Will the Credit Crunch Lead to Recession?

CentrePieceISSN 1362-3761 The Magazine of The Centre for Economic Performance Volume 13 Issue 1 Spring 2008 Unemployment and welfare to work Nurses’ pay Voting on interest rates Britain’s new homes WILL THE CREDIT CRUNCH LEAD TO RECESSION?

China’s entrepreneurs India’s foreign investment policy Management practices in China and India CentrePiece

CentrePiece is the magazine of the CEP director, John Van Reenen Centre for Economic Performance at the CEP research director, Stephen Machin London School of Economics. Articles in this issue reflect the opinions of the authors, not Editor, Romesh Vaitilingam of the Centre. Requests for permission to Design, DesignRaphael Ltd reproduce the articles should be sent to the Illustration p4, John Minnion Editor at the address below. Print, Ghyllprint Ltd

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Management gurus and the publishing into policy, practice and public CEP is hosting in early July. industry that sustains them often understanding. Elsewhere, we examine the often congratulate themselves on their In this issue of CentrePiece, we take perverse effects of regulation in Britain ‘thought leadership’, compiling endless a leaf out of the management crowd’s – the lethal impact of pay regulation in lists of ‘ultimate business thinkers’ and book with the launch of a series of healthcare; and how planning ‘most enduring ideas’. All very amusing reviews of CEP’s achievements, looking regulations stop us building houses – indeed, frequently lampooned by back at some of the ‘big ideas’ that where they’re most needed – and the columnists like Lucy Kellaway in the have emerged from the research and role of incentives – for the unemployed Financial Times – but disturbing too. their influence on both scholarship to get a job; and for novice monetary Despite the lack of intellectual and public policy. In the first article, policy-makers to conceal their true rigour in most business bestsellers John Van Reenen describes how the views on interest rates. and an absence of any evidence beyond Centre’s work on unemployment Finally, our cover story asks whether the anecdotal, they clearly have a and welfare have not only changed the the credit crunch will lead to recession ready market. way economists think about these and reaches a worrying conclusion. Economists and other serious social problems, but also led to policies like This too draws on enduring ideas scientists tend to be more modest in the New Deals. from economic research: the doctoral the claims they make for their ideas – CEP research of a more recent thesis of Federal Reserve chairman and they are typically more reluctant to vintage is making significant advances Ben Bernanke. When it comes to package their findings in a way that in the study of management itself, and management of the world economy, will attract an audience beyond here we report findings from our economists and their ideas are, academia. The Centre for Economic surveys of management practices in fortunately, more prominent than Performance (CEP) has always sought to China and India. Two other articles the business gurus. buck this trend: one of its central aims address key issues for these emerging is for top-quality economic research to giants of the world economy – and Romesh Vaitilingam have an impact on society through the much more will be discussed at a Editor long-term percolation of new ideas three-day conference on the topic that [email protected] CentrePiece Spring 2008

page 26 page 24 Where to build Britain’s Delayed doves new houses

Contents in brief...

page 2 page 7 Big ideas: unemployment and welfare to work Understanding trade unions John Van Reenen presents the first in a series of surveys of significant Richard Freeman has been honoured for research findings that have emerged from CEP his pioneering research on labour markets

page 4 page 8 The unemployment trap Can pay regulation kill? Barbara Petrongolo investigates whether the Job Seeker’s Allowance John Van Reenen and colleagues succeeded in getting people back to work examine the impact of regulating the labour market for nurses on hospital page 10 performance in England Can better management sustain growth in China and India? Nick Bloom and Rebecca Homkes evaluate management practices in the page 19 two countries’ manufacturing sectors India’s foreign investment policy: the impact on page 15 productivity China’s entrepreneurs Arunish Chawla considers what kinds of Linda Yueh explores what we know about the people who have liberalisation policies make a difference to driven China’s remarkable economic growth firms’ productivity

page 20 page 24 Will the credit crunch lead to recession? Delayed doves Nick Bloom suggests that uncertainty will lead to a slowdown much Stephen Hansen and Michael worse than we currently anticipate McMahon look back at the voting records of external members of the page 26 Monetary Policy Committee Where to build Britain’s new houses Tim Leunig argues for an end to the planning laws that constrain housing development in the South East

1 CentrePiece Spring 2008

To illustrate CEP’s impact on public policy and debate, John Van Reenen introduces and presents the first in a series of ‘big ideas’, surveying the significant research findings that have emerged from the Centre over the past three decades.

hat has economics our research can be disseminated to a policy implications are not accepted done for me lately? wider audience. immediately – or sometimes at all. Many I am often asked Our researchers are also formally are disproved by events or further about the purpose involved in policy-making in a number of investigation, but even the ones that prove of the Centre for different areas, serving on bodies such as to be right take time to be supported and WEconomic Performance (CEP). What the Low Pay Commission, the Monetary put into practice. This means, of course, impact have we had? How can we justify Policy Committee, the Migration Advisory that many of the new ideas that we have our funding? Service and pay review bodies, and been generating in recent years may not The CEP makes a difference in a variety advising business and non-governmental have an effect for many years to come. of ways. We evaluate public policies to see if organisations such as trade unions. Our first ‘big ideas’ overview looks at they have any benefits and, if so, to whom But this perhaps misses out what is unemployment and welfare to work. those benefits accrue and whether they most important: the long-term impact of Future commentaries will include the outweigh any costs. The literacy hour in the CEP. Starting in this issue of causes of rising wage inequality and primary schools, the Job Seeker’s Allowance CentrePiece, we have decided to give a policies to combat this inequality such for the unemployed, R&D tax credits and flavour of how our ideas have influenced as education, the minimum wage and many other policies have been subjected the world. As Keynes said in The General unions; declining social mobility; to our rigorous and objective assessment. Theory, ‘Madmen in authority, who hear productivity and competition; innovation Our findings can be used by governments voices in the air, are distilling their frenzy policies; economic geography; and and others to assess what worked in the from some academic scribbler of a few happiness and mental health. past and what needs to be changed in years back.’ Whatever your opinion of their the future. mental state, there is no question that Unemployment and Of course, many of these findings go policy-makers have been significantly welfare to work unattributed once they enter the national influenced by CEP research. Unemployment and welfare to work have bloodstream. Ideas, once accepted, are Obviously our ideas are not developed been one of the most high profile areas in often bastards. How many people know in a vacuum: we have many interactions which the combination of theory and that the decline in social mobility between with the wider research and policy careful empirical analysis at CEP led to the generations born in 1958 and 1970, community, above all with others in the policy developments. In turn, the mentioned repeatedly by politicians and economics faculty at the London School of recommendations that were adopted commentators, was first discovered by Economics (LSE). We are fortunate to be were evaluated and this allowed us to CEP researchers? part of the department that is the enhance our theoretical understanding of CEP researchers do not hide away from highest-ranked in the world outside the these issues. public debate. In 2007 alone, CEP research United States. In the aftermath of the Great appeared in the print, online or broadcast We have learned that it takes time for Depression and World War II, the media on more than 380 occasions. It is by academic ideas to percolate into public Keynesian consensus was that taking public communication seriously that consciousness. Our findings and their unemployment was essentially a problem

