Chapter Eleven Development, Transition, and Trade

Chapter Eleven

Development, Transition, and Trade

© 2003 South-Western/Thomson Learning

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Chapter Eleven Outline

1. Introduction

2. Defining Development

3. Development Issues

4. Agriculture, Industry, or Both?

5. North-South Issues

6. Developing Markets: Economies in Transition

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Introduction

• Many, but not all, developing countries face special challenges:– poverty, – illiteracy, – access to safe drinking water, – high infant mortality rates– many others

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Introduction

• We will now focus on trade-related issues for these countries.– Define and evaluate the magnitude of

the development task.– Highlight several distinct subgroups

that face different problems.– Outline prospects of developing

countries and economies-in-transition.

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Defining Development

• Gross national product (GNP)– Measures value of a country’s yearly output.

• High-income economies (in 2000): >$9,266/capita• Upper-middle-income: $2,996 to $9,265• Lower-middle-income: $756 to $2,995• Low-income: <$755

– Imperfect indicator of economic development:• Falls to account for variation in scope of market

transactions in different economies.• Fails to capture many issues relevant to development.

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Defining Development

• Other measures of development:– Infant mortality rates

• A measure of quality of life, income mortality may be high for a variety of reasons.

– Gini coefficient• A measure of income inequality with zero being perfect

equality and one being all income in the hands of one person.

• Table 11.1 lists these statistics for virtually every country in the world.

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Development Issues

• Developing countries, as a group, share some commonalities:– Most followed policies that favored the

industrialized sectors over primary-product production;

– Most isolated themselves from the international trading system; and

– The state dominated the typical developing-country economy.

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Development Issues

• North-South debate– Policy makers from developing economies argued

that their undeveloped status warranted special assistance from developed economies.• Most developed economies lie in the Northern

hemisphere.

• Modern economists now accept 2 basic points:1. Global trade theory does apply to the developing

countries; and2. Market-based international trading system

benefits developing countries that choose to participate.

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Development Issues

• Five basic trade-related issues have played central roles in policy debates:1. What is the proper role of agriculture in a

developing economy? What are appropriate policies towards all primary-product sectors?

2. What is the appropriate role for industrialization in development…and what policies can achieve the desired goals?

3. How can countries with modest resources gain access to new productivity-enhancing technologies?

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Development Issues

• Five basic trade-related issues have played central roles in policy debates (cont.):4. How can developing countries borrow to gain the

advantages of intertemporal trade without encountering debt crisis of the type that made the 1980s “a lost decade” in terms of growth for many borrowers?

5. To what extent is there an inevitable tradeoff between economic growth and environmental quality?

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Agriculture, Industry, or Both?

• Views on development, 1950-65:– Belief that poor developing economies were

fundamentally and structurally different from rich developed ones.

– Developing economies widely seen as prisoners of their dependence on agriculture and other primary goods; corresponding dependence on manufactured goods imported from developed countries.

• Developing countries were also thought to have far too much labor and far too little capital.

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• Import Substitution– Until recently, most developing countries

sought to limit their exposure to the world’s trading system by following this strategy.• Involved extensive use of trade barriers to

protect domestic industries from import competition.

• Focused on eliminating imported manufactures and encouraging the growth of domestic manufacturing.

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• Import Substitution– Form and extent differed from country to

country:• Brazil:Brazil: “Law of Similars” - firms that imported

goods similar to domestic goods would lose access to

– government credit,

– tax privileges, and

– right to bid on government contracts.

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• Import Substitution

• India:India: all imports required a license, and firms petitioning for one had to provide a letter from all potential domestic suppliers explaining why domestic firms could not meet the specifications.

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• Import Substitution• Turkey:Turkey: maintained a list of goods for

which import licenses would be granted – once domestic production of an item began, the good was removed from the list.

• Imports that competed with domestic goods were effectively banned.

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• Changing views on development:– Since 1965, views of economists on development

process have changed dramatically.– Many “facts” accepted earlier recognized as

incomplete, irrelevant, or just plain wrong.• Developing countries respond to prices/incentives and

can benefit from global trade based on comparative advantage and economies of scale.

