Bhalla Ppt Parallel5.2

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1

Surjit S Bhalla

Presented at the 8th Annual Global Development Conference,Beijing, China.

January 14-18, 2007

*Based on Bhalla, Surjit S., Second Among Equals: The Middle Class

Kingdoms of India and China , forthcoming, IIE, 2007

Governance and Development: WhichWay The Link?*



2

Governance & Growth: Cause & Effect

This paper examines the new conventionalwisdom i.e. that better institutions, or bettergovernance, causes higher growth and leads to

countries being richer.

While a simultaneity is recognized, both

theoretically and econometrically, the emphasishas largely been on a one way link from governance to development



3

Good Governance Is A Luxury Good

Our findings support the view that betterinstitutions are best viewed as a purchase of aBMW i.e. a luxury good. While better institutionsare found in higher income countries, it most likelyis because as countries become richer, they wantto acquire better institutions.

Macro data from all countries, and micro datafrom India, are used to test the relationshipbetween institutions and development.



4

What determines growth

Geography/Climate (Rainfall)

Catch-up

Demography

Institutions

Factor Accumulation

Human Capital

Policy



5

Geography: It does matter, but considerablyless than claimed.

Institutions – Matter the least; very likely

because “institutions” are a luxury good,determined by levels of income, and thereforenot vice-versa.

Policy – matters the most, but only one policy:

an undervalued exchange rate I.e. producecheaply and conquer the world

Determinants of Growth



6

New Determinants of Growth*

Some “New” Important Factors

Middle Class as an important driver (values,entrepreneurship, level playing field)

Undervaluation of real exchange rate (very old

determinant, previously called mercantilism)

*See Bhalla, Surjit S., Second Among The Equal: The Middle Class

Kingdoms of India and China, Institute of International Economics,forthcoming 2007.



7

Definition of Governance

Property rights

Law and order

Risk of expropriation

Political and civil liberties



8

Institutions in India: 1950-2006

Institutions likely better in India during the low growth period, 1950-1980.

All indicators suggest no improvement ininstitutions, and sometimes a deterioration; butgrowth considerably higher in the “bad” institution

period.

How much higher? Less than 2 % (1.6%) percapita during 1950-1980, and in the 1980-2006period, more than twice as high (4.0 % p.a.).



9

Governance: Corruption Increasing

1983 2003

China 5.1 3.4

Hong Kong 7.4 8.1

Indonesia 0.2 2.1

Malaysia 6.3 5.0Philippines 1.0 2.6

Singapore 8.4 9.3

South Korea 3.9 4.6

Taiwan 6.0 5.8

Thailand 2.4 3.5

Bangladesh 0.8 1.4India 3.7 2.9

Pakistan 1.5 2.3

Non Asian World 5.8 4.4

World 4.6 3.6

Source: Transparency International; higher number indicates less corruption



10

Performance of Indian Institutions

Particulars Data

Public Distribution of Food

Incidence-Access of poor to PDS schemes

(% of households with non-zero expenditure in PDS schemes)

Rice 32.6

Wheat 24.2

PDS (as % of total consumption of the poor)Rice 11.3

Wheat 5.7

Allocation and offtake of Wheat & Rice

Government Claims

Allocation (lakh tonnes) 101.8

Offtake 56.2

NSSO Consumption 29.2

Mid-day Meal programNo. of children covered (in million)

Government 99.0

NSSO 9.7

No. of meals

Government 2376.0

NSSO 266.0

Governance in India, 1999/2000



11

Governance in India – Food Distribution

Alloca

tion

Offtake,

Govt.

Actual,

NSSO

Leakages

(%)

Rice, Quantity (lakh tons)

Poor 44.2 39.8 21.2 46.6

Non Poor 93.0 72.1 66.0 8.5

All 137.3 111.9 87.2 22.0

Wheat, Quantity

Poor 32.4 30.2 6.9 77.1

Non Poor 69.4 26.0 22.4 14.0

All 101.8 56.2 29.3 47.9

Rice, estimates subsidy (Rs. Crore)

Poor 2505 1338 46.6

Non Poor 4039 3696 8.5

All 6544 5035 23.1

Wheat, estimates subsidy (Rs. Crore)

Poor 1147 262 77.1

Non Poor 676 581 14.0

All 1823 844 53.7



12

Leakages in the employment generation

programs (as % of the government claim) 1999

Government

Man days created (crores) 54.7

Total expenditure on schemes (Rs. crore) 5124Expenditure on wage bill (Rs. crore) 2050

