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Democratic Republic of Congo, Ethiopia, The Gambia, Ghana, Guinea, GuineaBissau, Honduras, Madagascar, Malawi, Niger, Rwanda, Sao Tome´ and Principe, Senegal, Sierra Leone, and Zambia – reached an interim period in adjustment and macroeconomic stabilization. As of early 2004, 11 HIPCs, still to be considered before the HIPC initiative expired at the end of the year, were Burundi, Central African Republic, Comoros, Republic of Congo, Ivory Coast, Lao PDR, Liberia, Myanmar, Somalia, Sudan, and Togo. Many in the last two categories may lack the political stability and bureaucratic capacity to undertake the World Bank/IMF’s required program.

The DCs’ and the international financial institutions’ continuation of writing down debt, liberalizing trade, and increasing aid to counter external shocks could spur HIPC leaders to undertake further long-term political and economic reforms, at least in some countries listed in the previous paragraph, if not to Sierra Leone, Liberia, Somalia, Sudan, Congo (Kinshasa), and Coteˆ d’Ivoire, where political conflict or blatant corruption precludes even minimally effective capital utilization. Indeed, in predatory states such as Sudan and Sierra Leone, the ruling elite and their clients “use their positions and access to resources to plunder the national economy through graft, corruption, and extortion, and to participate in private business activities” (Holsti 2000:251).

The immediate cost to DCs of a program similar to Jubilee 2000 for nonpredatory states is negligible. Efforts to “wipe the slate clean” for selected HIPCs could free political leaders, especially in Africa, of their inherited debts, and provide some breathing space to enable them to focus on long-range planning and investment to improve the general welfare and reduce their vulnerability to deadly political violence.11

What effect did the HIPC initiative have? HIPCs continued their trend of falling debt-service ratios. Latin American HIPCs’ ratios declined from 30 percent in 1992 to 14 percent in 1999 to 12 percent in 2001, whereas sub-Saharan HIPCs’ ratios fell from 17 percent in 1992 to 16 percent in 1999 to 9 percent in 2001 (World Bank 2003h:13). And the 10 countries that first completed adjustment under the enhanced HIPC debt initiative relief reduced their total debt service from $1.0 billion in 1998 to $0.6 billion in 2002, freeing resources to increase education and health spending from $1.4 billion in 1998 to $2.1 billion in 2002 (UNDP 2003:153).

The Policy Cartel

Mosley, Harrigan, and Toye (1991:Vol. 1) refer to the International Monetary Fund and World Bank as a “managed duopoly of policy advice.” Before arranging LDC debt writeoffs and write-downs, the World Bank, DC governments, or commercial banks require the IMF’s “seal of approval” in the form of a stabilization program.

11U.N. Secretary-General Kofi Annan (1998:6) “suggested that creditors consider clearing the entire debt stock of the poorest African countries while expanding the Highly Indebted Poor Countries program of the World Bank.”

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This requirement creates a monopoly position, leaving debtors little room to maneuver. Latin American and African debtors would benefit from the strengthening of independent financial power within the world economy. Yet, the Bretton Woods institutions, the World Bank and IMF, as charged by their DC and LDC shareholders, do not use their resources to write down or cancel debts. Both institutions must be satisfied that a borrower can repay a loan. There may be few alternatives to financial restrictions, devaluation, price liberalization, and deregulation for eliminating a chronic debt crisis.

The reader should consult Chapters 15, 17, and 19 for other factors influencing LDC external adjustment, with emphasis on sections that discuss direct foreign investment, concessional aid, DCs’ reduced trade barriers against LDCs, and LDC trade and exchange-rate policies to avoid biases against exports.

Conclusion

1.Some of the causes of the debt crisis have been global shocks and instability, a decline in the ratio of official aid to commercial loans, inefficiency, poor economic management, overvalued domestic currencies, and capital flight.

2.Lending to LDCs (especially Latin American) may be undermined by capital flight because perceived risk-adjusted returns are higher in haven countries than in LDCs. Equilibrium exchange rates, fiscal reform, increased efficiency of state enterprises, and nondiscriminatory haven country policies can help reduce flight, but ironically exchange controls also may be necessary sometimes.

