INDUSTRIALIZATION, POLICY, AND GROWTH: The Philippines versus East Asia*

Jamil Paolo S. Francisco Department of Economics School of Social Sciences Ateneo de Manila University

March 2008 *Draft only. Not for citation.

The story of Philippine industrialization started well. Rich in both natural and human resources, with then arguably one of the highest educational standards in the developing world, and with privileged access to the U.S. economy, the Philippines seemed well-equipped to meet the challenges of development as a newly-independent nation in the late 1940s. As the story progressed however, it became mostly disappointing. Both the country and its industrial sector were early leaders in East Asia, but neither has lived up to expectations. Figure 1.1 Growth of GDP and Industrial Output

This is in stark contrast with most of the countrys neighbors whose starting positions were less favorable but now enjoy per capita income levels much higher than that of the Philippines. The economies of Korea, Thailand, Malaysia, Taiwan and Singapore are notable examples. For instance, from being one of the poorest countries in the region, South Korea has become an industrialized OECD-member country in a little more than three decades. Objectives This paper reviews the path of Philippine economic history and the direction of government industrial policy from the 1960s to the present. A host of determinants are examined in an attempt to identify factors, from the traditional to the controversial, to which the countrys poor performance can be attributed. Towards the end of the paper, an empirical study is used to support the hypotheses offered. The papers research objectives are as follows: To review the path of Philippine industrialization and examine industrial policies in comparison with selected developing and newly-developed economies including but not limited to South Korea, Malaysia, and Taiwan.

To identify specific growth determinants that have contributed to the miracles of East Asia and assess the Philippine performance with reference to these factors.

To provide an empirical analysis in support of the growth determinants hypothesized in the discussions.

Trends in Industrial Output and Growth A sizeable manufacturing sector had formed in the 1950s and 60s, partly due to protectionist, importsubstituting policies, supported by a well-developed human capital base (Hill, 2003). In the late 60s, a policy shift towards export-orientation began to realize but the poor performance during the last 30 years seems to indicate that, since then, industrial policy has been either misguided, ineffective or lacking. Since the late 1960s, the growth of the manufacturing sector has been slow and its GDP share has persistently remained below 30%. Domestic manufactures continue to be mostly low-tech; and exports, although recently rising, have become increasingly concentrated in one particular product group (electronics) where the sectors value-added is low. Figure 1.1 reveals how an erratic growth path at comparatively low levels may have kept the country from reaching its full potential. The 1980s, for example, had essentially been a lost decade for the Philippines. The massive inflows of FDI during the period that led to rapid industrialization in the countrys neighbors such as Thailand and Malaysia had skipped the Philippines, which then faced huge political and economic challenges. It was during this decade that the country experienced its worse recession, with GDP shrinking by almost 10% for two consecutive years. The debt-driven pump-priming strategy adopted in the previous decade proved to be unsustainable as signs of trouble began to show in the early 1980s a growing balance-of-payments deficit, rising inflation, worrying budget deficits, and deteriorating market confidence . In 1983, the assassination of Benigno Aquino in late August precipitated economic collapse, and the rest is history so to speak. Industrialization has been characterized by a similar persistent boom-bust cycle, reflecting the overall economys performance. The fact that movement in industrial output seem to have closely followed fluctuations in total output can be attributed to the local manufacturing sectors predominantly inward orientation, which has made it mostly dependent on domestic demand. It is also worth noting how swings in industrial output growth have been more pronounced in every fluctuation of GDP growth a sign of stickiness between output trends. Reflecting its comparatively high initial income per capita and early push for industrialization, the Philippines had a relatively high share of manufacturing in the 1960s. Figure 1.2 reveals, however, that Philippine manufacturing share in output had remained almost unchanged in the last 30 years; whereas that of Korea and Malaysia had steadily increased until leveling off in the late 1980s and early 2000s respectively. Taiwans manufacturing share of output, on the other hand, has been declining after reaching its peak in the late 1980s. Figure 1.2 Manufacturing Share in Total Output for Selected Asian Countries

Korea, Malaysia, and most especially, Taiwan appear to be classic examples of Chenerys model of structural transformation from agricultural production to manufacturing and finally on to services as a country progresses. On the other hand, a closer inspection of Philippine data seems to test the possibility of leapfrogging from agriculture to services despite incomplete industrialization. Figure 1.3 Relative Shares of Agriculture, Industry, and Services

