ly

made , the dec i s ion makers can check o n each other, and i t beco m e s

harder to col lude i n corruptio n when there are more participants . C o l

lective decis ion making h a s been adopted to curb corruption a t various

levels of the party and the bureaucracy in China. For instance, in order

to curb c o rrup tion in making appointments , the Central Organizat i o n

Department i n 1 9 8 6 specified a quorum rule that requires two - thirds of

the members of the ministerial party group to be present when screen

ing a n o m i n e e for a bureau- level p o s i t i o n .

The Asian Financial Crisis and I t s Implications for China

Although FDI inflow into China has been among the highest in the

world in the last few years , the stock of FDl in China is still small relative

to its economic size. As privatization speeds up, more markets become

open , and the legal system improve s , there wil l be more o p p o rtunities

and a better e nvironment for foreign firms to invest in China. Thus, a

significant inflow of FDI into China may continue in the coming decade .

I n fact , as the regulatory and legal system improved , FDI agreements in

China have b e e n evolvin g fro m s h o r t term to l o n g t e r m , fro m s m all

scale to large sca le , fro m standard to s p ecifi c , fro m j o int ventures to

wholly foreign owned, and from coastal to inland regions in the last two

decades . Yet in China at present , given the widespread corruption and

i n e ffec tive l e gal p r o t e c t i o n o f p r o p e rty r igh t s , e s p e c ial ly i n t e l l e c t u a l

property r igh t s , foreign investors are s o m ewhat reluctant to invest i n

contract- and technology- intensive sectors . T h e ongoing privatizati o n of

SOEs a n d TVEs , a long with t h e i m p roving legal sys t e m , wi l l r e d u c e

corruption significantly. I t is important to build an effective legal system

to facilitate contract enforcement in dynamic sectors, such as high - tech

industry, in the long run . A necessary condit ion for estab l i shing an e f

fect ive l e gal sys t e m i s to minim ize corru p t i o n . I n a corru p t c o u n t ry,

political opening-up to opposition parties and economic opening-up to

the world market are eventually necessary to minimize corruption i n the

long run .

More generally, a s noted i n L i ( 1 999 ) . eco nomic deve lopm ent i s fun

dame ntal ly a process of establ i s h i n g i n fo rmal governance m e c h a n i s m s

a n d t h e n making t h e trans i t ion t o fo rmal governance structures . T h i s i s

consistent with historical facts , which had long been neglected by econo

m i s t s u n t i l very recently. B e fore fo r m a l gove r n a n c e was e s t ab l i sh e d ,

97


European business p e o p l e during the premodern per iod made agree

ments, to a large degree, outside the legal system (Greif 1 994) . Transition

away from personal reputation in the United States occurred o nly b e

twe e n 1 8 4 0 and 1 9 2 0 ( Z u c k e r 1 9 8 6 ) . D u r i n g t h i s t r a n s i t i o n p e r i o d ,

relational banking played a n important role in monitoring firms (Cantillo

Simon 1 998) . I t was the Glass - Steagall Act, the Securities Act, and other

regulations after the Great D epress ion that essent ial ly ended relatio n

ship - based finance in t h e U S ( Jacobs 1 99 1 , 1 43-45 ) . 2B

Unfortunately, as argued in Li ( 1 999) , transit ion fro m informal gov

e r n a n c e to fo rmal g o v e r n a n c e is u s u al ly a d i s c o n t i n u o u s p ro c e s s .

D e c e n t ral izat i o n o f i n fo rmal governance o r c h a n g e o f management

teams can disrupt governance at least in the short run because relations

( local person-specific information) among old p layers can be weakened,

whi le relat ions with / among new players o r formal rules are yet to be

established. In particular, when new management teams replace old ones,

and new players enter the market ( e . g . , due to financial l iberalization) ,

existing relations become useless or weakened , and relations with and

b etwe e n new players are yet t o be establ ished b y repeated plays and

tests . That i s , e ither exist ing relation - s p ecific information becomes in

val id o r bi lateral m o n o poly o f p rivate information breaks down.

The arrival of newcomers makes it harder for an incumbent to com

mit to exist ing relations . As a by-product , decentralization of informal

governance can result in "corruption with independent monopoly. " Before

decentralizati on ( e . g . , p olitical l iberalization) , different b ranches of the

government may j o i ntly maximize the value or the to tal br ibe across

c o m p l e m e ntary publ ic g o o d s . I n the process o f d e c e ntralizat ion , the

relation s between different branches of the government may be cut off.

S u b s e q u e ntly, d i ffe r e n t b ra n c h e s b e c o m e i n d e p e n d e n t m o n o p o l i s t s

p roviding public goods . This may result in severe inefficiencies if these

publ ic goods are complementary, as indicated e arlie r.

T h u s , b e fo re fo rmal govern a n c e i s e s t a b l i s h e d , t h e r e may b e a

vacuum in the governance structure after market d evelopment and lib

eralization have made informal governance dysfunctional . On the other

hand , there i s no guarantee that a formal governance system can be

established after l iberalization, and when it can be established it usually

involve s a long complex p r o c e s s . Transit ion fro m authoritarianism to

democracy is hardly smooth, and sufficient noise can trigger a war in the

p r o c e s s . Some product ive resources need to b e d iverted to cover the

fixe d cost o f set t ing up effect ive fo rmal governance . There are "fi s c al

externalit ies" in financing the setup; for each tax dol lar p aid by an in -

98


dividual , t h e s ocia l b e n e fit i s s ignificantly higher than his i n d i v i d u al

benefi t . To col lect taxes and to implement other rules effect ive ly, i t i s

necessary tu develop informational infrastructure, which itself i s a l o n g ,

evolutionary process .

The disrupt ion of governance after l iberalization can poss ibly l e ad

to a significant reduction in trade and investment in the short run . Aft e r

drastic trade l iberalization in 1 987 , the M exican footwear industry went

through a crisi s . One of the main reasons b ehind the crisis appeared t o

be the deterioration of the footwear association's function as an enforce

ment mechanism i n the o p e n e c o n o my. Similarly, the drast ic c ap i t a l

account opening-up in Indonesia a n d Thailand, a n d t h e sweeping p o

l itical opening-up in Korea in t h e 1 990s , might have aggravated, if n o t

triggered, t h e current financial crises in these economies . T h e p revious

control devices ( in p articular coordination devices) under a closed capi

tal market o r authoritarianism no longer function effectively while new

control devices under an open capital market o r democracy are yet to

b e establ ished. I n p articular, control devices built in governmental and

semigovernmental agencies become weakened or nonfunctioning as the

c a p i t a l m ar k e t b e c o m e s o p e n o r d e m o c racy p h a s e s in t o r e p l a c e

authori tarianism . M a rket a n d p rivate o rganizat io n s will i n c r e a s i n gly

replace governmental and semigovernmental c o o rdinat ion devi c e s in

financial and other industries but the process is likely to be bumpy and

lengthy.

So far, China has been able to avoid a financial crisis following the

Asian crisis . The major reasons are p erhaps that China has not yet imple

mented capital account opening-up or p o l it ical op en ing-up , and that

China has attracted mainly F D I , while the economies involved in crisis

accumulat e d large s h o r t - t e r m fo re ign d e b t s . Eve n t u al ly, :n o r d e r to

minimize corruption and to establish the rule of law to support techno

logical progre s s , both the capital market and the pol itical market must

open up in China, but when and how to open have profound impl ica

t ions for economic growth in general and for F D I inflow in particular.

To minimize the disruption of governance in transition, the Chinese gov

ernment should consisten tly but gradually reduce state control and open

up markets , and decen tralizing must b e accompanied by coordina ting,

i . e . , maintaining necessary existing relations and imp roving the regula

tory and legal framework.

As in its East Asian predecessors , China will experience d isrupt ion

of its governance structure in the process of decentralizat i o n . After the

mid- 1 990s , governmental withdrawal of its control rights from both SOEs

9 9


and TVEs started to accelerate . There have already been disruptions of corporate governance in many privatized firms where insiders or larger shareholders abuse their c o n trol rights to loot m i n o rity shareholders . However, China has two advan tages. F i rs t . as a la te follower, China has the advantage of learning from both the East Asian miracle and the East Asian cris is to minimize the economic costs of financial l iberalizat ion and pol i t ical transit ion. Second, China can resort to cross- regional (domestic) competition to speed up the transition from informal governance to fo rmal governance . As d iscussed earli e r, a l though pol i t ically China remains very centralize d , economically it is already much more

· decen

tral ized than many outs ide observers have perce ive d . There are about thirty provincial - level jur isdictions (most of which are as l arge as middles i z e d c o u n t r i e s ) , s o m e two t h o u s a n d c o u n t i e s and fifty t h o u s a n d townships . Local governm ents have significant incentives and autonomy to develop their e c o n o m i e s .

As indicated , cro s s - regional competit ion c a n discipl ine e a c h region to improve its governan ce structure to attract investment and limit corruption . Economic competition and decentralization can eventuallv lead to p o li t ical c o m p et i t ion and decentralizat ion . Cross - regional co�pet i t ion may speed up the development of the rule of law in China as it did in the UK i n the eighteenth century and in the U S i n the nineteenth century. Currently, provincial- level j urisdictions can make regional regulat ions , and special ad m i n istrative regions , such as Hong Kong, as well as s p ec ial e c o n o m i c z o n e s , such as Shenzhen and Hainan, can make s o m e regional laws . If o t h e r p rovi n c ia l - leve l jur i sd ic t ions are gran ted the rights to make regi o nal l aws in the future , cro s s - regi o n al competi t ion i n lawmaking wil l i n te n sify.

1 00

CHAPTER FIVE

CENTRALIZATION, POLITICAL TURNOVER, AND INVESTMENT IN THE PHILIPPINES Emmanuel S. de Dios and Hadi Saleh i Esfahani

Conventional wisdom postulates that systems governed by the formal

rule of law are l ikely to perform b etter than those in which rules may be

arbitrarily changed . This is suggested by Douglas North (e .g . , 1 997) , who

pointed out, in his work, the crucial role in development played by a clear

definition of property rights and by effect ive mechanisms for the settle

ment of disputes. In recent discussions, however, especially following the

Asian crisis , "rule of law" has come to b e interpreted in the formal and

high - political sense of conformity with systems found in Western indus

trial democracies, including the existence of checks and balances, regular

and predictable regime succession, and a formally independent judiciary.

Part of the p arad ox presented by the rapid growth of the East and South

east Asian countries is that at the time of their remarkable performance,

few of them confomled to this ideal. I Even countries where levels of corruption

and potential for arbitrariness were high continued to attract or generate high

levels of productive investments. On the other hand, the Philippines has also

contributed to this p aradox, albe i t in a reverse manner, namely, as the

exception that validated the rule . Contrary to what might be expected, the

country's long history of formal democratic institutions has been associ

ated with mediocre economic performance (though in the midst of the

Asian crisis , it has also been among the least affected economically) .

The quest ion s , therefore , are how gove rnance and growth m ay be

related and what some of the mechanisms are through which this relation

ship emerges . In particular, this chapter seeks to explain how and why

changes in governance systems in the Phil ippines ( 1 935- 1 972 , 1 9 72- 1 986 ,

and 1 986 to the present) have led to d ifferent patterns of corruption and

1 0 1

r Centralization, Political Turnover, and Investment in the Philippines

to better or worse investment outcomes, both within and between regimes.

Crucial to the explanation are ( 1 ) the reasons for uncertainty and (2 ) the

costs of investment within regimes and across regimes, which we trace to

the distribution of political mandates and to the system of political turn

over and succession, resp ectively.

Philippine Political Economy

Various interpretati ons of Philippine political economy share a com

mon emphasis on the characteristics determining the likelihood of the

"capture" of the state and its instrumentalities by vested interests based on

political "clans." Notwithstanding a certain amount of dissatisfaction and

subsequent amendments , most views have developed fro m an earl ier

tradition in Philippine political literature that came to b e known as the

"factional model" of Philippine politics (e.g. , Lande 1 965) . In that reading,

the economic elite is seen as being divided into various factions formed

out of historical alliances b ased on kinship and p atronage. Factions are

thought to be based on the political and economic power of the local elite,

referring originally to agricultural landownership. The resulting patron

client relations cut across l ines of social class; allied local interests and

influences were then successively consol idated upward and ultimately

found their expression in political factions contending p eriodically for direct

control of government.

The only possible significant exception to this characterization is the

episode o f authoritarianism under Marc o s , dating fro m 1 972 to 1 98 6 ,

when the p ower o f local interests was weakened with t h e suppression

o f Co ngress and regular elections, which had served as the traditional

channels fo r their express ion . 2

The postdictatorship period , beginning with the restoration of demo

cratic institutions in 1 986 , is broadly regarded as a return to the previous

era, although recent changes in economic structure, demography, culture,

and the occurrence of economic crises have suggested that clan- based

patron- client relations could be weakening at the edges.] In particular, the

previous understanding that the indispensable basis for such politics was

the system of large traditional landholdings has come increasingly under

question (e .g . , Sidel 1 995 , and from a slightly different viewpoint, Rive ra

1 995 ) . Most would nonetheless concede that, although weakened, clan

based patro n - cl ient relat ions that have long influenced the country 's

p olitical economic landscape are still present.

The intensity of political contests derives from the fact that the gov

ernment disposes over a significant amount of resources and exercises

1 02

1 Centralization, Political Turnover, and Investment in the Philippines

discretion over a wide sphere. The impliCit goal of elite struggles is to

control the state's machinery and resources and to skew their deployment

to favor specific interests. Powerful incentives then work to persuade in

cumbents to retain power indefinitely in order to protect such interests .

Conversely, turnovers-whether electoral contests or more fundamental

challenges to legitimacy, such as attempted coup s-may be viewed as

opportunities to attain or to retain this power.

The economic costs occasioned by such regimes can be seen to be

largely a priori. First are the obvious losses from competitive rent- seeking,

as factions seek to build up their capacities to compete for dominance. The

larger the prizes are (which could turn on the scope of the government's

influence over resource allocation) and the more evenly matched factions

are , the greater is the likelihoo d o f dissipation of resources in terms of

lobbying, maintaining retinues of followers, and so on.4 These losses from

classical rent-seeking result from the diversion of resources toward unpro

duCtive or purely dissipative uses, where these could have been invested

or allocated Dore efficiently.

Further losses, apart from those occasioned by rent-seeking, may arise

as investment is discouraged by uncertainty. In this respect, two potential

effects of democratic , decentralized regimes in raising investment uncer

tainty may b e distinguished. One effect owes to the greater challenge to

authority even in periods between turnovers; in short, internal uncertainty

among investors brought on by the diffusion of p ower even without a

regime change . Overlapping jurisdictions and systems of checks and bal

ances typically found in formal democracies could lead to gridlock or rents

or both. On the other hand, interperiod or interregime uncertainty results

from possibly large changes in policies , ranging from reversals of broad

policy initiatives to alterations of contracts. The threat of victory by hostile

factions may be viewed as leading to unsettling changes in policies that

further raise the cost and the risk of investing. Potential political challeng

ers may threaten to reverse the results of transactions accomplished under

the incumbent administration once they come to power. The possible shift

in policy consequent to turnover represents additional uncertainty and a

discouragement to investment. The next two sections discuss these in turn.

Checks and Balances and Intraregime Investment Uncertainty

A frequently noted source of investment uncertainty in demo cratic

systems is the challenge to policies arising from checks and balances . In

democracies , branches of government differ in their competencies but are

able to exercise countervailing power relative to other branches . Presiden-

1 03


tial systems vest the executive function in a separate branch (the exeCL1-

tive) : while parliamentary systems incorporate legislation and implemen

tation in a single body, the parliament. In all cases, however, the judiciary

would be an independent branch serving as a last recours e .

T h e appropriateness of pol icy-maker incentives cannot b e guaran

teed in most s ituations , such as when the leaders' expected tenure is not

very long or when the leaders benefit from the gains of particular inter

est groups much more than those of others . As a result , restriction on

p o l icy d iscret ion ( o r d i ffu s i o n o f p o wer) i s oft e n needed to enhance

credibility. Restricting discretion is not cost-free, however, s ince it makes

policy adjustment difficult . When power is diffused , each policy change

requires b argaining and negot iat ion among veto holders , which may

de lay p o licy resp o n s e s and may p revent s o m e effic ient changes that

would o therwise have occurred. A trade - o ff exi s t s , therefo r e , b etween

the costs and benefits of restricting discretion. This trade-off depends o n

each country's specific conditions, implying that different levels of power

concentratio n may be o ptimal for different countri e s .

The 1 93 5 Phil i p p i n e C o nst i tut ion t h a t w a s i n e ffec t from 1 946 to

1 972 was patterned largely after that of the United States and prescribed

a presidential system of government, with three equal branches , namely,

the Execut ive , Legis lat ive , and Judic iary. This system was s u s p e n d e d

u n d e r the authoritarian M arcos regime from 1 97 2 to 1 9 8 6 , but i t was

re instituted, with some impo rtant changes to b e discussed later, in the

1 987 Constitution drafted during the presid ency of Corazon Aquino.

Institutionally, the d i s persal of power inherent in the separation of

p owers and the system of checks and balances makes decis ions o p e n

to chal lenge from seve ral q u arters . I n the Phi l ip p i n e s , the p ower o f

Congress to conduct invest igations , or inquir ies , " in a i d of legislation"

i s regarded as particularly potent, given i ts r ight to subpoena witnesses ,

informants , and documents . As may be expected, the opposition is typ i

c ally at the fo refront o f t h e c h a l l e n g e to execut ive i n i t iat ives w i t h a

pub l i cly accepted role of "fiscal iz ing . " "

Delavs resulting from such political contingencies add obvious cos ts

to poten� ial i nvestment projects , so that there would be some value to

avo id ing the m . Not surprisingly, this arrangement can be parl ayed into

corrupt ion. In local pol it ical parlance , this modus operan d i i s known as

"1\C- DC" (short for "attack and collect, defend and collect" ) , vvhich refers

to the polit ical practice of role reversal. arguing alternat ive ly in favor of

o r against certain p roj ects , i n exchange for s o m e financ ia l or pol i t ical

c o n s i deratio n .

1 04

Centralization, Political Turnover, and Investment in the Philippines

Congressional investigations by themselves cannot reverse decisions ,

but they may be leveraged with the wide publicity devoted to the m , as

well as with a p o ss ib le ult imate recourse to the j udic iary. Suits fi led

before the Supreme Court by l egislators challenging execut ive dec i s ions

are almost a matter of course . The increased leeway for Supreme Court

intervention is a p roduct of the p o s t - M arcos experienc e . In an i n n ova

t ion seeking to prevent a repetition of the imposition of martial law that

paved the way for the Marcos dictato rship, the 1 987 Constitut ion al lows

the Supreme Court to review cases involving "grave abuse of discretio n . "

This h a s allowed the Court t o issue temporary restraining orders bind

ing o n the Executive Branch or any of its agencies . As ide from electoral

contests , therefore , this is another means for rivals to mount challenges

to init iatives fro m the poli t ically do minant fact ions . These examples are fully consistent with the " independent monopo

lists" model of corruption described b y Shleifer and Vishny i n 1 993 . These authors discuss the problem of corruption in the provis ion of a service or in access to a publ ic resource . They distinguish between three types of industrial organizatio n : ( l ) joint monopolists , where there is only one source of the service ; (2 ) independent monopolists , where two or more entities can provide the service; and (3 ) competition, where several entit ies are equally capable of p rovid ing the s e rvi c e .

Especially important in this respect i s t h e analytical observation

regarded as important through anecdotal evidence-that "corruption c o n

tracts " are not enforceable in courts , and there is many a sl ip between

the bribing transaction and the actual delivery of the good or the service

involved" ( Bardhan [ 1 99 7 , 1 3 2 4 1 attributes this to Boycko, Sh le i fe r, and

Vishny) . In the case of independent monopolists , concurrence by two or lIl o re

entit ies is required in order to obtain access to public resources or assets . Each entity may then act independently to maximize its retu rns , say i n the fo rm o f b r i b e s . A s a resul t , the a m o unts d e m a n d e d o f p o t e n t i a l investors is excess ive , which leads , other thi ngs be ing equa l , to a d e crease i n investment proj ects and , consequently, t o lower outpuL" flence , for instance , a deal may be i roned out with the agencies in the Execut ive , but this wou l d n o t guarantee its passage owing t o prior require ments .

This s i tuation m ay be contrasted with one wh ere there i s o n l y o n e bribe - taking m o n o p o l i s t , who s e t s the rate of " take" so that t o t a l bribe revenue is maximized. This can be atta ined , however, only if the rate of br ibes i s not set so high as to discourage investment unduly. As a result , while the total bribe- revenue col lected may be higher than the second, the

105


level of investment and output are higher in the first. Indeed, Shleifer and

Vishny ( 1 993 , 6 : 0) speculate dirf'ctly on the effect of the transition to the

post-Marcos regime: " New governments lose monopoly over bribe collec

t ion , and as a result multiple agencies take b ribes where o nly one did

before, leading to a much less efficient collection. In the Philippines under

Marcos , all corruption flowed to the top; since his demise, the number of

independent bribe takers has increased, and so the efficiency of resource

allocation has probably decl ined . "

It should be pointed out , how£ver, that the possibility of challenge and

decision reversals from different branches of government would also exist

even in the case of legitimate contracts. From the viewpoint of investment

uncertainty, the distinction between challenges motivated by corruption

and those that are not is of secondary importance. The same mechanisms

that exist for the free prosecution of legitimate social demands are avail

able for vested interests. In a similar vein, t h e extent to which losses as

sociated with rent- seeking are not themselves inherently associated with

the workings of democratic and constitutional regimes (e .g . , Brecher 1 982)

has been questioned. For example , that unions should have recourse to

the Supreme Court is unlikely to raise any objections. Yet it is difficult to

argue that the recourse to the courts should b e open only to certain en

tities and not others. A dilemma therefore exists on whether an attempt to

eliminate such rent-seeking costs does not lead either to the deprivation

of access to due process. I t may be argued that Congress, the courts , and

media are the counterbalance to arbitrary seizures and in this sense miti

gate the powers that would otherwise result in extreme bias in decisions.

Elections and Political Turnovers

Less noticeable than intraregime factors, however, have been regime

turnovers as a second source of uncertainty. The importance of turnover

e p i s o d e s in i n flu e n c i n g inve s t m e n t b e h av i o r is d i s c e r n i b l e t h rough

econometric evidence . M ovements of macroeconomic variables in the

Phi l ippines over the p a s t five decades , as in many other developing

countries , indicate a discernible influence of electoral cycles . In particu

lar, the budget deficit has had a clear tendency to rise in election years ,

which, in the polit ical business-cycles l iterature , has been attributed to

an attempt by incumbent leaders to boost the economy and distribute

public funds under their discretion to strengthen their political support . '

Nevertheless , unlike polit ical business cycles observed in other d eve l

o p i n g countries , larger e lect io n - year budget deficits in t h e Phi l ippines

have n o t unambiguously exp a n d e d the economy. Rather, e lect ions ap-

106


pear to be preceded by a decline in p rivate investment that counteracts the fiscal exp ansion and causes a slowdown. We attribute this behavior to inst i tut ional characterist ics i n the Phi l ippines and argue that thes e factors have not only added to instability in the economy but have also constrained the average investment rate to low levels .

The presence o f other factors influencing investment makes i t dif

ficult to obtain a simple p icture of the influence of political turnover ( if

any) on investment. The only satisfactory way to substantiate this claim

is to fully specify and estimate a model of investment behavior and test

whether pres ident ial e lect ions in the Phil ippines have a dist inct influ

ence o n the l evel o f investment . F o r this purp o s e , we take investment

to depend o n factors affecting profitability, which include inflat ion , p re

d i c t e d GDP ( g r o s s d o m e s t i c product ) growt h , the s t a t e of the current

account , the terms of trade , and indebtedness (represented by accumu

lated current account deficits) , the price of investment goods , as well as

p ol i t :cal r isk . ( Th e underlying model is descr ibed more closely in the

appendix) . Equations seeking to explain total investment and a p roxy for

private investment are estimated, and the results appear to support the

initial hyp o thesis of presidential elections having a distinct influence on

investment. I t wil l b e seen in most runs that the coefficient of a dummy

variable representing preelection years is both significant and negative .

This is true for total investment, for p rivate construction, as well as for

the sum o f p rivate construction and durable equipment , which is the

p roxy used for p rivate investment . 8 These results lend support to what

casual o b s e rvat ion would suggest , namely, that the uncertainty gener

ated by pres idential contests n egatively influences the l evel o f invest

ment. The evidence is thus broadly compatible with the factional model

of Phil ippine pol it ical economy d e s c ri b e d earli er.

The mechanism by which regime turnover affects investment in the

Philippines is clear. Suppose, for simplicity, there are two contending fac

tions that seek to gain control of government. With the electoral outcome

known , the losing faction will tend to restrict its own investment, ceteris

paribus, either in order to minimize the possibility of being taken over or

simply as a result of being discriminated against , for example , through

being unduly taxed. The winning faction, on the other hand, may invest

more aggress ively, having greater assurances regarding its security and

privileges. The period prior to the elections, however, is one of uncertainty

for both factions, so that investment by both should be expected to de

cline. Ultimately, a succeeding administration may often threaten to expose

and undo large deals concluded by its predecessor." It is important to note

107


that this is poss ib le , largely b ecause a good part of decis ions involve a

good deal of discret ion (espec ially on the part of the executive) .

This hypothesis is borne out historically. An extreme illustration of the

p ossibil ity of takeover was the stru ggle b etween the Marcos and Lopez

families (McCoy 1 993 ) , with the holdings of the latter, as well as those of

other elite famil ies , such as the Jacintos and Osmefias, being completely

taken over by the M arcoses and the cronies associated with them. These

same interests, however, were restored with the ascendancy of the Ramos

and Aquino administrations, while assets associated with the Marcos fam

ily (such as those of Eduardo Cojuangco, the Romualdezes, the Benedictos)

were expropriated or "sequestered , " i . e . , placed under government receiv

ership, Most recently, the pendulum swung once more in the other direc

t ion as the electoral victory of Pres ident Joseph Estrada in 1 998 opened

the door to at least a p artial rest i tution of the interests formerly allied

closely with the Marcos fam ily, who were strong Estrada supporters . I O

On a scale less grand, even predictable regime changes under demo

c r a t i c e l e c t i o n s i n t h e P h i l i p p i n e s c o n t r i b u t e to a g o o d d e al of

discontinuity and disruption in investment horizon s . Almost invariably,

it has been the practice of succeeding " unfr i e ndly" administrations to

question and scrutinize contracts and proj ects concluded by their pre

d e c e s s o r s , in the attempt to p rove that these have been r iddled with

c o rrupt ion and are d i sadvantageous to the publ ic . O n the o n e hand,

such ex post tran s p ar e n cy a n d a c c o u n t abi l i ty m ay b e viewed as an

advantage of pred ic table and d e m o c rat ic changeove r s . O n the other

han d , the practice undoubtedly increases the costs and uncertainty of

investment . and indeed may p l ay a p art i n the incumbent 's own de

mand fo r c o rrup t i o n . I nv e s t m e n t p roj e c t s b e gun u n d e r a p revi o u s

adminis trat ion may b e he ld hostage b y a n unfriendly successor, s ince

the latter 's co ncurrence is o ften needed for their c o ntinuation. This i s

most evident when publ ic contracts and payments are i nvolved , such

as those involvin g public infrastructure. In general . however, the prob

lem arises to the extent that any significant government action-such

as franchi s e s , taxes , o r tariff changes , support ing infrastructure-is a

requis i te c lement fo r a private p roj ect 's future viabil ity and the poss i

b i l i ty exi s ts that th is may b e withh e l d , o r that a p a s t act ion may b e

reve rse d . I t is easy to s e e that this n e e d fo r c o n t i n u i n g c o o p e rati o n

from the incllmbe� t may, with sufficient gui le , b e parlayed into a d e

m a n d fo r addit ional s ide payments , rais ing the costs o f investment .

A n alyt ically, t h i s s i t u a t i o n m ay a l s o b e c a s t as a n i n t e r t e m p o ral

i n t e rpretat ion o f the s a m e independent m o n o p o li s t s model of Sh lei fe r

1 08

1 !

Centralization, Political Turnover, and I nvestment in the Philippines

and Vishny d i s c u s s e d in the p revi o u s s e c t i o n . Prev i o u s a n d p re s e n t

administrations may be viewed a s independent monopol ists , each seek

ing to maximize its gains , causing "excess ive" d emands fo r corru pt i o n ,

with the p redictable result that investment i s d iscouraged . S o mewhat

less obvious i s the addit ional d is tort i o n reSUlt ing from p rivate age n t s ,

anticipating t h e p o ssibility that a b i a s for p rojects whose l ife - s pans do

not extend beyond the term of a "friendly" administration. The reSUl t ing

tendency to myopia when investments involve significant partic i patio n

o r concurrence fro m government is another source of ineffic iency.

Uncertainty and actual losses for exist ing interests wil l . to be sure,

result from any significant policy change, whether or not these are tar

geted against narrowly defined factions . The shift from an inward- looking

to an outward - looking strategy, or cutbacks in public spending as part

of a macroeconomic adjustment, for example , are certain to cross exist

ing narrow divisions , s ince factional divisions are l ikely to have interests

i n e i ther. What pr incipally dist inguishes one s i tuation fro m the other,

however, i s the scope for discrimin atory o r selective application of the

law. The fact that not the ent i re class o f interests but only some are

affected lessens the l ikel i h o o d of mass ive resistan c e , i n the classic d i

vide-and-rule tradition. I n t h e c a s e of t h e Marcos regime, for instanc e ,

t h e target ing of certain families , s u c h as the Lopezes a n d t h e J acinto s ,

coincided with accommodation of other large families , such a s t h e Zobel

Ayalas, and the positive favoring of other groups , such as that of Eduardo

Cojuangco and other cronies . The high degree of arbitrariness and s e

lectivity of fact ion- related expropriations a n d policy reversals results i n

greater investment uncertainty, in addit ion to t h o s e already present i n

large - scale systemwide changes in investment strategy.

A Benchmark Comparison

I t is tempting to associate the two types of i nvestment uncertai n t y

previously discussed with democracy per se a n d conclude that these are

specifi c o r inherent to such regimes . Even casual observation sugges ts ,

however, that massive discouragement of i nvestment does not occur i n

more advanced industrial countries with democratic systems of gove rn

ment. In such countries , investment ru l e s and att itudes toward property

rights do not change dram atically.

The question that arises . therefore , is how industrial democracies can

exist with these same institutions yet maintain a stable record of invest

ment. The answer proposed here i s diffusion of power. It is easy to see that

in a democratic country ( s ay, Denmark) with a homogenous p opUlat ion ,

1 09

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an open and stable economy, and an effective administrative system, a

governance structure with diffused power is likely to b e best for imple

menting efficient investment policies . Political openness and population

homogeneity could reduce the need for power diffusion, but on the whole

such a system should prosper without much concentration of power. This

is a benchmark that we use to assess appropriate arrangements for other

situations with different characteristics. From such a benchmark, however,

one may proceed to inquire into the significance of the costs of restricting

p olicy discretion, depending on socioeconomic characteristics that make

information processing and coordination among interest groups cumber

some. In p articular, the costs of diffused power should tend to rise with

the six factors that we present below.

1 . Heterogeneity of in terest groups in the society. As the pol ity becomes

more heterogeneous, bargaining among representatives of interest groups

becomes more cost ly. A higher l evel of p ower concentratio n could , in

principle , mitigate this problem. On the other hand, heterogeneity may

also induce biases in leaders ' incentives (as would happen if the gov

ernment was completely "captured" ) and affect its efficacy. The net effect

o n the trade-off, therefore , i s not entirely clear.

