Interpreting East Asian Growth and Innovation

Interpreting East Asian Growth and Innovation The Future of Miracles

Haider A. Khan

Interpreting East Asian Growth and Innovation

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Interpreting East Asian Growth and Innovation The Future of Miracles Haider A. Khan Professor of Economics University of Denver Colorado USA

© Haider A. Khan 2004 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 0–333–76077–8 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Khan, Haider. Interpreting East Asian growth and innovation : the future miracles / Haider A. Khan. p. cm. Includes bibliographical references and index. ISBN 0–333–76077–8 1. Technological innovations–Economic aspects–East Asia. 2. East Asia–Economic conditions. 3. Finance–East Asia. I. Title. HC460.5.Z9T445 2003 330.95–dc21

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Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

For Izumi And my three families in two continents – The Huttos, Khans and Otomos And my friends Abhijit, Chris Roderigo, Debraj, Gautam, Ira, Iwan Azis, James, Jeff, Judy, Kathy, Kunal, Martin, Masanori, Ronnie, Shubhashish, Steve and Sudipto who taught me that we discover our fundamental unity only when we truly respect our rich diversities

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Contents List of Tables

ix

List of Figures

xi

Acknowledgements

xiii

1

Introduction

1

2

The Miracle of East Asian Growth

8

3

Is Asian Miracle a Myth? The controversy over technical progress in East Asia Sources of long-term growth in East Asia Tales of cities and nations in East Asia : the growth paradox Total factor productivity for Korea Total factor productivity for Taiwan Appendix: a methodological critique of the growth accounting approach

17 18 19 24 24 25

Making a Miracle: A New Approach Can the new growth theory help? Increasing returns and positive feedback loops to the rescue Positive feedback loop innovation systems and strategic complementarities: the possibility of multiple equilibria Technological systems as complex structures A ‘simple’ non-linear model of complexity Translating the non-linear model Technology systems and POLIS The social accounting matrix and technology systems Further analysis of the modern technology system within a SAM Non-linearities and linear approximations Appendix: some criticisms of the new growth theory from the development economics perspective

32 32 35

South Korea: The Making of a POLIS? The development of modern technology in Korea

64 64

4

5

vii

30

37 39 41 46 47 50 55 60 61

viii Contents

Learning to innovate: the Korean national innovation system Modern technology system in a SAM for Korea

69 73

6

Taiwan: Building a POLIS The electronics sector in Taiwan But does Taiwan have a POLIS?

78 81 88

7

Asia’s Financial Blues: The End of POLIS? Financial structures and POLIS South Korea’s descent into chaos Prelude to the crisis: financial liberalization and investment growth The crisis unfolds Taiwan: playing a different game? Policies for financial system development Financial preferential policy Strategic industry financing system

93 95 96 96 101 103 114 118 120

Conclusions

122

8

Notes

130

Bibliography

133

Index

179

List of Tables 2.1 3.1 3.2 4.1 4.2 4.3 4.4 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 6.1 6.2 6.3 6.4 6.5 6.6 6.7 7.1 7.2

Growth and real per capita GDP, 1966–2004 Total factor productivity growth: Taiwan Modified factor productivity growth Alternative technology systems: modes of influence on income distribution Alternative technology systems: implications for the distribution of income Simplified schematic social accounting matrix Schematic representation of endogenous and exogenous accounts in a SAM Changes in South Korean technology import policy since 1978 The financial assistance system in South Korea South Korean development strategies by stages of development South Korean TI, FDI, and capital goods imports: 1962–91 Major R&D indicators in Korea Trends of intellectual property rights applied by Korean and foreign nationals Major product lineup of SEC SEC’s three-tiered R&D System Endogenous accounts in the SAM-TECH for South Korea, 1988 Economic growth indicators in Taiwan, 1953–92 Taiwanese exports of electronics: selected years 1970 to 1990 (US$bn) Taiwan: Electronics and information technology, production values and forecasts (US$bns) Tatung’s progress in electronics ACER behind-the-frontier innovations: a selection High-technology startups in Hsinchu science-based industrial park SAM-Tech classification for Taiwan Major indicators of the Korean economy, 1991–97 South Korea’s capital account balance (US$bn) ix

9 26 28 50 51 53 54 66 67 68 69 71 71 72 73 74 79 81 82 85 86 87 90 97 101

x List of Tables

7.3 7.4 7.5 7.6 8.1

The financial sources for the business sector (NT$mn, percent) Total assets of financial institutions in Taiwan (NT$mn, percent) Number of units of financial institutions in Taiwan Outstanding deposits and loans of financial institutions in Taiwan (NT$mn, percent) The ‘Washington Consensus’ and East Asia

108 111 112 113 127

List of Figures 6.1 7.1 7.2

Taiwan: government and research Systemic view of the political economy of taiwan’s financial structure The financial system in Taiwan

xi

84 105 106

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Acknowledgements Many people have helped me at various stages of this work. It is impossible to mention all of them by name. I have benefited greatly from the conversations with the following friends and colleagues: Jonathan Adelman, Ramesh Adhikari, Akhtar Ahmed, Sadiq Ahmed, Charles Becker, A.S. Bhalla, Gautam Bose, Richard Boyd, H.C. Choo, Hong-tack Chun, Philip Cohen, Walter Cohen, James Cole, Dilip Das, Judy Dean, Anil Deolalikar, George DeMartino, Jaime DeMelo, Shanta Devarajan, Jack Donnelly, Roger Downey, A.K. Dutt, Elizabeth Erikson, Tom Farer, Jesus Felipe, Hasan Ferdous, Gary Fields, James Foster, Manabu Fujimura, Ira Gang, Shubhashish Gangopadhaya, Gary Garofalo, Alan Gilbert, David Goldfischer, Ilene Grabel, Pascal Gregoire, Keith Griffin, John Grove, Rana Hasan, P. Heller, Nikhil Aziz Hemmady, Peter Ho, Song-Gee Hong, S. Hossain, Barry Hughes, Monzurul Huq, Ellen Hutto, Francis Hutto, Frank Hutto, Holly Hutto, Mary Jane Hutto, Nancy Hutto, Rogert Hutto, Michelene Ishay, James Jacob, Sailesh Jha, Martin Kenney, Steven Keuning, A.R. Khan, Enayetullah Khan, Kwang Suk Kim, Kyu-Soo Kim, Man-Jae Kim, Tadashi Kondo, Jay-Yoon Koo, John Kuark, Asfaw Kumssa, Frank Laird, Jungsoo Lee, David Levine, Victor Lippit, Devinder Malhotra, Sakah Mahmud, A. Mansur, J. McCamant, Richard Miller, Tracy Mott, Sudipto Mundle, Katherine Nanda, Ved Nanda, Soo-nam Oh, Izumi Otomo, Masami Otomo, Toshiko Otomo, Se-Il Park, Manoucher Parvin, Prasanta Pattanaik, Joyce Paysour, Ernesto Pernia, M.G. Quibria, M. Ravallion, Debraj Ray, Ghon Rhee, Seung Yoon Rhee, Sherman Robinson, E. Thomas Rowe, Kazu Sakai, Il Sakong, Abhijit Sengupta, Kunal Sengupta, George Shepherd, Reza Siregar, Kotaru Suzumura, Jan Svejnar, Joseph Szybwicz, Masanori and Yumi Tanabe, Kathy Terell, Myo Thant, Kazuo Ueda, W. Van Ginneken, Peter Van Ness, Chris Walker, Henry Wan, Randy Wray and Toru Yanagihara, Juzhong Zhuang and Kathy Zipp. The staff at Palgrave Macmillan have been helpful in a highly professional way. Without such help this book would not have seen timely publication. I am most grateful to Pat Baysa and Karin Hillen for preparing the final version. Their efficiency and cheerfulness made it possible to finish the project with a minimum of pain. xiii

xiv Acknowledgements

Anna Silverio and Keith Clay helped with earlier drafts. Teresa Cabellon and Rochie Ignacio also helped at the final stage. Keith Clay and Emma Banaria also provided valuable research assistance. Helene Wieting prepared the index and helped with all the stages of research and manuscript preparation. I am most grateful to her. I have learned how to articulate my arguments and observations regarding technology systems better from questions raised by participants in my seminars at the Graduate School of International Studies at the University of Denver and during talks at Cornell, Harvard, Tokyo and Tilburg, and several sessions at the American Economic Association meetings. My wife Izumi supported me not only with her love but also with her willingness to listen and criticize constructively. I am happy to say that she did not have to sacrifice her own life for this project; but without her constant encouragement and presence writing would not have been nearly as enjoyable as it has been. My sincere thanks to Rey-Ching Lu at GSIS, University of Denver, Professor Iwai, Professor Miwa and the staff at the CIRJE at the University of Tokyo, Professor Kamoike at Tohoku University, and Dr Eisuke Sakakibara at Keio University, for their generous assistance. Thank you all. HAIDER A. KHAN

The author and publishers wish to thank Elsevier Science Ltd, Harvard University Press and Stanford University Press for permission to reproduce copyright material. Every attempt has been made to trace the relevant copyright-holders’ materials, but if any have been inadvertently omitted then the publishers will be pleased to make the necessary arrangement at the earliest convenience.

1 Introduction

This book is an attempt to present a somewhat novel theory of innovation systems in the concrete context of the experience of growth and crisis in the East Asian economies. The historical focus, for reasons given below, is on the last few decades prior to the financial crisis. However the impact of the crisis is also analyzed in a separate chapter which underlines the need for combining corporate and international finance with economic theories of technical change in order to explain the technological trajectories in complex financial economies more completely. The overall framework is intended to be an evolutionary one. In this sense the work belongs to the growing tradition described by Dosi (2000) in the introductory essay to his collected scientific papers. There he credits pioneers such as Abramovitz, Nelson and Winter, and Freeman among others. This book also begins with and acknowledges the contributions of these authors. It builds on these seminal contributions, and tries to take seriously the idea of technology systems which is akin to Dosi’s concept of technological paradigms. Technological systems in developing economies are rather like a collection and somewhat complex coexistence of several paradigms in tension. An example of this is the idea of technological dualism whereby traditional and modern technological systems may coexist for quite a long time. I consider the questions related to the technological progress, or lack of it, in the East Asian context by formulating the problem in terms of the transition from one technological system to another. In terms of evolutionary economics, this means the investigation of the emergence – or lack of it – of a new, modern technological system in place of the old, traditional one. If there is genuine emergence in this sense, then the economy should also show capacities for 1

2 Interpreting East Asian Growth and Innovation

innovation. The challenge is to characterize the dynamics of the process adequately. This is why the study of concrete cases is essential. The development of theories and models in this book is followed immediately by two case studies from East Asia. The transitions of South Korea and Taiwan are examined within the concepts and models developed in the earlier chapters of the book. Is the East Asian growth experience a myth or a miracle? The interpretation of the spectacular growth performance of these economies (called high-performing Asian economies by a World Bank study) has given rise to a fierce debate among development and international economists over the last few years. One might observe somewhat cynically that like some other debates in the social sciences there may be more heat than light in the controversy. But it is also likely that the dust has not yet settled enough for us to see what has really happened. However, at one point this controversy seemed to have been largely overshadowed by the Asian financial turmoil. It is as if the financial woes of the Southeast Asian economies and then of Korea – which started in 1997 and then deepened – can show conclusively that the whole ‘miracle’ was really a myth. Without minimizing the significance or seriousness of the financial problems, it can nevertheless be seen that the financial turmoil cannot by itself be the incontrovertible proof of the long-run failure of these economies. To be sure, finance and growth are related (Schumpeter 1934, Levine 1997). It is also possibly true that the effects of the financial crisis may persist and even impair long-run growth potential. However, that can hardly settle the question of the long-run growth prospects for the economies. In particular, the role of technical progress would still need to be examined carefully. Therefore, finance is important but the really significant issue from the perspective of long-run growth is the one raised earlier. Do these economies display productivity growth via technological change? Furthermore, if technological change has taken place, to what extent is it endogenous or likely to be so in the future? In other words, have these economies developed the capacities to innovate, or are they likely to do so in the near future? This book attempts to offer a new perspective on this debate by going beyond the growth accounting or production function fitting approaches used by the participants. It can be seen as belonging broadly to attempts, most notably by Nelson and Pack (1996), to eschew the conceptual problems arising from the standard methodologies. It also begins from the idea that while technology is the key issue,

Introduction 3

for judging performances of entire economies we should begin with consideration of systems of technologies (James and Khan 1997a, 1997b) and ask ourselves how modern systems of technology can replace more traditional systems during the process of development. We should then ask ourselves if the South Korean and Taiwanese economies have in fact made this transition. This book argues that indeed a transition has been made by these two East Asian economies in particular, and goes further in investigating how permanent this transition is likely to be. In this sense also, the approach and conclusions are consistent with what Nelson and Pack call the the ‘assimilationist’ interpretation of the East Asian growth. In the view of a World Bank study and economists such as Lucas there is indeed a miracle; but this miracle can be explained largely by the ability of countries such as Korea and Taiwan to ‘get the basics right’. Lucas also adds theoretically the important ingredient of human capital to the analytical picture.1 Opposed to various neoclassical attempts to explain the ‘miracle’ are the heterodox economists. However, they too accept the assessment that the growth performance of these economies may indeed be a miracle. Where they differ from the neoclassical economists is in the explanation given for the seeming miracle. Writers such as Alice Amsden (1989) and Shahid Alam (1989) have emphasized the role of state intervention in creating some of the conditions for the miracle to happen. An entirely different and dissonant view within the neoclassical camp questions the interpretation of the historical record of high growth in these economies as being a miracle at all. Paul Krugman has been the most vocal and aggressive exponent of this view. However, his work draws heavily on the empirical work done by Kim and Lau (1992a, 1992b, 1992c, 1994a, 1994b, 1994c, 1994d, 1995) and Young (1995) among others. The upshot of this line of research has been to infer that the growth can be accounted for simply by accumulation of labour, capital and human capital. Again, this view is consistent with the orthodox neoclassical growth models. However, Krugman spells out clearly the pessimistic implications that have been glossed over in the general euphoria over the miracles in the neoclassical camp: ‘Mere increases in input, without an increase in the efficiency with which those inputs are used – investing in more machinery and infrastructure – must run into diminishing returns; input-driven growth is inherently limited’ (Krugman 1996b: 172).

4 Interpreting East Asian Growth and Innovation

If the factor accumulation story is true – and it seems to be within the standard production function approach as well as the metaproduction function framework – then indeed such high growth rates cannot be sustained in the long run. If the observed performance of these economies, in Krugman’s words, ‘is no more than what the most boringly conventional theory would lead us to expect’ then indeed the miracle is a myth. However, this need not be the end of all our conversations about the growth in East Asian economies. Perhaps only some particular ways of understanding the performances of these economies may end here. Future work on macroeconomic growth accounting or neoclassical model building may not offer much further insight. At the same time, re-entering the state-vs.-market debate at this point will also not address Krugman’s arguments directly. The seeming impasse can be overcome only by looking at growth in a more disaggregated manner. Krugman’s provocative essay actually raises the theoretical possibility of doing this. However, his almost exclusive reliance on results from aggregate growth accounting clearly suggests that he is not prepared to pursue this line of enquiry empirically for the East Asian economies: How, then, have today’s advanced nations been able to achieve sustained growth in per capita income over the last 150 years? The answer is that technological advances have led to a continual increase in total factor productivity – a continual rise in national income for each unit of input. In a famous estimate, MIT Professor Robert Solow concluded that technological progress has accounted for 80 percent of the long-term rise in US per capita income, with increased investment in capital explaining only the remaining 20 percent. (Krugman 1996b: 172–3) Although Krugman is still thinking within the terms of the standard Solow-type model and total factor productivity there is a recognition of the key role of technology that is missing from the earlier debates about the miracle. If we are to ascertain the true nature of the growth process in East Asia we must ask if there has been technological progress. In fact, the empirical work cited by Krugman answers this question in the negative. Indeed, at the macroeconomic level, given the data, there seems to be zero total factor productivity growth. One could, of course, raise various objections to the imperfections of the data but that really would not advance the debate either.

Introduction 5

However, if technology and innovation can become the focus of the debate then another alternative approach is possible. This approach is both economy-wide and disaggregated at the same time. In this book I use the concept of a positive feedback loop innovation system (POLIS: see Khan 1998, 2001a, 2001b) to examine whether countries such as Korea and Taiwan have any potential for creating self-sustaining innovation structures. The question is important in the light of Krugman’s assertions and earlier findings of growth accounting. If indeed there is no self-sustaining innovation structures (nor a realistic possibility of the creation of such structures in the near future) then logically one is compelled to concur with Krugman’s pessimism. If, on the other hand, there is a POLIS either in existence or in the making, then there may be some room for optimism. Our starting point, therefore, is that the profound issues raised by both the earlier debate on the East Asian industrialization or the most recent debate on the implications of growth accounting cannot be settled without further conceptual clarifications of innovation systems and empirical work following such clarifications. What then is a POLIS? A formal definition of a POLIS is given in Chapter 4 using a nonlinear model of a production economy. The fixed-point theorems proved there raise the possibilities of multiple equilibria in such economies. Here, I will offer an informal definition that recognizes the force of Krugman’s criticism. An economy with a POLIS has an innovative technological structure that can lead to non-diminishing returns to capital and human capital even in the long run. Such an economy will not just exhibit structural transformation from a predominantly agricultural to an industrial setting, but will also be characterized mainly by continuous transformations within the advanced industrial sectors. Most importantly, these continuous technological changes within the advanced sectors will lead to an overall high growth performance that can be sustained theoretically for an indefinite period.2 But this conceptual shift immediately raises questions regarding its applicability. Further modifications of the abstract model will be necessary for this. The organization of this book reflects these operational concerns as well. The next two chapters in essence review closely the debate within the neoclassical camp about the nature of the miracle, and are designed to motivate the reader to go beyond the macroeconomic models of growth used implicitly or explicitly by the various participants in this debate.

6 Interpreting East Asian Growth and Innovation

Chapter 4 offers an alternative methodology to the standard growth accounting. It also differs from the standard heterodox approaches in that an evolutionary, non-linear formal approach is presented. This is not intended to replace the political economy approaches, but rather to supplement them. The intention is to push the debate on state vs. markets to a different level. In a disaggregated yet economy-wide framework, the examination of policies as well as market forces can be carried out best by explicitly formalizing the non-linear relationships that characterize an economy with both markets and state. To this end the concept of POLIS is formalized in such a way that both markets and the government can be included. Existence of a possible POLIS is shown by characterizing multiple equilibria in a non-linear model with both increasing returns and technical progress. The existence of POLIS for economies defined on abstract function spaces is shown for both vector lattice and Banach spaces. Tarski’s and Amann’s fixed point theorems can be used to demonstrate formally such existence theorems. The empirical application is really what matters ultimately. For this, an economy-wide model based on social accounting matrices (SAMs) can be used. Chapter 4 shows how a successive series of SAMs can approximate the non-linear world of POLIS described earlier. Incorporation of R&D and human capital turns out to be the greatest of the empirical challenges in this context. The modelling approach is applied to both Korea and Taiwan using data from the late 1980s and early 1990s. A modest POLIS-effect is found in both cases. However, the effect is somewhat stronger for Taiwan. An institutional analysis – as far as that is possible, given the complexities of actual institutions – confirms the finding of the above POLIS-effect to some extent. However, serious problems may also lie ahead. The transformation of an underdeveloped economy from a largely rural–agricultural base to a predominantly urban–industrial one is almost half a miracle, given the fact that in the last two and a half centuries only a handful of countries have managed it. However, the ability to form a POLIS seems to be rarer still. For this, favorable domestic and international circumstances are necessary, but not sufficient. A critical mass of R&D expenditures as well as skilled scientific and technical personnel must be formed. At the same time, as will be pointed out in Chapter 4, a transformation of economic as well as social and political institutions will inevitably have to take place if innovation capabilities are to be more than temporary phenomena. Given the complexity of the transformation processes, it is too early to

Introduction 7

characterize these countries as having erected a fully functional POLIS structurally. On the other hand, the ‘miracle’ – while not nearly as miraculous as one might wish – does not seem to a be a complete myth. Only further historical development can determine the future trajectories of these ‘miracle’ economies.

2 The Miracle of East Asian Growth

When in 1993 the World Bank published a book with the dramatic title The East Asian Miracle it gave currency to an already widespread perception and interpretation of the growth process in that region. This particular study singled out eight economies: Japan, the ‘Four Tigers’ and three Southeast Asian countries. These economies were called the highperforming Asian economies (HPAEs). The book pointed out that since 1960, the HPAEs have grown more than twice as fast as the rest of East Asia, roughly three times as fast as Latin America and South Asia, and five times faster than Sub-Saharan Africa. They also significantly outperformed the industrial economies and the oil-rich Middle East–North Africa region. Between 1960 and 1985, real income per capita increased more than four times in Japan and the Four Tigers and more than doubled in the Southeast Asian NIEs. If growth were randomly distributed, there is roughly one chance in ten thousand that success would have been so regionally concentrated. (World Bank 1993: 2) The study went on to point out: The HPAEs have also been unusually successful at sharing the fruits of growth. The HPAEs enjoyed much higher per capita income growth at the same time that income distribution improved by as much or more than in other developing economies, with the exceptions of Korea and Taiwan, China, which began with highly equal income distributions. The HPAEs are the only economies that have high growth and declining inequality. Moreover, the fastest growing East Asian economies, Japan and the Four Tigers, are the most equal. 8

The Miracle of East Asian Growth 9 Table 2.1

Growth of real per capita GDP, 1966–2004 1966–73

World Industrial countries Asia (general) East Asia and Pacific Latin America and the Caribbean Europe and Central Asia Middle East and North Africa Sub-Saharan Africa

1974–90 1991–93

1993

1994

1995–2004

5.1 4.8 5.9 7.9

3.0 2.8 6.3 7.1

1.2 1.2 7.0 8.7

1.3 1.0 7.4 9.4

2.8 2.9 7.8 9.3

3.3 2.8 7.0 7.7

6.4

2.7

3.2

3.8

3.9

3.5

7.0

3.6

-9.4

-7.5

-7.5

3.4

8.5 4.7

0.7 2.2

3.4 0.6

1.8 0.8

0.3 2.2

3.2 3.8

Source: World Bank (1995).

…As a result of rapid, shared growth, human welfare has improved dramatically. Life expectancy in the developing HPAEs increased from 56 years in 1960 to 71 years in 1990. (In other low- and middle-income economies, life expectancy also rose considerably, from 36 and 49 to 62 and 66 years, respectively.) In the HPAEs, the proportion of people living in absolute poverty, lacking such basic necessities as clean water, food, and shelter, dropped – for example, from 58 percent in 1960 to 17 percent in 1990 in Indonesia, and from 37 percent to less than 5 percent in Malaysia during the same period. Absolute poverty also declined in other developing economies, but much less steeply, from 54 to 43 percent in India and from 50 to 21 percent in Brazil from 1960 to 1990. A host of other social and economic indicators, from education to appliance ownership, have also improved rapidly in the HPAEs and now are at levels that sometimes surpass those in industrial countries. (World Bank 1993: 2–5) According to this view high growth in the HPAEs has been accompanied by a rapid overall improvement of economic welfare. The World Bank study is also quite clear on the causes of East Asia’s success: In large measure the HPAEs achieved high growth by getting the basics right. Private domestic investment and rapidly growing human capital were the principal engines of growth. High levels of domestic financial savings sustained the HPAEs’ high investment levels. Agriculture, while declining in relative importance, experienced rapid growth and

10 Interpreting East Asian Growth and Innovation

productivity improvement. Population growth rates declined more rapidly in the HPAEs than in other parts of the developing world. And some of these economies also got a head start because they had a better-educated labor force and a more effective system of public administration. In this sense there is little that is ‘miraculous’ about the HPAEs’ superior record of growth; it is largely due to superior accumulation of physical and human capital. (World Bank 1993: 5) The soundness of development policy was also singled out as a causal factor: Fundamentally sound development policy was a major ingredient in achieving rapid growth. Macroeconomic management was unusually good and macroeconomic performance unusually stable, providing the essential framework for private investment. Policies to increase the integrity of the banking system, and to make it more accessible to nontraditional savers, raised the level of financial savings. Education policies that focused on primary and secondary schools generated rapid increases in labor force skills. Agricultural policies stressed productivity and did not tax the rural economy excessively. All the HPAEs kept price distortions within reasonable bounds and were open to foreign ideas and technology. (World Bank 1993: 5) The study went on to point out that government policies also played an important role. But these fundamental policies do not tell the entire story. In most of these economies, in one form or another, the government intervened – systematically and through multiple channels – to foster development, and in some cases the development of specific industries. Policy interventions took many forms: targeting and subsidizing credit to selected industries, keeping deposit rates low and maintaining ceilings on borrowing rates to increase profits and retained earnings, protecting domestic import substitutes, subsidizing declining industries, establishing and financially supporting government banks, making public investments in applied research, establishing firm- and industry-specific export targets, developing export marketing institutions, and sharing information, widely between public and private sectors. Some industries were promoted, while others were not. ( World Bank 1993: 5–6)

The Miracle of East Asian Growth 11

In interpreting the connections between government policies and success, however, the World Bank publication assumed a stance of studied caution: Our judgment is that in a few economies, mainly in Northeast Asia, in some instances, government interventions resulted in higher and more equal growth than otherwise would have occurred. However, the prerequisites for success were so rigorous that policy makers seeking to follow similar paths in other developing economies have often met with failure. What are these prerequisites? First, governments in Northeast Asia developed institutional mechanisms which allowed them to establish clear performance criteria for selective intervention and to monitor performance. Intervention has taken place in an unusually disciplined and performance-based manner. Second, the costs of interventions, both explicit and implicit, did not become excessive. When fiscal costs threatened the macroeconomic stability of Korea and Malaysia during their heavy and chemical industries drives, governments pulled back. In Japan the Ministry of Finance acted as a check on the ability of the Ministry of International Trade and Industry to carry out subsidy policies, and in Indonesia and Thailand balanced budget laws and legislative procedures constrained the scope for subsidies. Indeed, when selective interventions have threatened macroeconomic stability, HPAE governments have consistently come down on the side of prudent macroeconomic management. Price distortions arising form selective interventions were also less extreme than in many developing economies. (World Bank 1993: 6–7) The Bank document on East Asian Miracle does contain a section on coordination failures. This section offers a rather sophisticated view of a plurality of ways in which coordination can be achieved in economies. Coordination through prices may not always be possible. However, the point made by Martin Weitzman in 1974 that the price system is not widely used in allocating resources within many organizations is not recognized. Weitzman (1974: 478) pointed out: If there really were some basic intrinsic advantage to a system which employed prices as planning instruments, we would expect to observe many organizations operating with this mode of control, especially among multidivisional business firms in a competitive environment. Yet the allocation of resources within private

12 Interpreting East Asian Growth and Innovation

companies (not to mention governmental or nonprofit organizations) is almost never controlled by setting administered transfer prices of commodities and letting self-interested profit maximization do the rest. The price system as an allocator of internal resources does not pass the market test. Despite the attempt of the bank’s economists to offer a balanced view, it appears that ultimately the ‘miracle’ is to be explained by ‘market fundamentals.’ Whether this was intended as a strict interpretation or not, in practice this remains the accepted interpretation among many professionals within and outside the bank. In particular the export promotion strategy has received a disproportionate amount of attention in these debates. The emphasis on export promotion strategy as an explanation of the ‘East Asian miracle’, of course, predates the World Bank study. A number of contributions such as Keesing (1967), Bhagwati (1978), Little (1981), Krueger (1981) and Nishimizu and Robinson (1984) had already focused on this particular aspect. Empirical studies carried out to identify and validate the causal relationship between the export growth and economic growth in Asian NIEs by Michaely (1977), Balassa (1978), Tyler (1981), Kavoussi (1984), Jung and Marshall (1985) and Hsiao (1987) also predate the magisterial volume published by the bank in 1993. However, it was this publication that apparently gave (perhaps without fully intending to) the official imprimatur to the term ‘East Asian Miracle’. It should, however, be pointed out that neoclassical economists had by the early 1990s begun to search for rigorous foundations for explaining this growth process in a competitive framework. One example of the enthusiasm generated among the economists about the ‘miracle’ of Korean growth is the 1991 Fisher–Schultz lecture given at the European meetings of the Econometric Society by the then future Nobel laureate Robert E. Lucas, Jr. (Lucas 1993) Lucas’s lecture carries the title ‘Making A Miracle’. In the very first sentence, he contrasts the growth performance of the Philippines and Korea. Both countries had about the same starting point in 1960, with GDP per capita of approximately $640 in 1975 US dollars. However, Lucas points out, Korean GDP/capita from 1960 to 1988 grew at more than 3.5 times per annum than that of the Philippines. Lucas concludes categorically: I do not think it is in any way an exaggeration to refer to this continuing transformation of Korean society as a miracle, or to

The Miracle of East Asian Growth 13

apply the term to the very similar transformations that are occurring in Taiwan, Hong Kong, and Singapore. (Lucas 1993; emphasis added) During the course of his lecture Lucas raises important questions such as: how did it happen and why did it happen in Korea and Taiwan and not in countries like the Philippines? He goes on to view ‘the growth miracles as productivity miracles’. In other words, he chooses to focus on technology within the neoclassical paradigm. Ultimately, human capital and learning-by-doing are the fundamental determinants of the Lucasian ‘productivity miracle’. Lucas (1993) begins with the model of a single economy that uses physical capital and human capital to produce a single good, although we are cautioned that one cannot ‘obtain a theory of economic miracles in a purely aggregative set-up in which every country produces the same single good’. The single-country, single-good framework is used merely as a convenient device for stating the problem and narrowing down the theoretical possibilities. In such a model, the long-run growth rate of both capital and labor productivity is equal to the rate of growth of human capital. The ratio of physical to human capital will also converge to a constant in the limit. Therefore, in the long run, income must be proportional to the economy’s initial endowment of human capital. Thus, initial differences in human capital can lead to long-run divergences in income levels among countries. Lucas also shows that by modifying the human capital accumulation technology according to the approach taken by Parente and Prescott (1991) one can obtain convergence. The strategy here is to allow one country’s human capital growth rate to be a function of the overall level of human capital in the world. If the functional form is chosen appropriately, then countries with a lower than average level of human capital can accumulate this type of capital faster, leading to a fasterthan-average rate of overall economic growth. Ultimately, Lucas relies on learning-by-doing effects to explain the ‘miracle’. He recognizes that ‘[a] growth miracle sustained for a period of decades – must – involve the continual introduction of new goods, not merely continued learning on a fixed set of goods’. This raises the possibility of productivity levels dropping with continued learning of new processes. Using a model of an economy that produces a variety of goods indexed by quality, Lucas is able to derive the asymptotic growth rate for such an economy. This growth rate turns out to be a product

