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Coruption: The Boom and Bust of EastAsia

Governance and corruption have finalJy come to the fore of the


development debate. While interest in goverance began to surge in
the earl) 1990s, the East Asian crisis has catapulted the issue to
prominence. Analysts and academics. in a spate of anides and books,
have added their voices to the chon.s of criticism of the so-called
Asian miracle. Their verdict: Bad governance and corruption did the
"miracle" countries in.
Taking a different perspective. this book asks and attempts to answer
how these countries were able 10 attract enormous amounts of
investment and enjoy rapid growth (lver a thirty-year period despite
being perceived as hotbeds of corruption As convelllional wisdom
would have it. high rates of investment are inconsistent with high
levels of corruption. While this may be true in general. the chapters in
this volume suggest that we need to look illlO the nature of corruption.
Different types of corruption have varing effects On investment.
I. Edgardo Cll1IJOS is senior economist in the Strategy Policy
Depanment of the Asian Development Bank.
I/a-/ooll Clumg is professor at the Faculty of Economics and Politics,
Cambridge University
Emmalluel S. de Dios is professor in the School of Economics.
University of the Philippines.
Hadi Salehi Bfaltalli is professor in the Department of Economics.
University of Illinois at Urbana-Champaign.
Allell Hickell is assistant professor at the Depanment of Political Science,
University of Michigan. lie was previously assistant professor at the
Gra(lllatc School of Interational Relations and Pacific Studies.
Departmelll of Political Science, University of California at San Diego.
lomo K. S. is professor in lhe Department of Applied Economics,
University of Malaya.
SI.llhe Li is associate professor in the Depanmelll of Economics and
Finance. City University of Iiong Kong.
Peng Ua/l is director of Stalistical Research and Analysis. Nllmetrics
Management Systems. Santa Clara. California.
DO/lfld Lien is professor of economics and finance at the Umvcrsity of
Texas at Sn Antonio.
AlLdrew Macilltyre is professor in the Graduate School of International
Relations and Pacific Studies, Departmcnt of Political Science. University
of California at San Diego.
SalLjay PradlulI is senior governance advisor for the South Asia Region
at the World Bank.
Ateneo de Manila Univerit Prss
Kallpunan Avenue. Loyola Hi . Q.C.
P.O. Box 15, 109 . Manila
9
ISBN 971-550-377-2
CORUON
TE BOOM AD BUST OF EST AI
Eite b
J. ED Cs
ATENEO DE MANILA UNIVERSITY PRESS
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ATENEO DE MANIlA UNIVERSITY PRESS
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Copyright 2001 by Ateneo de Manila University and J. Edgardo Campos
Cover and book design by J. B. de la Pena
All rights reserved. No part of this publication may be reproduced. stored in a
retneval system. or transmitted in any form or by any means. electronic mechanical
photocopying. recording. or otherwise. without the written permission of ;he Publisher:
The National Library of the Philippines CIP Data
Corruption: the boom and bust of East Asia I
edited by J. Edgardo Campos; with contributions
from Ha-Joon Chang . .. I et al. J - Quezon City:
ADMU Press. c2001
1 v.
I. Financial crises - East Asia. 2. East Asia -
Economic conditions. 3. East Asia - Politics and
government - Corrupt practices. I. Campos. J. Edgardo.
II. Chang. Ha-Joon.
HB3722 332 2001 POI 1000025
ISBN 971-550-377-2
ACKNOWEDGMENTS
We gratefully acknowledge the financial support of the Foundation
for Advanced Study i n International Development (FASI D) of Japan and
the World Bank Institute (WBI) for this manuscript. Special thanks go to
Danny Lei pzi ger, former Chief of the Regul atory Reform and Private
Sector Development Division of the WBI; Farrukh Iqbal, former East Asia
Regi onal Coordi nat or for the WBI; and Mi chi ko Kakegawa, Program
Ofcer for FASID, under whose watch the various research papers were
initiated, and to Brian Levy and Stephan Haggard for their constructive
criticisms of the initial drafts of the chapter papers. We also wish to thank
participants of the Fifteenth WBIIFASI D Joi nt Seminar on Governance
and Private I nvestment i n East Asia for their comments and suggestions
on the revised versi ons of the chapter papers, Hannah Moore for her
patient editing of the penultimate version, Alice W Y Chan and Rebecca
Hi fe for their research assi stance, Daniele Evans for her pai nstaking
efforts at organi zi ng the workshops at which earli er drafts were pre
sented and di scussed, and Flor Guce for making sure the fi nal versi on
conformed to publi cati on guidel i nes.

