Erik Berglof: State Capacity and Structural Transformation of the Economy

Transition countries have gone through a particularly profound transformation of its economic structures and institutions. Part of that structural transformation is about redefining the role of the state to allow markets to operate. But the state must continue its transformation to facilitate the development of the private sector. And my focus is gonna be on that broader transformation of the state and how it can fill its role.

Many countries have gone through dramatic transformations, and we should ask ourselves why are we interested in understanding this transformation? And I think the basic purpose is to understand how we can achieve growth and increase prosperity, and of course, address inequalities. There is an empirical observation that will be the basis for this presentation is that countries that grow more rapidly at lower levels of income also tend to grow faster at higher levels of income. So rather than this middle-income trap, which suggests that countries get trapped at middle-income levels are not questioning at this point that this does exist, but what seems to be a pattern is that countries that grew faster at low levels of income actually tend to grow faster also later in their development. So my conjecture is that this comes from a superior ability of the state to adapt. And this what I call transformational capacity, in turn, is held by the pressure stemming from its engagement with the private sector. You can think of pressures from the private sector that are deleterious or undermine institutional development and economic growth. But I will try to point to aspects of this relationship that can be much more favorable to economic growth.

Structural transformation, we use as a term to look at how economic structures change the shift from agriculture to industry to services, the technological changes moving to higher value-added products and so on, increasing skill levels. All these economic structures have to be matched by institution. So when we talk about structural transformation, it's a combination of these changes in economic structures and the changes in institutions. And of course, as an economy moves towards the world technology frontier, it must change the institution. It must change or the it will change the economic structures. For example, you move towards smaller firms, and more important for smaller firms in technological development. But if you take a country now that faces this gradual approach to the world technology frontier, it also has to consider how technology evolves at the frontier. So all these changes now going on in terms of artificial intelligence and robotics and so on, that will affect what kind of industry, what kind of structure, what kind of institutions countries need to have once they reach that frontier or once they come close to it. But there's also another aspect which makes the situation for developing, emerging countries now more difficult is that they also face, I think, much more binding environmental and social constraints than maybe countries that try to make this transition 20 years or so ago. So a very rapidly change in technology at the frontier and more binding environmental and social constraints. And what we are looking for to explain or to generate and see how we can build is this transformational capacity, this ability of economies to transform their institutions and at the same time, change economic structures. I don't think I can say that it goes one way you can use your institution to help promote structural change in the economy, but vice versa, you need to adjust your institution. So we are trying to understand this transformational capacity of institutions and all the economic structures. And it's really the ability of an economy to transform itself and what I'm gonna focus on is the capacity of the state to transform itself. And the argument I'm gonna make is that we need to build in these transformational pressures on the state and the private sector and construct institution that respond to these pressures.

And I'm gonna use infrastructure investment as an illustration. Every society needs many forms of infrastructure investment, differing in complexity and risk to deliver key public goods like health care, transport, housing and so on. And to do that, we need many forms of contracts. So some of them involve full state ownership. Some involve partnerships between the public and the private sector. In a sense, you can also say that socialism was the kind of extreme form of state ownership. And you are then trying to move to a mixed economy so that the transition is also very much a kind of shift in the nature of contracts. Of course, what contacts are feasible depends on the state capacity and the state capacity to raise revenues and to enforce contracts. And the private sector capacity also matters. How well can they manage assets? How well can they innovate in terms of how they develop different projects and so on? And the infrastructure investment is interesting because it's an opportunity to look at how we can use the private sector's engagement to enhance the performance of individual projects, but also to use that as a way to reform entire sectors and economies. So if I go back and look at transition, this was really about developing the private sector, but it was also about developing the state.

We do remember the credo from the 1980s and 1990s was all about privatise, privatise, privatise. I remember sitting through meetings in the early nineties in Moscow and there was this representative from the IFC of the World Bank. And he would say in every meeting he would end with these three privatise, privatise, privatise. I think in retrospect, I think it's sort of understandable that there were these sorts of simplistic messages because it was very much about addressing inefficiencies in public infrastructure that was sort of obvious to everybody. They were not really actually unique to socialism, even though they were maybe most extreme there. But I think there was much less attention paid at a time to how to make privatization and success. If anything, the focus was on incentives, how to compensate performance and make sure that the rewards were related to performance. And there was this view that the market liberalization would solve everything. But it became clear that it wasn't enough. We just regulation on capital market discipline. You also needed a competition. And you needed, in particular, I would say, functioning governance, including a functioning state capacity.

