In This Issue

China The Right Response to IP Underdevelopment China GDP Revision Implemented Over 1993-2004 Argentina Abundance Argentine Style View GEF Archive

* The dominance of government over the market is a major barrier to IP development: The overwhelming power of the bureaucracy versus the market is a major deterrent against IP development.  Businesses tend to focus on short-term gains in such an environment.  China must limit government power to create an environment conducive to long-term corporate development, I believe.

* A ‘quick money’ psychology is preventing development of research universities: China’s universities appear to be focusing on leveraging their names to make quick money rather than teaching or research.  In my view, research universities should lead China’s IP development, and more research universities need to be developed.

Summary and conclusions

The Chinese government appears focused on promoting the development of indigenous intellectual property (IP).  Foreign capital and cheap labor-led exports and government-led fixed investment have powered economic development in the past 25 years.  Even though China has a large domestic market for consumer and technology products, foreign brands dominate its consumer market, and China’s investment depends on foreign technologies.  China has not created either a popular brand or a major technology.

The successful transformation of South Korea from a cost and quantity-led economy into a brand and technology-led one in the past five years has stimulated China’s desire to attempt the same.  The Chinese government will probably introduce substantive policies to promote the development of indigenous brands and technologies in 2006.  While these intentions are good, the government’s policies may not be able to archive its goals.

Tax incentives, standards and government procurement would likely be the instruments.  However, these would not address the problem of a prevailing ‘quick money’ psychology — the most important factor in the stunted development of consumer brands and proprietary technology — that is gripping China today. 

The overwhelming power of the government over the market is the main factor that drives the short-term perspective of Chinese businesses, I believe.  The best policy to promote the development of indigenous technologies and brands, in my view, is to decrease the power of the government and increase the role of the market in this area.

The limits to China’s development model

Foreign capital and cheap labor-led exports and government-led fixed investment have powered China’s economy over the past 25 years.  It has been a spectacular success.  The model leverages: (1) the export expertise among overseas Chinese to generate income with China’s vast labor pool; and (2) the strength of Chinese bureaucracy in mobilizing resources.   China’s real per capita income has averaged an 8.1% annual growth rate in the past quarter century. 

Despite its past successes, there is widespread angst among Chinese policymakers on its sustainability.  Three factors drive the anxiety.  First, overcapacity, even in infrastructure, is quite pronounced.  This has limited the economic benefit of the Chinese bureaucracy mobilizing resources for big projects.  The continuation of the current model could lead to more waste and eventually slower growth.

Second, China’s exports have become too big to sustain the current high growth rates.  They increased by 41 times or at 16% per annum between 1980 and 2005.  Mathematically, it is impossible for China to repeat this performance over the next quarter century or even the next decade.  If the current trend remains for another decade, China’s exports would become bigger than the combined total of Europe, Japan and the US today.  As these three economies are China’s main customers, this would be highly unlikely.  China’s export growth rate would likely cool to 6-8% annual growth over the next decade from 16% in the past, I believe.  Domestic demand therefore needs to play a bigger role for China’s growth to sustain.

Third, the quantity-led model has caused excessive environmental degradation and depletion of natural resources.  Eighty percent of China’s water resources are polluted, which could cause a health crisis.  China consumed 2.1 billion tons of coal last year and, if the trend continues, would consume twice as much in 10 years.  China accounts for 12.6% of global coal reserves but one-third of coal consumption, according to BP Energy.  If current trends persist, it could use up its coal reserves in four decades.

Chinese policymakers have raised concerns over the sustainability of growth in the past.  The last Five-Year Plan tried to focus on improving the quality of economic growth, but it failed to achieve a significant result.  The next Five-Year Plan to be unveiled in March 2006 will likely try again.  Yet I am concerned that the plan may not address the key issue here: the role of the government versus the market.  As long as the government adheres to a bureaucratic approach as opposed to a market-driven one, the growth model will be hard to change, in my view.

Responding to the Korea challenge

The success of Korea in transforming its economy from one characterized by quantity to a quality-based one in just five years has caused tremendous anxiety among Chinese bureaucrats.  They thought that Korea was similar to China, and the man in the street shared that view.  But Korea has taken off.  Only five years ago, it was still considered a typical East Asian economy that depended on low labor cost.  Today, Korean businesses have developed world-beating brands and products.

