Volume4 Number1 November 1998 - JICA Research Institute

2 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise ReformA. Asset ManagementB. "Misappropriation" in the Case of China's SOEsC. Changes in ControlIV. Decentralization and Sectoral OwnershipA. Decentralization and Sectoral "Capture"V. ConclusionReferencesINTRODUCTIONIn the complex process of economic development, proper design of macro- and micro- economicorganizations has assumed growing importance in recent years. Such organizations do not simplyimply a function mapping inputs to outputs in the Arrow-Debreu general equilibrium model, butrather comprise numerous economic players with differing objectives, and are characterized bya complex internal structure and external relationship with other organizations. One importantexample of such economic organization in development is the government. Besides being aneconomic organization itself, the government plays a coordinating role by selecting the properequilibrium from the equilibria generated by strategies of various economic players. 1Among the non-governmental economic organizations, the firms or enterprises play anextremely crucial role in economic development. In this paper, examination has accordinglybeen focused on the enterprise and its function. In particular, our interest is directed at the degreeto which the nature of the enterprise is linked to the initial conditions and past course of thatcountry's development.In examining the issue of economic organizations in economic development, China's SOE(state-owned enterprises) reform provides an excellent reference. The primary reason for this isthat the Chinese economy is in a transitional phase, and up to very recently has been managedunder socialist planning regime. The majority of SOEs which emerged under this planningregime were thus artificially designed and implemented. Secondly, China is a developing countrywith limited experience of a market economy generated with enterprise sector prior to the periodof planning economy. Accordingly, conditions are such that a sufficiently mature market economyThis is the revised version of the paper "Decentralization and Local Capture in China's State-ownedEnterprise Reform", presented at a workshop during the World Bank–Japan Research Fair held on December12, 1997. We would like to acknowledge extremely helpful comments from various World Bank staffparticipants in the workshop including Aart Kraay, Joseph Stiglitz, Lexin Colin Xu, and Shahid Yusuf. Inthe East Asia SOE Reform Study research project which served as a basis for this manuscript, numerouscontributions including provision of data were made by the staff of the Institute of Economics of the ChineseAcademy of Social Sciences. In particular, extremely helpful consultation was received from Yuan GangMing throughout the duration of the study. Assistant Professor Midori Kizaki of the Economics Department,Yokohama National University and Ken'ichi Imai of Institute of Developing Economies were indefatigablein their efforts in the project. In processing data, Masayuki Tachiiri participated as a very capable researchassistant. Finally, special thanks is extended to Professor Emeritus Shigeru Ishikawa of HitotsubashiUniversity and Aoyama Gakuin University for his continued and highly valued guidance during manuscriptdrafting, as well as in the course of the above workshop and other study phases leading up to the authoringof this paper.1 In Wada (1995, 1997), we discussed overall framework, government role, etc. with regard to theissue of organizations in economic development.

OECF Journal of Development Assistance Vol.4, No.1, 1998 3with modern enterprise institution will not readily evolve naturally, but rather there remains theneed to establish an appropriate firm structure to achieve this. And thirdly, China is confrontedat present with the absolute necessity of designing and creating a viable organizational form ofthe firm in order to launch a market economy.China's economic reform since 1978 has generated surprisingly high economic performance,while leaving many puzzles in its economic structure unknown. The most controversial issuesare those of rapid expansion of Township and Village Enterprises (TVEs) and the performanceof the state sector, especially its industrial SOEs. Toward these issues, there have been manyefforts to solve these puzzles. Regardless of these efforts, we have not seen any convergence ofdiscussion on China’s SOE reform, and more broadly, on state sector reform in economies intransition.This paper is one of such efforts trying to resolve the puzzle of China's SOEs. Focus of ourquestion can be summarized to the following three sets of questions.a) Factual level: Is performance of China's SOEs good or bad? Has their productivity improved?How bad is the decline of profitability of SOEs reported recently and if it is the case, inwhich sector or region the profitability has worsened?b) Analytical level: Admitting the fact reported by many literature that productivity of China'sSOEs have improved after the reform and that their financial performance has beendeteriorating, what is the relationship between them? Can we logically understand suchrelationship?c) Theoretical level: What is the major character of China's SOE reform? Is it different fromthe privatization strategies taken by the CEE and the FSU countries? Why has the differencebeen generated? How can we explain it theoretically, especially by the theory of the firmadvanced recently?To find the answers for such questions, we conducted a comprehensive SOE survey inChina ( 800 firms) by joint research with researchers from Institute of Economics, ChineseAcademy of Social Science (CASS). This paper is a product of such effort to investigate the SOEreform in China, whose economy has both transitional and developmental aspects of the reform.Our intention is to find a framework which can explain the SOE reform in such countries. 2A. State-Owned Enterprise Reform in Transitional EconomiesAs noted above, our analysis consists of three levels, factual level, analytical level, and theoreticallevel. An efficient algorithm to solve these three levels of problems seems to be a recursive one,solving the problem from theoretical level to factual level. Therefore, we first review briefly theexisting literature on SOE reform or on SOE privatization in economies in transition.2 This work is significantly inspired and influenced by the seminal work of Ishikawa (1960, 1997).Ishikawa (1997) proposed a staging approach to the analysis of China's SOEs. We do not propose theapproach in this paper, but the view expressed in this paper can be taken as an re-interpretation of Ishikawa’sapproach.

4 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise Reform1. Fiscal / Property Rights ViewThe first view taken by the existing literature on SOE reform in economics in transition is a viewtypically expressed in the World Bank's "World Development Report 1996". The view of thisreport was summarized in the introductory part of the chapter, "Property Rights and EnterpriseReform". To quote:"Transition requires changes that introduce financial discipline and increase entry ofnew firms, exit of unlivable firms, and competition. These spur needed restructuring,even in state enterprises. Ownership change, preferably to private ownership, in alarge share of the economy is also important. Once markets have been liberalized,governments cannot indefinitely control large parts of a dynamic, changing economy.Decentralizing ownership is the best way to increase competition and improveperformance." (pp. 44) (emphasis added)The view expressed here is that financial discipline, competition, private ownership, anddecentralization of ownership are the essential elements in SOE reform, or more broadly, intransition. For our convenience, we call this view as the "fiscal/property rights view".In WDR96, a procedure for preparation of privatization of SOEs is mentioned along thisview. The first step required for the preparation is hardening of budget constraint. Using the termin the report, financial discipline, which calls macroeconomic stabilization and termination ofsubsidy, is the most urgent measures to pave the road to privatization. The second step pointedout in the report is the establishment of property rights. After enough financial discipline andwell-defined property rights has been established, privatization can be implemented smoothly.The report recognized that the main difficulty in privatization lies in the transfer of managerialauthority of SOEs from state or collectives to private sector. This is not a mere transfer ofownership, but construction of a mechanism in which the ultimate authority and the responsibilityof management are supposed to be shouldered by managers. Especially, construction of "corporategovernance" mechanism, which is a part of corporate "property rights", is stressed. It exemplifiesthe difficulty by comparing several ways of privatization, such as direct sale, MEBO, voucherprivatization, and spontaneous privatization from the view point of fairness and feasibility.One of straightforward conclusion derived from the view is that China's SOE reform willsooner or later face a severe problem of public ownership if China fails to establish a mechanismof corporate governance under well defined property rights.2. Incentive ViewThe second view, which we call as the "incentive view", is particularly expressed by McMillan(1996). This view can be typically found in the following sentence."The transition economies, in particular China, show the incentive effects ofownership are not straightforward. Changes in contracted rights but not in ownershiphave brought big performance gains. And the boundaries between public and privateownership have been blurred." (pp.224) (emphasis added)

OECF Journal of Development Assistance Vol.4, No.1, 1998 5The main difference of the "incentive view" from the "fiscal/property rights view" is therecognition of importance of incentive effect of management. In this view, performance of SOEs isnot in a simple outcome of company's ownership pattern. Alternative mechanism, such as contractmanagement responsibility system in China, can work to achieve good performance of SOEs.In McMillan's paper, many aspects of SOE reform are touched upon, such as restructuringof the existing firms, internal incentives, behavior of people and incentives, selection of managers,capital market discipline, product market competition, market information, and property rights.At the heart of analysis of the incentive problem of SOEs, a mathematically sophisticated principalagentmodel is used. Here we omit mathematical exposition of principal-agent model, but theessence of the model lies in a commitment effect 3 of principal, which is often assumed to begovernment or planning departments, and in informational asymmetry between principal andagent such as moral hazard or adverse selection. The agent, which is often assumed to be an SOEmanager, has informationally advantageous position and collect informational rents, which theprincipal wants to extract. 4 The principal has to design an efficient mechanism to minimize suchinformational rents and maximize his utility function.A straightforward application of the incentive view to China's SOE reform is that elaborationof incentive system had worked in China. But the limitation of the incentive view is the boundarybetween government and enterprises. As Coase pointed out, the boundary of SOE is not clearenough to separate government and SOEs.These two views, the property rights view and incentive view can be used as complements,not substitutes. But for our analysis of China's SOEs, a problem will occur if these two viewswill not be able to explain the China's SOEs completely. In other words, we think that there is a"residual" which can not be explained by these two views. The theme of this paper is to explorethe possibility of finding the residual.B. Studies of China's State-Owned Enterprise ReformThere seem to be three approaches to the studies of China's SOE reform in economics. In theEnglish literature, the studies can be classified by two approaches such as empirical approachand theoretical approach (a comprehensive survey of the English literature was Jefferson andRawski (1994)). In Japan, there are many studies of China's SOEs (unfortunately most of themare in Japanese), which can be classified as descriptive approach. 5 We think that all of them areuseful and complementary for our analysis.1. Empirical ApproachThe earliest empirical research was started by the World Bank staff. Based on interviews with 203 Using the jargon in the field, "commitment" refers to the use of game-theoretic structure in Principal-Agent model. A sub-game perfect or other "sequential" equilibrium concepts are often exploited.4 Aghion and Tirole(1997) defined "formal" and "real" authority and control rights by a principalagentmodel. Since the field is still expanding, the distinction between the property rights theory and theincentive theory in modeling is not clear enough.5 Of course, there are several exceptions. Otsuka, Ryu and Murakami (1995) was one of suchexception. They conducted an econometric analysis of China's SOEs, using the data from the State StatisticalBureau.

6 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise ReformSOEs, this World Bank study, jointly conducted by CASS, provided many insights for pricingreform, status of planing, degree of autonomy, and situation of product market in early 1980. Inearly 1990s, a path-breaking empirical study appeared. The study conducted by CASS, Universityof Oxford, University of Michigan(later University of California, San Diego joined), funded bythe World Bank and the Ford Foundation, is the most important contribution to the field andincluded a comprehensive treatment of data gathered from 800 SOEs (the CASS sample). 6 Thereare many empirical works using the CASS sample. Groves et al (1994,1995) econometricallyestimated incentive effect of the reform. Hay et al (1994) constructed a model of behavioralequations of China's SOEs from the CASS data. More recently, Xu (1997) used the CASS samplefor an analysis of agency problem between government and SOE managers under Contract(Management) Responsibility system. 7Another line of research was estimates of TFP growth in China's state sector. Jefferson,Rawski and Zheng (1996) summarized the debate over TFP growth of China's state sector. In theseminal works of Jefferson and Rawski, they reported TFP growth of state sector. Their resultseems robust even if there are opposite results reported by the other authors. However, theyposed a big question regarding the increase in productivity.2. Theoretical ApproachTheoretical approach to the studies of China's SOE reform largely follows two views mentionedabove, the fiscal/property rights view and the incentive view.The fiscal/property rights view to China's SOE is prevailing. One of such example is Wong,Heady and Woo (1995). Their analysis starts from tax treatment of enterprises, and finds that thewage fund of SOEs was soared by the incentive-oriented Contract Responsibility system. Tocontrol such overconsumption and overinvestment, they propose a conversion of the incentive systemand the institutional constraints into more ownership-oriented mechanism, such as corporations.Simultaneously, they stress the importance of separating social services from SOEs.From the perspectives of well established fiscal policy and property rights, the problems ofChina's SOEs lies in the "formal" relationship between the SOEs and the government, such ascorporate tax system. China's SOEs are inefficient because of existence of burden of social security,housing, schools and hospitals. Most of these studies emphasizes the importance of problems intaxing and social securities.The incentive view to China's SOE is represented by McMillan and Naughton (1995). Theypoints out two incentive mechanism worked to improve formally inefficient SOEs. One is the changein internal incentive mechanism. Contract Management Responsibility system is the most famousmechanism. Another is strengthening of external incentives. As many authors pointed out, an increasein competition is complementary to such incentives. In this view, China's SOEs improved itsperformance measured by TFP because of strengthening of internal and external incentives.6 Our survey of SOEs largely follows the approach taken by the CASS sample. Contents of theCASS sample was summarized in the work of Dong(1995). The CASS sample covered industrial production,production cost, wage table, labor table, production time, investment items, profit table, balance sheet,distribution of profit, other related tables, totaling 321 items. Our survey included about 150 items in ourquestionnaire.7 Li (1997) offers another study measuring the impact of reform on TFP in China's SOEs by usingthe CASS sample.

OECF Journal of Development Assistance Vol.4, No.1, 1998 73. Descriptive ApproachThere are vast documents and papers for analysis of China's SOE reform in Japan. Most of theseliterature use data and information from Chinese papers, interviews, and other various routes.They largely deal with facts accumulated from such research efforts and we think they form abasis for our study of China's SOE reform. This approach, which we call "descriptive approach",incorporates rich amount of information and thinking by nature, often lost by econometric worksand mathematical modeling, at the expense of logical consistency and generalization. We wouldlike to fully utilize the diversity of such literature in our analysis and view that this approach isalso complementary to both empirical and theoretical approaches.4. Comprehensive ApproachThe objective of our study was to provide to the extent possible answers to the issues discussedabove. Specifically, a comprehensive approach was adopted which pursues study in three directions(albeit by methodology at a very preliminary stage), i.e. descriptive compilation of existing factsand figures, statistical analysis, and analysis from economic theory. On this basis, the ultimateobjective is that findings and recommendations of the study provide a meaningful referencepoint in the formulation of government policy.Plan of this paper is as follows. In the next section, we begin analysis at the factual level,fully utilizing survey results and census findings. Of particular importance here is the productivityanalysis and financial analysis. In section II, a more detailed analysis of cost data is carried outin order to achieve a comprehensive understanding of the findings of study in section I. Next,section III and IV are devoted to detailed examination of the results of the foregoing from thestandpoint of both incentives and property rights. In terms of incentives, the manner in whichmanagerial autonomy is granted is an extremely important issue. With regard to property rights,the manner in which management personnel are appointed, and the way in which control overmanagement is exercised within the corporate governance framework are crucial. In section V,an attempt is made to grasp, from the standpoint of decentralization of authority, those issueswhich cannot be understood solely in terms of incentives and property rights. On this basis,consideration is then given to the impact of and preconditions for decentralization. Conclusionsare presented in the final section.A. Productivity AnaysisI. FINDINGS FROM THE DATA SETS:PUZZLE OF CHINA'S SOESOur analysis begins with identification of the status which China's SOEs have occupied in industrialproduction (including a portion of mining, power generation and other related public projects) inthe Chinese economy. Fig. 1 indicates the proportion of total domestic production of SOEs. Inthe first half of the 1990s, total production in the state sector continued to show gradual growth.This growth, however, gradually tapered off to a point where a minus down-turn began in 1996.

8 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise ReformAlso, the share of total production of the state sector in comparison to other forms of ownershipdropped to 34% (roughly one-third) in 1996. This drop in share has been particularly marked inthe 1990s, and reflects expanded production by enterprises under other ownership forms (private,foreign, joint venture, etc.) as a result of large-scale direct investment from the foreign companiesstarted in this decade.Source: Chinese Statistical YearbookFig. 1 Trends in Gross Production Value by Type of OwnershipIt can be inferred that the importance of the state sector has declined from the standpoint ofproduction. The fact most studies conclude that in the coming years the state sector will continueto shrink, with collectively ownership and private sector enterprises taking the dominant role inproduction, is a result of this long-term trend. However, such an extremely simplistic predictionis not meaningful. It is essential that we consider the manner in which the state sector willcontinue to shrink, as well as new issues which will result from such shrinkage. Nevertheless,since our survey data is limited to the SOE sector, this study cannot effect a comparison betweenproductivity of the state-owned and non-state sectors. This issue is left for a future study.Although the importance of SOEs in Chinese economy has declined in relative terms, totalproduction of the state sector itself exhibited growth (albeit low) until 1996. This applies to theSOEs surveyed under our study as well. Overall, real (total production value at 1990 prices)industrial production by SOEs increased in the first half of the 1990s. Region-wise, productionlevel of SOEs in Sichuan province increased 1.5 fold during the period 1990~1995. Sector-wise,machinery production by SOEs in the same province showed marked growth in the 1990s.Next, let us take a look at production trends on an enterprise scale-wise basis (large, medium,small). In the case of our samples, no major difference in production trend by enterprise scale isseen; noteworthy, however, is the tapering off in recent years of production by medium-size enterprises.Production conditions can also be estimated from factory operating ratio. The distributionof operating ratio by region and by industry sector shows values in the 60% to 80% range.Overall, there is no indication of a decline in operating ratio up to 1995, and worsening of

OECF Journal of Development Assistance Vol.4, No.1, 1998 9productivity accordingly cannot be discerned on the basis of the said operating ratio.1. Capital and LaborIn relation to increased production, trends in numbers of labor and net fixed asset 8 for sampleSOEs are as shown in Table 1. Shown in Table 1, number of labor has declined since 1994.However, in the case of net fixed assets, growth has exceeded that of the nominal gross industrialproduction. Since the deflators to convert nominal gross industrial production and net fixedassets into real values are different, only an approximate comparison can be made here; however,it appears possible that although labor productivity increased after 1994, capital productivity mayhave declined.Table 1SOE Capital and Labor(10,000 yuan; persons; %)No. ofsamples1991 1992 1993 1994 1995Overall net fixed asset 795 2,166.31 2,459.24 3,162.64 3,826.64 5,193.80(Growth rate) 13.5 28.6 21.0 35.7Reference: Nominal production growth rate 20.9 31.0 16.2 11.6No. of labor 795 1,316.82 1,332.91 1,353.64 1,345.30 1,341.84(Growth rate) 1.2 1.6 -0.6 -0.3Region-wiseJilin: Net fixed asset 210 2,209.07 2,441.41 3,287.13 3,789.65 4,953.77No. of labor 210 1,182.66 1,189.89 1,193.89 1,173.25 1,180.76Sichuan: Net fixed asset 200 2,053.66 2,291.51 2,807.63 3,372.44 4,208.35No. of labor 200 1,401.05 1,418.92 1,465.59 1,441.44 1,447.07Hunan: Net fixed asset 200 2,385.52 2,729.70 3,177.25 4,557.38 6,210.88No. of labor 200 1,403.89 1,440.06 1,449.44 1,475.85 1,437.99Jiangsu: Net fixed asset 185 2,001.97 2,368.41 3,390.06 3,569.69 5,432.07No. of labor 185 1,283.92 1,286.43 1,310.41 1,295.54 1,306.99Source: Survey findings under this studyThe rapid growth in net fixed asset implies continued active investment in SOEs. On theother hand, the number of labor in SOEs has declined since 1994. These two facts imply asomewhat contradictory situation with regard to the surveyed enterprises in terms of activeinvestment and labor restructuring.A look at trends in fixed assets and number of labor on a scale-wise basis shows a largedifference in average fixed assets, with that in the case of large enterprises being around 4~5 foldthat of medium enterprises and over 10 fold that of small enterprises. Although not quite asgreat, the number of labor also shows a considerable variation with that for large enterprisesbeing around 3 fold the number for medium enterprises and roughly 9 fold that of small enterprises.From this, it can be concluded that large enterprises tend to be relatively capital intensive, whilesmall enterprises on the average are more labor intensive. In the case of all sizes of SOE, growthin number of labor has either been gradual, or has shrunk as in the case of small enterprises.8 Net fixed asset is computed by subtracting depreciation (cumulative) from the fixed asset.

10 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise ReformGrowth of net fixed assets shows a reverse growth trend with the asset value of small and mediumSOEs exhibiting sharp increase after 1994. This sharp increase is believed to have been influencedas well by the asset re-evaluation carried out in 1994.In the study of Otsuka, et al, real values for capital stock in the steel sector (p. 76 of theirreport) was estimated by taking figures for nominal production fixed asset value, and thebreakdown of the same in the form of nominal machinery and equipment value and nominalfactory building value (under our study these correspond to production management fixed assetbase cost, and machinery and equipment value, respectively), and dividing these by ex-factoryprice indices from industrial production plants and construction material manufacturing plants.In the case of China's SOEs, it is reported that much of the labor force is not directly engaged inproduction. For example, research (by the above mentioned Jefferson, Rawski and Zheng (1996))which carefully gauges productivity in the China's state sector adjusts production labor statisticsby eliminating from employment data personnel within the SOE who are engaged in service.In the case of our data as well, the same type of adjustment can be performed. For example,the average number of labor per single enterprise for the sample SOEs in 1995 is 1,341.8 persons.Of this number, the total persons (management personnel, technicians, and workers) actuallyengaged in production is estimated at an average 1,197.5. The remaining 114.3 persons (8.5% ofthe total labor force) are thus considered not to directly participate in production activity.When calculated solely in terms of the personnel directly engaged in production, numberof labor per enterprise peaked in 1993, and subsequently declined in 1994 and 1995. In contrastto this, number of layoffs increased. In terms of region-wise layoffs, the situation was mostsevere in Hunan province where number of layoffs per enterprise exceeded 50 in 1995. Inoverall terms as well, there is indication of a sharply growing number of layoffs despite increasein production.2. Total Factor Productivity AnalysisWith regard to SOE reform in China, the existence of SOE "inefficiency" (in other words, whetheror not SOE productivity has improved as a result of reform) in the absolute term is a point ofargument. As reference has been made to this argument at the outset of this paper, we would likehere to focus our discussion on productivity analysis of SOEs applying our data. Efficiencyanalysis in this case signifies Total Factor Productivity analysis. To begin by introducing theconclusion we reached in this light, Total Factor Productivity exhibited growth with the exceptionof data for 1994~1995. In other words, the efficiency of SOEs has improved. Total FactorProductivity in 1994~1995 declined despite labor cuts, and underlying this was the presence ofaggressive fixed asset investment.Zhang (1997) verified Total Factor Productivity of China's SOEs based on our data. Theregression analysis assumes the Cobb-Douglas production function Y = AK α L β M γ e u (where: Yis the production; A is the constant term; K is the net fixed asset value; L is the number of labor;M is the intermediate input value; u is the error term; and α, β, and γ are the production elasticityparameter.) Regression is performed by means of the logarithmic form lnY = lnA + αlnK +βlnL + γlnM + S tT t+ u, incorporating the technological improvement term T. By this function,Total Factor Productivity is expressed as TFP = y - (αk + βl + γm) (y, k, l, and m indicate thegrowth rate for each of those variables), and the contribution by each production element becomes

OECF Journal of Development Assistance Vol.4, No.1, 1998 11TFP/y, αk/y, βl/y and gm/y. Results are indicated in Table 2. According to these, with theexception of 1994~1994, the prior period shows growth in Total Factor Productivity reaching3.5% over the period 1991 to 1995.Table 2Estimate Results for SOE ProductivityCoefficient(t value)L K M T 92 T 93 T 94 T 95Constantterm0.20(10.2)0.24(14.9)0.56(48.4)0.08(2.2)0.10(2.9)0.12(3.4)Note : After adjustment, determinant coefficient is 0.8, and number of samples is 702Source: Zhang (1997)0.07(1.9)0.82(11.4)In terms of t value for each variable, and the determinant coefficient (F value) of theregression formula, the above estimation is concluded to have sufficient statistical meaning. Theproduction output elasticity value for intermediate inputs is high compared to that for labor andcapital. Furthermore, the term for technological improvement (constant term Ti) is in all cases apositive value, indicating a rise in productivity.Although showing gradual braking, production output has increased overall at anextremely fast pace (average of 7.7% for the period 1991~1995). This rapid growth ismainly the result of capital increase and improved productivity (average contribution ratioof 46% for the period 1991~1995). In contrast, labor force shows little effect. The capitalgrowth rate continues to accelerate and maintain a high level, with a commensurate rise incontribution (reaching 91% in 1994~1995). Although productivity shows a dispersed trend,it has risen overall an average 3.5% with a high contribution as well. In the case of fiscalyears with significantly high capital growth (1992/93, 1994/95), rise in productivity waseither low or negative, implying that excessive investment served to pull down productivity.Growth rate for production output varies depending on the sector, with the petrochemical andmachinery manufacture sectors showing particularly significant growth. This was supported bycapital growth and increased productivity, the latter exhibiting a sharp rise in comparison to othersectors. Depressed sectors were textiles, and construction and building materials. These experiencedsluggish capital growth compared to other sectors, and feature low output elasticity values in relationto capital as well. Increase in productivity for these sectors is also relatively low. Labor trends showlittle change among sectors, while capital has rapidly increased regardless of the sector. However,in the case of sectors where capital growth has been too rapid (metallurgy, food products · processing),productivity has dropped indicating again the adverse impact of excessive investment.B. Financial PerformanceIn this section, we will take a look at the issue of financial performance, generally reported to bea serious problem confronting China's SOEs.Firstly, let us examine the latest census data in order to ascertain deficit conditionsaffecting these enterprises. According to information of the State Statistical Bureau, some

12 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise Reform5,900 (roughly 40%) out of a total of 14,800 large industrial enterprises experienced deficitas of the end of 1996. In the case of small industrial enterprises, 26,220 (37.7%) out of69,500 were operating in the red. In this light, the enterprises sampled under our surveyexhibit overall a slightly more rapid deterioration than the national average; however, thesesampled SOEs are still concluded to present a reasonable picture of the nation-wide situationaffecting SOEs in this regard.Table 3 shows the trend in average figures for production value, total sales, and profittotal value for the surveyed SOEs over the period 1991 to 1995. During the said period, thesurveyed SOEs exhibited a continual decline in profit value beginning from the point inJuly 1993 when the Chinese economy experienced down-turn from expansion to tightening.The total figure for after-tax profit subsequently shows a minus value for 1995. 9Table 3Production Value, Sales Value and Profit Value for Surveyed SOEs (enterprise average values)(10,000 yuan, %)1991 1992 1993 1994 1995Industrial production (1990 price) 5,262.00 5,552.79 6,195.42 6,636.49 7,507.23(Growth rate) (5.5) (11.6) (7.1) (13.1)Industrial production (nominal) 4,774.23 5,775.46 7,563.94 8,794.02 9,837.62Product sales (nominal) 4,535.49 5,385.69 7,520.02 7,372.93 8,774.69Sales profit (nominal) 432.49 215.99 868.07 1,253.98 1,290.56Total profit (nominal) 83.21 192.75 187.38 169.73 11.61Profit after taxes (nominal) 39.74 92.81 131.65 97.25 -52.52Source: Survey findings under this studyAmong the sample SOEs, sharp decline in performance is a serious problem confrontingthose enterprises whose original performance was not at a good level to begin with. When the796 sample enterprises are grouped into four on the basis of performance, the worst one-fourthof these experience a sharp increase in deficit after 1993. At the next grouping level, enterprisesare operating at a border-line deficit. Geographically, this decline in profit rate is particularlymarked in the northeast region of the country (Jilin province, etc.). Sector-wise, significantdecline continues to be observed in the textile and machinery manufacture industries which havetraditionally been an SOE mainstay.Specifically in the case of the sample SOEs , the share of deficit enterprises dropped from 25%in 1991 to 21.7% in 1992. After that, this share shifted to an upswing at 33% in 1993, 40.5% in 1994and 45.1% in 1995 (in this year 356 out of the total 796 surveyed SOEs were thus operating in thered, which exceeds the national average). Table 4 shows the composition of deficit and profitenterprises. From this it can be seen that almost 60% of enterprises alternately exhibited deficit andprofit depending on circumstances from year to year. However, it should also be noted that some33% of the subject enterprises have continued to show a profit over the 5 year survey period.9 Under our study, SOE financial data is computed on the basis of the new accounting system (PRCEnterprise Accounting Standards, November 30, 1992; financial sector stipulation no. 5). (Also, wage andcapital related data has been collected in addition to accounting data).Sales profit = product sales - (sales base cost + marketing cost + sales tax and surcharge)Operating profit = sales profit + other business profit - (administrative cost + financial cost)Profit total value = operating profit + (investment income + extra-operating income) - extra-operating expenditure

OECF Journal of Development Assistance Vol.4, No.1, 1998 13Table 4Conditions of SOE Total Profit(No. of enterprises, %)No. of enterprises5 years continuous profit 264 (33.2%)5 years continuous deficit 58 ( 7.3%)Deficit and profit 474 (59.5%)Performance improvement each year 37 ( 4.6%)Performance decline each year 20 ( 2.5%)No change in performance each year 739 (92.8%)Next, let us examine theseSOEs in terms of ratio of total profitto total sales. Fig. 2 presents a graphof the simple average for this ratio(simple average computed from theratio values calculated for eachenterprise) on a province-wisebasis. As can be seen from thegraph, the ratio of total profit to totalsales for SOEs shows particularlyevident deterioration in the case ofJilin province. In terms of overallaverage as well, a continuousdecline is seen subsequent to theslight improvement achieved in1992. In Table 5, overall profit forthe sample SOEs is a plus figure;however, this is due to the presenceFig. 2 Average Ratio of Total Profit to Total Salesfor SOEs (region-wise)of a portion of high performance, highly profitable enterprises. In contrast, the high number ofsmall to medium enterprises which operate in the red causes the simple average for profitabilityto continue to be a negative value.In terms of sector-wise trend in the ratio of profit to sales (Fig. 3), public utility enterprisessuch as power, coal and water supply show erratic up and down behavior as a result of the impactof pricing policy by the government. Other sectors show an overall downward trend.Next, let us take a detailed look at enterprise profitability based on various categorizationsof data. Firstly, there is the categorization corresponding to the government entity (central orlocal) with jurisdiction over the SOE. According to our data, of the four types of jurisdiction (i.e.central government, provincial government, municipality and county · prefecture), SOEs underprovincial government jurisdiction exhibited the highest proportion of deficit enterprises.

14 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise ReformTable 5Average Ratio of Profit to Sales of State-owned Enterprises in China(Unit: %)1991 1992 1993 1994 1995Average of all enterprises -1.8 0.1 -7.1 -8.7 -13.8By regionJilin Province -0.4 -1.5 -20.5 -15.7 -30.3Hunan Province -1.9 -0.4 -7.2 -15.3 -12.7Sichuan Province 0.6 1 -1.2 -2.7 -8.7Jiangsu Province -5.8 2.4 1.9 -0.1 -1.7By industryMetallurgy 1.0 3.0 3.1 -3.5 -10.6Electric power, coal, water supply -41.7 -16.9 -55.6 -26.0 -27.6Petrochemicals 3.9 2.1 -2.0 -3.7 -5.4Machinery -3.0 1.2 -3.6 -5.1 -14.7Construction and building materials -1.4 4.0 2.4 -4.7 -11.0Food processing 2.6 1.7 0.2 -3.4 -5.3Textiles and spinning -12.6 -9.5 -20.5 -34.2 -33.7Printing and others 18.7 0.8 -32.4 -16.5 -19.5Average* (excluding electric power, etc.) -0.3 0.7 -5.3 -8.1 -13.3Note : The profit ratio to sales is calculated for individual enterprises, and its arithmetic average is obtained.Financial situation of China'sstate-owned enterprises(by industry)20100-10-20-30-40-5019911992199319941995Printing and othersTextiles and spinningFood processingConstruction and building materialsMachineryPetrochemicalsElectric power, coal, water supplyMetallurgyAverage* (excluding electric power, etc.)Average of all enterprisesFig. 3 Average Ratio of Profit to Sales of State-owned Enterprises in China (by industry)Of the sample SOEs under our survey, 83 enterprises are under the jurisdiction of thecentral government. In all cases, these are large enterprises exhibiting the largest total profits inthe first half of the 1990s. In other words, it can be said that this type of SOE provided themainstay for public finances. However, the proportion of deficit enterprises among these doubledover a four year period to account for 40 enterprises out of the total of 83. Among these, there arenumerous enterprises which show continued good performance over the said four year period,while at the same time a considerable number experienced continued deficit for the same period.

OECF Journal of Development Assistance Vol.4, No.1, 1998 15From this fact it can be seen that a divergence in performance of SOEs under central governmentjurisdiction is beginning to occur.Next are enterprises under the jurisdiction of the provincial government. Although theseoverall show profitability in the plus column, this group as mentioned above exhibits the largestproportion of deficit enterprises. Enterprises under municipality jurisdiction account for 60.4%of the total SOEs sampled; however, total profit generated by these showed down-turn to anegative figure in 1995. Although the specific proportion of deficit enterprises has increased inthe case of SOEs under county · prefecture jurisdiction, overall profit of this group has exhibitedimprovement with the exception of 1995.A look at the profitability of SOEs in terms of enterprise scale reveals that large SOEsshow better profitability and ratio of deficit enterprises than small and medium SOEs. Also, theratios of enterprises exhibiting continued improved performance as well as continued decline inperformance have increased in both cases for large SOEs. However, average profit for thisgroup peaked in 1993, after which it has declined. One can understand from this why a primarytarget for SOE reform is the poorly managed large enterprises. Specifically in terms of deficitconditions, medium enterprises exhibit the most serious situation.In terms of SOE profitability by sector, three sectors in particular, i.e. the petrochemical,machinery manufacturing and construction materials industries, have taken a downwardturn to deficit operation in recent years. A sector which has generally been in the red fromthe outset is the spinning · clothing · leather goods industry. In contrast, the public utilities(power, etc.) sector, metallurgy industry and food products industry operate overall in theblack. In terms of ratio of deficit enterprises, however, the proportion of these has increasedregardless of the sector. Particularly with regard to the metallurgy and spinning · clothing· leather goods industries, roughly half of the enterprises belonging to these two sectorsunder our survey were operating at a deficit in 1995, indicating the severity of conditionsin these sectors.Next, let us examine SOE profitability in terms of the period of SOE establishment. In thisregard, only those enterprises established prior to 1949 show overall profit in the plus column.In contrast, even new SOEs established after 1990 exhibit a high proportion of deficit enterprises,as well as a high average deficit value. This study finding, whereby older enterprises perform atbetter profitability, runs completely counter to the conventional thinking that overall deteriorationin SOE financial performance is primarily due to problems of aging equipment and the increasingburden over the years of social welfare responsibilities as confronted by the older enterprises.Given this fact, it becomes necessary to seek a different explanation for profit distribution basedon period of enterprise establishment.Finally, in terms of profitability on a province-wise basis, Jilin province in the northeastregion of the country shows the poorest performance. From the standpoint of overall profit,Sichuan exhibits a lower figure than Hunan province; however, when viewed in terms of theratio of deficit enterprises, the latter is characterized by a marked decline in SOE performance.In the case of Jiangsu province, average SOE profit is in the black and proportion of deficitenterprises is relatively low at 25.3%.

16 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise ReformC. Performance Gap of SOEsThe production performance and financial performance of SOEs has been evaluated. Next, wewill focus on the gap between production performance (which although experiencing a declininggrowth rate, still exhibits continued improvement in Total Factor Productivity), and thesignificantly deteriorating financial performance of SOEs. This is a long-standing puzzle onChina's SOEs.This performance gap has been cited under a number of studies to date. Perception amongChinese economists of the problem of gap in production and financial performance can be dividedinto two, i.e. (i) interpretation to the agency problem as a result of the interplay between thegovernment and enterprise management · insiders, and (ii) interpretation to the issue of nonexerciseof ownership rights by the government. In the case of the former, as discussed earlier,perception is premised on a decentralization of authority between the government and enterpriseas expressed under the principal-agent model. In the case of the latter, the position is taken thatthere is an inherent problem as before regarding the question of separation of government andenterprise. 10Raiser (1997) adopts an empirical approach using survey data for 180 enterprises to analyzethe gap between SOE production and financial performance. However, the data set used byRaiser lacks detailed cost data, and the relationship between improved productivity and worseningprofitability is analyzed on the basis of regression analysis by production function, and regressiveapplication of asset-profit ratio to managerial autonomy and production related indicators. Theconclusion of this analysis is that the main factor in declining profitability lies in increasedcompetition by new participation in heretofore protected markets, rather than insider control as aresult of strengthened managerial autonomy.So how can we solve the puzzle of the discrepancy between TFP growth and lowprofitability? It has not been clearly answered due to the difficulty of obtaining reliable financialinformation on SOE performance. IMF (1997) identifies the following factors as a cause ofdeclining profitability, but we think that none of them can constitute single most convincingreason.a) adverse aggregate demand movementsb) increased input costs, interest payments, taxesc) demand and supply factors in specific sectors: competition from other ownership forms,irrational SOE investment, and external conditionsd) credit policy, ande) institutional and accounting changes: social security burdens and accounting standardOne of convincing argument is that China's SOE worsens their performance due to mixedreasons as above. For policy options, one needs to identify the weight between many causes andstructure of the relationship between them. We therefore proceed our examination of cost structure10 Without being over-simplistic, it can be generally concluded in this regard that sino-economists inrecent years who have studied at graduate schools in the US and Europe tend towards a viewpoint in termsof the agency issue and insider control, while Chinese economists tend towards a viewpoint in terms of thequestion of separation of government and enterprise, and the issue of defective integrity of property rightsunder the tight government-enterprise linkage.

OECF Journal of Development Assistance Vol.4, No.1, 1998 17of China's SOEs.For our study, we adopted a cost analysis approach in addressing the issue of gap inproduction and financial performance. Specifically, we attempted to locate the causes of declinein SOE profitability through a detailed analysis of sales and cost structures at the micro-level.Firstly in this regard, let us compare survey data obtained over the period 1991 to 1995 (Table 6).Since some data is missing, there is a slight problem with overall consistency of the table;nevertheless, it is still possible to examine which cost increases have applied pressure on profits.Production costs themselves for the period have remained essentially steady. Accordingly, SOEoperating conditions do not appear to be subject to undue pressure on the basis of sales profit.Rather than manufacturing cost, administrative cost and financial cost are exerting pressure onenterprise operation.Table 6Average Cost Structure for the Sample Enterprises(10,000 yuan, %)1991 1992 1993 1994 1995Product sales 4,535.5 100.0 5,385.7 100.0 7,520.0 100.0 7,372.9 100.0 8,774.7 100.0Sales cost 3,602.5 79.4 4,367.4 81.1 6,011.3 79.9 5,678.4 77.0 6,923.5 78.9Total raw materials cost 2,887.7 63.7 3,145.0 58.4 3,908.3 52.0 4,097.8 55.6 4,863.3 55.4Total wages 362.1 8.0 415.4 7.7 523.9 7.0 667.7 9.1 807.8 9.2Product marketing cost 107.1 2.4 166.8 3.1 179.8 2.4 137.2 1.9 220.5 2.5Sales tax and value-added tax 406.3 9.0 655.5 12.2 469.8 6.2 311.0 4.2 350.6 4.0Sales profit 432.5 9.5 216.0 4.0 868.1 11.5 1,254.0 17.0 1,290.0 14.7Other operating profit 37.5 0.8 39.4 0.7 42.8 0.6 40.4 0.7 73.0 0.8Administrative cost 223.7 4.9 264.1 4.9 520.1 6.9 813.5 11.0 935.2 10.7Unemployment insurancecost out of the above17.4 0.4 22.4 0.4 62.6 0.8 108.9 1.5 138.9 1.6Financial cost 76.2 1.7 78.7 1.5 154.4 2.1 337.3 4.6 417.7 4.8Operating profit 112.0 2.5 183.2 3.4 235.1 3.1 148.9 2.0 4.9 0.1Investment income 7.4 0.2 4.8 0.1 15.6 0.2 36.4 0.5 41.6 0.5Ex-operational income 19.8 0.4 23.4 0.4 35.8 0.5 52.0 0.7 49.5 0.6Ex-operational expenditure 95.8 2.1 108.9 2.0 95.0 1.3 60.9 0.8 76.7 0.9Profit total value 83.2 1.8 192.8 3.6 187.4 2.5 169.7 2.3 11.6 0.1Source: Survey findings under this studyManagement cost here is defined as expenditure by the managerial tier for other than factory.This cost comprises a range of outlays including office operating expenses, union costs,management meeting expenses, consulting fees, entertaining expenses, land rents, technologyfees, employee education and training expenditure, R&D expenditures, etc. In the case of ourdata, breakdown of this administrative cost is clear only in terms of unemployment insurancecost; however, this accounts for only a small portion of the total. In reality, it can be consideredthat outlays to the local government such as the burden levy for regional development, etc., aswell as other costs which cannot be assigned to other cost categories have been lumped togetherunder this item.On the basis of the cost structure, the ratio of profit to sales for the surveyed enterprises hasnot declined over the period 1991 to 1995. In other words, solely on the basis of the enterprises

18 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise Reformwe surveyed, the fact that profitability of SOEs has declined as a result of competition is subjectto qualification. In terms of the enterprises overall, sales profit in 1991 was 9.5% of total sales,and this increased to 14.7% in 1995. In contrast, profit total value was 1.8% in 1991 and droppedto 0.1% in 1995. From this it can be concluded that administrative cost and financial cost haveput pressure on SOE profits in recent years.This conclusion is substantiated by census data as well. The subject census data indicatesthe financial structure in 1996 of enterprises under each category of ownership type. Accordingto the data, a large gap appears in administrative costs of SOEs and township-village enterprises(TVEs). From sales totaling 2.18 trillion yuan, medium and large SOEs made administrativecost outlays of approximately 200 billion yuan (around 9.1%) in 1996. In contrast, TVEs in thesame year made outlays for administrative cost of 47.6 billion yuan (only around 4.3%) againstsales of 1.1 trillion yuan. Furthermore, this ratio of administrative cost to sales total for SOEs isessentially consistent with the figure obtained in this regard (10.7%) from our own SOE surveydata. Given the fact that profit total values for medium to large SOEs and overall TVEs areroughly the same at around 47 billion yuan, one can readily see the extent of SOEs expenditureon administrative costs. Since the number of TVEs is approximately 10 fold that of medium andlarge SOEs, the administrative costs borne per single TVE are roughly 1/40 that per single SOE.It must be noted, however, that in terms of ratio to the previous year, administrative cost outlaysby the TVE show rapid increase.II. INCENTIVE STRUCTURE OF CHINA’S SOESHow should one interpret the issue of increased management and financial cost as clarified throughperformance analysis of SOEs, as well as the background issue of SOE investment regime? Inorder to understand these problems, it is necessary to clarify (i) to what degree managerialautonomy is granted SOE management, (ii) what types of incentive are given to management,and (iii) under what kind of property rights structure these occur. In this section, we will focusour analysis particular on the incentive structure affecting SOEs.A representative study which focuses on the incentive structure of China's SOEs is thework by McMillan and Naughton (1995). They emphasize two incentive strengtheningmechanisms at work in the increase of SOE productivity. One is an internal mechanism in theform of the contract responsibility system. The other is an external incentive mechanism fromexternal market competition.Our position with regard to these impacts is firstly that the incentive effect stemming fromcompetition, although recognized as a powerful force in determining economic efficiency, doesnot by itself resolve the issue of incentives under China's SOE reform. 11 A strict distinctionbetween internal and external incentives is difficult, and the modeling of the incentive effectfrom external competition can be somewhat specious. In order for inter-enterprise competitionto have a strengthening impact on internal incentives, various preconditions are necessary suchas (i) an independent enterprise management structure under which management assumes11 Shleifer and Vishny (1997), who have carried out the most extensive survey concerning the issueof corporate governance, take a negative position as well with regard to the view that management efficiencyis achieved by product market competition alone. Examples of study on competition and incentives inChina are Groves et al. (1994, 1995)

OECF Journal of Development Assistance Vol.4, No.1, 1998 19responsibility for enterprise operation, and (ii) the absence of external interference in enterprisemanagement, etc. Even in the case of the market economy of an industrialized country, forexample, the profit performance of a regulated industry can change tremendously depending onthe nature of the regulation structure. The presence of competition is important; however, suchcompetition can fluctuate markedly depending on market conditions.With regard to internal incentive mechanisms, opinion differs on the effectivity of thecontract system after 1987. 12 Our position here concerning the contract responsibility system isthat there exists an inherent problem in the discussion at one time of a complex problem whichactually encompasses two differing levels of issue.The first level of issue is as to whether adoption of the contract as a method of decentralizationof authority in itself was a positive or negative move. It is generally held that the contract systemfunctioned well in promoting decentralization within the agricultural sector. In the case of theindustrial sector, it considered that, in the absence of a market economy and with the addeddifficulty of establishing property rights, there would be no effective mechanism other than thecontract to foster decentralization of authority. Accordingly, adoption of the contract system inthe latter half of the 1980s was at that time perhaps the most appropriate choice in pursuingdecentralization.The second level of issue is whether or not the contract responsibility system functionseffectively in the establishment of incentive contracts. Under the contract system in China,various types of contract arrangement were attempted. It appears that some of these may havefailed due to informational asymmetry such as moral hazard, adverse selection, and a future taskin this regard will be to verify the actual incentive effect and appropriateness of contract designunder the various types of contracting.Given the need to verify incentive impacts in the 1990s, and the fact our data base is morerecent than that of other existing studies on China's SOEs (and has been updated with supplementaldata as well), a future task for us will be to carry out such a study. Here, however, we will limitourselves to an analysis of basic data, and an examination of the gap in production and financialperformance from the standpoint of incentives.A. Incentives from Managerial AutonomyThe granting of managerial autonomy to SOEs was the principal theme under SOE reform in the1980s. In 1987, managerial autonomy reform moved into a new phase with adoption of thecontract responsibility system. Our interest here, as discussed above, is the nature of managerialautonomy itself under a contract base.From our survey data (Table 7), it can be seen that a considerable amount of managerialautonomy in terms of production, marketing and price determination was delegated to SOEs inthe 1980s and first half of the 1990s. However, this autonomy still remains insufficient withregard to investment, asset purchase · disposal, and export/import activities by the SOE. As ofthe end of our survey in 1996, roughly 70% of SOE management possessed neither investmentautonomy, nor asset purchase/disposal rights. SOE management in China render decisions on12 Specifically, this refers to the opinion (McMillan and Naughton (1996)) that the contract systemhas been effective, and the converse viewpoint (Woo et al. (1995)) that the contract system has insteadcreated an agency problem and induced wage increases.

20 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise Reformday to day production and marketing activities; however, they lack authority in terms of the moredynamic decision-making which affects the whole enterprise, such as investment, etc. Thus,formulation of SOE growth and restructure strategy is not performed by management, but ratherremains the prerogative of the government sector. Furthermore, it can be concluded that SOEinvestment activity (function) does not reflect rational decisions rendered by SOE management, butinstead is a manifestation of decisions and actions taken by the government sector behind the SOE. 13Table 7Achievement of Managerial Autonomy by Surveyed SOEs (overall ratio)Content ofmanagement autonomyPrior to19801980~84 1985~89 1990(%)NonachievementProduction · Sales 4.6 17.7 32.4 31.5 13.7Pricing 1.5 11.8 26.5 38.6 21.9Hiring 1.0 4.5 19.5 37.4 37.6Firing 1.1 2.3 14.1 34.0 48.5Export 0.5 0.9 7.5 16.7 74.4Import 0.4 0.3 6.2 14.8 78.4Investment with repaymentperiod of under 2 years0.3 2.3 5.9 18.2 73.4Investment with repaymentperiod of 2 years or more0.3 2.0 5.2 16.5 76.1Asset purchase 1.0 4.0 7.4 19.2 68.3Asset sale 0.3 2.4 4.4 17.3 75.6Note : Figures indicate the ratio of enterprises which achieved managerial autonomy under the subjectitem during the designated period.Source: Survey findings under this studyIt is concluded that Chinese government is well cognizant of this situation of a portion ofmanagerial autonomy not having been turned over to the SOE. Particularly concerning managerialautonomy over SOE assets (i.e. asset purchase and sale powers), as discussed in the next section,property rights have been granted to SOE management only in very limited terms in light of theimpact of this authority on outflow of SOE assets. Nevertheless, establishment of complete SOEmanagerial autonomy is not possible without a transfer of definitive property rights in the formof extreme rights over asset disposal.B. Incentives from SOE DebtsHere let us examine another route for incentive strengthening in the form of debts. The objectiveof shifting from free subsidization of SOEs to compensated financing, with government financialburden in the form of lending via banking channels, is to bring about a "hardening" of "softbudget constraints". By reflecting the opportunity cost of capital through "hardening" of budgetconstraints, it was anticipated that an incentive to improve operational efficiency would beexternally imposed on SOE management as a result of loan interest payment and principal13 This investment "duality" is pointed out by Dong, Tang and Du (1995).

OECF Journal of Development Assistance Vol.4, No.1, 1998 21repayment burdens. As pointed out in the analysis of the gap in production and financialperformance of SOEs, the sharp rise in recent years of financial cost outlays apparently indicatessuccessful achievement of external incentive strengthening via imposition of liability burden onSOE management. However, a lingering question is as to whether this incentive is indeedsufficient.In Table 8, interest cost which should be paid by the SOEs under our survey has beencalculated from outstanding debt and average interest data, and compared with actual financialcost outlays. As a result, it can be seen that both short-term and long-term liabilities have sharplyrisen, reflecting increased investment, and this fact coupled with a rise in interest rates has causeda commensurate increase in interest burden. Nevertheless, the surprising fact is that, accordingto our calculations, despite a lower interest burden during the period 1991~1993, the proportionof interest actually paid vis à vis that which should have been paid was a low 25%. In contrast,despite a subsequent increase in liabilities and rise in interest rates as well (against a backgroundof tightened fiscal policy by the government), the proportion of interest actually paid by SOEsvis à vis that which should have been paid increased to more that 40%.When considering the incentive for improved operational efficiency as a result of debt, theincentive tool (appraisal of loans, etc.) in conjunction with borrowing is important; however,equally important as well is the incentive (monitoring of loan recovery, etc.) in conjunction withrepayment. In this sense, the condition under which only around 40% of interest due is actuallybeing paid indicates a weak incentive to improve operating efficiency, with continuation of theprevious practice of loose financing under deferred repayment terms.Table 8Average SOE Debts and Interest (enterprise average)(10,000 yuan, %)No. ofsamples1991 1992 1993 1994 1995Short term debts 789 2,413.4 2,820.2 4,405.7 5,008.0 6,216.2Long term debts 778 989.5 1,266.1 1,742.0 2,220.4 2,385.21~3 years 683 810.8 954.1 1,175.1 1,504.9 1,686.0Over 3 years 600 516.9 565.6 764.3 891.1 995.3Average interestShort term 648 8.5 8.9 9.9 10.8 11.51~3 years 640 6.7 7.1 8.2 12.5 13.1Over 3 years 541 5.4 5.7 6.7 7.4 7.9ComputationInterest which should be paid (A) 288.0 351.2 581.7 795.5 1,015.3Actual financial cost (B) 76.2 78.5 157.9 338.7 418.7(B) / (A) (%) 26.5 22.3 27.2 42.6 41.2Source: Survey findings under this studyThe increase in financial cost is the result of a high debt ratio. This ratio is relativelygreater for small to medium enterprises compared with large enterprises, and shows continuedoverall rise for all sizes of enterprise during the period 1991 to 1995 (see Table 9). Liquidity rateas a result of comparing highly liquid short term loans and assets among the various scales of

22 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise ReformSOE shows a continuous deterioration for all sizes of SOE over the survey period.Table 9Changes in Debt Ratio by Enterprise Scale (1991~95)Surveyed SOEs1995 Industry Census1991 1992 1993 1994 1995TotalenterprisesSOEsLargeDebt ratio 51.9 56.6 67.9 69.5 68.3 61.4 62.3(After adjustment*) 52.1 58.6 70.1 75.4 71.8Liquidity ratio 76.2 77.7 92.4 103.5 109.7 94.0 96.9MediumDebt ratio 63.5 64.9 77.2 80.7 76.1 69.7 71.8(After adjustment*) 64.7 67.9 81.4 84.5 77.7Liquidity ratio 90.0 85.8 102.4 116.7 127.3 109.4 116.1SmallDebt ratio 62.8 65.1 73.4 77.9 76.5 68.6 71.4(After adjustment*) 64.3 70.0 79.2 84.1 81.8Liquidity ratio 82.6 88.5 103.5 120.6 127.8 102.8 114.4Note : * Adjustment made by CASS staffSource: Survey findings under this study, and results of Industry Census(%)This type of high debt ratio results from either excessive investment in terms of expenditure,or excessive borrowing in terms of funding procurement. Specifically in this case, it is importantto identify which cause bears more weight. Firstly, the results of questionnaire survey of SOEmanagement regarding their degree of correct recognition of the reason for high loan ratio areshown in Table 10. According to the table, SOE management itself considers this high loan ratioto have been caused by insufficient financial support in coping with excessive past borrowingand liquidity. Here, inadequate financial support with regard to liquidity is very similar to theissue of "soft budget constraints". Nevertheless, the proportion of SOE management whichconsiders government investment to be inadequate is not very large, and in this sense the problemof "soft budget constraints" does not apply to long term funding. It is necessary to consider thispoint in terms of financial policy after 1994. Specifically, as of the final year of data collectionunder this study (1996), the impact of credit tightening had placed SOEs under severe liquidityconstraints. As a result, SOEs requested financial support particularly with regard to short-termfunding. On top of this, the inefficient banking system is concluded to have further aggravatedthe funding situation affecting SOEs.

OECF Journal of Development Assistance Vol.4, No.1, 1998 23Table 10Causes of Excessive Debt (overall composition ratio)Insufficient financial support forliquidityExtremelyimportantImportant Unimportant No relation37.2 30.7 12.1 19.8Excessive past borrowing 37.2 30.3 13.8 18.5New borrowing to cope with past debtproblem28.9 42.1 15.1 13.7Lack of funds on-hand 22.9 42.6 18.1 16.2Insufficient fixed capital investment bygovernmentNote : Multiple responses were possibleSource: Survey findings under this study21.0 26.0 18.0 34.8(%)Next, let us take a look at the types of lending institutions for SOE finance. According toour survey, the financial structure for investment comprises mainly bank financing as indicatedin Table 11. Financing extended by banks accounts for some 50~60% of total investment finance.In contrast, internal funding in the form of internal reserves, etc. accounts for only around 30%.IMF data ((1997), Table 12) indicates a different result concerning this point. The majordifference with the said IMF data is that extrabudgetary funding is indicated as the largest financeitem under the investment funding structure. As will be touched on later, it remains unclear as towhether this extrabudgetary funding (income, expenditure) is included or not within our data set.This IMF data suggests a very interesting fact regarding investment conditions from thestandpoint of funding outlays. Investment in state-owned units is primarily directed at energyand infrastructure, with investment in plant and equipment accounting for a relatively smallproportion of the total. On the basis of this situation, it can be seen that investment in stateownedunits is not necessarily concentrated in the area of production facility investment. Thuswhen considering the general issue of excessive SOE investment, this does not automaticallyimply an excessive investment in plant and equipment.Table 11Procurement of Fixed Asset Investment Funding by Surveyed SOEs (enterprise average)(10,000 yuan, %)1991 1992 1993 1994 1995Bank borrowings 352.1 428.8 572.1 720.2 827.7(65.6) (62.2) (64.3) (62.9) (55.6)Bond issue 9.3 16.4 34.7 22.7 41.8Stock issue 4.0 0.6 24.2 43.8 32.5Foreign capital – 0.1 3.8 16.3 36.4Investment by other enterprise(s) 17.0 21.9 26.3 22.3 30.3Funds on-hand 160.1 228.5 239.5 323.4 541.4(29.9) (33.2) (26.9) (28.2) (36.4)Total 536.3 688.9 890.2 1,146.3 1,488.9Source: Survey findings under this study

24 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise ReformTable 12Investment in Fixed Assets by State-owned Units (1991-96)(In billions of yuan)1991 1992 1993 1994 19951996(estimate)Total investment 371.4 549.9 792.6 961.6 1,089.0 1,236.0Breakdown by financing:State budget 37.8 34.6 47.6 54.4 53.1 55.1Others 333.6 515.3 745.0 907.2 1,035.9 1,180.9Of which: 1)Retained profits of enterprises andextrabudgetary operations of local 198.3 304.0 495.3 627.4 703.8 769.7governmentsDomestic bank loans 104.4 167.4 201.3 208.4 223.3 256.6Foreign capital 30.8 43.9 48.3 71.4 144.4 163.1Breakdown by sectorAgriculture 10.1 13.2 6.4 7.4 10.0 23.9Industry 211.3 276.0 357.2 393.3 442.1 490.9Of which : Energy 95.7 116.4 149.8 175.4 204.2 318.9Transport and communications 48.5 70.2 133.4 199.2 247.2 314.1Breakdown by typeConstruction 217.8 327.2 487.4 602.9 660.4 737.0Equipment 109.8 149.3 197.3 236.5 275.0 299.8Note : 1) As reported by the SSB; sum of components may not be equal to total due to rounding.Source: State Statistical Bureau, IMF (1997)Table 13 presents interesting results from the standpoint of the incentive impact induced bydebts. The findings of questionnaire survey of SOE management reveals that despite virtuallyall SOEs having liabilities in the form of bank debts, borrowings from other enterprises, unpaidtaxes, etc., management indicated that it directs any supplemental capital available towardsproduction and investment. This fact implies that in the case of SOE management, a debtrepayment incentive does not appear to exist, and instead other more powerful incentives are atwork. Thus from the standpoint of SOE management, the relationship with banks, tax authoritiesand other enterprises is superseded in importance by its direct relationship with the government,and the supervisory sector ultimately remains the top priority concern of management. Undersuch conditions, strengthening of the relative position of banks within this framework (such asintroduction of the Japanese main-bank system, etc.) cannot be easily achieved.

OECF Journal of Development Assistance Vol.4, No.1, 1998 25Table 13Responses by Management on Use of Supplemental Funding if Available(ratio to overall composition)MaximallyimportantImportant Unimportant No relationProduction · investment 76.1 17.1 4.5 2.3Payment of back taxes 38.6 46.9 8.4 6.2Repayment of loan principal 29.9 52.0 13.3 4.8Repayment of debts from otherenterprises9.0 55.5 27.1 8.3Dividends to investors 7.0 39.1 27.9 26.0Improvement of social welfareprograms6.3 43.8 41.0 8.9Increased bonuses to employees 6.5 37.9 44.0 11.6Payment to public utilities 3.8 16.7 49.6 29.9Source: Survey findings under this study(%)The problem of bank loans to SOEs, particularly those by special banks, winding up as badassets is an urgent issue at present, and this is substantiated by our data as well. However, thefundamental cause underlying this bad debt problem must be analyzed with particular care. Firstly,excessive investment from a funding outlay standpoint and failure of the same may be one factor;however, the target of investment is not necessarily plant and equipment. In other words, thedegree of correlation between investment content itself and enterprise profit remains unclear.Next, although it is recognized that investment funding is loan-financed, it is not clear as towhether this source is banking institutions or extrabudgetary funds. Specifically, it is not readilyapparent whether (i) investment funding is extended directly by banks to SOEs, after which ithas become bad debt, or (ii) investment funding is being extended to SOEs via some otherchannel. In this sense, it is a high likelihood that defining the bad assets held on the part ofspecial banks vis à vis SOEs will be extremely difficult. Finally, the principal root of the baddebt problem lies not in simple investment failure due to loose borrowing, but rather in a moresevere issue of fiscal discipline. This situation where SOE management does not adhere to eventhe most basic accounting and banking practices due to intervention by the supervisory sector isindicative of the degree to which incentives accorded to SOE management are out of sync witha market economy.III. PROPERTY RIGHTS STRUCTURE OF CHINA'S SOESBy means of incentive structure analysis of SOEs, it has been possible to explain the issue ofmanagerial autonomy in terms of internal incentive mechanisms, as well as the problem ofincentives imposed externally in the form of liability. However, there still remains the questionof SOE "ownership", an element essential to the establishment of an effective enterprise withina market economy. This question of ownership was confronted by Chinese government at the

OECF Journal of Development Assistance Vol.4, No.1, 1998 27Various problems emerge as a result of this insufficient asset evaluation and management.While the issues of hidden assets, asset stripping and difficulty in asset evaluation are important,a major problem is the fact that the central government, particularly the SAMB, does not possesresidual rights for control of assets (a fundamental condition of asset ownership). In other words,state assets become controlled by parties other than the true owner or his appointed proxy in theform of enterprise management thereby undermining the very integrity of the ownership rightitself. This lack of coercive control powers can readily manifest itself even where legal propertyrights have been clearly established, or ownership has been transferred to another party.B. "Misappropriation" in the Case of China's SOEsNext, let us examine the question of corporate governance and control. 16 The various analyses todate of China's SOEs from a property rights approach are generally in agreement regarding theincompleteness of corporate governance. One problem here is that fact that the number of SOEswhich have made the transition through share-holding to company, with a corporate governancemechanism as determined by the Company Law of 1993, remains small. At the same time, aneven more serious problem which can be cited is the lack of an enterprise control structure resultingfrom a legal framework for ownership rights which as yet does not function effectively.The incompleteness of corporate governance mechanism cannot be understood solely interms of incomplete managerial autonomy. Rather, a deeper analysis is necessary of who exactlycontrols the SOE. Here we will examine ultimate control rights to appoint and fire managementpersonnel, and veto powers over actions which affect the very nature of the enterprise itself suchas large-scale investment, and transfer · disposal of asset ownership, etc. 17 Under our study, wehave already seen that investment autonomy as well as purchase and disposal powers over assetshave not as yet been granted to SOE management. On the basis of survey data, let us now attemptto determine with which party or parties residual control rights over SOEs actually lie.Our study data clearly substantiates that SOE (residual) control rights lie with the supervisorysector. Table 14 shows a breakdown of method by which SOE management is determined. Inalmost all cases, SOE management is appointed by the supervisory sector. There are manyinstances where management personnel have achieved their status by moving up through theSOE employee ranks; however, in such case as well the ultimate approval for appointment tomanagerial positions is granted by the supervisory sector.Furthermore, decision-making authority in firing management also lies with the supervisorysector. Table 15 indicates the results of the question posed as to where authority for firingmanagement lies. In the overwhelming proportion of cases, this power is in the hands of thesupervisory sector. In contrast, the impact in this regard exerted by the State Asset ManagementBureau (which is supposed to be the proxy for state-ownership) is extremely small.SOE management subject to appointment or removal by the supervisory sector in the above16 Qian (1995) approaches the issue of SOE property rights in China in terms of enterprise theoryanalysis. Also, from the standpoint of descriptive analysis, there is a considerable body of literature availableon problems surrounding the Company Law and corporatization of SOEs.17 Qian (1996) posits this issue as a matter of "depoliticization", and discusses the fact that theincompleteness of SOE property rights derives from an as yet inadequate allocation of ultimate (residual)control rights of SOEs. Qian cites that such control rights remain as before in the hands of the governmentand party, and in this sense cannot be complete without "depoliticization" of SOE property rights.

28 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise Reformmanner may either be transferred to management of other SOEs, or promoted to the supervisorysector itself if they succeed in their management assignments. In other words, SOE managementhave the potential to eventually become supervisory sector insiders.Table 14Method of Determining SOE Management (ratio to overall composition)Ratio to overall compositionAppointment by supervisory sector 86.6Appointment by employees 3.7Appointment by board of directors 8.6Openly recruited 1.1Source: Survey findings under this study(%)Table 15Responses to Question of Who has Ultimate Authority in Firing Management(ratio to overall composition)MaximallyimportantImportant Unimportant No relationSupervisory sector 83.0 12.5 2.9 1.6National Investment Corporation 13.9 28.5 24.9 32.7State Assets Management Bureau 3.8 19.4 38.1 38.6Banks 1.6 10.2 42.2 45.8Other creditors 0.9 5.4 38.8 54.8Tax authorities 1.6 6.9 40.2 51.3Investors 2.7 8.5 32.4 56.4SOE management 5.6 46.2 25.5 22.7SOE employees 12.0 43.3 24.6 20.1Source: Survey findings under this study(%)What precisely then is the role and responsibility of SOE management under the abovesituation of personnel management rights being completely in the hands of the supervisory sector?In response to this question, the role and responsibility of SOE management can be deducedfrom the serious problems confronting SOE operation as set out in Table 16. From the table itcan be seen that the major operating problems as viewed by SOE management are concentratedin the area of funding procurement, particularly the procurement of short-term funds. In contrast,issues of operating pressures resulting from competition with either other SOEs or enterprisesunder differing ownership format, obsolete technology, lack of labor incentives, etc. are notperceived as serious problems by SOE management. In other words, the duties of China's SOEmanagement center on (i) execution of production and investment as directed by the supervisorysector, and (ii) the formulation of strategies to procure necessary investment and operating funds

OECF Journal of Development Assistance Vol.4, No.1, 1998 29to achieve the foregoing. In this sense, real operating authority has not been transferred to SOEmanagement, and "de facto ownership" continues as before in the hands of the supervisory sector."Boundary of the firm" of the SOE thus still remain ambiguous.Table 16Responses by Management to Severity of Confronted Problems(ratio to total number of enterprises sampled)ExtremelyimportantImportant Unimportant No relationInsufficient liquidity 53.9 30.7 10.4 5.0Insufficient investment funding 32.2 44.0 15.8 8.0Heavy interest burden 37.8 35.6 18.0 8.7Excessive deficit 31.7 38.2 22.9 7.3Heavy debt burden 31.3 31.5 26.6 10.6Surplus labor 27.1 33.3 25.9 13.7Lack of skilled labor 13.7 35.9 32.9 17.5Insufficient energy and productioninputs11.7 23.5 41.2 23.6Obsolete technology 10.1 29.6 41.0 19.3Lack of work spirit among employees 7.9 28.8 43.8 19.5Insufficient autonomy regardingproductionNote : Multiple responses were possibleSource: Survey findings under this study6.0 9.3 39.6 45.1(%)C. Changes in Control1. Liberalization and ControlNext, how is the control authority of the supervisory sector distributed under the present conditionof SOEs of varying scale and jurisdiction. In light of the difficulty of establishing effectiveindicators of "strength" in this regard, it becomes necessary to carry out an analogical interpretationusing separate proxy variables. In order to examine the manner in which the various supervisorysectors exert control over SOEs, we derived the relationship between SOE scale and jurisdictionfrom the distribution of indicators for control in determining SOE marketing and productionactivities. In general, control over marketing and production shows a high ratio for large enterprisesin the case of SOEs under the jurisdiction of the central government. Conversely, this ratio isrelatively high for small and medium enterprises in the case of SOEs under the jurisdiction ofprovincial, municipal, county and prefectural governments. On the basis of this trend, it can beseen that the assumed policy under the present SOE reform of “zhuada fangxiao" ("grab the bigone and let the little one go") takes on slightly different significance depending on the type ofjurisdiction. In other words, to use the above analogy, each supervisory sector "grabs" thoseenterprises of a scale most appropriate for its control, and lets the others "go". This in turn

30 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise Reformimplies that given the necessity of doing so, all levels of government are capable of "capturing"all levels of enterprise scale.2. Corporatization and Changes in Control StructureThe next question is whether or not the policy of corporatization being pursued under SOEreform will alter the above supervisory sector control structure. Since over 70% of SOEs remainun-incorporated as before and still under the company system according to our survey data, ourtentative evaluation of the possibility for control structure change as a result of corporatization isunfortunately negative (it should be noted, however, that this conclusion is based on an extremelysmall number of surveyed samples). Further substantiation of this conclusion is indicated inTable 17, which re-organizes in terms of management format type the cost structure data presentedunder the discussion of gap in production and financial performance.Table 17Cost Structure of SOEs by Management SystemEnterprise system(10,000 yuan, ratio to production sales amount: %)1991 1992 1993 1994 1995Product sales 4,591.2 100 5,425.4 100 7,324.5 100 6,769.7 100 7,727.2 100Total raw materials cost 2,935.8 64 3,186.3 59 3,899.7 53 3,846.5 57 4,367.7 57Wage 366.0 8 419.4 8 516.3 7 626.6 9 723.5 9Sales profit 437.1 10 200.2 4 807.9 11 1,147.2 17 1,151.1 15Administrative cost 226.7 5 262.8 5 504.7 7 757.8 11 838.0 11Financial cost 76.2 2 78.4 1 157.0 2 322.0 5 391.1 5Total profit 83.5 2 183.3 3 132.3 2 103.9 2 -28.5 0Company systemProduct sales 2,705.0 100 5,618.3 100 12,874.0 100 12,431.7 100 16,223.4 100Total raw materials cost 659.4 24 2,362.1 42 4,791.0 37 5,721.6 46 8,464.6 52Wage 240.7 9 349.2 6 757.8 6 1,043.0 8 1,554.6 10Sales profit 221.2 8 937.7 17 2,356.1 18 2,440.1 20 2,591.8 16Administrative cost 123.0 5 350.0 6 931.0 7 1,356.5 11 1,801.6 11Financial cost 91.5 3 108.3 2 208.1 2 461.5 4 625.9 4Total profit 49.8 2 687.5 12 1,455.8 11 970.2 8 413.5 3Source: Survey findings under this studyThe impact on cost structure as a result of changes in management format can be discernedfrom Table 17, i.e. although the ratio of financial cost drops slightly, the ratio of administrativecost remains exactly the same. Despite relatively better profit performance on the part of thecompany, the overall trend for these as well is one of deterioration in this regard. The fact thatchange in management format does not affect the enterprise cost structure forces the extremelypessimistic view that there is no clear-cut connection between corporatization and resolution ofthe SOE deficit problem.

OECF Journal of Development Assistance Vol.4, No.1, 1998 31IV. DECENTRALIZATION AND SECTORAL OWNERSHIPOur discussion has focused on clarifying the incomplete incentive structure and incompleteproperty rights affecting China's SOEs from the standpoint of the gap between production andfinancial performance. The next question is what type of structure has given rise to thisimperfection in incentive mechanisms and property rights. Central to this, we have been able toposit a behavior pattern on the part of each supervisory sector which in turn impacts on theactions and performance of the SOEs under the jurisdiction of each such sector. We now turn ourattention to the manner in which the behavior of the supervisory sector has altered under SOEreform and transition to a market economy.It is our belief that decentralization policy by Chinese government has a strong impact inthis regard. Decentralization is one facet of the broader policy of reform and liberalization, andas a result supervisory sectors have moved to "capture" the SOEs under their respective umbrellas.In other words, reform of the planning economy structure in China has been pursued in the formof market creation and decentralization of authority. This in turn has been carried out through adownward transfer of power based on the contract system. In terms of intensifying inter-regionalcompetition and leading to emergence of TVEs, it cannot be denied that this decentralizationstrategy has had a positive impact on reform. Nevertheless, essentially the same mechanism hasconversely been a cause as well in the decline of SOE financial performance.A. Decentralization and Sectoral "Capture"Let us take a look here at one typical example of change in the behavioral pattern of supervisorysectors in the face of decentralization. Specifically, this refers to the flow of extrabudgetaryfunds at each level of government in China, one income source of which is the previously discussedenterprise administrative cost. Although data on extrabudgetary funds is limited, such fundingin existence from the 1950s exhibited an extremely high growth following the start of economicreform and liberalization in 1978, reaching a level in 1992 equivalent to 93% of budgetary income.This is not a major problem provided this large amount of extrabudgetary income is treated as aspecial account. The specific problem here, however, is that government action (particularlythat of the SOE supervisory sector) as typified in this example of extrabudgetary income isdirectly linked to supervisory sector profit (i.e. "sector profit"). (according to Deng Ying Tao etal, 1990)Qian (1995), and Qian and Weingast (1996) cite the decentralization strategy at the heart ofeconomic reform in China as the impetus behind the high economic performance under Chinesereform. They describe this reform strategy as "market-preserving federalism, Chinese style",and point to the contract system adopted in three sectors under Chinese economic reform, i.e.contracts between the central and local governments, SOE contracts and agricultural sectorcontracts, as an instrument for decentralization. These economists postulate that decentralizationhas worked effectively in fostering "market-preserving federalism", and pursuit of transition to amarket economy.In contrast, it is our belief that this very decentralization has served to worsen the financialperformance of China's SOEs, and create destabilizing elements from a macroeconomic standpointin the form of increased extrabudgetary funds, etc. Even more importantly, decentralization has

32 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise Reformgiven rise to (or perhaps better put: "regenerated") mechanisms based on more inherentlytraditional, economic practices in China. The biggest problem in the case of incomplete modernincentive structure and property rights is that "proper" incentive and governance mechanismsare not accorded to enterprise management and actual owners, resulting in the potential emergenceof an economic entity which steers the enterprise towards objectives other than the properobjectives of profitabilty, overall public welfare, etc. In the case of developing countries, thesemisdirected objectives assume the form of traditional economic motives more deeply rooted inthe local community.The re-established traditional economic objective in the case of China's SOEs is representedby the above mentioned "supervisory sector profit", characterized by regionalism and sectorownership. Ishikawa (1997) refers to this traditional mode of ownership as the "sectoral ownershipsystem", under which sectors comprise the various levels of local government, and jurisdictionswithin the central government (corresponding to “ministries” in the case of Japan). Each sectoracts to capture real ownership of the SOEs under its control. This type of "sectorism" ischaracteristic of Chinese economic reform, and has grown in strength as a result of reform andliberalization policy. In itself, it can be considered the parameter behind SOE mechanisms inChina as discussed at the outset.Traditional economic elements are seen in many developing countries. These may bemanifested in diverse ways, sometimes taking the form of ethnicism or factionalism. Concerningthe potential for decentralization to regenerate traditional economic elements, the WorldDevelopment Report, 1997 by the World Bank stipulates that in the absence of agreed to rulesbetween the central and local government, the local government may profit from income whichwould otherwise not officially be distributed under an appropriate decentralization policy. Forexample, after the granting of autonomy to local governments in Poland, many local authoritiesattempted to extract from their jurisdictions a greater profit that otherwise would be channeled tothe central government (Warsaw), acting in much the same way as a pressure group. The resultis an increased inequality between administrative jurisdictions, giving rise to a new form ofsocial friction. In our perception, the same scenario can be applied to China by replacing the"local authorities" referred to in the above case of Poland with "supervisory sectors" as relevantto China. 18Beyond recognizing that "sectoral ownership" is not a modern ownership form, preciselywhat form of ownership is it? Although in specific terms "sectoral ownership" may manifestitself in diverse ways in developing countries, in a broad sense it is analogous to a kind of"collective ownership". This type of "collective ownership" is defined by Weizman and Xu(1993) as "vaguely defined cooperatives", and a clear inference made that the nature of the TVEin China is one of such "collective ownership". It is our view here that the "collective ownership"analogy does not stop at TVEs, but can be applied to "sectoral ownership" in the case of SOEs aswell. 19 Furthermore, it is possible to consider that as a result of "local capture", this "sectoralownership" has caused a distortion in distribution of resources and control rights. In this sense,18 Such type of SOE "local capture" induced by regional decentralization of financial authority undertransition policy can be seen in the case of Russia as well. Following collapse of the Soviet Union, regionalSOEs decentralized in the form of stronger managerial autonomy were in turn captured by the decentralizedoblasts resulting in delay of enterprise reform. This point is referred to by Kopits and Mihaljec (1993).19 The view that the China's SOE resembles a labor cooperative enterprise is set out by Zhao (chapter18) contained in Wen and Xu (1996).

OECF Journal of Development Assistance Vol.4, No.1, 1998 33one must conclude that the scenario of decentralization in the form of Chinese style, marketpreservingfederalism, etc. ultimately achieving decentralization at the individual level and givingrise to a true market economy is an extremely optimistic scenario. Thus in this context,"decentralization" does not fully equate to "market economy". In the specific case of China, thedecentralization that has accompanied reform of the planned economic structure has served topromote market economy development. At the same time, however, it has been a catalyst in theregeneration of the old custom of sector ownership. Furthermore, this practice is not necessarilycompatible with a modern ownership system under which property rights are clearly defined.Although this traditional, collective type of sector ownership has resulted in the success of theTVE, and promoted economic transition in China, it has on the other hand spurred the localcapture of SOEs created under the earlier period of planned economy. Of course, the problem of"local capture" would not occur under conditions of perfect incentive and property rights structures.Establishment of complete incentive and property rights mechanisms takes time, however, and itcan be stipulated that where decentralization is pursued against such a background of still evolvingmechanisms this type of "local capture" problem can arise.V. CONCLUSIONAs indicated at the outset, this paper does not have as its objective the development of a normativeargument. In other words, our target here is not to compare and rank different economicmechanisms. Our purpose rather is to recognize that incentive and property rights mechanismsin a transitional and developing economy such as that of China exist in an imperfect form, and toexamine the parameters which are a precondition for meaningful discussion in this regard.As in a typical SOE model under a transitional economy, it was anticipated that the shiftfrom a planned to a market economy would be achieved by altering (either gradually or abruptly)the enterprise objective function from national goals to a profit oriented, with resultant naturaltransformation of the SOE into a profit seeking entity. However, as we have explained up to thispoint, this view must be described as excessively naïve. Traditional economic elements, andelements heavily dependent on inherently Chinese parameters, have re-emerged in the case ofChina to fill the gap caused by decentralization without the existence of true market conditions.As one of these elements, we have attempted to isolate the traditional economic remnant inthe form of the "sector ownership system", and put forth the hypothesis (albeit in terms of stillincomplete analysis) that this element can explain a part of the gap between SOE production andfinancial performance. This traditional economic factor in actuality remains deeply rooted inbehavior principles of government outside the market economy framework, and has the potentialfor both positive and negative impact on market economy expansion itself.Finally, let us summarize in simple terms from a slightly normative angle the gap betweenplanning and actual market conditions; in other words, whether or not there exists a probleminherent in the incomplete incentive and property rights mechanisms. Generally, the biggestissue generated by the incompleteness of incentive and property rights mechanisms is the inabilityto prevent the intervention of an economic entity which possess objectives at variance withhealthy enterprise goals (these goals do not necessarily mean simple maximization of profit).The presence of a mechanism vacuum may invite external intervention due to an unofficial

34 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise Reformdirective by the government (comprising the supervisory sector), or change in an internal economicentity with the potential to undermine rents generated by the enterprise. Furthermore, the veryincompleteness of the mechanism structure itself precludes the ability to properly expunge thisintervening entity (a situation equating to "corporate abuse"). In conclusion, we wish to stressthe single point that costs incurred as the result of actions by such an entity have the potential tobe far greater than costs arising out of "market failure" or "government failure".REFERENCESAghion, Philippe and Jean Tirole (1997). "Formal and Real Authority in Organizations," Journalof Political Economy, vol.105, No.1, pp.1-29.Broadman, H.G. (ed.) (1996). Policy Options for Reform of Chinese State-Owned Enterprises Proceedingsof a Symposium in Beijing, June 1995, World Bank Discussion Paper No. 335, World Bank.Deng, Ying Tao et al (1990). "Analysis of Off-Budget Revenue in China", China People'sUniversity Publishing Company.Dong, Furen et al (1995). Study on Reform of State-owned Enterprise System in China, JinminShuppansha (in Chinese).Dong, Tang and Du (1995). "Research on Reform of Chinese State-owned Enterprise" JinminShuppansha.Fan, Gang (1996). "Growth of "Off-Budget Revenue" and Evolution of Local Governance inChina," mimeo.Groves, T., Y. Hong, J. McMillan and B. Naughton, (1994 ). "Autonomy and Incentives in ChineseState Enterprises, "Quarterly Journal of Economics, Vol. 109, No.1, Feb., pp.185-209.______ (1995). "China's Evolving Managerial Labor Market," Journal of Political Economy,Vol.103, No.4, Aug., pp.873-892.Hart, Oliver (1995). Firm, Contracts, and Financial Structure, Clarendon Press, Oxford.______ and J. Moore (1990). "Property Rights and the Nature of the Firm", Journal of PoliticalEconomy, Vol. 98, No. 6, pp.1119-1158.Hay, D., D. Morris, G. Liu and S. Yao (1994). Economic Reform and State-Owned Enterprises inChina, 1979-1987, Clarendon Press, Oxford.International Monetary Fund (1997). People's Republic of China-Selected Issues, IMF StaffCountry Report No. 97/72, International Monetary Fund.Ishikawa, Shigeru (1960). Structure of Capital Accumulation in China, Hitotsubashi University,Economic Research Book 11, Iwanami Shoten (in Japanese).______ (1997). "Market Economy Promotion Approach: Theoretical Positioning and itsApplication", Journal of Development Assistance , Vol. 4, No. 1, pp.44-78 (in Japanese).Jefferson, Gary, and Thomas Rawski (1994). "Enterprise Reform in Chinese Industry," Journalof Economic Perspectives, Vol.8, No.2, Spring, pp.47-70.______ (1994), "How Industrial Reform Worked in China: The Role of Innovation, Competition,and Property Rights, in Proceedings of the World Bank Annual Conference on DevelopmentEconomics 1994, World Bank.______ and Yuxin Zheng (1996), "Chinese Industrial Productivity: Trends, Measurement Issues,and Recent Developments," Journal of Comparative Economics, Vol.23, pp.146-180.Kopits, George, and D. Mihaljek (1993), "Fiscal Federalism and the New Independent States,"

OECF Journal of Development Assistance Vol.4, No.1, 1998 35in V. Tanzi ed. Transition to Market: Studies in Fiscal Reform, IMF.Li, Wei (1997), "The Impact of Economic Reform on the Performance of Chinese State Enterprises,1980-1989," Journal of Political Economy, Vol. 105, No.5, pp1080-1106.Liu, Xiaoxuan (1997), "Managerial Autonomy Structure, and Firm Behavior and Performance,"CASS, mimeo (in Chinese).McMillan, J. (1996). "Markets in transition", in Advances in Economics and Econometrics: Theoryand Applications, Seventh World Congress, Vol.II, Econometric Society Monographs,Cambridge University Press.______ and Barry Naughton (ed.) (1996). Reforming Asian Socialism: The Growth of MarketInstitutions, University of Michigan Press, Ann Arbor.______ (1996). "Reforming China's State-Owned Firms," in McMillan, J. and B. Naughton (ed.)Reforming Asian Socialism, University of Michigan Press.Otsuka, Keijiro, Ryu Toku Kyo and Naoki Murakami (1995). Macroeconomic Reform in China:Quantitative Analysis of Enterprises and Market, Nihon Keizai Shimbun (in Japanese).Qian, Yingyi (1995). "Reforming Corporate Governance and Finance in China," in Aoki, M andH-K Kim (ed.) Corporate Governance in Transitional Economies: Insider Control and theRole of Banks, EDI Development Studies, World Bank.______ (1996). "Enterprise Reform in China: Agency Problems and Political Control," TheEconomics of Transition,______ and Barry Weingast (1997). "Institutions, State Activism, and Economic Development:A Comparison of State-Owned and Township-Village Enterprises in China", in Aoki, M.,H-K. Kim and M. Okuno-Fujiwara (ed.) The Role of Government in East Asian EconomicDevelopment: Comparative Institutional Analysis, Clarendon Press, Oxford.Raiser, Martin (1997). "Evaluating Chinese Industrial Reforms: SOEs between Output Growthand Profit Decline," Asian Economic Journal, Vol.11, No.3, pp.299-323.Shleifer, Andrei and R. B. Vishny (1997). "A Survey of Corporate Governance," Journal ofFinance, Vol. L II, No.2, pp.737-783.Tanzi, Vito (ed.) (1993). Transition to Market, Studies in Fiscal Reform, International Monetary Fund.Wada, Yoshio (1995). "Economic Development and Design of Organization", Journal ofDevelopment Assistance Vol. 2, No.2, pp. 287-298.Wada, Yoshio (1997). "Economic Development and the Government", Journal of DevelopmentAssistance Vol. 4, No.1, pp. 79-123.Weitzman, Martin L. and C. Xu (1994). "Chinese Township-Village Enterprises as VaguelyDefined Cooperatives," Journal of Comparative Economics, Vol.18, pp121-145.Wen G. J. and D. Xu (ed.) (1996). The Reformability of China's State Sector, World Scientific.Wong, C. P. W., C. Heady and Wing Thye Woo (1995). Fiscal Management and Economic Reformin the Peoples Republic of China, an Asian Development Bank Publication, OxfordUniversity Press.World Bank (1996). Reform of State-Owned Enterprises, China and Mongolia Department, World Bank______ (1996). World Development Report 1996, From Plan to Market, Oxford University Press.______ (1996). World Development Report 1997, State in a Changing World, Oxford University Press.______ (1997). China's Management of Enterprise Assets: The State as Shareholder, China andMongolia Department, World Bank.Xu, Lixin Colin (1997). "How China's Government and State Enterprises Partitioned Property and ControlRights," Policy Research Working Paper No. 1743, Policy Research Department, World Bank.

