exchange to buy imports would arise, since these • Deterioration in the balance of payments
would be reduced. and debt position. The balance of payments
deteriorated because of:
• Infant industry argument. The theoretical
justification for import substitution was provided by increasing imports of capital equipment for
the infant industry argument that recommended the domestic firms as inputs in production
use of trade barriers to protect ‘infant’ domestic firms
against competition from imports (see page 377). an increased need for food imports due to the
inability of the agricultural sector to provide
Import-substitution policies and enough food
consequences
Import substitution policies had the following an outward flow of financial capital due to profit
common characteristics and consequences: repatriation of foreign multinational corporations
(profits taken to the home country), and by
• High levels of protection of domestic firms, domestic wealthy groups seeking high returns for
inefficiency and resource misallocation. their financial investments.
Protection took mainly the form of tariffs, quotas
and import licences. High levels of protection and • Encouragement of capital-intensive
the resulting lack of competition resulted in high production methods. Policy-makers encouraged
costs and inefficiency in private sector and public capital-intensive technologies, as it was believed
sector industries, as well as a misallocation of that this would promote more rapid growth. No
resources. Consumers also had to pay high prices for effort was made to increase access to credit or
consumer goods. provide other support for small entrepreneurs who
were more likely to use labour-intensive techniques.
• Overvalued exchange rates. Many developing
countries overvalued their exchange rates by fixing • Negative impacts on employment and
them at a higher level than the free market level, income distribution. Capital-intensive
reducing the price of imports and increasing the technologies and the neglect of small producers in
price of exports (see page 391). The objective was to agricultural and in the urban sectors worsened the
allow firms to import capital inputs more cheaply; problem of unemployment and contributed to the
however, it had two negative effects: development and growth of the urban informal
Cheap capital imports led to capital-intensive sector. Many countries also saw a worsening of
production methods (inappropriate technologies), income distribution and increasing poverty.
unemployment and growth of the urban informal
sector (see pages 441 and 465). • Limited possibilities for growth over the
It made agricultural exports more expensive, longer term. Whereas many countries did achieve
worsening rural poverty. increased rates of growth in the early periods of
import-substituting policies, there came a point
• Too much government intervention in the when it was no longer possible to grow through
economy. Most import-substituting countries import substitution. This was due to serious
relied heavily on industrial policies (interventionist inefficiencies (high costs) of production. Many firms
supply-side policies; see page 339), in which enjoying protection never ‘grew up’ to become
the government played a very important role efficient, lowcost producers, firms that should have
(protective trade barriers, overvalued exchange closed down were kept going, while others that
rates, subsidised credit, tax allowances, production should have been set up or expanded were not.
subsidies, wage subsidies, price controls, etc.),
as well as extensive public ownership of firms and • Greater likelihood of corruption. Strong
industries (fertilisers, steel, petrochemicals, cement, government intervention opened up possibilities
banking and financial services, infrastructure, and for corruption such as the payment of bribes to
many others). The result was to encourage serious government officials to secure particular policies
misallocation of resources and inefficiencies in (for example, more tariff protection).
production.
Many of the problems of import substitution were
• Neglect of agriculture. Agriculture was becoming obvious during the 1960s. A few countries
neglected, and due to the failure to make such as Egypt and India reacted by increasing
investments in the agricultural sector, there was an protective barriers for capital goods imports to solve
increased need for food imports. balance of payments problems. Some other countries
began to move towards a different approach, that
of export promotion, for example, Brazil, Israel,
Mexico, Singapore, South Korea and Taiwan, as well as
Chapter 17 Topics in economic development 483
southern European countries. By the 1970s and 1980s, • Some protection of domestic industries.
there was general agreement among economists that Protection of some domestic industries continued,
import substitution had not lived up to expectations. but only selectively (selective import substitution).
Export promotion • Requirements imposed on multinational
corporations. Specific requirements were imposed
b. Export promotion on multinational corporations in an effort to
maximise the benefits of foreign direct investments,
Export promotion refers to a growth and trade such as the promotion of research and development
strategy where a country attempts to achieve (R&D), transfer of desired and targeted technologies
economic growth by expanding its exports. Like into the domestic economy, training of domestic
import substitution, export promotion was based workers, and the use of local inputs where possible.
on strong government intervention, justified by
the idea that this is necessary to help countries • Large public investments in key areas.
develop a strong manufacturing sector oriented Governments spent heavily on education and skills,
towards exports. R&D, and expansion and modernisation of the
transport and communications infrastructure.
The experience of export promotion
Export-promotion strategies evolved gradually as an • Provision of incentives for private sector R&D
extension of import substitution. In many cases, the for high technology products. Governments
industries that became the strongest exporters were the provided strong incentives to private sector firms
ones that had earlier received strong import-substituting to engage in R&D in high technology areas, the
protection. (In these cases, import substitution was objective being to encourage the development of
successful as a temporary industrialisation strategy that domestic skill levels and technological developments
was transformed to an export orientation of protected appropriate to local conditions.
infant industries that ‘matured’.)
These policies resulted in immensely successful export
The economies that first turned to export performance and the achievement of very high
promotion included China, Hong Kong, Indonesia, economic growth rates. Since the 1950s, the newly
Japan, Malaysia, Singapore, South Korea, Taiwan and industrialising economies have been the fastest growing
Thailand. These form part of a group called the newly economies in the developing world. In addition, they
industrialising economies (NIEs); they are known as the succeeded in making significant improvements in their
Asian Tigers. While each economy was unique in the levels of economic and human development.
blend of policies, some typical policies included the
following: Factors behind the success of export
promotion over import substitution
• State ownership and control of financial Why were the NIEs, or the Asian Tigers, so successful?
institutions (banking and insurance). The following factors have been singled out:
This was done to provide subsidised credit to the
industries being promoted, such as for example • Expansion into foreign markets. Domestic
subsidised interest rates and other favourable production can grow beyond the domestic market,
borrowing terms. and can take advantage of economies of scale.
• Targeting of industries for export. Industries • Benefits of diversification. Industrial policies
that were selected for support were those that used began with support for simple, labour-intensive
increasingly higher skill levels and technological goods (for example, textiles and clothing), and
levels, aiming for higher value-added production later supported diversification into higher value-
activities. added manufacturing based on increasing skill and
technology levels (see pages 478 and 493).
• Industrial policies to support export
industries. Industrial policies included investment • Major investments in human capital.
grants, production subsidies to export industries, Governments made heavy investments in
exemptions from tariffs of imported inputs needed education, training and skills.
for export industries, tax exemptions, export
subsidies, and foreign exchange licences, special • Appropriate technologies. Governments
benefits granted to multinational corporations that supported R&D for the development of appropriate
were export oriented. technologies, as well as the transfer from abroad of
technologies appropriate to local conditions (see
page 465).
484 Section 4: Development economics
• Increased employment. There were increased • maintaining some government spending for health,
employment opportunities resulting from the use of education and infrastructure.
labour-intensive technologies.
Most of these measures involved freeing up markets
• Export earnings avoided balance of and cutting back on the role of government. They
payments problems. The result was significant were based on the idea that reliance on market forces
increases in exports and export earnings, which and free trade improves efficiency and the domestic
avoided balance of payments difficulties. and global allocation of resources, and increases
economic growth.
Trade liberalisation
Since the 1980s, many developing countries have
c. Trade liberalisation increasingly adopted liberalising policies by following
the policy prescriptions listed above. Examples
The Washington Consensus include Argentina, Brazil, China, Chile, India, Kenya,
The spectacular successes in export growth of the Sri Lanka, Tanzania, Turkey, the countries of East Asia,
Asian Tigers (NIEs) made a sharp contrast to the and many more. However, these countries did not
performance of the majority of developing countries. completely abandon their interventionist policies,
In the early 1980s, many of these were showing poor but instead began a gradual reduction of government
export and growth performance, and were also highly intervention in the market, with some countries
indebted. This was the time when monetarist/new liberalising more, or more rapidly, than others.
classical economists were introducing their supply-
side ideas, emphasising the importance of limited The effects of economic and trade
government intervention and the competitive free liberalisation
market. By the 1990s there was evidence that liberalisation of
trade and the economy was not bringing about the
As a trade and growth strategy, limited government expected benefits. The following conclusions on the
intervention meant trade liberalisation (the effects of liberalisation can be reached.
elimination of trade barriers to achieve free trade) and
a free market approach in the domestic economy. The Limited benefits for export growth and
free trade and free market approach to growth and diversification
development came to be known as the Washington Many countries found themselves losing their export
Consensus, because it was shared by the World Bank, shares in world markets (an export share is the
the International Monetary Fund, the United States proportion of a country’s exports in relation to global
Congress, and a number of US agencies (all of which exports). The losses were the greatest in Africa. The
are based in Washington, DC). The main policies UNDP notes that if, by the early 2000s, Africa had still
recommended by the Washington Consensus included: had its 1980 share of world exports, its exports would
be greater by US$119 billion (in constant $ in terms of
• trade liberalisation (lowering and eliminating tariff the year 2000); this is equivalent to about five times
and other barriers to trade) the amount of aid provided by donors in 2002.17
• interest rate liberalisation (freeing up of interest Whereas some countries increased their exports,
rates) on the whole liberalisation policies did not succeed
in helping developing countries diversify their
• moving toward freely floating exchange rates production into increased manufacturing for
export. In 2000, just five developing countries were
• privatisation responsible for two-thirds of developing country
low technology manufactured exports, while only
• deregulation six developing countries were responsible for more
than four-fifths of developing country medium
• lifting restrictions to foreign direct investments (by and high technology manufactured exports.18 In
multinational corporations) most Latin American and African countries, growth
• limiting borrowing by the government (keeping
budget deficits under control)
17 United Nations Development Programme, Human Development Report the first group are China (32%), Taiwan (11%), South Korea (10%), Mexico
2002 (available at http://hdr.undp.org/en/reports/). (8%) and India (6%). The six countries in the second group are South Korea
18 United Nations Development Programme, Human Development Report (16%), China (14%), Mexico (14%), Singapore (14%), Taiwan (14%) and
2005 (available at http://hdr.undp.org/en/reports/). The five countries in Malaysia (9%).
Chapter 17 Topics in economic development 485
of manufacturing exports was slow to moderate, Increasing income inequalities and poverty
and there was no significant change indicating within developing countries
diversification of production into manufacturing. In There is clear evidence that economic and trade
some Latin American countries there resulted a decline liberalisation have resulted in greater income
in the relative share of manufacturing. In general, the inequalities and poverty. A World Bank study notes
countries that tended to fare best were those that had that trade liberalisation leads to lower income growth
already developed significant export sectors (the East among the poorest 40% of the population, but higher
Asian countries).19 income growth for the higher income groups. In other
words, it helps the rich get richer and the poor get
Partly, these negative effects of liberalisation poorer.23
were due to the trade protection policies used
by developed countries on developing country The reason is that economic and trade liberalisation
exports, including protection of agriculture and creates both ‘winners’ and ‘losers’. When new export
tariff escalation (see page 479). In addition, they markets are opened up, those who find employment
were due to the growing reliance on free market in the production of export goods will be better off;
policies. Remember, the great successes of the East people who find jobs in a growing formal sector (if it
Asian countries were based on industrial policies is growing) will also gain; people with some education
involving strong government intervention. With less and skills may also gain as they are better able to
government support, many developing countries exploit new opportunities in the more competitive
were not able to perform well. environment made possible by liberalisation.
However, there will also be those who will become
Limited effects on economic growth worse off as a result of the changes introduced by
There is no evidence indicating that economic liberalisation and free (or freer) trade. They include:
and trade liberalisation encouraged economic
growth. According to well-known development • less educated or illiterate people, who are unable to
economists, ‘There is little evidence that open trade compete in the new environment
policies – in the form of lower tariff and non-tariff
barriers to trading – are significantly associated with • poor people who lack collateral, and who cannot
economic growth.’20 Furthermore, ‘Perhaps the most get credit to open or expand a business to take
comprehensive assessment of the links between advantage of new opportunities
economic growth and trade liberalisation undertaken
to date concluded that there is no clear link between • people who live in remote geographical areas with
them. This means that the projected benefits are no transport links to markets
merely hypothetical.’21
• people who have nothing to export, and no
According to the United Nations Development possibilities of producing for export
Programme:
• people in agriculture who switch to producing
‘One of the prevailing myths of globalization is that commodities for export, making themselves more
increased trade has been the catalyst for a new era of vulnerable to wide fluctuations (volatility) in cash-
convergence. The argument suggests that expanded crop prices
trade is narrowing the income gap between rich and
poor countries, with the developing world benefiting • people who lose their jobs as public employees
from access to new technologies and new markets. Like due to cutbacks in the size of the public sector (in
most myths, this one combines elements of truth with Zimbabwe, people in this category are referred to as
a large amount of exaggeration. Some countries are the ‘new poor’)
catching up, albeit from a low base. However, successful
integration is the exception rather than the rule, and • people who may become unemployed due to
trade drives global inequality as well as prosperity. For privatisation of public enterprises, which fire
the majority of countries the globalization story is one workers to lower costs
of divergence and marginalization.’22
• people affected by cuts in government spending on
merit goods, forced by a greater reliance on market
forces
19 S. M. Shafaeddin (2005) ‘Trade liberalisation and economic reform 21 L. Alan Winters (2000) ‘Trade liberalisation and poverty’, Paper,
in developing countries: structural change or de-industrialization?’, Centre for Economic Policy Research, London, and Centre for Economic
Discussion Paper, UN Conference on Trade and Development (UNCTAD), Performance, London School of Economics.
(available at www.unctad.org). 22 United Nations Development Programme, Human Development Report
20 F. Rodriguez and D. Rodrik (1999) ‘Trade policy and economic growth: a 2005.
skeptic’s guide to the cross-national evidence’, Discussion Paper, National 23 M. Lundberg and L. Squire (1999) Inequality and Growth: Lessons for
Bureau of Economic Research. Policy, The World Bank.
486 Section 4: Development economics
• people affected by lower levels of social protection continues to be important, but in developing countries
caused by supply-side policies (such as lower there should also be some government intervention to
minimum wages, lower protection against being help create the conditions needed for markets to work
fired, etc.; see page 341) without resulting in the negative effects described above.
The following are some of the ideas in this view:27
• people who are forced from the formal into the
informal sector, where wages are lower and social • Governments must support education, health
protection is non-existent, due to removal of trade services and infrastructure development, as well as
protection leading to the closure of formal sector research and development (R&D) and transfer of
firms that can no longer compete (in Zambia, for technology for both industry and agriculture.
example, formal employment fell by 15% in the
decade of the 1990s24). • Avoidance of large budget deficits is important, but
if contractionary fiscal policy is needed, it should
International trade theory recognises that free trade is not affect spending on education, health and
likely to give rise to both winners and losers. However, infrastructure.
it argues that since the overall gains will be greater
than the overall losses, the gainers can compensate • Governments must pay attention to the effects
the losers, with the result that no one need be worse of policies on income distribution, and must
off. Yet, in the real world, such compensation rarely (if pursue policies that promote income equality and
ever) takes place. alleviation of poverty.
The free market approach of the Washington • Governments must provide a proper regulatory
Consensus was questioned even by some individuals framework for markets to work effectively; for
within the World Bank itself. Joseph Stiglitz, as Chief example, there should be effective regulation for
Economist of the World Bank, wrote the following on competition (otherwise privatisations may lead to
the Washington Consensus in 1998: the development of private monopolies).
‘The neoliberal model25 accords the government • Efforts must be made to promote market-supporting
a minimal role, essentially one of ensuring institutions as these are a prerequisite for successful
macroeconomic stability, with an emphasis on price market-based economic development (property
stability, while getting out of the way to allow trade rights, an effective tax systems, effective banking
liberalisation, privatization, and getting the prices and credit system, etc.).
right. Many of these policies are necessary for markets
to work well and contribute to economic success, • Developed countries must assist economic
but they are far from sufficient. Some aspects of development by increasing foreign aid and
the neoliberal model might not even be necessary providing increased access to their markets for
conditions for strong growth, and if undertaken developing country exports.
without accompanying measures . . . they may not
bring many gains and could even lead to setbacks. • Developing countries should receive special
Some countries have closely followed the dictates of treatment by international trade agreements under
the neoliberal model, but have not seen especially the World Trade Organization regarding removal
strong economic performance. Other countries have of rich country trade protection measures (for
ignored many of the dictates . . . and have experienced example, in agriculture).
among the highest rates of sustained growth the world
has ever seen.’26 The New Development Consensus sees an important
role for governments in developing countries because
The New Development Consensus: of their special circumstances. Markets and free trade
trade liberalisation with government are important, but these cannot promote growth and
intervention development without human capital (health and
Since the late 1990s, supporters and critics of the education), technology development, infrastructure,
Washington Consensus have been moving towards a effective institutions, industrial policies and a trading
new consensus (the New Development Consensus), led system that encourages developing country exports.
by Joseph Stiglitz. In the new view, trade liberalisation Therefore, government intervention is important to help create
the conditions needed for markets and free trade to work well.
24 Winters (2000) ‘Trade liberalisation and poverty’. 27 Joseph E. Stiglitz (1998) ‘More instruments and broader goals: moving
25 By the term ‘neoliberal model’, Stiglitz is referring to the free market towards the Post-Washington Consensus’, Annual Lecture, World Institute
approach of the Washington Consensus. for Development Economics Research, Helsinki, 1998; and ‘Towards a new
26 Joseph E. Stiglitz (1998) ‘Knowledge for development: economic science, paradigm for fevelopment strategies and processes’, Prebisch Lecture,
economic policy, and economic advice’, Annual World Bank Conference on UNCTAD, Geneva, 1998.
Development Economics, Washington, DC, April 1998.
Chapter 17 Topics in economic development 487
Test your understanding 17.5 1 ‘The system helps to keep the peace.’ By
encouraging the smooth flow of trade and helping
1 (a) Define import substitution and explain why to resolve trade disputes, the WTO helps promote
it has an inward orientation. (b) What were some peace between countries.
factors that led most developing countries to
adopt import substitution as an industrialisation 2 ‘The system allows disputes to be handled
strategy in the 1950s? (c) Discuss some of constructively.’ Greater liberalisation means there is
the key policies that were associated with greater room for disputes. The WTO helps countries
import-substituting strategies. (d) Evaluate the settle their disputes in a constructive way.
effectiveness of these strategies with respect to
their impacts on economic performance and 3 ‘A system based on rules rather than power
economic growth and development. makes life easier for all.’ Decisions are made
by consensus, agreements are ratified by
2 (a) Define export promotion and explain governments, and all countries, including the rich
why it has an outward orientation. (b) What and the poor, have the right to challenge each
were some of the countries that adopted an other through the WTO.
export orientation during the 1960s, and what
prompted them to do so? (c) Discuss some 4 ‘Freer trade cuts the cost of living.’ Trade protection
of the key policies that were associated with raises prices; lower trade barriers made possible by
export promotion. (d) Evaluate the effectiveness the WTO result in lower prices.
of these policies with respect to economic
performance, export growth and economic 5 ‘It gives consumers more choice, and a broader
growth and development. range of qualities to choose from.’ More
international trade made possible by lower trade
3 (a) Define trade liberalisation, referring to barriers increases the range of goods and services
its objectives. (b) What were the main ideas available to consumers.
behind the Washington Consensus? (c) Explain
the connections between the market-based 6 ‘Trade raises income.’ Lower trade barriers increase
supply-side policies discussed in Chapter 12 and international trade, which leads to higher incomes.
the Washington Consensus.
7 ‘Trade stimulates economic growth, and that can
4 (a) Explain the effects of liberalising policies on be good for employment.’ Trade leads to increased
export growth, diversification, economic growth growth, and this may mean more employment
and income distribution. (b) What is the role (though some jobs are lost).
of government intervention according to the
New Development Consensus on liberalisation? 8 ‘The basic principles make the system economically
(c) How do the recommendations of the New more efficient, and they cut costs.’ Trade allows
Development Consensus fit with the policies countries to specialise and use resources more
pursued by the Asian Tigers that succeeded in efficiently.
achieving high rates of growth and broad-based
development? 9 ‘The system shields governments from narrow
interests.’ Governments can view trade policy in
The role of the World Trade Organization a more balanced way, defend themselves against
(WTO) narrow interests, and better represent the broader
interest.
d. The role of the WTO
10 ‘The system encourages good government.’
The objectives and functions of the WTO were Whereas trade protection may provide
described in Chapter 13. We will now evaluate its role opportunities for corruption and bad governance,
in economic growth and development. trade liberalisation means more discipline for the
government and improved governance.
