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Effects of Globalization on the Poor by Ryan Pitylak * University of
May 4th,
2006 Abstract
*
Supervised by Dr. (1) Globalization Defined Globalization can,
and has been, defined many different ways.
The way that globalization used herein is consistent with the
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 Economists disagree
about how to weight the components of globalization. Heshmati (2004) analyzed the
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
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Table 5 SINGLE
COMMODITY SHARE IN TOTAL COMMODITY EXPORTS Coffee Sugar
Uganda 97% 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
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
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.
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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
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
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
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
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
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
(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
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,
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
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
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
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
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
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
"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
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
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
This shows that
even though geography is a factor for economic success, it is not the main
factor. In
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
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/
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.
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
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
(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
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
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
(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
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
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
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.
(5.2) MERCOSUL
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.
The
devaluation of the real, and the subsequent decision to allow the currency to
float, lowered investor confidence because investors felt that
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
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
Conclusion
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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