Theories on development, such as Lewis two-sector model predict the structural shift away from the agricultural sector and towards the modern industrial sector. The Philippine case seems to be an exception however, since the share of industry has remained at more or less the same level, in spite of the decline in agriculture (Figure 1.3). Meanwhile, services now account for more than half of total production. The absence of a rapid and sizeable structural shift to the industrial sector is unique to the Philippines in the context of its South East Asian peers (Hill, 2003). It is also rather troubling, given the correlation between manufacturing share and GDP growth. Rodrik (2006), in a comparison of trends in manufacturing shares across five regions (East Asia, South Asia, Latin America, the Middle East and North Africa, and Sub-Saharan Africa) shows that the countries that have been growing most rapidly were those with large manufacturing sectors. Data from recent years reveal the continuing high-growth trend in the

industrial sector of most of the countrys neighbors and the Philippines relatively poor performance. Figure 1.4 shows growth rates of industry for selected countries between 1999 and 2004. Figure 1.4 Growth Rates of Industry for Selected Asian Countries

De-industrialization and the shift to services is expected in high per capita income countries like Korea, Taiwan, and Singapore but not in low per capita income countries like the Philippines. Figure 1.5 places Philippine per capita income in its regional context. Figure 1.5 Real GDP Per capita of Selected Asian Countries

Hill (2003) offers three explanations for the industrial sectors stagnation . First, he argues that trade liberalization in the 1980s through the 1990s provided average nominal protection rates to agriculture that exceeded those in manufacturing, creating a resource allocation bias against manufacturing. Following these reforms, the industrial sector had become increasingly labor-intensive, contributing to a fall in value-added. A second factor, according to Hill was the real appreciation of the peso through the 1990s up until the Asian financial crisis. This real

appreciation was due to small nominal appreciations of the local currency plus higher inflation in the countrys major trading partners. The overvalued peso reduced the competitiveness of Philippine manufactures. Finally, tightened labor market regulations pushed wages upward in the formal sector so that relative wage levels in the Philippines are now considered high compared to those of its neighbors, again also affecting competitiveness. Export Structure and Growth In 1960, the value of Philippine exports was a third more than that of Malaysias, four times that of Thailands, and about twenty times that of Koreas. By 1990, however, it was clear that the countrys exports had lagged far behind the late-bloomers. In 2005, the value of Korean exports was more than 6 times as much as the Philippines, Malaysias exports nearly three times as much, and Thailands exports twice as much. As a result of slow export growth, the level of Philippine exports has remained below that of many of its neighbors since the early 1990s (figure 1.6). Figure 1.7 shows export growth among Korea, Malaysia, and the Philippines. The trend line for the Philippines reveals a flat trend at low average growth at around 6 to 7% for the period 1960 to 2006.

Figure 1.6 Export Levels of Selected Asian Countries

Figure 1.7 Export Growth of Selected Asian Countries

Although export growth has generally been slow and erratic in the last 40 years, the early to mid-1990s saw seven consecutive years of positive growth, growing above 10% for four years. This significant acceleration has been mainly attributed to the infusion of foreign-owned electronics investments in export zones. Total value of exports in real terms more than doubled between 1990 and 1997. So tremendously successful has the electronics export sector become that it now dominates Philippine exports (merchandise), with electronics and machinery accounting for close to 70% of total export value in 2005. Although Malaysia and Korea are also heavily dependent on electronics exports, neither compares to the Philippine case. Figure 1.7 Export Dependence on Electronics and Machinery of Selected Countries (2005)

Over the period 1990-2000, total exports increased nominally by US$30.3 billion, manufactured exports rose by US$28.2 billion, while electronics and machinery increase by US$28.5 billion, meaning export growth was mainly led by manufactured exports, and among manufactured exports non-electronics exports actually declined slightly. It is

