Institutions and Growth in the Pacific

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Introduction. Since 1960s and 1970s, most of the Pacific Islands countries (PICs) have been performing at levels below what is needed for generally improved welfare. Living conditions appear to have been worsening for many of the people in most of these countries. Poor performance attributed to t

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Institutions and Growth in the Pacific

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1. Institutions and Growth in the Pacific by Mahendra Reddy Associate Professor of Economics, University of the South Pacific and Ron Duncan, Professor and Executive Director, Pacific Institute of Advanced Studies in Governance and Development, University of the South Pacific Suva, Fiji

2. Introduction Since 1960s and 1970s, most of the Pacific Islands countries (PICs) have been performing at levels below what is needed for generally improved welfare. Living conditions appear to have been worsening for many of the people in most of these countries. Poor performance attributed to the lack of an appropriate set of macroeconomic polices This belief has been the basis for economic reform since the mid 1980s. However, the results of reform programs have been mixed. New Institutional Economics suggest that the slow progress in growth and development in many developing countries is largely due to the lack of an appropriate set of institutions or the enforcement of institutions critical to economic growth and development.

3. Institutions broadly defined as constraints devised by human beings to provide a structure for political, economic and social interactions. =>Institutions influence the conduct of people in various areas of an economy such as the different levels of government, the bureaucracy, markets, and all other forms of non-governmental activities. => Institutions may be state or non-state, formal or informal. => State institutions cover aspects of public service delivery such as education, health, law and order, and security. => Non-state institutions are social institutions, values and norms. Formal institutions are constitutions, electoral systems, administrative systems, and law and justice systems.

4. These fundamental institutions determine the governmental and governance performance of an economy, Institutions may not be efficient and that they are very difficult to change. The “transaction costs” of moving to a more efficient institution will often be so high as to prevent the change; that is, the economy will be in a “second-best” world and indeed could be far from the optimum These transactions costs may reflect the ignorance and uncertainty of the people about what is in their best interests (e.g., most people do not understand the true benefits and costs of trade restrictions and therefore support protection of industries). Further, institutions will usually reflect the existing political power relationships within a society.

5. Douglas North (1991, 1994) argued that the institutions adopted by a country may not be efficient as the institutions adopted are determined by the predominant belief system and ultimately by those who hold power. The most fundamental source of change is individual learning and that the rate of learning will be influenced by competition. The greater the degree of monopoly power in a country the less the incentive to learn. Learning is important because it is the way in which ideas, ideologies, myths, dogmas and prejudices are changed and it is this “knowledge” that forms the basis of a society’s belief structure. In turn, belief structures—“the cumulative experience of past generations that is embodied in culture”—are transformed into the institutions of a society.

6. Culture may be the key to “path dependence” in institutional development, i.e., the influence of the past upon the present and future. While institutions may be changed relatively easily, the informal norms and other enforcement mechanisms that should underpin them may change only gradually. Societies that adopt the formal rules of another could have very different outcomes because of differences in belief systems, informal norms, and enforcement mechanisms. North’s emphasis on the importance of beliefs, informal norms, and other enforcement mechanisms can be seen as similar to Putnam’s (1993) socio-cultural factors, or “norms and networks of civic engagement”, in explaining differences in government performance in a situation where the basic institutions are similar. North (1990), Olson (1996), and de Soto (2000) have stressed the overriding importance of well-defined and secure private property rights and impartial enforcement of contracts between parties for the effective operation of a market economy.

7. If individual rights to factors of production (land, labour, and capital) are ill-defined in legislation and contracts made between parties to an economic exchange are not impartially enforced by the judicial system—and therefore property rights and contracts are not free from discriminatory intervention by politicians and bureaucrats—the costs of transactions and the costs of transformation in production will make economic activity infeasible or highly sub-optimal. Olson (1996) and de Soto (2000) explain the large and growing gap in incomes between the rich countries and those poor countries where incomes have grown slowly, if at all, as largely due to the absence of these basic institutions, not to the lack of capital, some inherent deficiency in work ethic, or some culturally determined behaviour. However, while “culture” may not directly explain the behaviour of individuals, according to Douglass North it may ultimately explain the institutional environment in which individuals find themselves and which determines their behaviour as a society.

