Economic_Growth

5 Economic Growth and the Balance-ofPayments Constraint Dr John McCombie Director Cambridge Centre for Economic and Public Policy University of Cambridge 1 Introduction Approaches to economic growth Two paradigms • The neoclassical supply-oriented approach, based on the production function and full employment • The Keynesian demand-oriented balance-of payments-constrained growth. Output may be less than full employment 2 The Growth Rates of Countries are Interlinked • The growth rates of even the advanced countries are inextricably linked – indeed the large OECD simulation macroeconomic model is known as the LINK model • The beggar-my-neighbour policies of the advanced countries in the 1930s. “Exporting unemployment” by tariffs and quotas. • Rapid post-war growth led by first the US and then Germany as the engine of growth. Rapid reduction of tariffs under GATT. It was the growth of world demand that became crucial for the Golden Age. • UK stop-go policies 1950-1973 associated with balance-ofpayments crisis. As output grows, so the current account deteriorates as imports increase rapidly, and exports grow at a constant rate determined by world demand. 3 But did not the floating exchange rates essentially delink the economies of the world' No • In the current crisis, attention is still focused on the degree to which the US and China can lead the world out of recession. • Cannot understand the growth of the middle income countries without reference to the balance of payments and international crises. The “lost decade of growth” in Latin American associated with balance-ofpayments crisis and collapse of the currency. Mexico, Brazil and Russia • The 1997 Asian Crisis; Globalisation has exacerbated the situation. Excessive borrowing; rapid turnaround from capital inflows to outflows, collapse of the currency; internal liquidity crisis as the repayments of debt in terms of the domestic currency rocketed. 4 The Ineffectiveness of Floating Exchange Rates • Once we move from considering the changes in the level of output, to the rate of growth, the role of the balance-of-payments becomes important, even with floating exchange rates. • Changes in the nominal real exchange rate may be short lived because of a rapid-pass through of import prices and “real wage resistance”. • The price elasticities may be low and the Marshall-Lerner conditions barely satisfied – Advanced countries: non-price rather than price competitiveness matters – Developing countries: price elasticities for primary commodities relative low. • With Keynesian import and export demand functions, to increase or decrease the growth of exports and imports requires a continuous real depreciation of the exchange rate. 5 Introduction The cumulative causation model we discussed last time: criticised by Thirlwall himself (Thirlwall, 1979) implicitly assumes (imports) M can grow permanently faster than (exports) X BUT, not true. The implied increasing foreign indebtedness will be ultimately unsustainable…  BoP constrained growth  consider the BoP constrained growth model 6 - The Balance-of-Payments Constraint “At the theoretical level, it can be stated as a fundamental proposition that no country can grow faster than the rate consistent with balance of payments equilibrium on current account unless it can finance ever-growing deficits, which in general it cannot”. (A. P Thirlwall) • As a rule of thumb international financial markets become distinctly nervous if the overseas debt to GDP ratio exceeds around 50%. It does, however, depend on the size and level of development of the country concerned. 7 The Balance-of-Payments Equilibrium Growth Model yP = the growth of productive capacity (maximum growth rate) yB = the balance-of- payments constrained growth rate yA = the actual growth rate yP > yB  yA Balance-of-payments constrained growth (lower rate of capital accumulation, technical progress, disguised unemployment) 8 The Balance-of-Payments Equilibrium Growth Model (1) Export demand equation x = z - (pd - pz - er) The growth of exports (x) is determined by the growth of world income (z) and the rate of change of relative prices (2) Import demand equation m = y +  (pd - pz - er) The growth of imports (m) is determined by the growth of domestic income (y) and the rate of change of relative prices. 9 The Balance-of-Payments Equilibrium Growth Model (3) Balance-of-payments identity x + (1-)f  m + pz – pd – er The (weighted) growth of exports and the (weighted) growth of capital flows must equal the growth of imports plus the rate of change of prices in a common currency. 