NSSO

Employment in public works (crores) 32

Employment in public works, rural poor (crores) 7.8

Total wage bill in public works (Rs. crore) 1414

Total wage bill in public works, rural poor (Rs. crore) 302

Leakage (% utilized for rural poor)

Physical 85.7

Financial 85.3

Governance in India – Employment Programs



13

Performance of mid day meal program in 1999

Government of India

Number of children covered (Mil) 99

Number of meals (crores) 2376Expenditure (Rs. Crore) 1500

NSSO

Number of children covered (Mil) 9.69

Number of meals (crores) 266

Leakage (%)

Number of children 90.21

Number of meals 88.80

Governance in India – Mid-day meals



14

Governance & Growth: Conventional Wisdom

That governance (institutions) cause economicgrowth to be higher

Several econometric tests confirm it.

“Institutions Rule”.

World Bank, IMF Presidents echo & recommend this result to all.



15

Governance & Growth - Cross CountryAnalysis

Several institution variables

ICRG (risk of expropriation), Heritage Foundation,political and civil liberties, Polity data, democracy and

dictatorship, World Bank data on governance, data oneconomic freedom.

Instruments – log settler mortality, legal origin, ethnic

fragmentation, colonial origin, middle class.

Geography variables: Latitude, mean temperature,minimum rainfall



16

Fragility of Results on the Efficacy ofInstitutions

Log per capita income = 1 .86 + 0.95*Risk

in 1995 (1.6) (5.4)

= 1.63 + 1.0*Risk - 0.007*Latitude

(1.1) (4.1) (-0.5)

Addition of Mean = -4.64 + 1.84*Risk - 0.029*Latitude + 0.075*Temperature - 0.025*RainTemperature and Rainfall (-0.41) (1.18) (-0.58) (0.64) (-0.73)

= -2.97 + 1.49*Risk + 0.075*Temperature - 0.017*Rain

(-0.43) (1.9) (0.75) (-0.98)

Acemogulu, Johnson & Robinson model

Original formulation: (instrumental variables, instrumentsis (log) settler mortality, 64 observations)



17

Experiments with Institutions

Several institutions such as “ political liberties” , “World Bank index of governance” , “Risk of expropriation” were tried.

Several instruments such as “settlers mortality”, “legal origin”,

“middle class” were used

Two different samples: set of countries considered by Acemoglu et.al. (2001) and all countries with population higher than one millionexcluding oil exporting countries.

Four different models using three different geography variables – latitude, mean temperature and minimum rainfall – and log per

capita income in 2005 as the dependent variable.

Four different models with growth 1960-2005 as dependentvariable.

In all, over 3000 models were estimated.



18

Success rate (%) of institution-growth models

Success (% ) at different stages - Institution growth models

First

Stage

First +

second

stage

Hansen

ID Test

Final

Pass

(%)

First

Stage

First +

second

stage

Hansen

ID Test

Final

Pass

(%)

Instrument

Ethnic fragmentation 35.0 35.0 19.6 6.9 15.6 15.6 10.9 1.7

Legal origin 30.0 7.5 5.0 0.4 71.9 12.5 11.5 1.4

(Log) Settler mortality - AJR 55.0 55.0 33.3 18.3 12.5 12.5 8.9 1.1

(Log) population density 35.0 22.5 19.2 4.3 25.0 9.4 6.8 0.6

School Enrollment (around 1890) 90.0 80.0 56.3 45.0 43.8 0.0 0.0 0.0

Middle class 87.5 80.0 51.3 41.0 37.5 9.4 7.3 0.7

Proportion of white settlers (1900) 80.0 75.0 48.8 36.6 28.1 0.0 0.0 0.0

Institution

World Bank composite index 72.9 64.3 46.8 30.1 42.9 14.3 6.1 0.9

Political liberties 50.0 42.9 21.4 9.2 28.6 0.0 0.0 0.0

Polity IV index 48.6 44.3 21.5 9.5 14.3 0.0 0.0 0.0

Risk of expropriation - AJR 64.3 51.4 33.1 17.0 48.2 19.6 9.5 1.9

Without undervaluation With undervaluation



19

Middle Class - Definition

Middle class: Defined as non-poor in thedeveloped world:

Constant across time and countries

In early stage of development middle class were elites

Presence of middle class enforces “good policy”- on infrastructure, on governance, and thereforehigher growth.



