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Working Paper No. 1
Trade Policy and Economic Development: How We Learn
Anne O. Krueger, January 1997

Sound research has contributed immensely in shaping economic policies that are conducive to economic growth. Using trade policy as an example, this paper analyzes the role of research and identifies the types of research that inform good policy. The evolution of trade policy from its initial development to the "conventional wisdom" of the 1990s, has had an important contemporaneous impact on policy. However, misapplication of sound theoretical principles, unrealistic assumptions, and search for "negative results" are the usual pitfalls that misguide economic research. In general, empirical research that test for the presence and order of magnitude of stylized facts can be invaluable for modeling and policy formulation. On this basis, refined interpretations of existing theories to produce empirically testable propositions can greatly improve the usefulness of policy-oriented research.

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Working Paper No. 2
Nominal Anchor Exchange Rate Policies as a Domestic Distortion
Anne O. Krueger, February 1997

This paper analyzes a nominal anchor exchange rate policy as a domestic distortion, in the tradition of international trade theory. It is shown that, in addition to the problems of sustainability and exit pinpointed in the exchange rate literature, a nominal anchor exchange rate policy, while in force, drives a wedge between the domestic and the international intertemporal marginal rates of substitution. The welfare cost of the Mexican use of the nominal anchor exchange rate policy prior to December 1994 is then estimated.

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Working Paper No. 3
The Overborrowing Syndrome: Are East Asian Economies Different?
Ronald I. McKinnon and Huw Pill, March 1997

The Mexican crisis of 1994-95 has again demonstrated the vulnerability of economies undertaking structural economic reform to financial crises associated with the reversal of excessive capital inflows. Several South East Asian countries may be suffering from similar problems, conveniently labeled the 'overborrowing syndrome'. In the context of a simple Fisherian two-period model, this paper develops a chronology of the boom - bust cycle associated with overborrowing. This suggests that Asian countries are less vulnerable, since their history of balanced economic growth and prompt policy reaction offers some hope of minimizing the destabilizing macroeconomic consequences of overborrowing that may have occurred

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Working Paper No. 4
Rationing, Spillover and Interlinking in Credit Markets: The Case of Rural Punjab
Clive Bell, T.N. Srinivasan and Christopher Udry, April 1997

A parallel market structure may exhibit extensive rationing in the regulated segment, and hence spillover of unsatisfied demand into the unregulated segment of the market. In the latter segment, the borrower can choose to bundle loan contracts with output marketing through the lender. Using data on Punjabi cultivators, econometric estimation of such a structure yields three principal findings: (i) most borrowers and non-borrowers alike were rationed in the regulated market; (ii) the demand for credit was fairly inelastic with respect to the interest rate; and (iii) a contractual provision that tied credit to output marketing made informal lenders willing to advance much bigger loans.

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Working Paper No. 5
India's Export Performance: A Comparative Analysis
TN Srinivasan, May 1997

Dr. Manmohan Singh, former Finance Minister and the chief architect of Indian Economic Reforms of 1991, had concluded in his seminal Oxford doctoral dissertation in the early sixties that openness in foreign trade was very important for India's development. Yet, until his significant reopening of India to foreign trade and investment in July 1991, India's export performance was spotty: stagnation until the sixties and again in the eighties interrupted by some significant growth in the mid-eighties. The paper, written in Dr. Singh's honor evaluates India's import performance in a comparative perspective. It confirms Dr. Singh's early assessment that India's domestic policies, rather than the external environment, are the dominant factors in its lack-luster performance. The future prospects are unlikely to be bright either unless infrastrucutural bottlenecks are removed by faster progress in privatization and by making it easier and profitable for private domestic and foreign investors to invest in the sector. A sensible exchange rate policy has to be pursued. The domestic financial sector has to be put on a sound footing with far reaching reforms. Labor and bankruptcy laws have to be amended to make entry and exit easier.

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Working Paper No. 6
Toward Virtual Exchange-Rate Stability in Western and Eastern Europe with or without EMU
Ronald I. McKinnon, June 1997

What should be the rules of the game for stabilizing exchange rates within the European Union, including Central and Eastern European countries which might join in the future? I propose rules that are consistent with "virtual" exchange rate stability. They are flexible enough for Western European countries not in EMU and for the transitional economies further east. Nevertheless, the rules are strong enough to allay fears of beggar-thy-neighbor undervaluations or other unfair trading practices.

A further set of issues arises if EMU should fail altogether. How should the existing ERM (European Exchange Rate Mechanism) be reorganized so it becomes less crisis prone, more easily facilitates accepting new members from further east, and constrains the range of exchange rate variation to be much less than the current nonfunctional + 15 percent on either side of parity? Here I propose that the ERM become more formally a Deutsche-Mark zone-but one where Germany becomes more accountable to the group. In particular, the Bundesbank would weigh price-level movements in other core member countries as well as in Germany.

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Working Paper No. 7
Democracy, Markets, Governance and Development
T. N. Srinivasan, June 1997

The trend towards democratization in politics, global integration and the market mechanism in the developing world in the last two decades of the twentieth century has revived interest in the theoretical and empirical analysis of the interrelationship between political democracy and economic development. The paper discusses selectively and critically some of the recent contributions to such an analysis and examines the role of governance and popular participation in development. It concludes that viewing democracy as a steady state equilibrium of political processes is problematic. The empirical evidence reviewed confirms that there is no necessary relationship between form of government (such as democracy and authoritarianism) and successful development. While elements of governance structures conducive to development can be identified, they are found in democracies as well as authoritarian regimes.

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Working Paper No. 8
The Rate of Growth of Productivity in Mexico, 1850-1933: Evidence from the Cotton Textile Industry
Armando Razo and Stephen Haber, August 1997

The period prior to the 1930's are somewhat of a statistical Dark Age for scholars of the Mexican economy. We know little about the evolution of prices, wages, outputs, capital stock, or productivity. The available estimates of Gross Domestic Product for this period therefore rest heavily on imputed values and controlled conjectures. The purpose of this article is to employ previously unused data sources (industry-specific censuses at the micro level) and techniques (including panel-data regressions) to estimate labour productivity and total factor productivity over the period 1850-1933. We focus on the cotton textile manufacture, the largest mechanised manufacturing industry during the period under study. Our findings indicate: (1) Substantial productivity growth prior to the Porfiriato; (2) Rapid productivity growth throughout the Porfiriato; (3) A swift, though incomplete, recovery from the Revolution during the 1920's; and, (4) An insignificant impact on productivity from the Great Depression. We also find evidence, contrary to the literature to date, that the large, joint stock, limited liability publicly traded firms that were founded during the Porfiriato had higher levels of total factor productivity than private firms only for a short period of time and eventually became less productive. One possible cause for this phenomenon is that these firms were suboptimally large, suggesting that there may have been significant imperfections in the Mexican capital market that restricted the access of smaller firms and instead allowed participant firms to be too large for the markets they faced. Our results also indicate that labor markets in Porfirian Mexico were efficient: there is a strong statistical relationship between the firm-level productivity and the wage level. This suggests that manufacturers may not have had the kind of monopsony power in labor markets that the historical literature indicates.

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Working Paper No. 9
Rational Atrophy: The U.S. Steel Industry
Aaron Tornell, September 1997

During the 1970s and 1980s the steel industry in the US enjoyed trade protection. However, higher prices were reflected in a higher wage premium relative to the rest of the manufacturing sector, and in a greater share of profits divested by integrated steel producers. Furthermore, available technological innovations were not adopted on a timely basis. This failure combined with trade protection, allowed new small firms (the minimills) to capture about 40% of the US steel market. In this paper we present a model that rationalizes these facts.

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Working Paper No. 10
Why Aren't Savings Rates in Latin America Procyclical?
Aaron Tornell and Phillip R. Lane, October 1997

We document a striking empirical regularity: Latin American savings rates are as a rule substantially less procyclical than for OECD countries and in some cases are actually countercyclical. We build a non-representative agent intertemporal macroeconomic model that rationalizes this phenomenon as the equilibrium outcome of interaction between multiple groups that have common access to aggregate income. We conclude by suggesting that institutional reform may hold the key to improving the cyclical behavior of savings in Latin America.

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Working Paper No. 11
Reform without Losers: An Interpretation of China's Dual-Track Approach to Transition
Lawrence J. Lau, Yingyi Qian and Gérard Roland, October 1997

We develop a simple model to analyze the "dual-track" approach to transition to a market economy as a mechanism for implementing efficient Pareto- improving economic reform, that is, reform achieving efficiency without creating losers. The approach, based on the continued enforcement of the existing plan while simultaneously liberalizing the market, can be understood as a method for making implicit lumpsum transfers to compensate potential losers of the reform. The model highlights the critical role of enforcement of the plan and full liberalization of the market track. We examine how the dual-track approach has worked in product and labor markets in China's economic reform in practice.

