Glob_06 ch01.pdf

Chapter 1The Pros and Cons of Globalization for

Developing CountriesA Review of the Theoretical Issues and the Empirical Debate

David Bigman*

IntroductionDespite the highly favorable views that most researchers in the academic communityand in the international development organizations hold on the globalization processand its impact on developing countries, and notwithstanding the strong support of theempirical evidence of the benefits that many developing countries have derived fromtheir integration with the global economy, the backlash against globalization continuesunabated. An online debate on Globalization and Poverty organized by the WorldBank Development Forum in mid-2000 echoed the loud and often very aggressiveprotests against globalization that erupted in Seattle, Washington, and Prague; nearlyall the participants in the debate emphasized the very negative impact of theglobalization process on the distribution of income and wealth between and withincountries:

Globalization may improve growth rates, increase productivity, enhancetechnological capability, but it cannot redistribute created wealth andincome in favor of the poor. In fact, it does the reverseit redistributeswealth and income in favor of the not so poor.

The participants underscored the harmful impact on the poor:

Money can be made by growing things for export on foreign-ownedcommercial farms No money can be made by the villager working her ownland when she cannot afford the few bags of fertilizer, the seeds and theinsecticides, courtesy of the structural adjustments, the liberalization, theremoval of support systems and the massive devaluations.

Many participants also noted that the market is by no means the panacea for the centralproblems that the majority of the population in developing countries is facing:

With the opening of our market, our country has become a supermarket offoreign goods, which are cheaper, killing our local industries, rendering

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* David Bigman: International Service for National Agricultural Research

many more jobless. The disparity between the rich and the poor haswidened, and although some may have benefited from the effect ofliberalized economy, the majority continue to languish in poverty.

The opposition against globalization unifies labor organizations that protest againstthe flight of jobs South of the border, human-rights groups opposed to sweat shopsthriving on child labor, environmentalists concerned about the damage to the globalhabitat, and radicals suspicious of the clout of multinational corporations that areperceived as the all-powerful agents of capitalism. The IMF, the World Bank, and theWTO, and, more generally, the high-income countries, are held responsible forinfluencing and largely determining the course of the globalization process. They arealso seen as the driving forces behind the policy reforms that the developing countrieshad to implement as part of their structural adjustment programs under the stewardshipof the IMF, the World Bank, and the WTO. However, while many passionateopponents of globalization view these reforms as unacceptable dictates, the reformshad actually quite positive effects on the economies of most developing countries. InEast Asia, most countries experienced unparalleled rates of economic growth duringthe past two decades; as a consequence, a large portion of their poor population waslifted out of poverty. Despite the crisis of 199798, which exposed serious weaknessesin their financial, social, and political systems, as well as in their institutions ofgovernance, most East Asian countries embarked on a course of comprehensivereforms to deal with the crisis, and they have entered the 21st century with reneweddrive.

In contrast, most countries of sub-Saharan Africa, and quite a few countries inSouth Asia, Latin America, and the Caribbean, did not benefit from the globalizationprocess, and, despite a series of structural adjustments, these countries are burdenedwith much the same structural problems that plagued their economies in the previouscentury, but which now aggravated by heavy debts and the AIDS epidemic. It has beengenerally agreed that the benefits brought about by the global trading system underGATT and the WTO have so far been distributed very unevenly between and withinnations. The rich industrial countries have reaped large gains from increased trade andfaster growth, whereas most poor nations have actually become worse off and theireconomies shrank during the past decade. As a result, the gap between the nations withthe poorest 20% of the worlds population (in terms of per capita income) and thenations with the 20% most affluent population has nearly doubled in the past twodecades, and many developing countries have been marginalized and practically cutoff from the mainstream of the global economy.

These contrasting experiences and the growing global income inequality arereflected in the heated debate and the diametrically opposed views on globalization.On the one side of the debate are the various protest groups that underscore the failedexperience of many sub-Saharan African and South Asian countries and thewidespread perception that globalization is detrimental to the poor even in countrieswhere it has had a positive impact on the economy at large. On the opposite side of thedebate is the majority of the economists who, backed by the supporting empiricalevidence on the gains from free trade, adhere to the neoclassical maxim that highlights

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the potential gains from trade and trade liberalization. The theoretical tenets emphasizethat, with trade liberalization, resources are allocated more efficiently to productiveuses, and low-income countries with an abundance of unskilled labor and significantlylower labor costs can expand output and employment in labor-intensive industries,thus accelerating their growth.1 The poor also stand to benefit from this growth, andtrade liberalization is therefore also good for the poor. These benefits are highlightedin several World Bank research papers that concluded that growth is good for thepoor (Dollar and Kraay 2000a) and that In general, the more rapid growth thatdeveloping countries experience as they integrate with the global economy translatesinto poverty reduction (Dollar 2001).

The positive effects of globalization on productivity are also thanks to the transferof advanced technologies and to the opportunities that developing countries can obtainfrom the flow of FDI. Another World Bank paper that focused on the impact of therising tide of FDI during the 1990s concluded that the flow of FDI was central to themore rapid growth that many developing countries achieved, and this growth alsocontributed to financing many government-led distribution programs that provideddirect assistance to the poor and improved the social safety nets (Klein andHadjimichael 2000).

Even ardent proponents of globalization agree, however, that the benefits fromfree trade and trade liberalization can be realized only after a transition period duringwhich the countrys institutions of governance and its legal system will have to berestructured, many public enterprises be privatized or dismantled and the marketsystem be strengthened. Given the transformation that most segments of the economyand most institution of governance will have to undergo, this transition may take muchlonger than expected and the process may sometimes be reversed under politicalpressures. In Indonesia and the Philippines, for example, it is not clear whether thecritical part of the transition was completed in the early 1990s with the expansion ofexport-oriented production, or whether it still continues through the first decade of 21stcentury, as the reforms reach the political institutions. Has China completed itstransition period with the economic reforms it implemented as it joined the WTO, orhas it just begun?

These questions are also echoed in what has become known as the debate over thepost-Washington consensus, which acknowledges the fragility of prescriptivepolicy packages of the form liberalize trade and set the price right and the likelihoodthat these prescriptions will fail in countries that lack proper institutions ofgovernance and have only a rudimentary market system. In the on-line debate onGlobalization and Poverty quoted earlier, many participants reflected these viewswhen they argued that the benefits from market deregulation and trade liberalizationare not likely to trickle down to the poor because, in the words of one of theparticipants, the main cause of poverty is the market, not market failure, sincemarkets fail to address strategic interests like food security. Other participants notedthat often their countries own institutions prevent a flowering market-based

The Pros and Cons of Globalization for Developing Countries 29

1. See, for example, the World Banks World Development Report 1999, p. 52, for a summary of thesebenefits.

development. Others emphasized unequivocally that Decades of external influencesin different forms have undermined and destroyed the traditional institutionalmechanisms while creating islands of modern institutions that are inefficient and aliento their society at large. Through this process, the North has imposed a money-basedeconomic system and such rules for participation upon the poorer nations of the world[that] have destroyed the traditional and local ways of wealth distribution in favor of acash economy ruled by international forces. Indeed, suspicion and even hostilitytoward the market, and strong opinions that unfettered market processes favor the richand powerful and their outcomes are inherently unjust are common.

Against the background of these opposing views and the resulting heated debateover the merits of globalization for developing countries, the objective of this chapteris to provide an overview of the main arguments raised by the two sides in the debateand evaluate the pros and cons of globalization for different groups of developingcountries. Section I reviews the theoretical issues raised in this debate and theempirical evidence on the impact of globalization on economic growth. The sectionincludes a survey of the development strategies that the international developmentorganizations, primarily the World Bank and the IMF, have promoted. In addition, thesection presents the main results of an empirical study on global income inequalitybased on the data of the GDP per capita of 152 developed and developing countriesover the period 196098. The first objective of this study is to identify and comparepatterns in the economic reforms that countries that have gained from the globalizationprocess have implemented in order to be integrated into the global economy, andpatterns in the economic policies of countries that were left behind; the secondobjective is to evaluate how inclusive the process of globalization has so far been.

