Trade strategies for Trade strategies for growth & developmentgrowth & development

Inward vs outward-orientedInward vs outward-orientedInternational trade strategies in LDCs have International trade strategies in LDCs have

formed the basis of growth & development formed the basis of growth & development strategies, so one can hardly consider one strategies, so one can hardly consider one without considering the other. without considering the other.

To start industrialization, LDCs have two To start industrialization, LDCs have two options:options:

1.1. Discourage IMPORTS whilst developing Discourage IMPORTS whilst developing substitutes substitutes →→ import substitutionimport substitution / / inward inward orientedoriented strategies. strategies.

2.2. Encourage EXPORTS to pay for needed imports Encourage EXPORTS to pay for needed imports → → export-led growthexport-led growth / / outward orientedoutward oriented strategies. strategies.

Four periodsFour periods

• 1950-60s: Import substitution with 1950-60s: Import substitution with strong government interventionstrong government intervention

• 1960s-1970s: Export-led with strong 1960s-1970s: Export-led with strong government interventiongovernment intervention

• 1980s-1990s: Export-led with market 1980s-1990s: Export-led with market liberalization (Washington consensus)liberalization (Washington consensus)

• Late 1990s-2000: Export-led with Late 1990s-2000: Export-led with selective government intervention selective government intervention (New Development consensus)(New Development consensus)

Import substitution (1950s-Import substitution (1950s-1960s)1960s)• Also known as Also known as import-substituting import-substituting

industrialisationindustrialisation

• DefinitionDefinition: growth and trade strategy : growth and trade strategy where a country begins to manufacture where a country begins to manufacture simple consumer goods oriented simple consumer goods oriented towards the domestic market in order towards the domestic market in order to promote the domestic industry. It to promote the domestic industry. It depends on protective measures that depends on protective measures that will prevent entry of imports that will prevent entry of imports that compete with domestic producers.compete with domestic producers.

RationaleRationale

1.1. Independence (from colonizers) seen Independence (from colonizers) seen as opportunity to modernize. Instead as opportunity to modernize. Instead of continuing to export commodities of continuing to export commodities to and import manufactures from to and import manufactures from DCs: shut out manufactured imports DCs: shut out manufactured imports from DCs and start producing those from DCs and start producing those goods domestically.goods domestically.

2.2. Historical experience of DCs, which Historical experience of DCs, which used import subs strategies in their used import subs strategies in their initial phases of development.initial phases of development.

3.3. Export pessimism in the 50s-60s Export pessimism in the 50s-60s caused by ↓Px and deterioration in caused by ↓Px and deterioration in balance of payments plus balance of payments plus expectation of long term expectation of long term deterioration of ToT.deterioration of ToT.

4.4. Avoiding BoP problems through Avoiding BoP problems through curtailment of imports.curtailment of imports.

5.5. Infant industry argument.Infant industry argument.

Import-substitution policies Import-substitution policies and consequencesand consequences

1.1. High protection of dom firms, High protection of dom firms, inefficiency and resource inefficiency and resource misallocation. Lack of competition→ misallocation. Lack of competition→ high costs + inefficiencies + high high costs + inefficiencies + high prices paid by consumers.prices paid by consumers.

2.2. Overvalued exchange rates, making Overvalued exchange rates, making imports of capital goods cheaper imports of capital goods cheaper and X more expensive. and X more expensive.

Negative effects:Negative effects:• Capital-intensive methods→ urban UE Capital-intensive methods→ urban UE

+ growth of informal sector+ growth of informal sector• X in agricultural sector more difficult X in agricultural sector more difficult

→worsen rural poverty→worsen rural poverty

3.3. Excessive gov intervention, leading Excessive gov intervention, leading to misallocation of resources and to misallocation of resources and inefficiencies in production.inefficiencies in production.

