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The political economy of private sector development in the Middle East and North Africa: Credible commitment, rent-seeking and institutionalization Philip Keefer, Development Research Group Draft: 4 November 2007 Prepared for the Flagship Report on Private Sector Development in MENA Summary The policy problem: Long-term low investment and growth plague MENA countries. The policy sources of slow growth have been difficult to decipher, however, since by many measures, including widely-used measures of governance, MENA countries do not rate below, and occasionally rate more highly, than fast growing comparator countries. This chapter examines the challenge of attracting private investment in countries where leaders are not selected in competitive elections. The political roots of low investment: Successful non-democracies have attracted private investment by encouraging the institutionalization of the ruling party, the bureaucracy, or the military: allowing for transparent promotion and recruitment; delegating substantial authority to low levels of the organization; and allowing intra-organization coordination. MENA countries exhibit considerably less institutionalization than comparator countries because institutionalization limits leader discretion and access to rents, and is less likely to be pursued in countries with high natural resource rents and intra-leadership discord. Reconciling reasonable aggregate governance and policy indicators and low investment: Lack of institutionalization implies weak governance and policies that encourage rent-seeking, neither of which show up in aggregate country indicators. Disaggregated data, however, indicates substantial divergence from aggregate indicators and provides a reasonable basis for concluding that low investment is, indeed, a consequence of the governance and policy environment, which in turn follows from reluctance to allow institutionalization. Recommendations: Though the obstacles to private investment identified here are deep-seated, the analysis characterizes the types of reforms that can make a difference: those that offer guarantees to investors without challenging leader aversion to institutionalization. These include limited geographic jurisdictions, such as Export Processing Zones, where the civil service overseeing regulatory activities can be transparently and meritocratically recruited; and accelerated growth-oriented public investment, the benefits of which fall when leaders renege on their commitments to investors. The political economy of private sector development in MENA: Credible commitment, rent-seeking and institutionalization Dissatisfaction among the governments and citizens of MENA countries with the rate of income and employment growth has motivated a search for policy solutions that would increase both. The most important undisputed economic lesson of the last 20 years is that private investment is essential to these goals. Country success in formulating policies that accelerate private investment depends on a range of factors, including their economic circumstances, technical capacity, agreement on which policies are appropriate, and political constraints on policy selection. This analysis is concerned with the last of these, the incentives of political leaders in MENA to adopt policies that promote private investment. The starting point of the analysis is that growth and investment in MENA, whether oil or non-oil, have lagged those in reasonable comparator countries. One possible explanation for this that emerges from current research on institutions and growth is the absence of competitive elections in most of MENA. However, MENA growth and investment lag considerably behind even East Asian countries that similarly lack competitive elections. Another common explanation is the influence of cronies and special interests on government policy. Here again, though, the question is why the influence of cronies has a more negative effect on growth and investment in MENA than in other countries. It is apparent that political leaders who are not competitively elected face widely varying incentives to pursue policies that promote private investment. This report outlines the sources of this variation and suggests explanations for the reluctance of leaders in MENA to adopt policies favorable to private investment. Such policies generally include low barriers to entry and competitive markets, equal treatment of private investors by government policy and, especially, credible commitments to private investors that their investments will not be expropriated. The central argument in the analysis here is that countries without lack competitive elections can achieve these objectives through the institutionalization of the ruling party, the bureaucracy or the military. In many nondemocracies, these organizations are not institutionalized: they do not exhibit such characteristics as internal transparency regarding compensation and promotion, explicit rights to coordinate internally, and considerable delegation of authority to lower levels of the organization. The absence of these organizational attributes prevent leaders from making credible promises to members of the organization, since members cannot easily contest reneging by leaders. Institutionalization, however, allows members to challenge leaders and limits leader discretion. At the same time, it allows leaders to credibly promise the organization’s members that they will not be expropriated if they invest, and that they will be rewarded if they accelerate growth. These characteristics promote private investment, first, by giving confidence to those inside the organization that they can invest without fear of expropriation and, second, by encouraging these members from promoting growth rather than exploiting their official positions to extract rents from private investors. Only in some countries that lack competitive elections, however, do politicians have incentives to create institutions that reduce barriers to entry and allow for credible commitments to large numbers of private investors. When they do, private investment can flourish, as China demonstrates. In other countries, leaders are reluctant to permit institutionalization: the losses in rents and tenure security outweigh the gains from greater private investment. As the discussion 2 below argues, lower rates of private investment in MENA countries can be traced to the lack of institutionalization, which in turn responds to country characteristics that make institutionalization less attractive to leaders than in many of the countries in East Asia. Country characteristics that make institutionalization less attractive in MENA countries than in East Asia range from high natural resource rents to high levels of intra-leadership conflict. The next section outlines the contrast between growth and investment in MENA and comparator countries, followed by an overview of various approaches to institutionalization and the apparent absence of institutionalization in most MENA countries. The report then turns to an explanation of reluctance to institutionalization, focusing most on natural resource rents and intra-leadership conflict. The failure to institutionalize should be evident in the policy environment; the section identifies policies that provide such evidence. Finally, the report turns to policy implications. These are significant. First, the usual benchmarks of economic liberalization, ranging from trade liberalization to the relaxation of rules governing business entry, will have less of a sustained growth effect in the absence of reforms that increase credibility. Second, reforms to increase credibility must take into account the persistently weak incentives for slow institutionalization in the region. This means, in particular, taking steps to make reforms credible to private investors outside of country elites. Such steps could include significant increases in productive public infrastructure investment, which benefits all entrepreneurs and not only the chosen few, and which is a costly signal of government commitment not to expropriate (since the political value of the infrastructure is degraded if it attracts little private investment); and limited institutionalization in the form of full transparency and meritocracy in the civil service in selected jurisdictions, such as Export Processing Zones, which are significant enough to support employment growth, but not enough to challenge leader aversion to institutionalization. Growth and investment in MENA Over the 20 years from 1985-2005, MENA countries grew substantially more slowly relative to plausible benchmark countries: East Asian countries, non-democracies, and other middle income countries (see Figure 1). In the more recent decade, 1995-2005, growth has been about the same across these groups (see Figure 2). However, MENA countries have not enjoyed the rapid growth acceleration that has characterized some of these East Asian countries. Moreover, poorer countries, all else equal, should offer a higher return to capital that would drives faster growth than in richer countries. Non-oil MENA countries (Lebanon, Egypt, Jordan, Morocco and Tunisia), with average per-capita incomes of $3,894, were 23 percent poorer in 1995 than seventeen East Asian comparators (not including Hong Kong), with average income per capita of $5,056.1 Nevertheless, they grew only slightly faster (2.5 percent versus 2.4 percent). 1 Income numbers are ppp-adjusted, in constant 2000 US dollars. 3 Figure 1: Average yearly growth in per capita income, 1985-2005 (purchasing power parity, constant 2000 dollars) 0 .01 .02 .03 Average real per capita income growth, 1985-2005 MENA Oil No competitive elections, 1984-2004 Middle Income MENA Non-oil East Asia Source: World Development Indicators, author calculations. The MENA oil countries with data are Syria, Saudi Arabia, Algeria, Yemen and Iran. The MENA non-oil countries with data are Tunisia, Egypt, Jordan, Lebanon and Morocco. 45 countries are in the group of comparators characterized by noncompetitive elections, 70 among the middle-income comparators and 17 among the East Asian countries. There are overlaps between the last three groups, but MENA countries are excluded from them. The comparison is starker if one looks at the five largest East Asian countries, China, Indonesia, the Philippines, Thailand and Vietnam. Their average incomes were slightly lower than the non-oil MENA countries in 1995, $3,498. However, the average growth of these countries from 1995 to 2005 was more than forty percent faster, at 3.6 percent per year. The contrast between East Asia and the major oil producers is similar. The five major oil producers with the largest populations, Algeria, Iran, Saudi Arabia, Syria and Yemen (all with populations greater than 50,000,000), had average incomes approximately the same as the East Asian comparators in 1995, $5,314. However, instead of growing at approximately the same rate as the East Asian comparators, per capita incomes in these countries grew only 1.8 percent per year in the succeeding 10 years, compared to 2.4 percent for the East Asian countries, and 3.6 percent for the five East Asian countries with populations greater than 50,000,000. This represented continued slippage relative to the East Asian benchmark: in the previous decade per capita incomes in East Asian countries had grown by 3.5 percent per year (5.4 percent for the four largest), while, in contrast, Syria grew at a 1.6 percent annual rate, Saudi Arabia by 0.16 percent, Iran by 0.1 percent and in Algeria, suffering through internal conflict, incomes per capita receded at a rate of 1.7 percent per year. 4 Figure 2: Average yearly growth in per capita income, 1995-2005 (purchasing power parity, constant 2000 dollars) 0 .01 .02 .03 Average real per capita income growth, 1995-2005 MENA Oil No competitive elections, 1994-2004 Middle Income MENA Non-oil East Asia Source: World Development Indicators, author calculations. The MENA oil countries with data are Syria, Saudi Arabia, Algeria, Yemen and Iran. The MENA non-oil countries with data are Tunisia, Egypt, Jordan, Lebanon and Morocco. 45 countries are in the group of comparators characterized by noncompetitive elections, 70 among the middle-income comparators and 17 among the East Asian countries. There are overlaps between the last three groups, but MENA countries are excluded from them. A proximate explanation for the difference in growth rates between East Asia and MENA is the low quality and quantity of investment. Although data coverage is less complete, there is a several percentage point gap in investment/GDP between comparator countries and MENA. Among thirteen East Asian comparators, private investment averaged 16.7 percent of GDP from 1995-2005, and among the four large East Asian countries, 18.5 percent (China’s average was 17.4 percent). The four oil producers with the largest populations averaged 14.8 percent, and the five non-oil producers 14.7 percent. There is little evidence that public investment can compensate for shortfalls in private investment, but even if it could, public investment quantities did not offset shortfalls in private investment: total investment was 22.4 percent in the non-oil MENA countries, compared to 26.4 in East Asia and 31.6 in China and Thailand. In the non-oil MENA countries where private investment was highest, Morocco and Lebanon (where private investment averaged 19 percent of GDP compared to 8.2 percent in Egypt), public investment averaged less than five percent of GDP, resembling more closely the less successful Philippines model than the Chinese. One measure of quality is the contribution of public investment to growth. This appears, as well, to have been higher in East Asia. To get a rough sense of this, one can take the sample of all countries, regress their growth over the period 1985-2005 on public and private investment in the first half of this period, 1985-1995, and ask whether investment in East Asian and MENA 5 countries is associated with higher or lower than average growth.2 As one would expect, given the common incentives of private actors to profit maximize, in neither MENA nor East Asia is private investment associated with different growth rates than in the average country (controlling for initial income per capita). Public investment, however, is associated with substantially different growth rates across regions. Public investment in either the non-oil MENA countries or in the oil producers in MENA with the largest populations