Potential benefits
The WTO claims to offer ten benefits to the global Many of these benefits are among the benefits of
trading system:28 free trade (1, 4, 5, 6, 7 and 8), while the rest are the
potential benefits of an effective system of trading
28 This information is taken from the WTO website, www.wto.org. rules (2, 3, 4 and 10). All are benefits arising from a
well-functioning global trading system. Yet the WTO
488 Section 4: Development economics is one of the most controversial organisations in
the world, rousing passionate feelings among both
supporters and critics. To understand the controversy, share of output in countries that are just beginning to
let’s take a step backwards and begin with a look at the industrialise.
GATT’s ‘Uruguay Round’, concluded in 1994.
Tariff escalation does not permit
Evaluating the Uruguay Round developing countries to diversify their
The Uruguay Round resulted in the most production and exports
comprehensive and far-reaching trade negotiations Tariff escalation (the practice of developed countries
in history. It succeeded in reducing tariffs for to impose lower tariffs on imports of raw materials
thousands of products, with tariffs dropping by 33% and increasing tariffs on semi-processed and processed
on average, and the share of goods with no tariffs products) works to discourage developing countries
increasing from 20–22% to 40–45%. It provided new from diversifying into food processing or other
rules for promotion of trade in services; protection manufacturing activities (see page 479). The Uruguay
of intellectual property (patents, new technologies, Round did not address the problem of tariff escalation.
books, databases, etc.); gradual elimination of
quotas in textiles and clothing; and restrictions Developed countries make increasing use
on agricultural subsidies (subsidies granted by of non-tariff barriers against developing
developed country governments to protect their country exports
farmers). Developed countries have been making increasing
use of non-tariff barriers to protect their domestic
While not all the agreements were put into effect markets against imports from developing countries
as planned, supporters argued that the Uruguay (anti-dumping measures and administrative, safety,
Round was a major success in furthering the cause of health and environmental standards). The agreements
free trade and a trading system that supports growth tried to reduce the scope of non-tariff barriers, but
and possibilities for improved standards of living they kept much flexibility in how the rules can be
everywhere. interpreted, allowing room for such measures to
continue to be used.
Critics argued that the agreements were ineffective
in providing countries with equal opportunities to Agricultural subsidies of developed
share in the benefits of increased trade, noting that the countries were not reduced
new trade rules supported developed country interests Whereas the Uruguay Round provided for reductions
far more than those of developing countries. in agricultural subsidies, these were not implemented
because of resistance in developed countries, and
Developed countries received greater tariff while there have been many discussions there has
reductions than developing ones been no move to enforce reductions.
Whereas developed country exports enjoyed tariff
reductions of 45% on average, developing country Protection of intellectual property increases
exports received tariff reductions of 20–25%. As a costs of acquiring new technology by
result of the Uruguay Round agreements, developing developing countries
countries face tariffs on their exports that are One of the areas of the Uruguay Round’s agreements
10% higher than the world average, and the least was that there would be increased protection of
developed (poorest) countries face tariffs that are intellectual property. This is an area of interest
30% higher. mainly to developed countries, because that is where
most of the new ‘intellectual property’ is generated.
Tariffs on textiles remained much higher Developing countries need to have greater access to
for developing country exports new ideas and technologies, and yet the protection
The agreements eliminated quotas on developing created by the agreements makes it more difficult and
country textile exports and also reduced tariffs costly for them to be able to acquire these.
on textiles, but following the reductions, tariffs
on developing country textiles exports were three Multinational corporations no longer have
times greater than the average tariffs on developed to buy supplies locally
country textile exports. This is of special importance Multinational corporations (MNCs) are firms based
to developing countries because textiles are a low in one country that produce in other countries as
technology industry that can make heavy use of the well (see Chapter 18). One of the benefits that MNCs
abundant supplies of labour in developing countries,
and for these reasons textiles usually make up a large
Chapter 17 Topics in economic development 489
may provide to developing countries is that if they the United States, the European Union and Japan,
purchase supplies locally, they generate increased repeatedly brought the meetings to a deadlock.
demand for locally produced goods and services, and Whereas the Doha Round was to end in 2004, the
therefore increased local employment. One of the agreement was postponed, and at the end of July
provisions of the Uruguay Round agreements was that 2008, it collapsed. Later it was once again revived,
MNCs are not obliged to buy materials locally. This but as of 2011 there were no signs that an agreement
provision is in the interests of MNCs (most of which was about to be reached.
have their base in developed countries), but it deprives
developing countries of important potential benefits. Unresolved issues between developed and
developing countries include the unwillingness of
The 1997 Human Development Report of the developed countries to eliminate their subsidies
United Nations Development Programme (UNDP) on agricultural products; the remaining high tariff
summarises the impacts of the Uruguay Round: protection against developing country exports;
continuing use of tariff escalation by developed
‘Poor countries often lose out because the rules of countries, as well as growing use of anti-dumping
the game are biased against them, particularly those and administrative, health, etc., standards as
relating to international trade. The Uruguay Round ‘hidden’ protection. Further important unresolved
made little difference. Although developing countries issues include environmental issues, labour issues,
have three-quarters of the world’s people, they will get intellectual property rights, and more.
only a quarter to a third of the income gains generated
and most of that will go to a few powerful exporters in Test your understanding 17.6
Asia and Latin America.’29
1 What are the objectives of the World Trade
Another study has estimated that of welfare gains Organization?
(measured in US dollars) attributed to the Uruguay
Round, 74% have gone to developed countries and 2 What are some positive contributions of the
26% to developing ones.30 World Trade Organization (and the GATT on
which it is based) to the global trading system?
The Doha Development Round: inability
to reach agreement 3 Identify some of the criticisms that are levelled
In 1999, the WTO initiated a ‘Millennium Round’ against the World Trade Organization.
of negotiations in Seattle. However, the talks broke
down before any agreement was reached, while in Bilateral and regional preferential trade
the meantime tens of thousands of people gathered agreements
to demonstrate against globalisation. In 2001, a
new attempt was made to begin negotiations under e. Bilateral and regional preferential trade agreements
the ‘Doha Development Round’ (launched in
Doha, Qatar). The mood at the time was very much In Chapter 15 we learned that bilateral and regional
influenced by the Millennium Declaration in which preferential trade agreements are an alternative path to
189 countries had committed themselves to reducing trade liberalisation than the multilateral approach of
extreme poverty in developing countries by pursuing the WTO.
the Millennium Development Goals (see page 450),
as well as other poverty alleviation initiatives inspired The growth of preferential trade
by the turn of the millennium. The Doha Round agreements
intended to address development and poverty issues, In the last few years, there has been a very large
and for this reason was termed a ‘Development’ increase in the number of bilateral and regional
Round. trade agreements around the world. The number of
trade agreements reported to the WTO grew from
However, not long after the Doha Round was 20 in 1990 to 159 in 2007, and was in the several
launched, it became apparent that developed hundreds by 2010. One reason for this growth is that
country interests were dominating the negotiations. many countries are becoming frustrated with what
Conflicts between developing and developed
countries, as well as serious disagreements between
29 United Nations Development Programme, Human Development Report 30 D. K. Brown, A. V. Deardorff and R. Stern (2002) ‘Computational analysis
1997 (available at http://hdr.undp.org/en/reports/), p. 85. of multilateral trade liberalisation in the Uruguay Round’, Discussion
Paper 489, School of Public Affairs, University of Michigan.
490 Section 4: Development economics
they believe is the slow progress made by the WTO. projects and new technology development that would
Another is that developing countries see in trading be mutually beneficial. They can work together on
blocs the possibilities of enjoying the benefits of free environmental issues of common interest.
trade, bypassing the obstacles created by rich country
trade protection, and at the same time maintaining All these factors greatly increase the likelihood that
some of the benefits of trade protection (toward non- integration will lead to increased growth and more
members). development.
Chapter 15 offered an evaluation of trading blocs While it is difficult for all the conditions listed
in terms of their advantages and disadvantages as a above to be met in practice, it is not surprising that
method to achieve free trade. (You should refer to this we usually find neighbouring countries forming
discussion as it is closely related to our present topic; regional blocs such as in Latin America (MERCOSUR),
see pages 415–16.) We will now evaluate trading blocs southeast Asia (ASEAN), eastern and southern Africa
as a strategy to achieve growth and development. To (COMESA), central Africa (CEMAC), Central America
do so, we must make the distinction between regional (CAIS), etc.
and bilateral trade agreements.
Bilateral free trade agreements (FTAs):
Regional free trade agreements (FTAs): risks for growth and development
potential benefits for growth and Most of the several hundred trade agreements in
development existence are bilateral, and most bilateral agreements
Economists generally agree that free trade agreements are between developing and developed countries
have the greatest potential to help developing that are not usually in the same geographical region
countries achieve growth and development when they (though there are exceptions). The developed
involve: countries mainly involved are first the United
States, which has made agreements with a number
• regional agreements of developing countries, followed by the European
Union (which though consisting of many countries
• geographical closeness acts as a unit) that also has agreements with
developing countries and transition economies, and
• a similar level of development and technological thirdly Japan, with agreements mainly in the Asia-
capabilities Pacific region.
• similar market sizes A bilateral agreement has the potential to provide
a developing country with access to the market of
• a shared commitment to co-operation. the developed country, and the prospect of gaining
such access (not available to other countries) is the
These conditions allow countries to achieve the reason why developing countries enter into such
benefits of integration listed on page 415. Regional agreements. However, this potential comes with some
groupings allow countries to expand their markets serious risks:
(and achieve economies of scale) and to diversify
production and exports. Larger markets increase • The developing country must make equal and
domestic and foreign direct investment. When matching (or ‘reciprocal’) cuts in tariff and other
countries are at a similar level of development and barriers, which are often much greater than those
have similar technological capabilities as well as required by WTO agreements. This puts even
similar market sizes, the new competition created efficient developing country firms at a competitive
by increased imports is more ‘fair’ and easier to disadvantage because they are forced to compete
deal with (it does not involve ‘unfair’ competitive with lower cost developed country firms (which are
advantages of foreign firms caused by lower costs larger, with greater technological, managerial and
due to use of more advanced technologies, greater marketing capabilities). The result may be to destroy
managerial know-how, larger size due to larger home even efficient local firms.
markets, etc.).
• When many developing countries form FTAs with
If there is a shared commitment to co-operation, the same developed country in order to gain market
there are several policies that can be pursued jointly access, the advantage they each hope to gain
by members so they can further benefit from their individually is lost, as they must now all compete
integration. They can invest in transport infrastructure with each other for the developed country market.
needed for trade, as well as in energy and water In addition, their exports may be unable to compete
supplies needed for growth and development. They with the lower cost domestically produced goods in
can collaborate on research and development (R&D)
Chapter 17 Topics in economic development 491
Real world focus
Free trade between the European Union (EU) and
African, Caribbean and Pacific (ACP) countries
Rich countries, led by the European Union and the United very small number of commodities for export. Many of these
States, are threatening to undermine the system of free trade depend on EU markets for more than 40% of their exports.
promoted by the World Trade Organization, by establishing Loss of access to EU markets would mean the loss of hundreds
bilateral preferential trade and investment agreements with of thousands of jobs, destroying their economies.
developing countries. Jagdish Bhagwati, an Indian economist
who is one of the most prominent international trade In the area of trade, whereas the Doha Round of the WTO
specialists, refers to the very numerous bilateral relationships negotiations had proposed that least developed countries be
of the newly emerging global trading system as a ‘spaghetti exempted from tariff cuts, all of the ACP countries must cut
bowl’, and as the ‘plague’ of special relationships. their tariffs on 80–98% of their trade with the EU over a 15-
year period, with no sector excluded. According to many
In 2000, the European Union (EU) and 79 African, experts, these tariff cuts are more than what is required by the
Caribbean and Pacific nations (ACP) signed the Cotonou current WTO rules.
Agreement (in Cotonou, Benin). The agreement, which came
into effect in 2003, has the stated aim of reducing poverty Trade liberalisation of the past 10–20 years has been
and promoting the integration of ACP nations into the global disastrous for many ACP countries. Instead of increasing
economy. This is to be done through bilateral ‘Economic competitiveness of local producers, market liberalisation
Partnership Agreements’ (EPAs) between the European Union often destroyed them. In Senegal, for example, one-third
and each individual ACP nation. Many of the ACP nations are of manufacturing jobs disappeared. The World Bank has
among the poorest in the world. acknowledged that its advice on opening up to free trade was
‘too optimistic’.
Since 2007–8, EPAs came under increasing criticism from
numerous sources, including ACP governments, international ACP countries’ export earnings are very low, because they
trade experts, local organisations of farmers and businesses, export agricultural products in their ‘raw’, unprocessed form.
United Nations agencies and the World Bank. The critics argue Whereas they should process and manufacture more, adding
that whereas the Cotonou Agreement was intended to benefit value to their production, they have been unable to do so
the ACP countries, the EPAs that are being negotiated and because of tariffs imposed by the EU (and other developed
signed will work against the interests of these countries, and will countries) on their processed exports (tariff escalation).
endanger their economic growth and development prospects.
The EU has not committed itself to eliminating the
It is noted that the EU is using bilateral agreements to protection it offers to its own farmers through subsidies.
gain access to ACP markets that it would not have been able However, it has agreed to offer tariff-free and quota-free
to achieve though the World Trade Organization (WTO), access for almost all ACP products. This should eliminate
where developing countries can join together and present the problem of tariff escalation. However, there are fears
their interests as one, thereby gaining a more favourable that ACP exports will be unable to compete in European
treatment. The bilateral nature of EPAs is a major threat to the markets, because of higher costs of production, and if they
multilateralism of the WTO. EPAs also weaken the ability of do succeed, and large quantities begin to enter EU markets,
developing countries to negotiate favourable agreements with the EU has ensured that it can use safeguards that will limit
the WTO, and they divide developing countries by creating the entry of such goods. At the same time, whereas 12–20%
different interests. EPAs lead to significant trade diversion as of ACP imports are exempted from having to cut tariffs, these
countries are forced to reduce their imports from lower cost, do not include manufacturing or high value-added products.
more efficient producers, and they increase the costs of trade as
each agreement has its own rules and bureaucratic procedures. Critics therefore argue that the new trading rules with the
EU lock ACP countries into existing patterns of trade, making
The EU has forced many ACP countries to sign EPAs, by it difficult for them to lower their dependence on commodities
threatening to eliminate their access to EU markets if they did and develop their manufacturing.
not do so. The countries that have been forced into signing
the EPAs are generally very poor, and highly dependent on a Source: ‘Partnership or power play?’ Oxfam International, April
2008; ‘Signing the future away’, Oxfam International, March 2007.
Applying your skills agreements as a means for poor countries to
grow and develop.
1 Why does Jagdish Bhagwati liken bilateral trade
agreements to a ‘spaghetti bowl’?
2 Compare and contrast bilateral trade
agreements with multilateral and regional trade
492 Section 4: Development economics
the developed country. Thus, increases in exports In the words of Joseph Stiglitz, ‘. . . a series of such
may be limited. agreements may leave many developing countries
worse off than they would be even with another unfair
• Increased imports and only slightly increasing multilateral agreement’ (reference is being made to the
exports may result in trade deficits, balance of Uruguay Round of the WTO).33
payments problems and increasing foreign debt.
They may also result in greater unemployment, Diversification
worsening income distribution and increased
poverty. f. Diversification
• Bilateral negotiations put developing countries at Diversification involves a reallocation of resources
a disadvantage due to weaker bargaining power into new activities that broaden the range of
compared to the multilateral negotiations of the goods or services produced. It was introduced on
WTO where they can join together and present their page 478, where we saw that a major disadvantage
interests as one, thereby gaining a more favourable of over-specialisation involves losing the benefits
treatment. For example, bilateral negotiations of diversification. We learned that diversification
cannot achieve a reduction in developed country by adding value to locally produced goods provides
agricultural subsidies, which is of crucial interest to the benefits of more varied production, increased
developing countries. employment, establishing more firms, and using
higher skill and technology levels.
• The developing country must agree to other
requirements not usually in its best interests (such It is hardly possible to overemphasise the
as freer rules on foreign direct investment, stricter importance of diversification as a strategy for growth
rules on intellectual property rights). and development. It permits countries to achieve the
following important objectives:
• Bilateral agreements divide developing countries
by creating different interests. Also, bilateral trade • Sustained increases in exports. It is not enough
agreements weaken regional trade agreements when to increase exports over a short period of time,
a member country makes a bilateral agreement with only to suffer a decline again; the increase must
a third country. be one that can be maintained over long periods.
This can only be achieved through diversification
According to the United Nations Conference on Trade into markets for which there is a sustained increase
and Development (UNCTAD),31 developing countries in global demand, a condition which commodity
are better off pursuing regional trade agreements. The exports do not satisfy. The UNDP notes that success
trend toward bilateral trade agreements: in world trade depends increasingly on entry into
higher value-added markets for manufactured
‘threatens the viability of existing regional cooperation goods.34
arrangements among developing countries, and, most
importantly, the options available to these countries for • Development of technological capabilities
pursuing their national development strategies. and skills. Diversification encourages
technological and skill developments; it provides
FTAs can result in some export gains, and possibly incentives to acquire new technologies and
increased FDI (foreign direct investment) flows, but the higher training, education and skill levels, which
size and durability of these benefits is highly uncertain, are very important for economic growth and
as are the net gains for trade and output growth. This is development. This was one factor behind the
because the FTA will most likely lead to an increase in spectacular success of the Asian Tigers discussed
imports, with implications for the trade balance and, above (see page 484).
in some cases, the external debt position. Moreover, if
future . . . FTAs are modeled on those that have been • Reduced vulnerability to short-term price
negotiated so far, it is likely that they will considerably volatility and long-term price declines.
reduce or fully remove policy options and instruments Diversification protects countries against losses from
available to a developing country to pursue its
development objectives.’32
31 UNCTAD is a United Nations organisation concerned with international 33 J. E. Stiglitz and A. Charlton (2005) Fair Trade For All, Oxford University
trade issues in developing countries. Press.
32 UNCTAD, Trade and Development Report, 2007 (available at http://www. 34 United Nations Development Programme, Human Development Report
unctad.org/en/docs/tdr2007_en.pdf). 2005 (available at http://hdr.undp.org/en/reports/).
Chapter 17 Topics in economic development 493
Theory of knowledge
Moral issues of trade liberalisation in developing countries
In the Theory of knowledge feature on page 380, we countries, at least partially at the expense of the less
considered the moral judgement that is implied in the developed – so much so that on average the world’s poorest
recommendation that countries adopt free trade. In this region was actually worse off at the end of the last round
section, our topic is broader and perhaps more serious, of trade negotiations;35 and an international environmental
and involves the moral implications of the trade (and agreement that provided that those rich countries who
economic) liberalisation policies recommended for today are polluting more be entitled to continue polluting
developing countries (and sometimes forced upon them; more into the future.’36
see page 485) by developed ones.
35 This is a reference to Sub-Saharan Africa.
The issues involved here are numerous, but can be 36 Joseph Stigltiz, ‘Ethics, economics advice and economic policy
divided into two broad categories: trade protection ’Initiative for Policy Dialogue, 24 October 2005.
policies of more developed countries that prevent 37 Joseph Stiglitz (2005) ‘Ethics, economics advice and economic
developing country access to their markets (agricultural policy’.
protection of farmers, high tariff barriers, tariff
escalation) and the trade liberalisation policies of the Thinking points
Washington Consensus, the WTO and bilateral trade
agreements. • Do developed country societies have a moral
obligation to help developing ones (especially the
Nobel Prize-winning economist Joseph Stiglitz, poorer ones)?
referring to the free market approach to international
trade that since the 1990s has dominated development • Consider the following question posed by Joseph
policies, writes the following about moral and Stiglitz. ‘At one level, it is natural for a country to
ethical issues in relations between developed and pursue its own interests. But … at what point does
developing countries: this pursuit of a country’s own interest (or, as is more
frequently the case, special interests within one’s
‘Economists have long bought into the importance of self- country) at the expense of the poor, become a moral
interest not only in explaining behavior, but also in yielding issue?’37
efficient outcomes. But economists have also long been
aware of the limitations of these perspectives. Not only does • Are developed countries morally justified in
the self-interest/market paradigm often fail to generate promoting bilateral free trade agreements with
efficient outcomes, but even when it does, these outcomes developing countries when they refuse to give up
may not [be consistent with] with notions of social justice . . . protection of their farmers?