And when we look back at the transition experience, I think that's what was missing at the beginning. Of course, there is a very important role of the state there to enable the private sector and force competition policy to improve corporate governance, to strengthen border governance and transparency and those things, to deliver important public goods, infrastructure, health, and education, and to invest in R&D or to build a broader ecosystem for its capital. All that was the role of the state. Of course, there was also need sometimes to have more vertical industrial policies really trying to build individual sectors or address sector-specific challenges like in finance or human capital or in an individual sector. So all these were responsibilities of the state. And we needed to build the capacity.

So people have thought about what is state capacity? There's a very instinct framework developed by Tim Besley and Torsten Persson to understand state capacity. And they talk about two essential features of state capacity. One is the fiscal, or what they call extractive capacity. When you look around the world, what is truly remarkable is how countries have been able or governments have been able to improve and increase their capacity to raise taxes. And this is really at the heart of creating any effective state. It's also absolutely important to move from kind of redistribute states that just transfers income from one part of the economy to another, or from one part of the population to another, to really fund public goods and invest in public goods. And that for that you need fiscal and extractive capacity. The second part of the state capacity in the Besley- Persson framework is legal or productive capacity. It's really about protection of property rights and contracts. And this is to enable growth-inducing activities. So on the one hand, in order to be able to extract, you want the economy to grow so you can you know what the same capacity to extract you can extract more. It's also to promote innovation, productivity and growth, but what I find is that fiscal and legal capacity are complements, and it's really also this complementarity been, on the other hand, what explains tax compliance and the quality of institutions. People are more willing to pay taxes if they get quality from institution, so they go about to measure this.

So here is looking at fiscal and legal capacity for different high- and low-income countries. So the red ones are high income, the low incomes are blue. And you can see that it's so clear. Correlation is not surprising. But it's just to show you here is one looking at the property rights protection and the tax share of GDP. Again, you see that there's a strong correlation between them. So there's a whole literature on how to strengthen state capacity.I won't go into that very much now, but there is common interest, public goods helps you build state capacity. So when you can deliver public goods that benefit large parts of the population, that helps build state capacity again, helps build both fiscal capacity, extractive capacity, and legal capacity. It creates incentive to raise revenues and it allows you to invest in growth. It increases opportunities and shares prosperity. All that is part of building this what they call the common interest society. And Tim Besley has a more recent paper talking about how this is really built from below. And it's really critical to build this kind of civic mindedness and give people a sense of common interest to build a state capacity.

So this is when we talk about the transformation of the state, this is very much part of how do you build this kind of culture of delivery of high quality public goods and a willingness of the population to support those kind of public goods. So if you look at specifically at the role of the state in transforming the infrastructure, you have here very large complex projects where the state has an important role in planning, delivering, and financing. We're talking about transport, energy, housing, and telecoms. And these differ very much in terms of their complexity there, different in terms of the role of capital and operational expenditures. But all of them need a coherent, long term vision and policy stability. Superficially, socialism offered that kind of policy stability. But we know that even within socialist economies, there was a lot of fluctuations over time and failed experiments, and a lot of instability even within the system. But it's really to deal with these important risks that are involved in infrastructure investment. It's about risk associated with construction, how long it takes, when it's done, and all those things. There is the demand risk. Will there be enough demand for these services in transport or energy, whatever. That's a risk that has to be shared between the parties delivering this infrastructure. And that's the policy risk that you build. And an energy sector, and suddenly is changed, or you promote renewable energy, and then you suddenly change the rules afterwards. And that kind of risk is something that also needs to be handled in infrastructure investment.

If we start with the incentive side, these utilities in the past were maybe not compensated based on performance, but they were actually often monopoly. So performance is not as easy to reward straightforwardly. You need regulations and standard. You needed to link sort of private providers and the public regulator. You need to create competition. And when you have monopolies it is very difficult. So you try to maybe create competition in the vertical sense. So you give concessions to private operators for a particular period of time. And then you auction out these concessions. And then you renew these auctions when the concessions run out. So that's a way to deal with incentive problems in infrastructure. And you can bundle construction and service provision together with a single operator, you can, for example, build an operator your own, you can allow the operator to do this. You could build and then lease it to the operator that also operates it. These are all several other forms of combination of contracts, but these have been the ones that have proven to provide the best incentives, and there are several papers on this. This leads to very long contracts and putting very large risks on the operator. So ultimately, you need to find a way of risk-sharing between the state and the operators, and has to be sort of an optimal trade-off, on the one hand, providing incentives and on the other, making sure that you share the risk so that you actually can attract private parties into the transaction. In addition to that, you need to provide incentives to actually generate new projects, and also financing a new project. This is a major problem in many parts of the world, what we call bankable projects that can actually attract funding, and that's a seriously incentive issue.

