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TRADE AND INVESTMENT
Trade
Free trade – implies free cross-border direct and indirect investment and technology
Advantages
1. Access to
a. physical capital – increase K/L
b. money – increase ability to buy K and raise K/L
c. new technology – increase ability to lower L and increase K/L
d. An actively trading country benefits from the new technologies that “spill over”
to it from its trading partners, such as through the knowledge embedded in
imported production equipment.
e. Access to human capital
2. some may argue that the cause-and-effect connection can also work in the opposite
direction: those countries that are most successful in economic development and
growth can afford to be more open to foreign trade (and thus to foreign
competition) and also tend to be more attractive for foreign investors.
Disadvantages
1. Competition
a. May be good, if it forces developing country to lower costs.
b. May be bad, if it forces companies in developing countries to close
c. Generally, companies in developing countries have not achieved the same lowcost economies of scale as companies in more developed countries have
attained
d. Company closings  more unemployment  lower effective demand
2. Developed countries also impose trade barriers
3. To help developing countries, developed countries should set low or no trade
barriers on agricultural and textile imports
Managed trade
 Tariffs
 Quotas
 Export restraints
 Legal prohibitions
 Currency manipulation
 Subsidies - developed countries provide subsidies to farmers – mostly Europe
Advantages
1. Employment
2. Short-term – protect industry until it achieves economies of scale
Disadvantages
1. Long-term – protects inefficiency
2. Retaliation
3. Trade wars
International Organizations
 International Monetary Fund (IMF) – short-term financing for BOP imbalances
 World Bank – long-term loans for social (overhead) capital projects
 World Trade Organization (WTO, preceded by the GATT until 1995) – trade agreements
Trade Theories
 Absolute advantage
 Comparative advantage – specialization and division of resources among countries
 Heckscher-Ohlin Factor Proportions Model
Differential growth experience
 BRICS
 Sub-Saharan Africa
 Some may argue that the cause-and-effect connection can also work in the opposite
direction: those countries that are most successful in economic development and
growth can afford to be more open to foreign trade (and thus to foreign competition)
and also tend to be more attractive for foreign investors.
Costs and benefits of participating in international trade also depend on such country-specific
factors as
1. the size of a country’s domestic market (bigger, trade less; smaller, trade more)
2. its natural resource endowment (1-2 major natural resources, trade more; more natural
resources, trade less)
3. its geographic location (transportation costs).
Measurement – the ratio of a country’s trade (exports plus imports) to its GDP or GNP
(exports plus imports)/GDP or (exports plus imports)/GNP
Fig. 12.1 Growth in GDP and Exports
North – synonymous with developed
South – synonymous with developing
Trade patterns
North-North Trade

Developed countries still trade mostly among themselves.
North-South Trade

In 1999 only 23 percent of world imports went to low- and middle-income countries,
of which 9 percent went to East Asia and the Pacific and only 1 percent to SubSaharan Africa and 1 percent to South Asia.

The Middle East and North Africa received about 2 percent of world imports, while
Europe and Central Asia and Latin America and the Caribbean received 5 percent
each.
South-South Trade

Even though developing countries have increased trade among themselves,
developed countries still remain their main trading partners, the best markets for
their exports, and the main source of their imports.
Terms of Trade – pH/pROW or pA/pM

TOT for most developing countries deteriorated in the 1980s and 1990s, because prices
of primary goods—which used to make up the largest share of developing country
exports—fell relative to prices of manufactured goods.

Developing countries that depend on primary products (agriculture and natural
resources) lost purchasing power as the prices of primary products, including oil, fell
1980-2000.

Developing countries have diversified and now export more manufactured goods, e.g.,
labor-intensive, low-knowledge products (clothes, carpets, some manually assembled
products) that allow these countries to create more jobs and make better use of their
abundant labor resources.

By contrast, developing country imports from developed countries are mostly capitaland knowledge-intensive manufactured goods—primarily machinery and transport
equipment—in which developed countries retain their comparative advantage.
Figure 12.2 Direction of trade in tradables
Impact on employment and wages

Does the growing competitive pressure of low-cost, labor-intensive imports from
developing countries push down the wages of unskilled workers in developed countries
(thus increasing the wage gap between skilled and unskilled workers, as in the United
Kingdom and United States) and push up unemployment, especially among low-skill
workers (as in Western Europe)?

