T Manuel: Ditchley Park Lecture

7 July 2006

Public policy and growth for Africa

Introduction

Thank you for inviting me to address you today.

This year marks the 10th anniversary of my tenure as Minister of Finance of
the Republic of South Africa, a 10-year period that has been marked by
international financial crises preceded ominously two years earlier by the 1994
crisis in Mexico, continuing through the Asian crisis in 1997 and the Russian
crisis in 1998 and flaring up again in 2001. Large shifts in investment
portfolios have sparked contagion again this year, prompted by inflation
concerns and interest rate hikes in the world’s largest economy and supported
by unprecedented current account deficits and surpluses across the major world
economies.

1 These global financial and economic imbalances put at risk the growth,
poverty and development achievements of poorer countries and pose special
challenges for the developing world.

2 I want to speak to you today about some of those challenges.

In doing so I want to venture into difficult terrain for governments to
provide some perspective on the case for an organic and national policy
response to the international environment and to globalisation in particular,
that takes advantage of the vast gains to be had from economic integration. And
I want to make a case that is cognisant of and sensitive to the
responsibilities of national governments and the power of the state in the face
of globalisation’s risks. Above all this perspective must strive for a positive
contribution from markets and states to the fulfilment of human economic,
cultural and social development.

This latter goal merits further consideration not least because it in some
senses captures the essence of what elected governments ought to be about.

Economics and finance are of course critical areas of public policy and
human welfare have increased as a result of the application of economics to
social organisation as well as relations and a wide variety of other public
issues. Nonetheless, we need to remain conscious of the temptation to too fully
apply the logic of the market to all human endeavours.

We live in a time in which the virtues of ‘economic man’ are lauded above
most other facets of humankind often to the detriment of our fully
comprehending and ensuring the role of community and state in public policy.
This has implications for how state and market are organised at the domestic
level and the institutions that give life to both, for regional initiatives to
create cross border economic activity and for what we do as an international
community to address poverty through aid and the international financial
system.

In the 1940s Karl Polanyi wrote about another period in our history where we
allowed economics to over determine social relations he described how radical
liberalism of the 19th century denied the “reality of society” and enabled an
unprecedented creation of wealth in the hands of elites.

3. In his view, the unemployment and destitution that was an integral part
of that wealth creation (and the shift from agricultural to industrial
societies) resulted eventually in the misery of fascism in Europe. History’s
lesson was of the need to prevent the aggregation of social and economic power
in the hands of too few by regulating economic power in a way that maximises
the freedoms of those without power. Regulation of markets and making them
reasonably competitive (or possible to enter) became a critical element of a
public policy that sought to steer in a sustainable way between the rights of
the individual and those of community and society.

From a practical point of view, such balances that Polanyi emphasises are
difficult to achieve. In a range of European countries in recent decades the
challenges presented by inflation, unemployment and globalisation have made
many people question the basic social balances achieved in the post-war era.
Offshoots of that questioning include the difficulties experienced in the
banlieues of Paris and the insecurities expressed around immigration and
migration across the north.

State and market in Africa

For most developing countries, the articulation and implementation of a
balanced public policy is an ongoing and relatively recent endeavour. For many
African countries, policy is addressed in an environment of extreme
deprivation, skills shortages and weak public institutions. Overcoming those
constraints requires broad-based economic growth alongside the imposition of
short-term costs that can be alleviated by policy. These ‘core and periphery’
challenges remain profound for countries that have no public systems for
providing the sort of financial or in kind transfers required to address the
needs of those people too old, young, or poor to adapt well to change.

4. Microeconomic policies to facilitate the shifting of people from old and
non-competitive industries to new industries and new forms of economic activity
are clearly important.

5. Such policies entail assertive re-skilling, high quality education and
access to social and other forms of capital to help and enable individuals to
take advantage of new economic opportunities.

But such policies also entail the movement of people out of established and
older communities and livelihoods and into new ones repeating the conditions of
social dislocation and misery described by Polanyi, which involved enclosure
and the movement of people from rural to urban settings. And if there is one
thing we know about societies it is that few of them embrace change as a way of
life. Economic and social dislocation is experienced in the present, while the
rewards of growth only in the future.