4.4. Neglect of agriculture → ↑need for Neglect of agriculture → ↑need for food importsfood imports

5.5. Deterioration of BoP and debt Deterioration of BoP and debt position due to:position due to:

a)a) ↑↑need for M of cap equipment and need for M of cap equipment and intermediate goodsintermediate goods

b)b) ↑↑need for food importsneed for food importsc)c) Outward flow of financial capital Outward flow of financial capital

caused by repatriation of profits by caused by repatriation of profits by MNCs and wealthy elites seeking MNCs and wealthy elites seeking safety for their financial investmentssafety for their financial investments

6.6. Encouragement of cap-intensive Encouragement of cap-intensive production methods, but no effort production methods, but no effort to ↑ access to credit or support to ↑ access to credit or support users of labour-intensive users of labour-intensive technologies.technologies.

7.7. Negative impacts on employment Negative impacts on employment and income distribution.and income distribution.

8.8. Limited possiblities for growth over Limited possiblities for growth over the longer term on the basis of import-the longer term on the basis of import-subs, due to inefficiencies of subs, due to inefficiencies of production and misallocation of production and misallocation of resources. For example, many firms resources. For example, many firms enjoying protection never became enjoying protection never became efficient.efficient.

9.9. More room for corruption favoured by More room for corruption favoured by strong government intervention strong government intervention (payments of bribes to gov officials in (payments of bribes to gov officials in order to secure particular policies).order to secure particular policies).

• Problems with import-substitution Problems with import-substitution became apparent in the 60s:became apparent in the 60s:– India, Egypt reacted by ↑protection for India, Egypt reacted by ↑protection for

cap goods imports and other cap goods imports and other intermediate goods in order to allevaite intermediate goods in order to allevaite BoP problems.BoP problems.

– Others (Brazil, Israel, Mexico, Singapore, Others (Brazil, Israel, Mexico, Singapore, South korea, Taiwan, Southern South korea, Taiwan, Southern European countries) moved towards European countries) moved towards export promotion.export promotion.

Export promotion (1960s-Export promotion (1960s-1970s)1970s)• Export-led growth strategyExport-led growth strategy: a growth : a growth

and trade strategy where a country and trade strategy where a country attempts to achieve economic growth attempts to achieve economic growth by expanding its exports. Based on by expanding its exports. Based on strong government intervention.strong government intervention.

• It is an outward-oriented strategy since It is an outward-oriented strategy since it looks outward towards foreign it looks outward towards foreign markets and provides stronger links markets and provides stronger links between the domestic and global between the domestic and global economies.economies.

• Strong gov intervention necessary to Strong gov intervention necessary to help countries develop a strong help countries develop a strong manuf sector oriented towards manuf sector oriented towards exports. exports.

• Most LDCs that turned to export Most LDCs that turned to export promotion had began their promotion had began their industrialization with import-industrialization with import-substitution. The stronger export substitution. The stronger export industries were in many cases the industries were in many cases the ones that had received protection.ones that had received protection.

• China, Hong Kong (more market-China, Hong Kong (more market-oriented), Indonesia, Japan, Malaysia, oriented), Indonesia, Japan, Malaysia, Singapore, South Korea, Taiwan, Singapore, South Korea, Taiwan, Thailand = Newly Industrializing Thailand = Newly Industrializing Economies (NIEs) or Asian Tigers. All Economies (NIEs) or Asian Tigers. All of them pursued export promotion of of them pursued export promotion of manufactured goods strongly manufactured goods strongly supported by gov intervention and supported by gov intervention and industrial policies.industrial policies.

Interventionist policiesInterventionist policies

1.1. State ownership and control of State ownership and control of financial institutionsfinancial institutions, in order to , in order to provide subsidized credit to the provide subsidized credit to the industries being promoted.industries being promoted.

2.2. Targeting of industriesTargeting of industries for export. for export.

3.3. Industrial policies to Industrial policies to support export support export industriesindustries: investment grants, : investment grants, production subsidies to export production subsidies to export industries, tax exemptions, export industries, tax exemptions, export subsidies...subsidies...

4.4. Some (selective) Some (selective) protectionprotection of of domestic industries.domestic industries.

5.5. Requirements on MNCsRequirements on MNCs in order to in order to maximize benefits of FDI: promotion maximize benefits of FDI: promotion of R&D, transfer of targeted of R&D, transfer of targeted technologies into the domestic technologies into the domestic economy, training of dom workers, economy, training of dom workers, use of local inputs.use of local inputs.