sometimes argued that high concentration on a narrow product group, particularly electronics is an inherently risky activity that does not provide the basis for sustainable, broad-based industrialization. For one, the electronics sector is said to be characterized by shallow linkages with the rest of the economy and is therefore prone to migration as soon as real labor costs begin to rise or fiscal incentives expire. Although the electronics industry covers a broad spectrum from labor-intensive, low value-added activities to high-skill, research-intensive ones, Philippine manufacturing activities have remained at the labor-intensive, low-value added end of such spectrum. Semiconductors are by far the largest item among the countrys electronics exports. Unfortunately, semiconductor manufacturing in the country is essentially an import-export operation, where local value-added is thin, backward linkages are not fully developed, and R&D contribution is negligible (Hill, 2003). A second, perhaps more fundamental concern is that such high export dependence on a narrow product group is contrary to the common pattern of outward-oriented industrialization in East Asia. Imbz and Wacziarg (2003) examined patterns of sectoral concentration in a large cross-section of countries, as well as within countries over time, and discovered that as incomes increase, economies become less concentrated and more diversified in production. Only upon reaching relatively high levels of income does further growth become associated with increased specialization. In other words, a graph of sectoral concentration versus income per capita produces a U-shaped curve. From this point of view then, Philippine dependence on electronics exports may be problematic. Rodrik (2006) puts it bluntly: diversification is a key correlate of economic developmentpoor countries produce a relatively narrow range of goods, while richer countries are engaged in a broad range of economic activities. Unlike many of its better-endowed neighbors, the Philippines had lost its comparative advantage in most resource-based industries (Hill, 2003). Figure 1.8 below illustrates how the countrys exports had shifted from primarily unprocessed metal, sugar, and wood products towards electronics and machinery. However, the countrys performance record in other labor-intensive industries, apart from electronics, has also been disappointing making the success of the electronics sector an oddity. Hill offers a plausible explanation. The answer appears to lie in the countrys export policy regime. Electronics has succeeded because of very liberal provisions applying to the exportprocessing zones, where most foreign-owned electronics investments have poured in. Firms in these special economic zones enjoy no foreign ownership restrictions, minimum bureaucratic hurdles, attractive fiscal incentives, adequate utility services, and quick access to international markets. In other words, electronics firms are spared from the constraints that have generally held back firms in the rest of the economy. The success of the Philippine electronics sector is no doubt an example of successful industrial policy in terms of picking winners at least in terms of providing incentives to export manufacturers that are allowed to locate themselves in the particular export-processing zones. Picking winners has resulted in mixed outcomes for the Philippines with a number of disappointing stories. In the late 1960s, the government sought to promote the countrys automotive industry through a special program that offered heavy protection to up to five local assemblers that were expected to steadily increase local content through subcontracting. As it turned out, anticipated technological transfers did not occur and subcontracting networks failed to proliferate (Hill 1985), but vested interests thereafter developed to maintain protection. In 1990, the cost of protection was equivalent to about 40% of the value of motor vehicles sold to consumers (Takacs, 1994). Despite its early lead, the Philippines had lost the auto industry to Thailand, which has become the regions leading automotive manufacturer. Figure 1.8 Shares of Selected Items in Total Philippine Exports

In the famed article by Hausmann, Hwang, and Rodrik (2005), an index of the income level of a countrys exports is constructed, and is made to demonstrate how the mix of goods that a country produces has important implications for economic growth. The index basically measures the quality of each countrys export basket. The study concludes that countries that produce a set of goods that are placed high on the spectrum tend to perform better than the ones that produce a lower quality of goods. Using an index of export productivity (EXPY) developed by the author closely following Hausmann, Hwang, and Rodrik, the Philippines appears second on the list in terms of export productivity among 12 selected countries in East Asia, and South and Central America. It may be to the surprise of many to see the Philippines receive one of the highest scores, suggesting that the country must then be one of the better performers. Table 1.1 Export Levels of Selected Asian Countries
Country Korea Philippines Malaysia China Mexico Thailand EXPY
11,814.51

Country Brazil India Indonesia Argentina Chile Vietnam

EXPY 8,660.06 8,337.84 8,193.36 7,619.88 7,182.38 6,836.39

11,502.12 10,974.02 10,785.95 10,758.99 10,613.77

A closer inspection of the export structure of countries provides valuable insight to the physical make-up of exports. In the analysis that follows, items are categorized into four groups: group I being the lowest, composed of low-income/low export productivity goods such as sugar, coffee, cereals, and beverages, and group IV being the highest, including goods such as medical products, precision equipment, machinery, and electronics (for a complete list of groupings, please refer to Appendix A). Since Philippine exports have been dominated by electronics and machinery, it is no surprise that group-IV items now make up about 70% of the countrys total exports. Figure 1.9 shows the export structure of the Philippines (a), Korea (b), and Malaysia (c). These three countries have the highest

group-IV concentrations of exports among those studied. In plain words, these three countries have the most hitech exports goods that have been mostly associated with high-income countries. Figure 1.9 Structure of Exports

