Cluster-based Development as an Opportunity for Job Creation and Poverty Reduction in Egypt

Xiaobo Zhang, IFPRI and Peking University

September 6, 2016Egyptian Center For Economic Studies (ECES) , Cairo

1

Clusters

Clusters are a geographic concentration of a large number of interconnected businesses.

They are ubiquitous in both developing and developed countries.

They are widely observed in the early industrialization period of developed countries. Adam Smith Wealth of Nations describes vividly the fine division of

labor for the linen shirt production across dispersed producers in nearby towns.

Alfred Marshalls Principle of Economics includes four chapters on industrial districts (the name preceding clusters).

2

Outlines

1. Why clusters are particularly suitable for early stages of development?

2. How to build clusters?3. Implications for Egypt in particular

3

Why Clusters Are Particularly Suitable for Low and Middle-Income Countries?Major constraints and strengths

4

Major constraints

Credit constraints: banks are not willing to extend credit to small and micro enterprises;

Weak institutions: extortions, lack of enforcement, and so on;

Poor infrastructure: high transportation cost, power outages.

5

Mainstream thinking on development

These constraints set low and mid-income countries apart from developed countries.

Therefore, it is crucial to first remove these constraints: Develop micro finance institutions (MFI) Institution rules Invest in infrastructure (road and electricity)

6

It is a daunting challenge to do so

It is impossible to set up a well-functioning financial system and sound institutions in a day; If low and middle-income countries can achieve these goals, they would have already been developed countries.

Facing a limited budget and many competing needs (such as education and public health), it is not an easy task for governments in low and middle-income countries to invest in infrastructure. 7

Failures of MFIs Banerjee, A., Duflo, E., Glennerster, R., &

Kinnan, C. (2015). The miracle of microfinance? Evidence from a randomized evaluation. American Economic Journal: Applied Economics, 7(1), 22-53.

MFIs do not have any impact on intended development outcomes.

8

Major findings In 2005, half of 104 slums in Hyderabad, India were randomly selected for

opening of a branch of a particular microfinance institution (Spandana) while the remainder were not, although other MFIs were free to enter those slums.

15 to 18 months after Spandana began lending in treated areas, households were no more likely to start any new business. There was no effect on average monthly expenditure per capita.

3 to 4 years after the initial expansion (after many of the control slums had started getting credit from Spandana and other MFIs ), the probabilities of borrowing from an MFI in treatment and comparison slums were the same. Consumption was still no different in treatment areas, and the average business was still no more profitable. There are no changes in any of the development outcomes that are often believed to be affected by microfinance, including health, education, and womens empowerment.

9

Alternative thinking Use existing strengths to generate dynamics in a

small place (for example, clusters).

In the small place, the seemingly large constraints can be overcome much easily than for a country as a whole.

Over time, hopefully the growth spillovers to other places and induces more institutional innovations

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Marshalls three advantages of industrial district:

Information flow

Market linkage

Labor pooling

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Role of clusters in overcoming financial constraints

Fine division of labor lowers the capital requirements of entry (Ruan and Zhang, 2009).

Social trust, repeated transactions, and proximity make it possible for producers to use trade credit and informal contracts to fill the void of formal financial and legal institutions (Grief, 1993).

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Page 13

Puyuan Cashmere Sweater Cluster

Zhejiang Province

Page 14

The Putting-out SystemYarn

Purchasing

Weaving Assembling Dyeing & Finishing Buttoning Ironing Printing

Packing SellingSweater Shops (VPCS)

New StyleDesigning

Computer Aided Designing

Integrated Producing Factories

Yarn Purchasing

Weaving Assembling

Dyeing & Finishing

Buttoning Ironing Printing

Packing SellingNew StyleDesigning

Computer Aided Designing

The Vertically-integrated System

Two business model in Puyuan Cluster

Ruan and Zhang, EDCC(2009)

Integrated factory

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Page 16

Market

Page 17

Production Organizers

Page 18

Family workshops

Page 19

Workers/entrepreneurs

Initial Capital Investment in PuyuanCashmere Sweater Cluster

Average (10,000 yuan)

