Towards the Next Generation of Newly Industrializing Economies: The Roles for Macroeconomic Policy and the Manufacturing Sector

Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 376

March 1990

TOWARDS THE NEXT GENERATION OF NEWLY INDUSTRIALIZING ECONOMIES: THE ROLES FOR MACROECONOMIC POLICY AND THE MANUFACTURING SECTOR

Catherine L. Mann

NOTE: International Finance Discussio circulated to stimulate discussion and publications to International Finance Discussion Papers (other than an

acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors.

n Papers are preliminary materials critical comment. References in

ABSTRACT

In the 1970s, the Newly Industrializing Economies (NIEs) emerged from the pack of developing countries by exporting manufactured goods. Some succeeded and some did not. In this decade, another set of developing countries are poised to become the next generation of NIEs. Which have the prerequisites of stable macroeconomic policies and the foundation for further manufacturing development? A review of the Latin and Asian NIEs’ experiences suggests criteria against which we can measure countries of the next generation.

Macroeconomic criteria include: the savings-investment imbalance, but also their levels; fiscal deficit and the sectoral allocation of government spending; the magnitude and change in domestic and external exposure to interest payments on debt; the variability, degree, and duration of misalignment of the real exchange rate. But macroeconomic stability, while necessary, is not sufficient for sustained growth and development.

A robust, competitive manufactured goods sector is also key. A growing manufactured goods sector increase the flexibility of the economy to respond to external and internal shocks and is associated with higher per capita income growth. World trade in manufactures is growing faster and at relatively better and less votatile terms of trade than trade in commodities. Criteria such as labor productivity in agriculture and manufacturing, population growth rates, and changes in the share of production and exports of manufactured goods provide evidence of which

countries of the new generation can take advantage of the manufacturing

dynamic.

Towards the Next Generation of Newly Industrializing Economies: The Roles for Macroeconomic Policy and the Manufacturing Sector

Catherine L. Mann?

I. Introduction

In the 1970s, the Newly Industrializing Economies or NIEs emerged from the pack of developing countries by exporting manufactured goods. During the decade of the 1980s, the development trajectory of some of these NIEs flattened as poor international conditions interacted with faulty macroeconomic policy; remember that originally Argentina, Brazil, and Mexico were designated NIEs, just as were Hong Kong, Singapore, South Korea, and Taiwan. In this decade, another set of developing economies stand apart as having the potential to become the next generation of successful NIEs; in addition, some of the original NIEs have corrected domestic policies and are poised for renewed growth. Among these countries which appear to have the both the prerequisite of stable macroeconomic policies and the foundations for further manufacturing development? Of course there can be no conclusive answer since the international environment remains in flux and domestic policies can quickly unravel. But examining data for the successful and unsuccessful original NIEs points to what combination of factors help

create an environment conducive to development success. Against this

1. The author is a staff economist in the Division of International Finance of the Board of Governors of the Federal Reserve System of the United States. This paper represents the views of the author and should not be interpreted as reflecting the view of the Board of Governors of the Federal Reserve System or other members of its staff.

This is the text of a lecture given for the program "The Global World Economy, Europe 1992, and Development Strategies" sponsored by The Center

for Applied Studies in International Negotiations, Geneva Switzerland, November 1989.

backdrop we can examine data for the potential "next generation" countries and judge which might lead its peers into the 21st century.

The paper is in five parts: First the importance of and foundations for a stable macroeconomic environment will be illustrated using data for the Asian and Latin NIEs. Key also is the sectoral distribution of government spending as this supports infrastructure (human and otherwise) for technological advance and development of the manufacturing sector. The next section examines macroeconomic and sectoral policies in a sample of next generation countries in light of this analysis. Section IV discusses why manufacturing is critical to a sustained development path. Manufacturing creates complex linkages through the domestic economy and is a laboratory for human skill and technology acquisition and refinement. In addition, manufacturing diminishes the effects of international shocks by contributing to higher overall growth, although it does not eliminate economic cycles. Section V addresses some of the policy questions associated with a development strategy based on manufacturing. For example, should the government target manufactures, particularly exports? Could there be a negative impact in international goods markets from many manufacturing-based development strategies? Given the unfavorable environment of international finance and protectionism, how can a country succeed in manufacturing development?

The overall importance of macroeconomic stability is established doctrine by now, given the history of the 1980s. But what evidence is there for a pivotal role for manufacturing in the development process? Chart 1 shows annual average growth rates for several groups of

developing economies for the decades of the 1960s, 1970s and 1980s. The

os! co as a 4+ HL

iP]

YT

NS OOO my oN

2a

CHART 1

GDP GROWTH 1960-87

ALL DCs -- All developing countrtes LAC -- Latin America and the Caribbean SSA -- Sub-Saharan Africa

4 NIEs -- 4 Asian NIEs

EXP MFR -- Exporters of Manufactures

See World Development Report 1988 for country classifications

C1 1960-70

= 1970-80

1980-87

four Asian NIEs, well known for their development strategy based on manufactured exports, have always out-paced the growth of other country groups. These data are most striking, but four countries are too few on which to base a policy recommendation. However, a much broader group of countries (the manufactures exporters, which includes countries with a share of manufactured goods in exports greater than 30 percent) also achieved high and increasing GDP growth rates in each decade. GNP growth rates increased for these countries even into the 1980s when the growth rates of all other country groups faltered. The exporters of manufactures is a diverse lot, including some countries such as Brazil (known more for its poor macroeconomic performance during the decade) and India (known more for its protection of domestic markets). Yet, the group as a whole did very well which suggests that a manufacturing base can partly compensate for failures in other areas of economic policy.

Chart 2 shows the relationship between growth rates of world output, world trade, export volume for all the developing countries, and export volume of the exporters of manufactures. Trade growth magnifies output growth; that is, trade growth rates evidence more cyclicality than domestic growth rates. Thus to a certain extent, the international environment introduces additional variability into domestic growth rates. Moreover, governments of the developing countries must deal with relatively more volatile trade growth than do the governments of the industrial countries.

Stressing manufactured exports does not insulate an economy from the cyclicality introduced through international trade. In fact, growth rates of manufactured exports are even more cyclical than are growth

rates of total export volume. So why encourage trade in manufactures?

3a

% Bs ify, { i

Ge6t ss PSBBL (CRG SCZ

io) 3) =

, 9 $Je

SIC] Yano’

a

JOCK

‘YPGOUL) ALUNIOA UO 2 am

) BINION Lodxy By

SUUITICWN SBI] PUOAA TY

INdINDG PULA |

AANITION 3AOVYL ONY LNdLNO GQ1IHOM

& LuVHO

OL

The growth rate of manufacturing exports has been substantially greater, often twice as great, as growth rates of all trade. Thus, while trade in manufactures does not reduce "risk" (that is, volatility in growth rates), it increases "return" (growth rates). Completing the capital market analogy, a higher risk portfolio will dominate a lower risk one if the higher risk one has sufficiently higher average returns. Thus, manufacturing is beneficial not because it insulates a country from economic cycles, but because it generates higher growth overall. Higher

growth creates the means for helping the economy through the cyclical

downturns. Il. Macroeconomics and Manufacturing -- Lessons from the NIEs

The history of the 1980s shows that countries that maintained stable macroeconomic conditions, kept exchange rates competitive, used international borrowing for investment and not consumption, and applied government funds to human and capital infrastructure development enjoyed faster and more sustained growth. Exporters of manufactured goods had the additional benefit (which was perhaps critical given the otherwise poor international environment) of being positioned to respond to burgeoning international markets for these goods. A quick review of the economic data for the original NIEs will bolster this view.”

In many ways the structure of production and the macroeconomic characteristics of the Asian and the Latin NIEs were not that different in the 1970s. The share of manufacturing in gross domestic production was about 30 percent for both groups. Both savings and investment rates

were about 5 percentage points higher in the Asian NIEs, although

2. The data shown in the text of the following paragraphs are in Tables presented later in the paper.

external borrowing as a share of GNP was about the same in both groups. However, significant differences in the characteristics of exports and in the borrowing instruments interacted with changes in the international environment to put the two groups on very different growth trajectories during the 1980s.

The Latin countries had the manufacturing capacity, but did not export manufactures. Primary commodity exports accounted for about 75 percent of total exports. In contrast, manufactured exports accounted for 90 percent of the exports of the less-well resource endowed Asian NIEs. During the 1980s, the terms of trade for manufactured goods improved by over 40 percent giving the Asian countries a massive terms of trade gain. Repaying external borrowing was easier and these countries could continue high rates of domestic investment without incurring additional debt. The Latin NIEs suffered a terms of trade loss making servicing debt that much more difficult. Why did the Latin NIEs not respond to the relative price change in favor of manufactured exports? These countries failed to maintain an exchange rate competitive enough to offset the less competitive industry that had developed in a protected environment; the Latin NIEs could not capture a piece of the rapidly expanding market for manufactures on their Northern doorstep (that is, the United States).

