Ryan Pitylak



Effects of Globalization on the Poor








Ryan Pitylak *

University of Texas - Austin



May 4th, 2006




Many contribute globalization to the downfall of the poor across the globe.  However, globalization can be pro-poor if a government implements the correct policies and institutions.  Although many countries have failed during their globalization process, these experiences provide any developing country with substantial information about how to avoid their problems during globalization.  Globalization is a process, and as such, requires careful decisions along the way.  Several examples of once-developing countries exist, and these countries are models for any developing country that is globalizing.  Avoiding globalization is not an option, because countries that have taken this route, such as Sub-Saharan Africa, are in a terrible state.



* Supervised by Dr. Valerie Bencivenga, Economics Department: University of Texas in Austin.

(1) Globalization Defined

Globalization can, and has been, defined many different ways.  The way that globalization used herein is consistent with the Kearny index of globalization.  Kearney/Foreign Policy Magazine created a database to determine how globalized 62 different countries are, and covers eight different regions of the world.  Table 1 shows the globalization index for 2005.

The four components that determine the extent to which each country has globalized are economic integration, personal contacts, technology, and political engagement.  Foreign Policy Magazine tracked each country throughout the past decade.  They chose these components because they are effective proxies of economic growth, world inequality, and world poverty. 

The calculations used to determine economic integration are: 1) trade, which is the sum of imports and exports; 2) foreign direct investment inflows and outflows; 3) portfolio capital inflows and outflows; and 4) net factor income paid to foreign factors of production.  Economic integration increases income inequality.

Personal contacts consist of international phone traffic, international travel and tourism, and cross-border capital transfers, such as bank loans, securities or aid, and remittances, which are defined as transfers of money by workers to their home countries.  Higher personal contacts reduce poverty.  The technology component is an aggregate of the number of internet users, internet hosts, and secure internet servers.  Both personal contacts and technology transfers decrease income inequality among people within a country.  The number of embassies in the country, the number of memberships in international organizations, and the number of UN Security Council missions undertaken during the year determine the political engagement statistic.  Political engagement is not correlated with Poverty or inequality with statistical significance.

Table 1

Source: Kearny (2005), from “Measuring Globalization,” Page 55


Economists disagree about how to weight the components of globalization.  Heshmati (2004) analyzed the Kearny index from 2002 and 2003, and he believes that the Kearny index weighs political and economic integration too highly.  The Heshmati index places a higher weight on technology than the Kearny index does.  Table 2 shows globalization by region according to the Heshmati index.  The Heshmati index ranks the Eastern Asian region higher than the Kearny index because Heshmati places a higher weight on technology.  Heshmati ranks Sub-Saharan Africa almost last because of its low levels of technology.  Table 2 shows the decomposition of each region, and its ranking.  Both indexes rank globalization based on the first three principal components (PC1), which are economic integration, personal contacts, and technology.  Larger PC1 numbers represent more globalization.


Table 2

Source            : Heshmati (2004)


(1.1) The Effects of Globalization

There are still a significant number of people living in poverty.  Table 3 contains data on the poverty levels by region.  A staggering 1.1 billion people live below the poverty line, which is defined as US$1, adjusted for PPP (Chen and Ravallion (2004), rewritten by Nissanke and Thorbecke (2005)).  It is unacceptable for this many people to be living in poverty.   


Table 3

                                                            2001 Poverty Statistics, using poverty line of $1 (1993)

                                                            Total               HCI Poverty   Headcount                

                                                            Number          Number          Index (HCI)     Poverty          

                                                            (millions)        (millions)        (percent)        gap*   

Sub-Saharan Africa                          524                  241                  46                    20

East Asia and the Pacific                 1747                245                  14                    3

South Asia                                         1351                432                  32                    7

Eastern Europe                                461                  14                    3                      0.8

Middle East and North Africa          222                  4                      2                      0.5

Latin America and the Caribbean   499                  50                    10                    3

*Poverty gap gives the aggregate income shortfall as a percentage of aggregate consumption.


Source:  World Bank (2006)


Heshmati (2004) finds that globalization reduces poverty. However, globalization only explains 9% of the variations in poverty across 62 different countries. Heshmati also finds that globalization reduces inequality by increasing the income or consumption of the poorest 20%.  However, globalization only explains 11% of the variations in income inequality.

Globalization can reduce poverty because it acts as a filter that magnifies the impact that institutions and policies have on the poor (Heshmati (2004)).  The outcome of globalization for the poor depends on the quality of economic institutions and policies (Bardhan (2004a)).  Therefore, if a country has sound policies are institutions, globalization can positively affect the poor.

The effects of globalization are difficult to isolate from other effects that have had significant impact on the poor.  However, some effects of globalization have been isolated, and follow:

1)      Capital saving technological change, which can be pro-poor if the poor are able to learn the technology, if skill-biased company demands more goods that are produced by unskilled, or if skill-biased company creates intermediate inputs that are used by an unskilled;

2)      Labor saving technological change, which is pro-poor because, in developing countries, it increases the marginal productivity to unskilled labor;

3)      Volatility of income, prices, or output in the short-run, which is bad for the poor, unless policies and institutions are implemented that to enhance macroeconomic stability;

4)      Extreme volatility for primary commodities, which is bad for the farmers that produce primary commodities, but is mixed for the poor who consume primary commodities because their prices, although volatile, are less expensive;

5)      Sector creation that can provide jobs for the poor;

6)      Potentially lower tariff rates, which can have an extremely positive pro-poor impact;

7)      Capital flows, which are pro-poor if the money is foreign direct investment, but are bad for the poor if the money is speculative (unhedged short-term capital attempting to make gains from arbitrage);

8)      Capital flight, which is bad for the poor, can occur unless there are regulations to regulate interest rates, ensure full disclosure of information, avoid moral hazard, avoid over-lending, and avoid lending to risky loan applicants.

Safety nets, such as education, health, and welfare reform, should be provided for the poor during trade and financial liberalization.  These institutions create an opportunity for those who are living in extreme poverty to learn skills that will increase their marginal productivity, and therefore their wage.   The redistribution of wealth, such as asset ownership for the poor, targeted lending, progressive taxes, and consumer subsidies, is also considered a safety net that can be used during crises or volatile times to help protect the poor from the cruelty of extreme poverty.  One drawback to a solution that provides safety nets to the poor is that targeting the losers from trade can be difficult.  Even though this may be difficult, targeted safety nets have been successful in different countries, such as South Korea and Taiwan. 

If redistribution is necessary to correct some of the short- and medium-term effects of globalization, then several methods of redistribution are possible.  Dagdeviren et al (2001) lists the different redistribution methods that can be used: increased asset ownership (such as land ownership by the poor, investment in infrastructure that are used by the poor), targeted lending, targeted education, progressive taxes, and consumer subsidies.  Some of these redistribution techniques will not work for low-income countries.  For example, low-income countries will have a hard time implementing minimum wage, targeted income, or wage subsidy programs, whereas middle-income countries will have more success with these programs.  Table 4 lists the different programs and their effectiveness.  Pressure must be placed on the governments in developing countries to provide the proper redistributive methods, in the short-term, that do not deter incentives that would have otherwise created a strong economy.  If redistribution is provided over the long-term, the incentives to become globally competitive are thwarted, and people will always require handouts.  People need to become self-sufficient, and therefore, redistribution must not carry into the long-term.

Table 4

Source: Dagdeviren et al. (2001)


The consensus among economists is that globalization can be pro-poor if the proper institutions and policies are in place.    Globalization can lead to lower poverty levels, but the proper preconditions (sound policies and institutions) must be in place, and maintained, so that the poor are not made worse.


(2.0) Trade Liberalization and Growth


Trade liberalization is one of the major steps in the globalization process because it leads to trade with other countries. The connection between trade liberalization and poverty must be divided into the impact of trade liberalization on growth and the impact of growth on poverty. 

Trade liberalization is important because trade should lead to growth, and pro-poor growth can have a dramatically positive impact on poverty reduction.  Trade leads to growth by increasing the price of the abundant factor, which is labor in developing countries, and by boosting total factor productivity growth (Frankel and Romer (1999), from Nissanke and Thorbecke (2005)).  Trade liberalization increases the price of labor according to the Heckscher-Ohlin theorem.  Trade liberalization boosts total factor productivity growth, which is output growth not caused by the growth of labor or capital inputs, because of technological innovations that increase the marginal productivity of an input.


(2.1) Volatility of Income or Prices after Trade Liberalization


Trade liberalization can lead to volatility in income or in the prices of goods.  Macroeconomic shocks, which can take many different forms, such as public budget mismanagement, balance of payments mismanagement, currency and banking crises, and hyperinflation, create this volatility (Montalbano et al. (2005)).  The World Bank (2000) reports that the people in the Central and Eastern European countries have a harder time smoothing consumption during time periods of volatile output (Montalbano et al. (2005)).  The poor typically do not have the ability to handle large shocks to consumption prices, and therefore volatility that leads to lower consumption levels harms the poor.  Volatility appears to be worse in developing countries whose policies and institutions are not as sound as they are in developed countries.  Initially after trade liberalization, countries with low GDP levels should expect some volatility, but this can subside in the long-run if trade leads to growth and therefore higher GDP levels.  Volatility is worse for primary commodities

During times of macroeconomic crises, when income levels are low, consumption levels are also low.    The poor in developing countries have a limited ability to save, and therefore, lower consumption levels can push people into poverty or extreme poverty.  The poor in developed countries have the ability to save, and therefore are better able to smooth consumption during volatile times.  Because the poor in developing countries are affected by consumption volatility more significantly than the poor in developed countries, my discussion focuses on the poor in developing countries.