• Developing economies can and do specialize in manufacturing.

• Developing countries’ terms of trade exhibit little or no long-term tendency to decline.

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• Failure of import substitution.– Infant-industry argument suffers from serious weaknesses.

– Many developing countries were tempted to build highly visible and symbolic national industries (steel or autos) with no regard for comparative advantage or economies of scale.

– Governments often failed in the task of choosing which industries to support.

– Import substitution failed to decrease dependence on imports.

– When developing countries emphasized capital-intensive production despite their labor abundance, they suffered high unemployment and chronically low wages and incomes.

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• Lessons from newly industrialized countries (NICs):– Common elements included reducing import

protection, removing policy biases against exports and agriculture, and allowing manufacturers to produce for export as well as for the domestic market.

– Key was shift away from import substitution toward policies that opened economy to global trade, FDI, foreign competition, and new technology.

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• Outward-oriented development– Best characterized as open to the world economy.– 1980s: shift by many developing countries from

inward-looking import substitution policies to more outward-oriented policies that recognized a role for exports.

– Involves exploiting comparative advantage and economies of scale and importing goods costly to produce domestically.

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• Outward-oriented development (cont.)– Evidence overwhelmingly favors outward-oriented

policies as strategy for development.• Countries that pursue such policies have higher average

growth rates than countries that use import substitution.

• These countries typically experience spurts in their growth rates when they switch from import substitution.

• Outward-oriented policy appears to promote higher growth rates in manufactured exports.

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• Lesson– Most economists now agree that openness plays

complex and essential roles in development:• Provides access to consumer goods, new technology, and

managerial and entrepreneurial resources.

• Also provides domestic firms with market discipline, incentives to reduce costs, and motivation to innovate as they face competition from foreign firms.

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North-South Issues

• Three specific areas of disagreement:1. Agricultural policies;

2. Technology-transfer and intellectual property issues; and

3. The environment.

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North-South Issues

• Agricultural policy– Import substitution policies discriminated against

agriculture in many ways:• Prices were kept artificially low.

– This practice discouraged production.– Also kept incomes low for a majority of the population, which

limited domestic demand for new, domestically-produced manufactured goods.

• Workers who lacked skills to work in industry became unemployed as agriculture sector shrank.

• When developing economies attempted to export agricultural products, they found that developed countries presented many trade barriers.

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North-South Issues

• Agricultural policy (cont.)– The effective rate of protection (ERP) provided by

a given nominal tariff on a finished product depends on the tariffs levied on inputs used in producing it.

• The lower the tariffs on inputs, the higher the rate of protection on the finished good.

– The developed countries’ practice of cascading tariffs, or tariff escalation, imposes increasing tariff rates as a good moves through the stages of production.

• Tariffs are lowest on raw materials and highest on finished manufactured goods.

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North-South Issues

• Agricultural policy (cont.)• Result is often an effective rate of protection on

processed and finished goods several times their nominal tariff rates.

– This limited developing countries’ efforts to move into processing and manufacturing.

– Uruguay Round resulted in some reforms:• WTO members no longer can grant new export

subsidies to agricultural goods.• Also required member countries to convert all nontariff

barriers into their tariff equivalents, which then became subject to negotiated schedule of tariff reductions (36% over 6 years).

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North-South Issues

• Agricultural policy (cont.)• Markets subject to prohibitive quotas in the past

(Japanese rice market) had to provide minimum access to imports.

– Figure 11.3 illustrates that absolute tariff cuts on natural-resource-based finished products exceeded those on raw materials and semi-manufactures.

– Therefore, the effective rates of protection provided to semi-manufactures and finished products in developed countries fell.

See Figure 11.1

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Figure 11.1: Cascading Tariffs on Natural-Resource-Based Products

0Raw materials Semi-

manufacturesFinishedproducts

2

4

5

6

7

8Percent

3

1

Pre-Uruguay Round tariff (%)Post-Uruguay Round tariff (%)

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North-South Issues

• Technology, intellectual property, and development– Technology is simply the set of rules that govern

how inputs or factors of production can be transformed into goods and services.

