Institutional Setting

An economy’s institutional endowments are critical to its growth potential. Endowments include formal constraints, such as constitutions, laws, and rules, as well as informal constraints, such as conventions, customs, and norms. Industrialized countries have established formal and informal constraints on human behavior that are more or less conducive to market transactions. Thus, institutions in these countries operate under fairly favorable conditions.

In comparison with the situation in developed countries, the institutional context of developing economies is much less favorable to market transactions. Regulatory rules and conventions are often weak and underdeveloped. Many developing economies lack the sound institutional structures needed to promote private enterprise and competition. Thus, policies that have worked elsewhere often result in disappointing economic outcomes when applied in the developing world. On a more micro level, regulatory regimes in developing countries can suffer from considerable deficiencies in management, often lacking skilled technocrats. This institutional weakness is further complicated by an inability, or unwillingness, of regulators to commit to some type of reform to reduce inconsistency and unpredictability, especially in countries with unstable political structures that lead to frequent changes in governments and where contracts are not protected by law.

Numerous studies have shown that regulatory offices in developing countries tend to be small, under-staffed for the task they face, and often more expensive to run (in relation to GDP) than those in developed economies. There is a lack of knowledgeable and trained regulatory staff, especially of economists, accountants, and lawyers skilled in regulatory policy analysis and contract design. In a survey of 22 regulators in 13 Asian countries, Jacobs (2003) identified the lack of well-trained staff as a major constraint on the quality of regulation. Regulatory staff often have limited understanding of policy analysis methods, such as regulatory impact assessment, which can assist in the implementation and design of new regulatory measures.

Issues of regulatory capacity and strong institutional structures are becoming increasingly important in Asia. The region is going to need to attract significant financing in order to meet the estimated $250 billion in annual infrastructure investment needed to support regional growth (Asian Development Bank [ADB] 2007). This amounts to around 6% of the region’s GDP. In 2007, ADB approved over $10 billion in loans and another $1.8 billion in grants and capacity building assistance. Between 1984 and 2005, cumulative private sector investment in the region has been about $284 billion, or an average of $12.9 billion per year. Looking at these figures, it is clear that there is a significant gap between available funds and what is required for investment in infrastructure. This is despite the fact that the region continues to have one of the highest savings rates in the world. To attract and deal effectively with additional funds, even from within Asia, significant restructuring of the region’s institutional capabilities is necessary. However, many countries do not have the capacity or regulatory framework to fund an infrastructure upgrade, or to gain enough investor confidence to attract private sector participation.

Even acknowledging the need for government initiatives, the call to increase government operations to strengthen institutional structures is often met with severe resistance by those in the position to provide such reforms. The link between growth and public finance in transition economies has still not been conclusively established, mostly due to a lack of data, making it difficult to argue effectively for an increase in the role of government in the region. There is broad consensus that there are three main factors that affect public finance and economic growth:

1. Macro stabilization (usually measured as inflation);
2. Market liberalization and structural reform; and
3. Initial conditions (for example, level of development).

Initial conditions in the Asia Pacific region are extremely diverse. Many of the economies have not achieved sustained macroeconomic stability. Liberalization and structural reform across the region have been inconsistent at best, and while initial conditions in established economies such as Singapore and Hong Kong, China create an atmosphere of relative stability and confidence, the same cannot be said for the rest of the region. Still, many countries struggle to find a balance between expanding institutions to address serious inadequacies, and reducing red tape and regulatory interference in order to attract foreign investment.

In a recent study, Pushak et al. (2007) found that while institutional quality is important, the impact of government on economic growth is not straightforward. Using a panel data study covering 25 countries over the period 1992–2004, the authors found that for established economies, the marginal benefits of public expenditure tend to fall as the size of the expenditures program grows. This builds on findings by de la Fuente (1997), who reported that for a given sample of Organisation for Economic Co-operation and Development (OECD) countries (data from 1960–1993 and 1970–1995), a decrease in total government expenditures increased growth rates. In the European Union (EU), for every $1 increase in government spending, there is an average decrease in private investment of $0.32 (Pushak et al. 2007). Further, the marginal cost of taxation has been shown to increase as the tax burden rises. All of these findings caution against government expansion. However, these relationships appear to rely a great deal on income levels. The authors therefore conclude that transition economies may find that with better quality governance, the “optimal” size of government in achieving high economic growth, could actually be higher than the accepted average (including developed economies).

Thus the effect of government size on economic growth can vary significantly, depending on the quality of public sector institutions or governance in a given country. Key drivers of economic growth may shift in relative importance over time, so that while the size of government does matter, its impact is nonlinear. Beyond certain expenditure thresholds, public spending has a negative impact on growth, while at levels below this cutoff, there is no measurable impact. As government expenditures grow, they may be associated with large distortionary taxation and regulatory activities, less efficient provision of services, and new opportunities for rent seeking and corruption. To the extent that increases in government expenditures are “quality” they do not necessarily impact negatively on growth. The size of government does not have adverse consequences when government is relatively more effective or public sector institutions stronger.

These findings may help explain the slow growth of private investment in the region. As stated above, East Asia has experienced faster growth in trade and GDP than Latin America, yet it falls behind as a destination for private investment, especially in infrastructure. Between 1984 and 2005, Asia as a whole accounted for less than 30% of private sector investment in infrastructure worldwide, while Latin America accounted for over 44% (World Bank, Private Participation in Infrastructure [PPI] database 2007).

