Reconfiguring Industrial Policy: A Framework with an Application to South Africa

The Policy Problem

Economists traditionally identify distortions that prevent market prices from signalling real marginal social costs and then design taxes or subsidies to reduce those gaps. Since market failures are presumed to be few and far in between, government intervention tends to be the exception rather than the rule. Private actors play little role in designing public solutions: either they free ride or they lobby for solutions that serve their particular interests.Some advocates call for robust interventions to address market failures. However, while sceptics assert that it is almost impossible to identify market imperfections.

Contrary to traditional framework, departures give a better handle on industrial policy while they help us move forward from the debates about its feasibility and desirability. It is presumed that relevant market failures that demand industrial policy in developing countries take three forms:

1.      Self-discovery externalities: Externalities caused by the process of learning what new products can be produced profitably in an economy.

2.      Coordination externalities: Decentralized markets are not good at coordinating simultaneous investments for new economic activities.

3.      Missing public inputs: The government has little knowledge of highly specific public inputs – legislation, accreditation, R&D, transport and other infrastructure specific to an industry –that private production typically requires.

These three types of market failures lie behind slow structural transformation and low economic growth.

It is assumed that economist, public officials, and the private sector do not know where the relevant distortions are. Industrial policy seeks to identify and respond to them. Since distortions are highly dimensional, solutions require complex bundles of measures of various kinds.  They cannot be resolved by cash subsidies or money transfers alone because the problems are missing markets or public inputs. The necessary solutions involve measures or activities (e.g., building specific infrastructure, passing laws, regulating markets, and providing services) which bring about purposeful capabilities.

Market failures of a country are determined by its patterns of specializations. It reflects its capacity to overcome coordination failures and other market failings that would have otherwise restrained existing activities. Given that it is difficult to coordinate the creation of capabilities for activities that do not yet exist; productive transformation favours goods that require capabilities that are similar to those that are already present. Also, as the public sector encourage differentiation in their application and on-going specification of their central purposes through regulation and certification and sets provisional framework goals, the private sector must establish a plan for meeting the goals and then to prove that they are actually doing so.

On-going self-discovery of market opportunities from changing social needs and patterns of economic cooperation is collaborative for firms because it encourages them to demonstrate the ability to produce a product but also to show the ability to improve its design or process in cooperation with the potential customer. Firms may need public inputs for this kind of collaboration, just as they may need public inputs to meet the obligations of framework regulation. In the pursuit of identifying distortions and remove obstacles, the private sector acquires knowledge that is crucial to the identification and elimination of high dimensional, non-monetizable distortions. However, firm self-discovery is subject to distortions of their own. Cooperation among private firms is not self-enforcing. They are voluntary at the time of agreement, but they require enforcement at the time of execution.

The private sector needs the government to help internalize the various externalities associated with the cost-discovery process and to provide the public inputs that only the government can bestow. The government, on the other hand, requires the assistance of firms and entrepreneurs because it needs to draw the relevant information about the obstacles and opportunities they face. It also has to be able to influence their behavior in the desired direction. Good industrial policy starts at this point, where institutional arrangements and practices that organize this collaboration are present.

From principles to policies

Traditional understanding of industrial policy, instruments are put in the service of a number of priority sectors, which have appealing features and a prevalence of the relevant market failures. Contrary to conventional methodology, strategic collaboration with the private sector must be emphasized. Processes and procedures are accentuated, rather than specific policy instruments or sectors.

The relevant questions that must be answered are: have we set up the institutions that employ the bureaucrats in an ongoing discussion of relevant themes with the private sector, and do we have the capacity to respond selectively and quickly, while using updated policies, to economic opportunities that are identified?

Industrial policy activities should therefore be oriented around two axes, one that works locally to improve the performance of existing industries, and another that works globally through strategic bets on new industries.

Industrial policy “in the small”

Industrial policy must focus on existing economic activities and put mechanisms that will identify and remove roadblocks of those activities. This will be driven by the goal of providing better public inputs to existing activities for higher productivity and quality as well as a higher chance that immediate products will emerge. Existing firms will be the best sources of information for the identification and co-development of public inputs.

