Trade and Development Policies: “Structural” Dilemmas

The United Nations Conference on Trade and Development (UNCTAD) is expected to offer distinct analyses and insights into the problems afflicting developing countries and the global economy in general. If therefore, one were to scan through only the Overview that reads like a nuanced crossover between rhetoric neo-liberal and heterodox views in the current economic policy discourse, the Trade and Development Report (TDR) 2006 published by the UNCTAD would have come as a disappointment. Even so, one would have just concluded that it was only symptomatic of the woes of our times. But, fortunately, going beyond the boundaries drawn by rhetoric, TDR 2006 does provide an insightful discussion of several fundamental contradictions within the current growth paradigm and the subsequent challenges facing developing countries in industrial, trade and macroeconomic policymaking. Titled ‘Global Partnership and National Policies for Development’, the Report thus revolves around the following two central themes: (1) the urgent need for economic policymaking to move beyond the Washington Consensus and the “inbuilt” and “implanted” constraints imposed on this by neo-liberal policies and institutions; and (2) the growing imbalances in the world economy.

The Report starts by pointing out that how the present phase of relatively fast growth in developing countries, driven by strong global demand originating mainly in the United States as before and amplified by the rapid expansion of the large Chinese economy, has also benefited from rising prices and continuing strong demand for primary commodities[1]. Against the backdrop of these positive prospects for growth, it highlights the recent turbulence in emerging market financial markets reflected in increasing volatility in stock, commodities and currency markets as well as in short-term capital outflows from some emerging markets (several East European countries as well as South Africa and Turkey). Even though in some cases, these episodes show similarities to the typical speculative cycle experienced in the Asian as well as in the Latin American or Russian crises of the 1990s, the current turbulence is limited only to some areas and to a number of countries with rather high current-account deficits. The conclusion is that most emerging-market economies appear to be in a position of strength owing to their current account surpluses and therefore, the risk of a financial crisis on a global scale originating in the developing world is relatively small.

This appears to be a rather naïve conclusion. No amount of foreign exchange reserves may prove sufficient to support a concerted speculative attack on an emerging market currency as the East Asian crises of the late 1990s showed. Further, most financial crises in the past were regional in the sense that it directly involved only countries of a specific region. But each of these regional crises has had significant global impact of one form or the other, including global recessions, due to very fact that financial and trade liberalization have increased the interlinkages between countries across regions. Thus, there is also a significant risk of contagion because several countries share similar vulnerabilities and common creditors.

Even as it underestimates the risks associated with an imminent large-scale financial crisis, the report cautions that prospects for growth in the coming years should be weighed against the increasing imbalances in the world economy, as their correction could have serious repercussions for developing countries.

Global Imbalances as a Systemic Problem
It is indeed significant that the UNCTAD has chosen to highlight concerns about growing global economic imbalances that have been repeatedly raised by several economists and analysts in the last few years[2]. Even though the previous year’s TDR also addressed the issue of growing global economic imbalances, TDR 2006 has built a robust theoretical analysis in Chapter I, through a detailed critique of the “static” savings-investment gap framework on which orthodox policy prescriptions are based[3].

The fact is that given the severe experience with financial crises associated with capital account liberalisation and a hands-off approach to exchange rate management, most countries affected by the crises in Asia and in Latin America have accumulated large current account surpluses. In fact, the South and East Asian countries recorded a large surplus on their current accounts (4.6 per cent of GDP) in 2005; and only ten of these 22 countries were in deficit. The Latin American region as a whole was also in surplus, in the order of 1.3 per cent of GDP[4]. While current surpluses do not necessarily result in increasing foreign exchange reserves, there are overall balance of payments surpluses in these countries. Some countries (like India) now have current deficits, but larger capital account surpluses. The stark fact, which is closely related, is that many of these developing countries are reinvesting these huge amounts of foreign exchange reserves mainly in securities such as government bonds in the rich countries. In particular, as has been highlighted by other authors, global savings flow primarily in the direction of the largest and richest developed country, the United States and its government bonds. Ironically, this is true even for many developing countries that have positive net capital inflows (like India and China) who then store it in reserves that are invested in the US, etc.