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Working Paper No. 12
A Unification of the Theory of Second Best
Pravin Krishna and Arvind Panagariya, November 1997

The received wisdom from the theory of second best is that the presence of distortions in some sectors of the economy would in general require intervention in other sectors as well. This paper offers a simple set of propositions which help unify the results of numerous papers involving the theory of second best, many of which appear to contradict this theory. The propositions identify how, in optimization problems in economics, pre-imposed quantitative restrictions enter differently from price restrictions. The implications of this difference for the conduct of second best optimum policies are also analyzed. In particular, the paper identifies and discusses the conditions under which the presence of distortions in some sectors does not undermine the case for non intervention in other mark

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Working Paper No. 13
On the Existence of Necessarily Welfare-Enhancing Free Trade Areas
Pravin Krishna and Arvind Panagariya, November 1997

This paper proves the existence of necessarily welfare improving Free Trade Areas (FTAs) and analyzes the implications of the formation of such FTAs for intra union prices and trade flows.

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Working Paper No. 14
Are Regional Trading Blocs "Natural"?
Pravin Krishna, November 1997

A central statement of the natural trading partners theory is that, on welfare grounds, trade blocs with geographically proximate countries should be preferred to trade blocs with distant ones, i.e., that regional trade blocs are less likely to be trade diverting and thus "natural". A limited version of this theory suggests that trade blocs with significant trading partners should be preferred over trade blocs with less significant ones. This paper examines both these hypotheses using US trade data for the years 1964-1995 by first estimating welfare effects that would result from preferential tariff reductions by the US against various trading partners and then correlating these estimates with bilateral volume of trade and with "distance". While the volume of bilateral trade is found to be significant, geographic proximity is found to have no effect. Thus, for the US, this paper rejects the argument that regional trading blocs are natural.

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Working Paper No. 15
Political Instability and Economic Performance: Evidence from Revolutionary Mexico
Stephen Haber and Armando Razo, November 1997

What is the relationship between political instability and economic growth? This article examines this question using insights from the New Institutional Economics applied to a canonical case: Revolutionary Mexico. We argue that investment and growth during and after the Revolution were less affected by political instability than one might predict based on the extant theoretical and empirical literature. We find that while investor expectations, output, and productivity were sensitive to the interdiction of factor and product markets during the years of intense revolutionary violence (1914-1917), the periods of political instability before (1910-1913) and afterwards (1918-1934) had relatively minor effects on investor confidence, investments in new plant and equipment, rates of entry and exit by firms, industrial structure, or productivity growth.

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Working Paper No. 16
From Federalism, Chinese Style, to Privatization, Chinese Style
Yuanzheng Cao, Yingyi Qian and Barry R. Weingast, December 1997

In 1994 China began a profound reform of its state-owned enterprises. We first describe and characterize this progress in two areas: privatization of small state-owned enterprises at the county level and mass layoffs of excess state workers at the city level. Local governments have initiated these reforms, which are proceeding in economically and politically sensible ways. We then argue that privatization, Chinese style, rests on an adequate economic and political foundation -- federalism, Chinese style. We suggest a range of incentives that propel local governments toward SOE reform, including their harder budget constraints and increased competition from the non-state sector. In this sense, federalism, Chinese style, has induced privatization, Chinese style.

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Working Paper No. 17
As the Century Turns: Analytics, Empirics and Politics of Development
T. N. Srinivasan, December 1997

The paper celebrates John Fei's life and contributions to economics by viewing them in the context of recent theoretical and empirical literature on the economics and politics of growth. It summarizes the lessons from the literature and development experience since the end of the second world war on the roles of the state, markets and other institutions in the development process. It highlights a major lesson, on which there is substantial agreement if not a consensus, on the importance of openness to foreign trade, technologies and capital flows to growth and on the importance of participatory democracy for political sustainability of growth-promoting policies.

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Working Paper No. 18
Job Stability in Developing and Developed Countries: Evidence from Colombia and the United States
Julie Anderson Schaffner, January 1998

This paper presents the first systematic comparison of job stability for developing and developed countries, and begins to analyze why long-lasting jobs are less prevalent in developing countries. It compares both cross-section distributions of current job tenure and estimates of job retention probabilities (derived by following synthetic cohorts over time) between Colombia and the United States, and within Colombia before and after a major liberalization of job security legislation. Jobs for males in private sector wage employment are significantly shorter in Colombia than in the United States. The most striking differences in job retention probabilities are for workers in their first year of tenure. Small increases in these low-tenure job retention rates after the liberalization of Colombian job security legislation are consistent with arguments that the original legislation encouraged "rotation" of low-tenure workers, but the effects are not large enough to suggest that legislative differences explain the entire cross-country retention rate difference. Cross-country job length differences diminish, but remain significant, after controlling simply for cross-country differences in the mix of production activities. Thus even when attempting to meet similar production objectives, Colombian employers seem to employ fewer long-term workers. This suggests that they face greater costs of implementing long-term employment contracts or the work organization practices that such contracts facilitate. The paper discusses possible reasons for such cost differences. Regardless of their source, higher costs of long-term employment contracting in developing countries may help explain why those countries exhibit higher rates of self employment and employment in very small establishments, as well as lower levels and growth rates of labor productivity and GDP per capita.

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Working Paper No. 19
International Overborrowing: A Decomposition of Credit and Currency Risks
Ronald I. McKinnon and Huw Pill, February 1998

The severity of the financial crises enveloping the 'tiger' economies of South East Asia in 1997 came as a surprise to many observers. This paper uses a simple Fisherian model of the 'overborrowing syndrome' to compare the Asian crises of 1997 with earlier overborrowing episodes in Mexico and Chile. While important similarities exist, the crises in South East Asia have been exacerbated by the unhedged foreign exchange positions of Asian banks. These open currency positions not only imposed significant additional losses on the banks following devaluation, they also magnified the scale of overborrowing during the cycle's initial boom phase. Failure to limit the exposure of banks to foreign exchange risk therefore increased the magnitude of the boom - bust overborrowing cycle both ex ante and ex post. The paper highlights the importance of effective regulation and supervision of capital markets, with a focus on limiting the speculative currency positions of banks, especially those that form the core of the domestic payments system and therefore enjoy a (possibly implicit) public guarantee. Improving the institutional infrastructure of financial supervision is the only effective way of mitigating the macroeconomic costs of overborrowing.

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Working Paper No. 20
Reform From Within
Aaron Tornell, January 1998

We present a model of endogenous institutional change that rationalizes reforms that have taken place in the context of economic crisis and drastic political change. Most of these reforms have been initiated by powerholders, even though they have ended worse-off relative to the status quo. The first point we make is that reform is the tool used by some powerful groups to limit the power of their political opponents. The second point is that groups with "common access" to the economy's resources find it individually rational to overappropriate resources. As a result the economy deteriorates. When the economy reaches a crisis, conflict among groups erupts. Reform is the result of this conflict.

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Working Paper No. 21
Exchange Rate Policies for Developing Countries: What has Changed?
Anne O.Krueger, March 1998

In the paper, the balance of payments crisis of the 1990's in Mexico and Asia are contrasted with earlier crises that led to IMF stabilization program. It is seen that even though capital account convertibility did not prevail, the same pressures mounted then as now as appreciated real exchange rates and current account deficits led to crisis.

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Working Paper No. 22
Indian Fiscal Federalism: Political Economy and Issues for Reform
Kenneth Kletzer and Nirvikar Singh, May 1998

India is a federal state where the institutions of fiscal federalism have been determined by a complex political, social and economic history, in addition to the guidelines imposed by its constitution and legal institutions. The institutional structure, within which tax, transfer and public spending programs are designed and implemented, can be an important tool for, or major impediment to, economic reform and development. Therefore, understanding how the fiscal federal structure works in India and the constraints given by its political economy are important inputs for analyzing the likely effects of reform. In this paper we begin the development of amodel of fiscal federalism in the Indian case that allows for self-interested government decisions, political pressure, and imperfect instruments of control. We show how costly influence activities may depend on the federal fiscal structure in place in India.