14 Interpreting East Asian Growth and Innovation

of the quality gradient parameter and the exogenously given rate at which better goods become producible. Using this model under alternative assumptions, Lucas claims, one can explain ‘the East Asian miracle’: The objective was to set down on paper a technology that is consistent with a growth miracle, which is to say, consistent with wide differences in productivity growth among similarly endowed economies. This has been done, following Stokey and Young, in a way that I think is consistent with the main features of the East Asian miracles, all of which have involved sustained movement of the workforce from less to more sophisticated products. A fast growing economy or sector under this technology is one that succeeds in concentrating its workforce on goods that are near its quality frontier, and thus in accumulating human capital rapidly through the high learning rates associated with new activities and through the spillover of this experience to the production of still newer goods. These hypotheses are consistent with commonly known facts, and have testable implications for many more. (Lucas 1993: 267) Lucas does not want to see economic miracles as a function of backwardness. As he puts it: A successful theory of economic miracles should, I think, offer the possibility of rapid growth episodes, but should not imply their occurrence as a simple consequence of relative backwardness. It should be as consistent with the Philippine experience as with the Korean. For the purpose of exploring these possibilities, the conventions of small, open economy trade theory are more suitable (as well as simpler to apply) than those of the theory of a closed, twocountry system. If the technology available to individual agents facing world prices has constant returns, then anything is possible. Some allocations will yield high external benefits and growth in production and wages; others will not. There will be a large number of possibilities, with individual agents in equilibrium indifferent between courses of action that have very different aggregative consequences. (Lucas 1993: 269) Within the context of the human capital and learning models it is also attractive to consider the connection between rapid productivity

The Miracle of East Asian Growth 15

growth and openness of the economy. Lucas makes this point against import-substitution quite forcefully: Consider two small economies facing the same world prices and similarly endowed, like Korea and the Philippines in 1960. Suppose that Korea somehow shifts its workforce onto the production of goods not formerly produced there, and continues to do so, while the Philippines continues to produce its traditional goods. Then according to the spillover theory, Korean production will grow more rapidly. But in 1960, Korean and Philippine incomes were about the same, so the mix of goods their consumers demanded was about the same. For this scenario to be possible, Korea needed to open up a large difference between the mix of goods produced and the mix consumed, a difference that could widen over time. Thus a large volume of trade is essential to a learning-based growth episode. One can use the same reasoning to see why import-substitution policies fail, despite what can initially appear to be successful in stimulating growth. Consider an economy that exports, say, agricultural products and imports most manufactured goods. If this economy shifts toward autarky through tariff and other barriers, its workforce will shift to formerly imported goods and rapid learning will occur. But this is a one-time stimulus to productivity, and thereafter the mix of goods produced in this closed system can change only slowly, as the consumption mix changes. Note that this argument has to do only with the pace of change in an economy’s production mix and does not involve scale, though it can obviously be reinforced by scale economies. (Lucas 1993: 269–70) I have spent some time on Lucas’s approach to the explanation of the miracle to underline the strengths of a theoretically plausible strategy. Lucas is by no means unaware of the objections one can raise to working only in one’s office with pen and paper. He ends up by strongly endorsing his approach, however: Can these – be viewed as a summary of things that are known about economic growth? After all, they are simply a sketch of some of the properties of mathematical models, purely fictional worlds, that certain economists have invented. How does one acquire knowledge about reality by working in one’s office with pen and paper? There is more to it, of course: Some of the numbers I have cited are products of decades-long research projects, and all of the models I

16 Interpreting East Asian Growth and Innovation

have reviewed have sharp implications that could be, and have not been, compared to observation. Even so, I think this inventive model-building process we are engaged in is an essential one, and I cannot imagine how we could possibly organize and make use of the mass of data available to us without it. If we understand the process of economic growth – or of anything else – we ought to be capable of demonstrating this knowledge by creating it in these pen and paper (and computer-equipped) laboratories of ours. If we know what an economic miracle is, we ought to be able to make one. (Lucas 1993: 271) Although one may be willing to agree with Lucas in principle, the question of specificity even at the theoretical level still remains. Making human capital the centerpiece in a theoretical model is not objectionable empirically; but it may be only a partial approach. This issue will be taken up for further investigation in Chapter 4. The theoretical approaches exemplified by Lucas, Stokey and others assume that the ‘miracle’ is a fact. They then explore ways of modeling an economy so that the fact would be consistently explained within the model. However, some recent criticisms challenge that assumption altogether. We need, therefore, to raise the question: is there, in fact, anything like a miracle in this whole episode of rapid East Asian growth? The next chapter explores the issues raised by this question.

3 Is the Asian Miracle a Myth?

We saw in the last chapter that the theoretical project outlined by Lucas takes the fact of a ‘miracle’ as a given. Therefore, the interpretation of growth as a miracle is seen as the empirical problem that requires a theoretical explanation. We have also discussed extensively the particular explanation advanced by Lucas. But is the interpretation of this growth process so straightforward? Is high growth in countries such as Korea and Taiwan also accompanied by a high rate of productivity growth? If it is so, what explains the productivity growth? If it is not, then the miracle would seem to stop short of the prospects for a sustained performance. In this latter case, the explanation of the non-performance on the productivity front would seem to be just as significant as the explanation of the miraculous performance on the growth front. In this chapter I begin with a critical analysis of some disquieting findings in the 1990s, even before the financial crises, regarding growth accounting and total factor productivity increase in the East Asian miracle economies. It should be noted that these studies did not go completely unchallenged; but it is important to understand the theoretical and empirical bases of these findings first. Having done this, I explore next the specific question of technology and growth in these economies. In the next chapter, I offer a specific methodological approach for studying the relations between technology and growth. It is seen there that following up on technology and learning in a serious manner also requires a close look at national innovation systems of these countries. The results discussed in this chapter cast some doubt on the merits of the easy enthusiasm that thinking in terms of ‘miracles’ might have generated. However, the strategy of investigation in the next chapter also calls for a look at the microstructure of 17

18 Interpreting East Asian Growth and Innovation

innovation at the sectoral or even at the firm level. In this sense my methodological approach is similar to that of the assimilationist school. The major difference is that along with the micro–sectoral investigation I also integrate the various sectors in terms of their interdependence. Finally, distribution is also integrated with production structure. Therefore, the present approach takes the assimilationist argument to the economy-wide level from both the production and the distribution side in a multi-sectoral framework.

The controversy over technical progress in East Asia In a very provocative essay Paul Krugman (1996b) challenges the wisdom of calling the growth performance of the East Asian countries a ‘miracle’. His essay, ‘The Myth of Asia’s Miracle’, starts out by offering ‘a cautionary tale’ regarding earlier Western envy and fear with respect to the growth performance of the former Soviet bloc countries in the 1950s. Krugman then points out that contrary to the West’s fearful expectations of being overtaken in the economic race, the whole Soviet-style economic system more or less collapsed a few decades later. The failure of these economies to post efficiency gains is identified as one of the major reasons for stagnation and subsequent collapse. Is there a close parallel between this story and the often told fables about the East Asian tigers? Krugman thinks that there are ‘surprising similarities’: The newly industrializing countries of Asia, like the Soviet Union of the 1950s, have achieved rapid growth in large part through an astonishing mobilization of resources. Once one accounts for the role of rapidly growing inputs in these countries’ growth, one finds little left to explain. Asian growth, like that of the Soviet Union in its high-growth era, seems to be driven by extraordinary growth in inputs like labor and capital rather than by gains in efficiency. (Krugman 1996b:174–5) Krugman cites the example of Singapore where the economy grew by 8.5 percent per year between 1966 and 1990. However, Krugman points out, such a phenomenal growth performance cannot be automatically associated with overall technical progress. Krugman tells us: The employed share of the population surged from 27 to 51 percent … investment as a share of output rose from 11 to more than 40 percent.

Is the Asian Miracle a Myth? 19

Even without going through the formal exercise of growth accounting, these numbers should make it obvious that Singapore’s growth has been largely on one-time changes in behavior that cannot be repeated. (Krugman 1996b: 175) However, Singapore, Krugman admits, is an extreme case. For other East Asian countries the situation may indeed be different. However, it is precisely in this respect that the empirical work by scholars such as Lau, Kim and Young seems quite discouraging. Their collective efforts raise a set of pertinent and vexing questions regarding growth, technology and ultimately the possibilities of a POLIS – in developing economies.

Sources of long-term growth in East Asia In a number of papers (Lau 1996, Kim and Lau 1992a, 1992b, 1992c, 1994a, 1994b, 1994c, 1994d) Lau and Kim have explored extensively the empirical features of growth accounting in the East Asian economies. Using a meta-production function approach, they utilize flexible functional forms to allow for non-neutral returns to scale and technical progress. One of the most significant hypotheses maintained in this approach is that of identical production functions in terms of ‘efficiency-equivalent’ units of output in all countries. It is found that the data cannot reject this hypothesis.1 In Kim and Lau (1994c) decomposition of the economic growth in a number of countries into the sources of growth is carried out. One characteristic of their approach is that it does not require the traditional assumptions of constant returns to scale, neutrality of technical progress, profit maximization and complete disembodiment. Their contrasting findings for the developed and developing nations were stark enough to raise quite a few eyebrows among the believers in the miracle. Kim and Lau (1994a, 1994b, 1994d) and Boskin and Lau (1990, 1994) find that technical progress is indeed the mainspring of growth in the developed countries. However, quite surprisingly, this is not the case for the Four Tigers. With embodied technical progress attributed to the technology parameter for the Tigers as a whole there is no role left for technical progress. For these four countries as a group, in this instance, capital, labor and human capital account for 64.25, 18.25 and 17.5 percent of their growth performances respectively. Together, these numbers are sufficient to account for all the growth. Nothing is left for technical progress to explain.

20 Interpreting East Asian Growth and Innovation

Is it wrong perhaps to put the whole burden of technical progress on the technology parameter? Is it necessary perhaps to consider capital as a source of embodied technical progress as well? This is not an unreasonable criticism of the above approach. However, calculations using this alternative assumption (which were repeated and verified for the most part) do not offer much hope. For this scenario the results on the average are almost identical to the situation where technical progress is parametrized. For Korea, our country of particular interest, the two sets of numbers are almost identical. In this case, 60.2 percent of the growth can be attributed to capital, 29 percent to labor and 19.8 percent to human capital. This lack of measured technical progress in the miracle economies is paradoxical. In particular the ‘catch-up’ hypothesis suggests that these high-growth economies should be exploiting technological opportunities available to them. What may have gone wrong? Lau (1996) offers a number of explanations of varying degrees of plausibility, as follows. First in line is whether the physical depreciation has been taken adequately into account. It may seem that since the gross capital stock rather than the net capital stock is used as a factor input in the aggregate production function, allowance has apparently not been made for the physical depreciation. If physical depreciation is significant then the measure for capital stock will be biased upwards. This will naturally bias the estimated capital augmentation rate: Thus, an estimated capital augmentation rate of zero may not necessarily imply a zero ‘true’ rate of capital augmentation – it is also consistent with the interpretation that the ‘true’ rate of capital augmentation is equal to, and hence offset by, the ‘true’ rate of depreciation, resulting in an estimate of zero for the measured capital augmentation rate. However, since the same concept of the gross capital stock is also used for the developed countries, the above argument cannot explain the fact that the estimated rates of capital augmentation are positive and statistically significant for the developed countries but low or negative and statistically insignificant for the developing countries.2 This last point may indeed be valid. However, one should also consider the possibility that there may be greater errors in the measurement of capital for the less-developed countries. It is not clear, however, why the error should work in the direction of hiding technical progress (Lau 1996: 81).

Is the Asian Miracle a Myth? 21

Lau goes on to make several other points: Second, as we have seen, there are significant measured economies of scale in all inputs taken together for the developing countries. For economies in which output and inputs are both growing, economies of scale and technical progress provide alternative explanations for the reason why doubling the inputs results in more than doubling the outputs. With data from a single country, it is difficult to distinguish between the existence of economies of scale and technical progress. However using the meta-production function approach, in which time-series data from several countries are pooled, it is possible to distinguish scale effects from technical progress, because at any given time, production at different scales is observed across countries and the same scale of production is observed in different countries at different time. Empirically, we have found that as far as the developing countries are concerned, it is economies of scale, rather than technical progress, that have been responsible for the good economic performance. Third, the effects of technical progress in the Boskin–Kim–Lau studies are essentially being captured by the time trend, which is supposed to reflect the influence of omitted or unmeasured variables, such as R&D capital; land, or more generally, the natural endowment of resources; and other intangible ‘investments,’ such as software and market development. However, it is likely that such omitted or unmeasured variables are actually relatively unimportant in the developing countries, where there has been, until very recently, little investment in R&D, especially in basic research. Thus the indigenously generated improvements in technology must be quite scarce in these countries. By contrast, the developed countries invest a significant percentage of their GDP and R&D and even greater amounts in innovation and other productivity-enhancing activities. Thus, it should not be surprising that technical progress, or the ‘residual’, is much larger in the developed countries than in the developing countries. It is also true that despite the very rapid capital deepening in the developing countries, their industries are by and large not knowledge- or technology-intensive, at least until recently. Moreover, the developing countries have been playing ‘catch-up’ in technology – the capital goods installed are likely to be on-the-shelf variety, and the possibility for indigenous improvements is limited. For all these reasons, the ‘residual’ due to omitted variables is likely to be small, or at least smaller, for the developing countries. (Lau 1996: 82)

22 Interpreting East Asian Growth and Innovation

As mentioned previously, even treating technical progress non-parametrically does not improve matters. The claim regarding increasing returns also requires careful consideration. We deal with this issue in the next chapter. Lau continues: Fourth, the industries in the developing countries typically employ mature technologies with limited innovation possibilities, and the capital goods for these technologies, mostly imported, have been fully priced (that is, the acquisition as well as royalty costs fully reflect the possible efficiency gains and the amortization of R&D and other developmental costs) in the international market, so there is little or no net increase in value-added, over and above the normal returns to the factor inputs. In other words, the ‘innovation rents’ have been largely captured by the foreign inventors, manufacturers and distributors of the new equipment or intermediate inputs, in markets that are only very imperfectly competitive. The ‘rents’ can also take the form of royalties and fees paid to the foreign technology licensers by the developing countries, which, for some sectors, can constitute a rising share of the output produced, reducing correspondingly the domestic part of the real value-added. Consequently, even if a new technology were adopted, its effect might not be reflected in the form of a higher real value-added, holding measured factor inputs constant. Fifth, it is possible that whatever technical progress there is in the world is mostly embodied in the capital goods used in the hightechnology industries; thus, the developing countries, with a much smaller high-technology sector, would not have been able to take advantage of it to the same extent as the developed countries. Sixth, it is possible that the growth of the ‘software’ component, broadly defined to include managerial methods and institutional environment as well as supporting infrastructure, lags behind the ‘hardware’ component in the developing countries – and hence the capital goods have not been able to realize their full potential productivity, especially in the non-tradable sectors, which are often also the most monopolistic. Seventh, it is also possible that positive technical progress in certain industries in the developing countries may be offset by rising inefficiency in certain other industries, especially those in the nontradable sectors, so that the economy as a whole exhibits no measured technical progress. (This is less likely to be true for an open and competitive economy such as Hong Kong’s.) Rising inefficiency

Is the Asian Miracle a Myth? 23

can persist only in protected markets, under monopolistic or oligopolistic conditions. Thus, technical progress at the microeconomic or industrial level may be nullified by the inefficiency caused by the lack of competition in the domestic market. Eighth, it is also possible that the efficiency of production may be negatively related to the rate of growth of the factor inputs, especially capital inputs, for given levels of the factor inputs, because of costs of adjustments and learning. Essentially, the more rapid the rates of growth of the factor inputs, especially that of capital, the further away is the economy from the steady state, and the productive potential of the new investments may not be fully realized. The rate of growth of the capital input may be taken to be a measure of the amount of disruption of necessary adjustment. If this is the case, the positive effect of any technical progress may be offset in the short term by the negative effect of overly rapid growth of factor inputs until their rates of growth decline to more absorbable, or ‘steady-state,’ levels. Thus, as long as a developing country continues in a phase of high input growth, the measured ‘residual’ may be small or negligible. Finally, it is also possible that improvements in the quality of life, such as a reduction in air pollution or traffic congestion, brought about by increased inputs of both capital and labor, may not be fully reflected in measured real GDP. In other words, not all of the output resulting from the inputs, and its growth over time, is captured by measured real GDP, and hence in the efficiency and productivity measurements.7 (Lau 1996: 82–3) Another finding of these studies is the complementary augmentation of physical capital and human capital simultaneously during technical progress. This line of reasoning accords very well with the strategic complementarity view presented in Chapter 2. Indeed, Lau (1996) offers this as an explanation of the non-existence of endogenous technical progress at the aggregated level for the East Asian economies: This complementarity may in fact be one reason why technical progress is not as yet an important source of economic growth in the developing countries. At the prevailing levels of physical capital and human capital, it has not yet become profitable for the developing countries to invest in R&D and other technical progress-creating activities. In time, with diminishing marginal productivity of physical capital and the increase in inputs complementary to technical

24 Interpreting East Asian Growth and Innovation

progress (physical and human capital), the attractiveness of technical progress creation will increase relative to traditional investment in physical capital. In this sense too, technical progress can also be said to be endogenous at the level of the aggregate economy. (Lau 1996: 83–4)

Tales of cities and nations in East Asia: the growth paradox Young (1992, 1994, 1995, 1998a, 1998b) has written a series of papers where the existing estimates of productivity growth for the East Asian economies are called into question. These papers point out, as do the works discussed in the previous section, that the assumption of high productivity growth in these economies cannot be accepted. On the contrary, the remarkably rapid growth of factor accumulation seems to explain their remarkable growth record. Thus Young’s work has become another source for vindicating Krugman’s thesis of the myth of the Asian miracle discussed earlier. Young (1995) uses the translog index of total factor productivity (TFP) growth and very careful estimates of factor accumulation to arrive at the final estimates of TFP. Average TFP for Hong Kong (1966–91) is found to be 2–3 percent per year. For Singapore (1966–90) it is only 0.2 percent. Taiwan posts a figure of 2.1 percent. For Korea TFP growth during 1966–90 turns out to be about 1.7 percent. One of the interesting features of Young’s empirical work is that the numbers above are the results of a set of separately derived small effects all coming together. Furthermore, these results point out the fallacy of the premise of high productivity growth in the manufacturing sectors of the East Asian NIEs, a premise shared by both theoretical and policy-oriented research in this area. The range of productivity growth in non-agricultural sectors turns out to be from a low of 0.2 percent for Singapore to a high of 2.3 percent for Hong Kong over the relevant period.

Total factor productivity for Korea Since in Chapter 5 I will be concerned with the existence of a POLIS in Korea it seems worthwhile to pay special attention to TFP calculations in Korea. I have tried to test Young’s claim regarding the ‘confluence of small effects’ by modifying carefully some of the estimates and recalculating the overall effect. The bottom line still remains the same – no more than a 1.8 percent per annum TFP growth for 1966 to 1994. The

Is the Asian Miracle a Myth? 25

slight increase is consistent with Young’s (and others’) observation that productivity growth in Korea shows an upward time-trend. The slope did increase in the 1980s and 1990s, but the overall rate is still significantly below the more optimistic pronouncements. The 1.8 percent TFP growth that I was able to derive contrasts with the Christensen, et al. (1980) estimate of 4.1 percent during 1960 to 1973. However, as Young has pointed out, their inclusion of land input and agricultural inventories biased the measure of capital stock. Both my estimate and Young’s are close to Pyo and Kwon’s (1991) estimate of 1.6 percent for the private sector during 1960–89. They also use the Korean Statistical Yearbook for hours of work estimates for 1960–62 and the economically active population survey from 1962 on. The change in methodology in 1962 may have given rise to a statistical artifact showing a very rapid increase in hours worked. This would account partially for the slightly lower estimate on their part.

Total factor productivity for Taiwan Taiwan is the second country I intend to analyze in depth later (Chapter 6). Hence a preliminary look at Taiwan’s productivity performance seems worthwhile. Table 3.1 (Table viii in Young 1995 shows the total factor productivity growth estimates by Young for Taiwan. It is interesting to note that the sectoral pattern of productivity growth in Taiwan seems to be quite different from the Korean pattern. Manufacturing and other industry have average growth rates of 1.7 percent and 1.4 percent, respectively. These sectors lag behind services. For the latter, the average growth rate is more than double – 3.5 percent per year. Young also points out that within the ‘other industry’ classification there are differences between the two countries as well: Thus, over the 1966–1990 period total factor productivity rose 3.7 percent per annum in Taiwanese mining (as compared with a decline of –1.1 percent per annum in Korea) and fell –0.2 percent per annum in Taiwanese electricity, gas and water (as compared with rapid growth of 5.2 percent per annum in Korea). Elsewhere, the performance of the two economies was more similar, with productivity in Taiwan rising 1.5 percent per annum in construction (2.2 percent Korea), 4.7 percent per annum in transport, storage and

26

Table 3.1

Total factor productivity growth: Taiwan

Time period Economy – excluding agriculture 1966–70 1970–80 1980–90 1966–90 Manufacturing 1966–70 1970–80 1980–90 1966–90 Other industry 1966–70 1970–80 1980–90 1966–90 Services 1966–70 1970–80 1980–90 1966–90

Labor share

Output

Aggregate capital

Weighted capital

0.111 0.103 0.078 0.094

0.152 0.137 0.085 0.118

0.171 0.144 0.083 0.123

0.043 0.068 0.024 0.046

0.044 0.068 0.032 0.049

0.034 0.015 0.033 0.026

0.739 0.739 0.749 0.743

0.168 0.121 0.072 0.108

0.207 0.145 0.078 0.128

0.214 0.146 0.079 0.130

0.078 0.100 0.012 0.059

0.075 0.101 0.021 0.063

0.031 0.001 0.028 0.017

0.558 0.566 0.613 0.579

0.104 0.112 0.059 0.088

0.177 0.165 0.058 0.122

0.190 0.169 0.060 0.127

0.100 0.063 0.012 0.048

0.096 0.066 0.018 0.051

0.020 0.013 0.027 0.014

0.702 0.691 0.692 0.695

0.087 0.094 0.090 0.091

0.145 0.134 0.094 0.119

0.162 0.139 0.092 0.123

0.018 0.049 0.036 0.038

0.023 0.050 0.038 0.040

0.040 0.029 0.039 0.035

0.828 0.827 0.777 0.811

Aggregate labor

Weighted labor

TFP

Is the Asian Miracle a Myth? 27

communications (3.4 percent Korea), and 0.2 percent per annum in finance, insurance, real estate, and business services (–0.1 percent in Korea). (Young 1995: 662) There are some statistical issues with respect to the Taiwanese authorities’ measurement of public sector output. According to Young: Whereas most national accounts authorities deflate public sector output by the wages of different types of public sector employees, leading to an approximately zero growth in output per effective worker, the Taiwanese national accounts incorporate a ‘quality adjustment,’ allowing for the growing (unmeasurable) productivity of public sector employees. According to my estimates, between 1966 and 1990 output per effective worker in the Taiwanese public sector grew 4.4 percent per annum (6.6 percent per annum if one includes military personnel in the denominator. (Young 1995: 662) After adjusting for the above treatment of public sector output the results change somewhat. Table 3.2 captures the changes. Young points out: As the reader can see, this adjustment has a large impact on the aggregate nonagricultural economy, where productivity growth falls to an average of 2.1 percent, and an even stronger impact on services, where productivity growth now appears to have averaged 2.6 percent (which nevertheless remains higher than manufacturing and other industry). Table [3.2] also presents estimates for the nonpublic sector nonagricultural Taiwanese economy, which sidesteps these measurement issues by excluding the public sector from consideration. I find that total factor productivity growth in the nonagricultural private sector Taiwanese economy averages 2.3 percent per annum between 1966 and 1990. Interestingly, the two sets of estimates for the aggregate economy, both with and without the public sector, show a substantial improvement in productivity growth during the 1980s, which is reminiscent of the results for Korea. (Young 1995: 663) The last sentence offers some hope for productivity change through technology in the 1980s. However, the conclusions Young reaches at the end of his essay would seem to dismiss this possibility. First of all,

28

Table 3.2 Time period

Modified factor productivity growth

Output

Aggregate capital

Weighted capital

Economy – excluding agriculture and with adjustment of public sector output 1966–70 0.092 0.171 0.152 1970–80 0.103 0.144 0.137 1980–90 0.073 0.083 0.085 1966–90 0.089 0.123 0.118 Services – with adjustment of public sector output 1966–70 0.050 0.162 0.145 1970–80 0.094 0.139 0.134 1980–90 0.082 0.092 0.094 1966–90 0.082 0.123 0.119 Economy – excluding agriculture and official public sector 1966–70 0.120 0.187 0.173 1970–80 0.112 0.145 0.141 1980–90 0.080 0.081 0.083 1966–90 0.100 0.125 0.122

TFP

Labor share

0.044 0.068 0.032 0.049

0.015 0.015 0.028 0.021

0.739 0.739 0.749 0.743

0.018 0.049 0.036 0.038

0.023 0.050 0.038 0.040

0.003 0.029 0.031 0.026

0.828 0.827 0.777 0.811

0.069 0.072 0.024 0.052

0.073 0.073 0.033 0.056

0.012 0.017 0.033 0.023

0.699 0.693 0.715 0.702

Aggregate labor

Weighted labor

0.043 0.068 0.024 0.046

Is the Asian Miracle a Myth? 29

he reiterates that productivity growth cannot be thought of as extraordinarily high: Underlying the pervasive influence of the East Asian NIEs on both theoretical and policy-oriented research in the economics profession lies a common premise: that productivity growth in these economies, particularly in their manufacturing sectors, has been extraordinarily high. The results of this paper, as summarized in Table [3.1], suggest that this premise is largely incorrect. Over the past two and a half decades, productivity growth in the aggregate nonagricultural economy of the NIEs ranges from a low of 0.2 percent in Singapore to a high of 2.3 percent in Hong Kong, whereas in manufacturing productivity growth ranges from a low of –01.0 percent in Singapore to a high of 3.0 percent in South Korea. For the purposes of comparison, Table [3.2] reproduces the results of two detailed cross-country studies of productivity growth, with methodologies similar to that used in this paper. As the reader can see, it is not particularly difficult to find either developed or less developed economies whose productivity performance, despite considerable slower growth of output per capita, has approximated or matched that of the NIEs. While, with the exception of Singapore, productivity growth in the NIEs is not particularly low, it is also, by postwar standards, not extraordinarily high. (Young 1995: 671) Young then goes on to state, without conscious irony: The results of this paper should be heartening to economists and policy-makers alike. If the remarkable postwar rise in East Asian living standards is primarily the result of one-shot increases in output brought about by the rise in participation rates, investment to GDP ratios, and educational standards and the intersectoral transfer of labor from agriculture to other sectors (e.g., manufacturing) with higher value added per worker, then economic theory is admirably well equipped to explain the East Asian experience. Neoclassical growth theory, with its emphasis on level changes in income and its well-articulated quantitative framework, can explain most of the differences between the performance of the NIEs and that of other postwar economies. (Young 1995: 673–5) If the Lau–Kim findings or Young’s findings on East Asia that are corroborated by my own econometric re-estimation are right then one

30 Interpreting East Asian Growth and Innovation

faces a problem similar to that faced by Sherlock Holmes in ‘Silver Blaze’. In this story Holmes is puzzled by the fact that the dog did not bark at night. In an analogous way we should be puzzled by the absence of technical progress in rapidly growing countries such as Korea and Taiwan. One possible route to take at this point is to investigate the state of the development of technology itself. Indeed, this will have been the most direct route; but there are numerous roadblocks which make straightforward econometric calculations a difficult if not impossible task. Still there are insights to be gained if we pursue the existing descriptive evidence with perseverance. A careful analysis should be rewarding in any event. But what is also required at this point is a framework of analysis that can enable us to look at technology and growth both at the macro level and at the sectoral and micro one. It will be seen that increasing returns, R&D and creation of a skilled scientific and technical work force lie at the heart of the debate regarding the East Asian economic performance. For this reason, we need to develop a rigorous theoretical framework that can be operationalized for carrying out the necessary empirical work. This is the task of the next chapter.

Appendix: a methodological critique of the growth accounting approach Here I consider some long-dormant criticisms of the neoclassical aggregate production function approach (see also Felipe 1997). These criticisms, if they are to be taken seriously, would seem to invalidate the neoclassical growth theory altogether. Furthermore, the empirical growth accounting and factor-shares fitting would also turn out to be tautological at best and meaningless at worst. In this appendix I summarize the basic criticisms in a loosely structured historical fashion. It may be recalled that the critics of the East Asian miracle called ‘accumulationists’ by Nelson and Pack (1996) start from the aggregate neoclassical production function and derive the following conclusions: 1. Growth is (almost) entirely due to the growth of factor inputs. 2. Total factor productivity growth is very slow. 3. There must be inevitable slowdown of this type of growth because of diminishing returns to capital. 4. According to Lau and Kim there is little evidence of catching up with the advanced countries.