8. Objective In this paper, the effectiveness of property rights to land and contract enforcement in Pacific Island countries. Further, we examine the impact of belief systems, education, societal norms, market structure, and enforcement mechanisms on the appropriateness and effectiveness of these institutions so important for the operation of markets.

9. Economic Performance In most of the Pacific island countries (PICs), average per capita incomes have shown little change since independence—in some cases over 30 years ago. In most of these countries, population growth rates are still high, Total fertility rates are around 4 in some cases (e.g., Papua New Guinea, Marshall Islands, Solomon Islands, and Vanuatu).

10. Economic Performance cont.. With population growth rates of 2.5 per cent or higher, the economies have had to average GDP growth of around 2.5 per cent just to maintain average per capita incomes. Visual observation indicates that some people have become quite wealthy, which, together with stagnant average per capita incomes, suggests that income distribution is worsening and poverty increasing. This observation is supported by the limited studies of poverty in the Pacific, which also suggest that poverty is worsening in most countries (ADB 2004).

11. Economic Performance cont.. Economic performance of the PICs in the second half of the 1990s and the first half of the 2000s varied considerably from country to country. Cook Islands, Fiji, Kiribati, Samoa, Tonga, and Tuvalu all had positive per capita GDP growth during this period, while Republic of the Marshall Islands (RMI), the Federated States of Micronesia (FSM), Solomon Islands, and Vanuatu experienced negative per capita GDP growth, on average. How have the PICs done by comparison with other developing countries?

12. Economic Performance cont.. The average 1995–2003 per capita GDP growth rates: Low Income (3.2 per cent) Lower Middle Income (3.6 per cent) Higher than that of the PICs (0.7 per cent average for 1995–2004) PICs are not doing as well as many other developing countries. For the 12 Caribbean countries for which World Bank per capita GDP data are available, the average per capita GDP growth rate for the period 1970–2003 (not all countries have data covering the full period) was 2.8 per cent. For the ten PICs for which these data are available, the average per capita GDP growth rate was one per cent. For the period 1995–2003, the average for the Caribbean countries was 1.6 per cent, compared to the 0.7 per cent average for the PICs for the 1995–2004 period.

13. Market Institutions in the Pacific Property rights to land In agriculture, the single most important institution is property rights over the land. Property rights refer to formal and informal institutions and arrangements that govern access to land and other resources, as well as the resulting claims that individuals hold on those resources and on the benefits they generate The way in which a country’s property rights is defined determines to a large extent the resource allocation pattern and, by extension, the level and nature of economic development. Without an appropriate institutional environment, farmers will have little regard for future land quality.

14. Market Institutions in the Pacific Cont.. Furthermore, without proper institutional protection, farmers will be reluctant to invest in land for fear of losing the value of investments made. If farmers resort to other means of acquiring this protection, it will raise transaction costs relative to the situation of institutional protection. The land tenure system can make available a bundle of rights that can govern access to and use of land. Exclusive property rights give rise to incentives for investing in land conservation, preventing reduction of future income streams, increasing future income streams, and the ability to enhance the value of land as a capital asset.

15. Market Institutions in the Pacific cont.. Long-term leasehold over land can provide the same set of incentives for farmers as freehold tenure. That is, with full transferability of the lease and therefore with the right to the benefits generated by investment of capital and time, the farmer will have the ability to borrow against the lease as collateral, and the incentive to invest both capital and personal effort to an optimal level. In the PICs, land, particularly land outside urban areas, is mostly held under customary ownership, to which there is strong cultural attachment. When population growth rates were very low, increasing land productivity was not important—especially in the Melanesian countries with abundant fertile land relative to their populations.

16. Market Institutions in the Pacific cont.. However, with increases in fertility rates and reductions in mortality and the resulting rapid population growth, there is a need to increase land productivity. In the absence of some form of leasehold tenure to make land available to individual investors, customary ownership is most unlikely to be the basis for rapid increases in productivity and economic growth. Table 1 shows per capita agricultural production (including subsistence production) for the seven PICs for which these data are available from the FAO data base. While total agricultural production of Fiji, Kiribati, Papua New Guinea, and Solomon Islands has been increasing since the 1960s, per capita agricultural production has been declining. In Papua New Guinea’s case, per capita production has been declining since the mid-1980s. The steep decline in Vanuatu’s per capita agricultural production, a country with population growing at around 2.5 per cent, must be of great concern.

