Development process in landlocked countries
There is a heavy concentration of poor countries in this category. When there
was no air transport, these countries had a hard time to trade.
Extensive growth, increase of eco proportional to the population.
Intensive growth, increase in capital, faster than the pop.
Being landlocked differs the process of intensive growth. Since trade
contributes to the development.
The recent experiences of eastern Asian countries, where growth relied on
exports to the rest of the world. Their growth is linked to there ability to trade
(Hong Kong, Singapore, ….). Landlocked countries are isolated and don’t
have access to trade as easily.
These empirical evidences show that trade is a vehicle to growth. So why are
there so many protests, as we have seen at the meeting of American states?
That meeting and the proposals was criticized. Why?
What’s important to know, is the symmetry that binds very large proposals.
What about the protection of workers? Putting down barriers, means that
businessmen can travel freely, goods can move across borders, but not
people. There are guarantees for capital owners, but not for workers.
The factors owned by poor countries, labor and land, aren’t protected… But
capital, intellectual property are.
When it comes to goods, there is an asymmetry. Some will travel freely, while
some other will not.
What about competition? Some gov will have to give up their monopoly.
Most of these services are largely subsidized, when it is liberalized, it also
means ending subsidies. So there is a market privatization of essential services,
where the gov as a major role to play. What would we say if schools were
privatized in CH? What about when it comes to health, water distribution.
There are strong economic reasons for keeping the gov managing these
services. In particular concerning externalities (ex. health, gov has to make
sure the population gets treated to prevent diseases to spread).
So the proposal of liberalizing would imply a high cost to a whole category of
Colonization can be taken has an example. When trade takes place, there
has to be a certain symmetry so that everyone gains from it. What we have
learned in third year is misleading in some aspect. For ex, the ricardian model
shows how when two countries, a big and a small, trade. The big country
trades at its own prices, so they see no change and all the gains go to the
The small country gets to trade at a different price, but the big country
doesn’t. This model assumes there is no transport costs and perfect
information. In reality, we find that international trade doesn’t take place that
way. Countries were setting up monopolies to conduct trade with their
colonies. Trade was heavily controlled; companies were paying in order to
have the right to trade. The colonies weren’t able to sell at world price; they
had to trade at prices offered by the trading company. So the ricardian
modell doesn’t reflect the reality, it supposes that the indigenous pop in north
America could trade with F or GB…
In UK, the profits during the colonial period were twice the resources from the
industrial revolution (?).
Negotiation power has also to be considered. Trade doesn’t necessarily imply
benefit for both parties. Trade implies benefit, but they’re not necessarily
shared, the strong party can take the best part. The trading relation ship has
to be taken into account.
For the American agreement, many small countries from south America
believe that trade terms aren’t equal.
A number of studies have shown the evolution of … ?
UK was primarily exporting manufactured goods and importing row materials
and primary products. But when looking at the patterns of trade and the
resources available, most row materials were coming from its colony and
LDC. What was found was that the relative price of import in the UK declined
at a rate of 1% per year between 1870 – 1938.
If the term of trade goes against the developing countries, the gains will tend
to decrease over time. The ability to buy imports and sell exports at a different
price will decrease. Over time then, the gap between the prices decreases
and also gains. So, by specializing, we may end up loosing. Instead of
specializing on primary products (which prices decline over time), developing
countries should diversify. Therefore specialization should go in the direction of
manufactured products, which price goes up.
Poor countries don’t have capital, but labor and land. The comparative
advantage theory tells them they should specialize in row products according
to their endowments.
Experiences of the economy of the current developed countries
These countries have put barriers to trade, in order to proceed to
industrialization faster. European countries have protected their industries with
tariffs, except UK, which was the leader. If they did it, why shouldn’t LDC
today use protectionism as a vehicle to develop? The weakness of the
argument is that it doesn’t go into the mechanisms.
Comparing the agricultural sector and the manufactured one, there may be
higher incomes in the manufacturing sector. This activity seems to be better
rewarded. So if you can shift your labor force to this sector, you’re likely to
improve your standard of living. Tech progresses occurring in agriculture are
made at a much slower pace than in the manufacturing sector. Workers are
trained on the job, new products are created … much faster than in
agriculture. If you want to be where the action is, then considering
manufacturization is a good idea.
An other point in the case of manufacturing. If you give enough time for a
manufacture to develop in a poor country, this country may even become
more performing than the prevailing world price.
The reasons that a poor country cannot manufacture: no skills, no machines in
place, no organized production … All these factors can be overcome. In the
long run, a poor country can gain experience and become highly
competitive. It’s only a question of initiating the process.
So here is the argument against free trade. LDC should turn to the future, the
problem is that certain industries may be profitable in the long run, but implies
costs in the short run. There are barriers for entrepreneur, like political
instability, uncertainties about environment, training the workers …
In all these cases, the gov should play a role by subsidizing the first producer
(training process, eliminating the imperfection in the capital market). The gov
should impose a tariff to protect the first entrepreneur.
The main argument to sustain the manufactured free trade has been used
against free trade. A tariff means revenue for the gov and is easy to set up,
it’s not what the economic theory tells us. So tariffs were imposed for practical
To the extend that you protect an industry with the aim of providing your own
country, there is a risk of inefficiency.