2. The frequency and magn itude of eco n o m ic sh ocks ( e . g . , adverse

terms of t rade shocks , natural disasters , s ignificant p opulation move

ments) . When a country faces significant economic shocks but otherwise

has the same condi t ions as the b en c hmark c a s e , the n e e d for t imely

p olicy adjustment increases . As a result, the net benefits turn in favor of

greater power concentrat ion .

3. The eco n o m ic sys tem 's lack of open n ess ( i . e . , markets are m o re

restricted ) . I f the o nly d e p arture from the benchmark case is reduced

eco nomic openness , the cost o f collecting and process ing information

rises for interest groups and their representatives . As a result , bargaining

becomes more costly, and p ower concentration, which reduces bargain

ing , becomes more b e nefic ial at the margin .

4. Weakness of the adm in istra tive system ( e .g . , inefficient administra

t ive o rganizat i o n s , low qual i ty o f p e r s o n n e l . low level of educat i o n ) .

Inabil ity of the bureaucracy to collect and process info rmation adds to

the costs of negotiation among interest-group representatives . This raises

the marginal net benefits of concentrated p ower. A weak administrative

system also impedes information process ing . Info rmatio nal imperfec

tions tend to give r i se to "wars of attrition" in interest- group bargaining,

which can be c o s t ly i n terms of resources and d e l ays in adj ustment (Ales ina and D razen 1 99 1 ) . I n o n e sense , c o n c e ntratio n of power r e -

1 1 2


solves this problem and allows a quicker and more flexible response to

changing circumstances , given the available information .

5 . Frequency of leadership turnover ( e .g. , term limits and fragmented

party system) . When the likelihood increases that government power will

shift from one group of politicians to another, discretion in the hands of

leadership can breed pol icy instability. This calls for increased diffusion

of power to the extent that such arrangements can survive political change. 1 1

6. The political system's lack of openness (such as more restricted media

and public expression) . Reduced opportunities for political expression and

p articipation by broad segments of the population limit the information

available to interest groups and, naturally, tend to raise the concentration

of power. However, these factors also expand the possibilities for oppor

tunistic behavior on the part of the leaders. As a result, some increase in

power diffusion may help increase credibility of policies. Lack of political

openness may also raise the costs of p ower diffusion, since it reduces the

availability of public information. However, this is unlikely to be a major

effect compared to the opportunities for favoritism that lack of polit ical

openness presents to leaders with concentrated power.

Institutions limit policy discretion essentially by conditioning changes

in policy and p olicy-making procedures on coordination by a number of

i ndependent agents representing different interests . Such a diffusion of

power can take the form of geographic decentralization (e .g . , federalism) ,

institutional decentralization (e .g . , independent central bank and regula

tory agencies ) , o r multiple veto p owers ( e . g . , presidential - p arliamentary

systems with bicameral legislature, independent constitutional courts, and

other e lected or nonelected bodies holding veto over p olicy changes ) .

Such arrangements can reduce the risk of opportunistic policy changes as

long as the represented interests are not closely aligned. As the number

of independent agents involved in various policy-making and procedure

setting processes diminishes and the degree of alignment among those

agents increases , the greater is the degree of power concentrat ion in the

government. To be sure, policy commitment is not an all -or-nothing var i

able. Rather, it is a variable with a continuum of degrees depending on the

incentives of policy makers, the nature of veto holders for each rule , and

the extent to which the rules specify the details of pol icy and restrict the

options for changing the details or the rules themselves .

On the face of i t s characteristics, the Philippines is a likely candidate

to benefit from a strong executive. In particular, the economy's proneness

to economic shocks, its lack of openness and administrative weakness are

factors that, on the face of it , argue for an increase in the concentration of

1 1 3


p ower. There is no need to deal at length with the record of shocks. The

heavy dependence of the Philippine economy on imported inputs renders

it vulnerable to both external and internal shocks. Examples of such shocks

that resulted in critical conditions were the second increase in oil prices

in 1 979 , the world recession of 1 982 , and the Gulf War crisis of 1 990 . In

addition, natural calamities , such as earthquakes and the Mount Pinatubo

volcano eruption of 1 99 1 , were also significant shocks.

Apart from the unsustainability of growth under a closed economic

sys t e m , the current framewo rk suggests that lack o f o p enness in the

economy has another effect, namely, that of raising transaction costs among

differing interest groups . One way of looking at this is to say that rent

seeking games are more likely to occur in closed, rather than in more open

economic systems. 1 2 Finally, the weak condition of the bureaucracy is also

part of the "stylized facts" about the Philippines, an observation made long

ago (e .g . , Corpuz 1 957) but still relevant . The framework, therefore, sug

gests a number of reasons why the Philippines should have a "centralized"

system. Indeed, the puzzle for the Philippines is how and why, given such

a framework, the experiment with authoritarianism has failed.

Extreme Centralization and Bias

Viewed differently, the problem of uncertainty brought about by intra

and interregime changes is the apparent inability of the government as

a whole to make credible or binding commitments . Commitment essen

t ially requires that pol icies are not amended in ways that punish inves

tors who make irreversible investments on the bas is of existing policies .

This can be achieved if the policy makers had the incentive to honor the

promises of past pol ic ies , or if their discret ion i s constrained by estab

l i shed rules that govern p o l icy change. F o r a p p r o p riate incentive s to

exist , polit icians in government (as individuals or as a p arty when po

litical parties are strong) should expect to have a good chance of be ing

in that pos i t ion i n the future and should value the ir reputation among

all p o t e ntial inves tors . Whe n the chances o f tu rnover in government

leadership are significant , then commitment depends on inst i tut iona l

arrangements fo r po l icy amendment .

Until recently, it would have appeared that both types of uncertain ty

r e fe r r e d to a b o v e c o u l d be r e s o l v e d by r e c o u r s e to s o m e fo r m o f

authoritarianism o r dictatorship. After all , assuming i t could b e achi eved ,

concentration of power and the discouragement of inst itutions that permit

the expl ic i t express ion o f in teres t -group c o m p et i t ion would minimize

transact ion costs and uncertainty. O n the other hand, if frequent turn-

1 14


overs are associated with policy instability, then regime longevity, ceteris

p aribus , might conversely be associated with greater policy consistency

and s h o u l d the refore al low fo r l o n g e r inve stment hor izo n s . In turn ,

incumb e n t rulers would have the i n c entive to temper c o rrupt ion d e

mands , leading to lower demand for corrupt ion .

The argument is similar to the ownership solution proposed for the

well-known "tragedy of the commons" problem. Free access to a resource

causes its overexploitation, which the assignment of monopoly ownership

solve s , s ince the so le owner ult imately reaps what he sows and must

therefore take the long view. In the same manner, contention for p ower

and interregime changes among different interest groups might be likened

to a one-time open season for public resources. The incentive is strong in

such cases for succeeding groups to extract as many rents as they can, i . e . ,

"make hay while the sun shines , " a tendency only somewhat tempered by

the infrequent need to stand for reelection. By contrast , security of tenure

is thought to reduce this need, since it lengthens the horizon over which

corruption rents may be collected. Before the Asian financial and economic

crisis, a good deal of this analysis certainly seemed to be borne out by the

experiences of such countries as Indonesia , M alaysia , and Singapore , in

which long- lived centralized regimes appeared to have facilitated the entry

of capital , p articularly foreign.

The recent history of political institutions in the Philippines may be

viewed as a process of experimentation i n solving the twin problems of

intraregime and interregime instabi l i ty, pr imarily along the d imens ion

of concentrat i o n of power as embodied in the executive . The start ing

p o int was the p re - M arcos regime governed by the 1 93 5 C o n s ti tut ion ,

which saw the power of the executive diluted in favor of Congress . This

was compounded by frequent turnovers . The broad result c o n formed

with that argued by Shleifer and Vishny, namely, the emergence of both

intra- and interregime uncertainty.

On the other hand, the authoritarian Marcos regime may be regarded

as an historical exp eriment with extreme centralizat ion that s ought to

addre ss the problem on both counts , first by the often brutal suppres

sion of competition among contending factions as well as social protest

from the masses and, second , by suspending the turnover that would

have resulted fro m e lect ions . The apologis ts of the regime were ful l y

aware of the need for justification, and the alleged urgency of preventing

the growing conflict between the extreme Left and the conservative "ol i

garchy" was cited as a reason fo r a "revolut ion fro m the center " that established the d ic tatorship .

1 1 5


It must be conceded that the early half of the Marcos dictatorship

(from 1 9 72- 1 980) was marked by a revival of investment and a respect

able rate o f e c o n o m i c growt h . Internat ional inst i tut ions , such as the

Internat ional M o n etary Fund and the Wo rld B ank, as well as foreign

(especially US) investors appeared to be persuaded at that time, and for

too long a t ime after, by the argument that centralization would result

in both greater policy coherence and continuity. 1 3 This p art of the story,

at least , presents no problems. Indeed, the anomalous part of that ex

p e r i e n c e , from the t h eoret ical viewp oint pursued h e r e , was that that

s i tuation could not b e sustained .

Monocausal explanations are always dangerous , h owever, and while

governance forms are undoubtedly important, they alone cannot be ex

pected to determine economic outcomes. The full set of reasons for the

failure o f the Marcos dictatorship 's self- consc ious attempt to emulate

the authoritarian regimes in the rest of the region remains a wide-open

field of study. An important e lement that can b e noted , however, i s the

fai lure of the M arcos d ictatorship to reach the same l evel of soci al le

gitimacy as the authoritarian regimes in the rest of East Asia . There was

almost no per iod during which the M arcos regime did n o t fac e some

form o f chal lenge to i ts rule , whether fro m e lements o f d ispossessed

and disenfranchised elite factions, the Catholic Church, the mass move

ment and armed resistance led by the Communist Party, or the armed

movement for the independence of Muslim Mindanao. I t is notable that ,

ultimately, a confluence of these forces-precipitated by a further split

in the Armed Forces-would bring down the dictatorship in 1 98 6 . 1 4

This consideration points to t h e importance of init ial conditions in

assess ing the long- term chances of centralizatio n as a solut ion to the

problem of commitment . The social basis required to legitimize an au

thoritarian solution to the problem of credible commitment was probably

less present in the Philippines than in other countries which successfully

adopted that solution. To begin with , relative to those other countries, the

Philippines in the 1 960s and 1 970s was characterized by an economically

independent and politically powerful elite. IS I t also had a well - developed

working- class and peasant movement, and a population with a relatively

high degree of literacy and political sophistication. lEi Hutchcroft ( 1 99 1 , 1 998)

observes that the Phi l ippine elite has historically been more powerful

relative to the state and the bureaucracy than the elite in other countries.

I n such circumstances , i t becomes unlikely that a simple capture of the

state machinery by a dictator would lead to easy co- opting of the elite. The

upshot is to raise the costs of a dictatorship's bid for legitimacy, since both

1 1 6

T Centralization, Political Turnover, and Investment in the Philippines

elite and working classes would-as they did-offer powerful resistance to large changes in the political rule in which they had invested.

Conflict p o t e n tial among interest groups is the term used here to

summarize this condition. I t refers to a situation where there are overlap

ping claims on resources by different interest groups , leading to the pos

sibil ity of sharp conflict . The condit ion i s present whenever a situation

approximates a constant-sum game, which is well known to have no Nash

equilibria. This may occur both within and across social strata. A simple

example would be a workers' movement with fairly set ideas about entitle

ments, not o nly for its own members but for the rest of society as well . 1 7

In such a situation, s ide p ayments are less likely to succeed, s ince the

utility of one p arty includes the assignment of a p articular level of utility

for the other. (In contrast to this, one might consider a trade union move

ment based p rimarily o n economic demand s . ) Another example is the

conflict b e tween two pol itical c lans competing for local electoral spoils ,

also a winner-take-all situation. These examples serve to illustrate the point

that when interests are extremely heterogeneous, any assignment is l ikely

to be regarded as biased or unfair by someone else . I S

In the context of heterogeneous interests even in the pre-martial law

period , it should b e clear that the inst i tutionalization of e lect ions , i . e . ,

predictable turnover, was a n important factor in p reventing t h e situation

from degenerating into one of complete capture and bias. For this rea

son as well , the various p articipants , notably contending elite fact ions ,

were content to play the game, thereby avoiding a war of attrition . The

suspension of this process of ritual factional capture of the state under

the dictatorship was a violation of implicit rules of the game, leading to

the emergence of sharp conflict .

A good deal of the Marcos regime's ultimate economic failure lay in

its inability to consolidate its grip on power and thus address the issue of

interregime uncertainty. The legitimacy of both the substance and meth

ods of the l arge -scal e property reassignments it made were never fully

accepted by o p p o sing elite fact ions , n o r by armed and unarmed mass

movements. As the challenge to legitimacy increased, especially after 1 982 ,

uncertainty increased both among foreign and domestic investors and

creditors, leading ultimately to the economic crisis of 1 984- 1 985 .

The assertion of wide- ranging authority entails a more difficult pro

cess of legit imization in soc iet ies where p o lit ical and economic claims

from el i te and from working- class groups overlap and are more c o m

prehensive, more articulated. A s a n il lustration, a society b a s e d predomi

nantly o n se lf- sufficient peasant farming, with central state institutions

1 1 7


playing only a minor and distant role in economic life , is l ikely to present

less resistance to an autho ritarian takeover o f the state. Much earlier.

M arx ( [ 1 869 ] 1 9 73 . 2 3 8-3 9 ) observed the connection b etween absolut

ism, o r Bonaparti sm. and the economic isolation and backwardness of

the French peasantry. I "

There are several reasons for overlapping claims. While o n e may b e

tempted to approximate this by the degree of inequality of wealth dis

tribution , this is certainly incomplete. I t is not measured inequality per

se that matters. but the lack of public acceptance of this inequality. This

in turn depends on the assertion of divergent rights and alternative legal

frameworks , and the determination that some other social arrangement

is superior. Educatio n , the spread of ideologies . o r familiarity with dif

fering social and economic arrangements are important, as well as the

existence of unclaimed resources . As an exampl e , deep divisions over

landownership claims in the Philippines are founded o n the assertion

of rights under differing frames of legitimacy, such as ancient claims on

ancestral domains, s imple usufruct and physical occupation, as well as

the legal titling system introduced under foreign occupation-all of which

are to some extent publicly accepted in varying degrees .

In the most general sense. what seems important is the social "space"

that government-or those who have captured it-can occupy without in

truding on preexisting claims or rights . The more numerous and the larger

such spaces are. the less disruptive authoritarianism is. and the less resis

tance it is likely to evoke. This "space" may be physical , as in the case of

unoccupied or unclaimed public lands that can be appropriated. I t may

be in terms of value. such as when the economy grows and the increment

is disproportionately distributed to favored interests. It may be intellectual

and ideological space . such as an uneducated and ideologically unsophis

ticated population that is content to moderate its claims on the rest of

society. leaving more room for dictators to assign the levers for the cre

ation of new wealth . In the Philippine experience, however, there appear

to be less of such "empty spaces" for the projection of authoritarian forms

without infringing on preexisting claims. In such circumstances. conflict

resolution is unlikely to b e simple . and the basis of authority itself d is

puted. Those "convergent expectations" which Arrow ( 1 974. 72) observed

to be the basis for viable authority will not exist .

Centralization with Term Limits

Motivated by a desire to check past authoritarian abuses, the framers

of the 1 987 Constitution reduced some of the president's powers and sought

1 1 8


to prevent the reemergence of a pure authoritarian form of government.

It set c lear term limits fo r the pres ident and s ought t o diminish the

executive's discretion in decision making through a clearer process of

legislative and j udicial review. Most notably, the Constitution prohibits the

reelection o f the president, although it grants a longer term of six years;

it prescribes longer congressional sessions (up from 1 00 days to eleven

months) to reduce the need for special sessions, whose agenda were thought

to be more prone to executive manipulation. It also provided for congres

sional review of declared states of emergency; and it broadened the scope

for judicial review of executive acts by constituting "grave abuse of discre

tion." More significantly, it has been noted that the 1 987 Constitution also

restricts the chief executive through detailed specification of rights and

entitlements, some of which are potentially in conflict (Sereno 1 999) .

For these reasons, it has almost become part of folk wisdom among

the business community that the p owers of the legislature and the j u

diciary have become reemphasized at t h e exp ense o f t h e presidency in

the postdictatorship regime. Consequently, i t has been thought that the

postdictatorship period and its economic consequences m ay b e ana

lyzed simply as a continuation o f the system prevailing under the 1 93 5

Constitution . 20 I n their famous art ic le , Shleife r and Vishny s p eculate

broadly that the return of democratic institutions in the Philippines has

probably increased the extent o f corruption owing to the reemergence

of mutual veto and deadlock among competing power centers. While the

dilutio n o f central powers has undoubtedly o ccurred, however, it would

go too far to say that the postdictatorship period has simply represented

a return to a p re - 1 9 72 regime o f alternating factionalism. Instead, the

current system must be understood as bearing the marks o f the earlier

pre-Marcos period, the period of dictatorship, and the reactions to both .

It is important to point out that, while its powers have been dimin

ished relative to the dictatorship, the presidency has remained a powerful

office that by and large dominates other branches of government . Among

the powers of the presidency that have remained are the item or partial

veto and the use of large discretionary funds not subj ect to congre s

sional appropriation or scrutiny (contingency. calamity. a n d intelligence

fu nd s ) . Notably. the pres ident a lso wields a p owerful influ e n c e over

Congress through bureaucratic discretion over the timing of the release

of funds for projects of locally elected officials. especially the "pork barrel "

of members o f the H o u s e o f Representative s . 2 1 I n additi o n . although

admittedly with new restrictio n s , the president c o ntinues to a p p oint

members o f the judici ary and the military.

119

r


The scope for executive discretion in matters of l icensing, bidding,

granting of incentives, and other aspects of regulatio n also remains large.

The entire l ib e ral izatio n and deregulation age n d a b e tween 1 9 8 1 and

1 996, including the revision of tariffs , was accomplished largely through

a succession of executive orders.22 In general, the executive's domina

t ion o f the civil service bureaucracy and the mil i tary provides i t with

access to information that is simply unavailable to other branches of the

government, especially the legislature . The national legislative agenda

is built around "priority bills" proposed by the president, while legisla

tion init iated by lawmakers themselves has tended t o be limited and

p arochial,2l What is more, enacted laws are often sketchy and abstract,

giving wide latitude to executive agencies in the formulation of " imple

menting rules and regulat ions . "

Perhaps the most telling manifestation o f presidential dominance is

its influence on the p attern of coalition formation in the legislature. All

the three postdictatorship administrations (Aquino, Ramos, and Estrada)

exercised heavy influence over Congress , due t o the instability of party

formations after presidential elections . Broad, heterogeneous coalitions

have invariably formed whose d e cl ared main purpose is to "support"

the incumbent executive, p revent executive retaliat ion , and to ensure

c o ntinuing access o f l o c al representatives to nat ional l argesse . While

" t u r n c o at i s m" a l s o e xi s t e d u n d e r the two - p arty sys t e m in the

predictatorship period, the current practice is a more cynical and wide

spread version, helped along by the higher transaction costs of forming

stable coalitions under the current multiparty system (see de Dios 1 999a

fo r a ful ler discussion) .

The system under the 1 987 Constitution is in many ways a curious

amalgam of traits from both the premartial law regime and the dictator

ship, the product of a remarkable historical evolution. From the latter it

retained many elements of centralization, albeit somewhat reduced. From

the former, it restored the predictabil ity of turnover. Each o f these is

meant to so lve a part icular governance p r o b l e m . In react ion to th e

excesses of the dictatorship, regular turnover is designed to address the

problem of extreme bias ; p redictable constitutional turnovers discour

age the indefinite extens ion o f p ower and its u s e against compet ing

interest groups, which has in the past led to crises owi ng to high conflict

potential. On the other hand, the implicit tolerance of greater centralized

p ower seeks to address the problem of gridlock and the "tragedy of the

commons" that lead to intraregime uncertainty, an undesirable feature

of the p remartial law regime.

1 20


While each of the features mentioned above is a response to a specific

problem, their j uxtap osit ion is not necessarily optimal. The p revi ous

analysis suggests that centralizatio n via a strong executive wo uld ad

dress the issue o f intraregime uncertainty by so lving the "commons "

problem. O n t h e other hand, when centralization is combined with fre

q u e n t turnovers, t h e p r o b l e m o f credible commitment reapp ears and

creates a problem o f interregime uncertainty. The large discretion a l

lowed the executive to change policies-together with observed past use

of that discretion to favor vested interests-makes it rational for inves

tors to wait out the results of impending p olitical contests. The already

documented importance of presidential elections in influencing invest

ment behavio r is exaggerated by the continuing large scope of p owers

possessed by the presidency. The inst i tut ional problem that recurs is

how the incumbent in a powerful position can make a credible commit

ment to certain pol ic ies , given the p o s s i b il i ty that his o r her equally

p owerful s u c c e s s o r m ay subsequently overturn these . N o t e that the

difficulty o f making a binding commitment increases all the more with

an increase in the p rerogatives associated with the posit ion. Hence the

p aradox that the stronger a p o s i t i o n i s , the weaker is the abi l i ty fo r

incumbents to make binding commitments . I n p u re authoritarian re

gimes, this problem is suspended, or at least p ostponed, since term limits

are indefinite . Where turnover is p rescribed, however, the problem re

curs with predictable regularity.

This framework can elucidate some of the governance factors respon

sible for the observed irregular behavio r o f investment and economic

performance in the post-Marcos era . During the Aquino administration,

the revival of investment immediately after the fall of the dictatorship was

associated with the resolution of the outstanding problem of bias . The

restoration of confiscated property, the removal of any further threat of

dispossession, and the greater social legitimacy of the Aquino government

( 1 986- 1 992) were factors that encouraged the return of investment confi

dence. This was shattered only b y the threat of military takeovers in 1 989

onward, which gave rise once more to interregime uncertainty. Investment

stability during the Ramos administration ( 1 992- 1 998) , on the other hand,

went hand in hand with a consummate use by the executive of the levers

available to i t . In particular, coalition politics in the legislature was suc

cessfully managed, underwritten by selective access of lawmakers to cen

tral government resources and rents. This use of pork-barrel politics effec

tively solved the potential problem of gridlock and, when combined with

executive discret ion over key reform areas, sustained a momentum o f

1 2 1

1 \ .

Centralization, Political Thrnover, and Investment in the Philippines

reforms that helped the country achieve a respectable rate of investment

and growth over the period.

Nevertheless , the crucial tension betwee n c entralization and turn

over was n o t e n t i r e l y r e s o l ve d . The c l o s i n g y e a r s o f the R a m o s

administration were taken up b y t h e recurrence o f interregime uncer

tainty, with a subsequent impact on investment. The very success of the

R a m o s administrat i o n reforms and their c l o s e a s s o c i a t i o n with t h e

p ol i t ical personalit ies o f t h a t administratio n brought up the question

whether they would b e continued by the succeeding regime. I t is worth

recal l ing that many key reforms (such as tariff- reform schedules , d e

regulation of interisland passenger shipping, telecommunications, p ower,

and water and s ewerage, to name only a few) were implemented through

executive or administrative orders, all o f which could, in principle , b e

reverse d . The threat o f reversal applies to large projects . Examples o f

those recently affected b y the transition between t h e Ramos and Estrada

administrat ions i n c l u d e real estate deals ( P EA-Amari ) , infrastructure

projects ( C B K - I mp s a) and equipment purchases ( M otorola deal with

the national pol ice ) . Furthermore, as already discussed , the actual o r

p ossible corruption attending s u c h transactions makes them vulnerable

to d e l ays , c o s t e s c al a ti o n s , o r outright cancel lat ion by a succeeding

administration, a l l of which in turn are factored into future decisions .

I n the long run, the demonstrable social costs arising fro m such a

situation are bound to raise calls for a reevaluation of the process, if not

the system itself. Quite apart from the social costs of such a process , a

strong Executive Branch also creates incentives for current officeholders

to p rolong thei r terms out of pure self- interest . The crit icism of term

limits under the current system is summed up in the now-popular adage

that "s ix years is too short for a good president and too long for a bad

o n e . " The demand fo r turnover arises fro m the danger o f capture and

c o n s e q u e n t b ias , on which account o n e would wish fo r recall to be

possible or for term limits to be short. Doing the latter, however, would

compromise the scope fo r action and continuity o f p o licy if the offi c e

h o l d e r happened to b e exe mplary.

Implications for Governance Design

Since the elections of 1 992 , political thought and practice have groped,

albeit imperfectly, to seek to ameliorate the problem of succession and

intertemporal credibility of commitment under the existing system. Chief

among this has b e e n the practice o f the incumbent " a n o i n t i n g " o r of

handpicking the p utative successor, as practiced by Coraz6n Aquino, who

1 22

Centralization, Political Thrnover, and Investment in the Philippines

endorsed Fidel Ramos as her successor, and also by Ramos who picked

Jose d e Venecia to succeed him. The success ion practice has been far

from perfect, however, having worked only once in two instances (Aquino

being succeeded by Ramos) . Obviously the criteria for "anointment" can

vary and may have little to do with what is needed to sustain a credible

reform commitment. Hence , for instance, a putative successor may be

selected mainly i n order to protect the incumbent and his asso ciated

interests against polit ical retaliation .

More ambitious attempts to resolve the succession issue have taken

the fo rm of s e eking t o change the r u l e s themselve s . This was m o s t

obvious in t h e initiatives encouraged-if not actually initiated-by ele

m e n t s of the R a m o s a d m i n i s t r a t i o n in late 1 9 9 7 t o a m e n d t h e

Constitution. The proposed amendments would have allowed t h e presi

dent to run for reelection, removing the present constitutional ban. The

reason given by the proponents of the move was the n e e d to ensure

continuity in pol ic ies . S ince the Ramos administration had been singu

larly successful in reviving and sustaining economic growth, i t was fel t

by some that it should be given a chance to continue i ts policies rather

than risk change. A variation on this proposal is the adoption of a long

standing proposal to shift to a parliamentary system, whose main merit

is seen in the continuity it allows, since no statutory term limits are set

for a prime minister.24 Moves to amend the charter in 1 997 were aborted

after strong o p p osit ion by a cro s s - s ect ion o f the popUlat ion, who re

garde d the initiatives (not without reason) as s elf- s e rving attempts o f

politicians to extend their tenure. I t d i d n o t help that, in a n obvious case

of l o groll ing, i . e . , po l itical horse trading, the amendments would also

have extended the terms of lawmakers who would pass on them. None

theless , term l imits and succession are deep structural issues that refuse

to go away. The administrati o n of Pre s i d e n t Joseph E s trada d e clared

itself open to the idea of constitutional change and had created a com

mission t o recommend amendments for the purpose . The Lower House

of Congress had, in the meantime, continued to work on a bil l to declare

Congress a constituent assembly to propose constitutional amendments .

In both instances term limits were certain to loom large as an issue .

From the viewpoint o f this chapter 's an alys is , recent p o l i t ical de

bates on the issue of term l imits in the Phi l ippines are unfortunately based on plausible but incomplete premises. 2s Those opposed to changes

in present term l imits view the p r o b l e m as s imply one o f p revent ing a

relapse into dictatorship and the risk of extreme bias that it entai l s . This

is certainly i nadequate, however, since i t denies or minimizes the p ro b -

1 23

1

...


lem of instability and credible commitment under the current system. At

the very least , a trade - o ff b etween the two must be acknowledged. O n

t h e other hand, those w h o appear correctly to perceive t h e problem of

instability, or what we have called credible commitment, seek implicitly

to solve i t not by questioning the importance o f strong central p ower,

but instead working solely for the suspension or extension of term l im

its . I n neither case i s the current state o f power c o n centrated i n the

p r e s idency questi o n e d . By c o n trast , our framewo rk points to s trong

centralizatio n itself as an ess ential reason fo r interregime uncertainty

and instabi l i ty. The c o n c e ntrat i o n of p ower i n the pres idency in the

Philippines is what makes even p redetermined turnovers unsettling and

fraught with uncertainty. An alternative proposal to interregime uncer

tainty, therefore, i s that o f weakening presidential p ower. Put another

way, if presidential discretion and p ower were much reduced, then the

issue of term limits would command much weaker interest .

A weakened presidency, to b e sure, carries its own consequences. As

already observed, central p ower emerged also in response to the "com

mons" problem. Nonetheless , as against insisting on extending term lim

its , reducing central p ower has the advantage o f not raising the stakes

o f state capture and the risks of extreme bias . As seen from the resistance

to the Marcos dictatorship as well as the Ramos administration's failed

attempt to amend the charter, all past efforts to increase central power

and l engthen term l imits h ave invariably l e d t o ser ious problems o f

legitimization , provoked d e e p suspicion, a n d generated massive social

opposit ion. It is valid to ask whether the social costs and goo dwill in

curred in such efforts can b e reasonably recouped by the putative ben

efits o f the changes endorsed. Indeed, i t i s l ikely that the oppos it io n

p rovoked by such efforts could themselves lead to the uncertainty and

investment instab il i ty they had so ught to avo i d .

I t is submitted h e r e i n s t e a d t h a t credible c o mmitment to pol icie s

would b e b e s t achieved if incumbents progres sively and irrevers ib ly

reduced their own s c o p e fo r discret ionary behavior, s ince that would

also reduce their successors ' leeway fo r reversing such policies . This is

one way to understand how privatization and deregulation work in stimu

lating business confidence; these are commitments to reduce discretion . cr;

As a corollary, a weaker presidency would imply the devolution of

more functions to other p arts of the government, no tably the bureau

cracy a n d local governments . An imp ortant reason for p o licy instability

across regimes is the turnover- related changes in appointments . Stabi l

i ty o f tenure up t o a c e rtain level o f the government would p rovi d e

1 24


p olicy continuity and consistency, notwithstanding frequent changes in adminis tratio n . In the Phil ip p i n e s the b ureaucracy is underp aid and defic ient i n training and qualificati o n s , making i t vulnerable b o th to patronage politics and corruption. I t is common practice in the country for winning candidates to treat government appointments as spoi ls to be distributed. While personnel changes in other countries of the region extend to two levels , involving those of secretary and undersecretary or their equivalents , p olitical appointees in the Philippines frequently go down to six levels , affecting positions as far as those of regional director and service director ( World Bank 1 997c, 93) . It is common that upon every change in administration, new appointees go through a learning period, while the bureaucracy itself is constrained to abandon projects associated with the p revious administration and p erforce concoct new ones more in keeping with the tastes of the incumbentY Security of tenure, higher p ay, and better training would go a long way toward improving the bureaucracy's autonomy and also ensuring p olicy continuity.

Similarly, a further devolution of central powers to local governments

would reduce the importance of the outcomes of national contests, since

it would remove sole discretion fro m national agencies and vest these

instead to local governments . Local devolution is a process that began in

1 99 1 with the passage of the Local Government Code and may usefully be

carried further. It may be argued, of course, that devolution merely shifts

discretion fro m one l evel o f the government to another, and that local

tyrants and warlords on their own turf may treat investors more arbitrarily

than a national dictator would. The big difference l ies in that investors

under a decentralized regime would have choices among different loca

t ions and regimes , effectively achieving a competitive regime. I n such

circumstances, it is known (again, Shleifer and Vishny 1 993) that rents and

exactions tend to be small, as different local governments compete with

each other for investments. Where authority is redundant or replicab l e

(rather than monopolized)'

corruption rents are minimized, for i f the privi

lege (e .g . , some license or incentive) cannot be obtained from one loca

tion, then it may be obtained from another.