Big2 id CentrePiece Spring 2008

of demand. Governments needed to get much as a treatise than as a that has been taken up by governments the level of aggregate demand right to manual of battlefield surgery. Its around the world, particularly in the UK maintain full employment through a purpose is clear: How to since 1997. mixture of monetary and, above all, fiscal understand, and then how to An example of this is the New Deal for policies. LSE economists like John Hicks reduce, unemployment in Europe, Young People, first suggested by Richard and Bill Phillips (of the famous Phillips by taking inventory of the Layard and introduced by Gordon Brown curve) were at the heart of this consensus. knowledge at hand.’ in 1998 (and later extended to other The appearance of ‘stagflation’ – groups on welfare, including single growing inflation and unemployment – First, there had to be intellectual mothers and disabled people). The in the 1970s shattered this happy foundations. This meant moving away philosophy of the reform was that long- state of affairs. Out of the crisis, from the textbook model of perfect term unemployment was a huge waste of Thatcherism drew on Milton Friedman’s competition in the labour market and resources as the jobless lost skills and work to emphasise the failure of considering a more subtle and realistic motivation and were no longer effectively demand management and the need for picture of how people worked. Together competing in the labour market and governments to allow the market to let with Dale Mortensen, Chris Pissarides dampening wage inflation. unemployment find its ‘natural’ level (the (director of CEP’s macroeconomics To combat this problem, a combination NAIRU or ‘non-accelerating inflation rate of programme from 1999 to 2007) of ‘carrot’ and ‘stick’ was needed. The unemployment’). Printing money to boost developed job search theory, now carrot was to give the unemployed help demand led only to accelerating inflation. regarded as the foundation for modern with job search through intensive In 1990, as the Thatcher era was unemployment theory. information and mentoring at job centres. drawing to a close, CEP was born. A major The basic idea is that it takes time for Those who still struggled to find work strand of our work (building on the former an employee to find a job and for an would be supported in subsidised work Centre for Labour Economics) agreed that employer to find an employee – so this and training programmes. The stick was there was a NAIRU as Friedman argued. means that there will be an equilibrium that those who refused work or other But rather than being something level of vacancies and unemployed as options would lose their benefits. Elements immutable and fixed in stone, individuals get ‘matched’ with jobs. of a sanctions approach had been tried microeconomic supply-side policies could Layard et al showed how many other before the Labour government but be used to lower the NAIRU and thereby models of imperfect competition without the support package, they had reduce unemployment. Simply cutting (bargaining, efficiency wages, etc.) only limited success. unemployment benefits was not the only had some similar implications. The story does not end there. A vital way of achieving lower unemployment. Second, these theories had to be part of policy is rigorous evaluation of The framework for this view was confronted with data both to test the whether it works or not. I was deeply published in the classic textbook models and to put numbers on the involved in the first evaluation of the New Unemployment: Macroeconomic strength of the relationships. Huge Deal, which required us to develop new Performance and the Labour Market by effort was invested in building up cross- techniques and combine new datasets. Richard Layard (CEP’s founder director), national macro and micro datasets that We found that the programme did appear Stephen Nickell and Richard Jackman could be used to perform statistically to have major benefits, raising the job (first edition 1992). Reviewing the 2005 rigorous analysis. finding rate by about 20%, and I argued edition in the Journal of Economic The next step was the implications for that on the whole these benefits Literature, MIT’s Olivier Blanchard wrote: policy. The basic message was that supply- outweighed the costs. Subsequent work side policies to improve the matching has tended to support this conclusion. ‘The book was and remains an process between jobless workers and The evaluations raised many questions: impressive achievement. The way vacancies were crucial. This implied an what should be the balance between the to read it however is not so agenda of ‘welfare to work’, something carrot and the stick? How effective is the training option? Why does the New Deal effect seem stronger when it was first introduced than later? Why is the aggregate effect not larger, and is the youth labour market now running into trouble? These questions feed back into further developments of the theory and other policies. The overall lesson is that careful economic research has real effects on policy and the world.

John Van Reenen is director of CEP. eas 3 CentrePiece Spring 2008

The Job Seeker’s Allowance was introduced in late 1996 to encourage benefit claimants to look for work. New research by Barbara Petrongolo investigates whether it has succeeded in breaking the ‘unemployment trap’. The unemployment trap

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he Job Seeker’s Allowance Figure 1: (JSA) was introduced in the UK Flows into and out of the claimant count on 7 October 1996. It replaced (seasonally adjusted) Tthe existing system of unemployment benefits and income 450,000 support, and is currently the main welfare October ■ Off-flow ■ support to the unemployed. It was 400,000 1996 On-flow intended to break the ‘unemployment 350,000 trap’ in which workers were discouraged from finding work because of the 300,000 availability of benefits. 250,000 The new system placed stringent 200,000 conditions on claimants – possibly forcing some to stop claiming without finding a 150,000 new job first. Individuals who drop out of 100,000 the welfare system may become more 50,000 detached from the labour market and put less effort into searching for a new job. 0 This may lower the employment rate in Jan 92 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08 the future – exactly the opposite effect of Year the one intended. Source: NOMIS. The JSA has two distinct components:

The contributory component, which Figure 2: has limited duration, is not means- The claimant count and the Labour Force Survey stock of tested and is based on previous unemployed (seasonally adjusted) national insurance contributions. This component replaced unemployment benefit. 300,000 October ■ Claimant count The means-tested component. 1996 ■ LFS unemployment stock In principle, this is an open-ended 250,000 measure that replaced income support. 200,000 The contributory component of the JSA is more stringent than the 150,000 unemployment benefit that it replaced. It is only payable for half a year (rather than 100,000 a full year), young people aged 16-25 receive less and there is no allowance for a 50,000 dependent spouse. In contrast, the means- tested component of the JSA is payable at the same level as the former measure of Feb 94 Feb 96 Feb 98 Feb 00 Feb 02 Feb 04 Feb 06 income support. And as most support is Year provided through this component, the total effect of the changes was not large. Source: NOMIS and ONS. The most significant break with the previous system was the substantial increase in evidence that claimants had to undertaken, such as each phone call provide to demonstrate that they were made to a potential employer. The search The Job Seeker’s looking for work. Claimants now have to diary is then checked against the initial sign a Jobseeker's Agreement in which agreement at fortnightly interviews with Allowance they agree to look for work actively and the Employment Service – or more introduced commit to a number of specific ‘search frequently if a claimant is suspected of steps’. Such steps might include how fraud. Claimants may be ‘directed’ by conditions to many employers they are going to contact the Employment Service staff to take ensure claimants every week or how many times they are specific steps. going to contact a job centre. If claimants are still unemployed after were looking Claimants are required to keep a 13 weeks, they are required to broaden for work detailed diary of each search step their search and may not turn down job