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Working Paper No. 23
Whither the World Bank and the IMF?
Anne O. Krueger, August 1998

This article assesses the possible future directions and roles of the International Monetary Fund and the World Bank. It first reviews their initially envisaged roles at Bretton Woods and their evolution, concluding that both institutions played valuable roles earlier on. But for both institutions, the world has changed and the questions as to their future are important. For the IMF, those questions center on its role in providing finance for poor developing countries in balance of payment difficulties and on its role for middle income countries in managing financial crises. For the World Bank, the question is whether it can and should gradually phase out lending for most middle income countries except in times of drastic policy reforms and focus on low-income countries, or whether it should address the "soft issues" of development.

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Working Paper No. 24
Trade Liberalization and Labor Demand Elasticities: Evidence from Turkey
Sajjid Chinoy, Pravin Krishna and Devashish Mitra, September 1998

In the recent debate over the impact of trade reform on factor markets, it has been argued that trade liberalization will lead to an increase in labor demand elasticities - thus placing labor markets under increased pressure. Using Turkish plant level data spanning the course of a dramatic trade liberalization, this idea is tested.

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Working Paper No. 25
Sovereign Debt as Intertemporal Barter
Kenneth M. Kletzer and Brian D. Wright, September 1998

Borrowing and lending between sovereign parties is modelled as intertemporal barter that smooths the consumption of a risk-averse party subject to endowment shocks. The surplus anticipated in the relationship offers sufficient incentive for cooperation by all parties, including any other competitive agents who are potential lenders to the sovereign. The sole punishments consist of renegotiation-proof changes in the path of future payments. We show that intertemporal trade can be sustained in the absence of any exogenous enforcement of lending relationships whatsoever. That is, borrowing and lending are possible under anarchy, and are supported by punishments that consist of cheating any cheater. Long-term implicit relationships may be fulfilled as the continual renegotiation of simple incomplete short-term loans. The analysis suggests that the crucial role of the explicit loan contract is the identification of the relationship and the parties involved.

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Working Paper No. 26
Market Structure, Demand and Endogenous Firm Efficiency
Pravin Krishna, September 1998

In a market of Bertrand firms managed by agents and with non-linear demand, the degree of firm efficiency is shown to be directly related to the number of firms in the market. This supports the conventional wisdom that product market competition disciplines firms into efficiency of operation. However, it stands in sharp contrast to, inter alia, the well known paper by Martin (1993), which arrived at the exact opposite result in a linear Cournot setting. The structure of demand is argued to be crucial.

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Working Paper No. 27
Stock Market Liberalization, Economic Reform, and Emerging Market Equity Prices
Peter Blair Henry, October 1998

On average, a country's first stock market liberalization causes a 29 percent revaluation of the domestic share price index in real dollar terms. This result suggests that the liberalizing countries experience an average fall of 29 percent in their aggregate cost of equity capital. Constructing a novel data set of policy reforms occurring contemporaneously with the stock market liberalizations, controlling for co-movements with world stock markets, and acknowledging the role of macroeconomic fundamentals allows for robust estimation of this effect. Emerging equity markets also respond positively to news of the economic reforms. In particular, trade liberalization causes a 16 percent revaluation of domestic share prices.

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Working Paper No. 28
Do Stock Market Liberalizations Cause Investment Booms?
Peter Blair Henry, November 1998

Stock market liberalizations lead private investment booms. In a sample of 11 developing countries that liberalized, one year later 9 of 11 experience growth rates of private investment above their non-liberalization median. In the second year after liberalization this number is 10 of 11. The mean growth rate of private investment in the two years immediately following stock market liberalization exceeds the sample mean by 23 percentage points. The relationship between private investment and stock market liberalization persists after controlling for world business cycle effects, contemporaneous economic reforms, and domestic fundamentals. Because the possibility of reverse causality cannot be ruled out, we cannot conclude that stock market liberalizations cause investment booms. Nevertheless, the evidence stands in sharp contrast with recent work that suggests capital account liberalization has no effect on investment.

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Working Paper No. 29
Taxes and Income Distribution in Chile: Some Unpleasant Redistributive Arithmetic
Eduardo Engel, Alexander Galetovic and Claudio Raddatz, November 1998

This paper quantifies the direct impact of taxes on income distribution at the household level in Chile and estimates the distributional effect of several changes in the tax structure. We find that income distributions before and after taxes are very similar(Gini coefficients of 0.488 and 0.496, respectively). Moreover, radical modifications of the tax structure, such as raising the value added tax from 18 to 25% or substituting a 20% flat tax for the present progressive income tax affect the after-tax distribution only slightly.

We present some arithmetic showing that the scope for direct income redistribution through progressivity of the tax system is rather limited. By contrast, for parameter values observed in Chile, and possibly in most developing countries, the targeting of expenditures and the level of the average tax rate are far more important determinants of income distribution after government transfers. Thus, a high-yield proportional tax can have a far bigger equalizing impact than a low-yield progressive tax. Moreover, a simple model shows that the optimal tax system is biased against progressive taxes and towards proportional taxes, with a bias that grows with the degree of inequality of pre-tax incomes.

Our results suggest that to reduce income inequality, the focus of discussion should be on the amount to be redistributed, the targeting of public spending, and the relative efficiency of alternative taxes, and not on the progressivity of the tax system.

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Working Paper No. 30a
The Assignment of Taxes and Expeditures in India
M. Govinda Rao and Nirvikar Singh, December 1998

In this paper, we review the basic theories of fiscal decentralization, apply them to the problem of tax and expenditure assignments in a federal system, and consider the Indian case in the light of economic principles. We note the centripetal bias of India's federal fiscal arrangements, which give the center indirect power over states' expenditure decisions, as well as creating a vertical fiscal imbalance that requires large center-state transfers. We describe some of the distortions that arise in the federal aspects of the current Indian tax system. In particular, we highlight internal trade barriers, inter-state tax exportation, and tax sharing arrangements as areas for reform.

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Working Paper No. 30b
Fiscal Overlapping, Concurrency and Competition in Indian Federalism
M. Govinda Rao and Nirvikar Singh, December 1998

In this paper we provide an overview and analysis of problems with, and reform efforts aimed at the different layers of the tax system in India. Overlapping in the commodity tax systems of the three levels of government in India has made the tax system non-transparent, and rendered the pursuit of the objectives of tax policy difficult. The incidence of taxes on commodities remains unknown and multiple taxation of commodities by different levels of government creates broad wedges between producer and consumer prices. Tax sharing arrangements between the center and states have created incentive problems for tax collection. At the state level, tax competition without appropriate constraints or coordination imposed by the center has led to a multitude of tax rates, "races to the bottom", interstate tax exportation, and interstate trade barriers. Reform efforts and proposals have focused both on improving the current system and on more comprehensive overhauls. In our analysis, We demonstrate the importance of examining the redistributive impacts across states of suggested major reassignments of tax powers. These must be carefully understood, in addition to impacts across the center and the states as a whole. We provide specific suggestions concerning the reform of state-level trade and consumption taxes in India, and for steps to follow in introducing a broad-based VAT in India.

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Working Paper No. 30c
Intergovernmental Transfers: Rationale, Design and Indian Experience
M. Govinda Rao and Nirvikar Singh, December 1998

Intergovernmental transfers have been employed in all federations to achieve a variety of political and economic objectives. However, an emphasis on economic objectives helps to focus the analysis on the ideal design of the transfer schemes and the departures from this can then be analysed in terms of various non-economic (political) objectives. In this paper, we present the economic rationale for transfers, analyse their appropriate design to fulfill the stated economic objectives and, within this conceptual framework, evaluate some aspects of the prevailing transfer systems in India. We highlight some of the vertical and horizontal fiscal imbalances in the Indian federal system, and discuss how a transfer system might deal with them.

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Working Paper No. 30d
An Analysis of Explicit and Implicit Intergovernmental Transfers in India
M. Govinda Rao and Nirvikar Singh, January 1999

In this paper, we provide a critical overview of central-state transfers in India. In addition to examining explicit transfers through the Finance Commission, Planning Commission and central ministries, we also analyze implicit transfers that operate through interstate tax exportation and subsidized lending to the states. We quantify equity impacts of these transfers, finding that formula-based transfers have been equalizing, helping to overcome lack of fiscal capacity in poorer states, but that implicit transfers tend to go disproportionately to richer states, canceling out much of the equity impact of explicit transfers. We also highlight some of the institutional weaknesses of the current methods of intergovernmental transfers in India. We therefore make a case for reforms that would include: channeling transfers through a single, permanent, professional agency; a rule-based system of transfers rather than expanding central discretion; a transfer system with appropriate fiscal incentives for the center and the states, and minimizing implicit transfers arising from undesirable policies such as interstate sales taxes, or badly targeted policies such as subsidized credit.

