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Economic Governance for Crisis Prevention

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Published: Tue, 20 Feb 2018

1.0 INTRODUCTION

The proposed research attempts to identify the critical components of economic governance in four Asian countries namely Malaysia, South Korea, Thailand and Indonesia. The study by employing in-depth case study analysis seeks to analyze the economic governance practices in these countries and its relationship to their economic growths. The study then attempts to investigate the links between economic governance and the Asian financial crisis in 1997, and the roles the economic governance could have played in the recovery process since the above countries had somehow recovered at somewhat different speed. Based on the identified components of economic governance considered imperative for sustainable and resilient economy, the study will develop an index namely Economic Governance Quality Index capturing the score of governance parameters by the countries during the booms and slumps of their economies throughout the period under study. Finally, the components of economic governance will be employed in panel data analysis to empirically determine their significance towards economic growth. Its findings then will be of significance in crisis prediction and prevention methods in which the identified key governance parameters are the core ingredients.

2.0 BACKGROUND

‘Good governance is perhaps the single most important factor in eradicating poverty and promoting development.’

Kofi Annan, former Secretary General of the United Nations.

The concept of governance has assumed a more central focus and been given key attention not only by the officials from the United Nations Development Program, the World Bank and the International Monetary Funds, but also from the policymakers in especially developing countries, aid’s donors, and regional organizations of economic cooperation as well as academics fraternity. Since the beginning of 1990s, there is a strong indication of growing emphasis that ‘good governance,’ together with democracy and protection of basic human rights, is indispensable for sustainable economic growth. Economic development cannot be achieved without the development of good governance, which is composed of competence and honesty, public accountability, and broader participation in discussion and decision making on central issues. In addition to traditional view of governance which is on the public governance, there is also a notable increase in the endeavors to grasp the concept of governance in a multi-dimensional perspective which includes economic governance. The relationship between governance and development is thus studied from diverse angles, especially in the vein of economic transformation, macroeconomic management and prevention of crisis as well as structural reforms. The Asian financial crisis in 1997 had somehow exposed the vulnerability of the once high-performing countries in the region, whose lack of governance practices was said as the main cause of the severe affects.

3.0 STATEMENT OF THE PROBLEM

The Asian economies success was once dubbed the ‘Asian Miracle,’ and a model to be emulated by other developing countries seeking higher growth. The success had introduced a growth model with emphasis on policies of setting the prices right, liberalizing the economy and the private sector as the engine of growth.

When financial crisis struck the Asian countries in 1997, and looking at the devastating effects the countries in the region had experienced following the malaise, many however started to raise questions whether the quality of governance practices in these countries had somehow contributed to the crisis. Furthermore, the fact that South Korea and Malaysia had somehow recovered rapidly from the crisis compared to Indonesia and Thailand has sparked off interests on what roles good governance could have played in the recovery process.

Hence, good governance has become a topic widely studied in the aftermath of the crisis. The discussions center on two main perspectives; firstly, the absence of good governance has been perceived as a MAJOR CAUSE of the crisis, and secondly, an inference is made that good governance is IMPERATIVE for durable and resilient economy. This study hence sets out to empirically identify and ascertain the governance parameters and their significance towards crisis prevention.

Since the study focuses on economic governance, and to avoid constant repetition, the word ‘governance’ used in this proposal should be taken in the context of economic point of view, unless explicit reference to other perspective of governance is relevant.

4.0 RESEARCH QUESTIONS

This study will attempt to answer the following questions:

What are the economic governance parameters presumed as crucially importance for sustainable and resilient economy?

How to capture the score of economic governance practices in the East Asian countries during the period under study?

How would the significance of governance parameters be empirically ascertained for the purpose of crisis prediction and prevention?

5.0 RESEARCH OBJECTIVES

The study hypothesized that good governance is imperative for sustainable and resilient economy, and the absence of such would result in increased vulnerability of the economy towards declining into crisis. Therefore, the objectives of the study are:

To identify the parameters of economic governance crucial for resilient and sustainable economy.

To develop an index of Economic Governance Quality capturing the score of economic governance practices by the East Asian countries during the period under study.

To empirically ascertain the significance of economic governance parameters towards growth via a dynamic estimation model whose findings then would be of importance for crisis prediction and prevention.

6.0 SIGNIFICANCE OF THE STUDY

It would be interesting to investigate what makes good governance and how do they link to economic growth in the four selected Asian countries. Furthermore, it would be crucially important to examine, from the governance perspective, how could the countries once considered by many as the fastest growing economies in the region were severely affected by the Asian crisis in 1997. Notwithstanding that, the fact that South Korea and Malaysia had made a more swift recovery than the other affected countries, it would therefore be interesting to analyze how the governance practices in the different countries facilitated the recovery process.