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behaviour of both claimants and non- claimants, their average search effort did not increase at all after the introduction of the JSA. Further effects of the JSA can be evaluated by comparing two groups of job seekers: those who became unemployed shortly after the introduction of the JSA; and those who became unemployed six months earlier (and then adjusting for seasonal factors using information on later cohorts of claimants). Although claimants affected by the The Job Seeker’s JSA system came off benefits more quickly Some workers Allowance reduced the than claimants did under the old system, appear to have number of claimants – they were 4% less likely to be in work a moved off the Job but it also reduced the year after they lost their job. This meant Seeker’s Allowance number of claimants that they were earning an average of and onto incapacity finding work £600 less a year. benefit What’s more, these effects were offers outside their main occupation stronger for young people (those aged up expenditure on unemployment benefits (although this is difficult to enforce). to the age of 24), who experienced more has been lower under the JSA, if we take A claimant who fails to meet these severe earnings losses than older workers account of the increase in incapacity requirements is threatened with temporary after the introduction of the JSA. benefits, it is not clear whether the total sanctions or disqualification from the As the JSA seems to have moved benefit expenditure was reduced. So it JSA entirely. claimants off benefits but not into new remains unclear whether the move from Some of the effects of the JSA can be jobs, it increased the number of non- the unemployment benefit and income seen by looking at flows of people into employed people who were not claiming support system to the JSA was beneficial and out of registered unemployment, as benefits. Figure 2 shows that the claimant either in terms of reducing benefits or of Figure 1 shows. Soon after the count – while being very close to the helping more people into work. introduction of the JSA, there was a large Labour Force Survey (LFS) measure of increase in the number of people stopping unemployment until 1996 – fell more This article summarises ‘What are the claiming the JSA, with no increase in the sharply than LFS unemployment after the Long-term Effects of UI? Evidence from the number of new claimants. This introduction of the JSA in late 1996. UK JSA Reform’ by Barbara Petrongolo, translated into a rapid decline in the So what happened to these workers CEP Discussion Paper No. 841 unemployment rate, which was already who were neither working nor claiming (http://cep.lse.ac.uk/pubs/download/ falling in the months before the reform benefits? Many may have become part of dp0841.pdf). came into effect. the ‘hidden unemployed’ – but there are Official evaluations of the JSA carried other possibilities. Barbara Petrongolo is a lecturer in out by the then Department of Social A study by Stephen Machin and Olivier economics at LSE and an associate in CEP’s Security (now the Department for Work Marie (2008) shows that crime in the UK labour markets programme. and Pensions) show that the JSA increased rose more in areas that were most the number of people stopping claiming affected by the tougher JSA benefit benefits. This was largely due to a regime. Could this mean that people Further reading ‘weeding out’ effect: those who were not pushed out of the benefit system by the serious about searching for a new job new, more stringent standards were Stephen Machin and Olivier Marie (2008), were forced off the register. turning to illicit methods of earning? ‘Crime and Benefit Sanctions’, Portuguese Their findings also show that the Possibly – but other factors could be at Economic Journal (special issue on labour average claimant increased his or her work as well, so we must be careful in economics), earlier version available efforts to find a new job. Of course, it is claiming this. as CEP Discussion Paper No. 645 possible that as less serious claimants were Another possibility is that people (http://cep.lse.ac.uk/pubs/download/ weeded out, only claimants who were simply moved onto other benefits, notably dp0645.pdf). trying to find a job remained. So it could incapacity benefits. Indeed, individuals be that the remaining claimants were the covered by the JSA are 3% more likely to Alan Manning (2005), ‘You Can't ones who were always more motivated, take up incapacity benefits – and thus be Always Get What You Want: The Impact rather than being motivated by the induced into longer-term dependency – of the UK Job Seeker’s Allowance’, JSA directly. than individuals not covered by the JSA. CEP Discussion Paper No. 697 Indeed, research by Alan Manning This has important consequences for (http://cep.lse.ac.uk/pubs/download/ (2005) finds that taking account of the government spending on welfare. While dp0697.pdf).

6 CentrePiece Spring 2008 in brief... Understanding trade unions and the labour market Richard Freeman, professor of economics at Harvard University, visiting professor at LSE and senior research fellow in CEP’s research programmes on labour markets and wellbeing, has been awarded the IZA Prize in Labor Economics 2007.

The prize, awarded by the Institute for the Study of Labor (IZA) in Bonn, honours the pioneering work of exceptionally creative scholars who have revolutionised encourage union leaders to be more aware of their key theoretical and empirical research on labour markets. The responsibility for the economy as a whole.’ prize committee includes Nobel Laureates George Akerlof and Joseph Stiglitz, and the previous winners are Jacob ’For more than three decades, Richard Freeman has been Mincer, Orley Ashenfelter, Ed Lazear, Dale Mortensen, among the internationally most active and influential David Card, Alan Krueger and CEP’s Chris Pissarides. labour economists. His research, which has greatly enriched the scientific debate, has also had a strong The award team said: ‘By drawing attention to important impact on policy debates around the globe. Among the social problems and trends, Richard Freeman has greatly institutions he has advised on economic policy issues are extended the range of issues addressed in modern labour the World Bank, the International Labour Organization economics. His analyses of inequality and discrimination, and the European Union. In addition, Freeman directs the the role of unions and the welfare state are extremely Program on Labor Studies at the National Bureau of valuable for the understanding of effective labour Economic Research.’ market policy.’