3.LDCs, especially Latin American, had an increase in their real external debt in the last quarter of the 20th century. The LDC debt service ratio more than doubled from the early 1970s to the late 1980s, but has fallen since then. The exposure of several major U.S. commercial banks to losses from LDC loan writeoffs or write-downs was substantial in the 1980s.

4.The ratio of debt service to GNP is not always a good indicator of the debt burden. Many large LDC debtors borrowed heavily because of their excellent international credit ratings.

5.Middle income countries account for almost four-fifths of the total outstanding debt of all LDCs. Yet the debt burden for low-income countries, such as the majority of sub-Saharan African countries, which have poor credit ratings, may be as heavy as for middle-income countries.

6.Cross-border capital movements benefited LDC recipients in the long run but, because of potential reverse outflows, increased vulnerability to financial and currency crises. These financial and currency crises, also caused by large bank bad debt, current account deficits, real currency appreciation, and fast credit growth, had a negative impact on economic growth.

7.In the late 1970s through the early years of the 21st century, developing countries with chronic external deficits required economic adjustment, imposed domestically or by the World Bank or IMF. In 1979, the World Bank began structural adjustment loans and soon thereafter sectoral adjustment loans. IMF loans of

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last resort were conditioned on an LDC implementing an acceptable macroeconomic stabilization program. Additionally, in 1986–87, the IMF initiated structural adjustment loans for LDCs experiencing unanticipated external shocks.

8.Finance officials in DCs instituted several plans for resolving the debt crisis. The Baker plan (1985) emphasized new loans from multilateral agencies and surplus countries, whereas the Brady plan (1989) stressed debt reduction or write-downs. One strategy for debt reductions, debt exchange, was used less frequently in the late 1990s and the years thereafter.

9.Debt write-downs require multilateral coordination among creditors to avoid the free-rider problem in which nonparticipating creditors benefit from the increased value of debt holdings.

10.Mosley, Harrigan, and Toye refer to the IMF and World Bank as a “managed duopoly of policy advice.” Before the World Bank, DC governments, or commercial bank arrange LDC debt write-downs, they require that the IMF approve the LDC’s macroeconomic stabilization program.

TERMS TO REVIEW

Baker plan

basis points

Brady plan

capital flight

debt exchanges

debt-for-development swaps

debt-for-nature swaps

Debt Reduction Facility

debt service

debt-service ratio

Enterprise for the Americas Initiative (EAI)

exchange control

Group of Seven (G7)

hedging

HIPC (highly-indebted poor countries’) initiative

QUESTIONS TO DISCUSS

IDA-eligible countries

London Club

London Interbank Offered Rate (LIBOR)

managed floating exchange-rate system

negative real interest rates

net transfers

Paris Club

policy cartel

propensity to flee

real domestic currency appreciation

real domestic currency depreciation

risk premium

total external debt (EDT)

1.Discuss the nature and origins of the LDCs’ external debt problem. What impact has the debt crisis had on LDC development? On DCs?

2.Define total external debt, debt service, and debt-service ratio? How useful is each of these indicators as a measure of the debt burden?

3.Who are the major LDC debtors? Explain the reasons for the discrepancies between the leading LDC debtors and LDCs with the greatest debt burdens.

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4.What is capital flight? What relevance does it have for the debt problem? What can source and haven countries do to reduce capital flight?

5.To what extent does the IMF play the role of the lender of last resort? To what extent does the IMF follow Walter Bagehot’s rule?

6.What are the causes of financial crises, such as the Asian crises?

7.Assess the views of fundamentalists versus the Columbia school in their explanation for the Asian financial crisis and how to resolve it.

8.What changes, if any, need to be made to the international financial architecture to spur growth and reduce poverty?

9.What changes are needed in sovereign debt restructuring?

