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DEBT AND TRADE: MAKING LINKAGES FOR THE PROMOTION OF DEVELOPMENT

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DEBT AND TRADE:

MAKING LINKAGES FOR THE

PROMOTION OF DEVELOPMENT

REPORT FROM A POLICY ROUNDTABLE

GENEVA, SWITZERLAND

Edited by Aldo Caliari

THE SOUTH CENTRE

In August 1995, the South Centre became a permanent intergovernmental organization of developing countries. In pursuing its objectives of promoting South solidarity, South-South cooperation, and

coordinated participation by developing countries in international forums, the South Centre prepares, publishes and distributes information, strategic analyses and recommendations on international economic, social and political matters of concern to the South. For

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studies and publications benefit from technical and intellectual capacities existing within South governments and institutions and among individuals of the South. Through working group sessions and

consultations involving experts from different parts of the South, and also from the North, common challenges faced by the South are studied and experience and knowledge are shared.

THE CENTER OF CONCERN

Rooted in Catholic social tradition, the Center of Concern works collaboratively to create a world where economic and social systems guarantee basic rights, uphold human dignity, promote sustainable livelihoods and renew Earth. (www.coc.org)

ACKNOWLEDGMENTS

This publication and the event that it documents were made possible thanks to generous support provided by (in alphabetical order) the Agence Française de Développement (AFD), the Ford Foundation, the

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© Center of Concern, 2009

DEBT AND TRADE:

MAKING LINKAGES FOR THE

PROMOTION OF DEVELOPMENT

TABLE OF CONTENTS

DEBT AND TRADE: MAKING LINKAGES FOR THE

PROMOTION OF DEVELOPMENT—AN INTRODUCTION Aldo Caliari and Vicente Paolo Yu........................................................... i

OPENING ADDRESS: LINKING DEBT, TRADE AND

FINANCE ISSUES

Yash Tandon .............................................................................................. xi

I. THE POLITICAL DIMENSIONS OF LINKING

DEBT AND TRADE .................................................................... 1

I.1 TIME FOR CHANGE IN GLOBAL TRADE AND FINANCIAL

GOVERNANCE.

Barry Herman.......................................................................... 1

II. THE TECHNICAL DIMENSIONS OF LINKING

DEBT AND TRADE ................................................................... 18

II.1. THE DEBT TRADE CAUSALITY IN BALANCE OF PAYMENTS

ACCOUNTING.

Jan Kregel ........................................................................... 18

II.2. CONCEPTUALIZING SOVEREIGN DEBT

Matthias Rau. ...................................................................... 24

III. THE POTENTIAL AND LIMITATIONS OF MARKET

ACCESS TRADE TRENDS AND WHAT THEY MEAN

IN TERMS OF INCOME GAINS FOR DEVELOPING

COUNTRIES................................................................................ 29

III.1. TRADE TRENDS AND WHAT THEY MEAN FOR

INCOME TRENDS OF DEVELOPING COUNTRIES Mr. Jörg Mayer ................................................................. 29

III.2. EXPORT-LED GROWTH BASED ON MANUFACTURES

Mr. Arslan Razmi .............................................................. 37

III.3. TEXTILES AND PREFERENCE EROSION:

THE CASE OF MAURITIUS

Mr. Umesh Sookmani ........................................................42

III.4. Mr. Matthew Odedokun ....................................................48

IV. ISSUES IN THE EXPORT GROWTH-DEBT

REPAYMENT LINK ...................................................................53

IV.1. Ms. Lida Nunez ...................................................................53

IV.2. Mr. Richard Kozul-Wright .................................................60

V. FOREIGN DIRECT INVESTMENT RULES AND THEIR

EFFECTS ON DEBT ...................................................................67

V.1. Professor Andreas Antoniou ..............................................67

V.2. Mr. Alfredo Calcagno ..........................................................70

V.3. Ms. Christina Weller............................................................80

VI. DOMESTIC MONETARY POLICY AND DEBT ...................87

VI.1. THE POLITICAL ECONOMY OF TRADE,

FINANCE AND THE EXCHANGE RATE

Mr. Luiz Carlos Bresser-Pereira ................................................87

VI.2. Mr. Heiner Flassbeck. ........................................................92

VI.3. Mr. Richard Kozul-Wright .................................................95

VII. DEFINING DEBT SUSTAINABILITY.....................................98

VII.1. Mr. Damian Ondo Mane ..................................................98

VII.2. Ms. Machiko Nissanke ....................................................101

VII.3. Mr. Matthew Odedokun ..................................................106

VIII. FACTORING TRADE PERFORMANCE INTO DEBT

SUSTAINABILITY ASSESSMENTS .....................................111

VIII.1. Mr. Manuel Montes .......................................................111

VIII.2. Ms. Cecile Valadier .......................................................115

Overview i

DEBT AND TRADE: MAKING LINKAGES FOR THE PROMOTION OF

DEVELOPMENT—AN INTRODUCTION

Aldo Caliari, Center of Concern and Vicente Paolo Yu, South Centre

This volume gathers the presentations delivered at the second in a series of policy roundtables

1 that had the objective of promoting an integrated

approach to policy-making on trade and finance. The premise of this and

the previous roundtable is that a holistic approach to policy –making in trade and finance can bring substantial improvements in ensuring systemic coherence and providing better development outcomes than an approach that would take such areas in isolation.

The roundtable “Debt and Trade: Making linkages for the Promotion of

Development” also jumped off from that same premise. This time, however, it singled out debt as a specific area of finance. The objective was to create a space to explore the potential implications that an

integrated approach that bridges trade and debt may have for policy-makers focusing on, or specializing separately in, each of those areas. We would like to express our deep appreciation to the participants at the

Seminar on Debt and Trade Linkages that was held in Geneva on 13-14 September 2007.

2

The next piece after this introductory section is a transcript of the inspirational opening speech delivered by Mr. Yash Tandon, the Executive Director of the South Centre (from January 2005 to February

2009), which sets the stage for the discussions that followed. Mr. Tandon lays out the way that the structural interdependence between debt and trade has operated as a constraint to development in developing

countries. The real debate, he argues, about debt and trade policy coherence is over space in which developing countries can freely pursue

1 The first in the series was called “Trade and Finance Linkages for Promoting Development”

which took place in 19-20 October 2006 in Geneva and was cosponsored by Center of Concern, South Centre and German Marshall Fund of the US. The proceedings were gathered in a book that is available from both South Centre and Center of Concern, and can be downloaded at http://www.southcentre.org/.

2Details on this second seminar are available at

http://southcentrenet.blogspot.com/2007/09/south-centre-organizes-seminar-on-debt.html.

their own development policies and priorities. The central questions are on the roles that both debt and trade can play in the economic reform

process, to what extent deeper integration into the current global economic framework is or is not desirable for developing countries, and the alternatives they have in strategically selecting their terms of engagement or disengagement.

Section I, with a focus on the political dimensions of linking debt and

trade, comprises only one presentation, by Mr. Barry Herman, of the New School in New York. Mr. Herman observes that the specialized economic institutions have strong mandates in their own fields, but that

there is no effective mechanism to bring about inter-institutional coherence. The Group of 7 has acted as the one forum where Heads of State meet and can make their respective trade, finance and development

ministers work together in institutions they share, but this is an exclusive forum. He traces the efforts to generate integrated discussions on trade and finance in a more inclusive forum back to UNCTAD in 1964. But such process gradually lost momentum. It is in this context of

failing mechanisms for coherence that he places the unique set of circumstances characterizing the lead up to the Monterrey Conference on Financing for Development in 2002. He states that the UN offers still

the best opportunity for a confidence-building process on global economic reform. As it was the case before the Monterrey Summit, this process requires extensive cross-fertilization between UN delegates and their finance and trade ministry colleagues.

In Section II, the focus is on the technical dimensions of linking debt

and trade. The presentation by Mr. Jan Kregel, of the Levy Institute, provides the right starting point by looking at “The debt-trade causality in balance of payments accounting.” Examining the experience of the

19th

century he argues that trade was seen as an engine of growth not because of a perceived efficiency of open versus closed trade but a result of foreign capital and labor inflows to the developing areas. These

flows created exactly the production and the exports processes that were necessary to allow the repayment of financial obligations. In contrast, the paradigm prevailing since the GATT system emphasizes separation of trade in goods from financial factors. It focuses on trade as a way to

create efficiency gains via opening closed markets, thus separated from the accompanying financial processes that were key to the 19

th century

concept of trade as an engine of growth. Trade is perceived as the cause,

not the consequence of financial flows, and gives rise to a theory on the adjustment of the balance of payments that relies on income adjustment.

Overview iii

But the impact of capital flows on trade cannot be simply wished away. So, as globalization and capital mobility progress, the relationship

becomes even clearer, and can be seen in how it is the investment decisions of large multinational companies that decide which parts of the production chain take place in different countries, and the trade patterns across them.

The intervention by Mr. Matthias Rau, from UNCTAD, takes on the

conceptualization of sovereign debt. His input is important for the characterization of the trade –debt relationship. It is usually understood that the need to generate foreign exchange for payment of external debt

is an important motivator for the generation of export income. But Mr. Rau explains that the share of domestic debt in developing countries has been growing and amounts to more than 50 percent of their total debt.

While this may represent a reduction of vulnerability to external shocks, there are also risks inherent to the greater reliance on domestic debt. At the time of this presentation, the period had been one of improved solvency indicators but the shift to domestic debt was also opening up

new risks in what he calls “the unexplained part of debt,” whose materialization he foresees could take place under less benign conditions.

Section III starts to address more concrete impacts of an integrated approach to debt and trade by looking at “The Potential and Limitations

of Market Access.” Indeed, a central idea behind the reform programs adopted by a large number of countries since the 1980s was that an export-oriented model would allow them to earn the foreign exchange to

attend growing external debt payments. Even today, there is a widespread perception that enlarged market access for developing country export products is the most direct trade response to solve the

debt problem in a sustainable way. Interventions were asked to address to what extent was there a relevant link between market access and a solution to the debt problem.

Mr. Joerg Mayer, from UNCTAD, shows that the relationship between trade growth and income growth is not a straightforward one. In fact,

while developing countries have increased their share in world manufacturing trade, their share in world manufacturing value added had declined. While this is true in the aggregate, it appears that trade and

income are most favorably related in countries that succeeded in upgrading their manufacturing activities toward more technology-intensive products. From this he draws important conclusions for trade

integration strategies. In order to improve income generation and, thus, debt servicing capacity, integration should rather be part of a wider

outward oriented industrialization strategy. While deep integration might simply boost exports of goods with high import content, strategic integration might make trade growth less pronounced, but generating a

denser domestic production network, thus favoring domestic income generation.

Prof. Arslan Razmi of the University of Massachusetts then assesses the case of developing countries that went for an export-led growth strategy based on manufactures, as opposed to commodities, as a way to improve

terms of trade. In his view, confirmed by looking at a sample of developing country exporters, the fact that many countries pursue similar export markets in similar products puts them in competition with

each other. The fallacy of composition, typically associated with commodities, becomes true for manufacturing exports, too. It creates incentives to lower costs and the short-term ways to do that are lower wages and /or an undervalued exchange rate. Moreover, it ensures that if

gains are made, they come at the expense of other developing countries. An important insight also emerges from his presentation regarding strategies of exchange rate undervaluation. While their export

consequences would usually affect more strongly other developing countries that compete in the same product, the currency composition of the external debt would lead to balance sheet effects that worsen the position relative to developed countries.

Mr. Umesh Sookmani, from the Mission of Mauritius at the UN and the

WTO in Geneva, offers a good complement to the previous intervention by presenting the experience of Mauritius. This is one of the countries that have made better use of trade preferences, transforming from a

monocrop agricultural economy in the 1970s through a gradual diversification into manufacturing, tourism, etc. But now that preferences are coming to an end it faces a number of challenges, that

may be aggravated with the liberalization being promoted in negotiations on non-agricultural market access. He details the negative effects on employment, Foreign Direct Investment and export revenue, as well as the possibility that deep cuts in industrial tariffs in traditional

markets of export may represent further erosion of its margins. At the end he presents an illustration of the measures that Mauritius is putting in place but also a clear sense that these measures cannot go very far

without support from the international community’s policies on aid, debt and trade.

Overview v

In the presentation that follows, Mr. Matthew Odedokun addresses the problem of commodity price instability and how it affects debt. In low

income countries generally the export structure is heavily focused on a few –sometimes one or two—commodities. The dynamics this creates is that during commodity boom years the excess revenue leads to

excessive borrowing –supported by less prudence by both lenders and borrowers. During the bust years, loans are taken to defend past commitments and complete projects started in good times, while debt service tends to be renegotiated into less favorable ones, due to

increased risk. He suggests an emphasis on three sets of measures: the prevention of exports price instability, the mitigation of its consequences, and policies and incentives to change management of the boom-bust cycle.

Section IV undertakes an exploration of selected “Issues in the export growth-debt repayment link.” The first presentation under this section, by Ms. Lida Nu!ez, from Corporación de Investigación y Acción Social y Económica (Colombia), addresses experience relevant to the export

growth-debt repayment link in Latin America. In this experience, increases in exports have failed to boost GPD growth significantly, with marginal improvements on the debt situation. The heavy focus on

natural resources that is a feature of the export basket may be a factor but some South American countries, especially in the MERCOSUR area, have diversified their exports. She identifies the difficulty in

adding value and knowledge to exports as the main limitation to the growth-boosting potential of exports. On the other hand, the export base bears the promise of a platform for strategies that boost domestic value

added and the intensification and extension of learning processes and innovation. The experience on FDI reinforce the notion that for it to lead to growth, it is crucial to avoid that it goes into enclaves, mere purchase of existing assets that may be associated to it and/or massive capital outflows in the form of royalties and dividends.

Mr. Richard Kozul-Wright, in the following presentation, argues that the debt crisis was also a crisis of inward-orientation, leading to a sort of win-win logic that focused on removing distortions and state intervention as a way to foster a virtuous growth cycle. But an

alternative view of the link between trade and development is on the rise again, one where a key aspect of trade policy is how to translate increased export revenue into investment in new lines of economic

activity. This thinking is validated by the finding that it is diversification, not specialization, that favors growth processes. He

points to the essential role of policy to drive manufacturing and changes of structure— “getting structure right”, as opposed to “getting incentives right.”

Foreshadowed in the previous section is the focus of Section V: FDI

rules and their relation to debt. One of the warnings of Mr. Kozul Wright at the end of his presentation is to not confuse linking investment to exports with attracting foreign investment. Indeed,

common advice to developing countries tends to equate the attraction of FDI with improvements in the balance of payment constraints, and the plugging of debt gaps. The presentations in this section offer three

perspectives in discerning the relationship between the role of FDI and debt. Professor Andreas Antoniou’s presentation, in a first take at this relationship. While it is argued that FDI stimulates growth and enhances

the competitiveness of the economy, thus diminishing the risk of default, there are also detrimental effects that FDI may have on the risk of default.

A second take at the relationship is in the intervention by Alfredo Calcagno, of UNCTAD. Drawing on a rich sample of country case

studies, he shows that the distribution of the rent of natural resources makes a big difference to whether the higher prices from these resources accrue to the local economy. The structure of foreign investment in the sector can determine that net income payments offset the improvements in terms of trade, erasing the potentially beneficial effects of trade.

Yet a third approach is contained in a presentation by Ms. Christina Weller, of Christian Aid. While she reinforces some of the points of the previous presenters, her intervention raises important points regarding

the interaction of the FDI regime with the capacity of governments to appropriately tax economic activity and stop capital flight. Given that public revenue is the crucial denominator in talking about debt risk and debt servicing capacity, the importance of this approach to FDI cannot

be overstated and bears clear implications for the regulation of FDI, some of which she mentions in her recommendations.

The following Section VI looks at debt and trade and how their link is modulated through monetary policy. Professor Bresser Pereira, from Getulio Vargas Institute and former Minister of Finance of Brazil, holds

that the exchange rate is a strategic macroeconomic price and that developing countries are better off managing it than letting it freely float. Otherwise, the tendency is towards an appreciation, due to Dutch

Overview vii

disease, growth cum foreign savings policy, or what he calls “exchange rate populism.” In this condition, contrary to conventional wisdom, the

equilibrium exchange rate will not be one that equilibrates intertemporally the current account, with negative consequences for the competitiveness or profitability of tradable industries.

In his presentation, Mr. Heiner Flassbeck, from UNCTAD, continues the thread of analysis on managed exchange rates but puts it in the

context of more structural regulatory gaps in international financial markets. Carrying money from low to high interest rate countries actually exacerbates the difficulties with a freely floating exchange rate

and is the main reason why exchange rates left to float will fluctuate farther, rather than closer, from equilibrium. On the other hand, not all countries can keep an undervalued currency. As long as large surpluses

of some countries need to be matched by large deficits in others, this is not a lasting solution and that is why UNCTAD advocates an international agreement on exchange rates that rationalizes the discussion on what equilibrium exchange rates are.

The section finishes with an intervention by Mr. Richard Kozul Wright

where he connects the earlier discussions on FDI and its impact on trade patterns with the one on domestic monetary policy. He speaks about the “financialization” of investment, meaning that finance is dominant not only in the short term, but also in the long term capital flows that were

considered a more beneficial form of FDI. He hypothesizes that, in such scenario, the view prevalent in the early post-war period, which treated FDI just as another capital flow, might make more sense as a framework

for analysis. Monetary policy of developing countries is likely to be a much bigger issue under this approach to FDI.

While the previous sections looked at the linkage between debt and trade more with an eye on trade or investment policy, Section VII moves to discuss the linkage with an eye on the debt sustainability and debt management policies.

Mr. Damian Ondo Mane, former Executive Director for one of the African Countries constituencies in the IMF, examines a number of issues that compromise debt sustainability in African low income countries. His view is that there are examples where trade has been used

to reduce poverty and wealth inequality, but that is far from being the case in Africa. Administrative capacity, economic infrastructure, the level of labor market skills available, as well as limitations in the

markets of export interest (tariff escalation, technical and scientific standards that cannot be fulfilled, etc.) are among the obstacles to

overcome. Debt sustainability and avoiding a new debt crisis are crucial to ensure investment reaches low income countries.

In next presentation Ms. Machiko Nissanke, Professor at School of Oriental and African Studies in London, observes that the donor and creditor community has identified policy failure to be the root of the

debt problem of low income countries. Thus, in aid and in debt sustainability assessments there is a heavy role attached to Performance-Based Allocation systems. But there is a direct connection between the

continued deterioration of the debt of low-income countries and their export dependence on commodities. Consequently, a focus on vulnerability to external shocks in guiding aid allocation and debt

sustainability processes would yield better results, as it more accurately would capture the reality of the target countries. She proposes state-contingent aid and debt contracts that operate as a sort of ex ante debt relief mechanism: a contingent credit line would be activated should an exogenous shock materialize.

In a presentation delivered under this section, Mr. Matthew Odedokun from the Commonwealth Secretariat addresses different concepts of debt sustainability and some of their intricacies. They are debt sustainability as a sustainable return on projects financed by such debt,

debt sustainability as debt repayment capacity and the human development concept. He advocates this latter could be adapted to incorporate not just spending to meet MDGs, but also spending to invest on trade that generates new public finance resources.

The final section, “Factoring trade performance into debt sustainability assessments” offers a complement and follow up to the previous one. Mr. Manuel Montes, from the UN Financing for Development Office, makes the point that before trying to infuse trade considerations in the

indicator it is important to understand to whom the indicator is intended to be of use. Debt sustainability indicators are currently of use to the lenders, they protect them. But borrowers arguably have an interest, too,

on shaping them. Trade is needed to service the debt so, to the extent that trade shocks are excluded from consideration in assessing debt sustainability, the risk is shifted to the borrower. He notes that the

current debt sustainability exercise incorporates stress testing, but does not distinguish between endogenous and exogenous shocks.

Overview ix

In the final presentation Ms. Cecile Valadier, from Ecole Normale Superieure of Paris, closely follows other presentations in holding that

the high concentration of exports in low income countries constitutes a vulnerability that plays a large role in determining debt distress events. As a response to this issue she introduces a lending instrument that can

decrease the likelihood of debt crises and costly restructuring processes. This is a concessional loan with a fixed grace period and a floating one. If a shock occurs, the borrower can make use of the floating grace period, thus smoothing debt service. In spite of a number of operational

challenges, there is promise that a mainstreaming of this mechanism could help practically factor trade performance of borrowers in debt sustainability.

Trade, debt and the global financial and economic crisis

While the policy roundtable took place in the cusp of an unprecedented boom of world trade, as this volume was being compiled and edited a

crisis that begun in the subprime mortgage market of the US in 2007 became a financial and economic crisis of global proportions.

As a result what was, in the aggregate, an improving debt situation for developing countries has taken again a turn for the worse. Global trade is expected to contract in a 10 per cent in 2009, the greatest contraction

since the Great Depression. Many developing countries have seen their situation of trade surplus rapidly turn into a deficit. This creates an environment where developing countries, much more highly dependent

on exports for their income, will see their access to foreign exchange diminished, and pressure on their public debt profiles intensified.

In the face of this crisis the agenda proposed throughout the contributions in this volume is far from having lost currency. On the contrary, their attentive reading will reveal that the crisis is not an

anomaly in what was an otherwise harmonious growth of trade, but rather the patterns and characteristics of the trade boom sowed the seeds of the vulnerability that countries are experiencing in these difficult times.

As the crisis exposes the fault lines throughout the current model that

links international trading and public debt, nationally and internationally, the material in this book represents a useful roadmap to the issues that need to be addressed. Indeed, only crisis recovery

measures that dare to reshape the paradigm linking trade and debt on the

basis of the lessons learned can lead to a more resilient and development-oriented global economy.

Introduction xi

OPENING ADDRESS:

LINKING DEBT, TRADE AND FINANCE ISSUES

Yash Tandon

Executive Director, South Centre

This meeting is the second meeting in a series that was organized to address the issue of the interface between trade and finance, which is

very critical. In the first meeting, that we had last year, the discussion was on trade and finance linkages to promote development. In this particular meeting we hope to address the issue of trade and debt, and

see the complex links between these two factors. We know that for those of us who come from the South, development has been a challenging objective, especially those of us who come from the smaller countries in the South – from Africa and the Caribbean – and therefore it’s very

important for us to be able to address critical dimensions of development in international trade.

The link between trade components and debt levels is highly

interdependent and complex. Debt can be, and often is, in many countries, a major constraint on development, and international trade. Poor trade performance, added to by declining terms of trade or

monetary crises, can bring about a downward trend in the development scenario. The problem of the large debt overhang in developing countries is a result of the confluence between the particular

circumstances of trade, within the international economic system, and the structure of that very system. That makes it very difficult to develop. We have structural constraints and circumstantial constraints to development.

There are a number of factors that can intensify these problems for

developing countries, and the ways in which each sector behaves, or is acted upon, by the global trading system, simply accentuates the debt crisis. The main factor is the continued reliance of many developing

countries on primary commodities, and low value-added goods. We have discovered over the years that on the account of the hasty trade liberalization on the part of many of those countries, one of the effects of that has been de-industrialization and in some countries, even de-

agriculturization. We have moved away from productive enterprises, through floating our human resources outside our countries.

xii Debt and Trade Making Linkages for the Promotion of Development

The unpredictable and volatile nature of finance also increases our vulnerability in the international system. Unable to rely on sure

incomes, the shift to higher value-added goods production is nearly impossible for many developing countries. The second factor is the continued application of poorly planned policy reform advice, especially

that type given by the Bretton Woods institutions and other governments. That policy advice factor is a major issue that we need to examine.

We must also deal with international trade and financial institution-sanctioned protectionism and discrimination against developing goods,

and limited amounts of support in breaking free from the debt trap. There are two dimensions here that we need to look into. We need to look both into the investment regime, and the trade regime. We haven’t

had the quality of investments in our countries that can add value to production in many of the countries in the South – by no means all countries in the South, but many countries in the South.

The global trading system as a whole and international trade, WTO, and IFIs, play of course a major role in the continuation of this trade debt

problem. There are trade commodity price stability, tariff and non-tariff barriers, and financial problems, financing and exchange rates – these create a system of destruction in which many poor countries are embedded. And to get out of this kind of structure is challenging to us.

The international trade groups designed and hosted by the WTO reflect

major inequalities between members and within the larger world trading system. Lop-sided free trade constitutes the main problem that continues to be inadequately approached. Conditionalities continue to be attached

to loans and debt relief mechanisms that are poorly designed and mismanaged by the Bretton Woods institutions. The accompanying policy advice tends to have as its aim the repayment of the debt, rather than addressing the root cause of the problem, mainly the low level of development of developing countries.

In recent years, as a result of debt relief to some poor countries in the South, especially in Africa and Latin America, for once, they made the possibility for us to exercise more policy space, more policy options, and one of the challenges that we must address, is how best we can

utilize this policy space that we now have, in order for us to design our own policies, independent of the Bretton Woods institutions. So the

Introduction xiii

question of trade and debt is something that we will examine closely within the next few days.

The global trade and debt policies must enable developing countries to maintain and even expand their policy space to allow for greater flexibility. The key question for global economic institutions, such as

the Bretton Woods institutions and the WTO therefore is whether they are in the present form capable of supporting this need for greater development policy space and flexibility for developing countries. Are

there actions that could be taken within their institutional constraints that could promote policy space? Are they, and other global institutions such as UNCTAD, capable of stabilizing the markets of concern to

developing countries, especially fabric commodities and low value-added manufacturers, to better assure them more reliable incomes in the short to medium-term, while promoting a system in producing and

trading higher value-added goods? These are questions we need to address.

Hence, the real debate central to debt and trade policy coherence and global economic policy-making is over space for development policies and priorities. The central question should be about the kinds of

economic development policies that will be taken, their sequencing, the roles that both debt and trade can play in the economic reform process, the extent to which deeper integration into the current global economic

framework is or is not desirable for developing countries, and the alternatives that developing countries have in strategically selecting their terms of engagement or disengagement with such a global economic framework. We need to keep our mind open, even to the

possibility of limited and selected disengagement from the global system, for some of our countries, in order for them to be able to organize their own production systems and their own regional

integration, so that, with a position of strength and increased economic power, they can renegotiate their entry into the global system on better terms than the present. So we must be open-minded about all possible options.