GDP growth and volatility is available for selected countries in Figure 1.  The coefficient of variation measures the ratio of the standard deviation to the mean.  This coefficient of variation therefore represents how volatile a country or region is, compared to the mean volatility of all countries.  Higher coefficients of variation mean higher volatility levels compared to the mean.  On average, countries with lower GDP levels experience higher volatility (Montalbano et al. (2005)).  Trade can lead to growth, and therefore higher GDP levels.  Eventually, higher GDP levels will lead to lower levels of volatility, and therefore the exposure to volatility that trade liberation creates can be offset, in the long-run.

There is conflicting evidence regarding whether macroeconomic policies and institutions can minimize the volatility.  Sindzingre (2005) argues that institutions may not be able to protect the poor from the effects of external shocks (such as volatility in the price of inputs).  The Western European countries, which have better macroeconomic policies and institutions than developing countries, have less volatility during trade shocks (Montalbano et al. (2005)).  The disagreement about the impact of sound policies and institutions appears to stem from the differences of macroeconomic policies and institutions among countries.  Sound macroeconomic policies and institutions are preconditions to globalization that should minimize the exposure to volatility from trade shocks. 

Forward-looking policies should be created to enhance macroeconomic stability.  These policies should support the trade liberalization process, work to decrease the impact of trade shocks on the domestic economy, and create coping mechanisms for whenever there are shocks, such as safety nets for the poor.   Governance of the trade liberalization process should be emphasized to ensure that policies are created which will limit the impact of shocks.  During volatile times, social safety nets must be established before liberalizing trade so the poor are not pushed into extreme poverty. 

In developing countries that produce primary commodities, increased terms of trade volatility has a negative impact on growth because increased volatility raises uncertainty, which leads lowers desired investment (Winters et al (2004)).  Since growth can have a positive effect reducing on poverty, the negative impact on growth hurts the potential for reducing poverty. 


Table 5


Coffee                                     Sugar                                      Cocoa

Uganda            97%                 Cuba               90%                 Ghana             75%

Burundi            89%                 Mauritius          90%                 Nigeria             74%

Angola             88%                 Guyana            60%                 Ivory Coast      39%

El Salvador      85%                 Swaziland       48%

Ethiopia           71%                 Jamaica          44%                 Tea

Colombia         70%                                                                 Sri Lanka         58%

Haiti                 70%                                                                 Kenya              31%    


Source:  Bencivenga (2005) from Kasliwal (1995)


Figure 1

Source: Kozul-Wright and Rayment (2004)


Countries whose main exports are primary commodities have exposure to terms of trade volatility.  Most developing countries are primary commodities exporters when they first open themselves up to trade; see Table 5 for details showing that the countries that are primary exporters are developing countries.  The income elasticity of demand for primary commodities is lower than manufactured goods.  The Prebisch-Singer hypothesis states that the terms of trade will hurt exporters of primary commodities over time because exporters will not be able to purchase as many imports.  An example of this problem was the price of corn, which is a primary commodity, in Mexico post NAFTA.  Farmers were exposed to world corn prices, and once international corn prices fell, the corn farmers in Mexico were hurt badly.  A report by UNCTAD (2004) states that increased trade of primary exports does not lead to reduced poverty in developing countries (Sindzingre (2005)).

Trade liberalization must be implemented slowly so that markets that are exposed to world prices can diversify into different goods or markets (Winters et al (2004)).  The best way to mitigate the terms of trade concern is to diversify away from exporting primary commodities.    Exporting manufactured goods has worked well for the East-Asian countries over the past few years. 

If price volatility causes prices to get too expensive, then social safety nets, such as deferred payments or subsidized inputs, may be provided so that producers can smooth production, and therefore smooth output.  These should only be considered as short-term solutions because long-term safety nets will impede incentives.

Increased competition leads to lower prices.  Lower prices, even though they may be volatile, are ultimately better for the consumer.  In addition, if there are many suppliers of a particular good, then consumers are no longer subject to the decisions of a limited number of suppliers. 

Those who are just above the poverty line are net producers of primary commodities, and therefore are hurt by the fall in primary commodity prices.  This can have an adverse effect on absolute poverty because more people may be below the poverty line than before trade.  However, lower prices of primary commodities will have a positive effect on the extreme poor because they are net consumers of primary commodities (Winters et al (2004)).

Minimizing volatility not only requires sound institutions and policies, but it also requires countries that already have bad policies and institutions to implement reform carefully.  Government purchasing programs are prime examples of programs that should be removed.  In West Africa, the official purchasing of cocoa was eliminated and price volatility in the short-run increased (Winters et al (2004)).   Increased price volatility decreases consumption smoothing, which is bad for both consumers, who will have to pay variable prices.  Increased price volatility is also bad for producers, who will have to receive variable prices.  However, the short-run price volatility is better than the possible long-term effects from government purchasing programs.  For example, some government sponsored Agricultural Marketing Boards implement price ceilings, which force farmers out of agriculture.  Government purchasing programs are an ineffective way to provide redistribution because they result in a dead-weight loss.  These programs should be avoided, but when they are already in place, they should be removed gradually and those affected by the transition should be provided safety nets during the short-run. 

Sound policies and institutions can minimize the volatility from trade shocks.  Safety nets should be provided for the poor who are unable to cope with the negative effects of volatility from trade shocks.  Safety nets, coupled with sound policies and institutions, will insure that globalization has the opportunity to be pro-poor.   Exporting products that have less exposure to world price fluctuations will also limit the volatility from trade.


(2.2) Tariffs and Subsidies

Trade is liberalized when tariffs and subsidies are reduced.  Negotiations among countries about changing tariffs and subsidies are slow.  No country wants to be at a competitive disadvantage from lowering its tariffs or subsidies before its trading partners lower theirs.  Unfortunately, the use of tariffs and subsidies create a suboptimal situation whereby resources are not used efficiently.  These inefficiencies hurt the poor. 

Without free trade, the developing countries remain too poor.  Trade can be advantageous for all participants because each country should produce the goods that it has a competitive advantage to produce.  A country has a comparative advantage to produce a good when it can produce the good cheaper than its trading partner can.  When country X (country Y) trades the goods that it has produced using its comparative advantage with country Y (country X), both countries gain because each countries is able to consume more total goods.

The Heckscher-Ohlin theorem predicts that trade will favor the abundant factor because a country will have a comparative advantage when it produces goods that use the abundant factor.  Goods that are imported use the scarce factor, according to the Heckscher-Ohlin theorem.  Therefore, when tariffs reduce the amount of goods imported in a developing country, consumers in the developing country have to purchase these goods from domestic sources.  These goods will cost more for the consumers, which can be bad for the poor if the cost of purchasing these goods is larger than the increased wage from producing these goods. 

In addition, according to the Stolper-Samuelson theorem, which predicts that an increase in the price of goods will lead to an increase in the price of the factor used intensively to produce those goods, the real reward to the scare factor (capital) will decrease and the real reward to the abundant factor (labor) will increase during free trade.  Therefore, high import tariffs depress the wages of unskilled laborers because wages do not raise to their free trade levels.

In the short-term, not all tariffs are bad.  Nissanke and Thorbecke (2005) argues that trade liberalization is the most successful when export promotion precedes import liberalization.  Export promotion occurs when export tariff rates are set low, when the exchange rate is undervalued, or when the government provides subsidies to firms that export.  This creates an incentive for domestic firms to produce goods for exportation.  The East Asian countries that followed this approach have had some success.  In addition, export promotion allows export producers to strengthen technological capabilities. 

Figure 2

Source:  Economist (2005d)

Larger gains to the people in developing countries would come from lower tariff rates than were discussed at the Doha WTO talks.  Figure 2 shows that the gains from free trade are larger than the gains from the tariffs and subsidies agreed upon at the Doha WTO talks. The World Bank estimates that "if trade in industrial and farm products were fully freed, the one-off gains from reallocating resources more efficiently could boost income in developing countries by $86 billion by 2015 and pull an extra 30 million people out of extreme poverty" (Economist (2005d)).  An agreement on free trade for services (from telecoms to legal work) and industrial goods would also lower poverty dramatically (Economist (2005b)).  The World Bank estimates that the gains from complete tariff reduction across all countries would result in $200 billion extra income world-wide, which would pull many people out of extreme poverty (Economist (2005d)).

Tariffs should be reduced in both developing and developed countries (Economist (2005c)).  Lower tariffs in developed countries will decrease poverty in developing countries because a large proportion of the poor in developing countries are farmers.  However, the representatives who participate in the WTO talks have focused too much attention on lowering tariffs and cutting subsidies in developed countries.  However, this is not the only problem: lower tariffs and subsidies in developing countries comprise half of the potential gains that developing countries can expect from free trade because one-third of trade for a developing country is with other developing countries (Economist (2005d)).  Tariffs and subsidies should be lowered incrementally to allow markets to adjust.  This has been the traditional policy of the World Trade Organization (WTO).