10.What plan should the international community adopt to resolve the debt crisis? In your answer, consider plans similar to the Brady Plan, debt exchanges, the HIPC initiative, and other options, as well as the roles of the World Bank, International Monetary Fund, and DCs.

11.What impact has incurring major external debt by LDCs had on global and country income distribution? What impact have attempts to reduce the debt crisis had on income distribution?

GUIDE TO READINGS

For an interchange between two giants of the profession, in which Harvard’s Kenneth Rogoff, then the IMF’s Director of Research, attacks the views of Columbia’s Joseph Stiglitz, sometime World Bank chief economist, on globalization and the IMF, see http://www.worldbank.org/, searching Stiglitz, then clicking “Presentation,” keywords “Economic Development Globalization.”

Annual publications by the World Bank, Global Development Finance (usually two volumes) and Global Economic Prospects and the Developing Countries, and the Organization for Economic Cooperation and Development’s (OECD’s) annual report of the Development Assistance Committee are major sources on LDC debt. Consult chapters on debt in UNCTAD’s Trade and Development Report and Least Developed Countries and the IMF’s World Economic Outlook. The Institute of International Economics in Washington, DC (http://www.iie.com), provides papers and lists useful monographs on debt problems.

For criticisms of the World Bank–IMF Washington Consensus approach, look at Nayyar’s edited book (2002) with articles by Stiglitz (2002c:218–253) and You (2002:209–237), Stiglitz (2000b), and a series of papers and speeches by Stiglitz in an edited book by Chang (2001). For a review of Stiglitz’s views on globalization, read Basu (2003:885–899).

Kaminsky, Reinhart, and Vegh (2003:51–74) analyze the “unholy trinity” of “fast and furious” financial contagion – herding (or informational cascades), trade linkages, and financial linkages.

For recommendations for a new international financial architecture, read Eichengreen (1999), Mistry (1999:93–116), Kenen (2001), Nayyar (2002), the International Financial Institution Advisory (Meltzer) Commission (2000), and the Stiglitz articles

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in the previous paragraph. On debt and international architecture, see Birdsall and Williamson (2002).

On sovereign debt restructuring, see Krueger (2002; 2003:70–79), Fischer (1999:85–104), and Reinhart and Rogoff (2004:57). On reducing IMF and G7 rescue packages and increasing creditor risk, see Roubini and Setser 2004.

The Fall 1999 issue of the Journal of Economic Perspectives on global financial instability has articles by Miskhkin (1999:3–20) on monetary framework, Rogoff (1999:21–42) on international institutions, Caprio and Honohan (1999:43–64) on restoring banking stability, Edwards (1999:65–84) on the effectiveness of capital controls, and Fischer (1999:85–104) on the need for an international lender of last resort. Krugman, The Return of Depression Economics (1999), and Barro (2001) are sources on the Asian crisis.

For a comparison of the Asian and Russian crises, see Montes and Popov (1999) and Chapter 17. Noble and Ravenhill (2000a) have an edited book on the Asian financial crisis and the international financial architecture.

For recent information on HIPCs and other debt issues, see http://www. worldbank.org/ or www.imf.org/, including the monthly Finance and Development at http://www.imf.org/external/pubs/ft/fandd/2004/03/index.htm and the bimonthly IMF Survey at http://www.imf.org/external/pubs/ft/survey/surveyx.htm.

Ranciere, Tornell, and Westerman (2003) use empirical analysis to assess financial liberalization.

Lessard and Williamson (1987) and Williamson and Lessard (1987) discuss the meaning, origins, and policy implications of capital flight.

17 International Trade

Scope of the Chapter

This chapter discusses the relationship between trade and economic growth, arguments for and against tariff protection, the shift in LDCs’ terms of trade, import substitution and export expansion in industry, DC import policies, expansion of primary export earnings, trade in services, protection of intellectual property rights, foreign exchange-rate policies, LDC regional integration, global production networks (the borderless economies), and protection of infant entrepreneurship.

Does Trade Cause Growth?