Is the Asian Miracle a Myth? 31

If the above facts are indeed true then it follows that these economies will not become economic powers threatening the advanced economies. At least this will not happen in the immediate future. Opposing the accumulationists are ‘assimilationists’ like Richard Nelson, Howard Pack and John Page. They express their dismay and disbelief quite dramatically: Totally autarchic and corrupt Burma exceeds the TFP growth of South Korea! … These results strain credulity and severely undermine the claim based on Young’s work that the HPAE were simply run-of-the mill countries in the period from 1970 to 1985. (Pack and Page 1994b: 253) Although Nelson and Pack go to great lengths in distinguishing their position from that of the accumulationists they raise no qualms about methodology. Only the substantive empirical claims of the accumulationists are questioned. However, starting with Wicksell as early as 1919, questions have been raised about the validity of the aggregate production function approach to growth and distribution. In 1953 Joan Robinson ignited the capital theory controversy with her Review of Economic Studies article ‘The Production Function and the Theory of Capital’. The subsequent flurry of articles from the two Cambridges resulted in a clarification of the meaning of capital and the conditions under which an aggregate production function itself is a meaningful entity. Essentially, the critique of the marginal productivity theory carries over into a critique, of the aggregate production function. Partly as a result of this devastating theoretical critique neoclassical growth theory went into a recession in the 1970s. The more recent critique of growth accounting revives another line of criticism of growth theory first stated with great clarity in an article by Phelps-Brown in 1957. There he points out that cross-sectional Cobb–Douglas production functions are not a hybrid; they are, in fact, indistinguishable from the cost identity. This line of criticism was pursued in the 1970s by Shaikh (1974). Felipe (1997), and others try to elucidate these issues further for Cobb–Douglas production functions as well as other production and cost functions. Their basic conclusion can be summed up as that of a circularity. The statistical findings do not provide an independent test of, say, the elasticity of substitution as a technological parameter. Likewise the growth accounting estimations of TFP do not by themselves justify the methodology of this approach.

4 Making a Miracle: A New Approach

As the discussion in the last two chapters has shown, a large part of the problem of resolving the debate between the miracle-mongers and miracle-breakers has to do with the characteristics of the growth process itself. In this chapter a systematic attempt will be made to arrive at a methodology for identifying the nature of the growth process in the East Asian economies. The key issue from this perspective is whether these countries have been able to create a positivefeedback loop innovation system (POLIS).

Can the new growth theory help? By the 1970s formal neoclassical growth theory must have run into rapidly diminishing returns from further research efforts. Romer (1991) has suggested that many theorists must have understood the necessity for making technical change endogenous. However, the theoretical and technical innovations that would be necessary in order to make such a theoretical venture feasible were not forthcoming until the late 1970s. In particular the paper by Dixit and Stiglitz (1977) on imperfect competition provided theorists in both the new growth theory and the new trade theory with the formal apparatus to make the necessary intellectual progress. Theoretical advances in several areas of economics have led to the identification of technology and innovation as the prime movers in the process of growth and wealth creation. Both the new growth theories and the new theories of international trade figure prominently among these advances.1 Solow (1994: 48) states that ‘no one could ever have intended to deny that technological progress is at least partially endogenous to the 32

Making a Miracle: A New Approach 33

economy – The question is whether one has anything useful to say about the process, in a form that can be made part of an aggregative growth model.’ In retrospect, it is clear that the new growth theorists have tried to answer precisely this challenge.2 The way the new growth theory rises to this challenge is by simply abandoning the idea of diminishing returns to capital. At the microeconomic level, the formal apparatus of a representative agent model with infinite-horizon intertemporal optimization to determine investment and the introduction of monopolistic competition provide the analytical foundations of this approach. Romer (1994) points to a number of stylized facts to motivate new growth theory. According to him, the basic challenge for the growth theories has been to incorporate the following propositions – or, as Romer seems to treat them – stylized facts: 1. There are many firms in a market economy. 2. Discoveries differ from other inputs because many people can use them at the same time. 3. Physical activities are amenable to replication. 4. The source of technological advance must be the activities of people. 5. Discoveries enable many individuals and firms to earn economic rents. The neoclassical model captures facts 1, 2 and 3 but not the others. Technology, in fact, is treated as a pure public good in this model. Endogenous growth theories also treat knowledge as a public good with spillover effects. At the same time these models try to accommodate fact 4 as well. Romer credits Arrow (1962) and Shell (1967) as early precursors in this formal venture. Early models of endogenous growth (for example, Romer 1986 or Lucas 1988) still did not capture fact 5. Romer (1986) assumes that aggregate output can be written in the following form: y = A(R)F(Rj, Kj, Lj) where y = aggregate output, Rj = stock of research results from expenditure on research and development by firm j, Kj = capital of firm j, and Lj = Labour in firm j. In order to exclude any prospects of monopoly power, F (.) has to be homogeneous of degree 1 in all its arguments. For Rj, this carries the implication that research is a rival good.

34 Interpreting East Asian Growth and Innovation

Once imperfect competition is admitted, however, the above sleightof-hand is no longer necessary. The key problem now becomes the specification of the evolution of technology. Grossman and Helpman (1991) present a model which specifies an evolutionary path different from that of a neoclassical model. Coe and Helpman (1993) demonstrate that domestic and foreign ‘knowledge capital stocks’ help to explain the growth in total factor productivity in OECD countries. In an even more specific study Eaton and Kortum (1993) find that the number of national scientists and engineers is a significant determinant of a country’s income level. The findings with regard to POLIS in Korea and Taiwan presented in the next two chapters will also support this line of thought. Earlier a study by Lichtenberg (1992) had found that the level of spending on R&D was also a significant variable in the determination of a nation’s output. In many plausible endogenous growth models (for example, Grossman and Helpman 1991a) successful innovation leads to increased productivity. The market leader earns monopoly rents until a rival firm discovers and markets a better version of the same product. The R&D expenditure is related to the prospects for earning economic rent. Firms are taking a necessary gamble here. By deciding to spend money on R&D the firm buys a chance at developing the future product. Firms may invest in knowledge up to the point where the marginal costs of such investment equals the marginal expected gain. Both physical and human capital accumulation can be introduced in such models in a straightforward manner. Extension of such innovation-based scenarios to open economies can provide new reasons for global integration. Rivera-Batiz and Romer (1991) show that integration may lead to greater access to a larger technical knowledge base (one could draw a mental picture showing the difference between North and South Korea in this respect) than would be available under autarky. It is also possible that exposure to international competition may reduce unnecessary industrial research. However, without ready access to the global research base this may not necessarily be the situation. It should also be recognized that free trade may not always be the best state of affairs. A country with abundant natural resources and unskilled labor (but not enough skilled labor) may specialize under free trade in activities that are not human-capital-intensive. In the long run, this may thwart technical progress and lower the steady state rate of growth. Technological spillovers may also mean that a small country must spend some time in catching up with the rivals in the world

Making a Miracle: A New Approach 35

market. Although this is not a scenario to be pursued by all countries under all circumstances, the chapters on Korea and Taiwan will show the relevance of ‘technology policies’ even in a regime of export-led growth.

Increasing returns and positive-feedback loops to the rescue The extension of the new growth theory to the problems of innovation in LDCs is not obvious. The models discussed above deal mainly with the well-developed innovation structure that is already in place in the industrialized economies. For the LDCs the problem is to create such a structure. This problem, as we will see soon, is intimately connected with the existence of multiple equilibria in complex economies. A positive-feedback loop leading to a virtuous cycle of growth and technology development is necessary for this purpose. For this reason the understanding of increasing returns in this context is also crucial. In the remainder of this chapter a theoretical exploration of innovation, increasing returns and multiple equilibria will be undertaken. According to Arrow, ‘increasing returns has had a long but uneasy presence in economic analysis’. Although given much prominence by Adam Smith, concerns with increasing returns were soon replaced by constant returns and perfect competition. Apart from the asides by Marshall in his otherwise competitive framework, sporadic attempts by Sraffa (1926), Joan Robinson in the 1930s and Kaldor in the 1950s did little to dislodge the orthodoxy. As observed previously, in the 1980s many growth models discarded the assumption of constant returns to capital. A byproduct of this venture is increasing returns to scale. More fundamentally, the work of Brian Arthur and his collaborators during the same period brought increasing returns to the forefront of mechanisms that drive modern market economies. Two sets of elegant lectures by Paul Krugman have also developed the spatial aspects of increasing returns (Krugman 1991, 1996a). In his autobiographical introduction to Innovation, Organization and Economic Dynamics (Dosi, 2000), Giovanni Dosi writes of the efforts at the Santa Fe Institute to understand complexity and increasing returns by economists like Brian Arthur, among others. Arthur (1994) emphasizes two fundamental aspects of increasing returns problems. The first is the commonality of economic issues captured by increasing returns. The second is the problem of determining how an equilibrium comes to be selected from among many existing equilibria. The model presented later in this chapter has multiple

36 Interpreting East Asian Growth and Innovation

equilibria in technology systems. It illustrates in a substantive way both of Arthur’s insights. In a market economy, ‘success’ is often cumulative or self-reinforcing. Typically, outcomes are not predictable in advance. However, once an equilibrium gets selected out of a number of long-run equilibria, there is a tendency to be locked in. Technically then, processes exhibit nonconvexities – violating the generic assumption of competitive equilibrium economics. Intellectually, the presence of self-reinforcing mechanisms sharing common features found in fields as far apart as enzyme reactions and the economics of technical change underlines the importance of such mechanisms in governing the dynamics of processes far from equilibrium, regardless of the field in which they occur. In Arthur (1989) the possibilities of lock-in and non-ergodicity are demonstrated rigorously in the case of competing technologies. Earlier in the classic 1985 paper ‘Clio and the Economics of QWERTY’, Paul David had introduced the idea of path dependence. This idea has gained rapid acceptance within the economics profession. It also has stimulated a number of subsequent studies providing these empirical approaches with the conceptual apparatus for studying the trajectories of technical change. In collaboration with Yuri M. Ermoliev and Yuri M. Kaniovski, Arthur used the Polya urn problem in a general form to model nonlinear processes. In the more general cases these models typically display multiple equilibria. These equilibria correspond to the stable fixed points of the associated ‘urn function’. History seems to matter in the selection process. One may raise the question, in the light of our discussion of the new growth theory in open economies, of how trade and self-reinforcing systems may be connected. How, for example, would trade liberalization affect the rate of technological change? The question is not easy to answer – again at least partially because of the presence of multiple equilibria. In the normal dynamics, the process may be smooth for some time, but suddenly when the change becomes cumulative, one equilibrium may collapse and another one may take over. Locally stable equilibria may become unstable; but the change from stability to instability is also an opportunity for a new ‘self-organization’ (Krugman 1996a). Location of technologies in different parts of the globe are not predetermined, but they may depend on history. History may, in turn, be to some extent determined by policies. Thus in a complex, non-linear world with technological uncertainties, standard

Making a Miracle: A New Approach 37

economic theory is largely silent on the technological road to take for a developing open economy.3

Positive-feedback loop innovation systems and strategic complementarities: the possibility of multiple equilibria Throughout the preceding discussion I have been stressing implicitly the motivation for taking the possibility of multiple equilibria in our economic models with technology seriously. One might ask: why are multiple equilibria so crucial in understanding the role of technology in the growth process of developing economies? One answer to this question is that those growth models that focus on one type of equilibrium (even when there may be more than one) may be misleading in a serious way. Concentrating on a unique equilibrium leads to the kind of deterministic view of economic history that history itself cannot support. Ignoring the possibilities of stagnation or different kinds of growth leaves us quite unprepared to explain the different growth trajectories (including stagnation for certain periods for certain countries) taken by different countries.4 In the light of recent economic history for instance, we may wish to ask why the Asian NIEs took off while the African economies stagnated (see, for example, Khan 1997c). One possible answer is that these countries somehow reached different kinds of equilibria. This answer, by itself, is of course not adequate and requires further elaboration. In the empirical cases of Korea and Taiwan, such a detailed elaboration will indeed be attempted later. Here, I wish to focus on the possibility of multiple equilibria theoretically when there is strategic complementarity between human capital and R&D. Strategic complementarity is particularly relevant in the context of the new theories of growth and technological change for at least two important reasons. In the first place two important strands of new growth theory have emphasized different aspects of growth generating elements. For example, Aghion and Howitt (1992) and Romer (1990c), among others, have emphasized investments in R&D as growth generating elements. On the other hand works by Lucas (1988) and Stokey (1991) have stressed the role of accumulating human capital in engendering and sustaining growth. Second – and of equal importance to the theoretical models – empirical evidence already exists for the significant effect that both human capital and R&D have on growth. Among others, Coe and Helpman (1993) and Lichtenberg (1992) have found that R&D has a significant effect on

38 Interpreting East Asian Growth and Innovation

growth. Khan and Thorbecke (1988) and Khan (1993) also corroborate this finding. On the human capital side, Mankiw et al. (1992) and Barro (1991) report the significance of human capital variables in understanding growth.5 It is also relevant here to consider the fact that some studies have uncovered a crucial interdependence between the incentives to invest in R&D and in human capital. For example, the study by Steedman and Wagner (1989) reveals that the differences in workforce skills is a major explanation for the superiority in both the greater R&D and innovativeness of German firms in clothing manufacture. It is clearly important to trace the implications of such interdependence for growth in an analytical model. Redding (1996) presents such a model. It is not the only one possible, of course. But the combination of a model of human capital accumulation with a ‘quality ladder’ model of R&D can address the implications of strategic complementarity in a fairly straightforward manner. All one needs to do is to investigate the relationship between human capital and R&D investments in the context of a dynamic model of endogenous growth. Equilibrium in a model of this type, workers’ investments in human capital, depend on the expected investment of capitalists in R&D. At the same time, the capitalist entrepreneurs’ willingness to invest in R&D can be shown to depend on the workers’ expected investment in human capital. One can follow through this approach logically and derive the Nash equilibrium under rational expectations. The characteristics of strategic complementarity between the two types of investment and the presence of pecuniary externalities (together with indivisibilities in R&D expenditures) create the possibilities of multiple equilibria. The existence of multiple equilibria creates possibilities for technology policies. It is interesting to note that two possible kinds of equilibria may exist under the above circumstances – a high-growth, high-quality equilibrium and a low-growth, low-quality equilibrium. In the lowgrowth equilibrium situation, the entrepreneurs do not expect the workers to invest in human capital and hence reduce their R&D investment. In a mutually reinforcing manner, the workers at the same time do not expect the capitalists to invest in R&D. Therefore, the workers in this model also reduce their investment in human capital. In the high-growth equilibrium, the size of innovation must be ‘sufficiently large’. The productivity from education (or human capital in general) must also be ‘sufficiently large’. The steady-state growth

Making a Miracle: A New Approach 39

rate is determined by both the rate of human capital accumulation and investment in R&D. In the high growth equilibrium a higher level of output is available for consumption. Redding (1996) proves the following proposition: A small, temporary subsidy towards the cost of R&D may induce the economy to select the high-skills equilibrium and can be selffinancing. Later I address the issue of whether or not such a subsidy (and an analogous one for human capital accumulation) has indeed played a major role in the Korean innovation system. It is important to only note here the difficulty in practice of determining when and by how much to subsidize such activities. Indeed, one of the trickiest issues raised by both strategic trade and strategic complementarity approaches to high technology is the question of subsidies. Careful work by Suzumura et al. (1988) and others (for example, the studies in Baldwin 1988 and Krugman and Smith 1994) reveal the difficulties that lie in wait for those who seek an easy vindication of industrial policy or protectionism. Another conclusion of these studies is that the payoff from strategic trade policy is likely to be rather modest. However, the same cannot always be asserted in case of subsidizing R&D or the cost of accumulating human capital. The stakes here can be quite high if strategic complementarities and indivisibilities are intrinsic features of the economy in question. If the difference between some subsidies and no subsidies is to be a highgrowth as opposed to a low-growth economy then neglect of R&D or human capital by the government may not be so benign after all. The discussion so far suggests that technology systems underlying the growth process may be complex. The next section addresses the issues raised by complex technology systems.

Technological systems as complex structures As the debate on the ‘East Asian miracle’ underlines, the key strategic question for a country that has made a technological transition from a traditional to a modern system concerns the prospects for long-term economic growth. Ultimately, it is the sustainable long-term rate of growth that will determine the wealth that can be distributed among personal consumption, investment, government spending on infrastructure and public services, and so on. However, some kind of

40 Interpreting East Asian Growth and Innovation

distributional consensus is a presupposition of the particular growth trajectory followed. Therefore, there is a strategic socio-political decision regarding distribution to be taken. Given the distributional characteristics of an economy, it is the creation of an innovation system that will determine the viability of a technology-based growth process. This process of building an innovation system is very much a path-dependent process. The central idea is that the provision of appropriate types of capital, labor and forms of organization for high value-added industries will lead to rapid productivity increases. However, to sustain such an increase, a domestic innovation system must be set up. There is a further requirement that this innovation system must fulfill. This is the requirement of a positive-feedback loop or a virtuous cycle of innovations. In the current period – Mark V, in Freeman and Perez’s (1988) terminology – such a system will require networks involving technologies such as minicomputers, semiconductors, robotics, fiber optics, genetics and so on. As Kitschelt (1991) has pointed out, there are two important dimensions of high technology – ‘coupling’ and ‘complexity’. Coupling refers to spatial or temporal linkages between different production steps. If the steps must be carried out at an identical location at the same time then they are coupled tightly. On the contrary, if they can be done at any location and the temporal sequence is not important then they are loosely coupled. An example of the latter is the computer technology (sub-) system. The complexity dimension of a technology system or subsystem is the feedback process referred to earlier. In a complex environment, the non-linear processes with feedbacks at work may lead to multiple equilibria. In this chapter I present a relatively simple non-linear model and show how easily multiple equilibria may exist in complex technology systems. But before presenting the formal model, I want to stress the informational and organizational implications of coupling and complexity. It is to be expected that tight coupling requires close monitoring and supervision. Loose coupling, on the other hand, permits considerable decentralization. Complex technology systems have large information requirements. This necessitates the creation and management of an information processing system. Large communications flows can overload the capacity of centralized management structures. Therefore, complex systems are more easily managed if they have loose coupling properties. Network coordination of relatively decentralized units may be the optimal organization of such loosely coupled complex systems.

Making a Miracle: A New Approach 41

Postwar development of technology (sub-) systems involving nuclear power, aircraft, spacecraft and large computers shows a tight coupling and complexity. This juxtaposition may have created scale characteristics and levels of risk that could only be managed, if at all, through various forms of intervention and regulation – usually on an ad hoc basis. However, the Mark V technologies mentioned before (for example, software, microprocessors and genetic engineering) bring forth substantial complexity in a loosely coupled setting. Network organizations may provide the most effective structures for such a situation. At the same time, returning to the question of technical progress in LDCs, we should realize that the problems faced by the typical developing economy are twofold. In the first place, the problem of the positive-feedback loop innovation system (POLIS) must be solved. After the creation of a POLIS, its transformation from Mark IV to Mark V phase must be carried through. Just as only a sinner may officially confess, only a country that has committed the technological sin of creating a POLIS can move forward to the next stage. It is in the creation of a POLIS that many of the stumbling blocks must be faced first. Technology, industrial and trade policies have been the key national policy instruments for creating a POLIS.

A ‘simple’ non-linear model of complexity In order to give the reader some idea of the problem of formalizing complex technological systems, in this section, I present a ‘simple’ non-linear model embodying distinct technological systems. The model is presented as a social accounting matrix representation of the socio-economic system that was first mentioned in an abstract form in Chapter 1. The next chapter will describe an empirical SAM for Korea. The key distinction here is the explicitly non-linear nature of the functional relationships. The key theorem shows the existence of equilibrium. It is important to underline that the equilibrium is not necessarily unique. Some further considerations (using Herbert Amann’s theorems on fixed points of increasing maps) show that multiple equilibria are the natural outcomes in such models. There would seem to be some role for domestic policy in guiding the economy to a particular equilibrium among many. As mentioned before, the virtue of an economy-wide approach to technology systems is the embodiment of various intersectoral linkages. In a SAM, such linkages are mappings from one set of accounts to

42 Interpreting East Asian Growth and Innovation

another. If there are no production activities then there are mappings connecting each activity with as many relevant other accounts (including other production activities) as possible. In terms of technology systems, the production activities can be broken down into a production (sub-) system and a set of innovative activities. In practice, this presents considerable difficulties of classification and empirical estimation. But conceptually the distinction has been made clear. One major component of the entire innovation system is, of course, the expenditures on R&D. In the SAM presented later, this can appear either as an aggregate expenditure along the column labeled R&D, or as a set of disaggregated expenditures.6 In the latter case these may be specified according to productive activities (for example, construction, electrical equipment and so on.) or by institutions (for example, private R&D expenditures, government R&D expenditures and so forth.). It should be emphasized that the dynamic effects of R&D on the economy can be captured only in a series of such SAMs over time. This approach is still at the conceptual stage, but appears to be quite appealing. One can contrast the possible policy experiments that can be undertaken within such a framework with the apparently ad hoc science and technology policies in many developing countries. In particular, the impact over time of a POLIS can be traced by building and maintaining such SAMs. Even without a complete SAM, partial (equilibrium or disequilibrium) analysis can be carried out that can approximate the system-wide results.7 In the following model, the main purpose is to establish a multiplicity of equilibria when the innovation system exhibits a non-linear relationship between parts of the socio-economic system. Such a relationship may obtain simply because of the existence of increasing returns to scale in production. Other types of non-linearities may also be present. However, the non-linearities in the production relations are the most relevant ones from the perspective of POLIS. Among other things this creates the possibility of moving from a technologically stagnant equilibrium to an equilibrium that makes a POLIS possible. Choice of new technology in a developing country is affected by research and development in at least three different ways. Such a country can attempt to develop new technology through R&D, as mentioned previously. This ultimately requires a positive-feedback loop innovation system in order to be self-sustaining. Another alternative is to adapt existing technology. This too requires a production system geared towards innovation in a limited way. A third alternative is to import technology or to acquire it through attracting foreign

Making a Miracle: A New Approach 43

direct investment. In practice, all these different forms may be combined. The abstract model below may be thought of as embodying all these different possibilities. However, the first option requires, among other things, a presence of multiple equilibria. In a unique equilibrium world the competitive equilibrium (under the assumption of complete markets) will always be the most efficient one. The presence of increasing returns usually destroys such competitive conditions. We begin with a number of productive activities reflecting the existing technological structure. We also incorporate the possibility of R&D as a separate productive activity. At the level of abstraction at which we are working, it is always possible to break R&D down into as many finite components as we want. In Chapter 4, a detailed description of modeling technology systems via SAMs is given. In Chapter 5, the empirical implementation of the ideas presented here and in Chapter 4 is carried out. The key relationship in this context is that between the endogenous accounts (usually, production activities, factors and households) and the exogenous ones. It is this relationship that is posited to be non-linear and this together with some assumptions on the mathematical space can lead to the existence of multiple equilibria, as shown below. We now turn to the formal part of the analysis. The analysis is carried out in abstract function spaces. In the first part the relevant space is a vector lattice over a real field R. In the second part some results on ordered Banach space are discussed.

I. The model on a lattice Define X as a vector lattice over a subring M of the real field R. Let x + = {x | x ∈ X , x ≥ 0} A non-linear mapping N is defined such that N: X+ → X+, N0 = 0. Given a vector of exogenous variables d, the following non-linear mapping describes a simultaneous non-linear equations model of an economy, E: x= Nx + d for a given d ∈ X+.

(1)

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This non-linear system represents a socio-economic system of the type described previously. In order to specify the model further, the following assumptions are necessary. 1. X is order complete; 2. N is an isotone mapping; 3. ∃ x^ ∈such that x^ ≥ Nx^ + d. In terms of the economics of the model, the non-linear mapping from the space of inputs to the space of the outputs allows for non-constant returns to scale and technical progress over time. The three assumptions are minimally necessary for the existence of an equilibrium. Assumption 3, in particular, ensures that there is some level of output vector which can be produced given the technical production conditions and demand structure. Existence of Multiple Equilibria Theorem: Under assumptions 1–3, there exists x*∈X+ so that x* is a solution of x = Nx + d . Proof: Consider the interval [0,x] = {x^ | x^ ∈X+, 0 ≤ x^ ≤ x} where xˆ is defined as in assumption 3. Take a mapping F: F : x∈X+ → Nx + d F is isotone and maps [0, x] into itself. Define a set D ≡ {x | x ∈ [0, x], x ≥ Fx}. By assumption 3, D is non-empty. We now show x ≡ inf D is a solution to x = Nx + d. x* ≡ inf D; therefore x* ≤ x, ∀ x∈D. F is isotone; therefore Fx* ≤ Fx ≤ x for each x ∈ D, implying Fx* ≤ x* From (2) we have F (Fx*) ≤ Fx*. Thus Fx* ∈ D; hence x* ≡ inf D ≤ Fx* so, Fx* ≤ x* ≤ Fx*. Therefore x* = Fx*.

Making a Miracle: A New Approach 45

This is an application of Tarski’s and Birkhoff’s theorem. The key feature to note here is that the equilibrium is not necessarily unique. It should also be noted that under additional assumptions on space X and the mapping N the computation of a fixed point can be done by standard methods (for example, Ortega and Rheinboldt). II. Multiple equilibria on Banach space In this section the results for multiple equilibria are extended to functionals on Banach space. We can define the model again for monotone iterations, this time on a non-empty subset of an ordered Banach space X. The mapping f:X → X is called compact if it is continuous and if f(x) is relatively compact. The map f is called completely continuous if f is continuous and maps bounded subsets of X into compact sets. Let X be a non-empty subset of some ordered set Y. A fixed point x of a map N:X → X is called minimal (maximal) if every fixed point y of N in X satisfies x ≤ y(y ≤ x) Theorem: Let (E, P) be an ordered Banach space and let D be a subset of E. Suppose that f:D → E is an increasing map which is compact on every order interval in D. If there exist y, yˆ∈D with y ≤ yˆ such that y ≤ f(y) and f(yˆ) ≤ yˆ, then f has a minimal fixed point x. Moreover, x ≤ y and x = lim Fk(y). That is, the minimal fixed point can be computed iteratively by means of the iteration scheme x0 = y xk+1 = f(xk)

k = 0, 1, 2, …

Moreover, the sequence (xk) is increasing. Proof: Since f is increasing, the hypotheses imply that f maps the order interval [y-, y] into itself. Consequently, the sequence (xk) is welldefined and, since it is contained in f [ y-, y], it is relatively compact. Hence it has at least one limit point. By induction, it is easily seen that the sequence (xk) is increasing. This implies that it has exactly one limit point x- and that the whole sequence converges to x-. Since f is continuous, x- is a fixed point of f. If x is an arbitrary fixed point in D such that x ≥ y-, then, by replacing y by x in the above argument, it follows that x- ≤ x. Hence x- is the minimal fixed point of f in ( y- + P) ∩

46 Interpreting East Asian Growth and Innovation

D. It should be observed that we do not claim that there exists a minimal fixed point of f in D. We can also show that if F: x ∈ X+ → Nx + d is an intersecting compact map in a non-empty order interval [x, x^ ] and x ≤ Fx and Fx^ ≤ x^ then F has a minimal fixed point x* and a maximal fixed point x**. Moreover, x* = lim Fk(x) and x** = lim Fk(x^). The first of the above sequences is increasing and the second is decreasing. The above results are applications and extensions of fixed point theorems for increasing maps on abstract spaces due to Herbert Amann (1976). It is intriguing that they find such natural applications in economics with evolving technology systems and non-constant returns to scale. Although those theorems provide some structure for the equilibria in the socio-economic structure with evolving technology systems, it is not specified a priori which equilibrium will be reached. The problem of equilibrium selection thus remains open. The idea behind POLIS can now be stated more formally. It is to reach a sequence of equilibria so that the maximal fixed points that are attainable are in fact reached through a combination of market forces and policy maneuvers over time. It is also to be understood that path-dependence of technology would rule out certain equilibria in the future. Thus initial choices of technologies can matter crucially at times.

Translating the non-linear model The models in the previous section, interpreted with due caution, demonstrate the theoretical possibility for a positive-feedback loop innovation system. However, it is far from transparent from the abstract model how such a system can be represented in actuality. In this chapter, an attempt will be made to first define precisely what technological systems are from an empirical standpoint. Based on this, an operational way of capturing such systems empirically will be presented. The vehicle chosen for such a representation is the social accounting matrix or SAM. SAMs are elaborate quantitative constructions based on social and economic data that can show the economy at a point in time with the necessary detail. How do we depict different technology systems in a SAM? How can we show the evolution of a technology system in such a construction? How do we incorporate R&D and other factors of significance in understanding innovation in a SAM? These are some of the questions we need to raise in the present chapter. At the end, I hope to convince the reader that through a series

Making a Miracle: A New Approach 47

of approximations the non-linearities and complexities of an innovation system can be approached meaningfully by using empirical SAMs for particular countries. In the next two chapters the applicability of these ideas is demonstrated under some hypothetical conditions by using SAMs constructed from historical data for the Korean economy and the Taiwanese economies.

Technology systems and POLIS As stated right at the outset, one of the main conceptual features of this book in exploring the effect of innovation on growth is the idea of a technology system. Conceiving of techniques not in isolation from one another but as a system with forward and backward linkages allows a system-wide way of looking at technologies. The main methodological way of translating the conceptual approach into operational categories will be the incorporation of two (or more) technology systems within a social accounting matrix. Empirically, this approach allows one to investigate the role of technology systems in the entire economy. Production techniques can be said to embody a range of different characteristics, such as the type and nature of the product, the organization of production, raw material and labour inputs and the scale and location of production (Stewart 1977). In orthodox economic theory, there is nothing that would suggest any systematic association between these various characteristics. Rather, one would expect a more or less random association of characteristics across techniques of varying labour-intensity. The alternative view adopted here, however, is that different technologies form part of distinct technological systems and that within each such system predictable relationships emerge between the variables just mentioned.8 In this view the emphasis is on the ‘systemic’ aspects of societies and especially the interrelations between technology, property rights and preferences in each type of society. One way to exemplify this procedure is to approach historically the evolution of technology systems in a given society. If a historical perspective thus helps to make a connection between the way production is organized, the type of technology and the scale of production, it also helps to provide associations between other characteristics of a production technology that were mentioned at the beginning of this section, thus further contributing to the idea that technology should be viewed in terms of a system rather than as a vector of isolated characteristics.