20

Definition of Middle Class

The middle class are the non-absolute poor in thedeveloped world.

Absolute poor poverty line, PPP $1.08 (1993 base)

Absolute poor, developed economies, PPP $ 7.7

In 2006 PPP prices, the two values are 1.42 and 10.1

Middle Class Line : approximately PPP$ 3700 percapita per year in 2006 prices.



21

Middle Class as an Institution

Middle class believes in property rights, free trade,rules of the game, anti corruption etc.

It is not the poor, nor the landed elite, nor theindustrial elite.

Purely out of self interest it believes in market“virtues”; only way for it to prosper.



22

Asia – Middle Class, Undervaluation andGrowth

China India Vietnam Brazil Korea Japan

1960-80

MC (%) 0.2 3.2 2.0 27.6 30.6 95.8

Growth effect of undervaluation (%) -1.5 -1.4 -0.3 0.6 0.5 -0.3

Per capita growth (%) 2.1 1.3 4.1 6.1 6.4

1980-90MC (%) 14.4 5.7 2.7 46.2 76.0 91.4

Growth effect of undervaluation (%) 4.0 1.4 3.3 -0.9 1.4 -0.7

Per capita growth (%) 5.4 3.3 3.0 -0.6 7.4 3.3

1990-2006

MC (%) 45.0 16.0 12.4 48.0 85.4 80.1

Growth effect of undervaluation (%) 2.2 1.9 0.1 0.4 0.7 -0.3

Per capita growth (%) 7.2 4.1 5.7 1.0 4.4 1.0

2006

MC (%) 70.4 31.8 28.7 50.3 75.0 72.9

Growth effect of undervaluation (%) 2.6 2.0 3.1 -4.7 -0.5 2.7

Per capita growth (%) 9.1 7.2 6.1 2.2 4.1 2.7



23

World: Middle Class and Income Growth

0

1

2

3

4

( L o g ) p e r c a p i t a i n c o m

e 1 9 9 6 P P P

0 . 0

2 0 . 0

4

0 . 0

6 0 . 0

1000 1500 1700 1820 1890 1913 1929 1950 1980 2006 2015 2025Year

Middle class (Log) per capita income per year




24


0

1

2

3

4

% g

r o w t h p e r a n n u m

0 . 0

2 0 . 0

4

0 . 0

6 0 . 0

1500 1700 1820 1913 1950 1980 1990 2000 2006 2015 2025Year

Middle class Income growth, p.c. per year

World: Middle Class and Income



25


21 27

27 22

29 11

25 7

14 4

1 2

0 2

0 1

0 1

0 10 20 30 40 50

2025

2015

2006

2000

1990

19801970

1960

1950

Share in World Middle Class

China India



26

Non-linear growth: Middle Class

Note: (log)2.1 $ a day is the poverty line for the developed countries

1980 2000 2006 2015

0

. 2

. 4

. 6

0 2 4 6Year

India: Income Distribution, 1980-2015



27

Non-linear Growth: Middle Class

Note: (log)2.1 $ a day is the poverty line for the developed countries

1980

2000

2006

2015

0

. 2

. 4

. 6

0 2 4 6Year

China: Income Distribution, 1980-2015



28

The Changing Middle Class World of India

23 5

8

17

32

73

90

0

2 0

4 0

6 0

8 0

1 0 0

1950 1980 1985 1990 2000 2006 2015 2025

India: Share of Middle Class in Population



29

0 1

10

23

48

70

84

71

0

2

0

4 0

6

0

8 0

1950 1980 1985 1990 2000 2006 2015 2025

China: Share of Middle Class in Population

The Changing Middle Class World of China



30

22

3334

36

41

49

6062

0

2 0

4 0

6 0

1950 1980 1985 1990 2000 2006 2015 2025

World: Share of Middle Class in Population

The Changing Middle Class in the World



31

Why Does Undervaluation Work

Model of investment

I = f(cost/productivity)

C α GDP per capita US$

P α GDP per capita PPP

R = (GDP US$/ US ex. rate) * (GDP PPP/ GDP US$)

Real exchange rate = (ex. Rate PPP)/ (ex. Rate US$)This is exactly the Balassa-Samuelson definition (but derived via demand for investment)



32

Why Does Undervaluation Work

Cheaper currency, greater undervaluation, more

incentives to invest, higher investment & highergrowth rate

May not lead to greater efficiency but does lead tohigher investment, and therefore higher growth.