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Working Paper No. 30e
Local Government Reform in India: Assignments, Institutions and Incentives
M. Govinda Rao and Nirvikar Singh, December 1998

India is undertaking a major reform of its rural and urban local governments. Constitutional reforms and subsequent supporting legislation change the assignment of tax and expenditure authorities to local governments, the methods of transfers from state to local governments, and the electoral and other institutional arrangements governing local governments. The ultimate goal is to achieve more effective delivery of services to constituent populations. In this paper, we review the financial situation and resources of India's local governments and analyze the political, managerial and other institutional constraints on effective local government service provision. Our main argument is that, while changes in assignments of expenditures and revenue authority are significant and necessary components of the ongoing reforms, the most crucial aspect is the reform of institutional structures to enhance efficiency, transparency and accountability with respect to revenue collection, expenditure decisions, and intergovernmental transfers. In this respect, there are parallels with India's broader, national-level economic reforms.

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Working Paper No. 31
Consumer Protection in Chile: Why So Little and So Late?
Eduardo Engel, January 1999

This article describes consumer protection policies, and then goes on to assess the degree of protection existing in Chile, both before and after the passing of the Consumer Law in March 1997. Two case studies are used to illustrate the degree to which consumers are protected in Chile. The first considers what happened in 1991 after the National Consumer Service (SERNAC) published contamination indices for processed meat analyzed in a study contracted by this service. The second case study analyzes to what an extent the private National Advertising Self-Regulation Council (CONAR) substitutes for a law dealing with false and deceptive advertising. The paper concludes that consumer protection in Chile is far from satisfactory, and that this is due to the absence of political actors interested in promoting the issue. Finally, a possible explanation for this absence is provided.

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Working Paper No. 32
Poisoned Grapes, Mad Cows and Protectionism
Eduardo Engel, January 1999

This paper studies two episodes where an exporting industry saw its sales plummet after importing countries banned their products to protect their citizens' health. The first case is the poisoned grapes crisis involving Chile and the United States in 1989. The second is the mad cows dispute between the United Kingdom and the European Union in 1996. These case studies motivate a new definition of "protectionist measure" which is applied to argue that the European Union's ban on British beef exports did not constitute a protectionist measure, while the US ban on Chilean fruit possibly classifies as such a measure.

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Working Paper No. 33
Toll Competition Among Congested Roads
Eduardo Engel, Ronald Fischer and Alexander Galetovic, February 1999

A growing number of roads, particularly in developing countries, are currently financed by the private sector via Build-Operate-and-Transfer (BOT) schemes. When the franchised road has no close substitute, the government must regulate tolls. Yet when there are many ways of getting from one point to another, regulation may be avoided by allowing competition between several franchise owners. This paper studies toll competition among private roads with congestion.

The paper derives two main results. First, an equilibrium in pure strategies with strictly positive tolls obtains. Equilibrium congestion is less than optimal, which runs counter to what is expected from price competition. While a lower toll reduces the out-of-pocket cost paid by a user, it increases the congestion cost thereby reducing the drivers' willingness to pay for using the road. Franchise holders partially internalize congestion costs when setting tolls, which softens price competition. Second, when demand and the number of roads increase at the same rate, tolls converge to the socially optimal level–that is, in the limit equilibrium tolls are just enough to make each driver internalize the congestion externality.

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Working Paper No. 34.
Latin America and the External Crisis: An Overview
Vittorio Corbo, March 1999

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Working Paper No. 35
The Role of Bank Restructuring in Recovering from Crises Mexico 1995-98
Anne Krueger and Aaron Tornell, April 1999

In this paper we analyze the evolution of the Mexican economy between 1995 and 1998. The remarkable recovery seen in aggregate activity has not been uniform across the economy. The tradable sector has grown strongly, while the non-tradable sector has recuperated only sluggishly. This asymmetric response is intimately linked with the severe credit crunch that Mexico has experienced since 1995. Although fresh domestic bank lending dried up, tradable firms obtained financing in the international capital market. This was not the case in the nontradable sector. A phenomenon that has gone hand in hand with the credit crunch is the steady increase in the share of non-performing loans. We analyze the reasons for this increase, the rationale for the partial bailout policy adopted in 1995, and we investigate why this policy stance did not solve the banking problem. An important lesson is that non-performing loans are unlikely to disappear on their own, even under a high GDP growth scenario. Furthermore, the existence of non-performing loans presents an obstacle for the banking system to adequately perform its functions. This raises the question of whether an alternative strategy under which all non-performing loans were recognized at once and the fiscal costs were all paid up-front would have been preferable.

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Working Paper No. 36
Understanding Tax Evasion Dynamics
Eduardo M. R. A. Engel and James R. Hines Jr., April 1999

Americans who are caught evading taxes in one year may be audited for prior years. While the IRS does not disclose its method of selecting tax returns for audit, it is widely believed that a taxpayer's probability of being audited is an increasing function of current evasion. Under these circumstances, a rational taxpayer's current evasion is a decreasing function of prior evasion, since, if audited and caught evading this year, the taxpayer may incur penalties for past evasions. The paper presents a model that formalizes this notion, and derives its implications for the responsiveness of individual and aggregate tax evasion to changes in the economic environment. The aggregate behavior of American taxpayers over the 1947-1993 period is consistent with the implications of this model. Specifically, aggregate tax evasion is higher in years in which past evasions are small relative to current tax liabilities - which is the case when incomes or tax rates rise. Furthermore, aggregate audit-related lines and penalties imposed by the IRS are positively related not only to aggregate current-year evasion but also to evasion in prior years. The estimates imply that the average tax evasion rate in the United States over this period is 42% lower than it would be if taxpayers were unconcerned about retrospective audits. Policy implications related to the effects of tax amnesties and the deterrence effect of retrospective audits and penalties are also discussed. Finally it should be noted that the model developed in this paper and its policy implications apply to any country where audits are retrospective and the probability of being audited increases with current evasion.

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Working Paper No. 37
Privatizing the Privatized
Aaron Tornell, May 1999

In the first part of this paper we argue that three reforms must be implemented if privatization is to increase efficiency. First, establishing unitary control rights within the firm. Second, making privatized firms face hard budget constraints. Third, establishing a non-corruptible judicial system and transparent bankruptcy procedures. The question arises as to what course of action should be undertaken when these reforms have not been undertaken and privatizers have only a small window of opportunity. Either they privatize hastily today, or not at all. Should they go ahead with privatization and hope that the newly privatized firms will create the demand for good laws? In the case of behemoths, the answer is not clear cut. Privatization without prior implementation of the three reforms mentioned above risks simply replacing government bureaucrats with private mafias (i.e., private groups with the power to extract fiscal transfers). These private mafias might behave more voraciously than the bureaucrats they are replacing, reducing aggregate efficiency and further hindering the growth of a competitive private sector. In the second part, we address the more traditional issues of auction design and of restructuring and regulation of monopolies with network externalities.

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Working Paper No. 38
Corporate Governance and East Asia Korea, Indonesia, Malaysia, Thailand
Kenneth E. Scott, May 1999

This paper explores the role of corporate governance in the Asian countries: Korea, Indonesia, Malaysia and Thailand. It argues that the focus in an analysis of corporate governance should be on the provision of external equity finance--the position of outside minority shareholders. The proportion of equity finance in the capital structure of firms is highly correlated with the status of corporate governance. In economies with extensive and concentrated family ownership of publicly traded companies, the mechanisms of corporate governance are likely to be weak. These propositions are examined in a review of the four countries. The paper concludes by recommending that strengthening of the effective limits on conflict of interest transactions by those in control of the firm would be of more immediate benefit than efforts to create managerial monitoring through development of a market for corporate control.

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Working Paper No. 39
Reciprocated Unilateralism: A Political Economy Approach
Pravin Krishna and Devashish Mitra, June 1999

Using the menu-auction approach to endogenous determination of tariffs and allowing additionally for lobby formation itself to be endogenous, this paper analyzes the impact of unilateral trade liberalization by one country on its partner's trade policies. We find that such unilateral liberalization generally induces reciprocal tariff reductions by the partner country. Intuitively, unilateral liberalization by one country has the effect of increasing the incentives for the export lobby in the partner country to form and to lobby effectively against the import competing lobby there for lower protection. The results stand in sharp contrast to the policy arguments that suggest that closing (or threatening to close) one's markets would help pry open the markets of others. The optimal tariff to be set by a large economy -- with endogenous lobby formation in partner countries and the consequent reciprocation by partner countries taken into account -- is shown to be smaller than it would otherwise be.