For the government to overcome the information, incentive, and resource obstacles, it must have:

·         A mechanism to promote systematic discussion among firms to identify and propose solutions to coordination failures.

·         A new budgetary procedure to increase the responsiveness of the public sector to the necessary actions.

·         A new monitoring procedure to discipline project selection while diffusing the lessons of its successes.

·         A set of operating principles.

First, a deliberation council of self-organized private firms must be set. Firms will be compelled to participate since participation would lead to the provision of public inputs. However, it may be necessary to provide some incentive to eliminate the free-rider problem or to help firms who cannot specify their needs for public inputs.

It is unclear whether existing industry associations and chambers are the right assembly. It will be more appropriate for groups organized around solving common “technical” problems of industries than associations whose main purpose is to lobby for standard forms of government aid. In addition, groupings must not only be organized around conventional industry lines. The demand for skilled craftsmen cuts across industry codes. Also, a port expansion project will have many industrial clients that rely on foreign trade in particular regions of the country.

Second, a centralized budget that can be spent on different public entities for the provision of necessary public goods must be created. This centralized budget enables the entity dealing with the private sector to pick the necessary services from the different public entities that provide them. It will also reduce another dilemma, the incentive problem, as it induces competition for resources among different government entities, which in turn approximates a market for responsiveness; the accountability mechanism of contracting with and monitoring by the central fund, rather than market competition among providers, ensures heightened responsiveness. The central fund aims to align government action to actual need in the long run. Bidders will increase the attractiveness of their proposals to meet the eligibility criteria and survive competition by increasing their commitments to co-invest.

Third, a monitoring system that allows the system to generalize its successes and learn from its mistakes must be established. In a volatile world, policies that seek to detect distortions will themselves be flawed. To improve these policies, a routine must be created not only to identify flaws in decision making, but also to help diagnose their cause, and highlight special cases where previous decision makers solved the problem. There should be an annual review of one key project of the deliberation council. The review teams must consist of a manager from a leading multinational in the relevant lines of business, an official from a widely admired development agency in another developing country, and the leader of a highly successful deliberation forum in another sector. Their focus would be on three questions:

·         Did the deliberation council include all those with the relevant capacities and interests, and if not, was its membership modified so that it did?

·         Did the discussion of possible projects consider reasonable alternatives, and was the final choice well motivated?

·         Has the project met its milestones? If not, is there a clear understanding of why and a matching adjustment of the project’s goals and timetable?

Operational rules must discipline this process. The plans of action that the deliberation councils generate will require actions by different ministries and public entities. For incentive reasons, transfers to the private sector are discouraged. Direct subsidies may be justified in some cases, but they would bring incentives that would reduce attention from the identification of public goods. Even though support to solve the free-rider problem must be provided, that would inflict a co-financing requirement. Proposals for transfers would need to pass some willingness-to-pay test. The maximize spillovers from problem identification must be maximized.

Rodrik (2004) and Hausmann and Rodrik (2006) suggested a list of operational criteria. They include:

·         Keeping the dialogue structure open and letting the private sector self-organize.

·         Enforcing transparency principles to limit rent-seeking and increase legitimacy vis-à-vis the rest of society.

·         Prioritizing public inputs.

·         Interventions are to be chosen so as to increase productivity, not in order to compensate sectors for their low productivity or to prop up at risk communities by subsidizing local economic activity in the guise of industrial policy.

·         Establishing clear criteria for success for interventions ex-ante, so that non-performance is diagnosed earlier and can be corrected.

·         Sunset clause: Money from the centralized budget may be temporary in nature. Money for longer term interventions would be supported for a while, but it would have to be incorporated to the budgets of those institutions.

·         Streamline decision-making and execution: A mid-level horizontal mechanism for the allocation of the central budget must be created so that it flows to the executing agencies without having to go through the Cabinet or Economic Cluster meetings.

·         Accountability: Financial controls must be placed and clear guidelines for deciding when to let losers go must be set.