Mean/Wage % of initial capital investment from banks

Yarn dealers 12.45 6.25 0.00

Family weaving workshops 7.31 3.65 2.90

Dyeing factories 340.07 170.05 20.63

Finishing factories 177.82 88.90 25.68

Printing workshops 10.60 5.30 0.00

Ironing workshops 3.83 1.90 0.00

Sweater shops 12.74 6.35 6.95

Three-wheeler drivers 0.54 0.25 0.00

Logistics company 4000.00 ------ 50.00

Integrated enterprises 263.84 131.90 21.13

Average (10,000 yuan)

Mean/Wage

% of initial capital investment from banks

Yarn dealers

12.45

6.25

0.00

Family weaving workshops

7.31

3.65

2.90

Dyeing factories

340.07

170.05

20.63

Finishing factories

177.82

88.90

25.68

Printing workshops

10.60

5.30

0.00

Ironing workshops

3.83

1.90

0.00

Sweater shops

12.74

6.35

6.95

Three-wheeler drivers

0.54

0.25

0.00

Logistics company

4000.00

------

50.00

Integrated enterprises

263.84

131.90

21.13

The Most Important Financing Source When Facing Working Capital Problems in Puyuan Cluster

Ruan and Zhang (EDCC 2009)21

Trade Credit in UK in the 19th Century

Indeed an understanding of industrial finance during the nineteenth century is impossible unless this [trade credit] taken into account. The factor acted as a link between the banks and the small makers who could not then resort to them for credit. Through the factor, industry was supplied with its working capital; for though the domestic workers and shop owners might not all receive their materials from the factor, they all depended on him for weekly advances from which they might meet their expenses of production.

--- G. C. Allen, The Industrial Development of Birmingham and the Black County 1860-1927, published in 1929. Page 155.

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Trade Credit in Ethiopia (Handloom Cluster)

Addis Ababa Electrified Not Electrified Source of raw materials (% of respondents) Open market 1.5 22.1 41.8 Third party 0.0 0.7 0.0 Shop 98.5 77.2 58.2

Most important supplier (% of respondents) Open market (same town) 2.6 24.1 19.9 Open market (other town) 0.0 0.7 28.8 Shopkeeper (same town) 91.3 69.0 20.6 Shopkeeper (other town) 6.2 6.2 30.8 Visiting trader 0.0 0.0 0.0 Other 0.0 0.0 0.0

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Zhang et al., JDS, 2011.

Addis Ababa

Electrified

Not Electrified

Source of raw materials (% of respondents)

Open market

1.5

22.1

41.8

Third party

0.0

0.7

0.0

Shop

98.5

77.2

58.2

Most important supplier (% of respondents)

Open market (same town)

2.6

24.1

19.9

Open market (other town)

0.0

0.7

28.8

Shopkeeper (same town)

91.3

69.0

20.6

Shopkeeper (other town)

6.2

6.2

30.8

Visiting trader

0.0

0.0

0.0

Other

0.0

0.0

0.0

Existing strengths in low and middle-income countries

Abundant in labor

Strong social capital at the community level (people know each other for generations).

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More advantages

Security

Flexible production structure under uncertainty

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Clustering as an adaption to predators

Story of brick factories in Gansu; Cicada phenomena:

North American genus, Magicicada, which has a number of distinct "broods" that go through a 17-year life cycle.

26

http://en.wikipedia.org/wiki/Magicicada

Industrial park in Bangladesh

More security;More space;Centrally provided gas;More stable power supply (supposedly).

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Clustering lowers effective tax rates

.01

.02

.03

.04

.05

Effe

ctiv

e ta

x ra

te

0 20 40 60 80 100Cluster measure

Note: Calculated by the author based on China Economic Census 2004.The tax rate is the average rate among firms in locations corresponding to each percentile of the cluster measure.

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Coping with weak institutions

By staying in clusters, entrepreneurs can better cope with weak institutions, such as lack of security, poor infrastructure, extortions, and high tax rate.