Agreement among countries for the appropriate tariff and subsidy amounts is difficult to attain.    Over the past year, the WTO has had several rounds of discussion about how much tariffs and subsidies should be lowered.  Observers of these talks agree that countries have a hard time reaching agreement (Economist (2005e)).  One problem that makes reaching agreement difficult is that several factions from both developing and developed countries want protectionism.  For example, during the Hong Kong WTO talks, South Korean rice farmers demonstrated against freer trade in their markets.  The rice farmers are concerned because they fear that world competition will lower the price of rice.   This creates problems for politicians who would like to negotiate for lower worldwide tariffs and subsidies.

Another problem that makes reaching agreement difficult is that the expected results of the WTO talks vary widely among countries (Economist (2005e)).  The European Union does not want to cut its farming subsidies (which, despite all of the focus on cutting subsidies, will only increase the gains from the trade by 2%).  The Americans do not expect to dramatically lower subsidies on cotton.  However, most countries agree that subsidies should be cut in the European Union and that subsidies should be cut further in America. 

Unfortunately, talks among countries have been relatively stagnant despite ongoing efforts.  Finding agreement among everyone has proven to be very difficult.  Academic and political efforts should be placed on finding an alternative approach to handling these WTO talks because the gains that can be made for the poor are enormous.  Furthermore, even when countries reach agreement about lower tariffs and subsidies, many of these countries do not implement them on time.  Emphasis needs to be placed on mechanisms that would create the necessary incentives for countries to implement lower tariffs and subsidies on time.

Tariff and subsidy reduction depend not only on successful negotiations and implementation but they must also be paired with an anti-dumping policy so that markets are not undermined.  Dumping occurs either when a foreign firm sells its goods to an international market sold for less than its production costs, or when the foreign firm sells its goods internationally for less than the firm sells the goods for in its own country.  The goal of the dumping firm is to gain market share or hurt competitors.  These actions hurt the natural competitiveness of markets because artificially low prices from dumping may limit (destroy) the creation (existence) of long-term competitive firms.  Anti-dumping policies can lead to protectionism, which is when the tariff structure of a country is set so that consumers favor domestically produced goods over imported goods, whereas anti-dumping policies are supposed to regulate the activity of dumping, not discourage goods from being imported (Beth Yarbrough and Robert Yarbrough (2000)).  Fortunately, the Uruguay Round of the WTO talks partially dealt with this problem.  If countries want to keep anti-dumping measures in effect for more than five years, they have to provide evidence to show that removing the protection would cause undue damage to domestic companies. 

This paper is emphasizing fair trade among all trading countries.  Fair trade requires common subsidy and tariff levels.  Fair trade allows countries to produce and export goods that have a comparative advantage.   Fair trade can be regional or global, and Deardorff (2005) finds that countries have a desire to join PTAs (Preferential Trade Areas), which are regional, when liberalizing trade.  This paper is not suggesting that trade zones are the best solution, because trade zones only benefit the countries that participate.  PTAs are worse than global fair trade because producers do not produce according to their comparative advantage because trade diversion, which is when the tariff structure among countries within a PTA favors goods produced within the PTA, creates an incentive for consumers to favor goods produced within the PTA.  Consumers would be able to consumer more goods if they could purchase goods produced by producers that have a comparative advantage.  PTAs also favor trade creation, which allows industries to grow when they might not have otherwise had a chance to compete in these sectors.  Although infant industry protection is justifiable in the short-term, in the long-term this protection creates a disincentive for industries to become globally competitive.

Until no PTA’s exist, global fair trade is not possible.  Therefore, with our current global structure of PTA’s, if a country does not join a PTA, it might have problems competing with countries that are part of the PTA region.  For example, suppose that Country X is not a part of the PTA.  Country X will lose against countries within a PTA.  The PTA countries will have a lower demand for Country X's exports because Country X's exports will be relatively more expensive compared to substitution products supplied through intra-regional trade.  PTA’s exist.  Therefore, assuming that PTA’s exist and that global fair trade is not an immediate option, a developing country should join PTAs when it can.  However, a developing country may have problems joining a PTA because many countries do not want to negotiate with developing countries. 

Changes in tariffs and subsidies are hard to enact.  The members of the WTO talks regularly delay these talks and the talks rarely attain drastic results.  Lower tariff and subsidy levels allow imported goods from developing countries the opportunity to compete with domestic goods in the developed country.  Overall, if all countries lowered tariffs and subsidies simultaneously, the gains from trade would far outweigh the negative effects that would occur to industries that are currently producing goods inefficiently.  Over the long-term, tariffs and subsidies hurt the poor because fair trade can lead to pro-poor growth.


(2.3) Introduction to the Labor Market

The poor can have a hard time gaining from trade liberalization because they are not equipped for exportation of the goods that they produce.  The wage of the poor will not increase unless the poor can find jobs linked with the export sector.  Trade can lead to higher prices for certain goods, but trade should lead to an increase in the real.  Assuming labor mobility, trade should lead to increased real wages for the poor.  Labor mobility allows workers to move from shrinking sectors into expanding sectors over the long-term.  Unemployment may arise in the short-term; however, mixed empirical evidence is available about whether unemployment rises in the short-term after tariff changes.

New sectors can develop, which can provide new jobs for the poor, after trade liberalized.  In Bangladesh, the new job availability in the clothing export sector has had a substantially positive effect on the lives of the women who were able to get the jobs.  Beth Yarbrough and Robert Yarbrough (2000) states that in the long-term, depreciation, retraining, and replacement will allow both capital and labor to flow among industries.  After trade liberalization, protected industries (industries with high import tariffs or large subsidies) will shrink because domestic consumers will prefer the less expensive imported goods.  Some laborers from the protected industries will have to move into the expanding industries to avoid receiving the lower wage from the once-protected industry that is now shrinking.   

In a developing country, producers will export goods produced that have a comparative advantage.  These goods will use unskilled labor because unskilled labor is the abundant factor in developing countries.  The prices of the goods produced with comparative advantage will increase, and therefore, according to the Stolper-Samuelson, the wages of workers in these sectors will increase.  The wages of the workers in the shrinking, once-protected, industries will decrease.  The consumption effect states that the higher priced goods produced by unskilled workers will lower the amount of goods that consumers can purchase, holding income constant.  According to the Heckscher-Ohlin model, the price of the abundant factor increases after trade.  The income effect states that, in developing countries, the nominal wage of unskilled workers increases because they are the abundant factor of production.  Goldberg et. al (2004) write about Jones (1965), who shows with the Heckscher-Ohlin model that over the long-term the consumption effect is smaller than the income effect, and therefore, the higher wages and prices in the unskilled labor market is beneficial for unskilled laborers. 

In the short-run, when factors are immobile, trade liberalization will have different effects depending on the preexisting tariff structure.  In protected sectors that employ unskilled workers, these workers will face lower wages or higher unemployment after tariff reductions.  Unskilled workers are already at the lower end of the income distribution, and are more likely to be closer to the poverty line.  The reduction of tariffs in these sectors may have contributed to increased poverty in some countries over the short-term. 

Although unemployment effects should only exist in the short-term, unemployment is important to study because increased unemployment drags people into poverty.  Therefore, during the short-term, those who become unemployed need a safety net to protect them from extreme poverty.  Goldberg et al (2004) explain that that a way to measure the effect of trade policy on unemployment is to look at the correlation between unemployment levels before and after tariff reductions. 

Household surveys performed by developing countries lack information about what industry the unemployed used to work in or about what industry they are currently seeking work in.  Goldberg et al (2004) explain that without transitional unemployment information, it is very difficult to gauge the impact of tariff reductions on unemployment.  

In sectors that have had tariffs reduced, they expected unemployment levels to be worse.  However, in Colombia, the difference between unemployment rates in the manufacturing sector, which had massive tariffs reduction, and unemployment rates in the non-tradable goods sector, which did not have massive tariffs reductions, was not significant (Goldberg et al. (2004)).  Therefore, Goldberg et al. (2004) conclude that unemployment does not rise in protected sectors after trade liberalization in the short-term.

Disagreement exists between Goldberg et al (2004) and Winters et al (2004) about the effect of trade liberalization on unemployment.  Whereas Goldberg et al (2004) state that there is no correlation between tariff reduction and unemployment, Winters et al (2004) write that the duration of unemployment was the longest in sectors that had the largest tariff reductions.  Winters et al (2004) explain that temporary unemployment may also exist while labor markets adjust to new prices in the goods market. 

Trade liberalization requires tariff and subsidy reduction.  Ideally, trade should be a net positive for the society, and enough money for transfers, in the short-term only, should be available to make everyone at least no worse off than before trade liberalization.  In the long-term, labor mobility will allow the unskilled laborers to move into growing sectors and receive higher real wages.


(2.4) Income Inequality

Economists generally view increased income inequality as having a negative impact on the poor.  Narrowing the skill gap between unskilled and skilled workers will lower income inequality.  However, even if trade liberalization increases income inequality, traditional sector enrichment will have an overall positive impact on the poor because absolute income relative to the cost of living increases for unskilled workers during traditional sector enrichment.  Heshmati (2004) concludes that increased trade has a small impact on reducing income inequality. 

Improved access to new technology after trade liberalization has increased the marginal productivity levels of skilled workers.  This has increased their per capita income levels.  Inequality will rise unless skilled-biased businesses create linkages with unskilled-biased businesses because these linkages can cause the absolute income levels of the poor to rise.  One example of a linkage is when a skilled-biased company demands more goods from an unskilled-biased company.  Another example of a linkage is when a skilled-biased company creates intermediate inputs that are used by an unskilled biased company.