36 Yoshio Wada, Incentives and Property Rights in China’s State-owned Enterprise ReformZhang, Ping (1997). "China's SOE in the 90s: Output, Input and TFP Analysis", CASS, mimeo(in Chinese).Zingales, Luigi (1997). "Corporate Governance", NBER Working Paper, No.6309, December,1997.Supplement: Characteristics of the DataA characteristic of this survey of Chinese state-owned enterprises is, as has be mentionedearlier, that it was a survey of the fiscal and financial conditions of approximately 800state-owned enterprises in the 4 provinces of Jilin, Szechwan, Hunan and Jiangsu. Thecharacteristics of the survey data on the targeted enterprises will be explained here in linewith Supplementary Table 1. The enterprises surveyed with regards to which data werecollected are state-owned enterprises in large and medium to smaller cities in the 4representative provinces situated in the eastern, western, southern and northern districtsof China. The survey targeted 8 representative industries comprised of metal, electricpower/ coal/ water works, petrochemical, machine manufacturing, construction material,food processing, textile, printing and others. In each province, enterprises in these industrieswere selected in a manner designed to eliminate biases but as Table 1 shows, the resultshows a preponderance of machine manufacturing, petrochemical and food processingenterprises.Moreover, although the selection process attempted to eliminate biases in the scale ofthe enterprises, the overall results reflect the fact that more enterprises are found as thescale becomes smaller and large numbers of medium scale enterprises have been included.The fact that there is a concentration on medium sized state-owned enterprises that aremost difficult to reform means that the survey gives a clear picture of the issue of reformof state-owned enterprises. In China, state-owned enterprises are managed by variouslevels of government (Level Separated Management). Which level of government exercisescontrol over a certain enterprise is a factor determining the characteristic of the stateownedenterprise. The distribution of jurisdiction is as shown in the table and the numberbelonging to the local level city is 480 or an overwhelming 60% of the total.With respect to the year of establishment of the state-owned enterprises surveyed, noparticular limits were established upon selecting the enterprises targeted in the survey.The distribution of establishment dates of the state-owned enterprises selected as surveytarget is shown in Supplementary Table 2. Even having set conditions on the region,industry, scale and jurisdiction, enterprises established in the 1950s and 60s are numerous.This indicates that a large number of the state-owned enterprises in China were establishedin this period. However, it is noteworthy that even after the 1980s when the reform ofstate-owned enterprises began, quite a large number of state-owned enterprises have beennewly established. This indicates that concurrent to the reform of state-owned enterprisesin the 1980s and 90s, new state-owned enterprises were still being established.

OECF Journal of Development Assistance Vol.4, No.1, 1998 37Supplementary Table 1Characteristics of Surveyed Enterprises(No. of enterprises)Jilin Sichuan Hunnan Jiangsu TotalTotal 210 200 200 186 796Sector-wideMetallurgy 5 5 7 6 23Power, coal and water supply 7 5 9 7 28Petrochemical 27 33 40 35 135Machinery 76 62 78 68 284Construction materials 28 23 16 15 82Food processing 25 49 20 26 120Textiles 24 15 18 22 79Printing, etc. 18 8 12 7 45Scale-wideLarge 46 39 44 51 180Medium 83 73 95 77 329Small 81 88 61 57 287Jurisdiction-wideCentral government 32 16 29 6 83Provintial government 23 10 21 5 59Municipal government 142 93 121 125 481County • prefecture government 4 75 23 43 146Other 9 6 6 6 27Note : Total number of enterprises is 795 where include one enterprise whose scale is unknown.From the perspectives of region, industry, scale, jurisdiction and year of establishment,the representative image of an enterprise among the enterprises targeted in this survey isa medium scale enterprise in machine manufacturing under the jurisdiction of a locallevel city and established in the 1950s. Enterprises that satisfy these 4 conditions withinthe data collected number 39 (4.9%) of the 796 enterprises surveyed.Targeting such state-owned enterprises, the survey collected quantitative informationon the fiscal conditions and productivity of the enterprises and qualitative informationthrough questionnaires submitted to the management. When compared to the surveyprimarily on information about state-owned enterprises in the 1980s conducted by theChinese Academy of Social Science, the years covered are 5 years and thus half of theformer survey, items in the quantitative and qualitative information number half so thattotal data are a quarter of the former survey. However, with respect to fiscal data, thissurvey almost completely covers all items included in financial statements and is moredetailed than the 1980s CASS survey.Supplementary Table 2Distribution of Surveyed Enterprises by Establishment Year(No. of enterprises, %)Year of establishment Number of enterprises (ratio)prior to 1949 74 ( 9.3)1950 ~ 59 297 ( 37.3)1960 ~ 69 147 ( 18.5)1970 ~ 79 159 ( 20.0)1980 ~ 89 103 ( 12.9)after 1990 16 ( 2.0)

THE REFORMS OF STATE-OWNEDENTERPRISES IN CHINA:A VIEWPOINT OF LAW AND ECONOMICSKaoru Hayashi*SUMMARY(1) The reform of state-owned enterprises has been pressed on in People's Republic of China(PRC) centering on two major concepts of "ownership" and "management right" of theenterprises. It was, however, difficult to keep these two concepts compatible, and as aresult, the reform has brought about such problems as decrease of the state property andinadequate autonomy of the enterprises simultaneously. In addition, the fact that over 80percent of state-owned enterprises remain in the stage of the "workshop system (gongchang zhi)" is the cause and result of the "property right problem (chan quan wen ti)" suchas segregation and valuation of the enterprise's property right. The fundamental reason ofthese problems lies in inconsistency between the existing laws and the market system.(2) The most effective solution of the above mentioned problems is to proceed with an enterprisereform in conformity with the company law. It was a great progress that promotion of theenterprise reform in the very same line was confirmed in the 15th session of NationalConvention of the Chinese Communist Party in September of 1997. The argument will,however, be brought up again over how the issues on public ownership should be settled.In the future, a flexibility of switching the way of thinking from ownership to regulationwill be needed.(3) It is hard to infer how the corporate governance in conformity with the company law inPRC be established only from what are provided in the positive laws. Therefore, it will benecessary to follow up its enforcement and to make an appropriate amendment when ithappens to be indispensable. Moreover, it is necessary to speed up preparation of a consistentcivil law system as well as to secure its effectiveness with due consideration for thedivergence between the enacted law and the "living law", in order to establish a legalsystem which is vital to the market economy.CONTENTSPrefaceI. "Law and Economics" of Ownership and Property RightsA. Juristic Approach* OECF Journal of Development Assistance Vol.4, No.1 (1998) pp.38-67©1998 by the Overseas Economic Cooperation Fund. All rights reserved.

OECF Journal of Development Assistance Vol.4, No.1, 1998 39B. Economic Approach and "Enterprise's Ownership"C. Viewpoint from "Law and Economics"II. State-owned Enterprises in PRC and "Enterprise's Ownership"A. "Ownership" and "Management" of Enterprises in the Laws Provided in PRCB. "Enterprise's Ownership" in the Nationalization StageC. "Separation of Two Rights" in the Reform and Opening Up StageD. Reform and Opening Up and Development of a Legal SystemE. Company Law and "Separation of Two Rights"III. Property Right ProblemA. "Separation of Two Rights" and "Property Right Problem"B. Various Aspects of Property Right ProblemC. Enterprise Management System and Property Right ProblemD. Characteristics of Property Right of State-owned Enterprises with Workshop SystemE. "Enterprise's Property Right" and Corporate Governance of State-owned Enterpriseswith Company SystemIV. Transition to the Market Economy and LawsA. Market Economy and Civil Law SystemB. Preparation of an Appropriate Legal System for Establishment of the MarketEconomy and Role of the GovernmentV. Conclusion: Difficulty of Reforming State-owned EnterprisesReferencesPREFACEIn this paper, we will discuss the true nature of the problem with state-owned enterprise reformin PRC and examine the future direction in which the reform is to be proceeded, therewith revealsomething of the point; what constitute the matters of state-owned enterprises and what theirreform ought to be, considering the state-owned enterprise reform in the eyes of the law. Especiallythe following two issues will be focused here; "separation of two rights (liang quan fen li)" as alegal issue of separation between ownership and management and "property right problem (changquan wen ti)" widely noticed in PRC at present, for the reason that these two issues are involvedin a matter of vital importance but with the greatest difficulty that is concerned with the relationbetween "public ownership" system and reform of enterprise's management autonomy / changein their management system, that they clearly show the difficulty of introducing and enforcing amarket (civil) law as a problem which accompanies transition to the market system, and furtherthat they have the elements in which a newly growing interdisciplinary attempt of "Law andEconomics" is to be applied extensively to development issues.It is vitally significant that the 1997 issue of the "World Development Report" by the WorldBank dealt with the problems accompanying economic system transition and that it threw a newlight on the importance of the function of the "law" and "legal system" in development issues,emphasizing that establishment of property right and appropriate enforcement of the relatedlaws are major premises for the response made by market players. Of course, the law or the legalsystem referred to here does not mean mere laws officially enacted but also the whole norms and

40 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewsanctions operating in the law and the social system including customary laws. In many developingcountries, the modern laws have been formed and developed overlappingly on the basis ofindigenous norms and laws (civil law / social law). In the analysis of the legal aspects regardingindividual development tasks like state-owned enterprise reform, it will be required to understandthe total functioning of these laws.I. "LAW AND ECONOMICS" OF OWNERSHIP ANDPROPERTY RIGHTSThe "property right" problem with the state-owned enterprises in PRC can be roughly dividedinto those related to its (a) "establishment", (b) "valuation", (c) "protection" and (d) "market." Inthe argument over these problems, juristic ideas and economic ideas are crossing each other."Ownership" and "property right" as juristic ideas have established definitions in terms of civillaw, while these terms have broad sense based on the practical situations and are flexibly used inthe field of economics. Accordingly, for easier understanding of our argument, we will first takeup the similarity and dissimilarity between juristic and economic approach to property right.A. Juristic ApproachIn the first place, we will review the system of rights. Right in the eyes of the law can be dividedinto property right and nonproperty right. Right is a benefit-sanction complex that is created tomeet with the needs of exchange in modern societies (market economy). The modern society(market economy) provides rights as fix the clear boundary between rightholders and force themto choose between all or nothing. 1Based on the Japanese law, property right can be defined as a private right enjoyed uponone's property and a exchangeable right such as ownership (on real property), creditor's right,intellectual property right etc., while nonproperty right can be defined as one's particular andunexchangeable right including personal rights (rights regarding one's body, honor, life, nameand credit), rights based on the family law (parental authority, marital right, succession right,etc.), rights based on collective laws (right of common interest) etc.Property right can be divided into the real right to keep a certain (corporeal) thing underone's direct control and the creditor's right that an obligee can claim for a certain action (payment)by the obligor. It is said that the ownership (on real property) is an exclusive right because itclaims a direct control of a thing, while the creditor's right is not exclusive because it is appliedto an obligee's relation to the other person. Ownership means the right of full and constant controlof an object concerning its use, gain and disposal and has a characteristic perfection of the rightapplication compared to the limited rights for limited or temporary use of an object.In the Anglo-American law, the distinction between property right and ownership is thesame as that of Japanese law stated above. 2 These two terms are often used interchangeably atthe colloquial level, because ownership is the ultimate and perfect property right with full andconstant control of an object. Historically, the right to control things, namely, ownership was1 Kawashima (1965) p.41 ff.2 Morimura (1995) p.5.

OECF Journal of Development Assistance Vol.4, No.1, 1998 41first acknowledged and permeated as a right, and afterwards, various usufructuary rights andcreditor's rights have formed and still are forming with the development of economy and marketsystem. Therefore, it is normally not so problematic to treat ownership as a typical propertyright, but with regard to the enterprise's ownership, the argument should be built up with theterminological difference between the concept used in the juristic definition and that commonlyused in economics.In the Chinese law, the understanding of ownership and property right is not so far fromwhat we have mentioned above. In the Chapter 5. of civil law, general rules enacted and enforcedin 1986, the "property possession right" and the "property right regarding property possessionright" are provided, and the former comes into the ownership category of the Japanese and theAnglo-American laws. However, it is not sure that there is a consensus in China on whether touse the word "property right" as a generic term for all the rights regarding one's property includingcreditor's rights, as mentioned later in the chapter of "Property Right Problem."B. Economic Approach and "Enterprise's Ownership"The term "Ownership" is often used in the context of economics in far broader sense than in thecontext of law. It is the right not only to control existing real things but also all the valuedobjects. 3 For example, it is also understood as the "residual right of control --- i.e. the right todecide the way of using one's property except its part assigned to others by laws or contracts". 4The term "property right" is also, however, widely used in regard to the establishment and thebelonging of rights.A characteristic of the economic approach to ownership is the extended application ofresidual control even to the "enterprise's ownership," i.e. the term "enterprise's ownership" isused as the right for capital owners to control the remainder left over after they paid to creditor,employees (salary) and executives (remuneration), but in reality, stockholders are not able todirectly control every business activities conducted by executives of the enterprise. The controlof employment of worker, salary, fringe benefits, expense account etc., for example, are passedinto the hands of executives and employees. The idea of "ownership" with perfect control is,therefore, does hardly hold good here. Needless to say, incomplete "ownership" is, in the eyes ofthe law, a self-contradictory idea. If so, how should we understand the "enterprise's ownership"in the context of law?The "separation between ownership and management" observed in the joint-stock companysystem has developed based upon two demands: necessity of financing in large quantity and ofsecuring specialties essential for business administration. The characteristics of the propertyright in such a case is as follows. On the one hand investors have a limited liability in the form ofstocks, but on the other hand the company as a juridical person owns property concerning everydaybusiness activities and controls individual relations to others concerning property right likeobligations, and investors are shut off from direct participation in any action concerned withproperty right of the company. Investors are able to exercise their stockholders' right accordingas their holdings through stockholders' voting or by bringing derivative suit in accordance withthe company law, articles of association etc., but it does not mean that they directly control the3 Kishida (1996) p.73.4 Milgrom and Roberts (1992). Japanese version, p.321.

42 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewproperty of the company. 5For example, in the case of joint-stock company in the Japanese law, stockholders' rightconsists of (a) the individual interest right, namely the property rights that every stockholder canpersonally exercise including the right to claim for dividend (commercial law, Art. 290 / Art.293), the right to claim for distribution of residual property (Art. 245), the right to claim fordividend of interest, preemptive right for new stocks, the right to claim stock purchase warrantetc., (b) the common interest right that its exercise by a stockholder affects other stockholders'right, including the stockholders' voting (Art. 239), the right to bring a derivative suit (Art. 267),the right to convene stockholders' meetings (Art. 237), the right to claim dismissal of directors(Art. 257) (minority stockholders' right) etc.These rights are exercisable within certain limits, and it is the principle that stockholders'liability is limited. Therefore, it is impossible to compare them to the perfection of ownership(on real property) regarding use, gain and disposal of an object (owners can exercise exclusivelytheir rights, enjoy the whole residual profit and assume the whole residual liability derivativefrom it). Of course, there are some exceptional cases, for example, a case that a company doestake a form of joint-stock company but it is nothing but a sole proprietorship in reality, and thatit is, therefore, hard to distinguish between properties belonging to the company and to the ownerhimself.In such a case, if the company becomes bankrupt for example, the "disregard of the corporatefiction (houjinkaku hinin)" is applied and the owner is put under an obligation to repay not onlyfrom the "corporate property" but from his own property. A legal fiction "to own enterprise" ishere practically realized by the characteristic of ownership to assume the residual liability. In thecase of partnerships where the corporate members (investors) hold unlimited liability, "enterprise'sownership" is also substantial.It is obvious, we knew from experience, that the "enterprise's ownership" is realizedaccording as the portion of individual owners and the extent of their participation in themanagement. However, in the case that the capital and administration scales are massive and that"separation between ownership and management" becomes distinct, stockholders as well as theother stakeholders like the company executives, creditors, employees etc. have obligee-obligorrelations with the company, and the stockholders' "ownership" forms a part of these relations. Inother words, the question "who owns the enterprise" is not automatically answered based on thehypothesis that "stockholders own the enterprise" but should be recognized as the question of themost appropriate entitlement of rights according as the extent of commitment to the managementby the stakeholders.In the case of the state-owned enterprise reform in PRC, however, it was required to solvethe "enterprise's ownership problem" against its historical background, about what we will arguelater in the Chapter II.C. Viewpoint from "Law and Economics"Here, we will a little digress from the main subject of this paper and enter a topic whether therecently formed and growing interdisciplinary attempt of "Law and Economics" is really applicableto matters in the field where law and economics have common grounds, especially to development5 Suzuki (1954)

OECF Journal of Development Assistance Vol.4, No.1, 1998 43issues. "Law and Economics" interprets legislation from the viewpoint of economics, analysesthe effect of laws on the economy and the society and suggests unique theory of legislationpolicy, by using legislation and individual provision of laws as well as the micro-economic pricetheory as main analysis criteria. 6 For example, as to norms, "Law and Economics" analyses andinterprets "judgement of illegality as based on economic interpretation of efficiency, 7 " and arguethat the reason for the illegality of property right infringement is that such an infringement hindersan efficient resource allocation.This approach meets with many criticisms. First, it is criticized that it contains inconsistencybetween economic interpretation of efficiency and axiom of justice proper to law. "Law andEconomics" has its origin in the "Coase's theory" that was brought up in "The Problem of SocialCost" by Coase. 8 What is explained in the theory is the following: if the transaction cost is zero,the efficient result can be achieved no matter whom the right is allocated to, while, if the transactioncost assumed by one party is higher than the other party, the efficient result can be achieved bylaying the compensation liability for damages on the latter party. For example, to settle a conflictof interests between an industrial polluter and the citizens, if it is more efficient (lower cost) tointroduce pollution control facilities and if the transaction cost is high, then the liability fordamages should be imposed on the industrial polluter, but in contrast, if the resettlement of thecitizens is the most efficient solution (the lowest cost), then the liability for damages should notbe imposed on the industrial polluter. Such an interpretation would be contrary to the axiom ofjustice that is expected of law, especially when the citizens had settled in the region before theindustrial polluter started to run. 9 To this criticism, however, we are able to set forth acounterargument that it is undeniable that the interpretation of efficiency is also an importantcriterion for settlement of ambiguous interests, distribution of rights which are not yet establishedor new situations concerning law accompanying economic and social development (e.g. "lender'sliability", "specialist liability" etc.).It is also criticized that "Law and Economics" is exclusively based on the theory of neoclassicalschool and on the assumption that every economic agent always behaves rationally, butwe can say, it does not mean that "Law and Economics" is necessarily (to be) "neo-classicalschool" itself. We rather expect it to analyze what responses economic agents will make to amulti-lateral legislation. 10In regard to development issues, legislation policies based on "Law and Economics" wouldbe possible in developed countries where the market system has already been established andindividual persons are assumed to be an agent unit in the markets in every respect, and it goeswithout saying that a theory formed and grown in developed countries is hard to apply directly todeveloping countries because the above-mentioned premises are not always correct there. 11 Itwould, however, be very useful to make legislation policies on the basis of the analysis concerningthe economy in developing countries how the behavior of economic agents is affected by asystem of norms and sanctions including laws and customary laws. That is to say, it is significantto understand the legislation in developing countries in the context of development policy as a6 About the outline of "Law and economics", see Hayashida (1996), Kishida (1996), Posner (1992), etc.7 Hayashida (1996) p.48.8 R.Coase (1960). "The Problem of Social Cost", Journal of Law and Economics.9 Morimura (1995) p.144.10 e.g. Ramzayer (1990)11 Yasuda (1992)

44 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewwhole.As it will be touched later, on legal problem with state-owned enterprise reform in PRC thecustomary laws and the general sense of law that are inherited from the traditional society, thelegislations formed in the socialist era and laws enacted in the course of reform and opening uphave influence, complicated with each other. It will be required to examine closely their functionsand interactions. In developing countries, modern laws are generally lying upon the inherentlaws rooted in the customary economy and the traditional society. Further, the modern law itselfconsists of the civil laws based on the market economy and regulation system developed with thestructuralist or socialist development strategies. It is thought to be vitally important to understandthe difference 12 between the principles on which the individual legal systems are based, in orderto grasp the true picture of the "living laws." In this paper, we will try to learn some useful ideasand points of view from "Law and Economics" with the awareness of its limitations.II. STATE-OWNED ENTERPRISES IN PRC AND"ENTERPRISE'S OWNERSHIP"A. "Ownership" and "Management" of Enterprises in the Laws Provided in PRCAs mentioned above, in the capitalist societies, "enterprise's ownership" can be recognized as thematter of distribution of rights among stakeholders, but the situations in PRC is quite different.The point is, of course, the prerequisites based on the principle of "public ownership (stateownership) of production means" that is deeply concerned with the basis of socialist principle. 13Actually, it is not too much to say that the reform of state-owned enterprises in PRC so far hasalways had the tensions against the "principle of public ownership" as a background, i.e. themanagement of enterprises needs to be flexibly executed to meet the changing situations ofeconomy and society and to achieve the efficiency, and for the sake of it the expansion ofenterprise's autonomy is required, but the more the enterprise's autonomy expands, the smallerbecomes the state control based on the principle of "public ownership," therefore the tensions arebrought about.In such a context, how the ownership of production means should be defined is first inquestion. There have been many disputes between various views and principles centering on thefollowing three typical points including strict and lax ones; 1) it is well enough if the capitalownership is nominally secured, 2) it becomes no matter how the right is nominally treated if thecontrol is practically secured or 3) it is necessary to secure the practical control through thecapital ownership. Now, it is meaningful to review how the state ownership of enterprises hasbeen established and what have been the points at issue.12 Yasuda (1996) classified the laws in developing countries into three types: indigenous laws,introduced laws and development laws, and their respective legal principles: cooperative principle, marketprinciple and directive principle, further their basement societies: communal society, economic society andpolitical society. ibid. P.292 ff.13 It was also argued in Japan over ownership as twofold right consisting of "ownership of merchandise"and "ownership of capital" but probably always in the Marxist context. (Yasuda, Nobuyuki (1992). "ChuugokuKigyou Soshiki Hou Josetsu (Introduction to the Corporation Law in People's Republic of China)" in Harioand Yasuda ed. (1992). p.164)

OECF Journal of Development Assistance Vol.4, No.1, 1998 45B. "Enterprise's Ownership" in the Nationalization Stage 14After the establishment of People's Republic of China in 1949, the government of PRC had tostart constructing a socialist system under the semicolonial economic condition controlled byimperialism, feudal power and bureaucrat capital. Therefore, the policy adopted in the industrialsection was not to be so radical. The foreign capital was commandeered but the native capitalwas actively introduced with the intention to start with the state capitalism and then graduallyshift to the socialist nationalization of enterprises. In the early stage of state capitalism as thevery first stage of this course, private enterprises owned by native capitalists were allowed to runthe business as before, while they had to obey the state economic control in purchasing the rawmaterials or selling the products.This stage lasted up to 1954 and as the next stage the era of the advanced state capitalismfollowed. In this stage, the transition of enterprise's ownership to joint management system bypublic and private owners started and came to be at its peak around 1956. In such a jointmanagement system, the right of "capitalist" was restricted only to receiving fixed dividend(fixed interest) at 5 per cent a year to their contribution amount for a certain period and they hadno more voice in enterprise's management. And further, from 1958 the next stage policy to mergethe joint management enterprises with state-owned enterprises was proceeded. The fixed interestwas later to be often the target of severe criticism as the vestige of capitalism, and finally thepayment of this interest was suspended during the period of the Cultural Revolution. After thereconfirmation of fixed interest as "legal income" in the constitution enacted in 1978, thesupplementary payments were made in 1979 and in 1980 and the period of payment expired. 15The fixed interest provoked disputes about the ownership of production means. There wasa sharp division of opinion. The "theory of forfeiture" asserted that the ownership of capitalistsceased to exist after introduction of the public-private joint management system, and standingright against it, the "theory of remaining" asserted that the ownership of capitalists was stillremaining. The difference between the viewpoints of these theories offers important clues toknow how the "ownership of enterprises" has been interpreted. 16The former regarded that the ownership of capitalists had changed into monetary form andwas not considered as the capital producing dividends any more but nothing more than a right ofclaim similar to that of creditors because they had no right regarding possession, use or disposalof the enterprise's property. From this viewpoint, it was also argued that the right based on stocksis also a right to claim similar to that of creditors as far as it remains the right to claim fordividends.On the other hand, the latter regarded the true nature of the right to claim for dividends asa "vestige of the capitalist ownership system" though the ownership had changed in its qualitythrough the process of property production, its valuation and calculation of fixed interest afterintroduction of the public-private joint management system and the capitalists surely had noright regarding possession, use or disposal of production means more. This viewpoint formed abasis for the political advocacy that a further step up of socialization of economy is needed.The disputes between these two theories were concerned with the questions; what affords14 The following explanation is taken from Yamauchi (1989).15 Nishimura (1984)16 The following lines are taken from Nishimura (1973) and Nishimura (1984).

46 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewthe legal ground for the payment of fixed interest and how the further socialization of enterprisesshould be proceeded. The principles of each theory may be summarized as follows; (a) "for thepractical management control belongs to the state, it does not matter if the capital is ownedprivately" or (b) "practical control of both the management and the ownership of the capitalsshould belong to the state." What they have in common is the assumption that the prerequisite forthe public ownership is the possession of (material) property of the enterprise or the practicalcontrol of possession, use and disposal. At this level, it was not taken into consideration at all todefine the ownership of enterprises only by the ownership of capital apart from the materialcontrol.Such an idea of material control lying behind has a great influence on the problem ofseparation between ownership and management right of enterprises ("separation of two rights(liang quan fen li)") and on the issue to whom belong the management and the property ofenterprises ("enterprise's property right"), i.e. the former makes it difficult to define theoreticallythe right of enterprises to autonomously manage their business ("enterprise's management right"),and the latter underlies a complicated situation for the practical management of the property.These two problems will be further examined from Chapter III. Both of them are, however, moreor less concerned with the matter of the "enterprise's property right," and thus, often overlap witheach other.C. "Separation of Two Rights" in the Reform and Opening Up StageCompared to the point at issue in the nationalization stage, the view of "enterprise's managementright" was altered in this stage as the reform of management autonomy from 1979 was advanced.Managers of enterprises were gradually allowed to autonomously run the business in the courseof the reform, and it was to create a new idea; (c) "if only the condition that the state owns thecapital is fulfilled, it is considered right to leave decisions about business management in chargeof managers." Though it remained ambiguous how far the state has or should have practicalcontrol over the managers' business decision, a way was opened up for the managers and theworkers (through bonus) to substantially control the "residual" left after fulfilling their dutyaccompanying contract or agreement or paying the tax to the state from the profits. This is,however, made the boundary between "enterprise's ownership" and "enterprise's managementright" quite ambiguous concerning the residual control. As to the legislation regarding this problemof "separation of two rights," namely between the ownership and the management of enterprises,trials and errors have been experienced. Here we will retrace the history of the legislation centeringon the "separation between ownership and management. 17 "D. Reform and Opening Up and Development of a Legal SystemIn regard to state-owned enterprise, the introduction of a modern enterprise system was requiredafter "Central Committee of Chinese Communist Party, third general assembly of the 11th sessionin 1978" to which PRC government always refers, and based on the principle "the Party takes thecollective leadership, workers take the democratic control and factory managers undertake the17 The sentences quoted from Chinese laws below are based on the Japanese translation by Miyasaka(ed.) (1995).

OECF Journal of Development Assistance Vol.4, No.1, 1998 47administrative direction of the enterprise," the "provisional act for the works of the state-ownedwork-shop managers" and the "provisional act for state-owned industrial enterprises" were enactedand enforced one after another from 1981. These acts and rules aimed at step up of managementautonomy while keeping the principle of public ownership in operation.In the general rules of the civil law enacted in 1986, article 82 stipulates that "enterprisewith public ownership legally enjoys the management right to the property to be managed andcontrolled by the enterprise that the state authorized to it" and article 48 "enterprise with publicownership as a juridical person takes on liability for civil affairs with the property to be managedand controlled by the enterprise that the state authorized to it." It means that the law givesrecognition to the "enterprise management right" and indicates the essential structure of the rightas authorization from the owner (the state = people). However, in the general rules of the civillaw, details of the enterprise management right are not yet provided.In the "Law for Industrial Enterprise with Public Ownership" (1988) (it is referred to as"State-owned Enterprise Law" or "SOE law" in World Bank Documents, etc.), contents of theenterprises management right are more concretely provided. This is a comprehensive lawconsisting of 8 chapters: (a) general rules (Art.1-15), (b) establishment, alteration and dissolutionof enterprise (Art.16-21), (c) rights and duties of enterprise (Art.22-43), (d) factory manager(Art.44-48), (e) workers and general assembly of representative workers (Art.49-54),(f) relationship between enterprise and government (Art.55-58), (g) legal liability (Art.59-64),and (h) supplementary rules (Art.65-69). It does not, however, contain provisions concerning thecapital.The Article 2 is the basic rule of the Industrial Enterprise Law (SOE Law). The Clause 1defines the factory with public ownership as "a unit of socialistic production and managementthat autonomously runs the business, takes responsibility on its own concerning profit and lossand operates by self-support accounting." The Clause 2 provides the nucleus of property right,i.e. it is stipulated that "property of enterprise belongs to public ownership and the state leave themanagement and control in charge of the enterprise in conformity with the principle of separationbetween ownership and management. The enterprise enjoys the right of possession, use anddisposal concerning the property authorized by the state." This provision is the basic definitionto "enterprise management right" in the Industrial Enterprise Law (SOE Law). The logical structureof the definition is that enterprise ownership belongs to people while the right to control, use anddisposal of property that is necessary for the business affairs executed by managers is legallyjustified by the authorization by the state as well as the possession of property by managers. TheClause 3 stipulates, similarly to the civil law, that "enterprise is recognized as a juridical personthat can take liability concerning the property that the state left in charge of it." The Clause 4 isthe provision concerning management contract system, lease system etc.The Clauses 22-43 of the Industrial Enterprise Law (SOE Law) define the boundary for theautonomy of enterprises. According to these provisions, though the directive plans made by thegovernment take precedence, enterprises are allowed to claim modification of the plans. Further,the autonomy of the enterprise concerning raw materials procurement, production, use of retainedfund etc. is also acknowledged with the limitation of conformity with the rules provided by theState Council. Concerning the fixed assets, the Clause 29 stipulates that "enterprise holds theright to rent out or sell the property and equipments that the state left in charge of it in accordancewith the rules provided by the State Council on condition that the transaction shall be used for

48 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewrenewal of the facilities and improvement of technology."In these provisions, the interpretation of the property as the object of management is stillambiguous, i.e. it is not clear whether the individual properties are to be directly controlled or themaintenance of the capital value as the aggregation of properties is to be controlled. This topicwill be treated in the chapter of "Property Right Problem."The Regulations for the Management Mechanism Reform of the SOE, if literally translated(referred to as "Autonomous Management Right Regulations" below) enacted in 1992 developedthe Industrial Enterprise Law (SOE Law) in 1988 toward enhancement of the enterprise'sautonomy. The regulations consist of (a) general rules (Art.1-5), (b) management right of enterprise(Art.6-22), (c) principle of self-liability for profit and loss (Art.23-30), (d) alteration and dissolutionof enterprise (Art.31-39), (e) relationship between enterprise and government (Art.40-46), (f)legal liability (Art.47-49) and (g) supplementary rules (Art.50-54). They provided more preciseand detailed rules concerning the autonomy allowed to the government than the IndustrialEnterprise Law (SOE Law) which attached the reservations, such as the conformity with therules by the State Council. They are, of course, based on the necessity to further intensity theenterprise's autonomy, and the provisions concerning enterprise's autonomy in the regulationsare vitally important to promote the state-owned enterprise's reform. They are generally called"14 rights of management autonomy;" decisions about production and management strategy(Art.8), determination of products and labor prices (Art.10), purchasing of materials (Art.11),import and export (Art.12), decisions on investment strategy (Art.13), control on retained fund(Art.14), disposal of properties (Art.15), joint management / merger (Art.16), employment oflabor force (Art.17), personal management (Art.18), internal organization (Art.20) and refusal ofrequisition (tan pai) (Art.21).Concerning "separation of two rights," Article 6 defines that "the management right meanshaving right to possess, use and dispose the property (of the enterprise) that the state left incharge of the enterprise." Here, the perception of "enterprise's property (right)" is worth noticing,but the fundamental stance of the similar provisions by the general rules of the civil law or theIndustrial Enterprise Law (SOE Law) is simply followed. Concerning the ownership of the state,Article 41 stipulates the following points:•The state holds the ownership of enterprise property, and the State Council exercises the rightas a representative. (Clause 1)•Enterprise property consists of investment by the state, properties producing profit and othersbelonging to public ownership but in charge of the enterprise regarding their running andmanagement. (Clause 2)Moreover, in order to secure the ownership of enterprise property, Article 42 stipulates thatthe financial standing as reported in the form of a balance sheet and profit-loss account should beexamined referring to indicators of maintenance and increase of enterprise's property value byaudit. Concerning assets and liabilities as well as profit and loss; that a distribution system of theprofit from the property between the state and the enterprise, e.g. distribution ratio or fixedamounts as due share, should be determined; and it also gives provisions concerning approval ofother investment projects than that are recognized as left in the enterprise's autonomy in Article13, the authority to take out mortgage on plants and equipments and to decide their alienation by

OECF Journal of Development Assistance Vol.4, No.1, 1998 49sale etc.The development from the Industrial Enterprise Law (SOE Law) to the AutonomousManagement Right Regulations involved an effort to expand "enterprise's autonomy" whilemaintaining a delicate balance with "enterprise's property right," by enumerating the restrictionsto enterprise's autonomy but maintaining the relations concerning ownership of enterprises. Therewere, however, some limitations in this approach.One of them is that the boundary between state-owned property and enterprise-ownedproperty is still ambiguous. For example, the Autonomous Management Right Regulations takea stance to grant property right to enterprises, but it also reconfirms that enterprise's property isowned by the state.In order to avoid the double property right to one object, the enterprise's property rightmust be defined as possession right authorized by the state, while the property right is originallyheld by state. If so defined, however, the relation between the two property rights means a simple"release (Xia Fang)" of the" administrative management right" from the government to theenterprise. 18 This structure accuse a severe problem concerning practical management ofenterprises. In the Chapter III, we will enter the details of this problem. In this case, it is impossibleto provide the rules for all the affairs in advance by laws and contracts, even if the restrictions to"management autonomy right" are enumerated in laws and if a comprehensive autonomy withinthe limitations provided by the laws is granted to enterprises. As a result, the line ministries try toremain in practical control of enterprise's management through exercising personnel right. If theline ministries keep the control, the principle of public ownership is formally realized, and yetthere is no guarantee in reality that the competent authority will act to represent the very interestsof public and effectively exercise the right to control enterprises. On the other hand, the enterprise'smanagers are able to take "information advantage." Accordingly, the both sides, the governmentand enterprises come to show a tendency to opportunistic behavior.Though there are now problems of decrease or "stripping" of state-owned property andinefficient management of it, the enterprise's autonomy is restricted in practice and experiencesan excessive intervention by the government that result in the increase of the management cost.Such problems of the management autonomy are considered to be caused by flaws in the presentlegal structure of "separation of two rights."E. Company Law and "Separation of Two Rights"The company law enacted in 1993 and enforced in the next year is said to be based on an detailedcomparative examination of the company laws of Japan and Western countries, so that it containssimilar provisions to that of international standard. It consists of the articles concerning twotypes of company system, namely limited liability company and joint stock limited company,and these provisions are not only applicable to state-owned enterprises, but also more widely toprivate companies or regardless of type of "ownership".In reorganizations of a state-owned enterprise according to the company law, the state, atfirst, as the promoter (or one of the promoters) invests with cash, spot goods, industrial propertyright, and land use right. The investment can be made either in the monetary form or non-monetaryform, but it is provided that all the invested capital necessarily valuated and calculated then18 OECF Research Paper No.24

50 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewconverted in the form of stocks (Art.8). Stock transfer should be in conformity with the law inthe case that there is the mechanism of authorization by the state (Art.148)Stockholders' general meeting is considered to be the supreme decision making organ of ajoint-stock company (Art.102), and it has competence to decide management principles and investmentplans, to assign and recall the secretaries, to assign and recall the auditors, to decide distribution ofprofits, to reconfirm the merger or liquidation, to amend the articles of association and so on. (Art.103).The board of secretaries (dong shi), which is equal to the board of directors in Japanese system,decides the management and investment plans and of the company (Art.112). The chair secretary iscompetent to represent the company and to execute the management (Art.113, 114).The contents of provisions are quite similar to that of developed countries and the law is nodoubt the most advanced one applicable to the reform of state-owned enterprise's mechanisms.However, it is clear that segregation and valuation of enterprise's property right is requisite toenter into this stage, and through state-owned enterprises could achieve the reform to transit tojoint stock company system, it would be another question whether they have the substance asjoint-stock companies. For the sake of it, account and tax audit systems will be supplementarilyrequired. The percentage of joint-stock limited companies of all the subject companies researchedby OECF increased from 1.8% in 1993 to 5.7% in 1995 and the percentage of limited liabilitycompanies from 0.4% to 2.4%, but most of them remain in the form of "workshop system" towhich the Industrial Enterprise Law (SOE Law) and the Autonomous Management RightRegulations are applied. 19We can not easily say that the problem of relation between "enterprise's ownership" and"enterprise's management right" would have been fundamentally settled with the transition to ajoint-stock company system. First, the state is still remaining the owner as a stockholder. However,in terms of the above-mentioned points at issue concerning the ownership and the managementof state-owned enterprises, this opens up a way to dynamic changes of ownership relation throughstock transfer or capital increase etc. while maintaining the basic principle that "to own capitalmeans to own the enterprise." We can safely expect that there were internally many confusionsand disputes both in theoretical and practical aspects on how far the existing ownership systemwill be durable, if the share owned by state decreases. It is obvious that this conceptual difficulty,along with the difficulty with segregation and valuation of property right, placed obstacles totransition to joint-stock company system. The statement in the 15 th session of the NationalConvention of the Chinese Communist Party gave an answer to the question, creating a momentumto the state-owned enterprise's reform toward a joint-stock company system. In the session, itwas suggested that the desirable economic system principle is "to develop diverse ownershipsystems on the basis of public ownership system" according to the company law; that "jointstockcompany system has an advantage for separation between ownership and management aswell as for more efficient running of business and capital …… and the important thing is bywhom the stocks might be owned," and that the practical control through the (simple majority ofthe) stocks should be the principle.However, it is still open to conjecture whether the problem of the separation between"ownership" and "management right" could be really settled even if the reform would be proceededon the basis of the above mentioned principle. It is quite possible that the state will be unable tomaintain the majority share or that the maintenance of the majority share by the state will place19 OECF ibid.

OECF Journal of Development Assistance Vol.4, No.1, 1998 51a great obstacle to development of the enterprise itself, as the stock market develops and enterprisesexpand. In such a situation, for example, such a question may be brought up as "whether the stateis considered to have practical control even with 10% of diversified shares."It is also possible that the state's share stands contrary to the interests of private investors.As stated in the chapter I, it may be simply impossible to keep the idea of "enterprise's ownership"which can not be fit to be a legal concept. Though enterprise's ownership is a question of vitalimportance to the socialist system, there remains pragmatic approach to replace "ownership" by"regulation."III. PROPERTY RIGHT PROBLEM (CHAN QUAN WEN TI)A. "Separation of Two Rights" and "Property Right Problem"It is also frequently observed in capitalist economies that the owners practically have influencein the matters concerning the company's property right or the mattes for managers' autonomousdecisions apart from the principles provided by laws. It depends much on the managers' relativestrength in practice how far they actually hold the "management autonomy." To think over therelation between property right and management autonomy of enterprises, two differentviewpoints, namely the viewpoints from legal structure and from practical relations are necessarilyrequired. It is already touched on above that it is actually hard to establish the enterprise' propertyright, caught between "enterprise's ownership" and "enterprise's management right." Thearguments over "separation of two rights" are concerned with a tenet of socialism, while the"property right problem" is widely discussed from a more practical viewpoint. In this chapter,we will examine the maters from a more practical angle including that the arguments over"separation of two rights" do not cover.The "property right problem" is an issue which includes many different and complicatedfields, but can be roughly divided into following three. 20Problems caused by unestablished boundary for property rights. This obscure boundarycauses two difficulties. On the one hand, state-owned properties are decreasing as a resultof business activities by enterprises, and on the other hand, enterprises can only inadequatelyexercise their management autonomy right, for example, their decisions on business affairsare restricted, because they are incompetent to autonomously dispose the properties even ifit is necessary to run the business.Problems caused by lack of appropriate valuation of properties. It brings about difficultiesespecially with investment in joint-management enterprises with foreign partners, mainlybecause there exists no property trading market, so that it is hard to decide standards forproperty valuation. It can also be considered as a problem of a underdeveloped or immaturemarket.Problems caused by indefiniteness of the agent and the system of property management.Because of this, little effort is put into maintenance and increase of properties, and as aresult, unprofitable investments are made and "unfeasible" projects are implemented. It is,20 Xie, Shi rong (1995) etc.

52 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewin a broad sense, a problem of inefficient management.Judging from the provision of the general rules of the civil law (1996), it may be possibleto simply interpret property right in Chinese laws similarly to its interpretation by the civil lawsin developed countries. It is, however, said that there are many different uses and interpretationsfor the word "property right" in practice, such as (a) the right to own property, (b) the right basedon ones property and of a series of behaviors concerning ownership, (c) the sum of diversifiedkinds of right concerning one's property as an object, (d) the right based on certain forms ofownership or possession and that which brings a certain profit to the owner or the possessor, (e)the right to be enjoyed based on certain types of properties by the one who is defined in laws asthe right-holder and the duty accompanying it, (f) the right concerning relations of ownershipthat are defined in laws, (g) the right to own property and the related rights, etc. 21The "control" is nucleus for both property right and ownership. As far as the public ownershipis considered as the principle, it is unavoidable that difficulties are brought about in decision towhom the enterprise's property right belongs or who should be considered as representatives forthe enterprises. This is not only a theoretical matter but also causes practical problems in manyrespects. To examine this point, an analysis of the legal structure by focusing more keenly onenterprise's property or enterprise's property right is required, but we will before take a look atactual problems that are recognized as the "property right problem."B. Various Aspects of Property Right Problema) Outflow of state-owned propertiesThe accurate data for loss of state-owned properties is not clear because the result of propertyrevaluation (qing suan he zi) implemented in 1994 is not totally disclosed, but it is said that"the loss amount has come to one trillion Yuan since 1984 and now continues to increase330 million Yuan per day. 22 " As the causes of it, unauthorized disposal and inappropriatemanagement of properties are pointed out in general. This is basically because boundariesbetween rights are not fixed and it is not clear to whom the right belongs or how far themanagement of the business affairs is authorized to enterprises. In regard to valuation ofproperty, inappropriate capital valuation in establishment of joint-management enterpriseswith foreign partners is often brought up as a criticism against external open economypolicy and now becomes a political issue. 23 It is also a problem in establishment of jointstockcompanies.b) Inadequate enterprise's autonomy and government control over their business activitiesFrom the above examinations about problems of related laws, it is obvious that enterprise'sautonomy is to be restricted in many respects, and actually it is frequently pointed out that21 Xie, Shi rong ibid. etc.22 Zhang, De lin (1993) p61.23 Zhang, De lin ibid. p.62 gives an example of a beverage manufacturer in He nan: it established ajoint venture with a foreign company and contributed 14.2 million Yuan in kind as a book value, but inrevaluation implemented by the government agency in charge of state-owned property that was valuated as30.98 million Yuan. In addition, it was turned out from the result of state-owned property revaluation forjoint ventures in 1992 that contribution by Chinese (state-owned) enterprises was 15.29 million Yuan asacquisition value, 12.892 billion Yuan as book value and 24.96 million Yuan as revaluation.

OECF Journal of Development Assistance Vol.4, No.1, 1998 53there are many restraints in practice. The OECF/RIDA research into enterprises (1997)also supports this. About 70% of the subject enterprises answered that they did not haveautonomy concerning investment and disposal of properties, 87% of them answered thatmanagers (factory managers) are assigned or appointed by the line ministries and 83%answered that the line ministries are most influential on assignment and dismissal ofmanagers. In short, enterprises practically have no personnel management right concerningemployment and changes in the staff. 24 In contrary, their autonomy for ordinary businessaffairs like decision of sales price etc. It is, however, no surprise because competition inmany markets especially in the markets of consumer goods are activated. Anyway, suchgreat restraints on investment and personnel means that the government is seizing theenterprises by the neck concerning basic decisions on management. This situation is thoughtto be a impediment to development of the factor market.One of the important conclusions drawn from the OECF/RIDA enterprise research(1997) is that increase of production cost especially of raw material costs, financial costsand management costs is the main cause of deteriorated financial stand and that managementcosts such as allotment of local development expenditure have been keenly increasingamong others and financially burden state-owned enterprises. 25 These data makes it clearthat enterprise's autonomy is not based on the substantial property right in real terms, butmerely on a downward links of administrative directives and authorities.c) Inadequate enforcement of related lawsFor a sound functioning of market economy, it is required not only that property right isestablished but also that laws for protection of the property right are appropriately enforced,but it turned to be clear from the OECF/RIDA research that there also exist problemsconcerning this point. Especially, the problem of fulfillment of financial obligations isprominent.The questionnaire of the OECF/RIDA enterprise research contained such items as; inshortage of fund, what will be prioritized in using it; and if additional fund is available,what will be prioritized in using it (allowed to choose as many as apply). To see the answersto the former question, though it is quite reasonable that 63% of the enterprises answeredthey will give priority to payment of wages to workers as it is considered to be the matter ofthe highest priority for most enterprises, but considerably many enterprises answered thatthey will not give priority to repayment of loan from banks and other enterprises (59.2%)or that shortage of fund will not affect distribution of fund use (74.3%). To the latter, 76.1%answered that they will give the highest priority to investment in production andmanagement, while only 29.9% give priority to repayment of bank loan and 9.0% torepayment of loan from other enterprises. The answers that there will be no prioritized areaor that additional fund will not affect are 18.1% and 35.4%, respectively. 26A direct cause of such weak awareness of credit is that bank loan has a function ofsoft budget as investment in its essence, for the aim of the switch over from governmentalinvestment to bankloan in 1983 (change of financing system from investment to loan)24 OECF Research Paper No.2425 OECF ibid.26 OECF ibid.

54 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of View(giving incentives to efficient management through screening function of banks andrepayment of money) was not fully achieved. However, in the course of commercial bankreform from 1994, some steps have been taken toward improvement of the situation, forexample, recovery of credit has been strictly conducted since then. Nevertheless, such aproblem of enforcement cannot be dissociated from government control over enterprise'smanagement. Enterprises receive specified or unspecified guarantees in return for thegovernment control, and these guarantees link with each other. In this link, "the last creditor,"namely the people (the state) should ultimately owe the debts. Such a structure may notonly undermine the legal fundamentals prerequisite to market economy system, but alsoseriously damage the system itself, for example by accumulation of huge amount of nonperforming asset.d) Undeveloped market and difficulty of valuationSince the foundation PRC has implemented 5 times (re-)valuation of state-owned propertyin 1951-52, 1962, 1971-72, 1979-80 and 1994. 27 The last one is especially significantbecause it was implemented after some advancement of the reform and open door policy,but the entire data of it have not yet officially announced. It is the matter of immenseconcern how difficult establishing boundaries between properties is and how muchunderdevelopment of the property market influenced on the valuation. It is evident that thevaluation was quite a troublesome task.Beside the valuation of property itself, the actual conditions of debt that enterprisesowe is also an important point. According to the statistics of state-owned factories andenterprises compiled in 1995, the percentage of debt against the total asset were considerablyhigh, 62.3% for large-sized enterprises, 71.3% for medium-sized enterprises and 71.6%for small-sized enterprises respectively. It is because the total capital input tends to beinsufficient as a result of the above mentioned policy switch over from investment to loan.It is probable that the real percentages of debt are higher when the debt amount off the bookis included.e) Lack of management responsibilityThe structure of management responsibility is the cause as well as the result of all theproblems that are enumerated above. It is the most serious that it is lacking in a sanctionmechanism for managers. According to the OECF / RIDA enterprise research, 87% of thesubject enterprises answered that managers are assigned by the line ministries and 83% ofthem answered that the line ministries are the most influential in personnel as referred toabove. Concerning the treatment of ex-managers after their retirement, many enterprisesanswered promotion (25.7%), transfer to other state-owned enterprise (28.5) and age limitretirement (31.6%), while only 6.7% answered demotion. 28 To see that many answeredpromotion, it is recognized that personnel management of state-owned enterprises concerningmanager's assignment and dismissal composes a part of the "job rotation" system in thegovernment structure, and that it is not clear how the management responsibility is to befulfilled.27 Xie, Shi rong op. cit. p.184 ff.28 OECF op. cit.

OECF Journal of Development Assistance Vol.4, No.1, 1998 55The problem of management responsibility was also pointed out in regard to contractwork (performance contract) system as the problem that the system "undertake the profitbut does not undertake the deficit." It is considered to be difficult to deter contractors fromopportunistic behavior, as it is a kind of performance contracts. 29 Such a quite unclearmanagement responsibility as well as the problem of inadequate enforcement of laws thatwe saw above distinctively illustrate the problems with state-owned enterprises that "themanagement system charges the people with risks."C. Enterprise Management System and Property Right ProblemThe "property right problem" is considered in the first place as the problem for enterprises withworkshop system which are prior to joint-stock companies or limited companies under thecompany law and to which the Industrial Enterprise Law (SOE Law) and the AutonomousManagement Right Regulations are applicable. In order to reorganize an enterprise into a companysystem based on the company law, establishment and valuation of property right are the minimumrequirements. Therefore, enterprises with company system are out of range. The reason why the"property right problem" is a main issue of the problems with state-owned enterprises is thatover 80% of state-owned enterprises remain in workshop system (87% according to the OECF /RIDA research). Most enterprises with workshop system were established in the course of thereform and opening up policy by setting the government departments up as independent enterprises,and there are many state-owned enterprises which only replace their signboards, i.e. only thenames were changed. The boundary between property rights of the line ministries and of theenterprises was unfixed and obscure from the very beginning. Now we will further study thecharacteristics of property rights relation.D. Characteristics of Property Right of State-owned Enterprises with Workshop SystemFor "enterprise's ownership" and "enterprise's management right" are separated in the structureof the "Industrial Enterprise Law (SOE Law)," separation between "ownership" as the originalright belonging to the state and "possession right" as the derivative right belonging to enterprisesthat is authorized by the former was the principle as described above. It is the basis of trade toauthorize practical possession.In this system, the relation between ownership as the original right and possession right asthe derivative right is problematic. Theoretically, use and disposal of properties at the level ofpossession right, namely by enterprises, are legally effective, only when the state approve it inadvance. Accordingly, relationships between owner and possessor always need an authorizationprocess. There may be many different forms for this authorization according to the individualcases, but as far as the possession right is authorized in a directive form, it is pointless in realityto interpret the possession right as enterprise's own right. Such a structure brings about a tendencyin terms of practical business that the state as the owner tries to directly control individual properties(in the form of real things) and even their value. In concrete, the properties of state-ownedenterprises are registered with property book and their disposal etc. are submitted to permissionby the government agencies in charge. Such a direct government control over enterprise's properties29 World Bank (1995)

56 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewto be used for business activities impedes flexible management and allows the government tointervene in the business. The inappropriate property management system is considered to lie inthe background of the situation that the autonomy concerning investment and disposal of propertiesis not secured for state-owned enterprises in reality. In terms of practical business, the structurethat separates "ownership" and "possession right" places obstacles in such a flexible managementthat enterprises can instantly take measures at any time to adopt informations from markets andmeet the situations, and as a result it will make the management system unstable. It was inevitablyrequired in the process of transition from the planned economy based upon real propertymanagement to the market-oriented mechanism 30 that the management should not be based onthe property management by registering individual things with a property book but on themonitoring of increase and maintenance of the asset and capital by a balance sheet. It is prerequisitefor this to execute an appropriate auditing. In other words, the separation between "ownership"and "possession right" characterizes the legal system of the "command economy" and is thoughtto be the most prominent factor inconsistent with the tide of transition to the market economysystem.Reflecting this requirement, the "SOE Property Regulations" enacted in 1994 stipulate inArticle 27 that "enterprise enjoys the corporate property right and independently controls theproperties for business management that the state left in charge of it, and the government as wellas the government agencies in charge are not able to directly control the corporate properties ofthe enterprise." The fact that such a provision is expressly given is the most distinct sign thatthere are difficulties in old laws. The SOE Property Regulations also provide that the registrationshall be administered based on the total assets and the total debts. They do not refer to the legalstructure of ownership and possession right, but they aim to solve the existing problems mainlyin terms of practical business. If the property right of enterprises is established and transitionfrom management based on property registration to that based on balance sheets, then theenterprise's property right concerning ordinary property management and the enterprise'smanagement right will be strengthened in real terms. In addition, it could be facilitated to ensurestability of the relations concerning the properties to be managed as well as their maintenanceand increase. These steps will make transition to company system based on the company lawmuch smoother.However, the SOE Property Regulations do not reach at the level of establishing theenterprise's property right. It causes many difficulties in legal relations to interpret the enterprise'sproperty right based on the separation between "ownership" and "management right." Thecompany law aims at solution of this problem by establishing the enterprise's property rightbased on the company systems of joint-stock company and limited company.E. "Enterprise's Property Right" and Corporate Governance of State-owned Enterpriseswith Company SystemThe company law is so far the most modernized and the closest to the world standard amongChinese laws related to enterprises, and it was confirmed in the 15th session of National Conventionof the Chinese Communist Party held in September 1997 to set the law at the center of the30 It is also called transition from "direct control" to "indirect control." Wang, Bao shu and Cui, Qinzhi (1992) etc.

OECF Journal of Development Assistance Vol.4, No.1, 1998 57enterprise reform.The Article 4 of the company law (1993) provides for the principles concerning relationsbetween property rights in the company system. The main points of the provision are thefollowings.(a)(b)(c)Stockholders of a company as investors enjoy the right to receive profits produced fromthe property, to decide principal business policies and to choose managers according totheir contribution to the capital of the company.The company enjoys the whole corporate property rights formed by the investment ofstockholders, enjoys the civil right and takes on liability for civil affairs by law.The state-owned properties in charge of the company belong to the state.The company law clearly defines companies as juridical persons to whom the rights andduties belong, and the right of investors and the enterprise's property right are distinctivelyseparated. On the other hand, it also contains the words "state-owned properties in enterprises,"and it means that the state is still able to execute the real property management as the owner ofproperties. It is really hard to understand why this provision exists. This is also inconsistent withother provisions. If it were forced to find some meaning, it would be assumed as one of thegrounds to provide some restrictions to transfer of the state-owned stocks. It may possibly saidthat this is the vestige of workshop system. Nevertheless, the company law does not provide thelogical structure of separation between "ownership" and "possession" and is universally applicableto any types of enterprises, i.e. state-owned enterprises, private enterprises and collectiveenterprises. Compared to the other existing laws, each of which aims at a certain type of ownershipof company, the company law can be said to have the universality as a enterprise related law.It is, therefore, the next task at the level of the company law to build up a corporategovernance. The provisions of the Chinese company law are not so different from that of developedcountries (see Appendix). However, the true pictures of the corporate governance is not madevisible only by comparing provisions. 31 Actually, there is sometimes a gap between the law andthe reality, and it is the same in developed countries. For example, in Japan the laws certainlygive stockholders wide range of power, but stockholders' governance is in real terms fastimpossible. 32 Therefore, in regard to the Chinese laws, we should observe how they will beaccepted by the society and stabilized as a "living law."The Chinese company law is unlikely to be permeated so soon, for the state will necessarilytry to secure enough share for a period of time to keep practical control over enterprises, and31 The Chinese company law also has a structure centering on stockholders' general meetings, but itis doubtful if stockholders have wider power than in Japan.32 In Japan, the commercial law was amended in 1993 and the commission for the stockholder'sderivative suit is drastically reduced. As a result, stockholder's derivative suit come to be frequently filed.Some people appreciate this as expansion of stockholder's right, while many criticize that the suits areindiscriminately filed and especially that it also brought about interventions by the small stockholders whohave very small commitment to management of the company. The amendments contain no provisions for astrict limitation of the stockholder's right for derivative suit in terms of the point of time when they acquirethe right to as stockholders and for a distinction between directors torts and their mismanagement. Thelimitations are, therefore, lax compared to that provided in the United States. This amendment also broughtabout many problems such as advance of business bureaucracy in enterprises, shorter-term managementstrategies, increase of "racketeering" etc. At least, this amendment cannot be regarded as the center ofJapanese corporate governance.

58 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewjudged from the development level of the market, it is also unlikely that the disinvestment willrapidly be advanced. The transition to company system is no radical solution of the problems,especially in the case that the state has majority share and is not interested in maintenance andincrease of the total assets or that exercise of the right by the company is impeded by interventionof the government agencies in charge (by the personnel right) or that the tacit guarantee mechanism(sometimes in return to the intervention) is operating. However, diversification of the forms ofcapital ownership will make it easy to deter the government and government agencies fromintervention, if the stockholders' check effectively functions.According to the company law, the state-owned enterprises with workshop system is ableto be transformed into any of the following systems: thorough privatization, a special system inwhich the state controls the most part (partial privatization) or a system in which the stocks arepossessed solely by the state. In the latter two cases, it will be required to take some supplementarysteps to set the state agencies which have shares at a right place for rightholders as "owners."First, the government department in charge of property management must be separated from thechain of the power of the line ministries. Secondly, the practical control that is necessary forproperty management must also be secured in terms of personnel by assigning directors, recruitingdirectors from outside the enterprise, etc. (According to the OECF / RIDA enterprise research,23.2% answered that the government department in charge of property management plays themost important or an important role in assigning managers, while 76.7% answered that it doesnot play an important role or has nothing to do. 33 ) In the course of transition to company system,the role played by institutional investors such as pension funds is thought to become significant,and this can also be connected with the pension reform. 34 The "property management contract"that is adopted by some enterprises is also noteworthy as a transitional step. In this system,managers contract to maintain and increase the property value of the enterprise, and this isconsidered to be a meaningful step to be adopted in the process preceding to transition to companysystem.To see the fact that there is a principle that the ultimate owner of state-owned enterprises isthe people and that the people ultimately owe the risks and losses in the preceding stage totransition and will continue to owe the risks and losses after transition to company system for acertain period of time, it is essential to improve the auditing system and to disclose the financialstandings of enterprises to the public.33 OECF op. cit.34 In the United States, hostile buyouts (leveraged buyout etc.) were frequently seen in 1980s, but in1990s the corporate governance by institutional investors has begun to draw attention. Pension funds haveincreased their share in the amount outstanding of all stocks from 1-2 % in 1950 up to 275 in 1990. Especiallypublic pension funds, for example "California Public Employee Retirement System (CalPERS)" etc. intensifytheir corporate governance through direct contact with the managers (it is the most common method atpresent) and other means, because they can more freely move as stockholders than corporate pension fundsetc. The way of the corporate governance conducted by public pension funds in the United States willprovide good examples for state-owned enterprise reform in PRC. See Sakakibara (1995), Morio and Morita(1994)

OECF Journal of Development Assistance Vol.4, No.1, 1998 59IV. TRANSITION TO THE MARKET ECONOMY AND LAWSA. Market Economy and Civil Law SystemIf the three principles of the private law (civil law), property right, freedom of contract andliability with fault are amplified in the context of "Law and Economics," the following threelaws are essential to the market economy system based on the trade: a) property right related lawfor creation and establishment of property right (law of property), b) contract related law fortransfer of property right (law of contract) and c) right infringement related law for protection ofproperty right (law of torts). For example, if the function of the contract law is insufficient, itcreates enormous transaction costs and as a result impedes the sound function of the market(Posner, 1992). The main issue of the matters for transition to market economy is how the civillaw order should be constructed or reconstructed. However, the initial conditions of the relatedlaws are different from country to country according to their situations and are influenced bysocialist laws or older laws and customs that have their origin in the era of traditional economyprior to the socialist era. In this paper, we have so far examined the matters concerning the stateownedenterprise reform in PRC, and it has become clearer to some extent that the problems arebrought about by inappropriate enforcement of laws.One of the factors for this is probably the "law-nihilism," namely the tendency that "Lawsdo exist but are not observed." This tendency has its roots in the traditional society prior to thesocialism. This problem has repeatedly pointed out still after the socialist system was established.In concrete, there is a tendency that customs and rules of family or a kind of community withoutuniversality are prioritized to laws as the norm covering the whole state or the whole society andthat the legal stability is rather neglected. In other words, there still remains the vestige of thetraditional society based on consanguineous or local communities that are locally organized andseparated from each other. 35 The problem of Chinese laws that is described as "rule of personprior to rule of law" is thought to be considerably deep ingrained.Neither did the sense of law formed in the mechanism of the command economy intensifythe legal stability. In contrary, it intensified the "rule of person prior to rule of law" throughdiscretionary intervention by the state. In PRC, there was a dispute over "civil law or economiclaw" in the relatively early stage of economic reform. 36 That was the dispute over priority ofthese laws, i.e. which is to be prioritized, the "civil law - the civil law order" that aims at maintainingstability of the trading system or the "economic law" that is provided in order to achieve certainpolicy objectives. It practically comes up, for example, as the matter how to settle conflicts whena private contract comes into conflict with administrative order. In PRC, the smooth functioningof command economy was given a greater weight. Needless to say, it is an essential prerequisitefor development of the market economy system to secure the legal stability, and the "generalrules of the civil law" in 1986 was an answer for it. However, as it was turned out by the OECF/ RIDA research, in the case of the enterprises with workshop system, the enterprise's propertyright is confined within a chain of administrative powers. Moreover, the low consciousness of35 See Niida (1952) and Hario, "Azia Shakaishugi Koku (Socialist Countries in Asia)" (1992: inHario and Yasuda, 1992)36 See Michiyama, Akiharu, "Chuugoku 'Keizai Hou' no 'Kawaranu' Ichi-danmen ('Remaining'characters of Chinese 'Economic Laws')" (1992: in Hario and Yasuda, 1992)

60 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewcredit between enterprises as well as between enterprises and banks indicates the functionaldisorder of contract system based on the civil law.B. Preparation of an Appropriate Legal System for Establishment of the Market Economyand Role of the GovernmentAt present, the system based on command economy remain in Chinese laws. For the developmentof the market economy system, it is urgently necessary to complement the laws based on the"three principles of private law." For the sake of it, it will be required to develop a consistentproperty law system covering all of general rules of the civil law, credit law (contract law) 37 andsuccession law, especially to establish a property right protection system with a compelling force.It will be also required to encourage the transaction of right for land use. This will lead to securingthe appropriate land valuation of enterprises through activation of the land use right market, andfurther it will lead to making it easy to pay off their debt by utilizing the landed property (especiallyfor the enterprises located in urban areas) and to raise funds by the land worth of collateral.In the reform of state-owned enterprises, the reform based on the company law(corporatization) is aimed at. However, even if such a corporatization is achieved, it is furthernecessary to legally re-define the position and the role of the state and to clearly confirm thathaving share is regarded as to "own." It will be necessary to delete misleading provisions remainingin the company law that may possibly be mistaken as allowance of continuous property controlby the state over state-owned properties. Moreover, in order to further develop the market economysystem, a change of the state's (government's) role as "owner" into social "regulator" will benecessary sooner or later.Concerning the laws related to state-owned enterprises in PRC, the gap between the lawfor the market economy system (civil law) and its interpretation or understanding brings aboutmany problems. In order to solve such problems, it will be necessary not only to enact additionallaws but also to take appropriate actions for their enforcement as well as their permeation. At thisstage, the stability and predictability of the application of law should be given the highest priority,because they will be the touchstone for the change from rule of person to rule of law in terms ofcivil laws.In PRC, there are 100 thousands state-owned enterprises all over the country, so the reformbased on the company law demands enormous human / capital resources. It is, therefore, consideredto be necessary not only to support the establishment of their management system but also to addsupport programs in the legal area as a part the implementation programs of state-ownedenterprise's reform and their promotion.creditors.37 World Bank (1997) emphasizes the necessity of intensifying fund restriction by protection of

OECF Journal of Development Assistance Vol.4, No.1, 1998 61V. CONCLUSION: DIFFICULTY OF STATE-OWNEDENTERPRISE REFORMConcerning the enterprise's property right, as described above, it will be necessary to change theview of the state's role from that the state has the stable ownership to that the state stands in arelative position among stakeholders and plays the "role of the regulating authority." However, ifthe matter of the "enterprise's property right" is settled to some extent as a result of the changestated above, there will still remain the matters proper to "regulation". Socialist ideology hasascribed its advantage and righteousness to avoiding fluctuation and instability unavoidable forthe capitalist market economy system. This idea of risk pool was also reflected in the idea ofwelfare state in capitalist countries. Nevertheless, as we saw in the structure of state-ownedenterprises in PRC, this system bears a mechanism of creating a huge risk due to the obscurenessof who owes the risks.Transition from unlimited liability to limited liability made it possible to meet the situationthat enterprise's business activities became large-scaled and complicated and helped to improvethe corporate system by shifting the risks from investors to creditors. State-owned system alsomade it possible, as a stage of the process of such improvement, to execute infrastructure businessesaccompanied by big risks and other large-sized investments by pooling the greater risks at thelevel of the society or the state. State-owned enterprise system is seen not only in socialist countriesbut also in capitalist countries. In terms of the shift of risks to the society, the social phenomenoncalled "Too big to fail" is a system of the same kind. It is also possible to see the nucleus of thematter is the specified or tacit guarantee mechanism.The defects of state-owned enterprise system was certainly made clear, but it is very difficultto design an alternative mechanism. One of the possible solutions is to approach from the viewpointof distribution of risks and its method. In distributing risks, the concept of "the lowest costavoider" used in the context of "Law and Economics" will be a good guide, i.e. distribution byallotting the political risks and regulation risks to the government, the business risks to managersand workers, and maintenance and management partly to beneficiaries. As the method to raisecapital reflecting this distribution, deliberate combination of equity, loan and bonds is regardedas the best. Concerning the last matter, further study is required, but we can say at least that thepercentage of loan has been so far too much in regard to the state-owned enterprises in PRC.APPENDIX: COMPARISON OF COMPANY LAW SYSTEMS INFOUR COUNTRIES (JOINT-STOCK COMPANY)Item: Stockholders' suggestion rightJapan• Stockholders or stockholder's groups that have 1% or 300 shares or more of all-issued stockshave the right to suggest specific matters as the subjects for discussion to stockholder's generalmeetings. In addition, when they have 3% shares, it is possible for them to convene a generalmeeting.

62 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewthe United States•Stockholders who have 1% or 100 shares or more of all-issued stocks have the right to suggestspecific matters as the subject of discussion to general meetings. However, the managers arenot bound by the vote on the stockholder's suggestion.Germany•Stockholders or stockholder's groups that have 5% or a million DM shares or more of capitalstock have the right to request the company to announce the objects of resolution.PRC•When 10% or more of all the stockholders request, an extraordinary general meeting must beheld. (There is no provision for the stockholder's suggestion right)Item: Assignment of managers / Initiative of stockholdersJapan•Stockholders directly assign directors.•Procedure of stockholder's suggestion right is applicablethe United States•Stockholders directly assign directors.•Assignment of directors is impossible with procedure of stockholder's suggestion. They haveto gather letters of proxy at their own expense.Germany•Stockholders directly assign auditors. The board of auditors assigns executive directors.PRC•Stockholders directly assign directors.•(There is no provision for the stockholder's suggestion right)Item: Dismissal of directorsJapan•Stockholders have the right to dismiss the directors by a special resolution at a general meeting(with attendance of more than 50% of all-issued stocks and with approval of their 2/3), indisregard to the existence of sufficient reasons.the United States•Stockholders have the right to dismiss the directors by simple majority at a general meeting (indisregard to the existence of sufficient reasons).Germany•Board of auditors have the right to dismiss executive directors, provided that sufficient reasons

OECF Journal of Development Assistance Vol.4, No.1, 1998 63exists, such as obvious neglect of duties.PRC• Stockholders have the right to dismiss the directors by ordinary procedure of resolution ( bysimple majority), provided that sufficient reasons exists.Item: Term of office of directorsJapan• 2 years at most.the United States• 1~3 years.Germany• 5 years at most.PRC• 3 years at most.Item: Business decisionJapan• The matters for resolution at stockholder's general meetings are limited to what are provided bythe commercial law or the articles of an association. Managers are authorized to autonomouslydecide concerning ordinary business affairs. However, stockholders have the right to requestamendment to the article of an association.the United States• Same as in Japan. However, it is more difficult for stockholders to control business decision ofmanagers than in Japan, for it is restricted by the SEC rules.Germany• Stockholders have no right to give orders to the board of directors concerning to managementof the company.PRC• Same as in Japan.Item: Remuneration of directorJapan• Remuneration of directors are determined at general meetings.

64 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of Viewthe United States•Remuneration of directors are determined by the board of directors.Germany•Remuneration of auditors are determined at general meetings, and that of directors by the boardof auditors.PRC•Remuneration to directors are determined at general meetings.Item: CapitalJapan•Dividend of profits --- it is limited within the residual amount after the capital, capital reserveand earned surplus reserve (more than 10% of surplus is reserved every business year until itamounts to 25% of the capital) are deducted from the net property of the company (the Commercelaw 290-1).the United States•There is little control. Even in the case that the net property is lower than the stated capital,dividends are payable from the surplus of the last two years. Capital surplus can be used assource of future dividends.Germany•It is necessary to reserve at least 5% of surplus every year until it amounts to 10% of the capital.PRC•10% of surplus is reserved as the legal surplus reserve, and 5-10% as the legal expenditure forpublic interest (until it amounts to 50% of the registered capital of the company).Item: Accounting principleJapan•In principle historical cost method is taken for valuation of liquid assets or corporate bonds,however lower of cost or market rule is also applicable. In the case that their market valueremarkably goes down, lower of cost or market rule is taken by compulsion.the United States•Market value method (it is regarded as important to provide information for stockholders andcreditors).Germany•Lower of cost or market rule.

OECF Journal of Development Assistance Vol.4, No.1, 1998 65PRC• Historical cost method.Item: Procedure of bankruptcyJapan• Liquidation or reconstruction. But in fact, private pay off in which banks participate is thecommon method.the United States• Liquidation or reconstruction. In the case of large-sized companies the latter is preferred.Germany• Liquidation is common. Private pay off in which banks participate is preferred.PRC(blank)Item: Stockholders' derivative suitJapan• Stockholders who continuously possess stocks for six months have the right to bring an actionagainst the directors etc. to blame for their mismanagement.the United States• Stockholders who possessed stocks when the directors etc. did something to cause the companya loss and have been possessing ever since have the right to suggest to bring an action againstthem. However, the motion to bring an action is submitted to the board of directors. When theboard of directors judges it improper, it is impossible to bring an action, except for specialcases. The court judges whether the representatives are qualified.Germany• There is no institution for stockholders' derivative suit.PRC• There is no provisions. (Concerning the right of stockholders, it is only provided that they havethe right to claim enjoin, in the case that resolutions at general meetings or by the board ofdirectors infringe on the lawful interests of them.)

66 Kaoru Hayashi, Reform of State-owned Enterprises: A Legal Point of ViewREFERENCESAi, Duo jun (1997). "Legal Issues in the Enterprise Reform in Chgina", Handout of WuhanSeminor, in Chinese.Aoki, Masahiko (1995). Keizai Shisutemu no Shinka to Tagensei (Development and Diversificationof Economic Systems), Touyou Keizai Shinpou-sha, in Japanese.Chong, Xiu ze (1994). Trade System of Property Right, in Chinese, Economic Daily Bulletin.Dong, Fu ren and Tang, Zong kun and Du, Hai yon (1995). Study of the State-owned EnterpriseReform in Chana, in Chinese, People's Press.Fukao, Mitsuhiro and Morita, Yasuko (1994). "Kooporeito Gabanansu ni okeru Ronten Seiri(Outline of the Matters concerning Corporate Governance)", Kinyuu Kenkyuu (Study inFinance), Vol. 13, No. 3, September 1994, Nihon Ginkou Kinyuu Kenkyuujo, in Japanese.Funabashi, Junich (1960). Bukken Hou (Real Law), first edition, Yuuikaku, in Japanese.Hario, Seikichi and Yasuda, Nobuyuki (1992). Chuugoku no Kaihatsu to Hou (Development andLaws in China), Institute of Developing Economies, in Japanese.Hayashida, Kiyoaki (1996). no Hou Riron (Legal Theory of ), in Japanese.Kaneko, Masaru (1997). Shijou to Seido no Seijikeizai-gaku (Political Economy of Market andInstitutions), Tokyo University Press, in Japanese.Kawashima, Takenobu (1965). Minpou Sousoku (General Rules of the Civil Law in Japan), firstedition, Yuuikaku, in Japanese.Kishida, Masao (1996). Hou to Keizaigaku (Law and Economics), Sinseisha, in Japanese.Kojima, Yoshiyasu (1989). Chuugoku Keizai Toukei / Keizai Hou Kaisetsu (Commentary onStatistics of Chinese Economy and Chinese Economic Laws) Institute of DevelopingEconomies, in Japanese.Miyasaka, Hiroshi ed. and translation (1997). Gendai Chuugoku Hourei-shuu (Collection of theModern Chinese Laws), revised and enlarged edition, Senshuu University Press, in Japanese.______ (1995). Kigyou-hou / Zei-hou Hen (Corporation Laws and Tax Laws), Housei UniversityPress, in Japanese.Morimura, Susumu (1995). Zaisan Ken no Hou Riron (Legal Theory of the Property Right),Koubundou, in Japanese.Niida, Noboru (1952). Chuugoku Housei Shi (History of Chinese laws), Iwanami Shoten, inJapanese.Nishimura, Koujirou (1984). Chuugoku ni okeru Kigyou no Kokuyuu-ka (Nationalization ofEnterprises in China), Seibundou, in Japanese.______ (1973). "Minzoku Shihonka no Seisan Shudan Shoyuuken ni t'uite (On the Ownershipof Production Means of Native Cipitalist)", Gendai Chuugoku Hou no Kihon Kouzou(Fundamental Structure of Modern Chinese Laws), Osakata, Naokichi (ed.), 1993, Instituteof Developing Economies, in Japanese.Okazaki, Tetsuji (1994). "Nihon ni okeru Kooporeito Gabanansu no Hattenn: RekishitekiPaasupekutibu (Development of Corporate Governance in Japan from the HistoricalPerspective)", Kinyuu Kenkyuu (Study in Finance), Vol. 13, No. 3, Nihon Ginkou KinyuuKenkyuujo, in Japanese.Paul Milgrom and John Roberts (1992). Economics, Organization and Management, Japanese

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ANALYSIS OF REFORM OF STATE-OWNEDENTERPRISES IN VIETNAM *Hisaaki Mitsui **Yoshio Wada ***SUMMARYComprehensive reform of state-owned enterprises in Vietnam commenced in November 1987when the cabinet agreed on Decision No. 217, at around the same time as the Doi Moi policybegan. It is exceedingly difficult to make a judgment on the reform because of the severerestrictions placed on information. Analysis of information acquired through independent surveys,joint researches and interviews, tends to indicate that production and financial performances ofVietnam's state-owned enterprises improved considerably in the early 1990s as a result ofemployment cutbacks, cutbacks in the number of state-owned enterprises, and most importantlypartnerships with foreign enterprises, entered into from the late 1980s to the early 1990s. However,endowment of a competitive environment and management/labor incentives remains insufficient,and the establishment of corporate governance began to take shape only after enactment of theState Enterprises Law in 1995.Given the fact that state-owned enterprises are the only modern industrial organizations inVietnam, the reform is falling badly behind at this stage, and it is difficult to point to effectivereform measures since Vietnam entered the 1990s, when the performance of state-ownedenterprises showed improvement. Because of the unsatisfactory state of the incentive and propertyrights mechanisms, there is the possibility that managers without business mind will take controlof the state-owned enterprises. Efforts must continue in the future to remove these managers,and to increase the "depth" of the market.CONTENTSI. IntroductionII. Survey of State-owned Enterprises, Production and Financial PerformancesA. Analysis of Production PerformanceB. Analysis of Financial Performance*This paper applies the analysis of Wada (1997) on the reform of state-owned enterprises in Chinato the reform of state-owned enterprises in Vietnam. We commenced analyses on the reforms of stateownedenterprises in China and Vietnam in 1996, under the research titled "Research on Reforms of theEast Asian state-owned enterprises." We received many suggestions in creating this paper, including advicefrom Dr. Ishikawa, professor emeritus of Hitotsubashi University/Aoyama Gakuin University, whoparticipated in the marked investigation. Furthermore, the views expressed in this paper are not necessarilyrepresentative of the views of the organizations that the authors belong to, and all responsibility with respectto the content of document, including any errors, lies solely with the authors.** Economic Advisor, RIDA, OECF*** Deputy Director, Planning and Administration Division, Coordination Department, OECFOECF Journal of Development Assistance Vol.4, No.1 (1998) pp.68-103©1998 by the Overseas Economic Cooperation Fund. All rights reserved.

OECF Journal of Development Assistance Vol.4, No.1, 1998 69III. Incentive Structure of State-owned EnterprisesA. Competitive EnvironmentB. Internal IncentiveC. Financial IncentivesIV. Corporate Governance ReformsA. EquitizationB. Asset Management of State-owned EnterprisesC. Corporate Grouping: Establishment of General CorporationsD. Legal Framework: The State-owned Enterprise LawE. The Right of Appointment and Personnel Management of State-owned EnterpriseDirectors and the Market for DirectorsV. ConclusionReferencesI. INTRODUCTIONThere are still many doubts with respect to economic reform in Vietnam, and evaluative opinionson the outcome of the reform still have not reached the stage at which some sort of agreementcan be made. A large amount of literature is available on the reform of state-owned enterprises inChina from China, Europe, America and Japan, and although not comprehensive, statistical datais provided, and although not much, there is some positive analysis. On the other hand, statisticaldata on the reform of state-owned enterprises in Vietnam is inadequate, and the amount of literatureavailable is limited with severe restrictions on gathering information.This paper attempts to analyze the present state of state-owned enterprises in Vietnam andthe course of their reform as much as possible given the restrictions placed on information. Inour analysis, we used the empirical approach based on research on state-owned enterprises inVietnam conducted jointly with the Central Institute for Economic Management (CIEM) ofVietnam from the end of 1996 to 1997. In addition to this, this paper based on our analyticalframework attempts to clarify the structure of state-owned enterprises in Vietnam, and the kindof planning and reform conditions upon which this structure depends.This paper is structured as follows: In the next chapter, an attempt is made to grasp theperformance of 200 state-owned enterprises based on a survey of them we conducted. Theperformance of state-owned enterprises needs to be assessed under the aspect of productionperformance and financial performance. To accurately measure production performance, it mustbe assessed in terms of a productivity analysis of all factors after analyzing the production function.However, it is extremely difficult to analyze the production function in a country like Vietnamwhere acquisition of price data is difficult, and hence in this paper, as an alternative, analysis iscarried out on the actual capital productivity and labour productivity deflated by available data.Financial performance should principally be judged by profit status after carrying out an analysisof income/expenditure structure, which is nominal data. Even here, it is difficult to acquire financialdata on state-owned enterprises in Vietnam. Therefore, our analysis of the financial performanceis only partial.After clarifying production and financial performance, it is necessary to understand the

70 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnamincentive structure as well as the property rights structure (corporate governance) to clarify thefactors that prescribe these performances and to examine the enterprise structure. The third chapterand the forth chapter carry on the analysis, focusing on incentives and property rights, respectively.The last chapter offers a breif conclusion.The incentive structure and the property rights structure may be sorted broadly as shown inthe following table. First, in incentives, there are internal incentives and external incentives, andthe boundary between them are not clear. An internal incentive structure includes the authority tomanage independently as well as a decision structure held by the proprietor, and a labor incentivestructure.The most important element of external incentives is the competitive environment. However,the macroeconomic environment (in other words, the market) and the fund- raising environment,such as financial systems, both have a significant influence over the incentives of enterprises.The property rights structure may also be distinguished as external and internal. The boundarybetween internal and external for property rights (boundaries between enterprises) is clear sinceit is determined by such things as the articles of association of company at its foundation. Animportant element of the internal property rights structure is where managerial responsibilitylies, including the function of the board of directors and the authority to appoint and dismissdirectors, and these differ from company to a company. Against this, the legal framework and itsapplication as external property rights do not differ from company to company, but apply uniformlyto all companies.Table 1Incentive Structure and Ownership StructureInternal(micro)External(macro)Incentive structureManagement autonomy, performancecontracts, labor incentives, etc.Competitive environment of the company(product market, raw materials market),fund-raising environmentOwnership structure (property rights)Component relating to corporategovernance such as the board of directorsand personnel affairs of the directors.Legal framework (such as company law,commercial law, and accounting law) andits application (cost accounting methodand market price method for valuation ofassets).II. SURVEY OF STATE-OWNED ENTERPRISES, PRODUCTIONAND FINANCIAL PERFORMANCESIt is possible to speculate somewhat on the macroeconomic status of Vietnam's state-ownedenterprises, despite the lack of statistics. However, many questions remain on the macroeconomicstructure. The authors therefore attempted to speculate on the production and financialperformances of Vietnam's state-owned enterprises by surveying 200 state-owned enterprises inVietnam. This section is a summary of the results of that survey.

OECF Journal of Development Assistance Vol.4, No.1, 1998 71A. Analysis of Production Performance1. Production and Size of EnterprisesTable 2 shows sales volume as well as employment in the surveyed enterprises, using data fromfiscal 1995. It shows sales figures and employment for each enterprise group as a weightedaverage by of region, jurisdiction and type of industry. The approximate averages for all surveyedenterprises were as follows: sales: 66 billion dong; employment: 600 workers; and sales peremployee: 109 million dong. By region, enterprises located in southern areas recorded the highestsales and employment figures, while those located in central regions were smallest in size. Byjurisdiction, enterprises under the control of the central government were far larger than thoseunder the jurisdiction of local governments, and the disparity in sales was more than three-fold.On the other hand, little difference was noted between enterprises established by the state andprivate enterprises nationalized by the state.Disparities in sales and employment figures by industry type were considerable. The foodindustry recorded the highest sales, at approximately 1.7 times the overall average. However,sales by the machinery industry was only about 30% of the overall average. On the other hand,the highest employment figures were recorded in the textiles and clothing industry, with firmsemploying an average of 1,200 workers. There was little difference among other industries, withaverage employment between 300 to 400 workers. The highest sales per employee were recordedin the food industry, with the figure approximately 2.4 times the overall average. On the otherhand, textiles and clothing, and machinery industries recorded sales per employee at only around40 to 50 percent of the overall average.From the sales and employment figures for 1995, we can conclude that large enterprisestend to be under the jurisdiction of the central government, located in the southern region, operatingin the food processing industry in terms of sales, and in the textiles/weaving industry in terms ofemployment.Table 2Sales Amount and Employment of the Surveyed EnterprisesSales amount(100 million dong)Employment(workers)Sale amount peremployeeAll enterprises 66,252 609 108.8Northern regionCentral regionSouthern region40,24720,517113,96056733480571.061.4141.6Central governmentLocal government100,57532,280762457132.070.6Established as state-owned enterpriseNationalized58,89284,071554743106.3113.2Food processingTextiles and clothingElectrical/electronic equipmentConstruction materialsChemicalsMachinery114,14254,86058,77887,98161,90619,6344331,270318423462347263.643.2184.8208.0134.056.6Note : Characteristics of state-owned enterprises, such as enterprises established by the state andnationalized enterprises, are explained in the appendix.Source: Results of this survey.

