Tuesday, 28 July 2009

Economic and export diversification are necessary conditions for development, but how do we achieve them?

by Xavier Cirera

For over 50 years economic and export diversification have ranked very high on the list of priorities for development policy. Already by the 1950s, the debates around the Prebisch-Singer hypothesis and the need for industrialisation, prioritised the need to diversify economies away from primary commodities because of unfavourable and declining terms of trade.

History shows that – at least until relatively high levels of per capita income are reached – economic development is associated with the evolving diversification of production into a progressively wider array of new types of industries and exported products (Imbs and Wacziarg, 2003). Diversification is associated with higher growth and makes economies less vulnerable to external shocks.

Export diversification is one of the main priorities of Aid for Trade programmes. The recent OECD report on Aid for Trade (Aid for Trade at a Glance 2009) identifies diversification as a binding constraint and a priority for these programmes. Also, more recently diversification appears to be a key component of climate change policies. In order to achieve resilient growth, economies need to diversify away from products with high-carbon emissions and commodities that are more vulnerable to climate shocks.

The list of benefits is long and clear, but what is not at all clear is how to achieve diversification. In fact, the record for most developing countries in the last decade of high economic and export growth shows little progress in this area. Most export growth has been with traditional exports, taking advantage of the most favourable commodity prices. So the question is do we know how to achieve diversification? More importantly how do firms introduce new products? I am afraid that we still do not have proper and effective answers to these questions.
Reference: Jean Imbs and Romain Wacziarg (2003) 'Stages of Diversification', American Economic Review, American Economic Association, 93.1: 63-86

Friday, 26 June 2009

Cold Shoulder for the UN Financial Crisis Meeting

by Richard Jolly

The meeting of the G20 last April was a big event – 20 countries attended, including most of the international economic power brokers. In contrast, the United Nations Conference on the World Financial Crisis and its Implications for the Developing World, which opened in New York on Wednesday 24 June, has only low level delegations from the developed countries, by Tuesday 23 the US had not even confirmed its participation.

The general coolness of the developed countries is hardly surprising. It has always been their policy to treat the UN as a sideshow on economic matters. Serious debate and decisions, they believe, should be taken in the Bretton Woods Institutions, where voting is weighted in their favour.

This approach is unfortunate. It leaves the developed countries visibly continuing policies which lack legitimacy and are failing the poorer countries. A common criticism of the G20 was that it excluded the great majority of middle-sized and poorer countries – some 170 out of the 192 UN member states.

This sidelining ignores the UN’s record of past contributions. It is the UN which first came up with the need for debt relief for poorer countries in the 1970s, adjustment with a human face in the 1980s, proposals for the Millennium Development Goals in the 1990s. All these ideas were met with scepticism or opposition when first proposed but later became mainstream. The world would arguably have lower levels of poverty and inequality if they had been accepted and adopted sooner.

This UN conference has already come up with a number of specific proposals for tackling the crisis, focussing on the needs of all countries with clear attention to the smaller and poorer ones not invited to the G20.

Like the G20 proposals, the UN Commission recommends a number of counter-cyclical measures of stimulus, co-ordinated to hasten recovery from the crisis, to hold back protectionist actions and to introduce greater regulation over financial and other markets. These measures are set in a frame of longer-term actions to tackle climate change and other environmental threats. The approach makes the important point that though decisions on these actions must be national, their adequacy must be judged on their global impacts.

The proposals also include a number of recommendations from which poorer developing countries would directly benefit including the creation of a new credit facility, new mechanisms for innovative finance, more policy making space for developing countries and opening advanced country markets to least developed countries’ exports.

The Commission has also proposed ideas for institutional reform of the International Monetary Fund (IMF). These included not only more seats and voting power for developing countries, in line with G20 proposals, but also the introduction of double or multiple majority weighting. This would be a major step toward credibility and legitimacy of decisions of the Bretton Woods Institutions. The Commission also proposed a Global Economic Coordination Council, as a global representative forum meeting annually at Head of State level, bringing together all the important global economic institutions, such as World Bank, the IMF, the World Trade Organisation, the International Labour Organisation and the UN secretariat and supported by an International panel.

There are other proposals – many sensible, many long-term, all bold. The agenda for debate and discussion is far more creative than emerged from the G20 and the proposals deserve serious consideration and it is in the interests of all countries to take them up in the months ahead. There is something for every part of the world to gain by avoiding repetition of the most serious financial crisis since the 1930s.

Tuesday, 2 June 2009

Larry Elliott is wrong about the 'shortage' of great economists

by Neil McCulloch

Was anyone else disappointed to read Larry Elliott's article in the Guardian on 1 June bemoaning the 'shortage' of great economists today? It demonstrates how out of touch with the real world of economics he is.