There is dispute about whether trade liberalization increases or decreases income inequality.  Winters et al (2004) highlights this dispute by stating that the East Asian countries have experienced a narrowed gap between skilled laborers and unskilled laborers after trade liberalization whereas the Latin American countries have experienced a wider gap between these two labor markets.  It is important to try to understand the difference between these two regions to learn why Latin America countries did not succeed in narrowing their income inequality gaps.  The East Asian countries, as mentioned in the Heshmati index earlier in this paper, are more globalized than the Latin American countries.  The East Asian countries implemented incentives to export, and expanded the primary education base, which both helped to narrow the wage gap.  An increased primary education base and limited export promotion is necessary to narrow the skills gap in a country after trade liberalization.

Until unskilled workers gain more skills, the income gap between unskilled and skilled wages increases initially after globalization (Nissanke and Thorbecke (2005), who write about Agénor (2002)).  Policies that focus on upgrading the skills of unskilled workers promotes modern sector enlargement, which is pro-poor for those the new skilled workers.   The unskilled workers in India became skilled through better health and education programs.  The incentives to become educated are also important.  India created a pro-business environment that attracted high-tech companies offering skilled-biased jobs.  This is a perfect example of modern sector enlargement, and the poor benefited from this environment.  Narrowing the gap between unskilled and skilled workers is possible when a country institutes the right policies and as the country becomes more globalized.


(2.5) Unskilled laborers

In the long run, an increased demand for unskilled labor in developing countries from trade will cause poverty to decline.  Trade has the ability to move some informal workers, who typically earn very low wages, into the formal wage market (Bardhan (2004a), who wrote about Hertel et al (2003)).  In developing countries, trade will lead to an increased demand for unskilled laborers, which will lead to an increased wage for these laborers.  In addition, a positive side effect of trade liberalization is increased compliance with minimum wage requirements (Goldberg et al (2004)). 

Two opposing effects affect the real income levels of unskilled workers.  The consumption effect lowers real income for these workers because they have to pay higher prices for unskilled labor goods, such as food.  The income effect raises real income because these workers are receiving higher wages.  According to the Heckscher-Ohlin model, the income effect is larger than the consumption effect, and therefore, the higher wages and higher prices are beneficial for unskilled laborers. 

According to the Stolper-Samuelson theorem, which predicts that an increase in the price of goods will lead to an increase in the price of the factor used intensively to produce those goods, the real reward to the scare factor (capital) will decrease and the real reward to the abundant factor (labor) will increase.  Therefore, the wages of unskilled laborers should increase after trade.  However, many unskilled laborers work in the agriculture sector, and therefore, there are counter-effects from trade, such as the effect of trade on primary commodities, that also affect the real wage of unskilled laborers.

Better fertilizers, irrigation systems, and other solutions aimed at increasing the marginal productivity will increase marginal productivity of unskilled workers in the agricultural sector.  The Green Revolution is an example of a period where the marginal productivity in agriculture increased in China because China had a comparative advantage in agriculture.  Focus on the agricultural sector is important in developing countries because many of these countries have a comparative advantage in agriculture.

Poor farmers do not typically gain from productivity improvements in agricultural productivity because these farmers lack the productive assets to increase their productivity.  Multinational corporations gain from the improvements in agricultural productivity (Nissanke and Thorbecke (2005)).  Institutions are necessary to prevent multinational corporations from taking all of the benefit from productivity improvements because multinational corporations may not share this extra wealth with the poor. 

Two successful globalizers, Taiwan and South Korea, were able to increase agricultural productivity (Nissanke and Thorbecke (2005)).  The poor can share in this success if the government provides small farmers with access to credit and insurance.  The government needs to encourage the formation of credit and insurance markets so that farmers can produce comparative advantage goods.  Bardhan (2004b) explains that farmers who produce primary commodities that are not comparative advantage goods will receive lower wages.  Poverty levels for these farmers will rise because they will not be able to compete in the world market. 

Safety nets must be provided to farmers so that they can produce their comparative advantage products.  Farmers will need to move from traditional crops into products such as fruits, vegetables, flowers, dairy products, and processed foods.  In addition to public adjustment services, farmers may also require storage (which allows farmers to avoid low prices in the post-harvest season), transportation, infrastructure, laws, and money for retooling and marketing so that they are not pushed out of business by the influx of large marketing chains.  Overall evidence suggests that these institutions will be pro-poor.

In Sub-Saharan Africa, the agricultural productivity did not increase. Sindzingre (2005) states that Sub-Saharan Africa’s agriculture sector was hurt by geographical constraints (weather), policy (resistance to reform), and institutional factors (price stabilization schemes, monopsonies, and agricultural marketing boards), which led to output stagnation.  Agricultural marketing boards have hurt the agriculture sectors in Sub-Saharan countries such as Nigeria and Zambia (Acemoglu et al (2004), who writes about Bates (1981)).  In developing countries, the poor are typically unskilled farmers, so these agricultural marketing boards are harmful to the poor. 

Without land rights, farmers will not expend as much energy producing goods.  Even worse, when the government takes away land from farmers, they have to find work elsewhere.  These farmers might find work on larger tenants, but they might earn lower wages.  For example, after the Ivory Coast opened up its markets to trade, the government of the Ivory Coast revoked land rights that were customarily allocated to farmers.  The Economist (Economist (2005a)) explains how Chinese farmers have also been losing their customary common land rights.  Farmers collectively owned agricultural land in China, but the government has recently converted the land to industrial use.  Governments need to consider carefully the ramifications of taking away land from farmers.  These actions can negatively affect the poor.

Trade opens up many avenues for unskilled workers to break away from poverty.  The real wages of unskilled workers should increase after trade.  Poor farmers can receive higher real wages by using better fertilizers, better irrigation systems, and other solutions that increase their marginal productivity.  The poor farmers need access to credit markets to be able to make the transition away from producing commodities, to purchase fertilizers, and to gain access to irrigation systems. 


(2.6) Skilled laborers:

Skilled workers are better equipped to take advantage of trade.  Those who can find jobs in sectors that export manufacturing goods will gain the most from trade.  Due to capital-intensive technology transfer, the marginal productivity of workers in manufacturing sectors is higher, and therefore, they receive higher wages.  Winters et al (2004) explain that finding employment in the formal sector, which includes manufacturing industries that export, is one of the surest ways to move out of poverty.  Table 6 shows the details about GDP distribution by sector.  This table emphasizes the distribution of income attributed to the agricultural sector in the developing countries and the distribution of income attributed to the manufacturing sector in developed countries.  It is strikingly obvious that there is a correlation between more developed countries and exporting manufactured goods.  The East Asian countries are a prime example of a region that was able to transition into exporting manufactured goods.  The countries in this region have much lower poverty levels than countries in regions that continue to export agricultural commodities, such as Sub-Saharan Africa.


Table 6


Distribution of GDP (percentages)

                                                Agriculture                Industry                      Services

                                                1965    1989    1994    1965    1989    1994    1965    1989    1994

Low income LDC’s                 44        32        28        28        37        34        28        31        36

            China and India           44        31        26        32        41        38        24        28        --

            Others                         44        33        38        17        28        21        37        39        39

Low-middle-income LDC’s     21        14        13        30        35        36        48        51        49

Upper-middle-income LDC’s  18        --          8          38        --          37        42        --          53

High-income LDC’s                8          4          --          45        41        --          46        54        --

Industrialized countries           5          --          »2        43        --          »30      54        --          »68


Note:  In the 1965 and 1989 data, countries are grouped according to 1989 per capita GDP.


Sources:  Bencivenga (2005) from World Development Reports, World Bank (1991), Table 3 and 1996, Table 12.


Trade openness causes productivity levels to increase (Goldberg et al (2004)).  If the increased productivity results in more profit for the firms, then the industry wages can be increased, provided these increased profits are shared with the employees.  However, the empirical evidence is mixed about whether or not industrial workers see this money.  Skill-intensive intermediate goods may be transferred from less developed countries to countries that are even less developed to be manufactured.  Kozul-Wright and Rayment (2004) explains that some Latin American and Sub-Sahara African countries are experiencing premature deindustrialization, despite the backward and forward linkages afforded by some industrial sectors, such as metalworking.  Premature deindustrialization is when a country stops producing manufactured goods, even though it may have a competitive advantage in producing those manufactured goods.  Latin American is an example of an environment that lacked foreign direct investment after the debt crisis in the late 1990’s.  This led to premature deindustrialization.  Table 7 shows details about the manufacturing output as a share of GDP by region, and emphasizes the fact that manufacturing in South America has been trending downwards.


Table 7

Source: Kozul-Wright and Rayment (2004)


Foreign direct investment can produce skill transfer and technology transfer to domestic producers (Kozul-Wright and Rayment (2004)).  Skill-based technical change leads to both a higher relative wage for skilled workers, and an increased share of skilled workers within most industries (Goldberg et al (2004)).  Most technological change is skilled-based because most research and development activities occur in developed countries (Nissanke and Thorbecke (2005)).  Technological change in developed countries focuses on decreasing the amount of labor required to perform a specific task because labor is scarce in developed countries.  Labor is abundant in developing countries, and therefore technological change that decreases the need for laborers may not have a significantly positive impact in a developing country. 