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Flexible production: In-house production versus outsourcing

[I]n fluctuating industries the manufacture might try to keep his overhead charges low by having an establishment large enough to deal with normal demand, and he might extend his output by employing garret-masters.

--- Allen (1929, page 156)

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Still true in China

A childrens garment factory in Zhili

Maintain 60 core workersOutsource any extra order

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Workers and contractors

A garment factory in Bangladesh32

How to Build Clusters?A four stage model, supported by case studies in China

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Clusters: 0 1 N Q0 1: Create something from nothing1 N: Quantity expansionN Q: Quality upgrading

34

Clusters: 01

Planting seeds is the most challenging part.

Three universally applicable guidelines 1. Subsidize first movers 2. Go in group3. Go step by step

35

Development as a self-discovery process(Hausmann and Rodrik, JDE 2003)

The first move takes a lot of risks. However, his success creates a large externality. Once seeing a successful example, others will imitate.

Thus, sometimes it makes sense for the government to (financially and politically) support the first mover.

36

37

Priemier Li visited 3W Coffee.The rent was highly subsidized

Inside coffee shop

Zhongguancun Startup Street

Strategies to attract first movers

Provide free/cheap land or tax breaks for leading firms in industrial parks;

Provide ready-to-go factory buildings

Create an enabling micro environment within clusters/industrial parks.

Need to review the literature more carefully to evaluate the evidence.

38

Go-in-group strategy

When Chinese firms invest overseas, they often go in group so as to pool resources to deal with some common concerns, such as on security, lack of infrastructure, short of suppliers, and red tapes.

39

Wenzhou footwear industry Bishan (Chongqing)

Wenzhou is the one of the largest footwear clusters in China. However, in recent years, due to rising wages and lack of land for industrial use, firms have lost competitive advantage in Wenzhou and started to look for places to relocate

Bishan in western China set up a 1,800-acre industry park for footwear industry.

Go in group: bring the whole supply chain

Bring the management team: a retired district party secretary in Wenzhoen footwear cluster was hired to lead the new industrial park for five years. After that, the management right was turned over to local government.

40

Going step by step Chinas industrial parks/SEZs follow a step by

step approach: first Shekou industrial park in 1979 (only 11km2), then larger scale Shenzhen special economic zone (328km2) in 1980, 14 coastal opening-up cities in 1984, finally Chinas joining WTO in 2001.

We observe the same experience in Tanzania.

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42

43

44

Bagamoyo Port: Tanzania begins construction on a mega project

$11billion are funded by China Merchants Holdings International and Oman's State Government Reserve Fund.

45

Slaves were once shipped from Bagamoyo across to the island of Zanzibar to slave markets.Now it is building the largest port in East Africa with 100 square km of special economic zone.

Clusters: 1N is easier than 01

There are many indigenous clusters. It is better to facilitate their growth than building new ones from scratch.

For example, Egypt has at least 145 clusters, which have been formed largely in the absence of government interventions.

46

Cluster development Because of lower capital requirement and other

advantage of collective efficiency, entry barriers are initially very low, resulting in a spurt of extensive firm growth.

In this stage, the government policy should focus on supporting cluster expansions, such as building market places, improving infrastructure, holding exhibits (generic marketing), and enhancing security.

47

Anding potato cluster Anding of Gansu Province used to be one of the

poorest places in China (poverty rate 78% in 1980) and didnt produce potato until 1960s.

Now it has become one of the three largest potato production centers in China.

Potato accounts for two-thirds of the cropping area; Anding provides every Chinese with one kg potato per year. Farmers generate about 60% of their income from potatoes.

48

Major potato production centers in China

Anding potato cluster

Zhang and Hu, 2015, World Development 49

Improve land quality

From the 1950s to 1990s, the government made great efforts to build terrace fields and irrigation facilities at the river basin level. Of the land compatible to terracing, 93.7% has been converted into terrace.