During the last two decades, private sector investment in the region’s infrastructure has fluctuated widely, reflecting its sensitivity to macroeconomic instability and the general investment climate (Sharan et al. 2007). This is evident in the pattern of investment in the region. Investment is highly concentrated in several countries, the top six, between 1984 and 2005, being: the PRC (25.3%), India (15%), Malaysia (15.5%), the Philippines (10.9%), Thailand (10.5%), and Indonesia (8.8%).

Across the developing world, investment in East Asia and the Pacific has been below what would be expected given the growth and strong trade figures in the region. Figure 2 [ PDF 16.2KB | 1 page ] shows that Latin America has led Asia in the number of PPI projects for most of the time period under consideration. In 2002, South Asia also passed East Asia and the Pacific, and Central Asia has shown recent signs that it could do the same. Given the outstanding performance of the region in most economic measurements, the lack of private investment has been a cause of concern for most governments in the region.

In terms of dollar investment, again Latin America leads, with the Europe and Central Asian region also demonstrating strong growth (Figure 3 [ PDF 17.3KB | 1 page ]). The lack of investor confidence in developing markets following the financial crisis of the late 1990s is clearly evident in the graph. Prior to this time period, growth in private sector investment was strong, but the region has yet to recover those levels. At the same time, since 2003, the South Asian region and the European and Central Asian region have both shown strong growth in dollar commitments from the private sector for transport ventures.

This performance becomes even more puzzling when regional differences in business environments are examined. Table 4 [ PDF 17.3KB | 1 page ] shows selected statistics on doing business across borders for four developing regions. East Asia and the Pacific consistently ranks at the top, with the exception of days for export (Latin American and Caribbean) and days to open a business (South Asia).

Another key difference in private investment patterns among the regions is shown in Figure 4 [ PDF 19.2KB | 1 page ]. While the private sector has invested in concession and divestiture projects in other regions, in East Asia and the Pacific, investment is concentrated in greenfield projects which account for more than two thirds of the total investment in the region. This reflects the cautious approach taken in East Asia and the Pacific as opposed to Latin America and Europe and Central Asia (consisting mostly of Eastern European projects), which, according to some, proceeded ahead in the privatization process without the deep sectoral and institutional reforms required to facilitate strong private sector participation (ADB 2004).

While the economic successes of some countries in the East Asia and Pacific region over the past 30 years were partly attributed to well performing public sectors, serious deficiencies in public sector governance were evident in many countries by the time of the 1997 financial crisis. Low levels of government accountability, transparency, and probity contributed to the crisis. Despite efforts to correct these deficiencies in the post-crisis environment, many problems remain. In particular, institutions of public financial accountability often fail to meet internationally accepted standards, especially with respect to procurement management and information systems in government. Decentralization is often put forth as the answer.

In some East Asian countries, initial progress on decentralization has been promising. Where decentralization ”leaps” have been attempted, as in Indonesia and the Philippines, they have gone fairly smoothly. Intergovernmental fiscal systems have been institutionalized, workers have been transferred from central ministries to local governments without significant disruptions, and local authorities have taken up service-delivery functions reasonably effectively. Where decentralization has proceeded more gradually, as in Cambodia and Viet Nam, it has produced some gains in service delivery and public participation at the local level (White and Smoke 2005).

But there have been problems. Uncertainty over functional responsibility among different levels of government threatens to reduce the efficiency and effectiveness of the regimes. There is a need to develop robust financial mechanisms for channeling money to subnational governments. In some countries, the failure to allocate sufficient own-source revenues to local governments has hampered their ability to deliver services. A further challenge relates to the accountability of local governments and the capacity of their management systems. A lack of capacity among local government officials can severely hinder development opportunities.

Few empirical studies have examined the impact of decentralization on governance in East Asian countries. One of the reasons is that most countries in the region began the decentralization process relatively recently: the Philippines and Viet Nam in the early 1990s, Thailand and Indonesia in the late 1990s, and Cambodia at the turn of the century. Of these, Indonesia and the Philippines have gone the furthest in implementing comprehensive programs. However, even these economies still struggle with effective implementation of decentralization, especially in the area of infrastructure, and specifically in transport.

Decentralization has become a catchall phrase for describing a process that is highly variable, that results from diverse motives, and that includes a range of practices and institutional reforms. But even as these varied reforms have been implemented and economic growth has progressed in the region, poverty has manifested itself in pockets of exclusion. Income and access to economic opportunity reveals increasing rather than decreasing inequality, both across the region and within countries. Such opportunity is sharply differentiated by age and gender, level of education, location (e.g., urban-rural, upland-lowland, geographic barriers to transportation and commerce), and ethnicity.

Further complicating the decentralization process and its impact on growth and infrastructure spending, is the nature of infrastructure projects themselves. The impact of economies of scale, and spillover effects associated with this type of investment, are difficult to manage, especially for local governments. Accounting for these factors is especially important when decentralizing decision making and giving responsibility to lower levels of government. When infrastructure projects cover multiple jurisdictions, such as in the management of water resources or trunk roads connecting regions, this becomes especially problematic. Community competition can often lead to inefficient outcomes and over-investment. Indeed, the need to ensure equity, harmonize standards, and ensure efficient revenue collection has put limits on decentralization.

However, infrastructure projects are widely used to promote decentralization. These projects engender strong opinions within the community on the types of projects and service improvements needed in a region. The process of defining priorities for infrastructure investment often provides local citizens with their first opportunity to participate in public decision-making. Participation at the local level, if it becomes widespread, provides support for the decentralization process as a whole. Indeed, it is often with transport projects that decentralization processes achieve their most intense validation, as communities rally around investment in a local road or bridge.

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