Like the Philippines, the export sectors of Korea and Malaysia are dominated by group-IV items, mostly electronics and machinery. But, there is no contention that unlike Korea and Malaysia, the Philippines is a lowincome country, and the countrys growth performance has been anything but remarkable. In 2006, Korean real GDP per capita (US$13,865) was twelve times as much as Philippine per capita income (US$1,175); Malaysias was four times as much (US$4,623). Per capita income growth from the period 1965-1995 averaged 7.2% in Korea, 4.8% in Malaysia, but only 1.2% in the Philippines. Does the Philippine case then present a challenge to the correlation between export mix and economic performance observed by Hausmann, Hwang, and Rodrik? An examination of the structure of domestic manufacturing is presented in the discussion that follows. Domestic Manufacturing and Industrial Policy Closer examination of domestic manufacturing reveals how the structure of Philippine exports is nothing like that of the manufacturing sector that comprises it. In contrast to how group-IV manufactures dominate the export sector, group-IV manufactures account for only 20% of the total value of domestic manufacturing. Meanwhile, group-I manufactures constitute more than half. Food, Beverage, and Tobacco has continued to dominate domestic manufacturing since the 1960s, accounting for 45% of domestic manufactures in 2006. Figure 1.10 Structure of Philippine Manufacturing Sector

The dissimilarity between the countrys export sector and its manufacturing industry is a peculiar case indeed. In Korea, Malaysia, and Taiwan, the structure of domestic manufacturing is similar to that of the export sector; with group-IV items dominating domestic manufacturing (refer to Appendix B). The inconsistency of the Philippine case raises a number of questions. How can the export sector thrive in high tech manufacturing while the rest of local industry continues to be dominated by low tech production? Why has the share of domestic industry languished while export manufactures (electronics) have led the growth of export share in total output in the last two decades? What is behind the success of electronics exports? What is behind the failure of domestic manufacturing? What role has industrial policy played? Johnson, Ostry, and Subramanian (2006) examined cases of growth acceleration and found that nearly all cases took place in the midst of a rapid increase in the share of manufactures in total exports. Jones and Olken (2005) found that accelerations were associated with increased manufacturing share of total employment. Neoclassical explanations of rapid growth in East Asia emphasize the role of sound fundamentals capital accumulation, macroeconomic stability, and outward-orientation with few price distortions. The World Banks report on the East Asian Miracle (1993) acknowledged the important role played by governments in Japan, Korea, Taiwan, and other Asian economies in getting the basics rights, along with interventions that promoted exports and encouraged savings and investment. Governments were said to have intervened heavily but in a market friendly way. One of the supposed secretes of success of the Asian tigers was the willingness and ability to adjust policy to meet the changing needs of their growing economies. Most of the debate about industrial policy in East Asia has centered on the seemingly unique ability of governments to identify strategic industries and allocate scarce resources towards them (Hernandez, 2004). These industries are usually those considered to have high export potential or high learning spillovers. The promotion of specific sectors changed the industrial structures of Japan, Korea, and later on, Taiwan. For example, the success of steel, shipbuilding, automobiles, and electronics in Korea has been attributed to successful government industrial policy. Nevertheless, there also have been disappointments such as the automotive industries in Malaysia and the Philippines. The soundness of picking winners certainly has been a point of contention but most economists agree that efforts to promote specific industries are unlikely to be successful without first getting the basics right. With few exceptions, East Asian economies have been successful whether because of or in spite of government intervention largely because of their fundamentals macroeconomic stability, investments in human capital, and adequate infrastructure. Hernandez (2004) cites the Philippines as an example of how picking winners could be unsuccessful without the right fundamentals in place. Determinants of East Asian Growth Capital accumulation is the primary key to growth in the neoclassical perspective. It is no surprise that most of the growth in East Asia during its miracle years has been attributed to this. Figure 1.11 shows how Philippine capital formation as a percentage of real GDP has seriously lagged behind that of its neighbors. The average in the last 20 years has been less than 23%, and in 2005, capital formation share of total output was as low as 16%. Figure 1.11 Capital Formation as Percentage of GDP for Selected Asian Countries

