Global Economic Environment

International Trade &

Economic Growth

Presented by:• Aiman Saeed Baloch • Hira Jawaid • Humair Ahmed

Humair Ahmed

Introduction

• This chapter talks about economic growth by analyzing the impact of:

• Factor endowments

• Improvement in Technology

• And how these factors impact the nation’s volume of trade, its terms of trade and the gains

from trade.

Growth of Factors of Production

• For this chapter we will assume that all units of labor and capital are homogenous.

• We also assume that the nation experiencing growth is producing only two commodities,

commodity X (labor (L) intensive) and commodity Y (capital (K) intensive), under constant

returns to scale.

Labor Growth & Capital Accumulation

• An increase in the endowment of labor and capital causes the nation’s production frontier to

shift outwards.

• If L and K grow at the same rate, the nation’s production frontier will shift outwards in all

directions at the rate of factor growth. (same slope, Balanced Growth)

• If only L grows, the output of both commodities grows because L is used in the production of

both commodities and L can be substituted for K to some extent. However the output of

commodity X (L intensive) grows faster than output of commodity Y.

• If only L grows, K/L will fall, along with the productivity of L, the returns to L, and real per capita income.

• On the other hand, if only K grows, K/L will rise, hence the productivity of L, the returns to L and the per capita income.

The Rybczynski Theorem

“The theorem states that at constant commodity

prices, an increase in the endowment of one

factor will increase by a greater proportion the

output of the commodity intensive in that

factor and will reduce the output of the other”

The Rybczynski Theorem – The Proof

• Doubling L and transferring some L and K from the production of commodity Y more than

doubles the production of commodity X.

• For commodity prices to remain constant with the growth of one factor, factor prices must

also remain constant.

• Factor prices can only remain constant if K/L and the productivity of both K & L remains

constant in the production of both commodities.

The Rybczynski Theorem – The Proof

• To fully employ the increase in L and leave K/L unchanged, the output of Y should fall in order

to release enough K to absorb all the increase in L.

• The increase in X expands by a greater proportion than the expansion in L because some

labor and capital are also transferred from the production of Y. This is called the

magnification effect.

Technical Progress

• Hicksian Technical Progress (John Hicks, 3 types)

• Neutral technical progress increases the productivity of L and K in the same proportion, hence K/L

remains the same. A given output can be produced with less L & less K.

• Labor-saving technical progress increases the productivity of K proportionately more than L. K is

substituted for L, K/L rises. Since more K is used per unit of L, its called labor saving. A given output can

be produced with fewer units of L & K but with higher K/L.

• Capital-saving technical progress increases the productivity of L proportionately more than K. L is

substituted for K, K/L falls. More L is used per unit of K, hence its called capital saving. A given output

can be produced with fewer units of K & L and lower K/L

Technical Progress & the Production Frontier

• With the same rate of neutral technical progress in the production of both the commodities,

the nation’s production frontier will shift out evenly at the rate of the progress (same slope).

• When the productivity of L and K double in the production of X only, the output of X doubles

for each unchanged output level of Y, and vice versa.

• In the absence of trade, all technical progress tends to increase the nation’s welfare,

because of a higher production frontier with same L and population.

Growth & Trade: The Small Country Case

• Effect of growth on production, consumption, trade and welfare when the nation is too small

to affect the relative commodity prices at which it trades, so that its terms of trade remain

constant.

• What happens to the volume of trade depends on the rates at which the output of the nation’s

exportable and importable commodities grow and on the consumption pattern of the nation

as its income expands through growth and trade

Effect of Growth on Trade

• If the output of the nation’s exportable commodity grows proportionately more than the output

of its importable commodity at constant relative commodity prices, then growth tends to lead

to greater than proportionate expansion of trade and is said to be protrade.

Otherwise it is either neutral or antitrade.

• If the nation’s consumption of its importable commodity increases proportionately more than

the nation’s consumption of its exportable commodity at constant prices, then the

consumption effect leads to a greater than proportionate expansion of trade and is

protrade.

Factor Growth, Trade & Welfare

• L doubles and nation 1’s terms of trade do not change with growth and trade.

• At point M, nation 1 produces more than twice of X than atpoint B but less of Y (rybczynski) at P(M)=P(B)=1

• Exchanges 150X for 150Y at point Z on the indifferencecurve VII.

• Protrade output (X increased, Y decreased)• Consumption also protrade (Y increases proportionately

more than X)• Both are normal goods.• Nation 1 is worse off after the growth, as its labor force

(and population) doubled while its total consumption less than doubled. (compare Z to E)

• Hence the welfare of the representative citizen declines.

