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Industrial and Developing Country Policy Linkages

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1994
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THERE ARE many channels through which industrial country performance affects the developing world. Yet with growing world economic interdependence, developing country performance may affect industrial country prospects as well. This argues for closer participation of developing countries in multilateral policy coordination.

It is customary to think of the interdependence of industrial and developing countries in a leader-follower context. Financial and exchange rate policies, labor market policies—including immigration controls—and a vast array of selective measures in the trade, agriculture, and industrial fields that serve particular sectoral interests have profound consequences for the economies of developing countries. Yet the underlying model of the world economy may be changing. Many developing countries have registered high rates of growth in recent years in the face of economic slowdown in the industrial world, and the rapid expansion of their markets is creating a growth impulse for industrial economies mired in recession. Moreover, emerging capital markets in some developing countries are opening up a range of new asset choices to investors in industrial countries as well, thereby binding developed and developing financial markets more closely.

Within this interdependence lies great diversity. The developing countries as a group are far from homogeneous—they are best visualized as strung along a development spectrum. Some of the middle-income countries have become important forces in the world economy in their own right and provide sizable markets for industrial country exports. Many of them have demonstrated the ability to compete successfully with industrial countries in a broad range of manufactures. Trade policies of industrial countries are thus of particular concern to them. As for international capital flows, only a select group of developing countries are able to attract private market funds while the remainder are still largely dependent on official flows. Indeed, the diversity within the developing world has reached a point where some countries are approaching industrial country status while others remain at, or even have regressed to, subsistence levels.

It would be premature to think of developing countries as the new locomotive of world growth. However, they might play such a role at critical cyclical turning points, when the margin of demand provided by rising exports to the developing countries could spell the difference between growth and the danger of recession persisting for one or more major industrial countries. In the United States, for example, the last recession would have persisted into 1991, and the recovery in 1991–92 would have been weaker, but for the strength provided by the increase in exports to the developing world (see chart). In addition to trade, developing and industrial countries are linked through exchange and interest rate policies that affect both domestic and international capital markets. The strength and direction of the policy linkages between the developed and developing worlds are changing subtly but perceptibly. However, the industrial world still remains the dominant partner by far.

Trade policy linkages

Trade policies represent one of the most direct links between industrial and developing country economies, and trade barriers can blunt growth potential for both groups. Developments in industrial country trade policies during the past decade present a mixed picture—tariffs, with some exceptions, have ceased to be a significant barrier to trade, but trade tensions have nevertheless grown. A more activist trade policy stance adopted by many industrial countries has resulted in significantly greater use of nontariff barriers and more frequent recourse to instruments of contingent protection. While many of these measures have been aimed at trade within industrial countries, they have also affected developing countries, especially in East Asia.

Nontariff barriers that affect developing countries are most extensive in agricultural products and textiles and apparel. For example, a recent World Bank study shows that nontariff measures cover as much as 80 percent of Bangladesh’s exports to OECD countries, 65 percent of OECD imports from Pakistan, and over 50 percent of OECD imports from Thailand (Table 1). Removal of these barriers could result in important export gains for a number of developing countries.

Table 1Trade barriers reduce export potential
Average tariffs and nontariff barriers

in OECD countries
Estimated effect of trade

barrier removal1
Average OECD tariff (percent)Percent of imports covered by nontariff measuresExports to OECD (million dollars)Percentage increase
Bangladesh6.980.5985104
Dominican Republic9.938.31,71295
Haiti11.216.7421100
India2.349.23,12335
Jamaica6.243.755562
Malaysia2.240.81,94316
Pakistan3.565.61,49258
Philippines5.735.92,82044
Sri Lanka8.363.91,016105
Thailand3.351.44,61343
Source: Global Economic Prospects and the Developing Countries, pp. 50–51, World Bank. 1993.

Other measures that restrict trade include voluntary export restraints and other managed trade arrangements as well as antidumping and countervailing duties that provide contingent protection. Even when these instruments are consistent with the General Agreement on Tariffs and Trade (GATT), invoking them frequently discourages new entrants into export markets. Developing countries affected by these measures have included Brazil, China, Korea, Singapore, Taiwan Province of China, and Thailand.

Developing countries contribute to US exports and growth

Index (trough, 1991 Q1=100)

Source: IMF staff estimates.