Section II focuses on the different approaches to the trade policy of a developingcountry in the current global trading system. The theoretical writings and empiricalevidence of the past two decades clearly support the basic tenets of the neo-classicalparadigm which hold that a labor-abundant developing country stands to reapsignificant gains from trade liberalization and an outward looking economic policy.But a number of issues require closer examination: One issue is the question whetherthe global trading system that evolved under the Uruguay Round Agreement of theGeneral Agreement on Tariffs and Trade, the WTO and the regional trade agreements,including the rules on food safety, the nontechnical barriers to trade, and IPR, is indeedthe system of free trade that the neoclassical economists envisaged. Other issues arerelated to the lessons from the Asian economic model: First, even the East Asiancountries adopted at the early stages of their development active policies that protectedand subsidized their infant industries in order to promote their exports. Second, thehigh and often unqualified praise that was heaped on the Asian model of capitalismuntil the 199798 financial crisis ignored major weaknesses in their systems ofgovernment and their legal and political institutions that were exposed during the crisisand that, to a large extent, were responsible for this crisis.

Another issue is related to the failure of most countries in sub-Saharan Africa andmany countries in South Asia and Latin America to develop an industrial base,particularly against the background of the Asia miracle. One factor that hamperedtheir growth performance is their focus on the production of import substitutes and the

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bias of their policies in favor of consumers and against producers; another factor is thebias in their trade policies against agriculture and in favor of industrialization. Theseissues are discussed in section III, which focuses on the agricultural sector and on thetrade and development policies that affected the rural population. The sectionunderscores the difficulties that the rural population had to face during and as an effectof the structural adjustment programs (SAPs) and the reforms to liberalize trade. Thechapter concludes with remarks that discuss some central considerations for theformulation of development policies.

Globalization and Economic Growth: Theory andEmpirical Evidence

The debates over development strategiesin retrospectThe debate over the structure of development strategies that would be most effectiveand socially most desirable for promoting growth and alleviating poverty, and over thebalance between these potentially conflicting objectives, went through distinct phasessince the early 1960s. In part, these phases reflected the wide differences in theexperience of different countries during different time periods; in part, they reflectedmarked disagreements over the ability to bring about a significant reduction in povertyby promoting economic growth alone, and over the need and the potential advantagesand disadvantages of accompanying these growth strategies with active incomedistribution measures.

The early economic growth literature that provided the intellectual foundation forthis debate emphasized the segmentation of the economy in developing countries intoa modern, mostly industrial sector in urban areas, and a traditional, mostly agriculturalsector in rural areas. Constraints on land availability and declining land quality,together with the continued rise in the rural population, reduce the marginal product oflabor in the traditional sector to near-subsistence levels and drive the surplus ofunskilled labor to urban areas. In this model, the embryonic modern sector cannotabsorb all the surplus labor and, at the early stages of development, this migrationwould lead to a rise in income inequality and poverty. However, abundance of cheapand mostly unskilled labor and open unemployment in urban areas, and disguisedunder-employment in rural areas, give incentives to increase production in the modernsector in labor-intensive industries. The rising demand for labor in the labor-intensiveindustries would gradually absorb the unemployed in urban areas and theunderemployed in rural areas, thus bringing about, over time, a reduction in povertyand income inequality at later stages of development.

The actual realization of this stylized model varied widely between countries andcontinents and between time periods. In the 1960swith the emergence of new nationstates throughout Asia and Africa and the rapid economic progress in all countriesacross all continentsthe focus was on economic growth as the most effectivestrategy for meeting the needs of the rapidly growing populations in the newlyindependent countries. In the 1970s, poverty and income inequalities were on the rise.In many countries in Latin America and the Caribbean, South Asia, and sub-Saharan


Africa, the pace of industrialization was too slow to absorb the flow of rural migrants,often because production in the modern sector, especially manufacturing of importsubstitutes, was highly capital intensive and did not provide enough employment.Despite the diminishing prospects of rural migrants to find employment in urban areas,migration from rural areas continued due to rapid population growth and dwindlingland resources, thus leading to higher poverty also in the urban areas.

Disillusion with the trickle-down effects of growth shifted the emphasis to astrategy that deals simultaneously with economic growth and poverty. The then WorldBanks President, Robert McNamara, expressed this shift by stating that [g]rowth, assuch, can be considered a necessary but not sufficient target of development strategy.In 1974, the Bank issued a document titled Redistribution with Growth that extendedthe goals of its development strategy by seeking to influence both the rate and thepatterns of growth in order to reach the poor. The document advocated policypackages consisting of a wide range of measures that included promotingemployment of unskilled labor, developing new technologies to make low-incomeworkers more productive, targeting investments on pockets of poverty, allocatingmore resources to the education of the poor, and providing for the basic needs of thepoor, particularly food and health care, from public sources. Redistribution withGrowth insisted that poverty-focused planning does not imply abandonment ofgrowth as an objective. It implies, instead, a redistribution of the benefits of growth.(p. xviii). The 1980 World Development Report echoed this theme and made the casefor a more concerted effort to secure the basic needs of the poor and argued for targetedinvestments in human development and technologies suitable for the poor primarily inrural areas.

During the almost three decades since the publication of Redistribution withGrowth, these strategies continued to evolve with the accumulation of moreexperience and data from a growing number of countries, and with the deepeningunderstanding of the economic and political processes in developing countries. The1980s brought two diametrically opposed experiences. At the one extreme was thefailed experience of many countries in Latin America and the Caribbean andsub-Saharan Africa with highly interventionist policies and large public spending thatled to high public debts, massive macroeconomic imbalances, stagnation, and growingpoverty. The debt crisis propelled the IMF and the World Bank to enter stage and giverise to policy-based lending: loans disbursed in exchange for policy reforms aimed atcorrecting macroeconomic imbalances and boosting productivity through structuralreforms. At the other extreme was the very successful experience of the East Asiancountries with rapid industrialization, high growth rates and a steep reduction inpoverty. The accelerated growth of their modern sector, led by labor-intensiveproduction for exports, brought about a gradual reduction in their unemployment and arise in incomes in their urban and rural areas that led, in turn, to a steep reduction inpoverty. Moreover, improving skills of the labor force enabled these newlyindustrialized countries to gradually move to higher, more advanced levels ofindustrial production and to products and production technologies that are morecapital- and more skilled-labor intensive. Although growth was accompanied in somecountries by rising income inequalities, it lifted all boats and steeply reduced

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poverty. The sharp differences between these experiences underscored the limitationsand potentially undesirable effects of proactive redistribution policies. Against thisbackground, the debate over the pros and cons of alternative growth strategies acquiredanother dimension with the renewal of old debates over the proper balance betweenmeasures to promote growth and measures to reduce income inequality and poverty,and over the desirability of government intervention in the economy even if this meantcurtailing the free market and reducing efficiency.

During the 1980s, the reforms focused on structural adjustment programs underwhich governments had to make firm commitments to economic restructuring thatfocused on trade liberalization, tax reform, realistic exchange rates, liberalization ofcapital markets and privatization in exchange for support by the World Bank and theIMF. In the early 1990s, the East Asia miracle highlighted the significance ofmarket-oriented structural adjustments. The World Banks 1990 World DevelopmentReport advocated a new strategy to combat poverty based on more effective marketincentives and better social and political institutions, infrastructure, and technology onthe one hand, and on direct measures of governments to provide social services such asprimary health care and education on the other hand. This two-pronged approach wasbased on more open markets and large-scale privatization accompanied by greatergovernment activism in the provision of public goods in health, education andinfrastructure. The 1990 World Development Report on Poverty concluded that [t]heevidence in this report suggests that rapid and politically sustainable progress onpoverty has been achieved by pursuing a strategy that has two equally importantelements. The first element is to promote the productive use of the poors mostabundant assetlabor. It calls for policies that harness market incentives, social andpolitical institutions, infrastructure, and technology to that end. The second is toprovide basic social services to the poor (p. 3). Specifically, the poverty reductionstrategy recommended in the report had three main components:1. Promoting broad-based growth that makes intensive use of labor in order to

increase the productivity of the poor and the economic opportunities available tothem.

2. Ensuring the access of the poor to good quality basic social services in order toenable them to take advantage of economic opportunities.