One of the results of the IZA prize will be a book based ’In various studies, Freeman has proven that unions on Richard Freeman’s articles published by Oxford perform multiple economically valuable functions which University Press. This will be about his research on labour reach far beyond their role in wage bargaining. These markets in the UK and continental Europe, work done contributions, which are among Freeman's most primarily at CEP. influential research, have revolutionised the perception of trade unionism in modern labour economics.’ Further reading ’In light of globalised markets and international competition, the trade unions' strategies should not be Alex Bryson and Richard Freeman (2006), confined to achieving higher wages. According to ‘What Voice Do British Workers Want?’, Freeman, modern unions must also provide a direct CEP Discussion Paper No. 731 channel of communication between workers and (http://cep.lse.ac.uk/pubs/download/dp0731.pdf). management and act as an intermediary to protect employment and foster the creation of new jobs.’ Richard Freeman (2005), ‘From the Webbs to the Web: The Contribution of the Internet to Reviving ’By serving as an institution of collective voice, unions Union Fortunes’, in Susan Fernie and David contribute to a higher level of job satisfaction and improve Metcalf (eds), Trade Unions: Resurgence or workers' loyalty to the firm. Freeman has demonstrated Demise?, Routledge (summarised in CentrePiece: that union influence not only reduces absenteeism but http://cep.lse.ac.uk/pubs/download/CP182.pdf). also promotes long-term employment relationships by lowering the number of quits. This reduction in labour Richard Freeman, ‘Are European Labor Markets as turnover lowers hiring and training costs. More Awful as All That?’, CEP Discussion Paper No. 644 importantly, it increases productivity by creating incentives (http://cep.lse.ac.uk/pubs/download/dp0644.pdf). to invest in workers' education and skill enhancement.’ Richard Freeman and Joel Rogers (1999), ‘In this respect, trade unions who act constructively are of What Workers Want, Cornell University Press. vital importance to overall economic performance. Freeman's research shows that non-dogmatic unions can Richard Freeman and James Medoff (1984), play a significant role in today's labour markets. It should What Do Unions Do?, Basic Books.

7 CentrePiece Spring 2008 in brief... Can pay regulation kill? John Van Reenen and colleagues present evidence on the impact of regulating the labour market for nurses on the performance of hospitals in England.

Nurses’ pay in England is set centrally with little local East where wages outside the public sector are pushed variation. This means that hospitals in high cost areas like up by the tightness of the labour market. London and the South East struggle to recruit and retain staff. As a consequence, our research finds that they treat Nowhere is centralised pay setting more important than fewer patients and have lower quality outcomes – for in the NHS. More than a quarter of a million nurses in example, much higher fatality rates among patients England have their pay set by a single pay review body. admitted with emergency heart attacks. The process allows some local flexibility, but in practice the gap between the wages paid to a nurse in Newcastle These effects are not trivial: the results suggest that a and one in London is small compared with the pay gap 10% increase in the gap between the wages paid to NHS between women in those areas who are not nurses. nurses and those paid to women working in the private sector locally raises the fatality rate among people The research looks at how centralised pay setting for admitted with a heart attack by about 5%. nurses in the NHS affects hospital performance by tracking changes in the outside wage and changes in Centralised pay setting happens in many public sector performance in over 100 English hospital trusts over a six- labour markets like health, teaching and the police. year period. People often worry about the minimum wage pricing people out of jobs. But when pay in a sector is set to be Common sense would suggest that hospitals located in almost the same across the country, it effectively imposes places where outside opportunities are better are going a maximum wage on people living in parts of the South to struggle to recruit, retain and motivate staff. This is

Centralised pay setting for nurses means that hospitals in high cost areas struggle to recruit and retain staff

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exactly what the study finds: in areas like London where experienced in working in the hospital. In the first map, the outside labour market is strong – where the wages of the areas with the highest outside wages are marked in nurses are lowest compared with their non-nurse red and those with the lowest outside wages are marked counterparts – nurse vacancy rates are higher and fewer in blue: it is clear that the large cities and the South East qualified nurses work in the NHS. have higher outside wages. The second map shows the intensity of use of agency nurses, and the spatial But these recruitment difficulties are not confined to the distribution is very similar to that of the first map: where human resources department. More worryingly, they feed outside wages are high, use of agency nurses is high. into a lower quality of service provision and poorer outcomes for patients. Hospitals in areas where the The study uses data from 1995 to 2002 and there have outside labour market is strong have lower volumes of been some relaxations in the rules since then with more activity relative to their staffing levels. They also have recruitment bonuses and cost of living allowances. But it higher fatality rates among patients who are admitted is still the case that public sector workers are taking a with emergency heart attacks. A 10% increase in the much bigger effective pay cut compared with similarly outside wage means a 5% increase in death rates from skilled workers in lower cost areas. heart attacks. The lessons can be used throughout the public sector. None of these effects are present in firms operating in Instead of across the board pay increases, the right thing the private sector. Nor do they seem to arise because to do is to allow wages in the high cost areas of the hospitals in high cost areas face greater financial South to increase at a much faster rate than the low cost problems or have patients who are sicker – in fact, areas of the North. This should be done in schools and patients in many high external wage areas generally have police departments as well as hospitals. Only then will the better health than those in low external wage areas. death premium of London be properly tackled.

One key problem is that hospitals that find it difficult to recruit permanent staff rely more on temporary agency This article summarises ‘Can Pay Regulation Kill? Panel Data Evidence staff. These nurses can be paid at a higher rate to get on the Effect of Labour Markets on Hospital Performance’ by Emma around the pay regulation. But they often tend to have Hall, Carol Propper and John Van Reenen, CEP Discussion Paper No. less experience and training, and will not know the 843 (http://cep.lse.ac.uk/pubs/download/dp0843.pdf). hospital as well as someone on a permanent contract. Emma Hall is at the Centre for Market and Public Organisation The maps in Figure 1 show the link between outside (CMPO) at the University of Bristol. Carol Propper is at CMPO and wages and use of temporary agency nurses who are less Imperial College, London. John Van Reenen is director of CEP.

Figure 1: Hospitals in high Outside wages and the use of agency nurses cost areas have

Highest outside wage higher fatality Highest intensity of agency nurses rates among patients admitted Lowest outside wage Lowest intensity of agency nurses with emergency heart attacks

9 CHINACHINACHINACHINACHINACHINACNACHINACHINACHINACHINACHINACHINACNACHINACHINACHINACHINAC INDIAINDIAINDIAINDIANDIAINDIAIAINDIAINDIAINDIANDIAINDIAI CentrePiece Spring 2008

The economies of China and India have been booming – but do they have the quality of CHINAC corporate management to sustain growth over CHINDIAINDIA the longer term? Using CEP’s global survey of over 4,000 firms, Nick Bloom and Rebecca Homkes evaluate management practices in the two countries’ manufacturing sectors.

