Developing Countries and the Dollar Jayati Ghosh

It is now generally recognised that the very large macroeconomic imbalances between the US and the rest of the world, which are associated with very large capital inflows into the US, are unsustainable beyond a point. There is no doubt that the current situation is absurd, and certainly counter to the perceived role of international financial markets, which are supposed to encourage flows of financial resources from capital-rich to capital-poor economies.

Two of the richest large economies – the United States and the United Kingdom – are net receivers of financial resources, in the US case amounting to more than 6 per cent of GDP. The United States currently receives slightly more than 70 per cent of total world savings as capital inflows. Earlier, Japan and the Euro area were the main financiers of the US deficits, but from around 2001, developing countries, especially in Asia, have become a significant source of such financing.

The newly industrialising countries of Asia (hereafter Asian NICs) have been sending out more than 6 per cent of GDP as capital outflow in the past three years. All other developing countries taken together (including China and India) are now exporting capital to the tune of 4 per cent of GDP.

For the United States, this allows for economic expansion based on foreign capital inflows, and also involves a growing burden of foreign debt. Currently 52 per cent of US Treasury Bills are held by foreigners, up from 20 per cent only five years ago. But the consequences for developing country governments which are increasingly the holders of this debt may be even more significant.

This remarkable extent of outflow of capital from the developing world obviously reflects an excess of domestic savings over domestic investment. However, this excess came about not because of any real increase in savings rates in the aggregate, but because investment rates have not gone up commensurately.

In the Asian NICs, the period of most significant increase in net lending abroad was when domestic savings rates were actually falling, because investment rates were falling even faster. For all other developing countries, net external lending has increased quite sharply in the recent past mainly because investment rates have stagnated even as savings rates have gone up.

In most developing countries, the savings increase has resulted from enhanced savings effort by the public sector, and not from household or private corporate savings. Therefore increases in domestic savings rates  in developing countries dominantly reflect fiscal consolidation and expenditure cutbacks by their governments.    So the major reason for the apparent excess of capital which is then being exported to the US and other developed countries is deflationary policies on the part of developing country governments, which suppress domestic consumption and investment.

The Asian NICs have mostly been in fiscal surplus since 2000, while the weighted average of fiscal deficits for all other developing countries was less than 2 per cent of GDP last year and is projected to come down to only 1 per cent of GDP in 2005. In the majority of developing countries, where savings rates have not increased, the increase in net lending abroad has been generated by lower investment rates, driven by compression of public investment.

This obviously has effects on current levels of economic activity, but it also affects future growth prospects because of the long-term potential losses of inadequate infrastructure investment, etc.  The deflationary effect of this fiscal strategy is reflected in lower levels of economic activity than could have been potentially achieved, as well as higher levels of unemployment. There has been an increase in open unemployment rates across developing Asia, where there is hardly any unemployment benefit or social security system.

The obvious question is: why are developing country governments pursuing such an apparently counterproductive policy which runs against the interests of their own current and future economic growth? The answer lies in a combination of international forces which have been unleashed by the collective adoption of certain national policies.

The first such force is the international domination of finance, which has resulted from national policies of financial deregulation, and created the possibility of large possibly destabilizing movements of speculative capital. It is certainly true that increasingly developing country governments all guard against the possibility of damaging capital flight by building up substantial foreign exchange reserves even when these may involve large fiscal losses.

But this is only part of the story. The second force which is dominant in development strategy today is the obsession with exports as the engine of growth. Across the developing world, the basic stimulus to growth is seen to come from increasing access to and getting larger shares of the international market, rather than building up the domestic market. Even in countries which do not show large trade surpluses at present, such as China and much of East Asia, the stimulus to growth still is seen to come from exports.

Since all countries except the US are playing this particular game, it follows that the US economy remains the most important stimulus not only to world trade but to world economic activity generally. Even for countries like China, where exports to the US account for only around one-fifth of total exports, this remains the driving force for the accumulation which then generates such high rates of aggregate growth and in turn high aggregate savings.

In this context, domestic deflation in developing countries becomes almost necessary to perpetuate the system which provides the current pattern of growth. By fuelling the US economic expansion, it ensures a continuing market for exports by the rest of the world. And central bank intervention to mop up the dollars that are then invested in US securities ensures that exchange rates do not appreciate to levels whereby exports would be affected.

But this very obsession with export growth as the means to development creates its own contradictions. It leads to heightened competitive pressure (the famous race to the bottom) which reduces unit values of exports even as export volumes may increase. It prompts technological changes in export and import competing industries which mean that new production tends to generate less employment, and therefore have lower domestic multiplier effects. In any case, all developing countries together cannot really hope to increase their share of world markets unless they diversify their ultimate export destinations. Most important, this strategy prevents more sustainable and equitable patterns of economic expansion based on the domestic market.

The peculiar paradoxes of the world economy today therefore reflect not only the political economy structures of international capitalism, but also policy choices by developing country governments with respect to both trade and finance. In such circumstances, financial liberalisation and trade promotion can become the means to undermine the development project in general.