The Report suggests that having learned that reliance on foreign savings rarely pays off as a sustainable development strategy, a growing number of developing countries have shifted to an alternative strategy that relies on trade surpluses as the engine for investment and growth. Since this strategy requires them to defend strategically favourable post-crisis competitive positions, they have unilaterally pegged their currency vis-à-vis the dollar at a slightly undervalued level.

However, the report does not address the channels through which this trade surplus is being generated in developing countries. As argued by Chandrasekhar and Ghosh (2005), there are two reasons why this could have occurred: crisis-induced deflation that restricted imports and generated a current account surplus, or unusual success as an exporter of goods and/or importer of foreign capital. While China and India may be countries that fall in the latter category, most other developing countries recorded surpluses by following deflationary policies and restricting domestic investment to below potential. Thus, the remarkable extent of capital outflow from the developing world came about not because of any real increase in savings rates in the aggregate (as the orthodox “savings glut” argument goes), but because investment rates have not gone up commensurately. The period of most significant increase in net lending abroad by Asian NICs, for example, was when domestic savings rates were actually falling, because investment rates were falling even faster. On the other hand, increases in domestic savings rates in other developing countries dominantly reflect fiscal consolidation and expenditure cutbacks by their governments. Growth is curtailed through deflation so that, even with a higher import-to-GDP ratio resulting from trade liberalisation, imports are kept at levels that imply a trade surplus[5]. This crucial link between the current account surpluses being generated by the emerging markets and the contractionary fiscal policies they adopt out of the compulsions of neo-liberal policy framework is one that the report fails to explore.

Further, reliance on trade surpluses as an engine of growth by all or most developing countries as the report argues cannot succeed for all, basically because of the race-to-the bottom with competitive export pricing and the reduction in export revenues this implies. Again, as TDR itself highlights, such a strategy can only function as long as there is at least one country in the global economy that accepts running the corresponding trade deficit. Clearly, the US seems to fit these attributes of an economy which will accept running large and rising trade deficits. But the problem is that the possibility of a slowdown in the United States economy looks increasingly likely. There is the prospect that this would entail further dollar depreciation, which would tend to restore competitiveness[6] and, together with the economic slowdown, would help re-balance the United States economy. But, given the existing structure and concentrated dependence of global growth on demand stimuli from the United States, a marked slowdown in the US growth could quite easily unravel the momentum seen in developing countries in recent times.

But there is another problem with the argument of developing countries’ reliance on trade surpluses. Whether it is one or more economies that will help balance trade across the globe, the point is that on the exporting countries’ side, there are several supply-side and demand side constraints that come in the way while countries try to export their way to economic growth. Ironically, the subsequent chapters of the report are in fact devoted to detailed discussions of these very constraints facing developing countries’ export-led development project.

National Development Policy Choices and Constraints
Another contribution of the TDR relates to national development strategies. It is noted that the Washington Consensus approach to development represented a shift away from the focus on capital accumulation to an almost exclusive reliance on improved efficiency in factor allocation generated by market forces. The latter was based on the belief that capital accumulation, the basic precondition both for output growth and economic restructuring would follow automatically from improved allocation of existing resources. This expectation was rarely met. Thus, the savings-led approach favoured by the mainstream view in economics is misleading.

If markets do not automatically deliver positive and stable growth rates of real income and catching up, then the dynamic view, highlighting the incentive of temporary monopoly rents for pioneering investors, is more than ever relevant for the development of the system as a whole. The report thus calls for active government policies to encourage investment and technological progress in support of a dynamic process of growth and structural change that benefits from – rather than being constrained by – integration into the world economy.

Against the backdrop of external constraints on development, and given the experience with reforms over the past 15 years as well as recent developments in economic theory concerning the creation of new areas of comparative advantage, the Report makes a strong case for the adoption of proactive trade and industrial policies. Supportive national economic policies advocated by this interpretation focus on strengthening the dynamic forces of markets related to information externalities, coordination externalities and dynamic economies of scale. The form of trade integration envisaged represents a mix of import substitution through temporary protection and export promotion using temporary subsidies. Contrary to orthodox dogma, fiscal incentives, directed public credit and subsidies are cited as measures that lower the cost of innovative investment and enable capital accumulation for sustained growth.

