How decentralisation supported development in East Asia

This article is the second in a series of three articles that tries to answer the title question drawing on lessons from East Asian countries. As noted in the first article, in the October issue of Policy Insights, the answer to the title question is that it is highly unlikely that Bangladesh, a large country of 161 million people with an increasingly sophisticated economy and society, can develop without decentralising. Future development will become more knowledge-intensive and institutionally demanding, needing strong governments that can coordinate and take initiative at both the central and the local levels. In such a scenario, it is highly improbable that Bangladesh will be able to sustain its growth and development with the current highly centralised government system.
Across the world, countries decentralise as they become wealthier. But it is the experience of East Asia’s spectacular growth and some of the region’s highly decentralised governments that draws out most clearly the linkages between development and decentralisation and provides relevant lessons. The first article in this three-article series laid out the context for decentralisation in Bangladesh and drew a contrast between a highly centralised Bangladesh and a highly decentralised East Asia. Drawing on international data, it showed how Bangladesh’s extreme centralisation—political and economic—adversely affects overall urban development. It then provided evidence to demonstrate that some of the dynamic East Asian countries are among the most decentralised not only among developing countries but also among all countries.
In this second article of the series, we explore how decentralisation has helped East Asian development. The third article will draw on the lessons of East Asian decentralisation, of both success and failure, and suggest a path to implement decentralisation in Bangladesh.

…it is the experience of East Asia’s spectacular growth and some of the region’s highly decentralised governments that draws out most clearly the linkages between development and decentralisation and provides relevant lessons.

So what role has decentralisation played in East Asian development? Decentralisation has boosted growth and development in East Asia through five channels. First, because local leaders and the people managed and even owned the local economy to varying degrees, they had powerful incentives to develop. Second, this ownership led to intense competition among provincial and district governments to achieve faster development. Thus, it was not only external global competition but also internal competition to develop that stimulated growth. Third, decentralisation and local governments piloted policy reforms, promoted experimentation and limited risks. Fourth, decentralisation helped find and train leaders. Fifth, it enabled high-quality urban development that is essential for sustaining long-term growth and structural change.

Decentralisation created ownership and incentives to develop

Because local governments managed and even owned significant parts of the local economies, they had strong incentives to develop them. They owned the state-owned enterprises, were partners in collectives and cooperatively owned companies, including the famous Town and Village Enterprises in the early stage of China’s reforms in the 1980s. Local governments in China could also own shares in private businesses. Leaders of local governments sometimes came from the private sector, as in the case of Indonesia’s popular President Joko Widodo, who was in the furniture business in the city of Solo before he became the city’s mayor. The success of local businesses and jobs for their people created prosperity for local governments and their officials. Thus, local governments in these countries became active in supporting the private sector, facilitating investment and creating employment.
A second reason local governments had incentives to develop the economy was that they had significant budgets and spending authority. On the expenditure side, local governments managed 40–80% of all government expenditures, over which they had substantial autonomy and discretion. These included not only current expenditures but also public investment expenditures, with subnational governments in countries such as China, Indonesia, Thailand and Vietnam accounting for 50% to nearly 80% of public investment. Local governments have considerable discretion over their budgets. In China and Vietnam, provincial party congresses approve their own budgets. In the Philippines, local governments prepare their budgets, which the next higher tier of government then reviews but only to ensure that they have observed due process and not to interfere with budget allocations. For example, the national government reviews cities and provincial budgets.
On the revenue side, local governments in countries such as China and Vietnam had incentives because they owned the tax base through tax-sharing formulas. As much as 40% of all tax revenues in these countries could be directly allocated to local governments. This incentive was famously demonstrated when China introduced a fiscal contract system for local governments between 1979 and 1994 under which local governments could keep the tax revenues they collected after paying the central government’s share of revenues. Provincial revenues increased by four times after this system was introduced. The rapid growth of rural and private enterprises and reforms in state-owned enterprises, all of which led to rapid job growth, boosted revenue growth in the provinces.
Overall, the first 15 years of Deng Xiaoping’s reforms were the years when the unleashing of local governments and private sector initiative energised China. Poverty halved and gross domestic product (GDP) increased by nearly four times in these 15 years, setting China on a robust trajectory of growth. After 1994, the ‘separating tax system’ was introduced to modernise the tax system. While redistributing some revenues back to the central government, the new policy assigned clear central government and sub-national government revenue shares. Their allocated share of revenues maintained local governments’ incentives to grow the economy to collect revenues even though taxes now were collected mostly by the central government. These tax-sharing structures in China under both the old and the new systems created incentives for local governments to behave like ‘helping-hand governments’ for businesses to share their revenues through profits and taxes rather than predatory ‘grabbing-hand governments’ that only extracted benefits from private companies. That is, local governments ‘took care of the hen that lays the golden egg instead of eating the hen’.
Third, local governments had incentives because the future political careers and reputations of local government leaders depended on their performance. In the case of elected governments such as in Indonesia, Korea and the Philippines, successful mayors of cities (Joko Widodo, Mayor of Solo and Mayor of Jakarta; Lee Myung-Bak, Mayor of Seoul; Rodrigo Duterte, Mayor of Davao) who performed well were later elected president of their country. In the case of China and Vietnam, the incentives for local leaders to achieve progress are no less. Leaders of local governments have their performance regularly monitored against a host of economic and social indicators and targets. Leaders who perform well then rise through the ranks into senior positions.