Firms and sectors that are able to make the necessary technological advances to become competitive in the world market will survive the globalization process.  Goldberg et al (2004) write about a study performed by Harrison and Hanson (1999) that shows a positive correlation between the number of skilled workers in Mexico and the competitiveness of the export sector in Mexico.  A positive side effect of trade openness is that it is associated with higher product quality and higher firm productivity.  From this, an increase in demand for skilled workers arises.

China, India, Bangladesh and Vietnam have all reduced poverty by moving from exporting primary commodities to exporting manufactured goods (Heshmati (2004)).  Governments must be careful to maintain macroeconomic stability during the high growth period of expanding manufacturing and services sectors (Nissanke and Thorbecke (2005)).  Macroeconomic instability, such as inflation, macroeconomic shocks that affect the price of inputs, or exchange rate shocks that affect the price of inputs and the market value of exports, can hinder the ability of these sectors to become globally competitive.   After the marginal productivity levels in the agricultural sector increased, the manufacturing and services sectors expanded, and this had a pro-poor impact in East Asian countries (Nissanke and Thorbecke (2005)).  This should also have a pro-poor impact in other developing countries.

"The elasticity of poverty reduction with respect to non-farm output growth varies depending on initial conditions, like literacy or land distribution" (Bardhan (2004b), who writes about Ravallion and Datt (2002)).  Non-farm growth is more pro-poor in countries that have lower initial landlessness and higher literacy rates (Ravallion and Datt (2002)).  Higher literacy correlates positively with higher levels of education because education leads to higher marginal productivity levels.  Landlessness may decrease the pro-poor impact of non-farm growth because governments where landlessness is prevalent may not have sound institutions and policies in place for the poor to take advantage of non-farm growth.  The poor need institutions, such as education and insurance, to prepare for non-farm labor.

Exportation from the manufacturing and services sectors helped the East Asian countries grow in a pro-poor fashion.  This method of production focus should be replicated in newly globalizing countries.  Globalization requires a “long-term vision for upgrading a country’s comparative advantages towards high value added activities by climbing the technology ladder step by step through learning and adaptation” (Nissanke and Thorbecke (2005)). 


(2.7) Decreased government revenue:

After trade liberalization, government revenue might go down.  Increased government revenue is important, because government spending can reduce poverty if it the money spent on productivity enhancing investments, such as research and development, infrastructure, such as roads and electricity, and development targeted directed on the poor (Fan et al. (1998)).  However, there appears to be no empirical evidence to support the claim that decreased government revenue increases poverty (Goldberg et al (2004)).  One way to reconcile these seemingly contradictory positions is to provide short-term redistributions from some of the net gains from trade (however, not through import, export, or trade taxes) to the poor.  In the long run, decreased government spending must be replaced with sound institutions and policies that create a catalyst for moving the poor out of poverty. 

However, despite all the concern about lower government revenue, Winters et al (2004) write about Ebrill, Stotsky, and Gropp (1999), who found in an empirical study that after countries reduced their tariffs, they did not have significantly lower government revenues than countries that did not reduce tariffs.  If government revenues do decrease, and the situation is such that lower revenues will lead to increased poverty, then alternative non-tariff sources of revenue must compensate for the fall in government receipts.  Replacement taxes should not be complex so that people will cooperate and so that the administrative overhead is low; this will create a profit maximization situation.  These taxes should be progressive so that the taxes do not burden the poor. 

Government spending is complicated because it can have a pro-poor impact if the government spends the money on the right programs.  However, because the poor are the least likely to vote, they do not have enough of a voice to receive ample government expenditures.  Winters et al (2004) explains that there is substantial evidence to support the fact most of the poor do not receive the benefits of government spending.  Therefore, the impact of globalization on government spending, even though it is statistically not significant, is not important because the poor are not receiving the benefits of governments spending anyways.


(3) Institutions and Policies

After trade liberalization, institutions and policies that keep people in poverty will only make matters worse for the poor.  Sound institutions and policies must be created before trade liberalization and financial liberalization because the impact of globalization “will depend on the initial conditions at the time of exposure and the effective design and implementation of policy to manage the integration process” (Kozul-Wright and Rayment (2004)).  Institutions and policies create a threshold effect for globalization, which means that institutions and policies have a larger impact than before globalization.  If institutions and policies are pro-poor (not pro-poor), then these institutions and policies will affect the poor even more positively (negatively) than before globalization.

Defining institutions is important because many economists use this term loosely.  The definition used herein is consistent with the definition used by Sindzingre (2005), who uses Douglass North’s (1990, 1991) definition.  Institutions are constraints that structure political, economic, and social interactions.  Institutions consist of formal regulations (such as constitutions, laws and property rights), and informal regulations (such as traditions, conventions, and norms of behavior).  Institutions reduce transaction costs, stabilize volatility, strengthen incentives, properly channel resources, and deliver flexible responses to uncertainty.  In addition, the causal link between globalization and institutions and the casual link between globalization and policies is unclear because the distinction between the isolated effects of institutions and policies is unclear. 


(3.1) Impact of institutions and policies

Institutions and policies create a threshold effect on the causal link between globalization and poverty (Nissanke and Thorbecke (2005)).  Based on the structure of policies and institutions, the effect of globalization on the poor can lead to several different outcomes.  Globalization can increase or decrease inequality.  Globalization can pull people out of poverty or it can push people into poverty.  The outcome for the poor depends on whether these institutions can successfully favor collective action of the poor, prevent collective action or the wealthy, regulate redistribution gains to ensure that the poor receive redistribution in the short-term and medium-term when necessary, and regulate insurance mechanisms to ensure that the poor have access to insurance and credit markets.

Sindzingre (2005) states that the effectiveness of an institution to positively affect the poor depends on the structure of human capital, the structure of the political economy, the level of social cohesion, and the relationship of the institution with other institutions.  The structure of the political economy is important because social polarization, oligarchic structures, or predatory regimes will mitigate the effectiveness of an institution.  The structure of human capital is important because institutions intended to lead to growth might not lead to growth if the population is poorly educated or does not have much technical ability.  The level of social cohesion is important because the poor must trust the institutions aimed at helping them.  The relationship among institutions is important because their ability to work together will contribute to their effectiveness.  

State institutions define policies (i.e. trade and taxation policies).  However, policies also determine the creation, destruction, or reformation of institutions.  The connection between policies and institutions is further illustrated when noting that the effectiveness of polices focused on the poor is contingent on the combination among institutions.  Policies use different combinations of institutions, and the effectiveness of the policy will depend on the strength of the relationship among institutions.  The strength of the relationship is a function of the historical depth and credibility of institutions, the way in which different institutions work together, the flexibility of institutions to be able to be transformed by globalization, and the level of access to the positive effects of globalization that is provided to the poor.  The power of the institutions also will determine the effectiveness of the policy.  For example, the combinations of state institutions (i.e. education and welfare reform) to create social service programs can positively affect the poor.  Another example to illustrate the importance of the connection among institutions is that business regulations would be ineffective without functioning judicial institutions. 

Informal regulations contribute to the effectiveness of an institution because social norms may modify the goals of an institution.  For example, social norms may dictate that institutions provide bribery payments to government officials, whereas the money should be spent performing the function of the institutions.  The government should not own financial institutions because conflicts of interest may arise, and these conflicts might lead to corrupt payments, poor investments, excessive hiring, and inappropriate plant locations.  This is already a problem in many countries because corruption has become so bad in some developing countries that the poor in these countries believe that institutions are the cause of their poverty.

Social norms that exist during globalization will create several poverty traps (Sindzingre (2005)).  These traps include: 1) the lack of information and ability to take collective action to demand better institutions and policies; 2) discrimination based on race or gender; and 3) redistributive gains for the wealthy and redistributive losses for the poor.  Non-corrupt institutions that protect and advance the rights of the poor can alleviate these poverty traps.  Corruption can limit benefits of globalization for the by blocking access to certain institutions (such as education, legal, or health services) (Sindzingre (2005)).

Domestic political economy structures and institutions, such as social polarization, oligarchic structures, and predatory regimes, may reduce to potential gains from globalization for the poor (Nissanke and Thorbecke (2005), who write about Sindzingre (2004)).  The goals of those who have political power will dictate the creation and destruction of institutions and policies (Acemoglu et al. (2004)).  For example, before the seventeenth century in England, the monarchs in England did not protect the property rights of others, and the monarchs used their power to tax producers arbitrarily and to allocate resources according to their desires as opposed to the economically efficient use of those resources. 

Institutions and policies that protect property rights create incentives for people to invest in physical or human capital.  For example, during the seventeenth century in England, the property rights of both land and capital owners strengthened.  These rights led to financial and commercial expansion.  Property rights also encouraged people to invest in technologies that increase efficiency. 

Some degree of equal opportunity in society, such as equal access and protection by the law, is necessary so that the gains from trade can spread more equally.  Acemoglu et al. (2004) explains that property rights and equal opportunity in society creates incentives to create efficient markets.  Before Korea split, the income levels were roughly identical.  In North Korea, the government abolished property rights and the government now makes economic decisions without regard to economic efficiency.  The per-capita income of a person in North Korea is similar to that of a person in sub-Saharan Africa.  In comparison to North Korea, South Korea protected private property rights and makes economic decisions based on economic efficiency.  South Korea has grown faster than almost any other country during recent years. 

