Free Trade and Free Capital flows can’t co-exist

by Prof Jan Kregel*

Bogota 9 Nov—Latin America has been a region that has had a tradition of industrialisation on the basis of domestic resources to provide a competitive export sector. CEPAL (Spanish acronym for the UN Regional Economic Commission for Latin America and the Caribbean), one of the organisers of this Consultation,has in the past been a centre of new approaches to domestic industrialisation on the basis of regional trade integration.

It is hence appropriate to question the presumption of the Agenda item that “increasing and consolidating external flows” is an appropriate strategy for financing for development.

The Preliminary Agenda for the UN Financing for Development High-Level Event, as well as the programme for the Regional Consultation, include discussions of external financial flows and trade as separate, and presumably complementary, sources of finance for development.

However, trade and external finance should be approached in an integrated manner. To see why, we must first define what is meant by trade as a source of finance for development. If this is taken to mean that trade can provide foreign financial resources in the same way as foreign capital inflows, then instead of complementarity we will find that the two are opposed!

This is easy to see from elementary balance of payments accounting which shows that the only way trade can provide net foreign capital inflows for financing development is if the current account is in surplus. On the other hand, if there is a net inflow of financial resources on capital account, then the current account of the balance of payments must be in deficit. It is clear that the current account cannot be in surplus and deficit at the same time. So, there may be a conflict between the two sources of external financial flows.

In the 19th century, the United Kingdom managed a trade deficit and a capital account deficit, since earnings on foreign investments provided more than enough to produce a current account surplus which provided strength for the sterling.  Developing countries more often exhibit trade and capital account surpluses with debt service that produces a current account surplus and persistent balance-of-payments crises.

First, we should note that this inconsistency is the result of assuming the maintenance of stable exchange rates. It might be thought that flexible rates would provide a solution, but reflection will show that this is not the case.

If a country has a current account surplus and a positive capital inflow there will be pressure on the currency to appreciate in real terms which will soon reduce export competitiveness and eliminate the current account surplus.

If the central bank of the country nonetheless attempts to keep the exchange rate stable, it will have to allow domestic liquidity to increase which will produce a boom in asset prices and financial instability; if it tries to sterilise the inflows this will require increasing domestic interest rates, damaging domestic investment prospects and attracting international arbitrage flows.

Thus, there appears to be no easy way in which a country can attract foreign financing for development from both trade and capital inflows.

There is an alternative way out of this seeming paradox, but it requires us to look at net resource flows, rather than at foreign capital flows. Indeed, it is my understanding that this was the original intent of the Financing for Development resolution in the UN General Assembly.

Trade can be a source of increased domestic resources for development without an export surplus if increasing the share of exports in GDP provides for increased import capacity and an improvement in the variety of consumption goods available to consumers or capital goods for producers.

While trade may appear to be a zero sum game since imports are always acquired through the use of domestic resources to produce the exports necessary to pay for them, a country’s total resources may be increased through trade if it benefits from improving terms of trade or if through specialisation it can acquire goods that could not be produced with the same efficiency at home as they are abroad.

Thus, if trade increases the purchasing power of domestic outputs, or increases overall productivity of domestic resources, it may increase total domestic resources for development.

Unfortunately, the experience of developing countries has been rather the opposite, given their dependence on primary commodity exports which brings in fewer and fewer manufactured imports in a process known as the declining terms of trade. In such conditions, trade may actually reduce the resources available for development.

Raul Prebisch’s discovery of the importance of the terms of trade is instructive. Argentina had accumulated large export surpluses as a result of sale of primary products to the belligerent countries during the second world war. Prebisch was in charge of planning the post-war utilisation of these accumulated reserves to provide Argentinean development. However, as time passed the plan could not be met because the prices of imports from industrialized countries were increasing and the purchasing power of the prior Argentinean exports was declining - causing a net loss in domestic resources.

It did not take much to realise that the same was true of current exports which were still primary commodities, thus leading to Prebisch’s recommendation that development be based on expanding exports into those areas, such as manufacturing, that were not subject to declining terms of trade. This required both expanding markets through regional preferences and integration, and the development of domestic industries capable of competing international markets.  Although it eventually acquired the name of import substitution, it was in fact an export creation programme.