72 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnam2. Labor and CapitalStrictly speaking, it is necessary to carry out a production function analysis to investigate theefficiency of labor and capital in state-owned enterprises. However, it is exceedingly difficult tocarry out this kind analysis in Vietnam's state-owned enterprises, where price data in particular islacking. In China, each state-owned enterprise submits reports on real production figures infixed price terms. However, this data was not attainable in Vietnam, and so production must firstbe converted into real terms using an arbitrary price.Given this kind of restriction, a method of comparing production in nominal terms andvalue-added with employment and fixed assets (also in nominal terms) may be used to investigatethe productivity of Vietnam's state-owned enterprises. This method is used below to examinelabor productivity and the capital-labor ratio of the surveyed enterprises (Table 3). Data on laborproductivity was found by first calculating the amount of value added, which was then dividedby employment. The value added for 1993 and 1996 was markedly insufficient, but is convertedto real terms using the industry deflator of Vietnam's national income statistics. The capital-laborratio was calculated by dividing the amount of fixed assets of the surveyed enterprises by theemployment figure. The value of fixed assets is also converted to real terms using the industrydeflator.Table 3Changes in Labor Productivity and the Capital-labor Ratio of Vietnam's State-owned Enterprises(Unit : 100 million dong/worker)Number of Real labor productivity Real capital-labor ratiosamples 1991 1993 1995 1991 1993 1995All enterprises 154 13.2 19.4 20.6 10.2 10.9 14.6Northern region 73 8.9 12.7 15.7 6.8 9.2 15.3Central region 37 12.7 18.4 24.1 8.5 8.2 8.9Southern region 44 26.7 36.5 24.5 22.0 17.1 16.0Central government 68 14.0 22.8 25.7 12.3 12.9 16.8Local government 86 12.0 14.7 13.1 7.3 8.0 11.5Tie-up with foreign capital 46 14.8 16.5 21.7 10.7 8.6 17.6No tie-up with foreign capital 108 12.7 20.5 20.2 10.0 11.7 13.3Founded as a state-owned enterprise 116 12.8 21.4 21.0 10.4 11.0 14.6Nationalized 38 14.7 9.3 19.6 9.3 10.0 14.8Food processing 27 13.1 14.2 16.6 10.6 10.1 7.7Textiles and clothing 37 9.0 12.1 17.0 7.9 8.0 16.1Electrical/electronic equipment 15 36.4 37.2 8.8 26.2 20.2 8.7Construction materials 24 11.7 25.8 55.1 11.0 11.6 25.5Chemicals 29 13.9 28.2 12.1 10.1 12.6 18.1Machinery manufacturing 22 8.4 7.4 26.3 5.2 7.8 14.3Note: Labor productivity = amount of value added / number of workers (100 million dong/worker)Capital productivity = amount of value added / amount of fixed assetsCapital-labor ratio = value of fixed assets / number of workers (100 million dong/worker)Prices for 1993 and 1996 are converted into real terms using the GDP deflator (industry).Overall labor productivity derived from data of all enterprises shows a steady rise from13.2 in 1991, to 19.4 in 1993, and to 20.6 in 1995. When this change is compared among different

OECF Journal of Development Assistance Vol.4, No.1, 1998 73regions, there was a significant disparity in labor productivity between the southern region andthe northern and central regions in 1991. However, the northern and central regions showedrapid growth in labor productivity in 1993 and 1995, so that by 1995 the disparity in laborproductivity had narrowed considerably. The gap between the southern region and the northernregion was almost three fold in 1991, but this had narrowed to a factor of about 1.5 in 1995.Similarly, the disparity between the southern region and the central region has narrowed to aboutthe same level in 1995, from about twice in 1991.A comparison between enterprises under the jurisdiction of the central government andthose under the control of local governments shows that enterprises under the jurisdiction of thecentral government had a higher labor productivity throughout the survey period, and this disparityhas been increasing every year. Labor productivity of enterprises under the central governmenthas increased from 14.5% in 1991, to 25.7% in 1995. However, the labor productivity of enterprisesunder the jurisdiction of local governments has shown only a slight increase, from 12.0% to13.1% over the same period. A comparison was also made between the enterprises which wereestablished as a state-owned enterprise at foundation, and enterprises which were transformedinto state-owned enterprise after foundation, but no notable disparity in labor productivity wasobserved. Furthermore, a comparison was also made between enterprises which have businessties with foreign companies and enterprises which have no such ties; here too, no major disparitywas observed.When labor productivity between different industries is compared, an increase in laborproductivity is observed for the construction materials and machinery manufacturing industriesfrom 1991 to 1995. The construction materials industry in particular has post an almost five-foldincrease in labor productivity, from 11.7 in 1991 to 55.1 in 1995. On the other hand, laborproductivity in the electrical/electronic industry has recorded a considerable drop. In 1991, thisindustry posted the highest labor productivity among the five industry types, at 36.4%. However,this fell to the lowest figure in 1995 with 8.8%.A comparison of labor productivity shows that productivity has increasing from 1991 to1995, for all state-owned enterprise sectors. We can also see that in 1991, enterprises located inthe south recorded far higher productivity than those located in the north. However, this gap hadnarrowed considerably by 1995. Furthermore, enterprises under the jurisdiction of the centralgovernment showed far greater productivity than those under the jurisdiction of local governments,and this gap grew during the survey period.Labor productivity here is derived by dividing the value added by the employment number.Hence changes in capital is not considered. Assuming that a large investment is made, and thecapital contribution is large, labor productivity will thus increase. Consequently, the capitallaborratio needs to be examined. The capital-labor ratio of all enterprises has been increasingsteadily, from 10.1 in 1991 to 10.9 in 1993, and further to 14.6 in 1995. In terms of regionaldisparity, the increase observed for enterprises located in the north has been most notable. Itincreased from 6.8 in 1991 to 15.3 in 1995, an rise of 2.3 times over a four-year period. Theincrease in labor productivity of enterprises located in the north during this period is because ofthe influence of active capital investment made over the same period. Taking into considerationthe fact that the average sales of enterprises located in the north are only about a third of those ofenterprises located in the south, it is not too difficult to see that massive capital investment wasmade to state-owned enterprises in the north during this four year period. On the other hand, the

74 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnamcapital-labor ratio of state-owned enterprises in the south dropped from 22.0% to 16.0% duringthis four year period, and for enterprises located in the central region, the figure remained ataround 8%. Therefore, investment contributed greatly towards an increase in labor productivityfor state-owned enterprises located in northern areas. However in the southern and the centralregions, it is thought that the value added increased not only because of the contribution ofcapital, but also because of an increase in actual productivity.When the gap between enterprises under the jurisdiction of the central government andenterprises under the jurisdiction of local governments is compared, the capital-labor ratio ofenterprises under the central government is constantly higher than that of enterprises under thelocal government. The gap between the two was almost double during the survey period.The main reason for the continued lead of productivity of enterprises under the central governmentover that of enterprises under local governments is the difference in efforts made to attractinginvestment.In a comparison between the enterprises established by the state and nationalized enterprises,there was little difference in the capital-labor ratio. Also, there was no significant influencecoming from whether an enterprise had foreign capital or not.In terms of the disparity between different types of industries, the capital-labor ratio of theconstruction materials industry recorded a significant increase, from 11.0 in 1991 to 25.5 in1995. This coincides with a major increase in labor productivity in the construction materialsindustry over the same period. On the other hand, the capital-labor ratio of the electrical/electronicequipment industry showed a considerable decline, from 26.2 to 8.7 over the same four yearperiod. This also coincides with the drop in labor productivity of the electrical/electronic equipmentindustry seen over the same period.A brief summary of what we learned from the comparison of capital-labor ratio follows.The capital-labor ratio of Vietnam's state-owned enterprises tended to rise overall from 1991 to1995. The capital-labor ratio of enterprises located in the north recorded a particularly significantincrease. Furthermore, the capital-labor ratio of enterprises under the jurisdiction of the centralgovernment also showed a considerable increase. The gains in labor productivity for both typesof enterprises can be attributed to active capital investment made in them. In terms of the type ofindustry, the construction materials industry posted a major increase in the capital-labor ratio,while the electrical/electronic equipment industry registered a decrease. These changes coincidewith the changes observed in labor productivity for both industries.In this analysis, the demand factor is not considered, as it is with a normal productionfunction analysis. Improvements in productivity of the southern and central regions can also beattributed to an increase in demand brought about by high economic growth. Productivity analysisof Vietnam's state-owned enterprises requires examination using a much larger amount of data,including the demand factor.B. Analysis of Financial PerformanceAlthough there is some disparity in terms of the type of industry and region, the productionperformance of Vietnam's state-owned enterprises has been shown to be at a reasonable level ingeneral. What of financial performance?

OECF Journal of Development Assistance Vol.4, No.1, 1998 751. Sales and Revenue VolumesFirst, we look at the sales figures of Vietnam's state-owned enterprises (Table 4). Growth in saleswas calculated over two periods of two years each, which comprise one period from 1991 to1993, and the other from 1993 to 1995. To investigate the growth rate, sales in 1993 and 1995must be converted to real terms in terms of 1991 price. Because there was no data on the rate ofthe price increase for each sector, price deflators of each industry were used as an alternativevariable and were converted to real terms. On top of the amount of sales for all industries, averagegrowth rates were also calculated for sales in terms of region, jurisdiction and type of industry.Table 4Growth in Sales of Surveyed Enterprises (in real terms)(Unit : %)1991 to 1993 1993 to 1995All enterprises 29.2 12.7Northern regionCentral regionSouthern regionCentral governmentLocal governmentEstablished as state-owned enterpriseNationalizedFood processingTextiles and clothingElectrical/electronic equipmentConstruction materialsChemicalsMachinery17.341.223.932.321.941.615.817.315.7137.149.310.851.422.323.38.318.7-2.524.6-3.010.910.83.415.219.124.0The real growth rate for the total sales of all enterprises from 1991 to 1993 was 29.2%.However, the growth rate from 1993 to 1995 fell to 12.7%. When changes in this growth rate areviewed in terms of regions, enterprises in the northern and the central regions showed higherrates than the overall average in both the 1991 to 1993 period and the 1993 to 1995 period. Onthe other hand, growth in sales of enterprises in the south was significantly lower than that ofenterprises in other regions. In terms of jurisdiction, enterprises under the central governmentrecorded significantly higher growth in sales than enterprises under local governments. Comparedwith a sales increase of 32.3% by the enterprises under the jurisdiction of central government,enterprises under local government control posted an increase of only 21.9%. Furthermore, salesof enterprises under the jurisdiction of local governments declined 2.5% from 1993 to 1995. Asimilar trend can be observed in a comparison between enterprises established by the state andenterprises which became state-owned after foundation. Sales growth was higher over both periodsfor enterprises established by the state at foundation. A drop of 3% was recorded between 1993and 1995 for enterprises requisitioned by the state. When surveyed enterprises are compared interms of the real growth rate of sales since 1991, higher growth rates were observed for enterprisesthat were located in the north, were under central government authority, or were established bythe state at foundation.

76 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in VietnamThere is also significant disparities in sales growth among industry sectors. The highestgrowth rate from 1991 to 1993 was recorded by the electrical/electronic industry, with a recordbreakingfigure of 137.1%. However, the rate fell significantly over the next two years to post thelowest figure among all industry types, at 3.4%. Other types of industries also posted a drop insales growth over both periods, except for the chemicals industry, in which the growth rate rosefrom 10.8% in the 1991 to 1993 period, to 24% in the 1993 to 1995 period.2. Cost StructureDuring the period 1991 to 1995, the ratio of production costs accounting for sales droppedmarginally (Table 5). The cost of raw materials and wages account for about three-quarters of allcost input. Changes in the cost structure can be observed in state-owned enterprises in all regionsand all industry types, with all enterprises reducing raw material cost and increasing the ratio ofwages and other payments. The increase in the cost of wages is especially significant, with theratio in 1995 increasing to 1.7 times the amount in 1991.Table 5Production Cost Structure of State-owned EnterprisesOverall199119931995RegionsNorthern region199119931995Central region199119931995Southern region199119931995Types of industriesFood processing199119931995Textiles and clothing199119931995Electrical/electronic199119931995Construction materials199119931995Chemicals199119931995Machinery199119931995Cost of rawmaterials70.669.561.768.470.268.071.369.458.270.268.269.584.675.243.948.545.358.274.881.681.964.473.968.679.875.468.664.058.556.0(Unit : Component ratio in % taking production cost at 100)Cost ofwages5.47.49.07.39.110.74.76.88.48.47.58.52.53.14.09.716.218.67.15.87.73.45.07.14.36.97.911.313.714.2Cost of socialsecurity0.60.90.61.31.41.00.40.70.51.21.10.90.20.40.40.91.71.30.80.80.30.60.60.50.61.00.51.71.81.0Cost ofdepreciation5.54.34.74.84.65.45.94.34.53.43.43.43.14.24.86.35.07.04.62.02.214.26.56.12.23.53.04.13.52.9Others17.818.024.018.214.815.017.818.928.416.819.817.69.517.246.834.631.815.012.79.87.916.814.017.813.113.213.718.922.426.0

OECF Journal of Development Assistance Vol.4, No.1, 1998 77The increase in the cost of wages can be attributed to an increase in wages and not to anincrease in employment. Wages in state-owned enterprises rose continuously from 1991 to 1995.The average monthly wage in 1991 was 192,000 dong. This increased to 432,000 dong in 1993,and to 713,000 dong in 1995; an annual increase of 92.6% (Table 6).Table 6Average Worker's Wage(Unit: 1000 Vietnamese dong)1991 1993 1995Overall 192.7 432.3 712.9Northern regionCentral regionSouthern regionCentral governmentLocal governmentFood processingTextiles and clothingElectrical/electronic equipmentConstruction materialsChemicalsMachinery107.9121.4334.0228.2115.9194.4191.9227.3193.3195.6124.1289.3204.9647.6490.0319.1375.7353.2595.3413.5510.5382.8595.7393.7862.9832.3500.0686.8571.81,103.2914.5856.4679.1For production costs, the amount in the "others" category has been increasing in manyindustries. This is a reflection of the many new costs that appeared between 1991 and 1995. Alarge part of this is the marketing cost. However, the cost of exhibitions and advertising,consultation costs (legal and technical), technology royalties and sales commissions, are amongthe costs that have all increased in the 1990s, and which are creating additional cost for enterprises.3. Profit RatioThe figure below as well as Table 7 describe the profitratio of surveyed enterprises in 1991, 1993 and1995. The profit ratio was calculated bydividing the enterprise's revenue bythe sales amount. They describeboth the average profit ratio of allenterprises, calculated by dividingthe sales amount of all enterprisesby the total sales amount, and theprofit ratio of enterprise groupscalculated in terms of regions andindustry types, and other factors.The average profit ratio for0.060.040.020919395Overall averageCentral regionNorthern regionSouthern regionall enterprises increased from 3.1% in 1991 to 3.3% in 1993, but fell to 2.6% over the followingtwo years until 1995. When this is assessed in terms of regions, the average for enterprises in the

78 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnamnorthern region increased from 1.1% in 1991 to 1.9% in 1993, but dropped to 0.9% in 1995. Thistrend of an increase followed by a decrease is common for all enterprises. However, the profitratio of enterprises in north is consistently higher than the overall average. On the other hand, theprofit ratio of enterprises in the central region is below the overall average.There is also a large disparity in the profit ratio for different industry types. The highestprofit ratio recorded among the six surveyed industry types was in construction materials in1993, with 5.4%. However, the profit ratio of this industry fell to -1.6% in 1995. High profitratios in 1995 were recorded in the food processing and electrical/electronic industries.Table 7Changes in the Profit Ratio on Sales of Surveyed Enterprises1991 1993 1995Average for all enterprises 3.1 3.3 2.6RegionsNorthern regionCentral regionSouthern regionTypes of industriesFood processingTextiles and clothingElectrical/electronic equipmentConstruction materialsChemicalsMachinery1.13.84.61.92.35.4(Unit : %)Note : Here, the profit ratio on sales for each enterprise was calculated, and asimple average was produced.1.84.24.53.42.91.71.83.53.35.43.92.20.92.24.84.72.24.3-1.63.72.5To this point, analysis of production and financial performances has been carried out,although without concrete result. Therefore, further analysis of more detailed data is needed inthe future. Nevertheless, although some deterioration in production performance and financialperformance is observed overall, it is not possible to say with any conviction that the currentsituation is either improving or worsening.III. INCENTIVE STRUCTURE OF STATE-OWNEDENTERPRISESFrom the analysis in the previous section, we have learned that the production performance ofVietnam's state-owned enterprises improved in the 1990s, although there are some disparities interms of industry and region, and their financial performance has been deteriorating, albeit notsignificantly, in recent years. If so, what is the structure of Vietnam's state-owned enterpriseswhich has created this kind of situation?

OECF Journal of Development Assistance Vol.4, No.1, 1998 79A. Competitive EnvironmentIn terms of the external competitive environment, state-owned enterprises account for a largeshare of most industries, as mentioned above, and because private enterprises are not nurtured,there is no situation of competition in the market environment with private enterprises. This canbe broadly predicted by analyzing how the surveyed enterprises evaluate their competitiveenvironment and their competitiveness. Here, products from the "leading enterprises in a region"and products from the "leading enterprises in Vietnam" are used for comparison, and state-ownedenterprises rank the competitiveness of their products into five grades. If they see their productsas having the same competitiveness as the top products, they assign a grade of "5." If they seetheir products as being largely uncompetitive, they give a grade of "1." The answers given fromthe two question groups are simply added together, and used as an index of a self-assessment oftheir competitiveness.Therefore, the highest value possible is "10," and the lowest value possible is "2." Theresults of the aggregates are shown in the following table.Table 8Self-assessment of Competitiveness by State-owned Enterprises (Indexed)Northern regionCentral regionSouthern regionCentral governmentLocal governmentEstablished as state-owned enterpriseNationalizedFood processingTextiles and clothingElectrical/electronic equipmentConstruction materialsChemicalsMachinery6.57.17.06.86.86.67.26.87.15.96.96.67.1When different regions are compared, enterprises in the north averaged 6.5, somewhatlower than the averages in the southern (7.0) and central (7.1) regions, with a self-assessment ofcompetitiveness that was weaker than others. Furthermore, when different types of industries arecompared, those industries which rated their competitiveness as being strong were the textiles/clothing industry (7.1) and the machinery industry (7.1), while the electrical/electronic industry(5.9) rated its competitiveness as being weak.When major competitors of the surveyed enterprises in the domestic market were examined,an overwhelming percent (69%) of respondents named other state-owned enterprises as beingthe major competitor. This was followed by both small and large private enterprises, at a percentageof around 36%. Other competitors named were at a similar level as private enterprises (36%),and included imported products (34%), smuggled goods (30%), and joint-ventures with foreigncapital (31%).By region, enterprises in the north competed most vigorously with other state-owned

80 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnamenterprises, followed by small-sized private enterprises. In the south, other state-owned enterpriseswere most frequently named as the major competitor, but competition with independent foreigncompanies, foreign capital joint-ventures, imported products and smuggled goods were somewhathigher than in other regions, with about 40% of enterprises naming them as competitors. However,competition with foreign capital and imported products was not as strong in the central region,and along with other state-owned enterprises, small private enterprises were named as majorcompetitors. From this result, we can deduce that competition is intensifying in the south wherethe economy is becoming more market oriented, and where there are more imports from overseas.However, that stage has yet to be reached in the northern and central regions.In a comparison of jurisdictions, major competitors of enterprises under the jurisdiction ofthe central government differs from those of enterprises under local government authority, exceptfor competition with other state-owned enterprises. Enterprises under central government namedforeign capital joint-venture enterprises, imported products and smuggled goods as majorcompetitors with a relatively high frequency, while competition was more intense with small andlarge private enterprises for enterprises under the control of local governments. This can beexplained by the fact that enterprises under the jurisdiction of local governments tend to besmaller in size.By industry type, competition with other state-owned enterprises was most significantoverall, but there were some differences in terms of other competitors. The food processingindustry tends to compete intensely with small private enterprises (47.2%) and large privateenterprises (41.7%), while the textiles and clothing industry named independent foreign companies(40.4) as major competitors, with overwhelming frequency.The electrical/electronic industry named foreign capital joint-ventures (59.1%), importedproducts (45.5%) and smuggled products (59.1%) as their major competitors. The constructionindustry tends to compete most fiercely with small private enterprises (42.9%), while the chemicalsindustry competed intensely with private enterprises and imported products, but especiallyvigorously with other state-owned enterprises (82.9%). The machinery industry named otherstate-owned enterprises most frequently (76.9%), but also named imported products often (41.4%).Table 9Major Competitors of Surveyed EnterprisesNocompetitorPrivate enterprises StateownedCooperativesocietyForeigncapitalForeigncapitaljointImportedproductsSmuggledproductsSmall Large ventureAll enterprises 3.5 36.5 36.0 69.0 8.0 24.5 30.5 64.0 30.0Northern region 6.2 44.4 37.0 75.3 11.1 13.6 25.9 32.1 32.1Central region 2.5 40.0 35.0 62.5 12.5 17.5 20.0 27.5 7.5Southern region 1.3 26.6 35.4 65.8 2.5 39.2 40.5 39.2 39.2Central government 4.0 33.3 28.3 75.8 5.1 24.2 34.3 44.4 38.4Local government 3.0 39.6 43.6 62.4 10.9 24.8 26.7 23.8 21.8Established as state-owned 4.2 35.9 36.6 66.2 8.5 20.4 30.3 29.6 23.9enterpriseNationalized 1.7 37.9 34.5 75.9 6.9 34.5 31.0 44.8 44.8Food processing 5.6 47.2 41.7 66.7 0.0 22.2 30.6 8.3 13.9Textiles and clothing 6.4 29.8 36.2 67.2 6.4 40.4 25.5 34.0 29.8Electrical/electronic0.0 27.3 27.3 63.6 9.1 27.3 59.1 45.5 59.1equipmentConstruction materials 0.0 45.2 29.0 77.4 12.9 19.4 35.5 38.7 16.1Chemicals 0.0 42.9 45.7 82.9 11.4 22.9 17.1 42.9 40.0Machinery 6.9 24.1 31.0 75.9 10.3 6.9 27.6 41.4 31.0

OECF Journal of Development Assistance Vol.4, No.1, 1998 81In general, competition between state-owned enterprises is most fierce, and competitorsdiffer from enterprise to enterprise depending on the region, jurisdiction and type of industry.Enterprises located in the south tend to compete intensely with foreign capital enterprises andimported products, while their northern counterparts tend to compete more with smaller privateenterprises, and do not tend to experience severe competition with foreign capital enterprisesand imported products. Furthermore, enterprises located in the central region also competevigorously with foreign capital companies and imported products. However, enterprises underthe jurisdiction of local governments tend to see private enterprises more as their competitors.Most state-owned enterprises acknowledged having competitors in the domestic market, andonly 3% of enterprises answered that they didn't have a competitor in the Vietnamese market.In the self-assessment of competitiveness, most state-owned enterprises saw their ownproducts as been very competitive, or competitive. However, these products have little or nocompetitiveness in the international market. This assessment indicates that Vietnam's state-ownedenterprises have better facilities, machinery, technology and skilled workers than domesticcompetitors, but are significantly behind foreign enterprises. Most enterprises perceive theirmain primary products as being the most competitive, suggesting that state-owned enterprisesare concentrating their resources in primary products.Vietnam's state-owned enterprises have yet to be exposed to international competition.However, domestic competition and competition with imported and smuggled products isintensifying, and judged from this angle, this could well be the reason for the slight drop in profitratio observed between 1993 to 1995.B. Internal IncentiveWhen the reform of Vietnam's state-owned enterprises and the reform of China's state-ownedenterprises are compared, the first notable difference is that, unlike the Chinese reforms, therewas no evidence of a performance contract format being employed in the reform of managementautonomy in Vietnam. In other words, management autonomy was granted to state-ownedenterprises in Vietnam all at once, within a relatively short period of time.1. Granting of Management AutonomyOur data confirms the above. According to our data, granting of management autonomy toVietnam's state-owned enterprises showed significant progress in the second half of the 1980s,in other words after cabinet Decision No. 217 was passed. The following table shows the aggregateresult of a survey conducted among the senior executives of surveyed enterprises on the questionof when management autonomy was granted. Here, management autonomy was categorizedinto seven items. These were "product structure and output," "export and import," "employment,""investment," "procurement and sale of input materials," "distribution of profit', and "dispositionof assets." The senior executives were asked when management autonomy was granted for eachof these seven categories.

82 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in VietnamTable 10Period when Management Autonomy was Granted to Enterprise Managers(responses by senior executives of enterprises)Product stcucture and outputExport and importEmploymentProcurement and sale of input materialsDistribution of profitInvestmentDisposition of assets1975-79 1980-85 1986-90 1991-94 1995, 965.57.07.03.05.02.02.08.08.58.06.56.02.52.055.544.544.538.031.534.526.019.026.526.522.520.033.527.02.53.03.02.03.06.03.0Notgranted9.510.511.028.034.521.540.0We can see from Table 10 that the largest number of enterprises were granted managementautonomy during the period 1986 to 1990. As a result, almost 90% of enterprises had managementautonomy for production structure and output in the 1990s. However, there is some difference asto when autonomy was granted for other category items. More than 60% of surveyed enterprisessaid they were granted autonomy for "product makeup and output volume," "export and import,"and "employment" by 1990. By 1996, about 90% of enterprises were entrusted with autonomousmanagement decisions. However, the granting of autonomy is lagging somewhat for remainingcategory items, especially with the "disposition of assets," only 60% of enterprises in 1996 saidthey had been granted autonomy. But when compared with the result of a survey conducted onChinese state-owned enterprises, these responses show a significantly higher ratio. 1 Having saidthis, one must not forget that the response ratio in Vietnam is solely based on judgments made bythe enterprises themselves, and may differ from the views of the administrative authorities oftheir jurisdiction. In terms of the system, all assets of Vietnam's state-owned enterprises belongto the General Department of Management of State Capital and Assets in Enterprises the GeneralDepartment of Management of State Capital and Assets in Enterprises of the Ministry of Finance,established at the end of 1995, and it is difficult to see how "the rights to dispose assets" isgranted to the heads of enterprises.Table 11 shows a comparison of management autonomy granted in terms of enterprisegrouping of the surveyed enterprises, using the same data. To simplify the comparison, an averagewas calculated for the year that management autonomy was granted for all category items. Theseaverages were deducted from 1997, the year the study was concluded, to produce an index. Inother words, if the average year when the autonomy was granted for all category items for anenterprise was 1990, then the autonomy index was 7 (=1997 - 1990) for this enterprise. Thelarger the index, the earlier total management autonomy was granted.1 For example, when the survey was conducted in 1996, less than 30% of enterprises in China saidthey were granted management autonomy in the area of "disposition of assets."

OECF Journal of Development Assistance Vol.4, No.1, 1998 83Table 11Comparison of when Management Autonomy was Granted forEach Grouping of State-owned EnterprisesNorthern regionCentral regionSouthern regionCentral governmentLocal governmentEstablished as state-owned enterpriseNationalizedFood processingTextiles and clothingElectrical/electronic equipmentConstruction materialsChemicalsMachinery5.56.75.96.05.95.76.75.66.66.44.75.96.4(Index)Note: The index is based on 1997, and shows how manyyears prior to the base year autonomy was granted.When this index is compared by region, enterprises in the north averaged 5.5, and enterprisesin the southern and central regions averaged 5.9 and 5.7 respectively. This indicates thatmanagement autonomy granted to enterprises in the north is somewhat behind the other tworegions. In a comparison between different jurisdictions, there was little difference betweenenterprises under the jurisdiction of the central government (6.0) and enterprises under thejurisdiction of local governments (5.9). On the other hand, when enterprises established by thestate are compared with those requisitioned by the state, requisitioned enterprises averaged 6.7compared with 5.7 for enterprises established by the state. It seems that former private enterpriseswere granted management autonomy earlier than enterprises established by the state at foundation.2. Preservation of Unprofitable DepartmentsLet us continue the examination from a different angle to clarify the degree of managementautonomy granted to proprietors of state-owned enterprises. Enterprises were asked whetherthey have an unprofitable department within the enterprise, and if they do, they were asked toname the main reason for it (Table 12). Nine possible responses were provided: "unstable market,""shortage of working capital," "outdated technology and facilities," "products lack appeal,""pressures of social security burdens," "government intervention," "surplus labor," "strict controlby supervisory offices," and "inappropriate management." From these nine choices, "socialsecurity," "government intervention," "surplus labor," and "strict control by supervisory offices"were interpreted as items suggesting administrative intervention in enterprise management.If these items rate high among the responses, we can presume that there is a degree ofadministrative intervention in management, and that management autonomy is not established.Table 13 shows the aggregate results of the response ratios for each response item in terms ofenterprise groupings.

84 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in VietnamTable 12Percentage of Enterprises with Unprofitable DepartmentsAll enterprises 34.0Northern regionsCentral regionsSouthern regionsCentral governmentLocal governments28.450.031.734.333.7(Unit: %)Table 13Reasons for Having Unprofitable Departments(Unit: %)Unstable marketShortage of working capitalOutdated technology and facilitiesLack of product appealSocial security burdensExcessive government interventionSurplus labor burdenControl by supervisory officesInappropriate managementNumber ofenterprises7459502525191676Northernregion7070482635303590RegionsCentralregion857050201510555Southernregion6840522824168812JurisdictionsCentralgovernment74535326182924123Localgovernments74654724329939The responses for whether an enterprise has an unprofitable department or not reveal that34% of enterprises did in fact have unprofitable departments. In other words, about a third ofsurveyed enterprises maintained an unprofitable department, for whatever reason. When acomparison is made by region, enterprises located in the central region recorded a significantlyhigher number of positive responses, at 50%. There was not much difference between enterpriseslocated in the north and those in the south. Also, there was little difference observed in a comparisonof jurisdictions. When the aggregated result of reasons for having an unprofitable department isviewed, the response with the highest average was "unstable market," with 74% of enterprisesnaming this as one of the reasons. This was then followed by a "shortage of working capital,"with 59%, and "superannuated technology and facilities," at 50%. Responses suggestingadministrative intervention in management showed the following results: "pressures of socialsecurity burdens" (25%), "government intervention" (19%), "surplus labor" (16%), and "strictcontrol by supervisory offices" (7%).When this is viewed in terms of region, enterprises located in the north showed a highresponse rate for items suggesting general administrative intervention. In particular, the rate ofresponses for the three items, "pressure of social security burdens" (35%), "governmentintervention" (30%), and "surplus labor" (35%), were considerably higher than in other regions.

OECF Journal of Development Assistance Vol.4, No.1, 1998 85This suggests that the establishment of management autonomy is not moving as quickly in thenorth and that there is a degree of administrative intervention in enterprise management in theregion. In terms of jurisdiction, enterprises under the authority of the central government averagedmore responses which suggest general administrative intervention. Except for "pressures of socialsecurity burdens," with a higher rate of response from enterprises under local governmentjurisdiction, other items, "government intervention," "surplus labor," and "strict control bysupervisory offices" received more responses from enterprises under the central government, at29%, 24%, and 12% respectively.One can presume that enterprises under the jurisdiction of the central government are understricter control from the administration.3. Relationship with Government DepartmentsAs mentioned above, the majority of managers of Vietnam's state-owned enterprises see themselvesas having management autonomy. However, we can see that, depending on the jurisdiction andthe region, a certain amount of government intervention remains. This indicates that the grantingof management autonomy has not necessarily been carried out uniformly, rather thatimplementation has been somewhat patchy. Let us look next at the relationship between stateownedenterprises and government agencies (Table 14).According to our data, all state-owned enterprises maintain some form of relationship withgovernment agencies. Of these enterprises, 68.5% maintain an ad hoc relationship. State-ownedenterprises under central government jurisdiction continue to have a more regular relationshipwith government agencies than those under local government jurisdiction. These former areunder the jurisdiction of the central government's line ministry, or profit from their transactionswith government agencies. Generally speaking, state-owned enterprises in all industries maintaina regular relationship with the government or government authorities, but this ratio is particularlyhigh among state-owned enterprises in the textiles/apparel processing industry. The most likelyreason for this is that almost all state-owned enterprises in the textiles/apparel processing industryare under the General Corporation umbrella and perform their transactions through this.Table 14Frequency of Contact between State-owned Enterprises and Government AgenciesNo contactVery limited contactAd hocEvery weekEvery monthTotalAll regions Northern region Central region Southern regionNumber ofenterprises041371445200Ratio(%)0.02.068.57.022.5100.0Number ofenterprises025951581Ratio(%)0.02.572.86.218.5100.0Number ofenterprises012621140Ratio(%)0.02.565.05.027.5100.0Number ofenterprises015271979Ratio(%)0.01.365.88.924.1100.0In connection with the purpose of state-owned enterprises maintaining a relationship withgovernment agencies, the majority (76.50%) of enterprises indicated that they value such a

86 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnamrelationship. The number one reason is legal help in connection to production and financialaffairs, and financial assistance for investment (providing a source of funds) (76.50%). Thesecond reason is obtaining information about the latest trends in the most recent technology(67%) and preferential treatment in finance (62.5%). The least important reason is to request asubsidy (18.5%).From these facts, it can be understood that even though state-owned enterprises had beengranted management autonomy, they are not necessarily able to raise funds by themselves.However, when they are faced with severe fund limitations and high interest, state-ownedenterprises expect government intervention and financial assistance. In addition to this, if financialassistance is expected, it is only natural that there is the chance of a change in the relationshipbetween state-owned enterprises with government agencies. Relatively few enterprises in contactwith government agencies seek subsidies from the budget. However, a majority of enterprises(62.5%) still seek preferential financial assistance from the government. From this, we can seethat in general, state-owned enterprises still rely on a government subsidy, albeit in a differentform.By region, state-owned enterprises in the north strongly desire to maintain a relationshipwith government agencies, whereas enterprises in the southern and central regions desire arelationship with government for specific purposes.The majority of state-owned enterprises in northern areas responded that their principal reasonfor maintaining a relationship with government agencies is to gain protection in the domesticmarket.The reason for contact with government agencies differs depending on the type of industry.The gathering of information on the latest technology is most important for industries such astextiles, apparel processing, construction materials, machinery manufacturing, and electrical/electronic equipment. This is understandable because technological reform in these industries ismost important. Moreover, there is strong demand for the government in the electrical/electronicequipment industry to protect domestic industry.The main purpose for government agency contact with state-owned enterprises includescollecting information on such matters as product trends (86%), daily financial conditions (79%),employment (68.5%), and production technology (59%), as well as acquiring technical informationon production by enterprises and products for sale (63.27%). Many state-owned enterprisesthemselves approve of the acquisition of information related to production and financial conditions(Table 15).State-owned enterprises located in the north tend to be more likely to approve of governmentagency contact with enterprises than state-owned enterprises in other regions. At the same time,it seems that state-owned enterprises in the north are trying to maintain a relationship withgovernment agencies by providing information about their industry, such as information onindustry performance. This seems to spring from the fact of the physical proximity of northernstate-owned enterprises to the government.

OECF Journal of Development Assistance Vol.4, No.1, 1998 87Table 15Principal Reasons for Contact of Government Agencies with State-owned EnterprisesInstruction on financialassistance for investmentInstruction on taxationincentives for investmentProvision of information onpreferential financial and fiscalmeasures for investmentProvision of information onproduction trendsProvision of information on thefinancial condition ofenterprisesProvision of information on theuse of laborProvision of information onproblems with productiontechnologyProvision of information ondemand for productsAll three regions Northern region Central region Southern regionNumber ofenterprises106101103172158137118127%53.050.551.586.079.068.559.063.5Number ofenterprises6058577469665963%74.171.670.491.485.281.572.877.8Number ofenterprises1815183632251724%45.037.545.090.080.062.542.560.0Number ofenterprises2828286257464240%35.435.435.478.572.258.253.250.6The majority of state-owned enterprises believe in a government role in industrialdevelopment, and 80.5% of them wanting government participation in a centralization of resourcesand strategic industrial support. Next, at 78%, was a desire for preferential government financefor strategic industries, followed by demand for preferential financial support for state-ownedenterprises (71.5%). Many enterprises (68.5%) want information on new technology and thesame number (68.5%) want a strengthening of import restrictions for a number of key industries.The results of the survey show that about one third of state-owned enterprises want direct financialsupport from the government for strategic industries and small and medium-sized enterprises.Like the different targets established by government agencies in order to maintain theirrelationship with state-owned enterprises, the role of the government in promoting industrialdevelopment is considered more important for state-owned enterprises located in the north.State-owned enterprises in the north place a high value on the role of the government formacroeconomic stability, while state-owned enterprises in the central region value directgovernment investment in strategic industries. Evaluation of the government's role does not varysignificantly by industry or by jurisdiction. There was much greater support for government taxincentives for small and medium-sized enterprises from state-owned enterprises under thejurisdiction of local governments than from state-owned enterprises under central governmentauthority. This is because state-owned enterprises under the jurisdiction of local governmentstend to be smaller in size. Currently, relatively few state-owned enterprises are receivinggovernment support, and the support given to those which are receiving it is limited to provisionof information and technological development. Only 32% of state-owned enterprises surveyedwere recipients of government support. Especially with respect to exports and imports, only10.5% of state-owned enterprises reported that they are receiving government support. Incomparison with state-owned enterprises in the central and southern regions, many enterprises

88 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnamin the north are receiving government support, but in our survey, a great many more state-ownedenterprises in the central region were recipients of government support (40% of the surveyedstate-owned enterprises). They replied that they were receiving low interest loans. By industry,machinery manufacturing firms were the most likely to be receiving government support, whichwas in the form of low interest loans (41.38%) and the provision of information and technology.The textiles/apparel processing industry were receiving information related to export markets.C. Financial IncentivesAs stated above, the weakness was observed in the incentive given from the outside competitiveenvironment to Vietnamese state-owned enterprises, internal performance contracts and theincentive from other mechanisms. The financial mechanism through fund raising and creditsserves as another mechanism providing incentives for corporate managers. For instance, bankscan provide an incentive to the management of debtors when the management situation isparticularly impaired. Does such an incentive mechanism function in Vietnam?1. Investment ActivitiesFirst, it should be examined whether state-owned enterprises actually invest in activities requiringfunds to grow (Table 16). During 1995, almost all state-owned enterprises made investment(82% of the entire enterprises). Some 70.1% invested in updating some of their facilities, and62.2% in measures to increase production capacity. Despite this, only 7.9% have completelymodernize machinery and equipment. During 1995, the most active facility investment was madeby the food processing industry, in which 88.9% of the industry participants made investment.Investment priorities vary depending on the industry: a partial update of facilities and machineryin the electrical/electronic equipment industry, and both a partial update of facilities and machinesand increase in production capacity in the chemicals industry.Table 16Investment Activities by State-owned Enterprises (1995)Enterprises which did notmake investmentEnterprises which madeinvestmentTotal modernisation ofequipmentPartial modernisation ofequipmentExpansion of productioncapacityAll regions North Middle SouthNumber ofenterprises3616413115102Ratio(%)18.082.07.970.162.2Number ofenterprises126955242Ratio(%)14.885.27.375.460.9Number ofenterprises103021919Ratio(%)25.075.06.763.363.3Number ofenterprises146564441Ratio(%)17.782.39.267.763.1

OECF Journal of Development Assistance Vol.4, No.1, 1998 89The scale of investment of the state-owned sector gradually increased from 1991 to 1995,and investment rose by at least 10 billion dong, accompanied by a decline in the number of stateownedenterprises with a capital size of 10 billion dong (Table 17).Table 17Structure of State-owned Enterprises by Investment Scale(Unit: %)Investment capital per enterprise 1991 1993 199510 billion dong or lessBetween 10 billion and 50 billion dong50 billion dong or more672212Total 100 100 100553015443323Investment capital is procured using retained earnings, bank loans and other loans. Withrespect to the distribution of investment capital, major sources of investment funds were investmentexpenditure from the national budget and retained earnings in 1991, and retained earnings andbank loans in 1995, a year in which more than a half of total investment capital was obtained bybank loans. During the period 1991 to 1995, the budget allotment drastically decreased from40.3% to 21.1% (Table 18). Similar to "Bo Gai Dai" in China, this phenomenon indicates thatgovernment policy has shifted from investment in state-owned enterprises as a subsidy paid outof the national budget and public investment to investment using bank loans.Table 18Structure of Investment Capital of State-owned Enterprises1991 1993 1995Investment from the government budget 40.3 35.1 21.1Investment raised by the firm self 38.0 31.9 30.5Bank loan 19.3 32.4 48.4Others 2.5 0.6 0.0The changed means of acquiring investment funds differs somewhat by region and industry(Table 19). The accumulated capital in the south occupies the largest share of total capital.Investment through budget allotments to state-owned enterprises rose in the south, while it fell inthe central and northern areas.

90 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in VietnamTable 19Comparison of Means of Acquiring Investment Funds by Enterprise (1995)GovernmentbudgetBank loanOwn capital(unit: %, million dong)Meaninvestment valueAll enterprises 19.8 51.8 28.3 3,252Northern regionCentral regionSouthern regionCentral governmentLocal governmentEstablished as state-owned enterpriseNationalizedFood processingTextiles and clothingElectrical/electronic equipmentConstruction materialsChemicalsMachinery18.41.524.522.115.121.416.626.912.922.211.915.435.762.487.438.644.666.753.049.426.776.055.856.360.731.219.211.136.933.318.225.534.146.411.122.031.823.933.02,4651,9794,7044,4162,1123,0863,6584,0113,2312,2983,7962,9552,8452. Loans from Banks to State-owned EnterprisesIt was confirmed that the fund raising channel is changing from investment through budgetallotment to bank loans among Vietnamese state-owned enterprises in the 1990's. As a result, thegradual increase has been recognized in the track record of loans from banks among many of thestate-owned enterprises. As for short-term lending, no differences are evident among regions,but there are disparities among industries: loans were made to all enterprises in the electrical/electronic equipment industry. Even in the apparel processing industry, which has the smallestshare of enterprise borrowing from banks, the rate is as high as 89.36%. The weaving industrydoes not require much investment because of its labor-intensive manufacturing system reflectingfrequent processing on consignment. More state-owned enterprises under central governmentauthority have the potential to borrow from banks than enterprises under local governments(central: 97.0% vs. local: 90.1%).Increased bank loans brought state-owned enterprises into debt. Loans from banks andinter-company debts occupy the greatest part of the debt structure of state-owned enterprises(accounting for a combined 90.6% of total debt) (Table 21). Bank borrowings occupy 55.92% ofall debts in state-owned enterprises. On the other hand, inter-corporate debts have in reality beenfar more prevalent than is shown by the low component ratio (34.68%). They distort the capitaldistribution among corporations and also adversely impact the state-owned enterprises' business.It often happens that a large portion of total debt can be occupied by nonpayment of taxes, wagesand bonuses. But fewer state-owned enterprises have these kinds of debts, compared to thosewhich have bank debts and inter-corporate debts.

OECF Journal of Development Assistance Vol.4, No.1, 1998 91Table 20Ratio of Surveyed Enterprises which have Actually Borrowed Loans from BanksShort-termborrowingMiddle and longterm borrowingAll enterprises 83.5 82.0Northern regionCentral regionSouthern regionCentral governmentLocal governmentEstablished as state-owned enterpriseNationalized86.482.581.089.977.283.882.885.275.082.386.977.282.481.0Table 21Structure of Debts in State-owned EnterprisesBank debtBorrowing from other companiesTaxes payableUnpaid wages and bonuses(Unit: %)Types of debts55.934.75.73.7State-owned enterprises in all regions, industries under both central and local governmentjurisdictions give special priority to payment of wages and bonuses to workers (73.5% of all ofenterprises) and payment of taxes to the tax office (72.5%) as measures when there is insufficientoperating capital. In 28% of cases, the highest priority is payment of taxes. Payment of principaland interest, payment of profits to the government and payment of inter-company debts are notgiven as much priority as payment of wages and bonuses.Table 22Comparison of Debt Distribution among Surveyed Enterprises (1996)Bank debtInter-companydebtTaxdelinquency(Unit: %)Unpaid wagesAll enterprises 48.4 34.9 9.6 7.1Northern regionCentral regionSouthern regionCentral governmentLocal governmentEstablished as state-owned enterpriseNationalized56.560.033.544.951.550.144.031.126.443.640.529.9236.97.95.313.86.812.19.79.44.58.39.27.96.46.09.9

92 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in VietnamComparing the types of debts by region, the ratio of inter-company debt exceeds that ofbank loans in the south while the opposite trend prevails in the central and northern regions(Table 22). The ratio of tax delinquency is high in enterprises in the south and among those underthe jurisdiction of local governments. The pressure of operating capital is a critical issue whenthere is a sharp rise of production. The response to the problem by enterprises in the southappears to be to borrow funds between companies, and put off tax and salary obligations.3. Difficulties in Fund AcquisitionOnly 8.5% of all enterprises see difficulties in borrowing term capital from banks. The majorityof state-owned enterprises find difficulties such as cumbersome procedures (74.86%), and highinterest rates (63.39%). Only 29.51% have problems with collateral. This demonstrates that stateownedenterprises inevitably face a number of difficulties in borrowing long-term capital inpractice.By region and industry, most state-owned enterprises in the north name cumbersomeprocedures as the major difficulty. In the central region, the shortage of collateral is deemed to begreatest hurdle. In the machine manufacturing and construction materials industries, the highinterest rate was the key difficulty in borrowing long-term capital. This stems from the lowprofitability of the machine manufacturing industry and the high profitability in the constructionmaterials industry. The machine manufacturing industry also named insufficient collateral as adifficulty in borrowing long-term capital. These results indicate that the arrangement of proceduresfor loans and deposits is advancing, interest rates have generally declined, and preferential interestrate treatment still remains for several key industries which have substantial borrowings despitetheir lack of profitability.Mid and long term borrowing was carried out by 51.2% of all enterprises. As reasons forthe increased borrowing, sufficient collateral and corporate reputation were named in 67.0% and38.5% of the cases respectively. Only 2.0% are bank loans guaranteed by foreign companies.Apparently, financial soundness, favorable performance and adequate collateral are the majordeterminants of the lack of long-term capital and the potential for long-term borrowing.Table 23Reasons for Availability of Term BorrowingsSufficientcollateralGovernmentguaranteeForeigncompanyguaranteeTrust atpersonallevel(Unit: %)OthersAll enterprises 67.0 15.0 2.0 38.5 3.0Northern regionCentral regionSouthern regionCentral governmentLocal governmentEstablished as state-owned enterpriseNationalized76.567.147.570.763.464.872.411.117.717.515.214.914.815.50.05.10.02.02.01.43.445.736.727.543.433.737.341.40.11.30.03.03.03.51.7

OECF Journal of Development Assistance Vol.4, No.1, 1998 93IV. CORPORATE GOVERNANCE REFORMSThe corporate governance of state-owned enterprises refers to the legal (or not yet legal) structurewhich regulates the ownership and management system of enterprises, including both stateownedand private companies. Several attempts have been made to establish a corporategovernance system since 1990, when the Company Law was formulated. Unfortunately, such ageneral framework determining the all-inclusive corporate management system has yet to appear.Property rights have not been set properly.This chapter summarizes attempts to reform corporate governance by the Vietnamesegovernment in the 1990's and also reviews the goal.A. EquitizationEquitization was first adopted as a trial for the purpose of reforming state-owned enterprises inthe area of corporate governance. Equitization is generally recognised as "exchanging corporationfor paper in the form of shares, and these are sold." This method of converting a company topaper and selling it is an extremely novel idea in Vietnam, where securities markets did not exist.The policies for equitization were presented to pilot enterprises by Cabinet Resolution No. 143in May 1990. This was followed by the Prime Minister's Resolution No. 203 in June 1992, whichmade seven companies pilot incorporated companies. However, the equitization of each companymoved forward very slowly, and little progress has been made to date, despite Prime Minister'sInstruction No. 84 in March 1993.According to official announcements, the three objectives of the equitization of Vietnamesestate-owned enterprises are to improve efficiency of corporate management, secure equipmentinvestment capital, and to provide a powerful motivation for employees. In this case, equitizationmodernizes the organization of enterprises, leading to more efficient management. It enables theinjection of employees and outside funds into state-owned enterprises and spurs facility investment.A mechanism is assumed which improves the work incentive among employees by allowingemployees to hold stocks.However, this assumed mechanism does not function satisfactorily. All seven enterpriseschosen for pilot companies have put off participating in the equitization program. Twenty-onecompanies were selected for this program, but to date none has been equitized. By mid-1996,equitization was actually implemented in only six enterprises. Many different reasons for thevery slow progress of the program have been named. The primary factors are a lack of clear,transparent guidelines (methods of evaluating assets and selling stocks), anxiety over the loss ofa preferential position as a state-owned enterprise, securing employment, and resistance bysupervising bodies.B. Asset Management of State-owned EnterprisesWith the increase in the management autonomy of state-owned enterprises in the late 1980s,poor use of national property, or its use as private property became an increasing problems. Inresponse, the Vietnamese government clarified a financial reporting system for state-ownedenterprises through an October 1994 Finance Ministry Ordinance. This enforcement of a state-

94 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnamowned enterprise management system led to the implementation of collective management bythe General Department of Management of State Capital and Assets in Enterprises in May 1995(established in October 1995). This collective management was achieved by splitting the FinancialDepartment, which falls under the People's Committees, into three "Financial Department, TaxDepartment and Department of Management of State Capital and Assets in Enterprises" as wellas by restructuring the Tax Department and the Department of Management of State Capital andAssets in Enterprises into local offices under the direct control of the Ministry of Finance. At thesame time, reform was undertaken in the central agencies, which are the supervising sections(especially the Ministry of Light Industry and the Ministry of Heavy Industry) and a range ofcontrols were lifted by the Industry Department of local People's Committees on state-ownedenterprises. As a result, the traditional supervisory bodies have through regulation becomesupervisors of entire industries.However, administration has been transferred to the Department of Management of StateCapital and Assets in Enterprises, and only the personnel administration of senior executivesremains in the province of the Industry Department, which is the supervising section. In practice,state-owned enterprises generally decide on a project's turnover and profit autonomously, and apost-report is prepared by the Industry Department based on these indices. This was deducedfrom the fact that the report form submitted to the Industry Department (and the Department ofManagement of State Capital and Assets in Enterprises) by state-owned enterprises monthlyincludes a section for sales and target profit, as well as the fact that a number of state-ownedenterprises (but not all) reported in interviews that they had targets for these two indices.C. Corporate Grouping: Establishment of General CorporationsAn attempt to set up 'unions' by integrating several state-owned enterprises in the same industryhad been made before the implementation of Doi Moi, as means of transferring part of the workof the administration to enterprises. After No. 91, the Prime Minister's Resolution in March1994, the unions came into practical effect with the reform of the state-owned enterprisesmanagement system. It was then thought that the corporate group which had existed as unionsbefore should be restructured as general corporations (Tong Cong Ty). There are two conditionsfor make a corporate group a general corporation: it must have seven member companies ormore, and it must have legal capital of 1 trillion dong. A legal basis for management of thisGeneral Corporation has been established in compliance with the State-Owned Enterprise Lawstated above.The State-Owned Enterprise Law described below regulates the following three objectivesin setting up the general corporation: abolishing the system of supervision; rationalizing investmentby state-owned enterprises; and realizing economies of scale. In reality, the major objectives areeconomies of scale and rationalizing investment. Under Vietnam's economic plan, the heavychemicals industry was developed based on the Chinese and Soviet models. Consequently, owingto the population scale, the demand to be self-supporting in industrial products, and the shortageof funds, it was decided to build small-scale industrial plants around the country, and this was themost serious problem. It was determined that the general corporation should be founded to integratethese small-scale industrial plants. Additionally, permission was given to include financialinstitutions for the procurement of funds.

OECF Journal of Development Assistance Vol.4, No.1, 1998 95General corporations are planned to be set up under the name of State Corporation, withtheir own regulations. The table below shows the major GCs established. In practical terms,these GCs do not differ from the original departments of the Ministry of Industry, which used tobe the supervising sections. Since the supervisory power has been transferred to the Departmentof Management of State Capital and Assets in Enterprises, as stated above, the main activities ofGCs seem to be limited to checking on the management of member enterprises through regularfinance reports and assigning foreign companies which make direct investments to state-ownedenterprises. With General Corporations, problems have arisen in a completely different area. Inparticular, general corporation serve as a rent-seeking mechanism by accepting direct investment.Table 24Major General Corporations in VietnamEnergy-relatedElectricity Corporation of Viet NamCoal Corporation of Viet NamViet Nam Petroleum Corporation (PETROVIETNAM)IndustryViet Nam Steel Corporation (VSC)Machine and Industrial Equipment Corporation (MIE)Viet Nam Electronics and Informatics Corporation (VIETTRONICS)Viet Nam Chemical Corpoiration (VINACHEM)Viet Nam Plastic Corporation (VINAPLAST)Viet Nam Textile and Garment Corporation (VINATEX)Cement Corporation of Viet NamAgriculture, forestry and fishingSeaproducts Export-Import Corporation (SEAPRODEX)Viet Nam Vegitable & Food Corporation (VINAFOOD)Viet Nam Rubber CorporationViet Nam Coffee CorporationViet Nam Tobacco CorporationTransport and communicationsViet Nam National Shipping Lines (VINALINES)Viet Nam Airlines CorporationViet Nam Post and Telecommunication CorporationVeit Nam Railways UnionD. Legal Framework: The State-owned Enterprise Law1. Establishment of the State-owned Enterprise LawThe establishment of the State-owned Enterprise Law in April 1995 was a major change in thelegal framework of state-owned enterprises and an important turning point in the reform of state-

96 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnamowned enterprises. The articles included in the State-owned Enterprise Law indicate policy relatingto state-owned enterprises, based on experience of the reform of state-owned enterprises duringthe past few years.The State-owned Enterprise Law was prepared with several basic requirements in mind.(1) To form a legal foundation for the management of state-owned enterprises and to maintainfairness with enterprises of other configurations covered by the Company Law (enacted in 1990),Foreign Investment Law, and Private Enterprise Law. (2) To guarantee the corporate status ofstate-owned enterprises and to establish independence and a system of self-responsibility. (3) Toestablish goals for state-owned enterprises, with a view to profits and the public good, withoutcreating a mechanism which confers different goals on different types of state-owned enterprise.(4) To identify the clear rights and responsibilities of state-owned enterprises, presupposing theprovision of sufficient incentives for state-owned enterprises, directors and workers. (5) To createan organizational model which guarantees effective monitoring and control by the state, havingtaken advantage of the flexibility and dynamism of directors. (6) To eliminate the representativenature of ownership of state-owned enterprises and the ambiguity of the management model ofstate-owned enterprises, and to manage state capital invested in state-owned enterprises.Vietnam's State-owned Enterprise Law was promulgated on April 20 1995 and is the mostimportant law relating to Vietnam's state-owned enterprises. The State-owned Enterprise Lawwas established separately from the Company Law (1990), and at present, legally, state-ownedenterprises and private enterprise have organizations with different corporate governance basedon completely different laws.The idea of administering foreign investment enterprises, private enterprises and stateownedenterprises in Vietnam with one law like China's Company Law (1993) is continuallydiscussed within Vietnam's government, and in this case, the plan is to unify the Company Lawand the State-owned Enterprise Law.2. Content of State-owned Enterprise LawVietnam's State-owned Enterprise Law sets out a comprehensive framework of corporategovernance for Vietnam's state-owned enterprises, but at present it is difficult to say that anorganization for state-owned enterprises based on this State-owned Enterprise Law has actuallybeen established. Therefore, the State-owned Enterprise Law can be seen as a law existing betweenthe organization to which state-owned enterprises aspire and the reality. A summary of Vietnam'sState-owned Enterprise Law should serve to clarify this point.Vietnam's State-owned Enterprise Law comprises nine sections in total, namely Section 1explaining general provisions; Section 2 explaining the rights and responsibilities of state-ownedenterprises; Section 3 stipulating the foundation, reorganization, dissolution and bankruptcy ofstate-owned enterprises; Section 4 stipulating state management and state ownership in relationto state-owned enterprises; Section 5 stipulating the management organization of state-ownedenterprises; Section 7 stipulating the management of state-owned stock in state-owned enterprises;Section 8 stipulating the treatment of contraventions; and Section 9 stipulating enforcementrules.The State-owned Enterprise Law applies to independent state-owned enterprises, but italso applies to all state-owned enterprises with self-supporting accounting. In other words, it

OECF Journal of Development Assistance Vol.4, No.1, 1998 97also includes member enterprises of state-owned enterprise groups such as general corporations.State enterprises are obliged to accomplish specific tasks and aims set by the state (this includesthe pursuit of profits, public interests, social policy and security policy). Under the State-ownedEnterprise Law, state-owned enterprises are classified as Business State Enterprises and PublicService State Enterprises. The corporate goal of the former is the pursuit of profits, while thegoal of the latter is the provision of public services in accordance with state policy. This distinctionis considered necessary to improve the efficiency of state-owned enterprises, and clarification ofthis distinction is believed to guarantee the ideal equality of legal status between Business StateEnterprises and enterprises in other sectors and to enable enterprises to become more competitive.Consequently, in the future all enterprises must be administered by one company law. The rightof independence of Public Service State Enterprises must be somewhat limited in comparisonwith Business State Enterprises. Public service state-owned enterprises ought to be subject tomore strict state management in accordance with their specific public aim.Section 4 of the State-owned Enterprise Law stipulates 3 types of corporate governanceconfigurations for state-owned enterprises, namely state corporation, state-owned enterprise witha management board of general directors and state-owned enterprise without a managementboard of general directors. State corporations are formed for different types of industry anddifferent regions. Stipulations regarding state corporations at national level are made separatelyby Decree. These separate Decrees are promulgated as the Model Statute on Organization andOperation of State Corporations dated 27 June 1995, and, for example, the ordinance for the coalcorporation is promulgated as the Statute on the Organization and Operation of the VietnamNational Coal Corporation dated 27 January 1995.3. Management Autonomy and Government Control in the State-owned Enterprise LawThe State-owned Enterprise Law can be seen as defining the rights of state-owned enterprisemanagers as state-owned enterprise owners and the rights of the state as state manager. Part 1 ofSection 2 explaining the rights of state-owned enterprises stipulates that all rights such as theright to use and to transfer state assets, the right of transfer, the right of decision in the corporateorganization, the right of import and export, the right of investment and the right of engagementand dismissal of workers are conferred on directors, if it is comformable with corporate goals.The content of Part 1 of Section 2 bestows on directors of state-owned enterprises managementindependence rights equal to or greater than the 14 management independence rights in China'sstate-owned enterprises. For example, based on the principle of capital preservation, state-ownedenterprises can manage, use, allot, lease and mortgage their assets. (However, the approval ofstate-related bodies is required in relation to important equipment and plants.) They can formjoint ventures, purchase stock in conformity with the law, increase capital depreciation and, bysecuring earnings for reinvestment, increase corporate accumulation. Furthermore, at their owndiscretion, state-owned enterprises can change corporate goals and alter organizationalconfiguration in the interests of technological innovation and business (State-owned EnterpriseLaw, Articles 6, 7 and 8).This mechanism, designed to guarantee the right of independence of state-owned enterprises,can only begin to function properly with the abolition of government intervention in the routinebusiness of state-owned enterprises and the maintenance of necessary state control for state-

98 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in Vietnamowned enterprises. This relationship is reflected in the following kinds of organizationalmechanisms and structures.a) In relation to the whole state sector, the state controls each sector's direction of development,including the roles and goals of business state-owned enterprises (State-owned EnterpriseLaw, Articles 3, 6 and 10). Moreover, the state asks state-owned enterprises to accept thatcompetition is the very key to survival (Bankruptcy Law). With regard to areas for whichstate-owned enterprises are founded or reestablished, the state carries out ranking in termsof priority and exerts restrictions (State-owned Enterprise Law, Article 13). The state makesclear conditions for the foundation, reorganization and dissolution of state-owned enterprises(State-owned Enterprise Law, Articles 16, 20, 22). The State-owned Enterprise Law andBankruptcy Law stipulate on the above from the viewpoint of restricting governmentintervention.b) In relation to individual state-owned enterprises, the state as owner only carries outsupervision about the kind of business conducted (business goals or public service goals),organizational items associated with corporate status such as corporate business strategy,goals and corporate foundation; changes in major assets associated with removal fromoffice, appointment and remuneration of state-owned enterprise directors, capital distributionand business goals; and capital and asset planning related to joint ventures. Decisions onstandards and norms relating to corporate rights of independence and corporate management;and important decisions relating to the distribution of net profits for reinvestment in theenterprise (State-owned Enterprise Law, Article 27).Therefore, it appears that the state's rights of control in relation to state-owned enterprisesare limited to strategic, long-term matters only, and, under the State-owned Enterprise Law,routine decisions except for the right of decision concerning capital, important equipment, plants,etc., are left to enterprise directors (State-owned Enterprise Law, Article 27, Section 1d).In Part 1 of Section 4, 'State control' in state-owned enterprises, state control is limited tomatters such as incentive policy, subsidies, protection of important state-owned enterprises,formulation of development plans, training of workers and directors and supervision of observanceof laws. Regulations concerning state intervention are fairly simple in relation to regulationsabout the rights of directors, and can be seen as a reflection of the intention to minimizeintervention. According to Part 2, instead of minimizing state intervention, the state is to use the'state ownership right.' Here, the rights of the state are limited to seeing whether state-ownedenterprises make efficient use of assets in production in order to guarantee a correct performancewithin the range of tasks conferred on state-owned enterprises. This type of approval includesnot only the supervision of business, but also the supervision of the assets, price decisions andother transactions of state-owned enterprises (State-owned Enterprise Law, Article 7).As owner, the state possesses several rights to supervise efficient use by state-ownedenterprises of capital and assets relating to the preservation and expansion of capital and assets.It also has the authority to reinvest corporate profits. When the state assesses the business ofstate-owned enterprises, state bodies must supervise and confirm whether the business registeredwith the Ministry of Planning and Investment and the business the state-owned enterprise is

OECF Journal of Development Assistance Vol.4, No.1, 1998 99currently executing are appropriate. State enterprises have the right of independence within thelimits of registered business goals and business areas.Supervision of preservation and expansion of state-owned enterprise capital and assetsconsists of activities such as the distribution of initial capital and the regular reassessment of thecapital amount based on a standard for which inflation is adjusted at an appropriate rate. Thesetasks are executed by the Ministry of Finance's General Department of Management of StateCapital and Assets in Enterprises. 2On the other hand, as corporations, state-owned enterprises receive from the state theauthority to manage and use state capital and assets based on the principle of responsibility forthe preservation and expansion of state capital and assets. Therefore, under the aforementionedprinciple, state-owned enterprises can transfer said capital and assets to other organizations,individuals or enterprises. (However, state approval is required for important matters.) 3 If astate-owned enterprise establishes a new enterprise through a tie-up with a non-state-ownedenterprise and transfers capital and assets or if a state-owned enterprise invests in a newlyestablished enterprise, state approval is necessary. 4This clause shows that, as ultimate owner, the state has the authority to control state-ownedenterprises. However, particularly for the transfer of assets through incorporation, state-ownedenterprises have to carry out troublesome procedures with considerable involvement of relatedstate bodies, in other words, line ministries, the Ministry of Finance, the Ministry of Planningand Investment and regional authorities.The division of powers between state bodies and the board of directors is seen as an importantmatter in the State-owned Enterprise Law. These state bodies include the government, governmentministries and agencies, each central body and people's committees. They supervise and controlstate-owned enterprises and are responsible for making state-owned enterprises accomplishstrategic goals and other public goals. The board of directors of state-owned enterprises is madeup of officials including government representatives, but for the main positions, to limitintervention, there are restrictions on staff sent by the state. The board of directors gives approvalfor corporate development policy and is responsible for state-owned enterprise development inconformity with conferred goals. The board receives capital from the state, supervises preservationand expansion of capital and accomplishes allotted tasks (State-owned Enterprise Law, Articles29 and 39). Therefore, authority for the essential part of state control is transferred to the boardof directors.This has helped to reduce management intervention by government ministries and agenciesand people's committees. However, such transfer of functions requires clear division of tasks,authority and responsibilities between the board of general directors and corporate directors, andclarification of the individual responsibilities of general directors and directors, particularly inrelation to the collective responsibility of the board of general directors.2 In this respect, currently there is debate that line ministries and regional people's committees shouldstill participate in the management of the state assets and capital held by state-owned enterprises. This isbecause these bodies have direct control over state-owned enterprises and have the authority to decideimportant matters concerning business for investment and investment strategy.3 Based on the fact that property rights are distributed based on the clause of Item 6, Article 2 of theState-owned Enterprise Law.4 Regarding investment in the joint venture enterprise or incorporation executed by the state-ownedenterprise in accordance with decisions by related state ministries and agencies and regional people'scommittees.

100 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in VietnamWhile on the one hand the State-owned Enterprise Law minimizes state intervention, onthe other hand, to guarantee the state's ability to control the accomplishment of state goals givento enterprises, it gives government the authority to decide necessary standards and norms formatters such as wages, which become the standard for wage decisions. (However, state-ownedenterprises have complete authority to decide about wage lists.) The state is given authorityconcerning the distribution of net profits to all types of funds and the maintenance of limitingcost control in relation to a number of products and services. These provisions do not cover allstate-owned enterprise activities. They only cover state control for the business goals of stateownedenterprises. In addition to the items which require government decisions and guidelines,state-owned enterprises must be run in accordance with the State-owned Enterprise Law andother enterprise-related laws (Tax Law, Labor Code, Law on Domestic Investment Encouragement,etc.).However, the degree to which the state ownership right is used differs depending on thegovernance configuration of the state-owned enterprise. For example, Section 2 of Chapter 5stipulates briefly concerning governance relating to state-owned enterprises without a managementboard of general directors. However, nothing whatsoever is stipulated regarding matters such asthe way directors are selected, and it appears that this type of state-owned enterprise has actuallyrenounced control.4. Application of the State-owned Enterprise LawThe contents of the State-owned Enterprise Law are more or less as outlined above, but as of1996, there were no signs that this State-owned Enterprise Law was being rigorously applied. Inmost enterprises there is no management board of general directors, and in addition, theclassification of business state-owned enterprises and public service state-owned enterprises isalso ambiguous. The State-owned Enterprise Law forms the legal foundation relating to matterssuch as the relation between state-owned enterprises and government; the concepts of stateownedenterprise, business state-owned enterprise and public service state-owned enterprise; theright of independence and the state duties of state-owned enterprises; the mechanisms formanagement and supervision of state-owned enterprises; the direction of development of stateownedenterprises and the arrangement of the relation of government and state-owned enterpriserights. However, a number of important points require greater examination and so the StateownedEnterprise Law makes no stipulations about them. These are matters such as corporatefinancial management, the criteria for dividing business state-owned enterprises and public servicestate-owned enterprises and large-scale state-owned enterprises with a board of general directors,and the incorporation of state-owned enterprises. 5 Furthermore, there are no clear stipulations ineither the State-owned Enterprise law or the Company Law for the currently common practice ofestablishing new companies through a joint venture by a state-owned enterprise with anotherenterprise. For example, there is no mention of where limited companies or joint stock companieswhich are established by state-owned enterprises, owned by the state and run under CompanyLaw should be registered.It is not clear from the concepts relating to state-owned enterprises, such as state investmentcapital, decisions about foundation and management by the state as owner, actually how a state-5 Decree No. 262-TTg dated 2 May 1995

OECF Journal of Development Assistance Vol.4, No.1, 1998 101owned enterprise should be run. In fact, some enterprises have been founded with 100% investmentby state-owned enterprises. In terms of capital, these enterprises are wholly state-ownedenterprises, but their management and business is no different from ordinary companies. Thestate gives considerable attention to the holding of these enterprises' stock, showing an interestas owner in the management of these enterprises. This contradiction arises from the existence oftwo laws, the State-owned Enterprise Law and the Company Law, and it is a problem whichought to be solved through the promulgation of a new company law.E. The Right of Appointment and Personnel Management of State-owned EnterpriseDirectors and the Market for DirectorsFrom the viewpoint of corporate governance, which determines the ownership and managementstructure of state-owned enterprises, the most important question is how to select the directors ofa state-owned enterprise, namely the problem of the right to appoint directors. Under the StateownedEnterprise Law, the owner of the state-owned enterprise, the government, chooses theenterprise's directors. In our survey, directors of state-owned enterprises are all appointed bysenior bodies, and the enterprises surveyed report that there are very few directors appointed inany other way. Other appointment methods include: (a) Appointment through competition byexamination (3.0%); (b) Approval of proposal by board of general directors (6.5%); (c) Valuingselection by staff representatives (8.5%). Appointments through these methods are common instate-owned enterprises in South Vietnam.It appears then that senior government bodies continue to maintain the right to choosedirectors of state-owned enterprises, but what kind of people are selected as the directors ofstate-owned enterprises? According to our survey on the special subjects of study, education andprevious employment of state-owned enterprise directors, the majority of such directors areuniversity graduates (94%). At two enterprises only (in Southern Region) the directors were highschool graduates. The percentage of directors who graduated from university is high in NorthVietnam (98.77%) and lowest in the central region (85%). All directors in machine manufacturing,chemical engineering and electronics industries are university graduates, but in fields such as thefood processing industry there are also some directors with lesser academic qualifications. Nodifferences are apparent in the academic qualifications of state-owned enterprises under thejurisdiction of central and regional governments.As for promotion, most directors (88%) are promoted internally, promotion from deputy plantmanager is particularly common (80%). Internal promotion is least common in the food processingindustry, but even here it represents 72.2%. It is extremely rare for directors to be appointed fromoutside the company. In only 9% of enterprises, government officials have been appointed as directors.Moreover, there are no instances of directors being selected from among the ordinary workers.Instances of directors being chosen from deputy plant managers was found in all regions.

102 Hisaaki Mitsui, Yoshio Wada, Analysis of Reform of State-owned Enterprises in VietnamV. CONCLUSIONVietnam's state-owned enterprise reforms began with Decree No. 217 of 1987 as theircomprehensive starting point, but state-owned enterprises ultimately came to hold the right ofmanagement independence due to the confusion which arose later. Such state-owned enterprisereforms have the same characteristics as Spontaneous Privatization. In Vietnam, where, to beginwith, the length of time a planned economy was implemented was also short, the creation of akind of 'laissez faire' environment did not necessarily have the positive effect in terms of a switchto a market economy. Since an outflow of assets and other behavior outside the sphere of stateownedenterprise activity occurred in the state-owned enterprises which were left to themselves,from the end of the 1980s the Vietnamese government attempted to regain control throughemployment cuts and a re-registration system. As a result, employment in all state sectors hasbeen cut, and, on seeing the increase in capital per enterprise, state-owned enterprises are graduallyexpanding production. Furthermore, the opening up of Vietnam to the rest of the world combinedwith the right of management autonomy has resulted in the formation of vigorous alliances betweenstate-owned enterprises and foreign enterprises.This can be seen as the mechanism for the improvement of the state sector's productionperformance in the 1990s. However, there are major problems in this scenario from the viewpointof a switch to a market economy. First, in terms of incentives, in state-owned enterprises wherethe management is given a completely free hand or where domestic competition is not so tough,the ability of directors to form a state-owned enterprise as a corporate entity has not been nurtured.The incompleteness of such an incentive system is ultimately a considerable disadvantage forthe formation of industrial organizations in Vietnam. At the same time, reform from the perspectiveof the right of property has also become problematic.The biggest problem with this kind of incomplete incentive system and incomplete right ofproperty is that corporate directors may have the incentive to conduct management incorrectly.In simpler terms, 'it is possible that corporate directors with motives other than corporatemanagement control state-owned enterprises.' For example, the mechanism to prevent stateownedenterprises from becoming personal property ought to be guaranteed legally and througha system which administers state-owned enterprises, but it is doubtful that this mechanism isguaranteed sufficiently by the current State Enterprise Law and the manifestation of the ownershipinterests by the General Department of State Capital and Assets in Enterprises. At the same time,since there is no mechanism to ensure that directors do not have the incentive to conductmanagement incorrectly, it is also doubtful that directors of state-owned enterprises are beinggiven the correct incentives.In respect to the problem of incentives, first, the government sector, which played the mainrole in founding state-owned enterprises and has subsequently supervised them for a long time,must give correct incentives to the directors of state-owned enterprises and must carry out sufficientperformance monitoring. The method of performance contracts adopted in China would enablereform to be made in this direction. Also, for credit relations to provide the incentive for greatermanagement efficiency, it is extremely important to create a market relation in the relation betweencredit and debt.As for the problem of the right of property, the government, which is the owner, must adopta unified legal framework. It appears that in Vietnam's state-owned enterprises at present there

OECF Journal of Development Assistance Vol.4, No.1, 1998 103are high hopes for the general corporation. However, in reality, the general corporation is theformer Ministry of Industry and it is hard to say that the incentives held by members of thegeneral corporation are always the incentives of a sound market economy. Furthermore, privateenterprises and state-owned enterprises must be administered under unified corporate governanceand a highly mobile market of directors must be created. This will ultimately improve themanagement efficiency of state-owned enterprises. At present, Vietnam does not have a marketcapable of producing such management resources. The first step lies in efforts to increase thedepth of the market and to introduce these management resources from overseas.REFERENCESIshikawa, Shigeru (1997). "An Approach for Promoting the Development of a Market Economy:A Theoretical Foundation and its Application", Development Assistance Research Vol. 4,No. 1.McMillan, J. and B. Naughton (ed.) (1996). Reforming Asian Socialism: The Growth of MarketInstitutions, University of Michigan Press, Ann Arbor.Mitsui, Hisaaki (1993). The Current Situation in the Industrial Sector and Development Issues,'Rapidly progressing Vietnam', Tsusan shiryo chosakai.Ohno, Izumi (1995). "A Study of the Problems Surrounding the Right of Property, Performanceand the Right of Management Independence - Based on the Results of a Survey of Enterprisesin Vietnam's Manufacturing Industry -", Development Assistance Research Vol. 2, No. 3.Overseas Economic Cooperation Fund (1995). "Transition Strategies and Economic Performance:'Gradualism' Revisited", OECF Discussion Papers No. 8.Wada, Yoshiro (1998). "Analysis of China's State Enterprise Reforms: Economic Developmentand Enterprises", Development Assistance Research, this issue.World Bank (1996). "Vietnam: Fiscal Decentralization and the Delivery of Rural Services", AnEconomic Report, Country Operations Division, East Asia and Pacific Region.______ (1997). "Vietnam: Deepening Reform for Growth", An Economic Report, PovertyReduction and Economic Management Unit, East Asia and Pacific Region.Yuen, N. C., N. J. Freeman and F. K. Huynh (ed.) (1996). State-Owned Enterprise Reform inVietnam: Lessons from Asia, Institute of Southeast Asia Studies, Singapore.

URBAN RAILWAY PROJECTS IN BANGKOK:MEASURES FOR SECURING FINANCIAL RESOURCES *Hitoshi Shoji **Michinari Togawa ***Tetsuo Kidokoro ****SUMMARYIn the "mega-cities" of developing countries, drastic urbanization caused by the rapid economicgrowth and increase in urban populations have brought about serious traffic congestion. Theintroduction of urban mass transit railways is considered an effective means of transport to dealwith these situation.This paper focuses on measures to secure the financial resources for urban railway projects.First, existing urban railway systems in world major cities are reviewed. Then, using thisknowledge, recommendations are made for urban railway projects in Bangkok, a major conclusionbeing that the projects beneficiaries should pay for its benefit. A simulation is also carried out todemonstrate the validity of our recommendations.CONTENTSI. Background and Purpose of this PaperII. Urban Railway Development and Government ParticipationA. History of Urban Railway DevelopmentB. The Merit and Benefit of Urban RailwaysIII. Urban Railway Development around the WorldA. Concepts of Responsibility for Construction and OperationB. Procurement of Urban Railway Construction FundsC. Value CaptureD. Support Measures for Railway OperationE. Private Sector InvolvementIV. Urban Railway in BangkokA. Current Situation of Urban TransportB. Past Plan*This paper is based on the study named Special Assistance of Development Policies and Projects(SADEP) which executed by Research Institute of Development Assistance (RIDA) of the OverseasEconomic Cooperation Fund, Japan (OECF). The original research was made by the consulting firm andthen reviewed by Associate Professor Kidokoro after its summarization by Messrs Shoji and Togawa.**Director, 1st division, Operations Department IV, OECF, Ex-Director, Sector Studies, RIDA, OECF***Researcher, the Institute of Mitsui & Co. for Trade and Economics Studies, Inc., Ex-EconomicAdvisor, Sector Studies, RIDA, OECF****Senior Research Advisor of RIDA, Associate Professor, Department of Urban Engineering,University of TokyoOECF Journal of Development Assistance Vol.4, No.1 (1998) pp.104-136©1998 by the Overseas Economic Cooperation Fund. All rights reserved.

OECF Journal of Development Assistance Vol.4, No.1, 1998 105C. Current Situation and Future PlanD. Public Organization and Finance/Tax SystemsE. Thai Government's ViewV. Proposals to Secure Financial ResourceA. Basic Concept for ProposalsB. Proposals of Concrete Individual MeasuresC. SimulationD. Conditions for Introducing the Recommended Measures and Further IssuesI. BACKGROUND AND PURPOSE OF THIS PAPERTraffic congestion, as a result of increased urbanization and rapid economic and populationgrowth, is a growing problem in many developing countries. The "mega-cities" of south eastAsia provide a clear illustration of the difficult condition. In an effort to reduce road congestion,urban mass transit railway (hereinafter urban railway) projects, such as subways, are plannedand, in part, under construction. The Overseas Economic Cooperation Fund, Japan (OECF) hasrecently experienced an increase in requests for finance for these sorts of projects.Urban railway projects require large initial investments and long term operation costs. Inimplementing projects in this sector, policy measures designed to secure financial resources arean important factor. The purpose of this paper is to make recommendation for financing urbanrailway projects in Bangkok based on the knowledge obtained from a comprehensive review ofexisting urban railways and their financing structures.II. URBAN RAILWAY DEVELOPMENT ANDGOVERNMENT PARTICIPATIONA. History of Urban Railway DevelopmentThe early rail-based transit systems in Europe, the U.S, and Japan were primarily financed andoperated by private corporations, and their capital intensive nature precluded large numbers ofoperators from providing transit service in the same geographical area. Although fares andoperating standards were regulated by governments much like other public utilities, the absenceof other competitive means of transport such as automobiles made the situation of nearlymonopolistic market in urban transport. Thus, urban railway has kept its self-supporting financewith profit until the end of 19th century. However, by the early 20th century, several factorsincluding economic recessions, excessive capital infrastructure investment, and the advent ofautomobile competition, changed the financial outlook for the urban railway. As their profitabilityas private enterprises began to decline, governments (except U.S.) began to participate in itsconstruction and operation by providing subsidy for the purpose of keeping public transportservices. Urban railway was made under management of public sectors.In Seoul, Hong Kong and Singapore, the urban railways started to operate after the

106 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resourcesautomobiles became the major transport mode. Seoul started to operate its first subway in 1974,so did Hong Kong in 1979 and Singapore in 1987.The modern urban railways including these Asian cities are put under competition withautomobiles. In addition, urban railways often need to be built either elevated or undergroundparticularly in the city centers where land is densely utilized, consequently, the large constructioncosts posed by this type of alignment is too great for the private sector so that it is hard for themto operate on private commercial basis. This explains why the Seoul Metropolitan Government(SMG) principally constructed its subway lines and these lines are operated by the publiccorporation which is 100% owned by SMG. The Hong Kong government committed itself tosupporting their subway by bearing approximately 78% of its construction cost, and furtherproviding the railway operator with land development rights over and around the stations. TheSingapore government also builds its subway and offers a variety of institutional and financialsupport mechanisms including charging only a nominal leasing to the railway operating publiccorporation. In short, governmental participation is necessary for the development of modernurban railway in highly developed city area under competition with automobiles.B. The Merit and Benefit of Urban Railwaysa) Merit as a public transportUrban railways have a number of advantages over other modes of transport, such as itsgreater capacity, speed and reliability. Furthermore, urban railways provide transportationfor the lower income population and it is less environmentally harmful and much moresafe. These factors indicate how urban railways are able to bring about various benefits notonly to passengers but also to the overall region where they are located.b) Economic benefits of urban railwaysUrban railways bring about a various economic benefits – not only to the passengers butalso to road users, property owners, and the regional economy. A system for classifyingurban railway benefits, beneficiaries, and measures to capture them is described below andin Fig. 1.(1) Benefit to urban railway usersNew rail users are able to save travel time compared to their previous means oftransport. This benefit can be captured through passenger fare payments to the urbanrailway operators.(2) Benefit to road traffic usersA shift in travel by former road users to the railway lowers the level of road trafficcongestion, and thus benefits the remaining road users. Since traffic speed is highlysensitive to traffic volume at the marginal road capacity, even a small volume ofusers switching modes can provide significant benefits to continuing road users.Governments (including local governments) are able to capture a part of these benefitsby collecting automobile-related taxes.

OECF Journal of Development Assistance Vol.4, No.1, 1998 107Railway ProjectTime Savings, ComfortableUse, etc.• Railway UsersReduction ofEnvironmental Pollution• Local CommunityIncrease of Land Values• Station Area Land OwnersReduction of Time Cost(Reduced Traffic Congestion)• Road UsersIncreased Economic Activities• Residents• Area CorporationsFares (=direct benefit)(Developers' Cost Sharing)(Property Tax/Surcharge)(Property Transaction Tax/Surcharge)(Vehicle Registration andGas Tax/ Surcharge)Corporate/PrivateIncome Tax/Surcharge(Vehicle Registration Tax/Surcharge,Area Licensing Surcharge, COx Tax etc.)(This benefit could be shared by road user (pollution cause).Railway OperatorCentral / Local GovernmentNote:: Benefits from Railway Project() = Opportunities of Value Capture (indirect benefit) by Railway ProjectFig. 1 Benefits from Newly Constructed Railways(3) Benefit to station area property ownersNew urban railways generally boost property values in station areas. The differenceis a type of benefit. This is the change of a part of the benefit described (1) above.Governments are also able to capture a part of this benefit through tax increase onproperty or on property transactions.(4) Benefit to station area property developersProperty developers that build along anticipated urban railway lines also receive theassociated benefits of enhanced land values. Governments are again able to capturea part of this benefit through tax increase on property or on property transactions.Railway operators can obtain a portion of "exaction" (fees based upon the idea thatthose developments that generate traffic should be required to pay for adequate publictransport facilities).(5) Benefit to regional economy and societyIn addition to the benefits mentioned above, urban rail may also generate benefits tothe overall regional economy and society. The following three kinds of benefits areconsidered most tangible.(a)Enhancement of the regional economy through the mitigation of road congestioneffects and the provision of a highly punctual means of urban transport;

108 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resources(b)(c)Development of local railway-related industries; andReduction of environmental pollution.The first and second items may be captured by the government through corporate orincome taxes. The environmental benefit could also be captured through anautomobile-related tax.c) Necessity for government involvement and support for urban railwaysWe consider here the necessity of government involvement and support for urban railwaysconstruction.(1) Intermediary of external monetary effectsSome external effects of railway development (such as increased station area landvalues and development potential) could theoretically be absorbed by raising theprice of urban railway service (i.e. passenger fares). In essence, if the fare wereraised, the increase in property value along the line would be less substantial. Such astrategy would transfer benefits through the "market." However, such fare structuresare typically not acceptable politically. In this case, the risks and returns are similarfor both the railway operator and the property owners/developers.It is possible for a railway operator to internalize some land development profitsthrough establishing a land property business, but still it could not capture such externalprofits completely. Government, on the other hand, is well equipped to absorb railwayinduceddevelopment profits through property taxes and exaction. Therefore, it isnot only desirable for the government to play a role as an intermediary for cyclingsuch monetary external benefits back to the railway, but the government is indeed theonly institution capable of effectively accomplishing such tasks.(2) Intermediary of external technical effectsBenefits of urban railway which does not go through the market mechanism (externaltechnical effects) are the following;(a)(b)Mitigation of road congestion for road users (automobiles, motorcycles, etc.);andBenefit to regional economy and society such as activation of regional economicactivities, development of railway-related industries, reduction of environmentalpollution.These external technical economy does not go through market mechanism atthe time of benefit reversion, so that the railway operator cannot absorb them byitself. If those external technical economy are not cycled to railway operator, urbanrailways will not be constructed at the socially desirable level which takes into accountof road traffic and environment. It is therefore necessary for the government, with itsactive involvement and support, as being an intermediary of those benefits, to makerailway operator to construct and operate urban railways at the socially desirable level.