However, the Report makes the point that that in order to foster diversification and technological upgrading, subsidies should be given only to investment that is undertaken to discover the cost function of new goods or new modes of production in the respective economy. The argument is that such policies should not be employed as defence mechanisms to support industries where production and employment are threatened the most by foreign competitors that have successfully upgraded their production. For example, the Report suggests that this general principle does not support selective trade protection or other selective support measures that many developed countries are still applying in agriculture or in labour-intensive manufacturing sectors such as the clothing industry.

There is a problem if this argument is applied in the case of agriculture in many developing and less developed countries. It is generally accepted that farming and associated activities constitute more than just production activities in these countries, and that they are a source of livelihood and food security for millions in the countryside. This distinction should have been mentioned by the report while discussing the applicability of this general principle. The second area which this general principle does not support is a large number of contemporary industrial policy measures which focus on attracting FDI and related export-oriented activities, where domestic production already exists.

Even as it advocates the need for proactive trade and industrial polices, the Report recognises and highlights the reduced degree of freedom that remains for policy implementation as a result of global production and financial integration. The Report makes a distinction between de facto (“inbuilt”) constraints that result from policy decisions relating to the form and degree of a country’s integration into the international economy and de jure (“implanted”) constraints on national policy autonomy that are the result of commitments to obligations and acceptance of rules set by international economic governance systems and institutions. But, it can be seen that this distinction between de jure and de facto constraints is more conceptual than real. Multilateral (as well as regional/bilateral) agreements are very much part and parcel of a country’s decision to integrate with the world economy through trade and financial liberalization. Thus, they are largely inseparable processes that overlap and reinforce each other. Thus, for all practical purposes, this distinction hardly matters for developing countries’ policy choices.

Most notable among de facto constraints is the loss of the ability to use the exchange rate as an effective instrument for external adjustment, or the interest rate as an instrument for influencing domestic demand and credit conditions, because of a reliance on private capital inflows to finance trade deficits following the opening up of the capital account. Indeed, this is what leads to the lack of coherence between the prevailing macroeconomic environment and microeconomic measures directed to expanding productive capacity and improving productivity. In order to provide a favourable macroeconomic framework, monetary policy has to take on a much broader responsibility than is stipulated by orthodox theory. In order to avoid excessive adjustment of interest rates and exchange rates with attendant adverse effects on the real economy, a more flexible and efficient approach for inflation control might be to consider the use of “supply side” tools including, for example, government influence on income negotiations and/or the redefinition of the inflation target depending on the origins of the inflationary pressure.

While discussing “de jure” constraints, the Report shows how the various WTO rules have made it far more difficult for developing countries to combine outward orientation with the policy instruments that the mature and late industrializers employed to promote economic diversification and technological upgrading. The Subsidies and Countervailing Measures (SCM) agreement is a good illustration of how WTO rules and commitments that are equally binding, legally, impose more binding constraints on developing countries economically. Even as countries still have the possibility to pursue policies (Article 8-type subsidies) relating to the provision of public funds in support of R&D and innovation activities, such subsidies are of primary concern to developed countries in their quest to develop high-tech capabilities and technological innovations. Further, subsidies impose a cost on public budgets, which developed countries can afford more easily than developing countries.

According to the report, regional or bilateral agreements with large developed countries offer substantial benefits to developing-country members as they usually provide greater market access than multilateral agreements, and often include a wider range of products than traditional trade preference schemes such as the Generalized System of Preferences (GSP). Moreover, their adoption is generally expected to lead to additional FDI. But empirical studies on existing US bilateral free trade agreements (FTAs) involving developing countries have shown that both greater market access and more FDI-led exports under such preferential trade agreements are largely an illusion[7]. Further, greater integration often involves additional steps towards regulatory disciplines, and thus further constrains the de jure ability of developing countries to adopt appropriate national regulatory and development policies, particularly with regard to FDI and intellectual property rights. This could make it even more difficult to develop the supply capacity needed to take advantage of improved export opportunities. Thus, the analysis in fact ends on a pessimistic note on developing country prospects.

