Why Corruption And Weak Institutions Are The Perfect Recipe For Emerging Markets

Yuen Yuen Ang is on a mission to turn our concept of how emerging markets successfully develop on its head. She proposes that we have it all backwards, that the well-established position that developing countries must get their institutions right before building stable economies is built on shaky ground. Rather, she says that allowing dynamic markets to flourish first — even if unregulated or corrupt — and building strong institutions later is actually the way to kick-start development.

Originally from Singapore, Ang grew up in a country in rapid transition which successfully emerged from the mire of corruption and disarray. She later applied this experience to her research of emerging markets in China, Nigeria, and other key points around the world, which cumulated in a new book called How China Escaped the Poverty Trap. I was recently able to talk with Ang via telephone about her book and insights on emerging markets for the following interview.

The title of your book is How China Escaped the Poverty Trap, so how would you define a poverty trap in this context?

The idea of a poverty trap is that when countries are poor they almost always have weak or bad institutions. For example, they have a lot of corruption, they have difficulty enforcing formal regulations — which even today in China you still have this problem — and they have a lack of rule of law, a lack of private property rights, and these things in academic language we call them mutually self-reinforcing. So when you’re poor you have bad institutions and when you have bad institutions it keeps you poor.

So the problem with development is how do you get out of that? Do you change your institutions first or do you get rich first? And for a very long time until today in the big development view nobody has been really grappling with this big chicken and egg problem.

So what my book does is to say I think we’ve been getting this whole debate wrong. In fact, if you go back in history and you very systematically lay out how the entire process unfolds, instead of thinking about development as one big arrow that either goes one way or the other, I show that the first step of development is always to build markets with weak institutions. Meaning, it may look corrupt, it may look like you have the wrong types of practices and the wrong types of property rights, but it’s all about people making use of the existing institutions they have to stimulate market activities, and the rise, the emergence of markets themselves down the road produces the impetus for creating the typical strong institutions that we see in a country like the US.

So this is a story of development that really goes head on with the conventional wisdom. A good example of this is Why Nations Fail, which is the best-selling book in development. The idea is first you need to get institutions right, first you need to eradicate corruption, you need to have private property rights, you need to have rule of law, you need to have all of these good things in place in order to have growth. But if you look at China that clearly was not the story. In fact, in the book I argue that if you look at other parts of the world, including the history of America’s development, that wasn’t the story either. So we’ve been getting the causal sequence wrong.

Could you explain a little more about how exactly China or other countries that you have researched did this?

The way I went about doing my research is I went to different parts of China. I picked the coast, I have one case in Zhejiang — the wealthiest place in Zhejiang — and then I picked a location in inland China, as well, so I have several cases. Instead of just looking at them today, because if you just look at them today you only get a partial picture, I actually go back through the entire history and trace the entire path of development from 1978 to 2014. So when you look at this entire path you realize that right in the beginning of the process it certainly was not the case that these localities have private property rights, have rule of law, have all of these good things to get their markets kick-started.

In fact, what I found is that they very cleverly and very creatively made use of a variety of methods that we think would be problematic or just outright wrong. So, for example, they make use of partial property rights, building on the Communist system. So instead of having property rights given to individuals you give property rights to collectives. Instead of having technocratic bureaucracies, like you have in Singapore, they make use of non-technocratic bureaucracies. For example, in the 80s on the coast they would take the entire bureaucracy — 20,000 — cadres and turn them into a massive sales force. It doesn’t matter what office you are in, you are basically asked to go out and find investors using your personal relationships.

We also see in the 1980s they make use of expenses that would strike us as kind of a corrupt system, because these bureaucrats are unleashed to go out to do development, look for investors, and they are given very powerful monetary incentives. So the formal pay until today is very low in China, but there is a very, very big variant in terms of performance pay. There are explicit rules, sometimes even written down in documents, where as a bureaucrat you can collect five percent of the value of investments that you bring in, for example.

So you have these various measures that if you look at them one by one it’s very strange and you think, ‘Wow, they’re doing it the wrong way, they’re doing it the way that it is not done in Singapore or it is not done in America.’ But in the particular context of being a startup economy, being an emerging market, these were the practices and the norms that actually best fit the constraints at the space and time, the type of goals, the types of development they were pursuing at the time, and so it actually worked.

If you look further down the historical path, later down the path in the 90s, in the 2000s, when you actually start to see markets growing in these parts of China, you’ll find that actually people’s preferences have changed and their institutions change. So if you look at Shanghai today, it looks very, very different than it looked in the 80s, 90s, and even in the 2000s. So that’s kind of the historical story that I lay out and kind of challenge the conventional viewpoint that we need to get the institutions right, we need to get governance right before we can get growth. That clearly was not the case.

What’s unusual about this is that most China books only talk about China but not about other countries, because it’s always the assumption that China’s experience is very unique and you can’t find it anywhere else. Actually in the final chapter of the book I look at three other country cases. One of them is Late Medieval Europe, the other is Antebellum, United States, and third is the rise of Nollywood in Nigeria. Despite that these are three very different cases in three very different time periods, you’ll find that the way markets had emerged were always through people creatively using the existing institutions that would always look wrong from the viewpoint of the modern observer.