The prices of primary products fluctuate much more than manufactured
ones. A small change of supply can provoke an abrupt change in prices.
Manufactured prices are set by a small number of firms, which have an
interest in keeping price stability. They increase and slow down production as
the market evolves. By diversifying the economy you prevent the country
from the macroeconomics shocks.
Income elasticity – demand elasticity. Increase in income provoke a low
increase in the demand of primary products and stronger revenues in
manufactured good and even stronger in services.
The dev country of the 20th c face different environment. ?
Differences in agricultural markets
In the 21st c we have much more interference in the primary sector (subsidies,
protectionism …) in the advanced countries.
Case of positive externalities
The fruits of technological progress are translated on the market by lower
prices in the manufacturing sector. In the agricultural sector, a technological
progress that reduces the costs doesn’t lower prices because of the low
In a perfect competitive industry, there are no entry barriers, so if an industry is
profitable, it will attract new companies. So a tech improvement will attract
new firms and therefore there is no persistent profit. So this is a difference
between agriculture and manufacturing sector.
Where there is greater scope to make benefits, there’s also a greater scope
for the growth of capital that can be reinvested.
This is an other argument that shows why developing country should develop
their manufacturing factor.
A country trying to develop its industry faces a strong competition form
industrialized countries which are more efficient. Consumer should have the
right to choose the best products at the best price.
From a global economy point of view, this situation isn’t the best one. Where
does growth occur if we remove capital stocks and rents? There are rents that
can result in further accumulation of capital in a developing country and that
can be transformed in other form of capital like labor or … These
accumulating savings can be used for developing education which in turn
developed the rents because of the increase in skills.
For a LDC this is one of the few sources that can generate increase in per
capita income and in the standard of living.
In a developed country, when an industry experience difficulties, the gov
prevents loss of the assets that can be prevented in order to preserve the
capital and the rent that goes with it.
So the relatively primitive manufacturing activities have to be protected in
developing country, to allow them to grow and eventually become
competitive. Any kind of activity that requires a lot of labor is a long term
comparative advantage for LDC. But it takes time and there is a potential as
China as demonstrated it.
So it may make sense to protect local economy in order to allow it to develop
and become competitive on the world market.
Specialization and production on …
Increasing productivity in subsistence agriculture provides a larger basket of
those consumed goods of the local economy. And if consumption per head
can be increased in subsistence goods, there is the creation of a floor below
which consumption per capita is not likely to go below. On international
market where prices are fluctuating, there is no guarantee of minimal
This creates reservation wages. So there will be other activities developing
where wages will be higher than the reservation wage. So a key to prosperity
in LDC is the existence of alternatives related to exports.
Q. How to increase the productivity of subsistence agriculture?
There are means like technical advices and technical infrastructure that can
One can say that a promising industry that goes bankrupts because of foreign
competition is good. But that’s not the right way of looking at the situation. A
company may not be profitable, but may be producing positive externalities.
By closing down the activity, it may cause the economy to shrink.
Free trade may not necessarily create an ideal environment for LDC to
The growth experience of industrialized country to industrializing country like us
after ww2. In the 19c, if trade was playing a fundamental role in the growth of
these countries, then there should be rapid growth of the export sector that
leads the rest of the economy. Trade should be the thing that moves first.
There should be period where exports growing before the GDP growth, in
some way leading the economy.
In fact, for the US in the 19c, the ratio of export to GDP was between 6-7%.
The economy wasn’t driven by exports. Exports are a constant share of
Agricultural exports where the main exports of the economy. 69% of gdp… ?
We should expect to see foreign investor to target the export sector. In the
case of the US, the most attractive sector is the railroads sector. But examining
the revenues of this sector, only 5% occur by carrying goods for export, the
rest comes from carrying people and goods for the local market.
For all these reasons cravis argues that trade doesn’t explain the rapid growth
of the economy. He points the facts that there was available land, which
attracted migration and therefore creates a population expansion. There are
also institution in place that are conducive in stimulating new business, a
legal system that protect property. So trade isn’t the main element.
At this stage we can conclude that the benefits of trade depends on many
circumstances, type of goods, country, capacity of the labor to learn and
become more productive, capacity of entrepreneurs, legal system,
infrastructure (roads, ….), stable gov, property rights, …
Depending on all these conditions, trade can be highly positive or be
Ex mining industry. If workers, ingenieurs, come from abroad, there is little
benefit for the local economy.
This is the case were the positive externalities are very limited. There are other
cases where externalities can be much more beneficial. Where the effect of
an increase of exports creates an increase for the local economy.
How much learning takes places?
Questions of linkages between the export sector and the local economy.
What happens to the revenues of export? Do they go to local factor owners
The next question is how is that spent? If it’s spent on local goods it stimulates
the local economy. How much of the income is saved, invested?
Those savings, how much are invested locally? Where there is political
instability, there is a tendency to place savings outside.
Distribution of income has an effect on social stability and therefore on the
attractivity of the country for investment.
Exports can make a positive contribution but also not.
Also the capacity of the country to support export
An infrastructure is needed (roads…) and a financial market. Financial
resources are required to take advantage of new opportunities. So there are
conditions for a country to be able to take advantage of an opportunity.