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Working Paper No. 40
The Chilean Infrastructure Concessions Program: Evaluation, Lessons and Prospects for the Future
Eduardo Engel, Ronald Fischer, and Alexander Galetovic, July 1999

This paper describes and evaluates the Chilean infrastructure concessions program, which is one of the main economic innovations carried out by the center-left coalition of political parties that has governed Chile since the return to democracy in 1990. The main principles underlying the economics of franchising are discussed and used to evaluate the program, thereby reviewing the privatizations of highways and seaports in detail. Compared with experiences in other countries, the results are promising. The infrastructure deficit has been greatly reduced, innovative ideas have been used successfully and several pitfalls have been avoided. However, since franchise terms are long, the final verdict will not be in for at least a decade. We offer various suggestions to increase the likelihood of a positive outcome. We believe implementing these suggestions would lead to important savings for taxpayers and users.

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Working Paper No. 41
Common Fundamentals in the Tequila and Asian Crises
Aaron Tornell, August 1999

We find that in 1995 and 1997 the crisis did not spread in a purely random way. The cross-country variation in the severity of the crisis was largely determined by three fundamentals: the strength of the banking system, the real appreciation, and the international liquidity of the country. We also find that the rule that links fundamentals to the crisis severity has been the same in both the Tequila and Asian crises.

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Working Paper No. 42
Exchange Rate Regimes for Emerging Markets: Moral Hazard and International Overborrowing
Ronald I. McKinnon and Huw Pill, September 1999

This paper investigates the role of the exchange rate regime in a simple Fisherian model of the overborrowing syndrome. Where domestic banks are subject to moral hazard, the choice of exchange rate regime may have important implications for the macroeconomic stability of the economy. Banks that enjoy government guarantees have an incentive to increase foreign borrowing and incur foreign exchange risks that are underwritten by the deposit insurance system. In the absence of capital controls, this increases the magnitude of overborrowing and leaves the economy both more vulnerable to speculative attack and more exposed to the real economic consequences of such an attack.

While "bad" exchange rate pegs will tend to exacerbate the problem of overborrowing in emerging markets, it is unclear that flexible exchange rate always dominate fixed exchange rates. A "good fix" - one that is credible and close to purchasing power parity - may reduce the "super risk premium" in domestic interest rates and thereby narrow the margin of temptation for banks to overborrow internationally. Contrary to the current consensus regarding the lessons that should be drawn from the Asian crisis, a good fix may better stabilise the domestic economy while limiting moral hazard in the banking system.

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Working Paper No. 43
Impediments and Innovation in International Rivers: The Waters of South Asia
Ben Crow and Nirikar Singh, November 1999

International cooperation over the major rivers in South Asia has become much closer in the last several years, despite nuclear tests in India and Pakistan, and rising tension between those states. Five important treaties or agreements, signed in 1996 and 1997, against a background of greater regional economic and non-governmental contact, could facilitate significant progress to mitigate flooding and drought, to provide a basis for greater regional cooperation, and to sustain irrigation expansion and industrial development. This paper identifies past impediments to cooperation, then examines how new agreements seem to offer negotiation on a wider range of issues than has previously been considered, and to expand the range of institutions involved in negotiations. Most notably, the new agreements expand the range of potential negotiating bodies beyond national governments to include cities, corporations, local governments and non-governmental organizations. This integration of diplomacy and economics could have far-reaching implications elsewhere, as well as in South Asia.

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Working Paper No. 44
The East Asian Dollar Standard, Life After Death?
Ronald I. McKinnon, November 1999

By keying on the US dollar, before 1997 the macroeconomic policies of the five East Asian crisis economies (Indonesia, Korea, Malaysia, Philippines, and Thailand) were (loosely) tied to each other. Their dollar exchange rates had been fairly stable for more than a decade, and, by the purchasing power parity criterion, were more or less correctly aligned with each other and with the American price level. This paper argues that overborrowing in the pre-1997 regime by these economies was primarily a regulatory problem, compounded by unnatural interest disparities. It was not due to exchange rate mismanagement per se. Appropriate domestic financial reforms would permit the East Asian five to restore a dollar-based exchange rate regime that would protect them from competitive devaluations. The advantages to them, and to the region, would be enhanced if Japan and the United States succeed in stabilizing the yen/dollar ratio, which would help, as well, to end deflation in Japan.

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Working Paper No. 45
Eight Lectures on Indian Economic Reforms
T. N. Srinivasan, November 1999

The paper is on the economic liberalization of reforms in India since July 1991. After independence in 1947, India had chosen an inward-oriented development strategy with the state playing a dominant role in the economy. This strategy, whose foundations were laid in the pre-independence era, had the support of political parties across the entire spectrum from left to right. State control was extensive, and covered foreign trade, investment (domestic and foreign), prices of essential commodities and internal trade. Government was also actively involved in provision of goods and services, not only of the traditional type of economic and social infrastructure, but others (e.g. hotel services) as well. The economic performance until the 1980's under the strategy was poor with per capita income growing at an annual average rate of 1.5 percent and the proportion of the poor population fluctuating around 50 percent with no time trend. In the 1980's macroeconomic prudence that was the hallmark of policy until then was abandoned in favor of an expansionist policy financed by borrowing at home and abroad at increasing cost. This expansionism, coupled with relaxation of some irksome state controls, delivered faster growth of per capita income at about 3.5 percent per year and also a significant reduction in poverty. But based as it was on an essentially unchanged development strategy and on accumulation of domestic and foreign debt, it inevitably led to a macroeconomic and balance of payments crisis in 1991. Not only the severity of the macroeconomic crisis, but also the collapse of the Soviet Union in 1991 and the spectacular growth of China since her opening in 1978, led to a disenchantment with the earlier development strategy. This paper analyzes the reforms undertaken in major sectors including agriculture, industry, foreign trade and investment, education, health, infrastructure, public finance and financial markets and their relevance for the overall objective of poverty eradication. This paper concludes that with further widening and deepening of reforms and integration of India with the world economy, the prospects are bright for sustained and rapid growth exceeding 7 percent per year.

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Working Paper No. 46
R&D and Technology Imports: The Indian Experience in the Eighties
Neeraja Sivaramayya and Ruchika Sah, December 1999

This paper looks at in-house R&D and technology imports in India during the eighties. We examine the relationship between the two and study their impact output. Our results show that R&D and technology imports have had a significant effect on improving productivity and that local R&D and technology imports are on an average substitutes. Finally, our results indicate that the 80's saw some growth in TFP attributable to an increase in knowledge capital; however, we find that TFP growth due to exogenous causes was negative during this period.

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Working Paper No. 47
Trade Creation and Trade Diversion under NAFTA
Anne O. Krueger, December 1999

Aggregate and more micro data on trade between the US, Canada, and Mexico are used to assess the early effects of Mexican entry into NAFTA. Although the shares of Mexican trade with the US and Canada have risen noticeably, several factors have contributed to this outcome. Mexico's reduction of tariffs and quantitative restrictions, and its alteration of exchange rate policy at the end of 1994 both were important. Based on early results, the impact of NAFTA over its first three years appears modest compared with the effects of other policy changes.

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Working Paper No. 48
Special and Differential Treatment in the Millennium Round
John Whalley, December 1999

This paper discusses special and differential treatment (SDT) for developing countries in a new WTO trade round. It argues that SDT introduced in the Uruguay Round represented a sharp departure from pre Uruguay Round SDT which had focused on special rights to protect and preferential market access, and was characterized by a wide range of delays, exemptions, best efforts endeavors from developed countries, technical assistance and other provisions. These new provisions were arrived at late on in negotiation, and were ad hoc in design. They nonetheless represented a new form of SDT relating to special rights needed on adjustment and policy capacity grounds as developing countries integrated into the WTO system. Despite general skepticism as to the value of SDT benefits, the challenge is to more carefully rationalize and target these provisions, and to elaborate on them.

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Working Paper No. 49
Missing Women, the Marriage Market and Economic Growth
Andrew D. Foster and Mark R. Rosenzweig, December 1999

Panel data from India during the initial years of the India green revolution are used to re-assess (i) whether gender differences in survival rates reflect gender differentials in the value of human capital and (ii) to what extent policies promoting economic growth can affect the female survival deficit in the absence of fundamental changes in cultural practices that differentiate the roles of men and women. A general equilibrium framework is used which incorporates patrilocal exogamy, whereby sons contribute to parental household incomes but daughters do not, and a marriage market in which dowry plays a role in equilibrating the supply and demand for human capital embodied in new brides. The empirical results indicate that (i) the relative survival rates of boys and girls respond in opposite directions to changing local and regional returns to human capital associated with economic growth, (ii) if economic growth propelled by agricultural technical change had been distributed uniformly across India on average girl survival would have increased relative to that of boys, and (iii) changes in women's participation in earnings activities had little to do with changing gender differentials in survival.