50

Adopt potato productionPotato is more suitable to the dry environment than wheat. Andingreceives only 380mm of rainfall per year, compared to 1000mm in Washington DC.

Potato was introduced in the 1960s as a secondary crop for coping with food shortage. However, wheat is much more appealing than potato in the Chinese diet. In addition, government had guaranteed procurement price for wheat but not potato.

The local government first asked village cadres to set up demonstration fields on their own land. It took years to scale up potato production as seen below.

51

Breed better varieties Gansu Academy of Agricultural Science bred a high yield variety for

starch processing (high starch and low sugar contents).

County agricultural extension station and a farmer accidently bred Xiadaping, the most popular vegetable potato; the Atlantic was imported from the US for chips and French fries.

The county set up a breeding center to produce toxin-free potato seeds. Anding is one of the largest potato breeding centers in China.

52

Price shocks and shift in government policy

0.00

0.20

0.40

0.60

0.80

1.00

1.20

0

100

200

300

400

500

600

700

800

900

1000

1996 1998 2000 2002 2004 2006 2008 2010

Cro

ppin

g ar

ea (m

illio

n m

u)

Pric

e (Y

uan/

ton)

Cropping area

Price

Shift in government policies from stimulating supply to expanding market53

Market equilibrium in the supply/demand expansion phases

54

Expand the market Establish trader and producer associations.

Update market information systems.

Set up a new system of local wholesale markets.

Apply for more freight car quotas.

Subsidize farmers to build storages.

55

Acquire and spread market information

The potato association sends informants to live in major wholesale markets nationwide to collect market information.

The county broadcasts the information in local media (radio, TV, and newspapers) and on large monitors in major gathering places (central squares, railway and bus stations).

Greater market transparency makes it harder for traders to cheat farmers.

56

The spatial distribution of markets over time

: Wholesale market: Village collection pointBlue: Built 1996-2000Red: Built 2001-2005Yellow: Built 2006-2010

57

Overcome transportation bottleneck

Lobby for more freight car quotas (up from 1507 in 2003, to 3605 in 2004, and 6145 in 2009).

Transportation cost to Shanghai:By car: 450 yuan/tonBy train: 225 yuan/ton

Anding to Guangzhou:Anding, China: potato train

58

http://www.cnr.cn/gsfw/gsxw/kx/200909/t20090926_505488451.htmlhttp://www.cnr.cn/gsfw/gsxw/kx/200909/t20090926_505488451.html

Build more storages (55% of annual output)

Farmers storage: 0.36 million tonsMore than 2 storages per household

Small natural ventilation storages: 0.185 million tons

Centrally air conditioned: 10000 ton each Natural ventilation storages: Medium size

200 YuanSubsidy/storage

59

Develop the processing sector

Local government intensified their effort to attract investors: Provide free land Help secure subsidized bank loans Guarantee stable potato supply

This is consistent with Hausmann and Rodriks idea development as a discovery process (because the first mover generates externality, it makes sense to subsidize it).

The number of processing plants increased from 0 in 2003, 2 in 2004, to 12 in 2009. Now it can process about 1/3 of total output.

60

Develop the processing sector

In 2004, the first two plants produced only starch.

Quickly, the product lines have become more diversified: Modified starch for industry use Frozen French fries for fast food chains Potato chips Potato flour Even export to the Middle East and Southeast

Asia.

61

Role of local government Developing cluster/industrial park is a continuous

process with constantly involving in overcoming constraints.

The one-size-fits-all type interventions may work for once, but not all the time.

After a policy helps remove one binding constraint, another emerges, that in turn, requires a new set of local policies.

Continuous tinkering is often required.

62

Clusters: NQ

The rapid quantity expansion often comes at a cost of quality.

As the quality problem accumulates, the likelihood of quality crisis increases.

Policies should shift from supporting quantity expansion to quality upgrading.

63

Wenzhou Footwear Industry Wenzhou (Chinas footwear capital): one billion pairs

of shoes per year. The cluster started in the late 1970s and early 1980s.

Production was dispersed in different households/workshops. The division of labor lowered the capital barriers to entry.