10 The Balance-of-Payments Equilibrium Growth Model (3) Balance-of-payments identity x + (1-)f  m Suppose relative prices do not change, then if the growth of imports is greater than export growth, there must borrowing from abroad; hence the growth of capital flows into the country. 11 Solution to the model We substitute the three equations into each other and solve for the growth of domestic income. yB  z  ( 1    )( pd  p f  er )  ( 1   ) f  The growth of output y is determined by the growth of world income z (as this determines the growth of exports x), the rate of change of relative prices (relative price competitiveness) and the growth of capital inflows f . 12 Solution to the model y z  ( 1    )( pd  p f  er )  ( 1   ) f  1. The first term is the effect of the exogenous growth of world income. 2. The second teem gives the effect of the changes in relative prices. 3. The third term gives the effect of real capital inflows/outflows. 13 Solution to the model The balance-of-payments equation yB  z  ( 1    )( pd  p f  er )  ( 1   ) f  But changes in relative prices have little effect on growth rates of X and M because of (i) Marshall-Lerner conditions just met or (ii) oligopolistic competition: ( 1    )( pd  p f  er )  0 14 Thirlwall’s Law Also if f = 0 so: yB = z/ = x/ UK  = 0.5  = 1.0 z = 4.0% x =2% yB = 2% JAPAN  = 3.5  = 1.0 z = 4.0% x= 14% yB = 14% If y = yB then we can infer that (i) the growth of capital flows is negligible (ii) price effects are also minimal 15 The Key to Differences in Export Growth The value of ; the world income elasticity of demand for a country’s exports. Differences reflect non-price competitiveness. Why do these values vary between countries' Composition of exports (not the advanced countries) Quality, delivery times, characteristics of the goods. The value of , the domestic income elasticity of imports may vary. High for developing countries. 16 The Weak and Strong Tests of the Law Compare y and yB (1) Weak Test yB = x/  estimated from import demand function (2) Strong Test yB= z/  and  estimated from export and import demand functions 17 The Dynamic Harrod Foreign Trade Multiplier Simplest possible model (With the usual notation.) • Y=C+X • Y= C+M • M= mY For expositional ease, following Harrod, we ignore investment, savings, government expenditure and taxation and relative prices. 18 The Dynamic Harrod Foreign Trade Multiplier If X = M (equilibrium on the current account) Y = X/m Consequently, Y = (1/m)X Y/Y = (1/m)(X/Y)(X/X) But (1/m)(X/Y) = 1/ So Y/Y = (X/X)/ or y = x/ (Thirlwall’s Law) 19 The Hicks Super-multiplier When we introduce other components of domestic demand ( I, G, etc), the effect of an increase is the Hicks super-multiplier which is (i) Harrod trade multiplier plus (ii) the effect of the relaxation of the balance-ofpayments constraint that allows other components of domestic demand to increase. 20 Parametric Tests of the Balance-of-Payments Constrained Growth Model • Regress y on yB Across Countries i.e. y = a + b yB : a = 0; b = 1 But, possibility of bias 1. Incomplete sample 2. Outlying observations • McCombie Test Calculate  () separately for each individual country (y  x/) and compare with estimated  (*). If  not significantly different from *, yB will be a good predictor of y. 21 Calculations of the Growth Rate Consistent with Balance-of-Payments Equilibrium 1951-1973 Country Change in GDP % Change in Exports (x) % 10.7 9.4 Income Elasticity of Demand for Imports () n.a. 1.94 Balance of Payments Equilibrium Growth Rate 4.84 Austria Belgium 5.1 4.4 Canada Denmark France Germany Italy Japan Netherlands Norway United Kingdom U.S.A. 4.6 4.2 5.0 5.7 5.1 9.5 5.0 4.2 2.7 3.7 6.9 6.1 8.1 10.8 11.7 15.4 10.1 7.2 4.1 5.1 1.20 1.31 1.62 1.89 2.25 1.23 1.82 1.40 1.51 1.51 5.75 4.65 5.00 5.71 5.20 12.52 5.55 5.14 2.71 3.38 22 Balance-of-Payments Constrained Growth: An Illustrative Example Initial growth rates yP Group I 5% Group II 5% yB  1.0 2.0  2.0 1.0 m 5% 10% x 10% 5% Balance-of-payments equilibrium growth rate yP Group I 5% Group II 5% yB 5% 2.5%  1.0 2.0  2.0 1.0 m 5% 5% x 5% 5% The countries comprising Group I which is the more competitive trading bloc may be (i) resource constrained (ii) policy constrained. Its growth rate determines the growth of Group II which is balance-of-payments constrained. 