Technical Progress, Trade & Welfare

• Neutral technical progress in the production of the exportable commodity only is protrade.

• In this case, with constant population and labor force, the welfare of the nation rises.

Relation Between Trade Liberalization and Endogenous Growth

Long-run Relationship Between Trade Orientation & Economic Growth (Endogenous Growth Theory)

• Firstly, import liberalization is expected to promote technology transfer through the import of advanced capital goods. The import of technologically superior capital goods is also enhanced by growing export receipts and higher inflows of foreign capital, which take into account the country’s ability to repay out of export earnings.

• Secondly, an export-oriented development strategy generally leads to higher growth. This is because there are some strictly economic factors, such as returns to scale, indivisibilities, and the impact of competition, that probably produce a more satisfactory economic performance under an export-oriented strategy than under import substitution.

• Thirdly, FDI brings export technology from industrial countries to developing countries as was the case in the East Asian economies.

• Fourthly, outward orientation makes it possible to use external capital for development without encountering serious problems in servicing the corresponding debt.

• Fifthly, the opening up of an economy is likely to speed up the rate of economic growth by leading to larger economies of scale in production due to the positive spillover effects emanating from technological developments in industrial countries.

• A more open economy and less distorted trade regime is often argued to result in a faster rate of absorption of technological progress originating in advanced countries

Aiman Saeed Baloch

Outline

• Effect of growth on welfare and TOT

• Immiserizing Growth

• Changing patterns of production and consumption

• Poverty and Growth

GROWTH AND TRADE: THE LARGE COUNTRY CASE

Effect of Growth on the Nation’s Terms of Trade and Welfare

• Terms-of-trade effect of growth:Growth expands nation’s volume of trade at constant

prices, TOT deteriorates.If growth reduces the volume of trade at constant

prices, TOT improve.EFFECT ON WELFARE= TOT + THE WEALTH EFFECT • WEALTH EFFECT:• It refers to the change in output per person as a result of

growth.• Relationship between TOT, the wealth effect and welfare.

Immiserizing Growth

• Immiserizing growth is a situation first proposed by Jagdish Bhagwati,in 1958.

• economic growth could result in a country being worse off than before the growth.

• If growth is heavily export based, TOT will fall.• Rarely, this fall in the terms of trade may be so large as to outweigh

the gains from growth, economy will be worse off.• ]There is a strong correlation between immiserizing growth and the

export of primary goods in developing countries.• Most economists now regard the concept of immiserizing growth as

more a theoretical point than a real-world issue.

Immiserizing Growth

How growth affects trade

• Growth can affect trade by– changing the pattern of production, either

increasing or decreasing the country’s desire to trade

– changing the pattern of consumption, either increasing or decreasing the country’s desire to trade

Production Effects of Growth

We classify the effects of production growth on trade into 5 cases :

1. pro-trade production effect of growth (area I)) growth can cause both production of export and import-competing goods to grow, with export good increasing more than the import-competing good

2. ultra-pro-trade production effect of growth (area II) growth can cause exports to increase and import goods to decrease,

Production Effects of Growth

3. anti-trade production effect of growth (area III)growth can cause both production of exports and import-competing goods to grow, with import-competing goods increasing more than exports

4. ultra-anti-trade production effect of growth (area IV)growth can cause import-competing goods to increase and export goods to decrease

Production Effects of Growth

5. Trade neutral production effectGrowth can have no effect at all on willingness to trade (growth moves production out along a ray from the origin)

pro-trade

ultra-pro-trade

anti-tradeultra-anti-trade

Production effect of growth on a country’s willingness to trade

neutral

Consumption Effects of Growth

• Tastes also change as a country increases its output capacity,

• and the shift in the indifference curve can have similar effects on willingness to trade that the shift in the ppf has.

Consumption Effects of Growth

• Why? With growth, the income distribution of the country changes – therefore the people whose tastes most strongly determine the distribution of income can change

(Example: growth in population due to immigration – the demand for western music and classic movies may fall, and demand for world music and anime (sp?) may rise)

Consumption Effects of Growth

There are again 5 possible cases

1. anti-trade consumption effect of growth (area I)growth can cause both demand for exports and import-competing goods to grow, with export-good demand increasing more than demand for import goods

2. ultra-anti-trade consumption effect of growth (area II)growth can cause demand for export goods to increase and import goods (and import-competing goods) to decrease,

Consumption Effects of Growth

3. pro-trade consumption effect of growth (area III) growth can cause demand for both exports and import goods to grow, with import demand increasing more than exports

4. ultra pro-trade consumption effect of growth (area IV) growth can cause demand for import goods to increase and demand for exports to decrease,

5. trade neutral consumption effect of growthgrowth can cause the country to increase both its demand for exports and import goods proportionally

• each of these effects are shown on the following graph

Consumption Effects of Growth

anti-trade

ultra-anti-trade

ultra-pro-trade

pro-trade

neutral

In the last 25 years, most countries have been advised to become more integrated with the global economy through exports.