has a slightly smaller growth effect than the average country, but significantly greater than average in the largest East Asian countries. Why would the effect of public investment differ across countries? One explanation is the degree to which private investors are free to take enter new markets opened up by public investment. Another is the degree to which governments use public investment to pursue growth rather than other objectives. On both counts, the political environment in MENA countries provides fewer incentives to target public investment to the pursuit of fast growth than do East Asian comparators. This chapter therefore explores the politics of government policies towards investment and growth in MENA. Credible commitment and investment in non-democracies In both democracies and non-democracies, political leaders pursue economic growth when the policies underlying growth are politically attractive. Those policies insulate private investors from arbitrary bureaucratic decision making and expropriatory behavior by government; encourage innovation, and promote easy entry into new markets and competition. It is not enough to embrace these policies, however. If investors do not believe that the policy commitments are credible, or if civil servants do not believe government promises to reward them in exchange for faithfully implementing the policies, the growth effects of policy reform are limited. In the past, scholars posited that competitive elections would both provide the essential institutional foundation of credible commitment and motivate politicians to pursue growth. However, countries with and without competitive elections exhibit no significant difference with respect to either private or total investment as a percentage of GDP. This is because both democracies and non-democracies differ significantly among themselves in the political incentives that they offer politicians to pursue investment- and growth-promoting policies. As a consequence, and as Table 1 illustrates, rates of private investment are almost identical in countries with and without competitive elections, though private investment in MENA is less, on average, than in both sets of comparators. An important element of heterogeneity among countries with competitive elections is political credibility. In many democracies, politicians are only able to make credible promises to narrow groups of citizens, those from the same geographic area or with whom politicians have had significant personal interaction. Under these circumstances, electoral competition does not drive politicians to make policies that benefit all citizens, but instead gives them incentives to pursue clientelist promises that benefit selected groups of citizens (Keefer and Vlaicu, 2 The illustration comes from variations on a regression such as the following: Growth (85-05) i = (private investment, 85-95) i +(public investment, 85-95) i +(Large East Asia) i +(Large East Asia) i *(priv. inv.) i +(Large East Asia) i *(pub. inv.) i + (MENA, no oil) i +(MENA, no oil) i *(priv. inv.) i +(MENA, no oil) i *(pub. inv.) i +(MENA, non-oil) i +(GDP/capita 1985) i + i 6 forthcoming). Broad investor protections, low entry barriers into markets and laws and regulations that open markets all suffer under these circumstances, since they all tend to deny benefits to narrow interests and to favor broad social interests. This is one reason why the rule of law and bureaucratic quality are lower in young democracies, and corruption higher: in young democracies, politicians are less likely to have the ability to make credible promises to broad groups of citizens (Keefer 2007). Table 1: Elections and private investment/GDP, 2004 (in percentages; number of countries in parentheses) Competitive Elections No Competitive Elections MENA 15.5 (56) 15.0 (47) 13.2 (9) Notes: Countries with competitive elections exhibit Legislative Index of Electoral Competitiveness (LIEC) =7 and an executive index (EIEC) =7. For EIEC=LIEC=5, elections have multiple candidates, but only candidates from one party win seats. For EIEC=LIEC=6, elections have multiple candidates, but the winner receives more than 75% of the vote. For EIEC=LIEC=7, no candidate receives more than 75% of the vote. In non-democratic countries, politicians have three reasons to appeal to narrow interests, and therefore to under-provide investor protections and government regulations that will attract capital from investors broadly. First, although, as the foregoing discussion makes clear, competitive elections are no guarantor of accountability, the absence of elections also means that broad groups of citizens face high costs in holding politicians accountable for policy favors to special interests (see, for example, Keefer 2006, demonstrating that special interest-driven banking crises are worse in non-democracies). Second, whereas in democracies politicians need special interests to finance their political campaigns, in non-democracies, special interests may play a bigger role, to defend the regime against potential violent overthrow. In exchange for this bigger role, however, special interests can demand greater rents and economic privileges, both of which are antithetical to growth. The third, as in democracies, is the difficulty of making credible promises to citizens. In democracies, elections allow citizens, at relatively low cost, to expel politicians who break their promises (though these promises may be clientelist rather than growth-promoting). In nondemocracies, leaders themselves choose how easily particular groups of citizens can expel them and how large those groups can be. That circle can be quite small, restricted to family, or large, as in the case of an institutionalized and large ruling party. The smaller the circle, the fewer are the investors who enjoy protection from arbitrary or predatory government actions against them and the less conducive are policies to growth. The remainder of this discussion focuses on the degree to which unelected leaders make different choices regarding how credible they wish to be, and how this helps explain substantial variation across autocracies in private investment and growth. How can unelected politicians make credible promises not to expropriate private investors? Unelected leaders can use two broad sets of arrangements to remain in power. One is to make themselves and their close relatives and associates the center of entrepreneurial activity in the country. Since leaders have no reason to expropriate themselves, this approach solves the credible commitment problem, but limits investment to a small group. The other choice leaders have is to embrace greater institutionalization, of a ruling party, bureaucracy or of the armed 7 forces, which reduces the costs to members of the institution (e.g., the ruling party) of expelling the leader. MENA countries tend to rely more on the first set of arrangements; faster growing democracies, such as China or Singapore, rely on the second. La économie, c’est moi Absent any institutional arrangements for constraining arbitrary or expropriatory behavior by leaders, one source of investment is leaders themselves and close associates and family members with whom personal relationships secure promises of non-expropriation. Faccio (2006), using data on 20,000 firms from 47 countries, finds that political connections can have high economic value (a new political connection increases firm value by one to four percent). The country where these connections were most pervasive was Indonesia, where 22 percent of firms had directors or owners who sit in the legislature; directors or owners who used to be politicians; or directors or owners who are friends with ministers or legislators. Systematic data on political connections are not available for the MENA countries examined in Figures 1 and 2 and Faccio does not analyze them. However, anecdotal evidence supports the conclusion that leaders and their close associates control large swaths of private sector activity across the MENA region. Owen (p. 67) argues that, prior to coup attempts in 1971-72, rents were concentrated in an extremely narrow circle in Morocco; following these attempts, it expanded to a circle of advisors drawn from 1,000, who were rewarded with privileged business opportunities. In Syria, the cousin of the president owns 55 percent of Syriatel, responsible for tax revenues amounting to 1.7 percent of GDP (Heydemann 2007, p. 14). Entrepreneurs in Algeria were categorical in stating that having a “name” (being from an elite family, and therefore closely connected to other elite families) was essential to avoiding expropriatory actions by officials. These arrangements are associated with high rents for the participants. Faccio (2006) notes, for example, that connections are highly correlated with corruption. They are, at the same time, a solution to the problem of credible commitment: leaders cannot expropriate themselves and are unlikely to expropriate family members and close associates. This solution limits investment and expertise to what leaders and close associates themselves can offer, unless investments by the leader in a firm provide a credible commitment to private co-investors that they will not be expropriated. If this is the case, leaders can leverage their own capital to attract new capital. It is not necessarily the case, however, that politically connected partners solve problems of credible commitment. Frequent disputes between private (especially foreign) and well-connected local partners make clear that co-investment by leaders and close associates is often a vehicle of rent extraction rather than protection.3 3 Under one circumstance, co-investments by leaders attract private investment that would otherwise not enter a country: when the loss of reputation from expropriating partners results in larger rent losses to the leader than the loss of reputation from expropriating investors generally. Future potential co-investors will be more reluctant to deal with leaders who reneged on their agreements with prior co-investors, just as future investors are more reluctant to enter a country when a ruler has expropriated earlier investors. Co-investment reduces the probability of expropriation only if the rents that leaders can extract from the private sector are greater when they co-invest than when they simply tax. This may be the case, however. For example, ownership gives rulers access to firm information that they would not otherwise have, making it more difficult for private investors to hide rents from the ruler. 8 The reliance on personal ties between leaders and investors need not be inimicable to economic growth. Haber, et al. (2003) document the utility of such ties in raising growth rates in Mexico for a prolonged period of time at the turn of the last century. However, a key attribute of the Mexican case was that state governors controlled their own militias, and therefore could defend their interests against potential incursions by the leader, Porfírio Díaz. In the Mexican case, therefore, close personal connections to governors or to Díaz himself were sufficient to overcome credibility problems. In countries where the leader exerts unquestioned authority over all citizens, the circle of potential investors tightens contracts accordingly. In rare circumstances, rulers need investors more than investors need rulers. Moore (2004) describes the history of business-state relations in Kuwait and writes that prior to the discovery of oil, “Manpower and financial power gave Kuwaiti merchants and early sense of equality with the ruling al-Sabahs. . . [P]olitics needed commerce.”(p. 31) Once oil was discovered, however, the ruling family could independently finance its own defence, among other things, and not rely on the labor force controlled by the merchants. This led to significant institutional changes. “The elected municipality board, which had served as an asil merchant enclave since 1932, was replaced with an appointed board of shaikhs. As royal family members took control of government ministries, merchant committees within those bodies, designed to provide policy input, were disbanded”(p. 42). Merchant leverage of the al-Sabah family was directly linked, however, to their ability to finance their own defense and, because of the small number of merchant families, their ability to coordinate a response to al-Sabah intrusions – a crucial feature of institutionalization that is discussed below. Jordan provides another example of this. Jordan exhibits little of the institutionalization that is discussed in the next section, but at the same time it has relatively high governance scores. Jordan’s ratings on the rule of law and corruption components of the World Bank’s Governance Index are larger than those of all other non-oil MENA countries. As Table 4 below reports, Jordanian firms are far less likely to report corruption as a major obstacle to doing business compared to firms in other countries. What explains this? Similar to Moore’s (2004) description of sheik-merchant relations in Kuwait, private enterprise in Jordan is to a large degree the province of Jordanians of Palestinian descent, who both lack family connections to the Hashemite ruling family and are outside the elite circles that control policy making (Moore 2004). This is unusual in the region. As in Kuwait, however, their interests are protected, at least partially, by their capacity for coordinated action, their relatively small numbers, and by the government’s interest in promoting employment in the Kingdom. However, the government has no interest in granting this group special rents. As a consequence, it is also the case that Jordanian firms report low access to bank financing (Table 4), and Jordanian manufacturing reports very low rates of firm concentration in manufacturing, with Gini coefficients of less than .10 compared to over .55 in Morocco and Egypt (Sekkat 2005). Low access to bank financing is clearly negative for investment. While the high rates of concentration in Morocco and Egypt may be undesirably high and a reflection of growth-stunting market power of incumbent firms, Jordan’s rate of concentration is lower than even wellfunctioning competitive economies (Ginis of approximately .40 are common in Europe and North America). The low Gini in Jordan may reflect a willingness of leaders to accept the diseconomies of small scale manufacturing in order to hinder the emergence of large and wellfunded actors from outside the support base of the government. 