OECF Journal of Development Assistance Vol.4, No.1, 1998 109(3) Securing long-term business risksThe construction of urban railways in mega-cities which have already been urbanizedand whose land acquisition cost and construction cost are high, necessitates hugeinitial investment and long-term revenue stream.The risks associated with such projects, and the necessary levels of capitalrequired, are generally too high for the private sector. Furthermore, other factors,such as land acquisition, pose obstacles to the private sector.In order for such projects to proceed, the private sector needs governmentsupport, either in the form of investment, loans or loan guarantees.(4) Planning and implementation of overall planFinally, it is necessary for the government to make and present a long-term frameworkfor railway construction, including determination of a preferable network anddevelopment phases, prioritization of railway lines, and definition of business systems.In addition, the government must take the initiative to guide overall tasks, such as theselection of business entities for construction and operation.It is clear from the preceding arguments that public involvement in and supportfor the construction of urban railways is a necessity. However, excessive politicalintervention, especially in areas such as line priority, tariff rates and safety standards,may hamper effective and efficient construction and operation of urban railwaysystems. It is important to draw a clear demarcation between the areas of responsibilitybetween the government and the rail industry.III. URBAN RAILWAY DEVELOPMENT AROUND THE WORLDA. Concepts of Responsibility for Construction and OperationAs shown in Table 1, the methods for constructing and operating urban railways reflect eachcountry's basic policies towards railway development, the relationship between central and localgovernments (in particular, the metropolitan city or region), and the division of responsibility forpublic transport projects between public and private sector. The various concepts may be roughlydivided into the three following types, in descending order of public participation:a) Public Responsibility: Urban railways are considered as public responsibility and the railwayoperator's profitability is not one of the requisites for approving a project. Public funds arethe major financial resource (Cases in Europe & U.S.).b) Financial Independence: Governments view urban railway operators as financiallyindependent without public subsidies, while endowing privileges such as exclusive landdevelopment (Cases in Hong Kong).c) Limited Assistance: Railways are basically self-supporting for infrastructure constructionand operation, while a limited amount of public subsides and institutional assistance is

110 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resourcesavailable (Cases in Japanese private railways).The United Kingdom and the United States, having previously followed the first concept,are now trying to introduce privatization in order to revitalize public railway construction andoperations.Table 1Each Country’s Urban Railway Principles(1/2)CountryPrinciplesThe UK • The central government bears full responsibility regarding urban railwayconstruction and operation in the Greater London area.• London Regional Transport (LRT), a state corporation, is in charge of subwayconstruction, while London Underground Ltd. (LUL), a subsidiary company ofLRT, operates subway service in the capital region. Several private enterprisesalso participate in construction and operations.• Most of the capital investment in LRT is financed by national subsidies. Thecentral government also provides subsidies for operation costs.• Recent government policies aim at introducing the idea of Private FinanceInitiatives (PFI) and encouraging private sector investment in railwayconstruction as well as their participation in railway operation throughconcession agreements. The privatization of British Railways and suburbanrailway concession arrangement with private companies have been promoted.France • Due to it being the capital region, the administration of Île de France 1including railways used to be controlled by the national government. But in1995, transportation planning duties were transferred to the region as adecentralization strategy.• The national government, Ile de France (regional) government, and railwayoperators (Regie Autonome des Transports Parisiens, RATP, and FrenchRailways, SNCF) share railway construction costs in the region.• There are also some operation subsidies such as national and regional funds tomake up the fare adjustment, and payroll tax designated for commuter pass andsocial discounts for the elderly and handicapped, and local governmentalsubsidies.Germany • Urban railways are considered to be a part of the urban infrastructure, and theresponsibility related to short-distance transportation which was onceprimarily allocated to the federal government was transferred to stategovernments after the privatization of the National Railways.• The federal, state, and local governments adjacent to a newly constructedrailway share the construction costs.• State governments oblige to bear losses from urban railway operation throughpart of the federal oil tax* revenue allocated.The UnitedStates• Based on the consensus that urban railways are the part of basic socialinfrastructure, the main sources of construction funding are nation-wide federalsubsidies, state, municipal, and county subsidies from their respective sources.• The majority of Metropolitan Transportation Authorities (MTAs) are alsosubsidized for their operational losses by both the federal and localgovernments.• Recently, the USDOT (Department of Transportation) has been promoting theprivate sectors’ participation in urban transportation projects to encourageprivate investment.1Ile de France Region is the metropolitan area of France, comprising of the City of Paris, which isan equal term to Province, and seven provinces surrounding Paris.

OECF Journal of Development Assistance Vol.4, No.1, 1998 111CountrySingaporeHong KongSouth KoreaJapan(2/2)Principles• As a part of its transit promotion policies, the Singapore governmentconstructed the country’s subway systems totally with their own resources inthe form of direct investment.• Infrastructure ownership and operation function are completely separated toachieve efficient operation and realization of an equal footing with roadtransportation.• The Hong Kong government is totally responsible for subway constructionincluding the financial burden.• The operation body is Mass Transit Railway Cooperation (MTRC), a publiccorporation.• The government endows MTRC with exclusive land development rights anddemands financial autonomy in operation to them without any governmentloan guarantees or subsidies.• MTRC allocates the profits from property development to railway constructionand operation costs.• Public sectors, especially local governments, take a responsibility of urbanrailway construction.• Local (municipal) subsides covering from solid financial bases, nationalsubsidies and low-rate loans are used for urban railway construction.• In the cities of Seoul and Inchon, municipal corporations operate subways oncommission.• Basically, urban railways are operated on a financial autonomy basis includingthe construction costs.• Not only public organizations such as the former National Railways and localauthorities, but also private railway companies have been playing substantialroles in constructing and operating urban railways.• Public subsidy and support for railway construction are available. Mainfinancing for construction and operation is fare revenue and value capture byrelated business deployment is utilized as an another financing method.Note : * Almost the same as gasoline tax in its usage, but the oil tax includes light oil, diesel oil, keroseneoil, in addition to gasoline.B. Procurement of Urban Railway Construction FundsFunds for capital investments in railway systems are raised by railway project implementingorganizations in each country through combinations of (1) capital contributions, (2) bonds, (3)loans, and (4) subsidies. These are summarized in Table 2-1, 2-2 and 3.a) CapitalAn important source of funding for most railway projects is direct capital investment bythe central and/or local governments. However, such capital assistance is usually notsufficient to fulfill all of the initial financial requirements and thus bonds and/or commercialborrowing are needed in many cases. In the case of Hong Kong and Private Finance Initiativeprojects in United Kingdom, governments provide capital for the construction organizationto raise initial investment.

Table 2-1Examples of Measures to Secure Financial Resources for Urban Mass Transit Railway (Part I)Measures to Secure Financial Resources England France Germany U.S.AFare Revenue (accumulated funds,internal reserves)Subsidy from Governmental Account(general tax revenue, general account)Subsidy from Governmental SpecificAccount (earmarked tax revenue, i.e. oiltax, car registration tax, consumptiontax, property tax, area licensing tax,other various surcharges)Reversion of Profit Accruing fromDevelopment (i.e. development charge,connecting passage construction charge,special assessment district (SAD), taxincrement financing (TIF),internalization of development profit byreal estate development etc.)Fund Raising (governmental soft loan,bond issue, overseas aid organizationloan, special business revenue)Introduction of Private Funds (privaterailway project, turnkey(design & build),full-turn key (BOT, BOO, etc)Covers only part of operationcost, not for repayment ofinitial construction costLondon Regional Transportreceives subsidy from Nationalgeneral fund.Subsidy from nationalgovernment covers majority ofcapital investment.No earmarking revenue exists.A residential tax increase wasproposed to reduce publictransport fares in London(1981), but rejected as illegal.Covers only part of operationcost, not for repayment ofinitial construction costSubsidies from general accountof central, regional and localgovernment for bothconstruction and operation.Fare discounts are compensatedby payroll charges from privatecompanies in Paris and localcities.Local additional taxes aretemporary collected forimprovements and constructionof station in Paris and localcities.Covers only part of operationcost, not for repayment ofinitial construction costA part of construction cost iscovered by general accounts ofcentral and local governments.Oil tax (national tax) isearmarked by Local TransportSubsidy Act.Oil tax is appropriated assubsidy for operation costs byLocal Decentralization Act.Increased revenue of oil tax hasbeen allocated to repayment ofrailway debt since 1994.Covers only part of operationcost, not for repayment ofinitial construction costBoth construction andoperation are covered bygeneral accounts of Federal,state and local governments.Rule of diversion of gas tax(road construction fund) torailway based on ISTEA, 1991.LA City raised fund from specialbenefit tax with SAD, LACounty raised fund fromincreased revenue of sales taxby local referendum.None None None LA City collected tax frombusiness alongside railway as aspecial benefit tax (tax fromspecial assessment district,SAD).NonePrivate finance is promoted byPrivate Finance Initiative (PFI)in a form of BOT, BOO.Regional government supplieslow-interest loan to operators.NoneVarious kind of bonds wereissued in NY (revenue bond,collateral bond for railwayfacilities).State railway bonds were issuedin LA by local referendum.None None Federal Transit Administrationpromotes turnkey style (design& build) projects financed byprivate companies.112 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resources

Table 2-2Examples of Measures to Secure Financial Resources for Urban Mass Transit Railway (Part II)Measures to Secure Financial Resources Singapore Hong Kong Korea JapanFare Revenue (accumulated funds, internalreserves)Subsidy from Governmental Account(general tax revenue, general account)Subsidy from Governmental SpecificAccount (earmarked tax revenue, i.e. oiltax, car registration tax, consumptiontax, property tax, area licensing tax,other various surcharges)Reversion of Profit Accruing fromDevelopment (i.e. development charge,connecting passage construction charge,special assessment district (SAD), taxincrement financing (TIF),internalization of development profit byreal estate development etc.)Fund Raising (governmental loan, bondissue, overseas aid organization loan,special business revenue)Introduction of Private Funds (privaterailway project, turnkey(design & build),full-turn key (BOT, BOO, etc)SMRT (operator) isobligated to retain areserve for maintenanceand improvement offacilities.100% of constructioncost covered by centralgovernment's subsidyfrom general account.No earmarking revenuesexists.NoneNone (SMRT isexempted fromcorporate tax for aperiod and the leasecharges on the systemsare lowered.)NoneMTRC (operator) coversoperation costs and haspaid back their debtportion of the initialinvestment.Most of the constructioncost is funded bygovernment's generalaccount.No other support system.No earmarking revenuesexists.By utilizing exclusive landdevelopment right givenby government, MTRCearned a large amount ofprofit from real estatedevelopment by jointventure with privatesector.MTRC raised fund for partof construction costs bybond issuance.No financial guarantee bygovernmentRevenue from joint realestate developmentprojects with privatesector is allotted to part ofconstruction costs.Covers only part of operationcost, not for repayment ofinitial construction costMost of the construction costis from Seoul City's generalaccount.A subsidy granted from“Special Account for TrafficFacility Improvement”.Traffic tax (specialconsumption tax on gasolineand light oil) has collectedsince 1995 as urban railwayimprovement fund.Transport Inducement ChargeTransport inducement chargesare collected from propertyowners of a certain floor areaand are used for special accountof local government.Seoul City issues urban railwaybonds which are obligatory topurchase upon car registration,subway related contracts etc.NonePrivate railway companies are responsible forfinancing not only the operation but for theconstruction and repayment.Some private companies are allowed to saverevenues from fare increases for future capitalimprovements.Subsidies from central government's generalaccount for subway and new town urban railwayexists.Subsidies for interest payment by JapanRailway Construction Public Corporation.Some local governments earmarks theadditional portion of corporate tax on thecorporations in project area for future railwayimprovement fund.Funds are established to facilitate railwayconstruction.New town developers are required to pay a halfof the construction cost of civil works portionand to provide their land for the railway atstandard price.Internalization of profit from the real estatedevelopments.Property owner's payment for connectionpassage between building and subway station inTokyo.Local governments raise fund by bond issuance.Internalization of profit from the real estatedevelopments.Fiscal loans for public corporations and a lowinterest loan for private railway improvement.Each private railway company has beenconstructing and operating its railway withfinancial autonomy.OECF Journal of Development Assistance Vol.4, No.1, 1998 113

Table 3Sharing Rates of Railway Construction Costs by CountryName of ProjectConstruction CostSharing RatesCentral Government Local Government Operator Value CaptureEngland, Croydon Tramlink 230 million pound Subsidy 54% None Private Trustee Corporation NoneGroup 46%England, Manchester Metrolink,Phase-1154 million pound Subsidy 31% Manchester City 45% Private Corporation 3%,Loan from EuropeanInvestment bank, etc. 21%NoneIl de France Region,Five Year Project Contract of PublicTransport Facility ConstructionGermany, S bahn, U bahnSubsidy 30% Il de France Region 50%(real term: 60-70%)Subsidy (oil tax revenue)60%(Former East Germanyregion 75%)State and regionalgovernment served byrailway 40%(Former East Germanyregion 25%)Loan from Il de France 20%USA, Los Angeles,US$ 1.42 billion Subsidy 56% State 17%, County 14%, None SAD 10%Red Line Subway, Section 1LA City 3%USA, Los Angeles,US$ 1.518 billion Subsidy 54% State 12%, County 23%, None SAD 3%Red Line Subway, Section 2LA City 8%Singapore, Mass Rapid Transit S$ 6.5 billion Subsidy 100% None None NoneHong Kong, Mass Transit Railway HK$ 26 billion Equity 78% None Loan from bank and bondissuance, etc. 22%15% of total constructioncost was collected from realestate development as of1990Hong Kong, Kowloon CantonRailway Corporation, New TownRailwayKorea, Seoul Subway Section 2 Won 8,830 billion Subsidy 17%Loan 4%NoneHK$ 1.1 billion None None 100% (KCRC pull downretained earnings.)Seoul City Subsidy 49%Bond Issuance and OECFloan 30%Japan, Chiba New Town Railway ¥ 10 billion Subsidy 9.5% Subsidy 9.5%,Equity 9%Local government is anoperator.Fiscal Investment & loansto Housing & UrbanDevelopment PublicCorporation(HUDPC) 35%,Private Bond 24%NoneNone50% of total constructioncost was collected from realestate developmentNoneDevelopment charges toLocal government andHUDPC 13%114 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resources

OECF Journal of Development Assistance Vol.4, No.1, 1998 115b) BondsIt is rare to cover the enough initial investment only by the capital, in many cases it isnecessary to issue bonds or receive loans. In this case, railway project implementingorganizations or related public authorities have issued bonds to finance their expenses.c) LoansThere are different types of railway construction loans such as loan from private banks,domestic governments, international organizations and foreign governments.(1) Loans from private banksA substantial portion of railway construction projects are often financed by privatebanks. This type of loan were applied to urban railways in Hong Kong and privaterailways in Japan,(2) Loans from domestic governmentsSome countries such as Japan, French and Korea, provide concessionary loans fromcentral/local governments for urban railway construction.(3) Loans from international organizations or foreign governmentsBorrowing from foreign countries or obtaining development loans from internationalorganizations such as the World Bank Group is also an option for urban railwayconstruction. Compared with borrowing from private banks, this type of fundingfeatures more favorable loan conditions in terms of interest rates, loan periods, andthe maximum amount of funds available. As such, many developing countries havefinanced their infrastructure needs in this manner. The Seoul Metropolitan Governmentfor instance, received a loan from the Overseas Economic Cooperation Fund of Japanto finance construction of its subway system.On the other hand, in some cases, international organizations impose conditionson their loans such as mandatory reforms of particular institutions and organizationsin the borrowing countries. In addition, foreign loans pose exchange rate risks if thelocal currency loses value with respect to the loan currency before it is paid off,which results in increasing repayment amount.d) SubsidiesAs construction costs for urban railway projects tend to be very high, government subsidiesare often a significant financial resource. National and local government subsidies may beroughly classified as either (1) subsidies from general tax revenues, or (2) subsidies fromearmarked taxes.(1) Subsidies from general tax revenuesIn the United Kingdom, Germany, France, Singapore, and South Korea, subsidiesfrom and investments financed by the general tax revenues of central and localgovernments cover the major portion of urban railway construction expenses.

116 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resources(2) Subsidies from earmarked taxesAmong the countries which have petroleum product taxes earmarked for roadconstruction and maintenance, Germany, the United States, and South Korea haveinstitutionalized appropriations of a part of these revenues for railway projects. Inaddition to earmarked tax revenues, other types of earmarked revenues include thefollowing cases:In France, road traffic and parking fines are allocated for improvements to accessbetween different transport systems (i.e. transfer walkway construction) and to roadconstruction. In Los Angeles County, U.S, a part of sales tax revenues are allocatedto subway construction.C. Value Capture (Reversion of Profit Accruing from Development)In some of the cases, for the purpose of raising large amount of initial investment, value captureschemes have been adopted. This scheme is mainly classified into a) government property taxrevenues and b) related business revenues as follows:a) Government property tax revenuesIn Los Angeles County, the county government levied "special benefit tax" to the areawhich benefited from subway construction. In Seoul, city government levied "transportinducement surcharge" to the facilities (such as department building) which inducedsurrounding transportation.Also in Japan, Kobe city government successfully negotiated with developmentcorporation to provide land for railway during construction of city transit railway. Thiswas based on "Development Guideline of Kobe City", which instituted the coordination ofdevelopment between city transit railway and urban development.b) Related business revenuesJapanese private railway company groups are also engaged in diversified business operationsincluding, real estate development, recreation facilities, retail stores, restaurants and hotels.Many of these ventures are located around the company's railway stations and help toreinforce rider-ship(numbers of passengers) and boost fare revenues. As an example, theHankyu and Tokyu Railways have developed significant residential communities andcommercial buildings along their lines in suburban areas. Although unrelated to businessrevenues, in Tokyo, building owners share a part of the construction costs for transferwalkways that connect subway stations and nearby buildings.Two more examples of railway-related businesses are land development by HongKong's Mass Transit Railway Corporation (MTRC) and the real estate ventures of theKowloon-Canton Railway Corporation (KCRC). Both of these agencies have been makingthe best use of the land development rights endowed upon them by the Hong Konggovernment. Some characteristics of MTRC's business ventures include joint ventureswith private sector corporations, under substantial responsibilities born by the private sector.In fact, approximately 15% of MTRC subway construction costs and half of the KCRCMun Yuen Long New Town Line's costs were financed by these joint ventures.

OECF Journal of Development Assistance Vol.4, No.1, 1998 117D. Support Measures For Railway OperationsIn order to cover railway operating costs, the fare revenues (the number of passenger) need to bemaximized. When fares fall short of operating costs, a) Subsidies from central and localgovernments, and b) Favorable tax and accounting conditions can be applied to reduce financialburdens on the railway operators. In addition, there are often other laws that also promote railwayconstruction projects.a) Subsidies from central and local governmentsIn European countries and the US, where passenger fares have been kept low, railwayoperators are generally provided with public subsidies to cover the shortfall between farerevenues and operating and maintenance expenses. However these operating subsidieshave been decreasing recently due to changing government financial priorities based onfinancial difficulty and benefit principle. As an alternate solution to the problem, somecountries have initiated attempts to reduce government spending by introducing privatesectorfunding for the railway operations.In France, low fare revenues and commuter passes and deficit-making railways aresubsidized by the government, a part of which is "Payroll Tax System" (Companies locatedwithin this region are obliged to pay approximately 2% of their payroll as a railway operationsubsidy).In Germany, a portion of federal mineral oil tax revenues are allocated to localgovernments to compensate for losses incurred by urban railway operation.In United States, federal, state, and local governments subsidize urban railwayoperations directly.b) Favorable treatment in taxation and accounting for railwaysSome countries have introduced favorable tax and finance systems for railway operators,including exemptions from corporate taxes. For instance the Singapore government hasprovided the subway operator, public corporation, with favors such as low facility leasingfees and an exemption from corporate taxes for a specified term at the beginning of theproject.c) Legislation of related lawsThe Croydon Tramlink project in the UK is supported by the Croydon Tramlink Act (whichwas enacted before the project started). These related laws intend to legislate project contentsand conditions in order to support smooth implementation.E. Private Sector InvolvementIn general there are two purposes for private sector involvement in urban railway projects:a) reduction of the public financial burden (central and local governments); and b) introductionof the efficient management skills.

118 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resourcesa) Reduction of public financial burdenA number of governments now regard financial deficits as very serious problems, and haveresorted to cutting back public expenditures as a measure to reduce the deficits. Thisapproach has led to the conclusion that governments can no longer afford to finance all theexpenses for urban railway projects (which usually require a sizable amount of resources).At the same time though, these governments recognize the necessity for public capital inurban railway construction. Therefore, private sector investments in this field are emergingas a way to ease to governmental deficits.b) Introduction of efficient management skillsIt is often perceived to be the case with public railway operators that a lack of incentives toimprove management and obscure divisions of business responsibilities has resulted intheir inefficient management. And as such, they can seldom be financially viable withoutenormous public subsidies to cover losses. In this case, incorporating private sectormanagement skills is to be a way to achieve a better use of human resources, cost reduction,and productivity enhancement – thus contributing to a decrease in government subsidies.c) Patterns of private sector involvementPatterns of private sector involvement projects are classified as follows, which depend onthe degree of private sector involvement such as procurement and construction of railwayfacilities, own and operation of facilities, management of facilities etc.(1) Build Own Operate (BOO) method. Under this scheme the private sector owns andoperates all of the railways facilities. Subsidies or low interest loans from governmentare available in some cases. This method is found in private railway projects in Japanand the UK's Croydon Tramlink Project.(2) Build Own Transfer (BOT) method. With this method the private sector, under contractto the government, raises funds for investment, constructs railway facilities and ownsand operates them for a limited period during which they recover their initialinvestment. Eventually, the private sector transfers all facilities to the public sector.The advantages of this method are that the government is able to commission new railwayswithout increasing public sector debt, there are also gains associated with private sectorefficiency in the construction and initial operation phases. Despite these advantagesBOT is rarely seen in the railway sector, due to the reluctance of the private sector toadopt the huge risks associated with the long periods of time necessary to recover thelarge initial investment. This method has been used in the UK based Manchester MetrolinkProject (partly undertaken with government finance), and the in Thailand.(3) Build Lease Transfer (BLT) is another method. Under it the private sector raisesfunds, constructs and owns the railway, while leasing the facilities to the publictransferred to the public sector. This method relieves the public sector from havingto raise the finance, while the private sector enjoys a secure lease income from thegovernment. This method has been employed in the UK's Docklands Light Railway

OECF Journal of Development Assistance Vol.4, No.1, 1998 119and Light Rail Project No. 3 in the Philippines.(4) The separation of infrastructure facilities, such as track and civil structures, fromoperating facilities is another possibility. Known as Design, Build, Operate andMaintain (DBOM), the rational for this method is that, by removing the high costs ofconstruction, the profitability of operating the railway is enhanced. This method alsoclarifies the responsibilities of the railway business management and promotes efficientmanagement. In the London Docklands Light Rail Project the government constructedthe civil infrastructure and procured all the facilities for operation, then entrusted, byconcession, operation and management of the railway to the private sector. Similarly, inthe case of the Bangkok Subway Project, government management to the private sector.IV. URBAN RAILWAY IN BANGKOKA. Current Situation of Urban TransportBangkok Metropolitan Administration (BMA), the administrative authority of capital city ofBangkok, produces about 40% of the total GDP of Thailand. In Bangkok, as the city structuredepends on road traffic, the road network suffers severe traffic congestion not only at the peakcommuting times but also during the day times due to increased number of vehicles in accordancewith increased income. The fact that vehicles' average speed is 10 km or less at a rush hourimplies transportation by roads is not functioning well as urban traffic system. Transport demandconcentrates in city center and resulted in such congestion. Further, as city area expands oversuburban areas, congested areas are also being extended.As shown in Table 4, among traffic modes in Bangkok, bus share (public and private buses)accounts for 47% of the total trips as the largest means of transportation followed by walking(19%), passenger cars (11%), and motorcycle (11%). The share of railway is only 0.2 %.Table 4Traffic modes' share in BangkokTraffic Mode Share (%)Walking 18.87Bicycle 0.72Motorcycle 10.78Passenger Car 11.13Taxi 1.59Samlor, Silor (three-wheeler, four-wheeler) 3.15Public Bus (including mini bus) 45.20Truck 5.24School Bus, Private Bus 2.12Railway 0.20Boat 0.68Others 0.32Total 100.00Source: The Study on Medium to Long Term Improvement/ManagementPlan of Road and Road Transport in Bangkok, JICA, 1990.

120 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial ResourcesGovernment bureaus have tried various measures to cope with the serious traffic problemsin Bangkok, approaching from the point of improvement on road based transportation. Thosemeasures are such as implementation of large-scale one way networks, implementation of buslanes, regulation on large-sized vehicle traffic, introduction of large-scale regional traffic controlsystem, introduction of microbuses with high quality services, introduction of canal water-buses,construction of overpasses, strengthening of traffic police, and change of bank opening hour.Although these measures worked in their own ways, the impact was limited under the rapidprogressing urban sprawl where the measures are not drastically solving the problems. Thus,introduction of urban railway as an alternative means of transportation is indispensable in orderto evade worsening traffic congestion.B. Past PlanLooking at the past history of urban railway plan in Bangkok, Thai government made an overallBangkok metropolitan region traffic development plan in cooperation with the German governmentbetween 1971 and 1975. The plan includes the construction of public mass transit such as urbanrailways. Based on the plan, an elevated-railway project called 'Sky Train' was drafted byExpressway and Rapid Transit Authority of Thailand (ETA). The project was opened to bid andprivate sectors were to construct and operate it under supervision of ETA but this project was notmaterialized successfully. As a result, in the end of 1980's, two elevated-railway projects wereproposed by different governmental organizations. Although either of them were not consistentwith the above-mentioned Sky Train Project, both of them started to construct in the middle of1990's with Thai government's authorization. These projects are named after project organizer,Hopewell Project and Tanayong Project, each of them supervised by State Railway of Thailand(SRT) and BMA respectively.In order to clear up the situation that different governmental organization promote theurban railway individually and each plan does not coordinated mutually, the government reconducteda survey, which aims to get rid of administrative redundancies in urban traffic plansand to find a way to construct effective urban railways networks. In consequence, the cabinetapproved the plan known as Initial System Project (ISP) in 1994, which contained a subwayconstruction project to be implemented by the government and two elevated railways projects tobe implemented by the private enterprises. Also in August 1992, Metropolitan Rapid TransitAuthority (MRTA), a public corporation, was established as the implementing agency for theurban railways construction. The Bangkok urban railway construction plan, which was preparedby Office of the Committee for Management of Land Traffic (OCMLT) and approved by theCabinet in 1994, includes the extension of ISP, totaling 238km. This is the current master plan ofurban railways construction (for the details of each line, refer to Table 5 and Fig. 2).

OECF Journal of Development Assistance Vol.4, No.1, 1998 121Source: Made from "Analysis of Bangkok MRT Initial System Plan"Fig. 2 Route of Urban Railways in Bangkok

122 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial ResourcesTable 5Outline of Bangkok Urban Railway Project(unit: km)Settled Lines under planning RouteLine Section Lines ExistingplanUnderconsiderationExtensionTotalBlue LineFirst Section20.0 - - 20.0(Bang Sue-Hua Lampong)B-1 (north-west extension) Bang Sue - Phra Nang Klao - 10.0 - 10.0BridgeB-2 (south-west extension) Hua Lampong-Bangkok Yai- - 12.4 - 12.4Bang KhaeTotal 20.0 22.4 - 42.4Green LineConcession Route 23.0 - - 23.0(Tanayong Project)G-1 (east extension) On Nut-Bang Na-Second- 16.2 - 16.2International AirportG-2 (north extension) Mor Chit-Rachayothin - 2.5 - 2.5G-3 (west extension) Sathorn-Wong Wien Yai - 3.0 - 3.0Total 23.0 21.7 - 44.7Red Line(Hopewell Project)R-1(westextension)First Concession Section 44.3 --Yommarat-Bangkok Noi-Taling - 9.6ChanTaling Chan-Outer Ring Road - -- 6.2R-2 (south west extension) Hua Lampong-Wong Wien Yai-PhonimitPhonimit-Outer Ring Road- - 5.05.0R-3 (east extension) Hua Mark-Second International - - 10.0 10.0AiportTotal 44.3 15.8 18.5 78.6Orange LineBang Kapi-Rathurana- 27.3 -27.3Rathurana-Ban Na- 16.4 -16.4Bang Kapi-Minburi- - 10.0 10.0Purple Line-3.5-44.39.63.56.2Total - 43.7 10.0 53.7Bang Phut-Bang Sue- 12.0 -12.0Bang Sue-Thewet- - 6.76.7Total - 12.0 6.7 18.7Grand Total 87.3 115.6 35.2 238.1Source: "Analysis of Bangkok MRT Initial System Plan," January 1997.C. Current Situation and Future PlanIn the current master plan, subway and Tanayong/BMA projects are progressing, while SRT willdecide to terminate concession contract with Hopewell in 1997 due to delay of the project.MRTA is responsible for supervising all the urban railways after ISP including currentsubway project. In current subway project, MRTA consider to introduce the project method thatMRTA is responsible for the construction of civil structure and provide concession to privatecorporation who is responsible for procurement of electrical and mechanical system and itsoperation.Initial construction fund will be raised by issuance of government bond and loan from theOverseas Economic Cooperation Fund, Japan (OECF). Its repayment is planned to be fromfiscal payment of Thai government and concession fee from private corporation if any.

OECF Journal of Development Assistance Vol.4, No.1, 1998 123Other two elevated-railway projects have same construction scheme: SRT and BMAprovided concession to private company, Hopewell and Tanayong respectively and after 30 yearsof concession period, each concessionaire transfer all the facilities to SRT and BMA. Privateconcessionaires are responsible for fund raising and its repayment as well as securing operationfund. In both of the projects, development projects together with railway are planned to increasethe feasibility of the railway projects. MRTA also consider station area development to capturethe profit from development and so establishment law of MRTA was revised to enable developmentprojects in 1997.D. Public Organization and Finance/Tax Systemsa) Public Organization Related to Urban Transport PolicyAs mentioned already, currently three urban railway lines are under construction by differentproject organizations. Fig. 3 is the outline and relation of those organization related to theadministration of urban railway. All of the ministries, authorities and agencies are authorizedto plan and execute with its administrative right and scope. The executing agencies ofurban railway are MRTA under Office of Prime Minister (OPM), SRT under Ministry ofTransport and Communications and BMA under Ministry of Interior. The Committee ofManagement of Land Traffic (CMLT), under OPM, is the only organization that has thepower to coordinate various traffic problems. CMLT is a committee consisting of somerepresentatives from the traffic-related organizations; and is in charge of traffic plans,determination and implementation of polices and regulations. OCMLT serves as thesecretariat of the committee.Fig. 3 Organization of Urban Railway in Bangkok

124 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial ResourcesThe railway project plans are coordinated and adjusted by the committee that isperiodically or in necessity invited by the concerned ministry in charge through severalministries. The projects in Bangkok are subject to approval of OCMLT and the Cabinetdecision. However, OCMLT has transferred recently to OPM and its character being acoordination body ever since its establishment, it has not sufficiently budgeted, andconsequently, its authority is weak in the Thai government and is not able to performthoroughly as the coordination function.The office being in charge of the urban development plan currently under elaborationcovers the period of 1997 and 2001 switched from DTCP to Urban Planning Division ofBMA. In the process of its elaboration, regular meetings are held between BMA andOCMLT which coordinates urban railway. However, no urban development plan, which isbased on urban railway plan has been elaborated.b) Current Finance/Tax Systems(1) Financial system of central governmentAbout 90% of the central government's revenue is dependent on taxes as shown inTable 6.Looking at this revenue structure from the viewpoint of capturing indirect benefitraised from urban railway, Motor Fuel Tax and Motor Vehicle Registration Tax arecollected as national tax . Motor Fuel Tax is imposed on gasoline and other oilproducts. BMA has authorized to add up to 10 satang/liter onto sales of oil productswithin its administrative area, but has not executed yet. Motor Vehicle RegistrationTax, on the other hand, is obligated to be paid every year when vehicles are registered.The central government collects the tax and allocate it all to the local governments inproportion to the decided ratio. BMA receives its share which is an important revenuesource. 2Table 6Annual Revenue of Thai Government(Unit : million bahts)Year 1995 Year 1996 Year 1997 (t*)amount ratio (%) amount ratio (%) amount ratio (%)1. Ordinary Income 715,000 100.0 834,200 100.0 984,000 100.01.1 Taxes 688,759 96.3 820,803 97.3 955,036 97.11.1.1 General sales tax 401,075 56.1 511,925 60.7 609,495 61.91.1.2 Specific sales tax 155,746 21.8 165,615 19.6 190,428 19.41.1.3 Import-export duty 123,630 17.6 137,064 16.3 149,000 15.11.1.4 Others 6,308 0.9 6,199 0.7 6,113 0.61.2 Sales of goods and services 22,284 3.1 23,950 2.8 24,309 2.51.3 State enterprises 44,000 6.2 49,850 5.9 55,500 5.61.4 Miscellaneous -40,043 - -51,403 - -50,845 -Source: The Bureau of Budget, Office of the Prime Minister, t* = tentative)2It was 3 billion bahts, 12% the BMA's revenue in 1994.

OECF Journal of Development Assistance Vol.4, No.1, 1998 125Earmark tax system for specific project does not exist. For the special accountsystem, there are only two funds; the Environment Fund for environment controlproject and the Petroleum Fund established for oil price stabilization in the past,which is almost out of use recently. Therefore budget allotment for urban railwayconstruction is decided by annual congressional deliberation.(2) Financial system of the local governmentsThe local governments' roles to impose and collect taxes are limited. The tax ratethat the local governments can impose is set very low at the moment and fixed acrossthe country. In consequence, public expenditures that the local governments spendfor the local public facilities are also low. The cumulative total of the publicexpenditure of the local government in the past 20 years, including BMA, does notreach 20% the central government's budget.There are three kinds of tax revenues in the local governments: (a) taxes to bedirectly imposed by the local government (a house and building tax, land developmenttax, etc.); (b) surcharges on the central government's taxes (surcharge on value-addedtax, surcharge on business tax, etc.); and (c) an allocation to the local governmentsfrom the collected local taxes by the central government 3 (motor vehicle tax, additionaltax on rice export, etc.).These accounts for more than 60% the total revenue of the local governments.As other revenue sources, there are a subsidy from the central government, real estaterevenue from the local-government-owned properties, fines, and public servicecharges. Local governments are totally dependent on subsidy from central governmentexcept for BMA.Problem in local tax is that ability of local government to collect taxes is lowerthan that of the central government. Even BMA, which receives the largest amountamong local governments, only collects 20 % (in 1995) of its budget revenue.Especially real estate-related tax is not collected properly from many corporations.In order to improve the tax collection, proper and effective real estate evaluatingtechnique enhancement of compelling force to impose and collect fines are necessary.(3) Tax allocation from central to local governmentOn the other hand, the city of Bangkok where key industries are concentrated producesabout 80% of the national tax revenue. Therefore the revenue structure of BMA isdifferent from that of the other highly subsidized local governments.However, in addition to the fact that local tax is not fully collected, national taxcollected from the administrative area of BMA is treated as tax revenue of MOIwhich then poured into a general fiscal revenue of the central government. The taxonce kept in the National Treasury and then re-allotted to BMA as budget underMOI. Comparing to national tax revenue of the central government, this amount ofbudget allotment is very small.As a result, local governments including BMA are forced to rely on the centralgovernment financially. Under such circumstances, it is impossible to construct urban3The central government collects local taxes and allocates all to the local governments.

126 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resourcesrailways only with local fiscal revenue.There is, however, a movement for decentralization of financing authority. Forexample, a bill to enable each local government to adopt its own house and buildingtax rate has been under examination at Ministry of Finance. Another bill to give anauthority to the local governments to determine fees and charges is going to beexamined. It is necessary to strengthen the local governments' taxation authority inorder to collect part of their investment fund from estate owners and land developerswho receive benefits from public transportation construction projects.E. Thai Government's ViewThe followings are the views of the relevant government organizations in charge of urban railwayprojects, especially of the on-going subway construction project under direction of the governmenton its financing. 4In general, repayment of current bonds and loans for the initial investment is not yet firm.The ideas of utilizing the Thai capital market, establishing an independent guarantee organizationfor public guarantee for private fund, are considered. While if the fare revenue cannot cover theoperating cost, Thai government subsidizes the operating corporation, except private initiativeproject. Actually in almost all the cases of urban railway, many finance officers in governmentrecognize that it is impossible to secure an operation cost and to repay an initial investment costonly by fare revenue. Their ideas of main revenue sources of urban railway are as follows:a) Fare revenueRelevant organization all agree that the most important financial resource is fare revenue.Whether private concessionaire can cover the operation cost and repayment of initialinvestment such as procurement of rolling stocks.Fares should be set in accordance with those of other means of transportation tomaximize social benefit. 5According to the calculation of the urban railways master plan approved by the Cabinetin 1994, the private concessionaire can cover the operation cost and pay off the loans andbonds for initial investment at a fare of 35 bahts. But the fare of 35 bahts is so high that itis difficult to gain enough passengers without some regulations toward the alternativetransportation such as controlled use of self-owned cars and to be accepted.b) Non-railway business revenueThe MRTA Establishment Act 6 stipulates that MRTA can implement joint project ofdevelopment with private sector. It, however, has only limited authority to land acquisition.In reality, there exists ample commercial development opportunities by utilizing stationyards, depot, and exclusive right for the space above the rail track. MRTA considers itdesirable to make one bid for the totality of project concessions at once, in order to certainly4Hearing among the relevant goverment organizations in March, 1997; Budget Bureau, the Officeof Prime Minister, OCMLT, the Office of Prime Minister, BMA, Fiscal Policy Office, Ministry of Finance,MRTA, National Economic and Social Development Board, SRT5Fare of the exisiting express air-conditioned vans is 20 bahts.6It prescribes the purposes and reasons to have established MRTA and its authority.

OECF Journal of Development Assistance Vol.4, No.1, 1998 127capture the benefits deriving from these related businesses. MRTA's calculation shows therevenue from non-rail business can account for 5-10% of the railway operation revenue.The revised MRTA act which was approved by the Cabinet in 1997 includes thefollowings and it make easier for MRTA to promote non-rail businesses.• the stipulations on the MRTA's authority on land acquisition are modified, so that it hasthe same authority as the other public agencies.• MRTA can obtain the right to use the underground without changing the private landownership.As an example of the measures for capturing benefits accruing from development,the recent JICA study 7 proposed to SRT how to promote the real estate development alongthe SRT lines including purchasing and readjusting of lands following the Japanese example,but SRT finds it risky for itself to get involved in land purchase and readjustment.c) Public financial support and its resourcesIt is becoming evident that further government expenditure is necessary for urban railwayconstruction, but the financial authority of the government has no clear prospects forresources. Although Fiscal Policy Office does not deny the possibility to introduce a newtax or to increase taxes, as it has already studied the introduction of them. However theyneed some explanation to the tax payers on what kind of benefits they can get throughurban railway construction. It also would like to avoid a new tax and increase taxes asmuch as possible since it is not easy to get an approval from the Cabinet.Fiscal Policy Office thinks finance of urban construction can be covered , in the longrun, by an increased tax revenue naturally generated in the expanding economy, without anew tax or tax increase. It thinks also changing the taxation system, establishing a new tax,or raising taxes should be conducted after the Thai industries become internationallycompetitive in the future and that it is enough to improve the capture rate and efficiency oftax collection at the moment. The reason for that strategy is that the Thai industry mayloose competitiveness.OCMLT consider that, after tax on gasoline is increased, such increased portion oftax should be utilized to construct urban railway. However, the increase of tax on gasolinecertainly opens large scale public debate, it thinks it wiser to examine that possibility of taxincrease for securing a sources of repayment, only after having acquired the financing forconstruction.MRTA thinks it should be the most acceptable, among motor-related taxes to raisegasoline tax and motor vehicle registration tax since area licensing system 8 and congestiontax were unsuccessful in the past.The Ministry of Finance also views that they can raise a fund which will be needed inthe future only from gasoline tax and motor vehicle registration tax.7JICA, "Study for Metropolitan Railway Transportation Reinforcement Plan Unified with UrbanDevelopment", in October 1995.8Toll required for passing designated areas. It is expected to control traffic congestion at the sametime to increase fiscal revenue.

128 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial ResourcesAmong the officials within the Thai government, under the policy of decentralization,there is a consensus on greater responsibility of BMA related to tax collection and fundraising, since it is BMA which concretely benefit from the urban railway. If Thai governmentpursue decentralization, BMA's tax base, income and asset evaluation system and taxcollection system needs to be improved and enhanced. Though the current BMA Actapproves the local governments to impose gasoline tax, it has never been implemented dueto the political opposition. Tax increase is not a easy task, but there is still some room forimprovement to increase tax revenue even under current taxation system.V. PROPOSALS TO SECURE FINANCIAL RESOURCESA. Basic Concept for ProposalsThe three basic concepts drawn from analyzing the existing examples of urban railways in variouscountries are as follows.a) Principles that beneficiaries should pay for its benefitDirect and indirect benefits are generated by urban railway construction. In order to securethe financing resources of urban railway construction, the principle that beneficiaries shouldpay for its benefit shall be applied. In addition to fare revenue which is the direct benefit,capture of indirect benefit and government subsidy are appropriate sources of financingand are needed to be examined in that order.b) Positive involvement of the Thai government and BMALocal governments leads construction and operation of urban railways in many cities inEurope and the US equipped with urban railways, as it provides direct and indirect benefitsto the area where urban railway is constructed. However, in Thailand, development projectsare promoted by the central government with ministries and specialized institution, in thesame way as the other developing countries. Unlike in the countries in Europe and the US,where local governments have the capability to plan and implement infrastructure projects,the local governments in the developing countries are not capable to do the same, and arenot backed financially.The urban railway network in Bangkok serves the whole metropolitan area, coveringnot only BMA administrative area but also that of peripheral local governments. OnlyBMA has special statue among the local government composing metropolitan area, and itslegal position is completely different from that of other local governments. Given suchsituation, it is only the Thai government which situates above the area administrated byindividual local government. The most appropriate institution for capturing indirect benefitand for cycling it to urban railway construction, based on the equal burden sharing is theThai government.Even within the existing tax system, BMA has its own financial resources with itsown collection and budget allocation. Therefore, BMA should capture indirect benefitthrough its own tax system within the BMA administrative area and allocated it to urban

OECF Journal of Development Assistance Vol.4, No.1, 1998 129railway construction.c) Introduction of the private sector initiative and know-howIntroduction of private initiative and know-how contributes to efficient construction andoperation, thus reduction of necessary fund. Private funds is considered to be one of theway to raise initial investment of public sector.B. Proposals of Concrete Individual MeasuresBased on the three concepts mentioned above, this paper recommends the following measuresfor securing financial resources. Some of the policies are expected to be difficult to introduce,these recommendations are, therefore, divided into three categories in accordance with thepossibility of introduction.In the following description, "short term" suggests that the measures needs immediateconsideration and can be realized in short term, "medium term" suggests the one which needs tobe examined from now on as a future orientation, and to be realized in medium term, and "mediumand long term" measures are the ones which are difficult to introduce at this time but are necessaryto examine in medium and long term.a) Direct measures to secure fund(1) Measures to increase fare revenueIn order to increase fare revenue, which is a direct benefit, the following measuresneed to be implemented:(a)(b)(c)Facility for transferring to other urban railway lines and to other mode of transport(short term)The measures to increase the usage of urban railway such as construction oftransfer facility with different lines and that of terminals of other mode oftransport such as buses at railway station, will increase the number of passengers.Enforcement of feeder services (short term)Related to the above mentioned (a), in order to increase the number of passengerof urban railway through the expansion of accessibility to railway, it is necessaryto consider the promotion plan of feeder service such as construction of busterminal.Coordination with suburban residential and commercial development (mediumterm)If the extension of urban railway is planned in order to provide transportationfor the passengers commuting between city center and suburban area, the railwayproject must be harmonized with redevelopment of city center, residential areadevelopment and city sub-center development.

130 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resources(d)Control of vehicle ownership and usage through taxation (medium and longterm)If the measures to control the ownership or usage of automobile are taken inaccordance with the development of urban railway, it leads not only to promotethe use of urban railway but also alleviate the traffic congestion and increasethe tax revenue. This measures is considered to be difficult to realize in shortterm as it accompanies increase of tax and introduction of new taxes.(2) Measures for indirect benefit captureAs mentioned before, indirect benefits generated by construction of railway arecaptured through property tax and the motor-related tax. Seeing Thai tax systemfrom this point of view, it exists already house and building tax and local developmenttax as property tax and motor vehicle registration tax and motor fuel tax as motorrelatedtax.Here, we propose treat a part of revenue from these taxes as earmarked tax, andallocate them for urban railway construction in Bangkok metropolitan area (Table 7).The tax rates utilized here are hypothetical, but we tried to be realistic. In addition,from the point of view of environmental consideration, introduction of environmentaltax is examined. Since the areas which benefit from the construction of urban railwayare considered to be limited, the portion of tax revenue, which only relates to realestate around stations is taken into account.Table 7Policy Measures to Capture the Indirect BenefitMeasures Current Rate Realistic Assumption(e) Increase of the car registrationtax in BMA area(f) Increase of the gas tax in BMAarea(g)Introduction of environmentaltax (new tax)(h)Ear-marking of a part of house &building tax that is considered tobe benefited from UMTRdevelopment(i) Ear-marking of a part of landbuilding tax that is considered tobe benefited from UMTRdevelopment(j) Introduction of charges fortransport inducementAverage 2,500 bahts/car/yearAverage 2.98 bahts/literNew tax (only on gas sales inBMA area)12.5 % of house & building taxamount appraisedNew tax (This tax currentlyexist, but its collection isinsufficient.)New ChargesAverage 3,000 bahts/car/year(Additional taxation of 500 bahts)Average 3.13 bahts/liter(Additional taxation of 0.15 bahts/liter,equal to outside BMA area)0.1 bahts/liter(Total 3.23 bahts/liter)5% of increased tax revenue from thearea within the circle with 500 mdiameter of newly opened UMTR stationNew taxation of 500 bahts/m 2 on newlydeveloped buildings of the area withinthe circle with 500 m diameter of newlyopened UMTR stationCharges to shopping mall, departmentstore, hotel, facilities for sightseeingetc., which are supposed to inducetransport demand.

OECF Journal of Development Assistance Vol.4, No.1, 1998 131As these are either increase of tax rate or introduction of new tax, its introductionin short term is not a easy task. However, once urban railway construction has beencompleted, it is considered that the whole society benefits from urban railwayconstruction. It is therefore appropriate to introduce these taxes at the time ofcompletion.b) Supporting measures for fund raisingIn this section, we propose the supportive measures, although they do not lead directly tolead fund raising.(k)(l)(m)(n)Strengthening of OCMLT's authority (short term)It is necessary to strengthen the administrative authority of OCMLT, currentlyconsidered as being insufficient, in order to establish a system which allows to capturethe indirect benefit and to allocate it to railway construction and which leads eachproject to a railway network, when fare increase measures and the new railway lineare being examined. Excessive administrative involvement on fare modification maymake lose private sector's incentives on investment.Introduction of private sector initiative (short term)In order to introduce the private sector initiative activity in the effective operationand maintenance, procurement and operation of facility, support measure, it isnecessary to establish a system for private sector to have incentive to invest.Coordination with Suburban Residential and Commercial Development Plans(medium term)As same as (c) above, the extension line plan should take into consideration thedevelopment of residential and commercial area alongside of it, in order to ensurepassengers. The future city development plan should be harmonized with the masterplan of urban railway.Connection fee for the underground passage between the metro station and the realproperty to be charged to the property owner (short term)As employed in the subway in Tokyo, this measure strengthen the usage of subwayby providing facilities for the passengers; the underground passage between subwaystation and commercial facilities such as department store is constructed at the expenseof real property owner. This method needs the negotiation with real estate developer.C. SimulationIn this section, we summarized the result of simulation of some cases. This simulation has beendone in order to examine the effectiveness of the measures to be employed, described in previoussection.

132 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resourcesa) Project schemeMRTA (a public corporation) is in charge of civil works for Blue Line, Orange Line, andPurple Line while the private sector is in charge of electric and machinery facilitiesconstructions and operation and maintenance of the system for 25 to 30 years.b) Method of simulation(1) Loan conditions• Long-term commercial loan: 25-year repayment with 10% interest p. a.• Short-term commercial loan: 10% interest p. a.• ODA loan: 25-year repayment (7 years grace period) with 2.7% interest p. a.• Government guaranteed bonds: 10-year repayment with 10% interest p. a.(2) Fund raising for the total subway construction cost 9• Case 1: Construction cost of subway Blue Line is provided by ODA loan andgovernment guaranteed bonds; all other lines will be financed bycommercial loans. Approximately 562,097 million bahts.• Case 2: Construction cost of Blue Line and the rest of the lines is financed byODA loan. Approximately 345,100 million bahats.(3) Repayment methodThe repayment period is 34 years, assuming the first loan is extended in 1997 and thelast one is 2007.The annual financial requirement for the construction will be borrowed by thegovernment, and its repayment is assured from the earmarked tax revenue of Table 7.The difference in the necessary amount and the revenue from the tax will be assuredfrom the expenditure from the general budget. Utilization of earmarked tax is up tothe break even point of investment requirement and repayment, and after that, operatingexpenses will be only covered by the fare revenue.(4) Fare revenueFare revenue is set at 15 bahts for the first ride and 1baht per kilometer is addedafterwards. All the fare revenue becomes the revenue of the operator of urban railway,and will be the source of operation and maintenance fee as well as the investment forelectrical-mechanical works. The difference between the fare revenue and operator'sexpense, if it exists, the difference (equals to benefit) will be divided into two betweenthe private operator and MRTA, i.e., the operator pays the 50% of its benefit asconcession fee.c) Result of simulationSeen from the proportion of the revenue from earmarked tax against the total project cost,effect of implementing individual measures are as follows:9Total subway construction cost includes the construction cost, interest under construction, paymentof interest and repayment of principle.

OECF Journal of Development Assistance Vol.4, No.1, 1998 133Table 8Impact of Proposed MeasuresMeasuresRatio to the total project costCase 1 Case 2Additional tax on car registration tax 19.4% 31.7%Additional tax on gas tax 7.3% 11.9%Introduction of environmental tax 4.9% 7.9%A portion of house and building tax increase 0.7% 1.2%Introduction of land development tax 4.0% 6.5%Motor vehicle registration tax effects the most against the total project cost. Thereare, however, no examples in the developed countries to have it for the financial resourcesof urban railway construction fund, except an example of motor fuel tax to be for anearmarked tax. It implies that introduction of taxes on use of vehicle is more reasonablethan that on possession of vehicles for urban railway improvement fund. A similar examplecan be seen in environment tax to control vehicle use from a point of view for environmentprotection. On the other hand, the effect of estate-related taxes such as house and buildingtax (property tax) and land development tax is small since it is difficult to specify thebenefits and it needs a wider area on tax collection.d) Financial share of the Thai governmentTaking the above thoughts and uncertainty of fare revenue, which depends on the numberof passengers into consideration, the result of the simulation is as follows (Table 8).Considering the difficulty and potentiality of introducing the measures, motor fueltax and environment tax are the most effective of all the suggested measures and should beprioritized to examine for the implementation. For a project cost which could not be coveredby fare revenue and earmarked tax, financial share of the government becomes necessary.Adding land development tax to this situation, the financial share of the Thai governmentis 83% in Case 1, and 74% in Case 2 (on condition that the fare revenue reaches only 50%the expected figures).The central and local governments will have to take the financial share for urbanrailway construction. It is necessary to examine new government funds like the above toreduce financial share of the government below the figures currently assumed.

134 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial ResourcesTable 9Result of Simulation: Share of Financial ResourcesCaseProjectRevenue from Revenue from the Implementation of Fiscal Burden of TotalCostConcession Fee Recommended Policies Thai government(%)(%)(%)(%)Case 1 562.1 100 % of 29 100 % of all measures 24 47 100billion expected 29 100 % of car registration tax 13 58 100bahts fare revenue only29 100% of gas tax, environmental 8 63 100tax only29 100% of gas tax environmental 11 60 100tax, land development tax only50 % of 3 100 % of all measures 30 67 100expected 3 100 % of car registration tax 17 80 100fare revenue only3 100% of gas tax, environmental 10 87 100tax3 100% of gas tax, environmental 14 83 100tax, land development tax onlyCase 2 345. 1 100 % of 40 100 % of all measures 34 26 100billion expected 40 100 % of car registration tax 20 40 100bahts fare revenue only40 100% of gas tax, environmental 12 48 100tax only40 100% of gas tax, environmental 16 44 100tax, land development tax only50 % of 5 100 % of all measures 46 49 100expected 5 100 % of car registration tax 26 69 100fare revenue only5 100% of gas tax, environmental 16 79 100tax only5 100% of gas tax, environmentaltax, land development tax only21 74 100D. Conditions for Introducing the Recommended Measures and Further Issuesa) National consensus for burdenThe thing required the most in future is to introduce a tax system based on the principle thatbeneficiary should pay for its benefit adopted with a national consensus to secure financialresources for urban railway construction. It is necessary for this system to take efficiencyand fairness into consideration to realize fair shares of burden among beneficiaries.b) Measures to introduce the private sector participationIt is necessary to clarify the role and responsibility of the public and private sectors inrelation to the introduction of private initiative. Clarification is required for a propermaintenance and service standard of the facilities of urban railway constructed and operatedby private sector, as well as for establishment of a system to bring about investment fromprivate sector, by avoiding an excess intervention of administration, such as forcing to risefare level unilaterally.c) Capture and cross-subsidization of development revenueElaboration of a law on reversion of profit accruing from development is desirable fromthe point of view of equality. For example, a new law which allows MRTA to sell the landwhich locates alongside with urban railway line and has been acquired at low price, to theproperty developer by adding the cost of urban railway construction and thereby cycling

OECF Journal of Development Assistance Vol.4, No.1, 1998 135the difference between the two for the repayment of initial investment. This is not possibleunder the current legislation. In addition, relaxation of the authority on right-on-wayacquisition and a concession for underground use will accelerate the reversion of profitaccruing from the development.d) Decentralization and strengthening administrative capacityIt is desirable that urban railway, which brings benefit to where it is constructed, should beadministrated by local government of the region.In the effort of Thai government to decentralize central government functions, it isdesirable to gradually transfer many of the authorities and financial resources for urbanrailway construction to BMA, a local government. In addition to the decentralization ofadministration system, it is necessary to improve the administrative capacity of local publicservice officer.Especially when introducing private sector activities, the ability to understandcomplicated contracts is indispensable, whereas even the central government officials areactually having difficulties in perfect comprehension. For local public service officer whohas no experiences in traditional public works, it is necessary to train them from the earlystage to be able to deal with private participation.REFERENCES(Japanese)Doboku gakkai (Japan Society of Civil Engineers) (1990). Kootsuu seibi seido - shikumi to kadai- (Transport Development Institution - System and Problem -), in Japanese.Doi, Masayuki (1995). Hatten tojyookoku kootuukeizai ron (Theory of transport economics indeveloping countries), Keiso shoboo, in Japanese.Hayashi, Yoshitugu (1993). Kootsu shakai shihon seibi no zaigen to kaihatsu rieki kangen -Shogaikoku no jirei wo majiete - (Financial resources of development of transportationInfrastructure and value capture - Case study in foreign countries -), Vol.104, Chuubukaihatu center (CRDRC), in Japanese.Kokusai kyooryoku jigyoodan (Japan International Cooperation Agency, JICA) (1995).Toshikaihatu to ittaika shita shutoken tetsudo yusooryoku zookyoo keikaku (Planning ofrailway transportation capacity in metropolitan area under integration of urbandevelopment), in Japanese.Nihon Kikai Yushutu Kumiai (Japan Machinery Center for Trade and Investment) (1995).Tojyookoku too ni okeru infra seibi kanren minkatsu project no dookoo to wagakuni notaioo choosa hookoku sho (Status of private initiative project of infrastructure relateddevelopment in developing countries and its counter measures of Japan), in Japanese.Okuno, Masahiro, Shinohara, Soichi and Kanemoto, Yoshitugu (1989). Kotsu seisaku no keizaigaku (Economics of Transport Policy), Nihon Keizai Shinbun Sha (The Nihon KeizaiShimbun Inc.), in Japanese.Takatsu, Shunji, Kazutoshi Yuyama and Yuzo Ando (1989). Koogai tetsudoo shinsen seibi nokaihatu rieki kangen ni yoru zaigen hoosaku no shian (The value capture trial in building

136 Hitoshi Shoji, Michinari Togawa, Tetsuo Kidokoro, Urban Railway Projects in Bangkok:Measures for Securing Financial Resourcesa suburban railway), Vol.32 No.12, Japan Railway Engineers' Association, in Japanese.Tetsudoo seibi kikin (Transportation Development Fund) (1992). Shogaikoku ni okeru tetsudoseibi hoosaku ni kansuru choosa hookokusho (Study on measures of railway developmentin foreign countries), in Japanese.______ (1994). Tetsudo jyosei handbook (Handbook of Support for Railway Development), inJapanese.Uemura, Kanae (1990). "Toshi kootsu seisaku no kiseki to kadai" ("History and Problems ofUrban Transportation Policy"), Un-yu to keizai (Transportation and Economy), Vol.50,No.6, Institute of Transportation Economics, in Japanese.Un-yu seisaku kenkyuu kai shoo iinkai (Committee of Transport Policy Study) (1995). Daitoshikenni okeru tetudoo seibi no zaigen kyooka no tameno teigen (Proposal for StrengtheningFinance of Railway in Urban Area), Zaidan hoojin un-yu keizai kenkyu center (Institutefor Transport Policy Studies), in Japanese.Zaidan hoojin kokusai kaihatsu center (International Development Center of Japan) (1986). Toshikootuu - Sekai ginkoo seisaku kenkyuu- (Urban Transport - Policy Study of World Bank -),in Japanese.(English )Bushell, Chirs (1997). Jane's Urban Transport Systems, 1996-1997, Jane's Information Group Inc.Halcrow Fox and Associates (1989). Study of Mass Rapid in Developing Countries, Transportand Road Research Laboratory, The Overseas Unit.JICA (1990). The Study on Medium to Long Term Improvement/Management Plan of Road andRoad Transport in Bangkok.______ (1997). The Study on Urban Environmental Improvement Program in BangkokMetropolitan Area, Final Report, Volume 2: Master Plan.Metropolitan Rapid Transit Authority (MRTA) (1997). MRTA Project (Blue Line).OCMLT (The Office of The Commission for the Management of Road Traffic) (1995). MassRapid Transit Systems Master Plan, Volume II Final Report.______ (1997). Analysis of Bangkok MRT Initial System Plan.

FUTURE CHALLENGES FOR THE ECONOMICRECOVERY OF THAILAND *Yuko Amano **Fumiharu Mieno ***SUMMARYThe econometric model to examine the impact of currency crisis in Thailand indicates that, in theabsence of additional stimulation measures, the Thai economy will settle into a phase of low ornegative growth accompanied by rising unemployment rate until 2001. Additional three measuresmust, therefore, be taken if the economy is to be steered away from this pessimistic scenario;- (1)increasing public investment, (2) increasing foreign direct investment through giving privilegeby BOI, and (3) increasing private corporate capital investment through IFCT concessional loansand following recovery of private bank lending. The results of simulation indicate that the mosteffective measure would be to boost public investment with immediate effect in 1999, to shiftemphasis from public investment to private capital investment in 2000 onwards and to promoteforeign direct investment throughout.CONTENTSI. Background of the Currency CrisisA. High Economic GrowthB. Background of Currency CrisisII. The Currency and Economic Crises -- Effects and MeasuresA. Effects of the Currency Crisis - Forecasts from the Baseline ScenarioB. Future Problems and Possible MeasuresC. Measures for Recovery from the Currency CrisisD. Other EffectsIII. Corporate Financing and the Impact of Policy InterventionA. Thailand's Financing StructureB. Thai Industry's Financing StructureC. Estimation of Lending and Investment FunctionsD. General Observations and Interpretation of the ResultsIV. Conclusion*Chapter I and II of this report, which was consigned by the Overseas Economic Cooperation Fundfrom an outside agency, was revised and augmented as necessary by Yuko Amano. Chapter III, which wasconsigned to Fumiharu Mieno, was revised and augmented as necessary by Amano.** Economist, Macro-Economic Studies, RIDA, OECF*** Visiting Researcher, Faculty of EconomicsThammasat University, ThailandOECF Journal of Development Assistance Vol.4, No.1 (1998) pp.137-191©1998 by the Overseas Economic Cooperation Fund. All rights reserved.

138 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandI. BACKGROUND OF THE CURRENCY CRISISA. High Economic GrowthIn 1988, Thai economy was in a period of rapid industrialization driven by an influx of foreigncompanies, and it resulted the high economic growth (Fig.1). This rapid growth of directinvestment derived that Japanese and NIES companies moved their production operation to seeklow-cost overseas production operations, since Japan and NIES had come under pressure torevalue their currencies in the second half of the 1980s and which were at the same time sufferingfrom rapid wage growth. Until the early 1990s, the destinations of new operation productionwere Thailand and Malaysia, because these physical and institutional infrastructures were relativelydeveloped. Consequently the character of Thai economy and its industrial structure was completelychanged in the period from 1980 to 1994, and primary industry declined from 23% to 10% in theGDP composition ratio; from 51 to 17% in export, and from 71% to 58% in employment.(%) (%)14713.312.2Foreign direct investment / NominalGDP (right scale)1211.2Real GDP growth rate (left scale)61089.58.68.18.48.98.8546425.54.60.4 0.60.41.82.52.81.91.81.30.60.70.85.532101985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 19960Sources : NESDB, and National Income of Thailand 1996Fig. 1 Foreign Direct Investment and Economic Growth1. Active Fixed Capital FormationThe effect of the influx of foreign direct investment was directly reflected in exports and, in theearly stages, it also contributed to high economic growth by stimulating active fixed capitalformation. Japan's high growth years were marked by a pattern whereby "investment gave riseto further investment" at its first stage. The pattern in Thailand was similar. A feature of the Thaisituation was the particularly high ratio of fixed capital formation (fixed capital formation: GDP).In Malaysia, for example, the GDP ratio of fixed capital formation did not exceed over 40% until

OECF Journal of Development Assistance Vol.4, No.1, 1998 1391994. Similarly in China, which recorded a major surge in fixed capital formation in the 1990s,the ratio is still less than 35%. In Thailand, by contrast, the fixed capital investment ratio hasremained consistently at or over 40% throughout the 1990s.2. Rapid Export GrowthIn the high growth years of the 1990s, surging exports were the main engine of growth. Thestructure of Thai exports also completely changed in terms both of items and of regions.The export ratio of food and other goods has declined, while the ratio of machinery hasincreased sharply. The ratio of intermediate categories has increased virtually across the board(Table 1). The rapid growth of exports is derived from the formation of an Asian productionnetwork supported by the economy in Japan, South Korea and Taiwan.A more detailed data shows that traditional items, such as textile and canned goods exportshas significantly decreased. By contrast, in the early 1990s, the major growth of electrical goodsexports electrical goods. In the second half of the decade, exports of machinery, particularlycomputers, have increased rapidly (Table 2). Considering the formation of the Asian productionnetwork, it is clearly observed that the development of the intra-regional specialization networkhas primarily developed in electric and machinery sectors.Table 1Export by Sectors(Bt 1 bil, %)1991 1992 1993 1994 1995 1996 1997Value Share Value Share Value Share Value Share Value Share Value Share Value ShareFoodstuffs 192.0 26.5 211.0 25.6 201.6 21.5 235.5 20.7 268.1 19.1 274.3 19.4 325.7 18.0Manufactures 120.9 16.7 136.2 16.5 177.6 19.0 189.6 16.7 254.4 18.1 225.1 15.9 279.5 15.5Machinery 175.7 24.2 220.1 26.7 281.1 30.0 380.8 33.5 475.5 33.8 536.8 38.0 691.1 38.2Other manufactures 164.2 22.6 178.5 21.6 189.9 20.3 227.4 20.0 255.8 18.2 207.4 14.7 240.4 13.3Total 725.6 100.0 824.6 100.0 935.9 100.0 1,137.6 100.0 1,406.3 100.0 1,412.1 100.0 1,807.1 100.0Sources : Bank of Thailand, Monthly Bulletin (Feb. 1998)Table 2Export Ratios of Thailand's Main Industrial Goods(Bt 1 bil, %)1991 1992 1993 1994 1995 1996 1997Value Share Value Share Value Share Value Share Value Share Value Share Value ShareTextile products 109.5 15.1 111.8 13.6 116.7 12.5 133.5 11.7 142.4 10.1 118.5 8.4 147.4 9.9Machinery 57.5 7.9 70.4 8.5 90.8 9.7 118.0 10.4 160.9 11.4 196.3 13.9 264.0 17.7Computers 46.4 6.4 55.4 6.7 62.7 6.7 92.1 8.1 128.4 9.1 165.2 11.7 227.7 15.3Jewelry 35.9 4.9 36.6 4.4 41.0 4.4 44.7 3.9 49.9 3.5 51.5 3.6 52.8 3.5Electrical equipment 44.2 6.1 56.7 6.9 75.6 8.1 102.4 9.9 130.2 9.3 137.5 9.7 178.8 12Ics 25.8 3.6 28.6 3.5 35.6 3.8 45.3 4 58.1 4.1 58.5 4.1 75.7 5.1Footwear 23.8 3.3 25.6 3.1 27.9 3 39.3 3.5 53.8 3.8 33.5 2.4 35.2 2.4Household electrical goods 47.9 6.6 60.4 7.3 62.6 6.7 88.1 7.7 102.8 7.3 106.6 7.5 134.9 9.1Base metals 14.8 2 15.5 1.9 19.3 2.1 24.7 2.2 34.2 2.4 36 2.5 46.9 3.1Canned goods 38.7 5.3 43 5.2 43 4.6 50.3 4.4 53.3 3.8 57.1 4.0 73.7 4.9Sources : Bank of Thailand, Monthly Bulletin (Feb. 1998)

140 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand3. Modernization of ConsumptionConsumption expanded steadily throughout the high economic growth period. Labor sharedeclined from 68% in 1991 to 65% in 1996, which is reflected the increase in the propensity toconsume. The main factor of the increase of the propensity to consume seems the rapid increasein the demand for consumer durable goods by the increase of incomes, particularly in the bigcities. Another important factor was financial liberalization -- this is discussed in more detaillater -- since financial liberalization generated the rapid growth of consumer loan, which madethe public easier to purchase consumer durable goods.B. Background of the Currency CrisisWhile the high economic growth continued, Thailand failed to improve fundamental economicstructure. Consequently, accumulated structural failures pressured Thai economy to the currencycrisis.1. Inflationary PressureInflation was not significantly higher than other high economic growth countries, (it was higherthan the Malaysian rate, for example), however, it has gradually risen since 1994. This derivedfrom temporary inflation due to not only unusual weather conditions but also the unimpressiveimprovement of labor productivity in most industries since the early 1990s -- this is argued atgreater length in the supplementary discussion. Labor productivity in the construction industriesactually declined between 1990 and 1995. While the economic growth was achieved in themanufacturing and tertiary industries by throwing additional labor at the problem rather than byimproving productivity. As this result, Thai economy has weakened its ability to absorb latentupward pressure on prices was to this extent reduced.2. International Balance of PaymentsExcept during a brief period of economic depression, The trade balance and current accountshave been almost permanently in deficit in Thai economy. The close relationship between directinvestment and the trade and current account deficits has often been pointed out. Periods ofactive investment are clearly accompanied with the increase in the current account deficit, andlulls of active investment are accompanied with declines in the deficit. Active fixed capitalformation is necessarily associated with an increase in imports in Thailand, where is insufficientwith capital goods industry. This has been particularly evident in the years since the 1988, whichwas the boom of foreign direct investment, when corporate capital investment was dominated byforeign corporations.The import ratio of capital goods has increased almost continuously through the 1990s ascapital goods has been the biggest import component. By contrast, the ratios of raw materialsand intermediate goods has declined (Table 3). Raw materials and intermediate goods consistnot only of chemical goods, metals but also of goods which are comparatively limited growthpotential, such as textiles and timber. Capital goods, on the other hand, consist primarily of

OECF Journal of Development Assistance Vol.4, No.1, 1998 141machinery, which is indispensable to the development of modern industries. In other words, theincrease in the import ratio of capital goods during this period reflected changes in the internalstructure of Thai manufacturing industries according to the transition to a modern industrialbase.Table 3Imports by Sector(Bt 1 bil, %)1991 1992 1993 1994 1995 1996 1997Value Share Value Share Value Share Value Share Value Share Value Share Value ShareConsumer goods 82.8 8.6 103.7 10.0 114.4 9.8 144.8 10.6 181.8 10.3 192.7 10.5 204.8 10.6Non-durable 36.2 3.8 45.2 4.4 48.8 4.2 55.8 4.1 66.5 3.8 72.9 4.0 81.1 4.2Durable 46.6 4.9 58.4 5.6 65.6 5.6 89.0 6.5 115.4 6.5 119.8 6.5 123.7 6.4Raw marerials and intermediate goods 329.6 34.4 331.3 32.1 349.4 30.0 394.6 28.8 509.6 28.9 473.6 25.8 496.3 25.8Capital goods 385.5 40.2 426 41.2 501.1 43 613.8 44.8 801.8 45.5 844.5 46.1 941.1 48.9Other goods 161.0 16.8 172.2 16.7 201.7 17.3 215.9 15.8 270.4 15.3 322.0 17.6 282.0 14.7Motor vehicles 47.3 4.9 58.4 5.7 82.7 7.1 95.1 6.9 121.9 6.9 116.8 6.4 68.0 3.5Fuel, etc. 87.7 9.1 83.8 8.1 86.5 7.4 91.6 6.7 115.2 6.5 157.4 8.6 168.3 8.7Sources : Bank of Thailand, Monthly Bulletin (Feb. 1998)Another trend is the import growth of consumer durable goods and automobile. While thisnaturally followed by the high level of capital investment and the modernization of privateconsumption, it also owes much to changes in the pattern of consumption that have accompaniedthe modernization and internationalization of Thai financial system. In other words, financialdevelopment, such as the increased availability of consumer credit, which accompanied theliberalization of the Thai financial system, prompted an increase in the propensity to consume,consequently, this manifested as increase in consumer goods imports.A comparison between the current account deficit and the flow of foreign direct investmentbetween 1988 and 1991 shows foreign direct investment covering approximately 24% of thecurrent account deficit, at its lowest point and 70% at its highest. From 1994, the ratio falls to10% or less. Foreign direct investment is generally held to be the most reliable method offinancing a balance of payments deficit. In other word, the growth of instability in the Thaieconomy is not only in the balance of payments deficit but also in the finance.3. Financial FactorsTable 4 shows the increase in external debt since 1990 to have been primarily accumulated inprivate sector borrowing. Prior to the establishment of BIBF, non-banks were the main institutesof foreign currency loans. However, the private sector has taken main roles of foreign currencyloans after BIBF was established. Since 1994, the combined share of total bank foreign currencylending by BIBF and the commercial banks has been greater than that by the non-banks. At thesame time, the central government took advantage from the growth of tax revenues to control itscumulative debt position under control (domestic debt was actually reduced). As a result, thegovernment's external debts remained stable.BIBF's loan portfolio shows its funds have been distributed to industry -- about 40 and

142 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand50% to manufacturers and another 13 to 18% to commercial sectors. Thus, BIBF has made animportant contribution to industrialization in the 1990s. However, BIBF has also distributedapproximately 10% of its funds to the real estate sector, and since 1994, about 20% has been lentto other financial institutions. Thus, BIBF has also played a part in supplementing the domesticsaving shortage. The composition of lending by the main financial institutions shows that banklending primarily directed towards the manufacturing and commercial sectors whereas financecompany loans tend to be weighted more heavily in favor of the real estate sector and consumercredit (Table 4). The emphasis on the finance companies' commitment to real estate inducedexcessive price rises of real estate, and this led to the financial crisis. Furthermore, the expansionof consumer credit led to an increase in the propensity to consume and this led to the increase inconsumer durable imports.Table 4Balance of External Debt(USD 1 bil)1992 1993 1994 1995 1996 1997Public sector debt 13.1 14.2 15.7 16.4 16.8 17.2Short-term debt 0.6 0 0.2 0.1 0.1 0.02Private sector debt 30.6 37.9 49.2 66.2 73.7 67.3Commercial banks 6.3 5.3 9.9 14.4 10.7 8.2BIBF - 7.7 18.1 27.5 31.2 30.1Non-Banks 24.3 24.9 21.2 24.2 31.9 29.1Short-term private sector debt 18.3 22.7 28.9 41 37.6 29.2Short-term commercial bank debt 5.5 4 6.4 10 8.4 5.7Short-term BIBF debt - 6.4 15.1 23.7 20.5 19.1Short-term non-bank debt 12.8 12.3 7.4 7.3 8.7 4.5Total 43.6 52.1 64.9 82.6 90.5 91.8Short-term total 18.9 22.6 29.2 41.1 37.6 29.22Sources : Bank of Thailand, Monthly Bulletin (Feb. 1998)Table 5Bank and Finance Company Lending by Business Sector(as at end 1995)Banks (29) Finance companies (91)Value (Bt 1 mil) Composition ratio (%) Value (Bt 1 mil) Composition ratio (%)Agriculture, forestry and fisheries 158,940 3.7 6,156 0.5Mining 24,985 0.6 4,723 0.4Manufacturing 1,097,338 25.8 185,674 14.3Construction 185,850 4.4 39,804 3.1Real estate 400,184 9.4 325,923 25.0Imports 139,976 3.3 20,092 1.5Exports 182,710 4.3 10,027 0.8Wholesale and retail 756,799 17.8 94,517 7.3Public utilities 108,106 2.5 24,806 1.9Financial institutions 339,204 8.0 129,829 10.0Services 333,296 7.8 75,216 5.8Installment sales 8,676 0.7Consumers 523,437 12.3 375,949 28.9Total 4,250,825 100.0 1,301,392 100.0Source: Bank of Thailand, Business and Industrial Statistics, 1995 edition

OECF Journal of Development Assistance Vol.4, No.1, 1998 143In the past, Thailand's monetary authorities effectively pegged the baht to the dollar.Borrowers were, of course, attracted by low interest rates and this led them to increase theirforeign currency borrowings. Unfortunately, borrowers tended to base fund procurement ondomestic-overseas rate spreads and they did not pay attention to exchange risk. In addition,deregulation of foreign currency borrowing in 1990 encouraged this tendency and theestablishment of BIBF in 1993 led to a surge in foreign currency borrowing.Under the circumstances, BIS banking regulation was strengthened, then banks which haduntil then been lending to the limit of their resources, were obliged to curtail their lending. Theimpact was great on those financial institutions which had achieved the rapid growth. Thisseriously deteriorated the balance of supply and demand for real estate, a market which had beenheavily dependent on the financial institutions for funds. As a result, the financial institutions'bad debt problems have been snowballed. Thus, the currency crisis occurred by the combinationof the financial factors and instability in the real economy due primarily to changes in the balanceof payments.II. THE CURRENCY AND ECONOMIC CRISES-- EFFECTS AND MEASURESCurrently (the end of April 1998), the Thai currency crisis -- the origins of which were outlinedin Chapter I -- appears to be over the worst situation, and the baht is improved to more stablecondition. However, there is growing concern that the adverse effects of the crisis on the realeconomy could be prolonged and more serious. It is essential to evaluate the currency crisisobjectively for considering the measures for the economic recovery.In this chapter, economic impact of the currency crisis over the next five years is forecastedby the econometric model. 1 Additionally, this chapter argues the effective measures for thecurrency crisis based on the forecast.A. Effects of the Currency Crisis - Forecasts from the Baseline ScenarioFirst, to clarify the medium- and long-term effects of the crisis, the canonical exogenous variablesare established and a medium-term economic forecast is analyzed for the five years from 1997 to2001. This is the basis for an examination of possible measures to the currency crisis; it is namedthe baseline scenario. The results are to identify problem areas and to examine possible measures,which are mentioned in the next section. Also, this part identifies risk factors -- Indonesianpolitical instability, devaluation of the Chinese yuan, etc. -- which might occur another economiccrisis in Asia.1. Assumptions of the Baseline ScenarioThe main exogenous variables of the baseline scenario are listed in Table 6. Since governmentfinal consumption expenditure and public fixed capital formation have a particularly strong effect1 The econometric model was developed by DIR in conjunction with the Bangkok Bank. Themodel uses 140 formulas, including 33 behavior equations.

144 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailandon other components, it is desirable to conform as nearly as possible to proposed fiscal policy byeliminating as much arbitrariness as possible. The obvious choice is to use the economic forecastin the Eighth National Economic and Social Development Plan, following Letter of Intent No.3(24/2/98). However, according to the budget plans in FY98 and FY99, the growth of publicfixed capital formation (real 6%) estimated in this forecast is difficult to achieve, at least in 1999.Therefore, the assumption that public fixed capital formation is negative real values up to2000 and no change in 2001. In the case of government final consumption expenditure andexchange rates, on the other hand, values from the forecast are directly used in the baselinescenario. The key points are listed in the box below; numerical values are shown in Table 6. Thebaseline scenario reflects the economic condition under the tight fiscal policy. It should be notedthat this is a pessimistic scenario.1) Currency depreciation (currency crisis) halts in 1998 after 1998, the exchange ratebegins to stabilize.2) Net dollar-based foreign direct investment increases remarkably from 1998 to 1999.3) Surging direct investment contributes to subsequent growth of current external demand.4) Government spending is sharply reduced in 1998, after that it does not increase inreal terms by 2001, which prevents the economic growth.5) US economy shows no fluctuation; Japanese economy is in a gradual recovery phase.6) There is no immediate strong growth of world trade (i.e. real world imports).Table 6Main Exogenous Variables -- Baseline scenario AssumptionsNet inward direct investment (Bt,Y/Y,%) 26.7 7.0 70.0 6.0 5.0 4.0Net inward direct investment (USD,Y/Y,%) 24.7 -13.6 18.6 19.2 6.6 3.7Exchange rate (Bt/US$) 25.4 31.4 45.0 40.0 39.4 39.5(Y/Y,%) 0.0 23.8 43.3 -11.1 -1.5 0.3Exchange rate (JPY/USD) 108.8 121.0 130.0 120.0 120.0 120.0(Y/Y,%) 0.0 11.2 7.4 -7.7 0.0 0.0Exchange rate (DM/USD) 1.5 1.7 1.9 1.8 1.7 1.7(Y/Y,%) 0.0 15.3 6.9 -2.7 -5.6 0.0GDP growth rate (Japan,Y/Y,%) 4.1 0.8 -1.5 0.2 1.0 2.0GDP growth rate (USA,Y/Y,%) 2.8 3.8 2.6 2.3 2.3 2.3Change in real Japanese imports -1.3 -0.3 -2.1 -0.7 0.7 1.1Change in real world imports (excl.Japan) 4.8 4.7 4.9 3.4 3.5 3.7Industrial product export price index(Y/Y,%) -1.4 1.1 2.8 2.5 2.6 2.7Crude oil price (Y/Y,%) 0.0 16.4 -25.8 0.4 1.5 2.0Government final consumption expenditure (nominal,Bt 1467,607 mil) 491,732 468,407 508,960 555,605 606,089(Y/Y,%) 13.2 5.2 -4.7 8.7 9.2 9.1Gross public fixed capital formation (nominal,Bt 1 mil) 470,706 561,190 443,225 353,282 345,140 351,343(Y/Y,%) 26.3 19.2 -21.0 -20.3 -2.3 1.8

OECF Journal of Development Assistance Vol.4, No.1, 1998 1452. Economic Forecast in the Baseline Scenarioa) OverviewAccording to main economic indicators in Table 7, it is observed that the adverse effects ofthe currency crisis is prolonged under the baseline scenario, and the Thai economy hasdeclined during the period of 1997 to 1999. The deterioration is particularly evident in1998: the inflation rate is around 10%, the economy shrinks by approximately 4.5% andthe unemployment rate also rises. In the absence of an engine of economic growth, theeconomy fails to get out of low growth in 2000 or 2001. At the same time, although there islittle evident deterioration in the trade balance, both unemployment and the fiscal balancedeteriorate significantly in this period. Specifically, the unemployment dips to7.18%, whichis the level since the second half of the 1980s, in 2001. Additionally, despite of curtail ofexpenditure, the fiscal balance dips to -3.23% of GDP.Table 7Main Economic Indicators under the Baseline Scenario1996 (act) 1997 (est) 1998 (est) 1999 (est) 2000 (est) 2001 (est)Real GDP growth rate 5.52 -0.91 -4.52 -1.75 0.89 2.31Unemployment rate 1.51 3.46 4.70 5.57 6.52 7.18Inflation (CPI) 5.85 5.61 10.76 7.03 2.96 2.60Inflation (WPI) 4.66 4.39 13.19 5.93 1.70 1.56Ratio of trade balance in GDP -9.08 -2.84 2.16 1.63 1.72 1.66Change in goods exports (USD) -1.73 2.43 4.86 3.85 5.64 5.37Change in goods imports (USD) 0.77 -15.22 -6.87 4.63 5.46 5.55Ratio of fiscal balance in GDP 0.74 -0.58 -1.83 -2.69 -3.01 -3.23Change in central government revenues 9.77 -0.64 -18.44 -9.48 2.44 4.71Change in central government expenditure 27.52 6.91 -10.28 -2.46 4.81 6.23b) Contributions of domestic and external demandTo further clarify the impact of the currency crisis, contributions of domestic and externaldemand to the economic growth is calculated 2 (Fig. 2).Contribution of external demand has increased rapidly in 1997 and 1998 due to weakbaht. After that the situation is reversed as the baht recovers. Despite the sharp deteriorationin 1998, the government and private sector demand minimally contributes to economicgrowth in the following period. As explained above, since private capital investment isheavily dependent on external demand, external demand is fundamentally supported theeconomic growth. Export begins to decline in US dollar base, consequently, both domesticdemand and the economic growth are stagnant. In other words, it indicates that the domesticdemand cannot lead to the economic recovery.2 To clarify the government sector contribution to the economic growth, total domestic demand isdivided into government and private sector contributions. Additionally, the private demand is sub-dividedinto corporate capital investment and other demand. This is because Thai corporate capital investment isclosely bound up with the growth of external demand (exports) it can be considered as a part of the externaldemand contribution.