6.6. Large public investments in key areas: Large public investments in key areas: education and skills, R&D, transport education and skills, R&D, transport and communications infrastructure.and communications infrastructure.

7.7. Incentives for R&D by private sector Incentives for R&D by private sector for high tech products. To encourage for high tech products. To encourage development of domestic skill levels development of domestic skill levels and technology appropriate to local and technology appropriate to local conditions.conditions.

These policies resulted in successful These policies resulted in successful export performance and the export performance and the achievement of very high economic achievement of very high economic growth rates. Since the 1950s, NIESs growth rates. Since the 1950s, NIESs have been the fastest growing have been the fastest growing economies in the developing world.economies in the developing world.

The Success of the Asian The Success of the Asian TigersTigers1.1.Expansion into foreign markets.Expansion into foreign markets.

2.2.Benefits of diversification.Benefits of diversification.

3.3.Major investments in human capital.Major investments in human capital.

4.4.Appropriate technologies.Appropriate technologies.

5.5. Increased employment (from the Increased employment (from the use of labour-intensive use of labour-intensive technologies).technologies).

6.6.Export earnings avoided balance of Export earnings avoided balance of payments problems.payments problems.

1980s-1990s: Export-led with 1980s-1990s: Export-led with Market Liberalization: Market Liberalization: Washington ConsensusWashington Consensus• Early 80s: Early 80s:

1.1. Poor econ and export performance in many Poor econ and export performance in many LDCs and high indebtednessLDCs and high indebtedness

2.2. Shift in thinking about econ growth and Shift in thinking about econ growth and development inspired by neoclassical model, development inspired by neoclassical model, which stressed importance of limiting gov which stressed importance of limiting gov intervention and allowing private sector to intervention and allowing private sector to operate in a competitive free-market operate in a competitive free-market environment. Outward orientation based on environment. Outward orientation based on free-trade.free-trade.

• Main policies recommended:Main policies recommended:1.1. Trade liberalisationTrade liberalisation

2.2. No restrictions to new FDI by MNCsNo restrictions to new FDI by MNCs

3.3. Sound fiscal policy (no excessive borrowing)Sound fiscal policy (no excessive borrowing)

4.4. Tax reformTax reform

5.5. Changing priorities of gov spending towards Changing priorities of gov spending towards health, education, infrastructurehealth, education, infrastructure

6.6. Interest rate liberalizationInterest rate liberalization

7.7. Market-determined exchange ratesMarket-determined exchange rates

8.8. PrivatizationPrivatization

9.9. DeregulationDeregulation

10.10.Securing property rightsSecuring property rights

• Rationale: reliance on market forces Rationale: reliance on market forces and free trade maximizes efficiency, and free trade maximizes efficiency, domestic and global allocation of domestic and global allocation of resources and economic growth.resources and economic growth.

• LDCs that have adopted these LDCs that have adopted these policies include Argentina, Brazil, policies include Argentina, Brazil, China, Chile, India, Kenya, Sri Lanka, China, Chile, India, Kenya, Sri Lanka, Tanzania, Turkey. They began a Tanzania, Turkey. They began a process of ↓gov intervention in the process of ↓gov intervention in the market.market.

• Strong influence of the World Bank Strong influence of the World Bank and the IMF, which lent these and the IMF, which lent these countries funds on the condition of countries funds on the condition of reorienting their economies towards reorienting their economies towards freer trade and freer market.freer trade and freer market.

Impacts of economic and Impacts of economic and trade liberalizationtrade liberalization

1.1. Limited benefits for export growth Limited benefits for export growth and diversification:and diversification:• Countries lost export shares in world Countries lost export shares in world

markets, especially in Africamarkets, especially in Africa• LDCs did not succeed in diversifying LDCs did not succeed in diversifying

their production into manufacturing. their production into manufacturing. Countries that performed best were Countries that performed best were those that had already developed those that had already developed significant export sectors.significant export sectors.