This insight may be extended to the global setting. To the extent that

a country is compelled to compete for trade and investment on an equal

footing with others, there is much less room for national authorities to

exercise discretion in changing the rules of the game, whether within or

across regimes, since the country must effectively compete with others

o ffering similar terms. As an upshot , the greater a country's commit

ments to global trade and investment rul e s , the less the scope for i ts

1 25


leaders (no matter how powerful they are internally) to arbitrarily change

these, since doing so would mean losing the business . One of the rec

ognized benefits of membership in such multilateral o rganizations as

the World Trade Organization ( WTO) , the Association of Southeast Asian

Nations (ASEAN) . or Asia Pacific Economic Cooperation (APEC) is that

it binds countries-regardless of changes in p olitical regimes-to cer

tain rules and norms of conduct. Though their results are likely to be in

greater dispute, loan conditions imposed by the International Monetary

Fund and the World Bank serve the same function . As a concrete ex

ample, compatibility with WIO rules has become an important deterrent

to otherwise resurgent protectionism; attempts to reimpose nontariff

measures on some products have been withdrawn for being WTO- i n

consistent. In effect, therefore, governments may choose t o reduce their

discretionary p ower by entering into global commitments; in this way

they also bind their successors , thus ensuring p olicy stability.

Finally, even Congress itself could do with some strengthening rela

tive to the presidency. This m ay seem initially surprising, since folk wis

dom already predicates that Congress has been too intrusive and obstruc

tionist, and sufficient examples exist of shortsighted and inept intervention

on the part of Congress.28 A proposal to expand these powers relative to

the Executive Branch may only worsen the situation of overlapping man

dates and gridlock. As argued above, however, the currently observed " ir

responsibility" by other branches of government is more likely part of an

expectational equilibrium, which precludes more rational behavior owing

to the assurance that the omnipotent presidency itself will always internal

ize difficulties and repair any damage . The fact that the chief executive

controls budgetary disbursements regardless of what Congress has allo

cated, for instance , makes i t futile for Congress to assume any responsi

bility in the magnitude of expenditures , or in the revenues needed to fi

nance them. It is arguable that the current expectational equilibrium would

change once the other branches of government realized that their choices

alone would decide final outcomes . H elping this along is a gradually

changing composition of Congress, which now sees an increasing share

of professionals, former civil servants , and new entrepreneurs.29 Nor is this

experience new; it is the same one that compels more and more local

officials to show prudent behavior once central functions and resources

are devolved to them. It is in this sense that we argue that a weaker presi

dency may make for a stronger state .

The demand for a more balanced relationship between the Executive

Branch and the legislature is also consistent with recent game- theory work

1 26


on the effects of power concentration and differentiation, in particular results obtained by Persson, Roland, and Tabellini ( 1 997) . For these authors the crucial elements for checks and balances are that ( l ) there should be some adversarial relationship between the executive and the legis l ature. and that (2) legislative decision making should require joint agreement bv both bodies. Mere separation of powers without the second requiremer;t simply leads to unbridled rent-seeking, which is analogous to Shl e ifer and Vishny's independent-monopolists result, where both executive and legislature seek to draw as much as they can from the "common pool " of public resources. Superior to this is a more centralized or authoritarian system (which Persson, Roland, and Tabellini call a "pure presidential " system without Congress) , s ince then, at least , the rent - seeking is not

competitive and is tempered by the desire to remain in office. Nevertheless, it can be shown that even better than a "pure presidential" system is

one where power is separated and checks and balances exist. The present system in the Philippines is somewhere in between a "pure presidential " sys t e m a n d o n e with genuine c h e cks and balances , alth o u gh t h e trivialization of the legislature and its control by the Executive Branch makes

the current system closer to the former than the latter. What is certainly important in the foregoing, however, is the suggestion that better economi� results may be obtained by taking the design of democratic institutions

more seriously, rather than simply abandoning them.

Conclusion

This chapter has argued that Philippine governance is at a crossroads

in its impact on economic performance. The polity has shirked from fur

ther costly experiments with dictatorship and instituted clear r u l es fo r

turnover and succession, as well as controls on discretionary behavior. On

the other hand, in recognition of the dangers of policy gridlock and double

marginalization , a strong central autho rity within democratic l i mits is

provided for. Based on the framework developed here , it is clear that such

a halfway house is unlikely to yield spectacular economic results . Helativc

to a well- run authoritarian government, the system is likely to extract m or e

corruption rents and generate greater policy instabil ity among investors.

In addition, policy instability and investment costs across regimes are also

likely to be greater than those of a "normally function ing" authoritarian

regime, owing to the infrequency of turnover in the latter.

Current discussions retlect the perceived tension hetvveen a social and

cultural commitment to democratic forms on the one hand and the need

to enhance economic performance on the other. In most national discus-

1 27


sions, the latter has been taken to mean a greater enhancement of central

power at the expense of other branches and levels of government, as well

as indefinite term limits for the executive. Not surprisingly, these ideas

have been taken to mean an endorsement of authoritarianism. We have

suggested, however, that the p erceived risk of extreme bias in these or

similar proposals make any further moves toward authoritarianism non

viable in the Philip p ines . Any such moves would likely lead to crises of

legitimacy and an intensification of interest-based political struggles, lead

ing to more erratic p rivate investment behavior. Instead, we have sug

gested that the problems of inter- and intraregime uncertainty b e dealt

with by reducing presidential p owers and prerogative through a more

determined devolution of executive power to the bureaucracy, local gov

ernments, Congress, the courts, and accession to multilateral agreements .

A final word is p erhaps in order regarding the country's relative per

formance in the Asian crisis . The Philippines has not been as badly af

fected as Thailand or Indonesia, and it may be asked whether the model

presented here can contribute something to an explanation. The technical

reasons for the weaker impact of the Asian crisis are certainly well known,

including the country's smaller debt-overhang, the shorter run-up to the

crisis, and better supervision of financial institutions. A more crucial ele

ment that should be taken into account, however, is that the country-in

contrast especially with Indonesia-did not experience a political crisis .

The obvious difference was that in the Philippines , unlike in Indonesia,

there was a prescribed electoral turnover, which in fact coincided with the

bottom of the crisis in 1 998 . The severe impact of the Asian crisis certainly

puts the adequacy and relevance of a country's institutions and system of

entitlements under scrutiny. It is an arguable proposition that the crisis

would have affected the Philippines more severely, ceteris paribus, if the

country had continued to be under the Marcos dictatorship. As it hap

pened, however, a political crisis was headed off, since the country had,

by that time, solved the problem of bias and legitimacy through the insti

tution of elections, providing a vent for any popular dissatisfaction.

The framework used here also suggests that the same institutions that

forestalled a political crisis for the Philippines may also prevent it from

recovering rapidly from the crisis . No changes in governance in the Phil

ippines have occurred that suggest that it will henceforth be able to grow

at rates shown in the past by high-performing East Asian countries. Invest

ment costs are likely to remain as high (and therefore investment just as

low) , owing to corruption rents and inter- and intraregime uncertainty. As

a corollary, it mllst be said that the same relative freedom of action on the

1 28


part of authoritarian regimes that created the opportunities for large gambles

(like investment i n strategic industries o r discrimination in favor of or

against certain groups) also carried the potential for enormous waste. When

large mistakes were made in the form of sectoral overinvestment or social

and economic discrimination, they laid the basis for social conflicts . Cen

tralization and indefinite tenure, therefore, created the potential for both

huge successes and colossal mistakes. It is the Philippines' misfortune (or

luck, depending o n how one views it) that it has avoided both.

APPENDIX A MODELAND TEST OF INVESTMENT WITH POLITICAL UNCERTAINTY

1 . Model. Suppose the price of one unit of investment goods is PI' and

the marginal unit of investment is expected to generate Q units of output.

Assume that Q is declining in the level of investment. For simplicity, let Q

= Z/lb, where b is a positive p arameter and Z represents the factors that

affect the profitability of investment, such as future national income, ex

pected government policy, terms of trade movements, etc. Suppose inves

tors face an infinite horizon of discrete periods. In each p eriod there is a

probability p of losing the returns on investment due to political factors .

Let the discount rate (excluding p olitical risk) be r and the depreciation

rate be 8 . The total expected return to the marginal unit of investment is :

TC ( l -p ) Q ( l -8 ) ( l -p J 2 Q + -------'---'-

( l + r)

Q

( l + r) -- - ( 1 -8 )

( l-p )

+ . . .

I f 8 i s small enough, ( 1 ) may b e approximated by

TC ( l -p ) Q

( r+p )

( 1 )

( 2 )

I f the interest rate i s i , the present value o f placing PI i n financial

markets would be iP/ r. In equilibrium, therefore, we must have TC = iP/r. Combining this with (2) and substituting for Q yields

r ( l -p ) blog I = log Z - log P - l o g i + log --I ( r-p )

1 29

( 3 )


The last term shows investment being inversely related to political

risk. Proxies for the first term are such variables as expected GDP growth,

expected government p olicy in response to current budget deficit and

inflation, expected balance of p ayments o r current account condition,

and expected terms of trade. We do not have the data for i, but omission

o f this variable should not affect the estimated coefficient of political

risk, since the inclusion of the budget deficit and inflation in the model

should control for the interest rate.

2. Empirical test. For the investment variable, we take total invest

ment as a p ercentage o f GDP over the p e r i o d 1 9 5 1 to 1 99 2 . We are

unfo rtunately unable to obtain a sufficiently long time series of p rivate

investment alone; hence, we resorted to running regressions of compo

n e n t s o f inve s t m e n t ( ag a i n , a s s h a r e s o f G D P) . that might c l o s ely

approximate p rivate investment . These include p rivate constructi o n

spending a n d investment in durable equipment. We also tried the sum

of these two as a p roxy.

To isolate the impact o n investment of a preelection year dummy,

which was our main interest , the following variabl e s were regressed

against total investment o r components of i t , as a proportion of GDP:

government deficit , accumulated current account deficits (a p roxy for

foreign indebtedness) . current account deficit lagged one period , the

terms of trade, the price of investment goods, and p rojected GDP growth.

Tables 1 and 2 in the text show typical results of regressions for three

investment variables (total investment, private construction, and p rivate

c onstruction plus durable equipment) . Inflation , the index for invest

ment goods prices , and p redicted GDP growth are generally significant

with the right signs . In other regressions (not included here) the other

variables also generally have the expected signs, and the regressions are

highly significant.

More important for our purposes , the coefficient of the preelection

year dummy is significant and negative for total investment and private

construction, though not quite so for equipment. (It is significant, though,

for private construction and durable equipment taken together.) Most

time series included in the model are AR ( l ) . and none has a unit root .

Including an autoregres s ive term in the regre s s i o n s is natural s ince

investment is serially correlated-investment projects take time to be

completed and usually span over a few years) . Using the Q - test , the

serial correlation of residuals is not significant .

1 30

CHAPTER SIX

GOVERNANCE, RENT - SEEKING, AND PRIVATE INVESTMENT IN MALAYSIA

lorna K S.

This chapter considers governance, rent-seeking, and private invest

ment in M al aysia from the late colonial period , i . e . , beginning in the

early 1 950s , and focuses on the periods s ince the introrluction of the

New Economic Policy (NEP) in the early 1 970s and the gradual "retreat"

fro m it s ince the m id - 1 9 8 0 s . It surveys the institutional evolution o f

postcolonial economic governance in M alaysia a n d its implications for

investment and growth, p articularly noting the changes under the lead

ership o f Prime M inister M ahathir M ohamad since the 1 980s . I t then

reassesses how the creation of rents and their deployment under the

New E c o n o m i c Pol icy ( 1 9 7 1 - 1 990) and u n d e r M ahathir 's l e adership

( l 98 1-present) have been primarily oriented toward interethnic redis

tribution , but have also sought to sustain investment and growth. In

particular, it shows how Mahathir's policy reforms have sought to mini

mize the apparent incompatibility between these two obj ectives. Finally,

it considers how these institutions o f rent creation and rent - s e eking

affected and continue to affect Malaysia's vulnerability to the East Asian

crises since mid - 1 997 .

The Postwar Economy in a Nutshell

In the p o s t - Second World War per iod , Malays ia experienced rela

tively rapi d growth , particularly during the Ko rean War boom, the oil

boom of the 1 970s and the relocation of East Asian industry into South

east Asia and China since the late 1 980s . Since 1 95 5 , the same rul ing

coal it ion has been continuously in p ower at the dominant federal level.

though the nature and degree of state intervention and publ ic - sector

1 3 1

I

Brian

Sticky Note

Unmarked set by Brian

n., !; !

Governance, Rent- Seeking, and Private I nvestment in Malaysia

expans ion had changed c o n s i d e rably, almo s t coming full circle by the

m i d - 1 99 0 s from the s i tuat io n fo llowing i n d e p e n d e n c e in 1 95 7 .

M alaya, a n d t h e n M alays ia , achieved impressive growth rates , c o n

s iderable infrastructure development, some economic d iversification (see

figure 1 ) i n agriculture and i n d u stry, imp roved soc ial s e rvices , amo n g

others , after independence and particularly during t h e 1 960s . Planning

has a lso grown i n s o p h i s t i c at i o n , i n terms o f i n fo r m a t i o n gather ing ,

preparation, and implementat ion , especial ly with the growth of the public

sector and increasing state intervention under the NEP The political and

economic i nterests of the dominant pol i tical interests have been largely

reflected and furthered by development pol ic ies . D evelopment pol ic ies ,

p l a n all ocat ions as well as implementat ion h ave reflected the nature ,

rol e , and or ientat ion of the s tate , the d o m i n a n t p o li t i c ally i n flu e n tia l

bus iness interests as wel l as their p o l it ical a n d e c o n o m i c pr iori t ie s .

Figure 1 G D P Shares by Sector in Malaysia, 1 960- 1 995

1 960 1 965 1 970 1 975 1 980 1 985

_ Agriculture _ Mining Manufacturing

1 990

Services

1 995

After i n d e p e n d en c e i n 1 9 5 7 , and i n part icular from the 1 960s , the

M a l ays ian economy dive rsified fro m rubber and t i n , the twin pil lars of

the colonial economy. H e l p e d by favorabl e commodity prices and some

early success in i m p o r t - s u b st i tut ing i n dust ri al izat i o n , the M alayan and

132

Governance, Rent-Seeking, and Private Investment in Malaysia

then M alaysian economy sustain e d high growth with low inflation u n t i l

the early 1 9 70s . The average an nual growth rate of the gross d o m est ic

product ( G D P ) in p e n i n s u l a r Malays i a was 5 .8 p e r c e n t during 1 9 57-

1 9 70 ( Hao 1 9 76 ) , whi le the G D P for the whole of M a l aysia rose by an

average of 7 .8 percent per year between 1 9 7 1 and 1 980 despite greater

i n s tabi l i ty ( M al aysia 1 9 8 1 ) . M a l ays i a's e c o n o my has grown rapidly by

internati o n al s tandards , with gro s s domest ic product ( G D P ) ave ragin g

about 7 p ercent over t h e last three decades . After experiencing unprec

e d e n t e d n e g a t ive growth i n 1 9 8 5 , due t o d e fl a t i o n ary p o l i c i e s i n

res p o n s e t o fis c al a n d debt cr ises a s well a s the col lap s e o f pr ices o f

several key commod i ty exp o rts , t h e M al aysi a n economy h a s susta ined

rapid expans ion s ince 1 987 . M eanwhile , inflat ion has been brought down

below 5 p e r c e n t per annum.

M alaysia has experienced generally favorable external circumstances

although rub b e r pr ices decl i n e d in the 1 96 0 s compared to the 1 9 5 0 s .

Ext e r n al c o n di t i o n s w e r e g e n e ral ly favo rable d u r i n g t h e 1 9 7 0 s . T h e

overall b alance of payments (for both capital a n d current accounts) was

p o s i t ive throughout the d e c a d e , d e s p i t e a n o i l - shock- i n du c e d r e c e s

s ion i n 1 973- 1 974 . During this period, the principal export commodit ies

were rubb e r, t in , s avved logs , p al m oi l , and p etrole u m . Pr imary c o m

m o d i t i e s a c c o u n t e d fo r 78 p e r c e n t o f t o t a l exports i n 1 9 70 a n d for 7 1

percent i n 1 980 , before decl ining to 55 percent in 1 985 and 1 5 . 9 p ercent

in 1 99 6 . S ince the 1 980s , t h e ranking of primary commodit ies in terms

of contr ibution to export earnings has been p etroleum and gas , t i mber

(sawed l o gs a n d sawed t imber) , palm o i l , and rubber ( the order m igh t

have b e e n temporarily tran s p o s e d i n except io nal years , e . g . , w i t h t h e

collapse of p alm oil or p etroleum p rices ) . The exp ort orientation o f t h e

M al ays i a n e c o n o my s i n c e t h e l a t e 1 9 6 0 s h a s b e e n s u s t a i n e d b y

M alaysi a's n e w i ndustr ies that are largely exp o r t - o r i e n t e d .

Primary commodity production continued to dominate t h e eco n o m y

i n the ea rly years aft e r i n d e p e n d e n c e . I n fac t , M alays ia e x t e n d e d i t s

colon ial p r e e m i n e n c e i n rubber, t i n , and p e p p e r to palm oi l and t r o p i

cal hardwo o d s . Petro leum grew fro m the m i d - 1 9 7 0 s , and p e t ro l e u m

gas as well as cocoa product ion b e c ame i ncreasingly s ign i fi c a n t fro m

the early 1 9 805 . Agriculture 's share of G D P has fal len fro m 3 1 p e rc e n t

i n 1 9 70 to 13 p e rcent i n 1 99 6 , whi le manufac t ur i n g 's s h are h a s r i s e n from 1 2 p ercent i n 1 9 70 to 3 5 percent in 1 99 6 . Economic l i b eral izat io n

and renewed exp o rt - l e d growth fro m the m i d - 1 9 8 0 s h a v e a l s o ac c e n

tuated the o p e n n e s s o f M al ays ia's e c o n o m y i n re c e n t years . W h i l e t h e eco n o my has l o n g b e e n o p e n , t h e rat i o o f e x p o r t s to G N P h a s r i s e n

1 33

,

Governance, Rent- Seeking, and Private Investment in M alaysia

from 43 percent in 1 970 to 60 percent in 1 985 and 82 p ercent in 1 99 6 .

M e anwhi le , the e x p o r t s h a r e o f pr imary c o m m o d i t i e s has fal len fro m

78 percent in 1 970 to 1 6 percent in 1 996 , with manufactures ' share ris

ing fro m 12 p e r c e n t t o 8 1 p e r c e n t over the same time p e r i o d (Bank

Negara Malaysia Annual Report, March 200 1 ) .

Investment Policies

Malaysian economic development has been shaped by the nature of

the ruling regimes and their respective agendas for national economic

development . The colonial period is depicted as one of laissez-faire, al

t h o u gh there i s evide n c e of c o n s i d e rable bias in favo r o f B ri t i sh

investments-against other foreign as well as domestic (especially Chi

nese) investments-particularly in determining access to that crucial asset

of a colonial economy built on the production and export of rubber and

tin, namely, land. All regime policies envisaged or at least implied different

sources of and roles for public as well as p rivate investment, including

foreign direct investment (FDI ) . Since M alaya attained independence in

1 95 7 , i t seems useful to distinguish three different p o s tcolonial regimes

with different development priorities as well as attitudes toward private

investments, which in turn affected the nature and consequences of access

to rents. This outline is followed by a more extensive review that seeks to

highlight the significant changes in the postcolonial era .

Postcolonial Economic D iversification

( Tunku Abdul Rahman, 1 95 7- 1 969)

The conservative postcolo nial All iance government was concerned

with checking B ritish capital divestment in the face of the uncertainties

of independen ce as well as the ongoing "emergency" against the com

munist - led insurgen cy. After independence , lais s e z - faire pol ic ies were

s t i l l g e n e rally pursued with s o m e e fforts at e c o n o m i c ( including agri

cultural and industrial ) diversification, greater rural development efforts

and relat ively m o d e s t but n o n etheless growi ng ethnic "affirmative ac

t ion" p o l i c i e s in favor o f ethnic Malays and other indigenous peopl es

( Bumiputera) . New investment incentives were offered to "p ioneer i n

d u s t r i e s " i n l i n e w i t h t h e gove r n m e n t 's " m i l d " i m p o rt - s u b s t i t u t i n g

industrial ization, which d i d n o t involve much publ ic sector investment ,

unlike the experience of " intermediate" regimes in other parts of South

e a s t A s i a . Var i o u s gove r n m e n t i n t e rv e n t i o n s thus c r e a t e d re n t s th a t

s e rved as i n c e nt ives to a t t ract i nvestments that w o u l d resul t in e c o

n o m i c divers i fi c a t i o n .

1 34


Growing State Intervention (Razak, 1 969- 1 976; Hussein, 1 9 76- 1 98 1 ; Mahathir, 1 98 1 - 1 985)

In the 1 970s, the New Economic Policy (NEP) involved increased state

intervention and public sector expansion (increasingly financed by p etro

leum revenues) , especially for interethnic redistribution. From the mid-

1 970s, some NEP measures deterred private investment by ethnic Chinese

as well as F D I . The NEP thus saw the state capturing, allocating, and

deploying rents for its redistributive goals. Meanwhile, the government's

new exp o rt- oriented industrialization policy, mainly involving new pol i

c ies and incentives (Le . , access to new rents) attracted FDI. In the early and

mid- 1 980s, the government-sponsored joint ventures with Japanese firms

to develop h eavy industries in the face of declining p rivate investment

from the mid - 1 970s. Though the NEP was widely seen as predatory and

exclusionary of the mainly Sino - M alaysian businesses in the national

economy, FDI continued to be encouraged-partly for countervailing rea

sons , especially for the relatively insulated, internationally competitive

exp o rt -oriented enclaves , such as fre e trade zones (FTZs) .

Partial Deregulation and New Regulation (Mahathir, 1 986-present)

Ringgit depreciation and p artial economic deregulation from the mid-

1 980s were accompanied by privatization, improved o fficial sup p o rt for

the p rivate sector ( " M alaysia Incorporate d " ) , increased investment in

centives , regressive "supply side-oriented" tax reforms and other p olicies

that encouraged p rivate investments . The more attractive business e n

vironment , including a n e w range o f investment incentives , attracted

F D I fro m Japan and other East Asian n ewly industrializing c o untries

(NICs) from the late 1 980s as well as greater domestic (including repa

triated) p rivate investments . The government also sought to accelerate

technological development besides contributing to the sustained e c o

nomic boom o f t h e last decade. O n c e again , a n e w regime defining the

conditions for access to rents (known as incentives ) has been a crucial

instrument of industrial policy, as in the two earlier postcolonial periods

identified above . Figure 2 shows the GDP and per capita GDP percent

age changes c o rrespo n ding with the above p eriodizat ion .

Colonial H eritage

Like so many other former c o l o n i e s , p o s t c o lo nial M alays ian h i s

tory h a s been shaped by developments of t h e colonial era. T h e colonial

authorit ies introduced the b asic governance framework within which

the M alaysian economy continues to function . Hence, M alaysian e c o -

1 3 5

� !

, i


Figure 2 Real Per Capita GDP and Annual GDP Growth Rates in Malaysia,

1 9 60- 1 99 5

RM ( 1 978 Prices) % Growth

Al l iance Phase NEP Phase Econ Libera l ization

- GDP % Growth - Per Cap GDP

n o m i c devel o p m e n t h a s b e e n greatly s h ap e d b y t h e ins t i tut ions o f

governance i mp o s e d by B ri t i sh co lo nia l i sm and the s u c c e s s o r p o s t

colonial state , though t h e relationship between economic transformation

and governance has been quite dialectical .

Malaysia's growth record in the last century h a s b e e n quite impres

sive. During colonial times, M alaya was, by far, Britain's most profitable

colony, credited with p roviding much of the export earnings which fi

nanced British postwar reconstruction . The openness of the M alaysian

e c o n o my-high even by deve l o p i n g country s t a n d ards-has b e e n a

feature of the structural transformation it has undergone, especially since

the British colonial period. Only a few types of industries were allowed

to develop by the c o l o nial authorit ies , who generally c o nsidered the

colonies as suppl iers of raw materials and importers of m anufacture d

goods . M o s t industrie s were set up then to reduce transport costs of

exp orted or imported go o d s , such as for refining t in ore and b ottling

imported drinks . Local industries developed most when economic rela

tions with the colonial p owers were weak, e . g . , during the First World

War, the Great Depress ion, and the Japanese occupat ion .

1 36

Governance, Rent-Seeking, and Private Investment in Mal . aysla

M al aysia's economic infrastructure, such as railways ro ads il ·

. ' al l' fi

' , P O r t s , u t lties-so CruCI lor pro table capitalist investment-was generall y more developed than in most other British colonies . Such infrastructure con -struction was p aid for by taxes levied on the population b y t h e co lo nial government. Colonial monopolies thwarted the development of a strong local entrepreneurial c lass producing for the domestic market; instf'ad , local businesses found it more profitable to engage in production for export, commerce, and usury. Although the Malaysian economy has changed sig

n i fi c antly s i n c e i n d e p e n d e n c e , m any d i ffe r e n c e s refl e c t i n g u neven

development can be traced to the crucial formative decades under colo

nial rule that shap e d the economic structure . Ethnic differences often

coincided with class and occupational differences originating in the colo

nial economy. Ethnic Malays remained l argely marginal to the growing

capitalist sector, with the Malay elite integrated into the colonial state

app aratu s , and the masses remaining i n the countryside as p easants .

Emerging business opportunities were mainly taken by some of the more

urbanized and commercially better connected Chinese.

Postcolonial Economic Diversification

The fo r m a t i o n of M al ays ia in S e p t e m b e r 1 9 63-wh i c h i n c l u d e d

Singap o r e , S ab ah and Sarawak-was p u s h e d through by the B ri t ish ,

although Singapore seceded i n Augu s t 1 96 5 . The Merdeka ( I n d e p e n

d e n c e ) Constitution largely preserved the colonial legal and admin i s

trative framework, especially t h e protection of property rights of British

b u s i n e s s i n t e r e s t s . B e s i d e s p r o vi d i n g the framework fo r a l o o s e l y

We s t m i n s t e r - s tyle p ar l iamentary sys t e m , i t i n c l u d e d p rovi s i o n s fo r

"Mal ay p rivilege" for the purpose of ethnic affirmative action , not only

on the basis of the historical economic deprivation of the community,

but also because of the M al ay claim to be ing an indigenous p e o p l e .

The federal administrative framework devolved authority over land and

other natural resources to the state governments .

With independence, the Alliance-a coalition of the political elite from

the three major ethnic groups-formally took over state power and politi

cal jurisdiction over postcolonial Malaya. Not unlike other newly indepen

dent countries , the postcolonial government embarked upon a program

of economic development emphasizing economic diversification and in

dustrialization . I n preparing for this polit ical transition, the British had

ensured that the radical nationalist and leftist forces who threatened their

economic interests were contained, while ethnic elite committed to pro

tecting British interests were trained to eventually inherit state power after

1 3 7

I

r

, i


independence in 1 95 7 . A basically probusiness environment was thus

assured . As a result, the postcolonial government continued to promote

private enterprise, while the economic interests of the former colonial power

were protected and greater foreign investment inflows encouraged .

Besides consolidating colonial property rights in the postcolonial

period to forestall capital flight, which had begun in the late colonial

period in the fifties, the independent Malayan government extended the

framework for governance to complete the transition from colonial sta

tus to nationhood, e .g . , with the establishment of a central bank. Various

rural and regional develop m e n t efforts s ought to s e cure the crucial

political support of rural Malays for the multiethnic ruling coalition, the

Alliance. New labor legislation replaced the special regulations created

during the emergency against the communist-led insurgency ( Jomo and

Todd 1 9 94) . New legislation and institutions were created to promote

import - substituting industrialization .

The Alliance government's p olicies reflected t h e interests a n d politi

cal compromise it embodied. Consistent with this compromise, the state

pursued a modest development strategy with minimal state intervention

except to diversify the economy and ensure suitable conditions for rapid

capital accumulation. The p ostcolonial government was committed to

defending B ritish interests in M alaya, which also enabled the predomi

nantly Chinese l o c al bus inesses to consol idate and strengthen their

position. The government also made some modest attempts to promote

the interests of the still nascent Malay business community, while un

dertaking more ambitious rural development programs to consolidate

rural M alay electoral support .

Government agricultural development policies have been essentially

conservative . The main thrust of rural development efforts involved new

land development by the Federal Land Development Authority (Felda) ,

other measures to increase agricultural productivity and rural incomes ,

as well as the provision of rural facilities , such as roads, schools, clinics ,

irrigation. Rural development was thus constrained by the government's

reluctance to act against p olitically influential landed interests . Mean

while, although biased and conservative , postcolonial rural development

efforts contrasted with British colonial neglect, especially in the prewar

period . Initially, such efforts were aimed at consolidating a polit ically

suppo rtive and loyal M alay yeoman peasantry without drastic redis

tributive measures.

Economic divers ification effo rts to reduce Malaysia's overreliance

on t in and rubber were carried out on two main fronts . Plantat ions ,

138


inc luding a n increas ing number of F e l d a - s p o n s o r e d s c h e m e s , were

encouraged to grow other crops , p articularly oil palms. The state also

encouraged manufacturing by offering incentives , p roviding infrastruc

ture and other supportive economic measures . The government also

encouraged industries to manufacture p reviously imported goods. Most

of these import-substituting industries were subsidiaries of foreign com

panies, finishing goods produced with imported materials for profitable

sale within the p rotected domestic market. Many of these industries only

replaced imports of finished goods with semifinished goods ( e . g . , the

automotive assembly industry) . The technology used, usually o riginally

developed in foreign conditions, was typically imported from the p arent

company abroad, often generating relatively little employment.

By the mid - 1 960s, it was quite clear that import- substituting indus

trialization was slowing down, due to the limited domestic market, and

generating little employment owing to the capital - intensive nature of

the industr ies as well as l imited l inkages to the rest o f the nat ional

economy. I n the second half o f the 1 960s , the government moved to

ward exp o rt - o riented industrializatio n , with the establishment o f the

Federal I n dustrial D evelopment Authority (now the Malaysian Indus

trial Development Authority, or M IDA) .

The Industrial Incentives Act was passed in 1 968, offering a different

set of incentives oriented to attracting more labor- intensive export-ori

ented industr ies as c o m p ared with those o f the i m p o rt - substituting

industries developed under the Pioneer Industries Ordinance of the pre

vi o u s d e c a d e . Lab o r l e g i s l a t i o n was a m e n d e d during t h e State o f

Emergency (May 1 969) to help create a n industrial relations climate more

attractive to these new industries by limiting trade union o rganization

and activity, and allowing women to work around the clock, i . e . , in shift

work. In the early 1 970s, the Free Trade Zones Act p rovided the legis

lation for the d evelopment of export -processing zones. Together with

other new incentives , free- trade zones and other facilities were set up for

this purp o s e . The new exp o rt - o riented industries seeking cheap labor

reduced unemployment as well as wages until the fall in unemployment

pushed wages up once again in the late 1 9 70s and early 1 980s .

As e thnic M al ay demands fo r i n c r e a s e d e ffo rts to e c o n o m i c ally

advance the community mounted in the mid- 1 960s, new institutions were

set up fo r this p u rp o s e , o ften in the form of publ ic or state - owned

enterprises (SOEs) . However, the p rivate sector- o riented development

strategy of the 1 960s largely precluded more direct government participation in p rofitable activities, which were left to private business interests.