146 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand(%)1050-5-10-15External demandDomestic demand(government)Domestic demand(private corporate capital investment)Domestic demand(other private sector demand)Real growth rate1997 1998 1999 2000 2001 (year)Fig. 2 Contributions of Domestic and External Demand to theEconomic Growth under the Baseline ScenarioB. Future Problems and Possible MeasuresThe results of the above forecast based on the baseline scenario indicate that the Thai economydeteriorates in 1998, and that slow growth is unavoidable. Thus, macroeconomic problems areoccurred in the future prospect. This section examines the effects of the currency crisis andseveral possible measures for the economic recovery.To examine concrete suggestions, effects of the currency crisis are categorized into shorttermand medium/long-term (Fig. 3).Short term effects Loss from revaluation on foreigncurrency debtEconomic depression 1998 Rising unemploymentCredit crunchMeasuresShort term measuresStabilization and reversal of exchange value of bahtDemand stimulatingeffectsMedium/long-term measures Additional public investmentJob creationReal interest rate riseInhibition of private capitalinvestmentMedium/long-term effects Downward deflection of economicgrowthProlonging ofunemployment problemLow interest lendingFunding for capitalinvestmentExport promotionIndustrial structuralchangeFunding via two-steploans, etc.Increase in foreigndirect investmentHuman resource developmentFig. 3 The Economic Crisis -- Effects and Measures

OECF Journal of Development Assistance Vol.4, No.1, 1998 1471. Future Issuesa) Weak economic growthIt is expected that the currency crisis precipitates a big business depression in the shortterm, and to deflect the economic growth trend to downward in the medium to long term.From the second half of the 1980s, Thailand achieved sustainable high economicgrowth by rapid growth of foreign direct investment. This was possible because of smoothfinancing of the current account deficit and allowing domestic over-investment. However,due to the recent currency crisis, it is more difficult to finance a large current accountdeficit. Therefore, there is a strong possibility that financial constraints will force adownward deflection of the long-term economic growth trend.b) UnemploymentThe effects of this downward deflection are significantly reflected in higher unemploymentin both the short and the medium to long term. As shown in the baseline scenario, the Thaijob market is expected to downsize from 1997 through 1999 and to keep slow employmentgrowth after that. This part examines the supply and demand of labor in detail.Table 8 shows the labor supply and demand. The situation is deteriorating rapidly,and the number of jobless expected to increase by about 300,000 in 1998, 400,000 in 1999,and between 200 and 300,000 in a year from 2000.The situation could be even worse than the expectation in the baseline scenario sincethe Bank of Thailand, for example, is forecasting the unemployment rate of around 5.6% in1998.Table 8Labor Supply and Demand in the Baseline Scenario1997 (est) 1998 (est) 1999 (est) 2000 (est) 2001 (est)Population (millions) 60.7 61.3 61.9 62.6 63.3Y/Y change (%) 1.0 1.0 1.0 1.0 1.1Participation rate (%) 53.6 53.6 53.6 53.6 53.6Labor force (millions) 32.6 32.9 33.2 33.5 33.9Y/Y change (%) 0.5 1.0 1.0 1.0 1.1Employees (millions) 30.8 31.3 31.4 31.4 31.5Y/Y change (%) -1.3 -0.3 0.1 0.0 0.4Unemployed persons (millions) 1.2 1.5 1.9 2.2 2.4Y/Y change (%) 130.0 37.3 19.8 18.0 11.4Unemployment rate (%) 3.5 4.7 5.6 6.5 7.2c) Impact of credit crunchThe credit crunch is considered serious enough in the short term to cause bankruptcy,including several companies which are comparatively strong financial structure. It could

148 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailandalso cause problems for the future as difficult financing conditions prompt private companiesto reduce capital investment. This leads to downshift of economic growth in the mediumtolong-term period.d) Other problemsOther effects of the currency crisis are: 1) increase in loss from revaluation of foreigncurrency debt in individual companies; 2) increase in the real interest burden shifting fromdollars to bahts. The first problem is hard to evaluate quantitatively, and difficult to analyzeby an econometric model. Same as the credit crunch, the second problem is an issue of midand long period since private companies curtail their capital investment.2. Measuresa) Short-term measuresAs explained, unemployment is expected to deteriorate from 1998 and a quick response isrequired. The private sector has been damaged by the currency crisis; therefore fiscalmeasures, increased public investment are effective. Although the implementation of fiscalmeasures, of course, conflict with retrenchment finance, required by the IMF as a conditionfor its support, the pros and cons of this approach are discussed more detailed later.b) Medium- and long-term measuresSince the credit crunch and increases in the real interest burden depress capital investment,measures are necessary for the medium to long term. Action must be taken to revitalizeprivate capital investment, such as low interest loans. Expansion of public finance throughtwo-step loans, for example, is helpful while the commercial banks remain reluctant lenders.Increase in the real interest burden which has accompanied the shift from dollar funding tobaht funding could also be mitigated by the introduction of low interest finance. 3In the medium and long term, the downward deflection of economic growth createsserious problems. The following requirements must be achieved for recovering Thaieconomic growth.First, export growth must be maintained. To this end, sustainable promotion of foreigndirect investment is crucial.Second, it is necessary to ensure that corporate capital investment is adequately funded.The current account deficit makes more difficult to finance and, if export is expanded, thencompanies need access to a ready supply of capital. Two-step loans could be one solution.Third, industry must be restructured so that imports grow more slowly than exports.This solution will take longer time than the other solution to achieve; however, it gives adirect effect on the first requirement because it stimulates export and improves the tradebalance.3 Analyzing the macroeconomic effects of this measure is be even more difficult; therefore, theanalysis to a simulation of the effects of increased lending rates is shown in Supplementary Table No.1 atthe end of this paper.

OECF Journal of Development Assistance Vol.4, No.1, 1998 149C. Measures for Recovery from the Currency CrisisThe previous part examines the likely effects of the currency crisis and suggested some possiblemeasures. This section outlines scenarios in 3 situations supplementation of public investment,increase foreign direct investment, increase in private capital investment, by the econometricmodel -- the same model as in the baseline simulation – which estimates the likely effects ofeach of policy options. Additionally, this analysis identifies feasible measures by combinationof the three options.1. Additional Public Investment Scenarioa) Assumptions and dimulation resultsThe first scenario is to increase public investment more than in the baseline scenario byswitching to an active fiscal policy stance.Under the IMF conditionality, the Thai government responded to the currency crisisby cutting planned expenditure to 81.5% of the original budget for FY98. In the discussionwith the IMF in February, the expenditure constraint was released to -2.0% of GDP.However, there was little scope for increased government spending under the severerestriction on the fiscal deficit because the baseline scenario forecasts that the fiscal deficitremains at -2.0% of GDP until 2001.Since the currency crisis damages on the private sector and it is still deteriorating,expansion of fiscal policy is essential. However, this is inconsistent with the retrenchmentfinance under the IMF conditionality.Following simulation is designed to find out the likely effect on the economy byreleasing the constraints on the fiscal deficit and increasing government expenditure (publicinvestment) to examine impact on improvement of currency crisis. The results of thissimulation assess the merits and demerits of the IMF conditionality, which is insistence onthe tight fiscal stance.Public fixed capital formation increases to 6% in the real base per year from 1999through 2001.All other assumptions are same in the baseline scenario.The results of simulation are shown in Table 9. The remarkable point is that theeconomic growth rate improves to 0.71%(from -1.75% by the baseline scenario) becauseof increase in public investment. On the other hand, due to the increase of public investment,the fiscal defisit is deteriorated. It also contributes to higher economic growth and lowerunemployment in the long-term. However, the expansion of demand leads to more imports,consequently, the trade balance deteriorates to -0.51% of GDP by 2001.

150 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandTable 9Main Economic Indicators under the Additional Public Investment Scenario(Unit: %)1997 (est) 1998 (est) 1999 (est) 2000 (est) 2001 (est)Real GDP growth rate -0.91 -4.52 0.71 1.98 2.90Unemployment rate 3.46 4.70 5.00 5.81 6.42Inflation (CPI) 5.61 10.76 7.27 3.10 2.86Inflation (WPI) 4.39 13.19 5.91 1.69 1.67Ratio of trade balance in GDP -2.84 2.18 0.51 -0.02 -0.51Change in goods exports (USD) 2.43 4.86 3.84 5.64 5.42Change in goods imports (USD) -15.22 -6.87 7.21 6.88 6.51Ratio of fiscal balance in GDP -0.58 -1.85 -3.73 -4.24 -4.60Change in central government revenues -0.64 -18.44 -3.20 5.29 6.67Change in central government expenditure 6.91 -10.28 10.22 8.05 8.39b) Contributions of domestic and external demandThe results of the analysis of the additional public investment scenario from the standpointof the contributions of domestic and external demand are illustrated in Fig. 4. In additionto the increase in the government's contribution, the contribution of external demand isreduced by import growth promoted by economic growth.10(%)50-5External demandDomestic demand(government)-10Domestic demand(private corporate capital investment)Domestic demand(other private sector demand)Real growth rate-151997 1998 1999 2000 2001 (Year)Fig. 4 Contributions of Domestic and External Demands under theAdditional Public Investment Scenarioc) Comparison with the baseline scenarioIn order to clarify differences between the 2 scenarios, 3 points are compared between thebaseline scenario and the additional public investment scenario. First, Fig. 5 illustrates the

OECF Journal of Development Assistance Vol.4, No.1, 1998 151changes in real GDP, and its domestic and external demands under the 2 scenarios.The results are consistent with Fig.6, and the domestic demand clearly increases; onthe other hand, the external demand decreases.Next focus is private final consumption, which shares a large part of domestic demand.Fig. 6 indicates the percentage of real household disposable income and real private finalconsumption expenditure(of the additional public investment scenario in) the baseline scenario.The figure shows an increase of about 3.0% in real final consumption expenditure by 2001.The baseline scenario forecasts the sharp growth of unemployment. Therefore, demandfor labor are compared between the baseline scenario and the Additional public investmentscenario. 4 The results indicate that the additional investment generates 270,000 new jobsby 2001, and significantly easing the problem of unemployment significantly mitigates.(%)76543210-1-2-3External demandDomestic demandGDP1998 1999 2000 2001 (Year)4.5(%)4.03.53.02.52.01.51.00.5Real disposableincomeReal private finalconsumption0.01998 1999 2000 2001(Year)Fig. 5 Changes in Real GDP Compared withDomestic and External DemandFig. 6 Changes in Consumptiond) ConclusionThe above analysis suggests that the active fiscal policy benefited the economic recovery ifavoiding serious deterioration of the trade and fiscal balances. When the private sector isin the a steep depression, the huge reduction in fiscal expenditure inevitably precipitates arecession. Therefore, it is necessary to reassess the value of fiscal remedies at least as ameans of ending recession in the short term.The current policy of cutting public investment is clearly antithetical to the results.There is no doubt the efficacy of tightening the fiscal position as recommended by the IMFas a means of stabilizing the exchange rate and bringing inflation under control. On theother hand, rigid adherence to this approach will have high social costs in terms, for example,in unemployment. Therefore, the further discussion is necessary about retrenchment finance.Finally, under the scenario, additional public investment is real public fixed capitalformation by 6% (approx. 10% nominal). It should be noted, however, that this isaccompanied by a large-scale deterioration in the fiscal balance.4 The model treats the supply of labor as being exogenously determined. We concentrate here,therefore, on the extent of the change in the demand for labor.

152 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand2. Additional Foreign Direct Investment Scenarioa) Assumptions and simulation resultsA second possible measure to the currency crisis is to promote foreign direct investment.As explained above, it is desirable to promote exports as a means of economic growthin the long-term. Generally speaking, measures for promoting export are increasing theamounts of export by strengthening competitive prices, or increasing the sales from exportsby improving value added items. Increasing the receive of foreign direct investment is agood way of achieving these measures.To evaluate the efficacy of this approach, effects of increasing foreign direct investmentis examined by the simulation. 5Foreign direct investment is 50% higher in baht than in the baseline scenariofrom 1999.All other assumptions are same as the baseline scenario.The results of the simulation are in Table 10.The result indicate, although GDP declines in 1999, the economic growth rate improvesrapidly to more than 3% in 2000 and 2001. This is because the time lag between operationand effects of direct investment. The unemployment and the fiscal balance are also improvedthan those under the baseline scenario. In 2000, for example, the real GDP growth improvesalso 2.26% comparing to under the baseline scenario. Unemployment is 0.54% lower andthe ratio of the fiscal balance to GDP is 0.31% better than in the baseline scenario.Increase in dollar based goods exports is estimated 9.58% in 2000 and 7.42% in2001. However, the net trade balance deteriorates comparing to under the baseline scenario.This is primarily due to the increase in imports generated by the expansion of domesticdemand.Table 10Main Economic Indicators under the Additional Foreign Direct Investment Scenario(Unit: %)1997 (est) 1998 (est) 1999 (est) 2000 (est) 2001 (est)Real GDP growth rate -0.91 -4.52 -1.48 3.15 3.62Unemployment rate 3.46 4.70 5.52 5.98 6.53Inflation (CPI) 5.61 10.76 7.05 3.17 2.74Inflation (WPI) 4.39 13.19 5.93 1.67 1.51Ratio of trade balance in GDP -2.84 2.18 1.37 1.44 1.33Change in goods exports (USD) 2.43 4.86 3.85 9.58 7.42Change in goods imports (USD) -15.22 -6.87 5.27 9.54 7.74Ratio of fiscal balance in GDP -0.58 -1.85 -2.65 -2.70 -2.77Change in central government revenues -0.64 -18.44 -8.83 4.92 6.40Change in central government expenditure 6.91 -10.28 -2.42 5.15 6.655 Since the model is unable to take account of future changes in the industrial structure, the effectsof increasing the value added element of exports is not examined.

OECF Journal of Development Assistance Vol.4, No.1, 1998 153b) Contributions of domestic and external demandThe results indicate that foreign direct investment contributes to the support for the Thaieconomy by higher external demand. Although the contribution of external demand actuallydeclines since 1999, private capital investment begins to increase, consequently, and it alsosupports the Thai economy in the additional foreign direct investment scenario.(%)1050-5External demandDomestic demand(government)-10Domestic demand(private corporate capital investment)Domestic demand(other private sector demand)Real growth rate-151997 1998 1999 2000 2001 (Year)Fig. 7 Contributions of Domestic and External Demand under theAdditional Foreign Direct Investment ScenarioNext, differences of economic growth pattern are observed between the pattern inthis growth pattern with the way in which the economy has developed since the second halfof the 1980s and the pattern under the supplemental foreign direct investment. Fig. 7shows the changing pattern of domestic and external demand contributions over the period.The GDP contribution of external demand has clearly been consistently small and at timesnegative. This is because import grows faster than export. As explained in the previouschapter, this problem derives primarily from the structure of Thai industry, which fails toattract supporting industries and materials industries and leads heavily dependence onimports for materials and parts. Failure to change the existing industrial structure is foreseento cause similar problems in the future, when economic growth recovers. The structuralchange inevitably needs a long time, of course, and the government must take immediatelyactions to avoid a serious deterioration of the trade balance.Under the additional foreign direct investment scenario, the contribution of externaldemand to economic growth is sufficient to prevent the rapid expansion of the trade deficitand of the current account deficit. However, the fiscal balance has been deteriorating.Unemployment also continues to deteriorate, although it is more slowly than under thebaseline scenario. In order to overcome these problems, high economic growth is required.

154 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailandc) Comparison with the baseline scenarioIn order to clarify differences between the 2 scenarios, 3 points are compared between thebaseline scenario and the additional foreign direct investment scenario. First, Fig. 8 illustratesthe changes in real GDP and in domestic and external demand. Fig. 8 indicates that moreforeign direct investment leads to increase domestic demand, but to decrease externaldemand. This is consistent with the results of the analysis of the contributions of domesticand external demand to the economic growth under the additional foreign direct investmentscenario.Fig. 9 illustrates the percentage differences between the additional foreign directinvestment scenario and the baseline scenario in domestic demand, namely real householddisposable income and real private final consumption expenditure. The cumulative effecton real private final consumption expenditure, for example, is 2.7% , which is higher thanunder the baseline scenario in 2001.The impact of foreign direct investment on the labor market is significantly beneficialbecause it creates 230,000 additional places to work in 2001.4(%)4.5(%)433Eternal demandDomestic demandGDP4.03.53.0Real disposableincomeReal private finalconsumption22.522.011.511.00-11998 1999 2000 2001(Year)0.50.01998 1999 2000 2001(Year)Fig. 8 Changes in real GDP Compared withDomestic and External DemandFig. 9 Changes in Consumptiond) ConclusionAlthough the results of the simulation indicates that the additional foreign direct investmentdoes not improve the balance of trade, it is forecasted that certain demand stimulatingeffects because the ratio of trade defisit in the GDP is estimated to keep 0.33% in 2001.Thus, in the medium- to long-term perspective, if the pattern of trade is restructured,such as promoting exports by increase in foreign direct investment and at the same time,controlling the expansion of import, then the downward deflection of economic growth isconsidered to be prevented. It is also important to strengthen financial support from overseas– in the form of two-step loans, for example – in order to make up for the current accountdeficit until the trade restructure is completed.Industries which primarily receive financial assistance should be determined, 1) toensure that the capital was provided for export industries for stimulating external demandeffect, and 2) to develop supporting industries which contribute to the development of asustainable trade growth.

OECF Journal of Development Assistance Vol.4, No.1, 1998 1553. Additional Private Capital Investment Scenarioa) Assumptions and simulation resultsA third measure to the currency crisis is to stimulate private capital investment which iscurtailed in response to the economic recession. One effective way of revitalizing privatecapital investment is policy finance, which includes two-step loans from organizationssuch as the OECF. This option is discussed in more detail in Chapter III. If credit crunchcauses the current reduction of capital investment, this could be alleviated by expandingpublic lending programs including two-step loans. As explained above, if the amount ofcapital supplied through public lending facilities is assumed to be directly converted intocapital investment, then the macroeconomic effects can be also measured. In the followingsimulation, increase in private capital investment is assumed to be precisely commensuratewith capital input to the sector through financial programs such as two-step loans.Private capital investment is increased by a real 6% F/Y from 1999 to 2001.All other assumptions are same as in the baseline scenario.Table 11Main Economic Indicators under the Additional Private Capital Investment Scenario(Unit: %)1997 (est) 1998 (est) 1999 (est) 2000 (est) 2001 (est)Real GDP growth rate -0.91 -4.52 -0.85 1.69 2.91Unemployment rate 3.46 4.70 5.34 6.15 6.70Inflation (CPI) 5.61 10.76 7.12 3.05 2.74Inflation (WPI) 4.39 13.19 5.93 1.70 1.61Ratio of trade balance in GDP -2.84 2.18 0.75 0.15 -0.55Change in goods exports (USD) 2.43 4.86 3.84 5.64 5.39Change in goods imports (USD) -15.22 -6.87 6.69 7.03 6.94Ratio of fiscal balance in GDP -0.58 -1.85 -2.44 -2.56 -2.59Change in central government revenues -0.64 -18.44 -7.34 4.52 6.57Change in central government expenditure 6.91 -10.28 -2.33 5.03 6.47Table 11 indicates that an increase in private capital investment can boost economic growthby improving the fiscal balance. It can also contributes to solution of unemployment problems.Specifically, the unemployment rate improves to 0.48% comparing to the baseline scenario in2001. However, since the additional private capital investment is higher elasticity of importsthan the public investment scenario, the growth of imports prevents of the improvement in GDP.This is discussed in more detail in the analysis of domestic and external contributions below.b) Contributions of domestic and external demandFig. 10 illustrates the contributions of domestic and external demand. Expansion of thedomestic demand contribution is observed, in addition, the external demand is diminishedby an increase in imports (Fig. 10).

156 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand10(%)50-5External demandDomestic demand(government)-10Domestic demand(private corporate capital investment)Domestic demand(other private sector demand)Real growth rate-151997 1998 1999 2000 2001 (Year)Fig. 10 Contributions of Domestic and External Demand under theAdditional Private Capital Investment Scenarioc) Comparison with baseline scenarioFig. 11 illustrates the percentage differences in the additional private corporate investmentscenario compared with the baseline scenario in two major components of domestic demand,namely real household disposable income and real private final consumption expenditure.The positive effect on domestic demand and the negative effect on external demand areobserved.The effects of the additional private capital investment scenario on private finalconsumption are compared with the baseline scenario in Fig. 12. The macroeconomiceffects are positive on both private final consumption and labor market. In 2001, for example,real private final consumption is boosted by upwards of 1.5% and approximately 170,000new places of work are created.5432(%)Eternal demandDomestic demandGDP(%)2.52.01.5Real disposableincomeReal private finalconsumption101.0-1-20.5-31998 1999 2000 2001 (Year)Fig. 11 Changes in Real GDP Compared withDomestic and External Demand0.01998 1999 2000 2001(Year)Fig. 12 Changes in Consumption

OECF Journal of Development Assistance Vol.4, No.1, 1998 157d) ConclusionIt is dearly expected that large increase in private capital investment generates the greatimpact on the macro-economy and demand stimulating effects. The demand stimulatingeffect is somewhat diminished by the high elasticity of imports to private investmentcomparing to the government investment; however, it offers the opportunities of introducingan additional measure of freedom into fiscal policy to improve the fiscal balance. Therefore,it is feasible to combine policies of fiscal expenditure and private capital investment forstimulating economy without seriously damaging the fiscal balance. However, since thelevel of financial support available in the form of two-step loans to private capital investmentis estimated about Bt 10 billion, the macroeconomic effects are considered to be limited.4. Comparison among ScenariosThe results of the three simulations: public investment, foreign direct investment and privatecapital investment, indicate that each simulation has both positive and negative effects on theeconomy. Increase in public investment, for example, has a fast-stimulating demand effect, butat the same time, it is possible to undermine the fiscal balance. On the other hand, increased incapital investment and foreign direct investment have positive effects both on exports and on thefiscal balance, but they need a long time to work (Table 12). This is clear in Fig. 3 in Section 2.2"Future problems and possible measure", which is recognized that public investment to thecategory of short-term measures and funding via two-step loans and increased foreign directinvestment as medium/long-term measures.(Index: 1998 100 = 100) 106104Baseline scenarioAdditional public investment scenarioAdditional foreign direct investment scenarioAdditional private corporate investment scenario102100981998(est) 1999(est) 2000(est) 2001(est)Fig. 13 Comparison of Real GDP (index) Values under the Three Scenarios

158 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandTable 12Comparison of Main Economic Indicators under Different Scenarios(Unit: %)Real GDP growth rate (%)1996 (act) 1997 (est) 1998 (est) 1999 (est) 2000 (est) 2001 (est)Baseline scenario 5.52 -0.91 -4.52 -1.75 0.89 2.31Additional public investment scenario 5.52 -0.91 -4.52 0.71 1.98 2.90Additional foreign direct investment scenario 5.52 -0.91 -4.52 -1.48 3.15 3.62Additional private corporate investment scenario 5.52 -0.91 -4.52 -0.85 1.69 2.91Unemployment rate (%)Baseline scenario 1.51 3.46 4.70 5.57 6.52 7.18Additional public investment scenario 1.51 3.46 4.70 5.00 5.81 6.42Additional foreign direct investment scenario 1.51 3.46 4.70 5.52 5.98 6.53Additional private corporate investment scenario 1.51 3.46 4.70 5.34 6.15 6.70Ratio of trade balance to GDP (%)Baseline scenario -9.08 -2.84 2.18 1.63 1.72 1.66Additional public investment scenario -9.08 -2.84 2.18 0.51 -0.02 -0.51Additional foreign direct investment scenario -9.08 -2.84 2.18 1.37 1.44 1.33Additional private corporate investment scenario -9.08 -2.84 2.18 0.75 0.15 -0.55Ratio of fiscal balance to GDP (%)Baseline scenario 0.74 -0.58 -1.85 -2.69 -3.01 -3.23Additional public investment scenario 0.74 -0.58 -1.85 -3.73 -4.24 -4.60Additional foreign direct investment scenario 0.74 -0.58 -1.85 -2.65 -2.70 -2.77Additional private corporate investment scenario 0.74 -0.58 -1.85 -2.44 -2.56 -2.59Note : means improvement by more than 1% in the baseline scenario.means improvement by more than in the baseline scenario.means deterioration by more than 1% in the baseline scenario.5. Composite Scenario-- additional public investment, additional foreign direct investment and additional privatecapital investment scenarios combined --The three scenarios are not mutually exclusive and they can be combined to improve the overalleffect by offsetting each other's weak points. Therefore, two combined scenarios are observed inorder to make up for the each scenario's weak points. Consequently, the results is evaluated whatis the best composite scenario for the economic recovery.Composite scenario No.1:Straight combination of the additional public investment, additional foreign directinvestment and additional private capital investment scenariosComposite scenario No.2: Real public investment expands 6% per year in 1999, after that the growth rate isset 0%. Foreign direct investment expands 50% more than in the baseline scenario since1999. Real private capital investment expands 6% per year since 2000.

OECF Journal of Development Assistance Vol.4, No.1, 1998 159Composite scenario No.1 is a combination of the additional public investment, additionalforeign direct investment and additional private capital investment scenarios without modification.By contrast, composite scenario No.2 considers the timing of the effects generated by theindividual scenarios and combines the early efficacy of the additional public investment scenarioand the positive features of the other two scenarios. Specifically, the scenario is assumed that"public investment increase in 1999; at the same time, foreign direct investment is encouragedderegulations, and from 2000 onwards, private capital investment is supported using programssuch as two-step loans" from 2000.First, the two composite scenarios are compared with the baseline scenario and the threemodified scenarios (Table 13). Composite scenario No.1 predicts relatively strong economicgrowth from 1999 with the significant improvement of unemployment. The rapid recovery alsoleads to high increase in imports; however, trade deficit is expected from 1999 onwards.In contrast, composite scenario No.2 estimates the positive economic growth begins in1999, and it is expected to exceed 3% in 2000 (Fig. 14). The scenario makes use of the fastaction of Additional Public Investment to generate growth and support the economy, but it securesthe same size fiscal deficit as the baseline scenario, which assumes the adoption of a tight fiscalpolicy, by 2001. The unemployment rate also holds steady within 5% during this period.The above indicates that composite scenario No.2 is the best scenario, which supports theeconomy and secures steady economic growth in the medium term, while at the same time, itprevents a significant deterioration of the trade and fiscal balances. Moreover, considering limitsto the financial assistance available to Thailand, there is also a trade-off relationship betweenfinancial assistance to the government and assistance to the private sector. Therefore, compositescenario No.2 is considered the most successfully for this trade-off by providing assistance to thegovernment sector, then providing assistance to the private sector.(Index: 1998=100)112Baseline scenario109Composite scenario No.1Composite scenario No.2106103100971998(est) 1999(est) 2000(est) 2001(est)Fig. 14 Comparison of Real GDP Growth under the Composite Scenarios

160 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandTable 13Comparison of Main Economic Indicators under the Baseline Scenario andTwo Composite Scenarios(Unit: %)Real GDP growth rate (%)1996 (act) 1997 (est) 1998 (est) 1999 (est) 2000 (est) 2001 (est)Baseline scenario 5.52 -0.91 -4.52 -1.75 0.89 2.31Composite scenario No.1 5.52 -0.91 -4.52 1.90 4.96 4.72Composite scenario No.2 5.52 -0.91 -4.52 0.97 4.21 4.08Unemployment rate (%)Baseline scenario 1.51 3.46 4.70 5.57 6.52 7.18Composite scenario No.1 3.46 3.46 4.70 4.71 4.92 5.35Composite scenario No.2 3.46 3.46 4.70 4.91 5.26 5.77Ratio of trade balance to GDP (%)Baseline scenario -9.08 -2.84 2.18 1.63 1.72 1.66Composite scenario No.1 -2.84 -2.84 2.18 -0.62 -1.79 -2.84Composite scenario No.2 -2.84 -2.84 2.18 0.24 -0.61 -1.33Ratio of fiscal balance to GDP (%)Baseline scenario 0.74 -0.58 -1.85 -2.69 -3.01 -3.23Composite scenario No.1 0.74 -0.58 -1.85 -3.34 -3.30 -3.27Composite scenario No.2 0.74 -0.58 -1.85 -3.64 -3.40 -3.18Note : " ", " ", " " : Refer to note to Table 12III. CORPORATE FINANCING AND THE IMPACT OFPOLICY INTERVENTIONIn the preceding chapters, the measures to mitigate the effects of the currency crisis are examinedwith combinations of public investment, private capital investment and foreign direct investment.To devise a detailed strategy based on increased capital expenditure and investment would,however, call for a more detailed analysis of current conditions and this would involve researchingprivate companies.Therefore, for the consideration of the effective way of assistance for Thai economy, thepresent chapter examines following two points.First is what limitations the structure of Financing in Thailand imposes on the way inwhich Thai companies fund capital investment. Specifically, what effects have a company'sattributes on its ability to raise money for capital investment.Second is whether the government policy intervention helped to reduce these problemsand, if so, how policy interventions contribute to reduce problems. Two types of governmentpolicy intervention are examined: Investment promotion policy as devised by the Board ofInvestment; Distribution of capital in accordance with the dictates of policy finance.A. Thailand's Financing StructuresAccording to the Modigliani-Miller theorem, in a perfect neo-classical capital market, the cost ofcapital to a firm is independent of the financing method used. It has been pointed out, however,that today, despite the existence of competitive fully-formed securities markets and a variety of

OECF Journal of Development Assistance Vol.4, No.1, 1998 161financial intermediaries, companies still face problems including external diseconomies due tothe asymmetry of information, rising costs of technical development, agency costs, and availability.In developing countries, however, the financial markets are not modern markets as weknow, even with all the problems we have just described. They are in practice complex and"imperfect". Financing mechanisms tend to reflect the history of the country and to form as theeconomy grows by a sort of trial and error process. Some of the resultant failings can be correctedas the market develops but many cannot; this is where the market's imperfections lie. Theinefficiencies that accompany market failure are consequently more serious in developing countrymarkets than they are in developed country markets.For example, although Thai economy is in transition, the functional inadequacies of thebanking sector and securities markets inhibit their response to the demand for funds and becomeobstacles for the development of Thai economy. There are several problems preventing thecommercial banks from adequately fulfilling their functions as intermediaries. These includefollowing facts: (1) commercial banks are often core companies of corporate groups and thisleads to uneven distribution of the funds at their disposal; (2) lending is extremely short term; (3)their information production skills are limited. Fourth fact relates to (4) the functional limitationsof the securities markets. Fifth fact compensates for the inadequacies of these four facts, whichis (5) the formation of joint ventures with foreign companies investing directly in Thailand.These facts are discussed in more detail below.B. Thai Industry's Financing Structure1. Survey Targets and Sample CompaniesWith the help of the above observations and individual company financial data, we will nowanalyze the structure of Financing in Thailand. 6 Sample companies were classified by attributeas shown in Tables 14 (1) and (2).The distributions of target companies classified as above are shown in Tables 15 (1) and(2).6 The companies that form the subjects of this analysis are the top 922 Thai manufacturing companieson a gross asset basis (1994). Companies were selected from among the manufacturers listed in FinancialDay 2000 published by Managers Information Service. Samples were taken between 1991 and 1995. TheThai companies chosen were either listed on SET or were non-listed companies with a duty to lodge financialstatements (asset and liability statements, income statements) with the Ministry of Commerce's Departmentof Commercial Registration. The above materials are open to inspection both in SET and in the Bureau butfor the purpose of the present analysis we used data prepared from these materials and held on a magneticstorage medium. Gaps and doubtful elements in the data reduced usable data to that relating to 685 companies.There have long been serious doubts about some of the data reported to the Department of CommercialRegistration; there is thus a clear need for careful scrutiny of data prior to use. For the present study, weeliminated obviously doubtful data but in-depth scrutiny of the analysis and of the data on which it is basedis yet to be undertaken.

162 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandTable 14 (1)Company Classifications and CategoriesIndustrial sectorClassificationFood processingTextiles and clothingTimber productsPaper and paper productsChemicalsNon-metalsMetals and machineryListed/unlistedSizelargeMediumSmallClassification method and categoriesBusinesses are first classified in accordance with the three-digit InternationalStandard Industrial Classification (ISIC). The classifications are thereaftercondensed into two-digit based groups. Classification is carried out inaccordance with "Financial Day 2000" published by MIS.Food, beverage and tobacco manufacturersWoven goods, clothing and footwear companiesTimber materials and product manufacturers (including furniture)Paper and paper product manufacturers, printers and publishersChemical products, petroleum and coal products and rubber productsNon-metallic mineral product manufacturers (excluding petroleum and coalproducts)Primary metals, metal goods, and machinery and equipment manufacturersCompanies classified by whether they are listed or otherwiseCompanies classified as large, medium or small by reference to their grossassets measured in accordance with IFCT standards.Gross assets more than Bt 1 billionGross assets more than Bt 100 million but not more than Bt 1 billionGross assets more than Bt 25 million but not more than Bt 100 millionBusiness group Businesses classified by business group. First we prepare a list of the top 40business groups 8 (Table 3-2) from Suehiro (1998). 9We then condense theseinto four main groups: (1) Financial conglomerates (groups); (2) Industrialgroups (groups); (3) Foreign groups; (4) Other groups. Next, we classified allcompanies from the Suehiro (1998) Other Companies Directory as belonging togroups (1), (2), (3) or (4). This classification can be applied only with largecompanies already covered in other materials and research.Financial conglomerates Groups including a commercial bank. Corresponds to the "financialconglomerates" refer to by Suehiro (1989), and Suehiro and Nanbara (1992).These groups are almost always centered around a commercial bank.Industrial groups Groups including a manufacturing company (including agribusinesses).Corresponds to the "industrial groups" and "agribusinesses" referred to bySuehiro (1989), and Suehiro and Nanbara (1992)Foreign groupsCompany groups in which the controlling entity is foreign. Defined here as agroup of which upwards of 40% is owned by a foreign company.Other groupsGroups other than those in to above.Table 14 (2)Policy Based Company ClassificationsClassificationInvestment CommitteeapprovedIFCT loan receivedSource: Suehiro Akira Database (1998)Classification method and attributesCompanies classified according to whether or not they have been approved by theInvestment Committee under the terms of the Industrial Investment Promotion Law.Classified as "approved companies" from the year following approval.Companies classified according to whether or not they have at any time received anIFCT loan in connection with an OECF project. Classified as "approved companies"from the year in which the loan is received.7 In this research, business groups are defined as groups containing two or more of the top 1,000companies identified as such by Suehiro (1998). Smaller business groups should be understood to fallwithin the scope of "Other groups".8 Unpublished materials

OECF Journal of Development Assistance Vol.4, No.1, 1998 163Table 15 (1)Company Distributions by Size and IndustryLarge Medium Small TotalIndustry [listed] [listed] [listed] [listed]Food processing 60 24 96 16 3 0 159 40Textiles and clothing 41 25 68 6 6 0 115 31Timber products 8 4 21 5 1 0 30 9Paper and paper products 22 8 21 1 0 0 43 9Chemical products 44 14 81 11 1 0 126 25Non-metals 28 14 21 4 0 0 49 18Metals, machinery, primary metals 71 16 89 4 3 0 163 20Total 274 105 397 47 14 0 685 152Table 15 (2)Company Distributions by Business Group and IndustryBanking Manufacturing Foreign groups Other TotalIndustry zaibatsu zaibatsu[listed] [listed] [listed] [listed] [listed]Food processing 12 1 13 8 9 3 26 12 60 24Textiles and clothing 0 0 12 9 6 3 23 13 41 25Timber products 0 0 0 0 1 1 7 3 8 4Paper and paper products 3 1 4 0 3 1 12 6 22 8Chemical products 0 0 10 5 14 2 20 7 44 14Non-metals 4 1 5 0 3 3 16 10 28 14Metals, machinery, primary metals 5 0 13 1 28 4 24 11 70 16Total 24 3 57 23 64 17 128 62 273 105Note: One large company cannot be readily classified.2. The Basic Finance StructureFig. 15 details various methods of breaking down the population of companies: business group,size, industrial classification, listing. It also collates details of liabilities and capital distilledfrom individual company asset and liability reports. Interesting features include:a) Structure as determined by listing statusThe net worth of listed companies tends on the whole to be much higher among listedcompanies than among non-listed ones (Figs 15 (1) and (2)). The all-company totals indicatea ratio of 42:22:36 for short-term borrowing (bank loans, bills and accounts payable), longtermborrowing and equity capital. This indicates a tendency to rely on short-term finance.By contrast, the listed company totals show a comparable ratio of 33:22:45. This indicatesheavier reliance on equity capital and limited reliance on long-term borrowing. This pointsto a tendency on the part of listed companies to use equity finance to fund their long-termactivities. The ratios of short-term borrowing are smaller across the board than those ofunlisted companies. Thai bank lending tends to be very short term with bills payable and

164 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailandcurrent account overdrafts accounting for a large proportion of the total. As a result, thereis an apparent tendency among manufacturers to fund the bulk of their capital investmentprograms out of short-term borrowing. Taken together, these trends indicate a tendency forlisted companies to replace their short-term borrowing with equity finance. There is evidentlya determination to reduce dependence on non-institutional forms of finance such as billsand accounts payable.b) Structure as determined by business group affiliationIn the following section we examine the characteristics of financing among business groups.The net worth ratios of the financial conglomerates is generally low. The extremelylow listing ratio of this group is clearly a factor although the basic structure is the sameamong unlisted and listed groups. Companies in this group tend to favor long-termborrowing in preference to short-term. This, coupled with their low equity ratios, is probablydue to the availability of long-term loans from the commercial banks at their centers andthe consequent absence of any need to roll over short-term borrowings. The low listingratio of this group can probably also be attributed to the availability of stable long-termfinance from the commercial banks at their hearts.In contrast, the industrial groups tend to have minimal long-term borrowing ratiosbalanced by extremely high equity capital ratios. The equity capital ratios of companies inthis group are also the highest among non-listed companies. The implication is that (1) theindustrial groups have less access than other groups to long-term borrowing from commercialbanks, and (2) they make up the shortfall in long-term finance with the help, for example,of capital increases underwritten by other members of their group. The equity capital ratioof the listed members of this group is extremely high at 48%. Although this suggests thatthey have listed for the purpose of securing long-term funds, the ratio of their long-termfunds to short-term bank loans remains little changed. In other words, companies in industrialgroups appear to have limited access to commercial bank lending whether listed or not.Foreign group companies tend to be rather dependent on equity capital and shorttermbank loans. In the case of the former, this is probably because most foreign companieshave established themselves in Thailand through a process of foreign direct investment; inthe latter case it is probably because they find it easier with the help of parent companyintermediation to obtain this type of funding from the affiliates of foreign banks in Thailand.The declining reliance on short-term funding among the companies in this group suggeststhat they are replacing short-term loans with equity capital.The reliance of companies in other groups on equity capital is limited, particularlyamong non-listed companies. The group is, on the other hand, heavily reliant on long-termloans which group members are obliged to secure from commercial banks that are frequentlyshort of funds themselves.c) Structure as determined by sizeSmall companies rely on short-term borrowing for more than 50% of their funds. This isbecause much of their funding takes the form of bills and accounts payable. On the otherhand, medium-sized companies rely more heavily on short-term bank loans. None of thesmall companies are listed and their reliance on equity capital is minimal. As a result they

OECF Journal of Development Assistance Vol.4, No.1, 1998 165are heavily dependent on short-term funding although long-term borrowing is starting toplay a more important role. One of the distinctive features of small companies is the heavyreliance they place on short-term funding in the form of bills and accounts payable.Medium-sized companies are more reliant than large companies on short-termborrowing and are to that extent less dependent on long-term borrowing. At 36%, theirequity capital ratios are lower than those of large companies although those of listed mediumsizedcompanies are high at 58%. The implication is that for listed medium-sized companies,the stock market represents an attractive alternative to both long- and short-term borrowing.Large companies tend as a rule to have relatively high long-term borrowing ratios,whether listed or not.Owners' equity = Owners' equity / Total assetsLong-term borrowing = Long-term borrowing / Total assetsShort-term borrowing = (Short-term bank loans + notes payable and accounts payable)/ Total assetsCapital investment = (Tangible fixed assets as of the end of the current year - Tangiblefixed assets as of the end of the previous year) / Total assets60%50%40%(1) All companiesOwners' equityShort-term borrowingLong-term borrowing30%20%10%0%LargecompaniesMediumcompaniesSmallcompaniesBankingzaibatsuManufacturingzaibatsuForeigngroupsotherFoodprocessingTextiles andclothingTimberproductsPaper andpaperproductsChemicalproductsNon-metalproductsMetal andmachineryFig. 15 Composition of Funding and Capital Investment by Company Type

166 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand60%50%(2) Listed companies40%30%Owners' equityShort-term borrowingLong-term borrowing20%10%0%LargecompaniesMediumcompaniesSmallcompaniesBankingzaibatsuManufacturingzaibatsuForeigngroupsotherFoodprocessingTextiles andclothingTimberproductsPaper andpaperproductsChemicalproductsNon-metalproductsMetal andmachinery10%(3) Capital investment8%Listed companiesAll companies6%4%2%0%LargecompaniesMediumcompaniesSmallcompaniesBankingzaibatsuManufacturingzaibatsuForeigngroupsotherFoodprocessingTextiles andclothingTimberproductsPaper andpaperproductsChemicalproductsNon-metalproductsMetal andmachineryNote: The structure of Financing is based on data for a single fiscal year (FY94); the capital investmentpattern was gleaned from panel data collected between 1990 and 1995.Fig. 15 Composition of Funding and Capital Investment by Company Type3. Normality TestsIn this section we use descriptive statistical methods to elucidate the trends discernible at individualcompany level in long- and short-term borrowing and in capital investment as affected by corporatecategories in the above group-level observations. The results will be used in the following sectionas a basis for the estimation of borrowing and investment functions.Our method of analysis (shown below) was to collect panel data relating to corporate

OECF Journal of Development Assistance Vol.4, No.1, 1998 167categories, long-term borrowing, short-term bank loans and other forms of short-term fundingfor each company and year, to compare the differences between the samples "with" and those"without" each attribute, and to determine whether the differences are significant or not by usingthe means and distributions of the samples to verify their normality. The standardizationcoefficients of the standard normal distributions is formulated as follows.Z =X 1− X 0δ 2 0n 0+ δ 1n 12X, and n denote the mean, standard deviation and number of samples.The index numbers indicate that samples either have or do not have a particularattribute. "1" = With, "0" = WithoutThe variables that will form the subject of our analysis are as follows:Capital investment = (Tangible fixed assets - Tangible fixed assets in previous year) / Total assets 9Long-term borrowing = Long-term borrowing / Total assetsShort-term borrowing = (Short-term bank loans + Bills and accounts payable) / Total assetsShort-term bank loans = Short-term bank loans / Total assets3,475 samples (685 companies) are used, the discrepancy being due to gaps both in corporatecategories and financial statements.The results of analysis of all target companies are shown in Table 16 (1). Let us look firstat business groups. Member companies of financial conglomerates tend to have comparativelyhigh levels of long-term borrowing and short-term borrowing but only low levels of short-termbank loans. It appears that members of these groups have ready access to the commercial bankat their center and thus combine their reliance on equity capital with a comparatively high levelof long-term borrowing. This tends to reduce their demand for short-term borrowing. It isnoticeable that financial conglomerates companies tend to have lower capital investment levelsthan companies in other groups (Fig. 15 (3)). Industrial groups companies have fairly highlevels both of short-term borrowing and of short-term bank loans. On the other hand, foreigngroups have high levels of capital investment but only low levels of long-term borrowing. Thissuggests that foreign group companies prefer direct equity investment by their parent companiesto raising funds in the secondary markets (see Kishi (1992), for example).9 Annual capital investment is normally calculated by deducting depreciation expense (or the annualincrease in accumulated depreciation) from the increase in gross tangible fixed assets during the year.However, since our target companies were inconsistent as to whether they showed tangible fixed assets netor gross in their financial reports, and since it was not always possible to obtain figures for depreciationexpense, we opted simply to treat the annual increase in items posted to tangible fixed asset accounts ascapital investment.

168 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandListed companies have a low preference for long- and short-term borrowing (Table 16 (4)).As explained in the previous section, they rely heavily on equity finance and maintain highlevels of equity capital. They also maintain comparatively high levels of capital investment.The following policy-related tendencies are observed (Table 16 (4)). First, companiesspecified by the Board of Investment had high levels of long-term borrowing and placed minimalreliance on short-term funds. Companies in receipt of IFCT loans are found to have low levels oflong-term borrowing.Table 16Normality Tests(1) By Company SizeNumber ofsamplesSample meanSamplevarianceDifferencebetween meansStandardizationcoefficientFund raising structureLong-term borrowingAll samples 3475 16.57% 0.0276Large companies 1353 17.05% 0.0293 0.0094 1.6064 *Medium companies 2056 15.92% 0.0251 -0.0133 -2.3014 **Small companies 66 46.86% 0.1003 0.3039 7.7759 ***Short-term borrowingAll samples 3475 33.21% 0.0500Large companies 1353 27.31% 0.0402 -0.0967 -13.0951 ***Medium companies 2056 36.58% 0.0509 0.0825 11.0049 **Small companies 66 49.28% 0.0898 0.1639 4.4201 **Short-term bank loansAll samples 3475 18.43% 0.0298Large companies 1353 17.20% 0.0251 -0.0205 -3.5106 ***Medium companies 2056 19.21% 0.0327 0.0189 3.2518 ***Small companies 66 20.87% 0.0358 0.0247 1.0508Capital investmentAll samples 2721 3.93% 0.0285Large companies 1062 5.31% 0.0366 0.0227 3.2677 ***Medium companies 1609 3.11% 0.0238 -0.0198 -2.9156 **Small companies 50 0.59% 0.0015 -0.0340 -5.3012 ***

OECF Journal of Development Assistance Vol.4, No.1, 1998 169(2) By Business Group (Large Companies)Number ofsamplesSample meanSamplevarianceDifferencebetween meansStandardizationcoefficientFund raising structureLong-term borrowingAll samples 1348 17.05% 0.0293Financial conglomerates 119 21.06% 0.0270 0.0399 2.5264 **Industrial groups 276 16.33% 0.0293 -0.0064 -0.5654Foreign groups 312 14.19% 0.0228 -0.0351 -3.4662 ***Oher groups 631 17.93% 0.0316 0.0175 1.8748 *Short-term borrowingAll samples 1348 27.12% 0.0394Financial conglomerates 119 24.69% 0.0402 -0.0242 -1.2641Industrial groups 276 29.73% 0.0342 0.0275 2.2237 *Foreign groups 312 25.98% 0.0362 -0.0148 -1.1853Oher groups 631 27.22% 0.0429 0.0019 0.1736Short-term bank loanAll samples 1348 16.96% 0.0238Financial conglomerates 119 13.36% 0.0181 -0.0361 -2.7699 **Industrial groups 276 19.51% 0.0265 0.0257 2.4055 **Foreign groups 312 16.55% 0.0213 -0.0053 -0.5528Oher groups 631 16.81% 0.0245 -0.0028 -0.3376Capital investmentAll samples 1050 3.67%Financial conglomerates 95 2.26% 0.0139 -0.0336 -2.4540 **Industrial groups 217 4.31% 0.0238 -0.0126 -1.0082Foreign groups 243 7.15% 0.0186 0.0238 2.1057 **Oher groups 495 5.51% 0.0559 0.0036 0.2971(3) IFCT loan ReceivedNumber ofsamplesSample meanSamplevarianceDifferencebetween meansStandardizationcoefficientFund raising structureLong-term borrowingAll samples 2952 15.62% 0.0247IFCT loan received 41 8.92% 0.0098 -0.0685 -4.3532 ***Short-term borrowingAll samples 2952 32.55% 0.0460IFCT loan received 41 28.97% 0.0317 -0.0363 -1.2929Short-term bank loanAll samples 2952 18.52% 0.0290IFCT loan received 41 20.00% 0.0257 0.0150 0.5941Capital investmentAll samples 2337 4.37% 0.0217IFCT loan received 31 7.61% 0.0129 0.0329 1.5937

170 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand(4) Other Attributes (BOI Privilege, SET listing)Number ofsamplesSample meanSamplevarianceFund raising structureLong-term borrowingAll samples 3299 16.44% 0.0270Investment CommitteeDifferencebetween meansStandardizationcoefficientspecification979 18.25% 0.0312 0.0271 4.1511 *SET listing 755 9.31% 0.0160 -0.1078 -18.9221 ***Short-term borrowingAll samples 3299 33.19% 0.0504Investment Committeespecification979 31.80% 0.0465 -0.0197 -2.3543 *SET listing 755 24.49% 0.0244 -0.1128 -15.3387 ***Short-term bank loanAll samples 3299 18.39% 0.0300Investment Committeespecification979 20.43% 0.0329 0.0294 4.3446 ***SET listing 755 16.80% 0.0200 -0.0212 -3.3688 ***Capital investmentAll samples 2558 3.90% 0.0295Investment Committeespecification793 3.54% 0.0151 -0.0043 -0.7015SET listing 602 5.04% 0.0111 0.0148 2.4514 **Note : *** = significant at 1%, ** = significant at 5%, * = significant at 10%C. Estimation of Lending and Investment FunctionsAn implication of the above analysis is that corporate and policy attributes have some sort ofeffect on bank lending and corporate borrowing. For a rigorous identification and analysis ofthese effects, however, it is necessary to control other factors in addition to the corporate andpolicy attributes of the sample. The present section attempts to estimate the lending function andthe capital investment functions in order to conduct accurate measurements of corporate bankborrowing and capital investment. The functions are formulated primarily on the pattern providedby Mieno (1997).1. Lending Functiona) Derivation of the functionThe model is based on the assumption that when preparing to lend, financial institutionscompare the expected return on their planned lending with the likely return on alternativeassets and only go ahead if the expected return from lending exceeds a given level. 10 Theterm "lending function" is used here to indicate a reduced form relating to loans in which10The model assumes simultaneous determination by the bank of lending amounts and rates underconditions of lending or bilateral monopoly. Under monopoly conditions, the bank will opt for the contractthat maximizes its profit on the demand-for-funds curve. If the costs of financing and other variable costsassociated with lending are considered separately, the bank's expected (net) return is given by the followingformula:EL = p(I ) ⋅ rL + (1 − p ( I )) ⋅ CO − r dL − C(L), r = D(L )

OECF Journal of Development Assistance Vol.4, No.1, 1998 171the amount and rate are determined simultaneously as the financial institution's main balance.This part estimates the lending function in accordance with the Tobit model.Determination of the lending amount and rate also depends on the demand-for-fundsfunction. When the agency costs of external funds are taken into account, the demand-forfundsfunction will be determined simultaneously with the capital investment function.With this in mind, this part also makes an estimate including retained earnings and the rateof return on total capital -- factors that determine the demand for funds -- as explanatoryvariables. The return on total capital and a risk dummy are also introduced as positive andnegative company related information. On the basis of the above, we can formulate theestimator for the lending function as follows.L = α 0 + α 1 rd + α 2 ER + α 3 Risk + α 4 INC + βAD + γ 0 (1 + δAD)PDL = Long-term borrowing / Total assets, Short-term borrowing / Total assets, Total borrowing /Total assetsr d= Call rateER = Expected return = Average rate of return on total capital (Current income / Total assets) of thisand the last 2 yearsRisk= Variable coefficient of the rate of return on total capital (Current income / Total assets) of thisand the last 2 yearsINC= Retained earnings = (Current income - Dividend payout - Directors' bonuses) / Total assetsThe object of our investigation is first to ascertain the effects of corporate categorieson lending levels. In other words, we want to introduce corporate categories into theestimator as dummy constants to evaluate the effects of each one on the lending level.Second, we want to ascertain the effects of policy factors -- specification by the Board ofin which p, r, L, CO, r d, C(•) and D(•) denote the bank's subjective probability of project success,gross lending rate, amount of loan, amount of collateral, financial institution's cost of funds (= rate of returnon alternative assets), lending expense function, and inverse function of the demand for funds. I denotespositive information about the project. In this case, the success of the project means a return in excess ofthe total payments of principal and interest, and repayment of the full amount by the borrower. Thefollowing assumptions are made with respect to p, C(•) and D(•):∂p< 0, C' (•) > 0, C"(•)> 0, D'(•)< 0, D"(•) = 0∂rAssuming the bank determines (L,r) in accordance with the profit maximization principle gives usthe first order condition p(I){D'(L)¥+D(L)}-r d= C'(L). The lending amount that satisfies this condition iswritten Lm(I,rd). From the principle of implicit function, this can be rewritten as∂L m(•) P'(I){D' (L) ⋅ L + D(L)}= −∂I 2P(I)D' (L) − C"( L)Since the denominator of the right hand side of the equation is negative and the first term inside thebraces in the numerator is negative and the second term positive, the sign of the whole will be determinedby the relative size of these two terms and cannot be determined in advance .Since the condition Lm > 0 must be satisfied for lending to take place, the lending function is as follows:⎧⎨⎩L = L m (I, r d )L = 0

172 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandInvestment and receipt of an IFCT loan -- on the lending level. Our aim is to measure notonly the average effect of policy factors but also the differences in the effects on companieswith different attributes. For this reason, in addition to the policy dummy, we will belooking to introduce cross-terms (coefficient dummies) to each of the corporate attributedummies. The actual estimator will thus look as follows.< Corporate category and policy effect estimator >L = α 0 + α 1 r d + α 2 ER + α 3 Risk + α 4 INC + βAD + γ 0 (1 + δAD)PDAD = Corporate category dummy vector:(1) Business groups: Corporate members of financial conglomerates, industrial groups, foreigngroups, other groups(2) Company size: Large, medium, small(3) Industry types: Companies in seven industrial categoriesPD = Policy dummy vector(1) Board of Investment specification: Sample companies that at least one year before were specifiedfor promotion by the Board of Investment under the terms of the Investment Promotion Act.(2) Loan received from the Industrial Finance Corporation of Thailand (IFCT): Sample companiesthat received IFCT finance as part of an OECF finance project.Sign conditions are "+" for α1, "-" for α3, α2 and α4 not determined.b) Lending function estimation resultsThe effects of two policy measures -- specification by the Board of Investment, receipt ofan IFCT loan -- on the lending function are measured for three corporate categories, namelytype of business group, size and industry. Sample related problems prevented us fromestimating the effects on business groups of receipt of an IFCT loan.Estimates are also prepared with respect to three types of Financing, namely longtermborrowing, short-term borrowing and overall borrowing. This made 15 types ofestimate in all. The results are summarized in Tables 17 (1) to (3).The estimates for general lending related factors show the risk coefficients, which wewould have expected to be negative, to be positive for each of long-term, short-term andoverall borrowing (Table 17 (1)). Another problem is the failure of the profit margin toreach a significant level. Retained earnings, on the other hand, were significant. There is,of course, a certain inevitability about these results since estimation techniques for banklending and corporate borrowing are not as yet fully established.Significant results are obtained in many areas with respect to the characteristic featuresof Financing in the various corporate attribute categories. First, the low level of long-termborrowing and the high level of short-term borrowing among members of financialconglomerates are found to be significant. This suggests that companies in financialconglomerates have a preference for short-term funds. Foreign group companies, on theother hand, tend to favor a rather low level of short-term borrowing. Second, large companiestend to be less reliant on long-term borrowing and more on short-term borrowing thanmedium-sized companies. Large companies are similarly found to be less reliant on overallborrowing than medium-sized companies. Third, two different patterns are observed withrespect to industry types: the chemical and the metal and machinery industries are found to

OECF Journal of Development Assistance Vol.4, No.1, 1998 173have a low preference for short-term borrowing and an extremely high preference for longtermborrowing; the non-metal industry, on the other hand, is found to rely much less onlong- than on short-term borrowing. Reliance on overall borrowing is on the low sideoverall.Table 17Lending Function(1) Lending Effects of Corporate CategoryAll companiesLarge companiesLong-termborrowingShort-termborrowingOverallborrowingLong-termborrowingShort-termborrowingOverallborrowingConstant term ( 0 ) 0.5679 0.7698 0.4128 0.2658 0.7233Call rate ( 1 ) -0.0155Rate of return on total assets ( 2) -0.3701 -0.4939 -0.6487 -0.6618 -0.6258Risk ( 3) 0.2217 0.1608 0.3114Internal reserves ( 4) -0.2420 -0.2575 -0.3363 -0.2427 -0.2084 -0.3156Corporate attributes ()Companies sizeLarge -0.1680 0.1871 -0.1329Medium -0.0858 0.1093 -0.0821IndustryTextiles and clothing -0.0879Timber productsPaper and paper products -0.1071 0.0705Chemicals 0.0246 -0.0376Non-metals -0.0869 0.0699 -0.0452 -0.0910 0.0506 -0.0425Machinery, metals, primary metals 0.0220 -0.0535 0.0403Business groupFinancial conglomerates -0.0625 0.0647Industrial groupsForeign groups -0.0497Notes : Only significant estimates are shown in the table.The all-industry values are the means of the estimation values in Supplementary Tables No.1 (2)and (4). The large companies values are taken from Supplementary Table No.1 (1).In the case of policy effects, a variety of different tendencies are identified.First, it is confirmed that the privilege by the Board of Investment led to an increasein short-term borrowing (Table 17 (2)). At the same time, a tendency to reduce long-termborrowing is observed to be significant at a level approaching 10%, the implication beingthat short- is being substituted for long-term borrowing. This tendency is found to beparticularly significant in large companies and in companies in the paper and paper products,chemicals, non-metals, and machinery and metal industries. Of these, the effect on overallborrowing is positive in the paper and paper products, and chemicals industries; this pointsto an overall increase in Financing activity (the sign is not significant). On the other hand,financial conglomerates and food processing companies are found to substitute long- forshort-term borrowing following privilege by the Board of Investment. This suggests thatonce they have been specified, companies in this group or industry start to replace theirshort-term loans with long-term ones. Finally, medium-sized companies are found toincrease their long-term borrowings but not to reduce their short-term borrowings. In

174 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailandother words, specification by the Board of Investment puts medium-sized companies in aposition to raise additional funds, particularly long-term funds. Thus, while the effects ofspecial incentive authorization from the BOI vary depending on a company's attributes,authorization is clearly effective in promoting higher levels of long-term borrowing in thecase of medium-size companies and companies in the food processing sector.Second, companies that have received loans from the IFCT generally show a tendencyto increase their long-term borrowing (Table 17 (3)). The tendency of timber productmanufacturers to respond to receipt of an IFCT loan by increasing their overall borrowingis found to be statistically significant.Table 17Lending Function(2) Lending Effects of Board of Investment PrivilegeInvestment Committee specificationLong-term borrowing Short-term borrowing Overall borrowingEstimate t value Estimate t value Estimate t valueGeneral effects -0.0108 -1.0653 0.0248 2.1649 ** 0.0039 0.3815Company sizeLarge -0.0372 -2.3950 ** 0.0321 1.8885 * -0.0101 -0.6542Medium 0.0089 2.2433 ** 0.0187 -0.5794 0.0144 1.1940IndustryFood processing 0.0539 2.5164 ** -0.0503 -2.0725 ** 0.0109 0.5092Textile and clothing -0.0069 -1.8998 * -0.0253 0.6801 -0.0104 -0.6669Timber products -0.0246 -1.6003 -0.0082 0.7486 -0.0142 -0.5116Paper and paper products -0.0687 -2.7359 ** 0.1084 3.2971 *** 0.0245 0.3031Chemicals -0.0067 -1.9256 * 0.0743 3.5161 *** 0.0233 0.3928Non-metals -0.0676 -2.6622 ** 0.0627 2.3224 ** -0.0129 -0.5210Machinery, metals, primary metals -0.0471 -3.3238 *** 0.0639 3.3028 *** -0.0060 -0.5546Business groupOther group -0.0672 -3.3489 *** 0.0533 2.4855 ** -0.0156 -0.7838Financial conglomerates 0.2092 3.5261 *** -0.1803 -2.9072 *** 0.0396 0.6715Industrial groups -0.0087 1.5830 0.0174 -0.9266 0.0011 0.4554Foreign groups -0.0601 0.1956 0.0564 0.0801 -0.0307 -0.4153Note : "Effects of Board of Investment specification" in Supplementary Tables No.1 (1), (2), (4)(3) Effects of Receipt of an IFCT loanIFCT financeParameter Long-term borrowing Short-term borrowing Overall borrowingEstimate t value Estimate t value Estimate t valueGeneral effects 0.0856 1.6429 * -0.0119 -0.2171 0.0466 0.8897Company sizeLarge 0.1069 1.5974 -0.0160 -0.2403 0.0454 0.6760Medium 0.0537 -0.5065 -0.0037 0.1088 0.0483 0.0271IndustryTextiles and clothing - - - - - -Timber products 0.2152 0.1172 0.0846 1.0796 0.2342 2.4129 **Paper and paper products - - - - - -Chemicals -0.0606 0.1406 -1.1934 -0.0006 -0.1089 -0.4220Non-metals - - - - - -Machinery, metals, primary metals - - - - - -Note : "Effects of receipt of IFCT finance" in Supplementary Tables No.1 (3), (5)

OECF Journal of Development Assistance Vol.4, No.1, 1998 1752. Investment Functiona) Derivation of the functionTobin's q is generally used as a basis for the estimation of capital investment. However,there are few examples even in studies of advanced western economies in which researchershave succeeded in directly estimating Tobin's q. This section follows the several studies,Okazaki and Horiuchi (1991) and Horiuchi and Sui (1995) among others in breaking Tobin'sq down into interest expense and the expected rate of return to create linear explanatoryvariables. Allowing for the effects of agency costs, two levels of fund, retained earningsand borrowings, are introduced into the capital investment function. The latter differsfrom the former in that the fund raiser incurs additional agency costs as a result, for example,of the asymmetry of knowledge. The level of retained earnings and borrowings can thus bethought of as having positive and negative effects respectively on investment.In the same way as the lending function, the corporate attribute and policy effects takeninto consideration will be the constant effect of corporate categories, the constant effect ofpolicy and the effect of policy on each corporate attribute. The estimator will thus be as follows:INV = α 0 + α 1 COC + α 2 ER + α 3 INC + α 4 BR + βAD + γ 0 (1 + δAD)PDα 1< 0, α 2> 0, α 3> 0, α 4< 0β, δ are Vector.INV = Capital investment = (Tangible fixed assets - Tangible fixed assets as of the end of the previousyear) / Total assetsCOC= Interest expense = (Interest paid ÅE Discount amount) / LiabilitiesER = Expected return = Average rate of return on total assets (Current income / Total assets) of thisand the last 2 yearsINC = Retained earnings = Undistributed profit / Total assetsBR = Borrowing = (Short-term borrowing + Long-term borrowing) / Total assetsAD = Corporate category dummy vector (as per lending function)PD = Policy dummy vector (as per lending function)In which the policy effect with respect to corporate attribute 1 is calculated by γ0 (1+δ1) and δ1 is thefirst element of σ.b) Investment function estimation resultsAs with the lending function, three corporate categories and two policy effects are used toestimate the capital investment function. We similarly omitted IFCT finance-business groupestimation. Thus five estimators were used 11 and the results of estimation are shown inSupplementary Tables No.2(1) and (2) and summarized in Tables 18 (1) and (2).11 Estimation by business group is carried out with respect to large companies only. The IFCTsamples are extremely limited in number and we therefore narrowed the focus with respect to companysize. There are no small company samples at all. Different samples are used with different estimators.

176 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandTable 18Investment Function(1) Capital Investment Stimulation Effect of Corporate CategoryAll companiesLarge companiesConstant term ( 0 ) 0.0110 0.0633Interest expense ( 1 ) -0.4783 -0.6404Rate of return on total assets ( 2 )Internal reserves ( 3) -0.0554Long-term borrowing ( 4)Corporate attributes ()Companies sizeLarge 0.0696Medium 0.0512IndustryTextiles and clothingTimber products 0.0228Paper and paper products 0.0421 0.0429Chemicals 0.0125Non-metalsMachinery, metals, primary metals 0.0158Business groupFinancial conglomerates -0.0542Industrial groupsForeign groupsNotes : Only significant estimates are shown in the table.The all-industry values are obtained by matching the size and industry values inSupplementary Table No.2 (1) with the appropriate sample populations. Thelarge company values are obtained by matching the relevant values from thebusiness group section in Supplementary Table No.2 (1) with the appropriatesample populations.Examination of the general elements in the results shows that interest expense have asignificant negative effect on capital investment. This is an appropriate result. On theother hand, although the effect of the rate of return on total assets is positive, its value is notsignificant (Table 18 (1)). Retained earnings are found to have a significant negative effecton all industries but the effect of borrowing (outside capital) is found to be insignificant.Overall, the investment function was found to produce broadly appropriate results althoughit did not show agency costs to have a significant effect.First, the investment level of financial conglomerates companies is found to besignificantly low. Second, the high level of investment among large companies is found tobe significant. Third, capital investment levels were found to be significantly high in thepaper and paper product industry. A tendency towards significantly high levels of investmentcan also be observed in the timber products, chemical, and machinery and metal industries.The results of the policy effects estimations are shown in Table 18 (2). First, thegeneral effect on investment levels of specification by the Board of Investment is clearlynot that significant overall. Clearly, companies in the textiles and clothing, and paper andpaper product industries have actually curtailed investment somewhat following

OECF Journal of Development Assistance Vol.4, No.1, 1998 177specification. Second, although a significant general effect is not observed in the case ofcompanies in receipt of IFCT loans, a tendency to increase investment was identified in thechemical industry. The effect of IFCT loans is found to be similarly insignificant withrespect to company size although it is positive in the case of medium-sized companies andnegative in the case of large ones.It is evident from the above that the receipt of IFCT finance by the chemical industryinduces an increase in capital investment in the following year. However, this tendency isnot evident in other industrial sectors and the causes of the increase need to be investigatedin more detail.Table 18Investment Function(2) Effects of Board of Investment Specification and IFCT loansInvestment Committee specificationIFCT financeParameter Estimate t value Estimate t valueGeneral effects -0.0050 -0.8675 0.0141 0.5143Company sizeLarge -0.0056 -0.6608 -0.0204 -0.5777Medium -0.0034 0.1937 0.0657 1.5593IndustryFood processing 0.0093 0.7649 - -Textile and clothing -0.0352 -2.4531 ** - -Timber products 0.0096 0.0135 0.0077 0.0077Paper and paper products -0.0476 -2.2425 ** - -Chemicals 0.0085 -0.0414 0.1767 0.1767 *Non-metals -0.0205 -1.1505 - -Machinery, metals, primary metals 0.0071 -0.1249 - -Business groupOther group -0.0135 -0.9445Banking zaibatsu 0.0354 1.1573Manufacturing zaibatsu 0.0006 0.5310Foreign groups -0.0269 -0.5198Note: The effects of Board of Investment specification in Supplementary Table No.2 (1) are preparedfrom the IFCT effects in Supplementary Table No.2 (2).D. General Observations and Interpretation of the ResultsThis completes our descriptive statistical analysis based on normality tests and our econometricanalysis using lending and capital investment functions. The results are summarized belowunder two heads: (1) Characteristic features of Financing and capital investment in selectedmanufacturing sectors (distinguished by sector attributes); (2) Policy effects arising out ofspecification by the BOI and the receipt of a loan from the IFCT. The results of estimationsmade using the above functions will be the first determination criteria. It should be noted in thecase of a result in identified only in the descriptive analysis. A note will also be appended toindicate inconsistencies between the results of our function based estimations and those of ourdescriptive statistical analysis.

178 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand1. Corporate Categorya) Classification by business groupCompanies in financial conglomerates are found to have only low levels of long-termborrowing and to prefer short-term borrowing. 12 At the same time, this group also shows astrong preference for low levels of capital investment. In contrast, industrial groupscompanies exhibit a strong preference for short-term borrowing. Foreign group companieshave low levels both of long- and of short-term borrowing but high levels of investment.This can indicate both that foreign group companies cover their investment requirementswith equity capital and also that funds are generally in short supply.b) Classification by company sizeLarge companies have low levels of long-term borrowing, a high proportion of them relyinginstead on short-term loans. 13 On the other hand, they have relative high levels of investment.Medium-sized companies also have low levels of long-term borrowing matched byhigh levels of short-term borrowing. Normality tests show them to have a strong preferencefor bank loans as against other forms of short-term borrowing. Capital investment levelswere lower than those of large companies.Normality tests also show small companies to be highly reliant on both long- andshort-term borrowing but to maintain low levels of capital investment.c) Classification by industryHigh reliance on long-term borrowing was identified in the chemical, and machinery andmetal industries. In contrast, companies in the non-metal industry are found to have generallylow levels of reliance on borrowing, particularly long-term borrowing, although their relianceon short-term borrowing is quite high. High levels of capital investment are observed inprocess industries such as the paper and paper products industry and the chemical industry.The timber products, and machinery and metals industries also have high levels ofinvestment.d) Classification by listingListed companies are observed to have high levels of equity capital and a correspondinglylow reliance on short- and long-term borrowing. This is doubtless because listed companiestend to finance their long-term activities by issuing shares. This also suggests that thereplacement of bank loans, particularly long-term loans, with equity finance is one of themotivations for listing. This conclusion is consistent with the extremely low frequency ofSET listings on the part of corporate members of financial conglomerates, which haveaccess to funds from their group bank.By contrast, non-listed companies have no access to the capital markets, whichconstitute one of the most effective means of raising long-term capital in Thailand.12 This is inconsistent with the results of normality tests.13 As above.

OECF Journal of Development Assistance Vol.4, No.1, 1998 1792. Policy Effectsa) BOI privilegeGenerally, specification by the BOI tends to prompt increased reliance on short-term funds.In sectoral terms, companies in the paper and paper product, chemical product, non-metals,and machinery and metals industries are observed to reduce their long-term borrowing andincrease short-term borrowing. A possible explanation for this tendency is that the incentiveto increase production following specification by the BOI boosts the demand for shorttermworking capital.The tendency of BOI privilege to stimulate capital investment remains unproven. Inother words, it would be difficult to claim that specification by the committee had anindisputably positive effect on long-term Financing and capital investment by themanufacturing industries. In the textiles and clothing, and paper and paper productsindustries in particular, privilege by the BOI led to a reduction in investment. This resultwill need to be analyzed further.In size terms, medium-sized companies tend to increase long-term borrowing followingspecification by the committee. Moreover, a tendency to replace short-term borrowingwith long-term borrowing is observed both in companies in the financial conglomeratesand in companies in the food processing industry.b) Receipt of IFCT loanThere is a generally observed tendency for receipt of an IFCT loan to generate a significantincrease in a company's long-term capital ratio and an increase in capital investment, althoughin the latter case not a significant one. 15 In sectoral terms, the chemical industry shows asignificant tendency to increase capital investment while the timber products industry isobserved to increase its overall borrowing. In other words, the receipt of an IFCT loan canbe said to have had a clear impact in two industrial sectors.1. Future StrategyIV. CONCLUSIONThe objective of this paper is to examine economic impact of the currency crisis. An econometricmodel is used to predict future economic situation. The "Baseline scenario" has the assumptionthat the Thai government adheres to the tight fiscal policy according to the Letter of Intent inFebruary this year, and takes no other measures to stimulate the economy. The simulation resultssuggest that, in the absence of additional stimulation measures, the Thai economy will settle intoa phase of low or negative growth accompanied by rising unemployment rate until 2001. Thebaseline scenario predicts: (1) real GDP grows at a negative rate in 1998 and 1999 and at a lowpositive rate in 2000 and 2001; (2) unemployment rate steadily increases and surpasses 7% in2001; (3) despite the maintenance of a tight fiscal stance, the fiscal deficit expands to more than15 Conclusions were difficult to draw with respect to the effects of an IFCT loan due to the severelylimited number of samples obtained. The above conclusions should be understood in this light.

180 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand3% of GDP from 2000 onwards.Additional measures must, therefore, be taken if the economy is to be steered away fromthis pessimistic scenario. Following three alternative scenarios are proposed to stimulate theeconomy; (1) increasing public investment, (2) increasing foreign direct investment throughgiving privilege by BOI, and (3) increasing private corporate capital investment through IFCTconcessional loans and following recovery of private bank lending. The results of simulationindicate that: (1) additional public investment has an immediate effect to stimulate the economy;however, the trade and fiscal balances both deteriorate from the positions indicated in the baselinescenario; (2) increased foreign direct investment and private corporate capital investment do notadversely affect the fiscal balance; however, the economy is not quickly responded with theGDP growth rate negative in 1999. In other words, each of the proposed remedies had bothpositive and negative effects.In order to supplement the deficiencies of these measures and to create a sustainable growthscenario, "composite scenario" is induced under which the three measures are combined. Theresults of simulation indicate that the most effective measure would be to boost public investmentwith immediate effect in 1999, to shift emphasis from public investment to private capitalinvestment in 2000 onwards and to promote foreign direct investment throughout. Byimplementing the composite scenario, the Thai government could expect positive growth in1999 and a resumption of growth of more than 3% in and after 2000. It would also keep thefiscal deficit to the level envisaged in the baseline scenario, which was premised on a tight fiscalpolicy stance, and prevent unemployment rate from rising out of the 5% range.2. Capital Investment and the Effects of Policy InterventionTo encourage private corporate capital investment, a detailed analysis should be made on whatsorts of companies have ready access to funds and how this is reflected in capital investment. InChapter III, financial and other data for 685 manufacturing companies are examined using arange of statistical techniques including descriptive analysis, and borrowing estimator and capitalinvestment estimator. The results of the analysis are summarized as follows.Fund raising and capital investment by company typeFund raising structures are different among each business types. Capital intensive industries,such as chemicals and machinery/metal industry tend to rely heavily on long-term borrowing,with maintaining low levels of short-term funds. These two sectors both maintain highlevels of capital investment, for which they clearly need access to long-term funds. Incontrast, the non-metal industry tends to rely on short-term borrowing and maintain relativelylow levels of long-term borrowing. The timber and the paper/ paper products industriesare found to maintain comparatively low levels of capital investment.In terms of size, all analyses show medium-sized companies have limited access tolong-term borrowing and rely primarily on short-term funds. On the other hand, mediumsizedcompanies make a higher level of capital investment than small-sized companies.These facts suggest that the supply of long-term funding is insufficient to satisfy mediumsizedcompanies demand for capital investment. In business group, members of bankingconglomerate are observed to maintain only low levels of capital investment.

OECF Journal of Development Assistance Vol.4, No.1, 1998 181Effects of policy interventionUsing the results of the above analysis, the effect of privilege by BOI is examined oncompanies' financial positions. The result points a tendency for companies to boost theirshort-term borrowing ratio in response to the privilege. This tendency to increase shorttermborrowing and reduce long-term funds is particularly evident in large companies andin companies in paper/ paper product, chemical, non-metal, and machinery/metal industries.By contrast, medium-sized companies are observed to increase their long-termborrowing ratios following BOI privilege. This means that privilege by the BOI substantiallyimproves the ability of medium-sized companies to raise long-term funds which they require.It should therefore be possible for the Thai government to improve the financial positionsof medium-sized companies by preparing incentive schemes in this way. Since the BOIprivilege have stressed foreign capital, it should also contribute to the promotion of "foreigndirect investment" based scenario described in section (1) above.However, BOI privilege fails to stimulate capital investment in many industries andgroups. Careful consideration must therefore be given to ways for giving BOI privilege tothese industries and groups.Next, the effects of IFCT concessional loans on corporate fund raising and capitalinvestment are examined. The results point an increase in long-term borrowing of companiesafter receipt of loans. The small number of samples obtained necessarily limits the validityof the results, but IFCT loans tend to act as signals to other financial institutions to promotetheir lending of long term loans to the companies. IFCT loans are also observed to stimulatecapital investment in the chemical industry.3. Targets and Problems of Policy InterventionIf we are to make the "Level of capital investment of each category " x-axis and the "Level oflong-term borrowing of each category" y-axis of a graph and plot the relative positions of corporategroups or category, it would effectively provide a "map" to target companies that the policyintervention has effect in. In other words, the outcome of policy intervention would effectivelybe determined by the map position (i.e. the precise combination of capital investment and longtermborrowing) of the companies targeted.Bearing in mind the fact that "policy intervention can have a positive stimulatory effect onprivate corporate capital investment", companies with following conditions should be targeted;companies that "have low long-term borrowing ratios and few alternative options", "have highlevels of capital investment", and "respond positively to policy initiatives designed to encouragecapital investment".Most obviously it is the unlisted in the securities market rather than the listed companiesthat tend to be more starving for funds. This is because unlisted companies have no alternativeto long-term borrowing. All analytical results showed medium-sized companies to have lowlong-term borrowing ratios. When the effects of policy initiatives are added in, it is evident thatmedium and small unlisted companies (1) are generally starved of long-term capital, but (2) increasetheir long-term borrowing and capital investment through privilege by BOI. Clearly this is a categorythat can be expected to increase its capital investment in response to such policy intervention.The final lesson to be learned from the results of this study is that, while some types of

182 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailandcompanies are responsive to policy intervention, others clearly are not. In other words, policyintervention as practiced in Thailand in the 1990s has demonstrably failed to enhance thefunctionality of the markets or to fulfill the sort of signaling function that would effectively plugthe gaps in the private sector's capacity for information production. Clearly, if we are to assistthe types of companies that are found by this study to have little benefit from policy intervention,we must first check the funding structure of the companies concerned and then tailor our assistanceto suit their demand for funds.Table 19Main Table (1) – Effects on Borrowing and Capital InvestmentCorporate CategoryIndustrial SectorNoteSizeBusiness GroupLong-TermBorrowingChemicalsMachinery andmetalsNon-metalsMediumLargeFinancialconglomeratesLending function estimatorShort-TermBorrowingChemicalsMachinery andmetalsNon-metalsMediumLargeFinancialconglomeratesForeign groupsOverallBorrowingNon-metalsInvestmentestimatorChemicalsMachinery andmetalsTimber productsPaper and paperproductsMediumLargeFinancialconglomerates: Classifications with positive significance are marked with a , those with negativesignificance with a .Table 19Main Table (2) – Effects of Policy InterventionEffects of BOIPrivilegeIndustrial SectorSizeBusiness GroupEffects of IFCTConcessional LoanIndustrial SectorLong-TermBorrowingFoodprocessingTextiles andclothingPaper and paperproductsChemicalsNon-metalsMachinery andmetalsMediumLargeFinancialconglomeratesOther groupsAll targetcompaniesLending function estimatorShort-TermBorrowingFood processingPaper and paperproductsChemicalsNon-metalsMachinery andmetalsLargeFinancialconglomeratesOther groupsOverallBorrowingTimberproductsInvestmentestimatorTextiles andclothingPaper and paperproductsChemicalsSizeBusiness GroupNote : Classifications with positive significance are marked with a , those with negativesignificance with a .