23 Comparing African with Asian Countries, (in percentage points) Country Actual Rate of Growth Terms of Trade Effect Export Volume Effect Real Capital Flows Effect Growth Rate Given by the Extended Model African Countries Algeria Benin Burkina Faso Burundi Cameroon Congo Cote d’Ivoire Egypt Ethiopia 4.90 2.90 4.20 5.60 5.50 6.59 4.50 6.90 2.20 10.15 1.44 -5.17 1.69 -1.12 0.42 0.39 -2.37 -0.09 4.21 0.96 3.03 3.21 7.08 3.88 4.23 4.36 0.74 -8.72 1.35 5.63 -1.26 0.00 2.38 0.81 7.31 2.53 5.64 3.75 3.50 3.65 5.97 6.67 5.43 9.30 3.17 Gabon Ghana Kenya Lesotho Madagascar 5.10 1.40 6.24 4.40 0.48 0.49 -3.81 -0.50 -3.43 -0.10 6.81 0.15 1.62 6.62 0.06 -0.04 2.88 5.59 1.55 0.95 7.33 -0.79 6.71 4.74 0.91 Mauritania Mauritius 2.30 5.80 0.68 0.92 1.58 5.13 0.42 0.19 2.69 6.23 24 Country Actual Rate of Growth 4.62 0.81 2.50 2.67 1.58 3.40 2.42 3.10 2.90 2.90 5.69 1.40 3.23 Terms of Trade Effect Export Volume Effect 2.83 1.79 1.28 1.56 -0.67 0.18 1.32 1.13 -0.55 2.31 5.24 -1.29 2.23 Real Capital Flows Effect Growth Rate Given by the Extended Model 4.96 0.20 2.48 2.83 1.75 4.07 8.03 3.20 4.79 3.00 7.59 -1.02 -1.41 25 Morocco Niger Nigeria Senegal Sierra Leone Somalia South Africa Sudan Tanzania Togo Tunisia Zambia Zimbabwe -1.34 -5.07 2.37 0.23 -0.23 -1.10 -1.03 0.14 0.33 0.08 0.87 -0.31 -2.40 3.47 3.47 -1.17 1.05 2.65 5.00 7.74 1.92 5.01 0.61 1.48 0.58 -1.24 Country Actual Rate of Growth Terms of Trade Effect Exports Volume Effect Real Capital Flows Effect Growth Rate Given by the Extended Model Asian Countries China 8.20 -0.02 6.43 0.26 6.67 Hong Kong India Indonesia Japan Korea Rep. of Malaysia Pakistan Philippines Sri Lanka Thailand AVERAGE FOR AFRICAN COUNTRIES AVERAGE FOR ASIAN COUNTRIES 9.07 4.31 10.76 4.20 9.11 7.08 5.04 3.70 4.30 6.80 -0.07 -0.85 1.82 -1.42 -0.81 -0.69 -0.44 0.22 -0.65 0.96 8.34 3.16 3.18 9.73 13.47 6.60 4.28 2.00 2.33 5.45 1.01 1.96 5.76 -4.63 -2.49 2.21 4.40 0.26 3.00 2.61 9.28 4.27 7.58 3.68 10.17 8.12 8.24 2.48 4.68 9.02 3.66 -0.27 2.45 1.80 3.98 26 6.60 -0.18 5.91 1.31 6.74 Estimates of Balance-of-Payments Constrained Growth for Asian and Latin American Countries Country GDP growth (y) Export growth (x) Income Elasticity of Demand for Imports () Balance of Payments Constrained Growth Rate (yB) Asian countries a Indonesia Malaysia Philippines Thailand 6.90 7.40 3.70 7.60 16.3 14.5 9.9 13.0 2.98 2.25 1.92 2.86 5.47 6.44 5.16 4.55 Latin American Countries b Costa Rica El Salvador Guatemala Honduras Nicaragua 4.7 3.4 3.8 3.8 2.6 5.8 3.3 4.4 2.7 3.4 1.10 1.75 1.35 3.70 2.04 5.26 1.88 3.34 0.73 2.10 27 An Example: Is Pakistan’s Growth Rate Balanceof-Payments Constrained' • Pakistan’s growth rate was about 6% in the 1960s. In the 1970s and 1980s it became a rapidly industrialising country but never at the rate of growth of the Asian Tigers or China. • Poverty reduction plan 7 to 7.5% growth per annum • But problem of recurrent balance-of-payments crises. • Latest was 2007-2008. Had to go to the IMF for a loan of $11.3 billion. • As Felipe and Lim (2008, p.8) put it: “in the case of Pakistan, the current deficit reflects low export growth… and, ultimately export competitiveness problems.” 28 Pakistan Economic Survey (2007-08, p. xvi-xvii) Pakistan’s exports suffer from serious structural issues which need to be addressed primarily by the industry itself, with government playing its role of a facilitator. Textile is the backbone of Pakistan’s exports but bears various tribulations. These include: (i) low value added and poor quality products fetching low international prices; (ii) the machinery installed in recent years has depreciated considerably relative to Pakistan’s competitors; (iii) these machines are power-intensive, less productive, and carry high maintenance cost; (iv) augmented wastage of inputs adding to the cost of production; (v) little or no efforts on the part of industry to improve their workers’ skills; (vi) industry spending less money on research and development and; (vii) export houses lacking capacity to meet bulk orders as well as meeting requirements of consumers in terms of fashion, design and delivery schedule. 29 The Balance-of-Payments Equilibrium Growth Rate: Growth Rates and Parameter Values. Pakistan 1980-2007 ____________________________________________________________________ Variable Value ____________________________________________________________________ y , growth of GDP 5.31% p.a. 3.00% p.a. 6.45 % p.a. 5.79 % p.a. -2.15 % p.a. -2.48% p.a 0.92 -0.23 1.51 -0.34 0.665 0.335 z, weighted growth of trading partners x, growth of exports r-px, growth of real remittances pX – pM, growth of terms of trade reer, rate of change of real effective exchange rate import income elasticity , import price elasticity , , export income elasticity , export price elasticity  average export share in foreign currency receipts X ,  R , average remittance share in foreign currency receipts The balance-of-payments equilibrium growth rates: Eq. (i) yBP     X x  ( reer )   R ( r  p X )  ( p X  p M )  5.05 (5.78) % p.a. Eq.