There are many superb economists working on extremely policy relevant issues affecting the world today. As only one example, last week I interviewed Paul Collier at the University of Oxford – an enormously influential economist who is tackling real policy problems about what generates and what stifles growth.

There are many others, including in the UK. Larry Elliott’s rant simply demonstrates how out of touch he is with the modern profession. He perpetuates the myth that economists only teach perfect competition, or that we believe that the price mechanism always works to align demand with supply. This is nonsense. Most of the maths that he complains about is trying to model the infinitely more complex world of uncertainty, imperfect competition, and asymmetric information. This is a point which the only modern economist he praises, Paul Krugman, makes with elegance in his chapter Models and Metaphors about the value of mathematical models in his excellent Development, Geography and Economic Theory (MIT, 1997).

Thursday, 21 May 2009

Empowering the IMF to do Business as Usual

By Xavier Cirera
In his entry on 18 May, John Humphrey clearly framed the implications of the current financial crisis for development and development studies into two sets of issues: i) what elements of the crisis will not return to where they were previously; and ii) what elements we would not like to return to the way they were beforehand. The crisis forces us to think about what went wrong. But at the same time, the crisis has opened up the space to discuss and reform previous policies, perhaps unrelated to the crisis, but that were, in our judgement, inadequate.

A clear example of this dual implication of the crisis for development is the current proposal to reform the IMF. The Fund is at the centre of the G-20’s proposed solution for the crisis. More money is being injected into the Fund in order to allow the IMF to help countries in crisis. Reform has been proposed, giving more power to emerging markets. The main idea, empowering the IMF to do business as usual.

But one question remains, do we want the IMF to do business as usual? More importantly, do we want the IMF? A year ago it was not clear what the role of the IMF was anymore. Not only that, countries such as Argentina or Venezuela were buying their ‘freedom’ out of the Fund by repaying in advance existing loans. Critiques have mounted over the years about the narrow-minded approach of the Fund to crisis and development in general. For example, could this massive counter-cyclical fiscal policy started by Britain and the US be tolerated by the IMF outside the OECD? Moreover, what is considered reckless domestic policy that justifies tight fiscal deficits? The Fund has very often ignored countries binding constraints to growth by focusing exclusively on an extremely tight fiscal policy. And more importantly, in the new G-20 proposal the Fund has no capacity to supervise the financial system; this task will be performed by the Financial Stability Board.

So why then reform the IMF? Why not provide the World Bank with financial capacity to rescue countries in case of crisis? Conditionality, then, would be linked to more general growth and poverty reduction policies rather than a narrow focus on fiscal policy. This seems to me a more coherent and effective approach to crisis support.

Monday, 18 May 2009

Reasons to be cheerful: Part one

By John Humphrey

The economies that have gained most from globalisation are now the ones that are suffering most – but this also implies that the countries that we want to see grow because they have not benefited so much from globalisation are not bearing the brunt of this crisis. What is the implication for development and development studies?

Reasons for pessimism
It is quite possible to be pessimistic about the current state of the world economy and the financial crisis. For the pessimists among us, last Friday's Financial Times web page provides an extensive buffet of bad news. Forget 'green shoots', things are still getting worse, and the only forecasts that are being revised upwards are those relating to toxic assets. The news is not good but there are reasons to be cheerful.

World Bank Forecast isn't bad news for everyone
Take the World Bank's 30 March Forecast Update for the 2009 Global Economic Prospects. Overall, the situation looks bad. From the November 2008 forecast, to the March 2009 forecast, real world GDP growth has been reduced by 2.6 per cent. The world economy is now expected to shrink by 1.7 per cent in 2009. Some countries have seen catastrophic (if the predictions are accurate) reversals in their prospects.

But, within these figures, there are important variations. The regions of the developing world where growth is expected to decline are Europe and Central Asia, where the forecast has been revised from +2.7 per cent to -2.0 per cent, and Latin America and the Caribbean (forecast revised from +4.0 per cent to -0.6 per cent). Elsewhere, things may be better. The prediction for growth in China is still 6.5 per cent for 2009 and 7.5 per cent for 2010. Indonesia is predicted to grow by 3.4 per cent in 2009 and 5.4 per cent in 2010. In addition to expected growth in East Asia and the Pacific, the World Bank is still forecasting positive real GDP growth in the Middle East and North Africa (+3.3 per cent), South Asia (+3.7 per cent – not confined to India, the projection for Bangladesh is +4.5 per cent), and sub-Saharan Africa, +2.4 per cent.

Obviously, these growth projections are lower than had been forecast in November 2008, but they are still positive. For Africa, they are positive in spite of sharp falls in commodity prices. As is well-known, prices of fuel and raw materials, in particular, fell sharply in the second half of 2008. Part of accelerated growth in sub-Saharan Africa in the past few years has been rising commodity prices. The good news is that subsequent falls in these prices have not done too much damage. In fact, there are (I should think) many more countries that are net importers of fuel and commodities than are net exporters, so the collapse of the commodity price bubble is not all bad news.

