Nafziger Economic Development (4th ed)

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FIGURE 17-11. Western Hemisphere Trade Agreements (c. 2000). Source: Frankel 1997:10.

until several years after 2005. But the 10 may benefit from reduced exchange rate risk when making transactions with the rest of the European Union, their major trading partners.

What role will LDCs have in determining the relative importance of the dollar and euro as a reserve currency? In addition, what effect will shifts from the dollar to the euro have on the massive capital flows to the United States, used to finance its chronic balance of payments deficit? Already, Jacques Polack (1998:60) states, the dollar-dominated world monetary system was replaced by a two and one-half polar system – the dollar, euro, and yen. Moreover, all Organization of Petroleum Exporting Countries (OPEC) states, except Nigeria and Venezuela, export more oil to the European Union than the United States. In 2003, OPEC holding funds in U.S. dollars subjected members to currency loss (Samii, Rajamanickam, and Thirunavukkarasu 2004). Only the United States’ more highly developed capital market slowed the switch away from the dollar.

Polack (1998:60) thinks that, by 2010, euro reserves will be as much as one-half dollar reserves. Moreover, as eurozone capital markets develop, Europeans will loan more to LDCs. Surely all of these changes would also reshape global specialization and trade patterns as well (Cohen 2001:294–314).

Promotion and Protection of Infant Entrepreneurship

The dynamic gains from learning management and technology by doing, for countries such as Malaysia, Thailand, India, and Latin American countries, are likely to be substantial, although they may be difficult to measure. Much of this dynamic learning can come from being open to international trade.

Importing from technologically advanced economies improves an LDC’s industrial efficiency. Moreover, LDC engineers and technicians may import a foreign machine, tear it apart, learn how it was put together, and modify it to fit local circumstances. The product-cycle model, discussed above, suggests that technological borrowing can proceed from imported product to a copy, usually inferior in quality, to slow improvement, with finer grades and specialties, which come with experience, improved endowment of human and physical capital, and a shift in comparative advantage. Examples of LDCs following this sequence include Japan in the 1880s and 1890s and the early decades of the 20th century, and the Asian Tigers after 1970.

An LDC can respond to the exacting demand of foreign consumers, as Japan’s textile industry did in the 1920s and 1930s, reorienting itself from silk to cotton and rayon goods demanded by American women. Or third world labor learns to produce inputs and parts to precise specifications. In the late 19th century, the Japanese improved their technology by working with Western firms (Lockwood 1954:331– 32; Economist 1995c:78; Nafziger 1995:38–39, 43, 47, 137). Later, in the 1980s and 1990s, as mentioned earlier, ASEAN labor learned to meet the specifications of advanced Japanese industry.

One alternative to protecting infant industry from foreign competition through tariffs is protecting infant entrepreneurship through restrictions on foreign investment. To be sure, limiting foreign capital by requiring majority local ownership in certain sectors, reserving other sectors entirely for local enterprise, and limiting repatriation of the profits of foreign capital and the earnings of foreign personnel (see Chapter 14) may discourage overseas investment and enterprise.

Still, as the Wall Street Journal indicated in mid-1994, “the foreign-investment blitz has been a mixed blessing for Mexico and Argentina, which have seen their currencies appreciate greatly against the dollar. The overvalued currencies make exports from Mexico and Argentina more expensive and imports cheaper.” As a result, both countries ran huge deficits in their international goods, services, and income accounts in the early 1990s.

In contrast to Mexico and Argentina, Chile favored local entrepreneurs and capitalists without drastic restrictions on foreign capital. Although economic liberalization in Chile in the early 1990s surpassed that of virtually all other Latin American countries, Chile had the most stringent controls among Latin countries on incoming capital, protecting local enterprise without distorting the foreign-exchange rate substantially. In 1994, the Chilean government required foreign companies (or Chilean companies with foreign collaborators) to offer a minimum issue of $25 million on the Chilean stock exchange and have approval from two foreign credit-rating agencies.