Compounding the terms of trade loss, the Latin NIEs took a further blow from the international environment. About 50 percent of the Latin debt was at variable rates, as compared to about 20 percent for the Asian NIEs. When LIBOR rose from 12 to 16 percent between 1979 and 1980, the debt service obligations for the Latin countries rose substantially

more than did the external obligations facing the Asian NIEs, to about 30

percent of exports. Moreover, the relatively lower savings rates in the Latin countries meant that after paying debt service, there were few internally-generated funds to spur the investment needed to produce manufactures competitively.

International shocks combined with different domestic policies and borrowing strategies propelled these two groups of NIEs along different paths. One wonders how things might have been different if the Latin countries could have turned their manufacturing capacity to exports: The two international shocks would have worked against each other instead of together. In the event, only perfect foresight and very determined policy by the Latin governments could have righted their economies. Instead government spending expanded to try to minimize the effects of the international shocks. Consumption rose and savings and investment rates dropped precipitously to about 15 percent of GNP.

Fiscal deficits were monetized, igniting inflation and further worsening the environment for investment. The result is the debt and growth crisis facing these countries.

Macroeconomic criteria

The experience of the Latin as compared to the Asian NIEs suggests criteria against which we can measure countries of the next generation. First the savings-investment balance is important, because of its implication for external indebtedness, but so are the levels. Sufficient domestic savings is an important buffer against changing availability of international finance. Robust private investment is important for manufacturing development that can respond flexibly to

changing international product demand.

Second, while fiscal imbalance does represent a drag on savings, zero balance should not necessarily be the objective. Both the size of the fiscal deficit and the use to which government spending is put are key determinants of whether a budget deficit is sustainable. Moreover how the deficit is financed has implications for inflation and determines the environment for private investment.

Third, the dynamics of interest payments means it is much harder to get out of a deficit once you are in it. Interest payments, especially those on external debt, rob the country of foreign currency resources. Interest payments on domestic debt magnify difficulties of achieving fiscal balance and distort domestic capital markets. In addition, highly variable payment streams probably contributes to macroeconomic instability. On the other hand, it is clear that productive use of borrowed funds can generate sufficient flow to repay debt. The moral is to use borrowed funds wisely, not to avoid borrowing.

Fourth, avoiding exchange rate misalignment is critical. Properly aligned and reasonably stable exchange rates are a barometer of macroeconomic policy, bolstering private domestic and foreign investment, as well as encouraging foreign lending. Misaligned exchange rate contribute to resource misallocation; even if manufacturing develops it will likely be inefficient and uncompetitive compared to international products. Since misaligned exchange rates ultimately cannot be maintained, additional resources will have to be expended to restructure those industries that developed behind the protective wall; these resources could be better put to new development, not restructuring. Moreover, competitive exchange rates give the proper

incentives to domestic consumers and help keep public industry efficient.

Sectoral criteria

Another lesson learned from the decade of the 1980s is that overall macroeconomic stability is a necessary but not sufficient condition for sustained growth and manufactures development. There are prerequisites for growth and spending in certain sectors that link into the macroeconomic objectives. First, development of the manufactured goods sector cannot come at the expense of agriculture. Agriculture must be efficient enough to release resources (both physical in the form of labor and financial in the form of savings) to support manufactures development. Thus, relative prices that promote balanced growth in both agriculture and manufactures yields superior growth in each and of the overall economy.

Second, one reason why a zero fiscal deficit may be an undesirable policy target is because the government should play a role in fostering an educated, healthy, orderly society, all prerequisites for overall growth and manufacturing development. Moreover, infrastructure with beneficial externalities for the manufacturing sector is a logical outlet for productive government spending.

Third, the financial system has the very important role in allocating borrowing and savings to projects in either the public or the private sector that will yield the highest return. But financial systems in many developing countries frequently are not independent of government or industry and may therefore be unable to efficiently allocate funds. (In some cases, banks are required to finance the government deficit; in other cases, banks are captive of industry.) Some countries have successfully intervened into the financial marketplace to allocate

credit. However, the record shows more failures from directed credit

than successes. An important ingredient in the successes was allowing a competitive fringe market, through a curb market or other forms of marketplace financing, as a necessary adjunct to targeted credit.

How do countries of the next generation compare when examined in light of the lessons learned from the NIEs? The countries designated "next generation" are a somewhat eclectic group which have shown development promise over the years (see Keesing, 1979; Balassa, 1971; and Bradford, 1987). Among this group, some will encounter development difficulties, while others not placed in this sample will undoubtedly emerge as successful manufacturers with fast, sustained growth. But looking at data for a subset of this sample will help focus on what are the key economic variables and, more importantly, why.

IIl. Macroeconomic Performance in the Next Generation

One of the first lessons of the NIEs in the 1980s was that both the investment-savings balance mattered (because of its consequences for external borrowings) and their levels (because low levels might imply insufficient internally generated funds for development or insufficient investment to support manufacturing). Table 1 shows the average investment and savings shares of GNP for three time periods -- 1965-1973, 1973-1980, and 1980-1987.

Data for selected NIEs are shown in the upper part of the Table. Korea's development strategy, one of the most successful of the original NIEs, depended initially on external finance. In the 1965-1973 period, investment outstripped savings, although savings rates were not particularly low. Over the course of the 1970s, both investment and savings shares rose dramatically, although external borrowing remained a

a high share of GNP until the late 1980s. During the 1980s, productive

9a

‘sazeoM snojtiea ‘jid0day juUeudoTSAeq P[aAOM ‘yue_G p[AJoM :a0anos ejeqg

2°47 8°SE 6'TE 7°12 Z°7€ T'TEe eTenzouspy L°6 €°Il 0°21 8°2T L°ST 0°21 Aensnin O'ST 8°€T 0° €T 7° SZ G'SZ 8°12 eoTY eBqsoo 0'9T 0°61 8°ST 6°61 8°8T 6°81 eT quotoo Lil ioral 6°11 7° LT €'LT €' 71 eTTYO eoTsAouy ut 3e', T° 82 4°67 9°72 6°7E 1°82 €°7 eTskeley 6°72 9°42 L°€t 0°82 c' 7 8°ST ey souopuy L°02 6°12 1’ 2 Z°SZ 6°92 €°%7Z pueT Tey etsy qseq T'2 9°€Z 8° LT 62 6°62 €°€2 etstuny, L°41 4° OT 9°€T L°@ 9°SZ 0'ST ooD010W : uPpsUPIAIATpPOW Z°9T HEL 2°11 €°1Z 9°02 8°ST eyuey T41s L’€l 9°TT ‘eu SLT c'LT T'91 ueqsTyed eT sv YyaAnos 8°7- 24 ‘e'u GST Cc’ LT L°4yT [edouess €'8T OT 2° LT T'°SZ 2°92 9°22 eAuay BOTAZV UoTIeAVUSH JFXON PaJo9TVS T'2Z S'02 6° VT 7° EZ? 2° 4% 9°02 OOTXOW 0°0€ L°SZ 9° LT 7° O€ OTE 6°€2 eaI0y 8°2 2°22 6°9T C42 Ct 7° 8T eTpuy O°LT €°61 T'61 L°61 6°€2 €'12 [Tze1g SHIN [eUFSTIO peaoe ToS L861T-O861T O86T-EL6T €L6T-S96T L861-O861 O861T-€L6T €261-S96T

SsuTAeS [BUOTIEN SSOI5D FUSij SOAUL OTjSsowog SSsOr5

(dN) JO Queorzed ‘se8ereae [enuur) s8uyaes pue quseujssauy

T GTavVL

investment in place contributed to a rising savings rate which allowed Korea to repay the debt borrowed earlier and still invest. The less successful development programs of Brazil, Mexico, and India had systematically lower savings and investment rates. As a share of GNP, the savings-investment imbalance was smaller for these countries, so that external borrowing was not so large. But it appears that investment was either insufficient or inefficient and thus has failed to create the additional savings needed to repay the debt.

Looking at the bottom panel, the next generation countries fall into three groups: (1) those with high saving and investment, with a moderate gap to be filled by international debt (the East Asian countries); (2) those basing their development strategy squarely on external finance with robust investment but lower rates of domestic savings (Kenya, Sri Lanka, Morocco, Costa Rica); (3) those avoiding borrowing or borrowing but not investing (Senegal, Pakistan, Chile, Uruguay). The first group is basically following the pattern of the successful NIEs, although with less reliance on external funding. Given the cost of international borrowing, this probably makes sense. The second group is much more dependent on external borrowing to finance investment. This puts a premium on investing in sectors and enterprises that can generate the surpluses to finance repayment. In the third group, the low levels of investment should cause some concern. How can these countries create the surplus to repay debt if they do not invest?

