l Global Research l Special Report | 00:01 GMT 10 October 2012 Economic reform: The unfinished agenda Contents 1. Overview 2 2. Executive summary 8 3. Growth matters 14 4. Is there a consensus on reform? 25 5. Reform has slowed 35 6. Market implications 48 6a. FX 49 6b. Rates and credit 50 6c. Equities 53 Country studies 7. Brazil – In need of infrastructure 58 8. China – Pay households a decent return on their savings 63 9. Hong Kong – Public matters, private solutions 70 Highlights 10. India – Overcoming the infrastructure deficit 77 Economic reform is the key to sustaining strong economic growth in emerging 11. Indonesia – Infrastructure and countries and restoring it in developed countries. This report assesses progress bureaucratic reform 83 in recent years, identifies shifting views on the best ways to accelerate economic 12. Japan – Labour-market reform 89 development, and provides studies of 14 emerging and major economies. 13. Nigeria – Escaping the oil curse 94 The pace of reform has slowed in many countries, apparently due to a mixture of 14. Singapore – The search for total complacency, resignation, disillusionment with market-oriented reforms, and political factor productivity 101 resistance. This follows a „golden era‟ of reforms in the 1990s which brought 15. South Korea – Boosting the accelerated growth and improved living standards in many emerging countries. services sector 106 16. Sri Lanka – Improving the climate We estimate that failure to pursue vigorous reform is costing emerging countries for investment and trade 111 1-3ppt of GDP growth. Successful reforms could boost GDP per capita in 2030 by 17. Taiwan – Leveraging mainland an extra 20% in Korea, Sri Lanka and Taiwan, 40% in Brazil, China, Indonesia, China‟s rapid growth 117 Nigeria and Thailand, and 50% in India. 18. Thailand – Boosting labour productivity 123 While there is considerable agreement on the best way for countries to grow and prosper, there are also important disputes, notably on the role of the state and 19. UAE – Reversing the trend in state-owned enterprises. State-led development has become more prominent. labour productivity 128 20. United States – The fiscal policy In each country study we analyse one key area of reform which would have a challenge 134 major impact. Recurring topics are improving infrastructure, liberalising labour markets and implementing bureaucratic and fiscal-policy reform. Edited by John Calverley, +1 905 534 0763 [email protected] For markets, economic reform is usually a major positive, boosting returns and smoothing volatility by encouraging economic growth, lowering interest rates and attracting new investors. Markets often move early, responding to expectations for reform ahead of implementation. Important disclosures can be found in the Disclosures Appendix All rights reserved. Standard Chartered Bank 2012 research.standardchartered.com Special Report 1. Economic reforms – An overview Gerard Lyons, +44 20 7885 6988, Gerard [email protected] Countries need a vision of why The focus of this report is reform. The word `reform‟ comes up periodically to reform is necessary, why the pain is describe what economies need to do to address either short- or longer-term issues. worth bearing and what success But, it seems, at times of economic difficulty, the word is used on a more regular might bring basis. The current crisis in the euro area is a classic example of this. At a time of great anxiety about how events in the euro area will evolve, increasing pressure is put on the countries on the periphery to undertake reform. Yet reform can mean many things. Often it is used in general terms to refer to changes that need to be implemented to the so-called „supply side‟ of an economy, aimed at improving efficiency, productivity or competitiveness, or a combination of all of these. Then again, it could refer to reform of an important economic sector, whether be it health or education. Among the many challenges of implementing reform is that it can take time, with the benefits showing through after a lag. Moreover, some people may lose, not gain, from the changes that may be necessary for a particular reform to be implemented. In the UK, a former Chancellor is credited with saying that he stopped being in favour of tax reform when he realised there were losers as well as winners. Losers often make more noise and, particularly in a democracy, politicians find reforms do not always help in winning elections. Perhaps one lesson is that reforms should ideally be implemented when economic conditions are good, not bad. Alas, all too often – and as seen in the euro area now – change is made when things are not going well, thus making an impact at a time when people, firms or economies are not best able to cope. Another lesson, arising from this, is the importance of framing the case for reform. That is, there is a need for a longer-term vision as to why reform is necessary, why the pain of reform is bearable and what success reform may bring. Three major structural changes Deleveraging in the West Reforms need to take place against The world economy is currently undergoing significant structural change. In our view, the background of profound there are at least three big changes that need to be highlighted. The first is a structural changes in the world negative one, namely the overhang of debt and the need to deleverage in the West. economy It is difficult to determine exactly how long this may take; Western economies may be only halfway through this process. Although debt levels are high, it is important to stress that debt is not the only problem. Indeed, in some countries, debt is a symptom of a lack of demand and weak economic growth. There are many important lessons from the financial crisis that are worth bearing in mind in any paper on reform. The crisis has highlighted that it is important to identify and address the right problem at the right time. The way I would stress it is that two wrongs do not make a right. First, it was wrong to keep interest rates too low and governments to be running such high deficits during a boom. But it is wrong to think that the way to address this is through austerity and by reducing deficits when the economy is bust. At a time when the private sector is not spending, there is a need for the public sector to step in, and spend, particularly if it can raise money at cheap rates. (See Standard Chartered Global Insight, 30 June 2011, „The seven rules of fiscal policy‟). At the very least, austerity measures need to be well-timed and 10 October 2012 2 Special Report 1. Economic reforms – An overview implemented gradually, responding to changing circumstances. But it is also important not to hide from addressing the need for reform, whether of the banking system, or of the pension system, two important areas of reform in the West. The structural changes the Western economies are undergoing not only leave many of them vulnerable to further economic shocks, but also make it hard to address some of the reform issues now. In this report we leave Europe alone and focus mostly on the so-called emerging economies. We also look at the US and Japan. I say `so-called‟ emerging countries because the term `emerging‟ has outlived its usefulness. And yet, it is still the commonly accepted term. We think that looking at countries on a region-by-region basis can often be more useful, accepting that there are big differences within regions, as well as between regions. The rise of emerging markets Emerging markets are stronger and As a group, emerging economies are not decoupled from events in the West. Indeed, better diversified than ever before, ahead of the crisis, one of our catch-phrases was "emerging economies are not but not decoupled from events in decoupled, but better insulated". So it proved. They were not immune to fall-out from the West problems in the West, but they had room for policy manoeuvre to respond and rebound. After the global recession of 2009, emerging economies helped drive about two-thirds of the pick-up in global growth in 2010, and have played a dominant role since. But they are still not decoupled, as the recent slowdown in exports testifies. However, we would now say that they are "not decoupled, but better diversified". This diversification reflects some structural changes across the emerging world, such as rising domestic demand as the middle class emerges, and increasing South-South trade – which we have often referred to as New Trade Corridors – involving increased flow of goods, commodities, remittances, people, and portfolio and direct investment between emerging countries. This leads directly to the second big structural shift impacting the world economy now. In 2010, we released a publication called „The Super-Cycle Report‟. The aim of this report was to highlight one of the major structural changes which we believed was already underway, namely the shift in the balance of economic and financial power from the West to the East. At a time when the world economy was facing great uncertainty and there was widespread caution about immediate prospects for the West, we felt it was important to stress some of the underlying changes. Yet, it is important to highlight that this does not mean that emerging economies will keep growing and that the outlook is always rosy; far from it. As we have emphasised, the business cycle exists in China and India, as it does elsewhere. Also, the trend in emerging economies may be up, but one should expect set-backs along the way.