Indeed, the Chinese market has been instrumental in Korea’s transformation.  The fact that Chinese growth has contributed to Korea’s transformation into a high value-added economy rather than doing so for China itself has caused added anxiety at home.  It has spotlighted the inadequacies of the Chinese system, and there is growing determination among Chinese bureaucrats to ‘do something’.

It is quite likely that the government would unveil a slew of policies to encourage indigenous growth of intellectual property (IP).  China’s strength lies its bureaucracy.  When the government wants to ‘do something’, it usually adopts a bureaucratic solution.  Tax incentives for targeted industries or activities are the most likely proposals, in my view.  As government finances have improved tremendously in the current boom, it is in a position to give out largesse.

Throwing money at the problem, however, may not be the most effective way to deal with it.  The absence of IP creation in China’s growth is not mainly a tax incentive issue, I believe.

The crowding-out effect of a dominating government

The overwhelming power of the government over the market in China is the primary factor behind the underdevelopment of the country’s private sector and the rarity of IP creation, in my view.  Bureaucratic power, rather than market rules, dominates China’s economy.  While there are rules, they can be changed arbitrarily by bureaucrats.  In such an environment, long-term business planning is not very meaningful.

A ‘quick money’ psychology is gripping Chinese society in general and the business sector in particular.  Cheap money is a very important factor, but the arbitrary power of the bureaucracy is the critical factor behind such a mentality in the business sector in two ways.  First, private businesses are unable to plan for the long term because they worry that their businesses could be taken away or ruined by rule changes.  Hence, they want to focus on short-term opportunities.

Second, managing relationships with the very strong bureaucracy is often at the heart of private companies’ business strategies.  By working with bureaucrats, companies are able to create short-term advantages to make profits.  This is why most private businesses depend directly or indirectly on government power for profits.

World-class companies emerge by winning in competitive markets.  When the government picks the winners, those winners rarely turn out to be world-class.  In my view, the Chinese government should accept that great companies can only emerge from a competitive market based on fixed rules.  The government’s main job, therefore, should be to foster such a rule-based competitive environment.  Some government directed interventions are necessary but must be thoroughly thought through.  Throwing money around usually leads to waste.

Reversing the ‘quick money’ psychology on campus

There are currently two models for technology creation: 1) the Japanese mode, which is based on sizeable R&D budgets at large companies — Korea has adopted this model; and 2) the US model, which is based on research universities turning out basic ideas that companies commercialize through a licensing system.  Both models can be successful.

Given China’s size, it could adopt both models.  However, as family or government-controlled businesses tend to dominate Chinese economies (Taiwan, Hong Kong and Southeast Asia), they are not well suited to company-based R&D, I believe.  Government-controlled businesses usually waste R&D money, while family-owned businesses usually under-spend in R&D.

I believe China needs to rely on research universities to create technology.  Unfortunately, its universities are trying to make quick money by leveraging their name, and teaching and research have tended to languish.  This is part of the ‘quick money’ story, in my view, and the country urgently needs to change this situation. 

First, I believe China needs to increase the focus of its universities on education and research.  Whenever a university becomes famous, it often tries to capitalize on this financially.  This needs to change.  First, what professors can do outside their university positions should be tightly defined, and professors should be discouraged from leveraging their university affiliation to make money, at the expense of teaching and research.  Thus, China’s universities need to ensure that their professors value teaching and research interests above commercial interests.

Second, China should adopt the US’ research grant system.  Much of the research funding for US universities is from government-related organizations such as NASA, NIH and the Department of Defense.  Such funds have led to technologies such as the Internet and gene splicing.

Building great research universities is the key to China’s indigenous technology development, in my view, and there are successful examples of such institutions globally.  China has the scale to make it a success, but needs to eradicate the prevailing ‘quick-money’ psychology on its campuses.