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Additionally, the foreign company had to pay a hefty capital-gains tax and wait one year to repatriate their funds abroad. Foreign investment was $21 billion in Mexico, $15 billion in Brazil, $11 billion in Argentina, and $4 billion in Venezuela, while only $1 billion in Chile in 1993. At the same time, however, Chilean entrepreneurs and savers responded with high levels of domestic capital formation and new ventures, and moderated the boom-and-bust and balance-of-payment cycles associated with foreign investment in the 1980s (ibid.). UNCTAD (1994a:136) thinks that the GATT’s Uruguay Round was unclear about how much LDC protection of domestic entrepreneurship and regulation of trade-related foreign investment were allowed.

Black Markets and Illegal Transactions

Black markets for foreign exchange form in response to restrictions on trade (tariffs, quotas, and administrative controls) and controls on currency transactions (as in Figure 17-9). In mid-1983, the premium for the black market relative to the official market for foreign exchange was 310 percent in Nigeria (that is, the black-market rate, —N 2.95 = $1 was 410 percent of the official rate, —N 0.72 = $1), 72 percent in Ecuador, 27 percent in Pakistan, 26 percent in Mexico, 6 percent in Morocco, and 3 percent in Malaysia. The imposition of exchange and trade restrictions creates incentives to overinvoice imported goods (depositing excess foreign-currency proceeds in foreign bank accounts) and smuggle. Illegal trade creates a demand for illegal currency, which stimulates its supply, leading to the establishment of a black market if the central bank is unable or unwilling to meet all the demand at the official price of foreign exchange. The major sources for the supply of illegal foreign currency comprise export smuggling, underinvoicing exports, overinvoicing imports, exchanges by foreign tourists or diversion of remittances through unofficial channels, and diversion by government officials in exchange for bribes or favors. Black markets for foreign exchange have several adverse effects on government authorities: the cost of enforcement, the loss of tariffs revenue, the encouragement of government corruption and rent seeking, and the loss of income to government on foreign currency transactions. Liberalizing the official market for foreign exchange, an action that usually depreciates the domestic currency, will usually reduce the black-market premium for foreign exchange.16

Although estimates are imprecise, illegal and black-market transactions are important components of international trade. The Overseas Development Council (ODC) estimates 1990 illegal narcotics (coca, cocaine, marijuana, and heroin) exports as 186 percent of legal export earnings in Columbia, 184 percent in Bolivia, 136 percent in Jamaica, 121 percent in Mexico, 90 percent in Peru, and 39 percent in Pakistan. The opium and heroin export percentage in Afghanistan and the Golden Triangle (Burma, Thailand, and Laos) and illegal export percentages in some other LDCs are also substantial (Economist, October 8, 1988, p. 22; Overseas Development Council

16Agenor (1992:5–25). In Colombia, however, the black market has consistently paid a premium for the domestic currency, the peso.

1991:30). For many LDCs, official measures of balance-of-payments components must be suspect.

Nafziger (2006b) discusses “A New International Economic Order: The UN General Assembly versus the New Liberalism.”

Conclusion

1.The LDCs generally gain from a free trade policy wherein they produce goods in which they have a comparative advantage. Factor endowment and technology help determine a country’s comparative advantage.

2.Exceptions to the free trade argument include increasing returns to scale, external economies, potential technological borrowing, changes in factor endowment, a revenue tariff, increased employment, improved balanced of trade, greater domestic stability, national defense, antidumping, and reduced luxury consumption. Yet most of these tariff arguments are weaker than many LDC economic policymakers think.

3.In the more than 100 years since the last quarter of the 19th century, the commodity terms of trade (price index of exports/price index of imports) of primary product exporters have probably fallen.

4.Export promotion is generally more effective than import substitution in expanding output and employment.

5.Rapid growth in LDC manufactured exports in the last few decades was primarily concentrated in middle-income countries, such as Taiwan, South Korea, Hong Kong, Singapore, Spain, Brazil, Thailand, Indonesia, and Malaysia.

6.Although the generalized system of tariff preferences and the 1970s’ Tokyo Round negotiations reduced DC tariffs on selected LDC imports, these gains may have been outweighed by losses from protectionist policies set up during the 1980s. Additionally, DCs increased nontariff trade barriers against LDC imports, especially labor-intensive goods, in the late 1970s, 1980s, and 1990s.

