free trade and free capital flows can

8/13/2019 Free Trade and Free Capital Flows Can

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Free Trade and Free Capital flows can‟t co-exist by Prof Jan Kregel* Bogota 9 Nov—Latin America has been a region that has had a tradition ofindustrialisation on the basis of domestic resources to provide a competitive exportsector. CEPAL (Spanish acronym for the UN Regional Economic Commission forLatin America and the Caribbean), one of the organisers of this Consultation,has inthe past been a centre of new approaches to domestic industrialisation on the basisof regional trade integration. It is hence appropriate to question the presumption of the Agenda item that“increasing and consolidating external flows” is an appropriate strategy for financing

for development. The Preliminary Agenda for the UN Financing for Development High-Level Event, aswell as the programme for the Regional Consultation, include discussions of externalfinancial flows and trade as separate, and presumably complementary, sources offinance for development. However, trade and external finance should be approached in an integrated manner.To see why, we must first define what is meant by trade as a source of finance fordevelopment. If this is taken to mean that trade can provide foreign financialresources in the same way as foreign capital inflows, then instead ofcomplementarity we will find that the two are opposed! This is easy to see from elementary balance of payments accounting which showsthat the only way trade can provide net foreign capital inflows for financingdevelopment is if the current account is in surplus. On the other hand, if there is anet inflow of financial resources on capital account, then the current account of thebalance of payments must be in deficit. It is clear that the current account cannot bein surplus and deficit at the same time. So, there may be a conflict between the twosources of external financial flows. In the 19

th

century, the United Kingdom managed a trade deficit and a capitalaccount deficit, since earnings on foreign investments provided more than enough toproduce a current account surplus which provided strength for the sterling.Developing countries more often exhibit trade and capital account surpluses with

debt service that produces a current account surplus and persistent balance-of-payments crises. First, we should note that this inconsistency is the result of assuming themaintenance of stable exchange rates. It might be thought that flexible rates wouldprovide a solution, but reflection will show that this is not the case.



If a country has a current account surplus and a positive capital inflow there will bepressure on the currency to appreciate in real terms which will soon reduce exportcompetitiveness and eliminate the current account surplus. If the central bank of the country nonetheless attempts to keep the exchange rate

stable, it will have to allow domestic liquidity to increase which will produce a boomin asset prices and financial instability; if it tries to sterilise the inflows this will requireincreasing domestic interest rates, damaging domestic investment prospects andattracting international arbitrage flows. Thus, there appears to be no easy way in which a country can attract foreignfinancing for development from both trade and capital inflows. There is an alternative way out of this seeming paradox, but it requires us to look atnet resource flows, rather than at foreign capital flows. Indeed, it is my understandingthat this was the original intent of the Financing for Development resolution in the UN

General Assembly. Trade can be a source of increased domestic resources for development without anexport surplus if increasing the share of exports in GDP provides for increasedimport capacity and an improvement in the variety of consumption goods available toconsumers or capital goods for producers. While trade may appear to be a zero sum game since imports are always acquiredthrough the use of domestic resources to produce the exports necessary to pay forthem, a country‟s total resources may be increased through trade if it benefits fromimproving terms of trade or if through specialisation it can acquire goods that couldnot be produced with the same efficiency at home as they are abroad. Thus, if trade increases the purchasing power of domestic outputs, or increasesoverall productivity of domestic resources, it may increase total domestic resourcesfor development. Unfortunately, the experience of developing countries has been rather the opposite,given their dependence on primary commodity exports which brings in fewer andfewer manufactured imports in a process known as the declining terms of trade. Insuch conditions, trade may actually reduce the resources available for development. Raul Prebisch‟s discovery of the importance of the terms of trade is instructive. Argentina had accumulated large export surpluses as a result of sale of primaryproducts to the belligerent countries during the second world war. Prebisch was incharge of planning the post-war utilisation of these accumulated reserves to provide Argentinean development. However, as time passed the plan could not be metbecause the prices of imports from industrialized countries were increasing and thepurchasing power of the prior Argentinean exports was declining - causing a net lossin domestic resources. It did not take much to realise that the same was true of current exports which were

still primary commodities, thus leading to Prebisch‟s recommendation thatdevelopment be based on expanding exports into those areas, such as