1 39

Governance, Rent-Seeking, and Private I nvestment in Malaysia

Hence , a relatively low proport ion of public deve lopment expenditure

was allocated to commerce and industry throughout the 1 960s . Increased

budgetary all ocations for education partly reflected the increased util i

zation of educational expenditure t o create a Malay middle class a s well

as meet ing the human resource r e q u i rements of the rapidly growing

and m o d ernizing M alays ian economy.

Income distribution in the 1 960s saw a growing gap between urban

and rural res idents and growing inequality b e tween the maj o r ethnic

gro u p s , with the M alays fall ing furthest behind. I ntraethnic economic

inequality was at its nadir in 1 95 7 , but by 1 970 was at its peak. Rather

than increasing class t e n s i o n s , the inequality was p e rceived i n racial

terms, in large part because of the increasing political mobilization along

ethnic l i n e s . H e n c e , M alay r e s e ntment of dominat ion by capital was

expressed primarily against ethnic Chinese , who comprised the b ulk of

bus inessmen , while n o n - M alay frustrations were directed against the

M alay- dominated state .

Such widespread ethnic percept ions resulted i n ethnopopulist op

p o s i t ion to the rul ing All iance government o f the 1 96 0 s . The general

election results and "race riots" of May 1 969 reflected the ethnic dimen

s i o n s o f the new p o s t c o l o nia l s o c i o e c o n o m i c o r d e r. M eanwh i l e , the

e merging M alay middle c lass , who e nj oyed nominal p o l it ical contro l

after independence, perceived the decline of British economic hegemony

giving way to Chinese ascendance . They b ecame more assert ive fro m

t h e mid- 1 960s , establ ishing clear pol i t ical dominance after M ay 1 969 .

Increased State Intervention, 1 970- 1 985

First announced in 1 970 , the New Economic Policy (NEP) sought to

create the socioeconomic conditions for "national unity" after the race

riots of May 1 969 through mass ive economic redistribution programs to

achieve its twin prongs of "poverty eradication" and the "restructuring of

soc iety. " The NEP 's Outl ine Perspective Plan (OPP) envisaged the inci

dence of p overty decl in ing from 49 p e rcent in p eninsular Malaysia in

1 9 7 0 to 16 p e rcent in 1 99 0 . " Restructuring soc ie ty" bas ically refers to

efforts to achieve interethnic parity in occupations and corporate wealth

ownership. The NEP sought to eliminate the identification of race with

economic function, primarily through ethnically differentiated financing

o f, and control led access to , tert iary level educatio n as well as public

s e c t o r e m p l oyment . The O P P also exp e c t e d to ra i se the B u miputera

(native M alay) share of corporate e quity from 2 . 4 percent in 1 970 to 30

p e rcent in 1 99 0 .

1 40

Governance, Rent-Seeking, and Private I nvestment in Malaysia

In the mid - 1 970s , petroleum production-off the East Coast of Pen

i n sular M alays ia-began providentially, as o i l prices so ared from 1 9 73 o nwar d s . The federal government qui ckly pushed through t h e Petro

leum Development Act of 1 974 to ensure its captur ing the l i on 's s h a re

of oil rents. Under the Federal Constitution, the state governments wou l d

have gotten t h e lion's share instead. Since the early 1 980s , petroleum gas

production-almost exclusively for export to Japan-has offered further

pr imary c o m m o d i ty earnings . Whi l e o i l rents susta ined m u c h o f the

public - s ector exp ansion from the mid - 1 970s unt i l the early 1 9 80s , they

have a lso been used to salvage and promote government- owned enter

prises s ince the mid - 1 980s . M al aysi a's largest b ank in the 1 98 0 s , Bank

Bumiputera M alaysia , was rescued twice-first in the mid - 1 980s after the

Bumiputera M alays ia Finance (BMF) s c andal i n Hong Kong, and then

again after the mid- 1 980s recession . The government poured large sums

into p restige p roj ects , such as the D aya Bumi p roj ect in the mid - 1 980s

and bui lding the world 's tal lest bui lding , the Kuala Lumpur City Centre

twin towers , in the mid- 1 990s .

D evelo p m e n t p olicy in the 1 9 70s aft e r the declarat ion o f the N E P

s aw gre ater s t a t e intervent ion in fi s c al resourc e allocat ion as w e l l a s

public s e c t o r ownership a n d control of business enterpri ses . F r o m t h e

1 960s , a n d especially in t h e 1 970s , t h e state established a large number

of p u b li c e n t e r p r i s e s i n all s e c t o r s , s o m e t i m e s i n co l lab o r a t i o n w i t h

private capital . The two main types of S O E s are statuto ry bodies estab

l ished by special legislation, and those o p e rating as private companies

registered under the 1 965 Companies Act. The major SOEs owned by the

federal , state , and regional authoritie s , in turn , have many subsidiar ies

and j o int ventures .

Public or state- owned enterprises were first introduced for t h e pur

pose of ethnic affirmative action or positive discrimination from the early

1 950s, and had grown modestly from the mid- 1 960s and very much faster

in the 1 970s. From ten in 1 957 and twenty- two in 1 960, the number of SOEs

grew to 1 09 by 1 970, 656 by 1 980 and 1 ,0 1 4 by 1 985, before almost ceasing

to grow, except for a few privileged projects favored by the Executive Branch .

Since the mid - 1 9 8 0 s , SOEs have been accused of increasing the publ ic

debt and , more generally, of inefficiency; the ir accumulated losses have

wasted investment resources , increased the government 's financial bur

den and slowed down economic growth (Kamal and Zainal 1 989) . From

the mid - 1 970s , there was a rapid increase in domestic and external debt ;

very serious gaps in the current account balance also started to emerge

because of dec l in ing commo dity exp o rt pr ices a n d weak demand fo r

1 4 1


manufactured exports. Private investments outside of the oil and gas sec

tor were negative (World Bank 1 983 ) .

Figure 3 Public Sector Expenditure i n Malaysia, 1 966- 1 99 5

RM Mi l l ion Expenditure

80,000

70 000

60 000

50 000

40 000

30 000

20 000

1 0 000

o

_ Development Expenditure

_ Expenditure as % of GDP

Expenditure as % of GDP

80%

70%

60%

50%

40%

30%

20%

1 0%

0 %

Meanwhile, the public sector's share of GNP rose from 29 .2 percent

in 1 970 to a peak of 58.4 percent in 1 98 1 , before falling to 25.3 percent

in 1 993 . In 1 982, public sector expenditure contributed 4.8 percent to the

GDP growth of nearly six percent, but s ince 1 984, its contribution to GDP

growth has declined (see figure 3) . The growth of SOEs from the 1 970s ,

especially heavy industries in the early 1 980s , had been accompanied

by declining capital productivity in the economy. The average incremen

tal capital-output ratio ( lCOR) rose from 2-3 in the 1 970s to 5-6 in the

early 1 980s while the public sector ICOR rose from 6-7 in the 1 970s to

1 5- 1 6 in the first half of the 1 980s .

Poor coordination and accountability of the SOE sector were very

evident . For instance , of more than 900 identifi e d SOEs in 1 984 , t h e

Ministry of Public Enterprises could only report annual returns for 269

enterprises , which recorded an accumulated loss o f RM 1 3 7 . 3 mil l ion

(Supian 1 988) . Their rapid growth has also involved generally inefficient

state intervention, almo s t s ingularly committed to interethnic wealth

redistribution, ostensibly favoring the politically dominant, but economi-

142


cally deprive d , indigenous community. In e ffect , however, such inter

vent ion has p ri m ari ly advan c e d the i n t e r e s t s of s e l f- aggran diz i n g ,

politically influential rentiers including some non- Bumiputeras , rather

than genuine entrepreneurs, thus preempting achievement of industrial

policy 0 bj ectives .

Malaysia experienced a severe economic recession during the mid-

1 980s due to a manifold combination of economic problems. Worldwide

influences, such as the global recession, tighter international l iquidity,

higher real interest rates after the debt crisis from the early 1 980s, lower

primary commodity prices , reduced international demand for manufac

tured exp o r t s ( e s p e c i al ly e l e c t r o n i c s ) and r e d u c e d fo re ign p rivate

investment inflows would have been difficult enough. The s e j o ined ,

however, with an overall decline ( largely due to p redatory p olicies d i

r e c t e d at e thnic Chinese b u s i n e s s interests ) i n d o m e s t i c p r ivate

inve s t m e n t a n d c o n centrat i o n o f r e m a i n i n g p rivate inve s t m e n t in

non tradeable sectors (e.g. , property, construction) , poorly chosen public

investments concentrated in heavily protected import-substituting heavy

industries (some of which also fai led on technical grounds) , as well as

deflationary fiscal and monetary policies beginning in 1 982 (except for

the prime minister's priority proj ects) .

Dur ing the 1 9 8 0- 1 9 8 2 i n t e r n at i o n al r e c e s s i o n , t h e gove r n m e n t

a d o p t e d countercyclical budgetary pol ic ies ( increasing p u b l i c s e c t o r

consumption , investment a n d employment) , which undermined gov

e r n m e n t fi s c al d i s c i p l i n e . Whi l e the gove r n m e n t may h ave

underestimated the nature and gravity of the recession, and therefore

thought it could spend its way out of it, the new Mahathir administration

(from mid- 1 9 8 l ) probably also hoped to s ecure a new electoral man

date through such generous deficit spending. Right after winning the

April 1 982 general election, the government announced an austerity drive,

cutting back public spending and abandoning the earlier e ffort to in

crease publ ic sector employment.

During the mid- 1 980s , private investments dropped fro m RM 1 3 . 3

billion i n 1 984 t o R M 1 0 . 1 billion i n 1 986, before rising again t o R M 1 0 . 5

b i l l i o n i n 1 9 8 7 . P e r h a p s more s ignificant ly, p r ivate inve s t m e n t as a

percentage of GNP had been declining since the beginning of the 1 980s,

from 19 percent during 1 979-1 984 to 14.4 percent in 1 987 (Bank Negara

1 988, 2) . Foreign corporate investment declined by 19 percent from 1 984

to RM 1 . 7 billion in 1 985, and RM 1 .4 billion in both 1 986 and 1 987 (Bank

Negara 1 988 , 1 95) . Meanwhile, public sector investment was constrained

by reduced resource availab il i ty after the p rofli gacy of the early 1 980s .

1 43


H igh levels of p u b l i c s e c t o r inve s tm e n t c o u l d o nly be s u s t a i n e d by

b orrowing externally, yet glo b al interest rates were high and such bor

rowing would have resulted in massive ext ernal debt .

Figure 4 Public Sector Employment as Proportion of Total Employment in

Malaysia, 1 970- 1 99 5

Thousands Employed

!m

1m

700

fro

500

400

300

200

100

0 % 0

�

� Employment _ % of Total

�

% of Total Employment

1 8%

1 6%

1 4 %

1 2%

1 0%

8 %

6 %

4 %

2 %

0 %

m Very important, by the mid- 1 980s there was growing dissatisfaction

with the government among some o f the more capable Bumiputeras ,

both in the public and p rivate sectors . I n a high - p ro file conference in

1 987 , both private - and public - sector Bumiputeras criticized what they

considered unfair government interference in the b us iness world . By

this time , large M alay- controlled business groups had already emerged

i n the c o r p o rate s c e n e , and s o m e were c a l l i n g fo r a l e s s regulated

economy. Indeed, some o f them viewed excessive intervention as hav

ing slowed e c o n omic growt h . and hence c o u n t e r p r o d u c t ive to the i r

interests (Khoo 1 992 ) . I n other words . the government could no longer

even claim an ethnic M alay mandate fo r its role in the economy.

After the second Plaza Hotel meeting in New York in 1 985 , the Japa

nese yen began to appreciate greatly against other major world currencies ,

p articularly the US dollar. As the value of the currencies of most East Asian

industrializing economies subsequently rose, raising comparative produc

tion- especially labor-costs in the process, the Malaysian ringgit declined,

even against the U S d o l la r. The b o o m throughou t Southeast Asia that

1 44

1 Governance, Rent-Seeking, and Private Investment in Malaysia

followed from the late 1 980s benefited greatly from investments from the

firs t - tier East Asian newly industrializing countries (NICs) experiencing

rising production costs and tightening labor markets as well as enforcing

stricter environmental restrictions . Some deregulation of the M alaysian

economy from 1 986 has also b e e n a b o o n to investments , with most

businesses benefiting from, and hence supportive of, such liberalization .

The turning point for government p olicy thus occurred around 1 986 .

The maj o r p rimary commodity- p rice col lapse ( involving p alm oi l and

t in) and the low point of the electronics business cycle had occurred the

p revious year. After January 1 986 , when p etroleum fell to its lowest price,

external demand for M alaysian exp orts , mainly p rimary commodit ies ,

b egan t o recover, a lbe i t s lowly. The s tructural transformat ion o f t h e

M alaysian economy h a s accelerated , with the p rimary s e c t o r declining

in relative significance compared to the much more rapid growth of the

secondary and tert iary sectors .

Acknowledging the problems and limitations o f the state- led h eavy

industrial izat ion strategy-o ft e n dubbed the s e c o n d round o f imp o rt

subst i tut ion-of the e arly and mid - 1 9 8 0 s , the government s o u gh t to

e n c ourage p riva t e , i n p articular fore ign , manufacturing inve s t m e n t s ,

especially in m o r e technologically sophisticated, export -oriented indus

tries , through the enactment o f the Promotion o f Investments Act in

1 9 8 6 . The t iming was p e rfec t , as manufacturers fro m N o rtheast Asia

(especially Japan. and later, Taiwan) rushed to relocate their industries

and thus take advantage o f the enhanced i n c entive s . re latively g o o d

infrastructure . a n d l a x environmental regulations as well as compara

tively low production costs due to the new exchange rates. I nitially driven

primarily by such East Asian export- oriented manufacturing investments .

the M alaysian economy recovered significantly beginning in 1 98 7 . and

has maintained growth rates of over 8 p ercent per annum s ince 1 98 8 .

The policy changes of t h e mid - 1 980s thus appear t o have b e e n suc

cessful . The subsequent economic turnaround has encouraged the attr i

bution of the recovery to the policy changes. However. as the p receding

account suggests , several different developments were occurring at the

same time , and while al l may well have contr ibuted to the recovery, it

�s difficult to disaggregate their respective contributions. After all , growth

III most economies of Southeast Asia seems to have accelerated at around

the same time, i . e . , from the late 1 980s .

In 1 990 , the twenty-year period of the Outline Perspective Plan (OPP)

for Malaysia's New Economic Policy (NEP) came to an end . The ambi

tious NEP targets had been largely achieved by 1 99 0 . with the greatest

1 45

I I

Governance, Rent- Seeking, and Private Investment in Malaysia

progress pr ior to the m i d - 1 98 0 s . Despite s o m e c o ntroversy over the

reliability and comparability of official data , reduction in poverty inci

dence has been impress ive , declining to 1 7 percent in 1 99 0 from 49

p ercent in 1 970. By 1 990, ethnic proportions in economic activities and

o ccupations broadly reflected demographic shares except in agriculture

and government services , which are predominantly Bumiputera, and in

the still Chinese-dominated wholesale and retail trade . For eight well

remunerated professional categories , the Bumiputera share rose from 6

p ercent in 1 970 to 25 percent in 1 990, with inertia alone ensuring con

tinued increases in the Bumiputera share thereafter. Through government

regulation of business opportunities and investments as well as prefer

ential policies for Bumiputera businesses , the Bumiputera share of equity

in publicly listed companies rose from l .5 percent in 1 969 to 1 8 percent

in 1 983 and 20 percent in 1 990 . ( Various observers have advanced per

suasive arguments suggesting considerable official underestimation of

the actual Bumiputera share of corporate wealth . )

Yet despite the considerable achievement of specific o p p targets, it

is far from clear whether progress had been made in achieving "national

unity, " the N E P 's ostens ible purpose , usually interpreted in terms of

improved interethnic relations . Relations between Malays and Chinese

were arguably tense in 1 987 due to the political machinations of certain

ambitious government political leaders. With the economy booming again

by 1 990 , ethnic tensions had largely receded. However, regional griev

ances-especially in the states of Sabah, Sarawak, and Kelantan-had

become more pronounced , while ethnic minorit ies-both n o n - M alay

Bumiputeras and n o n - Chinese n o n - B umiputeras-were c learly more

marginalized and alienated than ever before .

Confirmation of the change in policy direction since the mid- 1 980s

came with the adoption of Vision 2020, seen to favor growth, modern

izat ion , and industrial ization over the NEP 's emphasis o n interethnic

redistr ibuti o n . Wh ile fo reign investors continued to b e courted, the

government has a l so l iberalized some conditions for local Chinese in

vestments . Chinese capital has also been encouraged by various oth er

reforms , such as eas ier access to listing on the stock marke t . greater

official encouragement of small and medium industries (SMIs l . gove rn

ment efforts t o mitigate t h e Industrial Coordination Act of 1 975 , a s well

as the overall emphasis on market . rather than regulato ry, measures .

More recently, the o fficial pol icy of encouraging local fi rms (especially large corporations) to invest overseas-where the scope for obstructive

or predatory Malaysian government intervention is reduced and the pros-

146

Governance, Rent -Seeking, and Private Investment in Malaysia

p e cts for M alaysian government support more l ikely-has b e e n per

ceived as a sign of good faith from the government that i t is committed

to reducing intervention. Average annual GDP growth hovered around

1 1 - l 3 percent i n the period 1 988- 1 99 2 . Although foreign direct invest

ment leveled off by 1 992, increased domestic investments-inspired by

greater domestic investor confidence-have sustained rapid growth.

Mahathir's Policy Reforms and the New Business Governance

Soon after Mahathir's ascendance to the prime minister's office in

mid - 1 98 1 . he announced his "Look East" policy. Initially, this policy was

widely be l ieved to refer to effo rts to e mulate s p e cific aspects of the

Japanese and South Korean success in economic development , e s p e

c ially industrial izat ion . T h e s e i n c l u d e d s t a t e intervention to develop

heavy industries (Pura 1 985) , state encouragement of the establishment

of Japanese-style sago shasha trading agencies (Chee and Lee 1 985) , ef

forts to get the government bureaucracy to better serve private sector

interests (Shahari 1 985) and even privatization . It was thus seen as in

volving a fairly wid e - ranging series o f init iatives to become a NIC by

emulating the Japanese and South Korean economic successe s .

F r o m t h e mid- 1 980s , M ahathir t o o k great p ains to define t h e Look

East policy more narrowly in terms of a new work ethic, labor discipline,

and productivity. Thus, the Look E a s t p o licy later a p p e ared to be a

campaign to boost worker productivity by inducing hard work and pro

moting m o re e ffe ctive modes o f labor disc ipline associated with the

Japanese. Looking East has involved more than abstract exhortations to

work harder as is sometimes suggested. The official emphasis on a new

Japanese- style work ethic refers to the official desire to induce greater

productivity by wage labor in an industrial capitalist context. In fact. the

real thrust of the campaign appears to be the promotion of labor dis

cipline by reorganizing industrial relations to promote company loyalty

(e .g . , company welfarism, in-house unions ) , increase productivity (e .g . ,

work ethic, more incen tive payments) , and reduce losses (e .g . , quality

control circles , zero- defect groups) .

At the same time, the Mahathir administration also advanced the

" M alays ia I n c o rporated" s logan in an effort to imp rove relat ions b e

tween the government and the private sector. This was designed t o get

the gove r n m e n t to re turn to its " t radit ional " role of s e rving p rivate

business interests in place of the heavy government regulat ion o f the

1 970s and e a rly 1 9 8 0 s . I n Malaysia , the s logan soon came to refe r to

efforts to curb and rectify "excesses" associated with overzealous imple-

1 47

r Governance, Rent-Seeking, and Private Investment in Malaysia

mentation of the NEp, especially by Malay bureaucratic elements, mainly

resented by Chinese business interests . Later, fro m the late 1 980s and

especially in the 1 990s , there have been growing signs of government

support for the private sector, primarily for p olit ically well - connected

Bumiputeras in the domestic economy, and also for non-Bumiputeras.

The growth of SOEs was reversed from mid - 1 980s as the govern

m e n t increased m o n i t o ri n g and control over these age n c i e s . Po l icy

changes under the Mahathir administration had reversed the previously

growing role of the public sector in the economy except for the expen

sive heavy- industry projects he favored. Even the growth of these were

checked in the mid - 1 9 8 0 s with the worsening e c o n o mic cri s e s . F o r

Mahathir, SOEs were only to serve a s temporary vehicles for creating a

Bumiputera entrepreneurial community. As Mahathir consolidated his

p osi t ion in the late 1 98 0 s ( after fending off p o l it ical challenges fro m

ruling p arty colleagues following the economic difficulties of the mid-

1 980s) , privatization increasingly became an important means for spon

soring, supporting, and subsidizing the emergence and consolidation of

new p olit ically well - c o n nected (but supposedly more competent) and

predominantly, but not exclusively, Malay rentiers . Budget constraints

on SOEs tightened slowly and unevenly, while those deemed profitable

or potentially lucrative s o o n became candidates for privatization.

Privatization in M alaysia was o fficially announced in 1 98 3 , after

M ahathir had taken over as pr ime minister and launched his he avy

industrialization program through j oint ventures between new SOEs and

p rivate Japanese and South Korean firms. Unlike the Look East policy

and the Malaysia Incorporated concept, which were also associated with

Mahathir 's administrat ion and app e ared to have faded in significance

by the mid- 1 980s, privatization achieved new vigor from the late 1 980s.

I t had the support and encouragement of powerful international agen

cies , was promoted by Daim Zainuddin (appointed finance minister in

mid- 1 984) , and was viewed as a partial solution to the worsening fiscal

and debt problems of the mid- 1 980s (see EPU 1 985 ) .

T h e M al ays ian gove r n m e n t h a s s u m m e d u p i t s argum e n t s fo r

privatization in the following five points :

• Relieving the financial and administrative burden of the govern

m e n t in u n d ertaking a n d m a i n t a i n i n g a vast and c o n s t a n t ly

expanding network of services and investments in infrastructure

• Promoting competiti o n , improved effic iency, and increased pro

ductivity of the services

148


• Stimulating private entrepreneurship and investment . . . to accel

erate the rate of growth o f the economy

• Assisting in reducing the size and presence of the public sector,

with its monopolistic tendencies and bureaucratic support , in the

e c o n o my

• Contributing toward meeting the objectives of the New Economic

Policy (NEP) , especially as Bumiputera entrepreneurship and pres

ence have improved greatly s ince the early days of the NEP and

are therefore capable o f taking up their share o f the p rivatized

s e rvic e s

T h e official rationale for privatization in Malaysia h a s b e e n refuted

on many grounds , and there is considerable evidence of abuses in the

implementation o f the p olicy ( Jomo 1 995) . Although privatization may

enhance enterprise efficiency to increase profits for the private owners

concerned, such changes will not necessarily advance the public interest

or consumers on the whole. Since a major portion of such activities are

public monopolies , privatization has largely handed over such monopo

l ies to p rivate interests l ikely to use related advantages to increase

profitability. Private interests have only been interested in profitable or

p o tentially profitable activities and enterprises , meaning that the gov

ernment has been stuck with unprofitable and less profitable activities

that will only worsen public sector performance, already considered less

than efficient. Public sector inefficiencies and other problems need to be

overcome, but p rivatization in M al aysia has primarily enriched a few

with strong p olitical connections who have secured and seem likely to

secure the most profitable opportunities , while public welfare becomes

increasingly vulnerable to the power and interests of private business .

Nevertheless, the significance of the policy cannot be underestimated.

Perhaps , most important, it signaled the end of the era of public sector

expansion-and possible "crowding out" of private investments. The pol icy

also offered many lucrative opportunities for investment as state assets

were disposed off at handsome discounts or with opportunities to capture

huge rents , thus stimulating private investments and promptly strengthen

ing the Bumiputera commercial and industrial community, or at least those

favored by the Mahathir government. Short-term gains for the government 's

fiscal balance were also immediately realized. Consumer welfare losses

due to increased user charges and the conversion of public into private

monopolies-were partially offset by initial public enthusiasm for improved

services as well as the retreat of the bureaucracy and the public sector.

149


Under Mahathir's leadership since 1 98 1 , and especially since the mid-

1 9 80s , the government has been more explicit in emphasizing growt h ,

modernization, a n d industrialization a s national economic priorities . Due

to the Malay political elite's preoccupation with constraining Chinese wealth

accumulation and the limited entrepreneurial abilities of the nascent Malay

rentiers who emerged under the NEP, Malaysia's industrialization strategy

imitates Singapore-more than Taiwan or South Korea-by relying o n

foreign, rather than domestic-led manufacturing growth. At the same time ,

s ince 1 986 , the private sector has been given greater opportunity at the

expense of the public sector with privatization and some deregulation of

economic investment in addition to new regulations .

On 28 February 1 99 1 , two months after the end of the OPP period ,

M ahathir inaugurat e d the M alaysian B u s i n e s s C ounci l ( M B C ) with a

speech entitled " M alaysia: The Way Forward. " In his speech Mahathir set

out the national objective of achieving "fully developed country" status

by the year 2020. The M B C 's secretariat is located in the government

s p o n s o r e d , b u t n o m i n ally i n d e p en d e n t , think tank, the I n st i tute of

Strategic and I nternational Studies ( IS IS ) . ISIS is b elieved to have been

responsible for drafting and p ro moting the speech, which has two dis

t inct parts , and " Vision 2020" as the new national purpose . In the first

p art of the speech, nine "central strategic challenges" were identifi e d ,

with a view t o accelerating industrialization, growth, a n d modernization .

In mid- 1 99 1 , the M alaysian government announced its National De

velopment Pol icy ( N D P ) , wi th a t e n - year S e c o n d Out l ine Perspe ctive

Plan ( O PP2) for 1 9 9 1 -2 0 0 0 , fol lowed s everal weeks later by the S ixth

M alaysia Plan (6MP) for 1 9 9 1 - 1 99 5 . Hence, while the OPP2 and 6MP are

supposed to provid e a medium- term economic p olicy perspective , Vi

sion 2020 provides the long-term objectives . And while it is quite possible

that Vision 2020, like many other Mahathir p olicy innovations, may not

outlast his stay in office (and may even recede in significance before his

tenure is over) , i t has already succeeded in conforming and defining the

p olicy shift away from the narrow ethnic distributional objectives asso

ciated with the NEP. In 1 99 1 , it represented an explicit official reiteratio n

of the p olicy changes introduced by M ahathir earl ier in his tenure. e s

p e cially since t h e mid - 1 980s .

Vision 2020 can and has b e e n be interpreted as a reformulation of

the Rukunegara , o r National I d e o l o gy, a n d the New E c o n o m i c Pol icy

(NEP) , both announced in 1 97 0 . Its obj ectives are often seen as reflect

i n g the s e c o n d n a t i o n al o r " s o c ial c o ntract , " fo l lowing t h e fi rst o n e

expressed by the M e rdeka ( I ndependence) Constitut ion as well as the

1 50

T


various polit ical institutions and arrangements at the t ime of independence in 1 957. Mahathir secured a strong endorsement for this third "soc ial contract" with his resounding victory in the 1 995 general election .

While a t o n e level Vision 2020 represents a reiteration and reformu lation of the Rukunegara and the NEp, the apparently minor and subt le differences and the new context are crucial . Its significance lies primarily in its timing ( i .e . , right after the end of the OPP period)

' its long-term (three

decade) perspective and the clear s h i ft in e mphasis and p riority fro m interethnic redistribution t o growth modernization and industrializat ion. Understandably, there has been some enthusiasm, especially among nonMalays, for the speech's explicit commitment to forging a Malaysian nation (bangsa M alaysia) , transcending existing ethnic identities and loyalties and consistent with M ahathir 's 1 989 new U M N O constituti o n . Whereas the rhetoric of the Rukunegara and the NEP emphasized national unity-usually interpreted narrowly in terms of achieving interethnic economic parity b etwee n M al ays and Chinese-Vi s i o n 2 0 2 0 's "developed country" goal implies a narrower, more materialist ic and economic growth emphasis . Thus Vision 2020 has also redefined the purpose and role of the government, and consequently sought to transform public- private sector relations. Not surprisingly then, many related policy changes h ave b een appreciated by p rivate business interests , including:

• a more streamlined government bureaucracy, more responsive to investment and growth promot io n ;

• restraint o n n onfinanc ial public enterprise (NFPE) exp a n s i o n : • lower interest rates ; • a depreciated ringgit for export promotion, and foreign investm e n t : • n e w investment in centive s , espec ially with the Promotion o f I n

vestments Act 1 986 ; • rais ing o f Indu strial Coordinat ion Act ( I CA) exe m p tion levels : • reduction of real wage costs , greater labor flexibi l i ty and avai lab i l

ity of cheap migrant labor ; • less e mp h as i s o n ethnic redis tr ibut ion ( i n fact a s ll s p e n s i o n of

NEP requirements with the Pro motion of Investments Act 1 986 ) ; • bureaucratic d eregulat i o n ; • privatization of government enterprises a n d public p ro jects : a n d • contracting o u t of municipal services to the private secto r.

Vision 2 0 2 0 also envisages a more competitive , market - d i s c i p l i n ed , outward - looking, dynamic , rohust, self- reliant , resi l ient , divers i fi e d , b a l anced , adaptive , tech n o l ogical ly p rofi c i e n t and entrepreneu rial economy

1 5 1


with strong industrial l inkage s , product ive and knowledgeable human

resources , low inflation , exemplary work ethics , and with emphasis on

quality and excellence . The M B C speech a lso recognized various prob

lems plaguing M al ays ian industr ial izat i o n , inc luding manufactur ing 's

narrow b a s e , weak i n d u s t r ia l l i nkage s , i n s i g ni fi c a n t l o c al s u p p ly o f

i n t e rmediate p r o d u c t s , i n adequat e deve l o p m e n t o f i n d i g e n o u s t e c h

nology, t o o little value added, r is ing production ( including labor) costs ,

infrastructure bot t lenecks , serious shortages o f ski l led p ersonnel , the

need for p roduct as wel l as market divers ificat i o n , problems raised by

p ro t e c t i o n i s m , trade b l o c s , managed trad e , d o m e s t i c p rivate s e c t o r

p e rformance, a n d t h e need for agrarian reform as well as resource and

enviro nmental protecti o n .

In some important ways, then, Vision 2020 rep resents a partial return

of the pendulum to the relatively pro-private business policies of the first

dozen years after independence in 1 957 in contrast to the state interven

tion and public sector expansion of the next decade and a half under the

NEP. As noted above, Vision 2020 reiterated the policy changes undertaken

from the mid - 1 980s , init ially defended as a necessary, but temporary re

sponse to the mid- 1 980s recession. While not involving new policy changes,

Vision 2020 made the recent economic policies already in place more ex

pl ic it , coherent, and legitimate. Vis ion 2020 thus shifted emphasis away

from interethnic distributional concerns without abandoning them al to

gether. It also prioritized the challenges of late industrialization without

seeming oblivious to human welfare considerations .

As the reforms were staggered over a number of years during the mid-

1 980s, it is difficult and potentially misleading to credit these reforms with

the subsequent improved macroeconomic performance. Supporters of the

reforms point to a sustained economic boom since 1 987 as evidence of

their success . Critics, however, emphasize that the deflationary reforms

exacerbated the 1 985-1 986 recession, while the subsequent boom has been

primarily due to massive increases in foreign investment from East A s i a

a n d elsewhere as well as restored domestic private sector investor confi

dence. By the time the Vision 2020 statement appeared, Malaysia was wel l

o n the road t o economic recovery, with growth rates o f over 8 percent per

annum, in contrast to the negative growth for 1 985 .

