Poverty, Inclusive Growth and Development Strategy

1. Poverty, Inclusive Growth and Development Strategy Justin Yifu Lin Senior Vice President and Chief Economist December 3, 2008

2. Introduction • Poverty is the main social, economic problem in most developing countries • A sustainable and inclusive growth is the key to reduce poverty and to achieve the MDGs • Most economists agree now that the economic performance in a country is determined by the quality of its institution

3. Development Strategy Matters • But what determines the quality of institution? • My hypothesis is that the government’s development strategy matters for the quality of institution and, hence, the growth performance in a country

4. Development Strategy andAdvantage of Backwardness • Continuous technological innovation and industrial upgrading are the foundation for sustainable, dynamic growth in the modern world. • If a developing country adopts a comparative advantage following (CAF) strategy, it can benefit from the “advantage of backwardness” and catch up the developed countries. It can also achieve the ideal situation of growth with equity. • Most developing countries adopt a comparative advantage defying (CAD) strategy, which leads to various distortions and results in poor growth performance as well as worsening of income distribution in the developing countries

5. Modernization attempt • The political leaders in developing countries had the dream of modernization. • The political leaders viewed the development of capital-intensive, technologically advanced heavy industries that prevailed in the developed countries as the symbol of modernization. • The developing countries were capital-scarce economies and capital-intensive industries were not their comparative advantages. • The attempt to develop capital-intensive industries in a capital-scarce economy is a comparative-advantage defying strategy.

6. Endowment Structure and Industrial Structure The optimal industrial structure of an economy is endogenously determined by the economy’s endowment structure. The attempt to develop capital-intensive, heavy industry is a comparative advantage defying (CAD) strategy The firms in the CAD industries are nonviable in an open, competitive market and the government’s supports/protections are required for the nonviable firms. Capital K1 K J2 CAD strategy for developing countries J1 J I1 I Labour

7. Viability Problem and Distortions • The government’s measures to protect/subsidies the nonviable firms in the priority sectors of CAD strategy included: • Regulations of the entries to give the firms in the priority sectors a monopoly position so that they could charge high prices • Distortions of interest rates, foreign exchange rates and so on, and using administrative measures to allocate capital, foreign exchanges, and other materials to lower their costs of investment/operations • Those interventionist measures lead to rent seeking, crony capitalism, low efficiency, and poor development performance

8. CAF strategy and Market Institution Alternative to the CAD strategy is a comparative advantage-following (CAF) strategy, which attempts to facilitate the firms to follow the economy’s comparative advantage determined by the economy’s endowments. Firms in the CAF strategy will be viable and the economy will be competitive. Capital accumulation and upgrading of the endowment will be fast and the economy can benefit from the advantage of backwardness in the upgrading of technology/industry Firms will follow the economy’s comparative advantage if the factor prices reflects the relative abundance of each factor in endowments. Competitive markets are required for relative prices to reflect the relative abundances of factors in the economy’s endowments.

9. CAF Strategy and the Facilitating State The government in a developing country that adopts the CAF strategy may play a more active role than that of a minimal state. When the government pursues a CAF strategy, the endowment structure will upgrade very fast and it is desirable for the government to play certain role to facilitate the country’s industrial upgrading. Information Coordination Externalities

10. CAD Strategy and Income Distribution • The main asset that brings income to the poor is their own labor while the rich derive their income mainly from their capital. • CAD strategy is most detrimental to the poor, especially those in the rural areas, because the strategy would not create enough non-farm job opportunities for the poor, causing: • the wage rate to be repressed • the government to restrict out-migration or many of the out-migrant workers to become jobless • The CAD strategy eventually leads to various crises and the poor are the major victims

11. CAF strategy and growth with equity in a labor-abundant economy • The CAF strategy is pro-poor • It facilitates the development of labor-intensive industries when the economy is relatively labor abundant, upgrading the economy to more capital-intensive industries only when capital become more abundant. • There will be more jobs for the poor and the wage rate will increase when the economy upgrades to more capital intensive industries. • On the development process, capital turns from relatively scarce to relatively abundant and labor from relatively abundant to relative scarce. The returns to the poor’s specific asset, labor, increase and the returns to the rich’s asset, capital, declines .The result is growth with equity.

12. Development Strategy in a resource abundant economy • CAD strategy is bad for a resource-abundant economy • If such an economy follows CAF strategy to exploit its natural resources, should it develop labor-intensive manufacturing industries in the early stage of its development? • Most labor forces are in agriculture and are poor • Labor intensive industries • provide jobs for absorbing labors from the rural sector • pave the basis for industrial upgrading • Resource abundance is a double-edge sword. • If the wealth from natural resources is used to invest in human capital and infrastructure, the industrial upgrading will be much faster than a resource-poor country. • The wealth may be captured by powerful groups and the economy is prone to adopt CAD strategy

13. Testable Hypotheses H1: Over an extended period of time, the country that adopts a CAD strategy will have a poor growth performance. H2: Over an extended period of time, the country that adopts a CAD strategy will have less equitable income distribution.

14. The Proxy of Development Strategy The more a country pursues a CAD Strategy, the higher is TCI in the country.

15. H1: TCI and Growth

16. H2: TCI and Income Distribution

17. It is possible to achieve a sustained and inclusive growth in a developing country if the government has the right strategy for development!

18. Concluding Remarks • The CAF strategy is the key to a sustainable, inclusive and equitable growth in a developing country • Many developing countries adopted a CAD strategy because their political leaders did not understand a country’s industrial structure was endogenous to the country’s endowment structure. • Many distortionsin developing countries are endogenous to the viability issue of firms in CAD strategy’s priority sectors. • It is imperative for a developing country to eliminate the distortions so as to shift from a CAD strategy to a CAF strategy • A dual-track gradual approach to reforms will be more effective than a shock therapy because the endogeneity of distortions. • With a CAF strategy, among others, the government should • Supporting the development of labor-intensive SMEs • Provide education to the poorto facilitate their adaptability to job requirements • Invest in agricultural technology and rural infrastructure • Improve legal, financial, social and political institutionsto facilitate the transition to modern, industrial society.

19. Thank you