CONTENTS
INTRODUCTION
]. Edgardo Campos . . e e . . . e . . . . . e e . . e e e . e . . e e . e . . . e . e . e e e . . e . e e . . . . . e . . . e . . e . . . . e e . . . e . e . . e e . . . . . e e . . . e . . e . . . . . . . . . . e . 1
1 CORRUPTION AND ITS IMPLICATIONS FOR INVESTMENT
] Edgardo Campos, Donald Lien, and Sanjay Pradhan . . . . e e . . e e . . e . e e . . e e . . . . e . . . . e e e 1 1
2 INVESTMENT, PROPERTY RIGHTS, AND CORRUPTION IN INDONESIA
Andrew MacIntyre . . e . e . . . e e e . . . . e e e e . . e e . e . e . e e . . e e . . . e e . e . . . . . . . . . e e . . . . . . . . . . e e . . e . . . . e e . e . . . e e . . e e . . . . e . . . . e 25
3 STATE, CAPITAL, AND INVESTMENTS IN KOREA
Ha-]oon Chang e . . . . . . e . . e . e . . . . . . . . . e . e . . e e . e . . . e e . . e . . . . . . e e e . . . . e . . . e . . . . . . . e . . e . e . e . . . . . . . . . . . . . e . e e e . . . . e . . . . 45
4 GOVERNANCE AND INVESTMENT IN CHINA
Shuhe Li and Peng Lian . . . . . . . . . . . . . . . . . e . . e . . . e . . . . . . . e e e . . e . . . . . e e . . . . . . . e . . . . . . . . . . . . e . . e . e . . . e . . . . . . . e 69
5 CENTRALIZATION, POLITICAL TURNOVER, AND INVESTMENT IN THE PHILIPPINES
Emmanuel S. de Dios and Hadi Salehi Esfahani . . e . . . e . e . . . e . . . . . . . . . . e . . . . . . . . . . . . . . . . . 1 01
6 GOVERNANCE, RENT-SEEKING, AND PRIVATE INVESTMENT I N MALAYSIA
]omo K. S . . . . . . . . . . . . . . . . . . e . . . . . . . . . . . e . . . . . . . . . . . . e . e . . . . . . . . . . . . e . . . . . . . . . . . . . . . . . . . . . e . . . . . . . . . . . . . . . . . . . . . . . . . 131
7 GOVERNANCE AND GROWrH IN THAIlAND
Allen Hicken . . . . . . . . . . . . . . . . . . . . e . . . . . . . . . e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
NOTES . . . . . . . e . . e . . . . . . e . . . . . . . . . . e . . . . e . . . . . . e . . . . e e . . e . . . . e . . . . . . . . . . . . . e . . . . . . . . . . . . . . . . . . . . . e . . . e . . . . . . . . . . . . . . . . . . . . . . 183
REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . e . . . . . . . . . . . . . e . . . . e . . . e . e . . . . . . . . . . . . . . . . e . e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . e . . 198
INDEX . . . . . e e . . . . . . . . . . . . . . e e . . . . . . . . . . . . . . . . . . . . . . e . . e . . . . . . . . . . . - . . . . . . . . . . . . . . . . . . . . . + e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
INTRODUCTION
] Edgardo Campos
In this day and age, it has become fashi onable to talk about "good
governance" and i ts importance in stimulating and sustaining economic
growth. The current heightened interest i n this subject has been stimu
lated by the enhanced capacity of economists and political scientists to
model more ri gorously the incentive dynamics within di fferent gover
nance structures, to quantif the quality of governance, and to measure
its impact on economic performance (see, for instance, Kaufmann 1 996,
Urata and Kawai 1 999, Mauro 1 995) .
The East Asian financial crisis has heightened the concern not only
over good governance but al so over the rel ati onshi p between gover
nance and corruption. Many critics of the Asian miracle have argued that
the governance structures underpinning the East Asian economies have
been largely responsible for the crisis. I nterestingly, however, the quan
titative indices that have been used to rank countries in terms of corrup
tion, and more generally rule of law, either did not change much before
and after the crisis set in or changed in an "unexpected" direction. ! China
and I ndonesi a, for example, had always been ranked among the most
corrupt countries in the world, followed not too far down by Thailand
and the Philippines. Before the crisis, Malaysia was always ranked among
those with better rule of law.
The term "good governance" is somewhat slippery and ambiguous
as numerous defi ni ti ons permeate the l i terature. Whatever the defi ni
ti on, t here appears t o be a cons ens us that good governance mus t
necessarily encompass the protection of property rights. This has led to
the corol l ary that credi bl e contract enforcement i s necessary to attract
Introduction
productive investments and thus sti mulate economi c growth. I ndeed,
there is now reasonabl e empi ri cal evi dence that supports thi s thesi s
( see, for instance, Keefer and Knack 1995) .
Impli ci t in much of the literature on private property rights is the
assumption that formal l egal institutions, such as an independent j udi
ciary, are critical to the credible enforcement of contracts (see, for instance,
North and Weingast 1 989; North 1990) and hence for stimulating invest
ment and growth. 2 While not denying the importance of such institutions,
this volume questions the almost theological belief that countries with
out such i nsti tut i ons are desti ned to remai n poor and economi cally
underdevel oped. To be sure, i t does not chal l enge the val i di ty of the
Northian thesis: as many historians have shown, over the very long haul,
an economy will eventually stagnate if institutions that promote the rule
of law fail to develop. The volume, however, does raise the issue of what
happens in the interim between now and the almost invisible long-term
horizon. For busi nessmen and pol icy makers i n developi ng countri es,
the Northian prescri pti on is of little utility as they, thei r children, and
perhaps even their grandchildren wi l l have been dead by the time the
rul e of law emerges i n thei r countri es.
East Asi a's experi ence over the past thirty years provi des a window
into the labyrinth between the "now" and North's long haul. As the case
studies in this volume maintain, in East Asia informal, nonlegal arrange
ments emerged (over a rel atively short period of time) to fll the formal
institutional vacuum. These institutions made contracts enforceable and
thus encouraged inflows of private (and productive) investment. Indeed,
there is now a mountai n of evi dence i ndi cati ng large fows of private
investment into East Asia, both domestic and foreign, despite the weak
ness or even absence of l egal instituti ons.
The Asi an economic cri si s has brought governance and the rul e of
l aw i nto the forefront of di scussi ons and debates about the so- called
Asi an Mi racl e. The cri si s, many cri ti cs of the mi racl e argue, erupted
because of pervasive, i nsti tuti onali zed corrupti on made possi ble by a
dysfuncti onal, politi cally malleable legal system. The resulting calls for
i nsti tuti onal reform have been deafeni ng.
These critics, however, have lost sight of the obvi ous fact that thi rty
years of i mpressive, ext ensively document ed economi c performance
preceded the cri si s. Thi s vol ume attempts to address thi s seemi ng di
chotomy. To be sure, the volume does not purport to be another treatise
on the cri si s. Rather, i t si tuates the cri si s wi thin the larger context of
institutional change. As many of t he authors argue or imply, t he cri si s
2
Introduction
is on the one hand a manifestati on of institutional inertia in the midst
of a rapidly changing environment, and on the other a commentary on
the problems of transi ti on to a soci ety governed by the rule of law.
The East Asian Paradox
The experience of the six countries presented in this volume-China,
Indonesi a, Korea, Mal aysi a, Phili ppi nes, and Thailand-presents a dif
ficult paradox to proponents of "good governance." On the one hand,
these countries have managed to attract large flows of private i nvest
ment over a very long peri od (although the Philippines was a latecomer) .
On the other, with the excepti on of Malaysia, these countries have fea
tured pr omi nentl y i n t he "worl d's l i st" of mos t corrupt count r i es.3
Moreover, as conventi onal wisdom would have it, corrupti on in these
countri es i s highly correlated wi th a perceived weakness of l egal i nsti
tutions. Hence, the proponents of "good governance" are confronted with
exactly the opposi te of thei r revered gospel : in East Asi a, weak l egal
institutions have existed side by side with high levels of investment (not
to mention rapi d rates of growth) .
The volume attempts to resolve thi s paradox. I n different ways, a
number of the authors argue that instituti ons that promote the credible
enforcement of contracts have indeed existed in many of these East Asian
countries. These institutions, however, are of the informal, nonlegal variety
which the above proponents ofen perceive (and believe) to be detrimen
tal t o economi c growth because they propagate r ent - seeki ng and
consequent large- scale corruption. Their assumption is that if institutions
foster rent-seeking and corruption, then they must be inimical to growth.
By contrast, the authors argue that rents and corruption have been essen
tial to the credible enforcement of contracts and thus to the large infows
of investment. In his chapter on Indonesia, Macintyre makes this point
most crisply and vividly. He maintains that special features of the Suharto
regime had allowed it to function much like a j oint monopolist trying to
maximize profits across complementary products. Specifcally, he argues
that Suharto established and nurtured a political structure grounded on
two pillars, corruption and investment. The structure gave Suharto ample
opportunity to extract rents, to distribute it systematically across the bu
reaucratic and political landscape, and to keep the costs of generating the
rents from squeezing out long- term investments. A conscious decision to
open the capital account early in the regime's life efectively tied Suharto' s
hands and credibly committed his regime to honoring agreements with
investors: investors could take their money out if they sensed any unfa-
3
Introduction
vorable change in economic policies. Hence, Suharto and his regime had
strong incentives to ascertain that private investors were not subj ected to
independent, uncoordinated rent- seeking, bribe-taking eforts that discour
aged long- term investments. I n sum, while investors might have had to
fork out considerable rents, whether in the form of bribes or shares, they
were assured that their investments would be protected from harassment
and that agreements they had made with the government were adhered
to. The rents and associated corruption involved have been the glue that
has tied this i nformal system together and has made the system work
effectively over thirty years.
Si mi l arly, Li and Li an cont end that the pol i ti cal regi me in Chi na
behaves much l i ke a "j oi nt monopol i st. " They present an abstract sys
tem which they l abel market - preserving authoritarianism ( MPA) , argue
that China fts this abstraction reasonably well, and then conclude that
the basi c features of an MPA have l ed to a bal ance between pol i ti cal
centralization and economi c decentralization that ultimately pl aces con
straints on corruption i n order to attract private investment. Among the
more concrete, China- specific features of an MPA, they i denti f a set of
i nternal rul es governi ng recrui tment, promot i on, and behavi or withi n
the bureaucracy, an economi c performance- based system of promoti on
within the Communi st Party, collective decision- making mechanisms that
i ncrease transparency i n the proj ect- approval process, a graduated al
l ocat i on of cont r ol or aut hori t y at vert i cal l evel s of publ i c - s ect or
management-meani ng that lower- l evel offi ci al s have expl i ci t l imits to
what is within their authority, fscal decentralization, and a court system,
whi ch, whi l e cl early weak and inadequate, renders impartial j udgment
in cases where the verdict can be easily verifi ed by a third party. 4 Com
bined with the exi stence of a large overseas Chi nese capi tal i st cadre,
these features, the authors argue, have l ed to the adopti on of informa
ti on- reveal i ng mechani sms and the emergence of strong cross- regional
competi ti on as i nformal means to enforce investment agreements in
China, where formal legal institutions are weak, and, as a by- product, to
i ndirect means of containing corrupti on. 5
I n hi s chapter on Korea, Chang takes a sl i ghtly different route but
essenti al l y arri ves at a si mi l ar concl usi on: corrupt i on i s an essenti al
el ement of an "economic" governance system that has been very suc
cessful at sti mul ati ng private investment. The Korean government, he
argues, coul d and did set up a system of highly interventionist pol i ci es
that ( 1) made domesti c i nvestment much more attractive than consump
ti on, ( 2) created monopol y rents for l arge domesti c fi rms (chaebols) i n
4
Introduction
exchange for investing in productive, export- oriented activi ti es, (3) pro
vided implicit ( and illegal) wages to relatively poorly pai d publ i c ofci al s,
( 4) provided di screti onary funds to l ocal pol i ti ci ans to enabl e t hem t o
buy pol i ti cal support, and ( 5) l i mi t ed corrupti on fl ows to sect ors that
were l ess i mportant for internati onal competitiveness . Like i ts counter
parts in Indonesia and Chi na, thi s tightly kni t, relatively well - thought-out
system was glued together by rents and corrupti on.
Institutional Change and the East Asian Crisis
Hi ghly authoritarian regimes have governed each of the three coun
tries discussed above. One is thus tempted to deduce that democratizing
these regimes will improve governance and reduce corruption. Economi c
historians i ndi cate that over the l ong haul this i s l i kely to be the case.
Yet if worl d history i s any gui de, the transition peri od i s likely to be very
l ong. And in the transiti on, things may not get better until much later.
De Di os' s and Esfahani 's study on the Phi l i ppi nes i dentifi es a fun
dament al di l emma t hat may confront count ri es under goi ng such a
transiti on. Democratization tends to distribute power and political infu
ence more widely across different groups. This creates more so- cal l ed
veto poi nts i n t he deci si on- maki ng process and pot enti al l y l eads to
gridlock. I n the absence of firmly established democratic instituti ons, i t
l eads to what Shleifer and Vishny ( 1993) cal l an "independent monopo
l i st " regime of rent- seeki ng and corrupti on that si gni fi cantly i ncreases
transactions costs ( includi ng rent- seeking costs and associated levels of
corrupti on) . A natural , al most knee-j erk response to thi s has been to
maintain a strong executive branch of government, as thi s i s vi ewed as
a way to prevent gri dl ock and keep transacti ons costs from bursting at
the seams. As de Di os and Esfahani argue, thi s moves the system cl oser
to a "joi nt monopolist" regi me i n whi ch the executive has strong i ncen
tives to keep rent - seeki ng and corrupti on from sucki ng up i nvestment
and growth. Unfortunatel y, as these coauthors so vi vi dl y i l l ustrate i n
thei r analysi s of the Phi l i ppi nes' postwar experi ence, i t al so creates a
seri ous credi bl e commi tment probl em: a strong executi ve branch i n
creases t he ri sk to i nvest ors of havi ng agreement s reached under a
particular regime "reconstructed" if key pol i ti ci ans of that regime fai l to
win reelecti on or, as i n the case of the Phi li ppi nes, are restricted by law
to term limits. 6 The recent political events in the Philippines-the so- called
Peopl e Power Revol uti on 2-whi ch has led to the unseati ng of a dul y
elected president well withi n the constitutional term of si x years, highlights
the de Di os-Esfahani di l emma. The Presi dent, Joseph Estrada, exerci sed
5
Introduction
the full powers vested in him by the Constitution to infuence decisions
in favor of individuals and groups who could fork out large sums of money
in bribes. Wile this practice may not have been unique to him, the manner
in whi ch he had done so created consi derabl e uncertainty among the
business community and eventually shut off private investment. Presiden
tial infuence was exercised randomly, with little rhyme or reason, inevitably
afecting existing or proposed contractual arrangements; only the avail
abi l i ty and si ze of payoffs seem to have mattered. Even the supposed
built-in discipline of a "joint monopolist" came to be violated. 7 As Fabella
aptly put it, the president had moved beyond the "Tlight Zone" of cor
ruption and rent- seeking, i . e. , what could be tolerated by the economy,
thereby creating uncertainty and strong negative reactions from the busi
ness community and eventually from many segments of civil society.s The
dilemma of balancing the need for a strong executive and the potential for
gridlock is indeed a very real dilemma for nascent democracies, especially
those in transition from an authoritarian state.
Implicit in de Di os's and Esfahani 's argument is the assumption that
both the j udi ci ary and pol i ti cal parti es are weak. As the experi ence of
many former communist countries indicates, this is likely to be the case
for countri es undergoi ng the transi ti on to democrati c rul e. 9 Pol i ti cal
parti es are more l i kel y to represent temporary coal i ti ons rather than
i deol ogi cally grounded organizations and the j udi ci ary to be hampered
by l ack of experi ence and resources.
The discussion on the Philippines brings us to an inextricably linked
topic of this volume, namely, institutional change and the Asian economic
crisis. The Asian economic crisis has turned into a convenient instrument
for lambasting the absence or weakness of legal institutions in East Asian
countries and how these inadequacies have been the principal culprit for
these countri es' current woes. The criticisms, however, have l ost sight of
the fact that most of these countries have experienced rapid growth and
si gnifi cant reducti ons i n poverty over the last thirty years despite these
presumed institutional deficiencies. Through the postwar experiences of
six East Asian countri es, this vol ume addresses the faw in the logic un
derlying these criti ci sms and examines an underexpl ored di mensi on to
the crisis-institutional change as so espoused by North ( 1 981) .
MacI ntyre, Chang, and Li and Lian address this issue in their chap
ters. However, it is the chapter on Mal aysia that more vividly illustrates
the dynamics of institutional change and how the crisis is but a refec
ti on of these dynami cs. As North posi ts, instituti ons evolve in response
to technol ogical change. Jomo contends that rapid fnancial Iiberaliza-
6
Introduction
ti on, which i s a form of technol ogi cal change, al tered the Mal aysi an
economi c l andscape so drasti cally t hat i nsti tuti ons coul d not possi bl y
adapt to the changes quickly enough. The resul ting i nstitutional gap, he
concl udes, has brought forth the economi c cri si s.
Malaysia's postwar hi story and its experi ence with the current crisis
exemplif the difficulty of undergoing fundamental institutional change.
Among the six countries in this volume, Mal aysia is unique in the sense
that it has ranked consi derably hi gh on the "rul e of l aw" scal e as re
fected in various international surveys of busi nessmen ( or alternatively,
consi derably l ow on t he corrupt i on ranki ngs) . And yet , cri t i cs have
bl amed rent - seeki ng and corrupt practi ces for the country's failure to
thwart the Asi an contagi on. Jomo's chapter offers a sti ngi ng rebuke of
such critici sms. Like t he other authors, he makes a strong case for rent
s eeki ng and c orr upt i on as bei ng par t and par cel of " economi c"
governance and implicit contract enforcement in Mal aysi a. He emphati
cally argues, however, that financi al l i beral i zati on created a deep and
wi de i nst i t ut i onal gap t hat ul t i mat el y t r ansl at ed i nt o arguabl y t he
country's most seri ous postwar economi c cri si s. Financial liberalization
required changes in regulatory and legal institutions; and these changes
directly challenged the instituti onal arrangements that underpinned the
country's economic governance system, i . e. , arrangements that had rent
seeking and corruption at the very core of the country's "shared gro\h"
phenomenon. Hence, the requi red changes coul d not be expected to
emerge qui ckly. Not surpri si ngly, l i ke a body wi thout the natural de
fenses to thwart a virus, Malaysi a went i nto convul si on-the cri si s.
I n fact. J omo goes further i n el aborating hi s thesi s of i nsti tuti onal
inertia. He descri bes and analyzes in pai nstaking detail the constraints
current Prime Minister Mahathir confronted in trying to move the sys
tem away from the foundat i ons of the New Economi c Pol i cy ( NEPl.
which sought to redistribute wealth toward the economically di sadvan
taged but politically more influential Bumiputeras at the expense of other
ethni c groups, in parti cul ar the Chi nes e. Tomo concl udes that, in the
final analysi s, Mahathir had to build on the NEP in order to bring about
i nsti tuti onal change, a gradual process pushed al ong by a pol i ti cally
well - i nformed strategy and whi ch took more than a decade to unfol d.
To have expect ed t he regul at ory and l egal i nst i t ut i ons t o res pond
promptly t o the new environment thrust upon them by fi nancial l i ber
alizati on was thus , in his vi ew, unreal istic.
The Thai experi ence i l l ustrates essenti al l y the same phenomenon
but with a sl ightly different twi st. Hicken contends that financial l i ber-
7
Introduction
alizati on was the proverbial fi nal straw that broke the camel 's back. He
notes, however, that the makings of the crisis likely began a decade earlier.
Hicken compares the government's response to the macroeconomi c
cri si s of the early 1 980s wi th its response to the late 1 990s macroeco
nomic crisis brought forth by t he Asian fu. Until t he recent constitutional
change, Thai pol i ti cs was characterized by a weak separation between
the executive and legislative branches of government, multiple political
parties (each of which tends to be regionally based and includes com
pet i ng i nt er nal fact i ons ) , and an el ect oral system bi as ed t owards
individualistic or personalistic campaign strategies-as opposed t o strat
egies based on party reputation or a party's policy positions. On the one
hand, the fi rst i s conducive to the promot i on of wel far e- enhanci ng
national pol i ci es and to swift responses t o crisis; on t he other, t he sec
ond and t hi rd encourage gri dl ock, the passage of narrowly targeted
pol i ci es that award particul aristic benefits to a l egi sl ator's constituen
ci es, and the diversi on of government resources through corruption to
raise campaign funds. Hicken argues that these features did not change
fundamentally between the two crisis peri ods, and yet the government's
response was much di fferent . I n the earl i er per i od, the government
managed to push pol i ci es that stabilized the macroeconomy, attracted
huge fows of private investment, and encouraged economic growth. In
contrast, in the latter peri od, the government proved incapable of ad
dressi ng the burgeoni ng probl ems in the fi nanci al sector even though
there was cl ear recognition in some corners that these problems would
eventually derail the economy.
He posi ts that duri ng the early 1 980s pol i ti cal parti es needed the
mili tary's support to maintain pol itical stability. Back then the military
was still an i mportant (if not the dominant) player i n the political arena.
Moreover, the parties themselves were in constant di sagreement, unable
to forge compromi ses on leadership arrangements. So the military was
seen as a stabilizing force. The result was the appoi ntment of General
Prem as prime minister ( 1 980-1 988) with a mandate to get the country
out of the crisis . Being a nonelected PM, Prem was not tied down to the
narrow particularistic tendencies of regional politi cs. Hence, he had some
fl exi bi l i ty to push more nati onally encompassi ng economi c pol i ci es.
However, he ( and the military) recognized that he also needed the parties
to hel p govern the countryside; gone were the days when the mili tary
was the all - encompassi ng force whose unmi stakable presence was fel t
throughout the country. This led to what Hicken cal l s the "poli cy- patron
age" compromi se between Prem and the parti es: Prem would have the
8
Introduction
fexibility to fashion macroeconomic policies with little interference from
pol i ti ci ans and the parties would have control over sectoral mi ni stri es
whose mandates were more conducive to generating pork barrel proj ects.
Prem thus managed to insulate the economi c technocracy from pol itical
i nterference, appoi nti ng ( or i nfl uenci ng the appoi nt ment of) hi ghl y
qualified and respectable professi onal s to key positions in the four key
elite economi c agenci es-the Pl anning Mi ni stry ( NESDB) , the Mi ni stry
of Fi nance, the Budget Bureau, and the Central Bank.
Toward the l ate 1 980s and early 1 990s, the pol i ty began to change
si gni fi cantl y wi th a si gni fi cant mi ddl e cl ass sl owly emergi ng. As the
economy grew and the middle class expanded, demands for democrati
zati on i ncreased as wel l , l eadi ng eventual l y to the fi rst el ected pri me
minister. As Hicken points out, however, thi s opening up of the pol itical
system had a di sastrous effect on the elite agenci es that made up the
technocratic system. Whereas in the past these agencies were rel atively
insulated from political interference, with greater democratization they
became part of the spoils that accrued to members of the winning coali
tion. Hence, each of the elite agencies tended to be controlled by diferent
political parties bonded together by convenience and not by any common
political persuasion. This greatly weakened coordination among the agen
cies and biased economic decision making toward narrow concerns. This
l eft the agenci es l ess capabl e of respondi ng to the new environment
imposed by rapid financial liberalization which, as the Malaysian experi
ence suggests, creates unrealistic demands on institutions.
The Thai experi ence illustrates once again the difficulties of under
goi ng a transi ti on from an authoritarian to a democratic setti ng. The
shift to unstabl e, coal i ti on- based politics has had seri ous adverse con
s equences for economi c management . I n ti me, new i nst i t ut i onal
arrangement s will l i kel y emerge to respond to t he defi ci enci es. The
passage of the 1 998 Constituti on is a step in the right directi on. Yet given
the Philippines' experience, the evolution to a new, effective institutional
equi l i bri um will likely take a long ti me.
I ndonesi a, South Korea, Thailand, and Malaysia have i ndeed been
hit hard by a deep economi c crisis which began as a financial cri si s i n
Thai l and but qui ckly expl oded i nto a ful l - blown economi c cri si s and
spread rapi dl y to the other countri es . Whi l e spared the worst of the
problems, the Philippines has not escaped the contagi on. China, on the
other hand, appears to be weatheri ng the storm, posti ng a rather re
markable annual GDP growth rate of 7.8 percent for 1 998 whi l e the rest
of the regi on's economi es contracted or stagnat ed.
9
Introduction
The stri ki ng economi c performance of Chi na in the mi dst of the
region's most serious economi c crisis i n the postwar peri od i s perhaps
not surprising. Of the six countries studied in this volume, China is the
only one that still has considerable restrictions on fnancial markets and
these restri cti ons have i nsulated the country from the fi nanci al storm
that has ravaged the rest of East Asia. Its experience thus far provides
some support to the thesis of other authors in this volume: rapid fnan
cial liberalizati on i s bound to lead to economi c cri si s. I t also suggests
that gradual opening up of fnancial markets, rather than the " big bang, "
may be the appropriate approach for many developi ng countries.
Insti tuti ons do change but they do so very sl owly and usually in
response to-or pushed by-technological change. The liberalization of
fnancial markets i n the East Asian countries analyzed here represent a
maj or change in technol ogy that demanded correspondi ng changes in
the i nsti tuti onal arrangements governi ng the public sector and, most
important, the rent-extraction regime. This was not well understood and!
or well appreciated by the leadership and governments in the affected
countries. The result was a sluggish (some would say hesitant) response
that inevitably led to a ful l -bl own cri si s. Unmistakably, corruption has
been the boom and bust of East Asia.
Structure of the Volume
The volume is organized into seven chapters. It begins wth an econo
metric piece presenting cross- country evidence of the impact of governance
on investment. Chapter one, by Campos, Lien, and Pradhan, presents a
nuanced argument about the i mpact of "good" governance, whether
through formal or informal mechanisms, on investment. They show that,
indeed, governance matters, as refected by the fact that countries with
lower levels of corruption do attract higher levels of investment. However,
they also show that, given the level of corrupti on, the "predictability" of
corrupti on al so has a si gni ficant effect on i nvestment. Ceteris paribus,
countries in which corruption i s more predictable-meaning the likeli
hood that a payoff will lead to the actual granti ng of the illicit favor
sought-tend t o attract relatively higher levels of investment.
The rest of the volume presents six country case studies. I n varying
degrees, each illustrates and concretizes the phenomenon "predictabil
ity of corrupti on" and reconciles this phenomenon with the Northian
thesi s. The six follow i n sequence-Indonesia, South Korea, China, the
Philippines, Malaysi a, and Thailand.
1 0
W
CHAPTER ONE
CORRUPTION AD ITS
IMPLICTIONS FOR INVSTMENT
] Edgardo Campos, Donald Lien, and Sanjay Prdhan
In the last few years, corruption in developi ng countries has come
to the forefront of development thinking. Tight fscal situations at home
have made donor countries focus more on the i mpact of thei r ai d to
developing countries, raising concerns among bilateral and multilateral
aid agencies over the effect of corruption on economic performance. At
the same time, the trend towards democratization has made developing
country governments subject to greater scrutiny and accountability from
a broader segment of the general public. The fall of the Bucharam ad
ministration i n Ecuador, the convicti ons of two former presidents in South
Korea, the collapse of the Mobutu regime i n Zaire, the surprising res
ignati on of Suharto i n Indonesia, and the peaceful midterm ouster of a
democratically elected president in the Philippines, Joseph Estrada, are
all testi mony to the salience of corrupti on as a key i ssue upon which
governments are i ncreasi ngly being j udged.
Despi te t hi s , there remai ns a s i gni fi cant degree of ambivalence
among many poli cy makers about the real impact of corrupti on on the
economy. This less- than-enthusiastic response i s due in part to the so
called East Asian puzzle. I n a number of East Asian countries, high rates
of growth had been sustained over a long period despite high levels of
corruption. A number of independent organizations that have conducted
extensive surveys of busi nessmen throughout the world, e. g. , Transpar
ency Internati onal (TI ) , have ranked Chi na, Vietnam, I ndonesi a, and
Thai l and among the most corrupt countries. Yet, as table 1 shows, up
till the recent economi c crisi s, these countries have grown at phenom
enal rates and, more i mportant, attracted a considerable fow of private
11
Corruption and Its Implications for Investment
capi tal . Thi s obs ervation has pos ed a real chal l enge to the received
wisdom that corrupti on i mpedes economi c performance: it is inconsi s
tent with the theory that weak i nsti tuti ons of governance, of whi ch
corruption is a concrete manifestati on, discourage investments and thus
constrict growth.
Table 1 Corruption and Private Investment
/vaHal oolP vala
Coc^ly T'Ha^k ^gs ! 99j /va 00P0owl^Hala ' ^vasl1a^llo00P
Vatscoa. ! Jj ! 9BJ!995j' ! 9B! -! 993j
C^ ^a 243 ! ! .J5/ ^ a
val^a1 ^ a B.W ^ a
T^a`a^J 3 33 B 24 B5/
' ^Jo^asa 25 J ! 35
' ^Ja 2 3 5 4! ! ! ! !
cgy,l 2 B 3 B B J3
/a^ya 2 2! 3 2 ! ! J!
Baz 2 9 2 J ! 5 4
Vat co 3 3J ! J ! 3 B
\aw/aa a^J 943 2 4J ^ a
From World Development Indicators 1 997.
t 1990-19950nly
Scholarly concern over corruption predates the emergence of corrup
tion as a highly controversial issue among practitioners. Many scholars,
including Rose-Ackerman ( 1 978) . Klitgaard ( 1 988) , and Wade ( 1 982) , have
sought to understand better the complexities that underpin the existence
and persistence of corruption. In fact, much of the intellectual discussion
on the implications of rent-seeking activities ( Kreuger 1 974; Bhagwati 1 982;
Tul l ock et al. 1 988; Murphy, Shl eifer, and Vishny 1 993) and the role of
institutions ( North 1 98 1 and 1 990) for economi c performance touched
implicitly on the potential impact of corrupti on. l However, because thi s
i ntel l ectual strand has, up til l recently, not l ed to l arge cross- country
empirical testing, it has not been able to contribute efectively and con
vincingly to clarifing the consequences of corrupti on.
With the devel opment of better databases, a number of schol ars
have managed to undertake much- needed cross- country empiri cal re
search. I n what i s probabl y a semi nal pi ece of work i n thi s area, Mauro
12
Corruption and Its Implications for Investment
( 1 995) has provi ded econometric analysis and evidence of the negative
impact of corrupti on on investment and growth. More broadly, Keefer
and Knack ( 1 995) show empirically that weak institutions, as manifested
in part by the extent of corrupti on, i mpede economi c growth. In a dif
ferent vei n, Stone et al . ( 1 996) and Paul ( 1 995) use surveys to extract
evidence of high transactions costs that accompany activities commonly
bel i eved to be associated with corrupti on, e. g. , customs . Neverthel ess,
this research still fails to explain why a number of East Asian countri es
persi st as outl i ers .
Wei ( 1 997) has at t empt ed the first empiri cal anal ysi s that more
poignantly addresses the East Asia puzzl e. He shows that, control l i ng
for other fact ors such as GDP ( gros s domest i c product) I capi t a, the
i mpact of corrupti on on the fl ow of foreign direct investment ( FDI) i s
no different in East Asia relative to other countri es. 2 The i mpl i cati on is
that in East Asia other factors swamp the negative effect that corruption
has on FDI . This offers a possible explanation for why East Asian coun
tri es have grown more rapi dl y des pi t e s i gni fi cantl y hi gh l evel s of
corrupti on. There i s, however, one probl em with hi s analysi s: the i n
fows and outfows of FDI are domi nated by countries bel onging to the
Organizati on for Economi c Cooperati on and Devel opment ( OECD) . I t
is quite possi bl e that the results woul d be different if the OECD coun
tri es were excl uded from the sampl e as "hosts" of FDI or, alternatively,
if the dependent variable used was private investment ( both domesti c
and forei gn) . 3
In fact. other empirical fndings of Wei suggest that there is more to
the corrupti on story than meets the eye. He finds that ethnic ti es l ead
to higher fows of FDI and, in particular, that much of the FDI that fows
i nt o Chi na comes from overseas Chi nese. What thi s suggests is that
informal institutions may be an important omi tted vari able that affects
the nature of corruption and thus its impact on investment. It supports
the thesis that in East Asia, informal norms bound inseparably with illicit
exchanges help enforce intertemporal transacti ons that facilitate rel a
ti vely l arger infows of FDI .
This thesis i s consistent with the work of Shleifer and Vishny ( 1 993) .
Shleifer and Vishny analyze different types of corrupti on regimes-mo
nopolistic versus independent "suppliers" of bri be- generating products
an approach that is also evident in Kaufmann' s recent work (1996) . This
chapter foll ows thei r line of reasoning. That is, di fferent corrupti on re
gi mes have different effects on i nvestment. I n parti cular, we argue and
provi de empiri cal evi dence that regi mes i n which corrupt i on i s more
13
Corruption and Its Implications for Investment
"predictable" (in the sense that the favor, service, or product being sought
i s more likely to be granted) , ceteri s pari bus, have a smal l er negative
impact on investment than those in which it i s less predi ctable. How
ever, we al so show that the level of corruption matters as well. Given the
same degree of predictability, lower levels of corruption result in higher
levels of investment. In sum, we are able to categorize countri es i nto
three broad types : (1) those wi th hi gh l evel s of corrupt i on and l ow
predictability are the worst off in terms of attracting private investment;
( 2) those with high levels but greater predi ctability are better off than
those i n (1) in terms of attracting relatively higher levels of private in
vestment; and (3) those with low levels of corruption and high predict
ability are the most well - off. East Asi a's "puzzling economies" are likely
to fall in the second category.
This chapter is divi ded into three parts. In the first, we present and
discuss a more generalized versi on of the Shleifer / Vishny approach. We
then descri be our data ( incl udi ng thei r l i mi tat i ons) , the econometri c
model we used for our analysi s , and present our empi ri cal fi ndi ngs .
Finally, we draw some conclusions and make some suggestions for future
empirical research on corrupti on.
Why Predictability Matters
The underlying logic of our approach can be illustrated with a simple
exampl e. 4 Consi der a si tuati on i n which several firms are confronted
wi th the need to bri be several government offi ci al s in order to obtai n
a monopoly franchi se to provi de some publ i c servi ce. Each of the offi
ci al s has veto power over a fi rm's appl i cati on but none have absol ute
power to grant the franchi se. Suppose further that each of the oficials
comes from a different region in the country and each is biased toward
helping individuals who come from his or her regi on. Now contrast this
with a situation in which there is a single public ofcial who can decide
on awarding the franchise and that offcial has no regi onal sympathi es.
These two si tuati ons di ffer i n terms of the degree of uncertainty that
frms face about the possibility of actually obtaining the franchise should
it pay bribes. In the second, there is a much higher degree of certainty
barri ng any unfor es een i nt ervent i ons , t he fi r m wi t h t he hi ghes t
will i ngness to pay will get t he franchi se. I n t he fi rst, there i s no such
guarantee. I n al l likeli hood, therefore, frms will invest less if confronted
with the frst situation than when faced with the second, e. g. , the winning
firm ends up supplying completely depreci ated general - purpose dump
trucks (whi ch would make them mechani cally more troubl esome than
14
Corruption and Its Implications for Investment
average) for col l ecti ng the garbage as oppos ed to t rucks speci fi cal l y
desi gned for garbage col l ecti on-perhaps even new ones.
The fi rst situation i s what Shleifer and Vishny refer to as a regime
with independent "suppliers, " the second as one with a monopoly sup
pl i er. The key here, however, is not so much the di sti ncti on between
i ndependent versus monopol y s uppl i ers; i t i s one of predi ct abi l i ty.
Consi der again the second case of a si ngle publ i c offi ci al having mo
nopoly power over the granting of the franchise. That official obtains his
power from the office he or she holds . Suppose that the politics i n the
country i s such that ruling cliques change ever so often and with each
change comes a reshuffing or replacement of government offi ci als . In
this case the si ngl e publ i c offi cial may be i n offi ce for a very l i mi ted
ti me. When hi s replacement takes over, this indivi dual could deci de to
terminate the franchi se ( or make it extremely di ficult for the exi sti ng
franchisee to operate) . Hence the frm that originally obtained the fran
chise can never be certain that it wil l indeed maintain the rights accorded
to it. It could possibly pay additional bri bes to the new official but this
only shifts the uncertainty to the cost side of the equati on. In either case
the firm will be l ess willing to invest adequately to del iver the servi ce,
e. g. , they will provi de ful l y depreci ated general - purpose dump trucks
instead of real and newer garbage trucks.
Does Theory Meet Reality?
In this section, we explore the implications of a unique database for
the particular thesi s that we have proposed above. Speci fi cally, we hy
pothesize that the predi ctability embodi ed in a corruption regime i s as
i mportant as the extent of corrupti on. We test this usi ng data from a
large- scale survey of firms conducted for the World Devel opment Report
1 997 of the World Bank. Bel ow, we descri be the data, di scuss the vari
abl es we used, and present our test resul ts.
The Data
Though there has been considerable schol arly research on the issue
of corruption, only i n recent years have large- scale cross- country empiri
cal studies emerged. The main probl em with undertaki ng such a task was
the ahsence of data on corrupt i on. Because of the nature of the beas t ,
getti ng direct i nformati on on the extent of corrupti on i n any country and
especi al l y i n devel oping countries has been el usive. Wi th t he advent of
greater pol i t i cal and economi c openness worldwide, some i ndependent
organizations have managed to conduct worl dwide surveys of business-
1 5
Corruption and Its I mplications for I nvestment
men on a variety of issues, some of which relate to corruption, and have
been compiling and collating data fom these surveys. Indeed, the empiri
cal work that has emerged in the last few years has made extensive use
of databases from one or more of these organizations. s
To the best of our knowl edge, however, none of these surveys has
introduced questions that pertain specifically to the uncertainty surround
ing corruption in respondents' countries. As part of its efforts to prepare
and complete the World Development Report 1 997-The State in a Chang
i ng World, the Worl d Bank conducted a l arge cros s - country survey of
private busi nesses desi gned to obtai n informati on on a number of i n
stitutional i ssues: ( 1 ) the predictability of laws and pol i ci es, ( 2) political
instability and security of property, ( 3) government- busi ness i nterface,
( 4) bureaucratic red tape, and ( 5) the eficiency with which government
provides services. Questions pertaining to the extent and the uncertainty
surrounding corrupti on were included in (4) ; i n fact, of the eight ques
tions, four deal t wi th corruption. The relevant questi ons for thi s chapter
are presented in table 2.
Table 2 Survey Questions on Corruption
"I t i s common for fi rms i n my l i ne of busi ness to have to pay some i rregul ar ' addi ti onal payments' to
get thi ngs done." Thi s i s true
) al ways 2jmostl y (3) frequenHy 4) someti mes 5)sel dom )never
2 "Fi rms i n my l i ne of busi ness usual l y know i n advance about how much ' addi ti onal payment' i s. "
Thi s i s true
) al ways 2jmostl y (3) frequently 4) someti mes 5)sel dom )never
3. "Even i f a fi rm has to make an 'addi ti onal payment' i t al ways has to fear that i t wi l l be asked for
more, e.g . , by another ofi ci al ." Thi s i s true
) always 2jmostl y (3) frequently 4) someti mes 5)sel dom )never
4. "I f a firm pays the requi red ' addi ti onal payment' the seri ce i s usual l y al so del i vered as agreed."
Thi s i s true
) al ways 2jmostl y (3) frequenHy 4) someti mes 5)sel dom )never
The survey originated and was managed from the World Bank' s head
quarters in Washington, D. c. , but its implementation was facilitated through
1 6
Corruption and Its Implications for Investment
its field offi ces worldwi de. The survey covered sixty- nine countries ( i n
cl udi ng nine from the OECD) and drew responses from approximately
3, 700 companies. The same questionnaire was used in all the countri es,
and the target respondents in each country were local businessmen.
The Variables
Our basi c obj ective was to determi ne whether or not the "predi ct
ability" of corruption has a significant impact on economic performance.
By predictability, we mean the degree to which firms are confident that
they will in fact be able to obtain the "product" they are seeking, e. g. ,
a license or a franchise, if they pay bri bes. To quantif and encapsulate
"predictability" in variable form, we used the responses to questions 2
and 4 in tabl e 2. Speci fi cal ly, we cal cul ated a country average ( across
al l the responses from i ndividual firms in the country that compl eted
the questionnaire) for each questi on. Then we constructed the vari able
CORPRD as fol l ows :
CORPRD 7 - .5 x (country average for q. 2 + country average for q. 4)
We also wanted to test whether the extent of corrupti on mattered.
Previ ous empi ri cal work i ndi cated that hi gher l evel s of corrupti on i m
pede economi c performance. Moreover it i s possibl e that the degree of
predictability may be of more concern to firms than the extent of cor
ruption. " By incl udi ng a vari able that represents the extent of corrupti on,
we could t est thi s hypothesi s. We used the responses to questi on 1 to
construct the vari abl e COREXT. Speci fically,
COREXT 7 -country average for q. l.
In order to control for other factors that might affect investment, we
used the 1 990 val ues of GDP per capi ta (at purchasing power parity) and
as an alternati ve, secondary school enrol l ment. 7
For the dependent vari ables we used the rati o of gross investment
to GDP and the ratio of private investment to GDpB For the gross invest
ment variable we used the average over 1 990 to 1 994 and had fifty- nine
observations. For the private-investment variabl e, we used bot h the
average from 1 982 to 1 993 and from 1 990 to 1 993. Ideal l y, the l atter
woul d have been the independent variabl e of choice. Unfortunatel y, the
devel oping countries for which we coul d obtain annual data on private
investment fows did not map well onto the countries that were incl uded
1 7
-
Corruption and Its Implications for Investment
in the World Bank survey. 9 Hence, we had fewer observations-between
twenty- one and twenty- three.
The Empirical Results
In table 3 bel ow, we present results of OLS regressi ons using GDP
per capita and secondary enrol l ment alternatively as control vari abl es.
In equations ( 1 ) and ( 4) , we test onl y for the i mpact and significance of
the extent of corrupti on and i n equations ( 2) and (5) onl y for the pre
dictability of corruption. I n equations ( 3) and ( 6) , we incl ude both the
extent and the predictability. In all cases, the extent and the predictabil
ity variables have the correct sign. The predictability variable is signifcant
in all cases at least at the 5 percent level . The extent vari able is at best
significant at the 5 percent level .
Table 3 OLS Regression Results
Gross I nvestmentGDP as the Dependent Vari abl e
(t-statistics in parntheses)
Vari abl es } 2} 3}
I ntercept 9 222 3 20 4O4
39} 45O5} 22O}
Ln ( Enrol l ) 2443' 2 353' 25
2 2} 2 2O } O99}
Ln ( GDP)
COREXT 9 -4 '
O53} -/OO3}
CORPRD 2 95' 5 4'
2 } 2 9}
R2 9 O59 3O
adj . R2 423 029 O995
No. of Obs. 5 5 5
4} 5} }
- 9 -94O9 -329
- 4} - 9O5} -3O}
2 2 3' 2 24' 3 3
2 O92} 2 4} 25}
5 3 -43
453} - 52}
3 5' 5 532'
2 5} 2 59}
O4 45 95
0 52 5 2
5 5 5
NOE: Si gni fi cant at the I percent l evel ( * J . at the 5 percent level ( tJ . at the 1 0 percent level m.
1 8
Corruption and Its Implications for Investment
We undertook a considerable number of alternative regressions based
on potemial problems that in theory could arise. Among others, we tried
equations that included the cross-product of CORPRD and CORET, equa
ti ons usi ng vari ous permutati ons with and without one of these two
variables of interest, equations with both GDP per capita and secondary
enrollment as controls, and equations with a variable that refects the degree
of policy distortions in the country as the control (or in addition to another
control variable) . In sum, we ran a considerabl e number of alternative
regressions to effectively test the robustness of our fndings. Overal l , the
basic fndings held up: CORPRD has the right sign in all regressions and
is signifcant at least at the 5 percent level; CORE also has the right sign
but is at best signifcant at the 5 percent level and in some cases not sig
nifcant at all. We note, though, that in many cases, where both corruption
variables are included, the control variable was not statistically signifcant.
Table 4 Regression Results
Private I nvestment IGDP as Dependent Vari able
Varables ! } 2} 3} 4} 5} }
I ntrpt ! ! ! 4! 5 9! -! 2 OB ! O55 5 ! O - 2 5
! 4! } 4O2} -9593} ! 259} . 5 - 9 2}
Ln(Enroll) O 5
! .OB} OO}
Ln (GDP) 2 34 2 29
9 } 22}
COREXT -3 M4 -2 5 -5 92' -4 ! -302 - 53'
-! 9 O} - 22} -2 29} - 5} - 22} -249 }
CORPRD 3 O 244 9M' 4 O55 2 925 5 3O2'
2O9} 525} 2 3O } 252} M>} 2 5 4}
R2 > 20 499 49 4992 5O 4
adj . R2 O OM 4 O5 .07 34 4 3
NO. of Obs. 2 2 2 2 2 2
Note: Si gni fi cant at the I percent l evel ( * J . at the 5 percent l evel ( tJ . at the 1 0 percent l evel ( :) .
1 9
Corruption and Its Implications for Investment
In the above analys i s , we used gros s i nvest ment to GDP as the
dependent vari abl e. We investigated whether or not we coul d use the
available data on private investment to GDP to derive information that
would be consi stent with our fi ndi ngs ( though not necessarily of any
statistical significance) . In table 4 bel ow, we present OLS results usi ng
the average of private investment to GDP from 1 982-1 993 ( col umns 1-
3) and the average from 1 990 to 1 993 ( col umns 4-6) . These resul ts are
based on a smal l subset of countries included in the World Bank survey
and for which we could retrieve private investment data. In both sets of
regressi ons, we used either GDP per capita or secondary enrollment as
the control variabl e.
When GDP per capita i s used as the control variabl e, both the extent
and predictability variabl es have the right sign and are si gnificant at 5
percent. The control vari able is also of the correct sign and signifi cant
at the 10 percent level.
Because the sample size i s small-twenty- one to twenty- three ob
s ervati ons i n al l -thes e r esul t s mus t be i nt erpret ed wi th cauti on.
Neverthel ess, they provi de further evidence supporting our hypotheses.
Conclusion
Empirical evi dence i ndicating that corrupti on i mpedes growth and
investment has begun to emerge, with academics and scholars increas
ingly devoting more time to study the surrounding i ssues. These fndings
parallel the emerging concern of pol iticians and policy makers around
the world about the deleterious effects of corruption on economic per
formance and increasing efforts to try to address i ts underlying causes.
Despite these, there remains a l ot to l earn about corrupti on: i t s conse
quences, its causes, and effective strategi es for control l i ng i t.
Thi s chapt er has been motivat ed by a seemi ng paradox i n East
Asi a: the pos itive correl ati on between hi gh rates of i nvest ment and
growt h wi t h rel ati vel y hi gh l evel s of corrupt i on. Convent i onal wi s
dom i n economi c t heory suggest s that weak pr operty ri ght s, oft en
mani fest ed by hi gh l evel s of corrupt i on, retard i nvestment and thus
economi c growt h. East Asi a' s experi ence has pos ed a ser i ous chal
l enge to t hi s hypothesi s. The chapter attempts to unravel this paradox.
Specifically, it argues that it is not only the level of corruption that affects
investment but al so the nature of corrupt i on. Corrupti on regi mes that
are more predi ct abl e-i n t he s ens e that thos e s eeki ng favors from
gover nment do obt ai n t hos e favors-have l es s negati ve i mpact on
i nvest ment than t hose that are l es s predi ct abl e. I n many of East Asi a's
20
Corruption and Its Implications for Investment
miracle economi es, corruption is said to be well organized and system
ati c so that the degree of predi ctabi l i ty is rel atively high. This chapt er
thuS suggest s t hat , despi t e hi gh l evel s of corrupt i on, t hese mi racl e
economi es st i l l managed t o at t ract s i gni fi c ant l y hi gher l evel s of
i nvestment t han ot her devel opi ng countri es. The resul t: compared t o
many devel opi ng countri es, t hese countri es have grown faster despi t e
corrupt i on.
However, t he chapter al so poi nts out that whatever t he degree of
predi ct abi l i ty, more corrupt i on neces s ari l y means l ess i nves t ment .
Hence, to j ustify corrupti on on t he basi s of t he Eas t Asian paradox i s
mi sl eadi ng.
There sti l l i s much to l earn about corruption and economi c devel
opment. Research on this matter is very much in a nascent stage. One
i ssue that defi ni tely needs studyi ng i s the i mpl i cati on of hi ghly orga
nized ( and thus more predi ctabl e) forms of corrupti on for sustai ni ng
hi gh rates of growth. The chapter suggests that countri es can be cl as
sified into three categories: those with high levels and a low degree of
predi ctability i n corrupti on; those wi th hi gh l evel s and a hi gh degree
of predi ctabi l i ty; and those wi th l ow l evel s and a high degree of pre
dictability. East Asi a's mi racl e economi es fall into the second category,
the devel oped countries into the third. The implication here is that for
East Asi a's mi racl e economi es to move on to thei r next stage of eco
nomic devel opment, they would have to reduce t he level of corrupti on.
The expl osi on of the Asi an economi c cri si s suggests that thi s may i n
fact be the case.
The rest of t he volume presents country case studies that elaborate
on this Asi an paradox and suggest why it i s i nti matel y l i nked to the
crisis.
APPENDIX
MODELS OF PREDICTABI LITY
We present two si mpl e model s that encapsulate our noti on of pre
di ctabi l ity. In the fi rst, we present a two- peri od monopol i sti c regi me
which captures the effect of uncertai nty over ti me. I n the second, we
consi der an " O- ring" type corrupti on regi me. Thi s setup is akin to Shleifer
and Vishny' s ( 1 993) i ndependent corrupti on regi me.
"Monopoli sti c" Corrupti on and Uncertainty
Consider a firm that pl ans to make an investment over two peri ods.
A bri be i s needed for a si ngl e fi rm to operate successful l y. Let us con-
21
Corruption and Its I mplications for I nvestment
sider two scenari os. In the first, both the peri od 1 and period 2 bribes,
bl and bz ' are made known beforehand. By contrast, in the second, bl i s
known but bz is unknown. We assume that the firm will operate in the
second peri od only if the bri be is affordabl e; the investment is simply
abandoned if the bribe is too high. We can show that l ess investment will
occur in the second scenario. The outcome predictability is l ower as the
success or failure of a given bribe i n the second period is not known
until the second peri od.
Let I be the investment l evel of a specific firm. The cost of capital
i s c (I) . The investment lasts for two peri ods. I t generates an i ncome
stream of f( l) if it is in operation. To be in operation in period i, a bribe
payment of bi is required, i = 1 , 2. We begin with scenario 1 i n which bJ
and b2 are both known beforehand. Here the firm
'
s profit is
where 8 is the discount rate. The resulting frst order condition for proft
maximization is
1 1 ' ( l ) = ( 1 +8) /, ( l) - c ' ( l) : o .
An interior sol ution J' satisfing 1I ' (n = 0 exists if 1 J ' (n ; O . Other
wise, the firm wil l not invest at al l .
For scenario 2, we assume bl is known but b2 is a random variable.
I n this case, the firm will simply quit if b2 is not afordabl e. The firm's
expected profit functi on is then
1Al ) = ( /( l ) -bd + 8 E [ max(f( l ) - b:, O ) J -c ( l ) .
where E [ . J is the expectation operator. Let H ( . ) denote the probabil ity
distribution function of bz . The first order condition for expected profit
maximization is
f( l )
1z ' ( l) =f' ( l) + 8 f !' ( l ) dH( b2 ) - c ' ( l ) : O .
o
An interior sol ution 1" satisfing 1z ' W) = 0 exists if 12 W) ; O. Oth
erwi se, the firm wi l l not invest.
Throughout t he anal ys i s , we assume f( . ) i s a concave funct i on
and c ( . ) is a convex funct i on to ensure the s econd order condi t i ons
are s ati sfied. Because 1z
'
(n: 0, i t follows t hat [O : r. That i s, t he firm
22
Corruption and Its Implications for Investment
wil l invest l ess (if it ever does) when the second peri od bribe payment
is uncertai n. l o
O- Ring Corruption
Now assume once again there is a single firm but this time it needs
separate approvals from two ofcial s. I I Unl ess it obtains both approv
als, its investment will not be productive. We posit two scenarios. I n the
frst, the bribes offered to each official are made known beforehand; in
the other, only one of the bri bes i s known beforehand. Moreover, i n
either scenari o, if the second required bri be payment is too hi gh, the
firm simpl y quits and takes the l oss equival ent to the first bri be and
whatever capital costs i t has i ncurred. We show that l ess i nvestment
occurs under the second scenari o.
Herein, bl and b2 are bri be payments to the two corrupt oficial s. The
investment will not be i n operati on unl ess bot h payments are made.
Again, we consider two scenarios. I n scenario 1 , both bl and bz are known.
The firm's profit functi on is given by
The correspondi ng first order condi ti on for profit maximization is
1 l ' ( l ) = !' ( l ) - c ' ( l ) : O .
An interior sol ution II satisfing 1 I ' (Id = 0 exists if 1 I (II ) ; O . Other
wise, no investment wi l l be undertaken.
Under scenario 2, the firm pays bl first without knowing the exact
amount of bz . If b2 is affordabl e, it will be paid and the proj ect will be
undertaken. If it turns out that b 2 is large, the firm may then choose to
quit and take a l oss. I n this instance, we assume the firm l oses a portion
of the capital cost ac( 1) as well as the first bribe payment b l . The firm's
expected profit functi on is given by
1 2 ( l ) = E [ max ( f( l ) - ( l ) - bl - b2 , - ac( l ) - b] ) J .
or, more preci sely,
B
f (f(1 ) - c (1) - bl - bz ) dH( bz ) + f ( - ac ( l ) - b d dH( b2 )
a B
where B =f( l ) - ( 1 - a) c (l ) .
23
Corruption ad Its Implications for Investment
The resulting frst order condition i s 12 ' ( l) : 0, that i s,
(f(1) - c' (1) ) He t(I ) ( l - u ) c (1) ) -uc' ( 1) [ 1 - H ( f(I ) - ( l -) c ( I) ) ] : O.
A interior solution satisfing 1z' (Iz) ~ 0 exsts if 1z (Iz) ;:O. Otherse,
no investment wl be undertaken. Again, it i s easily seen that I ;:l That
i s, the uncertainty with the second bribe payment reduces the invest
ment amount.
24
CHAPTER TWO
INVSTMENT, PROPERTY RIGHTS, AD
CORRUPTION IN INDONESI
Andrew Macntre
The noti on that investors, particularly private investors, require i n
dependent and effecti ve l egal i nsti tuti ons t o contai n corrupt i on and
secure their property rights enj oys very wi de currency i n both the aca
demic literature (North 1 98 1 , North and Weingast 1 989, Root 1 989) and
the policy community ( World Bank 1 997b and c, RESPONDACON III 1 996,
El l i ot 1 996, Transparency Internati onal 1 997) . I t i s not hard to under
stand why the core idea here has been so widely embraced by economists
and political economists from Smith and Marx to the current generation
of institutional theorists centering on Douglas North. If contracts cannot
be enforced i n a reasonably obj ective way and if governments are not
constrained from acting corruptly or capri ci ously, t he risks to potential
investors are l ikel y to become very high. And yet, as all students of East
Asia know, there are a number of countries i n the region that have ex
peri enced strong investment and strong economi c growth over several
decades i n an i nstitutional environment bearing little, i f any, compari
Son to that normally prescri bed by the l i terature. I ndonesi a i s one of
these countri es.
How are we to explain such cases? One recourse is to highlight the
fact that from the viewpoi nt of economi c hi story, several decades are
barel y remarkabl e and that over the l onger haul the bi t e of North' s
institutionalist l ogi c will i ndeed be fel t. I n other words, the high- growth
economi es of East Asi a wi l l ei ther devel op an adequate i nsti tuti onal
framework or thei r economi c performance will fal l away. This may be
so. Indeed, some commentators woul d have it that this was t he funda
mental l e s s on of t he Asi an ec onomi c cr i s i s of 1 9 9 7- 1 9 9 8 : l ack of
25
Investment, Property Rights, and Corruption in Indonesia
transparency, crony capi tali sm, and corrupti on fi nally caught up with the
region and, accordi ngly, the whole economi c house of cards col l apsed.
Yet thi s i s much too si mpl e. Asi a's economi c cri si s was about very much
more than transparency and property ri ghts, as i l l ustrat ed by Chi na' s
abi l i ty to ride out the economi c storm rel atively unscathed.
I do not di spute the noti on that the absence of reasonably secure
property ri ghts i s a seri ous obstacl e to i nvest ment and growth. I do,
however, questi on the noti on that this can only be achi eved on the basi s
of an i ndependent l egal syst em. Based on a novel i nt erpret at i on of
I ndonesi a's experi ences, I suggest that there are other mechani sms that
can functi on as sati sfactory alternates i n the interim, though thei r dura
bi l ity i s limited. I n the long run, an independent legal system does seem
l i kely to be the most rel i abl e foundati on for securi ng property ri ght s .
However, busi ness peopl e, pol i cy makers, and even soci al sci enti sts have
much shorter t i me hor i zons. For them, such a pos i t i on is of l i mi t ed
i mmedi ate uti li ty. I f a country can achi eve strong investment fows and
strong economi c growth for thirty- odd years without i nstituti onal trans
parency and an effecti ve legal framework, then peopl e i nt erest ed i n
maki ng money, i n maki ng publ i c pol i cy, and i n theori zi ng the i nterac
ti on between the two, have a strong i nterest i n understandi ng how thi s
i s possi bl e.
Thi s chapt er offer s a t hr ee- s t ep expl anat i on for t he puzzl e of
I ndonesi a's combi nati on of pervasive corrupti on and strong i nvestment
under Suharto. The first i s to poi nt to standard economi c factors i nfu
enci ng expected rates of return on i nvestment. I f there are very l arge
profi t s to be had, i nvestors are l i kel y to be wi l l i ng to bear i ncreased
cost s associ ated with bri bery and i ncreased ri sks associ ated wi t h l ess
certai n property ri ghts . These are fami l i ar argument s, but i mportant
nonethel ess. The second step i n the argument shi fts the focus i n a more
pol i ti cal di recti on. Drawi ng on the work of Shl ei fer and Vi shny ( 1 993) .
I argue that the prevai l i ng pol i ti cal structure in I ndonesi a duri ng the
New Order peri od 0966-1 988) gave Presi dent Suharto the opportuni ty
and, more i mportant, the i ncentive to allow corrupti on to fl ouri sh but
to ensure that i ts costs di d not drive down i nvestment. Key to this was
the presi dent's abi l i ty to moni tor the behavi or of offi ci al s and enforce
hi s core preferences, thereby mi ni mizi ng agency l oss. The thi rd step i s
to argue that whi l e the i ncentives of pol i ti cal l eaders are an i mportant
part of the story, there sti l l remai ns a mi ssi ng l i nk needed to reassure
investors about the fut ure behavi or of government. Thi s last pi ece in the
puzzl e i nvol ves the government tyi ng its own hands in order t o make
26
Investment, Property Rights, and Corruption in Indonesia
a credi ble commi tment about the future pol i cy envi ronment to the i n
vestment communi ty.
I n the next secti on I will lay out the relevant empi ri cal evi dence on
Indonesi a's i nvestment record and i ts i nsti tuti onal - setti ng. The secti on
following that contai ns the core analysi s, proceedi ng through the three
stages of the argument outlined above. The fundamental argument here
i s that whi l e a Northi an logic i s compel l i ng over the long term, i t has
much less to tell us about the short and medi um term and may obscure
rudi mentary alternatives that can substi tute effectively for a si gni fi cant
peri od of ti me. The final secti on draws the threads together and refects
upon the current economi c collapse and the sadly i roni c likeli hood that
movement to more open and transparent pol i ti cs i n I ndonesi a i s l ikely
to l ead to worse probl ems of corrupt i on and property ri ghts .
The Empirical Record
The fi gure for total investment as percentage of GOP i n Indonesi a
l i ke the cor r espondi ng fi gures for the ot her hi gh- growth devel opi ng
economi es of East Asi a-i s not parti cul arly remarkable by worl d stan
dards. As figure 1 shows, the average result for Indonesi a between 1 966
and 1 994 was roughly comparable ( 25. 0 percent) with the wei ghted re
sult for al l of devel opi ng Asi a (22. 1 percent) and al l developi ng countri es
( 2l. 4 percent) .
Figure 1 Average Total I nvestment as a Percentage of GDp 1 966-1 994
0 '
fa
I ndonesi a
SOJC T: IfYearbook 1 996, 1 54-57.
Al l Devel opi ng
Asi a
NOTE: fi gues for regi ons are wei ghted averages.
27
Al l Devel opi ng
Countri es
Investment, Property Rights, and Corruption in Indonesia
I f we focus on private investment, however, we see a quite di fferent
story. As fgure 2 shows, between 1 980 and 1 994 Indonesia ( along with the
other hi gh- growth East Asian economi es) had a markedly higher average
l evel of private investment than other parts of the devel opi ng worl d.
Figure 2 Average Public and Private Investment as a Percentage of GDP
1 980-1 994
/
_ Pri vate I /GDP Publ i c I /GDP
I ndonesi a East Asi a South Asi a Lati n Ameri ca Mi ddl e East Sub-Saharan
& Cari bbean & North Africa Africa
SOIJHCI : J aspersen. Aylward. and Suml i nski 1 995.
Nm E Fi gures for regi ons are si mpl e averages.
I f we di saggregate total invest ment to hi ghl i ght the contri buti on of
forei gn capi tal and l ocal capi tal , I ndonesi a emerges as an i ntermedi ate
case by East Asi an standards. As figures 3 and 4 show, FDI as percentage
of t ot al i nvest ment i n I ndones i a has been markedl y l ess t han i n t he
more ope n e c onomi e s of Thai l and and par t i cul arl y Mal ays i a and
Singapore, but greater than i n the more restrictive Northeast Asian NI Cs,
Taiwan and Sout h Korea. I f consi st ent dat a seri es were avai l abl e up to
the outbreak of the Asi an economi c crisi s, they woul d show I ndonesi a
comi ng to resembl e the pattern of the Philippi nes and Thail and, as for
ei gn i nvestment has cont i nued to ri se as a port i on of t otal i nvestment
i n t he l ast few years .
28
Figure 3 Direct Foreign Investment as a Percentage of Total Investment:
Indonesia, Taiwan, and Korea, 1 965-1 994
Z/
Z/
5/
I ndo^asia _Taiwan m/oaa
J/
5/
J/
/
-J/
95 9 ! 9? ! 95 ! 9B ! ! 9 ! 9 9
SOURCE: IPS, various issues.
NOTE: Three-year moving averages.
The surge of FDI i nto I ndonesi a i n the l ate 1 960s and early 1 970s
represents t he return of "ol d" and "new" capi tal fol l owi ng the massive
capital fight from the country i n the mid- 1 960s.
Figure 4 Direct Foreign Investment as a Percentage of Total Investment:
4/
4/
5/
J /
5/
0/
5 /
! 0/
Philippines, Thailand, and Mal aysia, 1 965-1 994
_ Phi l i ppi nes _ Thailan Mal aysi a
! 95 99 92 ! 95 ! 9B ! 9! ! 9 ! 9 ! 9! !9
SOURCE: IrS. various i ssues.
NOTE: Three-year movi ng averages.
29
Investment, Property Rights, and Corruption in Indonesia
Why woul d pri vat e i nvestors-whet her l ocal or forei gn-ri sk t hei r
money i n a set t i ng where the l egal system was of such doubtful stand
i ng t hat Supr eme Court j us t i ces r i di cul ed t hei r col l eagues as bei ng
hopel essly corrupt . where t he presi dent hi msel f acknowl edges that the
l egal syst em was bes et wi t h deep- seated pr obl ems of corrupt i on. and
more poi nt edl y. where bus i nes s peopl e l argel y abandoned t he not i on
t hat the l egal system was an effecti ve vehi cl e for arbitrati ng commerci al
di s put es? Beyond wel l - recogni zed probl ems wi th i t s formal l egal sys
t e m. I ndone s i a al s o has a r e put at i on for s ys t emi c cr onyi s m and
corrupt i on i n t he admi ni strat i on of goverment . I n t he l at er years of
Suharto's rul e, endl ess compl ai nts were di rected at t he rapaci ous renti er
busi ness practi ces of hi s chi l dren, grandchi l dren, and busi ness associ
at es, as wel l as the offspri ng and associ ates of ot her seni or offi ci al s. Yet
thi s was scarcel y a new phenomenon; if one were to scan the pages of
t he press ten or twenty years ago one woul d encounter t he same com
pl ai nt s about an ol der generati on of pl ayers. I n short , al though many
of t he charact ers surroundi ng Suhart o had changed, t he same basi c
pattern had been i n pl ace si nce t he earl y days of t he r egi me. I ndeed,
t he l i terature on I ndonesi an pol iti cal economy groans under t he weight
of anecdotal evi dence of pervasive cl i entel i sm and corrupti on ( Robi son
1 986, Pangari buan 1 995, MacI ntyre 1 994. Muhai mi n 1 99 1 . Schwarz 1 994.
Wi nt ers 1 994) .
Private investors operati ng in I ndonesi a-ranging from US tel ecom
muni cat i ons compani es , J apanes e car manufact ur er s. and Canadi an
gol dmi ni ng compani es to large I ndonesi an constructi on compani es and
smal l I ndonesi an ri ce far mers-al l had t o grappl e wi th the i mportance
of pol i ti cal connecti ons. Al though there was some sectoral vari at i on. in
general the bettcr one's connect i ons , the great er one's chances of secur
i ng t he pl um deal s , obt ai ni ng prcferent i al r egul at ory t reat ment . and
es capi ng i nconveni ent cont ract ual obl i gat i ons . Conversel y and more
worryingly, the weaker one's connect i ons the more vul nerabl e one was
to fal l i ng vi cti m t o the predat ory t radi ng pract i ces of t hose who were
wel l connect ed. Such pract i ces range from fi nanci al i mpost s to forced
mergers and takeovers. I t i s scarcel y surpri si ng t hen that the i nt erna
ti onal i ndexes of nat i onal corrupti on consi stentl y gave I ndonesi a a very
l ow ranki ng. And yet , as we have seen. i n spi t e of the negati ve effects
one mi ght expect thi s t o have on ri sk as s es s ment s and cal cul at i ons
about t he cos t of doi ng bus i nes s , forei gn and l ocal fi rms have cont i n
ued t o i nvest st rongl y i n I ndonesi a. Thi s i s not what t he convent i onal
i nst i t ut i onal i s t wi s dom woul d l ead one t o expect .
30
Investment, Property Rights, and Corruption in Indonesia
Explanations
How then are we t o expl ai n the coexi st ence i n I ndonesi a of strong
private i nvest ment and growth on the one hand, and weak l egal guar
antees of property ri ghts wi th widespread corrupti on on the other? The
explanati on devel oped here i s i n three parts; the fi rst deal s with tradi
ti onal economi c fact ors, whi l e t he second and thi rd focus on pol i t i cal
vari abl es underpi nni ng governance arrangement s.
Economic Conditions and Rates of Return
The recent upsurge of theoreti cal i nterest i n governance shoul d not
cause us t o l ose si ght of t he i mport ance of more fami l i ar-and t hus
perhaps l ess exci ti ng-economi c vari abl es t hat i nfuence i nvest ors' ex
pectati ons about rates of return. The essenti al poi nt here i s si mpl e, but
important nonethel ess. I f t he expected rate of return i s suffi ci entl y high.
investors wi ll be willing t o bear some i ncreased cost s associ at ed wi th
bribery and some i ncreased risk associ ated wi th the uncertai nty of for
mal property rights. I n I ndonesi a's case there were a number of i mportant
fact ors that contri but ed t o the creat i on of a busi ness envi ronment i n
whi ch good rates of return coul d be expect ed. These can be organi zed
under four broad headi ngs: the prevail i ng rate of economi c growth, the
macroeconomi c set t i ng. t he mi croeconomi c i ncenti ve st ruct ure. and
sector- speci fi c factor endowment s.
The fi rst of these i s so obvi ous i t can easily be overl ooked: growth
itself begets further i nvestment. Once solid growth rates were bei ng re
corded i n I ndonesi a in the l ate 1 960s and early 1 970s. this i n itself became
a maj or factor encouraging further investment. The i mportance of a gen
erally sound macroeconomi c framework for i nvestors al so requi res l i ttl e
discussi on. This has been one of the defi ni ng and most wi del y di scussed
features of the New Order ( Hi l l 1 996; Battacharya and Pangestu 1 993;
Woo, Glassburner. and Nasuti on 1 994; Little et al . 1 993; Booth 1 992; Worl d
Bank 1 993a and b) . By compari son with the record of macroeconomi c
management pr i or t o 1 966. what fol l owed seems s pectacul arl y good.
The key el ements were stabl e exchange- rate management. a sati sfactory
i nfat i onary record, a caut i ous approach to spendi ng, a good s avi ngs
rate, and invest ment i n publ i c i nfrastructure and human capi tal .
S omewhat more ambi guous , but nonet hel es s i mpor t ant . wer e
mi croeconomi c i ncenti ves. On t he one hand. vari ous rounds of l i beral
i zi ng t r ade and i nve s t me nt r efo rms have be e n wi del y hai l e d as
encouragi ng i nvest ment by removi ng di s t or t i ons and creat i ng a l es s
31
Investment, Property Rights, and Corruption in Indonesia
uneven commerci al pl aying fi el d. On the other hand, and i n seemi ng
contradiction, other illiberal microeconomic measures to restrict or elimi
nate competition in particular sectors were also powerful i ncentives to
other investors who stood to capture the rents thus created.
A fi nal general category of factors that had a significant impact on
calculati ons of expected rates of return pertains to factor endowments.
The most gl ari ng exampl e of this was of course the oil and gas sector;
the natural resource rents that stood to be captured by investors in this
sector were very substantial i ndeed. Similar stori es can al so be told of
the timber and mining industries, and indeed of the abundance of cheap
labor for the manufacturing sector.
To summarize, we need to be clear that traditional economi c vari
ables bearing on proj ected rates of return assuredly had an i mportant
beari ng on the will i ngness of private i nvest ors t o commi t capi tal to
Suharto' s I ndonesi a. Al though no seri ous empi ri cal measurement of
profitability in I ndonesi a i s presented ( such calculati ons would be ex
tremely problematic) , a priori there can be little doubt that conventional
economic variables pl ay an important part in explaining the strong fow
of private i nvestment over the past thirty years .
This much is not diffcult to agree upon. However, there remain good
grounds for believing that this does not provi de the whole explanation
to our puzzl e. Recent comparative empi ri cal works by Mauro ( 1 995) ,
Keefer and Knack ( 1 995) , Jaspersen et al . ( 1 995) and the Worl d Bank
( l 997b and c) poi nt to some correlation between the quality of institu
ti onal arrangements and economi c performance. Pl ai nly, thi s i s very
slippery ground, both empi ri cally and theoretically. While these broad
gauge quantitative studi es can be regarded as suggestive only, they do at
l east provi de some empi ri cal support for the vi ew that i nsti tuti onal
weakness will tend to produce a drag on investment and growth. And,
of course, this is a central tenet of the whole Northian institutionalist logic.
Assumi ng poor economic governance does i ndeed exert a signi fi
cant negative i nfuence on investment and growth once we control for
rates of return consi derati ons, the remaining task becomes one of ex
plaining why this has not proven more of a probl em in Indonesi a. It is
to this more interesting challenge that I now turn.
I nsti tuti ons and Poli ti cal I ncentives
The second stage of my expl anati on focuses squarely on possi bl e
connecti ons between the i nsti tuti onal envi ronment and the nat ure of
governance, and expl ores t he incentives available to poli tical leaders. I do
32
Investment, Property Rights, and Corruption in Indonesia
this by drawi ng on and adopting the now widely discussed work on cor
ruption by Shleifer and Vishny ( 1 993) . They draw an analogy from indus
trial organization theory to model the consequences of the political and
institutional environment on the level of corruption and the extent to which
it inhibits investment and economic growth. The underlying model is that
of Augustin Cournot's ( [ 1 838J 1 971 ) complementary monopolies, that is, a
contrast between the pricing decisions of a singl e monopolist who pro
duces strongly complementary goods and multiple independent monopo
lists, each producing only one of t he strongly complementary goods. The
single monopolist wll have an incentive to price his goods in a concerted
fashi on, because pushi ng up the pri ce of one of his goods will tend to
push down demand for the others since consumers require all . Conversely,
where there are multiple independent monopolists, even though the goods
remain strongly compl ementary, they will tend to push up the pri ce of
their respective products and all will sufer.
Shlei fer and Vishny take this i nsight and apply it to corrupti on by
focusi ng on bri bery and the market for government regulatory goods
(Le. , licenses and permits needed by frms to do business) . They assume
t here are mul t i pl e r egul at ory goods i nvol ved and t here is s t r ong
compl ementarity among them all ( s o that potential investors will need
a bui l di ng permi t, and an i mport l i cense, and empl oyment contracts ,
etc) . For present purposes, the relevant poi nt is the contrast they draw
between two styl i zed models of the market for government regulatory
goods under authoritarian or weakly democratic political conditions and
where corruption is rife (and, by implication, legal institutions are weak) ;
one highly centralized, and the other much less so. In the first, national
pol i ti cal l eadershi p exerci ses a suffi ci entl y strong gri p on regul atory
agencies that we can think of the relevant sections of the state as func
ti oni ng al most l i ke a si ngle centrally coordi nated monopoly for bri be
collecting. Strong political l eaders are abl e to prevent regul atory agen
ci es from act i ng i ndependently and to ensure t hat a healthy share of
bri bes col l ect ed fl ows upwards, with the remai nder bei ng di stri buted
proporti onately and promptly among rel evant offi ci al s . In short, offi
ci al s i n regul at ory agenci es are unabl e to operate i ndependentl y to
maxi mi ze thei r own take. Under thi s model , i f a fi rm i s seeki ng the
necessary permits to establish a factory it acquires secure property rights
to the package of regul atory "goods" thus purchased once i t has pro
vi ded the appropriate corrupt i nducements.
The second model i s one i n whi ch pol i t i cal control i s weaker and
l ess central i zed. Instead of a si tuati on approxi mati ng a si ngle monopo-
33
Investment, Property Rights, and Corruption in Indonesia
l i st , there i s a mul t i t ude of i ndependent monopol i st s sel l i ng compl e
mentary regul atory goods. Because t he pol i ti cal l eadershi p i s unabl e to
exerci se effect ive control over bureaucrati c agenci es, offi ci al s ( or thei r
r especti ve agenci es as a whol e) seek t o maxi mi ze thei r own take by
act i ng as i ndependent monopol ists and pushi ng up pri ces wi t hout re
gard for t he effect on overall demand for government goods. Al so, unl ike
the si ngl e monopol i st model , i n this si t uat i on the fi rm purchasi ng al l
these government goods can never be sure it has secure property rights
as any agency might subsequentl y seek to extract further bri bes. The
weaker the pol i ti cal l eadershi p's control , the greater the scope for i nde
pendent and uncoordi nat ed extract i on by offi ci al s pursui ng thei r own
i ndivi dual i nterests. Moreover, i f the l eader i s not confi dent that coor
di nat i on can be enforced, hi s or her best i nt erest s are served by acti ng
as an i ndependent monopol i st as wel l , and competi ng di rectly wi th al l
other offi ci al s. ( Crudely, i f you can' t beat them, j oi n them. )
The key point t o be drawn from Shl eifer and Vishny i s that there may
be an i mportant analyti cal di sti ncti on to be drawn between si tuati ons in
which corrupti on i s pervasive but the framework of government i s ti ghtly
centralized and those where it i s l oosel y central ized. I f the l eader enj oys
strong control over regul atory agenci es, then we can think of his or her
i nt erest s on the pri ci ng of br i bes as bei ng equi val ent t o thos e of t he
si ngle monopol i st under condi ti ons of strong compl ementarity. As such,
he or she has a di rect i nterest i n i mposi ng coordi nat i on and ensuri ng
that no i ndividual agency enri ches i tsel f at the expense of the system as
a whol e, and the pol iti cal l eadershi p i n parti cul ar. On the other hand,
where t he l eader enj oys onl y weak cont rol over regul at ory agenci es ,
ofci al s wil l be far l es s constrai ned. Facing the i ncentive structure of the
i ndependent monopol i sts under condi ti ons of st rong compl ementari ty,
they wi l l s eek to maxi mi ze t hei r own takes by dri vi ng up t he br i bes
necessary t o obt ai n the parti cul ar regul atory goods t hat t hey cont rol ,
even though this will drive down overall demand. Accordi ng to this l ogi c,
strongl y central i zed government wi l l produce l ower i ndi vi dual bri bes,
but a higher level of overal l rent col l ected ( because more bri bes wi l l be
col l ect ed) . A l ooser, l es s - cent ral i zed goverment wi l l produce hi gher
individual bri bes, but l ower overall rent col l ecti on ( because fewer bri bes
wi l l be col l ect ed) -des pi t e pervas i ve co rrupt i on i n bot h. And, mor e
i mportant from an overal l economi c vi ewpoi nt , cor rupt i on under con
di t i ons of l oosel y cent ral i zed gover nment wi l l be more i nj ur i o u s t o
economi c growth because i t wi l l r educe economi c act i vi t y by dr i vi ng
down demand for the government goods necessary for fi rms to go about
34
Investment, Property Rights, and Corruption in Indonesia
thei r product ive busi ness. Note the count eri ntui tive resul t here: under
condi t i ons of strong central i zat i on t here wil l be more bri bes col l ect ed
and hi gher t ot al revenue ext ract ed from t he pri vate s ect or, but l es s
damage wil be done t o t he economy becaus e t he br i bes wi l l not be
pri ced excessively ( that i s , they wi l l not dri ve down demand significantly) .
Shleifer and Vishny's i nsight i nto the pri ci ng of bri bes and, by exten
si on, the security of property ri ghts, i s a powerful one. To ope rationalize
i t, however, we need to dissect more careful l y the political precondi ti ons
for these styl i zed model s they sketch. To thi nk of a si ngl e monopol i st
si mply as a strong or centralized government i s to sl i de too qui ckly over
key det ai l s. A s pect rum of government s in the nondemocrat i c worl d
woul d fal l under thi s headi ng, and yet fai l to behave according to expec
tati ons. The key i ssue i s not regime- type, but t he i nsti tuti onal capabi lity
of the l eader t o mi ni mi ze probl ems of agency l oss-offi ci al s behavi ng
i n a manner contrary to the l eader's wi shes. Whi l e there i s a range of
mechani s ms by whi ch agency l os s can be al l evi at ed ( Ki ewi et and
McCubbi ns 1 99 1 , ch. 2) , i n most devel opi ng country contexts monitoring
and enforcement are pivotal . Gi ven that no l eader can di rectly control
all deci si ons on the sal e of regul atory goods, hi s or her abi lity t o mi ni
mi ze probl ems of agency l oss wi l l depend on the l eader's abi li ty to know
whether errant behavior is taking pl ace and then to deter i t. Many l ead
ers-part i cul arl y i n authori tari an set t i ngs-have an abi l i ty t o puni sh;
much l ess common i s an abi l ity to moni t or effectively. Accordingly, few
pol iti cal l eaders are in si tuati ons whi ch give them the abi l i ty-and thus
the i ncenti ve-to enforce " coordi nat i on" among t hei r rent - harvest i ng
agents. Not surpri si ngly, then, unpredi ctabl e and destructive patterns of
corrupti on ( the mul ti pl e i ndependent monopol i sts) are very common i n
devel opi ng count ri es .
I argue that I ndonesi a was abl e to escape thi s common syndrome
because for many years t he pol i ti cal and i nsti tuti onal framework was a
remarkabl e approxi mati on of the economi cal ly l ess destructi ve si ngl e
monopol i st mode l. The pol i t i cal framework devel oped under Suharto
di d i ndeed central i ze power heavily around the presi dent and gave hi m
a credi bl e capabi l i ty for moni t ori ng the behavi or of hi s agents i n the
bureauc racy and puni s hi ng thos e that devi ated si gni fi cantl y from hi s
core preferences.
I n t er ms of formal goverment i nst it ut i ons, the consti tuti onal frame
work ti l ted power massivel y i n favor of the presi dent ( MacI ntyre 1 999b) .
Al though t her e were regul ar el ect i ons for t he l egi sl at ur e, t he gover n
ment had t he aut hor i t y to vet al l candi dat es , i ncl udi ng party l eaders
3S
Investment, Property Rights, and Corruption in Indonesia
Elections were managed in an elaborate system that biased things heavily
towards the government party and more particul arly the executive ( i n
cluding appointing military officers to 20 percent of seats) . Not surpris
ingl y, al though the l egi sl ature had the right to initiate and amend or
bl ock legislation, in practice it never did. Further, the president had very
wi de- ranging decree powers.
The president directly controlled the hiring and fring of those in all
seni or positions ( in all agenci es, state enterpri ses, and the judi ci ary) in
the civilian bureaucracy-which is the point of sale of regulatory goods.
He al so had effective formal monitoring mechanisms such as military or
former military officials ( as i nspector generals) in all publ i c instituti ons
who reported back to the office of the presidency. The armed forces were
the most politically sensitive secti on of the bureaucracy. Here, too, the
presi dent had appointment powers for all significant positions ( actively
involving hi msel f i n deci si ons at l east as far down the organizati onal
hi erarchy as col onel) . However, precisely because of the central i mpor
tance of the armed forces in Indonesi an pol itical life, all senior positions
were subj ect to regular rotati on.
I n the terms of the i nstitutionalist literature concerned with agency
probl ems, all of these formal monitoring mechani sms were of the " po
l i ce patrol " variety, t hat i s, i nsti tuti ons desi gned to det ect and report
violations ( McCubbins and Schwartz 1 984) . Less formal, but al so poten
tially valuabl e, were "fire alarm" networks-arrangements in which third
parties coul d alert the pol itical l eadership to an outbreak of probl ems.
Perhaps the most i mportant of these was the rel ati onshi p many l ocal
and foreign frms would establish with one or more pol itically connected
i ndivi dual s-such as a former mi l i tary offi cer or seni or offi ci al ( l ocal
fi rms, bei ng predomi nantl y Chi nese, di d thi s for pol i ti cal protecti on;
foreign firms for protection as well as for information) . If a firm encoun
tered seriously capricious action by officials that j eopardized operati ons,
it coul d use its connecti ons to convey its grievances to a higher authority
through informal mil i tary and bureaucratic networks.
The empi ri cal point to be made here i s that I ndonesi a' s pol i ti cal
architecture centralized power around the presi dency; al l relevant pl ay
ers owed thei r posi ti ons di rectly to the presi dent, and he mai ntai ned
effective moni tori ng capabi l i ti es of admi ni strative behavi or and, very
cl early, effective enforcement capabi l i ti es. Thi s is not to suggest that
Indonesi a had a finely tuned and effi ci ently coordinated bureaucracy
pl ainly thi s was far from the case. Nor is it to suggest that these various
oversi ght mechani sms were used for the pri mary purpose of detecti ng
36
Investment, Property Rights, and Corruption in Indonesia
excessively corrupt offi ci al s-agai n, this was pl ainly far from the case.
Simply, my purpose i s to argue that unlike many authoritarian l eaders,
suharto did have access to quite extensive information about the behav
ior of regul atory agenci es and di d have the abi l i ty to puni sh offi ci al s
whose behavi or deviated signifi cantly from hi s core preferences.
Suharto di d not have to intervene often to keep t he system goi ng;
periodic demonstrati ons were suffi ci ent. A stri ki ng i l l ustrati on was the
sudden and dramati c pr esi dent i al decree to di sempower the ent i re
customs bureau i n 1 985 when corrupti on on t he waterfront became a
serious probl em. Overnight, that bureaucratic function was instead del
egated to a foreign company ( Nasuti on 1 985, 1 3-1 4) . I n 1 986, when i t
became apparent that the textile industry was bei ng j eopardized by an
overly greedy cotton import monopoly, executive action led to the di s
bandi ng of the monopoly and the firi ng of seni or offi ci al s ( MacI ntyre
1 99 1 , ch. 4) . I n 1 996, when corruption problems in the transport ministry
became too blatant, the minister was ultimately permitted to retain his
posi ti on, but only after bei ng subj ected to publ i c humiliation. None of
these i nterventi ons was desi gned to el i mi nate corrupti on-the enti re
regime was bui l t upon maximizing corruption-but al l had the effect of
curtailing corruption that had become suffciently costly or disruptive as
to pose a serious threat to continued investor confidence in that sector.
Suharto was in a position whereby he could maximize his own interests
by allowing bounded corruption to fourish. The bounds were what the
market woul d bear. A pl ethora of moni t ori ng mechani sms kept hi m
sufficiently informed if seri ous probl ems emerged and hi s far- reachi ng
powers enabl ed hi m to deal wi th greedy or unrel i abl e offi ci al s who
endangered the system. To be sure, the system was nei ther fool proof
nor refi ned ( as il l ustrated by any number of anecdotes from investors
who di d become di senchanted) . My contenti on i s that it was a rough
system of oversi ght and enforcement that worked suffi ci ently wel l to
keep a remarkable number of investors sufficiently happy for a remark
ably l ong per i od of t i me. Thi s syst em pr oduced bot h wel come and
unwel come outcomes: investment and economi c growth were remark
ably strong, and corruption penetrated almost every part of the economy.
If Indonesia's formal political institutions provided the president with
substantial monitoring and enforcement capabiliti es, its informal institu
tions gave him a strong incentive to maximize the fow of rents up to his
office. Permeating Indonesia's formal pol i ti cal i nsti tuti ons was a vast i n
formal network of patron-client relationships through which coursed much
of the lifeblood of pol i tical l ife. Suharto was the paramount figure i n thi s
37
Investment, Property Rights, and Corruption in Indonesia
network. Crucial to the sustenance of this hi erarchical support network
was his abi l ity to di stri bute patronage, most not abl y money. Thus, in
addi ti on to any personal accumul at ory i mpul ses, the presi dent had a
fundamental interest in maximizing the discretionary resources that fow
up to him, as they were cri ti cal to his political survival.
I nsti tuti onally, then, the posi ti on of Suharto was much like that of
t he si ngl e monopol i st . He had the abi l i ty and i ncentive to enforce co
ordi nati on on the pri ci ng of bri bes and preservati on of property rights
of investors. This ensured both the maximizati on of the rents captured
for his own use as well as an envi ronment of predictability for investors
with regulatory goods bei ng supplied at a pri ce the market would bear.
Institutions and Credible Commitments
The Shl eifer and Vishny model ofers i mportant i nsights into why a
pol itical l eader in a strong posi ti on has an i ncentive structure to ensure
that the pricing of bri bes and the incidence of capricious action are tem
pered by what the market will bear. The exi stence of this incentive struc
ture is dependent upon the i nsti tuti onal setti ng. This i s the second key
step i n resolving the puzzle. We now have a pl ausi bl e expl anati on for
why a l eader in pol i ti cal and i nsti tuti onal ci rcumstances, such as those
of Suharto, had an unusually powerful i ncentive to " hol d the ri ng" and
enforce moderati on. However, the fact that a l eader has an i nterest
even a st rong i nterest-i n a parti cul ar course of act i on by no means
guarantees that he or she wi l l consi stently fol l ow that course of acti on.
Precisely because power i n Indonesi a was so heavily centralized, Suharto
was unconstrai ned by l egal or basi c pol i t i cal i nsti tuti ons: he coul d re
verse di rect i on at any poi nt . Drawi ng on Shugart and Carey' s ( 1 992)
cl assi fication of the rel ative powers of popularly elected presidents, Hadi
Esfahani ( 1 996) has noted that the Phi l i ppi ne presi dency i s one of the
most powerful ( vi s - a- vi s the l egi sl at ure) in the democrati c worl d and
argued that thi s creates real probl ems of commi t ment . Even a qui ck
gl ance at the I ndonesi an si t uat i on reveal s that the I ndonesi an presi
dency under Suharto was even l ess constrai ned. Although it may be i n
the interest of t he president to ensure moderati on i n t he pricing of brib
ery and capri ci ous behavi or by offi ci al s , what confi dence can investors
have th at the presi dent wi l l in fact do so for the life of thei r investment
pl ans, parti cul arl y i n a si tuati on where power i s so massively concen
t J' ated and j udi cial, l egisl ative, and regul atory veto points so scarce? How
can i nvestors have confi dence that t he government has a fundament al
commi t ment to ensuri ng a t ol erabl e busi ness e nvi ronment?
38
Investment, Property Rights, and Corruption in Indonesia
North and Weingast ( 1 989, 804) argue:
A ruler can establish such commitment in two ways. One is by set
t i ng a pr ecedent of " r espons i bl e behavi or, " appear i ng t o be
committed t o a set of rules that he or she will consistently enforce.
The second is by bei ng constrained to obey a set of rules that do not
permi t l eeway for vi ol ati ng commi t ment s. We have very sel dom
observed t he former, in good part because t he pressures and con
tinual strain of fiscal necessity eventually l ed rulers to " irresponsibl e
behavi or" and the violation of agreements .
Under Suharto, the Indonesian government did both. As noted ear
l i er, at the level of macroeconomic pol i cy, there was cl early a sustained
effort from the late 1 960s on to maintain reasonably sound and consis
t ent pol i cy set t i ngs. A s ol i d r ecor d of r el at i vel y s t abl e exchange
management, tol erabl e i nfati on, cauti ous spending, good savings, and
good investment in public infrastructure and human capital all presum
ably hel ped t o encourage investor confdence over the years. As North
and Weingast point out, however, a good track record, although helpful ,
provi des no guarantee about future behavi or.
Of greater importance in terms of providing a credible commitment
to restrain arbitrar behavior by state officials and minimize investment
threatening corruption was the decision to open the capital account and
make the currency ful l y converti bl e i n 1 970. Thi s was cri ti cal in two
respect s. Fi rst, given the count ry' s dismal economi c record up t o the
mid - 1 960s, this move was presumabl y pivotal in reassuri ng investors
( both foreign and l ocal ) that they coul d get money out of the country
if thi ngs went wrong. Secondly, and in the l onger run probabl y more
i mportant, in adopting this measure (well before most other developi ng
countries) , the government was effectively tying its own hands. The open
capi tal account created a powerful earl y warni ng system of i nvest or
di scont ent t hat woul d exerci se a powerful di sci pl i ne on government
behavi or. By al l owi ng capi tal to move freel y, the government was , i n
effect, enabl i ng investors to puni sh it i f the busi ness envi ronment de
teri orat ed. Unl i ke ot her aspect s of i t s economi c pol i cy behavi or, thi s
commi t ment t o guarantee an accept abl e busi ness envi ronment had
strong credibil ity. Although t he openi ng of t he capital account had only
the status of a decree and was thus, in principle, easily changed, in practice
it would be extremely costly to revoke. Abandoning it would be a mas
sive di s i ncent i ve t o furt her i nves t ment ; wi t h col l aps i ng i nves t ment
creat i ng very s har p economi c and, ul t i mat ely, pol i ti cal cost s for t he
39
Investment, Property Rights, and Corruption in Indonesia
government. More than any other si ngl e pol i cy measure, this si gnal ed
a commi tment to investors. I t was a nearly irrevocabl e act of sel f- regu
l at i on t hat provi ded grounds for broad confi dence about the overal l
nature of the pol i cy environment.
To summarize the argument thus far, I have been concerned with the
puzzle of why, for roughly three decades, Indonesi a was able to generate
strong investment fows and economi c growth when its legal institutions
were so weak and corrupt i on so widespread. A three- part answer has
been presented. First, various standard economic variables combined to
create an environment where hi gh rates of return coul d be expect ed.
Second, building on t he logic laid out by Shleifer and Vishny, we can see
that t he pol itical and i nsti tuti onal circumstances of Suharto's I ndonesi a
were such that they gave the l eader a powerful i ncentive to ensure that
bribes were not priced excessively and that arbitrary behavi or was con
tai ned wi thi n tol erabl e l i mi t s; i n short, to ensure that corrupti on was
conducted i n an orderl y fashi on wi thi n the l i mi ts of what the market
would bear. Note that this economi c i ncentive structure was dependent
upon a political structure and a set of formal and i nformal institutional
mechani sms that reduced agency l oss by permi tti ng efective executive
oversi ght and punitive acti on. This second st ep i n the argument pro
vi des us with a pl ausi bl e expl anati on as to how and why Suharto was
abl e to ensure that whi l e corrupt practices fouri shed, i t di d so within
limits tol erabl e to investors. Yet thi s second step i n the argument also
introduces a paradox: the i nstitutional conditions that underpinned the
presi dent's ability and i ncentive to maintain orderly and market - consi s
tent corrupti on al so made future government pol i ci es uncertai n si nce
they were so easy to reverse. That i s, the very factors that encouraged
the presi dent to ensure moderati on al so had the potenti al to i ncrease
risk for investors. The thi rd step of my argument tackl es thi s probl em
by focusi ng on al ternative i nsti tuti onal mechani sms for promoti ng i n
vestor confi dence about future patterns of governance. I n the absence
of an i ndependent l egal system other forms of guarantees to investors
about the future are possi bl e. In I ndonesi a's case, the openi ng of the
capi tal account i n 1 970 provi ded a powerful approxi mati on of such a
credible commitment. Consciously or otherwi se, this quickly came to be
a strong constraint on future pol icy action. Because it was such a potent
symbol to invest ors, the cost s of reversi ng the rul e became extremely
hi gh. Here, then, was a regul at ory commi tment upon which investors
coul d reasonably begi n to pl an, si nce i n a fundamental sense, the gov
ernment was tying i ts own hands.
40
Investment, Property Rights, and Corruption in Indonesia
One of the impl ications of this argument i s that we need to qualif
the very widely accepted Northian argument that i n the absence of solid
l egal i nsti tuti ons, economic devel opment cannot take pl ace. I f we l i mit
oursel ves st ri ctl y to a Northi an framework, as refect ed i n emphat i c
cl ai ms, such as "the i nabi l i ty of soci eti es to devel op effecti ve, low- cost
enforcement of contracts is the most important source of both historical
stagnat i on and cont emporary underdevel opment in the Thi rd Worl d"
( North 1 990, 54) , it is di ffi cul t to account for thirty years of sustai ned
strong private investment and economi c growth i n Indonesi a. Indonesi a's
experi ence suggests that in the absence of an effective l egal framework,
private investment can still proceed at a heal thy pace i f there are other
factors that al l ay investor uncertainty. Gi ven certain pol i ti cal and i nsti
tutional condi ti ons, a l eader presi di ng over a hi ghly corrupt regime can
have both the ability and the i ncentive to provi de an attractive envi ron
ment for i nvest ors. To an economi c hi st ori an three decades of strong
economi c growth may be of l i ttl e moment, but t o schol ars and poli cy
makers wi th shorter time frames thi s i s not something that can be l i ghtly
set asi de.
And yet , having taken pai ns to devel op t hi s alternative argument, i t
must al so be recognized that t he system devel oped under Suharto could
not last i ndefi ni t ely. Even i f not dest abi l i zed by exogenous fact ors, i t
cont ai ned unavoi dabl e s ources of endogenous breakdown. Fi rst , the
system coul d onl y functi on for so l ong as there are efective oversight
and puni tive capabi l i ti es at the di sposal of the pol itical l eadershi p. The
political and i nsti tuti onal condi ti ons that provide for both of these si
multaneousl y are not common. And even where t hey are present , they
can be di spl aced as a result of a change i n l eadershi p personnel i f the
new l eader i s unable to sustain the structures of his or her predecessor.
Moreover, even if it survives l eadershi p transi t i on, thi s syst em carri es
the seeds of its own destruction, si nce sustained investment and growth
sooner or l at er give ri se to soci oeconomi c change and pressures for
democrati zat i on whi ch, in turn, wi l l t end to undermi ne the enabl i ng
politi cal and i nstitutional condi ti ons themselves. I n short, t he economi c
success of the system i s likely ultimately to undermine the pol itical and
instituti onal foundati ons that sustai n it. Second, while wi despread but
market - tol erabl e corrupti on may be economi cally acceptabl e to inves
t ors, i t i s l i kely, over t i me, to prove corrosive to the l egi ti macy of the
regi me, thus bringing its stabi li ty i nto doubt. Thi rd, and perhaps more
i mportant, as an economy matures and becomes more i ntegrated re
gionally and gl oball y, t he addi ti onal costs associ ated with operati ng i n
41
Investment, Property Rights, and Corruption in Indonesia
this commercial environment that were at one time acceptable are l ikely
to become decreasi ngly s o. As t he barri ers to l ocal and forei gn i n
vest ors shi ft i ng t hei r money t o anot her venue become l ower, t hese
invest ors are l ess likely to accept added risks and cost arising from this
envi ronment .
Notwithstanding i ts economic utility over a prol onged peri od, I do
not propose t hat the system of economi c governance I ndonesi a had in
pl ace under Suharto can be viewed as a satisfactory long- term alterna
tive to a system of robust and transparent property rights mai ntai ned
through an i ndependent judiciary. I do contend, however, that Indonesia's
experi ence suggests we need to recognize that there may be adequate
substitutes that can serve for a significant peri od as an alternative basis
for investor confi dence and, thus, growth.
Crisis, Collapse, and Consequences
As we now know, the system created under Suharto was swept away
by exogenous fact ors before it coul d col l apse for any of the i nternal
reasons mentioned above. Thi s i s not the pl ace for a sustained analysi s
of the Asi an economi c cri si s or the ensui ng col l apse of Suharto's rule. l
Nonethel ess, some bri ef di scussi on i s necessary, for although the crisis
was clearly about very much more than corruption and property rights,
I argue that there was an important underlying connection between the
i nsti tuti onal foundat i ons of the syst em of governance under Suharto
and the extent of economi c devastati on whi ch ul ti mately unfol ded. I n
very si mpl i fi ed terms, what happened i n I ndonesi a aft er a cont agi on
effect i ntroduced currency i nstability was a compl ete unraveling of i n
vest or confi dence. Without doubt there were mul ti pl e factors at work
here. but important among these were the calculations l ocal and foreign
i nves t ors made about the l i kel i hood of the I ndonesi an government
res pondi ng effect i vel y t o t he mount i ng cr i si s of confi dence. Whi l e
Suharto's government di d earn praise from the markets in the early phase
of the crisis for its decisive reform action, this was soon reversed as the
government action became increasi ngly erratic and unpredi ctabl e. with
Suharto reversing promises for reform almost as quickly as he was making
them. I n a crisis si tuati on this inconstant behavior was highly destruc
tive, for it suggested that Suharto was no l onger committed to maintaining
a more or less sound economic policy environment. This robbed inves
tors of that which they craved most-confi dence that t he presi dent would
steer a steady course through economi c turbul ence as he had done i n
the past.
42
Investment, Property Rights, and Corruption i n Indonesia
In a pol i tical system as highly centralized as I ndonesia' s, Suharto's
actions were all - important, for there were no institutional constraints on
hi s pol i c? behavior. I f he chose not t o pursue pol i ci es demanded by
nervous Invest ors, t here was no i nsti tuti onal mechani sm for opposing
hi m. And her e, of cour s e, we ret urn t o the pr obl em embedded in
Indonesia's political structure discussed earlier: if there were no institu
t i onal cons trai nt s on pr esi dent i al act i on, how coul d i nves t or s have
confidence in his pol icy promi ses? I argued above that thi s fundamental
probl em had been mi ti gated by a combi nat i on of factors-a hi gh ex
pected rate of return, a track record of reasonably sound macroeconomic
pol i cy, and i mportant, an open capi t al account . Thi s combi nat i on of
factors, however, was of l ittl e benefi t i n these radically altered circum
s t ances . In the face of cur r ency uncert ai nty, i nves t ors r us hed for
dollars-thereby negating the restraining by-products of the open capi
tal account. That i s t o say, whi l e potent i n normal ti mes, the threat of
capital rushi ng out ceased to be a meaningfl constraint on government
behavi or once capi tal was already rushi ng out .
I n short, t he very institutional conditions that produced such a highly
centralized poli ti cal syst em and underpi nned Suharto's abi l i ty to con
tain corruption and arbitrary behavi or within tolerable limits also ensured
that if he behaved erratically the damage to investor confdence coul d
be very great because there was no effective means of constraining hi m.
In such a situati on, the onl y real opti on for investors was exit. And with
no means of removi ng hi m from offi ce short of upheaval , I ndonesi a
cont i nued t o bl eed capi tal t hrough 1 998 unt i l t he ensui ng economi c
hardship fi nally produced a massive pol i ti cal backl ash. Whi l e t hey do
not account for Suharto's motives, we can thus see political institutions
as a key factor in the system of governance that produced strong invest
ment i nfows for many years, and al so a key factor contributing to the
sudden and massive outflow of capi tal i n 1 997 and 1 998. 2
Finally, it i s worth pausing to refect on t he likely consequences for
corrupti on and the security of property rights of the massive pol itical
changes currently unfol di ng in I ndonesi a. At the ti me of thi s wri ti ng,
I donesi a appears to be midway through a process of pol i tical transi
tion from a highly centralized pattern of authoritarian government to an
emerging democratic framework of government. While there are many
potenti al pi tfal l s, there i s a good chance I ndonesi a will at least get to
exper i ment wi th democracy. There are many ways i n whi ch t hi s i s a
wel come devel opment . And, if one fol l owed an unqual i fi ed Northi an
logic, one might concl ude that thi s is a wel come devel opment for inves-
43
Investment, Property Rights, and Corruption in Indonesia
tors as well , si nce this represents an important step i n the direction of
more transparent governance and a more i ndependent l egal syst em.
Here again, however, it i s critical to recognize that while this logic holds
true for the l ong run, the short- to medi um- term outl ook i s very differ
ent. In practi ce, Indonesi a's swi ng from centralized authoritarian rule to
more democratic government is likely to be associated with a decidedly
less attractive investment than i n the past.
The road t o a trul y i ndependent l egal syst em i s a very l ong one
i ndeed, and there i s no reason to expect that I ndonesi a will di scover a
shortcut. For the past three decades a reasonabl e investment envi ron
ment has been mai ntai ned on the basi s of hi ghly centralized pol i ti cs .
This is now all in the process of being swept away. Almost by definition,
i t i s very unlikely that the leaders of Indonesi a's new political framework
will have the i nst i t ut i onal and pol i ti cal capabi l i ti es for oversi ght and
punitive intervention enj oyed by Suharto. As far as the i ssues of corrup
tion and property rights are concerned, Indonesi a i s thus l ikely to enter
a very uncert ai n i nt ermedi at e zone-i t has progres s ed beyond ti ght
political centralizati on, but i t i s still a l ong way from a truly independent
legal syst em. I n terms of the theoreti cal framework di scussed earl i er,
Indonesi a is thus l ikely to shift from a situation in which there is a single
monopol i st for bribes to the much more distortionary situation i n which
there are mUl ti pl e i ndependent monopol i sts. I roni cal ly, then, the shi ft
from di ctatorshi p to some sembl ance of democracy is l ikely to be ac
compani ed by a much more del eteri ous pattern of corrupti on. Crudely
put , t he one t hi ng worse than organi zed corrupt i on is di sorgani zed
corrupti on.
I n cl osi ng, I cert ai nly do not mean t o suggest that the process of
political change i n I ndonesi a i s something to be feared or resi sted. Far
from it. There are many i mportant benefits that can come which reach
far beyond the investment environment. We should, however, be under
no i l lusi ons that al l good things necessarily come together.
44
CHAPTER THREE
STATE, CAPITAL, AD INVSTMENTS IN KORE
Ha-joon Chang
Korea's performance in rai si ng i nvest ment s si nce the early 1 960s
has been i mpressive by any standard, especially given i ts poor perfor
mance during the earl i er postwar period. l As we can see i n table 1, unti l
the early 1 960s the share of investment i n Korea's GDP ( gross domesti c
product) was very l ow ( 1 2. 5 percent duri ng 1 953-1 962) , and only about
one- thi rd of thi s was domesti cally financed. The average nati onal sav
ings rate during this peri od was 4 percent, while per capita income was
$82. This compares unfavorably with the performances of countries like
Kenya ( $72) , Thai l and ( $88) , and Sudan ( $9 1 ) , whi ch, despi t e si mi l ar
per capi t a i ncomes, managed 1 5-20 percent i nvest ment rates . Mor e
over, some countri es with even l ower per capi t a i ncome t han Korea,
such as Tanzani a ( then Tanganyika) and Burma ( both $50) , managed
hi gher rates of i nvestment, al though there were countri es with hi gher
per capi t a i ncomes t hat had l ower i nves t ment rat es ( Paraguay, t he
Phi l i ppi nes, and Chi l e) . However, t he Korean i nvest ment rate started
i ncreasi ng rapi dl y begi nni ng the early 1 960s. By 1 966, i t was al ready
over 20 percent and by the mi d - 1 970s , i t was nearly 30 percent ( the
average for 1 974-1 978 was 29. 5 percent ) and rarel y fal l i ng bel ow 30
percent thereafter.
What i s es peci al l y not abl e about t he Korean i nvest ment perfor
mance i s t hat i t has been achi eved t hrough a hi ghl y i nt ervent i oni st
investment governance regime ( even by t he East Asian standards) , whi ch.
according to conventi onal wisdom. shoul d l ead to poor investment per
for manc e . I nde e d. fol l owi ng the 1 99 7 de bt cr i s i s , i t has be c ome
fashi onabl e t o argue that i t was preci sel y because of t he i nefi ci enci es
45
State, Capital, and Investments in Korea
and corruption generated by this interventionist investment governance
regime that the country had such a spectacular crash ( Brittan 1 997 and
Krugman 1 998) .
Later in this chapter I shall argue that the recent crisis in Korea owes
a lot to the unravel i ng of the "tradi ti onal " i nterventi oni st governance
regi me that began i n the l ate 1 980s but accel erated after 1 993, rather
than to i t s persistence ( for more details, see Chang 1 998b and Chang et
al . 1 998) . The mai n ai m of thi s chapter, however, i s to descri be and
analyze the workings of Korea's "traditional" regime of governance as i t
relates to investment, whi ch, despite the many l essons that it provi des
for other devel opi ng countri es, has been mi sunderstood.
The "Traditional" Korean Investment Governance System, 1 961 -1 993
The regime of investment governance that supported Korea's spec
tacular devel opment was established i n 1 96 1 , following the coup d' etat
by Gen. Park Chung Hee i n 1 96 1 . As soon as it came to power, the Park
regime nationalized all the banks, which had initially been confscated
from the J apanese col onizers and put under government ownershi p
but were l ater privati zed by the Rhee regime duri ng the l ate 1 950s. At
the same ti me, the Park regime i mpri soned many promi nent busi ness
men on the charge of having accumulated wealth through " illicit" means
( e. g. , usi ng political connecti ons) . He then rel eased them i n return for
their promi ses to "serve the nation through enterpri se, " which basically
meant building new plants in state- designated industries (the so- called
Illicit Wealth Accumulation epi sode; see Jones and Sakong 1 980, 69-70,
2 8 1 -82) .
With t hese two s evere bl ows, the busi ness communi ty suddenly
became morally questi onabl e-cri mi nal s were parol ed on the condi
ti on t hat they di d as t hey were tol d-and economi cally a paper tiger,
devoid of the power to make investment deci si ons, the ultimate capi
tal i st prerogative.
The logic of this system has been analyzed and studied extensively
by a number of schol ars ( see, for i nstance. Amsden 1 989. Chang 1 993.
Campos and Root 1 996, Haggard 1 990) . So we shall not delve into this
any further. The i mportant poi nt for this chapt er i s that the syst em
enabl ed t he Korean government to formulate. i mpl ement. and enforce
a set of i nterrel ated pol i ci es that created a gargantuan t i dal wave of
productive investment. These pol i ci es became part and parcel of t he
governance regi me. at fi rst stemming from i t but ulti mately feedi ng into
and sustai ni ng it.
46
p
State, Capital, and Investments in Korea
Policies to Maintain Stability
The i mportance of pol i ti cal and economi c stabi l i ty in encouragi ng
i nvest ment s i s frequentl y emphasi zed i n many i nt ernat i onal pol i cy
maki ng ci rcl es. and at thi s level of general i ty i t i s very di fcult t o argue
agai nst such a statement. Pol i ti cal and economi c i nstabi l i ty obvi ousl y
shrinks the potenti al i nvestors' ti me hori zon. and wi l l di scourage com
mitments of resources to projects whose returns are far i n the future and
often uncertai n but whi ch may be cruci al for modern i ndustri al devel
opment . The Keynes i an not i on of " ani mal s pi r i t " and t he not i on of
" i nvestors' confi dence" frequently used i n pol i cy di scussi ons i n Korea
( and i ndeed i n other countri es) retect such concern.
More recently. however. there has been a t endency among mai n
stream economi sts to i nterpret t hi s i ssue of stabi l i ty very narrowly and
basi cally reduce i t to the achi evement (or otherwi se) of very l ow i nta
ti on ( say, bel ow 5 percent) . And i n thi s context the East Asi an countri es.
i ncl udi ng Korea. have oft en been paraded as exampl es of the i nvest
ment boosti ng effect of low i ntat i on. However. as some recent studi es
show, there i s no stati sti cal correl at i on between growth and i ntat i on
rat e i f the l at t er i s moderate ( say. l ess t han 40 percent; see Bruno and
Easterly 1 994) . Moreover. the East Asi an experi ences. especi ally those of
Japan and Korea duri ng t hei r earl i er peri ods of devel opment . do not
l end much support to thi s argument.
From 1 961 unti l the 1 980s. the Korean state pursued what can be
cal l ed a " proi nvest ment " macroeconomi c pol i cy. putti ng emphasi s on
mai nt ai ni ng hi gh l evel s of i nvest ment . even at the cost of moderate
i ntati on. rather than achi evi ng speci fi c quanti tati ve targets regardi ng
i ntat i on or budget defi ci t s ( Chang 1 993 ) . Average rat es of i nt1 at i on
( measured by t he average annual growth of t he consumer pri ce i ndex)
i n Korea were 1 7. 4 percent in the 1 960s and 1 9. 8 percent i n the 1 970s.
hi gher t han the i ntat i on rat es duri ng the same peri od i n many Lat i n
Ameri can countri es ( for whose "troubl es" i ntati on i s often bl amed) . "
Even dur i ng t he early 1 980s. when Korea was i n t he mi ddl e of i t s
bi ggest stabilization exercise si nce 1 961 (that i s. until t he 1 997 cri si s) . the
government fi ne-tuned its macroeconomic poli cy to ensure that i t di d not
kill off investors' confi dence ( and thus i nvestment s) . even i f that meant
allowing more i ntat i on. Dur i ng this peri od. the i nvestment / CDP rati o i n
Korea was kept at a level only a fracti on l ower than what it achi eved during
the investment boom years under t he heavy and chemi cal i ndustri al i za
ti on ( Hell program. As we see in tabl e 1 . the i nvestment rate averaged 29. 8
47
State, Capital, and Investments in Korea State, Capital, and Investments in Korea
percent during the period 1 981 -1 986, against 30. 8 percent during the 1 974- Table 1 continued
1 979 peri od, suggesting that the stabilizati on program in Korea di d not 9 29 9 22 9 c 5 3 c c
hurt investments ( see Chang 1 987, for some detailed analyses of this sta- 92 25 9 24 4 5 5 3 c
bilization experience) . This was unlike similar situations in other countries. 95J 29 4 2 c 2J 5 c 5 9
9 3J c 29 9 23 4 c 4 5
Table 1 Investment and Its Financing in Korea, 1 953-1 993
955 3J 3 29 5 23 c J 9
(As percentage of GNP at current prices)
9 29 2 33 2 c J -4 3
9 3J J 3 3 3J 5 c 5 - 2
Yaa 0oss \al o^a` vala 0ova11a^l og^
9 3 39 3 3 5 5 -
'^vasl1a^l Sav ^gs Sav ^gs Sav ^gs Sav ^gs
959 33 5 3c 2 25 4 9 2 3
9J 5 4 5 B 2 2 4 c 9 3 35 9 2 4 5 5 J 9
95 9 c c 9 3 2 5 3 9 39 3c 25 3 5 3 J
9 2 3 5 2 2 4 92 3c 5 34 9 2 5 5
9 5 9 9 2 9 9 993 34 4 34 9 2c 4 5 5 J
9 5 3 5 5 5 c 3 9 B
9 2 9 4 9 5 J 3 5
SOURCE: Bank of Korea, NationalAccounts, 1 987 (for t he series between 1953 and 1970) and Bank
of Korea, National Accounts, 1 994 (for the series between 1970 and 1993) .
99 4 2 c 9 2 c 9
NOTES: The seri es between 1953 and 1970 and the seri es between 1970 and 1 993 are not fully
9 9 5 2 9 2 5 c
compati bl e due to changes i n accounti ng method.
9 3 2 2 9 4 5 5 c
p= prel i mi nary estimates
92 2 5 3 2 4 5 c J
9J 5 5 9 J 4 J 4
Policies to Control Capital Flight
9 4 J 5 5 3 J 4 c 9 In any country, especially i n the early stages of devel opment, capital
95 5 J 4 5 c 4 fight has t o be prevented i n order t o ensure that whatever i nvesti bl e
9 2 c 5 9 2 5 5 surplus is generated i n the economy stays i n the country and therefore
9 2 9 4 3 4 5 5 has a greater likelihood of bei ng reinvested. The threat of capi tal fight
9 25 9 5 9 J c 2 is a common one among the developing countri es, but it was even more
99 25 5 5 5 2 9 5 9 J c seri ous for Korea because of the constant ( real and i magi ned) threat
9J 2c 5 3 J 5 c 5 9 3 from North Korea. Even during t he best of times, this would have pro-
9 24 3 5 2 c J c 9 vi ded a very strong i ncentive for capi t al fi ght. Peri ods of hei ghtened
9 24 5 c 5 J 5 5 political tensi on ( e. g. , t he l at e 1 970s, right after t he US withdrew a maj or
92 2J 9 3 5 J 2 3 3 3 mil itary unit) or macroeconomic instabil ity and general economi c down-
93 25 2 22 c 9 c 3 J 2 2 turn ( such as t he earl y 1 980s) provi ded even stronger i ncenti ve.
94 3 5 2J 3 5 2 J c As a result, the Korean state implemented a very strict regime of capital
95 25 c 5 5 c 2 5 5 9 controls. Every economi c transaction involvi ng foreign exchange had to be
9c 2c 5 24 2 9 4 5 made through the banks under government ownership and/ or control , and
9 25 3 2 5 23 4 4 -J maj or attempts at capital fi ght could be puni shed with a death sentence.
95 32 5 29 9 24 5 2 2 The effectiveness of capital control in Korea can be shown by t he fact that
99 35 5 25 5 22 2 c 3 c 4 in the build- up to the debt crisis of the early 1 980s, there was virtually no
9 3 9 23 2 5 5 5 5 capital fight from Korea, then the fourth largest debtor country in the worl d.
Continued In contrast , other maj or debtor countries in Latin America (except Brazil)
48 49
State, Capital, and Investments in Korea
suffered from massive capital fl i ght, esti mated by Sachs ( 1 984) to have
been someti mes as bi g as the total debt of the country. Some countri es,
notably I ndonesi a and Mal aysi a, have managed to prevent capi tal fight
without strict control of capital outfow. This would not have been possible
i n Korea until recently, when the growing economic and military power of
the country ( especi al l y vis - a- vi s North Korea) al l evi ated the confi dence
probl em that the country's investors had for a l ong ti me.
Policies to Control Luxury Consumption
Keeping the investible surplus inside the national border through capital
control s may have been the fi rst step toward guaranteei ng its rei nvest
ment , but there i s still a l ong way to go before it is actually invested. One
obvious hurdle i s that t he potential investor classes who control such surplus
may consume it in "luxury" goods, rather ta invest it. The economics behind
luxury consumption is not so simple as to alow us to say that higher lury
consumption necessarily reduces investments or that restraint of such con
sumption necessarily requires government intervention. 3 The issue is more
than a moral one devoi d of economi c meani ng, as many mai nstream
economi sts bel i eve ( for a more detai l ed di scussi on on the economi cs of
l uxury consumpti on, see Chang 1 997; for some phi l osophi cal di scussi on
of the i ssue. see Berry 1 994) . Parti cul arly i n many devel opi ng countri es
where i mports of l UXury goods ( or the parts and components needed to
produce them) are i n competi ti on for scarce forei gn exchange with the
capital goods necessary for investment, the control of l uxury- goods con
sumpti on becomes even more i mportant for encouraging investment.
Whether or not one bel ieves that l uxury-goods consumption has to be
controlled at the early stage of development, it is very cl ear that there was
a deliberate, and very effective, restraint on luxury-goods consumpti on in
Korea ( for further empi ri cal det ai l s, see Chang 1 997) . The country has
imposed heavy tariffs and domestic taxes on, and sometimes even bnned
the domest i c producti on as well as the i mportati on of, certain " l uxury"
products especially in the earl i er days of i ts devel opment . For exampie,
t he government i mposed hi gh taxes on car ownershi p and gasol i ne i n
order to di scourage passenger-car ownership unt i l t he ht e 1 980s. Tabl e 2
shows that Korea has had the lowest number of passenger cars compared
with any of the advanced and devel opi ng countri es at comparable level s
of devel opment-beat i ng Japan, the runner- up, by substanti al margi ns.
Si mi l arly, forei gn travel was banned unt i l the early 1 9805, and was onlv
l i beral i zed-although there sti l l are restri cti ons on
'
the amount of mone
one can take ahroad-i n 1 988. Aft er the l i heral i zat i on, forei gn t ouri s
50
State, Capital, and Investments in Korea
expenditures increased fvefold in three years ( thus suggesting that the low
expenditure earl ier was not due to any "cultural " aversion to spending as
i s somet i mes suggest ed) . One does not hear st ori es about Korean t op
executi ves l i vi ng i n two- bedroom fats as i n early postwar J apan; st i l l ,
anecdotal stories and casual observations confirm that living standards of
t he investi ng cl ass i n Korea have been l ow by i nternati onal standards. I
One i mportant, and usually i gnored, functi on of control on l uxury
goods consumpti on i s i n the real m of pol i ti cs, that i s, i ts rol e i n creating
a sense of " shared growth" ( the term i s from Campos and Root 1 996) .
By restraining the extent to which the el i te coul d enj oy thei r weal th for
personal pl easure, thi s control on consumpt i on created a sense of na
ti onal "community" wi t h a common goal , for which everyone i s sharing
the burdens and the frui ts of growth i n a "fai r" ( i f not equal ) measure.
Thi s i n turn contri but ed t o pol i ti cal stabi l i ty ( whi ch i ndi rectl y contri b
ut ed to i nvest ment growth by shori ng up i nvest ors' confi dence) -more
than the mere exi stence of "equal i ncome di stri buti on" which has been
frequentl y ci t ed as t he source of East Asi an pol i t i cal stabi l i ty.
Policies to Discipline the Recipients of the State-Created Rents
Havng ensured that investible surpl us stays at home and i s not wasted
in luxury- goods consumption, there still remains the probl em of ensuring
that the subsequent investments are made productively, as " bad" invest
ments wi l l si mply waste resources. Some woul d argue that t he market
signals wl di rect the investors i nto the right areas, but we know that thi s
is simply not true as a general proposi ti on. Especially i n the context of l ate
devel opment, industrial devel opment requi res the creation of rents by the
state to i nduce investments i n i ndustri es where there are already estab
lished producers abroad. However, the statement that the creation of rents
by the state i s a necessar condition for devel opment does not mean that
it i s suffi ci ent . This i s because, once they are awarded the state- created
rents, the investors may have l i ttl e i ncentive to rai se productivity, as the
market di sci pl i ne has been temporarily weakened (or someti mes el i mi
nated altogether) . So it becomes crucial for the state to pl ay the di sci plinarian
rol e. The subject of state di sci pl i ne has been rather extensively di scussed
elsewhere, and thus does not require an el aboration; but let us make a few
remarks here ( for further di sclssi ons, Chang 1 993; see al so Toye 1 987,
Amsden J 989, and Evans 1 995) .
The Sll ccess of the Korean state in di sci pl i ni ng the reci pi ent s of i t s
rents can be attribut ed at one level to the famousl y ( or notori ousl y, de
pendi ng on one' s pos i t i on) enor mous power t hat i t wi el ds over
5 1
State, Capital, and Investments in Korea
corporati ons through its control over bank credi t and other fi nanci al
sources. However, if i t i s to be used productively, thi s power has to be
exercised with a commitment to productivity growth-otherwise it will be
a route to "crony capitalism" a la Marcos ( Hawes 1 987) . In the Korean case,
such commitment essentially stemmed from its brand of develop mentalist
ideol ogy, which put emphasis on catching up with the West through pro
ductivity growth. At a more practical level, the success of state discipline
in Korea is the result of a number of factors (for more detailed discussions,
see Chang 1 993) . Fi rst of al l , the choi ce of "strategi c" industri es that were
to be supported by the state was made with a high degree of realism ( i . e. ,
a whol esal e catch- up across al l i ndustri es, as i n t he case of I ndi a, was
never attempted) even if the choice seemed too risky to many people ( e. g. ,
the forays into steel and shipbuilding in the 1 970s) . Secondly, the empha
sis on exports made it possible for the state to judge enterprise performance
relatively "obj ectively" by watching their performances i n the world mar
ket , al though it was by no means bl i ndly accepti ng them as the onl y
performance cri teri on. Fi nally, pol i ci es were desi gned on the basi s of
detailed information on the state of the economy and business conditions
i n state- supported industri es. This informati on was col l ected from man
datory reports by the state- supported enterprises and by various public
and semipublic agenci es ( e. g. , the state trading agency KOTR, together
with the embassies, collected information on export markets) .
One bi g contrast between the Korean state and i ts counterparts i n
many devel opi ng count ri es i s perhaps that i t was wi l l i ng and abl e t o
di sci pl i ne even t he most powerful congl omerates . Thi s is confirmed by
the fact that unti l recently there had been a rapi d turnover i n ranking
among the top chaebols ( congl omerates) , whi ch would not be there if
state- created rents simpl y served the functi on of provi di ng l arge firms
with a comfortable life as happened in many other countri es. Only two
of the ten biggest chaebols i n 1 966 were among the top ten i n 1 974; only
five of the top ten i n 1 974 were i n the top ten in 1 980; only six of the
1 980 top ten were i n the top ten i n 1 985 ( Chang 1 994, 1 23) . Thi s i s an
i mpressive rate of turnover despi te the recent stabil ization in the rank
i ng of the top chaebol s ( as the top ones grew so big it became difficult
to di sl odge them-eight of the top ten in 1 985 were i n the 1 989 top ten;
Chung and Yang 1 992, tables 1 and 2, appendi x to ch. 5) .
Policies to Control Foreign Capital Infows
Korea has rel i ed heavily on foreign capi t al i nflows but onl y in the
form of l oans . As we can see in tabl e 3 , i t s rel i ance on FDr has been
52
L
O t