18. Market Institutions in the Pacific cont … TFP study by Reddy and Duncan (2005) reveal that the estimates made of efficiency and technical change show that TFP in these countries has been negative or barely positive over the past 42 years. Given Pacific people’s attachment to the concept of customary ownership of land, it appears that the most desirable way to create secure individual tenure is to create a system of long-term leasehold within the customary system. Leases must have full transferability to ensure that they can be used as collateral for commercial credit. Through the development of its leasehold system for customary land, Fiji was able to maintain a large sugar industry based on smallholder farmers and is sustaining a large and growing tourism industry.

19. Impartial contract enforcement The lack of interest in the PICs in establishing clear property rights and impartially enforcing contracts is evident from the International Finance Corporation’s (2005) Doing Business database. Estimates of the costs of registering property and resolving contracts in several PICs are shown in the table below. As shown there, the transaction costs of registering property and settling contract disputes are extremely high, especially the latter. On average, in these countries it takes well over one year to settle a contract dispute. In Papua New Guinea and Solomon Islands the monetary costs of doing so are prohibitive.

21. Impartial contract enforcement cont.. In the Melanesian countries (Papua New Guinea, Fiji, Solomon Islands, and Vanuatu) a “culture” of compensation claims has developed, whereby if investment projects such as mines or tourist resorts developed on customary land are successful, the landowners claim additional benefits under the contract. Unfortunately, in many cases the governments have not stood behind the contracts and allowed the compensation claims to proceed. These contract disputes have increased the uncertainty of the investment climate.

22. Explaining the status quo Following independence from the colonial powers, the new national governments in these primarily clan-based PICs took on many of the productive activities outside of agriculture, as well as utilities and major infrastructure such as ports. Manufacturing, largely in the form of minimal processing activities, was widely supported through protection. This approach to development, with government playing a major role in productive activities and use of trade barriers to promote import substitution, was in vogue at the time of the PICs’ independence in the late-1960s and early 1970s. However, unlike in other developing countries, in the Pacific there is a reluctance to move away from this development paradigm. Of the PICs only Tonga, an absolute monarchy, was not colonized.

23. Explaining the status quo cont.. Explaining this reluctance and the consequent lack of support for private markets is a key issue in understanding economic performance in the Pacific. The central thesis of this paper is that the communal culture of the Pacific countries is comfortable with the extent and form of government involvement in the economy that the ‘big government, import-substitution’ development paradigm involves. Moreover, this belief system is reinforced by the existing education systems and the monopoly positions established within the economies.

24. Explaining the status quo cont.. The traditional authority structure of the PICs remains important, with village or clan “chiefs” or “big men” playing a major role in the government of the people. Often, there is considerable tension between the national governments established following independence and the traditional authorities. These tensions create loyalty conflicts within the minds of the people. The traditional authority structures are less participatory than what is seen as desirable in the conception of democratic governance. However, there is an acceptance of the authoritarian nature of the traditional governance structures and this acceptance appears to fit comfortably with acceptance of the predominant role of central governments in economic life.

25. Explaining the status quo cont.. The acceptance of the ‘big government’ paradigm of development is promoted by education systems within the region. Open markets and movement away from the communal system are seen as undesirable by social scientists who rail against the imperialist behaviour of the advanced economies and the perceived disadvantages that the PICs will suffer as the result of globalisation. The communal system, with its strong clan loyalties, does present difficulties for the establishment of a market economy because markets depend heavily upon transactions between parties that do not know each other. The close clan ties on the one hand and the long-standing distrust of other groups on the other hand mean that there is little of the kind of trust (social capital) that is needed in a market economy.