This shows that even though geography is a factor for economic success, it is not the main factor.  In South Korea, only 4% of the population is below the poverty line (Central Intelligence Agency (2006)).  South Korea exported $250.6 billion and imported $214.2 billion in 2004.  With a GDP of $925.1 billion in 2004, exports were 27% as a percentage of GDP and imports were 23% as a percentage of GDP.  In North Korea, exports were $1.2 billion and imports were $2.1 billion in 2003.  With a GDP of $40 billion, imports and exports were less than 5% of GDP.  South Korea's success came from its market economy, which thrived on trading with other countries, whereas North Korea's trade remains small. 

Globalization increases the wages of educated workers and reduces the wages of workers who have no education (Nissanke and Thorbecke (2005)).  Public expenditures on primary and secondary education decrease inequality, but tertiary does not generally help the poor because primarily middle- and high-income classes seek tertiary education (Dagdeviren et al (2001).  Higher education levels may lead to higher wage jobs (Goldberg et al (2004)).  Therefore, basic education is necessary for everyone so that globalization can have an equalization effect on incomes.

The government can provide safety nets in the short- and medium-term to the poor that are hurt by globalization. Some safety nets, such as health care and welfare systems, are institutions.  Sindzingre (2005) states that the difference between the success of the safety nets program in South Korea, which has a successful safety nets program, compared to the safety nets program in Sub-Saharan Africa, which have failing safety nets programs, is explained by successful combinations among institutions, among policies, and among institutions and policies.  The institutions and policies in Sub-Saharan Africa are representative of the predatory political regimes in this region.  In contrast, the institutions and policies in Taiwan represent growth based on small- and medium-sized companies with pro-poor results.

If the country has good policies and institutions, trade liberalization should be a net positive for an economy.  Macroeconomic stability, high investment/GDP ratios, human capital development, infrastructure development, and institutions development are all important economic factors that will ensure that globalization will lead to growth (Heshmati (2004)).  The right combination of public policies, laws, institutions, and political environment (such as democracy) will lead to an economy that benefits the poor (Singzingre (2005)).


(4) Financial Liberalization

Financial liberation is another major component to globalization.  Financial liberalization starts with financial markets opening up to private banks.  Increased competition in the banking sector creates a better banking sector when sound regulations and policies are present.  These regulations and policies are necessary for a strong banking sector.   Countries should create regulations to avoid moral hazard, over-lending, lending to risky loan applicants, and disclosure that is anything short of full disclosure.  Before opening up financial markets to external capital flows, a country needs to liberalize its domestic financial market, regulate interest rates so that they do not become excessively high, and implement a strong banking system, which requires a powerful legal framework and effective bank examiners.

Avoiding bad financial policies and frameworks is as important as implementing good financial policies and frameworks.  The set of requirements in the Maastricht Treaty is a good baseline of financial goals that developing countries should pursue.  These requirements are: (1) a public sector deficit/GDP ratio less than 3 percent, (2) a national debt/GDP ratio less than 60 percent, and (3) inflation less than 3 percent.  Beim and Calomiris (2001) add that a developing country should also keep its fiscal deficits low so that the fixed exchange rate does not become overvalued.  In addition, they state that a developing country should build international reserves so that the country can support its currency during speculative attacks and bank runs, and anchor its currency to a strong external currency by promising that it will purchase domestic currency for the chosen foreign currency.  Anchoring the currency to a strong external currency is important because the money supply will automatically adjust to monetary inflows and outflows.

Import substitution can negatively affect the poor.  Exchange rate overvaluation, a standard policy for import substitution regimes, can cause speculators to attack the currency and cause devaluation.  Unexpected devaluation lowers the value of the currency, and this unexpectedly lowers the purchasing power of consumers, which will always negatively affect the poor.  Unexpected devaluation can also lower confidence about a country’s macroeconomic stability, which can lead to capital flight.  Capital flight, as already mentioned, has a negative impact on the poor.

            Strong banking systems are necessary to avoid financial crises, which hurt the poor.  Argentina has had problems with its banking system, but has made a substantial effort to reform its banking system.  Argentina’s central bank abandoned its currency board at the end of 2001 and stopped payments on its external debts, which drastically lowers the confidence of depositors and investors.  In addition, Argentina imposed price controls in March 2006 because of high inflation.  Even though Argentina has had these problems, it is still valuable to look at the reforms that Argentina made over the past decade because it gives an outline, although not perfect, of what reforms should be considered.

Beim and Calomiris (2001) write about information gathered from World Bank (1998) and Calomiris and Powell (2002) that explain the steps taken by Argentina to reform its banking system: “[t]he Central Bank [of Argentina] continued the process of reform, including the following items: 1) To provide liquidity in future crises, bank reserve requirements were raised to 20 percent of deposits, which is an unusually high level.  However, this was not a tax because this money held by central bank pay interest, which is also unusual. 2) The government instituted a “contingent repo facility” where international banks provided potential liquidity protection lending to the government to cover another 10 percent of deposits.  3) Capital requirements for banks start at 11.5 percent, and are higher for higher capital to loan risk (measured by loan interest rates) and market risk.  In addition, banks were obliged to issue subordinated debt equal to at least 2 percent of their deposits, to provide additional capital market risk assessment and risk monitoring.  4) The bankruptcy laws were reformed.  5) The banking supervisory process was strengthened to conform with the “Core Principles for Effective Supervision,” which was issued by the Basel Committee.  6) The Central Bank sponsored the collection and dissemination of the name of every corporate and individual borrower in the country together with its aggregate debt and credit rating on a scale of 1-6, and some information about the financial condition of borrowing firms.  The government sells a monthly CD-ROM that gives data on all persons and firms that have defaulted on debt.  7) A modest private deposit insurance fund (SEDESA) was instituted to cover up to $10,000 per person, supported by each bank paying in 0.03-0.06 percent of deposits” (Beim and Calomiris (2001)).

Prasad et al. (2003) states that there is no evidence to support that financial integration has a positive effect on growth.  Although Prasad et al. (2003) find that financial integration alone does not cause growth, financial integration is a filter for the effects caused by the fundamentals in a country.  If the fundamentals are sound, then financial integration can lead to pro-poor growth (Griffith-Jones and Gottschalk (2006)).

However, this casts too simple a picture on the relationship between financial integration and the poor, because Prasad et al. (2003) show that consumption volatility increases at low to moderate stages of financial integration.  Higher consumption volatility is bad for the poor because negative swings in consumption power can push some people into poverty or absolute poverty.  This short-term problem is resolved when strong fundamentals exist and after the domestic financial sector fully integrates with the global financial sector. 

Some fundamentals that lead to better results from financial integration are robust legal and supervisory frameworks, low levels of corruption, high degree of transparency, and good corporate government (Prasad et al. (2003)).  Strong legal frameworks encourage higher total factor productivity growth.  Greater degrees of transparency, which is a form of governance, minimizes herding behavior, can lead to instability in financial markets.  Corruption has strong negative effects on foreign direct investment.  Foreign direct investment has a strongly positive impact on growth.  In the long-run, being financially integrated has a positive impact on the country because it can better compete in the global marketplace.  If a country has both policies and institutions that encourage sectors that positively affect the poor, then financial integration can have a positive impact on the poor in the long-run.


(4.1) Monetary Policy, Inflation, and Credit

When the government has a deficit, it needs to cover this deficit by selling international reserves, borrowing money, or by monetizing its deficit.  A government monetizes its deficit when it prints new bonds and sells them to the central bank in exchange for newly printed money.  Government deficits can create financial instability through several methods utilized to lower a budget deficit.  Monetization of a budget deficit, which is when the government prints more money, leads to inflation because the government is essentially creating a larger monetary base.  Inflation devalues the purchasing power of the money that people currently hold because inflation requires more money than before the inflation to purchase the same good.  Therefore, inflation immediately devalued any citizen’s savings.  Agenor (1998) states that the poor are negatively impacted when a government monetizes its budget deficit.  The poor keep most of their money in currency, which now has less purchasing power, whereas the wealthy keep more of their money in assets and the value of these assets rise in value when inflation rises.

Inflation rates that are higher than world inflation will cause problems.  Money supply increases need to be at par with world inflation levels. Moderate (extreme) inflation rates can cause modern (extreme) exchange rate volatility. (Beim and Calomiris (2001)).  The central bank controls inflation by selecting a targeted inflation rage (inflation targeting) and reaching this target by adjusting interest rates or by changing the monetary base.  The central bank targets low inflation rates to keep the consumer price index annual inflation growth rate down.  This system has worked remarkably well in keeping inflationary pressure down in Peru, where inflation rates have been kept within announced targets.

Inflation volatility depresses the financial sector because loans are not provided when expected inflation can not be gauged.  Investors require high risk premiums to offset the risk of negative real interest rates if future inflation is greater than expected future inflation.  The risk premium creates loans that are too expensive for borrowers.  For this reason, inflation volatility creates inefficiency in the loan market.  Money is not used efficiently unless an efficient loan market exists.  The poor will be affected by this because they are not going to get loans that they could use to start or grow their businesses.

Credit constraints on the poor will result in risk adverse activities because a poor farmer who does not have access to extra capital will not be able to spend the additional money required to invest in a risky activity that may otherwise lead to an increase in the farmer’s marginal productivity (Winters et al. (2004)).   This will decrease the likelihood that the poor will be able to move into profitable, but risky, activities to break out of poverty.  To limit strategic default, which is when a borrower takes the loan without repayment, some banks require borrowers to have collateral.  Collateral is something that the poor typically do not have.