7.For DCs with no tariff on LDC primary products but a substantial tariff on manufacturing and processing that uses primary goods as inputs, the nominal rate of protection is less than the effective rate of protection.

8.Expanding primary exports stimulated rapid economic growth in a number of Western countries in the 19th century, but this approach has had a more limited impact on growth in today’s LDCs.

9.Although the IMF’s and European Union’s compensatory financing schemes have helped stabilize LDC export earnings, a common fund has not been established, and buffer stock agreements have been of limited value.

10.Agricultural subsidies in the United States, European Union, and Japan are major barriers against LDC farm exports.

11.The LDCs with a foreign exchange price below the market-clearing price can improve import rationing, encourage import substitution, and promote exports by depreciating their currencies. Yet, the gains may be limited if domestic prices are still repressed.

QUESTIONS TO DISCUSS

1.What are the major arguments for and against tariffs in LDCs? in DCs?

2.Present the four arguments for tariffs you consider strongest and then indicate their weaknesses.

3.Discuss the adequacy of using a model with three factors – land, labor, and capital – in determining comparative advantage. How would we extend the Heckscher–Ohlin model to explain LDC comparative advantage more realistically?

4.Discuss whether a capital-poor LDC would better import capital-intensive goods from abroad, attract capital from abroad, subsidize and spur production shifting comparative advantage to these goods, or use liberalized policies for capital and other factor markets.

5.Do LDCs face historically deteriorating terms of trade?

6.What are the major arguments for DC protection against LDCs? How valid are these arguments?

7.Which is more effective in expanding LDC output and employment: export expansion or import substitution? What policies avoid biases against exports?

8.Name and then characterize those LDCs that were most successful in expanding exports in the last quarter of a century or so.

9.Why is the nominal rate of tariff protection a poor gauge of the effective rate of protection for processed and manufactured goods?

10.Why are nominal exchange-rate changes inadequate when calculating currency depreciation or appreciation? Indicate how to calculate the real exchange rate.

11.Which LDCs have gained the most from participation in global production networks (GPNs)? What are the reasons for their gains? What strategies can nonGPN LDCs use to become a part of a global production network?

12.What DC changes in tariff policies would aid LDC development?

13.What changes should LDCs make in trade policy to increase their gains from globalization?

14.How much progress has the WTO/GATT system made in facilitating the trade expansion of LDCs since 1960? What changes would you recommend to the WTO/GATT system to expand LDCs’ gains from trade further?

15.What changes are needed in WTO agreements for LDCs to benefit from agricultural trade? From trade in services?

16.Indicate the nature of the present international exchange-rate system and how it affects LDCs.

17.Under what circumstances might a LDC gain from depreciating its currency? What are some of the advantages of depreciation?

18.Why may efforts to achieve a market-clearing exchange rate not improve economic efficiency and growth in a domestic economy that is otherwise not liberalized?

19.Can an LDC attain all three of the following goals: stable exchange rates, free capital mobility, and national control over monetary policy? If not, which goals

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should have the highest priorities and what should be the tradeoffs among the various goals?

20.Discuss why LDCs have made so few gains in their attempts at regional economic integration.

21.Should WTO/GATT encourage the expansion of regional integration among LDCs? If not, what alternatives would you recommend?

22.What policies might an LDC undertake to reduce the premium for the black market for foreign exchange?

23.What changes do LDCs want in the international economic order? What progress has been made in implementing these demands? Are any of the demands inconsistent? Are any contrary to LDC interests?

24.Discuss the relative merits of the positions of liberals and the U.N. General Assembly concerning changes in the international economic order.

GUIDE TO READINGS

Frankel and Romer (1999:379–399); Sachs and Warner (1997); and Winters (2004:F10-F15) have discussions of the relationship between trade and growth. World Bank (2004f:40–47) discusses how trade affects productivity.