There are countries where exports are taking place, but it doesn’t benefit to
the population of the country and the rest of the economy.
The eco produces a certain amount of output some is for local consumption,
some is for export. There is a positive relationship between export and output.
He looks at the ration between exports and GNP: X/GNP and looks at the rate
of change ^. ^x -^gnp ≈^gnp. This correlation is only valid for countries which
already have an industrialization base.
M performs an other exercise and looks at the proportion of trade in GNP
growth : x/gnp and ^gnp. It turned out there is no positive relationship.
Countries that are big exporters do not necessarily grow fast.
Countries grow with their exports, but when exports stop growing …?
If there is only a little part of output produce for the local economy, then the
economy relies on exports.
What is the impact on GNP if the country growth accelerate? M shows that a
1% increase in the rate of growth of exports engender a 0,04% increase in
After ww2 and the decolonization process, there was a great enthusiasm
among economist. It was believed that developing country would catch up
easily with the developed country. Colonization was taught to be the cause
of underdevelopment and that free country would finally benefit from what
they produce and accumulate capital and develop.
After the great depression, the Keynesian was a break through in economic
theory. It was giving the government responsibility in the eco. The gov was
supposed to create demand in order to get things going.
The hypothesis of vicious circle that entrepreneur will undertake large
investment project (in order to benefit from economies of scales) only if there
is a demand. So there was a concern that private investors concerned only
with their gains wouldn’t undertake big project because there were afraid it
would fail. If you have a shoes factory that develops economies of scale,
there will be a large amount of shoes produced, but who will buy them?
So one isolated industry may not find enough buyers. But if there are enough
industries, there will be enough demand. So there are demands externalities,
the expansion of one industry creates demand for other industries: demand
spill over. When en entrepreneur evaluates the rentability of one project, he
only pays attention to the net profit of one industry and doesn’t take other
industries into account. So an entrepreneur may not find it profitable to carry
out a large project. So there is a market failure.
The answer proposed by …. Is that the gov should undertake a big push effort
and coordinate investment on a large scale in the economy. Subsidy:
providing infrastructure (roads, power plants, water facilities …), plus a
coordinate push. Without it some entrepreneur will conclude that their project
This raises the question of trade. What if you can’t export your production?
So there is the notion that there is a role for the gov to correct the market
There are side effects. When you build the first factory, it is easier to build the
next one, when you teach the labor forces, then other industries benefit from
this skilled labor. So in helping one entrepreneur, it will also help the others.
When you help a large amount of entrepreneur, there is an internalization of
the externality and everyone benefits.
The optimistic view after ww2 did not materialise.
An other problem in world economy is how to stimulate the economy. Gov
were trying to sustain supply and demand at the same time by trying to
stimulate investments in various industries so that …
If you have a shoes industry, you need a certain number of activities (leather,
assemble line, color…). So Hirschman says that a big shock to one key
element should be given in order to produce a reaction from the private
sector to provide the necessary elements for the industry.
There were also …. Economics concerned by trade having a negative impact
on a country opening to trade. They view trade as a danger to the
development process and argue that the gains of trade diminish. They
conclude that the country is hit by its trading relationship.
We talked about trade having a negative impact on small industry. The
question is taking advantage of an opportunity when you don’t have the
capital to materialize it and create a rent. If you have rents coming in, you
can look for new opportunities and invest them again. So anything that cuts
the rents off, like cutting off small industries has a big effect in a developing
country. In a developed country, there are plenty of rents to take advantage
of new opportunities.
Unemployment in developing countries is more concerning than in
developed country, were there are the means to move labor from one sector
to an other. In a LDC there is much less possibility of moving unemployed
M also sees development as being dualistic in the developing countries. If you
have a stimulus trough trade, there will be a center of attraction. It will also
have negative impact on other sector of the economy. These centers of
attraction will have negative impact on the development process of the less
developed area. Development doesn’t take place evenly across a country.
What happens is that the growth in certain regions attracts resources from
other less developed regions. So there will be capital, labour… moving to the
growing area, but at the same time it deprive other area from the resources
to the extend to which these resources are mobile. It leaves the periphery in a
worse position than there were before the stimulus. It creates a situation of
uneven development. So it leads to a decline of welfare of other regions. This
unevenness requires the intervention from the gov.
After ww2: tariffs in order to keep local production by raising prices.
An alternative to the tariff is a quota.
There are several mechanisms to attribute the quota. Auction, first importer,
A trade restriction provokes a dead weight loss DWL. So why would a gov
impose a trade distortion? In order to provoke positive externalities.
This is right for a small economy. The case is different if the country has a
negotiating power to lower the price. So the capacity of a country to
influence the price it pays for import can brings a different situation. A small
country can influence the price in a non-competitive market.
In a competitive market, a big country can force foreign suppliers to change
their price strategy by imposing a market.
When markets are segmented, there can be a different price for the same
product in different geographical area. To the extend that market are
segmented (different types of specifications, policies …), there will be
different prices in different country. So the price changes in the market
depend on the purchasing power of consumers.