OECF Journal of Development Assistance Vol.4, No.1, 1998 183Supplementary Table No.1 (1)The Lending Function and the Effects of Board of Investment Specification by Business GroupLong-term borrowing Short-term borrowing Overall borrowingEstimate t value Estimate t value Estimate t value 0.4128 3.9194 *** 0.2658 2.3499 ** 0.7233 6.9033 *** -0.0054 -0.6590 -0.0056 -0.6382 -0.0155 -1.8962 * -0.1489 -1.2178 -0.6618 -4.5815 *** -0.6258 -5.1453 *** 0.1773 0.4324 -0.0864 -0.0813 0.5023 1.2316 -0.2427 -5.8846 *** -0.2084 -4.1269 *** -0.3156 -7.6920 *** -0.0625 -2.1510 ** 0.0647 2.1352 ** -0.0184 -0.6353 0.0124 0.5750 0.0107 0.4692 0.0199 0.9310 -0.0056 -0.2579 -0.0497 -2.0916 ** -0.0309 -1.4389 0.0247 1.0808 -0.0879 -3.5797 *** -0.0330 -1.4527 -0.0412 -0.9891 -0.0397 -0.8820 -0.0600 -1.4459 -0.1071 -3.6416 *** 0.0705 2.3215 *** -0.0363 -1.2405 0.0222 0.9871 0.0078 0.3270 0.0331 1.4785 -0.0910 -3.6948 *** 0.0506 1.9694 * -0.0425 -1.7344 * 0.0403 1.9623 * -0.0298 -1.3720 0.0143 0.6982 -0.0672 -3.3489 *** 0.0533 2.4855 ** -0.0156 -0.7838 0.2092 3.5261 *** -0.1803 -2.9072 *** 0.0396 0.6715 0.0585 1.5830 -0.0359 -0.9266 0.0167 0.4554 0.0071 0.1956 0.0031 0.0801 -0.0151 -0.4153 -0.0672 0.0533 -0.0156 0.2092 -0.1803 0.0396 -0.0087 0.0174 0.0011 -0.0601 0.0564 -0.0307Supplementary Table No.1 (2)The Lending Function and the Effects of Investment Committee Specification by Company SizeLong-term borrowing Short-term borrowing Overall borrowingEstimate t value Estimate t value Estimate t value 0.5729 7.0750 *** 0.0499 0.5114 0.7723 9.5494 *** -0.0029 -0.5095 -0.0050 -0.7620 -0.0085 -1.4844 -0.3695 -5.1693 *** -0.5122 -5.5974 *** -0.6545 -9.1685 *** 0.2207 3.3584 *** 0.16888 1.7597 * 0.3136 4.7787 *** -0.2417 -8.1935 *** -0.2583 -6.6584 *** -0.3364 -11.4155 *** -0.1646 -4.5638 *** 0.1843 3.6111 *** -0.1318 -3.6574 *** -0.0872 -2.4384 ** 0.1056 2.0818 ** -0.0847 -2.3719 ** 0.0115 0.7697 -0.0207 -1.1938 -0.0011 -0.0709 -0.0446 -1.8622 * 0.0144 0.5248 -0.0218 -0.9109 -0.0328 -1.5310 0.0558 2.4012 0.0074 0.3437 0.0175 1.2088 -0.0181 -1.0871 0.0081 0.5579 -0.1006 -5.1039 *** 0.0837 3.9306 *** -0.0475 -2.4112 ** 0.0093 0.6701 -0.0379 -2.3779 ** -0.0077 -0.5583 -0.0372 -2.3950 ** 0.0321 1.8885 * -0.0101 -0.6542 0.0461 2.2433 ** -0.0133 -0.5794 0.0245 1.1940 -0.0372 0.0321 -0.0101 0.0089 0.0187 0.0144

184 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandSupplementary Table No.1 (3)The Lending Function and the Effects of IFCT Loans by Company SizeLong-term borrowing Short-term borrowing Overall borrowingEstimate t value Estimate t value Estimate t value 0.3188 2.8724 *** 0.3067 2.5318 ** 0.6672 5.9856 *** -0.0025 -0.4308 -0.0027 -0.4143 -0.0070 -1.1761 -0.2908 -3.7703 *** -0.6213 -6.5985 *** -0.6262 -8.0849 *** 0.1763 0.6946 0.8206 2.9917 *** 0.5678 2.2279 ** -0.2663 -8.4503 *** -0.2098 -5.5121 *** -0.3416 -10.7946 *** 0.0707 0.8704 -0.0858 -0.9652 -0.0506 -0.6195 0.1507 1.8574 * -0.1483 -1.6701 * 0.0019 0.0229 0.0165 1.0845 -0.0350 -2.1255 ** -0.0028 -0.1824 -0.0448 -1.7637 * -0.0204 -0.7227 -0.0433 -1.6992 * -0.0270 -1.2455 0.0455 2.0294 ** 0.0052 0.2382 0.0230 1.5272 -0.0297 -1.8075 * 0.0023 0.1541 -0.0888 -4.4515 *** 0.0570 2.7612 ** -0.0542 -2.7055 *** 0.0157 1.1122 -0.0405 -2.6267 ** -0.0057 -0.4018 0.1069 1.5974 -0.0160 -0.2403 0.0454 0.6760 -0.0531 -0.5065 0.0123 0.1088 0.0029 0.0271 0.1069 -0.0160 0.0454 0.0537 -0.0037 0.0483Supplementary table No.1 (4)The Lending Function and the Effects of Board of Investment Specification by IndustryLong-term borrowing Short-term borrowing Overall borrowingEstimate t value Estimate t value Estimate t value 0.5628 6.9465 *** 0.0551 0.5677 0.7673 9.4566 *** -0.0033 -0.5721 -0.0047 -0.7149 -0.0085 -1.4768 -0.3707 -5.1505 *** -0.4755 -5.2043 *** -0.6428 -8.9191 *** 0.2227 3.3930 *** 0.1526 1.5976 0.3092 4.7025 ** -0.2423 -8.2165 *** -0.2567 -6.6447 *** -0.3363 -11.3855 *** -0.1713 -4.7803 *** 0.1898 3.7556 *** -0.1340 -3.7325 *** -0.0843 -2.3657 ** 0.1130 2.2471 ** -0.0795 -2.2286 ** 0.0257 1.4535 -0.0238 -1.1954 0.0046 0.2611 -0.0215 -0.6934 0.0079 0.2257 -0.0127 -0.4082 0.0006 0.0219 0.0064 0.2239 -0.0005 -0.0179 0.0317 1.8172 * -0.0572 -2.8061 ** 0.0021 0.1190 -0.0731 -3.2546 *** 0.0560 2.3127 ** -0.0430 -1.9089 * 0.0347 2.1383 ** -0.0691 -3.6951 *** -0.0044 -0.2689 0.0539 2.5164 ** -0.0503 -2.0725 ** 0.0109 0.5092 -0.0608 -1.8998 * 0.0250 0.6801 -0.0214 -0.6669 -0.0784 -1.6003 0.0421 0.7486 -0.0251 -0.5116 -0.1225 -2.7359 ** 0.1588 3.2971 *** 0.0136 0.3031 -0.0605 -1.9256 * 0.1246 3.5161 *** 0.0124 0.3928 -0.1215 -2.6622 ** 0.1130 2.3224 ** -0.0238 -0.5210 -0.1010 -3.3238 *** 0.1142 3.3028 *** -0.0169 -0.5546 0.0539 -0.0503 0.0109 -0.0069 -0.0253 -0.0104 -0.0246 -0.0082 -0.0142 -0.0687 0.1084 0.0245 -0.0067 0.0743 0.0233 -0.0676 0.0627 -0.0129 -0.0471 0.0639 -0.0060

OECF Journal of Development Assistance Vol.4, No.1, 1998 185Supplementary Table No.1 (5)The Lending Function and the Effects of IFCT Loans by IndustryLong-term borrowing Short-term borrowing Overall borrowingEstimate t value Estimate t value Estimate t value 0.3174 2.8626 *** 0.3046 2.5153 ** 0.6650 5.9796 *** -0.0025 -0.4187 -0.0026 -0.3998 -0.0069 -1.1603 -0.2780 -3.5951 *** -0.6075 -6.4333 ** -0.6072 -7.8277 *** 0.1583 0.6242 0.8004 2.9170 ** 0.5412 2.1274 ** -0.2690 -8.5354 *** -0.2124 -5.5746 *** -0.3459 -10.9413 *** 0.0713 0.8786 -0.0858 -0.9650 -0.0498 -0.6118 0.1510 1.8632 * -0.1479 -1.6666 0.0024 0.0301 0.0161 1.0532 -0.0350 -2.1258 ** -0.0034 -0.2236 -0.0570 -2.1858 ** -0.0307 -1.0500 -0.0603 -2.3062 ** -0.0277 -1.2802 0.0454 2.0230 ** 0.0042 0.1937 0.0233 1.5402 -0.0286 -1.7417 0.0026 0.1734 -0.0897 -4.5007 *** 0.0568 2.7482 *** -0.0554 -2.7727 *** 0.0149 1.0500 -0.0408 -2.6453 ** -0.0069 -0.4865 0.0390 0.0813 -0.0420 -0.5191 -0.0494 -0.6058 - - - - - - 0.1762 0.1172 0.1267 1.0796 0.2837 2.4129 ** - - - - - - -0.0996 0.1406 -1.1514 -0.0006 -0.0595 -0.4220 - - - - - - - - - - - - 0.0390 -0.0420 -0.0494 - - - 0.2152 0.0846 0.2342 - - - -0.0606 -1.1934 -0.1089 - - - - - -

186 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandSupplementary Table No.2 (1)The Investment Function and the Effects of Board of Investment SpecificationLong-term borrowing Short-term borrowing Overall borrowingEstimate t value Estimate t value Estimate t value 0.0633 2.8686 ** 0.0134 0.5898 0.0086 0.3760 -0.6404 -4.2491 *** -0.4724 -5.8182 *** -0.4842 -5.9695 *** 0.0193 0.2409 0.0487 1.3513 0.0489 1.3481 -0.0333 -1.1060 -0.0569 -3.3497 *** -0.0539 -3.1704 *** 0.0391 1.5292 0.0116 0.8959 0.0115 0.8890 -0.0542 -2.6310 *** -0.0213 -1.3803 0.0057 0.3684 -0.0133 -0.8130 -0.0041 -0.4852 0.0091 0.9131 0.0298 1.0052 0.0239 1.7646 * 0.0217 1.2364 0.0429 2.0455 ** 0.0324 2.6732 *** 0.0518 3.4873 *** 0.0202 1.2498 0.0130 1.5672 0.0120 1.2054 ** 0.0059 0.3320 -0.0047 -0.4190 0.0027 0.2103 0.0185 1.2447 0.0159 2.0134 ** 0.0157 1.7024 * 0.0459 2.2661 ** 0.0474 2.3565 ** 0.0338 1.6928 * 0.0349 1.7553 * -0.0135 -0.9445 -0.0056 -0.6608 0.0093 0.7649 0.0488 1.1573 0.0140 0.5310 -0.0134 -0.5198 0.0022 0.1937 -0.0445 -2.4531 ** 0.0004 0.0135 -0.0568 -2.2425 ** -0.0007 -0.0414 -0.0298 -1.1505 -0.0021 -0.1249 -0.0135 0.0354 0.0006 -0.0269 -0.0056 0.0000 0.0093 -0.0352 0.0096 -0.0476 0.0085 -0.0205 0.0071

OECF Journal of Development Assistance Vol.4, No.1, 1998 187Supplementary Table No.2 (2)The Investment Function and the Effects of an IFCT LoanBy companyBy industryEstimate t value Estimate t value0.0393 0.8941 0.0392 0.8915-0.5370 -6.7853 *** -0.5377 -6.7881 ***0.0448 1.1832 0.0451 1.1868-0.0594 -3.4856 *** -0.0597 -3.4892 ***0.0109 0.8602 0.0113 0.8904-0.0077 -0.9603 -0.0078 -0.9724 0.0224 1.6745 * 0.0235 1.7075 * 0.0217 1.8994 * 0.0215 1.8838 * 0.0097 1.2043 0.0091 1.1295 -0.0024 -0.2252 -0.0025 -0.23420.0205 2.7336 *** 0.0204 2.7131 *** 0.0230 0.5380 0.0230 0.5383 0.0189 0.4422 0.0190 0.4436 -0.0204 -0.5777 -0.0291 -0.67720.0861 1.5593 - - 0.0368 0.5940 - - 0.1399 1.8879 * - -- - -0.0204 0.0657 - 0.0077 - 0.1767 * --

188 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of Thailand60%Short-term borrowing50%40%41.1%41.8%51.4%37.7%39.3%Medium companyLarge company39.9%40.5%37.1%Small company42.9%32.4%30%29.5%30.4%21.1%26.6%31.2%31.9%20%19.4%16.7%16.4%10%0%Food processingTextiles andclothingTimber products Paper and paperproductsChemicalproductsNon-metalsMetals andmachinery25%Long-term borrowing22.1%20%15%10%Small company18.3%Medium company15.9%Largecompany11.8%10.6%9.1%13.2%11.1%12.1%16.3%16.0%14.0%9.2%8.9%18.7%5.6%5%4.0%0%Food processingTextiles andclothingTimber products Paper and paperproductsChemicalproductsNon-metalsMetals andmachinerySupplementary Fig. No.1 Structure of Funding and Capital Investment by Industryand by Company Size (1)

OECF Journal of Development Assistance Vol.4, No.1, 1998 18910%Capital investiment8.8%8%Large company7.1% 7.2%6%Mediumcompany6.2% 6.1%4%4.0%3.5%Smallcompany4.8%3.8%3.7%3.7%2.4%2%0.7%1.1%-1.5%0%2.9% 2.0% 1.3%-2%Food processingTextiles andclothingTimber products Paper and paperproductsChemicalproductsNon-metalsMetals andmachinery50%45%Equitycapital48.7%47.3%Large companyMedium companySmall company40%38.8%38.8%36.3%37.0%37.4%37.0%39.5%37.3%35%30%31.8%28.9%29.8%34.6%31.8%29.7%25%23.3%24.0%20.9%20%15%10%5%0%Food processingTextiles andclothingTimber products Paper and paperproductsChemicalproductsNon-metalsMetals andmachinerySupplementary Fig. No.1 Structure of Funding and Capital Investment by Industryand by Company Size (2)

190 Yuko Amano, Fumiharu Mieno, Future Challenges for the Economic Recovery of ThailandREFERENCES(Japanese)Arasawa, Masada. "Job Training in Thailand", Ajia Keizai Shuppankai.Asako, Kazumi and Masayuki Otaki (ed.). "Modern Macrodynamics", The University of TokyoPress.Fukuda, Shin-ichi, Hiroshi Teruyama, Akihiro Kamiya and Ji Cong (1995). "Effects of IntroducingPolicy Finance into the Manufacturing Sector: An Information Creation Function basedApproach", Economic Analysis.Fukuda, Shin-ichi and Ji Cong (1995). "Asymmetry of Information and Agency Problems, andthe Finance Composition Ratio of Long-term Funds", Economic Research.Hanazaki, Masaharu and Kazuyo Hachisuka (1994). "Development Bank Finance and CorporateCapital Investment".Horiuchi, Akiyoshi and Qing-Yuan Sui (1994). "Development Banks as Information Producers",Keimei Kaizuka and Kazuo Ueda (ed.): "The Finance System in an Age of Reform".JETRO Bangkok Center / Bangkok Japanese Chamber of Commerce and Industry (ed.). "AnOverview of Economic Conditions in the Kingdom of Thailand 97/98".Kishi, Shinsei (1992). "Economic Development and Finance Policy", Toyokeizai Shinposha.Mieno, Fumiharu (1997). "Development Bank Finance as a Means of Inducing Funds in SelectiveGovernment Intervention", Japanese Economic Research.Okazaki, Tatsuko and Akiyoshi Horiuchi (1991). "Corporate Capital Investment and the MainbankRelationship", Financial Research, Bank of Japan.Okuda, Hidenobu and Masaaki Kuroyanagi (1998). "An Introduction to Development Finance".Shintani, Masahiko. "Quantitative Research into the Development of the Thai Economy: 1950-1990", Seinan Gakuin University Institute of Scientific Research Bulletin No.27.Suehiro, Akira and Shin Nanbara (1992). "Thailand's Zaibatsu", Dobunkan.Teranishi, Shigero (1992). "Industrialization and the Financial System", Toyokeizai Shinposha.(English)Bank of Thailand (1996a). "Analyzing Thailand's Current Account Deficit", Bank of ThailandEconomic Focus Jan.-Mar. 1996.______ (1996b). Forms C.B.1.1,&C.B.1.2 COMPARATIVE STATE OF CONDITION (December31, 1996).______ (1996c). "Private Saving in Thailand", Bank of Thailand Economic Focus Apr.-Jun.1996.______ (1996d). "Thailand's Inflation", Bank of Thailand Economic Focus Oct.-Dec. 1996.______ (1996e). "Analyzing Thailand's Short-Term Debt", Bank of Thailand Economic FocusJul-Sep 1996.______ (1998). Monthly Statistical Release; January 1998.______ . Monthly Bulletin.Bureau of the Budget. Thailand's Budget in Brief.Ministry of Industry (1998). Thailand Industrial Survey Jan. 1998.______ . "Industrial Restructuring Master Plan".NESDB. National Income of Thailand 1996 edition.

OECF Journal of Development Assistance Vol.4, No.1, 1998 191Suehiro, Akira (1989). Capital Accumulation in Thailand 1855-1985, Centre for East AsianCultural Studies.UNCTAD/ICC (1998). "The Financial Crisis in Asia and Foreign Direct Investment", Mar.1998.

REGIONAL DISPARITIES IN INDONESIATetsuro Takeda *Ryosuke Nakata **SUMMARYThis survey analyzes the current state of regional disparities (economic, infrastructure and sociallevel) in Indonesia and the factors behind these disparities. The result of this survey hopes to beuseful for the policies for "the reduction of regional disparities".Indonesia has various disparities in economic and social levels between the developedwestern region and the less developed eastern region. Extreme disparities may trigger socialunrest. Under these situations, the central government has aimed the reduction of regionaldisparities in the 6 th Development 5-Year Program (1994-98 Fiscal Year) and the 2 nd Long-TermDevelopment Program (1994-2018 Fiscal Year) by promoting regional development with theenforcement of regional governments.A significant correlation is observed between infrastructure development and regionaleconomic development. In sum, level of infrastructure development is one factor to cause regionaleconomic disparities.Regional governments budget is insufficient both in scale and quality, and most of them isdependent on the fiscal transfer. In order to reduce regional disparities, the fiscal transfer fromthe central government should be distributed to less developed regions with consideration intoregional disparities and regional characteristics.In order to promote regional development with the active autonomy of regional governmentswhich the government of Indonesia aims, enhancement of regional finance and regionaldevelopment initiative, and improvement of capacity of regional administration are effectivemeasures.CONTENTSINTRODUCTIONI. Current State of Regional Disparities in IndonesiaII. Factors Behind Regional DisparitiesIII. Regional Development Fund and Fiscal TransferIV. Measures for Reducing Regional DisparitiesReferences*Economist, Macro-Economic Studies, RIDA, OECF**Deputy Director, 2nd Division, Operation Department I, Ex-Deputy Director, Macro-EconomicStudies, RIDA, OECFOECF Journal of Development Assistance Vol.4, No.1 (1998) pp.192-215©1998 by the Overseas Economic Cooperation Fund. All rights reserved.

OECF Journal of Development Assistance Vol.4, No.1, 1998 193INTRODUCTIONIndonesia has various disparities in economic and social standards between the highly developedwestern region and the less developed eastern region. Extreme disparities may trigger socialunrest. Taking these situations into consideration, the central government has aimed the reductionof regional disparities in the 6th Development 5-year Program (1994-1998 fiscal year) and the2nd Long-Term Development Program (1994-2018 fiscal year) by promoting regionaldevelopment with the active autonomy of regional governments.This survey analyzes the current state of regional disparities (economical, infrastructureand social level) in Indonesia and the factors behind these disparities. With comparing Indonesiawith China and Brazil which are similarly large countries, this research studies the policies forthe reduction of regional disparities. It is hoped that the results of the survey will prove useful indetermining the policies for "the reduction of regional disparities", which is one of main objectivesof the government of Indonesia.

194 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in IndonesiaI. CURRENT STATE OF REGIONAL DISPARITIES ININDONESIAThroughout the first Long-Term Development Program (1969-1993), the regional developmentof Indonesia has made significant progress through the development of the infrastructure. Theprogress of development in individual state, however, is not even, and various regional disparitieshave been created. In the 3rd Development 5-year Program (1979-1983 fiscal year), the centralgovernment announced the reduction of regional disparities as the prime target for the first time,and endeavored to reduce these disparities through the subsequent 5-year development program.Against this background, the central government is planning — in the current 6th Development5-year Program and the 2nd Long-Term Development Program — to proceed regionaldevelopment as it's important policy issue, with the active autonomy of regional governments.60% of the population is concentrated in Jawa, which represents only 7% of the total areaof the country (Jawa and Sumatera). The western area of Indonesia, equivalent to only 32% totalarea, shares 81% of the population and 83% of national GDP.Table 1Disparities by Regions (as of 1995)[billionrupiah]GDPPopulation[%] [1,000] [%]Per capitaGDP[1,000rupiah]AreaLiteracyrate[km 2 ] [%] [%]Sumatera 99,898 22.6 40,831 21.0 2,447 473,481 24.7 92.8Jawa 267,611 60.6 117,629 60.4 2,275 137,747 7.2 86.5Kalimantan 39,519 9.0 10,470 5.4 3,774 539,460 28.1 89.2Sulawesi 17,701 4.0 13,732 7.1 1,289 189,216 9.9 86.8Others 16,647 3.8 12,093 6.2 1,377 579,413 30.2 77.9Total 441,375 100.0 194,755 100.0 2,266 1,919,317 100.0 87.4Source: Statistic Indonesia (BPS), Financial Statistics (BPS)Looking at GDP per capita of each province (excluding petroleum & gas), there is a largedisparity of as much as 9.6 times between Jakarta(the highest area) and Nusa Tenggara Timur(the lowest area). This disparity is close to both that of China (9.8 times) and larger than that ofBrazil (7.4 times). In the comparison by coefficient of variation, — (standard deviation /averagevalue: the larger the value means the larger disparity) — the disparity among the provinces ofIndonesia is the highest among the 3 countries.

OECF Journal of Development Assistance Vol.4, No.1, 1998 195Table 2International Comparison of Disparities of GDP Per Capita among ProvincesLargest disparity among provincesCountry (State with largest earning / statewith lowest earning)Indonesia 9.6 (5.7)(Provinces of Jakarta and NusaTenggara Timur)FluctuationcoefficientNumber ofprovincesYear ofsurvey0.866 27 1993China 9.8 (4.1) 0.669 30 1994Brazil 7.4 0.584 27 1994Note : ( ) excludes Jakarta in case of Indonesia; and Shanghai, Beijing and Tianjing in case of China.Source: OECF (1997a), OECF (1997b)By using coefficient of variation of GDP per capita of the provinces, it can be seen that the disparityof GDP per capita among the provinces has been decreasing consistently since 1985. However, sincepetroleum & gas revenues are all taken by the central government, the disparity of GDP per capita excludingpetroleum & gas, which represents the wealth of provinces, has been expanding since 1985.Fluctuation coefficient1.31.21.11.00.90.80.70.6Per capita GDPPer capita GDP(excluding petroleum & gas)0.51985 90 91 92 93 94 95 96Fig. 1 Change of Coefficient of VariationSocial disparities are also extensive. The disparity in the rate of literacy is 47 points between theprovince with the highest literacy rate (Jakarta: 98%) and the province with the lowest literacy rate (TimorTimur: 51%). This disparity is higher than that of both Brazil (35 points) and China (35 points).

196 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in IndonesiaTable 3International Comparison of Disparities of Literacy Rate among ProvincesCountryIndonesiaChinaBrazilLargest disparityamong provinces47 points35 points35 pointsTop 3 provinces98% (Jakarta )97% (Sulawesi Utara )95% (Sumatera Utara)91% (Beijing)91% (Liangnei)91% (Tianging)92% (Rio Grande Do Sul)91% (Sao Paulo)91% (Rio De Janeiro)Bottom 3 provinces51% (Timor Timur )72% (Irian Jaya)74% (Nusa Tenggara Barat )56% (Tibet)72% (Gansu)72% (Tsinghai)57% (Alagoas)59% (Piauí)62% (Paraíba)Year ofsurvey199519941990Source: From varies sourcesFirst, the regional disparities in infant mortality, one of the indices of public welfare, areanalyzed. Average infant mortality in all provinces has been falling from 142.8‰ (1971) 1 to109.6‰ (1980) and to 71.0‰ (1990), The average infant mortality has been declining in 20years (Refer to Table 4). However, infant mortality in Indonesia is still higher than the rates ofChina and Brazil (Refer to Table 5), further improvements to the medical and health care ofinfants are needed for Indonesia.Table 4Provincial Infant Mortality[‰]1971 1980 1990 1971 1980 1990Aceh 143 93 58 Kalimantan Barat 144 119 81Sumatera Utara 121 89 61 Kalimantan Tengah 129 100 58Sumatera Barat 152 121 74 Kalimantan Selatan 165 123 91Riau 146 110 65 Kalimantan Timur 104 100 58Jambi 154 121 74 Kalimantan 1 3 6 1 1 1 7 2Sumatera Selatan 155 102 71 Sulawesi Utara 114 93 63Bengkulu 167 111 69 Sulawesi Tengah 150 130 92Lambeng 146 99 39 Sulawesi Selatan 161 111 70Sumatera Note1 148 106 64 Sulawesi Tenggara 167 116 77Jakarta 129 82 40 Sulawesi 1 4 8 1 1 3 7 6Jawa Barat 167 134 90 Nusa Tenggara Barat 221 189 145Jawa Tengah 144 99 65 Nusa Tenggara Timur 154 128 77Yogyakarta 102 62 42 Maluku 143 123 76Jawa Timur 120 97 64 Irian Jaya 86 105 80Bali 130 92 51 Timor Timur 85Jawa 1 3 2 9 4 5 9 Others 1 5 1 1 3 6 9 3Provincial simple average Note2 142.8 109.6 71.0Inter-provincial standard 26.8 23.1 20.7deviation Note3Fluctuation coefficient Note4 0.19 0.21 0.29Note : 1 Mathematical average of regional infant mortality2 Mathematical average of national provincial infant mortality3 Standard deviation of national provincial infant mortality4 Inter-provincial standard deviation / provincial simple averageSource: University of Indonesia1‰ indicates 1/1000, and means the infant mortality per population of 1000.

OECF Journal of Development Assistance Vol.4, No.1, 1998 197Table 5International Comparison of Infant MortalityCountry 1980~85 1989~94Indonesia 109.6 (1980) 71.0 (1990)China 37 30Brazil 71 56Source: Social Indicators of Development (World Bank)II. FACTORS BEHIND REGIONAL DISPARITIESThe results of regression analysis indicate that provincial GDP per capita (excluding petroleum& gas) has significant correlations between private sector investment (domestic and overseas)and the government’s development expenditure with significant level 1%. In other words, it isobserved that the infrastructure developed by the government with the abundant revenue frompetroleum and gas has prompted private sector investment and economic growth.Table 6Provincial GDP per capita (excluding petroleum & gas) and amount of per capita accumulatedinvestment: Result of multiple regression analysisPer capita GDP(excluding petroleumand gas)Governmentdevelopmentexpenditure Note 1Private sectorNote 2investmentConstant Adj.R21990 0.0053 ** 0.2064 ** 165.4 * 0.64161993 0.0052 ** 0.4943 ** 382.8 0.6237Note : 1 1990 indicates the accumulated per capita provincial government development expenditureby provinces (1987-1990); 1993 indicates the accumulated per capita provincial governmentdevelopment expenditure (1987-1994).2 1990 indicates the total value of the accumulated per capita provincial domestic private sectorinvestment (1968-1990) and the accumulated overseas private sector investment (1967-1990);1993 indicates the total value of the accumulated per capita provincial domestic private sectorinvestment (1968-8/1993) and the accumulated overseas private sector investment (1967-6/1993).3 ** and * respectively indicate 1% and 5% significant levels.Source: Computed from the Indonesia Financial Statistics (Bank Indonesia), Financial Statistics (BPS).Similarly, a significant correlation is observed between infrastructure development (electricpower, waterworks, telephones, etc.) and economic growth. This demonstrates that a level of theinfrastructure become a factor of economic disparities, hence, governmental expenditure doesplay a substantial role for reduction of regional disparities. Details about regional disparities ininfrastructure development and correlation between infrastructure and GDP per capita are analyzed.(1) Electric PowerFluctuation coefficients of the provincial per capita of electric power supply, have decreased

198 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in Indonesiasince 1983; however, again increased from 1988, and in 1993 the level of electric powersupply exceeded to the level of 1983 (Refer to Figs 2-3). Thus, the regional disparities haveexpanded again since 1989, and in 1993 the disparities exceeded to the level of 1983.0.60Fluctuation coefficient0.580.560.540.520.500.480.460.440.420.4083 84 85 86 87 88 89 90 91 92 93 [Year]Note: Calculated excluding JakartaFig. 2 Transition of Coefficient of Variation (per capita electric power supply)Per capita GDP[1000 rupiah/per capita]900.0800.0700.0600.0Observation valueTheoretical valueKalimantanJawa500.0400.0Sumatera300.0Sulawesiy=57.79x+153.9200.0Correlation100.0Otherscoefficient : 0.6464Value P : 0.00120.00.0 2.0 4.0 6.0 8.0 10.0Number of telephone lines per population[Lines per 1000]Note : 1 Per capita GDP and per capita electric power supply, respectively from 1993 data2 Calculated excluding Aceh, Riau, Jakarta and Kalimantan Timur.Fig. 3 Correlation of GDP Per Capita and Per Capita Electric Power Supply

OECF Journal of Development Assistance Vol.4, No.1, 1998 199A regression analysis was conducted between GDP per capita and electric powersupply. Under the 1% significant level, a significant correlation is observed between GDPper capita and electric supply (a correlational coefficient of 0.5460 and P-value 2 of 0.0070)(Refer to Fig. 3). This indicates that electric power supply had a strong explanatory forceon GDP, since electric power is the main energy for regional light industries.(2) WaterworksThe waterworks administration frequently covered 2 provinces; it is difficult to observeexpansion of regional disparities by the fluctuation coefficients. Therefore, the fluctuationcoefficients were calculated based on the following assumptions: (1) the 2 provinces underthe same administration had the same density of water supply; and (2) calculating thecoefficients of the years 1992 and 1993, excluding Jakarta because of its predominantvalues. Fig. 4 indicates the fluctuation coefficients have decreased and the provincialdisparities of water supply per capita have declined.This does not only means that provinces in the eastern Indonesia have started catchingup with the western Indonesia, but also some provinces in the eastern Indonesia, such asSulawesi Utara and Kalimantan Timur, have come up to the 1st and 2nd positions higherthan the western provinces after 1988.0.65Fluctuation coefficient0.60.550.50.450.483 84 85 86 87 88 89 90 91 92 93 [Year]Note: 1992 and 1993, calculated excluding JakartaFig. 4 Reference: Changes to Coefficient of Variation (water supply per capita)According to the regression analysis, there is a significant correlation between GDPper capita and water supply per capita at the 1% significant level (Refer to Fig. 5).2The value P, in examination of non-correlation, is a probability to compare with the significantlevel capable of discarding the non-regression hypothesis that "correlation coefficient of population betweentwo variables is zero." It can be said that if the value P is less than the significant level, it is notable at thesignificant level (there is a correlation between the two variables).

200 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in IndonesiaPer capita GDP[1,000 rupiah/person]900800700600500400300200100Observation valueTheoretical valuey=43.64x+309.9Correlational coefficient: 0.6179Value P: 0.001700.0 2.0 4.0 6.0 8.0 10.0 12.0Volume of per capita water supply[m 3 /person]Note : 1 Per capita GDP and per capita water supply volume respectively from 1993 data2 Calculated excluding Aceh, Riau, Jakarta and Kalimantan TimurFig. 5 Correlation of GDP Per Capita and Water Supply Per Capita(3) Telephone LinesThe fluctuation coefficients of provincial per capita telephone lines significantly decreasedfrom 1981 to 1985, after that the coefficients have slowly decreased. Thus, the provincialdisparities have been shrinking gradually 3 (Refer to Fig. 6).0.70Fluctuation coefficient0.600.500.400.300.200.100.0075 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 [Year]Note : There were considerable discrepancies in the data regarding Jakarta, Jawa Baratand Timor Timur between the years of 1989/90 and the years before and afterthis, hence these 2 years were complemented by the Figs for 1988 and 1991.Fig. 6 Changes to the Coefficient of Variation (per capita telephone lines)3Due to the lack of credibility of the data for 1989 and 1990, there were incompatible coefficient ofvariation, and hence examination is made excluding the years 1989 and 1990.

OECF Journal of Development Assistance Vol.4, No.1, 1998 201A regression analysis was conducted between GDP per capita and telephone lines,and the result proved a strong correlation at the 1% significant level (Refer to Fig. 7).Per capita GDP[1000 rupiah/per capita]900.0Observation value800.0Theoretical value700.0Kalimantan Jawa600.0500.0400.0Sumatera300.0Sulawesi y=57.79x+153.9200.0Correlationcoefficient : 0.6464100.0OthersValue P: 0.00120.00.0 2.0 4.0 6.0 8.0 10.0Number of telephone lines per population[Lines per 1000]Note : 1 Per capita GDP and per capita telephone lines, respectively from 1993 data2 Calculated excluding Aceh, Riau, Jakarta, Bali and Kalimantan TimurFig. 7 Correlation of GDP Per Capita and Per Capita Telephone LinesA telephone line is a fundamental element to the economic infrastructure. Whenopening a new enterprise, particularly in service sector, more than one telephone line isrequired; therefore, telecommunications infrastructure must have a strong correlation withthe number of new enterprise.III. REGIONAL DEVELOPMENT FUND ANDFISCAL TRANSFERRegional development of large scale countries is often undertaken by each regional government(such as in case of China and Brazil), due to the diversity of each region and the distance fromcapital cities. Indonesia is also proceeding plans with the active autonomy of regionalgovernments(in the Long-Term Development Program and the current 5-year developmentprogram). Regional government's budget, however, is insufficient both in scale and quality.In 1994, the total revenue of the provincial governments reached 9,709.1 billion rupiah,which represented only 13% of the revenue (72.353 trillion rupiah) of the central government inthe same year. This total provincial revenue is remarkably lower than that of China (92% ofcentral government) and Brazil (356%).

202 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in IndonesiaTable 7International Comparison of Ratio of Provincial Revenue against Central Government RevenueCentral governmentrevenueProvincial revenueRatio of provincialrevenue against centralgovernment revenueYear of surveyIndonesia 72.353 trillion rupiah 9,709.1 billion rupiah 13.4% 1994 fiscal yearChina 325.7 billion yuan 298.6 billion yuan 91.7% 1995 fiscal yearBrazil 481 million real 1,710 million real 355.5% 1993 fiscal yearJapan 73.4305 trillion yen 50.9337 trillion yen 69.4% 1994 fiscal yearSource: Financial Statistics (BPS), China Statistics Yearbook, Government Finance Statistics Yearbook(IMF), Financial Statistics of 1996 (Survey Department of Budget Bureau, Ministry of Finance,Japan), Regional Financial Statistics Yearbook of 1996 (Regional Finance Research Society of Japan)The provincial revenue consists of the provincial government’s own revenue (regionaltaxes, commissions) (31%), revenue distribution from the central government(8%), non-restrictedsubsidies (block INPRES) (12%), and the amount carried over from the previous year (6%).Provincial government can spend 57% of the total revenue under its control. The level of provincialgovernment revenue is remarkably lower than that of China and Brazil (more than 80%).Table 8Revenue Structure of Provincial GovernmentsSumatera Jawa Kalimantan Sulawesi OthersProvincialtotalProvincial government’sown revenue25.5 36.9 16.0 20.1 11.0 31.0Carry-over from previousyear4.5 6.7 7.5 1.7 4.1 6.0Revenue distribution 10.7 5.1 19.1 7.5 13.9 7.8Central governmentsubsidy and grant59.3 50.5 56.9 70.6 71.0 54.7Development revenue 0.0 0.8 0.5 0.0 0.0 0.5Total revenue 100.0 100.0 100.0 100.0 100.0 100.0Table 9International Comparison of Provincial Government's Own Revenue against Total ProvincialGovernment RevenueRatio of ownrevenueYear of surveyRemarkIndonesia 31% 1994 fiscal year Total revenue within spending power of provincialgovernment is 57% including revenue distribution of 8%,subsidy without restriction of use of 12%, and carry-overfrom previous year of 6%.China 81% 1992 fiscal yearBrazil 81% 1994 fiscal yearSource: Financial Statistics of the First Level Government, China Financial Yearbook, Ministério deFazenda

OECF Journal of Development Assistance Vol.4, No.1, 1998 203In Indonesia, a major portion of the revenue of regional governments is dependent on fiscaltransfer from the central government — the second level local governments are partially dependenton fiscal transfer from the first level local governments. Thus, fiscal transfer has an importantrole for regional development as well as for the overall national economy. Consequently, thecentral government is capable of influencing regional development by controlling the fiscal transferto local governments.System of Fiscal TransferFiscal transfer is classified into subsidies and grants: such as INPRES, and subsidy for regionalautonomy (SDO), and revenue distribution, which is the half of national taxes. In the first levellocal governments, the share of the revenue by the fiscal transfer was 63% in the fiscal year1994; which, however, is still lower than in the fiscal year 1987 (74%). Thus, the ratio of thedependent revenue on the central government has gradually decreased (Refer to Fig. 8).[%]80.070.060.050.070.665.363.559.7Regional government’s own revenueRevenue distributionCentral government subsidies & grants58.561.760.954.740.030.020.010.021.022.43.2 5.922.026.38.2 6.625.06.824.06.726.27.731.07.80.01987 1988 1989 1990 1991 1992 1993 1994[Year term]Note : Total value of the first level local governmentsSource: Financial Statistics of the First Level Local Governments (BPS)Fig. 8 Share of the Central Government Subsidies in the Revenue of theFirst Level Local GovernmentsFiscal transfer is necessary in order to reduce regional financial disparities and to securethe stabilization of local revenues. Over dependence on fiscal transfer, however, is not desirablefor local finance. Following problems are caused by over dependence on fiscal transfer:Most of fiscal transfer is restricted about its use by the central government; therefore,decision power of local governments' expenditure is limited.Because the independent revenue source is fragile in local governments, it is hard to increase

204 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in Indonesiaof tax revenue from success of development and to enhance the development incentive. 4The most desirable local budget structure is securing independent revenue stable own fundbased on local taxes. Additionally, the independent revenue shares the main part of local revenue.Nevertheless, the first problem (restriction of use) is improved by entrusting the local governmentswith the payment authorization to as well as fiscal transfer.Based on this argument, the World Bank has been negotiating with BAPPENAS for 3 yearsin order to expand regional authority of subsidies' use. Originally, INPRES has been grantedwith strict restrictions on the use by sector. Therefore, the local governments have been limitedtheir use of subsidies. The World Bank advised that block grants 5 should be consolidated so thatthe regional governments can use subsidies more freely. As this result, block grants have beenexpanded, and, BAPPENAS agreed to further expand the authority of block grants to the regionalgovernments from April 1, 1997.Along with the expansion of block grants, increase of revenue distribution contributes tothe expansion of payment authority of the local governments. As in the case of the gift tax, 6 forexample the consumption gift tax 7 in Japan, revenue distribution is common in developed countries,but is rare in less developed countries. Gift tax (Japan) is collected by the central government,and a part of it is distributed to the local governments. The revenue distribution in Indonesia;however, is a system that some taxes and commission revenues individually collected by thelocal governments, and it is shared between the central government and the local governments.The central government has the discretional power over the use in the local governments.It will take a considerable time to introduce new local taxes or to improve the tax collectionsystem and to expand local tax collection at the same level as the current dependent revenue. Ina short period, a realistic policy is to promote local autonomy by increasing block grants andrevenue distribution in the fiscal transfer, and expanding the payment authority of the localgovernments. The expansion of payment authority increases development works in the localgovernments; however, this helps to foster the fields of business planning, the operational knowhow,and administrative capability in the local governments.Provincial revenue per capita 8 (Refer to Table 10) is examined to prove how the fiscaltransfer influences the disparities in provincial budget.4The development incentive refers to a situation where, if more effective development project isundertaken by a provincial government, more benefit will return to the provincial government itself as aresult. For example, when a development work is undertaken by a provincial government to meet the needsof the area, the regional economy will be revitalized, and the increased tax revenue will accrue to theprovincial revenue.5General purpose subsidies. Comparatively less restricted in use. The subsidies with restricted useare referred to as Specific Grants (specific purpose grant).6In gift taxes, there are consumption gift taxes, local road gift taxes, special ??? gift taxes, petroleum& gas gift taxes, and aeronautical fuel gift taxes.7As consumption gift tax, to date 20% of the consumption tax have been distributed; however, from1997, this was separated as local consumption tax from the consumption tax which is a state tax. Kurokawa(1995)8Revenue includes fiscal transfer (subsidies, grants and revenue distribution) plus carryover fromthe previous year, independent revenue of the local governments and development revenue.

OECF Journal of Development Assistance Vol.4, No.1, 1998 205Table 10Provincial Revenue per Capita[Rupiah/person]Fiscal year 1986 1987 1988 1989 1990 1991 1992 1993 1994Rankingof 1994Aceh 23,795 24,001 25,773 31,425 34,543 41,904 46,847 53,098 54,704 10Sumatera Utara 20,457 22,220 24,014 26,929 31,070 32,381 36,265 43,364 49,700 12Sumatera Barat 10,498 10,762 13,523 15,913 17,357 19,346 20,845 23,632 28,553 23Riau 18,697 19,288 23,967 38,107 47,801 60,642 64,798 63,506 59,604 9Jambi 14,629 13,879 16,023 18,563 23,864 30,273 33,487 37,832 40,168 16Sumatera Selatan 12,470 12,297 12,940 15,000 19,866 22,005 23,213 25,966 27,209 24Bengkulu 22,283 21,870 24,838 26,211 34,203 39,676 43,498 46,528 49,597 14Lambeng 15,564 15,910 17,670 20,533 24,573 26,397 29,943 15,841 18,956 27Sumatera Total Note1 18,311 18,909 20,893 24,924 30,215 33,905 37,158 38,672 41,796Jakarta 50,754 54,934 64,049 74,963 119,526 147,404 160,763 190,672 244,650 1Jawa Barat 12,668 13,726 14,680 16,881 19,511 22,224 24,927 29,568 34,507 20Jawa Tengah 15,117 16,106 16,852 18,917 21,332 24,433 28,798 35,203 38,701 18Yogyakarta 29,787 28,465 31,207 31,660 36,637 45,902 50,832 61,933 67,494 8Jawa Timur 14,279 16,029 17,408 19,320 22,812 26,079 29,083 34,353 39,200 17Bali 28,202 29,485 34,636 40,557 52,234 36,896 33,249 35,154 42,997 15Jawa Total 17,633 19,075 20,912 23,743 29,714 34,342 38,314 45,667 54,136Kalimantan Barat 22,351 22,833 26,248 30,105 37,044 42,399 48,040 57,296 34,145 21Kalimantan Tengah 40,192 39,320 45,657 52,360 65,132 81,774 95,542 115,162 120,704 2Kalimantan Selatan 29,146 29,120 31,987 37,213 43,250 48,696 59,664 72,964 78,592 7Kalimantan Timur 40,687 39,062 45,458 55,850 75,312 88,430 99,345 96,344 111,141 3Kalimantan Total 30,577 30,341 34,685 40,765 51,018 59,870 69,524 79,028 76,715Sulawesi Utara 34,325 36,246 40,174 44,734 50,292 60,401 67,448 36,065 36,771 19Sulawesi Tengah 29,991 31,830 33,070 39,868 53,485 61,075 70,503 84,473 88,471 5Sulawesi Selatan 7,931 7,795 8,938 11,439 15,268 17,385 17,569 18,890 22,273 25Sulawesi Tenggara 23,670 17,789 21,453 19,284 31,120 38,854 39,461 48,946 49,657 13Sulawesi Total 17,667 17,669 19,670 22,715 29,131 34,211 37,095 34,754 37,488Nusa Tenggara Barat 8,255 7,913 8,897 10,433 14,548 18,013 18,406 20,460 22,036 26Nusa Tenggara Timur 10,343 8,541 9,401 11,729 15,604 20,559 24,004 25,926 31,904 22Maluku 19,884 15,758 19,481 26,160 36,161 41,493 44,091 48,647 51,009 11Irian Jaya 34,427 34,174 40,932 48,404 70,077 76,555 92,715 98,303 106,141 4Timor Timur 49,404 39,067 37,413 42,419 52,495 61,274 77,882 84,377 87,559 6Total of others 17,309 15,287 17,420 21,246 29,562 34,735 40,102 43,562 47,848National total Note2 18,113 18,999 21,021 24,294 30,417 35,141 39,276 44,579 50,689Provincial simple 23,697 23,275 26,174 30,555 39,449 45,647 51,156 55,722 60,609average Note3Inter-provincial 12,026 11,819 13,397 15,800 23,498 28,546 32,544 37,866 46,304standard deviation Note4Fluctuationcoefficient Note5 0.51 0.51 0.51 0.52 0.60 0.63 0.64 0.68 0.76Note : 1 Total of regional revenue / regional population2 Total of national revenue / national population3 Mathematical average of provincial revenue per capita4 Standard deviation of provincial revenue per capita5 Provincial standard deviation / provincial simple average6 Population of 1990 from population census; for other fiscal years, calculated using growthrate according to Figs from the fiscal years 1985 and 1990Source: Financial Statistics (BPS), Statistics Indonesia (BPS)The disparities of provincial revenue per capita are observed by the changes to coefficientsof variation. The coefficients of variation have gradually increased since the fiscal year 1986,and the provincial disparities in revenue per capita have expanded moderately. However, accordingto the comparison of the change in coefficients of variation provincial disparities between therevenue per capita and the revenue (after revenue transfer) per capita, both coefficients haveincreased trend on a time-sequential basis; the coefficients of variation of the per capita revenue

206 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in Indonesiaafter fiscal transfer are much lower than the coefficient of variation of the per capita revenuebefore fiscal transfer (Refer to Fig. 9).The coefficient of variation of the revenue per capita before fiscal transfer is 1.00 in thefiscal year 1986 and 1.82 in the fiscal year 1994. On the other hand, the coefficient of variationof the revenue per capita after fiscal transfer is up from 0.51 up to 0.76.Thus, the coefficient of variation of the revenue per capita after fiscal transfer is always abouthalf of the coefficient of the revenue per capita revenue before fiscal transfer; while the provincialdisparity of the revenue per capita after fiscal transfer has slightly increased. Consequently, the fiscaltransfer is alleviating the provincial disparity to a considerable extent. Fiscal transfer, therefore, isfunctioning to mitigate, if not to the extent of eliminating, the provincial fiscal disparities.Fluctuation coefficient2.001.801.601.401.201.000.800.600.400.20Per capita revenue before fiscal ransferPer capita revenue after fiscal transfer1986 1987 1988 1989 1990 1991 1992 1993 1994[Fiscal year]Source: Financial Statistics (BPS), Statistics Indonesia (BPS)Fig. 9 Comparison of the Coefficient of Variation of Revenue Per Capita andRevenue Per Capita (fiscal transfer)It is understood that fiscal transfer has contributed to decrease the provincial fiscal disparities;however, a question remains: whether fiscal transfer is properly distributed for reducing thedisparities of infrastructure development. This question is examined by provincial GDP per capitaand the total road kilometers per unit area, as a measure of regional economic development aswell as social development.A regression analysis is conducted during the fiscal years 1986-1994, and shows thecorrelational coefficient of 0.326 and P value of 0.097, which indicates a significant correlationis not observed between GDP per capita and the accumulated fiscal transfer per capita (Refer toFig. 10). Another regression analysis observes the correlational coefficient of 0.098 and P valueof 0.627. Thus, a significant correlation is not observed between the total road kilometers perunit area and the accumulated fiscal transfer per capita (1986-1994 fiscal year) (Refer to Fig. 11).In sum, fiscal transfer should be distributed preferentially to socially and economically lessdeveloped regions; however, a significant correlation is not observed between GDP per capitaand total road kilometers per unit area, and this indicates that fiscal transfer is not distributed toregions, which are required for regional development.

OECF Journal of Development Assistance Vol.4, No.1, 1998 207Per capita GDP[1,000 rupiah]10,0009,0008,0007,0006,0005,0004,000West IndonesiaEast IndonesiaCorrelational coefficient : 0.326P Value: 0.09673,0002,0001,000-0 100 200 300 400 500 600Accumulated fiscal transfer per capita(1986-1994 fiscal year) [1,000 rupiah]Note : 1 Population from data of Intercensal Population Survey2 GDP from data of the fiscal year 1995Sources : Financial Statistics (BPS), Statistics Indonesia (BPS)Fig. 10 Relationship between GDP Per Capita and Accumulated Fiscal Transfer Per CapitaTotal road kilometers per unit area(1994) [Km / 1,000 Km 2 ]1,6001,4001,2001,000800West IndonesiaEast IndonesiaCorrelational coefficient : 0.098P Value : 0.6267600400200-- 100 200 300 400 500 600Accumulated fiscal transfer per capita(1986-1994) [1,000 rupiah]Note : 1 Population from data of the fiscal year 19942 Jakarta (10,171 [Km/1,000 Km 2 ]) and Yogyakarta (4,478 [Km/1,000Km 2 ]) are excluded from the table due to their large population.Sources : Financial Statistics (BPS), Statistics Indonesia (BPS)Fig. 11 Relationship between Total Road Kilometers Per Unit Area andAccumulated Fiscal Transfer Per Capita

208 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in IndonesiaIV. MEASURES FOR REDUCING REGIONAL DISPARITIESAs the government of Indonesia declares its policy (in the 2nd Long-Term Development Programand the 6th Development 5-year Program), reduction of regional disparities of growth is animportant policy for strengthening the national integration of Indonesia.This chapter examines the measures for reducing regional disparities, from the point ofassisting the studies by the government of Indonesia. At the same time, the chapter analyzes themeasures for more effective regional development with respect to the autonomy of the localgovernments as well as the less developed regions.For reduction of regional disparities, the following measures are considered to be effective.(1) Develop infrastructure in the less developed regions and stimulates private sector investmentthe regional characteristic industries, which leads activating the regional economyIt is an effective means for reducing regional disparities to the infrastructure developmentin less developed areas and improve regional infrastructure disparities. Chapter 2 provesthat strong correlations are observed between regional economies and the governmentdevelopment expenditure, and private sector investments. The government developmentexpenditure is mainly invested for infrastructure development, and private sector investmentsconcentrate to the areas with developed infrastructure. Regional economy is developed bythe expansion of public and private sector investments, and stimulates further investments.In order to develop the favorable economic environment, promotion of infrastructure inless developed regions is important. And, area development for more private sectorinvestment is deemed an essential solution for reducing regional disparities.(2) Provide fiscal transfer to local governments in due consideration of regional disparitiesand characteristicsGenerally, it is difficult to judge which is the more effective means for regional development:decentralized administration or centralized administration, because of differences in levelsof national development or political situations. In Indonesia, it needs more argument whichapproach is more effective. However, same as decentralization in other developing nations, 9Indonesia is taking the decentralization policy due to the racial movements, and in the 2ndLong-Term Development Program and the 6th Development 5-year Program, "enhancementof decentralization and local autonomy" are declared as these goals. Decentralization hasto be actively promoted by the government of Indonesia in order to strengthen nationalintegration as well as reduction of regional disparities.Local budget — essential funds for autonomy of local governments — depends onfiscal transfer from the central government. Therefore, it is necessary that the fiscal transferis distributed preferentially to the less developed regions not only in order to reduce regionaldisparities but also to upgrade the infrastructure in the less developed regions.Presently, however, the fiscal transfer is functioning to decrease the financial9For example, the "World Development Report 1997" of the World Bank [1997] recognizes localdecentralization as "activities in bringing public services closer to regional needs and preferences, properlyresponding, and providing opportunities for building accountable governments from the bottom up."Furthermore, in order to succeed decentralization, it points out the necessity of "distribution of authorizationof budget by local governments” and “design of appropriate central and local inter-governmental subsidies."

OECF Journal of Development Assistance Vol.4, No.1, 1998 209disparities, it is not functioning for the reduction of regional disparities in the economy andlevels of infrastructure.In addition, observing the number of projects submitted by the government of Indonesiato CGI (Consultative Group on Indonesia), 10 more than 90% were concentrated in thewestern Indonesia in 1997, 11 and there is no policy to promote preferential development inthe eastern regions (Refer to Fig. 12).100%90%80%70%60%50%40%30%20%10%0%1994 1995 1996 1997Source: Indonesian government dataOthersSulawesiKalimantanJawaSumateraFig. 12 Ratio of the Number of Projects Requested by theGovernment of Indonesia to CGIFor future reduction of regional disparities, it would be necessary to promotepreferential infrastructure development in the less developed regions, particularly in theeastern regions. Consequently, regional distribution should be made preferentially to theless developed regions.There are further measures for more effective regional development under autonomousadministration of local governments, including development in the less developed areas.(3) Increase the own revenue of the regional governments and promote decentralization inexpenditure, in order for the regional governments to undertake effective developmentIt is necessary to increase the ratio of funds under the local governments in order that thelocal governments administrate their own development fund. In a long period, desirablepolicy is to increase local tax revenue, for example, by implementing new local taxes orswitching state taxes to local taxes, in order to expand the own fiscal source of the localgovernments. In a short period, however, it may be realistic to strengthen the local budgetby transferring the power of disbursement of fiscal transfer, such as increasing revenuedistribution of the state taxes and the Block INPRES.10The projects are more than 10 sectors including electric power, road, water resource, irrigation,education, etc., most of them are covering infrastructure development.11More than 80% of the total number requests during the fiscal years 1994-1997 is concentrated inthe western Indonesia.

210 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in IndonesiaWhat the most important to enhance the development incentive of the localgovernments is expanding the own fiscal source of the regional governments — BlockINPRES, revenue distribution of the state taxes, etc.Development incentives are:Step 1 : Expansion of the power of disbursement by the local governments, whichleads to regional development by autonomous administration.Step 2 : Autonomous administration by the local governments, which enableseffective development reflecting regional needs and vitalizing the regionaleconomy.Step 3 : Activation of the regional economy, which promotes revenue increase oflocal governments by the increase of tax collection.Thus, more effective regional development directly contributes to developmentinitiative by the local governments under the environment which ultimately benefits thelocal governments.Expanding the local government's power of disbursement builds a system whichexpects effective regional development.The regulation P5D, issued by the Department of Home Affairs in 1982 (guidelinefor regional development program and administration), stipulates a regional developmentprogram planning process which is called the “bottom-up system” 12 for more effectiveregional development needs.In the bottom-up system, projects are deliberated from lower governments to thehigher governments — from village governments district governments regencygovernments provincial governments the central government. A developmentcoordination conference which is called Rakorbang, is held in each government level todiscuss development projects, then the projects are submitted to the higher governments(Refer to Fig. 13). In the bottom-up system, the first conference is the village developmentunit (LKMD), which consists of residents, therefore this system can reflect the developmentneeds of the local residents.In reality, however, the bottom-up system has many problems, and is not currentlyfunctioning ideally. According to Matsui [1997], 12 5 problems are observed in the bottomupsystem.In the regency development coordination conference, conflicts of interest occur amongvarious agencies and as a result, projects are deliberated at the provincial level withoutproper coordination.Adjustment of conference schedules are not smoothly decided because of poorcommunication between provinces and regencies.Clear development strategies are not defined in the regency development coordinationconference.The low awareness in the regency officers, who negotiate with the provincial officers,prevent improving the coordination between the regency and the province.12Further details in Matsui [1997].

OECF Journal of Development Assistance Vol.4, No.1, 1998 211The village development unit (LKMD), which is discussion of development problemsin a village, is not functioning sufficiently, and as a result, the bottom-up system isstarting from the district governments.CentrallevelCentral governmentNational DevelopmentPlanning BoardNational DevelopmentCoordination ConferenceNational DevelopmentCoordination PreliminaryConferenceProvinciallevelCentral governmentprovincial office /provincialgovernmentOperations BoardProvincial DevelopmentBoardProvincial InvestmentProgram CoordinationConferenceProvincial DevelopmentCoordination ConferenceProvincial DevelopmentCoordination PreliminaryConferenceRegionallevelCentral governmentprovincial office /provincialgovernment OperationsBoardRegional DevelopmentPlanning BoardRegional InvestmentPlan CoordinationConferenceRegional DevelopmentCoordination ConferenceRegional DevelopmentCoordination PreliminaryConferenceDistrictlevelDistrict governmentVillagelevelVillage development unitSource: Matsui [1997]Fig. 13 Flow of Regional Development Program Planning by the Bottom-up System(4) Enhance the administrative capabilities of regional governments by strengtheninghuman resource developmentThe problems in the bottom-up system do not derive from the inherent faults of this system,but from the lack of awareness and development planning capabilities of the participatinglocal governments. Since the bottom-up system is, ideally, capable of reflecting the needsof the local people, it is important to develop the awareness and capability about regionaldevelopment of the local governments and to improve development administrativecapabilities for the effective functioning of this system.Thus, it cannot be said that the local governments are presently sufficient withdevelopment administrative capabilities for regional development autonomy. In order toimprove these capabilities, the bottom-up system should be activated for more activecommunication among the various governments, and for technology transfer from the highergovernments to the lower governments.To summarize, in order to continue sustainable development and to keep nationalintegration of Indonesia, it is necessary to carry out regional development, by the local

212 Tetsuro Takeda, Ryosuke Nakata, Regional Disparities in Indonesiagovernments under the bottom-up system and to reduce regional disparities of infrastructuredevelopment and economy (Refer to Fig. 14).For OECF, it is necessary to expand our studies about the more effective regionaldevelopment works, considering regional disparities. In addition, it may also be necessary1) to consider infrastructure development and to develop human resources in the lessdeveloped areas; and 2) to enhance the participation of the local governments and localautonomy in development projects for providing opportunities to improve the localadministrative capabilities.Increase the ratio ofBlock INPRESExpansion of revenuedistributionEnhancement of the regionaldevelopment capabilities of the localgovernmentsExpansion of local taxcollectionPlanning the bottomupsystemRegional development under the local government autonomyFig. 14 Steps of Regional Development under Local Government AutonomyREFERENCES(Japanese)Coordination Department of Economic Planning Agency (1996). APEC Keizai Tenbo (APECeconomic prospect), Ministry of Finance Printing Bureau, in Japanese.Fujimori, Hideo (ed.) (1989). Hatten Tojokoku ni okeru Genchika Seisaku no Hyoka (Evaluationof Localization Policies in Developing Countries), Asia Economic Research Center, inJapanese.General Research and Development Institute (ed.) (1995). Chugoku no Chiiki Keizai kakusa toChiiki Keizai Kaihatsu ni kansuru Jisshoteki Kenkyu (Empirical Studies of RegionalEconomic Disparities and Regional Economic Development of China), in Japanese.Hara, Yonosuke (1994). Tonan Ajia Shokoku no Keizai Hatten (Economic Development ofSoutheast Asian Countries), Libroport, in Japanese.Igusa, Kunio and Bob Wildyahaltono (eds.) (1994). AFTA to Indonesia Keizai (AFTA andIndonesian Economy), Asia Economic Research Center, in Japanese.

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OECF Journal of Development Assistance Vol.4, No.1, 1998 215(English)Bird, Kelly (1996). "Industrial Concentration and Competition in Manufacturing", The IndonesianQuarterly vol.XXIV, No.2, Center for Strategic and International Studies.Elizondo, Raul Livas and Paul Krugman (1992). "Trade Policy and Third World Metropolis",NBER Working Paper No. 4238.Henderson, J. Vernon and Ari Kuncoro (1996). "Industrial Centralization in Indonesia", TheWorld Bank Economic Review Vol.10 No.3.Isserman, Andrew M. (1994). "Comment on Urban Concentration: The Role of Increasing Returnsand Transport Costs by Krugman", Proceedings of the World Bank Annual Conference onDevelopment Economics 1994.Krugman, Paul (1991). Geography and Trade.______ (1994). "Urban Concentration: The Role of Increasing Returns and Transport Costs",Proceedings of the World Bank Annual Confrence on Development Economics 1994.______ (1995). Development, Geography, and Economic Theory.Luhulima, C.P.F. (1994). "Indonesia's Initiative in APEC", The Indonesian Quarterly vol.XXII,No.4, Center for Strategic and International Studies.Ministry of Home Affairs, Indonesia (1995). "IDT Program Implementation Guidance".Ministry of Public Works, Indonesia (1996). "A Profile of Public Works InfrastructureDevelopment in The Sixth Five Year Development Plan".Myrdal, Gunnar (1957). "Economic Theory and Underdeveloped Regions", London : Duckworth.Osada, Hiroshi (1996). "APEC and Indonesia: Impacts of Liberalization Policies on theManufacturing Industries and the Problems in the Future", APEC Discussion Paper SeriesNo.5, GSID, Nagoya University.Pangestu, Mari (1995). "ASEAN Free Trade Area (AFTA): An Indonesian Perspective", TheIndonesian Quarterly vol.XXIII, No.1, Center for Strategic and International Studies.______ (1996). Economic Reform, Deregulation and Privatization - The Indonesian Experience,Center for Strategic and International Studies.Rosen, K. and M. Rodnick (1980). "The Size Distribution of Cities: An Examination of thePareto Law and Primacy", Journal of Urban Economics 8.Sandwip, Kumar Das and Alokesh Barua (1996). "Regional Inequalities, Economic Growth andLiberalization: A Study of the Indian Economy", The Journal of Development Study Vol.32,No.3 1996.Smoke, Paul and Blane D. Lewis (1996). "Fiscal Decentralization in Indonesia: A New Approachto an Old Idea", World Development Vol.24, No.8.Soesastro, Hadi (1995). "ASEAN Economic Cooperation: The Long Journey to AFTA", TheIndonesian Quarterly vol.XXIII, No.1, Center for Strategic and International Studies.______ (1996). "Policies Towards Foreign Direct Investment – New Challenges Facing AsianDeveloping Countries", The Indonesian Quarterly vol.XXIV, No.2, Center for Strategicand International Studies.UNCTAD (1994). Trade and Development Report 1994, United Nations.______ (1996). Trade and Development Report 1996, United Nations.World Bank (1989)."Indonesia Basic Education Study".______ (1994). "Intergovernmental Fiscal Relations in Indonesia : Issues and Reform Options".______ (1996). "Indonesia Dimensions of Growth".

HOW MAINTENANCE FOR IRRIGATIONPROJECTS SHOULD ADAPT TO CHANGES INTHE LOCAL COMMUNITY– Taking the Lankeme Irrigation Project inIndonesia as a Case Study –Masami Mizuno *Katsuhiko Nakadate **Rie Makita ***SUMMARY(1) Taking the Lankeme Irrigation Project as a case study, this report will examine the changescaused by the project in the project area and study the effective way of operation andmaintenance to cope with these changes.(2) There are two kinds of changes brought by the project. One is the changes promoted by theproject. The other is the changes generated by the project.(3) In this report, "maintenance of the irrigation project" is defined as "to lessen and to justifythe cost for organizing and operation of water users' associations" which was newly causedby the project.(4) As the lessons for the maintenance of irrigation projects in the future, this report will summarizethe points to be considered at the stage of preparation of the project, implementation ofthe project and operation and maintenance of the project respectively.CONTENTSIntroductionI. Summary of the Lankeme Irrigation Project and Its Subject AreaA. BackgroundB. Summary of the Project AreaC. Project EffectsII. Changes Brought by the Lankeme Irrigation Project in Its Subject AreaA. Changes Which were Promoted by the Irrigation ProjectB. Changes Generated by the Irrigation ProjectIII. How to Deal with These ChangesA. Support for the Diversification of Agriculture*Ministry of Agriculture, Forestry and Fisheries, National Research Institute of AgriculturalEconomics, Overseas Dept., Senior Researcher**A Representative, OECF Hanoi Office (Former Evaluation Officer, Post Evaluation, RIDA, OECF)***Economic Adviser, Sector Studies, RIDA, OECFOECF Journal of Development Assistance Vol.4, No.1 (1998) pp.216-242©1998 by the Overseas Economic Cooperation Fund. All rights reserved.

OECF Journal of Development Assistance Vol.4, No.1, 1998 217B. Solution of the Labor ShortageC. Support for New Farming PracticesD. Securing Diversity in Cropping SystemsE. Dealing with New Regional DisparitiesF. Restrictions on Conversion of Farm Land to Other ApplicationsG. Empowerment of Farmers' OrganizationsIV. General Lessons on the Maintenance of Irrigation ProjectA. Points which should be Considered at the Development Survey StageB. Matters to Consider during the Construction PeriodC. Matters to Consider after Construction is CompleteAfterwordReferencesFig. 1 Project Location

218 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local CommunityINTRODUCTION– What does the Maintenance of an Irrigation Project Mean? –For an irrigation project to succeed, it must maximize and sustain the increase in productionafforded by the project. The key to this success is the effective and efficient use of the completedirrigation facilities by those who stand to benefit from them. By now, executing agencies and thedonor countries have come to look at the project as a continuing whole, including the maintenanceof the facilities as well as their construction.The physical side of maintenance means the cleaning and repair of the waterways themselves,but maintenance is commonly given a much wider interpretation, which includes the creation ofwater distribution plans by water users' associations organized by the beneficiary farmers, thecollection of water use fees to pay for repairs, and the provision of communal labor. This couldbe called "irrigation management", which covers the full range of activities related to the irrigationfacilities. 1 In this report we would like to discuss a form of maintenance of irrigation projectswhich builds a suitable environment within which farmers can come forward to join water users'associations, pay water use fees, provide their labor and generally take an active role.The aspect of the environment surrounding the farmers, who are the main beneficiaries ofthe project, which is easiest to overlook, is the ongoing change in the community in which theylive. The Lankeme Irrigation Project is far from unique in taking over ten years from thedevelopment study to completion. It is easy to see that by the time the project is complete thecommunity it serves could be very different from that which existed when the project was planned.It is also important to be aware that there are two types of change that can occur in the community.One type is the change that would have happened in the long term even if the project had notbeen implemented, but have been assisted and accelerated by outside intervention. The othertype is the emergence of new situations and conditions which would have been impossible withoutthe implementation of the project.Thus, an intervention made for a certain objective (improvement of crops, in the case of theLankeme Irrigation Project), creates new attendant circumstances in the local community. Ifmaintenance is pushed forward with only the initial planned objectives in mind and ignores thesenew circumstances, it will never be possible to motivate the farmers who are expected to take onthe task of maintenance. In order to sustain the main objective, which is to increase crop production,the problems of new circumstances must be solved and the operation guided into a more suitabledirection. Where obvious changes such as large-scale population migration or environmentaldegradation are observed during the construction stage of a project, some revision of the scopeof the project must be made. At the maintenance stage which follows the completion ofconstruction, I believe the farmers will not be able to carry on the task effectively before thesystem has adapted responsively to new changes which have happened or are happening.The implementation of the Lankeme Irrigation Project has achieved its anticipated targetsby increasing unit yields of rice and the efficiency of cultivation (these effects have been describedin detail in the preceding post-evaluation report). At the present stage this project is unarguably1For example, Kikuchi (1991) defined irrigation management as "the hydrological, engineering,systematic, organizational and operational management issues involved in the maintenance of irrigationsystems".

OECF Journal of Development Assistance Vol.4, No.1, 1998 219successful. However, less than two years have passed since the completion of the constructionstage and there are already unmistakable changes in the way farmers work, and in other economicactivities.Chapter II of this report will examine the changes caused by the Lankeme Irrigation Projectin the project area. These changes were clearly observed in a sample survey of farmers 2 conductedby a contracted local consultant between December 1996 and January 1997, and a two-weekinterview-based field survey conducted in late February and early March 1997.Chapter III will study promising individual measures and support methods which could beemployed to cope with the changes which were clarified in Chapter II. Chapter IV will take theLankeme Irrigation Project as a case study to draw lessons which are common to the whole fieldof maintenance in irrigation projects, and suggest guidelines which should be incorporated intofuture efforts in this field.I. SUMMARY OF THE LANKEME IRRIGATION PROJECTA. BackgroundIndonesia has the world's fourth largest population, which stood at 193 million in 1995. Thestable supply of food for this population has been one of the greatest tasks facing the country'sdevelopment since independence. Self sufficiency in rice production is given the greatest emphasisas it is expected to deliver numerous direct and indirect benefits. Beyond stabilizing the domesticfood supply situation and saving on foreign exchange in the long term by cutting rice imports,rice production contributes to social stability by raising the income of farmers and underpinningthe rural economy.In the late 1970s, when Indonesia was asking Japan for aid, it was still very difficult for thecountry to break free of its dependence on imports. Development policies for increased foodproduction were of the highest importance. Incidentally, over the three years 1975~1977 theaverage annual volume of rice imports was 1,322,000 tons, worth US$484.8 million. Thisrepresented 11.7% of all imports and 53.9% of imports of consumption goods. In 1984 theIndonesian Government proclaimed complete self-sufficiency in rice production, but rice importscontinued after that point. In 1988 imports remained above 30,000 tons, indicating that domesticsupply of rice was failing to keep pace with rising demand. The improvement in diet whichaccompanies improved living standards was increasing the per-capita consumption of rice. Atthe same time, Indonesia's population was growing at an annual rate of 2.3% (the annual averagebetween 1971 and 1980), so this also increased rice consumption. The increase in demand resultingfrom a growing population consuming more per head made increased domestic rice production,and the reduction of rice imports, extremely important. Accordingly, it was made one of thehighest priorities of national economic development.This situation led the Indonesian Government to draw up the "General Plan for Central2Ninety farms were sampled in a questionnaire survey. The sampled farms comprised 44 farms intwo villages in the upstream zone, 31 farms from one village in the central zone and 15 farms from onevillage in the downstream zone. The average household size of the selected farms was 4.7 people. Nearlyall of the farmers were of the indigenous Bugis people, with no migrants from Java or other new settlers.

220 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local CommunityWater Resources in South Sulawesi Province" 3 as a comprehensive master plan for thedevelopment of agriculture in South Sulawesi Province. The plan was intended to improve unityields and make rice crop irrigation more efficient through the construction of new irrigationfacilities and the improvement of existing facilities. Specifically, the plan involved theimplementation of nine irrigation projects around Lake Tempe in the center of the province. TheIndonesian Government chose to make South Sulawesi one of its key areas for the promotion ofagriculture, with emphasis on rice, because it combines a number of advantages. Among others,it enjoys exceptionally favorable conditions for rice production and it has long been irrigated bynatural rainfall and small-scale irrigation facilities. It transfers around 280,000 tons annually tocompensate for rice shortages in East Kalimantan, Maluku, and Irian Jaya Island. Thus, thisprovince has a very important role, underpinning the supplies of rice to neighboring areas of thecountry which do not produce enough. The Lankeme Irrigation Project was given the highestpriority among the nine irrigation projects on the basis of the consideration of the followingfactors: The state of infrastructure in the project area. The size of people will have to beresettled from inundated areas. The ripple effects which will propagate to surrounding areas.This project was financed by OECF. The construction was commenced in July 1990 and completedin January 1995. Table 1 shows the developed irrigation area and constructed main facilities bythe project.Table 1Irrigated Area and Main FacilitiesProject scopeIrrigated development areaIrrigation facilitiesIntake weirSero headrace channelLankeme trunk water systemSecondary waterway systemSmall waterway systemConnecting waterwayDrainage canalTerminal improvementActual7,291ha(including additional irrigation area of 891ha)2213.89km26.79km23.64km (7 route)18.80km (9 routes)3.44km (4 routes)2.84km (1 route)7,291haB. Summary of the Project Area (see Fig. 1)The Lankeme region, which is the target region for this project, is located in the center of SouthSulawesi Province which is the south end of Sulawesi Island. It is 30km south of Lake Tempe,part of the rich grain-producing belt. Administratively, it covers four districts and includes 133The Indonesian Government asked the Japanese Government for its assistance in the formation ofthis plan, and the plan was drawn up by JICA (completed in March 1980)

OECF Journal of Development Assistance Vol.4, No.1, 1998 221villages. The population of the subject area was approximately 98,000 in 1980, in a total of16,100 households. Of these households, 78% (12,600) were farming families.The center of South Sulawesi Province is located four degrees south of the Equator. It hasa typical tropical monsoon climate, clearly divided between the rainy season (March to July), thedry season (August to October) and the middle season (November to February). The temperaturestays in the range 26.1~28.2˚C all year, with relative humidity varying between 71% and 75%,so there are few differences between seasons. The average annual rainfall is 1,650mm, with mostof that concentrated in the rainy and middle seasons. The annual average hours of sunshine perday is 6.4h/day.The favorable climate and abundant water enjoyed by the project area make rice cultivationpossible all year round. Before this project, 85% of the rice paddies in the region yielded twocrops per year, producing 28,200 tons per year. The unit yield is 4.4t/ha, considerably above the3.3t/ha which is the average for Indonesia as a whole.C. Project EffectsDividing the project, for convenience, into upstream, central and downstream zones, the newirrigation systems introduced by the project achieved year-round water supply in the upstreamzone from 1992, in the central zone from 1994 and in the downstream zone from 1995. Thoughthe project has yet to develop its full effect, the major impact of the project could be summarizedin the following two points.a) Expanded cropped areaComparing the cropped area in each growing season, before the project 6,138ha wascultivated in the rainy season (96% of the total area at the time), rising to 7,291ha after theproject, an increase of 19% (1,153ha). In the dry season the cropped area was 4,153ha(65%), rising to 6,699ha, an increase of 61% (2,546ha). Comparing year-round figures, thetotal cropped area before the project was 10,291ha, rising to 13,990ha, a rise of 35.9%(3,699ha). Of the increase, 68.8% (2,546ha) was the increase in dry-season cropped area.This indicates that year-round irrigation has largely been achieved.b) Increased rice productionBefore the implementation of the project (at the time of the appraisal), the unit yields forrice were 4.6t/ha in the rainy season and 4.75t/ha in the dry season, an average of 4.66t/ha.According to the results of the rural survey, the rainy season yield was 5.01t/ha(an increaseof 9%), the dry season yield was 5.32t/ha (an increase of 12%) and the overall average was5.17t/ha (an increase of 11%). Compared to the national average yield for Indonesia (4.34t/ha in 1995), the average yield in the project area (5.17t/ha) was about 20% up. This yield ison a par with the average unit rice yields in Bali Province and the island of Java which arethe ricebowls of the nation.On the other hand, within Sulawesi, South Sulawesi Province has the highest yieldson the island, at an average of 4.73t/ha (in 1995). In Soppeng the yield was 4.34t/ha in1989, but this rose to 5.47t/ha by 1995, ranking third within South Sulawesi Province.Therefore, the yield in the Lankeme Irrigation Project area is 19% above the average unit

222 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Communityyield for the province, but it is also 5.5% below the average unit yield for Soppeng as awhole. However, this was the situation only two years after the completion of the project,when it was still developing its effects. Unit yields in the project area can be expected torise in the future.If we assume that the results of the rural sample survey accurately reflect the level ofunit yields for the project area as a whole, as Table 2 shows, the project has achieved a58.2% rise in production.Table 2Movements in Rice Production(Unit: ton)Before After Increases (%)Rainy season crop 26,087 36,528 10,441 (40.0)Dry season crop 19,519 35,639 16,120 (82.6)Total production volume 45,606 72,167 26,561 (58.2)Source: Estimated from the findings of the rural surveyII. CHANGES BROUGHT BY THE LANKEME IRRIGATIONPROJECT IN ITS SUBJECT AREAThe greatest change produced by this irrigation project is the attainment of the intended effect,namely increases in the unit yield and production volume of rice. However, in this chapter wewill concentrate on the changes in attendant circumstances which, although they were not mainobjectives of the project, have happened or are happening now.Firstly, there are the changes which would have reached farming society even without theimplementation of this project, but which are accelerated by the project. In the case of this project,visible changes of this type include diversification of farming, in the form of [1] expandedproduction of secondary crops in paddy fields, [2] more widespread raising of livestock and [3]more widespread raising of fish in paddy fields, and also [4] shortage of labor and [5] changes infarming practices. Next there are the changes which would never have occurred if the projecthad not been implemented, but appeared when it was. These were [1] fixing of cropping into setpatterns, [2] the organization and operation of water users' associations, [3] new disparities betweenareas and [4] rising land prices.A. Changes Which were Promoted by the Irrigation ProjectAs Table 3 shows, the results of the sample survey reveal the expected increase in income fromrice cultivation after the implementation of the Lankeme Irrigation Project. However, the rate ofincrease in non-rice income was higher, and the share of farmers' incomes generated by non-ricecrops rose. This clearly indicates that farmers are now working to diversify the crops they grow.

OECF Journal of Development Assistance Vol.4, No.1, 1998 223Table 3Changes in the Average Income of FarmersBefore the project(Unit: Rp.1,000)Income 2,429.5Share of total income 87.2%Rice income Income 3,030.8After the projectShare of total income 85.3%Before the projectGrowth rate 24.7%Income 357.8Share of total income 12.8%Non-rice income Income 521.8After the projectShare of total income 14.7%Growth rate 45.8%Before the project 2,787.3Total income After the project 3,552.6Growth rate 27.5%Note: 1. Total income is the income of the household for the year, excluding remittances from membersworking outside the village and wages from other work.2. Non-rice income is derived by subtracting rice income from total income. It includes incomefrom upland cropping, livestock, fish, timber, handicrafts, shipping of agricultural products, retailsales and other commercial income.The trends for diversification towards secondary paddy field crops, livestock and paddyfield fisheries are examined below in detail.a) Expanded production of secondary crops in paddy fieldsIn the JICA Lankeme Irrigation Development Plan Implementation Study Report (March1980), the fourth of the five key points of development was "to introduce a diversity ofcrops, while concentrating on rice". 4 A recommendation given for a desirable crop systemwas "rice crop - secondary paddy field crop - rice crop". Clearly despite the fact that increasedrice production was still accorded the highest priority, 5 consideration was already beinggiven to crop diversification as a secondary effect of the irrigation project, and to theintroduction of the secondary crops generally known as parawija (maize, peanuts etc.).According to the Ministry of Public Works, there has been a great improvement inirrigation conditions in the dry season, resulting in a marked increase in the area of landunder parawija crops in the beneficiary area after the project. The area under maize rosefrom 329ha before the project to 3,781 after, peanuts rose from 12ha to 2,064ha and soybeans from 2ha to 1,049ha. These are extraordinary jumps in the cultivated areas, which4The other key points are as follows:To stabilize the yield and the production volume from the unstable rainy season rice crop. Toincrease the cropped area for rice in the dry season. To raise crop efficiency as far as possible. Tostrengthen agriculture support organizations.5Self sufficiency in rice production was achieved in 1984. However, production since then has beenunstable, and the country is still not completely independent of imports.

224 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Communityindicate that many farmers began to cultivate parawija crops after the implementation ofthe project.In the sample survey which surveyed 90 farms, there were seven farms which beganparawija cultivation after the project (all of which began growing peanuts) and 28 whichcontinued such cultivation. Most farmers increased their rice income after the project, sosome 60% of the farmers (55 farms) still felt that their rice crop alone was adequate. Thisincludes those who stopped cultivating parawija after the project to concentrate on rice.The other 40% were diversifying their crops rather than relying entirely on rice, and somanaged to increase their agricultural production (see Table 4). Furthermore, consideringthe following points, there is clearly a will among farmers to pursue efficient secondarycrop production, and we can expect more farmers to start doing so in future.All farmers who continued to grow the same crop experienced an increase in incomefrom that crop. Ten farmers switched from maize to more profitable peanuts. All thefarmers who made a new start in secondary crops chose to grow peanuts.Table 4Production Situation in ParawijaBefore theprojectAfter theprojectRice only 47 (52%) 55(61%)Rice + maize 5 ( 6%) 0 ( 0%)(Unit: farm)Switch from maize to peanuts 10(11%)Rice + peanuts 32(35%) 35(39%) Start of new production 7 ( 8%)Rice + maize + peanuts 6 ( 7%) 0 ( 0%)Total (100%) 90 90Continued production 18 (20%)b) More widespread raising of livestockThe more widespread raising of livestock is another example of the diversified activity offarmers. Livestock did not feature at all in the development plan, and stock farming is stillfar from becoming one of the area's main industries. 6 Nevertheless, the results of thesample survey show that the number of farms owning poultry and livestock (either for theirown consumption or for sale) rose from 16 farms (17%) before the project to 39 farms(43%) after the project. Of those, 23 farms had newly begun raising chickens. These farmsalso saw considerable rises in their income from rice after the project. Most of them werein the downstream zone near Watansoppeng. Of those farms which were able to buy poultryusing the increased income from greater rice production, those farmers with good access tomarkets were the fastest to move into this new area of business.Nine farms (10%) had the sale of eggs and other livestock produce as their secondlargest source of income. Eight of these saw their income from the sale of such produce6In the whole of South Sulawesi Province, livestock did not represent more than 4.1% of the GRDPfor the agricultural sector in 1994. (Source: Sulawesi Selatan Dalam Angka 1995).

OECF Journal of Development Assistance Vol.4, No.1, 1998 225increase dramatically after the project 8 . The number of farms earning income from the saleof the livestock themselves rose to 16, of which 14 had increased their income by buyingnew stock to expand their business after the project. Overall, the expansion of livestockrelatedbusinesses made possible by increased income from rice is small in scale, but itshould be regarded as one of the secondary effects of the Lankeme Irrigation Project.c) More widespread raising of fish in paddy fieldsThe 1980 development survey did not find out the state of enclosed fisheries at that time,but it seems to have been almost nonexistent. However, the recommendations sectioncontained in the report of that development survey contained this conservative suggestionwhich hinted at future possibilities: "Freshwater fisheries in the project area, particularlythe breeding of freshwater fish in the trunk canals and immediately upstream of intakeweirs, present a good opportunity for farmers to broaden their range of operations. Thereforeresearch and investigation into freshwater fisheries should be strongly promoted".As Table 5 shows, fish were raised in paddy fields before the implementation of theproject, but farmers were not particularly enthusiastic in this type of work. However, althoughthe statistics have yet to reflect this, many people in the area say that the abundant availabilityof water since the project has made fish rearing more common. For example, in the villageof Timus, which I visited, the local community independently constructed water tanks (6mx 4m x 1.5m deep) in the branch of the irrigation canal, although this was not part of thegovernment plan. After the project, tanks of this kind were constructed at eight places inthe prefecture. Fish have been introduced to 6% of the paddy field area in Timus villageand 20% in the village of R. Gading.Table 5Movements in the Production Volume of Paddy Field Fisheries in Soppeng Prefecture(Unit: tons)Year 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994Production volume 50.1 53.1 52.4 55.5 60.7 57.3 71.6 117.9 97.9 47.0 14.6 64.6 90.3Share of the entirefisheries industry *0.68% 0.86% 0.98% 1.25% 1.37% 1.21% 1.42% 2.22% 1.65% 0.69% 0.27% 1.16% 1.65%Source: Kabupaten Soppeng Dalam Angka 1991 and 1994* The four classifications are lake, marsh, river, paddy field (including ponds).The current method employed is to buy baby fish, raise them and sell them. Nobodycollects eggs and hatches them to obtain baby fish. The fish produced are only shipped toWatansoppeng and other local markets and there are no agents to sell fish to. There is onlythe most simple distribution route. It is possible to use farmers' startup credit (Kredit UsahaTani: KUT) for the construction of fishery pools for fish raising, and there is a generaltrend toward increased consumption of fish as consumers' diets improve, so increasingnumbers of farmers can be expected to begin operating paddy field fisheries.7One of these farms began to sell livestock produce after the project and this became the farm'sprimary source of income (55% of total income), surpassing rice.

226 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Communityd) Shortage of laborIn the area of the Lankeme Irrigation Project at the time of the development survey, it wasnoted there was a severe shortage of employment opportunities in the dry season, whichwas the main cause of seasonal migrations from the area to Kalimantan . These migrationswere growing larger every year. In short, the surplus workforce in the area was becoming aproblem by 1980. There are various documents which convincingly suggest that the increasedcropping rate caused by the irrigation project increased the workforce employed inagriculture in the area. In the sample survey, 16 of the 90 farms sampled increased theirworkers after the project, three increased the number of days they employed day laborersand two increased both the number of workers and the number of days of labor. Theremaining 69 farms reported no change. None of the farms decreased their employment.Another factor which indicates the increase in employment is that the wages of agriculturallaborers rose by 40~50% after the project. 8 In our field interviews, some respondentsindicated that they had problems finding enough laborers.In Soppeng Prefecture in 1993 the population depending on agricultural labor fortheir livelihood amounted to 10,318 households (29% of the total population). 9 Regrettably,we have been unable to find sufficient documentation to support any judgement on theposition and standard of living of agricultural laborers relative to land-owning farmers andsharecroppers. This is because there are various social strata of residents in the area whocan become agricultural laborers. The sample survey showed that in 16 of the 90 farms thefarmers were working their own farms and were also supplementing their income bysupplying their labor to other farms. Of these, 13 increased their employment income as aresult of the increased demand (and increased wages) for labor after the project.An interview survey of the village of R. Gading revealed that the village took inlaborers from other nearby villages at harvest times. These workers were mainly cocoagrowers, who have a higher level of income than the inhabitants of R. Gading, but are ableto take on additional work because they have free time. As the development survey indicated,most agricultural laborers come from poorer areas which have fewer employmentopportunities, but it is not true to say that they are all from poorer social strata with lesschances to find jobs.Therefore it is illogical to assume that as the opportunities for agricultural laborincrease, the incidence of working on other islands will decrease (in other words, thatagricultural laborers will return to South Sulawesi to work in rice farming). In the interviewsurvey, farmers in the region said that the demand for labor in Malaysia and elsewhere isstill an attractive opportunity for the young people of Sulawesi, and there is no change inthe trend towards leaving Sulawesi for work elsewhere. Furthermore, even if the parentsare farmers, the children commonly leave to study in Ujung Pandang or on other islands8According to the results of the sample survey, the daily wage before the project was Rp4,000~5,000,rising to Rp6,000~7,000 after the project. Employment opportunities are greater the further the positiondown stream and wages rise similarly. At the average exchange rate for 1995, US$1=Rp2,249. (Source:The Economist Intelligence Unit, Country Profile - Indonesia 1996~97, London). The price of fertilizer,another input commodity in the area, rose by 10~30% after the project, so it can be inferred that evencompared to other commodities the rise in demand for hired labor was large.9Source: Dinas Pertanian Tanaman Pangan, Propinsi Sulawesi Selatan, Statistik Pertanian TanamanPangan Tahun 1994, Ujung Pandang 1995.

OECF Journal of Development Assistance Vol.4, No.1, 1998 227and find jobs there. The survey revealed that there are already concerns over succession infarming. In any country, economic progress is accompanied by long-term demographicshifts away from agriculture and from rural areas to the cities, which lead to ruraldepopulation problems. The reliance which already exists in the Lankeme Irrigation Projectarea on seasonal labor from outside the area indicates that the area will face a labor shortageat least until labor saving through mechanization compensates for the increase in agriculturalwork brought by this project.e) Changes in farming practicesIn the rice-growing region of Asia the so-called "Green Revolution", which combined thebuilding of modern irrigation facilities with innovations in agricultural techniques, proceededunder state guidance towards the great political and economic target of self-sufficiency infood supply. This process has also brought considerable changes to the farmers themselves.Let us examine these changes in more detail in the case of the Lankeme Irrigation Project.The increases in unit yields and crop rates, which have been steadily increasing riceproduction, are not simply products of the increase in water supply. Farmers have beenworking to introduce intensive techniques such as the adoption of high-yielding varietiesand thorough fertilization. The interview survey in the area showed that farmers have beenconducting cultivation trials to find the varieties best suited to their farms from the list ofrecommended varieties, as well as trying different varieties to match the rainy and dryseasons. The results of the sample survey of farmers showed that the quantity of chemicalfertilizer applied to each hectare rose by 23% from 299.7kg/ha before the project to 369.8kg/ha afterwards. This is a high level of fertilizer use compared to the national average forIndonesia, which was 303.2kg/ha in 1992 and 284.2kg/ha 10 in 1994. 11However, while it is true that the farmers take a very positive attitude to farming, theydo not have a clear sense of themselves as commercial farmers. In the above figures forfertilizer application, many of the sampled farmers may have simply answered that theywere applying the standard amount recommended by their agricultural improvement officer(315kg/ha, according to the Prefectural Bureau of Agriculture). In the course of fieldinspections, other researchers and authors of this report have seen fertilizer usage belowthe standard amount, or fertilizer which was not applied evenly over the field.The state of the education service, which attempts to propagate uniform farmingtechniques set by the government, is behind these problems. It is still unable to provideprescriptions for fertilizer application and other actions to match the conditions of eachfarming area.Furthermore, most farmers in the area do not seem to have any opportunity to accuratelygrasp the amount they produce (or the amount they have available to sell) and their unityields. The field interview survey found that the custom of "Bawon", in which a number ofharvest workers share the harvest they have gathered with the farm owner in fixed shares,10Source: Central Bureau of Statistics, Statistik Indonesia 1995.11Under the sharecropping system in the downstream zone of the Lankeme Irrigation Project, it iscustomary for the landowners and the sharecroppers to share the cost of fertilizer. The landowner can onlyjudge whether or not the fertilizer which he paid for was applied properly from the harvest yield, but thelandowner has power over the sharecroppers and can ensure that a certain level of fertilizer application ismaintained.