The Delicate Politics of Changing Governance

Vis ion 2020 symbolized improved governance , which renewed p r i

vate investor confidence i n the Malaysian government and was preceded

by indirect and p ar t i al rep u d i at ion o f the NEP. Th e N E P had enj oyed

1 52


considerable support fro m the pol i t ically crit ical Bumiputera commu

nity (especially ethnic M alays ) , who were generally seen to b e the pr i

mary beneficiaries of both the poverty reduction and interethnic redis

tribution measures associated with it . For non-Bumiputeras who did not

opt for "exi t " i n the form of emigration or capital fl ight , the costs of a

voice in the form of political opposition or dissent have often been quite

high. Yet under the ethnic exclusionary policies often associated with the

NEp, " loyalty" was hardly rewarded except for a select few in the p olitical

or business elite who were will ing and able to successfully col laborate

with the ethnic M alay elite for their mutual benefit. Most others, includ

ing p o li t ically uninfluential small and medium- s ized bus inessmen, re

luctantly resigned themselves to the NEP as a necessary cost of cit izen

ship, c ivil p e ace, and personal security, in the aftermath of the traumatic

events o f M ay 1 96 9 .

Not surpris ingly, therefore, M ahathir c o u l d n o t s imply replace t h e

NEP with h i s own economic agenda when he first came t o l e a d t h e nation.

The NEP had long been the legitimizing ideology for M al ay hegemony,

on which b asis the ruling UMNO had dominated the country since the

mid- 1 950s . Moreover, the exp ectations generated by the promise of the

NEP could not b e ignored, especially if M ahathir was to retain po lit ical

dominance i n national and p arty e lect ions . For the sake of cont inued

legitimacy, h e needed to formally allow the NEP to run its course until

1 990 , although he quietly announced its suspension in early 1 986 , citing

the rec e s s i o n as his pretext for d o i n g so. This also p rovided a decent

interval for a transit ion p eriod that could not be denounced as i l legit i

mate as the N E P was sti l l offic ially i n p lace .

Nonetheless , many o f Mahathir 's e arly p o l icy i n i t iat ives fai l e d to

garner wid e s p re a d s u p p o rt . F o r exa m p l e , t h e L o o k E a s t p o l icy was

ambiguously receive d , and eventually faded away. The h eavy i ndustr i

al izat i o n p o l icy i s now p rivately acknowledged to have b e e n i l l - co n

ceived and sometimes even unfairly blamed for the economic cris is of

the mid- 1 980s . The national car project is still touted as a great success

despite the heavy protection it st i l l requires (and the unlikel ihood o f i t

becoming internat ionally com pet i t ive and e c o n o m i cally viable i n the

medium term) . Though the M alays i a Incorporated pol icy was wel l re

ce ived by C h i n e s e and foreign b u s i n e s s interests , o thers were largely

indifferent, and the predominantly M alay bureaucrats dragged their feet ,

probably c o rrectly perceiving i t as implying their resubordinat io n .

The Executive Branch under M ahathir wrested control of t h e govern

ment from the bureaucrats during the 1 980s . B ureaucrats , who were io-

1 53

1. 1


creasingly relied upon in the 1 970s , i . e . , the e arly NEP period, thus lost

much influence under M ahathir who has made much more use of out

side (mainly foreign) consultants as well as " think tanks" outside of the

established bureaucratic structure . Bureaucrats, who had developed much

administrative clout under the NEp, were being asked to cooperate with

t h e very sector ( the e thnic Chin e s e - dominated private sector ) , which

they once lorded over.

Increased government intervent ion s ince the 1 97 0 s has also b e e n

associated with greater opportunities for corruption a n d other forms o f

abu s e , w i t h which the predo minantly M alay b u reaucrat s , pol i t ic ians ,

and pol i t i cally int1uential bus inessmen are associat e d . There is also a

strong tendency to associate the creation and distribution of rents with

the N E P, p art icularly with government e fforts to create a Bumiputera

commercial and industr ial community ( B C I C ) . I ronically, whi le inter

ethnic redistr ibut ion e fforts-offic ially and p o p ularly termed "restru c

turing (society) " in Malaysi a-were strongly associated with t h e expan

s ion of the public sector in the 1 9705 , they have increasingly been linked

wit h privatization in the last decade. Hence , although rents created by

government intervention have often been captured by non-Bumiputeras,

including foreign business interests , they are st i l l general ly p e rce ived

in ethnic terms.

On the other hand , growing popular resentment and frustration with

the public sector contributed to popular acceptance of privatization , in

p articular since employee interests were generally protected in the maj o r

p rivatizatio n s . Privat izat ion has generally b e e n reaso nably well man

aged by the government to ensure popular p art ic ipat ion and enthusi

asm (mainly through d ispersed and discounted share issues) , although

its adverse consequences for consumer welfare and the public interest

are i n c reasingly recogn ized . Insofar as privatizatio n has been pursued

in conditions of buoyant growth , some adverse consequences have been

o b s c u r e d wh ile t h e p o l i cy h as c l a imed credit fo r the strength o f the

e c o n o m i c recove ry.

By the t ime of the announcement of the new post - 1 990 pol ic ies i n

early 1 99 1 , the post- 1 986 economic recovery had been sustained for four

years . Thus, the economic policy changes of the mid- 1 980s-initially an

nounced as necessary compromises in the face of economic crises-were

re i terated and c o nsolidated as part of broader strategy to bui ld a n ew

Malaysia , i . e . . Vision 2020. What were once portrayed as unavoidable con

cessions to economic realities have since been recast as virtuous pol icies

i n their own right .

1 54


Governance and Rents

It is useful to consider what good governance really means for private investment by cons idering t h e nature and consequences o f rent c r e ation , distribut ion , a n d deployment by t h e government . T h e preceding review suggests a combination of at least two different forces at work . Rents have been created and allocated so as to enco urage investments in new p roductive activit ies , which have accelerated the diversification of the economy from its colonial i nheritance . Much of this has emphasized industrialization, initially on the basis o f import substitution, then �xport promotion, heavy industrializat ion , and technological upgrading 111 the 1 990s . However, constraints to better governance have meant that �he M alaysian state has not b e e n capable of designing and e ffect ively Implement ing the kind o f se lective industrial p o licy pract iced by the Japanese and South Korean governments .

The avai labi l i ty of natural resource rents has been very significant fo r growt h , exp o r t s , government reve n u e , and h e n c e , fis c al capaci ty, allowing the government greater latitude and capacity than most other governments i n the worl d . Such res o u rc e wealth and Malaysia's relatively small p o pulation enabled the public sector to grow i n the 1 9705 and early 1 980s with a "soft budget constraint , " which not only allowed, but a lso even encouraged vari ous extravagances . Such fiscal " irresponsibility" seemed to increase with greater state intervention (Bowie 1 99 1 ) and the availability o f enhanced oi l revenues from the mid- 1 970s-until the economic and political crises of the mid- 1 980s brought about greater fiscal discipl ine and tighter budget constraints for public enterpr i ses .

Redistribution, especially along interethnic l ines, has been the other major goal of rent creation and deployment in Malaysia. After increasing Malay bureaucratic hegemony in the 1 960s , the role and influence of the predominantly Malay civil service were significantly enhanced with the NEp, o nly to give way to an increasingly assertive Executive B ranch and a more politically influential rentier business community since the 1 980s . Public sector expansion under the NEP was also accompanied by other interventions which h ad a cumulative crowding-out effect (with �pec ifi c �thn i c hues)

' reflected in significant capital flight a n d declining p rivate

mvestments from the mid- 1 9 7 0 s , and especially in the e arly 1 980s . S ince the 1 970s , the allocation o f rents by the state has ostensibly

been pr imarily i ntended to redistribute wealth in favor of Bumiputera� and to pro mote the development o f B u m i p u tera capi ta i is ts . N e p o t i s m and p o l i t i c al b ias i n favo r o f c r o n i e s o f the s a m e ethnic g r o u p a r e a l s o

1 55

...

Governance, Rent- Seeking, and Private Investment in M alaysia

l ikely to be p erceived as evidence of ethnic bias , even though common

ethnici ty may not have been the main consideration for such favoritism.

Such percept ions of ethnic bias have not o nly exacerbated ethnic rela

t ions but have also d iscouraged investments by those who s e e them

s elves as less favored o r l ikely to be discr iminated against .

However. although yielding handsome returns, the bus iness opera

t ions of those benefiting from state- allocated rents have rarely been "en

trepreneurial " in a Schumpeterian sense . Instead , they have been p ri

m a r i l y d e r i v e d fro m t h e r e l at ive ly p r o t e c t e d i m p o rt - s ub s t i tu t i n g

manufacturing sector, services , and other "nontradeables , " such a s real

property, constructio n , uti l i t ies , domestic infrastructure, and transport .

Others have gained from maj o r, often complex financial and other cor

porate maneuvers rather than from significant productivity gains or other

improvements in terms of international competit ive n e s s .

H e n c e , i t can b e argu e d t h a t the allocat ion and appropriat ion o f

such rents have not required the enhancement of the economy's p r o

ductive capabilities a n d have . therefore, contributed little to t h e M alay

sian economy. However, insofar as these involve straightfo rward trans

fers . there i s relatively l i ttle rent dissipation except b y investors incurring

addit ional transact ion cos ts . such as in trying to identify and p erhaps

even help finance suitable Bumiputera partners . I n any case . NEP "re

structur ing" was not supposed to involve "rob b i n g Peter to p ay Paul "

( i . e . . a zero - sum game ) . but to red istribute new wealth created ( i . e . , a

p o s i tive sum game. os tens ibly with a "win - win" interethnic outcome) .

Hence . existing property rights have generally not been violated. although

redistribution has often been affected by assigning other (especially new)

r ights and other claims to rents along ethnic and "political " ( i . e . . by those

with p o l i t i ca l p ower and i n fl u e n c e ) l i n e s . However, s u c h interethn i c

redistribution efforts-an d the structure of rights thus created-may have

been necessary to ensure the pol i tical and economic stabil ity so crucial

to investment, growth , and structural change .

The economic effects of redistributive state intervention have . there

fo re , gene rally b e e n qui te d i ffe rent from those n e c e ssary to enhan ce

stru ctural change and economic diversifi cation. However, they have also

b e e n more vari e d . Red is t r ibut ion has i nvolved rents b e i n g stru c tu r e d

and offered by t h e government i n various ways to favor certain demo

graphic groups or regi o n s . H ere , o n e might d i s t ingu i s h between those

d i s c ri m i n atorv measures that enhance t h e p r o d u c t iv i ty o f e c o n o m ic

resources ( e . g �, productive educat ion . train ing as wel l as infrastructural

investments ) and those that s i m p l y transfe r economic resources . Also ,

1 56


one can d is tinguish among determinants of access-between schemes

equally accessible to a l l from a favored group, and those i nvolving further

compet i t i o n , se lect ion , o r allocat ion p r o c e s s e s , which may encourage

ren t - s e eking behavior.

While violating ethnically bl ind meritocratic principles undoubtedly

breeds ethnic frustrations and resentment among those who p e rce ive

thems elves as d i s cr iminated agai n s t , there is no c lear evi d e n c e that

greater investments among the l e s s academically succes sful are e c o

nomically wasteful , i . e . , that t h e s o c i al rates o f return on educat ional

investments among the less educationally successful are lower than those

for the more successful . especially since the latter tend to cost more and

also expect greater remuneratio n .

S o m e redistributive programs may also have favorable consequences

for productive investments , e . g . , the p rovision of credit without collat

eral to poor people by the Grameen B ank- like Ikhtiar scheme has facil i

tated very product ive investments reflected in high repayment rates as

well as other positive social as well as economic indicators. I t should be

stressed that many redistributive interventions have made contributions

to enhancing pro ductivity. For example , ethnically biased investments

in human- resource development have certainly contributed to produc

tivity gains , e . g . , by overc oming vario u s co lonial , cul tural , and urban

biases , and facilitating employment in modern economic activities char

acterized by higher p roductivity, although i t is unclear what the overall

economic effects of such ethnic bias h ave b e e n .

While s imple wealth transfers do n o t have p o s it ive c o n s e q uences

fo r product iv i ty enhancement , they d o s e e m to h ave adve rse c o n s e

quences by d i s c ouraging investments o t h e r t h a n t h o s e wh ere the r e

turns outweigh any anticipated wealth transfer ( t o others ) . F o r example .

the Industrial Coordination Act ( l eA) requirement-that private manu

facturing firms beyond a certain size have to ensure that at least 30 percent

of e q u i ty is own e d by Bumiputera interes ts-has p ro b ably adversel\'

affected the development of the manufacturing sector. Such condi t ions

must have d i scouraged non- Bumiputera investments i n manufac t ur i n g

a s investors ant ic ipated losses ( e . g . , from d iscounted stock transfers t o

Bumiputera partners who might also eventually demand more) a s well

as new r isks due to shared ownership . It is l ikely that such investors

wo uld be l e s s re t icent i n making investments i f they d i d not have to

incur such addit io nal costs and face greater uncertainty.

Without such intervent ions . however. it is un l ike ly that Bumi putera bus iness interests wou l d have made s lich s ign ifi cant i nroads into s e c -

1 57


tors of the economy long dominated by ethnic Chinese or foreigners. If

such redistribution has contributed to the greater polit ical and economic

securi ty so vi tal to sustaining economic investment and growth, i t may

be c o n s i dered a necessary cost , although there may be other, cheaper

means of attaining such stabi l ity. One has to consider whether this was

the cheapest or most economic option available , given the nature of the

pol i t i cal sett lement .

Although the Malay business community has grown rapidly, with many

e l e me n ts appearing to have developed various degrees of independence

from the state, most retain, cultivate, and ultimately rely on their connec

tions with top UMNO leaders to secure continued patronage while, in tum,

providing financial and other backing for their political patrons. Such rentier

activities have had profound implications for M alaysia's politics and busi

ness , particularly with the ascendance of business-based political factions

within UMNo. For all sides, political and business patronage involving the

state has remained the primary means to consolidate and enhance busi

ness as well as pol i t ical interests ( Gomez and Jomo 1 997 ) .

" Restructur ing "-or interethnic redistribut ive interventions-seems

to have been most easily "captured" and abused , with some unfavorable

conseq uences for effic iency. Such abuse has been facil itated by the l im

ited accountabi l i ty requirements required by the government and en

hanced by minimal transparency of the rent a l lo cat ion processes ( "ex

ecut ive prerogative s " ) . I ts governance capacity in other regards suggests

that the lack of transparency and accountability is by choice, and not just

i n s t i t u t i o nally inher i ted . T h u s , while s o m e state i n t e rvent ions in the

e c o n o my-an d the rents thus created-have enhanced accumulat io n ,

economic d iversification, and late industrialization , not all interventions

have contributed. to productivity enhancement .

While the rat ionale for most government intervention in Malays ia i s

o s t e n s i b ly to p romote d evelopment . one can d i s tinguish interve n t i o n s

intended to i n duce growth a n d structural change from those with red i s

tributive and populist polit ical motives . The pol it ical legit imacy, accept

abi l i ty. a n d pr io rity of interethnic redis trib utive economic measures i n

Malays ia have been especially important in shaping perceptions of gov

ernment i n terve nt ion , especially along ethnic l ines . Proponents of such

redistribut ion not only emphasize its progress ive aspects. e . g . , "compen

sati ng for historical (colonial ) neglect or underdeve lopment . " but also its

a l leged soc ia l ly and p o l i t i cally stabi l iz ing consequences . so cru c i al fo r

sustained economic growth. Critics emphasize various abuses which have

ari sen, particularly in the course of implementing ostensibly ethnic redis-

1 58


tributive measures; most important, p erhaps , the priority given to such

measures has tended to compromise and undermine the efficacy of inter

ventions with other objectives as well , e .g . , privatization ( Jomo 1 995) .

It is therefore necessary to distinguish b etween redistributive mea

sures that also enhance productivity and those that merely involve wealth

transfers. Our earlier review suggests that while considerable rent-seek

ing has o ccurred i n M al ays ia , not all rents h ave been diss ipated by

socially unproductive rent-seeking activities . Many of the rents created

have actually contributed toward enhancing productive capacity, though

this has generally not occurred very efficiently except for a few notable

exceptions (e .g . , the effect of the export duty on crude palm oil in induc

ing r e fi n i n g c a p a c i ty inve s t m e n t s , whi c h eventual ly p r o v e d to b e

internationally competitive) .

Thus, s o m ewhat ironically, b o th the N E P 's ethnic "restructuring"

a g e n d a a s well as s u b s e q u e n t e c o n o m i c l i b e ra l izat i o n , e s p e c i a l ly

privatization, have facilitated significant private capture of rents by the

polit ically well - c o nnected, presumably with some sharing o f the rents

captured with those allocating them. Such appropriation and transfer of

rents may well violate n o t i o n s of fai r n e s s , inc luding t h o s e d e e m e d

desirable for h e althy comp etit ion , but may not in themselves b e s o

cially wasteful s i n c e they essentially o nly involve rent transfers . H ow

ever, insofar as expenses may be incurred in efforts to secure such rents

( e . g . , e l e c t i o n camp aign exp e n s e s ) , they would be largely wastefu l ,

involving dissipation of the rents created . Their respective proportions

would b e determined by the nature of the rent-seeking regime created

by the intervent ion , and would have considerable bearing-together

with other relevant factors-on the efficiency of the new rights created

by the intervention.

The more effective linkage of rent access and capture to the achieve

ment of specific policy goals has enhan ced efficacy in the use of rents

as incentives and may, in certain circumstances, have reduced rent d i s

s ipat i o n . F o r exampl e , al lowing the c o m p any to col lect t o l l s o n t h e

privatized North- South Highway as soon as it was built created an i n

centive for t h e comp any to speed up completion of t h e h ighway a n d

thus be a b l e to collect more in tol ls .

Meanwhile , accumulation in the " i nternationalized" s ectors o f the

economy has not been significantly undermined by the magnitude and

nature of these rents , and has instead ensured much of the growth and

dynamism of the Malaysian economy. The continued and recently e n hanced allocation of rents in favor of industrialization. especially of the

1 59


exp o rt - o riented vari ety ( Rasiah 1 9 96 ) , has ensured rapid growth, par

t icularly in recent years . However, this has been mainly under fo reign

co ntrol . which raises some doubts about the sustainabi l i ty of th e pro

cess . Rents have effectively served as incentives for foreign i nvestors to

relocate export- oriented production in Malaysia, which has been respon

sible for the rapid growth of most such manufacturing in the 1 970s and

again since the late 1 980s . Some government policy reforms-including

more effective implementation and enforcement ( e . g . , with the introduc

t i o n of " o n e - s t o p a ge n c i e s " ) -h ave r e d u c e d c 1 i e n t e l i s t p ay- o Us to

gove rnment officials and p o l it ic ians fo r such fi r m s , which e s s e nt ial ly

operate within the realm of the global , rather than the national economy.

It needs to be emphasized that Malaysia has not really experienced

the kin ds of very painfu l economic problems t h a t o t h e r l e s s fortunate

economies of the South experienced in the 1 980s . For instance, Malaysia

has never really suffered from severe capital shortages , and did not bor

row very heavily from abroad unti l the early 1 980s (when liquidity was

tighter and real interest rates higher) . And unlike some other late borrow

ers (e .g . , India) , its spending-and therefore borrowing binge-came to an

end by the mid- 1 980s . Malaysia has also had considerable resource rents

to call upon, and a relatively small population to distribute them to.

N everth e l e s s , the M alays i a n case suggests that i m p roved gove r

n a n c e-in t h e fo r m o f p ar t i al d e re g u l a t i o n a n d " i nv e s t o r - fr i e n d l y "

reregulation-has b e e n crit ical fo r t h e chief executive's capacity to qui

et ly abandon N E P- related p o l i c i e s d e s p i t e c o n s i d e rable s u p p o rt and

expectat ions (which he effect ively discredi ted by referr ing to them as

part of a " subs idy mental i ty " ) . M ahathir has effe ctively used and d e

ployed t h e enhanced resources a n d powers a t t h e disposal of t h e Execu

tive Branch to great advantage , bringing about partial and selective eco

n o m i c l iberalizat i on favo red by b u s i n e s s i n t e r e s t s , i n c l u d i n g fo re ign

investors . Malaysian gove rn ance has been enhanced by s o m e effect ive

state i n s titutions and capabil i t ies , authoritarian powers , abundant ec o

n o m i c resources ( i n cluding resource rents ) , and a vi s io nary a s we l l a s

determined p o l it ical l eadership . H ence , the govern m e n t has been a b l e

to ensur e rapid growth with a h igh investment rate , and con tai n poten

t ia l ly d e s tabil izing c o n tl i c t s , a lbeit in the face o f some crit icism of i ts

abuse of its p owers ( Crouch 1 99 2 ) .

The 1 997 Debacle

Malaysi a's , and m o re g e n e r a l l v S o u t h e a s t A s i a 's , e c o n o mi c b o o m

h a d b e e n built on rent ier i n st i tut ions . M u c h of t h e retained wealth gen-

1 60


erated had been captured by those in p ower and their business cronies ,

who in turn contributed to growth by reinvesting much of their captured

rents , mainly in the "protected" domestic economy, e .g . , in import -sub

s t i tut ing industr ies , commerce , s e rvi c e s , and p rivat ized ut i l i t i es and

infrastructure . D e spite various weakn e s s e s , this Southeast As ian b rand

of ersatz capital ism-involving changing forms of ren tier cronyism-had

sustained rapid growth for three or fou r decades .

Interestingly, bus iness organizations , relations, practices , and norms

that had p revi o u sly been credited with helping create and sustain the

Southeast Asian economic miracle have s ince been condemned as the

sources of the debacle . I t also became fashionable in some quarters to

suggest that such practices and developments had their roots in J apanese

or more generically East Asian culture, where norms and relationships that

influence relat ions between the state and the p rivate sector (as well as

among businesses) that invariably involve welfare- reducing, if not down

r ight d e b il i tat ing , ren t - s eeking b e h avio r. I n s o far as s u c h relat ions are

believed to exclude outsiders , their elimination is believed to contribute

to leveling the playing field and bringing about an inevitable convergence

toward supposedly Anglo -American s tyle arm's - length market relations .

Once i t was c lear that the region's macroeconomic indicators were

not seriously awry, and in the wake of the recent debate on Asian values

and other cultural , institutional , and behavioral differences , many com

mentators increasingly invoked Southeast Asian cronyism and its alleged

consequences as new explanations for the crises . Most such critics con

d e m n e d s o m e c ar i c a t u r e d i m a g e o f r e nt - s e ek i n g i n t h e r e g i o n-as

retlected in various all eged departures fro m s o m e "market fundamen

talist" ideal-to explain the crises , usually ignoring a l l the subtlety and

nuance of extant analyses of rent - s eeking in the region. Thus , Southeast

Asia's financial turmoil came to he portrayed as having been induced hy

alleged crony capital ism and rent - s eeking in the region .

It would be difficult , however, to show that rent - seeking and cron\"

capitalism have actually precipitated the crisis or that they can satisfacto

rily explain its bases and or ig ins . As I have argued in this chapter, the

arrangements (or various incarnations of i t ) which have underpinned ren t i er

cronyism have been part and parcel of rapid economic development in

Malaysia throughout the postwar era . To say that such arrangements led

to the crisis is like saying that the exercise that one has been doing to keep

healthy all these years i s responsib l e for a recent heart attack.

What can be s a i d t h o u g h , a n d I have d i s c u s s e d t h i s exte n s ively elsewhere , i s that cronyism (and n e p ot ism) c e rtai n l y influenced o ffi c i a l

1 6 1

t 'i

H I


policy responses to the crises in Malaysia ( Jomo 1 998 ) . More important,

such influences-real as well as imagined-may well have exacerbated

the crises and are likely to continue to undermine confidence in govern

ment efforts , and thus delay recovery.

There is now little serious disagreement that the economic turmoil

since mid - 1 997 began as currency and liquidity crises . I t is also increas

ingly agreed that the crises were principally due to the undermining of

p revious systems of financial governance due to deregulatio n and other

developments associated with the growing influence of financial inter

ests at both international and national levels as well as other pressures

for financial l iberalization and globalizat ion. I t i s now also increasingly

acknowledged that the currency and liquidity crises became crises of the

"real economy" mainly due to inappropriate government-and I M F

policy responses as the problems emerged (e .g . , Radelet and Sachs 1 998 ;

Jomo 1 99 8 ) .

The failure of government to respond adequately and quickly is p artly

due to the mismatch between the institutional arrangements in the finan

cial sector, e .g . , regulations and the capacity to implement and monitor

p e rformance of b anks, and the demands of financial l iberalizat ion and

globalization ( Jomo 1 998 ) . I t has also been due , however, to the institu

tional inertia of rentier cronyism as evidenced by the reticence of govern

ment to c lose b adly p e rforming corporat ions and cut support for the

politically influential (Gomez and Jomo 1 999)-both of which would have

given the international financial community more confidence in the will

ingness and ability of the government to stop the hemorrhage .

1 62

C HAPTER SEVEN

GOVERNANCE AND GROWTH IN THAILAND Allen Hicken

Like the other countries in this study, Thailand has experienced rapid

e c o n o m i c growth and large - scale fore ign direct inve s t m e n t ( F D I ) for

much of the last two decades. I n fact , b etween 1 986 and 1 990 , Thailand

had the fas tes t growing e c o n o my i n the world ( Warr and Bhanupong

1 996 ) . However, th is period of impress ive performance is b racketed o n

one s ide by serious economic p roblems o f t h e e arly- mid- 1 980s a n d by

the economic deterioration and eventually crisis of the mid- late - 1 990s .

What explains the varying fortunes of the Thai economy? Certainly, some

of the explanations can b e traced to factors completely outside of Thai

land. The oil shocks of the 1 970s , combined with the glo b al recession

during the first half of the 1 980s , brought tremendous strain to bear on

the Thai economy. The depreciation o f the dollar relative to other cur

rencies and a flood of FDI from northeast Asia in the middle of the late

1 980s provided the fuel for the economic boom. Finally, the apprecia

t ion of the dollar, combined with greater competit ion for both fo reign

investment and export markets , had negative effects on Thailand's eco

nomic p e rformance in the middle o f the la te 1 990s .

H owever , i n t e r n a t i o n a l e c o n o m i c fa c t o rs d o n o t fu l l y e x p l a i n

Thailand's economic performance over t ime. Policy makers can respond

to changes in the international economic e nvironment in a variety o f

ways-some of which are conducive to investment and growth and some

of which are not . I n the Thai case , the economic adj ustments init iated

during the e arly p art of the mid - 1 9 8 0 s p aved the way fo r the sub s e quent high growth, while the failure of t h e government to adj ust during

the 1 99 0 s co n tribu te d t o t h e d e t e r i o r a t i o n a n d e v e n t u a l crash of the

1 63

u

Governance and Growth in Thailand

e c o n o m y. T h i s c h a p t e r fo c u s e s on e xp l a i n i n g t h e d i ffe r e n c e in t h e gove r n m e n t 's p o l i c y re s p o n s e d u r i n g t h e s e p e r i o d s . C o n s i s t e n t with this vol u me's theme I emphasize the l ink between governance, invest ment , and growth and d e m o nstrate that the q u a li ty of governance i n Thai land h a s dec l ined s i n c e t h e late 1 980s with p red ic table effects o n

e c o n o m i c performance .

The chapter i s organi z e d as fol lows: I first br iefly review the macroeconomic shocks of the 1 970s and early 1 9805 , the ir effect on the Thai e c o n o my and gove rn m e n t 's res p o n s e to these shocks . [ then turn m y attention t o t h e l i n k between a country's polit ical structure a n d t h e quality of governance, arguing that given Thailand 's polit ical structure, the "good governance" in the early p art of the mid - 1 980s should be viewed as the exception rather than the rule . I explain how Thailand was able to overcome some of the weaknesses inherent in its polit ical system during this period and thus lay the fou ndation for the later economic boom. Finally, I d i s c u s s how the q u al i ty o f governance was u n d e r m i n e d i n the late 1 98 0 s and 1 990s and how this had affected p r o s p e ct s for growth and investment .

External Shocks and Macroeconomic Adjustment

As the Thai economy entered the 1 980s i t was struggl ing to adj ust to the same external shocks bes ieging much of the developing world at the t ime. The two oi l shocks in the 1 970s caused a severe deterioratio n i n Thai land 's terms o f trad e . Rather than u n d e rtaking pa infu l adj u s t m e n t , Thai land chose to b o rrow internat ionally. ] In i t ial ly t h i s strateg\'

was attract ive given the lower international i n terest rates . However, a� interest rates began to c l imb in the late 1 970s and early 1 980s it becamc clear that bo rrowing i n t e rn ational ly could no longer serve as a s u b st i

tute fo r economic ad j ustment . [ n the meantime , Thailand had b u i l t u p

a substantial debt burden . Yet even as the debt burde n was growing, t h e

gove rn m e n t 's a b i l i ty to s e r v i c e th i s debt was b e c o m i n g p r o b l e m a t i c .

N a t i o n a l s av i n gs had d e c l i n e d s h a r p l y i n the e a r l y 1 9 8 0 s a n d ex p o r t

c o m p e t i t ive n e s s was growi n g weaker. The bal a n c e o f p a v m e n t s a n d

p u b l i c sector defi c i ts were large and c le arly u n s u s t a i n a b l e ( Wa rr a n d

Bhanupong 1 99 6 ) .

To summarize , as the economy entered the e a rly p a r t o f th e m i d -

1 980s , major structural adj ustments and economic refo rms were requ i red

in order to keep the p r o b l e m s from d e g e n e r a t i n g i n t o a cr i s i s . M a j o r

l e n ders , i n c l u d i n g t h e Wo rld B a n k and t h e I M E viewed t h e e C O n O ll1\

with growin g alarm ( D o n e r and Anek 1 994 ) , T h e gove r n m e n t of Pre m

1 64

T Governance and Growth in Thailand

T i n s u l a n o n d a r e s p o n d e d by i m p l e m e n t i n g c o s t l y b u t n e e d e d p o l icy

reforms in several areas , " For exampl e , in the early 1 980s interest rates

were ra ised in order to p roduce a p o s i t ive real interest rate and s low

capital flight . The baht was also d evalued , first i n 1 98 1 and then again

in 1 984 . Foreign borrowing was curtailed and the Bank of Thailand was

given greater power over the financial sector. In 1 983 a pol icy to l imi t

c red i t was introduced and chit fun d credit c o m p anies were outl awe d .

Govern m e n t s p e n d i n g was a l s o s lashed a n d several large - s cale i n fra

structure pro jects were scrapped or sca led back . Finally, macroeconomic

policy makin g was centralized under the direct ion and protect ion of Prem

( m o re o n th is point below) ,

Although these policy responses by Prem's government were at times

b elated and reluctant ( WaIT and Bhanupong 1 99 6 , 2(9 ) the needed re

forms were carried out. [n fact, reforms were implemented even in the face

of strong oppos i t ion fro m pol i t ical p art ies , bus iness grou p s , and most

significantly, the military. As a result of these reforms the macroeconomy

was stabilized. By 1 985 the current account deficit had been reduced fro m

7 .3 percent of GDP (gross domestic p ro d uct) in 1 9 8 1 to 4 percent . The

depreciation of the dollar (to which the baht was pegged) relat ive to other

currencies after the 1 985 Plaza Accord further strengthened Thailand's terms

of trade and led to a current account surplus in 1 986 (see table next page) .

The budget deficit was also brought dov\11 fro m 4 .7 percent of GDP in 1 982

to 1 . 1 percent in 1 987 , and finally to a surplus of 1 . 7 percent i n 1 988 .

