Ethiopia: Time to Recast Role of Developmental State?

 The process of economic growth is not as well understood as one might think. Why have some countries succeeded in sustaining growth for long periods and become wealthy, while others have failed and remained poor? Economists have put forth many explanations, including geography, historical accidents, culture, enlightened leadership, and more. But the most satisfactory explanation seems to be the following.

The successful economies have developed industries that are consistent with their resource endowment; in other words, they capitalised on their comparative advantage.

A country increases its income levels by specialisation and trade (a simple but profound observation we generally attribute to Adam Smith). This is pertinent to both domestic economic transactions and international trade. The pattern of competitive specialisation is defined by the resource endowment of the country.

Typically, a low-income country starts with abundance of unskilled labour and shortage of capital. As it accumulates capital and skilled labour (or human capital), its resource endowment changes. The country can move from labour-intensive industries to more capital and skill intensive industries, raising the general income levels.

In this process, two things are essential.

First is the accumulation of “capital,” both financial and human. This needs to be backed up by rising levels of savings. Accumulation of financial capital also plays a direct role in the process of raising incomes. The people earn more by becoming more skilled workers as well as “owners” of increasing amounts of capital (often indirectly through pension funds). This is why savings are so important.

Accumulation of domestic capital is important for another reason. Foreign capital tends to be an unpredictable and fickle source of investment.

Second, the transaction costs must be reduced so that exchange of all kinds will thrive. It requires “institutional changes” over time to make such transactions more efficient. If transaction costs remain high, trading will not expand and the latent comparative advantages will not lead to any actual gains. In many low income countries, I suspect that this is what holds them back the most.

Yet it often does not receive systematic policy attention, because it is a complex challenge and inefficiency often benefits some vested interests.

On both counts, Ethiopia faces serious challenges.

Accumulation of financial and human capital: Whereas in East Asian forerunners of industrialisation, savings rates rose rapidly to 30pc of GDP or more, they are stuck below 10pc in Ethiopia. As I have already discussed in my observations last week, the Ethiopian government has recently increased its direct borrowing from the central bank, as a key instrument to get around this problem.

But this has rekindled inflation, turned real interest rates negative, and has surely dampened the incentive for households to save.

A stable macroeconomic framework is the anchor for increasing savings. Furthermore, many households in remote areas do not have ready access to banking services.  Encouraging the expansion of simple banking services into rural areas will have to be an important element of the strategy to raise domestic savings.

Human capital accumulation has been significant, but there is much more to be done.  Although the quantity has expanded dramatically, from primary to tertiary levels, the quality has remained poor. The effort to achieve universal primary education is of course laudable. But, unless the children are reaching some minimum threshold of learning (e.g., functional literacy), it will neither help children become more productive, nor help the economy improve its resource endowment.

Some recent evidence raises serious concerns in this regard.

Transaction costs: When transaction costs are reduced and competition is promoted, a certain pattern of industrialisation seems to emerge. It is characterised by a dense web of firms, with many small and medium size enterprises (SMEs) linking up with a relatively small number of large firms. This seems to be the way to raise productivity, promote innovation, and create a dynamic economic machine. In successful East Asian economies, this pattern has been evident.

But this is not happening in Ethiopia. A recent study by John Sutton and Nebil Kellow, an Enterprise Map of Ethiopia, looked at the 50 leading industrial firms in Ethiopia. A striking finding is that none of them had started as a small firm. The business environment is unusually hostile to small firms in Ethiopia. If few small firms can succeed in growing into large firms, the economy will be lacking in dynamism. (Just think of Sony, Apple, or more recently Li Fang of China; they all started very small.)

Another recent study, by the World Bank, has found that one key reason why Ethiopian manufacturers lag behind their competitors in China and Vietnam is the absence of extensive subcontracting networks and clustering. There is a gulf between the relatively small number of large firms and many thousands of very small firms. They are not linked.

I believe that much of this has to do with high transaction costs. When availability of key inputs or spare parts for machines is unpredictable, when electricity supply is unreliable, when contract enforcement is very uncertain and costly, or when price ceilings maybe imposed, small firms suffer far more than large firms, because they do not have the deep pocket to deal with such costs.

Large firms are naturally reluctant to subcontract with small firms, for they are not confident of their ability to deliver.

New Developmental State

I believe that the role of the state in facilitating or guiding the development process is largely defined by the two key requirements outlined above (accumulation of capital and reduction of transaction costs). In the past, Ethiopia’s government has done much to improve infrastructure (an important part of capital stock no doubt) and expansion of access to basic education. But, they are not adequate to meet the two broad requirements.

In light of this, it seems that the government should focus on two things. First, it should place far greater emphasis on increasing domestic savings and improving the quality of education. Without it, the fundamental resource endowment of Ethiopia cannot be upgraded.

Second, on the broad issue of transaction costs and industrialisation, the government should focus more on two things. One is improving the environment for small and medium enterprises (SMEs). This would entail addressing issues related to regulatory barriers, macro instability, and policy uncertainty. It might also entail developing a stronger system to support SMEs, with finance and technical assistance.

To be sure, the government has done much to help micro-enterprises with micro-credits. This is important as a pro-poor intervention. But supporting SMEs with similar, focused support is essential for growth and industrial success.

The other area of focus is competition. It is what drives down transaction costs. It also encourages subcontracting by large firms, as a way of achieving greater efficiency.

For a country in a great hurry to regain the lost time and accelerate industrialisation, this more indirect approach to accelerating development may seem much too passive and lame.

Why can’t the government blaze the way by supporting large projects and demonstrating how it can be done?

The government often argues that to have big impact, it needs big projects. In fact, big investors often get significant incentives in the way of land, tax relief, and credit, to compensate for high transaction costs in Ethiopia. They may even be attracted by the prevailing inefficiency, for they can as first movers entrench themselves in the economy where they may not face much competition.

In the meantime, the problems of small firms go unaddressed.

Unless Ethiopia succeeds in creating a dynamic SME sector, it will likely hit a glass ceiling of competitive weakness sooner or later. Competitiveness of the economy will come from the strong linkages between the large-firm segment and the SME segment.

They need to grow together. In the end, the trick is to create a virtuous circle of growth.  This requires a sophisticated set of careful interventions, not always strong and visible actions.

I think the time has come for Ethiopia to adopt Developmental State 2.0.

By Ken Ohashi

Ken Ohashi, World Bank’s Country Director for Ethiopia.