It comes as no surprise though that capital formation in the Philippines has been weak, given that the countrys savings rates have been anemic, well below East Asian standards (figure 1.12). Much of the countrys economic activity has for many years been mostly consumption-driven. Investor confidence has generally been low, especially plagued by corruption concerns and bureaucratic red tape. Partly to blame as well may be the countrys chronic fiscal deficits. Unlike the governments of most of its high-growth neighbors, successive Philippine governments have almost always been net borrowers. Also to blame may be the fact that the Philippines had not experienced long periods of sustained growth similar to that experienced by each of East Asias best performers. Political instability in almost every decade since independence has exacerbated the cyclical nature of the countrys economic performance. In a study by Harrigan (1998), high savings rates were seen to invariably follow periods of sustained growth. Figure 1.1 at the beginning of this report illustrates how growth has been erratic since 1980, with boom-bust cycles occurring every 4 to 5 years.

Figure 1.12 Savings Rates across Selected Asian Countries

Investments in skills and infrastructure explain a great deal of how Japan, Korea, Taiwan, China and Singapore moved up the technology ladder (Hernandez, 2004). . The governments of these economies pursued policies to promote the development of high-tech sectors such as electronics and semiconductors. Along with these investments of course, came new technologies and learning opportunities. Japan and Korea especially relied on licensing and reverse engineering to access foreign technology. Large industrial conglomerates like the chaebol in Korea were given subsidized credit, protection from imported goods, and fiscal incentives. Discipline, however, was attached to the protection afforded them by government. Firms were required to report their performance regularly, so the government had up-to-date information of the developments in each sector. Government support often depended on export performance. Individual firms that met export targets were given more favorable treatment (Hernandez, 2004). In Taiwan, on the other hand, public research institutions played a larger role in promoting new technologies and coordinating industry-specific R&D. Singapore, meanwhile, relied heavily on FDI to bring in both foreign capital and foreign technology. However, it was not enough for Singapore to simply attract FDI; it also sought to increase the ability of local firms and workers to absorb new technology through domestic linkages and on-the-job training. Soon, the agency in charge of attracting foreign investments began to focus on increasingly more sophisticated technologies. As local economies progressed, research and development began to provide the key to sustained growth in East Asia. The flying geese hypothesis postulates how countries shift from labor-intensive to capital-intensive industries as real wages begin to rise and developing countries begin to lose their comparative advantage in cheap labor. This was seen in Korea and Taiwan following Japan, and then in Malaysia and Singapore following Taiwan and Korea. By the time developing economies reach the turning point, simply borrowing technology from developed countries becomes inadequate. R&D then begins to play an important role in developing new home-grown technologies. Figure 1.12 below shows estimates from various sources of R&D expenditure as a share of total output for selected countries in different years between 2002 and 2004.

Figure 1.12 R&D Share of Total Expenditures for Selected Countries

Source: Nationmaster.com

Philippine R&D expenditure is estimated at a mere 0.11% as of 2002. It is argued, however, that since the Philippines has yet to reach its turning point, it still has the luxury of being a technology borrower (Hill, 2003). According to Hill, more than worrying about research and development spending, the government should focus on removing barriers to the inflow of technology, and on ensuring sufficient absorptive capacity for these new technologies to be utilized by local economic agents. Whether growth in East Asia can be attributed to factor accumulation or to advances total factor productivity (TFP) has been the subject of much debate. A number of these found the contribution of TFP growth to output growth in the region to be negligible (Kim and Lau 1994, Young 1992, 1995), suggesting that the secret behind the East Asian miracle was nothing particularly extraordinary. Table 1.2 below summarizes the findings of a number of studies as compiled by Wong and Ng (2001). In contrast, high and sustained rates of investment in the region have no parallel among developing countries.