One determination of the gross domestic savings rate is the size of the fiscal deficit. The righthand set of columns in Table 2 show the central government deficit as a share of GNP for two years, 1972 and

1987. For some of the group (2) countries, a key reason for the dearth

10a

TABLE 2

Government Spending

Share of Central Gov't Expenditure Share of GNP Education Health Deficit 1972 1987 1972 1987 1972 1987

Selected Original NIEs

Brazil 8.3 n.a. 6.7 n.a -0.3 -13.3 Korea 15.8 18.3 1.2 2.3 -3.9 0.5 India 2.3 2.7 1.5 1.9 -3.4 -8.1 Mexico 16.4 8.7 5.1 1.3 -2.9 -9.5 Singapore 15.7 18.2 7.8 4.1 1.3 1.4 Selected Next Generation Africa Kenya 21.9 23.1 7.9 6.6 -3.9 -4.6 Mauritius 13.5 12.4 10.3 7.6 -1.2 0.2 EEE South Asia Pakistan 1.2 1.6 1.1 0.9 -6.9 -8.2 Sri Lanka 13.0 7.8 6.4 5.4 -5.3 -8.9 Mediterranean Morocco 19.2 16.9 4.8 2.9 -3.9 -9 3 Tunisia 30.5 n.a. 7.4 n.a. -0.9 n.a. eee East Asia Thailand 19.9 19.3 3.7 6.1 -4.2 -2.3 Indonesia 7.4 8.8 1.4 1.5 -2.5 -0.9 Malaysia 23.4 n.a. 6.8 naa. -9.4 -8.2 Sr Latin America Chile 14.3 12.5 8.2 6.0 -13.0 0.1 Costa Rica 28.3 16.2 16.2 19.3 -4.5 -4.8 Uruguay 9.5 7.1 1.6 4.8 -2.5 -0.7 Venezuela 18.6 19.6 11.7 10.0 -0.2 -2.1 All Developing 12.2 10.4 5.9 4.6 -3.5 -7.7

Data Source: World Bank, World Development Report, various years.

-11-

of domestic savings and the greater dependence on external finance is the size of the fiscal deficit -- see Kenya and Sri Lanka for example. On the other hand, Pakistan and Malaysia, countries with very different savings and investment profiles, also have high fiscal deficits, suggesting that the link between external borrowing and fiscal spending is not immutable. .

Some of the next generation and several of the original NIEs have experienced rather unstable fiscal shares, starting out with large deficits in the 1970s that have been reduced over the period. See Brazil, India, Mexico, Sri Lanka, Morocco, Chile, for example. While controlling budget deficits is laudable, where the budget gets cut is also important. Comparing the two lefthand columns to the righthand column in the Table suggest that countries that have had unstable fiscal shares may have more difficulty in maintaining investment programs in human capital with long-term payback -- in health and education, for example. Mexico, Sri Lanka, Morocco, and Chile have cut back substantially on the share of central government spending on health and eduction. The foundation for any development strategy, although particularly one based on manufacturing, is education and health. (Notice that these shares rose for Korea and Singapore.) So a drop in government spending in these two areas could be a bad harbinger. On the other hand, the efficiency of government spending cannot be discerned from these data. It is quite conceivable that lower rates of spending could be better targeted and yield superior health and educational delivery systems.

Just as human capital investment helps prepare the labor force

for manufacturing employment, government spending on capital

infrastructure can be part of industrial development. Research by

Shah (1988) suggests that profitability of private manufacturing investment in Mexico is positively associated with moderate government investment in infrastructure. Kahn and Reinhart (1989) emphasize that there are limits to the benefits of government investment. For a set of 24 developing economies, they show that real economic growth is positively correlated with the share of private investment to total investment. But their data also show that even countries with the highest growth have had at least 20 percent of total investment accounted for by government investment. Moreover, a high share of private investment does not guarantee high growth. Clearly, efficient allocation of funds to private industry as well as efficient construction and operation of those firms are key. Thus, providing an economic environment conducive to investment and assuring that private and public investment is responding to the proper pricing and allocative signals is important.

External debt service obligations can impact the domestic environment for investment and can affect the allocative signals of the real exchange rate and real interest rate. To repay international debt and stay on a postive growth trajectory, countries must affect two reallocations -- one internal between consumption and savings and one external between domestic demand and exports -- while at the same time maintaining investment. For different countries, one or the other (or both) transfers has been the more difficult. Table 3 shows external debt service obligations as a share of GNP (as a measure of the internal transfer) and as a share of exports (as a measure of the external

transfer) for three years, 1970, 1980, and 1987.

12a

“SOTQRL 349d PTIOM ‘YUeG plTiom :eo1nog eqeq

7°27 WL €°€T o's 6° £°0 eTenzoue, 9°97 9°S 7°21 OZ L°1Z L°t Aen3nig Tet c'4 8°9T c*4 0'OT 6°2 BOTY BIS00 L°O€ o'd 6°8 9°T 9°IT LT BT quozoo T'1z 0'8 6°12 ZS 2°61 T'€ eTTYD eoTAouy uTIeyT €°9T Z°0T c'2 9°T 8'€ L°T eTskeley TL O'T 9°4 €°0 "etu ‘Bru eutyo 6°L2 Z°8 6°L 77 o'Z 6°0 eT Souopuy 9°€T 2°47 o's 1 ev€ 9°0 pue[ Tey] etsy q3sey PSF T'%7% 6°6 6OT o's T8T L’y eTstuny 7° €2 18 T'L2 8°9 0's 9° 1 oD0010R uPsUPATEITpOW T'9T ZS L°s TZ 8°OT TZ eyuey Tas 7° LT °€ Set c*z 2°12 6°T ueqsTyeg etsy yqnos SY YNOS Z°9 €°t 8°S O'€ Z€ vt sntjTaney Z°1Z T°9 8°6T Z°9 6°72 8°0 Tedeues 8°82 c°9 €°2T L’€ 079 o'z ekuey BOTAZV UoTyersUSy IKON poyoopes 7° T 7°? O'T €°Z 9°0 L°0 erzodesuts T'0€ 7°9 T'2E a) 9°€2 6°T OoTXOW 6°92 7° OT €°2T 9°” S61 O'€ Pa10y 6°9T el TL 9°0 S12 60 eTpuy L°9% 72 9°7E cE S21 6°0 l}zeag

SHIN [PUTSTIO posssyes

SyIOdNy JOY IND joy Syr0dxq JO % IND JOR syq0dxG JO %Y IND JO 7 Z861 0861 Ol6T

sqazodxq Jo % ‘aNd Jo x SUOTIBZTTGO eOTAIeS Aqeq Teuz94xY

€ WIdvL

For countries where external debt service is a high share of exports (for example, Brazil, Mexico, Kenya, Senegal, and Colombia) the external transfer problem is the more acute and may affect government policies toward the exchange rate which then affects investment. When external transfer requirements are high, the foreign currency constraint binds and governments try to avoid exchange depreciations. But exchange rate overvaluation makes investment in export industries look unprofitable, thus exacerbating the foreign currency constraint and encourages inefficient investment in import-competing industries. Finally, overvaluation may create expectations of a devaluation and put pressure on domestic inflation, leading to greater uncertainty in the environment for domestic investment.

For some countries, in addition to the foreign currency transfer problem, there is the problem of raising sufficient funds through domestic savings to finance debt service. A high debt service to GNP ratio implies a need to reduce consumption so that domestic savings can be transferred to external creditors. To maintain investment rates implies a still greater contraction in consumption. Korea, Morocco, Tunisia, Indonesia, Malaysia, and most of the Latin American group have a dual problem of affecting both internal and external transfers. It appears that Korea, Malaysia, and maybe Indonesia and Tunisia have increased savings sufficiently to affect the internal transfer, and exported enough to affect the external transfer while still maintaining investment rates.

The burden of external debt increased much more quickly for some of the next generation countries than for the others. Rapid changes in

debt burdens make it more difficult to keep macroeconomic policy on

track. The external transfer problem worsened quickly for Korea, Kenya, Tunisia, Indonesia, Malaysia, Colombia, Venezuela. The change in the internal transfer burden was striking for Korea, Mexico, Senegal, Morocco, Indonesia, Colombia, Venezuela. Reducing consumption to affect the internal transfer is difficult, and countries may borrow instead, which worsens both problems. This might have been the case for Mexico, Colombia, Venezuela.