In the long run, liberal international trade is a source of growth (Sachs and Warner 1997; Baldwin 2003).1 Is the high correlation between trade and GDP per capita a result of income causing trade or trade causing growth? Jeffrey A. Frankel and David Romer (1999:379–399) test the direction of causation by constructing a measure of trade based on geographic characteristics rather than on income. They then use this measure to estimate the effect of trade, if any, on per capita income. They find that a 1-percentage-point increase in trade to GDP increases income per person by 1/2–2 percent. Trade mainly raises income by spurring the growth of productivity per input; in addition trade affects income by stimulating physical and human capital accumulation.2 Alan Winters (2004:F10–F15) attributes the productivity gains to increased import competition, technological improvements embodied in imports, export expansion, and learning through trade.

However, Greenaway, Morgan, and Wright (1997) show that, in the short run, trade liberalization by LDCs in the 1980s and 1990s was associated with deterioration in growth. But, the effect of trade openness on the poorest portion of the LDC population is uncertain. Lars Lundberg and Lyn Squire (1999), who use Sachs and

1International trade is liberal if average tariff rates are below 40 percent, average quota and licensing coverage of imports are less than 40 percent, the black market exchange-rate premium is less than 20 percent, and there are no extreme controls (taxes, quotas, or state monopolies) on exports (Sachs and Warner 1997). Rodriguez and Rodrik (1999) criticize the Sachs–Warner approach, arguing that illiberal trade is highly correlated with other growth inhibitors that may be the source of poor economic performance.

2In response to criticism, Frankel and Rose (2002) achieve the same results when they include institutions in their equation.

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Warner’s measure for openness and liberal trade, find that openness is negatively correlated with income growth among the poorest 40 percent of LDCs’ population but positively correlated with growth among higher-income groups. However, David Dollar and Aart Kraay (2004:F26), who examine decade to decade changes, find that with trade liberalization, “the percentage changes in incomes of the poor [bottom 20 percent] on average are equal to percentage changes in average incomes,” although the variation around the trend is substantial. Alan Winters, Neil McCulloch, and Andrew McKay (2004:72–115) think that trade liberalization, by increasing productivity, may be the most cost-effective antipoverty policy. Indeed, William Cline (2004:xiv, 171–226) estimates that gains from global free trade would be $200 billion (at 1997 prices) yearly (half the gains to LDCs), reducing $2/day poverty by 500 million over 15 years. Vietnam, for example, reduced poverty from 75 percent of the population in 1988 to 37 percent in 1998 during the height of its globalization (Dollar and Kraay 2004:F29).

Ashok Parikh (2004) finds that trade liberalization promotes economic growth on the supply side through more efficient resource allocation, increased competition, and a greater flow of ideas and knowledge. However, growth has a negative impact on the trade balance that in turn could have negative effects on growth through a reduced trade balance and adverse terms of trade. Thus trade liberalization, which promotes economic growth, can constrain growth through an adverse impact on the balance of payments.

Moreover, trade liberalization amid stabilization, even if politically possible, may perpetuate a government budget crisis. As mentioned in Chapter 5, Mosley, Harrigan, and Toye (1991, vol. 1:110–116) argue that early liberalization of external trade and supply-side stimulation in “one glorious burst” can result in rising unemployment, inflation, and capital flight, and the subsequent undermining of adjustment programs. The policy implications are that liberal trade is beneficial in the long run, if not undertaken abruptly but sequenced as part of a comprehensive program of economic reform (see Chapter 19).

Arguments for Trade: Comparative Advantage

Costs, prices, and returns vary from one country to another. A country gains by trading what it produces most cheaply to people for whom production is costly or even impossible. In exchange, the country receives what it produces expensively at the other country’s cheaper costs. To explain these mutual trade benefits, international economists still accept the doctrine of comparative advantage formulated by Adam Smith and David Ricardo, English classical economists of the late 18th and early 19th centuries.