The distress of African economies and societies means, moreover, that the
universal political calculus of assessing who reaps the rewards and suffers the
costs of policy change is insufficient. A further delicate calculus is required
to assess just how much instability an already fragile economic and social
fabric can withstand. Will the political reaction to a reform confound the
reform process in its entirety?

The good news is that economic reform need not follow the standard
Washington consensus approach, even though most of the policies entailed in it
are good for growth in themselves. The point is simply that since the 1980s,
research on growth has generated lots of heat but also interesting
perspectives. As Rodrik has highlighted institutional development in an economy
need not follow one model and is more likely to be successful if it respects
and adapts to local characteristics. And many of the instances where countries
successfully and sustainably increased the rate of economic growth, they
frequently did it by targeting particular constraints to growth through quite
limited reforms.

6. Clearly, the State has an active role to play in most aspects of economic
development particularly in the ongoing effort to ensure that markets are
efficient. But to be able to fulfil that regulatory role, Africa’s States need
to radically increase their capacity to define appropriate policies and to
implement them. Institutional development is a prerequisite for policy
definition and even more so for implementation. Regulatory systems and public
institutions require the consistent application of skills and intellectual
capital to create them and to sustain them. These are resources that are in
short supply in developing countries and in Africa in particular suggesting the
importance of the sustained provision of financial assistance and other means
of freeing up resources for development.

Kermal Dervis has expressed the point well, “As hard as it is to achieve the
world urgently needs a combination of substantial foreign aid in the form of
grants, perhaps at least twice the amount that is currently available with a
mechanism to ensure that these resources are actually put to good use. There is
really nothing that automatically leads to the inclusion in the world economy
of countries that have been marginalised by history, geography, civil war,
governance failures and/or foreign power struggles on their soil.”
Globalisation does not “work” for these countries. China and India can use the
apparatus of the nation state to “create” linkages between their own prosperous
regions and their poor regions. Somalia and Sierra Leone can do very little on
their own to create equivalent linkages between themselves and the dynamic
parts of the world economy.

7. Developing appropriate and effective state institutions will help
developing countries to better address their international challenges. Yet many
deplore the risks associated with globalisation with economic integration and
international finance despite the potentially dramatic and positive
implications for economic development. Countries need to have “the desire to
integrate in the world economy,” just as they need to maintain macroeconomic
policies that limit fiscal deficits and the build up of debt.

8. I have suggested that the development of domestic markets is needed in
African economies. But it is also true that African economies are small the
South African economy with a Gross Domestic Product (GDP) of about US$235
billion constitutes three quarters of the GDP of Sub-Saharan Africa.

9. For that reason, regional and continental integration of markets is
critical to market development, growth in nascent industries and for
diversification. Without serious advances in trade integration Africa’s
economies will remain at the mercy of destabilising terms of trade shocks and
other asymmetric shocks that can set development back by decades.

Yet to address those shocks and enable more appropriate trade regimes in
Africa, related public institutions and systems again require extensive
development. Most African economies retain fairly high trade barriers because
of weaknesses in revenue collection from other forms of taxation. Reducing
trade barriers, therefore, needs to be achieved alongside the development of
effective revenue administration. Financial shocks emanating from the cessation
or sudden resumption of foreign aid are also often destabilising especially for
African economies because even small imbalances can disrupt thin markets and
because the adjustment process is often impeded, rather than facilitated by the
policy response.

In particular, adjustment processes usually place the burden of adjustment
on politically underrepresented social groups, leading to an increase and
perpetuation of poverty. Some marginalised groups become permanently locked out
of economic opportunity, distorting the distribution of income, reducing the
potential growth of the economy and giving rise to political instability.

Many of these sorts of political economy challenges would be made more
tractable if the global trading environment supported production and exports
from developing economies. Subsidies and protection perpetuates the dependence
of African economies on colonial era trading relationships and undermines the
independence that most countries need to sustain development.

One means of addressing the dependence problem would be for Africa to
coalesce national economic demands into politically sound regional economic
institutions. This would provide Africa greater institutional leverage to
address the need for a fairer global trade regime, some capacity to address the
impact of capital flows and reform of global economic governance.