The real exchange rate is one of the key allocative mechanisms for investment and consumption. Chart 3 shows real exchange rates for several regions of the developing world. Given the behavior of growth rates across the regions (Chart 1) it appears that the level of the real exchange rate, the duration of misalignment, and perhaps also short-term volatility matters for growth. Africa was misaligned for longest and subsequently sustained the largest real depreciation, although the change for Western Hemisphere (predominantly Latin American countries) is on the same order of magnitude. Clearly, producers, investors, and consumers in these two regions faced very large relative price changes during the 1980s. For investors, choosing product type or plant location was difficult. For firms operating under the conditions of an appreciated exchange rate in the early 1980s, the transition to the lower exchange rate required substantial restructuring or resulted in bankruptcy. Consumers saw living standards plummet. Moreover, the massive realignment of exchange rates is unlikely to yield immediate results. It takes time for investors to recognize what industries are competitive at the new exchange rate, even more so as investors are likely to wait to ;

see whether policies and lower real rates prevail. The Western

Hemisphere real exchange rate dipped and bobbed several times during the

14a CHART 3

REAL EFFECTIVE EXCHANGE RATES

DEVELOPING COUNTRIES

130

120 * Western Hemisphere

110

Middle East “A a f~

90

Europe

80

70

60

50

1979 1980 1981 1982 1983. 1984 1985 1986 1987 1988

' Real effective exchange rates are calculated on the basis of consumer price indices.

SOURCE: IMF, World Economic Outlook, Apri] 1989

1980s, for example. Overall, it is not surprising that investment and growth rates in the 1980s were lowest in in Africa and Latin America.

One indication of whether the environment is conducive to domestic investment is whether foreign investors find it attractive. Foreign investors respond to the same allocative Signals and are as concerned about the long-term health of the economy as are domestic entrepreneurs. While foreign investors may face relatively more government interference, they may have a more ready source of financing. Table 4 shows the pattern of net private direct investment. In most of the NIEs, foreign direct investment increased even as the current accounts started heading into surplus. Two exceptions however point to the importance of the regulatory environment (India) and the macro environment (Brazil) for discouraging direct investment flows.

The data for the next generation countries also show how direct investment inflows mirror other policies. Some of the more stable next generation countries show increased net direct investment inflows and increased reliance on foreign direct investment to finance external deficits. See particularly Indonesia, Thailand, Colombia, Costa Rica. In other countries, such as Morocco, Tunisia, Kenya, Malaysia, direct investment increases until the mid 1980s when macroeconomic imbalances Started to derail economic growth and net direct investment flows fell. Some of these countries are back on track and direct investment has picked up again. In all cases, direct investment flows are an important source of external financing.

The quality of the labor force is one factor that contributes to the investment environment. This is particularly difficult to measure

and its relationship to government policies in the sectors of education

15a

“SOTqel PTAOM ‘yUe_ PTAOM :e0An0g eReqG “eoueTeq QunoooR Ausetino eaTatsed qQuew3ne smo[J 20U eATIATSOg + “@oueTeq QUNODSe JusrTINS sATIeS9U USSTOM SMOTJF JOU sATIeZEN -

6°T 12 “e+ 90T . “Ot 98 “T+ GS “61+ 817 - €?c- eT enzousepj

- C- - 8 - - 9 - 4° Ov 062 ‘e'u ‘eu e'u ‘eu Aen3nig

ce LT 9 €'12 G9 L°9T GS el 87 L°T€ 69 L°€€ 97 BoTY e3S09

“LET + 67€ o°9¢6 9TOT T'LT TTS 9°72 IS co’ 61 €€ LTT 6¢ eT quoT[op

T Tt 46 Loy cg BIT 6ST 78 OLT c OL 0S - 6L- eTTYyoD PoTouy uTQeT EEE OV TPT

“LOE + CLS L°176 669 T9€ T9ZT 0°70€ vE6 8°OL IS€ “GLTT+ 76 BTsAelTeW

“9L6+ 699T 0°6 TEOT T'9T €7G 8°T LS ‘e'u ‘eu ‘eeu Btu euTtyo

€°02 TAs] T' 91 OTE 9°47 C60 7°9 Ost 6° 9LY 1°22? €8 eTsouopul

ele OLZ €°OL O9T T'?1 87E 7°83 98T G’e€ (ZG Cc’ YT €v pueTTeuy eTsy 3seyg ee SVS

6' 26 76 8° EZ OvT O'LE €22 T'9L 9€7¢ G°92 GY o°8T 9T etstuny,

8° 7E + LS oS 02 T's 97 8°S 68 “0. 0 0° CT 02 Od0010W uBsUPITTZITpep SSS PUP TTOITPOW

T's 62 van Se 0°9 BE 7'C €v ¢°29 69 me) 0 eyuey Tag

1°8 c9 (jn) 8Z o°ST 62 a9 cL O'T II €’e €? ueqAsTyAed eTsy yanos eee SV HN'G

“T9 + 7Y L°97 8 T'6 4 “0 T “TI+ (4 “Od+ Z sntqtTaney

- os- - €- - 9€- €'Z El 9°8T 91 cil ¢ Tedaues

(98) 7'°T Le €°9 cl L°82 OS BL 82 CL OT (an yT eAuay BOTATV

uoTIeTIUS5 QXON pe zd9aTIS

“@8Tt+ 286 0°76S T68 €° 6ST 776 6° CL SETI 9° Cv 677 6°ST €6 erzode8uts

“€6 + 877E T° 16+ 0647 €° 6+ 067 €°9¢ 98T? 0°ST O19 7°62 ECE OoTxXeW

yp ot BTV 9°22? 002 - LS- - L- 8°? €s¢ €°6 99 eot0y

(on) €S2 Ov°€ O9T 7°Z €9 “0 8 0°0O 0 0°0O 0 eTpul

"7O + 7872 8° €T TSZ 6°SE 002 6° 6T 0S2 e'u e'u ‘e'u "Btu Zuoy Buoy

9°St 28S 0°79 L9ZT f° 02 PLET 0°?T v7CT O°LT O6TT €°L7 LOv [tzeag

SHIN [TPUrSTAQ peqosypes “% [oat x ToAoT % Teas, —T_— ToAoT Ys [SKST YF YSrst Z86T C86L €86L O86L SL6T OL6L

TeTOTFFO VTOFOq Junoooe QuerAno Jo Queorzed pue Tareq (SleTTOP “S'n Jo suotTTTw) JUSUASSAUT YOOATG os9eATAgG I9N

‘slejysuelg

% HIdVL

and health is difficult to discern. One economic measure is labor productivity. Table 5 shows labor productivity in the agriculture and manufacturing sectors. Increasing productivity in both sectors go hand in hand and are good signs of economic vitality. Korea, India, Pakistan, Thailand, and Indonesia have quickly rising productivity in both agriculture and manufacturing. In contrast, stagnant agricultural productivity seems associated with stagnant productivity in manufacturing as in the case of Kenya, Mauritius, Tunisia, Brazil, and Mexico. These data suggest that manufacturing productivity depends on a robust agricultural sector which in turn suggests that government incentives should be balanced and not favor one sector at the expense of the other.

Perhaps least amenable to government intervention but most important for the economic prospects of developing countries is population growth. Table 6 shows average population growth rates for two periods (1965-1980 and 1980-1987) for the NIEs and next generation countries. All of the NIEs had population growth rates that declined between the two periods. Some of the next generation countries have rising population growth rates.

Population growth rates as well as their direction over time are important harbingers of development prospects for several reasons. First, growth in GNP per capita is often used to gauge the current stage and degree of success of a development strategy. Simple mathematics shows that two countries with the same rate of GNP growth will appear to be headed along very different development paths because of their population growth rates. For example, a GNP growth rate of 6 percent per year is a quite respectable 4 percent per capita GNP growth if population

growth is 2 percent. If population growth is 4 percent, that same GNP

l6a

TABLE 5

Labor Productivity

In Agriculture —______In Manufacturing Food Production Per Capita Real Gross Ouput per Employee 1979 - 1981 = 100 1980 = 100 1985-1987 1970 1984 1985 1986 Selected Original NIEs Brazil 107 71 68 70 78 India 109 95 142 153 164 Korea 100 40 139 141 158 Mexico 97 77 111 109 104 Singapore 94 73 114 114 126 Selected Next Generation ~ Africa Kenya 93 38 93 94 96 Senegal 105 n.a, 96 102 103 Mauritius 103 139 96 80 74

>= anne ne

South Asia

Pakistan 105 51 150 164 179 Sri Lanka -- 70 111 135 n.a. Mediterranean Morocco 109 n.a. n.a. n.a. n.a. Tunisia 114 95 91 87 83 East Asia Thailand 107 68 133 138 140 Indonesia 117 42 138 157 186 China 124 n.a. n.a. -- -- Malaysia 126 n.a. n.a. -- -- Latin America Chile 104 60 n.a. -- -- Colombia 97 84 110 126 140 Costa Rica 92 n.a. 174 155 144 Uruguay 100 n.a. 112 108 107 Venezuela 93 118 111 109 106

Data Source: World Bank, World Development Report, various years.