26. Explaining the status quo cont.. Many of those who have become well off in the PICs have largely acquired their wealth due to government-created monopoly positions through, for example, restricting trade and investment, or from privileged positions in parasatal organisations. Therefore, in the Pacific there is a virtual absence of vested interests in open markets. As most of the relatively small private sectors have been established behind trade barriers, existing private sector interests are generally antagonistic towards opening the economy to trade and investment as this would mean increased competition for them. The frequent too-close relationships between the private sector interests and politicians in these small economies increase the difficulty of achieving micro-economic reform.

27. Explaining the status quo cont.. The difficulties that development assistance agencies have experienced in trying to assist PICs to liberalise their international trade and investment regimes, to privatise their state-owned enterprises, to create more favourable conditions for private investment, and to reduce the use of commodity price stabilisation schemes and agricultural and development banks appears to stem largely from this antipathy towards open markets. The antipathy towards open markets also helps to explain the lack of interest in establishing secure property rights and ensuring impartial enforcement of contracts. Development assistance agencies have not understood the lack of interest in open markets, secure property rights, and impartial enforcement of contracts and have not given sufficient attention to how to progress economic reform in such circumstances. Economic reform has to be internally driven. Development assistance agencies can play only a supporting role. Development assistance agencies may be supporting the status quo by the direction of assistance through the existing governments, thereby providing economic resources for continuing with existing arrangements.

28. Changing the status quo Given that institutional change will be resisted by those benefiting from the existing arrangements, it would appear that there are two possible courses of action for those hoping to change the status quo: to design reforms in such a way that the existing power holders benefit as well as the remainder of society; and to reduce the levels of development assistance where such assistance is supporting existing institutional arrangements or making it possible to persist with the high costs of existing arrangements. Educating the public about the problems arising from existing institutional arrangements may also be helpful. The threat of withdrawal of aid in order to try to bring about institutional reform may not be very effective in the Pacific as there are many potential aid donors.

29. Changing the status quo cont.. It is now widely appreciated that there has to be a significant degree of “ownership” on the part of a government and its people in order for any programs aimed at bringing about change to be successful. Given the extent to which the various forms of governance are contested within these communities, it is clear that there will have to be substantial discussions within these communities over the kinds of changes that will be accepted. Changes in belief systems take a long time to bring about and involve significant learning.

30. Changing the status quo cont… Suggestions for changes in governance: dialogue on issues of community participation in formation of government, roles of government, etc between the development agencies and Pacific communities and within Pacific communities should be begun without delay. The differences are unlikely to be resolved easily and therefore this dialogue should be seen as a long-term process. However, without substantial closure of the differences over the way forward on these issues there is likely to be little benefit from development expenditure on efforts to improve governance and ultimately economic performance. Similar debates are long-standing in countries such as Australia, Canada, New Zealand and the United States, where tensions between the communally based institutions of the minority indigenous peoples and the introduced institutions of the majority settler populations have not been settled.

31. Changing the status quo cont.. Therefore, it should not be surprising that similar tensions have not been resolved in the short period of independence in the Pacific. There is a special problem in Fiji, where the large introduced Indian population with its limited access to land has been forced towards reliance on the introduced institutions based on individualism, as compared to the communally-based system of the indigenous population. This basic difference in views over the appropriate institutional structure in such an ethnically divided society raises special problems in achieving consensus. An important point to note is that these discussions should be driven by the Pacific peoples themselves, not by the development assistance agencies. Otherwise, genuine ownership of any changes or reforms will not occur.

32. Changing the status quo cont.. The importance of country “ownership” of reforms is now understood by development agencies. However, putting appropriate mechanisms in place to ensure that ownership of proposed changes actually rarely occurs. Development agencies can assist the dialogue by generating research to improve knowledge where there is lack of understanding or uncertainty. Dialogue must be led by people who understand the socio-cultural and political contexts of the country and therefore understand the belief systems and other factors supporting the attitudes towards any proposed changes. Leadership of these issues must be developed within the communities themselves. Besides the inappropriateness of reforms attempted previously and the lack of ownership to support the reforms, there has been a general breakdown in the implementation of reforms.

