Trade deficits in LDCs

Ruth TarrantThe Open University and Peter Symonds College

Outline

• Issues facing (African)LDCs post WW2• Independence and its implications for

development• The size and funding of trade deficits for LDCs– Focus on Tanzania

• African LDCs today

The (African) colonies post WW2

Exploitation of primary products for reconstruction

Foreign exchange generated by exports kept by colonial powers

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

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

Colonial powers prevented secondary / tertiary education

Independence

Independence

Neo-colonialism

Nation building / gain

authorityKeynesian

Aid / trade dependent

Diplomatic pressure

‘removal’ of ‘hostile’ leaders

Heavy state intervention:

banking, education,

infrastructure‘developmentalism’

ideology led to authoritarian governance Mimic USSR:

achieve growth

BUT

INEQUALITY• basic needs not met• focus on capital intensive industry• rate of urbanisation > rate of wage growth

PRIMARY PRODUCT DEPENDENCY• No manufactured X• decline in terms of trade = vulnerability• World Bank!

NO TRANSFORMATION OF AGRICULTURE• urban – rural income gap• need to import food• no growth

FAILURE TO ENCOURAGE ENTERPRISE• ideological aversion to entrepreneurship• education still lacking

RENT-SEEKING GOVERNMENTS• short-termism• inability to consider longer-term growth/development

The ‘crisis years’, 1974-early 1980s

• 1975-1983: only 3 years saw any positive growth, on average, in Africa

• 1983: African economies’ GDP per capita fell on average by 5%

• Why?– Falling commodity prices and falling demand

• Recession in the developed world

• Consequences– Balance of payments crises– Economic stagnation and decline

The ‘crisis years’ – available policies

• Option 1– Accept BoP crisis as

structural & long-term

– Restructure economy

– Change the development model

• Option 2– See BoP crisis as

temporary– Borrow from abroad

to finance the deficit– Advice and pressure

from external lenders e.g. World Bank / IMF

The adjustment years, early 1980s to mid 1990s

• Option 2 ‘chosen’– Copy East Asian model• Rely on markets, not gov’t intervention• Export orientation rather than import substitution is

key– Slash public sector spending– Focus on primary product comparative advantage

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“While some aspects of this [Asian] model (for instance, greater political insulation of economic policy makers) could reasonable be achieved in African countries, the extensive co-ordinated economic interventions of the East Asian states are well beyond the administrative

faculties of most African governments”Lewis, 1996

“...no major expansion occurred in the diversity of products exported by most of the sub-Saharan African countries, although there one or two exceptions like

Madagascar and Kenya. Indeed, the product composition of some of the African countries’ exports

may have become more concentrated”Ng and Yeats, 2000

Far from supporting a minimalist approach to the state, these examples have shown that development requires an effective state, one that plays a catalytic, facilitating role, encouraging and complementing the activities of

private businesses and individuals...History has repeatedly shown that good government is not a

luxury but a vital necessity. Without an effective state, sustainable development, both economic and social is

impossible”Wolfensohn, 1997

A familiar macroeconomic framework

GDP = C + I + G + X – M GDP = (C + I + G) + X – M GDP = Domestic Absorption + X – M GDP + M – X = Domestic Absorption GDP + trade gap = Domestic Absorption

So, if an economy spends more on final goods and services than it can produce, its imports will exceed its exports by the value of the excess expenditure over GDP. This ‘trade deficit’

must be financed i.e. paid for

Tanzania persistently has a trade gap about 10% - 18% above GDP, although now shrinking

LDCs and trade deficits

• Very common in 1980s and 1990s!– Dramatic fall in commodity prices– Global recessions of 1981-82 and 1991-93– Increased protectionism in developed world

against LDC exports

Financing trade deficits using current flows

• Factor payments• Wages, rent, interest and profit

• Transfer payment• Payments not made in return for providing factors of

production– Official grants from govt’s, NGOs or international institutions– Money received from permanent overseas factors

Tanzanian factor payments have a negative balance, and transfer payments historically fund around a

quarter of the trade deficit

Other methods

• Draw on official foreign exchange reserves• Capital account transactions– Dealing in financial assets (public and/or private)– FDI from abroad• Requires good rates of interest!

LDCs such as Tanzania hold very limited foreign exchange reserves. Small, low income countries also

tend to have limited access to capital markets, as their economies are vulnerable. Historically, Tanzania found it difficult to attract FDI but rising tourism and demand

for commodities from China is helping.

Remaining options?GDP + trade gap = domestic absorption

Now subtract Consumption (public + private)from both sides

Savings + trade gap = Investment

Rearranging, gives:

Trade gap (i.e. M – X) = Investment - Savings

This is the key relationship for many macro policy makers in LDCs

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

Implications for LDCsLow income

Low savings ratio Low absolute savings

Investment cannot be funded domestically

Aid is an essential source of finance for investment

Aid used for investment in:- Import-substituting industry- Capital-intensive industry

Investment managed by donors

Foreign aid ‘matched’ by domestic spending

- Gov’t had to print money!- Rising inflation

- Falling real incomes- More aid = more inflation = more

poverty

Consequences

Falling real income, overly rapid urbanisation, mass unemployment due to investment in capital-intensive

industries, internal political strife

Increasing trade deficit

Even more aid!

Worsened by falling terms of trade!

1987 - 20011. Export volumes increased

by 9.9% p.a.2. Exports of services

(tourism) grew most quickly, and agricultural exports least quickly

3. Rate of increase in export volumes not matched by rate of increase in purchasing power of exports – negative for agricultural exports!

‘Reversion to the mean’

Shocks aside, most African current account deficits now appear to be stable

(exceptions are Burkina Faso, Ghana, Lesotho, Mauritania and Senegal, which will become more reliant on international transfers)

Attempts to reduce deficits (e.g. devaluation) will only have short-run, temporary effects – no difference to

long run deficit

Chinese FDI

Rising terms of trade

Rising purchasing

power

Shelter from financial crisis

Debt relief

Political stability

Chinese FDI

Incredible growth

Sound economic

management

Recent Tanzanian key economic data

1998 2007

Gov’t spending as % of GDP 12.4% 20.8%

Investment as % of GDP 14.6% 45%

Consumption as % of GDP 82.8% 72.3%

GDP (2001 = 100) 80.5 152

Value of Exports (2001 = 100) 82 183

Value of Imports (2001 = 100) 95 178

• Shrinking trade gap• Reduced reliance on aid• Productive investment

Conclusions

Hope!

Thanks to...

• Mark Holmes, Loughborough University• Thandika Mkandawire, the UN, the Open

University, DfiD and the LSE• Marc Wuyts and Sam Wangwe, the OU