Decentralisation stimulated competition for development

Decentralisation of the local economy created intense competition to develop among local governments in China, Indonesia, the Philippines and Vietnam. Local governments competed to raise agricultural productivity, attract investment by state and private sector firms, develop manufacturing and provide good jobs for their constituents. Along with external competition through international trade, the internal regional race to grow was the twin driver of growth and development in these countries. Decentralisation in China combined with the rise of private firms, widespread privatisation and the shedding of more than 40 million public sector industrial jobs in the 1990s. Suddenly, tens of millions of experienced workers became available for the newly set up Town and Village Enterprises and privately owned enterprises. Many of the experienced workers also became entrepreneurs.

Decentralisation of the local economy created intense competition to develop among local governments in China, Indonesia, the Philippines and Vietnam.

However, firms could not set up factories just on their own. There needed to be agglomeration—that is, a significant enough number of firms had to be in a city or town to make them attractive to other investors. It was the competition among proactive local governments to attract these investors that made this agglomeration an accelerated process. This agglomeration, in turn, created the economies of scale to build infrastructure and attract skilled labour. As a result of these agglomerations, not only China’s large cities but also many of its small and medium towns flourished by becoming specialised in one unique product, such as trousers, shirts, socks, leather products, plastics—including toilet seats—and dairy products.
Local governments played the driving role in providing these economies of scale and agglomeration benefits by setting up industrial parks and economic zones. As economist Stephen Cheung, a long-time China observer, has noted, China’s ‘industrial heartlands of the Pearl and Yangtze deltas, reveals the cut-throat competition between localities for business. Local governments compete for capital investment and local officials attend conferences all over China and even abroad to solicit this investment.’ Local governments offer full cooperation: ‘You want a business license? The locality will assign someone to do the walking and talking for you. Want a building permit? They will give you one with money-back guarantees. Unhappy about that dirty creek passing through the site? They may offer to build a small lake for you. They will help you find architects and builders and, at the production phase, recruit workers for a reasonable fee. They sell their cheap electricity, sell their parks and entertainment’ (McGregor, 2010). In short, local governments competed vigorously with each other to create a friendly business environment, attract investment and generate jobs for their people.
In Vietnam, the popularity of the Provincial Competitiveness Index (PCI) perhaps best expresses the keen competition among the provinces. This index, an initiative of the Vietnam Chamber of Commerce and Industry with government support, has used a survey of thousands of firms (most recently of 10,000 enterprises in several sectors) since 2005 to provide a regular report and ranking on the performance of Vietnam’s provinces in providing a business-friendly environment. The index measures entry costs for firms, land availability, policy and regulatory transparency, cutting of red tape and the provincial government’s proactivity in supporting business. A separate PCI Infrastructure index measures provincial performance in providing high-quality industrial zones, roads, public services and information technology. Those reasonably informed about Vietnam’s economy will not be surprised to learn that the dynamic Da Nang province has consistently ranked as the top province on the PCI in recent years. Other countries, such as Indonesia and the Philippines, have also carried out investment climate surveys to identify which governments are doing better and which worse.
In Indonesia also there has been a similar ranking of local government performance. Investment services, investment promotion, commitment of the government to the private sector, infrastructure, access to land and labour and other similar services were the criteria for ranking local governments. There is also a ranking of 240 city and district governments based on surveys reported in The Asia Foundation’s Local Economic Governance. Research has provided evidence that investment in infrastructure has increased under local governments in relatively underdeveloped areas. As in the case of China, local government leaders of Indonesia and Vietnam are active in seeking out investors through frequently attending trade and investment conferences.