The other aspect of the relationship between the state and the private sector is about governance. It's very important, like in any financial contract, how you allocate return streams and the risks and so on associated with those, and how you allocate control rights. It's very much the same in infrastructure, and governance is about that. You have to ask, should private investors be senior creditors? Should they have some intermediate form, or should it be equity? If debt, should it be guaranteed by government sovereign guarantees? And what control right should the private investors have? What protections against all odds by the government? Most investors typically prefer security in low-risk brownfield assets, and greenfield investments from new projects have many risks – construction, regulatory, demand risks, very long payback periods, as I mentioned. Most investors only want to hold senior, secured and ideally guaranteed debt, and they also want their holdings to be liquid, even if they’re long term, so they can sell them if they need to. All these suggest the need of risk-sharing between the private investors and the government. This is the way also to provide incentives for the state to participate, to contribute, and to learn. What I'm looking for is the kind of transformational pressures that are inherent in this kind of arrangement.

If you look at infrastructure, the role of the state and the private sector is not only about risk sharing, but also about governance. It's about how to internalize the externality of public goods without excluding the beneficiaries or without excessively including the beneficiaries. The sophistication of government and the private sector evolves over time. As they get more sophisticated in handling this, they can develop more sophisticated ways of interacting and learn from each other. What is also very important is that this environment of infrastructure investments, of course infrastructure investments stretch over such a long period of time, a lot changes happen over time. And they may force renegotiations, actually very often force renegotiations with very few of these long-term contracts unable renegotiated. To give you an example of a type of contract that are being increasingly trying to emulate. It is called value capture, like when you try to make sure that the benefits of these particular infrastructure investments. For example, companies that are close to a new subway or a new bridge or places where people living, their idea is to try to extract value and use that to finance the investment. This is what we call value capture. The metro transit thing in Hong Kong is an example of all that works. And again, it's an example of how by thinking ahead and working with the government and the private sector, you can find ways of funding projects that otherwise would not happen.

If you look back at the infrastructure privatizations of the eighties and the nineties, there have been many disappointments not only in transition countries. This early evidence was encouraging, but the infrastructure finance volume has come down since the global financial crisis. Particularly, we don't seem to be able to generate enough greenfield infrastructure investments. And this literature on PPPs, public private partnerships, seem to be entirely focused on incentives and not really on the financing and these governance issues that I mentioned. PPP investments have also become very expensive compared to public funding because of pricing risk and other extra cost, and that means the user costs go up and often combine with deteriorating service because of budget cuts and so on. All this has given infrastructure privatization, PPP in particular, a bad name. In fact, infrastructure investment has anything slowed down, even though needs are huge and rapidly growing. So we definitely need new ways of mobilizing capital and sharing risks. But it's very important when we do that, we also keep in mind these pressures to transform the state and the private sector. It is not enough just to build hospitals, but you also need to improve and create pressures to improve how they operate, whether they operate efficiently or not. That's the key to getting this transformation of the state and the transformation of the private sector to work together, and part of that is also to encourage more sustainability in a more long-term approach to impact on the climate and local environment.

So I think when we, so we want to see how we can use the private sector to transform the state. Often we know that the public sectors are neglected, low salaries, weak results framework, poor human capital because of this. But we want to harness the private sectors’ energy and skills, getting quick feedback from markets and incentives to respond and so on. These cannot translate directly to the public sector where most cases not, but you can still bring in some of that. Also when it comes to private sector management techniques, it's important to recognize that managing in the public sector is different from managing the private sector, but there are still valuable techniques in bench marking and certification and so on that can help you develop the public sector. And I think what's important also is that once you have state-owned firms, if you can apply functional equivalence so that if they behave as if they were private and with the proper management and living up to proper standards, they should be also treated as in the same way by regulation. That, I think, is the ultimate goal. And again, you can see how this builds pressures to transform the state by also transforming the private sector.