It is my and the South Centre’s hope that through this seminar, we may

able to move a step forward in discerning the answers to these questions. Of course we are facing a rapidly changing world, economically, politically, and climatically, and changing conditions require innovative

responses, fresh perspectives, and flexible solutions. We do have the possibility of exploiting the new political geographic configuration that

xiv Debt and Trade Making Linkages for the Promotion of Development

has now shifted – some of the energies of economic development, from the North to countries of the South like China, Brazil, and South Africa

– and we must see if these new possibilities open up options for the smaller countries in the South to be able to engage or realign themselves differently from what they have been into in the last thirty or forty years.

So we need flexible solutions, we need open minds, we need alternatives, we need to look into details in the relationship between

debt and finance. I hope that the deliberations of this meeting will perhaps inform current debate and I hope they’ll also inform the debate on financial development that takes place in October in New York. I

hope that with the membership of this meeting – as I can see many of you come from very experienced backgrounds from your countries, engaged in not only academic discourse, but also policy making – I hope

this is a source of rich interaction among you, and that we are able to address some of the challenging questions that face us as we go into the next decade. On behalf of the South Centre, and our co-sponsors, I’d like to welcome you and to wish you a good discussion. Thank you.

The Political Dimensions of Linking Debt and Trade 1

SECTION I

THE POLITICAL DIMENSIONS OF LINKING DEBT AND TRADE

TIME FOR CHANGE IN GLOBAL TRADE AND

FINANCIAL GOVERNANCE

Barry Herman

Graduate Program in International Affairs, The New School, New York

One of the advantages of retiring from a long career in the UN Secretariat and rejoining academia is that you can step back from daily responsibilities. You can ask yourself, “After almost 30 years, what

sense does it all make?” I have begun to think about that and I will say some things to you today based on such reflections.

I’ve been asked to address global political dimensions of the linkages between the international trade and external debt of developing countries. I am basically going to make three points, and then draw a

conclusion. First, international trade and external finance — and thus trade and debt — are so intimately linked that it is amazing we even need to think about linkages. Probably the reason has to do with my

second point, which is that international policy makers have largely separated decision making on international trade and financial policy into distinct, specialized forums. There should be no surprise if the

decisions they reach are not always consistent with broad international policy goals. Third, while there is one international forum at which coherent policy decisions can be made on trade and financial policy, most countries have been excluded from participating in it. The

decisions that are made in that forum presumably accord at least with the policy goals of the countries that participate in making them. My conclusion is that the world is not better for this structure. The current

challenges in the major international trade and financial institutions only underline the problem. Policy makers in the North and South would do well to ask themselves how to reach better international decisions on

trade and financial policy. The intergovernmental conference at the end of 2008 in Doha, Qatar to review the Monterrey Consensus on Financing for Development provides an opportunity to kick off a collective effort to design a more balanced and effective structure.

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3 In a post-script, I will point to a proposal (not my own) on how to start looking, post-Doha.

2 Debt and Trade Making Linkages for the Promotion of Development

Trade and Finance Are Inextricably Intertwined

First point, perhaps not necessary to state explicitly, but for

completeness here it is: international trade requires international finance and vice versa. Trade is not on a cash basis; trade takes time and so it needs to be financed. Also, from the start, ships carrying international

trade also carried the mail, including not only commercial and personal mail but also securities. Shipping — and electronic communication today — is an internationally provided service and thus itself part of international trade. So, international trade and finance have always been intimately linked.

Trade has even provided opportunities for creating financial securities that are then traded on domestic financial markets. A prominent example is the “banker’s acceptance” in which an importer takes a loan

from a bank in his country which accepts to pay a foreign exporter’s bill for goods shipped. The importer repays the bank after selling the imported goods. The bank can hold the acceptance until repayment by the importer on maturity of the loan, or sell it on the local financial

market at a discount. The buyer of such a security receives the face value of the security when it matures and thus gets his money back plus interest; he has bought a short-term bank-issued security and could not

care less that it finances international trade. When did this market start? It was already known in 12

th century Europe.

You can also say, at least at the level of a country as a whole, that international finance does nothing more than change the time path of a nation’s international trade. Twenty years ago I was working for a UN

commission concerned about African debt,4 when a member of the

commission, Robert Hormats of Goldman Sachs, made the simple and in the context startling observation that external debt is simply

postponed trade. What he meant is that when financial flows are accommodating, the total value of imports into a country can exceed exports and the balance of trade in goods and services will then be

negative. The deficit would be financed by financial inflows; there is a “net transfer” of financial resources to the country. For the most part, these inflows are not grants; they are loans. Add them up and you have the country’s foreign debt.

5 The makers of loans expect that at a later

4 See Financing Africa’s Recovery (Report and Recommendations of the Advisory Group on Financial Flows to Africa, Sir Douglas Wass, Chairman), United Nations, New York, 1988.

5 To be precise, the “net transfer” comprises all financial flows in and out of a country,

including interest and profit payments, direct and equity portfolio investment, and grants and


point they will be repaid, which means at the country level that at some point the trade balance has to be reversed. You then have a balance of

trade surplus and thus a net financial transfer abroad; exports will be greater than imports. The policy question is only a matter of when it is appropriate for the shift to take place. That is the nature of the intimate

linkage of international finance and trade at the macroeconomic level. Economists have been talking about these issues for the longest time.

Furthermore, the International Monetary Fund (IMF) today examines the linkages of international trade and finance of member countries as part of its standard, annual “Article IV consultations.” It considers the

prospective sustainability of each country’s external debt by looking at the future path of the ratio of external debt to export revenues under “baseline” and alternative scenarios.

6 If the exercise shows that the ratio

“explodes” at some future point or under some potential economic shock that is tested, such as a significant devaluation of the exchange rate, the debt is deemed excessive and policy adjustments are recommended. For low-income countries, the Fund goes a step further,

in cooperation with the World Bank, and assesses the current external-debt-to-export ratio against a set of benchmarks meant to flag when the debt is too high, at which point official creditors are asked to switch

support of the country from loans to grants (whether or which creditors do so is a separate story).

In carrying out their debt sustainability analyses, IMF and the Bank cannot help but notice the linkages of trade and debt. They may see that developed country import restraints on developing country exports

impede their achieving debt sustainability, but they are impotent to do anything about it. They must also accept the volatility of international commodity markets as a given. Policies that might address these issues

are classified as trade policies and are thus beyond the mandate of the two institutions.

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loans made to and by residents of the country or its government (see United Nations, World

Economic Situation and Prospects, issued annually, which regularly tracks the net financial transfers of groups of developing countries). For most developing countries, especially at an

early stage of their development, the net transfer primarily comprises foreign lending to the country.

6 It similarly analyzes the dynamics of total government debt relative to gross domestic product under multiple scenarios.

7 This notwithstanding, IMF and World Bank are widely accused of asymmetrically pushing developing countries to unilaterally remove their trade barriers as part of the conditionality for

financial support (see “The IMF’s Approach to International Trade Policy Issues: Preliminary


The Power Politics of Debt and Trade

The relationship of a developing country to its foreign government and

multilateral official creditors is obviously a political one, by definition. But this is only one aspect of the politics of international debt. From early in the 19

th century until Second World War, much of the

international financial flows that were not directly financing trade were monies lent to the governments of developing countries, usually in the form of foreign private purchases of sovereign bonds or of corporate bonds linked to major government supported infrastructure projects,

such as building railroads. When some of the borrowing governments found they could not repay, bondholders formed national committees to try to recoup their investments and often complained to their own

governments. That being the age of imperialism, the governments sometimes — albeit infrequently — took military action in support of the defaulted creditors. The most famous examples were the bombing

of the port of Veracruz, Mexico by Great Britain, France and Spain in 1861 (followed by the French invasion in 1863), and the joint blockade of the ports of Venezuela by Germany, Britain and Italy in 1902-3 to capture customs house revenues to pay off the debt.

Outright interventions to collect sovereign debts not only were extreme

ways to settle financial disputes, but they also provided excuses for expanding imperial influence over developing countries and territories, as in Tunisia (1869-70) and Egypt (1876), as well as in Latin America.

Thus, when intergovernmental peace conferences were convoked in Europe to seek ways to settle international disputes short of war, one focus of attention was sovereign debt crises. The result in this case was

the “Convention Respecting the Limitation of the Employment of Force for the Recovery of Contract Debts” signed at The Hague in 1907. It sought to substitute international arbitration for invasion of defaulting debtor countries.

While the United States supported this treaty, it had also earlier taken a

unilateral policy stance. The new policy, announced by President Theodore Roosevelt in 1904, took the form of a corollary to the “Monroe Doctrine,” which the United States had proclaimed in 1823 and which said that any European attempt to recapture the newly

independent countries in Latin America would be regarded as a hostile act by the United States (not that the US was in a position to do much

Draft Issues Paper for an Evaluation by the Independent Evaluation Office (IEO),” IMF, March 18, 2008).


about it at that time). Roosevelt’s corollary was that European governments should also not invade to collect debts from defaulting

Latin American governments. This did not necessarily mean debt relief, however, but that the United States would help collect the debts for the European creditors (as well as its own). The US would itself invade if

deemed necessary, as it did in the Dominican Republic in 1904. In other cases, the US worked with local governments having distressed debt who understood Roosevelt’s threat and who with US intermediation reached settlements with their foreign bondholders, as in Colombia and

Venezuela in 1905, Costa Rica in 1911, Nicaragua in 1912 and Guatemala in 1913.

8 The policy stood until 1933, when the other

President Roosevelt, Franklin Delano Roosevelt, replaced it with the “Good Neighbor Policy.”

In each of the cases noted, economic adjustment policies had to be adopted by the debtor countries so they could generate enough resources for foreign debt servicing. In the period since the end of Second World War, this has been done in a more subtle way through adjustment

programs arranged with multilateral institutions. In other words, if one judges that the current international system for sovereign debt workouts is excessively creditor friendly, I think you can see that it has deep historical roots.

The Executive Committee of the World Economy

Just as the emerging United States and the major European powers

reached an accommodation on handling Latin American external debt problems in the early 20

th century, essentially the same governments,

joined by Japan, took a leadership role in developing international

policies on developing country debt in the second half of the century. Indeed, to the degree that there is coherence in any area of international trade and financial policies today, it is due to the same self-appointed club of governments that set the policy on sovereign debt workouts. I

am referring, of course, to the Group of 7 (G7), which has met annually at summit level since 1976.

9 The Group was formed in the aftermath of

8 See Kris James Mitchener and James Weidenmer, “Empire, Public Goods and the Roosevelt

Corollary,” Journal of Economic History, vol. 65, No. 3 (September, 2005), pp. 658-692. Another good source on this period is Christian Suter and Hanspeter Stamm, “Coping with

Global Debt Crises: Debt Settlements, 1820-1986,” Comparative Studies in Society and History, vol. 34, No. 4 (October, 1992), pp. 645-678.

9 Members are Canada, France, Germany, Italy, Japan, United Kingdom and United States, as well as the European Commission, which represents the members of the European Union on trade policy matters.


the collapse of the “Bretton Woods system” of international monetary relations that had been established after the Second World War.

Although there has always been a “variable geometry” of important countries that come together on specific issues, the G7 became the

standing forum of the major developed countries for global economic policy reform and coherence. It formulated “the” general policy strategy for the world economy, which has been to move toward full

trade and financial liberalization, on the argument that this would foster global economic stability, growth and development. Implementation of the policy strategy has been uneven, however, as the group has pressed

harder for action in some areas and less in others, and as it has pressed some countries more consistently to liberalize than others. The G7 has always been, after all, a political body. That is, on the one hand, the

general strategy is meant to apply across the board. On the other hand, the more independent the country, the less its policy makers were willing to apply the strategy whole cloth (consider the successful resistance to liberalizing short-term capital flows in China or India). In

addition, the stronger politically the sector within a G7 country, the more completely the country would itself ignore the liberalization prescription (agricultural protectionism in the G7 owing to effectively organized farmers being an especially telling case in point).

When the G7 does reach a consensus on a policy matter in the trade and

financial realm, it is then generally adopted and implemented by one or more of the relevant global trade and financial institutions, which the club has been able to control, at least until recently. The World Trade

Organization (WTO) — successor in 1995 to the General Agreement on Tariffs and Trade (GATT) — serves as the main forum for global trade policy negotiations and oversight of national trade policy commitments,

although certain commercial policy issues, such as cooperation on cross-border aspects of tax policy and setting limits to competition between officially supported export credit agencies (as on interest rates), have

been assigned to the more limited membership Organization for Economic Cooperation and Development. The G7 charged the IMF, in essence, to align the economic policies of the rest of the world (excluding the Soviet bloc while it existed) with the G7 strategy, sharing

the “structural adjustment” part of this job with the World Bank and the regional development banks.

While adhering fairly constantly to its general policy orientation, the G7 has been somewhat more flexible in its membership. Thus, after the

Cold War ended it began post-summit meetings with the Russian


Federation and in 1997 invited Russia into the club itself, creating the “G8.” By the same token, the Heads of State of the G8 have also invited

groups of developing country leaders to meet with them from time to time on the fringes of their summits. Finally, in 2007 the G8 formulated a more permanent outreach project in the “Heiligendamm Process.” In

this, under Germany’s leadership, they sought to bring the governments of Brazil, China, India, Mexico and South Africa closer to their fold as the “O5,” at least for a two-year trial period of discussions on a menu of economic policy matters of mutual concern.

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How the Specialized Institutions Interact

Whether or not the G8 invitation to the O5 bears fruit, no major reform has yet taken place in the structure or governance of the specialized

institutions that implement the international economic policy decisions of the “executive committee.” The first thing to observe is that each of the specialized economic institutions, especially WTO, IMF and the

World Bank, has a strong mandate in its own field and that there is no effective mechanism to bring about inter-institution coherence other than the fact that the G7 heads of state can make their respective trade,

finance and development ministers work together in the institutions they share in governing.

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On paper, the international trade and financial institutions are meant to cooperate with each other. Indeed, IMF’s charter states that its purpose includes facilitating “the expansion and balanced growth of international

trade.”12

In fact, the ministerial oversight committees of the Bretton Woods institutions — the International Monetary and Financial

10 The issues, as stated in the joint communiqué of Germany and the 5

leaders at the Heiligendamm Summit (June 2007), were: “promoting cross

border investment to our mutual benefit; promoting research and

innovation; development, particularly Africa; and sharing knowledge for

improving energy efficiency.” It may be noted that the G20, described

below, only deals with financial issues and that proposals to raise it to heads

of state level have not borne fruit.

11 To be fair, the G7 is less in control in the WTO than in the Fund and Bank. Under the GATT, once a deal was brokered between the US, Europe and Japan, it was fairly certain to be adopted globally. This can no longer be assured in the larger WTO.

12 See Articles of Agreement of the International Monetary Fund, adopted at the United Nations Monetary and Financial Conference, Bretton Woods, New Hampshire, July 22, 1944, Article I.


Committee (24 finance ministers and central bank governors) and the Development Committee (24 finance and development cooperation

ministers) — do not hesitate to discuss aspects of trade policy as they impinge on their respective mandates. But these committees are not empowered to reach decisions on trade policy.

13 In addition, the WTO’s

founding documents include an explicit declaration to cooperate with the IMF and the World Bank to achieve “greater coherence in global economic policymaking,” while mutually respecting the mandates and autonomy of each institution.

14 In practice, this has meant merely that

senior managers of the Fund and Bank are given observer status at the ministerial meetings of the WTO (consisting of trade ministers of the full membership), and similarly management of WTO may attend the

Bank/Fund ministerial meetings.15

This does not add up to a mechanism to reach coherence among international trade and financial policies.

UNCTAD and the UN General Assembly

Once upon a time, however, there was a broad international effort to forge a coherent set of international economic policies that would be consistent with promoting the development of the developing countries.

The effort began with the United Nations Conference on Trade and Development (UNCTAD) in 1964. You will find that integrated discussions of trade and finance took place at that conference and that the follow up mechanism that was instituted after the conference sought

to continue such discussions to the point of negotiation on specific trade and financial policies. A permanent structure was created of specialized standing commissions under an overarching body, the Trade and

Development Board (TDB). Every four years, UNCTAD would meet as a major international conference, assess the work so far, and give new discussion and negotiation mandates for the next four years, which the TDB would oversee.

Although certain policy measures were successfully negotiated already

13 Formally, the committees are advisory in their own institutions, as the executive boards and boards of governors have decision-making power; nevertheless, the policy advice of the committees is routinely implemented by the IMF and the World Bank.

14 See “Declaration on the Contribution of the World Trade Organization to Achieving Greater

Coherence in Global Economic Policymaking,” which forms part of the “legal texts” concluding the Uruguay Round, adopted in Marrakesh, April 15, 1994.

15 This notwithstanding, cooperation on technical assistance and staff consultation on specialized topics have been more intense.


in the 1960s, such as the Generalized System of [Tariff] Preferences (1968), UNCTAD reached its high point as a negotiating forum on a

range of trade and financial issues in the 1970s. While it was not empowered to strengthen the overall policy coherence with development in IMF, the World Bank or the GATT, donor governments made

commitments in UNCTAD on aid and debt policies (including retroactively adjusting the terms of outstanding aid loans to match the easier terms of more recent loans, and agreeing on a nascent set of principles for renegotiating sovereign debt). The Integrated Program for

Commodities produced detailed agreements to smooth out price fluctuations on specific international markets, including through the use of buffer stocks (which IMF agreed to support through a new window

for loans to make buffer stock purchases). Agreements were also reached on international shipping.

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Although I am sure the specific negotiations were never easy, I imagine they benefited from a political commitment reached in the UN General Assembly in 1974, which called for the establishment of a New

International Economic Order (NIEO). It was not an accident that the special Assembly meeting that issued the call took place soon after the first sharp increase in petroleum prices managed by the Organization of

the Petroleum Exporting Countries (OPEC). This was followed in 1975 by another special session of the General Assembly on economic issues that did not break any new ground, although separately, the IMF

adopted special lending programs for oil-importing developing countries in distress.

There was a view that the 1975 General Assembly session failed to produce more than a non-committal text because too many countries had to be brought together to reach consensus. Thus, a smaller group of

countries from the North and South was convoked as the Conference on International Economic Cooperation in Paris in 1976. The implicit deal that was targeted was more stable oil markets in exchange for enhanced

trade and financial cooperation for development. But there was no breakthrough in Paris either and at the end of the decade the discussions returned to the United Nations.

This is where I entered the scene as a junior staff member of the UN Secretariat in New York. It was a time of major change in the

16 See UNCTAD, Beyond Conventional Wisdom in Development Policy: An Intellectual History of UNCTAD, 1964-2004, United Nations, 2004.


Secretariat. UNCTAD had decided to consolidate its staff in Geneva and reduced its New York office to representational duties in the

General Assembly. Some of the economists who remained behind in New York joined the Department of Economic and Social Affairs, which was also reorganizing. Most important in our context is that

France sent Jean Ripert to be the new Under-Secretary-General in charge of that department. As he told a small team of DESA and ex-UNCTAD staff that would assist him, he came with a mandate from France to try to make a success of the resumed North-South Dialogue at

the UN. He had a limited and, he knew, temporary opportunity. He felt, however, that there was enough good will for one more attempt to forge a comprehensive deal for development.

It failed and I witnessed the moment it happened. The General

Assembly had convoked itself in 1979 as a Committee of the Whole (COW) to continue the Paris discussions. Some governments sent senior officials to lead their negotiations, underlining the importance of the opportunity. And yet, the discussions got stuck on words. There was no political will to negotiate on substance.

The COW had broken into working groups on the different chapters of the proposed declaration. I was assigned to assist in the one dealing with financial cooperation. Like the other groups, it met in one of what were then smoke-filled rooms in the basement of the UN building in

New York. But instead of negotiating on actual policies, the country representatives were hung up on whether they should spell the New International Economic Order with upper or lower-case letters, and

whether it should be “a” new international order or “the” new order. Lower-level diplomats carried out the negotiations, but senior officials might come in from time to time to listen to how they were going.

Richard Cooper, who was US Under-Secretary of State for Economic Affairs in the administration of Jimmy Carter, came to listen to this conversation and after a few moments said in a stage whisper that this

was [expletive deleted] and he got up and left.17

That was the end of it. He was right. There would be no breakthrough here either.

Things only got worse for the North-South Dialogue in the 1980s. The United States joined the United Kingdom as a market fundamentalist regime in 1981, while rolling back inflation became the first priority of

economic policy in all the G7 countries, whatever the cost and whoever

17 I asked him about it many years later and he only denied the expletive.


would bear it. In the widespread recession that followed, oil and other commodity prices plummeted, after having peaked at the end of the

inflationary 1970s. The ensuing debt crisis hobbled many major (and minor) developing countries. Latin America would later refer to the 1980s as the “lost decade,” and Africa would see per capita output fall

in the 1980s and then again in the 1990s. One may conclude that the North no longer felt it needed to cut a deal with the South. Indeed, UNCTAD lost its role as a negotiating forum and today its quadrennial conferences — I hesitate to say this but I think it is true — merely set

the research and technical assistance agenda of the organization until the next conference.

The Monterrey Opening

There is an aspect of the story above that is not much commented upon. The UN is a foreign ministry forum, just as IMF is a finance ministry/central bank forum and WTO is for trade ministries. Whenever

the UN found itself a locus for substantive North-South economic policy agreements, it seems it was always for foreign policy reasons. Initially, development policy followed naturally from the UN’s role in

decolonization. But decolonization was largely over by the 1970s so something else must have brought foreign policy makers to call for an NIEO at the UN.

Indeed, the North was then absorbing the fact that power over a central commodity had been grabbed by certain countries of the South. A

number of major commodity prices had long been controlled, often in collaboration between producers and consumers, such as the supportive role the US tin stockpile played in helping to manage the international

tin price. OPEC, on the other hand, was purely a supplier organization, even if some of its members were close allies of the major powers.

18 It

has even been said — but I have no way to know if it is true — that Henry Kissinger, US Secretary of State in the administrations of Richard

Nixon and Gerald Ford, conceived the 1974 General Assembly special session on the NIEO as a way to talk the developing world into exhaustion, doing nothing while seeming to do something. In fact, that

is too cynical, as some policy advances were made after 1974, including

18 The discovery that OPEC could effectively increase oil prices sent a shock wave through the US administration and Congress at the time. Some “hawks” clamored for military intervention

to “defend” oil production and transportation lines. They were civilians, of course, while the military authorities cautioned that they were unprepared for a desert war (private conversations, US Army War College, Carlisle Barracks, Pennsylvania, 1974).


in UNCTAD as mentioned earlier.

In any event, by the 1980s, OPEC showed itself to be less formidable than feared, and all the joint international commodity arrangements with economic provisions eventually broke down. The attention of foreign

ministries at the UN was increasingly limited to the political side of the house; economic discussions were a side-show and some governments sent less and less skilled diplomats to cover the discussions that did take

place. The action on economic policy matters was elsewhere. Indeed, when WTO was created, the trade negotiators very explicitly decided not to become a specialized agency of the United Nations.

Nevertheless, the North-South Dialogue never fully disappeared from the UN. In 1980 there was an effort to get a “global round” of

negotiations going; it never happened. In 1990 there was another effort. In 1997 the newly appointed Deputy Permanent Representative of Venezuela, Ambassador Oscar de Rojas, decided to try again. This time

it led to the 2002 International Conference on Financing for Development (FfD), which adopted the Monterrey Consensus.

The process that led to the summit meeting at Monterrey was unique. It is the only major UN conference that originated as a developing country proposal. It began as a Latin American initiative, was adopted by the

developing country governments at the UN represented by the Group of 77, but then it also drew support from the United States, joined by Japan and the Republic of Korea, and finally the Europeans. It found a

champion in the World Bank, which seconded staff to assist the UN Secretariat in preparing for the conference and was supported as well by the IMF and the management of WTO.

This is not the place to discuss in any detail how the process of preparing Monterrey overcame the hesitancy of most governments to

look to the UN as a potentially serious forum on international economic matters.

19 I would instead just note that several factors made the UN an

attractive political forum on economic policy and Monterrey an

opportune occasion. First, the credibility of the IMF and World Bank had been increasingly challenged as the 1990s wore on, not only in

19 For that, and a discussion of backsliding after 2002, see Barry Herman, “The Politics of Inclusion in the Monterrey Process,” in Jessica Green and W. Bradnee Chambers, eds., The

Politics of Participation in Sustainable Development Governance (United Nations University Press, 2006); also available as DESA Working Paper No. 23, United Nations (ST/ESA/2006/DWP/23), April 2006.


developing countries that had been through “structural adjustment,” but also in the legislatures of some donor countries, especially the US.

Second, the UN had successfully given voice to the European social agenda through the global UN conferences on environment, gender and social affairs more broadly. Indeed, it appears that World Bank

management appreciated that the anti-poverty focus of its new President, James Wolfensohn, could benefit from embracing the UN. Third, the onset of the Asian financial crisis in 1997, followed by the meltdown of Russia while IMF held its hand in 1998, brought the

reappearance of “financial architecture reform” to the world policy agenda after two decades without major institutional change. This time, the developing countries were demanding a bigger voice in international

policy reform and it was hard to argue against their view; nevertheless, the G7 response maintained its centrality by selectively inviting certain finance ministers and central bank governors to meet with them in a new

Group of 20 (G20).20

Fourth, the “9/11” bombing of the World Trade Center in New York shook the confidence of the developed world in its own physical security, raising the attractiveness of pending possibilities to reach out in an expression of solidarity with the developing world.

I do not want to suggest Monterrey was a North-South love-in.

Relations were always delicate among governments and with the specialized multilateral institutions, in particular with WTO. The degree of delicacy as regards WTO is perhaps worth noting as an extreme

example (with the other institutions it was rather just under the surface). Allow me one anecdote to give you a sense of this.

In 2001, the Chairman of the Trade and Development Committee of WTO, Ambassador Nathan Irumba (Uganda), while in New York, invited the Bureau of the FfD Preparatory Committee to come to the

WTO in Geneva and have an informal inter-governmental and inter-institutional meeting to help advance FfD preparations. The Bureau had already met with the Executive Boards of the IMF and the World Bank.

