Trade deficits in LDCs

1. Trade deficits in LDCs Ruth Tarrant The Open University and Peter Symonds College

2. Outline • Issues facing (African)LDCs post WW2 • Independence and its implications for development • The size and funding of trade deficits for LDCs • Focus on Tanzania • African LDCs today

3. The (African) colonies post WW2

4. Exploitation of primary products for reconstruction

5. Foreign exchange generated by exports kept by colonial powers

6. No import-substitution measures allowed. Colonies = markets for colonial powers

7. Allied victory / creation of UN led to social pressure for independence and progress

8. Colonial powers prevented secondary / tertiary education

9. Independence

10. Diplomatic pressure Aid / trade dependent ‘removal’ of ‘hostile’ leaders Neo-colonialism Heavy state intervention: banking, education, infrastructure Independence Nation building / gain authority ‘developmentalism’ ideology led to authoritarian governance Keynesian Mimic USSR: achieve growth

11. PRIMARY PRODUCT DEPENDENCY • No manufactured X • decline in terms of trade = vulnerability • World Bank! • INEQUALITY • basic needs not met • focus on capital intensive industry • rate of urbanisation > rate of wage growth • FAILURE TO ENCOURAGE ENTERPRISE • ideological aversion to entrepreneurship • education still lacking • NO TRANSFORMATION OF AGRICULTURE • urban – rural income gap • need to import food • no growth BUT • RENT-SEEKING GOVERNMENTS • short-termism • inability to consider longer-term growth/development

12. The ‘crisis years’, 1974-early 1980s • 1975-1983: only 3 years saw any positive growth, on average, in Africa • 1983: African economies’ GDP per capita fell on average by 5% • Why? • Falling commodity prices and falling demand • Recession in the developed world • Consequences • Balance of payments crises • Economic stagnation and decline

13. The ‘crisis years’ – available policies • Option 2 • See BoP crisis as temporary • Borrow from abroad to finance the deficit • Advice and pressure from external lenders e.g. World Bank / IMF • Option 1 • Accept BoP crisis as structural & long-term • Restructure economy • Change the development model

14. The adjustment years, early 1980s to mid 1990s • Option 2 ‘chosen’ • Copy East Asian model • Rely on markets, not gov’t intervention • Export orientation rather than import substitution is key • Slash public sector spending • Focus on primary product comparative advantage

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16. “While some aspects of this [Asian] model (for instance, greater political insulation of economic policy makers) could reasonable be achieved in African countries, the extensive co-ordinated economic interventions of the East Asian states are well beyond the administrative faculties of most African governments” Lewis, 1996 “...no major expansion occurred in the diversity of products exported by most of the sub-Saharan African countries, although there one or two exceptions like Madagascar and Kenya. Indeed, the product composition of some of the African countries’ exports may have become more concentrated” Ng and Yeats, 2000

17. Far from supporting a minimalist approach to the state, these examples have shown that development requires an effective state, one that plays a catalytic, facilitating role, encouraging and complementing the activities of private businesses and individuals...History has repeatedly shown that good government is not a luxury but a vital necessity. Without an effective state, sustainable development, both economic and social is impossible” Wolfensohn, 1997

19. A familiar macroeconomic framework GDP = C + I + G + X – M GDP = (C + I + G) + X – M GDP = Domestic Absorption + X – M GDP + M – X = Domestic Absorption GDP + trade gap = Domestic Absorption So, if an economy spends more on final goods and services than it can produce, its imports will exceed its exports by the value of the excess expenditure over GDP. This ‘trade deficit’ must be financed i.e. paid for Tanzania persistently has a trade gap about 10% - 18% above GDP, although now shrinking

20. LDCs and trade deficits • Very common in 1980s and 1990s! • Dramatic fall in commodity prices • Global recessions of 1981-82 and 1991-93 • Increased protectionism in developed world against LDC exports

21. Financing trade deficits using current flows • Factor payments • Wages, rent, interest and profit • Transfer payment • Payments not made in return for providing factors of production • Official grants from govt’s, NGOs or international institutions • Money received from permanent overseas factors Tanzanian factor payments have a negative balance, and transfer payments historically fund around a quarter of the trade deficit

22. Other methods • Draw on official foreign exchange reserves • Capital account transactions • Dealing in financial assets (public and/or private) • FDI from abroad • Requires good rates of interest! LDCs such as Tanzania hold very limited foreign exchange reserves. Small, low income countries also tend to have limited access to capital markets, as their economies are vulnerable. Historically, Tanzania found it difficult to attract FDI but rising tourism and demand for commodities from China is helping.

23. Remaining options? GDP + trade gap = domestic absorption Now subtract Consumption (public + private)from both sides Savings + trade gap = Investment Rearranging, gives: Trade gap (i.e. M – X) = Investment - Savings This is the key relationship for many macro policy makers in LDCs

24. Mean African current account deficit (% GDP) 1960 to 2000

25. Implications for LDCs Low income Low savings ratio Low absolute savings Investment cannot be funded domestically Aid is an essential source of finance for investment

26. Aid used for investment in: • Import-substituting industry • Capital-intensive industry • Investment managed by donors • Foreign aid ‘matched’ by domestic spending • Gov’t had to print money! • Rising inflation • Falling real incomes • More aid = more inflation = more poverty

27. Consequences Falling real income, overly rapid urbanisation, mass unemployment due to investment in capital-intensive industries, internal political strife Increasing trade deficit Even more aid! Worsened by falling terms of trade!

28. 1987 - 2001 Export volumes increased by 9.9% p.a. Exports of services (tourism) grew most quickly, and agricultural exports least quickly 3. Rate of increase in export volumes not matched by rate of increase in purchasing power of exports – negative for agricultural exports!

29. ‘Reversion to the mean’ Shocks aside, most African current account deficits now appear to be stable (exceptions are Burkina Faso, Ghana, Lesotho, Mauritania and Senegal, which will become more reliant on international transfers) Attempts to reduce deficits (e.g. devaluation) will only have short-run, temporary effects – no difference to long run deficit

30. Sound economic management Shelter from financial crisis Chinese FDI Rising terms of trade Chinese FDI Rising purchasing power Debt relief Incredible growth Political stability

31. Recent Tanzanian key economic data

33. Conclusions • Shrinking trade gap • Reduced reliance on aid • Productive investment Hope!

34. Thanks to... • Mark Holmes, Loughborough University • ThandikaMkandawire, the UN, the Open University, DfiD and the LSE • Marc Wuytsand Sam Wangwe, the OU