Table 1.2 TFP Growth Estimates across Selected Asian Countries

Inclusive Years Kim and Lau (1966-1990) Young (1966-1990) Lindaur and Roemer (1965-1990) World Bank, Miracle (1980-1989) Thomas and Wong (1960-1990) Hsieh (1966-1990) Manti (1970-1990) Collins and Bosworth (1960-1984) (1984-1995)

Korea 1.2 1.7 4.9 3.1 2.1 1.7 1.4 1.5 2.1

Taiwan 1.2 2.6 4.9 3.8 3.6 3.8 2.1 2.0 3.8

Hong Kong 2.4 2.3 3.6 3.6 4.0 2.8 2.4 -

Singapore Malaysia 1.9 0.2 3.6 1.2 2.8 2.2 1.4 1.5 3.1 1.1 1.1 2.2 0.4 0.9 1.4

Thailand 3.2 2.5 1.6 1.8 3.3

Source: Wong and Ng (2001)

Whether gains in TFP or factor accumulation (or both) are behind the miracle of East Asia, Philippine performance has been poor compared to its peers in either criterion. It should therefore not come as a surprise that the country had failed to achieve the levels of development enjoyed by its neighbors. The role of trade policies in East Asia has also been the subject of debate, particularly on how these policies may have supported industrial policy. In contrast to Latin and South American countries, export shares in East Asia have been large (Figure 1.13). In the early 2000s, for example, Malaysian exports were valued at about 120% of GDP, Thai exports at around 70%, and Vietnamese exports at around 60%. During the same period, Chilean exports were only at around 35%, Mexican exports at around 30%, and Argentine exports at around 25%. Trade regimes in East Asia have been largely described as export-oriented, while those in Latin and South America have been considered rather inward-looking characterized by protectionist trade regimes and importsubstitution. It is important to note however, that many East Asian economies, with Hong Kong and Singapore as notable exceptions, had also used high tariffs and quantitative restrictions to protect local industries. These policies however were offset by incentives regimes and exchange rate policies meant to promote exports (Hernandez, 2004). After brief experimentation with import-substitution, Taiwan moved to export-orientation in 1958, introducing duty exemption schemes and export processing zones to promote foreign investment in the export sector. Korea followed in the mid-1960s, but kept restriction on foreign investment. Indonesia, Thailand, and Malaysia abandoned import-substitution and began promoting exports in the 1980s. By then, Taiwan and Korea had significantly liberalized their economies, while China began to reduce tariffs and started to welcome foreign investments (Hernandez, 2004). As discussed in the earlier section on exports, a remarkable trend in East Asia during this period is the increase in the share of manufactured goods in total exports, replacing agricultural products as the primary export of the region. This is true for the Philippines, as electrical and non-electrical machinery began to surpass wood, sugar, and metal ore exports by the late 1980s. Similar shifts are observed in Malaysia (Figure 1.14) and Indonesia. In contrast, no similar shifts have occurred in Latin and South American countries like Argentina and Brazil, with the exception of Mexico (refer to Appendix C). Figure 1.13 Exports as Percentage of GDP across Selected Countries

Figure 1.14 Shares of Selected Items in Total Exports

Figure 1.14 Shares of Selected Items in Total Exports

The rise of manufactures in total exports, along with the growth of exports in general, is associated with higher economy-wide productivity growth. Westphal (2001) proposes that the existence of export-related knowledgetransfer mechanisms may be higher for new export products rather than continuing exports. This means that the shift from traditional exports to new exports of electronics and machinery may have been instrumental in helping East Asian economies access foreign technologies. It may not be surprising then that the periods during which group-IV export shares in Korea and Malaysia began to rise, have also been periods of high GDP growth. In this light, a possible explanation to the disappointing development record of the Philippines in spite of its remarkable performance in group-IV export growth is the economys inability to absorb new technologies from the hitech export sectors and to develop domestic linkages through backward integration. Hill (2003) proposes that the enclave nature of export processing zones may be partly to blame. Unfortunately, technology transfer to the rest of the economy and backward integration may not be automatic. For this reason, the countrys share of group-IV manufactures in total domestic output remains small in spite of the very high share of group-IV goods in total exports. In summary, three factors appear to be the most important determinants of growth in East Asia. These are: capital formation, the adoption (rather than invention) of new technologies, and export-orientation. Determinants of Group-IV Manufacturing Share An empirical analysis of the shares of group-IV items in domestic manufacturing and its possible determinants is performed on pooled data from four Asian economies Korea, Malaysia, Taiwan, and the Philippines from the period 1989-2005. A cross-weighted panel regression with fixed effects is chosen among several models. Using cross-sectional weights helps correct heteroskedasticity, common in cross-sectional data from multiple heterogeneous sample sources as in the case of the four economies under study. Assigning fixed effects estimates different intercepts for each cross-section. The general specifications for each cross-section are as follows: grp4percap = + 1 pcapform + 2 rgdppercap + 3 reer + 4 mfgshare + 5 ar(1) + (1)