48 Interpreting East Asian Growth and Innovation

Stewart (1977), for example, has shown how, at any point in time, techniques tend to be developed against a background of a particular technology package. … Any single technical innovation has to fit in with the rest of the system both in terms of the requirements it imposes for inputs and in terms of the demand for the goods. A new technique must use inputs that are available, or can be made available, and must provide output which will fit into further production if it is an intermediate good, or into consumption patterns if it is a consumer good. … There are technological linkages between different parts of the system which mean that much of technology comes as a package, which cannot be separated and introduced bit-by-bit, but which goes together. (Steward 1977: 7) In most developing countries, however, there is no one technological system; rather a range of systems can be identified with features that may often be highly disparate, reflecting the historical conditions at a particular point of time. At the one extreme, for example, are technology systems which represent the period of ‘precapitalist’ economic formations. In these societies, the technological relationships within the system have a strong geographical component. Production and consumption activities, that is to say, tend to be closely related in a particular geographical location: ‘[T]he greater part of the products are produced for the satisfaction of the immediate needs of the community not as commodities’ (Marx 1946 [1867]: 377). This (typically rather isolated) locality would usually exhibit a heavy degree of reliance on unskilled labour and self-employment (or family labour) as the mode of production, and it would usually exhibit minimal links with external technology systems (put otherwise, there would be highly limited leakages out of the system, as occur, for example, when imports from other systems take place). Such a technology system, furthermore, tends to make intensive use of local labour and other inputs per unit of output (as one would expect in a system lacking modern technologies and advanced technological capabilities). In a model with multiple equilibria, getting stuck with such a technology system in equilibrium is not out of the question. At the other extreme, the modern sector of most developing countries closely resembles the technology system that is found in developed countries. This means, among other things, production techniques that are associated with the following characteristics: high-

Making a Miracle: A New Approach 49

income sophisticated products; high levels of investment per head; educated and skilled labour inputs; high levels of labour productivity; close links, via backward and forward linkages to the modern technological system (frequently via a heavy dependence on imported inputs from developed countries). Table 4.1 juxtaposes these contrasting aspects of traditional and modern technology systems and it also shows the mechanisms through which these differences are likely to bear on the distribution of income. In some cases, for example, the differences bear on the direct and indirect employment effects that can be expected from traditional as opposed to modern technologies, while in other cases the differences bear on backward linkage effects or the dispersion of incomes across production units of varying sizes. Table 4.2 combines the information contained in each row of Table 4.1 into a set of eight propositions about the differential effects of traditional and modern technologies on the distribution of income. It is important to note that the concern of the present book is the further evolution of the modern technology system. By way of contrast, in Khan (2002) and James and Khan (1993, 1997a, 1997b) the emphasis is on the distinction between the traditional and modern systems. Here it is assumed that either through ‘inexorable laws of history’ or by accident (for my purpose it does not really matter which is the case) the modern system has replaced the traditional one. It is also assumed that this state of affairs is irreversible. The focus of the enquiry then shifts to the characterization of the modern system. Does it have an autonomous character or is it dependent on borrowings from abroad? If the former is the case, then what are the interconnections among the parts of this system? In particular, do these connections exhibit features that form a POLIS? I attempt to answer such questions (and others) within the framework of a SAM with embodied technologies. Theoretically, the approach to the innovative modern high-technology system development adopted here is also consistent with the neoSchumpeterian approach. The focus of analysis at the micro level is on interactive learning, described in Chapter 2. The macroeconomic structure is built on this microfoundation. Technology itself is not just a collection of blueprints or machines but also tacit knowledge not easily transferred. Therefore, development and accumulation of human capital will be necessary before the takeoff into a POLIS can be realized. The innovation process also requires a synergy of producer and user. Thus the existence of markets for end-use or the creation of such

50 Interpreting East Asian Growth and Innovation

markets over time is also a requirement of successful innovation. The resulting trajectory of technical progress is continuous under a normal regime of innovation. But discontinuities occur when new opportunities arise and a new set of innovations swarm on the economic horizon creating opportunities for a big jump in productivity.

The social accounting matrix and technology systems In this section, the social accounting matrix is presented as a data gathering framework as well as an analytical tool for studying technology Table 4.1 tribution

Alternative technology systems: modes of influence on income dis-

Traditional technology system

Modern technology system

(a) Labour-intensive methods of production (b) Non-capitalist mode of production

Capital-intensive methods of Direct employment production effect Capitalist mode of production

(c) Dispersed small-scale Production concentrated in production units small number of large-scale units (d) Relatively high Relatively low labour-tolabour-to-output output ratio throughout ratio throughout production chain production chain (e) Relatively high Relatively low non-labournon-labour-(input)(input)-to-output ratio to-output ratio throughout production throughout chain production chain (f) Uses mainly inputs Uses mainly inputs from from own system own system (g) Relatively low Relatively high (savings and (savings and import) import) leakages from the leakages from the system system (h) Consumes a Consumes a relatively high relatively high proportion of its own proportion of its products own products Source: James and Khan (1997a).

Mode of influence on income distribution

Share of income accruing to factors of production Dispersion of incomes across production units Indirect employment effect

Backward linkages

Backward linkages Linkages

Consumption linkages

Making a Miracle: A New Approach 51 Table 4.2 income

Alternative technology systems: implications for the distribution of

Traditional technology system

Modern technology system

(a) Generates high amount of direct employment (b) Relatively high percentage of value added accrues to rural self-employed, household family members (c) Wide geographical dispersion of income among small-scale units (d) Generates high amount of indirect employment through backward linkage (e) Generates relatively large backward linkage effects (f) Linkages generated mainly within the traditional system (g) Linkages within the system relatively unaffected by leakages (h) Consumption linkage to (traditional) products within the system

Generates low amount of direct employment Relatively high percentage of value added accrues to (local and foreign) companies as profits Concentrated income generation among large-scale units Generates low amount of indirect employment through backward linkages Generates relatively small backward linkage effects Linkages generated mainly within the modern system Linkages within the system subject to relatively substantial leakages Consumption linkage to (modern) products within the system

Source: James and Khan (1997a).

systems. The origins of social accounting can be traced as far back as Gregory King’s efforts in 1681, but more recent work stems from the attempts by Richard Stone, Graham Pyatt, Erik Thorbecke and others.9 A useful summary of the recent state of the art can be found in Khan (1997a) In the methodological framework of this study, the SAM is used for mapping production and distribution at the economy-wide level. In this and the next section, first a general SAM is described. Then it is shown how one rather straightforward method for studying the impact of different technology systems within this framework follows logically from such a structure. The model presented here is a simple version of a class of SAM-based general equilibrium models.10 It summarizes succinctly the interdependence between productive activities, factor shares, household income distribution, balance of payments, capital accounts and so on for the economy as a whole at a point in time. Given the technical conditions of production, the value added is distributed to the factors in a determinate fashion. The value added accrued by the factors is further received by households according to

52 Interpreting East Asian Growth and Innovation

their ownership of assets and the prevailing wage structure. In the matrix form, the SAM consists of rows and columns representing receipts and expenditures, respectively. As an accounting constraint receipts must equal expenditures. It is through a further classification of technologies within a subset of productive activities that different technology systems can be operationalized via the structure of a modified SAM. Such a SAM, constructed for Indonesia, has been called a SAM-TECH by Khan and Thorbecke (1988). The term is accepted here as a shorthand way of referring to SAMs which embody a number of different technology systems. The theoretical justification for this is the persistence of structural disequilibrium during the evolution of an economic system. Alternatively, technological evolution could also be viewed as a process of ‘punctuated equilibria’ with long periods of slow evolution and then the relatively rapid emergence of a modern technological system which all but replaces the older one. In the case of Korea the earlier work in Khan (1997a) captured the coexistence of traditional and modern technology systems just before the emergence of the latter as the dominant system. The present work pushes it several steps further by looking at the further evolution of the modern system for Korea and Taiwan in Chapters 5 and 6, respectively. The conceptual and empirical issues regarding the identification of dual-technology systems and, the related transitional dynamics are discussed in Khan (1997a). Here the focus is on the modern technology system in the context of the East Asian growth debate. In other words, the key to the resolution of this debate is seen to be the presence or absence of a self-sustaining innovation structure in the modern technology system. As mentioned to previously, the empirical features will be investigated for Korea and Taiwan later in the book. For the moment, the following brief discussion of simple fixed-price models is intended to underline the difficulties of implementing the non-linear models on abstract topological spaces presented earlier in this chapter. However, I can promise that the reader will not have to wait in suspense for too long. At the end of this chapter a reasonable compromise for investigating non-linearities within a linear modeling approach based on a SAM is advanced. This approach is based on a strategy of successive approximations. In Chapter 5 some preliminary empirical results are offered for the modern technology system in Korea to partially justify, in an empirical context, the approach developed in this chapter. Chapter 6 presents the case of Taiwan to further illustrate

Making a Miracle: A New Approach 53

the use of SAM-based modeling strategy for identifying a POLIS in a real world economy. As is elaborated further in Khan and Thorbecke (1988), the SAM framework can be used to depict a set of linear relationships in a fixedcoefficient model. For deciding the question of determination, the accounts need to be divided into exogenous and endogenous ones. For instance, in the Korean SAM, there are three aggregate endogenous accounts. These are the factors, households and production activities, leaving the government, capital and the rest of the world accounts as exogenous.11 Looking at Table 4.3, which represents a SAM, we can see immediately that y=n+x

(1)

y=l+t

(2)

Now, if we divide the entries in the matrix Tnn by the corresponding total income (that is, yn), we can define a corresponding matrix of

Table 4.3

Simplified schematic social accounting matrix

Endogenous accounts Exogenous

Receipts

Expenditures Endogenous Account 1 2 3

Exogenous Total 4 5

Factors

l

0

0

T1.3

x1

y1

Households

2

T2.1

T2.2

0

x2

y2

Production activities

3

0

T3.2

T3.3

x3

y3

Sum of other accounts

4

l1

l2

l3

t

yx

Total

5

y’1

y’2

y’3

y’4

54 Interpreting East Asian Growth and Innovation

average expenditure propensities. Let us call this matrix A. We now have: y = n + x = Ay + x

(3)

y = (l – A) –1 x = Mx

(4)

M has been called the matrix of accounting multipliers by Thorbecke, for these multipliers, when computed, can account for the results (for example, income, consumption, and so on) obtained in the SAM without explaining the process that led to them. Let us now partition the matrix A in the following way.12  0  A =  A2.1  0

0 A2.2 A3.2

A1.3   0  A3.3 

Given the accounts factors, household and the production activities, we see that the income levels of these accounts (call them y1, y2, y3 respectively) are determined as functions of the exogenous demand of all other accounts. In this respect, what we have is a reduced-form model which can be consistent with a number of structural forms. This is quite satisfactory as far as tracing the effects of a certain injection in the economy is concerned or for prediction purposes when the structural coefficients are more or less unchanged. One limitation of the accounting multiplier matrix M as derived in equation (4) is that it implies unitary expenditure elasticities (the prevailing average expenditure propensities in A are assumed to apply to any

Receipts

Table 4.4 in a SAM

Schematic representation of endogenous and exogenous accounts

Endogenous

Expenditures Sum Exogenous

Tnn

n

Exogenous

Leakages Txn

l

Totals

y’n

Endogenous

Source: Khan and Thorbecke (1982).

Injections Tnx Residual balances Txx y’x

Sum

Totals

x

yn

t

yx

Making a Miracle: A New Approach 55

incremental injection). A more realistic alternative is to specify a matrix of marginal expenditure propensities (Cn below) corresponding to the observed income and expenditure elasticities of the different agents, under the assumption that prices remain fixed. Expressing the changes in income (dy) resulting from changes in injections (dx), one obtains dyn = Cndyn + dx = (l – Cn) –1 dx = Mcdx Mc has been christened a fixed-price multiplier matrix and its advantage is that it allows any non-negative income and expenditure elasticities to be reflected in its structure. In particular, in exploring the macroeconomic effects of exogenous changes in the output of different product-cum-technologies on other macroeconomic variables, it would be very unrealistic to assume that consumers react to any given proportional change in their incomes by increasing expenditures on the different commodities by exactly that same proportion (that is, assuming that the income elasticities of demand of the various socioeconomic household groups for the various commodities were all unitary). Since the expenditure (income) elasticity is equal to the ratio of the marginal expenditure propensity (MEPi) to the average expenditure propensity (AEPi) of any given good i, it follows that the marginal expenditure propensity can be readily obtained once the expenditure elasticity and the average expenditure propensities are known, that is

ey1 =

MEPi AEPi

where ey1 = income elasticity of demand

MEPi = e yi • AEPi

Thus, given the matrix A32 of average expenditure propensities, and the corresponding expenditure elasticities of demand, Yi, the corresponding marginal expenditure propensities matrix C32 could easily be derived.13

Further analysis of the modern technology system within a SAM The key to incorporating the evolution of modern sector is to understand the role of R&D within this sector in the SAM framework.

56 Interpreting East Asian Growth and Innovation

Conceptually, R&D as an activity is a stream of expenditures by companies as well as the government. The major problem would seem to be the contradiction between the static nature of the SAM framework and the dynamic effects of R&D on the economy. First we need to see if this problem can be resolved. Choice of new technology in a developing country is affected by R&D in at least two different ways. A developing country can attempt to develop new ‘appropriate’ technology through R&D, or it can adapt the existing technology to its needs. In the latter case, research expenditures with the goal of modifying the existing technology may be necessary. This includes the adaptation of imported technology to suit local conditions as well as the upgrading of traditional technologies. In a positive feedback loop innovation system, the evolution of modern system may or may not be consistent with such adaptation or upgrading. For the moment we can simplify the discussion by ignoring this issue. However, this does not mean that adaptation or upgrading are not important. In fact, even for high technology, some firm-specific adaptive activities may be necessary, as Chapter 5 shows. In the literature on R&D in developed countries a distinction is made between research (sometimes between ‘basic’ and ‘applied’ research) and ‘development’. Whereas the end-result of research is ‘pure’ or applicable knowledge, development attempts to reduce research findings into practice. Thus, for new technologies, products or processes to be realized, research is a necessary but not sufficient condition. In practice, however, it is often very difficult, if not impossible, to identify research and development as two separate categories because the same branch and in some cases the same personnel may be involved in both activities. Furthermore, the linkages between research and development are difficult to quantify. How much research is necessary before development can begin? Once development begins, is there no need for further research? There are no context-free, unambiguous answers to these questions. Therefore, in what follows I treat R&D as a symbiotic whole when looking at their impact on the evolution of the modern technological system and the economy at large. How then are we to link R&D with the evolution of a technology system? As suggested initially, the introduction of R&D as a separate activity may be something of a starting point. In analogy with the technological link now we can think of an ‘R&D link’ in the evolution of technologies. Since a given SAM is static, a series of SAMs can try to capture serially the effects of R&D on the technology system.

Making a Miracle: A New Approach 57

In a given SAM for a definite period we simply now have one more row and column, that is, R&D, giving us an (n + 1) x (n + 1) SAM. In the accounting sense, this is all transparent in the form of transactions between the new R&D account and the rest of the economy. The current flows from and to the R&D account are captured by the entries in R&D column and row respectively. Incidentally, it is thus also possible to capture the financing of R&D by domestic or foreign sources and by public or private ones. The public financing of R&D is captured by the flow of funds from the government account to the R&D and to a lesser extent by the R&D entries of publicly owned corporations. For this latter information to be shown, however, the productive activities need to be identified according to the types of ownership. If carried through in this manner, such a classification and mapping will also identify the foreign financing of R&D as the expenditure flows from foreign owned firms. The residual will be domestic private financing of R&D. In the next chapter the information on financing of R&D in Korea is presented and analyzed. A more comprehensive and direct way to display R&D according to its mode of financing for each and every sector is to further break down the R&D column according to the different ways of financing the R&D expenditures. In this formulation, there should be one column for foreign private R&D, one for domestic private R&D and so on. However, this will require an even more detailed breakdown of R&D data than in the previous case. The above proposal can serve as an accounting device but runs into serious difficulties as a basis for economy-wide modeling of technology. The major problem, as alluded to before, is that the effects of R&D on technology are essentially dynamic whereas the framework presented so far is completely static. Typically, several years of lead time will be necessary for a new technology to be developed. Therefore, the fixed-price multipliers derived from a SAM cannot reveal the dynamic effects of R&D on the technology system. This does not of course imply that econometric or CGE models incorporating R&D cannot be at least partially based on such SAMs, or that the SAM entries cannot be used as a base year solution for a relevant CGE model. However, further modification of the SAM framework is possible. One strategy for capturing the dynamic effects discussed previously is through the introduction of lags in the R&D accounts, treating R&D as an intermediate input of production. This strategy requires one to make

58 Interpreting East Asian Growth and Innovation

the assumption that the expenditure on R&D in a sector in the past caused the present increase in its productivity. By analogy, current R&D expenditures in a particular sector will lead to increases of productivity in the future. Thus, if Rj,t0 is the expenditure of the jth sector on R&D at period t0, the output effect on this sector may be observed after a period t1 (> t0) in the future. The effect may continue for a number of years up to another future period t2 (> t1). The value of t1 and t2 will depend upon the industry characteristics and the type of R&D undertaken. The impact of R&D on the productivity of technology systems can be reflected more accurately if the marginal effect of R&D on input–output coefficients can be computed for an increase in R&D. Symbolically, a ij (t) = input of activity i into activity j in period t Rj (t) = R&D input into activity j in time t Then a ij (t1) = f [Rj (t0), Ak] Here,

i, j = 1, 2, … , n

k = 1, 2, … , m t1 > t0 Ak are other factors which shift productivity. It may seem that with technological progress one should observe that aij (t1) is less than or equal to aij (t0) in a particular sector. However, this is too restrictive, since technological progress may very well call for less use of one type of intermediate input and more of another. Thus one may observe a decrease in the use of cotton fibers along with an increase in the use of synthetic fibers in the textile industry. However, total factor productivity must increase. In terms of the matrix of average propensities the approach outlined above can be rewritten in the following manner: As before, let  0  A =  A2.1  0

0 A2.2 A3.2

A1.3   0  A3.3 

Making a Miracle: A New Approach 59

The A-matrix, of course, now includes R&D as another productive activity. After an increase in R&D expenditures, Rj, a new average propensities matrix A* can be obtained for the future:  0  A =  A2.1  0  *

0 A2.2 A3.2

A1*.3   0  A3*.3  

The above approach still involves considerable simplification of reality. Among other things it abstracts to some extent from the external effects of R&D expenditures. In the real world, as the discussion of spillovers suggests, quite frequently R&D in one activity will also lead to productivity gains in other, perhaps related activities. Thus, in agriculture the expenditure for research on rice may lead to productivity gains for other crops as well. In the industrial sector, research in microprocessors will certainly affect related activities in the computer industry, but may also lead to productivity gains in other areas of information technology not directly related to the microprocessors. One possible empirical strategy for solving this problem is to obtain econometric estimates of the approximate spillover effects of R&D. However this is by itself a considerably demanding enterprise. In addition to the above, it should also be noted that the proposed framework ignores the cumulative effects of R&D. R&D expenditures in one period may result in not just a one-shot increase in productivity, but rather to a cumulative effect for several periods following a decay process until future effects monotonically approach zero. Further econometric work with distributed lag specifications may be one way of estimating such effects over the relevant time period. It needs to be realized, however, that ignoring these effects, as in the next chapter, is not under certain circumstances a research handicap. If the hypothesis under investigation is the non-existence of POLIS (as the work of Krugman, Lau and others discussed previously would seem to imply in the context of innovation and growth in Asian economies) then an a fortiori argument can be constructed if the empirical result points to some positive productivity effects of R&D. In other words, the actual productivity-enhancing effects of R&D may be larger than the measured impact. The above discussion is at the same time intended to inject a necessary note of caution regarding a mechanical application of the

60 Interpreting East Asian Growth and Innovation

approach to innovation outlined so far. Keeping in mind the qualifications a properly nuanced interpretation of the empirical findings may nevertheless provide insights into the national or regional innovation processes at work.

Non-linearities and linear approximations Finally we come to the issue of reconciling the linearity of the fixedprice multiplier models and the non-linearities involved in increasing returns. With linearities, we seem to be back to the world of constant returns. Is this an insurmountable roadblock? The answer is that it need not be. However, one must be careful not to claim too much. All we can hope to achieve here is to make successive approximations. Therefore, the strategy for capturing intertemporal effects may be used in a limited way to approximate scale effects at a point in time. Since the utilization of inputs, including R&D, must vary according to scale of production, we can vary them in a manner so that the variations are consistent with the underlying production functions with increasing returns to scale. Theoretically, choosing a series of discrete points from the continuous production mappings would merely require choosing a finite subset from an infinite set of points. In empirical work, however, it may be impractical to hope for more than a few such points. Even these few points will typically involve some measurement error. Therefore, great caution will be necessary in interpreting the results. In the next chapter only two plausible transformations are found for Korea as well as some implausible ones. However the plausibility in this instance, as the subsequent discussion in that chapter will try to show, really stems from the overall view of the structure and performance of the Korean economy over the last two decades and not on some pristine, a priori mathematical theorem. In Chapter 6 the application of this method to Taiwan shows further how adequate approximations to reality can indeed be made. This chapter has been concerned with the conceptual and theoretical issues related to a positive feedback loop innovation system. Starting with a consideration of the role of R&D and human capital in recent models of growth we were led to consider the roles of increasing returns and strategic complementarities. These considerations led to the formulation of a POLIS structure of innovation for a successful developing country. At first an abstract non-linear model with multiple equilibria was discussed. The discussion on technology systems in a

Making a Miracle: A New Approach 61

SAM shows, with some necessary qualifications, how POLIS can be made operational in the context of a growing economy. As mentioned at the beginning, the main purpose of this chapter was to develop an alternative methodological approach to analyze East Asian growth. By now, this has been largely accomplished. I can, therefore, turn to the question of analyzing the East Asian growth in the next two chapters. The problem, as the reader must now be aware, has been reformulated in the following way: can the East Asian economies be said to have constructed positive feedback loop innovation systems? The next two chapters attempt to answer this question for Korea and Taiwan, respectively.

Appendix: some criticisms of the new growth theory from the development economics perspective The new growth theory has reintroduced concerns with increasing returns and innovation into the mainstream growth theory in a formal way. The new emphasis on fixed costs and non-convexities in this literature has opened up areas of economic analysis that were not pursued with such rigor until recently. However, contrary to the claim made on behalf of this theory some earlier models – Arrow (1962) and Uzawa (1965), to mention only two– endogenized technical progress in various ways. As mentioned in this chapter, Kaldor’s models dealt explicitly with technical progress. In the Kaldor–Mirrlees model (1962) investment is the vehicle of technical progress. Shell (1967) is an attempt to model innovative activity that Romer (1986) recognized later. What Romer (1986) and Lucas (1988) models did mainly was to formalize some ideas of dynamic externalities in a competitive framework. However, do these models by themselves constitute a substantial breakthrough in development economics? The answer, I believe, is that they do not. The convergence controversy has received much attention in the discussions about new and old growth theories. The empirical work that the controversy has spawned is a rather dubious medley of crosscountry regressions. The proliferation of variables on the right-hand side of the equations has legitimately raised the question of whether this ‘kitchen sink approach’ really explains anything. The main conclusion reached so far seems to be that the lack of convergence of per capita income growth is inconsistent with the assumption of identical technological opportunity sets for all countries of the world. This is a result that actually confirms some of the older Lewis–Dobb–Sen-type

62 Interpreting East Asian Growth and Innovation

formulations of the development process. Bardhan (1994) seems to be on the mark when he remarks that The main result reached on the basis of dubious cross-country regressions and even more dubious data quality, that the lack of convergence in per capita income growth rates across countries belies the standard presumption of the availability of the same technological opportunities in all countries of the world, is not particularly earth-shaking from the point of view of development economics. (Bardhan 1994: 4) Bardhan (1994) also points out correctly that this already voluminous literature offers very little to the reader who wants to know what factors determine the international differences in productivity growth. The argument in the main body of this chapter was motivated partly by criticisms of this sort of the new growth theory and empirics. Of course, the new growth theory also offers formal models of endogenous technical progress. Industrial organization theorists in the late 1970s were finally able to offer some tractable models of imperfect competition. The adoption of Dixit–Stiglitz functional form in the growth and trade literature has given rise to its own differentiated spectrum of intellectual product differentiation and innovation. But by adopting the Dixit–Stiglitz type consumer preference structures most of these models ignore the actually existing asymmetries of sectoral demand patterns between the rich and poor countries. Models of product differentiation capture in a way the innovation in product variety but the Kaldorian concern with increasing returns is not captured. One important omission of ‘quality ladder’ models is the existence of different vintages of capital. By assuming away the presence of older vintages which are made obsolete immediately after the introduction of new vintage inputs the models can no longer address the issue that is at the heart of the systems approach to technology presented in Chapter 4 in this book. An evolutionary approach to technology systems cannot ignore the coexistence of different vintages. Furthermore, the very question of the existence of POLIS cannot be raised without assuming a system of heterogeneous capital and labor. The new growth and trade theories of product innovation do focus our attention on non-convexities arising from large fixed costs. However, the non-convexities may matter also in a fundamental way when increasing returns are modeled explicitly in a rigorous way.

Making a Miracle: A New Approach 63

Tarski’s fixed-point theorem, in particular, helps us to follow this route of attacking the modeling issue formally. In addition to incorporating the non-convexities arising from fixed costs of innovation, nonconvexities arising from the dynamics of industrial transformation can also be captured by the approach adopted in this book.

5 Korea: The Making of a POLIS?

The purpose of this chapter is to answer the question: has Korea succeeded in constructing a positive-feedback loop innovation system? After the theoretical discussion in the previous chapter the importance of this question is obvious. However, strategies for finding the answer are less transparent. The discussion in the previous chapter calls for disaggregated analysis; but it is not clear a priori what the appropriate level of disaggregation should be. Both microlevel evidence and macroeconomic connections need to be taken into account. Data limitations also inhibit detailed inquiry. Keeping this in mind, we will nevertheless try to explore both microeconomic factors at the firm level and connections among different sectors. Needless to say, research and development will be an important area of investigation. Strategic complementarities with human capital will also need to be considered, in line with the arguments presented in Chapter 4. Ultimately, the understanding of the process of the creation of a POLIS involves addressing a host of different factors – economic, political, social and cultural. The emphasis of this chapter and the next is on the economic factors (including economic policy); but this is not to imply that other factors have been insignificant. However, the modest aim of this book is to explore the economic factors as fully as possible without denying the importance of non-economic factors.1 Accordingly, we can now turn to economic analysis of the development of modern technology in Korea.