9 A related strategy is an affinity-based one, in which investors from the same background as the leader believe that they are less likely to be expropriated than others. One manifestation of this in MENA is the economic prominence of the Allawi in Syria. Affinity could imply that the leader’s personal utility increases in the welfare of members of the group (e.g., as in Robinson and Verdier 20XX). The leader therefore avoids behavior that hurts the group, while members of the group support the leader because challengers are unlikely to share the leader’s affinity for them. This is a fragile strategy. It requires easily observable cues that distinguish members of the affinity group from all others, as well as the belief that the leader prefers the affinity group above others. It also requires that the affinity group not be too large. If it is large, the leader gains more from expropriating all members of the group and losing their political support than he does from protecting their property rights and retaining their support. Finally, even if the strategy works, it extends only to members of the affinity group; other private investors dare not enter. Institutionalizing restraints on the leader Absent elections, citizens cannot easily contest actions by leaders against their interests. They confront significant collective action costs in coordinating their response, including a lack of information on whether a leader has in fact acted arbitrarily and against their interests and an inability to make agreements with each other about participating in coordinated action against the leader. Leaders themselves affect these costs, whether by placing prohibitions on citizen assembly or restrictions on media access. The circle of investors willing to trust leader commitments not to expropriate, and of civil servants willing to believe leader compensation promises if they implement pro-growth policies, are both small. Information, for example, is essential both for holding leaders accountable and for coordination among citizens. Limits on citizen access to information are greater in countries where investment depends more on personal connections between investors and politicians, consistent with the idea that barriers to collective action by citizens are greater in such countries. Faccio (2006) finds more restrictions on press freedom in countries where politically-connected firms are more pervasive. Her evidence does not extend to the MENA region. However, the market share of state-owned newspapers, a plausible proxy for restrictions on press freedom, is much higher in MENA countries: in 2000, for all the countries for which there is data, the market share was 74 percent in four large MENA oil countries, 60 percent in four non-oil MENA countries, 60 percent in all non-democracies, but only 36 percent in four large East Asian countries. By reducing these collective action costs for some subset of citizens, allowing them to coordinate freely, leaders simultaneously increase their own vulnerability to revolt and the prospects for private investment. Where average citizens have little access to information and are relatively unable to make agreements with other citizens to coordinate a response to ruler actions, this subset of citizens has better access to information and the ability to make agreements with other members of the group. Leaders must necessarily give all members of this group greater scope for taking independent action without consulting the ruler, otherwise all efforts to coordinate are instantly regarded with suspicion. In practice, an institutionalized ruling party, such as the Chinese Communist Party; an institutionalized civil service, as in Singapore; or an institutionalized military, as in Indonesia or Chile, all constitute subgroups of citizens with superior ability to coordinate a response to arbitrary leader actions. 10 These organizations have several key attributes that facilitate coordination by their members. They include: a hierarchical structure that is intended to facilitate coordinated action generally (e.g., to provide public services, mobilize political support, or to defend the country), and therefore against the ruler in the event of arbitrary behavior; the ability to enforce intraorganizational agreements without the leader’s intervention, allowing group members to make credible agreements with each other; stability of membership and career paths, leading to frequent and long-term interactions among group members, further enhancing the capacity to make credible agreements; transparent reward systems that quickly expose arbitrary treatment of group members by the leader, without which the group could not easily coordinate a response to arbitrary treatment; and decentralized responsibility for tasks, which gives scope for coordination efforts to emerge throughout the organization, without which leaders could simply co-opt those at the top of the organization, undermining the point of institutionalization. The next three sections discuss institutionalization of bureaucracies, ruling parties and the military as possible institutionalization strategies. The conclusion in each case is that there is little evidence of institutionalization in MENA. The Syria case is typical: though he came to power as the leader of an apparently ideologically- and class-oriented party with an institutional identity separate from the leader, Hafiz al-Asad quickly asserted personal control over all three major power institutions: the party as general secretary, and the government and military (as pres). His personal Alawite clients dominated the military police, including several praetorian guard units and intelligence organs. As Hinnebusch (p. 146) concludes, ideology faded as the regime’s source of support, replaced by patronage and personal/tribal ties to the regime. 4 Institutionalized bureaucracies The Singaporean civil service reflects all of the attributes of institutionalization. First, it is structured to provide a high level of public services, requiring ample ability to coordinate within and across ministries. Second, it has promotion and compensation standards tied to the successful achievement of service provision, so that successful coordination is actually rewarded. By 2006, 40 percent of average civil service and 50 percent of senior civil service total compensation was performance-based.5 These ratios are higher not only than other public sectors around the world, but also most private sector employment contracts. Third, Singapore has extended substantial discretion to civil servants. For example, in the early 1980s, community policing was introduced, one of the attributes of which is to generate substantial police-community interaction and to endow police with substantial discretion to tackle crime and crime prevention in their patrol areas. Workplace and food safety regulators were also allowed to defer prosecution for firms in violation. By the 1990s, agency counter staff were appraised on manners, job knowledge, and helpfulness to the public (Burns 15-16). More 4 The family-based governing systems of the Gulf states also generally do not exhibit institutionalization. However, the families are so large and the consequences of conflict over succession so grave for the entire family, that they have occasionally attempted to formalize certain aspects of family rule. In Saudi Arabia, for example, King Abd alAziz decreed in 1932 that only his own offspring and those of his brothers and of families related to his common history and marriage were “royal” and given stipends. This list was edited twice by King Faisal after 1958 (Owen, p. 58). 5 See the VOG (Vibrancy, Opportunities and Growth) website of the Public Service of Singapore and its information on the variable component of civil service compensation: https://app.vog.gov.sg/StaticContent/FAQ.aspx#5. 11 broadly, the Block Vote Budget Allocation system introduced in 1989 set a target of total expenditure for each ministry is set as a percent of national income. Following budget approval, each ministry could then spend according to stated objectives, but could freely shift funds and manpower between programs and activities. In particular, the budgeting process allowed ministries to use unexpected surpluses from one area to achieve objectives in other areas without going back to the legislature or cabinet for approval. Finally, performance standards are transparent, as a result of significant investments that Singapore has made in its management information systems. The Singapore Government Management Accounting System (SIGMA) was introduced in 1992. This computer-based information and analytical system allowed exact costing of public sector activities. Resultsbased budgeting was then possible and was introduced in 1994, linking budgets – and compensation – to precise performance and cost targets (Jones 1999). These bureaucratic characteristics are associated with a high level of performance. Looking only at non-democracies, the first two columns of Table 2 compare average values, over the period 2000-2005, of the International Country Risk Guide measure of bureaucratic quality and the World Bank Governance Index, for Singapore, two sets of MENA countries and China, controlling for the 2000 values of other country characteristics that affect the costs of supplying high quality bureaucratic performance in a country. 6 Singapore performs significantly above the average non-democracy. The ICRG bureaucratic quality variable ranges from zero to six. Singapore scores 1.1 points, almost one standard deviation, higher than the average nondemocracy, controlling for other country characteristics. The institutional arrangements exhibited by the Singaporean civil service should encourage investment for two reasons. The usual reason is that investor risks are lower when they confront a predictable, high quality bureaucracy. The second reason, to which less attention has been paid, is that the very characteristics of the Singaporean civil service make it difficult for the government to renege on its promises to compensate the bureaucracy for treating investors well. These characteristics (internal transparency and stability) endow the civil service with the ability to coordinate a response to government should it renege on these promises. Column 3 of Table 2 indicates that Singapore is, indeed, exceptional among non-democracies in its ability to attract private investment, with private investment/GDP ten percentage points higher in Singapore than the average non-democracy.7 Of course, the government needed a motivation to make these promises in the first place – that is, it needed a political motivation to seek growth. Such a rationale, and the reason why it is not common across all non-democracies, is explored in the next section of this chapter. Neither governance nor investment are different in the MENA oil countries than in the average non-democracy. However, Table 2 highlights two puzzles with respect to the non-oil MENA countries. First, governance is significantly better than average, approximately one-half 6 Table 2 results are robust to the use of period averages for all right hand side variables, as well. The use of initial values mitigates feedback effects from governance and investment back to income and other right hand side variables. 7 This regression controls for income/capita to take into account diminishing returns to investment in richer countries with larger capital stocks. Consistent with this, higher income countries attract significantly less investment, all else equal. 12 a standard deviation. However, there is little sign in the public sector organization of these countries of the meritocracy and bureaucratic coordination that characterizes the Singaporean public sector. Performance-based contracts are nearly unknown, promotions are largely seniority-based, and recruitment is heavily clientelist. For example, the World Bank (2004) report on governance in MENA reported that appointments to the civil service in Syria are based on demonstrations of loyalty rather than on merit (p. 50). Loyalty to one’s immediate superiors as a basis for recruitment leads to a personalized rather than institutionalized civil service. The second puzzle is that, while governance is above average, private investment is slightly (though not significantly) worse than average. Table 2: Singapore, governance quality and investment across non-democracies, 2000-2005 Dependent variable: Bureaucratic Quality (ICRG), 2000-2005 World Bank Governance Index, 2000-2005 Private Investment/GDP, 2000-2005 GDP/capita, ppp-adjusted, $US, 000s, 2000 .13 (.01) .16 (.06) -.65 (.01) MENA, No Oil .65 (.10) 1.11 (.00) -.92 (.74) MENA, Oil, Large .23 (.42) .15 (.56) -.71 (.75) China -4.02 (.17) 3.95 (.07) 17.61 (.27) Singapore 1.10 (.05) 1.95 (.07) 10.42 (.00) Population (millions) .004 (.09) -.002 (.49) -.053 (.08) Land Area (millions) -.14 (.56) -.17 (.36) 1.61 (.25) Percent population rural .01 (.14) -.005 (.68) -.01 (.92) Percent population under 14 yrs -.04 (.05) -.004 (.84) -.46 (.00) R-squared .51 .59 .27 N, countries 41 63 54 Notes: Ordinary least squares, p-values based on robust standard errors reported in parentheses. Constant not reported. Right hand side variables all measured in year 2000; ICRG Bureaucratic Quality, World Bank Governance Index and Private Investment are averages over the period 2000-2005. Sources: Data from World Development Indicators, World Bank Institute and International Country Risk Guide. 