228 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Communityis still practiced widely in the project area. 12 Therefore the amount known as the harvestgathered by a farmer who has worked the land is not the same as the actual production fromany single field. Rather, it is the production of his land minus the amount he has given aspayment in kind to others for their work in the harvest (which is a portion of the cost ofproduction for the farmer). Thus the owner or manager of the farm never sees more thanaround 90% of the total produce from the farm. The distribution of harvested produce firstbetween the other farmers and laborers who work for the harvest is seen as more importantthan finding out exactly how much was produced. When this kind of method is used, it isclearly not the kind of strategic farming which tries to gauge the relationship between anincrease in fertilizer application and the resulting increase in unit yield.Overall, while the farmers have an enthusiastic and positive approach to farming,there has been no great change in their ideas and attitude to farming practices since theproject. To look at it another way, there is still ample scope for further increases in yield.B. Changes Generated by the Irrigation Projecta) Fixing of cropping into set patternsA traditional water use organization centered on water managers (known as ulu-ulu ormandruwae) has apparently existed in the project area for a long time. A water distributionsystem agreed between farmers operated when non-scientific or semi-scientific irrigationwas used. When the modern irrigation facilities constructed for the project are used, theirmanagement is divided between government administration, which handles trunk andsecondary canals, and water users' associations (P3As) formed by farmers, which handletertiary and smaller waterways. This arrangement has created a point of contact betweenthe administration and the farmers, and while decisions are taken after adequate dialogwith water users' associations, the form of the system is undeniably that the administrationsets the water supply plans and the farmers follow them.The method employed is to divide the project area into four zones and supply waterto these zones sequentially. For example, for the rainy season crop water is supplied toZone I over 1st~15th April, to Zone II over 16th~30th April, to Zone III over 1st~15th Mayand to Zone IV over 16th~30th May. The supply periods are staggered in the same way forthe dry season crop. The sequence in which the zones receive their irrigation water andtheir boundaries are fixed, with no annual rotation between zones. When this kind of watersupply plan is rigidly set and the farmers must follow it, they are unable to exercise thesame level of independent discretion in their farming, and all details down to the croppingsystems become rigidly fixed.Now, only a short time after the completion of the project, farmers are well satisfiedwith the benefits of an increased and stabilized supply of water, so we did not hear anynotable complaints, but once farmers have become used to the current level of supply theyare likely to dislike the lack of freedom inherent in the present restricted type of watersupply planning.The sample survey of farmers found almost no dissatisfied farmers in the upstream12The shares of the harvest volume varies between farm owners, but in general in this region theharvesters receive one tenth of what the owner receives.

OECF Journal of Development Assistance Vol.4, No.1, 1998 229and central zones, but in the downstream zone some 40% of farmers responded that "Waterdistribution is not fair". If we assume that the diversification of farming which was indicatedin the preceding section (1. Changes which were promoted by the irrigation project) is thepattern of the future, the fixed water supply plan will be an impediment to the expandedproduction of parawija crops, and it will be difficult to make arrangements for hired labor,which is in short supply, within the narrow time frame.b) The organization and operation of water users' associationsThe building of modern facilities after non-scientific or semi-scientific irrigation has,naturally, changed the design of water canals. Therefore it was not possible to convert theexisting, traditional, water use organizations into new water users' associations (P3As) withoutmaking some changes, and the change involved some alteration of the membership composition.Even though the organization of the P3As was handed down from above (from theadministration), it is not surprising to see that the reorganization was a comparatively simpleprocess. The farmers of the Lankeme Irrigation Project area are highly reliant on rice and theyare well aware of the importance of water. However, though the organization of the waterusers' associations was completed uneventfully, whether or not associations with an organizationimposed from above will function smoothly is another question.After the reform to the new water users' associations, the next major change to affectfarmers is the addition of management fees for terminal waterways, which have not beencharged in the past, to the existing association fees which have been charged so far. Thepolicy of the Indonesian Government has been to bear the costs of maintenance managementfor the terminal waterways as well as the secondary and trunk canals. Since 1987 thegovernment has been working towards the collection of water use fees (which were calledIPEP at the time and which were renamed IPAIR in 1989). However, even now whennearly ten years have passed since the introduction of water use fees, their collection cannotbe described as a success. According to the Ministry of Public Works, the rate of introductionof IPAIR charges is no more than 30% in South Sulawesi as a whole, and the actual collectionrate is apparently considerably lower still. In the Lankeme Irrigation Project area, thecompletion of the irrigation works was followed by a program of explanations to farmers inthe region to prepare for the introduction of IPAIR charges for the rainy season crop of 1997.The collection of water use charges in order to make the beneficiaries of irrigationbear the maintenance costs for irrigation facilities, which had previously been borne by thegovernment, should be seen as the scrapping of a de facto subsidy. Now that irrigationdevelopment has made two rice crops a year possible on most paddy fields, the actual levelof water use charges is so low as to present no problem. 13 A more significant problem isthe lack of clear incentives for the independent involvement of farmers in the maintenancemanagement of irrigation facilities. This problem can be summarized in three points:(i)It is difficult for association members to grasp how the charges they pay will be used.The fees they had paid in the past were used for the maintenance of the terminal13Considering the examples of other regions, the annual water use charge is around 1% of grossfarming income. The amount is determined by each prefecture, but the decision in Soppeng prefecture hasbeen delayed.

230 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Community(ii)(iii)waterways they used for themselves, so all the farmers who formed the membershipof the associations could clearly see where the money went. IPAIR fees are collectedfrom each water users' associations and combined into a lump sum payment to theIrrigation Department of the Prefectural Bureau of Public Works. This money is widelyused for trunk and secondary canals and even for the terminal waterways used byother associations, so there is no way for those who pay the charges to clearly graspwhat is done with the money.Both the association members and the administration are unclear as to the appropriatelevel of water use charges. Even if an IPAIR figure is decided with reference to thoseset for other regions, there is no way of knowing whether such a charge will besufficient to cover all the maintenance needs or how much of the necessary work itwill cover.When the above-mentioned diversification of agricultural production is assumed, thefarmers will be unable to accept the payment of water use fees if the water supplyplan and the maintenance of irrigation canals does not support this diversification.In this way, the modern irrigation facilities have posed new problems to both thefarmers and the government concerning the running of the associations' various activities,including the organization of new types of water users' associations and the collection ofnew water use charges.c) New regional disparitiesOriginally there was very little disparity between different parts of the project area, and atthe time of the development survey no consideration was given to this issue. Table 6 showsthe results for the ninety farms sampled in the sample survey, which were divided betweenupstream, central and downstream zones. Although the table shows almost no disparitybetween the cropped area in each zone (per crop), there are significant differences betweenunit yields and income per household.Table 6Disparities Within the Project AreaCropped area perhouseholdUnitDryyields(ton/Rainyha)AverageRice crop incomeper household(Rp./year)Total income perhousehold(Rp./year)Before4.77(101)4.25(100)4.51(101)2448(101)3203(112)Upstream Zone Central Zone Downstream Zone Average of the Whole1.3 1.0 1.1 1.1After5.04(95)4.95(99)5.00(97)2886(95)3709(102)Growthrate5.7%16.5%10.9%17.9%15.8%Before4.14(88)3.76(88)3.95(88)2028(83)2168(76)After4.85(91)4.55(91)4.70(91)2683(89)3197(88)Growthrate17.1%21.0%19.0%32.3%47.4%Before5.41(115)5.02(118)5.21(116)3205(132)3326(116)After7.05(1355.98(119)6.52(126)4173(138)4352(120)Growthrate30.3%19.1%25.1%30.2%30.9%Before4.70(100)425(100)448(100)2430(100)2867(100)After5.32(100)5.01(100)5.17(100)3031(100)3639(100)GrowthrateNote : Figures in ( ) are indices, with 100 being the averages for all zones for before and after the project.13.2%17.9%15.4%24.7%26.9%

OECF Journal of Development Assistance Vol.4, No.1, 1998 231Before the implementation of the project, the rankings of the zones in both productivityand income levels were the downstream zone the highest, then the upstream zone and thecentral zone the lowest. This ranking remained unchanged after the project, but the centralzone showed considerable improvement and the downstream zone became even moreprosperous. Overall, the effects of the Lankeme Irrigation Project became increasinglypronounced with increasing distance downstream. This is generally because the downstreamzone had more difficulty than the upstream zone in securing water supplies, and this problemwas solved by the project. The downstream zone also enjoys greater access to educationalservices and markets for its produce and this advantage can be seen as another factor behindimproved productivity and increased income in areas further downstream. The results ofthe sample survey show that the number of times each area received educational servicesof some kind (the monthly average for each household) was the lowest in the upstreamzone, followed by the central zone, and highest in the downstream zone. This is becausethe distance to the nearest educational service station is shorter further downstream (seeTable 7). Also, in the three zones the farmers receive educational contacts from the PrefecturalBureau of Agriculture only, but the downstream zone receives a wider range of servicesfrom three or four agencies.Table 7Access to Educational ServiceNumber of uses(No./ months)Distance to the nearesteducational stationAverage of theUpstream Zone Central Zone Downstream ZoneWholeBefore After Before After Before After Before After1.5 2.3 2.1 2.7 1.0 3.1 1.6 2.68.6 3.5 1.2 1.2 2.4 0.9 5.0 2.3Note : Services include cultivation guidance, water management, loan, marketing, post-harvest processing etc.The reasons are unclear, but this project made a contribution to narrowing disparitiesbetween the zones by improving the productivity and income levels of the central zone,which was somewhat depressed before the project. On the other hand, it was the springboardfor the downstream zone to rise to a better position than those of the other zones. Thedownstream zone also has an edge in opportunities to diversify agriculture, and this edgewill widen the economic disparity between the downstream zone and the other two. Cleardisparities are very likely to emerge in what had been a comparatively homogenous society.d) Rising land pricesAs the project raises the productivity of the land, the value of that land naturally rises. Theinterview survey in the field found the price of paddy fields to be Rp5 million before theproject. After the project this rose three or four times to Rp15~20 million. This makes itdifficult for sharecroppers to become landowning farmers, and for farmers to increase thesize of their farms. In the long term, this could easily become an obstacle to the developmentof agriculture.It is also becoming difficult for sharecroppers to find land even to rent. As the land

232 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Communityprice rises and water becomes plentiful, the land becomes an attractive asset holding forthe owner, leading some to take land that they had been renting to sharecroppers and startfarming it for themselves. The increasing difficulty faced by would-be sharecroppers infinding land could become another factor driving them to work elsewhere.As a long-term change, when land prices rise they can encourage the conversion ofpaddy fields, particularly in the downstream zone near to the town, to more profitable nonagriculturaluses. Ironically, a project which aimed to boost the rice crop could end uppromoting industries other than agriculture.III. HOW TO DEAL WITH THESE CHANGESIn the sample survey of farmers, 100% of respondents said "We now receive an adequate watersupply" and 99% said "Our water supply volume increased after the project". Furthermore, 92%of the sampled farmers were satisfied with the current distribution of water. At first sight theredoes not appear to be any impediment to participation in water users' association activities andpayment of water use fees. However, the changes indicated in the preceding chapter are certainlyunder way in the project region, and if they are overlooked the project will not earn such afavorable evaluations in two, five or ten years. This is because to sustain the farmers' satisfactionwith the project, the effects of the project must be sustained.If we bring the changes explained in the preceding chapter within the broad scope of themaintenance of the irrigation project, it includes the burden of the "organization and operation ofthe water users' associations" as shown in Figure 1. This is one of the changes created by theproject, and it can be reduced and suitably distributed using the effects of other changes. This isa part of the project's maintenance. Below, we will examine how each item should be incorporatedinto the broad definition of maintenance. In other words, how incentives should be raised tomake the farmers enthusiastic in their approach to the operation of the water users' associationsand the payment of the water use charges.Support for the diversificationof agriculture1. (1)(2)(3)Solution of the labor shortage1. (4)Support for new farmingpractices1. (5)Reducing the burdens of thewater users' associations2. (2)Ways of allowing diversity incropping systems2. (1)Support for the areas that loseout in new regional disparities2. (3)Restriction of the threat ofconversion of agricultural landto other applications, spurred byrising land prices.2. (4)Note : The final figures in each box are references to the numbers of the corresponding sections.Fig. 2 Broad View of Maintenance for the Irrigation Project– Case of the Lankeme Irrigation Project –

OECF Journal of Development Assistance Vol.4, No.1, 1998 233A. Support for the Diversification of Agriculturea) The direction of diversificationThe diversification of agriculture can be considered on at least three levels. First, there isdiversification away from food crops to include produce such as garden plants, livestockand fish raising. Basically this direction of diversification selects highly profitable cropsfor which rising demand can be expected. Second there is expansion of production into thefood processing industries "downstream" of agricultural production. The third direction isto expand into non-agricultural production in rural areas.In connection with the first direction, it should be pointed out that the irrigation projecthas made rice production itself a more valuable cash crop than it was before. Farmersregard rice as a far more commercial crop than they did before, and this awareness mayhave prompted them to try other commercial crops. Therefore to promote rice, the secondarypaddy field crops and other upland crops, stock raising and fish raising must also besupported. The land in this area is not suitable for a complete switch away from rice toother crops. In the future, land-intensive agriculture, to make the maximum use of limitedland area, will be more in evidence, but the combination of paddy field rice and secondarycrops should be promoted. This approach avoids the dangers of price fluctuations and pestdamage, as well as problems of upland cropping such as soil salination and damage due torepeated crops. 14The necessity of combining elements of directions two and three in the strategy foragricultural diversification is confirmed by the high population density, which there hasalways been in Indonesia's rice-growing areas, and the small per-capita area of cultivableland available to the farming population. If the income level of farmers is to be raised,problems of economic adjustment will inevitably surface in the agricultural sector in thefuture in the forms of farmers combining occupations or leaving farming, their villages, orboth. However, the third direction for diversification, that towards the promotion of nonagriculturalsectors, is not a desirable choice when the commercial value of rice is sufficientlyhigh. Rice milling businesses already exist in the project area in some numbers, and thepath to diversification should begin with the integration of these and other agriculturalproduce processing industries, which are examples of the second direction, into the economyof the region.b) Educational services to support diversificationAccess to the educational services, which were provided after the implementation of theproject, was greatly improved following the findings of the sample survey of farmers. Theincrease in rice production, which has been seen since the irrigation project, can be seen asthe fruit of providing irrigation facilities as a package with other services. 15 Therefore,educational services of all kinds certainly have a major role to play in the pursuit of the firsttwo diversification directions listed above.In the tropics, as in temperate regions, commercial vegetable cultivation must satisfyat least one of two conditions to be successful. The conditions are proximity (in travel14Watanabe, other (1996), p.89.15Refer to Table 5.

234 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Communitytime) to a city as a major center of consumption and favorable cultivation conditions (in thetropics, this means a relatively cool climate and irrigation facilities) .16 The greatestconsumption center of South Sulawesi Province is the province capital, Ujung Pandang,which is over six hours away along the paved road which is passable by truck. This makesit difficult to start the commercial cultivation of vegetables with only the addition of irrigationfacilities. The same applies to raising livestock and fish. Therefore, for the time being,consumption in local markets should be the prime concern when providing educationalservices to improve the production techniques of the farmers.The field interview survey found that the farmers are highly interested in cocoa andother plantation crops. In recent years Indonesia has overtaken Malaysia as a SoutheastAsian cocoa producer, and cocoa aimed at markets in Java and in nearby countries is certainlya more promising crop than vegetables destined for Ujung Pandang and other largeconsumption centers nearer at hand. 17 However, if this kind of market-oriented productionis to be taken up, the effort must be made in concert with the distribution sector. To thisend, educational services must go beyond their narrower scope and build up an improvedsupport service to nurture the region as a production center. This service must constructivelycoordinate local administrators, cooperative societies, farmers' organizations, water users'associations and any other relevant agencies existing in the community.c) Water distribution systems to enable diversificationIndividual farmers must be guaranteed the freedom to draw up their own crop plans if thediversification of production is to succeed. If the water supply system divides the projectarea into four zones as it does now, limitations are placed on the farmers' range of options.Mizutani (1996) listed three factors related to the performance of irrigation among thefactors which restrict the diversification of crops in paddy field irrigation areas:(i)(ii)(iii)The communal nature of water useThe public nature of water useThe individuality of water useMizutani holds that "The agencies which guide the formation of water users'associations appear to aim to make the communal and public aspects of water use the coreof the associations, but these aspects are not the targets of the participating farmers. For thefarmers, the associations are no more than one means of achieving the kind of individualwater use that can lead to crop diversification". 18 Looking at the Lankeme Irrigation Projectarea in the light of Mizutani's interpretations, the formation of water users' associations andthe setting of clear water supply plans can secure the communal and public aspects ofwater use, but it will be extremely difficult to reconcile these aspects with that of individuality.As crops become increasingly diverse, the demand for individual water use will inevitably16Watanabe, other (1996), p.8817According to the FAO Production Yearbook Vol.49 - 1995, the average annual production of cocoabeans in 1989-'91 was 240,000 tons in Malaysia and 140,000 tons in Indonesia. However, in 1995 Malaysiaproduced 130,000 tons and Indonesia produced 240,000 tons. Indonesia has a clear advantage in the levelof wages.18Mizutani (1996), pp. 207-218.

OECF Journal of Development Assistance Vol.4, No.1, 1998 235intensify. This is not a problem which can be handled internally by each water users'association; it is truly an issue for the community as a whole. As such, water rights at thelevel of individual fields must be considered. The optimum form of irrigation as a wholemust be re-examined, including the facilities themselves, and in some cases plot-to-plotirrigation between paddy fields can be improved, the density of waterways can be increasedor other measures taken.B. Solution of the Labor Shortagea) Promotion of labor savingThe trend towards labor shortage was unimaginable in Indonesia until recently, but sincethe start of the 1990s a shortage of agricultural labor began to emerge, centering on Java.We must calmly accept the fact that this problem has reached South Sulawesi Province.If this trend continues, a gradual shift can be expected from rice cultivation bytransplantation of seedlings to the direct sowing method, which requires less labor. Thisdevelopment can already be seen in Java, where research is progressing to spread techniquesfor more productive direct-sowing cultivation. This research must go beyond thedevelopment of suitable techniques suitable for Java, to adapt such techniques for conditionsin Sulawesi. The research and propagation of labor-saving agricultural techniques is a suitablefield for cooperation with JICA.On the other hand, considering the fact that the majority of farmers rely on hiredplowing by hand tractors, 19 the region has clearly begun to show a drift towardsmechanization for labor saving. 20 However, the sample survey revealed that of the ninetyfarms sampled, only one actually owned a hand tractor. The agricultural cooperatives musttake steps to make it easier to use hand tractors. Measures could include the joint purchaseand use of tractors and the use of credit to buy tractors.b) Rational water distribution systemsWhen the same cropping system is used under a rigid water distribution system in anyregion, it compels all farmers in the region to transplant seedlings at the same time and toharvest at the same time. This concentrates demands for large numbers of workers in certainrestricted time frames. Considering the trend towards labor shortage, a rigidly fixed waterdistribution plan risks concentrating the excessive labor demand in one period and leavinga labor surplus at other times. The water distribution plan should be altered to avoid thissituation by staggering the timing of each operation by appropriate amounts. This makes iteasier for employers to hire workers and provides workers with employment opportunitiesthroughout the year. Furthermore, it allows farmers to supply their labor to other farmers inbusy seasons.19Hired plowing refers to paying wages for the work of plowing only. Some workers own or renthand tractors and specialize in plowing for pay to supplement their income.20The sample survey found that of the 90 farms, 60 (67%) used tractors before the project, rising to73 farms (81%) after the project. However, the work of plowing was either given to other laborers in theform of hired plowing or done by the farmer in person, and the distinction was not necessarily made clear.The charge for tractor plowing per hectare rose by approximately 50% after the project.

236 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Communityc) Support for agricultural laborersThere are many variables concerning the people who earn income by taking on agriculturalwork on a short-term basis, and they must be studied further, but most do not own theirown land and also have difficulty farming and paying sharecropping fees. Among agriculturallaborers, there are some who leave their areas to work in Malaysia and elsewhere, andthese are comparatively prosperous, while others form the lowest stratum in the community,and this disparity must not be overlooked. For these laborers at the bottom of the heap, theirrigation project has brought a temporary benefit in the form of increased employmentopportunities, but for as long as they remain no more than a convenient source of musclefor their employers, they cannot put down roots and become productive farmers. They arelike a reserve army, saving some money while waiting to be posted to work elsewhere. Toavoid a shortage of labor in the future, it is very important that agricultural laborers begiven more opportunities to acquire skills and the chance to start farming as sharecroppers.C. Support for New Farming Practicesa) Provision of more detailed and responsive educational servicesAs was mentioned briefly in the preceding chapter, the main aim of the grassroots educationalservices is to spread the uniform package of agricultural techniques which has been definedby the government. They have not reached the stage of trying to deliver better, moreindividualized services to farmers who have begun to take an enthusiastic approach towardsfarm management. Such detailed farming techniques will be learned by each farmerindividually over a period of time, and the true role of the educational services and farmertraining is to support them in this process. Interviews with the Prefectural Bureau ofAgriculture found that there were six education field workers to cover the nine villages inthe Lankeme Irrigation Project area, which is probably not enough.The number of educational field workers must be increased, but these workersthemselves require training. Rather than uniformly dispensing what they have learned, it isimportant that they learn the flexibility and adaptability they need to make suitable choicesof techniques for each field.b) Improving the abilities of water users' associationsThe water users' associations do not exist solely to collect the water use charges requiredby the government. Their true duty is to represent the interests of their members and tosecure the maximum possible amount of water for their needs. At the moment, however,the supply of water is stable and increasing, so as organizations they are not facing anyvery difficult problems, and they lack any opportunity to affirm that duty. However, theperception of farming among the farmers who make up the water users' associations isgradually shifting, and their expectations and demands of the associations are rising.The first thing that is needed to support the growth of this kind of organized activityis a systematic framework. According to a circular from the Indonesian Ministry of HomeAffairs (dated 11th November 1989), they were considering a system organizing multiplewater users' associations around single secondary canals into water users' associationfederations to respond more broadly to the demands of their membership. This idea must

OECF Journal of Development Assistance Vol.4, No.1, 1998 237be put into practice, rather than ending as no more than a proposal on paper. Another ideais to provide each association with opportunities to learn from the work of the bestassociations.At preset the water users' associations do not have to negotiate with externalbureaucratic organizations for the interests of their members and struggle to win the waterthey need when they need it. There are no significant issues to be faced in the coordinationof interests within and between associations. Nevertheless, the very absence of problemsmakes this an important time for the associations to build their experience of associationactivity, and hone their problem-solving abilities.D. Securing Diversity in Cropping SystemsThe cropping systems, which the administration have pressed on the farmers through theimplementation of the irrigation project, restrict the natural drift of the times towards diversity,which would have carried on if the project had never happened. If the kind of independent watersupply mentioned above can be achieved and used to allow farmers the freedom to choose cropplans at their own discretion, the potential for agricultural diversification will be secured and thelabor shortage alleviated. Moreover, this is an essential step towards the autonomy of the farmersin agricultural production, considering the fact that the administration side can transfer themaintenance of irrigation facilities, including the burden of water use charges, to the farmers.E. Dealing with New Regional Disparitiesa) Building farm roads in the upstream and central zones and securing transport accessOf the newly-emerging regional disparities, the most serious problem is presented by thephysical access to markets and educational services, which is very much less convenientfrom the upstream and central zones than it is from the downstream zone. Also, all officialactivities and service in the upstream and central zones are fettered by the inconvenienceof transport to those zones. This is true when the staff of the terminal irrigation officeinspect the irrigation canals, and when the water managers open and close the sluice gates,and when the officials responsible for water users' association finances tour the associationsto collect their association fees and water use charges. The implementation of the irrigationproject has caused a real increase in traffic volume, which makes the building of farmroads and the securing of light trucks, motorbikes and other means of transport essentialelements of the project's maintenance.b) Strengthening educational services in the upstream and central zonesAn interview survey of the Prefectural Bureau of Agriculture revealed that there was noincrease in the number of educational field workers after the project, just an increase intheir workload. It has already been indicated that the level of usage of educational servicesin the upstream and central zones is not high (see table 5), but considering the inconvenienceof transport to these zones, the frequency of visits by educational field workers to farmersthere is lower than the frequency in the downstream zone, and the quality of the service hasprobably declined further following the project. Services in the upstream and central zones

238 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Communityshould be improved in all areas, including cultivation guidance, water management, loan,marketing and post-harvest processing.F. Restrictions on Conversion of Farm Land to Other ApplicationsThe impact which rising land prices will have on farming and other economic activity is closelyrelated to another big subject: the type of land use plan Indonesia will have in the future (or, whatthe direction of Japan's aid policy will be). The area requires more detailed study, and with thedata now available it would be inappropriate to state a policy direction. In this report I will go nofurther than to indicate two necessary objectives:(i)(ii)Sharecroppers in the downstream area, which can be expected to be converted away fromagriculture relatively early, should be made into landowning farmers and given whateversupport they need to continue farming there.Legal restrictions should be put in place to prevent the uncontrolled conversion of farmland to other applications.G. Empowerment of Farmers' OrganizationsThe six points above put forward methods for responding to change in order to reduce the burdenon the farmers involved in water users' associations, but of course these aspects do not existindependently in the community. They are all interlinked within the community and it is impossibleto take any one and discuss it in isolation. To put the six types of support mentioned in thischapter into effect, the farmers must be given full opportunity to speak their views and theremust be a mechanism for transmitting their wishes, clearly and accurately, to the administration.If this mechanism is to come from what already exists in the community, it will be based on theactivities of the water users' associations, cooperative societies, farmers' organizations, villagedevelopment committees (LKMD) and other organizations with farmers as their membership.This survey did not find enough data about these organizations which involve farmers, butat present it is true to say that cooperation and coordination between the various organizationsand their work is poor, and they are not being put to effective use. Perhaps this is because therehas been no reason so far to rely on their strength. However, the implementation of the projectwas the start of a gradual process for the farmers of greater assimilation into a broader economicsphere. In the course of this process, it will be extremely important for the farmers to be effectivelyorganized in order to deal with the changes they face. Specifically, coordination between theroles of the many existing organizations and the establishment of a regional federation unifyingthe smaller organizations should be seriously considered.

OECF Journal of Development Assistance Vol.4, No.1, 1998 239IV. GENERAL LESSONS ON THE MAINTENANCE OFIRRIGATION PROJECTSDrawing on the observations of the Lankeme Irrigation Project contained in the preceding chapters,this chapter examines the major lessons which can be learned for the maintenance of irrigationprojects.A. Points which should be Considered at the Development Survey Stagea) Finding out who are the beneficiariesOf course, the beneficiaries of an irrigation project are the farmers of the area, but whilethey are the beneficiaries they are also the main group responsible for maintenance. If thefarmers are taken to be beneficiaries only, it can be said that nearly all farmers who ownpaddy fields in the project area will benefit to some extent, so there is no reason not to lumpthem all together without any more detailed classification. However, if the farmers areregarded as the ones who take on the task of maintenance, that is to say, if they become thepeople with the most control over the sustainability of the project, the diversity of thefarmers becomes highly significant. The farmers, or the members of village communities,are not a homogenous group. They must be divided into at least three groups, landowningfarmers, sharecroppers and agricultural laborers, and studied in those groups. On the basisof these groupings, the development survey should prepare some kind of outlook for eachgroup, covering the following aspects.• Will each grouping benefit from the project or not?• How will the roles to be played in maintenance management differ between the groups?• Will each group derive a degree of benefit in proportion to the burden the project willplace on them?b) Use of traditional water users' organizationsIn regions which have a history of paddy field agriculture, there is likely to be an existingorganization of farmers to mediate in the use of agricultural water resources. In the LankemeIrrigation Project area there were village irrigation organizations which predated the project,which ordered water distribution in a system centered on the mandruwae, a water manager.Water use charges were already being collected, in the form of donated labor, a fixed amountof unhulled rice, or cash. In this way the beneficiaries bore the expenses of maintenance,including an allowance for the mandruwae. However, in government-implemented irrigationprojects, these methods, which are already rooted in the community, are not reinforced orhelped to revive. Instead they are dissected and discarded to be reassembled into new wateruse organizations operating on completely different principles. After this process, it takes alot of time and effort to get the operations of the new organizations on track. This is true inmany areas, not just in the Lankeme Irrigation Project area.In the development surveys for agricultural projects in recent years, the staff concernedwith technical aspects and economic analysis have been joined by additional staff concernedwith farmers' associations and other organizational aspects, enabling survey teams to consider

240 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local Communitythese matters in more detail. In future, the existing, traditional organizations should beused as the base, and projects should be planned with a view to revitalizing theseorganizations, and rooting modern irrigation techniques in the community.c) Finding out what the traditional farming practices areThe character of a community must not be forgotten when positioning the irrigation projectwithin that community. At the very least, any farming practices peculiar to that area mustbe found and studied. Taking Indonesia as an example, when rice farmers (both landowningand sharecropping farmers) have to harvest their crops, they allow anyone who wants totake part in the harvesting to do so, without limit. These volunteers receive, between them,between one tenth and one sixth of the farmer's harvest in payment (the share varies withregional practice). This long-standing traditional way of harvesting is generally known asbaon.The grasp the survey gains of the economics of farmers in the above three groups(landowning farmers, sharecroppers and agricultural laborers) will be greatly influencedby whether or not it is known that this social custom of mutual redistribution and help isused. Also in Indonesia, when there are great population pressures and the numberparticipating in the harvest becomes unmanageably large, there is a visible shift from baonto the use of specialist agents who are contracted to bring in the harvest. Under this method,which is usually called tebasan, the contracted agent has total control over all stages of theharvest and determines the distribution rates. It is easy to see that the methods of determininga farmer's production and the parts played by the workers will differ enormously betweenregions which use tebasan and regions which use baon. The conclusions reached by thedevelopment survey will be changed depending on whether or not these differences areunderstood. In short, it has an impact on whether or not it will be possible to reach anunderstanding with farmers over the broader meaning of maintenance for the irrigationproject.The inclusion of someone in the development survey team, who is well aware offarming practices in the project area, is a necessity. We must absolutely avoid the situationwhere those working on the survey base the survey's assumptions on the practices they arefamiliar with (for example, Japanese practices), while they are unaware of how things arereally done.B. Matters to Consider during the Construction Perioda) Methods to grasp changes in the communityIn general, when construction begins, the construction workers and the management ofconstruction become the prime concern of those in charge of the project. There does notseem to be enough time to take another look at the impact the project is having on thecommunity. Where it takes a long time, ten years or more, to complete the project, thepoints studied at the time of the development survey must be reviewed at some intermediatestage. What the community wants from the project must also be rechecked.At present the OECF may conducts a SAPI (Survey to Assist Project Implementation)survey at the implementation stage, but the budget is limited, and these are only conducted

OECF Journal of Development Assistance Vol.4, No.1, 1998 241when there are clearly problems with the project which may prevent its completion. Ideally,a survey should be conducted partway through the implementation of every project tograsp changes in the community before problems come to the surface. In practice, it isdifficult to do this with SAPI surveys. A more practical approach is for the grassrootsofficials of the executing agency, or the consultants responsible for the site, to keep an eyeon the situation, and be forthright in reviewing the project plan and making comments onthe maintenance system and support services which should follow the project.b) Preparation of a broad irrigation management strategyIf irrigation management means the building of physical management systems and theorganization of water users' associations, two or three years before the completion of theproject is not too soon to start preparing, and work should certainly have begun immediatelyafter the completion. However, as was noted above, work on broadly-defined irrigationmanagement as defined in this report must be based on a knowledge of the long-termchanges that happen before the project is completed. Ways of dealing with these changesmust be prepared in parallel with the progress of the project.C. Matters to Consider after Construction is Completea) Ongoing post-evaluationThe OECF conducts successive post-evaluations of completed projects, with at least onebeing conducted before the executing agency loses the relevant information (usually withinfive years of project completion). However, one survey is not enough if we are to improvethe sustainability of the project by responding appropriately to changes in the community.In an ideal situation the donor side would be able to monitor the situation continuously. Inpractice, the project is finally transferred to the authority of the local authorities of the areaand to the farmers themselves, so these groups must be armed with the ability to keep agrasp on changes at the level of regional administrative, and take suitable action.b) The provision of services to respond to changesThe full effects of an irrigation project will not be realized just by building the irrigationfacilities. It is essential to combine them with support services 21 (technical guidance,introduction of improved varieties, finance, marketing etc.). The content of these supportservices must be tailored to match the changes that the project has caused, both directlyand indirectly, in the community.The services which should be provided to farmers after the completion of the irrigationproject are the most promising field for the dispatch of JICA experts and other forms ofcooperation with a JICA scheme. An accurate grasp of changes in the community is alsoessential to the successful combination of OECF hardware and JICA software.21There are many studies which point to this conclusion, and that by Shibuta (1995) is a good examplefor reference.

242 Masami Mizuno, Katsuhiko Nakadate, Rie Makita, How Maintenance for Irrigation Projectsshould Adapt to Changes in the Local CommunityAFTERWORD– Challenges for the Future –This report has been built around an awareness of problems which we gained through postevaluationof the Lankeme Irrigation Project. An accurate portrayal of change in a communityreally requires long-term observation and time series analysis spanning the planning stage andthe construction period and continuing beyond completion. This paper does not have the backingof such data and therefore I am doing no more than advancing a supposition. For the LankemeIrrigation Project, follow-up surveys should be conducted, and the changes that arise in the significanceof water management in the community should be observed. If it is possible to track changescontinuously in the future, this monitoring will provide many insights into subjects which are currentlybeing debated, such as the sustainability of irrigation projects and participatory irrigation management.There is no doubt that irrigation projects are a form of outside intervention which stimulatesthe subject community by raising agricultural production. However, when something new is broughtinto a traditional society, that thing, however good it is, also places a burden on the society. What thepeople responsible for development must do is take this situation seriously and add further interventionsas necessary, once they have a clear understanding of what needs to be done.REFERENCESAsian Productivity Organization (1991). "Management of Irrigation Facilities in Asia and thePacific", Tokyo.Bruns, B. and Helmi (1996). "Participatory Irrigation Management in Indonesia: Lessons fromExperience and Issues for the Future" (A background paper prepared for the Economic DevelopmentInstitute, World Bank and the Food and Agriculture Organization, U.N.), November 1996.International Agriculture and Forestry Cooperation Association (ed.) (1994). "Agriculture andForestry Industries in Indonesia – Present Status and Issues for Development –", Dec.1994, in Japanese.Japan International Cooperation Agency (1981). "Lankeme Irrigation Development Project",March 1981, in Japanese.Kanazawa, Natsuki (1993). Changing Agriculture and Farmers in Asia, The University of TokyoShuppankai, in Japanese.Kikuchi, Masao (1992). "Strategies for Proper Management of Irrigation System in AsianDeveloping Countries – Case Study Primarily on Sri Lanka –", Agricultural IntegratedResearch Vol. 46, No.1, January 1992, in Japanese.Mizutani, Shoichi (1996). "Water Utility System Under Energy Restriction – Experience of 'Sbuck'in Indonesia –", Drain and Distribution of Water Energy Resources, Chapter 2, Associationof Agriculture, Mountain, Fishing Village and Culture, in Japanese.Nippon Koei Co., Ltd. (1995). "Final Investigation Report on Gililan Irrigation DevelopmentProject in the Republic of Indonesia", June 1995, in Japanese.Shibuta, Kenichi (1995). "Sustainability of Agricultural Issues – Case Study on Sri Lanka, TheMahabeli Regional Development Project (C District)", Journal of Development AssistanceVol.2, No.3, Dec. 1995, in Japanese.Watanabe, Hiroyuki etc. (ed.) (1996). "Tropical Agriculture", Asakura Shoten, in Japanese.

HIGHER EDUCATION INTHREE SOUTHEAST ASIAN COUNTRIES *— Results of a Student Survey —Hitoshi Shoji **Hajime Ino ***Aki Sudo ****SUMMARYThis report discusses the current issues on higher education in three Southeast Asian countries ofThailand, Indonesia, and the Philippines, based on questionnaire surveys focusing on the followingquestions: (1) Is there equal opportunity to receive higher education?, (2) Does the current stateof higher education provide appropriate educational content?, and (3) Does higher educationrespond to society's needs?Through the analyses of the survey results, some tendencies were revealed, such as: in themajority of cases, expenses for higher education are born by families; private universities aremainly attended by students from higher income groups, while in contrast, public universitieshave more students from comparatively lower income groups; the scholarship systems furnishfunds mainly to students who have high academic attainment and/or are from lower incomefamilies; and the level of satisfaction is low with regard to facilities and quality of teaching staff.The report also reviewed ODA loan projects in the field of higher education and providesome implications for future education projects based on the study results.CONTENTSI. OverviewA. Background of the StudyB. Strategy of the StudyC. Methodology of SurveysII. Financial Situation of Students in Higher EducationA. University Type and Characteristics of University StudentsB. Schooling ExpensesC. Student Financial Support*This article is a summary of OECF Research Papers No. 22, which was jointly written by ProfessorYano's Research Laboratory and the Research Group for Sector Studies in the Research Institute ofDevelopment Assistance, guided by Professor Masakazu Yano, of the Department of Social Engineering,Tokyo Institute of Technology, as a RIDA senior research advisor.**Hitoshi Shoji, Director, 1st Division, Operations Department IV, OECF, Ex-Senior Economist,Director, Sector Studies, RIDA, OECF***Hajime Ino, Technical Advisor, Sector Studies, RIDA, OECF**** Aki Sudo, Ex-Economist, Sector Studies, RIDA, OECFOECF Journal of Development Assistance Vol.4, No.1 (1998) pp.243-267©1998 by the Overseas Economic Cooperation Fund. All rights reserved.

244 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian CountriesIII. Purpose of Entering University and Levels of Satisfaction with Student Life andDemand for ImprovementA. Purpose of Entering University and Attitudes toward Studies after EnteringUniversityB. Level of Satisfaction and Demand for ImprovementC. Teaching Staff Quality and Facilities from the Perspective of University InstitutionsIV. Career Choices and Expectations after GraduationA. Anticipated Starting SalaryB. Anxiety for EmploymentC. Career Choice after GraduationD. University Education Seen from the CompanyV. Study at Japanese Graduate Schools from the Viewpoint of Foreign GraduateStudentsA. Purposes in Studying at Japanese Graduate SchoolsB. Effects of Foreign Study in Terms of Educational ConditionsC. Effects of Foreign Study on Students' Employment OpportunitiesVI. Implications for ODA LoansA. ODA Loan Projects for Higher Education to DateB. Implications for ODA Loan ProjectsReferencesI. OVERVIEWA. Background of the StudyHigher education in the three Southeast Asian countries of Thailand, Indonesia, and the Philippinesexpanded together with the economic development during 1970s and 1980s. The expansion wassupported by the private educational institutions, which require high tuition fees. Thischaracteristic is similar to the expansion process of higher education in Japan, being in contrastto that in Europe, in which the public sector plays the main role. The notion of paying children'seducational expenses on the part of families seems to be natural in Asia.As we enter the age of knowledge-intensive economy, the expansion of higher education isstarting to be "re-recognized" as a new worldwide phenomenon. In such an economy, due tofinancially strained circumstances, fund procurement for higher education expenses is becominga major policy task. Though the major conventional sources of fund procurement have been thegovernment and the families, it is becoming necessary to adopt a pluralistic approach whichseeks funds from sources other than the two (such as university service programs, donations,corporate support, and alumnae support). Without promoting this sort of diversification of fundsources, maintenance of the higher education system will become increasingly difficult in thefuture. Considering these trends, the Asian experience may offer valuable ideas in thecontemplation of higher education worldwide.

OECF Journal of Development Assistance Vol.4, No.1, 1998 245B. Strategy of the StudySeveral approaches may be proposed for the actual survey plan. In this research, emphasis isplaced on a student survey (hereinafter "the Student Survey"). The main reason for choosing thisapproach is that the internal state of education could not be well understood from a considerationof macro data materials exclusively. Furthermore, approaching the issue by considering who isavailing themselves of higher education, would be a convenient viewpoint for analyzing educationpolicy objectives "comprehensively".Generally, the following three can be deemed essential education policy objectives:(1) Equal opportunity for education(2) Internal efficiency of the educational system(3) External efficiency in terms of employment and unemployment of graduatesTo achieve these three objectives, procurement of education funding from plural sourcesand efficient distribution of the funds are required. To this end, when we designed the StudentSurvey the following approaches were conceived.The first question is to ascertain who is attending universities. It is expected that the choiceof the type of university, such as public or private, differ depending on family income level, andacademic attainment. These variations offer a framework for considering the procurement anddistribution of education funds such as equality of educational opportunities, the role of public(private) universities, and the allocation of scholarships.The second question is, how students evaluate the current state of education. Though it isextremely difficult to evaluate the internal efficiency of education, this type of subjective evaluationby students is one important way to view internal efficiency.The third question concerns the career orientation of students after graduation. To evaluateexternal efficiency, it is usually desirable to survey graduates. In this survey, however, we surveyedmainly undergraduates concerning their hopes for employment, intending thereby to clarifyproblem areas in career guidance in universities.With the intention of supplementing the Student Survey, the following additional threesurveys were planned: the University Survey, the Company Survey, and the Foreign StudentSurvey.The samples in the surveys are quite limited and some questions are not suitable forquantitative comparison, which means that our surveys are not able to evaluate comprehensivetrends of higher education in each country. Whilst acknowledging its limitations, our surveyswere implemented with an awareness of the issues as stated in the following sections, as onemeans of gaining insight into the current state of higher education in the those countries.C. Methodology of Surveysa) The student surveyTwo hundred questionnaires were sent to students at nine institutions in each of the threetarget countries. In each of the three target countries, two institutions were chosen fromeach of the following categories: prestigious public university, prestigious private university,

246 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian Countriesnon-prestigious public university, and non-prestigious private university; one vocationalschool was also selected. 1 Distribution of the questionnaires was entrusted to each instituteof higher education with instructions to request replies from currently enrolled studentswith a majority in their fourth-year of studies. The names of universities which replied tothe questionnaire are listed in Table 1. The numbers of questionnaires collected were:Thailand 777 from 6 universities, Indonesia 870 from 7 universities, and the Philippines1115 from 7 universities.Table 1Name of University for Student SurveyCountry Name of University University TypeThailand Chulalongkorn University Public PrestigiousKing Mongkut’s Institute of Technology Public Non-Pres.Srinakharinwirot University Public Non-Pres.Minburi Technical College Public VocationalBangkok University Private PrestigiousAssumption University Private PrestigiousIndonesia Bandung Institute of Technology Public PrestigiousIndonesia University Public PrestigiousMulawarman University Public Non-Pres.Syiah Kuala University Public Non-Pres.Trisakti University Private PrestigiousIndonesia Institute of Technology Private Non-Pres.Christian University of Indonesia Private Non-Pres.Philippines University of the Philippines Public PrestigiousSouthwestern University Public Non-Pres.Technological University of the Philippines Public Non-Pres.Marikina Institute of Science and Technology Public VocationalUniversity of Santo Tomas Private PrestigiousFar Eastern University Private Non-Pres.University of the East Private Non-Pres.Notes : "Non-Pres." means "non-prestigious".b) The university surveyQuestionnaires were sent to 21 universities in each of the three target countries. The numbersof questionnaires returned were: 7 from Thailand, 10 from Indonesia, and 8 from thePhilippines.In the University Survey, although at least one response was received from each typeof university in each country, all the universities in the Student Survey were not necessarilythe same as those in the University Survey. Results of the University Survey was only1 In classifying institutions as prestigious or non-prestigious , we observed the classifications generallyrecognized in the given countries. The institutions were not classified in accordance with a strict definition.

OECF Journal of Development Assistance Vol.4, No.1, 1998 247utilized to supplement the Student Survey.c) The company surveyQuestionnaires were sent to 13 government agencies, 8 private companies and a few othercompanies, through the Chambers of Commerce and Industry in each of the three targetcountries. The numbers of questionnaires returned were: 26 from Thailand, 14 fromIndonesia, and 15 from the Philippines.d) The foreign student surveyQuestionnaires were sent to Japanese graduate schools with the request that they be filledout by foreign students from Thailand, Indonesia, and the Philippines. The followinguniversities were included: Tokyo Institute of Technology, Hiroshima University, NagoyaUniversity, University of Tokyo, Saitama University, Hokkaido University, and KeioUniversity. Among the foreign students studying at these universities, Indonesian studentswho are receiving OECF funded "Overseas Scholarship Programs" are included. Thenumbers of questionnaires returned were 68 from Thai students, 158 from Indonesian students,and 38 from Philippine students. The total number of 268 is slightly over 20% of all theforeign students from the three target countries who are studying at Japanese graduate schools.II. FINANCIAL SITUATION OF STUDENTS INHIGHER EDUCATIONIn this section, equal opportunities for higher education is examined from the perspectives ofstudents' family income and academic attainment. Scholarship systems and tuition exemptionsystems provide financial support for students who come from lower income families with highacademic attainment. Upon ascertaining the current state of students' income and expenditure,we attempt to understand the current state of those financial support systems and define theproblems.A. University Type and Characteristics of University Studentsa) University students from the perspective of family incomeThe following are relationship between family income and usage of university. In referringstudents' family income, we have divided the whole sample into 5 income groups (theIncome Group). Under this classification method, students' family incomes are listed inorder of amount and are then divided into groups so that each group comprises an equalnumber of students. 2 Table 2 indicates the boundaries in US$, where Group 1 is the lowestincome bracket, and Group 5 is the highest.2 However, it should be noted that there are cases when the groups are not necessarily equal due tothe existence of odd numbers.

248 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian CountriesTable 2Classification Boundaries of Income Groups(Unit: US$)Thailand Indonesia The PhilippinesGroup 1 0 0 0 Group 2 4,100 1,500 2,150 Group 3 12,100 3,000 3,800 Group 4 23,000 4,100 6,000 Group 5 50,000 10,000 12,000 GDP/capita 2,696 965 1,030Fig. 1 indicates the pattern of usage of public and private universities for each countryby the Income Group. Since the total number of students at public and private universitiesin the three target countries varies, we adjusted the figures so that the number of students isuniform at public and private universities in each country.The figure demonstrates that the usage rate of private universities is approximatelyproportionate to family income in all the countries: public universities are used more bystudents from lower income families, private universities are used more by students fromhigher income families.100.0%80.0%60.0%1.Thailand2.Indonesia3.The Philippines40.0%20.0%0.0%Group 1 Group 2 Group 3 Group 4 Group 5Fig. 1 Usage Rate of Private Universities in Each Countryb) University types and students' characteristicsIn this section, we examine the relationship between student characteristic ("family income"and "academic attainment") and university type ("public or private" and "prestigious ornon-prestigious"). In this survey, high school grades were used for rating academicattainment. Students were divided into 5 brackets with boundaries of 5%, 25%, 75%, 95%from the top, namely Top, Upper, Middle, Lower, and Bottom. 33 In all three target countries, very few students belong to the bottom two groups, and it can also beseen that if the top two groups combined, they account for approximately 50%. Thus, it can be said that thegrades of students targeted by this survey are limited to a fairly high level.

OECF Journal of Development Assistance Vol.4, No.1, 1998 249Fig. 2 through Fig. 4 show the various distinctions of university students in terms ofaverage levels of family income and academic attainments of the respondent students foreach country, plotted by university. The symbols indicate university type, for example"Pu/Np" refers to non-prestigious public universities. The figures in parenthesis are thesequential number in the same university types, and "(v)" indicates vocational school. Foracademic attainment, 3 points are assigned for the Top, 2 points for the Upper, and 1 pointfor the Middle. Small variations exist from country to country, but the possibility of adefinite relationship between university types and the various student distinctions can berecognized.Commonly in the three countries, at prestigious public universities, many studentshave both high academic attainment and high family income. At non-prestigious publicuniversities, many students have high academic attainment irrespective of family income.At private universities, many students are with high family income though their academicattainment is relatively low.In Thailand, a tendency is evident in which children of higher income families attendprivate universities and children of lower income families attend public universities. Atprestigious private universities, the students tend to come from higher income families, butdo not have a high level of academic attainment. At public universities, irrespective offamily income, there are more students with high grades than at private universities. Amongpublic universities, there is a wide range of family incomes, which implies that the door isopen to those from lower income families. Furthermore, the family income of vocationalschool students is extremely low.100,000Pr/P(1)80,000Pr/P(2) Pu/P(1)60,000Pu/Np(1)40,000Pu/Np(2)20,000Pu/Np(v)01 1.5 2 2.5Academic AttainmentPu/P (1) : Chulalongkorn Univ.Pu/Np (1): King Mongkut's Instituteof TechnologyPu/Np (2): Srinakharinwirot Univ.Pu/Np (v): Minburi Tech. CollegePr/P (1) : Bangkok Univ.Pr/P (2) : Assumption Univ.Fig. 2 Student Distinctions by University Type (Thailand)In Indonesia, a tendency is observed that the levels of academic attainment is high atpublic universities and low at private universities. The income gap among students' familiesseems relatively small. It can be argued that both academic attainment and family incomemust be high in order to attend public universities.

250 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian Countries20,00015,00010,0005,000Pr/P(1)Pr/Np(2)Pu/Np(2)Pu/Np(1)Pr/Np(1)Pu/P(2)Pu/P(1)Pu/P (1) : Indonesia Univ.Pu/P (2) : Bandung Inst. of Tech.Pu/Np (1): Syiah Kuala Univ.Pu/Np (2): Mulawarman Univ.Pr/P (1) : Trisakti Univ.Pr/Np (1): Indonesia Inst. of Tech.Pr/Np (2): Christian Univ. of Indonesia01 1.5 2 2.5Academic AttainmentFig. 3 Student Distinctions by University Type (Indonesia)In the Philippines, the academic level is higher at public than at private universities.However, while the door is open to students from lower income families at publicuniversities, it seems that at private universities, the door is open only to students with highfamily incomes, and that academic attainment is not as high as that at public universities.20,00015,00010,0005,000Pr/Np (1)Pr/Np (2)Pu/Np (v)Pr/P (1)Pu/Np (1)Pu/Np (2)Pu/P (1)Pu/P (1) :Univ. of the PhilippinesPu/Np (1):Southwestern Univ.Pu/Np (2):Tech. Univ. of the PhilippinesPu/Np (v):Marikina Inst. of Science andTechnologyPr/P (1) :Univ. of Santo TomasPr/Np (1):Far Eastern Univ.Pr/Np (2):Univ. of the East01 1.5 2 2.5Academic AttainmentFig. 4 Student Distinctions by University Type (The Philippines)B. Schooling Expensesa) Students' expendituresTable 3 gives the average figures of students' expenditures in each country. These figuresshow that tuition and food are the main expense items across the three target countries. Asa proportion of total expenditure, tuition is in the range of 20%±3% and food is 24%±3%.The ratio of students' total expenditures at private universities to those of public universitieswere: 3.2 times in Thailand, 2.2 in Indonesia, and 1.5 in the Philippines.

OECF Journal of Development Assistance Vol.4, No.1, 1998 251Table 3Students' ExpendituresItem Thailand Indonesia Philippines(Unit: US$)Tuition 695 20.3% 474 22.6% 442 17.7%Books/Materials 227 6.6% 247 11.8% 188 7.5%Food 901 26.3% 446 21.3% 557 22.3%Housing/Utilities 277 8.1% 253 12.1% 438 17.5%Transportation 441 12.8% 210 10.0% 244 9.8%Entertainment 367 10.7% 208 9.9% 253 10.1%Others 523 15.3% 259 12.3% 375 15.0%Total 3,432 100.0% 2,097 100.0% 2,496 100.0%b) Students' incomeTables 4 shows student income sources in each country. It can be seen that allowancesfrom home account for a large portion of student income in all of the countries. In contrast,the percentage accounted for by scholarships is small. In contrast, students seem to makelittle personal effort to make money for their education through part-time or permanentjobs.Table 4Students' IncomeThailand Indonesia Philippines(Unit: US$)Allowance 2,031 75.7% 1,298 76.7% 1,077 79.0%Scholarship 105 3.9% 83 4.9% 64 4.7%Permanent Job 321 12.0% 86 5.1% 55 4.0%Part-time Job 169 6.3% 126 7.5% 92 6.8%Other 58 2.1% 100 5.9% 75 5.5%Total 2,685 100.0% 1,694 100.0% 1,364 100.0%c) Allowances from household budgetTable 5 indicates the amount of allowance from home per student by country and by publicor private university. "Pr/Pu" is the ratio of the allowance of private university students tothe allowance of public university students. Also, "Gap 5:1" on the bottom line of the tableindicates the ratio of the allowance amount of Group 5 against that of Group 1.The "Gap 5:1" of Thailand is 1.3 times, which is indeed not very large, but those ofIndonesia and the Philippines are in a spread of approximately 2 to 4 times, which may besignificant. In another question, students in lower income group say that it is difficult toattend university only with allowances, which is suggesting that the economic burden ofattending university is large for lower income group. This tendency is common both inpublic and private universities. However, the difference in household allowances is smaller

252 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian Countriesthan the gap in family incomes among the groups as shown in Table 2, which suggests thateven lower income families provide educational expenses according to necessity.Table 5Allowances from Household BudgetsThailand Indonesia The Philippines(Unit: US$)Public Private Pr/Pu Public Private Pr/Pu Public Private Pr/PuGroup 1 1,582 2,331 1.47 460 998 2.17 581 571 0.98Group 2 1,715 2,088 1.22 582 943 1.62 663 1,241 1.87Group 3 1,773 2,444 1.38 636 1,853 2.91 1,298 1,061 0.82Group 4 2,017 2,458 1.22 884 1,643 1.86 1,387 1,281 0.92Group 5 2,063 3,019 1.46 1,984 2,111 1.06 1,782 2,038 1.14Average 1,781 2,529 1.42 807 1,773 2.20 1,022 1,397 1.37Gap (5:1) 1.30 1.30 4.3 2.12 3.07 3.57C. Student Financial Supporta) Current state of scholarshipsTable 6 and 7 indicate the distribution of scholarship by viewing the percentage of studentsreceiving scholarships by university type and the average scholarship amount for studentsreceiving scholarships.Table 6Percentage of Students Receiving Scholarships by University TypeThailand Indonesia PhilippinesPrestigiousNon-Pres.AveragePrestigiousNon-Pres.AveragePrestigiousNon-Pres.Public 10.7% 7.2% 8.0% 33.0% 27.0% 29.0% 41.9% 12.9% 19.2%Private 6.0% 6.0% 11.1% 24.5% 19.5% 12.8% 12.4% 12.6%Average 7.0% 7.2% 7.1% 25.2% 26.2% 25.9% 24.5% 12.7% 16.1%Note : "—" indicates that no corresponding sample exists.Table 7Average Scholarship AmountThailand Indonesia PhilippinesAveragePrestigiousNon-Pres.AveragePrestigiousNon-Pres.AveragePrestigiousNon-Pres.(Unit: US$)Public 1,495 220 742 428 239 318 674 250 478Private 675 675 363 344 353 632 288 445Average 1,202 220 729 421 247 321 661 265 467Note : "—" indicates that no corresponding sample exists.Average

OECF Journal of Development Assistance Vol.4, No.1, 1998 253In Thailand, outstanding features are that the percentage of scholarships allocation islow and that the amounts awarded to students at prestigious public universities ispredominantly large. In Indonesia, the distribution to universities of each type is relativelyeven. In the Philippines, the allocation to the prestigious public universities is prominent,and the amount awarded to students at prestigious university is quite large.b) Scholarship allocationGenerally there are two standards for determining scholarship allocation, the needs basisand the merit basis. The needs basis means that scholarships are allocated depending onfinancial need and are for the purpose of amending inequality of opportunity due to thedifference in income levels. The merit basis suggests that scholarships are allocateddepending on academic attainment, and brilliant students are given priority. Fig. 5 displaysdistribution percentage of scholarship by students' academic attainment, and Fig. 6 displaysthat by the Income Group. According to the figures, it seems that all the three countries areallocating scholarships on both the needs basis and the merit basis.40%30%40%30%ThailandIndonesiaPhilippines20%20%10%10%0%Top Upper MiddleAcademic Attainment0%Group 1 Group 2 Group 3 Group 4 Group 5Family Income GroupFig. 5 Merit Basis ScholarshipFig. 6 Needs Basis ScholarshipNotes:*1 The "Percentage of scholarship allocation" is the percentage of students who receive scholarshipin all the sample students.*2 In Fig. 5, the Lower and Bottom bracket were omitted because the samples are small.c) Current state of tuition fees and the tuition exemption systemThe averages for tuition fees in each country are indicated in Table 8. Looking at the table,the differences in tuition fees between public and private universities in the three countriesis evident. The gap in Thailand is larger than in the other two countries; Indonesia liesapproximately in the median; and in the Philippines, the gap is small.

254 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian CountriesTable 8Average Amounts of Tuition FeesThailand Indonesia PhilippinesPrestigiousNon-Pres.AveragePrestigiousNon-Pres.AveragePrestigiousNon-Pres.(Unit: US$)Public Lib.Arts 248 136 192 231 166 175 458 153 187Science 170 243 234 333 195 243 565 656 630Private Lib.Arts 1,652 1,652 1,083 801 1,041 586 368 493Science 2,168 2,168 1,001 946 969 600 511 545Note : "—" indicates that no corresponding sample exists.Table 9 displays the percentage of students receiving tuition exemptions by universitytype. Almost uniformly in all three target countries, a large number of students at prestigiousuniversities are receiving tuition exemptions. Comparing the percentage of studentsreceiving tuition exemptions with that of the scholarship system (see Table 6), the percentageof students receiving tuition exemptions is generally higher in all three target countries. Itcan thus be seen that the tuition exemption system is a more prevalent method of studentfinancial support.Table 9Percentage of Students Receiving Tuition Exemptions by University TypeThailand Indonesia PhilippinesAveragePrestigiousNon-Pres.AveragePrestigiousNon-Pres.AveragePrestigiousNon-Pres.AveragePublic 18.8% 17.0% 17.4% 25.8% 20.6% 22.2% 46.8% 16.8% 23.6%Private 27.0% 27.0% 65.0% 34.0% 46.5% 11.6% 15.4% 13.9%Average 25.2% 17.0% 21.4% 41.5% 24.8% 30.7% 26.1% 16.2% 19.1%In the relationship between the family income and academic attainment of studentsreceiving tuition exemptions, no conspicuous tendencies such as the needs basis or meritbasis standards of scholarship systems could be detected. Standards different from thoseof scholarship systems may have been applied for tuition exemptions.III. PURPOSE OF ENTERING UNIVERSITY AND LEVELS OFSATISFACTION WITH STUDENT LIFE ANDDEMAND FOR IMPROVEMENTIn this chapter, the current conditions of and problems in university education as perceived bystudents shall be discussed from the following viewpoints: purpose of entering university andattitude of study after entering; students' level of satisfaction and demand for improvement.

OECF Journal of Development Assistance Vol.4, No.1, 1998 255A. Purpose of Entering University and Attitudes toward Studies after Entering UniversityThe question on the purpose of entering university consists of 12 alternatives shown in Table 10.Commonly in the three countries, the percentages of students are high who selected "knowledgeand technology immediately useful in the real world", "acquisition of advanced knowledge andtechnology", and "improvement of one's own abilities", which suggests that students have anidea of their purpose, which is to acquire knowledge and abilities that will be useful in finding ajob after graduation. On the other hand, not much weight is given to what may be called thescholarly inquiry aspect as a purpose.Table 10Purpose of Entering University (Unit: %)Thailand Indonesia PhilippinesKnowledge and technology useful in the real world 60.1 59.8 58.8Acquisition of degrees and academic career 49.6 25.6 60.7Acquisition of advanced knowledge and technology 32.0 40.1 36.9Improvement of one's own abilities 38.0 32.3 29.0Study in major field systematically 32.4 24.2 42.6Forming humanities 20.0 31.6 23.8Acquisition of licenses and qualifications 17.9 15.0 20.4Learning how to study 12.1 9.8 3.7Improvement of career by changing job 4.2 17.4 3.2Enjoyment of student life through after-school activities 11.7 8.1 2.8Acquisition of practical issues 8.0 8.2 3.6Acquisition of general education 3.2 8.4 4.6Others 1.4 1.0 1.5Note : % indicates the percentage of students who chose corresponding item from multiple-choice question.Table 11 shows students' attitudes toward studying after entering university. Almost morethan half of the students in each country replied "Studies are very interesting", which implies thatthey are enthusiastic about studying. The percentage is particularly high in Indonesia. In theother two countries, many students seem to want to change their university or major. Moreover,at private universities in Thailand, relatively many students only want to graduate.Table 11Studies After Entering University (Unit: %)Thailand Indonesia PhilippinesPub. Priv. Pub. Priv. Pub. Priv.Studies are very interesting 44.9 50.6 68.3 66.0 54.3 49.7Want to transfer to a different university 14.7 6.9 8.1 9.5 13.3 22.0Want to change major 17.5 8.7 6.2 5.3 12.8 9.1Lost interest in studying, but want to graduate 11.1 24.1 11.1 12.3 11.9 9.1Want to quit university 0.7 1.5 1.1 1.1 0.5 1.2Other 11.1 8.1 5.3 6.0 7.1 9.1Invalid response 1.4 3.6 1.6 4.9 1.6 2.7Total 100.0 100.0 100.0 100.0 100.0 100.0

256 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian CountriesB. Level of Satisfaction and Demand for ImprovementFig. 7 shows that common characteristics among the three countries include that level ofsatisfaction is low with career guidance and laboratory equipment, and high with curriculum andlecture contents. The patterns of trend are very similar between Indonesia and the Philippines.3.83.63.43.232.82.62.42.22Thailand Indonesia The Philippines(Unit: points)Note : The highest level of satisfaction was given five (5) points.Fig. 7 Levels of SatisfactionQuestions about demand for improvement are to be examined the satisfaction from anotherangle, but other new questions, such as questions about scholarship, studying abroad, quality ofteaching staff, are added. As similar to the results of "Level of Satisfaction", this "Demand forImprovement" showed the same overall results (See Fig. 8).Overall trend is similar among the three countries. The only remarkable difference may bea low demand of improvement for financial support, such as scholarships, and facilities inThailand. Demand of improvement for equipment / facility and career guidance is high assuggested in the analysis of level of satisfaction. A new finding in this analysis is that demandfor improvement in teaching staff quality is also high, which was stated in students' opinion.

OECF Journal of Development Assistance Vol.4, No.1, 1998 2572.72.52.32.11.91.7Thailand Indonesia The Philippines1.5Note : The highest level of demand for improvement was given three (3) points.Fig. 8 Level of Demand for ImprovementC. Teaching Staff Quality and Facilities from the Perspective of University InstitutionsInvestigating teaching staff's position should be helpful to verify the high dissatisfaction withteaching staff's quality. In Thailand, while at public universities experienced associate andassistance professors conduct many of the classes, at private universities, many of the classes areconducted by young lecturers. In Indonesia, both at public and private universities, the percentageof lecturers and assistants is high. In the Philippines also, the percentage of lecturers and assistantsis high, but more assistance professors conduct classes at private universities.Lower salary is often cited as a reason why teaching staff of high quality are not availablein such countries. The survey results show: in Thailand, salary of teaching staff at universities isalmost the same as government officials (lower than corporate employees); in Indonesia, at publicuniversities, it is same as government officials, and at private universities it is same as or slightlylower than corporate employees; in the Philippines, at public universities, it is lower thangovernment officials, at private universities, it is between government officials and corporateemployees.Looking at capital expenditures, which may be used to evaluate how university facilitiesare improved, private universities spend more budget for facilities than public universities in allthe three countries. This result supports the fact that students at private universities are moresatisfied with facilities.

258 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian CountriesIV. CAREER CHOICES AND EXPECTATIONSAFTER GRADUATIONA. Anticipated Starting SalaryHere, we analyze how the anticipated starting salary varies according to relative family income.Fig. 9 show ratios of anticipated starting salary calculated as a percentage of family income bythe Income Group. Generally speaking, students in lower income group expects higher startingsalary.(Unit: US$)4.54Thailand Indonesia Philippines3.532.521.510.50Group 1 Group 2 Group 3 Group 4 Group 5Income GroupNotes : A value of more than 1 means that students expect higher starting salarythan their family income.Fig. 9 Anticipated Starting Salary for Five Income BracketsAs clearly indicated in the above table, lower income groups give higher values to theratio. At Group 1, the ratios are more than 4 in Thailand and Indonesia, and more than 2 in thePhilippines. Commonly in all the three countries, it is shown that students seek for more affluentlife.B. Anxiety for Employmenta) Anxiety over obtaining employmentThe presence of anxiety over obtaining employment is an indicator of whether theprogression from the completion of higher education to employment at a company issmoothly connected (See Table 12). Generally, the level of students' anxiety is very high.The fact that students' demand for improvement about career guidance is intense can beexplained by such anxiety.

OECF Journal of Development Assistance Vol.4, No.1, 1998 259Table 12Anxiety Over Obtaining EmploymentExtremeAnxietyAnxiety No Anxiety InvalidTotal(persons)Thailand 20.9 57.8 20.0 1.3 100.0 (784)Indonesia 37.9 45.0 14.5 2.6 100.0 (876)Philippines 46.6 40.2 12.0 1.3 100.0(1120)(%)b) Anxiety for utilizing specialtyStudents' anxiety about whether they can utilize their specialty when working also seemsintense. The anxiety is high in the Philippines, followed by Indonesia and Thailand (SeeTable 13).Table 13Specialty Utilization AnxietyExtremeAnxietyAnxiety No Anxiety InvalidTotal(persons)Thailand 20.3 43.9 34.2 1.7 100.0 (784)Indonesia 28.5 30.3 38.0 3.2 100.0 (876)Philippines 42.1 39.5 16.9 1.6 100.0(1120)(%)C. Career Choice after GraduationA common trend of career choice after graduation in the three countries is that employment toprivate companies is not so large, which shows that private companies are not large enough as alabor market for university graduates. The employment at government offices is said to be notwidely open. By specialty, many students hope to obtain employment in sectors close to theirspecialty, with education major students hoping to become civil servants for example, andagriculture, fishery and forestry majors hoping to work in the agriculture, fishery and forestry.As can be seen, the manufacturing industry claims only a small share of university graduates,and the mainstream jobs for university graduates are white-collar jobs in the social infrastructuresector, such as civil service, transportation / communications, and the finance industry.

260 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian CountriesTable 14Students Whose Place of Employment is DecidedThailand Indonesia PhilippinesGovernment 2.8% 9.4% 11.4%Private Company 35.7% 37.9% 36.8%University or Research Institutes 2.4% 6.5% 3.0%Teaching Staff 1.7% 4.9% 7.4%Self-employed Business 14.3% 13.4% 13.1%Family Business 7.0% 2.2% 3.3%Study at Foreign University 20.2% 10.2% 5.8%Study at Domestic Graduate School 5.0% 1.1% 3.8%Undecided 6.1% 4.3% 2.6%Other 1.5% 2.1% 8.0%Invalid 3.3% 8.1% 4.9%(%)D. University Education Seen from the CompanyHere, an overview will be given on how higher education is evaluated from the standpoint ofemployers using the data from the Company Survey.a) What is demanded from higher educationIn response to "What is your opinion on the quality of man power ?", no governmentoffices or other organizations answered that it is "ineffective". They seem to think thatuniversity education is generally effective, although slight problems may exist.Analyzing the answers of "What do you expect for the present university education?",it can be seen that whereas government offices and companies in Thailand want students tohave the knowledge necessary to become working members of society, in Indonesia andthe Philippines, students are expected to have acquired the skills generally associated withuniversity education (See Table 15). Though answers to "Foreign Language Ability" forThailand and Indonesia show a high number, that for the Philippines is quite low, namelyzero. The reason seems that English is an official language in the Philippines.Under the question asking about "points for improvement in university education",mainly the following are demanded: "financial support" in Thailand, "facilities" and"improvement of study guidance" in Indonesia, "teaching staff quality", "financial support","facilities" and "career guidance" in the Philippines (See Table 16). It may be said thatthere is a fairly high degree of consistency with the Student Survey.

OECF Journal of Development Assistance Vol.4, No.1, 1998 261Table 15Knowledge and Skills from University Education Desired by OrganizationsThailand Indonesia PhilippinesThe Most Advanced Knowledge regarding Speci alties 5 7% 6 14% 9 23%Broad Knowledge Regarding Specia l ties 7 10% 8 19% 7 18%Knowledge Concerning Compu t ers and Data Proces sing 4 5% 2 5% 5 13%Fundamental Knowl edge of Science and Techno logy 4 5% 7 17% 6 15%Fundamental Knowl edge of Humani ties and Socia l Sciences 3 4% 1 2% 3 8%Foreig n Language Ability 17 23% 7 17% 0 0%Social Rules and Morali ty 8 11% 1 2% 2 5%Native Language Expres sion Abili t y 2 3% 0 0% 0 0%Logical Think i ng Abili t y 7 10% 4 10% 5 13%Abili t y to Accomp lish Work 16 22% 6 14% 2 5%Note : This question is answered with multiple choices of up to 3.Table 16Points for Improvement in University EducationItem Thailand Indonesia PhilippinesCurriculum 7 30% 4 36% 3 27%Teaching Staff Quality 7 33% 2 20% 6 67%Facilities and Equipment 6 29% 7 58% 5 45%Study Guidance 7 32% 5 45% 1 11%Guidance to Study Abroad 1 5% 2 20% 1 13%Welfare Facilities 3 15% 3 30% 3 38%Facilities for After-school Activities 3 16% 3 27% 2 25%Financial Support (Scholarships, etc.) 9 45% 1 10% 5 56%Career Guidance 8 35% 3 27% 4 44%Note : The numbers are those of government offices and private companies that responded"extremely important" to each item.V. STUDY AT JAPANESE GRADUATE SCHOOLS FROM THEVIEWPOINT OF FOREIGN GRADUATE STUDENTSIn this chapter, we try to analyze the following three points through the opinions of studentsattending Japanese graduate schools from the three target countries: (1) purpose of studying at aJapanese graduate school, (2) effects of foreign study in terms of educational conditions, and (3)effects of foreign study in terms of obtaining employment.A. Purposes in Studying at Japanese Graduate SchoolsExamining the purposes of foreign students in studying at Japanese graduate schools, as Table

262 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian Countries17 shows, the highest is "acquisition of advanced knowledge and technology", followed by"acquisition of degrees and academic career". This result is different from that of the StudentSurvey; the percentages of "Acquisition of advanced knowledge and technology" are much higherthan those in the Student Survey among the three countries. It may be because most of thestudents studying abroad want to obtain employment at universities or research institutes.Table 17Foreign Students' Purposes by Country(Unit: %)Thailand Indonesia PhilippinesAcquisition of advanced knowledge and technology 73.5 (32.0) 77.7 (40.1) 79.0 (36.9)Acquisition of degrees and academic career 52.9 (49.6) 52.5 (25.6) 60.5 (60.7)Acquisition of broad and general culture 42.6 (3.2) 16.5 (8.4) 13.2 (4.6)Study in major field systematically 29.4 (32.4) 37.3 (24.2) 44.7 (42.6)Knowledge and technology useful in the real world 25.0 (60.1) 23.4 (59.8) 52.6 (58.8)Improvement of one's own abilities 25.0 (38.0) 46.8 (32.3) 23.7 (29.0)Forming humanities 10.3 (20.0) 7.0 (31.6) 0.0 (23.8)Acquisition of practical issues 5.9 (8.0) 7.0 (8.2) 5.3 (3.6)Learning how to study 5.9 (12.1) 5.1 (9.8) 2.6 (3.7)Acquisition of licenses and qualifications 4.4 (17.9) 3.2 (15.0) 0.0 (20.4)Enjoyment of student life thru. after-school activities 2.9 (11.7) 0.6 (8.1) 0.0 (2.8)Improvement of career by changing job 1.5 (4.2) 7.0 (17.4) 7.9 (3.2)Note : Numbers in parentheses are those in Table 10 for the Student Survey.B. Effects of Foreign Study in Terms of Educational ConditionsNext, we examine the effects of foreign study in Japan by seeing changes in levels of satisfactionand demand for improvement in education between before and after studying abroad.a) Level of satisfaction with undergraduate education in home countryLooking at undergraduate education in home countries, there is a trend toward a relativelyhigh level of satisfaction with the software aspects such as curriculum and lecture contentsin the three target countries. On the other hand, the level of satisfaction is lower for thehardware aspects such as libraries and laboratory equipment, and for career guidance. Theseresults are supporting the results of Chapter Three.b) Levels of satisfaction with Japanese graduate school educationIn Japan's graduate school education, satisfaction with the hardware aspects such as thelibrary and laboratory equipment is particularly high. In contrast, satisfaction is low forsoftware aspects such as lecture contents, teaching method, and career guidance.Changes in levels of satisfaction before and after foreign study are shown in Fig. 10.After coming to Japan, the level of satisfaction with hardware, such as libraries and laboratoryequipment, becomes larger. On the other hand, the level of satisfaction with software, suchas curriculum, teaching method, and lecture contents, gets smaller. Moreover, the level ofsatisfaction with career guidance still remains comparatively low.

OECF Journal of Development Assistance Vol.4, No.1, 1998 2634.404.204.003.803.603.403.203.002.802.60AfterBefore2.40Note : The highest level of satisfaction was given five (5) points.Fig. 10 Comparison of Level of Satisfaction in Home Country and in JapanC. Effects of Foreign Study on Students' Employment OpportunitiesAsked about preferences regarding employment before foreign study at the time they graduatedfrom undergraduate schools in their home countries, university or research institute (36.3%)took the first place, followed by government office, company, and foreign or further study. Andonly 40% of those students responded that they felt they could obtain employment as they hope.After foreign study, the percentage of students whose preferred places of employment areuniversity or research institutes grows to approximately 54%, which is still the first place. Sincefew students responded that they hoped to continue with further studies after the conclusion oftheir studies in Japan, it can be assumed that students plan to make their study at Japanese graduateschools is the last phase of their education for the time being. Looking at the ratio for matchesbetween actual place of employment and preferred place of employment, it can be seen that forapproximately 90% of those who preferred to obtain employment at government offices oruniversities and research institutes, their actual place of employment does in fact match theirpreferred place of employment, which may indicate that foreign study in Japan has a certaineffect on obtaining employment.

264 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian CountriesVI. IMPLICATIONS FOR ODA LOANSA. ODA Loan Projects for Higher Education to DateThe amount of ODA loan commitments to higher education is increasing annually.Characteristically, ODA loan projects from the 1970s through the 1980s mainly provided scientificand technological equipment and medical appliances. In addition to such conventional supply ofequipment, since the end of the 1980s, the scope of eligible projects has been widened to includeconstruction and the equipping of university buildings; research expenses; the dispatch ofspecialists who conduct technological cooperation for the improvement and development ofeducation and research functions in the given country; and domestic training and foreign study.In 1970s and 1980s, the target countries for these projects were South Korea and Indonesia only,but starting in the 1990s, ASEAN countries such as Indonesia, Thailand, the Philippines andMalaysia, have been provided with this type of ODA loans. Indonesia, in particular, has receivedODA loans of this kind almost every year (see Fig. 11).600005000040000300002000010000IndonesiaThe PhilippinesSouth KoreaThailandMalaysia01976-801981-851986-901991-95YearFig. 11 OECF's Loan Commitments to Higher Education by CountryProjects in which ODA loans are supplied may be broadly classified into three types: projectsthat are mainly for the provision and improvement of facilities and equipment, OverseasScholarship Program which assist study abroad, and thirdly, combinations of the first two. Amongthese, the largest amounts are provided for projects involving the provision of facilities. Recently,projects are being started in which Overseas Scholarship Program and the provision of facilitiesare being conducted in conjunction with each other (see Fig. 12).

OECF Journal of Development Assistance Vol.4, No.1, 1998 265Combined22%OverseasScholarship19%FacilitiesProvision59%Fig. 12 Loan Commitments to Higher Education by TypeIn this survey, the result shows that, among the foreign students studying in Japan, includingthose who came to Japan on Overseas Scholarship Program, a high percentage of them obtainemployment at universities and research institutes in their home countries after completing theirstudies in Japan. Thus, it may be conceived that foreign study in Japan , partly supported byOverseas Scholarship Program, contributes to improvement in the quality of institutions of highereducation in the students' home countries.B. Implications for ODA Loan Projectsa) Clarification of the position of policies for human resources development in the mediumtolong-term development strategyDue to a shift in the emphasis in education in the 1980s, Southeast Asian countries havejust started to put efforts into elementary and higher education. However, when theadvancement of the industrial structure of any given country is considered, it can be seenthat highly qualified people need to be sent into the industrial world in response to thedevelopment of the economy, and so the enhancement of higher education, with an emphasison the natural sciences and engineering, is indispensable. In this survey, it was discoveredthat a discontinuity phase exists, due to income restrictions, between the completion ofelementary/secondary education and higher education. Moreover, it was discovered that asimilar phase exists between the completion of higher education and obtaining employment.It seems that the development plans of the countries and the human resource developmentnecessary for those plans are not currently being synchronized, making the implementationof the development plans difficult. Consequently, in the future, there would seem to be aneed for the OECF to ascertain whether or not the series of steps in the educational process,including elementary and secondary education, are clearly coordinated with developmentstrategies and plans.

266 Hitoshi Shoji, Hajime Ino, Aki Sudo, Higher Education in Three Southeast Asian Countriesb) Improvement of teaching staff quality and university facilitiesIn this survey, students expressed strong dissatisfaction with the university hardware aspectsof laboratory equipment and libraries, and with the software aspects of teaching staff quality.From these results, it can be discerned that the needs for facilities provision projects thathave been conducted with ODA loans to date, are as strong as ever. In addition, since theresults show that both domestic facilities and teaching staff are poor, they support thethinking behind the foreign student policy which allows brilliant students to study in foreigncountries. Consequently, it was confirmed that the forms of assistance implemented untilnow will continue to be important. However, if improvement is made only in a university'sfacilities, the problems indicated in the quality of the teaching staff at the university willremain. The efforts expended on facility improvement will not be fully realized unless theteaching staff at the universities is trained in conjunction with the improvement to theuniversity's facilities to raise the level of education. Furthermore, looking at the result thatforeign study in Japan is effective, for obtaining employment at universities and researchinstitutes, both for foreign students receiving ODA loans for scholarship programs andothers, a desirable outcome would be that these students assume teaching positions atinstitutions of higher education in their home countries and bring about the necessaryimprovement in the quality of education at these institutions.c) The need for an overall survey concerning labor markets in developing countriesIn this survey, it was pointed out that a problem exists in the connection between universitiesand labor markets. It is necessary to proceed with further surveys concerning the type ofrelationship that exists between the two. However, when providing assistance for highereducation, such assistance cannot be effectively implemented unless we identify thecondition of the labor markets, which are positioned next in the process after universities,establish the path from universities to labor markets, and clarify what kind of personnel arenecessary. Consequently, in providing assistance for the two points above-mentioned, it isprobably necessary to ascertain what sort of personnel are actually necessary and whetherthe mechanisms for effectively distributing the required personnel to the appropriate placesare established in the country that is to receive the assistance. Especially in regard to themechanisms for effectively distributing personnel, although statistics for percentages ofuniversity graduates, etc., in the labor market are mentioned in existing studies, no materialsare available that take analysis as far as labor practices related to the recruitment of newgraduates. This is an area where future studies are expected.REFERENCES(Japanese)Go, Shosho (1994). Ajia ni okeru Koutou Kyouiku Kakudai Katei no Hikaku Kenkyuu(Comparative Research on the Expansion Process of Higher Education in Asia), Master'sthesis in social engineering, Tokyo Institute of Technology, in Japanese.International Labor Section of the Minister of Labor's Secretariat (ed.) (1997). Kaigai RoudouHakusho - Shuyoukoku ni okeru Jinzai Ikusei eno Torikumi (White Paper on Overseas

OECF Journal of Development Assistance Vol.4, No.1, 1998 267Labor - Efforts for Human Resource Development in Major Countries), in Japanese.Japanese Chamber of Commerce in Bangkok (1995). Chingin Roumu Jittai Chousa Houkokusho(Survey Report on the Actual Condition of Wages and Labor), in Japanese.Japanese International Cooperation Agency (ed.) 1994. Kaihatsu to Kyouiku - Bun'yabetu EnjoKenkyuukai Houkokusho (Research Report on Assistance for Development and Educationby Sector), in Japanese.Ministry of Education (ed.) (1996). Wagakuni no Bunkyou Shisaku (Our Country's EducationalPolicy), (published 1994), in Japanese.______ (1995). Daigaku Kaikaku no Kongo no Kadai ni tsuite no Chousa Kenkyuu Houkokusho(Research Report on Survey Concerning Future Topics in University Reform). NikkeiResearch, in Japanese.The Overseas Economic Cooperation Fund (ed.) 1997. Kaigai Keizai Kyouryoku Binran (OECFHandbook 1997), in Japanese.Toyoda, Toshio (ed.) (1994). Kaihatsu to Shakai - Kyouiku wo Chuushin toshite (Developmentand Society - Focusing on Education), Institute of Developing Economies, in Japanese.Umakoshi, Toru (ed.) (1993). Gendai Ajia no Kyouiku - Sono Dentou to Kakushin (Education inModern Asia - Its Traditions and Innovations), Toshindo, in Japanese.______ (trans.) (1993). Juuzoku kara Jiritu e - Ajia no Daigaku (From Dependence to Autonomy- The Development of Asian Universities). Tamagawa University Press, in Japanese.Ushiogi, Morikazu (1986). Ajia Shokoku ni okeru Chuutou Kyouiku Seisaku no Doukou Bunseki(Trend Analysis of Secondary Education Policies in Asian Countries), Survey reportcommissioned by Ministry of Foreign Affairs, in Japanese.Yano, Masakazu (1996). Koutou Kyouiku no Keizai Bunseki to Seisaku (Economic Analysis andPolicies in Higher Education), Tamagawa University Press, in Japanese.______ (1982). Kyouiku no Keizaigaku (The Economics of Education), Dai-ichi Hôki, in Japanese.(English)The Overseas Economic Cooperation Fund (1997). Human Resources Development: OECF LoanEfforts and Issues, Staff Working Paper Operations Department I.UNESCO (1995). World Education Report.______ (1995). Statistical Yearbook 1995.World Bank (1994). Higher Education: The Lessons and Experience, Washington, DC: TheWorld Bank.______ (1995). Priorities and Strategies for Education. Washington, DC: The World Bank.Ziderman, A. and D. Albrecht (1995). Financing Universities in Developing Countries, London:The Falmer Press.

MACROECONOMIC IMPLICATIONS OFOIL BOOM IN AZERBAIJANTaku Yamabe *SUMMARYAzerbaijan achieved positive GDP growth in real terms in 1996 for the first time since itsindependence, and is currently riding an underlying trend of recovery. As the fiscal balance andthe balance of payments are improving, the exchange rate and prices are stabilizing. Amidst theimplementation of structural reforms in the economy, foreign direct investment related to oildevelopment are increasing.While oil boom in Azerbaijan will contribute to dramatic improvement of the fiscal balanceand the balance of payments, it is leading to the Dutch Disease, i.e., the shrinkage of themanufacturing industry due to real exchange rate appreciation caused by increased domesticspending and labor movement arising from changes in relative marginal labor productivity. Thegovernment is advised to implement financial measures to relieve upward pressure on the realexchange rate, as well as foster the manufacturing industry through measures to promote smalland medium sized enterprises and enhancing economic infrastructure, in order to maintain itssustainable development process.CONTENTSIntroductionI. Macroeconomic Background of AzerbaijanII. Direct Impact of Oil Boom on Macro Balance StatisticsA. Oil Industry TrendsB. Impact of Oil Boom on Macro Balance StatisticsIII. Impact of Oil Boom on Industrial StructureA. Current State of Non-Oil IndustriesB. Theoretical Framework Related to Impact of Oil BoomC. Application to Azerbaijani IndustryIV. Policy Issues for Sustainable Economic DevelopmentReferences*Economist, Macro-Economic Studies, RIDA, OECFOECF Journal of Development Assistance Vol.4, No.1 (1998) pp.268-301©1998 by the Overseas Economic Cooperation Fund. All rights reserved.