53
State, Capital, and Investments in Korea
among the l owest i n the worl d. Until recently, before the Korean fi rms
became credit worthy enough to be able to borrow in the international
capi tal market, al l the foreign l oans were underwri tten by the govern
ment
'
and as a resul t had to be approved by t he government . Whi l e
there were some wel l - known cases of failed proj ects financed by foreign
l oans, in general the government can be credited for havi ng put empha
si s on the ( di rect and i ndi rect ) foreign- exchange- generati ng abi l ity of
the proj ects when approving foreign borrowing. This contri buted to the
country's survival of the debt cri si s hy keepi ng the debt - servi ce ratio
l ower than other l arge debt or countri es.
Whi l e the forei gn borrowing story i s i nteresti ng enough, the more
i nteresti ng part of the Korean investment governance regime l i es in i ts
pol icies toward FDI ( forei gn di rect investment) , especially given the cur
r ent ent hus i as m about gl obal i zat i on and the r ol e of t r ansnat i onal
corporati ons, or TNCs ( for criticisms of t he globalization thesi s, see Hirst
and Thompson 1 996, Wade 1 996, Evans 1 997, and Chang 1 998a) . Unlike
some ot her devel opi ng countri es, whi ch ost ensi bl y pursued " t echno
l ogi cal self- sufciency" only to end up reproducing obsol ete technologies
imported decades ago in the absence of independent R and D ( research
and devel opment) capabi l i ti es, Korea has always been keen on gaini ng
access t o t he most advanced t echnol ogi es that they can handl e. The
country' s pol i cy makers have been of the view, though, that accepting a
"package" of fnance, technol ogi es, managerial skills, and other capabi l i
ties offered by TNCs is not as good for l ong- term industrial development
as encouraging nat i onal fi rms to construct their own packages, usi ng
t hei r own managerial skill s-obvi ousl y wi th some necessary outsourcing
( for further detail s, see Chang 1 998c) .
Thus , t he Korean government i mposed rest ri ct i ons on t he areas
where TNCs coul d enter. And even when entry was al l owed, it encour
aged j oi nt ventures, preferabl y under l ocal maj ori ty ownershi p, i n an
attempt to facil i tate the transfer of core t echnol ogi es and manageri al
skil l s. For exampl e, unti l the mi d- 1 980s, even in sectors where FDI was
al l owed, forei gn ownershi p above 50 percent was pr ohi bi t ed except
where FDI was deemed to be of "strategi c" i mportance, whi ch covered
onl y about 13 percent of all the manufacturi ng i ndust ri es ( EPB 1 98 1 .
70) . " As a result of such pol i ci es, by the mi d- 1 980s only 5 percent of TNC
subsi di ari es i n Korea were whol ly owned, whereas the correspondi ng
fi gures were 50 percent for Mexi co and 60 percent for Brazil, countri es
which are often bel i eved to have had much more "anti forei gn" pol i ci es
than Korea ( Evans 1 9B7, 20B) .
54
State, Capital, and Investments in Korea
Table 3 The Ratio of FDI Infows to Gross Domestic Capital Formation for
Various Regions and Selected Countries (annual average in %)
! 9! -5 ! 9BO ! 9B! 5 ! 9B-9O ! 99! -93
/``Coc^las ^ a ^ a 2 3 4 ! 3 B
0ava`o,aJ ^ a ^. a 2 2 4 3 3
cco,aa^J^o^ ^ a ^ a 2 5 9 5
/csla ! B O 9 ! 3 ! 5 ! 5
?^ ! B ! 9 2 O 4 !
0a1a^y 2 ! O B ! 2 2 O ! 4
\al^a`a^Js ! 4 5 ! ! 3 3 ! O
SwaJa^ O O 5 ! 4 O 9 5
J / 3 B 4 5 ! 4 ! O O
SwLa|`a^J ^. a ^ a 2 3 5 3 3 !
JS/ O 9 2 O 2 9 9 3 2
Ca^aJa 3 ! ! O 5 B 4 3
Ja,a^ O ! O ! O ! O O O !
0ava`o,^g ^ a ^ a 3 3 3 2 5
/l ^ a ^ a 2 3 3 5 4
cal^/1a|ca ^ a ^ a 4 ! 4. 2 5
Aa^|^a O ! 2 ! 5 O ! ! ! 3
Baz ` 4 2 3 9 4 3 ! ! 5
C^ ` a - 3 4 2 2O B 5
Vat co 3 5 3 5 O 5 B
/s a ^ a ^ a 3 ! 2 B 5 5
Ba^g`aJas^ ^ a ^ a O O O ! O 2
C^ ^a O O O ! O 9 2 ! ! O4
do^g/o^g 5 9 4 2 9 ! 2 9 5
' ^J a O 3 O ! O ! O 3 O 4
'^Jo^asa 4 2 4 O 9 2 ! 4 5
/oa ! 9 O 4 O 5 ! 2 O
Va` ays a ! 5 2 ! ! 9 ! O B ! ! 24
a\sla^ O 5 O 9 ! 3 2 3 3 4
^ ` ,, ^as ! O O 9 O B 4
S^gap ! 5 O ! ! 4 35 O 3 4
Tawa^ ! 4 ! 2 ! 5 3 2
T^a`a^J 3 O ! 5 3 O 5 4
Tc|\ay ^ a ^ a O B 2 ! 3 2
caslacco,a ^ a ^ a O O O ! ! 2 2
SOURCE: U NCTAD, World Irwestment Report, 1 993, annex tabl e 3 ( for the 1 97 1 -1 980 data) and
World Inllestmellt Report, 1 995, annex table 5 ( for the rest) . Reproduced from Chang ( forthcomi ng) .
Pol i cy measures other than the ones concerni ng entry and owner
shi p were al so used t o control the acti vi ti es of TNCs. Fi rst of al l , the
technol ogy that was to be brought i n by the investing TNCs was care
55
State, Capital, and Investments in Korea
fully screened, and checked whether it was not overly obsolete or whether
the royalties charged on the local subsidiaries, if any, were not excessive.
Secondly, there were measures to maximize technology spillovers. Those
investors who were more willing to transfer technol ogies were selected
over the others who were not, unless they were t oo far behind techno
l ogically.6 Finally, l ocal content requirements were quite strictly imposed,
i n order to maximize t echnol ogi cal spillovers from TNC presence. We
shoul d note, however, that the targets for l ocalization were set realisti
cally, so that they woul d not seri ously hurt the export competitiveness
of the country-in some i ndustries, they were less strictly appl ied to the
products desti ned for the export market-and that supporting pol i ci es
that facilitate l ocalization ( e. g. , support for R and D) were al so provi ded.
Some Puzzles
Accordi ng to conventi onal wisdom, the ki nd of investment gover
nance system that we find in Korea is an i deal recipe for disaster as i t
creates i neffi ci ent resource al l ocati on due t o i nformati onal probl ems,
and is l i abl e to expl oitati on by self- seeking bureaucrats, and gives ri se
t o rent - seeking and corrupti on. I f these probl ems are real , how coul d
Korea sustai n a spectacul ar economi c performance wi th its regi me of
investment governance? Trying to answer t hi s question may allow us to
draw some useful l essons as t o what shoul d be t he i ngredi ent s of a
successful investment governance system in a devel opi ng country.
Informational Problem
One common obj ecti on to government i nterventi on in investment
deci sions is that the government does not possess the necessary infor
mati on to make i nt el l i gent i nvest ment deci si ons. Whi l e i t cannot be
deni ed that the Korean state has made a substanti al number of " bad"
investment deci si ons, it is al so true t hat many of its investment deci
si ons have been hugely, if unexpectedly, successful . Korea's deci si on to
enter i nto steel maki ng and shipbuilding i n t he 1 970s faced criticism
both at home and abroad, i ncl udi ng obj ecti ons from the World Bank.
Thi s suggests that t he i nformati onal probl em usually taken as i nsur
mountable by opponent s of state i nterventi on may not actually be so
seri ous ( for further el aborati on, see Chang 1 994, ch. 3) .
First of all, we should not forget that insufcient information does not
prevent us from planning our future economi c l i fe. Actually, the uncer
tainty of the fture i s exactly the reason why we plan for the fture, though
given our " bounded rati onal ity, " we should not have excessive trust i n our
56
State, Capital, and Investments in Korea
ability to control our future through planning. And i ndeed, overcomi n
uncertainty is one of the most important functions of business manage
ment , especi al l y in l arge modern cor porat i ons ( Ri chardso n 1 960 ,
Williamson 1 975, Stinchcombe 1 990) . I t i s inadequate t o argue that the
state should not attempt to plan the future of the national economy be
cause of insufficient information, when firms can and do plan their Own
future despite-or rather, precisely because of-insufficient informati on.
Second, we need to question t he widespread belief that t he informa
tional probl em for intelligent state i nterventi on is so great as t o make
intervention ineffective, while frms do not suffer from such a probl em.
In fact, entrepreneurs themselves often operate on the basi s of " informed
guesses" or "animal spirits" in making investment decisions. Moreover,
much of the information used by the firm to make investment decisions
( e. g. , esti mates of present and future demands, the availability of best
practice technology) are readily available to anybody, and not j ust to the
frm itself. I t should also be noted that a large part of the i nformati on
used by the firm is acquired from external sources, such as consultants,
research i nsti tutes, and state agenci es ( e. g. , central statistical bureau) .
In addition, the common assumpti on that those who are "doing the
business" have " better" information than those who are trying to inter
vene from " hi gh above" shoul d not be bl i ndly accept ed. Behi nd this
argument l i es the assumption that " local " i nformati on is always better
than "gl obal " i nformati on because i t is more fi nely meshed. However,
peopl e with " localized" i nformati on may make a substantively less ra
ti onal deci si on than those with more "gl obal " i nformati on, due t o the
"subgoal i denti fication" probl em (the term is from Simon 1 979) . I f the
aim of government policy is to improve the effi ci ency of the economy
as a whol e, it may actually be better, under certain circumstances, not to
be affected by the "l ocalized" information possessed by the firm. Particu
larly when the decision involves externalities which are not borne out by
the frm, the state can make a better decision solely due to the more global
nature of its obj ective, and not because it is a superior being.
Last but not least. the problem of identifing good investment oppor
tunities is far less serious for late- developing countries than for the countries
on the frontier of world technological progress. This is because late devel
opers have the "second- mover advantage, " by which we mean that they
can watch the frontier countries and learn from their experiences. 7 Even in
a country like Japan, which was pretty close to the fronti er of i ndustrial
development even during its postwar catch-up period, it is recognized that
"setting pri ori ti es, pi cking the next likely winners, has not been di fficult
57
State, Capital, and Investments in Korea
throughout the postwar period when the obj ectives of policy were prima
rily ' catching up' obj ectives" ( Dore 1 986, 1 35) . In the case of Korea, which
lagged even farther behi nd, the probl em has been even l ess.
Bureaucratic Self- Seeking
Another argument that is frequently empl oyed against an i nterven
ti oni st approach to i nvestment governance i s that, whether or not the
bureaucrats have the ability to make intelligent decisions, these decisions
should not be left wth them because they would pursue their own selfsh
obj ectives in making such decisions. And indeed we can obsere this kind
of behavior-such as maximizing the budget they control rather than public
welfare-even in the most renowned bureaucracies, including that of Korea.
How, then, was it possible that bureaucratic self-seeking did not have such
an adverse impact i n the Korean case?
First of all, it needs to be emphasized that, while i t contains an impor
tant grain of truth, the sel f- seeki ng-bureaucrats argument i s based on a
misconception of human motivation ( for further details, see Chang 1 994,
ch. 1 ) . Bureaucrats, l i ke any other individual , can and do act i n a fashi on
that is not solely self- interested, and they often thi nk of themselves, rightly
or wrongly, as the guardians of the public (or national) interest and act to
promote it. It is another matter entirely whether their perceptions of the
public interest are correct ones. One such reason is that "public spiritedness, "
altruism, and so on are often hel d as genuine principles, and not as a thin
veil to disguise self- interest. If whatever moral concerns peopl e have are
si mply described as peculiar forms of sel f- i nterest, then the self- interest
hyothesis will in fact become empt Secondly, as demonstrated by modern
experimental psychol ogy, deci si on frameworks do i nfuence peopl e's de
cision ( Tversky and Kahnemann 1 986) . Bureaucrats usually face questions
put in terms of public interest, which wl invoke a preference ordering that
di ffers from what i s used in private deci si on- making si tuati ons.
Even with such qual i ficati ons, it cannot be deni ed that bureaucrats
have the tendency to expl oit the power conferred on them by their ofces
in order to pursue their own interests. This makes the organizational structure
of the bureaucracy quite important, as it wll shape the incentive structure
for the bureaucrats. However, the success of a bureaucracy in controlling
sel f- seeking by its members goes much further than setting formal rul es
against such behavior. As Simon ( 1 99 1 ) argues, a successful organizati on
has to be one that musters organizational l oyalty among its members, as
otherwise the organization would have to spend an enormous amount of
time and resources in bargai ni ng and monitoring thei r performances. I n
58
State, Capital, and Investments in Korea
this context, the remark from a top executive of the l arge Japanese steel
company, Kobe Steel, whom I encountered in a World Bank conference, is
instructive. The executive claimed that given the diversity and complexity
of the company's operations, there was no way he and others sitting on
the board could make an informed decision about most of t he proj ects put
forward to them by their subordinates. He argued, however, that they are
not worried because they believe that most of their company empl oyees
are doi ng their best to advance the i nterest of the company. This would
sound like a non sequitur to those who bel i eve i n the neocl assi cal view
of human nature, but this i s essenti al ly how a successful bureaucracy
operates-be i t the privat e- sector busi ness bureaucracy of Kobe Steel or
t he respected government bureaucraci es of Korea, France, or Britain.
The exi st ence of a "good" bureaucracy that has the organi zati onal
structure and organizational cul ture that can prevent bureaucrati c sel f
seeking has frequently been singled out by many peopl e as one of those
conditions that enabled Korea (and other East Asian countries) to success
fully pursue an interventionist approach to investment governance. While
I absolutely agree with this view, I would like to warn the readers against
believing that the existence of such a bureaucracy was, to borrow a popu
lar but obfuscating phrase, a benefcial " initial condition" that the country
possessed for hi stori cal reasons. Contrary to the popul ar bel i ef, the Ko
rean bureaucracy in the early postwar years was suffering from bad orga
nization, compromised meritocracy, and lack of technical expertise-it was
sending its bureaucrats for training to the Philippi nes and Pakistan until
the late 1 960s. Thus the countr had to spend a l ot of time and energy in
reforming the organizational structure of the bureaucracy and training the
bureaucrats before it coul d establish the kind of bureaucracy that it has
now ( Cheng et al. 1 996) . B
Rent - Seeking and Corruption
One popular argument against state intervention in investment deci
si ons is that it can l ead to rent-seeking and corruption ( for a comprehen
sive criticism of the theory of rent - seeking, see Chang 1 994, chs. 1 -2) . In
the current policy discourse, it is common to equate rent - seeking and cor
ruption (or more precisely, bribing) with each other, but these two need
to be clearly distinguished (Chang 1 994, 29-30) . Strictly speaking, what are
known as "rent- seeking costs" are essentially transaction costs arising from
the diversion of resources from other "productive" activities to "unproduc
tive" l obbying activi ti es ( based on the i mportant but frequently i gnored
assumption that the economy was previously in a state of full employment
59
State, Capital, and Investments in Korea
and thus the diverted resources had already been productively employed
el sewhere) . Bri bi ng, on the other hand, is essenti ally a resource transfer
to the holders of publ i c ofces and thus has no ( or very little) transaction
cost implications. However, does the fact that bribery is a transfer mean that
corruption does not matter? Of course not, because there are important " in
direct" ways in which bribery matters for t he effci ency of t he economy.
Corruption and Capital Accumulation
One i mportant way in which transfer of weal th through bribing can
have an impact on the economy is by transferring wealth between groups
with different savings l in vestments propensiti es. I f the wealth was trans
fer r ed from an i ndi vi dual ( or a group) wi t h a l ower cons umpt i on
propensity t o another i ndividual ( or another group) with a higher con
sumpti on propensi ty, the economy may suffer i n the l ong run, as this
may reduce investment.
I t i s not i mpl ausi bl e that those who are bri bed ( i . e. , pol i ti ci ans or
bureaucrats) have a typi cally higher propensity to consume than those
who bri be ( i . e. , busi nessmen) . However, the di sti ncti on between busi
nessmen and politicians / bureaucrats i n t hi s regard i s somewhat spurious,
because many of the l atter, especi ally i n devel opi ng countri es, doubl e
as busi nessmen, i f only as "sl eepi ng partners. " I f those who are taking
bribes do not have a higher propensity to consume than those who are
giving bribes, the presumed negative effect of corrupti on on investment
and capi tal accumulation may be negl i gibl e. Actually, thi s may be one
cl ue to how such a "corrupt " country as Korea ( as well as some other
countries in Asi a, such as Japan or Indonesi a) experienced a rapid capi
tal accumulation. All in all , without knowing the exact circuit of corruption
money in a particular country, it i s not possi bl e to predict how corrup
ti on will affect capital accumulati on.
However, there i s another reason why corrupti on may lower capital
accumulation that is quite separate from differential consumption propen
sities. Wealth made out of bribes i s more likely to be shipped out of a
country than other forms of wealth ( as thi s will reduce the chance of
detection for corrupt dealings and will make it easier for t he bribe recipi
ent to fee the country in the worst case) . I f such capital fight occurs,
domestic accumulation will have been harmed by corruption, even when
the corrupt official has the same savings propensity as the businessman
who gives the bribe. In a country like Korea, therefore, the exi stence of
capital control may have been more important than is often supposed in
ensuring high capital accumulation, given the high level of corruption. "
60
State, Capital, and Investments in Korea
Corruption and the Quality of Government Decision Making
The real trouble with corruption is not simply that it transfers money
to publ i c offi ci al s but that i t i s i ntended to i nfuence the substance of
decisions by those officials. At this poi nt, we should note that the i nfu
ence of bribery on government decisi on making i s not entirely negative.
Bri bery may have posi tive indi rect effi ci ency consequences when it i s
used as a "signal " for one's superior ability as a producer to make profit
(as heavy adverti si ng may be used as a " si gnal " for superi or - product
qual ity) . Of course, the t roubl e i s t hat t hi s signal i s not noi se- free, as
there i s no necessary correl ati on between someone' s abi l i ty as a pro
ducer i n t he par t i cul ar i ndus t ry wher e he or s he i s t ryi ng t o get
government support and hi s or her ability to mobilize funds i n general .
For exampl e, a person may be able to mobilize a l ot of money because
of his ability to make arbitrage gai ns, but that does not prove that he will
be a good manager of the industrial frm for which he is hopi ng to get
a l icense. If this is the case, the positive nature of the signaling functi on
of bri bery may be severely l i mi ted. I ndeed, someti mes the exact pur
pose of bri bery is to " j am the si gnal " so t hat one coul d conceal one' s
(relative) incompetence in the area i n which one wants to be chosen for
government favor by usi ng the money from other areas where one i s
more competent.
Then how can we explain the fact that a corrupt country l i ke Korea
could maintain a high degree of rationality i n government deci si on mak
ing? There are a few possibl e explanations, although none of them can
be supported by robust empirical data, given the nature of the subj ect.
Fi rst, there has been some minimum threshol d of busi ness competence
that a frm has to possess before it can enter the " bri bery market. " In the
Korean case, this has been achieved by ( implicitly) confining the poten
ti al recipients of state- created rents to a small group of congl omerates,
namely the chaebol s, with already proven busi ness track records , and
thi s way t he most effi ci ency- damagi ng cases of corrupt i on coul d be
structurally prevented. Second, it can be argued that corruption i n Korea
is confi ned to certain sectors that may not be so i mportant for interna
t i onal compet i t i venes s . As is the cas e i n many ot her count r i es ,
nontradabl e sectors like defense, constructi on, urban pl anni ng, among
others have been the most popular areas of corruption i n Korea, whereas
corrupt i on s eems t o have been l es s i n t radabl e sect ors where poor
performance can be qui ckly exposed. ' o Thi rd, i t i s wi del y accept ed i n
Korea that there has been l ess corrupti on i n t he cri ti cal " technocrati c"
part of the government where many substantively i mportant deci si ons
61
State, Capital, and Investments in Korea
are made, whereas it is quite widespread among the top pol iticians and
the lower- l evel bureaucrats. Fi nally, the publ i c commi tment of succes
si ve Korean pol i t i cal regi mes t o productivity growth and catchi ng up,
mani fested i n nati onal and sectoral pl anni ng exerci ses, seems to have
put certain limits to the degree of "distortion" that bri bi ng can have on
bureaucrati c deci si ons.
Political Functions of Corruption: Implicit Wages,
Redistribution, and Legitimacy
Another possible explanation for the apparently weak (if not exactly
nonexistent) negative effect of bri bery on the economy i n countries like
Korea is that a substantial portion of bribery is i n the form of what is called
tukkap (literally, "money for rice cakes") . It is not pai d to particular public
ofcial s i n relation to a particular proj ect, but is pai d to most (if not all)
of the infuential politicians and bureaucrats to keep them "sweet. " l l
To the extent that bribery takes the form of tukkap and does not result
i n specifc instances of favoritism, it is a pure transfer which does not even
have the "signal j amming" efect that we mentioned above. I propose that
this kind of bribery is better understood as an element of " implicit wages"
for the politicians and bureaucrats who are bribed. Indeed, many Korean
bureaucrats and politicians claim that they would not take the bribes if
they were getting salaries comparable to what they could get if they were
employed i n the private sector-of course, taking into account the higher
social status that government jobs carry. Indeed, one reason why Singapore
has little corruption seems to be that it pays its public fgures salaries that
are competitive with private sector salari es.
One addi ti onal i nteresti ng twi st to this story i s that i n Korea, as in
many devel opi ng countri es, a l arge part of the tukkap- styl e bri bery di
rected to the politicians ( i f not the bureaucrats) ends up being transferred
to their constituents, especially the poorer ones. Indeed, many politicians
claim that the need for this further transfer to their consti tuents is the
biggest reason why they take tukkap. And to the extent that this is t
.
rue, this
kind of bri bery works as a channel for i ncome redistributi on.
Then the obvi ous questi on is why countries l i ke Korea cannot raise
extra taxes from busi nessmen equival ent to the tukkap they are paying
anyway, and then use the money, frst, to raise wages for pol iticians and
bureaucrats to take care of the " i mplicit wages" el ement, thus reducing
their needs to take bribes; and second, to set up a decent welfare state so
that the politicians do not need to take bribes for redistributive purposes
and make the redistributi on l ess subj ect to things l i ke party l oyalty and
62
State, Capital, and Investments i,} Korea
personal connections. This way, the businessmen will pay exactly the same
amount of money i n increased taxes rather than i n bri bes ( or even l ess,
as they do not have to pay the "risk premium" to those who are taki ng the
bribes) , the pol i ti ci ans and the bureaucrats wi l l get all the money they
used to get illegally or semilegally as a part of their l egitimate salaries now,
and the poor will get the same amount of transfer from the rich, but now
through institutionalized welfare schemes rather than dependi ng on thei r
attractiveness to particular pol iticians.
However, there are many pol i ti cal and i deol ogi cal obst acl es to such
obvious reforms i n Korea, many of which al so apply to other countri es.
First of al l , regarding the " implicit wage" function of corruption, it shoul d
be noted that the prevailing Confucian i deol ogy regarding publ i c service
requires that the public ofcials pursue a life of "clean poverty" (chungbin) ,
making it diffcult to raise salaries for the politicians and the bureaucrats
in the Singaporean manner. Second, in relation to the "redistributive" func
tion of corruption, it should be noted that the absence of the welfare state
i deol ogy and of the pol itical coalitions to back it means that the Korean
government's power to raise taxes for redistributive purposes is l i mi ted.
Moreover, pol i ti ci ans who currentl y run " l ocal welfare states" have an
incentive to keep discretion over the exact manner of redistributive trans
fer, which will be threatened by giving everyone an entitlement to a certain
level of i ncome through the welfare state. And those who are paying the
tukkap also prefer to have their money redistributed through the pol i ti
ci ans, rather than di rectly to the poor, as this wil l i ncrease thei r overal l
infuences on the pol i ti ci ans.
The inability of the Korean society to accept the function of corrupti on
as a channel to provide i mpl i ci t wages to publ i c sector empl oyees and as
a channel of income redistributi on to the poor has meant that the sorely
needed reforms of the taxation system, the publ ic sector sal ary structure,
and the social welfare system that wl l institutionalize the existing transfers
have not happened (or even been di scussed widely) . Thi s, i n turn, h as
meant that the whole system of "corrupt" transfers persists because many
peopl e need it. The probl em is that the wi despread corruption has l ed to
a legitimacy crisis for the country's pol itical system, because accordi ng to
the formal rul es that currently govern the processes of i ncome generation,
transfers, and entitl ements, most of the "pol itical transfers" that are going
on now are i l l egal . Indeed, this i nherent vul nerabil ity to l egiti macy crisi s,
rather than i ts effect on capi tal accumul at i on or gover nment deci s i on
rati onal i ty, may be the bi ggest pr obl em wi th corrupt i on i n t he Korean
society ( and in many other societies that suffer from a si mi l ar probl em) .
63
State, Capital, and Investments in Korea
The Demise of the "Traditional" Regime of
Investment Governance, 1 993-1 997
Since the l ate 1 980s, but especially from 1 993, when the Kim Young
Sam government took power, the Korean regime of investment governance
underwent i mportant changes i n more " l i beral " di rect i ons-the most
important changes being t he abolition of the pl anning ministry (the Eco
nomi c Pl anni ng Board) , the severe weakeni ng of i ndustri al pol i cy, and
l arge- scal e financi al l i beral ization ( more on these l ater) . What were the
forces driving such changes?
First of all , as the Korean economy approaches the worl d's technologi
cal frontier, the informational beneft that the government can derive from
the country's late- devel oper status ( see above) has been diminished. And
as a resul t , there has been a growi ng opi ni on i nsi de and out si de the
government that it is not so simple anyore to decide where to push invest
ments as it used to be, and therefore more and more things have to be "lef
to the maket." Of course, it is not clear whether this argument is convincing.
Korea is still some way away from the worl d's technological frontier except
i n a few industries, and thus the loss of " latecomer's advantage i n govern
ment intervention" is still not so complete. And the experi ence of Japan
shows that even in a highly advanced economy there are a lot of positive
things that the goverment can do in terms of physica investment coordina
tion or promotion of cooperative R and D investments. Nevertheless, by the
mid- 1 990s, the belief that the Korean economy fnally reached a stage where
government orchestration of investment is at best redundant and at worst
harmful had establ i shed i tsel f strongly among the Korean elite ci rcl es.
Second, the past (and present) association of the interventionist state
with pol i ti cal authori tari ani sm and corrupti on has lent strength to the
opinion that a l ess interventionist state i s needed to rid the country of such
undesirable features. Needless to say, such a simplistic view of state inter
venti oni sm i s not warranted. For exampl e, the Pi nochet regime i n Chile
combi ned a hi gh degree of economic l i beral ization with pol itical repres
sion. For another exampl e, corruption in the Korean context cannot be
el iminated without some structural reforms that I suggested in the previ
ous secti on, which may actually require an increased role of the state at
least in certain areas (such as taxation and social welfare) . Even so, the grip
that this opinion has over the public mind had been very strong, and gave
i mpetus to a general ized attack on state i nterventi oni sm.
I n addi ti on, duri ng the l ast several years , Korea has wi tnessed the
tremendous ri se of free- market i deol ogy, strongly i nfuenced by its ascent
64
State, Capital, and Investments in Korea
on the world scal e. The limits of neol i beral free- market reforms are too
well known to di scuss here, but the sway that the free- market i deol ogy i s
holding in the country during the l ast several years has been truly remark
able. Especi ally with their growing financial muscles and their increasing
outward investments, the chaebol s have become much more aggressive
i n asserting their bel i ef i n a free market-the best manifestati on of thi s
bei ng the 1 997 document from the research i nsti tute attached to thei r
association ( Korean Federation of Industries) , which was hastily withdrawn
after publ ic uproar i n response to its call for a radical reduction of state
activi ti es ( e. g. , to abolish all government ministries except defense and
foreign afairs, to cut the number of government employees by 90 percent,
to deregulate ever market i maginabl e, etc. ) Y
Added t o all these had been the increasing external pressures for lib
eralizati on. During the last decade or so, following the Korean success in
international markets, the US and the European Union have been engaged
i n active " trade di pl omacy" with Korea, whi ch involves demands for do
mestic deregulation to enhance market access as well as trade liberalization.
The signing of the World Trade Organization ( WIO) agreement has also
rei ned i n Korea's pol i cy freedom more than before, although we shoul d
not forget that the ol d General Agreement on Tariffs and Trade ( GATT)
system did not necessarily allow much more freedom to developing coun
tries than now, except perhaps i n the area of TRIPs (trade- related intellectual
property rights; for more details, see Ayuz et al . 1 998) . Korea's accession
to the Organization for Economic Cooperation and Development ( OECD)
has al so obligated the country toward greater liberalization, especially of
the capital market.
All the above factors have conspired to bring about important changes
i n the i nvestment governance regi me of Korea si nce 1 993. Whi l e there
were al so changes, such as the narrowing of the defi ni ti on of "stabi l ity"
(and thus more narrow concern for infation) and the increasing relaxation
of lUXUry consumpti on control regi me, the two most i mportant changes
were the fnancial liberalization program that vastly reduced the state control
on capital i nfows (and outfows to a l esser extent) and the abol i ti on of
national and sectoral pl anni ng exerci ses, epi tomized by the abol i ti on of
the Economic Planning Board ( EPB) . This chapter argues that contrary to
conventional wisdom, it was these changes rather than the persistence of
the "traditional " regime of investment governance that l ed to the 1 997 cri si s
( for further detail s, see Chang 1 998b and Chang et al . 1 998) .
First of al l, the financial l i beralization program that was implemented
in 1 993-partly as a response to US pressure and partly in a bi d to quali f
65
State, Capital, and Investments in Korea
for OEeD membership-was wide- ranging in its scope, proposing, among
other things, to deregulate interest rates, abolish "policy loans, " grant more
manageri al autonomy to the banks , reduce entry barri ers to fi nanci al
markets, and, most important, liberalize the capital account. The ultimate
result of these changes was the now well - known huge foreign debt build
up, where the country's foreign debt nearly trebled from $44 billion in 1 993
to $ 1 20 billion in September 1 997 ( although it fell slightly to $ 11 6 billion
by November 1 997) . 1l The probl em wi th this debt bui l d- up was not pri
marily with i ts scal e but wi th i ts maturity structure, where, exploiting more
l ax regul ati ons on short - t erm l oans, the share of short- term debt ( debt
with l ess than a year's maturity) rose from an already high 43. 7 percent i n
1 993 to an astonishing 58. 3 percent at the end of 1 996 ( BAl , 1 998) . 1 4 When
the "contagi on effect" from the Southeast Asi an cri si s and a number of
hi gh- profi l e corporate fai l ures ( st eel - maker Hanbo and car- maker Ki a)
shook international investor "confi dence" i n Korea i n the last quarter of
1 997, such poor maturi ty structure of forei gn l oans meant t hat i t was
i mpossi bl e for the country to stem the outfow of foreign exchange.
The abolition of national and sectoral planning was also a critical factor
in the making of the 1 997 crisi s. Soon afer it came to power i n 1 993, the
Kim Young Sam government, in a gesture to show its commitment to free
market refor m, abol i shed t he EPB, whi ch had t i l l then orchest rat ed
government economi c pol i cy si nce 1 96 1 . I t al so turned the ambiguous
attitude that the previous Roh Tae-Woo government showed toward sectoral
i ndust rial pol i cy i nto an outri ght aversi on, and practi cally termi nated
sectoral industrial pol i ci es, except in the form of technol ogy support i n a
few hi gh- tech i ndustri es. Now free from the government coordination of
investments to avoi d "duplicative" investments, the chaebols went for an
i nvestment spree fuel ed by foreign borrowng, whi ch resulted in the build
up of excess capacity i n a number of maj or i ndustri es ( semi conductor,
steel . automobi l e, et c. ) that hurt export prices and corporate profitability.
At the same time, the abolition of pl anning, despite the i nitial expectation,
made the corrupti on probl em worse. As revealed graphically through the
corrupt i on scandal that surrounded the meteori c ri se and the dramati c
col l apse of Hanbo Steel . the aboli ti on of pl anning now exposed even the
core manufacturing i ndustri es to corrupti on, by eliminating the "rati onal "
cri teria that put clear l i mi ts on how i nfuential politici ans and bureaucrats
coul d extend favors to t hei r "payi ng customers" ( see above) .
Thus seen, t he changi ng economi c, pol i t ical , and i deol ogical condi
t i ons t hat prevai l ed i n Korea si nce the l at e 1 980s, and especi al l y si nce
1 993 , had l ed t o s i gni fi cant changes i n Korea's regi me of i nvestment
66
State, Capital, and Investments in Korea
governance. The unfortunate thing is that. even from the poi nt of view
of t hose who thi nk the tradi ti onal regi me had more or l ess out l ived i t s
useful ness ( a viewpoi nt I do not not share) , i t can be sai d t hat s ome
critical el ements of this regime were abol i shed without put ti ng al t erna
tive mechanisms i n pl ace to take over what were regarded as l egi t i mate
funct i ons. For exampl e, l i beral i zi ng i nternati onal capi tal fl ows wi t hout
establ i shi ng proper mechani sms for fi nanci al supervi si on was a cri t i cal
mistake that resulted i n t he debt crisis. I n another exampl e, abol i ti on of
sectoral pl anni ng without establ i shi ng mechani sms through which the
manufacturers themselves coul d coordinate investments ( as it happened
i n Japan especi ally between the 1 950s and the 1 970s) resul ted i n dupl i
cative i nvest ment s that brought about corporate col l apse and export
probl ems that contri buted to the 1 997 cri si s.
Conclusions
What concl usi ons can we draw from our di scussi on?
First of al l , our discussion shows that investment governance is a subj ect
that spans an array of issues much wider than what the current discussions
of the subj ect typi cally cover: infati on, regulat i on, property right s, and
social infrastructure. I n the case of Korea, it involved controls on the extents
and the forms of capital infows and outfows, disciplining the recipients
of state- created rents, and even controlling l uxury consumpti on, all of which
were achieved through the use of a wide range of policy measures regard
ing taxation, credit allocati on, ownership control , local contents requi re
ment, and so on. I t even has an i mportant pol itical dimension, as it i n
volved the construction of the sense of the national "community" through
controls on lUXUry consumption or restri cti ons on capital fli ght.
Second, the Korean experi ence shows that, whi l e there are obvi ous
problems wi th an interventionist regi me of investment governance ( such
as i nformati onal constrai nt, bureaucrati c abuse, rent - seeking, and cor
rupti on) , such probl ems are by no means i nsurmountabl e. Our di scus
si ons suggest that there are a l ot of mi sconcepti ons and exaggerati ons
i n the currently popular discourses on these probl ems. At vari ous poi nts,
we argued that the origins of t hese probl ems are much more compl ex
than what i s usually suggested. We al so argued that these probl ems cannot
be remedi ed in Korea, as in most devel opi ng count ri es , by the means
t hat are usual l y sugge s t ed ( e . g. , abo l i s hi ng r egul at i ons and di s e m
powering the bureaucracy) , but require a fundament al i nst i t ut i onal re
form and the abandonment of the hypocri sy about t he nature of publ i c
servi ce. I ndeed, we poi nt ed out t hat t he fai l ure t o make s uch i nst i t u-
67
T
I
State, Capital, and I nvestments in Korea
ti onal and i deol ogi cal changes might seri ousl y damage the vi abi l ity of
the Korean regi me of i nvestment governance.
Third, our di scussi on of t he Korean case shows that a "nationalistic"
governance of investments can be very successful , contrary to what many
proponents of the currently popular gl obalizati on thesis argue. Pol i ci es
to prevent capi tal fi ght and keep the capi tal invested at home, govern
ment interventi ons to di rect investments to "nati onally" desirabl e areas,
the creation of a sense of nati onal community with a common purpose
through ( al though not si mply by) control s on lUxury consumpti on, and
the control s on the extents and t he forms of foreign di rect investments
are all elements of such a regi me. We poi nted out that the globalizati on
thesi s i s, at least as yet, far too exaggerated, and that there is sti l l a l arge
scope for nati onal pol i cy aut onomy. Perhaps i t may sound t oo cyni cal
to suggest that the el i te i n many countri es are now usi ng gl obalizati on
as a convenient excuse for thei r abandonment of any attempt at bui l d
i ng a nati onal communi ty and pursui ng a nat i onal agenda, tasks that
would require certain sacrifces on their part. However, i n a worl d made
up of rather tightly bound national political uni ts, the failure to construct
a regime of invest ment governance that i s fi rmly nati onal i n i ts basi c
scope can onl y l ead to economi c stagnati on and a fundamental desta
bi l i zati on of the pol i ti cal uni ts i n the l ong run.
Fi nal ly, our analysi s of t he recent changes i n t he Korean regime of
i nvestment goverance and i t s contri buti on to t he country's 1 997 for
ei gn debt crisis shows the difi cul ti es involved i n i nsti tuti onal reforms.
Even accepti ng that Korea really needed the large- scal e fi nanci al l i ber
alization ( especially capital account liberalizati on) and the abandonment
of sel ective i ndustri al pol icy i t undert ook aft er 1 993 (a view I do not
agree with, as ment i oned above) , i ts recent experi ence cl early shows
how unwise i t was t o make these changes wi thout putti ng i n pl ace a
devel oped fi nanci al s upervi s ory sys t em and i nt erfi rm coordi nat i on
mechanisms that can take over the functi ons that the government con
t r ol of t he fi nanci al syst em and sel ective i ndustrial pol i cy have pl ayed
in the Korean investment governance regi me. Even when some compo
nents of the investment governance regime ( or for that matter any regime
of governance) are becomi ng l ess effective and are creati ng more un
desi rabl e si de effects than before, radical changes to t hem shoul d not
be made until the possibl e consequences of such changes for t he work
ings of the overall regi me have been thought through.
68
CHAPTER FOUR
GOVRNANCE AND INVESTMENT IN CHINA
Shuhe Li and Peng Lian
One of the most challenging pol iti cal - economi c puzzl es of the 1 990s
i s how to explain the coexstence of large- scale foreign direct investment
( FDI) and widespread corruption i n China. On the one hand, according
to the I nternati onal Monetary Fund ( IMF) , Chi na has been ranked sec
ond aft er the Uni ted Stat es as a host country for FDI si nce 1 993 ( see
t abl e 1 ) . Chi na's FDI i nfl ow- GDP ( gross domest i c product) rati o was
al so ranked second only to Singapore i n 1 994 ( see tabl e 2) . I On the other
hand, Chi na i s generally regarded as one of the most corrupt countri es
i n the worl d. Accordi ng to a survey of the Pol iti cal and Economi c Ri s k
Consultancy (Asian Intelligence 1 995) , Chi na was rated by foreign man
agers as the most corrupt among eleven Asian countri es, including I ndi a
and I ndonesi a. China was also ranked by Transparency Internati onal as
one of the most corrupt countries i n the world i n 1 996 ( see ch. 2 ) . Some
estimate t hat one- third to one- half of al l deal s si gned in Chi na invol ve
some form of corruption, with bri bes hovering between 1 -1 0 percent of
sal es, and "there are probably as many types of corrupti on as there are
types of t ea" ( Kei j zer 1 995) .
The Chi nese devel opment experi ence seems to defy the pres umed
wisdom as stated by the president of t he World Bank: " We need to deal
wi th the cancer of corrupti on. . . . We can give advi ce, encouragement,
and support to governments that wish to fight corruption-and it is these
governments that, over t i me, wi l l attract the l arger vol ume of i nvest
ment. "2 Cl early t he coexistence of wi despread corruption and fast- growing
FDI i n Chi na i s an intriguing puzzl e for students of economi c devel op
ment. As known, FDI will occur when there ar e hi gh transacti on costs
69
Governance and Investment in China
Table 1 Foreign Di rect Investment Annual I nfow in Reporting Economy
Table I continued
(Millions of us dollars)
Greece 52 ,JJ5 , 35 , 44 9 9 , J53
Country 959 9 99 92 93 J 95 I cel and 2 3 3 4 5 4
I rel and 8 , Jc2 ,435 , 3 93 2, 3
Asi a 4,2c9 5, 42 2J, 9 25, 59 +,9J 52, 5 5 c3,223
I tal y 2, cc c,4 2, 4J 3, 95J 4, 353 2, c3 4, 59
Afghani stan, I . S. of N/ A N/ A N/A N/A N/A N/A N/ A
Netherl ands 5, 5c3 2, 39 c,3 c , 9J , cc 5, c c J, 225
Bangl adesh N/ A 3 4 4 2
Norway , 5 9 , JJ3 395 c 2, JJ3 c23 N/A
Cambodi a N/ A N/A N/A 3 5 6 5
Portugal , 3 2, c J 2,445 , 53 , 53 ,2J 6
Chi na, Peopl e' s Republ i c of 3, 393 3,45 4, 3cc , 5c 2,5 5 33,5 35, B9
Spai n 5,425 3,9B 2,493 3,2c 5, 44 9, 359 c, 25J
Fi ji 9 8 5 5 2 6 c
Sweden , 5 2 , 952 c, 35 5 3, J5 c, 24 4, 23
I ndi a N/ A N/A N/A N/ A N/ A N/A N/A
Switerl and 2, 52 4, 9c 3, 5 ,249 89 4, J 2,cJJ
I ndonesi a 2 , J93 ,452 , 2, JJ4 2, J9 4, 35
United Ki ngdom 3J,553 32,42 c, 2 3 c, 35 5,54 J, 295 32, 2J5
Ki ri bati N/ A N/A N/A N/ A - N/A N/A
Korea , 5 B 5J 2 58 8 , c
SOURCE: I MF Balallce ofPayments Statistics Yarbook 1 996, 58, 59.
Lao Peopl e' s Democratic Republ i c 4 c 5 4 42 7
Mal aysi a , cc5 2, 332 3, 995 5, 53 5, JJc 4, 35 N/ A involved in exporting or licensing a product to a foreign company. In other
Mal di ves 4 c N/ A N/A words, unlike trade, FDI typi cally involves l ong- term and asset - specifi c
Mongol i a N/ A N/A N/A 2 5 J
agreements . I n additi on, foreign investors typi cally have l ess information
Myanmar 5 c 2 2 N/ A N/ A N/A
and connection to the host nati on. How could the uncertainties and costs
Nepal N/ A N/A N/A N/ A N/A N/ A N/A
of transacti ons reSUl ti ng from opportuni sti c behavi or and the hol d- up
Paki stan 2 J 2^4 25 3 3 4 9 N/ A
probl em be reduced i n an environment of corrupt l egal and administra-
Papua New Gui nea 2J3 55 2J3 2 2 5 4
Phi l i ppi nes 5 5 54 225 , 235 , 59 ,45
tive systems? In parti cul ar, given the fact that the s tate i tsel f coul d be
Si ngapore 2, 55 5 55 4, 55 2,2J4 4, c5c 5, 45J c, 9 2
predatory, how coul d Chi na make credibl e commitments to attract FDI ?
Sol omon I sl ands 2 J 5 4 N/A N/A N/A This puzzle is certainly not unique to China. In fact, it has been ob-
Sri Lanka 2 4 4 23 9 N/A served i n ot her Asi an countri es, such as I ndonesi a ( see ch. 2 ) , where
Thai l and , 5 2444 2, J 4 2, 3 , 5J4 , 3cc 2, Jc5
corruption and FDI were both remarkably high before the recent fnancial
Tonga N/A N/ A N/A 2 N/ A N/A
crisis occurred. In his discussion of economic transition, Robert Hall high-
Vanuatu 9 3 25 Z Z I 3
lights this puzzle as follows: " It is axi omatic that contract enforcement is
Western Samoa N/ A N/ A N/ A N/A N/ A N/ A N/ A
Asi a ( not speci fi ed) , J4 45J , 49 , 39 , 2 2, J25 2, 95c
a key to successful Eastern European l i beralization . . . . It i s noteworthy
I ndustri al Countries cc 5 4 c9, cJ4 2, 9 , c9 3c,459 39, 5 3 2J5, 9J9
that the most rapi d growth in the worl d in the past decade has been
United States c 3J 4, 9 5 22 J J , 55J 43, J 4 4c, cJ cJ,23J
achi eved in Asi an countri es where contractual relati ons are l ess hi ghl y
Canada 5 J29 , 555 2, 4J 4, 5 4, 99 , 299 J, 5c
developed and enforcement is less reliable . . . . It is a fascinating topi c for
Austral i a 5, 29 c,452 4, J3 5, J35 3, JJ5 4, J5 3, J
additional research to figure out why Asian countries have been so suc-
Japan JJ , cJ , 295 2, c Z 9c 5 cessful " ( Weri n and Wij kander 1 992, 34 1 ) .
New Zeal and c2 , 35 , 29J 2, J5c 2,4c9 2, 524 2, 5J9 This chapter attempts to provi de some i nsi ghts into the corrupti on-
Austria 6 3 9 9 , 3 35
FDI puzzle in China. In the next section we submit a framework, the LCM,
Bel gi um-Luxembourg , J2J 5, J4 9, 3c3 ,25c J, 5J ,43 N/A
whi ch hi ghl i ghts three mechani sms: l ocal i nformati on and i nformati on
Denmark J9J , 32 , 553 J 3 5 JJc 4 39
intermediaries (L) , cross- regional competi ti on ( C) , and market- preservi ng
Fi nl and 49 52 233 39 8 , 49c 59
authori tari ani sm ( M) at the i ndi vi dual , regi onal and national l evel s , re-
France J3J4 3, 53 5 53 2 ,5J 2J, 5 c,c25 23 35
Germany 52 2 532 4 J5 2, c2 , 5 5 5 5 5, 935
spectively. When it is too costly and too uncertai n to use a corrupt l egal
Conti nued
system, such mechanisms can help enforce agreements and property rights.
70
71
-
Governance and Investment in China
Table 2 FOI! GDP and FOI ! GNP in 1 994 ( ')
Country FDI 1 1 GDp2 FDI 1 IGNp3 Country FDI 1 I GDp2 FDI 1 IGNp3
Asi a 2 59 J 5 Westem Samoa N A N A
Afgrl ani stan, I . S , of N/ A N A Asia (not specified) N A N A
Bangladesh J J4 J J I ndustrial Countries J J J 5
Camboi a N/ A N A United States J J J 9
Chi na, Peopl e' s Republ i c of 4 3 Canada 3 25
Fij i N A J 4 Australia 42 4
I ndia N A N A Japn J J2 J J3
I ndonesia 2 J 3 New Zeal and 4 9 4 >
Kirbab N A N A Austria J J M
Kora J 2 J 5 Bel gi um-Luxemburg 3 25 3.5
Lao Peopl e' s Oem, Republ i c N A N A Denmar 3 43 4 M
Mal aysi a 2 2 Fi nland 53 52
Mal di ves N A N A Frnc 25 4
Mongol i a J 9 N A Germany N A J J5
Myanmar N A N A Greec 2 J 5
Nepal N A N A I cl and N A N A
Pakistan J 5 J Ireland 9 9
Papua New Gui nea -JJ9 -J I tal y J 2 J 2
Phi l i ppi nes 2 45 J 5 Netherands J 9
Si ngapre .95 53 Norway J 5 J 2
Sol omon I sl ands N A N A Portugal 4 J
Sri Lanka .42 J 29 Spain 94 . 4
Thailand J 95 J 3 Sweden 3. 5 4 4
T
a
N A N A Switerland 55 2 33
Vanuatu N A J7 United Ki ngdom J J 95
ScJ lll FS OF BASI C DAI ,\:
1 , I MF, B(l I(l l ce o(Paymell ls Stalislics Yeariook 1 996, 58, 59,
2, The World Bank, World Delleiopmell l Report 1 996, 2 1 0, 2 1 1 ,
:, The Worl d Bank, World Delleiopmenl Report 1 996, 1 88, 1 89, 222 ( PPP based GNP) ,
After that, we speci fi cal ly expl ore the Chi nese case. We argue that
overseas Chi nese capi tal i st s, fi scal decentral i zati on and pos t - Mao r e
gimes primarily facilitate t he three mechanisms, respectively, and hence
contri bute to the l arge- scal e i nfow of FDI . At the same ti me, however,
government control and regional publ i c ownership without an indepen
dent j udici ary system have provi ded a hotbed for corrupti on in China's
transi ti on economy. As nonowners of publ i c assets but with signifi cant
control rights, Chi nese i ndustrial bureaucrats have both i ncentives and
opportuni ti es to take bri bes from pri vate invest ors ( i ncl udi ng forei gn
investors) i n exchange for giving some publ i c assets to the l atter party,
expl icitl y or i mpl i ci tly. Al though government control and publ i c owner-
72
Governance and Investment in China
sip make corrpti on wi desrad (scope) , corrupti on i s somewhat pre-
di ctabl e, coordmated, and l i mi ted to not easily verifiabl e t l' ans
.
, act I ons
( degree) due to the LCM in Chi na. Partl y as a resul t, the corrupt i on-
ind
.
uced unce
.
rtainti es for
.
the
,
returns to FDI are mitigated, thus making
Chma a relatively attractIve si te for FDL In the l ast secti on, we di scuss
the recent financial crisis in Asia and the implications for China in terms
of state governance and FDL
State Governance, Informal Enforcement, and FDI
In this chapter, corruption is defined as the abuse of public assets or
public authority for personal gai n. 3 By thi s definition, corruption generally
occurs i f publ i c property rights and! or publ i c authority are not well de
fned. The scope of corruption is thus positively correlated with the range
of ambiguity of public property rights and regulatory authority: When there
are more distortions in prices, agreements, and regulations an
'
d more noise,
there are more opportunities for corruption. Corrupt ofcial s can purposely
make confusing rules and change them randomly so as to create oppor
tunities to increase bri be taking and to reduce the ri sk of being detected.
In the case of Chi na, bureaucrat s and managers of st at e- owned
enterpri ses ( SOEs) and township and village enterpri ses ( TVEs) are not
owners of publ i c asset s, yet have si gni fi cant control rights over these
assets. Thus they have both i ncentives and opportunities to take bri bes
from private i nvestors by givi ng some publ i c assets to the l atter party,
expl i ci tl y or i mpl i ci tly. 4 Thi s makes it possi bl e for a private i nvestor to
l ower hi s average cost-the annualized val ue of the "free" publ i c assets
i s greater than the bri be. Consequently, he woul d have l i ttl e i ncent i ve
to reveal the si tuati on. Product competi ti on forces other private i nves
tors to bri be because otherwi se thei r average costs wi l l be hi gher and
they wi l l ose market share.
Given the fact that corruption is widespread in China-fostered bv a
legal system that l eaves much to be desired in terms of enforcing agre
ments and property rights-some informal and semiformal enforcement
mechani sms must have contri buted to the rapid expansi on of FDL We
submit that there are two fundamental forces that help enforce agreements
informally or indirectly: local information ( with partners) and competition
(with rivals) . A person's local information about his business partner con
sists of hi s personal knowl edge about t he partner's identity, credit historv,
reputati on, financial status, and so on. Local i nformation
'
is rel ation- sp
cific, and it is generally accumulated among relatives, town mates, fri ends,
and col l eagues. Two parti es wi th common l ocal i nformati on can reduce
73
Governance and Investment in China
the uncertainties of their transactions and information asymmetry between
them. More important, if two parties do not have mutual l ocal information,
but each of them has mutual local information with a common third party,
then the third party can play the role of an information intermediar. Contract
guarantee and personal recommendati ons are commonly observed ex
amples of informati on intermediaries.
By transi tivi ty, a wi de network may be est abl i shed on i nformati on
intermediaries. \hen such a network is interregional or international , it can
facilitate cross- regional or cross- country agreements. Such private ordering
can help enforce not only the kind of agreements that are not verifi able
by a third party, but also the kind of agreements that are verifiabl e by a
third party but neverthel ess cannot be impartially enforced by law.
\hen it i s too costly or too uncertain to use a corrupt l egal system
to settle disputes, parties to a transaction can resort to l ocal information
and informati on i ntermedi ari es to enforce agreements informally. Local
information shared among business partners can hel p them to conduct
busi ness outside the l egal system, thus functi oni ng as a substitute for
l egal enforcement.
Competition provi des another driving force for contract enforcement.
I n particular, cross- regi onal competition will force each regi on t o reduce
uncertainties and costs of transactions i n its j urisdiction. The initial driving
force may come from product compet i t i on i n a spot market , such as
exchanges of fi nal product s ( especially consumpt i on goods for which
enforcement i s rel atively easy) , and the resul tant taxes that market ex
change gener at es . The r egi ons wi th mor e effe ct i ve enfor cement
mechanisms have competitive advantages, such as l ower costs over rival
regi ons , and thus wi l l at t ract more economi c act ivity. Thus , product
compet i t i on may t ri gger compet i t i on i n t he desi gn of enfor cement
mechani sms. I n equi l i bri um all regi ons or groups may be " forced" t o
adopt effi ci ent ( though i nformal ) enforcement mechani sms . "
However, a proper governance structure i s needed to facilitate these
two forces. Fi rst, for l ocal informati on to be uti l i zed effect ively, it must
be the case t hat i ndivi dual s have economi c freedom to conduct trans
actions and to choose busi ness partners, and that there i s a (minimum)
political order i n the society such that there i s no rampant robbery and
arbitrary confi scati on. " Second, for competi tive forces to be effective. i t
must be t he case that fi rms and regi onal government s have autonomy
to make primary economi c deci si ons in response to compet i t ive pres
sures but cannot erect trade barriers. I n countries where rule of l aw and
democratic pri nci pl es have been i ngrai ned, these condi ti ons are gener-
74
Governance and Investment in China
ally met . In count ri es where they are not , a regi me that i s pol i t i cal l y
more central i zed and economi cal l y more decentral i zed may be a rea
s onabl e al t ernati ve . That i s , ci t i zens may be forbi dden t o organi ze
opposi ti on pol itical parties and to demonstrate on t he streets, but they
are al l owed to trade and i nvest . Local goverments may be granted a
l arge degree of autonomy over economi c deci si on making, though the
ul ti mate pol i ti cal authority i s the central government, and the nati onal
government i s abl e to mai ntai n a common market . '
Cros s - r egi onal compet i t i on i mpl i es t hat regi ons chargi ng mor e
bri bes and givi ng up fewer col l ective asset s wi l l l ose FDI t o ot her re
gions. Hence, in equilibrium, bribes will be l ow enough to keep busi ness
proftabl e. Indeed, from the viewpoi nt of bri be givers, it i s possi bl e that
the value of bri bery- induced favorabl e treatments i s larger than the bri be
i tsel f, and thus the bri be gi ver can be better of as a resul t. This i s be
cause compet i t i on among di ffer ent r egi ons ( br i be t akers) t ends t o
increase the value of favorable treatments and decrease the size of bribes.
Compet i t i on among bri be givers may l i mi t pot enti al i neffi ci enci es
from corrupti on. I n fact, under certai n condi ti ons bri bery i s equival ent
to competitive bi ddi ng ( Beck and Maher 1 986) . I f the bri be taker cares
onl y about the amount of the bri be ( i . e. , he does not di scriminate among
bri be givers) and there is sufi ci ent i nformation, then the most efci ent
bri be gi ver can defeat all others si nce he i s abl e to submi t the l argest
( "profi tabl e" ) bri be. Thus , resources are al l ocated to the most effi ci ent
user despi t e corrupt i on.
I n sum, before democracy and t he rule of l aw are firmly establ ished,
we need a governance structure to ful fi l l three basi c institutional con
di t i ons : fi r s t , hous ehol ds and fi r ms have aut onomy t o make
microeconomi c deci si ons; second, fi rms and l ocal governments are not
able to erect trade barri ers; third, there i s no rampant robbery and ar
bi trary confi scati on. These condi t i ons create an envi ronment that en
courages t he use of l ocal i nformat i on/ i nt ermedi ari es and pr omot es
cross- regi onal competi ti on.
Not e that these are also the condi ti ons that preserve markets. I n Li
and Lian ( 1 999) , we argue that these condi ti ons can be met under market
preseruing authoritarianism ( MPA) .
We defi ne an MPA as follows : A state is authoritarian if there exi sts
a domi nant group of pol i ti ci ans whos e control over the country rests
more upon the obedi ence of the ci ti zens than upon thei r parti ci patory
consent. An authoritarian state in a devel opi ng or i ndustrializing economy
is market- preserving if the fol l owi ng condi t i ons hol d:
75
Governance and Investment in China
Ml . Subj ect to changing internati onal and domesti c constraints, in
particular competitive pressures, senior leaders ( or the dominant
party) perceive that i t i s i n their best i nterests to preserve the
market in order to facilitate catching-up;
M2. Seni or l eaders ( or the domi nant party) are abl e to make thei r
policy on market-based catching-up more credible, i . e. , not easily
subj ect to pol itical whim, by i mposi ng sel f- constraints through
allocating sufcient autonomy (including authority, information,
and resources) to a l arge set of pol iti cal and, more i mportant,
economi c deci si on makers i n an instituti onal i zed way;
M3. Senior leaders (or the dominant party) are able to control agency
problems of bureaucrats and businessmen, as well as other politi
cians, by imposing constraints on them by designing and fostering
institutions, such as incentive schemes, checks, coordinati on, and
enforcement devi ces, i . e. , balancing autonomy and control.
Given the fact that seni or leaders have domi nant power i n an au
thoritarian regime, Ml i s a necessary condition for economic catching-up
under authoritarianism. Ml assures the compatibility of the seni or l ead
ers' i ncentives wi th the preservati on of the market. Both constraints and
experi ences shape the perceived i nterests of pol iti ci ans. Pol iti ci ans will
adopt pol i ci es that are i n their best perceived i nt erest s. I nternati onal
constraints may range from foreign occupati on, military threat, interna
t i onal sancti ons (or support) to economi c competi ti on. 8
To make their commitment t o market-based catching-up policies cred
i bl e, seni or l eaders ( or the domi nant party) i n an authoritarian regi me
have to tie their own hands wi th both international and domesti c con
straints. The former includes signing international treaties and opening up
markets. Violating treaties and reversing open-door policies may rui n the
country's i nternat i onal reputati on and possibl y resul t i n i nternati onal
sancti ons, and thus can be very costly. Open markets provide opportuni
ties for investors to escape should predatory behavior occur. A predominant
means of tying the pol iticians' hands with domestic constraints is to all o
cate sufcient autonomy systematically to a large segment of the population.
This may take the form of allocating authority of pol i cy implementation
to technocrats, autonomy to local governments, and economic freedom to
fi rms and individuals i n an i nstitutionalized way.
Autonomy, however, needs to be counterbal anced with appropriate
control s. Agency problems can be managed through checking and coor
di nat i on devi ces al ong t hree di mens i ons : vert i cal ( or hi erarchi cal ) ,
horizontal ( or cross-function) , and intertemporal ( or cross-ti me) . Examples
76
Governance and Investment in China
of checking devi ces are 0) vertical checking-hierarchical review, moni
toring, graduated controL and regular reporting to a higher authority; ( 2)
horizontal checking-col l ective deci si on- making mechanisms and i nfor
mation exchange/ peer monitori ng of performance through del i berati on
councils; and ( 3) intertemporal checking-term limitations, rotations, and
the exchange of posi ti ons among pol iticians and bureaucrats.
Exampl es of coordination devi ces are ( 1 ) vertical coordinati on-j oi nt
efforts under the guidance of a pi l ot agency or one or more designated
pol i ti cal l eader ( s) ; ( 2) hori zontal coordi nati on-del i berati on counci l s ,
industry- speci fi c and cross- i ndustry busi ness associ ati ons, antitrust and
anti l ocal - prot ect i oni sm regul at i ons, i nformal s oci al networks ; and ( 3)
intertemporal coordination-mechanisms that reduce undesirable policy
swings and shocks and i nduce l ong- term and stabl e cooperation, such
as the smooth and partial replacement of politicians and bureaucrats, as
wel l as meritocratic recruitment of bureaucrats, and a bal anced seni ority
cum merit - based promoti on system in the bureaucracy.
Clearly, an MPA fosters the three i nstitutional condi ti ons: autonomy,
no trade barriers, and political order. This i mpl i es that the two informal
mechani sms ( l ocal i nformat i on and cros s - regi onal compet i t i on) can
funct i on i n an MPA. Fi rst , Ml i mpl i es t hat seni or l eaders have strong
i ncentives to mai ntai n publ i c order and to give firms and househol ds
t he freedom to make micro economi c deci si ons. M2 assures t hat house
hol ds and fi rms wi l l i n fact have autonomy t o make mi croeconomi c
deci si ons ( i n response to competitive pressures) . M3 assures that fi rms
and l ocal governments will not easily be able to erect trade barri ers. It
al so i mpl i es that some modi cum of pol i ti cal order can be mai ntai ned.
An MPA constrains corruption indirectly through facilitating cross- re
gi onal compet i t i on and the use of l ocal i nformat i on mechani sms. As
described above ( M3) , control mechanisms can constrain corruption directly.
For example, appropriately designed arrangements governing recruitment,
promoti on, and conduct within the bureaucracy have been shown to
constrain bribe- taking (Evans and Rausch 1 996) . The same is true of collective
decision- making mechanisms that increase transparency in the proj ect ap
proval process. When a proj ect requires collective approval, it becomes more
difcult for individual decision makers to extract rents unless they can collude.
As anoter example, "graduated allocation of control or authority" at vertical
levels of management ( i n the publ i c sector) places explici t limits to what
is withi n an ofcial 's authorit, which in turn puts upper limits on bri besY
M3 i ncludes cross- checki ng devices, e. g. , appeals courts, anti bri bery
bureaus, party di sci pl i ne commi ttees, that make it easi er to detect court
77
Governance and Investment in China
verdicts that are unequivocably wrong. This i mpl i es that disputes whose
contentions can be easily veri fied by a third party, e. g. , the appeals court,
will be less susceptible to corruption since the j udges would be more hesitant
to bias decisions incorrectly. l O Hence, corruption wl tend to be concentrated
mainly on disputes that are not easily verifable by a third party, e. g. , those
that involve complex technical i ssues. For purposes of di scussi on, we will
call this type of corruption " impl icit " : corrupti on is more l ikely to occur
because of the technical compl exity involved i n the dispute.
Corrupti on varies from sector to sector, tending to be more severe in
sectors where the rents are l arge and where agreements are techni cally
more specifc, making it harder to detect corruption. Such sectors include
aircraft and construction ( Hines 1 995) and new technologies.
I
I Since FDI
from devel oped countri es to devel opi ng countries generally brings new
technologies to the host country, it provides good opportunities for brib
ery. However, it is important to note that corruption in this case (which is
i mpl i ci t) may not necessarily i mply serious contract enforcement prob
l ems. Surely the host party, generally, has better l ocal i nformati on and
connection with the l ocal courts. However, it is the foreign investor's de
faults that are often harder to be verifed by a third party, given that typi
cally the foreign investor provides complex technol ogy and the host pro
vi des l and and l abor. The foreign investor does not need to worry t oo
much about breach of contract by the host since this can be easily verifed
by a third party and hence be enforced by a court. Inversely, given i ts
better connection to local courts, the host need not worry too much about
breach of contract by the foreign investor, either. Moreover, as long as the
courts in the host country are only implicitly corrupt, and the contracting
parties have freedom to choose international arbitrati on, FDI agreements
can be i ndirectly enforced by wel l - defi ned mechanisms i n some devel
oped countri es. Thi s i s because ( i nternational) arbitrated awards them
selves can be easily verifi ed by a third party and enforced in the courts of
the host country. I "
We bel i eve that, overal l , more corruption may increase uncertainties
and costs of transacti ons and hence reduce FDI . Wei ( 1 996) reports that
corruption and FDI are negatively correlated and there is no exception for
Eastern Asian countri es. The negative effects of corruption are often exag
gerated, however. Thi s is because bri bes may not only work as ti ps to
speed up bureaucratic procedures and to get around inefficient rul es, but
also as indicated, under certain conditions bri bery is equival ent to com
petitive bi ddi ng. More i mportant, the damage from corruption crucially
depends on the nature and structure of the corruption regime. In the case
78