16b

TABLE 6

Population Growth Rates

1965-1980 1980-1987

Selected Original NIEs Brazil

Hong Kong India Korea Mexico Singapore

FPWHNDND bh DrOWOF PNOrNHE PN Pore AND

Selected Next Generation Africa Kenya Senegal Mauritius

Hh w AW POs Our

eee South Asia

Pakistan Sri Lanka

Hw co rw oe

Mediterranean Morocco Tunisia

an

i) rw Np

_)S eeeeeSSSSSSSSSSSSSSSSSSSSSsSssSsSSSsesessssssSSSSSSFee East Asia

Thailand 2.9 2.0 Indonesia 2.4 2.1 China 2.2 1.2 Malaysia 2.5 2.7

Latin Americ Latin America

Chile 1.7 1.7 Colombia 2.2 1.9 Costa Rica 2.7 2.3 Uruguay 0.4 0.5 Venezuela 3.5 2.8 All Developing 2.3 2.0

Data Source: World Bank, World Development Report, various years.

growth rate turns into a much less impressive 2 percent growth in GNP per capita. Gross savings rates apparently are lower at low rates of growth in GNP per capita, in part because private savings is lower and in part because social spending is higher. High rates of population growth Squander gains made in the economy as a whole and push the country toward a low-level development path.

Several of the next generation countries have a serious problem with population growth rates. Kenya is a particular example, but Senegal, Morocco, Tunisia, and Malaysia have high and more importantly increasing population growth rates. In contrast, other next generation countries have made substantial progress in bringing population growth rates down to reasonable levels, most of the Latin countries for example. Some of these countries have struggled with macroeconomic imbalances; the lower population growth rates have helped solidify gains made in GNP growth rates to the overall benefit of the development strategy.

In summary, the record suggests that successful development depends on a stable macroeconomic environment where there is sufficient domestic savings to keep external borrowing within reasonable bounds ; where the rate of investment is high enough and invested efficiently so as to provide a high enough return to both repay debt and reinvest; where relative prices, particularly the exchange rate, are "correct" and play an important allocative role: and where government spending on social and physical infrastructure supports private investment, not competes with it. But how does manufacturing play an important role in the development strategy? And does this mean that manufacturing development should be

fostered at all costs?

IV. Manufacturing and the importance of international markets.

A development strategy should be balanced across sectors, particularly including agriculture. As noted by the labor productivity measure, manufacturing is not likely to be robust if the agricultural sector is not healthy. But manufacturing does play a key role in development and productivity in primary commodities is not enough for development success. Research Suggests that manufacturing encourages complex internal linkages through the domestic economy. The ensuing dynamic increases skill levels and encourages further investment in flexible technology. These are honed and strengthened by manufacturing for export to international markets. Another important feature of international markets is that relative prices of manufactured exports are less volatile, world demand for manufactures is more robust in the face of recessions, and world trade in manufactured goods is increasing in value as compared to the markets for primary commodities.

The foundation of the manufacturing dynamic is "learning by doing". Amsden’s research (1983, 1986) suggests that the NIEs created a comparative advantage in skill-intensive goods partly by educating the labor force and partly by allowing small private enterprise to flourish. Skill-intensive goods are relatively labor intensive, but lie somewhere between rote assembly and automated output. Production may be introduced via licensing, joint ventures, or foreign direct investment, or homeoriginated based on a perceived market need. Even if initially foreign, domestic producers tailor the products and production technology to best fit local conditions. In this tailoring process, workers improve skills in production, engineers learn about product design and production

technology, and managers learn about marketing and plant organization;

all of these improve the competitiveness of the next generation of products produced by the firm. Moreover, these operational and organizational skills learned in the skill-intensive sector diffuse through the economy as auxiliary enterprises develop.

The manufacturing dynamic is important regardless of the level of development. or the endowment of resources. In fact, research presented in Figure 3.7 of the World Development Report 1987 indicates that the positive relationship between rate of growth of GNP per capita and valued added in manufacturing is highest at lowest levels of income per head. This suggests that the poorer countries have the most to gain, in terms of GNP per capita growth rates, from the process of industrialization. Moreover, research presented in Box 3.3 in the same Report shows that countries of similar size and similar levels of resource endowments have systematically higher per capita GNP levels if the country pursues an industrialization strategy instead of relying on primary commodity wealth for growth.

Amsden suggests that the most important international markets for skill-intensive goods are the developing country markets. This may be because, in comparison to goods traded between the industrial and the developing country markets, product demand characteristics (product type, quality, after-sales-service) in developing country markets are relatively similar. Linder (1961) originated this hypothesis to explain patterns of trade in similar products between the industrial countries. He suggested that countries with similar factor endowments and level of development have broadly similar tastes and trade differentiated products

because local firms cannot satisfy minority tastes efficiently.

There are two rationales for an international focus for any development strategy incorporating manufactures -- price efficiency and production efficiency. Competing against international prices encourages proper resource allocation and relative price efficiency across sectors within an economy. This is true whether products are exports competing outside the domestic market or domestic goods competing against freelytraded imports to the domestic market. Second, since many developing economies are small, tapping international demand through exports encourages efficient scale of production. Expanding the scale and scope of production furthers the diffusion of skills throughout the economy and contributes to the manufacturing dynamic.

However, integrating into international markets can magnify domestic business cycles. Chart 2 noted the greater cyclicality of international trade volume. Another source of international variability is changes in the international terms of trade. Chart 4 shows changes in the terms of trade for developing countries according to different classifications of exports: non-oil, manufactures, primary commodities. Also shown is the terms of trade for the Asian NIEs.

Primary commodity exporters faced massive changes in their terms of trade over the 1980s. Even without the other events of the 1980s, it would have been very difficult for government policies or the private sector to smooth such big swings. Of course the more common experience was that windfalls accompanying a boom financed new programs which were not cut back when the boom faded; they instead became key components of the fiscal deficits. Volatility in the international terms of trade

makes the challenges to government policy and the costs of policy failure

that much greater.

Terms of Trade

Developing Countries

20a

CHART 4

SUDIJOP “S'Q Ul YUSedUed

1981 1982 1983 1984 1985 1986 1987 1988

1980

NIEs

A

primary

©

mfg

non—oil

o

The substantially smaller swings in the international terms of trade facing manufactures exporters were an important element aiding policy stability and growth in these countries. Moreover just as Chart 2

< noted an overall increase in the growth rate of international demand for manufactured products, there was also an overall improvement in the manufacturing terms of trade during the 1980s.

To take advantage of domestic and international demand for manufactured goods, the composition of production and trade in a country needs to be increasingly industrial. Successful industrialization, the diffusion of the skill-intensive learning process throughout the economy, seems to be associated with increasing shares of more complex and highervalued added products -- from lower-technology textiles to highertechnology machinery. This transition shows evidence of production flexibility, that labor and capital are mobile or can be retrained and reinvested. Production is not rigid but can be shifted to meet changing product demands. Countries evidencing changing patterns of production and export would seem to be in a good position to exploit international markets.

Both the composition of production and of trade are important. Countries whose industries have developed in an environment of international competition are likely to show structural change in both the composition of production and of trade. Countries following an inward-looking development strategy based on protected industrialization might show the transition to an increasing share of manufactured goods in total production but will not likely show any increase in the share of manufectured goods in exports. These data would not indicate successful

manufacturing development since protected industry is less conducive to

fostering skill development and the manufacturing dynamic. Countries that show structural change primarily in exports could be seeking to redress the inward-focus of an earlier industrialization strategy.

Table 7 shows the composition of manufacturing production for 1965 and 1987. Table 8 shows the composition of merchandise exports for 1970 and 1987. As expected, the NIEs to a greater or lesser degree show increasing shares in the production and export of high-value-added products such as machinery and transport. Virtually all of the next generation countries show substantially increased shares of othermanufactures in exports (after all, this is partly the basis for the sample of countries). But only some of the countries show changes in domestic production patterns consistent with balanced industrialization for domestic and export markets. Mauritius, Thailand, and Malaysia have undergone substantial restructuring of domestic production from agriculture into textiles and clothing and even into machinery and transport over this 16 year period. Most of the Latin countries have had little change in the structure of production over the 16 year period, but have altered the pattern of exports to focus increasingly on manufactured exports. This may indicate internal restructuring within the manufacturing sector from inefficient, inwardly directed production to more efficient, outwardly directed exports. Such restructuring uses investment funds that could have been used to create higher-valued added production, increasing the skill level of the economy. Nevertheless, there is learning in the restructuring. Once completed, these countries will be better able to compete in international markets.