Group-IV domestic manufacturing output per capita (grp4percap) is regressed on capital formation as a percentage of GDP (pcapform), real GDP per capita (rgdppercap), real effective exchange rate (reer), share of

manufacturing in total output (mfgshare), and an auto-regressive term. Capital formation is expected to be positively related to the dependent variable, as group-IV manufacturing usually demands heavy investment in physical capital and public infrastructure. Capital formation can also be an implicit indicator of new technology absorption. Investment in physical capital generally requires adoption of foreign technologies to put the new capital to use. Real per capita output is also expected to be positively related to group-IV manufacturing as rich countries tend to produce mostly hi-tech, high-level manufactured goods. The real effective exchange rate, on the other hand, may be either positively or negatively related to the dependent variable. A high REER makes imported capital equipment more affordable to domestic manufacturers, while a low REER makes a countrys exports cheaper abroad. Recall that several studies have suggested that export-orientation may have been one of the keys of East Asian success. Meanwhile, total manufacturing share in GDP is expected to be positively related to group-IV manufacturing. A positive relationship will confirm the notion that as an economy develops, its manufacturing sector thrives and diversifies, which results in an increase in per capita income. Finally, an auto-regressive term is added mainly to reduce serial auto-correlation. Regression results are highly satisfactory. All coefficients are found to be statistically significant (at 90% confidence for pcapform and 99% for all other variables), and signs are as expected. Table 1.2 Regression Output*
Dependent Variable: GRP4RPERCAP Method: GLS (Cross Section Weights) Variable Coefficient Std. Error t-Statistic PCAPFORM 0.438240 0.238654 1.836299 RGDPPERCAP 0.154877 0.013060 11.85918 REER -0.267339 0.082892 -3.225125 MFGSHARE 38.04589 2.045383 18.60086 AR(1) 0.702689 0.089986 7.808901 Fixed Effects _PHI--C -992.9149 _KOR--C -1427.178 _MAL--C -1020.057 _TAI--C -1151.835 Weighted Statistics R-squared 0.997872 Mean dependent var Adjusted R-squared 0.997562 S.D. dependent var S.E. of regression 42.56848 Sum squared resid Log likelihood -299.9511 F-statistic Durbin-Watson stat 1.649973 Prob(F-statistic) Unweighted Statistics R-squared 0.996602 Mean dependent var Adjusted R-squared 0.996107 S.D. dependent var S.E. of regression 42.56849 Sum squared resid Durbin-Watson stat 1.335705

Prob. 0.0717 0.0000 0.0021 0.0000 0.0000

1102.278 862.1886 99664.13 3223.693 0.000000 861.1021 682.2814 99664.21

*Output generated using Eviews 4.1 As expected, a higher proportion of GDP put into capital formation leads to greater group-IV manufacturing per capita output. Also as expected, real per capital output is positively related to the dependent variable. The results confirm the neoclassical view on the importance of capital accumulation. A country intent on producing hi-tech, high-