The findings from this study are expected to provide a significant contribution to the existing governance literatures especially from the economic perspective since it attempts to discover the critical components of economic governance that are imperative for sustainable and resilient economy. Policy makers not only from the countries under study but also from other developing countries may utilize the findings of the study to evaluate their economic governance practices and be able therefore to make necessary adjustments and required changes with the objectives of registering better growth and strengthening the economy against any possibility of future crisis. The researchers from world organizations and academic community may also be interested with the findings since the study attempts to develop a new feasible dynamic estimation model to analyze the relationship between the components of economic governance and growth, of which they could use as a basis for their future research undertaking in the similar field. In addition, the findings could also stimulate and facilitate them to search for additional approaches to counter or justify the results of this study.

7.0 LITERATURE REVIEW

Good governance has become a topic widely debated by academicians and economic communities especially in the aftermath of the Asian financial crisis in 1997. The discussions in this context center on two main perspectives; first, the absence of good governance has been perceived as a major cause of the crisis, and the second prognosis is drawn by inference, namely, that good governance is imperative for durable development (Lam, 2003). Therefore, to have a better understanding of the governance, this section discusses definitions and indicators of the governance, its relationship with the economic growth, how it links to the crisis and its roles in the recovery process, and finally how could these governance factors be used for crisis prevention.

7.1 Definitions and indicators of governance

Definitions and indicators of governance can be found in numerous literatures. A top-down approach is best used to understand the concept of governance, where a general or broad definition of governance will be firstly explored before moving on to a more specific definition. The World Bank continuously updates key governance indicators in its regular publication of ‘Governance Matters,’ a governance study encompassing many aspects like political, social, economic, legal and moral. Meanwhile, the International Monetary Funds (IMF) has been doing a great deal of works in an effort to promote governance in the financial sector management through Financial Sector Assessment Programs (FSAPs) which include regulatory, risk management and aid management.

7.1.1 Broad definition of governance

From the viewpoint of United Nations Development Program (1997), the definition of governance is ‘the exercise of economic, political administrative authority to manage a country’s affairs at all levels. It comprises mechanisms, processes and institutions, through which citizens and groups articulate their interests, exercise their legal rights, meet their obligation and mediate their differences.’

Good governance is, among other things, participatory, transparent and accountable, effective and equitable, and it promotes the rule of law. It ensures that political, social and economic priorities are based on broad consensus in society and that the voices of the poorest and the most vulnerable are heard in decision-making over the allocation of development resources (Abdellatif, 2003).

In its report, Governance and Sustainable Human Development in 1997, the UNDP acknowledges the following as core characteristics of good governance, i.e. participation, rule of law, transparency, responsiveness, consensus orientation, equity, effectiveness and efficiency, accountability, and strategic vision.

A report by the World Bank (2006) entitled ‘Governance Matters V’ covering 213 countries and territories since 1996 until 2005, presented the latest version of the worldwide governance indicators, namely voice and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rule of law, and control of corruption.

Meanwhile, Inada (2003) discussed the governance in Indonesia where the word ‘governance’ is translated as ‘Tata Pemerintahan.’ It however has different meanings covering different agendas from political systems to corporate governance. They includes political democratization, reorganization of police and the military, curing the problems of corruption, collusion, and nepotism (KKN), justice reform system, decentralization, financial management, corporate governance, and state-owned enterprise reforms.

Shimomura (2003) in his case study of governance in Thailand adopted pluralist democracy, accountability, transparency, predictability, and openness in the manner of exercising power, rule of law, effective and efficient public sector management, prevention of corruption, and prevention of excessive military expenditures as the standard definition of good governance.

7.1.2 Governance from economic perspective

According to Dixit (2006), economic governance consists of the processes that support economic activities and economic transactions by protecting property rights, enforcing contracts, and taking collective actions to provide appropriate physical and organizational infrastructure. These processes are carried out within institutions, formal and informal. He described that the field of economic governance studies and compares the performance of different institutions under different conditions, the evolution of these institutions, and the transitions from one set of institution to another.

Meanwhile, Huther & Shah (1998), Gonzalez & Mendoza (2001) and Mahani (2003) defined governance as a multi-faceted concept, encompassing all aspects of the exercise of authority through both formal and informal institutions in the management of resources. In other words, governance is:

‘An exercise of economic power in the management of resource endowment of a country done through mechanisms, processes, and institutions through which citizens and groups can articulate their interest, exercise legal rights, meet their obligations and mediate their differences.’