The development of modern technology in Korea Whatever the record in the 1960s and 1970s, by the 1980s Korea did enter a largely modern technology-centered era (Khan 1997a). 64

Korea: The Making of a POLIS? 65

Therefore, we need to investigate the situation since 1985 in order to see the source and role of this modern technology system. First, it is necessary to look at the transfer of technology from abroad to Korea. In the process we also will have an opportunity to examine Teitel’s characterization of the three phases of technological development. According to Teitel (1984a, 1984b) the first phase is the acquisition of technology from abroad; the second phase involves the modification of borrowed technology. The final phase is the generation of technology at home. This acquisition–modification–creation process can be observed in the history of economic evolution of the advanced industrial countries. In 1972 the government of Korea passed the Technology Development Promotion Act (TDPA) the purpose of which was to facilitate technology imports. This coincided with the establishment of Technology Imports Counseling Center at the Korea Institute of Science and Technology. At the same time the Korea Development Bank’s ‘technology development fund’ originated as a source of financing. The following year the TDPA was further liberalized to relax the approval criteria for imported technologies. The third and fourth five-year economic development plans emphasized the role of heavy and chemical industries. A form of industrial policy can be seen to be at work here. Table 5.1 summarizes the changes in technology import policy since 1978. The financial assistance facilities also played important roles. These are presented in Table 5.2. Table 5.3 from Khan (1997a) shows the declared industrialization and technology strategies during the decades of the 1960s, 1970s and 1980s. It is important to note that promotion of high-tech industries became a goal only in the 1980s. As Table 5.1 shows, changes in technology import policy since 1978 have become more liberal. The openness that existed with respect to trade in consumer goods can be said to have been extended to capital goods with embodied technology. Table 5.2 shows the general structure of the financial assistance system. Clearly, without such financing, technology imports would be hampered. These policies are consistent with the general development strategies by stages of development as shown in Table 5.3. It is interesting to note that as the Korean economy has grown it has progressively imported more technology. More than 75 percent of all foreign technologies imported between 1962 and 1991 came from Japan and the US. Table 5.4 shows TI (technology imports), FDI (foreign direct investment) and capital goods imports by Korea. The

66 Interpreting East Asian Growth and Innovation Table 5.1

Changes in South Korean technology import policy since 1978

Period

Contents

Industry

First step(April 1978)

Automatic approval items: • Advance payment less than $30 000, royalty rates less than 3%, license period less than 3 years • Total royalty less than $100 000 Automatic approval items: • Advance payment less than $50 000, royalty rate less than 10%, license period less than 10 years Automatic approval items: Royalty rate less 10%, license period less than 10 years Delegation of approval authority to the competent ministry Transition from the approval system to a reporting system Transfer of trademarks only permitted Delegation of approval authority to Class A foreign exchange banks under the Foreign Exchange Control Act, except in cases where the license period exceeds 3 years and the total royalty exceeds $100 000 or the royalty rate exceeds 2% (or initial payment exceeds $50 000)

Machinery, shipbuilding, electrical goods, electronics, fabricated metal products, chemicals, textiles All industries, except nuclear energy and defense industry

Second step (April 1979)

Third step(July 1980)

Fourth step (September 1982) Fifth step (July 1984) Sixth step (July 1986) Seventh step (July 1988)

All industries

All industries All industries All industries All industries

Source: Korea Industrial Technology Association (1992: 9).

growth in imported technology and capital goods is noticeable throughout the 1980s. The adoption and diffusion of technology (imported or otherwise acquired), as Chapter 4 has shown, will inevitably require various lengths of time. On the demand side, the profitability of imported technology must be a major factor. However direct measures are impossible to get. A proxy that follows the strategy of Khan (1997a) is obtained by considering the profitability of the large and medium enterprises which are assumed to use imported technology. Adaptabilities of technologies also matter. The extent to which

Korea: The Making of a POLIS? 67 Table 5.2

The financial assistance system in South Korea

Government subsidy

Loan by policy fund

General loan

Assistance to venture capital Technology credit guarantee

Direct subsidy to private firms or industrial technology research association who participate in a special R&D project or industrial basic technology development project for 40–80% of R&D fund Annual 5.0 to 10.5% interest rate loan on R&D and commercialization of new technology Loan assistance to R&D and commercialization of new technology by Korea Development Bank, Small–Medium Firm Bank, and other banks; same interest rates as bank loans Korea General Technology Fund (Inc.) Technology Credit Guarantee Fund

Source: KIET (1992).

imported technologies can be adapted to domestic needs and circumstances also depends mainly on the technological capabilities of the host firms. Here, too, the large and medium enterprises will generally have a better chance of adapting the foreign technology. It is possible to collect the relevant information and to organize this information in a SAM-TECH format. Looking at the information organized as a SAM-TECH as well as closely within its components results in the following observations: 1. With the exception of heavy industries, large and medium firms import relatively new technologies. This is consistent with Khan’s (1997a) finding that the production functions in different firm sizes within the same industry differ. 2. Large firms also seem to have greater bargaining power. They have shorter waiting periods for the adoption of foreign technology. 3. Industries with competitive structures import technology at a slower rate than those which are oligopolistic. 4. In its acquisition, the price of new technology seems less of a determinant than the perceived needs of the firm. In other words demand for technology imports has been inelastic in many cases. Given the prevalence of foreign technology in a number of sectors, one should expect more productivity increase in these sectors than in

68 Interpreting East Asian Growth and Innovation Table 5.3

South Korean development strategies by stages of development

Period

Direction of industrialization

1960s

1. Establishment of the 1. Expanding education in foundation for industrialization science and technology and 2. Fostering of importtraining in skills substitution industries 2. Establishment of the legal 3. Expansion of export-oriented and institutional basis for the light industries (mainly laborpromotion of science and intensive industries) technology 3. Facilitating the importation of advanced technologies 4. Enhancing the sophistication 1. Upgrading technological and of industries and fostering the scientific training in priority heavy and chemical industries areas 5. Promotion of small- and 2. Facilitating the adaptation medium- sized industries and improvement of 6. Strengthening the imported technologies competitiveness of industries through the establishment in the international market of research entities in private industries 3. Strengthening industrial technology research and development capability 7. Enhancing the quality of 1. Providing the large-scale export goods recruitment from abroad and 8. Promotion of skill-intensive training of highly qualified industries (high-tech industries) scientific and technological 9. Fostering of information manpower industry 2. Liberalization of technology imports 3. Preparation for an information-oriented society

1970s

1980s

Technological development strategy

Source: Excerpted from Khan (1997a).

the other sectors with less than state-of-the-art technology. On the whole, this does turn out to be the case. However, the average for the foreign technology-intensive sectors turns out to be 2.8 percent TFP growth annually from 1980 to 1994. Were imported technology the only source of technology for the modern technology system, then the question of whether or not Korea has a POLIS could be settled immediately. The short answer would be that indeed it has no POLIS. However, the policies of the Korean government and the efforts of large Korean firms to create a national innovation system cannot be passed over in silence. In the next section, the Korean national innovation system is examined.

Korea: The Making of a POLIS? 69 Table 5.4 Year

South Korean TI, FDI and capital goods imports: 1962–91

TI payment TI case (A, $m)

FDI* (B, $m)

FDI* case

A/B (%)

Capital goods C/total imports imports (C, $m) (%)

62–66 0.8 67–71 20.4 72–76 96.5 77 58.1 78 85.1 79 93.9 80 107.2 81 107.1 82 115.7 83 149.5 84 213.2 85 295.5 86 411.0 87 523.7 88 676.3 89 888.6 90 1 087.0 91 1 183.8

33 285 434 168 297 291 222 247 308 362 437 454 517 637 751 763 738 592

47.4 218.6 879.4 83.6 149.4 191.3 143.1 153.1 189.0 269.4 422.3 532.1 354.7 1 063.3 1 282.7 1 090.2 802.5 1 396.0

39 350 851 54 51 55 40 44 56 75 104 127 203 362 342 336 296 287

1.7 9.3 11.0 69.5 57.0 49.1 74.9 70.0 61.2 55.5 50.5 55.4 115.9 49.3 52.7 81.5 135.5 84.8

486.0 2 668.0 8 106.0 3 008.1 5 080.3 6 314.0 5 125.0 6 158.2 6 232.7 7 814.7 10 106.3 11 078.9 11 340.2 14 552.4 19 033.4 22 370.3 25 451.3 30 092.0

18.9 30.8 27.3 27.8 33.9 31.0 23.0 23.6 25.7 29.8 33.0 35.6 35.9 35.5 36.7 36.4 36.4 36.9

Total 6 109.3 Ratio (%) (3.1)

7 526

9 268.8

3672 (4.8)

65.9

195 016.0 (100)

33.3

Note: *Approval basis. Sources: Korea Industrial Technology Association (1992b); Ministry of Finance (1991); Korean Statistical Association (1992).

Learning to innovate: the Korean national innovation system Larry Westphal, Howard Pack, Sherman Robinson and Hollis Chenery, among others, have emphasized the role of industrial policy in an export-led economy like South Korea. According to Westphal (1990:41): Korea provides an illuminating case of state intervention to promote economic development. Like many other third world governments, Korea’s government has selectively intervened to affect the allocation of resources among industrial activities. It has also used similar policies: taxes and subsidies, credit rationing, various kinds of licensing, and the creation of public enterprises … but these policies have been applied in the context of a radically different development strategy, one of export-led industrialization.

70 Interpreting East Asian Growth and Innovation

If one follows a Schumpeterian approach to technology creation as a cascade of interlinked systemic activities, the possibilities for economies of scale and scope leading to the establishment of a POLIS arise out of the conjunction of a market system open to the world economy and selective interventions. Promotion of targeted infant industries has been part of this strategy of selective interventions in Korea. Examples include cement, fertilizer and petroleum refining in the 1960s. These were followed by steel and petrochemicals. In the late 1970s, shipbuilding, other chemicals, capital goods and durable consumer goods appeared on the list. More recently, electronic and information technologies are being promoted. Do these industries innovate? Even if they individually do innovate, do the industrial, governmental and social institutions connected to the innovation process add up to an innovation system? Furthermore, is the innovation system, if it exists, characterized by positive feedbacks? One quantitative indicator of the possibility of an innovation system would be the trend in R&D. Table 5.5 shows the major R&D indicators in Korea. Between 1965 and 1990 the expenditures increased more than five hundred times. However, the major takeoff has really been since the mid-1980s. Noticeable also is the reversal of the roles of public and private sectors. In 1990 the private sector provided 84 percent of R&D funds. The number of research personnel is also an important indicator of the possibilities of a national innovation system. In the case of Korea, the number of core scientists increased by more than thirty times between 1965 and 1990. Here again, companies and universities are now the first and second largest employers of researchers, respectively. Another important indicator of an innovation system is the number of patents. In the late 1980s and early 1990s the number of Korean patents grew, on the average, at a rate of 17.1 percent (see Table 5.6). In absolute terms, however, Korea seems to be still far behind the advanced industrial nations. One special feature of the Korean industrial system in general and its innovation system in particular, is the role played by its chaebols, the big business conglomerates, in developing and improving industrial technologies. With large endowments of capital and modern complex organizational structures the chaebols can recruit the best human resources, identify and purchase the best foreign technology and obtain preferential financing. They have also established R&D and technical training facilities recognizing the importance of in-house R&D capability.

Korea: The Making of a POLIS? 71 Table 5.5

Major R&D indicators in Korea

R&D expenditure ($ Million) Funds from government (A) Funds from private sources (B) A:B R&D/Manufacturing sales (%) GNP ($m.) R&D/GNP (%) R&D researchers (persons ) Research institutes Universities Companies R&D researches per 10 000 pop.

1965

1975

1980

8 7.2 0.8 90:10 n.a. 2759 0.29 2765 n.a. n.a. n.a. 1.0

88 59 29 67:33 0.35 20 952 0.42 10 275 5308 2312 2655 2.9

321 186 135 52:48 0.65 55 345 0.58 18 434 4598 8695 5141 4.8

1985

1990

1298 4481 247 717 1051 3764 19:81 16:84 1.51 2.07 87 703 234 607 1.48 1.91 41 473 70 503 7154 10 434 14 935 21 332 18 996 38 737 10.1 16.4

Sources: Ministry of Science and Technology (various years); Kim (1997:370).

Table 5.6 Trends of intellectual property rights applied by Korean and foreign nationals (unit: case, %) 1986

1989

1990

1991

Average growth rate (1986–91)

Patents Utility models Industrial designs Trade marks

12 759 22 401 18 731 28 031

23 315 21 530 18 196 39 832

25 820 22 654 18 769 46 826

28 132 25 895 20 097 46 612

17.1 2.9 1.4 10.7

Total

81 922

102 873

114 069

120 736

8.1

Korean nat’ls Foreign nat’ls

63 256 18 666

68 300 27 271

81 713 32 356

90 659 30 077

7.5 10.0

Source: Office of Patents Administration (various dates).

The government established the Ministry of Science and Technology (MOST) in the 1960s. It also has initiated a long-term science and technology development plan. Most government ministries and bureaucratic strata have been involved in one way or another in formulating and implementing the science and technology policies. The government has also pursued a scientific and technical human resources management policy. In the late 1960s, Kwahakwha Undong or the Science Movement was supported by MOST. The creation of a university system has certainly led to an increase in the stock and flow of human capital. However,

72 Interpreting East Asian Growth and Innovation

Korea still has a long way to go before it can claim to have created a world-class research university system. At the microeconomic level R&D capacity building by a firm can be illustrated by discussing the example of Samsung Electronics Company (SEC). SEC is Korea’s largest integrated electronics company. Table 5.7 shows the diverse product lines of SEC. In the semiconductor field, Samsung developed 64K DRAMs in 1983. In 1990 it shared in the making of 16M DRAM. SEC also exports an electronic switching system (Time Division Exchange or TDX) to other LDCs, manufactures digital, cellular and satellite transmission systems, active in fiberoptic communication systems and offers a full line of products in the microcomputer field. Perhaps better known among consumers is the line of domestic electronics products of SEC ranging from TVs to microwave ovens. SEC has a three-tiered R&D system shown in Table 5.8. Samsung Advanced Institute of Technology (SAIT) carries out research into basic or core technologies. Application technology and mid-term projects are the responsibility of the research centers associated with SEC’s four business sectors. Finally, on the production technology side research teams attached to each division unit work closely with production and marketing people to make new or improved products. Table 5.7

Major product lineup of SEC

Business sector

Product line

Audio and video business

TV, LCD projector, VCR, camcorder, component audio, CDP, MD, DCC, LDP, MOD, CD-I, CD-ROM Refrigerator, microwave oven, air conditioner, washing machine, vacuum cleaner Minicomputer, Microcomputer, Desktop PC, Laptop/Note PC, pen base PC, palmtop PC, network system, work station, optical filing system, teleconference system, CTS, BAS TDX, modem, MUX, PAD, facsimile, typewriter, copier, key phone, pager, car phone, handheld phone, optical communication system, optical fiber DRAM, SRAM, EEPROM, MASK ROM, specialty memory, TPH, TFT, LCD, CIS Discrete, MOSIC, linear IC, ASIC, logic IC, micro component, DSP

Consumer electronics business Computer system business

Telecommunication system business

Memory devices business Micro devices business

Source: Public Relations Office Samsung Electronics (1993:47).

Korea: The Making of a POLIS? 73 Table 5.8

SEC’s three-tiered R&D system Samsung Electronic Company

Integrated research centers Role

Establishment of technological foundation for growth of company

Research team and design office attached to business sector Maximization of company’s profit

Strengthening of Cooperation with SAIT Research area

New products development and commercialization on a short- and mid-term basis

Samsung Advanced Institute of Technology

Establishment of technological foundation for the growth of the group Technical supports to affiliate companies

Commercialization of new products on a short-term basis

Diversification of models, improvement of functions and cost reduction of existing products

Development of new products on mid- and long-term bases Development of core technologies, bottleneck technologies, and new materials and parts

Source: Twenty Years History of SEC: 837.

The discussion so far shows the strengths and limitations of both the standard macro and micro approaches in addressing the question posed at the beginning of this chapter. At the macro level, statistical results may overstate or understate the overall innovative capability. At the same time the results on the whole warn against a casual optimism regarding East Asian growth in general and Korea in particular. The micro considerations show that in contrast to macropessimism some companies such as SEC do have considerable innovative capabilities. However, it is not obvious if the SEC experience is generalizable for Korea as a whole or even a few sectors. For this we need a multisectoral approach. The next section tries to do precisely this.

The modern technology system in a SAM for Korea The starting points for identifying the modern technology system in Korea in the late 1980s were the two earlier SAM-TECHs built by

74 Interpreting East Asian Growth and Innovation

Svejner and Thorbecke (1980)2 and Brewer and Hamza (1983) Khan (1997a). The accounts in the earlier SAM are given in Table 5.9 (sectors 1 to 77): Table 5.9 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16–30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55

Endogenous accounts in the SAM-TECH for South Korea, 1988 Engineers Technicians Skilled workers Apprentices Unskilled White collar Self-employed (manufacturing) Self-employed in service Capital Agricultural workers Workers in farm size 1 Workers in farm size 2 Workers in farm size 3 Workers in farm size 4 Government workers Same as 1–15 except that they now refer to households as opposed to factors Cereals Other agriculture Fishing Processed food (M) Processed food (T) Mining Cotton yarn (M) Cotton yarn (T) Woollen and worsted yarn (M) Woollen and worsted yarn (T) Other (M) Other (T) Cotton fabric (M) Cotton fabric (T) Woollen and worsted fabric (M) Woollen and worsted fabric (T) Others Finished textile products Lumber and furniture Chemical products (M) Chemical products (T) Charcoal and wood Crude oil Coal (M) Coal (T)

Korea: The Making of a POLIS? 75 Table 5.9 Endogenous accounts in the SAM-TECH for South Korea, 1988 – Continued 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78

Briquettes Dried coal Fuel oils Gasoline Carbide Electricity Gas services Cement, non-metallic mineral products Metal products (M) Metal products (T) Machinery Transport equipment Beverages and tobacco (M) Beverages and tobacco (T) Other consumer products Construction Real estate Transportation and communication Trade and banking (M) Trade and banking (T) Education Medical, personal and other services Research and development

Notes: M= modern, T = traditional.

As the reader must have noticed, in the above table, the modern SAM-TECH (ModSAM-TECH) is constructed by adding R&D rows and columns according to the scheme identified in Chapter 4. Thus a 78 multi 78 endogenous account SAM is formed. The basis of the SAM is the updated input–output table for 1988. The factors and household classification systems were maintained as before (Khan, 1997a). The focus is on identifying productivity and value-added changes; but some attention also needs to be paid to the distributional characteristics of the innovation system. Furthermore, in line with the strategy outlined in the last section of Chapter 4 two successive approximations for two different scale levels are made. One is for 1986 GDP and the second is for the increment in two years. In the latter case coefficients are changed in proportion to growth. This is most probably a lower bound increasing returns assumption. On the whole this involves a change in average propensity of less than one percent (Euysung Kim 1996).

76 Interpreting East Asian Growth and Innovation

The simple multiplier exercises indicate a modest POLIS effect. For each 1 percent injection of R&D, output in the ModSAM-TECH increases by 2.5 percent. The modern technological system shows a range of increase varying between 2 percent and 3.6 percent. Admittedly the assumption of excess capacity is significant here. If the economy is near full employment then additions to capacity will need to be made. For that, a series of projected ModSAM-TECHs will be necessary. In the shortrun, inflation is more likely. On the distributional side the engineers, managers and in general skilled workers gain disproportionately from the POLIS effect. It may be expected that if Korea’s trade increases with other LDCs, with relatively more unskilled workers, then through factor–price equalization (according to the factor–price equalization theorem in standard trade theory), skilled/unskilled remuneration ratio will further deteriorate for Korea. Thus on the distributional side, for the less skilled anyway, POLIS is a mixed blessing. It should be mentioned here that some recent work by Euysung Kim (Kim, 1996) corroborates weakly the results I derived from the multisectoral ModSAM-TECH above. Kim examines the significance of productivity growth and its relationship to trade policy in Korea. His study uses a panel data set of 36 manufacturing industries over nine subperiods from 1966 to 1988. He is able to reject the assumptions of both perfect competition and constant returns. About a third of the 36 industries examined show clear increasing returns. By taking into account both imperfect competition and non-constant returns, Kim (1996) re-estimates TFP growth. Although the re-estimated TFP growth rates are quite small, an important linkage between trade liberalization and productivity performance emerges. According to this study, TFP growth rates may have been raised by 2 percent on the average during the last two decades. In summary, in this chapter I have considered the claims about the growth process in Korea by both the miracle-claimers and the miracledeniers. The macro evidence seems to favor the latter. However, a more detailed investigation at the sectoral and micro level raises the possibility of a POLIS in Korea’s modern technology system. An approximate and crude empirical implementation of the formal model of POLIS constructed in Chapter 4, via a SAM-TECH for Korea confirms this modest hope. However, Korea now faces the challenge of innovating in an increasingly competitive global environment. Also, the rewards from innovation, even if the Korean POLIS becomes a reality, would seem to be unevenly distributed.

Korea: The Making of a POLIS? 77

In retrospect, the ability of a small, open economy to build an innovation system may be seen to depend crucially on the strategic complementarity between R&D promoting activities and human capital deepening processes. While the human capital aspects of Korean development have been explored extensively, the understanding of the R&D process remains incomplete. The results of this chapter, however tentative, can provide further motivation for such studies for Korea and other countries. In the next chapter, the nature of the innovation in the other significant East Asian miracle economy, Taiwan, will be explored.

6 Taiwan: Building a POLIS

In this chapter another East Asian ‘miracle’ country – Taiwan – is studied. While Taiwan’s pattern of development may look similar to that of Korea there are significant differences as well. The history of the development of Taiwan shows a greater reliance on direct foreign investment, more direct government ownership of enterprises and a greater role of small and medium enterprises in the manufacturing sector. Table 6.1a and 6.1b show selected indicators related to growth for the Taiwan economy for various years. The early development policy in Taiwan was aimed at increasing agricultural output and developing an infrastructure. Light manufacturing industries were also promoted. Import-substitution policy was pursued till the mid-1960s. U.S. foreign aid played a crucial role in financing imports and early capital formation. The switch to a regime of export promotion took place in the mid1960s, as in the case of Korea. Initially exports of the light manufacturing industries such as textiles and consumer electronics were stimulated. At the same time, Taiwan pursued a long-term strategy of building a more complex industrial structure including steel, petrochemicals, machine tools and electronic equipment. The new, outward-looking strategy was accompanied by a series of financial and fiscal measures to facilitate export financing and to help establish export processing zones. From the beginning, Taiwan made a special effort to promote high-technology sectors through publicly funded research laboratories. Later, an industrial park was created specifically for high-technology industries. In the wake of the 1973 oil crisis a policy of major infrastructure projects was introduced. Subsequently, capital goods producing sectors 78

Taiwan: Building a POLIS 79 Table 6.1a Economic growth indicators in Taiwan, 1953–92 (the period of transition from the traditional to the modern technology system) Indicator GDP per capita (NT$ at 1986 prices) Annual growth rate (%) Population growth rate Gross domestic saving/ GDP (%) Gross domestic investment/ GDP (%) Current account/ GDP(%) Export/GDP (%) Import/GDP (%) Export growth rate (%) Import growth rate (%) Literacy rate (%) Secondary school enrollment rate (%) Higher education enrollment rate (%)’

1953 19 942

1953–62 1963–72 1973–82

1983–92 1992

24 973

43 542

87 794

165 281 213 907

3.68

7.89

5.56

6.23

5.59

3.81

3.51

2.82

1.91

1.11

0.95

14.45

15.15

23.78

31.81

33.45

28.42

14.04

16.86

23.25

30.73

21.80

23.91

0.40 8.64 13.81

-1.71 10.43 16.87

0.54 26.05 26.06

1.08 48.75 47.26

11.65 52.47 42.21

4.51 44.24 41.90

9.23

25.42

9.36

10.59

6.39

56.01

6.59 62.88

21.44 76.84

7.95 87.84

12.92 91.92

10.89 93.59

17.73

29.28

54.79

66.52

81.33

85.20

1.35

2.73

l4.86

17.85

25.27

38.62

Table 6.1b Economic growth indicators in Taiwan, 1995–2000 ( the period of transition from the traditional to the modern technology system) Indicator

1995

GDP per capita (NT$ at 1986 prices) 330 801 annual growth rate (%) 6.40 population growth rate 0.84 gross domestic saving/ GDP (%) 27.47 gross domestic investment/GDP (%) 24.93 current account/ GDP(%) 3.79 export/GDP (%) 42.03 import/GDP (%) 39.08

1996

1998

2000

358 995 6.10 0.79

410 476 4.60 0.85

435 761 5.90 0.83

27.11

26.20

25.52

22.87

24.72

22.57

3.81 41.37 36.66

3.74 41.32 39.19

4.10 47.66 45.10

80 Interpreting East Asian Growth and Innovation Table 6.1b Economic growth indicators in Taiwan, 1995–2000 ( the period of transition from the traditional to the modern technology system) – Continued Indicator

1995

1996

1998

2000

export growth rate (%) import growth rate (%) literacy rate (%) secondary school enrollment rate (%) higher education enrollment rate (%)’

20.0 21.33 94.00

3.84 -1.14 94.3

-9.42 -8.53 94.9

21.98 26.49 95.6

95.93

95.66

97.21

99.61

45.32

46.42

51.06

60.85

Sources: Annual growth rate, population growth rate, literacy rate: Social Indicators (2000); GDP per capita, gross domestic investment/GDP, export growth rate, import growth rate: Quarterly National Economic Trends (August 2001); gross domestic saving/GDP, export/GDP, import/GDP: Economic Statistics Annuals Taiwan Area, The Republic of China (2000); secondary school enrollment rate, higher education enrollment rate: Education Statistics of The Republic of China (2000). Current account/GDP: Economic Statistics Annuals Taiwan Area, The Republic of China, various years up to 2000.

were promoted heavily. As a result Taiwan broadened its export base to include machinery and related equipment. The second oil shock (1978–9) also led to substantial changes in Taiwan’s industrial policies. Overcapacity and the lack of competitiveness in a number of firms were addressed by a strategy of scaling-down industrialization plans. Strategically selected firms, however, were aided by special grants and loans. Foreign investment in capitalintensive sectors was encouraged further in order to effect a transfer of technology and knowledge. The new orientation in the 1980s has meant an emphasis on hightechnology and skill-intensive activities. Specifically, three areas – information, electronics and machinery – were identified as strategic. Precision instruments, machine tools, VCRs, telecommunications equipment and computers are products that were targeted for special treatment. In spite of the openness, flexibility and strategic vision of the Taiwanese economy there may be problems in creating a POLIS. The predominance of small firms may be a handicap where large R&D expenditures may be necessary for high-tech ventures. The strategic complement of R&D – skilled human components – may also create a bottleneck in some sectors. Thus, whether Taiwan has succeeded in creating a POLIS is an open and non-trivial question. However, there is one particular sector in which Taiwan may have achieved a mature

Taiwan: Building a POLIS 81

capability to innovate, namely electronics. The next section will discuss the state of the electronics sector as a prelude to a discussion of an economy-wide capability to innovate.1

The electronics sector in Taiwan In spite of the cycles in the electronics industry and turbulence during the late nineties, the history of this sector’s growth in Taiwan through the 1980s is an indispensable element of Taiwan’s attempt to build a POLIS. From a humble beginning in the 1950s – when Taiwan first started producing transistor radios – to the present, the electronics sector has grown to include many advanced products. Among them are the various components of personal computers, advanced work stations and other microelectronic products. Companies such as Tatung and ACER have sales exceeding one billion dollars. A number of small firms such as Sampo Corporation and United Microelectronic Corporation have shown tremendous growth in recent years. The share of foreign-owned firms also declined during the 1980s and 1990s. However, even now the foreign-owned firms account for more than 25 percent of the industry output. Small and medium firms (defined as firms with less than 300 employees) dominate the industry. This means that unlike South Korea the innovation occurs in relatively small firms. Modifications that take this fact into account are therefore necessary in building a SAM-Tech for Taiwan as is shown in the following section. Exports of electronic goods accelerated throughout the 1970s and 1980s. In the 1990s also Taiwan enjoyed a healthy growth in exportables in this sector. Table 6.2 shows the export figures for selected years. Table 6.2 Taiwanese exports of electronics: selected years 1970 to 1990 (the period of building the electronics sector) (US$ b) Year 1970 1974 1980 1985 1987 1990 Source: Hobday (1995: 99).

Exports 0.2 1.2 4.1 4.9 10.6 17.2

82 Interpreting East Asian Growth and Innovation

Table 6.3 shows the plans for the year 2005 for the electronics industry. Information products are forecast to be the leading edge in the industry. Nearly US$6 billion of total computer production was exported. Of this 40 percent went to North America and 41 percent to Europe. Japan imported only 2 percent of the computer exports; but Asia-Pacific accounted for about 14 percent. Although the takeoff in the electronics sector appears to be a market phenomenon, government policies also played a role. In May 1979, the Executive Yuan put forth the Science and Technology Development Program. This program identified information technology systems as an area of emphasis for future R&D. The idea for establishing the Institute for Information Industry was also hatched during this period. The Ministry of Economic Affairs moved quickly. In July 1979, the implementation plan for computer technology was contracted out to the Industrial Technology Research Institute. The Council for Economic Planning and Development prepared a ten-year plan, 1980–89. The plan provided targets for R&D expenditures and human capital supply among other things. The Electronics Research Services Organization was given responsibility for coordinating the transfer of technology from foreign companies. By all indicators the ambitious plans succeeded for the most part. By the 1990s Taiwanese firms took their place among innovative designers of PCs, electronic notebooks, and circuit boards. Many new companies such as Datatech were started in the 1980s. Several of them (including Datatech) grew to be successful. During this time Taiwan also surpassed

Table 6.3 Taiwan: electronics and information technology, production values and forecasts (US$b) Output 1990 Information products Automation Consumer electronics Telecommunications Semiconductors Total

6.9 2.8 2.3 1.9 1.5 15.4

Forecast 2005 35 12.1 5.5 10.2 7.0 69.8

Average annual growth (%) 15.1 12.5 7.0 14.0 14.0

Source: Hobday 1995: 100; author’s own estimates subject to some assumptions: the major ones are the growth of skill levels and physical capital, and the absence of a major financial crisis.

Taiwan: Building a POLIS 83

Great Britain to become the fifth largest producer of semiconductors in the world. In describing the relationship between government and industry in the innovative sectors, Figure 6.1, which is modified from Liu (1993), may be helpful. Under an overall imitative strategy (Chiang, 1990), Taiwan decided to follow the leaders in already established technologies. The objective has been to compete by cutting costs through productive efficiency. The government has taken the responsibility for acquiring technology from abroad. It has also fostered advanced research, which the government-supported research institutes, utilizing skilled scientists and engineers, have been crucial for carrying on before the results are transferred to the private sector. Furthermore, economic incentives are provided to the strategic sectors. In terms of complementary human capital accumulation many Taiwanese went abroad to acquire advanced education and skills in science and technology. A number of local employees were also trained in the foreign multinationals where they were employed as engineers, technicians and managers. Lucrative financial incentives were offered to attract skilled Taiwanese living abroad. As Hobday (1995) points out, there seem to be a least five types of strategic firms in the electronics industry. These are: foreign corporations and joint ventures; the major local manufacturing groups; hightechnology startup firms; government-sponsored ventures; and the traditional small and medium enterprises that cluster together in special market niches. The combined effect of strategic interactions among these actors has been the rapid growth and expansion in the industry as a whole even when some individual firms have declined. There is an almost classic Schumpeterian scenario unfolding before our very eyes in this sector. It may not be out of place to discuss the role of the major private manufacturing groups and government-sponsored startups here. Both Chapponniere and Fouquin (1989) and Hobday (1995) have discussed the activities of these actors in Taiwan. The following brief discussion highlights the actions of these diverse economic agents in creating the conditions for a ‘POLIS’, at least within the electronics sector. The progress of Tatung in the development of their electronics industry, according to Hobday, is representative of the entire electronics industry in Taiwan. In the 1970s, electronics became the industrial group’s largest operation. Table 6.4 shows Tatung’s progress in electronics. The electronics maker began to produce

84

Objetives

Results

Diffiusion channels

FDI

Rent-sharing Scope

New products

Key technologies transfer Technological information diffusion

Resources New technologies project

Intellectual environment

Industrial competitiveness

Management improvement

Time Experienced managers and engineers Budget Figure 6.1

Patents

Human capital

Taiwan: government and research. (Note that there are feedback processes both within and among the above modules).