CausesCauses of these negative impacts: of these negative impacts:

a.a. Protectionist policies by DCsProtectionist policies by DCs

b.b. Growing reliance on free market policiesGrowing reliance on free market policies

2.2. Limited impacts on economic growthLimited impacts on economic growth

• No hard evidence suggesting that a No hard evidence suggesting that a greater outward orientation based on greater outward orientation based on freer trade during 80s, 90s has been freer trade during 80s, 90s has been responsible for more rapid econ responsible for more rapid econ growth.growth.

• Great variability in performance.Great variability in performance.

• Some economists see no link Some economists see no link between econ growth and trade between econ growth and trade liberalization.liberalization.

• Some countries better able to Some countries better able to benefit from freer trade. Low benefit from freer trade. Low income countries perform the income countries perform the worst→ ↑inequalities between rich worst→ ↑inequalities between rich and poor.and poor.

3.3. Increasing income inequalities and Increasing income inequalities and poverty within LDCs. World Bank study poverty within LDCs. World Bank study reveals that the correlation between reveals that the correlation between trade liberalization and income growth trade liberalization and income growth isis

– Negative among the 40% poorest of the Negative among the 40% poorest of the populationpopulation

– Positive among the higher income groupsPositive among the higher income groups

So it helps the rich get richer and the poor So it helps the rich get richer and the poor get poorer.get poorer.

ReasonReason: econ and trade liberalization : econ and trade liberalization give rise to winners and losers.give rise to winners and losers.

WINNERSWINNERSWorkers in Workers in

exporting exporting industriesindustries

Workers in growing Workers in growing formal sectorsformal sectors

Higher skilled, Higher skilled, educated people, educated people, with more chances with more chances in the competitive in the competitive environmentenvironment

LOSERSLOSERSLess educated peopleLess educated peoplePoor people with no Poor people with no

collateral (unable to collateral (unable to obtain credit)obtain credit)

People in remote areas People in remote areas with no transport links with no transport links to marketsto markets

People in agriculturePeople in agriculturePeople affected by People affected by

lower levels of social lower levels of social protectionprotection

People forced from the People forced from the formal to the informal formal to the informal sector ...sector ...

• According to int’al trade theory, free According to int’al trade theory, free trade originates overall gains that trade originates overall gains that are likely to be greater than the are likely to be greater than the overall losses. However, in the real overall losses. However, in the real world this rarely occurs, with the world this rarely occurs, with the result that some people are worse off result that some people are worse off due to freer trade and freer markets.due to freer trade and freer markets.

• Late 1990s: the Washington Late 1990s: the Washington consensus was called into question consensus was called into question even by the Chief economist of the even by the Chief economist of the World bank, Joseph Stiglitz.World bank, Joseph Stiglitz.

Late 1990s-2000s: Export-led Late 1990s-2000s: Export-led growth strategies with growth strategies with selective gov intervention: The selective gov intervention: The New Development ConsensusNew Development Consensus

• Gov.’s role in LDCs should be Gov.’s role in LDCs should be complemented (not substituted) by complemented (not substituted) by markets.markets.

• Governments must support education, Governments must support education, health and infrastructure health and infrastructure development, as well as R&D for both development, as well as R&D for both industry and agriculture.industry and agriculture.

• Gov should pursue policies that promote Gov should pursue policies that promote income equality and poverty alleviation.income equality and poverty alleviation.

• Gov must provide Gov must provide regulatory framework regulatory framework for marketsfor markets to work efficiently: to work efficiently: regulation of financial system and regulation of financial system and regulatory framework for competition regulatory framework for competition (to avoid development of private (to avoid development of private monopolies.monopolies.

• Market-supporting institutions (tax Market-supporting institutions (tax systems, property rights, banking & systems, property rights, banking & credit...) should be promotes.credit...) should be promotes.

• DCs must assist econ development DCs must assist econ development by ↑foreign aid and providing by ↑foreign aid and providing increased access to their markets by increased access to their markets by LDCs.LDCs.