Current losers were recent winners
I also find a reason to be cheerful in the analysis of the impact of the financial crisis in East Asia. A recent presentation by Takatoshi Kato from the IMF emphasises just how much the financial crisis is beginning to impact on East Asia. Two things, in particular, attracted my attention. The first was that the recent downward revision of growth forecasts in East Asia was substantially greater than would have been predicted on the basis of the concurrent downward revision of growth forecasts in Europe and North America. This implies the crisis is starting to become "home-grown". This is not a reason to be cheerful. But across the world there is a strong correlation between the rate of contraction of GDP in the fourth quarter of 2008 and the share of advanced manufacturing in GDP.

Why does this make me cheerful, schadenfreude aside? Well, the economies that are suffering most badly in the short-term are the ones that have done pretty well in recent years. The big fallers are Taiwan, Singapore, Korea, Japan, Germany etc. Mexico is in there, and this is probably the result of the value chain issue in industry classification – "advanced manufacturing" based on products categories is compatible with "not very advanced processing". Overall, though, the export-oriented and increasingly high-tech economies that have gained most so far from globalisation are the ones that are suffering most. Not surprising, given the nature of this global crisis. But surely, this also implies that the countries that we want to see grow because they have not benefited so much globalisation are not bearing the brunt of this crisis? This is good.

What this means for development
So, this makes me cheerful. It also makes me want to think very carefully about what the implication of the current financial crisis is for development and development studies. Let's suppose that (i) the world economy does pull out of recession some time late in 2010, and (ii) the poorest countries do not bear the brunt of the crisis. Could we go back to business as usual? Or, to put the question more helpfully, which parts of business do we not want to see go back to "usual", and which parts of business will be incapable of getting back to usual? If the crisis is focused on the most globalised economies, we might see some more fundamental shifts emerging out of the crisis.

Wednesday, 25 March 2009

The Financial Crisis and China

By John Humphrey
Expectations about the impact of the financial crisis in China seem to have gone through three phases. The first was optimistic, suggesting that China had become more delinked from the global economy and less dependent on exports. The second was more pessimistic, driven by the realisation last year that there were very substantial declines in Chinese exports. There were estimates that as many as 20 million people lost their jobs in the heavily export-oriented cities of the coastal South. The third phase, which has just become evident, is a view that there will be a slowdown, but not a crisis. The IMF has reduced its prediction of growth in the current year to 6.5%, but this is still good by global standards, even if half the rate of a couple of years ago. In part, this cautious optimism is the result of government measures to stimulate the economy by promoting infrastructure spending and rural incomes.

There has been a dramatic fall in imports into China, particularly from the East Asian region. As China's exports fall, so does demand for the imported parts and components that are incorporated into the export product. However, rather sensational data showing drastic year-on-year falls in imports may overestimate the problem. First, the overall level of imports must have fallen in part because of the decline in commodity prices in 2008. We need more data on import volumes as well as values. Second, there might well be a short-term de-stocking tendency. Demand for Chinese products in the United States and Europe fell sharply last year. As it takes time for products to reach these markets, retailers will suffer over-stocking as deliveries are maintained at previous levels for some time after sales start to fall (or in the case of garments, they may pile up in the warehouses of suppliers in Europe and the US). Faced with excess stocks, retailers not only cut back orders to reflect the new lower level of demand, but also compensate for the excess stocks that have built up. The same effect happens to assemblers in China. They carry on producing, experience a decline in orders and then reduce production to compensate for both over-stocking and lower demand. They, in turn, go through the same processes with their suppliers. If this effect really does occur, it means that short-term falls in imports of components could be much greater than the medium-term equilibrium level of production and demand during the crisis.

Tuesday, 24 March 2009

Tax Policy, at Last!

By Xavier Cirera

I am delighted to hear that the US House of Representatives is considering levying a 90% tax on bonuses paid to employees with incomes above $250,000. I even think that the proposal falls short; for those working in institutions being rescued with taxpayers’ money, the tax should be large enough to make the bonuses equal the amount they would be receiving if they were on unemployment benefits. But most important is that this news represents a very good opportunity to raise the forgotten issue of tax policy.

The current crisis has clearly exposed that incentives in the financial sector are largely distorted to obtain short run profits, jeopardising long run sustainability of financial institutions. The blame so far lies on risk models and lack of financial supervision. However, this omits a well known fact that one of the most important tools of governments for curbing incentives is taxes. Any standard economics textbook very clearly shows that when the social costs of an activity exceed the private costs of agents engaged in that activity, this should be taxed to equalise private and social costs (i.e. the pollution case). On the contrary, we have seen how, in the financial sector, incentives (bonuses) have been taxed mainly at capital gains tax rates, which are lower than the income tax that most households pay with much lower income levels. This is just an example of how taxation policy has been ignored for many years.