Taiwan: Building a POLIS 85

black-and-white TVs by 1964 and 14-inch color monitors for computers by the early 1990s. The company also currently produces other household electronics and electric goods in its manufacturing plants around the world. Tatung, like the typical South Korean chaebol, first gained its manufacturing knowledge through technical cooperation deals. By investing capital in joint venture projects with foreign companies the Tatung group gained further through licensing agreements while learning technological skills through OEM deals. Tatung absorbed and adapted foreign technology, learning to modify, re-engineer and redesign consumer goods to fit customer needs. While production initially involved little R&D, the group did employ more than five hundred R&D staff by 1990. However, the job of this mainly engineering staff was in advanced engineering rather than ‘blue sky research’ Finally, just as production technology has been passed to industries in Taiwan by the more advanced manufacturing nations, by the mid-1980s Tatung was transferring its production technologies to its subsidiaries in lower cost East Asian countries (Hobday, 1995). ACER is representative of the high-technology startup companies which began to appear in Taiwan in the late 1970s and early 1980s. ACER relied on product innovation and original equipment manufacturing (OEM) with experience gained by individuals who had worked overseas in US firms or universities. Many of the other recent start-ups, like ACER, have used OEM to some extent, and most were unknown outside of Asia despite brand name sales. Table 6.5 shows the development and innovations of ACER. Table 6.4

Tatung’s progress in electronics during the building of POLIS

Product Black-and-white TVs Colour TVs Black-and-white TV picture tubes VCRs High-resolution colour TV picture tubes Colour TV tubes PCs Hard disk drives TV chips/ASICs Sun workstation clones Fourteen-inch colour monitors Source: Hobday (1995: 113).

Introduction date 1964 1969 1980 1982 1982 mid-1980s mid-1980s mid-1980s late 1980s 1989 1991

86 Interpreting East Asian Growth and Innovation Table 6.5 Attempts to build a POLIS, but actually catching up first? ACER behind-the-frontier innovations: a selection 1984 1986 1988 1989 1991 1992 1993 1993 1993

Developed its own version of the 4-bit microcomputer (later followed by 8-bit, 6-bit and 32-bit PCs) Launched the world’s second 32-bit PC, after Compaq but ahead of IBM Began developing supercomputer technology using the Unix operation system Produced its own semiconductor ASIC to compete with IBM’s PS/2 technology Formed a joint company with TI (and the Taiwanese Government) to make memory chips (DRAMs) in Taiwan Formed alliances with Daimler Benz and Smith Corona to develop specialist microelectronics technology Produced a novel PC using a reduced instruction-set (RISC) chip running Microsoft’s Windows NT operating system Licensed its own US-patented ChipUp technology to Intel (in return for royalties) Received royalties from National Semiconductor, TI, Unisys, NEC and other companies for licensing out its PC chipset designs

Source: Hobday (1995: 117).

ACER, according to many observers of technology in Taiwan, exemplifies many of the strengths and weaknesses of Taiwan’s hightechnology startups. ACER started with only 11 engineers in 1976 and had total sales reaching some US$1.4 billion by 1993. ACER led the local computer industry in the 1980s with 60 percent of sales being name brand through OBM. The company began to distribute directly to customers abroad during this period in order to challenge other brand leaders and move beyond OEM. However, the company began to retreat from OBM to OEM and ODM sales after heavy losses between 1990 and 1993. The above discussion shows that there are strengths or advantages and weaknesses or disadvantages for companies like ACER. The strengths or advantages for these companies have been that they were able to benefit tremendously from the improving technological infrastructure and established market channels; they were able to bypass the consumer electronics phase of the 1970s, thus allowing them to enter the market at a higher technology level, and they have received greater benefits from managers and engineers educated abroad. The weaknesses or disadvantages for these companies has been mainly the difficulty they have encountered as latecomers. Specifically in the ACER case, the company sustained heavy losses in own-brand sales.

Taiwan: Building a POLIS 87

This forced the company to move from OBM back to OEM, once again making ACER dependent on the global leaders of core technologies. Unless and until these latecomers make the full transition to OBM and develop in-house technologies, they will be dependent on the global leaders and unable to compete on an equal basis (Hobday, 1995). The final grouping to be discussed here is the government-sponsored start-ups. Table 6.6 shows the companies working at the governmentdeveloped Hsinchu facility and their relationship with international companies. In one case of government-sponsored startups, the government has taken a ‘hands-on’ approach offering direct and indirect assistance, to include tax incentives and loans, and the use of science park facilities at Hsinchu to entice overseas Taiwanese to return to Taiwan. MTI, a telecommunications equipment maker, is one example. The government was greatly responsible for initiating this firm. In another example, the Winbond Electronics Corporation, the government arranged for technology transfers for Winbond. Winbond’s founder and eventually many of its employees came from the Industrial Technology Research Institute, a state-controlled organization that trained engineers in advanced semiconductors and transferred technology. The company took advantage of the needs and demands for technology in the local market. With technological transfers and innovation, Winbond was able to compete in a number of areas not only locally but internationally as well. However, shortages in investment capital, poor brand name recognition and uncertain Table 6.6 The fragile beginnings of POLIS: high-technology startups in Hsinchu science-based industrial park Firm

Start date

Sector

Sources of senior staff, technology and training

Microelectronics Technology Inc. United Fibre Optics Communications Inc. TECOM Macronix Winbond Electronics Corp Taiwan Semiconductor Manufacturing Corp.

1983

Telecom

HP, Harris, TRW

1986

Telecom

1980 1989 1987

Telecom Semiconductors Semiconductors

Sumitomo (J), Philips (H), AT&T, STC (UK) Bell Labs, IBM Intel, VLSI-Tech RCA, HP

1987

Semiconductor foundry

Harris, Burrows, RCS, Philips (H), IBM

Source: Hobday (1995: 118).

88 Interpreting East Asian Growth and Innovation

distribution arrangements meant that the company remained dependent on international leaders for technological innovation and capital goods. A final example of a government-sponsored start-up is United Fiber Optic Communications Inc (UFOC). The government, specifically the Ministry of Economic Affairs Industrial Development Bureau, felt that Taiwan needed an indigenous fiber optic producer. This government agency called together the four largest copper producers and the local telecommunications operator within Taiwan to form a joint venture company, UFOC. The new venture attempted to obtain licensing agreements with four other international companies, finally deciding on one of them, AT&T. UFOC is representative of the other startup companies in Taiwan. Faced with the option of continuing to purchase its know-how from international competitors or investing heavily in its own in-house technology, each of these companies has usually had to rely on the former for continued learning and technology. This suggests some of the difficulties of latecomers in overcoming the OEM path to further development (Hobday, 1995). Nevertheless, innovation can be carried out with support from the state. It should be highlighted that the ups and downs of the electronics industry mentioned at the beginning of our discussion make any confident predictions regarding POLIS, based on this historical development, quite hazardous. In particular the last half of the 1990s was quite turbulent for this sector. Fortunately, the multisectoral and interdependent models developed earlier place more emphasis on linkages and non-linear relations. Important as the electronics sector is, once an overall POLIS structure is in place, cyclical swings can dampen innovation, but not stop it completely. But the crucial question is precisely this: has the economy in question actually built a POLIS?

But does Taiwan have a POLIS? The foregoing discussion leads to the conclusion that at least in the electronics sector the Taiwanese firms have become innovators on an ongoing basis. It may even be said that there is a localized POLIS in the sector, as it were. But are the linkages with the rest of the economy sound enough to generate an overall POLIS effect? Are the R&D activities elsewhere in the economy being stimulated in such a way that an

Taiwan: Building a POLIS 89

ongoing economy-wide positive feedback loop leading to a virtuous cycle of innovation and growth can be said to exist? Let us recall that both Lau and Kim and Young separately arrived at the conclusion that for Taiwan also, in terms of total factor productivity growth the macro evidence does not support the hypothesis growth through technical change. In the terminology developed here those findings may be read as a rejection of the hypothesis that a POLIS exists in Taiwan at present. Lau (1996: Table 2) presents the results of his alternative growth accounting. According to his findings capital, labor and human capital account for 70, 14 and 16 percent of the growth in Taiwan. This leaves exactly zero for technical progress. How can one reconcile the detailed microeconomic evidence of the previous section with this macroeconomic finding? As in Chapter 5, the approach followed here is to construct two successive SAM-TECHS with the modern high-tech sectors included. The same approximation strategy used previously can once again be utilized in order to apply the insights of the non-linear theoretical model of POLIS to the Taiwanese case. The years used are 1990 and 1992. The intention here is to capture the structural change in the modern technology system as completely as possible. The production, household and factors in Taiwan all have somewhat different classifications from those of South Korea. This is inevitable in a study of comparative economic structures in two different countries. In both the SAMs, however, R&D could be included as a separate activity. Classifications of factors (fewer in numbers in Taiwan) in both cases includes a separate category for engineering, technical and professional personnel. The total number of households in Taiwan is ten. On the production side the activities have been disaggregated more for the non-agricultural sectors. A separate disaggregated sector for the electronics industry has been created in order to pinpoint and test the importance of this sector for the Taiwanese economy. The dualistic breakdown of activities has not been pursued for Taiwan. The reason for this is that we are interested solely in sectors which are primarily modern R&D intensive. We also focus exclusively on the high-technology sectors within manufacturing. Thus the range of analysis is narrower for Taiwan than for South Korea. But future extensions may be possible if one is interested, for example, in agricultural technologies. Table 6.7 below gives a complete description of endogenous accounts for the Taiwan SAM.

90 Interpreting East Asian Growth and Innovation Table 6.7 1 2 3 4 5 6 7 8 9 10 11–20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43

SAM-Tech classification for Taiwan, 1990 and 1992 Engineers Technicians Skilled workers Apprentices Unskilled White collar Self-employed (manufacturing) Self-employed in service Capital Agricultural workers Same as 1–15 except that they now refer to households as opposed to factors Cereals Other agriculture Fishing Processed food Mining Textiles Lumber and furniture Chemical products Energy Electronics (including computers) Cement, non-metallic mineral products Metal products Machinery Transport equipment Beverages and tobacco Other consumer products Construction Real estate Transportation and communication Trade and banking Education Medical, personal and other services Research and development

In the above table, just as in South Korea, the modern SAM-TECH (ModSAM-TECH) is constructed by adding R&D rows and columns according to the scheme identified in Chapter 4. Thus, a 43 × 43 endogenous account SAM is formed in Taiwan. The basis of the SAM, again as in the case of South Korea, is the updated input–output table specially modified for the SAM-TECH. The factors and household classification systems have less detail than the Korean SAM as observed before, but still include the most relevant categories for the

Taiwan: Building a POLIS 91

formation of a POLIS. The focus here is also on identifying productivity and value-added changes, but some attention always needs to be paid to the distributional characteristics of the innovation system. As mentioned before, in line with the strategy outlined in the last section of Chapter 4, two successive approximations for two different scales are made. One is for 1990 GDP and the second is for the increment in two years. Again, in the latter case coefficients are changed in proportion to growth. Once again, in all probability, it embodies a conservative increasing returns assumption because of the particular linear approximation scheme used. For Taiwan, the simple multiplier exercises indicate a somewhat greater effect than Korea. For each 1 percent injection of R&D, output in the ModSAM-TECH increases by about 3 percent. The modern technological system shows a range of increase varying between 2.5 percent and 4 percent. The electronics sector also shows the expected increasing returns effect. It should be recognized that the assumption of excess capacity is significant here. If the economy is near full employment additions to capacity will need to be made. In fact, such additions have occurred for both Taiwan and Korea. To capture the capacity-building effect a series of projected ModSAM-TECHs for Taiwan and Korea will be necessary. In the short run, some inflation has accompanied the growth process. It is worth emphasising that, as in South Korea, the engineers, managers, technicians and in general skilled workers, gain disproportionately from the POLIS effect. As in the case of Korea future trade increases of Taiwan with other LDCs with relatively more unskilled workers may bring factor–price equalization (according to the factor–price equalization theorem in standard trade theory) into play. Under such circumstances the skilled/unskilled remuneration ratio will further deteriorate for Taiwan. Thus on the distributional side, in Taiwan as in South Korea, for the less skilled anyway, POLIS may turn out to be a mixed blessing. In summary, this chapter has considered carefully the empirical evidence regarding innovation in Taiwan. Signs that Taiwan is building a POLIS are somewhat stronger than in the Korean case. In keeping with the caveats of the evolutionary approach, however, we must not hasten to pronounce Taiwan as a mature innovating country yet. There are still weaknesses even in the high-technology sector. For example, in spite of the government’s efforts, by and large, Taiwan still follows the

92 Interpreting East Asian Growth and Innovation

imitative strategy. There remain several open questions as to if, when and how Taiwan can follow an autonomous innovation strategy. Beyond the high-technology sector, the rest of the economy is not as well integrated as it needs to be before a POLIS can be self-sustaining. But clearly, more than a mere beginning has been made.

7 Asia’s Financial Blues: The End of POLIS?

The East Asian financial crisis was by all accounts the most significant event in the world economy in 1997. The topic dominated the headlines, attracted the attention of the world and generated much despairing rhetoric. The economists naturally joined the cacophony of condemnations. The dismal science had never looked so dismal since the great depression of the 1930s. Without doubt, the speed and depth of the collapse of financial markets in East Asia caught everyone by surprise. Neither the existing surveillance mechanisms nor markets warned the euphoric investors adequately of impending calamity. The reversal of fortunes in East Asia came suddenly and surprised even the experts. The contagion spread rapidly, engulfing a number of economies in quick succession. It started as a currency crisis, then became a financial crisis. By 1998 it had become a full-blown economic crisis. The actual trigger for the crisis was the 1996 export slowdown in Asia. The cyclical downturn in the demand for electronics, in conjunction with a rising dollar and a declining yen, slowed export growth and led to some skepticism about future growth. The initial export downturn and growing skepticism threatened the inflow of foreign capital, now badly needed to sustain the increasing current account deficits. This in turn led to market concerns about the more or less fixed exchange rates, culminating in pressure on them and their eventual collapse. Investors suffering losses started to withdraw from these markets, and the bubble in asset prices burst. Falling asset prices resulted in insolvency of financial intermediaries, resulting in a fullfledged financial crisis. Although the 1996 export slowdown triggered the currency crisis, the roots of the financial crisis go much deeper. It is important to note 93

94 Interpreting East Asian Growth and Innovation

the fact that the crisis occurred in those countries in the region that were more advanced and more integrated with global financial markets and, for that reason, were more successful in attracting large inflows of foreign private capital. In this sense, the crisis can be viewed as a new challenge facing the Asian developing countries as they move up the ladder of economic development. It is fair to say that the problems were not confined just to the affected economies and they can emerge in other developing countries when they reach a similar stage of economic development and integration globally. But this is cold comfort for the economies that were so affected, at least in the short run. Why were the affected countries so vulnerable? To begin with, there were weaknesses in financial and exchange rate management in these economies. For all practical purposes, these countries had all pegged their currencies to the US dollar for a decade or so. With good investment potential built up by past economic success, foreign capital inflows accelerated, especially since the capital accounts were liberalized. To keep the local currencies from appreciating and to curb inflation, much of the foreign capital inflow was sterilized. The sterilization led to an increase in the gap between domestic interest rates and international market rates, which, coupled with a fixed exchange rate system, further encouraged foreign capital to flow into the countries. Clearly, massive capital inflows increased the level of investment. But the institutional capacities in the financial sectors of these countries were not robust enough to manage these inflows effectively. In essence, these countries lacked the capability to allocate capital resources efficiently through a mechanism that would penalize excessively risky behavior while rewarding productive use of capital. Poor corporate governance due to lack of transparency as well as inadequate accounting and auditing standards also contributed to the emergence of such overly risky behavior. Short-term external loans were often used for financing projects with long gestation periods. This led to a mismatch in maturities of financial instruments. Significant amounts of the foreign capital inflows were also invested in private real estate and other non-traded sectors prone to speculation. Such risky behavior in the asset markets created bubbles that had to burst eventually. Thus, in contrast to the Latin American crises, the Asian crisis was mostly a private-sector phenomenon. To make the situation worse, a self-reinforcing vicious circle occurred between currency and asset market declines and banking and corporate failures. The falling currency drastically increased the local currency equivalent of the foreign debt owed by local enterprises, which in turn

Asia’s Financial Blues: The End of POLIS? 95

exacerbated the currency decline. The fall of asset market prices decreased the capital of the banks which held the assets, and increased the level of non-performing loans to the corporate sector which used assets as collateral. The vicious circle contributed to the drastic depreciation of currencies and the large number of banking and corporate bankruptcies that are still plaguing some countries. To all intents and purposes, the Asian financial crisis put a halt to the steady capital accumulation in Southeast Asia and South Korea. In Taiwan, too, the growth rate slowed, but unlike in South Korea the economy was not crippled. Something of value, therefore, can be learned by comparing the financial policies and systems of South Korea and Taiwan. In the rest of this chapter, this is what I plan to do. At the end, I hope to give the reader a better appreciation of the role of financial institutions in creating and maintaining a POLIS. In particular, the crucial role of an appropriate regulatory structure combined with the capacity of a developmental state to implement the appropriate regulations will be highlighted.

Financial structures and POLIS The chapters on South Korea and Taiwan have already alluded to the need for financing long-lived capital assets associated with building a POLIS. It is also easy to see that the financing of R&D and human capital formation is also crucial for this purpose. It can be argued that the historic evolution of the financial institutions in both these countries helped the firms to obtain financing for the construction of POLIS. However, in the 1990s the two economies evolved quite differently. A contrast between the deregulation in Korea and a much more cautious approach to dismantling the financial controls and regulations in Taiwan can be instructive in assessing the future trajectories of their POLIS-building efforts. What should be kept in mind is that the requirements of financing arise out of the needs of building a POLIS, and not the other way around. Therefore, the financial crunch can put a halt to the further building; but easy finance by itself cannot ensure the building of a POLIS. What is remarkable in both the South Korean and the Taiwanese cases is the attention both these countries paid to the need for financing when such needs arose. To anticipate the argument in the rest of the chapter, the recent financial and economic crisis exposes South Korea to a period of great instability and contraction. Under the current circumstances it will be

96 Interpreting East Asian Growth and Innovation

foolhardy to expect an uninterrupted building of POLIS there. However, with proper recognition of the need for continuing the building of a POLIS once the crisis is over, steps can be taken to preserve knowledge, resources and institutional structures that will be crucial in the future. This line of argument will also reveal the hazards of an uncritical globalization of financial sectors. The Taiwanese case will serve as the contrast to the Korean example in this argument. Therefore, in what follows, I first discuss the evolution of the Korean crisis. I then contrast this with the more static financial structure in Taiwan. At the end, we can draw the conclusion – at least tentatively – that for a developing economy, proper financial management is essential for building a POLIS. For this, the free financial markets globally may not always help. On the contrary, a premature liberalization of the capital account and domestic financial sector deregulation may play havoc with plans for building an endogenous innovation structure.

South Korea’s descent into chaos Over a two-month period from October 1997 to December 1997 South Korea was reduced from being the eleventh largest economy in the world to one that had to go begging hat-in-hand in order to survive. This sudden shift took even the IMF by surprise. As late as October, 1997 the IMF mission visiting Seoul had given South Korea a clean bill of economic and financial health. What went wrong? The best approach to answering this question is historical. In order to understand the recent crisis we need to go back several years and from there trace our way towards the crisis. Prelude to the crisis: financial liberalization and investment growth During the few years preceding the crisis, Korea did not experience the kind of double-digit growth that it had during an earlier period, but the economic growth from 1993 to the beginning of 1997 was on average a respectable 7.6 percent per annum. It peaked in 1996 at nearly 9 percent, as shown in Table 7.1. The economy was, as in the past, fueled by exports. However, growth during this period occurred with unusually high investment. As a matter of fact, investment was so high that it outstripped Korea’s high savings rate, which itself was well above 30 percent. In many respects, this high investment was a positive development as

Asia’s Financial Blues: The End of POLIS? 97 Table 7.1

Major indicators of the Korean Economy, 1991–97 (percent) 1996

1997*

8.6 8.9 9.1 9.3 8.7 8.8 7.0 7.2 7.6 8.3 4.2 1.0 11.8 11.7 4.5 8.7 23.6 15.8 14.6 25.3 21.8 221.3 0.3 0.5

7.1 7.4 7.9 6.9 6.9 7.1 7.1 6.3 8.2 14.5 13.9 1.4

6.1 6.3 2.4 5.0 4.8 6.5 –2.1 0.9 –5.9 24.2 6.5 –

60.4

60.0

61.2

63.3

–

34.7 36.6 –1.3

35.1 35.1 0.3

35.2 36.1 –1.0

35.9 37.0 –1.8

34.3 38.2 –4.8

34.2 36.1 –1.9

0.6 0.5 0.0

0.0 –1.6 –1.6

4.4 0.4 –3.8

1.2 1.7 0.5

–3.6 5.0 8.9

9.3 4.7

6.2 2.2

4.8 1.5

6.3 2.8

4.5 4.7

1991

1992

1993

1994

GDP Non-agricultural Domestic demand† Consumption (Private) (Public) Fixed investment (Construction) (Equipment) Commodity exports Commodity imports Increase in stocks/GDP

9.1 10.0 10.5 9.3 9.5 8.5 12.6 13.0 12.1 12.2 19.4 0.5

5.1 5.0 3.9 6.8 6.6 7.6 –0.8 –0.6 –1.1 10.9 4.0 0.0

5.8 6.5 5.3 5.3 5.7 3.0 5.2 8.9 –0.1 9.7 5.6 –0.9

Compensation of employees/NI Gross savings/GDP Gross investment/GDP Current account/GDP

60.2

61.0

35.9 38.9 –2.8

Terms of trade Unit export price Unit import price Consumer price index Producer price index

1995

–12.3 –10.3 –13.4 –14.9 –1.2 –5.3 4.9 2.7

4.4 3.8

Notes: *The figures under GDP are averages from the first quarter to the third quarter. † Domestic demand = consumption + fixed investment. Sources: Bank of Korea, National Income, various issues; Bank of Korea, Balance of Payments, various issues; National Statistical Office, Consumer Price Index, various issues.

the economy was coming out of a mild recession during the period 1991–92, but it was also partly responsible for a sharp increase in the current account deficit. There were two major reasons for this high investment: the strengthening of the yen and the financial liberalization and market opening. Both these factors increased the availability of foreign credit. Until the spring of 1995, when the yen hit the level of 79.5 to the dollar, the Japanese currency appreciated continuously. Consequently, the East Asian countries were becoming increasingly competitive vis-à-vis Japan in exports of manufactures, and increasing even further their export earnings. This resulted in a great deal of direct foreign investment and domestic capital formation throughout East Asia. Korea benefited the most of all East Asian countries from the high yen

98 Interpreting East Asian Growth and Innovation

because it competed directly with Japan in many industries where Japan was the leading exporter. The second factor which led to the investment boom was the accelerated deregulation of domestic markets and the relaxation of restrictions on capital account transactions. The market deregulation greatly reduced the scope of industrial policy, while financial market opening facilitated capital inflows. These changes were also responsible for the massive increase in investment. From the 1960s and through the 1980s, there were many restrictions on foreign capital inflows. Through its industrial policy, the government regulated the inflow of foreign capital and coordinated many of the investment decisions of the chaebols that were and still remain the backbone of the Korean economy. By early 1990s it was thought that the national political economy had become too complex for the government to make sound investment decisions for the chaebols. Korea had also come under increasing pressure from developed countries demanding that the policy-makers should liberalize Korea’s financial sector. Liberalization began in earnest in 1993 immediately after the inauguration of the administration of Kim Yon Sam and was accelerated by Korea’s accession to the OECD as its twenty-ninth member. The upshot of all this was that the government lost much of its control over investment activity, and the domestic financial institutions were allowed greater freedom in borrowing from the international financial markets and in lending to domestic enterprises. Let us take a quick look at the major financial liberalization measures in the 1990s. From 1991 to July 1997 interest rates were deregulated in four stages. In the final stage, in 1997 all lending and borrowing rates except demand deposits were liberalized. During the same period more managerial autonomy was given to the banks. Barriers to entry to financial activities were also lowered significantly. For example, in 1994 greater freedom was given to the banks to increase capital, to establish new branches and to determine dividend payments. A series of measures (1990, 1993, 1994, 1995) ensured the continuous expansion of the securities business of deposit money banks. By 1995, banks and life insurance companies were also free to sell government and public bonds over the counter. Also, by this time securities companies were given permission to handle foreign exchange business. By 1996, limits on maximum maturities for loans and deposits of banks had been abolished. In terms of foreign exchange market liberalization Korea had adopted the market-average foreign exchange system by 1990. By

Asia’s Financial Blues: The End of POLIS? 99

1991, the requirements for documentation showing real non-financial source of demand for foreign exchange transactions had been eased considerably. In the same year as the Foreign Exchange Management Act was revised its result, the basis of regulation, was changed from a positive system to a negative one. Foreign currency call markets were also set up. By 1993, non-residents could avail of free market accounts, and partial Won settlements for exporting or importing visible items. 1994 saw the introduction of a foreign Exchange Reform Plan. The plan gave a detailed schedule for the reform of foreign exchange market structure. By 1995, the so-called Foreign Exchange Concentration System had also seen relaxed considerably. From 1992 to 1997 there was progressively wider capital market opening. By 1992, foreign investors were allowed to invest directly in Korean stock markets, albeit with ownership ceilings. By 1994, foreigners were being invited to purchase government bonds issued at internationally competitive interest rates, and equity-linked bonds issued by firms. In January 1997 non-guaranteed long-term bonds issued by small and medium firms were added to this list. In the same month foreigners were also allowed to buy non-guaranteed convertibles bonds issued by large enterprises. By this time the residents could already invest in overseas securities via beneficiary certificates. In 1995 the ceiling on any domestic institutional investor’s overseas portfolio had also been abolished. Foreign commercial loans were allowed without government approval in so far as they met the guideline established in May 1995. From January 1997, private companies engaged in major infrastructure projects were allowed to borrow overseas to pay for domestic construction costs. At the same time, borrowings related to foreign direct investments were liberalized. Since the early 1990s, policy loans and credit control have gradually been reduced. In 1993, a planned termination of all policy loans by 1997 was announced, beginning with a step-wise reduction in policy loans to specific sectors (for example, export industries and small and medium-sized firms). Also, the controls on the share of a bank’s loans to major conglomerates in its total loans were simplified and slimmed down. The irony of the situation was that Korean financial institutions were not adequately prepared for financial market liberalization and market opening because they had not developed expertise in credit analysis, risk management, due diligence and international finance in general. The supervisory authorities were also pressured to overhaul their

100 Interpreting East Asian Growth and Innovation

regulatory system to make it more compatible with a liberalized system. In the process, many restrictions and control measures were eliminated or relaxed. At the same time the authorities did not install a new system of prudential regulation, which was needed to safeguard the stability and soundness of financial institutions. In these developments lay the potential of a serious financial crisis. During the 1990s, all of the large chaebols also expanded their investment in Korea’s major industries in an attempt to maintain their respective relative positions. Their management system with the decision-making concentrated at the top made it difficult for the chaebols to adjust their investment and output to changes in market conditions rapidly. The chaebols were reluctant to issue equities, as doing so could lead to a loss of control by the major controlling families. Therefore the chaebols became highly leveraged. One survey has revealed that the average debt-to-equity ratio of the 30 largest chaebols was more than 380 percent in 1996, four times as high as that of Taiwan. Between 1993 and 1996, there was a net foreign capital inflow of $46.3 billion, more than ten times the total net inflow for the entire decade of the 1980s. For the most part, these inflows were induced by large interest rate differentials between the domestic and foreign financial markets and consisted of short-term portfolio investment as shown in Table 7.2. Most of this new capital was used to finance investment in Korea’s major export-oriented industries; electronics, automobiles, iron and steel, shipbuilding, petrochemicals and so on. Many Korean chaebols participated in a major direct investment effort in foreign countries, especially in Europe and Southeast Asia. In 1993, Korea’s total foreign direct investment was about $13 billion. Only a year later it jumped to $23 billion. The mode of financing of this FDI was mainly through foreign credit. Needless to say this also made Korea more vulnerable to adverse financial shocks. The shock finally came in late 1996 when the Japanese yen began to decline. With the depreciation of the yen, Korean exporters found themselves suddenly losing competitiveness in their traditional export markets of North America and Europe. To make matters worse, terms of trade also moved against Korea. Table 7.2 shows quite clearly how inventories of exporters started to increase and were financed by dear short-term credit from the merchant banks. The government refused to come to the aid of chaebols strapped in debt. Corporate bankruptcies began to occur and came so rapidly in succession that soon there was a cascade of them. At the same time, the volume of non-performing loans at financial institutions also began to skyrocket. The twin

Asia’s Financial Blues: The End of POLIS? 101 Table 7.2

South Korea’s capital account balance (US$b*) 1992 1993 1994

Liabilities 8.8 8.4 Loans and foreign investment 5.2 8.7 Public –0.6 –1.8 Commercial –0.5 –1.1 Direct investment 0.6 0.5 Portfolio investment 5.8 11.0 Trade credit 0.9 –0.4 Others † 2.7 0.1 Assets 0.5 1.5 Direct investment 1.0 1.1 Portfolio investment 0 0.3 Export on credits –1.7 –0.7 Others 1.2 0.9 Balance 8.3 6.9 (liabilities–assets)

1995 1996

1997 First half July to November

13.4

20.0

26.4

13.8

2.5

7.4 –0.3 –0.3 0.8

9.4 –0.5 –0.2 1.2

13.4 –0.5 –0.2 2.0

8.8 –0.2 0.1 1.1

5.3 –0.1 0.8 0.8

7.3 2.2 3.8 4.4 2.1 0.5 –0.1 2.0 9.0

8.9 3.6 7.0 6.6 3.1 0.4 0.9 2.2 13.4

12.1 6.6 6.4 9.4 3.9 0.9 0.6 3.9 17.0

7.7 2.1 2.9 3.1 1.8 0.7 0.1 3.4 10.6

3.8 –0.1 –2.6 0.3 0.4 0.3 0.5 –0.9 2.3

Notes: *A positive balance indicates capital inflow. A positive figure under liabilities or assets means an increase. †Others includes the change of the liabilities of merchant bank corporations and development institutions, such as the Korea Development Bank, Korea Long-term Credit Bank, and Korea Export and Import Bank. Source: Bank of Korea, Balance of Payments. various Issues.

burdens of non-performing loans and corporate bankruptcies launched a full-scale financial crisis.