Ethics in the relationship between developed and less • How fair are the trade rules of the WTO?
developed countries dictates that the developed countries
treat the less developed countries fairly, aware of their • Do the organisations of the Washington
disadvantaged economic position, and acknowledging that Consensus bear any moral responsibility toward
taking advantage of one’s own economic power inevitably developing countries for mistaken policies
will hurt the poor within developing countries. [There are] that in some cases were damaging to the
several instances where, in global economic relationships, poor of those countries (such as countries in
this precept has been grossly violated: an international trade Sub-Saharan Africa)?
agenda set to advance the interests of the more developed
fluctuating export prices and deteriorating terms of materials can work to stimulate industry. This
trade (see pages 431 and 479). is called ‘vertical diversification’, and involves
increased processing of raw materials. A number
• Use of domestic primary commodities. of developing countries provided a major boost to
Countries that already produce primary products their growth and development through this type
are in a special position to use these as the basis of diversification (for example, Malaysia, Thailand,
for their diversification into manufacturing, as Indonesia, China, Chile and Mauritius).
the domestic availability of the necessary raw
494 Section 4: Development economics
Test your understanding 17.7 Today, most countries have convertible currencies
for current account transactions. The benefits of
1 Compare and contrast the roles of the WTO currency convertibility for current account transactions
and regional and bilateral trade agreements are based on the idea that international trade should
as methods to advance the growth and take place in competitive markets, where prices
development prospects of developing countries. determined in free markets act as signals and convey
all necessary information regarding the quantities
2 Discuss the potential advantages and and qualities of internationally traded goods and
disadvantages of (a) bilateral trade agreements, services, promoting global efficiency in trade. Non-
and (b) regional trade agreements as a strategy convertibility for international trade purposes restricts
to promote growth and development in the amount of foreign exchange that can be bought
developing countries. and sold and prevents the functioning of the market
mechanism: it impedes international trade flows in
3 Explain how diversification can help a accordance with the forces of supply and demand,
developing country grow and develop. it encourages inefficient resource allocation, it
encourages inefficiency in production, and it prevents
Capital liberalisation economic activities from taking place in accordance
with the preferences of consumers and producers.
Whereas there is no learning outcome on capital Clearly, convertibility for current account transactions
liberalisation in this section of the IB syllabus, offers major advantages, and for this reason has been
Section 4.8 of the syllabus refers to ‘liberalised capital adopted in most countries in the world.
flows’ as one type of market-oriented policy that
should be evaluated for its strengths and weaknesses. Non-convertibility for financial
It is therefore discussed in this chapter. account transactions
The most common form of non-convertibility today
The meaning of capital liberalisation involves financial account transactions. This does
Capital liberalisation refers to the free movement not mean that there is no convertibility for financial
of financial capital in and out of a country. It occurs account flows; rather it means that there is government
through the elimination of exchange controls (see control over what flows are permissible. Exceptions are
Chapter 14, page 389), which are government made for debt service payments, for funds to be used
restrictions on the quantity of foreign exchange that in inward foreign direct investments (when a foreign
can be bought by domestic residents of a country, thus multinational corporation wants to invest in the local
limiting the outflows of funds. A country that has economy), and other kinds of financial capital flows,
exchange controls has a non-convertible currency; the such as for inward flows due to borrowing from abroad
domestic currency cannot be freely exchanged for (or or for financial investments by foreigners.
‘converted into’) foreign currencies. Non-convertibility
of a currency may apply to current account or Many developing countries still maintain non-
financial account transactions. convertibility for financial account flows for the
following reasons:
A fully convertible currency, by contrast, is one that can
be freely exchanged for other foreign currencies. Capital • To avoid capital flight, which is the large-scale transfer
liberalisation therefore involves the elimination of of funds to another country, usually undertaken
exchange controls, making a currency fully convertible. when residents or businesses of a country are fearful
that their wealth or income are threatened (due to
Non-convertibility for current the possibility of confiscation, or sudden increases
account transactions in taxation, or high rates of inflation, serious
The practice of non-convertibility for current account balance of payments problems and the possibility of
transactions (mainly foreign trade) was common in devaluation/depreciation, political instability, and so
earlier decades, when tight government control of on). Capital flight can be a serious problem because
foreign exchange was justified on the grounds that it involves a loss of financial capital that could
governments must be able to influence international have been invested domestically. Also, as it consists
trade to pursue particular objectives, such as of the sale of the domestic currency (to buy the
promotion of key industries and sectors, often in foreign exchange that leaves the country), it exerts
connection with import-substituting policies. The a downward pressure on the value of the currency.
domestic currency could be exchanged for foreign If there are restrictions on currency convertibility,
currencies only for specific imports and exports. financial capital cannot leave the country.
Chapter 17 Topics in economic development 495
• To avoid currency speculation, which involves buying are unlikely to occur, and that there is no need for it to
and selling of foreign exchange in the expectation isolate its domestic monetary policy from its external
of making short-term profits (see Chapter 14, page sector. Developing countries must therefore have:
385). Currency speculation can lead to exchange rate
instability with negative consequences for investment • a stable political system and economic policy
and economic growth; this is avoided when the orientation, inspiring confidence in the economy
currency is non-convertible for capital flows.
• sound fiscal and monetary policies that encourage
• To assist in conducting a monetary policy confidence
independently of exchange rate considerations.
Consider an economy in recession, where the • sound macroeconomic policies that work to avoid
government would like to pursue an expansionary wide exchange rate fluctuations and large balance of
monetary policy (i.e. lower interest rates) to stimulate payments deficits
economic activity. If the currency is fully convertible,
lower interest rates will result in financial capital • strong financial institutions that operate under
outflows, currency depreciation and possibly prudent government regulation so as to avoid
balance of payments difficulties. If the currency excessive risks
is non-convertible for financial capital flows, the
lower interest rate will not lead to a capital outflow, • a market orientation of the economy, with a well-
there will be no depreciation, and the country can functioning price system that facilitates a more
pursue its pro-growth policy without worrying about efficient allocation of resources and financial capital
consequences in the foreign sector. that inspires confidence in the market mechanism.
On the other hand, full convertibility offers Some of these conditions have not yet been fully met in
advantages by permitting or encouraging: many developing countries; this explains the continued
use of non-convertible currencies for capital flows.
• access by domestic residents to foreign capital
markets, and offering opportunities to diversify Currency convertibility and
their financial investments financial crises
The severe financial and economic crisis experienced
• access by domestic residents to more varied and by several East Asian countries in the late 1990s (South
cheaper sources of finance for investment and trade Korea, Thailand, Indonesia) provides evidence of the
risks of undertaking full capital liberalisation prior to
• foreign direct investment meeting all of the above conditions. These economies,
which on the whole had been reasonably successful with
• inflows of financial capital as foreigners make respect to their growth and development performance,
domestic financial investments in the knowledge had extended convertibility of their currencies from the
that they can sell their assets and take their current to the financial account (under severe pressure
financial capital out of the country if they so wish to do so by the International Monetary Fund). In
1997, an imminent recession, together with declining
• competition between financial institutions, confidence in the economy and the financial system,
resulting in greater efficiency and lower costs triggered speculative attacks on their currencies,
resulting in massive capital flight, and significant
• an efficient global allocation of savings, since savers downward pressures on the values of the currencies. The
are free to make financial investments anywhere in International Monetary Fund stepped in with loans and
the world where they can obtain the highest returns, imposed higher interest rates (a tight monetary policy)
with positive impacts on global rates of growth. on the grounds that these would stop the capital flight
and help support the currencies, however the downward
Full convertibility also prevents the development pressure on the currencies continued because confidence
of a black or informal market for buying and selling was so low. At the same time, high interest rates created
foreign exchange. Due to all of the above factors, it massive contractions in economic activity (negative
contributes to greater economic growth. growth), with devastating effects on the lives of millions
of people (huge increases in unemployment, poverty,
Conditions that should be met before hunger and malnutrition).
adopting full currency convertibility
In order for a country to fully liberalise its currency, At that time, a number of well-known economists
it must first create an economic and political argued that non-convertibility for capital flows should
environment that will minimise the risks of full be re-imposed, so that interest rates could be lowered
convertibility. It must be reasonably certain that capital to ease the recession without the risk of continuing
flight, currency speculation and exchange rate volatility
496 Section 4: Development economics
capital flight. It was argued that had the currencies been and political environments that minimise the risks can
non-convertible for capital flows from the beginning, they fully liberalise their financial capital flows.
the financial crisis might well have been avoided. In the
words of Nobel Prize-winning economist Joseph Stiglitz, Test your understanding 17.8
‘I believe that capital account liberalization was the
single most important factor leading to the crisis’ (emphasis 1 Explain the meaning of capital liberalisation.
in original).38 (Note that Stiglitz uses the term ‘capital 2 What are the potential advantages and risks of
account’ to refer to what is actually the ‘financial
account’; see Chapter 14, page 398.) full capital liberalisation?
3 What conditions must be met before a country
Currency convertibility for the financial account,
therefore, offers benefits that come with major risks; can safely liberalise its capital flows?
only when developing countries have created economic
Real world focus
Can developing countries imitate the trade and growth
strategies of the Asian Tigers?
Why were the Asian Tigers able to grow and develop higher value-added production through support of education
successfully using export promotion, while countries that and training, research and development (R&D) and the
opened up to international trade in later years were less adoption of appropriate technologies making heavy use of
successful? The answer to this question has two parts. abundant labour supplies, support to industries targeted for
exports, etc. By contrast, those developing countries that
The first part of the answer is that the Asian Tigers faced opened up to international trade in the context of market-
lower trade barriers on their exports of manufactured and based policies could not rely on this type of government
processed goods to developed countries than developing support for their export industries.
countries faced in later years. Some tariff and non-tariff
barriers in rich countries on manufactured and processed Therefore, developing countries that opened up to trade
goods exports from developing countries were increased during the 1980s did not fare as well as the Asian Tigers,
during the 1980s, after the successful entry of East Asian partly because they faced high trade barriers on their
exports into developed country markets. This increased exports, and partly because their growth and development
protection was undertaken to protect developed country strategy was market-led, thus not permitting much
domestic producers against low-cost competing goods, government support for export industries.
and to protect their workers against losing their jobs due to
the entry of low-cost imports. In view of the above, what can developing countries do
at present? We can conclude with the following general
Some of these trade barriers have since been reduced comments:
as a result of the Uruguay Round of the World Trade
Organization (WTO) agreements; however, barriers still • A trade strategy that is open to international trade is
remain at high levels. The difficulties of the Doha Round to superior to import substitution.A strategy encouraging
reach agreement were in large measure due to inability to exports offers far greater potential for economic growth
agree on further reductions of trade barriers to developing and development. The reasons for this can be found
country exports (see page 490). both in the arguments outlining the benefits of trade,
as well as in the disappointing experiences of countries
The second part of the answer to the question is that that pursued import-substitution strategies.
countries that opened up to international trade in the 1980s
did not follow the strategy of the Asian Tigers. The Asian • There are significant advantages in a strategy open
Tigers’ export promotion was based on strong government to trade based on diversification of exports into
intervention, whereas countries that turned to more open manufacturing and higher value-added activities. By
international trade in the 1980s did so on the basis of market- diversifying production into manufacturing, processing
based policies. The successes of the Asian Tigers owed a lot and higher value-added activities for both domestic
to government intervention in the form of industrial policies. consumption and export, developing countries avoid the
These encouraged the development of manufacturing and disadvantages of excessive specialisation in primary goods
(continued over)
38 Joseph E. Stiglitz (2002) Globalization and its Discontents, Penguin.
Chapter 17 Topics in economic development 497
production and export, and also benefit from opportunities development.39 Developing countries should be aware
to increase employment, and skill and technology levels. that bilateral trading agreements with rich countries pose
major risks to their growth and development efforts, and
• Developed country trade protection is a major that they are likely to be better off liberalising their trade
obstacle to a successful trade strategy in developing through multilateral agreements of the WTO rather then
countries. Trade protection by developed countries through bilateral trade agreements.
prevents developing countries from capturing the benefits • International trade as a growth and development
of international trade, since trade protection limits their strategy is likely to be more successful when
access to large and growing developed country markets. accompanied by industrial policies. It is likely that
market-based policies are not as effective as industrial
• Trade liberalisation among countries that are at policies as the basis for a trade strategy. Many developing
different stages of economic development may countries, especially the poorer ones, do not have the
be dangerous for the relatively less developed necessary institutions that support the development of
countries. Experience shows that trade liberalisation infrastructure, human capital (health and education),
among partners who are highly unequal can lead to de- technology development, etc. These ideas are reflected
industrialisation (loss of industry) due to the inability in the New Development Consensus. In certain cases, an
to compete, increased poverty, greater unemployment outward orientation focused on increasing exports may
and a larger informal sector. The benefits of trade also include some selective import-substituting policies,
liberalisation in such instances are captured mainly by involving protection of certain industries on the basis of
the economically stronger trading partners. the infant industry argument, one of the strategies of the
Asian Tigers.
• A possible way out of these problems may be through
the formation of regional trading blocs as the basis • Developing countries should be cautious about
of an outward orientation of developing countries. adopting full capital liberalisation on financial
In view of barriers to trade imposed by developed account transactions. Full currency convertibility
countries, and the dangers of trade liberalisation among should be adopted when countries have the economic
economically unequal partners, many economists suggest and political conditions that minimise the risks of full
that developing countries should form regional trading convertibility.
blocs. Increased integration through more trade between
countries within geographical groupings could allow them 39 Note, however, that while regional trading blocs may offer
to enjoy the benefits of increased exports, while avoiding major potential advantages to the members of the bloc, there may
some of the risks and obstacles created by rich country result greater inefficiency and resource misallocation on a global
protection. Trade liberalisation is far more likelty to be scale (see Chapter 15, page 416).
mutually beneficial to trading partners when it takes place
among countries that are at a similar level of economic 2 What trade and growth strategies open to
developing countries today are likely to be
Applying your skills more successful?
1 Why is it more difficult for developing
countries today to imitate the trade and
growth strategies of the Asian Tigers?
Assessment Higher level
• Exam practice: Paper 2, Chapter 17
The Student’s CD-ROM at the back of this book
provides practice of examination questions based on SL/HL core topics (Text/data 14–20,
the material you have studied in this chapter. questions B.2–B.13)
Standard level
• Exam practice: Paper 2, Chapter 17
SL/HL core topics (Text/data 14–20,
questions B.2–B.13)
498 Section 4: Development economics
Development economics
Chapter 18
Foreign sources of finance
and foreign debt
In this chapter we will study foreign direct investment (FDI), foreign aid, multilateral assistance, and the debt
problem of developing countries.
18.1 The meaning of foreign sources as credits in the balance of payments, because they
of finance involve inflows of foreign exchange, and therefore
work to balance out debits.
The topics we will study in this chapter are all related
to foreign sources of finance. Foreign sources of Figure 18.1 shows the main foreign sources of
finance refer to funds that flow into a country from finance (in the top row) in relation to the topics we
abroad, other than payments received for exports of will study in this chapter, which appear in bold-face
goods and services. These inward flows are recorded boxes. In developing countries, these inflows of funds
are often used to pay for trade deficits, though they
have other functions as well.1
Foreign aid: Non- Private Remittances
concessional concessional investment
financial flows
lending
Official Non- Public lending: Private Foreign Foreign Income from
Development governmental multilateral lending: portfolio direct workers
organisations assistance foreign investment investment abroad
Assistance (World Bank, commercial
(ODA) (NGOs) IMF) banks
Foreign
government
debt
Figure 18.1 Main sources of foreign finance in developing countries
1 Remittances, involving income from workers abroad, were briefly banks will be discussed in the present chapter in the history of the
discussed in Chapter 16, page 452, and foreign portfolio investment was government debt problem, page 520.
mentioned in Chapter 14, page 385. Private lending by foreign commercial
Chapter 18 Foreign sources of finance and foreign debt 499
In general, the functions of foreign sources of three decades their growth has been explosive. For
finance are the following: the greater part of the 20th century, foreign direct
investment originated in developed countries and was
• Helping countries acquire foreign exchange. also directed mainly towards developed countries.
Foreign sources of finance create credits in the Since the 1980s, developing countries have been
balance of payments. Therefore, if there is a deficit receiving an increasing share of total foreign direct
in the current account, which is likely to be due to a investment inflows, approaching half of total annual
trade deficit, these inflows lead to a supply of foreign FDI inflows (see Table 18.1 below).
exchange (credits) used to pay for this deficit.2
Multinational corporations have their headquarters
• Adding to insufficient domestic savings. mostly in developed countries, dominated by the
Developing countries, because of their relatively low European Union, Japan and the United States.
incomes, often have a low amount of savings, leading However, developing and transition countries are
to low levels of investment. Foreign sources of finance rapidly increasing their share in global foreign direct
can be used in addition to domestic savings to help investments. While in 1990 only 10% of total MNCs
countries increase investments in numerous areas had headquarters in developing countries, in 2009
that support growth and development. this share had risen to more than 25%.3 Whereas most
multinational corporations are privately owned, there
• Adding to technical skills, management are also a few state-owned firms that are expanding
skills and technology. Developing countries abroad, particularly from developing countries.
often have low levels of skills and technology.
Some foreign sources of finance can help countries The scope and growth of multinational
develop their skills and technology levels, which are corporations
a big push in favour of growth and development. The world of multinational corporations is vast and
growing very rapidly. In the early 1990s, there were an
18.2 Foreign direct investment and estimated 37 000 multinational corporations globally;
multinational corporations (MNCs) by 2009, they had increased to 82 000 and employed
80 million people in their foreign affiliates alone. The
The nature of foreign direct production of their foreign affiliates (i.e. excluding
investment and multinational production in home countries) amounted to 11% of
corporations
Host region % of % of
Describe the nature of foreign direct investment (FDI) and world developing
multinational corporations (MNCs). World countries
Economically more developed 100.0
Introducing multinational corporations countries 54.2
Foreign direct investment (FDI) is investment Economically less developed
by firms based in one country (the home country) countries 45.8 100.0
in productive activities in another country (the host
country). A firm that undertakes foreign direct investment Latin America and Caribbean 11.2 24.4
is referred to as a multinational corporation North Africa and Middle East 8.3 18.1
(MNC), because it operates in more than one country. A Sub-Saharan Africa 3.9 8.4
‘corporation’ is a type of firm composed of a legal entity East Asia 14.8 32.4
that is separate from the individuals who own it. (of which, China) (9.1) (19.9)
South and South East Asia and 7.7 16.7
Multinational corporations run business operations Oceania
in both the home country and in other (host)
countries. Historically, MNCs have been active Table 18.1 Geographical distribution of foreign direct investment inflows,
since about the middle of the 19th century. Their 2009
importance grew in the 1950s when US multinationals
stepped up their investments in Europe as part of Source: UNCTAD, World Investment Report 2010.
European postwar reconstruction. In the last two to
2 It might be thought that foreign sources of finance are recorded in the 3 United Nations Conference on Trade and Development (UNCTAD), World
balance of payments as credits in the financial account, but this is not always Investment Report 2010.
the case. For example, grants and concessional financial flows, as well as
remittances are entered under ‘current transfers’ in the current account.
500 Section 4 Development economics
global GDP and the value of their exports was 33% of within the country, it can more easily capture
global exports.4 a market share, as well as speed up delivery of
products and save on transportation costs.
The larger of the multinational corporations are
enormous in size. In 2008, the top ten non-financial • bypass trade barriers. Producing in countries
multinational corporations (ranked by size of foreign with trade barriers allows MNCs to bypass these and
assets) had total assets of US$3 trillion, and total sales secure access to local markets.
of $2.3 trillion.5 In 2008, the value of sales of the top
ten MNCs was about three times the total GDP of all • lower costs of production. Labour costs as a rule
the countries of Sub-Saharan Africa combined, and the take up a large proportion of total production costs,
value of their total assets was nearly four times Sub- and developing countries generally have lower
Saharan African GDP. Further, their total assets were labour costs than in developed countries. This is a
about the same as the GDP of China, and two and a key reason for example, why the United States has
half times the GDP of India.6 multinational corporations operating in Mexico.
Yet foreign direct investment remains a small share • use locally produced raw materials. If an
of total private investment in developing countries; MNC needs raw materials in the form of natural
total investment by local firms tends to be far greater resources for its production, it is far less costly
than total investment by multinational corporations. to obtain them locally than to import them, on
This raises an interesting question. If foreign direct account of transportation costs.
investment forms only a small share of total private
investment in developing countries, why is it the subject • further their activities in natural resource
of heated discussions and controversy? The answer extraction. Some MNCs specialide in the
is that foreign direct investment is qualitatively very extraction of natural resources (oil, aluminium,
different from local investment. It differs because of bauxite, etc.). Many developing countries are very
the very large size of MNCs, their significant economic rich in natural resources (for example in Africa), and
and political power, and their superior technical and therefore it is natural for MNCs to want to locate in
managerial expertise, know-how and technologies. such resource-rich countries.
Foreign direct investment is by far the most Developing country characteristics
important source of foreign finance flows to that attract multinational
developing countries. However, for many low-income corporations
developing countries that are almost completely
bypassed by MNCs, foreign aid is the main source of Describe the characteristics of economically less
foreign finance. developed countries that attract FDI, including low cost
factor inputs, a regulatory framework that favours profit
Why MNCs expand into economically repatriation and favourable tax rules.
less developed countries
Geographical distribution of foreign
Explain the reasons why MNCs expand into economically direct investment
less developed countries. Table 18.1 shows the distribution of global foreign
direct investment inflows between developed and
Multinational corporations expand into developing developing countries, as well as between geographical
countries (as elsewhere) in the hope of securing higher regions. In 2009, the share of developing country
profits. Developing countries offer possibilities for inflows was over 46% of global inflows.