I’m trying to make the case that actually if you look at the sequence of development in China it is not unique to China but China provides one illustration of it. So I would like to make the case that in addition to being important to scholars it has huge policy implications. . . The idea that you can actually take what you have and then turn it around into something that can actually stimulate markets. That’s something very practical for someone who works in development.

Do you see a point in China or the other case studies that you’ve looked at where institutions need to be strengthened in order for the country to continue growing? Where is the breaking point that this more organic system needs to get more formal?

That is exactly one of the key points of the book. At first, you can make use of things like corruption, informal institutions, connections to kick-start markets, but at some point when you actually start having a market somethings are going to have to change, and China on a national level is now at this point. It is a middle income economy, and if it wants to continue growing it needs to change a lot of its institutions. So this is the point in China things like democracy, things like political reform actually do become important for continued development. But if you’d taken this discussion back in the 80s, 90s, even 2000s it was not clear that you need political reform to have development. But I do think that China has now reached a point where it actually does need to change its institutions, including its political institutions in order to continue this process.

Did you look at any case studies where countries have tried to develop in the conventional way, trying to strengthen institutions first before building their markets and seeing it not really work out so well?

Not in this book, but I think you can find many examples that other people try to make. If you look at Why Nations Fail it will try to give you the impression that England in 1688 had a glorious revolution, killed the king, put in a parliament, and then they had growth. So you do find people trying to make a case of that. But, personally, when I read these accounts I don’t find them that convincing because they give you a snapshot of the process of where you put in a good institution and this was followed by a good outcome. So they make these causal arguments that you need to have these good institutions.

But the point of my book is that if you push the causal factor back further, where did those good institutions come from in the first place? You find that they always have to start with institutions in poor, developing countries. They almost always look corrupt. That has to be the starting point. So we look at the World Bank who keeps saying good governance matters but they have very little case evidence that that is the case. But they do provide a lot of correlation evidence using statistics. And if you look at it statistically in terms of correlation you will find a lot of evidence because rich countries tend to have good institutions. So if you just take the correlation of it that makes sense, but if you actually try to ask them to give me a case where someone has a lot of corruption and then overnight they turn it into good institutions and then had growth, these cases are actually very rare.

One case that I know was Singapore. Singapore is a very rare case where there was a very determined, very capable leader like Lee Kwan Yew and his team, and they eradicated corruption and they turned things around. That is a very exceptional case. It’s exceptional because we benefited greatly from the British legacy. The British had already built up this set of institutions, which were not great but they were already in place. So when Lee Kwan Yew and his team took over they could build upon what was left to them.

But if you go to places like China in 1978 or Nigeria today or any other developing country, they do not have these sorts of good colonial legacies to build on. Instead, they face corruption, they face widespread informal relationships, property rights are weak, and various other problems. So what I’m arguing is that instead of looking at these as only problems, a lot of times they can be turned into market building strategies.

What role do you think that Chinese culture, as far as social networks and business networks, the drive to work hard, and family pressure to make money play into this?

Good question, I get that a lot. I don’t buy the cultural argument because if we think that Chinese culture is important, well, we know that Chinese culture hasn’t much changed in the past 100 years so why is it that in the past 100 years we’ve seen ups and downs? We’ve seen all kinds of outcomes — extreme failure, extreme success. So logically you can’t say that culture explains all of this. Culture can’t explain success or failure at the same time. So we really need to look for other factors and other types of strategies to explain this big change that China had and it’s not clear to me that culture has changed during this time. It’s a popular argument that people make but it’s often I think a lazy argument, like when people can’t come up with something they say, ‘oh, it’s Chinese culture.’ But I don’t think it’s helpful in terms of trying to understand the experience of this country, which is very remarkable for anyone who studies development. Historically, we’ve never seen a country change so fast, so widespread, and for so long.

During this period of development China had a lot of weak institutions but also had a central government that was pushing lots of money down from above into these weak institutions and essentially pushing money through the domestic economy, stimulating these economies, intentionally building infrastructure, and intentionally seeding growth. How does this play into what you’ve seen because that fact isn’t as replicable in many other countries?

One of the misconceptions that I try to correct is the idea that from the beginning that the central government had been strong and had money. It actually was the opposite of the central government being able to pump a lot of money into the system. This is something that we see in the past ten years, so today we see the central government with thousands of dollars to be able to put into the stock market and infrastructure. But in the 80s and in the 90s it was actually the opposite. Especially in the 80s. One of Deng Xiaoping’s famous instructions to the leaders in Guangdong, because Guangdong was the first province to open up, [was] that the central does not have money, so the only thing we can give to you is autonomy. So that actually is the China story. In the beginning the central government was really poor and local governments were even poorer, so nobody had any money. So instead of giving money, the central government gave these places a lot of autonomy, a lot of space to create opportunities. So by the time you get to the 90s you get growth, you get a lot of tax revenue being generated on the coast, which the central government then re-centralized in 1993, which then gives rise to the capacity of the central government that today has so much money. But that was actually not something that we find at the very beginning.