The fru it of the stru ctural adj ustment under Prem was a stable and

restructured m acroeconomy. This placed Thailand in a pos i t ion to take

advantage of the flood of investment fro m Northeast Asia during the l ate

1 980s . As c o m p anies in Japan , Taiwan , and Hong Kong s o u ght to move

more production offshore in response to currency appreciation and risi ng

labor costs , Thailand 's sound macroeconomy m ade it an attractive choice

for investors . B etween 1 987 and 1 988 total foreign d i rect investment in

Thailand more than tripled; FDI from N ortheast Asia increased more than

fourfo ld . Total and Northeast Asian FDI doubled again between 1 988 and

1 990. This Dood of i nvestment helped fuel the boom in the broader econom\'

over the same period (see table next pagel .

Thai l a n d 's res p o n s e s to the e c o n o m i c chal lenges of the ear ly- a n d

m i d - 1 9 8 0 s , and t h e growth t h e s e responses m a d e poss ible , a r e i m p r e s

s ive o n t h e i r o w n m e r i t . J {owever, they are eve n more impress ive when

o n e c o n s i d e rs the po l i t i ca l s tructure wi t h i n wh i c h Thai p o l icy makers typ ical ly operate, As descr ibed be l ow, Thai la n d 's pol i t i ca l s tructure often

m akes "go o d gove r n a n c e" a d i ffi c u l t go a l to a c h i eve ,

1 65

r �j

u


GOP Growth FO I Inflation Rate Current Account Budget Surplus ( % ) (m i l l ions o f US $) (GOP deflator) Balance (% of GOP) (% of GOP)

1 980 5.2 1 90 1 2.7 -6.4 4 .9

1981 5.9 291 8.4 -7.3 -3.4

1982 5.4 191 5 . 1 -2.7 -6.4

1 983 5 .6 350 3.7 -7.2 -3.4

1984 5.8 401 1 .4 -5.0 -4.0

1 985 4 .6 1 63 2.2 -4.0 -5.2

1 986 5 .5 263 1 .7 0.6 -4.2

1 987 9 .5 352 4.7 -0.7 -2.2

1 988 13.3 1 , 1 05 5.9 -2.7 0.6

1 989 1 2 .2 1 ,776 6 . 1 -3.5 2.9

1990 1 1 .2 2,444 5.8 -8.5 4.5

1991 8.6 2,0 14 5.7 -7.7 4.7

1992 8 . 1 2, 1 1 3 4.5 -5.7 2.8

1993 8.4 1 ,804 3.3 -5. 1 2 . 1

1994 8.9 P66 5 . 1 -5.6 1 .8

1995 8.8 2,068 6.0 -8. 1 2.9

1996 5.5 2,336 4.0 -8. 1 2.4

1997 -0.4 3,745 5.4 -1 .9 -0.9

SOURCE: World Delle/opmell l Indicators 1 999 (CD - ROM) .

Political Structure and Governance

The quality of governance in Thailand, or any other political system,

is in part a reflection of two factors : first, the incentives policy makers face,

and second, their capabilities to pursue their preferred policies (Cox and

McCubbins 200 1 ) .1 The incentives and capabilities politicians have in order

to pursue policies that ( 1 ) bring long-term benefits at short-term costs, or

(2) benefit society as a whole, but impose concentrated costs on small ,

powerful groups, are important determinants of the quality of governance

in any country. For purposes of this chapter I label these long-term, broadly

beneficial types of policies as "national policies . " 4 Examples include such

policies as lower tariffs , prudential regulation, and education reform.

Governance Incentives

Political actors in all systems face choices regarding the types of poli

cies they will pursue and to which interests they will respond. Certain

1 66

1 Governance and Growth in Thailand

features of the political system, particularly the electoral rules and party

system, generate incentives that shape how these choices are made. Cer

tain electoral rules , for instance, provide incentives for candidates and

voters to place a relatively high value on party label while others encour

age candidate - centered campaigning." The party system, too, affects the

value of party label. Where the party system is made up of political parties

with established electoral histories , clear policy positions , and internal

cohesion, then party labels will tend to carry weight with voters and can

didates. If, on the other hand, parties come and go from election to election,

candidates switch parties frequently, and parties are riddled by factional

problems, then the value of party labels is undermined .

When party labels are weak, candidates must rely on building up their

personal reputations and personal networks of support in order to be

elected. This provides strong incentives for candidates to direct benefits

(e.g. , pork barrel funds and patronage) toward their narrow constituencies.

As individual candidates they cannot credibly claim credit for the provi

sion of national goods and pol icies , nor can they gain much electoral

advantage by claiming to be a member of a p arty that delivered national

policies, especially when coalition governments are the norm. However,

they can claim credit for particularistic goods and services targeted to their

specific constituents and supporters. Indeed, their electoral fates depend

primarily upon their ability to deliver targeted benefits to narrow constitu

encies rather than more general benefits to broader constituencies. Thai

politicians are not unique in their focus on narrow constituencies. There

is an extensive literature on the way the electoral and party systems shape

the size of a politician's constituency in countries as diverse as Japan, Italy,

Taiwan and Brazil (see, for example, Reed 1 994; Cox and Thies 1 998 ; Carey

and Shugart 1 995 ; Lijphart 1 994; and Katz 1 986) .

Whether or not the parties that make up the party system are na

tional parties also affects political actors' incentives. Parties that have a

nationwide basis o f support are generally m o re likely to pursue "na

tional " pol ic ies benefiting a large segment of society-than are parties

with smaller bases of support, such as regionally based parties, or single

issue p arties (M ainwaring and Scully 1 99 5 ) . " The extent to wh ich the

party system is composed of national parties also bears directly on the

capability of policy makers to govern, the subject of the next section.

Governance Capability

The road to hell is p aved with go o d intentions . Even with the best

of incentives, p o licy makers may sti l l fai l to enact much needed pol icies .

1 67


For "good governance" to exist , p olitical actors must h ave not only the

i n c e nt ives to pass nat i o n al p o l i c i e s , but also the capabi l i ty to do s o .

Cap abil i ty i s large l y a fun c t i o n o f the numb e r o f v e t o p l ayers in t h e

system-the larger t h e number of veto players, t h e more difficult it will

be for a government to act in a decisive manner ( Tsebelis 1 99 5 , Cox and

M c Cubbins 20 0 l ) .

I t i s important t o dist inguish between inst i tut ional veto points and

veto players . Institutional veto p oints are tbe points in the pol icy- mak

ing process where attempts to change old pol ic ies o r adopt new ones

can be overturned. Veto players are those actors, collective or individual,

that sit at the various veto points. The number of veto points is a func

t ion of a country's constitutional structure. Is there a separation of powers

b etwe e n different b ranch e s or levels of government? The numb e r of

veto p l ayers is largely a funct ion of the p arty system-the number o f

political parties a n d their cohesion. The party system, in turn, is shaped

by the electoral system along with elements of the national institutional

structure ( Hicken 1 999 ) .

A system might have only one institutional veto p o int (e .g . , a unitary.

unicameral parliamentary system without an independent j udiciary) yet

because of a multiparty system. have coalition governments. Thus . while

such a system would h ave o nly one inst i tuti o n al veto point , it would

have more than one veto player. Again , the greater the number of veto

players . the less decisive a government is expected to be. ceteris paribus .

Similarly, a system with mUltiple veto points (e .g . , a presidential syste m )

might st i ll be decis ive if one stro n g p arty contro l s all the veto p o i nt s . '

Governance Incentives and Capabilities i n Thailand

Both the i ncent ives to provide nat ional pol icy and the capabi l i ty t o

d o s o a r e somewhat l a c k i n g i n the T h a i p o l i t i c a l sys tem as i t ex is te d

p r i o r to the new C o n s t i t u t i o n o f 1 9 9 7 . T h a i l a n d i s a c o n s t i t u t i o n a l

m o n archy and a unitary, as o p p o s e d to federa l . s tate . Th e k i n g is t il e

head of state and the pr ime minis ter h eads the government . T h a i l a n d

is a p arl iamentary system with t h e National Assembly divided into two

bodies : the H ouse of Representatives and the Senate . Th e S e n a t e d u e s

not have veto power ( e . g . . i t can only de lay legis lat io n ) a n d , u n t i l t h e

1 99 7 Const i tut i o n . was a n a p p o i nted bo dy." To sum m arize , T h ai l a n d 's

pol i t ical system is characterized by a single i n st i tu t i o n al vcto p o i n t . T h e re

is no formal separation of powers b e tween t h e Executive a n d l .egi s l at ive

branches as is the case i n the Ph i l ip p ines or Korea; n e i t h e r d o T h a i l oc a l

governments exercise s ignifi cant p ower ( N e l s o n 1 99 8 ) .

1 68


On the other hand . the Thai p arty sys tem produces mult iple veto

playe rs . The e lecto ral ru les ( p art i c u l arly two - and thre e - member dis

tricts ) , combined with the weakness o f Thai p ol i t ical p arties , produce

mult iple parties at the district and national levels (Hicken 1 99 8 , 1 999 ) . "

The result is numerous parties in p arliament and coalition government

(see table below) . In addition, virtually every party consists of two or more

factions in competition with one another. The large number of parties in

the Cabinet , combined with the fact ional d i vis ions withi n nearly every

party, means that a large number of actors are typically involved in the

policy- making process (multiple veto p layers ) . This has an obvious im

pact o n the capability of the government to produce national pol ic ies .

Number o f Parties in Parl iament

Number of Parties in Cabinet

1986

14

4

1 988

15

6

1 992b

11

5

1 995

11

7

1996

1 1

6

SOlJR(TS: Ecolloll7 isl inteiligent Ull il CO l / ll tl}' Report: Thailund (variolls years ) ; report o f the

Elect ion to the H ouse of Representatives (var iolls years ) , E lect ion Divi s i o n . D e p artment o f Local

Administrati o n , Interior Ministry.

Thai p o l i t i c ians a lso gene rally lack s t r o n g i n c e ntives to p r o d u c e

national po l ic ies . T h a i parties have generally fai led to l i n k acros s d i s

t r i c t s t o fo rm l a r g e n at i o n al p a r t i e s a n d i n s t e a d r e m a i n l o c al l y o r

region ally b a s e d . As a resu l t , a party 's const i tuency is s o mething l e s s

than a natio nal constituency. I I } In addit ion , the consensus of virtually all

students of Thai p o l i t ics as well as Thai p o l i ticians and party leaders is

that party labels are weak. I I Candidates tend to rely on p ersonal vote

gett ing strategi es when campaign ing , rather than campaigning on the

reputati on or pol icy po si t ion of the party. Given this , we would expect

most Thai po l iticians to be more concerned with channeling benefits t o

their supporters than with the conduct of national policy. These support

ers can include both the voters in a politician's electoral district and any

groups or ind ividuals that help finance campaigning (business interests .

p o l i t i c al patro n s , among others ) .

To sum marize, Thai polit icians lacked strong incentives to consider

interests beyond those of their local constituency and supporters , at least

p r ior to the new Consti tut io n . However, even i f some pol i t ic ians had

such incentive s , p o l icy m aking wou l d remain d ifficult g iven the l arge number o f veto p l ayers in t h e Thai po l i t ica l sys t em . T h e expectati o n ,

1 69


then, is that Thailand should have had difficulty delivering the types of

national policies conducive to long- term growth and investment (e .g . ,

macroeconomic stability, infrastructure, education and training, pruden

tial regulation) .

The puzzle then is given the political structure j ust described, how

is it that Thailand was able to enj oy such high levels of foreign invest

ment and economic growth. How does one explain the apparent conflict

between expectations and outcomes? Relatedly, how does one explain

the deterioration of the economy in the middle p art of the late - 1 990s

after years of strong performance? In the next section I provide a partial

answer to these questions by looking at ( 1 ) the informal institutional

arrangements adopted by the Thai government to overcome some of

the governance problems inherent in the political system, and (2) the

erosion of those informal arrangements over t ime.

Prem, Parties, and the Policy-Patronage Compromise

O n e way p o licy makers can combat governance p roblems is by

creating new formal institutions . 1 2 Independent central banks , currency

b o ards , and independent regulatory agencies are examples of institu

tional tools created to help ensure that policy making and implemen

tation are timely and free from interference by p oliticians and special

interests . In Thai land , h owever, the pr imary so lut ion to governance

problems during most of the 1 980s came in the guise of informal, though

significant, institutional arrangements. Sp ecifically, a comp romise was

struck between Prime Minister Prem Tinsulanonda and party politicians .

I label this compromise the "policy-patronage compromise." I will first

discuss the unique position of Prime Minister Prem, his incentives and

capabilities relative to most of the prime ministers that followed him .

and then turn my attention t o the compromise itself.

Prime Minister Prem Tinsulanonda

Prem became prime minister in 1 980 until 1 988 . He was not. how

eve r, an e lected m e m b e r o f p ar l iament . D u r i n g t h is p e r i o d , wh i c h

Chai- anan Samudavanij a ( 1 9 89 ) calls "semidemo cracy, " Thai gove r n

ments came t o power via competitive elections . While elections were

held, the leaders of the various political parties were unable to reach an

agreement over who among them should be the premier. The heads of

the p ol it ical parties a lso real ized that mil i tary s u p p o rt remained an

indispensable condition for stable government. And so they asked Gen.

Prem Tinsulanonda, commander of the army, to head the government

1 70


as prime minister. 1 3 With his mil itary b ackground Prem e nj oyed the

support of important factions within the military. He also enj oyed the

backing of the king.

As he was not a p o lit ician, Prem did not fac e the same electoral

constraints as elected politicians. He was not directly accountable to the

narrow constituencies that were the focus of party politicians. Numerous

scholars have noted that Prem was able to stand above factional p arty

politics and take a broader view than the typical elected p olitic ians . 1 4

However, while Prem's incentives to provide national policies may not

have been as weak as other political actors, he still had to work with a

coalition of factionalized parties as part of the policy-making process. In

other words, there were still mUltiple veto players in the policy process,

even under Premo This can be seen clearly by looking at the number of

laws passed by the Prem governments compared to other governments.

During Prem's tenure, an average of 2 . 7 laws per month were enacted

by the legislature. This is comp arable to the figure for Prem's elected

successor, Chatichai Choonhavan-2 .3 per month-but much less than

during that of nondemocratic governments-6.4 per month (Christensen

and Ammar 1 993) .

In short, the support of elected party politicians could not be taken

for granted. In fact , Prem's predecessor, General Kriengsak, had been

forced to step down as prime minister in 1 980 due , in part, to h is failure

to maintain the support of party leaders. In order to avoid a similar fate ,

and find a way around the governance problems associated with mul

tiple veto players, Prem forged a compromise with political party leaders .

The Policy- P atronage Compromise

Prem and his advisors were aware that they needed the support of

the political parties for stability and legitimacy purposes. However, they

felt it was necessary to keep politiCians from interfering in certain p arts

of the policy- making process-p articularly macroeconomic p olicy. For

their part, politicians were anxious to enjoy the spoils of government,

but were also keenly aware of the need to maintain the support of the

military. The excesses and instability of democratic governments from

1 973- 1 976 had been part of the justification behind a return to military rule . The result was a compromise between Prem (and the technocrats) and the leaders of the various politi cal p arties . Macroeconomic p olicy would be insulated and run by Pre m - b acked technocrats , and Prem's appointees would have the ability to set some limits on corruption and rent-seeking on the part of the p olitical parties . In exchange, the political

1 7 1

r ,


parties would be given control of the sectoral ministries ( e . g .. Commerce,

Industry, Education) and would be allowed to run them with very l i tt le

interference from the prime minister (Chr istensen et al . 1 993 ) . l �

Insulation o f Macroeconomic Policy

As discussed earl ier, the foundation of Thailan d 's economic success

b eg i n n i n g i n the late 1 9 8 0 s was i t s p ru d e n t m a c ro e c o n o m i c p o l i cy.

Thai land was able to adj u s t to t h e external s h o cks of t h e 1 9 7 0 s and

1 980s and achieve economic stability because i t followed cautious eco

nomic p olicies and adopted needed reforms ( Warr and Bhanupong 1 996) .

H owever, it was the info rmal po l icy- p atro n age compromise that gave

p o l i cy makers the p o l i t ica l s p a c e to a d o p t t h e s e caut ious e c o n o m i c

p o l i c e s . P r e m was a b l e to s h i e l d k e y economic officials from pressures

fro m those who might o p p o s e reforms, particularly p ol it ical p arties . It

i s not a coincidence that most of the policies designed to combat the

e c o n o m i c p ro b l e m s o f the 1 9 8 0 s were m a c ro e c o n o m i c or fin a n c i a l

pol ic ies . Macroeconomic policy under Prem was centralized and headed

by technocrats . 1 6 The budgetary process was also kept out of the hands

of pol iticians and centralized in the Budget Bureau. Four o rganizations

emerged as the key groups in charge of macroeconomic management :

the Budget Bureau, the National Economic and Social D evelopment Board

(NESDB) . the Ministry of Finance , and the Bank of Thailand . Concerns

over economic stabi l i ty had led p revious military governments to insu

late these important macroeconomic agencies and this pattern continued

under Prem (Christensen et al . 1 997) . Prime M inister Prem was directly

over three o f these agencies and indirectly over the Bank of Thailand

( t h e h e ad o f the B ank o f Thai land is appointed and r e moved by t h e

minister of Finance) . 1 7 T h e s e o rganizations, typically headed b y tech n o

crats and largely insulated from political and electoral pressures , were

a b l e t o act d e c i s ively t o p r o d u c e the n a t i o n al p o l i c i e s n e c e s s ary t o

overcome the cri ses of the e arly- a n d mi d - 1 9 8 0 s a n d l a y the gro u n d

work for future economic growt h .

To summarize, t h e p olicy-patronage compromise essentially reduced

the number of veto p layers in the area of macro e c o n o m i c p o l icy and

allowed p olicy makers with b roader interests than the typ ical pol i t ician

to set policy. Thus, this group had the incentives and capability t o impl e

m e n t c o s t ly b u t n e e d e d p o l i cy refo r m s , w h i c h w e r e o ften s t r o n g ly

opposed by the military, pol i t ical part i e s , and / o r business grou p s . The

outcome of this compromise was the stabilization and economic reform

pol ic ies o f the Prem p e riod .

1 72


The Collapse of the Compromise

The nature o f Thai pol i t ics fundamentally changed in 1 9 8 8 when

Chatichai Choonhavan , MP and head of the Chart Thai Party, was named

prime minis ter. The choice of Chatichai marked the first time under the

1 9 78 Co nst i tut ion that the prime minis ter 's p o s i t ion was given to an

elected polit ician . 1 H As a polit ician, Chatichai was under the same pres

sure to bui ld and maintai n a p e rs o n al e lectoral network as any other

Thai polit ician. For Chatichai and the other members of his p arty, e lec

toral victory (and future electoral success) stemmed from their ability or

potential to d irect resources to their local constituents and supporters .

In short , as an elected politician and p arty leader, Chatichai had a much

narrower constituency than did Prem and his tenure as prime minister

depended o n the continued support of p o lit icians with equally narrow

constituencies .

Chatichai 's victory also marked the tr iumph of provincial politicians

in the pol i t ical process . Chatichai 's p arty achieved electoral success by

convincing many p rovincial politicians to run under the Chart Thai ban

ner. This class of politicians, backed by the provincial business elite, had

been growing in strength over the course of the 1 970s and 1 98 0 s . 1 9 As

a group, the p rovincial politicians did not generally have strong national

po l icy go als . I n s t e a d , they were m o s t c o ncerned with protect ing and

promoting the narrow business interests of their constituency, the pro

vincial business elite .Lo Other Chart Thai party leaders included B anharn

S i lp a - arc h a , t h e p rovi n c i al b u s i n e s s m a n d u b b e d " Th e M o b i l e ATM "

because o f his readiness to extend financial assistance t o p olitical can

didates , and Pramuan Sabhavasu , another provincial businessman who

made his fortune in the construction industry and was a maj o r financier

of Chart Thai candidates. In short , Chatichai 's victory brought to p ower

pol i t ic ians who lacked incentives to p rovide certain nat ional p o l i c i e s .

This was n o t o nly b e c a u s e t h e e l e c t o ral a n d p arty sys t e m s c o m p e l

p oliticians t o focus on local , narrow interests , but also because t h e key

members of provincial pol iticians ' constituencies were often either d is

interested o r opposed to such pol ic ies . B e s i d e s u n d e rm i n i n g t h e n a t i o n al p o l icy i n c e n t ive s i n t h e Thai

pol i t ical system, Chatichai 's victory a lso introduced additional veto playe rs i n to the system. First, as party leader, Chatichai not only had to worry about keepi ng other parties in the coalit ion happy, as Pre

"m did , but h�

also had to co n t e n d with the var i o u s fact io n s within h i s own p a rty. Second , the pol iticization of the prime minister's office led directly to the

1 73

I , I

1,1 1\


p oliticization of the once technocratic and insulated economic agencies .

Under Chatichai , virtually every Cabinet p o s i t i o n went to an e lected

p olit ician. The Minist ry o f F inance was no except ion with the finance

portfolio having been given to Chart Thai financier Pramuan Sabhavasu.

The Ministry of Finance also b ecame subj ect to the instability charac

teristic of coalition government. During the eight years Prem was prime

minister, there were o nly three finance ministers. In the ten years since,

thirteen men had served as finance minister-one of whom served two

separate terms.

Further, Chatichai sought to decrease the influence of the techn o

cratic NESDB in economic pol icy making. Under Prem, t h e NESDB was

given a c entral ro le over e c o nomic p o licy maki n g . N o t only was the

o rganization in charge of economic planning but i t was a lso given eco

nomic coordinating and monitoring responsibilities . The secretary-gen

e ral of the NESDB also sat as the head of the " Economic Cabinet , " the

C o u n cil o f E c o n o m i c M inis ters ( C EM )'

which was e n d owed with ful l

Cabinet powers. From this p osit ion the NESDB was able to screen, and

o c c as ionally veto , the p ork- barrel p roj ects o f the e lected ministers in

Prem Cabinets ( Ungpakorn 1 99 2 , Anek 1 99 2 a) . Not surpr is ingly, t h e

N E S D B aroused a c o nsiderable a m o u n t o f resentment o n the p art o f

elected pol iticians . T h e Chatichai government expelled t h e N E S D B from

the Cabinet and removed its coordinating and monitoring responsibili

t ies . The director of the NESDB resigned in protest and was replaced by

"a m o re p liable techno crat" (Pasuk and B aker 1 99 5 , 3 5 0 ) . F inal ly, the

power over government contracts was taken fro m the NESDB and placed

under the control o f i ndividual ministri e s . In short , by pushing aside

the technocrats, marginalizing the NESDB, and giving control over gov

ernment contracts to individual ministers, Chatichai 's government shifted

control of policy and resources from the insulated technocracy to elected

p ol i t ic ians ( i b id . ) . L I As a resul t , macro e c o n o mic and financial p o l icy

making b egan to fall vict im to the same governance constraints (poor

incentives a nd multiple veto players) that h ad been the rule in the area

of sectoral pol i cy.

I t is important to note that n o t every government p o s t was co m

p l e t e l y t a k e n o v e r b y e l e c t e d p o l i t i c i a n s aft e r 1 9 8 8 . E l e c t e d p r i m e

ministers have not infrequently appointed technocrats t o head the eco

nomic portfol ios in an effort to boost their Cabinet"s credib ility in the

eyes o f fo reign a n d d o m est ic inve s t o r s . Even Ch at ichai a p p o i n t e d a

technocrat to head the Ministry of Finance later in his term. However.

these technocrats were st i l l accountable to e lected p oliticians with nar-

1 74


row constituencies as opposed to a nonpartisan premier with a broader

constituency. Thus, these technocrats usually lacked the authority and

autonomy that their predecessors p o s s e s s e d . 22

The Consequences of Poor Governance

It is easy to point to the recent crisis as prima facie evidence of the

governance problems characteristic of the Thai political system.23 How

ever, the consequences of poor incentives and weak capability could be

s e e n l o n g b e fo re 1 99 7 . As two cr is is commentators n o t e d , "many had

seen [ th e crisis ] coming for some t ime. But l itt le had b e e n d o n e . Eco

n o m i c p ol i c y making and fin a n c i al c o n t r o l s h a d lagged b e h i n d t h e

changes in t h e nature a n d t h e p a c e o f t h e economy. Politics h a d g o t i n

t h e way" (Pasuk and B aker 1 99 8 , 94 ) .

For reasons discussed earlier Thai p oliticians are focused o n attend

ing to the interests of narrow constituencies . They have very little interest

in establishing connections with broader interest groups that might be

concerned with the conduct of "national" policy. They do have relation

ships with business (both rural and urban) and many o f the p oliticians

are b u s i n e s s m e n thems elves , b u t the p urp o s e of the c o n n ec t i o n s is

mainly to raise c o rruption money, through the grants o f p roje c t s and

concessions to individual firms (Ammar 1 997 ) . In short , p o lit icians are

interested in fi r m / business s p ecific p ol ic ies , rath e r than broader "na

t ional " p o l i cy. Thu s , po l i tic ians tend t o view the publ ic treasury as a

milking cow, with the p oliticians' job being to channel the milk to their

constituents and supporters . Some of this was accomplished via the legal

use of all ocation of public resourc e s . In addition , polit icians als o used

t h e sectoral ministries as so urces o f c o rruption money.

Sectoral Policy

As ment ioned above, sectoral p olicy was never organized the way macro e c o n o m i c p o l icy was under Premo B ecause of this , s igns of t h e m i s m a n a g e m e n t o f s e c t o ral m i n i s t r i e s b y p o l i t i c i a n s a p p e ared well befo re the macroeconomy began to suffer. In 1 990 , desp ite the stro ng and growing demand for a better educated workforce , Thailand ranked last among the ASEAN Five in terms of the percentage of the populatio n enrolled in secondary school, a n d last in terms of t h e p ercentage graduated fro m secondary institutions ( World Development Indicators 1 999) . Despite rhetoric by politicians and a general recognition that Thailand's educational system needed reform, in 1 99 8 Thailand 's basic educat ion infrastructure st i l l l agged behind the rest o f the region (LaB 1 998) . A s

1 75

l


the economic boom took on full steam in the late 1 980s there was also

a recognized gap in the demand for skilled workers and the actual supply

( TD R I 1 9 8 8 , 1 99 2 ) . I n 1 993 the director of the I n d u s tr ial Promotions

Dep artment of the Japan External Trade Organizat ion ( JETRO) warned

that if Thailand did not solve its skilled- labor bottleneck, "Japanese firms

(would) increasingly look to places like Vietnam, where you have a better

educated work force" (quoted in Bello et al. 1 998 , 57) . A full ten years had

p assed since policy makers first recognized the need to boost the supply

of skilled labor. Despi te all o f the plans and proposals over this t ime,

a severe shortage of skilled labor continues to b e a problem (Doner and

B rimble 1 998 ) .

Infrastructure bottlenecks, especially in the area of ground transpor

tation and water, were already a maj o r concern i n the late 1 980s . Yet

despite the severe and growing deficiencies i n infrastructure, the gov

e r n m e n t has fai l e d to d e v e l o p a c l e a r i n fr a s t r u c t u r e d e ve l o p m e n t

p olicy-one symptom of t h e large number o f veto players and politician's

lack of interests in national p olicy. Indeed, even at the level of individual

infrastructure projects , there has been very little in the way of nationally

c o o rdinated planning (Anuphap 1 997 ) . 2 .'

Taking transportation as an example, in 1 993 an international traffic

congestion team concluded that Bangkok had p o ssibly the worst traffic

congestion of any similarly sized city in the world ( Bello et al. 1 998) . By

1 99 6 the government had managed to construct o nly n inety- one kilo

meters of expressways-an accomplishment that took thirteen years to

complete ( ib id . ) . At the end of 1 998 none o f the various mass transit

projects were operational, although some had been in the works for ten

years o r more. Policy- making p aralysis , with different ministries / polit i

cal factions backing different projects , together with widespread charges

of corruption, led to long delays or the outright cancellation of proposed

proj ects . " "

H aving fai led t o develop c o h e r e n t , c o o r d i n a t e d publ ic p o licy t o

address the economy 's growing infrastructure n e e d s , the gove rn m e n t

turned t o selective privatization i n the areas o f telecommunicat ions and

transportation, hoping the private sector could do what the government

could not . On i ts face privatization may seem like a "national" policy. In

practice, however, privatization policy was turned to benefi t the n arrow,

private interests, rather than the public interest. Instead of selling off the

state enterprises that were in charge of telecommunications and trans

p o rtati o n , and lett ing them fac e competi t ion , po l icy makers opted to

keep the i r monopol ies i n t a c t . Ins tead , s t a t e - owned e n terpr i ses were

1 76


forced to grant "concessions" to p rivate companies to undertake maj o r

n e w investment proj ects . " Public interest was the first casualty o f the

system of concess ions that were granted during this per io d " (Ammar

1 997 , 1 6) . The negotiation process was far from fair and transparent and

concessions were rewarded to those with good political connections on

very favorable contractual terms ( ib id . ) .

M acroeconomic Policy

The collapse of the policy- p atronage compromise in 1 988 subj ected

macroeconomic p ol icy to many of the same pol i t ical constraints that

sectoral p olicy had operated under. However, the effects of these constraints

did not immediately appear for at least three reasons. First, the economic

b o o m was j us t moving i n t o h i gh gear whe n Chat ichai a s s u m e d t h e

premiership a n d t h e momentum carried t h e economy forward despite the

changes put in place by Chatichai. Second, the economic b o o m got its

second wind as the financial sector was l iberalized , a process that was

completed by 1 993 with the opening of the Bangkok International Banking

Facility ( B I B F ) .26 Financial l iberalization brought a flood of new money

into the Thai economy that fueled a stock market and real estate boom.

A t h i r d r e a s o n fo r the d e l ay e d o n s e t of s ym p t o m s in t h e

macroeconomy can be traced t o the appointment of Anand Panyarachun

as prime minister after a military coup in 1 99 1 . Anand, a highly respected

diplomat and b u s i n e s s m a n , was c h o s e n by the mil i tary to h e a d two

interim governments b etween 1 99 1 and 1 99 2 . He was not a p olit ician

and filled the maj o ri ty of his Cabinet with respected technocrats , busi

nessmen, and government officials rather than polit icians. Without the

electoral , partisan, or coalitional constraints that most governments face ,

o n e would exp ect Anand 's government to b e quite good at p rovid i n g

national p ol ic ies , a s long a s t h e interests of t h e military were not t o o

badly abu s e d . I n fact , Anand carried o u t a long l ist of large - s c ale na

tional p olicy reforms. He reduced tariffs , cut taxes, and reformed the t ax

law, and lifted exchange controls . He increased the pay of bureaucrats ,

formed the Stock Exchange Commission to oversee the Thai stock market ,

and pushed a proposal to create the ASEAN Free Trade Area (AFTA) . He

formed an elect ion monitoring organization (Pol l Watch) , launched new infrastructure p roj ects , set up new rules for screening projects and se lect ing c o n t ractors o r concess ionaires and o p e n e d up the p r o c e s s to greater public scrutiny (Pasuk and B aker 1 99 5 , various n ews sources ) . In short , the Anand government app ears to have acted more decisively and in response to broader societal interests than his e lected counterparts .

1 77


Despite Anand's reforms, the inability of the government to adjust

to the changing e c o n o my b e gan to manifes t i tself by 1 99 3 . The eco

nomic factors behind the d eter iorati o n o f Thailand's macro e c o n o my

during the 1 990s have been the subj ect o f several studies (see , for ex

ample, Yos and Pakorn 1 998 o r Pas uk and B aker 1 998) . Large amounts

o f c ap ital inflows , such as Thailand experienced in the late 1 980s and

1 990s , put the macroeconomy under great strain. Sound p olicies were

n e e d e d to manage the flow of cap ital and its u s e s i n the e c o n o my.