·         Universalize: A formal process must be built where an initiative may be re-designed or expanded in order to benefit more activities.

Industrial policy “in the large”: strategic bets

To sustain and encourage further economic growth, an industry or activity should be developed, and then backed up. This requires more centralization and more prioritization. A second set of institutions can have a much wider range in its exploration of the production space than can deliberation councils. They are more capable of motivating capacity-building “jumps.”

One possible model is a venture fund. A venture fund is an institution that: continuously searches for opportunities that has the technical capacity to evaluate projects, their proponents, and the financial resources to fund business plans; recognizes mistakes as they occur; organizes the corrections for the said mistakes; and is guided by the concern to generate profitable companies that the private sector will want to take over.

Venture funds are similar to the private-sector venture capitalists. However, there are significant differences between them. Venture capitalists in developed economies are numerous and they compete for the best of the many deals presented to them. In developing countries, the public venture fund likely becomes to be a monopolist. It has to generate ideas for strategic projects rather than choose among them. The venture fund has to swing between organizing coalitions to support its projects, or championing and developing the projects through loose and often fragile coalitions of innovators. In the few developing countries that have public venture funds, the guiding motives were often more political than economic since choices are in neither case disciplined by competition with other similar institutions.

In some countries, the necessary capabilities for developing a public venture fund often dwells in development banks. Development banks have technical expertise, knowledge of the real sector, financial resources, and autonomy from politics. All these characteristics make them suitable for the venture fund role. Development banks have been usually seen as sources of long-term finance and have been used for various social and commercial goals. They can be viewed as instruments of strategic bets.

The public venture fund must center its decisions on clear criteria for success and failure. Industrial policies are experimental, and strategic leaps are the most experimental of them all. For a number of countries, successes have more than paid for the mistakes. Without clear ideas of what constitutes success and observable criteria for monitoring it, failures will be inevitable. A vital performance metric in the tradable sector is productivity. Increases in employment or output unaccompanied by improvements in productivity are very unmanageable. While productivity is difficult to measure, almost every domain in the tradable sector now establishes and updates benchmarks considered as serviceable proxies. Firms that do not measure their progress by these benchmarks are improbable to keep up with those that do. The venture fund can expect the projects it supports to scale themselves in the relevant ways, and then draw on these and other routine comparisons, as well as forecast audits by business and technical consultants to judge the progress of its undertakings.

It is expected that many promoted activities will fail. This is alright since the absence of failure is a sign that the government’s industrial policies are not bold enough. The crucial test of whether industrial policy is working is not whether a government can reliably pick winners but whether a government is able to let losers go. The objective should be not to minimize the risk of mistakes, but rather to minimize the costs of the mistakes that inevitably occur on the way to success.

An application to South Africa

South Africa currently has a plenty of instruments and agencies that devise and implement industrial policies. The Department of Trade and Industry (DTI) develops customized sector programs (CSPs), administers the Motor Industry Development Program (MIDP), and offers cash and other incentives. The Department of Public Enterprises has a large capital expenditure program that intends to develop local supplier capacity through its Supplier Development Program. The Department of Minerals and Energy is in the process of formulating a program to encourage beneficiation of precious minerals. The Industrial Development Corporation (IDC) finances SMEs and BEE equity deals and funds some self-discovery activities. In addition, provincial governments have their own investment promotion agencies (like Wesgro in the Western Cape) to encourage investment in their regions.

However, the private sector and the government are not connecting effectively, information are not passed adequately, needs are not well identified, policy instruments are not targeted, and self-correction mechanisms are not in place. The good news is that many elements of a better policy scheme are in place that it is possible to build on existing institutions in some important cases. On the other hand, there are programs that have outlasted their usefulness and have to be modified to serve the purposes for which they were originally conceived. In between are also cases where current arrangements are disorganized. Hence, it is advisable to create institutions with overlapping responsibilities and let competition ensue. Finally, there are initiatives that must improve the background or framework conditions; the most important of these must be addressed first.