13 A potential explanation for these puzzles begins to emerge when one removes the control for income per capita in the first two columns of Table 2. In this new specification, the Singapore advantage grows; the non-oil MENA advantage disappears, however. Only compared to other countries with their levels of income per capita, therefore, do non-oil MENA countries do better with regard to governance; this is not enough to attract private investment. Political stability explains why non-oil MENA countries exhibit a governance advantage in Table 2, controlling for per capita income. Compared to all non-democratic countries, the non-oil MENA countries (not including Lebanon) exhibit much greater political stability, a difference that grows if one focuses on non-democratic countries with approximately the same incomes as the non-oil MENA countries. The average tenure of leaders of the non-oil MENA countries was approximately 15 years in 2000; it was approximately 10 years for all other nondemocracies, and just more than eight years for 12 non-democracies with similar incomes per capita. Political stability, measured as the fraction of years in which a leader of a country was replaced, was less than two percent from 1990 – 2004 for the non-oil MENA countries and more than eight percent for other non-democracies. If one controls for these factors, the bureaucratic quality advantage that non-oil MENA countries exhibit in column 1 falls from .65 to .12 and is entirely insignificant.8 Political stability, therefore, allows leaders to build credible arrangements grounded in personal relationships. The Table 2 governance advantage that MENA non-oil countries exhibit may be better than in other countries with similar incomes not because they have more institutionalized governments, but because they offer more propitious circumstances for building the non-institutional basis of credibility. Institutionalized ruling parties Institutionalized political parties are another, more common, vehicle through which leaders of non-democracies can limit their discretion and, correspondingly, encourage investment by private actors lacking personal connections to them. The Chinese Communist Party is the best example of such a party. Mao resolutely resisted institutionalization of the party and, correspondingly, party members were exposed to, and actually experienced, frequent purges, including those of the Cultural Revolution. Intra-party credible commitments were not possible. Growth, not coincidentally, was slow. 8 These controls have no effect on the World Bank Governance Index, even when the index component, Government Effectiveness, is used instead of the whole index. One likely explanation for this is that the criteria for evaluating bureaucratic quality used by International Country Risk Guide differ from those used by other inputs into the World Bank’s Government Effectiveness measure. ICRG emphasizes an “established mechanism for recruitment and training”, a key element in the discussion here regarding bureaucratic institutionalization, but does not mention the credibility of government commitment to its policies. However, Global Insight’s rating is weighted five times more heavily than ICRG’s in the construction of the Governance Effectiveness measure. Its criteria are not available on its website. However, the description of the World Bank’s measure of government effectiveness does not mention recruitment and training, but does emphasize government credibility generally. See, http://info.worldbank.org/governance/wgi2007/pdf/booklet_decade_of_measuring_governance.pdf. Political stability could have little effect on policy credibility (if successive politicians have similar policy incentives) but a considerable effect on bureaucratic quality (as new politicians bring in new bureaucrats whom they can trust or in order to satisfy patronage obligations). 14 Following Mao’s death, as party leaders felt an increasing imperative to spur economic growth, Deng Xiaoping introduced numerous reforms that increased the credibility of leader commitments to party members. One of these was to disband the Red Guard. Others included, as in Singapore, transparent promotion schemes, greater information dissemination among party members, and performance-based promotion schemes. Significant authority was also delegated to party members, particularly to pursue economic growth. At first, cadres were allowed to promote township and village enterprises. Later, rules were changed to give them leeway to promote private investment in their jurisdictions. Cadres were promoted based largely on their achievement of employment and growth objectives (Gehlbach and Keefer 2007). China itself is evidence of the importance that an institutionalized ruling party can have in limiting the discretion of unelected leaders: private investment soared after party institutionalization was introduced. Gehlbach and Keefer (2007) report more systematic evidence from a cross-country comparison of democratic episodes. They argue that, in the absence of data on party institutionalization itself, one can use the average age of ruling parties as a proxy. On the one hand, more institutionalized ruling parties can better defend themselves from regime challenges (since they can coordinate a more effective response to challenges, as in Keefer 2007). On the other hand, institutionalization can take time to take root, so older ruling parties are more likely to be institutionalized than younger ruling parties. Taking alternative explanations for ruling party age into account, by controlling as well for the length of the nondemocratic episode and the tenure of the individual ruler, as well as numerous other country characteristics, they identify a large, positive association between the age of the ruling party and private investment. Consistent with the argument that institutionalization protects those inside the organization better than those outside, party age has a smaller effect on foreign direct investment. Table 3 reproduces these results. Although in many MENA countries the political and economic elite are members of the ruling party, and membership in the ruling party is an important criterion for bureaucratic advancement, institutionalized ruling parties are not characteristic of the region. Whereas the Chinese Communist Party is integrated into every aspect of the state and the party itself offers a transparent career path for the ambitious, this is not the case in MENA. The leader of the party remains the hub of decision making, delegating little and promoting and rewarding party members at his discretion. Consistent with this, attracting private investment has not, historically, been a priority for most countries in the region. Interlocutors in Algeria indicate that economic growth is still not a major government concern. Owen’s (1992) review of the evolution of parties in Tunisia and Algeria, and of the Ba’th parties in Iraq and Syria indicates the absence of party institutionalization, even in situations where the ruling party was apparently prominent. Tunisia’s Neo-Destour Party, founded in 1934 by Habib Bourguiba and associates, was indeed a well-organized party by 1955, the year before independence, with a political bureau, national congress, 100 branches and a small army. In the 1960s, the party’s membership was 400,000, more than 10 percent of the population. The party dominated five national organizations for students, women, agriculturalists, businessmen and merchants (Owen p. 255). However, despite its breadth, party organization was fundamentally weak; by the end of the 1960s, the central bureaucracy of the party had only 140 staff (Owen p. 257). Party institutions were gradually absorbed into the government administration and subordinated to Bourguiba’s personal discretion. In 1974, Bourguiba has the party congress 15 declare him president for life, declares that he will appoint members to the political bureau, rather than the party’s central committee (Owen p. 257). Table 3: Party Institutionalization and Investment in Non-Democracies Dependent variable: Private Inv. /GDP Base sample More autocratic FDI/GDP Base sample More autocratic Age of ruling party 0.088 (0.01) 0.109 (0.00) 0.026 (0.15) 0.022 (0.26) Years in office 0.072 (0.43) -0.050 (0.70) 0.017 (0.78) 0.050 (0.62) Political Instability 0.677 (0.90) 0.880 (0.89) -3.144 (0.04) -1.753 (0.14) Length of Non-Dem. Episode 0.012 0.103 -0.090 -0.045 (0.92) (0.53) (0.27) (0.71) Frankel-Romer Trade index -2.115 (0.04) -2.381 (0.13) 1.415 (0.00) 0.766 (0.03) Percent population young -0.465 (0.00) -0.431 (0.03) -0.052 (0.33) -0.013 (0.80) Population, millions -0.011 (0.01) -0.011 (0.09) -0.002 (0.24) -0.003 (0.25) Percent population rural -0.011 (0.80) -0.018 (0.75) 0.020 (0.27) 0.003 (0.88) Land area, millions 0.086 (0.84) -0.186 (0.85) 0.500 (0.10) 0.531 (0.20) -0.027 (0.91) 107, 86 0.28 0.013 (0.96) 87, 76 0.27 -0.029 (0.78) 125,100 0.17 -0.058 (0.49) 105,90 0.1 GDP/capita, PPP, thousands USD N, countries R-squared Note: Ordinary least squares, clustered and robust standard errors; p-values reported in parentheses. Units of observation are non-democratic episodes, defined in the base sample, as continuous years in which countries exhibit either a Legislative Index of Electoral Competitiveness (LIEC) <7 or an executive index (EIEC) <7. In the more autocratic subsample, the criteria are LIEC<7 AND EIEC<7. See Table 1 notes (political data from Database of Political Institutions, other data from World Development Indicators). Source: Gehlbach and Keefer (2007). In Algeria, Houari Boumedienne took over in a 1965 coup, and began immediately to deconstruct the ruling Front de Liberation Nationale, giving control of it to veterans of the independence war (Owen p. 258). In the mid-1970s, he made efforts to build up the party as a vehicle of political mobilization. This late effort at institutionalization ended with his death in 16 1979, when his successor, Chadli Ben Jalid, assumed the power to appoint members of the political bureau (abandoning internal party elections), and reduced the number of party commissions from 11 to 5 (Owen, p. 259). The Ba’th parties in Iraq and Syria had many of the trappings of institutionalization, but their internal organization remained subject to the discretion of the rulers. Rulers were careful to avoid party organization that would permit party members to threaten their rule. Key to this was the establishment of competing organizations, particularly security forces, that also reported to them (much as Mao had undermined the Communist Party by establishing the Red Guard, outside the party and reporting to him). In Syria, the civilian Ba’th party was parallel to the Ba’th apparatus in the army, dominated by General Hafiz al-Asad (Owen 261), who overthrew the civilian party in a coup in 1970. He used the party as an instrument of government, but gave it no role over internal security, predominantly Alawi, or the army. Recruitment to the party was based on regional and sectarian considerations rather than on the ideological principles for which the Ba’th Party was historically known (Owen 261-62). Figure 3: Party institutionalization in MENA and non-democratic comparator countries -20 0 20 40 60 Ruling Party Age - Leader Tenure, Non-democracies, 2004 MENA Oil MENA Non-oil Middle Income Large East Asia Large MENA Oil No competitive elections East Asia Note: Each bar is the average of the difference between the age of the ruling party and the number of years that the leader has been in power. In countries where there is no ruling party, as in some Gulf States, this number is negative. The Iraq Ba’th party came to power in July 1968. From then until Saddam Hussein assumed power in 1979, the army and the Ba’th party were two separate and competing entities. Hussein was in charge of the civilian party apparatus, building up a disciplined and secretive civilian party apparatus, carefully recruiting members who then supervised the public administration, from which it was independent. The party was present in every military unity, school, university and neighborhood (Owen p. 262). However, again, key elements of institutionalization, including transparent standards for party member advancement and low barriers to intra-party communication and coordination were not present. Ideological bonds among party members were diminished, as in Syria. 17 Figure 3 demonstrates that these qualitative comparisons are reflected in a systematic quantitative difference between MENA countries and faster growing countries such as those in East Asia. In 2004, all three subsets of MENA countries had parties more clearly dominated by the party leader (in the sense that the leader’s tenure was close to or greater than the party’s age) than middle-income non-democracies, all East Asian non-democracies, and the largest East Asian non-democracies (China, Vietnam, etc.). Transitions from one leader to another are another way to assess the level of ruling party institutionalization. In the MENA region, transitions have generally followed the death, not always natural, of the previous leader. This has often accompanied at least a change in the name of the ruling party, if not its wholesale dismantling. In China and Vietnam, in contrast, party institutionalization is reflected in the fact that leadership transitions have been regular and undertaken prior to the death of incumbents. Military institutionalization The military plays an important role in the selection of leaders in many MENA countries; its institutionalization would therefore be an important source of investor security. Comparative information about military institutionalization is not widely available, however. Available information, though, suggests that non-democratic countries exhibit substantial variation in this regard, with some exhibiting substantially freer flows of information internally, more transparent and meritocratic promotion and recruitment criteria and greater delegation of responsibility throughout the organization. Indonesia is an example of one such country. In 1968, Indonesia began to enjoy continuous high rates of growth and investment, with a brief interruption in 1981, until the Suharto regime collapsed in 1998 and national income shrank by 13 percent. At the same time, significant changes were made in the institutionalization of the Indonesian military. In 1969, President Suharto centralized control of a badly divided military under a commander in chief and gave it a territorial structure – with regional commands subdivided into district and local commands down to the village level (Callahan p. 11 and Global Security, Indonesia). The reorganization seemed to delegate substantial discretion to low command levels, reflecting a national security objective of preventing countervailing organizations from forming (Callahan p. 11). “ABRI’s military operations relied on a well-developed doctrine of national defense called Total People’s Defense, based on experience during the struggle for independence. This doctrine proclaimed that Indonesia could neither afford to maintain a large military apparatus nor would it compromise its hard-won independence by sacrificing its nonaligned status and depending on other nations to provide its defense. Instead, the nation would defend itself through a strategy of territorial guerrilla warfare in which the armed forces, deployed throughout the nation, would serve as a cadre force to rally and lead the entire population in a people’s war of defense. . .” (Global Security, Indonesia). The success of this strategy required close bonds between citizen and soldier to encourage support of entire population; in support of this objective, the army mobilized for local development efforts. Suharto leveraged military institutionalization by seconding active-duty military into civilian jobs. “In 1977, more than 21,000 ABRI personnel were seconded to civilian jobs, with a slow decline over the next two decades (16,0000 in 1980, and probably 14,000 in 1992).” In 1973, fully one-third of cabinet ministers, two thirds of provincial governors and half of ambassadors were active-duty or retired ABRI officers. By 1995, these percentages had declined 18 to 24 percent, 40 percent and 17 percent, respectively” (Callahan, p. 11). Because the military had relatively transparent internal promotion criteria that rewarded effective performance in these positions and insulated officers from arbitrary removal, seconded officers had both the incentive and capacity to make credible commitments to outsiders. This extended to retired officers, who appeared as directors and senior managers of private firms. Their personal relationships with investors ensured that they would not renege on agreements with those investors; their position in an institutionalized military hierarchy secured their ability to protect private investors from other expropriatory threats. Of course, members of the Indonesian military, as with members of the institutionalized parties and bureaucracies discussed earlier, received higher rents than non-members. These rents helped cement loyalty to the regime, but because of institutionalization, the rents were not too high to obstruct growth. It is noteworthy, however, that beginning in the 1990s, Suharto began to dismantle military institutions. He more overtly “played powerful generals off one another, probably resulting in multiple informal chains of command that led only to Suharto.” (Callahan p. 13). Discipline broke down among the lower ranks of soldiers “and was non-existent in many regions.”