MNCs to:
Foreign direct investment in developing countries
• increase sales and revenues. Some developing is not evenly distributed throughout geographical
countries have large or rapidly growing markets regions, as Table 18.1 indicates. In 2009, East Asia
(for example, China, India and countries in Latin (mainly China) and Latin America and the Caribbean
America), which offer the potential for large had the largest shares of FDI inflows, while Sub-
increases in sales and revenues. If the firm is located Saharan Africa was lagging far behind. However,
4 UNCTAD, World Investment Report 2010. (Japan), Total (France), EDF (France), Ford Motor Company (United States),
5 UNCTAD, World Investment Report 2009. The top ten non-financial E.ON AG (Germany).
firms (ranked by foreign assets) and their respective home countries were 6 Calculated from data in UNCTAD, World Investment Report 2010, and
General Electric (United States), Vodafone Group (United Kingdom), United Nations Development Programme, Human Development Report
Royal Dutch/Shell Group (Netherlands/United Kingdom), British Petroleum 2010.
(United Kingdom), ExxonMobil (United States), Toyota Motor Corporation
Chapter 18 Foreign sources of finance and foreign debt 501
though small, Sub-Saharan Africa’s share is growing • well-functioning infrastructure, including
rapidly, as it was only 2% of the world total in 2005. transportation and communications, that will
facilitate imports and exports
Four developing countries alone, Brazil, Russia,
India and China, received 19% of world FDI inflows, • a well-educated labour force.
corresponding to 40% of developing country inflows.
These countries are known as ‘BRIC’ (from the first The characteristics required of host countries are
letter of each country); they are similar in that they those that provide MNCs with the freedom to pursue
have very large and rapidly growing domestic markets, their economic interests with the least amount of
liberalised economies and a great wealth of natural government interference, in a safe economic and
resources. By contrast, many of the poorest countries political environment that minimises uncertainties
in the world receive negligible amounts of foreign and potential risks of losses on their investments.
direct investment. Recipients of the largest amounts of foreign direct
investment are countries that best satisfy these
Attractive characteristics of developing conditions, and are mostly concentrated in the
countries middle-income groups (upper middle and lower
The above pattern suggests that multinational middle) of developing countries.
corporations are highly selective in their choice of
hosts, preferring to invest in countries that display In view of the requirements of MNCs, it is easy to
certain characteristics. Aside from seeking host see that the rapid growth of foreign direct investment
countries that provide low-cost labour and natural around the world in the past two to three decades
resources, they are attracted to countries offering has been driven by the liberalisation of the global
an economic and political environment that is economy and the domestic economies of many
most likely to ensure profitability and safety. The countries. Since the 1980s, as developing countries
most important of these characteristics include the turned more and more toward the market as the
following: basis for policy, so MNCs have found it profitable to
establish affiliates in hospitable foreign countries that
• political stability and political institutions that accommodate their needs.
ensure a stable political environment
Advantages and disadvantages of
• a stable macroeconomic environment (low FDI for economically less developed
inflation, stable currency, acceptable levels of countries
foreign debt, absence of major balance of payments
problems) Evaluate the impact of foreign direct investment (FDI) for
economically less developed countries.
• an institutional environment that favours foreign
direct investment, such as Multinational corporations are profit-seeking entities;
they are not organisations concerned with the growth
freedom to repatriate profits (i.e. send profits to and development problems of developing countries.
the home country) Why then do developing countries view them as
a mechanism that can help accelerate growth and
freedom to engage in foreign exchange development?
transactions (no exchange controls, thus
can import possible needed inputs without Potential advantages of MNCs for host
restrictions; see page 495) developing countries
favourable tax rules (to ensure low tax payments) • MNCs can supplement insufficient foreign
exchange earnings. Investment funds flowing
lack of restrictions regarding foreign ownership into a country from abroad appear as credits in the
financial account, and can help offset a current
well-established property rights account deficit. As the activities of multinational
corporations are usually export oriented, the
rules that minimise the risk of nationalisation (a country’s exports are expected to increase, resulting
takeover of private property by the state) in increased export earnings and positive effects on
the country’s balance of payments position.
• a liberalised (free market) economy with limited
government intervention (including privatisation of • MNCs can supplement and improve upon
state-owned enterprises) local technical skills, management skills and
technology. When multinational corporations set
• liberal (free market) trade policy with an emphasis
on exports
• large markets
• rapid economic growth and expectations of
continued rapid growth
502 Section 4 Development economics
up affiliates in developing countries, they bring with activities that result in foreign exchange outflows.
them technical and managerial expertise, as well as These outflows may occur because of repatriation
new production technologies, which can be learned of profits (profits sent back to the host country);
and adopted by the local labour force (workers or because MNCs import raw materials and other
and managers) and local businesses. This involves inputs for use in production; or because they
technological improvements as well as improvements finance their activities by borrowing from the
in human capital (the acquisition of new skills parent corporation in the home country, in which
and knowledge by the local labour force), and is case they must repay the loan plus pay interest. The
considered to be one of the important advantages of result is that the net inflows of foreign exchange
foreign direct investment for developing countries. (inflows minus outflows) may be small.
• MNCs can supplement insufficient domestic • MNCs may not improve on local technical
savings and increase investment and new skills, management skills and technology.
capital formation. The inflows of FDI funds into Critics argue that MNCs’ influence on the
a country can supplement insufficient domestic development of local skills may be very small, as in
savings, increasing the amount of investment. practice the links between MNC activities and the
local economy are often limited, in which case local
• MNCs can lead to greater tax revenues in the workers do not have the opportunity to learn from
host country. If multinational corporations are the MNC. Also, MNCs often hire personnel from the
taxed by the government of the host country, this home country, thus limiting learning opportunities
will contribute to increased tax revenues. for the local labour force.
• MNCs can help promote local industry. When • MNCs may not lead to greater tax revenues in
MNCs buy locally produced goods and services as the host country. While MNCs are taxed by host
inputs into their production, they promote the country governments, they enjoy many tax privileges
development of local industries. This may lead to the and benefits, often lowering the amount of tax paid.
growth of existing local firms, or the establishment Tax benefits are offered as an incentive to attract MNCs
of new local firms to provide inputs to the MNC. into the host country. Another reason why MNCs pay
less tax involves the practice of transfer pricing, which
• MNCs can increase local employment and allows MNCs to lower their stated profits. Transfer
help lower unemployment in the host pricing works in the following way. Many MNCs buy
country. By establishing productive facilities and sell inputs and intermediate products from their
(investing) in the host country, MNCs can increase various affiliates in other countries. By claiming to
employment by hiring local workers. In addition, local tax authorities that the prices they have paid for
the promotion of local industry also contributes to the purchase of inputs from their affiliates abroad is
increasing domestic employment. higher than the actual price paid, their profits appear
lower than true profits. Since the amount of tax paid is
• MNCs can lead to higher economic growth in a percentage of profit, lower-stated profits mean lower
the host country. Increased levels of investment, taxes (sometimes significantly lower). It is estimated
improved technology and increases in human that lost tax revenues due to transfer pricing are in the
capital as well as the promotion of local industry billions of dollars each year.
and greater tax revenues, can lead to higher
economic growth in the host country with increased • MNCs may not help promote local industry. The
possibilities for pursuing development objectives. operation of MNCs sometimes forces local competing
firms to go out of business, or alternatively does not
Potential disadvantages of MNCs for host permit new local firms to establish themselves in
developing countries industries that are directly competitive with the MNC.
We will now consider the point of view that the • MNCs may not help lower unemployment
benefits listed above may not come about. In addition, in the host country. If, as noted above, MNCs
we will consider some possible negative effects of prevent the development of local industry, then
MNCs on growth and development. their job-creating impact will be limited. In
addition, some MNCs may sometimes import into
Why the benefits listed above might not the host country capital-intensive technologies
come about that are inappropriate to local conditions given
large labour supplies, thus contributing to
• MNCs may not always supplement unemployment and underemployment, and the
insufficient foreign exchange earnings. growth of the urban informal sector. (However,
MNCs usually do bring foreign exchange into
the host country. However, MNCs also engage in
Chapter 18 Foreign sources of finance and foreign debt 503
some MNCs engage in labour-intensive activities because little or no labour protection results in
that make extensive use of cheap local labour). lower costs of production; and they are interested
in investing in countries with weak environmental
Further possible negative effects of MNCs regulations, as this allows them to avoid costs
associated with environmental protection. When the
• MNCs and environmental degradation. interests of MNCs and those of developing countries
MNCs often pursue activities that cause serious conflict, developing country governments find
environmental degradation. They prefer to invest in themselves in a weak bargaining position because
countries that impose few environmental restrictions, if they do not give in to MNC demands, they will
and they have been known to engage in activities that lose the investment to another developing country
have caused tremendous environmental damage.7 that is more willing to compromise. For example, in
Moreover, MNCs are responsible for the production Thailand and Peru, MNCs threatened to relocate to
of the bulk of industrial pollutants (such as other countries if environmental regulations were
chlorofluorocarbons, a main cause of ozone depletion, enforced. In Peru, a mining company pressured
as well as pesticides, plastics, petroleum, industrial the government not to undertake health tests for
chemicals, and many others). It has been estimated children living close to the mining operations.
that about 80% of greenhouse gas emissions are
caused by substances produced by MNCs. • Competition between developing countries
to host MNCs and the ‘race to the bottom’.
• MNCs promote inappropriate consumption Many developing countries compete with each
patterns in developing countries. Critics other over which will create better conditions to
charge that MNCs, through advertising, create new attract MNCs. Yet MNC demands may conflict with
consumption needs and promote inappropriate what is in a country’s best interests. This has been
consumption patterns. This charge applies to termed ‘the race to the bottom’, because the desire
the role of MNCs in developed countries as well, to host MNCs may involve sacrifices of needed
but what makes it more powerful in the case of development, lowering government tax revenues,
developing countries is that populations plagued and use of local resources for infrastructure instead
by hunger, malnutrition, disease and lack of basic of merit good provision. Additional sacrifices may
services can less afford to spend their small incomes involve too much economic and trade liberalisation.
on unnecessary goods while their basic needs
remain unsatisfied. Examples include consumption Test your understanding 18.1
of soft drinks, sweets, fast foods, white bread,
expensive brand name goods, and many others. 1 (a) Describe foreign direct investment (FDI) and
multinational corporations (MNCs). (b) Explain
• MNCs may use government resources to why MNCs have an interest in expanding
build infrastructure needed by MNCs rather into developing countries. (c) In view of their
than for poverty alleviation. MNCs sometimes relatively small share in total private investment
require infrastructure (road systems, ports, in developing countries, why are MNCs a highly
telecommunications, etc.) which the developing controversial topic?
country must make available if it is to become
attractive as a host country. To build these types of 2 (a) What characteristics of developing countries
infrastructure, it may have to shift some of its scarce do MNCs look for when deciding where to
resources away from needed merit goods (clean invest? (b) How can you account for the fact
water, sanitation, schools and health care services) that low-income countries receive negligible
and toward infrastructure for MNCs. amounts of foreign direct investment?
(c) What factors account for the massive growth
• MNCs may use their economic and political in foreign direct investment in developing
power to bring about policies that may work countries in recent years?
against economic development. The very large
size of many MNCs gives them exceptional economic 3 Explain some advantages and some
and political power that they can use to influence disadvantages of MNCs in developing countries.
host governments to pursue policies that are in their
own interests but against economic development. 4 Why have some observers referred to the
For example, MNCs are interested in investing in competition between developing countries to
countries that have weak labour protection laws, attract MNCs as the ‘race to the bottom’?
7 One of the greatest disasters caused by MNCs involved an and permanent health problems. While destruction on such a
explosion in a Union Carbide plant in India in 1984 that killed scale is unusual, there are numerous well-documented cases of
more than 20 000 people and left more than 100 000 with serious MNCs undertaking environmentally unsustainable activities.
504 Section 4 Development economics
Real world focus
MNCs, pollution, and social responsibility
Oil MNCs in Nigeria by lowering sales. Therefore, corporations face an
The Niger delta (in Nigeria), with 606 oil fields, has been incentive to engage in socially beneficial behaviour.
termed the ‘pollution capital of the world’. It is estimated Issues of particular concern are the environment and
that more oil is spilled in the delta each year than was lost workers’ rights.
in the Gulf of Mexico from the leak in BP’s Deepwater
Horizon rig in the spring of 2010. Local people can • Limiting the power of corporations. MNCs are usually
hardly believe the measures taken in the United States large oligopolies that try to increase their market power
to protect the Louisiana shoreline from the effects of the by limiting competition between them. Governments
spill. The head of Friends of the Earth International (an in the home countries should try to discourage the
environmental NGO [non-governmental organisation]) growth of excessive market power by preventing anti-
says, ‘We see frantic efforts being made to stop the spill in competitive behaviour and promoting competition
the US. But in Nigeria, oil companies largely ignore their between them.
spills, cover them up and destroy people’s livelihood and
environments. The Gulf spill can be seen as a metaphor • Improving corporate governance. Laws should
for what is happening daily in the oilfields of Nigeria and be enacted that would make corporations behave in
other parts of Africa.’ ways that are consistent with the broader public interest.
For example, just as cheating stockholders is a crime, so
Source: John Vidal, ‘Nigeria’s agony dwarfs the Gulf oil spill. The US new laws could be passed that would consider causing
and Europe ignore it’ in the Guardian, 30 May 2010. environmental damage to be a crime.
Measures to increase MNC responsiveness to • Global laws for a global economy. The establishment
developing country needs of an international legal framework would allow parties
Nobel Prize-winning economist Joseph E. Stiglitz suggests across national boundaries who have been injured by a
a ‘five-pronged agenda’ that would help developing particular activity to band together and file a single suit
countries gain the potential benefits of MNCs while against the offender. Moreover, developed countries
reducing corporate abuses: could (and should) provide legal assistance for the poor
in developing countries.
• Improving corporate social responsibility.
Multinational corporations are highly visible, and • Reducing the scope of corruption. It is well known
are keenly aware of their public image. They can be that MNCs engage in corrupt behaviour, which includes
held in check by the knowledge that practices that do everything from bribing officials to be allowed to bypass
not meet with ethical standards are likely to damage laws and regulations, to evading taxes and engaging in
their reputation with the public. A negative image of transfer pricing. Efforts on an international scale should
a corporation held by its customers can lower profits be made to reduce corruption.
Source: Adapted from Joseph E. Stiglitz (2006) Making Globalization
Work, W. W. Norton.
Applying your skills
How can the global community help Nigeria
(and other countries) reduce the environmental
destruction caused by oil (and other) MNCs?
Chapter 18 Foreign sources of finance and foreign debt 505
18.3 Foreign aid economic, social or political conditions. In Figure 18.2,
which provides an overview of foreign aid, we see that
Understanding foreign aid for such transfers to be considered as foreign aid, they
must satisfy two conditions:
Explain that aid is extended to economically less developed
countries either by governments of donor countries, in • They must be concessional, which means that the
which case it is called official development assistance transfers involve more favourable conditions than
(ODA), or by non-governmental organisations (NGOs). could be achieved in the market. In other words, when
Explain that humanitarian aid consists of food aid, medical the aid involves loans, interest rates are lower and
aid and emergency relief aid. repayment periods are longer than borrowers would
Explain that development aid consists of grants, get in the commercial banking system. Also, the aid
concessional long-term loans, project aid that includes may involve grants, which are gifts of either money
support for schools and hospitals, and programme aid or goods and services that do not need to be repaid.
that includes support for sectors such as the education
sector and the financial sector. • They must be non-commercial, meaning that they
must not involve buying and selling (commerce)
Foreign aid is defined as the transfer of funds or or other activities concerned with making a profit.
goods and services to developing countries with the
main objective to bring about improvements in their Figure 18.2 also shows what does not account as
foreign aid, for example military aid, peacekeeping,
Foreign aid is Foreign aid is not refugee assistance, and others. The reason these
• concessional • military aid activities are not ‘foreign aid’ (though they involve aid
• non-commercial • peacekeeping of some sort) is that they are not directly concerned
• refugee assistance with bringing about improvements in the economic,
• anti-terrorism social or political conditions of developing countries.
• most multilateral
development Under ‘Who offers foreign aid’ in Figure 18.2, we
assistance see there are two sources of aid. The first is Official
Development Assistance (ODA), provided by developed
Who offers foreign aid country governments, and the second is aid provided by
non-governmental organisations (NGOs). All the providers
Official Development Non-governmental of aid (whether governments or organisations) are
Assistance organisations referred to as ‘donors’ of aid; the developing countries
that receive the aid are ‘recipients’ of aid.
(ODA public aid) (NGOs, private or
civil society aid) Under ‘Types of foreign aid’ in the figure, we
see that there are two main categories of aid:
Types of foreign aid humanitarian and development.
Humanitarian aid Development aid Humanitarian aid
• food aid • project aid Humanitarian aid involves aid extended in
• medical aid • programme aid regions where there are emergencies caused by
• emergency relief aid • technical assistance violent conflicts or natural disasters such as floods,
• debt relief earthquakes and tsunamis. They are intended to save
lives, to ensure access to basic necessities such as
How aid is offered food, water, shelter and health care, and to provide
assistance with reconstruction work in order to help
• grants • grants displaced people cope.
• goods in kind • concessional,
As shown in Figure 18.2, humanitarian aid is
long-term loans extended by donors through grants (sending money
• debt forgiveness as a gift) or through goods-in-kind (food, medical
supplies, blankets, etc.).
(for debt releif)
Development aid
Figure 18.2 Overview of foreign aid Development aid is intended to help developing
countries achieve their economic growth and
development objectives. It may take the following forms:
506 Section 4 Development economics
• Project aid involves financial support for specific organisations, which transfer the funds to
projects, such as building schools, clinics, hospitals, developing country governments
irrigation systems or other agricultural infrastructure.
• through NGOs – donor governments transfer ODA
• Programme aid involves financial support funds to NGOs which spend them in developing
to sectors, such as education, health care, countries.
agriculture, urban development, the financial
sector (credit, banking, insurance), energy, the The donor countries include most of the members
environment, or others. of the Organisation for Economic Co-operation and
Development (OECD), some members of the Organization
• Technical assistance involves the provision of of the Petroleum Exporting Countries (OPEC), and more
technical advice by developed country specialists recently also some eastern European countries.
such as doctors, teachers, agronomists, etc.
Technical assistance may sometimes be part of International organisations providing ODA include
project aid or programme aid. United Nations agencies; single-issue funds like the
Global Fund for Aids, Tuberculosis and Malaria; the
• Debt relief. Very poor countries with high levels International Development Association (IDA, which
of foreign debt sometimes receive aid involving is an organisation of the World Bank8), regional
some debt forgiveness (see page 522 below). development banks (such as the European Bank for
Reconstruction and Development (EBRD), the Inter-
As Figure 18.2 indicates, development aid is extended American Development Bank (IDB); the International
by donors through grants or through concessional Monetary Fund (IMF) assistance for debt relief under
long-term loans as well as debt forgiveness. debt relief initiatives.
Humanitarian aid and development aid are offered Donor motives for providing ODA
by both ODA and NGOs. Whatever the kind of aid, Donor countries are motivated to provide aid through
whenever it involves financial inflows, these enter as ODA for a variety of reasons:
credits in the balance of payments, thus bringing in
foreign exchange and helping countries offset possible • Political and strategic motives. Historically
deficits in their trade balance. and to the present, political and strategic motives
have played a strong role in motivating donor
Official Development Assistance countries to provide aid. During the Cold War, the
(ODA) United States provided aid to restrict the spread
of communism. The Soviet Union provided aid to
Explain the motivations of economically more developed communist states as well as some non-communist
countries giving aid. states with communist leanings. European powers
provided aid to their former colonies. Often aid
Who are the donors of ODA? has been used to support regimes in developing
Official Development Assistance (ODA), all countries that are considered to be ‘friendly’ to the
of which is public in the sense that it comes from interests of the donor governments.
government funds, forms the largest part of foreign
aid. Most ODA funds (nearly three-quarters) take the • Economic motives. Economic motives of donor
form of grants. countries, historically and to the present, have also
played a significant role in prompting donor provision
ODA funds reach developing countries in three ways: of aid. Developed countries often regard it to be in
their interest to assist countries with which they have
• through bilateral aid, which is the most important strong economic ties. For example, much of Japan’s
way – funds go directly from the donor government aid is directed towards neighbouring countries with
to the developing country recipient; examples of which it has strong trade and investment links. The
bilateral aid agencies are USAID (US Agency for practice of tied aid (to be discussed below), is an
Internal Development) in the important example of economic motives of donors.