level manufactures must invest in physical capital and public infrastructure to succeed. Due to lack of time-series data on research & development expenditures across the selected countries, the significance of investments in new technology could not be tested directly. However, if capital formation were to be taken as an implicit indicator of the adoption of new technology, the results also confirm the hypothesis on the importance of technology absorption. This is clearly a problem for the Philippines where capital formation has remained weak for decades, due to both low domestic savings rates and low FDI inflows, minimizing potential for technology adoption. Meanwhile, as earlier mentioned, R&D spending is estimated at a dismal 0.11% of total output. The negative relationship between REER and the dependent variable suggests the important role of exports in domestic manufacturing. One obvious reason is that greater exports, particularly of items under group-IV, directly translate to greater group-IV domestic output. Again, a low REER makes a countrys exports more affordable to foreign consumers. A second, more interesting possibility is that greater exports may mean a greater need to be globally competitive. For a countrys exports to be successful in world markets, firms must continually strive for costefficiency, world-class quality, and product innovation. The larger the export sector is and the more integrated it is with the rest of the economy, the better the quality of local firms. Technology transfer and backward integration allow the local manufacturing sector to thrive. Weak export growth in the Philippines means the country has lagged behind its Asian neighbors in taking advantage of world markets. As a result, the drive to be globally competitive among local firms in the manufacturing industry is weak. The diminutive size of the Philippine export sector relative to its neighbors (figure 1.6) may be directly related to the concentration of its small industrial base on low-tech group-I manufactures. The strong positive relationship between manufacturing share in total output and the dependent variable suggests that the Philippine domestic manufacturing sectors heavy concentration (about 50%) on group-I items may, in turn, be attributed to the small size of the countrys industrial base. It comes as no surprise that Korea, Malaysia and Taiwan, economies with historically larger industrial sectors, produce more group-IV goods than the Philippines. Conclusion and Policy Recommendations It appears that most of the hypotheses quoted in this paper are supported by empirical evidence provided in the preceding section. In conclusion, capital formation, the adoption of new technology, and export-orientation are the most important determinants of growth in East Asia. The model shows that capital formation, made possible through increased domestic savings and investment, and augmented by FDI, is indeed imperative to growth. Most authors agree that the East Asian miracle can be mostly attributed to simply getting the basics right. For the Philippines, the challenge is clearly to increase the rate of investment, both private and public. Growth in recent years has been largely consumption-led, worrying some economists about its sustainability. If the country is to finally follow the lead of its more prosperous neighbors, it must seriously strive to make the big push out of its low and deteriorating investment-to-GDP ratio. Public investment receives special attention here as inadequate infrastructure continues to hold back private investment. The argument that low savings rates simply follow low income levels is a convenient excuse, but Chinas recent growth spurt attests to the possibility of high savings despite low levels of per capita income. Investments shortfalls may hide deeper challenges. Here the unexplained factors like corruption, political stability, property rights, enforceability of contracts, peace and order, and perhaps even culture play important implicit roles. Quantifying and empirically testing the significance of these implicit variables remain a challenge, but most economists agree that these make up a large part of the residuals of any decent regression of growth on its traditional determinants. Whatever the direct role of these unexplained factors on development may be, the conclusion of this paper is that

capital formation is absolutely necessary for growth, and peace and order or political stability is the key to faster capital accumulation then let the government prioritize these concerns. The country needs rapid capital formation at all costs, so to speak. The adoption of new technologies is a second key determinant. Developing countries during this age of globalization have access to the best and latest technologies available. The flying geese hypothesis predicts the transfer of industries, along with the essential technologies, from more developed to less developed economies with relatively cheaper labor costs. Unfortunately, although the Philippine industrial sector remains far from being completely developed, labor costs are no longer the cheapest in the region. FDI-led industrial and technological development thus becomes more challenging. Nonetheless, success in the electronics sector (and more recently, business process outsourcing in the services sector) prove that it is still possible to attract sizeable technological transfers and capital inflows into the country, wherever comparative advantage or economies of scale exist. However, as the story of the countrys electronics exports sector shows, attracting foreign investments and technology transfer into particular sectors is one thing, establishing backward linkages is another. Inadequate transport and energy infrastructure, inappropriate incentives, bureaucratic red tape, weak entrepreneurial spirit, and lack of managerial skills are some of the concerns. Whether its the enclave nature of export processing zones or the lack of infrastructure for backward integration and technological spread, government must address the obstacles that keep the Philippines from taking advantage of technologies already available in pocket sectors. The current misalignment between the countrys hi-tech, group-IV dominated export sector and low-tech domestic manufacturing industry is a clear indicator of failure in adopting new technologies. In recent years, growth in services, particularly in the business process outsourcing (BPO) sector has been remarkably high. However, although BPOs have provided much-needed employment, not-to-mention have spurred the recent office-space development boom in the real estate market, an economy that leapfrogs into services without having developed a sizeable industrial base might not be maximizing its full growth potential. The recently published Asian Development Outlook summarizes: services alone cannot sustain growth. A sustainable growth path can only be achieved by walking on two legs, so to speak a tandem of commercial services and industrial activity. Finally, as East Asias miracle economies have demonstrated, export-orientation provides not only access to foreign direct investments and technology transfer, it can also create incentives for firms to become globally competitive thereby increasing efficiency among local producers. The promises of both the world economy and increasingly integrated regional markets are too large to ignore. Intra-regional trade in East Asia for example has been steadily increasing. It will be to the benefit of the Philippines to take advantage of the increased integration by becoming part of the regional assembly line.

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