Governance and I nvestment in China
of China, although corruption is widespread i n scope, its character i s shaped
and its impact constrained by the MPA directly through M3 and i ndirectly
through facilitating cross- regional competition. In addition, si nce an MPA
is a rel atively centralized governance structure politically, it helps "coordi
nate" corrupt i on. Suppose, for i nst ance, there are several government
agenci es that supply compl ementary publ i c goods and act l ike a j oi nt
monopol i st. \ The effect of corruption on private investment would t hen
approximate that of a l ocal tax ( Shleifer and Vishny 1 993) . 1 4
I n the following secti on, we argue that overseas Chinese capitalists,
fiscal decentral izati on, and the post - Mao regi me have pri marily faci l i
t at ed t he t hr ee mechani s ms ( t he LCM) , res pect i vel y, and henc e
contri buted t o t he l arge- scal e fow of FDI i nto Chi na.
The Chinese Case
The Role of Formal Enforcement Devices in FDI
I n the last two decades, Chi na has enacted vari ous l aws and regu
l ati ons t o govern FDI and to curb corrupt i on. There are three maj or
types of FDI i n China and they are governed by the Law of Equity Joi nt
Ventures ( passed i n 1 979 and revi sed i n 1 990)
'
the Law of Whol l y For
eign- Owned Enterprises ( 1 986) and the Law of Contractual Joint Ventures
( 1 988) . Equity j oint ventures are j oint - stock enterprises hel d by Chi nese
and foreign partners with the l atter's share amounti ng to no l ess than
25 percent i n general . Once an equi ty j oint venture is establi shed, chang
ing the r egi s t er ed capi t al woul d r equi r e gover nment appr oval . I n
contractual ( or cooperative) j oint ventures , profits can be di stri buted at
any proporti on agreed upon and each party has separate l i abi l i ty. Typi
cally, t he foreign partner provi des technol ogy and machi nery, while the
Chi nese s i de provi des l and, l abor, and mat eri al s. I n whol l y forei gn
owned enterpri ses, 1 00 percent of t he capital i s provided by t he foreign
investor who hol ds both residual control and residual clai ms; there are
restrictions on such investment in industries as public utilities, transpor
tati on, real estate, i nsurance, and banki ng.
Corrupt bureaucrats may favor j oint ventures more than whol l y for
eign- owned enterprises. In exchange for bribes from foreign investors, the
Chinese party may deliberately underestimate the value of state assets as
shares in equity j oi nt ventures, and agree to a lower state share of profts
i contractual j oint ventures. This prediction is consistent with the obseration
that the proportion of wholly foreign- owned enterprises remained low until
the early 1 990s when legal development began to accelerate ( see tabl e 3) .
79
-
Governance and Investment in China
Table 3 Accumulated Foreign Direct Investment from 1 979 to 1 993
(Value Unit: in US$ billion)
VoJa
Toe`
cqclyJo ^lva^lca
Coo,aalvaJo^lva^lc
w^o``yoag^-lc^JaJc^la,sas
Jo^l0ava`o,1a^l
mc15a ol
o|acls
4, 225
3, 0
2,245
33,M
9
Co^laclca`
' ^vasl1a^l/1oc^l
22 59
O5 29
5 O
55 42
3
SOURCE: Almanac of China' Foreign Relations and Trde 1 994, 48.
/clca`Haa`zaJ
/1oc^l
9
3259
3552
59
3
I t is interesting to assess the impact of the American Foreign Corrupt
Practices Act of 1 977 that prohibits American i ndividuals and corporations
from bribing foreign government offcials. Empirical studies, such as Hines's
( 1 995) and Wei 's ( 1 997) , suggest that this act tends to reduce American
investments i n corrupt countries. We believe such effects are very limited
( as reported by Wei 1 996) , not only because this act may provide a com
mitment device for American investors to say no to foreign demand for
bribery, but also, more i mportant, because there are many implicit ways
of corruption and there is a lack of incentive for people to report on them.
Many American firms get third- party consultancies to do the bribing for
them. In the case of China, " by far the most common form of corruption
is the solicitation of trips abroad . . . . Perhaps the ultimate gif is education
. . . many companies have sponsored individuals whom they met i n the
course of busi ness negoti ati ons" ( Kei j zer 1 995, 1 84-86) . Si nce the act
punishes American investors when they or their partners in the j oint ven
tures bribe l ocal officials, some American investors i n China may prefer
wholly foreign- owned enterprises over j oi nt ventures because of the For
ei gn Corrupt Practices Act.
To safeguard foreign investors' property ri ght s, Chi na enacted the
Economi c Contract Law I nvolving Foreign Interest i n 1 985. I t stipulates
that for matters not covered by the law of the People's Republic of China
(PRC) , international practice should be followed, and that parties have the
freedom to choose the means of dispute settlement: negotiation, media
tion, arbitration, or litigation. The Arbitration Law enacted in 1 994 specifes
that contracting parties have the freedom to choose Chinese or interna
tional arbitration, and the people's courts in China enforce both Chinese
and international arbitral awards ( see also the Civil Procedure Law en
acted i n 1 99 1 ) . China has signed treaties of bilateral protection of foreign
80
Governance and Investment in China
investments with more than seventy countries since 1 982. China is now a
member of the " International Convention of Investment Disputes between
Host Country and Foreign Private Investors. "
To curb corrupti on, Chi na has enacted more than twenty l aws and
regulati ons si nce 1 982. The maj or ones are arti cl es 1 55 and 1 85 of the
Criminal Law (passed in 1 982) , and the supplementary regulations regard
ing the punishment of crimes of corruption and bribery ( passed i n 1 988)
are the maj or ones among more than twenty laws and regulations enacted
since 1 982 to curb corruption. Furthermore, China set up two maj or orga
nizations: the Ministry of Supervision in 1 987, and the Department of Anti
Embezzl ement and Bribery ( within the Mi ni stry of Procurators) in 1 995.
Given t he fact that t he judiciary system i s not independent. it is not sur
prising that such anticorruption agencies are not independent either. 1 5 In
addition, the desi gned framework of l egal procedures i tsel f i s vulnerable
to j udges' di screti on. I t i s not consi dered illegal for j udges to meet pri
vately with litigants or their agents. Some organizations, such as banks and
customs, are not allowed to release evi dence to litigating parties or their
lawyers; thus j udges must gather and can control such evi dence.
Although such "formal rul es" cannot i mpartially enforce agreements
and eliminate corrupti on, they do pl ay two i mportant rol es. Fi rst, they,
along with other checking devi ces, set limits on corrupti on. The poi nt i s
that although government control and publ i c ownership result i n wide
spread corruption, the degree of corruption is l argely implicit. Second, the
formal rules serve as coordination devices among transaction parties, and
as a benchmark for di spute settl ement through negoti ati on, medi ati on,
and arbitration. I n other words, the i nformal and semiformal settlement
of disputes are affected by the formal rules. I t is the j oint functioning of
both i nformal and formal enforcement mechanisms that reduces overall
uncertainties and costs of transactions and contributes to the large infow
of FDI into China. However, as will be el aborated on later, at the outset
of reform. i nformal enforcement mechani sms perhaps pl ayed a more
important role. As reform proceeds. formal enforcement mechanisms have
become i ncreasi ngly more bi ndi ng and efective.
The Role of Local I nformation and Information Intermediaries in FDI
Wank ( 1 996) . in hi s field study of guanxi-Chinese for l ocal relati on
ships. or connections- and market expansion in Xamen. Fuj ian province
i n 1 988- 1 990. exami nes how busi nessmen cul tivate connect i ons wi th
bureaucrats or " invest" in building the connections. and how such connec
tions help reduce uncertainties and facilitate cross- regional exchanges. I n
8 1
Governance and Investment in China
particular, in exchange for bribes, bureaucrats can help businessmen to get
licenses, loans, material s, and projects, and protect businessmen from erup
tive pol icy shocks and di screti onary regulatory abuses. The mechani sm
works between l ocal or forei gn busi nessmen and Chi nese bureaucrats .
Among foreign investors in Chi na, overseas Chi nese capi tal i sts are the
most conspi cuous.
The distribution of sources, as wel l as cross- regional destinati ons, of
FDI i n Chi na cl early support the hypothesi s on l ocal i nformati on and
i nformati on i ntermedi ari es. FDI i n Chi na i s mai nl y from Hong Kong,
followed by investment from Taiwan, especially i n the 1 980s. As shown in
table 4, for accumulated FDI from 1 979 to 1 993, about 68 percent came
from Hong Kong and 8 percent from Taiwan. Even in 1 994, about 60 percent
came from Hong Kong, and 1 0 percent from Taiwan. These figures hol d
despite the fact that the fgures for Hong Kong's investments i n China are
exaggerated for two reasons. Part of Hong Kong's investments in China are
"round trip" investments by mainland investors seeking favorabl e treat
ment for foreign investments. Another i s "stop trip" investments by Western
investors using Hong Kong as an informati on i ntermedi ary.
Table 4 Accumulated Amount of Investment from Major Countries 1 979-1 993
Coc^ly Hag o^} \c15aol /oll^a Co^laclca` /oll^a a-,|o|acl
o|acls Coc^l, s '^vasl1a^l Coc^l|ys ' ^vasl1a^l/1oc^l
To ^JS$5 ` ` o^} Toe` ^JS$! , }
do^g/o^g& Vacao ! ! 4, ! 4 5 5 ! 50929 B0 ! , 320
J S ! 2, 0! ! 9 !442 5 ! ,200
Tawa^ov ^c a 20,9B2 ! 2 0 ! B432 B 3 B0
Ja,a^ , ! B0 4 ! BB95 4 0 ! , 230
0a1a^y 5 0 J 45 0 2, 50
S ^ga,oa 3, ! 22 4 B3 2 2 ! , 550
B|la^ 0 4 3 025 ! 4 4, 9! 0
T^a`a^J ! , 399 0 B 2 095 0 9 ! ,490
/cslaa , 309 0 B ! 24 0 9
Ca^aJa ! , 50 0 9 ! B! 0 B , ! 0
SOURCE: Almanac o(Chi na's Foreign Relations and Trade 1 994, 49.
Western investors ( as wel l as bi g compani es i n Hong Kong) began
si gni fi cant di rect i nvest ment s i n Chi na onl y aft er 1 992 and many of
them i nvest i n Chi na through Hong Kong. I nvestors from Hong Kong
and Taiwan are mostl y Chi nese and most have rel ati ves i n Chi na ( es
peci al l y i n Guangdong and Fuj i anJ . and hence have l ocal i nformati on
82
Governance and Investment in China
i n their hometowns. According to the Australian government 's East Asi a
Analyti cal Unit in Canberra, there are about fifty mi l l i on ethnic Chi nese
resi dents in Southeast Asia, and a maj ority of those are descendants of
southern Chinese. I t i s not surprising, therefore, that FDI i n Guangdong
al one account s for 20 to 30 percent of al l FDI in Chi na.
In hi s study of Hong Kong's production subcontracting activities in the
Pearl River Delta of Guangdong from 1 986 to 1 989, Leung ( 1 993, 284) found
that among forty- seven surveyed agreements, thirteen were through ki n
ship; sixteen were through other Hong Kong frms, who invested earlier in
the delta region and served as information intermediaries; and eight were
through other l arge Chi nese SOEs, who served as intermediaries and to
whom the Chi nese subcontractors were affliated. Of the subcontractors
through kinship, the maj ori ty were i n the hometowns and the rest were
ofen in the contractors' immediate neighboring counties. In general, there
were not many serious disputes between the Hong Kong investors and the
Chinese subcontractors. Only two Hong Kong frms expressed strong dis
satisfacti on. Thus, such informal enforcement based on l ocal information
and i nformation intermediaries seems to be effective.
The geographic di stri buti on of Hong Kong's investment in the del ta
regi on was attributed, accordi ng to Leung ( 1 993) . mainly to the distribu
tion of guanxi, and to a lesser extent to the differences i n l ocation, l abor
cost and quality, and l and avail abi l i ty. In ot her words, factors related to
information and enforcement are pri mary determinants of FDI desti na
ti ons, whi l e the conventi onal factors are secondary.
The investment of Hong Kong-l i sted China Strategic Hol dings ( CSH)
i n Chi na provi des an illuminating case. By the mid- 1 990s CSH had be
come perhaps the second l argest forei gn investor i n Chi na, control l i ng
more than ei ghty compani es and owni ng stakes i n wel l over 1 00 others
( Hsi eh 1 996) . I t s chai rman, Oei Hong Leong, a son of the chairman of
Indonesi a's Si nar Mas, i s a master of l ocal informati on and i nformati on
intermediari es. I n 1 992, he took over forty-one SOEs (including some beer
compani es) i n hi s hometown Quanzhou i n Fuj ian provi nce, and a large
tire SOE i n Shanxi provi nce where he stayed during the Cultural Revol u
tion. In both pl aces, he has good local informati on. Part of his investments
were covered by l oans from Western banks, and the l oans were guaranteed
by his father's Sinar Mas. His father served as an information intermediary
between hi m and the Western banks. In 1 993, Oei l i sted the Shanxi tire
company ( reorganized with some other tire compani es in China) i n the
New York Stock Exchange and Goodyear acquired 24 percent of the shares.
In 1 995, Oei sold 75 percent of the shares of some of his beer companies
83
Governance and Investment in China
to the second largest beer company in Japan. Note that Oei served as an
information intermediary between the Chinese companies and other for
eign companies. A similar case is that of Robert Kuok, a Chinese Malaysian
tycoon, selected as Coca-Cola's exclusive partner i n China because of his
extensive network i n Southeast Asia and China, as well as his extraordi
nary ability to use information intermediaries. 1 6
Cross- Regional Competition for FDI
The distribution of j urisdictional destinations of FOI across different
levels of government is consistent with our hypothesis of cross- regional
competi ti on for FOI , whi ch has mainly gone to the j uri sdi cti ons of re
gi onal and l ocal governments. Among 2998 fi rm- speci fi c operations of
multinational corporations in China, from 1 979 to 1 993 ( Tse, Pan, and Au,
1 996, table 2) , about 30 percent of all operations worked with provincial
governments, about 50 percent with municipal / county governments, and
the remaining 20 percent with the central government. To get around gradu
ated control , a local government often divides a big proj ect into several
smal l proj ects for approval within its own sphere of authority.
To compete for FDI , governments at the provi ncial level and, more
i mportant, at the muni ci pal i ty/ county level , desi gned institutions to re
duce uncertainties and costs of transactions. For instance, to compete with
neighboring counties, Nanhai, Shunde, and Zhongshan i n the Pearl River
Delta of Guangdong, Dongguan county set up an "FOI Service Company"
in 1 984 to serve as a coordinated and organized FDI contract approver as
well as an enforcer. Before this company was set up, a foreign investor
needed to go to more than ten government agencies, such as the Bureau
of Administration for Industry and Commerce, the Commission of Foreign
Trade and Economic Cooperation, and the land bureau and environmental
agency, to have a proj ect approved. Now he only needs to go to the service
company to get all the approvals within a few hours. The service company
also serves as a mediator for contract disputes involving foreign interests.
Such regional development is a result of the restructured capacity and
incentives of local governments in the reform era, which has been part of
the market- preserving authoritarian regime in China since 1 978.
Market - Preserving Authoritarianism
The infow of FOI i nto Chi na started in 1 979 and accel erated after
1 992, mirroring the changing political - economic institutions i n China. l 7 In
this secti on, we apply the MPA framework previously devel oped to ana
lyze China's credible commitment to preserve the market for catching-up
84

Governance and Investment in China
under authoritarianism during the 1 978-1 998 peri od. Correspondi ng to
Ml , M2, and M3 specifed under a market- preserving authoritarianism, We
shall discuss incentive compatibility (competition) , autonomy ( decentral i
zation) , and control ( coordination) , i n turn.
Competitive pressures and experiences (Ml)
After initiating economic reform i n 1 978, Deng Xiaoping and his col
leagues shaped the regi me as market - preserving authoritari ani sm. They
imitated the market-preserving authoritarianism of other East Asian coun
tries such as Taiwan, Singapore, and South Korea from the early 1 960s to
the late 1 980s. Both competitive pressures and experiences led Deng and
other senior leaders to preserve the market in order to facitate catching-up.
In the late 1 970s, China faced a strong military threat from the Soviet Union
as well as economic competition from Japan and the four little dragons.
Economic catching-up was thus vital to the nation and the regi me. Inter
nally, the Deng faction had to compete with the Hua Guofeng faction, which
represented the legacy of Mao. To defeat the Hua clique, Deng had to come
up with more effci ent pol i ci es to mobilize mass support.
At that t i me, the central i zed economi c pl anni ng system had been
practi ced i n Chi na for three decades already and had l ed t o di sastrous
economi c consequences. By this time, market mechanisms adopted i n
neighbori ng economi es, such as Japan and the four l i ttl e dragons, had
brought double- digit annual growth for decades. I S In particular, the sharp
contrast i n performances between mainland China and Taiwan, between
North Korea and South Korea, and between East Germany and West
Germany, confirmed the superi ori ty of the market mechani sm over the
planning system.
Like in other East Asi an countri es, China's strong landlord cl ass had
been wiped out after land reform i n the late 1 940s and the early 1 950s.
Labor unions were restricted, and the military was controlled tightly by the
party and the seni or l eaders. As a result, at the outset of reform, seni or
leaders did not foresee an imminent (internal) threat from a strong interest
group; and by designing proper control devi ces and adopti ng a shared
growth pol icy, they could avoid threats from an emerging strong interest
group i n the process of devel opment. I n addi ti on, seni or l eaders used
various tactics to balance different interests. For instance, Mao analyzed
the balancing of the so- called Ten Great Relationships, such as devel op
ment between agriculture and industry and devel opment between coastal
regions and i nl and regi ons. At the same ti me, devel opment coul d hel p
upgrade mi l i tary technol ogy and better fi nance the armed forces, thus
85
r
I '
I
Governance and Investment in China
minimizing external military threats, which were increasingly replaced by
international economi c competition after the end of the Cold War. Mi ni
mi zed external military threats or increased international economi c com
peti tiveness resul ti ng from devel opmental pol i ci es, i n turn, can further
strengthen the position of an authoritarian regime. 1 9 In short, for Deng and
other senior leaders in his faction, it seems that the perceived risk of regime
col l apse resulting from market devel opment and catchi ng-up was suffi
ciently low. On the other hand, they expected the market-based catching
up to strengthen their posi ti ons.
Decentralization ofauthorit and autonomy (M2)
Given that senior l eaders are motivated to adopt market-based catch
ing-up policies, they need to make their poli cies credible in order to achieve
their goas. As discussed previously, for this purpose the senior leaders have
to restrain themselves with both interational and domestic constraints. The
former include the signing of international treaties and the opening up of
markets. For the latter, senior l eaders need to i mpose sel f- constraints by
al l ocati ng suffi ci ent aut onomy to a l arge set of pol i ti cal and economi c
deci si on makers i n an institutionalized way, so that i t i s infeasible or too
costly to reverse. Si nce 1 978 Deng and his col l eagues have gradually but
systematically opened China's door to the rest of the world, and they have
allocated and granted signi ficant autonomy (including authority, informa
tion, and resources) to househol ds, frms, l ocal governments, and mi ni s
terial bureaucrats, whi l e reducing or restricting their own authority.
International constraints. I n 1 978 Deng and his col leagues adopted
an open-door policy. Thereafter China signed dozens of multilateral inter
national treaties and many bilateral agreements. In particular, as indicated,
by the end of 1 994 Chi na had si gned treati es on ( mutual ) protecti on of
foreign investment with sixty-seven countries. At the same time, China has
opened up markets i n an i ncreasi ng number of regi ons and industries .
Si nce 1 993 China has ranked second only to the US in attracting foreign
di rect investment. More recently, in order to meet the requi rements of
j oini ng the World Trade Organizati on, wi der openi ng- up i s under way.
Increasing economic feedom of households and individuals. Fi rst .
t he househol d responsi bi l i ty system was wi del y adopt ed i n t he early
1 980s. Although l and conti nues to be col l ectively owned ( usuall y at the
vil l age level ) , rural househol ds have gai ned al most compl ete l and- use
rights by leasing contracts. Land l eases have been extended from short
term ( e. g. , three to fi ve years) to l ong term ( e. g. , ten to thi rty years) by
nati onal regulati ons. Second, afer the early 1 980s l ocal resi dents began
86
Governance and Investment in China
to directly el ect del egates to the peopl e's congresses at bot h t he town
shi p and county l evel s. Peopl e's congresses have become i ncreasi ngl y
infuential . Beginning in 1 987-1 988, the heads of vil l age commi ttees were
di rectly el ected. The di rect el ecti on of townshi p heads was pl anned i n
the Fi fteenth Party Congress hel d i n 1 997. Thi rd, and more general l y,
i ndi vi dual economi c and ci vi l freedoms have been s i gni fi cant l y ex
panded. I ndivi dual s i n both r ural and ur ban ar eas are i ncr eas i ngl y
allowed to trade, invest, and migrate freel y, and more i mportant , to set
up private enterpri ses . Private busi ness enterpri ses have spread rapi dl y
from craft s, food processi ng, and retai l i ng t o textil es, el ectroni cs , and
raw materi al s , especi al l y after the early 1 990s.
I n 1 993, t he State Administrati on of I ndustry and Commerce i ssued
" Some Poi nts on Enhanci ng the Devel opment of I ndivi dual and Private
Business. " It specifes the following measures to stimulate private business:
l . Resigned and retired party and government officials can conduct
private busi ness;
2. Unl ess speci fied otherwise i n state l aws and regulations, privat e
busi nesses can operate i n any sect or and i n any form;
3. Pri vate ent erpri ses can t ake over st at e- owned and col l ect i ve
enterpri ses.
Thes e measures have great l y enl arged t he aut onomy of pri vat e
enterpri ses and have sped up the devel opment of private busi nesses .
Increasing autonomy of state-owned enterprises. The aut onomy of
(urban) SOEs was expanded in t hree st eps. Fi rst , i n the l ate 1 970s a nd
the early 1 980s, SOEs began t o have some limited operati onal autonomy
and to have t he right to retain some of t he profi ts. Second, from t he mi d-
1 980s to the early 1 990s, more autonomy was i nsti tuti onal i zed i n t he
management contract responsi bi l i ty system ( MCRS) . Under t he MCRS,
i ndustri al bureaucrats and managers si gn contracts speci fyi ng perfor
mance targets , control ri ght s , and compensat i on schemes. The MCRS
became wi despread after 1 987, and by 1 989 most SOEs had adopted the
MCRS. Third, si nce the early 1 990s an increasing number of SOEs as wel l
as TVEs have bec ome share - hol di ng c ompani es or h ave be e n ful l y
privati zed. I n 1 9 78, al most 8 0 percent of t he t ot al nat i onal i ndust ri al
out pu t was deri ved from SOEs. By 1 99 5 , the SOEs' share of t he t ot al
i ndust rial out put had shrunk to onl y one- thi rd ( Chill a Slatistica1 Yenr
book 1 996, 403) . A recent survey esti mates that more than 70 percent of
the small SOEs i n Shandong and several other provi nces have been flly
or partially privati zed ( Chi na Refor m Foundat i on 1 997) .
87
Governance and Investment in China
The mi rror i mage of the expandi ng autonomy of SOEs and other
enterprises and privatization has been the shrinking authority of economic
and industrial bureaus. According to a survey conducted i n 1 995, about
50-60 percent of the surveyed bureaus reported that their authority had
decreased over the previ ous year, and 30-40 percent reported that their
authority remai ned unchanged. 20 I n 1 998 the Fi rst Sessi on of the Ninth
Nati onal Peopl e's Congress adopted a bl uepri nt t o restructure the State
Council drastically withi n three years: some forty ministries and commis
sions have been reduced to twenty-nine; most industry- specific ministries
have been abolished; the number of staff members has been cut by about
hal f. Local governments will be si mi l arly streaml i ned, resul ti ng i n the
significant reduction i n the government's economi c authority.
Autonomy of intermediar business organizations. The autonomy of
enterprises has been strengthened by the forming of various intermediary
business organizations. Enterprises are allowed or encouraged to organize
vari ous enterpri se groups and busi ness associ ati ons. Enterpri se groups
frst began to emerge when the then- State Planning Commission and the
State Economi c Commi ssi on i ssued " Several Poi nts on Establishing and
Developing Enterprise Groups" i n 1 987. 2 1 I n 1 995 the government issued
" Provsional Regulations on the Establishment and Management of Enter
pri se Groups" that set forth the pri nci pl e of vol untary parti ci pati on of
i ndividual enterprises i n enterprise groups. The resultant Chinese enter
prise groups are likely to resembl e the Japanese keiretsu or the Korean
chaebol ( congl omerates) i n the coming decades.
Increasing autonomy of local governments. The autonomy of l ocal
governments has i ncreased through the fiscal revenue- shari ng system,
the 1 982 Consti tuti on, and vari ous other decentral i zati on pol i ci es. The
fi scal revenue- shari ng system was first introduced i n 1 980, renewed in
1 984 and 1 988 with some modi fi cati ons, and conti nued through 1 993 .
Under thi s syst em, l ower- l evel governments had an obl i gati on to sub
mi t a fixed amount or a fixed proporti on of t hei r fiscal revenues to the
government l evel just above them and they were allowed to retain the
remai nder for t hemsel ves . Thus, l ocal government s had the right of
resi dual cl ai ms. The 1 982 Consti tuti on granted provincial - level govern
ments the authority to make broad regi onal economi c regulati ons. The
central government has al so granted control ri ghts over a great number
of state- owned ent erpri ses to l ocal government s. By the end of 1 983 ,
control rights over the maj ority of state- owned enterpri ses were trans
ferred to l ocal governments. By 1 985, state- owned i ndustrial enterprises
control l ed by the central government accounted for only 20 percent of
88

Governance and I nvestment in China
total i ndustrial output of all enterpri ses at or above the townshi p l evel
( Qi an and Wei ngast 1 995) . By 1 994, it was esti mated that l ocal gover n
ments at vari ous levels control l ed about 65 percent of the assets of al l
state- owned ent erpri ses ( Chi na Reform Foundat i on 1 997) .
The decentralizati on policy has granted l ocal governments great au
tonomy to control their economies, including autonomy to establish new
firms, to make investment with "sel f- rai sed funds, " and to manage and
restructure their firms. Consequently, decentralizati on forced local govern
ments to compete \ith one another and helped to marketize t he national
economy. Although local governments may still use some planning mecha
nisms to control their enterprises, they can do business with other regions
only through bargaining, since no one region has authority over the oth
ers. The relationship between provinces, cities, counties, townships, and
villages i s more or less market - ori ented ( for more details on this aspect
of decentralization, see Li , Li , and Zhang 1 998) .
At the early stage of decentral i zati on, many l ocal governments at
tempted to protect thei r enterprises from competition from other regions
by erecting trade barri ers . However, as the si ze of each l ocal economy
becomes smal l er and the number of l ocal economi es increases at lower
government l evel s, the erection of trade barriers by a l ocal government
becomes more cost ly, and hence competi t i on becomes more i nt ense.
Protectioni sm often failed because efficiency gains from exchange si gni fi
cantly exceeded the net benefts of erecting trade barriers, as both informal
and formal arrangements emerged to capture the gains. In the late 1 980s,
l ocal governments began to formulate treaties pl edging to protect each
other's enterprises as their own. For instance, it i s reported that Shanghai
signed agreements for "the protection of the legitimate rights and interests
of enterpri ses" with nine provinces. 22 In 1 99 1 , sixty- four courts from ei ght
prefectures and municipaliti es along the Yangtze River i n Hunan and Hubei
provi nces si gned agreements for the j udi ciary cooperati on of the settl e
ment of cross- regi onal economic disputes. The two hi ghest courts of the
provinces i ni ti ated these agreements to mi tigate l ocal protecti oni sm i n
lower-level courtS. Ll In 1 993, t he central government enacted the " Law of
Anti - i mproper Competiti on, " i n which article 7 prohibi ts local governments
from using administrative means to erect trade barri ers.
Increasing autonomy of technocrats. The autonomy of technocrats
has also expanded signi fi cantly. Bureaucratic el i te transformati on, ai med
at repl aci ng the ol d and l ess educated wi th young professi onal s , hegan
i n t he earl y 1 980s, and was l argely compl eted i n t he early 1 990s by vari ous
forms of mandatory reti rement programs. " " After 1 984, personnel control
89
Governance and Investment in China
was decentralized as the " two- level down management" was replaced by
the " one- l evel down management " at each l evel of government . For
i nstance. t he Central Party Personnel Agency. formerly t he Central Or
ganizati on Department. now directly controls only t he ministers and vi ce
mi ni sters of the central government and governors and vi ce governors
of the provincial governments. I n 1 987. the Thirteenth Congress of the
Chi nese Communi st Party deci ded to set up a civil servi ce system. In
1 993. after experiments i n six bureaus of the State Council. i n Harbin and
i n Shenzhen ( Deng 1 994. 3 ) . a formal civil servi ce system emphasi zi ng
a merit- based sel ecti on ( such as entrance exams) and promoti on system
was i mpl emented. Thus. i n the reform era the bureaucracy has become
i ncreasi ngly stabl e and i ndependent ( as di scussed bel ow) .
Such widely diffused autonomy makes it very costly or infeasible for
seni or l eaders to retrieve the decentralized authori ty from the hands of
such a vast number of households. frms. l ocal governments. and bureau
crats. The public can use the information and resources available to it to
defend and to conceal its vested authority and interests in case of a policy
reversal . The decentralizati on of authority has been further strengthened
by sel f- imposed constrai nts on the seni or l eaders themselves. To make
their market-based developmental policies more credible. Deng and hi s col
leagues desi gned the Central Advi sory Commi ssi on i n 1 982 to restrict the
authority of the powerful first - generation seni or l eaders. including them
selves. Infuential party and military veterans were called to resi gn from
their active posts to become members of the advi sory commission. which
had only symbol i c authori ty. The commi ssi on was abol i shed i n 1 992.
Control devices (M3)
Authority decentralization and autonomy are necessary but not sufi
ci ent for market-based catching- up under authoritarianism. As indicated
i n M3. autonomy needs to be balanced by controf. 2" The key mechanisms
of control include incentive schemes. checking. coordination and enforce
ment devices in governmental agencies. intermediary agencies. and private
agencies. Institutional devices. such as checking and coordination devices.
can be designed along vertical . horizontal. or intertemporal dimensi ons.
Incentive schemes. Performance-based incentive schemes have gradu
ally developed within both the part and the bureaucracy si nce 1 978. They
were parti ally instituti onalized in the "cadre contract responsi bi l i ty sys
tem" i nt roduced in t he mi d- 1 980s. Under t hi s syst em. a hi gher- l evel
government designs and supervises performance- based contracts wi th i ts
i mmedi at e subordi nat e government s. Typi cal ly. such economi c perfor-
90

Governance and Investment in China
mance goal s as output and profi ts are among the key determi nant s of
payments and promoti on. Performance- based i ncentive schemes Wi t hi n
the bureaucracy became more i nsti tuti onal i zed after 1 987 when a c i vi l
service system was advocated. and especially after 1 993 when a civi l sys
t em was formal l y i nt roduced . In t he ci vi l servi ce syst em are gui di n g
principles on rewards and punishment. and on the distribution of rewards
along vertical ( hi erarchy) . horizontal ( cross- functi on) . and intertemporal
( cross- time) dimensions based primarily on ( fifteen) ranks. The distribu
ti on of rewards based on rank i n the civil service system i s taken as a
reference for party and militar officials as well as other staff members in
public agenci es.
Speci fically. the i ncentives for party and government ofci al s have
been structured al ong the fol l owi ng l i nes. Fi rst . overall compensat i on
for officials includes both pecuniary and nonpecuniary rewards obtained
during and after offi ce hours. The rewards include personal income. on
the- j ob consumpt i on. benefits from soci al status and from power ( con
t rol rights) . benefts for their family members. relatives. and friends. and
fture benefits for the officials themselves. When an ofci al l eaves offi ce.
he may be promoted to an upper- level government posi ti on. or he may
become a manager i n an enterprise that was previ ously under his con
t rol . Ei t her way. returns after l eaving offi ce may depend on one's pri or
performance i n offi ce. Second. the fi scal revenue- shari ng syst em pro
vi ded i ncentives for an upper- level of government to adopt performance
based compensat i on schemes for offi ci al s of l ower- l evel government s
under i ts j uri sdi ct i on. Under t he fi scal revenue- shari ng system. a l ocal
government takes the "resi dual " after submi tti ng t he speci fi ed tax rev
enues to the upper- l evel government . Given that tax revenue i s pos i
tively correl ated t o t ot al out put . a l ocal government i s provided wi t h
i ncentives to l i nk the promot i on of l ower- l evel government offi ci al s t o
their economi c performance.
Checking devices. Bot h t he cadre contract responsibil ity system and
t he civil serice system have buil t-in ex ante and interim checki ng devi ces.
Ex ante checking devi ces refer to predesi gned measures to reduce o el i mi
nate opportunities for corruption and mi sconduct. Interim checking devices
refer to monitoring measures in the process. Ex ante and i nteri m checki ng
devices i ncl ude ( 1 ) vertical checking devi ces. such as hierarchical revi ew,
monitori ng. graduated contrl . and regular reporting to higher authori ties;
( 2) intertemporal checking devices. such as term l i mitati ons. rotat i ons, and
the exchanging of posi ti ons amongst pol i ti ci ans and bureaucrat s; (3) hori
zontal checki ng devi ces. such as col l ective deci si on- maki ng mechani sms
9 1
Governance and Investment in China
and deliberation councils (to be discussed i n further detail below) ; and (4)
other checki ng devi ces. such as the "challenge system" ( huibi zhidll) .
Ex post checki ng devi ces are also desi gned to check corrupti on and
mi sconduct after they occur. Such devi ces i ncl ude the Central Party Di s
ci pl i ne Commi ssi on for the party. and the Mi ni stry of Supervision ( estab
l i shed i n 1 949, abol i shed i n 1 959, and restored i n 1 987) , and the Depart
ment of Anti - Embezzl ement and Bri bery ( set up under the Mi ni stry of
Procurators i n 1 995) for the bureaucracy. '" Moreover, there are bureaus
correspondi ng to these organi zati ons at vari ous l ocal government level s.
Such devi ces at the subnati onal l evel s become more effective as cross
regi onal competition i ntensi fi es. Facing economic competition from neigh
bori ng regi ons, each l ocal government i s "forced" to i mprove i ts i nsti tu
ti onal arrangements. i ncl udi ng checki ng devices, to attract investment.
Coordination devices. We now examine the coordination devices within
the party and the bureaucracy. Pol i ti ci ans in China are organized under
t he Chi nese Communi st Party commi ttees at vari ous l evel s. The party
commi ttee at each level di rectly controls the top personnel of the party
committees i mmedi ately below i t. At the national level, the representative
party organization i s the Central Committee, and the main working orga
nization is the Political Bureau. The core organizati on nested in the Political
Bureau is the Political Bureau Standing Committee ( PBSC) , which coordi
nates the seni or leaders. The PBSC serves as a " board of di rectors" of the
Chi nese Communi st Party-a "nesti ng structure" that functions as a verti
cal coordi nati on devi ce.
Starting i n the Deng era. the seven members of the PBSC are supposed
t o represent di fferent maj or i nt erest groups or organi zations, thus func
ti oni ng as a hori zontal coordi nat i on device. The PBSC typi cally consists of
the paramount leader, and two ol d. two medi um- aged, and two relativel y
young seni or l eaders. Each term of the PBSC i s fi ve years and, i n each
successi ve t erm. t he two ol dest members general l y wi l l resi gn and be
r epl aced by t he younger one s . Thi s arrangement funct i ons as an
intertemporal coordi nation devi ce to facilitate smooth transi tion. A similar
"graduated- age- structure" i s also bui lt i nto the ci vil service system to fa
ci l i tate smooth personnel transi ti ons i n the bureaucracy ( Deng 1 994, 5) .
Bureaucrati c agenci es are generally organi zed around a pi l ot agency.
Thi s arrangement funct i ons as a vert i cal coor di nat i on devi ce i n t he
bureaucracy. At t he nat i onal l evel . l i ke i t s count erpart s i n Japan ( t he
Mi ni s t ry of I nt ernat i onal Trade and I ndus try ( MI T! ) ) and Korea ( t he
Economi c Pl anni ng Board) . t he State Pl anni ng Commi ssi on ( SPC) func
ti oned as a pi l ot agency before 1 993. and t he State Economi c and Trade
92
+
Governance and Investment in China
Commi ssi on ( SETC) became a pi l ot agency aft er i t s est abl i shment in
1 993, and es peci al l y aft er i t s cons ol i dat i on i n 1 998 under t he maj or
restructuri ng of t he State Counci l . As most i ndustry- speci fi c mi ni stri es
wi l l cease t o exi st , t hei r regul at ory funct i ons will be transferred to the
newly est abl i shed i ndustri al bureaus wi t hi n t he SETC.
Within t he SPC, t he SETe, and other agenci es, important deci si ons are
general l y deci ded col l ecti vel y and i mpl ement ed by i ndi vi dual sY Thi s
mechanism i s known as "collective leadership and individual responsi bility"
or "democratc centralism. " Cross-ministeria j oint decisions are generally made
i n some form of del i beration counci ls. Like the del i beration counci l s i ni
tiated by MITI i n Japan and the export - promotion meetings i n Korea, there
are "joint meetings" ( lianxi huiyi) , "j oint approval meetings" ( huiqian hll iyi) ,
and " State Counci l ofi ci al meeti ngs" (glowuyuan bangolg huiyi) at the
national level, and "on-site ofcial meetings" (xianchang bangong hliyi) at
various local level s i n Chi na. One te of j oint meeti ng is the "state- owned
enterpri se reform j oint meeti ng. " On the average, once per quarter, the
SETC, the SPC, and other agenci es, such as the State Commission for Re
structuring Economi c System (also to be restructured) , the Mi ni stry of Fi
nance, and the Peopl e's Bank of Chi na, j oi ntly di scuss matters regarding
SOE reform. These are exampl es of horizontal coordi nati on devi ces.
The i ntertemporal coordi nati on devi ces i ncl ude t he smoot h and par
tial repl acement of bureaucrats, and t he l ong- term meri t - and- seni ority
based promotion schemes i n the civil service system. The bureaucracy in
China is remarkably stabl e. As shown i n tabl e 5 and 6, the average tenure
of premiers has been more than ten years. Tables 7 and 8 show that when
Li Peng succeeded Zhao Ziyang as premier in 1 988, only about half of the
ministers were replaced, and the vice ministers and bureau heads remained
largely unchanged.
Tabl e 5 The Tenure of Premiers in the State Council of China
Premi er
Zhou Enl ai
Hua Guofeng (Acti ng Premi er)
Hua Guofeng
Zhao Zi yang
Li Peng (Acti ng Premi er)
Li Peng
Zhu Rongji
Tenur
Oct 1 949 - Jan 1 976
Jan 1 976 - Apr 1 976
Apr 1 976 - Sep 1 980
Sep 1 980 - Nov 1 987
Nov 1 987 - Apr 1 988
Apr 1 988 - Mar 1 998
Mar 1 998 -
SOURCE Mal col m Lamb. Direcrory o/Oficia/s (l 1 d Org(l l i:ariolls ill Chilla ( New York: M. F.
Sharpe. 1 994) . 1 67.
93
r
Table 6 Average Ti me in Ofice
Period Duration
Premi er 99 995 4
Secretary General a 9495 995 42
Forei gn Affai rs 99 995 4
State Pl anni ng Commi ssi on 95295 4
State Economi c & Trade Commi ssi on 99395 2
State Commi ssi on for Restructuri ng Economy 95295 3
State Educati on Commi ssi onb 949J 595 4
State Sci ence &
Technol ogy Commi ssi onc 955c, 95 2
Nati onal Defensed 954 595 3
Nati onal Defense Sci ence,
Technol ogy & I ndustry Commi ssi on 95295 3
State Nati onal i ti es Affai rs Commi ssi one 949J 595 3
Publ i c Securi tyf 9493, 595 4
State Secu rity 95395 2
Supervi si on9 94959, 595 5
Ci vi l Afai rs 9595
Justi ceh 94959 993 24
Fi nance' 94954,J95 3
I nternal T rade 99395 2
Forei gn Trade & Economi c Cooperati on 95295 3
Personnel ' 95J54, 5595
Labor* 94954, 5595 2
Geol ogy & Mi neral Resources 95295 3
Construction 95595
Power I ndustryl 9952, 9395 5
Coal l ndustryk 955J 555, 9395 3
Rai l waysl 949J, 595 4
Communi catl onsm 949c5, J95 4
Machi ne- Bui l di ng I ndustry Commi ssi ont 95255, 9395 5
El ectroni cs I ndustryt 95255, 9395 5
Metal l urgi cal l ndustryn 95ccc, J95 3
Chemi cal l ndustryO 95cc2, cc9 595 25
Posts & Communi cali onsP 949J, 395 4
Water Resourcesq 94955, 952 5595 9
Agri cul turer 9495c, 952 5595
ForestryS 94959 9cJ 995 2
Cul ture! 949J 595 4
Radi o, Ci nema & Tel evi si on 95295 3
Publ i c Heal thU 949c 355 3
State Fami l y Pl anni ng Commi sSi on 95 -95 4
State Physi cal Cul t ure & Sports Commi ssi onv 952 95 25
94
No. of
ofcials
4
9

4
2
3
5
2
4
9
2
4
3
c
9
2
4
3
4
3
2
3
5
J
J
3
4

c
4

5
5
3

4
c
Average
ti me i n ofce
5
4 c
c 5
c 4
2
3 25
3 42
9
4 c3
c 5
9 5
4 59
c
4 5
5 c
4
3 33

3 25
3 c
3
4 33
3 5
c
3 5
4
4
2 c
2
5
3 5

4 5
2 53
3 c3
5 3
4 33
4 29
3 5
4
Continued
Table 1 continued
ao,` a sBa^\olC^ ^a
/cJlo-0a^aa` sDeparment
949c4, 395
95395
3
2
J
3
3
4
SOURCES OF R [LI: Director) of Oficials all d Orgal l izations in China, 1 994, An Last (;(1 /(
Book. The GOllemment Ltaders ofPR. China, 1 995, Canada Mirror Books.
Nrm,s:
, Abolished i n 1 954; amalgamated with the newly establ ished Mi ni stry of Labor and Personnel
i n May 1 982 to Apr. 1 988 and restored i n Apr. 1 988.
t Amal gamated wi th the newl y establ i shed Mi ni stry of Machi ne Bui l di ng and El ectroni cs
Industry duri ng Apr. 1 988 to Mar. 1 993 and restored i n Mar. 1 993.
a. Abol i shed i n 1 975 and restored i n 1 978.
b. Abol i shed i n June 1 970 and restored i n Jan. 1 975.
c. Establ i shed i n 1 958 and suspended duri ng the Cul tural Revol uti on; resumed operations i n
Sept. 1 977.
d. No offci al s were i denti fied duri ng Sept. 1 9 7 1 to Jan. 1 975.
e. Abol i shed i n June 1 970 and restored i n Mar. 1 978.
f. No ofci al s were i denti fi ed duri ng Aug. 1 973 to Jan. 1 975.
g. Abol i shed i n 1 959 and restored i n Dec. 1 986.
h. Abol i shed i n 1 959 and restored i n 1 979.
i . No ofi ci al s i denti fed duri ng J une 1 954 to June 1 970.
j . Amal gamated wi th the Mi ni stry of Water Conservancy i n Mar. 1 982-Mar. 1 993 and then
restored.
k. Amalgamated wi th the Mi ni stry of Fuel and Chemicals Industries duri ng Nov. 1 970 to Jan.
1 975 and then restored; became part of the newl y established Mi nistry of Energy Resources from Apr.
1 988 to Mar. 1 993 and then restored.
I. Absorbed by the newly establ i shed Mi ni stry of Communi cati ons i n Nov. 1 970. Restored in
Jan. 1 975.
m. No offci al s were i denti fi ed duri ng 1 966 to 1 969. The mi ni stry absorbed the Mi ni stry of
Rai lways i n Nov. 1 970.
n. No offci al s were i denti fied duri ng 1 967 to 1 969.
o. No offci al s were i denti fied i n 1 963-1 966. Amalgamated wi th the Mi ni stry of Fuel and
Chemicals Industri es i n Nov. 1 970. Restored i n Mar. 1 978 as a resul t of the divi sion of the Mi ni stry of
Petroleum and Chemi cal s Industry.
p. Amalgamated with the Mi ni stry of Rai lways and Mi ni stry of Communi cati ons in 1 970.
Restored i n May 1 973 after the abol i ti on of the di rectorates of Post s and Tel ecommuni cati ons.
q. Amalgamated with the Ministry of Power and formed the Mi ni stry ofWater Conservancy and
Power during Feb. 1 958 to 1 979 and Mar. 1 982 to Apr. 1 988; restored i n Apr. 1 988 si nce the abol i ti on
of the Mi ni stry of Water Conservancy and Power.
r. No offi ci al s were i denti fi ed i n 1 957-1 978 under the name of the Mi ni stry of Agri cul ture.
Absorbed by the Mi ni stry of Agricul ture and Forestry in Nov. 1 970. Restored i n Feb. 1 979 wi th the
di vi sion of the Mi nistry of Agri cul ture and Forestry, renamed and given expanded rol es i n May 1 982.
Between then and Apr. 1 988, the organization was styled Mi ni st r1 of Agri culture, Ani mal Husbandry
and Fi sheri es.
s. No ofcial s were identifed in 1 960-1 966 under the name of the :ni strv ofForestr; absorbed
by Mi ni stry of Agri cul ture and Forestry in Nov. 1 970 and restored i n Feb. 1 979.
.
t. Abolished in 1 970 and restored in Jan. 1 975 after the abolition of the Culture Group under the
State Counci l .
u. No offi ci al s were i denti fed i n 1 967-1 971.
v. No ofci al s were i dentifi ed in 1 9531 970. Recommenced operati ons fol l owi ng the Cul tural
Revol uti on i n June 1 970.
w. No offi ci al s were i denti fi ed i n 1 965-Ma1 1 973.
95
Table 7 Change of Vice Premiers, State Councilors, and Ministers in 1 988
J^Ja
a1 a/^ao 9B}
J^Ja
a1 a. 9BB}
mool,av ocsoNc a` s ^
9BBas/ol l ^alola`^o
ol o1 c a` s ^ 9B
Tola`^ooloca` s Tola`^oolo1ca`s mool,av ocso c a` s
v caa1 as 5 3 2 4
SlalaCoc^c `os 9 2 B B
V ^slas 4 42 24 52
Toe` 6 5 2 45
SOURCE OF RAW DATA: People1 Republic of China Year/wok 1 987. 1 .88 ( Hongkong: Evergreen
Publ i shi ng) .
Table 8 Change of Vice Ministers and Heads of Bureaus in 1 988
V ^ sly/Co11 ss o^ mo olv ca1 ^ slas mo ol^aaJsol5caacs
J^Ja J^Ja mool J^Ja J^Ja mo ol
1a 1a ,avocs a1a 1a ,avocs
Zo . oca`s Zo L oca`s
movB} 0ac BB} ^ 9BB mov B} 0acBB} ^ 9BB
as/ol as/ol
T T mo ol l^aloe`^o T T mo ol l^alola`^o
^o ol ^o ol ,avocs oca`s ^ool ^o ol ,avocs ooa`s
oca`s oca`s oca`s ^ 9B oca`s ooa`s oca`s ^ 9B
Slala` a^^ ^gCo11 ss o^' 2 0 0 435 5 4 2 423
V ^ slyol ^a^ca 5 5 3 0 B J
ao,` a sBa^\olC^ ^a 4 5 4 J 3 3 3 9
V ^slqoloag^TaJa
& cco^o1 cCoo,aalo^ B 5 9 5 BB2
V ^ slyolCo11ace 5 5 3 0 3 4 3 J
SlalaHa^sldo^oll^a
cco^o1yCo11 ss o^ 3 2 0 0 3 2 3 J
V ^ slyolJcslca 3 2 2 J
Ca^la`Baaaaol
` ^Jasly& Co11aca 5 5 5 J 4 4 J
SOl i Ke O RAI D.I.\: Mal col m Lamb. Directory ot(fticia/s a lid Or{(Iiariol l S il l Chilla Ue,
York: M. E. Sharpe. 1 994) .
' I n Apri l 1 988 t he State Economi c Commissi on was abol i shed and much of i ts work was t aken
over by the State Pl anni ng Commi ssi on and provi nci al authori ti es. To make a consi stent compari son,
figures i n November 1 987 i ncl ude offi ci al s of t he St at e Economi c Commi ssi on.
96
Governance and I nvestment in China
Note t hat bes i des servi ng as hori zont al coordi nat i on devi ces , t he
col l ective deci si on- maki ng mechani sms and del i berati on coulci l s al so
functi on as horizont al checki ng devi ces. When deci si ons are col l ect i vel y
made, t he deci si on makers can check on each ot her, and i t becomes
harder to col l ude i n corrupti on when there are more parti ci pants . Col
l ective deci si on making has been adopt ed to curb corrupti on at vari ous
l evels of the party and the bureaucracy i n Chi na. For i nstance, in order
to curb corrupt i on i n maki ng appoi nt ment s , the Central Organi zat i on
Department i n 1 986 speci fi ed a quorum rul e that requires two- thi rds of
the members of the mi ni sterial party group to be present when screen
i ng a nomi nee for a bureau- l evel posi t i on.
The Asian Financial Crisis and I t s Implications for China
Although FDI infow into China has been among the hi ghest i n the
world i n the l ast few years, the stock of FDl i n Chi na i s still small relative
to its economi c si ze. As privati zati on speeds up, more markets become
open, and t he l egal syst em i mproves , there wi l l be more opportuni ti es
and a bet t er envi ronment for forei gn fi rms to i nvest i n Chi na. Thus, a
signifi cant i nfow of FDI into Chi na may conti nue in the comi ng decade.
I n fact, as the regulatory and l egal system improved, FDI agreements i n
Chi na have been evol vi ng from s hor t t erm t o l ong t er m, from smal l
scal e t o l arge scal e, from standard t o s peci fi c, from j oi nt ventures t o
wholly foreign owned, and from coastal to i nl and regi ons i n the l ast two
decades. Yet in Chi na at present , given t he wi despread corrupt i on and
i neffecti ve l egal pr ot ect i on of pr operty ri ght s , es peci al l y i nt el l ect ual
property ri ght s , forei gn i nvest ors are somewhat rel uctant t o i nvest i n
contract- and technol ogy- i ntensive sectors. The ongoi ng privatizati on of
SOEs and TVEs , al ong wi t h t he i mprovi ng l egal syst em, wi l l r educe
corrupti on si gni fi cantly. I t is i mportant to bui l d an effective l egal system
to faci l i tate contract enforcement i n dynamic sectors, such as hi gh- tech
i ndustry, in t he l ong run. A necessary condi t i on for establ i shi ng an ef
fect ive l egal sys t em i s to mi ni mi ze corrupt i on. I n a corrupt count ry,
pol i tical openi ng- up to opposi ti on parti es and economi c openi ng- up to
the world market are eventual l y necessary to mi ni mize corrupti on i n the
l ong run.
More generally, a s noted i n Li ( 1 999) . economi c devel opment i s fun
dament al l y a process of establ i s hi ng i nformal gover nance mechani s ms
and t hen maki ng t he transi t i on t o formal governance structures. Thi s i s
consi stent wi th hi stori cal facts , whi ch had l ong been negl ected by econo
mi st s unt i l very recentl y. Be fore for mal gover nance was es t abl i she d,
97
Governance and Investment in China
European busi ness peopl e duri ng the premodern peri od made agree
ments, to a l arge degree, outsi de t he legal system (Greif 1 994) . Transition
away from personal reputati on i n the Uni ted States occurred only be
t we e n 1 840 and 1 92 0 ( Zucker 1 986) . Dur i ng t hi s t r ans i t i on per i od,
relational banking played an i mportant role in moni toring frms ( Cantillo
Simon 1 998) . I t was t he Gl ass- Steagall Act, the Securities Act, and other
regul ati ons after t he Great Depressi on that essent i al l y ended rel ati on
shi p- based fi nance i n t he US ( J acobs 1 99 1 , 1 43-45) .
2
B
Unfortunately, as argued in Li ( 1 999) , transi t i on from i nformal gov
er nance to formal governance is us ual l y a di s c ont i nuous proc e s s .
Decent ral i zat i on of i nformal governance or change of management
teams can disrupt governance at l east i n t he short run because relations
( l ocal person- speci fic i nformat i on) among ol d players can be weakened,
whi l e rel at i ons wi th/ among new pl ayers or formal rul es are yet t o be
establ i shed. I n particular, when new management teams replace ol d ones,
and new pl ayers enter t he market ( e. g. , due to financi al l i beralizati on) ,
exi sti ng rel ati ons become usel ess or weakened, and rel ati ons with and
between new pl ayers are yet t o be est abl i shed by repeat ed pl ays and
tests. That i s, ei ther exi st i ng rel ati on- s peci fi c i nformati on becomes i n
val i d or bi l at eral monopol y of private i nformat i on breaks down.
The arrival of newcomers makes i t harder for an incumbent to com
mi t to exi sti ng rel ati ons. As a by- product, decentralizati on of i nformal
governance can result i n "corrupti on with i ndependent monopoly. " Before
decentralizati on ( e. g. , pol i ti cal l i beralizati on) , di fferent branches of the
government may j oi ntl y maxi mi ze the value or the t otal bri be across
compl ement ary publ i c goods . I n t he process of decentral i zat i on, t he
rel ati ons between di fferent branches of the government may be cut off.
Subs equent l y, di ffer ent branches become i ndependent monopol i s t s
provi di ng publ i c goods. Thi s may resul t i n severe i neffi ci enci es i f these
publ i c goods are compl ementary, as i ndi cated earli er.
Thus , before formal governance i s es t abl i s hed, t her e may be a
vacuum in the governance structure after market devel opment and l i b
eralizati on have made i nformal governance dysfuncti onal . On the other
hand, there i s no guarant ee t hat a formal governance system can be
establ i shed after l i beral izati on, and when it can be establ i shed i t usually
i nvolves a l ong compl ex process. Transi t i on from aut hori t ari ani sm to
democracy i s hardly smooth, and sufci ent noi se can trigger a war i n the
pr oces s . Some product i ve resources need t o be divert ed t o cover t he
fixed cost of set t i ng up effect ive formal governance. There are " fi scal
external i ti es" in fi nanci ng t he set up; for each tax dol l ar pai d by an i n-
98
Governance and Investment in China
di vi dual , t he s oci al benefi t i s si gni fi cantl y hi gher t han hi s i nd i vi dual
benefi t . To col l ect taxes and to i mpl ement ot her rul es effect i vel y, i t i s
necessary tu devel op i nformati onal i nfrastructure, which i tsel f i s a l ong,
evol ut i onary process.
The di srupt i on of governance aft er l i beral i zati on can possi bl y l ead
to a significant reducti on in trade and investment in the short run. Aft er
drasti c trade l i beral i zation i n 1 987, t he Mexican footwear i ndustry went
through a crisi s. One of the mai n reasons behind the crisis appeared t o
be t he deteri orati on of t he footwear associ ati on's functi on as an enforce
ment mechani sm i n t he open economy. Si mi l arly, t he drast i c capi t al
account openi ng- up i n I ndonesi a and Thai l and, and t he sweepi ng po
l i ti cal openi ng- up i n Korea i n t he 1 990s, mi ght have aggravat ed, i f not
triggered, t he current financi al cri ses i n t hese economi es. The previous
control devi ces ( i n particular coordi nati on devi ces) under a closed capi
tal market or authoritarianism no longer functi on efectively whi l e new
control devi ces under an open capital market or democracy are yet t o
be establ i shed. I n parti cul ar, control devi ces bui l t i n governmental and
semigovernmental agenci es become weakened or nonfuncti oni ng as t he
capi t al mar ket be c ome s ope n or de moc racy phas es i n t o r epl ace
aut hori t ari ani sm. Market and pri vate organi zat i ons wi l l i ncreasi ngl y
repl ace government al and semi government al coordi nat i on devi ces i n
fnancial and ot her industries but the process is likely to be bumpy and
l engthy.
So far, Chi na has been abl e to avoi d a fi nanci al cri si s fol l owi ng the
Asi an crisi s. The maj or reasons are perhaps that Chi na has not yet i mpl e
mented capi tal account openi ng- up or pol i t i cal openi ng- up, and t hat
Chi na has attracted mai nl y FDI , whi l e t he economi es involved i n cri si s
accumul at e d l arge s hor t - t er m forei gn debt s . Event ual ly, : n or der t o
minimize corruption and to establi sh t he rule of law to support techno
l ogi cal progress, both the capi tal market and the pol i ti cal market must
open up i n Chi na, but when and how t o open have profound i mpl i ca
ti ons for economi c growth i n general and for FDI i nfow i n parti cul ar.
To minimize the di srupti on of governance in transi ti on, the Chi nese gov
ernment shoul d consistently but gradually reduce state control and open
up market s, and decentralizing must be accompani ed by coordi nating,
i . e. , mai ntai ni ng necessary exi sti ng relati ons and i mproving the regul a
t ory and l egal framework.
As i n i ts East Asi an predecessors , Chi na wi l l experi ence di srupt i on
of i ts governance structure i n the process of decentral i zat i on. Aft er t he
mi d- 1 990s, governmental withdrawal of i ts control ri ghts from both SOEs
99
Governance and I nvestment in China
and TVEs start ed to accel erate. There have al ready been di srupti ons of
corporate goverance in many privatized firms where i nsi ders or larger
sharehol ders abuse t hei r cont rol rights t o loot mi nori ty sharehol ders.
However, Chi na has t wo advant ages. Fi rst . as a l at e fol l ower, Chi na has
the advantage of l earni ng from bot h t he East Asian miracle and the East
Asian cri si s t o mi ni mi ze the economi c cost s of fi nanci al l i beral i zat i on
and pol i ti cal transi ti on. Second, Chi na can resort to cross- regi onal ( do
mesti c) competi ti on to speed up t he transition from i nformal governance
to formal governance. As di scussed earli er, al t hough pol i t i cal l y Chi na
remai ns very central i zed, economi cal ly it i s al ready much more

decen
tral i zed than many out si de observers have perceived. There are about
thirty provinci al - level j uri sdi cti ons ( most of which are as l arge as mi ddl e
s i z e d count r i e s ) , s ome t wo t hous and c ount i es and fifty t hous and
townshi ps. Local governments have significant i ncentives and autonomy
t o devel op t hei r economi es.
As i ndi cated, cross- regi onal competi ti on can di sci pl i ne each regi on
to i mprove its governance structure to attract investment and limit cor
rupti on. Economi c competi ti on and decentralizati on can eventuallv l ead
t o pol i t i cal compet i t i on and decentral i zat i on. Cross- regi onal copet i
t i on may speed up t he devel opment of t he rule of l aw in Chi na as i t di d
i n t he UK i n t he ei ght eent h cent ury and i n t he US i n t he ni net eent h
century. Current ly, provi nci al - level j uri sdi cti ons can make regi onal regu
l ati ons, and speci al admi ni strative regi ons, such as Hong Kong, as well
as s peci al economi c zones , such as Shenzhen and Hai nan, can make
some regi onal laws . If ot her provi nci al - level j uri sdi ct i ons are grant ed
t he rights to make regi onal l aws i n t he future, cros s - regi onal compet i
t i on i n lawmaki ng wi l l i nt ensi fy.
1 00
CHAPTER FI VE
CENTRALIZATION, POLITICAL TURNOVER,
AD INVESTMENT IN THE PHILIPPINES
Emmanuel S. de Dios and Hadi Salehi Esfahani
Conventional wisdom postulates that systems governed by the formal
rule of l aw are l ikely to perform better than those in which rules may be
arbitrarily changed. This is suggested by Douglas North ( e. g. , 1 997) , who
pointed out, i n his work, the crucial role i n development pl ayed by a clear
defni ti on of property rights and by effect ive mechani sms for the settl e
ment of di sputes. I n recent di scussi ons, however, especi ally fol lowing the
Asian cri si s, "rul e of l aw" has come t o be i nterpreted i n the formal and
hi gh- pol i ti cal sense of conformity with systems found i n Western i ndus
trial democraci es, including the existence of checks and bal ances, regular
and predictable regime successi on, and a formally i ndependent j udi ci ary.
Part of the paradox presented by the rapid growth of the East and South
east Asian countries is that at the ti me of their remarkabl e performance,
few of them confomed to this ideal. I Even countries where levels of corruption
ad potential for arbitrariness were high continued to attract or generate high
levels of productive investments. On the other hand, the Philippi nes has al so
contri buted t o thi s paradox, al bei t i n a reverse manner, namely, as the
exception that validated the rul e. Contrary to what might be expected, the
country's l ong hi story of formal democratic institutions has been associ
ated wi th medi ocre economi c performance ( though in the mi dst of the
Asi an cri si s , it has also been among the l east affected economi cally) .
The quest i ons , therefore, are how goverance and growth may be
related and what some of the mechanisms are through whi ch this relation
shi p emerges. In parti cul ar, thi s chapter seeks to expl ai n how and why
changes i n governance systems in the Phi l i ppi nes ( 1 935-1 972, 1 972-1 986,
and 1 986 to the present) have l ed to di fferent patterns of corrupti on and
1 0 1

Centralization, Political Turnover, and Investment in the Philippines


to better or worse investment outcomes, both within and between regimes.
Cruci al to the explanation are ( 1 ) the reasons for uncertainty and ( 2) the
costs of investment within regimes and across regimes, which we trace to
the distribution of political mandates and to the system of political turn
over and successi on, respectively.
Philippine Political Economy
Various interpretati ons of Philippine political economy share a com
mon emphasi s on the characteri sti cs determi ni ng the likeli hood of the
"capture" of the state and i ts instrumentalities by vested interests based on
political "clans. " Notwithstanding a certai n amount of dissatisfaction and
subsequent amendment s, most vi ews have devel oped from an earl i er
tradition i n Phil i ppi ne pol i ti cal l i terature t hat came to be known as the
"factional model" of Philippine politics ( e. g. , Lande 1 965) . In that reading,
the economi c elite is seen as being divided into various factions formed
out of hi storical alliances based on kinship and patronage. Facti ons are
thought to be based on the political and economic power of the local elite,
referri ng originally to agricultural landownershi p. The resulting patron
cl i ent relations cut across l i nes of soci al cl ass; al l i ed l ocal interests and
i nfuences were then successively consol i dat ed upward and ul ti matel y
found thei r expression i n political factions contending periodically for direct
control of government.
The only possi bl e significant exception to this characterization i s the
epi sode of authori tari ani sm under Marcos, dating from 1 972 t o 1 986,
when the power of l ocal i nterests was weakened with t he suppressi on
of Congress and regul ar el ecti ons, whi ch had served as the tradi ti onal
channel s for thei r expressi on. 2
The postdictatorship peri od, beginning with the restoration of demo
cratic institutions in 1 986, is broadly regarded as a return to the previous
era, although recent changes in economic structure, demography, culture,
and the occurrence of economi c cri ses have suggested that cl an- based
patron- client relations coul d be weakening at the edges. ] In particular, the
previous understanding that the indispensable basis for such politics was
the system of large traditional landholdings has come increasingly under
question ( e. g. , Sidel 1 995, and from a slightly different viewpoi nt, Rivera
1 995) . Most would nonethel ess concede that, although weakened, clan
based patron- cl i ent rel at i ons that have l ong i nfl uenced the country's
political economi c l andscape are still present.
The intensity of political contests derives from the fact that the gov
ernment di sposes over a si gni fi cant amount of resources and exerci ses
1 02

Centralization, Political Turnover, and Investment in the Philippines


di screti on over a wide sphere. The i mpl i Ci t goal of elite struggl es i s to
control the state's machinery and resources and to skew their deployment
to favor specifc interests. Powerful incentives then work to persuade in
cumbents to retain power indefinitely i n order to protect such interests.
Conversely, turnovers-whether el ectoral contests or more fundamental
chal l enges to l egi ti macy, such as attempted coups-may be viewed as
opportunities to attain or to retain this power.
The economi c costs occasi oned by such regimes can be seen to be
largely a priori. First are the obvious l osses from competitive rent- seeking,
as factions seek to buil d up their capacities to compete for dominance. The
l arger the prizes are (which could turn on the scope of the government's
infuence over resource all ocation) and the more evenly matched factions
are, the greater i s the likelihood of di ssi pati on of resources i n terms of
lobbying, maintaining retinues of followers, and so on. 4 These losses from
classical rent- seeking result from the diversion of resources toward unpro
duCtive or purely dissipative uses, where these could have been invested
or allocated Dore efci ently.
Further losses, apart from those occasioned by rent-seeking, may arise
as investment is discouraged by uncertainty. In this respect, two potential
effects of democratic, decentralized regimes i n raising investment uncer
tainty may be distingui shed. One efect owes to the greater chal l enge to
authority even i n periods between turnovers; i n short, internal uncertainty
among i nvestors brought on by the di ffusi on of power even without a
regime change. Overlapping j urisdictions and systems of checks and bal
ances tpically found in formal democracies coul d l ead to gridlock or rents
or both. On the other hand, interperiod or interregime uncertai nty results
from possi bly large changes i n pol i ci es, ranging from reversals of broad
policy initiatives to alterations of contracts. The threat of victory by hostile
factions may be viewed as leading to unsettling changes i n pol i ci es that
frther raise the cost and the risk of investing. Potential political challeng
ers may threaten to reverse the results of transactions accomplished under
the incumbent administration once they come to power. The possible shift
in policy consequent to turnover represents additional uncertainty and a
discouragement to investment. The next two sections discuss these in tur.
Checks and Balances and Intraregime Investment Uncertainty
A frequently noted source of invest ment uncertainty in democratic
systems i s the challenge to policies arising from checks and balances. I n
democracies, branches of government differ in their competencies but are
able to exercise countervailing power relative to other branches. Presiden-
1 03