• Due to their special circumstances, Due to their special circumstances, LDCs should receive special LDCs should receive special treatment by int’al trade agreements treatment by int’al trade agreements regarding removal of their regarding removal of their protectionist measures.protectionist measures.

RemarkRemark::

• Unlike the strongly interventionist Unlike the strongly interventionist supply-side policies pursued by the supply-side policies pursued by the Asian tigers, that focused on direct Asian tigers, that focused on direct support and protection against support and protection against competition, the New Dev Consensus competition, the New Dev Consensus favours the establishment of favours the establishment of institutions and conditions that institutions and conditions that assist assist firms to do well in a competitive firms to do well in a competitive market environmentmarket environment. .

Support for:Support for:– R&D in targeted areasR&D in targeted areas– Vocational training and educationVocational training and education– Small firms Small firms – Development of infrastructureDevelopment of infrastructure

• Justification for industrial policies: Justification for industrial policies: numerous kinds of market failures numerous kinds of market failures that may prevent countries/markets that may prevent countries/markets from:from:– Setting up the needed private firmsSetting up the needed private firms– Undertaking the necessary R&DUndertaking the necessary R&D– InnovatingInnovating– Importing appropriate technologiesImporting appropriate technologies

Evaluation of Inward and Evaluation of Inward and Outward-oriented strategiesOutward-oriented strategies• BenefitsBenefits: those of international free trade: those of international free trade

– Increased dom. production and consumtion Increased dom. production and consumtion due to specializationdue to specialization

– Economies of scaleEconomies of scale– Greater variety and quality of g+sGreater variety and quality of g+s– Allows countries to acquire needed resourcesAllows countries to acquire needed resources– Flow of new ideas and technologyFlow of new ideas and technology– Increased X + more efficiency = Larger Increased X + more efficiency = Larger

growth ratesgrowth rates

• ObstaclesObstaclesa)a) If countries specialize in production & If countries specialize in production &

export of primary commodities:export of primary commodities:– Unstable export revenues due to price Unstable export revenues due to price

volatility.volatility.– Deteriorating ToT for exporters of Deteriorating ToT for exporters of

primary commodities over long periods primary commodities over long periods of time (due to low YED for these of time (due to low YED for these exports, among other)exports, among other)

– Rich country protection of their farmers Rich country protection of their farmers may limit access to rich country markets may limit access to rich country markets and cause price and cause price ↓ ↓ of protected of protected commodities.commodities.

b)b) If countries specialize in production If countries specialize in production and X of and X of manufactured goodsmanufactured goods::

Protectionist policies imposed by DCs:Protectionist policies imposed by DCs:– Prevent access to the large and rich Prevent access to the large and rich

marketsmarkets

– Discourage diversification of LDC into Discourage diversification of LDC into manufacturing and higher VA activities manufacturing and higher VA activities (tariff escalation, admin and technical (tariff escalation, admin and technical barriers)barriers)

Can LDCs imitate the trade and Can LDCs imitate the trade and growth strategies of the Asian growth strategies of the Asian Tigers?Tigers?

1.1. The Asian Tigers faced The Asian Tigers faced lower trade lower trade barriersbarriers on their X of manufactures to DCs. on their X of manufactures to DCs. Some trade barriers were increased during Some trade barriers were increased during the 1980s, after the entry of East Asian the 1980s, after the entry of East Asian exports into DCs markets. This was in order exports into DCs markets. This was in order to protectto protect• domestic producers against low cost domestic producers against low cost

competing goods and competing goods and • their workers against losing their jobs due their workers against losing their jobs due

to entry of low cost importsto entry of low cost imports

2.2. The Asian Tigers’ outward orientation The Asian Tigers’ outward orientation was export promotion was export promotion with strong gov with strong gov interventionintervention, whereas countries in the , whereas countries in the 80s opened to international trade on the 80s opened to international trade on the basis of market-based policies. basis of market-based policies. Interventionist supply-side policies Interventionist supply-side policies played a key role in the development of played a key role in the development of manufacturing and higher VA production. manufacturing and higher VA production. LDCs that opened up to int’al trade in the LDCs that opened up to int’al trade in the context of market-based policies could context of market-based policies could not rely on government support for their not rely on government support for their export industries.export industries.