Decentralisation facilitated experimentation and reforms and reduced risks

It may be difficult to appreciate that reforms by local governments over the past 40 years were the first sparks behind China’s spectacular rise. In a story that has now become history, changes started when local communist party officials of a village in the then-impoverished Anhui province of China decided to experiment. They gave 18 farming households the right to cultivate plots of land on their own and sell their production after they had met their supply quotas. Production boomed in those plots. The news of this successful experiment spread, and another province, Sichuan, carried out a similar experiment. In 1979, Deng Xiaoping, the reforming leader of China, directed all provincial leaders to emulate the system in their jurisdictions. A 15-year lease was given to households to use the land for agricultural purposes. They had to meet the government-set quota, and the rest of the produce would be theirs to consume or sell. The experiment, later famously known as the Household Responsibility System, exceeded all expectations. By 1984, 24 million households had subscribed to the system. Farmer annual incomes rose from a mere $47 to $105 within the decade. Agriculture production rose 5% every year during the 1980s. The land lease to farmers was extended in 1993 to 20 years and then in 2003 to 30 years.
Reforms continue to have local government roots. As was patiently explained to me by some bright officials from China’s Ministry of Finance a few years ago, reforms in China are rarely planned from the beginning as a national policy. They start with some trial-and-error experiments by some county or provincial governments. Based on the success of a trial, the new policies then spread spontaneously to other provinces before being formally adopted by the country. While this was especially the case for many of China’s reforms in the early stages, it also applies for recent reforms such as when Shanghai set the Pilot Special Free Trade Zone. One reason behind the impressive success of special economic zones in the East Asia region has been the active leadership of local governments in managing these zones in partnership with the private sector.
China even allows provinces to experiment with the design of decentralisation. They follow two models. Under the ‘province managing county’ model, the provincial government directly manages the prefectures and counties in the province. Direct intergovernmental relations between provincial and prefecture and county governments set up revenue and expenditure assignments, intergovernmental transfers and subsidies, borrowing and budgetary allocations. This more decentralised model is encouraged by the central government. However, some provinces follow a parallel, more hierarchical, model in the ‘prefecture managing county’ model. Under this model, intergovernmental fiscal relations are defined only between the provincial government and the prefecture governments. The prefecture then has the responsibility of managing the counties.
In Vietnam, similarly, it was local government and party leaders who led reforms through ‘fence-breaking’ experiments, sometimes carried out without Hanoi’s approval. Fence-breaking experiments in agriculture mainly involved distributing the commune’s land to farmers and directly contracting procurement prices with them that were higher than those set by the national plan. In the north, experiments were secretly carried out in Haiphong province when members of Doan Xa commune were given land on lease to cultivate on their own using a ‘sneak contract’. Production increased by six times. The party secretary of Haiphong then decided to extend the experiment to the whole province.
But it was Ho Chi Minh City that became the ‘reform leader’, carrying out bold market reform experiments. Rice was purchased from farmers at market price funded by local banks, all without the permission of the central government. The practice soon spread to other parts of the country and became known as ‘the Ba Thi model’, named after the official who had carried out the reform. During the 1990s, Ho Chi Minh City, along with other provinces and cities, was granted authority to carry out local expenditures, especially on infrastructure, and to approve foreign investment projects in the city. These powers to approve foreign investment have now been extended to other provinces. Da Nang city, ranked as the most investment-friendly city between 2012 and 2016, now has 546 foreign direct investment projects, with total investment of more than $3 billion. Vietnam’s provincial governments have been proactive in reaching out to large multinational companies and enterprises through their embassies and international trade and investment promotion organisations.
In Indonesia, too, policy reform experiments first carried out by local governments were later scaled up and adopted for the whole country. These included introducing e-procurement by governments pioneered first by the city of Surabaya, Indonesia’s second largest city, located in north-east Java. Other such reforms have included making regulations more transparent and introducing one-stop centres to streamline procedures in providing business licences.