– Technology transfer• Developing economies point out two aspects of current

technology arrangement that work to their disadvantage:1. The terms on which developing-country firms can gain access

to new technologies; and2. Concerns the nature of the technology itself and its

appropriateness for developing countries.

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North-South Issues

• Technology, intellectual property, and development (cont.)– Prices charged for licenses to use new technologies

has slowed the spread of technology from developed to developing countries.

• Previously, many MNEs restricted the degree of technology transfer to their foreign subsidiaries.

– Today, evidence indicates that the use of the latest techniques and research in foreign markets is increasing.

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North-South Issues

• Intellectual property– Trade disputes over intellectual property involve

trade in goods that infringe on foreign copyrights, trademarks, industrial secrets, and patents, including counterfeit goods.

• Recently, trade in goods containing important intellectual-property elements has grown much faster than trade overall.

– Growth of developing economies’ markets has made innovating firms eager to sell there, but the developing countries’ weak intellectual-property laws have limited the profitability of doing so.

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North-South Issues

• Intellectual property (cont.)– Several factors complicate international

negotiations over intellectual property rules:• Difficulty in determining optimal level of protection.• Obvious distributional consequence of rule changes.

– Strengthening IPR laws will cause short-term gains in the developed countries and short-term losses in the developing countries.

– Uruguay Round agreement on IPR:• Members now grant national treatment: foreign

intellectual property receives equal protection to that granted to domestic intellectual property.

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North-South Issues

• Debts for development– Defining and measuring external debt

(borrowing from abroad) – Figure 11.2.• Sources of country borrowing: bonds sold abroad to

private investors, official lending, FDI, and foreign bank loans.

• Total debt can be divided into short-term debt, long-term debt, and use of credit from the IMF.

See

Figure 11.2

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Figure 11.2: Taxonomy of Developing Country Debts

Total External Debt

Use of IMF Credit Short-term Debt

PrivateNon-guaranteed Debt

Long-term Debt

By Debtor

Official Creditors

By Creditor

Public and PubliclyGuaranteed Debt

Private Creditors

Debt Instruments

Foreign DirectInvestment

Equity Instruments

Portfolio Equity

Bond Issues Bank Loans

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North-South Issues

• Debts for development (cont.)• 1980s: almost all debt was government-owned or

guaranteed.– Defaults during the debt crisis would have been government or

sovereign defaults.

– Disincentive for developing governments not to default: such behavior would result in inability to borrow in the future.

– Debt can be classified by type of creditor:• Official debt: owed to governments and international

organizations.• Commercial, unofficial, or market debt: owed to private

sources.

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North-South Issues

• Debts for development (cont.)– Two main types of borrowing by nature of

payments:• Borrowing using debt instruments.

– Obligate the debtor to make payments of a fixed amount to the creditor at a specified date.

• Borrowing using equity instruments.– Debtor and creditor agree to share in the fortunes of the

project, good or bad, with the shares determined in advance.

– Advantage is that when an investment project fails, the payments owed by debtor to creditors automatically fall, eliminating the risk of default.

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North-South Issues

• Debts for development (cont.)– General rule of debt

• All borrowing must conform to simple rules to avoid repayment and default problems:1. Funds should finance projects that produce returns

sufficient to pay the interest of the loan;

2. The maturity of the loan, or time over which the loan must be repaid, matches that of the financed projects; and

3. The possibility of unforeseen events is evaluated in calculating the total acceptable amount of debt.

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North-South Issues

• Debts for development (cont.)– Insolvency: when a borrower used debt to finance

consumption in excess of income, the borrowed funds do not produce the returns to cover repayment.

– Liquidity problem: loans that come due before the investment projects they fund become productive – the borrower can afford to repay, but not on schedule.

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North-South Issues

• Debts for development (cont.)– What went wrong in the 1980s?

• Many countries used short-term loans to finance long-term investment projects that, even if successful, would not possibly produce returns in time to repay the loans.