United States and DFID (Department for Tied aid forces the recipients of aid to spend a portion
International Development) in the United Kingdom of aid funds to buy goods and services from the donor
country, thus providing significant economic benefits
• through multilateral aid, going indirectly to donor countries.
from donor governments to international
8 The International Development Association (IDA) is part of the World loans, i.e. soft loans – unlike World Bank loans, which are extended on
Bank but it offers the poorest of developing countries concessional commercial terms.
Chapter 18 Foreign sources of finance and foreign debt 507
• Humanitarian and moral motives. Some aid However, there are major exceptions from the pattern
is provided on humanitarian grounds for short- where countries with lower GNI per capita receive more
term emergency assistance, such as in the case of ODA per capita. For example, upper middle income
famines, wars or natural disasters. Concern about countries receive the same ODA per capita as lower
the extent of poverty in developing countries middle income countries, though they have GNI per
is a motive for allocating aid funds for long- capita levels more than two and a half times greater than
term development purposes. The Millennium the latter. They also receive about one-fourth the ODA
Development Goals (MDGs) adopted in 2000 were per capita of lower income countries, though their GNI
a global commitment to the alleviation of extreme per capita is about eight times greater.
poverty, hunger, malnutrition, disease, premature
deaths and environmental damage (see Chapter 16, The Middle East and North Africa, with GNI per
pages 450–51), and aid funds are often linked with capita about three times greater than in South Asia,
achieving these goals. receive eight times the amount of aid per capita, and
14 times the amount of aid given to East Asia and
The evidence on the distribution of ODA funds across the Pacific, which has a much lower GNI per capita.
countries suggests that all these motives play a role in Further, Europe and Central Asia,9 with a GNI per
the thinking of donors. This can be seen in Table 18.2, capita more than four times greater than South Asia’s,
showing ODA per capita and GNI per capita for receive nearly double the per capita aid.
developing countries grouped by income level and by
geographical regions (GNI is measured in US$ PPP to The reasons for these patterns can be found in the
ensure that GNI figures are comparable across regions; strategic importance that donor countries attach to the
see Chapter 16, page 453). We can see that low-income Middle East and North Africa, as well as to Europe and
countries receive more ODA per capita than lower Central Asia.
middle and upper middle income countries. Similarly,
sub-Saharan Africa, with its relatively low GNI per The problem of tied aid
capita also receives a large amount of ODA per capita.
Explain that aid might also come in the form of tied aid.
Low income ODA $ per GNI $ PPP per
Lower middle income capita (2007) capita (2007) Tied aid refers to the practice where donors make
Upper middle income the recipients of aid spend a portion of borrowed
37 1494 funds to buy goods and services from the donor
country. It occurs only in the context of bilateral
9 4543 (not multilateral) aid, and gives rise to several serious
disadvantages:
9 11 868
• Recipient countries cannot seek lower price
East Asia and Pacific 4 4937 alternatives for the goods and services they are
13 11 115 forced to buy from the donor country. It has been
Europe and Central Asia 12 9321 estimated that tied aid reduces the value of aid by
11–30%, and in the case of tied food aid the costs
Latin America and the 56 7385 to the recipient country are as much as 40% higher
Caribbean than in the market.10 This means that recipients of
7 2537 tied aid face much higher than necessary import
Middle East and North 44 1870 costs.
Africa
• Having to buy specific goods and services
South Asia from the donor country often results in
buying inappropriate, capital-intensive
Sub-Saharan Africa technologies.
Table 18.2 Official Development Assistance (ODA) by level of • Those who benefit from tied aid are usually
development and by region large firms in developed countries whose goods
and services the recipient countries are forced to
Source: Data on ODA from The World Bank, World Development Report, buy. This is a kind of support for industry
2010; data on GNI $ PPP per capita from The World Bank, World Development
Report, 2009.
9 This group includes eastern European countries undergoing a transition 10 United Nations Development Programme, Human Development Report
from central planning under communism to mixed market economies, as 2005 (available at http://hdr.undp.org/en/reports/).
well as the Central Asian states of the former Soviet Union.
508 Section 4 Development economics
of developed countries, occurring at the referred to as comprising a third sector (the first and
expense of poor country development second being the government and market sectors).
objectives.
NGOs include a wide variety of organisations, such
Approximately one-third to one-half of bilateral aid is as charitable organisations, non-profit organisations,
tied aid. nationally based groups with a national or
international reach, locally based community groups,
Comparing and contrasting ODA to two or grassroots organisations, and they may operate in
developing countries developed or developing countries (or both). Among
the better known international NGOs (INGOs) are
Compare and contrast the extent, nature and sources of Amnesty International, Greenpeace, Oxfam, Save
ODA to two economically less developed countries. the Children and World Wide Fund for Nature, also
known as the World Wildlife Fund (both abbreviated
As our discussion above suggests, aid financed by ODA as WWF).
can vary widely across recipient countries depending
on the amount of aid (some countries receive much NGOs in developing countries have grown
more than others), the type of aid (humanitarian massively in numbers and in involvement since the
aid, project aid, programme aid), the form it takes 1980s. It is estimated that developing countries now
(grants and concessional loans) the sectors that are have several tens of thousands of national NGOs,
supported, and the sources of aid (donor countries and several hundreds of thousands of community-
offering bilateral aid, international organisations based NGOs. A growing number of these now have
offering multilateral aid, or NGOs). In addition, it consultative status with United Nations agencies; from
can vary widely with respect to how effective it is in 41 in 1948, the number of NGOs with consultative
helping recipient countries achieve their growth and status today is in the thousands. Most of these are
development objectives (this will be discussed below). small local groups pursuing development objectives
You will be given the opportunity to compare two within a relatively small community.
developing countries with respect to these factors in a
data response question (see CD-ROM ‘Exam practice: NGOs obtain their funds from private voluntary
Paper 2’ chapter, page 35). contributions including private sector corporations
and, increasingly, from bilateral and multilateral ODA
Private (civil society) aid: non- funds. In other words, more and more of ODA funds
governmental organisations (NGOs) are channelled through NGOs, particularly in the case
of humanitarian assistance. The reason for this is that
Explain that, for the most part, the priority of NGOs is NGOs can perform functions that are not performed
to provide aid on a small scale to achieve development as effectively by national governments (see page 512
objectives. below).
Non-governmental organisations (NGOs) are the NGOs are involved in a vast range of activities,
second type of aid flowing into developing countries including provision of humanitarian aid in times
(see Figure 18.1, page 500). Like ODA, they involve of crisis, promotion of sustainable development,
concessional flows, but they are all grants (there are no promotion of community development, service
loans that must be repaid). delivery, poverty alleviation, protection of child
health, promotion of women’s rights, promotion
The World Bank defines NGOs as ‘private of small-scale entrepreneurs, support of the poor in
organizations that pursue activities to relieve the informal sector, provision of technical assistance
suffering, promote the interests of the poor, protect to small farmers, provision of credit to poor people
the environment, provide basic social services, or (micro-credit schemes), research activities, political
undertake community development.’11 NGOs are advocacy, support for people’s movements, and
‘private’ in the sense that they are not part of any more.
governmental structure; they are not private in the
sense of being part of the market system. NGOs are Evaluating foreign aid
an expression of civil society, and as such are often
Evaluate the effectiveness of foreign aid in contributing to
economic development.
11 The World Bank, Operational Directive 14.70, 28 August 1989.
Chapter 18 Foreign sources of finance and foreign debt 509
Arguments in favour of Official income distribution can be a barrier to growth and
Development Assistance (ODA) development (see page 473).
Aid and the poverty cycle Aid and economic growth
Very poor societies trapped in the poverty cycle face a There is strong evidence that aid leads to economic
savings–investment constraint due to very low incomes growth, because it makes possible increased
(see Chapter 16, page 444). To emerge from a poverty investment and consumption levels, leading to
cycle, poor people and poor communities need the increased volumes of output. Evidence cited by the
government to intervene by undertaking the necessary UNDP indicates that countries in Sub-Saharan Africa
investments in physical, human and natural capital. that rely heavily on aid (Mozambique, Tanzania and
However, if the government does not have enough tax Uganda) have achieved high growth rates.13
revenues, the only way the country, or community
within a country, can escape the poverty cycle is Aid and the Millennium Development Goals
through foreign aid that makes up for the lack of (MDGs)
savings. The United Nations Development Programme The provision of aid is crucially important to the
(UNDP), providing examples, notes that spending on achievement of the Millennium Development Goals
health in Sub-Saharan Africa is US$3–10 per person, (MDGs; see pages 450–51). Much of the aid is closely
while the cost of providing basic health care is $30 per linked to the achievement of these goals. According to
person. Low-income countries do not have enough the United Nations Development Programme, it will
funds to provide universal primary education, as well not be possible for developing countries to achieve the
as basic infrastructure services.12 To be able to finance MDGs without enough aid.
these services themselves, poor countries would need
to achieve economic growth that would provide them Aid, the debt trap and debt relief
with increased economic resources that can be used Countries that are heavily indebted (have high levels of
to invest in health, education and infrastructure. debt) face serious negative consequences for their growth
However, economic growth is not possible unless there and development, especially when caught in a ‘debt
is first some investment in these areas. Therefore, trap’, where they must go on borrowing more and more
these countries are caught in a poverty cycle from in order to service old debts (see page 521 below). Aid for
which they can escape only if foreign aid provides the debt relief helps countries reduce their debt burden and
financing for these investments. releases resources that can be used for poverty reduction
and economic growth and development.
Aid and provision of basic services
Even if a country is not caught in a poverty cycle, Factors that limit the effectiveness
aid can make resources available for investments in of Official Development Assistance
health, education and infrastructure, which can help (ODA)
poor people improve their employment opportunities A number of factors limit the effectiveness of aid as
and improve their incomes. In a number of Sub- a mechanism for achieving economic and human
Saharan African countries, foreign aid is an important development and poverty alleviation. The most
component of social budgets; in Tanzania, it accounts important of these include the following.
for more than one-third of social spending. In
Zambia, US$5 out of $8 of health spending per capita Tied aid
is due to foreign aid. Many of these programmes One of the most important limitations of the
contribute to significantly limiting the incidence of effectiveness of ODA funds is the practice of tied aid,
preventable diseases and reducing infant and child whose disadvantages for developing countries were
deaths: in Egypt, for example, an aid-funded diarrhoea explained above (page 508).
programme reduced infant deaths by 82% in five years
and prevented 300 000 child deaths. Conditional aid (conditionality)
Most donors of ODA impose numerous conditions
Aid and improved income distribution that must be met by the recipients of aid. Donors
By focusing on the most disadvantaged groups in see these conditions as a mechanism for forcing
society, aid can help improve the relative income developing countries to make important policy
positions of the beneficiaries and contribute to changes, as well as for ensuring that aid funds
improved income distribution. Highly unequal are used effectively. The kinds of conditions that
12 United Nations Development Programme, Human Development Report 13 United Nations Development Programme, Human Development Report
2005. 2005.
510 Section 4 Development economics
are imposed vary from requiring the recipient to Aid may not reach those most in need
pursue policies intended to achieve a greater market Aid resources are not allocated on the basis of the greatest
orientation in the economy (such as privatisation, need for poverty alleviation. There are two aspects to this
elimination of protective trade barriers, greater issue: the distribution of aid funds across countries, and
reliance on the price mechanism, etc.), to forcing the the use of aid funds within recipient countries. We have
recipient to accept particular projects that have been already seen in connection with the first that bilateral
decided upon by the donors. Conditional lending has donors do not always allocate aid resources according
been found to create disadvantages for developing to country needs. The second, involving the use of aid
countries. Donors do not pay sufficient attention funds within countries, is related to a number of factors:
to the preferences of the government or of the recipient country governments may not be genuinely
population groups the project is intended to benefit. committed to poverty alleviation; they may lack the
Policy prescriptions by donors may be incorrect; they necessary expertise to design and implement poverty
may not fit in with the government’s development alleviation policies; tied aid may favour projects that are
strategy and priorities; and they may weaken the not appropriate for poverty alleviation; donors may select
recipient government’s authority and accountability projects that are not the most effective from the point of
to its citizens. view of poverty alleviation.
Aid volatility and unpredictability Aid may be associated with corruption
The flow of aid funds (particularly bilateral flows) Corruption involves misuse of aid funds by recipient
into developing countries is volatile (unstable) and countries, and is a key problem associated with the
unpredictable. This is partly due to changing volumes provision of aid. Corruption is a reflection of the
of aid in donor budgets, and changing donor priorities degree of transparency and accountability in public
on how to allocate aid funds. This makes it difficult affairs, and tends to be more prominent the lower the
for recipient governments to implement policies that per capita income of a country.
depend on aid funds, as they cannot be sure if and
when funds will be available to undertake necessary The quantity of aid and poverty alleviation
investments and activities. In very poor countries that Donors have repeatedly promised to allocate 0.7%
depend heavily on aid for provision of basic services of their GNI for ODA. As Table 18.3 indicates, a few
(such as education or health care services), disruptions countries more than meet this target. However, others
in aid flows can have very serious effects on the do not, and since some of these are among the larger
welfare of the population groups affected by the and wealthier donors, it means that overall ODA funds
aid cuts.
Country ODA/GNI (%) Country ODA/GNI (%)
Unco-ordinated donors
In any recipient country there are usually large Australia 0.29 Luxembourg 1.04
numbers of donors (bilateral and multilateral) who
finance unco-ordinated activities, giving rise to Austria 0.30 Netherlands 0.82
numerous inefficiencies in the use of aid resources.
Sometimes the numbers of aid-funded projects are in Belgium 0.55 New Zealand 0.28
the hundreds. Lack of co-ordination of such projects
results in overlapping and duplication of some Canada 0.30 Norway 1.06
projects, inconsistencies between other projects, and
the lack of coherence in the entire aid effort. Denmark 0.88 Portugal 0.23
Aid may substitute for rather than Finland 0.54 Spain 0.46
supplement domestic resources
Aid resources are intended to supplement insufficient France 0.47 Sweden 1.12
domestic resources. A possible danger is that
governments in recipient countries may use aid funds Germany 0.35 Switzerland 0.45
to substitute for domestic resources, and not make
enough effort to increase domestic revenues through Greece 0.19 United Kingdom 0.52
taxation. The evidence on this issue is mixed; whereas
some countries have been unable to raise tax rates in Ireland 0.54 United States 0.21
spite of growth, others have succeeded in increasing
tax revenues even as aid increases rapidly. Italy 0.16 Total DAC 0.31
Japan 0.18
Table 18.3 ODA as a proportion of GNI of DAC* donors, 2009
* DAC = Development Assistance Committee, a forum of bilateral
donors of the Organisation for Economic Co-operation and
Development (OECD).
Source: Data from OECD, Aid statistics – data and databases (www.oecd.org/
dac/stats/data)
Chapter 18 Foreign sources of finance and foreign debt 511
are far less than the target amount. According to the with their beneficiaries, can be more creative and
United Nations Development Programme, if rich innovative in devising solutions to very specific
countries fail to follow through on their commitments, problems that arise in local settings.
developing countries will be unable to make the
investments in health, education and infrastructure Independent assessment of problems and
needed to improve welfare and support the economy pursuit of solutions
on the scale required to achieve the MDGs. Unlike government programmes, which must conform
to general policy guidelines and are subject to
Advantages of NGO: why NGOs are following government agendas, NGOs have a greater
growing in importance degree of freedom to use their expertise and technical
More and more bilateral and multilateral donors knowledge to assess problems independently and
of ODA are channelling their funds through NGOs arrive at suggestions for solutions. In addition, NGOs
because of their ability to perform some functions also enjoy more freedom because their activities are
better than developing country governments. The not subject to the conditions often imposed by donors
reasons for better performance include: of aid (conditionality); and they are not subject to the
restrictions associated with tied aid.
Strong anti-poverty orientation of activities
NGO activities are for the most part concerned with Enjoying the trust of beneficiaries
reaching poor people and helping them emerge from Poor people are often highly suspicious and
their poverty. Governments often have difficulties in mistrusting of government officials and
reaching the very poor; NGOs have an advantage by administrators, feeling at best neglected and at worst
working very closely with communities of poor people exploited. NGOs sometimes enjoy greater trust than
and responding to their particular needs as these governments, because of their close relationship with
arise in their own particular economic, social and project beneficiaries, and their commitment to solving
environmental conditions. problems at grassroots level.
Working closely with project beneficiaries Advocacy and raising public awareness
One of the strongest advantages of NGOs is that they and support
work closely with their beneficiaries, involving local Poor people usually lack political voice and
people in the design and implementation of development representation, and their concerns are not heard at higher
projects. Involvement by local people allows them to government levels. NGOs play an important leadership
provide inputs into deciding what problems should be role in acting as advocates on public policy issues, and
addressed and how they should be solved, and gives them ensuring that poor people’s concerns are heard.
a sense of ownership and commitment to the project,
all of which contribute greatly to success. Moreover, this Criticisms of NGOs
approach contributes to the promotion of self-help and Critics charge that NGOs have a number of weaknesses:
mutual assistance in problems of development.
Small size and weakness of many NGOs
Contributing to democratisation NGOs may be too small and weak to be able to play an
Such participatory practices contribute to a process of important role as agents of change and development.
democratisation, which can be important in countries They often have limited resources, and may face
that do not have democratic institutions. difficulties in attracting skilled personnel, so that the
effectiveness of their projects may be limited.
Offering expertise and advice
International NGOs accumulate experience from a Possible loss of independence due to
variety of countries and local settings, many of which growing dependence on governments and
may be relevant and transferable to similar settings aid agencies for funding
in other countries. They recruit experts in a variety One of the potential strengths of NGOs is their ability
of areas in accordance with need, and the experts are to act independently, free of constraints imposed
highly motivated out of a strong commitment to the by governments, aid agencies and bilateral and
objectives of the NGO with which they are affiliated. multilateral donors. However, as they become more
and more dependent on these outside sources for their
Ability to be innovative funding, they may lose their independence if they are
Unlike governments, which often take a uniform forced to conform to the demands of funders.
approach to problems, NGOs, by working closely
512 Section 4 Development economics
Real world focus
Food aid for developing countries
Many people believe that food aid consists of handouts of for recipient countries because it leads to an increase in
free food. Yet this is only one type of food aid provided by the supply of food in local markets, resulting in cheap
rich countries, falling within the category of humanitarian food that has forced millions of small farmers to go out of
aid, intended to prevent hunger and malnutrition in business, and to lose their sole source of income. Lower
countries facing serious food shortages. In addition, there prices also mean reduced incentives for local farmers to
is another type of food aid called ‘programme food aid’, produce food, and increased dependence on food aid or on
which is unrelated to hunger and malnutrition, and is not food imports. An NGO, CARE, has argued that this type
free of charge to the people who receive it. of food aid causes rather than reduces poverty, by harming
the people it is intended to help.
Programme food aid grew many years ago out of
the practice of developed countries to subsidise their Further, programme food aid is tied aid. The
agricultural production. The subsidies gave rise to US government must buy the food to be used as aid
surpluses that governments needed to dispose of. Food aid from US agricultural producers, and the food must be
offered them one way to do this. Programme food aid is transported on US ships. This results in much higher
now being gradually phased out by most donor countries, than necessary food costs and transportation costs. A
but continues to be a part of food aid provided by the proposal in the United States to ‘untie’ a portion of
United States. the aid would allow the US government to purchase
food in local (developing country) markets, and
Programme food aid is a type of bilateral aid involving would result in greatly reducing travel distance and
donations of food from a rich country government to transportation costs while supporting local production.
a developing country one. The developing country However, the proposal was not approved. Supporters of
government then sells the food locally at low prices, programme food aid in the US government argue that
and uses the revenues to finance economic growth and large commercial farming and shipping interests are
development. Donor governments sometimes donate the important allies in the fight to end poverty.
food to non-governmental organisations (NGOs) involved
with promoting economic development. These NGOs also A number of other donor countries have started to
sell the donated food locally at low prices and use the provide cash rather than food as food aid. Many NGOs
proceeds to finance economic development projects. prefer cash donations for food aid because these offer
greater flexibility, including the ability to buy food locally
Programme food aid has some potential advantages. and boost demand for locally produced food, as well as to
Through sales of food at low prices, it can help prevent buy the right kind of food according to local needs.
sharp food price increases, and can make food more
affordable to poor people. It reduces the need for food Source: Adapted from: ‘Square pegs in round holes: how the
imports, results in savings of foreign exchange, and can Farm Bill squanders chances for a pro-development trade deal’,
help countries improve their balance of payments. It allows Oxfam Briefing Note, 21 July 2008; Margaret Besheer, ‘US food aid
governments and NGOs to raise funds that can be used for groups debate practice of monetization’ in Voice of America, 2
economic growth and development. September 2007; Celia W. Dugger, ‘Charity finds that US food aid
for Africa hurts instead of helps’ in International Herald Tribune, 14
Yet according to some NGOs, programme food aid August 2007.
also has serious flaws. It is argued that this aid is harmful
Applying your skills 3 Explain the advantages and disadvantages of
programme food aid.