manufacturing, that were not subject to declining terms of trade. This required bothexpanding markets through regional preferences and integration, and thedevelopment of domestic industries capable of competing international markets. Although it eventually acquired the name of import substitution, it was in fact anexport creation programme. Thus, trade as a source of increasing the resources for development depends onimproving developing countries‟ terms of trade. The obvious implication is that eitherthere must be an active policy to determine export-import compositions or there mustbe policies to influence the prices of commodity exports. Both are difficult in thepresence of „market-friendly‟ policies and „rules-based level playing fields.‟ It would thus appear that external financial flows are the primary means to increaseresources for development. External flows can be used to finance a current accountdeficit composed of imports of consumption goods, often thought to be associatedwith a deficient household saving ratio or excessive public sector deficits, or it can

finance the import of productive capital goods. The former is often thought to be the archetypical case of Latin America and thecause of the persistent balance of payments crises that produce the seeminglyeternal external constraints on growth. However, even a “good” deficit (often called a“Lawson” after the former British Chancellor of the Exchequer), associated with highprivate and public sector savings ratios, may lead to difficulties, as evidenced in the Asian crisis where the deficits financed the creation of excess productive capacity,falling profitability and productivity and asset price speculation which led to a sharpcapital reversal and an external constraint similar to that faced in Latin America. It thus seems that the composition of the current account deficit financed by capitalinflows makes little difference to the external constraint. What then are the conditions in which external flows (meaning all types of privateflows - bank lending, portfolio flows and direct investment flows) will providefinancing for development? There are two problems associated with external flows. The first is that they areforeign currency loans that have to be serviced, either through interest payments orprofit remittances to foreign owners. Using foreign capital to finance consumption

imports provides no revenues to service the loans. Capital goods may, but only ifthey provide for increased domestic exports sufficient to generate the foreigncurrency necessary to meet the interest or profit and principal payments. But, even the provision of additional exports is not enough. There must be exportmarkets. Here the developed countries have a role to play. They must recognise that theycannot expect their loans by their nationals to developing countries to be repaidunless they provide developing countries with the export markets to generate theforeign exchange earnings necessary to repay them.



Finally, the cost of servicing depends on interest rates which must be sufficiently lowto allow the investment to generate profits. Just as using exports to “finance” importsto be used in development does not increase total resources unless it leads to anincrease in overall domestic productivity or in the terms of trade, the use of foreigncapital to finance imports does not increase domestic resources unless the net

present value of the increased domestic production and export earnings are greaterthan the capital inflow, and export earnings are sufficient to cover debt service. This is the equivalent of the terms of trade in the discussion of trade in thegeneration of financing for development, only it is an inter-temporal terms of trade;the interest rate will determine the net present value of the increased output andexports of the investments financed with foreign capital inflows. As pointed out at an earlier panel session, Colombia is currently paying a premium ofover 500 basis points above developed country interest rate levels. There are no domestic investment projects that will produce net present valuesabove their initial borrowing costs at those interest rates. If developing countriesborrow at those rates they will never be able to pay the debt service for the simplereason that the interest rate is much higher than either domestic growth rates, profitrates or the growth rates of exports. In this case external borrowing becomes a constraint on growth and developmentand can only produce recurrent financial crises. Not only should developing countries not accept external finance in these conditions,developed countries should not provide it. Thus, external flows can be used to increase the resources available fordevelopment only if it is recognised that they are inherently linked to trade throughexport capacity and market access, and that increased exports can only supportexternal financial flows if interest rates are below the potential rates of increase inproductivity and profitability in the projects that they finance. The major difficulty that is faced by developing countries in using trade and externalflows as sources of resources for development is that the current regimes governinginternational trade and finance do not allow a country direct control over the size or

use of capital inflows, nor the composition of its import and export basket, whileinterest rates are set by conditions in the developed country markets. The multilateral financing institutions serve to ensure that the developed countrieshave the unrestricted right to invest in developing countries, and that developingcountries adopt the policies necessary to ensure that they repay the lending, withoutconsideration for the impact on net resources flows or domestic resources. TheWorld Trade Organization (WTO) ensures that developed countries have free accessto developing country markets, without concern for the impact on import compositionor export capability. Since the consequences for net resource flows to developing countries are not theprimary concern of any of these institutions, and the decisions of developed country

free trade and free capital flows can

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