Empirical studies appear to suggest that although trade with developing countries
affects the structure of industry and the demand for industrial labor in developed
countries, the main reasons for the wage and unemployment problems are internal and
stem from labor-saving technological progress and postindustrial economic
restructuring.
Immigration – international mobility of labor
Types of migration
 Employment-related – alternative to trade-influenced wages
o rapid rise in migration of qualified and highly qualified workers, most notably
in response to labor shortages in the information and communications
sectors of developed countries, but also in the research and development,
health, and education sectors.
o demand is also high for low-skilled foreign labor for tasks resistant to
automation, such as care of the elderly, house cleaning, agriculture, and
construction.
o “brain drain” from developing countries
 Refugees
 People seeking political asylum
South  North migration
 Destination countries: USA, Germany, Japan, Australia, Canada, the United Kingdom,
Switzerland, and Italy.
 Origination countries: Mexico!
Why?
 Increasing gap between developed and developing countries
 Population growth rates still higher in developing countries than developed
countries
 Declining costs of migration (information and transportation costs)
THE WALL?
Investment – international mobility of capital
Types
 Direct foreign investment – real capital (TNCs/MNCs and > 10% of shares)
 Indirect (bank loans and portfolio) foreign investment
o borrowing and lending
o shareholding (< 10% of shares
 Official development assistance (ODA) – foreign government aid - food aid,
emergency relief, technical assistance, peacekeeping efforts, and financing for
construction projects.
o Post WW II – to developing countries – motivated by the desire to support
their political allies and trade partners, to expand the markets for their
exports, and to reduce poverty and military conflicts threatening
international security.
o Post-perestroika – to transition countries – Eastern Europe and Central Asia,
former centrally planned economies also started to receive official
assistance, aimed primarily at supporting market reforms.
Table 13.1 Net capital flows
Distribution of FDI among developing countries remains extremely unequal.
 China, Brazil, Mexico, Argentina rec’d the most – about the same amount as all other
countries
 The bulk of FDI flows tends to go to middle income countries, so the exclusion of the
poorest countries may have contributed to further widening of global income
disparities.
 Sub-Saharan Africa as a whole receives about 5% of all FDI and most is concentrated
in countries rich in petroleum and minerals.
Attraction factors – favorable investment climate:
 Stable political regime
 Liberal and predictable government regulation
 Good prospects for economic growth – strong effective demand
 Infrastructure
o Utilities
o Communication system
o Transportation system
 Skilled labor supply
 Easy convertibility of the national currency
 Tax considerations
Advantages to developing country
 advanced technologies


managerial and marketing skills
easier access to export markets
Disadvantages to developing country
 insensitivity of foreign companies
 exploitation of local workers
 at hint of political trouble, foreign capital flees
Indirect foreign investment
 portfolio investment is even more dangerous than foreign direct investment,
because portfolio investors—who own only a small percentage of shares in a
company and have little or no influence on its management—are much more likely
to try to get rid of these shares at the first sign or suspicion of falling profits.
Official Development Assistance (ODA)
 most important source of foreign financial flows for countries that are unable to attract
private capital or private borrowing
 Declining as % of GDP since peak in 1960s
Three types:
o Grants, which do not have to be repaid.
o Concessional loans, which have to be repaid but at lower interest rates and over
longer periods than commercial bank loans.
o Contributions to multilateral institutions promoting development, such as the
United Nations, International Monetary Fund, World Bank, and regional
development banks (Asian Development Bank, African Development Bank, InterAmerican Development Bank).

Donor countries concern: Aid may not be used efficiently enough in the countries with
poor policy environments and particularly in those suffering from high levels of
corruption among government officials. Large amounts of development aid can be
wasted in such countries, while they could have brought considerable improvements to
people’s lives in other countries.

“Tied” aid: requires recipients to purchase goods and services from the donor country or
from a specified group of countries.
o Tying arrangements may prevent a recipient from misappropriating or
mismanaging aid receipts,
o but they may also reduce the value of aid if the arrangements are motivated by a
desire to benefit suppliers of certain countries, and
o that may prevent recipients from buying at the lowest price.

“Tied up” by conditionalities or “policy-based assistance”
o aid depends on the enactment of certain policy reforms that donors see as
beneficial for recipient countries’ economic growth and poverty reduction, e.g.,
aid to transition countries is often tied to the speed of market reforms.

Aid to “heavily indebted poor countries” (HIPCs)
o International Monetary Fund and the World Bank program launched in 1996
o Aims to reduce the unsustainable burden of foreign debt
o In order to qualify for assistance under this program, countries must be not only
poor (low-income countries, by World Bank criteria), and not only severely
indebted (with the sum of foreign debt exceeding 150 percent of their export
returns), but they must also be able to show their ability to develop and
implement their own poverty reduction strategies.
o The goal is to make sure that the budget funds that will be freed up from
servicing those countries’ foreign debt will indeed be used in the interests of
their development rather than diverted to other uses (such as military).
Further issues:
1. Would you agree that the quality of national policies aimed at economic growth and
poverty reduction should as a rule govern donors’ decisions to provide aid to this or that
country?
2. Which other ways of improving ODA’s effectiveness would you suggest?
How does trade affect growth graph?
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