(ii)* yBP      X z  (    X )( reer )   R ( r  p X )  ( p X  p M )  4.06 (5.07) % p.a. _____________________________________________________________________ Notes: * See section 4.3. Figures in parentheses are the balance of payments equilibrium growth rate when  and  are each constrained to take the value of -0.5 Sources: IMF International Financial Statistics database, Pakistan Federal Bureau of Statistics, ADB sources. 30 Contribution of the Components of the Ex Post Balance-of-Payments Growth Rate to the Actual Growth Rate: Pakistan, 1980-2007 (A) Component Weak Test Exports,  X x ,  (B) Strong Test 58% (3.06 pp) 40% (2.11 pp) 23% (1.23 pp) -0.44% (-2.34 pp) 24% (1.25 pp) 100% (5.30)   X z   R ( r  pX )  88% (4.66 pp) 40% (2.11 pp) 12% (0.62 pp) -44% (-2.34 pp) 5% (0.26 pp) 100% (5.30) Unrequited remittances, Real effective exchange rate, Terms of trade, Financial flows, Total Notes:  ( reer ) (   X  )( reer ) ,   ( p X  pM )   F ( f  pX )  The figures in parentheses are the contributions expressed as a percentage point growth rate (pp). Columns may not sum to the value of the totals because of rounding errors. 31 Policy Implications • Supply characteristics are important. Improve  • It is no use if Pakistan is able to manufacture, say, cheap brass automobile radiators when technology has moved on so that the leading world automobile manufacturers are now using aluminium radiators. (The exception is that Pakistan can sell these radiators in its small protected domestic market.) • Hausmann and Rodrik’s method for calculating the sophistication of exports. • Take an export category; calculate each country’s productivity and produce an index using the weighted country figures. Then see the percentage of exports that a country has in this export category. The initial level of this variable is a very good predictor of a country’s subsequent growth rate. 32 33 Policy Implications • Tariff protection to reduce , but needs a sunset clause. • Subsidies for exports, but again a sunset clause. 34 Extending the Theoretical Model for an Individual Country 35 The Country Growth Equation The equation yB = z/ is an equilibrium locus. We need to introduce another element into the model. From the traditional Keynesian income expenditure model we have (ignoring the balance of payments): Income = (1/k)(Exports + Other Autonomous Expenditure) Y = (1/k)(X + A) where 1/k is the traditional Keynesian multiplier. But exports are a function of world income so X = f(Z). 36 Thus, in terms of growth rates we have the growth of output: y = f(autonomous expenditure growth) + g1(export growth) y = f(autonomous expenditure growth) + g2(world income growth or the growth of the other trading bloc). In other words, the growth of income will increase if export growth, investment growth or the growth of government expenditures increase. 37 y = f(autonomous expenditure growth) + g2(world income growth or the growth of the other trading bloc). We shall term this the country growth equation. It is shown in Figure 1 as the dotted line AA together with yB. 38 Figure 1 Balance-of-Payments Equilibrium Growth y yB  A  Z  2% A 0.5 4% 39 Z The working of the model So let us suppose that the country is growing below its potential and the government decides to increase the growth of its expenditures through deficit financing. This shifts the line AA upwards. But this is unsustainable as it needs the rate of growth of output given by f to be covered by the growth of financial inflows. 40 Figure 2 An Increase in the Growth of Autonomous Expenditure y A1 f A1 Ao  yB   z  Ao 4% 41 Z Increase in non-price competitiveness We can see how an increase in non-price competitiveness will allow the country to increase its rate of growth without encountering the balance-of-payments constraint. 42 Figure 3 An Increase in Non-price Competitiveness yB  1 z 1 A1 y yB  0 z 0 A1 A0 A0 4% 43 Z A World Recession We can see how if a major country reduces its growth for policy reasons (e.g. to combat inflation), it will induce a slower rate of growth of the other countries because of the balance-ofpayments constraint. 44 Figure 4 The Effect of a World Recession y yB   z  2% b f’ a 1% 45 2% 4% Z Lifting the Balance-of-Payments Constraint: Policy Implications 1. 2. Currency Devaluation More Capital Inflows 3. 4. Import Restrictions Structural Change The Balance of Payments Does Not Look After Itself! 46