Concluding remarksConcluding remarks

1.1. An outward oriented trade strategy is An outward oriented trade strategy is superior to an inward-oriented one.superior to an inward-oriented one.

2.2. Significant advantages in an outward-Significant advantages in an outward-oriented strategy based on oriented strategy based on diversification of Xs into manufacturing diversification of Xs into manufacturing and higher VA activities.and higher VA activities.

3.3. DC protectionism is a major obstacle.DC protectionism is a major obstacle.

Role of the WTORole of the WTO

Bilateral and regional preferential Bilateral and regional preferential trade agreements (FTAs)trade agreements (FTAs)• Due to the slow progress made by the Due to the slow progress made by the

WTO, the number of bilateral and WTO, the number of bilateral and regional trade agreements has regional trade agreements has increased (159 in 2007, several increased (159 in 2007, several hundreds in 2010). LDCs see in trading hundreds in 2010). LDCs see in trading blocs a way to benefit from free trade blocs a way to benefit from free trade without the obstacles imposed by DCs.without the obstacles imposed by DCs.

• Examples: EMRCOSUR, ASEAN, Examples: EMRCOSUR, ASEAN, COMESA, CEMAC, CAIS, etc.COMESA, CEMAC, CAIS, etc.

Regional FTAsRegional FTAs

• They have the greatest potential to They have the greatest potential to help developing countries achieve help developing countries achieve growth & dev when they involve:growth & dev when they involve:– Regional agreementsRegional agreements– Geographical closenessGeographical closeness– Similar level of dev and technological Similar level of dev and technological

capabilitiescapabilities– Similar market sizesSimilar market sizes– Shared commitment to cooperationShared commitment to cooperation

• Benefits:Benefits:1.1. Expand markets (economies of scale) Expand markets (economies of scale)

and diversify production and exports.and diversify production and exports.

2.2. Larger markets increase domestic and Larger markets increase domestic and foreign direct investment.foreign direct investment.

3.3. If similar level of development: more If similar level of development: more fair competition.fair competition.

4.4. If shared commitment to cooperation: If shared commitment to cooperation: policies can be pursued that increase policies can be pursued that increase the benefits of integration (investment the benefits of integration (investment in infrastructure, R&D collaboration, in infrastructure, R&D collaboration, cooperation in environmental issues).cooperation in environmental issues).

Bilateral FTAs: limitationsBilateral FTAs: limitations

• Most bilateral agreements are Most bilateral agreements are between developing and developed between developing and developed countries that are not usually in the countries that are not usually in the same geographical region. US with same geographical region. US with LDCs, EU with LDCs and transition LDCs, EU with LDCs and transition economies, Japan with Asia-Pacific economies, Japan with Asia-Pacific region.region.

• The prospect of gaining access to the The prospect of gaining access to the market of the DC is the reason for market of the DC is the reason for LDCs to enter into such agreements.LDCs to enter into such agreements.

• There are some risks:There are some risks:– The LDC must make equal and matching The LDC must make equal and matching

cuts in tariff and other barriers. This puts cuts in tariff and other barriers. This puts even efficient LDC firms at a competitive even efficient LDC firms at a competitive disadvantage as they are forced to disadvantage as they are forced to compete with lower cost DC firms. compete with lower cost DC firms.

– Problem with many LDCs forming FTAs Problem with many LDCs forming FTAs with the same DC in order to gain market with the same DC in order to gain market access, as they must compete with each access, as they must compete with each other for the developed country market. other for the developed country market. They also face competition from lower They also face competition from lower cost producers in the DC.cost producers in the DC.

– Trade deficits, Balance of payments problems Trade deficits, Balance of payments problems and foreign debt may be caused by increased and foreign debt may be caused by increased imports and only slightly increasing exports.imports and only slightly increasing exports.