20 The G20 first met in 1999, after the G7 tried meetings with different configurations of

middle-sized economies (G22, G33). Besides the G7, the members include Argentina, Australia, Brazil, China, India, Indonesia, Republic of Korea, Mexico, Russian Federation, Saudi Arabia, South Africa, and Turkey. The finance minister of the rotating Presidency of the

Council of the European Union and the head of the European Central Bank attend as well. “To ensure global economic forums and institutions work together,” the heads of IMF and the World Bank and the chairs of the two Bretton Woods ministerial committees also attend (See

www.g20.org). The latter notwithstanding, the G20 have sufficient weight and influence to assure that any policy consensus they might reach is also adopted by those ministerial committees.


It only made sense that it also meet with the WTO. A WTO colleague privately described the Trade and Development Committee as less a

negotiating forum than a “church meeting,” but the Bureau saw it as an opportunity and went anyway. The first meeting at WTO was with the Director-General, Michael Moore, accompanied by Ambassador Stuart

Harbinson (Hong Kong, China), the Chair of the General Council, which is the committee of the whole that oversees WTO activities between ministerial meetings. Senior WTO management also participated. The discussions were very friendly but also frank. After

that, it was all downhill. The inter-governmental meeting began with WTO staff giving briefings on the current state of negotiations in the different WTO committees, which lasted for about an hour. The

Chairman then said thank you and adjourned the meeting. The Chair of the UN committee, Ambassador Jørgen Bøjer (Denmark), rose to complain that the UN delegation had come all the way from New York

to have a meeting and now they were not having a meeting. The WTO Chair said, in effect, “That’s right. We are not ready to talk to you.” And no interchange on substantive matters took place.

Conclusion: Use the UN Opportunity to Start a New Reform

Process

It is now seven years later. WTO negotiations are stuck. The organization continues to go through the motions of negotiations even

though the negotiating authority of one major party, the United States, has expired and will not be renewed before 2009 when a new US president is in office. The IMF has run out of “paying customers,” in

that when Turkey repays its last outstanding loan, there will be very few (and small) non-concessional loans still outstanding. This may only be temporary, but several countries have repaid their loans before they

were due and all former customers are seeking a large enough cushion of foreign exchange reserves to prevent having to return to IMF for help under its traditional conditionality. The World Bank is still recovering

from the presidency of Paul Wolfowitz and the distrust he sowed in borrowing countries. Meanwhile, the US financial crisis that began in the summer of 2007 has caused bank failures in Europe as well as in the US, and is raising questions once again of the need for international

financial architecture reform. This time, developing countries are not yet victims and are concerned to stop the crisis from spreading to them. They also want to protect their overseas financial assets invested in the

developed world. Taking all these factors together, perhaps it is again time for a political meeting on international economic reform at the UN.


The G7 or G8 will not be able to solve what it seems fair to call a crisis of international economic cooperation. It will not do for the G8 to

unilaterally decide who should speak for the rest of the world in discussions with them on global economic policy. Indeed, nobody elected the G8 to carry out global economic policy leadership. And

even if the 7 original countries were the dominant economic powers in the 1970s, they do not have quite the same exclusive centrality today, and it is even less clear that they will be the right club 10 years from now. Moreover, while there is a certain logic in a two-stage structure

for global economic policy oversight, there needs to be a global legitimating process for selecting the “executive committee,” as well as a mechanism for the committee to report back to the world as a whole

and take on board the views of all relevant stakeholders in an appropriate global forum. Such a process need not always lead to the globally best decisions, but the contending interests would be able to grapple together more fairly and openly.

Is such a global governance structure possible? Yes, in principle, but it

would be a stretch to realize it any time soon. An “Economic Security Council” created by and reporting to the United Nations, taking a coherent and effective approach to all aspects of international economic

policy to benefit development and global well being is conceivable. Unfortunately, the confidence of governments and peoples in the UN just does not now exist for creating such an organ and asking the UN to

serve as the forum to which it would report. But such confidence could be created in time if governments acted in concert to make the UN more effective. A less attractive alternative is to build a new global body

elsewhere. Doing nothing solves nothing. In any event, small states as well as big states would have to believe in the ability of the process to develop mutually supportive policies to advance key economic goals, as well as for the world as a whole to vet them thoroughly so as to actually commit themselves to action when they adopt them.

As in the run-up to Monterrey, the UN has again created an opportunity to give a political impulse to a confidence-building process on global economic reform. As in 2002, there is a political need for it again today. The General Assembly decision to hold a high-level intergovernmental

FfD conference in Doha, November 29 – December 2, 2008 could bring together many heads of state, as well as financial, trade and foreign ministers, although this level of participation is far from assured. To

help prepare for that meeting, the General Assembly is undertaking a review in the first half of 2008 of the policy measures in the Monterrey Consensus. As of this writing, the meetings have had a positive tone


and involved a number of responsible officials from capitals.

The success of Monterrey in 2002, however, came after an important period of cross-fertilization between UN delegates and their finance and trade ministry colleagues. There was even a “Philadelphia Group,”

drawn from the offices of executive directors of the Bank and Fund from European countries and also Canada, and UN delegates from New York, who would meet in Philadelphia halfway between New York and

Washington for lunches and to coordinate views. There was also some but not enough interaction between foreign and finance ministry staff of developing countries. For Doha to work as well as Monterrey, these

channels of inter-ministry communication need to be rebuilt. But they also need to be built for the first time with representatives from the WTO, who should get over feeling that the UN is never a useful forum.

While inter-ministry discussions can still be strengthened in the run-up to Doha, there is not enough time to develop a set of concrete reform

proposals and get a consensus on them among UN representatives, let alone across ministries. However, there is enough time to agree to start the conversation in a serious way.

Postscript: A Post-Doha Follow-up Mechanism

The world is not ready for a global conference to redesign the international system. It is not even ready for a preparatory body to lay the groundwork for such a conference. It should be recalled that it took

5 years from the collapse of the Bretton Woods system in 1971, when the US delinked the dollar from gold, to agreement on the design of the post-Bretton Woods system in 1976 (as expressed in the vote on the

Second Amendment to the IMF Articles of Agreement). As in the 1970s, the first step today is for the realization to spread that the problems will not be resolved with small adjustments in the major trade

and financial institutions that leave the overall structures unchanged. This will have to be followed by an intensive period of discussion of reform proposals, until a consensus develops around one plan or

another. Adopting the new structure is the last major step, although further reforms and revised practices will surely follow, as the “kinks” are worked out of the new structure.

Perhaps the world will soon be ready to start an intergovernmental conversation about the need for a major reform in the international

system. One proposal that could facilitate such a discussion was recently put forward. It is enticing in the modest and vague way of diplomacy at its best. The proposal was made by Ambassador Eduardo Galvez,


Multilateral Policy Director in the Ministry of Foreign Affairs of Chile. To quote from his presentation at the General Assembly’s FfD review meeting on systemic issues on March 11, 2008:

Creation of an integrated multi-stakeholder Forum, Council, or a

Committee on FfD

! Composition

" Representatives of governmental organs of the UN (GA and ECOSOC), IMF, World Bank, and WTO

" Representatives from specialized agencies, i.e. ILO, UN Funds and Programs

" Civil society and the private sector

! Objective: to change the nature of the existing “dialogues” of the

UN and the Bretton Woods Institutions and WTO for an integrated

review of the chapters of the Monterrey Consensus.

Galvez is essentially calling on FfD stakeholders to shape his rough idea into a plan to take forward from Doha. It is a call that deserves to be answered.


SECTION II

THE TECHNICAL DIMENSIONS OF LINKING DEBT AND TRADE

THE DEBT-TRADE CAUSALITY IN

BALANCE OF PAYMENTS ACCOUNTING

Jan Kregel

Levy Institute

In order to formulate the appropriate approach to the follow up process of Financing for Development it is important to first evaluate the successes and failures of the Monterrey Consensus. In diplomatic terms

the process was an unqualified success. Attempts to hold a conference on financing and development had been going on for some 10 or 15 years after the dismay caused by the Latin American debt crisis of the

1980s. It was thus a success that the conference took place and that a consensus was produced.

However from an economic point of view, the assessment has to be more qualified and considered relative to the three basic issues that had been set by the Group of 77. The first was that it would be a process, an

on ongoing process. However, it cannot be considered to be an ongoing process evolving with changes in international conditions and the international environment because the Monterrey Consensus is generally

considered an untouchable document that cannot be changed. This is one of the greatest challenges in the follow up process.

The second was that it would give developing countries a “seat at the table” in discussions of financial issues and reform of the international financial system. This also meant a seat at the table for the UN

economic agencies, on an equal footing with the specialized agencies that are in fact a part of the UN system. Neither can this be presented as a success. Paradoxically, what has happened is that the World Bank and

the IMF and the WTO have been given a seat at the UN table, participating and vetting UN documents. On the other hand, UN representatives are never invited to technical meetings dealing with these issues or invited to take part in the decision making process that

takes place in the international financial institutions, despite the fact that there is a protocol that allows for these discussions.

The Potential and Limitations of Market Access 19

The third item related to systemic issues, that is, changes in the international financial system. After the Asian crisis this was a very hot

topic and President Clinton announced that this was to be the priority of international policy – but this lasted for about nine months and the issues were reduced to a minimum for the Monterrey Consensus. In fact

the multilateral financial institutions argued very strongly that they really had no place on the agenda as they were their responsibility. So much for the seat at the table. Thus, in these three areas it is clear that they remain to be fulfilled and thus should be given priority in the follow up process.

The Monterrey Consensus has separate chapters on finance, trade, debt, and aid. These are all looked as alternative sources of financing for development. However, it is clear that for any reasonable person, all of

these things are intimately linked. But nonetheless the document considers them as more or less independent measures. What I would like to stress in the rest of this presentation is not so much the interaction between them, but rather what we might call the direction of causation

among them. That is, do debt problems arise from trade, or does trade cause or produce financing or debt problems? I will support the discussion with reference to what is considered the traditional development literature, the literature of the pioneers in development.

For the early development theorists it was commonly accepted that trade

was an engine of growth. But trade was an engine of growth in a very precise sense that is not always recognized today. Trade produced an increase in global demand, not because of countries opening their closed

domestic markets to trade, but because of the impact of international flows of labor and capital on growth in the 19

th century by providing

strong support to global domestic demand that produced expanding

global trade and expanding global incomes. So the issue was not one of the economic efficiency of closed versus open trade, but rather one of providing a source of support for international demand.

Foreign capital inflows in this period had a positive dynamic influence on domestic conditions because the developing country populations

were of origin that had experience in using capital to expand economic production. All of the traditional economists who looked at trade in this period saw it as a process by which foreign investment in developing

countries provided an export platform for primary commodities, finance for development of domestic industry, and as providing substantial


infrastructure support, such as transportation that complemented the increasing exports.

So that while trade was the visible engine of growth, in fact the real engine of the growth of trade was the transfer of labor and capital to

receptive “areas of recent settlement” as developing countries were called in official documents. It was a successful process because it created the exports that were necessary to meet the debt service on the

foreign capital investments. So early, influential UN documents dealing with international capital flows in the pre and inter-war period, make the point that the external accounts of developing countries were balanced.

This means that developing countries had no problem meeting their financial obligations through the sale of exports. There was no difficulty in financing the balance of payments. In modern terminology,

we could look at this as analogous to the financing that occurred during the dot com era, known as “vendor finance” in which the seller lent credit to the buyer to buy its goods, but also bought the buyer’s goods so the debt could be repaid. So trade was clearly an engine of growth, but it was clearly through the movement of capital and labor.

During this period, economists implicitly assumed that factors were immobile. Ragnar Nurkse has noted that economists’ theories somehow tend to be precisely out of phase with reality. During a period when trade was dominated by factor mobility, economic theory thought the

opposite. The importance in mentioning this is to show that once upon a time we did believe that there was a causation that went from finance to trade. It was the financial flows that created the counter flows of trade.

The contribution of the pioneers in development was to point out that

the inherent logic of the 19th

century integration of financial flows would be impossible after the 1930s. The conditions that prevailed in Latin America and the global economy in the 19

th century no longer

existed after two world wars and the great slump -- the system could not

be resurrected. So something had to take its place. What took its place came in the form of what we now call the international financial architecture: the Bretton Woods System. The Bretton Woods System

was based on three very simple principles. First, the breakdown of the 19

th century system was caused by excessive debt accumulation. So the

new system should not have massive accumulations of debt. Second, if

there was to be no debt accumulation, there could really be no free private capital flows, because private capitals flows cause the accumulation of debt. Finally, the international system should be set up


in order to support the introduction of a system of multilateral, “most favored nation” (MFN) trade amongst nations. This was basically due

to a change in position of the US government and a UK/US agreement in the Atlantic Charter, where the UK gave up its system of imperial preferences and its idea that a closed economy was the most full

efficient to produce full employment. The Bretton Woods system then required something to manage exchange rates because it was also believed that exchange rate policies were used to gain advantage in international trade. So the IMF was set up as a way to support the return

of multilateral trade. It was to be accompanied by the introduction of a commercial treaty that was to deal with the negotiations of tariffs and subsidies, again with the idea of moving back towards an MFN system.

In the end, the UN International Conference on Trade and Employment,

which produced the Havana Charter, turned out to be much broader. It dealt with the role of developing countries as well as dealing with employment policy because the idea that the U.S. had behind the idea of a commercial entity was subsumed under what became the GATT

Protocol. In fact it was pre-negotiated and close inspection suggests that it actually represented the implementation of the old trade theory, that is looking at trade as a means of creating efficiency gains by opening

closed markets, as the support for economic growth. As noted above, this was completely different from the 19

th century view of trade as an

engine growth.

As we know, GATT was the only idea that survived from this process. It placed an emphasis or a separation of trade in goods from the

financial factors that had been so important in the 19th

century. In fact, those financial factors had been eliminated. Private capital flows were supposed to be negotiated through the multilateral financial institutions.

The IMF was to determine exchange rates. This is where we the divorce of trade and finance is completed. This was further supported by Keynesian theory, which deals with aggregate demand. Aggregate

demand is expenditures on goods, plus investment, government expenditures, and net exports. There is no place for international capital flows to have a direct impact on aggregate demand. So the system was set up as one where finance would have a small role to play, and the

theory gave it no role. So by definition, the emphasis was on the trade of goods and the opening of markets.

Now the difficulty with all of this is that private capital flows were not eliminated, exchange rates were not managed, and by the 1960s and


1970s, all of the conditions that prevailed in the 19th

century had returned. But they returned in an optic in which no one paid a great deal

of attention to the impact of financial flows on trade. The dominant position was that finance only had a role in balancing surpluses and deficits in goods trade. That it was a purely passive or below-the-line

factor. Finance had no basic role in determining trading patterns. The juxtaposition I want to give is that if we look at the 19

th century

everybody agreed that finance determined trade flows. If a British company wanted to sell locomotives, it financed the developing country

so that it could buy the locomotives. This is the vendor finance discussed above. It was finance that determined the trade flows. By the time of Bretton Woods it was generally believed that the flow of goods

was determined independent of finance. You influence goods flows by going to GATT or negotiating tariff reductions, and if there was a trade imbalance, that imbalance would be financed through borrowing from the IMF and eliminated by adjusting income levels.

The petroleum crisis and the Uruguay Round both had a strong impact

on the return of private capital flows as a dominant force in trade discussions. After the petroleum crisis private markets were encouraged to provide the finance imbalances that had got beyond the resources of

the IMF. After the Uruguay Round, the reduction of tariff barriers made it more attractive for international investors to invest in developing countries and then to split their production chains across developing

countries. So the current globalized financial system closely resembles the 19

th century. The capital flows determine trade flows. The

decisions of the very large globalized production companies to invest in

country A or B determines what part of the production chain takes place in that country and then determines whether it is sent to A, B or C for further processing. The inter-linkages of trade flows are determined by the direct investment decisions of large global companies.

Unfortunately we still tend to believe that trade and finance are independent and that finance is the adaptive rather than the dominant element.

The final point is that as a result of the idea that goods flows determine financial flows, there is a tendency to look at trade imbalances and to

calculate the impact of trade on national incomes by considering that the current account is more or less identical with the commercial balance: the trade in goods and services. That is, the factor services balance,

which is basically payment for capital services – debt service, and income from labor, tends to be overlooked. When there is no


international factor mobility, obviously this item in the balance of payments disappears. When there is substantial international factor

mobility, this item in the balance of payments can be very important. This is where the relationship between trade, debt and finance comes in. If we accept that we have returned to a 19

th century position where

finance is dominant, but we no longer have this very nice balance between the impact of capital inflows and outflows, if capital flows are unbalanced, which they are for almost all countries, then the factor services balance becomes very important.

Current balance of payments adjustment theories rely on income

adjustments. But the factor services balance is not determined by income adjustments, but by interest rates and the international financial system. So when looking at the current system, there is not only a

mistake or misrepresentation as far as the causal relationship between finance and trade, there is also a misrepresentation in terms of the description of the balance of payments adjustment process. Because implicitly the balance of payment adjustment processes are primarily

those that deal with the goods account without having a basic impact on the capital account.

Consider negotiations, either in international trade or within the international financial institutions. Because of financial globalization, it is no longer true that the national accounts of a given nation correspond

to the economic interest of the corporations domiciled in the nation. Why? For a large global corporation, a large amount of profits come from investing in overseas production and then importing that

production back for sale in your home country. These are technically imports to the nation, but as far as the firm is concerned, they are part of an integrated global process generating profits. These profits may be

booked abroad or repatriated. How they are handled has a direct impact on the factor of services balance and a direct impact on the particular interests of firms and countries. If you take a U.S. company with

substantial interests abroad, and the output of foreign production is imported into the U.S., generating profits, it is no longer the case that the company has the same interest as it had when its production took place domestically. Thus, it will probably be in favor of measures in

order to increase domestic markets to foreign imports, whereas domestic producers will want to close those particular markets, setting up a conflict between domestic corporations and those that are global. So

that within the globalized system, we find the trade accounts no longer represent the economic interests, the economic trade flows and our


national accounts no longer represent our economic interests. The U.S. Department of Commerce attempts to calculate the difference between

the balance of payments of U.S. corporations and the balance of payments of the U.S. If we look at the balance of payments from the point of view of the home country of the corporations, it is substantially

better than the balance of payments of the U.S. Simply by taking into account the profits that are earned by U.S. corporations on their operations abroad. This is a simple example that demonstrates how the inter-relationship between trade and finance creates difficulties in

identifying interest groups, reaching settlements that appeal to general interest, and that the statistics we use really no longer represent the reality of the globally intergrated economic system.

Thus, an additional area in pursuing the follow up to Monterrey is to

introduce the inter-relationship between trade, debt and finance, and the role of the international financial system in support and interaction between these areas that promotes financing for development.

CONCEPTUALIZING SOVEREIGN DEBT

Matthias Rau

UNCTAD

The topic of my presentation is "Conceptualizing Sovereign Debt". I will give you an overview of sovereign debt markets, notably the predominant changes we have seen in the debt structure in recent years.

Secondly, I will focus on the so-called “unexplained” part of the debt. Lastly, I will come up with some preliminary policy recommendations. I will show that we are in a period of favorable economic conditions that

allow countries either to repay their debt, to reschedule the debt, or to issue domestic debt in a favorable environment. The latter changes are good for the debt structure, but to understand its overall impact, we need

to do more research regarding the vulnerability of these changes in the debt. The ongoing work we are doing at UNCTAD is focusing on these issues. We are also conducting debt sustainability research and we are in the midst of setting up a comprehensive database on domestic debt.

Moreover, the UNCTAD debt management program is getting more into portfolio and risk management training.

The Recent Changes in Sovereign Debt

There has been an increase in external debt over the last few years. As you can see in figure A, this increase has flattened though. There has


been a decrease in major solvency indicators, which is due to two factors. First, external debt was not increasing tremendously. But in

addition the denominator of this ratio, GDP, has risen significantly for many developing countries. More importantly, there has been a shift in the debt structure due to a rise in domestic debt. The share of domestic

debt nowadays accounts for more than 50% of the total debt that developing countries have (see figure B). This change in the debt structure has been accompanied by a shift in recent research activities too. Researchers are now aware that the level of external debt is as important as its structure.

Figure A - Total External Debt

As mentioned before, external debt has often been the major source of vulnerabilities due to external shocks, which is why the IMF focuses on this. This is also reasonable. There are examples where even relatively

small external shocks can create financial crises. The question remains whether domestic debt and the recent shift towards domestic debt actually changes anything in that respect. Is domestic debt actually a

safer debt instrument? Of course, if you look at a portfolio consisting solely of foreign currency denominated debt, the actual risk is quite high. If you have a mix of foreign and local currency, the risk becomes smaller, as the exposure to FX risk is reduced. But does such a shift

solve the vulnerability problem and to what extent? The answer of course depends on many factors. It depends on whether the domestic debt is issued in foreign or local currency, where it should naturally be

Total external debt

2742

2851

2767

2367

2090

1522

0

700

1400

2100

2800

3500

1990-94 1995-98 1999-03 2004 2005 2006e

Source: UNCTAD calculations

billo

ns o

f U

SD


used in local currency. But there are also pros and cons even for debt denominated in local currency. Secondly, it does not solve the

vulnerability problem because of the “unexplained part of debt" (see Campos et al. (2006)).

Figure B - Public Debt Composition in Developing

Countries (in % of GDP)


Let me start a more detailed discussion of this by focusing on the pros of domestic debt first. As the domestic central bank cannot print foreign

currency, a country has to rely on export earnings and other forms of FX inflows for its debt service. Thus, if you expand domestic debt in domestic currency, there is no chance of a currency mismatch.

Moreover, funds from the international financial markets are very volatile and often subject to sudden stops. If you focus on domestic debt in local currency, these are all factors that vanish. Secondly, domestic debt gives a potential for financial market development. There

is empirical evidence that shows that the corporate bond market is improving if you improve domestic financial markets, if you make them more liquid. Additionally, medium and long-term instruments of

government debt help to create a yield curve which is beneficial for the entire economy.

There are also downsides and risks of domestic debt. If you issue domestic debt chiefly to domestic recipients, this issue is mainly an internal resource transfer and there is no additionality as in the case with


external financing. Thus, even if you do not have a currency mismatch, you could still have a "material mismatch", i.e. domestic debt could

crowd out domestic resources. There is some empirical research that suggests that the positive impacts of market creation that I just mentioned before are about the same size as the crowding out effect.

Moreover, institutional investors in the domestic country could absorb too much of this debt and this could have an impact on the stability of the domestic financial markets in general. Lastly, there is also a direct cost issue. Based on a particular economic environment, the interest rate costs of external debts are generally lower.

Let me turn now to the so-called "unexplained part of debt". Usually you would think that the change in the debt stock from one period to another is explained by the fiscal deficit of the government. However,

this does not hold empirically. What is actually given is that the change in the debt stock is calculated by the deficit plus some factor which can be called SFT, the so-called "stock flow reconciliation". What is this factor about? What is its economic interpretation? It can be a balance

sheet effect due to variations in the FX rate, it can be contingent liabilities emanating from the domestic economy, for instance from banking crisis. What is its actual size? Based on calculations of my

colleague Ugo Panizza, the unexplained part is quite substantial (see figure C for a breakdown by region).

Figure C - The Unexplained Part of Debt



Current economic theory says that the unexplained part of debt is basically inflation that causes devaluation and balance sheet affects and

also contingent liabilities from domestic financial sectors. However, these two effects only account for 20% of the within-country variation of the SFT. So economic theory does not explain the SFT well and we

are still at the beginning of understanding what these debt dynamics actually drives.

Let me briefly touch upon the fiscal policy implications. As we all know, current fiscal deficits do not only matter for a current budget, but also for future years. So the safest debt policy is still a non-diverging

fiscal policy which tries to keep expenses under control. But we also need to have improved debt management and better risk management, as the structure of public debt changed dramatically over the last years.

There is also a need for continuously strong technical assistance in this area.

To conclude, despite the recent turmoil in international financial markets, we are still living in a world of favorable economic conditions that have helped developing countries to stabilize their debt burdens.

But there is inherent risk in the newly structured debt portfolios that might only show up once these favorable conditions vanish. We start to understand that debt structure matters but we do not know yet in which ways. This is what the research on the unexplained part of debt tries to

explain. We need to understand better the inherent debt portfolio dynamics, and research in this area needs to be advanced. We have seen major shifts toward domestic debt, which is welcomed because it makes

most debt portfolios safer. But we are also aware that this is not a general solution for ensuring debt sustainability.


SECTION III

THE POTENTIAL AND LIMITATIONS OF MARKET ACCESS

TRADE TRENDS AND WHAT THEY MEAN IN TERMS OF

INCOME GAINS FOR DEVELOPING COUNTRIES

Mr. Jörg Mayer

UNCTAD

The relationship between trade and income is an extremely vast subject. I suppose that all of you are aware of the empirical literature on the welfare and income effects of multilateral trade liberalization. Rather

than looking at the effects of import liberalization, I want to focus my presentation on exports. More precisely, I want to address whether a trade integration strategy focused on market access and export volumes

actually succeeds in boosting foreign exchange earnings and income, and thus makes it easier to service debt.

I would like to start by showing some empirical evidence on the relationship between income and trade, especially exports. I will do this focusing on two countries – Mexico and the Republic of Korea. I chose

these two countries because they have followed very different integration strategies. Mexico has followed what you might want to call “deep integration”, where the focus is on maximizing exports. The Republic of Korea has followed a more strategic way of integration.

The first slide (1) reflects annual changes in imports, exports, and GDP

for the group of developing economies as a whole. It shows that overall there is no close correlation. There have been significant changes in both imports and exports, while income growth has been fairly stable.

Since the second half of the 1980s, the growth of exports has almost always been larger than the growth of income. A striking feature is that since the Asian crisis, very strong changes in the growth rates of exports and imports have translated into changes in income in the same

direction, albeit with a smaller size. This suggests the emergence of a closer link between changes in imports, exports and income over the past few years.


Slide 1: Changes in merchandise imports and exports,

and in real GDP, 1980–2006, per cent

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1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Exports Imports Real GDP

More important than the link between total trade and income is the relationship between trade in manufactures and income. This is because

of the special role of industry in economic development. This slide (2) compares world market shares in manufacturing value added and world market shares in manufactured exports. Making such a comparison is difficult because the definition of manufactures in income statistics

differs from that in export statistics. Income statistics has a much broader notion of manufactures. This means that for a comparison as the one in the slide, one has either to reduce the coverage of manufactures

in income statistics or to expand the coverage in export statistics; the latter is much easier. Hence, in this comparison manufactured exports also include processed primary products, such as refined petroleum.