Krugman and Obstfeld (2003) clearly explain the theory of comparative advantage. Black (1959) analyzes arguments for tariffs. Romer (1994a:5–38) discusses the welfare costs of trade restrictions. Batra (1992) argues against free trade for the United States.

Chang (2002) chides DCs for pulling the protectionist ladder just after using it for their early industrialization. However, Ethier (2002) would reject Chang’s approach, pointing out that global tariffs are much lower today than in the 19th century.

David (1991, 1995) and his other writings show how comparative advantage is path-dependent.

Cline (2004) analyzes trade policy and poverty reduction, and trade and income distribution (1997), including a discussion of Wood (1994). Udry (2003) has a clear presentation of the child labor issue. Antweiler, Copeland, and Taylor (2001:877– 908) analyze trade and the environment.

World Bank, Global Economic Prospects (GEP), including the 2004 edition cited in Nafziger (2006a), discusses global production networks.

Bhagwati (2002b:33–44) uses arguments of avoiding rent seeking and spurring growth in support of free trade. Bhagwati (2004) discusses In Defense of Globalization, Oxford: Oxford University Press.

Mann (1999) shows U.S. comparative advantages from outsourcing overseas. Kingston (2004:309–320) shows how the WTO’s intellectual property rights’

rules extends DC market power and harms technological transfer to and imitation by LDCs, a major contributor to the growth of latecomers in the last two centuries.

The IMF’s World Economic Outlook analyzes recent prospects for trade and growth.

Kojima (1978:134–151) analyzes the differences between U.S. and Japanese MNC investments abroad. Shinohara (1982:32–33, 72–75, 127–128) examines the boomerang effect from imports in reverse or intensification of competition in third markets arising from Japanese expansion of technology to other Asian countries. Shojiro (1992) discusses Japan’s borderless Asian economy.

Burfisher and colleagues (2003) show the effect of eliminating farm tariffs and subsidies on world agriculture. Ray et al. (2003) have an insightful analysis of farm subsidies from the U.S. perspective.

See Reisen (1993:21–23) on the impossible trinity.

Mussa (2002) analyzes the Argentina currency crisis; Montes and Popov (1999) the Russian and Asian crises; and Goldstein (1998) the Asian crises.

Goldstein (2002) discusses managed floating for LDCs wishing to exit a currency crisis.

On the major regional trade blocs and their effect on resource allocation, see Frankel (1997), World Bank (2003h:322–324), Schiff and Winters (2003), and Krueger (1999:105–124).

Edwards (1993:1358–1393) surveys the literature on trade liberalization and growth.

Wyplosz (2001) analyzes the effect of the euro on LDCs. For further insights on the euro, growths of the E.U. accession states, and the impossible trinity, see Finance and Development 41(2) (June 2004) (http://www.imf.org/external/pubs/ft/fandd/ 2004/06/index.htm).

Spraos (1983) and Giorgio Ardeni and Wright (1992:802–812) have good discussions of the concepts and controversies concerning terms of trade and the Prebisch– Singer thesis.

On exchange-rate regimes and capital flows, see the special issue of Annals of the American Academy of Political and Social Science, Tavlas and Ulan (2002).

Reisen (1993:21–23) explains the difficulty of LDCs’ maintaining stable exchange rates, free capital mobility, and national control over monetary policy.

Hufbauer and Schott (1994) and Hufbauer and Schott (1993) have a thorough analysis of the impact of NAFTA on member countries and the costs and benefits of following various sequences toward Western Hemisphere economic integration. Hallett (1994:121–146) and Pohl and Sorsa (1994:147–155) examine what effect the European Union has on trade diversion and creation in LDCs. Schott (2004) examines the United States’ scattered free trade negotiations.

Borjas and Ramey (1995:1075–1110) show that foreign competition in highly concentrated industries was an important factor contributing to the increase in the returns to skills and increases in wage inequality in the United States.

Miron and Zwiebel (1995) make the economic case against drug prohibition. They argue that a free market for currently illegal drugs would reduce violence and property crimes. The prohibition of drugs increases their cartelization, thus increasing the marginal benefit and diminishing the marginal cost of violence.