And that brings me to innovation, which is very central to productivity growth because innovation incorporates imitation, adaptation, genuine innovation, and products and processes, and ways of organizing yourselves that are genuinely new to the global economy. Innovation helps you bring new technologies that enhance innovation, about intellectual property, or R&D policy regulation and competition policy, ultimately about improving efficiency, both in terms of resource allocation and what kind of management practices are used. As I said at the very beginning, and I think this is very important to remember when we look at these transformational pressures on the state and the private sector, and how they interplay. The role of the state and the private changes as the economy moves closer to the world technology frontier. It becomes more important to have financial system, for example, that can provide risk capital to smaller firms. More of the innovation comes in smaller firms and new firms rather than existing firms. So you need to adjust both the funding system but also regulation and so on to adjust to that. As technological change accelerates, again, that puts even more pressure on getting these new firms in, and environmental and social constraints put pressures on sustainability, getting those kind of technologies that allow you to meet environment and social standards. So these pressures, as I said, are particularly strong enough for emerging and developing economies that want to reach the state of advanced economies. And it's probably more difficult today to do that than 20 years ago. And that's what we need to really understand, how we can enhance the transformational capacity of individual economies.

As the one last comment, since I'm now again back to working in a development finance institution, I think that development finance institutions can really serve as catalysts for bringing out these transformational pressures by helping to engage the state and amplifying direct private sector activity so that really helps improve what the state does and how it works to help enable the private sector. Development finance institutions can help manage political risk in many different ways, but particularly in the way they are owned by the countries where they operate. They have tools that private financial institutions don't have, and they can share financial risk. They are backed up by the credit worthiness of shareholder governments, and that helps them to absorb that risk .I think there are limits to how much they can absorb, but it's an important part of what they do. They can help promote the environment of infrastructure investment, the business climate, and the broader institutional quality. This is something that's very difficult for individual financial institutions to do. For example, these development finance institutions, they can be particularly effective in building sector contexts, for example, building the energy transition, going from carbon-based sources to renewable sources, building that whole through ecosystem of institutions and economic structures that are needed to achieve that transition.  These development finance institutions are well adapted to play that role. Of course, the capital that they can provide on their own books is limited, but I think the real possibility here is to allow these development finance institutions to become essentially channels for institutional capital going in to emerging and developing countries, and particularly going into infrastructure, and using the fact that you have all these through institutions that are managing long term capital, the pension funds, and so on, giving them long term assets to place with high returns in emerging and developing countries. We know that this is very difficult, and a lot of these risks that are discussed before makes this complicated. And there is an understanding now that we need to make this liquid. But what is important here is that the development finance institution had the capacity and should develop skills to monitor these investments that may be individual institution investors cannot develop. So the development finance institutions can help to amplify the pressures of transformation, both from the state and private sector.

Let me summarize that. We started with this notion of structural transformation that is about transforming both economic structures and institutions, and they need to be compatible. We were looking for some kind of transformational capacity of institutions and structures that could really help bring about innovation and explain also why some countries seem to be able to grow faster at all levels of income and what are the sources of that transformational capacity. And of course, what is the role of the state in enabling the private sector to develop, and also how to use the private sector to develop the state transformational capacity that the state has comes, I argue, in large part from its ability to learn and interact with the private sector. I emphasized that privatization is not a panacea. It needs institutions. It needs a context. But it can play a very important role and it doesn't necessarily mean you have to give everything to private investors of private operators. There are many solutions in between. You have to think about what the optimal risk sharing arrangement and the optimal governance arrangement is, but clearly involving the private sector has many opportunities. And these public private partnerships are difficult, but when they work, they can be truly developmental. Thank you very much.

【Q & A】

1. When you say the “state”, do you refer to the summation of the military service, the court, the administration, the legislation, and so on so forth? And of which, among all these agencies of the state, would you see the administration part? Is government the most important component?

When I use the state here, I think of all the sort of public institutions. But of course, on top of the state institutions, the agencies, and as you said, the military and so on, there needs to be strategic thinking and a capacity to use these tools of the state. I think a large part of developing the state is to improve the relationship between the commanding heights of the government and all these agencies and instruments that the government has.

2. How do you see the difference between state and the government? Would you see that, roughly speaking, they are the same?

It's a good question. I've used it as identical as the contrast between private sector and the public sector, you can say that in some way the government is hovering over it all and providing the context for this interaction between the state and the private sector. But it's probably fair to say that most of the political sort of decision making and so on. That's where the government is involved in the state is not involved in the same direct way in the private sector. But it is probably work for a distinction to make even in the framework that I'm thinking about, I haven't made that distinction in this particular presentation.