Slide 2: Share in world exports of manufactures and manufacturing

value added, 1990 and 2004, per cent

The evidence shows that developed countries have increased their share

in world manufacturing value added, while their share in world manufactured exports has declined. Hence, in a sense, developed countries are trading less but earning more. The opposite holds for

developing countries. Their share in world manufactured exports has risen much more than their share in world manufacturing value added. This general development is exemplified by Mexico whose share in

world manufactured exports has increased much more than its share in world manufacturing value added. Asia shows the opposite picture: the Republic of Korea has tripled its share in world manufactured exports but also experienced a substantial increase in its share of world manufacturing value added.

Moving back to overall trade, the next slide (3) shows that exports from Mexico have increased about five fold over the past 15 years; the slide also shows that Mexico’s trade account has been in deficit during the

entire 15-year period, except for a few years immediately after the 1994-crisis. This means that Mexico has not had any net foreign- exchange earnings from trade.

1990 2004 1990 2004

Developed countries 64.5 70.4 74.1 66.3

Developing countries 16.6 24.5 18.9 31.5

Latin America & Car. 7.1 4.5 4.3 4.0

Mexico 1.1 1.6 0.8 2.1

South & East Asia 7.4 17.8 7.6 24.2

Rep of Korea 1.4 2.4 1.1 3.3

China 3.3 8.9 1.0 7.6

Africa 0.9 0.8 1.2 1.2

MVA Manufactured exports


Slide 3: Mexico: Merchandise trade and real effective exchange rate,

1980–2006, US$ billion and index numbers

By contrast, the next slide (4) shows that the Republic of Korea has experienced an increase in exports similar to that in Mexico, but that for Korea this increase in exports has been associated with a trade surplus.

The cases of both Mexico and the Republic of Korea also show that movements in the real exchange rate play an important role for the evolution of trade, as in both countries a depreciation of the real effective exchange rate valuation has been followed by a shift of the

trade balance from deficit to surplus. This indicates that in addition to trade policy, macroeconomic policies affect the trade account through their impact on the real exchange rate.

Slide 4: Republic of Korea: Merchandise trade and real effective

exchange rate, 1980–2006, US$ billion and index numbers

I would now like to look in more detail at the relationship between trade in manufactures and manufacturing value added in Mexico and the Republic of Korea. In the case of Mexico, NAFTA, which entered into force in 1994, marks an important event because it has introduced

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Exports Imports Trade balance REER a (right scale)


preferential access to the North American market. The slide (5) shows that 1994 also marks the beginning of a strong increase in Mexico’s

manufactured exports and an even stronger increase in its manufactured imports. This means that Mexico’s trade account has been in deficit even if we look only at manufactures.

Slide 5: Mexico: Trade and value added in manufactures, 1984–2005,

US$ billion

Again, this is in sharp contrast to the experience of the Republic of

Korea. The next slide (6) shows that since 1995 Korea has experienced an increase in manufactured exports similar to that of Mexico, but that its manufactured imports have increased much less. This suggests that

manufacturing in the Republic Korea is much stronger rooted in the domestic economy: there are fewer imports but more spillover effects


and linkages, so that overall manufacturing activities have a much stronger positive impact on income.

Slide 6: Republic of Korea: Trade and value added in manufactures,

1995–2005, US$ billion

The difference in the composition of manufacturing value added probably goes a long way in explaining this divergence between Mexico and the Republic of Korea. The next slide (7) shows that Mexico’s

sectoral composition of manufacturing value added has hardly changed since the early 1980s. The importance of labour-intensive manufactures slightly declined, but overall not much has changed.

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Slide 7: Mexico: Manufacturing value added by selected product

categories, 1980–2003, per cent of constant 1985-US$ values

The picture for the Republic of Korea is quite different, as shown in the next slide (8). The share of technology intensive manufactures has strongly increased, while the shares of labour- and resource-intensive manufacturers have declined.

Slide 8: Republic of Korea: Manufacturing value added by selected

product categories, 1980–2003, per cent of constant 1985-US$ values

To sum up the evidence shown so far, it appears that there is no clear correlation between trade and income trends in developing economies,

although there is wide variation across developing countries. Trade and income trends appear to be related most favorably in those countries

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Resource-intensive manufactures Labour-intensive manufactures

Technology-intensive manufactures


which succeeded in upgrading their manufacturing activities towards more technology-intensive products.

What does this imply for economic policies or integration

strategies?

Two broad integration strategies may be distinguished. There is, first,

deep integration, which may approximate Mexico’s strategy. Deep integration emphasizes world market forces and aims at efficiency gains from specialization and market access. This strategy puts particular emphasis on the liberalization of the import regime and the attraction of

FDI. FDI is meant to bring the dynamic elements (such as technology transfer) needed for economic development. This strategy also relates to engaging in free trade agreements with developed economies, such as through NAFTA.

A second strategy, which may be called “strategic trade integration”, emphasizes a more measured, selective and non-linear path of import liberalization. This strategy can imply that for certain products tariffs are lowered at some point but increased at some later time. The general idea

behind this kind of tariff modulation is that import substitution is to some extent a natural process of economic development as the domestic economy learns how to produce in a competitive way things that used to

be imported. Strategic trade integration also gives more weight to trade agreements among developing countries, as well as to regional cooperation, rather than to trade agreements between developed and

developing countries. Moreover, regional cooperation should not be limited to trade but extend also to exchange-rate and other monetary and financial issues. To summarize, this strategy sees the impact of trade on

income to be strongest if trade unleashes dynamic forces like learning, innovation, scale economies, and if it accelerates capital accumulation.

In sum, trade integration must be part of a wider outward oriented industrialization strategy in order to generate positive income effects. Deep integration tends to boost exports but mostly of those goods that

have a high import content, contribute little to domestic income generation and provide little improvement in debt servicing capacity. By contrast, strategic integration tends to make trade growth less pronounced, but it generates a denser domestic production network and therefore better supports domestic income generation.


EXPORT-LED GROWTH BASED ON MANUFACTURES

Arslan Razmi

University of Massachussets

I will mostly talk about manufacturing exports-based growth, a strategy

many developing countries have explicitly or implicitly adopted over the last couple of decades. So the old picture of developing economies as exporters of primary commodities is not true anymore. Back in 1980,

manufacturing was about 23% of developing country exports, now it is higher than 70%. So this picture has changed quite drastically (see figure 1 below, which has been borrowed from Razmi and Blecker, 2008), although a significant portion of this change is due to a few

highly successful exporters in east and south east Asia. As far as the composition of manufacturing exports, the fastest growth has been in mostly electronics and transportation equipment.

Figure 1

Now, some context. Why the sudden shift? Again the story is familiar so I won’t spend much time on it. The debt crisis was a big part of it. That crisis in the early 1980s convinced a lot of developing countries to

shift to export-led growth in order to be in a better position to repay their external debts. The perception was that since manufactures provide a more stable environment, as far as terms of trade are

concerned, it is better to opt for export-led growth in manufactures as

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opposed to primary commodities. A number of developing countries have hugely benefited from this strategy. China is a great example. But

other countries have not; for example, Mexico and Latin America. Inequality has also worsened in many developing countries. Although its hard to find reliable data on inequality in these countries, the general

conclusion appears to be that it has increased significantly in many developed and developing countries. While trade theory would predict this development for capital- and skilled labor-abundant developed countries, the same development in labor-abundant developing countries

raises serious questions. Part of the reason it appears is that if a number of developing countries pursue similar export markets in similar products, creating incentives for lowering costs to maintain

competitiveness. In the short run, one way to lower costs is to lower wages and/or maintain an undervalued real exchange rate. So this is what my talk is mostly about, that is, the kinds of conditions created

when a number of countries try to pursue export-led growth in similar sectors.

Now if you look at most policy related discussion, or the way most

economists treat export-led growth, the major issues considered are mostly supply side. That’s based on the classical view of reciprocal demand, which says roughly that if you export, you also earn, meaning that you can import more from others, so that demand doesn’t become

an issue. But if you think about it, that’s not true for many developing country exporters of manufactures, because their export strategies are not based on exporting to each other, but rather on exporting to

industrialized countries. In a world where several developing countries are focusing on a single developed market in similar sectors, the elasticity of substitution is higher, which means that they are competing

against each other, and must continuously lower their costs in order to be able to successfully do so. This is likely to lead to downward pressure on wages. In fact, adverse terms of trade effects is one of the

reasons why recent empirical and computable general equilibrium studies show much lower gains for developing countries from further multilateral trade liberalization than was being projected a few years ago.

What I’m going to spend the next 5 or 6 minutes talking about is recent work, mainly my own with Robert Blecker at American University. We took the 18 largest developing country exporters of manufactured

products (more than 70% of their exports being manufactured). We considered their exports to the 10 largest industrialized importers. The


sample here is the 1980s, the 1990s and the early 2000s. The main issue here is whether there exists a fallacy of composition in the simultaneous

pursuit of export-led growth by a number of developing countries in the sense that some countries could successfully pursue such a strategy but only at the expense of other developing countries. Put differently, do

developing countries compete mostly with each other or industrialized producers when they export? If they compete with industrialized producers, then the fallacy of composition is not a problem in the same sense as it would be if the mostly compete with each other. Second,

well if they do compete with each other in exports, does that affect their output growth in the short run? What we found was that most developing country exports mostly compete with other developing

countries. But there are important exceptions, namely South Korea, Taiwan, and Mexico. These three countries have a much higher proportion of high tech manufactures in their export baskets compared

to the average developing country. What we generally found was that high tech markets were generally immune from the fallacy of composition problem. What does that mean? I’ll come back to this

theme, but it raises a few concerns about export-led growth by countries that are beginning to enter the field at the lower rungs of the technological ladder. In the 1960s and 1970s when South Korea entered the field, it had very few competitors. That’s not true for countries

entering it today, as the lower end of the ladder is already quite crowded.

But what about real exchange rates and output growth? What kind of

relationship would you expect to see there? The traditional view is that a real exchange rate depreciation could be good or bad for output in the short run. Good in the sense that it gives a boost to exports and

encourages a shifting of resources from nontradeable to tradeable sectors. That’s a good thing. What are the drawbacks? Well there is a huge body of literature on this question. One of the possible

contractuary effects is the balance sheet effect. If you devalue in a big way, your debt all of a sudden become much larger, so there is a huge possible negative balance sheet effect. Furthermore, if capitalists tend to spend less, it means a real depreciation could have a negative effect

on aggregate demand and growth. However, recent research has found robust support for the relationship between devaluation and growth. Relatively little is known about what causes growth, but at least in the

last few years, the real exchange rate has emerged as one relatively robust candidate. This applies to sustained episodes of growth.


But the question is that although undervalued real exchange rates may appear to help launch sustained growth episodes, but when you devalue

your currency, you don’t just devalue it against other developing country competitors, you also devalue it against industrial countries. Can those two devaluations have different kinds of effects? Why? Well

because if most developing countries compete with each other, you would expect the competitive effect coming from a real devaluation to tend to work in a country’s favor when the real devaluation is against the competitors. But at the same time it is also devaluing against the

dollar and euro, and you would expect to see the balance sheet effect to be stronger on that front. That’s really briefly, with strong qualifications, what we find empirically. Devaluations against other

developing countries tend to be helpful, but against industrial countries not so much.

Another very preliminary piece of evidence. What I’m showing here is

from UNCTAD recent World Economic Situation and Prospects, 2007. In recent years, as oil prices have gone up and commodities have become more expensive, what you see here is that manufactures-

exporting developing countries have done the least well in terms of terms of trade. This is partially because of the price of oil. But it also suggests that manufactures-exporting developing countries cannot pass through the price of oil into the prices of their products due to a high

degree of international competition in their export sectors.

Figure 2


Thank you.

References

Razmi, A. and Blecker, R., “Developing country exports of manufactures: moving up the ladder to escape the fallacy of composition?” Journal of Development Studies, 44(1), January, 2008.

Blecker, R. and Razmi, A., “The Fallacy of Composition and Contractionary Devaluations: Output Effects of Real Exchange Rate Shocks in Semi-Industrialised Countries,” Cambridge Journal of

Economics, 32(1), January, 2008.


TEXTILES AND PREFERENCE EROSION:

THE CASE OF MAURITIUS

Mr. Umesh Sookmani

Permanent Mission of Mauritius to the UN /WTO

Introduction

The issues we are discussing in this seminar, as well as what was discussed in the previous one, are closely related to the current debate of how to finance economic reform in the context of liberalization or

globalization. Hence the linkage between debt, trade and development is a headline theme.

It is given that for any country to be able to integrate the world economy or liberalise its trade, it will necessarily have to undertake major economic and structural reforms. And to be effective, reforms have to

cover all sectors of the economy, be it agriculture, manufacturing or services. Such reforms are generally painful and have high political, social and economic costs. Especially when it comes to opening up

trade and competition in a sector that has enjoyed protection in both the local and external markets, to be profitable and at the same time have a say in political affairs.

Preference has never been a gift to a number of small vulnerable countries like Mauritius. Historical and economic as well as legal and

moral underpinnings amply justify it however. Mauritius and many other countries have made optimal and positive use of preferential arrangements. Thus. Mauritius should not be penalized for being exemplary student.

But we have to reckon that the value of preferences is gradually being

eroded. The end of the Multi Fibre Agreement and the need to make the Cotonou Agreement WTO-compatible say it all. While we should continue to fight to preserve our preferential advantages, we should also

use the time between now and the end of preferences to prepare our economies to become globally competitive as well diversify the economic base to enhance economic resilience.

Like many ACP States, Mauritius is facing the challenges of moving away from dependence on trade preferences to open competition in the

global economy. And it must do so in an unusually difficult environment which we attribute to the triple shocks of the dismantling


of the Multifibre Agreement, soaring oil prices and the sharp cuts in the guaranteed sugar price in the EU market. It is a well-known fact that as

a small island developing state, Mauritius is further inhibited by a host of factors of vulnerability such as remoteness and insularity, susceptibility to natural disasters, limited diversification due to a very

narrow resource base and small domestic market. Nonetheless, as a result of major economic reforms and political stability, it has tried to position itself as a viable economy in the region. The early stage of its development was characterized by a mono-crop agricultural economy,

exporting mainly sugar to the EU. From the 1970s, Mauritius has witnessed a gradual transformation of its economy by successfully diversifying into other sectors such as manufacturing, tourism, financial

services and is presently engaged in developing the information technology sector. The sustainability of the economy and social developments are, however, still dependent on commodity trade.

The textile and clothing industry has played an important role in the development of the Export Processing Zone (EPZ) of Mauritius and has

contributed in harnessing economic growth. This sector has significantly benefited from the Lome and Cotonou trading arrangements with the EC and the US GSP Schemes as well as the Multifibre Agreement, in terms

of guaranteed market access. The textile boom in the 1980s further enhanced economic growth and has contributed to attract foreign direct investment.

The clothing industry, however, started to face serious challenges as a result of changes taking place in the international trading landscape

including (i) the dismantling of the Agreement on Textile and

Clothing and (ii) trade liberalization forcing in NAMA under the

DDA is a further challenging factor.

Let me briefly address the issue of the termination of the ATC and its impact in the Mauritian economy. The elimination of textile and

clothing quotas by January 2005 have had many ramifications. While some big emerging developing countries have seen their market share expanding, small exporters like Mauritius have been negatively affected.

There have been massive lay-off and closure of several factories in the textile sector coupled with a deceleration in economic growth.

The proponents of free trade would argue that trade liberalisation would increase world prosperity on the basis of principles such as comparative advantage. Such theory fails to take into account the particular


circumstances of small economies. Indeed, in a real world situation, factors such as transport costs and the advantages of economies of scale

are key determinants for competitiveness. Taking the case of Mauritius, the high transport costs associated with the export of textile and clothing products seriously impinge on its competitiveness. Moreover, the

limited production capacity inhibits its ability to reap the benefits of economies of scale. Given the uneven level of plain field, the multilateral trading system should address the specific concerns of small and vulnerable economies by providing such economies with all

necessary flexibilities to enable their integration into the global trading system. The textile and clothing industry in Mauritius is a clear evidence of the need for a fairer multilateral trading system.

Textile and Clothing Industry in Mauritius

The Multifibre Agreement has played a catalyst role in developing the clothing industry in Mauritius. It led to the establishment of the Export

Processing Zone (EPZ) in the 1970s, which has helped to harness export-led growth. The guaranteed market access under the quota regime and the availability of semi-skilled and cheap labour were instrumental in attracting both domestic and foreign investment.

The preferential market access granted by the EU under the Lomé I-IV

and Cotonou Agreements and by the US under the Africa Growth and Opportunity Act, has also been instrumental in developing our clothing sector. The strengthening of incentive schemes within the Export

Processing Zone (EPZ) has further enhanced the development of this sector. The clothing sector account for nearly 85% of the total EPZ exports in value, 90% of the EPZ employment and about 55% of the

total number of EPZ companies. Around two thirds of the production are exported quota free and duty free to the EU market under the Cotonou Agreement. The US, however, remains the major single destination for the Mauritian clothing textile.

The textile and clothing exports represented an average of 60% of the

total manufactures export from the year 1994-2000. Thereby underlining its importance in terms of foreign exchange earnings. However, due to developments in the international declining trend in the textile and clothing export as well as a deceleration of growth in the

sector. In 1990, there was a total of 361 firms in the textile and clothing industry. By the end of 2003, approximately 89 firms had shut down, representing a 25% fall. During the year 2002 and 2003 alone, 33


enterprises ceased their operation. With the loss of the MFA preferences and the increasing competition from low cost high volume textile

producers, exports registered an average decline of 7% over three consecutive years and job losses of 30% of employment in the sector…mainly women of over 40 years with the attendant difficulty of finding alternative employment.

The disadvantages of removing quotas for Mauritius

The rise in the labour costs and inability to benefit from economies of scale, high freight costs and soaring prices of raw materials have been

major factors in declining competitiveness. Moreover, reliance in only two main traditional markets (EU and US) and concentration on a limited range of production have seriously handicapped the industry.

Impact of the abolition of the Multifibre Agreement on the

Mauritian economy

(a) Employment

The declining industry was reflected by a sharp increase in the rate of unemployment for a country which had witnessed virtually zero

unemployment for more than a decade. Indeed, during the last six years however, employment in the industry has been in decline from 80,900 to 67,200 workers representing a decline by nearly 16%. [In 2002, the

clothing sector employed 72 034 workers whilst the textile sector

accounted for 4,536 representing a combined level of employment of

76570, which was nearly 88% of the Export Processing Zone and 15.6%

of the national employment. The level of employment in 2003 stood at

67251, representing a decline by 9313 as compared to the previous

year. Employment loss from 1999 to the first quarter of 2004 was

around 18,460 workers. Female employment is the most affected as

women workers who dominate the sector. ] Overall, job losses have put additional pressure on the Government to recycle the redundant workers to other sectors of the economy.

(b) Foreign direct investment

Furthermore, with the gradual erosion of the preferential market access to the traditional markets coupled with the rising labour cost, foreign

direct investment has been on the decline. Besides, some of the existing foreign investors decided to delocalize to more competitive destinations, leading to further factory closures..


(c) Export revenue

Another serious impact following the termination of the quota system has in terms of fall in the export revenue. Indeed, the EPZ registered a loss of Rs 1.4 billion from the year 2002 to 2003. This shortfall had a

de-multiplier effect on the overall economy, thereby putting severe financial stress on the Government to meet the rising demand of basic welfare services such as health and education and infrastructure development needs.

Tariff protection

Another challenging factor is the call for aggressive trade liberalization

of trade in the context of the NAMA negotiations at the WTO. Indeed, competitive exporting countries want a higher tariff cut while small, less competitive countries prefer a lower cut. The main contention by the

latter is that they would like to see tariff cuts in non-agricultural goods including in the textiles and clothing sector in countries which are the traditional markets for small suppliers such as Mauritius under the Cotonou and AGOA trade arrangements. Such cuts will inevitably

further erode the preferential margin enjoyed by these small suppliers who run the high risk of being crowded out even long before the end of the implementation period for tariff reduction commitments.

5. Measures to cope with market liberalization in the textile and

clothing sector.

The survival of the textile and clothing industry in countries like

Mauritius will depend to a large extent on achieving vertical integration, which includes the development of ancillary industries in order to reduce the dependency on imported inputs such as yarn.

(a) New markets (Enterprise Programme)

Another measure consists of efforts to penetrate new markets which requires an appropriate marketing strategy. In this respect, the import potential in the regional market must be assessed. Mauritius is currently

engaged in this process, while at the same time it is also trying to consolidate its advantage in niche markets with the label “Made in

Mauritius” as well as concentrate in production with high value addition to increase export revenue.


(b) Upgrading of skills and technical expertise / Empowerment

Programme.

Furthermore, through the Empowerment Programme efforts are being made to support the development of SMEs with a focus on taking advantage of emerging regional markets. In addition, the programme

aims at training and re-skilling programmes, preferably in the form of on the job training, to assist in recycling workers from sunset to sunrise activities whilst upgrading skills.

Solutions to Deal with the Issue of Preference Erosion

The case of Mauritius provides ample justification for addressing the issue of preferential erosion for both trade-based and non trade-based solutions. In terms of the trade-based solutions, we are calling, amongst

others, for a longer implementation period implementation of WTO tariff reduction commitments by preference granting countries for products benefiting from longstanding preferences.

With regard to non trade-based solutions, it is important to draw attention to the fact that such solutions should be a substitute to -but

rather complementary to the trade solution. The Aid for Trade initiative being canvassed at the level of the WTO takes all its importance in this respect.

The question is whether there would be a positive response of the development partners when they have pledged resources under the “Aid

for Trade” initiative, especially in Hong Kong and other fora. This is the only additional pot of money that has been floated as an incentive for trade liberalization. Hopefully it will be concessional in nature. And

it will not just be a relabeling of existing DDA under the 4 core areas of support that the WTO has endorsed after wide ranging consultations. Trade Related Technical Assistance and Capacity Building, Trade-

Related Infrastructure and Trade Related Accompanying Measures are all critical ingredients that developing countries will require simultaneously if they are to integrate in the world economy. If we can

apply AFT resources for these types of programmes on concessional terms, we would go a long way of drawing a perimeter around the triangle of Debt, Trade and Development.

Mauritius is pushing aid for trade as a regional venture, in particular within COMESA. This is why we are pressing for regional instruments

and assistance to move to free trade in the COMESA region as a


platform to later integrate into the world economy. In this regard, we hope that the COMESA empowerment programme would deliver in subjective of supporting the development of SMEs.

To conclude, Mauritius is making tremendous efforts to move from

reliance on preferences to global competitiveness. However, this strategy relies on heavy investment of about US dollars 5 billion over the next ten years and about half from the private sector with a large

dose of FDI including a lot of public-private partnership for infrastructure. Half will come from the public sector including our own national budget. But a large chunk will need to come from the

international community. In view of the strained public finances, high domestic and triple shocks, we need assistance on better than market terms and count on the Aid for Trade initiative in this respect. The

multilateral trading system, to be credible, must deliver on this initiative in full cognizance of the fact that countries that liberalize their trade and open to the world confront challenges that require a multilateral response in addition to a pro-active public policy response. Mauritius is test case.

I thank you for your attention.

Mr. Matthew Odedokun

Commonwealth Secretariat

Good evening ladies and gentlemen. Let me point out up front that I am filling in for my colleague who was unable to come. This is the topic

assigned to him. But when I came this morning, one of the organizers approached me to fill in for him. This means that I have not prepared a formal presentation on this. I have just jotted down a few points. The

issues now are: (1) how does the instability of commodity prices affect debt and (2) what can be said about the latest rise in trends and do they affect the long term decline? So it is on those issues that I will speak.

The few things that I have jotted down will be broken into four sections. First, I will look into the HIPCs and how the export structures present

challenges. Second, I will look at how instability of export prices affects debt. Third, I will look at current rising trends. Next, I will look at some


policy measures. Finally, I will look at what the Commonwealth Secretariat is doing on these issues.

Starting with the HIPCs and export structures: HIPCs, which are heavily indebted poor countries – that is the official name for them, by this

definition they have low-income, they are very poor, and they have traditionally been heavily indebted. HIPCs, and actually low income countries generally, rely heavily on commodity exports. They have not

been able to diversify into manufacturing, services or other exports. Apart from producing traditional commodities, they also concentrate on few of them. If they export tea and coffee, they only grow tea and

coffee. There are not other agricultural products. Even within the commodities market, they have not diversified and this is a common characteristic of most of most low-income countries including HIPCs.

The HIPCs have been recipients of debt relief. Some of them have seen benefits; others are in the process of experiencing benefits and some

have not benefited, actually, of any debt relief, yet. To receive aid, they must meet some policy criteria with the World Bank or the IMF – they must have programs with the IMF or World Bank. Underlying these

policy programs there are certain projections by the Bretton Woods institutions about their exports. Most of the time, these export projections are found to be overly optimistic. And before I go on, I have to mention that one of the criteria for qualification is that debt-to-GDP

ratio has to be 150%. Or for some countries it has to be above 250%. That is the indebtedness criteria. So for these countries, when the export projections are overly optimistic, it reduces the amount of debt that is

subject to relief. In other words, if export projections are overly optimistic, it also means that the projected debt-export ratio will be overstated and, when the time comes, it will end up that exports will be

less than envisioned. So at the end of the day, you will see that the indebtedness ratio will be higher than anticipated. So at the end of the HIPC relief, that is after getting whatever relief they qualify for, we

discover that they are now back to square one because the exports have been found to be much less than anticipated. Because of this many of them end up, after receiving relief, becoming heavily indebted again according to the official definition (debt-exports indicator).

If and when it is discovered that exports were overestimated, HIPC

countries can then qualify for “topping up” relief just to top the existing relief. What we are seeing here is that export instability has been a drain


of HIPC debt relief. Many of them do not get the relief that they should get.

Now, concerning how instability of exports prices affects debt, presently, to the best of my knowledge, there is no articulate view in the

literature nor has there been any rigorous theoretical exposition on why export price instability should aggravate debt burdens. Logically you can wonder during the exports boom why can’t you save enough and

then when the bad years come then you use what you have saved to reduce your debt or something like that. What we need now is an articulated framework that will link exports instability and debt burden.