1. A new budgetary procedure to obtain information on missing public inputs and pay for them

It is recommended that a certain share (4%) of economic cluster department budgets be assigned to a central fund to finance specific public inputs. The public input must enhance productivity (especially in tradable sectors) and not just profitability. The fund would ask for proposals from firms, which would then be examined by a technical secretariat. An interdepartmental committee would make the final decisions. In exceptional cases, when the goal of projects is to establish long-lived training or research organizations, public taxing authority may be delegated to public-private bodies, contingent on continuing demonstration that they are meeting agreed objectives and that the tax is levied only on its members. This increases the responsiveness of government as a whole to the needs of industrial policy and its legitimate beneficiaries. On the other hand, it creates a competitor to the Customized Sector Programs as a sponsor for the whole range of projects associated with industrial policy in the small.

Unlike the Critical Infrastructure Fund (CIF), there are no restrictions on who can apply for the funds. Also, “infrastructure” would be interpreted to include any public input that enhances private-sector productivity. Lastly, a much larger fund is considered, one that can have a real impact on the investment and capacity decisions of private firms.

2. Reorienting the IDC towards self-discovery activities

Although the IDC has undertaken self-discovery activities, it has plenty of room to expand and engage in strategic bets. It must act much more like a venture fund and much less like a commercial bank. It must be more pro-active in scanning for investment opportunities in new economic activities, more willing to get involved in the very early stages of an industry’s development and in greenfield investments, and have a greater appetite for project risk. It should strengthen its monitoring activities to make sure that it can recognize and get out of failures.

3. An overhauled MIDP that will strengthen the supplier base

The incentives must be focused away from exports and towards incentivizing capacity expansion and generation in supplier industries directly. A gradual phasing out of the IRCC scheme is recommended, as well as its replacement by a supplier-base promotion scheme that consists of two “windows:”

·         A standard incentive that takes the form of a subsidy on the wage bill or the capital cost for new capacity by first-tier suppliers to OEMs.

·         An ‘open window’ where the support depends on specific needs of the firms in question.

It would be important in for the government to clearly communicate its new objectives and policies to the industry. Firms that are unable or unwilling to make a commitment to creating a supplier base, even with the incentives provided towards that end, are probably not worth keeping.

4. Improving the CSP processes

The CSP is a collection of very unequal industrial policy initiatives grouped under a common rubric. In the capital equipment industry, there is a productive dialogue between the DTI and the sector, but the broader policy system appears to have failed to respond to this discussion quickly appropriately. In the BPO sector, a useful market analysis was produced, which led to a strategic bet on the industry and temporary wage bill subsidies to encourage new investments. However, it had no specification of criteria for success, no monitoring of progress, and no continuing discussion with the emergent industry about possible next steps. Given these difficulties, it is suggested that CSP be supplemented with the project selection and monitoring mechanisms established in connection with the central fund.

5. Avoiding forced beneficiation

Giving incentives to domestic processing of natural resources is not a sensible policy. A policy focused on beneficiation has a narrow focus and it tends to encourage the wrong activities and generate inefficiency. A better approach would be to extend an offset option to domestic investments in tradables that do not lie downstream. It is more probable for the costs of beneficiation to be measured less in the poor investments it induces than in the opportunities it obscures.

Conclusion

Industrial policy helps firms find processes for new lines of comparative advantage. Its implementation is itself a process of discovery about the right institutional practices that are needed. That is why benchmarking, monitoring, and experimentation are so important. Internalizing what industrial policy is about and striving to bring practice in line with its objectives are more important than making sure one starts with the “right” set of policies.

The most important lesson from East Asia is that industrial policy is a mind-set. It rejects hasty reforms in favor of: experimentation; transformative change through identification of bottlenecks and self-correction; and small investments followed by well-organized attention to make projects work.

Source:

Hausmann, Ricardo, Dani Rodrik, and Charles F. Sabel, “Reconfiguring Industrial Policy: A Framework with an Application to South Africa.” CID Working Paper No. 168, Center for International Development, (May 2008).