China
GDP Revision Implemented Over 1993-2004
Jan 10, 2006

Denise Yam, CFA (Hong Kong)

Chinareleases more details on GDP revision: Following revisions to the 2004 production-based GDP statistic announced on December 20, 2005 (see GDP Revision Does Not Alter Overinvestment Story, December 21, 2005), new data have been released for nominal GDP and real GDP growth for 1993-2004 (Exhibit 1), with a production-based breakdown.  The upward revision in top-line nominal GDP rose from 2% in 1993 to 16.8% in 2004.  Real GDP growth rates have risen by an average of 0.5 percentage point over the 12-year period, with 2004 growth now reported at 10.1%, against 9.3% originally.

Tertiary industry accounts for the bulk of the upward revisions: The nationwide economic census conducted in 2004 primarily uncovered service-sector output that was unaccounted for in the previous national income accounts.  Because the last census on the tertiary industry was conducted in 1992 (and was assumed to have adequately captured service-sector output up till then), the accumulated “omission” through to 2004 has been progressively credited to data from 1993.  Tertiary industry value-added in 2004 (Rmb6.5 trn) is now 49% larger than previously reported, and makes up 41% of GDP (Exhibit 2).  Smaller revisions were also made to the primary (lifted by 0.9% in 2004) and secondary (+2.1%) industries.

We forecast 2005 GDP of around Rmb18 trn: Our current forecasts incorporate slower growth momentum in 2005 compared with 2004.  A 13% gain takes nominal GDP to Rmb18.1 trn.  In real terms, our current growth forecast (based on the old data series) stands at 9.3%, but this is subject to upside risk given the latest revisions.

Cross-provincial income and wealth gap should widen with revision: As the development of the service sector was faster in the more advanced coastal provinces, the GDP upward revision was probably larger in the already higher-income provinces, therefore revealing a larger income and wealth gap among geographical regions, with which the government has become increasingly concerned as a cause for social discontent.  Detailed data should be made available at a later stage.

Expenditure-based series yet to be revised: The latest revisions take the production-based GDP series considerably above the expenditure-based series, which has yet to be revised.  It is uncertain how and when this will be implemented.

Regional average growth rates lifted: Inputting China’s revised GDP series to our regional aggregates lifts the weighted average growth rates from 1993 onwards.  In particular, non-Japan Asia is now estimated to have grown 7.9% in real terms in 2004, against 7.5% before the revision.  For 2005, we estimate regional average growth of 7.1%, versus 6.9% before the revision.

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Argentina
Abundance Argentine Style
Jan 10, 2006

Gray Newman and Luis Arcentales, CFA (New York)

Argentina was in the spotlight twice during the first week of the year: first, for paying off the IMF in full to the tune of $9.5 billion and, second, for posting an inflation rate for the year (12.3%) that was more than double that of the previous year.  Two separate and unrelated events?  I would argue, no.  Instead, both the IMF repayment and rising inflation are outgrowths of the abundance that not only Argentina, but all of Latin America, has been enjoying in recent years and is likely to enjoy again in 2006. 

While abundance provides the region with a much-needed boost to growth and incomes, it also presents a series of challenges that in the long term can undermine healthy and sustainable growth for the region.  Unfortunately, in Argentina’s case the evidence to date puts it in the camp of the “problem countries” whose track record with abundance is reason for concern (see “Latin America: Abundance Continues” in GEF dated December 6, 2005). 

IMF: no need to cry

The move to repay the IMF in advance, first announced last month just two days after Brazil had pledged to do the same, has generated a fair number of questions.  While the move was largely praised in Argentina, many argued that it was more of a political move than an act to strengthen the Argentine economy.  And critics have argued that it prevents the IMF from playing any role in policy formulation and hence gives the Kirchner administration even freer reign on the policy front.  Finally, some have viewed the act of taking the reserves of the central bank — a special decree had to be issued to permit the move — as a worrisome confirmation that not even the semblance of central bank autonomy remains.

I think the critics have exaggerated their case and, indeed, I would argue that those who have spoken out in favor, as well as those who have criticized the move, run the risk of exaggerating the significance of the repayment.  The move tells us a great deal about the abundance facing economies throughout the region, but precious little about how Argentina will act in the future. 

It seems clear that the move had a political aim.  While the amount owed to the IMF represented less than 8% of Argentina’s gross public debt and was smaller than the combined amounts owed to the World Bank and the Inter-American Development Bank, the IMF looms large on the Argentine street.  The IMF more than any other institution or any government, for that matter, had come to epitomize what went wrong in Argentina in the late 1990s and earlier this decade.   Paying the IMF off early is all but certain to boost the popularity of the Kirchner administration in the near term. 