Centralization, Political Turnover, and Investment in the Philippines


tial systems vest the executive function i n a separate branch ( the exeC-
tive) : while parliamentary systems incorporate legislation and i mpl emen
tati on i n a single body, the parliament. In al l cases, however, the j udiciary
would be an i ndependent branch serving as a l ast recours e.
The appropri at eness of pol i cy- maker i ncentives cannot be guaran
t eed in most s i tuati ons, such as when the l eaders' expected tenure is not
very l ong or when the l eaders benefit from the gai ns of particular i nter
est groups much more than t hose of others . As a resul t, restri cti on on
pol i cy di scret i on ( or di ffus i on of power) i s oft en needed t o enhance
credi bi l i ty. Restri cti ng di screti on i s not cost- free, however, si nce it makes
pol i cy adj ustment diffi cul t. When power i s di ffused, each pol i cy change
requi res bargai ni ng and negot i at i on among veto hol ders , whi ch may
del ay pol i cy respons es and may prevent s ome effi ci ent changes t hat
woul d otherwi se have occurred. A trade- off exi st s, t herefor e, between
t he costs and benefts of restricting discreti on. This trade- off depends on
each country's specifi c condi ti ons, i mplying that di ferent levels of power
concentrati on may be opti mal for di fferent count ri es .
The 1 935 Phil i ppi ne Const i t ut i on t hat was i n effect from 1 946 t o
1 972 was patterned largely after that of t he Uni ted States and prescribed
a presi denti al system of government, with three equal branches, namely,
t he Execut i ve, Legi sl at i ve, and J udi ci ary. Thi s syst em was s us pended
under t he authori tari an Marcos regi me from 1 972 t o 1 986, but i t was
rei nsti tuted, wi th some i mportant changes to be di scussed l ater, i n the
1 987 Consti tuti on draft ed duri ng the presi dency of Corazon Aqui no.
I nsti tuti onally, the di spersal of power i nherent i n the separati on of
powers and the syst em of checks and bal ances makes deci si ons open
t o chal l enge from several quart ers . I n t he Phi l i ppi nes , t he power of
Congress to conduct i nvest i gat i ons, or i nqui ri es , " i n ai d of l egi sl ati on"
i s regarded as particularl y potent, gi ven i ts ri ght to subpoena wi tnesses,
i nformants , and document s. As may be expected, the opposi ti on i s typi
cal l y at t he forefront of t he chal l enge t o execut i ve i ni t i ati ves wi t h a
publ i cl y accepted rol e of "fi scal i zi ng. " "
Del avs resulting from such pol i ti cal contingenci es add obvi ous cost s
to pot enial i nvestment proj ect s, so that there woul d be some val ue t o
avoi di ng them. Not surpri si ngly, thi s arrangement can be parl ayed i nt o
corrupt i on. In l ocal pol iti cal parlance, thi s modus operandi i s known as
"1C- DC" ( short for "attack and collect, defend and col l ect" ) , vvhich refers
to the pol i ti cal practi ce of rol e reversal argui ng alt erat ivel y i n favor of
or agai nst certai n proj ect s , i n exchange for s ome fi nanci al or pol i t i cal
cons i derati on.
1 04
Centralization, Political Turnover, and Investment in the Philippines
Congressi onal investigations by themselves cannot reverse deci si ons,
but they may be leveraged wi t h the wi de publicity devoted t o them, as
wel l as wi t h a possi bl e ul ti mate recourse t o t he j udi ci ary. Sui ts fi l ed
before the Supreme Court by l egi sl ators chal l engi ng executi ve deci si ons
are al most a matter of course. The i ncreased l eeway for Supreme Court
i nterventi on i s a product of the post - Marcos experi ence. I n an i nnova
t i on seeking to prevent a repeti ti on of the i mposi ti on of martial l aw t hat
paved the way for the Marcos di ctato rshi p, the 1 987 Consti tut i on al l ows
the Supreme Court to review cases i nvol vi ng "grave abuse of di scretion. "
Thi s has allowed the Court t o i ssue t emporary restrai ni ng orders bi nd
i ng on the Executive Branch or any of i ts agenci es. Asi de from el ectoral
contests, therefore, this i s another means for rivals to mount chall enges
to i ni t iati ves from the poli t i cally domi nant fact i ons.
These exampl es are fully consi stent with the " i ndependent monopo
l i sts" model of corrupti on descri bed by Shleifer and Vishny i n 1 993. These
authors di scuss the probl em of corrupt i on i n the provi si on of a servi ce
or i n access to a publ i c resour ce. They di sti ngui sh between three types
of i ndustrial organization: ( l ) j oi nt monopol i sts, where there i s onl y one
source of the servi ce; ( 2) i ndependent monopol i sts, where two or more
enti ti es can provi de the servi ce; and ( 3) competi ti on, where several enti ti es
are equal l y capabl e of provi di ng t he s ervi ce.
Especi ally i mportant i n thi s respect i s t he analytical observati on
regarded as i mportant through anecdotal evi dence-that "corrupti on con
tracts" are not enforceabl e i n court s, and there i s many a sl i p between
t he bri bi ng transacti on and the actual del ivery of the good or the servi ce
involved" ( Bardhan [ 1 997, 1 3241 attri butes thi s to Boycko, Shl ei fer, and
Vi shny) .
In the case of i ndependent monopol i sts, concurrence by two or lore
enti ti es is requi red in order to obtai n access to public resources or assets .
Each enti ty may then act i ndependentl y to maxi mize i ts returns, say i n
t he form of br i bes . As a resul t , t he amount s demanded o f pot ent i al
i nvest ors is excessive, whi ch l eads, ot her thi ngs bei ng equal , to a de
crease i n investment proj ects and, consequently, t o l ower outpuL" fl ence,
for i nst ance, a deal may be i roned out wi th the agenci es i n the Execut i ve ,
but t hi s woul d not guarant ee i ts passage owi ng t o pri or requi rement s .
Thi s si tuati on may be cont rasted wi th one where t here i s onl y one
bri be- taki ng monopol i st , who set s t he rate of " t ake" so that t ot al bri be
revenue i s maxi mi zed. Thi s can be att ai ned, however, onl y i f the rate of
bri bes i s not set so hi gh as to di scourage i nvestment unduly. As a resul t,
whi l e the total bri be- revenue col l ected may be hi gher than the second, the
1 05

Centralization, Political Turnover, and Investment in the Philippines


level of investment and output are higher in the frst. Indeed, Shleifer and
Vishny ( 1 993, 6 : 0) speculate dirfctly on the efect of the transition to the
post- Marcos regi me: " New governments lose monopoly over bribe col l ec
t i on, and as a resul t mul ti pl e agenci es take bri bes where only one di d
before, leading to a much less efcient collection. I n the Philippines under
Marcos, all corruption fowed to the top; since his demi se, the number of
i ndependent bri be takers has increased, and so the efficiency of resource
al l ocati on has probably decl i ned. "
It should be pointed out , howver, that t he possibility of challenge and
decision reversals from different branches of government would also exist
even i n the case of legitimate contracts. From the viewpoint of investment
uncertainty, the di sti ncti on between challenges motivated by corrupti on
and those that are not is of secondary importance. The same mechanisms
that exist for the free prosecuti on of legitimate social demands are avail
able for vested i nterests. I n a similar vein, t he extent to whi ch losses as
soci ated wi th rent- seeking are not themselves i nherently associ ated wi th
the workings of democratic and constitutional regi mes ( e. g. , Brecher 1 982)
has been questi oned. For exampl e, that uni ons shoul d have recourse to
the Supreme Court is unlikely to rai se any obj ecti ons. Yet i t i s difcult to
argue that the recourse to the courts shoul d be open only to certai n en
tities and not others. A dilemma therefore exists on whether an attempt to
el i mi nate such rent - seeking costs does not l ead ei ther to the deprivati on
of access to due process. I t may be argued that Congress, the courts, and
media are the counterbalance to arbitrary seizures and i n this sense miti
gate the powers that would otherwise result i n extreme bias i n decisions.
Elections and Political Turnovers
Less noti ceabl e than i ntraregi me factors, however, have been regi me
turnovers as a second source of uncertainty. The i mportance of turnover
epi s odes i n i nfl uenci ng i nves t ment behavi or is di s cer ni bl e t hrough
econometri c evi dence. Movements of macroeconomi c vari abl es i n t he
Phi l i ppi nes over t he past five decades, as i n many ot her devel opi ng
countri es, indicate a di scerni bl e i nfuence of el ectoral cycl es. In particu
l ar, the budget defi ci t has had a cl ear tendency to ri se in el ecti on years,
whi ch, in the pol i ti cal busi ness- cycles l i terature, has been attri buted t o
an at t empt by i ncumbent l eaders to boost the economy and di stri bute
publ i c funds under thei r di screti on to strengthen thei r pol itical support. '
Neverthel ess , unl i ke pol i ti cal busi ness cycl es observed i n ot her devel
opi ng countri es, l arger el ect i on- year budget defi ci ts i n t he Phi l i ppi nes
have not unambi guously expanded the economy. Rather, el ect i ons ap-
106
Centralization, Political Turnover, and Investment in the Philippines
pear to be preceded by a decl i ne in private investment that counteract s
the fi scal expansi on and causes a sl owdown. We attri bute thi s behavi or
to i nst i t ut i onal characteri sti cs i n the Phi l i ppi nes and argue t hat thes e
factors have not only added to i nstabi l i ty in the economy but have al so
const rai ned t he average i nvest ment rate to l ow l evel s.
The presence of ot her factors i nfuenci ng i nvestment makes i t di f
ficult to obtai n a si mpl e picture of the i nfuence of pol i ti cal turnover ( i f
any) on i nvestment. The only sati sfactory way to substanti ate thi s cl ai m
is to fully speci f and estimate a model of investment behavior and test
whet her presi dent i al el ect i ons i n t he Phi l i ppi nes have a di st i nct i nfu
ence on t he l evel of i nvest ment . For thi s purpose, we t ake i nvestment
to depend on factors affecti ng profitabi l i ty, whi ch i ncl ude i nfat i on, pre
di ct ed GDP ( gr oss domest i c product ) growt h, t he st at e of t he current
account , the t erms of trade, and i ndebtedness ( represented by accumu
lated current account deficits) , the pri ce of investment goods, as well as
pol i t : cal ri sk. ( The underlyi ng model is descri bed more cl osel y in t he
appendix) . Equati ons seeking to expl ai n t ot al investment and a proxy for
private i nvestment are esti mated, and the results appear to support the
i ni ti al hypothesi s of presi denti al el ecti ons having a di sti nct i nfuence on
investment. I t wi l l be seen i n most runs that the coeffci ent of a dummy
variabl e representi ng preel ecti on years is both si gni fi cant and negative.
This is true for t otal investment, for private constructi on, as well as for
t he sum of pri vate const ruct i on and durabl e equi pment , whi ch is t he
proxy used for private i nvestment. 8 These resul t s l end support t o what
casual observat i on would suggest , namely, that t he uncertai nty gener
at ed by presi denti al cont est s negati vel y i nfl uences the l evel of i nvest
ment. The evi dence is thus broadly compati bl e wi th the facti onal model
of Phi l i ppi ne pol i ti cal economy descri bed earl i er.
The mechani sm by which regime turnover affects i nvestment in the
Philippi nes is clear. Suppose, for si mpl i ci ty, there are two contendi ng fac
tions that seek to gain control of government. With t he electoral outcome
known, the l osi ng facti on wi l l tend to restri ct i ts own investment, ceteri s
paribus, either i n order to mi ni mi ze the possi bility of being taken over or
si mply as a resul t of bei ng di scri mi nated agai nst , for exampl e, through
bei ng unduly taxed. The winning facti on, on the other hand, may invest
more aggressively, havi ng greater assurances regardi ng its security and
privileges. The peri od pri or to the elections, however, is one of uncertainty
for both facti ons, so that investment by both shoul d be expect ed to de
cline. Ultimately, a succeeding administration may often threaten to expose
and undo l arge deal s concl uded by its predecessor. " I t is important to note
107

Centralization, Political Turnover, and I nvestment in the Philippines


that this i s possi bl e, largely because a good part of deci si ons involve a
good deal of di scret i on ( especi ally on the part of the executive) .
This hypothesis is borne out histori cally. An extreme illustration of the
possi bi l ity of takeover was the struggle between the Marcos and Lopez
families (McCoy 1 993 ) , with the holdings of the latter, as well as those of
other elite famil i es, such as the J aci ntos and Osmefas, bei ng completely
taken over by the Marcoses and the croni es associ ated with them. These
same interests, however, were restored with the ascendancy of the Ramos
and Aquino administrations, while assets associated with the Marcos fam
ily (such as those of Eduardo Coj uangco, t he Romualdezes, t he Benedictos)
were expropriated or "sequestered, " i . e. , placed under government receiv
ership, Most recently, the pendulum swung once more i n the other direc
t i on as the el ectoral vi ctory of Presi dent J oseph Estrada i n 1 998 opened
t he door to at l east a parti al resti tuti on of the i nterests formerly al l i ed
cl osely wi th the Marcos fami ly, who were strong Estrada supporters . I O
On a scal e l ess grand, even predi ctabl e regi me changes under demo
cr at i c e l e c t i ons i n t he Phi l i ppi ne s c ont r i but e to a good de al of
di sconti nuity and di srupti on i n investment horizons. Al most invariably,
it has been the practi ce of succeedi ng " unfr i endl y" admi nistrati ons t o
questi on and scruti ni ze contracts and proj ect s concl uded by thei r pre
decessor s, i n t he at t empt t o prove that t hese have been ri ddl ed wi t h
corrupt i on and are di sadvantageous t o t he publ i c. On t he one hand,
such ex post t rans par ency and account abi l i t y may be vi ewed as an
advantage of predi ct abl e and democrat i c changeover s . On t he ot her
hand, the practi ce undoubt edly i ncreases the cost s and uncertai nty of
i nvest ment . and i ndeed may pl ay a part i n t he i ncumbent 's own de
mand for corrupt i on. I nves t ment proj ect s be gun under a previ ous
admi ni strat i on may be hel d host age by an unfri endl y successor, si nce
t he l atter's concurrence i s oft en needed for t hei r cont i nuat i on. Thi s i s
most evi dent when publ i c contracts and payment s are i nvolved, such
as t hose involving publ i c i nfrastructure. In general . however, the prob
l em ari ses t o the ext ent that any si gni fi cant government acti on-such
as franchi s es , taxes , or t ari ff changes , support i ng i nfrastructure-i s a
requi si t e cl ement for a private proj ect 's fut ure vi abi l i ty and the poss i
bi l i ty exi st s that t hi s may be wi thhel d, or t hat a past act i on may be
rever sed. I t is easy to s ee t hat t hi s need for cont i nui ng cooperati o n
from t he i ncll mbet may, wi th suffi ci ent gui l e, be parlayed i nt o a de
mand for addi t i onal si de payment s , rai si ng the costs of i nvest ment .
Analyt i cal l y, t hi s s i t uat i on may al s o be cas t as an i nt ert emporal
i nt erpret at i on of t he same i ndependent monopol i st s model of Shl ei fer
1 08
1
!
Centralization, Political Turnover, and I nvestment in the Philippines
and Vi shny di s cus s ed in the previ ous s ect i on. Previ ous and pres ent
admi ni strati ons may be vi ewed as i ndependent monopol i sts, each seek
ing to maxi mi ze its gai ns, causi ng "excessive" demands for corru pt i on,
with t he predi ct abl e resul t that i nvest ment i s di scouraged. Somewhat
less obvi ous i s t he addi t i onal di st ort i on reSUl t i ng from private agent s ,
anti ci pati ng t he possi bility that a bi as for proj ects whose l i fe- s pans do
not extend beyond t he t erm of a " fri endl y" administrati on. The reSUl t i ng
t endency t o myopi a when invest ment s i nvolve si gnifi cant parti ci pation
or concurrence from government is anot her source of i neffi ci ency.
Uncertai nty and actual l osses for exi st i ng i nterests wil l . to be sure,
result from any si gni fi cant policy change, whether or not these are tar
geted against narrowly defi ned facti ons. The shift from an inward- l ooking
t o an outward- l ooki ng strategy, or cutbacks i n publ i c spendi ng as part
of a macroeconomi c adj ustment, for exampl e, are certain to cross exi st
i ng narrow di vi si ons, si nce facti onal di vi si ons are l ikely to have i nterests
i n ei t her. What pri nci pal l y di st i ngui shes one si t uat i on from t he ot her,
however, i s t he scope for di scri mi natory or sel ective appl i cati on of the
l aw. The fact that not t he ent i re cl ass of i nt erest s but onl y some are
affect ed l essens the l i kel i hood of massive resi st ance, i n t he cl assi c di
vi de- and- rul e tradi ti on. I n t he cas e of t he Marcos regi me, for i nstance,
t he target i ng of certai n fami l i es , s uch as t he Lopezes and t he J aci ntos,
coi nci ded with accommodati on of other large famil i es, such as t he Zobel
Ayalas, and the posi tive favori ng of other groups, such as that of Eduardo
Cojuangco and other croni es. The hi gh degree of arbi trari ness and s e
l ectivity of fact i on- rel ated expropri ati ons and pol i cy reversal s resul ts i n
greater i nvest ment uncertai nty, i n addi t i on t o t hos e al ready present i n
large- scal e systemwi de changes i n i nvest ment st rategy.
A Benchmark Comparison
I t is tempti ng to associ ate the two types of i nvestment uncertai nt y
previ ously di scussed with democracy per se and concl ude that these are
speci fi c or i nherent to such regi mes. Even casual observati on suggest s,
however, t hat massive di scouragement of i nvest ment does not occur i n
more advanced i ndustrial countri es with democrati c systems of gover
ment. In such countri es , investment rul es and atti tudes toward property
ri ghts do not change dramati cal ly.
The questi on that ari ses. therefore, is how i ndustri al democracies can
exi st wi th these same i nsti tuti ons yet maintain a stabl e record of i nvest
ment. The answer proposed here i s di ffusi on of power. It i s easy to see that
in a democrati c country ( say, Denmark) wi th a homogenous popUl at i on,
1 09
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Centralization, Political Turnover, and Investment in the Philippines
an open and stabl e economy, and an effective admi ni strative syst em, a
governance structure with di ffused power is likely to be best for i mpl e
menti ng effi ci ent investment pol i ci es. Political openness and popul ati on
homogeneity coul d reduce the need for power difusi on, but on the whole
such a system should prosper without much concentration of power. This
i s a benchmark that we use to assess appropriate arrangements for other
situations with different characteristics. From such a benchmark, however,
one may proceed to inquire into the signifcance of the costs of restricting
pol i cy di screti on, dependi ng on soci oeconomi c characteristics that make
information processi ng and coordination among interest groups cumber
some. I n particular, the costs of diffused power shoul d tend to ri se with
the six factors that we present below.
1 . Heterogeneit of interest groups in the societ. As the pol ity becomes
more heterogeneous, bargaini ng among representatives of i nterest groups
becomes more cost ly. A hi gher l evel of power concentrati on coul d, i n
pri nci pl e, mitigate thi s probl em. On the other hand, heterogeneity may
also i nduce bi ases i n l eaders' i ncenti ves (as woul d happen i f the gov
ernment was compl etely "captured" ) and afect i ts effcacy. The net effect
on the trade- off, therefore, i s not enti rely cl ear.
2. The frequency and magnitude of economic shocks ( e. g. , adverse
t erms of t rade shocks, nat ural di sast ers, si gni fi cant popul ati on move
ments) . When a country faces signifcant economi c shocks but otherwise
has the same condi t i ons as the benchmark case, the need for t i mel y
policy adj ustment i ncreases. As a result, t he net benefits t urn i n favor of
greater power concentrat i on.
3. The economic system's l ack of openness ( i . e. , market s are more
restri cted) . I f the only departure from the benchmark case is reduced
economi c openness, t he cost of col l ecti ng and processi ng i nformati on
ri ses for i nterest groups and thei r representatives. As a resul t, bargai ni ng
becomes more costly, and power concentrati on, whi ch reduces bargai n
i ng, becomes more benefi ci al at the margi n.
4. Weakness of the administrati ve system ( e. g. , i neffi ci ent administra
t ive organi zat i ons , low qual i t y of per sonnel . low level of educat i on) .
I nabi l i ty of the bureaucracy to col l ect and process i nformati on adds to
the costs of negotiation among i nterest - group representatives. This raises
the marginal net benefi ts of concentrated power. A weak admi ni strative
system al so i mpedes i nformat i on processi ng. I nformati onal i mperfec
ti ons t end to give ri se to "wars of attriti on" i n i nterest- group bargai ni ng,
whi ch can be cost l y i n t erms of resources and del ays i n adj ust ment
( Al esi na and Drazen 1 99 1 ) . I n one sense, concentrati on of power r e-
1 1 2
Centralization, Political Turnover, and Investment in the Philippines
solves this probl em and allows a qui cker and more fexi bl e response to
changing ci rcumst ances, given the avai l abl e i nformat i on.
5. Frequency of leadership turnover ( e. g. , t erm limits and fragmented
party system) . When the likelihood i ncreases that government power will
shift from one group of politicians to another, discretion i n the hands of
l eadershi p can breed pol icy i nstabi l i ty. This calls for i ncreased di ffusi on
of power to the extent that such arrangements can survive political change.
1 1
6. The political system's lack ofopenness (such as more restricted media
and public expression) . Reduced opportunities for political expressi on and
parti ci pati on by broad segments of the popul ati on l i mi t the i nformation
available to interest groups and, naturally, tend to raise the concentration
of power. However, these factors also expand the possi bi l i ti es for oppor
tunistic behavior on the part of the leaders. As a result, some i ncrease i n
power diffusi on may help i ncrease credibility of pol i ci es. Lack of political
openness may also raise the costs of power diffusi on, since it reduces the
avail abi l i ty of publ ic i nformation. However, this i s unlikely to be a maj or
effect compared to the opportuni ti es for favori ti sm that l ack of pol i ti cal
openness presents to l eaders with concentrated power.
Institutions limit policy discretion essentially by conditioning changes
i n policy and policy- making procedures on coordination by a number of
i ndependent agents representi ng di fferent i nterests . Such a di ffusi on of
power can take the form of geographi c decentralization ( e. g. , federal i sm) ,
instituti onal decentralization ( e. g. , i ndependent central bank and regula
tory agencies) , or multiple veto powers ( e. g. , presi denti al - parl i amentary
systems with bi cameral legislature, independent constitutional courts, and
ot her el ect ed or nonel ect ed bodi es hol di ng veto over pol i cy changes) .
Such arrangements can reduce the risk of opportunistic policy changes as
l ong as the represented i nterests are not cl osely aligned. As the number
of i ndependent agents involved i n various pol i cy- making and procedure
setti ng processes di mi ni shes and the degree of al i gnment among those
agents increases, the greater i s the degree of power concentrat i on i n the
government. To be sure, policy commi tment is not an all - or-nothing vari
able. Rather, it i s a variable with a continuum of degrees depending on the
incentives of policy makers, the nature of veto holders for each rul e, and
the extent to which the rules specif the details of pol i cy and restrict the
opti ons for changing the detai l s or the rules themselves.
On t he face of i t s characteri sti cs, t he Philippines is a likely candidate
to benefi t from a strong executive. In parti cular, the economy's proneness
to economi c shocks, its lack of openness and admini strative weakness are
factors that, on the face of it, argue for an increase in the concentration of
1 1 3
r
Centralization, Political Turnover, and Investment in the Philippines
power. There i s no need to deal at l ength with the record of shocks. The
heavy dependence of the Philippine economy on i mported inputs renders
it vulnerable to both externa and internal shocks. Examples of such shocks
that resulted i n critical condi ti ons were the second i ncrease in oil pri ces
i n 1 979, the worl d recessi on of 1 982, and the Gulf War cri si s of 1 990. I n
additi on, natural calamities, such as earthquakes and t he Mount Pinatubo
vol cano erupti on of 1 99 1 , were also si gni fi cant shocks.
Apart from the unsustai nabi l ity of growth under a cl osed economi c
sys t em, t he current framework suggests t hat l ack of openness i n the
economy has another effect, namely, that of raising transaction costs among
di fferi ng i nterest groups . One way of l ooki ng at this i s to say that rent
seeking games are more likely to occur in cl osed, rather than in more open
economi c systems. 1 2 Finally, the weak condi ti on of the bureaucracy i s also
part of the "stylized facts" about the Philippi nes, an observation made long
ago ( e. g. , Corpuz 1 957) but still relevant . The framework, therefore, sug
gests a number of reasons why the Philippi nes shoul d have a "centralized"
system. Indeed, the puzzle for the Philippi nes is how and why, given such
a framework, the experi ment with authoritariani sm has fai l ed.
Extreme Centralization and Bias
Viewed differently, the problem of uncertainty brought about by intra
and i nterregime changes i s the apparent i nabi l i ty of the government as
a whol e to make credi bl e or bi ndi ng commi tments. Commitment essen
ti ally requires that pol i ci es are not amended i n ways that puni sh inves
t ors who make irreversi bl e investments on the basi s of existing pol i ci es.
Thi s can be achieved if the pol i cy makers had t he i ncentive to honor t he
promi ses of past pol i ci es, or if t hei r di scret i on i s constrai ned by estab
l i shed rul es that govern pol i cy change. For appr opri at e i ncent ives t o
exi st , pol i ti ci ans i n goverment ( as i ndivi dual s or as a party when po
l i ti cal parti es are st rong) shoul d expect to have a good chance of bei ng
i n t hat posi t i on i n the future and shoul d value t hei r reputati on among
al l pot enti al i nvest ors. When t he chances of t urnover i n government
l eadershi p are si gni fi cant , t hen commi t ment depends on i nst i t ut i onal
arrangement s for pol i cy amendment .
Until recently, it would have appeared t hat bot h types of uncertainty
r efer r ed to above coul d be r es ol ved by r ecour s e to s ome fo r m of
authori tarianism or dictatorship. After all, assumi ng i t coul d be achi eved,
concentration of power and t he di scouragement of i nsti tuti ons t hat permi t
t he expl i ci t expressi on of i nt erest - group compet i t i on woul d mi ni mi ze
transact i on cost s and uncertai nty. On the other hand, i f frequent turn-
1 1 4
Centralization, Political Turnover, and Investment in the Philippines
overs are associated with pol icy i nstabi lity, then regime l ongevity, ceteri s
paribus, mi ght conversely be associ ated with greater policy consi stency
and s houl d t herefore al l ow for l onger i nvest ment hori zons . I n turn,
i ncumbent rul ers woul d have t he i ncenti ve to t emper corrupt i on de
mands , l eadi ng t o l ower demand for corrupt i on.
The argument i s similar to the ownershi p sol uti on proposed for the
well- known "tragedy of the commons" problem. Free access to a resource
causes its overexpl oitation, which the assignment of monopoly ownership
sol ves , si nce the sol e owner ul t i matel y reaps what he sows and must
therefore take the l ong vi ew. I n the same manner, contenti on for power
and interregime changes among diferent interest groups might be likened
to a one- time open season for public resources. The incentive i s strong i n
such cases for succeedi ng groups to extract as many rents as they can, i . e. ,
"make hay while t he sun shines, " a tendency only somewhat tempered by
the infrequent need to stand for reelecti on. By contrast, security of tenure
i s thought to reduce this need, since i t lengthens the horizon over whi ch
corruption rents may be collected. Before the Asi an fnancial and economic
crisis, a good deal of this analysis certainly seemed to be borne out by the
experi ences of such countri es as I ndonesi a, Mal aysi a, and Si ngapore, in
whi ch long- lived centralized regimes appeared to have facilitated the entry
of capi tal , particularly forei gn.
The recent hi story of pol i ti cal i nsti tuti ons i n the Philippi nes may be
viewed as a process of experi mentati on i n solving the twin probl ems of
i ntraregi me and i nt erregi me i nst abi l i ty, pri marily al ong t he di mensi on
of concentrat i on of power as embodi ed i n t he executi ve. The starti ng
poi nt was t he pre - Marcos regi me governed by t he 1 935 Cons ti t ut i on,
whi ch saw the power of the executive di l uted i n favor of Congress. Thi s
was compounded by frequent turnovers . The broad resul t conformed
with t hat argued by Shl eifer and Vi shny, namely, the emergence of bot h
i nt ra- and i nt erregi me uncertai nty.
On the other hand, the authoritarian Marcos regime may be regarded
as an hi st ori cal experi ment wi th extreme central i zat i on that s ought to
address the probl em on both counts, first by the often brutal suppres
si on of competi ti on among contendi ng facti ons as well as soci al protest
from t he masses and, second, by suspendi ng the turnover that woul d
have resul t ed from el ect i ons. The apol ogi st s of t he regi me were ful l y
aware of the need for j ustifi cati on, and the aleged urgency of preventing
the growing confi ct between the extreme Left and the conservative "ol i
garchy" was ci ted as a reason for a "revol ut i on from t he cent er" that
establ i shed t he di ctatorship.
1 1 5
Centralization, Political Turnover, and Investment in the Philippines
It must be conceded that the early hal f of the Marcos di ctatorshi p
( from 1 972-1 980) was marked by a revival of investment and a respect
abl e rat e of economi c growt h. I nt ernat i onal i nst i t ut i ons, such as the
I nt ernat i onal Monetary Fund and t he Worl d Bank, as wel l as forei gn
( especi ally US) investors appeared to be persuaded at that ti me, and for
t oo l ong a ti me aft er, by t he argument that central i zati on woul d resul t
i n both greater policy coherence and conti nuity. 1 3 Thi s part of the story,
at l east, presents no probl ems. I ndeed, t he anomal ous part of that ex
per i ence, from the t heoret i cal viewpoi nt pursued her e, was that t hat
si t uat i on coul d not be sust ai ned.
Monocausal expl anati ons are always dangerous, however, and whi l e
governance forms are undoubtedly i mportant, they al one cannot be ex
pected to determi ne economi c outcomes. The full set of reasons for the
fail ure of t he Marcos di ct at orshi p's sel f- consci ous attempt t o emul ate
t he authoritarian regi mes i n the rest of the regi on remai ns a wide- open
fiel d of study. An i mport ant el ement t hat can be not ed, however, i s t he
fai l ure of t he Marcos di ctatorshi p to reach t he same l evel of soci al l e
gitimacy as the authori tarian regimes i n the rest of East Asi a. There was
al most no peri od duri ng whi ch the Marcos regi me did not face some
form of chal l enge t o i t s rul e, whet her from el ement s of di spossessed
and di senfranchi sed el i te facti ons, t he Cathol i c Church, the mass move
ment and armed resi stance l ed by the Communi st Party, or t he armed
movement for the i ndependence of Musl i m Mi ndanao. I t i s notabl e that,
ul ti matel y, a confuence of these forces-preci pi tated by a further spl i t
i n t he Armed Forces-woul d bri ng down t he di ctatorshi p i n 1 986. 1 4
Thi s consi derati on poi nts to t he i mportance of i ni ti al condi ti ons i n
assessi ng t he l ong- t erm chances of central i zati on as a sol ut i on to t he
probl em of commi tment . The social basi s requi red t o l egi ti mi ze an au
thoritarian solution to the problem of credible commitment was probably
l ess present in the Phi l i ppi nes than i n other countries which successfully
adopted that soluti on. To begi n with, relative to those other countries, the
Philippines i n the 1 960s and 1 970s was characterized by an economi cally
i ndependent and pol itically powerful elite. I S I t also had a well - developed
worki ng- class and peasant movement, and a population wi th a rel atively
high degree of literacy and political sophisticati on. l Hutchcroft ( 1 99 1 , 1 998)
observes that t he Phi l i ppi ne el i te has hi st ori cal l y been more powerful
relative to the state and the bureaucracy than the elite in other countri es.
I n such circumstances , i t becomes unl i kel y that a si mpl e capture of the
state machinery by a di ctator woul d lead to easy co- opting of the elite. The
upshot is to raise the costs of a dictatorship's bi d for l egitimacy, since both
1 1 6

Centralization, Political Turnover, and Investment in the Philippines


el i te and working cl asses would-as they did-ofer powerful resi stance
to l arge changes i n the political rul e i n whi ch they had invested.
Confi ct pot enti al among i nterest groups i s t he term used here t o
summarize t hi s condition. I t refers to a situation where there are overlap
pi ng claims on resources by different interest groups, leading to the pos
si bi l i ty of sharp confi ct. The condi t i on i s present whenever a si tuati on
approximates a constant- sum game, whi ch is well known to have no Nash
equi l i bri a. This may occur both wi thi n and across social strata. A si mpl e
exampl e woul d be a workers' movement with fairly set i deas about entitl e
ments, not only for i ts own members but for the rest of soci ety as well . 1 7
In such a si tuati on, si de payments are l ess l i kel y to succeed, si nce t he
utility of one party includes the assignment of a particular level of utility
for the other. (In contrast to this, one might consider a trade union move
ment based pri mari l y on economi c demands . ) Another exampl e is t he
confi ct between t wo pol iti cal cl ans competi ng for l ocal el ectoral spoi l s,
also a winner- take- all situati on. These examples serve to illustrate the point
that when interests are extremely heterogeneous, any assignment i s l ikely
to be regarded as bi ased or unfai r by someone el se.
I S
I n the context of heterogeneous i nterests even i n the pre- martial l aw
peri od, it shoul d be cl ear that t he i nsti tuti onal i zati on of el ect i ons, i . e. ,
predi ctabl e turnover, was an i mportant factor i n preventi ng t he si tuati on
from degenerati ng i nto one of compl ete capture and bi as. For thi s rea
son as wel l , t he vari ous parti ci pant s, not abl y contendi ng el i te fact i ons,
were cont ent to pl ay the game, t hereby avoi di ng a war of attriti on. The
suspensi on of thi s process of ritual facti onal capture of the state under
the di ctatorshi p was a viol ati on of i mpl i ci t rul es of the game, l eadi ng to
t he emergence of sharp confi ct .
A good deal of the Marcos regi me's ultimate economi c failure l ay i n
its inability to consolidate its gri p on power and thus address the issue of
interregime uncertainty. The legitimacy of both the substance and meth
ods of the l arge- scal e property reassi gnments i t made were never fully
accept ed by opposi ng elite fact i ons, nor by armed and unarmed mass
movements. As the challenge to l egitimacy increased, especially after 1 982,
uncertai nty i ncreased bot h among forei gn and domesti c invest ors and
credi tors, l eadi ng ultimately to the economi c crisis of 1 984-1 985.
The asserti on of wi de- ranging authority entails a more di ffi cul t pro
cess of l egi ti mi zati on i n soci et i es where pol i ti cal and economi c cl ai ms
from el i t e and from worki ng- cl ass groups overl ap and are more com
prehensive, more arti cul ated. As an i l l ustrati on, a soci ety bas ed predomi
nantl y on sel f- suffi ci ent peasant farmi ng, wi th central state i nsti tuti ons
1 1 7
Centralization, Political Turnover, and Investment in the Philippines
playing only a minor and distant role in economi c life, is l ikely to present
less resi stance to an authori tari an takeover of the state. Much earl i er.
Marx ( [ 1 869] 1 973. 238-39) observed the connect i on between absol ut
i sm, or Bonaparti sm. and the economi c i sol ati on and backwardness of
t he French peasantry. I "
There are several reasons for overl apping claims. While one may be
tempted to approximate this by the degree of i nequal i ty of wealth di s
tribution, thi s i s certainly i ncompl ete. I t i s not measured i nequality per
se that matters. but the l ack of publ i c acceptance of thi s inequality. This
in turn depends on the assertion of divergent rights and alternative l egal
frameworks, and the determination that some other social arrangement
i s superi or. Education, the spread of i deol ogi es. or familiarity with dif
fering social and economi c arrangements are i mportant, as well as the
exi stence of unclaimed resources. As an exampl e, deep divisi ons over
l andownership cl aims in the Phi l i ppi nes are founded on the asserti on
of rights under difering frames of l egitimacy, such as anci ent claims on
ancestral domains, si mpl e usufruct and physi cal occupati on, as well as
t he legal titling system introduced under foreign occupation-all of which
are to some extent publ i cl y accepted i n varying degrees.
In the most general sense. what seems important is the social "space"
that government-or those who have captured it-can occupy without in
truding on preexisting claims or rights. The more numerous and the l arger
such spaces are. the less disruptive authoritarianism is. and the less resis
tance it is likely to evoke. This "space" may be physical , as in the case of
unoccupied or unclaimed public lands that can be appropriated. I t may
be in terms of value. such as when the economy grows and the increment
is disproportionately distributed to favored interests. It may be intellectual
and ideological space. such as an uneducated and ideologically unsophi s
ticated population that i s content to moderate i ts cl ai ms on the rest of
soci ety. leaving more room for dictators to assi gn the l evers for the cre
ation of new wealth. In the Philippine experience, however, there appear
to be less of such "empty spaces" for the proj ection of authoritarian forms
without infringing on preexisting claims. In such circumstances. confi ct
resolution i s unlikely to be simple. and the basi s of authority itself di s
puted. Those "convergent expectations" which Arrow ( 1 974. 72) observed
to be the basis for viabl e authority will not exi st.
Centralization with Term Limits
Motivated by a desire to check past authoritarian abuses, the framers
of the 1 987 Constitution reduced some of the president's powers and sought
1 1 8
Centralization, Political Turnover, and Investment in the Philippines
to prevent the reemergence of a pure authoritarian form of government.
It set cl ear term l i mi ts for the presi dent and s ought t o di mi ni sh the
executive's di screti on i n deci si on making through a clearer process of
legislative and j udicial review. Most notably, the Constitution prohibits the
reelection of the president, although it grants a longer term of six years;
it prescribes l onger congressi onal sessi ons (up from 1 00 days to el even
months) to reduce the need for special sessions, whose agenda were thought
to be more prone to executive manipulation. It also provded for congres
sional review of declared states of emergency; and it broadened the scope
for j udicial revew of executive acts by constituting "grave abuse of discre
tion. " More signifcantly, it has been noted that the 1 987 Constitution also
restricts the chief executive through detailed specification of rights and
entitlements, some of which are potentially in confict ( Sereno 1 999) .
For these reasons, it has almost become part of folk wisdom among
the busi ness community that the powers of the legislature and the j u
diciary have become reemphasized at t he expense of t he presi dency i n
the postdictatorship regime. Consequently, i t has been thought that the
post di ct at orshi p peri od and i ts economi c consequences may be ana
lyzed simply as a continuation of the system prevailing under the 1 935
Consti tuti on. 20 I n thei r famous art i cl e, Shl ei fer and Vi shny specul ate
broadly that the return of democratic institutions in the Philippines has
probably i ncreased the extent of corrupti on owing to the reemergence
of mutual veto and deadl ock among competing power centers. While the
dilution of central powers has undoubtedly occurred, however, it would
go too far to say that the postdictatorship period has simply represented
a return t o a pre- 1 972 regime of alternating facti onal i sm. I nstead, the
current system must be understood as bearing the marks of the earlier
pre- Marcos period, the period of dictatorship, and the reactions to both.
It is i mportant to point out that, while its powers have been dimin
ished relative to the dictatorship, the presidency has remained a powerful
office that by and l arge dominates other branches of government . Among
the powers of the presidency that have remained are the i tem or partial
veto and the use of large di scret i onary funds not subj ect to congres
sional appropriation or scrutiny ( contingency. calamity. and intelligence
funds) . Not ably. the presi dent al so wi el ds a powerful i nfl uence over
Congress through bureaucratic discretion over the timing of the release
of funds for proj ects of l ocally elected ofcials. especially the "pork barrel "
of members of t he House of Representati ves . 2 1 I n addi ti on. al though
admi ttedly wi th new restri cti ons, t he presi dent cont i nues t o appoi nt
members of the j udi ci ary and the mil itary.
119
r
Centralization, Political Turnover, and Investment in the Philippines
The scope for executive di screti on in matters of l i censing, bi ddi ng,
granti ng of incentives, and other aspects of regulation also remai ns large.
The enti re l i beral i zati on and deregul ati on agenda between 1 9 8 1 and
1 996, including t he revi si on of tariffs, was accomplished largely through
a successi on of executive orders. 22 In general, the executive's domi na
t i on of the civil servi ce bureaucracy and the mi l i tary provi des i t with
access to information that is simply unavailable to other branches of the
government, especially the l egi sl ature. The nati onal l egi sl ative agenda
i s bui l t around "pri ori ty bi l l s" proposed by the presi dent, whi l e l egi sl a
ti on i ni t i ated by l awmakers themselves has tended t o be l i mi ted and
parochial, 2l What i s more, enacted l aws are ofen sketchy and abstract,
giving wide latitude to executive agencies i n the formulation of " impl e
menti ng rul es and regulat i ons. "
Perhaps t he most telling mani festation of presi denti al dominance i s
its infuence on the pattern of coal i ti on formation i n the legislature. All
the three postdictatorship administrations (Aquino, Ramos, and Estrada)
exerci sed heavy i nfuence over Congress, due t o the i nstabi l ity of party
formations after presi dential el ecti ons . Broad, heterogeneous coal i ti ons
have i nvari ably formed whose decl ared mai n purpose i s t o "support "
the i ncumbent executi ve, prevent executive retal i at i on, and t o ensure
cont i nui ng access of l ocal representatives t o nat i onal l argesse. Whi l e
" t ur ncoat i s m" al so exi s t ed under t he two - part y sys t em i n t he
predi ctatorship peri od, t he current practice i s a more cynical and wide
spread versi on, hel ped along by the hi gher transacti on costs of forming
stable coalitions under the current multiparty system ( see de Di os 1 999a
for a ful l er di scussi on) .
The system under the 1 987 Constitution is in many ways a curious
amalgam of traits from both the premartial law regime and the dictator
ship, the product of a remarkabl e historical evol uti on. From the latter it
retained many elements of centralization, albei t somewhat reduced. From
the former, i t restored the predi ctabi l i ty of t urnover. Each of these i s
meant t o solve a part i cul ar governance pr obl em. In react i on t o the
excesses of the dictatorship, regular turnover is desi gned to address the
probl em of extreme bi as; predi ctabl e consti tuti onal turnovers di scour
age the i ndefi ni t e ext ensi on of power and i ts use agai nst compet i ng
interest groups, which has in the past led to crises owi ng to high confict
potential. On the other hand, the implicit tolerance of greater centralized
power seeks to address the probl em of gri dl ock and the "tragedy of the
commons" that l ead to i ntraregime uncertai nty, an undesirable feature
of the premarti al law regi me.
1 20
Centralization, Political Turnover, and Investment in the Philippines
Whi le each of the features mentioned above is a response to a speci fi c
probl em, thei r j uxtaposi t i on i s not necessarily opti mal . The previ ous
analysi s suggests that central i zati on vi a a strong executive woul d ad
dress the i ssue of i ntraregi me uncertai nty by solvi ng the " commons"
probl em. On t he other hand, when centralizati on is combi ned with fre
quent turnovers, t he probl em of credi bl e commi tment reappears and
creates a probl em of i nterregi me uncertai nty. The large di screti on al
lowed the executive to change pol i ci es-together with observed past use
of that di screti on to favor vested i nterests-makes i t rational for inves
tors to wait out the results of i mpendi ng political contests. The already
documented i mportance of presi denti al el ecti ons i n i nfuenci ng i nvest
ment behavior i s exaggerated by the conti nui ng l arge scope of powers
possessed by the presi dency. The i nst i t ut i onal probl em that recurs is
how the incumbent i n a powerful posi ti on can make a credible commit
ment t o cert ai n pol i ci es, given the possi bil i ty that hi s or her equally
powerful successor may subsequentl y overturn t hese. Not e that the
dificulty of making a bi ndi ng commitment increases all the more with
an increase i n the prerogatives associ ated with the posi ti on. Hence the
paradox that the st ronger a posi t i on i s , the weaker i s the abi l i t y for
i ncumbents to make bi ndi ng commi t ment s. I n pure authori tari an re
gimes, this probl em is suspended, or at least postponed, since term limits
are i ndefi ni te. Where turnover i s prescri bed, however, the probl em re
curs with predi ctabl e regularity.
This framework can elucidate some of the governance factors respon
si bl e for the observed irregular behavi or of i nvestment and economi c
performance i n t he post- Marcos era. During t he Aquino admini strati on,
the revival of investment immediately afer t he fall of t he dictatorship was
associ ated with the resol uti on of the outstandi ng probl em of bi as. The
restoration of confiscated property, the removal of any further threat of
dispossession, and the greater social legitimacy of the Aquino government
( 1 986-1 992) were factors that encouraged the return of investment confi
dence. This was shattered only by the threat of military takeovers i n 1 989
onward, which gave ri se once more to interregime uncertainty. Investment
stability during the Ramos administration ( 1 992-1 998) , on the other hand,
went hand in hand with a consummate use by the executive of the levers
available to i t. In particular, coalition politics in the l egi slature was suc
cessfully managed, underwritten by selective access of lawmakers to cen
tral government resources and rents. Thi s use of pork-barrel politics effec
tively solved the potential problem of gridlock and, when combi ned with
executive di screti on over key reform areas, sustai ned a momentum of
1 21
1 \ .
Centralization, Political Trnover, and Investment in the Philippines
reforms that helped the country achieve a respectable rate of investment
and growth over the peri od.
Neverthel ess, the cruci al tensi on between central i zati on and turn
over was not ent i rel y r es ol ve d. The cl os i ng year s of the Ramos
admi ni strati on were taken up by t he recurrence of i nterregi me uncer
tainty, with a subsequent i mpact on investment. The very success of the
Ramos admi ni st rat i on reforms and t hei r cl os e as s oci at i on with t he
pol i t i cal personal i ti es of t hat admi ni strati on brought up the quest i on
whether they would be conti nued by t he succeedi ng regime. I t i s worth
recal l i ng that many key reforms ( such as tari ff- reform schedul es, de
regulation of interisland passenger shipping, tel ecommunications, power,
and water and sewerage, to name only a few) were impl emented through
executive or admi ni strative orders, all of which coul d, i n pri nci pl e, be
reversed. The threat of reversal appl i es t o l arge proj ect s. Exampl es of
those recently afected by the transition between t he Ramos and Estrada
admi ni strat i ons i ncl ude real est at e deal s ( PEA- Amari ) , i nfrastructure
proj ects ( CBK- I mps a) and equi pment purchases ( Mot orol a deal wi th
the nati onal pol i ce) . Furthermore, as al ready di scussed, the actual or
possi bl e corrupti on attendi ng such transacti ons makes them vulnerabl e
t o del ays , cos t es cal ati ons , or out ri ght cancel l at i on by a succeedi ng
admi nistrati on, al l of which i n turn are factored i nt o future deci si ons.
I n the l ong run, the demonstrabl e soci al cost s ari si ng from such a
situation are bound to raise calls for a reevaluation of the process, if not
the system itself. Qui te apart from the social costs of such a process, a
strong Executive Branch also creates i ncentives for current offceholders
to prol ong thei r terms out of pure sel f- i nterest. The cri ti ci sm of t erm
limits under the current system is summed up in the now- popul ar adage
that "six years i s too short for a good presi dent and too long for a bad
one. " The demand for turnover ari ses from the danger of capture and
consequent bi as, on whi ch account one woul d wi sh for recal l t o be
possi bl e or for term limits to be short. Doing the latter, however, would
compromi se the scope for action and conti nuity of policy i f the offi ce
hol der happened t o be exempl ary.
Implications for Governance Design
Since the el ections of 1 992, pol itical thought and practice have groped,
al bei t i mperfectly, to seek to ameliorate the probl em of successi on and
intertemporal credibil i ty of commitment under the existing system. Chief
among thi s has been the practi ce of the i ncumbent " anoi nt i ng" or of
handpicking the putative successor, as practiced by Coraz6n Aquino, who
1 22
Centralization, Political Trnover, and Investment in the Philippines
endorsed Fi del Ramos as her successor, and also by Ramos who picked
Jose de Veneci a to succeed him. The successi on practice has been far
from perfect, however, having worked only once in two instances (Aquino
being succeeded by Ramos) . Obviously the criteria for "anoi ntment" can
vary and may have little to do with what i s needed to sustain a credible
reform commi tment. Hence, for i nstance, a putative successor may be
sel ect ed mai nl y i n order to prot ect the i ncumbent and hi s associ ated
i nterests against pol i ti cal retal i ati on.
More ambitious attempts to resolve t he successi on i ssue have taken
the form of s eeki ng t o change the rul es t hemsel ves . Thi s was mos t
obvious i n t he i ni ti atives encouraged-if not actually i ni ti ated-by el e
ment s of the Ramos admi ni s t r at i on i n l ate 1 99 7 t o amend t he
Constituti on. The proposed amendments would have allowed t he presi
dent to run for reelection, removing the present constitutional ban. The
reason given by the proponent s of the move was the need to ensure
conti nuity i n pol i ci es. Si nce t he Ramos admi ni stration had been si ngu
l arl y successful i n reviving and sustai ni ng economi c growth, i t was fel t
by some t hat i t should be given a chance to continue i t s pol i ci es rather
than risk change. A variation on this proposal i s the adoption of a l ong
standing proposal to shift to a parliamentary system, whose main meri t
is seen i n the continuity i t al l ows, si nce no statutory term l i mi ts are set
for a pri me mi ni ster. 24 Moves to amend the charter i n 1 997 were aborted
aft er st rong opposi t i on by a cros s - sect i on of the popUl at i on, who re
garded the i ni tiati ves ( not without reason) as s el f- servi ng at t empt s of
politicians to extend their tenure. I t di d not help that, i n an obvious case
of l ogrol l i ng, i . e. , pol i ti cal horse tradi ng, the amendments would al so
have extended the terms of lawmakers who would pass on them. None
theless, term l i mi ts and successi on are deep structural i ssues that refuse
to go away. The admi ni strati on of Presi dent Joseph Estrada decl ared
itself open to the i dea of consti tuti onal change and had created a com
mi ssi on t o recommend amendments for the purpose. The Lower House
of Congress had, i n the meantime, continued to work on a bi l l to declare
Congress a constituent assembly to propose constitutional amendments.
I n both i nstances term l i mi ts were certai n to l oom l arge as an i ssue.
From the viewpoi nt of thi s chapt er's analysi s, recent pol i ti cal de
bates on the i ssue of term l i mi ts i n the Phi l i ppi nes are unfortunatel y
based on pl ausibl e but incomplete premi ses. 2 s Those opposed to changes
in present term l i mi t s vi ew t he probl em as si mpl y one of prevent i ng a
relapse into di ctatorshi p and the risk of extreme bi as that it entai l s. Thi s
is certainly i nadequate, however, si nce i t deni es or mi ni mizes t he prob-
1 23

..
Centralization, Political Turnover, and Investment in the Philippines
lem of instability and credibl e commitment under the current system. At
the very l east, a trade- off between the two must be acknowl edged. On
t he other hand, those who appear correctly to perceive t he probl em of
instabil ity, or what we have called credi bl e commi tment, seek implicitly
t o solve i t not by questi oni ng the i mportance of strong central power,
but i nstead worki ng solely for the suspensi on or extensi on of term l i m
i ts . I n nei ther case i s t he current state of power concentrated i n t he
pres i dency questi oned. By contrast , our framework poi nt s t o st rong
central i zati on i tsel f as an essenti al reason for i nt erregi me uncertai nty
and i nst abi l i ty. The concentrat i on of power i n t he presi dency in t he
Phil ippines i s what makes even predetermined turnovers unsettling and
fraught wi t h uncertai nty. An al ternative proposal t o i nterregime uncer
tai nty, therefore, i s that of weakeni ng presi denti al power. Put another
way, i f presi denti al di screti on and power were much reduced, then the
i ssue of term l i mi ts woul d command much weaker i nterest.
A weakened presidency, to be sure, carries its own consequences. As
already observed, central power emerged also i n response to the "com
mons" probl em. Nonetheless, as against i nsi sti ng on extending term l i m
i ts, reduci ng central power has the advantage of not rai si ng the stakes
of state capture and the risks of extreme bi as. As seen from the resistance
t o the Marcos di ctatorshi p as wel l as the Ramos admi ni stration's fai l ed
attempt to amend the charter, all past efforts to i ncrease central power
and l engthen term l i mi t s have i nvari abl y l ed t o seri ous probl ems of
l egi ti mizati on, provoked deep suspi ci on, and generated massive soci al
opposit i on. It is val i d to ask whether the soci al cost s and goodwill i n
curred i n such efforts can be reasonably recouped by t he putative ben
efi ts of the changes endorsed. I ndeed, i t i s l i kel y that the opposi ti on
provoked by such efforts coul d themselves l ead to the uncertai nty and
i nvestment i nstabi l i ty they had sought to avoi d.
I t i s submi tted here i nst ead t hat credi bl e commi tment to pol i ci es
woul d be best achi eved if i ncumbent s progres si vel y and i rreversi bl y
reduced thei r own scope for di screti onary behavi or, si nce t hat woul d
al so reduce their successors' l eeway for reversi ng such pol i ci es. This i s
one way to understand how privatization and deregulation work in stimu
lating business confi dence; these are commitments to reduce discretion.
cr;
As a corol l ary, a weaker presi dency woul d i mpl y the devol uti on of
more functi ons to other parts of the government, notably the bureau
cracy and l ocal governments. An important reason for pol icy i nstabi l i ty
across regimes is the turnover- related changes in appoi ntment s. Stabi l
i ty of tenure up t o a cert ai n l evel of the government woul d provi de
1 24
Centralization, Political Turnover, and Investment in the Philippines
policy continuity and consi stency, notwithstanding frequent changes i n
admi ni strati on. In t he Phi l i ppi nes t he bureaucracy i s underpai d and
defi ci ent i n trai ni ng and qual i fi cati ons , maki ng i t vul nerabl e both t o
patronage poli ti cs and corrupti on. I t i s common practice i n the country
for wi nni ng candi dates to treat government appointments as spoi l s to
be distributed. While personnel changes i n other countries of the region
extend to two levels, involving those of secretary and undersecretary or
their equival ents, poli ti cal appoi ntees i n the Phi l ippi nes frequently go
down to six levels, affecting positi ons as far as those of regi onal director
and serice director ( World Bank 1 997c, 93) . It is common that upon every
change i n administrati on, new appoi ntees go through a l earning peri od,
while the bureaucracy i tself i s constrai ned to abandon proj ects associ
ated wi th the previ ous admini stration and perforce concoct new ones
more i n keepi ng wi th the tastes of the i ncumbentY Security of tenure,
hi gher pay, and better training woul d go a long way toward i mproving
t he bureaucracy's aut onomy and also ensuri ng pol icy conti nui ty.
Similarly, a frther devolution of central powers to l ocal governments
would reduce the importance of the outcomes of national contests, since
it would remove sole di screti on from nati onal agenci es and vest these
instead to l ocal governments. Local devolution is a process that began in
1 99 1 with the passage of the Local Government Code and may usefully be
carried further. It may be argued, of course, that devolution merely shifts
di screti on from one l evel of the government to another, and that l ocal
tyrants and warlords on their own turf may treat investors more arbitrarily
than a nati onal di ctator woul d. The bi g di ference l i es in that investors
under a decentralized regi me would have choi ces among diferent l oca
ti ons and regi mes, effectively achi evi ng a competi tive regi me. I n such
circumstances, it i s known (again, Shleifer and Vishny 1 993) that rents and
exactions tend to be small, as different l ocal governments compete with
each other for investments. Where authori ty i s redundant or repl i cabl e
(rather than monopolized)
'
corruption rents are minimized, for i f the privi
lege ( e. g. , some l i cense or incentive) cannot be obtained from one l oca
tion, then it may be obtained from another.
This i nsight may be extended to the gl obal setting. To the extent that
a country i s compel l ed to compete for trade and investment on an equal
footi ng with others, there is much l ess room for national authori ti es to
exercise discretion in changing the rules of the game, whether within or
across regi mes, si nce the country must effectively compete wi th others
offeri ng si mi l ar terms. As an upshot , the greater a country's commi t
ments t o gl obal t rade and invest ment rul es, t he l ess the scope for i t s
1 25
Centralization, Political Trnover, and Investment in the Philippines
leaders (no matter how powerful they are internally) to arbitrarily change
these, si nce doing so would mean l osi ng the busi ness. One of the rec
ogni zed benefits of membershi p in such mul ti l ateral organizati ons as
the World Trade Organization ( WTO) , the Association of Southeast Asian
Nati ons (ASEAN) . or Asia Paci fic Economi c Cooperati on (APEC) is that
i t bi nds countri es-regardl ess of changes i n pol i ti cal regi mes-to cer
tain rules and norms of conduct. Though their results are likely to be i n
greater dispute, l oan conditions imposed by the International Monetary
Fund and the World Bank serve the same functi on. As a concrete ex
ample, compatibility with WIO rules has become an i mportant deterrent
t o otherwise resurgent protecti oni sm; attempts to rei mpose nontari ff
measures on some products have been wi thdrawn for bei ng WTO- i n
consistent. I n effect, therefore, governments may choose t o reduce their
di screti onary power by enteri ng into global commi tments; i n this way
they al so bi nd thei r successors, thus ensuri ng pol i cy stabi l i ty.
Finally, even Congress itself could do with some strengthening rela
tive to the presidency. This may seem initially surprising, since folk wis
dom already predicates that Congress has been too intrusive and obstruc
tionist, and sufcient examples exist of shortsighted and inept intervention
on the part of Congress. 28 A proposal to expand these powers relative to
the Executive Branch may only worsen the situati on of overlapping man
dates and gridlock. As argued above, however, the currently observed " ir
responsibility" by other branches of government is more likely part of an
expectational equilibrium, which precludes more rati onal behavior owing
to the assurance that the omnipotent presidency itself will always internal
ize difficulties and repair any damage. The fact that the chief executive
controls budgetary disbursements regardless of what Congress has all o
cated, for instance, makes i t futile for Congress to assume any responsi
bility in the magnitude of expenditures, or in the revenues needed to fi
nance them. It is arguable that the current expectational equilibrium would
change once the other branches of government realized that their choices
al one would deci de fi nal out comes. Hel pi ng this al ong i s a gradually
changing composition of Congress, which now sees an increasing share
of professionals, former civil serants, and new entrepreneurs. 29 Nor is this
experi ence new; it is the same one that compel s more and more local
ofcials to show prudent behavior once central functions and resources
are devolved to them. It is in this sense that we argue that a weaker presi
dency may make for a stronger state.
The demand for a more balanced relati onshi p between the Executive
Branch and the legislature is also consistent with recent game- theor work
1 26
Centralization, Political Turnover, and Investment in the Philippines
on the efects of power concentration and diferentiation, in particular results
obtained by Persson, Roland, and Tabellini ( 1 997) . For these aut hors the
crucial elements for checks and balances are that ( l ) there should be some
adversarial relationship between the executive and the l egi sl ature. and
that ( 2) legislative decision making should require j oint agreement bv both
bodies. Mere separation of powers without the second requi remer;t si m
ply leads to unbri dl ed rent - seeking, which i s analogous to Shl ei fer and
Vishny's i ndependent-monopolists result, where both executi ve and leg
islature seek to draw as much as they can from the "common pool " of
public resources. Superior to this is a more centralized or authori tari an
system (whi ch Persson, Roland, and Tabellini call a "pure presi dent i al "
system without Congress) , si nce then, at l east, the rent - seeki ng is not
competitive and is tempered by t he desire to remain in office. Neverthe
less, it can be shown that even better than a "pure presidenti al " system i s
one where power is separated and checks and balances exist. The present
system in the Philippines is somewhere in between a "pure presidential "
syst em and one wi th genui ne checks and bal ances, al though t he
trivi alization of the legislature and its control by the Executive Branch makes
the current system closer to the former than the l atter. What is certai nly
important in the foregoing, however, is the suggestion that better economi
results may be obtained by taking the design of democratic instituti ons
more seriously, rather than simply abandoning them.
Conclusion
This chapter has argued that Philippine governance i s at a crossroads
in its impact on economic performance. The polity has shi rked from fur
ther costly experi ments with dictatorship and i nsti tuted cl ear r u l es for
turnover and succession, as well as controls on discretionar behavi or. On
the other hand, in recognition of the dangers of policy gridlock and doubl e
marginalizati on, a strong central authority wi t hi n democrati c l i mi t s i s
provided for. Based on the framework developed here, it is clear that such
a halfay house is unlikely to yield spectacular economic resul ts. Hel ativc
to a well - run authoritarian government, the system is li kely to extract mor e
corruption rents and generate greater policy i nstabil i ty among i nvestors.
In addition, policy instability and investment costs across regimes are al so
likely to be greater than those of a "normally functi oni ng" authori tari an
regime, owi ng to the i nfrequency of turnover i n the latter.
Current discussions retlect the perceived tension hetveen a social and
cultural commitment to democratic forms on the one hand and the need
to enhance economic performance on the other. In most national di scus-
1 27
r
Centralization, Political Turnover, and Investment in the Philippines
sions, the latter has been taken to mean a greater enhancement of central
power at the expense of other branches and levels of government, as well
as i ndefinite term l i mi ts for the executive. Not surpri si ngly, these i deas
have been taken to mean an endorsement of authoritariani sm. We have
suggested, however, that the perceived risk of extreme bi as in these or
similar proposal s make any further moves toward authoritarianism non
viable i n t he Philippines . Any such moves would likely l ead to crises of
legitimacy and an intensifcation of interest-based political struggl es, lead
i ng to more erratic private investment behavi or. I nstead, we have sug
gested that the probl ems of i nter- and intraregime uncertainty be deal t
with by reduci ng presi denti al powers and prerogative through a more
determi ned devolution of executive power to the bureaucracy, l ocal gov
ernments, Congress, the courts, and accession to multilateral agreements.
A final word is perhaps in order regarding the country's relative per
formance i n the Asian cri si s. The Phi l i ppi nes has not been as badly af
fected as Thailand or Indonesia, and it may be asked whether the model
presented here can contribute something to an explanation. The technical
reasons for the weaker impact of the Asian crisis are certainly well known,
including the country's smal l er debt- overhang, the shorter run-up to the
crisis, and better supervi si on of financial instituti ons. A more crucial el e
ment that shoul d be taken into account, however, is that the country-in
contrast especially with I ndonesia-did not experi ence a political crisi s.
The obvious difference was that i n t he Philippi nes, unlike i n Indonesi a,
there was a prescribed electoral turnover, which in fact coincided with the
bottom of the crisis in 1 998. The severe impact of the Asian crisis certainly
puts the adequacy and relevance of a country's institutions and system of
entitl ements under scrutiny. It i s an arguable proposi ti on that the crisis
would have affected the Philippines more severely, ceteris paribus, if the
country had conti nued to be under the Marcos dictatorship. As it hap
pened, however, a political crisis was headed off, si nce the country had,
by that time, solved the problem of bias and legitimacy through the insti
tuti on of elections, provi di ng a vent for any popul ar di ssatisfaction.
The framework used here al so suggests that the same institutions that
forestalled a pol itical crisis for the Philippi nes may also prevent it from
recovering rapidly from the crisi s. No changes i n governance in the Phil
ippines have occurred that suggest that it will henceforth be able to grow
at rates shown in the past by high- performing East Asian countries. I nvest
ment costs are likely to remain as high (and therefore investment just as
low) , owing to corruption rents and inter- and intraregime uncertainty. As
a corollary, it mlst be said that the same relative freedom of action on the
1 28
Centralization, Political Turnover, and Investment in the Philippines
part of autoritarian regimes that created the opportunities for large gambles
(like i nvestment i n strategic i ndustri es or di scriminati on i n favor of or
against certain groups) also carried the potential for enormous waste. When
large mistakes were made in the form of sectoral overinvestment or social
and economic discrimination, they laid the basis for social conficts. Cen
tralizati on and indefinite tenure, therefore, created the potential for both
huge successes and colossal mistakes. It i s the Philippines' misfortune ( or
l uck, dependi ng on how one views i t) that it has avoi ded both.
APPENDIX
A MODELAND TEST OF INVSTMENT WITH POLITIC UNCERTANTY
1 . Model. Suppose the price of one unit of investment goods is P
I
' and
the margina unit of investment is expected to generate Q units of output.
Assume that Q is declining in the l evel of investment. For simplicity, let Q
~ Z/ l
b
, where b is a positive parameter and Z represents the factors that
afect the profitability of investment, such as fture national income, ex
pected government policy, terms of trade movements, etc. Suppose inves
tors face an infinite horizon of discrete peri ods. I n each period there is a
probabilit p of l osing the returns on investment due to political factors.
Let the discount rate (excluding political risk) be r and the depreci ation
rate be 8 . The tota expected return to the marginal unit of investment is:
T
( l -p ) Q ( l -8 ) ( l -p J 2 Q
+ ----- --
( l + r)
Q
( l + r)
( 1 8 )
( l -p )
+ . . .
I f 8 i s smal l enough, ( 1 ) may b e approxi mated by
T
( l -p ) Q
( r+p )
( 1 )
( 2 )
I f the i nterest rate i s i, the present val ue o f pl aci ng P
I
i n financi al
markets woul d be iP/ r. In equilibrium, therefore, we must have T iP/r.
Combi ni ng thi s with ( 2) and substi tuti ng for Q yi el ds
r ( l -p )
bl og I l og Z - l og P - l og i + l og -
I
( r-p )
1 29
( 3 )
Centralization, Political Turnover, and Investment in the Philippines
The last term shows investment bei ng inversely related to pol itical
risk. Proxes for the frst term are such variables as expected GDP growth,
expected government policy in response to current budget defici t and
i nfati on, expected bal ance of payments or current account condi ti on,
and expected terms of trade. We do not have the data for i, but omission
of thi s variable should not affect the estimated coeffi ci ent of poli ti cal
risk, since the inclusion of the budget deficit and infation in the model
should control for the i nterest rate.
2. Empirical test. For the investment vari abl e, we take total invest
ment as a percentage of GDP over the per i od 1 9 5 1 to 1 992. We are
unfortunately unable to obtain a sufficiently l ong time seri es of private
investment alone; hence, we resorted to running regressi ons of compo
nent s of i nvest ment ( agai n, as shar es of GDP) . that mi ght cl os el y
approxi mate private i nvest ment . These i ncl ude pri vate constructi on
spendi ng and investment i n durable equi pment. We also tried the sum
of these two as a proxy.
To i sol ate the i mpact on investment of a preel ecti on year dummy,
whi ch was our mai n i nt erest , the fol l owi ng vari abl es were regressed
against total investment or components of i t , as a proporti on of GDP:
government defi ci t, accumul ated current account defi ci ts ( a proxy for
forei gn i ndebtedness) . current account defi ci t l agged one peri od, the
terms of trade, the pri ce of investment goods, and proj ected GDP growth.
Tables 1 and 2 in the text show typical results of regressions for three
investment variables (total investment, private constructi on, and private
constructi on pl us durabl e equi pment) . I nfati on, the i ndex for invest
ment goods pri ces, and predi cted GDP growth are generally significant
with the right signs. I n other regressi ons (not included here) the other
variables also generally have the expected signs, and the regressions are
hi ghly si gnifi cant.
More i mportant for our purposes, the coeffi ci ent of the preelection
year dummy is signifi cant and negative for total investment and private
construction, though not quite so for equipment. (It is signifcant, though,
for private constructi on and durable equi pment taken together. ) Most
time seri es included in the model are AR( l ) . and none has a uni t root.
I ncl udi ng an autoregres s ive term i n the regressi ons i s natural si nce
investment is seri ally correl ated-investment proj ects take time to be
compl et ed and usually span over a few years) . Usi ng the Q- test, the
serial correlation of resi dual s is not si gni fi cant.
1 30
CHAPTER SIX
G
OVRNANCE, RENT - SEEKING, AND PRIVATE
INVESTMENT IN MYSIA
lora K S.
This chapter considers governance, rent- seeking, and private invest
ment i n Mal aysi a from the late col oni al peri od, i . e. , begi nni ng i n the
early 1 950s, and focuses on the peri ods si nce the i ntroructi on of the
New Economic Policy ( NEP) in the early 1 970s and the gradual "retreat"
from i t si nce the mi d - 1 980s. It surveys the i nsti tuti onal evol uti on of
postcol oni al economi c governance i n Mal aysi a and its i mpl i cati ons for
investment and growth, particularly noting the changes under the lead
ershi p of Prime Mini ster Mahathi r Mohamad since the 1 980s. I t then
reassesses how the creation of rents and thei r depl oyment under the
New Economi c Pol i cy ( 1 97 1 - 1 990) and under Mahathi r' s l eadershi p
( l 98 1 -present) have been pri marily ori ented toward i nterethni c redi s
tri buti on, but have al so sought to sustai n i nvestment and growth. I n
particular, it shows how Mahathir's policy reforms have sought to mini
mize the apparent incompatibility between these two obj ectives. Finally,
it consi ders how t hese i nsti tuti ons of rent creati on and rent - seeki ng
affected and conti nue to afect Mal aysia's vulnerability to the East Asian
cri ses si nce mid - 1 997.
The Postwar Economy i n a Nutshell
In the post - Second Worl d War peri od, Mal aysi a experi enced rela
tively rapi d growth, parti cularly during the Korean War boom, the oi l
boom of the 1 970s and the rel ocation of East Asi an industry into South
east Asia and Chi na si nce the l ate 1 980s . Si nce 1 955, the same rul i ng
coal i ti on has been conti nuously i n power at the domi nant federal level.
though the nature and degree of state i nt erventi on and publ i c- sector
1 3 1
I