OECF Journal of Development Assistance Vol.4, No.1, 1998 269INTRODUCTIONAzerbaijan experienced a rapid economic decline just after its independence in October 1991. Tostabilize the macroeconomic situations, the government implemented tightening policies underthe guidance of the IMF, and made structural adjustments in 1995. Also with political stabilizationand rapid inflow of foreign direct investment related to oil, Azerbaijan achieved the positiveGDP growth in real terms in 1996 for the first time since its independence. How Azerbaijan linksthe oil boom, which is currently the focus of international attention, to its economic development,holds the key to sustainable economic development. The main objective of this paper is to examinethe impact of the oil boom on Azerbaijan's economy and to investigate policy issues for achievingsustainable economic development.The paper is composed of four chapters. After briefly reviewing the macroeconomic situationin Chapter I, Chapter II surveys the current state and future outlook of the oil industry of Azerbaijan,and then examines the direct impact of the oil boom on macro balance statistics including thebalance of payments, the fiscal balance, and the foreign debt burden. Chapter III examines theimpact on the economy of oil boom through change in the real exchange rate and labor movements,within the framework of the Dutch Disease theory. Chapter IV examines measures considerednecessary for Azerbaijan to achieve sustainable economic development, based on the results ofthe discussion up to Chapter III.I. MACROECONOMIC BACKGROUND OF AZERBAIJAN1. Economic Confusion Following Collapse of Soviet Union (1991 to 1994)Immediately after the country's independence, the Azerbaijani economy rapidly sank due to theloss of industrial and trade links, the confusion accompanying the introduction of market principles,and conflict with Armenia. Real GDP fell approximately 20% each year, and in 1994, had sunkto half the level when the country gained independence (Table 1). Due to a large fall in taxrevenue caused by a drop in production of state-owned enterprises, the country recorded a budgetTable 1Macroeconomic Indices in Azerbaijan1992 1993 1994 1995 1996Real GDP growth rate -22.1% -23.1% -18.1% -12.0% 1.0%Fiscal balance (% of GDP) 2.7% -12.6% -11.5% -4.3% -2.7%Revenues 49.0% 33.4% 24.5% 15.3% 16.2%Expenditures 46.3% 46.0% 36.0% 19.6% 18.9%% change in CPI (from previous year) - - 1880.0% 84.6% 6.8%Current account balance (US$ millions) - -160 -121 -379 -333Balance of payments (US$ millions) - - -79 145 525Note : Fiscal figures for 1996 are predicted values.Source: Real GDP growth and % change in CPI data were provided by CIS Statistics Committee.Other data from IMF.

270 Taku Yamabe, Macroeconomic Implications of Oil Boom in Azerbaijandeficit exceeding 10%. Moreover, the liberalization of prices and the insufficient supply of goods,combined with the lack of independence of the central bank from the government, resulted inhyperinflation of 1,880%. The balance of payments became negative due to a worsening tradebalance, and the country's foreign currency reserves fell to US$1 million in 1993.2. Shift toward Tightening Policy and Macroeconomic Stabilization (1995 to 1997)In order to stabilize the macroeconomic situation, the government initiated drastic economicreforms from January 1995, receiving support from the IMF and other multilateral donors. Inresponse to political and economic stabilization, the flow of foreign direct investments toAzerbaijan began increasing, and the resulting revitalization of the service and constructionindustries enabled the country to post positive real GDP growth for 1996, the first time sinceindependence. The budget deficit reduced by radical expenditure reforms, such as reduction ofsubsidies. This resulted in the reduction of the central bank finance, which in turn slowed downinflation, leading to an appreciation in the nominal exchange rate, from 4,494.3 manat per US$in August 1995, to 3,918.0 manat per US$ in October 1997. With regard to the balance of payments,while the current account balance deficit is deepening, the overall balance has become positive,reflecting the increase in foreign direct investments related to oil.3. Structural Adjustments for Transition to Market EconomyAzerbaijan has phased in price liberalization since 1992. Most prices have been liberalized,except public services such as transportation and energy. The privatization of state-ownedenterprises has been progressing steadily since the commencement of a new program in 1996.The privatization of small state-owned enterprises is almost complete, and the privatization ofmedium-sized state-owned enterprises is now in progress. The government plans to initiate theprivatization of large state-owned enterprises in 1998. Trade liberalization has been largelyachieved. Export-related restrictions and duties have been almost entirely eliminated and thecustoms duty system is being simplified. With regard to reforms in the financial sector, thegovernment is engaged in reforms of the four largest state-owned banks and is raising minimumcapital requirements in order to establish a sound banking system.II. DIRECT IMPACT OF OIL BOOM ONMACRO BALANCE STATISTICSThe abundant oil resources are expected to play the central role for Azerbaijan's sustainableeconomic development, but the impact of oil development on Azerbaijan's economy has notbeen sufficiently discussed so far. II and III will examine the impact of oil development onAzerbaijan's economy. First, this chapter will discuss the current state and outlook of Azerbaijan'soil industry, and then examine the direct impact of oil boom on macro balance statistics, such asbalance of payments, fiscal balance and external debt burden.

OECF Journal of Development Assistance Vol.4, No.1, 1998 271A. Oil Industry Trends1. Oil Resources in AzerbaijanAzerbaijan's oil fields has been exploited for a long time, and at the beginning of the 20th century,about half of the world's crude oil was produced in Azerbaijan. During the Soviet era, Azerbaijanwas the third largest producer, following Russia and Kazafustan. However, because of exhaustingonshore oil fields, inadequate oil field maintenance, and lack of technological improvements,Azerbaijan's crude oil production has been falling since 1987. Production of crude oil in 1996was 185,000 barrels a day, of which 170,000 barrels were used for domestic consumption, andthe remaining 15,000 barrels were refined and then exported. Since the oil industry accounts for21% of GDP (1995), and oil exports shares 61.4% of total exports (1996), oil is an importantproduct for the national economy. 1However, according to the survey conducted by major European and US oil companiesafter the collapse of the Soviet Union revealed that existing oil fields whose production hasfallen could be revived through the introduction of the latest technologies, and that there werenew oil fields of considerable size off the coast of the Caspian Sea. As of the end of 1996, therewere 7 billion barrels of confirmed oil reserves (the equivalent of 3.3 times of Japan's annualconsumption) (Table 2).Table 2World's Confirmed Crude Oil ReservesUnit: billion of barrels)Country Confirmed reserves Country Confirmed reserves1 Saudi Arabia 261.5 11 China 24.02 Iraq 112.0 12 Tunisia 15.53 UAE 97.8 13 Norway 11.24 Kuwait 96.5 14 Algeria 9.25 Iran 93.0 15 Kazakstan 8.06 Venezuela 64.9 16 Azerbaijan 7.07 Mexico 48.8 17 Canada 6.98 Russia 48.7 18 Angola 5.49 USA 29.8 19 Oman 5.110 Libya 29.5 20 Indonesia 5.0Source: British PetroleumThis is a conservative figure calculated after the trial exploitation and estimated reservesare nearly four times greater, which is 28.5 billion barrels. 2 Of this total, over 95% is locatedoffshore. Moreover, estimated reserves for all countries bordering the Caspian Sea, includingKazakstan (43.8 billion barrels) and Turkmenistan (2.3 billion barrels) but excluding Russia and1Production and export figures are from British Petroleum. Other figures are provided by Ministryof Commerce and Ministry of Economy. Oil production as percentage of GDP and oil export as percentageof total exports include imported oil refined in Azerbaijan.2Survey by Japan Association for Trade with Russia and Central-Eastern Europe

272 Taku Yamabe, Macroeconomic Implications of Oil Boom in AzerbaijanIran are 74.6 billion barrels. If these reserves are confirmed, this would make this the region withthe fifth largest oil reserves in the world, after Iran.2. Current Status and Outlook of Oil Developmenta) Development of new oil fieldsSince the development of new oil fields requires European and US development drillingtechnology, and Azerbaijan does not have enough domestic capital, the government hasadopted a policy of aggressively inviting foreign capital for oil exploitation. The first contractwas concluded with the Azerbaijan International Operating Company (AIOC) in September1994, which covers the three oil fields of Azeri, Chirag, and Guneshli: (ACG) (Fig. 1). Thisdevelopment plan is divided in two phases. The first phase involves the development of thedeep layer of the existing Chirag oil field, and its commercial production has begun sinceNovember 1997. The second phase involves the development of the other two oil fields,and the production of these fields is predicted to expand gradually from the year 2001.After Azerbaijan's contract with AIOC, the flow of foreign investments was activated, andas of November 1997, nine oil development contracts have been signed. 3Fig. 1 Map of Caspian Sea Offshore Oil Fields3Out of this total, two contracts were waiting for ratification by Parliament.

OECF Journal of Development Assistance Vol.4, No.1, 1998 273b) Crude oil production outlookThe outlook for crude oil production 4 is as shown in Fig. 2, which summarizes the resultsof interviews with AIOC corporations. 5 Daily production of crude oil is 180,000 barrels in1997, the year when early production of the Chirag oil field starts, and will reach 230,000barrels in 2001 when the second stage development of the AIOC project starts. From 2004,when development of the Shakh Deniz oil field will begin, crude oil production will rapidlyincrease, reaching 600,000 barrels in 2005, and 1 million barrels in 2008. In 2013, whenproduction reaches the maximum, daily production is predicted approximately 1.2 millionbarrels.1,000 bbl/d140012001000800600400200Existing oilfieldsNew oil fields01996 1998 2000 2002 2004 2006 2008 2010 2012 2014Source: Prepared by the author based on data with interview of AIOC corporations.Fig. 2 Crude Oil Production Outlookc) Pipeline construction planThe pipeline currently in use only is to Novorossiysk on the Black Sea via Russia, and hasa transport capacity of approximately 100,000 barrels per day. This pipeline is used totransport the crude oil of the Chirag oil field, which started production in November 1997.In addition, Azerbaijan is building another pipeline going to Supsa on the Black Sea viaGeorgia ( in Fig. 3), which will have a transport capacity of approximately 100,000barrels per day. This pipeline is planned to complete by the end of 1998. The two pipelineswill have a combined transport capacity of only approximately 200,000 barrels per day,which will be insufficient to carry total crude oil output once production in the secondphase of the AIOC kicks in. Based on this prediction, the Azerbaijani government isconsidering to build a main pipeline to Mediterranean through Georgia and Turkey ( ).However, this plan is not yet concrete, and other pipeline route candidates, such as routesvia Russia ( ), via Armenia, and via Iran, are currently under consideration.There are two old refineries in the suburbs of Baku, with a combined annual refining4There are various outlooks for crude oil production; for example, in government documents at the1998 C/G Conference the maximum daily production was 200,000 barrels (2015) in the most optimisticoutlook, and 140,000 barrels in the most pessimistic (2013). Therefore, estimates in this report are fairlyconservative.5There are 11 participating corporations: BP, Amoco, Unocal, Lukoil, Pennzoil, Statoil, Exxon,TPAO, Itochu Oil Exploration, Ramoco, and Delta.

274 Taku Yamabe, Macroeconomic Implications of Oil Boom in Azerbaijancapacity of approximately 20 million tons. Approximately 70% of their production is usedfor domestic consumption.Azerbaijan to the Black Sea through GeorgiaAzerbaijan to the Black Sea through the Russian FederationAzerbaijan to the Mediterranean Sea through Georgia and TurkeyBurgas to Alexandroupolis (Bosphorus by-pass)Fig. 3 Candidate Routes for New PipelineB. Impact of Oil Boom on Macro Balance Statistics1. Impact on Balance of PaymentsAccording to the crude oil production outlook examined above, on the assumption that the dailydomestic consumption of oil, which is currently 170,000 barrels, rises at an annual rate of 7%, 6daily export of 670,000 barrels would be secured in 2010. Provided that the price of crude oil isUS$20 per barrel, 7 the total value of crude oil exports would be approximately US$4.9 billion(Fig. 4). This represents approximately 1.6 times the 1996 GDP. Since oil development in thenext few years will be accompanied by increasing imports of machinery and materials as well astechnical services, Azerbaijan's current account balance deficit will expand. On the other hand,6Estimate based on IMF prediction of 1997-1998 GDP.7Estimate based on following North Sea blend prices: US$20.8 (1996), US$19.3 (January toSeptember 1997).

OECF Journal of Development Assistance Vol.4, No.1, 1998 275direct investments related to oil and signing bonus from oil development contracts will result ina rising surplus in the balance of capital account. According to projections by the World Bank,imports of materials and equipment and the inflow of capital will both peak in 2004, with theformer reaching US$1.2 billion and the latter US$2 billion.The net impact of oil development on the balance of payments will always be a surplus,and this surplus is expected to rapidly grow from about the year 2004.600050004000US$ millions30002000100001996-10001998 2000 2002 2004 2006 2008 2010 2012 2014-2000Crude oil export (net)Impact of oil-related capital inflowImpact of oil-related material and equipment importsImpact of oil development on balance of paymentNote : Oil-related material/equipment imports and oil-related capital infloware assumed to grow at a constant rate until 2004, and then stabilize.Source: Estimate of the author based on various materials.Fig. 4 Impact of Oil Boom on Balance of Payments2. Impact on Fiscal BalanceThe Azerbaijani government's revenues from the development of new oil fields consist ofAzerbaijan's share from product sharing (PS) contracts, increased tax revenue, and non-taxrevenue. In PS contracts, the government first receives a signing bonus after signing of the contract.With regard to profit sharing after the commencement of production, half of the productionvalue is appropriated for the recovery of capital cost and operating costs until capital cost recoveryis completed. According to the IMF (1995), the share of the remainder between the Azerbaijanigovernment and major oil companies is 50% for each side, but this share of profits varies accordingto each oil development contract, and the more recent the contract, the greater the share reservedby the Azerbaijani government.Oil-related taxes include corporate profit tax, value added tax, and excise tax. However, inthe case of newly developed oil fields, production as a rule being reserved for exports, there areno prospects of value added tax and excise tax revenues for the Azerbaijani government. Therefore,only corporate profit tax revenue is expected to increase. Furthermore, as mentioned earlier, oilno longer comes under a strategic commodity export tax, as this tax was abolished in 1997.

276 Taku Yamabe, Macroeconomic Implications of Oil Boom in AzerbaijanNon-tax revenues include royalties introduced in November 1995 and pipeline passage feeincome. With regard to the former, payments by domestic consumers are in arrears, and thefinancial position of the State Oil Company of Azerbaijan Republic (SOCAR) has deteriorated,so that SOCAR royalty payments to the government are in arrears. As a result, the revenueexpansion effect has failed to materialize. With regard to pipeline passage fees, because the routeof the main pipeline has still not been decided, the total amount of fees cannot be predicted. Inthe case of the Georgia route, the income of US$0.26 per barrel is expected.60005000US$ millions400030002000100001996-10001999 2002 2005 2008 2011 2014Impact of increased production from new oil fieldsImpact of reduced production at existing oil fieldsImpact of future crude oil production on government revenuesSource: Estimate of the author based on various materials.Fig. 5 Impact of Crude Oil Production on Government RevenuesAccording to IMF forecasts (1995), the ratio of government revenues to total from new oilfields production such as the government's share from contracts, corporate profit tax, royalties,etc., will be 33% until 2005, which is the year when the capital cost will be recovered, and willincrease to 60% thereafter. On the other hand, the Azerbaijani government receives 100% profitsfrom the existing oil fields; therefore, even if new production compensate for the productiondecline on existing fields, actual government revenues will decline.A quantitative analysis of the net impact of oil production on the fiscal balance reveals thatfrom 2004, when revenues from new oil fields will cover the reduction in revenues from productionon existing oil fields, oil development will have a positive impact on the fiscal balance (Fig. 5).Thereafter, new oil field production will increase, and in 2013, a US$4.1 billion surplus will beachieved. This is equivalent to approximately 7 times the government revenue in 1996.3. Impact on Future Debt RepaymentIn this section, following a survey of Azerbaijan's external debt, the impact of oil developmenton future debt repayment will be examined. In examining the debt burden, it is desirable toestimate the future macroeconomic indices by the regression analysis based on macroeconomicmodels such as the IMF's Financial Programming Model or the World Bank's RMSM. However,

OECF Journal of Development Assistance Vol.4, No.1, 1998 277former Soviet Union countries all have experienced structural changes 8 around 1990, and thedata before 1990 is the regional data in one country; therefore, there is a significant obstacle touse such data. Moreover, since the impact of oil development on future debt repayment is itselfa large theme, we limit the examination to the direct impact of oil development on future debtrepayment, disregarding other macroeconomic factors.a) Current status of foreign debtAfter the collapse of the Soviet Union, the division of the assets and debts accumulated bythe Soviet Union remained to be solved. Azerbaijan signed a zero-option agreement withRussia in September 1993, which meant in principle that Azerbaijan gave up all its claimsto the ex-Soviet Union's credit, in exchange for which Russia would take also assume all ofAzerbaijan's part of the ex-Soviet Union's debt. As a result, Azerbaijan's debts are all afterits independence.After its independence, Azerbaijan took out loans for food imports, and as a result,had cumulative public and private debt of US$355 million as of the end of 1993, whichincreased to US$1.128 billion as of the end of 1994 (Table 3). From 1995 onward, alongwith commencement of the macroeconomic stabilization program, financing by the IMF,World Bank, EBRD, etc. started actively increasing, so that Azerbaijan's debt shot up toUS$3.21 billion as of the end of 1995, and US$5.487 billion as of the end of 1996.The total foreign currency reserves of the ANB was only US$1 million at the end of1993, but thanks to the subsequent increase in foreign direct investments and signing bonusfrom the oil development contracts, the reserves have increased to US$119 million as ofthe end of 1995, and US$157 million as of the end of 1996.Table 3Composition of Foreign DebtUnit: US$ million)1993 1994 1995 1996Medium and long-term debt 35.5 103.2 206.1 n.a.Public and publicly guaranteed 35.5 103.2 206.1 n.a.Multilateral 0.0 8.4 98.8 139.2Bilateral 35.5 94.8 107.3 n.a.Private guaranteed 0.0 0.0 0.0 0.0Private nonguaranteed 0.0 0.0 0.0 0.0Short-term debt 0.0 9.6 14.0 n.a.IMF credit 0.0 0.0 100.9 212.6Principal arrears 0.0 20.3 30.5 n.a.Total debt stock 35.5 112.8 321.0 548.7Total debt stock / GNP (%) 0.8 2.9 9.2 17.8Gross foreign reserves of the ANB 1 2 119 157Note : Foreign reserve figures are as of year end.Source: World Bank (1997 b). 1996 figures and foreign reserves are from Ministry of Financeand Azerbaijan National Bank.8Adam (1993), Perron (1989), etc., performed regression analyses related to structural reforms, butsince these are not the main theme of this report, this paper limits to mentioning them.

278 Taku Yamabe, Macroeconomic Implications of Oil Boom in Azerbaijanb) Assessment of Azerbaijan's debt service capacityWith regard to Azerbaijan's foreign borrowing, a ceiling has been set up under the EFF andESAF programs, which applies to short-term loans of 1 year or less and non-consessionalmedium and long-term loans. The annual ceiling of US$300 million has been set for nonconsessionalloans, which is not applied to IMF credit and concessional loans such as fromIDA and OECF.As the case 1, the impact of oil development on the repayment for the existing debtwas examined (Fig. 6). The examination maintained 9 the assumptions described in sectionsII.B.1 and II.B.2; that is, effects which are not directly related to oil development, on thebalance of capital account and the balance of trade, etc., were disregarded. Moreover, withregard to the fiscal condition of Azerbaijan, we assumed that the expected increase incapital expenditures will entirely be financed by the increase in revenues from non-oilrelated revenues, in other words, that the portion of the fiscal balance not related to oildevelopment will continue unchanged.First, with regard to foreign currency reserves, the overall balance of payments, asdescribed in section II.B.1, was positive from the beginning, and the balance surplus willstart growing rapidly from about 2004, and by 2001, foreign currency reserves will reachUS$1 billion, and approximately US$55.3 billion in 2014. Therefore, from the point of thebalance of payments, no problems are found regarding Azerbaijan's ability to repay its debtas long as it does not contract a huge amount of short-term debt.600005000040000300002000010000US$ millions60005000400030002000100001996 2000 2004 2008 2012-10000Trend in foreign reserve after debt repayment (left scale)Trend in fiscal balance after debt repayment (right scale)0-1000Source: Estimate of the author based on various materialsFig. 6 Relationship between Oil Development and Debt Repayment (Case 1)On the other hand, the fiscal deficit has been increasing, and as described in sectionII.B.2, the government revenues from the oil industry will continue to decrease until 2001,9Plans about repayment of existing debt were estimated based on interviews with the Ministry ofFinance, etc.

OECF Journal of Development Assistance Vol.4, No.1, 1998 279causing the fiscal deficit to widen. Adding in the amount required for debt repayment, thefiscal deficit will reach a peak of approximately US$446 million in 2001. Thereafter, newoil production will take off and the government revenues will increase, thus causing a dropin the fiscal deficit, and a fiscal surplus is predicted from 2004. The fiscal surplus is forecastto ultimately reach approximately US$3.9 billion in 2013. Therefore, from a fiscal viewpoint,since more short-term loans will deteriorate the fiscal balance, it is generally consideredthat they should be kept under control, whereas long-term loans are unlikely to causeproblems in particular.The case 2 assumes that the World Bank will implement a financing program for theAzerbaijan 10 as planned, and that non-concessional loans will be taken up to the ceilingover a period of three years (Fig. 7). Further, the condition for these non-concessionalloans is assumed to be 5% interest and repayment over 10 years (2-year grace period). Theimpact of only repayment, not inflow, of new loans on macroeconomic statistics isconsidered.600005000040000300002000010000US$ millions60005000400030002000100001996 2000 2004 2008 2012-10000Trend in foreign reserve after debt repayment (left scale)Trend in fiscal balance after debt repayment (right scale)0-1000Source: Estimate of the author based on various materialsFig. 7 Relationship between Oil Development and Debt Repayment (Case 2)With regard to foreign currency reserves, in the same way as with case 1, regardlessof the increase in short-term debt repayment, the expansion in balance of payments surpluswill result in an increase in foreign currency reserve, US$700 million in 2001, andapproximately US$54 billion in 2014.On the other hand, due to the increase in the debt repayment amount, the fiscal deficitwill initially be greater than in case 1, and will peak in 2001 at approximately US$567million. Thereafter, the fiscal balance will improve, and become surplus in 2005. Ultimately,the fiscal surplus is forecasted to reach US$3.926 billion in 2013.Based on the results of the above analyses, the foreign currency reserve will increaseyear by year and it will particularly increase from 2004; therefore, Azerbaijan's medium-10Annual IDA financing of US$110 million over three years from FY1997 (July to June).

280 Taku Yamabe, Macroeconomic Implications of Oil Boom in Azerbaijanand long-term debt service capacity should not be a problem. Although the speed of theforeign currency reserves buildup differs between two cases, both cases are on the sametrend, and as long as Azerbaijan observes its agreement with the IMF regarding the ceilingfor non-concessional loans, there should be no problem.With regard to the fiscal balance as well, a surplus will be achieved from 2004 in case1, and from 2005 in case 2, and thereafter will expand, so that it is considered that Azerbaijanwill have no problems with repayment of its medium- and long-term debt. However, before2004 or 2005, the fiscal deficit will continue, and especially until 2001, will continue toexpand. The expansion of the fiscal deficit increases the possibility of inflation, so that aprudent approach to short-term loans is desirable (see Table 4).III. IMPACT OF OIL BOOM ON INDUSTRIAL STRUCTUREIn Chapter II, we examined the direct impact of the oil boom on macro balance statistics. In thischapter, we will examine the impact of oil development on the industrial structure, that is to say,its repercussions on other industries. First, we will briefly describe the current state of non-oilindustries. Then we will survey the theory of trade booms, and based on this theoretical framework,study the impact of the oil boom on Azerbaijan's industrial structure.A. Current State of Non-oil Industries1. Mining and ManufacturingPrior to its independence, Azerbaijan was the principal machinery producer of the Soviet Union,and manufactured oil-related equipment, TVs, refrigerators, and so on. It exported oil-relatedequipment and refrigerators to other republics, and notably for oil-related equipment, suppliedapproximately 70% of the Soviet Union's needs. However, due to the loss of export markets afterits independence, difficulties with parts and material procurement, technological obsolescenceand falling productivity, the output declined considerably. The cut-off of governmental subsidiesand favorable bank loans were other major factors in the fall in production. Main light industriesare textiles and food processing. Azerbaijan is one of the main cotton producers among CIScountries, and has four textile plants that use domestically grown cotton. The government hasmade the construction of cotton mills a priority, and aims to further develop the textile industry. 11However the consumer goods industries, including the textile industry, are currently havingdifficulties maintaining its competitiveness in the face of imports for the same reason as themachine industry.As shown in Table 5, the production of major manufactured goods is declining. However,CIS countries are all experiencing the same conditions, so that there have not been major changesregarding their respective ranking among CIS countries.11EIU (1997)

Table 4Impact of Oil Development on Macro Balance Statistics(US$ millions/year)1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Crude oil production (1,000 bbl/d) 185 180 195 205 220 230 270 320 450 600 750 900 1050 1080 1110 1140 1170 1200 1200Production on new oil fields (1,000 bbl/d)* 185 165 150 135 120 110 100 90 85 80 75 70 65 60 60 55 55 50 40Domestic consumption of crude oil (1,000 bbl/d)* 170 182 195 208 223 238 255 273 292 313 334 358 383 410 438 469 502 537 575Oil exports (1,000 bbl/d) 15 -2 0 -3 -3 -8 15 47 158 287 416 542 667 670 672 671 668 663 625Crude oil export amount (net)* - -14 3 -24 -21 -62 109 343 1153 2098 3034 3958 4870 4893 4903 4898 4877 4840 4566Related capital inflow amount - 250 500 750 1000 1250 1500 1750 2000 2000 2000 2000 2000 2000 2000 2000 2000 2000 2000Related materials and equipment import amount - 150 300 450 600 750 900 1050 1200 1200 1200 1200 1200 1200 1200 1200 1200 1200 1200Impact of oil development on overall balance of payments - 86 203 276 379 438 709 1043 1953 2898 3834 4758 5670 5693 5703 5698 5677 5640 5366Government revenues from new oil field production - 36 108 169 241 289 410 554 879 1253 2957 3635 4314 4468 4599 4752 4884 5037 5081Reduction in government revenues from decline in production on - -146 -245 -365 -475 -548 -621 -694 -730 -767 -803 -840 -876 -913 -913 -919 -949 -986 -1059existing oil fieldsImpact of oil development on fiscal balance - -110 -147 -196 -234 -258 -211 -139 149 486 2154 2796 3438 3555 3687 3803 3935 4052 4022Planned debt repayment amount (case 1) - 130 100 90 100 90 70 50 30 30 20 20 20 20 20 15 15 15 15Trend in foreign currency reserves after debt repayment (case 1) 157 113 216 402 681 1030 1668 2662 4584 7453 11267 16004 21654 27328 33011 38694 44356 49981 55332Trend in fiscal balance after debt repayment (case 1) -98 -338 -345 -384 -432 -446 -379 -287 21 358 2036 2678 3320 3437 3569 3690 3822 3939 3909Planned debt repayment amount (case 2) - 130 116 112 185 221 224 199 173 167 152 146 107 69 33 28 28 28 28Trend in foreign currency reserves after debt repayment (case 2) 157 113 200 354 548 776 1260 2105 3884 6616 10298 14909 20472 26097 31767 37437 43086 48698 54036Trend in fiscal balance after debt repayment (case 2) -98 -338 -361 -416 -517 -567 -533 -436 -122 221 1904 2552 3233 3388 3556 3677 3809 3926 3896Note : 1 Domestic consumption of crude oil is assumed to grow 7% annually based on IMF projections for 1997 and 1998 GDP.2 Crude oil prices are assumed to be US$20/barrel for the estimated period, based on following North Sea blend prices: US$20.8 (1996), US$19.3 (January toSeptember 1997).3 The share of government revenues is estimated at 33% of production amount until 2005, when capital cost will be recovered, and then 60%, based on IMF forecastabout AIOC oil fields.4 New loans are not considered in case 1. In case 2 it is assumed that the World Bank financing program (US$330 million over three years from FY1997) will befully implemented and that the government will take loans over three years up to the ceiling (US$300 million/year) set for non-concessional loans in agreementwith the IMF. Further, the assumed condition for these non-concessional loans is 5% interest and repayment over 10 years (2-year grace period).5 With regard to new loans, only the repayment amount is considered, and the impact of loans on macroeconomic statistics is not taken into account.Sources : Crude oil production data obtained through interviews with AIOC companies; Repayment schedule for existing debt estimated based on interviews with Ministryof Finance, etcOECF Journal of Development Assistance Vol.4, No.1, 1998 281

282 Taku Yamabe, Macroeconomic Implications of Oil Boom in AzerbaijanTable 5Selected Industrial Production1992 Ranking within CIS 1996 Ranking within CISMetallurgical products (1,000 tons) 0.3 8 0.002 7Iron ore (1,000 tons) 360 - 4 -Refrigerators (1,000 units) 223 4 6.9 4Textiles (1 million m 2 ) 108 9 23 8Trucks (1,000 units) 0.4 6 - -TVs (1,000 units) 5.9 8 1.2 8Air conditioners (1,000 units) 295 - 64 -Source: CIS Statistics CommitteeIn terms of the regional distribution of enterprises, small- and large-sized enterprises(excluding service enterprises) are concentrated in Baku (Table 6). Baku is the seat of the majorindustries, including the oil industry. Azerbaijan's second largest industrial city, Sumgait, locatednorth of Baku, is a heavy industry district that produces a large number of petrochemical products,chemicals, aluminium goods, and so on. However, some of the district's plants have had to closedue to environmental pollution issues. The government has designated Sumgait as a free economiczone to attract foreign investments, and is planning to promote export industries. It has alreadydrawn up a 25-year plan for the rehabilitation of Sumgait's industrial facilities. 12 Almost allother industrial cities are located inland, and although statistics are not available, light industriesare dominant in these cities.Table 6Number of Medium- and Large-sized Enterprises in Major CitiesCity Number of enterprises City Number of enterprisesBaku 497 Mingechaur 21Sumgait 39 Ali Bayramly 19Ganja 37 Yevlakh 10Lenkoran 22 Nakhichevan 37Source: State Committee of StatisticsAzerbaijan has abundant mineral resources including iron ore, aluminium, zinc, and copper.Estimated reserves of iron ore, for example, range between 200 and 250 million tons. However,mining equipment and technology is not sufficiently modern for the effective development ofthese mineral resources, and investments from overseas are not growing. Azerbaijan has onlylimited natural reserves of gold. In addition to being located on land occupied by Armenia, theyhave already been almost entirely mined out. 1312Ibid.13Ibid.

OECF Journal of Development Assistance Vol.4, No.1, 1998 2832. AgricultureAgriculture is the principal industry in Azerbaijan. It accounts for approximately 30% of GDPand employs a little under 40% of the total employment. The main cash crops are cotton, grapes,and vegetables. Azerbaijan was a major producer of cotton in the Soviet Union, but due to thedrastic price increase in imported fertilizer, and a shortage of spare parts for harvesting machinery,crop yields fell by almost half in the five years following independence (Table 7). Approximately70% of the country's agricultural output is exported without processing.The main vegetable and grape producing region is the lowland region at the center of thecountry. This region is currently either under the control of Armenia or is a danger zone. Moreover,the parts that are not danger zones are often suffering from a war-ravaged traffic network.Furthermore, due to the price increase in imported fertilizer and the loss of export markets,vegetable production fell from 805,000 tons in 1991 to 586,000 tons in 1996, and the productionyield of grapes fell from 1,126,000 tons in 1991 to 309,000 tons in 1995, a drop of more than70%. Production of wheat, dairy products, and meat, which are Azerbaijan's other majoragricultural products, is mostly for domestic consumption. The large proportion of this output isfor producer consumption. Most of the rest is sold directly to consumers and retailers since theprices offered by governmental purchasing organization are unattractively low. The above productsare not produced in sufficient quantities to make Azerbaijan self-sufficient, and the countrycurrently depends on imports and food aid. This is one of the contributing factors behind thecountry's widening trade balance deficit. Azerbaijan imports most of its food from Russia andTurkey, and imports linked to humanitarian aid from the European Union are recently on the rise.The government is currently promoting land privatization to revitalize the agricultural sector.Although progress in this area has been slow, a considerable amount of land has been practically'privatized' through long-term leasing contracts. The 'privatized' land accounts for almost half ofAzerbaijan's entire arable land.Table 7Major Agricultural Production(Unit: 1,000 tons)1991 1992 1993 1994 1995 1996Cereals (refined weight) 1346 1285 1100 1039 921 1019Cotton (amount purchased) 540 336 284 284 250 274Potatoes 180 156 152 150 200 209Vegetables 805 555 488 471 500 586Grapes 1126 607 411 314 309 -Fruits (excluding citrus crops) 496 401 346 323 324 322Meat (unprocessed) 153 113 93 84 82 85Milk 948 850 798 784 827 841Eggs (1 million unit) 958 812 584 494 456 476Source: CIS Statistics Committee and State Committee of Statistics

284 Taku Yamabe, Macroeconomic Implications of Oil Boom in Azerbaijan3. ServiceThe service industry is expanding the fastest in Azerbaijan's economy as a result of the introductionof market economy. In particular in Baku, the influx of foreigners due to oil boom has led to thecreation of a large number of retail stores, cafeterias, restaurants and hotels, targeting foreigners.However, the service industry is also the largest in Azerbaijan's underground economy, whichmakes it difficult to grasp statistically. Furthermore, this is a relatively low value added industry,so that, compared to the number of workers it employs, it is considered to make a relatively smallcontribution to the GDP. 144. ConstructionThe construction industry, like other industries, contracted considerably after 1991. Residentialconstruction stagnated due to the low income level and the lack of estate mortgages. Moreover,readiness to invest weakened due to economic uncertainty, so that the construction volume ofoffice buildings also dropped. However, since direct investments related to oil started flowing in1994, construction demand directly linked to oil development has recovered with stablemacroeconomic situation, It has been followed by rising demand for office buildings and hotels,so that the construction industry as a whole is showing signs of recovery. As of March 1997, outof a total of 705 construction firms, 416, or 59%, were operational. 15B. Theoretical Framework Related to Impact of Oil BoomThis section surveys theories about trade booms developed from the 1980s, providing thetheoretical framework for the following section. The Dutch Disease theory is a classical but stillthe most prevalent theory in this field. 16 It explains that a primary commodity export boom willcause the manufacturing industry to decline, leading to the creation of a fragile economic structuredominated by a single industry; at the same time, such a boom will deprive the country in questionof dynamic external benefit opportunities created by the manufacturing industry. Consideredwithin a static framework, contraction of the manufacturing industry would not particularly be aproblem if the income level of the whole country rises through efficient resource allocation.However, in the case that some positive dynamic externality exists within the manufacturingindustry, 17 for example if the manufacturing industry is characterized by a high growth rate inproductivity, it promotes technological progress in other industries, or it contributes to thedevelopment of human capital, contraction of the manufacturing industry will have a negativeimpact on economic growth.14Ibid.15Ibid.16Corden and Neary (1982)17Although the theme of whether or not a positive dynamic externality exists has not been sufficientlystudied, the assumption of "learning by doing" or dynamic economies of scale in the manufacturing industryis commonly made in theoretical research. The existence of dynamic externality in the overall economy arediscussed within the framework of endogenous growth theories. For more information, refer to Barro andSala-i-Martin (1995).

OECF Journal of Development Assistance Vol.4, No.1, 1998 2851. Dutch Disease Theory (core model)The Dutch Disease theory involves the following three sectors: the Booming Tradable Sector(specific primary industry), the Non-Booming Tradable Sector (manufacturing industry,agriculture, etc.), and the Non-Tradable Sector (service industry, etc.). The following assumptionsare also made: Tradables are subject to given international prices (assuming the case of a smallcountry), capital is sector-specific, and labor freely moves among sectors toward wageequalization. Under these assumptions, if an export boom occurs for a primary commodity andcapital flows into that country as a result, the Non-Booming Tradable Sector will shrink by a"spending effect" and a "resource movement effect".Since additional funds obtained through an export boom are paid out by factor owners orthe government via tax collection, the relative price of non-tradable to tradable rises (Fig. 8:point O point A), leading to the real exchange rate appreciation, provided that the incomeelasticity of non-tradable demand is positive. This causes labor movement from the Non-BoomingTradable Sector to the Non-Tradable Sector, and the production of the Non-Booming TradableSector industries declines, which is called the "Spending Effect."On the other hand, the marginal labor productivity of the Booming Tradable Sector risesdue to the export boom, which causes labor to move from the Non-Booming Tradable Sector andthe Non-Tradable Sector to the Booming Tradable Sector. Moreover, labor movement from theNon-Tradable Sector to the Booming Tradable Sector causes excessive demand for non-tradablebecause it pushes up the supply curve of the Non-Tradable Sector (Fig. 8: point A point B). Asa result, there is upward pressure on the real exchange rate, causing additional labor movementfrom the Non-Booming Tradable Sector to the Non-Tradable Sector (Fig. 8: point B point C).The decline effect of this two-stage labor movement on the Non-Booming Tradable Sector iscalled "Resource Movement Effect" 18 (Fig. 9).D 1D 2D 0BCAS 1S 0Indirect resourcemovement effectODirect resourcemovement effectSpending effectNon-tradable demandFig. 8 Non-Tradable Sector in Dutch Disease18Since the effect resulting from labor movement from the Non-Booming Tradable Sector to theBooming Sector does not involve the change of the real exchange rate, it is called "direct resource movementeffect". The effect created by labor movement from the Non-Booming Tradable Sector to the Non-TradableSector is called "indirect resource movement effect."

286 Taku Yamabe, Macroeconomic Implications of Oil Boom in AzerbaijanBoomingtradable sectorDirect resourcemovement effectDirect resourcemovement effectNon-boomingtradable sectorIndirect resourcemovement effectNon-tradablesectorFig. 9 Resource Movement Effect of Dutch DiseaseWith regard to the Non-Tradable Sector, the spending effect together with the indirectresource movement effect, and the direct resource movement effect work in opposite directions,so that while production rises in some cases, it also declines in other cases.2. Dutch Disease Theory (non sector-specific capital model)The core model assumes that there is no capital movement among sectors, but if this assumptionis relaxed, the Non-Booming Tradable Sector does not necessarily contract. 19 Provided thatcapital movement between the Non-Booming Tradable Sector and the Non-Tradable Sector ispossible, and that the Non-Tradable Sector is more labor-intensive than the Non-Booming TradableSector, these two sectors would make up a mini-Heckscher-Ohlin economy 20 (Fig. 10). Accordingto Rybczynski's theorem, when labor moves to the Booming Tradable Sector due to an exportboom, wage-rental ratio rises, and as a result, unit cost of non-tradable rises compared to the unitcost of non-booming tradable. As a result, the profitability of the Non-Tradable Sector becomeslower than that of the Non-Booming Tradable Sector. Provided that the offset from the spendingeffect is small, the Non-Booming Tradable Sector will expand until wage-rental ratio returns tothe original level.Moreover, taking the same approach, even if the core model assumption that there is nocapital movement among sectors is maintained, a relatively capital-intensive industry within theNon-Booming Tradable sector will not necessarily contract. 2119Corden (1984).20The Heckscher-Ohlin theory holds that since the relative endowment of production factors (capitaland labor) differs for each country, and since the concentration of the factors required for production differsaccording to products, each country tends to specialize in the products that use the production factor it hasa relatively abundant supply of, and tends to import the products that use the production factor it is relativelypoor in, in order to obtain trade benefit. G.F. Heckscher and B.G. Ohlin created their theory by developingRicardo's factor productivity theory.21Cassing and Warr (1982).

OECF Journal of Development Assistance Vol.4, No.1, 1998 287Booming tradablesectorNon-boomingtradable sectorCapital-intensiveCapital and laborNon-tradablesectorLabor-intensiveFig. 10 Case of Capital Movement outside the Booming Tradable Sector3. Construction Boom TheoryThe issues addressed by the Dutch Disease theory are addressed from a dynamic viewpoint, butsince the analytical framework itself is static, export booms are inevitably treated as beingpermanent. In recent years, however, attempts at finer theorization of the impact of export boomson non-tradable have been made by dividing export booms into permanent and temporary ones,and in addition to the traditional division into tradables and non-tradables, by adopting the divisioninto consumer goods and capital goods. 22 According to Friedman's permanent income hypothesis,the propensity to save rises when export booms are temporary, while it is not affected when thebooms are permanent. This means that there is a positive correlation between current income andthe propensity to save only in the case of temporary booms. Based on the general assumptionthat developing countries do not have perfect access to international capital markets, that is tosay, interest on borrowing on the international capital market is higher than interest on lending,additional savings arising from booms will be directed to domestic investments.On the other hand, as observed earlier, since export booms cause relative prices of nontradableto rise, marginal capital productivity in this sector will rise in relative terms. Moreover,since the capital-labor ratio in this sector becomes lower in case of a net labor inflow, whichcauses marginal capital productivity in this sector to rise even in absolute terms, in other words,as measured by non-tradable unit. In this way, export booms cause domestic investments to riseby having an influence on marginal efficiency of investment. Table 8 summarizes the aboveprocess. Domestic investments increase due to the boom, and the extent of upward pressure oninvestments depends on the length of the boom period.The increase in domestic investments brings about a relative rise in demand for capitalgoods compared to consumer goods. Since the supply of tradable is perfectly elastic to internationalprices, additional demand for capital goods raises relative prices of non-tradable capital goodscompared to tradable capital goods. As a result, the price of non-tradable capital goods rises,which means "construction boom."22Bevan, Collier and Gunning (1987, 1990, 1992).

288 Taku Yamabe, Macroeconomic Implications of Oil Boom in AzerbaijanTable 8Impact of Export Booms in Construction Boom TheoryEffect on propensity tosaveEffect on marginal efficiencyof investment(Unit: 1,000 tons)Net effect on domesticinvestmentsTemporary boom + + +Permanent boom None + +C. Application to Azerbaijani IndustryThis section surveys recent trends in Azerbaijan's industry, based on the theoretical frameworkdiscussed in the previous section. As seen in Chapter II, new oil field production just began in1997, and the export boom will start in earnest in a few years. However, Dutch Disease phenomenahave already appeared in Azerbaijan. Foreign direct investments related to the anticipated oilproduction have started flowing in since as early as 1994. Moreover, the balance of paymentsbecame positive in 1995, and the balance surplus has been widening. Since "spending effect" ofthe Dutch Disease is brought about by the influx of foreign currency, even though oil exportsmay not yet have started, the fact that foreign currency is coming into the country is consideredto result in the same effect. The marginal labor productivity is affected because the production ofnon-oil industries falls greatly relative to that of the oil industry. Therefore, the "resource movementeffect" should also be seen in Azerbaijan even without the expansion of a specific primary industry.The trends in the real exchange rate, labor market, and industrial production are discussedbelow from the viewpoint of "spending effect" and "resource movement effect".1. Movements in Real Exchange RateThe real exchange rate (RER) is defined as the relative value of tradable prices (Pt) compared tonon-tradable prices (Pn), i.e. RER=Pt/Pn. Here, a decrease in the RER value means an appreciationin the real exchange rate. An alternate definition can be made based on the purchasing powerparity theory, where the real exchange rate is expressed as the foreign price level (P*) relative tothe domestic price level (P), i.e. RER = nominal exchange rate (national currency/foreign currency)x P*/P. Generally, the classification into tradables/non-tradables and price data for each type ofgoods being difficult to obtain, the latter definition is usually adopted.Employing the latter approach, we calculated the real exchange rate. Due to data limitations,we substituted the US industrial goods price index for P*, and the consumer price index (CPI) ofAzerbaijan for P. As can be seen in Fig.11 and Table 9, the real exchange rate has been appreciating.Until the end of 1994, although price liberalization and the growing fiscal deficit as well as theadditional money supply caused hyperinflation, the nominal exchange rate did not depreciateproportionally, due in part to the fact that foreign exchange liberalization did not progress sufficiently. Adepreciation in the real exchange rate during the same period is not necessarily related to oil development.Following the start of the macroeconomic stabilization program in 1995, the real exchangerate is still appreciating, although its rate of change in the real exchange rate became lower. Theinflow of capital is increasing, and the overall balance of payments has turned to surplus in 1995

OECF Journal of Development Assistance Vol.4, No.1, 1998 289by expanding surplus of capital account. This in turn has led to the nominal exchange rate startingto appreciate in August 1995. On the other hand, although hyperinflation has been stamped out,there still continues to be upward pressure on prices due to the increase in domestic spendingresulting from the inflow of capital, so that the appreciation in the nominal exchange rate is notoffset. As a result, the real exchange rate is appreciating. It is considered that the appreciation inthe real exchange rate from 1995 has thus been caused in large part by the increase in capitalinflow, of which the greatest proportion is oil-related (Table 10). Thus, the oil boom should beregarded as a major factor in the real exchange rate appreciation from 1995.RER(Manat/US$)Start of stabilizationprogramStart of nominal exchangerate appreciation93.1 7 94.1 7 95.1 7 96.1 7 97.193.1 94.1 95.1 7 96.1 7 97.1Note : Although semi-annual data about the price increase from January to June1997 is available, data for individual months could not be obtained. Thus asteady monthly increase rate has been assumed.Source: Calculations by the author using data from IFS, Azerbaijan National Bank,and CIS Statistics Committee.Fig. 11 Real Exchange RateTable 9Real Exchange RateNominal rate P * P RER(Manat/US$) Index (1993.1 = 100)1993/7 118.8 100.9 251.9 94.31994/1 311.0 100.3 1,246.4 49.61994/7 980.0 102.2 4,388.4 45.21995/1 4,268.7 104.5 21,824.2 40.51995/7 4,477.7 106.6 27,416.5 34.51996/1 4,443.2 106.6 32,172.2 29.21996/7 4,298.0 107.2 31,917.3 28.61997/1 4,095.0 110.1 33,707.7 26.51997/6 3,992.0 105.5 34,046.1 25.0Note : See note for Fig. 3-4 above about assumption.Source: Same as above.

290 Taku Yamabe, Macroeconomic Implications of Oil Boom in AzerbaijanTable 10Status of Foreign Investments1995 1996 1997*US$1,000 % US$1,000 % US$1,000 %Total investment amount 154,699.3 100.0 519,084.4 100.0 754,299.0 100.0Oil-related 139,787.7 90.4 416,236.0 80.2 484,692.0 64.3Non-oil related 14,911.6 9.6 102,848.4 19.8 269,607.0 35.7Turkey 6,781.1 4.4 45,300.0 8.7 118,300.0 15.7USA 2,144.4 1.4 41,500.0 8.0 94,602.0 12.5Germany 1,230.4 0.8 4,203.0 0.8 16,002.0 2.1Switzerland 1,230.4 0.8 3,953.0 0.8 9,300.0 1.2UAE 660.2 0.4 1,700.0 0.3 6,500.0 0.9Russia 656.7 0.4 2,300.0 0.4 5,502.0 0.7England 683.4 0.4 1,204.0 0.2 4,801.0 0.6Iran 952.1 0.6 1,010.0 0.2 2,600.0 0.3Others 572.9 0.4 1,678.4 0.3 12,000.0 1.6Note : Figs for 1997 are as of the end of September 1997.Source: State Committee of StatisticsAdditional foreign currency revenues from capital inflow translate into upward pressureon the nominal exchange rate. Moreover, the money supply growth from foreign currencyexchange in the financial sector and the expenditure increase for non-tradables caused by theDutch Disease in the real sector exerts upward pressure on domestic prices. Eventually, realexchange rate appreciates due to an appreciation of nominal exchange rate and the domesticprice increase. To avoid this, the money supply must be controlled through sterilization measuressuch as issuing government bonds. However, in the case of Azerbaijan, the money supply hasbeen rising steadily, 23 as shown in Fig. 12.16001 billion manat140012001000800600400200M0M2095.1 7 96.1 7 97.1 7Source: Azerbaijan National BankFig. 12 Money Supply Growth23Since the data about the real money supply is not available, the nominal money supply is shown.The increase in the real GDP being from 1996 and the annual rate not exceeding 1%, however, it is easy topresume that the money supply has been increasing even in real terms.

OECF Journal of Development Assistance Vol.4, No.1, 1998 291A calculation of the rate of change in the velocity of currency circulation using the quantitytheory of money reveals that the rate of change was negative in 1995 and 1996, as shown inTable 11. It is considered that during this two-year period, regardless of the growth in the moneysupply, the velocity has diminished due to the loss of trust in the financial system, which in turnhas eliminated the upward pressure on prices. From the beginning of 1997, however, the velocityhas been rising. If the growth of the money supply maintains a steady rate in real terms, the resultwill be a rise in inflationary pressure.Table 11Changes in Velocity of Currency Circulation1995 1996 1997*Velocity change -49.5% -17.9% 10.1%Note : 1 1997 figure is as of the end of June 1997.2 M2 was used as the measure of the money supply forcalculations.Source: Calculated based on data from CIS Statistics Board and StateCommittee of Statistics.In summary, Azerbaijan is experiencing an appreciating real exchange rate, and DutchDisease phenomena are considered to be appearing in the form of the spending effect and indirectresource movement effect. Currently, although a rise in the money supply is observable,inflationary pressure remains low due to the loss of trust in the financial system, and as a result,the appreciation in the real exchange rate has been relatively mild. However, the Dutch Diseasemay rear its head in the future as oil industry starts really booming and reforms in the financialsector progress.2. Labor Market TrendsAzerbaijan's had a total employment of 2.886 million in 1996 (Table 12). Due to the economicdecline following independence, the unemployment rate has risen, but in 1996 employment beganrecovering. The official unemployment rate announced by the government was 1.1%, and thenumber of unemployed was only 4,601. However, these numbers are only made up of the personswho actually registered as unemployed, and since registration procedures are troublesomecompared to the meager benefits available, actual unemployment numbers are considerably largerthan reported. 24 The actual unemployment rate is as high as 17% in 1995 according to IMFcalculation.The oil industry is the only tradables industry whose employment figures are rising. Itrecorded a rise in its number of workers of 22,700 (Table 13). The Non-Booming TradableSector has seen its work force shrink by 103,900 workers excluding agriculture. If agriculture,which accounts for 31.8% of the total employment, is included, the decline in the total workforce of the Non-Booming Tradable Sector becomes 196,500 persons, which means that additional6.8% of the workforce has become jobless. A look at the average annual rate of change inemployment shows that, as predicted by the Dutch Disease theory, the workforce in the oil industry24World Bank (1997 a).

292 Taku Yamabe, Macroeconomic Implications of Oil Boom in Azerbaijanhas increased by 2.1%, while the workforce of the Non-Booming Tradable Sector (excludingagriculture) has fallen by 6.0%.Table 12Unemployment Trend1992 1993 1994 1995 1996 1997*Total employment (1,000 persons) 2922.0 2916.6 2851.3 2837.3 2886.0 -Registered applicants for employment 56,163 44,339 32,009 29,904 26,049 -Registered unemployed persons 14,522 11,304 6,640 5,967 4,601 5,887o/w Persons receiving unemployment benefit 2,907 1,556 1,914 2,223 2,280 1,130Actual unemployment rate (%) 15 16 15 17 - -Unemployment rate based on registered base (%) 0.2 0.7 0.8 1.0 1.1 -Note : Figs for 1997 are as of September 1997.Source: Work force figures are from CIS Statistics Committee; Unemployment rate figures are fromIMF; Other figures are from Ministry of Economy.Table 13Number of Workers by Industry1992 1993 1994 1995 1996 Change(Unit: 1,000 persons)Average annualrate of changeOil industry (including natural gas) 25.7 27.1 27.8 29.9 28.4 2.7 2.1%Power 22.2 23.8 25.0 24.8 21.5 -0.7 -0.6%Steel 9.6 9.9 9.1 7.6 7.0 -2.6 -5.4%Non-ferrous metals 9.4 8.6 7.8 7.0 6.2 -3.2 -6.8%Chemicals and petrochemicals 23.6 23.0 21.9 21.3 20.0 -3.6 -3.1%Machinery 65.3 59.9 55.6 46.9 40.7 -24.6 -7.5%Capital-intensive industries total 130.1 125.2 119.4 107.6 95.4 -34.7 -5.3%Metal working 24.1 21.3 17.5 15.5 13.8 -10.3 -8.5%Wood working and paper making 11.4 8.7 6.8 4.9 3.7 -7.7 -13.5%Building materials 24.5 23.7 20.2 16.8 13.0 -11.5 -9.4%Food 52.0 49.6 50.4 37.3 32.3 -19.7 -7.6%Light industry (textiles, garment, leather) 82.9 67.3 70.0 60.2 49.4 -33.5 -8.1%Labor-intensive industries total 194.9 170.6 164.9 134.7 112.2 -82.7 -8.5%Other industries 22.2 44.5 44.5 32.1 35.7 13.5 12.2%Agriculture 1010.0 939.1 951.0 872.9 917.4 -92.6 -1.8%Non-booming tradable sector total(excluding agriculture) 347.2 340.3 328.8 274.4 243.3 -103.9 -6.0%(including agriculture) 1357.2 1279.4 1279.8 1147.3 1160.7 -196.5 -2.9%Transportation and communications 122.0 111.7 110.0 93.0 168.3 46.3 7.6%Construction 226.0 212.3 191.0 180.8 164.1 -61.9 -5.5%Trade, etc. 152.0 174.4 175.0 392.0 456.6 304.6 40.1%Major non-tradable industries total 500.0 498.4 476.0 665.8 789.0 289.0 11.6%Total employment 2922.0 2916.6 2851.3 2837.3 2886.0 -36.0 -0.2%Source: State Committee of Statistics, Ministry of Economy

OECF Journal of Development Assistance Vol.4, No.1, 1998 293Furthermore, if one divides the Non-Booming Tradable Sector into capital-intensive andlabor-intensive industries, 25 during the period for 1992-1996, the work force of the labor-intensiveindustries has declined at an annual rate of 8.5%, or a total of 82,700 persons, while that ofcapital-intensive ones has declined at an annual rate of only 5.3%, or a total of 34,700. Thismatches the prediction of the non sector-specific capital model prediction of the Dutch Diseasetheory described in section III.B.2.Next, an examination of the Non-Booming Tradable Sector trends reveals that in the majorindustries, for which statistical data is available, the work force has risen by 289,000 persons,which represents an average annual rate of increase of 11.6%. The work force employed incommerce, in particular, has tripled in the period for 1992-1996, recording a very high averageannual rate of growth of 40.1%. This makes commerce the second largest employer after agricultureas of 1996. Moreover, commerce also comprises a large segment of the underground economythat is not accounted for in these figures, and the number of persons actually employed in thisindustry should be considerably higher than reported.In the Dutch Disease theory, labor is assumed to move freely among the sectors towardwage equalization. In Azerbaijan, however, the oil industry, which is highly capital-intensive,does not absorb a large number of workers, and further, is characterized by the fact that it requiresa high proportion of high specialized workers, so that it actually presents barriers to labor entry.In the case of Azerbaijan, the Non-Tradable Sector, and principally commerce, instead of the oilindustry, is the sector to absorb labor who has become surplus due to the decline in marginallabor productivity in the Non-Booming Tradable Sector.The fact that wage differentials have arisen due to the existence of labor entry barriersamong industries can be verified from the wage levels by industry indicated in Table 14. The oilindustry had a wage level 3 to 4 times higher than other industries. Monthly wages in 1996converted into US$ show that, compared to US$87.9 in the booming oil industry, average monthlywages in non-booming tradable industries (excluding agriculture) and major non-tradableindustries were US$24.3 and US$26.5, respectively. With regard to the rise in wages from 1994to 1996, the oil industry recorded a rise of US$33.9, compared to an average of US$9.3 for nonboomingtradable industries (excluding agriculture), and an average of US$12.8 for major nontradableindustries excluding agriculture, a difference of 3 to 4 times. 26Whereas wages in the oil industry, which has low labor absorption potential, have risen,the wage level in the commerce industry, which is industry most capable of absorbing unemployedworkers, is remarkably low, with both the absolute amount and increase amount beingapproximately one tenth of the oil industry. In this way, Azerbaijan's labor market is undergoinga widening rift in wage levels as the oil boom progresses.25For classification, see Okawa and Kohama (1993), pp. 103-104.26Even in the Non-Booming Tradable Sector, dollar-converted wages have been rising. Possiblereasons behind this are the existence of downward rigidity of wages and the fact that each year's results arenot necessarily consistent due to the inconsistent relation between annual average official rate and annualwage payment period.

294 Taku Yamabe, Macroeconomic Implications of Oil Boom in AzerbaijanTable 14Wage Levels by Industry(Unit: US$/month)1993 1994 1995 1996Amount o fincrease i nlast 2 yearsOil industry (including natural gas) 63.9 54.0 62.7 87.9 33.9Non-booming tradable industriesPower 45.1 33.9 34.6 43.1 9.2Steel 39.8 10.9 9.7 24.0 13.0Non-ferrous metals 37.7 13.8 12.5 14.0 0.2Chemicals and petrochemicals 29.5 16.0 19.7 29.9 14.0Machinery and metal working 32.8 16.7 16.5 28.8 12.0Wood working and paper making 29.0 11.7 9.9 16.3 4.6Construction materials 33.0 13.4 15.2 28.0 14.6Food 24.0 7.2 9.2 11.8 4.7Light industry (textiles, garments, leather) 24.4 11.8 14.3 22.9 11.1Agriculture - 5.9 6.0 7.7 1.8Non-booming tradable average(excluding agriculture) 32.8 15.1 15.7 24.3 9.3(including agriculture) - 14.2 14.8 22.7 8.5Non-tradable industriesTransportation - 14.0 19.8 31.8 17.7Communications - 16.5 19.0 28.7 12.2Construction materials - 18.9 22.1 37.0 18.1Commerce - 5.5 6.5 8.6 3.1Major non-tradable industries average - 13.7 16.9 26.5 12.8Note : Average values are arithmetic averages.Source: Manat-denominated wages provided by State Committee of Statistics and Ministry of Economydivided by average annual official parity rate of IFS.3. Industrial Sector ProductionAn examination of the production share of the oil industry and the non-oil industries in theindustrial sector (tradable sector) shows that in 1992, the oil industry's production share was23.4% versus 76.6% for non-oil industries. In the following five-year period, the share of the oilindustry reached 54.4% in 1997 versus 45.6% for non-oil industries. Thus the oil industryaccounted for more than half of the industrial sector's output value (Table 15).Furthermore, if one divides non-oil industries into capital-intensive and labor-intensiveindustries, labor-intensive industries' output value fell by 17.3% versus only 10.5% for capitalintensiveindustries, which means that capital-intensive industries have relatively expanded withinthe Non-Booming Tradable Sector. This result supports the non sector-specific capital model ofthe Dutch Disease theory.

OECF Journal of Development Assistance Vol.4, No.1, 1998 295Table 15Industrial Sector Production Composition(Unit: %)1992 1993 1994 1995 1996 1997* % changeOil industry (including natural gas) 23.4 18.7 33.4 46.2 52.4 54.4 31.0Power 7.0 11.0 16.7 19.2 17.9 13.9 6.9Steel 2.6 2.5 0.7 0.2 0.1 0.3 -2.3Non-ferrous metals 4.6 2.9 1.3 0.9 0.2 0.7 -3.9Chemicals and petrochemicals 7.0 7.7 5.4 5.4 4.5 3.2 -3.8Machinery 11.3 13.6 5.9 2.8 2.6 3.9 -7.4Capital-intensive industries total 32.5 37.7 30.0 28.5 25.3 22.0 -10.5Metal working 1.7 2.5 1.4 0.8 1.0 1.0 -0.7Wood working and paper making 1.5 1.3 0.5 0.2 0.1 0.1 -1.4Construction materials 3.3 5.0 3.0 1.5 1.1 1.0 -2.3Food 14.5 13.3 11.6 6.6 7.4 11.5 -3.0Light industry (textiles, garment, leather) 16.0 14.8 11.5 9.5 8.2 6.1 -9.9Labor-intensive industries total 37.0 36.9 28.0 18.6 17.8 19.7 -17.3Others 7.1 6.9 8.6 6.5 4.4 3.9 -3.2Non-booming tradable industries total 76.6 81.5 66.6 53.6 47.5 45.6 -31.0Note : Figs for 1997 are as of the end of September 1997.Source: State Committee of StatisticsNext, we examine whether domestic demand for capital goods has grown as predicted bythe construction boom theory. Since a precise classification of capital goods and consumer goodsis difficult, construction materials, steel, and machinery have been selected as typical capitalindustries. All industries have seen their share decline, with construction recording a contractionof 2.3%, steel 2.3%, and machinery 7.4%. This does not necessarily support the theory. Onepossible reason is that the propensity to save has not changed because the oil development boomis regarded as long-term. In the case of Azerbaijan, oil-related capital inflow just started in 1994,and it is predicted to have a delayed impact on domestic investments. Moreover, a rise in thepropensity to save, as the financial sector reforms progress, is also possible. Thus the potentialfor the phenomena predicted by the theory to arise cannot be denied.As a summary of the above results, the overall trend is that Dutch Disease phenomena areobservable as the booming oil industry expands its share, while the share of non-booming tradableindustries, particularly labor-intensive ones, shrinks. With regard to the "spending effect," thereal exchange rate has begun appreciating due to capital inflow related to oil. However, inflationis currently moderate due to a fall in the velocity of currency circulation so that there is no strongupward pressure on the real exchange rate. With regard to the "resource movement effect," theoil industry has low labor absorption potential, so that there is only a limited direct resourcemovement effect. However, a large indirect resource movement effect is considered to exist,since there is considerable labor movement from the Non-Booming Tradable Sector to the Non-Tradable Sector, particularly to the commerce. Moreover, the barrier to labor movement into theoil industry and the rise in relative productivity have caused a rise in oil industry wages, andwage differentials between the oil industry and surplus labor absorption industries such as thecommerce is growing wide.The degree to which the oil boom is contributing to the phenomena analyzed above cannotbe established clearly. For example, labor movement through the appreciating real exchange rate

296 Taku Yamabe, Macroeconomic Implications of Oil Boom in Azerbaijanis partly caused by deteriorating terms of trade due to CIS countries raising the price of theirexports toward Azerbaijan, and various difficulties having arisen from the dissolution of theSoviet Union. Moreover, the GDP share represented by the private sector did not exceed 40% in1997. 27 so that the public sector is still dominant in the economy. Since employment by stateownedenterprises does not necessarily respond quickly to changes in marginal labor productivity,more detailed analyses at the firm level are desirable. Nevertheless, the above analysis is enoughto confirm the trend that, if the oil boom starts in earnest, the oil industry will steadily expandwhile non-booming tradable industries, particularly labor-intensive ones, become smaller, surpluslabor will be absorbed by commerce, construction, and other non-tradable industries, and wagedifferentials will keep on expanding.IV. POLICY ISSUES FOR SUSTAINABLEECONOMIC DEVELOPMENTThe macroeconomic stabilization program begun from 1995 resulted in the control of inflation,the stabilization of the exchange rate, and the reduction of the fiscal deficit. Trade liberalization,financial system reforms, and the privatization of state-owned enterprises, are all progressingsteadily, and multilateral donors' view of Azerbaijan's future is optimistic overall. In this chapter,based on the results of Chapter 3, we examine the policy issues considered to be necessary forAzerbaijan to overcome the Dutch Disease and achieve sustainable economic development.1. Relaxation of Upward Pressure on Real Exchange RateThere are two major prescriptions to enable Azerbaijan to mitigate the Dutch Disease and achievecontinuous growth. First, in order to control the "spending effect," Azerbaijan will have to weakenthe upward pressure on the real exchange rate. To achieve this, it will have to prevent excessivedomestic spending by the sterilization of foreign currency earnings and foreign investments suchas the purchase of foreign bonds.Crude oil production will start having a net positive effect on the fiscal balance from 2004.The additional funds flow into the private sector until then. Since spending of additional funds isdone by the private sector, it does not fall under governmental control. Therefore, initial measuresto relax upward pressure are likely to consist of financial measures, namely sterilization policies.As financial reforms take hold, the velocity of currency circulation and the monetary multiplierwill rise, so maintaining the current growth in the money supply on a real base will result inincreasing domestic prices and an appreciating real exchange rate. Therefore, a tightening policywill have to be maintained.From 2004 onward, additional funds will also start flowing to the government, so that, inorder to relieve upward pressure on the real exchange rate, the government will have to directthese additional funds to foreign investments such as the purchase of foreign bonds. Moreover,during the initial stage while the Dutch Disease does not grow more severe, it would be worth forthe government to consider improving the infrastructure by overseas borrowings, and to use theadditional funds from 2004, when the oil industry really starts booming, for the repayment of27EBRD (1997)

OECF Journal of Development Assistance Vol.4, No.1, 1998 297these loans, so as to avoid overly rapid changes.2. Fostering of Manufacturing IndustryThe other prescription consists in curbing the "resource movement effect" by activating non-oilindustries, particularly manufacturing. This will require stimulating investments in these industries,but as domestic investment funds are limited at present, Azerbaijan has no choice but to dependon direct investments from abroad. However, although the macroeconomic situation has stabilizedand an environment for foreign investment is being put in place, including a foreign investmentprotection law, interviews with local enterprises reveal that foreign investors are still discouragedby various invisible barriers such as corruption and bribery at the lower echelons. For this reason,foreign direct investments in the manufacturing industry are still scarce. As shown in 10, foreigndirect investments are growing steadily, but the majority are oil-related. Although direct foreigninvestments are also growing in non oil-related industries, they are mostly directed to theconstruction and service industries. In the manufacturing industry, food processing received apaltry US$23,000 in investments, and as of the end of 1996, not a single direct investment hasgone to the machine and chemical industries, etc.. This situation points the necessity of pressingahead with public sector reforms and increasing the transparency of investment procedures.Another important policy objective for the government should be the development of smallandmedium-sized enterprises. As described earlier, the oil industry consists of large-sizedenterprises, so that the promotion of small- and medium-sized ones will contribute to thedevelopment of non-oil industries. Further, there is the consideration of the geographic locationof small- and medium-sized enterprises, which are for the most part situated in the countryside.This means that promoting these enterprises is a way of slowing migration into Baku, a trend thatwill be difficult to avoid due to labor movement among sectors and increasing wage differentials.The government is aware of the necessity of promoting small- and medium-sized enterprises,and has designed a state support program for small- to medium-sized enterprises implemented intwo stages, the first one from 1993 to 1995, and the second one from 1997 to 2000. This programconsists mainly of creating a favorable investment environment, including support forimprovement of company-related laws, and financial and technical assistance for small- andmedium-sized enterprises. The National Fund on Support for Entrepreneurship and the Smalland Medium sized Enterprises Development Agency have also been established. The governmentprogram plans to use a national budget, local budgets, fund aid and investments from overseas,and donations as funding sources, in addition to the above entrepreneur support fund. Reliablefunding sources have not yet been secured, and thus it appears that the results of these activitieswill not necessarily be as great as expected.3. Reinforcement of Economic InfrastructureIt is considered to be vital for Azerbaijan, which has a small domestic market, to expand itsexport markets in relation to the revitalization of its manufacturing industry. However, the countrycontinues to be hampered by various barriers, including antiquated systems dating back to theSoviet Era and an infrastructure mainly oriented toward Russia.The World Bank (1996 b) used a gravity model to perform a series of estimates concerning

298 Taku Yamabe, Macroeconomic Implications of Oil Boom in AzerbaijanCIS countries' export partners. The gravity model explains the size of trade flows between twocountries in terms of demand-supply factors. Typical factors include population and GDP, andadditional indices affecting trade flows are selected on a case-by-case basis. As part of its estimates,the World Bank has set coefficients for independent variables based on panel data of 76 countriesspanning the years 1984 to 1986, and by inserting ex-Soviet block nations' data in this model,estimated what the export partner shares would be if they had a market economy (Table 16).According to these estimates, Azerbaijan's exports would be 57% to OECD countries, 24% toCIS countries, 8% to Central and East European countries, and 10% to all other countries. In1985, however, Azerbaijan's exports to CIS countries amounted to 94% of its total exports, andexports to the rest of the world amounted to only 6%.In 1995, exports to CIS countries fell from 94% to 41%, but provided that export partnershares are constant, this percentage is still 17% higher than the estimate yielded by the gravitymodel. On the other hand, Azerbaijan's total exports to OECD countries do not exceed 14%,which is 43 points lower than the estimated value. The exports to Central and Eastern Europeancountries, which are comparatively close geographically, are also almost nil. Other developingcountries are in the process of replacing CIS countries as major export destinations. Amongthese, Iran and Turkey take more than half of Azerbaijan's exports, which can be explained inlarge part by the fact that they are close to Azerbaijan both in geographic and political terms.Table 16Potential Export Partner Share Estimated with Gravity ModelCIScountriesEFTAandEUOtherOECDcountriesOECDcountriestotalActual 1985 figures 94% 6%Central andEasternEuropecountriesChina(Unit: %)OtherdevelopingcountriesActual 1995 figures (a) 41% 14% 0% 14% 0% 1% 44%Estimates using gravity model (b) 24% 35% 22% 57% 8% 1% 9%Potential trade share increase (b)-(a) -17% 21% 22% 43% 8% 0% -35%Source: World Bank (1996 b)Based on the above results, one way that exports by Azerbaijan's manufacturing industrycould be expanded would be to stimulate exports to OECD countries. Azerbaijan is no exceptionamong CIS countries in that it shares with them trade shift barriers that include a lopsidedtransportation infrastructure, insufficient communications and other economic infrastructures,and a disadvantageous geographic location. 28 While aiming to expand exports to Europe andother areas, the government must reinforce its transportation channels to neighboring countries,improve access to major arteries from provincial locations where small- and medium-sizedenterprises are concentrated, and enhance the other economic infrastructure.28World Bank (1996 b)

OECF Journal of Development Assistance Vol.4, No.1, 1998 2994. ConclusionImmediately after its independence, Azerbaijan saw its production decline due to variouscomplications related to the introduction of market principles and ethnic conflicts and, whilebeing hit with four-digit annual inflation, fell into an economic state of chaos. However, thanksto the cessation of the conflicts and the accompanying political stabilization, and further, thestart of its macroeconomic stabilization program, Azerbaijan achieved positive GDP growth inreal terms in 1996, and is currently riding an underlying trend of recovery. As the fiscal balanceand the balance of payments are improving, the exchange rate and prices are stabilizing. Amidstthe implementation of structural reforms in the economy, foreign direct investments related tooil development are increasing. The oil development boom will contribute to improve Azerbaijan'sbalance of payments through capital inflow and oil exports, and the fiscal balance, which untilnow has been in deficit, will be in surplus from 2004. Although the government must approachshort-term borrowing with caution, since the improvement of the fiscal balance is unlikely due toimports of oil-related materials and equipment and recovery of capital cost in the short term,Azerbaijan should not have problems in particular regarding its ability to pay back loans in themedium and long term.In order to achieve sustainable economic development, Azerbaijan must effectively link itsoil boom to economic development. On the other hand, the oil boom holds the potential ofcausing the manufacturing industry to shrink due to an appreciation in the real exchange ratecaused by increased domestic spending and labor movement arising from changes in marginallabor productivity. Therefore, there is a possibility that Azerbaijan may fall into a weak industrialstructure and suffer the loss of positive dynamic externality brought by the manufacturing industry,thereby derailing its long-term development process. The government must implement financialmeasures to relieve upward pressure on the real exchange rate, as well as develop the manufacturingindustry through measures to promote small- and medium-sized enterprises and enhancingeconomic infrastructure, in order to maintain its sustainable development process.Responding to the efforts of the Azerbaijani government to overcome these problems, Japan'scooperation need not be limited to financial cooperation for building the infrastructure, but couldalso include other areas such as intellectual and financial cooperation for small- and mediumsizedenterprises. In this field, Japan has experience promoting small- and medium-sized domesticenterprises through governmental financial institutions such as Japan Small Business Corporation,Small Business Finance Corporation, Central Cooperative Bank for Commerce and Industry,and People's Finance Corporation. Moreover, as described in section IV.1, in order to preventextreme changes due to foreign currency inflow when the oil industry starts really booming, thegovernment has an option to finance infrastructure projects with OECF loans, which has a graceperiod of 7 to 10 years, so that Azerbaijan can apply its foreign currency earnings after the oilboom starts in earnest to repay its loans rather than just flow in.This report has examined issues related to making Azerbaijan's incipient economic growtha long-term one from the viewpoint of the Dutch Disease. It goes without saying that other issuesnot mentioned in this report, such as the improvement of the pension system and other socialsecurity systems, which have shrunk under government budget contractions, and the reconstructionof war-torn areas, are important tasks that remain to be handled. Furthermore, many obstaclesare predicted to stand in the way of actual implementation of the policy measures discussed in

300 Taku Yamabe, Macroeconomic Implications of Oil Boom in Azerbaijanthis chapter. First, holding in check spending of earned foreign currency will clash with opposingpolitical pressure for raising domestic spending. Moreover, regarding the development of themanufacturing industry, measures to promote small- and medium-sized enterprises and buildingthe economic infrastructure are required, but these themes are not independent of the issue ofcurbing domestic spending, and in many cases are in a tradeoff relationship with it. Greatexpectations rest on the Azerbaijani government to implement balanced economic management.REFERENCESAdam, C. S. (1993). Testing for Regime Shifts in Short-Sample African Macroeconomic Data: ASurvey of Some Monte Carlo Evidence, CSAE Working Paper WPS 93.1.Baev, P. (1997). Russia's Policies in the Caucasus, The Royal Institute of International Affairs.Barro, R. J. and X. Sala-i-Martin (1995). Economic Growth, McGraw Hill.Bevan, D. L., P. Collier and J.W. Gunning (1987). "Consequences of a Commodity Boom in aControlled Economy: Accumulation and Redistribution in Kenya 1975-83", World BankEconomic Review, Volume 1, Number 3.______ (1990). Controlled Open Economies: a Neoclassical Approach to Structuralism,Clarendon Press.______ (1992). "Anatomy of a Temporary Trade Shock: The Kenyan Coffee Boom of 1976-9",Journal of African Economies, Vol. 1, No. 2.Cassing, J. H. and P. G. Warr (1982). The Distributional Impact of a Resource Boom, WorkingPaper No. 065, Working Papers in Economics and Econometrics, Faculty of Economicsand Research School of Social Sciences, Australian National University, Canberra.Corden, W. M. (1984). "Booming Sector and Dutch Disease Economics: Survey andConsolidation", Oxford Economic Papers 36.______ and J. P. Neary (1982). "Booming Sector and De-Industrialisation in a Small OpenEconomy", Economic Journal, December 1982.Eastwood, R. K. and A. J.Venables (1982). "The Macroeconomic Implications of a ResourceDiscovery in an Open Economy", Economic Journal, December 1982.Economic Intelligence Unit (1997). Country Profile - Azerbaijan -.Euromoney Research Guides (1997). Banking Services in Central Asia and Transcaucasia,Euromoney Publications PLC.European Bank for Reconstruction and Development (1997). Transition Report 1997 - EnterprisePerformance and Growth -.Freedman, M. (1958). A Theory of Consumption Function, Princeton University Press.International Monetary Fund (1993). Azerbaijan Economic Review 1993.______ (1995). Azerbaijan Republic - Recent Economic Developments.______ (1997). Azerbaijan Republic - Recent Economic Developments.Japan Association for Trade with Russia and Central-Eastern Europe (1990). Soren no SekiyuJosei (Sekiyu Ryutu Gourika Chosa) (Oil Situation in the USSR (Oil DistributionRationalization Survey)), in Japanese.______ (1993). Kyu-Sorenpoukyowakoku Kunibetsu Keizai Jittai Chosa (Survey on EconomicConditions in Ex-Soviet Republics), in Japanese.

OECF Journal of Development Assistance Vol.4, No.1, 1998 301______ (1997). Nihon - Chuo Ajia Boeki Yoran (Azerbaijan Hen) (Japan and Central AsiaTrade Summary (Azerbaijan)), in Japanese.Japan Forum on International Relations (1996). Keizai Kyoryoku Keikaku SakuteinotamenoKisochosa – Kunibetsu Keizai Kyoryoku Keikaku (Caucasian 3goku) (Basic Survey forEconomic Cooperation Planning – Economic Cooperation Planning by Country (3Caucasian Nations)), in Japanese.Okawa, K. and H. Ohama (1993). Keizai Hatten Ron: Nihon no Keiken to Hattenn Tojokoku(Theory of Economic Development: Japan's Experience and Developing Countries), ToyouKeizai Shinposha, in Japanese.Perron, P. (1989). "The Great Crash: The Oil Price Shock and the Unit Root Hypothesis",Econometrica, Vol. 57, No.6, 1989.Romer, M. (1985). "Dutch Disease in Developing Countries: Swallowing Bitter Medicine", inMats Lundahl (ed.), The Primary Sector in Economic Development, Croom-Helms.Rybezynski, T. M. (1955). "Factor Endowment and Relative Commodity Prices", Economica,November 1955.United Nations Development Programme (1997). Azeribaijan Human Development Report 1997.Wijnbergen, S. (1984). "Inflation, Employment, and the Dutch Disease in Oil-Exporting Countries:A Short-Run Disequilibrium Analysis", Quarterly Journal of Economics, May 1984.World Bank (1996 a). The World Bank in Central Asia and Azerbaijan.______ (1996 b). Foreign Trade in the Transition - The International Environment and DomesticPolicy -.______ (1996 c). Statistical Handbook 1996 - States of the Former USSR -.______ (1997 a). Azerbaijan Poverty Assessment.______ (1997 b). Global Development Finance.Wunder, S. (1991). Dutch Disease Theory and the Case of Columbia, University of Copenhagen,Institute of Economics.

OECF Journal of Development Assistance Vol.3, No.2, 1998 303 1995/Vol.1 No.1 – 1998/Vol.4 No.1Volume 1 Number 1 July 1995ArticlesChikao TsukudaIn Search of General Principles for Infrastructure ProjectsKaitoku YamamotoInternational Trends in Development Assistance and JapanSpecial Feature: The Role of the Government in DevelopmentKazumi GotoThe Main Issues of the East Asian Miracle: The World Bank Report as Assessed by UK CriticsIzumi OhnoBeyond the "East Asian Miracle" – How the Asian Commentators See the Phenomenon and the Future –Keiichi Matsukaze & Izumi OhnoThe Role of the Government and the Response of the Private Sector– The Pattern of Development in the Republic of Korea and Thailand –Kazuto Tsuji, Yojiro Sekiguchi & Aya YamatoGovernment Responsibilities in the Telecommunications SectorKazuto TsujiA Proposal Concerning Effective Ways to Extend Policy-Based Directed Credit AssistanceResearchMasaru Kaneko, Katsumi Nishina & Shinya AokiSurvey of State Governments Finance in India – Summary –Volume 1 Number 2 March 1996ArticlesKazumi Goto & Philip ActonThe Search of Forming Strategic Development Management Capability– A New Frontier for Development Studies –Izumi OhnoReview of Debates over Transition Strategies: "Gradualism" RevisitedIzumi OhnoOwnership, Performance, and Managerial Autonomy – A Survey of Manufacturing Enterprises in Viet Nam –Katsumi Nishina & Hisae SakataStructural Adjustment and Industrial Development in Ghana– From Point of View of Macroeconomic and Financial Issues –Noboru Watanabe, Minoru Nambu, Masayoshi Tsurumi, Katsumi Nishina, Shin Minematsu & Masaya YajimaFiscal and Financial Reforms and Regional Development in ChinaIntroduction: The Current Status of the Open-Up Policy

304 Back NumberRyosuke NakataSocioeconomic Profile of Black Community of South AfricaKazuto Tsuji, Hiroshi Ueno, Yojiro Sekiguchi & Aya YamatoPolicy-Based Directed Credit Programs in the PhilippinesMegumi MutoCommunity Participation in Maintenance Management of Small-Scale Projects– In Reference to Post-Evaluation Report on Small Swamp Inland Fisheries Project in Thailand –Volume 2 Number 1 October 1996Special Feature: Viet Nam – Transition and Development –Hiroshi HarutaReform of State Owned Enterprises (SOEs) in Viet Nam– Corporate Governance in the Transition to Market Economy –Kiyoshi AmadaFinancial Sector Reforms during Economic Development and Transition to a Market Economy– A Case of Viet Nam –Shinya AokiViet Nam’s State Finance in Transition – Towards Economic Development by Using Market Mechanisms –Kazumi Goto, Kaoru Hayashi & Kazuto TsujiThe “East Asian Miracle” as Intellectual Public Property– With Special Reference to the Use of Policy-Based Directed Credit to Support Marginalized Sectors –Kenichi ShibutaSustainability of the Irrigation Project – In Reference to Post Evaluation Report on Democratic SocialistRepublic of Sri Lanka Mahaweli Development Project (System - C) –Aya KonishiPublic Lending Schemes for Pollution Control in Japan– Reference Materials for Future Environmental Two-Step Loans –Volume 2 Number 2 March 1997Kazumi GotoBeyond the "Structural Adjustment" and the "East Asian Miracle"– Development Management Re-examined –Noboru Watanabe, Mikio Murasaki & Shin MinematsuThe Myanmar Economy – Its Current Status and Future Challenges –Toshitaka OhtakaAnalysis and Evaluation of Privatization of Malaysia Telecommunications SectorYuji OhnoAn Argument on Cost Recovery of Railway Investments in Developing Countries– Experimental Proposal in the Case of Thai Railways –Nobuo Hazeyama & John S. ArthurLessons from Japan for Human Resources Development in Developing Countries

OECF Journal of Development Assistance Vol.3, No.2, 1998 305Hiroaki Tamura & Naomi HaraSummary of the OECF-sponsored Japan-Korea Economic Cooperation SymposiumThe Future of Japan-Korea Cooperation – Current Issues on Development Assistance and a NewPartnership in Development Assistance –Volume 3 Number 1 August 1997Kazumi GotoSome Thoughts on Development and Aid – Japan's Strategic Response –Yoshio WadaAssistance Strategy for Transitional Economies and Japan's ODA LoansHitoshi Shoji & Ryoichi YamagishiPrivate Sector Financed Infrastructure Development in Developing CountriesHitoshi Shoji & Mitsunobu ToyoshimaInformation Technology Service Industry in Developing Countries – Cases in India and Singapore –Hitoshi Shoji & Ryoichi YamagishiPrescription for Promotion of Urban Improvement in Bangkok – Focus on the Systemic Aspect –Kazuto Tsuji, Yojiro Sekiguchi & Rie MakitaNew Trends of Farm Management Styles in ChinaToshiyuki OtakaFinancial Sustainability of Chinese State-owned EnterprisesYasuo MiyauchiEfficient Management of the Electric Power Sector in EgyptKayo Murata & Yuko TokuraCurrent Status of Women in Development in PakistanVolume 3 Number 2 March 1998Special Feature: A New Vision of Development Cooperation for the 21st Century – Symposium / WorkshopCo-sponsored by the Overseas Economic Cooperation Fund (OECF) and the World Bank –Shinji NamboSocial Investment Funds in Latin AmericaShin Minematsu, Hisae Sakata, Xiao-Ping Zheng & Junichi YamadaThe Major Issues of the Regional Development Strategies in ChinaMikio Murasaki & Chie MatsushitaThe Privatization Policies in Pakistan – Current Situation and Future Challenges –Hiroshi Osada & Hiroaki SanoThe Future Challenges for Nepalese Economy – Focused on Debt Servicing Capacity –Rie MakitaRural Development Administration for Poverty Eradication in Malaysia– Focusing on Coordination Mechanisms –

306 Back NumberVolume 4 Number 1 November 1998SPECIAL FEATURE:"Special Assistance for Development Policies and Projects" (SADEP) SchemeFORWARDKoichi Kosumi"Special Assistance for Development Policies and Projects" SchemeYoshio WadaIncentives and Property Rights in China's State-owned Enterprise ReformKaoru HayashiThe Reforms of State-owned Enterprises in China: A Viewpoint of Law and EconomicsHisaaki Mitsui & Yoshio WadaAnalysis of Reform of State-owned Enterprises in VietnamHitoshi Shoji, Michinari Togawa & Tetsuo KidokoroUrban Railway Projects in Bangkok: Measures for Securing Financial ResourcesYuko Amano & Fumiharu MienoFuture Challenges for the Economic Recovery of ThailandTetsuro Takeda & Ryosuke NakataRegional Disparities in IndonesiaMasami Mizuno, Katsuhiko Nakadate & Rie MakitaHow Maintenance for Irrigation Projects should Adapt to Changes in the Local Community– Taking the Lankeme Irrigation Project in Indonesia as a Case Study –Hitoshi Shoji, Hajime Ino & Aki SudoHigher Education in Three Southeast Asian Countries – Results of a Student Survey –Taku YamabeMacroeconomic Implications of Oil Boom in Azerbaijan

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