May 2003 / No. 23

Global Economy

The increased mobility of capital, together with continued restrictions over labor movements, has extended the reach of international production networks.

Testing Trade Waters

Global Trends and Prospects: Growth in the world economy slowed sharply in 2001; performance was weak in all three leading economic regions in the developed world, and the spillover effects on developing countries were much stronger than in previous downturns in the 1990s. Several emerging-market economies in East Asia and Latin America entered into recession; only China and India, two large and relatively closed economies, were by and large immune from the downward pressure of world markets. Growth in Africa remained at a level similar to that of the previous year. For developing countries as a whole growth was only to 2.1%, down from 5.4% in the previous year.

The United States economy entered into recession, and the belief that the Euro area would be unaffected proved unfounded. Faltering exports, lower profits of affiliates in the United States, and an overly cautious monetary and fiscal response all contributed to a decline in the growth rate for the Euro in 2001 to about 1.5%. Unemployment, which had been falling for three years, stabilized at the relatively high level of 8.5%.

International trade played a major role in transmitting the slowdown in the industrial world to developing countries. After growing by 14% in 2000, export volumes for developing countries grew by less than 1% in 2001. All major developing regions were affected, but the impact was most marked in East and South Asia, where exports had grown particularly fast in 2000. The sharp drop in oil prices from their peak in late 2000 also reduced revenues for oil exporters. By contrast, prices for some commodities exported by African countries held up well in 2001.

Capital flows to developing countries in 2001 remained at the low levels prevailing since the Asian financial crisis in 1997. Foreign Direct Investment (FDI) has held up better: flows to Latin America made that region the largest net recipient of capital flows. However, the resilience of FDI seems unlikely to persist into 2002. Only China, which saw net inflows rise in 2001, seems likely to continue attracting inflows on an even larger scale, now that it has acceded to the WTO.

Exchange rates in developing countries have been relatively stable. The major exceptions were Argentina and Turkey, which were forced to float their currencies provoking in both cases considerable financial turmoil.

As a result of active policies to stimulate domestic demand most Asian economies returned to positive growth in the last quarter of 2001. Some Latin American and transition economies also managed to buck the global trend earlier in the year. However, growth in the industrial world is unlikely to return quickly to the 3% that appears to be necessary to support a vigorous increase in employment and income in the developing world. Reaching such an objective would require substantial increases in the demand for the exports of developing countries, a major recovery in commodity prices, and a strong increase in capital flows, for which there is little prospect at present.

In such a context of slow global growth, improved market access could provide a useful boost to activity in developing countries and greater use of regional trade and financing mechanisms may provide relief from external constraints and protection against financial instability. Nevertheless, many developing countries will continue to require substantial official financial support if they are to be protected from the effects of the difficult external economic environments.

Developing Countries in World Trade: Fundamentally, the basic policy challenge facing most developing countries remains how best to channel the elemental forces of trade and industry to wealth creation and the satisfaction of human desires. Shifting away from their dependence on the export of primary commodities towards greater production and exports of industrial products has often been viewed as a means of their participating more effectively in the international division of labor. Manufacturers are expected to offer better prospects for export earnings not only because they allow for a more rapid productivity growth and expansion of production, but also because they hold out the promise of greater price stability even as volumes expand, thereby avoiding the declining terms of trade that have frustrated the long-term growth performance of many commodity-dependent economies.

Since the early 1980s, moves to rapidly liberalize trade and FDI have strongly influenced policy makers in many developing countries in their thinking about this challenge.

During this period the exports of developing countries have, indeed, grown faster than the world average and now account for almost one third of world merchandise trade. Much of that growth has been in assembly, which today account for 70% of the exports of developing countries; for some products developing country exports account for around half or more of world exports. More importantly, many developing countries appear to have succeeded in moving into technology-intensive manufactured exports, which have been among the most rapidly growing products in world trade over the past two decades, notably electronic appliances.

Clearly, for many developing countries, getting the most out of the international trading system is no longer just a matter of shifting away from commodity exports. At the same time, many of the same forces that adversely affected price and productivity dynamics in the primary sector, including the competitive structure of markets, income elasticity and technological weakness, need to be re-examined in the light of recent trends associated with the increased participation of developing countries in the international trading system.

Dynamic Products in World Trade: Over the past two decades the value of world merchandise exports has grown at an average rate of around 8% per annum, compared to less than 6% growth in global output and income. Among the 225 products examined, exports of some have grown at rates three times as fast as the growth in global income, whereas for others export values have declined in absolute terms. It is mainly primary commodities, but also some manufactures, which have registered sluggish or negative growth rates. The growth of trade in about one third of all products, including both primary commodities and manufactures, has lagged behind the growth of global income.

A common feature of these market-dynamic manufactures is that the sectors in which they are produced exhibit strong productivity growth.

Differences in income elasticity, product innovation and changing consumption patterns, and shifts in competitiveness of industries across countries, can explain why some products are more dynamic in world markets than others. However, differences in the speed of liberalization of markets have also played a significant role. A particularly important influence in recent years has been the commercial policies of many developed countries, which limit access to their markets.