(Callahan p. 15).9 The effects of de-institutionalization were evident in May 1998, when in the face of the popular uprisings that brought the regime down, the military could neither save nor overthrow him (Callahan p. 15). In MENA countries, the balance between meritocratic and personalistic organization of the military appears to be more strongly weighted towards the latter. Sadaam Hussein’s management of the Iraqi armed forces provides the most extreme example of this. Hashim summarizes his discussion of Hussein’s policy throughout his rule to rotate officers, to replace even successful officers with even incompetent loyalists, to establish competing armed forces, even at substantial cost to military readiness. “Even though Iraq faced a higher threat environment in the 1990s vis a vis both external and internal threats, in [Saddam Hussein’s] mind it was the most proximate force to him, the Iraqi military, which continued to represent the gravest threat” (p. 14). Outside observers rate the Syrian army as one of the largest and best-trained in the region. Nevertheless, in contrast to assessments of how the Indonesian armed forces are organized, observers point to the unwillingness of staff officers or field commanders to show initiative or to react independently to a crisis without the consent of the chain of command (Bennett 2001). Ethnic identity plays a significant role in officer recruitment; Alawi and Druze minorities, key support groups of the government, are dominant in the officer corps (Global Security, Syria). The political importance of these limits on the institutionalization of the military were made clear when a general who attempted to increase the level of institutionalization, by increasing the emphasis on merit in major military appointments, was replaced after disputes with the brother-in-law of the president, who was in charge of major military appointments and dismissals (Gambill 2002). Similarly, observers argue that commanders of the Egyptian army are reluctant to extend operational flexibility to brigade and battalion commanders, noting that “Officers below brigade 9 The motivation for deinstitutionalization is not documented, but is plausibly one of the following: a decline in the risk of insurgency (reducing the value of an institutionalized military); an increase in internal threats to the regime from the military; and related to this a potential decline in the willingness of the regime to share rents with the military. 19 level rarely made tactical decisions and required the approval of higher-ranking authorities before they modified any operations.” (Global Security, Egypt). None of this implies a generally casual attitude towards military readiness. For example, during the 1980s, the Egyptian armed forces implemented a concerted effort to improve the quality and efficiency of the defense system by introducing modern armaments and reducing the number of personnel (Global Security, Egypt). Generally, though, organizational enhancements within the military that would increase both delegation of authority downwards and the ability of units to coordinate joint operations entail greater regime risk than leaders in the region are willing to countenance. Available information therefore suggests that personal loyalty of officers to the leader plays a greater role in promotion, at the expense of more transparent and meritocratic promotion criteria. Responsibilities are not delegated to lower ranking officers as they are elsewhere; information flows are truncated; and outside observers claim that greater mistrust exists between officers and enlisted men and across units. These characteristics create obstacles to the ability of the military to coordinate in opposition to the regime. This increases leader security, but because the military provides no significant bulwark against arbitrary behavior by the leader, it undermines leader ability to make credible commitments to investors. Summarizing: The policy implications of institutionalization Institutionalization enhances private investment in three ways. First, it enables leaders to make credible agreements with civil servants to pursue actions that are only partially observable by leaders and that are essential to promoting private investment. The performance contracts that characterize the Singaporean civil service, or the reward system that the Chinese have put in place for local officials, by conditioning promotion on growth, all require that civil servants or party members believe that the promises of bonuses and promotions in exchange for performance are credible. The institutionalization of the party or the bureaucracy allow those promises to be made, such that rulers can implement growth-promoting policies (Keefer and Gehlbach). Second, institutionalization protects investors from expropriation. This is a direct consequence of institutionalization, since those within the institutionalized organization, whether party, bureaucracy or military, are at less risk of expropriation. It is also an indirect consequence, since those within the institutionalized organization can leverage their personal relationships to extend an umbrella of credibility over those outside of the organization, as with joint ventures between private investors and party officials in China or between retired military and private investors in Indonesia. Third, institutionalization necessarily curbs rent-seeking: it does not make sense for leaders to institutionalize, making themselves more vulnerable to overthrow, without a corresponding growth payoff. That payoff will not materialize if markets that were closed prior to institutionalization remain closed afterwards. Given the advantages of institutionalization, it remains, first, to ask why MENA countries have been reluctant to institutionalize and, second, to establish whether the policy environment in MENA mirrors what we expect in the absence of institutionalization. These are the subject of the sections that follow. Why the reluctance to institutionalize? The willingness of leaders to choose institutionalization to boost investor confidence depends on an essential tradeoff. Leaders can make broad promises to many investors only if 20 many investors believe that they can impose costs on the leader in the event that they are expropriated. However, the easier it is for citizens to contest expropriation or the low rates of job creation that are caused by expropriation, the easier it is for them to force leaders to reduce the share of rents that they extract from the economy. This tradeoff suggests several circumstances under which institutionalization might be desirable. First, it is an attractive strategy when the returns to private investment are high and when rents in the absence of private investment are low. In these cases, institutionalization attracts investment, improving citizen incomes and reducing their incentive to revolt, and does so at low cost in terms of natural resource or other rents that leaders must surrender to newly organized citizens. In countries with large natural resource rents, incentives to institutionalize are low. The returns to private investment are low (the exchange rate effects of resource exports reduce the rate of return to the manufacture of tradeables), reducing the payoff to institutionalization; leader incentives to expropriate are lower, since high natural resource rents are, in and of themselves, a motivation for revolution that leaders seek not to exacerbate; and institutionalization imposes higher costs on leaders in terms of natural resource rents that they must surrender.10 Second, where the leadership group cannot make credible deals among themselves, it is difficult for them to agree to institutionalize. They cannot be sure that, in the course of institutionalization, other members of the group will not take advantage of them, or will make specific decisions related to institutionalization that harm their interests. For example, in Algeria, different each power center in the government (e.g., the heads of the military and secret service) controls a different source of rents. Institutionalization requires that their control over that source of rents be loosened; the order in which loosening proceeds, however, is one of many details that is critical and difficult to manage. The discussion that follows focuses on these two determinants of institutionalization, but there is a third, the intrinsic dissatisfaction of citizens and their propensity to revolt, that also affects leader decisions to institutionalize. Keefer and Gehlbach (2007) argue that a higher threat of revolt (that is, a greater ability of citizens to undertake collective action) reduces leaders’ ability to extract rents from the members of the organization (e.g., the ruling party) to which they grant greater information access. The easier is collective action by citizens, therefore, the less inclined are leaders to institutionalize. Systematic comparative evidence makes it difficult to say more about this issue in the case of MENA countries, but the prevalence of well-armed clans in, for example, Yemen, or the extent to which sectarian groups are mobilized in many countries, suggests that the costs of collective action in the MENA region may be lower than in East Asia, and a deterrent to institutionalization. The first argument suggests that where natural resource rents are large, institutionalization is less likely. In fact, the oil-producers in the MENA region exhibit low rates of institutionalization. As is well-known, the natural resource rents available to them are, by any standard, large. One way to see this is to compare the rents extracted in MENA from energy, forests or minerals, the variables energy, forest and mineral depletion as a fraction of Gross 10 This is similar to the arguments in Acemoglu and Robinson (2007) about the conditions under which nondemocratic leaders accede to democratization. 21 National Income with the rents extracted in comparator countries.11 Differences are slight with regard to forest and mineral resources, but of course large with regard to energy. As Figure 4 makes clear, the ten MENA oil countries, including the five largest of these, derived 30 percent of GNI from oil rents in 1995, rising (for the seven countries with data) to 54 percent by 2005 (with the run-up in crude oil prices). Natural resources are not the only source of rents and some non-oil countries have had access to non-oil-based rents. Egypt and Jordan, for example, have historically received large amounts of foreign assistance that have been de-linked from development objectives. In Egypt, prior to 1990, foreign aid was 8.7 percent of GNI and in Jordan more than 18 percent. In contrast, in East Asian countries with populations greater than 2 million (excluding Pacific Islands), aid was 2.1 percent of GNI; it was only 1.1 percent in the largest East Asian countries. From 1990 to 2004, aid averaged half of its earlier level in both Jordan and Egypt. By 2004, it had dropped to approximately 5 percent in Jordan and two percent in Egypt. In East Asia, thanks to very large aid flows to Cambodia (10 percent of GNI), Laos (11 percent), Mongolia (16 percent), and Papua New Guinea (8 percent), aid flows in 2004 were 3.6 percent of GDP. Figure 4: Rents from Energy Extraction in MENA and Comparator Countries 0 20 40 60 Energy Rents/GNI 1995 1996 1997 1998 1999 2000 2001 2002 2003 year MENA Oil MENA Non-oil No competitive elections 2004 2005 MENA Oil, Large East Asia Middle Income Note: GNI is Gross National Income. Energy rents are volumes of energy extracted times world prices (or relevant market, for natural gas), less costs of extraction. Source: World Development Indicators and Hamilton and Clemens 1999). 11 Depletion rates are calculated as the total volumes of resources extracted times their world price, less costs of extraction, from World Bank staff estimates, in World Bank Development Indicators. See Hamilton and Clemens (1999). 