Doing Diagnostics and Identifying Binding Constraints

Sta. Ana is the Coordinator of Action for Economic Reforms. This piece was published in the Business World on October 13, 2008, pages S1/4 to S1/5.

It is proper that we give special attention to the impact of the global financial meltdown on the Philippines.  At the same time, this should not distract us from focusing on the main binding constraints on Philippine growth.

The crash of financial markets worldwide adversely affects investments, exports, and jobs, among other things. But it is another matter to say that the global crisis has become the domestic growth’s main bottleneck.

Even before the onset of the worldwide crisis, the Philippine economy already faced weak investor confidence and rising poverty, despite the growth spurt. The global problem in this sense magnifies and compounds our internal problems.

Before applying new prescriptions, we first need a diagnosis.  First off, we must state that growth diagnostics recognizes that what works for one country or for a set of countries will not necessarily work for the Philippines. The binding constraints and the enabling conditions differ from one country to another.

Until now, some economists and policymakers drive policy on the basis of their faith in principles.  Trade is welfare enhancing; hence liberalize trade.  Capital is scarce and must be allocated efficiently; hence liberalize capital flows.

But a new thinking has emerged in the wake of the failure of the pro-liberalization Washington Consensus, which was everyone’s blueprint of what ought to be done

The new framework—doing diagnostics to identify the main binding constraints—does not repudiate the core economic principles that the Washington Consensus transformed into dogma.

Said another way, the fundamental economic principles are high levels of abstraction.  The challenge is how such abstractions are mapped onto concrete country conditions.  Take for example the basic principles of secure property rights and rule of law.  Communist China, the country that has registered the highest growth rates sustained over a long period of time, is hardly the model of secure formal property rights and rule of law.  So what explains its growth despite the weakness of property rights and rule of law?

One way to look at this puzzle is to examine Chinese innovations in the incentives and institutional arrangements concerning property rights and rule of law.

The lesson that we can draw from the failed Washington Consensus is that a priori prescriptions—a comprehensive list at that—must be avoided.   Similarly, immediately and simultaneously removing all distortions in the economy or putting in place as many reforms as possible is an impossible strategy.  Some of the reforms may not be sensitive to the main binding constraints.  Worse, they can even complicate the problems in the immediate term, thus damaging the over-all reform process.

The growth diagnostics alternative entails a thorough exercise that pinpoints the main binding constraints on growth and identifies the priority policies that address the said constraints. The subtext is that the policy menu is thin.

Analyses and decisions are based on the evidence, and the different decisions are weighed towards having a priority.

The diagnostics-and-binding-constraints approach likewise cautions us not to equate the most binding constraint with the one that has the biggest economic distortion.  For instance, a tariff on one good with substitutes creates a significant distortion, but it does not necessarily have a high impact on social cost.

In doing growth diagnostics, we are guided by a decision tree. As we descend from the treetop and move from one branch to another, we ask the relevant questions:

Why is growth low or sluggish? Why is there a low level of investments and entrepreneurship?  Does it stem from low return to economic activity, poor appropriability, or the high cost of finance?

If low return to economic activity is the plausible reason, is it because of low social returns such as poor education or deteriorating human capital?  Or perhaps, poor infrastructure?

Or is it a case of low appropriability?  Which in turn can be traced to either government failures like widespread corruption and macroeconomic mismanagement or market failures such as access to technology as well as information and coordination problems.

If on the other hand, low investments originate from high cost of financing, we need to see whether international or domestic finance is the culprit.  It may be the case that financing is hampered by high intermediation costs or low savings/revenues.

What I have enumerated is actually a sample of the proximate determinants of growth.  This is nevertheless a good starting point to lead the inquiry into the specifics of the binding constraints.

The point is diagnostics will lead us to specific variables that constrain growth. This in turn will help us identify the priority or a narrow set of priorities that will have the biggest and most direct impact on relieving the principal binding constraints on growth.

To quote Ricardo Hausmann et al (2005),  “the principle to follow is simple: go for the reforms that alleviate the most binding constraints, and hence produce the biggest bang for the reform buck. Rather than utilize a spray-gun approach, in the hope that we will somehow hit the target, focus on the bottlenecks directly.”

Thus, a universal prescription like the Washington Consensus becomes irrelevant in growth diagnostics.  One will find varying binding constraints and concomitantly differing reforms for similarly situated countries.

The approach of identifying the binding constraints has become a fad, and there’s a danger that it can be applied mechanically. Nevertheless, we do not lack good examples of how this is done.

In Egypt, a main binding constraint was the inefficiency of the financial system in allocating savings to domestic investments (Klaus Enders, March 2007).

In Brazil, a binding constraint then was the inadequacy of domestic savings resulting in high cost of financing for investments (Ricardo Hausmann et al, March 2005).

In Mongolia the binding constraints included poor transportation, corruption, distortionary taxes, and coordination failures (Elena Ianchovichina and Sudarshan Gooptu, November 2007).

In Zimbabwe, the binding constraint is obviously the problem of governance, personified by Robert Mugabe.

How about the Philippine case?

A World Bank paper (Alessandro Bocchi, 2007) identified three main binding constraints for the Philippines, namely: 1) the exchange rate, with the peso’s appreciation in 2007 (this changed course in 2008 amidst inflation and global uncertainties) 2) the fiscal imbalance, and 3) “elite capture.”

The Asian Development Bank study (2007) said that the Philippines’ binding constraints included the fiscal situation, inadequate infrastructure, and governance.

The World Bank and ADB studies are fairly recent and thus remain instructive as we cope with the domestic consequences of the crash of the world’s financial markets.

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