The crisis unfolds The crisis unfolded with unexpected speed. The first major victim was the Hanbo group. A large producer that specialized in iron and steel, it was Korea’s fourteenth-largest chaebol. Hanbo was unable to meet the payments of the principal and interest on its borrowings. It was supposed to be restructured through a workout program organized by its credit banks. As it turned out, Hanbo was placed under court receivership because the workout program did not succeed. Thus began a series of corporate debacles in one of the most successful Asian economies. The Hanbo collapse revealed that many loans to this group had been made under political pressure. The pervasiveness of corruption discov-

102 Interpreting East Asian Growth and Innovation

ered in Korea was one of the major factors in foreign investors’ loss of confidence in the government and the economy in general. Even in retrospect it seems amazing to hear the claim that informed participants did not know about these. It is more likely that the market participants knew – the full extent of knowledge may, however, be debatable – but believed that the government would bail out the firms in trouble. Most astonishing among the developments that followed and the one that caused the government to lose a great deal of its credibility was the near-bankruptcy of the Kia Group in July. At first, the Kia Group, the nation’s eighth-largest chaebol, was also to be covered by a workout program, but this too proved impractical. By the first week of September, six chaebols including Kia were either placed under a workout plan or else became insolvent. These chaebols accounted for about 10.4 percent of the total assets of the 30 largest chaebols. But the damage to credibility in asset markets was already done. By September foreign investors were already to stampede out of the Korean equities. By October foreign investors moved out of the stock market in droves, and Korean banks were increasingly unable to rollover their short-term foreign loans. In order to avoid default, they were forced to turn to the Bank of Korea for liquidity or to resort to the foreign overnight loan markets. On 19 November, the government announced a reform package which included measures for disposal of non-performing loans and widening of the exchange rate fluctuation band. This, however, did little to stop the panic. It was too little, too late. The government finally announced to the public its decision to approach the IMF to ask it for assistance. The negotiations between the Korean government and the IMF were completed in a record time of only 10 days on 3 December. The IMF agreed to provide a total of $21 billion to be disbursed in 11 installments over a three-year period from its emergency financing and other facilities. It also secured financial commitments totalling $36 billion from the World Bank, the Asian Development Bank, the United States, Japan, Germany, Canada, the United Kingdom, Australia and other international organizations and countries, which would serve as a second line of defense. The IMF conditionalities required tight monetary policy, a fiscal surplus, sweeping financial reform, further liberalization of the financial markets, and also two conditions which were unusual for an IMF program: greater flexibility in the labor market and restructuring of the chaebols. On closer examination one discovers that these really were standard

Asia’s Financial Blues: The End of POLIS? 103

measures, forced to fit an unprecedented situation. It is not surprising that the IMF measures did little to allay fears and stabilize the financial markets and the foreign exchange market. The won/dollar exchange rate continued to depreciate. Bankruptcies and business closures proceeded apace. Rumors had begun to circulate among the foreign investors that Korea might have to declare a debt moratorium. The IMF and US treasury must have both realized that stronger measures would be required to shore up confidence and boost the Korean economy. Finally, on Christmas Eve, the IMF and the G-7 countries came up with a $10 billion emergency financing program. It appears that this emergency finance did succeed in turning market sentiment around by demonstrating the resolve of the IMF and G-7 to rescue Korea from financial collapse. In retrospect it is now clear that the IMF served as a lender of last resort in the East Asian financial crisis. This was true especially during the Korean crisis. The predictable effects of the IMF program were a sharp increase in the domestic interest rates and a substantial depreciation of the won/dollar exchange rate. The monetary contraction dried up the availability of bank credit, especially to small and medium firms. This led to further contraction in the real economy. A genuine debtdeflation type of economic crisis humbled one of the most successful Asian economies. It is doubtful wether innovators such as Samsung will have the technological advantages that were being planned earlier. A period of uncertainty and struggle awaits.

Taiwan: playing a different game? In contrast with South Korea, Taiwan managed to avert both a currency crisis and a financial crisis. Not only did it survive the turbulence in 1997, but its economy grew at 6.8 percent – quite a respectable showing in times of great regional economic turmoil. This was due largely to sustained growth in finance, insurance, real estate and social services. The manufacturing sector was slowing down, but investment for POLIS still continued. In order to understand Taiwan’s somewhat different performance it will be useful to look into the structure of its financial institutions. The contrast with post-1993 Korea will be immediately apparent. Figure 7.1 gives a snapshot of the financial system in Taiwan. The Ministry of Finance (MOF) and the Central Bank (CB) are the two major government institutions responsible for maintaining orderly

104 Interpreting East Asian Growth and Innovation

markets. Within the general financial system there is a preferential subsystem that, among other things, finances some aspects of building a POLIS. Thus, in contrast to the relatively laissez-faire industrial institutions, the financial system relies more on controls and directives. The existence of a dual financial system has a historical background. The formal financial system has always been subject to strict control, and, except a few private banks established by overseas Chinese or those that were transformed for specific political reasons, banks were regulated directly by being government-owned. Bank interest rates were controlled by the Central Bank and official interest rates usually adjusted more slowly than the market-determined rate through demand and supply. These regulations were maintained for decades until 1989, when a new Banking Law was promulgated and bank privatization and interest rate liberalization were adopted. The longregulated banking system could not meet the rising market demand for funds. One problem is that government banks tend to operate conservatively. Those firms which can afford to present collateral more easily have an edge in receiving bank loans. Usually, big firms have more easy access to credit compared with small and medium businesses, which have difficulty obtaining funds from government commercial banks. Those businesses have to pursue underground capital, and an informal financial market has grown accordingly. As a result, formal and informal financial markets coexist. This is a major characteristic of Taiwan’s financial market (Figure 7.2). The formal financial system is composed of two subsystems: one is financial institutions, the other is financial markets. Financial institutions include two groups, namely the monetary institutions which create credit money and other financial institutions which cannot do so because of legal restrictions. The first group of financial institutions includes the Central Bank of China (CBC), commercial banks (domestic banks and local branches of foreign banks), specialized banks and cooperatives (credit cooperative associations, credit departments of fishermen’s associations). Specialized banks include the Export–Import Bank of China (trade financing activities), the Farmers Bank of China (farm financing activities), Land Bank of Finance (real estate financing activities), the Cooperative Bank of Taiwan (cooperative-related financing activities), and the Central Trust of China (dealing with government-purchaserelated financing activities). Other financial institutions cannot create money, but they can mobilize idle money to finance investments. They are the postal

Government unit

Financial policy

Policy of financial system development– regulation and liberalization

Financial system

Industry

General financial system

General industries

Preferential financial subsystem

Specific industries Export industries Strategic industries Small and medium enterprises

Ministry of Finance Financial preferential policy Central Bank Monetary policy Foreign exchange policy

Figure 7.1

Systemic view of the political economy of Taiwan’s financial structure 105

Formal financial system

Financial institutions

Financial markets

Credit companies Informal (organizations) financial system

The financial system in Taiwan

Investment and trust companies Life insurance companies Insurance companies Property and casualty insurance companies

Bills finance companies Taiwan Stock Exchange Corporation

Capital market

Figure 7.2

Credit cooperative associations Credit departments of farmers’ associations Credit departments of fishermen’s associations

The postal savings systems Other financial institutions

Money market Financial system

Central Bank of China Commercial banks Full service domestic banks Specialized banks Local branches of foreign banks Medium and small business banks Cooperative financial — cooperative bank institutions of Taiwan

106

Monetary institutions

Fuh-Hwa Securities Finance Company Brokers Security dealers Traders Foreign exchange market

Financial installment Financial leasing companies Financial investment companies Unorganized markets

(Types of transactions)

Unsecured borrowings and lendings Secured borrowings and lendings Loans against post-dated checks Deposits with firms Mutual loans and savings Financial installment credit Financial leasing Others

Asia’s Financial Blues: The End of POLIS? 107

savings system, investment and trust companies, and insurance companies. Financial markets include the money market and the capital market. Broadly speaking, the foreign exchange market can also be included. The money market is the short-run fund market. Financial instruments in the money market include treasury bills, commercial paper, bankers’ acceptances and negotiable certificates of deposits. These instruments are usually exchanged in the three local bills finance companies. The Central Bank often enters this market to execute open-market operations for the purpose of controlling the money supply. The capital market is a place for long-term bill transactions. Financial instruments in the capital market include stocks, government bonds, corporate bonds and bank debentures. The stock market grew dramatically in the 1980s. The Taiwan Stock Exchange Corporation is the exchange center, and Fuh-Hwa Securities Finance Companies deal with finance demand for funds and securities. The operation of foreign exchange activities is executed by the Central Bank and authorized foreign exchange banks. The authorized banks are where foreign exchange transactions take place, and include some major domestic banks plus local branches of foreign banks. The informal financial markets include all the financial activities which are not approved by the Ministry of Finance. Financial installment credit companies, financial leasing companies and financial investment companies are registered companies under the Ministry of Economic Affairs. However, they operate their activities as financial institutions. Any activity of financial intermediation by a business not approved by the Ministry of Finance is illegal. Therefore, these companies are classified as informal financial markets. There are many kinds of transactions in this market. Unsecured borrowings and lendings, secured borrowings and lendings, and loans against post-dated checks are popular informal financial activities. ‘Deposits with firms’ means that some businesses collect funds from their employees, even from the general public. ‘Mutual loans and savings’ is commonly used as a way to pool savings of relatives and friends. Given the above structure of the financial system, there are four kinds of financial sources for the business sector: financial institutions, the money market, the capital market and the curb market. Table 7.3 shows the shares of these financial sources from 1964 to 1991. The money market did not appear until 1976. Table 7.3 shows that financial institutions are the most important financial source, which on average from 1976 to 1991 contributed 54.9 percent of total

End of year 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988

108

Table 7.3

Financial sources for the business sector in Taiwan (NT$ mn, percent) Financial institutions Amount % 13 708 16 940 20 889 30 250 37 021 40 267 48 886 75 837 95 138 127 716 175 311 217 673 252 236 277 295 342 513 428 490 573 574 637 221 755 500 821 159 852 272 866 343 989 694 1 185 375 1 458 643

47.81 48.33 50.40 61.24 61.12 60.18 61.04 62.98 67.20 65.30 67.83 66.64 64.48 59.34 57.40 55.90 53.51 53.67 54.47 54.14 51.60 47.81 47.88 50.60 55.89

Money market Amount %

2 207 9 949 17 373 46 687 65 464 109 769 133 288 159 425 195 908 195 423 154 510 138 066 129 308

0.56 2.13 2.91 6.09 6.11 9.24 9.61 10.51 11.86 10.79 7.47 5.89 4.95

Capital market % Amount 7 410 9 190 8 180 5 930 7 450 8 150 8 930 9 100 10 590 16 843 24 964 32 797 48 714 63 085 81 166 104 789 131 867 158 080 186 622 201 999 232 801 252 536 287 471 338 976 395 663

25.84 26.22 19.74 12.01 12.30 12.18 11.15 7.56 7.48 8.61 9.66 10.04 12.45 13.50 13.60 13.67 12.30 13.31 13.45 13.32 14.09 13.94 13.91 14.47 15.16

Curb market Amount % 7 555 8 922 12 377 13 213 16 102 18 490 22 267 35 468 35 842 51 034 58 188 76 191 88 050 116 976 155 707 186 596 301 978 282 576 311 601 334 103 370 819 497 613 635 558 680 352 626 114

26.35 25.45 29.86 26.75 26.58 27.64 27.80 29.46 25.32 26.09 22.51 23.32 22.51 25.03 26.09 24.34 28.09 23.78 22.47 22.03 22.45 27.46 30.74 29.04 23.99

Total Amount 28 673 35 052 41 446 49 393 60 573 66 907 80 083 120 405 141 570 195 593 258 463 326 661 391 207 467 305 596 759 766 562 1 071 983 1 188 046 1 387 011 1 516 686 1 651 800 1 811 915 2 067 233 2 342 769 2 609 728

Table 7.3 End of year 1989 1990 1991 Ave. of 1976–91

Financial sources for the business sector in Taiwan (NT$ mn, percent) – Continued Financial institutions Amount %

Money market Amount %

Capital market % Amount

Curb market Amount %

Total Amount

1 822 109 2 103 235 2 475 989

57.81 56.89 58.07

191 768 347 112 344 554

6.08 9.39 8.08

466 729 558 025 680 825

14.81 15.09 15.97

671 103 688 663 762 497

21.29 18.63 17.88

3 151 709 3 697 035 4 263 865

990 128

54.97

140 051

6.98

261 834

13.94

419 338

24.11

1 811 351

109

110 Interpreting East Asian Growth and Innovation

financial sources for businesses. The curb market is the second biggest financial source for firms, and is 24.11 percent of total financial sources. The capital market provides only 13.94 percent of financial sources for firms. The money market has provided only 6.98 percent on average since it was established. In other words, the level of direct finance is rather small and the market has not been popular. The indirect finance market is comparatively larger, and has provided most of the funds. Table 7.4 shows the relative assets of various financial institutions. Taking 1993 as an example, in terms of assets, the Central Bank processes about 15 percent of total financial institutions. Depository institutions have 67.99 percent. Among depository institutions, domestic banks have the largest share – 44.07 percent. Other financial institutions have lower market shares. The market shares of assets for other financial institutions in 1993 can be ranked in descending order as follows: the postal savings system, life insurance companies, investment and trust companies, property and casualty insurance companies, securities finance companies, and the smallest, bill finance companies. The postal savings system grew swiftly after the 1970s because the system provided convenience owing due to the widespread nature of its service units. The number of units for each type of financial institution can be observed in Table 7.5. In 1991, there are 17 domestic banks, with 773 branches. Each domestic bank is allowed to open a maximum of three branches every year. A new bank can open only five branches when established. Foreign banks were allowed to open only one branch until 1987. Credit cooperatives and credit departments of farmers’ and fishermen’s associations have more units and more branches, but most of them are small, so that their market share of assets is comparatively low. What deserves mention is that the number of branches in the postal savings system has been the largest. However, the number of domestic banks rose sharply to 34 banks, because banking privatization was allowed from 1989 onwards when the new Banking Law was promulgated. The market share of loans and deposits can be seen in Table 7.6. In 1991, domestic banks had 44.45 percent of total deposits, and 63.45 percent of total loans. Obviously, domestic banks have comprised the major portion of Taiwan’s financial system. If we include local branches of foreign banks and medium business banks in this classification, then the market share for banks increases. Other financial institutions, although they provide different services and

Asia’s Financial Blues: The End of POLIS? 111 Table 7.4

Total assets of financial institutions in Taiwan (NT$mn, percent)

Institutions Central Bank Depository institutions 1. Domestic banks 2. Local branches of foreign banks 3. Medium business banks 4. Credit cooperatives 5. Credit department of farmers’ and fishermen’s associations Subtotal Other financial institutions 1. Investment and trust companies 2. Postal savings systems 3. Life insurance companies 4. Property and casualty insurance companies 5. Bills finance companies 6. Securities finance companies Subtotal Total

1981

Total assets (end of year) 1986 1991

1993

523 199 (21.67)

1 749 414 (27.73)

2 253 616 (18.46)

2 651 884 (14.87)

1 138 614 (47.17) 120 253 (4.98) 78 610 (3.26) 136 619 (5.65) 105 926 (4.39)

2 596 284 (41.16) 142 449 (2.26) 250 337 (3.97) 336 470 (5.33) 328 598 (5.21)

5 830 846 (42.66) 293 098 (2.14) 847 609 (6.20) 1 030 168 (7.54) 775 889 (5.68)

7 828 474 (44.07) 370 117 (2.08) 1 196 629 (6.74) 1 556 681 (8.76) 1 124 925 (6.33)

1 580 022 (65.46)

3 654 138 (57.93)

8 777 610 12 076 826 (64.22) (67.99)

81,513 (3.38) 182,812 (7.57) 29,765 (1.23) 9,221 (0.38) 5,110 (0.21) 2,350 (0.10)

118,838 (1.88) 738,173 (11.70) 18,904 (0.30) 16,710 (0.26) 7,511 (0.12) 4,577 (0.07)

310 771 (12.87) 2 413 992 (100.0)

904 713 (14.34) 6 308 265 (100.0)

523,640 (3.83) 1,274,640 (9.33) 448,638 (3.28) 36,643 (0.27) 34,702 (0.25) 48,843 (0.36)

443,557 (2.50) 1,714,125 (9.65) 699,479 (3.94) 56,029 (0.32) 44,008 (0.25) 86,070 (0.48)

2 367 106 3 043 268 (17.32) (17.13) 13 668 332 17 761 978 (100.0) (100.0)

Source: Central Bank of China, Financial Statistics Monthly (various issues).

have grown quickly in terms of number of branches, have less than 10 percent of the market share. The foreign exchange market is the place where the exchanges of foreign reserves take place. The central bank and the authorized foreign exchange banks exchange foreign reserves mutually. Authorized foreign exchange banks include domestic banks and local branches of

112

Table 7.5

Number of units of financial institutions in Taiwan

Institutions Total Domestic banks Local branches of foreign banks Credit cooperatives Credit departments of farmers’ and fishermen’s associations Medium business banks Investment and trust companies Insurance companies Postal savings system Bills finance companies Securities finance companies

1961 December Firms Branches

1971 December Firms Branches

1981 December Branches Firms

1991 December Firms Branches

1993 October Firms Branches

409 10

1 369 260

431 14

1 897 417

441 15

3 060 580

495 17

4 196 773

526 34

4 388 1 145

1 80 291

1 153 385

6 78 294

6 228 394

24 74 284

24 286 784

36 74 311

47 499 1 096

37 74 312

32 522 851

8

84

8

118

8

195

8

298

8

402

1

1

6

6

8

31

8

70

6

49

17 1 –

34 451 –

24 1 –

80 648 –

23 1 3

167 1 023 5

36 1 3

181 1 121 20

50 1 3

156 1 258 22

–

–

–

–

1

1

1

1

1

2

Notes: 1. Data do not include the Central Bank of China, or the Central Deposit Insurance Corporation. 2. The number of branches includes head offices. Source: Ministry of Finance (1986).

Asia’s Financial Blues: The End of POLIS? 113

Table 7.6 Outstanding deposits and loans of financial institutions in Taiwan (NT$ mn, percent)

Institutions

1961

Domestic banks

14 120 (75.57) Local branches of 6 foreign banks (0.03) Medium business 915 banks (4.90) Credit cooperatives 1 892 (10.13) Credit department 1 105 of farmers’ and (5.91) fishermen’s association Postal savings 632 systems (3.38) Investment and – trust companies Life insurance 15 companies (0.08) Total

Items (end of year) Institutions Domestic banks Local branches of foreign banks Medium business banks Credit cooperatives Credit department of farmers’ and fishermen’s associations Postal savings systems Investment and trust companies

18 685 (100.0)

Deposits (end of year) 1971 1981 1991

1993

76 288 (65.21) 157 (0.13) 5 858 (5.01) 12 983 (11.10) 6 557 (5.60)

633 456 (53.48) 5,104 (0.43) 56 713 (4.97) 126 301 (10.66) 89 964 (7.60)

3 725 216 (42.90) 75 736 (0.87) 679 028 (7.82) 988 339 (11.38) 726 331 (8.36)

5 122 308 (44.79) 122 456 (1.07) 971 010 (8.49) 1 493 538 (13.06) 1 058 591 (9.26)

11 812 (10.10) 1 167 (1.00) 2 167 (1.85)

165 751 (13.99) 78 398 (6.62) 28 838 (2.43)

1 242 914 (14.31) 494,780 (5.70) 451 983 (8.66)

1 607 323 (14.05) 376 609 (3.29) 685 669 (5.99)

116 989 (100.0)

1 184 525 (100.0)

8 684 327 (100.0)

11 437 504 (100.0)

Loans (end of year) 1961

1971

1981

1991

1993

14 358 (82.15) 70 (0.40) 659 (3.77) 1 235 (7.07) 817 (4.67)

92 289 (75.54) 4 743 (3.88) 5 506 (4.51) 8 719 (7.14) 4 972 (4.07)

885 035 (66.94) 107 753 (8.15) 68 750 (5.20) 88 028 (6.66) 66 464 (5.03)

4 742 106 (63.45) 235 704 (3.15) 727 231 (9.73) 582 911 (7.80) 395 002 (5.29)

6 722 477 (62.83) 279 349 (2.61) 1 044 710 (9.76) 926 602 (8.66) 702 295 (6.56)

56 (0.32) 277 (1.59)

479 (0.39) 3 746 (3.06)

1 873 (0.14) 78 210 (5.91)

24 918 (0.33) 448 780 (6.00)

104 701 (0.98) 407 154 (3.81)

114 Interpreting East Asian Growth and Innovation Table 7.6 Outstanding deposits and loans of financial institutions in Taiwan (NT$ mn, percent) – Continued Items (end of year) Institutions

Loans (end of year) 1961

1971

1981

1991

1993

Life insurance companies

5 (0.03)

1 721 (1.41)

26 085 (1.97)

317 360 (4.25)

512 249 (4.79)

Total

17 478 (100.0)

122 184 (100.0)

1 322 198 (100.0)

7 474 012 (100.0)

10 699 537 (100.0)

Notes: Outstanding loans includes loans, investments and holdings of real estates. Deposits are those held by enterprises and individuals, plus government deposits. Source: Central Bank of China, Taipei. Financial Statistics Monthly, Taiwan District, Republic of China.

foreign banks. In 1992, there were 55 authorized foreign exchange banks, composed of 17 domestic banks (247 branches) and 38 foreign banks (48 branches).

Policies for financial system development Since World War II, Taiwan’s financing system has been strictly controlled. Although financial liberalization has been on the agenda, its speed was not accelerated until the 1980s. The major component of the financial system is the banking system. Therefore, when we discuss the development of the financial system, we always take the development of the banking system as being representative. The regulations on the establishment of new banks, regulations on foreign banks and the activities of bank operations have been significant historically. These restrictions have been gradually eased, but not completely erased. 1. Interest rate regulation and deregulation The purpose of regulation of interest rates at the beginning stage of economic development is to provide low-cost capital to entrepreneurs. After the economy grows to some extent, interest rate liberalization is pursued, presumably to improve the allocational efficiency of financial market. The government in Taiwan has controlled bank interest rates for a long time. Only in recent years have they been decontrolled. Prior to 1975, the government-prescribed interest rates for loans and deposits

Asia’s Financial Blues: The End of POLIS? 115

were all uniform. In 1975, the government required that uniform interest rates for deposits would be prescribed by the Central Bank of China, and that the ceiling and floor interest rates for bank loans would be fixed by the Interest Rate Recommendation Committee of Banks Association and subject to the approval of the central bank. The financial institutions can be further classified into several subsystems according to their functions and activities. Besides the commercial financing system, there is the trade financing system, the small and medium business financing system and the strategic industries financing system, among others. These subsystems other than the commercial financing system can be called the financial preferential system. This is so because they can engage in preferential financing for specific industries. Subsequently, several adjustments were made to gradually enlarge the range between the ceiling and floor interest rates for bank loans. The interest rates for banks debentures and negotiable call loans were allowed to fluctuate freely in 1980. In 1985, the ceiling limit for interest on loans was abolished, with only the floor limit retained. Since the promulgation of the new Banking Law on 19 July 1989, both the ceiling and floor limits for interest rates on deposits and loans have been abolished, and interest rate liberalization finally completed. The interest rate recommendation committee was dissolved at the same time. Before private commercial banks started operations, although interest rates could technically be decided by each bank, market interest rates remained quite stable for a period of time. The cost of capital for the three major commercial banks were similar so that their interest rate structures were also alike. After interest rate liberalization, they acted as the price leader for a while in a Stackelberg fashion. The interest rates of the three were identical most of the time. In effect, they monopolized the market. However, since the new private banks began to prepare for establishment in late 1991, the variances of the prime rate of different banks widened, from 0.24 percent before August of 1991 to over 0.45 percent after September 1991. The trend continued through the rest of the 90s. 2. Deregulation of private banks In order to completely secure the stability of financial markets and control the flow of funds, the government still prefers governmentowned financial institutions to private banks. However, the efficiency of government banks is considered to be much lower than that of private banks. Yang’s (1993) study on their relative efficiency supports

116 Interpreting East Asian Growth and Innovation

the above assertion. However, private banks have also been known to engage in risky lending as well. Banking privatization is one of major financial reforms in Taiwan’s financial history. Deregulation of private banks was allowed by the Banking Law of 1989. In June 1991, 15 new banks were authorized. By April 1993, 17 banks were established and operating, creating better service attitudes and more competition in the whole banking industry. However, Taiwanese authorities have become convinced of the need for prudential and other regulatory structures for private banks in the aftermath of the Asian crisis. 3. Control and deregulation of ownership of banks Owning the banks allows the government, to have the power to determine the direction of funds. From the viewpoint of public policy, the government can execute industrial policy through government banks better than through private banks. Banks in Taiwan were not allowed to be privatized until the Banking Law of 1989. Although there were four private banks, three of them were owned by overseas Chinese, the fourth being recast from the Bank of China for political considerations. Government banks have been criticized on the grounds that their operations restrict efficiency and their attitudes are much too conservative. In order to increase the banks’ ability to self-manage, some measures were attempted. The three major commercial banks sold their share of stock from the government to the public in 1990. However, this act was not successful because the stock market was in recession and few people purchased the stocks. The proposal of selling shares was then delayed further. In addition, several drafts of ‘The Law on the Management of Government Banks’ were proposed, written and modified, but they were not approved by the Legislative Yuan. As alluded to earlier, both privatization and regulation continue to be policy objectives in Taiwan. 4. Restrictions on foreign banks In order to attract foreign capital, local branches of foreign banks were welcomed. On the other hand, in order not to put too much pressure on local financial institutions, foreign banks are even now restricted to some extent. However, although restricted, activities of foreign banks did create some competition for local banks. In the face of the global tide of financial internationalization, the regulations on foreign banks were gradually reduced.

Asia’s Financial Blues: The End of POLIS? 117

The number of local branches for each foreign bank is clear proof of restriction. The foreign banks were allowed to open just one branch before 1986. In 1987, the legality of a second branch was first approved. In 1991, a third branch was also approved. By the end of 1989, each government bank had 55.7 branches on average, while foreign banks had just 1.2 branches. 5. Broadening of bank activities Following the declared trend of financial liberalization and financial internationalization, approved activities for banks were broadened gradually. For example, in the past, bills transactions were allowed to be conducted only by bills finance companies. However, in 1992 these activities were opened to some private banks. The Ministry of Finance moved to develop the banking industry into a universal banking system. But going slow has been the standard procedure while the declared policy is to liberalize and deregulate. 6. Toward financial internationalization Several steps have been taken to move toward financial internationalization. These include the following: 1. 2. 3. 4.

The establishment of foreign financial institutions. The establishment of foreign branches of domestic banks. Interbank call market for foreign reserves. The release of control on capital movement. The government-set limit on capital outflow per capita each year was $5 million, and capital inflow per capita each year was $50 000. This restriction has been adjusted to a $5 million ceiling for both capital inflow and outflow. 5. The plan to establish Taipei as an Asian financial center as part of the APROC plan. The government of Taiwan wants to follow Singapore, Japan and Hong Kong to become one of the Asian financial centers. Abundant savings, foreign reserves, and highlyeducated human resources can be advantages. However, some other features still need to be improved: free capital movement, a preferential tax system, information systems, and internationally accommodating financial regulations and affiliated financial services. It will take time for Taipei to reach appropriate standards and become a financial center with global credentials, if indeed it ever succeeds.

118 Interpreting East Asian Growth and Innovation

Financial preferential policy In order to stimulate industrial development and fulfill specific purposes, financial preferential policies were and still are often adopted by the government. Some financial subsystems were specifically established for this function. One can think of examples such as an export financing system, the small and medium business financing system, and the strategic industries financing system. Some selective credit policies were and still are occasionally executed as well. The special loans give some privileges to some selected customers. Such privileges include low interest rates and easier access to funds. Some special loans, such as strategic industry loans, are executed by the particular specialized banks. Some other loans are executed by domestic general banks and foreign banks. A good example would be loans for export. Others, such as small and medium enterprise loans, are executed by a combination of both specialized banks and general banks. The preferential financial subsystems have clearly been important in financing industrial development and more recently the building of a POLIS. A brief description and analysis can reveal the broad contours of this process. 1. The export financing system General commercial banks extend loans for exports with preferential interest rates, and provide easier financing terms for exports. The Export–Import Bank of China also plays an important role, providing insurance, loans and guarantees for exports. Ever since export promotion was proposed in the 1960s as Taiwan’s economic development strategy, export financing policy has been important. (Other export incentives include rebates of custom duties and commodity taxes on imported raw materials, tax exemptions, retention of foreign exchange earnings for the import of raw materials and machinery, and so on.) To some extent, Taiwan’s excellent economic performance during the 1960s and early 1970s can be attributed to its outward-oriented development policies which were supported by an inward-looking financial system. Export industries received high priority in credit rationing, and were granted low-interest loans to provide financing for reshipment production financing and the import of raw materials. After the 1970s, as a continuous trade surplus led to increased foreign exchange reserves, the authorities gradually reduced the interest rate difference. This preferential policy lasted for many years until 1989.