I want to also suggest and running contrary to much of the public discourse
on the topic that national sovereignty may be enhanced through integration,
despite the piecemeal loss of sovereignty in some areas. When applied to the
pressures of globalisation this thesis seems to me to hold even more strongly,
globalisation can be addressed in regional and global institutions in such a
way as to increase the power of states and better reflect the social and
economic preferences of their citizens.

This idea seems especially pertinent and potentially rewarding in a regional
context. Limited infrastructure, non-existent regulation or limited enforcement
capacity thin and undiversified markets for finance, goods and services all
limit the extent to which African economies develop. Deeper regional
co-operation could occur by basing regional economic communities in Africa on
free trade agreements and customs unions of regional neighbours and then
progressively linking them to each other through phased reduction of tariffs
and non-tariff barriers.

The practice of trade policy and its outcomes across the continent is of
course diverse. While some regions remain in low level equilibria others have
made great strides in bedding down policy, creating better regulation and
achieving macroeconomic stability and are reaping the rewards in terms of
higher investment and more rapid growth.

To get some sense of the macroeconomic improvement, the average inflation
rate for Sub-Saharan Africa from 1995 to 2005 was 18 percent.

10. By 2005 this had fallen to 11 percent and is expected to be about eight
percent in 2007. The average budget balance in the region is expected to be a
surplus of 2,1 percent in 2006. And average GDP growth for 2005 was 5,5 percent
and is expected to be 5,8 in 2006. Greatly improved macroeconomic performance
will translate into rising employment and income over time, but remains
insufficient to address the enormity of the poverty problems affecting the
region. Roughly half the population continues to survive on less than $1 a
day.

While the developing world has largely embraced the need to shift to open
economies, greater competition and the risks associated with getting policy
right or wrong, the developed world continues to flirt with the opposite.
Non-tariff barriers such as phytosanitary criteria – stifle production in
developing countries. The lack of progress on the current Doha round of trade
talks reflects a disturbing level of insecurity about the economic future in
developed economies.

Multilateral trade relationships also require a change in focus. Africa’s
approach to the World Trade Organisation (WTO) needs to emphasise long-term
gains from progressive liberalisation, supported by the specific effort to
remove trade-distorting subsidies in developed economies.

11. In some ways, agreement at a multilateral level may provide momentum to
efforts to rationalise Africa’s regional trade blocs and lower tariffs
remaining between the blocs.

The role of government in the economy therefore remains central to the task
of making markets work for local communities and those without capital. Markets
need to work with less rent seeking and more efficiency as a policy rule to
maximise investment, employment and growth in income. More generally,
geographic and man made constraints to growth should be priority targets for
most African governments.

And in terms of the continent as a whole, public infrastructure development
should be more aggressively aligned with the evolution of population centres
rather than remain relics of antiquated and obsolete colonial economic
relationships.

As the commission for Africa report points out, poor infrastructure remains
a severe impediment to more rapid growth and poverty reduction:
‘In some regions of Africa, farmers lose as much as half of what they produce
for lack of adequate post harvests storage. Across the region, women and girls
currently walk an average of six kilometres to collect water. The life of those
living in urban slums is made still worse by the lack of infrastructure, only
seven percent have access to sewerage services for example leading to economic
costs in terms of health and lost work hours.’

12. Infrastructure needs have become more pressing as China, the United
States (US) and other major world economies focus their attention ever more on
Africa as a provider of raw materials. African countries need market
development, efficient and fair public institutions and leadership and major
communications and transport infrastructure that reflects African economies,
not just the needs of the world’s greatest commodity importers. Africa’s
development and welfare depends in part on how commodity wealth is used to
create intellectual, cultural and social wealth and in part on how African
states align policy for economic development beyond the production of
commodities. In addition to institutions and markets, another key area of work
is addressing the challenge of international finance to which I now turn.

International finance and the international financial system

Some of the basic concerns raised by Polanyi about the role of public policy
in national economies have regained their former importance because of the
expansion of financial and capital markets.

Not unlike the 19th century, free flows of capital today play a major role
in determining what happens in national and regional economies. And although
most of the developed world has moved to floating exchange rates to create room
for manoeuvre relative to the international financial and capital markets,
interaction with those markets remains largely mediated by fixed exchange rate
policies in most of the developing world.