According to Mahani (2003), indicators of economic governance are:

Macroeconomic management – fiscal management, level of government debt, unemployment and inflation.

Investment – size and trend of foreign and domestic investments, capital flows and allocation of resources.

Trade regime – trade orientation, export and import performance and balance of payment position.

Financial sector management – the banking sector and capital market.

Exchange rate regime.

Private sector participation – privatization and corporate governance.

Social development – income distribution and level of poverty.

Lanyi & Lee (1999) studied on various aspects of ‘economic governance,’ that is, the way in which economic life is governed and regulated – which does not mean solely governance by the government. They first discussed the political basis of economic governance which is in their view crucial for the way in which different aspects of economic governance operate. The other aspects include the governance of macroeconomic policy making, and the interrelated issues of financial and corporate governance.

From political perspective, they argued that economic governance in a market economy consists partly of direct control or indirect influence exerted by the government and of governance exercised within markets themselves on the other part; but even self-governance by markets operates within the legal, judicial and regulatory framework that has been erected and is supported by the government. The optimum role of government in this context is ‘market-augmenting government.’

Furthermore, they defined macroeconomic governance as the political and administrative processes by which macroeconomic policies are formulated, implemented, and evaluated. They argued that technically the same policies can be carried out with equal effectiveness by either an autocratic or a democratic government. An autocratic government, if supported by well-trained technocrats, is likely to come up with first-class macroeconomic governance. Nevertheless, there may be factors that over time lead to deterioration in the quality of these policies in an autocratic government, as well as problems in the ability of such governments to adjust policies in response to changes in economic circumstances.

The working definition of governance used for financial and corporate governance depends on the key distinction between principals and agents. In this context, they defined governance as the legal and institutional arrangements governing the behavior of an economic entity, by which owners, creditors, markets and the government compel or induce agents to behave according to the interests of the principals, or those of the broader society.

In this regard, two key elements of governance are discussed. First, there is the structure of incentives and rules facing agents with regard to such matters as granting and terminating lending, bankruptcy, the rights of boards of directors, compensation structure, and the termination of employment. Second, there is the structure of the information flow from agents to principals, that is, the rules and incentives affecting accountability, transparency and disclosure of information. In both cases, the government plays a key role in setting the rules by which private actors operate.

Meanwhile, Das & Quintyn (2002) in their study on the role of regulatory governance in crisis prevention and crisis management have identified four main components of the regulatory governance practices, namely independence, accountability, transparency and integrity. The study explored the quality of regulatory governance based on the financial system evaluations under the Financial Sector Assessment Programs (FSAPs).

Introduced in May 1999, FSAPs is a joint effort by the IMF and World Bank aims to increase the effectiveness of efforts to promote the soundness of financial systems in member countries. Supported by experts from a range of national agencies and standard-setting bodies, works under the program seek to identify the strengths and vulnerabilities of a country’s financial system; to determine how key sources of risk are being managed; to ascertain the sectors’ developmental and technical assistance needs; and to help prioritize policy responses (IMF & the World Bank, 2005).

Regulatory governance applies to those institutions that possess legal powers to regulate, supervise and/or intervene in the financial sector, which include agencies like central bank, sectoral regulators and supervisors, deposit insurance agencies, and in systemic crisis situations, restructuring agencies and asset management companies.

Regulatory agencies need a fair degree of independence from the political sphere and from the supervised entities to achieve good regulatory governance. Agency independence increases the possibility of making credible policy commitments and improves transparency and stability of the output.

Independence goes hand in hand with accountability. Accountability is essential for the agency to justify its action against the background of the mandate given to it. Independent agents should be accountable not only to those who delegated the responsibility – the government or legislature – but also to the public who fall under their functional realm.

Transparency in monetary and financial policies refers to an environment in which objectives, frameworks, decisions, and their rationale, data and other information, as well as terms of accountability, are provided to the public in a comprehensive, accessible, and timely manner. Global integration of financial markets and products require greater degree of transparency in monetary and financial policies, and in regulatory regimes and processes, as a means of containing market uncertainty. Increased transparency supports accountability, protect the independence and eventually increase commitment to prudent behavior and risk control in the financial business.

The final component of regulatory governance is integrity which reflects the mechanisms that ensure that staff of the agencies can pursue institutional goals of good regulatory governance without compromising them due to their own behavior, or self-interest.

