The linkages between trade and finance bear a closer look, explains Kenneth Rogoff, the IMF’s Economic Counsellor and Director of its Research Department. He reports here on the findings of Chapters II and III of the IMF’s World Economic Outlook, September 2002, which take up several pressing issues, notably the risks posed by abrupt reversals of capital flows when there are sizable current account imbalances, the high global costs of continued industrial country protection of agricultural sectors, corporate balance sheet issues in emerging markets, and the symbiotic relationship between trade and financial integration. Chapter I of the World Economic Outlook, including its economic projections, will be released on September 25.

Abstract

The linkages between trade and finance bear a closer look, explains Kenneth Rogoff, the IMF’s Economic Counsellor and Director of its Research Department. He reports here on the findings of Chapters II and III of the IMF’s World Economic Outlook, September 2002, which take up several pressing issues, notably the risks posed by abrupt reversals of capital flows when there are sizable current account imbalances, the high global costs of continued industrial country protection of agricultural sectors, corporate balance sheet issues in emerging markets, and the symbiotic relationship between trade and financial integration. Chapter I of the World Economic Outlook, including its economic projections, will be released on September 25.

Trade and finance linkages

Timeliness is not the only reason for the IMF’s World Economic Outlook to take up the relationship between trade and finance. While international trade and finance have individually received a lot of analytical attention, the linkages between the two key dimensions of international economic integration have often been ignored. The World Economic Outlook, September 2002, sees these linkages as critical—a viewpoint that has recently come to the fore of thinking on international financial policy.

Sustainable current external imbalances?

Much of the recent concern about exchange rate misalignments has focused on the U.S. current account deficit, which has widened to about 4 percent of GDP. Given that one country’s deficit is the rest of the world’s surplus, however, it is best to look at this issue from a broader multilateral perspective. There is now a gap of some 2½ percent of global GDP between the current account surpluses of continental Europe and east Asia (dominated by the euro area and Japan, respectively) and the deficit countries, dominated by the United States. Indeed, relative to the size of trade flows, current account imbalances have risen to levels virtually unseen before in industrial countries in the postwar era.

This problem is not specific to deficit countries or to surplus countries; rather, it is a problem of the system as a whole. The first essay in Chapter II—“How Worrisome Are External Imbalances?”—assesses the risks that the capital flows supporting these imbalances will unwind quickly, thus resulting in larger, and potentially disruptive, short-term exchange rate movements than would occur if the financial imbalances were to unwind slowly.

Although there is no easy prescription for mitigating these risks, these concerns strengthen the case for policymakers in deficit countries to pursue medium-term fiscal consolidation—the evidence shows that this reduces the likelihood of a disorderly outcome—and for policymakers in surplus countries to press ahead rapidly with structural reforms to make their economies more flexible and to boost growth. Expanding global trade would also help because the more open economies are to trade, the less exchange rate adjustment is required to achieve a given current account reversal.

Industrial countries’ agricultural support amounts to over 30 percent of their agricultural output.

—World Economic Outlook

Costs of agricultural protection

Markets for basic agricultural commodities such as grain are often thought of as textbook examples of highly organized competitive markets in which prices respond rapidly to divergences between demand and supply. So it is something of a paradox that there are so many countries in which the agricultural sector is among the most heavily subsidized and protected. In “How Do Industrial Country Agricultural Policies Affect Developing Countries?” the second essay in Chapter II notes that industrial countries’ agricultural support amounts to over 30 percent of their agricultural output.

Quantitatively, the largest burden of these subsidies falls on consumers and taxpayers in industrial countries, but, unfortunately, the effects also fall heavily on the rest of the world, including many poor countries, notably in sub-Saharan Africa. These costs are particularly large for certain commodities such as cotton. Industrial countries should be in the vanguard of multilateral efforts to get rid of farm subsidies given the large resources at their disposal and the small size of their farm sectors. The welfare gains would be substantial (see chart, this page), and such an initiative would spur similar reforms in developing countries, which would further increase welfare gains. The impetus for similar reforms in developing countries is of particular importance, because the adverse effects of developing countries’ own trade restrictions are significantly larger than the costs imposed by industrial country protection—not just on agriculture but also on manufactures and services.

Emerging markets’ corporate performance

The Asian crisis of 1997–98 and successive crises in Latin America have underlined the role that healthy corporate and bank balance sheets can play in maintaining financial stability. The third essay in Chapter II, “Capital Structure and Corporate Performance Across Emerging Markets,” looks at trends in corporate health and financial vulnerabilities across 18 emerging market countries, focusing particularly on differences between east Asian firms and their counterparts in the emerging market economies of Europe and Latin America.