13. We should refresh our understanding of the burden of fixed exchange
rates on policy orientation and the internal functioning of developing
economies. As Polanyi noted in 1944 of the collapse of the Gold Standard:
‘Currency had become the pivot of national politics. Under a modern money
economy nobody could fail to experience daily the shrinking or expanding of the
financial yardstick; populations became currency conscious.’

The international market forces that national governments contend with today
are dynamic and dwarf public resources daily turnover in global foreign
exchange markets increased by nearly 40 percent in real terms between 2001 and
2004 to close to US$2 trillion. The South African rand share of total foreign
exchange turnover doubled from 2001 to 2004 to nearly one percent.

14. One of the key realisations in the aftermath of the Asian crisis (and
reinforced by Argentina) was that different approaches to exchange rates and
domestic regulatory institutions and governance matter, not just for prevention
of crises but also for their resolution and the recovery of the stricken
economies. To get a handle on domestic weaknesses that make economies prone to
crisis, a range of emerging market economies were invited to the discussions on
prevention and resolution and helped in the formulation of new codes and
standards.

All of this has been immensely beneficial for the international financial
system, the strengthening of regulatory and oversight functions in national
systems and the spreading of knowledge. Global economic governance and hence
reform of the international financial architecture, however, remains
incomplete.

We need a multilateral basis for overcoming future bouts of financial
contagion, to maintain the connection between developing economies and
international capital and goods markets and enable them to grow and reduce
poverty.

At the same time, the international monetary and financial architecture that
we have had since the creation of the Bretton Woods system has not kept pace
with developments in these vast international markets. Regulation and systems
for addressing market turbulence and failure are not adequate to the task they
are confronted with. Neither the World Bank nor the International Monetary Fund
has the financial or political clout to prevent financial crises, limit them
when they do occur or even to materially help national governments to minimise
the damage caused to economies by them.

The logical extension of the new role of emerging market economies and other
developing countries would have been to reform the governance of multilateral
institutions to enable them to take part in the decision making of those
bodies. Not only would this strengthen reform efforts and reduce the contingent
costs of future crises, but would also strengthen the legitimacy of those
institutions in other parts of the developing world thereby helping to start
developing countries on the right institutional and policy footing as they
develop into emerging market economies.
The issue of the legitimacy of the international financial institutions (IFIs)
becomes ever more salient when the costs and benefits of appropriately
overcoming the problems of core and periphery are considered. How do the IFIs
‘sell’ the sort of radical policies that may be needed to help the rural Sahel
dweller cope with economic change when their very legitimacy is so easily put
into question? How effective is policy advice on the choice to privatise,
corporatise or to nationalise when too often it appears to be driven more by
the prevailing political diet rather than a pragmatic assessment of the issues
and a clear sense of the long-run public interest?

The impact of certain ‘ideas’ on advice can run far beyond what is
necessitated by the logic of the original insight. To give an example, the IMF
continued to advocate the adoption of fixed exchange rates for smaller
economies long after there was evidence that international financial markets
could distinguish between good and bad performing small economies and hence
small economies could attract more capital inflows by running more sound
macroeconomic policies, in contrast to the prevailing wisdom of needing to
“import credibility”. The ‘impossible trinity’ wasn’t broken in the process but
increasingly sophisticated and liquid financial markets in practice meant that
the monetary choice for smaller open economies was no longer so biased towards
giving up monetary sovereignty.

15. Smart policies could lower risk premiums and the interest rate spread
paid over US treasury bills.

While the rapid development of international financial and capital markets
makes life more risky in the sense that more is at stake, they also enable
policy choices to be made that in the past were not possible. Policy makers can
draw on a much wider array of experiences from more countries and regions of
the world than ever before to exercise their responsibilities to pursue
economic development in the public interest.

The IMF and the World Bank should, at the very least, be at the forefront of
efforts to help emerging market economies and developing countries to overcome
the constraints they face in accessing international capital or in responding
to large and rapid inflows and outflows of capital. Few developing countries
can borrow in their own currencies.

16. Borrowing costs can fluctuate greatly especially for those countries
borrowing in dollars. In the event of a currency crisis, interest payments in
foreign currency rise causing deeper recessions. Estimates by Hausmann and
Rigobon show that after shocks debt to GDP ratios in a large sample of
developing countries have raised 10 - 20 percent higher than would have been
the case with debt denominated in local currency.