22 High levels of foreign aid, particularly when they are not conditioned on policies consistent with development and growth, are essentially free resources that are an additional disincentive for regime liberalization. Though Egypt’s rents from all sources – oil and foreign aid – dropped by half in the 1990s compared to the 1980s, the recent run-up in oil prices has substantially boosted them again. Energy rents/GNI rose from 3.2 percent to 17.4 percent over the period 1995-2005. The control of land also offers a source of rents when small investments to improve land lead yield large returns. In Tunisia, returns to land ownership are high because of tourism and investment from oil states in residential property. Consistent with land as a source of high rents, observers report considerable involvement by the ruling family in land deals. The process of institutionalization is also difficult when members of leadership groups (those who enjoy personal or affinity relationships with the ruler) to make credible agreements with each other that, in the process of institutionalization, their relative positions will be preserved and their absolute rents not reduced. In China, for example, the key leaders who needed to agree to party institutionalization under Deng Xiaoping had served together in the Chinese Civil War and participated in the difficult Long March (ten percent of those who started the March finished it). This gave them an ample basis on which to build credible intraleadership agreements. Not only did they have a long history of personal interaction, but internecine conflict would have undermined the nation-building objectives for which they had made great sacrifices. The basis for credible intra-leadership agreements seems to be less present in MENA. Ayubi points to the intensity of intra-familial conflict in the Gulf states, which he illustrates with the cases of Abu Dhabi, where of the nine Amirs since 1818, five were murdered; two were deposed; and two died natural deaths, and of Sharjah, where of the eight leaders from 1803, two were murdered; three deposed; and three died natural deaths (Ayubi, p. 254). He also counts three dozen actual and abortive coups in the Arab world over the period 1940-1969 (p. 258). The importance of coup threats (essentially, threats from groups close to the leadership, not revolutionary threats from citizens at large) also led the Jordanian leadership to deinstitutionalize. In 1957, coup threats against King Hussein led him to take command of the army, to outlaw political parties, and tp allow only rare meetings of the parliament (once between 1974-84). He limited his cabinet to only a small group of ministers, and the political elite was a small group emanating from several hundred families (Owen, 1992, p. 65). Owen (1992, p. 202) also argues that internal conflict and disagreement about key aspects of public policy, such as how best to pursue pan-Arabism, have consistently challenged armies in the MENA region. For example, prior to 1967, young officers (typically, radical nationalists) in Syria, Egypt and Iraq overthrew their generals and attempted coups. While the military was reequipped and professionalized following the 1967 war, the dangers posed by increased organization within the military were offset by the creation of new paramilitary organizations in charge of internal security, the Central Security Police in Egypt, and the Defence Companies in Syria controlled by the president’s brother. President Sadat repeatedly changed the minister of defense and chief of staff. In Iraq, officials from the Ba’th party closely oversaw army operations. Hinnebusch (p. 86) reports as well that by the early 1960s, the Syrian army was divided on sectarian, geographic and ideological lines. 23 In Tunisia, interlocutors report the difficulties within the ruling family of controlling corrupt behavior by members of the ruling family, such as the evasion of taxes. This is a common problem, but again points to the fact that members of the ruling clique can have sharply different attitudes towards institutionalization, making agreements about institutionalization difficult to reach. Algerian respondents point out that key officials would countenance institutional reforms, but are concerned that their accumulated rents would be jeopardized. Reports by close observers reveal clear examples of the difficulties of credible intraleadership agreement in Algeria. The largest private bank, Khalifa, was founded by the son of the secret service chief during the internal conflict of the 1990s. The bank engaged in massive insider lending and 3 billion dollars were lost; these losses came at the expense of the other key actors in Algeria. The inability to make credible deals among leaders regarding private banking led to financial sector policies in which no domestically owned private banks are allowed (the sale of the largest state-owned bank has gone to short-listing three times, and three times the process has been halted), and the remaining foreign-owned banks are not allowed to lend or receive financing from any shareholder, including the parent bank. The financial sector provides other illustrations of intra-elite tensions. The biggest stateowned bank credit, equal to 4.5 times the equity of the bank, was to a company linked to the army chief of staff. When the president dismissed him, the bank called this loan and the company collapsed. However, in return, the president had to close down a large enterprise that was controlled by individuals close to him and the secret service. Another well-placed observer indicated that state-owned banks are reluctant to make private sector loans because of “tensions with the generals.” Again, this can be explained by the mistrust among elites about how the costs and benefits of rent-seeking will be shared among them.12 In all of these cases, the inability to make credible agreements has led to policies that reduce the rents available to everyone. These same observers report that intra-elite disagreement extends to the issues of concern here, such as democratization (or, more modestly, institutionalization). For example, although the elections were considered a disappointment for the government, particularly the drop in turnout from 46 percent in 2002 to 30 percent in 2007, in the post-election period no key actors were replaced in any ministry. Elites cannot reach agreements that would improve even their own aggregate welfare. Defusing opposition and maintaining support in the absence of institutionalization Another way to judge whether MENA governments are reluctant to institutionalize is to examine whether they pursue alternative strategies to defusing opposition. One of these is to undertake redistribution to some citizens, such that recipients of redistribution believe that revolt will not leave them better off, while non-recipients believe that they will not succeed in staging a revolt without the cooperation of those who receive the redistribution. One way in which this strategy can manifest itself is the creation of a large civil service and military. Beneficiaries are most likely to believe that they will lose them in the event of a fall in the regime and are therefore least likely to support insurgency (see, for example, Robinson and Verdier XX). Non- 12 This same observer reports that every state-owned enterprise is controlled by a different center of power, so loans from state-owned banks that go to the private sector divert resources away from SOEs. 24 recipients of these jobs, observing that all public sector workers, constituting a significant fraction of the population, are supportive of the government, see their chances for successful revolt correspondingly decline. Although details on the public sector wage bill in MENA are harder to compile, the available information points to much higher spending than in comparator countries. In 2001, in the three non-oil MENA countries for which data are available from World Development Indicators, public sector wages as a fraction of GDP were reported to be approximately 19 percent in Jordan, 10 percent in Lebanon and 11 percent in Tunisia. The oil countries with data report roughly similar figures: Bahrain and Kuwait, at approximately 16 percent, and Iran at 9 percent. The contrast with East Asian countries (with data) is sharp: corresponding figures for Indonesia, Cambodia and Singapore were 1 percent, 4 percent and 5 percent. Papua New Guinea was the highest, at 7.4 percent of GDP, but demonstrates the lack of connection between spending and performance, since its bureaucratic quality was below average in East Asia. The 2005 Unified Survey has data for more recent years, though for fewer countries. These show Algeria with a government wage bill of approximately 7.5 percent of GDP from 2001-05; Egypt with a bill of approximately 7.8 percent over that period; Iran starting with a wage bill of almost 10 percent in 2001, plummeting to 5 percent by 2005; Morocco steady at between 12 and 13 percent; Syria rising from 9.5 percent to 11 percent; and Tunisia steady at approximately 12 percent.13 In contrast, in 2005 spending in East Asia averaged less than 6 percent for those countries with data: Indonesia spent 1.3 percent of GDP on public sector wages, the Philippines 5.5 percent, Thailand 5.9 percent and Malaysia 5.2 percent. More detailed and revealing data are also, unfortunately, older. Schiavo-Campo, et al. (1997) collected thorough information on the wages, numbers and total wage bill associated with public sector employment in a large number of countries. Their data reveal that, at least at that time, MENA countries had much larger government workforces and offered more generous compensation to government workers. In Algeria, Bahrain, Egypt, Jordan, Lebanon, Morocco, Syria, Tunisia, West Bank-Gaza and Yemen, they found total government employment averaged 8.4 percent of the labor force (3.3 percent of the population); that the average government wage was 3.4 times GDP/capita; and that the total government wage bill was 9.8 percent of GDP. In contrast, figures for Latin America were 4.7 percent of the labor force (1.9 percent of population); a lower average wage of 2.5 times GDP/capita, and a total wage bill of 4.9 percent of GDP. Among East Asian countries, these numbers were lower still. In China, 2.8 percent of the labor force, or 1.7 percent of the population, were employed by the government, for a total wage bill amounting to 3.8 percent of GDP, with average wages amounting to 1.3 times GDP/capita. In Singapore, with its much-vaunted and famously well-paid civil service, two percent of the labor force, or .9 percent of the population, were government employees, and the total wage bill was 4.6 percent of GDP. Although salaries in Singapore are high, though, they are only 2.1 times GDP/capita. In Indonesia, finally, a fast-growing, poorer country with a lessadmired civil service, government employment is 2 percent of the labor force, 1 percent of the population, earning average wages amounting to 1.6 times GDP/capita, amounting to a total wage bill of 3 percent of GDP. 13 This alternative data source is largely consistent with the World Development Indicators (where the two overlap). It is, however, dramatically and inexplicably lower in the case of Jordan. World Development Indicators reports that in 2003, the government wage bill in Jordan was 20.5 percent; Unified Survey reports 5.8 percent. 25 Consistent with the idea that MENA governments have chosen to use public sector jobs to defuse opposition, rather than institutionalization, militaries and military spending are also larger. In the large oil countries, military spending was 5.8 percent of GDP in 2004 and military personnel was 3.02 percent of the labor force, about the same as in the smaller oil countries. Among the MENA countries with no oil, spending was 4.1 percent of GDP and military personnel comprised 3.9 percent of the labor force. In East Asia, military personnel constituted a similar fraction of the labor force (3.6 percent in East Asian countries generally, 3.1 percent in the largest of them), but a much smaller fraction of spending (1.9 percent of GDP in all East Asian countries, 1.3 percent in the largest ones). In Latin America, both spending and personnel were low: 1.3 percent and .78 percent, respectively. Privileged involvement by the military in the private sector is another device to build regime support. For example, Syria’s military operates the largest construction business in the country, according to Ayubi (p. 276). Military involvement in the economy is common, as well, in East Asia, including Thailand, China and Indonesia. The difference in MENA is that, because the military is less institutionalized, military involvement is more likely to be characterized by a narrow investor base and higher barriers to entry for non-military investors. As the evidence in Table 2 indicates, these larger expenditures do not translate into greater efficiency, since bureaucratic quality is not higher in MENA countries than in comparator countries that spend less. On the contrary, given a lack of institutionalization, leaders cannot easily monitor or contract with the public sector to induce high performance. Shirking is easier when institutionalization is low. As a consequence, in addition to the greater measured rewards that governments offer to public sector employees to gain their support, they also offer greater opportunities to shirk compared to countries in which governments opt for institutionalization and smaller public sectors. Two additional empirical regularities are consistent with the conclusion that institutionalization lowers the public sector wage bill and raises bureaucratic quality. First, a measure of bureaucratic quality from International Country Risk Guide is positively associated with one measure of institutionalization, the age of the ruling party in non-democracies. Gehlbach and Keefer (2007) report regressions showing that corruption is significantly lower, across a variety of specifications, when the age of the ruling party is higher. Second, controlling for income per capita, the correlation between the public sector wage bill and bureaucratic quality is insignificant (since 2000) or significantly negative (in the period before 2000). The contrast between Algeria and Indonesia provides a useful illustration of the dynamics of institutionalization. In Algeria, as in Indonesia, the military played a large role during serious episodes of civil unrest. This implies that leaders would place a high premium on a wellfunctioning military, and therefore on institutionalization of the military. However, set against the rewards of increased security that institutionalization brings are the costs in terms of rents foregone. Fuel exports as a fraction of GDP in Indonesia in 1968, just before a major reorganization of the military took place, were only 4 percent of GDP, compared to 12 percent in Algeria in 1966 and 15.3 percent in 1968. In Indonesia, fuel exports rose as high as 19.2 percent of GDP in 1981, but in that same year were 32 percent of GDP in Algeria. Incentives to institutionalize the military were persistently lower in Algeria than in Indonesia. Given its reluctance to institutionalize, Algeria would be expected to engage in greater public spending to defuse opposition. Patterns of government spending reflect this. From 1994 – 26 1998 (the last year of the Suharto regime), government expenditures in Algeria averaged 24 percent, compared to 15.5 percent in Indonesia. Most of these expenditures flowed to wages and the military. Public sector wages were 9 percent of GDP in Algeria and 2.3 percent in Indonesia. Military expenditures were 3.4 percent of GDP in Algeria and 1.4 percent in Indonesia. In contrast, goods and services were 17.5 percent of government expenditures in Indonesia and only 6.3 percent in Algeria.14 Governance and barriers to entry in MENA vs. comparator countries To the extent that MENA countries exhibit less institutionalization and a more personalized basis for credible investor-politician or bureaucrat-politician interaction, we would expect to see public policies towards investment that are associated with less institutionalization: a greater risk of expropriation of investor assets, greater rent-seeking (since a lack of institutionalization allows governments to extract greater rents from the economy), and more barriers to entry and less competitive markets (reluctance to remove these barriers undermines the rationale for institutionalization in the first place). Figure 5: Governance in MENA and Comparators, 2004 -1.5 -1 -.5 0 World Bank Governance Index MENA Oil No competitive elections Large East Asia MENA Non-oil East Asia Middle Income Source: World Bank Institute, World Bank Governance Index Note: The index is the sum of only the rule of law and corruption indicators (omitting voice, regulatory effectiveness, and policy stability). The MENA oil sample contains the United Arab Emirates, Bahrain, Algeria, Iran, Iraq, Kuwait, Libya, Oman, Qatar, Saudi Arabia and Syria. The MENA non-oil sample consists of Egypt, Lebanon, Morocco, Jordan and Tunisia. There are no MENA countries in the remaining groups. 