3. Providing social safety nets for the most vulnerable members of society.

The 1990 World Development Report recommended a growth strategy that includesinvestments in industries and production technologies that can absorb surplus labor aswell as investments in human capital to allow the poor to take advantage and reap thebenefits of new technologies. The World Banks Poverty Reduction Handbook of 1993and Adjustment in Africa of 1994 echoed the message of the 1990 World DevelopmentReport by emphasizing the importance of an outward-oriented strategy and export-ledgrowth. The Handbook emphasized the need to promote trade and exploit thecomparative advantage of developing countries in products and production processesthat are labor-intensive; in contrast, tariffs and other restrictions on trade are likely toinhibit growth and increase unemployment and poverty by giving incentives tocapital-intensive production of import substitutes. A study conducted by the World


Banks Office of Executive Directors in 1995 titled The Social Impact of AdjustmentOperations emphasized that growth is the most significant process affecting povertyand that a consistent implementation of sound macroeconomic policies is essential forpromoting sustainable growth. A subsequent study titled Social Dimension ofAdjustment, conducted by the Banks independent Operations Evaluation Departmentin 1996, concluded that good macro-economic policies and measures, combined withrelevant sectoral policies and appropriate public expenditure allocation, provide afavorable environment for sustained growth and poverty reduction. The studyfound, however, that in most countries, the actual reduction in poverty was quite smalland high levels of income inequality and poverty persisted.

Addressing the controversy over the seeming trade-off between growth andequality, Bruno (1995) noted that, although direct action on health, education, andnutrition can improve the quality of life for the poor, growth is the only strategy thatcan secure a sustained reduction in poverty and provide the resources that arenecessary for any direct action to reach the poor. The 1995 World Development Reportreiterated the conclusion that open trading relations [and] domestic policies thatpromote labor-demanding growth are central to equitable growth. The World Bankand the IMF therefore relentlessly pushed developing countries in the direction of theWTO system. However, the Banks 1995 report also noted that growth may augmentincome inequalities and that

[s]ome groups of relatively poor workers have experienced large gains in the pastthirty yearsespecially in Asia. But there is no worldwide convergence betweenrich and poor workers. Indeed, there are risks that workers in poorer countries willfall further behind, as low investment and educational attainment widendisparities. Some workers, especially in sub-Saharan Africa, could be increasinglymarginalized. And those left out of the general prosperity in countries that areenjoying growth could suffer permanent losses, setting in motion intergenerationalcycles of neglect (p. 21).

These considerations led to the argument that in these countries the government musttake active measures to secure the livelihood of the poor, even if these measures mayrestrict the free market and diminish the countrys growth prospects. The counter-argument asserted that, by reducing the countrys rate of growth, the governmentmight in fact defeat the long-term goal of reducing poverty.

During the past decade, it has been increasingly recognized, however, that asuccessful implementation of policy reforms depends on the countrys institutions ofgovernance, and that the weakness of the institutions in the majority of the developingcountries was the principal obstacle for the success of their structural adjustmentprograms. In the East Asian countries, weak institutions contributed to the 199798financial crisis; in many countries in Latin America and the Caribbean, the weaknessof institutions contributed to aggravate the impact of the global crisis on theireconomies, and in nearly all the countries in sub-Saharan Africa, weak institutionswere not only the main obstacle to the implementation of the reforms, but also the mainreason for the continuous political and social unrest. It has been realized that, in all

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developing countries, the reforms were too narrowly focused on macroeconomicpolicy and that the new agenda must stress also anticorruption efforts, effectivecorporate governance, banking transparency and independence, strong capitalmarkets, and adequate social safety nets. The World Bank and the IMF made concertedefforts to work with governments to implement codes of best practices in a variety oftechnical areas such as banking regulation and supervision, corporate governance, andaccounting.

The World Development Report of the year 2000 adopted a much wider definitionof poverty, which includes not only income shortfalls and low levels of health andeducation, but also powerlessness, voicelessness, vulnerability, and fear. This verywide definition of poverty also calls for a much larger menu of policies to combatpoverty, ranging from fostering economic growth, strengthening the rule of law,promoting community development and gender equity, to closing the digital andknowledge divide. To be able to attack the wider dimensions of poverty, the WorldBank has continuously diversified its own operations by adopting new goals and newwork areas in order to assist countries in education, science, health, child nutrition,population, industrial development, trade policy, and the environment. This expansionreflected not only the Banks propensity to grow, but often also pressing needs that hadnot been adequately addressed by the existing development institutions, primarily theother agencies of the UN system; in addition, it also reflected the growing influence ofnongovernmental organizations (NGOs) that pushed for the incorporation of issuessuch as the environment, the role of women in development, human rights anddemocracy into the Banks agenda, although some critics claim that this expansionreflects mostly the Banks inability to sort out its priorities.

In principle, each of the above actions is essential to tackle the wider dimensions ofpoverty. However, given the limited resources that developing countries cancommand, not all of these actions are feasible, and it is therefore necessary to establishclear priorities and trade-offs. The Bretton Woods institutions have a clearcomparative advantage in advising on, and supporting the implementation of, actionsthat affect a countrys economy, and even among these actions, it is necessary toestablish priorities. However, by widening the definition of poverty, spreading thin theWorld Banks resources, and, without determining priorities, extending the menu ofactions beyond the scope of the Banks comparative advantagethus also divertinggovernments (and the World Bank) from the task of promoting growth and economicefficiencythe 2000 World Development Report may have reduced the Bankseffectiveness and its influence over the choice of a development strategy.

While the debates over development strategies have always reflected topicalconcerns of the time, they often remained too abstract and generic in that they failed torecognize the substantial differences between countries. These differences cast doubton the notion that a development strategy can be formulated in the abstract or that it canyield a menu of actions and policy recommendations that apply to all countries.Lumping all the developing countries together and advocating a one-size-fits-alldevelopment strategy with a blueprint of actions can be oversimplifying and possiblyeven misleading. For each country, it is necessary to recognize its unique geographic,socio-economic and political conditions, to establish priorities that reflect these


conditions, and to identify the critical areas on which its economic policy should focus.Recommendations to promote labor-intensive growth and open trade (WorldDevelopment Report 1990), or to promote opportunity, facilitate empowerment, andenhance security (World Development Report 2000), may fail to recognizecountry-specific needs and differences in the underlying conditions.

Thus, while in most East Asian countries growth proved to be the most effectivestrategy for reducing poverty, many Latin American and Caribbean countriesexperienced a much smaller reduction in poverty with growth. Their greater sensitivityto the needs of the poor made it necessary to accompany the pro-growth policies withadditional measures to ensure a more equal distribution of the growing nationalincome. The experience in a considerable number of sub-Saharan African countriesshowed that for them, administrative restrictions on exchange and interest rates, oreven on the government budget, proved to be quite useless, since these countries lackthe necessary institutions and the rule of law to ensure the proper implementation ofthese policies. In these countries, the main focus of policy reforms at the early stages ofdevelopment should therefore be on measures to strengthen the institutions ofgovernment and the rule of law. Indeed, one lesson of the East Asian crisis is that evenin the relatively more advanced developing countries, economic policy must placemuch greater emphasis on institution building, strengthening the rule of law, fightingcorruption, etc. The second lesson is that a countrys growth is function not only of itsendowments of labor, capital, and natural resources, but also of the strength of itspublic and private institutions and its legal and political systems.

The neo-classical prescription for promoting growth in alabor-abundant countryThe present discussions on growth and employment in a labor-abundant developingcountry take their origin in the neoclassical writings, particularly the labor-surplusmodel of Lewis (1954), Fei and Ranis (1964), which dominated much of the economicdevelopment literature in the 1960s and 1970s. In Lewis model of a dual (orsegmented) economy of a labor-abundant developing country with two distinctsectors, the modern, mostly industrial sector in the urban areas operates along thetraditional, mostly agricultural sector in rural areas. The low living standards in ruralareas drive many to the urban centers and increase the supply of unskilled and lowwage workers (Table 1.1). In the early stages of development, the rural-urban migrantsjoin the ranks of the under- and unemployed in the urban areas due to the limitedemployment available in the modern sector. Empirical studies estimated that in manycountries the rate of unemployment in urban areas exceeded 20% of the labor force(Berry and Sabot 1978; Berry 1989). Nevertheless, rural-urban migration continuedunabated.

Harris and Thodaro (1970) explained the continued flow of migrants despite therising urban unemployment by the migrants (subjective) expectations for higherwages that took into account not only the wage differential between urban and ruralareas, but also the probability of finding employment. Rural migrants were alsoattracted by the better facilities for health and education and the better quality of water

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supplies in urban areas that reflected the large bias in government expenditures (Lipton1977; Larson and Mundlak 1997). In many developing countries, industrial growthremained, however, quite slow and capital intensive despite the large supply of labor,and the bulk of new jobs in urban areas were not created in the modern sector, but in theinformal, traditional urban sector that includes basic manufacturing and small-scalecommerce and services, where production is highly labor-intensive and earnings arelow (Berry 1989).