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Working Paper No. 50
The Choice of Structural Model in Trade-Wages Decompositions
Lisandro Abrego and John Whalley, January 2000

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Despite a large volume of literature, there has been relatively little numerical use of structural models when trying to decompose observed wage changes resulting from joint trade and technology shocks into portions attributable to each source. This paper highlights a series of difficulties with the numerical performance of widely used theoretical structures for decomposition experiments, which raise questions as to their suitability for this purpose. For small open economies, the conventional Heckscher-Ohlin-type model implemented with convenient functional forms (Cobb-Douglas, CES) reveals problems of specialisation unless the price changes accompanying trade shocks are small. As a result, this model is typically unable to accommodate large international price changes in performing decompositions. The model can also yield wide ranges for decomposition from alternative parameterisations consistent with the same wage change. In addition, as Leamer (1994) has argued, the structure can only meaningfully accommodate sector-biased rather than factor-biased technical change in the small open economy case. A differentiated goods model which generalises Heckscher-Ohlin removes problems of specialisation and is able to accommodate large price and wage changes, but introduces demand side responses to trade shocks which greatly reduce the effect of trade on wages. It also performs in implausible ways in the presence of sector-biased technical change. Our conclusion is both that the choice of structural model seemingly matters for decomposing observed wage changes into trade and technology components, and that structural models based on standard trade theory seemingly have numerical properties that make them not wholly satisfactory for this purpose. We also argue that reduced-form methods that do not allow for discrimination between alternative model parameterisations may not be that informative for trade-wages decompositions.

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Working Paper No. 51
The Environmental Regime in Developing Countries
Raghbendra Jha and John Whalley, January 2000

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This paper discusses the set of environmental externalities that are commonly found in the developing world (the environmental regime) along with the policy responses, if any, commonly used to these. Included are the direct effects of industrial emissions, air and water quality impacts of untreated waste (industrial and human waste), congestion effects of traffic, soil erosion, and open access resource problems (including forests). We note the tendency in much literature of the last few years to equate environmental problems in developing countries with pollutants (or emissions). The paper argues that to discuss environmental problems in developing countries (or to compare with developed countries) without reference to degradation as well as pollutants is incomplete; their effects are large and pervasive, and their severity and interaction with economic process often differs sharply from that of pollutants. The paper concludes with a discussion of how environmental policy in developing countries differs from that found in developed countries in light of the focus on degradation effects.

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Working Paper No. 52
Debt Management in Brazil: Evaluation of the Real Plan and Challenges Ahead
Alfonso S. Bevilaqua and Marcio G.P. Garcia, February 2000

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The Brazilian domestic debt has posed two challenges to policy makers: it has grown very fast and its maturity is extremely short. This has prompted fears that a default or a compulsory lengthening scheme would be imposed. Here, we analyze the domestic public debt management experience in Brazil, searching for policy prescriptions for the next few years. After briefly reviewing the recent domestic public debt history, we decompose the large rise in deferral bonded debt during 1995-1998, searching for its macroeconomic causes. The main culprits are the extremely high interest payments--which were caused by the weak fiscal stance and the quasi-fixed exchange-rate regime, and the accumulation of assets of doubtful value, much of which may have to be written off in the future. Simulation exercises of the net debt path for the near future underscore the importance of a tighter fiscal stance to prevent the debt-GDP ratio from growing further. Given the need to quickly lengthen the debt maturity, our main policy advice is to foster and rely more on, inflation-linked bonds.

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Working Paper No. 53
Latin America and the External Crisis: An Overview
Vittorio Corbo, February 2000

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The international crisis of the past three years arrived when most Latin American countries were successfully adapting their policies to achieve and maintain macroeconomic stability, create a more open trade regime with fewer distortions, develop a more robust financial system along with competitive market structures, and restructure the public sector. The onset of international crisis put stress on economic policies in the regions: it resulted, in particular, in a sharp deterioration in the terms of trade, a substantial increase in borrowing spreads and a sudden reduction of capital flows. That, in turn, put pressure on current accounts and exchange rate regimes, and forced the introduction of restrictive fiscal and monetary policies.

By contrast with previous crises, this time most Latin American countries avoided policy action to seal off their economies and to introduce expansionary fiscal and monetary policies in an attempt to stabilize output. The typical response has been to introduce restrictive macroeconomic policies to reduce current account deficits and to facilitate the real depreciation that must accompany a drop in the terms of trade. A number of countries have adopted more flexible exchange rate regimes, meaning that they are targeting the rate of inflation in adopting an appropriate monetary anchor. Fiscal discipline and Central Bank independence provide the institutional underpinnings for the inflation target strategy.

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Working Paper No. 54
Cronyism and its Discontents
Anne O. Krueger, March 2000

PDF version of this paper | PDF version of figures 1 & 2 associated with this paper

There are interesting parallels between the management of state-owned enterprises (SOEs) and enterprises run by crony capitalists. With SOEs, low real rates of return are generated for a variety of political reasons: to expand employment, to favor regions, to appoint the well connected as managers, and to continue to operate uneconomic enterprises.

In the case of crony capitalism, owners of companies receive credit and may expand because their firms' size is a political asset ("too big to fail"); they may mislocate in the country's capital to be close to those they wish to influence, regardless of cost; and because they receive subsidized credit regardless of prospective real returns, cronies can persist in business even when their activities are no longer economic. In effect, just like SOE's, they too are subject to a soft budget constraint.

Nothing about the lessons of recent crises in emerging markets implies that the economic growth of the 1960s and early 1970s was not spectacular: it was. Opportunities for very high real rates of social and private return were unleashed and were seized with consequent rapid growth. That many financial systems were underdeveloped and the criteria for lending were flawed, undoubtedly led to some misallocation of loanable funds, although bankers can make mistakes, too. But as the huge opportunities for profit that had arisen because of the alignment of incentives with real payoffs were seized, economies developed, and the scope for misallocation of investible funds increased.

As the real rate of return on capital fell for whatever reason, and the implicit subsidy in domestic credit also dropped, the flaws in financial systems and the commitment to cronies (or chaebols) became increasingly costly, just as SOE losses mount over time. Whether the problem is crony capitalism or SOEs, long-run satisfactory economic performance can be resumed only when means are found to allocate resources to best uses with arms-length transactions.

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Working Paper No. 55
When Will China's Financial System Meet China's Needs
Nicholas R. Lardy, April 2000

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Over-investment in property development, excess production capacity and a massive inventory buildup are current symptoms of inefficient financial intermediation in China. Although a series of important financial reforms have been undertaken in recent years, the results are compromised by the lack of related institutional reforms and inadequate competition in the financial and capital markets. More importantly, the bank restructuring required to resolve the problems of non-performing loans poses a serious fiscal challenge. Optimistic assessments of the potential for debt-equity swaps fail to account adequately for the recent fiscal deterioration and the accumulation of contingent government liabilities. This paper constructs three scenarios that make different assumptions about the pace of revenue and expenditure growth, as well as the adoption of commercial discipline in bank operations. Comparing these scenarios suggests that revenue buoyancy and the creation of a credit culture are both indispensable for a successful recapitalization of ChinaÕs huge state-owned banks.

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Working Paper No. 56
What Will Make Chinese Agriculture More Productive
Jikun Huang, Justin Lin and Scott Rozelle, August 2000

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This paper reviews China's development strategies in agriculture, the reforms that it has pursued in the past for achieving its current level of food security, raising agricultural productivity and augmenting farm income. It evaluates the effects that these strategies and reforms have had on agricultural production, with emphasis on the role of technology innovation and adoption. Finally, we seek to identify constraints and challenges that China will face and to analyze the scope for further agricultural and rural reforms. In particular, three scenarios with different underlying assumptions of technology investment and trade liberalization are presented to highlight the potential impact on grain self-sufficiency.

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Working Paper No. 57
State-owned Enterprises, Shirking and Trade Liberalization
Madanmohan Ghosh and John Whalley, August 2000

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We explore the implications of trade liberalization in economies with State Owned enterprises (SOEs) and shirking. SOEs are modelled as controlled by the members of the enterprise who determine output and effort levels, while facing output prices and wage rates set by government. Enterprise members must collectively meet a budget constraint that the value of sales equals the enterprise wage bill plus an exogenous enterprise commitment to the state budget. Labour can shirk either through low on the job effort (leisure), or through moonlighting to second jobs in the private sector. Three alternative formulations of equilibria in SOE economies are explored, and in these trade liberalization can produce effects opposite from conventional competitive models. In particular, the output of import competing SOEs increases rather than falls, and negative effects on imports can also occur. These models when calibrated to 1995 data for Vietnam also suggest quantitatively much larger impacts from trade liberalization than is the case for comparable conventional competitive models. This is because departures from Pareto optimality in SOE economies can be large and trade liberalization acts to discipline shirking associated with these inefficiencies. The implication we draw from our analysis is that to evaluate policy initiatives, such as trade liberalization, in developing and transition economies without explicitly recognizing the role that SOEs can play may be misleading. This is especially the case where SOEs account for a significant fraction of economic activity and shirking is involved.