However, the politicization of the technocratic ministries, and the result

ing increased number of veto players with narrow constituencies, made

it difficult for the government to respond with the requisite policies . I n

the remainder of this chapter I focus o n t h e way in which governance

problems affected policy making in two areas : financial regulation and

fis c al pol icyP This is especially evident in the area o f financial sector

regulat i o n . Thai la n d 's fin a n c i a l architecture and regulatory system

needed to b e adapted to manage the increased flow of foreign capital .

However, the government failed to make the needed reforms. Elected

politicians had few incentives to push for a clearer accounting by finan

cial institutions and b orrowers o n how funds were being used. A new

regulat o ry framework would b ring very little addition al electoral sup

port from voters . On the other hand, regulation was a threat to many of

the businesses that were typically p art of a p o litician's constituency. In

additi o n , multiple veto p layers i n the p ol icy p r o c e s s made it nearly

impossible to find a policy on which all the relevant actors could agree .

The resul t , according to a report by the Wo rld B a n k , was " a p rivate

enterprise system where few controls [were1 imposed, increased mate

rial standards and p rivate gains [were] secured at an observable c o m

munal expense" ( World B ank 1 99 1 , 6 ) .

The agency that had the specific responsib il i ty fo r regulating t h e

financial sector was t h e B a n k of Thailand. I n d e e d , much of t h e b lame

for the crisis has been laid at the feet of the Central Bank . However, even

its strongest critics acknowledge that the bank's failure to better regulatE'

the financial system was due p artly to its loss of autonomy from polit ical

i n fl u e n c e s . With the c o l l a p s e o f the p o l icy- p a t r o n a ge c o m p r o m i s e ,

elected politicians began to assert more co ntrol over t h e Bank o f Thai

land. The governor 's p o sit ion in the b ank was increasingly held at the

pleasure of the elected pol iticians (Ammar 1 997 ) . " H The b ank governo r

does not serve a fixed term. Instead, he is appointed and removed by

the minister o f Fin a n c e . The Ministry o f F i n ance 's c o m i n g under th e

influence of elected politicians led to what Ammar Siamwalla calls "im-

1 78

T


plicit interventions" by some elected p olit icians in the p olicies of the

Bank of Thailand. That is , the governor would anticipate the preferences

of the Finance minister and follow the current political l ine whe n de

signing p o licy (Ammar 1 99 7 , 7 1 ) .

Obviously, concrete evidence o f " implicit intervention" is difficult to

come by. And even where political interference is more direct, it gener

ally goes undocumented: there are no memos from politicians o rdering

a particular action to b e investigated . However, the way in which the

B ank o f Thailand responded to fundamental problems in the fin ancial

sector is consistent with a story o f p olitical p ressure and influence . By

the mid- 1 99 0 s the financial sector was in serious trouble . The lack of

oversight had allowed cronyism and other imprudent lending practices

to fl ourish , a p o int driven home by the B angkok Bank o f Commerce

(BBC) scanda[ . 29

The scandal involving the B B C hit the headlines in 1 996 , whe n an

opposition p olitician raised the issue o f the b ank and its political con

nections in the context of a confidence debate. The BBC had p erpetrated

massive fraud involving, among other things , shady land deals, suspect

loans , and stock market speculati o n . In the middle of the scandal was

Group 1 6 , a co llection of ambitious pol iticians who joined together in

1 99 2 . Some o f the members o f Group 16 had sat o n a p arliamentary

committee charged with investigating some o f the BBC's business deal

ings. Rather than pushing for stronger b ank regulation or reform, some

members o f the group elected to j oi n forces with the BBC in a large

number o f pyramid schemes (Pasuk and B aker 1 998 ) .

The B B C 's bad debts rose steadily in 1 992 and 1 993 but it was not

until 1 994 that the Bank o f Thailand noted that there were too many

questionable loans. By 1 99 5 , however, internal Bank of Thailand docu

ments showed that the Central B ank comprehended the scale of the BBC

mess . However, rather than take actions to c lose the b ank and push for

the prosecution of the BBe's officers, the governor of the B ank o f Thai

land pulled together over fifty billio n b aht and pumped the funds into

the bank, where they then disappeared ( ibid . ) Even at the end of 1 99 5 ,

when bank regulators reported to t h e governor that the BBC was techni

cally bankrupt, that fraud was beyond question and that the b ank's officers

were criminally liable, the governor did not take strong action (ibid . ) . I t

was only after someone within the B ank of Thailand leaked the details o f

the scandal to an opposition politician that the affair came to light .

There has been a g o o d deal o f s p e c u l atio n o n the motivati o n b e

hin d the action ( o r inaction) o f t h e Central Bank gove r n o r. All egation s

1 79

r Governance and Growth in Thailand

range from p e rsonal connections with B B C o fficers to gross incompe

tence. Nonetheless, the political connection continues t o stand out. Some

m e m b e r s o f the gover n m e n t c o al i t i o n were without a d o u b t d e e p ly

involved in the affairs of the B B C . I n addit ion, there were widespread

allegations that the BBC had helped finance the 1 995 electoral victory of

Banharn Silpa-archa's Chart Thai Party. As prime minister, Banharn swept

away any lingering vestiges of an autonomous, technocratic Ministry of

F inance by appointing two individuals who lacked experience in mac

roeconomic management o r any independent base o f pol it ical support

as minister. Both were completely dependent on Banharn' s support to

remain in o ffi c e . The s e individuals were charged with overseeing the

work of the B ank of Thailand . Indeed, Thailand's two most p restigious

univers i t ies , Thammasat and Chulalongko rn, expl ic i tly drew the con

nection between the Central Bank's failure to regulate and direct political

interference in the weeks after the B B C scandal broke ( ib id . ) .

While the B B C was certainly the highest profi le case , many other

financia l inst i tut ions were fee l ing the b i te o f p o o r asset qual i ty and

m i smanagement during t h e m i d - 1 990s . Under p ol i t ical p re s sure , the

B ank o f Thailand offered abundant credits to finance companies and

commercial b anks between 1 994 and 1 997 ( Yos and Pakorn 1 998) . Un

fortunately, these rescue attempts were in conflict with broader macro

e c o n o m i c obj e c t i ve s . As t h e e c o n omy b e gan t o h e a t u p fro m 1 9 9 3

onward, t h e Central B ank tried to curb inflation by raising interest rates

and limiting credit. I-Iowever, the funds pumped into the financial sys

tem by the central bank tended to enlarge the money supply, encour

agi n g more spending and exacerbating both inflation and current ac

count deficits ( ibid . ) .

F iscal p olicy a lso ran counter to efforts to stabi l ize the economy.

This was espec ially true during the B anharn administrat ion . Pr ior to

Banharn the budget surplus had acted to offset capital inflows and eco

nomic overheating (Narongchai et al. 1 993) . Politicians pillaged the public

treasury each year but revenues were growing fast enough to keep up

with political demand. This changed with the election of Banharn's Chart

Thai p arty in 1 9 9 5 . B anharn was the p e rso nificat ion of a p rovincia l

politician and had been a member of Chatichai 's " buffet cabinet" of 1 988-

1 99 1 . Banharn's Cabinet was dubbed the " 7 - eleven" cabinet . Composed

of seven parties and eleven maj o r factions, decisive action in any policy

area was unlikely. However, it quickly became apparent that this govern

ment had no interest in national pol icy. Instead, i t was in the business

of corruption and patronage, and, l ike the convenience store , was open

1 80


fo r b u s i n e s s s ev e n d ays a we e k , twe n ty- fo u r h o u r s a d ay. O n e o f

Banharn's first actions a s p remier was t o increase planned budget ex

penditures by 10 p ercent (Pasuk and B aker 1 998) . A deputy leader of the

Chart Thai p arty and s p e aker o f the H o u s e est imated that half o f all

budget project money was lost to corruption ( The Nation, 19 May 1 996) .

Not surprisingly, the budget surplus quickly evapo rated and by late

1 996 the budget was moving into deficit . Fearing that they would soon

be forced to cut their budgets , many departments accelerated the spend

ing of their budget allocations (Pasuk and Baker 1 998) . This caused one

technocrat to comment that " [p j oliticians want to spend money to help

the people who elect them. You cannot expect them to put stabili ty ahead

of all e lse" (Chalongphop Sussangkarn 1 996 ) . In short , p ol i t ic ians b e

came more responsive t o their narrow constituencies than they h a d been

to the broader public interest .

Conclusion

The recent economic crisis has brought the issue of governance to

the forefront. as is certainly true of Thailand. While not all of the blame

can be laid at the feet of the polit icians and the p olit ical system, there

rem 'lin quest ions o f why the government did not take more c o n crete

s teps to p revent the cr is is , and why the response was s low once the

cris is hit . I t i s also interesting to compare the recent cris is with that of

the early- and mid - 1 98 0 s . There are differences between the two p e ri

ods, certainly, but there are some striking parallels. In both time p e riods

maj o r structural and financial adjustments were required to p revent

problems from escalating into a crisis . The current account and exchange

rate were a concern in both p e riods as was external indebtedness . F i

nally, the country's traditionally strong reputation among foreign financial

institutions and investors was weakening (Doner and Anek 1 994) . H ow

ever, the government 's response to the two cr ises differed greatly. The

Prem governments in 1 9 8 1 and 1 984 were able to devalue the currency

and carry out other reforms in the fac e o f strong opposit ion fro m the

business sector, p olit ical p art ies , and the military.

Contrary to the Prem government's earlier decisive action to reform the econ o my, as the cr is is l o o m e d and then broke in 1 9 9 6 a n d 1 9 9 7

Thailand's pol icy makers faltered (MacIntyre 1 999a) . 30 Crit icisms of the

government 's res p o n s e often point to the lack of dec isiven ess o n the

part of pol icy makers and the ir t ies to narrow, special interests. Indeed,

one Thai economist argues t hat because s o m any Thais h ad b egun to

see their government as incapable o f fo rmulat ing and i m p l em e n t i n g

1 8 1


the needed policies in response to the crisis , the I M F intervention was

generally regarded favorably, at least in the beginning. The I M F essen

tially filled a gap in authority (Ammar 1 997) , as what one would expect

given the incentives and capabilities of Thai policy makers to push for

national pol ic ies .

To summarize, the interaction of the electoral and party systems in

Thailand, prior to the new Constitution, produced a political system filled

with mUltiple veto players who were focused on their narrow constitu

encies and supporters . The result was a political system where pol icy

m akers lacked both the strong incentives and the capability to pursue

national policies. Prem was able to avoid many of the governance prob

lems associated with this p olit ical system by agreeing to an informal

compromise with the leaders of the various p olitical p arties . Prem and

the technocrats were left alone to manage the macroeconomy while the

p olitical parties received the sectoral ministries . When the compromise

ended in 1 988 , the governance problems began to resurface. Multiple

veto p layers made it difficult to formulate policy responses promptly,

and the incentives of p o l icy makers were such that they were more

concerned with their supporters' narrow interests than with the interests

o f the broader economy.

Finally, in the wake of the crisis Thailand adopted a new Constitu

tion. It makes numerous changes i n the political system, many of wh ich

could have a significant impact on governance. I mention only two here :

the switch to single- member districts and the addition of a nationwide

p arty l ist . 3 l Over time, single - member districts and the party l ist sho u l d

decrease the number of p arties and, thus, the number of veto players in

the system. The result wil l be more decis ive policy making. The pam'

lists should also help strengthen party labels and broaden the const i tu

enc ies o f Cabinet members , thus giving them a greater i n c e n t ive t o

provide national policies. I n short, given Thailand 's new institutions and

institutional arrangements , there i s some room for optimism regard i n g

t h e quality of future governan ce in Thailand .

1 82

NOTES

Notes to Introduction

1 . See, for instance, the annual rankings of I nternational Country

Risk Guide ( ICRG) .

2. Note that we use the term " institutions" in North's ( 1 98 1 ) sense: an

institution embodies a system of the rules, procedures, and norms, formal

and informal, that govern the behavior of a given set of individuals; those

rules , procedures , or norms are formally referred to as institutional ar

rangements. A merit-based recruitment and promotion system embodies

a set of rules and procedures that govern the behavior of civil servants .

Hence, i t is an institution. An annual performance appraisal requiring both

peer evaluations and the evaluation o f one 's immediate superior is an

embodied institutional arrangement. The judiciary is an institution; the

rules, procedures, and norms for selecting members of the Supreme Court

are part of an institutional arrangement. The common fields system in

medieval Western Europe is an institution; the peasant norms embodied

in this system are an institutional arrangement.

3. A number of o rganizations , p rivate or nonprofit , have provided

country ran kings based on the perceived extent of corruption o f busi

nessmen: to name a few, Transparency International, International Coun

try Risk Guide , and Political Risk and Consulting Inc .

4. The implication of the last is that, under certain circumstances, nascent

formal legal institutions can place limits on corruption, albeit weak ones.

5 . These refer to kinship ties, local networks of friends and relatives ,

or intermediaries with intimate knowledge of both potential nonlocal investor(s) and p otential local partner(s) .

1 83

r Notes to Pages 5-1 8

6 . For a related. more general argument. s e e MacIntyre. " Institutions

and Inve s t o r s : The Pol i t ics of the F inancial C r i s i s i n Southeast As ia"

(unpublished manuscript . University of California . San Diego. 1 999) .

7 . Why this happened is a thesis topic in and of itself. Suffice it to

say that the combination of rent- seekers with very short- term horizons

surrounding the president. the diverse coalition of groups that brought

him to power. and the president's p enchant for repaying favors had much

to contribute to distorting the decis ion- making process .

8 . See " The J 2 K Cr is i s and the Economy" (unpublished manuscript .

S c h o o l of Economics . University of t h e Phil ip p ines ) .

9 . I n fact . this app e ars t o b e the motivat ion b e h i n d Shlei fe r and

Vishny's ( 1 993 ) s e minal piece o n corrupti o n .

Notes to Chapter 1 ( Corruption a n d Its Implications for Investment)

1 . The Murphy. Shleifer. and Vishny paper ( 1 993) in fact provides much

of the theoretical motivations. if not underpinnings. for the now well-known

Shleifer-Vishny piece on corruption regimes ( 1 993) .

2 . The test for the coefficient of the dummy variable for East Asia in

his regressions are insignificant.

3 . Moreover. the comparators that practitioners have in mind when

citing the East Asia puzzle are other developing countries .

4 . For an analytical model of corruption and uncertainty. see Campos.

Lien. and Pradhan 1997 .

5 . Mauro ( 1 995) , for instance. used survey data collected annually by

The Economist Intelligence Unit. Keefer and Knack ( 1 995) based their find

ings on survey data conducted annually by the Investor Country Risk Guide

(lCRG) . Other survey-based data are available from Transparency International

(Geneva) , The World Competitiveness Report (Davos) and Political Risk Con

SUlting. Inc. (Hong Kong) . The data that these surveys contain are still of an

indirect nature. It is practically impossible to obtain accurate information of

sufficient breadth on actual amounts of bribes and the like. Hence. the best one

can do is work with survey responses from individuals affected by corruption.

6 . In the extreme case. corruption per se would represent a pure in

come transfer or a tax provided it was fully predic table .

7. More specifically. we used the natural logarithm of both variables.

8 . Data on per capita GDP. enrollment rates. and investment as a percent

of GDP come from the World Development Indicators (various years ) .

9 . The IFC began publishing an annual report on private investment

flows to developing countries in 1 990. To our knowledge. there is no other

source of informatio n on this issue that is as extens ive as this.

1 84

Notes to Pages 23-47

1 0 . In the case of a corner solutio n . the results are ambigu ous .

1 1 . The analysis here of O- Ring corruption assumes investors are risk

neutral . I f investors are risk- adverse then greater uncertainty necessarily

leads to less investment; if they are risk takers. the results are reversed. If

they are risk-neutral then under certain conditions greater uncertainty may

in fact lead to more investment as might happen by analogy in thinly

capitalized markets . The investors in our model (and more typical of in

vestors in real capital in developing countries) are not of this type. We are

grateful to D avid Ellerman for pointing out this problem.

Notes to Chapter 2 (In vestment, Property Rights, and Corruption

in Indonesia)

The following people have all helpe d with the development of this

paper: E d Camp o s . S tephan H aggard. H al Hil l . John M c Mil lan . B arry

Naughton. Sanjay Pradhan. Rizal Ramli . John Sidel . Djisman Simandj untak.

and Ali Wardhana. I am grateful to them all. Research for the paper was

made p o s s ib l e by generous funding fro m the Asia Research Centre at

Murdoch University (Western Australia) and the World Bank.

1. A substantial body of research is now emerging on this topic. My analy

sis of the crisis in Indonesia is set out more fully in a forthcoming publication.

For other empirically grounded interpretations. see McLeod 1 998. Soesastro

and Basri 1 998. Hill 1 998. Robison and Rosser 1998, Azis 1 998. and Pincus 1998.

2 . The institutional framework permitted Suharto to behave erratically.

but it did not cause him to do so. To know why Suharto chose to behave

in the erratic way he did. we need to know about his political preferences.

There is much speculation on this subject. but little firm evidence. Am o n g

the most frequently encountered guesses are that he was simply unwill ing

to cut back the p rivileges of his children (ef. his willingness to cut back

crony privileges in previous crises) ; that he suffered from seriously inad

equate information on the true precariousness of the economic s i tu a t i o n

because his advisers no longer dared to bring him unwelcome news ; or

that he suffered from seriously diminished political judgment through some

combination of age and hubris .

Notes to Chapter 3 (Sta te, Capital, and In vestments in Korea)

1 . Except for those of Korea. the figures cited in the rest of this para

graph are for 1 96 1 . and are from Kindleberger 1 965 . table 1 . 1. (per capita

income figures) and figure 5.2 ( investment figures ) .

2 . I n the 1 960s . the Korean inflation rate was higher than those o f

Venezuela ( 1 .3 percent) Bol ivia ( 3 . 5 p e rcent ) . Mexico ( 3 . 6 perce n t ) . Peru

1 85

..


( 1 0 . 4 percent ) , and Colombia ( 1 1 . 9 percent) , and was n o t much lower

than that o f Argentina (2 1 . 7 percent) . I n the 1 97 0 s , i t was higher than

those found in Venezuela ( 1 2 . 1 p ercent) , Ecuador ( 1 4 . 4 p ercent ) , and

M exico ( 1 9 . 3 percent ) , and was not much lower than those found in

Colombia (22 .0 percent) or Bolivia (22 .3 percent) . See Singh 1 995 , table

5, for further information .

3 . For example, following Max Weber's classic work, i t i s widely ac

cepted that the Protestant ethic restrained l Uxury consumption by the

entrepreneurial class in the early phases of capitalist development in Western

Europe. I thank Chung H. Lee for reminding me of this important point .

4 . A piece of information corroborating this i s the extremely small

wage differential between the top managers and the workers that pre

vails i n Korea. According to the data collected by the consulting com

p an y Towers P e r r i n , of the twenty- t h r e e m e d iu m - s iz e d c o u n t r i e s

surveyed , Korea h a d t h e smallest wage gap b etwee n t h e t o p managers

and the workers (the former being only 8 times of the latter) . Countries

like Venezuela (84 times) , Brazil (48 times) , Hong Kong (43 times) , Mexico

(43 times) , Malaysia (42 times) , Singapore (35 times) Argentina (30 times) ,

U S (24 t imes) , South Africa (23 t imes) showed high differentials , while

countries like New Zealand (9 times) , Switzerland ( 1 0 t imes) , Japan ( 1 0

t imes) , Sweden ( 1 1 times ) , and Germany ( 1 1 t imes) , showed low differ

entials . I t i s interesting to note the high -wage differential in other East

Asian countries , such as Hong Kong, Malaysia, and Singapore. The data

was reported in 1 / 2 August 1 99 8 issue of t h e Financial Times.

5. These included industries where access to proprietary technology

was deemed essential for further development o f the industry, and i n

dustries where the capital requirements and / or the risks involved in the

investment were very large. The ownership ceiling was also relaxed if ( 1 )

the investments were made i n the free- trade zones ; (2 ) the investments

were made by ove rseas Koreans ; o r (3) the investments would "d iver

s i fy" the o rig ins o f FDI into the country-namely, investments fro m

countries other than the US and Japan, which had previously dominated

the Korean FDI scene. For detai ls , see EPB 1 98 1 , 70-7 1 .

6 . The recent awarding of the contract for the fast- train project to the

Angl o - French j o int venture (GEC Alsthom) organized around the pro

ducer o f French TGV over i ts J apanese and German competi tors , who

o ffered technologically super ior products , i s a go o d example o f such

pol icy orientation (see Chang 1 99 8 a fo r furth e r d etai ls ) .

7 . Need l e s s t o s ay, t h i s h a s t o b e s e t agai n s t t h e " s e c o n d - mover

disadvantage, " which means that the fi rst movers would reap more rents.

1 86


8. For a discussion of bureaucratic organization and reform in East

Asia, see Campos and Root 1 996 . For empirical analysis of key attributes

o f a well- funct ioning bureaucracy, see Evans and Rausch 1 99 7 .

9 . D o e s t h i s m e a n t h a t w e n e e d tough capital c o ntrol in o r d e r to

moderate the negative impact of corrupt ion o n capital accumulat ion?

The matter is not that simple. In some countries, corruption is rampant

but a lot of capital stays home even without severe capital control (e .g . ,

Indonesia) . Also, there is a reverse feedback. In some countries, corrup

tion is such that there is no effective capital control (e .g . , Russia) . So we

need t o know more abo u t the country to b e able to say that c a p ital

control is necessary, feasible, or effective in reducing the negative effect

of corruption o n accumulation .

1 0 . This certainly appears to be the case in Japan. See Okimoto 1 989

for results of a survey o f government ministr ies i n Japan.

1 1 . See Campo s and Root 1 99 6 .

1 2 . B etwee n 1 990 a n d 1 99 3 , t h e share o f Korea's outward F D I as a

proport ion o f its GDP was 0 . 4 5 percent . While outward F D I increased

dramatically during the last few years (from $ 1 .26 billion in 1 993 to $4 . 1 3

b il l ion i n 1 99 6 ) , this i s st i l l j ust over 1 p e rc e n t of GDP, which i s well

below the OECD average of 1 . 85 percent (for 1 990- 1 993) . I n stock terms,

Korea's outward FDI stock was equivalent to 3 . 1 6 percent of GDP as of

1 994 , which is far less than the OECD average of 1 4 .94 percent. All fig

ures are fro m KDI ( 1 99 6 ) , except for the outward FDI figure for 1 99 6 ,

which is fro m Far Eastern Economic Review, 1 M ay 1 99 7 , 44 .

1 3 . The definit ion of foreign debt here follows the World Bank defi

nition, and therefore is different from the concept of "external liabili t ies , "

which includes the offshore borrowings o f Korean banks and overseas

borrowings of the overseas branches and subsidiaries of Korean banks .

The I M F and the Korean government started using this defini t ion fo l

lowing their accord on 28 December 1 997 . At the end of November 1 99 7 ,

Korea's external liabilities amounted to $ 1 57 billion, of whic h $ 9 2 b i l l ion

was of less than a year's maturity.

1 4 . Korea's foreign deb t / GNP ratio was only 22 percent in 1 99 6 and

stil l arollnd 25 percent on the eve of the crisis . This falls far short of the

World Bank threshold of 48 percent where a country is downgraded fro m

" less indebted" to "moderately indebted , " not to speak of the 80 percent

threshold where i t qualifies as "severely indebted" (see World Bank 1 997 ,

1 : 4950 , for t h e definit ions ) . The foreign debt / GN P ratio at t h e end of

1 995 was 70 percent for Mexico, 5 7 percent for Indonesia , 3 5 percent for

Th ailand, 33 percent for Argent ina, and 24 percent for Brazi l . I n terms of

1 87


another common indicator of debt burden, Korea was st i l l b elow the World Bank "warning threshold" of 18 p e rcent at 5 .8 p ercent in 1 99 6 . T h i s c o mpares v e r y favo rably w i t h t h o s e o f o t h e r c o u n t ri e s s u c h as M exico ( 2 4 . 2 p e rcent ) , B razil ( 39 .7 p ercent) , I n d o n e s i a (30 .9 p e rcent ) , and Thailand ( l 0 .2 percent) in 1 99 5 . All the above figures cited are from World Bank ( 1 997 ) country tables .

Notes to Chapter 4 (Governance and Investment in China) I . The Financial Times ( 3 0 April 1 99 7 ) states that "China received

about a quarter of a l l FDI to developing countr ies b etween 1 979 and

1 997 , according to the World Bank Global Finance report , " and that "some

200 o f the world 's 500 largest transnat ional c o r p o rat ions have e stab

l i shed a presence in China s ince 1 990 . "

2 . James D . Wolfensolm, in Transition 7 (Sept / Oct . 1 996 ) : 9 .

3 . Some gift giving is s e e n as showing respect or pre-communication

i n China and in some other East Asian countri e s , but as corruption in

the West . Thus corrupt ion in China, as perceived by the West , may b e

s o m ewhat exaggerated.

4 . The dual- track price system introduced in 1 984 i s another factor

co ntributing to the widespread corruption.

S . Note that competit ion among br ibe givers can increase b ribe s ,

whi le competit ion amo n g b r i b e takers tends to reduce br ibe .

6 . This implies that the degree of corruption is l imited; for instance,

the t ax authority cannot arbitrarily tax business activi t ies .

7 . And national elections ( if any) may be more superficial , and local

e lect ions are more substantial .

8 . See Wa de 1 990 and Campos and Root 1 99 6 for examples .

9 . I f everyo ne was c o rrupt a ll the way to t h e t o p t h i s , of course ,

creates the possibility of an inverted pyramid of corruption: money flows

to the top with those at high e r p osit ions receiving more .

1 0 . B ribery may help speed up o r delay the process of case settl e

ment , but m a y n o t a l t e r the verd icts .

1 1 . For exam p l e , s e e the s c an d a l s o f t h e Ta i p e i s u bway syste m ,

Ko rean urban construct ion, and Japan's Mini stry o f Constructi o n .

1 2 . International arbitrat i o n will develop further after C h i n a j o i n s

t h e WrG .

1 3 . If they a c t a s independent monopolists , t h e n co rruption will be

s imilar to random rob b e ry and hence have the worst consequences .

1 4 . Put differently, centralized or coordinated corruption is similar to

the organized robbery of a stationary bandit in Olson's ( 1 993) terminology.

1 88

Notes to Pages 8 1 -89

1 5 . In China, the Standing Committee of National People's Congress

(not the Supreme C ourt) interprets the C o nstitution and laws . Judges

lack tenure in o ffice . Courts are subj ect to the control o f Co mmunist

Party committees and people's co ngre s s e s in the same jur isdict ion .

1 6 . I n c i d e ntal ly, R o b e rt Kuok was n a m e d t h e w o r l d 's s h rewd e s t

businessman by Forbes ( s e e Forbes, 2 8 July 1 99 7 ) .

1 7 . This subsect ion is drawn fro m Li and Lian 1 99 9 .

1 8 . During t h e Mao e r a (the 1 95 0 s a n d t h e 1 960s) , both a planning

system and a market system were stil l at a trial stage in East Asia . Mao

did not have p ersonal exp eriences to compare a planning economy with

a market economy. Thus, he did not perceive that i t was in his interest

to pursue catching- up p o l i c i e s b a s e d on market mechanisms . Unl ike

Mao, Deng had witnessed a functioning market economy in France in

his e arly youth.

19 . During his famous southern tour in 1 992 , Deng clearly indicated

that if China did not develop , or d evel o p e d t o o s lowly, relative to i t s

n e i gh b o ri n g c o u n t r i e s , t h e C h i ne s e p e o p l e w o u l d n o t b e s a t i s fi e d

with the Chinese Communist Party. He also indicated that i f the reform

did not imp rove the l iving s tandards o f the maj o rity o f the p e o p l e ,

t h e Chinese Communist Party might n o t b e able to survive t h e J u n e 4

I ncident .

20 . State Commission for Restructuring the Economic System, " The

Role o f Government in China: An Analysis of a Survey, " in Almanac of

Ch ina's Economy 1 996 ( Beij ing: China Statistical Publishing House , 976-

80 , table 2 . 1 ) .

2 1 . I t was o ffic i al ly r e p o r t e d that b y 1 9 9 0 there were a b o u t 4 3 0

enterprise groups . In 1 99 1 , the State Council selected fifty-s ix enterprise

groups for exp e rimentation on managerial and regul atory matters .

2 2 . S e e Yan g J i s h e n g , " E ast - We s t D i a l o g u e i n C h i n a , " Liaowa llg

zhoukan (Out look Weekly) , overseas e d . 9 , 2 7 Feb ruary 1 9 8 9 , 5-7 . See

also , D o n al d C . Clarke , " Th e Creat ion o f a Legal Structure fo r Market

Institutions in China," in Reform ing Asian Socialism: The Growth of Market

Institutions, eds . John McMillan and B arry Naughton (Ann Arbor : Univer

s i ty of Michigan Press , 1 996 ) , 5 1 , 5 6 .

2 3 . Fazh i ribao ( Legal System D aily) , 24 July 1 99 1 . 1 .

24 . As Fairbank ( 1 992 , 409) observed , " During the five years to 1 985 ,

more than a million senior CCP (Chinese Communist Party) cadres were

pensioned off. In September 1 98 5 , 1 3 1 high- ranking veterans resigned .

Generally they retained the i r p erquisites as members of a new C e n tral

Advisory Commiss ion of the CCP headed by Deng . . . M o s t local offi -

1 89

Notes to Pages 89- 1 04

cials as of 1 978 had finished only junior middle school. By 1 984 half of

them were college graduates. Among higher officials in party and gov

ernment before 1 9 8 1 only about a quarter, but by 1 984, two - thirds or

more, were college graduates . " By 1 995 , about 90 p ercent of local offi

cials were college graduates (see State Commission for Restructuring the

Economic System, "The Role of Government in China: An Analysis of a

Survey, " in Almanac of Ch ina 's Economy 1 996 [Beij ing: China Statistical

Publishing House] , 9 76-80 , table 1 . 2 ) .

2 5 . Interestingly, one of the major slogans of the Chinese Commu

nist Party under Deng was "yao liang shuo ying" : deepening economic

reform on the one hand and consolidating political control on the other.

Central to the former is autonomy and decentralization and central to

the latter is control and coordination .

26. These agencies also design ex ante and interim checking devices.

27 . The SPC was renamed the State Development Planning Commis

sion in the 1 998 State Council restructuring.

28. Thus, there is little difference between East and West or between

North and South other than being in different stages of development.

The popular media terms ''Asian value" and "Asian crony capitalism" have

little value and are misleading.

Notes to Chapter 5 (Centralization, Political Turnover, and Investment

in the Philippines)

We are deeply grateful to Jose Edgardo Campos for support and

suggestions but are entirely responsible for the views expressed here as

well as for any omissions and errors .

1 . Indeed, the recent Asian financial turmoiL which devastated hith

erto rapidly growing economies, has been interpreted j ournalistically as

a vindication of the simple superiority of governance systems patterned

after those of Western democracies .

2 . This does not include Marcos's first term as president, which began

in 1 969 and was due to end in November 1 97 2 .

3 . See , for instance , de Dios 1 999a for a discussion o f h o w thes e

changes may affect clan -based relations .

4 . This presumes rent -seeking- related expenditures by factions are

strategic complements , that is , own-spending by any faction increases

with the spending by others .

5 . This local term, " fiscalizing," gives a more constructive connota

tion to the older political term "fil ibuster, " which was too o bviously as

sociated with obstruction .