- Structural adjustment policies- WTO- Free Trade Agreements- Bilateral investment treaties

More Economic Growth and Trade And More Poverty. Why?

AgricultureFAO: of 23 ‘food groups’ in 102 developing countries from 1980 -2003,

import surge frequency between 7,131 – 12,167 times. • Senegal – tomato paste – imports increased by 15 times, 50% local

production decline. • Burkina Faso – tomato paste – imports increased 4 times – 50% local

production decline. • Jamaica – vegetable oils – 2 times increase, 68% drop in production• Haiti – rice – imports increased by 13 times• Kenya – dairy, dramatic increase, cuts in local milk sales• Benin – chicken – 17 times, declined local production• Kenya – sugar – 4 times, 79% cut in employment, 160,000

households saw incomes contract.

More Economic Growth and Trade And More Poverty. Why?

Manufacturing Sector: • Policy of export expansion in a large number of developing countries

has not been adopted together with sound policies to expand the domestic production base.

• Without increasing the manufactured value added (MVA), a country’s economic development cannot be sustained over the long term.

• Eg.Jamica, Ghana, Colombia, Uruguay, Paraguay: moderate to high levels of manufactured export growth, but negative MVA in the 1990s.

• After 2 decades of reform, Ghana’s growth in MVA was significantly negative, at -3.5 in the 1990s, i.e. severe deindustrialisation (Shefaeddin, 2005).

Hira Jawaid

Case of Pakistan

Looking back..

• Being impressed by the magic of Western industrialization, most developing countries including Pakistan equated development with IS during 1950s and 1960s.

• Strategy of IS industrialization was adopted through • over-valued exchange rate• use of quantitative controls on imports • Export taxes on principal agricultural exports: cotton and jute.

• Basic objectives of the policy were:• strengthen the industrial base • achieve self reliance• protect domestic infant industries• insulate the domestic economy from external shocks stemming from international capital markets• reduce the chronic balance of payments deficits and use scarce foreign exchange resources.

• To achieve these objectives, the government imposed various quantitative and qualitative restrictions on trade to protect domestic industries.

Era of 60s..

• During 1960s, more liberal policies being opted by the Govt for encouraging the private sector to play a greater role, although highly protected trade regime remained effective.

• Some additional policies were introduced to encourage exports such as, • an overvalued exchange rate• export bonuses• preferential credit access to industries with export potential • automatic renewal of import licenses,

• Consequently, both industrial production and exports registered a reasonable increase during this period.

Era of 70s..

• This trend was reversed during 1970s because of nationalization of industries, financial institutions and an increasing domination of public sector in the economic activities.

• During 70s, export promotion (EP) emerged as a desirable strategy of development because of :

• fall in external financial assistance

• persistent balance of payments problems• disillusionment with IS and enviable export performance of few Eastern nations,

• Govt . took various measures to boost exports such as, • devaluation of Pak-rupee vis-à-vis US-dollar,• elimination of export bonus scheme • discontinuation of restrictive import licensing scheme

• But these steps do not register any significant impacts on exports.

Era of 80s..

• Pakistan started liberalizing the economy with the help of IMF and World Bank in 1982- 83 with a view to improving the efficiency of the economy by increasing the role of the private sector.

• The reforms included • de-linking of the rupee from US dollar in January 1982• price deregulation of a large number of products• denationalization of industry• imports liberalization• export expansion schemes.

• Most of these reforms were implemented by mid-1980s. • The process of liberalization started during 6th Five-Year-Plan (1983-88) and was

implemented with great force after 1988.

Steps towards liberalization..• Beginning 90s -Government pursued vigorous trade liberalization to convert the economy from a

relatively inward looking to an open & outward looking economy

• Government took a number of measures during 1990s that includes: – Privatization– liberalization of trade and foreign exchange– opening up its capital markets to foreign investors.

• Since 90s, the most specific measure undertaken by the government includes:• Reduction of maximum tariff rate on imports from 225% in 1986-87 to 25% in 2005 The average tariff rate has come down to

11% as compared to 65% a decade earlier . • Similarly, the number of custom duty slabs were reduced from 13 in 1996-97 to 4.• Quantitative import restrictions were lifted except those relating to security, health, and public morals, religious and culturre. • All para-tariffs have been merged in to the statutory tariff regime• import duties on 4000 items were reduced.