14 Although Algerian income per capita was slightly more than twice Indonesian income per capita, differences in income per capita are not a good explanation for these differences. Government expenditures/GDP, for example, are not significantly correlated with income/capita in 1994 and could, at most, explain 2 percentage points of the 15 percentage point difference between the two countries. 27 In her work looking at the political connections of private firms, Faccio (2006) finds more cross-border restrictions on investment and security purchases in countries where connections are more widespread. Surprisingly, though, along some dimensions, MENA rates as well or better than comparator countries. These comparisons turn out to be misleading for several reasons explored below, including the fact that governments need only one regulatory instrument to deter private investment, even if all other regulations are highly favorable. In fact, governance, finance and trade barriers all seem to constitute more serious obstacles to firm entry in MENA than in comparator countries. According the World Bank’s Governance Index, MENA countries, whether oil or nonoil, have higher governance scores than other groups (Figure 5). The difference with comparator groups is significant, amounting to almost one standard deviation by 2004 (results are similar for 2005, when data do not allow non-democratic countries to be identified). Some de jure barriers to entry also seem to be lower in MENA countries. Figure 6 compares MENA values for the costs of starting a business as a fraction of income per capita with those of other countries. These costs are taken for 2004; results are again the same for 2005, for which it is not possible to identify countries lacking competitive elections. They indicate that, compared to the average country lacking competitive elections, the costs in MENA are more than 20 percentage points less as a fraction of GDP. They are also lower than middle income countries and only slightly higher than East Asian or large East Asian countries. Figure 6: The costs of starting a business in MENA and comparator countries, 2004 0 20 40 60 80 Costs of Starting a Business as Percent of GDP/capita MENA Oil No competitive elections Large East Asia MENA Non-oil East Asia Middle Income Source: World Bank Doing Business Indicators Note: The MENA oil sample contains 12 countries, United Arab Emirates, Bahrain, Algeria, Iran, Iraq, Kuwait, Libya, Oman, Qatar, Saudi Arabia and Syria. The MENA non-oil sample contains Egypt, Lebanon, Morocco, Jordan and Tunisia. There are no MENA countries in the remaining groups. 28 Access to finance is another key issue in development and, once again, according to some measures of financial development, such as liquid liabilities of the banking sector as a fraction of GDP, the financial sector in non-oil MENA countries is much larger than in other regions. Although an unusually large fraction of these liabilities are funneled to the public sector, Figure 7 illustrates that the quantity of domestic credit that goes to the private sector is also larger in non-oil MENA countries. The conclusions that emerge from Figures 5-7 are inconsistent with interviews with entrepreneurs, however, who throughout the region report that members of elite families have significantly greater protection from unwelcome government interference than others and that entry into markets controlled by elite interests is not easy. Interviews and detailed firm surveys in countries across the region suggest significant barriers to entry and political influence on firms; comparing similar responses in East Asia suggests that the influence of regime “insiders” on the economic prospects of “outsiders” either through outright expropriatory activity, or through arbitrary regulatory or constract dispute resolutions, or through regulatory barriers to entry, including those related to access to premises (land), is worse in MENA, not better, as the figures suggest. Figure 7: Private sector access to credit in MENA and comparators 0 20 40 60 80 Domestic Credit to the Private Sector/GDP, 2005 MENA Oil No competitive elections, 2004 East Asia MENA Non-oil Middle Income Source: World Development Indicators. Note: The MENA Oil countries for which this data are available are Yemen, Qatar, Iran, Kuwait, Saudi Arabia, Libya, Bahrain, Algeria, and United Arab Emirates. The MENA non-oil countries are Tunisia, Jordan, Morocco, Egypt and Lebanon. 69 countries are in the Middle Income group, 48 in the no competitive elections group, and 21 in the East Asia group. There are no MENA countries in the remaining groups. For three reasons, aggregate indicators and the assessments of outside observers may not accurately depict the differences in barriers to entry between MENA and comparator countries. First, officials may not respect de jure rules and regulations in practice. For example, even if overall de jure obstacles are low, enforcement may differ across classes of firms, creating a competitive advantage that, de facto, prevents entry. In Tunisia, for example, many barriers to 29 trade have fallen, highlighted by the rapid inclusion of Tunisia in a free trade zone with the European Union. In the midst of this friendly de jure environment, however, entrepreneurs complain that prominent individuals are increasingly bringing goods into the country without paying value-added taxes. While tariffs are low and the VAT is quite average, by evading the VAT, these importers gain a 15 percent cost advantage over others. There is also considerable variation between the hypothetical (de jure) costs of business start up in Figure 6 and firm assessments of those costs in the surveys.15 The de jure costs of starting a business (in percent of per capita income) were 30 for Algeria, 63 for Egypt, 52 for Jordan, 12.2 for Morocco and 34.2 for Syria. They were 450 for Cambodia, 57.4 for Vietnam and 15.8 for China, no better or slightly worse than the MENA countries. In contrast, in their survey responses, a lower percentage of firms in the three East Asian countries reported business licensing and permits (not necessarily for starting up) as a severe or major obstacle to the operation and growth of their business than in any of the MENA countries. In Algeria, 24 percent of medium-sized respondents reported business permitting as a considerable obstacle. The percentages were 23 percent for Egypt, 22 percent for Jordan, 19 percent for Morocco, and 48 percent for Syria. In contrast, only 6 percent of Cambodian respondents, 2 percent of Vietnamese respondents, and 18 percent of Chinese respondents classified permitting as a substantial obstacle. A second explanation for the divergence of firm-level and aggregate assessments appears to be that governance evaluations focus on the representative or median potential investor, though across countries, it is the position of non-representative investor that may differ substantially. The World Bank Doing Business Indicators, for example, explicitly evaluates the de jure obstacles to entrepreneurial activity for a representative firm of a particular size and in a particular business. This is valuable information. However, as the foregoing discussion implies, the median potential investor may be untouched by institutionalization. Fast-growing countries that have institutionalized extend the direct benefits of institutionalization to far less than one-half of the population (60,000,000, in the case of the Chinese Communist Party). For this fraction, the security of property rights and the reliability of regulatory and contract dispute resolutions are both high. In countries that have not institutionalized, such as MENA countries, the fraction of citizens that benefit from the strong protections of institutionalized restraints on the executive is smaller. Even if it is the case that the median citizen confronts no worse, or even a somewhat better governance environment than the median citizen in comparator countries, the fraction that enjoys great security is likely to be the driver of growth. Aggregate indicators of governance also do not distinguish the types of rents that officials extract. For example, in one country where entrants confront severe barriers to entry and favored incumbents are well-treated, observers would see little expropriatory behavior and could rate country governance more positively. In another country where incumbents are less protected, but where officials extract rents from most enterprises, but those rents are capped and made 15 Both the de jure assessments and survey responses are informative about effects on firms. It is not possible to use either of these indicators to say anything about the broader social welfare implications of business regulation, since this depends on the content of the regulations and whether they respond to market inefficiencies, neither of which are observable. 30 predictable by institutionalization, governance might be viewed as poor, though investment would be high. Third, aggregate depictions may be inaccurate because it only takes one onerous regulation to block firm entry, even if all other regulations are favorable. Finance and trade barriers may be the source of those barriers in MENA. There is evidence that all three distortions affect broad comparisons of governance and other barriers to entry between MENA and other countries. Table 4 indicates substantial difference between individual firm perceptions of governance and other barriers to firm entry than those in Figures 5-7. For example, the last columns of Table 4 summarize the fraction of firms that regard corruption as a “major or severe” obstacle.16 These results do not mirror the governance assessments in Figure 5. Rather than having a distinctly better governance environment for firms, MENA exhibits significant heterogeneity and, on average, little difference compared to East Asia. Firms in Egypt and Syria are significantly more likely than firms in the other countries to identify corruption as an obstacle, and Morocco and Jordan the least, with China and Algeria in the middle.17 The extent to which corrupt payments are an obstacle need not correlate with the quantity of bribes that they pay. Where bribes are payments to officials for exclusive access to lucrative markets, or for permission to impose large costs on the country at large (e.g., pollution beyond statutory norms or tax payments below legal obligations), individual firms would not regard them as an obstacle. On the other hand, where bribes are payments to avoid expropriation of firm assets (e.g., having premises shut down, workers declared illegal, goods released from customs), or to avoid selective enforcement of laws that are generally unenforced (creating a competitive disadvantage for the target firm), firms are more likely to regard corruption as an obstacle.18 While one cannot say that corruption is less of a problem for society as a whole for countries where firms do not cite corruption as a major obstacle, one can say that in countries where they do, as in MENA, corruption is both a problem for firms and for society. The evidence that finance is a significant barrier to entry is even more compelling, both for its breadth and objectivity. Nee and Opper (2006) confirm that political access matters for credit access in China: among 66 firms listed on the Shanghai Stock Exchange, firms with CEOs who are politically active are more likely to have access to bank credits than firms that do not. Despite this, however, as Table 4 makes clear, firms are more likely to use bank financing in China and less likely to rank it as a severe or major obstacle, than they are in those MENA countries for which data are available. 16 The World Bank governance indicators for the countries represented in Table 4 are similar to the regional averages reported in Figure 6. 17 Note that firm responses for Lao PDR almost certainly reflect the sensitivity of the question and respondent reluctance to answer negatively. Lao PDR has the lowest World Bank Governance scores of the countries in Table 4. 18 This means, of course, that it is not necessarily good for a country as a whole if firm respondents to this question report that corruption is not an obstacle for them; however, if firms report that corruption is an obstacle, this is likely to signal a lack of credible commitment in firm-state relations. 