A publication of the Asian Development Bank No. 2     December 2008
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Political stability and forward-looking governments have helped Asian economies grow from within
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Asia’s Delicate Balancing Act

High levels of inequality can threaten stability and growth, but low or moderate levels may be healthiest

Photo by Mervin Malonzo

Globalization offers a tremendous opportunity to increase well-being at all levels of society, especially in highly entrepreneurial areas such as South and East Asia. Yet that opportunity could be wasted in many countries because inequality is rising. It’s a trend that could lead to serious economic and political problems in the future, despite strong growth in the present. Can it be controlled or even reversed?

In light of Asia’s recent economic history, this is a new and unwelcome development. Up until the 1990s, Asian economies— such as the Republic of Korea; Japan; and Taipei,China—were known for a surprising absence of high inequality during periods of rapid growth. Yet for Asia’s new emerging powers, the story line has changed. At the root of that change are the unmistakable patterns of globalization.

Asia has lately been enjoying some of the fastest economic growth in the world, largely because globalization has helped it to be connected with other regions as a supplier of raw materials, manufactures, services, and finance. To be sure, political stability and forward-looking governments have helped Asian economies grow from within as well. But two thirds of the world’s product markets lie outside of Asia.

Cambodia presents an excellent example of this situation, and of the phenomenon of inequality. The government of Hun Sen, who was recently reelected Prime Minister after 23 years with at least a share of power, has gradually encouraged Cambodians to diversify their economy and to pursue export markets. Tourism has flourished, as has a nascent textile industry. With help from experienced advisors, business people, and consultants— including hundreds of formerly exiled or expatriated Cambodians—the country has targeted niche markets in wealthy countries, such as apparel manufactured under high labor standards and organic rice.

Growth in Cambodia has averaged over 10% in the last several years. Exports rose from about $700 million in 1997 to over $4 billion in 2007. The average purchasing power of Cambodian families has more than doubled. Yet inequality is growing at both ends of the income spectrum—as the rich become fabulously richer, many poor Cambodians are getting poorer.

Why is this happening? In Cambodia, as in the majority of developing countries across Asia and the world, it’s easier to take advantage of the opportunities offered by globalization if you’re already well-to-do. Wealthier people tend to be more educated and more informed about markets abroad. They can detect the opportunities to export or attract foreign investment, and they have the money and know-how to follow through.

“Global markets are bigger, deeper, richer, and they do provide more opportunities for people that already have some assets,” says Nancy Birdsall, founding president of the Center for Global Development in Washington. “It can be financial wealth, but the key assets in the global economy are education and skills.”

Wealthy, educated people also tend to be better connected with government. Though it is now a democracy, Cambodia has an immature regulatory system and a fragmented tax-and-transfer system. Entrepreneurs can easily get tangled in red tape; Cambodia ranks 145th out of 178 countries in the World Bank’s annual survey on the ease of doing business. If you have money, though, these apparent problems are an advantage. You can use your money to cut through red tape and skirt regulations, and you won’t have to surrender much to the government as long as you stay in its good graces. In addition, Birdsall says, you’re likely to have access to economic opportunities controlled by the government, such as building contracts and import licenses.

How does this situation look on the ground? In Cambodia, dozens of poor villages in Phnom Penh and Sihanoukville, the capital and the principal port city, have been bulldozed to make way for new ventures. Land on the outskirts of Phnom Penh has been turned into manufacturing corridors, and beachfront property near Sihanoukville is being converted into resorts and shipping facilities.

Even in rural areas, wealthy business people are managing to take land from under the feet of families who have farmed it for generations. Because those families never had official titles, a little bit of legal expertise and a friend in the government can often be enough to turf them out. The World Bank and other donors are working feverishly to create titles for tens of thousands of Cambodian families—with the approval of the government—but many Cambodians have already lost their homes and livelihoods.

This story is not unique across Asia. Even in a democracy such as India, villages and slums have been summarily cleared to make way for new infrastructure, like roads and train links. The situation came to a head most recently in West Bengal, where the government bought land from farmers to make room for a Tata auto plant. After Tata took possession, the farmers began to protest, claiming that they had been compelled to sell at cut-rate prices. Finally, in September, the farmers blocked access to the plant and construction stopped. The irony was that the plant was supposed to produce the Tata Nano, the world’s least-expensive car and potentially a poverty-reduction mechanism in itself.

The backlash can occur even among middle-class people. In Bangkok, thousands took to the streets in September to rally against perceived corruption in the Thai government. These people were not indigents asking for a handout. Rather, they were ordinary workers who felt that their economic opportunities were being impinged and subverted by their nation’s wealthy elite.

Hundreds of millions of people have indeed been lifted out of poverty in the People’s Republic of China (PRC), India, and other fast-growing nations. At the same time, many citizens of those countries have become incredibly rich. They, too, have profited from the enormous opportunities created by globalization, and sometimes by the lack of checks on their ambition in their home countries.

Affecting Investment Inequality can cause social disorder and political instability
Photo by Eric Sales

This trend is creating vulnerability in Asia. High levels of inequality can be toxic for stability and growth. Research by economists at the Massachusetts Institute of Technology suggests that a low to moderate level of inequality is the healthiest situation; zero inequality suggests a socialist system, with little incentive for entrepreneurs, while high inequality concentrates wealth and opportunity in too few hands and opens the door to civil conflict.