Asia’s Financial Blues: The End of POLIS? 119

In the trade financing system, the Export–Import Bank of the Republic of China (Eximbank) still plays a significant role. The bank was established on 11 January, 1979, and is a state-owned specialized bank which provides specific medium and long-term export–import credits and guarantee services under the supervision of the Ministry of Finance. Starting on 1 April of its founding year, Eximbank also took over the responsibility for the export insurance services from the Chung Kuo Insurance Corporation. In accordance with the Export–Import Bank of the Republic of China Act, the objectives of the bank are to support government economic and trade policies and to assist local firms in expanding external trade and engage in overseas investments, with the aims of promoting national economic development and further enhancing international economic cooperation. 2. Small and medium business financing system Small and medium businesses are the most active sector of the entire economy in terms of number of firms, employees, value of products and other relevant criteria. However, they still have difficulties obtaining loans from formal financial markets. In order to solve this problem, a small and medium business financing system was established within the formal financial system. This system is composed of banks, – that is, commercial and special banks (medium business banks), Medium Business Credit Guarantee Funds (MBCGF) and the small business Integrated Assistance Center. The following functions are provided by this system. 1. Financing. In addition to commercial banks, the medium business banks are the specialized banks which do SME financing. These specialized banks were transformed from mutual savings companies after 1975 when the Law of Banking was revised. Only one of them is government-owned, the Medium Business Banks of Taiwan (MBBT). All others (regional) are private. Each bank has its own channel for its source of funds. The MBBT accepts transfer deposits from the postal savings system and the support of the government Development Fund of the Executive Yuan. Special loans in various programs are usually lent out through government banks. Furthermore, the credit cooperative associations and credit departments of farmers’ and fishermen’s associations are not directly connected with SMEs, but they may provide part of the funding demand of SMEs.

120 Interpreting East Asian Growth and Innovation

2. Guarantees. The establishment of the SMBCGF (Small and Medium Business Corporations General Financing), a non-profit organization, provides vital assistance to SMEs that usually do not have healthy financial structure or sufficient collateral. The SMBCGF not only provides credit guarantees to SMEs that are rich in development potential and lack collateral, assisting them to obtain financing funds from financial institutions for sound development, but also simultaneously shares the financing risk with the financing institutions to enhance the institutions’ confidence in SME financing. 3. Assistance. In July 1982, seven provincial banks donated funds to establish the Small Business Integrated Assistance Center to provide assistance to SMEs that encounter difficulties in applying for financing through provincial banks or suffer unhealthy financing management. Financing diagnosis and financial management assistance are two primary service items of the center. The functioning mechanism of the entire SME financial system can be described as follows: An SME applies to banks directly for financing. If the bank is skeptical about the SME’s capability of repayment, the bank may apply to the SMBCGF to guarantee a certain percentage of the loan. The SME may also ask for diagnostic assistance of its operation, management, technology and marketing in order to prepare a report as a reference to encourage the bank to approve the loan.

Strategic industry financing system This is perhaps the most crucial for our purpose. The building of a POLIS would have been impossible without this. Preferential policies for strategic industries were introduced in 1982 and six criteria were adopted which the selected strategic industries must meet to be so designated: high linkage effect, high market potential, high technological intensity, high degree of value added, low energy coefficient and low level of pollution emissions. Within these strategic industries, certain products are designated to be actively promoted, most of which are in the mechanical engineering products sector and the information and electronics sector. The list of selected products has been amended several times and a few products from the biochemical and material industries were included after 1986. Taiwan’s government offers two preferential measures for the purpose of subsidizing the strategic industries. One is preferential loans, the other is technology and management guidance. Preferential

Asia’s Financial Blues: The End of POLIS? 121

loans are administered both by a pool of funds administered by the Bank of Communications and by a pool of funds administered by the Medium Business Bank of Taiwan. Funds for both pools are supplied partially by the government’s Development Fund. Yang (1993) evaluated the costs and benefits of this policy empirically and found that the amount of the ratio of financial support does not seem to play an important role in the technology improvement and management improvement activities of firms. However, re-estimating Yang’s relationships using more recent and detailed data shows an absolute as well as a ratio effect. On both counts the preferential policies have successfully directed credit to strategic industries with positive effects. In 1992, the Six-Year National Development Plan was promulgated. In this plan, some new key industries were added, mainly from sectors such as biochemical and material industries. The recent policy affirms this trend and tries to deepen it. Originally, the plan targeted total expenditures of NT$8 trillion. This amount would require a great deal of domestic savings and foreign capital to accommodate the investment. In 1993, the size of plan was reduced to a smaller scale. However, the need for funds is still very acute. In order to solve the funding problem, the government designed several methods of collecting funds, such as the issuance of government bonds, an increase of tax bases and even the setting-up of a ‘Japanese’-style fiscal investment and loan program to pool postal savings and pension funds. The appropriateness of these approaches were widely discussed domestically. In the aftermath of the financial crisis in Asia, domestic investment went up further. One might look at the lengthy description of the monetary and financial controls and simply conclude that these are inappropriate instruments for a complex economy making its transition to a POLIS. However, such a conclusion would be hasty for at least two reasons. First, Taiwan has shown itself capable of reforming the financial system slowly while creating a POLIS. Second, the plight of Korea shows that the hubris of fancying that one is a member of the club of privileged countries that led to deregulation is indeed a tragic flaw. The contrasting examples of Korea and Taiwan show that building a POLIS requires a healthy financial system. The health of the financial system depends on a deft combination of market and non-market institutions. Overregulation can cripple an economy. So can a sudden and inappropriate move towards financial liberalization. The oldfashioned virtues of prudence and caution seem attractive all of a sudden after the economic tragedy in South Korea.

8 Conclusions

In a study that deserves to be much more widely discussed than it has been so far, Kazushi Ohkawa (1993) advances the hypothesis that ‘the varied growth performances of developing economies’ are to be explained primarily by each nation’s social capability to absorb knowledge which will permit the capital formation necessary to raise production capacity. Without ignoring the traditional sectors completely, Ohkawa emphasizes the need for stressing the modern manufacturing sectors. However, Ohkawa also limits his study to considering only the so-called imitative processes of technological change. Even this restricted scope allows him to consider the importance of technology (albeit borrowed technology) in the growth process. In this study I have allowed the technological aspect of growth in East Asia to take the next logical step. That is to say, I have tried to go beyond the study of catch-up technology and to raise the question of innovation processes – Schumpeterian or otherwise – in countries like Korea and Taiwan. Somewhat provocatively, the study has addressed the question of the analysis of growth in East Asia by focusing directly on the ‘miracle’ of East Asian growth literature. This has the advantage of showing clearly what is missing from the current debate. But it also carries the danger of overstating the role of technology at the expense of some of the other factors discussed in the literature. I hope the reader will agree that an attempt has been made to avoid this danger. However, I will let the reader decide whether I have succeeded in this attempt. The analysis of growth in East Asia here relies crucially on a number of emerging concepts with regard to the operation of complex production economies. Our understanding of complex economic systems in particular is still in its infancy. Therefore, the concepts developed here 122

Conclusions 123

and their empirical applications can be only provisional and tentative. In particular, the idea of a POLIS should be given more detailed formalization in future work. This should take into account the role of stochastic elements as well as time more completely than do the abstract models of Chapter 4. In empirical applications as well, more detailed modeling using flexible prices and decision-making over time using intertemporal budget constraints should improve applied work considerably. Applied dynamic CGE models can be used to model POLIS in equilibrium. Departures from equilibrium can also be addressed rigorously in appropriate variants of such models. Of course, such models will rely mainly on ‘structural’ features of technology systems as the heart of the explanans schema rather than on marginal price adjustments at the same time as the effects of such adjustments are taken into account. The above qualifications notwithstanding, the present approach does reveal that analyzing complex technological systems can be a rewarding exercise, even at the current crude level of our knowledge. However, the already substantial literature on East Asian growth shows a schizophrenic state of affairs in this regard. At the detailed institutional level of description and analysis complexities are often acknowledged and their implications are explained. In the formal, theoretical work simplifying assumptions are made about the nature of the economy. Such simplifications, it can be argued, are necessary and inevitable. It is certainly understandable that as theoretical economists we want to keep our models tractable. Yet quite often we forget that such tractability is often purchased at a price. In the immortal words – at least among economists – of Milton Friedman, ‘There is no such thing as a free lunch.’ Forgetting this fact has led some to make claims about the East Asian growth process that ignore crucial and fairly wellknown features of the East Asian economies. In trying to understand the nature of this growth process at the aggregate level, some economists have shown considerable ingenuity. Yet the ensuing debate about the econometric results has often ignored the complications that such approaches avoid. Thus there have been heated discussions that have failed to shed much light on the particularities of the growth process. To paraphrase Richard Brinsley Sheridan, the literature is voluminous but not always very luminous. A ready response to the above characterization of the present state of research on East Asian growth can justifiably be to ask what other alternatives there are. Truly, if the somewhat dichotomous and

124 Interpreting East Asian Growth and Innovation

independent theoretical and institutional approaches are the only two possibilities, then we are at an impasse. However, it needs to be recognized that this impasse is at least partly of a theoretical and conceptual nature. It is the task of a more appropriate theory to break out of a certain simple mode in which the investigation has been confined so far. One need either denigrate the theoretical attempts made so far or deny the role of abstractions in order to advance the debate. Quite to the contrary, theory will always require a certain distance from the so-called real world. In order to achieve clarity and insight a set of appropriate abstractions will always be the sine qua non for a theoretician. The challenge is to make abstractions that are likely to provide further illumination. The abstract models of Chapter 4 were motivated by these concerns. Without claiming completeness they show the possibilities for theorizing about complex economic structures. Once both appreciative and formal theoretical works, to use Richard Nelson’s memorable distinction, start to move in this direction then further conceptual innovations and formal rigor can proceed hand in hand. The concrete results obtained so far in the chapters on Korea and Taiwan show how the idea of a POLIS can be operationalized. Although this operationalization in the present instance has involved linear approximations to a non-linear model, future work can attempt to overcome this problem. The tentative interpretation of the results is that both Korea and Taiwan show a modest POLIS effect. In other words, they are beginning to build structures of innovation that could possibly prove to be self-sustaining. Whether such self-sustaining virtuous positive-feedback loops in the innovation systems will become a reality is not certain, however. Much more patient work at the micro level on specific sectors and industries may be necessary for a definitive answer to the question of a sustainable POLIS. In this book, a small beginning in this direction has been made. In Chapter 5, attempts by the electronics sector in Korea to build an innovation-led production system were explored. In particular, the efforts of Samsung Electronics Company seem to be headed in the direction of creating a domestic innovation structure. However, the economy-wide effects are still not clearly noticeable. It will perhaps take some time before such effects become discernible. There are also problems ahead that must be solved. At the same time there are good reasons to believe that in an economy-wide sense there is some movement towards a POLIS. This could be encouraging news. This overall effect is clearly not caused by

Conclusions 125

just one company; there are many sectors of the Korean economy using modern technology that are trying to innovate. Once again, lasting success can be measured only as time passes. In judging the potential for lasting technological success for a country like Korea (or for any other country, for that matter) financial factors cannot be ignored. Sudden pressures on immature financial systems called upon to support the building of a POLIS may lead to a shortage of funds. On the financial side itself, quick liberalization or lack of prudential regulation can lead to excess volatility affecting long-term financing of projects crucial to the building of a POLIS. A detailed discussion and analysis of the complex issues involved here are the subject of a future volume. But the preliminary analysis in Chapter 7 shows how financial fragility can imperil the POLIS-building project. Elsewhere I have addressed the problems of the Asian financial crisis in the context of both globalization and the developmental state (Kumssa and Khan 1998, Khan and Siregar, 1998). It has been argued, for example, that countries such as South Korea or MIT (Malaysia, Indonesia and Thailand) turned out to be inconsistent developmental states (IDS). An IDS is characterized by developmental goals and policies that are not consistent over time. In a systemic sense the dynamic time-inconsistency creates a type of financial fragility that elsewhere I have called organic financial fragility. Roughly, organic financial fragility results from the political economic processes within the economy itself. Policies change, as they must with different stages of development. But there is usually an incongruence between the demands for the creation of POLIS and the developments in the financial sector leading towards premature liberalization. The contrast between Korea and Taiwan illustrates this. The example of Taiwan also shows that the dangers of organic financial fragility must be recognized in time. Thus the historical evolution of the financial sector in Taiwan must not be read as an exceptional case. Rather, it is a clear example of how a certain caution is a necessary element in institution-building in the financial sector. Needless to say, the caution may at times be simply a product of bureaucratic inertia. The policy message from the theory of organic financial fragility is not to keep financial institutions in a static state of suspended animation. Rather the message is to create institutions that, through a system of checks and balances, can monitor themselves. A set of imperatives for institutional change at different stages should flow naturally from this type of self-monitoring. Thus the need for a regulatory environment

126 Interpreting East Asian Growth and Innovation

complementing the market should be a natural corollary of the organic financial fragility approach. Following this approach a state can transform itself from being an inconsistent developmental state to a relatively more consistent development state – at least in the sphere of financial institutions development. Such development should make the economic signals from POLIS-building activities and the financial institutions mutually consistent. Turning again to the building of POLIS – let us recall that in Chapter 6 the innovation system for Taiwan was studied. Here again, interestingly, an overall economy-wide POLIS effect was found. What is even more interesting is that this effect was somewhat stronger for Taiwan than for Korea. In contrast to Korea, Taiwan is dominated by small and medium firms, and therefore a Chandlerian economies of scale and scope story cannot be told so easily in this case. What may be happening in the Taiwan example is that small and medium firms are utilizing bold catch-up strategies and are using human resources to complement R&D at the same time. The study of the electronics sector shows that to a great extent this may be true. Here again, it would be foolhardy to predict an ongoing sustained cycle of innovations. All one can say is that in the absence of major political upheavals, capital flight or labor unrest, and so on, Taiwan stands possibly the best chance of forming a genuine positive-feedback loop innovation system among all the newly industrialized economies. However, any further predictions must be unfounded at our present level of understanding. The evolutionary approach to technical change implicit in the idea of technology systems adopted here implies that many fortuitous circumstances may make the task of (mechanical) prediction hazardous at best and worthless at worst. Technological transitions and the creation of a POLIS through a combination of favorable circumstances and policies are certainly possible but not inevitable. In explaining such possibilities for Korea and Taiwan, it would appear that outward-looking strategies with minimal distortions are to be preferred over continuous import substitution and protectionism. Yet one must not forget or ignore some important nuances. As Dani Rodrik, among others, has pointed out, countries such as Korea and Taiwan did not mechanically follow what has come to be known as the Washington consensus. Table 8.1 illustrates this last point. Rodrik gives Korea a score of ‘about five (out of ten)’ on following the current orthodox prescriptions. He points out that Korea ‘managed fiscal expenditures and revenues rather well, avoiding macroeconomic

Conclusions 127 Table 8.1

The ‘Washington consensus’ and East Asia

Elements of the washington consensus 1. Fiscal discipline 2. Redirection of public expenditure priorities toward health, education and infrastructure 3. Tax reform, including the broadening of the tax base and cutting marginal tax rates 4. Unified and competitive exchange rates 5. Secure property rights

6. Deregulation 7. Trade liberalization 8. Privatization

9. Elimination of barriers to direct foreign investment (DFI) 10. Financial liberalization

South Korea

Taiwan

Yes, generally Yes

Yes Yes

Yes, generally

Yes

Yes (except for limited time period) President Park begins his rule in 1961 by imprisoning leading businessmen and threatening confiscation of their assets Limited Limited until the 1980s No; government established many public enterprises during 1950s and 1960s

Yes

DFI heavily restricted Limited until the 1980s

Yes

Limited Limited until the 1980s No; government established many public enterprises during 1950s and 1960s DFI subject to government control Limited until the 1980s

Sources: Williamson (1994) for South Korea; Rodrik (1996) for Taiwan.

stop–go cycles and high inflation – [South Korea] also consistently maintained unified exchange ratio – and competitive parities for the most part (Rodrik 1996: 18). However, Korea also had financial repression (or, to use Stiglitz’s term, ‘financial restraint’) and subsidized credit. The import regime was not liberalized very significantly until the 1980s. Administrative guidance occurred (although the expression was not official, as in Japan) in the form of heavy interference in the private investment decisions of the firms. As Amsden (1989) and

128 Interpreting East Asian Growth and Innovation

Jones and Sakong (1980) among others have pointed out, instead of privatizing the public enterprises, Korea actually increased its reliance on such entities in the 1960s. These observations raise a puzzle that has not been resolved in a satisfactory way in the existing literature. How could Korea (and more generally the East Asian tigers with the exception of Hong Kong) avoid the disasters usually associated with interventionist policies? How could protectionism, credit subsidies and industrial policy work in countries like Korea when they seem to have failed in other developing countries? Although the larger parts of such questions may not be answered with certainty at present1 in the area of technology and innovation, it is clear that Korea and Taiwan were able to ‘discipline’ the private sector. At the same time, incentives were created to identify innovative activities and carry them out. Apart from the usual homilies about ‘hard’ versus ‘soft’ states, one might be able to go further by looking at the initial conditions for the take-off of these economies. The first special feature in both cases is a high degree of emphasis on education. This led to the opportunities for creating a skilled labor force for the kind of technological transition discussed here. The second factor, however, was perhaps of even greater political economic importance. In contrast with many other developing countries the income and wealth inequalities in Korea and Taiwan were not very high in the 1960s. Structural reforms (for instance, land reform) and historical accidents both account for this state of affairs. The absence of large landed or industrial interest groups gave the government a certain kind of autonomy. Instead of having to mediate among conflicting social and economic sectors, the government could in fact follow almost consensual growth-oriented policies. Perhaps this autonomy also made possible a rigorous supervision of bureaucracy and prevented it from being captured by one special interest group or being too intrusive. Recent work (for example, Alesina and Rodrik (1994) and Persson and Tabellini (1994)) on the relationship between equality and growth would seem to corroborate this point. It must be admitted that we still do not understand very well the precise dynamics of the relationship between equality and growth. However, an initial situation of severe inequality may well foreclose the autonomy that states may need to pursue a modern technological transition towards development. Instead of distribution being a minor, subsidiary concern – if at all – the findings of this study should make it a central concern for developing countries. Policies for egalitarian

Conclusions 129

distribution may also have further technological development implications as well. These policies may lead to a well-nourished, educated labor force willing and able to participate in a technologically advanced economy. Thus, a nuanced, distributionally sensitive technology policy under appropriate historical conditions could lead to the creation of a POLIS where self-sustaining innovation becomes the defining characteristic. Finally, it should be emphasized that the whole miracle-vs.-myth debate avoids at least one central normative issue in economic development. Will growth enhance the welfare and quality of life of the great majority of people in these economies? In terms of the capability approach of Sen and Nussbaum (1993) and others2 one can ask: will growth be capability-enhancing? It is crucial to answer this question in order to assess the qualitative importance of growth, with or without a POLIS. This, however, is the task of a future volume.The theoretical approach outlined in this book already contains distributional linkages; but a full analysis of economic well-being within a POLIS only begins at this point. Thus, the end of the present work can be considered only the beginning of future work on the full social meaning of POLIS.

Notes 1

Introduction

1. World Bank (1993); Lucas (1993). It will be clear from the argument developed in the subsequent chapters that the treatment of technology in these widely cited pieces leaves much to be desired. Innovation requires a base of physical and human capital; but it also requires an institutional set up, knowledge creation and application on a sustained basis. The concept of a POLIS is meant to capture these complex processes in a systemic manner. 2. The reader may note that the literature on the endogenous growth theory with interactions between human capital and R&D also offers prospects of sustained growth. Of course, critics in the past have pointed out that any theory that allows growth without limits ignores the second law of thermodynamics. See for example Georgescu-Roegen (1971), Daly and Cobb (1989) and Boulding (1966) among others. Therefore, the energy and environmental constraints that might apply should be kept in mind. But for any such set of constraints the above conditions mentioned in the text are assumed to apply when a POLIS exists.

3

The Myth of an Asian Miracle?

1. Indeed after repeating the exercise for a cross-section of Asian economies separately, I could not reject this hypothesis either. 2. Unless one were to assume, in addition, that the ‘true’ depreciation rate is higher in the developing countries than in the developed countries, because of various factors such as the mix of outputs. However, we may also note that Japan, which is supposed to have a high ‘depreciation’ rate, also has a high estimated rate of capital augmentation. In any case, given the magnitudes of the estimated capital augmentation rates of the developed countries, the implied ‘true’ depreciation rates would have to be implausibly high. 3. Another way in which there may be little or no net increase in value added, even with the adoption of new equipment and technology, is if critical components that are needed as intermediate inputs can be imported only at high monopolistic prices. Thus, the benefits of the new technology are appropriated by the foreign manufacturers and suppliers of the critical components. Examples of such critical components include microprocessors, liquid crystal displays, and MS-DOS and Microsoft Windows softwares for notebook computers; plastic lenses for cameras; and recording heads for video-camera recorders.

4

Making a Miracle: A New Approach

1. It seems to me that theories of both types engage in conceptualization and the exploration of logical relations among concepts. However, appreciative theory proceeds without the help of a formal mathematical apparatus most of the time. 130

Notes 131 2. Solow (1994) is an attempt to assess the achievements and the shortcomings of the new growth theoretical models, as discussed later in this chapter. 3. Khan (1997a) presents some preliminary thoughts and a model (in Chapter 2) emphasizing this point. 4. The recent debate on convergence can also be viewed in this context as countries moving through different paths and different equilibria forming a complex of dynamic trajectories. 5. As the subsequent discussion shows, complementarities between R&D and human capital may be far more important than has been thought previously. This is a major aspect of the positive feedback loop innovation systems discussed later. 6. Both types of specifications are possible in principle. In practice, as in the case of South Korea in Chapter 5, the availability of data will often determine what type of specification will be used. 7. If SAMs are available at regular intervals (Indonesia is one such country), then models with flexible prices, different closure rules, etc., can be constructed over time. 8. This does not imply that these relationships are fixed. The reasonable interpretation is that for distinct two technology systems the range of covariations among the different variables will show distinct and regular patterns in each case. These covariational differences will then establish the differences between the two technology systems. 9. For a description of SAM as a data gathering device, see Pyatt and Thorbecke (1976). 10. In Walrasian general equilibrium models the flexible price vector determines the equilibrium. In a Keynesian (dis)equilibrium model in the short run the quantities vary while the price vector remains fixed. It is, of course, possible to build more complex models of CGE variety based on both orthodox and heterodox economic theories. 11. See Khan and Thorbecke (1976) ch. III; the presentations here follow the cited work closely. 12. Ibid. 13. See Pyatt and Round (1979).

5

Korea: The Making of a POLIS?

1. As emphasized earlier, the evolutionary approach to technology followed here is definitely not a mechanical theory. Even in the economic realm, complexities and uncertainties in economic interaction will take the analysis further from standard practice. The challenge is to do this in a rigorous and (if possible) formal framework. 2. The SAM-TECH built by Thorbecke can be found in Svejnar and Thorbecke (1980, 1982).

6

Taiwan: Builing a POLIS

1. Of course, it is not being claimed that having an apparently self-sustaining innovation structure in one sector is sufficient for a POLIS. For this we must examine the economy-wide linkages.

132 Notes

Conclusions 1. World Bank (1993) and Fishlow et al. (1994) present two divergent approaches and conclusions on this. 2. See also the discussion by Crocker (1995) and Khan (2001b).

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Index ACER 81, 85 ,86, 87 Alam, Shahid 3 Amann’s fixed point theorems 6 Amsden, Alice 3 Arrow, K.J. 33, 35, 61 Arthur, Brian 35, 36 Asian Development Bank 145

financial structures 95, 105 financial system 95, 103, 104, 105, 106, 107, 110, 114, 118, 119, 120, 121 Friedman, Milton 123

backward linkages 47, 49, 51 Banach space 6, 43, 45 bank 10, 11, 12, 66, 67, 75, 90, 95, 98, 99, 100, 101, 102, 103, 104, 106, 107 Bank of Taiwan 121 Bardhan, P. 62

Hanbo group 8 Hobday, Michael 81, 82, 83, 85, 86, 87, 88, 150, 169 HPAEs (high-performing Asian economies) 8, 9, 10, 31 human capital 3, 5, 6, 9, 10, 13, 14, 16, 19, 20, 23, 24, 34, 37, 38, 39, 49, 60, 64, 71, 77, 82

GDP

capabilities 6, 48, 67, 73, 138, 140, 157, 164 capital augmentation rate 20 capital market 99, 106, 107, 108, 109, 110, 133 Central Trust of China 57 Chandlerian economies of scale 126 compact 45, 46 complexity 6, 35, 40, 41, 171 consumption 15

imitative 83, 92, 122 increasing returns 6, 22, 30, 35, 42, 43, 60, 61, 62, 75, 76, 91, 135, 156, 161, 168 innovation system 1, 5, 17, 32, 37, 39, 40, 41, 42, 46, 47, 56, 60, 61, 64, 68, 69, 75, 77, 91, 140, 150, 153, 154, 163 Inter-American Development Bank 174 interest rate 67

diffusion channels 84 diffusion of technology 66 diffusion technology 134, 137, 141, 143, 144, 146, 147, 171, 172, 175 disequilibrium 42, 52, 151, 159

James, Jeffrey

East Asian miracle 14, 17, 30, 39 employment 48, 49, 50, 51, 76, 151, 153, 156, 157, 170 endogenous accounts 43, 53, 54 exogenous accounts 43, 53, 54 FDI (foreign direct investment) 42–3, 65, 69 financial liberalization 96, 97, 98, 117, 121, 127

9, 12, 21, 23, 29

3, 49, 50, 51, 140, 151

Kaldor, Nicholus 35, 61, 62 Kaldor–Mirrlees model 61 Khan, Haides A. 3, 5, 37, 38, 49, 50, 51, 52, 53, 54, 64, 65, 66, 67, 68, 74, 75, 125 Kim, Euysung 3, 75 King, Gregory 51 Korean Development Bank 101, 155 Krugman, Pane 3, 4, 5, 18, 19, 24, 35, 36, 39, 59 lattice

179

6

180 Index Lau, Lawrence J. 3, 19, 20, 21, 22, 23, 24, 29, 30, 59, 89, 137, 154, 157, 158 Lucas, R.E. 3, 12, 13, 14, 15, 16, 17, 33, 37, 61, 130, 159 marginal expenditure propensity 55 marginal productivity 23, 31 Ministry of Finance (MOF) 11 Ministry of Science and Technology (MOST) 73 Ministry of Trade and Industry (MITI) 11 modern systems of technology 3 modern technology 1, 48, 49, 50, 51, 52, 55, 64, 65, 68, 73, 76, 79, 80, 89, 125, 173 modSAM-Tech 75, 76, 90, 91 money market 106, 107, 108, 109, 110 multiple equllibria 5, 6, 35, 36, 37, 38, 40, 41, 43, 44, 45, 48, 60 Nelson, Richard 1, 2, 3, 30, 31 neoclassical growth model 3 neoclassical growth theory 29 new growth theory 32, 35, 36, 37, 61, 62, 131 newly industrializing economics (NIEs) 8, 12, 24, 29, 37 non-linear 36, 40, 41, 42, 43, 44, 46, 52, 60 non-linearities 42, 47, 52, 60 Nussbaum, Martha 129, 140, 164, 171 OECD 34 OEM (original equipment manufacturing) 85, 86, 87, 88, 150 Pack, Howard 2, 3, 30, 31 Page, John D 31 POLIS 5, 6, 7, 19, 24, 41, 42, 46, 47, 53, 59, 60, 61, 62, 64, 65, 67, 68, 69, 70 productive activity 5, 42, 43 productivity growth 2, 4, 14, 15, 17, 24, 25, 27, 28, 29, 37, 62, 64

productivity miracles Pyatt, Graham 51 QWERTY

13

36

R&D 6, 21, 22, 23, 30, 71, 73, 80, 82, 85, 88, 89, 91, 95, 126, 130, 131, 133, 137, 140, 148, 155, 159, 160, 162 R&D link 56 Robinson, Joan 35 Robinson, Sherman 12 Rodrik, Dani 126 Romer, Paul M. 32, 33, 34, 37, 61 SAMs (social accounting matrices) 6, 41, 42, 43, 46, 47, 49, 50, 51, 52, 53, 54, 55, 73 SAM-Tech 67, 73, 74, 75, 76, 81, 89, 90, 131 Schumpeter, Joseph A. 2 Schumpeterian 47 Sen, A.K. 61, 129, 164, 170, 171 small and medium business 144 Smith, Adam 35, 39 Solow, Robert 4, 32 state v. market debate 4, 6 Stewart, Frances 47, 48, 172, 173 Stone, Richard 51 strategic complementarity 23, 37, 39, 60, 167 strategic industry 120 strategy 12, 13, 15, 17, 52, 53, 57, 59, 60, 66, 68, 69, 70, 75, 78, 80, 83, 89, 91, 92, 137, 138, 140, 141, 150, 157, 165, 168 Tarski’s fixed-point theorem 6, 45, 63 Tatung 81, 83, 85 TDPA (Technology Development Promotion Act) 65 technological spillovers 34 technology 1, 2, 3, 4, 5, 10, 13, 14, 17, 19, 20, 21, 22, 27, 30, 32, 33, 35, 36, 37, 39 technology systems 36, 40, 41, 42, 43, 46, 47, 48, 49, 50, 51, 52, 55, 56, 57, 58, 60, 62

Index 181 Thorbecke, Erik 38, 51, 52, 53, 54, 74, 131, 134, 141, 153, 166, 174, 175 technology imports 65 total factor productivity (TFP) 4, 17, 24, 25, 26, 27, 30, 34, 39, 58, 60, 89, 139, 144, 145, 150 unemployment 91, 146 United Fiber Optic Communications Inc. (UFOC) 88

venture capital

67

Washington Consensus 127 Weitzman, Martin 11 World Bank 2, 3, 8, 9, 10, 11, 12, 133, 136, 137, 138, 139, 140, 141, 152, 156, 157, 158 Young, Alwyn 3, 14, 19, 24, 25, 27, 29, 31, 89, 165, 178