Mushtaq H. Khan, SOAS

1. Industrial Policy, Organizational Capabilities and GovernanceIEA-World Bank Roundtable on Industrial PolicyPretoria July 3-4 2012 Mushtaq H. Khan, SOAS

2. Capabilities and Competitiveness • The state’s ‘governance capabilities’ are a key determinant of the effectiveness of its industrial policies: but what are these capabilities? • The types of industrial policies that are necessary clearly determine the types of governance capabilities that are required • ► Since governance capabilities take time to change, lateral thinking is required to identify ways of solving problems that can be successfully implemented in particular contexts • Developing countries typically lack the ‘good governance’ capabilities required for protecting and regulating efficient markets, and they are also usually far away from having ‘developmental state’ capabilities • Industrial policies are required if market (private contracting) failures constrain the acquisition and absorption of new, more productive, technologies in any sector • But there are potentially many different types of market failures, each requiring different types of interventions and capacities to resolve

3. Why Technology/Industrial Policy?

4. Market failures and Industrial Policy • Coordination failures and appropriation problems associated with investments in skills and discovery are well known • However, a somewhat different and more important problem is that financing effective learning-by-doing requires the solution of significant incentive compatibility problems • Ignoring the requirements of policy design that is compatible with available governance capabilities (particularly in this area) has often resulted in poor industrial policy results • Policies and governance capacities for industrial policy depend on the range of relevant market failures but learning-by-doing is important in virtually every case • Fortunately there are usually multiple solutions to similar market failures and hence solutions can be attempted that are more likely to be implementable

5. Organizational Capabilities and Competitiveness • Developing countries often find that despite lower wages for the appropriate formal skills and even in sectors where machinery and technology are freely available, production does not take off • A critical missing factor is the know-how of organizing production using modern production techniques • Traditionally described as the absence of ‘entrepreneurship’ this actually involves a broad range of missing organizational capabilities • This ‘knowledge’ is not ‘codified’: it is ‘tacit knowledge’ that can only be acquired through ‘learning-by-doing’ • However, cross-country evidence suggests that ‘doing’ is necessary but not sufficient for acquiring organizational and technological capabilities • Success requires high levels of ‘effort’ in learning new capabilities (not to be confused with effort in general)

6. Learning and Finance • Missing organizational capabilities implies that investments in these sectors are not immediately profitable • The purchase of assets like machinery or land can be financed by banks with the assets serving as collateral • But financing an unknown period of loss-making is more difficult unless the entrepreneur is willing to back indefinite operating losses with personal collateral • The risks involved often preclude private investment in technology acquisition in new sectors • On the other hand, if support is available to finance implicit losses this can paradoxically reduce the compulsion to put in high levels of effort in learning • Achieving competitiveness requires efficient routines for production, inventory management, quality control, sales, marketing and the management of external bottlenecks • Achieving this is a high-effort process involving the management of distributive and other conflicts with costs and risks for managers • In the absence of compulsions, managers can become ‘satisficers’ putting in lower levels of effort in learning and experimentation, and this is widely observed in many industrial policy experiments

7. Learning and Finance • Developing countries have often used blanket protection of ‘infant industries’ as a way of financing learning, but in many cases the conditions for performance improvements were not credible and infants refused to grow up • As a result, industrial policies were often abandoned in the 1980s or transformed into horizontal (investment climate type) policies not just because of strengthening neo-liberal ideologies but also because (in many but not all cases) outcomes were poor • The core of the problem is that learning-by-doing requires the opportunity to engage in doing (loss financing) but is only successful if high levels of effort in learning can be ensured • The problem is to both finance an uncertain learning process and to ensure that stakeholders have compulsions to put in high levels of effort in changing organizational design and routines to achieve competitiveness within a reasonable timescale

8. Competitiveness and Learning With missing tacit knowledge a developing country can lack competitiveness even in sectors where it has a formally skilled workforce

9. Financing learning faces a significant incentive alignment problem because the loss-financing is ex ante and success ‘achieves’ a loss of the financing rents and exposure to market competition Learning and Effort

10. Opportunities versus Compulsions • This problem is different from the discovery problem identified by Hausmann and Rodrik and is more serious in terms of governance requirements for its solution • The problem identified by H&R is that once a viable sector is discovered (and this assumes that there are ‘hidden’ capabilities in a country) entry will compete away high profits, destroying the incentive to invest in discovery. • In reality, entry does not have this effect on wages in most labour surplus countries and the productivity gap is initially so great that even in successful sectors, first mover firms tend to earn ‘normal’ profits • Thus the failure to invest in many cases cannot be explained by the fear of losing excess profits that are unlikely to emerge and that are also unlikely to disappear if they did emerge: the problem lies somewhere else