When a country imposes a tariff to a company that has a market power, the
company is going to adapt its retail price in the country imposing the tariff. So
P* isn’t constant in all country. The idea that a small country can’t influence
market price, is only true under the condition of perfect competition. In a non
competitive market, even a small country can influence the price.
What about export taxes?
There are various types of reasons (political ex).
What are the effects? It reduces exports and generates a tax revenue for the
government. It also increases the consumer revenue. It’s expansive in
The problem with tariff is that not all components are available locally and
have to be imported. Yet these components can be imported at an
interesting price. So the country can set low taxes on intermediate goods and
set high tariff on final goods.
An other element was that there was restriction on entry from foreign
competitors. One way of doing this is to give a license for importing certain
components. This is a way of keeping competition out (not only foreign one,
but also local one).
In most of the LDC, there was a set of policies used to protect the economy.
These policies were imposing tariffs in diverse forms and subsidizing exports.
There are various instruments in order to achieve these ends.
What are the effects of a production subsidy?
The effect of a subsidy affects only the producers while consumers are
unaffected. The difference is that the DWL is smaller than with the tariff (only
one triangle). By subsidizing production instead of exports, part of the DWL
can be avoided.
So there is a whole array of instrument to influence consumption and
production. What are the general policies for country?
An other technical issue is the degree of effective protection. Suppose there is
a 100% tariff on imported goods, what does it mean for the various domestic
factories? Is the effect the same for all of them? No, not every company
producing export competing goods will gain the same. Suppose you are
producing motorcycle. The engine is a complex part and the country hasn’t
the capacity to produce it. So it will have to be imported or assembled
elsewhere. So motorcycles receive protection at a rate of 100% to facilitate
the development of this activity. Typically the gov allows the company to
imports the parts of the engine duty free. So there is a 0% tax on the engine
parts. What is the effective protection?
If the price on world market is 1000$, imposing a domestic tariff means that
the domestic price is 2000$.
If the price of the engine on world market is 500$, so this price contributes to
one half of the price of the final goods. The country can buy an engine and
turn it to a motor cycle for 500$ at world price, and 1500$ at domestic price.
So with the tariff, the company gets to 200% more.
The formula for the effective rate of protection is tj=(aijti)/(I-aij).
The larger is aij, the greater is the share, the higher is the effective rate of
protection. The nominal rate doesn’t really tell us anything about the effective
rate of protection, which is a much more accurate indicator.
What are the consequences for the BoP? When a country imports row
material and intermediates goods in order to produce goods for exports, then
the country is dependant on imports. In order to generate adjustment on
trade balance in case of disturbance, to generate a trade surplus is more
diffcult. The consequence of reducing imports will threaten exports. At the
same time it’s also difficult to increase exports. So there are greater difficulties
on generating more exports. So we end up with a very rigid structure on the
One solution found by country is imposing luxury goods, but the country
doesn’t have the possibility to produce these goods and it creates more
If policies change all the time and there is an environment in which lobbying
… this shakes up the whole system and it becomes inefficient.
There’s also countries where intermediate outputs are rationed like India. So
the country can’t sell more unit, it can try to sell at a higher price, by
increasing the quality. But in general it’s inefficient
Is competition good or not?
Restricting domestic competition is not efficient. Competition on the domestic
market is a healthier process, because it forces company to improve their
efficiency. If a company doesn’t react to competitors, they will loose clients
and eventually suffer losses. The company may be sold to the more efficient
company that will use its capital in a better way. There is a change in hands
from ineffective to effective companies.
But this process is very different than opening the country to trade, a process
which destroys all capital in the country.
Acquiring the capital to produce import competing goods
The incentives target capital. It is very different than tariff and subsidy which
are targeting production. There are a number of different inputs for an
industry. If you sustain the machine, the entrepreneur will choose a technique
that relies more on technical capital than on labor…
The problem of lobbying
Entrepreneur should be concentrated on managing their activity and not on
Waste associated with smuggling also includes the police costs. None of them
would be necessary in case of free trade.
Allowing protection to local conglomerates gives them an opportunity to
develop. But the import substitution strategy engender a lack of competition
and efficiency, resources could have been used more efficiently.
Import substitution gives the incentive for entrepreneurs to develop even
though they weren’t competitive and helped industries to develop. This is a
benefit, but it also implies costs for the consumers that have to pay a higher
In developing countries, industries requiring low skills were developed using
second hand machinery with the protection of import substitution.
In the 1980-90, in the case of East Asia countries have embarked on the easy
import substitution strategy. Firms have become competitive and authorities
have encouraged firms (export promotion – import substitution). Ex: Taiwan
exporting wigs. The economy became more advanced, the labor force
became trained, capital became more abundant … there was a more
ambitious project to keep up and produce more sophisticated goods, like
electronics and cars. The cases of these economies that have enjoyed rapid
growth are exception. They have benefited from a good political
environment in Korea, Taiwan and the US. They have received counseling …
These countries were used as show cases in front of the communist world.
During the VN war, it was part of a strategy to prevent socialism from
expanding. It brought improvement in the standard of living and “proved”
the superiority of the capitalist model.
Much depends on external factors and these are often neglected. The Asian
tigers involved two city states that were used as transition points (Hong-Kong
and Singapore). These had a geographical advantage to provide services for
trade. They benefited high rates of growth because of that. Asian tigers
benefited very much from exports market offered to them.