!;
!
Governance, Rent- Seeking, and Private I nvestment in Malaysia
expansi on had changed consi derably, almos t comi ng ful l ci rcl e by t he
mi d- 1 990s from t he si t uat i on fol l owi ng i ndependence i n 1 957.
Mal aya, and t hen Mal aysi a, achi eved i mpressive growth rat es, con
si derable i nfrastructure devel opment, some economi c diversi fi cati on ( see
fi gure 1 ) i n agri cul ture and i ndustry, i mproved soci al s ervi ces, among
others, after i ndependence and parti cularly duri ng t he 1 960s. Pl anni ng
has al so grown i n s ophi s t i cat i on, i n t erms of i nfor mat i on gatheri ng,
preparati on, and i mpl ementat i on, especi al ly with t he growth of t he publ i c
sector and increasi ng state i nterventi on under the NEP The poli ti cal and
economi c i nterests of the domi nant pol i ti cal i nterests have been largely
refected and furthered by devel opment pol i ci es. Devel opment pol i ci es,
pl an all ocat i ons as wel l as i mpl ement at i on have refl ect ed t he nature,
rol e, and or i entat i on of t he st at e, t he domi nant poli t i cally i nfluenti al
busi ness i nt erest s as wel l as t hei r pol it i cal and economi c pri ori t i es.
Figure 1 GDP Shares by Sector i n Malaysia, 1 960-1 995
1 90 1 95 1 970 1 975 1 980 1 985
_ A:a |ae QV Vaala:|a
1 9
Sev :e
1 95
Aft er i ndependence i n 1 957, and i n part i cul ar from t he 1 960s , t he
Mal aysi an economy diversi fi ed from rubber and t i n, the twi n pi l l ars of
the col oni al economy. Hel ped by favorabl e commodity pri ces and some
eary success in i mpor t - subst i t ut i ng i ndust ri al izati on, t he Mal ayan and
1 32
Governance, Rent- Seeking, and Private I nvestment in Malaysia
then Mal aysi an economy sustai ned hi gh growth with low i nfati on unt i l
t he early 1 970s. The average annual growth rate of the gross domest i c
product ( GDP) i n peni ns ul ar Mal ays i a was 5. 8 per cent duri ng 1 957-
1 970 ( Hao 1 976) , whi l e t he GDP for t he whol e of Mal aysi a rose by an
average of 7. 8 percent per year between 1 9 7 1 and 1 980 despi t e greater
i ns t abi l i ty ( Mal aysi a 1 98 1 ) . Mal aysi a' s economy has grown rapi dl y by
i nt ernati onal st andards, wi th gross domest i c product ( GDP) averagi ng
about 7 percent over t he l ast three decades. After experi enci ng unprec
e de nt e d n egat i ve growt h i n 1 9 8 5 , due t o de fl at i onary pol i c i e s i n
res pons e t o fi scal and debt cri ses a s wel l a s t he col l aps e o f pri ces of
several key commodi ty exports , t he Mal aysi an economy has sust ai ned
rapi d expansi on si nce 1 987. Meanwhi l e, i nfat i on has been brought down
bel ow 5 per cent per annum.
Mal aysi a has experi enced generally favorable external ci rcumstances
al though rubber pri ces decl i ned i n t he 1 960s compared t o t he 1 950s .
Ext er nal c ondi t i ons wer e general l y favor abl e dur i ng t he 1 970s . The
overall bal ance of payments ( for both capi tal and current accounts) was
pos i ti ve t hroughout t he decade, des pi t e an oi l - shock- i nduced r eces
si on i n 1 973-1 974. Duri ng thi s peri od, the pri nci pal export commodi ti es
were rubber, ti n, s aved l ogs, pal m oi l , and petrol eum. Pri mary com
modi t i es account ed for 78 per cent of t ot al exports i n 1 970 and for 71
percent i n 1 980, before decl i ni ng to 55 percent i n 1 985 and 1 5. 9 percent
i n 1 996. Si nce the 1 980s, t he ranki ng of pri mary commodi t i es i n t erms
of cont ri but i on to export eari ngs has been petrol eum and gas, t i mber
( sawed l ogs and sawed ti mber) , pal m oi l , and rubber ( the order mi ght
have been t emporari l y transposed i n except i onal years , e . g. , wi t h t he
col lapse of pal m oi l or petrol eum pri ces) . The export ori entati on of t he
Mal ays i a n e c o nomy s i nc e t he l at e 1 9 60 s has be e n s us t ai ne d by
Mal aysi a' s ne w i ndust ri es that are l argel y expor t - or i ent ed.
Pri mary commodity producti on cont i nued to domi nate t he economy
i n t he early years aft er i ndependence. I n fact , Malays i a ext e n ded i t s
col oni al pr eemi nence i n rubber, t i n, and pepper t o pal m oi l and t r opi
cal hardwoods . Pet rol eum grew from t he mi d- 1 970s , and pet rol e u m
gas as wel l as cocoa product i on became i ncreasi ngl y s i gni fi cant from
the early 1 9805. Agri cul ture's share of GDP has fal l en from 3 1 perc ent
i n 1 970 to 1 percent i n 1 996, whi l e manufact ur i ng' s s hare has r i s en
from 1 2 percent i n 1 970 to 35 percent i n 1 996. Economi c l i beral i zati on
and renewed export - l ed growth from t he mi d- 1 980s have al so accen
tuat ed t he opennes s of Mal aysi a' s economy i n recent years. Whi l e t he
economy has l ong been open, t he rat i o of expor t s to GNP has r i s en
1 33

Governance, Rent- Seeking, and Private Investment in Malaysia
from 43 percent in 1 970 to 60 percent i n 1 985 and 82 percent in 1 996.
Meanwhi l e, t he expor t shar e of pri mary commodi t i es has fal l en from
78 percent i n 1 970 t o 1 6 percent i n 1 996, with manufactures' share ri s
i ng from 12 per cent t o 8 1 per cent over t he same ti me per i od ( Bank
Negara Malaysia Annual Report, March 200 1 ) .
Investment Policies
Mal aysi an economi c devel opment has been shaped by the nature of
the ruling regimes and t hei r respective agendas for nat i onal economi c
devel opment . The col onial peri od i s depi ct ed as one of l ai ssez-faire, al
t hough there i s evi denc e of cons i derabl e bi as i n favor of Bri t i sh
i nvest ment s-agai nst ot her forei gn as well as domesti c ( especi ally Chi
nese) investments-particularly in determining access to that crucial asset
of a col oni al economy built on the production and export of rubber and
ti n, namely, land. All regime policies envisaged or at least implied diferent
sources of and rol es for publ i c as well as private investment, i ncl uding
forei gn di rect investment ( FDI ) . Si nce Mal aya attai ned i ndependence in
1 957, i t seems useful t o di stingui sh three di ferent postcol onial regi mes
wit h di fferent development pri ori ti es as well as attitudes toward private
investments, which in turn afcted the nature and consequences of access
to rents. This outline i s followed by a more extensive review that seeks to
hi ghli ght the signifi cant changes i n t he postcol onial era.
Postcolonial Economic Diversifcation
( Tunku Abdul Rahman, 1 957-1 969)
The conservati ve post col oni al Al l i ance government was concerned
wi th checki ng Bri ti sh capi tal di vest ment i n the face of the uncertainti es
of i ndependence as well as t he ongoi ng "emergency" against the com
muni st - l ed i nsurgency. Aft er i ndependence, l ai ssez- fai re pol i ci es were
st i l l generally pursued wi th some effort s at economi c ( i ncl udi ng agri
cultural and i ndustri al ) diversi fi cati on, greater rural devel opment efforts
and rel at i vel y modest but nonet hel ess growi ng ethni c "affi rmative ac
t i on" pol i ci es i n favor of et hni c Mal ays and ot her i ndi genous peopl es
( Bumi put era) . New i nvest ment i ncent ives were offered to " pi oneer i n
dus t r i es " i n l i ne wi t h t he gover nment ' s " mi l d" i mport - s ubs t i t ut i ng
i ndustri al i zati on, whi ch di d not involve much publ i c sect or i nvestment ,
unl ike the experi ence of " i ntermedi ate" regimes in ot her parts of South
eas t As i a. Var i ous gover nment i nt ervent i ons thus cr eat ed rent s t hat
s erved as i ncent i ves t o at t ract i nvest ment s t hat woul d resul t i n eco
nomi c di ver si fi cat i on.
1 34
Governance, Rent- Seeking, and Private Investment in Malaysia
Growing State Intervention (Razak, 1 969-1 976; Hussein, 1 976-1 981 ;
Mahathir, 1 981 -1 985)
I n the 1 970s, the New Economic Policy (NEP) involved increased state
intervention and public sector expansion (increasingly fnanced by petro
l eum revenues) , especi ally for interethnic redi stributi on. From the mi d-
1 970s, some NEP measures deterred private investment by ethnic Chinese
as wel l as FDI . The NEP thus saw the state capturi ng, all ocati ng, and
depl oying rents for its redistributive goals. Meanwhile, the government's
new export- ori ented i ndustrialization pol i cy, mainly involvi ng new pol i
ci es and incentives ( Le. , access to new rents) attracted FDI . I n the early and
mid- 1 980s, the government- sponsored joint ventures with Japanese frms
to devel op heavy i ndustri es i n the face of decl i ni ng private investment
from the mid- 1 970s. Though the NEP was widely seen as predatory and
excl usi onary of the mai nl y Si no- Mal aysi an busi nesses i n the nati onal
economy, FDI continued to be encouraged-partly for countervailing rea
sons, especial l y for the rel atively i nsul ated, i nternati onally competi tive
export - ori ented enclaves, such as free trade zones ( FTZs) .
Partial Deregulation and New Regulation (Mahathir, 1 986-present)
Ringgit depreciation and partial economi c deregulati on from the mi d-
1 980s were accompani ed by privatizati on, improved official support for
the private sect or ( " Malaysi a I ncorporated" ) , i ncreased investment i n
centives, regressive "supply si de- ori ented" tax reforms and ot her policies
that encouraged private investments. The more attractive busi ness en
vironment, i ncl udi ng a new range of i nvestment i ncenti ves , attract ed
FDI from J apan and ot her East Asi an newly i ndustri al i zi ng countri es
( NI Cs) from the l ate 1 980s as wel l as greater domesti c ( incl uding repa
tri ated) private investments. The government al so sought to accel erate
technol ogi cal devel opment besi des contri buti ng t o the sustai ned eco
nomi c boom of t he l ast decade. Once agai n, a new regime defi ni ng the
condi ti ons for access t o rents (known as i ncentives) has been a cruci al
instrument of industrial pol i cy, as in the two earlier postcolonial peri ods
i dent i fi ed above. Fi gure 2 shows the GDP and per capi ta GDP percent
age changes correspondi ng with t he above peri odi zat i on.
Colonial Heritage
Like so many ot her former col oni es, post col oni al Malaysi an hi s
t ory has been shaped by devel opments of t he col oni al era. The col oni al
aut hori t i es i nt roduced the basi c governance framework wi thi n whi ch
the Malaysi an economy conti nues to functi on. Hence, Mal aysi an eco-
1 35

!
, i
Governance, Rent - Seeking, and Private Investment in Malaysia
Figure 2 Real Per Capita GDP and Annual GDP Growth Rates in Malaysia,
1 960-1 995
RM , J5 :e,
% 0oW|^
^ a:e^ae \c ^ae c:o. ea za| o
-0% 0oW| ^e a, 0
nomi c devel opment has been greatl y shaped by t he i nst i t ut i ons of
governance i mpos ed by Bri t i sh col oni al i sm and t he successor post
col onial state, though t he relationship between economi c transformation
and governance has been qui te di al ecti cal .
Mal aysi a's growth record i n the l ast century has been quite impres
sive. During col oni al times, Mal aya was, by far, Britain's most profitable
col ony, credi ted with provi di ng much of the export earni ngs whi ch fi
nanced Bri ti sh postwar reconstruction. The openness of the Mal aysian
economy-hi gh even by devel opi ng country st andards-has been a
feature of the structural transformation it has undergone, especially since
the British col onial period. Only a few types of industries were allowed
t o devel op by the col oni al authori t i es, who general l y consi dered t he
col oni es as suppl i ers of raw materi al s and i mporters of manufactured
goods. Mos t i ndustri es were set up t hen to reduce transport cost s of
exported or i mported goods , such as for refi ni ng t i n ore and bottl i ng
i mported drinks. Local i ndustries devel oped most when economi c rel a
ti ons with the col oni al powers were weak, e. g. , duri ng the Fi rst Worl d
War, the Great Depressi on, and the Japanese occupat i on.
1 36
Governance, Rent- Seeking, and Private Investment in Mal
.
aysla
Mal aysi a's economi c i nfrastructure, such as railways roads
i
.
' al l f
, POr t s ,
ut lties-so CruCI lor pro table capitalist investment-was generall y
more
devel oped than in most other British col oni es. Such i nfrastructure con-
struction was pai d for by taxes levied on the population by t he col oni al
government. Col onial monopol i es thwarted the devel opment of a strong
l ocal entrepreneurial cl ass produci ng for the domesti c market; instfad,
local businesses found it more proftable to engage in production for export,
commerce, and usur Although the Malaysian economy has changed sig
ni fi cant l y s i nce i ndependence, many di fferences refl ect i ng uneven
development can be traced to the crucial formative decades under col o
ni al rule that shaped the economi c structure. Ethni c differences often
coincided wth class and occupational diferences originating i n the colo
ni al economy. Ethnic Mal ays remai ned l argely marginal to the growing
capi tal i st sector, with the Mal ay elite i ntegrated into the col oni al state
apparatus, and the masses remai ni ng i n the countrysi de as peasant s.
Emerging business opportunities were mainly taken by some of the more
urbanized and commerci ally better connected Chinese.
Postcolonial Economic Diversifcation
The format i on of Mal aysi a in Sept ember 1 963-whi ch i ncl uded
Si ngapore, Sabah and Sarawak-was pus hed through by t he Bri t i sh,
al though Si ngapore seceded i n August 1 965. The Merdeka ( I ndepen
dence) Consti tuti on l argely preserved t he col oni al l egal and admini s
trative framework, especi ally t he protecti on of property rights of British
bus i nes s i nt er es t s . Bes i des pr ovi di ng the framework for a l oo s el y
Wes t mi ns t er - s tyl e parl i ament ary sys t em, i t i ncl uded provi s i ons for
"Mal ay privi l ege" for the purpose of ethni c affi rmative acti on, not only
on the basis of the hi stori cal economi c deprivati on of the communi ty,
but al so because of the Mal ay cl ai m to bei ng an i ndi genous peopl e.
The federal admi ni strative framework devolved authority over l and and
other natural resources to the state government s.
With independence, t he Alliance-a coalition of the political elite from
the three maj or ethnic groups-formaly took over state power and politi
cal j urisdiction over postcolonia Malaya. Not unlike other newly indepen
dent countries, the postcol oni al government embarked upon a program
of economi c devel opment emphasizing economi c diversification and i n
dustrialization. I n preparing for this pol i ti cal transi ti on, the Bri ti sh had
ensured that the radical nationalist and l efti st forces who threatened their
economi c interests were contained, while ethnic elite commi tted to pro
tecting British interests were trained to eventually inherit state power afer
1 37

, i
Governance, Rent-Seeking, and Private Investment in Malaysia
i ndependence i n 1 957. A basi cally probusi ness envi ronment was thus
assured. As a result, the postcolonial government continued to promote
private enterprise, while the economic interests of the former colonial power
were protected and greater foreign investment infows encouraged.
Besi des consol i dati ng col oni al property rights i n the postcol oni al
peri od to forestall capi tal fi ght, whi ch had begun in the l ate col onial
peri od in the ffties, the independent Malayan government extended the
framework for governance to complete the transiti on from colonial sta
tus to nationhood, e. g. , with the establishment of a central bank. Various
rural and regi onal devel opment efforts s ought t o s ecure the cruci al
pol itical support of rural Malays for the multiethnic ruling coaliti on, the
Alli ance. New labor legislation replaced the special regulations created
during the emergency against the communist-l ed insurgency ( Jomo and
Todd 1 994) . New l egi sl ati on and institutions were created to promote
i mport - substituting i ndustrialization.
The Alliance government's policies refected t he interests and politi
cal compromise it embodi ed. Consistent with this compromise, the state
pursued a modest development strategy with minimal state intervention
except to diversif the economy and ensure suitable conditions for rapid
capital accumulati on. The postcol onial government was commi tted to
defending British interests i n Mal aya, which also enabled the predomi
nantly Chi nese l ocal busi nesses to consol i date and strengthen t hei r
positi on. The government al so made some modest attempts to promote
the interests of the still nascent Mal ay business communi ty, while un
dertaking more ambitious rural devel opment programs to consol i date
rural Mal ay el ectoral support.
Government agricultural development policies have been essentially
conservative. The main thrust of rural development efforts involved new
l and devel opment by the Federal Land Development Authority ( Felda) ,
other measures to increase agricultural productivity and rural incomes ,
as well as the provision of rural facilities, such as roads, schools, clinics,
irrigation. Rural development was thus constrai ned by the government's
reluctance to act against pol i ti cally i nfuenti al l anded interests . Mean
while, although bi ased and conservative, postcolonial rural development
eforts contrasted with British colonial negl ect, especially in the prewar
peri od. Ini ti ally, such efforts were aimed at consol i dati ng a pol i ti cally
supportive and loyal Malay yeoman peasantry wi thout drasti c redi s
tributive measures.
Economi c di versi fi cati on efforts to reduce Mal aysi a' s overrel i ance
on ti n and rubber were carri ed out on two mai n front s. Pl antat i ons ,
138
Governance, Rent-Seeking, and Private Investment in Malaysia
i ncl udi ng an i ncreasi ng number of Fel da- s ponsor ed schemes, were
encouraged to grow other crops, particul arly oi l palms. The state al so
encouraged manufacturing by offering i ncentives, providing i nfrastruc
ture and ot her supportive economi c measures. The government al so
encouraged industries to manufacture previ ously i mported goods. Most
of these i mport- substituting industries were subsidiaries of foreign com
pani es, finishing goods produced wi th i mported materials for profitable
sale within the protected domestic market. Many of these industries only
repl aced i mports of fi ni shed goods with semi fi ni shed goods ( e. g. , the
automotive assembly industry) . The technol ogy used, usually originally
developed i n foreign conditions, was typically imported from the parent
company abroad, often generating rel atively little empl oyment.
By the mid- 1 960s, it was qui te clear that i mport- substituting indus
trializati on was slowing down, due to the limited domesti c market, and
generati ng little empl oyment owing to the capi tal - i ntensive nature of
the i ndust ri es as wel l as l i mi t ed l i nkages to the rest of the nat i onal
economy. I n the second hal f of the 1 960s, the government moved to
ward export - ori ent ed i ndustri al i zati on, wi th the establ i shment of the
Federal I ndustri al Devel opment Authority ( now the Malaysi an I ndus
trial Devel opment Authority, or MIDA) .
The I ndustrial Incentives Act was passed in 1 968, ofering a different
set of i ncentives oriented to attracting more l abor- intensive export- ori
ent ed i ndust ri es as compared wi th those of the i mport - substi tuti ng
industries developed under the Pi oneer Industries Ordinance of the pre
vi ous dec ade. Labor l egi sl at i on was amended duri ng t he State of
Emergency ( May 1 969) to help create a n industrial relations climate more
attractive to these new industries by l i mi ti ng trade uni on organization
and activity, and allowing women to work around the clock, i . e. , in shif
work. I n the early 1 970s, the Free Trade Zones Act provi ded the l egi s
l ati on for the devel opment of export - processi ng zones. Together with
other new i ncentives, free- trade zones and other facilities were set up for
this purpose. The new export - ori ented i ndustri es seeking cheap l abor
reduced unemployment as well as wages until the fall in unemployment
pushed wages up once again i n the late 1 970s and early 1 980s.
As et hni c Mal ay demands for i ncr eased efforts to economi cal l y
advance the community mounted in the mi d- 1 960s, new institutions were
set up for thi s purpos e, often in the form of publ i c or state- owned
enterpri ses ( SOEs) . However, the private sector- ori ented devel opment
strategy of the 1 960s largely precluded more direct government parti ci
pati on i n proftable activi ti es, whi ch were l eft to private busi ness interests.
1 39
Governance, Rent- Seeking, and Private I nvestment in Malaysia
Hence, a rel atively low proport i on of publ i c devel opment expendi ture
was al l ocated to commerce and i ndustry throughout the 1 960s. Increased
budgetary all ocati ons for educati on partly refected the i ncreased util i
zation of educational expenditure t o create a Mal ay mi ddl e class as well
as meet i ng the human resource r equi rement s of the rapi dl y growi ng
and moderni zi ng Malaysi an economy.
I ncome di stri buti on in the 1 960s saw a growing gap between urban
and rural resi dent s and growing i nequal i ty between the maj or et hni c
groups, wi t h the Malays fal l i ng furthest behi nd. I ntraethni c economi c
i nequality was at i ts nadi r i n 1 957, but by 1 970 was at i ts peak. Rather
than i ncreasi ng cl ass t ens i ons , t he i nequal i ty was perceived i n raci al
terms, in large part because of the increasing pol i ti cal mobilization along
et hni c l i nes. Hence, Mal ay r esent ment of domi nat i on by capi tal was
expressed primarily against ethni c Chi nese, who compri sed the bul k of
busi nessmen, whi l e non- Mal ay frustrati ons were di rected agai nst t he
Malay- domi nat ed st at e.
Such wi despread et hni c percept i ons resul t ed i n et hnopopul i st op
posi t i on t o t he rul i ng Al l i ance government of t he 1 960s . The general
el ecti on resul ts and "race ri ots" of May 1 969 refected the ethnic di men
s i ons of the new pos t col oni al s oci oeconomi c or der. Meanwhi l e, t he
emergi ng Mal ay mi ddl e cl ass, who enj oyed nomi nal pol i t i cal cont rol
aft er i ndependence, perceived the decl i ne of Bri ti sh economi c hegemony
gi vi ng way t o Chi nese ascendance. They became more assert ive from
t he mi d- 1 960s, est abl i shi ng cl ear pol i t i cal domi nance aft er May 1 969.
Increased State Intervention, 1 970-1 985
Fi rst announced i n 1 970, the New Economi c Policy ( NEP) sought to
create the soci oeconomi c condi ti ons for "nati onal unity" aft er the race
ri ots of May 1 969 through massi ve economic redi stri buti on programs to
achieve its twin prongs of "poverty eradication" and the "restructuring of
soci ety. " The NEP's Out l i ne Perspective Pl an ( OPP) envi saged the i nci
dence of poverty decl i ni ng from 49 percent i n peni nsul ar Mal aysi a i n
1 970 t o 16 percent i n 1 990. " Rest ructuri ng soci ety" basi cally refers to
efforts to achieve i nterethni c parity in occupati ons and corporate wealth
ownershi p. The NEP sought to el i mi nate the i denti fi cati on of race with
economi c functi on, pri marily through ethni cally di fferenti ated fi nanci ng
of, and control l ed access t o, tert iary l evel educati on as well as publ i c
s ect or empl oyment . The OPP al so expect ed to rai se t he Bumi put era
( native Mal ay) share of corporate equi ty from 2. 4 percent i n 1 970 to 30
percent i n 1 990.
1 40
Governance, Rent- Seeking, and Private I nvestment in Malaysia
In the mi d- 1 970s, petroleum producti on-off the East Coast of Pen
i nsul ar Mal ays i a-began provi dent i ally, as oi l pri ces soared from 1 973
onwar ds. The federal goverment qui ckly pushed t hrough t he Pet ro
l eum Devel opment Act of 1 974 to ensure i ts capturi ng the l i on' s share
of oi l rents. Under the Federal Consti tuti on, the state goverment s woul d
have gotten t he l i on's share i nstead. Si nce the early 1 980s, petrol eum gas
producti on-al most excl usively for export to Japan-has offered furt her
pri mary commodi ty earni ngs. Whi l e oi l rent s sust ai ned much of t he
publ i c- s ect or expansi on from the mi d- 1 970s unt i l the earl y 1 980s, t hey
have al so been used to salvage and promot e government- owned enter
pri ses si nce t he mi d - 1 980s. Mal aysi a' s l argest bank i n t he 1 980s, Bank
Bumi putera Mal aysi a, was rescued twice-frst i n the mid- 1 980s after t he
Bumi put era Mal aysi a Fi nance ( BMF) scandal i n Hong Kong, and then
again after the mi d- 1 980s recessi on. The government poured l arge sums
i nto presti ge proj ect s, such as the Daya Bumi proj ect i n the mi d - 1 980s
and bui l di ng the worl d's t al l est bui l di ng, the Kuala Lumpur Ci t y Centre
twin towers, i n the mi d- 1 990s.
Devel opment pol i cy i n t he 1 970s aft er t he decl arat i on of t he NEP
s aw great er s t at e i nt ervent i on i n fi scal r esource al l ocat i on as wel l as
publ i c s ect or ownershi p and control of busi ness enterpri ses. Fr om t he
1 960s, and especi ally i n t he 1 970s, t he state establ i shed a large number
of publi c ent er pr i ses i n al l s ect or s , s omet i mes i n col l abor at i on wi t h
private capi tal . The two mai n types of SOEs are statutory bodi es estab
l i shed by speci al l egi sl ati on, and t hose operati ng as private compani es
registered under the 1 965 Compani es Act. The maj or SOEs owned by the
federal , state, and regi onal authori ti es , i n turn, have many subsi di ari es
and j oi nt ventures .
Publ i c or state- owned enterpri ses were first i ntroduced for t he pur
pose of ethnic affrmative action or posi tive di scrimination from t he earl y
1 950s, and had grown modestly from the mi d- 1 960s and very much faster
i n the 1 970s. From ten in 1 957 and twenty- two in 1 960, the number of SOEs
grew to 1 09 by 1 970, 656 by 1 980 and 1 , 0 1 4 by 1 985, before al most ceasi ng
to grow, except for a few privileged proj ects favored by the Executive Branch.
Si nce the mi d- 1 980s, SOEs have been accused of i ncreasi ng the publ i c
debt and, more generally, of i neffi ci ency; t hei r accumulated l osses have
wasted investment resources, i ncreased the government 's fi nanci al bur
den and sl owed down economi c growth ( Kamal and Zai nal 1 989) . From
the mid- 1 970s, there was a rapi d i ncrease in domesti c and external debt;
very seri ous gaps i n the current account bal ance al so started to emerge
because of decl i ni ng commodi ty export pri ces and weak demand for
1 4 1
Governance, Rent- Seeking, and Private Investment in Malaysia
manufactured exports. Private investments outside of the oil and gas sec
tor were negative ( World Bank 1 983) .
Figure 3 Public Sector Expenditure i n Malaysia, 1 966-1 995
HVV ` ` o^
ct,a^Jlca
BJJJJ
J JO
J O
5J JO
4J O
3J O
2J O
J O
o
_ 0ava`o,1a^l
ct,a^Jlca
_ ct,a^Jlca
as/ ol00
ct,a^Jlca
as/ ol00
BJ/
J/
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5J/
4J/
3J/
2J/
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J /
Meanwhile, the publ i c sector's share of GNP rose from 29. 2 percent
in 1 970 to a peak of 58. 4 percent in 1 98 1 , before falling to 25. 3 percent
in 1 993. I n 1 982, public sector expenditure contributed 4. 8 percent to the
GDP growth of nearly six percent, but since 1 984, its contribution to GDP
growth has declined (see figure 3) . The growth of SOEs from the 1 970s,
especially heavy i ndustri es i n the early 1 980s, had been accompani ed
by declining capital productivity in the economy. The average incremen
tal capital- output ratio ( lCOR) rose from 2-3 in the 1 970s to 5-6 i n the
early 1 980s while the publ i c sector ICOR rose from 6-7 in the 1 970s to
1 5-1 6 in the first half of the 1 980s.
Poor coordi nati on and accountability of the SOE sector were very
evi dent. For i nstance, of more than 900 i denti fi ed SOEs in 1 984, t he
Mi ni stry of Public Enterpri ses coul d only report annual returns for 269
enterpri ses, whi ch recorded an accumul ated loss of RM1 37. 3 mi l l i on
( Supi an 1 988) . Their rapid growth has al so involved generally i neffici ent
state i nterventi on, al most si ngul arly commi tted to i nterethni c weal th
redistribution, ostensibly favoring the poli ti cally dominant, but economi-
142
Governance, Rent- Seeking, and Private Investment in Malaysia
cally deprived, i ndi genous communi ty. In effect, however, such i nter
vent i on has pri mari l y advanced the i nt er est s of s el f- aggrandi zi ng,
pol i ti cally i nfuential rentiers i ncl udi ng some non- Bumi puteras, rather
than genuine entrepreneurs, thus preempting achievement of industrial
pol icy 0 bj ectives .
Mal aysi a experienced a severe economi c recessi on during the mi d-
1 980s due to a manifold combination of economic problems. Worl dwide
i nfuences, such as the gl obal recessi on, tighter internati onal l i qui di ty,
higher real interest rates after the debt crisis from the early 1 980s, lower
primary commodity prices, reduced internati onal demand for manufac
tured expor t s ( es peci al l y el ect r oni cs ) and r educed forei gn pri vat e
i nvest ment i nfows woul d have been di ffi cul t enough. Thes e j oi ned,
however, with an overall decl i ne ( l argely due to predatory pol i ci es di
r ect ed at et hni c Chi nese bus i nes s i nt erest s) i n domes t i c pri vate
i nves t ment and concent rat i on of r emai ni ng pri vate i nves t ment i n
non tradeable sectors (e. g. , property, construction) , poorly chosen public
investments concentrated in heavily protected import-substituting heavy
industries ( some of whi ch also fai l ed on techni cal grounds) , as well as
defationary fscal and monetary pol i ci es beginning i n 1 982 ( except for
the pri me mi ni ster' s pri ority proj ects) .
Duri ng t he 1 980- 1 982 i nt ernat i onal r eces s i on, t he gover nment
adopt ed countercycl i cal budgetary pol i ci es ( i ncreasi ng publ i c s ect or
consumpti on, i nvestment and empl oyment) , whi ch undermi ned gov
er nment fi s c al di s ci pl i ne. Whi l e the gover nment may have
underesti mated the nature and gravity of the recessi on, and therefore
thought it could spend its way out of it, the new Mahathir administration
( from mi d- 1 9 8 l ) probably also hoped to secure a new el ectoral man
date through such generous defi ci t spendi ng. Ri ght after wi nni ng the
April 1 982 general electi on, the government announced an austerity drive,
cutting back publ i c spendi ng and abandoni ng the earl i er effort to i n
crease publ i c sector empl oyment.
Duri ng the mi d- 1 980s, private investments dropped from RM1 3 . 3
bil l i on i n 1 984 t o RM 1 0. 1 billion i n 1 986, before rising again t o RM 1 0. 5
bi l l i on i n 1 987. Per haps more si gni fi cant ly, pri vate i nvest ment as a
percentage of GNP had been declining since the beginning of the 1 980s,
from 19 percent during 1 979-1 984 to 14. 4 percent in 1 987 ( Bank Negara
1 988, 2) . Foreign corporate investment declined by 19 percent from 1 984
to RM1 . 7 billion in 1 985, and RM1 . 4 billion i n both 1 986 and 1 987 ( Bank
Negara 1 988, 1 95) . Meanwhi le, public sector investment was constrai ned
by reduced resource availabi l i ty after the profi gacy of the early 1 980s.
1 43
Governance, Rent-Seeking, and Private Investment in Malaysia
Hi gh l evel s of publ i c s ect or i nves tment coul d o nly be sust ai ned by
borrowi ng externally, yet gl obal i nterest rates were hi gh and such bor
rowi ng woul d have resul t ed i n massive ext ernal debt .
Figure 4 Public Sector Employment as Proportion of Total Employment i n
Mal aysia, 1 970-1 995
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Very i mportant, by the mi d- 1 980s there was growi ng di ssatisfaction
with the government among some of t he more capabl e Bumi put eras ,
bot h in t he publ i c and pri vate sect ors. I n a hi gh- profi l e conference in
1 987, both private- and publ i c- sect or Bumi puteras cri ti ci zed what they
consi dered unfair government i nt erference in the busi ness worl d. By
thi s ti me, l arge Mal ay- control l ed busi ness groups had already emerged
i n the cor porat e s cene, and s ome were cal l i ng for a l es s regul ated
economy. I ndeed, some of them viewed excessive i ntervent i on as hav
i ng sl owed economi c growt h. and hence count er pr oduct ive t o thei r
i nterests ( Khoo 1 992) . I n other words. the government coul d no l onger
even cl ai m an ethni c Malay mandate for i ts rol e in the economy.
After the second Plaza Hotel meeting in New York in 1 985, the Japa
nese yen began to appreciate greatly against other maj or world currencies,
particularly the US dollar. As the value of the currencies of most East Asian
industrializing economies subsequently rose, raising comparative produc
tion- especially labor-costs in the process, the Malaysian ringgit declined,
even agai nst the US dol l ar. The boom throughout Southeast Asia that
1 44

Governance, Rent-Seeking, and Private Investment in Malaysia


followed from the late 1 980s benefted greatly from investments from the
first - ti er East Asi an newly i ndustrializing countri es ( NI Cs) experi enci ng
rising production costs and tightening l abor markets as well as enforcing
stricter envi ronmental restricti ons. Some deregulation of the Malaysian
economy from 1 986 has also been a boon to i nvest ment s, wi th most
busi nesses benefting from, and hence supportive of, such l i beralization.
The turning poi nt for government policy t hus occurred around 1 986.
The maj or pri mary commodity- pri ce col l apse ( i nvolving pal m oi l and
ti n) and the l ow poi nt of the electronics busi ness cycle had occurred the
previous year. After January 1 986, when petroleum fell to its lowest pri ce,
external demand for Malaysian export s, mai nl y pri mary commodi t i es,
began t o recover, al bei t sl owly. The st ruct ural t ransformat i on of t he
Mal aysi an economy has accel erat ed, with the pri mary sect or decl i ni ng
i n relative signifi cance compared to the much more rapi d growth of the
secondary and terti ary sectors.
Acknowl edging the probl ems and limitati ons of the state- l ed heavy
i ndust ri al i zat i on st rategy-oft en dubbed t he second round of i mport
subst i t ut i on-of t he earl y and mi d- 1 980s , t he government s ought t o
encourage pri vat e, i n part i cul ar forei gn, manufact uri ng i nvest ment s,
especially i n mor e technol ogically sophi sti cated, export - ori ented i ndus
tri es, through the enactment of t he Promoti on of I nvest ment s Act i n
1 986. The ti mi ng was perfect , as manufact urers from Nort heast Asi a
( especially Japan. and l ater, Taiwan) rushed to rel ocate t hei r i ndustri es
and t hus take advantage of t he enhanced i ncenti ves . rel ati vel y good
i nfrastructure. and l ax environment al regul ati ons as well as compara
tively l ow producti on costs due to the new exchange rates. I nitially driven
pri marily by such East Asian export- ori ented manufacturing investments.
the Mal aysi an economy recovered si gni fi cantly begi nni ng i n 1 987. and
has mai ntai ned growth rates of over 8 percent per annum si nce 1 988.
The pol icy changes of t he mi d- 1 980s thus appear t o have been suc
cessful . The subsequent economi c turnaround has encouraged the attri
buti on of t he recovery to t he pol i cy changes. However. as t he precedi ng
account suggests, several different devel opments were occurri ng at the
same time, and while al l may well have cont ri but ed to the recovery, i t
s di fficult to disaggregate their respective contributi ons. After all, growth
II most economi es of Southeast Asia seems to have accelerated at around
the same ti me, i . e. , from the l ate 1 980s.
I n 1 990, the twenty-year period of the Outl i ne Perspective Pl an ( OPP)
for Malaysi a's New Economic Policy ( NEP) came t o an end. The ambi
tious NEP targets had been l argely achieved by 1 990. with the greatest
1 45

Governance, Rent- Seeking, and Private Investment in Malaysia
progress pri or to the mi d- 1 980s . Despi te some controversy over the
rel iability and comparability of offi ci al data, reducti on in poverty i nci
dence has been i mpressive, decl i ni ng to 1 7 percent i n 1 990 from 49
percent in 1 970. By 1 990, ethni c proportions in economi c activities and
occupations broadly refected demographi c shares except in agriculture
and government servi ces, whi ch are predominantly Bumi putera, and in
the stil l Chi nese- domi nated whol esal e and retail trade. For eight wel l
remunerated professi onal categori es, the Bumiputera share rose from 6
percent in 1 970 to 25 percent in 1 990, with inertia al one ensuring con
ti nued increases in the Bumiputera share thereafter. Through government
regulation of busi ness opportuni ties and investments as well as prefer
ential policies for Bumiputera businesses, the Bumiputera share of equity
in publicly listed companies rose from l . 5 percent in 1 969 to 1 8 percent
i n 1 983 and 20 percent in 1 990. ( Various observers have advanced per
suasive arguments suggesti ng consi derable offi ci al underesti mati on of
the actual Bumiputera share of corporate wealth. )
Yet despite the consi derable achievement of specifi c opp targets, it
is far from clear whether progress had been made in achieving "national
uni ty, " the NEP's ost ensi bl e purpose, usual l y i nterpreted in terms of
i mproved interethnic relati ons. Relations between Mal ays and Chi nese
were arguably tense in 1 987 due to the political machinations of certain
ambitious government political l eaders. With the economy booming again
by 1 990, ethnic tensi ons had l argely receded. However, regional griev
ances-especi ally i n the states of Sabah, Sarawak, and Kel antan-had
become more pronounced, while ethnic mi nori ti es-both non- Mal ay
Bumi puteras and non- Chi nese non- Bumi puteras-were cl early more
margi nal i zed and al i enated t han ever before.
Confirmati on of the change in policy direction si nce the mid- 1 980s
came with the adopti on of Vi si on 2020, seen to favor growth, modern
izat i on, and i ndustri al i zati on over the NEP's emphasi s on i nterethni c
redi stri buti on. Whi l e forei gn i nvest ors conti nued t o be cout ed, t he
government has al so l i beral ized some condi ti ons for l ocal Chi nese i n
vestments. Chi nese capital has al so been encouraged by vari ous other
reforms , such as easi er access t o l isti ng on the stock market . greater
official encouragement of smal l and medi um industries ( SMI sl . gover
ment efforts t o mitigate t he Industrial Coordination Act of 1 975, as wel l
as the overall emphasi s on market . rat her than regul atory, measures .
More recently, the offi ci al pol i cy of encouraging l ocal fi rms ( especi al l y
large corporations) to invest overseas-where the scope for obstructive
or predatory Mal aysian government intervention is reduced and the pros-
146
Governance, Rent - Seeking, and Private Investment in Malaysia
pects for Mal aysi an government support more l i kely-has been per
ceived as a sign of good faith from t he government that i t is committed
to reduci ng i nterventi on. Average annual GDP growth hovered around
1 1 -l 3 percent i n the peri od 1 988-1 992. Although foreign di rect invest
ment l eveled off by 1 992, i ncreased domesti c investments-i nspi red by
greater domesti c investor confi dence-have sustai ned rapid growt h.
Mahathir's Policy Reforms and the New Business Governance
Soon after Mahathir's ascendance to the pri me mi ni ster' s ofi ce in
mid - 1 98 1 . he announced his "Look East" pol icy. Initially, this pol i cy was
wi del y bel i eved to refer to efforts to emul ate s peci fi c aspect s of the
Japanese and South Korean success i n economi c devel opment , espe
ci al l y i ndustri al i zat i on. These i ncl uded st at e i nterventi on to devel op
heavy industries (Pura 1 985) , state encouragement of t he establishment
of Japanese- style sago shasha trading agenci es ( Chee and Lee 1 985) , ef
forts to get the government bureaucracy to better serve private sector
interests ( Shahari 1 985) and even privatizati on. It was thus seen as i n
volvi ng a fairly wi de- rangi ng seri es of i ni ti atives to become a NI C by
emul ati ng the Japanese and South Korean economi c successes.
Fr om t he mi d- 1 980s, Mahathir t ook great pai ns to defi ne t he Look
East policy more narrowly in terms of a new work ethi c, l abor discipline,
and producti vi ty. Thus, the Look East pol i cy l at er appeared t o be a
campaign to boost worker productivity by inducing hard work and pro
moti ng more effective modes of l abor di sci pli ne associ ated with the
Japanese. Looking East has involved more than abstract exortati ons to
work harder as i s sometimes suggested. The official emphasis on a new
Japanese- style work ethic refers to the offi ci al desi re to i nduce greater
productivity by wage labor in an industrial capitalist context. I n fact. the
real thrust of the campaign appears to be the promotion of labor di s
cipline by reorganizing industrial relations to promote company l oyalty
( e. g. , company welfarism, i n- house uni ons) , increase productivity ( e. g. ,
work ethi c, more i ncentive payments) , and reduce l osses ( e. g. , quality
control circl es, zero- defect groups) .
At the same ti me, the Mahathi r admi ni strati on al so advanced the
" Mal aysi a I ncorporat ed" sl ogan i n an effort to i mprove rel at i ons be
tween the government and the private sector. This was desi gned t o get
the gover nment to ret urn to i ts " t radi t i onal " rol e of s ervi ng private
busi ness i nterests in pl ace of the heavy government regulat i on of the
1 970s and early 1 980s. I n Malaysi a, the sl ogan soon came t o refer to
eforts to curb and recti f "excesses" associ ated wi th overzeal ous i mpl e-
1 47

Governance, Rent- Seeking, and Private Investment in Malaysia


mentation of the NEp especi ally by Malay bureaucratic elements, mainly
resented by Chi nese busi ness i nterests. Later, from the late 1 980s and
especially i n the 1 990s, there have been growi ng si gns of government
support for the private sector, pri marily for pol i ti cal l y wel l - connected
Bumi puteras in the domesti c economy, and al so for non- Bumiputeras.
The growth of SOEs was reversed from mi d- 1 980s as the govern
ment i ncreased moni t ori ng and cont rol over these agenci es. Pol i cy
changes under the Mahathir administration had reversed the previously
growing role of the public sector in the economy except for the expen
sive heavy- industry proj ects he favored. Even the growth of these were
checked in the mi d- 1 980s with the worseni ng economi c cri s es . For
Mahathir, SOEs were only to serve as temporary vehi cl es for creating a
Bumi putera entrepreneuri al community. As Mahathi r consol i dated hi s
posi t i on i n the l ate 1 980s ( after fendi ng off pol i ti cal chal l enges from
ruling party col l eagues fol l owing the economi c di fi cul ti es of the mi d-
1 980s) , privatization increasingly became an important means for spon
soring, supporting, and subsidizing the emergence and consolidation of
new pol i ti cally wel l - connected ( but supposedly more competent) and
predomi nantly, but not excl usively, Mal ay renti ers. Budget constraints
on SOEs tightened slowly and unevenly, while those deemed profitable
or pot entially l ucrative soon became candi dates for privatizati on.
Privati zati on i n Mal aysi a was offi ci al l y announced i n 1 983, aft er
Mahathi r had t aken over as pri me mi ni st er and l aunched hi s heavy
industrialization program through j oint ventures between new SOEs and
private Japanese and South Korean fi rms. Unlike the Look East pol icy
and the Mal aysia Incorporated concept, which were also associated with
Mahathi r's admi ni strat i on and appeared to have faded in si gni fi cance
by the mid- 1 980s, privatization achieved new vi gor from the l ate 1 980s.
I t had the support and encouragement of powerful international agen
ci es, was promoted by Dai m Zainuddin ( appoi nted fi nance mi ni ster i n
mi d- 1 984) , and was viewed as a partial sol uti on to the worseni ng fi scal
and debt probl ems of the mi d- 1 980s ( see EPU 1 985) .
The Mal aysi an gover nment has s ummed up i t s argument s fo r
privatization in the fol l owi ng five poi nts:
Rel i eving the financi al and admini strative burden of the govern
ment i n undert aki ng and mai nt ai ni ng a vast and cons t ant l y
expanding network of servi ces and investments in i nfrastructure
Promoti ng competi ti on, i mproved effi ci ency, and i ncreased pro
ductivity of the servi ces
148
Governance, Rent-Seeking, and Private Investment in Malaysia
Stimulating private entrepreneurship and investment . . . to accel
erate the rate of growth of the economy
Assi sti ng in reducing the si ze and presence of the publ i c sect or,
with its monopolistic tendencies and bureaucratic support, in the
economy
Contributing toward meeting the objectives of the New Economi c
Pol i cy ( NEP) , especially as Bumiputera entrepreneurship and pres
ence have i mproved greatly si nce the early days of the NEP and
are therefore capabl e of taking up their share of the privati zed
servi ces
The offi ci al rati onal e for privatization i n Malaysia has been refuted
on many grounds, and there i s consi derabl e evi dence of abuses i n the
i mpl ementati on of the policy ( Jomo 1 995) . Although privatizati on may
enhance enterpri se effi ci ency to i ncrease profits for the private owners
concerned, such changes will not necessarily advance the public interest
or consumers on the whol e. Since a maj or portion of such activities are
public monopol i es, privatization has largely handed over such monopo
l i es t o pri vate i nt erest s l i kely to use rel ated advant ages t o i ncrease
profitability. Private interests have onl y been interested in proftable or
potenti ally profitable activities and enterpri ses, meani ng that the gov
ernment has been stuck with unproftable and less proftable activities
that will only worsen public sector performance, already considered less
than efficient. Public sector inefficiencies and other problems need to be
overcome, but privati zati on i n Mal aysi a has pri marily enri ched a few
with strong political connecti ons who have secured and seem likely to
secure the most profitable opportuniti es, whi l e public wel fare becomes
i ncreasi ngly vul nerable to the power and i nterests of private busi ness.
Nevertheless, the signifcance of the policy cannot be underestimated.
Perhaps, most i mportant, it signaled the end of the era of public sector
expansion-and possible "crowding out" of private investments. The pol icy
also ofered many l ucrative opportunities for investment as state assets
were di sposed off at handsome discounts or with opportunities to capture
huge rents, thus stimulating private investments and promptly strengthen
ing the Bumiputera commercial and industrial community, or at least those
favored by the Mahathir government. Short-term gains for the government 's
fscal balance were also immediately realized. Consumer welfare l osses
due to increased user charges and the conversion of publ i c into private
monopolies-were partially offset by initial public enthusiasm for improved
services as well as the retreat of the bureaucracy and the public sector.
149
Governance, Rent-Seeking, and Private Investment in Malaysia
Under Mahathir's leadership since 1 98 1 , and especially since the mi d-
1 9 80s, the government has been more expl i ci t i n emphasi zi ng growt h,
modernization, and industrialization as national economic priorities. Due
to the Malay political elite's preoccupation with constraining Chinese wealth
accumulation and the limited entrepreneurial abilities of the nascent Malay
rentiers who emerged under the NEP Malaysia's industrialization strategy
i mi tates Si ngapore-more than Taiwan or South Korea-by relying on
foreign, rather than domestic-led manufacturing growth. At the same time,
si nce 1 986, t he private sector has been given greater opportunity at the
expense of the public sector with privatizati on and some deregulation of
economic investment i n addition to new regulati ons.
On 28 February 1 99 1 , two months afer the end of the OPP period,
Mahathi r i naugurat ed the Mal aysi an Busi ness Counci l ( MBC) with a
speech entitl ed " Mal aysia: The Way Forward. " In his speech Mahathir set
out the national obj ective of achieving "fully devel oped country" status
by the year 2020. The MBC's secretari at is l ocated i n the government
s pons or ed, but nomi nal l y i ndependent , t hi nk tank, t he I nst i t ut e of
Strategic and I nternati onal Studi es ( I SI S) . I SI S is believed to have been
responsi bl e for drafti ng and promoting the speech, whi ch has two di s
ti nct parts, and " Vi si on 2020" as the new nati onal purpose. I n the first
part of the speech, nine " central strategi c chall enges" were i dentifi ed,
with a view t o accelerating industrializati on, growth, and modernization.
In mid- 1 99 1 , the Malaysian government announced its National De
vel opment Pol i cy ( NDP) , wi t h a t en- year Second Out l i ne Perspecti ve
Pl an ( OPP2) for 1 9 9 1 -2000, fol l owed s everal weeks l ater by the Sixth
Malaysia Plan (6MP) for 1 991 -1 995. Hence, while the OPP2 and 6MP are
supposed to provi de a medi um- term economi c pol i cy perspective, Vi
si on 2020 provides the l ong- term obj ectives. And while it is qui te possi bl e
that Visi on 2020, like many other Mahathir policy i nnovati ons, may not
outlast his stay in ofi ce ( and may even recede in significance before hi s
tenure is over) , i t has already succeeded in conformi ng and defining the
policy shi ft away from the narrow ethnic distributi onal obj ectives asso
ci ated with the NEP In 1 99 1 , it represented an explicit ofi cial reiteration
of the policy changes i ntroduced by Mahathi r earl i er in hi s t enure. es
pecially si nce t he mi d- 1 980s .
Visi on 2020 can and has been be i nterpreted as a reformul ati on of
the Rukunegara, or Nati onal I deol ogy, and t he New Economi c Pol i cy
( NEP) , both announced in 1 970. I ts obj ectives are oft en seen as refl ect
i ng t he s econd nat i onal or " s oci al cont ract , " fol l owi ng t he fi rst one
expressed by the Merdeka ( I ndependence) Const i t ut i on as well as the
1 50
T
Governance, Rent- Seeking, and Private I nvestment in Malaysia
vari ous pol i ti cal i nsti tuti ons and arrangement s at the ti me of i ndepen
dence i n 1 957. Mahathir secured a strong endorsement for this third "soci al
contract " with his resoundi ng vict ory in the 1 995 general el ecti on.
While at one level Visi on 2020 represents a reiterati on and reformu
lati on of the Rukunegara and the NEp the apparently minor and subt l e
differences and t he new context are crucial . I ts signifi cance lies primarily
in its timing ( i . e. , right after the end of the OPP peri od)
'
its long-term (three
decade) perspective and the clear s hi ft i n e mphasi s and pri ori ty from
interethnic redistribution t o growth moderni zati on and i ndustrializat i on.
Understandably, there has been some enthusiasm, especi ally among non
Malays, for the speech's explicit commitment to forging a Malaysian nation
( bangsa Malaysia) , transcending existing ethnic identities and loyalties and
consi stent with Mahathi r's 1 989 new UMNO consti tuti on. Whereas the
rhetoric of the Rukunegara and the NEP emphasized national unity-usu
ally interpreted narrowly in terms of achievi ng interethnic economi c parity
between Mal ays and Chi nese-Vi si on 2020 's "devel oped country" goal
i mpl i es a narrower, more materi ali sti c and economi c growth emphasi s.
Thus Visi on 2020 has al so redefi ned t he purpose and rol e of the govern
ment, and consequently sought to transform publ i c- private sector rel a
ti ons. Not surprisingly then, many rel ated pol i cy changes have been ap
preciated by private busi ness i nterests , i ncl udi ng:
a more streaml i ned government bureaucracy, more responsive to
invest ment and growth promot i on ;
restrai nt o n nonfi nanci al publ i c ent erpri se ( NFPE) expansi on:
l ower i nt erest rates ;
a depreciated ringgit for export promoti on, and foreign investment :
new i nvest ment i ncent ives , especi ally wi th t he Promot i on of I n
vestments Act 1 986;
rai si ng of I ndustri al Coordi nat i on Act ( I CA) exempt i on l evel s :
reducti on of real wage costs, greater l abor fexi bi l i ty and avai l abi l
ity of cheap mi grant l abor;
l ess e mphas i s on et hni c redi st ri but i on ( i n fact a sll s pens i on of
NEP requi rements wi t h t he Promot i on of I nvest ment s Act 1 986) ;
bureaucrati c deregul at i on;
pri vati zati on of government ent erpri ses and publ i c proj ect s : a nd
contracti ng out of muni ci pal servi ces to the private secto r.
Vi si on 2020 al so envi sages a more competi tive, market - di s ci pl i n ed ,
outward- l ooki ng, dynami c, rohust, sel f- rel i ant, resi l i ent , di vers i fi ed, bal
anced , adapt ive, t echnol ogi cal l y profi ci ent and ent repreneuri al economy
1 5 1
Governance, Rent- Seeking, and Private Investment in Malaysia
wi th strong i ndustri al l i nkages , product ive and knowl edgeabl e human
resources, l ow i nfati on, exempl ary work ethi cs, and wi th emphasi s on
qual i ty and excel l ence. The MBC speech al so recogni zed vari ous prob
l ems pl agui ng Mal aysi an i ndustri al i zat i on, i ncl udi ng manufact uri ng's
narrow bas e, weak i ndus t ri al l i nkages , i ns i gni fi cant l ocal s uppl y of
i nt ermedi at e pr oduct s, i nadequat e devel opment of i ndi genous t ech
nol ogy, t oo l i ttl e val ue added, ri si ng producti on ( i ncl udi ng l abor) costs,
i nfrastructure bot t l enecks, seri ous short ages of ski l l ed personnel , t he
need for product as wel l as market di versi fi cat i on, probl ems rai sed by
prot ect i oni s m, trade bl ocs , managed t rade, domes t i c pri vat e s ect or
performance, and t he need for agrarian reform as wel l as resource and
envi ronmental prot ecti on.
In some important ways, then, Visi on 2020 represents a partial return
of the pendulum to the relatively pro- private busi ness pol i ci es of the frst
dozen years after i ndependence i n 1 957 i n contrast to the state interven
tion and public sector expansi on of the next decade and a hal f under the
NEP As noted above, Visi on 2020 reiterated the policy changes undertaken
from the mid - 1 980s, i ni ti ally defended as a necessary, but temporary re
sponse to the mid- 1 980s recessi on. Whi le not involving new policy changes,
Vi si on 2020 made the recent economic pol i ci es already i n place more ex
pl i ci t, coherent, and l egi ti mate. Visi on 2020 thus shi ft ed emphasi s away
from i nterethni c di stri buti onal concerns without abandoni ng them al t o
gether. I t al so pri oritized the challenges of l at e i ndustri alization wi thout
seemi ng obl ivi ous t o human welfare consi derati ons.
As t he reforms were staggered over a number of years during the mid-
1 980s, it is difcult and potentially misleading to credi t these reforms wi th
the subsequent improved macroeconomi c performance. Supporters of the
reforms poi nt to a sustai ned economi c boom si nce 1 987 as evi dence of
thei r success. Cri ti cs, however, emphasi ze that the defl ati onary refor ms
exacerbated t he 1 985-1 986 recessi on, while t he subsequent boom has been
pri marily due to massive i ncreases i n foreign investment from East Asi a
and el sewhere as well as restored domesti c private sector investor confi
dence. By the time the Visi on 2020 statement appeared, Mal aysia was wel l
on the road t o economi c recovery, with growth rates of over 8 percent per
annum, in contrast to the negative growth for 1 985.
The Delicate Politics of Changing Governance
Vi si on 2020 symbol i zed i mproved governance, whi ch renewed pr i
vate investor confi dence i n the Mal aysian government and was preceded
by i ndi rect and part i al repudi at i on of t he NEP The NEP had enj oyed
1 52
Governance, Rent- Seeking, and Private Investment in Malaysia
consi derabl e support from the pol i t i cal l y cri ti cal Bumi putera commu
ni t y ( especi al l y ethni c Mal ays) , who were generally seen t o be t he pri
mary benefci ari es of both the poverty reducti on and i nterethni c redi s
tributi on measures associ ated with i t. For non- Bumi puteras who di d not
opt for "exi t " i n the form of emi grati on or capi tal fi ght , the cost s of a
voi ce in the form of pol i ti cal opposi ti on or di ssent have oft en been qui te
high. Yet under the ethni c exclusi onary pol i ci es often associ ated wi th the
NEp " l oyalty" was hardly rewarded except for a sel ect few i n the political
or busi ness elite who were will i ng and able t o successful l y col l aborate
wi th the ethni c Malay elite for thei r mutual beneft. Most others, i ncl ud
i ng poli t i cal l y uninfl uenti al smal l and medi um- s ized busi nessmen, re
l uctantly resi gned themselves to the NEP as a necessary cost of ci ti zen
ship, civil peace, and personal securi ty, i n the aftermath of the traumati c
events of May 1 969.
Not surpri si ngly, therefore, Mahat hi r coul d not si mpl y repl ace t he
NEP with hi s own economi c agenda when he first came t o l ead t he nati on.
The NEP had l ong been the l egi ti mi zi ng i deol ogy for Mal ay hegemony,
on which basi s the rul i ng UMNO had domi nated the count ry si nce the
mi d- 1 950s. Moreover, the expectati ons generated by the promi se of the
NEP coul d not be i gnored, especi ally i f Mahathi r was to retai n poli ti cal
domi nance i n nat i onal and party el ect i ons. For t he sake of cont i nued
l egi ti macy, he needed to formally allow t he NEP to run i ts course unti l
1 990, al though he qui etly announced i ts suspensi on i n early 1 986, ci ti ng
the reces s i on as hi s pret ext for doi ng so. Thi s al so provi ded a decent
i nterval for a transi ti on peri od t hat coul d not be denounced as i l l egi ti
mate as t he NEP was sti l l offi ci al l y i n pl ace.
Nonet hel ess, many of Mahat hi r' s earl y pol i cy i ni t i at i ves fai l ed t o
garner wi des pread s upport . For exampl e, t he Look Eas t pol i cy was
ambi guously received, and event ually faded away. The heavy i ndust r i
al i zat i on pol i cy i s now pri vatel y acknowl edged to have been i l l - co n
cei ved and somet i mes even unfai rly bl amed for the economi c cri si s of
the mi d- 1 980s. The nati onal car proj ect is sti ll touted as a great success
despi te t he heavy protecti on i t sti l l requi res ( and the unl i kel i hood of i t
becomi ng i nt ernat i onal l y compet i t i ve and economi cally vi abl e i n t he
medi um t erm) . Though t he Mal aysi a I ncorporated pol i cy was wel l r e
ceived by Chi nese and forei gn bus i nes s i nt erest s, ot hers were l argel y
i ndi fferent, and the predomi nantly Malay bureaucrats dragged thei r feet ,
probably correctly perceivi ng i t as i mplyi ng thei r resubordi nat i on.
The Executive Branch under Mahathir wrested control of t he govern
ment from the bureaucrats duri ng the 1 980s. B ureaucrat s, who were i o-
1 53