The move does almost nothing to Argentina’s net public debt (net of reserves).  It does reduce Argentina’s gross public debt by $9.5 billion, but that reduction is offset by the reduction in reserves: the net effect is zero (excluding any interest calculations).  And, while reserves now stand near $18.6 billion versus just over $28 billion before the repayment, Argentina has not been in a position to need to use its reserves.  On the contrary, it has spent most of the past year trying to limit its currency from strengthening further and has intervened to soak up large dollar inflows, thereby accumulating reserves.  International reserves rose by $8.4 billion in 2005.  And even with the reserve reduction of last week, the level of reserves fully covers Argentina’s monetary base of roughly $18.2 billion. 

All the talk of raiding the central bank is a bit overdone, in my view.  First, reserve accumulation policy is hardly at the core of central bank autonomy.  Even in Mexico, which has made significant strides to provide for central bank autonomy, the reserve accumulation policy is ultimately set by the finance ministry.  Second, in most countries IMF funding is through the central bank.  In the case of Argentina, many of the funds were used largely to shore up the country’s dwindling reserves in 2001.  And finally, for those who characterize the move as “seizure”, I find it difficult to imagine that they could come up with a better use for the proceeds than to prepay the IMF.  If the need arises in the future, a history of prompt payment or, in this case, full prepayment to the IMF, is likely to serve Argentina better than if it had used the inflows of the past year for some other purpose.

The real problem, in my view, is focusing on the prepayment for a sign of what is to come.  The IMF was not the problem that the Argentine street imagined, but neither was it the solution that time and time again investors abroad hoped for.  Both the elation in the Argentine street and the concern among investors abroad that the IMF has been taken out of the picture are misguided.  From my vantage point, Argentina’s long-term success will be a function of what happens in Buenos Aires, not in Washington.  And that is why the news on the inflation front has me much more concerned than the IMF repayment. 

Inflation: why 15% and not 20%?

The news that inflation hit 12.3% for 2005 suggests that Argentina is finally facing the limits to its current model.  After posting annual growth rates near 9% for three years now, Argentina is no longer able to grow at a rapid pace without rising inflation.  Unlike the short-lived spike in inflation in 2002 following the devaluation of the peso, Argentina’s recent inflationary upturn appears to be much deeper and more problematic.

Today’s inflationary uptick comes as Argentina’s output gap appears to have closed, and despite the fact that the currency has been very stable.  I think that, short of a dramatic turnaround in investment spending, Argentina’s economy is going to need to slow during the course of 2006 or the result is likely to be a more severe upturn in inflation. 

What concerns me is that it is not clear that the authorities fully understand the dynamic surrounding the inflation challenge.  Instead of taking action to attract new investment and implement fiscal and monetary policies to ease growth until investment spending gains ground, the moves in recent months have focused on the consequences of inflation and not its root causes.  Jawboning supermarkets to keep prices down either did not work — witness the 1.1% hike in consumer prices in December, the largest monthly hike in 15 years — or if it did, the risks to inflation when prices begin to reset is that much greater.  The government’s other favored tool, to hike export taxes to limit the profitability of sending production abroad, has little merit either.  Neither move represents a long-term solution, I feel, and each is likely to boomerang by eroding investor confidence and producing yet another bout of inflation during 2006. 

Bottom line

In some ways, the absence of the IMF might just turn out to be positive.  Rather than have to negotiate with the IMF on whether or not monetary and fiscal policies are adequate to deal with inflation, Argentine policymakers will have no one but themselves to blame if things go awry.  My concern, however, is that policymakers appear to have chosen to live with more inflation and there is a hint that the policy “solution” may be to allow the currency to depreciate a bit more so as to keep inflation from leading to an important appreciation of the peso.

A prolonged bout of inflation above 10% is not stable: it is likely to lead to a dangerous inflationary spiral if the monetary and fiscal authorities do not move to contain it.  At first, the dangers of this policy mix were obscured as a dramatic output gap permitted Argentina to post rapid growth with little inflationary risk.  But, with that gap now closed, policymakers need to respond.  So far, the response has been disconcerting.

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