Why promoting export rather than looking for inner markets?
In the case of Taiwan and Korea, restriction on import served to stimulate
local industry and stimulate exports. Exports firms were allowed to import duty
free goods if they were exporting a certain amount of goods.
An other way was offering direct subsidies (bonus for repatriating exports
gains, lending for firms achieving export target). Close cooperation between
the private sector and the government encouraged entrepreneur. So there is
a coordination role for the gov. At the same time in Korea, the gov was very
authoritarian; policies were supporting entrepreneurs and repressed labor
movements. All that resulted in successful export policy and allowed the
industry to reach leading technology and develop competitive industries.
How smuggling affect welfare under an import substitution policy?
So far we have studied the effect of a tariff in … here were going to look at
the effect of the tariff in all sectors. Then we’ll examine the implication of
smuggling. This activity introduces new costs because it transports goods
illegally which is more costly than traditional channels. Tariff evasion brings the
economy closer to free trade and can improve welfare to some extends.
Consumers optimize their consumption where the budget constraint meets
their indifference curves… Income consumption line is traced with the
combination of different budget and indifference curves.
The introduction of a tariff induces a new budget constraint for consumers.
This shift allows us to build a new graph and find out the consequences on the
Tariff revenue is assumed to be given to the citizens as a transfer. The
consumers can therefore choose on which goods they will spend this transfer.
When the tariff revenues are given back to the consumers, then the impact
on … is cancelled. With that logic, we get consumption points where the
international price ratio is parallel to the consumption line. There is a loss of
What happens with smuggling?
Introducing goods in the economy is costly and absorbs resources. Smugglers
will have to charge more than the world price.
There’s always smuggling taking place with a tariff. What are the
consequences? Smuggling costs are only the melting iceberg cap. A fraction
of the good being transported disappear, it’s the simplest way. If sugar is
being transported from one location to an other, say 10% evaporates… If we
have transport using capital labor, then the production possibility frontier will
shift. So we assume that smuggling doesn’t involve labor and capital in order
to simplify the analysis.
Say 25% melts away during the transport. So you buy 1 unit and 0.75 arrives.
That is still cheaper from the point of view of the consumer, but 33% more
expansive for the buyer. The goods smuggled aren’t any different.
Domestic price of good A will be 1.33 the world price. Smuggling replaces
trade. Consumers pay 1.33 time the world price.
The level of welfare is unaffected from smuggling; there is no change in utility.
Both consumption points Ct and Cs are placed on the same utility curve.
If the cost of smuggling is higher, what happens? If more goods melt away or
the authority are more vigilant, the price of smuggled merchandise will be
higher hence the price line will be steeper. In that situation it’s not possible
anymore to reach Ut curve and the level of welfare is therefore lower.
So the tariff make the situation worse in bringing consumption from C* to Ct.
Then smuggling gets the situation even worse in bringing consumption from Ct
So smuggling can make things even worse than just a tariff. Smuggling is
absorbing resources and worsens the term of trade. Eventually all this can be
considered to be imposed by the trade regime. For any given trade regime,
the cost of the smuggling activity can depend from the type of good, the
geography of the country, the vigilance of the authority, … the cost can vary
and isn’t fixed. It can be considerable : 5-10% of GDP! It’s an additional cost
of protection which has to be taken into account with the potential benefit of
putting a tariff in place.
The capacity of smuggler to evade customs depends of the volume of trade
taking place. If smugglers and officials are the same people, it has been
observed that official trade is used to mask unofficial trade. Many of the
official importers end up with smuggling activities themselves. What’s
interesting is that the domestic price and the world price are getting closer.
The importers are in fact paying a lower tariff rates. This situation assumes that
official importers have good relations with the customs. In that case the
system is corrupted.
In the case of exports, the domestic price tends to be higher than the world
price minus the export tax.
So restrictive trade policies not only worsen the term of the trade … but
generate a waste of resources through smuggling that cost a certain
percentage of GDP every year. Such trade regime also creates an unstable
environment making investors more cautious when considering making
investment in the country. They will prefer a more constant policy.
This subject became very popular discussing in the 80’. Questions were raised
about the debt problem. In 1973 with the oil crisis, there was a shift of
revenues between industrialized countries and oil producing countries. Oil
producing countries weren’t able to spend their new revenues home. They
had no skilled labor and no infrastructure to develop production at home.
So these countries made large deposit in the advanced countries. Advanced
countries went into recession; this made investors reluctant to invest the large
savings from the oil producing countries. So they turned to the developing
world to find places to invest the money. These countries had been outside
the international development system for a long time. Going back to the
great depression, they weren’t able to pay their debt and therefore were put
aside the system. This happened especially in Latin America. The creditors got
only peanuts back for their investment. No other investors were willing to loan
money to theses countries. In the 60’ they started settling up their debt. But
the oil crisis came and huge amount of money was seeking places to be
invested and there were these Latin American countries that were lowly
indebted making them good candidates for lending the money. This went on
throughout the 70’. In 79 the US Reserve changed its politic in order to deal
with the macro economic choc from the oil crisis. It was decided to get red of
inflation. Because development countries had borrowed money at floating
rate of interest, they end up eventually with up to 18% interest rates. Many of
the firms in the developing countries which had the ability to grow and
borrow money ended up in a difficult situation.