Having said that, anecdotal evidence and economic logic still suggest that there must be a relationship and it is on this basis that I want to enunciate some reasons why export instability can aggravate debt burdens.

I will divide it into two theses: (1) during boom years there are two

reasons for aggravated debt burden. One is that during boom years lenders push countries to borrow excessively due to the resulting high repayment capacity. It is official multilateral, and in some cases

bilateral, agencies who are pushing these loans and it is very common nowadays if you have some booms in the commodity markets. Second, lenders abandon lending criteria. They also insist on getting regimes to pay their debts. In other words, resources available to these countries are

not as much as they should have been. A good example is the case of Nigeria. About one and a half years ago, Nigeria was forced to repay its US$ 30 billion loan to the Paris Club through a form of debt buyback.

They bought the 30 billion dollar loan for a US$ 12 billion upfront payment or 40 cents for every dollar. And their insistence on repayment explains why the resources weren’t available as they should have been during the boom years just because of the boom in the crude oil markets.

Now, countries themselves – country governments – tend to become less

prudent during the boom years and they become more corrupt so that is the defining characteristic of the boom period. The country governments embark on ambitious projects that are often left uncompleted at the end

of the boom cycle necessitating borrowing at disadvantageous terms during the bust years to complete the projects or otherwise leave the projects abandoned uncompleted. So that is another explanation of why borrowing increases during the boom years.


Countries do not embark on a smoothening of spending across complete boom and bust cycles. Spending should be smoothed over the entire

cycle. But what they tend to do is spend on the basis of liquidity. In other words, we get resources now, we don’t care about rainy days, and we spend it now. That is what happened during the boom years. Let us

look briefly at what happened during the bust years. The countries incur loans at less favorable terms to complete existing projects to finance existing and often imprudent commitments. That is what they are doing when things get bad. The commitments have already been made and

they have to meet those commitments. There are loans to defend past spending level profiles, they continue to service existing debt incurred during the boom years sometimes leading to refinancing or renegotiation

of such loans at disadvantageous political and/or financial terms. The real value of domestic currency falls during bust years and exacerbates the pain or cost of servicing foreign debt. Those are some of the reasons

why there is a relationship between export instability and debt burdens over the entire cycle.

In terms of rising trends, there seems to be a partial correlation of below-trend price levels that have been prevailing in the past. In other words there seems to have been a rise in the commodity exports and

export earnings of many low income countries. But we discover that most of these increases are apparent. When you measure it in dollar terms, they seem to be higher. But when you measure it in real terms,

they are not as high as the dollar amounts suggest. Second, the booms are not evenly distributed across developing countries. Many countries have not benefited from the commodity export booms– particularly the

small islands. And what we now call a boom is actually a correction of very low prices that have prevailed in the past few decades. It’s just a partial correction but people still call it a boom nevertheless.

In terms of policy measures, I would like to quickly address what can we now do in the face of this phenomenon. I have suggested three

issues. One is that we need to adopt measures on exports price instability protection to guard against export price instability. There are serious measures which we can not discuss fully at this forum such as measures to diversify export bases of low-income countries so they may

be able to shift into manufacturing. Within the primary commodities they can diversify also. Then there are the international commodity agreements that may be able to stabilize prices of exports and so on. But

these have not succeeded over the years and I do not know how to make these succeed. So that is something we will have to work through and


discuss. One suggestion -- that is measures on export price instability prevention -- and that is measures on mitigating consequences of export

price instability. Given that we have to live with export price instability, what can we do to mitigate the consequences? In this sense we can have export price insurance arrangements – there are various schemes which I

can not enunciate here. Related to that is EU/IMF Compensatory Financing Facility, exogenous shock facility, and so on. Those are some of the things but I can’t develop the intricacies and challenges of those measures.

So I have mentioned measures on export price instability preventions. I

have also mentioned policies on mitigating consequences of export price instability. We can also talk about managing export price instability – the boom and bust phases of the cycle. One is technical capacity

building for the low income countries. Second is raising awareness among low income countries of the need for them to maintain some type of back-up or some type of measure to save some of what they earn during the boom years so they can fall back on it during the bust years.

There is the need to raise awareness and there is also the need to build the capacity to do it. With regard to this need, one can suggest multi-lateral initiatives as a part of the Integrated Framework for Trade-

Related Technical Assistance. In this case, too, there may be a multilateral initiative along that line. Then there should be criteria for declaring international lending limits because it is during these boom

years that we have international creditors pushing credit to these poor countries. We are pretty much aware of the conflict between the World Bank, China, and so on – both sides competing to lend to developing

countries. The World Bank is insisting that it has created the borrowing space and the idea is that should have the monopoly of it and China is saying “well, that is available to all of us and all of us can now lend to them.” And at any rate, there is now the need for international lending

criteria and if you lend imprudently, then you are left alone. You cannot, during a bust year, insist on getting repaid through the sweat of these very poor countries.

Issues in the Export Growth-Debt Repayment Link 53

SECTION IV

ISSUES IN THE EXPORT GROWTH-DEBT REPAYMENT LINK

Ms. Lida Nu!ez

Corporación de Investigación y Acción Social y Económica, Colombia

Good Afternoon. It’s pleasure to be here with you. I think the presentation that I have prepared for today makes some progress and

wraps up the discussion of the past panelists. So, I am going to try to make some points quickly.

The purpose of this presentation is, based on available data, to demonstrate that not necessarily the increase of exports or foreign direct investment has generated domestic growth and greater incomes in Latin

America. This is because the policies to give incentives to trade and FDI include: diminishing the taxes paid by companies (national, international, or multinational) and, as a consequence, there is a

reduction of the government’s intake. The economic sectors in which exports or FDI are concentrated and much more of the increase in exports on FDI, are based on commodities or resource-based products.

To identify the links between exports growth and economic growth it is necessary to analyze differentiated impacts of economic liberalization

and consider issues like the sequence of openness, the coordination between trade and financial liberalization, the degree of commercial liberalization, the macro-economic situation, institutional stability, the

role of public policy, and monetary and exchange rate policy. This argument was proposed and discussed by Rodrik, Harrison and Vamvakidis, among others, in the 90’s.

If we compare export growth and economic growth in some Latin American countries we cannot find causal determination running from

one to the other. For example, in Brazil and Ecuador during the period 2002 – 2005, in spite of the big increase in exports, their GDP didn’t grow as well. In Mexico the GDP was not affected because of the

behavior of exports. In Argentina, exports did not grow the same proportion that GDP did in this period.


In fact the growth of countries in the region remains low especially compared with other experiences of outward-looking growth. These

difference may simply be due to the fact that exports are not growing enough and/or don’t generate enough linkages with the rest of the production fabric. In real numbers, we can also say as a fact that 62% of

the region’s growth between 1990 and 2004 was attributable to non-export GDP.

Graph 1

The region’s economic history over the past 30 years includes a strong

acceleration of export growth measured at constant prices. As shown in the graphic (Graph 1), thus far in this decade, the average 10-year growth rate for exports is 9 percent, that is somewhat more than 7.5


percent recorded in the 1980s and 90s and 5 percent in the 1970s. Between the 1990s decade, the volume of the region’s exports grew at

an annual rate of 9.5 percent which was above the world average. The problems that arose in the international economy between 2001 and 2002 interrupted this growth trend. That gave way to a recovery in 2003

that resulted in an expansion of Latin American exports at annual rates of over 10 percent in these two years.

Although the rise in exports is part of a trend that has been observed over the last twenty five years, exports have grown even more rapidly in terms of both volume and value. The expansion in exports has been led

by Mexico and some of the Central American and Caribbean countries including the Dominican Republic, Costa Rica, Guatemala, Haiti, and Honduras. These and other countries in the area have continued to step

up their maquila-based trade with the United States. The increase of Mexico and the Caribbean countries is entirely due to higher exports of manufacturs while South America has had the strongest growth in the market for natural resources and resource-based products.

In South America, on the other hand, all the countries except Chile, have

registered considerably lower growth rates for exports. This situation was reversed in 2003, however, and since then the South American countries have been leading the region’s export growth. Although these countries’ share of world exports has diminished, they have recorded a

small increase in their share of world trade in primary commodities and manufacturing based on primary goods.

Nevertheless the participation of Latin America in global exports doesn’t grow at the same speed as increases in volume as shown in the graphic on participation on global exports.

In general, South American countries have for the most part been

involved in horizontal trade networks consisting largely of resource-based products. Although their target markets are more diversified, they also have larger inter-regional trade flows. A distinction should be made

between the Andean countries and the MERCOSUR bloc since the Andean have a much more concentrated exports basket in terms of both destination and products.

Generally speaking, over the past 20 years, Latin America has significantly increased the diversification of its exports basket, even as

the concentration of its target markets has risen slightly (this rise hides considerable differences across countries). As shown in the graphic


(Graph 2), all the countries diversified their products, with the exception of Venezuela and to a lesser extent Uruguay and Peru, although diversification was substantially greater in Central America and Mexico.

Graph 2

It is often claimed that exports based on natural resources have limited potential spillovers for the rest of the economy and therefore have less of an impact on growth. Some empirical studies suggested that countries

with an abundance of natural resources tend to grow slower than those where they are scarce. There are many reasons to explain why natural resources may contribute less to economic growth. Among others, we

can mention the following. First, when there is a sharp difference in productivity levels between the natural resources sector and the rest of the economy, the equilibrium exchange rate may generate hefty earnings

for producers of natural resources while at the same time preventing other industries from being competitive at the international level, including a large part of the manufacturing sector. This is the sort of disease that Prof. Bresser mentioned before. This sort of disease

reduces importance of the manufacturing sector and can be a real problem if the traits of this sector (linkages, economies of scale, learning externalities) make it crucial to growth, as it is often the case.

Second, commodity prices are more volatile that the prices of manufactured goods, which generates more volatile growth in the


absence of export diversification. Third, in many commodity-producing activities, particularly mining, remoteness from population centers

hampers the formation of backward linkages both in terms of service generation and production of goods. On the other hands, and fourth, exporters of differentiated products must innovate, including in terms of

marketing channels, to distinguish themselves from the competition in order to maintain their profitability. This provides incentives for expenditure on innovation defined in a broad sense to include the capacity to adapt and create which in turn creates positive externalities.

Differentiated products are usually associated with manufactures but non-traditional agricultural products can be differentiated as well.

I think two points should be made in this regard. First, the importance of the most technologically-intensive products is exaggerated by the

growing importance of international production networks that increase trade and dominate prices without adding value. This means that the volume of international trade, in the last two years at least, is not a good indicator of the buoyancy of demand but rather of how prices are

managed. However, this does not invalidate the fact that the demand for such high technology products is indeed more buoyant than the demand for products made from natural resources or low- technology goods.

Second, the differing access that primary and particularly agricultural products have to the developed countries markets also partly explains

this set of dynamics. According to Machinea and Vera, in a recent study of ECLAC on Latin America, although exports of the region had increased and diversified significantly in recent years, in some cases,

shifting towards intermediate and high-technology goods and away from commodities, the results have not been satisfactory in terms of growth. While acknowledging that the growth rate depends on a combination of

factors beyond export performance, there is no evidence that exports have the same growth-boosting potential in Latin American countries as countries such as those in South East Asia or China.

The difficulty that Latin American countries have had in adding value and especially knowledge to exports is what has limited the potential of

these exports to boost growth. In other words, although it is possible to add value on the basis of natural resources, it is not usually a spontaneous process but one that requires coordinated action between

public and private sectors. In this sense the region’s export base, which has been growing stronger and has been extremely buoyant in recent years, may be a promising platform for launching strategies aimed at


increasing the domestic value added of exports as well as strategies for intensifying and extending learning processes, technical processes, and innovation.

Now I would like to focus on the effects of foreign direct investment.

These effects on the growth rate of the national economy will also depend on the capacity to generate multidirectional linkages between the activities receiving the FDI and other local activities. This will depend

on the type of FDI involved and on the sectors concerned and, hence, on what interests have attracted the FDI in question. Ideally, production linkages will generate benefit in terms of technology transfer, human

resources training, and the development of local businesses. In order for this to occur however, the firms must not be set up in enclaves. Potentially negative effects could include the crowding out of local

business by transnational firms either financially or in terms of access to inputs. In that sense the effect of FDI on GDP growth depends on the sectors in which it is located. The effect of FDI will tend to be negative in the primary sector, positive in the manufacturing sector and

ambiguous in the services sector, while total FDI does not have a clear impact on growth. These results are not surprising since the relevant micro-economic effects tend to be greater in manufacturing activities. In

certain enclave-based primary activities, no such effects are generated and in some cases the only effects are a depletion of natural resources and massive capital outflows in the form of royalties and dividends.

However, other primary activities offer greater potential for stimulating the productive structure. If most FDI in the primary sector is channeled into mining activity, this might explain the negative effects of such investment on growth in that sector.

Latin America is one of the regions that has received one of the most

important flows of FDI measured in terms of GDP during the 1990s. Today the situation has changed. Meanwhile the major privatization of South America made it the main recipient of FDI within Latin America.

In Mexico and the Caribbean, FDI inflows have come mainly from US corporations interested in setting up portions of their international

integrated production systems in the manufacturing sector. These FDI flows have generally involved the creation of new sets and have succeeded in raising the level of international competitiveness of the

region as measured by its international exports share. Seventy five percent of the investment received by Mexico and the Caribbean basin during the decade of the 1990s was in the form of greenfield


investments (new assets). In most cases there has not been any impact in terms of national integration particularly from the standpoint of

technology transfer and assimilation, production linkages, human resources training, or local enterprise development.

For South America, as we can see in the graphic (Graph 3), most such inflows have consisted of market-seeking FDI from European transnational corporations in the service sector which received 60

percent of investment from 1996 to 2003. Natural resource-seeking FDI is also significant in this region and accounted for 19 percent of total FDI during the period. FDI orientated towards the manufacturing sector,

at about 21 percent, has usually been aimed at taking advantage of the benefits of the regional integration, particularly in the context of the MERCOSUR bloc. Much of the market-seeking FDI has taken the form

of mergers or acquisitions – about 55 percent of the total-- and has been driving the privatization and deregulation processes implemented throughout the 90s.

Graph 3

As a conclusion we can say that, first the impact that exports have on

growth will depend on the types of goods or services involved and on their potential effectiveness in generating positive externalities and dynamic linkages with the rest of the production structure. Similarly, in the case of foreign direct investment, there is no unequivocally positive

relationship between FDI and growth, as the link between the two depends on the type of FDI, on, in particular, the target sector, and on whether the investment involves greenfield investment or the purchase of existing assets.


Second, in terms of the incomes for Latin American countries, we have seen that the levels of openness and the benefits granted to increase

exports and FDI are one of the most important factors that can rather delay growth and, on the contrary, cause the governments to have to increase their debt (internal and external).

Mr. Richard Kozul-Wright UN Department of Economic and Social Affairs

Thank you very much. Let me again extend Jomo’s apologies. I’m not going to pretend I’m talking for Jomo, rather I will draw on my own -- which to some extent will repeat things that have already been said this

afternoon – work that I undertook with Joerg and others in the context of the Trade and Development Report but also work that is underway in DESA and has been aired recently in the World Economic and Social

Survey particularly the 2006 WESS which dealt with growth divergences. There is, consequently, I think some degree of overlap with some of the presentations that have taken place this afternoon.

I guess it’s no great insight – and I think Professor Razmi mentioned this –to say that the debt crisis of the early 1980’s triggered a major

reassessment of development strategies away from more inward-oriented approaches to development policy towards essentially, one encouraging domestic firms to compete on international markets. There

has been some dispute about what were the possible forces behind that, whether in fact it was driven by internal factors or whether there was external coercion (from international financial institutions and donor

countries), but what is certain is that it was given strong ideological backing by conventional economic thinkers wherever they happened to be located. The idea of a win-win logic attached to this shift of strategy

was a fairly visible part of the debate beginning in the early 1980s and I don’t think it’s again a great revelation to this audience that the idea of rapid and complete trade liberalization was promoted on the belief that this would essentially generate big efficiency gains for all players in the

global international system based upon specialization of certain activities – specialization that was essentially determined by the weight of particular factors of production whereby countries essentially were

expected to export those goods in which they had an abundance of a particular resource, importing those goods which contained resources that were scarce in their own country.


This was the kind of win-win logic which would promote a virtuous growth circle away from the kind of stop-go cycles that it was believed

had plagued the more inwardly oriented development strategies of the 1960s and 1970s. In terms of the overall policy orientation, it was a policy orientation that essentially focused on getting incentives right;

removing the kinds of distortions that had traditionally been associated with state interventions of one-kind or another and in where the world market – because it was least vulnerable to state-oriented distortions -- was the one that held out the best hope of providing the kind of

incentive structure that would produce efficiency gains and virtuous growth circles.

Of course, as Jan mentioned this morning, this is only one view of the role of trade and its links to development and there are plenty of other

discourses which look at the role of trade in development very differently. In particular, trade – at least for more heterodox economists – has always been seen as one way of tackling the kinds of constraints on growth and development that have plagued the ambitions of many

poorer countries: technological backwardness, market size, the lack of a vibrant capital goods sector. Challenging these constraints has been linked with a more aggressive trade strategy but not so much one

centred around getting incentives right as about getting structure right. And it’s the structural aspects of development and the links between structure and trade which is what policy makers need to focus upon.

And, from that perspective, a key aspect of the trade policy issue is rather how to translate increased export revenues into investment in new lines of economic activity, new lines of production and to keep that kind

of virtuous circle going through the constant upgrading of economic activity and the constant diversification into new lines of production.

While this kind of approach was essentially marginalized by the debt crisis, I would make the contention that it is now coming back into the debates about development policy. I want to, in a way, sum up what we

mean by the assertion that structure matters, what that means from the kind of work we were doing with the Trade and Development Report and subsequently in the World Economic and Social Survey.

I guess, crudely, economic development from this perspective is essentially about moving to high productivity activities and sectors in

which industrialization, in one way or another, plays a pivotal role in achieving that goal. There are a series of stylized facts that for too long have been forgotten but I think are worth recalling because they


underscore the importance of that kind of thinking when it comes to the evaluation of development policy. The first one, and I suppose it is one

that’s reverberated around the room today, is that most rapidly growing economies, most successful developing economies of the past 40 years and indeed of the last 20 years, have had large and growing

manufacturing sectors. The success stories that everybody comes back to, particularly in East Asia, are all industry driven success stories and that includes China most recently. So, rapid growth and expansion of the manufacturing sector seem to go hand in hand as they did in the

developing experiences of the European periphery after 1945 and the European core and the United States in the late 19

th and early 20

th

centuries.

Related to that, most growth takeoffs are also closely linked to rapid

manufacturing expansion. When people focus on growth takeoffs, they usually have in mind -- and rightly so – that this is linked to the rapid expansion of the manufacturing sector usually based upon of course at the early stages of development, low skill or unskilled labor and

unskilled products. So growth takeoffs are usually associated with an industrial drive of some sort or another.

And I think a final point that is worth highlighting is that – and thework by Imes and Wosieg and Rodrik and others have insisted on this and shown this through more applied work—is that the success of an

industrial takeoff and subsequent processes of industrial upgrading is not based so much on specialization of economic activity but on the diversification of economic activity. If you map the degree of

diversification on one axis and the level of income on the other, you will find essentially an inverted U-shaped relationship, i.e. as a country develops from a low-level of development towards a middle-income and

higher-income level you will see an increase in the degree of diversification of the economy and as the economy reaches a certain level of income, usually around $9,000 – 10,000, you will see the degree

of diversification decreasing. So there is a clear relationship between the level of diversification and the country’s level of income and from a policy perspective in the key stages of development it’s not specialization that seems to matter for economic success, but rather the degree of diversification.

Not surprisingly, these kind of underlying structural dynamics are also reflected in most countries’ trade profiles. So, evidence that is reported in the World Economic and Social Survey shows that countries that


promote more sophisticated goods more medium and high-technology goods are precisely the countries that grow the fastest. This shouldn’t

be surprising given that the underling economic structures also reflect that kind of dynamic. But certainly the evidence that we report shows that. And studies that have told a similar diversification story focusing

directly on export products also show that as a country moves up the income ladder, its export profile also becomes more diversified, with again a threshold level of income around $9,000 - $10,000 as critical, after which the export profile tends to become more specialized particularly as countries move into the service sector.

These broad trends, I think, are fairly familiar from the classical development literature. Of course there’s no rigid pattern and I don’t think anyone suggests that there is a type of blueprint in terms of the

links between structure and economic development and there is plenty of room for individual country specificity in terms of examining these kinds of profiles but the broad trends do seem to be quite clear.

And of course, underlying the broad trends, are a set of familiar economic driving forces that in one way or another help to explain the

relationship between structure and income growth. These are the things that Joerg and other people talked about this afternoon, about the links between industrialization and scale economies, industrialization and learning, industrialization and linkages all of which seem to be much

more intense when it comes to industry and manufacturing than is the case with primary sector, or indeed, with most service based activities. So the classical stories about the driving forces of growth are attached to, if not synonymous with, a rapid pace of industrialization.

From the demand side of course, the argument is reinforced because there tends to be positive price and income elasticities attached to manufacturing products and that tends to create a kind of virtuous circle between the supply–side (productivity growth) and demand side (market

expansion). And the classic story at least remains fairly well in place. On top of that, we have argued extensively in the Trade and Development Report that there are very strong links between

industrialization and a rapid pace of capital accumulation or gross capital fixed formation. There is a very close link, and I would argue that it has a lot to do with the fact that manufacturing activity (once it is

located outside the neo-classical world) is intimately associated with the process of rent creation and rents are a major force driving the profit-investment nexus which underpins rapid economic growth in developing


and developed economies alike. So, investment, industrialization, profits, rents are an intimate part of the underlying dynamic.

And finally, I think industrialization matters, as again someone mentioned earlier, because it is associated with intensive spillover

effects – the kinds of assets that are created in the manufacturing sector are not necessarily locked into a single line of activities but there are spillovers and linkages and social networks that come with the creation

of industrial assets which have a major impact on the kinds of opportunities which are constantly being created in an industrial environment which are missing from, or are weaker at least, in the primary sector or service driven activities.

The bottom line of course in terms of the implications of this is of course

that this is a world where policies matter intensively to the final outcomes. It’s not simply a question of, given resource endowments or given initial conditions or indeed of getting incentives right, it’s very

much a question of policy being able to drive these underlying levers of industrialization and structural change. And so the stress is much more intensively on an active policy agenda than is the case with more

conventional conceptions of trade and the links between trade and development.

I wanted to say something about what Joerg and Professor Razmi talked about earlier which is the possibility that countries have been trading more and earning less. I hope that now the elements of that argument

have been presented and I don’t have to go over that. But I think that needs to be factored into any useful discussion of past and future trade policy discussions. I’ll wrap up with some policy implications of taking

structure seriously, and some “dos”and “don’ts” of trade and trade policy that developing country policymakers and indeed negotiators at the WTO need to think harder about than, I will argue, they have been doing over the past few decades.

So let me just run through a set of ‘dos’ and ‘don’ts’. I’ll start with the

don’ts. The first ‘not to do’ that follows from this kind of perspective and this appreciation of structure is don’t confuse development with

competitiveness. Competitiveness has become a popular buzzword across the policy making debates in the developed and the developing

world. And we have argued constantly in the Trade and Development Report, that doing so confuses the responsibilities of firms with the responsibilities of national policy makers. At its worst competitiveness


is simply a buzzword for the perpetuation for a set of failed liberalization, privatization regulation policies. The constant harking to

competitiveness as the essence of the development challenge is one that’s had a major distortion on thinking about the development agenda over the last couple of decades and I think policy makers need to get away from doing that.

The second don’t is don’t confuse the importance of strengthening

the links between investment and exports with attracting foreign

direct investment. I think this is a conclusion that perhaps the previous presenter would also want us to draw but certainly while we would

argue that the need to strengthen the links between investment and exporting is a key nexus of any sustainable development strategy, that shouldn’t be confused with attracting foreign direct investment which

has been shown to be a lag variable in the growth and development process. I think you could argue that policy makers in too many developing countries have been drawn into that confusion. And it’s a dangerous one that needs to be seriously rethought.

The third don’t is don’t confuse integration with outward

orientation. Integration has both an internal and external dimension. And in many respects, internal integration, the building of domestic linkages of one kind or another on both the market and supply-side, is actually the key to getting development policy right. And external

integration in many respects comes out of and reinforces successful internal integration rather than the other way around. But domestic internal linkages remains, al a Hirshman, a key to successful development policy.

And finally, I would argue, and more controversially, perhaps don’t

confuse economic nationalism with populist insularity. The constant harking against economic nationalism in the conventional literature and in the conventional economic press has been tremendously damaging to

the thinking about the policy challenges facing developing countries over the course of the last two decades. The importance of economic nationalism needs to be revisited in this age of so-called ‘globalization’

if developing countries are going to build the kind of institutions and policies that they need to sustain growth.

Time has prevented me from suggesting in any detail what policies developing countries need to pursue and perhaps I will leave that for later. There is no magic formula here but broadly speaking a much


more pro-investment, pro-growth kind of macro-economic policy is required. Fiscal and monetary policy needs to be oriented away from

austerity measures, from a singular focus on inflation as the measure of what constitutes good macro-economic policy. We need greater policy space for industrial measures, technological upgrading, the management

of FDI and the support of domestic industry – particularly big domestic firms contra the fixation that comes out of the competitiveness literature and the competitiveness mindset which focuses on small and medium-sized enterprises as the key to economic growth. No industrialized

country developed through the promotion of small firms. It’s big firms that drive investment and it’s these big firms that drive exports. If you look at the figures for the United States, the number of firms involved in

exporting is insignificant. I think its 1% of American firms that export or even less perhaps. And these are big firms; they’re not small firms. The promotion of big firms, which has gone off the agenda, I’m sorry to

say needs, to be brought back. Of course mobilization of public investment in that respect becomes a necessary compliment of a pro-industrial, pro-growth macro strategy. And I think just bringing these

elements back into the development agenda is where we need to go if we are going to move forward in terms of not only alleviating poverty but in terms of tackling the problems debt and finance that were talked about this morning.

Thank you.