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Working Paper No. 58
How Much Can Regional Integration Do to Unify China's Markets
Barry Naughton, August 2000

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Much of the current literature portrays China as a group of insufficiently specialized regional economies, meaning that national economic integration is low. This paper challenges this portrayal by examining data that show inter-provincial trade in 1992 was in fact large. Comparative analysis also suggests that China behaves much more like a single country than a close-knit international trading bloc. Moreover, comparisons with 1987 demonstrate that the growth of inter-provincial trade in 1987-92 exceeded that of provincial GDP and foreign trade during the same period. The results indicate, however, that trade is dominated by intra-industry trade in manufactured goods. Data deficiencies prevent firm conclusions, but the impression persists that significant barriers still exist to the movement of factors of production, and to trade in services and intermediate goods.

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Working Paper No. 59
The More Law, the More...? Measuring Legal Reform in the People's Republic of China
William Alford, August 2000

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This paper starts by evaluating the state-led legal development in China during the reform period, focusing on the building of a body of substantive laws, legal institutions, processes, and the clarification of roles for institutional actors. It proceeds to examine the relationship between legal development and economic growth. In particular, it questions the notion that more formal legal institutions, rules and trained personnel are synonymous with the greater respect for the rule of law that seems to be necessary for economic growth. The complexity of the Chinese situation are under-appreciated by many observers who underestimate the difficulties of improving legal measures that are "best practices" and work well in Western countries in a "top-down" manner in China. Any analysis of the impact of the law on Chinese economic development must consider the extent to which laws can perform well only when they are societally generated. Moreover, China's situation is complicated further by the Communist Party's exemption of itself from formal and informal legal constraints. At a theoretical level, this paper calls for broadening the inquiry as to why law matters to the economy, beyond simple devotion to the rule of law. In this context, a priority for research is to examine the interplay between formal rules and informal norms, and to assess their interaction within the Chinese society.

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Working Paper No. 60
China's War on Poverty
Scott Rozelle, Linxiu Zhang, Jikun Huang, August 2000

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China's poverty reduction in the past two decades has been impressive; but the effectiveness of the poverty alleviation programs still needs to be thoroughly investigated. In doing so, this paper reviews the development of China's poor area policies over the twenty years, emphasizing on how investment funds have been allocated under the poverty alleviation programs. Through simple econometric analysis, we discover that poverty alleviation can be largely attributed to economic growth, and the effectiveness of the poverty programs has been limited by problems related to targeting, project design and inefficient fund allocation. We also find that household-based projects and funds that directly reach the local agencies have contributed the most to the success of such programs. Finally, the paper advocates a different strategy for poverty alleviation that focuses on investment in human capital.

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Working Paper No. 61
Bending without Breaking, The Adaptability of Chinese Political Institutions
Jean C. Oi, October 2000

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Chinese economic reforms in the past 20 years have brought profound changes on China’s economy and its society. During that period, the Chinese government has undertaken limited, albeit significant, political changes, at a time when economic reforms have unleashed forces that jeopardize political stability. This paper examines the extent to which such cautious political changes can accommodate, ameliorate, or diffuse political tension. The increase in overt expressions of rural and urban discontent might stem from the complex strategy that the state has employed to encourage political participation and redirect blame in order to secure its control. These efforts to relieve political tension and preserve legitimacy by gradually yielding to societal demands represent a “bending-without-breaking” approach, of which the Organic Law on Villagers’ Committees is an excellent example. After presenting a more realistic assessment of the political impact of social unrest, this paper concludes that, although there is still room for political maneuvering through gradual political reform, challenges for the state remain significant.

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Working Paper No. 62
The Political Economy of China’s Rural-Urban Divide
Dennis Tao Yang and Cai Fang, August 2000

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China’s economic inequalities between rural and urban regions were high but stable during the centrally planned period. Since the inception of reforms in 1978, the disparities have exhibited a marked cyclical pattern: the declines in early years were followed by a period of increases and then by renewed declines. We find that the sharp sectoral divide in the planning episode was a result of industrial development strategy, but since the reforms the politically powerful urban population has pressured the government for fast income growth using various transfer programs. The central government has maintained an urban bias in order to preserve regime stability and political legitimacy. Our analysis indicates that, although the urban coalition may pressure the state for favors, political activities are not a necessary condition for the existence of an urban bias. As this study on China shows, the pursuit of industrial development strategy alone can result in a rural-urban divide. We suggest that removing distortions in factor markets is the policy reform most needed to bridge China’s rural-urban gulf.

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Working Paper No. 63
Reforming WTO Decision Making: Lessons from Singapore and Seattle
Richard Blackhurst, August 2000

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As developing countries began to participate more actively in GATT activities, the so-called “concentric circles model” became the organization’s de facto way of coping with the problem that while membership in virtually every GATT body was open to all members, once the active participation in a meeting exceeded a certain number (say 25), the group’s work became increasingly cumbersome, inefficient and ultimately impossible. Under this model, an issue-specific “inner circle” of members functions as a discussion, debate and negotiating group for the issue at hand. It either reports the results of its efforts to a larger circle of members, or directly to the entire membership, which is asked to take a consensus decision on the recommendations. Carried over to the WTO, this model was heavily criticized by many countries at the first WTO Ministerial Conference in Singapore in December 1996, and was again even more roundly—and publicly—attacked at the 1999 Ministerial Conference in Seattle. This paper argues that in those instances in which it is impossible to constitute an inner circle—or “green room meeting”—without excluding one or more WTO members wishing to be included, continued reliance on the informal concentric circles model can only progressively damage the WTO’s ability to function, as well as its internal and external credibility. It then goes on to make the case for creating a formal “WTO Consultative Board” whose design and operating procedures would draw on the strong points of both GATT’s Consultative Group of 18 (1975-87) and the IMF/World Bank Boards, while at the same time avoiding the shortcomings—from a WTO perspective—of both. The discussion includes a look at which WTO members are likely to initially oppose the creation of such a Board, and which members could be expected to support the proposal.

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Working Paper No. 64
Trade Policy, Structural Change and China’s Trade Growth
Will Martin, Betina Dimaranan, Thomas W. Hertel, and Elena Ianchovichina, August 2000

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During the past twenty years, the Chinese economy has become substantially more integrated into the world economy. China’s share of world exports has risen dramatically, and its composition has shifted strongly away from primary commodities towards manufactures. China’s recent offers for WTO accession involve another large step forward in integrating China into the world economy. To assess the implications of these reforms, and the underlying changes in the economy, we project the structure of the world economy forward to 2005 taking into account the pressures for change resulting from income growth and biased factor accumulation. Our very broad projections suggest that China will continue to increase its share of the world economy and world trade. The increase in China’s trade share depends heavily on the extent of liberalization, with a close-to-final proposal estimated to result in an increase in China’s shares of world export (and import) markets from around three and a half percent in 1995 to over six percent by 2005.

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Working Paper No. 65
Housing Reform in Urban China
Jeffrey Zax, August 2000

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Two decades of China's urban housing reform has produced significant quantitative and qualitative improvements. Despite various policies aimed to promote owner-occupied residential housing, the extent of commodification has been limited, and, in particular, most ownership transactions are independent of market considerations. This paper analyzes the reasons why significant commercial owner-occupancy has failed to materialize. On the one hand, the multiplicity of prices fails to reflect real market prices. On the other hand, flawed planning (which led to inappropriate real estate development) and extra charges have pushed most housing costs well beyond the reach of ordinary Chinese people. Although work units have gradually replaced the government as the dominant provider of urban housing, the implicit subsidies to employees of governments, and urban work units further complicate the question of who has actually "paid" for Chinese urban housing. This paper explores the related institutional reforms in the areas of land allocation and pricing, property rights, mortgage financing, informal housing and property taxation, which must accompany successful housing reform. The paper concludes by advocating an alternative agenda of housing commodification.