The prospect of the rapid proliferation of regional trading arrangements also affects the policies that link developed and developing countries because it raises concerns about the potential of these arrangements to fragment international trade. It has been estimated that almost one half of world exports may be covered by existing or proposed preferential trade arrangements, including the North American Free Trade Agreement (NAFTA) and its possible expansion, and the extension of the European Union arrangements to much of the rest of Europe. The basic concern is that these developments might, in some instances, discourage open multilateral trade and thereby have a negative effect on countries excluded from the regional groups.

Another set of concerns arises from the implicit coercion that developing countries may face to satisfy the claims of environmental, labor, and other interests in industrial countries. Environmental protection and labor welfare standards that are affordable in high-income countries may undermine the basis for comparative advantage in poorer countries.

In recent years developing countries have increasingly adopted market-oriented, trade-promoting policies on the premise that an external environment of unrestricted trading opportunities and access to markets and resources would be maintained. Thus, any backsliding in the trade area by industrial countries would seriously damage the ability of developing countries to pursue open market policies and, ultimately, hamper world growth prospects.

Global capital markets

The capital account relationship between industrial and developing countries in the postwar period has been characterized by significant changes: the share of foreign direct investment has increased sharply; and, although official development assistance and lending by multilateral financial institutions have remained large, private capital flows have achieved an almost equal share in recent years as bonds and equity investments have gained in importance (Table 2).

Table 2Capital flows to developing countries1(percentage share in total)
Types of finance1971–761977–811982–881989–92
Foreign direct investment10.88.510.617.7
Portfolio equity......3.3
Bonds1.42.53.15.7
Commercial bank loans35.843.527.916.2
Supplier and export credits9.210.311.711.4
Official loans30.926.435.731.9
Grants11.98.810.9138
Total (percent)100.0100.0100.0100.0
Total (billion dollars)41.2110.9125.5175.3
Source: IMF staff estimates...: Data not available.

There is controversy about how much of this change is attributable to push factors—policies and circumstances in the industrial countries—and how much to pull factors—better policies and improving conditions in the recipient countries. An IMF study of capital inflows in ten Latin American countries (see “Capital Inflows and Real Exchange Rate Appreciation in Latin America,” by Calvo, Leiderman, and Reinhart, IMF Staff Papers, Vol. 40, 1993) concluded that external factors contributed to about half of the inflows, especially following the onset of recession in 1989 in the United States. Other external developments included regulatory changes in the United States that resulted in a reduction in transaction costs and in liquidity requirements for countries tapping the US capital markets large-scale turmoil in the Middle East, which probably motivated a relocation of regional savings; and actual or prospective changes in regional trading arrangements, represented, for example, by the passage of NAFTA.

As for pull factors, capital inflows were clearly attracted to developing countries that successfully stabilized their economies and followed up with far-reaching structural reforms.

Better policymaking. The better investment climate in many developing countries reflects in part the radical improvement in the quality of their policymaking. For the strong performers, economic reform has reduced public dissaving and raised private saving at a time when budgetary deficits have been on the rise in industrial countries. In a sense, some developing countries could claim to be outperforming the countries to which their own currencies are linked. Similarly, structural reforms in the trade, investment, and financial market areas have lowered the cost of capital while promoting efficient resource mobilization and allocation.

Improved credit-worthiness. A part of the improvement illustrates the beneficial effects of cooperation between creditors and debtors, both official and private. Debt-reduction operations have improved the credit-worthiness of a number of heavily indebted countries, leading to a rapid decline in risk premiums, as indicated by lower spreads on international capital markets. Better credit-worthiness is also demonstrated by the success of extensive privatization programs in attracting large inflows of foreign capital and capital held abroad by domestic residents.

Exchange rates

Developing countries have also been affected by changing cross rates among the major international currencies and the prospect of further changes from the recent widening of margins for fluctuation or, in some cases, their temporary abandonment. The most direct effect is transmitted through the pegs that a substantial number of these countries maintain to the major currencies. Changes in exchange rates can induce changes in trade flows, although these effects may emerge only gradually. Even where the peg is to a basket of currencies, changing exchange rate relationships within the basket produce movements that might require changes in the peg itself.