At the same time the exports earnings declined because of … and the
So there is a bad situation on the demand side, a …, … developing countries
end up not being able to pay their interest. In 1992 Mexico is the first. What we
have is a situation where commercial banks have made all these loans to the
developing countries and these countries cannot pay anymore their interest.
If these interest aren’t paid within 6 months, regulation requires bank to adjust
their books – 100 of billions of $ - potentially leading to bankruptcy. The
authorities had to do something to unlock the situation. That’s were the IMF
and the WB come into play to help developing countries. In fact the money
flawed directly to commercial banks. Many LDC accepted this arrangement:
IMF and WB paying their interest while agreeing to reform their economy in
order to be able to pay interest. The objective was to use their productive
capacities and the revenue to pay the interests.
The Concerned for the official was how to keep the banking system and how
to make the development countries able to pay interests.
So what are the benefits for LDC from trade liberalization? Very little:
You get access to intermediate goods that allow … Policies were set which
didn’t restricted access to inputs. This was encouraging final goods
production. The argument that opening up the economy would bring …
You can take advantage of economies of scales. Market in a protected
economy is narrow and liberalization allows to enlarge it and make
economies of scale. But that’s a false argument; other economies also have
to be open.
The less the government intervene, the better. Reagan and Tatcher.
Schumpeter (economic historian) analyses period of rapid growth and come
to the point that something has to happen to move the economiy – some
king of a choc. The introduction of a new good can be such a thing – ex the
introduction of steamships, telephones, computers, … New methods of
production, new markets, conquest of a new source of supply of resources
(Spain and Portugal), carry out new organization of the industry (line of
production – Ford). So if you open your market, you’re not really creating new
opportunities to you but to others. The opportunity is if others open their
markets. In the case of LDC, opening their eco doesn’t create opportunities.
There is a very negative impact for LDC, they face international competition
and don’t get access to new markets. This creates unemployment, recession.
The most unfortunate element in this scenario is the fact that LDC had to
abandon import substitution. This was a necessary evil because LDC hadn’t
access to foreign markets. It would have been in the interest of the LDC to
open gradually. It would have enabled them to slowly improve their
efficiency. The abrupt foreign competition destroyed their productive
capacity. Firms suddenly unprofitable don’t have the capacity to diversify or
invest to improve their efficiency. So the rapid adjustment was too abrupt and
resulted in too much dislocation, too much unemployment.
If investors aren’t confident that the gov policy will last in the long term, then
they will hesitate to invest according to the new policy.
A successful liberalization policy implies an increase in exports and a
decrease of imports where the country has a comparative advantage. In
order to achieve this goal investment is needed. So the gov has to give
credibility to its new liberal policy.
House holds also have to be taken into consideration.
On the one hand it can increase the trade deficit.
On the other, households consumption expand at the expanse of saving. It
will reduce the availability of saving for investment.
Durable: any consumer goods which last more than a year.
The exporter’s profitability depends on whether the policy is permanent. If
exporters don’t believe the policy is permanent they will not engage and
develop the sector, nor will they lobby on the gov to keep this policy. On the
other hand, sector facing import competition will lobby against liberalization
and they are likely to succeed.
So if the gov isn’t credible, liberalization will not succeed and may do more
harm than goods by creating macro economic disturbances.
Exports rates … ? the objective of the liberalization policy is to shift resources
from the import competing sector to the export sector. ….
Lack of credibility often derives from policy inconsistencies. In LDC, an
important source of revenue comes from the tariff in place. So liberalizing cuts
the gov revenue and put it under pressure. The gov is facing a tight budget
and experiences difficulties providing the basic services to the population
and pay its debts. The gov may face a strong public opposition and may be
forced to go back.
An other example of inconsistency is when a gov sets a fixed exchange rate.
The gov is doing that in an attempt to create a macro eco stability, this in
order to convince the pop that ex rate will remain stable. Liberalization
however call for a devaluation. L is making the import price higher but export
sector is unaffected. Therefore this sector needs help. Receiving more local
currency is a support for the export sector. By decreasing the exchange rate,
the export sector receives support and the import sector is less attractive.
An other problem is the devaluation of companies and the debts to foreign
creditors. When interests are in foreign currency and the home currency is
being devaluated interest expressed in home currency become higher.
There’s also the issue of dynamic inconsistency of policy. This problem arises
when the gov offers certain incentives and then removes them once the
investors have done what the gov was expecting. So what we observe is that
the gov offers subsidy to the export sector and when exports are developing,
the gov suddenly changes its mind and remove the subsidy.
This raises the question of whether agents can trust the gov. in LDC the answer
is often no in the contrary to advanced countries. In AC, the gov has more
resources and the system relies on credibility. A reverse in policy undermining
its credibility would be devastating for the economy.
A third reason given by R is that the motives of the gov may be unclear.
In that case, the agents are skeptical and suspect that the gov has
introduced lib under pressure.
A last reason is the anticipated cost of liberalizing.