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Working Paper No. 66
Social Welfare in China in the Context of Three Transitions
Athar Hussain, August 2000

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This paper conducts a comprehensive review and evaluation of China’s social welfare development in the context of socio-economic changes characterized by three transitions. The analysis first focuses on the urban and rural social security systems by examining the arrangements for income maintenance in old age and unemployment, as well as the effectiveness of such provisions. This paper goes on to describe the current status of healthcare provision in urban and rural areas, and explore ways to finance adequate medical care and eradicate preventable illnesses. Finally, the paper identifies the major impediments in the implementation of social security reforms aimed at replacing the inherited system.

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Working Paper No. 67
India's Reforms Achievements and Arrears
Ashok V. Desai, October 2000

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When India’s economic reforms began in 1991, the immediate crisis and by the Fund-Bank conditionalities that accompanied their assistance defined them. The limited reforms succeeded so well that they have receded into obscurity. Almost all the political groups that opposed them have now embraced a reform agenda. As a result, reforms have lost focus, and acquired a range of often contradictory meanings. This paper defines a set of reforms still required if the gains made hitherto are to be consolidated and India’s economic performance is to be decisively improved. The reforms must begin with the administration. The present first-past-the-post system of election has favoured parochial and sectarian forces, and failed to ensure governments with a decisive majority; it needs to be replaced by proportional representation with a high cut-off point which would eliminate minor parties from the legislatures. They should be elected partly on universal adult suffrage as now and partly by income tax payers with votes in proportion to tax paid; budgets and financial legislation should require the approval of taxpayers’ representatives. The gazetted officers of the civil service at present are appointed for life; they should instead get ten-year contracts, so that their numbers can be matched with the work to be done. The present free-for-all civil service examination should be replaced by an examination in a small number of practically useful subjects. The junior bureaucracy should be appointed on short-term contracts that should not extend beyond the age of thirty. All government salaries should be comparable to those obtaining in the private sector; judges’ salaries should be comparable to those of the lawyers who argue before them. The present patchwork of states should be replaced by a larger number of states centred on the major cities; within the states, communities should have considerable freedom to set up their own local authorities. Import duties and import restrictions should be abolished; protection to domestic producers should be given only by means of the exchange rate. The present excise duty and income tax on profits should be replaced by a flat-rate value added tax, in addition to which there may be a personal income tax. State-owned banks should be mutualized and sold to depositors. Their business should be divided into custody of depositors’ cash and investment of the depositors’ funds. On deposited cash, banks should offer complete security and no return. In addition, they should offer depositors a range of investment options varying in liquidity, risk and return. To improve liquidity and reduce risk, Reserve Bank should encourage the emergence of local bill markets in which businesses can raise money and banks can invest. Regulators should be given clear and non-overlapping tasks, and their authority should be commensurate with their tasks. Regulators should be appointed who are not beholden to the government, and they must have powers of instant punishment. Regulators who oversee natural monopolies should enforce the common carrier principle and the principle of fair pricing. The government should privatize schools, and limit itself to subsidizing students - not schools and colleges. DTH television should be extensively used to impart education; the government should confine itself to setting common standards. The aim should be to create a political system that can learn from its own performance and improve upon it.

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Working Paper No. 68
Can China Grow and Safeguard Its Environment? The Case of Industrial Pollution
David Wheeler, Hua Wang, and Susmita Dasgupta, October 2000

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China’s remarkable industrial growth during the reform era brought with it severely adverse environmental effects. In particular, industrial air pollution induces high incidences of respiratory diseases in heavily-polluted urban centers. However, China’s own experience during the past decade shows that this damage can be substantially reduced at modest cost. Reform-induced changes in sectoral composition, ownership and scale of production have already reduced the potential polluting effects of rapid industrialization. The paper constructs three scenarios projecting the pollution damage under different assumptions about policy choices. The comparisons based on these scenarios argue for stringent emission regulations that are extremely cost-effective in reducing pollution intensity. Cost-benefit analysis also warrants further industrial air pollution abatement in China’s polluted cities.

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Working Paper No. 69
China's Transition to a Market Economy: How Far across the River?
Yingyi Qian and Jinglian Wu, May 2000

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China's two-decade reform since 1979 has evolved in two stages, with the November 1993 decision marking a turning point. The essence of this decision is to replace the planning system with a modern market system. We examine the process of change in the mind-set of the leadership and analyze its political, economic, and intellectual basis. We then evaluate the progress made during the first five years (1994-98) . To investigate the remaining challenges, we choose to focus on what we regard as the core issue: establishment of a free and competitive enterprise system by changing the government-business relationship to an arm's-length type. Three necessary tasks are: (i) transforming state-owned enterprises; (ii) promoting private enterprises; and (iii) establishing the rule of law. In each, we assess the current status and analyze the opportunities and difficulties for future development.

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Working Paper No. 70
The Peril and The Promise: Broader implications of the Indian Presence in Information Technologies
Ashok V. Desai, October 2000

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The boom in India’s software exports creates a rare opportunity to raise India’s growth rate while it lasts, and could, if handled correctly, raise its long-term growth rate even after the boom ends. The kind of growth that has transformed East Asian economies within a generation is within India’s reach. But if mishandled, the boom could disrupt the economy in the short run and leave it poorer in the long run. Mishandling is inherent in the current economic institutions and policies; urgent macroeconomic reforms are essential if India is to take full advantage of the software boom. The danger emanates from two trends that have emerged from a dialogue between the government and the software industry. First, the industry has asked the government for exclusive concessions and promotional measures, some of which have already been granted. These favour the software industry at the expense of other industries; such industry-level concessions complicate administration and increase the scope for corruption. Second, the government and the industry have agreed on a projected export growth rate that is much lower than what has been achieved in the 1990s, and have instead sought to boost the growth of the domestic software market by means of a range of government expenditure programmes and subsidies. Such measures benefit the industry at the expense of the taxpayer. The correct policy would be to maximize the export growth rate, and to use the export earnings to maximize growth of real GDP. Rapid growth of software exports would, by itself, tend to raise exchange reserves and money supply; it would encourage appreciation of the Rupee and fuel domestic inflation. Both these effects would make domestic producers less competitive, and would lead to demands for increased protection. On past record, the government is likely to yield to such demands. Greater protection would make producers even less competitive, and bring down exports, including software exports. Thus if the present trade policy continues, the software export boom would be cut short, and would result in no lasting economic benefit. Just as the oil price rise in the 1970s brought quick but ephemeral prosperity to major oil producers but nothing beyond high inflation and overvalued exchange rates in the long run, India too could end up with no lasting benefits to show. But the software export boom will lift the foreign exchange constraint for some years. If that breathing space is used to raise domestic savings and to invest them productively, India can end up with higher long-term growth. But if it wants to achieve this, it will need to take a number of urgent steps. Amongst them are the dismantling of the high level of tariff protection and increased reliance on the exchange rate to maintain the competitiveness of the domestic industry; reform of the civil service so as to achieve parity of private and public sector wages, and thus to reduce the incentive for corruption, and entry and exit of personnel at all levels to tailor the public sector labour force to the work to be done and reduce the scope for corruption; improvement of tax collection and achievement of a fiscal surplus; and reform of labour laws to permit flexible working and easier mobility of labour. These reforms together would spell a redefinition of the relations between the government and industry; instead of using political power for the benefit of interest groups, they would work together for national benefit.

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Working Paper No. 71
Is Disinflation Good for Growth?
Peter Blair Henry, October 2000

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When countries attempt to stabilize annual inflation rates greater than 40 percent, the domestic stock market appreciates by 24 percent on average. Therefore, the long-run growth benefit of reducing high inflation outweighs the short-run cost. In contrast, the average market response is economically weak and statistically insignificant if the pre-stabilization inflation rate is less than 40 percent. Hence, the net growth benefit of reducing moderate inflation is negligible. The first result seems more consistent with the rational expectations view of disinflation than with the traditional view. The second result appears more consistent with the traditional view than with rational expectations. Together, the results suggest that neither view sufficiently captures the real effects of disinflation across all ranges of initial inflation. The stock market responses also help predict the change in inflation and output in the following year. This additional result indicates that the stock market evidence for the 81 disinflation episodes studied here is not spurious.

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Working Paper No. 72
Courts and Relational Contracts
Simon Johnson, John McMillan and Christopher Woodruff, November 2000

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Post-communist countries offer new evidence on the relative importance of courts and relationships in enforcing contracts. Belief in the effectiveness of courts has a significant positive effect on the level of trust shown in new relationships between firms and their customers. Well-functioning courts also encourage entrepreneurs to try out new suppliers. A major role of the courts is to support the development of new relationships. While relationships can sustain existing interactions, workable courts help new int