Thus, trade as a source of increasing the resources for development depends on improving developing countries’ terms of trade. The obvious implication is that either there must be an active policy to determine export-import compositions or there must be policies to influence the prices of commodity exports. Both are difficult in the presence of ‘market-friendly’ policies and ‘rules-based level playing fields.’

It would thus appear that external financial flows are the primary means to increase resources for development. External flows can be used to finance a current account deficit composed of imports of consumption goods, often thought to be associated with a deficient household saving ratio or excessive public sector deficits, or it can finance the import of productive capital goods.

The former is often thought to be the archetypical case of Latin America and the cause of the persistent balance of payments crises that produce the seemingly eternal external constraints on growth. However, even a “good” deficit (often called a “Lawson” after the former British Chancellor of the Exchequer), associated with high private and public sector savings ratios, may lead to difficulties, as evidenced in the Asian crisis where the deficits financed the creation of excess productive capacity, falling profitability and productivity and asset price speculation which led to a sharp capital reversal and an external constraint similar to that faced in Latin America.

It thus seems that the composition of the current account deficit financed by capital inflows makes little difference to the external constraint.

What then are the conditions in which external flows (meaning all types of private flows - bank lending, portfolio flows and direct investment flows) will provide financing for development?

There are two problems associated with external flows. The first is that they are foreign currency loans that have to be serviced, either through interest payments or profit remittances to foreign owners. Using foreign capital to finance consumption imports provides no revenues to service the loans. Capital goods may, but only if they provide for increased domestic exports sufficient to generate the foreign currency necessary to meet the interest or profit and principal payments.

But, even the provision of additional exports is not enough. There must be export markets.

Here the developed countries have a role to play. They must recognise that they cannot expect their loans by their nationals to developing countries to be repaid unless they provide developing countries with the export markets to generate the foreign exchange earnings necessary to repay them.

Finally, the cost of servicing depends on interest rates which must be sufficiently low to allow the investment to generate profits. Just as using exports to “finance” imports to be used in development does not increase total resources unless it leads to an increase in overall domestic productivity or in the terms of trade, the use of foreign capital to finance imports does not increase domestic resources unless the net present value of the increased domestic production and export earnings are greater than the capital inflow, and export earnings are sufficient to cover debt service.

This is the equivalent of the terms of trade in the discussion of trade in the generation of financing for development, only it is an inter-temporal terms of trade; the interest rate will determine the net present value of the increased output and exports of the investments financed with foreign capital inflows.

As pointed out at an earlier panel session, Colombia is currently paying a premium of over 500 basis points above developed country interest rate levels.

There are no domestic investment projects that will produce net present values above their initial borrowing costs at those interest rates. If developing countries borrow at those rates they will never be able to pay the debt service for the simple reason that the interest rate is much higher than either domestic growth rates, profit rates or the growth rates of exports.

In this case external borrowing becomes a constraint on growth and development and can only produce recurrent financial crises.

Not only should developing countries not accept external finance in these conditions, developed countries should not provide it.

Thus, external flows can be used to increase the resources available for development only if it is recognised that they are inherently linked to trade through export capacity and market access, and that increased exports can only support external financial flows if interest rates are below the potential rates of increase in productivity and profitability in the projects that they finance.

The major difficulty that is faced by developing countries in using trade and external flows as sources of resources for development is that the current regimes governing international trade and finance do not allow a country direct control over the size or use of capital inflows, nor the composition of its import and export basket, while interest rates are set by conditions in the developed country markets.

The multilateral financing institutions serve to ensure that the developed countries have the unrestricted right to invest in developing countries, and that developing countries adopt the policies necessary to ensure that they repay the lending, without consideration for the impact on net resources flows or domestic resources. The World Trade Organization (WTO) ensures that developed countries have free access to developing country markets, without concern for the impact on import composition or export capability.

Since the consequences for net resource flows to developing countries are not the primary concern of any of these institutions, and the decisions of developed country financial institutions and multinational companies that engage in international production and trade are not concerned with these issues there is little likelihood that either trade or external finance can become sources of increased net resources flows to developing countries by simply reinforcing free multilateral trade and free international capital flows.

[* Prof.Jan Kregel is a senior economist and financial expert at the UN Conference on Trade and Development. The above is based on a presentation by him at a panel session in Bogota, Colombia, last week during the Latin American and Caribbean Regional Consultation on Financing for Development, organized by ECLAC]. .

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