Since the international markets can play such a major role in

the industrialization process, an important question facing exporters of

22a

‘saeek snoyiea ‘JxrOdeYy JueuddTeAeg pli0n ‘yUegG pTazoH :e9o0anog e3eq

Tl 8 6 6 8 €l €Z O€ eBTenzouay OT 9 8 l 8T TZ 6c 7 Aen3nin OT l 9 9 Ot ZI LY 8Y BOTY B3S09 €l Tl 8 8 yI 02 7 TE eBTquioToo 8 S 4 Il l ZI LZ LT eTTyO PoOTASUy uT Rey See OFT OUTY UTIET yT 6 €Z 8 S € 12 92 etskeley OT - 92 - €T - €l - eutyo OT - OT - Tl - €Z - eTseuopul 9 9 yT 6 LT €l O€ ev pueTTeyL eTsy 3seq See SSP ET €T l 7 61 8T LT 62 etstuny Tl - OT - 9T - 92 - odD010W . uUPSUPIASRTpoW ees NP OUHATOITPOW - Tt - OT - 61 - 92 eyue] Tas ral 6 8 9 TZ BE vE "2 ueqsTyeg eTsy yanos ee eeeeeeeeeeeeSSSSSSSSSSSSSSSSSSSeeeeeeeeee BS ANOS V7] € € c 6€ 9 SE GL snTjTaney LZ 9 9 Z ST 61 84 TS yTesoues 6 l vT 8T al 6 SE TE ehucy BOTATV uof AersVUIs 4XON PPVIITIS 8 ” 94 8Z S S 9 ral etodeZuts rat Tl aT €1 rat SI 72 82 OoTXEW 6 Tl 72 Tl LT LT ST 92 eor10y z Z 02 9T Ov Ty 9 % suoy 3uoy St v1 92 0z 9T TZ Il €T etpul 6 OT 72 a4 ral €T ST 9T [rzeag SHIN [PU}STAO padooTeS 986T OZ6T 9861 OZ6T S861 OZ6T 986T OZ6T sTPoTwey) 9 DO

(seoTad quezino ‘!peppe entea jo aazeys) uoftjonporzg Buyanqoezynuey Jo uoFazsoduog

Z ATavL

‘saeef snojiea ‘Fxodsy JusudoTeaseq PTsoM ‘yueg p[zoM :e02no0g e3Keq

TT S TY LT 9T v4 SoTajunon suTddojTeacg Ty eu 0 9 Z z 0 eTenzousy LT 4 TY G € 0 Aen8n1ign eu c €€ ST L T BOTY e3809 7 z 02 3 iH 6 STqWoTOS 0 0 9 v € I eTTYO eoTowy utqey eee FOF FEW UTIET € 0 €T 4 LZ 4 etske[eW eu eu 99 ev V7] € euty9 S 0 02 T € € eT seuopuy 8T 0 TY? 7] el 0 pueT Tey eIsy 3seq eee SSP 62 4 GS 61 9 0 eTstTuny, 9T T 84 S I 0 oo0010W uPourI19jIpey eee PUTTER TPOW SZ 0 Be T rd 0 eyueyT Fas 2 TY 62 79 ce € I uejsTxeg Q eBTSY YInos “I eee ES IMO eu 0 BE 0 4 0 snTQ Taney eu T TT z 7 T Tedoues eu 0 ST 9 @ 0. ekusy BOTAZV WoTyeTSUSy JXON poroopas 9 9 62 02 €¥ Il erode3uts 4 € 61 ST 82 T OoTXEW G2 Le 6S 9S €¢ € Pot0y 9T 9€ 6S 8 OT T eTpul 7€ oy OZ 18 2 9 Buoy Suoy € T 82 rh LT r4 [rzerg SHIN [PUTSTIO poyooyos L861 S96T

SOTTIXOL YOTYM FO

sjiodxq esypuryortey Jo uoyzayzsoduog

8 Y1dVL

manufactured goods is how receptive the international marketplace is for their exports. Table 9 shows income and price elasticities for exports (total and manufactures only) of different developing country groups to different regions of the world. The income elasticity of developingcountry manufactures exports to the industrial world (line 1) is greater than that for all exports to any group (2.91 on line la), and compares favorably to income elasticities for trade between the industrial countries (which are in general around and below 2.0; see for example in Marquez, 1988). Looking at individual markets (line 2), except for the Japanese market, the income elasticity for developing-country manufactured exports is well above 2.0. These elasticity estimates imply that a 1 percent increase in GNP of these industrial countries yields a 2 percent increase in export volume of the developing countries. Moreover, since income elasticities for industrial country and developing country exports to the industrial markets are overall similar, it suggests that the developing-country manufactured exports are not inferior goods and

are not obviously discriminated against in the industrial-country

markets.

However, the income elasticity of developing-country manufactured exports to the developing world is low -- below 1.0 (line lb). As developing countries grow, they import proportionately less from

other developing countries as compared to how much the developed countries import as they grow -- this is after correcting for different GNP values. This is opposite to what Amsden suggests should be the case to achieve maximum "learning by doing". Two possible explanations for the lower income elasticity both suggest that developing countries can

benefit from increased trade among themselves. The type of manufactured

23a TABLE 9 Estimates of Price and Income Elasticities

for Exports of Developing Countries to Regions of the Norld

Developing Country Exporting Group Price , income to Importing Group Elasticity Elasticity

1. Manufactures Exporters

a. to Industrial -0.83%** 2.91%** b. to Non-oil Developing -0.37 0. 85%** 2. Developing countries manufactures to Canada -3.06* 2.06* to Germany -0.84* 3.38%** to Japan -2.36* 0.74 to U.K. -0.53 2.70%** to U.S. -1.26%** 2.96%* 3. Asia manufactures to World 0.00 1.35%** Europe manufactures -0.25* 2.32%* to World Western Hemisphere -0.61* 4. 54%* to World

* significant at the 10%, ** at the 5% confidence interval.

Source: 1) Bond, M., "Export Demand and Supply for Groups of Non-Oil

Developing Countries," IMF Staff Papers, 32:1 (1985).

2) Marquez, J. and C. McNeilly, “Income and Price Elasticities for Exports of Developing Countries," Review of Economics and Statistics, forthcoming.

3) Bond, M., "An Econometric Study of Exports of Manufactures from Developing Countries," IMF Working Papers WP/87/55, International Monetary Fund, 1987.

goods that developing countries trade with each other may have lower income elasticities than the goods they trade with the developed world. Diffusion of manufacturing skills through auxiliary units in the domestic economy is aided by producing for both domestic consumption and for export; producing goods that only developed countries can (or want to) purchase limits this diffusion. The lower income elasticity may also reflect import protection in the developing countries against just the kinds of manufactured goods that are most suitable for developing country markets. Tariff rates in the developing countries are much higher than in the industrial countries and the developing countries also use quantitative restraints. Protecting against manufactured imports leads to production inefficiencies within the country and also chokes-off opportunities for the developing countries to grow and prosper together through intra- industry trade in manufactures. Price elasticities for some of these directions-of-trade indicate the importance of keeping the real exchange rate competitive. A price elasticity of -1 indicates that al percent increase in export prices would yield a 1 percent decline in export volume, so no change in nominal éxports. Non-zero price elasticities mean that a country could “vary the international price of the product without an offsetting change in volume. The point is not that countries should strategically change prices, but that these empirical estimates suggest that misaligned exchange rates (which are a determinant of export prices) can have important consequences for export demand and external balance. How much do the developing countries as a group lose by limiting

trade among themselves in manufactured products? Trade patterns can be

crudely divided into two types -- Heckscher-Ohlin trade and intraindustry trade. Heckscher-Ohlin trade is the familiar trade pattern generated by a trade theory based on differences in endowments. Products embody the factor resources of the economy and dissimilar products are traded for each other by economies of dissimilar factor endowments. By contrast, intra-industry trade is in products with similar factor embodiments. It is generated by economies of scale in production and taste differences within a country. Intra-industry trade is primarily in manufactured goods and is observed particularly between countries with relatively small-scale markets. Intra-industry trade has expanded faster as a share of total trade beginning at least in the 1950s. Countries pursuing strategies of producing for domestic and export markets in manufactured products have risen the tide of increased world demand for differentiated manufactures.

Table 10 shows estimates of the importance of Heckscher-Ohlin type variables and intra-industry type variables for total trade of the industrial and the developing countries. Three trade directions are shown: trade between the industrial countries (column 1), trade between the developing countries (column 2), and trade between the industrial and the developing countries (column 3). The Heckscher-Ohlin type variables proxy for differences in factor endowments (physical capital intensity, human capital intensity) and similarities in "tastes" (per capital income, inequality in per capita income). The intra-industry type variables proxy for characteristics of product and production (product differentiation, marketing costs, economies of scale, industry concentration, off-shore assembly). Other variables proxy for conditions

of the trading environment (trade protection, trade area, language).

25a

“T°6 ®TIPL

yst [sug LET‘2

TS?7°0 96T TT- L£SL°C1- LOT’ €@ TOT T

SEC E- €18°c-

STI ¢- OOT?