The increased mobility of capital, together with continued restrictions over labor movements, has extended the reach of international production networks, thereby accelerating the growth of trade in a number of sectors where production chains can be split up and located in different countries.

Trade and Industry: New Links, Old Challenges: While developing countries as a whole appear to have become more active and dynamic participants in world trade over the past two decades, closer examination shows a great deal of diversity in the modalities of their participation in the international division of labor:

• First, many countries have not been able to move away from primary commodities, the markets for which are relatively stagnant or declining. However, growth in trade in several primary commodities has been as rapid as in some manufacturing sectors, and countries which have successfully entered such sectors have experienced a significant expansion in their exports and incomes;

• Second, most developing countries that have been able to shift from primary commodities to assembly have done so by focusing on resource-based, labor-intensive products, which generally lack dynamism in world markets;

• Third, a number of developing countries have seen their exports rise rapidly in skill- and technology-intensive products, which have enjoyed a rapid expansion in world trade in the past two decades. However, with some notable exceptions, the involvement of developing countries in such products is confined to labor-intensive, assembly-type processes with little value addition. Consequently, the share of some of these countries in world manufacturing income actually fell.

• Finally, a few countries have seen sharp increases in their shares in world manufacturing value addition which matched or exceeded increases in their shares in world manufacturing trade.

Competition and the Fallacy of Composition: What a country can earn from its participation in the trading system, including through value chains, depends, inter alia, on the global supply of the goods produced and exported relative to demand. Unfavorable trends on both counts, resulting in declining terms of trade for commodities, have been a longstanding source of anxiety for policy makers in developing countries. Relying on manufactured exports to galvanize growth was regarded as a solution to this problem. As a result of increased participation of several highly populated, low-income countries in world trade in recent years, as much as 70% of the labor force employed in sectors participating in world trade is low skilled.

However, there is still a considerable amount of surplus labor in such countries, and many large countries are not yet fully integrated into the international trading system. Thus, a simultaneous export drive by developing countries in labor-intensive manufacturing, or increased competition among them to attract FDI as locations for labor-intensive processes of otherwise high-tech activities organized in international production networks, could rekindle the fallacy of composition problem, upsetting the development aspirations of outward-oriented economies and creating serious systemic tensions in the trading system. The dangers of overproducing standardized mass products with high import dependence are typified by the electronics sector, where developing country export prices appear to be more volatile and to have fallen more steeply after 1995 than the same products traded among developed countries.

Implications of China’s Accession to the WTO: The accession of China to the WTO has raised the issue of the possible impact of the adoption of multilateral trade disciplines on the trade performance of China itself as well as of its trading partners. For China, it implies, above all, opening up its markets to greater foreign competition and commercial presence. The experience of liberalization episodes in Latin America and transition economies suggests that this can pose a challenge to economic policy makers. However, China’s big advantage is that it is joining the multilateral system from a position of strength: spectacular success in export expansion, a sound and sustained balance-of-payments position, and abundant international reserves. Moreover, it is well placed to resist excessive import pressures linked to repressed consumer demand, which have derailed other liberalization episodes.

Enterprises and workers in the state-owned sector will face the most difficult challenges. These enterprises operate in agriculture, but are particularly prominent in heavy industry, including power, steel, chemicals and armaments, as well as the service sector.

The consequences of restructuring and increasing unemployment in vulnerable sectors can be offset through industrial expansion elsewhere. Sectors such as clothing, electronic appliances, leather products and other light industries are expected to enjoy improved export opportunities following accession.

Policy issues: The basic policy issue facing developing countries in the trading system is not, fundamentally, one of more or less trade liberalization, but now best to extract from their participation in that system the elements that will promote economic development. For some this is still a matter of switching from primary commodities, but for many others it is a question of increasing the value-added component of manufacturing exports.

It would be wrong to suggest that making good on the bargain struck in the Uruguay Round by providing improved access to markets in areas of interest to developing countries carries no, or only small, adjustment costs in industrial countries. Prolonged periods of high unemployment and slow growth in those countries have led many low-skilled communities to resist further concessions on trade. But renewed protectionism is not the way forward.

Developing countries also need to strike the right policy balance. Continuing efforts to ensure a pro-investment policy regime through an appropriate mix of macroeconomic and market pressures and incentives will be required to meet target growth rates of 6% and above. But much more will be needed to stimulate dynamic export-investment links. Developing countries must be able to graduate across the full spectrum of manufacturing industries to ensure that more of the productive activities generating trade stay at home and to help avert the problems associated with fallacy of composition. This will call for a faster expansion of domestic markets and a rapid technological upgrading through targeted trade and industrial policies and a well-devised approach to FDI.

Finally, many larger developing countries will need to find ways of utilizing domestic sources of growth more fully. This suggests that the outward orientation of their economies may decline as they grow richer and their home market expands. For smaller countries regional arrangements could provide the right context for galvanizing the forces of trade and industry.