Foreign Direct Investment Rules and Their effects on Debt 67

SECTION V

FOREIGN DIRECT INVESTMENT RULES AND THEIR

EFFECTS ON DEBT

Professor Andreas Antoniou


According to established economic wisdom, under certain conditions, the level of public debt in developed economies is irrelevant, at least in the long run. The question is what happens in the short run and in the case of emerging economies. The level of public debt levels is relevant

if accompanied by other aggravating factors, such as highly risky short term debt, accompanied by an accommodating monetary fiscal policy. As the level of public debt increases, countries a more tempted to

renegotiate terms, thus increasing the likelihood of default and country risk.

Recent empirical work on debt defaults provides evidence that defaults depend on three mutually reinforcing quality-related factors: the quality of the country’s economy, the quality of its institutions and political

system and the quality of its debt. Indeed, an Inter-American Development Bank (IADB) study shows that, contrary to common wisdom, budget deficits account for only 5 per cent of Debt/GDP

growth, 95 per cent being attributed to “stock-flow reconciliation”. Stock-flow reconciliation depends on real exchange rate effects, but also on contingent liabilities, the safety of the banking sector and

composition of the debt. So, even with a prudential fiscal policy, fully transparent budgets, and a properly regulated and safe banking sector, emerging economies are still subject to sudden debt explosions due to balance sheet effects. Furthermore, international debt markets are

notoriously imperfect thus increasing the uncertainty of their debt. Furthermore, one needs to point out that when dealing with debt, and to the extent that it affects the costs of borrowing, the main concern is the

risk of default. In turn, the risk of default depends on the debt burden, i.e. the composition and maturity of the debt stock, as it relates to the country’s ability to pay and its sensitivity to external shocks.


Orthodoxy dictates that FDI stimulates growth and reduces poverty; at the same time, and by the same token, by enhancing the competitiveness

of the economy and stimulating export, FDI has a beneficial effect on the quality of debt and thus the risk of default. However, reality is more complex. Recent investment data from UNCTAD have identified a

number of trends in FDI flows that could, potentially, have detrimental effect on risk of default. These include, the increasing share of mergers and acquisitions cross-border FDI, mainly in the services sector, a significant percentage of which is from collective investment funds with

an investment horizon of less than 10 years, and from transition and developing economies. Transition and developing economies mainly invest in their own regions, actually in the sub-regions. Not only that,

but this investment is undiversified, mainly in services and mining. So these are some of the trends that have come out of the study and relate to the things I was saying just now.

Now of course, we have other elements of risks that can trigger sudden outflows that are more host-related. These include TRIPS, foreign

balance requirements, litigations, balance of payment safeguards that the WTO still allows, etc.

To conclude, how all these things come together, we can explore during the discussion. But clearly because a big chunk of the debt is due to balance sheet effects, it doesn’t mean of course that budget deficits are

irrelevant, but that prudent fiscal policies are not enough to reduce the risk of debt. You also have to look at other elements of vulnerability, which is basically the debt denomination and the maturity, as this comes

out of the IADB study. In some case, like in the Latin American and Caribbean countries, there is a trade off between these two terms, in the sense that domestic debt is often short-term compared to foreign debt;

this conundrum is sometimes addressed through indexed bonds but that is not always possible. But of course, one still has the problems of the inherent volatilities of the emerging markets themselves and that of the global financial markets, what should be done about it.

Very interestingly, studies seem to indicate that there are many policies

developing countries could use to reduce risk. For example countries could sell the debt directly to the market which would develop the domestic market, though this is not always possible. These are all in

cases to resolve crises, not to prevent them. What could we do to prevent a debt crisis?


The study identifies a number of recommendations which I am sure

have made a number of people in Washington smile, especially on 19th Street, in terms of what the IMF should be doing to help countries deal with this. Some of the options they offer are fairly interesting. First of

all, disbursing funds directly to the market rather than to governments. So get the IMF to act as a lender of last resort and do a little bit what the central banks are doing right now to deal with the mortgage crisis. The

IMF could also provide technical assistance to make things more efficient. They also suggest the IMF should be doing more to strengthen domestic markets. Another recommendation they make that is

controversial is that the Fund should issue local currency in markets, that would help develop the domestic markets.

Of course there are broader issues here. In the Doha Round people began to question the whole nexus between trade dynamics and debt relations. People think we need to be more careful about how these

dynamics works. Other people look at alternative approaches to debt. Aldo and some of his colleagues have talked about alternative ways to look at debt. What this means in terms of FDI, to answer your questions from yesterday. I think it is important that countries start taking

advantage of the trend identified in the study that we have now developing and transition countries FDI. Another element that some countries should be doing is encourage to enhance poverty reducing,

MDG-related FDI, rather than simply extractive industries and services. This is what people were talking about yesterday as far as diversifying the economic bases of the countries. They will have a beneficial effect not only on the debt as well as on the growth.

Macro and micro effect, I wanted to talk here about an ECLAC study

that tries to measure the impact of FDI on MERCOSUR. According to the study, the effects are mixed. There are not many bad things going on, but not a lot of good things going on, either. The conclusion of the

study is that you have to direct investment to developing niche of the country, which is, of course, nothing earth-shattering, we all know that. But I think it’s important to rescue the idea that, since FDI may not be

bad, but it does not bring anything good, necessarily, either, then we have to be careful to bring the discussion to the right level.

Finally, and I think this came out yesterday. We may be learning from the Korean experience that we should look at FDI in a different way. We should not look at FDI as something coming from outside that


hopefully works. We should have a more systematic way to link FDI to a strategic industrial policy. As we all know, that is what the Asian

Tigers did. They had a specific strategic approach to industrial policy and, yet, FDI was part of that policy, not the other way around. So it is important that, I think, we take some advice from that.

But as Prof. Razmi mentioned yesterday, if we follow that advice, are we not having the problem that a fallacy of composition is emerging if

every country tries to do what the Asian countries did? I’m just asking the question about whether this concern would apply. I do not have an answer, I am just throwing out the question. So thank you very much.

Mr. Alfredo Calcagno, UNCTAD

Thank you. As you said, most of the data I will show you in this

presentation are taken from the Trade and Development Report of 2005 and the last Trade and Development Report, 2007; or were prepared for these reports but were not used in their final version. The presentation

will show you as a starting point what has happened with the terms of trade in developing countries. But also, we tried to see what the actual impact was on the countries. It’s not enough to say: "terms of trade

have increased or decreased". We must also assess what it means for specific economies in their balance of payments, their income, and in their fiscal accounts. We measured it basically through two effects: the effects of changes in the terms of trade which explains the difference

between GDP and gross domestic income, and the net income payments. Sometimes a country may gain from better prices for natural resources, but if those resources are exploited by foreign firms, it may also face

higher net income payments. This poses the question of the distribution of natural rents which is a very old topic for developing countries. We have in economic history cases of countries that used natural rents for

development and other countries where natural resources were only an enclave and did not promote development.

The starting point is shown in these graphs [Graph 1]. We see that, beginning in 2003 and especially 2004, terms of trade have dramatically changed for a group of countries. If we classify the countries according

to their exports, we have oil exporters and exporters of minerals and mining products that are the main winners. On the other hand, exporters of manufacturers suffered deterioration in their terms of trade, which is


something new. The group that has not shown big changes in the terms

of trade includes exporters of manufacturers and primary commodities such as Mexico, Malaysia, and Vietnam; these countries are mainly exporters of manufacturers but also export oil. The South African

Republic, which exports manufactures and mining products, is also in this group.

The question is: "so what?". When we began the study of the changes in terms of trade in 2004, we saw that the country that had the biggest improvement in terms of trade was Sierra Leone, which was not a

success story. Improvement in terms of trade certainly helps, but is not a sufficient condition for growth and development. Chile [Graph 2] is another example of a country with big improvements of terms of trade since 2003.

In 2001 Chile's terms of trade deteriorated, and as a result, gross

domestic income grew less than GDP that year. The difference between the two growth rates measures the loss of income, in terms of GDP, that specific year. Since 2003, gross domestic income grew much more than

gross domestic product, thanks to the improvements in the terms of trade; but at the same time the gross national income grew much less than the gross domestic income, the difference between them being the

changes in the net income payments. Most of the gains from the terms of trade have in fact been captured by transnational corporations. This poses a question that has huge ramifications for domestic countries and

their policies: that of the distribution of the natural rent. This question is particularly relevant in mining exporters, such as the case of Peru [Graph 3].


Graph 1


Graph 2

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Graph 3

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Peru exports copper and gold and has benefited from improving terms of trade since 2003, as evidenced by gross domestic income growing faster

than gross domestic product. But the increase in income payments has counterbalanced the gains from the changes in terms of trade. As a result, in 2006 we have “no gains and no losses”, so to speak. The entire

gains from the terms of trade have been offset by higher payment remittances.

In Zambia [Graph 4] we also have a considerable portion of the gains from trade that does not remain within the country.

Graph 4

The picture is different for most oil exporters. Big oil exporting

countries did not privatize their firm. This is the case of Saudi Arabia [Graph 5]. As a result, the huge gain from the terms of trade, which represents 10 to 15 points of GDP, was not lost because of increased

profit remittances. The two lines in the graph (the gross domestic income and the gross national income) follow the same pattern. This is also true in Algeria [Graph 6] and becomes true in Bolivia [Graph 7]. In

Bolivia the payments of profit remittances more than offset the gains from the terms of trade in 2003. That year Bolivia had big political problems – a change in government and a change in its gas policy. The share of the gas rent captured by the state increased significantly. Since


then, you see that gross national income follows the growth in the gross domestic income.

Graph 5

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Just to be complete, this slide shows the case of an exporter of manufactures, China [Graph 8]. The gross national income grows at the

lower rate than the gross national product because of the terms of trade deterioration.

Graph 8

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This slide [Graph 9] shows the aggregate results for 2004 to 2006. On

average, the exporters of manufacturers have lost a bit more than 1% of income in terms of GDP due to declining terms of trade, but have little effect in net income payments. Oil exporters had a very big positive effect from changes in the terms of trade, an annual gain of 7 points of

GDP, and little effect in net income payments, so that the overall positive impact remains very high. The exporters of mining products had a positive and wide effect on national income from the changes in

terms of trade that was mostly offset through higher net income payments.

Graph 9

These are numbers estimated on the base of balance of payments and national accounts statistics. It is necessary to go into more details for understanding the economic mechanisms behind these numbers. This is

what we did for some countries in the 2005 Report. These [Graph 10] are the figures of the fiscal income from the copper industry in Chile. We see that most of the rent was not captured by the state but remained

in the hands of the transnational companies, and this is the main reason why most of the gains from the terms of trade were sterilized by profit


remittances. Most of the public rent, the three quarters of it, was obtained through the state owned enterprise of copper, Codelco: that

enterprise produces only 1/3 of the copper in Chile, but explains three quarters of the fiscal revenues from copper. Why? Because the strategy of attracting FDI was through generous taxation conditions, such as low taxation rates and accelerated depreciation rules.

Graph 10

In Ecuador [Graph 11] there is one public company, PetroEcuador, whose share in production has been reduced dramatically from 70% to 1/3 in 2003, as shown in the table, though it has recently increased again

because one private company has been acquired by the state. But with 1/3 of the industry about " of state revenue from oil came from PetroEcuador. What I would like to highlight from these data is that the

income tax is generally low: for a transnational company, the way to maximize real profits is to maximize accounting losses. And the most sure way for a developing country to get a significant share of the rent from primary production is through the ownership of the firm or through

royalties. In the case of Ecuador, we first calculated the rent obtained from oil production and then how much of it goes to the government. We found that almost 2/3 of the oil rent goes to the government, 30 per

cent is obtained by transnational companies, and the rest goes to the


consumers; we also found that most of the public rent was obtained through Petroecuador.

Graph 11

What can we conclude from this evidence? First, we have very large differences in the distribution of the rent from country to country. This is not due to different productive structures or to technical matters, but

to differences in taxation policies and in the ownership of enterprises. Among the oil exporting countries, most of the rent is captured by the State in the Gulf and North African countries. The public share in the oil rent is lower in sub-Saharan countries. The most extreme case is

Chad, which only captures 7% of export revenues in 2004. This is a very interesting case because much has been done, with the leadership of the World Bank, for earmarking the government revenues from oil

exploitation, creating for instance a fund for future generations, funds for poverty reduction and to finance priority projects. Only 13.5% of oil revenues were going to the regular budget. But as the royalties were so

low, taxation revenues were so low; all this was like an irrigation system with channels and very sophisticated devices but without water. The agreement did not work and had to be re-negotiated. We also need to

learn about the structure of taxation. And something that must be


avoided among developing countries is this kind of race to the bottom in terms of taxation conditions or environmental rules for attracting FDI.

This has been a problem in the mining sector that explains why conditions are so favorable to the transnational and unfavorable to the states. This has been the central message we are trying to convey. At

present, many countries are reconsidering the distribution of the rent, since its amount has dramatically increased. This is happening not only in developing countries but also in countries like the United Kingdom, who changed the rules of the game by increasing the tax on oil revenues.

This is also happening in Latin America and transition economies. I believe that the question of the distribution of the rent generated in primary activities is something we are going to continue to live with in the next years. Thank you.

Ms. Christina Weller

Christian Aid

The received wisdom is that foreign investment – at least when we’re

talking about FDI - overwhelmingly brings benefits to developing countries to finance their development.

Whilst portfolio investment has been tainted by the East Asia financial crisis of the late 1990s - so that even the IMF is moving back from blithe advice to developing countries to liberalise their capital markets -

it is perceived that FDI does not suffer from the same volatility and herd-like mentality that saw liberalization of portfolio investment spark a massive rise in banking and currency crises in developing countries in 1980s and 1990s.

FDI is not approached with the same caution. It is seen as more stable

and essentially benign, at its best its supporters describe in terms of a jackpot of financial benefits for developing countries:

- FDI is a way of bridging the savings gap and provides capital for cash-strapped economies that would otherwise see critical investment projects go unrealized;

- It increases and diversifies a countries’ exports and Forex earnings;

- It improves the external payments balance


- It generates revenue for the government through taxes on its economic activity and profits.

As if this were not enough, FDI is the gift that just keeps on giving, providing other effects that improve a country’s economic efficiency and productivity, for example, through demonstration effects, or technology transfer.

The only problem concerning FDI for developing countries, as the logic

goes, is that they don’t get enough of it. And this is because they don’t do enough to fling open the doors to foreign investment and to make them comfortable as possible once they’ve arrived…

Unfortunately not all foreign investors, especially multinationals (for reasons we’ll see later) have read the hype. Even the G8 admitted in its

last communiqué on investment that developing countries’ experiences of FDI have been “disappointing”. I would go further and say that without active management by the host government and better

cooperation from the home state (to ensure better behaviour by the investor) the balance sheet for FDI in developing countries has been, and will continue to be pretty poor.

It isn’t always the case that FDI injects capital into projects that would otherwise go unfunded. The majority of FDI goes into “brownfield” investment, or takeovers.

- Incoming firms don’t just add to economic activity they can put local firms out of business or stymie their future development.

- Their effects on forex and trade flows are also not guaranteed. Firms might import more than they export. Modern business practices of fragmented international supply chains often means that a country is simply one stage importing most inputs,

together with an end to local content requirements and trade balancing requirements lends itself to this situation.

Two aspects of the potential limitation and even reversal of the benefits of FDI examined by Christian Aid are their effects on government revenue and on capital flight.

Christian Aid research in the commodities sector showed that

governments are getting a miserable proportion of the dramatic gains


that have arisen from rocketing commodity prices in recent years – something that should have been a good news bonanza for developing countries.

Take the case of Zambia. Between 2002 and 2006 the price of copper

increased five-fold. Developing countries account for three quarters of the world’s mined copper. But countries like Zambia are not reaping the benefits. World Bank and IMF advice and conditions encouraged

Zambia to privatize its copper mines and processing in the 1990s. They were sold off to a number of Canadian and UK firms. Incentives and secret deals were put in place to hook those investors. They

- paid no import duties on inputs for mining activity

- benefited from VAT refunds

- often paid only a 0.6% royalty rate (one of the lowest, some African countries have rates of 20%)

- a lower corporate tax rate.

A 2004 World Bank study showed that Zambian mining companies enjoy a marginal tax rate of zero. Meantime their profits have skyrocketed, one company KCM say profits rise from $52.7 to $206.3

million in only one year (2005-06). In his budget speech of that year, the Minister predicted royalty earnings for the government of only $11 million, only 0.1% of the value of production. Zambia is selling key natural resources on the cheap and providing facilities for investors that are not paying their way.

Similar stories can be told for other countries such as the Philippines or Bolivia. Yet respected neo mainstream institutions like the World and McKinsey are in agreement that such incentives do little to attract investment.

The second issue I would like to raise with respect to the financial

impact of multinationals in particular investing in developing countries is the opportunity it creates for various forms of capital flight.

For Christian Aid this means the illicit transfer of funds beyond the reach of the domestic authorities so that it can no longer be used to generate growth, employment or development. It comes in different

forms, varying in degrees of (recognized) illegality. The one I am going


to discuss now is the issue of aggressive tax avoidance practices through transfer pricing malpractice.

In case some of you are less familiar with the niceties of tax law and accounting – transfer pricing is a legitimate practice that allows authorities to tax transactions between parts of the same multinational company located in different tax jurisdictions. As these transactions do

not take place in the open market, principles are used to estimate their value and the tax that must be paid on them.

Unfortunately the current rules leave too much leeway for companies to overprice the imports and underprice the exports in regimes with higher

taxation in order to register the majority of their profit in preferential tax regimes or tax havens and avoid paying heavy taxes on them.

Some of the more egregious examples are:

- TV antennas from China priced at 4 cents

- Rocket launchers from Bolivia priced at $40

- A bulldozer from America priced at $528

At the other end of the scale we have:

- Japanese tweezers that cost $4896

- German hacksaw blades that cost $5485

Raymond Baker who has examined this issue in depth estimated that 60% of such transactions in African are mispriced.

Transfer pricing can only exist with the presence of MNCs as investors, a liberal investment regime and the existence of tax havens.

The cost to developing countries is huge – Christian Aid has put an estimate of the cost of illicit capital flight for developing countries in 2006 at over $500 billion dollars, compare this to $104 billion in aid in that same year, and think of the $150-200 billion per year that the UN estimates are needed to finance the MDGs.


What needs to change?

It’s not just MNC behaviour that is the problem. MNCs – for better or often for worse – operate to maximize their profits within the rules that impinge on them. (Although they should not be discouraged from unilaterally improving their conduct).

Currently there is an unholy mix of rules that give too many freedoms to investors, not enough freedoms to developing country governments, a situation reinforced by poor advice/practice being pushed by donors and IFIs.

As investors have increased their global scope, countries – often under

advice- have become reluctant to heavily regulate and discipline them and instead compete to offer them freedoms and incentives.

Simultaneously authorities become less able to monitor their activities and enforce the rules that do exist. The ability to be based in several jurisdictions has become a great way to make sure no one can see what you are doing, or do very much about it when they do.

This can only be overcome by international cooperation on disciplines and their enforcement – currently this is too weak.

To take the case of tax avoidance and how to tackle this unhappy coincidence of problems.

First we increase disciplines on MNCs:

The Tax Justice Network and Publish What You Pay NGO campaigns

are calling for a new international accounting standard that requires companies to systematically report the scale of economic activity, profits and taxes paid in each jurisdiction.

Second call is to increase banking transparency and automatic information exchange

This will give tax authorities the information they need to know if appropriate taxes are being paid.

There is also a need to tighten existing anti-avoidance rules which leave

too many grey areas, and allows too much discretion for companies – TJN recommends a general anti-avoidance principle being introduced, for example.


Second we give rights back to governments:

RTAs, BITS, TRIMS, GATS all deprive developing countries of tools they need to ensure FDI benefits their country financially

Balance of payments, forex, exporting and local content performance

requirements can all be used to ensure a positive balance sheet for developing countries.

To give a concrete example of how allowing performance requirements could help, Botswana has joint ownership of its national diamond company and therefore benefits from its growing economic success –

this is part of the reason that the industry contributes 80% of government revenues. Think what joint venture requirements might have meant for Zambia to benefit from the copper boom.

Another requirement of these deals that limit the ability of the government to make sure capital remains within the country or that

profits are reinvested locally – is the requirement to fully liberalise current and capital payments – frequently found in RTAs, even in draft EU-ACP EPA texts – rhetorically at least intended to improved development prospects of some of the world’s poorest countries. .

Finally, these kinds of agreement need to give back to countries the

explicit overarching right to regulate to achieve development objectives. Without this, strong investor protection provisions present risks for governments.

To give another example. Bolivia is another country that we studied

with respect to the costs of selling off its natural resource assets – in this case oil and gas – and foregone revenue due to tax incentives. We calculated that Bolivia actually finished up with a negative balance sheet when foregone revenues were taken into account. We are not the only

ones to conclude that national resources were being sold too cheaply and that foreign investors were enjoying overly generous terms. Local protests and opposition led the Bolivian government to introduce a new

32% royalty on hydrocarbons – boosting government revenue by $307 million. The foreign firms wrote to the government reminding them of their commitments and the risk of legal action – being sued at the World Bank’s court for investors.


Finally, IFIs and donors need to change their practices

Advice, conditions and other tools – like doing business rankings and investment climate assessments - all encourage developing countries put in simple terms to tax less and to regulate less.

Donors are complicit in this and also push the same through trade and investment deals.

To give some examples, in our Bolivia case the IMF refused to sign a

new standby agreement if Bolivia proceeded with its threatened royalty rise. This would have provided a signal to other sources of funding to cut ties.

Conclude

The enthusiasm with respect to FDI has been misplaced. We are not against FDI in developing countries, far from it, but unless current practice and rules change this is likely to remain the case.

There needs to be much less focus on attracting investment at all costs,

and much more focus on counting the costs of investment and giving governments – home and host – the tools they need to manage it effectively.

Domestic Monetary Policy and Debt 87

SECTION VI

DOMESTIC MONETARY POLICY AND DEBT

THE POLITICAL ECONOMY OF TRADE, FINANCE,

AND THE EXCHANGE RATE

Mr. Luiz Carlos Bresser-Pereira

Getulio Vargas Institute

Since the Breton Woods agreements trade policy and international policy finance are separated partners. IMF and World Bank take care of finance policy; WTO, from trade negotiations. Why such separation

despite the fact that trade and finance are intimately linked? The fact that finance is required to finance trade is not the only link: the central link is defined by the exchange rate. This separation is also present in

the academic disciplines: Trade theory deals with tariffs, while international finance and macroeconomics take charge of exchange rates. Following the logic of the global governance system, trade is supposed to be negotiated at WTO, while the exchange rate should not

be negotiated since it would be an endogenous macroeconomic price that is part of an optimum macroeconomic policy that IMF is supposed to know. Yet, as the figure illustrates, there is a major intersection

between trade policy and financial policy: the exchange rate. This intersection is so important that it makes little sense to negotiate tariffs without assuming stable exchange rates. If, for instance, a country’s

currency depreciates 20% in relation to another, this is the same that to impose a tariff of 20% on imports.

TRADE FINANCE

Exchange rate


Trade and Finance

The separation between trade and finance exists essentially because the

global economic architecture is defined by the rich countries, and it is not on the interest of the rich countries to include exchange rate in the trade discussions. They know how strategic this macroeconomic price

is. Besides, they suspect that exists a chronic tendency to the over-appreciation of developing countries’ currencies that would justify, as a trade-off, higher tariff protection. On the other hand, it is on the interest of rich countries to relate positively finance with economic development.

The interest of countries is to have a competitive or equilibrium exchange rate instead of an over-valued one, and, contrarily to conventional wisdom, a positive relation between international finance and economic growth is the exception, not the rule.

Economists usually define the equilibrium exchange rate as the one that

equilibrates intertemporally the current account. Yet, an additional and necessary condition is that tradable industries using technology in the state of the art are profitable or competitive at such rate. In rich

countries these two conditions are normally present. Not in developing ones, in which there is a tendency to the over-appreciation of the exchange rate. That tendency has four major causes. Three of them (the attraction that higher interests and expected rates of profit exert on

foreign investors, the growth cum foreign savings policy recommended by rich countries and by the two international financial institutions, and exchange rate populism) are inter-related and make the exchange rate

more appreciated than the one that balances intertemporally the current account. The three involve the increase of capital inflows that appreciates the exchange rate. The first is a purely economic variable,

the second a policy variable, and the third, the perverse attitude of many politicians in developing countries to use an exchange rate anchor to control inflation, increase wages and consumption, and facilitate their

reelection if the inevitable balance of payment crisis does not come before. The interesting thing on this is that IMF, by adopting the US Treasury’s policy of growth cum foreign savings in the 1990s, became coalescent with exchange rate populism despite criticizing so insistently

fiscal populism. The only difference between them is that in fiscal populism it is the state that spends more than it gets, while in exchange rate populism it is the nation that does that.


The fourth and more important cause of the tendency to the over-appreciation of the exchange rate in developing countries is the Dutch

disease. The commodities benefited by ricardian rents press down in such extent as to cause that the exchange rate that balances the current account becomes more appreciated than the one that makes viable or

profitable other tradable industries using technology in the state of the art.

Given this tendency, the only way to achieve a competitive exchange rate today is by managing it –in the context of a floating exchange rate. Yet, rich countries oppose strongly such management. Since the major

rich countries have their currencies as international reserve currencies, they cannot manage them; if they do, they would lose trust – and trust is everything for a reserve currency. Thus, they reject that developing

countries manage their own currencies to neutralize the over-appreciation tendency. First, they reject the possibility of exchange rate management: the long term exchange rate would be a fully endogenous price. Second, they charge the developing countries that do manage their

currencies, of creating a “beggar-thy-neighbor” situation: exchange rate management would imply gains for the managing country at the expenses of the other countries. Third, they call the management of

floating exchange rate, in a depreciatory way, ‘dirty’ float. Finally, they do not hesitate listing the ‘evils’ of a devalued exchange rate: higher inflation, lower wages, increased costs of servicing the debt, etc. Among

all these arguments, the only serious one is or could be beggar-thy-neighbor indictment. Yet, such charge would make sense if developing countries were involved in retaliatory devaluations. That is not the case.

What they are doing is just neutralizing the over-appreciation of their currencies.