Can better management sustain growth in China and India?

he phenomenal growth of able to adopt world-class management (Bloom, Dorgan et al, 2007). During the China’s manufacturing sector practices, then the phenomenal growth summer of 2006, our team contacted over over the last decade has rates of these industries may continue for 4,000 medium-sized manufacturing firms been fuelled in large part by many years. across Europe, India, Japan and the United a seemingly inexhaustible CEP’s research programme with States, and spoke directly with plant supplyT of cheap labour. The opening of the McKinsey & Company and Stanford managers about their firms’ management Chinese economy has enabled a country University makes it possible to compare practices. In the summer of 2007, we with one fifth of the world’s population to management quality in China and India extended this survey to China. make more use of that resource. Labour shortages in urban areas are supported by Measuring management in a systematic way requires mass migration from the countryside. Measuring codifying the concept of good and bad management into a But even in China, the supply of workers management measure applicable to different firms. We used an interview- is not infinite and economic growth is based management practice evaluation tool that defines and leading to wage growth. With rapidly practices scores from 1 (worst practice) to 5 (best practice) across 18 increasing wage rates and an ageing of the key management practices that appear to matter to population (due in large part to the industrial firms, based on McKinsey’s expertise in working one-child policy instituted in 1978), with thousands of companies across several decades. For full Chinese manufacturing is set to change. details of the survey methodology, including all the Can China’s manufacturing sector questions, see Bloom and Van Reenen (2007). continue to grow even with rapidly rising bills? And what about the other Asian The 18 practices fall into four broad areas: giant: can Indian manufacturing start to Shopfloor operations: have companies adopted both the catch up with China by raising its annual letter and the spirit of lean manufacturing? growth rate to the 10%-plus levels that Performance monitoring: how well do companies track China has enjoyed? what goes on inside their firms? One key factor is the quality of Target setting: do companies set the right targets, track management in these countries. the right outcomes and take appropriate action if the two If management practices are poor in don’t tally? comparison with those in Europe, Japan and Incentive setting: are companies hiring, developing and the United States, Chinese and Indian firms keeping the right people and providing them with will be less able to compete as their costs incentives to succeed? increase. But if Chinese and Indian firms are

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Figure 1: The average Chinese and Indian firms are the worst managed on average Chinese and Indian firm is United States Germany better managed Sweden than a quarter Japan UK of UK firms France Italy Poland Portugal Greece China India

2.5 2.6 2.7 2.8 2.9 3.0 3.1 3.2 3.3 3.4 3.5 The bars indicate for each country the average score on the 18 management questions (1=worst practice, 5=best practice).

The average Chinese developed countries – Germany, Japan, and Indian firm is poorly Sweden and the United States – are well managed managed. France, Italy, Poland and the UK The research finds that comparing across are all solidly mid-table, while worryingly all the countries in the sample, the for Portugal and Greece, their average management scores for Chinese management practices appear to be only and Indian firms are the lowest (see Figure slightly better than those in China and 1). Despite recent media attention for the India. This suggests that the OECD impact of principles of lean manufacturing countries’ advantages in management in China and India, both countries still lag should not be overstated and that China behind in terms of modern manufacturing and India may be catching up. techniques and practices. Their firms also What’s more, although the average underperform in terms of incentive Chinese and Indian firm performs badly, structures and people management. this disguises tremendous variation in By comparison, firms from more management practices within each country. The best Chinese and Indian firms are as well managed as those in the UK For each company in the study, researchers interviewed one and the United States (see Figure 2). or two senior plant-level managers, who knew only that they Indeed, rather alarmingly for the were taking part in a ‘research’ project. These managers British and Americans, many of their firms were selected because they were senior enough to have a – about a quarter of UK firms and 15% of reasonable perspective on what happens in a company but US firms – are actually worse managed not so senior that they might be out of touch with the than the average Chinese and Indian shopfloor. The interviews relied on open questions and the firms. And while roughly one third of well interviewers were trained to probe for details of practices on managed Chinese and Indian firms are the ground. foreign multinationals, two thirds are excellently run domestic firms. The interviews were run by an international team of 47 Another notable result illustrated in postgraduate students (mainly MBAs), who worked from CEP Figure 2 is the marked variation in in a specially created survey centre during the summer of management practices in India, especially 2006. This was a 24-hour operation since the Chinese day in comparison with China. While India has starts at midnight in London, just before managers on the a large upper and lower tail of over- and West Coast of the United States pack up to go home. underperforming firms, Chinese firms are solidly clustered slightly below average. The domestic Indian firms with poor management practices are typically government owned or family firms that practice primogeniture (handing down the CEO position to the eldest son). They stand

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Figure 2: in sharp contrast to some of India’s well- Chinese and Indian firms are better managed than about known industrial giants, which operate 25% of UK firms and 15% of US firms using world-class management practices. India also displays a substantially larger spread of productivity across 10 China manufacturing plants than China. This 8 suggests that there is something in the Indian business environment that is 6 conducive to much more variation in 4 management practices and productivity

2 than in China, a phenomenon we are currently researching. 0 13524Which firms are getting it right? 10 India To understand why China and India have 8 these underperforming firms with poor

6 management practices, we segmented the firms by broad ownership category. We 4 find that multinational firms are well

2 managed everywhere. These firms are typically the Chinese and Indian 0 manufacturing operations of successful 13524 European, Japanese and US firms, which

10 UK have transferred their world-class management practices abroad. 8 In stark contrast, foreign joint ventures

6 – in which foreign and domestic firms share ownership – tend to struggle. Most 4 of these ventures are located in China. 2 They date from regulations introduced in

0 1979, which required foreign investors to 13524set up joint ventures with local firms in order to gain entry to the market. (It was 10 United States not until 1986 that the first wholly-owned foreign enterprise was established.) 8 Given the complex management 6 structures that shared ownership entails

4 (multiple layers of domestic and foreign management and shareholder boards), 2 managerial clashes seem to have plagued

0 the organisation of operations and 13524incentives. Combined with the inherent cultural and language clashes, these Average management score foreign joint ventures adopted substantially in China and India worse management practices than even many domestic firms. The charts show the distribution of firms across management scores Other firms that are poorly managed (1=worst practice, 5=best practice) within each country. are those owned and run by families. Such firms are particularly common in India but rare in China (there has been a more recent drive towards private family ownership in China, but this was difficult prior to 1979). Given the difficulties of separating ownership from control in India Government firms and firms (arising from problems in the legal system), family firms rarely bring in external owned and run by families are management. very poorly managed Government firms are also extremely

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Figure 3: badly run in both countries (and indeed Foreign multinationals are well managed in China and across all the countries in the sample), India, but foreign joint ventures are not with particularly weak management of workers and a lack of modern manufacturing techniques. Foreign multinational In recent years, there has been a strong push in former Chinese state- Family owned but external CEO owned firms towards dispersing ownership among their workers. With reforms to Domestic firm, non-family owned India’s legal system, government and family-run firms may diminish in Foreign joint venture (China only) importance there as well. This may pave the way to a brighter future for the two Family owned, family CEO countries’ manufacturing sectors if firms can adapt their practices to match those Government of their competitors.