17. One way of dealing with this was the Argentine approach of using a
currency board, but this meant, as with any fixed exchange rate regime that
Argentina was adopting US monetary policy. In the 1990s, US dollar appreciation
from massive and sustained capital inflows enabled the US to keep interest
rates low but reduced exports. High productivity growth in the US kept the
economy growing but the same could not be said for countries with dollar debt.
Slower growth in exports and lower productivity meant that those countries’
service costs rose and when growth slowed their debt and macroeconomic policies
became less sustainable or unsustainable.

18. At the same time, foreign debt makes it difficult to improve export
growth through real depreciation of the exchange rate because the depreciation
increases the debt burden and the cost of servicing it.

The upshot is that high foreign currency debt severely constrains policy,
both fixing the exchange rate and deliberate depreciation can lead to crisis.
All of this is exacerbated by the premiums developing countries are required to
pay in order to borrow at all which for stable emerging market borrowers over
the past two years have fluctuated between 200 and 500 basis points above the
yield on US treasuries.

Now, consider the problem of African countries that depend on commodity
exports or any small number of exports that constitute the bulk of export
earnings. With commodity prices declining over the past several decades many
developing countries don’t even need to incur more foreign currency debt to
become unsustainable the trend decline in commodity prices does it for them at
any given level of debt.

In recent years, increases in debt predicated on a greater ability to
finance repayments as a result of much higher commodity prices merely makes the
problem even more pertinent what will happen in the next few years if and when
commodity prices fall?

19. From historical perspective, the lessons are evident. Oxfam’s assessment
of the effects of declining coffee prices on the Ugandan and Burundi economies
is worth reviewing.

20. Burundi depends on coffee for about 80 percent of their total export
revenue, so that a cut in prices of 50 percent results in a drop in total
export revenue of 40 percent. Over the past year, the price for copper has
increased by about 93 percent and by 52 percent since December 2005 vastly
increasing the terms of trade of countries like Chile and Zambia and the
contribution of copper to national income but also creating the risk that
inappropriate use of the increase in national wealth will end in economic
disaster.

The dependence created by the inability of developing countries to raise
foreign debt in their own currency could be broken in various ways. Some
analysts have suggested that the International Development Association (IDA)
lend to developing countries using an inflation indexed domestic currency unit
of account.

21. This could be created from a basket of developing country currencies in
order to spread risk and would require only a very marginal increase in yields
to compensate for the additional risk. In times of economic stress, debt
burdens would not rise, GDP would be less volatile and overall welfare
significantly improved.

The African continent in particular is highly vulnerable to shocks, be they
a sudden drop in the price of an important export commodity, a drought or
exchange rate devaluation. The frequency and severity of shocks has been
growing. For example, a commission for Africa background paper pointed out
those 44 African countries have suffered natural disasters in the last 10
years.

22. In addition, 28 African countries are judged to be potentially
vulnerable to aid shocks due to their high aid dependency ratios and 24
countries are very vulnerable to export shocks because they depend on only one
product for more than 50 percent of their export revenues. And at least 13
African countries have suffered foreign private capital crises over the past 10
years.

Mechanisms for addressing volatile prices for goods on which many countries’
economic fortunes are largely or wholly dependent would seem to be a useful
thing for the IFIs to focus on, even if not especially novel. At the same time,
forms of financial assistance to address balance of payments crises of a
broader nature such as those initiated by financial contagion should be an
important aspect of any serious effort to revamp the tools of the IMF.

Concluding comments

The importance of addressing the international environment has been deepened
by globalisation, forcing states to adapt to fulfil their old functions. For
African states to balance the distribution of economic burdens and
opportunities requires creativity and active, capable state institutions
governance reforms and technical capacity building should go hand in hand. They
need to be inventive and devise new policies and new ways of resolving the
problems caused by globalisation achieving the balances highlighted by Polanyi
of providing economic security and income stability at the same time as they
encourage economic activity.

Chalmers Johnson’s ‘developmental state’ implying conscious proactive policy
articulation and implementation is a useful model for most developing countries
in part because of the need to prevent domination of underdeveloped and under
regulated markets by local and international firms and elites with excessive
market power.