1 Explain the difference between humanitarian
aid and programme aid (which is a type of 4 Using a diagram, explain how an increase in
development aid). the supply of food due to food aid results in
lower prices that reduce incentives for local
2 What is ‘tied aid’? What are its disadvantages farmers to grow food.
for developing countries?
NGOs may attract the best qualified personnel that may deprive governments of scarce
personnel away from government highly qualified personnel, as NGOs are often in a
The growing role of NGOs in development position to offer higher salaries and benefits than
creates a demand for technical experts and the government.
Chapter 18 Foreign sources of finance and foreign debt 513
Challenge to state authority and that because of corruption and mishandling, aid
Whereas governments generally welcome NGOs that does not reach those most in need. The conclusion is
complement their activities in poverty alleviation, that, in spite of several decades of experience during
they often dislike the advocacy role taken on by many which rich country governments have spent billions
NGOs, which may conflict with government policy or of dollars on aid, many countries are still as poor as
question its authority. ever. Aid has therefore failed to contribute to growth
and development, and to poverty alleviation.
The consensus view on NGOs overall is favourable.
However, NGOs must act in partnership with the In contrast to aid, international trade can
government, and must not be considered to be a make important contributions to growth and
replacement of government. Governments have crucial development and poverty alleviation, as shown by the
roles to play in the development process, which NGOs, highly successful growth and development performance
even under the most favourable circumstances, cannot of East Asian countries. However, if developing
possibly undertake. Governments are essential for countries are to exploit their trade potential to the
establishing an overall policy framework for the economy, benefit of their growth and development, developed
including a framework for sustainable development; for countries should eliminate their trade protection
providing a legal, institutional and regulatory framework policies, as well as protection of their agricultures.
for the economy; for pursuing policies to ensure economic
stability; and for correcting market failures. Arguments supporting the ‘trade and aid’
perspective
An example of an NGO, the Grameen Bank, which Supporters of ‘trade and aid’ argue that while trade
provides credit to poor people in Bangladesh, is and export growth are very important for growth and
discussed on page 469. development, they are not enough in the case of low-
income (very poor) developing countries.
Comparing and contrasting the
roles of aid and trade Many of the serious weaknesses of aid are the
responsibility of donors. These include tied aid,
Compare and contrast the roles of aid and trade in conditionality of aid, volatility and unpredictability
economic development. of aid, and lack of donor co-ordination of aid.
There is strong pressure on donors by aid organisations
There has been an ongoing debate for decades to correct these problems, to make aid more effective.
regarding the relative roles of foreign aid and
international trade in economic growth and At the same time, there are some situations where
development. We will examine the controversy by international trade may be unable to help, making aid
considering three popular slogans, each representing a necessary:
different perspective:
• Rich country agricultural subsidies. As long
• ‘trade, not aid’ as these are in place, developing countries that
depend on exports of protected goods cannot rely
• ‘trade and aid’ on trade to grow and develop.
• ‘aid for trade’. • Developing country dependence on
commodity exports. Some of the poorest
Arguments supporting the ‘trade, not aid’ countries in the world depend on production and
perspective export of primary commodities and are hurt by price
Supporters of the ‘trade, not aid’ perspective argue volatility and deteriorating terms of trade. These
that development should be based on an expansion countries cannot grow and develop by use of trade.
of international trade and increasing exports of
developing countries, while aid should be limited • The poverty cycle. Countries trapped in the poverty
if not altogether abandoned. The arguments centre cycle cannot escape from this by means of trade.
on two main points: the failures of aid to effectively
address the problem of growth and development; • Countries may have little to export. Many
and the ability of trade to make major contributions poor countries cannot take advantage of trade
to growth and development, provided rich countries opportunities because they have difficulties
abandon their protectionist policies. moving into new areas of production of goods
that can be exported. Limited access to credit is
Regarding the failures of aid, its critics emphasise a major obstacle to opening up a new business
the dangers of corruption, the idea that aid replaces that produces for export. For example, in 2001
government funds rather than supplementing them, the European Union opened its markets to
imports from the poorest developing countries
514 Section 4 Development economics
by eliminating most tariffs and other trade abilities to export. This view is based on the idea that
restrictions, and yet there was hardly any many poor countries face institutional constraints
noticeable increase in the exports of these that prevent them from taking advantage of growing
countries. Aid is therefore essential to help such international markets. Even if all rich country trade
countries develop the necessary institutions that protection disappeared overnight, countries that do
will help them move into production for export. not have the institutions enabling them to increase
and diversify their exports will experience limited
• Exclusion of geographically isolated benefits from trade.
communities and countries. There are many
poor communities, particularly in landlocked The constraints faced by developing countries
countries, which are geographically isolated and have include everything from high transport costs due to
no access to markets, to urban centres or to ports. It poor transport networks, limited access to credit, poor
is very difficult for the people in these communities power supplies adding to costs of production, high
to be integrated into the market economy, much less administrative costs related to complicated border
to participate in the benefits of increasing exports. procedures, and lack of institutional capacity to meet
As an example, development economist Jeffrey Sachs technical and sanitary standards increasingly required
uses the extreme case of Mongolia, which is: by importing countries.
‘1500 kilometres away from big population centres This approach requires that aid and trade policies be
and has a few million people. Half of the people live integrated, so that a policy geared toward increasing
in yurts. Their connectivity is low. They have no exports is based on assistance aiming to strengthen the
viable industry right now. They sell some camel hair abilities of developing countries to achieve increases in
but can’t process it because they get a higher price exports. The ‘aid for trade’ would be in addition to, and
by selling it to China, which processes it at much not a replacement of Official Development Assistance
lower costs and gets it out of the ports cheaper than (ODA) funds. Moreover, efforts to address institutional
they can do by having a knitting factory in Ulan constraints to trade should not concentrate only
Bator. The real economic answer is for Mongolians on very poor developing countries (which receive
to leave. But that’s not the answer for Mongolia.’14 ODA funds), but also on middle-income developing
countries (which do not qualify for ODA funds).
Examples abound. In Zambia (which is landlocked),
the cost of shipping a tonne of maize to its Test your understanding 18.2
neighbour Tanzania is greater than sending a tonne
of maize from Tanzania to Europe or the United 1 Define foreign aid, using the concept of
States. Poor roads in Uganda increase transport costs concessional flows.
by 80%. Geographical isolation makes countries
such as these, or isolated communities within 2 Distinguish between (a) ODA and NGOs,
countries, unable to compete in international (b) humanitarian aid and development aid, and
markets, and therefore unable to take advantage (c) project aid and programme aid, explaining
of the potential benefits of trade in the absence in each case what these consist of.
of major investments in communications and
transportation, which can be greatly facilitated by 3 What factors motivate donor governments to
the provision of aid. provide foreign aid?
Arguments supporting the ‘aid for trade’ 4 (a) Explain the meaning of tied aid and the
perspective reasons it limits the effectiveness of aid.
More and more economists believe that to be able to (b) What other factors limit aid’s effectiveness?
benefit from international trade, developing countries
must have the institutional capacity to increase their 5 (a) What kinds of activities do NGOs support
exports. This perspective is an extension of the ‘trade in developing countries? (b) Why is more and
and aid’ perspective; it asserts that both trade and more ODA channelled through NGOs? (c) What
aid are important to growth and development, and, are some strengths and weaknesses of NGOs?
in addition, aid and trade should be linked together
so that a portion of aid is used to support the 6 Explain some arguments (a) in favour of foreign
development of institutions that improve a country’s aid, and (b) against foreign aid.
14 Jeffrey Sachs, ‘Why “Trade, Not Aid” isn’t enough’, interview in Business 7 Discuss the roles of aid and trade in economic
Week, 10 October 2000. development.
Chapter 18 Foreign sources of finance and foreign debt 515
18.4 Multilateral development • the International Development Association (IDA),
assistance established in 1960, which has similar activities to
the IBRD but extends loans to low income countries
Examine the current roles of the IMF and the World Bank on highly concessional terms.
in promoting economic development.
The IBRD and IDA are complemented by three
Multilateral development assistance involves additional organisations, that focus mainly on private
lending to developing countries on non-concessional investments in developing countries. The International
terms, in other words with rates of interest and Finance Corporation (IFC), established in 1956,
repayment periods determined in the market. finances private sector investments. The International
Centre for Settlement of Investment Disputes (ICSID),
There are a number of major multilateral lenders to established in 1966, provides a forum for the settlement
developing countries such as: of investment disputes in developing countries. The
Multilateral Investment Guarantee Agency (MIGA),
• multilateral development banks,which lend in order established in 1988, provides insurance to multinational
to support economic growth and development, corporations against political risk, and helps promote
including the: foreign direct investment in developing countries.
World Bank
African Development Bank The importance of the World Bank as a
Asian Development Bank development assistance organisation lies mainly in its
Inter-American Development Bank role as a lender of funds to governments, and therefore
European Bank for Reconstruction and focuses on the roles of the IBRD and IDA.
Development
Brief history of World Bank activities
• the International Monetary Fund, which lends in The World Bank’s activities have changed their focus
order to alleviate external payments difficulties. over the years. In the early years of its involvement
with developing countries, the World Bank focused on
Lending by both multilateral development banks lending for the development of infrastructure, such as
and by the International Monetary Fund differ energy, transport, telecommunications and irrigation.
from commercial bank lending because they are
involved with lending for economic development By the early 1970s, the World Bank had turned its
or international financial stability, rather than for attention towards poverty alleviation. At the time, it
commercial or profit reasons. grew enormously through an expansion of its funding
and technical personnel, and greatly stepped up its
The World Bank lending to developing countries. It redirected a portion
of its lending towards poverty alleviation, promising to
The World Bank is a development assistance help the poorest 40% of developing country populations
organisation that extends long-term loans to developing through projects focusing on water supplies, sanitation,
country governments for the purpose of promoting education, health, employment, and more.
economic development and structural change. It was
established in 1944, at the end of the Second World At the end of the 1970s and in the early 1980s,
War, as part of an effort to help reconstruct Europe. the Bank’s focus changed once more to a new type of
Its activities were extended to developing countries lending: structural adjustment loans (SALs) intended
from the late 1950s when European reconstruction was to change the course of policy-making in developing
completed. It is composed of 187 member states that are countries by reducing government intervention and
its joint owners. It consists of two organisations: promoting competition and the role of markets. The
focus of SALs was on dismantling interventionist
• the International Bank for Reconstruction and policies and reorienting them towards the market
Development (IBRD), which lends on non- system. It was believed that a strong market orientation
concessional (i.e. commercial) terms to middle of the economy would help developing countries
income developing countries, therefore its activities expand their exports and increase their rates of growth.
and lending do not form part of foreign aid; by
far the greatest part of World Bank lending for Loans were intended to provide assistance in
development purposes (about 75%) is offered by the areas like the removal of price controls; interest rate
IBRD, and for this reason the World Bank, for the liberalisation (freeing up of interest rates); trade
most part, is not considered to be an aid agency. liberalisation (lowering and eliminating tariff and other
barriers to trade); eliminating restrictions to new foreign
516 Section 4 Development economics direct investments (by multinational corporations);
privatisation (aimed at reducing the size of the public
sector); deregulation (aimed at increasing the scope of dams that displace indigenous people), as well as
market forces); cuts in government spending (to reduce environmentally unsustainable projects (such as
budget deficits); and others. Acceptance of the measures building infrastructure that destroys the natural
included in the loans was a condition that had to be environment and local ecosystem). In recent years,
met in order for a country to qualify for a loan. the World Bank has become far more aware of
the social and environmental implications of the
SALs were a method used by the World Bank in projects it funds, and currently makes greater efforts
assisting (and forcing) developing countries to adopt to ensure that project objectives are consistent with
economic and trade liberalisation policies (according social and environmental concerns.
to the Washington Consensus; see page 485). By
the 1990s, SALs had come under very strong and • World Bank governance dominated by
widespread criticism because of their negative rich countries. The World Bank is owned by its
consequences on developing country economies. 185 member states; however, voting power in its
governance is determined by the size of financial
Current World Bank activities contributions made by each country to the
Since the mid-1990s, the World Bank has again shifted organisation, which are in proportion to the size of
towards a poverty orientation, and has committed each economy. This clearly gives far greater power
itself to helping countries achieve the Millennium to rich countries. Critics argue that decisions are
Development Goals. It also began to focus on sustainable made without due regard for the needs and wishes
development. Its poverty-oriented projects are meant to of developing countries, which, being the poorest,
be environmentally sustainable; they must not give rise to have the least representation in decision-making.
environmental destruction, and whenever possible they
must also improve upon the quality of the environment. • Excessive interference in countries’ domestic
affairs. Critics argue that the World Bank
In addition, the World Bank has changed its views interferes excessively in the domestic policy affairs
on the appropriate role of government in economic of developing countries.
growth and development. According to the new
perspective, poverty alleviation requires intervention • Conditional assistance (lending).
by governments in many areas: education, health care, Conditional assistance (or conditional lending)
public health, infrastructure (water, sanitation, transport, refers to the imposition of conditions that must be
irrigation, and many others); access to credit by the met by borrowing countries to qualify for a loan.
poor; land reforms for a more equitable distribution (It is also one of the problems of foreign aid; see
of agricultural land; policies to reverse environmental page 510.) The World Bank sees the imposition of
degradation; policies to help the poor escape the poverty conditions as a mechanism for inducing desirable
cycle; policies to promote gender equity. (These issues policy changes. Conditional lending is problematic
had been ignored by SALs, with negative consequences because it deprives countries of control over their
for income distribution, poverty and the environment.) domestic economic activities.
The World Bank is also paying increasing attention • Damaging effect on developing countries.
to the need for institutional development, based on One of the strongest criticisms involves the
the idea that markets need institutions that provide negative effects on developing country economies
education and health services; ensure availability of structural adjustment lending. SALs have been
of and access to necessary infrastructure (water, criticised for increasing income inequalities and
sanitation, transport, etc.); provide an effective and poverty within developing countries, because of
equitable taxation system; ensure access to credit by such factors as increasing unemployment, cuts
all who need it; secure property rights; minimise the in provision of merit goods by governments, cuts
possibilities for the exercise of corruption; empower in food subsidies, introduction of payments of fees
women and other disadvantaged groups; promote for health and education, and limited possibilities
appropriate technology development and innovation; for the poor and the unskilled to take advantage
give a political voice to the economically weak; ensure of opportunities opened up by the freer market
and promote competition; and more. environment. Increasing poverty is considered by
many to be among the World Bank’s greatest failures.
Evaluating the role of the World Bank
Some of the more important issues include the following: • Inadequate attention to poverty alleviation.
Although the World Bank has in recent years turned
• Social and environmental concerns. The World its attention to poverty issues, critics argue that it is
Bank has been criticised for implementing socially not doing enough to meet the challenges of extreme
unsound projects (such as building hydroelectric poverty in developing countries by not allocating
Chapter 18 Foreign sources of finance and foreign debt 517
enough funds for loans intended to meet the policies, vary from country to country, but typically
needed investments in education, health services, include the following:
and infrastructure (clean water supplies, sanitation,
etc.). In addition, it has been criticised for not doing • tight monetary policy, through increases in interest
enough in the area of debt relief through the Heavily rates, intended to lower aggregate demand, reduce
Indebted Poor Countries (HIPC) Initiative (see page the level of economic activity and reduce demand for
522 below); many very poor and highly indebted imports while encouraging inflows of financial capital,
countries do not qualify for debt relief because, thereby helping the balance of payments position
according to requirements for eligibility established
by the World Bank, they are not poor enough or • tight fiscal policy, also intended to lower aggregate
indebted enough. The result is that a number of demand and reduce the level of economic activity,
countries do not receive the assistance they require. through cuts in government spending (including
cuts in provision of merit goods, such as health
The International Monetary Fund services, education, infrastructure, etc.) and cuts
in food and other subsidies, as well as increases in
The International Monetary Fund (IMF) is a taxation, and the imposition of fees for schooling
multilateral financial institution that was established and health care services15
jointly with the World Bank in 1944 with the original
purpose of lending to countries experiencing balance • currency devaluation or depreciation, intended to
of payments deficits under the system of fixed discourage imports and encourage exports and help
exchange rates that existed at the time. Its objectives the balance of payments position
have changed over the years in accordance with the
evolution of the international financial system. At the • cuts in real wages (i.e. wages after taking into
present time, the IMF is composed of 185 member account the impact of price changes), to reduce
countries. Its purpose is to oversee the global financial aggregate demand and the level of economic activity
system, follow the macroeconomic policies of its
member countries, stabilise exchange rates and help • liberalisation policies, such as eliminating or
countries that experience difficulties making their reducing controls on prices, interest rates, imports
international payments by extending them short-term and foreign exchange, to promote a free market and
loans on commercial (i.e. non-concessional) terms. free trade environment.
Activities of the International Evaluating the role of the International
Monetary Fund Monetary Fund
In the first two decades of IMF’s existence, more than The IMF is a far more controversial institution
half of its lending was to developed countries. Its role in than the World Bank, and is subject to more
developing countries grew with the debt crisis beginning intense criticism due to the highly negative impact
in the 1970s and 1980s. This was the time when many on countries that almost always results from its
poor oil-importing countries developed serious balance stabilisation policies. While it shares some of the
of payments difficulties as a result of dramatic increases criticisms against the World Bank, the main criticism
in oil import expenditures (see page 520 below). During focuses on the harshness of the measures that
the 1990s, the IMF expanded its lending to transition borrowers are forced to adopt. The criticisms may be
economies in central and eastern Europe and the former summarised as follows:
Soviet Union. Since 2008 its lending has increased
significantly to countries around the world as a result • IMF governance dominated by rich
of international payments difficulties brought on by countries. As with the World Bank voting power
the global financial crisis, including some developed in its governance is in proportion to the size of each
countries (Greece, Iceland, Ireland, Portugal). economy, giving rich countries far greater power in
decision-making.
The loans provided by the IMF usually come with
a package of policies that the country must adopt as a • Excessive interference in countries’ domestic
condition for receiving the loan (another example of affairs. Even more than in the case of the World
conditionality). These policies, known as stabilisation Bank, critics argue that IMF interference in domestic
economies is far too great.
15 Countries with serious balance of payments problems also typically face
large government budget deficits (an excess of government spending over • Conditional lending (conditionality).
government revenues), and so an additional objective of these policies is Loans are made available only on condition that
to reduce government spending and increase revenues in order to reduce
the size of the budget deficit.
518 Section 4 Development economics
the borrowing country agrees to implement the in alleviating external payments problems, the
stabilisation policies designed by the IMF. Given success tends to be short-lived. The fundamental
their vulnerability in times of severe external balance of payments problem of many developing
payments difficulties, countries are forced to accept countries does not get resolved through IMF loans
harsh conditions that run counter to their growth and restrictive macroeconomic policies. Experience
and development objectives. shows that many countries that have tried the
IMF programme suffer not only increasing poverty
• Damaging effects on developing countries. but also low or negative rates of growth, and
IMF policies come at an immense human cost. therefore are unable to ‘grow’ out of their balance of
Stabilisation policies have the impact of lowering payments difficulties or external debt problems.
economic growth, often creating a recession with
increasing unemployment and increasing levels of 18.5 The role of international debt
poverty. In developing countries that in any case
face high unemployment and underemployment, Explaining foreign debt and why
the effects can be devastating. Cuts in real wages countries borrow from abroad
where wages are low to begin with, cuts in
government spending on merit goods and food Outline the meaning of foreign debt and explain why
subsidies on which many poor people depend for countries borrow from foreign creditors.
their physical survival, the imposition of fees for
schooling and health care services among people The meaning of foreign debt
who cannot afford them, along with the increases A country’s foreign debt refers to its level of external
in poverty that arise from liberalisation policies, debt, meaning the total amount of debt (public and
are wholly inconsistent with economic growth and private) incurred by borrowing from foreign creditors
development objectives. (i.e. lenders). The problem of developing country debt
involves large volumes of public (i.e. government) debt.