Independence, accountability, transparency and integrity interact and reinforce each other. Independence and accountability represent two sides of the same coin, while transparency is a vehicle for safeguarding independence and key instrument to make accountability work. Transparency also helps to establish and safeguard integrity.

7.2 Governance relationship with development and growth

Economic governance is often studied through its role in the promotion of growth. This is done by setting policies, incentives and institutions that create an environment conducive to sustained stable growth through efficient management of a country’s resources. It means managing a country’s resources in a way that is accountable to, and representative of, the community; transparent, that is, open and predictable; and efficient and equitable in terms of the use, and distribution of, resources. Hence, good and effective governance requires government policies that encourage and efficiently manage investment and economic growth, support a fair and efficient public sector, strengthen the rule of law, protect human rights, and foster public participation and representation in decision making.

Among the many studies that have examined the economic governance and growth nexus is such as that of Barro (1997). He studied the concept of growth based on the conditional convergence hypothesis which centers on the speed of economic growth in a country towards its steady-state level. He had empirically identified that more schooling, better health, lower fertility rate, less government consumption relative to GDP, greater adherence to uncorrupted rule of law, improvements in terms of trade changes, and lower inflation all go hand-in-hand with faster economic growth.

Furthermore, he also explored on the interplay between economic and political development, and found that there is nonlinear relationship between democracy and growth. According to his findings, in countries with low levels of political freedom, a marginal increase in political freedom is associated with an acceleration in growth. However, at high levels of political freedom, a marginal increase in political freedom is associated with a slowing in growth.

Huther & Shah (1998) also studied the relationship between governance and growth and found that countries that practiced good governance have also enjoyed high growth. They developed a governance index featuring four sub-indices, i.e. citizen participation index (CP), government orientation index (GO), social development index (SD) and economic management index (EM) and each of the sub-indices has several components. For the Economic Management index, its components are outward orientation, central bank interdependence, and debt-to-GDP ratio which were used to assess trade policy, monetary policy and fiscal policy respectively.

Gonzalez & Mendoza (2001) argued that Southeast Asia provides ample evidence that there is a remarkable connection between administrative guidance and economic upturn. They compared the average growth rate of national output during the last decade against the quality of country governance and found that the high-performing economies – Singapore and Malaysia – have the edge in public management. Those left behind, such as the Philippines and Indonesia, have poor management structures.

A study by Inada (2003) on Indonesia governance showed the importance of political stability and effective economic management as key elements for sustainable economic development among many governance factors.

Bordo (2007) provides a good qualitative analysis on the possible determinant of emerging market crises from the perspective of balance sheet approach, which then put at center stage the importance of financial development. Though he never mention the word ‘governance’ itself, he outlines the deep institutional determinants of financial development – including the governance parameters such as the rule of law, protection of property rights, political stability, and representative democracy – towards achieving financial stability. He further conjectures about the ways countries learn from their financial crises to improve their institutions and grow up to financial stability.

7.3 Governance link to crisis and roles in recovery process

Lanyi & Lee (1999) presented a strong case that governance issues were important in the East Asian crisis. They hypothesized that transparency and accountability in macroeconomic policymaking, in the operation of the financial system, and in corporate governance do serve to lessen a country’s vulnerability to financial crises and to strengthen the ability to deal with crises when they occur.

They also hypothesized that a democratic political system, in which leaders are held accountable to their electorate by both direct election of the executive and an elected legislature – as well as by an independent judiciary and a free press and civil society – is less likely to collapse in the face of economic and financial difficulties than is a country run by an autocratic government, which imposes severe restraints on the public expression of opinion and dissemination of information.

On the political basis of economic governance, they have suggested a hypothesis regarding the kind of political regimes likely to produce an effective, growth-enhancing, market-augmenting government. It is the type of political regime that is especially effective in the early stages of economic development may be less suited to fostering the creation of a full-fledged, sophisticated market economy at a later stage.

They argued that there certainly seems to be some indications of this in the Asian experience, where authoritarian regimes fostered rapid growth when these economies were at relatively low income levels, but seems to be evolving toward more democratic models to deal with demands for greater market autonomy. They however suggested that even if a case can be made for the desirability of democratization as a market economy becomes more sophisticated, the varied historical examples warrant the need to find out more about the conditions under which either an autocratic or a democratic government can be market-augmenting, or not.

They further highlighted that it would be useful to find historical examples of, and develop plausible scenarios for, the transition from discretionary (an autocratic government) to arm’s-length (a democratic government) approaches to state economic governance, and to define the most effective ways in which the international community might assist with this transition.