Credit markets that only provide capital to a limited number of people result in goods markets with oligopolies (Sindzingre (2005)).  Credit markets need to be available to everyone to avoid a market of oligopolies.  Governments create directed credit programs that focus lending in specific sectors.  Page (1994) explains that the directed credit programs in Hong Kong, the Republic of Korea, Singapore, Taiwan, Indonesia, Malaysia, and Thailand have been successful because the export sectors received needed injections of capital.  Despite the gains that can be made through directed credit programs, banks will eventually participate in over-lending because the incentives to lend to these selected sectors can stay too high.  Directed credit programs must be constrained under specific time frames so that the export sectors are provided incentives to become internationally competitive.


(4.2) Capital Controls and Capital Flows

Financial sector liberalization exposes developing countries to short-term capital flows, which can increase the financial sector's vulnerability to external shocks (Nissanke and Thorbecke (2005)). Capital should seek out higher returns from capital-scarce countries because capital should exhibit higher marginal productivity in developing countries.  In reality, capital does not flow in this manner because of the Lucas paradox, which finds that the marginal productivity of capital is higher in rich countries than in poor countries because Lucas found that the return to scale of human capital is increasing with respect to the human capital stock of the country.  The majority of capital flows into areas based on their ability to work as asset diversification as opposed to searching out higher marginal productivities to capital.  Therefore, capital also flows to rich countries for this reason.

Capital controls are a set of determinants that define how capital will flow in and out of a country.  Capital controls should not be removed until banking fundamentals, inflation, and interest rates are under control.  If inflation is not under control, then the fixed exchange rate can become overvalued.  After the exchange rate becomes overvalued, any unhedged short-term capital inflows will flow out of the country (capital flight).  If interest rates are too high, unhedged short-term capital inflows will take advantage of the arbitrage.  After the arbitrage is gone, the unhedged short-term capital inflows will flow out of the country. Capital flight occurs when a country is pegging an overvalued exchange rate.  Concern may arise that there will be capital flight if everyone knows that the exchange rate is overvalued, the international reserves are low, and there are no capital controls.  The best way to avoid capital flight is to enforce a strong financial sector, with good governance, and a floating exchange rate.  Capital flight can move the financial sector into a banking crisis, which hurts the poor. 

Effective capital controls that regulate and control destabilizing capital flows, such as preventing a large stock of foreign financial capital from building, is necessary to maintain strong financial health (Kozul-Wright and Rayment (2004)).  The suggested techniques to control capital “range from market-based measures -- intervention in the foreign exchange market, more flexible exchange rate bands, non-interest bearing reserve requirements on foreign liabilities, or taxes [that narrow] the international arbitrage margin – to direct controls on, say, banks’ net external positions, borrowing abroad by non-banks, or on foreign equity participation in domestic firms” (Kozul-Wright and Rayment (2004)).  Attention needs to be paid to the confidence of investors to make sure that these measures do not deter foreign direct investment.

Foreign direct investment is one of the best forms of capital inflows that a country can receive from investors.  The capital flight problem is avoided with foreign direct investment because foreign direct investment is a long-term capital inflow.  Furthermore, foreign direct investment leads to growth.  The availability of foreign direct investment has varied throughout time and by region.  Because of this elusive nature of foreign direct investment, many people have studied why countries will receive countries when they do.  My discussion that follows about foreign direct investment includes examples about why countries have stopped receiving foreign direct investment, states policies that must be followed to receive foreign direct investment, and details some of the effects of foreign direct investment.

Following the debt crisis of the 1990’s, foreign direct investment in Latin America and Africa has been sparse despite their regulations that encourage financial openness.  Kozul-Wright and Rayment (2004) restate research conducted by UNCTAD (2003) that shows that foreign direct investment in these countries has not only been less exported-oriented, but also it has often come at the expense of public investment.  It is better when foreign direct investment is used in export-oriented sectors.  Governments can stifle the effectiveness of foreign direct investment by use foreign direct investment as a way to finance current-account deficits.

Economic uncertainty, such as inflation, will drive foreign direct investment inflows away.  Investors will put their foreign direct investments money in developing countries that have low cost labor that has high skills and high productivity levels.  Furthermore, Regional Trade Agreements between countries will increase foreign direct investment inflows.  Policies within the developing country will determine foreign direct investment inflows dramatically.  Host countries must have good policies regarding repatriation of profits and capital, liberal technology policies, and easy entry and operation.  

An analysis of opportunity, risk and market reform factors in relation to foreign direct investment inflows with respect to seven Latin American countries, Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela, was conducted by Trevino, Daniels, and Arbeláez (2002).  They found that privatization had a positive correlation with foreign direct investment inflows because firms saw this as a country’s positive attitude towards private enterprise. 

They also found that there was a positive correlation between the host country’s capital account liberalization and inward foreign direct investment.  They found that the size of GDP correlates positively with foreign direct investment inflows.  Furthermore, they found there was a significant correlation between percentage changes in the consumer price index and foreign direct investment inflows.  Lower inflation rate gives an indication that the host country’s output can compete with international competition in the future.  They also found that the higher a host country’s current account deficit, the lower are foreign direct investment inflows.

Foreign direct investment is that it appears to be limited in its ability to create backwards linkage to the rest of the economy (Kozul-Wright and Rayment (2004)). Although backward linkages may not occur, the multi-national corporations brought into the developing country by foreign direct investment should bring skill-biased technology, which may lead to modern sector enlargement growth.  Modern sector enlargement growth is pro-poor. 

Developing differentiated and efficient clusters of skilled labor for particular market increases the foreign direct investment inflows.  Multinational corporations put foreign direct investment in countries that can create this skilled market.  An example of this is in India where hundreds of thousands of trained programmers know how to perform highly skilled tasks for international organizations.  This attracts a high level of foreign direct investment inflows and should be replicated in other developing countries.


(4.3) Exchange Rates

The correct exchange rate system that should be used by a country depends on the quality of its fundamentals.  Beim and Calomiris (2001) explain that if a country has sound policies and institutions, and has little to no deficit, that it should choose a crawling peg, fixed exchange rate.  Fixed exchange rates allow a country to gain creditability in the global economy if it can maintain a fixed exchange rate that does not become overvalued, and that does not lead to economic crisis.  Most developing countries do not have the discipline to deal with the periodic stress of high interest rates and contraction that can result from fixed exchange rates.  Kozul-Wright and Rayment (2004) writes about Helleiner (2003), who states that successful management of the exchange rate means choosing a rate that will remain competitive over the long-run and making adjustments when faced with external shocks.  When the wrong exchange rate is chosen, unhedged short-term private financial flows that are interested in taking advantage of arbitrage and speculative gains will enter the developing country.  These types of financial flows can create financial crises, which hurt the poor.

Floating exchange rates do not offer a developing country the opportunity to increase its credibility and therefore is not the right way to control exchange rates.  Financial policies that keep inflation and debt low help to stop the overvaluation of fixed exchange rates.  If a country has an overvalued exchange rate, switching away from a fixed exchange rate to a floating exchange rate can perpetuate a bank run that will lead to a financial crisis.  Financial crises disproportionately lower the consumption power of the poor, so making letting an exchange rate become overvalued can lead to a dangerously impact the poor.

Fixed exchange rates have the advantage of building trust in the world economic community if the peg can be sustained without becoming overvalued.  This requires low fiscal deficits, inflation rates not exceeding world inflation rates, and a large level of financial reserves to defend small speculative attacks.  Volatility in the exchange rate from a floating exchange rate can be problematic for trade (Beim and Calomiris (2001)). 

A fixed exchange rate that becomes overvalued will be the target of a speculative attack because speculators believe they can make money when the currency is devalued.  The speculators sell domestic currency and purchase foreign currency, anticipating that the central bank will not be able to continue supplying the speculators with foreign currency.  Once the central bank runs out of foreign currency, it must devalue the exchange rate.  When speculators attack the fixed exchange rate, the economy will experience periods of high interest rates and economic contraction (Beim and Calomiris (2001)). 

To defend a fixed exchange rate from depreciation, some central banks sterilize the capital outflows by purchasing local currency bonds held by banks in exchange for domestic money.  The central bank replaces the outgoing foreign reserves with government bonds and, therefore, maintains the same amount of total assets. This policy prevents a monetary contraction from financial outflows even though the central bank now has less foreign assets.  This will eventually lead to a financial crisis because it worsens the ratio of domestic money to international reserves, which creates incentive for speculators to attack the weaker international reserves further.   Devaluation will follow a successful speculative attack, and devaluation can lead to capital flight and financial crisis.  Overvalued fixed exchange rates can lead to financial crises.  These crises disproportionately lower the consumption power of the poor because poor hold most of their assets in money.


(5) Crises and Shocks

Financial crises are one of the fastest ways to affect negatively the poor in a developing nation.  The East Asian Financial Crisis hurt the poor in East Asia.   The MERCOSUL contagion crisis hurt the poor in Latin America.  Prasad et al. (2003) state that when countries are opening up their financial and trade markets, that these countries expose themselves to financial crises that can arise at low- and medium- levels of financial integration.  To illustrate the impact that crises have on the poor, Montalbano, Federici, Triulzi, and Pietrobelli (2005) report that more than two percent of potential annual per capita consumption growth has been lost due to crisis volatility for countries in the Baltic region.  Countries must focus on becoming more financially integrated and creating sound policies and institutions to limit the risk of financial crises. 