• IMF stabilisation policies based on a flawed
concept. Some economists argue that in addition Foreign government debt (see Figure 18.1) arises
to the human cost, there may be something from three sources: (i) government borrowing from
fundamentally wrong with the stabilisation concept multilateral organisations, (ii) government borrowing
pursued by the IMF. The reason is that whatever from foreign commercial banks, and (iii) government
success the IMF stabilisation policies have had sales of bonds to foreigners.16
Test your understanding 18.3 Borrowing has major costs, which take the
form of ‘debt servicing’; this involves payment
1 The lending activities of multilateral of the principal (the amou nt of the loan) plus
organisations such as the World Bank and IMF interest. When a country borrows from a foreign
are sometimes referred to as ‘foreign aid’. Why creditor, the debt service payments must be
is this mostly an incorrect use of the term made in foreign exchange, which can come from
‘foreign aid’? increased exports, reduced imports, or financing from
external sources. Under favourable circumstances,
2 (a) What is the role of the World Bank in debt service payments are made possible by greater
developing countries? (b) Explain why many economic growth and increased export earnings.
of its lending programmes have come under
criticism. (c) Evaluate the role of the World Why countries borrow from foreign
Bank as a development assistance organisation. sources
Borrowing from foreign sources enters the balance
3 (a) What is the role of the International of payments as a credit in the financial account and
Monetary Fund? (b) Why is it unpopular in helps countries pay for deficits (an excess of debits)
countries to which it lends? (c) Evaluate the in the current account. Therefore, a very important
role of the International Monetary Fund in its reason why countries borrow from abroad is to acquire
aim to assist countries with balance of payments foreign exchange allowing them to pay for an excess
difficulties.
16 The sale of government bonds as a form of borrowing is explained on borrowing, as some commercial bank lending and some foreign portfolio
page 330, footnote 5. Note that only some, not all, of private lending by investments involve private borrowers.
commercial banks and foreign portfolio investment involves government
Chapter 18 Foreign sources of finance and foreign debt 519
of imports over exports (a trade deficit). A trade loanable funds, began aggressively competing with
deficit allows a country to reach a point outside its each other to lend to developing countries. The
production possibilities curve (PPC), meaning it enjoys developing countries’ need for new loans coincided
more goods and services than it can produce itself with the international banking system’s need to make
(see page 399), but this means it must have a method new loans. This lending pattern came to be known as
of paying for the extra goods and services; borrowing ‘petrodollar recycling’, involving commercial banks
from abroad is one method allowing it to do this. The lending to oil-importing countries the same funds
rationale, over the longer term, is that countries will that came from oil exporters, to allow the developing
spend at least a portion of imports made possible by countries to continue to import oil.
foreign finance on capital goods that are inputs in
production, which will accelerate their growth and As commercial banks competed with each other to
their exports, so that over the longer term they will be lend as much as possible of their petrodollars, they
able to pay back their debts plus interest. did not take care to lend prudently. There was a belief
that if there were losses on their loans (if developing
Yet the developing countries suffering today countries could not make loan re-payments),
from high levels of debt have been victims of an the losses would be covered by the public sector
unfortunate set of circumstances: low growth in (developed country governments, the World Bank and
export earnings, higher import costs, lower than International Monetary Fund).
expected (and sometimes negative) rates of economic
growth, as well as increasing interest rates (which In the meantime, developed country governments
increase the cost of debt servicing). These supported the rapid growth of commercial bank
circumstances give rise to serious problems in the lending to developing countries, because they saw
balance of payments, resulting in an ever-growing petrodollar recycling as an opportunity to cut back on
need for foreign borrowing. foreign aid and development assistance. Developing
countries, for their part, did not always spend the loan
How some developing countries became funds wisely. While a portion of the funds was used
heavily indebted for investments in infrastructure and debt servicing, in
Before the 1970s, borrowing by developing country some countries loan funds supported public spending
governments took place on a small scale. Countries that should have been financed by government tax
borrowed from international organisations like the revenues. This allowed governments to enjoy broad
World Bank and International Monetary Fund as well political support by maintaining low tax rates as
as foreign governments, mainly in order to supplement well as poor and low tax collection. Loan funds were
insufficient savings and increase domestic resources to sometimes used to finance the operation of inefficient
pursue growth and development objectives. public enterprises; even worse, they often disappeared
into the pockets of corrupt bureaucrats and elites.
The beginnings of the debt problem date back to
the oil shock of 1973–74, when the Organization of A second oil price shock occurred in 1979. Apart
the Petroleum Exporting Countries (OPEC) suddenly from increased import costs and reduced export
increased the price of oil. Almost overnight, oil- revenues, developing countries also faced deteriorating
importing developing countries were faced with terms of trade due to falling commodity prices,
larger import expenditures due to higher oil prices. In developed country trade protection, and higher interest
addition, they faced lower export revenues because rates on their loans due to tight monetary policies
the oil price increases created recessions (stagflation) in developed countries. Developing countries were
in developed countries, resulting in a lower demand faced with two options: they could pursue restrictive
for developing country exports. These two events monetary and fiscal policies to create a recession that
resulted in larger trade and current account deficits would cut back on imports, thus saving on the need
in developing countries, creating a need for increased for foreign exchange (expenditure reducing policies;
foreign borrowing that would provide the foreign see page 408); or they could borrow more. As more
exchange needed to cover their deficits. borrowing was preferable to recession, levels of debt in
many countries reached massive proportions.
A related event made it easier for developing
countries to borrow more. After the oil price increases By the early 1980s, the level of debt had grown
the OPEC nations found themselves with much massively in some countries, especially in Latin America
larger oil revenues, much of which they deposited in and Sub-Saharan Africa, and some were on the verge of
commercial banks in developed countries, mainly in bankruptcy. Commercial banks and the international
the United States, Europe and Japan. The commercial community suddenly woke up to the possibility of a
banks, seeing very large increases in their supply of banking collapse and a major global financial crisis,
should countries default on their loans.
520 Section 4 Development economics
Debt rescheduling and conditional country benefits, because it can significantly lower the
assistance level of its debt by giving up some of its assets. Much
of Latin American privatisation occurred this way.
Explain that in some cases countries have become heavily However, a key problem is that foreign corporations can
indebted, requiring rescheduling of the debt payments be persuaded to engage in a debt-for-equity swap only
and/or conditional assistance from international if they acquire the state assets at a low price. As a result,
organisations, including the IMF and the World Bank. governments lose control of some of their major assets
to foreign-owned corporations at a price that is far lower
Beginning in 1982, the international community, led than if these assets were sold at market prices.
by the International Monetary Fund, the World Bank
and the US government, stepped in with a series of Consequences of high levels of
measures to prevent developing country defaults. foreign debt
Debt rescheduling Explain why the servicing of international debt causes
One of these measures was debt rescheduling balance of payments problems and has an opportunity
(restructuring), involving new loans by commercial cost in terms of foregone spending on development
banks to developing country debtors, but on better objectives.
terms. Debt rescheduling did not include debt
forgiveness, as the loan still had to be paid back in full; High levels of foreign debt have strong negative effects
it involved granting of new loans that were stretched on the economies of debtor countries.
out over longer periods of time and at lower interest
rates. The loans were used to pay off some of the old Balance of payments problems
loans, and therefore ease the pain of having to service When a country borrows from foreign institutions,
the debts. whether these are commercial banks or multilateral
organisations like the World Bank and IMF, its debt
IMF lending and stabilisation policies servicing obligations (repayment of loan plus payment of
A second measure involved turning to the International interest) must be paid in foreign exchange. If its export
Monetary Fund (IMF) for loans that would help cover earnings are not enough to cover its foreign exchange
large and growing current account deficits. The role of needs for debt servicing, it can borrow more from abroad
the IMF in this regard was explained on page 518 above. to acquire the needed foreign exchange. However, as it
The loans were conditional in that they were made only borrows more, its debt servicing obligations increase.
if the borrowing country government agreed to pursue This means that there will be continuous pressure on the
stabilisation policies prescribed by the IMF (tight fiscal balance of payments and a constant quest for foreign
and monetary policies, liberalisation policies, etc.). exchange with which to service the debt.
World Bank lending and structural Possibility of a debt trap
adjustment loans As levels of debt rise, there comes a point where the
At the same time that countries turned to the IMF, level of debt cannot be sustained: new debt requires
they often also borrowed from the World Bank, which higher debt service payments, which require more
also made conditional loans. These were the structural foreign borrowing, which leads to more debt servicing
adjustment loans (SALs) explained above on page 516, payments, and so on, in a self-reinforcing spiral in
which forced the borrowing country government to which the country is trapped. This has been termed
pursue economic and trade liberalisation policies to the ‘debt trap’, involving a situation where a country
qualify for receiving a loan. must keep on taking out new loans in order to pay
back the old ones. Many countries, particularly in
Other initiatives: debt-for-equity swaps Latin America and Sub-Saharan Africa, were caught in
Another measure involved ‘debt-for-equity swaps’. a debt trap during the 1980s.
This occurs when a highly indebted country exchanges
a portion of its debt for equity, which is taken up by Opportunity costs
foreign corporations. What this means is that the Large debt service payments have major opportunity
foreign corporation takes responsibility for a portion of costs because the government has fewer resources to
a government’s debt, and in exchange the government invest in social services (health, education, etc.) and
gives it ownership of some of its assets (such as a infrastructure, all necessary for poverty alleviation and
telephone company or a steel mill). The indebted economic growth and development.
Chapter 18 Foreign sources of finance and foreign debt 521
In addition, since a highly indebted country is made available through debt relief, in other words
forced to use a large portion of its export earnings the country’s savings from debt reduction, must
for debt servicing, it has less foreign exchange to be spent on projects that attack poverty, such as
pay for imports of needed capital equipment, other the development of rural infrastructure, providing
production inputs and goods and services generally. health services and education, creating new jobs, and
The foregone imports are an additional opportunity providing family planning services.
cost with negative consequences for economic
growth. The HICP Initiative is considered to be a welcome
step in the direction of solving the debt problem, but
Lower private investment has been criticised for several reasons:
Fears that a government may be unable to service
its debts create uncertainty regarding economic • The level of debt reduction which the programme
conditions and scare away private investors, both makes possible (level of debt is to be reduced to
domestic and foreign. Even if investment does 150% of exports) is considered insufficient; if a
take place, it is more likely to involve short-term country’s export earnings fall for whatever reason, it
investment projects with quick returns, rather than risks sliding back towards a debt trap.
longer-term ones with greater potentials to support
economic growth. • The programme takes effect too slowly, risking that
the benefits of debt relief may follow too slowly to
Lower economic growth be of much use to the countries.
The above three factors, lower public investments in
merit goods, lower imports of production inputs and • Some measures that are imposed as conditions for
lower private investment, work to lower economic a country to qualify are too severe (for example,
growth in highly indebted countries. This in turn charging fees for schools and hospitals, privatising
translates into a reduced ability to service debts. key public enterprises such as electricity and
telephone, reductions in government expenditures
Debt cancellation and the that reduce the provision of social services and
HIPC initiative infrastructure).
Explain that the burden of debt has led to pressure to • There are many other countries that are highly
cancel the debt of heavily indebted countries. indebted but which have not been included in
the HIPC Initiative; these countries, whose debt
The difficulties caused by high levels of debt situation is considered to be more manageable, are
have led to pressure on creditors to cancel debts still suffering the consequences of high levels of
of highly indebted countries. In 1996, the World debt, yet are unable to benefit from debt relief.
Bank and IMF began the Heavily Indebted Poor
Countries (HIPC) Initiative, intended to provide Test your understanding 18.4
debt relief to some highly indebted poor countries
by cancelling a portion of their debts. In 2005, this 1 (a) What is the meaning of foreign debt?
was supplemented by the Multilateral Debt Relief (b) Why do economically less developed
Initiative (MDRI), which provides 100% debt relief countries borrow from abroad? (c) How did
for debts by three multilateral organisations (the many developing countries find themselves
International Development Association (IDA) of the with high levels of foreign debt?
World Bank, the IMF and the African Development
Fund). 2 (a) Explain the policies adopted by the IMF and
World Bank to help countries with high levels
To qualify for debt cancellation, countries must of foreign debt meet their debt obligations.
have a per capita GNI below a particular level; they (b) Why have these policies been criticised
must have a debt level that cannot be sustained (refer also to pages 516 and 518)?
(i.e. they must be in a debt trap); they must show
evidence that they are following certain elements 3 What are the main economic consequences
of IMF and World Bank policies (such as cutting of high levels of foreign debt for developing
government expenditures and liberalising their countries, and how do these affect their growth
markets); and they must commit themselves to and development efforts?
pursuing a poverty reduction strategy. The funds
4 (a) What are some debt relief initiatives?
522 Section 4 Development economics (b) What would be some advantages of debt
cancellation for heavily indebted countries?
Assessment Higher level
• Exam practice: Paper 2, Chapter 18
The Student’s CD-ROM at the back of this book
provides practice of examination questions based on SL/HL core topics (Text/data 19–26, questions
the material you have studied in this chapter. B.10–B.23)
Standard level
• Exam practice: Paper 2, Chapter 18,
SL/HL core topics (Text/data 19–26, questions
B.10– B.23)
Chapter 18 Foreign sources of finance and foreign debt 523
Development economics
Chapter 19
Consequences of economic
growth and the balance
between markets and
intervention
In this chapter we will consider two final topics, the consequences of economic growth and the balance between
markets and government intervention.
19.1 Consequences of economic This indicates that there is a greater potential for people
growth to increase their consumption of goods and services, and
Discuss the possible consequences of economic growth, improve their standards of living.
including the possible impacts on living standards, However, remember that GDP per capita or income
unemployment, inflation, the distribution of income,
the current account of the balance of payments, and per capita is only an average measure, and does not
sustainability. tell us how the increase in income is distributed or
whether there is a broadly distributed improvement in
This topic is actually part of Chapter 11 (page 301) but living standards. More appropriate measures of living
is discussed here because it requires an understanding standards are provided by the Human Development
of topics considered in subsequent chapters. Index (HDI; see Chapter 16, pages 450–51), as well
as other indicators of development, such as infant
Economic growth impacts upon many aspects of mortality or maternal mortality (see page 456). The
the economy, and some of its possible consequences interesting question therefore is whether economic
are positive while others may be negative. It is growth leads to human and economic development,
important to note that many of these consequences, measured as improvements in a country’s HDI or
whether positive or negative, are not inevitable, but other development indicators. (See also pages 13
rather follow from the ways that growth is pursued. and 436–38 on the relationship between growth and
development.)
Economic growth and living standards
According to studies making cross-country
If the total GDP of a country increases faster than its comparisons, economic growth is associated with
population, then an increase in GDP per capita results. improvements in indicators measuring economic and
human development.1 This is what we would expect,
1 International Monetary Fund (2001) Finance and Development, since growth provides additional resources allowing
Volume 38, Number 2, June. for improvements in standards of living. However,
524 Section 4 Development economics
improvements in development indicators are highly example, very poor countries need to invest more
variable, so that for a given rate of growth they in primary education to achieve universal literacy
are in some cases small and in others much larger. (see page 457), rather than in secondary or tertiary
What accounts for differences in the contributions education. Some countries may need to invest more
made by economic growth to standard of living in safe drinking water or sanitation rather than
improvements? in health care services in order to have a greater
impact on health. The greater the effectiveness
According to an important study of this topic of spending, the greater the impacts on human
for developing countries,2 major factors allowing development.
economic growth to have positive effects on
economic and human development include the For example, Nepal showed the fastest increase in
following: its HDI in the period 1980–2007, whereas its rates
of economic growth have been low, averaging 1.9%
• The distribution of income. The greater per year over 30 years.3 Yet India, with much higher
the income going to poorer households, the growth rates, has made much smaller progress
greater the potential for contributing to human in its HDI. Nepal’s progress is attributed to the
development, as the poorer households are emphasis placed by the government on education
those with the greatest deprivations in terms of and health.
education and health. If increases in income made
possible by economic growth bypass the poorer A major study of data between 1970 and 2005 for
households, growth has limited effects on human 111 countries by the United Nations Development
development. Programme (UNDP)4 shows that the greatest
improvements in literacy and life expectancy (two
• Household spending on items that promote components of the HDI; see page 459) are not occurring
human development. The greater the share of in the fastest growing economies of the world (the only
household income spent on goods and services such two exceptions being China and Korea). Factors
as food, education and health care, the greater the contributing to HDI improvements are government
effect on human development. expansion of education and health care, together
with the international community’s contribution of
• The share of income controlled by women. vaccines and antibiotics. According to the head of
The greater this is, the stronger the impact on the report’s research team, ‘The increase in human
human development (see also page 470 on the role development is actually an example of how state
of women). intervention works’.
• Government spending on items that Therefore, while economic growth offers the potential
promote human development. This relates to achieve improvements in human development and
to the share of the government budget allocated standards of living, these improvements do not occur
to priority areas like education, health care and automatically as a result of economic growth but require
infrastructure including clean water supplies and appropriate policies to make effective use of the
sanitation; the larger this is, the greater the effects resources growth makes available.
of growth on human development.
Economic growth and unemployment
• Contributions by non-governmental
organisations (NGOs). Because of their poverty To understand the effects of economic growth
orientation and their general effectiveness on unemployment, we must make a distinction
in reaching poor people, NGOs contribute between different types of unemployment, the
to increasing the impact of growth on more key distinction being between cyclical and natural
development and higher standards of living. (of which structural is the most important). In
addition, it is useful to make a distinction between
• Effectiveness of spending to promote economic growth occurring in the expansionary
human development. Depending on their phase of the business cycle, and long-term economic
level of development, different countries have
different needs, which determine the effectiveness
of spending to achieve human development. For
2 Gustav Ranis and Frances Stewart, ‘Economic growth and 4 United Nations Development Programme, Human Development
human development in Latin America’ in Cepal Review, Report 2010.
December 2002.
3 United Nations Development Programme, Human Development
Report 2009.
Chapter 19 Consequences of economic growth and the balance between markets and intervention 525
growth shown by increases in potential output (see It follows then, that long-term reductions in
Chapter 9, page 256). unemployment require economic growth, but not all
economic growth results in lower unemployment.
Economic growth due to the expansionary phase While economic growth offers the potential to reduce
of the business cycle affects cyclical unemployment, unemployment, whether or not this will occur depends on
which as we know falls in an expansion (and the particular factors and policies that lead to growth.
increases in a contraction). If aggregate demand
continues to increase beyond the full employment Economic growth and inflation
level of real GDP, leading to an inflationary gap,
unemployment falls below the natural rate. As in the case of unemployment, it is useful to make
However, this will only be temporary as government a distinction between economic growth due to the
authorities are likely to step in with contractionary expansionary phase of the business cycle, and long-
policies intended to close the inflationary gap and term economic growth or increases in potential
bring real GDP back toward its potential level with output. In addition, the effects of growth on inflation
unemployment returning to the natural rate. depend partly on whether we use a monetarist/new
classical or Keynesian approach.
Therefore, economic growth due to the short-term
fluctuations of the business cycle can mainly reduce In the expansionary phase of the business cycle,
(and possibly eliminate) cyclical unemployment, as real GDP increases due to increases in aggregate
but with only a temporary impact on natural demand, the price level remains constant in the
unemployment. Keynesian model because of spare capacity and the
presence of unemployed resources in the economy;
Sustained (not temporary) reductions in natural, this involves real GDP increases along the horizontal
and particularly structural, unemployment may result part of the AS curve, as shown in Figure 9.13
from long-term economic growth, involving increases (page 254). However, as real GDP approaches the
in potential output, shown by rightward shifts in the level of potential output, resource bottlenecks
LRAS or Keynesian AS curves (see page 256). Increases begin to cause increases in resource and product
in potential output are caused by supply-side factors, prices, and continued aggregate demand increases
such as increases in resource quantities, improvements beyond the level of potential output become highly
in resource quality, technological change, etc. inflationary.
However, not all increases in potential output lower
natural unemployment. Depending on the particular In the new classical/monetarist model, an increase
factors that cause potential output to increase, natural and in aggregate demand always causes an increase in the
price level, even if the economy is initially in recession
therefore structural unemployment may increase, decrease, (see Figure 9.4(a), page 245); in the long run an
increase in AD leads only to price level increases (see
or remain the same. Figure 9.13, page 254).
In certain situations, economic growth may itself Therefore, while there is disagreement between the
lead to increases in structural unemployment (a two models on what happens to the price level in a
part of natural unemployment). This could occur recession, there is agreement between them that growth
when growth results from technological changes caused by increases in aggregate demand at about or
leading to a fall in the demand for certain labour beyond the level of potential output is inflationary.
skills (see page 268). In developing countries, growth
could result from the introduction of inappropriate In addition, there is agreement between the two
technologies (such as capital intensive technologies), models that long-term economic growth, involving
which would cause unemployment to rise. increases in potential output, work to reduce
inflationary pressures. This can be seen clearly in
Economic policies pursued by government can Figure 9.15 (page 256), where increases in aggregate
also work both ways, either increasing or reducing demand are matched by increases in the LRAS
unemployment over the longer term. This topic was and AS curves respectively. With increases in the
discussed in Chapter 12, page 344, where our analysis productive capacity of the economy due to economic
of the effects of supply-side policies on unemployment growth, growth in aggregate demand can be easily
showed that market-based policies based on labour met without causing upward pressures on the price
market reforms, and certain interventionist policies level. (See also the discussion on the ability of
including investments in human capital, can work supply-side policies to reduce inflationary pressures,
to reduce the natural rate of unemployment. Other page 344.)
market-based policies, however, such as privatisation,
and trade and market liberalisation, may work to
increase it.