In many East Asian and some Latin American countries, in contrast, rapid growthof labor-intensive and export-oriented industries led to a gradual reduction inunemployment, a rise in real wages, and a reduction in poverty in both urban and ruralareas. In Korea, Adelman and Robinson (1978) concluded the strategy oflabor-intensive, export-led growth produced significantly higher incomes for thepoorer half of the population and a far more equal relative distribution (p. 127). InIndonesia, Thailand, and Malaysia, the industrial growth led to an annual rise of over2% in the real incomes of the rural population. Accumulation of both physical andhuman capita enabled the East Asian countries to move to higher, more advancedlevels of industrial production, and to products and production technologies that aremore capital-intensive and require more skilled labor.

Table 1.2 demonstrates the large differences between the rates of growth ofdifferent countries during the past four decades. The economies of the sub-SaharanAfrican countries generally stagnated; in Latin America and the Caribbean, growthrates were higher, but they varied widely between countries. In these two groups ofcountries, many of the poor remained in rural areas and did not benefit much from thegrowth in the urban sector. In the East Asian countries, in contrast, the rates of growthin labor-intensive export industries were high enough to absorb the surplus labor


Table 1.1. Demographic Characteristics of Selected Developing Countries: 197395Annual growth rate of the population Share of urban population

overall urban rural mid-1970s mid-1980s mid-1990s

LACBrazil 2.2 4.1 -2.45 59 71 87Chile 1.8 2.4 -0.9 77 82 87Peru 2.3 3.6 -0.3 59 67 76

AfricaGhana 3.9 5.3 3.0 33 38 43Kenya 4.3 8.0 3.5 12 17 24Tanzania 3.4 8.6 2.5 9 14 23

AsiaIndia 2.1 4.2 1.2 19 24 30Indonesia 2.1 4.8 1.2 18 24 31Pakistan 2.7 4.3 2.0 25 29 34

Source: World Bank, various tables

despite the continued migration to urban areas; as a result, the rate of unemploymentdeclined, both urban wages and rural earnings increased and poverty declined.

Table 1.2 also highlights the reasons for the criticism of the labor surplus model,because it fails to explain why in so many labor-abundant economies growth was veryslow and industrialization faltered, while in other countries growth was very rapid andindustrialization was highly successful. There is also criticism of the models failure toexplain the changes in income distribution that took place during the growth process:many countries that experienced rather similar growth rates of the average per capitaGDP had wide differences in the changes in the level of poverty. In Mexico, thePhilippines, Nigeria, and few other countries, growth was accompanied by a rise inincome inequality to the extent that poverty actually increased.

A large number of empirical studies tested Kuznets hypothesis either incross-section studies of many developing countries or in time-series analysis ofindividual countries. Many of these studies, particularly the ones that conducted across-section analysis (Adelman and Morris 1973; Ahluwalia 1976; Chenery andSyrquin 1975), tended to confirm Kuznets hypothesis, and thus strengthened theinclination to adopt a development strategy that puts greater emphasis onredistribution measures. Since the initial impact of growth is to increase incomeinequalities, so the argument went, and since this effect can last for quite some time,growth must be accompanied by active redistribution measures. Chenery (1971)asserted that growth that does not change the resource allocation in favor of the poorconstitutes growth with little development, and recommended proactiveredistributive measures if economic growth does not bring about a significantreduction in poverty.

During the 1990s, with the accumulation of more data on income distribution in alarge number of developing countries over a longer time period, several studiesexamined again Kuznets hypothesis, but this time in a time series analysis (Bruno,

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Table 1.2. Growth of GDP Per Capita in Selected Countries: 196097Country 1960 1997 Average annual change (%)South Korea 885 10,500 6.9Taiwan 1355 13,250 6.4

Ghana 875 850 -0.1Senegal 1015 1095 0.2Mozambique 1125 805 -0.9

Brazil 1745 5500 3.2Mexico 2800 6300 2.2Argentina 3295 4750 1.0GDP per capita in US$ in 1985 prices.Source: World Bank, various tables.

Ravallion, and Squire 1995; Ravallion 1995; Ravallion and Chen 1996). These studiesconcluded that, while the trends in income inequality with growth differ significantlyacross countries, there is no evidence that growth has any discernible systematicimpact on inequality. In a sample of household surveys from a large number ofcountries, Ravallion and Chen found that in only half of the cases growth wasassociated with an increase in inequality. Bruno et al. emphasized that although thereare exceptions, as a rule, sustainable economic growth benefits all layers of societyroughly in proportion to their initial standard of living.

Based on the evidence of the last decades, there seems to be no credible support forKuznets hypothesis. These studies also confirmed that positive economic growth wassignificantly associated with a falling incidence of poverty, and that economiccontraction was associated with a rising incidence of poverty. Bruno et al. calculatedwith data of 20 countries over the period 198493 that a 10% increase in mean percapita consumption led to an average 20% decline in the proportion of the populationliving on less than $1 per day. Lipton and Ravallion (1995) calculated with the data ofeight developing countries that a distribution neutral growth at an annual rate of 2% inmean per capita consumption would lead to a decline in the poverty gap of 3 to 8%.These findings motivated a change in the approach to development strategy in themid-1990s in favor of a strategy that gives much greater weight to growth andadvocates re-distributive measures only in countries where there is clear evidence thatthe growth process is narrowly based and leaves out large segments of the population.In most countries, though, this approach emphasized the potentially undesirableeffects of re-distributive measures on economic incentives and efficiency. The debateon these issues is far from over, and the more recent chapters in this debate arediscussed later on.

Globalization and global income distribution 196098:Has there been a convergence?A large number of studies sought to estimate the changes in the global incomedistribution between and within countries during the second half of the 20th century.Blotho and Toniolo (1999), drawing on data for 49 countries, found that the measure ofglobal income inequality shows a modest trend toward convergence starting in 1980.Melchio, Telle, and Wiig (2000) evaluated the changes in income inequality betweencountries on the basis of a sample of 115 countries and they also found that, after arelatively stable period during the 1950s through the 1970s, global incomes tended toconverge from the mid-1980s through the mid-1990s. Other studies used differentsamples and slightly different time periods, but came essentially to the sameconclusion (Schultz 1988; Firebaugh 1999; Radetzki and Jonsson 2000). In a sampleof 100 countries, Clark, Kraay, and Dollar (see Dollar 2001) found that worldwideinequality increased during 196075, but declined during 197595, largely due to theaccelerated growth in China and India. Using household survey data drawn from 91countries for 1988 and 1993, Milanovic (1999) reached a different conclusion.According to his estimates, income inequality, measured by the Gini index, rosemarginally from 63 to 66, primarily due to an increase in income inequality between


countries, rather than rising inequalities within countries. These seemingly conflictingconclusions reflect primarily differences in the sample of countries and time periodson which they draw and the small changesup or downthat these analyses indicate.The question examined in this section is whether the trends in global income inequalityindicated by these global measures indeed represent a tendency of global incomes toconverge, and whether they indicate that the globalization process has therefore beeninclusive, as several recent World Bank reports maintain (see e.g., Dollar 2001).

The analysis in this section is based on household survey data from a larger sampleof countries that includes also the ex-centrally planned countries, but it focuses only onincome inequalities between countries that represent only part, though a central part, ofthe global income inequality. Nevertheless, the estimates of the trends in incomeinequality between countries since 1960 are in agreement with the results of most ofthe studies mentioned above. According to these estimates, the three main measures ofinequality indicated that there has been a decline in global income inequality duringthe past two decades after a period of relative stability during the 1960s and 1970s.This analysis also shows, however, that the global measures of inequality do notprovide an adequate representation of the widening gap between the richest and thepoorest countries.

During 196096, the worlds average GDP per capita increased by nearly 80% inreal terms, but growth rates varied widely between countries and regions: In SSA, theannual average growth rate of GDP per capita was less than 1% during the past fourdecades, and it actually declined in the past two decades, whereas in East Asia, theaverage GDP per capita increased since 1980 at an annual rate of over 4.5% (Table 1.3and Figure 1.1). This rapid economic growth of one group of developing countries andthe relative stagnation in the other group had two conflicting effects on the globalincome distribution: On the one hand, the Asian miracle and the accelerated growthof India and some Latin American countries during the 1990s closed the income gapbetween these countries and the developed countries. On the other hand, the gapbetween the average GDP per capita in the least developed countries, particularly in

40 Chapter 1

Table 1.3. Trends in GDP Per Capita in Selected Regions 196096 (in PPPExchange Rates in 1985 Prices)Region Number of

countries*Population

1990(millions)

GDP per capita (in USD$) Annual growth rate196096 198096

1960 1980 1996

South Asia 6 1,105 781 935 1,333 1.5 2.2East Asia 18 1,671 630 1,242 2,251 3.5 3.8SSA 45 478 761 1,130 1,036 0.9 -0.5LAC 32 421 2,447 4,537 4,480 1.6 -0.1Devped cts 28 858 6,205 11,347 14,259 2.4 1.4World 164 5,064 2,250 3,806 4,000 1.6 0.3* Including the CIS countries

sub-Saharan Africa, and that in the developed countries has widened significantly. Asa consequence of these conflicting trends, global income inequality changed relativelylittle during most of these years (depending on the measure) and the main impact wason the relative position of countries on the global income ladder. What conclusions canbe drawn from these changes about the convergence of the global income distribution?