            Kozul-Wright and Rayment (2004) explain a typical exchange rate crisis as follows.  After a country deregulates its financial market and capital account, the developing country attracts short-term capital with stable exchange rates and tight monetary policies.  The banking sector over-lends to businesses that want to take advantage of the low interest rates offered abroad.  New capital inflows create interest rates that are relatively low for domestic firms compared to before financial deregulation.    Eventually, these policies create upward pressure is on the exchange rate, and sterilization (the sale of domestic bonds to offset reserve inflows so that the monetary base can remain unaffected) of capital inflows puts upward pressure on interest rates because the monetary base is smaller than it otherwise should be.  When investors realize that the overvalued exchange rate might fall, investors might quickly remove their short-term capital (commonly referred to as capital flight).

Early models of currency crisis (first generation models) view currency crises as arising from the monetization of fiscal deficits together with fixed exchange rates.  The first generation models show how long the country can depend on its reserves after monetary or fiscal policies that are expansionary.  The key element of this modeling includes the maintenance of a fixed exchange rate.  Broner (2003) explains that Krugman (1979) found that speculators attack the central bank’s stock of foreign reserves.  Speculators attack the currency when foreign reserves are low and the current account deficit is high.  This would occur in the absence of any random shocks.  The advantage of this model is that a probability function predicts the timing of a crisis.  This model predicts that speculators will attack the currency when the shadow exchange rate, which is the predicted exchange rate that would occur if the reserves were exhausted and the exchange rate were allowed to float, has depreciated as much as the current fixed exchange rate.

            Second generation models are less about the government’s ability to defend its fixed exchange rate, but rather their willingness to defend it.  The government in this model would abandon a fixed exchange rate, or devalue its currency, if necessary.  The cost associated with abandoning a fixed exchange rate could include raising interest rates, and therefore depressing the local economy.  If the central bank can bear these costs, then the government would abandon (in theory) the fixed exchange rate.  The costs associated with defending a fixed exchange rate include unemployment, an increase in short-term debt, and the depletion of reserves.  Investor confidence is difficult to predict, but the rate of reduction in reserve levels does influence their confidence levels.

Some second generation models identify ranges of likelihood that a crisis will occur.  If the probability is certain of a crisis, then a speculative attack would cause the exchange rate to collapse.  If the probability is not certain of a crisis, then external factors, such as investor confidence, information dissemination, and coordination among speculators are extremely important in the potentiality of a crisis.

The major difference between the first generation and the second generation model is whether or not the government will defend a currency attack and also maintain a fixed exchange rate.  Fixed exchange rates are poor methods of defense and a floating exchange rate is better.  Countries will still defend their currency in the second generation model, but this defense will happen through interest rate hikes and monetary base expansion.  These methods of defense are much less detrimental in the long term.


(5.1) East Asian Financial Crisis

The sudden decrease in the real incomes of the poor during the East Asian Financial crisis hurt the poor.  The weak banking sector led to banking crises, which led to increased unemployment and decreased output.  Winters et al. (2004) state that during the Asian Financial Crisis real wages fell in Indonesia in the first year of the Asian Financial Crisis by 42% for urban workers and 32% for rural workers.  Employment levels stayed constant, but lower prices translated into lower real wages for employees.  The poor lacked safety nets to sustain income levels during this transitory period. 

Indonesia, a country affected by the Asian Economic Crisis, is a perfect study for how financial crises can arise.  Undercapitalized banks and low reserve requirements made Indonesian banks particularly susceptible to liquidity crises.  The banking sector was not ready to handle the large levels of financial inflows, which led to overinvestment in the corporate and real estate markets.  Overinvestment is a major problem in developing countries because deregulation of the financial market, coupled with opening up the capital account, creates an excess supply of capital.  Overinvestment leads to risky lending, which eventually creates financial instability. 

Enoch, Frécaut and Kovanen (2003) explain that some banks were owned by local conglomerates, and that these banks would lend money to the conglomerates at levels above legal requirements (commonly refereed to as directed lending).  Poor governance existed because there was an information gap between what the bank managers knew about their loan portfolio and what the supervisory organization knew.  Chua (2005) states that the banks owned by conglomerates ignored legal lending requirements, and provided their conglomerates with levels of capital above what they should have received.

Private debt levels increased dramatically during the 1990’s, and an increasing amount of the debt was denominated in United States dollars.  When the currency of the developing countries in East Asia depreciated against the dollar, the cost of this debt became burdensome.  Increasingly, banks made loans for projects that were too risky.  In Indonesia, bailouts were required by the Bank of Indonesia to keep the banking and corporate sector from failing.  These bailouts led to moral hazard problems from borrowers, commercial banks, and government banks.  Borrowers did not believe that the government banks were aggressive about collecting loan payments, so some borrowers did not service their debts.  Commercial banks attracted depositors at interest rates above what they were able to receive from lending.  Government banks knew that they the government would bail them out, so they invested in very risky projects and had a very high non-performing loan rate.

High levels of unhedged short-term financial liabilities created exposure to capital flight.  Overvalued fixed exchange rates will depreciate when a government decides to float its exchange rate.  This led to capital outflows that caused the exchange rate to depreciate even further.  The banks were not able to handle this scale of capital flight because capitalization was too low. 



The poor are hurt disproportionately during contractionary periods (Nissanke and Thorbecke (2005), who write about Birdsall (2002)).  Dagdeviren (2001) adds that inequality rises during recessions, which is consistent with the fact that unemployment levels increase during times of recession.  In early stages of financial integration and diversification, developing countries have significant exposure to contagion. 

Contagion is categorized one of two different ways: fundamentals based contagion and pure contagion.  Fundamentals-based contagion occurs when a crisis in one country increases an investor’s risk assessment of other countries.  If the developing country has weak fundamentals, the new risk assessment may cause the investor to pull money out of the developing country.  Prasad et al. (2004) write about Van Rijckeghem and Weder (2000) and Kaminsky and Reinhart (2001), who documented the fact that most banking lending to developing countries is in the form of unhedged short-term financial liabilities.  This form of financial liability has much more exposure to capital flight.  Pure contagion is when fundamentals do not stop capital flight because herd or momentum trading causes the capital flight. 

Prasad et al. write that “in addition to ‘pure contagion,’ financial integration exposes developing economies to the risks associated with destabilizing investor behavior that is not related to fundamentals” (Prasad et al (2004)).  Countries need to focus on gaining foreign direct investment instead of bank borrowing and portfolio flows because foreign direct investment has the least amount of exposure to problems related to financial crises.  Foreign direct investment is inherently a long-term investment, and can therefore be a way of insulating a country from pure contagion or herd behavior.

MERCOSUL is a perfect example of contagion at work.  Brazil’s financial crisis led to financial crisis in Argentina and Uruguay.  The Central Bank in Brazil adopted a policy of nominal devaluation that outpaced consumer price inflation to resist speculative attack (Sgard (2003)).  This inflation targeting policy of nominal devaluation led to a depreciation of the Brazilian local currency, the real.  The real was devaluated even further because of difficulties in the capital account and because of the government’s inability to service its debt.

The devaluation of the real, and the subsequent decision to allow the currency to float, lowered investor confidence because investors felt that Brazil would default on its public debt, which would lead to high inflation.  This is what happened in Indonesia during the East Asian Financial Crisis.

The international consequences of devaluation were that there was a switch from a trade deficit to a trade surplus, which had a major impact on Brazils trading partners.  The largest threat of contagion came to the MERCOSUL partners, namely Argentina, Paraguay, and Uruguay.  Argentina was exporting 30% of its exports to Brazil before the devaluation.  Exports from Argentina and Uruguay to Brazil lowered, and this pushed these economies into recessions

Brazil was Argentina’s largest trading partner, and therefore, Brazil’s depreciation caused Argentina to fall into a recession for four years because the goods exported from Argentina to Brazil were sold much less than before Brazil’s depreciation.  The Argentine Currency Board did not stop exchange rate overvaluation and fiscal indiscipline after the fall of Brazil’s real and these bad policies eventually lead to a run on the banks.  Eventually, Argentina defaulted on its external debt.  The gravity of this result accentuates the importance of good macroeconomic policy when absorbing shocks from other countries.  Not all shocks can be absorbed, but stopping both exchange rate overvaluation and fiscal indiscipline is necessary.



            Globalization can be pro-poor if the developing country implements the correct policies and institutions.  Globalization magnifies the effects of policies and institutions, so policies and institutions that are bad for the poor or that create macroeconomic instability will hurt the poor even more after globalization.  Countries need to make a committed effort to implementing policies and institutions that strengthen the trade and financial sectors.  These institutions and policies must also fend off problems, such as trade shocks, speculative attacks, volatility, and corruption.  Problems are larger after a country globalizes because it is open to massive shocks, but countries must join the globalization trend because those who do not globalize become worse-off, such as the Sub-Saharan African countries, after other countries globalize.  Countries that want to help their poor must globalize, and they must do so carefully, implementing the proper institutions and policies.


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Copyright (c) 2006 Ryan Pitylak All rights reserved.
Austin, Texas (TX).