2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3.0 3.1 3.2 Managerial over-optimism is The bars indicate the average score on the 18 management questions (1=worst practice, not equated with strong 5=best practice) for each type of firm ownership in China and India. management practices Since good management is strongly linked Figure 4: Chinese and Indian managers are more over-confident with good performance, why is it that not than European, US and Japanese managers all firms make a priority of improving their practices? To examine the possible causes ■ Self-assessed management of this disconnect, we asked managers as ■ Our management score a final question in the interview to assess the overall management performance of United States their firm. To avoid false modesty, they were asked to exclude their personal Germany performance from the calculation. The answers indicate that Chinese and Sweden Indian managers are particularly over- optimistic about their management Japan practices. The average Chinese and Indian firm’s self-assessment is that its UK management is better than the average French, Italian, Japanese, Polish, Swedish, France UK and US firm. This is particularly striking given how Italy poorly managed the average Chinese and Indian firms are in comparison with their Poland European, Japanese and US counterparts. In fact, the only country with distinctly Portugal more optimistic managers is Greece, which has the third-worst managed firms in the Greece sample.

China Chinese and Indian firms tend to be highly centralised India More than management practices, the degree of management autonomy within a firm can affect its productivity, especially 2.4 2.6 2.8 3.0 3.2 3.4 3.6 3.8 in terms of its ability to implement processes and make timely decisions. We Average self-assessed management score in China and India find huge variations in the extent to which power is centralised within firms’ The bars indicate for each country the average score on the 18 management questions and the corporate headquarters rather than average score on the self-assessed management question: ‘Excluding yourself, how well delegated to individual plant managers. managed is your firm on a scale of 1 to 10, where 1 is worst practice, 10 is best practice and 5 is The corporate headquarters of some average’. The scores are divided by 2 to put them on the same scale as our management scores. 13 CHINACHINACHINACHINACHINACHINACNACHINACHINACHINACHINACHINACHINACNACHINACHINACHINACHINAC INDIAINDIAINDIAINDIANDIAINDIAIAINDIAINDIAINDIANDIAINDIAI CentrePiece Spring 2008

firms treat their production plants almost Figure 5: as independent entities, letting plant Asian firms are much more centralised (hierarchical) than managers make decisions on hiring, Northern European and US firms investment, sales and product development. But others directly control Sweden almost every aspect of their plants’ United States activities, leaving little decision-making UK power to plant managers. Germany To investigate this variation in Italy decentralisation, we asked plant managers France about the degree of autonomy they had in Portugal four activities: hiring new full-time workers; Poland making capital investments; controlling China their sales and marketing; and introducing India new products. We combined these four Japan indicators into one overall measure of plant Greece managers’ autonomy, where high values indicate that decisions are decentralised to -0.5 -0.4 -0.3 -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 plant managers and low values indicate More centralised production More decentralised production that they are taken at corporate (plant managers have (plant managers have headquarters. little autonomy) lots of autonomy)

Figure 5 plots this measure of Average degree of plant manager autonomy over hiring, autonomy across countries. The substantial investment, sales and new products, by country variation is evident as firms in Northern Europe and the United States are typically decentralised compared with the very hierarchical ones in Asia and Southern Europe. In related work (Bloom, Sadun and Van management practices towards those in Chinese and Indian Reenen, 2007), we find that this degree of Europe and United States. Thus, even as firms are much more decentralisation is positively related to the Chinese and Indian wage rates and raw centralised than productivity of information technology (IT). materials costs start to rise, the negative Firms in which managers and workers are effects could be offset by an improvement Northern European more autonomous appear to make much in management practices. and US firms better use of IT, presumably because their But a possible cloud on the horizon for greater operating freedom enables them to these countries is the hierarchical Further reading experiment and adapt the IT to their local organisation of their firms, which, as our environment. research shows, impedes the effective Nick Bloom, Stephen Dorgan, John Dowdy, This highlights a potential future adoption of IT. Whether Chinese and Christos Genakos, Raffaella Sadun and John problem for Chinese and Indian firms. Indian firms can also modernise the Van Reenen (2007), ’Management Practices Their highly centralised management organisation of their firms alongside their and Productivity: Why They Matter’ structures are likely to be less effective as management practices is a key question, (http://cep.lse.ac.uk/management/ production technologies become and one that CEP researchers will continue Management_Practice_and_Productivity.pdf). increasingly computer-intensive. to investigate. Nick Bloom and John Van Reenen (2007), The future of Chinese and ‘Measuring and Explaining Management Indian manufacturing This research was jointly funded by the Practices across Firms and Nations’, While the results of our survey highlight Anglo-German Foundation and the Economic Quarterly Journal of Economics 122(4): the fact that Chinese and India firms have and Social Research Council. 1351-408 (earlier version available as CEP below average management practices, this Discussion Paper No. 716: is mainly due to a long tail of poorly run Nick Bloom is an assistant professor of http://cep.lse.ac.uk/pubs/download/ government and traditional family firms. As economics at Stanford University and a dp0716.pdf). the two countries develop, both in terms research associate in CEP’s productivity and of local markets and ownership structures, innovation programme. Nick Bloom, Raffaella Sadun and the proportion of these firms should John Van Reenen (2007), ‘Measuring and continue to shrink rapidly. Rebecca Homkes is management research Explaining Decentralisation across Firms and The newly organised and changing project manager in CEP’s productivity and Countries’, LSE/Stanford mimeo firms that adopt competitive best practices innovation programme, and has been (http://www.stanford.edu/~nbloom/ should push average standards of overseeing the Chinese survey. decent.pdf).

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China’s remarkable economic growth has been achieved through the rapid CHINAC emergence of a dynamic private sector. CHINDIAINDIA Linda Yueh explores what we know about the generation of self-employed entrepreneurs who have driven this transformation.