– In Bilateral negotiations LDCs have less In Bilateral negotiations LDCs have less bargaining power than when they act as one in bargaining power than when they act as one in multilateral negotiations.multilateral negotiations.

– LDCs must often agree to other requirements, LDCs must often agree to other requirements, such as on IP rights or freer rules on FDI.such as on IP rights or freer rules on FDI.

– Bilateral agreements weaken regional trade Bilateral agreements weaken regional trade agreements when one of the members makes agreements when one of the members makes a bilateral agreement with a third country.a bilateral agreement with a third country.

• LDCs are better off pursuing regional trade LDCs are better off pursuing regional trade agreements (UNCTAD)agreements (UNCTAD)

DiversificationDiversification• Benefits: More varied production, Benefits: More varied production,

increased employment, establishment increased employment, establishment of more firms, use of higher skill and of more firms, use of higher skill and technology levels.technology levels.

• It allows countries to achieve the It allows countries to achieve the following objectives:following objectives:1.1. Sustained increases in exports. Can only Sustained increases in exports. Can only

be achieved through diversification into be achieved through diversification into markets for which there is a sustained markets for which there is a sustained increase in global demand (not true for increase in global demand (not true for commodity exports)commodity exports)

2.2. Development of technological capabilities Development of technological capabilities and skills. Diversification provides and skills. Diversification provides incentives to acquire new technologies incentives to acquire new technologies and higher training, education and skill and higher training, education and skill levels (success of Asian Tigers).levels (success of Asian Tigers).

3.3. Reduced vulnerability to short-term price Reduced vulnerability to short-term price volatility and long-term price declines.volatility and long-term price declines.

4.4. Use of domestic primary commodities. Use of domestic primary commodities. These can be used as the basis for These can be used as the basis for diversification into manufacturing, as the diversification into manufacturing, as the domestic availability of the raw materials domestic availability of the raw materials can work to stimulate industry (‘vertical can work to stimulate industry (‘vertical diversification’).diversification’).

Capital liberalisationCapital liberalisation• Definition: the free movement of financial Definition: the free movement of financial

capital in and out of a country. It occurs capital in and out of a country. It occurs through the elimination of exchange through the elimination of exchange controls (restrictions on the quantity of controls (restrictions on the quantity of foreign exchange that can be bought by foreign exchange that can be bought by domestic residents of a country).domestic residents of a country).

• Non-convertible currency: the domestic Non-convertible currency: the domestic currency cannot be freely exchanged for currency cannot be freely exchanged for foreign currencies. It may apply to foreign currencies. It may apply to current account or financial account current account or financial account transactions.transactions.

• Fully convertible currency: can be Fully convertible currency: can be freely exchanged for other foreign freely exchanged for other foreign currencies.currencies.

• Capital liberalisation involves the Capital liberalisation involves the elimination of exchange controls, elimination of exchange controls, making a currency fully convertible.making a currency fully convertible.

Capital flightCapital flight

• Definition: Large scale transfer of Definition: Large scale transfer of privately owned financial capital to privately owned financial capital to another country.another country.

• It results from high uncertainty and It results from high uncertainty and risk of holding domestic assets due to:risk of holding domestic assets due to:• Risk of confiscationRisk of confiscation• Sudden Sudden ↑↑ taxation taxation• Political instabilityPolitical instability• Anything leading to loss of value of the Anything leading to loss of value of the

domestic currency.domestic currency.

1.1. Non-convertibility for current Non-convertibility for current account transactionsaccount transactions (mainly foreign (mainly foreign trade). Conversion of currencies is trade). Conversion of currencies is subject to gov restrictions. For subject to gov restrictions. For example , only for specific imports and example , only for specific imports and exports consistent with gov objectives.exports consistent with gov objectives.

• Today most countries have convertible Today most countries have convertible currencies for CA transactions.currencies for CA transactions.

• Benefits of currency convertibility: Benefits of currency convertibility: based on the principle that Int’al trade based on the principle that Int’al trade should be conducted in the context of should be conducted in the context of competitive mkts. competitive mkts.