526 Section 4 Development economics
Economic growth and the distribution economies (in central and eastern Europe and
of income the former Soviet Union) have additionally been
influenced by the switch to market economies and the
A large number of studies have been carried out loss of government protection of vulnerable groups.
investigating the relationship between growth in In developing countries, income inequalities increased
GDP per capita and income distribution in developing due to economic and trade liberalisation, which
and developed countries. The results have been we have seen gives rise to both winners and losers
inconclusive: while in some countries income (Chapter 17, page 486). While those who can take
distribution worsened in the early periods of growth advantage of new opportunities gain, many become
and then improved, in some others the opposite worse off, if they are less educated or skilled, cannot
happened, while in many others, income distribution get credit, are geographically isolated, have nothing to
did not show any clear pattern of change. These results produce for export, lose their jobs due to privatisations
lead to the conclusion that there is no clear relationship or reductions in the size of the government sector,
between growth in GDP per capita and income distribution; and so on.
instead, what happens to income distribution as a
country grows is a reflection of particular conditions In addition, income distribution in developing
in each country and the kinds of growth policies that countries can worsen as a result of economic growth
are pursued. due to inappropriate government policies, such as:
For example, many countries in Latin America had • the introduction of capital-using (labour-saving)
highly unequal income distributions to begin with; technologies in industry and agriculture, creating
income distribution in these countries has tended rural and urban unemployment
to remain highly unequal. A number of countries in
East Asia (for example Taiwan and South Korea) had • low levels of government investment in human
far more equal income distributions when they began capital, which negatively affect people on lower
their rapid growth, and this remained so even with incomes and the poor disproportionately more
rapid growth during the 1970s and 1980s. In addition, than wealthier people
countries of East Asia placed a strong emphasis on the
development of human capital, a policy that played • allocating most services and infrastructure
a key role in ensuring broad-based participation in investments to urban areas and ignoring the rural
the benefits of growth, with positive effects on the sector where most of the poor live
equality of income distribution.
• within the urban sector, concentrating
Yet, income inequalities in many countries around infrastructure and services investments within
the world have been widening over the past three or the formal (modern and highly paid) sector and
so decades. They have been growing in China, India, ignoring the urban slums.
Indonesia, Thailand and other East Asian and South-
East Asian countries that had achieved greater income You may remember that many of the policy
equality and reductions in poverty in their early years prescriptions of the New Development Consensus
of growth. Russia and most other central and eastern emerging in the late 1990s to early 2000s (see
European countries have similarly been experiencing Chapter 17, page 487) try to address these kinds
sharp rises in income inequalities. A number of of problems. If countries follow these policy
countries in Latin America have seen growing prescriptions, they may prevent a further worsening
inequalities as well. Almost all OECD5 countries in income distribution and may even see an
also show worsening income distributions, with the improvement, even as they continue to experience
most serious deteriorations appearing in Sweden, economic growth.
the United Kingdom and the United States. Some of
these countries have also experienced increases in the It can therefore be concluded that economic growth is
number of households below the poverty line. neither ‘good’ nor ‘bad’ for income distribution; this instead
depends very much on the kinds of policies countries adopt
In both developed and developing countries, a in order to achieve growth.
major factor behind increasing income inequalities
has been the growing use of market-based supply- Economic growth and the current account
side policies (see Chapter 12, page 344). Transition
Short-term economic growth, occurring over the
business cycle, may lead to a larger current account
5 The OECD is the Organisation for Economic Co-operation and
Development.
Chapter 19 Consequences of economic growth and the balance between markets and intervention 527
deficit (or a smaller current account surplus). The Therefore, in examining the relationship between
reason is that increasing incomes lead to an increase economic growth and the current account balance of
in the demand for imports, and therefore a worsening a country, we may find economic growth leading to a
balance of trade (the most important part of the larger deficit or smaller surplus in the upward phase of the
current account balance). This is especially the business cycle, while over the longer term we are likely to
case if consumers’ marginal propensity to import is find that there is no clear relationship: as the economy
high, indicating that a large fraction of an increase in grows, the current account balance may improve, stay
incomes leaks out of the spending flow to purchase the same or worsen, depending on what happens to
imports (see Chapter 8, page 217); or when the the factors listed above.
demand for imports is income elastic, indicating that
a given percentage increase in income will lead to Economic growth and sustainability
a proportionately larger increase in the quantity of
imports demanded. Experience shows that growth, especially rapid
growth, often leads to unsustainable resource use
However, when a country experiences long-term (particularly in the case of common access resources;
economic growth, the trade balance (and the current see Chapter 5, page 123). For example, very high
account balance) are determined by factors that are growth rates in East Asian countries have been
likely to be unrelated to the rate of economic growth, associated with serious environmental losses taking
such as the following: the form of very high levels of urban air pollution,
soil degradation due to soil erosion, waterlogging
• The international competitiveness of and overgrazing, threats to biodiversity, and
domestic industries. If domestic industries serious deforestation. The reasons were explored in
are efficient, low-cost producers, they may have Chapter 5. Industrialisation based on fossil fuels is
a competitive advantage over other countries, a major source of pollution (negative production
resulting in higher levels of exports, and therefore a externalities). Increasing incomes lead to consumption
smaller trade deficit (or larger trade surplus) even as patterns also based on greater fossil fuel consumption
the economy grows. (use of cars, air conditioners, etc., creating negative
consumption externalities). Other activities, such as
• Exchange rates. If the country’s exchange rate is commercial logging and agricultural practices based
weak or undervalued (relative to its market value; on a lack of pricing mechanism for common access
see page 391) it creates an artificial competitive resources result in their unsustainable use. In addition,
advantage, resulting in more exports and fewer economic activities due to poverty similarly lead to
imports, working to reduce the size of a trade environmental losses.
deficit, even as the economy may be growing.
Experiences like these have led to the widespread
• The degree of export orientation of the belief that economic growth and environmental
economy. Economic growth that depends heavily sustainability are conflicting objectives: more of one
on increases in exports may result in strong trade means less of the other. Many governments around
surpluses even as incomes increase. A good example the world base their policies on this belief by following
is China, which has been achieving high rates of the ‘grow now, clean up later’ way of thinking, which
growth together with large trade surpluses. argues that since using resources to preserve the
environment reduces growth, it is preferable to pursue
• Growth of incomes of trading partners. growth with all its negative effects on the environment,
If incomes abroad are growing rapidly and and postpone the ‘clean-up’ job of environmental
for extended periods, there will likely result preservation for later when incomes will be higher.6
increases in exports, even as the country itself is This way of thinking is followed not only by rapidly
growing. growing economies, but also slow-growth economies,
because the evidence shows that even countries that
• The degree of protectionist trade policies do not experience rapid growth also suffer major
faced by exports. If a country’s exports do not environmental losses.
face trade barriers in other countries, it may be able
to increase its exports (assuming it is an efficient
producer) even as its economy grows.
6 For example, the installation of pollution-control equipment Setting limits to deforestation for timber places restrictions
involves greater costs for firms, which may mean lower profits, on the growth of the timber industry. Therefore, allocating
lower investment and lower economic growth. Switching to resources for environmental protection arguably translates
environmentally sound agricultural practices similarly involves into smaller increases in output and hence lower economic
costs that may cut into future economic growth prospects. growth.
528 Section 4 Development economics
Theory of knowledge
The conflict between economic growth and sustainability
The apparent conflict between growth and sustainability of goods and services would include improvements in
arises because of the way economic growth is defined. The the quality of environmental resources resulting from
idea of conflict follows from the conventional measure investments in natural capital.
of economic growth, taken to be the increase in real GDP
per capita. This in turn depends on the definition of GDP, The problem of the conflict between growth
which is the value of all goods and services produced in a (conventionally defined) and sustainability is related
country in the course of a year. to economists’ systematic neglect of the factor of
production ‘land’. Growth models in mainstream
As you may remember from Chapter 8, this measure economics show how output increases in relation to
of aggregate output suffers from a serious limitation labour and capital (in the sense of physical capital),
because it does not account for environmental and sometimes also considering human capital, while
human health losses that arise from environmental completely ignoring land, that was taken to be an
degradation. This limitation would be corrected unimportant factor that was permanently fixed in
if countries adopted green accounting methods quantity and quality. It is only in recent years that land
that calculated green GDP (page 225). If economic has been redefined by environmental economists to
growth was calculated as rates of increase in green consist of ‘natural capital’, which can be destroyed or
GDP per capita, environmental destruction (as well improved through investments (see page 297).
as possible negative health consequences) would be
accounted for in the measure of GDP, which would be Thinking points
correspondingly reduced: we would find that in most
countries around the world economic growth rates • How does the way we think of (or define)
would be far lower than those based on conventional growth affect its relationship to the environment?
GDP measures, and in many cases would be negative.
If a country has positive GDP per capita growth but • Do we have a moral obligation to nature and the
negative green GDP per capita growth, this means that environment?
its losses due to environmental degradation are greater
than its gains due to increased production of goods • Is our choice of how to measure growth based on
and services. economic or moral criteria (or both)?
If economic growth were defined as increases in green • If growth were defined as increases in green real GDP
real GDP per capita, the only way to achieve high rates of per capita, would there be a conflict between growth
growth would be by increasing the production of goods and sustainable resource use?
and services without causing environmental destruction
(or causing only small amounts of environmental • If governments began using green accounting
destruction); alternatively, increases in the production methods, would production and consumption
patterns necessarily change so as to become more
consistent with sustainability?
Yet, there are a number of things seriously policies aiming to limit negative environmental
wrong with this way of thinking. One is that some externalities. A third, related reason is that it is
environmental damage is irreversible; it will not be not growth itself that is bad for the environment, but
possible to correct the damage in the future, and rather the ways that growth is pursued. If growth
some resources will be lost forever. For example, lost were pursued differently, it need not conflict with
biodiversity can never be recovered; lost lives due environmental sustainability. A fourth reason is that
to pollution-induced illnesses can similarly never growth based on unsustainable resource use may lead
be recovered. A second is that it justifies government to destruction of natural resources on such a wide scale
inaction on the environment. Governments and policy- that the possibility of continued future growth may be
makers often wrongly assume that environmental threatened.
issues will automatically be regained in the future
as incomes increase with growth. This is unrealistic, Modern growth theory shows that economic
because preservation of the environment requires growth and environmental sustainability are in fact
consistent with each other, and can be successfully
Chapter 19 Consequences of economic growth and the balance between markets and intervention 529
pursued together under certain conditions, such as the A concluding note
following:
We have examined the effects of economic growth on
• Governments implement market-based policies that a number of factors. Note that all these factors can also
‘internalise the externalities’, thus not only correcting impact on economic growth:
them (at least in part) but also providing incentives
for sustainable resource use and promotion of green • Living standards. Economic growth can
(or ‘clean’) technologies (see page 105). be expected to impact on living standards,
but improved living standards measured as
• Governments pursue more environmental improvements in human development, involving
regulations that encourage pollution-free improved human capital or reduced income
technological change (green technologies). inequalities, are major factors contributing to
economic growth (see pages 463 and 473).
• There is an increased emphasis on human capital in
production (which is pollution-free) as opposed to • Unemployment. Economic growth may
physical capital. lower cyclical or structural unemployment, but
reductions in unemployment can contribute
• An increased emphasis on ‘green’ investments, to economic growth by making better use of
which promote growth while not hurting the available resources (movement closer to the
environment: building public transportation economy’s production possibilities curve (PPC);
systems; investing in insulation in homes and see page 295).
buildings; investing in clean technology research
and development (R&D) and clean technologies (see • Inflation. Economic growth may contribute to a
page 128). higher rate of inflation, but a high rate of inflation
may contribute to lower economic growth, by
• There are changes in the structure of the discouraging investment (see page 279).
economy toward more services (which tend to be
pollution-free), together with more investments in • Distribution of income. Economic growth can
the protection of natural resources. make the distribution of income more or less equal
(equitable), but a more equal distribution of income
As incomes increase with economic growth, has a positive effect on growth (see page 473).
more resources are made available with which
governments can pursue the above kinds of policies, • Current account of the balance of payments.
encouraging economic growth at the same time Economic growth may worsen the current account,
that they encourage sustainability. Therefore, but a serious current account deficit can lower
economic growth and sustainability can be pursued economic growth by increasing the need for foreign
together provided governments take appropriate borrowing (see page 407).
measures to ensure sustainable resource use. This is the
very meaning behind the concept of ‘sustainable • Sustainability. Economic growth that
development’ (see page 122). ignores the effects on the environment
leads to environmental unsustainability, but
However, even under the best possible unsustainability also leads to lower economic
circumstances where all of the above conditions growth due to destruction of common access
are fulfilled, modern growth theories show that resources. On the other hand, economic growth
there is a maximum rate of growth that is consistent based on the principle of sustainable development
with environmental sustainability, and that if an leads to environmental preservation, which in turn
economy exceeds this rate, resource use will can be expected to lead to higher economic growth
become unsustainable. The reason is that pursuit of in the future.
sustainability uses up some resources (for example
anti-pollution controls, costs of regulation, etc.), and The likelihood of a two-way causality, where economic
these resources represent an opportunity cost in terms growth impacts upon factors such as the above, and
of lost economic growth. Note, however, that this where these factors in turn impact upon economic
only applies to a loss of a portion of very high rates of growth, sometimes makes it difficult in the real world
growth.7 to determine what causes what.
7 You may be wondering what these rates of growth are. It is not enough is known about the costs and benefits of growth and
possible to attach numerical values to these given the present environmental sustainability.
state of economists’ and scientists’ knowledge, because not
530 Section 4 Development economics
Test your understanding 19.1 Market-oriented policies are based on the idea that free
markets, working under competitive conditions, offer a
Explain the possible consequences of economic method to answer the what to produce and how to produce
growth on (a) living standards, (b) unemployment, questions of resource allocation in the best possible
(c) inflation, (d) income distribution, (e) the way. With market-determined prices working as signals
current account, and (f) sustainability. and incentives, markets co-ordinate the countless
independent decisions of consumers, firms and resource
19.2 Balance between markets owners, allowing social surplus to be maximised, thus
and intervention achieving allocative efficiency (see page 43).
Most countries in the world today are mixed market At the same time, the pursuit of self-interest by
economies, meaning economies strongly based all economic decision-makers (consumers, firms and
on markets, but with a degree of government resource-owners) gives rise to incentives for hard work,
intervention. However, countries differ enormously risk-taking, innovation and investment, which lead
with respect to the degree and types of government to higher levels of output (economic growth) and
intervention. This raises the questions: how much possibly higher standards of living. The operation of
should governments intervene in developing markets therefore also promotes general welfare by
countries, and what are the appropriate roles of achieving economic growth.
markets and intervention? This topic directly addresses
one of the four central themes of this course (page 14). It thus follows that policies encouraging
competition, such as deregulation, privatisation and
This section brings together many topics examined in anti-monopoly regulation, which work by freeing
previous chapters. You will therefore frequently be referred market forces and making markets more competitive,
to the relevant pages for a review of the important issues. are intended to result in greater efficiency in
production, lower prices and improved quality, and
Strengths and weaknesses of market- a better allocation of resources, as well as increased
oriented policies levels of output, or economic growth.
Market-oriented policies, as the term suggests, are Labour market reforms similarly promote free
based on the market mechanism introduced in Chapter 2. market forces in labour markets, allowing the
Market-oriented policies we have studied include: allocation of resources to improve. Incentive-related
policies, involving adjustments to various types
• market-based supply-side policies, including: of taxes, are intended to work by improving the
policies encouraging competition (deregulation, incentives to work, innovate and invest, thus making
privatisation and anti-monopoly regulation the signalling and incentive functions of the price
(page 340) mechanism more effective, again improving the
labour market reforms (page 341) allocation of resources and also allowing for economic
incentive-related policies (page 342) growth.
• trade liberalisation (free or freer trade; page 485) Trade liberalisation is based on the same ideas, and
• freely floating exchange rates (page 382) has the same intended benefits. The elimination of trade
• liberalised capital flows, or the absence of exchange barriers and the opening up of countries to free trade
has the effect of making markets much larger than they
controls which limit the amount of foreign would be with trade barriers. The result of larger free
exchange that can be purchased with the domestic markets is to increase competition, increase efficiency in
currency (page 495). production, lower prices and improve quality, increase
consumer choice, improve the allocation of resources,
Strengths and allow for greater economic growth.
Discuss the positive outcomes of market-oriented policies Freely floating exchange rates are simply another
(such as liberalised trade and capital flows, privatisation aspect of the price mechanism of free markets. A
and deregulation), including a more efficient allocation of market-determined exchange rate is one that reflects
resources and economic growth. the forces of supply and demand for a currency, and
therefore can effectively carry out the signalling and
incentive function of prices (here applied to the ‘price’
of a currency) for those carrying out international
transactions of all kinds. Just as a market-determined
price of a good ‘clears’ the market, so too a freely
floating exchange rate automatically adjusts to excess
Chapter 19 Consequences of economic growth and the balance between markets and intervention 531
demand or supply of a currency, bringing about a firms would be able to increase their output if they
balance in the balance of payments and offering began producing in a market requiring skilled labour.
greater flexibility to policy-makers to pursue policies However, they will not enter this market if the skilled
needed domestically (see page 403). labour is not available; at the same time, workers will
not acquire the skills if the firms that could hire them
Liberalised capital flows (or absence of exchange do not exist. As a result, the firms do not enter this
controls) allow domestic residents to purchase any market, and the workers do not acquire the skills. Both
amount of foreign exchange without restrictions, the firms and the workers get stuck in a position where
whether for imports, or for travel or investment abroad, they are worse off than they would have been if they
etc. This is important for attracting multinational could co-ordinate their activities and simultaneously
corporations (MNCs) because it means the MNC is free enter the new market and acquire the necessary skills.
to repatriate profits or to purchase inputs from abroad
(import them). In addition, free capital flows mean a In another example, farmers could increase their
more efficient global allocation of savings, since savers production of agricultural goods for sale in the
are free to make financial investments anywhere in market, but to do this they need intermediaries, or
the world without restrictions, in accordance with the ‘middlemen’, who will effectively represent them in
expected profitability of their investments. distant markets. As long as the middlemen are not
available, the farmers will not begin producing for
Weaknesses the market; and as long as the agricultural output for
the market is not produced, the middlemen will not
Discuss the negative outcomes of market-oriented become available.8 The farmers get stuck in a position
strategies, including market failure, the development of a where they are producing less output than they could,
dual economy and income inequalities. and potential middlemen that could have benefited
themselves and the economy do not emerge. Everyone
Market failure is worse off, and the possibilities for expanding output
One of the most important weaknesses of market- remain unrealised.
oriented strategies is that they cannot deal with the
issue of market failures, discussed in Chapter 5. While Co-ordination failures arise when two or more
this issue is important for any country, it is of special activities that must begin simultaneously fail to do
importance in many developing countries where so, even though decision-makers make economic
market failures of all kinds are far more widespread. decisions that are in their best self-interest. The
inability of decision-makers to co-ordinate their
Market failures we have studied include: behaviours results in an outcome where everyone
is worse off than they would have been had co-
• negative environmental externalities (of production ordination been possible. These failures lead to
and consumption) and the problems of common underdevelopment traps, where people are trapped in
access resources a situation from which they cannot escape without
outside help.
• insufficient provision of merit goods (goods with
positive consumption externalities) including Weak or missing market institutions To be able
education, health care and infrastructure, such as to function effectively, markets need an institutional
sanitation, clean water supplies, road and transport and legal environment that is often missing in less
systems, irrigation, power supplies, etc. developed countries (and some transition economies).
This environment must include enforcement of
• failure to provide public goods property rights, enforcement of legal contracts,
effective legal recourse, a stable currency, a well-
• abuse of monopoly power developed banking and insurance system, an effective
road and utility infrastructure system, and readily
• information asymmetries available information on prices, quantities and
quality of goods, services and resources to consumers,
There are two additional failures of concern to firms and resource owners. In the absence of these
developing countries: co-ordination failures and weak conditions, markets are highly imperfect in their
or missing market institutions. functions and fail to function effectively.
Co-ordination failures Co-ordination failures
provide a possible explanation for the failure of firms
to be set up and to contribute to growth. Suppose that
8 See Michael P. Todaro and Stephen C. Smith (2006) Economic
Development, Pearson Education, where these ideas are explored
more fully.
532 Section 4 Development economics
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