China’s entrepreneurs

he central feature of who have had the wherewithal to start a China’s economy is China’s transition from a business or work for themselves? What increasingly driven centrally planned economy kinds of personal traits differentiate them by competition, is the development of the from people who choose not to embrace innovation and non-state sector – private entrepreneurship? The findings from a productivity Tfirms led by an emerging class of national household survey conducted in entrepreneurs. In 1978, the first year of reform in China, the state sector Figure 1: accounted for over 90% of the country’s State-owned enterprises’ share of GDP,1978-2005 GDP; by 2005, this had fallen to less than half (see Figure 1). Not all of China’s growth 100% achievements can be attributed to 90% entrepreneurs. Rural industries – the 80% township and village enterprises – contributed a growing proportion from 70% the early 1980s onwards and accounted 60% for nearly a third of GDP in the mid- 50% 1990s. And foreign investors also played a 40% role from around that time. But since the late 1990s, China’s 30% entrepreneurs have been the key driver of 20% growth. They are the creators of the 10% de novo firms that are forming a dynamic 0% and innovative private sector – an

essential force in any developing country 1978 1980 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 (see, for example, Wu, 2002, and Zhang Year et al, 2006). What do we know about the people Source: China’s National Bureau of Statistics

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urban China in 2000 shed some light on Not until the dismantling of the Communist Party these questions. employment system and the massive membership makes an layoffs accompanying the restructuring of individual less likely to The rise of China’s state-owned enterprises in the mid-1990s be an entrepreneur entrepreneurial class did private Chinese firms begin to The dramatic growth in the share of self- flourish (Knight and Yueh, 2004). And by why they started their own business, 37% employed entrepreneurs in the Chinese providing an alternative source of said that it was because they had the workforce is evident from the mid-1990s employment and revenue, the emerging requisite skills and experience, 17% (see Figure 2). It is most apparent in the non-state sector has given the started a business by joining in with rural areas where there were no recorded government leeway in its efforts to relatives, 11% had property and 7% private enterprises until 1994. downsize and reform state-owned had funds. The upward trend continues in urban enterprises (Fan, 1994). areas as in the country as a whole. But in Another institutional challenge faced Comparing entrepreneurs rural areas, self-employment now seems by entrepreneurs has been limited access and non-entrepreneurs to be falling. Given the massive migration to credit. A recent estimate by the first So which characteristics distinguish from rural to urban areas, this may well Chinese chief economist of the World entrepreneurs from non-entrepreneurs in reflect the limited opportunities for rural Bank suggests that out of 40 million small China? Comparing people who have industries to develop when competing and medium-sized enterprises in China in started their own business as their primary against the advantages of urban 2006, less than half of 1% could obtain or secondary job with people who remain companies and markets. loans from banks (Lin, 2007). in paid employment, the first notable Overall, the increase in Aspiring entrepreneurs have also faced difference is in annual incomes. As entrepreneurship in China bodes well for a shortage of key assets such as land Figure 3 shows, between 1995 and 1999, sustained economic growth. But the or property (the property market did the average entrepreneur earned over emergence of China’s entrepreneurs has not develop until the late 1990s) and 35% more than the average person in not been without obstacles. By insecure property rights in a system that paid employment. guaranteeing employment and providing did not protect private ownership officially As Table 1 shows, there are a social security in the absence of a national until 2004. Having property in China large number of similarities between safety net, the lifetime employment suggests being fairly well connected as entrepreneurs and non-entrepreneurs. system in the state-owned enterprises urban (and, for the most part, rural) land The average age of both groups is 35, (known as the ‘iron rice bowl’) strongly is state-owned and privatisation of land both have identical years of education and discouraged urban workers from and buildings has only begun recently. nearly 85% of both groups are married. becoming self-employed. When the survey asked entrepreneurs There are, though, a number of

Figure 2: Entrepreneurs as a percentage of total employment in China: national, urban and rural areas

12% ■ Urban ■ National ■ 10% Rural

8% China’s

6% entrepreneurs are more likely 4% to have 2% experienced

0% unemployment 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 than people Year in paid ■ Entrepreneurs Source: China’s National Bureau of Statistics employment

16 CHINACHINACHINACHINACHINACHINACHINACH INDIAINDIAINDIAINDIAINDIAINDIANDIAINDIAI CentrePiece Spring 2008

significant differences. The first is that Figure 3: nearly 18% of non-entrepreneurs are Annual incomes of Chinese entrepreneurs and members of the Chinese Communist Party non-entrepreneurs in renminbi (RMB) compared with just 6% of entrepreneurs. It may be that Party membership protects 9000 ■ Entrepreneurs ■ against retrenchment and thus reduces the Non-entrepreneurs Non-entrepreneurs likelihood of someone stepping out into 8000 the private sector. 7000 Entrepreneurs Second, nearly a third of entrepreneurs 6000 have experienced unemployment compared with less than a fifth of non- 5000 RMB entrepreneurs. This makes the difference 4000 in incomes all that more remarkable, as 3000 individuals who have experienced unemployment tend to suffer from 2000 ‘scarring’, which results in a lower wage 1000 when they are in work again. But having 0 experienced unemployment during the 1995 1996 1997 1998 1999 large-scale layoffs of the mid- to late Year 1990s seems to be a significant factor in becoming an entrepreneur. Source: Chinese Household Income Project survey, 2000 Third, entrepreneurs have larger social networks. In the context of a weak legal system and opaque regulatory structure, perhaps it is not surprising that starting one’s own business requires contacts to secure supplies and distribution as well as operating licences.

The personal traits of Table 1: Differences between Chinese entrepreneurs Chinese entrepreneurs and non-entrepreneurs Considering all of the relevant personal, socio-economic and attitudinal traits, Personal characteristics Entrepreneurs Non-entrepreneurs estimates of the probability of Age 35.6 35.8 entrepreneurship find that women and Years of employment experience 12.3 22.8 people who have been in employment for Have experienced layoff 27.8% 19.2% a number of years are less likely to be Years of education 9.4 9.4 entrepreneurs. Some features of an Gender 55.7% male 49.7% male individual’s socio-economic background 44.3% female 51.3% female also affect his or her potential for Marital status 83.4% married 84.2% married entrepreneurship. Communist Party member 6.2% 17.7% Having a more educated mother or Social network (size) 8.2 6.4 one who is in a non-manual or professional job increases the likelihood of Socio-economic background entrepreneurship, while having a father Father’s education (years) 5.4 5.2 who is a Communist Party member Mother’s education (years) 6.0 5.9 decreases the likelihood. Mothers who are Father is/was Communist Party member 26.5% 34.2% more accomplished seem to encourage Mother is/was Communist Party member 8.7% 10.8% their children to start their own Father is/was self-employed 3.9% 2.8% businesses, while fathers with connections Mother is/was self-employed 1.7% 1.8% to the Party seem to reduce the job Father is/was non-manual worker 22.3% 28.4% insecurity of their children. Mother is/was non-manual worker 8.1% 13.7% Having a larger social network and a willingness to embrace risk also Income significantly increases the likelihood of Annual income (RMB) 8475 5986 becoming an entrepreneur. Average annual income (RMB), 1995-98 5751 4312 A number of questions about attitudes asked of a sample that had experienced Source: Chinese Household Income Project survey, 2000 unemployment are also revealing. When