€cl'0 c6E 0

sadnoiy OM, out

ueeMjeg opery

‘Spooy peanjoegnuey UT Suxeajeg Sper uysuey)

‘peqou se

esen3nj10g ‘ystueds ‘youeagq ‘yst{3uq VLIVI €6E °C T€8'?T- 7L6°T- 767° 62 LéL'0

OTE *Z- 7L8°7@

9S0°2 T70°%

€€2'°0 TSO0°O

SOTAJUNOD BUTAOToAdg suouy epeay

(41 3e QueoTsTusTs {Te “squUeTOTJJe00 uoTsse13e1) Spooy psanjoeynuey ut epeay ArAsnpuly-eazquy pue eperzl UF TYO-rA9syoOsyooy

ueTAeuTpUROS ‘uPwIeED ‘youerg ‘ysT [sug VWldd ‘Oa

O00OT "2 6726 °8- 0L0°6- 000°02 702 °T

8ST '€- 702°2

L£ST'Tetl T

92T'0- 8LT'0

SOTIVUNGD PodoToAeq suowy epery

OU ATAVL

‘suemneg pue essetTeg wor peadopy :aoanos

‘e8en3uel 10 were epeaq WUSOTFFOOO QueOTJIUSsTS seqeotpuy x

xOZeNZuLy] xPOTe Oper UOTIEQ{UATAO apeal

ATquiesse art0ys-Jjz0 uoTIeAQUeD.UOD ArQAsnpuU] aTeOs Jo satuouclg Sj{sod BulTqey1eW UuOFIeTIUSTeTFJTP Aonporg

Aqt[enbeut suoouy awooUuy

AjTTenbeuy ewoout yeaqtdeo leg ewuoouT Teqtdeo azeg

Ajysuequt Teqtdeo ueumy AqTsuequtT Teqtdes [eotsdug

STqeTIER

Comparing the coefficients on the Heckscher-Ohlin proxies between the three columns indicates that many of the Heckscher-Ohlin factors are relatively more important in trade between the industrial and the developing countries than they are for trade within either of the two groups -- physical capital intensity and degree of income inequality, for example. This is as expected according to the basis of the Heckscher- Ohlin theory.

Intra-industry trade factors are important determinants of trade patterns within each group. Note particularly the importance of intraindustry factors for trade between the developing countries. The coefficients on economies of scale and off-shore assembly are greatest for trade between the developing countries. Product differentiation is somewhat less important in intra-developing country trade than it is in intra-industrial country trade. These estimates support the hypothesis that developing countries can gain from trade in manufactured goods, and particularly so with their own neighbors.

Protection contracts trade and trade openness increases trade regardless of the direction of trade. Trade openness is significant in all markets, indicating the overall importance of trade policies for affecting the level of trade. But comparing coefficients suggests that increased trade openness by the developing countries would increase intra-developing country trade by more than it would increase trade between industrial and developing countries. These coefficients are elasticities and therefore do not measure which of the markets is most important in absolute magnitude; undoubtedly the industrial market is

more important in value terms. Nevertheless the results suggest that

developing countries’ trade would benefit a great deal from market opening measures in developing country markets.

Other factors, such as regional affiliation and cultural similarity further support the hypothesis that manufactures growth is supported by trade to other developing-country markets. Whether an official organization is necessary or geographical closeness is sufficient to encourage trade in manufactures is not clear.

Results reported in Tables 9 and 10 suggested that intradeveloping country trade and particularly intra-industry trade in manufactured products are key sources of growth in international trade for the developing countries. What does the trend in intra-developing country trade and intra-industry trade between the developing countries look like? Chart 5 shows intra-developing country trade as a share of their total trade with the world for five annual observations over a 25 year period and for six categories of manufactured goods.

Intra-developing country trade is a very important trade pattern, but it has declined in the 1980s. In a number of important categories of high-valued added manufactures (chemicals, machinery and transport, and iron and steel), the developing country markets account for 40 to 50 percent of developing country trade flows. However, in most product categories, while intra-developing country trade flows increased in the 1970s, they have dropped off in the 1980s. The developing country increasingly turned away from their own markets to the markets in the industrial countries during the 1980s. This is a partly a reflection of the robust growth of manufactured imports into the United States and the

stagnation of much of the developing world during the 1980s. But it is a

LDC Trade with LDCs

as a share of LOC trade with World

27a

CHART 5

SO EO RE 3

OO KOSS 2

kL aa ke ae bee x

SE NSNENENENENENE NENTS 5

ZL OZ PPP s

A

2

E

2

3

LO OKONO: S

SOROS 5

Viki uuu dbz S

SEK S

A A A A A 2 OOOO ON ONO

SERBS LR RE RO EY E

UL uu eae Lu aa 2

RS SOAS SQ ROSSA LLL L LL ZL 77

VA

SKN an

all

0.6 0.5 0.4 0.3 0.2 )

@PD4} JO}O JO JUeduaed

1985

4

KX

be

V7 1975 KAJ 1980 [XZ] 1983

[X_]} 1970

trend that goes counter to the direction which would yield the greatest percentage increase in trade flows of manufactured goods,

Some countries did increase intra-industry trade with other countries in the developing world. Chart 6 shows the index of intraindustry trade for trade between East Asian countries and the other developing countries. An index number of 1.0 indicates that 100 percent of the trade flows between two trading parties (in this case, East Asia and the rest-of-the-developing world, and adjusted for trade imbalances) was in similar products. It would appear that one element in the success of the development strategy of the Asian NIEs was maintaining high levels of intra-industry trade with other developing countries. In all of the manufactures categories, 60 percent or more of the trade between East Asia and other developing countries was trade in similar products. Moreover, intra-industry trade between these two groups rose during the turbulent 1980s.

In summary, production and trade in manufactured products, particularly trade with other developing countries, appear to have been key elements in the success of the original NIEs. Next generation countries that create an environment conducive to investment in business and labor which nurtures the manufacturing dynamic at home and penetrates markets abroad, not just of the industrial countries but of their

neighbors as well, are in the best position to succeed in the 1990s.

Intra—Industry Trade East Asia with Developing Countries

28a

CHART 6

COOOL OOOO OL

OCCA CO. CAAA AM SXLGSGGKGEG MI (ZIP IP IPI COEOCOCOOCOO OES

NS A CEOCCO CO OCOCCOL LR LEE LEE SSCLGLGKLECESEK UZ PIP IPP CEECOOCOe COOOL [—LLLLE EE LE EE SVLSGGGEGESK ZL IL IP IP IDO VEC CCC OEE ECC CS PL TP PIP TDI I

m a ~ © a : ) : fo) ro) ro) fo) fo) fo) ©) ro) fo)

apos} Aajsnpul—djur jo xe pur

iron/steel

KX 1985

tex/app

[XZ] 1983

oth/mfg

RNAI 1980

mach/trans

V7 1975

chem

[X_] 1970

V. Policy Issues

The conclusions of the previous sections on the prerequisites of macroeconomic policies and the importance of manufactures lead to some policy questions. Some have a domestic focus, others international. The selection of policy issues discussed here is, of course, hardly exhaustive. (1) Given the importance of manufacturing development, should a country follow a targeted industrial strategy using export subsidies and import protection? (2) How can countries achieve manufactures growth in the current international environment of reduced international capital flows? (3) If all developing countries follow a manufactures-oriented development strategy, will the international terms of trade in manufactures turn against all of them? (4) Protectionism and regionalism are on the increase worldwide, in both developing- and industrial-country markets; how can a manufacturing drive succeed?

(1) The record shows virtually universal failure when countries have tried to force the manufacturing dynamic with industrialization at all costs. This is because hand-in-hand with the objective goes excessive taxation of other sectors of the economy (frequently agriculture), excessive and thus inefficient government and private spending, excessive and poorly allocated domestic and international borrowing, and inappropriate exchange rates.

Even when an development strategy is balanced between industry and other sectors of the economy, governments that attempt to “pick (manufacturing) winners" usually fail. There are very few industries for which export subsidies or import protection are economically sound policies based on arguments such as economies of scale

or infant industry. Moreover, research on "“directly-unproductive

activities" points to political economy reasons for avoiding special treatment of particular industries.

More important than targeting winners, government policies should concentrate on maintaining a stable and favorable environment for investment and growth, in particular, a competitive real exchange rate. This is the most important price signal for consumption and for domestic and foreign investors.

(2) The deterioration in the flow of bank capital to the developing world puts a premium on domestic savings. Fiscal deficits kept within reasonable bounds contributes to public savings. Private savings is enhanced by a stable environment and growth and some sort of financial arrangement that returns a positive rate of return. Most of the factors that contribute to domestic savings will also attract foreign capital. The role for foreign direct investment should not be understated.

(3) The basic point of the theory underlying intra-industry trade is that countries trade manufactured products with each other. Thus growth in one country based on exports of one type of manufactures should yield greater demand for other manufactured products which can be the exports of another country. In the data as well, the evidence is that the international terms of trade in manufactures improved over the last decade even as a number of successful new exporters entered the world trading arena.

In a world where trade among countries in manufactured goods is key, there is a premium on correct price signals and good

understanding of the target market. "Market niches" in trade are most

important, which may imply reliance on international marketing agents or expatriates in order to penetrate markets.