In 1960, the East Asian countries were at the bottom of the global income ladderwith an average GDP per capita that was some 20% lower than that of the sub-SaharanAfrican and South Asian countries; in 1998, the average GDP per capita in East Asiawas more than double the average GDP in sub-Saharan Africa. As a result, most EastAsian countries climbed to much higher levels on that ladder, while the sub-Saharancountries fell to the bottom (Figure 1.2). In 1960, over 80% of the population in thelower one-third of the global income distribution were in the East Asian countries; in1998, 65% of the population in the lower one-third of the global income distributionwere in South Asia and 31% in sub-Saharan Africa. In 1960, less than 15% of thepopulation at the higher one-third of the global income distribution were fromdeveloping countries; by 1998, their share had risen to 40% (Figure 1.3a and 1.3b).

Table 1.4 shows the changes in global income inequality during 196098, asindicated by the three most common measures of income inequality: the Ginicoefficient, Theils measure, and the coefficient of variations (CV). All three measuresindicate that there were only minute changes in income inequality during the 1960sand 1970s, but since 1980 and until 1998, the decline has been more noticeable. Duringthe 1990s, the decline in the measures of global income inequality was primarily due tothe rapid growth in China and India and the large share of these countries in the globalpopulation. As a result, these two countries, along with most other East Asiancountries and some countries in Latin America and the Caribbean, moved to a higherposition on the global income ladder, whereas the countries in sub-Saharan Africadropped to the bottom. The relatively small changes in the three global measures donot show, however, the changes in the relative position of countries on the globalincome ladder, nor do they show the growing absolute gap between the richest and the


-4

-2

0

2

4

6

8

SouthAsia

East Asia

SSA

MENA

LAC

Ex-Cent.Plan.

Developed

World

1960-1980

1980-1996

1997-1998

Figure 1.1. Average annual growth rates of GDP per capita in main regional groups,196098Source: IMF

poorest countries. The two other measures in Table 1.4 indicate that the gap betweenthe group of high-income developed countries and the group of sub-Saharan Africancountries has increased by nearly 80% during these years, and the gap between themost affluent country (the US) and the poorest country (indicated in the table by theMax/Min Ratio) has increased by over 60%.

Several other observations are noteworthy:1. During the 1980s and the 1990s, the share of the sub-Saharan African countries in

the lowest quintile of the global income distribution has nearly tripled from 11.8%to 31.5%, while the share of the East Asian countries in the lowest quintile fellsharply from 35.1 to 7.3% despite their growing population.

2. The share of the South Asian countries in the lowest one-third of the global incomedistribution increased during the 1980s and 1990s despite the relatively more rapidgrowth of India, and these countries now constitute more than two-thirds of thelowest income group.

3. In the 1960s and 1970s, the share of the East Asian countries in the lowest incomegroup was more than three-quarters, but by 1996 this share had dropped to nearlyzero.

4. The share of the East Asian countries in the middle-income group rose fromaround 10% in the 1960s and 1970s to around three-quarters by the end of the1990s.

5. The share of the developed countries in the highest one-third of the global incomedistribution declined from 64% in 1960 to 43% in 1996, but this was due to thedecline in their share in the global population.

42 Chapter 1

50

100

150

200

250

300

350

1960 1970 1980 1990 1996

South Asia East AsiaSSA MENALAC Ex-centrally plannedDeveloped

1985

US

Dolla

rs

Figure 1.2. Index of GDP per capita (PPP adjusted) by regions, 196096


00,10,20,30,40,50,60,70,80,9

South Asia East Asia SSA MENA LAC Ex-CentrallyPlanned

Developed

Low

Medium

High

Figure 1.3a. The Share of Regions in the Three Income Groups: 1960

00,10,20,30,40,50,60,70,80,9

South Asia East Asia SSA MENA LAC Ex-CentrallyPlanned

Developed

Low

Medium

High

Figure 1.3b. The Share of Regions in the Three Income Groups: 1996

Table 1.4. Measures of Inter-Country Income Inequality 196098Indicator 1960 1970 1980 1990 1998 Change: 196098 (%)

Max/min ratio1 38.55 43.67 47.26 61.93 62.97 +63.3Developed/SSA

ratio 28.15 9.18 10.04 12.26 14.53 +78.3

Gini Coefficient 0.63 0.63 0.62 0.60 0.58 - 8.1Theils Measure 0.60 0.61 0.60 0.56 0.49 -17.6Coeff. ofVariations

1.58 1.55 1.52 1.52 1.48 - 6.3

1. The ratio between the average GDP per capita in the US and in the poorest country.2. The ratio between the average GDP in the developed countries and the average in the SSA countries.

As a result of these changes, the gap between the average GDP per capita in thedeveloped countries and that in the sub-Saharan African countries has increasedsharply, while the gap between the developed countries and the East Asian countrieshas narrowed by over 40%. During these years, the share of South Asia andsub-Saharan Africa in the worlds population rose from 27% to 33.4%, while the shareof the developed countries dropped from 21% to 16%. As a result of all these changes,the gap between the average GDP in the group of developing countries and the averagein the group of developed countries has changed by only 13%, and the measures ofincome inequality within the group of developing countries have actually declined.

These changes do not reflect, however, a convergence of the global incomedistribution, since the gap between the richest and the poorest countries, i.e., the heightof the income ladder, has increased significantly. Clearly, for the populations in thecountries in sub-Saharan Africa, in most of South Asia, and in Latin America and theCaribbean, globalization was not inclusive, and the gap between their standard ofliving and that of the developed countries is now wider than ever. For the population inEast Asia, India, and some Latin American countries, in contrast, globalization wasindeed inclusive, and they enjoyed a rapid increase in their standard of living both inabsolute and in relative terms. An attempt to draw a general conclusion from theseopposing trends and apply it for the average or the representative people indeveloped and developing countries is a rather meaningless exercise in statistics.Instead, the sharp difference between these opposing trends makes it necessary to drawdifferent conclusions for the group of countries that benefited from globalization andfor the group of countries that were left behind.

The critical question in this connection is whether the differences between thesetwo groups of countries reflect also the differences in their development strategies. Inother words, were the countries that reformed their economies able to gain fromglobalization and managed to achieve unparalleled rates of economic growth and asharp reduction in poverty, and were the countries that failed to restructure theireconomies unable to integrate themselves into the mainstream of the global economyand, as a consequence, did they see their economies shrink and their number of poorincrease? A complete answer to this question would require a more thorough analysis,but the reviews of the country experiences in this volume suggest that there is no suchclear correspondence. Quite a few countries, including several countries insub-Saharan Africa, made considerable efforts to reform their economies but wereunable to integrate into the global economy due to a host of other reasons.

Table 1.5 summarizes the trends in poverty in the main groups of developingcountries and in the world during the 1990s. These trends in the incidence of povertywere reflected also in the changes in the rates of child mortality during the 1990s.Whereas in most East Asian and South Asian countries there was a reduction in the rateof child mortality during these years, in most sub-Saharan African countries this rateincreased. In nearly all Asian countries (Cambodia is one exception), child mortalitydeclined during the 1990. The steepest decline was in the East Asian countries: inIndonesia the rate declined from 97 to 52, and in the Philippines it dropped from 68 to47. In sub-Saharan Africa, in contrast, child mortality increased in most countries.

44 Chapter 1

The large differences between the patterns and rates of growth of different groupsof developing countries underscore the fact that lumping all the developing countriestogether and conducting the analysis in terms of North vs South, or developed vsdeveloping countries is becoming increasingly misleading.