So to that extent that story is widely applicable to many developing countries, because they do not have money, they do not have capacity in the conventional sense, so a lot of times what they have is, ‘well, we can have autonomy and we can provide the space to make good use of whatever opportunities we have.’

One of my cases in addition to China is the rise of Nollywood in Nigeria. I wanted to include Nigeria because it is a typical weak state. So you can’t say that Nollywood succeeded in Nigeria because the government was strong; it was actually the exact opposite of that. What is really fascinating in the Nollywood story is that in the 1990s, when this industry first started, they had absolutely no condition for a film industry. There was no IPR protection, no state funding, and Nigeria was so dangerous that people couldn’t go out to watch movies. So you just think about this and wonder how in 20 years time Nigeria has the world’s third largest film industry. The story was that in the 1990s Nigerian film makers made use of piracy as a marketing and distribution tool. This happened to work really well in a terrain like Nigeria, where you need people with a lot of local knowledge and informal connections, in order to distribute film rapidly and widely. So even though they are two very different countries, Nigeria and China, the kind of one similarity that we can draw out of it is in the absence of capacity and the absence of money and resources you do see markets arising from people making creative use of what appears to be the problem.

In business schools the reason why we are interested in emerging markets is because we are thinking, ‘what kind of opportunities can we find, can we create in the absence of good conditions?’ So I do see that there are generalize-able lessons from China, and it’s not because in the beginning that the central government had a lot of money and a lot of capacity; it was actually the opposite of that.

What can the global community learn from China’s experience?

I can begin by saying what they should not learn. It’s not true that the whole China model is good; there are many aspects of it that are not good. If we look at the global development community, the World Bank, the IMF, despite the fact that China has been tremendously successful — the most successful country at eradicating poverty — we are generally very reluctant to use China as a model. So you don’t see them discussing China when they are talking about how do we end poverty. I think the key reason for that is because China is not a democracy. So it is very hard for a global leader to say, ‘well, you know, we should learn from China.’ Because obviously we can’t. We shouldn’t recommend an autocracy.

So at the outset, what I would argue is that there are certain things we should not learn from China: A) We should not emulate that it is an authoritarian regime. They happen to be an authoritarian regime and it happens to have certain advantages for development, but having an autocratic system is very dangerous. Before that they had Mao. So Mao used the same instrument and it was disastrous. So we’re not going to learn autocracy from China. I also do not recommend that we learn very heavy-handed intervention from the government, which we sometimes see — which we now see in the stock market, for example.

But what I do think the global development community should learn is that there is actually a lot of freedom and creativity below the central government. So once you get to the localities, to the townships, to the towns, to the villages, China’s development is actually very much a bottom-up model. So you see vastly different methods for promoting development that are very much localized and tailored to local conditions. So even within Zhejiang province, if I travel from one part of Zhejiang to another part of Zhejiang, you see like, ‘wow it’s a very different way of doing things.’ So it is just creativity and localization and diversification within China that’s the thing we don’t really know about, we don’t talk about that very much in the press.

If you look more closely at this localization, what is at the heart of their success is that in the beginning of this process they make good use of whatever they have, and these things often look corrupt, they look wrong, but they use it to kick-start development. So I think that is what the global development community should learn, because the common policy practice is to go around to poor countries and then insist that they should then get institutions right before aid or loans will be given out to them. A lot of times when you insist that these countries copy institutions it actually makes things worse. So they might kind of pretend to do the reforms and at the end the formal institutions — it might be a court, for example — and find that nobody wants to use it, that nobody trusts the law. So that is a recurring problem in development, because we are so firmly embedded in the view that you need to get institutions right first. So this is the lesson that we should learn from China.

The first step of development you might think of it as getting institutions wrong first, making use of what appears to be the problem and then using it to kick-start development. So that I think is the big lesson.

What do you recommend as a proper course of action for emerging markets to develop and mature?

Learn to build markets with weak institutions. Emerging markets are defined by opportunities in the midst of chaos and corruption. My book argues that in order to tap this potential, policymakers and businesses alike must learn to leverage existing “weak” institutions in developing societies to kick-start development. In developing countries like China, what seems like corruption may be turned into incentive schemes, primitive village ties may function as networks, piracy may be informal marketing, and so on.

Design organizations to acquire deep local knowledge. In order to build markets with weak institutions, one must acquire deep local knowledge of emerging markets. Yet many organizations are not designed to acquire local knowledge. Instead, they prefer convenient, one-size-fits-all solutions.

In short, indigenous institutions are the raw material of development in emerging markets. Yet from the perspective of wealthy democracies, such institutions often look weak and are therefore dismissed. Spotting opportunities in emerging markets require that we change the mindset that only what exists in developed nations is good and everything else is bad. It also requires modifying organizations, so that professionals are willing and able to acquire deep local knowledge of emerging markets.