• In 2000s, in order to encourage FDI, restrictions on capital inflows and outflows were gradually lifted.– Investors allowed to purchase up to 100 percent of the equity ion repatriable basis

• These measures have brought down effective rate of protection, eliminate the anti-export bias and promote competitive and efficient industries.

The Liberal Economy..• Comparing liberalization in economy with the growth in exports:

• 1990s growth in exports - 5.6% per annum• 1980s growth in exports – 8.5% • 1970s growth in exports - 14.97%

• Pakistan's greater integration with the rest of the world is reflected by the trade openness indicator• Trade to GDP in 99-2000 – 25.8%• Trade to GDP in 2007-08 - 36%• If services trade is included the increase is higher are 42% in 2007-08 from 28% in 1999-00

• Taking a long term view of Pakistan’s export performance over the last ten years, Pakistan’s share in the global market has declined by more than 1/3 to 0.13% in 2009 from 0.21 % in 1999.

• During the last few decades, global trade has undergone a major structural change as far as the product composition and geography of trade is concerned.

• The principle reason deteriorating condition is the erosion of the competitiveness of Pakistan’s traditional exports in general and the country’s weakness in diversifying its product and market mix.

Growth rates of Exports & Imports & degree of Openness (%)

Export Concentration

• Lack of diversification in Pakistan’s exports

• Concentration on five items : Cotton manufacturers, leather, rice, synthetic textile & sports goods.

• These 5 items accounts for 73.5% of total exports during 2008-09.• Signs of changing concentration – share of other items in exports increased to 26.5% in 2008-09 from

17.4% in 2002-04.

Composition of exports

• Over years, composition has changed drastically in favor of manufactured goods rather than primary goods.

• Share of manufactured goods increased from 64% in 1995 to 75% in 2009

• Share of primary products started to increased in 2009 owing to tremendous increase in rice exports.

• However , there is a need to shift towards he higher value added and scale intensive products

Direction of Exports

• Low level of trade to GDP – failure of the trade diplomacy

• Lack of diversification in the export markets since the last 60 years.

• US has the highest share; followed by UK.• With deepening of financial crisis, Pakistan's export market is likely to witness contraction of around 3%

as predicted by IMF

• Except for Saudi Arabia, almost all major markets exhibited a declining trend in their respective share in overall exports

Concentration of Imports

• 75% of the country’s imports consist of only 8 categories.

• Within these items petroleum products account for major share; followed by machinery• During 2009, machinery, petroleum and petroleum products and chemicals accounted for a share of

61.5% in total imports.

• This also shows that our imports are highly price inelastic as compared to or exports which are highly elastic.

Direction for Imports

• Pakistan's import are concentrated in a very few markets• USA, Japan, Kuwait, Saudi Arabia, Germany, UK and Malaysia.

• They account for 40% of the imports

• Saudi Arabia enjoys the distinction of major import origin since 2002-03

Terms of Trade

• Terms of Trade represent the relative prices of exports in terms of prices for imports.

• Persistent deterioration in ToT for almost two decades now.

• Decline of 11.5% in 2007-08 and further decline of 2.1% in 2008-09

• Deterioration in 2009 is the lowest since 2003, this reflects the declining international prices of the commodities and oil.

• Reason for deterioration of trade index is that the unit value of the index of imports is rising at a faster pace than the unit value of exports

Worker’s Remittances

• Workers’ remittance inflows have been on the rise since FY2001 and have played a key role in supporting growth and reducing poverty in the country.

• Growing more than six fold since FY2001, they amounted to 4.7% of GDP in FY2009, up from 1.5% in FY2001.

• Such inflows have been instrumental in boosting private consumption of households and have supported a property and real estate boom.

• They amounted to over 5% of private consumption expenditure during FY2003–2009.

Remittance Inflows..

• The United States, Saudi Arabia, and the United Arab Emirates are the largest source countries of remittances, contributing almost two thirds of total inflows.

• Remittances from these countries increased significantly due to reaction to the events surrounding 11 September 2001, when, among other factors, governments placed heavy emphasis on official channels for international payments.

• Remittance inflows have provided critical support to Pakistan’s balance of payments by helping keep its current account deficit in check.

• In FY2009, they financed 63% of the trade deficit and were equivalent to twice the level of foreign direct investment.

• In the two previous fiscal years, remittances on average financed about half the trade deficit and were higher than foreign direct investment.