International Trade and Trade Policies in Developing Countries

The changing concept of comparative advantageInternational trade economists have long maintained that a liberal and outward-oriented trade regime is the best strategy for a small economy to increase its welfareand income by optimizing the allocation of its resources in production according to thecountrys comparative advantage, and by minimizing the incentives for unproductiveactivities associated with protection, such as smuggling, lobbying, and tariff evasion.Additional channels through which trade can precipitate growth include higher returnsto investments by increasing the market size with trade, higher productivity throughimports and diffusion of advanced technologies, and pressures to rationalize thegovernment trade and macroeconomic policies. Sachs and Warner (1995) estimatedthat open economies grew about 2.5% faster than closed economies, with even greaterdifferences among developing countries. Tarr and Rutherford (1998) use a CGE modelto estimate that a 10% reduction in average tariff (from 20 to 10%) brings about awelfare gain of 10 to 37% of the present value of consumption (depending on the typeof taxes that are being used to replace lost tariff revenues).

The neoclassical theory emphasizes the driving force of low wages, abundance ofunskilled labor and labor-intensive production technologies in promoting trade andspecialization in a labor-abundant country. This analysis is based on an aggregatemodel in which production is a function of labor and capital, and technologies arecharacterized by the proportions (or intensities) of labor and capital in production.Different proportions of labor and capital in the production of different goods, anddifferent endowments of labor and capital in different countries provide the incentivesfor specialization in production and for trade. This model is the basis of the widely


Table 1.5. Trends in World Poverty during the 1990s

Region 1990 1998

No. (million) Poverty rate No. (million) Poverty rateEA 450 27.6 280 15.6LAC 74 16.8 78 15.6SA 495 44.0 522 40.0SSA 242 47.7 291 46.3World* 1276 29.0 1200 24.0Source: World Development Report 2000.* Includes also MENA and the ex-centrally planned economies

employed Heckscher-Ohlin model that separates consumption and production, andshows how the location of production is determined by differences in the technologyand by differences in factor endowments between regions and countries thatdetermine, in turn, their comparative advantage. The model predicts that, as tradebarriers are reduced, production will relocate according to comparative advantage(with relatively unskilled labor-intensive activities moving to relatively unskilledlabor-abundant locations). As this occurs, the changes in demand for factors ofproduction will tend to equalize factor prices across countries.

In this model, the patterns of trade are determined by ranking goods according totheir factor intensities; the labor-abundant country has a comparative advantage in theproduction of labor-intensive goods. Rybczynskis theorem strengthens thisconclusion by showing that, under fairly general conditions, an increase in laborsupplyor an increase in labor productivity (Corden)brings about an increase in theproduction of labor-intensive goods. Specialization in production and movements ofgoods between countries, in line with their comparative advantage, are substitutes forthe movement of factors of production, and trade therefore narrows the differencesbetween factor prices. However, the comparative advantage of a country need not befixed. It may change over time with the changes in its factor endowments andproductivity and with changes in its production technologies. The higher the rate ofgrowth of a countrys labor force, the larger the proportion of labor-intensive goods inproduction and the larger the comparative advantage of the country in the productionof labor-intensive goods. The larger the flow of capital from the capital-abundant tothe labor-abundant country, the smaller the comparative advantage of the former incapital-intensive goods.

Labor-intensive production. In the neo-classical Heckscher-Ohlin two-factor model,labor intensity of a given production technology or a given product is determined bythe capital-labor ratio in production. One production technology is said to be morelabor-intensive than another if the capital-labor ratio in the first technology is lowerthan in the second. Several production technologies can be ranked from the mostlabor-intensive to the least, according to the corresponding capital-labor ratios, thusemphasizing that labor intensity is a relative concept. Moreover, the same product canbe more labor intensive than another in one factor price ratio, but more capitalintensive than another in another factor price ratio. (This is known as factorreversal). In empirical studies within a given country, the physical definition oflabor intensity is replaced by a cost definition that evaluates the shares of labor andcapital costs in the total costs.

For this comparison, it is necessary to remove first any price and cost distortionsdue to subsidies or taxes targeted on some of the industries. A considerable number ofarticles have examined various modifications and extensions of the neoclassical modelof comparative advantage in order to adjust the model to todays conditions in theglobal economy. Most of these contributions still focus on production technologies,factor requirements, and factor endowments as the driving forces for specializationand international trade. Wood and Berge (1997) argued that the concept ofcomparative advantage in the Heckscher-Ohlin model is no longer suitable for todays

46 Chapter 1

conditions for two reasons. First, the high mobility of capital has led to major changesin factor endowments across countries, thereby continuously changing theircomparative advantage. Second, since there is little difference between primaryproducts and simple manufactured products in the intensity of unskilled labor intheir production, the only factors that distinguish the modern sector from thetraditional one are land and skilled labor. On these grounds, they concluded that[c]ountries that have a lot of land and low levels of education should concentrate onopportunities for progress within the narrow primary category (p. 1468). This,however, is a static strategy that ignores the dynamic aspects of comparative advantageand the potential to raise the levels of education and thereby acquire new technologiesand change the countrys specialization.

The more recent writings on the dynamic nature of a countrys comparativeadvantage highlighted the following additional factors: The effects of investment in R&D that can change a developing countrys

comparative advantage by allowing it to produce and export high quality products.(Okamoto and Woodland 1998);

The impact of change in a countrys technological capabilities, and thus also in itscomparative advantage, due to higher skills of its labor force with better educationand training. (Pietrobelli 1997);

The impact of demand shifts in the more affluent North to higher-quality productsas an effect of the rise in income that shifts the production in the North tohigher-quality products, while production of an increasing number of relativelylower quality products is shifted to the South, where labor costs are lower (Flamand Helpman 1987).

In addition to these traditional gains from trade through the more efficient allocationof resources that is achieved with trade, there will be the following additional gainswhen the domestic market can be made more competitive and production betterorganized:1. Pro-competitive gains. These are the effects of increased imports on the

competitive behavior of firms in the domestic market by disciplining themonopolistic or oligopolistic behavior of firms, forcing them to behave in morecompetitive ways.

2. Gains from economies of scale. As the quantity produced by one firm increases,its average cost decreases. This may be the result of economies of specialization(firms operating on a larger scale can match inputs more closely to tasks), ofindivisibilities in production, or of the greater efficiency of large machinescompared to small ones. The decline in average costs leads, in turn, to lower prices.

3. Gains from the rationalization of production. Competitive imports force localproducers to increase efficiency or to exit the market. As a result, the number ofdomestic firms declines and the level of production of each remaining firmincreases. Tthe remaining domestic firms are necessarily more efficient and canreap the benefits of economies of scale.


4. Gains from the increase in variety. The larger variety of products that becomeavailable as the country opens up to trade give consumers higher levels ofsatisfaction.

The globalization of trade and research, the growing weight of multinationalcorporations in world trade, production, and investments, and the rapid technologicaladvancements all promoted greater specialization in production and introducedconsiderable changes in the comparative advantage of both developed and developingcountries. These changes were precipitated by the large flows of investment capital todeveloping countries, by the growing share of skilled labor in these countries thatenabled them to produce advanced manufacturing products, and by the rapidadvancements of information and communication technologies that changed theconcept of distance in all transactions. These changes help explain the significanttransformation of the structures of industrial production in the East Asian countries.The initial industrialization process in these countries was led by the production oftextiles and simple industrial products. Gradually, the production base expanded toinclude more sophisticated manufactured products such as machinery, steel,automobiles, and later to still more advanced products such as computers andelectronics, which are more capital intensive and more skilled-labor intensive.However, not even the production of textiles and clothing could take place at the initialstages of the industrialization process without a considerable inflow of capital, since atthe time these countries were primarily agrarian and lacked the capital necessary forthe production of these simple and labor-intensive goods. Although theindustrialization process also brought a rise in wages, the rise in labor productivity wasmore rapid and the comparative advantage of the East Asian countries against thedeveloped countries was therefore maintained. Nevertheless, the structure of theirproduction and trade gradually changed with the establishment of more advancedindustries that were attracted by the increasingly better trained and more skilled labor.