Two results from this study are particularly noteworthy. First, policies that promote openness to foreign investors have a positive effect in helping corporations reduce their leverage (debt-to-equity ratios) and extend the maturity of their debts. This is not to deny the heightened risks of exchange rate mismatches, but, in terms of debt maturity and composition, openness helps rather than hurts. Second, leverage also seems to have much to do with the level of domestic financial development. In particular, corporations in countries at intermediate levels of financial development often have particularly high leverage ratios compared with countries that have more primitive or more advanced financial systems, in part because their financial systems tend to be based primarily on bank lending and other debt instruments.

The essay suggests that a higher level of economic development may help explain why east Asian firms still tend to have higher leverage ratios than their counterparts in the emerging market economies of Europe and Latin America, even after the Asian debt crisis of the 1990s. (Another likely factor is the increased ability of corporates to borrow in countries with more stable macroeconomic policy histories.) Past a certain point, however, as a country develops and its financial system matures, equity markets often become more important, leading to lower leverage ratios. If east Asian countries are indeed on the cusp, where further development begins to lead to lower leverage ratios, then this differential may abate in the coming decade.

A02ufig01

Agricultural liberalization improves welfare

(percent of GDP)

Citation: IMF Survey 0031, 017; 10.5089/9781451928532.023.A002

Data: IMF, World Economic Outlook, September 2002

Trade and financial integration

Globalization is one of the major forces affecting the world. The relationship between its two main facets—trade integration and financial market integration—is the focus of the September World Economic Outlook’s Chapter III. Historically, international trade and finance have generally moved hand in hand (see chart, page 276). Empirically, the two reinforce each other, with greater financial integration tending to increase trade, and more trade requiring larger international financing.

The benefits from opening up to the rest of the world are greatest in terms of reduced macroeconomic volatility and fewer financial crises when progress is made on opening to both trade and finance.

—World Economic Outlook

What Chapter III finds is that the benefits from opening up to the rest of the world are greatest in terms of reduced macroeconomic volatility and fewer financial crises when progress is made in opening to both trade and finance. Theoretically, there is also a fairly clear link. It is now well known that a fall in the costs of trade can significantly expand financial market integration measured by the level of risk-sharing across countries. Indeed, one can potentially explain much of the differences in the level of capital market integration across countries by trade frictions, broadly defined to include not only transport and tariffs but also other factors, such as differences in language and legal systems (also see, “The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?” by Maurice Obstfeld and Kenneth Rogoff, NBER Macroeconomics Annual 2000).

A02ufig02

Trade and financial openness are complementary

Citation: IMF Survey 0031, 017; 10.5089/9781451928532.023.A002

Data: IMF, World Economic Outlook, September 2002Note: Trade openness is defined as the sum of imports and exports as a ratio to GDP, averaged over 1975–99. Financial openness is defined as the average gross stock of accumulated foreign direct investment and portfolio flows as a ratio to GDP, averaged over 1975–99.

While a steady fall in trade costs has certainly been the driving force for global integration throughout modern history, the roots of the change have differed somewhat over time. During the last great era of globalization, 1870–1914, integration was driven mainly by changes in technology. During the modern post–World War II era, however, policy has been at least as important. While financial and trade integration have generally moved in broad correspondence, there have been cases where policy-driven liberalization in financial markets has leaped ahead, and the supporting changes needed to achieve trade integration never materialized. This can lead to problems, including financial crises, as Chapter II of the World Economic Outlook, April 2002, examined, and as the current study takes up again.

Given the importance of opening up to finance and trade, Chapter III also contains a detailed investigation of why some regions seem to trade so much more than others. Much of the analysis is based on the so-called gravity model of trade—a model that controls for factors such as country size, distance from trading partners, and policy restrictiveness. Overall, the results suggest that while trade policy restrictiveness is quite important in explaining the lower trading levels of developing countries compared with their industrial country brethren, other factors, such as the level of economic development and inherited geography, turn out to be even more important. Low income per capita is central to explaining the relatively low level of “South-South” trade; as consumers in poor countries use a relatively narrow range of products, such countries will naturally trade less with each other, even relative to income.

Many countries also suffer from the problem of geographic isolation and, in some cases, being land-locked. Indeed, geography alone accounts for roughly 40 percent of the difference in trade levels across countries. Trade and balance of payments restrictions, in contrast, appear to account for between 10 and 20 percent of the shortfall in bilateral trade flows. We can conclude from this that, over the next century, we are likely to see increased globalization as a result of not only continued improvements in the global transportation and communications systems and active policy measures to reduce trade restrictions, but also simply further economic development. Globalization is not only a source of growth; it is also a natural outcome of it.

Copies of the World Economic Outlook, September 2002, are available for $49.00 (academic rate, $46.00) each. For ordering information, see page 285.

IMF Survey, Volume 31, Issue 17
Author: International Monetary Fund. External Relations Dept.