The omission of taxation from economic policy has not only affected financial sector incentives. Domestic taxation remains a serious constraint for developing countries’ growth, which tends to have a small income tax base. Efforts have been made to implement VAT schemes in many LDCs. Nevertheless, advances on direct taxation remain very modest. Many developing countries rely mainly on trade taxes and taxing a few firms in the formal sector, and some of these taxes can be quite distortive.

The positive link between tax and the quality of governance (pdf) is well documented (example by IDS colleague, Mick Moore). The question is then why tax policy has ranked so low in donor policy agendas. Even the IMF, in charge of policing fiscal deficits, has put far more emphasis on disciplining expenditure than on achieving a sound and diversified tax base. In addition, as Adrian Wood suggests , it is likely that aid flows have undermined any incentives for governments to prioritise the increase in tax revenue.

Whatever the reasons are for the marginalisation of tax policies from economic policy agendas, let’s hope that the current crisis pushes taxation back on the development agenda. Taxation is not only important for equity, but also for efficiency and growth.

Monday, 23 February 2009

'Toxic' Assets, Contagion and the Financial Crisis

By Xavier Cirera

An interesting question regarding the spread of the current financial crisis is the extent to which banks in developing countries hold 'toxic' assets. This is critical to understanding the channels through which the crisis will spread to developing countries. It is already evident that there is a significant impact on developing countries from a reduction in demand in OECD countries (the trade channel). Recent news about a substantial decrease in exports from China is alarming. However, less clear is the impact through bank lending.

The bank lending channel depends on the bank asset position, which in turn may depend on whether the bank is foreign owned and the use of bank finance by domestic firms. Financial development in developing countries varies greatly between emerging markets and LDCs. One may think that the banking system in Latin America and Asia is clearly more exposed to the global banking crisis than financially underdeveloped banks in Sub-Saharan Africa. In addition, firms’ access to bank finance is very restricted in Sub-Saharan Africa and other LDCs. As a result, it may seem that LDCs are quite isolated from the financial channel of contagion since banks have a less vulnerable position and play a less important role in firms’ finance. Interestingly, so far there are no news reports about large bank collapses and rescues in LDCs.

However, greater isolation from the financial channel does not imply that the impact of the current crisis on GDP growth in LDCs will not be large. Some LDCs are already experiencing the drop in demand from OECD countries.

If you are interested in the issue of 'toxic' assets, do not miss the excellent note from my colleague Neil McCulloch on what to do about them.

Wednesday, 4 February 2009

On China Currency Manipulation and Multilateralism

By Xavier Cirera
One collateral impact of any financial crisis is the risk of raising protectionism. One clear example is the warning thrown by recently appointed US Secretary of State, Timothy Geithner, that China has been manipulating its currency, which increases the risk of creating a US-China trade row. The idea that the renminbi is undervalued is nothing new, and a large number of academic papers have tried to quantify this undervaluation. However, the tone of the US administration seems to have changed substantially with the new Obama team, and one wonders whether this change would have occurred in a context of economic stability. A bilateral trade dispute between the US and China would be bad news for the world economy, and could open the door to the indiscriminate use of protectionist measures by other countries.

The effect of government policies achieving currency undervaluation is similar to the impact of an import tariff or an export subsidy. Currency undervaluation has an impact on trade volumes and on the current account, since it generates cheaper exports and larger current account surpluses. Undoubtedly, an undervalued renminbi has a large impact on the US current account balance with China. However, what is less clear is the competitive impact of the undervaluation on US producers. The existing evidence is not clear about whether Chinese products compete directly with higher quality products from the US and EU countries. While there has been a significant overlap between exports from China and high-income countries, and significant quality upgrading in some areas, in general most Chinese exports are of lower quality and, therefore, do not compete directly. On the contrary, China is the main platform for outsourcing and assembling many products originated in the US and the EU. So despite the existing fear of ‘unfair’ Chinese competition in the US and the EU, any Chinese currency manipulation has larger direct competitive impacts on other Asian and middle income countries. Besides, if the Chinese currency is undervalued, it is likely to be undervalued with most currencies, not only the US dollar.

So why then so much bilateral focus US-China? Clearly, the emergence of a new super power creates tensions with the existing one, and history shows that transitions can be difficult and violent. However, the risk, in my view, is to marginalise developing countries from the new arising system of global governance and polarisation of power. Asian drivers should be the catalyst to change the rules of the game, and design a system of global governance where developing countries, not only India and China, are adequately represented, nominally and with de facto decision power in multilateral institutions. A good start could be the Chinese currency row. Developing countries are also affected by Chinese currency ‘manipulation’ and, therefore, this issue should be addressed at the multilateral level.