The multinational corporations were perhaps the most important vehicles thatbrought about this change. In their search for the least costly forms of production, thesecorporations established or expanded affiliates in the East Asian countries andtransferred to them, or to independent contractors, the production of labor-intensiveproducts. Labor costs were, however, not the only consideration of the multinationalcorporations; their choices were also influenced by the relatively stable politicalconditions in most countries and by the direct government support that thesecorporations received. Although labor costs were equally low or even lower in SouthAsia and sub-Saharan Africa, these countries were much less attractive tomultinational corporations and other investors. Despite striking similarities betweenthese groups of developing countries in their initial conditions in the 1960s, the hugedifferences between them in the depth of the industrialization process and the pace ofthe transition to the production of higher-quality and more sophisticated products are,first and foremost, testimony to the fact that the concept of comparative advantage canno longer be narrowly defined, as in the Heckscher-Ohlin model, only in terms ofproduction technology, the direct costs of labor and capital, and the relative intensities

48 Chapter 1

of labor and capital. Other factors are also pivotal in determining the costs ofproduction and the countrys comparative advantage. They include: Access to markets. In this context, access refers not only to the geographical

distance, but to all the components that determine transport costs, including inlandand sea transport costs and the costs of insurance and financial services for trade.Although the African countries are closer to the European markets than are theEast Asian countries, high inland costs due to the distance to the port and poor roadinfrastructure considerably reduce their access to these markets. Access to marketsis also determined by tariff and/or quota protection and by other barriers to trade,including those established by bilateral or regional trade agreements. In the globaleconomy, accessibility is also determined by access to supply chains that controlthe trade and marketing of many commodities at the wholesale and retail levels.

Access to advanced technologies. Low labor productivity, due to high levels ofilliteracy, prevents many developing countries from taking full advantage of theirlabor abundance and low labor costs. In the agricultural sector, the use oftraditional technologies, traditional crop varieties, and low yielding cropmanagement practices in the indigenous agricultural systems constrain farmers toproducing only self-consumption or for the local market and prevent thedevelopment of agricultural exports. The transfer of advanced productiontechnologies and methods from developed countries can accelerate growth andraise labor productivity in the developing countries. The key question is, however,what barriers prevent or slow down the transfer of these technologies and whatpolicy measures can accelerate their diffusion. On the one hand, access toadvanced technologies is limited by the lack of necessary skills, by low investmentin R&D, and, increasingly, by the costs and restrictions on the transfer oftechnologies due to IPR and patent issues. On the other hand, modern informationand communication technologies, including the Internet, reduce communicationcosts and break down geographical borders, thus speeding up the diffusion ofknowledge and advanced technologies.

Economic and political stability. These are essential non-tangible conditions thatdetermine investment risks and costs. Until the 1998 crisis, investors in Asiancountries enjoyed very stable political conditions. This stability was often assuredby authoritarian rule, but opposition was significantly mitigated by the success inraising the standard of living. When these standards fell sharply during the crisis,political stability was severely shaken in many, if not most, of these countries. Inmost sub-Saharan Africa, political stability is all but lacking. Continued wars,frequent changes in policies and in the regimes themselves, weak institutions oflaw enforcement, and widespread corruption significantly raise business risks,discourage investment, increase insurance costs, and are highly detrimental to bothinternal and external trade.

(Relatively) stable labor market. The Asian countrieseach according to itslevel of developmentadopted elements of the Japanese system of lifelongemployment, seniority-based wages, and enterprise labor unions that securedworkers loyalty to their employers. Government welfare programs arerudimentary even in South Korea and Taiwan, and labor unions focus their


demands mainly on job protection. In Latin America, labor unions are national andthey are very active in their countrys politics. The pressures exerted by the unionsand their political power triggered government intervention through minimum-wage legislation and relatively high wages in the public sector. These interventionsdistorted the price of labor and inhibited the absorption of surplus labor.

Functioning markets. The economies of many developing countries were, andstill are, plagued by massive price distortions and a host of restrictions that preventthe development of functioning markets. The removal of these distortions andrestrictions is necessary not only to attract foreign investors, but also to createprofit incentives for domestic private enterprises, and thereby boost productionand streamline labor allocation. In sub-Saharan Africa, the haphazard andincomplete market reforms were noted as one of the central reasons for slowgrowth (World Bank 1994). However, even among the most successful East Asianand Latin American countries, market reforms were limited in two ways. First, thegovernments in these countries maintained and even expanded some pricedistortions that were designed to support local enterprises and encourage industrialproduction. Second, the removal of distortions and the development of functioningmarkets were often confined to producer services and to what Radelet and Sachs(1997) termed the export platform.

Government interventions. In all Asian countries, government investments ininfrastructure, health, and education, as well as direct investments in enterpriseswere pivotal at the early stages of the industrialization process. These, togetherwith large-scale interventions in many other forms, gave strong incentives toforeign and domestic entrepreneurs to invest in local industries. Indeed, even theWorld Bank (1993) survey of the Asian miracle provided details on moreproactive tactics of direct intervention that the Asian government often adopted atthe early stages of their development. The report acknowledged that theneo-classical, getting the basics right policies do not tell the entire story. In eachof these economies the government also intervened to foster development, oftensystematically and through multiple channels. Policy interventions took manyforms: targeted and subsidized credit to selected industries, low deposit rates, andceilings on borrowing rates to increase profits and retain earnings, protection ofdomestic import substitutes, subsidies to declining industries, the establishmentand financial support of government banks, public investment in applied research,firm- and industry-specific export targets, development of export marketinginstitutions, and wide sharing of information between public and private sectors.

Two additional factors that, from the public welfare point of view, must be considerednegative have an impact on the comparative advantage of a country: Absence of labor laws. In addition to minimum wages, companies in the

developed countries must provide high social benefits that include pensioncontributions, vacation, paid sick leave, social security, and health benefits, etc.They are also bound by occupational safety and health rules. In many developingcountries, there are no such laws, not even with respect to child labor.

50 Chapter 1

Low environmental standards. Against the high and rising standards ofenvironmental protection and pollution control in the US and Western Europe, thevery low standards and lax enforcement in most developing countries give them anadvantage in highly polluting production processes (Bhagwati 1997).

On these grounds, producers in importing countries that maintain high environmentaland labor standards claim that the lax standards maintained in some exportingcountries give those countries an unfair competitive edge. Indeed, the pressures ofmany groups and labor unions in the developed countries to enforce minimumenvironmental standards and child labor laws under WTO agreements reflect not onlya genuine concern for these issues, but also efforts to lower the comparative advantagethat these exporting countries have on account of their low environmental standardsand the absence of labor laws.

Low labor costs, combined with all the other factors that determine the cost ofcapital and the risk for foreign investors, created the conditions that changed thecomparative advantage of East Asian countries and enabled them to specialize inmanufacturing production and to attract foreign investors. Other developing countries,particularly in Latin America, offered some of these components, but few couldcompete with the conditions investors found in East Asia. Obviously, not all of thesecomponents are positive or beneficial to the country in the long term, nor are theyequally tenable in all countries. However, the rapid growth of the East Asianeconomies, their dramatic downfall in 1997 and 1998, and the equally dramaticrecovery of most of them since 1999 emphasize the need to take into account the entirespectrum and all the components that determine the comparative advantage of acountry, not just the abundance and low cost of unskilled labor, in order to have a morecomplete understanding of the East Asian miracle and in order to apply the lessonsfrom this miracle in the design of development policies for other countries.

Outward- vs inward-oriented growth strategyWhile the debate about the most suitable growth strategy for a labor-abundanteconomy has always been loaded with controversies, the dominating view was that, forthe majority of developing countries, the prospects of growth are closely linked toindustrialization. Even in the primarily agricultural countries of sub-Saharan Africa,long-term growth was linked to increasing the domestic value added throughprocessing, and in practically all countries, per capita GDP grew with the rise in theratio of manufactured to primary products. During the past decade, discussions on themost suitable industrial strategy were dominated by the rapid growth of the East Asianeconomies that was achieved through an outward-oriented development process and arapid increase in exports. The discussions centered on the following key questions: How significant was the outward-oriented strategy? How significant was the focus on industrialization? What was the role of the other components of the growth strategy of the East Asian

countries, including government investment in infrastructure and education andthe large subsidies to foreign direct investment (FDI, see Box 1.1)?


52 Chapter 1

Box 1.1. Foreign Direct Investment (FDI)Since the early 1980s, world FDI flows have grown faster than either the worldtrade or the world output. The flows of FDI to East Asia and, to a lesser extent, tothe other developing countries, grew at an average annual rate of over 30% in thefirst half of the 1990s, from less than $35bn per year to around $100bn by 1994, andat an average annual rate of 15% in the second part of the 1990s to over $250 billionin 2000, but their share of total investment flows declined from 43% in 1997 to21% by the end of the decade as an effect of the financial crisis in East Asia. Morethan half of these investments were made in East Asian countries, whereas the flowto Latin America and the Caribbean (primarily Chile, Argentina, and Brazil) grewat much lower rates, and only a trickle reached sub-Saharan Africa. The Asiancrisis had a significant and immediate impact on this flow. Indonesia, for example,had an FDI inflow in excess of $4bn during 199497, but in 1998, with theemergence of the crisis, this flow dried out, and in 1999 there was a net outflow ofover $2bn. China was the main beneficiary of this change of direction of FDI, andin 1999, it had an inflow of nearly $50bn. Some Latin American countries also hadlarger inflows in recent years due, in part, to the outflow of capital away from thecrisis countries in East Asia. In 1999, the FDI flow to Brazil exceeded $30bn, andthe FDI flow to Argentina reached nearly $25bn.