Assume a world of two countries (for example, a LDC like Pakistan and a DC like Japan) and two commodities (for example, textiles and steel). Other classical assumptions include

1.Given productive resources (land, labor, and capital) that can be combined in only the same fixed proportion in both countries

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	TABLE 17-1. Comparative Costs of Textiles and
	Steel in Pakistan and Japan
		Pakistan	Japan
	Textiles (price per meter)	Rs. 50	Y300
	Steel (price per ton)	Rs. 200	Y400

2.Full employment of productive resources

3.Given technical knowledge

4.Given tastes

5.Pure competition (so the firm is a pricetaker)

6.No movement of labor and capital between countries but free movement of these resources within a country

7.Export value equal to import value for each country

8.No transportation costs

The theory states that world (that is, two-country) welfare is greatest when each country exports products whose comparative costs are lower at home than abroad and imports goods whose comparative costs are lower abroad than at home.

International trade and specialization are determined by comparative costs, not absolute costs. Absolute cost comparisons require some standard unit, such as a common currency (for example, textiles $5 a meter in Pakistan and $10 in Japan). But you cannot compare absolute costs without an exchange rate (such as a Pakistani rupee price of the Japanese yen).

Assume that before international trade, the price of textiles is Rs. 50 per meter in Pakistan and Y300 in Japan, and the price of steel per ton is Rs. 200 and Y400 (shown in Table 17-1).

We cannot conclude that both textiles and steel are cheaper in Pakistan simply because it takes fewer rupees than yen to buy them. The two currencies are different units of measuring price, and there is no established relationship between them. If Japan issued a new currency, converting old yen into new ones at a ratio of 100:1, both products would then sell for fewer yen than rupees, even though the real situation had not changed.

It is easy to compare relative prices, however. The ratio of the price of steel to that of textiles is 4:3 in Japan and 4:1 in Pakistan. Hence, the relative price of steel is lower in Japan than in Pakistan, and the relative price of textiles is lower in Pakistan than in Japan. Thus, Pakistan has a comparative cost advantage in textiles and Japan a comparative cost advantage in steel.

To demonstrate that the LDC (Pakistan) gains when exporting textiles in exchange for Japanese steel, we must use an exchange rate (for example, rupee price of the yen) to convert comparative prices into absolute price differences. Pakistanis will demand Japanese steel if they can buy yen for less than half a rupee per 1 yen. Why? Because steel is absolutely cheaper in Japan than in Pakistan. If, for example,

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people purchase 1 yen for one-fourth of a rupee, Japanese steel sells for Rs. 100 (Y400) – cheaper than the Pakistani steel price or Rs. 200. By contrast, the Japanese will buy Pakistani textiles if they can sell 1 yen for more than one-sixth of a rupee. At an exchange rate of 1 yen per one-fourth of a rupee, for example, the Japanese can buy Pakistani textiles for Y200 (Rs. 50) – cheaper than the Japanese price of Y300.

International trade takes place at any exchange rate between half a rupee per 1 yen (the maximum rupee price per yen to induce Pakistanis to trade) and one-sixth of a rupee per 1 yen (the minimum rupee price per yen to induce the Japanese to trade). Within this range, the absolute price of steel is lower in Japan than in Pakistan, and the absolute price of textiles is lower in Pakistan than in Japan, so both countries gain from trade.

This exchange-rate range is not arbitrary. If it is more than half a rupee per 1 yen, there is no trade, because Pakistan does not demand any Japanese goods. If it is less than one-sixth of a rupee per yen, there is no trade, because Japan demands no Pakistani goods.

Given our assumption, if relative prices are the same in the two countries before trade, there will be no trade. If, for example, the relative prices of steel and textiles are Rs. 200 and Rs. 50 in Pakistan, and Y1,200 and Y300 in Japan, there is no exchange rate at which both countries demand a good from the other.

Pakistan gains (or at least does not lose) by specializing in and exporting textiles, in which it has a comparative cost advantage, and by importing steel, in which it has a comparative cost disadvantage. Pakistan obtains steel more cheaply by using its productive resources to produce textiles, and trading them at a mutually advantageous rate for steel, rather than by producing steel at home.