Decentralisation helped identify and train leaders

Identifying and training capable national leaders is a critical challenge for countries, and decentralisation provides the path to meet this challenge. It was their records of effective leadership as mayors of cities (Joko Widodo Mayor of Solo and Mayor of Jakarta, Lee Myung-Bak as Mayor of Seoul, Rodrigo Duterte as Mayor of Davao) that led to their election as national leaders in Indonesia, Korea and the Philippines, respectively. In a democratic system, decentralised governments offer leaders opportunities to compete with one another to prove their ability to provide services and use public resources effectively. The people also get an opportunity to observe these leaders’ performance. Without such opportunities to identify leaders, the benefits of democracies can be limited. As Nobel prize-winning economist Roger Myerson has pointed out, if the people do not have any means to recognise emerging leaders, they may perceive that there are no alternatives to existing leaders. In such a scenario, the population may continue to support existing leaders even if their performance is disappointing.
It is worth stressing that it is not just in electoral democracies that decentralisation offers a way to identify leaders. In countries such as China and Vietnam, national leaders emerge after they have proved themselves through their work to develop prefectures and provinces. Current President of China Xi Jinping spent most of his career in the two poor provinces of Shaanxi and Hebei, and the wealthier provinces of Fujian and Zhejiang, establishing a track record of being an effective leader before being promoted to the national scene. Many of China’s Politburo members—who wield the power behind the government—similarly have demonstrated their competence by running local government before rising to the national scene. In fact, five of the current Politburo members are also presently provincial party chiefs. The prestige of being the party chief of an important province in China equals the prestige of being a central government cabinet member.
But who observes the performance of the provincial governments and party leaders in China and Vietnam? It is done both by the central government and by the people of the province, prefecture, county or district. The central government uses a range of performance indicators to evaluate leaders from the top. But it also encourages, tacitly or explicitly, monitoring by the people, by allowing them to express their disapproval of leaders through social media and even through public demonstrations. As part of this, the central government has collected and reported statistics on public protests in provinces that have reportedly numbered 180,000 in recent years.

Decentralisation promoted high-quality urban development

Development and growth typically start with a boost in agricultural productivity, but then, very soon, it is cities and towns that sustain growth. Cities provide essential services such as marketplaces where trading can take place; financial services that can supply credit for industries and services to operate; facilities for educating and training people in large numbers to work in manufacturing and services; and health care, artistic, cultural and sports opportunities that make city life attractive. By concentrating many people and economic activities in a relatively small area, cities enable industries to enjoy the benefits of economies of scale and agglomeration that lower costs and raise productivity, firm profits and the wages of workers.
The city, in short, is a microcosm of the national economy except that it is far denser and more infrastructure-intensive. Internal and external transport, power, telecommunications, water supply, sewage and sanitation services, housing for a high density of people and land for commercial and industrial construction that will create jobs all become necessary for urban development. So also do critical services such as health, education, public safety and security. Further, these activities need to be financed in a sustainable manner drawing on city taxes, transfers from the central government or borrowing. These finances then need to be used effectively and not wasted.
Good urban development thus needs well-performing local governments to carry out detailed planning, implementation and the effective coordination of different public services. All these activities require granular information on how the city is performing and the issues confronting its development. City and town management, to use economics jargon, addresses market coordination failures and information asymmetry problems continually.
It should be readily apparent that such management cannot be done from a distance by centralised governments. Central governments will lack the detailed knowledge of needs as well as the incentives to respond to them adequately. Competent local governments and leaders thus become essential for the proper development of cities and towns. According to the World Charter of Local Self-Governments, local governments should be nationally legislated and, if possible, constitutionally guaranteed. Developing countries are far short of these goals. But, even in countries where de jure such local governments exist, de facto they are weak.
The East Asian experience provides valuable lessons on urban development. Countries such as China, Indonesia, the Philippines, Thailand and Vietnam, and earlier Japan, Korea and Taiwan, have seen the fastest growth of cities and towns (in the past four to five decades) ever seen in world history. At present, some of these countries are among the most urbanised in the world. In Korea, for instance, 96% of the population lives in towns and cities. In developing East Asian countries—that is, excluding Hong Kong, Japan, Korea, Singapore and Taiwan—the share of the urban population has increased from 19% to 52% over the past 40 years. That is, some 833 million more people are living in cities in these countries than there were 40 years ago, in the mid-1970s. In comparison, the share of urban population in South Asia has grown from 20% to 33% over the same period—a significant increase but far less than what took place in East Asia.

The critical lesson of urban development in East Asia is not only that it has taken place rapidly but also that it has been of high quality.

The critical lesson of urban development in East Asia is not only that it has taken place rapidly but also that it has been of high quality. Cities there have been successful in providing the public services needed to attract investment in industries and services, create good jobs and thereby avoid the growth of huge urban slum populations that we see in South Asia and Africa. This high-quality urban development has been possible because city and town governments have had the resources, authority and accountability to play an effective role thanks to decentralisation.
In closing, it is worth stressing that decentralisation was not a panacea for East Asia’s development. There were many successes, but there were failures too. An important lesson that emerges from this experience is that the process, the design and the implementation are critical for decentralisation’s success. In the next and final article, we will use these experiences of East Asia’s decentralisation to draw lessons for Bangladesh.

References

McGregor, J. (2010) The Party. The Secret World of China’s Communist Rulers. New York: Harper.