Furthermore, they believed that empirical work on macroeconomic governance would need to tap into the huge literature on macroeconomic policies and their effect, and link existing work with variables that reveal the quality of governance. Unfortunately, such variables are hard to quantify; but perhaps a classification of regimes together with a classification of the way macroeconomic policy is organized, could yield ways of exploring the relationships between the political and administrative variables, on the one hand, and the more familiar economic variables on the other.

In other words, it would be interesting to look how the macroeconomic policies are formulated, implemented and evaluated through the governance perspective, to understand whether adherence to, or lack of, the governance practices could influence the outcome of the macroeconomic policies, as well as to determine conditions that would lead to good quality policies which would eventually identify the appropriate type of market-augmenting government as the market economy progresses.

Besides, they also made preliminary attempts to trace the relationship between empirical indicators of financial and corporate governance with some governance variables that have been developed by others. They however suggested that one needs to look more carefully, perhaps through case studies, at the realities of financial and corporate governance in particular cases and the linkage between indicators of these types of financial and corporate governance with the more carefully articulated classification of political regimes.

Specifically with regard to the adjustment of most severely affected countries to the Asian crisis, they suggested that it would be interesting to examine the reasons why recovery in Korea has been more rapid than in the Indonesia and Thailand.

Similarly, it would also be interesting to investigate Malaysia’s speedy recovery from the crisis even though the country did not subscribe to the IMF recovery prescriptions. Mahani (2003) highlighted that after the rapid recovery of the Asian economies in 1999, discussion of the causes of the crisis has been centered on the quality of economic governance in these economies.

The East Asian economies success was at one time a model to be emulated by other developing countries, but after the 1997 financial turbulence, doubts were raised about the quality of economic governance in these Asian countries. Questions were raised whether the governance in these economies contributed to the crisis when countries like Indonesia, Malaysia, Thailand and South Korea experienced sharp economic contraction during the crisis.

She further highlighted that questions on the quality of governance centered on the issue whether or not the same economic governance that produced high growth also weakens the economies and makes them vulnerable to external shocks, whether the economic governance fails to avoid market failures in pursuing its high growth strategy, whether the conditions for good governance always the same irrespective of the stage of economic development, and whether the crony capitalism a result of the governance failure since it was among the widely acknowledged factors contributing to the crisis.

To know whether economic governance had made the economy vulnerable to a crisis, it is crucially important to examine the causes of the crisis and to link them with the economic weak points. Was the crisis due to the imprudent economic management or due to external factors? Although external factors have been recognized as the key cause for the crisis, domestic shortcomings were also responsible for deepening or aggravating the impact of the crisis.

Furthermore, Malaysia’s own crisis remedies and the rejection of the IMF’s standard crisis solutions open the debate on what is good economic governance. She argued that the 1997 Asian experience showed the economic governance framework by the IMF and the World Bank has some weaknesses, namely unfettered short term capital flows, lack of long-term and broader macroeconomic objectives when growth is driven by the private sector, and minimal attention given to socioeconomic issues such as income distribution.

The rapid recovery by Malaysia and Korea, which adopted different strategies shows that there are alternative ways to respond to a crisis, implying that there is also no single definition of economic governance. Policy flexibility arising from good economic governance before the crisis made it possible to Malaysia to take response measures specially tailored to its need and situation, and rejecting one-size-fits-all prescriptions by the IMF.

7.4 Governance roles in crisis prevention

The rapid pace and spread of globalization pose stiff challenges to economic governance as new criteria and developments may impose a heavier governance burden on the government and economy. One of the biggest challenges is the increasingly volatile international flow of capital that makes economic governance much more difficult as economic fundamentals are not the only factors that determine performance. Global integration also limits the choice of measures that are available to a country in making its response. Yet good governance is essential for sustained economic growth.

The challenge is to determine what good governance consists of under these changing conditions. Ever better economic management is called for, to preserve economic resilience and prevent external shocks from turning into crises. Thus, a close and critical evaluation of the new economic governance parameters and institutions is essential.

8.0 OVERVIEW ON THE STUDY OF GOVERNANCE

8.1 Development of the study of governance

Inada (2003) outlined the development in the study of governance over the last 10 years which can be categorized into several types:

Identifying factors of governance: what factors are the governance factors that affect the performance of the economies of developing countries? Example – World Bank (1992) documented such factors as accountability, transparency, predictable legal framework, efficiency of the public sector, etc.

Categori


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