33. Changing the status quo cont.. This may happen because of a lack of capacity, shortages of appropriate staff, the lack of support for those given charge of taking the reforms forward, or resistance to reform from powerful interest groups. Capacity and staff shortages may be overcome through training. However, these factors are probably much less important in explaining the “implementation gap” than the latter two factors. Often, reform programs are handed over by development agencies to local staff, who then receive little support during the implementation process. There needs to be ongoing support that can act in a mentoring role when difficulties arise and can flag when reform programs are running into blockages.

34. Changing the status quo cont.. Powerful interest groups will often play upon the fears and uncertainties of people to build resistance to reforms. These resistances have to be challenged by well-informed analysis, which may need to be supported by research. For example, trade and investment liberalisation reforms are usually resisted by local business interests who are being protected by existing legislation and regulation. Often these business interests are branches of multi-national firms that have been granted a monopoly over the domestic market through tariffs or other forms of import restriction. Often too there is a close relationship between these expatriate businesses and local businessmen/politicians, which ensures a strong barrier against reform.

35. Changing the status quo cont.. The fears of local people about losses of jobs and increases in prices from the opening of markets to competition are fostered to reinforce the resistance. The lack of understanding that allows such resistance to reforms to be successful has to be countered by public education. The role of traditional authorities in governmental structures is something that has to receive substantial consideration. However, increasingly there is healthy questioning of the deference expected for traditional leaders’ decisions, as well as of the manner in which elected political leaders hide behind “tradition” in response to criticisms of their actions.

36. Summary and Conclusion PIC economies growth rates has not been rapid enough to exceed the rate of population growth and lead to decreasing average per capita incomes. This paper specifically addresses only the link between poverty/hardship and institutions and in particular the insecurity of property rights and contracts. There is a lack of land over which secure individual tenure is available and there is a high incidence of disputes over the land that has been made available for investment. Fiji’s model could be used by other PICs. However, problems have developed with Fiji’s system and these should be recognised and improvements made if Fiji is to create a more favourable investment environment.

37. Summary and Conclusion cont… Insecurity over land for investment is one of the factors responsible for Fiji’s investment to GDP ratio now being about one-half what it was in the late 1970s. In the other Pacific countries there are various initiatives being examined and implemented in efforts to mobilise land for productive activities. These should be encouraged. The Melanesian PICs have an abundance of land relative to their population, however, in most cases there has been no growth in productivity under the present form of customary ownership. Given the rapid population growth in most of the PICs, there must be increasing hardship in the rural areas—part of the reason for the rapid growth of urban centres in all of the Pacific countries. Moreover, it is quite likely that with rapid industrial growth in metropolitan countries close to PICs, land will be pulled away from agriculture towards the non-agricultural sector, raising demand for agricultural products from PICs. However, the ability of the PICs to service these markets will depend to a large extent on whether the appropriate institutional changes can be made to ensure the security of title to land so necessary for accessing credit and having an optimal level of individual effort devoted to production.

38. Summary and Conclusion cont… Moreover, it is quite likely that with rapid industrial growth in metropolitan countries close to PICs, land will be pulled away from agriculture towards the non-agricultural sector, raising demand for agricultural products from PICs. However, the ability of the PICs to service these markets will depend to a large extent on whether the appropriate institutional changes can be made to ensure the security of title to land so necessary for accessing credit and having an optimal level of individual effort devoted to production. The history of the PICs has shown that achieving macro-economic stability following a fiscal crisis can be achieved in a relatively short time (for example, as demonstrated on several occasions in Papua New Guinea). However, achieving the kinds of micro-economic reform urged by the international finance agencies and bilateral donors has proven very difficult.

39. Summary and Conclusion cont… The reasons for this appear to be manifold. The large areas of the PIC economies that have been occupied by governments since independence mean that there is little local support for free markets and, in particular, there are few champions of open markets among political leaders. The highly interventionist role of national governments appears to sit comfortably with the authoritarian nature of traditional village governance structures. Changing the institutional status quo in these situations will clearly take considerable time and involve considerable research, education, and discussion in order to establish the necessary domestic ownership of change. However, the substantial difference between the population growth rate and the rate of growth of agricultural productivity means that there will be increasing pressure for change to the land tenure system in order to generate higher agricultural productivity.

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