However, easy entry made it difficult to control quality in the cluster.

By 1987, Wenzhou shoes were notorious for its bad quality with nicknames including day shoes, week shoes, and falling heel hoes.

64

Wenzhou footwear industry On August 8, 1987, Chinas Industrial and Commercial

Administration burned 5,000 thousands of Wenzhou shoes and had the event broadcasted on TV. Subsequently, Wenzhou shoes were burnt in ten other cities.

Wenzhou footwear industry was on the verge of collapse. Under the pressure, the local government and the industry joined hands in making some changes:

Established footwear association, which blacklisted enterprises with a bad reputation and shamed them with all its members.

Set up a footwear quality management office, which certified all the shoes produced in Wenzhou.

Provided various incentives for firms with sound brand names and banned those firms with bad reputation from posting advertisement in Wenzhou. 65

Major local industrial polices prior to and after a crisis

0

5

10

15

20

25

30

35

40

Prior to a crisis After a crisis

Quantity expansion Quality upgrade

Ruan and Zhang, 2015 66

Implications for Egypt in Particular

67

Egypts strengths

People are extremely enterprising. Entrepreneurship is in the blood.

Rather high population density

Robust power supply and good infrastructure

68

Strategies Pay more attention to indigenous clusters, which

have been largely off the official radar screen. First map them out.

Take advantage of the global relocations of labor-intensive manufacturing industries

69

Align local governments interest

Most clusters/industrial parks are at the local level. Their development involves constantly tinkering with various bottlenecks.

It is important to put local governments on the drivers seat considering their informational advantage over the central government.

A question arises: how to align local governments interest with local economic development?

70

Align local governments interest

In China, local governments have strong embedded interests in promoting cluster/industrial park development: Fiscal competition among local governments Career competition among local officials

More research is needed to understand the incentive structures of local governments in other countries, including Egypt

71

Cluster-based Development as an Opportunity for Job Creation and Poverty Reduction in EgyptClustersOutlinesWhy Clusters Are Particularly Suitable for Low and Middle-Income Countries?Major constraints and strengthsMajor constraintsMainstream thinking on developmentIt is a daunting challenge to do soFailures of MFIsMajor findingsAlternative thinkingMarshalls three advantages of industrial district:Role of clusters in overcoming financial constraintsPuyuan Cashmere Sweater ClusterThe Putting-out SystemIntegrated factorySlide Number 16Production OrganizersSlide Number 18Workers/entrepreneurs Initial Capital Investment in Puyuan Cashmere Sweater ClusterSlide Number 21Trade Credit in UK in the 19th CenturyTrade Credit in Ethiopia (Handloom Cluster)Existing strengths in low and middle-income countriesMore advantagesClustering as an adaption to predatorsIndustrial park in BangladeshClustering lowers effective tax ratesCoping with weak institutionsFlexible production: In-house production versus outsourcingStill true in ChinaWorkers and contractorsHow to Build Clusters?A four stage model, supported by case studies in ChinaClusters: 0 1 N QClusters: 01Development as a self-discovery process(Hausmann and Rodrik, JDE 2003)Slide Number 37Strategies to attract first moversGo-in-group strategyWenzhou footwear industry Bishan (Chongqing)Going step by stepSlide Number 42Slide Number 43Slide Number 44Slide Number 45Clusters: 1N is easier than 01Cluster developmentAnding potato cluster Major potato production centers in ChinaImprove land qualityAdopt potato productionBreed better varietiesPrice shocks and shift in government policyMarket equilibrium in the supply/demand expansion phasesExpand the marketAcquire and spread market informationThe spatial distribution of markets over timeOvercome transportation bottleneckBuild more storages (55% of annual output)Develop the processing sectorDevelop the processing sectorRole of local governmentClusters: NQWenzhou Footwear IndustryWenzhou footwear industryMajor local industrial polices prior to and after a crisisImplications for Egypt in ParticularEgypts strengthsStrategiesAlign local governments interestAlign local governments interest