Governance, Rent- Seeking, and Private Investment in Malaysia
creasingly rel i ed upon in the 1 970s, i . e. , the early NEP peri od, thus l ost
much i nfuence under Mahathir who has made much more use of out
si de ( mai nly foreign) consultants as well as "t hi nk t anks" out si de of t he
establi shed bureaucratic structure. Bureaucrats, who had devel oped much
admi ni strative clout under the NEp were being asked to cooperate with
t he very sect or ( t he et hni c Chi nes e- domi nat ed pri vate sect or) , whi ch
they once l orded over.
I ncreased government i nt ervent i on si nce t he 1 970s has al so been
associ ated with greater opportuni ti es for corrupti on and other forms of
abus e, wi t h whi ch the predomi nantl y Mal ay bureaucrat s , pol i t i ci ans,
and pol i t i cally i ntuent i al busi nessmen are associ at ed. There is al so a
strong tendency to associ ate the creati on and di stri buti on of rents with
the NEP, part i cul arly wi th government effort s t o creat e a Bumi put era
commerci al and i ndust ri al communi ty ( BCI C) . I roni cally, whi l e i nt er
et hni c redi st ri but i on efforts-offi ci ally and popul arly t ermed "restruc
turi ng ( society) " i n Mal aysi a-were strongly associ ated with t he expan
si on of t he publ i c sect or i n the 1 9705, they have i ncreasingly been li nked
wi t h privatizati on i n the l ast decade. Hence, al though rents created by
government i ntervent i on have often been captured by non- Bumi puteras,
i ncl udi ng forei gn busi ness i nt erest s, they are sti l l general ly perceived
i n ethni c terms.
On the other hand, growi ng popul ar resentment and frustrati on wi th
the publ i c sector contri buted to popular acceptance of privatizati on, i n
particular si nce empl oyee interests were generally protected i n the maj or
pri vati zati ons . Pri vat i zat i on has generally been reasonably wel l man
aged by t he government t o ensure popul ar part i ci pat i on and enthusi
asm ( mai nly through di spersed and di scounted share i ssues) , although
i ts adverse consequences for consumer welfare and the public i nterest
are i ncreasi ngly recogni zed. I nsofar as privati zati on has been pursued
i n condi ti ons of buoyant growth , some adverse consequences have been
obscur ed whi l e t he pol i cy has cl ai med credi t for the strength of t he
economi c recovery.
By the t i me of the announcement of the new post - 1 990 pol i ci es i n
early 1 99 1 , the post- 1 986 economic recovery had been sustai ned for four
years. Thus, the economi c pol i cy changes of the mi d- 1 980s-i ni tially an
nounced as necessary compromises i n t he face of economi c crises-were
rei t erated and consol i dated as part of broader strategy to bui l d a new
Malaysi a, i . e . . Vision 2020. Wat were once portrayed as unavoidable con
cessi ons to economi c realiti es have si nce been recast as virtuous pol i cies
i n thei r own right .
1 54
Governance, Rent-Seeking, and Private Investment in Malaysia
Governance ad Rents
It i s useful to consi der what good governance really means for private
i nvest ment by consi deri ng t he nat ure and consequences of rent cr e
ati on, di stri but i on, and depl oyment by t he government . The precedi ng
review suggests a combinati on of at l east two di fferent forces at work.
Rents have been created and all ocat ed so as to encourage i nvestments
i n new product ive acti vi ti es, whi ch have accel erated the diversi fi cati on
of the economy from i ts col onial i nheri tance. Much of this has empha
si zed i ndustriali zati on, i nitially on the basi s of i mport substi tuti on, then
xport promoti on, heavy i ndustri al i zat i on, and technol ogi cal upgradi ng
11 the 1 990s. However, constraints to better governance have meant that
he Mal aysi an state has not been capabl e of desi gni ng and effect ively
I mpl ement i ng the kind of sel ecti ve i ndustri al pol i cy pract i ced by the
J apanese and Sout h Korean government s.
The avai l abi l i ty of natural resource rent s has been very si gni fi cant
for growt h, expor t s, government revenue, and hence, fi scal capaci ty,
allowi ng the government greater l ati tude and capaci ty than most other
government s i n t he worl d. Such res ource weal th and Mal aysi a's rel a
ti vel y smal l popul ati on enabl ed t he publ i c sector to grow i n the 1 9705
and early 1 980s with a "soft budget constraint , " which not onl y allowed,
but al so even encouraged vari ous extravagances. Such fiscal " irrespon
si bi l i ty" seemed to i ncrease with greater state i nterventi on ( Bowie 1 99 1 )
and the availabi li ty o f enhanced oi l revenues from the mi d- 1 970s-until
the economi c and pol iti cal crises of the mi d- 1 980s brought about greater
fi scal di sci pl i ne and tighter budget constrai nts for publ i c enterpri ses.
Redi stri buti on, especi ally along i nterethni c l i nes, has been t he other
maj or goal of rent creati on and deployment i n Malaysi a. After increasi ng
Malay bureaucratic hegemony i n the 1 960s, the rol e and i nfuence of t he
predomi nantly Malay civil servi ce were si gni fi cantly enhanced wi t h t he
NEp only to give way to an i ncreasi ngly assertive Executive Branch and
a more pol i ti cally i nfuential renti er busi ness community si nce the 1 980s .
Publ i c sector expansi on under t he NEP was also accompani ed by other
i nterventi ons which had a cumul ative crowdi ng- out effect (with peci fi c
thni c hues)
'
refected i n si gni fi cant capi tal fight and decl i ni ng private
mvest ment s from the mi d- 1 970s, and especi ally i n the early 1 980s .
Si nce t he 1 970s, the all ocat i on of rents by the state has ost ensi bly
been pri marily i ntended to redi stri bute wealth in favor of Bumi put era
and to promot e t he devel opment of Bumi putera capi t ai i st s . Nepot i sm
and pol i t i cal bi as i n favor of croni es of t he same et hni c group are al so
1 55
..
Governance, Rent - Seeking, and Private I nvestment in Malaysia
l i kel y to be perceived as evi dence of ethni c bi as, even though common
ethni ci ty may not have been the main consi derati on for such favoritism.
Such percept i ons of et hni c bi as have not only exacerbated ethni c rel a
t i ons but have al so di scouraged i nvest ment s by t hose who s ee t hem
s el ves as l ess favored or l i kel y t o be di scri mi nat ed agai nst .
However. al though yi el di ng handsome returns, t he busi ness opera
t i ons of those benefi ti ng from state- allocated rents have rarely been " en
t repreneuri al " i n a Schumpet eri an sense. I nst ead, they have been pri
mar i l y der i ved from t he r el at i vel y pr ot ec t ed i mport - s ubs t i t ut i ng
manufacturi ng sect or, servi ces, and other " nontradeabl es, " such as real
property, constructi on, uti l i ti es, domesti c i nfrastructure, and transport .
Ot hers have gained from maj or, oft en compl ex financi al and other cor
porate maneuvers rather t han from significant productivity gains or other
i mprovement s i n terms of i nt ernat i onal competi ti veness.
Hence, i t can be argued t hat t he all ocat i on and appropri at i on of
such rents have not requi red t he enhancement of t he economy's pr o
ductive capabi l i ti es and have. therefore, contri buted l i ttl e t o t he Malay
sian economy. However, i nsofar as these involve strai ghtforward trans
fers. there i s relatively l i ttl e rent di ssi pati on except by i nvestors incurring
addi t i onal transact i on cost s. such as i n trying t o i dentify and perhaps
even hel p fi nance sui tabl e Bumi put era partners. I n any case. NEP " re
st ruct uri ng" was not supposed t o involve "robbi ng Pet er t o pay Paul "
( i . e . . a zero- sum game) . but to redi stri bute new weal th created ( i . e. , a
posi tive sum game. ost ensibl y wi th a "wi n- wi n" i nt eret hni c out come) .
Hence. existing property rights have generally not been vi ol ated. although
redi stri buti on has often been affected by assigning other ( especi ally new)
ri ghts and other cl ai ms to rents along ethni c and "pol itical " ( i . e . . by those
wi th pol i t i cal power and i nfl uence) l i nes . However, s uch i nt eret hni c
redi stri buti on efforts-and the structure of rights thus created-may have
been necessary to ensure the pol i tical and economi c stabi l ity so cruci al
t o i nvestment, growth, and structural change.
The economi c effects of redi stri butive state i nterventi on have. there
fore , generally been qui t e di fferent from t hose necessary to enhance
st ructural change and economi c diversifi cati on. However, they have also
been more vari ed. Redi st ri but i on has i nvol ved rent s bei ng struc t ur ed
and offered by t he government i n vari ous ways to favor certai n demo
graphi c groups or regi ons . Here, one mi ght di st i ngui sh between t hose
di s cri mi nat orv measures t hat enhance t he pr oduct i vi ty of economi c
resources ( e. g, productive educat i on. trai ni ng as wel l as i nfrastructural
i nvest ment s) and t hose that s i mpl y transfer economi c resources. Al so,
1 56
Governance, Rent-Seeking, and Private Investment in Malaysia
one can di sti ngui sh among det ermi nant s of access-between schemes
equally accessi bl e to al l from a favored group, and t hose i nvolvi ng further
compet i ti on, sel ect i on, or all ocat i on pr ocesses, whi ch may encourage
rent - s eeki ng behavi or.
While vi ol ati ng ethni cally bl i nd meri tocrati c pri nci pl es undoubtedly
breeds et hni c frustrati ons and resent ment among t hose who perceive
t hems el ves as di s cri mi nat ed agai ns t , t here is no cl ear evi dence t hat
great er i nvest ment s among t he l es s academi cal l y succes sful are eco
nomi cal ly wast eful , i . e. , that t he soci al rates of ret urn on educat i onal
investments among the l ess educati onally successful are lower than those
for the more successful . especi ally si nce the latter tend to cost more and
al so expect greater remunerati on.
Some redi stributive programs may al so have favorabl e consequences
for productive i nvest ment s, e. g. , the provi si on of credi t without col l at
eral to poor peopl e by the Grameen Bank- like I khti ar scheme has faci l i
tated very product i ve i nvestments refected i n hi gh repayment rates as
well as other posi tive soci al as well as economi c i ndi cators. I t shoul d be
stressed that many redi stri butive i nterventi ons have made contri buti ons
to enhanci ng productivi ty. For exampl e, et hni cal l y bi ased i nvest ment s
i n human- resource devel opment have certai nl y contribut ed t o produc
ti vi ty gai ns , e . g. , by overcomi ng vari ous col oni al , cul t ural , and urban
bi ases, and faci l i tati ng empl oyment i n modern economi c activi ti es char
acteri zed by higher productivity, although i t i s unclear what the overall
economi c effect s of such ethni c bi as have been.
Whi l e si mpl e weal th transfers do not have pos i ti ve cons equences
for product ivi t y enhancement , t hey do seem t o have adverse cons e
quences by di scouragi ng i nvest ment s ot her t han t hos e where t he r e
turns outweigh any anti ci pated wealth transfer ( t o others) . For exampl e.
the I ndustri al Coordi nati on Act ( l eA) requi rement-that pri vate manu
facturing firms beyond a certain size have to ensure that at l east 30 percent
of equi ty i s owned by Bumi put era i nt erest s-has probabl y adversel \'
affected the devel opment of the manufacturi ng sector. Such condi t i ons
must have di scouraged non- Bumi putera i nvestments i n manufact ur i ng
as i nvestors ant i ci pat ed l osses ( e. g. , from di scounted stock transfers t o
Bumi putera partners who mi ght al so eventually demand more) as well
as new ri sks due t o shared ownershi p. It i s l i kel y that such i nvest ors
woul d be l ess ret i cent i n maki ng i nvest ment s i f t hey di d not have to
i ncur such addi ti onal costs and face greater uncertai nty.
Wi thout such i nt ervent i ons. however. it is unl i kel y that Bumi put era
busi ness i nt erest s woul d have made s li ch si gni fi cant i nroads i nt o s ec-
1 57
Governance, Rent- Seeking, and Private I nvestment in Malaysia
tors of the economy l ong domi nated by ethni c Chi nese or forei gners. If
such redi stri buti on has contri buted to the greater pol i ti cal and economi c
securi ty so vi tal to sustai ni ng economi c i nvestment and growt h, i t may
be cons i dered a necessary cost , al t hough there may be ot her, cheaper
means of attai ni ng such stabi l ity. One has to consi der whether thi s was
the cheapest or most economi c opti on availabl e, given the nature of the
pol i t i cal settl ement.
Although the Malay busi ness community has grown rapi dly, with many
el ements appeari ng to have devel oped vari ous degrees of i ndependence
from the state, most retain, cultivate, and ultimately rely on thei r connec
ti ons wi th top UMNO l eaders to secure conti nued patronage whi l e, i n tum,
providi ng fi nanci al and other backing for thei r poli ti cal patrons. Such rentier
activi ti es have had profound i mpl i cati ons for Mal aysi a's poli ti cs and busi
ness, particularly wi th the ascendance of busi ness-based poli ti cal facti ons
within UMNo. For al l si des, poli ti cal and busi ness patronage involving the
state has remai ned the pri mary means to consol i date and enhance busi
ness as wel l as pol i t i cal i nterests ( Gomez and J omo 1 997) .
" Restruct uri ng"-or i nterethni c redi stri but ive i nt erventi ons-seems
to have been most easi ly "captured" and abused, wi t h some unfavorable
consequences for effi ci ency. Such abuse has been faci l i tated by the l i m
i t ed account abi l i ty requi rements requi red by t he government and en
hanced by mi ni mal transparency of the rent al l ocat i on processes ( "ex
ecut ive prerogatives" ) . I t s governance capaci ty i n other regards suggests
that the l ack of transparency and accountabi li ty i s by choi ce, and not just
i ns t i t ut i onal l y i nheri t ed. Thus, whi le some st at e i nt ervent i ons i n t he
economy-and t he rent s t hus creat ed-have enhanced accumul at i on,
economi c di versi fi cati on, and l ate i ndustrializati on, not all i nterventi ons
have cont ri but ed to producti vi ty enhancement.
Whi l e the rat i onal e for most government i nterventi on i n Malaysia i s
os t ens i bl y to promot e devel opment . one can di sti ngui sh i nt ervent i ons
i nt ended t o i nduce growth and structural change from those with redi s
tri buti ve and popul i st pol i ti cal motives. The pol i ti cal l egi ti macy, accept
abi l i ty. and pri ori ty of i nt eret hni c redi s tri butive economi c measures i n
Mal aysi a have been especially i mportant i n shapi ng percepti ons of gov
ernment i nt ervent i on, especi ally al ong ethni c l i nes. Proponents of such
redi stri but i on not onl y emphasize i ts progressive aspects. e. g. , "compen
sati ng for hi storical ( col oni al ) neglect or underdevel opment . " but al so i ts
al l eged soci al l y and pol i t i cally st abi l i zi ng consequences. so cruci al for
sustai ned economi c growt h. Critics emphasize vari ous abuses which have
ari sen, parti cul arl y in the course of impl ementi ng ostensi bly ethni c redi s-
1 58
Governance, Rent-Seeking, and Private Investment in Malaysia
tributive measures; most i mportant, perhaps, the priority given to such
measures has tended to compromise and undermine the efcacy of inter
ventions with other obj ectives as well , e. g. , privatization ( Jomo 1 995) .
It is therefore necessary to distinguish between redistributive mea
sures that also enhance productivity and those that merely involve wealth
transfers. Our earlier review suggests that while considerable rent- seek
i ng has occurred i n Mal aysi a, not al l rents have been di ssi pat ed by
socially unproductive rent- seeking activiti es. Many of the rents created
have actually contributed toward enhancing productive capacity, though
this has generally not occurred very eficiently except for a few notable
exceptions ( e. g. , the efect of the export duty on crude palm oil in induc
ing refi ni ng capaci ty i nves t ment s , whi ch event ual l y pr oved t o be
i nternati onally competitive) .
Thus, somewhat i roni cally, both the NEP's ethni c "restructuri ng"
agenda as wel l as s ubs equent ec onomi c l i beral i zat i on, e s pe c i al l y
privatizati on, have facilitated significant private capture of rents by the
pol i ti cally well - connected, presumably with some sharing of the rents
captured with those all ocating them. Such appropriati on and transfer of
rents may wel l vi ol ate not i ons of fai r ness, i ncl udi ng t hose deemed
desi rabl e for healthy competi ti on, but may not i n themselves be s o
ci ally wasteful s i nce they essenti ally only involve rent transfers. How
ever, i nsofar as expenses may be i ncurred i n efforts to secure such rents
( e. g. , el ect i on campai gn expens es ) , they woul d be l argel y wasteful ,
involving di ssi pati on of the rents created. Their respective proporti ons
woul d be determi ned by the nature of the rent-seeking regi me created
by the i nt ervent i on, and woul d have consi derabl e beari ng-t ogether
with other relevant factors-on the effi ci ency of the new rights created
by the i nterventi on.
The more effective linkage of rent access and capture to the achieve
ment of specific pol icy goals has enhanced effi cacy in the use of rents
as incentives and may, in certai n circumstances, have reduced rent di s
si pat i on. For exampl e, al l owi ng the company t o col l ect t ol l s on t he
privatized North- South Hi ghway as soon as it was built created an i n
centive for t he company to speed up compl eti on of t he hi ghway and
thus be abl e to col l ect more in tol l s.
Meanwhi l e, accumul ati on in the " i nternati onal i zed" s ect ors of the
economy has not been significantly undermined by the magni tude and
nature of these rents, and has instead ensured much of the growth and
dynami sm of the Mal aysi an economy. The conti nued and recentl y en
hanced allocati on of rents i n favor of i ndustrializati on. especi ally of the
1 59
Governance, Rent- Seeking, and Private I nvestment in Malaysia
export - ori ent ed vari ety ( Rasi ah 1 996) , has ensured rapi d growt h, par
t i cul arly i n recent years. However, thi s has been mai nl y under forei gn
control . whi ch rai ses some doubt s about the sust ai nabi l i ty of the pro
cess. Rent s have effectively served as i ncentives for forei gn i nvestors to
relocate export- ori ented producti on in Malaysi a, which has been respon
si bl e for the rapid growth of most such manufacturi ng i n the 1 970s and
again si nce the late 1 980s. Some government policy reforms-i ncl udi ng
more effective i mpl ementati on and enforcement ( e. g. , wi th the introduc
t i on of " one - s t op age nc i e s " ) -have r educed c 1 i ent el i s t pay- oUs to
government offi ci al s and pol i t i ci ans for such fi r ms, whi ch es s ent i al l y
operate within the realm of the global , rather than the nati onal economy.
It needs to be emphasi zed that Mal aysi a has not really experi enced
t he kinds of very pai nful economi c probl ems t hat ot her l es s fortunate
economi es of the South experi enced in the 1 980s. For i nstance, Mal aysi a
has never really suffered from severe capital shortages, and di d not bor
row very heavily from abroad unti l the early 1 980s ( when l i qui di ty was
tighter and real i nterest rates higher) . And unlike some other l ate borrow
ers ( e. g. , India) , its spending-and therefore borrowing binge-came to an
end by the mi d- 1 980s. Malaysia has also had consi derable resource rents
to call upon, and a relatively small popul ati on to di stri bute them to.
Neverthel es s , t he Mal ays i an case suggest s t hat i mproved gover
nance-i n t he for m of par t i al deregul at i on and " i nves t or - fr i endl y"
reregul ati on-has been cri ti cal for t he chi ef execut ive's capacity to qui
et l y abandon NEP- rel at ed pol i ci es des pi t e cons i derabl e s upport and
expect at i ons ( whi ch he effect i vel y di scredi t ed by referri ng t o t hem as
part of a " subs idy ment al i ty" ) . Mahat hi r has effecti vel y used and de
pl oyed t he enhanced resources and powers at t he di sposal of t he Execu
tive Branch to great advantage, bri ngi ng about pari al and sel ective eco
nomi c l i beral i zati on favored by busi ness i nt er es t s , i ncl udi ng fo r ei gn
i nvest ors. Mal aysian goverance has been enhanced by s ome effect i ve
state i nsti tuti ons and capabi l i t i es, aut horitarian powers , abundant eco
nomi c resources ( i ncl udi ng resource rent s ) , and a vi si onary as wel l as
det ermi ned pol i ti cal l eadershi p. Hence, the government has been abl e
to ensur e rapi d growth with a hi gh invest ment rate, and contai n poten
t i al l y destabi l i zi ng contl i ct s, al bei t in t he face of some cri ti ci sm of i t s
abuse of i ts powers ( Crouch 1 992) .
The 1 997 Debacle
Mal aysi a' s , and more gener al l v Sout heas t As i a' s , economi c boom
had been bui l t on renti er i nst i tut i ons. Much of t he retai ned weal th gen-
1 60
Governance, Rent- Seeking, and Private I nvestment in Malaysia
erated had been captured by those i n power and thei r busi ness croni es,
who in turn contri buted to growth by reinvesting much of thei r captured
rents, mai nl y i n the "protected" domesti c economy, e. g. , i n i mport - sub
st i t ut i ng i ndust ri es, commerce, s ervi ces , and pri vat i zed ut i l i t i es and
i nfrastruct ure. Despi te vari ous weaknesses, thi s Southeast Asi an brand
of ersatz capi tal i sm-involving changi ng forms of rentier cronyism-had
sust ai ned rapi d growth for three or four decades.
Interesti ngly, busi ness organizati ons, relati ons, practi ces, and norms
that had previ ously been credi ted with hel pi ng create and sust ai n the
Southeast Asian economi c miracle have si nce been condemned as the
sources of the debacl e. I t al so became fashi onabl e i n some quarters to
suggest that such practices and devel opments had thei r roots i n J apanese
or more generically East Asian cul ture, where norms and relationships that
i nfuence rel at i ons between the state and the private sect or (as well as
among busi nesses) that invariably involve welfare- reduci ng, i f not down
ri ght debil i t at i ng, rent - s eeki ng behavi or. I nsofar as such rel at i ons are
bel ieved to exclude outsi ders, thei r elimination i s bel i eved to contri bute
to leveling the pl aying field and bringing about an i nevitable convergence
toward supposedl y Angl o-Ameri can s tyle arm's - l ength market relati ons.
Once i t was cl ear t hat the regi on' s macroeconomi c i ndi cat ors were
not seri ously awry, and i n the wake of the recent debate on Asi an val ues
and other cul tural , i nsti tuti onal , and behavioral di fferences, many com
mentators i ncreasi ngly invoked Southeast Asi an cronyism and its alleged
consequences as new expl anations for the cri ses. Most such cri ti cs con
demned s ome c ar i cat ur ed i mage of r ent - s e eki ng i n t he r egi on-as
retl ect ed i n vari ous all eged departures from s ome "market fundamen
tal i st " i deal-to expl ai n the cri ses, usually i gnori ng al l t he subtl ety and
nuance of extant analyses of rent - seeking i n the regi on. Thus, Southeast
Asi a's fi nanci al turmoil came to he portrayed as havi ng been i nduced hy
al l eged crony capi tal i sm and rent - s eeki ng i n the regi on.
I t woul d be di ffi cul t , however, to show t hat rent - seeking and cron\"
capital i sm have actually precipitated the crisis or that they can satisfact o
rily expl ai n i ts bases and ori gi ns. As I have argued in t hi s chapt er, t he
arrangements ( or various incarnations of i t ) which have underpinned rent i er
cronyi sm have been part and parcel of rapi d economi c devel opment i n
Malaysia throughout the postwar era. To say t hat such arrangements l ed
t o t he crisis is like saying that the exercise that one has been doing to keep
healthy al l these years i s responsi bl e for a recent heart attack.
What can be s ai d t hough, and I have di s cus s ed t hi s ext ens i vel y
el sewhere, i s that cronyi sm ( and nepot i sm) certai nl y i nfuenced offi ci al
1 61

'

Governance, Rent- Seeking, and Private Investment in Malaysia
policy responses to the cri ses i n Malaysi a ( Jomo 1 998) . More i mportant,
such i nfl uences-real as well as i magi ned-may well have exacerbated
the cri ses and are likely t o continue to undermi ne confdence i n govern
ment effort s, and thus del ay recovery.
There is now l i ttl e seri ous di sagreement that the economi c turmoi l
si nce mid - 1 997 began as currency and liquidity crises. I t i s also i ncreas
i ngly agreed that the cri ses were pri nci pally due t o the undermi ni ng of
previ ous systems of fi nanci al governance due t o deregulati on and other
devel opments associ ated with the growi ng i nfl uence of financi al i nter
ests at both i nternati onal and nati onal l evel s as well as other pressures
for financi al l i beral i zati on and globalizat i on. I t i s now also i ncreasi ngly
acknowledged that the currency and liquidity crises became crises of the
"real economy" mai nl y due t o i nappropri at e government-and I MF
pol i cy responses as the probl ems emerged ( e. g. , Radel et and Sachs 1 998;
J omo 1 998) .
The failure of government to respond adequately and quickly is partly
due to the mismatch between the institutional arrangements in the fnan
ci al sector, e. g. , regul ati ons and the capacity t o i mpl ement and moni tor
performance of banks, and the demands of financi al l i beralizat i on and
globalizati on ( Jomo 1 998) . I t has also been due, however, to the i nsti tu
ti onal inertia of renti er cronyi sm as evidenced by the reticence of govern
ment t o cl ose badly performi ng corporat i ons and cut support for t he
politically infuential ( Gomez and Jomo 1 999) -both of which would have
given the internati onal financial community more confi dence in the will
i ngness and abi li ty of the government to stop the hemorrhage.
1 62
CHAPTER SEVEN
GOVERNANCE AND GROWH IN THILAND
Al len Hicken
Like the other countri es i n this study, Thailand has experi enced rapid
economi c growth and l arge- scal e forei gn di rect i nvest ment ( FDI ) for
much of the l ast two decades. I n fact , between 1 986 and 1 990, Thailand
had the fast est growi ng economy i n the world ( Warr and Bhanupong
1 996) . However, t hi s peri od of i mpressive performance i s bracket ed on
one si de by seri ous economi c probl ems of t he early- mi d- 1 980s and by
the economi c deteri orati on and eventually cri si s of the mi d- l ate - 1 990s.
What expl ai ns t he varying fortunes of t he Thai economy? Certainly, some
of t he expl anati ons can be traced t o factors compl etely outsi de of Thai
land. The oil shocks of t he 1 970s, combi ned with the gl obal recessi on
during the first hal f of the 1 980s, brought tremendous strain t o bear on
the Thai economy. The depreci ati on of the dol l ar relative t o other cur
renci es and a food of FDI from northeast Asia i n the middle of the l ate
1 980s provi ded the fuel for the economi c boom. Fi nally, t he appreci a
ti on of t he dol l ar, combi ned wi th greater competi t i on for bot h foreign
investment and export market s, had negative effects on Thail and's eco
nomi c performance i n t he mi ddl e of the l at e 1 990s.
However, i nt er nat i o nal e c onomi c fac t ors do not ful l y exp l a i n
Thailand's economi c performance over t i me. Policy makers can respond
to changes i n the i nternati onal economi c environment i n a vari ety of
ways-some of which are conducive to investment and growth and some
of which are not . I n the Thai case, the economi c adj ustments i ni ti ated
duri ng t he early part of t he mi d- 1 980s paved t he way for t he subs e
quent hi gh growth, while the fai lure of t he government t o adj ust duri ng
the 1 990s cont ri buted t o t he det eri orat i on and event ual crash of the
1 63

Governance and Growth in Thailand


e c onomy. Thi s chapt er foc us es on expl ai ni ng t he di ffer ence in t he
gover nment ' s pol i cy res pons e dur i ng t hese per i ods . Cons i st ent wi t h
thi s vol ume' s t heme I emphasi ze the l i nk between governance, i nvest
ment , and growth and demonstrate t hat t he quali ty of governance i n
Thai l and has decl i ned s i nce t he l ate 1 980s wi th predi ctabl e effect s on
economi c performance.
The chapter i s organi zed as fol l ows: I fi rst bri efly revi ew the mac
roeconomi c shocks of the 1 970s and early 1 9805, t hei r effect on t he Thai
economy and goverment 's response t o t hese shocks. [ then turn my
attenti on t o t he l i nk between a country's pol i ti cal structure and t he quali ty
of governance, argui ng that given Thail and's pol i ti cal structure, the "good
governance" i n the early part of t he mi d - 1 980s shoul d be viewed as the
excepti on rather than the rul e. I expl ai n how Thai land was able to over
come some of the weaknesses inherent i n i ts pol i ti cal system duri ng thi s
peri od and thus l ay the foundati on for the l ater economi c boom. Fi nally,
I di s cus s how t he qual i t y of governance was under mi ned i n t he l at e
1 980s and 1 990s and how t hi s had affect ed pr os pect s for growth and
i nvest ment .
External Shocks and Macroeconomic Adj ustment
As the Thai economy ent ered the 1 980s i t was struggl i ng to adj ust
to the same external shocks besi egi ng much of the devel opi ng worl d at
the t i me. The two oi l shocks in the 1 970s caused a severe deteri orati on
i n Thai l and's t erms of trade. Rather than undert aki ng pai nful adj us t
ment , Thai l and chose to borrow i nt ernat i onal l y. ] I ni t i al l y t hi s strateg\'
was attract ive gi ven t he l ower i nternati onal i nterest rat es. However, a
i nterest rates began to cl i mb i n t he l at e 1 970s and early 1 980s i t becamc
cl ear t hat borrowi ng i nt erat i onal l y coul d no l onger serve as a s ubst i
tute for economi c adj ust ment . [ n the meanti me, Thai l and had bui l t up
a substanti al debt burden. Yet even as the debt burden was growi ng, t h e
gove rmen t ' s abi l i ty to s er vi ce t hi s debt was becomi ng pr obl ema t i c .
Nat i onal s av i ngs had decl i ned s har pl y i n t he ear l y 1 980s a n d ex por t
c ompet i t i venes s was growi ng weaker. The bal anc e of pavment s an d
publ i c sect or defi ci t s were l arge and cl earl y uns us t ai n abl e ( Warr and
Bhanupong 1 996) .
To summari ze, as t he economy ent ered t he early par t of the mi d -
1 980s, maj or structural adj ustments and economi c reforms were requi red
i n order to keep the pr obl ems from degener at i ng i nt o a cri s i s . Maj or
l enders, i ncl udi ng t he Worl d Bank and t he I ME vi ewed t he eCOnOll1\
wi th growi ng al arm ( Doner and Anek 1 994) , The gover nment of Prem
1 64

Governance and Growth in Thailand


Ti ns ul anonda r esponded by i mpl ement i ng cost l y but needed pol i cy
reforms i n several areas , " For exampl e , i n the early 1 980s i nt erest rates
were rai sed i n order to produce a posi t i ve real i nt erest rate and sl ow
capi tal fi ght. The baht was al so deval ued, fi rst i n 1 98 1 and t hen agai n
i n 1 984. Forei gn borrowi ng was curtai l ed and the Bank of Thai l and was
given greater power over the fi nanci al sect or. In 1 983 a pol i cy t o l i mi t
cr edi t was i nt roduced and chi t fund credi t compani es were outl awed.
Government s pendi ng was al s o sl ashed and several l arge- s cal e i nfra
structure proj ects were scrapped or scal ed back. Fi nally, macroeconomi c
pol icy making was central i zed under the di rect i on and prot ect i on of Prem
( more on t hi s poi nt bel ow) ,
Although these pol icy responses by Prem's government were at ti mes
bel ated and rel uctant ( WaIT and Bhanupong 1 996, 2(9) the needed re
forms were carried out. [ n fact, reforms were implemented even i n t he face
of strong opposi t i on from pol i t i cal part i es, busi ness groups , and most
signifi cantly, t he mi l i tary. As a result of t hese reforms t he macroeconomy
was stabilized. By 1 985 the current account defi ci t had been reduced from
7. 3 percent of GDP ( gross domest i c product) i n 1 981 to 4 percent . The
depreciation of the dol l ar (to whi ch the baht was pegged) relat ive to other
currenci es after the 1 985 Plaza Accord further strengthened Thailand's terms
of trade and led to a current account surplus i n 1 986 ( see tabl e next page) .
The budget defi ci t was also brought dov1 from 4. 7 percent of GDP in 1 982
to 1 . 1 percent i n 1 987, and fi nally to a surpl us of 1 . 7 percent i n 1 988.
The frui t of the structural adj ust ment under Prem was a st abl e and
restructured macroeconomy. Thi s pl aced Thai l and i n a posi t i on to take
advantage of the food of i nvestment from Northeast Asi a duri ng the l ate
1 980s. As compani es in J apan, Taiwan, and Hong Kong sought to move
more producti on offshore i n response to currency appreci ati on and ri si ng
labor costs, Thai land's sound macroeconomy made it an attractive choi ce
for i nvest ors. Between 1 987 and 1 988 total forei gn di rect invest ment i n
Thai l and more than tripl ed; FDI from Northeast Asi a i ncreased more than
fourfol d. Ttal and Northeast Asi an FDI doubl ed agai n between 1 988 and
1 990. Thi s Dood of i nvestment hel ped fuel the boom i n the broader econom\'
over the same period ( see table next pagel .
Thai l and' s responses to t he economi c chal l enges of the earl y- and
mi d- 1 980s , and t he growth t hes e responses made possi bl e, ar e i mpr es
si ve on t hei r own mer i t . J {owever, they are even more i mpressi ve when
one cons i ders the pol i t i cal st ruct ure wi t hi n wh i ch Thai pol i cy makers
typi cal l y operate, As descri bed bel ow, Thai l and's pol i t i cal st ruct ure oft en
makes " good gover nance" a di ffi cul t goal to achi eve,
1 65

Governance and Growth in Thailand


000owt^ 0' '^1alo^Hala Cca^l/cc^l BcJgalSc` cs
/} ' ` o^so l JS$} 00Ja1aloj Ba` a^ca/ol00Pj /ol00Pj
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SOURC: World Delle/opmell l Indicators 1 999 (CD- ROM) .
Political Structure and Governance
The quality of governance in Thailand, or any other political system,
is in part a refection of two factors: frst, the incentives policy makers face,
and second, their capabilities to pursue their preferred policies (Cox and
McCubbins 2001 ) . 1 The incentives and capabilities politicians have in order
to pursue policies that ( 1 ) bring long-term benefts at short- term costs, or
(2) benefit society as a whol e, but impose concentrated costs on small ,
powerfl groups, are important determinants of the quality of governance
in any country. For purposes of this chapter I label these long-term, broadly
beneficial types of policies as "national policies. "4 Examples include such
policies as lower tarifs, prudential regulation, and education reform.
Governance I ncentives
Political actors in all systems face choices regarding the types of poli
ci es they will pursue and to which interests they will respond. Certain
1 66

Governance and Growth in Thailand


features of the political system, particularly the electoral rules and party
system, generate incentives that shape how these choices are made. Cer
tain el ectoral rul es, for instance, provide i ncentives for candi dates and
voters to place a relatively high value on party label while others encour
age candidate- centered campaigning. " The party system, too, affects the
value of party label. Where the party system is made up of political parties
with established el ectoral histori es, cl ear policy posi tions, and i nternal
cohesion, then party labels will tend to carry weight with voters and can
didates. If, on the other hand, parties come and go from election to election,
candidates switch parties frequently, and parties are riddled by factional
probl ems, then the value of party labels is undermined.
Wen party labels are weak, candidates must rely on building up their
personal reputati ons and personal networks of support i n order to be
elected. This provides strong incentives for candidates t o direct benefts
(e. g. , pork barrel fnds and patronage) toward their narrow constituencies.
As individual candidates they cannot credibly claim credit for the provi
si on of nati onal goods and pol i ci es, nor can they gain much el ectoral
advantage by claiming to be a member of a party that delivered national
pol i ci es, especi ally when coal ition governments are the norm. However,
they can claim credit for particularistic goods and servces targeted to their
specifc constituents and supporters. Indeed, their electoral fates depend
primarily upon their ability to deliver targeted benefts to narrow constitu
encies rather than more general benefits to broader constituenci es. Thai
politicians are not unique in their focus on narrow constituencies. There
is an extensive literature on the way the electoral and party systems shape
the size of a politician's constituency in countries as diverse as Japan, Italy,
Taiwan and Brazil (see, for example, Reed 1 994; Cox and Thies 1 998; Carey
and Shugart 1 995; Lij phart 1 994; and Katz 1 986) .
Whether or not the parties that make up the party system are na
ti onal parties also afects political actors' incentives. Parti es that have a
nati onwi de basi s of support are generally more l ikel y to pursue " na
tional " pol i ci es benefiting a large segment of soci ety-than are parties
with smaller bases of support, such as regionally based parti es, or singl e
i ssue parti es ( Mainwaring and Scul ly 1 995) . " The extent to whi ch the
party system is composed of nati onal parties also bears directly on the
capabil ity of policy makers to govern, the subject of the next secti on.
Governance Capability
The road to hel l is paved wi th good i nt ent i ons. Even wi th the best
of incentives, poli cy makers may sti l l fai l to enact much needed pol i ci es.
1 67
Governance and Growth in Thailand
For "good governance" t o exi st , pol i ti cal actors must have not onl y t he
i ncent ives t o pass nat i onal pol i ci es, but al so t he capabi l i ty to do s o.
Capabi l i t y i s l argel y a funct i on of t he number of vet o pl ayers i n t he
system-the larger t he number of veto pl ayers, t he more diffi cul t i t will
be for a government to act in a deci sive manner ( Tsebel i s 1 995, Cox and
McCubbi ns 200 l ) .
I t i s i mportant t o di st i ngui sh between i nst i t ut i onal veto poi nts and
veto pl ayers . I nsti tuti onal veto poi nts are t be poi nts i n the pol icy- mak
ing process where att empt s t o change ol d pol i ci es or adopt new ones
can be overturned. Veto players are those actors, col l ective or i ndi vi dual ,
that si t at the vari ous veto poi nts. The number of veto points i s a func
ti on of a country's consti tuti onal structure. I s t here a separati on of powers
between di fferent branches or l evel s of government ? The number of
vet o pl ayers is l argel y a funct i on of the party system-the number of
political parties and thei r cohesi on. The party system, i n turn, i s shaped
by the el ectoral system al ong with el ements of the nati onal i nsti tuti onal
structure ( Hi cken 1 999) .
A system mi ght have only one i nsti tuti onal veto point ( e. g. , a unitary.
uni cameral parli amentary system without an i ndependent j udi ci ary) yet
because of a multiparty system. have coalition governments. Thus . while
such a syst em would have onl y one i nst i t uti onal veto poi nt , it woul d
have more than one veto pl ayer. Agai n, the greater the number of veto
pl ayers . the less deci sive a government i s expected to be. ceteris paribus.
Si mi l arly, a system with mUl ti pl e veto poi nts ( e. g. , a presi dential system)
mi ght st i ll be deci si ve i f one strong party control s all t he veto poi nt s . '
Governance Incentives and Capabilities i n Thailand
Both the i ncent i ves to provide nat i onal pol i cy and the capabi l i t y t o
do s o ar e somewhat l acki ng i n t he Thai pol i t i cal syst em as i t exi st ed
pr i or t o t he new Cons t i t ut i on of 1 99 7 . Thai l and i s a cons t i t ut i on a l
monarchy and a uni tary, as opposed to federal . st at e. The ki ng is t il e
head of state and t he pri me mi ni st er heads the government . Thai l and
i s a parl i amentary syst em with t he Nati onal Assembly di vi ded i nt o t wo
bodi es: the House of Representati ves and the Senat e. The Senat e dues
not have veto power ( e. g . . i t can onl y del ay l egi sl at i on) a nd, unt i l t he
1 997 Const i t ut i on. was an appoi nt ed body. " To summari ze, Thai l a nd ' s
pol i ti cal system is characterized by a singl e i nst i tut i onal vct o poi nt . There
is no formal separation of powers between t he Executi ve and l . egi s l at i ve
branches as is the case i n the Phi l ippi nes o Korea; nei t her do Thai l ocal
government s exerci se si gni fi cant power ( Nel son 1 998) .
1 68
Governance and Growth in Thailand
On the ot her hand. the Thai party syst em produces mul t i pl e vet o
pl ayers . The el ect oral rul es ( part i cul arl y two- and t hree- member di s
tri cts) , combi ned with t he weakness of Thai pol i t i cal parti es , produce
mul t i pl e parti es at t he di stri ct and nati onal levels ( Hicken 1 998, 1 999) . "
The resul t is numerous parti es in parl i ament and coal i ti on government
( see table below) . In addition, virtually every party consists of two or more
facti ons i n competition wi th one another. The large number of parti es i n
the Cabi net , combi ned with the fact i onal di vi si ons withi n nearl y every
party, means that a l arge number of actors are typi cal ly i nvolved i n the
pol i cy- maki ng process ( mul ti pl e veto pl ayers) . This has an obvi ous i m
pact on t he capabi l i ty of the government to produce nati onal pol i ci es.
\a1eof a| e ^a a1e^|
\a1eof a1 e ^Ca ^e|
9%
4
4
9B
5

992

5
995

SOlJ R(S: Ecol l oll isl inteiligent Ull il COl / ll tl}' Report: Thai lund ( vari oll s years ) ; report of the
El ect i on to t he House of Representati ves ( vari ols years) , El ect i on Di vi si on. Department of Local
Admi ni strati on, Interi or Mi ni stry.
Thai pol i t i ci ans al so general l y l ack st r ong i ncent i ves t o pr oduce
nat i onal pol i ci es. Thai parti es have general l y fai l ed to l i nk acros s di s
t r i ct s t o form l ar ge nat i onal par t i es and i nst ead r emai n l oc al l y or
regi onal l y bas ed. As a resul t , a party's const i t uency i s s omet hi ng l e s s
than a national consti tuency.
I
I } In addi ti on, the consensus of virtually al l
students of Thai pol i ti cs as well as Thai pol i ti ci ans and party leaders is
that party l abel s are weak. I I Candi dates tend to rel y on personal vot e
get t i ng strategi es when campai gni ng, rather t han campai gni ng on t he
reputati on or pol i cy posi t i on of t he party. Gi ven thi s, we woul d expect
most Thai pol i ti ci ans to be more concerned with channeling benefi ts t o
thei r supporters than with the conduct of nati onal pol i cy. These support
ers can i ncl ude both the voters in a politician's el ectoral district and any
groups or individuals that hel p fi nance campaigning ( busi ness i nterest s.
pol i t i cal patrons , among ot hers) .
To summari ze, Thai pol i ti ci ans l acked strong i ncentives to consi der
i nterests beyond t hose of t hei r l ocal consti tuency and supporters, at l east
pri or to t he new Consti t ut i on. However, even i f some pol i t i ci ans had
such i ncenti ves , pol i cy maki ng woul d remai n di ffi cul t gi ven t he l arge
number of veto pl ayers i n t he Thai pol i ti cal syst em. The expect ati on,
1 69
Governance and Growth in Thailand
then, is that Thailand shoul d have had dificulty del ivering the types of
nati onal poli ci es conducive to l ong- term growth and i nvestment ( e. g. ,
macroeconomic stability, infrastructure, education and training, pruden
tial regulati on) .
The puzzle then is given the pol itical structure j ust descri bed, how
is it that Thailand was able to enj oy such high levels of foreign invest
ment and economi c growth. How does one explain the apparent confict
between expectati ons and outcomes? Relatedly, how does one expl ai n
the deteri orati on of the economy i n the mi ddl e part of the late- 1 990s
after years of strong performance? I n the next section I provide a partial
answer to these questi ons by l ooki ng at ( 1 ) the i nformal i nsti tuti onal
arrangements adopted by the Thai government to overcome some of
the governance probl ems i nherent in the pol i ti cal system, and ( 2) the
erosi on of those i nformal arrangements over ti me.
Prem, Parties, and the Policy- Patronage Compromise
One way pol i cy makers can combat governance probl ems i s by
creating new formal institutions. 1 2 Independent central banks, currency
boards, and i ndependent regul atory agenci es are exampl es of i nsti tu
ti onal tool s created to hel p ensure that policy making and i mpl emen
tation are ti mel y and free from i nterference by pol i ti ci ans and speci al
i nt erest s. I n Thai l and, however, the pri mary sol ut i on to governance
problems during most of the 1 980s came in the guise of informal, though
si gni fi cant, instituti onal arrangements. Speci fi cal ly, a compromi se was
struck between Prime Minister Prem Tinsulanonda and party politicians.
I l abel thi s compromi se the "policy-patronage compromi se. " I will fi rst
di scuss the unique position of Prime Minister Prem, hi s incentives and
capabil i ti es rel ative to most of the prime mi ni sters that followed hi m.
and then turn my attenti on t o the compromi se itself.
Prime Minister Prem Tinsulanonda
Prem became prime minister in 1 980 until 1 988. He was not. how
eve r, an el ect ed member of parl i ament . Dur i ng t hi s per i od, whi ch
Chai - anan Samudavanij a ( 1 989) cal l s "semi democracy, " Thai gover n
ments came t o power via competi tive el ecti ons. Whi l e el ecti ons were
held, the leaders of the various political parties were unable to reach an
agreement over who among them shoul d be the premi er. The heads of
the pol i ti cal parti es al so real i zed that mi l i tary s upport remai ned an
i ndi spensabl e condition for stable government. And so they asked Gen.
Prem Tinsulanonda, commander of the army, to head the government
1 70
Governance and Growth in Thailand
as pri me mi ni st er. 1 3 With hi s mi l i t ary background Prem enj oyed the
support of i mportant facti ons within the mi l i tary. He al so enj oyed the
backing of the king.
As he was not a pol i ti ci an, Prem did not face the same el ect oral
constraints as el ected politicians. He was not directly accountable to the
narrow constituencies that were the focus of party politicians. Numerous
scholars have noted that Prem was abl e to stand above facti onal party
pol i ti cs and take a broader view than the typi cal el ected pol i ti ci ans. 1 4
However, whi l e Prem's i ncentives to provide nati onal pol i ci es may not
have been as weak as other political actors, he still had to work with a
coalition of factionalized parties as part of the pol i cy- making process. I n
other words, there were still mUltiple veto pl ayers in the policy process,
even under Premo This can be seen clearly by l ooking at the number of
l aws passed by the Prem governments compared to other governments.
During Prem's tenure, an average of 2. 7 l aws per month were enacted
by the l egi sl ature. Thi s is comparabl e to the fi gure for Prem's el ected
successor, Chatichai Choonhavan-2. 3 per month-but much l ess than
during that of nondemocratic governments-6. 4 per month (Christensen
and Ammar 1 993) .
In short, the support of elected party politicians could not be taken
for grant ed. I n fact, Prem' s predecessor, General Kri engsak, had been
forced to step down as prime minister in 1 980 due, in part, to hi s failure
to maintain the support of party leaders. I n order to avoid a similar fate,
and find a way around t he governance probl ems associated with mul
ti pl e veto pl ayers, Prem forged a compromi se with political party leaders.
The Policy- Patronage Compromise
Prem and hi s advi sors were aware that they needed the support of
the political parties for stability and l egitimacy purposes. However, they
felt it was necessary to keep politiCians from interfering in certain parts
of the pol i cy- making process-particularly macroeconomic pol i cy. For
their part, pol i ti ci ans were anxi ous to enj oy the spoi l s of government,
but were also keenly aware of the need to maintain the support of the
military. The excesses and instabil ity of democratic governments from
1 973-1 976 had been part of t he j ustification behind a return to military
rul e. The result was a compromise between Prem (and the technocrats)
and the l eaders of the vari ous politi cal parti es. Macroeconomi c policy
woul d be i nsul ated and run by Prem- backed technocrats, and Prem' s
appointees woul d have the abil ity to set some limits on corrupti on and
rent-seeking on the part of the political parties. I n exchange, the pol itical
1 71
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Governance and Growh in Thailand
parti es would be given control of the sectoral mi ni stri es ( e. g . . Commerce,
I ndustry, Educati on) and woul d be all owed to run them with very l i ttl e
i nt erference from the pri me mi ni ster ( Chri st ensen et al . 1 993) . l
I nsulation of Macroeconomic Policy
As di scussed earl i er, the foundati on of Thai land's economi c success
begi nni ng i n the l ate 1 980s was i t s p rudent macroeconomi c pol i cy.
Thai l and was abl e to adj ust to t he ext ernal shocks of t he 1 970s and
1 980s and achieve economi c stabi lity because i t fol l owed cauti ous eco
nomi c pol i ci es and adopted needed reforms ( Warr and Bhanupong 1 996) .
However, it was t he i nformal pol i cy- patronage compromi se that gave
pol i cy makers the pol i t i cal s pace to adopt t hes e caut i ous economi c
pol i ces. Pr em was abl e t o shi el d key economi c offi ci al s from pressures
from those who mi ght oppose reforms, parti cul arly pol i ti cal parti es. I t
i s not a coi nci dence that most of t he pol i ci es desi gned t o combat the
economi c probl ems of the 1 980s were macroe conomi c or fi nanci al
pol i ci es. Macroeconomi c pol i cy under Prem was centralized and headed
by technocrats . 1 6 The budgetary process was al so kept out of the hands
of pol iti ci ans and central i zed i n the Budget Bureau. Four organizati ons
emerged as t he key groups i n charge of macroeconomi c management :
the Budget Bureau, the Nati onal Economi c and Social Development Board
( NESDB) . the Mi nistry of Fi nance, and the Bank of Thai l and. Concerns
over economi c stabi l i ty had l ed previ ous mi l i tary governments to i nsu
l ate these i mportant macroeconomi c agenci es and this pattern continued
under Prem ( Chri stensen et al . 1 997) . Pri me Mi ni ster Prem was directly
over three of t hese agenci es and i ndi rectly over the Bank of Thai l and
( t he head of t he Bank of Thai l and i s appoi nt ed and r emoved by t he
mi ni ster of Fi nance) . 1 7 These organizati ons, typi cally headed by techno
crats and largely i nsul ated from pol i ti cal and el ect oral pressures, were
abl e t o act deci s i vel y t o pr oduce the nat i onal pol i ci es neces s ary t o
overcome t he cri ses of t he earl y- and mi d- 1 980s and l ay t he ground
work for future economi c growt h.
To summarize, t he pol i cy-patronage compromi se essenti ally reduced
the number of veto pl ayers i n the area of macroeconomi c pol i cy and
allowed pol i cy makers wi t h broader i nterests than t he typi cal pol i tician
to set pol i cy. Thus, thi s group had the i ncentives and capabi l i ty t o impl e
ment cos t l y but needed pol i cy refor ms , whi ch wer e oft en st r ongl y
opposed by the mi l i tary, pol i ti cal part i es , and/ or busi ness groups . The
out come of t hi s compromi se was the stabil ization and economi c reform
pol i ci es of t he Prem peri od .
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Governance and Growh in Thailand
The Collapse of the Compromise
The nat ure of Thai pol i t i cs fundamental l y changed i n 1 988 when
Chatichai Choonhavan, MP and head of the Chart Thai Party, was named
pri me mi ni ster. The choi ce of Chatichai marked the first ti me under the
1 978 Const i t ut i on that t he pri me mi ni st er' s pos i t i on was gi ven t o an
el ected pol i ti ci an. 1 H As a pol i ti ci an, Chati chai was under the same pres
sure t o bui l d and mai ntai n a personal el ect oral network as any ot her
Thai pol i ti ci an. For Chati chai and the other members of hi s party, el ec
toral victory ( and future electoral success) stemmed from t hei r abi li ty or
pot enti al t o di rect resources t o thei r l ocal consti tuents and support ers.
In short, as an el ected politician and party l eader, Chati chai had a much
narrower consti tuency than di d Prem and his tenure as prime mi ni ster
depended on t he conti nued support of poli ti ci ans with equally narrow
consti tuenci es.
Chati chai ' s vi ctory al so marked the t ri umph of provinci al poli ti ci ans
i n t he pol i t i cal process. Chati chai 's party achi eved el ectoral success by
convi nci ng many provincial poli ti ci ans to run under the Chart Thai ban
ner. This class of poli ti ci ans, backed by the provinci al busi ness eli te, had
been growi ng i n strength over t he course of t he 1 970s and 1 980s. 1 9 As
a group, the provi nci al pol iticians di d not generally have strong nati onal
pol i cy goal s . I nst ead, t hey were mos t concerned wi th prot ect i ng and
promoti ng t he narrow busi ness i nt erest s of thei r consti tuency, t he pro
vinci al busi ness el i te. Lo Other Chart Thai party l eaders i ncl uded Banharn
Si l pa- archa, t he provi nci al bus i nes s man dubbed " The Mobi l e ATM"
because o f hi s readi ness to extend financi al assi stance t o pol i ti cal can
di dat es, and Pramuan Sabhavasu, another provi nci al busi nessman who
made his fortune i n the constructi on i ndustry and was a maj or financi er
of Chart Thai candi dates. In short, Chati chai 's victory brought to power
pol i t i ci ans who l acked i ncenti ves t o provi de certai n nat i onal pol i ci es.
Thi s was not onl y becaus e t he el ect oral and party sys t ems c ompe l
pol i ti ci ans t o focus on l ocal , narrow i nterests, but also because t he key
members of provi nci al pol iti ci ans' consti tuenci es were oft en ei t her di s
i nt erest ed or opposed t o such pol i ci es.
B es i des undermi ni ng t he nat i onal pol i cy i ncent ives i n t he Thai
pol i tical system, Chatichai 's victory al so i ntroduced addi ti onal veto pl ay
ers i nto the system. First, as party l eader, Chatichai not only had to worry
about keepi ng other parti es in the coal i ti on happy, as Pre
"
m di d, but h
al so had to cont end wi th t he var i ous fact i ons wi t hi n hi s own party.
Second, the pol i ticization of the pri me mi ni ster's ofi ce l ed di rectly to the
1 73
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Governance and Growh in Thailand
politicization of the once technocratic and insulated economi c agenci es.
Under Chati chai , vi rtual l y every Cabi net pos i t i on went t o an el ect ed
pol i ti ci an. The Mi ni st ry of Fi nance was no except i on with the finance
portfolio having been given to Chart Thai fnancier Pramuan Sabhavasu.
The Mi ni stry of Fi nance al so became subj ect t o t he i nstabi l i ty charac
teristic of coal i ti on government. During the eight years Prem was prime
minister, there were only three finance ministers. I n the t en years since,
thi rteen men had served as finance mi ni ster-one of whom served two
separate terms.
Further, Chati chai sought t o decrease the i nfuence of the t echno
cratic NESDB i n economi c pol icy making. Under Prem, t he NESDB was
given a central rol e over economi c pol i cy maki ng. Not only was t he
organizati on in charge of economi c pl anni ng but i t was al so given eco
nomi c coordi nati ng and monitori ng responsi biliti es. The secret ary- gen
eral of the NESDB al so sat as the head of the " Economi c Cabi net , " the
Counci l of Economi c Mi ni st ers ( CEM)
'
whi ch was endowed wi th ful l
Cabi net powers. From t hi s posi ti on t he NESDB was abl e t o screen, and
occasi onal l y vet o, t he pork- barrel proj ect s of t he el ect ed mi ni st ers i n
Prem Cabi net s ( Ungpakorn 1 992 , Anek 1 99 2 a) . Not surpri si ngl y, t he
NESDB aroused a consi derabl e amount of resent ment on t he part of
el ected pol iticians. The Chatichai government expel l ed t he NESDB from
t he Cabi net and removed i ts coordinating and moni tori ng responsi bi l i
t i es. The director of the NESDB resi gned i n protest and was repl aced by
" a more pli abl e t echnocrat " ( Pasuk and Baker 1 995, 350) . Fi nal ly, t he
power over government contracts was t aken from the NESDB and pl aced
under t he control of i ndi vi dual mi ni st ri es. In short , by pushi ng asi de
the technocrats, marginalizing the NESDB, and givi ng control over gov
ernment contracts t o i ndivi dual ministers, Chatichai 's government shifted
control of policy and resources from the i nsul ated technocracy t o el ected
pol i t i ci ans ( i bi d. ) . L I As a resul t , macroeconomi c and fi nanci al pol i cy
maki ng began to fall vi ct i m to the same governance constrai nts ( poor
i ncentives and mul ti pl e veto pl ayers) t hat had been t he rule i n t he area
of sect oral pol i cy.
I t is i mport ant to not e that not every government post was com
pl et el y t aken over by el ec t ed pol i t i ci ans aft er 1 98 8 . El ect ed pr i me
mi ni sters have not i nfrequently appoi nted technocrats t o head the eco
nomi c portfol i os in an effort to boost thei r Cabi net "s credi bility in the
eyes of forei gn and domest i c i nves t or s . Even Chat i chai appoi nt ed a
t echnocrat to head t he Mi ni stry of Fi nance l ater in hi s t erm. However.
these technocrats were sti l l accountabl e to el ect ed pol i ti ci ans with nar-
1 74
Governance and Growh in Thailand
row consti tuenci es as opposed to a nonpartisan premi er with a broader
consti tuency. Thus, t hese t echnocrats usual l y l acked t he authority and
autonomy t hat t hei r predecessors possessed. 22
The Consequences of Poor Governance
It is easy to poi nt to the recent crisis as prima facie evi dence of the
governance probl ems characteristic of the Thai political syst em. 23 How
ever, the consequences of poor i ncentives and weak capability coul d be
seen l ong before 1 997. As t wo cri si s comment at ors not ed, "many had
seen [ the cri si s] comi ng for some t i me. But l i ttl e had been done. Eco
nomi c p ol i cy maki ng and fi nanci al cont rol s had l agged behi nd t he
changes in t he nature and t he pace of t he economy. Politics had got i n
t he way" ( Pasuk and Baker 1 998, 94) .
For reasons discussed earlier Thai politicians are focused on attend
i ng to the i nterests of narrow constituenci es. They have very little interest
i n establ i shi ng connecti ons with broader interest groups that might be
concerned with the conduct of "national" pol i cy. They do have relation
ships with busi ness ( bot h rural and urban) and many of the pol iticians
are bus i nes s men t hemselves , but the p urpos e of t he connect i ons is
mai nl y t o raise corrupt i on money, through t he grants of proj ect s and
concessi ons t o i ndividual frms ( Ammar 1 997) . In short, poli ti ci ans are
i nt erest ed in fi r m/ busi ness speci fi c pol i ci es, rather than broader "na
t i onal " pol i cy. Thus, pol i ti ci ans t end t o vi ew t he publ i c t reasury as a
milki ng cow, with t he politicians' j ob bei ng to channel the milk to their
constituents and supporters. Some of this was accomplished via the l egal
use of all ocati on of publ i c resources. In addi ti on, pol i ti ci ans al s o used
t he sect oral mi ni stri es as sources of corrupt i on money.
Sectoral Policy
As ment i oned above, sect oral pol i cy was never organi zed the way
macroeconomi c pol i cy was under Premo Because of t hi s, si gns of t he
mi s management of s ect oral mi ni s t r i es by pol i t i ci ans appeared wel l
before t he macroeconomy began t o suffer. I n 1 990, despi te t he st rong
and growi ng demand for a better educated workforce, Thail and ranked
last among the ASEAN Five in terms of the percentage of the popul ation
enroll ed i n secondary school , and last in terms of t he percentage gradu
ated from secondary i nsti tuti ons ( World Development Indicators 1 999) .
Despi te rhetori c by politicians and a general recogniti on that Thailand's
educati onal system needed reform, in 1 998 Thai l and's basi c educat i on
i nfrastructure st i l l l agged behi nd t he rest of the regi on ( LaB 1 998) . As
1 75