The agents experiencing a loss in revenue will organize and lobby the gov,
workers in the import competing sectors may strike, there may be social
instability. Entrepreneurs are powerful figures, they have accumulated wealth,
they have diversified (banking, media, …). These large enterprises may have
their own bank (like in Chili), in a period of lib, there is a loss of profitability and
these company will borrow money from their own bank. So interest rates are
rising. That means that company in the export sector will not be able to get
credit at an affordable price.
In order to get credibility, the gov can make commitment to international org.
An agreement with an IO that prevents it from deviating from its policy.
… domestic policy…
Measures that focus on trade lib that would result in low reduction of gov ….
Financial system are often heavily controlled by gov. in LDC, gov are telling
bank what interest rate to do, … lib of these financial market is important in
order to achieve efficiency. The allocation of credit should be regulated by
the market and interest rate.
In order to succeed in any kind of reform, you need to have resources
allocated efficiently including credit.
Liberalization of the capital account
Trade accounts reflect all imports and exports. There’s also trade and services.
The current account is the sum of the current account and the balance of
If someone buys a treasury bond, it is considered as a capital outflow.
If someone buys a share in a national company there is a capital inflow.
All this is in the current account, when added the three, we get ?
Trade in assets has been highly restricted. Residents are not free to buy foreign
assets. Why is capital account lib important in the context of trade lib?
Lib of trade involves a realocaiton of resources, this requires an increases of
investment ine the export sector and this finanicing ofhte coems from abroad.
So we need to allow firms to borrow from abroad. On the other hand we do
not want households to borrow from foreign banks to buy durable. …
A more conservative approach to lib of the cap account would be only after
trade has successfully been lib.
If trade hasn’t been lib, then the current account cannot be lib. When you
have trade restriction in place, you have distorted system of prices where
profitability in the import competing sector is reflecting the high price of
importables. If you allow for borrowing to take place, they will be tempted to
invest in the import competing sector. As the LDC has the … to buy import at
world prices it means that investment are made to a sector which isn’t
competitive. So there is a waste of resources that is augmented with capital
The speed by which the trade is lib
There is a possibility of:
liberalizing trade abruptly, ex cold turkey.
liberalizing trade gradually. The two policies are very different.
When lib is abrupt, this can result in very high adjustment costs. Sector will
notice that they are much less productive. The advantage of doing things
It’s easier to get the public to accept lib in an atmosphere of crisis. In the
1980’ LDC was …
The adjustment costs of a rapid lib tend to be higher, than with a gradual lib.
The problem is that productive factors find themselves to be unproductive.
That leads to certain externalities which should be avoided. There are a sharp
drop in expenditures.
Nurkse Kravis Myrdal Hirshman Rosenstein-Rodin
… Debt problem
The focus today will be about the resolution of this problem.
The big problem is the enormous interest burden. They are significant amount
relative to GDP and trade. So when LDC were confronted with their
obligations, international org have mediating between these countries and
commercial banks to make sure commercial bank would get paid on time
even though LDC don’t have the capacity to pay.
There was pressure on LDC to restructure their economy. Elements were
privatization program. LDC had to sell valuable asset to pay interests.
It was a difficult period, during which, LDC were no longer receiving credits.
When the crisis developed, the bank found no more interest in lending money
to LDC. So suddenly, instead of capital flowing in, it stopped and the banks
asked to pay interest and to some extend pay back money. So capital flows
reversed and went out. This engendered a lack of investment …
From the point of view of the creditors, this kind of stagnation wasn’t
conducive. There were various proposals to light the burden of these debts to
allow growth to come back. Numerous programs were discussed. These were
designed to reduce the burden of the debt.
For many LDC it was impossible to pay the interest at the rates. The idea
came to use that as an instrument to make investment. If a country has a low
capacity to pay its debt, then it would be sold against … ? So one possible
way of resolving the prob was to lend money …
The … plan proposed the idea that an international facility would buy the
debt and then reschedule the debt according to the capacity of the
When a country is heavily indebted, investors like local firm and individual
prefer to take the money out. They fear that when making an investment,
they will not find their money back. That kind of capital flight is enormous. Ex
Argentineans were lending abroad what the gov needed inside.
So there is a shortage of investment. There is a prospect of high taxation that
can take various forms like the inflation tax. The gov may practice high rate of
tax on capital and earnings.
All kinds of strategies have been employed.
Giving the ability to exchange the debt with private firms, so that they will pay
These schemes have been debated for over a decade. A number of
countries managed to show progress relatively quickly and resumed a pattern
of growth. If the economy is growing and the debt is stabilized, then there is a
decrease of the ration of debt to GDP. This whole problem was removed from
the headlines in the 1990s.
In the 1990s there is a new generation of crisis generated by the liberalization
of capital accounts. …
Current account imbalances
A current account deficit is a situation where you’re importing too much. It’s a
problem because it is accumulating debts. If your CA is growing at the rate of
the economy, the dept to GDP ration will be growing. If the CA is
imbalanced, the debt is financing imports. So to keep the ratio of debt to
GDP stable you nee a situation where at least … interest.
Investors extrapolate information and try to find out where the ratio of debt to
GDP is heading. Larges deficits in the CA rel to GDP means large ….