2.2. Non-convertibility for financial Non-convertibility for financial account (FA) transactionsaccount (FA) transactions. . Implies gov control over what flows Implies gov control over what flows are permissible. Exceptions for: are permissible. Exceptions for: debt service payments, funds to be debt service payments, funds to be used in inward FDI, inward flows used in inward FDI, inward flows due to borrowing, financial due to borrowing, financial investment by foreigners.investment by foreigners.

ReasonsReasons::a)a) To avoid Capital flight, as financial To avoid Capital flight, as financial

capital cannot leave the country if the capital cannot leave the country if the domestic currency cannot be domestic currency cannot be converted into foreign currencies.converted into foreign currencies.

b)b) To avoid Currency speculation, which To avoid Currency speculation, which can lead to currency instability.can lead to currency instability.

c)c) Ability to conduct monetary policy Ability to conduct monetary policy independently of exchange rate independently of exchange rate considerations. In case of a recession, considerations. In case of a recession, for example, the interest rate can be for example, the interest rate can be lowered without risk of a depreciation.lowered without risk of a depreciation.

• BenefitsBenefits of full convertibility for FA of full convertibility for FA::1.1. Access to foreign capital markets Access to foreign capital markets

(ability to diversify financial (ability to diversify financial investments).investments).

2.2. Access to more varied and cheaper Access to more varied and cheaper sources of finance.sources of finance.

3.3. Encourages FDI.Encourages FDI.4.4. Permits inflows of financial capital, as Permits inflows of financial capital, as

foreigners know they can sell their foreigners know they can sell their assets if they wish.assets if they wish.

5.5. ↑↑ competition among financial competition among financial institutions institutions → → ↑ ↑ efficiency + ↓ costs.efficiency + ↓ costs.

6.6. Prevents black market for foreign Prevents black market for foreign exchangeexchange

7.7. 1 to 6 contribute to greater 1 to 6 contribute to greater economic growth.economic growth.

8.8. Facilitates efficient global allocation Facilitates efficient global allocation of savings.of savings.

ConditionsConditions to be met before full to be met before full convertibility.convertibility.

1)1) Stable political systemStable political system2)2) Sound fiscal and monetary policies that Sound fiscal and monetary policies that

encourage confidence in domestic assets and encourage confidence in domestic assets and currency.currency.

3)3) Sound macro policies that work to avoid wide Sound macro policies that work to avoid wide exchange rate fluctuations and large BOP exchange rate fluctuations and large BOP deficits.deficits.

4)4) Strong financial institutions that operate Strong financial institutions that operate under gov regulation to avoid excessive risks.under gov regulation to avoid excessive risks.

5)5) Mkt orientation, with well-functioning price Mkt orientation, with well-functioning price system that facilitates more efficient system that facilitates more efficient allocation of resources and financial capital.allocation of resources and financial capital.

• Currency convertibility and financial crises. Currency convertibility and financial crises. Several East Asian countries experienced a severe Several East Asian countries experienced a severe

financial and economic crisis in the late 90s. These financial and economic crisis in the late 90s. These economies had extended convertibility of their economies had extended convertibility of their currencies to the FA (under pressure from the IMF). currencies to the FA (under pressure from the IMF).

In 1997, recession + declining confidence in the In 1997, recession + declining confidence in the economy triggered attacks on their currencies, economy triggered attacks on their currencies, resulting in massive capital flight and downward resulting in massive capital flight and downward pressures on the value of their currencies.pressures on the value of their currencies.

IMF stepped in with loans and imposed tight IMF stepped in with loans and imposed tight monetary policy in order to curtail capital flight and monetary policy in order to curtail capital flight and help support the currencies. However, confidence help support the currencies. However, confidence was low and downward pressure on curr continued. was low and downward pressure on curr continued. High High ii created negative growth, higher UE and created negative growth, higher UE and poverty.poverty.

According to Stiglitz, FA liberalization ‘...was the According to Stiglitz, FA liberalization ‘...was the single most important factor leading to the crisis’.single most important factor leading to the crisis’.