33

Undervaluation of Currency: the Balassa-Samuelson model

eth

tza

bgd

cmr

nga

ghapak

vnmindphlegy

dza

idn

dom

lka

per

col

bwabra

chn

mex

tha

pol

rusmysarg

chl

mus

prt

kor

oan

deugbr

jpn

sgp

irl

usa

0

. 5

1

1 . 5

0 1 2 3 4 5(Log) Per capita income (1993 PPP $)

Predicted value Undervaluation (actual)

2006

Undervaluation



34

Some Present Undervaluation Levels

Country 1960 1994 2006

United Kingdom -31.1 9.6 28.0

Germany -0.6 38.6 28.5

Japan -6.9 61.9 19.1

United States -19.0 -8.1

China 195.1 -12.1 -55.5

Vietnam 31.4 -25.0

India 143.2 39.9 -12.2

Pakistan 152.2 46.3 21.5

Brazil 24.7 30.1 23.7

Mexico 12.6 24.6 23.5

Chile 21.8 -19.5 -24.8

Undervaluation (in %)



35

Popular Misconceptions of Costs to CurrencyUndervaluation

A popular perception is that developing countrieslose from undervaluing their currency.

Undervaluation means accumulation if reserves,and these reserves yield a very low rate ofinterests and are invested in a depreciatingcurrency (US dollar)

Reality is that the gains from undervaluation(higher growth) far outweigh any costs.



36

Consequences of high benefit cost ratio toundervaluation

Implication – Developing countries (and Japan)unlikely to sell the dollar.

Doing so would be a case of own goal, or “apne pair pe apni kulhadi ” (axing one’s own feet).

The following calculations for India & Chinadocument the evidence.



37

How much Does Foreign ReserveAccumulation Cost?

Elasticity of undervaluation: -.03 (an underestimate)

For every 10 % devaluation GDP increases by .3 %

Undervaluation: India (%) : 13Undervaluation: China (%): 55

Indian GDP = 800 billion dollars;

Chinese GDP: 2000 billion dollars



38

Calculation of costs of FX accumulation: India

Addition to FX reserves each year: 20 billion

Marginal cost of these reserves (at 3% per annumhigher interest rate domestically): $ 600 million

Marginal extra growth from undervaluation: Impact

per percent of undervaluation (.03) multiplied by themagnitude of undervaluation (.03*13) = 0.5 % ofGDP or .005*800 = 4 billion



39

Calculation of costs of FX accumulation: China

Addition to FX reserves each year: 100 billion

Cost of these reserves (4% per annum): 4 billionExtra growth from undervaluation: .03*55 = 1.7 %of GDP or .017* 2000 bil = 34 billion

Cost-Benefit Analysis of undervaluation:

India 4/0.6 or 6.5 times the “investment”

China 34/4 or 8.5 times the “investment”



40

High Growth Episodes & Undervaluation

Time

period

Average

growth

Average

Uvdervaluation

(%)

Average

change in

undervaluation

(%)

OECD

United States 1960-89 2.4 -15.1 -2.2

United Kingdom 1960-80 2.2 -16.5 2.9Germany 1960-80 3.3 7.7 1.8

Japan 1960-80 6.4 -5.9 1

Emerging Markets

Brazil 1960-80 4.1 28.4 -2.5

Chile 1990-2005 4 -29.5 -1.1

Indonesia 1960-80 3.1 97.8 0

Malaysia 1960-80 4.4 81.1 -2.1

Singapore 1960-80 6.8 50.1 -3.6South Korea 1960-80 5.7 44.2 -3.1

Taiwan 1960-80 6.7 49.6 -2.2

Thailand 1960-80 4.5 72.7 -2.6

Vietnam 1991-2005 5.7 10.1 -0.5

China 1980-2005 6.4 26.5 -8.2

India 1991-2005 4.1 19.3 -5.5



41

Conclusion

Institutions (governance) is a luxury good. Rich countries have

more of it. But it does not mean that institutions cause growth ?

What does cause growth is “liberalization” defined as rules of the

game as dictated by the “market”.

The middle class, for its own benefit, believes in liberalization.

Another important contribution to growth is undervaluation of

currency.

But what if everybody does undervalues? That is when the benefitswill end.

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Bhalla Ppt Parallel5.2