In the global economic system, commercial globalization represents a major opportunity to developing countries. What is not on their interest is financial liberalization. Yet, rich countries are permanently pressing

middle and poor developing countries to practice financial and trade liberalization. Middle income countries resisting financial liberalization is understandable. Yet, given the fact that these countries don’t have anymore infant industries that require protection and have cheap labor

that give them an advantage in international trade, it is not so easy to comprehend why they also resist trade liberalization. The only explanation is that they react to trade liberalization because their

exchange rate is over-appreciated, or, in other words, because they are unable to neutralize the tendency to its over-appreciation. When they are


able to do that, as it is, for instance, the case of the Asian dynamic countries, they dispense tariff protection, and take full advantage of commercial globalization.

Development and Finance

I hope that it is now clear why rich countries refuse to discuss trade and

finance together. Yet, they insist in linking development and finance. According to their economists, foreign finance or external savings would be essential to economic development. Why? Rich countries and conventional economics do not bother to explain why since it would be

self-evident – an assumption, a ‘basic truth’ not requiring further argument: “it is natural that the capital rich countries should transfer their capitals to capital poor countries”.

Yet, this assumption is similar as to affirm that the land is flat. Actually,

international ‘development finance’ and the growth cum foreign savings policy are on the interest of the rich, not on the developing countries. Rich countries benefit from the interests received, and their financial agents are ready to ignore prudent lending practices. Currency

appreciation reduces the competitiveness of middle income developing countries – what is welcome by its rich competitors. Finally, developing countries that accept the growth cum foreign savings policy turn more dependent on their creditors, whose power in this way increased.

The growth cum foreign savings policy is not on the interest of

developing countries Actually, current account deficits (another name for foreign savings) are usually detrimental to the financed countries. The negative consequences go from the worse one – balance of payment

crisis – to other two equally damaging: on one side, financial fragility, financial dependence, and confidence building policy, and, on the other, over-apreciation of the local currency, artificially increased wages and

domestic consumption, and high substitution of foreign for domestic savings. The exceptional case in which foreign savings cause growth, instead of impeding it, is when the country is already growing rapidly,

profit expectations are high, and increase in wages are directed toward investment instead of consumption.

Policy Conclusions

Which are the policy conclusions for developing countries from this analysis?


o First, keep fiscal accounts balanced. A capable state is a non- indebted state.

o Second, keep current account balanced or run surpluses. Do not engage in new debt, and gradually pay old debt if this is

possible, or, in other words, if debt renegotiation is not a must. A strong nation is a non-indebted nation.

o Third, create your own national or regional banks to finance investment: business enterprises need long term finance, countries do not.

o Fourth, manage your exchange rate, resorting, if necessary, to

controlling capital inflows so to avoid overvaluation of your currency. If the case is of Dutch disease, do not hesitate in taxing or charging royalties on the respective commodities: The

exchange rate is not fully endogenous. The over-appreciation of the local currencies is a permanent threat that must be neutralized.

o Fifth, do not be afraid of economic nationalism. Do not accept the confusion between nationalism and populism. Be as nationalist as the rich nations are.

Bresser-Pereira’s Related Papers

Bresser-Pereira, Luiz Carlos & Yoshiaki Nakano (2002) "Economic growth with foreign savings?" Paper presented at the Seventh

International Post Keynesian Workshop, Kansas City, Mi., June 28-July 3 2002. Available in the original at www.bresserpereira.org.br, and, in Portuguese, Revista de Economia Política 22(2) April 2003: 3-27.

Bresser-Pereira, Luiz Carlos (2004) “Brazil’s quasi-stagnation and the

growth cum foreign savings strategy”. International Journal of Political

Economy 32(4): 76-102.Bresser-Pereira, Luiz Carlos and Paulo Gala (2007) “Why foreign savings fail to cause growth”. In Eric Berr, ed. (2007) Elgar book to be published. Available at

www.bresserpereira.org.br, and, in Portuguese, Revista de Economia

Política 27 (1): janeiro: 3-19.

Bresser-Pereira, Luiz Carlos (2007) “Dutch disease and its neutralization: a Ricardian approach”. Revista de Economia Política 28 (1): to be published. Available at www.bresserpereira.org.br.


Mr. Heiner Flassbeck

UNCTAD

I agree with most of what Professor Pereira said, I would say 90%. I

have some things to add more than to disagree. If you read today’s newspapers, you will learn that a small Baltic state, Latvia, is now reaching a current account deficit of 40% of GDP. Wages in dollar

terms are rising by 40% too, but annually. Consumption is booming, the growth rate is high, everyone is happy and the currency is strong. There is a lot of inflow of short term capital. Why? Well, interest rates are quite high. Inflation is 10%, short term interest rates are 15%. Many

foreign investors think it’s a good short-term investment despite its mushrooming indebtedness.

Another interesting example is Iceland. Iceland has an inflation rate of 10% and short interest rates of 15%. Its current account is reaching 25%

deficit of GDP, but the Icelandic currency has also been strong for a long time because the famous Japanese housewives are investing their money in Iceland. Compared to 0% in Japan, 15% is quite a bit. So confidence has been there for long, the currency was strong and the

country was happy to have the confidence of the international investors. Only recently the nice picture got some cracks and the currency dropped sharply.

I should mention Brazil, which is a famous example too. Brazil has returned in terms of its real exchange rate against the dollar to the levels

it had before the 1999 crisis. But 1999 was at the verge of disaster. I remember back then having had discussions with many officials who said the devaluation would not really help because the Brazilian supply

curve is not elastic enough, suppliers are not really wiling to use the devaluation. One year later everyone said, “oh what a success, it’s a miracle, we are the most successful people in the world because we used

the devaluation most successfully.” Now it is the other way around. An article in the financial times last week was guessing why Brazil isn’t doing so well, why growth rates are around 3% only, but not around

10%? Only at the margins on the article did they mention that the currency was quite high. But one could feel that the author was convinced that the exchange rate could not be the main problem, the exchange rate is a monetary phenomenon that only touches the surface, looking deeper would reveal much bigger “structural” problems.


What we have done, and I just want to introduce it briefly, we have repeated in this Trade and Development Report an exercise we first did

in 2004. We have been looking at the international speculation a bit more consistently. We have done a simple exercise: we ask what you would do, if you have say a million dollars to invest just for three

months, would you choose emerging markets or just industrialized countries. The result is simple: carry trade, which means money being carried from Japan, a low interest country to a high interest country like Brazil or Iceland is dominating international capital flows. Carrying

money from low inflation and low interest rate countries to high inflation countries with high short-term nominal interest rates is big business. Unfortunately, it is just the opposite of what economists would

expect. Every good economist would expect that there would be counter-speculation that would lead to a devaluation of the currency in the high inflation countries because high inflation countries are

countries have a problem with deteriorating competitiveness compared to the rest of the world. And the currencies of countries losing competitiveness should devalue but not revalue. So it is just the other

way round as it should be. But all the good economists from all around the world are playing the three apes, “I don’t hear, I don’t see and I don’t say.”

So let’s look at a number of countries with Brazil first. The bottom line is that Brazil has come from a very high level of its real effective

exchange rate. After the crisis the Brazilian currency went down and increased the competitiveness of the country significantly. But, due to its orthodox monetary regime Brazil was all the time after the crisis

quite an interesting target for international speculation because its interest rates were and are very high. Brazil has, let me say it cautiously, a quite orthodox monetary policy although the central bank tried to bring the interest rate down from 18% to 12% or 13%, which is still

quite high, given an inflation of 6 %. So what happens is that Brazil gets flooded with short-term money, it gets a lot of savings so to say. But we shouldn’t call it savings, it has nothing to do with savings, and it can’t

be spent either. Its good for nothing, it’s just there. And the interesting thing is that in Brazil the Central Bank is intervening time and again in the currency market to dampen the appreciation. But intervention in this

regime is very costly and useless in the end. In other words, their rising international reserves show they don’t like this inflow but they can’t stop it as long as they continue with the orthodox monetary policy. As


soon as this commodity boom is over, the manufacturing industry will be deeply hit by this kind of price movement.

Well just to wrap up, what we need is international regulation or go the other way around and do it like the Chinese. On the upper third of this

chart you see how the Chinese got it straight. They had a big financial crisis too, which no one remembers in 1993 and 1994. They also had a huge devaluation of their currency at that time, but after the crisis they

fixed the exchange rate at a low level and basically till 2005. They also brought down the interest rate to an extremely low level and the inflation rate at the same time. Indeed, China achieved something that is

very hard to achieve. They achieved a booming economy of 10% growth annually and they avoided inflation. This extraordinary performance allowed them to de-attract international speculation,

although there were some inflows of nonresident Chinese that led to a built-up of reserves, but that was not costly because of the low domestic interest rates. China was clearly superior to the rest of the world.

If you look more systematically at the Asian model of adjusting to the world economy in the last ten years and compare with Latin American

the difference could not be bigger. What is important to note from a global point of view is that both situations are not sustainable. Why are they not sustainable? Well, in Brazil the real economy will be badly hurt by the high interest rate and the high exchange rate. In China the

situation is not sustainable because not all the countries can have an undervalued currency. Not all the big countries can be undervalued. The world cannot be undervalued against itself; there must be a counter. The

counter for China is the United States, with a tremendous deficit, which cannot go on forever, although at the moment it is not rising very much. So undervaluation is a solution for emerging markets for a time, but it is

not the solution forever. This is why UNCTAD is asking for an international code of conduct or an international agreement on exchange rates where one has to struggle with what the equilibrium rate is. But

never the less I think we must go in that direction or else otherwise the whole discussion about trade liberalization, without including finance and price for international trade, is a fiction. People are talking about things that really do not exist because they do not talk about the relevant

factors that determine this development. So for developing countries, in the short term, the Chinese solution is the right one. Thank you very much.


Mr. Richard Kozul-Wright

UN DESA

I will actually focus on the determinants of FDI and then go back to

some thoughts about the link between monetary policy and FDI. I guess the problem with dealing with FDI is that there is no consistent theory of FDI in the way that we have a theory of international trade; even if you

don’t like it, the latter is a well developed body of analytical and empirical work.

There are of course plenty of ideas about what drives FDI but a consistent framework remains illusive. In the early post-war period FDI was treated as really just another capital flow and it was treated as

simply a question of risk and return calculations on the part of home country firms. This kind of rather crude (arbitrage) view of what might drive FDI flows was challenged by Steve Hymer in the 1960s who

linked the movement of international firms to the kind of real economic dynamics that created huge national firms in the first place, firms that were only then in a position to consider replicating their activities abroad. It was much more a question of scale economies, monopoly

ownership, rent seeking, etc. that drove large firms to invest abroad. This perspective also gave rise to a developmental perspective in which the costs and benefits of FDI could be more carefully weighed, and with a strong applied focus.

Hymer’s analysis was at some point captured by a more conventional

view which focused on the transaction costs and efficiency properties of firms as they moved abroad. The so-called “eclectic paradigm” joined ownership and locational advantages to possible efficiency gains at the

firm level from internalizing activities and the spillover effects at the host country level through the leakage of technological and managerial assets. I guess that is where the current FDI theory lies, driven by this

idea that efficient firms will bring such advantages to countries so long as they have accommodating policies that encourage open markets, minimal state intervention, minimal taxes, etc. The critical assumption,

of course, is that things spillover in a fairly predictable and automatic fashion, and they do so quickly and rapidly. From this perspective the TNC becomes an engine of catch-up growth. But the literature does not really back up this kind of assumption with strong empirical evidence.

There is little evidence to suggest that technological benefits,


productivity benefits, managerial benefits, etc spillover in a very significant way, to host developing countries. So a large part of the FDI literature seems to me to fail on this assumption of automatic spillovers.

In a way, this shouldn’t be surprising. If you go back to the Hymer’

approach in which FDI is driven by rent-seeking activity, the point was that FDI (in the manufacturing and service sectors at least) flows primarily similar countries. Most of it is intra-industry flows, which

depends on there being a set of sophisticated conditions already in place and that define a location as attractive to sophisticated firms. In that sense, FDI is unlikely to be a driving factor in the growth process, but

rather it depends on an already successful growth process being in place. The fact that FDI has not gone to developing countries in any significant amount should not be a surprise.

Hymer’s analysis was very much based on the assumption that all FDI is green field FDI, meaning FDI in new plant and equipment. Of course

the big change that has happened beginning in the early 1980s is that the vast majority of FDI flows is not green field, it is of course in the form of mergers and acquisitions. This is true in developed countries and

most developing countries, though not all. It is certainly true for Latin America, but probably not for East Asia, which is still probably mostly dominated by greenfield types of flows.

And of course if FDI does take the form of mergers and acquisitions there is an interesting question about whether the old view of FDI as a

form of capital flow, is actually more relevant today than when it was challenged by Hymer in the 1960s. The big worry of course is that the “financialization” of investment activity doesn’t only apply to just

domestic activity, but also foreign activity. In that case, the role of monetary policy is likely to be a much bigger issue regarding FDI for developing countries than it was in the 1960s. So there does seem to be a shift at some point, back towards the kind of more classical form of

FDI. This is one that, it must be said, seems to have very little positive impacts on growth dynamics and may well carry the kinds of negative speculative influences that are a driving force behind appreciated

exchange rates. It therefore kicks into a vicious circle where the dominance of finance is not only entering through the traditional short term capital flows but is also itself attached to what people traditionally

see as a more beneficial type of capital flow – namely FDI. That kind of classical distinction between short-term and long-term flows, short-term being more likely to be debt creating, more volatile, whereas long-term


flows are more stable and beneficial in terms of the productive assets that they bring, is probably far less of a useful dichotomy today than it

was 20 or 30 years ago. This is obviously a major problem for policy makers who are looking to establish a longer-term development strategy based around strengthening productive investment.

But regardless of the shifting composition of FDI, there are serious underlying political economy issues that need to be tackled to strike a

better balance between internal and external integration. The nature of domestic elites for example has a major bearing on the way in which international flows and domestic capacities influence the growth

process. The way in which the Latin American capitalist class has been formed in the post-war period and its relation to the developmental state is very different from the East Asian experience. As a consequence, the

role of FDI in Asia is very different than in Latin America. It is not a question of size really, we know East Asia did not attract large amounts of FDI, but I think most people would agree that the FDI they did attract was an important element in their growth process. In terms of the kinds

of investment export nexus that they themselves were creating, this was complimented by the kinds of FDI they were able to attract and they used a set of fairly interventionist policies, including macroeconomic

policies, to ensure the FDI that did enter would be complimentary to efforts at domestic resource mobilisation. So in that sense, there are some significant underlying structural issues that impact the FDI and the

role of the developmental state, that must be figured in a discussion on the way in which monetary policy and macro-economic policy helps or hinders a development process. Recognising this would be a call for at

least some regional nuances when we are talking about these issues. Thank you.


SECTION VII

DEFINING DEBT SUSTAINABILITY

Mr. Damian Ondo Mane

Former IMF Executive Director, African Countries II

To deal with the poverty issue it is important to realize it is a global issue, it cannot be dealt with as if it was the issue of a specific country.

For instance, In Monterrey we said we have to deal with the issue of poverty, but no one said that in order to get debt cancellation you have to reach the Decision Point at the IMF. Which then means you are

dealing with a political issue. An IMF program has to be fully financed. By whom ? By donors. If they do not want to cancel your debt, the program cannot be fulfilled, there is no money to do that. So it is sort of a chicken and egg issue. When they agreed to put the money, then you

can reach Decision Point. But when you have debt cancellation, you do not have the additional resources. So you are running into another problem. Then you have to go to China, Brazil, a number of new donors, to find those additional resources.

Before I discuss on the issue of debt sustainability and aid, I want to

state a few facts. No country has been lifted out of poverty through aid alone. They need access to international markets and foreign investment to allow their economies to develop and diversify. The dismantling of trade barriers to poor countries is a crucial part of the equation.

In order to trade, peace and stability are needed. So there is also a link to be made between these efforts and the creation of peace and stability. There are scholars who say that with US$ 250 GDP per capita, you have a probability to get a war in five years. At US$ 600, that probability is cut in half. Above USD 5,000, the probability of war gets very low.

Low–income countries in Africa have also the issue of rents from natural resources, they have to better manage them. In some cases, the fact that those natural resources exist means that countries become less accountable.

Since the 1950s, the trade has increased thirty–fold. The creation of the

European Union, to bring an example, was a good thing because it had a good impact on European development and peace.

Defining Debt Sustainability 99

Now, on debt sustainability and job creation: debt sustainability and fiscal space are key elements in development. I view the emphasis on

debt sustainability as an excuse by donors to not deal with the key problem of globalization and the way the problems are faced by developing countries. From time to time, those problems were something that the international community tried to put on the agenda.

The IMF and the World Bank programs have been advising low income

countries on the need for trade liberalization. I think we have to look at that in two ways. As instruments to perpetuate inequality, all the way to reduce poverty. As I mentioned, the creation of the European Union is a

good example of how countries can share between rich and poor their wealth. But it is not the case in Africa, or for low income countries. Low income countries, in order to benefit from trade liberalization, have to

increase their own administrative capacity and deal with lack of economic infrastructure that leaves them in a situation of less competitiveness of their tradable products in international markets.

Regarding the trade effects on low income countries, the trade policies promoted by some OECD countries have generated negative impacts on

poor countries, making those economies lower their revenue and, therefore, exacerbate the risk of conflict. I have already mentioned the extent to which the level of GDP influences the probability of eruption of conflict. We know those policies: tariff barriers, tariff escalation for

processed goods, imposition of technical and scientific standards that low income countries cannot fulfill, etc.

The continued dependence of many low income countries on exports of a small number of commodities, and so on and so forth.

Another issue that African countries have to start dealing with, is the historical comparison between Asia and Africa. I have already

mentioned what is being presented in the specific cases of Korea, China, and so on. Let me be quite frank. The guarantees those countries had in the past were that there was this strong communist country in Asia,

China, and to secure liberal markets , the international community had to risk putting money there. But now we are facing in Africa a different situation. Maybe if there was a strong communist country in Africa more money would flow in, which would reduce the risk.

Finally, let me say a few words about the commitments taken by the

international community. Before that, we in low income countries have to recognize that the effective use of trade and investment opportunities


can help countries fight poverty and those national development efforts need to be supported by an enabling international economic environment.

Also we have to recognize that the appropriate role of the government in

market oriented economies varies from country to country. In this regard, the issues of how to mobilize domestic resources and attracting and making effective use of the international investment and assistance

for sustainable high rates of growth, full employment, poverty reduction, etc, also differ from country to country. The level of skills in labor market contributions is a positive way in which developing countries have to deal to overcome these development issues.

The tool of government capacity is also a key ingredient. To address all

these challenges, the international community has committed to ensure that trade plays its full part in improving economic growth, employment and sustainable development for all. Also it has committed to increase

trade and foreign investment which both can be significant sources of employment. Also the international community committed to address the marginalization of LDCs and, in particular, small economies in international trade markets.

Let me conclude by saying that the issue of debt sustainability is

important to avoid a new debt crisis. We have to focus on how investment can reach low income countries. Debt sustainability should be part of the equation, so we can take it into account when we project

the economic growth. It should not be a slogan for developed countries to fulfill their commitments. Low income countries also have to better manage their economies and address their organizational problems. That constitutes in my view the key challenge for them.

The costing of MDGs programs, and the visibility of those programs

and lack of national development strategies, as well as the diversification of aid conditionalities, in an environment of low national capacity, exacerbate the challenging situation for low income countries.

We have to design development strategies taking into account that we are living in a global and interdependent world.


Ms. Machiko Nissanke

Professor of Economics, SOAS, University of London

In economic literature, the issue of debt sustainability is usually

discussed in relation to theoretical models, such as the growth-cum-debt model, the debt cycle model, the three gap model or the intertemporal borrowing/lending model. The conditions for the successful realisation

of the income-enhancing debt strategy are summarised in the early literature as follows:

1. additions to external debt is used for growth-enhancing productive investment;

2. the marginal domestic savings rate should exceed the investment ratio required by the target growth rate, so that debt will eventually begin to decline;

3. the growth rate targeted by the strategy exceeds a stable world interest rate;

4. the marginal product of capital should exceed the cost of borrowing.

The first two conditions derived from these models focus on the

aggregate investment- saving gap in discussing the issue of debt sustainability, while the third and fourth conditions underscores the need for a concessional debt facility for low-income countries. In contrast, the

literature that deals with the issue of liquidity and solvency of external debt focuses attention exclusively on the external performance of the economy in relation to debt service obligations. In particular it

emphasizes that since external debt should be paid in foreign currencies, a country’s ability to generate stable foreign exchange earnings is a most critical condition. That is, the growth of exports is most critical for

sustaining external debt. This critical condition is less likely to be met in a consistent and stable manner by low-income developing countries dependent on primary commodity exports, even if debt is incurred in concessional terms with very low, predictable interest payment schedules such as IDA loans.

In reality, variables influencing their primary resource gaps and debt dynamics follow much more complicated and highly volatile time paths,


as prices of their main exports- primary commodities- exhibited a sharp downward trends as well as extremely high volatility. For many

countries, all measures for their debt payment capacity, i.e. terms of trade adjusted income, purchasing power of exports and the terms of trade, have continuously followed a sharp deterioration in the 1980s and

1990s. In our view, it is the ‘commodity crisis’ of this scale that offers one of the effective explanations for the protracted debt crisis afflicting commodity-dependent low income countries. This powerful story has been often untold or mentioned as a marginal contributing factor to the

debt crisis. It should be noted that the beginning of debt crisis of poor countries in the late 1970 did indeed coincide exactly with that of the ‘conveniently forgotten’ commodity crisis. The debt stock had kept

increasing over time in the 1980s despite repeated interest amortization and progressive substitution of non-concessional debt for concessional debt, as the debt payment capacity of low-income countries had declined

over time. Consequently, a severe debt overhang, i.e. the condition arising from excessive amount of debt in relation to debtor’s repayment capacity, had arrived by the late 1980s. Under a severe debt overhang,

the capacity and willingness of debtors to invest is severely impaired due to the liquidity and incentive effects.

Despite major efforts to alleviate the debt burden, the main debt indicators deteriorated with a series of convulsions throughout the 1990s. A question has been raised repeatedly as to why the debt burdens

of poor countries remain so onerous. In our view, one of the answers to this lies in the reluctance of the donor community to grapple effectively with commodity price shocks or terms of trade shocks - one of the critical factors shaping debt dynamics.

Instead, the donor community was quick to identify policy failure

(government dirigistre economic policy failure) as the root of the problem of LICs facing severe liquidity crises in the 1980s. Structural Adjustment Loans were used, under ex-ante policy conditionality, as an

effective leverage for three purposes: i) an incentive for reform, ii) financing the ‘cost of adjustment’, and iii) defensive lending to service external debt. In the debate, the objectives of policy conditionality are seen as:

• paternalism, where donors believe they know what is best for the recipient;


• bribery, when donors persuade recipients to implement reforms that are otherwise not undertaken;

• restraints, when donors place conditions to prevent the recipient from policy reversal on reforms;

• signalling to the private sector and other donors that the reform programme is sincere.

In the ensued aid effectiveness debate, the poor performance of ex ante

policy conditionality was evaluated from a perspective of the moral hazard problem in the Principal-Agent model, leading to a shift from the ‘incentive-based’ ex ante conditionality to the ‘selectivity-based’ ex-

post conditionality. The aid effectiveness debate was conducted in parallel in search for debt relief efforts and the HIPCs I and II

In the HIPCs I and II, the process conditionality was added to the streamlined policy conditionality. Consequently, the debt sustainability analysis was integrated into the ‘performance based’ aid allocation

process. Replacing Structural Adjustment Programmes with ‘Comprehensive Development Framework,’ there was a rhetoric for creating a ‘new aid architecture’ that could accommodate ownership and partnership.

Under the new aid architecture, the ‘selectivity’ principle in the

performance-based system (PBA) has become dominated in aid allocation processes such as IDA and the Debt Sustainability Analysis (DSA) conducted by the IFIs. However, this principle is based on very

thin and controversial empirical studies, essentially on cross-country regressions on the aid-growth nexus to establish conditions under which aid could contribute to economic growth. The Country Policy and

Institutional Assessment (CPIA) by the World Bank staff based on such poor regression analyses was used to establish the claim that “aid is growth-enhancing in countries with ‘good’ economic policies” and in search for “poverty efficient aid allocation”. These empirical studies

have been challenged on a technical ground by many mainstream economists and are by now largely discredited (see the Deaton Report). But they were very influential in the policy circle: the CPIA-PBA based

system has been adopted by many donors (US an Dutch, EU) as well as in the World Bank- IDA allocation.


Indeed the IDA allocation formula is dominated by the CPIA, rather than per capita income measures that reflect recipients’ needs. Hence, the CPIA suffers from critical drawbacks:

• it is based on subjective scores ( not objective measures);

• it is an eclectic mix of input (policy choices and institutional

quality) and output (outcomes) contaminated with intermediate variables;

• many indicators reflect outcomes influenced by exogenous events.

• what is assessed is often endogenous to growth, not independent of growth outcomes.

• There is no recognition that the quality of institutions and the implemental capacity for policies are a reflection of structural characteristics of low-income economies.

• It is an imposition of a ‘universal’ development model by he

donor community (an overlap with the extended list of policy conditionality).

Similarly, the empirical basis underlying the Debt Sustainability Framework conducted at the World Bank and IMF is also thin. Yet, CPIA is assigned a central role in determining debt sustainability

thresholds. Any planned exercise of forward-looking DSA over 10 year period is bound to fail, as Debt Sustainability itself is an elusive concept, and low-income countries continue to be exposed to large scale shocks and a high degree of uncertainty.

It is high time to assign a central role to vulnerability in guiding both the

aid allocation process and the debt sustainability in place of CPIA. Instead, a state-contingent aid (debt) contract as ex ante debt relief mechanism should be seriously considered. Indeed, the subsidised

contingent loans are superior over outright grants for countries with high vulnerability to external shocks. State-contingent contracts are incentive-compatible by indexing repayment to the state of nature rather

than the ability to pay as Krugman showed. Under such contracts, a contingent credit line could be made available as quick, unconditional disbursement upon verification of exogenous shocks and events.


In short, the CPIA-based aid allocation mechanisms or debt sustainability analysis is not an ideal base to conduct a meaningful

policy dialogue. Under the World Bank/IMF new aid architecture, recipient governments and donors tend to position themselves in an ‘aid power’ game, resulting in an inferior non-cooperative equilibrium.