Unless the gov convinces that it is temporary, investors will get worried. As
soon as investors become concerned and the inflow of capital dry out, the
interest rates grows up significantly. The country finds it hard to finance its CA
deficit and has to … The country can set a fix exchange rate, but the CB has
to use its reserves until they get depleted. When that happens, the CB
devaluates the currency. There are many consequences; this is one way how
a crisis occurs when there is a CA deficit.
Unbalance between fiscal revenue and expenditures. A gov that spends
more than it earns, relies on borrowing.
One way of financing the gov is to oblige the banks to buy a certain amount
gov bonds. As the deficit persists, the debt to GDP grows and the scope for
getting full payment of the gov bonds diminishes. Growing out of public debt
is a painful process that goes on for a long period of time and constrains the
gov in its activities. The gov has an incentive to print bills, causing inflation.
If there is fear over the future value of the currency, then asset holders
convert their money into foreign currency or capital flight. This put more
pressure on the gov to devaluate. So either large CA deficit or fiscal deficit
make the eco vulnerable to a crisis.
Tendency of debts of private firms, of institutions, of gov to be:
in foreign currency
in the form of debt instead of equity
How the deficits are being financed?
If you have long term debts, ex 30 years. There is plenty of time to spend the
money wisely on productive long term investment. You don’t have to worry
that the lender would ask suddenly for its money.
When borrowing on a three month basis, every three month the lender need
to be convinced you have the capacity to repay in order to reconduct the
loan. The more you can show your capacity, the lower the interest rate. If you
have difficulties, for various reasons, it can result in a situation where you are
unable to get credit and you need to pay back the loan. This can cause a
So CA difficulties and budget difficulties pushes country to a short terms …
Currency used to the denomination to the debt
The risk of a devaluation makes the interest rate go up. The perception of the
devaluation increases to cost of borrowing in local currency.
Perceptions of agents about the long term credit worriness
There has to be a perception that the country will be able to deal with current
account deficit and budget deficit. These can be transitory. How do they
come up? A country can face interesting opportunities which requires
massive investment. This may cause deficit (budget and CA), but it may not
be bad at all. So if the resources are being used efficiently and are likely to
generate income, then it’s not an alarming situation.
So the question is what the gov is spending on. Investors will look at whether
the gov will be able to stabilize the situation.
Poor banking regulation
Many country have a developing banking system. Banking regulation have to
be strengthen. Restriction have to be made on the degree of risk bank may
take, what kinds of loans, to whom, … In many cases there is expanding
landing in real estate because prices are going up. When there is a collapse
in real estate prices, then the banking system becomes vulnerable. So too
much landing, make the banks vulnerable.
For a company willing to expand, one way is to sell parts of its shares in an
organized market or to individual investors. An other way is to borrow money
abroad. … A small elite in the corporate sector well connected with the
gov… this makes outsiders and investors reluctant to buy shares, they are
afraid of not getting their full shares benefits. Then the company has to
borrow money to the bank. So great reliance on debt and less reliance on
equity. “Crony capital”
With the poor regulations affecting the banking sys, firms have the possibility
of having extensive landing taking places from banks in a way that makes
them vulnerable. If all eggs are put in the same basket (real estate), the sys is
threatened when a crisis comes. In AC, there is a mechanism that makes
bank diversify their investment. Much has been done since the Asian crisis.
An other source of vulnerability in LDC are political shocks
When there is an election, which can imply significant changes in economic
policy. In AC, the election impacts are minor, because all party follow pretty
much the same policy. In LDC, the political sys is less mature and economies
are experiencing more fluctuation and inequalities, there are therefore
uncertainties with elections. One cannot be sure of what the administration
This results usually in capital flights before elections. Loans are too harder to
renew. So there are worries especially if the country is in a bad shape
In a key commodity, ex petroleum. Can make investors worry about the
ability of the country to pay its debts accumulation. People may not always
be informed, but concerns are enough for investors…
Country dependent on a few commodities for their exports are vulnerable.
Change in the rate of interest, ex change in the US attempting to control
Contagion, LDC are linked to their neighbors, when one facing difficulties and
change its policy, this will affect neighboring economies, ex Argentina
changing its currency rate. Such shifts results in deteriorating CA for other
economies. They then must convince foreign creditors they will hold.
So there is a connection through trade account.
Investors don’t investigate fully the state of the economy. The typical way to
gather information in a country is … not always sufficient. Large financial
institutions are well connected with gov officials in the country where they
invest as well as in their own country. So, much of the smaller investors, won’t
have the same kind of informations. So there is a kind of contagion going
through the financial market, investors sell and ask questions later.
Observers don’t know really who is selling, they scared and sell. So there can
be moves on the market based on concerns… In a world where information is
imperfect, agents don’t always act according t the reality.
So why smart people don’t buy, when prices are lowering. A country having
difficulties due to a crash in price assets which may be due to irrational
concerns, faces a set of real difficulties.
Focus on the gov budget deficit making the country vulnerable. The time a
country can defend a fix currency exchange depends on the …
When a gov has a deficit and no one wants to buy its bonds, the only way is
to make the central bank buy these bonds. The CB buys the bonds in
exchange of newly printed money; this process is called monetization of a
We assume everyone knows every information about the economy.