Notwithstanding the financial turmoil in East Asia in 1998, global FDI inflowsincreased for the seventh consecutive year to reach $430-440 billion, becoming animportant source of private external finance for the developing countries.According to the latest FDI data released by UNCTAD, world FDI flows increasedby 18% in 2000 to a record US$1.3 trillion, compared with only $203 billion in1990. Much of this investment was driven by corporations buying or merging withcompanies in other countries, contributing to increasingly global multinationalfirms. Most FDI flows went to the industrialized world. FDI flows to thedeveloping countries overall grew by 8% to US$240 billion, and to the economiesin transition of Central and Eastern Europe by 9% to US$25 billion. However, FDIflows to Latin America and the Caribbean declined in 2000 by 22% to US$86billion, primarily as an effect of the evolving crisis in Argentina, and the flows toAfrica continued to decline.

The factors that determine the inflow of FDI into a country and make thecountry a desirable destination for FDI include political and economic stability, themarket size, the availability of natural resources and human capital, the countrysgrowth prospects, and the existence of favorable investment and tax regimes. Arecent UNCTAD report concludes, however, that such traditional features,although still important, no longer constitute the most significant driving forces. Ina world increasingly characterized by a global and highly interconnected tradingsystem, companies look for places to invest that offer specific advantages, such as agood communications infrastructure and intangibles such as political stability andbusiness culture. The direct effects of FDI on the host country are the product of theFDIs effects on factor endowments and rewards. These investments improve

What was the rise in total factor productivity in these countries, and what was itscontribution to their economic growth relative to the contribution of the largeresource mobilization? How effective was export promotion industrialization vs.import substitution?

To answer these questions, this section surveys the discussions in the economicliterature and reviews the experience of selected countries.

In their highly influential research on trade and industrialization, Little, Scitovsky,and Scott (1970) provided a thorough account of the connection between anexport-oriented growth strategy and the rate of economic growth. They emphasizedthe effects of competitive conditions in the world markets on exporting enterprises thatforce countries to eliminate distortions, thus leading to better macroeconomicperformance and more rapid growth. In contrast, efficiency considerations aresecondary behind the walls of protection, and (infant) industries (even construction)have little incentive to select the more cost-effective and labor-intensive technologies.The World Banks World Development Report of 1987 and 1990 noted that the highwalls of protection often reduced the use of labor in the formal sector, whereas moreopen and outward-oriented trade regimes tend to support more labor-intensive patternsof industrial expansion in both import-competing and export industries. Bhagwati(1982) highlighted another distortion of an inward-oriented trade regime that is a resultof its heavy reliance on market restrictions and state intervention and is therefore morelikely to create an environment that is more congenial to directly unproductive profitseeking. With open, outward-oriented strategies, in contrast, the state is less involved,and profit seeking is more likely to be productive. Bhagwati noted the wide consensusamong economists that an outward-oriented trade strategy helps the process ofindustrialization and economic growth. In his words: The question of the wisdom ofan outward-oriented (export-promotion) strategy may be considered to have beensettled (1987, p. 257).

There is, however, no conclusive empirical evidence that in all countries aninward-oriented development strategy based on import substitution would indeedreduce longer-term growth rates. In a comprehensive cross-country study, Chenery,Robinson, and Syrquin (1986) showed that the average yearly GDP growth rate in


productivity, raise the marginal product of labor, and reduce the marginal product ofcapital, thereby promoting economic growth and exports and raising incomes andwages. There are also indirect effects (or externalities) of FDI that are due to theimpact of foreign multinational corporations on their host economies. These effectsmay vary, however, between industries and countries, depending on thecharacteristics of the host country and the policy environment.

The large flows of FDI to the EA countries and the growing integration andglobalization of the capital markets increased their capacity (that came to beperceived as good risks) to access these markets directly in order to secure fundingfor projects that in the past could only be financed through the World Bank.

semi-industrial economies that adopted import-substitution policies was only a fewtenths of a percent lower than the growth rate in countries that adopted export-promotion strategies. McCarthy, Taylor, and Talati (1987) used a different grouping ofcountries, based on per capita GNP, and showed that the fast-growing countries did nothave, on average, a higher (or increasing) share of exports in GDP. Easterly and Levine(1994), however, established a clearer causal relationship between enhanced exportsperformance and more rapid growth in extended cross-section studies.

Two factors may affect the straightforward calculus of the gains and relative meritsof an outward-oriented trade policy. The first is the importance of trade taxes in thebudgetary revenues of developing countries. An IMF survey of the 36 least developedcountries (LDCs, see Box 1.2) found that trade taxes account on average for 5% ofGDP, or about one-third of total tax revenues. The implementation of a broadlydefined trade reform that includes the overhaul of customs administration orcompliance with WTO obligations requires heavy budgetary outlays. The secondfactor is the strategic trade policy, emphasized by the new trade theory, whichjustifies protection in the presence of strategic interactions among firms in domesticand international markets (i.e., when a change in the behavior of firm 1 leads to achange in the optimal behavior and a strategic response of firm 2). By choosing anoptimal import tariff or subsidy, the government can affect the strategic game playedby firms in international markets to the advantage of domestic firms. Often, however,the strategic trade policy literature gives rise to contradictory results depending on thetype of market structure and the form of competitive rivalry. As a result, this literaturehas generally been considered of little use in the guidance of governments tradepolicy. There are also doubts about its relevance for trade policy in developing

54 Chapter 1

Box 1.2. The Least Developed CountriesSince 1971, countries with weak economies and deep poverty have beencategorized as Least Developed Countries (LDCs). By the end of the 1990s, 49countries with a combined population of 610 million, equivalent to 10.5% of theworld population, were identified as LDCs. Most of these countries are insub-Saharan Africa. In 1981, the United Nations General Assembly held the firstUN Conference on the Least Developed Countries in Paris, in which it adopted theSubstantial New Programme of Action for the 1980s for the Least DevelopedCountries. However, despite major policy reforms initiated by many LDCs tocarry out a structural transformation of their domestic economies, and supportivemeasures taken by donors, the economic situation of these countries as a wholeworsened during the 1980s. The Second UN Conference on the Least DevelopedCountries held in Paris in September 1990 formulated national and internationalpolicies and measures for accelerating the development process in the LDCs,drawing on the experience and lessons from the 1980s. A mid-term review of theimplementation of the program of action for the LDCs for the 1990s concluded,however, that these countries continue to be marginalized.

countries, which tend to be primary product exporters, since the production of primaryproducts is rarely characterized by large economies of scale.

The success of East Asian countries in achieving high rates of economic growthmade export promotion, spurred by open trade and market liberalization, the strategyof choice. The World Bank study titled The East Asian Miracle (1993) emphasized theprominent role of export-oriented policies in the economic miracle of the East Asiancountries. The report paid close attention to the process of industrialization in thesecountries that initially took advantage of the abundance of cheap labor by building upindustries with highly labor-intensive production that required mostly unskilled labor.Perhaps the most obvious example is the clothing industry, which is highly labor-intensive and in which developing countries have a clear comparative advantage.Although higher productivity in the developed countries could offset part of theirhigher labor costs, the very low labor costs in Indonesia, China, and Pakistan, whichwere only 5 to 10% of those in the US, allowed these countries to produce muchcheaper clothing despite their less productive technologies. In East Asia, the clothingindustry was the quintessential foundation on which the industrial base was graduallybuilt as these countries accumulated more know-how, developed a better-skilled laborforce, and opened their economies to foreign investment. In other developingcountries, the agricultural sector can play this role, as we see in Part III.

The World Bank account of the East Asian miracle emphasized the importanceof market-oriented incentives that led to large gains in efficiency and factorproductivity. These incentives were created by setting the correct price signals throughthe unification of the exchange rate, the measured devaluation, and the removal ofvarious distortions on the one hand, and the disciplining force of open trade andexport-promotion strategies on the other. The pressures of international competitionand the greater role of the market se

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