“Inequality can cause a lot of social disorder and political instability, which will affect investment,” says Guanghua Wan, senior poverty reduction specialist at the Asian Development Bank in Manila. “The macro environment is not conducive for investment, and investment, of course, is important for growth.”

Education is another channel through which inequality can affect long-term growth. “Inequality is not good for human capital formation,” Wan says. Even if children of poor families have the talent to finish school and go to university, he says, their parents might not be able to pay the fees. Moreover, poor families tend to have more children, while rich families concentrate their spending on one or two kids.

The education example can be extended to economic opportunities in general, whether in an educational or an entrepreneurial setting. “The distribution of ability in a population is presumably not correlated with the distribution of current wealth,” Birdsall says. “You have a lot of poor people who never are able to exploit their ability.”

According to her research, inequality can cause a sort of feedback loop that leads to worsening economic outcomes over time. That danger seems to arise when countries pass a level of 0.42 in the Gini coefficient, a popular measure of income distribution. A Gini coefficient of 0 implies a perfectly equal distribution of income; a Gini coefficient of 1 implies that all the income in an economy goes to one person.

These numbers are set to rise, if they haven’t already. “Most countries are increasing inequality,” says Dipak Mazumdar, a senior fellow at the Munk Center of International Studies at the University of Toronto. “The single most important thing is high rates of return to education in developing countries. Most of the best jobs are for educated people. I’m not even talking about higher education, I’m talking about secondary.”

Education and training are crucial for the high-skilled manufacturing jobs that are contributing to growth across Asia, as well as for the service sector. The service sector presents an additional challenge, Mazumdar says, because it is extremely heterogeneous; jobs range from finance positions with skyhigh salaries to low-paying cleaning shifts in tourist hotels. As the sector grows, inequality rises almost automatically.

This sectoral shift in incomes is being accompanied by geographical shifts as well. According to Mazumdar, much of the inequality that is developing now has a regional element. “Some regions benefit much more than others,” he says. “This is particularly important in China. There will be huge regional inequalities.” The situation is similar, however, in India, Indonesia, and Thailand. “Even in a smaller country, you have this,” Mazumdar said.

In the PRC, the regional divide is a product not just of economic happenstance but also of explicit policy. Wan says: “Urban residents have tremendous preference in gaining university entry. It’s not only the quality of schools. Apart from that, they have a different entrance requirement for urban residents and rural residents. It’s a political thing.”

To avoid the risks of inequality, new policies may have to take these sectoral and regional elements into account. “The educational system is clearly necessary, but it will not reverse the regional inequality,” Mazumdar says. “Educated people will always go where the better jobs are.”

He proposes a two-pronged strategy— enhancing the productivity of agriculture in rural regions, primarily through better access to water; and encouraging industries that might normally locate in existing urban hubs to base themselves in less-developed areas.

“You can certainly do something about promoting industries that would not ordinarily go there,” he says, either through public investment or subsidies.

That kind of solution might work in India, but Wan argues that in the PRC it would be part of a losing battle against the rural-to-urban wave.

“PRC’s rural economy accounts for about 12% of national income, and you have about 60% to 65% of people living in rural areas,” he explains. “How can you bridge that gap? It’s too large to bridge through transfers. The only solution is to move these people from rural areas to get a piece of the urban pie.”

Rather than trying to transfer rural areas into employment centers, Wan suggests that the government should work to accelerate the process of migration. He proposes a complete about-face in the PRC’s treatment of migrant workers, who have fewer rights than longtime residents of the cities where they work. Wan says that they should instead be given privileged status, to encourage more rural people to move to cities.

In cities, he adds, the government will find it easier to reach people with other kinds of benefits, like education. “I’m not saying it’s going to be without problems,” he says. “It’s going to be one of the huge human development projects in human history. But I think it’s doable.”

Given the scale of these changes, a generation may pass before they significantly affect inequality. But because the risks of inequality are present today, governments may also want to consider shorter-term solutions. Birdsall says governments could do much to improve the economic frameworks affecting income distribution.

First, she notes, much of the difference in inequality between the United States and Europe comes from the tax-and-transfer system, which can be changed relatively quickly. “Governments should look at their tax regimes,” she says. “There’s probably room for them to become a little more progressive without becoming completely inefficient and over-burdensome on businesses.”

Second, she says, capital markets in Asia have a long way to go. Banking regulations in particular could be changed to give poor people more access to finance for entrepreneurial endeavors. “Governments should look carefully at the prudential arrangements and banking supervision. It’s much more than microfinance in the Muhammad Yunus variety. It’s developing mechanisms that give banks more of an incentive to lend to people who may not have as much collateral.” Clarifying property rights and giving titled land to poor people would help provide that collateral, she adds.

Birdsall’s main recommendation, however, is a lesson from history. The poorest countries in Asia, she says, “should follow the model that Taipei,China and Korea set in the 60s, which was very major investments in education and in roads that reach rural areas. Roads and schools, because those investments—which in that context were done because of the fear of Communism— that’s what made it possible for them to grow without inequality.”