11. Financing Instruments • The ‘design’ of the financing instrument is critical and depends on the ‘market failure’ being addressed • If discovery were the problem the solution would be to organize ‘trials’, and the governance task is to ensure that failed trials do not keep getting financed • But if compulsions for effort are the problem and the political settlement makes it difficult the specify or enforce particular conditions, the financing strategy can fail because of inadequate compulsions for effort • All or almost trials can then result in poor outcomes without specific attention to this deeper problem • The East Asian industrial policy regimes operated in political settlements where political authorities had significant enforcement capabilities and long time horizons: ambitious financing instruments came with credible conditions that created compulsions for rapid organizational learning

12. Political Settlements and Industrial Policy • Political Settlements describe the macro political equilibrium between institutions and the distribution of bargaining power across organizations. • The macro political settlement describes the relative power of different types of organizations, which in turn determines the cost of enforcing particular institutions • The ‘strong patrimonialism’ of the East Asian countries was a very unusual political settlement where political and bureaucratic organizations could credibly discipline the temporary learning rents of economic organizations • More typically developing countries have had weaker patrimonialism (dominant party systems like the Indian Congress or the ANC), weak authoritarianism (as in Pakistan and many African authoritarian regimes) and increasingly, competitive clientelism (developing country democracy) with weaker enforcement capabilities and shorter time horizons

13. Financing Instruments in competitive clientelism • Successful learning in ‘competitive clientelist’ contexts has typically involved a public and a private component of financing that together created both opportunities and strong compulsions for effort • The garments industry takeoff in Bangladesh was based on a ‘public policy’ component (the MFA) and a private component based on a financing agreement between Desh and Daewoo that together financed a very successful learning process • The details of the design were critical: both the technology provider and the learner had strong incentives to transmit and acquire the know-how • The learner had a lot to lose (their investments in assets) but was not expected to fully finance the learning: the risk-return mix was very successful, Desh expected it would take 5 years to become competitive but they achieved competitiveness in 18 months • The Indian auto takeoff in the 1980s was similar: implicit public subsidies came from a protected domestic market with private co-financing by multinationals in joint venture partnerships • Design was again critical: Credible enforcement of 70% domestic content requirements (no longer possible now with WTO) and the expectation that domestic market protection would come down resulted in strong compulsions for effort in transferring know-how

14. Financing Instruments • The policy environment has changed (no temporary global rents like the MFA, no more domestic content, almost no tariffs) • This makes the case stronger for well-designed public financing instruments targeted towards capability development • The critical condition is that contractual conditions supporting effort have to be credible and enforceable • The political settlement is difficult to change, but other critical variables like the technologies supported, the identity of the firms and the design of the ‘financing instrument’ are policy variables • Successful learning involved financing that created incentives and compulsions on both transmitters and recipients of know-how, and firms could not credibly sustain loss-financing using political mechanism to prolong the support • The details of the financing instruments varied significantly but satisfied these conditions in sectors with different technologies • The policy challenge is to deliberately replicate these conditions in new areas with financing instruments that deliberately attempt to create incentives and compulsions for effort

15. Learning in clientelist settings • In the case of the Bangladeshi garments and Indian pharmaceutical and automobile industries, the combination of public and private financing of learning was very important • With weaker state enforcement capabilities, private incentives linked to partial private financing are important • In the case of automobiles and pharmaceuticals in India, the prior history of capability development under previous industrial policy regimes had narrowed the competitiveness gap considerably • Private financing created strong incentives for effort in learning but this was made a feasible gamble by ‘public’ financing that further reduced the size of the mountain that had to be climbed • Once productive organizations had learnt to learn, learning continued and the public financing could also be gradually reduced or removed • In all these cases there was also a commitment at the political level to support specific sectors with a few critical policy instruments for ‘nationalist’ or ‘political’ reasons

16. Implications for Africa • The enforcement and implementation constraints set by domestic political settlements need to be explicitly recognized • The ability of the relevant economic organizations to block terms or renegotiate them is a critical concern: this depends on the nature of the technology being supported and the political connections and bargaining power of particular types of firms • Strategies that require the enforcement of high-effort conditions on powerful organizations are likely to fail • The distance from the competitiveness frontier determines the credibility of strategies: too great a distance is unviable with limited governance capabilities for enforcing conditions for effort because they require long-lasting rents • Low levels of initial capabilities imply that industrial policy has to aim lower in the quality chain to begin with • Rents are also likely to be needed to create incentives for foreign partners to transfer organizational knowledge. If the technology provider does not have credible incentives and compulsions to transfer the know-how, the strategy as a whole is likely to fail • Ensuring some of these critical conditions in the design of the industrial policy is a major challenge