We should find a more balanced assessment as to why low income countries in Africa have for so long failed to change its disadvantaged

form of international linkages with the rest of the world. The recent literature on Africa’s Growth Tragedy attributes to many factors such as natural and institutional endowments, the quality of institutions and

governance and geography, sovereign fragmentation, ethno-linguistic fractionalization and geographical disadvantages. Their disadvantages in natural endowments and geographical locations can be overcome only

by concerted efforts in infrastructure buildings. In the absence of extensive transport infrastructures, geographical disadvantages (low population density, distances among settlements, or limited coastlines, etc.) lead to the high transport cost intensity of trade and limit the level

and scope of production and trade, and prohibit from exploiting economies of scale. Poor infrastructure is definitely a key contributing factor to disadvantaged positions facing firms operating in Africa

through the high transaction costs. It is also a critical impediment to poverty reduction by escalating the cost of delivery of public services to the poor.

The real tragedy in Africa is that the priority of the development agenda has been set by the donor community on a shifting ground: from the

capital shortage diagnosis in the 1960s and 1970s, to the policy failures diagnosis in the 1980s, the institutional failures diagnosis in the 1990s, and finally, the infrastructure failure in the 2000s. It should not be

forgotten that the donor community reduced aid to economic infrastructure projects in relative to overall aid as well as to social infrastructures in SSA with a belief that infrastructure and utility services could be provided through the privatization drive.

The belated recognition of Africa’s disadvantages in infrastructure

development has entailed a heavy cost in terms of foregone economic growth and poverty reduction.

As both economic and social infrastructures are ‘public goods’ at the early stage of economic development, the under-provision of public


goods is one of key conditions impeding economic and social development in Africa.

With fiscal retrenchment dictated under pro-cyclical demand management under the IMF programmes, governments have been left

with little capacity and resources to undertake public infrastructure investment on a sustained basis. With under provision of public goods and other characteristics of states, disenfranchised private agents and

rural farmers refrained from making forward-looking productive investments.

Now, it is necessary to build a genuine partnership between donors and recipients and to restore a genuine ownership to economic policy in hands of recipient governments. The new scheme should be predicated

on the aid relationships where policy learning/ experimentation and institutional experimentation/innovation are encouraged and the sense of ownership and partnership is restored. There is a need for building

confidence/trust and information endowments in the donor-recipient relationships. The lack of sense of ownership propagates and promotes a cheating behaviour—the need for cultivating a proper trust to produce

positive public goods- economic development. We should work hard towards instituting incentive compatible aid-and debt-contracts. It is equally important to create a conducive environment for building a developmental state, capable of designing and implementing a genuine

home grown development model, debated and supported by domestic constituencies. We also have to be serious about improving the international system of debt negotiation and restructuring as well as to

guarantee access to technology and markets. Finally, financing global development in the 21st century and meeting the MDGs require a set of new innovative financing instruments.

Mr. Matthew Odedokun


Good afternoon. What I want to talk about is a review of debt sustainability concepts and the purposes served by each of them. Three

alternative concepts can be identified, as follows (even though there are some more at the theoretical level). First one, linking returns on projects financed with debt with interest rate on that debt. Second one, capacity to repay. And the third one is the human development concept.


The theoretical concept, linking returns on projects financed with debt with the interest rate on that debt. This is broadly similar to the “golden

rule” that economic growth should not be less than the rate of interest. This one is a special form of it: debt is sustainable as long as the rate of return on projects financed with debt is no lower than the interest rate on

the debt. The purpose of the concept is to draw attention to the need to judiciously utilize the loan proceeds, so the productivity of the projects financed with the debt exceeds the borrowing costs. According to this is the need to refrain from borrowing if the condition is not met. At the

practical level it is very difficult to identify the rate of return on projects financed with debt. This is because debt does not necessarily go to finance particular projects, but it is rather part of a pool of funds.

Another use of this concept is that it is at the heart of the implementa-

tion of prudential borrowing guidelines and conditionalities of the Bretton Woods Institutions in the programs with their client countries. According to this, foreign borrowing that does not have a prospect of being judiciously utilized would be disallowed by them. But this concept has a number of drawbacks and challenges.

The second concept, the applied concept, is debt repayment capacity. We have a lot to say here. The concept tries to answer the question: to what level should the debt of a country be reduced in order to enable it to service the remaining debts? In other words, where do you see the

debtor having problems in servicing its debts. It expresses amounts of debt or debt service payments in relation to some financial and economic indicators of capacity to service such debts. There are three

popular numerators: nominal debt stock, NPV of debt stock, debt service (due or projected). Then there are three popular denominators: GDP, exports (in various forms) and government revenue. When the

above numerators and denominators are combined, the results will be several alternative measures of debt sustainability that indicate repayment capacity. Each of these has its own relative merits, depending on the circumstances.

This debt repayment capacity notion of sustainability serves different

purposes, depending on whether we are looking at them from the point of view of the debtors or creditors. The advantages or disadvantages depend on the perspective from which we are looking at it. With regards

to the purposes it serves, first, it is very used in defining HIPC eligibility, that is, indebtedness criteria below which low income countries will not qualify as HIPC. For a low income country that


qualifies as HIPC, it also provides a threshold. If when you get all your debt relief, you do not reduce your debt below this threshold, you would not be eligible.

For a given or predetermined threshold, it would be to the advantage of

a low income country to have its debt ratio measured as very high. If you boost the debt ratio it would be to the advantage of the debtor country. This is quite important in looking at public sector debt. When

you look at the total debt, this is, combined public sector debt (which combines foreign and domestic) it would raise the debt indicator ratio, in order to get as much as possible of the foreign component relieved. In

other words the argument is not you should relieve domestic debt, but to get as much as possible of the foreign component relieved. At the Commonwealth Secretariat we are working towards having the concept

of debt enlarged to include both the domestic and foreign. This would also help achieve more equitable treatment of low income countries with different intensities of foreign debt. Some countries do not have much foreign debt, but have a high domestic debt burden. If, in a country, you

do not include the domestic debt stock of the public sector you are putting them at a disadvantage because the implication on the government budget is the same, whether debt is foreign or domestic.

Lowering the threshold would serve the same purpose. If instead of raising the debt indicator for individual countries, the threshold is

lowered, it would serve the same concept. If the limit, if the threshold is reduced to zero, this would represent a debt write-off and that is what many advocates are clamoring for.

This debt sustainability concept is being used by the Bretton Woods

Institutions in its Debt Sustainability Framework (DSF) which is used, in turn, to determine both volumes and terms of IDA resource transfers. In low income country with large debt ratios vis-à-vis the ratios of their debt risk categories –as determined by the countries’ policy and

institutional assessments (CPIAs). In low income countries with high debt ratios vis-à-vis the threshold of their debt risk categories these countries would get reduced volumes but IDA grants only in 50-50 grants and borrowing.

It is difficult to say a priori whether this is an advantage or disadvantage

for debtor countries affected. On the one hand, you get grants, but, on the other, reduced volume.


The third use, also by the Bretton Woods Institutions, and also on the basis of the Debt Sustainability Framework, is the use to impose

borrowing ceilings, including zero ceilings. This takes place especially in the context of the IMF PRGF. The higher the debt ratio of the country vis-à-vis the threshold of the debt risk category it belongs to, the more

its borrowing discretion would be constrained. So, why a high debt ratio is an advantage in getting a country to qualify as HIPC and getting a substantial portion of debt relieved, here it is a disadvantage, a constrain to its capacity to borrow. To mitigate this disadvantage, a low income

country has to improve its CPIA score. If an LIC can improve its CPIA score, it can mitigate this disadvantage.

To conclude the assessment of the concept of debt repayment capacity, we should point out that has a number of drawbacks and challenges,

even for the creditors. Numerators do not take into account the composition of the debt, currency and maturity, for example. Denominators also fail to take into account composition (e.g., primary exports, or diversified exports, they are only looking at volumes). The

ratios also fail to take into account a number of political and institutional characteristics that affect debt repayment capacity.

It is this later challenge that has led the BWIs to classify low income countries in three debt risk categories based on the World Bank CPIA. According to this classification, which is rather ad hoc and bedeviled

with its own challenges, low income countries that have weak policy and institutional capacities are deemed to suffer unsustainable debts at lower levels of debt indicator ratios than countries with higher policy and institutional capacities.

I move to the third concept: the human development concept of debt sustainability. According to this concept that is advocated by many NGOs and several intergovernmental organizations, capacity to repay debt should only be from residual resources after the government has

met its priority spending, including internationally agreed development goals. For example, according to Eurodad, debt sustainability should be redefined as the level of debt that allows countries to meet the MDGs by 2015 without increasing debt ratios.

The UN Secretary General in an earlier report submitted for decisions

by Heads of State and Government in September 2005 at the High Level meeting on Financing for Development was reported to have commented that “to move forward, we should redefine debt


sustainability as the level of debt that allows a country to achieve the MDGs by 2015 without an increase in debt ratios. For most HIPC

countries this would require exclusively grants-based finance and 100 % debt cancellation, while for many heavily indebted middle income countries it will require significantly more debt reduction than has yet been offered.“

The motive or purpose served by this human development debt

sustainability concept is to lower as much as possible the debt sustainability threshold that qualifies countries as HIPC, or for debt relief in general. In the limit, if this threshold is lowered to zero, all countries that qualify would also enjoy 100 % debt cancellation.

Summing up, each debt sustainability concept has its own merits and

serves its own purposes depending on the perspective. But for the purpose of linking debt policy with poverty reduction and the achievement of other components of the MDGs, the human

development-based debt sustainability concept is the most relevant one. We at the Commonwealth Secretariat are not only supportive of it, but also advocate it.

In terms of linking trade and debt, we see it as relevant, too. In this regard, trade contributes to poverty reduction. So we can even redefine

the concept, look at government spending needed to meet MDGs, as well as to promote trade. In other words, tradable sectors should be promoted and, as a consequence, whatever amounts are needed for that, one cannot used to service debts.

Thank you very much.

Factoring trade performance into debt sustainability assessments 111

SECTION VIII

FACTORING TRADE PERFORMANCE INTO DEBT

SUSTAINABILITY ASSESSMENTS

Mr. Manuel Montes

UN Financing for Development Office

Good Afternoon. I found it a bit tragic that Machiko couldn’t present the WIDER paper because it’s really important paper in this session and

now she’s going over it a little bit but not in great detail. So the topic of this session is about debt sustainability in a way that supports improved trade performance for development. If we like to talk about markets, the

problem that this session highlights is that there are missing institutions required to made markets. Because there are missing institutions they have got more handicapped institutions and the handicapped mechanism

is the debt sustainability framework which Machiko talked about. My remarks have also been provoked by Charles Wyplozs’s recent paper on debt sustainability and the Nissanke and Ferrarini discussion.

The way we got here is that the debt crisis led to policy lending instead addressing the issue of missing institutions and establishing them. One

key missing institution is that of greater stability in commodity prices. If the short-term tragic-comic gyrations in the price of an indispensable commodity create enough distress, the long-term uncertainty in its price

not only undermines investment but creates a long-term hazard in terms of globally warming. Machiko presents a story which begins with sudden commodity price declines, followed by policy lending and ending up with more debt. After we got to the situation of more debt,

the international community then has to figure out how to undertake debt relief even though the debt is actually linked to solve this missing institution of trying to deal with the question of commodity prices. And

debt relief then begot this HIPC treadmill and HIPC then begot debt sustainability. Debt sustainability was an abstract concept but now debt sustainability is a very specific term now being used to very specific contexts.

So what is at stake here? I am taking debt sustainability in the specific

term that’s being used now. But the other one, as this session is all about, debt sustainability estimates do not actually incorporate the problem of trade and absorbing trade shocks: this is the point that the


paper emphasizes. The authors actually present a proposal for a state contingent debt sustainability framework. But this paper identifies other

missing institutions – the absence of an aid system. Because otherwise it is not just a matter of tweaking or changing the debt sustainability index as it is computed, you also need another institution to make it work.

What is the role of the debt sustainability and trade intersection? Well,

the IMF website says the number one objective of debt sustainability is to be helpful to the borrower, to the debtor, and it’s supposed to help guide the borrowing decisions of the LICs, low incomes countries, so

that it matches their financing needs with their current and prospective repayment ability. Now, one can always define the objective, the question is: who are the biggest users of the index? Well, logically the

creditors are the main needers of the index. (I don’t know if this argument has been made before but I think it is logical.) Machiko discusses this too - it prevents poor countries from borrowing beyond levels defined by these indices and therefore it protects, first of all, the

community of lenders. However, it’s very important for borrowers to have an important role in defining what debt sustainability means. The underlying borrower’s interest in debt sustainability design is to make

sure that debt sustainability does not present a constraint to borrow in order maintain growth and therefore the ability to service debt. It is these considerations, the definition of the numerator, the nature of the

denominator in the debt sustainability framework – that you can start arguing about if you are on the borrowers’ side or the lenders’ side. It is the bitter reality of this mechanism that it is lenders and donors - donors

include those with the dual role of being lenders and gatekeepers at the same time such as the IFIs – who are actually the most important users of the debt sustainability index.

So what is at stake is: what qualities should this debt sustainability measurement have in order that they have the greatest utility to whom?

This is part of the first question that needs to be asked – do we want it to have the greatest utility to borrowers? Most of the critiques of the debt sustainability framework are coming from the supposed advocates of borrowers. But the indices themselves are not for the use of the

borrowers. If borrowers had their choices, we might not have any of these indices in the end, right? And what is the specific topic of discussion is about whether we should include trade considerations in

indices that might in the first instance not be in the interest of borrowers. Would improving trade consideration improve the utility of debt


sustainability indicators to the lending community? The problem is because debt relief begot debt sustainability, these indices have what I

call the Petraeus syndrome (commander of US forces in Iraq); debt sustainability is the only game in town. Trying to predict them and trying to say what is wrong with them, even infusing trade

considerations is probably not a completely worthless exercise. They have become, for LICs, the most relevant indicator of creditworthiness. While in the past you always used a lot of indicators, and one has to admit the international private sector uses a wider range, and probably

more sophisticated indicators in looking at place to invest and lend in emerging markets, in the case of LICs, debt sustainability indicators are information technology. For the LICs there is only one Petreaus.

Are these indicators useful as they are constituted? First of all, Machiko

shows that in the current incarnation there is a very heavy element of arbitrariness and instability built into the Country Policy and Institutional Assessment (CPIA), which is an important part of the World Bank-IMF debt sustainability framework. Wyplozs makes the

important point that any way to set up a DSA, a debt sustainability assessment, is by nature an exercise in arbitrariness. There are many ways to define sustainability and there are alternative definitions of debt

sustainability. For example, one definition that is interesting is that debt is sustainable if it is on a non-increasing trend. Wyplosz makes the point that if you look at the way that the British have borrowed money

through their history, it has zoomed up and down but the one thing that the British have never done is defaulting on their public debt – but in my view, this is a measure of the British capacity for draconian measures.

It’s really hard to put down what debt sustainability should really be. If at this time the current buzzword about the debt sustainability framework is that it should be forward looking as opposed to the traditional framework that is just backward looking, I agree with

Wyplosz that making it forward-looking would make it even more arbitrary. And he’s saying: isn’t is less arbitrary if the debt sustainability index is taken as an attempt to describe the current status

of the debt of the country? But that’s not the way that Machiko Nissanke’s model works. The paper seeks to change the indicator so that it incorporates the problem of trade volatility and its implications on the build-up of developing country debt.

In many cases the original debt buildup was rooted in the trade problem.

Many of the debt build up of developing countries came from their commodity problems. Secondly, trade has a very important role after the


debt has been built up because trade is needed in order to service of debt. This is where the debt sustainability index comes in. Not

addressing trade in the official debt sustainability assessment is technically questionable – not addressing the debt because avoiding it creates an inequitable market-sharing which undermines the market-

consistent incentives and the discipline that is required. What happens is that you transfer the risk to the borrower. The current DSA approach is forward-looking but it doesn’t include the role of exogenous shocks – shocks that are completely beyond the control of the borrowing side.

They have run some stress tests but these tests don’t explicitly differentiate between what are exogenous and other shocks. There are alternative scenarios of key macro-economic fiscal and external debt but

the external shocks have completely nothing to do with them. And third, I think you can make the argument that excluding shocks that are not under the control of the borrowing country shifts the risk to the

debtor. And HIPC Finance Ministers have repeatedly requested rapid and affordable contingency financing mechanisms to be disbursed immediately in the event of these shocks. They have also called for

realistic long term projections and taking full account of the nature of past external shocks.

So, I go two ways here. The second is to try to support the Nissanke proposal. The first is to say “forget it”, about debt sustainability indicators. Let’s remove the forecasting exercise and turn the debt

sustainability framework into an assessment of the current status. Either way, it’s very useful to think about the process aspects of the debt sustainability assessments. The Monterrey Process in 2002 coughed up

the earth shaking view that both creditors and debtors have equal responsibility in causing and resolving debt problems, even in the international sphere (even that view has accepted in domestic circles for at least a century). Why not have debt sustainability assessments be

undertaken by a truly independent body, but not the credit rating agencies who have already proven they are independent at all in the lead-up to and collapse in the Asian financial crisis. It’s become a very

tricky thing now for a lot of African countries because there is now a new conception in this field called free-riders. So Chinese want to lend to some African countries that may be breaching their debt sustainability

ceilings, but because they aren’t part of the process of lending, they are now called free riders because they are trying to lend to countries whose debt has already been written off.


I would also argue for using a variety of indicators instead of consolidating all kinds of data points into one. And then let each lender

decide. Each lender and each potential lender decides on their own whether to lend more or to write off or to do something. It could also mean installing debt contingent debt contracts itself. For each debt

contract you could have a debt-contingent contract especially when you are writing debt contracts in commodity dependent low-income countries.

Then you might consider state contingent aid mechanisms the other missing - even the aid side of the equation could be theoretically

adapted to have a contingent mechanism. And that’s certainly a political decision: to what extent should aid donors be willing to do this but in a sense permits real partnership and ownership for problems that are completely beyond the control of debtor?

A second aspect of the Nissanke approach in the contingency debt

sustainability framework is trying to deal with infrequent and exceptionally large shocks. And in fact they have a very comprehensive way of looking at it. What you do then is differentiate between

indigenous and exogenous components. But even within exogenous components, you put in a trade term. If it’s a trade term, the domestic authority should incorporate it into their own policies, and then you only take out of your assessment the part that is not part of the trade terms

and the subpart of the exogenous shock. Then they suggest a contingent fund facility, another institution that would give debt relief based on a country’s observed degree of exogenous factors. I’ll stop here.

Ms. Cecile Valadier

Ecole Normale Superieure (Paris)

Good afternoon. What I am going to present here is a joint work with Daniel Cohen and the French Agency for Development which was

written this year. First, let me give you some of the motivations behind our study. As you know, the international community has engaged in a process of debt reductions that took the form of the HIPC initiative in

1996 and more recently in 2005 of the multilateral debt relief initiative. These have been seen as evidence of the failure of the so-called soft loan strategy. It has raised doubts on lending poorest countries as a relevant policy instrument. It has been argued that these countries are not able to


repay their loans for lack of institutional capacity mainly. This is the very reason why they do not have access to international financial

markets. Following the argument, unless an international financial institution can expect to be better repaid, they should abandon loans in favor of grants only.

We explore in this paper another reason that makes these countries more prone to default which is their vulnerability to external shocks and more

precisely to export shocks. For example, for 24 HIPCs, 70% of total exports are made of unprocessed primary commodities. This high concentration of exports leads to a great volatility of their export

revenues as a result of frequent price and quantity shocks. For example, we calculated that the export revenues (which are price times volume) fluctuated between 43% to 105% of their average between 1970 and

2005. We argue that this particular vulnerability is one important determinant of the debt crises and it should be taken into account when we think about lending again.

Our paper estimates the extent to which export shocks contribute to the increased likelihood of a debt distress event (I won’t go into the details

of the estimation and the results for lack of time). I’d like also to present a simple debt instrument that could be adopted by official donors in order to prevent the build up of debt problems following export shocks. The concessional loan that I am going to present here

can decrease significantly the likelihood of a debt crisis and prevent costly debt restructuring processes. It should be mentioned here that the French Agency for Development with whom we worked closely this

year, has already committed to use this kind of loan when lending again to former HIPCs starting in 2007.

How do we define a shock? As a simple yardstick we define export shock as periods during which a country’s export earnings fall below 95% of the average of their 5 past years. This definition aims at coping

with exceptional downward movement with respect to the trend but not with the rend itself. It encourages the appropriate adjustment to recurrent and permanent shocks while benefiting the country faced with

the shock. To give you a flavor of the links between export shocks defined in this manner and debt distress situations, you can look at this table. The first line shows the number of debt distress events that a

sample of 135 developing countries faced from 1970 to 2004 and then shows the number of debt distress events that were preceded by an


export shock. In total, 71 debt distress events and 38 preceded by an export shock, which is 54%. For HIPCs, it increases to 59%.

Let me now describe the principle of our concessional loan proposal. Basically, it’s very much in line with what Professor Nissanke talked

about. It is to link the country’s repayments with its ability to pay and in this case export revenues. Concessional loans to the poorest countries usually take a very simple form. They have long maturities,

very long grace periods and low interest rates. For example, a typical IDA loan stretches over 40 years, has a 10 year grace period and carries a .75 interest rate. The logic of having low interest rates is

straightforward; the country being poor it cannot pay for much. The logic for having long grace periods is less obvious. They are generally intended to give time to the country to launch a project that’s financed

through the loan. We believe the long grace period carries a perverse incentive, as the debt service starts way into the future. There may be no clear distinction between a loan and grant for a government whose time horizon is short or at least no real internalization of the cost of

borrowing. Therefore we transformed the long grace period into a fixed grace period and a floating one, which a country can use when an external shock occurs.

We believe that such a mechanism is welfare improving as compared to previous, typical concessional loans as it helps smoothing the debt

service. If no bad shocks occur during the loan the floating grace is redeemed to the country through a shortening of the maturity of the loan. Here are some calibrations on this loan design, with a 30-year

maturity, a 1 or 1.5% interest rate and a 5-year initial grace period and a floating grace period which can be drawn upon from year 6 to year 30 in the event of an export shock. Countries may be hit by a shock during

the five years after their initial grace period, which is to say that if worse comes to worse, the country has to draw on its floating grace for five years. If it’s not the case the repayments start in year 6 and constitute a

financial effort on the part of the country compared to the worst case scenario therefore it is possible to expand the right to suspension as time passes up to the market remuneration on these repayments. This table illustrates the flexibility of concessional loan and it compares the two

extreme situations a country could face: if a country is hit by consecutive shocks right after its initial grace period or if a county is never hit by a shock. The first line is the option with a 1% interest rate

and the second is the option with the 1.5% interest rate. So, if a country is hit by a shock right after the initial grace period, it can draw upon the


floating grace period 5 times for 5 years in a row. If the interest rate charge is 1.5%, it can draw on the grace period for 6 years in a row. So

it adds a year and increases the interest rate to add to the flexibility. If the country is never hit by a shock, in the end the loan can be repaid in year 23 instead of year 30 or in year 21 instead of year 30. It should be

noted that there is no mutualization between countries in order to preserve incentives, which is to say that countries with no shocks are not penalized relative to the other countries.

There are operational challenges to the implementation of such a criterion in order to allow for the use of the floating grace period. We

chose to link the repayments of the country with its export earnings expressed in the same currency as the one in which the loan must be repaid. Export earnings are a natural indicator of a country’s ability to

face its debt repayment obligations in foreign currencies and they have many advantages. Export revenues capture two kinds of shocks, price and quantity shocks. Commodity price volatility is an important determinant of export revenues volatility for countries highly dependent

on a few commodities. Nevertheless, shocks on quantities also tend to explain a good part of the volatility… For 17 country-commodity pairs, quantity and price volatility appear to be of comparable magnitude with

the tendency for quantity effects to exceed price effects and quantities are also likely to be affected by presumably exogenous factors such as weather conditions, drought, strike, or wars. Moreover, focusing

specifically on commodity prices have a major drawback, which is to assume that the country’s export structure is not going to change to manufactured goods at least for the next 30 to 40 years which is the loan

maturity but even prevents this country from diversifying away from commodities in order to benefit from this scheme. This is why we chose export revenues and not just commodity prices.

Nevertheless, two main difficulties emerge: incentives and timeliness. We have to take into account the type of incentives this type of loan will

generate for a borrowing government in terms of policy and reporting. The borrowing country must not be able to misreport its trade statistics in order to benefit from payment suspensions. Therefore we chose to use mirror trade statistics, which is to say that we use the other

countries’ imports from the borrowing country. Moreover the scheme is designed so as to mitigate the bad incentives as there are only limited amounts of suspension to draw upon. Therefore, there is no benefit in triggering the mechanism when you don’t need to.


Export revenues are usually known with a significant lag which could impact the efficiency of such a mechanism, which relies critically on the

availability of export data with very little lag. This constraint led us to focus on merchandise export revenues which are more readily available than total export earnings. Both are very well correlated for most poor

countries. In our sample we have on average a coefficient of correlation of 89% and we use a trade database that provides comprehensive data on trade flows within 68 countries and the rest of the world on a monthly basis and it includes OECD countries, Asian, and Latin

American Countries which allows us to recover the value of their trade partners exports especially African countries. This date is very readily available and has at most a four-month lag.

Once we have defined what constitutes an export shock, the

automaticity of the suspension is an important feature of the loan. If the criterion is met, the mechanism can be triggered by the country. However it should not be an obligation. The country can draw upon its floating grace periodif it’s hit by a shock but is not forced to do so. As a

matter of fact, its ability to pay may not be considerably affected by the shock especially if it has a lot of reserves.

As a conclusion, after debt relief initiatives, low income countries are able to finance part of their needs through borrowing and this new context of restored debt sustainability should be preserved. We should

think of innovative lending strategies in order not to reproduce the mistakes of the past. We should especially take into account the low-income countries vulnerability to export shock. It’s a good thing that

this kind of idea is beginning to start in the donor agencies such as the French Agency for Development but I must stress here that the coordination between donors is essential to the functioning of one such

tool and one single initiative is not enough to make this work. Thank you.

DEBT AND TRADE: MAKING LINKAGES FOR THE PROMOTION OF DEVELOPMENT

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