Although the theory can be made more realistic by including several countries, several commodities, imperfect competition, variable factor proportions, increasing costs, transport costs, and so on, these changed assumptions complicate the exposition but do not invalidate the principle of free trade according to a country’s comparative advantage. For example, the factor proportions theory or Heckscher– Ohlin theorem (Ohlin 1933; Heckscher 1950:272–300), introduced by two Swedish economists, shows that a nation gains from trade by exporting the commodity whose production requires the intensive use of the country’s relatively abundant (and cheap) factor of production and importing the good whose production requires the intensive use of the relatively scarce factor. International trade is based on differences in factor endowment, such as Pakistani labor abundance and Japanese capital abundance. Pakistan has a comparative advantage in labor-intensive goods (textiles) and Japan comparative advantages in capital-intensive goods (steel), meaning textile opportunity costs (measured by steel output forgone per textile unit produced) are greater in Japan than in Pakistan.3

3Kenen (1994:19–85) elaborates on the theory of comparative advantage, the Heckscher–Ohlin thesis, and the Leontief paradox contradicting that thesis. Burtless (1995:800–816) and Wood (1995) discuss the effect of trade on wages in DCs and LDCs.

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Does foreign investment in LDCs follow comparative advantage? The Japanese economist Kiyoshi Kojima (1978:134–151) argues that whereas U.S. MNCs invest abroad because of monopoly advantages from patents, technology, management, and marketing (see Chapter 15), Japanese (and Korean) MNCs invest in LDCs to take advantage of their comparative advantage in natural resources or in labor-intensive commodities, a pattern that promotes trade and specialization. Critics from the anti– Davos World Social Forum, discussed in Chapter 15, would object not so much to free trade under pure competition according to comparative advantage but free, footloose, capital movements that allegedly contribute to oligopolistic concentration similar to that in coffee roasting and processing (Chapter 7).

Table 4-3 shows that about three-fourths of DCs’ trade is with other DCs; indeed, DCs comprise 76 percent of the world’s trade. The majority of the trade, then, is between economies with similar factor proportions, an abundance of capital and skilled labor and not along Heckscher–Ohlin lines (see intra-industry trade).

Comparative advantage may be based on a technological advantage (as in Japan, the United States, and Germany), perhaps a Schumpeterian innovation like a new product or production process that gives the country a temporary monopoly in the world market until other countries are able to imitate. The product cycle model indicates that while a product requires highly skilled labor in the beginning, later as markets grow and techniques become common knowledge, a good becomes standardized, so that less-sophisticated countries can mass produce the item with less skilled labor. Advanced economies have a comparative advantage in nonstandardized goods, while LDCs have a comparative advantage in standardized goods (Vernon 1966:190–207). Product cycle is illustrated by specialization in cotton textiles shifting from England (the mid-18th to mid-19th centuries) to Japan (the late 19th to early 20th centuries) to South Korea, Taiwan, China, Hong Kong, and Singapore (beginning in the 1960s) subsequently joined by Thailand (in the 1980s). Call center outsourcing cycled from rural Nebraska to Ireland to India, with the prospect that rising wages there with growth could shift outsourcing to other low-income economies (Slater 2004:A7). Automobiles shifted from the United States (through the late 1960s) to Japan (the mid-1970s through the late 1980s), to South Korea, with the next shift uncertain – a shift among high-income economies with a global seamless network producing a world car, or to a newly industrializing country such as China or Malaysia. Foreign investment and technological transfer by U.S. automobile companies in Japan (for example, General Motors with Isuzu and Ford with Mazda) and Japanese companies in South Korea (Mitsubishi with Hyundai) have helped shift comparative advantage. Indeed, the Japanese economist Miyohei Shinohara (1982:32–33, 72– 75, 127–128) speaks of a boomerang effect, imports in reverse or intensification of competition in third markets arising from Japanese enterprise expansion in, and technology exports to, other Asian countries. But the Japanese economist Shojiro Tokunaga and his collaborators regard this competitive intensification from third markets as part of a Japanese-led specialized international division of knowledge that enables Japanese companies to maintain competition in the face of yen appreciation (see later).