23. The idea of the developmental state also reminds us of the importance of
public services and basic fairness in the interaction between communities and
markets, enabling people to engage in economic activity and protecting them
from those who would abuse the predisposition of democracies towards freedom.
In large part the means of achieving those aims is by providing certain types
of freedoms to all members of the community. As Amartya Sen has put it:
“Development can be seen as a process of expanding the real freedoms that
people enjoy” and by “the removal of major sources of un-freedom poverty as
well as tyranny, poor economic opportunities as well as social deprivation,
neglect of public facilities as well as intolerance or over-activity of
repressive states.”

24. State capacity and institutional development also matters for how
societies respond to the international environment. Weak states tend to view
international economic integration as a threat but integration like other
policy choices should be subject to economic cost benefit assessment. National
sovereignty may be enhanced through integration, as economic development
creates the resources for better defined and implemented policies and public
services in areas that matter more such as education and health. Globalisation
too can be addressed in such a way as to increase the power of states and
better reflect the social and economic preferences of their citizens. But
getting there requires us to see institutional design and the skills to make
institutions effective as a clear and critical need for most African
countries.

Within the international system we need to ensure that our multilateral
institutions help African and other developing countries to address these
issues. Tying us together as an international community, the Monterrey
Consensus forged a partnership to address the economic aspects of our problems.
Developing countries were meant to undertake policy and institutional reforms.
Developed countries agreed to assist in those efforts and to create an enabling
international economic environment.

Tragically, we have made little progress on much of the consensus. Far too
many of the policies and practices of developed countries weigh against it
cultural exclusion, economic protection, political manipulation and favouritism
have not disappeared with the dismantling of the Berlin Wall. The underlying
disorders are generated mostly unconsciously and indirectly from the
interaction of insecurity and the need for change that come together in
national political systems. That they influence the neutral sounding processes
like donor aid, trade negotiations and international financial architecture
that developing countries depend on for their own development remains intensely
problematic.

The drive at the international level from Monterrey through Gleneagles has
been to win agreement that large chunks of new financial assistance are
required up front to lay the basis for countries to develop beyond reliance on
foreign financial aid. The means for ensuring that funds are used in a
transparent and accountable way, one of the primary complaints of donors are
there. Great strides have been made to set out principles by which the present
bureaucratic clutter that passes for aid systems can be cleaned up and made
transparent. Direct budget support and other channels for aid can be easily
monitored to increase accountability. Stronger government systems for finance,
policy development and implementation will provide the returns to the upfront
assistance by directly reducing the dependence of poor countries on assistance
in the first place.

At the Gleneagles Summit which occurred precisely a year ago the Group of
Eight (G-8) committed to increasing their aid to Africa by US$25 billion per
annum by 2010. Preliminary data shows Official Development Assistance (ODA) to
developing countries from G-8 members increased by US$21 billion in 2005.
However, US$17 billion of this went towards writing off debts in Nigeria and
Iraq. In its analysis, the Data report 25 argues that in order to make progress
towards the 2010 goal, G-8 donors will have to increase their development
assistance to Africa by US$4 billion each year for the next five years.

Insufficient and badly directed development finance, poor advice on policy,
difficult questions of trade protection and inadequate international financial
systems all point to the inadequacy of the current decision making structures
for international economic affairs. Reform is necessary and in my view if
developing countries had a greater say in the running of these institutions
there would be a greater sense of ownership and legitimacy.

In a world of volatile capital flows, powerful financial markets and
destabilising macroeconomic policy decisions the major financial contributors
to the IMF and World Bank need to recognise the prudential character of reform
as the financial costs associated with crisis grow ever higher.

That hope, however, is merely a reflection of a more general point that for
too many societies around the world the idea of a reasonably stable
international financial and economic order is quickly becoming a remnant of a
multilateral past even as the social and economic implications of our deeper
interdependence raise the risks associated with economic integration.

Where poverty is so pervasive, we need to make certain that the touch of
globalisation on our most marginalised populations lifts and nurtures rather
than condemns. That is the central task confronting us as leaders in the
developing world and as members of the international community if we want to
support economic integration and realise human development.

Issued by: Ministry of Finance
7 July 2006