31 Table 4: Bank finance and corruption in MENA and East Asia Percent of firms that list access to and cost of financing as a “major or severe” obstacle Percent of working capital financed with bank credits Percent of firms that list corruption as a “major or severe” obstacle Medium firms (20-99 employees) Large firms (100+ employees) Medium firms Large firms Medium firms Large firms Algeria (2002) 62.08 (199) 54.34 (66) 14.02 (184) 15.58 (59) 31.91 (193) 18.05 (65) Egypt (2004) 35.97 (262) 41.54 (142) 5.46 (351) 10.84 (169) 50.44 (346) 50.49 (167) Jordan (2006) 7.31 (184) 5.64 (88) 9.72 (185) 11.53 (88) 9.77 (184) 3.90 (88) Morocco (2004) 85.36 (321) 86.36 (242) 1.79 (321) 6.31 (242) 14.64 (321) 21.49 (242) Syria (2003) 30.25 (224) 22.84 (43) 3.27 (206) 3.55 (38) 62.82 (226) 56.73 (42) Cambodia (2003) 13.97 (56) 3.48 (25) 3.19 (69) 2.8 (25) 43.76 (68) 31.74 (25) China (2003) 27.30 (370) 33.83 (541) 19.79 (657) 37.71 (746) 28.38 (370) 25.32 (541) Lao PDR (2005) 15.87 (63) 14.29 (28) 9.00 (60) 4.18 (28) 1.59 (63) 0 (28) Vietnam (2005) 44.9 (374) 41.02 (527) 20.37 (385) 36.85 (528) 11.50 (340) 10.33 (471) Source: The World Bank, Investment Climate Surveys (various years). Countries with competitively elected leaders are omitted (e.g., Indonesia). http://www.enterprisesurveys.org. The key indicator that bank financing is problematic for firms is whether firms rank bank financing as an obstacle and exhibit low levels of bank financing, relative to firms in other countries. Firms in Jordan, Cambodia, and Lao PDR tended not to regard finance as an obstacle, but also tended not to use bank financing for working capital. However, the difference between the fraction of firms in Algeria, Egypt, Morocco and Syria that described bank financing as an important obstacle and did not report using bank financing for working capital was as much as three times higher than in China. The fraction of firms that reported using bank financing for 32 working capital was much lower in these countries than in China (as much as 10 times less, comparing Chinese and Syrian medium-sized firms).19 Table 4 suggests a substantial mismatch between the bank credit that Figure 7 reports is flowing to the private sector and firm reports of whether that credit is actually reaching them. Further evidence that total domestic credits to the private sector (Figure 7) are a misleading indicator of the costs of access to finance comes from a recent report on the financial sector in Egypt illustrates this (World Bank 2006). Using data from the Central Bank of Egypt, the study concludes that 565 borrowers (approximately 0.2 percent of total borrowers) receive more than 50 percent of total credits issued by Egyptian banks to the private sector (Table 2.1, p. 22). The importance of large deposits also suggests that access to credit is a barrier to entry. When it is costly for banks to verify the liquidity position condition of firms, as when accounting systems and audit standards are poor, or when banks face few competitive pressures, banks can demand that potential borrowers place significant funds on deposit as a condition for lending. In Egypt, competitive pressures on banks are few: most loans (more than 50 percent) and most branches (85 percent) are held by state-owned or state-controlled banks (p. 24).20 Extremely large deposits (greater than 5,000,000 Egyptian pounds) constitute 22 percent of total deposits at state-owned banks (and much less than five percent at all other banks). In these same situations, demands for collateral can be larger than in more efficient and competitive financial systems (e.g., exceeding the value of the loans). In fact, firm responses to the surveys used in Table 4 indicate that MENA firms are more likely to report that access to land is a “major or severe” obstacle: 35 percent of medium-sized firms in Algeria, 26 percent in Egypt; 42 percent in Morocco; 38 percent in Syria; but only 3 percent in Cambodia and 12 percent in China. Of course, barriers to land access are a problem beyond their impact on credit markets and can also reflect official efforts to set up barriers to market entry to potential competitors of favored incumbents. One final piece of evidence that barriers to entry are significant in MENA countries, despite apparently favorable aggregate governance and business climate indicators, is the comparison of trade policies in Figure 8. It is notoriously difficult to provide “apples to apples” 19 Moroccan and Algerian firms report significantly higher rates of bank access to capital for new investment (e.g., 31 percent of large firms in Algeria compared to 28 percent of firms in China use bank capital for new investment). It is easier to interpret answers to the working capital question, however: working capital refers to percent of total financing from banks, while the investment question refers to any bank financing, no matter how small; answers are less likely to refer to bank access in years past; the use of banks for working capital is less likely to be influenced by access to bond and equity markets; directed credit by governments is more likely to target investment than working capital; and the question about working capital was less likely to be viewed as hypothetical by respondents. 20 This is typical of the region: in Algeria, state-owned banks control approximately 91 percent of assets and liabilities in the financial sector while in the Kingdoms of Jordan and Morocco, although state-ownership is less important (zero and 23 percent of all lending, respectively), private banks have close links to the ruling families. State-owned banks may be an important vehicle for solving commitment problems in non-institutionalized countries, at least between leaders and large private enterprises. By authorizing large loans from state-owned banks to these enterprises, leaders confront the risk that if they expropriate the rents of the firm, they will render large liabilities of the firm unpayable. The losses to the state-owned bank must then be absorbed either by the rulers themselves or by depositors (including citizens generally, as well as the other large enterprises that have large sums on deposit). To the extent that citizens bear the costs of the default, revolt risk is more likely; to the extent that rulers or other enterprises bear the cost, rulers lose rents. 33 comparisons of trade policies.21 Figure 8 describes the results of the most sophisticated effort to do so. It shows that trade barriers are only low in those MENA countries with no comparative advantage in manufacturing (Oman, Saudi Arabia, Bahrain). However, in countries such as Morocco, Egypt and Algeria, all with substantial unemployment, larger markets, and excellent access to EU markets, trade barriers are high. There are, of course, well-known examples from East Asia that suggest trade protection is not inimicable to growth. Korea, for example, combined high trade barriers, fast growth and large manufacturing exports. The difference, however, is in degrees of institutionalization: Korean governments were able to credibly condition trade protection on export growth. MENA governments do not, and perhaps cannot.22 Figure 8: Trade Restrictiveness, selected MENA countries and comparators Overall Trade Restrictiveness, Manufacturing (Tariff and NT Barriers) Malaysia Indonesia China Tunisia Morocco Jordan Egypt Algeria 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 Source: Source: Kee, Nicita and Olarreaga 2006 Low investment rates are not the only consequence of the trade, finance and governance barriers identified here. Another is enterprise structure. In particular, there is some, at least anecdotal evidence that MENA firms are more likely to be vertically integrated than their counterparts in more “institutionalized” countries. Under some special circumstances, vertical integration constitutes a barrier to entry, one that benefits even those incumbents that do not 21The mix of non-tariff and tariff barriers varies from country to country and the trade weights used in weighting trade barriers on specific goods depend on the barriers themselves. 22 Egypt has recently undertaken trade reforms (over the period 2004-06). Recent economic developments (significant accelerations in reported FDI and economic growth) appear to have been very positive, underlining the role that trade barriers play in keeping out growth-promoting entry. It is possible that investment and growth improvements reflect the formalization of pre-existing informal and unreported activity; they are, however, nonetheless striking. 34 benefit from special rent-seeking arrangements with governments. Box 1 describes the apparent role of vertical integration in MENA countries. Box 1: Vertical Integration, institutionalization and barriers to entry in MENA Successful firms in the MENA region appear to be more vertically integrated, from raw material processing through to the manufacture of final outputs, than their counterparts in the same industries in more institutionalized countries. In conversation, the owner of at least one vertically integrated firm indicated explicitly that vertical integration was an important tool to deter competition. Sekkat reports that vertical integration in the rebar (steel) industry is associated with market domination in Egypt. The owner of one firm in North Africa, with a large market share in the manufacture of window frames, described his firm’s steady progression upstream, going from purchasing finished polyvinyl chloride (PVC) inputs to buying PVC powder and producing the PVC needed to build window frames entirely in-house; and going from buying glass to manufacturing it in-house. A large cable manufacturer in Egypt made the same upstream move into the manufacture of PVC inputs into cable. Vertical integration is an obstacle to competition only under narrow conditions. In particular, it deters entry only if a) vertically integrated firms are more efficient (otherwise, two non-integrated upstream and downstream firms could do business to produce final output at equal or lower cost and drive out the vertically integrated firm) and b) costs of entry (e.g., of capital or of finding managerial talent) are high for potential entrants (so that they cannot enter with sufficient scale to compete with the vertically-integrated incumbent). The industries mentioned above, such as window frames, are far less vertically integrated in institutionalized countries, where one or both of these conditions does not hold. However, in non-institutionalized countries, as in MENA, imports of inputs are costly (e.g., because of port functioning and other trade barriers); contracts are harder to enforce (e.g., when property rights weak); and especially when hold-up is possible (when specific assets are required to produce for downstream firm); and financial markets heavily favor incumbents. The market for managerial talent is also known to be thin in MENA. If starting a verticallyintegrated enterprise is more technically and organizationally demanding, and the market for managerial talent is thin, then incumbents (who already have mastered the complexities of one stage of production) can vertically integrate more cheaply than entrants can start a verticallyintegrated competing firm. Note that these particular firms do not necessarily benefit from regime largesse. Their only advantage is perhaps to have owners from elite families, with names sufficient to shield them from expropriation by government officials, but not to extract substantial subsidies or entry protection. Unfortunately, although such firms are likely to thrive in the face of business environment improvements, they are unlikely to support improvements in the business environment that would make entry cheaper, not least because the value of their investments in vertical integration would fall. In sum, although the portrait of the business environment painted by Figures 4, 5 and 6 paint a positive picture of the MENA business environment, there are numerous reasons to believe that this picture is not entirely accurate. Incumbents seeking to preserve rents, and political decision makers seeking to aid incumbents, need only one policy instrument to keep out entrants. No matter how liberal a country’s policy environment might appear in general, a mere handful of restrictive policies could nevertheless successfully deter most entry, as could the 35 ability of a handful of firms to receive favorable, ad hoc exceptions to even generally liberal business regulations and taxes. This appears to be the case in MENA. Policy Implications for MENA Some of the underlying issues identified here that undermine political incentives to promote private investment are not susceptible to simple policy fixes, such as the reluctance to institutionalize because natural resource rents are high or social unrest is simmering or the leadership group is not cohesive. In all of these cases, however, governments desire faster growth, they are simply unwilling to make the institutional concessions necessary to achieve it. The policy challenge is to find ways to provide investor guarantees that do not require institutional changes that leaders oppose. Two reforms in particular may improve the investment climate and the credibility of government commitments without challenging leader reluctance to institutionalize. The first is Special Export Zones, with dedicated regulatory oversight, meritocratically and transparently chosen, that is compensated based on the success of the zones. Ideally, of course, such standards would be applied to the entire civil service, but this would involve excessive institutionalization from the point of view of leader political calculations. For example, a Chinese-style system of compensating governors and mayors based on local economic growth would require sacrificing other, more clientelist and personalist criteria in the selection and compensation of these officials. The second possible reform is substantially increased investment in growth-oriented infrastructure. Governments have more to lose by reneging on commitments to private investors if the political payoffs to large infrastructure investments are low in the absence of a private investor response. Infrastructure thus has a double payoff in terms of attracting private investment: it directly lowers costs of doing business, and it raises government costs of reneging on commitments not to expropriate. Public investment has played a large role in Chinese growth, and exceeds, as a percent of GDP, public investment in any other country. Such reforms are not easy to implement in a broadly unsympathetic political environment. For example, it is difficult for governments to credibly promise bonuses in exchange for success. In EPZs this can be addressed by arranging for compensation to be paid directly by zone occupants. 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