Governance and Growh in Thailand


the economi c boom took on full steam in the late 1 980s there was also
a recognized gap i n the demand for skilled workers and the actual supply
( TDRI 1 988, 1 992) . I n 1 993 t he di rect or of t he I ndustri al Promot i ons
Department of the J apan External Trade Organi zat i on ( J ETRO) warned
that i f Thailand did not solve i ts skilled- labor bottleneck, "Japanese firms
( would) increasingly l ook to places like Vietnam, where you have a better
educated work force" ( quoted i n Bello et al. 1 998, 57) . A full ten years had
passed si nce pol i cy makers first recognized the need to boost the supply
of ski ll ed l abor. Despi t e all of the plans and proposal s over this t i me,
a severe shortage of skill ed l abor conti nues to be a probl em ( Doner and
Bri mbl e 1 998) .
I nfrastructure bottlenecks, especi ally in the area of ground transpor
tati on and water, were al ready a maj or concern i n t he l ate 1 980s. Yet
despi t e the severe and growi ng defi ci enci es i n i nfrastructure, t he gov
er nment has fai l ed to devel op a cl ear i nfr as t r uct ur e devel opment
poli cy-one symptom of t he large number of veto pl ayers and politician's
lack of interests i n nati onal pol icy. I ndeed, even at the l evel of individual
i nfrastructure proj ects, there has been very little in the way of nationally
coordi nated pl anni ng ( Anuphap 1 997) .
2
.'
Taki ng transportati on as an example, in 1 993 an i nternati onal traffic
congesti on team concl uded that Bangkok had possi bly the worst traffic
congesti on of any similarly si zed ci ty in the world ( Bello et al. 1 998) . By
1 996 t he government had managed t o construct only ni nety- one kil o
met ers of expressways-an accompl i shment t hat t ook thi rteen years to
compl et e ( i bi d. ) . At t he end of 1 998 none of t he vari ous mass transi t
proj ects were operational, although some had been i n the works for ten
years or more. Pol i cy- maki ng paralysi s, with di fferent mi ni stri es / pol i ti
cal facti ons backing di fferent proj ects, together with wi despread charges
of corruption, led to long delays or the outright cancellati on of proposed
proj ect s. " "
Havi ng fai l ed t o devel op coher ent , coor di nat ed publ i c pol i cy t o
address t he economy' s growi ng i nfrastructure needs , t he government
turned t o selective privatizati on i n the areas of tel ecommuni cat i ons and
transportati on, hopi ng the private sector could do what t he government
coul d not. On i t s face privatizati on may seem like a "nati onal " pol i cy. I n
practi ce, however, privatizati on pol icy was turned to benefi t t he narrow,
private i nterests, rather than the public i nterest. Instead of selling off the
state enterpri ses that were in charge of tel ecommuni cati ons and trans
port ati on, and l et t i ng t hem face compet i t i on, pol i cy makers opt ed t o
keep t hei r monopol i es i nt act . I nst ead, st at e- owned ent er pr i ses were
1 76
Governance and Growh in Thailand
forced to grant "concessi ons" to private compani es to undertake maj or
new i nvest ment proj ect s. " Publ i c i nt erest was the first casualty of t he
syst em of concessi ons that were grant ed duri ng thi s peri od" ( Ammar
1 997, 1 6) . The negoti ati on process was far from fair and transparent and
concessi ons were rewarded to those with good pol i ti cal connecti ons on
very favorabl e contractual terms ( i bi d. ) .
Macroeconomic Policy
The col l apse of the policy- patronage compromi se in 1 988 subj ected
macroeconomi c pol i cy t o many of t he same pol i t i cal constrai nts that
sectoral policy had operated under. However, the effects of these constraints
did not immediately appear for at least three reasons. First, the economic
boom was j us t movi ng i nt o hi gh gear whe n Chat i chai assumed t he
premiership and t he momentum carried t he economy forward despite the
changes put in place by Chati chai . Second, the economi c boom got its
second wind as the financi al sect or was l i beralized, a process that was
completed by 1 993 with the opening of the Bangkok I nternational Banking
Facility ( BI BF) . 26 Fi nanci al l i beralizati on brought a food of new money
into the Thai economy that fuel ed a stock market and real estate boom.
A t hi r d r e as on for t he del ayed ons e t of sympt oms i n t he
macroeconomy can be traced t o the appoi ntment of Anand Panyarachun
as prime mi ni ster aft er a military coup i n 1 99 1 . Anand, a hi ghly respected
di pl omat and busi nessman, was chos en by the mi l i t ary t o head two
i nteri m government s between 1 99 1 and 1 992. He was not a pol i ti ci an
and fil l ed the maj ori ty of hi s Cabi net with respected technocrats, busi
nessmen, and government ofi ci al s rather than pol i ti ci ans. Without the
el ectoral , parti san, or coalitional constraints that most governments face,
one woul d expect Anand's government t o be qui t e good at providi ng
nati onal pol i ci es, as l ong as t he i nt erest s of t he mi l i tary were not t oo
badly abused. I n fact , Anand carri ed out a l ong l i st of l arge- scale na
tional policy reforms. He reduced tariffs , cut taes, and reformed t he t ax
law, and l ifted exchange control s. He i ncreased the pay of bureaucrat s,
formed the St ock Exchange Commi ssi on t o oversee the Thai st ock market,
and pushed a proposal to create the ASEAN Free Trade Area (AFTA) . He
formed an el ect i on moni tori ng organizati on ( Pol l Watch) , launched new
i nfrastructure proj ect s, set up new rul es for screeni ng proj ects and se
l ect i ng cont ract ors or concessi onai res and opened up t he pr ocess t o
greater public scrutiny ( Pasuk and Baker 1 995, various news sources) . I n
short , the Anand government appears to have acted more deci sively and
i n response t o broader soci etal i nt erest s t han hi s el ect ed count erpart s .
1 77
Governance and Growh in Thailand
Despite Anand's reforms, the i nability of the government t o adj ust
t o the changi ng economy began t o mani fest i tsel f by 1 993. The eco
nomi c factors behi nd the det eri orati on of Thai l and' s macroeconomy
duri ng the 1 990s have been the subj ect of several studi es ( see, for ex
ample, Yos and Pakorn 1 998 or Pas uk and Baker 1 998) . Large amounts
of capital i nflows , such as Thai l and experi enced i n the l ate 1 980s and
1 990s, put the macroeconomy under great strai n. Sound pol i ci es were
needed t o manage t he fl ow of capi tal and i ts us es i n t he economy.
However, the politicization of the technocratic ministries, and the result
ing increased number of veto pl ayers with narrow constituenci es, made
it difcult for the government to respond with the requisite policies. I n
the remai nder of this chapter I focus on t he way i n which governance
probl ems afected policy making i n two areas : financi al regul ati on and
fiscal pol i cyP Thi s i s especi ally evi dent i n the area of financi al sector
regul at i on. Thai l and' s fi nanci al archi tecture and regul at ory system
needed to be adapted to manage the i ncreased fow of foreign capi tal .
However, the government fai l ed to make the needed reforms. El ected
politicians had few incentives to push for a clearer accounting by fnan
cial insti tuti ons and borrowers on how funds were being used. A new
regul at ory framework would bri ng very l i ttl e addi ti onal electoral sup
port from voters. On the other hand, regulation was a threat to many of
the businesses that were typi cal ly part of a poli ti cian's consti tuency. I n
addi ti on, mul ti pl e veto pl ayers i n the pol i cy pr oces s made i t nearly
i mpossible to find a pol i cy on which all the relevant actors coul d agree.
The resul t , accordi ng to a report by t he Worl d Bank, was " a pri vate
enterpri se system where few controls [ were1 i mposed, i ncreased mat e
rial standards and private gai ns [ were] secured at an observable com
munal expense" ( Worl d Bank 1 99 1 , 6) .
The agency that had the speci fi c responsi bi l i ty for regul ati ng t he
financi al sector was t he Bank of Thai l and. I ndeed, much of t he bl ame
for t he crisis has been laid at t he feet of t he Central Bank. However, even
its strongest critics acknowledge that the bank's failure to better regul atE
the financial system was due partly to its l oss of autonomy from pol i ti cal
i nfl uences . With t he col l aps e of t he pol i cy- pat r onage compr omi s e,
el ected politicians began to assert more control over t he Bank of Thai
land. The governor's posi ti on i n the bank was i ncreasi ngl y hel d at t he
pl easure of the el ected pol i ti ci ans (Ammar 1 997) . " H The bank governor
does not serve a fixed term. I nstead, he is appoi nt ed and removed by
the mi ni st er of Finance. The Ministry of Fi nance's comi ng under t he
infuence of el ected politicians l ed to what Ammar Siamwalla cal l s "im-
1 78
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Governance and Growh in Thailand
pl i ci t i nt erventi ons" by some el ected pol i ti ci ans in the pol i ci es of the
Bank of Thailand. That i s, the governor would anticipate the preferences
of the Fi nance minister and follow the current pol iti cal l i ne when de
si gni ng pol i cy (Ammar 1 997, 7 1 ) .
Obvi ously, concrete evi dence o f " implicit intervention" is difficult to
come by. And even where political interference i s more direct, it gener
ally goes undocumented: there are no memos from politicians ordering
a particular action to be investi gated. However, the way i n which the
Bank of Thai l and responded to fundamental problems i n the financi al
sector i s consi stent wi th a story of political pressure and i nfuence. By
the mi d- 1 990s the fi nanci al sector was i n seri ous troubl e. The lack of
oversi ght had allowed cronyism and other i mprudent l endi ng practices
to fouri sh, a poi nt dri ven home by the Bangkok Bank of Commerce
( BBC) scanda[ . 29
The scandal involving the BBC hi t the headl i nes in 1 996, when an
opposi ti on politician raised the i ssue of the bank and its political con
nections in t he context of a confdence debate. The BBC had perpetrated
massive fraud involvi ng, among other things, shady land deals, suspect
l oans, and stock market speculati on. I n the middle of the scandal was
Group 1 6, a coll ecti on of ambi ti ous pol iti ci ans who j oi ned together i n
1 992. Some of the members of Group 16 had sat on a parl i amentary
committee charged with investigating some of the BBC's busi ness deal
ings. Rather than pushi ng for stronger bank regulation or reform, some
members of the group el ected t o j oi n forces wi th the BBC i n a l arge
number of pyrami d schemes ( Pasuk and Baker 1 998) .
The BBC's bad debts rose steadily in 1 992 and 1 993 but it was not
unti l 1 994 that the Bank of Thai l and not ed that there were t oo many
questi onabl e l oans. By 1 995, however, i nternal Bank of Thailand docu
ments showed that t he Central Bank comprehended t he scale of t he BBC
mess. However, rather than take acti ons to cl ose t he bank and push for
the prosecuti on of the BBe's ofi cers, the governor of the Bank of Thai
land pul l ed together over fifty billi on baht and pumped the funds into
the bank, where they then disappeared ( i bi d. ) Even at the end of 1 995,
when bank regulators reported to t he governor that the BBC was techni
cally bankrupt, that fraud was beyond question and that the bank's ofcers
were cri minally liable, the governor did not take strong action ( i bi d. ) . I t
was only after someone within the Bank of Thailand leaked the details of
the scandal t o an opposition politician that the affair came to light.
There has been a good deal of specul ation on the motivati on be
hind the action ( or inaction) of t he Central Bank governor. All egations
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Governance and Growh in Thailand


range from personal connect i ons with BBC offi cers t o gross i ncompe
tence. Nonethel ess, the pol i ti cal connection continues t o stand out. Some
member s of t he gover nment coal i t i on were wi t hout a doubt deeply
involved in the affai rs of the BBC. I n addi ti on, there were wi despread
allegati ons that the BBC had hel ped finance the 1 995 el ectoral victor of
Banharn Silpa- archa's Chart Thai Party. As pri me mi ni ster, Banharn swept
away any lingering vesti ges of an autonomous, technocratic Mi ni stry of
Fi nance by appointi ng t wo i ndividuals who l acked experi ence i n mac
roeconomi c management or any i ndependent base of pol i ti cal support
as mi ni ster. Both were compl etely dependent on Banharn' s support t o
remai n i n offi ce. Thes e i ndivi dual s were charged wi th overseei ng t he
work of the Bank of Thai l and. I ndeed, Thail and's t wo most presti gi ous
uni versi t i es, Thammasat and Chul al ongkorn, expl i ci tly drew t he con
necti on between t he Central Bank's failure to regulate and direct political
i nt erference in the weeks aft er the BBC scandal broke ( i bi d. ) .
Whi l e t he BBC was certai nl y the hi ghest profi l e case, many ot her
fi nanci al i nst i t ut i ons were feel i ng t he bi t e of poor asset qual i ty and
mi smanagement duri ng t he mi d- 1 990s. Under p ol i t i cal pressure, t he
Bank of Thai l and offered abundant credi ts t o finance compani es and
commerci al banks between 1 994 and 1 997 ( Yos and Pakorn 1 998) . Un
fortunately, t hese rescue attempts were i n confi ct wi t h broader macro
economi c obj ect i ve s . As t he economy began t o heat up from 1 993
onward, t he Central Bank tri ed to curb i nfati on by rai si ng i nterest rates
and limiting credit. I-owever, the funds pumped i nto the financi al sys
t em by the central bank t ended to enl arge the money supply, encour
agi ng more spendi ng and exacerbati ng both i nfat i on and current ac
count defi ci ts ( i bi d. ) .
Fi scal pol i cy al so ran count er to efforts to st abi l i ze t he economy.
Thi s was especi ally t rue duri ng t he Banharn admi ni st rat i on. Pri or t o
Banharn t he budget surplus had acted to offset capi tal infows and eco
nomi c overheating ( Narongchai et al. 1 993) . Politicians pillaged the public
treasury each year but revenues were growing fast enough to keep up
with pol i ti cal demand. This changed with the election of Banharn's Chart
Thai party i n 1 995. Banharn was the personi fi cat i on of a provi nci al
pol i ti ci an and had been a member of Chatichai 's " buffet cabi net" of 1 988-
1 99 1 . Banharn's Cabi net was dubbed the " 7- el even" cabi net. Composed
of seven parties and eleven maj or facti ons, decisive acti on in any pol i cy
area was unlikely. However, it quickly became apparent that this govern
ment had no i nterest i n nati onal pol i cy. I nstead, i t was in the busi ness
of corrupti on and patronage, and, l i ke the conveni ence st ore, was open
1 80
Governance and Growh in Thailand
fo r bus i nes s s even days a we ek, t wenty- four hour s a day. One of
Banharn's fi rst acti ons as premi er was t o i ncrease pl anned budget ex
pendi tures by 10 percent ( Pasuk and Baker 1 998) . A deputy l eader of the
Chart Thai party and speaker of t he Hous e est i mat ed that half of all
budget project money was l ost to corrupti on ( The Nation, 19 May 1 996) .
Not surpri singly, the budget surpl us qui ckly evaporated and by l ate
1 996 the budget was movi ng i nto defi ci t. Fearing that they would soon
be forced to cut t hei r budgets , many departments accelerated the spend
i ng of t hei r budget allocations ( Pasuk and Baker 1 998) . This caused one
technocrat t o comment that " [ pj ol i ti ci ans want to spend money t o hel p
the peopl e who el ect them. You cannot expect them to put stabili ty ahead
of all el se" ( Chal ongphop Sussangkarn 1 996) . I n short , pol i t i ci ans be
came more responsive t o thei r narrow consti tuenci es than they had been
to the broader publ i c i nterest.
Conclusion
The recent economi c cri si s has brought the i ssue of governance to
the forefront. as i s certainly true of Thailand. Whi l e not all of the bl ame
can be l ai d at the feet of the pol i ti ci ans and the pol i ti cal syst em, there
rem 'li n quest i ons of why the government di d not take more concret e
st eps t o prevent t he cri si s, and why t he response was sl ow once t he
cri si s hi t. I t i s al so i nteresti ng to compare the recent cri si s wi t h that of
the earl y- and mi d - 1 980s. There are di fferences between the two peri
ods, certainly, but there are some striking parallels. I n both ti me peri ods
maj or st ruct ural and fi nanci al adj ust ment s were requi red t o prevent
problems from escalating i nt o a crisi s. The current account and exchange
rate were a concern i n both peri ods as was external i ndebt edness. Fi
nally, t he country's traditionally strong reputati on among foreign financial
institutions and investors was weakeni ng ( Doner and Anek 1 994) . How
ever, the government 's response to the two cri ses di ffered greatly. The
Prem governments i n 1 981 and 1 984 were abl e to devalue the currency
and carry out ot her reforms in the face of strong opposi t i on from t he
busi ness sect or, pol i ti cal parti es, and t he mi l i tary.
Contrary to the Prem government's earl i er deci sive acti on to reform
t he economy, as t he cri si s l oomed and t hen broke i n 1 996 and 1 997
Thai l and's pol i cy makers fal tered ( MacI ntyre 1 999a) . 30 Cri ti ci sms of t he
government 's response oft en poi nt t o t he l ack of deci si veness on t he
part of pol icy makers and t hei r t i es to narrow, speci al i nterests. I ndeed,
one Thai economi st argues t hat because s o many Thai s had begun to
see thei r government as i ncapabl e of formul at i ng and i mpl ement i ng
1 8 1
Governance and Growh in Thailand
the needed pol i ci es in response to the crisi s, the I MF i ntervention was
generally regarded favorably, at l east i n the begi nni ng. The I MF essen
tially fil l ed a gap in authori ty (Ammar 1 997) , as what one would expect
given the i ncentives and capabi l i ti es of Thai policy makers to push for
nati onal pol i ci es.
To summarize, the interaction of t he electoral and party systems i n
Thailand, prior to the new Constitution, produced a pol itical system filled
with mUltiple veto pl ayers who were focused on their narrow consti tu
enci es and supporters. The resul t was a pol i ti cal system where pol icy
makers lacked both the strong i ncentives and the capabi lity to pursue
national pol icies. Prem was able to avoid many of the governance prob
lems associ ated with thi s pol i ti cal system by agreei ng to an i nformal
compromi se wi th the l eaders of the various pol i ti cal parti es. Prem and
the technocrats were l eft alone to manage the macroeconomy while the
political parties received the sectoral ministries. When the compromi se
ended i n 1 988, the governance probl ems began to resurface. Mul ti pl e
veto pl ayers made i t di ffi cul t to formulate pol i cy responses promptly,
and the i ncenti ves of pol i cy makers were such that they were more
concerned with their supporters' narrow interests than with the interests
of the broader economy.
Finally, in the wake of the crisis Thailand adopted a new Constitu
tion. It makes numerous changes i n the political system, many of which
coul d have a significant i mpact on governance. I menti on only two here:
the switch to si ngl e- member districts and the addi ti on of a nationwi de
party l i st. 3l Over time, si ngl e- member districts and the party l i st shoul d
decrease the number of parties and, thus, the number of veto players i n
the system. The resul t wi l l be more deci sive poli cy maki ng. The pam'
lists should also help strengthen party labels and broaden the const i tu
enci es of Cabi net members, thus gi vi ng them a greater i ncent i ve t o
provide national pol icies. I n short, given Thailand's new i nsti tuti ons and
institutional arrangements, there i s some room for opti mi sm regardi ng
t he qual ity of future governance in Thai l and.
1 82
NOTES
Notes to Introduction
1 . See, for i nstance, the annual rankings of I nternati onal Country
Ri sk Gui de ( I CRG) .
2. Note that we use the term " institutions" in North's ( 1 98 1 ) sense: an
institution embodies a system of the rules, procedures, and norms, formal
and informal, that govern the behavior of a given set of individuals; those
rules, procedures, or norms are formally referred to as institutional ar
rangements. A merit- based recruitment and promotion system embodies
a set of rules and procedures that govern the behavior of civil servants.
Hence, i t is an institution. A annual performance appraisal requiring both
peer evaluati ons and the evaluati on of one's i mmedi ate superi or is an
embodied institutional arrangement. The j udi ci ary i s an institution; the
rules, procedures, and norms for selecting members of the Supreme Court
are part of an institutional arrangement. The common fi el ds system i n
medieval Western Europe is an institution; the peasant norms embodied
in this system are an institutional arrangement.
3. A number of organizations , private or nonprofi t, have provi ded
country ran ki ngs based on the perceived extent of corrupti on of busi
nessmen: to name a few, Transparency International, International Coun
try Risk Guide, and Pol itical Risk and Consul ti ng I nc.
4. The implication of the last is that, under certain circumstances, nascent
formal legal institutions can place limits on corruption, albeit weak ones.
5. These refer to kinship ti es, l ocal networks of friends and relatives,
or i ntermedi ari es wi t h i ntimate knowl edge of both potenti al nonl ocal
investor( s) and potential l ocal partner( s) .
1 83

Notes to Pages 5-1 8


6. For a related. more general argument. s e e MacI ntyre. " I nstitutions
and I nvest or s: The Pol i t i cs of the Fi nanci al Cr i si s i n Sout heast Asi a"
( unpubl i shed manuscri pt . Universi ty of Cal i forni a. San Di ego. 1 999) .
7. Why thi s happened is a thesi s topi c in and of i tsel f. Suffi ce it t o
say t hat the combi nati on of rent - seekers wi t h very short - t erm hori zons
surroundi ng the presi dent. t he diverse coal i ti on of groups that brought
hi m to power. and the presi dent's penchant for repaying favors had much
to contri bute to di st orti ng the deci si on- maki ng process.
8. See " The J 2K Cri si s and the Economy" ( unpubl i shed manuscri pt .
School of Economi cs. Uni versi ty of t he Phi l ippines) .
9. I n fact . t hi s appears t o be t he mot i vat i on behi nd Shl ei fer and
Vi shny's ( 1 993) semi nal pi ece on corrupti on.
Notes to Chapter 1 ( Corruption and Its Implications for Investment)
1 . The Murphy. Shleifer. and Vishny paper ( 1 993) in fact provides much
of the theoretical motivati ons. if not underpinnings. for the now well-known
Shl ei fer-Vi shny pi ece on corrupti on regi mes ( 1 993) .
2 . The test for the coeffi ci ent of the dummy variable for East Asia i n
hi s regressi ons are i nsi gni fi cant.
3. Moreover. the comparators that practiti oners have i n mi nd when
ci ti ng the East Asi a puzzle are other developi ng countri es.
4. For an analyical model of corruption and uncertaint. see Campos.
Li en. and Pradhan 1 997.
5. Mauro ( 1 995) , for i nstance. used survey data collected annually by
The Economist Intelligence Unit. Keefer and Knack ( 1 995) based their fnd
ings on survey data conducted annually by the I nvestor Countr Risk Guide
(lCRG) . Other survey-based data are available fom Transparency Internationa
(Geneva) , The World Competitiveness Report (Davos) and Political Risk Con
SUlting. Inc. (Hong Kong) . The data that these surveys contain are still of an
indirect nature. It is practically impossible to obtain accurate information of
sufcient breadth on actual amounts of bribes and the like. Hence. the best one
can do is work with survey responses fom individuals afected by corruption.
6. I n the extreme case. corruption per se would represent a pure i n
come transfer or a tax provi ded it was fully predic table.
7. More speci fically. we used the natural logarithm of both vari abl es.
8. Data on per capi ta GDP enrollment rates. and investment as a percent
of GDP come from the World Devel opment I ndi cators (vari ous years) .
9. The I FC began publ i shi ng an annual report on privat e investment
fows to developing countri es in 1 990. To our knowledge. there is no other
source of i nformati on on thi s i ssue that i s as ext ensive as thi s.
1 84
Notes to Pages 23-47
1 0 . In the case of a corner sol ut i on. the resul ts are ambi guous.
1 1 . The analysis here of O- Ring corruption assumes investors are risk
neutral . I f investors are risk- adverse then greater uncertainty necessaril y
leads to l ess investment; if they are risk takers. the results are reversed. I f
they are risk- neutral then under certain conditions greater uncertaint may
in fact l ead t o more i nvestment as mi ght happen by anal ogy in thi nl y
capitalized markets. The investors i n our model (and more typical of i n
vestors in real capital i n developing countries) are not of thi s type. We are
grateful to David Ellerman for poi nti ng out thi s probl em.
Notes to Chapter 2 (Investment, Propert Rights, and Corruption
in Indonesia)
The fol l owi ng peopl e have all hel ped with the devel opment of thi s
paper: Ed Campos . St ephan Haggard. Hal Hi l l . John McMi l l an. Barry
Naughton. Sanj ay Pradhan. Rizal Raml i . John Si del . Djisman Simandj untak.
and Ali Wardhana. I am grateful to them all. Research for the paper was
made pos s ibl e by generous fundi ng from the Asi a Research Cent re at
Murdoch Universi ty ( Western Australia) and the World Bank.
1. A substantial body of research is now emerging on this topic. My analy
sis of the crisis i Indonesia is set out more fl y i a forthcomng publication.
For other empirically grounded interpretations. see McLeod 1 998. Soesastro
and Basri 1 998. Hill 1 998. Robison and Rosser 1 998, Ais 1 998. and Pincus 1998.
2. The institutional framework permitted Suharto to behave erratically.
but it did not cause hi m to do so. To know why Suharto chose to behave
in the erratic way he di d. we need to know about his political preferences.
There is much speculation on this subject. but little frm evidence. Among
t he most frequently encountered guesses are that he was simply unwill i ng
to cut back the privi l eges of hi s chi l dren ( ef. hi s willingness to cut back
crony privi leges i n previ ous cri ses) ; t hat he sufered from seriously i nad
equate information on the true precariousness of the economi c si tuat i on
because hi s advi sers no longer dared to bring hi m unwel come news ; o
that he sufered from seriously diminished political j udgment through some
combi nati on of age and hubri s.
Notes to Chapter 3 ( State, Capital, and Investments in Korea)
1 . Except for those of Korea. the fgures ci ted in the rest of this para
graph are for 1 96 1 . and are from Kindleberger 1 965. table 1 . 1. ( per capi ta
i ncome fi gures) and figure 5. 2 ( i nvest ment fi gures) .
2. I n t he 1 960s. t he Korean i nfati on rate was hi gher t han t hose of
Venezuel a ( 1 . 3 percent) Bol ivi a ( 3. 5 percent ) . Mexico ( 3. 6 percent ) . Peru
1 85
.
Notes to Pages 47-57
( 1 0. 4 percent ) , and Col ombi a ( 1 1 . 9 percent) , and was not much l ower
than that of Argenti na ( 2 1 . 7 percent) . I n the 1 970s, i t was hi gher than
those found i n Venezuel a ( 1 2 . 1 percent) , Ecuador ( 1 4. 4 percent ) , and
Mexi co ( 1 9. 3 percent ) , and was not much l ower than those found i n
Col ombi a ( 22. 0 percent) or Bol ivia ( 22. 3 percent) . See Si ngh 1 995, table
5, for further i nformati on.
3. For exampl e, fol l owi ng Max Weber's cl assi c work, i t i s wi dely ac
cept ed t hat t he Protestant et hi c restrai ned l Uxury consumpt i on by the
entrepreneurial class in the early phases of capitalist development in Western
Europe. I thank Chung H. Lee for reminding me of this i mportant poi nt.
4. A pi ece of i nformati on corroborati ng thi s i s the extremely smal l
wage di ferenti al between the t op managers and the workers that pre
vai ls i n Korea. Accordi ng t o the data col l ected by t he consul ti ng com
p any Towers Per r i n, of the t wenty- t hr ee medi um- s i z e d count r i es
surveyed, Korea had t he smal l est wage gap between t he t op managers
and the workers (the former bei ng only 8 times of the latter) . Countries
like Venezuela ( 84 times) , Brazil ( 48 times) , Hong Kong ( 43 times) , Mexi co
( 43 ti mes) , Malaysia ( 42 times) , Si ngapore ( 35 ti mes) Argentina ( 30 times) ,
US ( 24 ti mes) , South Afri ca ( 23 ti mes) showed hi gh di fferenti al s, while
countri es like New Zealand ( 9 ti mes) , Switzerland ( 1 0 ti mes) , Japan ( 1 0
ti mes) , Sweden ( 1 1 ti mes) , and Germany ( 1 1 ti mes) , showed l ow di ffer
enti al s. I t i s i nteresti ng t o not e the hi gh- wage di fferenti al i n other East
Asi an countri es, such as Hong Kong, Mal aysi a, and Si ngapore. The data
was reported i n 1 / 2 August 1 998 i ssue of t he Financial Times.
5. These included i ndustri es where access to propri etary technol ogy
was deemed essenti al for further devel opment of the i ndustry, and i n
dustries where the capital requirements and/ or t he risks i nvolved i n the
investment were very large. The ownershi p ceiling was also relaxed if ( 1 )
the investments were made i n the free- trade zones; ( 2) the investments
were made by overseas Koreans; or ( 3) the i nvest ment s woul d " di ver
si fy" t he ori gi ns of FDI i nto t he count ry-namely, i nvest ment s from
countries other than the US and Japan, which had previ ousl y dominated
the Korean FDI scene. For det ai l s, see EPB 1 98 1 , 70-7 1 .
6. The recent awardi ng of the contract for the fast- trai n proj ect to the
Angl o- French j oi nt venture ( GEC Al sthom) organi zed around t he pro
ducer of French TGV over i t s J apanese and German compet i t ors, who
offered t echnol ogi cal l y superi or product s , i s a good exampl e of such
pol i cy ori entati on ( see Chang 1 998a for further detai l s) .
7 . Needl ess t o s ay, t hi s has t o b e s et agai ns t t he " s econd- mover
di sadvantage, " whi ch means t hat t he fi rst movers would reap more rents.
1 86
Notes to Pages 59-66
8. For a di scussi on of bureaucratic organization and reform in East
Asi a, see Campos and Root 1 996. For empirical analysi s of key attributes
of a well- funct i oni ng bureaucracy, see Evans and Rausch 1 997.
9. Does t hi s mean t hat we need tough capi t al control i n or der t o
moderate t he negative i mpact of corrupt i on on capi t al accumul at i on?
The matter i s not t hat si mpl e. I n some countri es, corrupti on i s rampant
but a l ot of capital stays home even without severe capital control ( e. g. ,
I ndonesia) . Also, there i s a reverse feedback. I n some countri es, corrup
ti on is such that there is no effective capital control ( e. g. , Russi a) . So we
need t o know more about t he country to be abl e to say t hat capi t al
control i s necessary, feasible, or effective i n reduci ng t he negative effect
of corrupti on on accumul ati on.
1 0. This certainly appears to be t he case i n Japan. See Okimoto 1 989
for resul ts of a survey of government mi ni stri es i n Japan.
1 1 . See Campos and Root 1 996.
1 2. Between 1 990 and 1 993, t he share of Korea's outward FDI as a
proport i on of i ts GDP was 0. 45 percent . Whi l e outward FDI i ncreased
dramatically during t he l ast few years ( from $ 1 . 26 bi l l i on i n 1 993 to $4. 1 3
bil l i on i n 1 996) , thi s i s sti l l j ust over 1 percent of GDP, whi ch i s well
below the OECD average of 1 . 85 percent ( for 1 990-1 993) . I n stock terms,
Korea's outward FDI stock was equival ent t o 3 . 1 6 percent of GDP as of
1 994, whi ch i s far l ess than the OECD average of 1 4. 94 percent. All fig
ures are from KDI ( 1 996) , except for t he outward FDI figure for 1 996,
whi ch i s from Far Eastern Economic Review, 1 May 1 997, 44.
1 3. The defi ni ti on of foreign debt here fol l ows the World Bank defi
nition, and therefore i s different from t he concept of "external li abi l i t i es, "
whi ch i ncl udes the offshore borrowi ngs of Korean banks and overseas
borrowi ngs of the overseas branches and subsi di ari es of Korean banks.
The I MF and the Korean government st art ed usi ng thi s defi ni t i on fol
lowing their accord on 28 December 1 997. At t he end of November 1 997,
Korea's external liabilities amounted to $ 1 57 bi l l i on, of which $92 bi l l i on
was of l ess t han a year' s maturi ty.
1 4. Korea's foreign debt / GNP ratio was only 22 percent in 1 996 and
sti l l arollnd 25 percent on the eve of the crisi s. Thi s falls far short of the
World Bank threshol d of 48 percent where a country is downgraded from
" less i ndebted" to "moderately indebted, " not to speak of t he 80 percent
threshol d where i t qualifi es as "severely i ndebted" ( see World Bank 1 997,
1 : 4950 , for t he defi nit i ons) . The forei gn debt / GNP rati o at t he end of
1 995 was 70 percent for Mexico, 57 percent for I ndonesi a, 35 percent for
Thailand, 33 percent for Argent i na, and 24 percent for Brazi l . I n t erms of
1 87
Notes to Pages 66-79
anot her common i ndi cat or of debt burden, Korea was st i l l bel ow t he
Worl d Bank " warni ng threshol d" of 1 8 percent at 5. 8 percent i n 1 996.
Thi s compares ver y favorabl y wi t h t hose of ot her count ri es such as
Mexi co ( 24. 2 percent ) , Brazi l ( 39. 7 percent ) , I ndonesi a ( 30. 9 percent ) ,
and Thailand ( l 0. 2 percent) in 1 995. All the above fi gures ci ted are from
Worl d Bank ( 1 997) count ry t abl es.
Notes to Chapter 4 ( Governance and Investment in China)
I . The Fi nancial Times ( 30 Apri l 1 997) st at es that " Chi na received
about a quart er of al l FDI t o devel opi ng count ri es between 1 979 and
1 997, according to the World Bank Gl obal Fi nance report , " and that "some
200 of t he worl d's 500 l argest transnat i onal cor porat i ons have estab
l i shed a presence in Chi na si nce 1 990. "
2 . J ames D. Wolfensol m, i n Transition 7 ( Sept / Oct. 1 996) : 9.
3. Some gift giving i s s een as showi ng respect or pre- communication
i n China and i n some ot her East Asi an countri es, but as corrupti on i n
t he West . Thus corrupt i on i n Chi na, as perceived by the West, may be
somewhat exaggerat ed.
4. The dual - track pri ce syst em i ntroduced i n 1 984 i s another factor
contri buti ng to the wi despread corrupt i on.
S. Not e that competi t i on among bri be gi vers can i ncrease bri bes ,
whi l e competi ti on among br i be takers t ends to reduce bri be.
6. Thi s i mpl i es that t he degree of corrupti on i s l i mi ted; for i nstance,
the t ax authority cannot arbi trari l y tax busi ness acti vi t i es.
7. And national el ecti ons ( i f any) may be more superfi ci al , and l ocal
el ect i ons are more substanti al .
8. See Wade 1 990 and Campos and Root 1 996 for exampl es.
9. I f everyone was corr upt all t he way t o t he t op t hi s, of course ,
creates the possibi l i ty of an inverted pyramid of corrupti on: money fows
to the t op wi th t hose at hi gher posi t i ons receivi ng more.
1 0. Bri bery may hel p speed up or del ay t he process of case settl e
ment , but may not al t er t he verdi cts.
1 1 . For exampl e, s e e the s candal s of t he Tai pei s ubway syst em,
Korean urban const ruct i on, and Japan' s Mi ni st ry o f Constructi on.
1 2 . I nt ernati onal arbi trat i on will devel op furt her aft er Chi na j oi ns
t he W.
1 3. I f they act as i ndependent monopol i sts, t hen corrupti on will be
si mi l ar t o random robbery and hence have t he worst consequences.
1 4. Put di fferently, central i zed or coordinated corrupti on is simil ar to
the organized robbery of a stati onary bandit in Ol son's ( 1 993) terminol ogy.
1 88
Notes to Pages 81 -89
1 5. I n China, the Standing Commi ttee of National Peopl e's Congress
( not the Supreme Court) i nterpret s the Consti tuti on and l aws. J udges
l ack tenure i n offi ce. Court s are subj ect t o t he cont rol of Communi st
Party commi t t ees and peopl e's congres s es i n the same j uri sdi ct i on.
1 6 . I nci dent al l y, Robert Kuok was named t he wor l d' s s hrewdes t
busi nessman by Forbes ( see Forbes, 28 Jul y 1 997) .
1 7 . This subsect i on is drawn from Li and Li an 1 999.
1 8. During t he Mao er a ( the 1 950s and t he 1 960s) , both a pl anni ng
system and a market system were sti l l at a tri al stage i n East Asi a. Mao
did not have personal experi ences to compare a pl anning economy with
a market economy. Thus, he did not percei ve that i t was i n hi s i nterest
t o pursue cat chi ng- up pol i ci es bas ed on market mechani sms. Unl i ke
Mao, Deng had wi tnessed a functi oni ng market economy i n France i n
hi s early youth.
19. Duri ng hi s famous southern t our i n 1 992, Deng cl early indicated
that i f China di d not devel op, or devel oped t oo sl owly, rel ative t o i t s
nei ghbori ng count r i es , t he Chi ne s e pe o pl e woul d not b e s at i s fi ed
with the Chi nese Communi st Party. He al so indicated that i f the reform
di d not i mprove t he l i vi ng st andards of t he maj ori ty of t he peopl e,
t he Chi nese Communi st Party might not be abl e t o survive t he J une 4
I nci dent .
20. State Commi ssi on for Restructuri ng the Economi c System, " The
Rol e of Government i n Chi na: An Analysi s of a Survey, " i n Almanac of
China's Economy 1 996 ( Beij ing: China Statistical Publishing House, 976-
80, tabl e 2 . 1 ) .
2 1 . I t was offi ci al l y r epor t ed t hat b y 1 990 t here were about 430
enterprise groups. I n 1 99 1 , the State Council sel ected fifty- six enterpri se
groups for experi mentati on on manageri al and regul atory matters .
2 2 . Se e Yang J i s heng, " East - We s t Di al ogue i n Chi na, " Li aowall g
zhoukan ( Out l ook Weekly) , overseas ed. 9 , 27 February 1 989, 5-7 . See
al so, Donal d C. Cl arke, " The Creat i on of a Legal Structure for Market
Institutions in Chi na, " in Reforming Asian Socialism: The Growth of Market
Institutions, eds. John McMillan and Barry Naughton (Ann Arbor: Univer
si ty of Mi chi gan Press , 1 996) , 5 1 , 56.
23. Fazhi ribao ( Legal System Daily) , 24 Jul y 1 99 1 . 1 .
24. As Fairbank ( 1 992, 409) observed, " Duri ng the five years to 1 985,
more than a mi l l i on seni or CCP ( Chi nese Communi st Party) cadres were
pensi oned off. In September 1 985, 1 3 1 hi gh- ranki ng veterans resi gned.
Generally t hey retained t hei r perqui si tes as members of a new Central
Advi sory Commi ssi on of the CCP headed by Deng . . + Most l ocal offi -
1 89
Notes to Pages 89-104
cials as of 1 978 had fini shed only j uni or middle school . By 1 984 half of
them were college graduates. Among higher ofi ci al s in party and gov
ernment before 1 9 8 1 only about a quarter, but by 1 984, two- thirds or
more, were college graduates. " By 1 995, about 90 percent of l ocal offi
cials were college graduates ( see State Commission for Restructuring the
Economi c System, " The Role of Government in China: An Analysis of a
Survey, " in Almanac of China' Economy 1 996 [ Beij i ng: China Statistical
Publ i shi ng House] , 976-80, table 1 . 2) .
25. Interestingly, one of the maj or slogans of the Chi nese Commu
ni st Party under Deng was "yao liang shuo ying" : deepening economic
reform on the one hand and consolidating political control on the other.
Central to the former is autonomy and decentralization and central to
the latter is control and coordination.
26. These agencies also design ex ante and interim checking devi ces.
27. The SPC was renamed the State Devel opment Pl anni ng Commi s
si on i n the 1 998 State Counci l restructuring.
28. Thus, there is little difference between East and West or between
North and South other than bei ng in di fferent stages of development.
The popular media terms ' 'sian value" and "Asian crony capitalism" have
l i ttl e value and are mi sl eadi ng.
Notes to Chapter 5 ( Centralization, Political Turnover and Investment
in the Philippines)
We are deepl y grateful to Jose Edgardo Campos for support and
suggestions but are entirely responsible for the views expressed here as
wel l as for any omi ssi ons and errors.
1 . Indeed, the recent Asi an financial turmoiL which devastated hith
erto rapidly growing economi es, has been interpreted j ournalistically as
a vi ndication of the simple superiority of governance systems patterned
aft er those of Western democracies.
2. This does not include Marcos's first term as president, which began
in 1 969 and was due to end in November 1 972.
3 . See, for i nstance, de Di os 1 999a for a di scussi on of how these
changes may affect clan- based relations.
4. Thi s presumes rent - seeking- related expendi tures by facti ons are
strategic complements , t hat i s, own- spendi ng by any facti on i ncreases
wi th the spendi ng by others.
5. Thi s l ocal term, " fi scal i zi ng, " gives a more constructive connota
ti on to the ol der political term "fil i buster, " which was too obviously as
soci ated with obstruction.
1 90
Notes to Pages 1 05-1 4
6. Not e that this does not mean t he actual amount of bri bes taken
is greatest. The di scouragement of investment proj ects also implies that
the amount of bri bes col l ected decl i nes.
7. The l i terature on pol i ti cal busi ness cycl es i s vast. Exi st ence of
rati onal pol i ti cal busi ness cycles has been questi oned by a number of
theorists. Several recent studi es, however, have shown that such cycl es
can exst when i ncumbent leaders have superi or information about the
economy or when some i nterest groups can use coal i ti on dynami cs to
extract rent from others. Empirically, a great deal of evi dence supports
the exi st ence of pol i ti cal busi ness cycl es i n devel opi ng countri es, al
though not i n devel oped countri es.
8. Unfortunately, for t he years pri or to 1 970, we are unable to obtain
a seri es that divi des investment neatly between private and pUbl i c. We
therefore add private construction and total durable equipment to con
sti tute a proxy vari abl e for private fixed i nvestment and take govern
ment cons t r uct i o n as a pr oxy for publ i c fixed i nves t ment . Thi s
approximati on i s j usti fi ed by t he smal l er rol e that government pl ayed
i n durable equi pment pri or to the martial l aw peri od when l arge- scale
experi mentati on with public corporati ons began; prior to that peri od,
publ i c i nvestment consi sted mostl y of publ i c works.
9. Recently, the Estrada administration accused the previ ous one of
granting " behest" loans, or "l oans on command. " One case was t he land
reclamation deal mentioned earlier; another was the accusation that the
previous administration granted behest l oans to i nterests cl ose to i t.
10. A signal event in the rehabilitation of the Marcos faction has been
the election of Eduardo Cojuangco as chairman of San Miguel Corpora
tion, one of the largest Philippine congl omerates. Mr. Cojuangco was the
most important Marcos crony, and President Estrada ran under the minor
ity political party Cojuangco headed. Si nce 1 986, Cojuangco' s shares in
San Miguel have been under government sequestration, and he was pre
vented from exercising any infuence in the corporati on. It is significant
that the government representatives in the San Miguel board were those
chiefy responsi bl e for Cojuangco's return from economic limbo.
I I . Obvi ously, there are some types of l eadership turnover, such as
coups and revolutions, that tend to concentrate power anyway, whether
it is di fuse or not, pri or to change. Our focus here is on more regular
leadership changes that l eave the deci si on- making process and di stri
bution of power i ntact.
1 2 . One may say, however, that a substitute for thi s has been the
parameters set by conditionality on the part of the I MF and to a l esser
1 9 1
-
Notes to Pages 1 1 4-20
extent the World Bank duri ng the 1 970s and 1 980s. Typi cally effective
duri ng cri si s peri ods, these programs substi tuted for the i nformati on
that openness to international markets may have provi ded. To that extent,
the lines for the rent- seeking contests were defi ned i n terms of the al
l owabl e budgets and taxes that needed to be passed.
1 3. An important source of uncertainty for Americans at t he time was
the i mpending end of "parity rights, " a legacy from the US occupation,
which gave national treatment t o US investors, particularly i n the matter
of asset ownershi p.
14. For an overview, see de Di os, Daroy, and Kalaw- Tirol 1 988.
1 5. Another countr in a similar situation would have been India. I t
is noteworthy that development theorists writing in the 1 950s and 1 960s
regarded India and the Philippi nes as the countries most l ikely to suc
ceed i n devel opment terms .
1 6. Recall that the Philippine Revolution of 1 896 was the frst in Asia
to be waged on explicitly Western republican and democratic principles
from the French Revolution. The democratic political canon was suspended
but not contradicted by the US occupati on. I ndeed, it might have been
strengthened by the example of the Americans' own democratic system.
1 7. I n the Philippi nes this broader view is used to distinguish purely
economi c uni oni sm from the i deol ogi cal or mi l i tant variety.
1 8. Wry political wisdom captures this when it states that no one in
the country ever "l oses" an election, one i s only always "cheated. "
1 9. Marx ( [ 1 869] 1 983) i n a si mi l ar vein would write i n frustration
that absolutism, or Bonaparti sm, was based on the backwardness of the
French peasantry. He went as far as to doubt whether they formed a
cl ass, noting that they were connected purely l ocally, with few interests
at the national level and no pol iti cal organization.
20. This is by no means unqualified; some authors have poi nted t o
factors which suggest that qualitative changes are possi bl e, if they have
not actually occurred, owing to economi c changes, demographic forces,
gl obalizati on, educati on, and the emergence of an organi zed ci ti zenry
duri ng the Marcos di ctatorshi p i tsel f ( see, e. g. , Kerkvl i et and Moj ares
1 99 1 , 10 and de Di os 1 999a for a di scussi on) .
2 1 . For a recent di scussi on, see de Di os 1 999b.
22. Notthstanding the fact that tarifs are part of revenues and, there
fore, a legislative prerogative, a loophole in the tarif code exists, allowing
the president to revise tariffs when Congress is not in sessi on.
23. Wurfel ( 1 988, 85) provi des a descri pti on of the premartial l aw
peri od that is still relevant when he writes that "al most all bills of gen-
1 92
Notes to Pages 1 20-66
eral i nterest were fi rst drafted by the executive branch. Fewer than a
hundred bills were passed each year, and the president had much to say
about whi ch became l aw . . . . A maj ority of bills passed by both houses
were particularisti c; they granted utility franchises for exampl e, created
barri os, or changed the names of schools. Congressmen fled thousands
of speci al interest bi l l s every sessi on, doing favors for [ their] l ocal po
litical liders or simply trying to impress unsophisticated constituents. As
a result, the priorities of the technocrats on the president's staff clashed
with those of congressmen. " This situation, of course, became even more
pronounced under the dictatorship, when the legislature either di d not
exist or was reduced to a rubber stamp. Thi s practice is still current, to
the extent the post dictatorship presi dency has more prerogatives than
i t had before marti al l aw.
24. This proposal was al so support ed by the reputabl e Phi l i ppi ne
Constitutional Associ ati on.
25. Admittedly at least partially self- serving on the part of incumbent
pol i ti ci ans.
26. Thi s is not to deny that favoring particular interests is also pos
si bl e i n the process of privatization and deregulation.
27. These i nefi ci enci es i ncl ude the mi nor di spl ays of sycophancy
involved in inventing acronyms for proj ects that invariably spell out the
i ncumbent presi dent's name, i . e. , FI DEL under Ramos and ERAP under
Estrada. Of course, thi s al so means that these programs must be scrapped
or redrawn once the administration changes.
28. Economi c deci si ons by the Supreme Court-most recently on
foreign investment in the Manila Hotel-have particularly attracted con
t roversy.
29. A study by the I nstitute for Popul ar Democracy ( 1 994) observes
that members of the Lower House who came from ol i garchi c fami l i es
had been reduced from 1 69 ( of a total membership of 250) i n 1 987 to
1 45 by 1 992.
Notes t o Chapter 7 ( Governance and Growth i n Thailand)
1 . See Warr and Bhanupong 1 996 for a detai l ed descri pti on of the
shocks and pol i cy responses.
2. See Doner and Anek 1 994 and Warr and Bhanupong 1 996 for more
detail s.
3. Other factors certainly affect governance as well, among t hem the
interests and behavior of private actors. However, in this chapter I focus
primarily on the i ncentives and capabi l i ti es of pol i cy makers.
1 93

Notes to Pages 1 66-69


4. National policies include classic public goods, such as defense, as
well as goods or policies that may l ook a lot like public goods, but might
not meet the strict publ i c goods definition ( nonrival rous consumpti on
and nonexcl udabi l ity) . Educati on and currency deval uati ons are two
exampl es of col l ective, but not strictly, public goods. In principl e, edu
cati on i s certainly an excl udabl e good-individual s mi ght be excl uded
on the basis of their ethnicity, their citizenship status, their income, etc.
A currency deval uation might not meet the nonrival rous consumption
cri teri a. As peopl e "consume" the deval ued currency by purchasing i t,
the currency will appreciate over time, ceteris paribus. The more peopl e
purchase the currency the greater the appreciati on.
5. For exampl e, el ectoral rul es that require voters to vote for party
lists or that pool votes among candidates of the same party tend to be
associated with a strong attachment to party l abel on t he part of both
candi dates and voters . On the other hand, where voters cast multiple
votes or where the el ectoral rul es facilitate intraparty competi ti on the
val ue of the party label is diminished ( Carey and Shugart 1 995, Shugat
and Mainwaring 1 997, Cox and McCubbi ns 200 1 ) .
6 . For theories o n when groups have incentives t o form nationwide
parties as opposed to smal l er parties see Chhi bber and Kol l man 1 998,
Cox 1 999, and Hicken 1 999.
7. Capability is also a reflection of administrative capacity-namely,
the quality of the bureaucracy ( Cox and McCubbins 200 1 ) . The bureau
crats have a key role t o pl ay i n the pol icy- maki ng process. They are
often a key source of i nformati on for policy makers and are al so del
egated the task of policy i mpl ementati on. Where administrative capac
i ty i s l ow due t o di vi s i ons wi t hi n the bur eaucracy, c orr upt i on, or
i ncompetence, the capabil ity t o produce and i mpl ement good pol i ci es
is undermined. The quality of political leadership could al so be included
in this category.
8. The rol e of the Senate i n policy making is an extremely under
studied topi c and one that deserves more attention ( see Chai-anan 1 989
for some di scussi on of the role of the Senate) .
9. Parties al so fail to forge strong links across di stri cts, provinces,
and regions t o form large, national parties, although t he extent of link
age failure varies somewhat by region and party. For a more detai l ed
analysi s of l i nkage, the number of parti es and regi onal vari ati ons i n
Thai l and see Hi cken 1 999.
1 0. The two parti es t hat have come cl osest to becomi ng nati onal
parties in recent elections are the Democrat and New Aspiration Parties.
1 94
T
Notes to Pages 1 69-73
However, even these parties draw most of their support from one or two
regions (the South and Bangkok for the Democrats and the Northeast for
the NAP) .
1 1 . King ( 1 996) and Albritton ( 1 996) are the l one dissenters that I am
aware of. They argue that the weakness of Thai party l abel s has been
exaggerated and that party l abel s do matter to voters.
12. A well - known example comes from seventeenth- century England
(North and Weingast 1 989) . The addition of Parliament as a check on the
English monarch's actions made it more difcult for the Crown to renege
on public debt commi tments. As a result commitments to repay were
more credible and England was able to borrow money at lower interests
than would have otherwi se been possi bl e.
13. Prem actually followed t he one-year t erm of General Kriengsak,
who resi gned i n 1 980.
14. See, for exampl e, Anek 1 992a and Pasuk and Baker 1 995.
1 5. I t is important t o note that the " bifurcation" of policy can actually
be traced back to the Sarit era ( see Christensen et al. 1 997) . I n 1 958 the
management of macroeconomi c policy was reformed and technocrats
put i n charge of the pol i cy- making process. However, management of
sectoral policy was not reformed and remained a bastion of corruption
and patronage ( i bid. ) . The uniqueness of the policy- patronage compro
mise under Prem i s that el ectoral politicians were given a piece of the
pie and were able to keep it. (Elected pol iticians were also appointed to
sectoral Cabi net posts i n 1 975 but l ost control of t hose posts after a
military coup in 1 976) .
1 6. A few positi ons were fil l ed up by pol i ti ci ans with strong eco
nomi c backgrounds. Boonchu Rochanasathi an, head of t he SAP party
and a former bank president, was chosen as Prem's frst deputy minister
in charge of economic affairs. However, when Boonchu and Prem clashed
over stabilization measures, Boonchu resigned his post and the SAP l eft
the government coalition. ( Boonchu wanted to increase fiscal spendi ng
in an effort to try and jump start the economy whi le Prem and his advi sors
preferred a stabilizati on package) . After Boonchu and the SAP l eft the
Cabi net, Prem assumed a greater rol e i n economic policy maki ng and
appointed nonparty peopl e, mostly technocrats or retired bureaucrats,
to t he key economi c posts (Anek 1 992b) .
1 7 . For more i nformati on about the specific funct i ons of each of
these groups see Anek 1 992a, 1 992b and Chri stensen et al . 1 993.
1 8. Researchers poi nt to several factors that contri buted to t he rela
tive decline in the poli tical infuence of the military over the course of
1 95
r
I
Notes to Pages 1 73-75
the 1 980s, culminating in the selection of an elected pol itician as prime
minister in 1 988. These factors include the end of the communist insur
gency, splits, and generati onal shifts within the armed services, interna
tional infuences, economic development and the growing political power
of economic elite, and an alliance between the new economic elite and
political parties ( see for example Chai- anan 1 989, 1 993, 1 997; Suchit 1 989;
Sukhumband 1 993) . The fact that Chati chai was a retired general al so
helped facilitate the transition from a nonelected to an elected premier.
1 9. James Ockey ( 1 992, 1 994) and Philip Robertson ( 1 996) are among
those who have chroni cl ed the rise of these powerful provincial busi
nessmen, or Chao Pho, and thei r entry i nto party politics. These busi
nessmen became active supporters of candidates and political parties in
an effort to gain more i nfuence i n the pol i cy process. I t was al so the
case that Bangkok-based politicians, preferring to run i n rural constitu
encies rather than i n ultracompetitive Bangkok, sought out the support
and assi stance of the provincial busi ness elite ( Ockey 1 992) .
20. The fortunes of provi nci al busi ness el i te were often based on
concessions or monopolies, such as mining, timber, liquor production and
distribution, and petrol distribution, granted by the government ( Ockey
1 992) . One would exect, then, that they would be against any attempts to
remove concessions, dismantle monopolies, or make the process of grant
ing contracts more competitive and transparent.
2 1 . The JPPCC met a si mil ar fate. The JPPCC was created by Prem
to be the vehicle through which urban busi ness i nterests would infu
ence policy Chatichai reduced the rol e of the JPPCC i n a bid to allow
elected Cabinet ministers (and the provincial business interests that they
represent ed) to gain more di scret i on over economi c pol i cy maki ng.
Compared to a nearly monthly meeting schedule under Prem, the JPPCC
met only five times in 1 988, four in 1 989, and twi ce i n 1 990.
22. While the incentives and capabilities of politicians are the focus
of this essay, there are certainl y other factors that contri buted to the
decline in the quality of governance. One of the most significant is the
hollowing out and politicization of the bureaucracy that occurred during
the late 1 980s and 1 990s ( Ammar 1 997) . Duri ng the economi c boom
many of the most compet ent and wel l - trai ned bureaucrats l eft thei r
government j obs for hi gher paying positions in the private sector. Col
l ege graduates also began opti ng for hi gh- paying careers in the private
sect or over j obs i n the bureaucracy. This reduced the capacity of the
bureaucracy to analyze the potential problems facing the economy, and
to ofer accurate information and sound advice to pol i cy makers. With-
1 96
T
Notes to Pages 175-82
out accurate information, policy makers' capability to enact sound policy
was further undermi ned. However, even the strongest advocates of the
bureaucrati c- decl i ne expl anati on recogni ze the need to account for
pol itical factors as wel l. " Since the failure of the technocracy coul d in
principle be ultimately corrected by the pol itical leadership, it has to be
explained why the Thai political system fail ed to deliver that l eadership"
(Ammar 1 997, 64) .
23. Thi s is not to say, however, that poor governance is the only
reason behind the cri si s.
24. The cl osest thing to a comprehensive infrastructure development
plan was the East Seaboard Devel opment-a green- fi el d devel opment
proj ect compos ed of export pr ocessi ng zones, an i ndust ri al area, a
teleport, and a deep seaport. However, even this proj ect ran into signif
cant diffi cul ti es ( see Anuphap 1 997 for more detail s) .
25. Thailand's performance in the area of the environment has been
equal l y di smal .
26. For more i nformation on the BISE see Pakorn 1 994, Ammar 1 997,
and Nukul 1 998.
27. There i s room for much more research on t he l i nks between
pol i ti cs and policy making during t he 1 990s. A particularly i nteresti ng
questi on i s what rol e politics pl ayed i n the failure of the Bank of Thai
land to deval ue the currency pri or to the July 1 997 foat.
28. See Ammar 1 997 for a di scussi on of how an i ncrease i n the de
facto number of veto pl ayers within the Bank of Thai l and i tsel f al so
contributed to the deteri oration of policy.
29. See Pasuk and Baker 1 998 for more i nformati on on the BBC
scandal .
30. For detailed accounts of the crisis in Thailand, see MacIntyre 1 999a,
Bhanupong 1 998, Ammar 1 997, Pasuk and Baker 1 999, Warr 1 998, and
Lauridsen 1 998.
3 1 . For a cl oser l ook at t he impl ications of t he new 1 997 Constitu-
ti on, see Hicken forthcoming a, and Hicken forthcoming b.
1 97

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21 4
1
INDEX
Administrative capacity, 1 94n. 7
Agricultural development, Malay
sia, 1 38
Alliance, The, Malaysia, 1 37-38
American Foreign Corrupt
Practices Act of 1 977, 80
Anand, Panyarachun, 1 77
Anand government, 1 77-78
Aquino, Corazon, 1 04, 1 22-23
Aquino administration, 1 2 1
Arbitration Law, China, 80
ASEN. See Association of South-
east Asian Nations
Asian crony capital ism, 1 90n. 28
Asian fnancial crisis: 1-3, 6, 25-26, 40,
1 90n. l ; efect on China, 97-100;
impact on the Philippines, 128
Asian miracl e, 2
Asian val ue, 1 90n. 28
Association of Southeast Asian
Nations, 1 26
Autonomy of local governments,
China, 88-89
Autonomy of technocrats, China,
89-90
2 1 5
Baht devaluation, 1 65
Bangkok Bank of Commerce, 1 79-80
Bangkok International Banking
Facility, 1 77
Banharn, Silpa- archa, 1 73
Banharn administration, 1 80-8 1
Bank Bumiputera, Malaysia, 1 41
Bank of Thailand, 1 65, 1 72, 1 78-
79, 1 97n. 28
BI BF See Bangkok International
Banking Facility
BMF See Bumiputera Mal aysia
Finance
Boonchu Rochanasathian, 1 95n. 16
Bribery, 2 1-22, 60-63, 1 88n. 1 0
Budget Bureau, Thailand, 1 72
Bumiputera, 1 40, 1 44, 146. 1 53.
1 55, 1 57
Bumiputera Malaysia Finance, 1 41
Bureaucracy, 58-59, 1 25
Bureaucrats, 58, 73, 82, 1 94n. 7
Cpital account, Indonesia, 390. 43
Capital accumulation, Korea. 60
Capital control. 1 87n= 9
Index
Capital fight, Korea, 49-50
Capital infow, Korea, 52-56
Central Advi sory Commi ssi on,
Chi na, 90
Central Party Discipline Commis
sion, China, 92
Central Party Personnel Agency,
China, 90
Centralization in government,
Philippines, 1 1 4-22
Chaebols, 52, 61 , 65-66
Chao Pho, 1 96n. 1 9
Chart Thai Party, 1 73
Checks and balances, 1 03-6, 1 27
China, Peopl e's Republic of: 3-4;
corruption in, 73-79; foreign
direct investment, 69-84, 97;
formal governance, 98-1 00
China Strategic Holdings, 83
Chinese Communist Party, 92
Civil Service System, Chi na, 90-93
Cojuangco, Eduardo, 1 9 1 n. 1 0
Commodity producti on, Mal aysi a,
1 33-34
Companies Act of 1 965, Malaysia, 1 41
Congress. Philippi nes, 1 93n. 29
Conglomerates, Korea. See
Chaebols
Constituti on: Philippi nes, 1 03,
1 1 9-20, 1 23; Mal aysia, 1 5 1 ;
Thailand, 1 68, 1 73, 1 82
Coordination devices, China, 92-97
Corruption: 3-5, 1 3-14, 1 84n. 5,
1 87n. 9, 1 88n. 6; and capital
accumulation, 60; and gover
nance, 61-62; and implications
for investment, 1 1-24; model of
predictability, 1 7-24; political
fnctions of, 62-64; survey
questions on, 1 6
21 6
Corrupti on, monopol istic, 2 1 -23
Criminal law, Chi na, 8 1
Cronyi sm, 1 61 -62
CSH. See China Strategic Holdings
Daim, Zainuddi n, 1 48
Daya Bumi project, 1 4 1
De Venecia, Jose, 1 23
Debacle of 1 997, 1 60-62
Decentralization of autonomy, 86- 91
Decentralization of authority, 86, 89
Democrat Part Thailand, 1 94n. 1 0
Democratic institutions, 5
Deng Xaoping, 85-86, 92, 1 89n. 24
Department of Anti- Embezzlement
and Bribery, China, 8 1 , 92
Difusi on of power, Philippi nes,
1 1 1 -1 4
Dual- tract price system, 1 88n. 4
East Asian paradox, 3-5, 1 1-1 4
East Seaboard Development,
Thailand, 1 97n. 24
Economic Contract Law, China, 80
Economic deregulati on, Mal aysia,
1 3 5
Economic diversification, Malay
sia, 1 34, 1 37-40
Economic governance system, 4-
5, 32-42, 46-56
Economic hi story, 25-26
Economic Planning Board, Korea,
64-65
Economic reforms, Thailand, 1 65
Economic stability, Korea, 47-49
Educational system, Thailand, 1 75
Elections, 1 06-9, 1 70, 1 94n. 5
Employment I ndex, Mal aysia, 1 44
Ersatz capital i sm, 1 61
Estrada, Joseph, 5-6, 1 08
Index
Estrada administration, 1 23, 1 91 n. 9
Ethnic Malay. See Bumiputera
Fm Service Company, China, 84
Federal Land Devel opment
Authority, Mal aysia, 1 38
Financial regulati on, Thailand, 1 78
Fiscal policy, Thailand, 1 80
Fiscalizing, 1 90n. 5
Foreign capital infows, Korea, 52-56
Foreign debt, Korea, 1 87n. 1 3
Forei gn di rect investment: Chi na,
69-73, 80, 1 88n. 1 ; I ndonesi a,
28-29; Korea, 54-56, 1 86n. 5;
Mal aysia, 1 35; Thailand, 1 65-66
Foreign direct investment l aws,
China, 73-74, 79-8 1
Free Trade Zones Act, Malaysia, 1 39
GATT See General Agreement on
Tariffs and Trade
General Agreement on Tarifs and
Trade, 65
General Kriengsak, 1 77, 1 9n. 1 3
Gift giving, China, 1 88n. 3
Goverance: 1-2; China, 9B-I00; Phil-
i ppi nes, 1 0 1-2, 1 1 2; Thail and,
1 66-70, 1 75, 1 93n. 3, 1 96n. 22
Government decision making, 61-62
Government intervention on
investment, 56-58, 1 40-47
Government regulati ons, Indone
sia, 33-35
Grameen Bank-l ike Ikhtiar, 1 57
Gross domestic product: 1 7-20 ,
27-28
Guanxi, 81
Hong Kong, 82-83
Hua Guofeng, 85
Illicit wealth accumulation, 46
Indonesia: corruption in, 25-4;
economic conditions in, 3 1-32,
42; institutions, 32-38; invest
ment
'
27-30; legal system, 30,
40-41 , 44; political incentives,
32-38; political system, 43;
private cronyism, 30; systemic
cronyism, 30
Industrial Coordination Act,
Mal aysia, 1 46, 1 57
Industrial Incentives Act, Malaysia,
1 39
Industrial organization theory, 33
I nformal enforcements. See
Foreign direct investment
l aws, China
I nfrastructure devel opment pol icy,
Thailand, 1 76-77
Institute of Strategic and I nterna
tional Studi es, Mal aysia, 1 50
I nstitutional change, 6-7
Instituti ons: 1 83n. 2; and credible
commitments, 38-42; in
Indonesi a, 36-38; and politi
cal incentives, 32-38
I ntermediary business organiza
tions, China, 81 -84, 88
International arbitration, China,
1 88n. 1 2
International Convention of Invest
ment Disputes, 8 1
I nternational Country Risk Guide,
1 83n. 3
21 7
Interational Monetary Fund, 1 1 6, 1 26
I ntraregime investment, Philip
pi ne, 1 03-6
Investment Act of 1986, Malaysia, 1 51
I nvestment governance, Korea, 54,
64-67
Index
I nvestment model, Phil i ppi nes,
1 29-30
ISIS. See Institute of Strategic Inter
nati onal Studi es, Malaysia
Japan External Trade Organiza-
tion, 1 76
Judiciary, Philippines, 1 05, 1 1 9
Keynesian theory, 47
Kim Young Sam government, 64, 66
Korea: capital fight i n, 49-50;
corruption i n, 4, 60-63; and
foreign capital infows, 52-56;
investment i n, 45-49; luxury
consumption in, 50-5 1 ; state
created rents i n, 5 1-52
Korean Federation of Industries, 65
Korean I nvestment Governance
System, 46-56
Kuok, Robert, 84, 1 89n. 1 6
Kuala Lumpur City Centre, 1 41
Law of Equity Joint Ventures,
Chi na, 79
Law of Contractual Joint Ventures,
Chi na, 79
Law of Wholly Foreign- Owned
Enterprises, China, 79
LCM framework, China, 7 1 -73, 79
Legal system: 2-3; of China, 73-74,
97; of I ndonesia, 30, 40-4 1 , 44
Legislature, Philippi nes, 1 1 9-20,
1 26, 1 93n. 29
Local government code, Phili p-
pi nes, 125
Local informati on, 81 -84
Look East policy, Malaysia, 1 47, 1 53
Lopez family, 1 08
Luxury consumption, Korea, 50-5 1
21 8
Macroeconomi c policy: Korea,
47-48; Thailand, 1 7 1-72, 74,
1 77-8 1 , 1 95n. 1 5
Mahathir, Mohammad, 7 , 1 3 1 , 1 35
Mahathir administration, 1 43
Mahathir's Policy Reforms, 1 47-52
Malaysia: 3, 6-7; colonial heritage,
1 35-37; economi c boom i n,
1 60-62; economi c diversifca
tion i n, 1 34-40; economic
infrastructure, 137, 1 54;
economic recessi on, 1 34;
investment policy of, 134;
investments, 1 43-44; postwar
economy, 1 3 1-34; and state
interventi on, 1 40-47
Malaysia Incorporated, 1 47-48, 1 53
Malaysi a Busi ness Council, 1 50
Malaysi a Industrial Devel opment
Authority, 1 39
Manufacturing investments,
Malaysi a, 1 45
Mao Xedong, 85-86
Mao era, 1 89n. 1 8
Marcos, Ferdinand, 1 04
Marcos family, 1 08
Marcos regi me, 1 1 6
Market - preserving authoritarianism,
China, 4, 75-79, 84-86
Merdeka Constitution, 137
MIDA. See Malaysian Industrial
Development Authority
Ministry of Public Enterprises,
Mal aysia, 1 42
Ministry of Finance, Thailand,
1 72, 1 74
Ministry of Supersion, China, 81 , 92
Monopol i es, singl e, 33
Monopol i es, compl ementary, 33
Monopol ies, multitude, 34, 44
Index
Monopolistic corrption, 21 -23, 1 05
MPA. See Market- preserving
authoritarianism
National Devel opment Policy,
Malaysi a, 1 50
Natonal Economic and Social Devel
opment, Thailand, 1 72, 1 74
Nepotism, 1 61 -62
New Aspirati on Party, Thailand,
1 94n. 1 0
New busi ness governance,
Malaysi a, 1 47-52
New Economi c Policy, Malaysi a,
7, 1 3 1 , 135, 1 40, 1 52-53
New Order period, Indonesia, 26, 31
New regulati on, Malaysia, 1 35
Northian framework, 41
OECD. See Organization for
Economi c Cooperation and
Development
OeL Hong Leong, 83-84
OLS regressi on, 1 8-1 9
Organizati on for Economi c Coop-
eration and Development, 13, 65
O- ring corruption, 23-24, 1 85n. 1 1
Outline of Perspective Plan,
Malaysia, 1 40, 145-46
Parity rights, 1 92n. 1 3
Park, Chung Hee, 46
Parliamentary system, Philippines,
123
Party system, Thailand, 1 67-68
Patronage, Thailand, 1 7 1-72
PBSC. See Political Bureau of
Standing Committee
Pearl River Delta of Guangdong, 83
Peopl e Power Revol ution, 2, 5
Petroleum Development Act,
Mal aysi a, 1 4 1
Petroleum production, Malaysia, 1 41
Philippi ne Constitutional Associ a
ti on, 1 93n. 24
Philippine elite, 1 1 6-1 7
Philippine Revolution of 1 896,
1 92n. 16
Philippines: 3, 56; bureaucracy, 1 25;
corrption i n, 1 05; elections,
1 069; governance system, 1 01 -
2, 1 22-27; political economy,
1 02-3; political institutions,
1 15-18; presidency, 38
Pi oneer Industries Ordinance,
Mal aysi a, 1 39
Plaza Accord of 1 985, Thailand, 1 65
Political and Economic Risk
Consultancy, 69
Political Bureau Standing Com
mittee, China, 92
Political business cycle, 1 9 1 n. 7
Political control, China, 90-93,
1 90n. 25
Political economy, Philippines, 1 02-3
Political institutions, Indonesia, 36-38
Political parties, 6, 8, 1 94n. 9
Political Risk and Consultancy
Inc. , 1 83n. 3
Political stability, Korea, 47-49
Political system, Thailand, 1 82
Political turnover, Philippi nes,
1 06-9
Politics of governance, Thailand,
1 52-60
21 9
Pork-barrel politics, Philippi nes,
1 2 1 -22
Poverty reducti on, Malaysia, 1 46
Power, devolution of, 1 24-25
Power, diffusion of, 1 09-1 4
Index
Pramuan, Sabhavasu, 1 73
Prem Tinsulanonda, 8-9, 1 64-65,
1 70-7 1
Pre- martial l aw period, 192n. 23
Presidents, Philippines, 1 09, 1 1 9,
1 20-24
Presidential system, Philippines, 1 04
Prime Minister, tenure of, China, 93
Privatization: Mal aysia, 148-49,
1 54; Philippines, 1 93n. 26;
Thailand, 1 76
Promotion of Investments Act,
Malaysi a, 145
Propert rights, Indonesia, 25-26, 35
Provincial politicians, Thailand, 1 73
Public goods, Thailand, 1 94n. 4
Public investment, Phil i ppi nes,
1 9 1 n. 8
Public sector expenditure, Mal ay
sia, 1 42
Ramos, Fidel V 1 23
Ramos administrati on, 1 2 1 -23
Redistribution of wealth, Mal ay-
sia, 1 55-58
Regime of I nvestment Gover
nance, 1 993-1 997, 64-67
Regulatory agencies, 33
Rent- seeking: 5; Korea, 5 1-52, 59-
63; Mal aysia, 1 55-6 1 ;
Thail and, 1 7 1-72
Rentier cronyism, 1 61
Roh Tae- Woo government, 66
Rule of law, 1 01
Rural development, Mal aysia, 1 38
Sabah, 1 37
Sarawak, 1 37
Second Outline Perspective Plan,
Mal aysi a, 1 50
220
Sectoral policy, Thailand, 1 75-77
Singapore, 1 37
Sixth Malaysia Plan, 1 50
Southeast Asia economi c boom,
1 60-62
SPC. See State Planning Commis
si on, China
Standing Committee of National
Peopl e's Congress, China,
1 89n. 1 5
State intervention, Mal aysia, 1 35
State Administration of Industry
and Commerce, China, 87
State Counci l of Chi na, 93-96
State- created rents, 5 1-52, 1 55
State Economic and Trade Com-
mission, China, 92-93
State in a Changing World, 1 6
State- owned enterpri ses: China,
73, 87-88; Malaysia, 1 41-42,
1 48; Thailand, 1 76-77
State Planning Commission,
China, 92
Stock Exchange Commission,
Thailand, 1 77
Suharto, 3-, 26, 35-38, 40, 42, 1 85n. 2
Systemic cronyi sm, 30
Tariffs, 1 92n. 22
Technocrats, Thailand, 1 72, 1 74-75
Ten Great Relationships, China, 85
Thai party system, 1 69-7 1
Thai pol itical system, 8-9, 1 66-7 1
Thailand: economic condition,
1 63-66; infrastructure devel
opment pol i cy, 1 76; political
structure, 1 66-1 70
Township and village enterprise,
China, 73
1
Index
Trade deregulati on, Phil i ppi nes,
1 20, 1 93n. 26
Trade liberalizati on, 65, 1 20
Transnational corporations, 54-56
Transparency International , 69,
1 83n. 3
Tukkapg 62
Tunku Abdul Rahman, 134
221
UMNO constitution, 1 5 1
Vision 2020, Malaysia, 1 46, 1 50-52
Wage differential, Korea, 1 86n. 4
World Development Report, 1 6
World Trade Organizati on, 65, 1 26