1 90

Notes to Pages 1 05- 1 4

6 . N o t e that this d o e s n o t mean t h e actual amount of bribes taken

is greatest. The discouragement of investment proj ects also implies that

the amount of bribes collected decl ines .

7 . The l i terature o n p olit ical business cycles i s vast . Existence of

rational p olitical business cycles has been questioned by a number of

theorists. Several recent studies, however, have shown that such cycles

can exist when incumbent leaders have superior information about the

economy o r when some interest groups can use coalition dynamics to

extract rent fro m others. Empirically, a great deal of evidence supports

the existence of pol itical business cycles in developing countri e s , al

though not in developed countries .

8 . Unfortunately, for the years prior to 1 970, we are unable to obtain

a series that divides investment neatly b etween private and pUblic . We

therefore add private construction and total durable equipment to con

stitute a p roxy variable for p rivate fixe d investment and take govern

ment c o n s tr u c t io n as a p r o xy fo r p u b l i c fix e d i n ve s t m e n t . This

approximation is j ustified by the smaller ro le that government played

in durable equipment prior to the martial law period when large- scale

experimentation with public corporations began; prior to that period,

publ ic investment consisted mostly o f public works .

9 . Recently, the Estrada administration accused the p revious one of

granting "behest" loans, or " loans on command." One case was the land

reclamation deal mentioned earlier; another was the accusation that the

previous administration granted b ehest l o ans to interests close to it .

10 . A signal event in the rehabilitation of the Marcos faction has been

the election of Eduardo Cojuangco as chairman of San Miguel Corpora

tion, one of the largest Philippine conglomerates . Mr. Cojuangco was the

most important Marcos crony, and President Estrada ran under the minor

ity political party Cojuangco headed. Since 1 986, Cojuangco's shares in

San Miguel have been under government sequestration, and he was pre

vented from exercising any influence in the corporation. It is significant

that the government representatives in the San Miguel board were those

chiefly responsible for Cojuangco's return from economic limbo.

I I . Obviously, there are some types of leadership turnover, such as

coups and revolutions, that tend to concentrate power anyway, whether

it is diffuse or not , prior to change. Our focus here is on more regular

leadership changes that leave the decis ion- making process and distri

b ution of power intact.

1 2 . One may say, however, that a substitute for this has been the parameters set by conditionality on the part of the I M F and to a lesser

1 9 1

-

Notes to Pages 1 1 4-20

extent the World Bank during the 1 9 70s and 1 980s . Typically effective

during crisis periods , these programs substituted for the information

that openness to international markets may have p rovided. To that extent,

the lines for the rent- s eeking contests were defined in terms of the al

lowable budgets and taxes that needed to b e passed .

1 3 . An important source of uncertainty for Americans at the time was

the impending end of "parity rights, " a legacy fro m the US occupation ,

which gave national treatment t o US investors, particularly in the matter

of asset ownership.

14. For an overview, see de Dios, Daroy, and Kalaw-Tirol 1 988 .

1 5 . Another country in a similar situation would have been India. I t

is noteworthy that development theorists writing in the 1 950s and 1 960s

regarded India and the Philippines as the countries most l ikely to suc

ceed in development terms .

1 6 . Recall that the Philippine Revolution of 1 896 was the first in Asia

to be waged on explicitly Western republican and democratic principles

from the French Revolution. The democratic political canon was suspended

but not contradicted by the US o ccupation. Indeed, it might have been

strengthened by the example of the Americans' own democratic system.

1 7 . In the Philippines this broader view is used to distinguish purely

economic unionism fro m the ideological or militant variety.

1 8 . Wry political wisdom captures this when it states that no one in

the country ever " loses" an election, one is o nly always "cheated . "

19 . M arx ( [ 1 869] 1 983) in a similar vein would write in frustration

that absolutism, or Bonapartism, was based on the backwardness of the

French p e asantry. He went as far as to doubt whether they formed a

class, noting that they were connected purely locally, with few interests

at the national level and no pol itical o rganizatio n .

20 . This is b y no means unqualified; s o m e authors have pointed t o

factors which suggest that qualitative changes are possible, if they have

not actually occurred , owing to economic changes , demographic forces,

globalization, education , and the emergence of an o rganized citizenry

during the M arcos dictatorship itself ( see , e . g . , Kerkvliet and M oj ares

1 99 1 , 10 and de Dios 1 99 9 a for a discussion) .

2 1 . For a recent discussion, see de Dios 1 999b.

22. Notwithstanding the fact that tariffs are part of revenues and, there

fore, a legislative prerogative, a loophole in the tariff code exists, allowing

the president to revise tariffs when Congress is not in session.

23. Wurfel ( 1 98 8 , 85 ) p rovides a description of the p remartial law period that is still relevant when he writes that "almost all bills of gen-

1 92

Notes to Pages 1 20-66

eral interest were first drafted by the executive branch. Fewer than a

hundred bills were passed each year, and the president had much to say

about which became law . . . . A majority of bills passed by both houses

were p articularistic; they granted utility franchises for example, created

barrios, or changed the names of schools. Congressmen filed thousands

of special interest bills every session, doing favors for [their] local p o

litical liders or simply trying to impress unsophisticated constituents. As

a result, the priorities of the technocrats on the p resident's staff clashed

with those of congressmen." This situation, of course, became even more

pronounced under the dictatorship, when the legislature either did not

exist or was reduced to a rubber stamp. This practice is still current, to

the extent the postdictatorship presidency has more p rerogatives than

it had before martial law.

24 . This proposal was also supported by the reputable Phil ippine

Constitutional Association.

25 . Admittedly at least partially self-serving on the part of incumbent

politicians.

26 . This is not to deny that favoring p articular interests is also pos

sible in the process of p rivatizatio n and deregulation .

2 7 . These inefficiencies include the minor displays of sycophancy

involved in inventing acronyms for projects that invariably spell out the

incumbent p resident's name, i .e . , FIDEL under Ramos and ERAP under

Estrada. Of course, this also means that these programs must be scrapped

or redrawn once the administration changes .

2 8 . Economic dec is ions by the Supreme Court-most recently o n

foreign investment in the Manila Hotel-have particularly attracted con

troversy.

29 . A study by the Institute for Popular Democracy ( 1 994) observes

that members of the Lower House who came fro m oligarchic families

had been reduced from 1 69 (of a total membership of 250) in 1 987 to

1 45 by 1 99 2 .

Notes t o Chapter 7 (Governance and Growth i n Thailand) 1 . See Warr and Bhanupong 1 996 for a detailed description of the

shocks and p olicy responses .

2 . See Doner and Anek 1 994 and Warr and Bhanupong 1 996 for more detail s .

3 . Other factors certainly affect governance as well, among them the

interests and behavior of private actors. However, in this chapter I focus

primarily on the incentives and capabilities of policy makers .

1 93

r Notes to Pages 1 66-69

4. National policies include classic public goods, such as defense, as

well as goods or policies that may look a lot like public goods, but might

not meet the strict public goods definition (nonrivalrous consumption

and nonexcludabil ity) . Education and currency devaluations are two

examples of collective, but not strictly, public goods. In principle, edu

cation is certainly an excludable good-individuals might be excluded

on the basis of their ethnicity, their citizenship status, their income, etc.

A currency devaluation might not meet the nonrivalrous consumption

criteria. As people "consume" the devalued currency by purchasing it ,

the currency will appreciate over time, ceteris p aribus. The more people

purchase the currency the greater the appreciation.

5 . For example , electoral rules that require voters to vote for party

lists or that pool votes among candidates of the same p arty tend to b e

associated with a strong attachment to party label o n t h e part of both

candidates and voters . O n the other hand, where voters cast multiple

votes o r where the electoral rules facilitate intraparty competition the

value of the p arty label is diminished (Carey and Shugart 1 995 , Shugart

and M ainwaring 1 99 7 , Cox and McCubbins 200 1 ) .

6 . For theories o n when groups have incentives t o form nationwide

p arties as opposed to smaller p arties see Chhibber and Kollman 1 99 8 ,

C o x 1 999 , a n d Hicken 1 999 .

7 . Capability is also a reflection of administrative capacity-namely,

the quality of the bureaucracy (Cox and McCubbins 200 1 ) . The bureau

crats h ave a key role to p l ay in the p o licy- making process . They are

o ften a key source of info rmation for policy makers and are also del

egated the task of policy implementation. Where administrative capac

i ty i s l ow due t o divi s i o n s within the b u r e a u c racy, c o rr u p t i o n , o r

incompetence, the capabil ity t o produce and implement good policies

is undermined. The quality of political leadership could also be included

in this category.

8 . The role of the Senate in policy making is an extremely under

studied topic and one that deserves more attention (see Chai-anan 1 989

for some discussion of the role of the Senate) .

9 . Parties also fail to forge strong links across districts , province s ,

a n d regions t o form large , national parties, although t h e extent of link

age failure varies somewhat by region and p arty. For a more detailed

analys is of l inkage , the number of parties and regional vari ations in

Thailand see Hicken 1 999 .

10 . The two p arties that have come closest to becoming national parties in recent elections are the Democrat and New Aspiration Parties .

1 94

T


However, even these p arties draw most of their support from one or two

regions (the South and Bangkok for the Democrats and the Northeast for

the NAP) .

1 1 . King ( 1 996) and Albritton ( 1 996) are the lone dissenters that I am

aware of. They argue that the weakness o f Thai p arty labels has been

exaggerated and that party labels do matter to voters .

12 . A well -known example comes from seventeenth-century England

(North and Weingast 1 989) . The addition of Parliament as a check on the

English monarch's actions made it more difficult for the Crown to renege

on public debt commitments . As a result commitments to repay were

more credible and England was able to borrow money at lower interests

than would have otherwise been p o s sible .

13 . Prem actually followed the one-year term of General Kriengsak,

who resigned in 1 980 .

14 . See , for example , Anek 1 992a and Pasuk and B aker 1 99 5 .

1 5 . I t is important t o note that the " bifurcation" of policy c a n actually

be traced back to the Sarit era (see Christensen et al. 1 997) . In 1 958 the

management of macroeconomic p o licy was reformed and technocrats

put in charge of the p olicy- making process . However, management of

sectoral policy was not reformed and remained a bastion of corruption

and patronage (ibid . ) . The uniqueness of the policy-patronage compro

mise under Prem is that electoral politicians were given a piece of the

pie and were able to keep it. (Elected politicians were also appointed to

sectoral Cabinet p o s ts in 1 975 but lost control of those p o sts after a

military coup in 1 976) .

1 6 . A few p o s it ions were fil led up by p oliticians with strong e c o

n o m i c b ackgrounds . B o o nchu Rochanasathian, h e a d of t h e SAP party

and a former bank president, was chosen as Prem's first deputy minister

in charge of economic affairs. However, when Boonchu and Prem clashed

over stabilization measures, Boonchu resigned his post and the SAP left

the government coalition . (Boonchu wanted to increase fiscal spending

in an effort to try and jump start the economy while Prem and his advisors

preferred a stabilization package) . After Boonchu and the SAP left the

Cabinet, Prem assumed a greater role in economic policy making and

appointed nonparty people, mostly technocrats or retired bureaucrats ,

to the key economic posts (Anek 1 992b) .

1 7 . F o r more information about the specific funct ions of each of

these group s see Anek 1 992a, 1 992b and Christensen et al . 1 99 3 .

1 8 . Researchers point to several factors that contributed to t h e rela

tive decline in the polit ical influence of the military over the course of

1 9 5

r

\ I


the 1 980s, culminating in the selection of an elected politician as prime

minister in 1 988. These factors include the end of the communist insur

gency, splits, and generational shifts within the armed services, interna

tional influences, economic development and the growing political power

of economic elite, and an alliance between the new economic elite and

political parties (see for example Chai-anan 1 989, 1 993, 1 997 ; Suchit 1 989;

Sukhumband 1 993) . The fact that Chatichai was a retired general also

helped facilitate the transition from a nonelected to an elected premier.

1 9 . James Ockey ( 1 992 , 1 994) and Philip Robertson ( 1 996) are among

those who have chronicled the rise of these powerful p rovincial busi

nessmen, or Chao Pho, and their entry into p arty politic s . These busi

nessmen became active supporters of candidates and political parties in

an effort to gain more influence in the p ol icy process . I t was also the

case that B angkok-based p oliticians, preferring to run in rural constitu

encies rather than in ultracompetitive B angkok, sought out the support

and assistance of the p rovincial business elite ( O ckey 1 992) .

2 0 . The fortunes o f p rovincial business elite were often b ased o n

concessions or monopolies, such a s mining, timber, liquor production and

distribution, and petrol distribution, granted by the government (Ockey

1 992) . One would expect, then, that they would be against any attempts to

remove concessions, dismantle monopolies, or make the process of grant

ing contracts more competitive and transparent.

2 1 . The JPPCC met a similar fate. The JPPCC was created by Prem

to be the vehicle through which urban business interests would influ

ence policy. Chatichai reduced the role of the JPPCC in a bid to allow

elected Cabinet ministers (and the provincial business interests that they

represented) to gain more discret ion over e c o n o m i c pol icy making.

Compared to a nearly monthly meeting schedule under Prem, the JPPCC

met only five times in 1 988 , four in 1 989, and twice in 1 990 .

22 . While the incentives and capabilities of p oliticians are the focus

of this essay, there are certainly other factors that contributed to the

decline in the quality of governance. One of the most significant is the

hollowing out and politicization of the bureaucracy that occurred during

the late 1 980s and 1 990s (Ammar 1 997 ) . During the economic boom

many o f the most competent and wel l - trained bureaucrats left their

government jobs for higher paying positions in the private sector. Col

lege graduates also began opting for high-paying careers in the private

sector over j o b s in the bureaucracy. This reduced the cap acity of the

bureaucracy to analyze the potential problems facing the economy, and

to offer accurate information and sound advice to policy makers. With-

1 96

T

Notes to Pages 1 7 5-82

out accurate information, policy makers' capability to enact sound policy

was further undermined. However, even the strongest advocates of the

bureaucrati c - decl ine explanation r e c o gnize the need to account fo r

political factors as well . " Since the failure of the technocracy could in

principle be ultimately corrected by the political leadership, it has to be

explained why the Thai political system failed to deliver that leadership"

(Ammar 1 99 7 , 64) .

2 3 . This is not to s ay, however, that p o o r governance is the o nly

reason behind the crisis .

24. The closest thing to a comprehensive infrastructure development

plan was the East Seaboard Development-a green-field development

proj e c t c o m p o s e d o f expo rt p r o c e s s i n g z o n e s , an industr ia l area, a

teleport, and a deep seaport. However, even this project ran into signifi

cant difficulties (see Anuphap 1 99 7 for more details) .

25 . Thailand's performance in the area of the environment has been

equally dismal .

26. For more i nformation on the BISE see Pakorn 1 994, Ammar 1997 ,

and Nukul 1 9 9 8 .

2 7 . There is room for m u c h more research o n t h e l inks b etwee n

politics a n d p o licy making during t h e 1 990s . A p articularly interesting

question is what role politics played in the failure of the B ank of Thai

land to devalue the currency prior to the July 1 997 float .

2 8 . See Ammar 1 997 for a discussion of how an increase in the de

facto number o f veto players within the B ank of Thailand itself also

contributed to the deterioration o f policy.

2 9 . S e e Pasuk and B aker 1 99 8 for more info rmation o n the B B C

scandal.

30. For detailed accounts of the crisis in Thailand, see MacIntyre 1 999a,

Bhanupong 1 99 8 , Ammar 1 997 , Pasuk and B aker 1 999 , Warr 1 998 , and

Lauridsen 1 998 .

3 1 . For a closer look at the implications of the new 1 997 Constitu-

tion, see Hicken forthcoming a, and Hicken forthcoming b .

1 97

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1

INDEX

Administrative capacity, 1 94n. 7

Agricultural development, Malay

sia, 1 3 8

Alliance, The, Malaysia, 1 3 7-38

American Foreign Corrupt

Practices Act of 1 977, 80

Anand, Panyarachun, 1 77

Anand government, 1 77-78

Aquino, Corazon, 1 04 , 1 22-23

Aquino administration, 1 2 1

Arbitration Law, China, 80

ASEAN. See Association of South-

east Asian Nations

Asian crony capitalism, 1 90n. 28

Asian financial crisis: 1-3, 6, 25-26, 40,

1 90n. l ; effect on China, 97-100;

impact on the Philippines, 128

Asian miracle, 2

Asian value, 1 90n. 28

Association of Southeast Asian

Nations, 1 2 6

Autonomy of local governments,

China, 88-89

Autonomy of technocrats , China,

89-90

2 1 5

Baht devaluation, 1 65

Bangkok Bank of Commerce, 1 79-80

B angkok International Banking

Facility, 1 77

B anharn, Silpa-archa, 1 73

Banharn administration, 1 80-8 1

B ank Bumiputera, Malaysia, 1 4 1

Bank of Thailand, 1 65 , 1 72 , 1 78-

79, 1 97n. 28

BIBF. See Bangkok International

Banking Facility

BMF. See Bumiputera Malaysia

Finance

Boonchu Rochanasathian, 1 95n. 16

Bribery, 2 1-22, 60-63 , 1 88n. 1 0

Budget Bureau, Thailand, 1 72

Bumiputera, 1 40, 1 44, 146 . 1 53 .

1 55 , 1 57

Bumiputera Malaysia Finance, 1 4 1

Bureaucracy, 58-59, 1 2 5

Bureaucrats, 58, 73, 82, 1 94n. 7

Capital account, Indonesia, 39-40. 43

Capital accumulation, Korea. 60

Capital control. 1 87n . 9

Index

Capital flight, Korea, 49-50

Capital inflow, Korea, 52-56

Central Advisory Commission,

China, 90

Central Party Discipline Commis

sion, China, 92

Central Party Personnel Agency,

China, 90

Centralization in government,

Philippines, 1 1 4-22

Chaebols, 52, 6 1 , 65-66

Chao Pho, 1 96n. 1 9

Chart Thai Party, 1 73

Checks and balances, 1 03-6, 1 2 7

China, People's Republic of: 3-4 ;

corruption in, 73-79; foreign

direct investment, 69-84, 97;

formal governance, 98- 1 00

China Strategic Holdings, 83

Chinese Communist Party, 92

Civil Service System, China, 90-93

Cojuangco, Eduardo, 1 9 1 n. 1 0

Commodity production, M alaysia,

1 33-34

Companies Act of 1965, Malaysia, 1 4 1

Congress . Philippines, 1 93n . 2 9

Conglomerates, Korea. S e e

Chaebols

Constitution: Philippines, 1 03 ,

1 1 9-20, 1 23 ; Malaysia, 1 5 1 ;

Thailand, 1 68 , 1 73 , 1 82

Coordination devices, China, 92-97

Corruption: 3-5, 13-14, 1 84n.5,

1 87n. 9, 188n. 6; and capital

accumulation, 60; and gover

nance, 61-62; and implications

for investment, 1 1-24; model of

predictability, 1 7-24; political

functions of, 62-64; survey

questions on, 1 6

2 1 6

Corruption, monopolistic, 2 1-23

Criminal law, China, 8 1

Cronyism, 1 6 1 -62

CSH. See China Strategic Holdings

Daim, Zainuddin, 1 48

Daya Bumi project, 1 4 1

D e Venecia, Jose, 1 23

Debacle of 1 997 , 1 60-62

Decentralization of autonomy, 86--9 1

Decentralization o f authority, 86, 89

Democrat Party, Thailand, 1 94n. 1 0

Democratic institutions, 5

Deng Xiaoping, 85-86, 92, 1 89n. 24

Department of Anti-Embezzlement

and Bribery, China, 8 1 , 92

Diffusion of power, Philippines,

1 1 1 - 1 4

Dual-tract p rice system, 1 88n. 4

East Asian paradox, 3-5 , 1 1- 1 4

East Seaboard Development,

Thailand, 1 97n. 24

Economic Contract Law, China, 80

Economic deregulation, Malaysia,

1 3 5

Economic diversification, M alay

sia, 1 34 , 1 37-40

Economic governance system, 4-

5, 32-42, 46-56

Economic history, 25-26

Economic Planning Board, Korea,

64-65

Economic reforms, Thailand, 1 65

Economic stability, Korea, 47-49

Educational system, Thailand, 1 75

Elections, 1 06-9 , 1 70 , 1 94n. 5

Employment Index, Malaysia, 1 44

Ersatz capitalism, 1 6 1

Estrada, Joseph, 5-6, 1 08

Index

Estrada administration, 1 23 , 1 9 1 n. 9

Ethnic Malay. See Bumiputera

Fm Service Company, China, 84

Federal Land Development

Authority, Malaysia, 1 3 8

Financial regulation, Thailand, 1 78

Fiscal policy, Thailand, 1 80

Fiscalizing, 1 90n. 5

Foreign capital inflows, Korea, 52-56

Foreign debt, Korea, 1 87n. 1 3

Foreign direct investment: China,

69-73 , 80 , 1 88n . 1 ; Indonesia,

2 8-29 ; Korea , 54-56 , 1 86n. 5 ;

Malaysia, 135 ; Thailand, 1 65-66

Foreign direct investment laws,

China, 73-74, 79-8 1

Free Trade Zones Act, Malaysia, 1 39

GATT. See General Agreement on

Tariffs and Trade

General Agreement on Tariffs and

Trade, 65

General Kriengsak, 1 77 , 1 9n. 1 3

Gift giving, China, 1 88n. 3

Governance: 1-2; China, 9B-I00; Phil-

ippines , 1 0 1-2 , 1 1 2 ; Thailand,

1 66--70, 1 75, 1 93n. 3 , 1 96n. 22

Government decision making, 61-62

Government intervention on

investment, 56-58 , 1 40-47

Government regulations, Indone

sia, 33-35

Grameen Bank-like Ikhtiar, 1 5 7

Gross domestic product: 1 7-20 ,

27-28

Guanxi, 8 1

Hong Kong, 82-83

Hua Guofeng, 85

Illicit wealth accumulation, 46

Indonesia: corruption in, 25-44;

economic conditions in, 3 1-32,

42; institutions, 32-38; invest

ment'

27-30; legal system, 30,

40-41 , 44; political incentives,

32-38; political system, 43;

private cronyism, 30; systemic

cronyism, 30

Industrial Coordination Act,

M alaysia, 1 46, 1 57

Industrial Incentives Act, Malaysia,

1 3 9

Industrial organization theory, 3 3

Informal enforcements. See

Foreign direct investment

laws , China

Infrastructure development policy,

Thailand, 1 76-77

Institute of Strategic and Interna

tional Studies, Malaysia, 1 50

Institutional change, 6-7

Institutions: 1 83n. 2; and credible

commitments, 38-42; in

Indonesia, 36-38 ; and politi

cal incentives, 32-38

Intermediary business organiza

tions, China, 8 1 -84, 88

International arbitration, China,

1 88n. 1 2

International Convention o f Invest

ment Disputes, 8 1

International Country Risk Guide,

1 83n. 3

2 1 7

International Monetary Fund, 1 16, 126

Intraregime investment, Philip

pine, 1 03-6

Investment Act of 1986, Malaysia, 1 5 1

Investment governance, Korea, 54,

64-67

Index

Investment model, Philippines,

1 2 9-30

ISIS. See Institute of Strategic Inter

national Studies , Malaysia

Japan External Trade Organiza-

tion, 1 76

Judiciary, Philippines, 1 05 , 1 1 9

Keynesian theory, 47

Kim Young Sam government, 64, 66

Korea: capital flight in, 49-50 ;

corruption in, 4 , 60-63 ; and

foreign capital inflows, 52-56;

investment in, 45-49; luxury

consumption in, 50-5 1 ; state

created rents in, 5 1-52

Korean Federation of Industries, 65

Korean Investment Governance

System, 46-56

Kuok, Robert, 84, 1 89n. 1 6

Kuala Lumpur City Centre, 1 4 1

Law of Equity Joint Ventures ,

China, 79

Law of Contractual Joint Ventures,

China, 79

Law of Wholly Foreign- Owned

Enterprises, China, 79

LCM framework, China, 7 1-73 , 79

Legal system: 2-3; of China, 73-74,

97 ; of Indonesia, 30, 40-4 1 , 44

Legislature, Philippines, 1 1 9-20,

1 26, 1 93n. 29

Local government code, Philip-

pines , 125

Local information, 8 1 -84

Look East policy, Malaysia, 1 47, 1 53

Lopez family, 1 08

Luxury consumption, Korea, 50-5 1

2 1 8

Macroeconomic p olicy: Korea,

47-48; Thailand, 1 7 1-72 , 74,

1 77-8 1 , 1 95n. 1 5

Mahathir, Mohammad, 7 , 1 3 1 , 135

Mahathir administration, 1 43

Mahathir's Policy Reforms, 1 4 7-52

Malaysia: 3, 6-7 ; colonial heritage,

135-37; economic boom in,

1 60-62 ; economic diversifica

tion in, 134-40 ; economic

infrastructure, 137, 1 54;

economic recession, 1 34 ;

investment policy of, 134 ;

investments , 1 43-44; postwar

economy, 1 3 1-34; and state

intervention, 1 40-47

Malaysia Incorporated, 1 47-48, 1 53

Malaysia Business Council , 1 50

Malaysia Industrial Development

Authority, 139

Manufacturing investments,

Malaysia, 1 45

Mao Xedong, 85-86

Mao era, 1 89n. 1 8

Marcos, Ferdinand, 1 04

Marcos family, 1 08

Marcos regime, 1 1 6

Market -preserving authoritarianism,

China, 4, 75-79, 84-86

Merdeka Constitution, 137

MIDA. See Malaysian Industrial

Development Authority

Ministry of Public Enterprises,

Malaysia, 1 42

Ministry of Finance, Thailand,

1 72 , 1 74

Ministry of Supervision, China, 8 1 , 92

Monopolies, single, 33

Monopolies, complementary, 33

Monopolies, multitude, 34, 44

Index

Monopolistic corruption, 21-23, 1 05

MPA. See Market-preserving

authoritarianism

National Development Policy,

Malaysia, 1 50

National Economic and Social Devel

opment, Thailand, 1 72, 1 74

Nepotism, 1 6 1 -62

New Asp iration Party, Thailand,

1 94n. 1 0

New business governance,

Malaysia, 1 47-52

New Economic Policy, Malaysia,

7 , 1 3 1 , 135, 1 40 , 1 52-53

New Order period, Indonesia, 26, 3 1

New regulation, M alaysia, 1 3 5

Northian framework, 4 1

OECD. See Organization for

Economic Cooperation and

Development

OeL Hong Leong, 83-84

OLS regression, 1 8- 1 9

Organization for Economic Coop-

eration and Development, 13, 65

O-ring corruption, 23-24, 1 85n. 1 1

Outline of Perspective Plan,

Malaysia, 1 40 , 145-46

Parity rights, 1 92n. 1 3

Park, Chung H e e , 4 6

Parliamentary system, Philippines,

123

Party system, Thailand, 1 67-68

Patronage, Thailand, 1 7 1-72

PBSC. See Political Bureau of

Standing Committee

Pearl River Delta of Guangdong, 83

People Power Revolution, 2, 5

Petroleum Development Act,

M alaysia , 1 4 1

Petroleum production, Malaysia, 1 4 1

Philippine Constitutional Associa

tion, 1 93n. 24

Philippine elite , 1 1 6-1 7

Philippine Revolution o f 1 896,

1 92n. 16

Philippines: 3 , 5-6; bureaucracy, 1 25;

corruption in, 105-6; elections,

1 06-9; governance system, 1 0 1 -

2 , 1 22-27; political economy,

1 02-3; political institutions,

1 15-18 ; presidency, 38

Pioneer Industries Ordinance,

Malaysia, 1 3 9

Plaza Accord o f 1 985, Thailand, 1 65

Political and Economic Risk

Consultancy, 69

Political Bureau Standing Com

mittee , China, 92

Political business cycle, 1 9 1 n. 7

Political control, China, 90-93,

1 90n. 25

Political economy, Philippines, 1 02-3

Political institutions, Indonesia, 36-38

Political parties, 6, 8, 1 94n. 9

Political Risk and Consultancy

Inc., 1 83n. 3

Political stability, Korea, 47-49

Political system, Thailand, 1 82

Political turnover, Philippines,

1 06-9

Politics of governance, Thailand,

1 5 2-60

2 1 9

Pork-barrel politics, Philippines,

1 2 1-22

Poverty reduction, Malaysia, 1 46

Power, devolution of, 1 24-25

Power, diffusion of, 1 09- 1 4

Index

Pramuan, Sabhavasu, 1 73

Prem Tinsulanonda, 8-9 , 1 64-65,

1 70-7 1

Pre-martial law period, 192n. 23

Presidents, Philippines, 1 09 , 1 1 9 ,

1 20-24

Presidential system, Philippines, 1 04

Prime Minister, tenure of, China, 93

Privatization: Malaysia, 148-49 ,

1 54 ; Philippines, 1 93n. 26;

Thailand, 1 76

Promotion of Investments Act,

M alaysia, 145

Property rights, Indonesia, 25-26, 35

Provincial politicians, Thailand, 1 73

Public goods, Thailand, 1 94n. 4

Public investment, Philippines,

1 9 1 n. 8

Public sector expenditure, M alay

sia, 1 42

Ramos, Fidel V. 1 23

Ramos administration, 1 2 1 -23

Redistribution of wealth, M alay-

sia, 1 55-58

Regime of Investment Gover

nance, 1 993- 1 997, 64-67

Regulatory agencies, 33

Rent-seeking: 5 ; Korea, 5 1-52 , 59-

63; Malaysia, 1 55-6 1 ;

Thailand, 1 7 1-72

Rentier cronyism, 1 6 1

Roh Tae-Woo government, 66

Rule of law, 1 0 1

Rural development, Malaysia, 1 3 8

Sabah, 1 3 7

Sarawak, 1 3 7

Second Outline Perspective Plan,

M alaysia, 1 50

220

Sectoral policy, Thailand, 1 75-77

Singapore, 1 3 7

Sixth Malaysia Plan, 1 50

Southeast Asia economic boom,

1 60-62

SPC. See State Planning Commis

sion, China

Standing Committee of National

People's Congress , China,

1 89n. 1 5

State intervention, M alaysia, 135

State Administration of Industry

and Commerce, China, 87

State Council of China, 93-96

State-created rents, 5 1-52 , 1 55

State Economic and Trade Com-

mission, China, 92-93

State in a Changing World, 1 6

State-owned enterprises: China,

73, 87-88; Malaysia, 1 4 1-42,

1 48; Thailand, 1 76-77

State Planning Commission,

China, 92

Stock Exchange Commission,

Thailand, 1 77

Suharto , 3-4, 26, 35-38, 40, 42, 1 85n. 2

Systemic cronyism, 30

Tariffs, 1 92n. 22

Technocrats, Thailand, 1 72 , 1 74-75

Ten Great Relationships, China, 85

Thai party system, 1 69-7 1

Thai political system, 8-9 , 1 66-7 1

Thailand: economic condition ,

1 63-66; infrastructure devel

opment policy, 1 76; political

structure, 1 66- 1 70

Township and village enterprise,

China, 73

1 Index

Trade deregulation, Philippines,

1 20 , 1 93n. 26

Trade liberalization, 65 , 1 20

Transnational corporations, 54-56

Transparency International, 69,

1 83n. 3

Tukkap, 62

Tunku Abdul Rahman, 134

22 1

UMNO constitution, 1 5 1

Vision 2020, Malaysia, 146, 1 50-52

Wage differential, Korea, 1 86n. 4

World Development Report , 1 6

World Trade Organization, 65 , 1 26

corruption the boom and bust of eastasia

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