• Both debtors and creditors failed to account for possibility of future changes in world economy.

– Faulty forecasts of future commodity prices.

– Developing countries assumed that developed countries’ economic policies would not change.

• World recession caused many changes: reduced export demand, higher interest rates, and currency depreciations.

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North-South Issues

• What Did We Learn?– Needed: economic stability in developing countries

and increase in foreign direct investment levels.

– Two large problems remain:1. Continuing high levels of debt in low-income economies; and

2. Continuing reliance by most developing countries on external capital flows to fund development-related investment.

– Figure 11.3b summarizes borrowing by type of creditor – official flows still comprise the bulk of capital to low-income economies.

See Figure 11.3

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Figure 11.3a: Severely Indebted Low-Income Countries and Capital Flows to Them, 1992-1998

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Figure 11.3b: Severely Indebted Low-Income Countries and Capital Flows to Them, 1992-1998

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North-South Issues

• Economic development and the environment– Several characteristics of environmental issues combine

to produce controversy and difficulties in global policy making:1. Lack of scientific consensus on physical effects of some types of

pollution (e.g., greenhouse gases) makes agreements difficult to reach.

2. Countries with different income levels demand different levels of environmental protection.

3. Environmental restrictions provided an easy disguise for protectionism.

4. Different population densities, geography, and past pollution levels imply that countries’ assimilative capabilities vary widely.

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Economies in Transition

• Countries shifting from centrally-planned economies to market-oriented economies.– Market-based economic system relies on prices to

allocate resources, signal trends, and provide incentives.

– Centrally-planned economy relies on government planning to decide what and how much to produce and how much to pay factors of production.

• Soviet Union started using this system in the 1920s.– After WWII, Soviet Union and its satellites formed Council for

Mutual Economic Assistance (CMEA or COMECON) to manage their intra-group trade.

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• Original CMEA members:– Soviet Union– Poland– Hungary– Czechoslovakia– Bulgaria– Romania

• Later members:– East Germany, Vietnam, Cuba, and Albania.

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• Nature of centrally-planned economies imposed many barriers to efficient international trade:1. Large government bureaucracies;

2. Inconvertibility of their currencies; and

3. Gave weak incentives to producers to make high-quality goods demanded by world markets.1. CMEA amounted to trading system that ignored

comparative advantage, overemphasized regional specialization and economies of scale, channeled trade to group members at expense of potential trade with West, and ignored market prices and product quality.

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• Painful transition from central planning…– 1989: Perestroika allowed Soviet firms to trade

directly with foreign firms.– Some countries began large-scale reforms early,

creating short-run economic shocks.• Poland, Mongolia, Czech Republic, Slovenia, and

Slovakia; today their economies are growing.

– Western officials complain about lack of credible economic data from some of these countries.

• GNP calculations include many state-owned operations which are overvalued.

• Some currencies are maintained at artificial levels.

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• Reform agenda and prospects:– Eliminate price controls and introduce market-

determined prices.– Cut government subsidies to industry.– Remove restrictions on private ownership and

market activities.– Cut military spending and the role of government

in the economy.– Assure macroeconomic stability.– Provide incentives for improved productivity and

quality.

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• Reform agenda and prospects (cont.):– Privatization– Design systems for effective corporate governance.– Create independent central banks to administer

monetary and foreign-exchange policies.– Build legal system to protect private property.– Institute transparent accounting systems.

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Key Terms in Chapter 11

• Gross national product (GNP)

• North-South debate

• Import substitution

• Newly industrializing countries (NICs)

• Outward-oriented growth

• Effective rate of protection (ERP)

• Cascading tariffs (tariff escalation)

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• Technology

• Technology transfer

• Intellectual property

• External debt

• Government (sovereign) defaults

• Official debt

• Commercial (unofficial or market) debt

• Debt instruments

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• Equity instruments

• Maturity

• Insolvency

• Liquidity problem

• Economies in transition

• Market-based economic system

• Centrally planned economy

• Council for Mutual Economic Assistance (CMEA or COMECON)

Documents

Chapter Eleven Development, Transition, and Trade