Another set of effects arises when the currency composition of debt-servicing obligations does not match the currency composition of a country’s export receipts. This is most clearly apparent in countries that have significant liabilities not denominated in US dollars but whose export earnings are denominated predominantly in US dollars, as in the case of oil and other primary commodity producers. The effects are by no means uniform; they depend upon the currency composition of the outstanding debt, whether the debt is at fixed or adjustable interest rates, and its maturity pattern, among other variables.

Interest rate changes associated with exchange rate fluctuations can amplify these disturbances. In countries where private sectors have access to international capital markets, the overall liability position, as well as sovereign external liabilities is affected. Financial derivatives have enabled hedging of certain risks, and private firms in developing countries have generally been quick to take advantage of such facilities. Nevertheless, to the extent that exchange and interest rate risk is increased by fluctuations in the exchange rate relationships among the major currencies, the cost of external liability management is intensified.

Fiscal policies and real interest rates. Because of their impact on the debt-service burden of developing countries and on the relative attractiveness of investing in emerging financial markets, developments in real interest rates in industrial countries’ capital markets are especially important for the economies of developing countries.

In the past decade, fiscal imbalances have influenced the level of real interest rates prevailing in industrial countries. These rates averaged 4–7 percentage points higher in the 1980s than in earlier periods of low inflation when real interest rates in most industrial countries averaged 1–3 percent. Many reasons have been advanced for the higher real rates in the 1980s, including the rise in the ratio of gross public debt to nominal GDP from about 40 percent for the seven largest industrial countries in 1970 to over 63 percent in 1992. Although the effect of accumulating government debt on real interest rates is by no means a settled issue, empirical evidence does suggest the impact is significant when high fiscal deficits are combined with a tightening of monetary policy, such as happened toward the end of the 1970s in the United States. Even after monetary policy moved back to a more accommodative stance at the turn of the 1980s, the resultant decline in nominal interest rates did not produce an equivalent decline in real interest rates.

With public indebtedness continuing to rise relative to GDP, one might expect long-term rates to remain higher in the 1990s than the levels prevailing in the 1960s and the first half of the 1970s. Model simulations by the staff of the World Bank indicate that, everything considered, developing countries could lose between 0.5 percent and 1 percent a year of income growth over the medium term as a consequence of continued high real interest rates.

A prognosis of this kind emphasizes the direct concern of developing countries in the mix and stance of industrial country macroeconomic policies. This concern is intensified in the face of longer-range issues raised by aging populations and other financial commitments of industrial countries, especially those relating to the support of farm incomes and health care costs.

How strong are linkages?

Developing countries’ economic performance has improved over the past decade, suggesting that they may have a larger role to play than in the past in shaping policies that link industrial and developing countries. While this may be true to some extent, the influence of developing countries on the industrial countries is still relatively mild and intermittent, compared to that of the industrial world, and is confined to a select subset of the developing countries. This is primarily because the industrial countries, whose weight in the global economy is predominant, largely shape the external environment in which the developing countries can best grow and prosper. The principal elements of this environment—industrial country growth, as it affects demand for developing country exports; access to export markets; real interest rates and the terms of external finance; exchange rates; commodity prices and the terms of trade—are likely to remain largely beyond the control of developing countries.

Especially vulnerable are the poorer countries that depend heavily on concessional funding for their development. These countries are the most sensitive to the effects of budgetary policies in donor countries. Their concerns have intensified with the appearance of new claimants in Eastern Europe and the states of the former Soviet Union for aid funds that are not growing commensurately and may even be shrinking in real terms. Of equal concern are additional capital requirements to meet the demand for environmental safeguards that are being pushed increasingly as conditions for aid.

Most worrisome is the question of whether the higher growth now being registered in certain parts of the developing world as a direct consequence of policy improvements can be maintained if the current uncertainties in the global economy persist or worsen. There is little doubt that if protectionist pressures in industrial countries were to intensify, the ability of developing country policymakers to continue pursuing market-oriented reforms would be gravely weakened.

But it is not only in the trade area that these linkages apply. As the preceding analysis has indicated, developing country performance is affected by the macroeconomic policies of the industrial countries through several channels. A greater regard for the implications of industrial country macroeconomic policies for developing country performance is thus not a matter of altruism. Rather, there is a need to recognize the fact that this performance is not only affected by, but also directly affects, the prospects for recovery and growth in the industrial world. In a world economy where downside risks abound, an urgent task for the international community must be to draw attention to these interdependencies.

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