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considering an opportunity for work, both This article summarises ‘China’s Forays by entrepreneurs and non-entrepreneurs Entrepreneurs’ by Linda Yueh, value wages, social security provision, University of Oxford, Department of Chinese good working conditions and the ability to Economics, Discussion Paper No. 324 entrepreneurs learn skills on the job. (http://www.economics.ox.ac.uk/Research/wp/ But they differ in that entrepreneurs pdf/paper324.pdf) and forthcoming in into overseas do not worry as much about job stability World Development. or job dignity, and curiously, despite their markets are as higher earnings, they are less inclined than Linda Yueh is fellow in economics at St inevitable as the non-entrepreneurs to hope that their Edmund Hall, University of Oxford, and an rise of China children will become entrepreneurs. And associate in CEP’s globalisation programme. as is found among entrepreneurs across the world, the drive to earn money is a significant determinant of Further reading entrepreneurship. Simeon Djankov, Edward Miguel, Yingyi Qian, Conclusion Gerard Roland and Ekaterina Zhuravskaya The remarkable growth of China has been (2005), ‘Who are Russia’s Entrepreneurs?’, driven by various engines. The most Journal of the European Economic notable is the development of the non- Association 3(2-3): 587-97. state sector, fuelled by the desire of millions of Chinese people to seek a better Gang Fan (1994), ‘Incremental Change and life. The easing of the state’s control over Dual-track Transition: Understanding the the economy allowed the emergence of a Case of China’, Economic Policy 19(supp): generation of entrepreneurs, who have 99-122. transformed the economy into one increasingly driven by competition, John Knight and Linda Yueh (2004), ‘Job innovation and productivity. Mobility of Residents and Migrants in Urban The personal traits of China’s China’, Journal of Comparative Economics entrepreneurs have much in common with 32(4): 637-60. those who remained in paid employment. But there are also notable differences: Justin Yifu Lin (2007), ‘Developing Small and being female, older or a member of the Medium Bank to Improve Financial Communist Party all significantly reduce Structure’, China Center for Economic the probability of becoming an Research, Peking University,Working Paper entrepreneur. (in Chinese). These traits are not dissimilar to entrepreneurs elsewhere (see, for example, Xiaogang Wu (2002), ’Embracing the Market: Djankov et al, 2005). Being female and Entry into Self-employment in Transitional older tend to discourage people from China, 1978-1996’, William Davidson Institute starting their own business in many Working Paper No. 512. countries. And as in the West, social networks, a healthy attitude to risk and an Jian Zhang, Linxiu Zhang, Scott Rozelle and inclination to work hard are all traits Steve Boucher (2006),’ Self-employment with associated with entrepreneurs in China. Chinese Characteristics: The Forgotten Until recently, not much was known Engine of Rural China’s Growth’, about these entrepreneurs, but the Contemporary Economic Policy 24(3): 446-58. emerging picture is one of a group of individuals who are able to navigate China’s uncertain institutional terrain and find opportunities in the world’s potentially most significant market. Their foray into overseas markets is as inevitable as the rise of China.

18 CHINACHINACHINACHINACHINACHINACHINACH INDIAINDIAINDIAINDIAINDIAINDIANDIAINDIAI CentrePiece Spring 2008 in brief... India’s foreign investment policy: the impact on productivity What kind of liberalisation policies can make a difference to firms’ productivity? Research by Arunish Chawla explores this question in the context of India’s economic liberalisation of the 1990s. He analyses the impact of foreign investment policy on the performance of Indian manufacturing firms over a 15-year period.

A particularly striking feature of India’s foreign significantly from technology spillovers, they need to investment regime since the 1990s has been that it be technologically advanced or close to the ‘technology encourages the adoption of foreign technology by frontier’. domestic firms while at the same time opening up these industry sectors to foreign investors. So liberalisation But in vertically integrated industries (where firms operate consists of two distinct components: at more than one stage of the production process), previous research suggests that the effect of FDI on Foreign direct investment (FDI), defined by the productivity is positive. This implies that both domestic International Monetary Fund as a foreign firm taking at and foreign firms benefit from technology spillovers. least a 10% stake in a domestic firm. Foreign technology agreements (FTA), more ‘arm’s- Chawla’s research finds that liberalisation of the foreign length’ transactions in which a foreign firm enters into investment regime in India has significantly improved the partnership with a domestic firm. performance of manufacturing firms. This is surprising as the sample mainly consists of firms that compete at a The relative importance of the two components can be single stage of production. What seems to have happened gauged by the fact that in the post-reform period is that the policy of encouraging FTAs has had an effect (between August 1991 and January 2005 in this study), equivalent to technology spillovers, moving domestic firms the number of FDI projects approved by the Indian closer to the technology frontier, albeit through different government was nearly 19,000 and the number of FTAs means. approved was just over 7,600. Since the industries studied were simultaneously Unlike in many East Asian countries, Indian policy-makers subjected to both FDI and FTA liberalisation, it is not easy have resisted the temptation to offer subsidies to to distinguish between the effects of two policies. foreign investors (at least until very recently). Instead, To do this, the research looks in detail at the motor vehicle they have pursued a two-pronged strategy of inviting industry. It finds that in this sector at least, the two FDI from foreign firms as well as encouraging FTAs by elements of the foreign investment regime have been domestic firms. complementary in their positive impact on firms’ productivity. Previous research has shown that increasing FDI leads to greater competition in industries where firms compete India’s experiences are often compared with China’s, and with each other at a single stage of the production while the latter has attracted greater FDI inflows than the process. The effect of increased competitive pressure is to former since the early 1990s, India has attracted greater lower the mark-ups that domestic firms are able to portfolio investment and the ratio of market capitalisation charge, thereby reducing their measured productivity. of its listed firms to GDP has been higher. What’s more, Indian firms now invest so much abroad that FDI outflows This is typically not outweighed by any productivity almost match FDI inflows. benefits to domestic firms from observing and copying the techniques used by foreign firms – what are known as The fact that India’s foreign investment liberalisation treats ‘technology spillovers’. For firms in these industries to gain foreign technology and direct investment as inseparable is important here. Such a policy is bound to have effects beyond the simple enumeration of FDI inflow figures. At least one important implication of this policy is its positive India’s liberalisation has been successful effect on the productivity of manufacturing firms.

by its openness to both foreign Arunish Chawla is an occasional research investment and foreign technology assistant in CEP’s globalisation programme.

19 CentrePiece Spring 2008

Recent research by Nick Bloom – as well as research of an earlier vintage by Fed chairman Ben Bernanke – suggests that the impact of the credit crunch on uncertainty will lead to an economic slowdown much worse than we currently anticipate.