(4) Trends in protection are a cause for concern. In the industrial countries (and even in some of the successful NIEs), protection is frequently given to products in which a country is losing comparative advantage. These are often the products in which the next generation of NIEs could excel and which help spark the manufacturing dynamic. By the same token, each developing country that protects its home market reduces overall the opportunity for intra-developing country trade. The policy issue that all governments need to analyze is what is the basis for protecting domestic markets and what are the costs.

Second, developing country governments need to be seriously involved in the Uruguay Round of Multilateral Trade Negotiations. Much of the Uruguay Round goes well beyond tariff negotiations: issues of trade in services and complete revamping of the rules for trade in agriculture and textiles are being discussed and are important areas for interchange between the industrial and developing countries. But protection facing the developing countries in other developing-country markets are more often than not tariffs. The CATT has a long and very successful history of tariff negotiations. A very important part of developing country participation in the Uruguay Round should be the developing countries discussing with each other how to improve the

environment for intra-developing country trade in manufactured goods.

- 32 -

References

Amsden, Alice H. "’De-Skilling’, Skilled Commodities, and the NICs’ Emerging Competitive Advantage". American Economic Review, 73:2

(1983).

. "The Direction of Trade -- Past and Present -- and the ‘Learning Effects’ of Exports to Different Directions". Journal of Development Economics, 23:4 (1986).

Balassa, Bela. The Newly Industrializing Countries in the World Economy. Pergamon Press: New York, 1981.

and Associates. The Structure of Protection in the Developing Countries. Published for the World Bank and the Inter-American Development Bank by The John Hopkins Press, Baltimore, 1971.

and Luc Bauwens. Changing Trade Patterns in Maunufactured

Goods: An Econometric Investigation. North Holland: New York, 1988.

Bhagwati, Jagdish. Foreign Trade Regimes and Economic Development:

Anatomy and Consequences of Exchange Control Regimes. Published by Ballinger Publishing Co., Cambridge for National Bureau of Economic Research, 1978.

Bond, Marian. "Export Demand and Supply for Groups of Non-Oil Developing Countries". IMF Staff Papers, 32:1 (1985).

- "An Econometric Study of Exports of Manufactures From Developing Countries". IMF Working Paper WP/87/55, International Monetary Fund, August 1987.

Bradford, Colin I. Jr. "NICs and the Next-Tier NICs as Transitional Economies", in Colin I. Bradford Jr. and William H. Branson eds.

Trade _ and Structural Change in Pacific Asia. The University of Chicago Press: Chicago, 1987.

Clavijo, Fernando and Riccardo Faini. "Differentiatin Cyclical and Long- Term Income Elasticities of Import Demand". PPR Working Paper WPS 197, World Bank, May 1989.

Edwards, Sebastian. Exchange Rate Misalignment in Developing Countries. World Bank Occasional Paper no. 1/New Series. Published for the

World Bank by The Johns Hopkins Press, Baltimore, 1988.

. Real Exchange Rates, Devaluation, and Adjustment: Exchange Rate Policy in Developing Countries. MIT Press: Cambridge, 1989.

Fishlow, Albert, Jean Carriere, and Sueo Sekiguchi. Trade in

Manufactured Products with Developing Countries: Reinforcing North-South Partnership. Report of the Trilateral Task Force on North-South Trade to the Trilateral Commission. Triangle Papers no. 21, The Trilateral Commision, 1981.

International Monetary Fund. World Economic Outlook. April, 1989.

Kahn, Mohsin S. and Carmen M. Reinhart. "Private Investment and Economic Growth in Developing Countries". IMF Working Paper WP/89/60, International Monetary Fund, July 1989.

Keesing, Donald B. "World Trade and Output of Manufactures: Structural Trends and Developing Countries’ Exports". World Bank Staff Working Paper no. 316, World Bank, 1979.

Krueger, Anne 0. "Growth, Distortions, and Patterns of Trade among Many Countries". Princeton Studies in International Finance'‘no. 40, International Finance Section: Princeton University, February 1977.

Linder, Stephan B. An Essay on Trade and Transformation. John Wiley:

New York, 1961.

Mann, Catherine L. "Lift-Off: The Next Generation of NICs". The International Economy, 2:6 (1988).

Marquez, Jaime. “Income and Price Elasticites of Foreign Trade Flows: Econometric Estimation and Analysis of the U.S. Trade Deficit". International Finance Discussion Papers no. 324, Federal Reserve

Board, 1988. and Caryl McNeilly. "Income and Price Elasticities for Exports of Developing Countries". Review of Economics and

Statistics, forthcoming.

and - "Can Debtor Countries Service Their Debts? Income and Price Elasticities for Exports of Developing Countries". International Finance Discussion Papers no. 277,

Federal Reserve Board, 1986.

Shah, Anwar. "Public Infrastructure and Private Sector Profitability and Productivity in Mexico". PPR Working Papers WPS 100, World Bank, September 1988.

World Bank. "Adjustment Lending: An Evaluation of Ten Years of Experience". Policy and Research Series, no. 1, 1988.

- World Development Report 1989. Oxford University Press: New York, 1989.

—__.. World Development Report 1987. Oxford University Press: New York, 1987.

- World Tables. Various years.

—_- World Debt Tables. Various years.

United Nations. International Trade Statistics Yearbook.. Various sbternational jlrade Statistics Yearbook.

years.

IFDP NUMBER

376

375

374

373

372

371

370

369

368

367

366

365

364

363

362

- 34 -

International Finance Discussion Papers

TITLES 1990

Towards the Next Generation of Newly Industrializing Economies: The Roles for Macroeconomic Policy and the Manufacturing Sector

The Dynamics of Interest Rate and Tax Rules in a Stochastic Model

Stock Markets, Growth, and Policy Prospects for Sustained Improvement in U.S. External Balance: Structural Change versus

Policy Change

International Financial Markets and the U.S. External Imbalance

Why Hasn't Trade Grown Faster Than Income? Inter-Industry Trade Over the Past Century

Contractionary Devaluation with Black Markets for Foreign Exchange

1989

Exchange Rate Variability and the Level of International Trade

A Substitute for the Capital Stock Variable in Investment Functions

An Empirical Assessment of Non-Linearities In Models of Exchange Rate Determination

Equilibrium in a Production Economy with an Income Tax

Tariffs and the Macroeconomy: from the USA

Evidence

European Integration, Exchange Rate Management, and Monetary Reform: A Review of the Major Issues

Savings Rates and Output Variability in Industrial Countries

Determinants of Japanese Direct Investment in U.S. Manufacturing Industries

AUTHOR (s)

Catherine L. Mann

Eric M. Leeper

Ross Levine

Catherine L. Mann

Deborah Danker Peter Hooper

Joseph E. Gagnon Andrew K. Rose

Steven B. Kamin

Joseph E. Gagnon

Guy V.G. Stevens Richard A. Meese Andrew K. Rose

Wilbur John Coleman II Andrew K. Rose

Jonathan D. Ostry

Garry J. Schinasi

Garry J. Schinasi Joseph E. Gagnon

Catherine L. Mann

Please address requests for copies to International Finance Discussion Papers, Division of International Finance, Stop 24, Board of Governors of the

Federal Reserve System, Washington, D.C.

20551.

IFDP NUMBER

361

360

359

358

357

356

355

354

353

352

351

350

349

348

347

346

345

- 35 -

International Finance Discussion Papers TITLES

The U.S. and U.K. Activities of Japanese Banks: 1980-1988

Policy Rules, Information, and Fiscal Effects in a "Ricardian" Model

A Forward-Looking Multicountry Model: MX3

Implications for Future U.S. Net Investment Payments of Growing U.S Net International Indebtedness

U.S. Policy on the Problems of International Debt

International Economic Policy: The Role of Exchange Rates

An Econometric Analysis of UK Money Demand in Monetary Trends in the United States and the United Kingdom by Milton Friedman and Anna J. Schwartz

Encompassing and Rational Expectations: How Sequential Corroboration Can Imply Refutation

The United States as a Heavily Indebted Country

External Debt and Developing Country Growth

An Algorithm to Solve Dynamic Models

Implications of the U.S. Current Account Deficit

Financial Integration in the European Community

Exact and Approximate Multi-Period Mean-Square Forecast Errors for Dynamic Econometric Models

Macroeconomic Policies, Competitiveness, and U.S. External Adjustment

Exchange Rates and U.S. External Adjustment in the Short Run and the Long Run

U.S. External Adjustment:

Progress and Prospects

AUTHOR(s)

Henry S. Terrell Robert S. Dohner Barbara R. Lowrey

Eric M. Leeper Joseph E. Gagnon Lois E. Stekler William L. Helkie Edwin M. Truman

Edwin M. Truman

David F. Hendry Neil R. Ericsson

Neil R. Ericsson David F. Hendry

David H. Howard

Steven B. Kamin Robert B. Kahn Ross Levine

Wilbur John Coleman IT

David H. Howard

Sydney J. Key

Neil R. Ericsson Jaime R. Marquez

Peter Hooper

Peter Hooper

William L. Helkie Peter Hooper