Where are the Solutions?
The Report advocates that in order to assuage the situation and to enable all developing countries to reach the Millennium Development Goals (MDGs), the global partnership for development, stipulated in Goal 8 of the MDGs, needs to be strengthened further. However, it is pointed out that the current system of global economic governance does not seem to be satisfactory because of two overlapping asymmetries. First, unlike in the trade arena, current international monetary and financial arrangements are not organized around a multilateral rules-based system that applies a specific set of core principles to all participants. This asymmetry has particularly strong adverse effects on developing countries according to the Report, because self-centred national monetary and financial policies can have much more damaging effects than those caused by trade and trade-related policies. Second, the multilateral rules and commitments governing international economic relations are, in legal terms, equally binding for all participants, but in economic terms they are biased towards an accommodation of the requirements of the national economic strategies of developed countries. There is a direct corollary to this: the institution that is in charge of promoting exchange-rate stability and of avoiding excessive and prolonged payments disequilibria is unable to impose meaningful disciplines on the policies of those economies that run the most significant external imbalances and whose exchange-rate volatility has the most significant negative impact on the international economy.

It follows that while the Report calls for a global partnership for development that ensures the right balance between sovereignty in national economic policymaking on the one hand and multilateral disciplines and collective governance on the other, this can hardly be achieved in the real economic policymaking arena. When rules, in which developing countries have little say, are being formulated and become part of their “obligations”[8], evidently very little flexibility is actually afforded to developing and less developed countries to undertake institutional reform in the manner suggested by the Report. The conditions for development and the agenda are already set. Therefore, the global partnership for development should first and foremost ensure effective developing country participation in international policymaking that impacts their development strategies. The Report stops short of calling for this critical challenge facing the global development project. In fact, this lack of developing country participation in global economic policymaking is precisely the reason why UNCTAD ironically has to talk of “the urgent need to move beyond Washington Consensus” nearly two decades after it has been discredited in Latin America’s lost decade.

It is indeed crucial to ensure actual developing country participation in rule-making before we insist on a “multilateral rules-based system” in finance as in the case of trade. Otherwise, we would be compromising for more instances of Special and Differential Treatment (S&DT) provisions that have no teeth; or ending up with ever more instances of serious and adverse development consequences of “multilateral rules” imposed from the top. The latter is being envisaged, for instance, in the case of the revised capital adequacy norms for banks prescribed by Basel II. The need of the hour therefore is an aggressive expansion of enlightened developing country engagement in international policymaking institutions and agencies, and to ensure that the march towards global harmonisation of economic policies can be checked so as to maintain adequate policy space for each country’s development needs.

[1] Annex I to Chapter I of the report contains a detailed discussion of the reasons behind the current commodity price boom and the implications for terms of trade.

[2] See, for instance, the analyses by several authors in Ann Pettifor (ed.), 2003, Real World Economic Outlook: Debt and Deflation, Palgrave Macmillan. Also see, Chandrasekhar C.P. and Jayati Ghosh, 2005a, The Myth of a Global Savings Glut”, available at http://www.networkideas.org/focus/Sep2005/fo30_Balance_Payments.htm 

[3] See Annex II to Chapter I on the debate on savings-investment theory.

[4] By contrast, in Central and Eastern Europe and the CIS region, 21 out of 25 countries recorded relatively high and stable current-account deficits of around 5 to 6 per cent of GDP during the last ten years.

[5] See Chandrasekhar and Ghosh, 2005a, and Chandrasekhar, C.P. and Jayati Ghosh, 2005b, “Developing Countries and the Dollar”, at http://www.networkideas.org/focus/Sep2005/fo30_Balance_Payments.htm 

[6] In fact, this is already being suggested by some authors. See Baily, Martin Neil and Robert Z. Lawrence, 2006, “Can America Still Compete or Does It Need a New Trade Paradigm?”, Policy Brief No. PB06-9, Peter G. Peterson Institute for International Economics, Washington.

[7] See the analyses in the papers presented at the 2nd Workshop on “ASEAN Expert Collaboration for FTA Negotiations with the United States”, Bangkok, Thailand, 3-4 August, 2006, available at http://www.networkideas.org/feathm/aug2006/ft19_Abstracts_Bangkok.htm

[8] Kallummal, Murali and Smitha Francis, 2005, Sub-Federal Governance and Global Harmonisation of Policies” available at http://www.networkideas.org/focus/feb2005/Global_Harmonisation.pdf