Effect of Global Financial Meltdown..

• Economic activity in both the developed and emerging economies weakened,– the impact was more severe for developed economies.

• Direct impact on business and industry was worsened by a sharp shrinkage in consumer demand as credit dried up, and job losses accelerated.

• All developed economies recorded output contraction in ‘09 – US, for instance, is expected to record its worst

contraction in the last sixty years.

• Although the FIs in developing economies, fared much better than their developed economy counterparts, these economies are also expected to record substantial slowdown in economic growth.

Effect of Global financial Crisis on Pakistan

Global economic meltdown is affecting our economy via 3 indirect channels:

• Sharp drop in Oil Prices, leading to sharp easing of import demand pressures

• Contradiction in global demand, trade and related activity is impacting adversely the demand

for our exports and remittances from EU and US particularly

• Constricted access to international credit markets and lower investor appetite for risk is

affecting capital inflows, and depressing local asset prices and is reducing already low

investment level.

Pakistan's Current account

• In FY09, CA deficit contracted considerably to 5.3% of GDP from 8.4% in FY08, after continuous expansion in the last four years.

• Previously, CA deficit mainly increased because of higher import prices & sharp fall in financial inflows which led to a rapid depletion of foreign exchange reserves along with substantial pressure on exchange rate.

• In FY2009, tighter demand management policies and lower international oil prices led to a contraction in imports by over 10% as compared to 2008 and an improvement in the trade account, but in the context of a 5.9% drop in exports.

Export Position and Financial Account• Effect of power crisis and global economic downturn on textile exports (account ing for 50% of exports)

• The Pakistan rupee fell by 18.7% against the dollar in FY09, essentially offsetting the impact of high inflation on competitiveness.

• Increase in rice exports made possible by the bumper crop, reduced the drop in exports.

• Cement exports also surged (by 71%) on the back of strong demand from Afghanistan and India and from expansion into new markets in Africa and elsewhere.

• Workers’ remittances showed a 21% increase in FY2009.

• Weakening in the financial account made it difficult to finance CA deficit.

• Foreign direct investment fell by a third in FY2009 & portfolio investment had a large net outflow of nearly $1.1 billion

• Credit from the IMF under a standby arrangement agreed to in November 2008 and increased disbursements from multilateral and bilateral institutions boosted foreign financing

Indicators for CA sustainability• Saving and investment ratio

• In light of twin deficit identity, CA deficit can emerge from either a fall in saving or increase in investment. • CA deficit is less worrisome when it is used to finance investment rather than consumption (lower saving). • Higher investment enhances the productive capacity of the economy which can be used to service the

foreign debt.

• Growth rate of output • Higher growth rate make the country more reliable to service its external debt. • Country can generate CA deficit while maintaining stable ratio of net foreign liabilities to GDP.

• Openness-ratio of export to GDP • Ability of a country to sustain current account deficit also weakens with a narrow export base.• It is relatively easy for a country to service its debt with higher export to GDP ratio.

• Composition and size of capital flows • Current account deficit financed from foreign direct investment and official creditors is more sustainable than

those financed from portfolio and short term private inflows which are vulnerable to changes in market conditions.

• Exchange rate flexibility and policy • Degree of flexibility of exchange rate also effects. • Deficit is more sustainable in the countries where exchange rate adjusts to new fundamentals in case of

external shocks.

Pakistan’s key Indicators of Current Account Sustainability

• It is generally believed that close attention should be paid to any current account deficit in access of 5% of GDP, particularly if it is financed in a way that can cause reversal (Edwards, 2000).

• In case of Pakistan, most of these indicators show signs of weakness.

» (Indicators are a % of GDP)

Prospects for Pakistan

• Improvement in the CA through contraction in imports alone is unsustainable.

• CA will be fundamentally improved only when the Govt build a much larger export base.

• Pakistan’s economic outlook in FY2010 will be shaped by both internal policies and global economic developments.

• Internally, economic outcomes will depend on the Government’s ability to achieve the desired balance between fiscal consolidation and revival of growth.

• Externally, the outlook will depend on the degree of improvement in major trading partners; the consequent impact on Pakistan’s exports and on receipts of workers’ remittances; and developments in global oil prices.

• Global recession, if prolonged, poses an obvious risk to Pakistan’s economic recovery and stabilization through weakening exports, workers’ remittances, and inflows of private capital.

• Finally, revival of higher growth is predicated on continued improvement in the domestic security situation, which is critically important to foster both domestic and foreign investment and to strengthen private sector participation in key sectors of the economy.